Sii

International Certificate in Investment Management The Official Learning and Reference Manual

1st Edition, July 2007 This Workbook relates to syllabus version 1.0 and will cover examinations from 17th September 2007 to 30th April 2009.

PROFESSIONALISM

INTEGRITY

EXCELLENCE

INTERNATIONAL CERTIFICATE

IN

INVESTMENT MANAGEMENT

Welcome to the International Certificate in Investment Management study material for the Securities & Investment Institute’s Certificate Programme. This manual has been written to prepare you for the Securities & Investment Institute’s International Certificate in Investment Management examination.

PUBLISHED BY: Securities & Investment Institute © Securities & Investment Institute 2007 8 Eastcheap London EC3M 1AE Tel: 020 7645 0600 Fax: 020 7645 0601

This is an educational manual only and the Securities & Investment Institute accepts no responsibility for persons undertaking trading or investments in whatever form. While every effort has been made to ensure its accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the publisher or authors. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the copyright owner. Warning: Any unauthorised act in relation to all or any part of the material in this publication may result in both a civil claim for damages and criminal prosecution. A Learning Map, which contains the full syllabus, appears at the end of this workbook. The syllabus can also be viewed on the Institute’s website at www.sii.org.uk and is also available by contacting Client Services on 020 7645 0680. Please note that the examination is based upon the syllabus. Candidates are reminded to check the ‘Examination Content Update’ (ECU) area of the Institute's website (www.sii.org.uk) on a regular basis for updates that could affect their examination as a result of industry change. 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. They should not be seen as a 'mock' examination or necessarily indicative of the level of the questions in the corresponding examination.

Workbook version: 1.3 (August 2008)

FOREWORD Learning and Professional Development with the SII The SII is the leading professional body for the securities and investment industry in the UK. 40,000 of its examinations are taken each year in the UK and around the world. This learning manual (or ‘workbook’ as it is often known in the industry) provides not only a thorough preparation for the appropriate SII examination, but is a valuable desktop reference for practitioners. It can also be used as a learning tool for readers interested in knowing more, but not necessarily entering an examination. The SII official learning manuals ensure that candidates gain a comprehensive understanding of examination content. Our material is written and updated by industry specialists and reviewed by experienced, senior figures in the financial services industry. Exam and manual quality is assured through a rigorous editorial system of practitioner panels and boards. SII examinations are used extensively by firms to meet the requirements of the UK regulator, the FSA. The SII also works closely with a number of international regulators which recognise our examinations and the manuals supporting them. SII learning manuals are normally revised annually. It is important that candidates check they purchase the correct version for the period when they wish to take their examination. Between versions, candidates should keep abreast of the latest industry developments through the Content Update area of the SII website. SII is also pleased to endorse the workbooks published by 7City Learning and BPP for candidates preparing for SII examinations. The SII produces a range of elearning revision tools such as Revision Express, Regulatory Refresher and eIAQ that can be used in conjunction with our learning and reference manuals. For further details, please visit www.sii.org.uk As a Professional Body, 35,000 SII members subscribe to the SII Code of Conduct and the SII has a significant voice in the industry, standing for professionalism, excellence and the promotion of trust and integrity. Continuing professional development (CPD) is at the heart of the Institute's values. Our CPD scheme is available free of charge to members, and this includes an on-line record keeping system as well as regular seminars, conferences and professional networks in specialist subject areas, all of which cover a range of current industry topics. Reading this manual and taking an SII examination is credited as professional development within the SIICPD scheme. To learn more about SII membership visit our website at www.sii.org.uk We hope that you will find this manual useful and interesting. Once you have completed it you will find helpful suggestions on qualifications and membership progression with the SII.

Ruth Martin Managing Director

CONTENTS

Chapter 1:

Economics

1

Chapter 2:

Financial Mathematics and Statistics

49

Chapter 3:

Industry Regulation

87

Chapter 4:

Asset Classes

95

Chapter 5:

Financial Markets

181

Chapter 6:

Accounting

205

Chapter 7:

Investment Analysis

237

Chapter 8:

Taxation

263

Chapter 9:

Portfolio Management

269

Chapter 10:

Performance Measurement

313

Appendix

333

Glossary

337

It is estimated that this workbook will require approximately 100 hours of study time.

ECONOMICS

1. 2.

1

MICROECONOMIC THEORY MACROECONOMIC ANALYSIS

3 19

This syllabus area will provide approximately 8 of the 100 examination questions

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1. MICROECONOMIC THEORY 1.1

Introduction

The study of economics can be divided into two broad categories: microeconomics and macroeconomics. Microeconomics, as its name suggests, is the smaller picture view of the economy: that is, the study of the decisions made by individuals and firms in a particular market. Macroeconomics, however, takes the bigger picture view by seeking to explain how, by aggregating the resulting impact of these decisions on individual markets, variables such as national income, employment and inflation are determined. We look at microeconomics first and macroeconomics in Section 2 of this chapter. In both cases, we mainly take an intuitive rather than a mathematical or algebraic approach to the subject. That is to say, we concentrate on the more practical aspects of economics and those that relate most directly to the role of the portfolio manager, without delving too deeply into the rigor underpinning many microeconomic and macroeconomic models. We also apply the other things being equal caveat throughout the chapter. Therefore, when considering the impact of a change in one factor or variable on another variable, market or the economy as a whole, we assume all other variables remain constant, so that the effect of the change can be isolated.

1.2 The Determination of Price and Output LEARNING OBJECTIVES 1.1.1

Understand how price is determined and the interaction of supply and demand

Price and output in the free market are determined by the interaction of demand and supply. That is, the demand for goods and services from individuals, or consumers, and the supply of production from firms. In effect, an auction process takes place in each market as profit-seeking firms strive to satisfy customers' needs and desires, each buyer and seller being guided by their own self-interest. This process was described by Adam Smith, the founding father of modern economics, as the workings of the invisible hand.

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Price

P1

P2

Demand Curve O

Q1

Q2

Quantity

Figure 1: The Demand Curve The demand curve represents the quantity of a particular good consumers will buy at a given price. Although termed a curve, it is usually depicted as a negatively sloped straight line; the negative slope representing the inverse linear relationship between the price of a good and the quantity demanded. This inverse relationship is shown in the above diagram. A change in the price of a good then, generates movement along the demand curve. However, a change in anything other than a change in the price of this particular good could be met by a parallel shift in the demand curve either to the right or to the left. That is, a greater or lesser quantity of the good will be demanded at each price level, respectively. Price Decrease Increase in in Demand Demand

P1

O

Q0

Q1

Q2

Quantity

Figure 2: Shifts in the Demand Curve

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Such parallel shifts can result from: 1. The price of other goods changing. The direction of the shift depends on whether these other goods are: i. substitutes - products that may be purchased instead of the good in question, such as coffee instead of tea; or ii. complements - products that are typically purchased in conjunction with this particular product - coffee and coffee-complement, for example. If the price of tea rises, then the demand for coffee will increase at each price level, leading to the coffee demand curve shifting to the right, such that quantity Q2 will be demanded at price P1. Conversely, if the price of coffee-complement increases, so the demand for coffee will fall, resulting in the demand curve shifting to the left; Q0 being demanded at P1. 2. Growth in consumers’ income. A rise in income should result in increased demand for the good at each price level, ie, the demand curve shifting to the right, assuming the good is a normal good. This is true of all luxury goods and some day-to-day necessities. However, if the good is an inferior good, then the demand curve will shift to left in response to consumers moving away from this product to another more desirable, or more innovative, product. 3. Changing consumer tastes. This can also result in the demand curve shifting to either the left or right depending on whether or not the product is currently fashionable. Price

Supply curve

P1

P2

Q2

Q1

Quantity

Figure 3: The Supply Curve The supply curve depicts the amount of a particular good firms are prepared to supply at a given price. Movement along the supply curve results in a greater quantity being supplied the higher the price. However, once again, a change in anything other than a change in the price of the good could result in the supply curve shifting to either the left or right.

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Price S1

S0 Decrease in supply

S2

Increase in supply

P1

Q0

Q1

Q2

Quantity

Figure 4: Shifts in the Supply Curve For instance, an increase in the cost of production resulting from rising resource prices will see the supply curve shift to the left. Conversely, a more efficient production process resulting from utilising new production technology or increased competition from new firms entering the industry will shift the curve to the right.

Price S1

P2

}

Excess supply

P1

D1

Q1

Q2

Quantity

Figure 5: Equilibrium

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The interaction of demand and supply will determine the quantity of the good and the price at which it is to be supplied. This result is known as reaching a state of equilibrium. At this point demand and supply are equal, with output Q1 being produced at price P1. P1 is known as the market clearing price. If, for example, output Q2 had been produced rather than Q1, insufficient demand for these goods at price P2 would have resulted in the building up of surplus stocks. Production would have contracted until the price of these unsold stocks had been forced down to the market clearing price of P1. Whether the goods in question are doughnuts or derivatives, the price mechanism always brings supply and demand back into equilibrium when a market is allowed to operate freely. This is known as Says Law: supply creates its own demand. You need look no further than your local fruit and vegetable market to see the free market at its most efficient, with transparent pricing equating supply and demand.

1.3

Elasticities of Demand

LEARNING OBJECTIVES 1.1.2

Be able to calculate elasticities of demand

Elasticity measures the sensitivity of the quantity of output demanded to changes in: 1. the price of the good; 2. the prices of substitutes and complements; and 3. consumers’ income.

Price Elasticity of Demand (PED) The price elasticity of demand (PED) quantifies the extent to which the demand for a particular good changes in proportion to small changes in its price. By knowing the PED of a product, firms are able to calculate the impact a small price rise or price reduction will have on the total revenue generated by the product. Total revenue is simply calculated by multiplying the quantity of the product demanded by its price per unit. Formally put, the PED = percentage change in quantity small percentage change in price So, for example, if a gadget is priced at £2, 1,000 units are sold. If, however, the price is reduced to £1.90 per unit, 1,200 units would be sold. A 5% reduction in price, therefore, results in a 20% increase in the volume of sales, thereby increasing total sales revenue from £2,000 (1,000 units x £2) to £2,280 (1,200 units x £1.90). The PED of a gadget, therefore = + 20% = -4 -5%

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The PED of -4 tells us that for a 5% reduction in price, the quantity demanded will increase at four times the rate. The reason for the PED having a negative value is that, as we have seen, when price falls so the quantity of a normal good demanded rises and visa versa. Where a percentage change in price per unit results in a proportionately greater quantity demanded and, therefore, an increase in total revenue, then demand for the good is said to be elastic. When the opposite is true, demand is inelastic. So, ignoring the minus sign, demand is elastic when the PED is greater than one but less than infinity and inelastic when less than one.

Price

infinite elasticity = -α elastic demand > -1

}

-

unit elasticity = -1 inelastic demand < -1

+ -

}

zero elasticity = 0

+ 0

Quantity -

revenue lost from price reduction

+

revenue gained from price reduction

Figure 6: Price Elasticity of Demand (PED) As the diagram above illustrates, linear demand curves are rarely elastic or inelastic along their entire length as the PED falls as you move down the curve. At the two extremes of the linear demand curve, however, you have the point of infinite elasticity where there is no demand for the good and that of zero elasticity where a fixed quantity of the good is demanded with the price set at zero. An infinitely elastic demand curve is perfectly elastic, or horizontal, along its entire length whilst a demand curve with zero elasticity is perfectly inelastic, or vertical. The above diagram also shows the point of unit elasticity, where the PED is equal to -1. As you move down the elastic section of the demand curve towards this point, successive price decreases result in diminishing though still proportionately greater - quantity increases. This has the effect of slowing the rate at which total revenue increases. Total revenue is maximised at the point of unit elasticity. Beyond this point, however, total revenue decreases as on the inelastic part of the demand curve successive price cuts result in proportionately and successively smaller quantity increases. The total revenue pattern for a linear demand curve is shown below.

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Total Revenue Unit elasticity Elastic demand

0 Example of total revenue pattern

Inelastic demand

Q1

Quantity

0 50 100 180 280 360 400 360 280 180 100 50 0 Rate of total revenue increase diminishing

Total revenue maximised

Rate of total revenue decrease accelerating

Figure 7: Price Elasticity of Demand and Total Revenue We will come back to this point shortly when looking at profit maximisation. Knowing the PED for a good or service is particularly useful when a firm wishes to employ discriminatory or differential pricing by segmenting the market for its product and charging each market segment a different price. Rail companies, for instance, meet inelastic demand for peak services with higher prices than for elastic off-peak travel. Larger multi-branded motor vehicle manufacturers also operate discriminatory pricing through their various marques. There are numerous factors that determine the PED for a good. These include: i. Substitutes. In the short run, consumers may find it difficult to adjust their behaviour or spending patterns in response to a price rise unless there is a viable alternative. A rise in the cost of peak time train travel faced by city commuters illustrates this. However, if over time substitutes become available, the demand for this good or service becomes increasingly price elastic. The availability of choice alters spending patterns. ii. The percentage of an individual’s total income, or budget, devoted to the good. Goods that account for a small percentage of one’s income are usually price inelastic. iii. Habit forming goods. Goods that can become addictive, such as tobacco, are also price inelastic.

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Cross Elasticities of Demand (XED) As already mentioned, a change in the price of substitutes and complements for a good impact on the quantity demanded and influence its PED. These so-called cross elasticities of demand (XED) are positive for substitutes and negative for complements. So if the price of coffee rises, so the demand for its substitute, tea, increases, resulting in a parallel shift to the right in the tea demand curve. The XED =

percentage change in quantity small percentage change in the price of a complement or substitute

Income Elasticity of Demand (YED) The income elasticity of demand (YED) for a good is the percentage change in the quantity demanded given a small change in income. The YED =

percentage change in quantity small percentage change in income

As noted earlier, rising income results in increased demand for normal goods. Therefore, all normal goods have a positive YED. This is represented by a parallel shift to the right in the demand curve. You may recall that normal goods include luxuries and some necessities. By definition, luxury goods have a YED of greater than one, in that as consumers’ income increases so the proportion of total income spent on luxury items increases at a greater rate. The necessities of life, however, have a YED of one or less. Some necessities have positive values, others negative. Those with negative values are inferior goods. That is, goods that account for a smaller percentage of an individual’s budget as their income rises. Product innovation often distinguishes a normal good from an inferior good. For instance, rising income levels has seen a shift away from commoditised portable CD players - once a luxury item - to technologically superior ipods. Again, knowing the YED for a particular good or service helps firms plan for future production and assists government in deciding how to raise revenue from applying indirect, or expenditure, taxes, such as VAT, given forecasts of income growth.

1.4

The Theory of the Firm

LEARNING OBJECTIVES 1.1.3

Understand the theory of the firm (see the syllabus learning map at the back of this book for the full version of this learning objective)

In economics, a simplifying assumption is made that firms seek to maximise profits. Although firms have other objectives, which we explore throughout this text, we will stay with this assumption for the purpose of the foregoing analysis. Firms maximise profit by equating marginal revenue (MR) to marginal cost (MC). That is, a firm will manufacture units of a product until the extra, or marginal, revenue generated by the sale of one additional unit equals the cost of producing this one additional unit.

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So, profits are maximised where: MR = MC

£

unit price elasticity of demand

reducing price for all output

Average revenue (AR)

Quantity

Marginal revenue (MR)

Figure 8: Total Average and Marginal Revenue Looking at the revenue side of the equation first, we know that the more units of a product we buy from a firm, the lower the average price per unit we expect to pay. That is, the price per unit of all output falls as the quantity demanded increases. This is depicted by the average revenue (AR) curve, which is also the demand curve for the product. The progressively smaller additional amount of revenue received from the sale of each additional unit of product as we move down the AR curve is illustrated by the MR curve. You will notice that the slope of the MR curve is steeper than that of the AR curve given this progressively smaller contribution made to total revenue as the sale of units increases. MR will always be lower than AR. For example, if one gadget can be sold for £10, the total revenue, average revenue and marginal revenue from selling this one unit is £10. However, in order to sell a second unit, the price, or average revenue, must be reduced to, say, £9 per gadget. Since the total revenue has increased from £10 to £18, the marginal revenue from this sale is £8. If the sale of a third gadget requires the price to be reduced to £8 per unit, ie, average revenue falls to £8 per unit, marginal revenue falls to £6. At the point where the MR curve cuts the horizontal axis, any additional sales will detract from the firm’s total revenue. By producing and selling quantity Q1, the firm maximises its revenue. You may recall that at this point on the demand, or AR, curve there is unit price elasticity of demand for the product. Below this point, the demand curve is inelastic, so any further fall in price resulting from increasing sales of the product will reduce total revenue.

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Cost

Short run marginal cost (SRMC)

increasing returns to labour

C decreasing returns to labour Short run average total cost (SRATC)

B Short run average variable cost (SRAVC)

A

O

QO

Quantity

Figure 9: Short Run Average and Marginal Costs Moving now to the cost side of the equation. In economics, the treatment of costs is unique in three respects. Firstly, costs are defined not as financial but as opportunity costs; that is, the cost of foregoing the next best alternative course of action. Secondly, cost includes what is termed normal profit, or the required rate of return for the firm to remain in business. Finally, economics distinguishes between the short run and the long run when analysing the behaviour of costs. In the short run, it is assumed that the stock of capital equipment available to each firm and its efficiency in the production process is fixed. This gives rise to what is known as a fixed cost; fixed because the cost will be incurred regardless of production. The only resources available in varying quantities to the firm in the short run are labour and raw materials. Both, therefore, are variable costs. In the short run, the SRATC faced by the firm in its production is given by the sum of this fixed and variable cost divided by the number of units produced. The SRMC curve depicts the cost to the firm of increasing its production by one additional unit of output. Therefore, in the same way that MR is the increase in total revenue resulting from the sale of one additional gadget, so SRMC is the increase in total cost resulting from the production of this additional unit. As the amount of labour employed in the production process increases so the SRATC of producing additional units falls, as a direct result of the fixed cost being spread over a greater number of units and increasing returns to labour, or rising productivity. At output Q0, the optimal level of production, SRATC is minimised. This is shown as point B. At this point, the SRMC curve cuts the SRATC curve, as marginal cost and average total cost are now the same. However, beyond this level of output, the marginal cost of producing one additional unit is greater than the average total cost of producing Q0 plus this one additional unit, as shown by the SRMC curve rising above the SRATC curve. This causes the SRATC curve to rise. The reason for this is that diminishing returns to labour begin to set in as the increased use of labour becomes less productive given that the firm’s productive capacity is constrained by a fixed amount of capital equipment. Progressively, this effect begins to far outweigh that of spreading the fixed cost across a greater amount of production, resulting in the slope of the rising SRATC curve becoming steeper.

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Finally, in the short run, each firm only needs to cover its variable costs of production with the revenue generated by product sales when deciding whether or not to produce units, as the fixed costs will be incurred regardless of any production decision. In this context, fixed costs are known as sunk costs. Many large scale vehicle manufacturers are currently only covering their variable costs. Any revenue generated over and above this level will, however, contribute towards meeting these fixed costs. Given this, the firm’s supply curve is depicted as being between points A and C on the SRMC curve. Revenue, cost

SRMC C

B

A

0

Qoptimal

Quantity MR

Figure 10: The Optimal Level of Output As you may recall, a firm’s profits are maximised at that level of output where MR = MC. If, for example, the MR from selling another gadget is £5 whereas the MC associated with producing this extra unit is only £4, then the gadget should be produced and sold. Conversely, if the MR was £4 and the associated MC, £5, then it would not be in the firm’s interest to produce another gadget. However, although in the short run the optimal level of output (Qoptimal) for a firm is given where the MR and SRMC curves intersect, the firm will only make a profit at this level of output if its fixed costs are being covered. If the firm is not covering all of its fixed costs at Qoptimal, it will continue to produce gadgets in the short run so long as its can meet its variable costs at this level of production. In the long run all factors of production, or inputs to the production process, are variable. The long run average total cost (LRATC) curve shows the minimum average cost way to produce different levels of output given this flexibility. In effect, however, the long run is an amalgam of a series of short runs, though without the capital constraints. This has the result that each point on the LRATC curve will not necessarily correspond with the lowest point on each of the SRATC curves, where the stock of capital equipment is fixed. What differentiates the short run from the long run then is the length of time necessary for adjustments to be made to each and every one of the factors of production used in the production process. The question of how long is the long run remains, however. The economist John Maynard Keynes once famously remarked that in the long run we are all dead!

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In the long run, the production process benefits from economies of scale as the firm’s productive capacity increases. Note that the term economies of scale rather than simply increasing returns to labour is used here, given the flexibility with which all factors of production can be employed. Production costs are minimised on the LRATC curve at Q2, known as the minimum efficient scale (MES). Beyond this point diseconomies of scale set in as management bureaucracy negatively impacts the production process. Cost

SRATC1

Diseconomies of scale SRATC2 SRATC3

Long run average total cost (LRATC)

Economies of scale Minimum efficient scale (MES) O

Q2

Quantity

Figure 11: Long Run Average Total Cost (LRATC) Finally, in the long run, unlike in the short run, all costs of production must be covered when making the decision to produce output. Remember, so long as the revenue generated by product sales are covering all costs, then the firm will be making a normal profit.

1.5

Industrial Structure

s to rier r a B

xit de n a ry ent

PERFECT COMPETITION

MONOPOLISTIC COMPETITION

Ability to influence price

OLIGOPOLY MONOPOLY

Number of firms in industry

Figure 12: Industrial structure

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The above diagram provides a simplified representation of different market structures. Although it does not necessarily follow that in all industries the greater the number of firms, the more competitive the industry, for the purposes of simplifying the analysis of firms’ production decisions based on profit maximisation, it is a useful assumption to make. At one extreme of the industrial structure spectrum lies the monopolist, the single supplier to an entire industry in the enviable position of being able to set the market price and generate supernormal profits. At the other extreme lies the perfectly competitive firm that operates within an industry containing an infinite number of firms, each of which accepts the market price for a homogeneous product set by the interaction of consumer demand for the industry’s total supply. In the long run, perfectly competitive firms only generate normal profits. Positioned between these two extreme industrial structures are two models of imperfect competition that represent the majority of real world markets: oligopoly and monopolistic competition. An oligopoly exists where a limited number of highly interdependent firms dominate an industry, typically through either implicit or explicit collusion on price and output, whereas monopolistic competition is found in an industry characterised by a large number of firms each of which produces a product that, although not homogeneous in that each is subtly differentiated, is a close substitute for others produced within the industry. Oligopolistic and monopolistically competitive firms, having some influence on their own output and pricing decisions, generate profits somewhere between the normal and supernormal levels mainly through subtle product differentiation, defensive advertising to increase brand loyalty and so reduce the elasticity of demand for their product and through limited price competition. £

LRATC2

LRATC3

LRATC1 Demand curve Quantity

Figure 13: Minimum Efficient Scale (MES) There are a number of factors that determine industrial structure, the most important of which is the size of each firm’s minimum efficient scale (MES) relative to the output of the industry in which it operates. MES is, in turn, determined by the size and profile of the LRATC curve faced by firms in the industry relative to the size of the market and so dictates how many firms each industry can profitably support. This is shown in the diagram above. A perfectly competitive industry, for instance, would be characterised by a large number of firms each with a MES representing a minute fraction of the industry’s total output. This is shown by LRATC1. International Certificate in Investment Management

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However, a so-called natural monopoly - one that benefits from significant economies of scale would have an enormous MES relative to the size of the market, as depicted by LRATC3. In this case, the industry can only support a single firm profitably. Where firms in an industry face a LRATC curve given by LRATC2, as no one firm can profitably supply the entire industry, an oligopoly would form. However, as many industries are populated with firms of varying sizes and cost bases and not all firms operate at the lowest point of their LRATC curve, economists also use the 3-firm concentration ratio to determine the structure of an industry. This they do by calculating the percentage of industry output produced by the industry’s three largest firms. Whereas an oligopoly will have a high concentration ratio, a perfectly competitive industry will have a particularly low concentration ratio.

1.6

Perfect Competition

LEARNING OBJECTIVES 1.1.4

Understand firm and industry behaviour under perfect competition

£

Ps Pp

Marginal cost (MC)

Average total cost (ATC) SUPERNORMAL PROFITS

AR = MR

Average variable cost (AVC)

Qp Qs

Quantity

Figure 14: A Perfectly Competitive Firm Perfect competition is a theoretical representation of how a perfectly free market would operate where no one buyer or seller is able to influence the price of a single homogeneous product. Although impossible to fully replicate in practice, the market for grain comes close to meeting the assumed characteristics of a perfectly competitive industry, as the actions of an individual grain farmer or a grain merchant are unlikely to influence the market price of grain. Both, therefore, are described as being price takers. The characteristics of a perfectly competitive industry are as follows: i. no one firm dominates the industry which contains an infinite number of firms; ii. firms do not face any barriers to entry or exit from the industry;

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iii. a single homogeneous product is produced by all firms in the industry; iv. there is a single market price at which all output produced by any one firm can be sold; v. there are an infinite number of consumers who all face the same market price; and vi. perfect information about the product, its price and each firm's output is freely available to all. Given these assumptions, each firm in a perfectly competitive industry faces a horizontal, or perfectly elastic, demand curve where average revenue (AR) is the same as the marginal revenue (MR). Remember, a single price PP has been set by the interaction of industry supply and consumer demand in the marketplace. Given that each firm’s output represents a minute fraction of total industry output, their individual output decisions will not affect the industry price, so each firm can sell as much or as little of their output as they wish at this price. To maximise profits, however, they will set output at QP where MR = MC. At this point they are covering all of their costs and generating normal profit. They are, therefore, in a state of equilibrium. If, however, this single industry price rises, because of a reduction in industry supply for whatever reason, to Ps, each firm would then produce quantity QS, generating supernormal profits in the process. These supernormal profits are simply the revenue generated in excess of average total costs at QS. However, this state of disequilibrium would not last for long, as other firms learning of these supernormal profits, given freely available information, would be attracted to the market in search of these excess returns. Inevitably, the resulting increase in supply would shift the industry supply curve to the right, eventually driving the price back down to PP, eliminating the supernormal profits in the process. Equilibrium will be restored once each firm is again producing at the point where MR = MC.

1.7

Monopoly and Oligopoly

LEARNING OBJECTIVES 1.1.5

Understand firm and industry behaviour under monopoly and oligoploy

£ CONSUMER SURPLUS

DEADWEIGHT LOSS

Marginal cost (MC)

Pm Average total cost (ATC)

SUPERNORMAL PROFITS

PP Average revenue (AR)

Qm

QP

Quantity

Marginal revenue (MR)

Figure 15: Monopoly International Certificate in Investment Management

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The monopolist being an industry’s sole supplier, unlike a perfectly competitive firm, is able to set rather than accept the market price for its output. Facing a demand curve represented by the average revenue (AR) it receives for selling successive amounts of output, the monopolist, like any other profit-maximising firm, sets its output where MR = MC. However, at output QM and price PM, the monopolist not only maximises its profits but also generates sustainable supernormal profits. You will also notice that the monopolist only operates at a single point on the elastic part of the demand curve and does not have a supply curve. Moreover, the only time a monopolist would change its output decision and move along the elastic part of the demand curve would be in response to a shift in its MC curve. A shift to the right may be as a result of falling labour costs, for instance. The socially desirable or optimum level of output QP, where a perfectly competitive firm would produce if faced with this demand curve and the same cost structure, would never be chosen by the monopolist as only normal profits would be generated at this point. Given the monopolist’s ability to set price solely on the elastic part of the demand curve, it is in an ideal position to engage in price discrimination and in same instances, perfect price discrimination; that is, charge each and every customer a different price for its output so as to eliminate what is known as consumer surplus. Consumer surplus arises where a firm, by setting a single price for its output, forgoes the additional revenue that could have been generated by segmenting the market for its product and charging each segment a different price. Monopolies are usually the result of industries that require large scale capital investment to fully exploit the enormous economies of scale on offer. These natural monopolies mainly comprise utility companies that substantially invest in the nation's infrastructure. Some firms, however, gain monopoly status through being the original innovator in what proves to be a growth industry - a phenomenon known as first mover advantage - and retain this status by patenting the product or by creating other barriers to entry. Some may prevent new firms from entering the industry by engaging in anti-competitive behaviour such as creating products that can only be used in conjunction with others that only they produce, or spending large sums on advertising to raise the fixed costs of entering the industry. Recognising the deadweight loss, or inefficient allocation of resources, that monopolies create by restricting output and raising price above marginal cost, the price and output decisions of most natural monopolies are now regulated or have been introduced to limited competition. Those monopolies that operate in industries with limited economies of scale, however, can also be split up into smaller and less dominant companies by the regulatory authorities. Controls also exist on preventing monopolies being created through merger and takeover activity. This we investigate in Chapter 3. However, where a monopoly constantly faces the threat of new entrants to the industry and does not have a significant cost or non-price advantage over these potential competitors, it may be forced to revise its output and pricing decisions to stymie this threat. That is, it may be forced to adopt limit pricing by setting a price below that which generates supernormal profits. As a new entrant could produce output (QP - QM) profitably if covering its average total cost then so long as the monopolist sets output so that price is below the level at which these costs are covered then it will counter the threat of enticing new entrants to the industry and maintain its profits above the normal level.

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2. MACROECONOMIC ANALYSIS 2.1

Introduction

Having considered the allocation of resources and the determination of price and output within different industrial structures, we now turn to look at how key economic variables are determined in the macroeconomy. As in the previous section, we take a mainly intuitive rather than a purely mathematical or algebraic approach to the subject and apply the other things being equal caveat when analysing the effect of a change in one variable or input on another or the economy as a whole, again to isolate the effect of this change.

2.2

The Determination of National Income

LEARNING OBJECTIVES 1.2.1

Know how national income is determined, composed and measured in both an open and closed economy

We saw in our analysis of microeconomics that at the very simplest level an economy comprises two distinct groups or economic agents, individuals, or consumers, and firms. Individuals supply firms with the productive resources of the economy - land, labour and capital - or the inputs to the production process, in exchange for an income. In turn, these individuals use this income to buy the entire output produced by firms employing these resources. This gives rise to the circular flow of income. This economic activity can be measured in one of three ways: by the total income paid by firms to individuals, by individuals total expenditure on firms’ output or by the value of total output generated by firms. Each measure should produce the same answer in this simple economy. However, as economies develop from simple agrarian barter based societies through to being manufacturing based and finally services based, or post-industrial, economies with developed monetary and financial systems, so this simple model of the economy becomes more complex.

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PAYMENT FOR INPUTS TO PRODUCTION PROCESS

CONSUMERS

DIRECT TAXATION TRANSFER PAYMENTS

DIRECT TAXATION

GOVERNMENT

FIRMS

INDIRECT TAXATION GOVERNMENT SPENDING

INCOME SPENT ON DOMESTIC PRODUCTION IMPORTS SAVINGS

OVERSEAS ECONOMIES

EXPORTS INVESTMENT

FINANCIAL MARKETS AND INSTITUTIONS

Figure 16: The Circular Flow of Income In addition to individuals saving some of their income for future consumption and financial markets and institutions channelling these savings to firms to invest in both new and replacement capital equipment for future production as well as in stocks of finished goods and raw materials to meet future consumer demand, government spending and taxation decisions along with international trade also become an integral part of the economic system. Consequently, the circular flow becomes subject to injections in the form of business investment, government spending and firms’ exports to overseas economies and leakages in the form of saving, taxation and imported goods and services. Moreover, by engaging in international trade, an economy that could once be described as closed becomes an open economy. So long as total leakages are exactly counteracted by total injections in the circular flow, we can imply that the difference between the amount that individuals are saving and firms are investing is equal to the difference between what the government is spending and receiving in tax revenue plus the difference between exports and imports. Therefore, any imbalance between what the government is spending and receiving as tax revenue, for instance, must be met by an imbalance between saving and investment and/or between exports and imports. At a national level, the amount of economic activity within the circular flow is measured by the National Income Accounts on either an income, expenditure or output basis and stated in terms of Gross Domestic Product (GDP) or Gross National Income (GNI).

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GDP measures the total market value of all final goods and services produced domestically typically during a calendar year. Market value is the value of output at current prices inclusive of indirect taxes, such as VAT, whilst final output is defined as that purchased by the end user of a product or service. This latter point is particularly important as national income accounting, by: 1. distinguishing between final goods and those intermediate products or inputs used in a prior production process, and 2. employing the concept of value added, avoids any double counting in the national accounts. For instance, if a brick company produced £5m of bricks, having bought in £1m of clay from a clayextracting firm that owns the clay pits, the value added to the brick company’s final output would be £4m. If a house builder then purchased these bricks to build houses subsequently sold for £10m, a further £5m would be added to the national accounts that have already accounted for the £1m and £4m. To summarise then, the UK’s GDP is calculated by measuring the income, expenditure or output generated over the course of a calendar year from the production of finished goods and the supply of services originating in the UK inclusive of indirect taxes. The citizenship or tax residency of the individual or firm generating this output in the UK is immaterial. An outline of the components comprising the income measure of GDP is shown below: Income from employment plus

income from self-employment

plus

gross trading profits of companies

plus

gross trading surpluses of public corporations and general government enterprises

plus

rental income

=

GDP AT FACTOR COST

minus

depreciation of the nation’s existing capital stock

=

NET DOMESTIC PRODUCT AT FACTOR COST

An outline of the components comprising the expenditure measure of GDP is shown below: Consumer spending (C) plus

business investment spending and investment in stocks (I)

plus

government spending (G)

=

TOTAL DOMESTIC EXPENDITURE

plus

exported goods and services (X)

=

TOTAL FINAL EXPENDITURE

minus

imported goods and services (M)

=

GDP AT MARKET PRICES (Y)

minus

indirect taxes

plus

subsidies

=

GDP AT FACTOR COST

minus

depreciation of the nation’s existing capital stock

=

NET DOMESTIC PRODUCT AT FACTOR COST

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In a mature post-industrial economy such that in the UK or the US, consumer spending makes the greatest contribution to GDP, accounting for around two-thirds of its total at market prices. Government spending net of taxation, depending on the government’s fiscal policy stance, which we will consider shortly, accounts for up to about 5% of GDP whilst business spending and net trade typically represents up to one third of GDP at market prices. What differentiates GDP from GNP is that GNP also includes the contribution made during the calendar year to an economy’s circular flow by its nationals - both firms and individuals - based overseas. This contribution is known as net property income and comprises wages, profits, interest and dividends. GNP at market prices, therefore, is simply GDP at market prices plus net property income generated from overseas economies by UK factors of production. By dividing GDP (or GNP) by population, one obtains GDP (GNP) per head or GDP (GNP) per capita. GDP per capita along with growth of GDP between calendar years, more commonly known as economic growth, are used as barometers of national prosperity. However, whereas GDP and GDP per capita are calculated at market prices, or in nominal terms, economic growth is always expressed in real terms. The difference between real and nominal GDP is accounted for by a broadly based measure of inflation known as the GDP deflator. For instance, if a nation’s GDP in period t0 was £800bn but rose in period t1 to £850bn whilst the index value (we look at index values in Chapter 10) of its GDP deflator in t0 was 140 but rose to 145 in t1, the GDP of £850bn expressed in real, or t0, terms would be: £850bn x 140/145 = £820.7bn A real increase in GDP from £800bn to £820.7bn, represents economic growth of: (£820.7bn - £800bn)/

£800bn = 2.6% rather than nominal growth of (£850bn - £800bn)/ (145 - 140)/ £800bn = 6.25% which includes inflation of 140 = 3.6% between t0 and t1. Inflation is considered later in this chapter. Note: real growth does not equal nominal growth minus inflation. Rather real growth =

[

]

(1 + nominal growth) - 1 (1 + inflation)

Economic growth as a barometer of national prosperity, or standard of living does, however, have significant shortcomings: 1. The effects of economic growth may just benefit a narrow section of society rather than society as a whole, depending on the composition and distribution of GDP; 2. GDP and, therefore, economic growth only capture those aspects of economic activity that are measurable. Therefore, both fail to account for: a. the undesirable side effects of economic activity, such as pollution and congestion; b. non-marketable production such as DIY; c. the, albeit subjective, value attributed to leisure activities; d. economic activity in the so-called shadow economy, where, as a result of tax evasion, certain activities go unrecorded. In the UK, this activity is estimated to equate to about 5% of GDP, though in many other countries with mature economic systems, estimates as high as 20% of GDP are not uncommon.

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As we shall see, 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: 1. The growth and productivity of the labour force. In a mature economy, the labour force typically grows at about 0.5% per annum, though in countries such as the USA where immigrant labour is increasingly employed, the annual growth rate has been in excess of 1%. Long term productivity growth is dependent on factors such as education and training and the utilisation of labour saving new technology. Moreover, productivity gains are more difficult to extract in a post-industrialised economy than one with a large manufacturing base. Since the early 1970s both the UK and USA economies have been transformed into post-industrial economies. Long term productivity growth in each has averaged about 1.25% and 1.75% per annum respectively. 2. 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. 3. The extent to which an economy’s infrastructure is maintained and developed to cope with growing transport, communication and energy needs. Given these factors, the UK’s long term trend rate of economic growth has averaged a little over 2% per annum, whilst that of the USA has averaged nearly 3%. In developing economies, however, which are operating at a lower level of GDP but with generally higher savings and investment rates as a percentage GDP and more rapid growth in their labour forces than their more mature counterparts, economic growth rates approaching 10% per annum are not uncommon. For example, China is expected to grow around 8% per annum over the next few years and be one of the fastest growing economies in the world. Dubai, India and Saudi Arabia are also currently recording similar high rates of economic growth. This trend rate of growth also defines an economy’s potential output level or full employment level of output. That 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. However, 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. Unlike in microeconomics where the establishment of a market-clearing price in a single market brings supply and demand into equilibrium, in macroeconomics the interaction of individual markets and sectors may cause the economy to operate in a state of disequilibrium, often for significant periods of time. This we consider when we examine fiscal and monetary policy.

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2.3

The Economic Cycle

LEARNING OBJECTIVES 1.2.2

Know the stages of the economic cycle

The fact that actual growth fluctuates and deviates from trend growth in the short term gives rise to the economic cycle, or business cycle.

GDP GROWTH ECONOMIC PEAK EXPANSION TREND GROWTH

ECONOMIC TROUGH RECESSION

DECELERATION

BOOM

ACCELERATION

CONTRACTION

RECOVERY

0

TIME

Figure 17: The Economic Cycle Economic cycles describe the course an economy conventionally takes, usually over a 7 to 10 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. 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. Moreover, whilst successive economic expansions have increased in length, recessions have become shorter and generally less pronounced. According to a recent Organisation for Economic Cooperation and Development (OECD) study, this smoothing out of the economic cycle has been as a result of the growth of the service sector in those developed economies that comprise the OECD; service sector output being much less volatile than manufacturing output. It has also stemmed from the economic stability resulting from the successful reduction in inflation, itself brought about by governments allowing their central banks to set an independent monetary policy. Each of these points is considered shortly.

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What causes cycles has been the subject of much academic debate and literature. However, in a post-industrial, or an increasingly service-based economy, such as the UK’s, individuals’ savings decisions and firms’ decisions to invest in or disinvest of capital equipment and inventories are thought to have a significant influence on the course the cycle takes as, indeed, are changes in government fiscal policy and central bank monetary policy. Certainly in the recent past, the boom stage of the cycle has been characterised by firms’ over investing in capital equipment and inventories, this being financed through excessive borrowing, in an attempt to satisfy rising consumer demand, itself financed by cheap and readily available credit and boom-inspired gains made on financial and property assets. The catalyst for subsequent decelerations, however, has typically been the adverse effect of rising interest rates - engineered to pre-empt or respond to the resulting inflationary pressures arising from this excess demand - on heavily indebted firms and consumers. As the cost of credit increases, consumers cut back on their spending, so causing firms to reduce production and run down their existing inventories. Being left with spare productive capacity, firms then have little incentive to invest in new capital equipment, especially when the cost of finance has increased. A vicious circle can then develop as firms go bust, consumers lose their jobs and demand decelerates, in stark contrast to the virtuous circle that develops during the boom stage of the cycle. Once again, each of these points will be considered later in this chapter. Where an economy is positioned in the economic cycle also determines the performance of the various asset, or investment, classes. This is covered in Chapters 4 and 9. Finally, empirical evidence shows that if the short term peaks and troughs of conventional cycles are ignored, economic cycles of 50 years or so pervade economies. These Kondratieff cycles flow from the benefits of innovation and investment in new technology.

2.4

Aggregate Demand and Aggregate Supply

Returning to the determination of national income, we saw from the expenditure method of accounting for GDP at market prices (Y) that total spending or aggregate demand in the economy originates from several sources, such that: Y = C + I + G + (X - M) We will now briefly consider each of these components, what influences them and what their impact, both individually and collectively, is on the level of national income within a simple aggregate demand model.

Consumer spending (C) C is driven by: a. the level of national income (Y); b. consumer confidence; c. actual and expected changes in the level of consumers’ wealth, known as wealth effects; d. expectations of future income; and e. the availability and cost of credit.

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Consumer spending (C)

c(1-t)Y = slope of line Consumption function = a+c (1 - t)Y a

0 National income (Y)

Figure 18: The Consumption Function The consumption function shows the planned level of consumer spending at each level of national income, or GDP. You will notice, however, that this spending comprises two components: an autonomous or fixed amount of spending that is independent of the national income level, shown by the point at which the consumption function intersects with the vertical axis, representing spending on necessities, and an amount that varies directly with GDP, denoted by c(1 - t)Y. This latter element is known as the marginal propensity to consume (MPC) and determines what proportion of consumers’ post-tax, or disposable, income is spent, rather than saved, on goods and services. ‘t’ is the rate of direct taxation imposed by the government. The steeper the slope of the consumption function, the higher the MPC out of post-tax income. Necessarily, the marginal propensity to save (MPS) is given by 1 - MPC. Obviously, by incorporating factors that make this model dynamic such as consumer confidence itself determined by job security and employment prospects - changes in the level of wealth, the availability and cost of borrowing and expectations of future income levels, so the relationship between consumer spending and national income becomes more complex. Knowing that consumer spending usually accounts for about two-thirds of demand in a mature economy, its importance can never be overlooked. Therefore, 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 firms’ output, leading to a reduction in the demand by firms for labour and other resources, which itself then results in a further decline in the demand for firms’ output and so on. As we will see when considering fiscal policy, 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.

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Business Investment (I) I is the amount firms spend on capital equipment and stocks built up in anticipation of consumer demand. I is determined by: a. firms’ ability to invest given the level of their retained profits and the cost of external finance; b. business confidence and expectations of future returns from this investment spending; c. the rate of technological innovation; and d. the rate at which the capital stock is depreciating. Interest rate (r)

MEI = slope of line

0

Business investment spending (I)

Figure 19: The Investment Schedule In a basic aggregate demand model, investment spending is assumed to be autonomous, or independent, of the level of national income. The investment schedule, therefore, depicts the relationship between the level of investment spending and the rate of interest for a given expectation of future investment returns. This is known as the marginal efficiency of investment (MEI). The steeper the slope of the investment schedule, the higher the marginal efficiency of investment and, therefore, the more inelastic investment spending is in relation to the cost of finance. However, investment spending is also sensitive to an autonomous change in the demand for firms’ output, the rate of technological innovation and the rate of depreciation of the capital stock. A change in any one of these variables will result in a shift in the investment schedule and, therefore, to a greater or lesser amount of business investment being undertaken at each level of the interest rate.

Government Spending (G) An increase in government spending and/or a reduction in the level or rate of taxation can be used to stimulate the level of demand in an economy in the short term. As with business investment spending and that element of consumer spending that is considered autonomous, government spending is assumed to be independent of the level of national income within a basic model of aggregate demand.

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Government spending takes many forms. It includes infrastructure spending, spending on public services and transfer, or benefit, payments to individuals. All but the latter are captured within the national accounts. Government spending can be financed through a combination of direct and indirect taxation and/or borrowing. Tax cuts, however, can be financed through borrowing and/or a reduction in government spending. Collectively government spending, taxation and borrowing are known as fiscal policy. When the government spends the same as it is receiving in tax revenue, it runs a balanced budget. However, if it is receiving more in tax revenue than it is spending, then it is running a budget surplus and a budget deficit if the opposite is true. The extent to which the government needs to borrow to finance this deficit is given by the Public Sector Net Cash Requirement (PSNCR). The financing of successive fiscal deficits gives rise to the national debt. Fiscal policy has been an important feature of modern day economies, mainly being used to boost deficient demand in an attempt to move the economy back to its full employment level of output. Until the 1930s, economies had largely relied on market forces to achieve the potential or full employment level of output; a point we will consider when looking at fiscal policy later in this chapter. Suffice to say at this stage that the impact of an increase in government spending on the level of national income is always greater than that of an equivalent tax cut, given that a proportion of the latter is often saved or spent on imported goods whereas the former is injected directly to the circular flow. The political impact of a tax cut though is often far greater. Having considered three of the four components of aggregate demand - those that exist within a closed economy - we now need to examine how they collectively impact the output of the economy. General price level (P)

Aggregate demand (AD) O National income (Y)

Figure 20: Aggregate Demand This diagram is similar to that of the demand curve in microeconomics but differs in that it shows the aggregate, or total, demand in the economy at each general, or average, price level as you move along the AD curve. The AD curve is unpinned by the following equation: Y = C + I + G, or Y = [a + c(1 - t)Y] + I + G

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An autonomous change, or shift, in any one of the above sources of demand or spending will shift the AD curve to the right if demand is increased or to the left if decreased. However this shift will increase national income disproportionately. The reason for this is the existence of the multiplier. If, for example, the government increased the level of its spending by £100m, thereby shifting the AD curve to the right, the resulting increase in national income would be greater than £100m since the recipients of this sum would then spend a proportion of it on other goods and services whilst the recipients of that smaller sum would do the same. This process would continue until the multiplier effect has worked itself throughout the economy. The closed economy multiplier is given by: 1/ (1 - [MPC (1 - tax rate)]) You will notice that the multiplier only takes account of the one variable that is assumed to vary directly with the level of national income, namely the marginal propensity to consume out of disposable income: MPC (1 - tax rate). Example Introvasia has a MPS = 0.3 and a tax rate (t) = 0.2. What is the value of the economy’s multiplier? Solution MPC = 1 - MPS = 0.7 Multiplier = 1/(1 - [ 0.7 (1 - 0.2)]) = 2.27 So, an increase in G = 100, would result in national income increasing by 100 x 2.27 = 227, other things being equal. In a closed economy, this autonomous stimulus to demand could also have originated from an increase in the level of business investment collectively undertaken by firms or through an autonomous shift in the consumption function. However, we haven’t yet considered the final component of aggregate demand - net exports - that which makes a closed economy an open economy - and in particular its impact on the multiplier.

Net Trade (X - M) Net trade represents the difference between the value of goods and services exported (X) and those imported (M). By bringing net trade into the equation, depending upon whether the economy is a net importer or net exporter, giving rise to a trade deficit and trade surplus respectively, the position of the AD curve will be affected as the aggregate demand equation now becomes: Y = C + I + G + (X - M)

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In simple aggregate demand models, exports are assumed to be autonomous of the level of domestic national income; being determined instead by the level of national income within overseas economies. Imports, however, are assumed to be directly related to the level of domestic national income: this direct relationship being given by the marginal propensity to import goods and services (MPM). As imports are a leakage from the circular flow of national income, the MPM will necessarily dampen the value of the multiplier in an open economy. The open economy multiplier is given by: 1/ {(1 - [MPC (1 - tax rate)]) + MPM} As with the closed economy multiplier, only those variables that are assumed to vary directly with national income are included. Example In Extrovasia, an open economy, the MPC is 0.7, t = 0.2 and MPM = 0.1. Calculate the open economy multiplier. Solution Multiplier = 1/{(1 - [0.7 (1 - 0.2)]) + 0.1} = 1.85 So an increase in G = 100 would result in national income increasing by 100 x 1.85 = 185. In an open economy, this autonomous stimulus to demand could have emanated from any other autonomous shift in domestic spending or, indeed, an increase in the level of exports. Having considered aggregate demand, we now turn to aggregate supply. General price level (P)

Long run aggregate supply (LRAS)

Short run aggregate supply (SRAS)

O

YF

National income (Y)

Figure 21: Aggregate Supply

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Aggregate supply quantifies the amount of output firms are prepared to supply at each general price level, assuming the price of inputs to the production process are fixed. As in microeconomics, we need to differentiate between the short and long run. The LRAS curve denotes the economy’s potential or full employment level of output (Yf) given the amount of resources, available technology and rate of productivity it can draw upon, whereas the SRAS curve is subject to diminishing returns to labour as a consequence of a fixed capital stock. Shifts in the LRAS curve follow from changes in the amount of available resources, technological innovation and the efficiency of production techniques whereas changes in production costs, principally the wage rate, and other factors that impact the production process in the short term - known as supply shocks will shift the SRAS curve. Through the interaction of the AD and LRAS curves, we arrive at the economy’s full employment equilibrium level of output and general price level. However, we know that short term fluctuations in economic activity mean that the economy can operate in disequilibrium - that is, either above or below its full employment level of output - often for significant periods of time. The aggregate demand and supply framework can, therefore, be utilised to illustrate how different policy prescriptions available to governments can be used in an attempt to bring aggregate demand and supply back into equilibrium.

2.5

Fiscal and Monetary Policy

LEARNING OBJECTIVES 1.2.4

Know the nature, determination and measurement of the money supply

1.2.5

Understand the role, basis and framework within which monetary and fiscal policy operate

Governments can use a variety of policy instruments when attempting to reduce short term cyclical fluctuations in economic activity so as to maintain the economy at or near its full employment level of output. Collectively, these measures are known as stabilisation policies and are categorised under the broad headings of fiscal policy and monetary policy. It should be noted that neither fiscal or monetary policy alone can alter the level of economic activity in the long term. In the foregoing analysis we will concentrate on the situation where output is below the full employment level, that is where there is a deflationary gap, rather than when the opposite is true and an inflationary gap exists.

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Fiscal policy General price level (P)

LRAS

SRAS1 SRAS2

A B

AD O

YF

National income (Y)

Figure 22: Classical Economics Applying microeconomic principles, classical economists believed that at the macroeconomic level, if the economy was operating below the full employment level of output at point A, input prices, principally wages, and the price of output would automatically fall to restore equilibrium at point B. (Classical economics was founded by Adam Smith in the 18th century and is based upon the premise that individuals, or economic agents, act rationally.) However, prices and wages are rarely as flexible as this. In fact, they are often described as being sticky, or resistant to downward pressure. Recognising this, the Keynesian economic revolution, which originated during the Great Depression of the 1930s, marked a dramatic departure away from the classical view of markets, notably labour markets, being self-correcting at the macroeconomic level. Instead, government intervention, or demand management, was deemed necessary to return the economy back to full employment. Stimulating deficient demand, rather than supply, was considered the key to achieving full employment in the Keynesian world. As we already know, this demand management, or fiscal policy, combines government spending, taxation and borrowing policies. However, demand management takes two forms: 1. A discretionary, or proactive, approach to demand management is that which is deliberately implemented to either boost or restrain demand. The former is known as an expansionary fiscal policy whilst the latter is referred to as a restrictive or tight fiscal policy. 2. A passive approach to demand management whereby spending on transfer, or social security, payments automatically increases, and tax revenue decreases, as the economic cycle moves into its recessionary phase. These are known as automatic or built-in stabilisers.

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Determining whether or not government is pursuing an expansionary or a restrictive fiscal policy is not always easy. Although the existence of a budget deficit, or PSNCR, may imply that an expansionary fiscal stance is being adopted, this deficit may simply be as a result of the economy operating below its full employment level. So as to establish whether this deficit has been caused by structural or cyclical factors and to determine the fiscal stance being taken, economists usually calculate whether a budget deficit, budget surplus or balanced budget would result at current government spending and tax rates if the economy was operating at full employment, rather than below this level. LRAS

General price level (P)

SRAS C

A AD2 AD1 O

YF

National income (Y)

Figure 23: Keynesian Economics The diagram above depicts the result of pursuing an expansionary fiscal policy when the economy is operating at below full employment within a simple aggregate demand and supply framework. Reinforced by the multiplier, this fiscal expansion shifts the AD curve from point A to point C, thereby returning the economy to its full employment level of output, albeit at a higher general price level. We will return to this latter point shortly when examining the relationship between unemployment and inflation. There are, however, three practical problems associated with fiscal policy: 1. Time-lags. The length of time that elapses between recognising the need for action - based on economic data that is itself time-lagged - implementing the appropriate policy and the policy impacting the economy can be considerable. So much so that these time-lags can render fiscal policy a destabilising rather than stabilising influence, especially if fiscal policy is used excessively in an attempt to fine tune demand as it used to be immediately before and after general elections. 2. Crowding out. If an expansionary fiscal policy is financed through borrowing, this borrowing will increase the market rate of interest to the detriment of that element of business investment and some consumer spending that would have been undertaken at the lower interest rate. 3. Higher future tax rates. Pursuing an expansionary fiscal policy may result in a higher future tax burden being imposed on the economy.

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Although fiscal policy was used as the key policy instrument by successive governments between the late 1930s and mid-1970s, during the early 1970s an economic condition known as stagflation a combination of rising unemployment and high rates of inflation - had begun to pervade the world economy, despite the implementation of reactive Keynesian demand management policies to counter this. Governments, therefore, began instead to adopt alternative policies developed by the new classical economists, or monetarists.

Monetary Policy Monetarists adopted the classical economic proposition that markets are essentially self-correcting, taking the view that government intervention can prove to be a destabilising influence on the economy in the short run. However, for markets to self-correct, monetarists recognised that the distorting influence of inflation on the ability of the price mechanism to clear markets needed to be controlled. Monetarists believed that inflation and short run fluctuations in economic activity stemmed solely from the growth and instability of the domestic money supply. This proposition was based on Fisher’s Quantity Theory of Money, originally formulated in 1911. The Quantity Theory is given by: MV = PY, where M = the money supply; V = the velocity of circulation of money, or demand for money; P = the average price level and Y = real GDP. The Quantity Theory is a truism, or an identity, in that both sides of the equation measure the same thing: nominal, or money, GDP. MV measures the money, or nominal, value of transactions within a period - that is, the amount of money in the economy multiplied by the number of times it changes hands - whilst PY denotes the total money value of output in the economy. By assuming that in the short term both V and Y are either stable or at least change very slowly and in a predictable fashion - we already know that Y does to a degree - a model was developed to explain inflation purely as a result of increases in the money supply. This theory basically states that an increase in the money supply (M) leads to price increases (P) of the same proportion (ie, inflation). After all, when the supply of any commodity increases, so its value decreases. Monetarists believed that by limiting the rate of money supply growth to the trend rate of economic growth, stable growth without inflation would be achieved and market forces could be left to bring the economy back into full employment equilibrium. Discretionary fiscal policy, especially that financed through borrowing, was actively discouraged as in addition to crowding out business investment, unpredictable increases in the money supply would result. However, as with Keynesian demand management, there are also several problems with the monetarist proposition:

1. Defining the Money Supply The money supply is the amount of money that exists in the economy at any point in time. However, before the money supply can be quantified, the term money must be defined.

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Money is anything that is generally acceptable as a means of settling a debt. Money, therefore, must fulfil several functions. Most importantly, it must overcome the problem of finding someone else with matching trading requirements, known as the mutual coincidence of wants problem, and the associated search costs encountered with exchange through a system of barter, by acting as an acceptable medium of exchange. It must also act as a store of value for future consumption by maintaining its purchasing power and provide a unit of account against which the price of goods and services can be compared. To be acceptable, however, money must also be easily recognisable, divisible, portable and durable. In a developed economy, money takes the form of fiat currency. That is, currency that has no intrinsic value but which is demanded for what it can itself purchase. As a result of the various forms that money can take in an economy with a sophisticated financial system, it will probably come as no surprise that there is no single definition of the money supply. Since 1976, several measures of the money supply have been defined and redefined in the UK. However, only two measures remain: M0 and M4. M0, the monetary base, is the narrowest measure of the two in that it only contains notes and coins in circulation and banks operational deposits at the Bank of England - the UK’s central bank- whilst M4, the broadest measure, is defined as M0 plus bank and building society deposits. The definition of the money supply is further complicated by the existence of credit creation and the money multiplier. As banks are only required to hold a small proportion of their deposits as reserves to meet day-to-day withdrawals - known as the reserve ratio - they can lend out the significant remainder, assuming that bank depositors’ required ratio of cash holdings to deposits does not exceed this ratio. This is known as fractional reserve banking. As a sizeable proportion of each loan made from bank deposits is redeposited and then extended as another loan, so credit is created and the money supply expands. The impact on the money supply can be quantified by multiplying the level of cash deposits in the banking system by the money multiplier, which is given by: 1/ reserve ratio So, a bank with $100,000 of cash deposits subject to a 10% reserve ratio will create loans of $900,000 until a total of $100,000/0.1 = $1m of deposits are on the bank’s books with $100,000 of cash being held to satisfy the reserve ratio requirement.

2. Controlling the Money Supply Since the 1970s, the Bank of England has attempted to control the money supply through a variety of monetary policy measures: a. The imposition of qualitative and quantitative credit controls, changing the reserve ratio and imposing special deposits on banks so as to restrict the ability of the banking system to create credit, and b. Setting the price of money - or base rate - through its operations in the money markets and repo markets. This it does through injecting or withdrawing liquidity to or from the banking system by either buying or selling short term bills or government bonds. We return to money markets and repo markets in Chapter 4. However, as a result of disintermediation and securitisation - the substitution by firms of raising finance through the issue of securities rather than through bank loans - and a relatively price inelastic demand for bank lending, monetary control has never proved totally effective. International Certificate in Investment Management

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3. The Velocity of Circulation of Money To compound this, the velocity of circulation of money, or the demand for money, is not stable or predictable in the short run. This is mainly as a result of financial innovation, deregulation and structural changes in financial markets as well as changes in the rate of inflation and rate of interest. Therefore, changes in the money supply do not directly translate into changes in the price level.

4. Time-Lags As with fiscal policy, considerable time-lags exist between recognising the need for action through to the implementation of policy having an effect on the economy. Time-lags of up to 12 months typically exist between the date of implementing monetary policy and its effect working through to the economy. As a consequence of these factors, formal control of the money supply in the UK was abandoned in the late-1980s.

Concluding Comments Arguably, governments’ failure to adopt the ideas of Keynesians and Monetarists to the letter when formulating and implementing their policies probably explains why so many economic problems failed to be solved or, in some cases, were exacerbated. Most governments now adopt a pragmatic approach to controlling the level of economic activity through a combination of fiscal and monetary policy, though in an increasingly integrated world, controlling the level of activity in an open economy in isolation is difficult as financial markets rather than individual governments and central banks tend to dictate economic policy.

2.6

Unemployment and Inflation

LEARNING OBJECTIVES 1.2.7

Know how inflation and unemployment are determined, measured and their inter-relationship

Unemployment Unemployment can be defined as the percentage of the labour force registered as available to work at the current wage rate. In the market-clearing world of the classical economists, however, it was believed that unemployment was purely voluntary; a consequence of workers demanding too high a wage rate thereby pricing themselves out of a job. By accepting a lower wage rate, this voluntary unemployment would disappear. In the Keynesian world of demand management though, involuntary, rather than voluntary, unemployment was seen to exist as a result of deficient demand and sticky prices and wage rates, resistant to downward pressure.

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There are, of course, many other reasons why unemployment exists, two of which are described by structural unemployment and frictional unemployment. The former arises as a result of the changing nature of the economy where certain skills in particular sectors of the economy become redundant, whilst the latter is a consequence of workers being between jobs in the hope of securing a higher wage rate for their skills.

The Trade off Between Unemployment and Inflation Earlier, when considering the impact of Keynesian demand management policies in restoring the economy to full employment, we saw that the general price level in the economy rose as a consequence. Accepted as a side effect of fiscal policy, it became apparent that a trade off between unemployment and inflation existed. This idea was formalised by a Keynesian economist, A W Phillips in 1958, in what became known as the Phillips curve. Inflation rate (%)

O

Unemployment rate (U) %

Figure 24: The Phillips Curve Representing an established empirical relationship between the rate of inflation - the rate at which the general price level rises - and the rate of unemployment, the Phillips curve appeared to suggest that it was possible to trade off a rate of inflation with a politically acceptable rate of involuntary unemployment through the implementation of demand management policies. However, the emergence of stagflation - the undesirable combination of stagnant or falling output and employment allied to high and rising inflation - in the early 1970s put paid to this simple relationship.

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Inflation rate (%)

Long run Phillips curve (NAIRU)

3 B O

C Unemployment rate (U) % A

Short run Phillips curve2 (SRPC2) Short run Phillips curve1 (SRPC1)

Figure 25: The Expectations Augmented Phillips Curve The monetarists restated the Phillips curve relationship to explain the existence of stagflation by introducing the concept of a natural rate of unemployment, or a non-accelerating inflation rate of unemployment (NAIRU), and workers’ inflation expectations to the model. A distinction was also made between short run and long run Phillips curves. Whereas the economy could operate temporarily below its NAIRU on a short run Phillips curve, in the long run it would always move along the vertical long run Phillips curve represented by its NAIRU. To explain, assume the economy starts at point A where it is operating at its NAIRU, with 0% inflation. Workers expectations of future inflation based on the recent past are also set at 0%. Aggregate demand is then stimulated through government spending. A reduction in voluntary employment results as firms, in response to increased orders for their output, raise their wage rates to attract workers. This takes the economy to point B on SRPC1, where increased demand for employment and output has resulted in inflation of, say, 3%, though workers inflation expectations remain at 0%. Those workers attracted by the higher nominal wage rates on offer soon realise that the real value of these wages is no greater than before, as a result of the increase in the general price level, and decide to leave the labour market. Their failure to anticipate this higher inflation as the economy moved towards point B had resulted from money illusion. With inflation expectations now set at 3%, however, the economy moves from SRPC1 to SRPC2 at point C, which coincides with the LRPC or NAIRU. Given the existence of NAIRU and inflation expectations, the monetarist model concludes that discretionary demand management policies are ineffective in reducing unemployment for anything other than short periods of time and ultimately result in higher prices. NAIRU, which includes structural and frictional unemployment, can be reduced though through the adoption of supply side policies, such as retraining those with redundant skills, reducing employment taxes and providing less generous unemployment benefits. Moreover, it has been argued by proponents of the new paradigm that technological innovation and its resulting productivity gains has created a new economy that can operate at a higher employment level, or a lower NAIRU, without accompanying inflation.

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Inflation Inflation is the rate of change in the general price level or the erosion in the purchasing power of money. During the late 1970s and early 1980s in the UK, given a high and rising inflation rate, there was a marked policy shift away from targeting unemployment to making inflation the prime focus of economic policy. Although unemployment results in a waste of economic resources as actual GDP will be below potential GDP, from a political standpoint it tends not to be shared equally by society, whereas the economic costs inflation imposes on society are considered more far reaching, for the following reasons: 1. It hinders the ability of the price mechanism to clear markets. 2. It reduces the spending power of those dependent on fixed incomes. 3. Individuals are not rewarded for saving as borrowers gain at the expense of savers. This occurs when the inflation rate exceeds the nominal interest rate. That is, the real interest rate is negative. Real interest rates are calculated as follows: Real interest rate = [1 + nominal interest rate] - 1 [1 + inflation rate] 4. It creates uncertainty leading to firms deferring investment decisions and consumers spending decisions. 5. Time is spent guarding against inflation rather than being devoted to more productive means. 6. Exported goods and services become less competitive internationally. It is important, however, to distinguish between inflation that can be anticipated and that which cannot when assessing its costs. If inflation can be fully anticipated by society then its costs can be minimised. Inflation is typically categorised as either: 1. Cost-push inflation. If firms face increased costs and inelastic demand for their output, the likelihood is these rising costs will be passed on to the end consumer. Consumers will in turn demand higher wages from firms causing a wage price spiral to develop. This was certainly the case following the oil price shocks of 1973 and 1980; or 2. Demand-pull inflation. When the economy is operating beyond its full employment level of output, prices are pulled up as a result of an inflationary gap emerging. This excess demand can often stem from the optimism that accompanies rising asset prices but has resulted on innumerable occasions from politically inspired tax cuts. Inflation can be measured in several ways. However, the two most widely monitored are: 1. retail prices; and 2. producer prices. The most well recognised measure of inflation in the UK is the Retail Price Index (RPI). Originally launched in 1947, this measures the rate at which the prices of a representative basket of goods and services purchased by the average UK household - that is, excluding the top 4% of income earners and pensioners - have changed over the course of a month. Needless to say, the composition and weighting of the various goods and services in the basket has altered dramatically since its inception.

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There are a number of different RPI measures. The three most keenly observed are the headline RPI, RPIX, which excludes mortgage interest payments, and RPIY, which further excludes VAT and the council tax. The RPI indices are usually published within 2 weeks of the end of the month covered. European Union (EU) countries, of which the UK is one, also each calculate a consumer prices index (CPI) so that inflation rates can be compared between EU nations on a uniform basis. The CPI differs from the RPIX both in its method of construction and in totally excluding owneroccupied housing costs. We return to RPIX and CPI when looking at central banks later in this chapter and index numbers in Chapter 10. Inflation at the “factory gate” is measured by two Producer Price Indices (PPIs). These are usually published at about the same time as the RPI indices. The input index measures the rate at which the prices of raw materials and other inputs to production processes are increasing and the output index how the prices of goods leaving factories are behaving. The producer price indices are a useful indicator of inflationary pressures that may eventually feed through to RPIX.

2.7

Deflation

LEARNING OBJECTIVES 1.2.7

Know how deflation and unemployment are determined, measured and their inter-relationship

Deflation is defined as a general fall in the price level. Although not experienced as a worldwide phenomenon since the 1930s, deflation has been in evidence over the past 10 years in countries such as Japan. Deflation typically results from negative demand shocks, such as the bursting of the 1990s technology bubble, and from excess capacity and production and, in turn, creates a vicious circle of reduced spending and a reluctance to borrow as the real burden of debt in an environment of falling prices, in stark contrast to that in a period of rising prices, increases. Although deflation posed a threat to the world economy in 2003, this threat is now thought to have passed with the majority of the world's central bankers now more concerned about the return of inflation. It should be noted that falling prices are not necessarily a destructive force per se and, indeed, can be beneficial if they are as a result of positive supply shocks, such as rising productivity growth and greater price competition caused by the globalisation of the world economy and increased price transparency.

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2.8

International Trade

LEARNING OBJECTIVES 1.2.3

Understand the composition of the balance of payments and the factors behind and benefits of international trade and capital flows

International trade is the exchange of goods and services between countries. It is conducted because it confers the following benefits on those countries that participate in this exchange: 1. Specialisation. Economies of scale in the production of a particular good or provision of a particular service can be fully exploited if the MES is not being achieved when producing solely for the domestic market. Increased production levels can also take full advantage of and further develop any particular skill possessed by the labour force, known as the division of labour. This point can be taken one stage further. Even though a particular country, country A, may have an absolute cost advantage, ie, is more efficient in the production or provision of two particular goods or services over another nation, country B, there is still scope for A and B to collectively benefit from international trade if each specialises solely in the provision of the good or service where they have a comparative cost advantage. So, if A specialises in the provision of the good or service where its absolute and comparative cost advantage over B is greatest whilst B concentrates solely on the provision of the good or service where A’s cost advantage is smallest, ie, where B’s comparative advantage is greatest, by trading each other’s production both can be shown to be better off in terms of the positive impact this specialisation and trade has on their respective GNPs. This is known as the law of comparative advantage. 2. Competition. Global competition in the provision of goods and services results in improved choice and quality of products as well as more competitive prices and productivity improvements in the industries concerned. Despite the substantial benefits of conducting international trade free from any governmental interference, governments often engage in protectionism, or the erection of trade barriers, in the misguided belief that certain domestic industries, often those that are inefficiently run, should be protected against global competition. This usually results in some sort of trade retaliation. However, the General Agreement on Tariffs and Trade (GATT) of 1948, which created an international trade organisation with responsibility for liberalising international trade, a role since assumed by the World Trade Organisation (WTO), has led to a gradual reduction in these barriers to free trade.

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The Balance of Payments The balance of payments is a summary of all economic transactions between one country and the rest of the world typically conducted over a calendar year. The main components of the balance of payments are as follows: 1. The trade balance. This comprises a visible trade balance - the difference between the value of imported and exported goods and an invisible trade balance - the difference between the value of imported and exported services. Being a post-industrial economy, the UK typically runs a deficit on visible trade but an invisible trade surplus. Also, being an open economy, imports and exports combined total over 50% of UK GDP. 2. The current account. The current account is equal to the trade balance less government transfer payments to overseas economies plus the net flow of interest, profits and dividends derived from net UK holdings of overseas assets. This latter net flow can be substantial given that the UK is one of the world’s largest owners of overseas assets. 3. The financial account. This accounts for the net amount of long and short term capital that has flowed between the UK and the rest of the world over the period. Long term capital flows are known as foreign direct investment (FDI) and include the overseas expansion plans of multinational companies, whether that results in the financing of a new plant or acquiring an existing business. Short term capital flows, typically footloose movements of capital attracted by potentially high short term returns, however, are termed portfolio investment. For the balance of payments to balance, the current account must equal the financial account plus or minus a balancing item - used to rectify the many errors in compiling the balance of payments plus or minus any change in central bank foreign currency reserves. We look at central banks, such as the Bank of England, shortly. Current Account = Financial Account +/- Balancing Item +/- Change in Central Bank foreign currency reserves

So a current account deficit resulting from the UK being a net importer of overseas goods and services must be met by a net inflow of capital from overseas taking account of any measurement errors and any Bank of England intervention in the foreign currency market. Central bank currency intervention is considered in the next section.

2.9

Exchange Rates

An exchange rate is the price of one currency in terms of another. Between 1945 and 1972, world currencies operated under the Bretton Woods fixed exchange rate system. All currencies were formally linked to the US dollar, which was itself convertible into gold at a fixed price. Although this fixed rate between world currencies and the dollar and the price of gold could and did change with formal revaluations and devaluations, the system collapsed in the early 1970s and was replaced by a floating exchange rate system. Under a floating exchange rate system, the exchange rate is set by the demand for and supply of a currency against all others, though a currency’s value is often influenced by central bank intervention in the currency markets. This is known as managed floating.

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Currencies can also operate within semi-fixed exchange rate systems such as the European Exchange Rate Mechanism (ERM), of 1979 to 1998, whereby each currency within the system is fixed against a central exchange rate but is permitted to deviate either side of this central rate by a pre-specified percentage. Although most world currencies currently operate within a system of managed floating, some currencies remain formally pegged to the US dollar, whilst others are managed against a basket of currencies - known as a crawling peg - or operate within regional fixed exchange rate systems.

The Effect of the Exchange Rate on International Competitiveness In an open economy, such as the UK’s, where international trade accounts for a significant share of GDP, having the “right” exchange rate is imperative. The example below illustrates how the exchange rate impacts on the price and, therefore, the competitiveness of imports and exports of goods and services. Imported baseballs from the US Cost in £ for $1 baseball £1.00 £0.50 £2.00

£:$ exchange rate £1=$1 £1=$2 £1=$0.50

Exported cricket balls to the US Cost in $ for £1 cricket ball $1.00 $2.00 $0.50

Figure 26: The Importance of the Exchange Rate Taking this one stage further, the overall effect of a change in the exchange rate on the UK trade balance assuming that demand is price elastic and all other factors, such as productivity, are held constant is as follows: 1. A rise in the nominal value of sterling will reduce a trade surplus or worsen a trade deficit as: a. exports will be less competitive, unless UK exporters reduce their sterling prices; whereas b. imports will be more competitive, unless exporters to the UK raise their prices. 2. A fall in the nominal value of sterling will increase a trade surplus or reduce a trade deficit as: a. exports will be more competitive, unless UK exporters raise their sterling prices; whereas b. imports will be less competitive, unless exporters to the UK 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. One way of establishing international competitiveness is by calculating the real exchange rate. The UK’s real exchange rate relative to that of the USA can be formally stated as: Real exchange rate = UK price level x USD US price level £

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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 USA without a compensating weakening of the nominal exchange rate, so 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 elasticities 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 whilst reducing export prices, thereby worsening the trade balance. However once consumers adjust to these new relative prices so the trade balance will improve. The trade balance, therefore, tends to experience a J-curve effect. We return to looking at exchange rates in Chapter 5.

2.10 Central Banks LEARNING OBJECTIVES 1.2.6

Know the role of central banks and of the major G8 central banks

Central banks operate at the very centre of a nation’s financial system. Most are public bodies though increasingly central banks operate independently of government control or political interference and usually have the following responsibilities: 1. acting as banker to the banking system by accepting deposits from and lending to commercial banks; 2. acting as banker to the government; 3. managing the national debt; 4. regulating the domestic banking system; 5. acting as lender of last resort to the banking system in financial crises to prevent the systematic collapse of the banking system; 6. setting the official short term rate of interest; 7. controlling the money supply; 8. issuing notes and coins; 9. holding the nation’s gold and foreign currency reserves to defend and influence the value of a nation’s currency through intervention in the currency markets; and 10.providing a depositors protection scheme for bank deposits.

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People’s Bank of China (PBC or PBoC) China’s central bank was established in 1948. In 2003 the Standing Committee of the Tenth National People’s Congress approved laws to strengthen the bank’s responsibility for financial stability, monetary policy and managing financial risk.

Central Bank of the UAE (CBUAE) The central bank was established in 1980. It’s head office is in Abu Dhabi, with five branches located in Al Ain, Dubai, Fujairah, Ras Al Khaimah and Sharjah. Some of the main responsibilities of the central bank include directing monetary, banking and credit policies, financial stability and supervision of the banking system.

Central Bank of Egypt Egypt’s central bank was established in 1961 and is based in Cairo. Some of the bank’s main responsibities include controlling monetary, banking and credit policies, financial stability, issuing currency and banking supervision.

European Central Bank (ECB) The ECB is based in Frankfurt, Germany. It assumed its central banking responsibilities upon the creation of the euro, on 1 January 1999. The euro has since been adopted by 12 of the 25 member states of the European Union (EU), which have collectively created an economic region known as the Eurozone. The ECB is principally responsible for setting monetary policy for the entire Eurozone with the sole objective of maintaining internal price stability. Its objective of keeping inflation (as defined by the Harmonised Consumer Prices index (HICP)) “close to but below 2% in the medium term” is achieved by making reference to those factors, such as the external value of the euro and growth in the money supply, that may influence inflation. The ECB sets its monetary policy through its president and council, the latter comprising the governors of each of the Eurozone’s national central banks. Although the ECB acts independently of EU member governments when conducting monetary policy, it has on occasion succumbed to political persuasion. It is also one of the few central banks that does not act as a lender of last resort to the banking system.

Reserve Bank of India The Reserve Bank of India was established in 1935 and is based in Mumbai. The main function of the bank is to ensure monetary stability in India. It is also required to issue currency, manage foreign exchange, and to regulate and supervise the financial system.

Bank of Japan (BOJ) Japan’s central bank has a statutory duty to maintain price stability. It is also responsible for the country’s monetary policy, issuing and managing the external value of the Japanese yen and acting as lender of last resort to the Japanese banking system. Until very recently, the BOJ was also subject to a degree of political interference.

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Saudia Arabian Monetary Agency (SAMA) The central bank of the Kingdom of Saudi Arabia was established in 1952 and is based in Riyadh. It is responsible for monetary policy, financial stability, issuing currency, acting as a banker to the government and managing foreign exchange reserves.

Bank of England The UK’s central bank was founded in 1694, originally as a commercial bank but was nationalised in 1946. It wasn’t until 1997 that the Bank gained operational independence in setting UK monetary policy, in line with that of most other developed nations, when the Bank of England’s Monetary Policy Committee (MPC) was established. Since November 2003, the MPC has been subject to meeting a rolling two year target of 2% for the Consumer Prices Index (CPI) set by the Chancellor of the Exchequer. This it does by setting the base rate, the UK’s administratively set short-term interest rate, and the MPC’s sole policy instrument. In addition to its short-term interest rate setting role, the Bank also assumes responsibility for all other traditional central bank activities, with the exception of: 1. Supervising the banking system. 2. Managing the national debt. This is the responsibility of the Treasury. 3. Providing a depositors protection scheme for bank deposits. This is now provided by the FSA through its Financial Services Compensation Scheme (FSCS).

Federal Reserve The Federal Reserve System in the USA dates back to 1913. The Fed, as it is known, comprises 12 regional Federal Reserve Banks, each of whom monitors the activities of and provides liquidity to the banks in their region. Although free from political interference, the Fed is governed by a sevenstrong board appointed by the President of the United States of America. This governing board in addition to the presidents of 6 of the 12 Federal Reserve Banks make up the Federal Open Market Committee (FOMC). The chairman of the FOMC, also appointed by the USA President, takes responsibility for the committee’s decisions, which are directed towards the FOMC’s statutory duty of promoting price stability and full employment. The FOMC meets every six weeks or so to examine the latest economic data and the many economic and financial indicators it monitors to gauge the health of the economy to determine whether the economically sensitive Fed Funds rate should be altered in response to its findings. Very occasionally it meets in emergency session as and when circumstances dictate. As lender of last resort to the USA banking system, the Fed has, in recent years, rescued a number of USA financial institutions and markets from collapse and prevented widespread panic, or systematic risk, spreading throughout the financial system by judicious use of the Fed Funds rate.

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Economics - A Conclusion Having read this chapter, you may have come to the conclusion that economics is very much an inexact science as a result of: 1. the many interacting factors, relationships and destabilising influences that exist within and outside of the domestic economy; 2. the fallibility of government and central bank policy instruments that seek to control economic activity in the short term; and 3. the unpredictability of intangible factors such as business and consumer confidence. With so many factors influencing the economy at any given time, it is almost impossible to establish with any certainty the contribution or impact that any one factor or change in policy will have on the economy. Indeed, much of what has been considered in this chapter has been on the basis of applying the other things being equal caveat so as to isolate the effect of a change in one variable on another. That is not to say that economics should be ignored or discarded. Indeed, so long as you can accept its limitations, it can provide an invaluable framework for decision making within the portfolio management process, especially in evaluating and assessing the desirability of competing investment opportunities. This we consider in Chapters 4 and 9.

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FINANCIAL MATHEMATICS AND STATISTICS 1. 2.

2

STATISTICS FINANCIAL MATHEMATICS

51 70

This syllabus area will provide approximately 7 of the 100 examination questions

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1. STATISTICS 1.1

Introduction

The ability to source and interpret all kinds of information, both qualitative and quantitative, in a timely fashion is key to the portfolio management process. However, since information, or data, can be sourced from a variety of media, is presented in a wide range of formats and is not always in a readily usable form, becoming familiar with information sources and being able to assimilate data is imperative if informed investment decisions are to be made and investment opportunities are to be capitalised upon.

1.2

Sourcing and Presenting Data

LEARNING OBJECTIVES 2.1.1

Understand where financial data may be sourced from and how it can be presented

Data Sourcing Although portfolio managers mainly rely on economic, financial and statistical information when making investment decisions, social and demographic as well as scientific, legislative and market research data are frequently drawn upon. Where such information pre-exists, it is termed secondary data. Secondary data is available from and compiled by a diverse range of bodies and institutions either with a particular user group in mind or for general consumption and typically requires further analysis if each user is to maximise the value of the information contained within it. Information or material that is specifically commissioned for a particular purpose, however, is known as primary data and should satisfy the originator’s exact information needs. Increasingly, data is being made available via electronic means, though paper based information IS still a key source. Information sources relevant to the portfolio manager include: 1. Internet websites. These range from those that provide up-to-the-minute general and finance news to those which provide access to comprehensive and more specialist economic, social, demographic and industry information. 2. Commercial quote vendors that provide real time security pricing information as well as historic security and economic data. 3. Company financial statements. 4. Share price charts. 5. Independent company analysis provided by specialist research consultancies and credit rating agencies. 6. Authoritative in-depth analysis of financial, economic and social trends produced by government statistical departments, central banks, international agencies such as the World Bank, International Monetary Fund (IMF) and Organisation for Economic Cooperation and Development (OECD), business schools and other academic research organisations. 7. Economic bulletins and financial reports. 8. Newspapers and other journals. International Certificate in Investment Management

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When dealing with data, you must be able to distinguish whether the information relates to an entire population or a sample of a population. Where a population is being considered then every member of a particular group will be included in the analysis. A sample is a subset of the population and is the group that will be examined. It is often the case that populations become so large and cumbersome that using and making inferences from samples is the only viable and cost effective means of analysing the population. The larger this sample is, the more representative it will be of the population. This sample can either be selected randomly from the population, in that each constituent has an equal chance or probability of being included, or non-randomly if it is believed that by intervening in the selection process a more representative sample of the population will be obtained. From hereon we will be concentrating solely on numerical, or quantitative, data. Numerical data can be categorised into that which is continuous, where numbers in a data series can assume any value, or discrete, where the numbers in the data series are restricted to specific values, such as whole numbers.

Data Presentation Raw numerical data can be presented in a wide variety of tabulated and graphical formats to enhance its informational value and ease of interpretation.

Tabulated Data Tabulated numerical data often takes the form of a frequency distribution. A distribution is where the observed numerical values of the subject or variable being considered are arranged in order of their size or value. Take the example of the real annual percentage returns achieved by UK equities over the past 100 years. This data can be presented in ascending order of returns with a frequency of occurrence assigned either to each individual return or to a group of returns. Grouping, or banding, of observed values is typically used when copious amounts of data need to be consolidated so that the information can be conveyed in a more meaningful way. So the data may disclose that a 10.1% return has been achieved on two occasions, a 10.4% return on one occasion and an 11% return on four occasions. Alternatively, a frequency of three could be assigned to a 10.1% to 10.5% band of returns and four to a 10.6% to 11% band, or a frequency of seven to a larger 10.1% to 11% band. The width of the band, or interval, used will necessarily impact on the usefulness of the data and should, therefore, be chosen carefully. By adding these frequencies together in ascending order, a cumulative frequency distribution can be derived. From this, one can deduce what percentage of returns are either equal to or less than a particular return so as to gain an insight to the nature of UK equity returns over time.

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Graphical Data Numerical data presented graphically, or pictorially, can often assist in interpreting the underlying information. This is true of most tabulated data, especially the type of data we have just considered. The more popular forms that graphically presented data can take, include: 1. line and scatter graphs and charts; 2. bar charts; and 3. pie charts. y-axis

Dependent variable

slope of line = b a O

x-axis Independent variable

Figure 1: Regression Analysis Graphical presentation of data is particularly useful for when an apparent cause-and-effect, or causal, relationship between two variables is being illustrated. By causal it is meant that one of the variables is either thought or known to determine the other. The former is known as the independent variable (X) and is plotted on the horizontal, or x-axis, of a graph, whilst the latter, the dependent variable (Y), is scaled on the vertical, or y-axis. For instance, the annual rate of economic growth over the past 100 years could be plotted against our real annual UK equity returns to see if any apparent cause-and-effect relationship exists. In this instance, economic growth would act as the independent variable whilst the equity returns would be the dependent variable, with a series of points scattered between the two axes representing the observed co-movement between the two variables. In order to quantify this apparent association between these two variables, a linear relationship is established through regression analysis. To achieve this, regression analysis employs a concept known as least squares regression, which by drawing on the data calculates the position of a unique straight line that best represents, or best fits, the collective position of all of these points. This it does by calculating how to collectively minimise the square of each of the vertical distances of these points from a single straight line. The resulting line of best fit is underpinned by the following equation: Y = a + bX, where a = the value of Y when X = 0 and b = the rate at which Y increases proportionately with X if a positive relationship exists or decreases if there is a negative relationship, denoted by -bX. You may recall from Chapter 1 that the relationship between planned consumer expenditure and disposable income, as encapsulated within the consumption function, was given by a similar equation: C = a + c(1- t)Y.

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Drawing on the above diagram, a is where this unique straight line cuts the y-axis and b the slope of this line. So if a = 5 and b = 0.8, then if X = 10, Y = 5 + 0.8 (10) = 13. It should be noted, however, that regression analysis by itself does not prove causation. It is perfectly possible that the relationship between the two variables is not causal but has arisen purely by chance. The derivation of the line of best fit is set out in Appendix 1 for those of you who wish to further your understanding of this topic. Arithmetic scale

O

Arithmetic scale

Figure 2:Accelerating rate of increase in dependent variable using arithmetic scale

Log scale 1000

100

10

O

Arithmetic scale

Figure 3: Accelerating rate of increase in dependent variable using semi-log scale

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When plotting data graphically, the scale of the axes used on the graph should be taken into consideration if the data is to convey the right message to the user or be interpreted correctly. For instance, if a logarithmic scale is used on the y-axis but a conventional arithmetic scale is used on the x-axis, a so-called semi-log scale is created. A logarithmic scale is one whereby as you move up the y-axis each successive value increases by a fixed multiple of the previous value. Therefore, a concave relationship between two variables using an arithmetic scale, depicting an accelerating rate of increase in the dependent variable in response to successive increases in the independent variable, would, given a semi-log scale, be transformed into a linear relationship. The range and spacing of the values used on each scale also affects the depicted relationship.

1.3

Measures of Central Tendency and Dispersion

LEARNING OBJECTIVES 2.1.2

Be able to calculate the measures of central tendency: arithmetic mean; geometric mean; median; mode

Dealing mainly with raw numerical data or with ordered numerical distributions, you must be able to make inferences about the data being considered and ideally use it to make predictions about the population. Statistics makes this possible by drawing on what are known as measures of central tendency and measures of dispersion. All of the following calculations can be performed quickly and simply using a Casio fx-83 MS calculator. Measures of central tendency establish a single number or value that is typical of the distribution. That is, the value for which there is a tendency for the other values in the distribution to surround. Measures of dispersion, however, quantify the extent to which these other values within the distribution are spread around, or deviate from, this single number.

Measures of Central Tendency The three most commonly used measures of central tendency are the arithmetic mean, median and mode. 1. Arithmetic mean ( x ).The arithmetic mean is the most common and most familiar of the three measures and for raw data is established by using the following formula: x = Σx/n, where Σx is the sum (Σ) of each of the observed values (x) and n the number of observations, or items. Where data has been collated as a frequency distribution, the mean ( x ) = Σfx/Σf, where f is the frequency with which each value, or item, appears within the distribution. Where raw data has been tabulated into a frequency distribution, n becomes Σf. 2. Median (xm). The median is the mid-point or middle value within an ordered distribution containing an odd number of observed values or the arithmetic mean of the middle two values in an ordered distribution containing an even number of values. So, within a distribution of 50 observed values, the median will be the mean of the 25th and 26th value in this ordered sequence of numbers whereas if the distribution contains 49 values, the median will be the 25th value in the sequence. That is to say, 50% of the distribution’s values lie above this value whilst 50% lie below. This can be summarised by using the following equation:

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x value = (n + 1)/ . Where there is a frequency distribution the median becomes the (Σf + 1)/ m 2 2 value. 3. Mode (xf). The mode is the value or values that occur most frequently in the distribution. That is, more than one value can represent the mode of a distribution. From what we know of these measures of central tendency, several conclusions can be drawn. Firstly, whilst it is possible that both the mean and median may result in a number or value that isn’t contained within the distribution, the mode will always be one or more of the observed values. Secondly, only the mean will be influenced by any extreme values within the distribution as only the mean takes every value into account; the median and mode do not. Real annual percentage investment returns from UK equities over 16 years Type of Distribution Return (% pa) 1 2 3 4 5 Total frequency ( Σf)

Symmetrical Frequency 1 3 8 3 1 16

Negatively Skewed Frequency 1 3 4 6 2 16

Positively Skewed Frequency 2 6 4 3 1 16

The relationship between the mean, median and mode depends on how evenly the values are distributed within the sample or population. Given the hypothetical data above, we can illustrate how the size and position of each of these three measures of central tendency compare given distributions with the same minimum and maximum observed values but with different frequencies assigned to each value within the distribution.

The relationship between the mean, median and mode (using continuous data) Frequency

mean = median = mode

Ascending order of values

Figure 4: Symmetrical Distribution

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Frequency

mean<median<mode

Ascending order of values

Figure 5: Negatively Skewed Distribution Frequency

mode<median<mean

Ascending order of values

Figure 6: Positively Skewed Distribution Where the distribution is symmetrical - that is where the ordered data is normally distributed - the three measures of central tendency will produce the same value, in this example, 3%. Each of these measures is positioned at the peak of this symmetrical, continuous, bell shaped normal curve. Where the data is asymmetrical, or skewed, however, each measure of central tendency will produce a different value. For a negatively skewed distribution, where a larger number of observed values are concentrated towards the higher end of the distribution, the mode, which always pinpoints where a frequency distribution peaks, will be greater than median which will be greater than the mean. International Certificate in Investment Management

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The following calculations show this: 1. Mean ( x ) = Σfx/Σf = [(1 x 1%) + (3 x 2%) + (4 x 3%) + (6 x 4%) + (2 x 5%)]/16 = 3.3%. 2. Median (xm) = (Σf+1)/2 value = (16 + 1)/2 = 8.5th value = (3 + 4)/2 = 3.5%. 3. Mode (xf) = 4%. For a positively skewed distribution, where a greater number of observed values are at the lower end of the distribution, the ordering of the mean, median and mode are reversed: 1. Mean ( x ) = 2.7%. 2. Median (xm) = 2.5%. 3. Mode (xf) = 2%. Although under most circumstances the mean tends to be a more stable measure of central tendency than the median when moving between samples of a population, when distributions are highly skewed with extreme values, such as the distribution of annual investment returns over long time periods, or the distribution of household income, the median often provides a more representative measure of central tendency. This quality is also possessed by the geometric mean. (For instance, if an investment fund lost 60% of its value in year 1 but gained 30% in year 2 and 50% in year 3, its arithmetic mean performance would have been 6.67% even though it had lost 22% of its initial value over the 3 year period).

Geometric mean The geometric mean ( x g) is established by taking the nth root of the product of n values (product simply means multiplication), such that: x g = n√(x1 x x2... x xn) = (x1 x x2... x xn)1/n, where x1 is the first value and xn the nth value.

(x1 x x2 ...x xn) is known as a geometric progression.

Example What is the geometric mean of 1, 3, 5 and 10?

Solution x g = (1 x 3 x 5 x 10)1/4 = 3.49

However, the geometric mean will always result in a number that is less than the arithmetic mean ( x ), considered to be the most representative measure of central tendency in most, though, not all situations:

x = Σx/n = (1 + 3+ 5 + 10)/4 = 4.75

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Despite this shortcoming, geometric progressions and geometric means have a fundamental use in portfolio management. Geometric progressions can be used to establish the compounded value of a variable over time, with the geometric mean then being employed to determine the average compound annual growth rate implied by this cumulative growth. This is covered more fully later in the next section and in Chapter 4 when we look at fixed interest securities.

Measures of Dispersion

LEARNING OBJECTIVES 2.1.3

Be able to calculate the measures of dispersion: variance (sample/population); standard deviation (sample/population); range

The extent to which the observed values within a distribution deviate or are spread around this average value, or central point, can be quantified through the use of dispersion measures. Intuitively we should only be concerned with the dispersion of values that surround the mean and median as the scatter of data around the mode, assuming of course that only one mode exists, provides little, if any, useful information about the distribution. To calculate the degree of dispersion around the mean, the variance or standard deviation of the distribution must be established, whereas for the median, the range, interquartile range, deciles and percentiles are typically determined. Starting with dispersion around the median, as we know, the median represents the mid-point of an ordered distribution of numerical values. So, given the distribution below of 21 discrete values in ascending order, the median is the (21 + 1)/2 = 11th value, 6. 1,1,2,2,3,5,5,5,6,6,6,7,10,10,10,12,14,20,20,20,45 The first of the dispersion measures used with the median is the range. This simply deducts the lowest value in the distribution from the highest value. Therefore, for the above distribution, we arrive at 45 - 1 = 44. However, this number does not provide a great deal of information about the other values that lie within this range unless the numbers are evenly distributed around the median, which in the above example they are not. In fact, the distribution’s highest value severely distorts the informational value of the range. To remedy this, the interquartile range can be employed. The range is divided into four quarters or quartiles; in the same way that the median divides the distribution into two halves. The interquartile range measures dispersion from the top of the first quartile (Q1) to the top of the third quartile (Q3); that is the middle 50% range of values within the distribution. Given this distribution of 21 values placed in ascending order, Q1 will be the ¼ (n + 1) value = ¼ (21 + 1) = 5.5th value = (3 + 5)/2 = 4 and Q3 the ¾ (21 + 1) = 16.5th value = (12 + 14)/2 = 13. The interquartile range then = 13 - 4 = 9. This is a far more representative measure of dispersion than the value of 44 given by the range. When data is presented in a frequency distribution, Q1 would be given by the ¼ (Σf + 1) value and that of Q3 by the ¾ (Σf + 1) value.

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Deciles representing 1/10ths of the distribution and percentiles, 1/100ths are calculated in a similar fashion. Indeed, the 25th percentile of a distribution defines Q1, the median the 50th percentile, whilst the 75th percentile defines Q3. We will see in Chapter 10, how performance measurement statistics are typically categorised into quartiles and often deciles and percentiles. The diagram below summarises each of these measures. Values arranged in ascending order Minimum value

1/ 4

Maximum value

Interquartile range

of values

1/ 4

1/ 4

of values

Q1 = 25th percentile

of values

Q2 = Median = 50th percentile

1/ 4

of values

Q3 = 75th percentile

Range

Figure 7: Measure of Dispersion Around the Median Having considered those measures of dispersion that relate to the median, we now consider the calculation of the variance (σ2) and standard deviation (s) around the arithmetic mean ( x ). As the arithmetic mean takes account of every value within a distribution, unlike the median or mode, the mean can be defined as that value where sum of the differences, or deviations, of the other items in the distribution from this value will equal zero. Given that the mean of the distribution below is 10, confirm to yourself that by subtracting each item from 10, the sum of the negative differences cancel out the sum of the positive differences to produce zero. 1,1,2,2,3,5,5,5,6,6,6,7,10,10,10,12,14,20,20,20,45 The variance draws on this characteristic of the mean as it is defined as the arithmetic mean of the sum of the squared deviations from the mean, whilst the standard deviation is the square root of the variance. 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. All of this will become clear shortly. Several formulae exist to calculate these two measures of dispersion. Which of these is used depends on whether the distribution represents a population or a sample of the population and whether the data is presented as ordered raw data, as above, or as a frequency distribution. When calculating the variance and standard deviation of ordered raw data, the following formulae are employed:

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Population Formulae Variance (σ2) = Σ(x - x )2 n Standard deviation (σ) = √variance =

√(

Σ(x - x )2

n

)

Sample Formulae Variance (σ2) = Σ(x - x )2 (n - 1) Standard deviation (σ) = √variance =

√

(Σ(x - x )2) (n - 1)

Assuming, however, that the distribution data has been tabulated as a frequency distribution, the formulae become:

Population Formulae Variance (σ2) = Σf (x - x )2 Σf Standard deviation (σ) = √variance =

√

(Σf (x - x )2)

√

(Σf (x - x )2)

Σf

Sample Formulae Variance (σ2) = Σf (x - x )2 (Σf - 1) Standard deviation (σ) = √variance =

(Σf - 1)

You will notice several differences between the ordered raw data and frequency distribution data formulae. Firstly, the Σ in the numerator of the raw data equations becomes Σf in the frequency distribution formulae numerators. Secondly, the n in the raw data population denominator and (n 1) in the sample denominator changes to Σf and (Σf - 1) in the frequency distribution denominators, respectively. You may recall that n is the total number of observations within a distribution of ordered raw data whereas Σf is the sum total of frequencies in a frequency distribution. The reason why - 1 appears in the denominator for both sample formulae is because the sample may not be fully representative of the underlying population: the smaller the sample size the less representative the sample is likely to be of the population. By subtracting one from the sum of the number of observations (n) or frequencies (f), the greater the likelihood that the measure of dispersion produced by the sample will be representative of the population. So, the smaller the sample size the larger the variance and standard deviation. However, as the sample size approaches that of the population so this adjustment has a progressively smaller affect on these measures of dispersion.

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Although the variances and standard deviations of both ordered raw and frequency distribution data can be calculated quickly and easily by using the Casio fx-83MS calculator, it is useful to work through their calculation manually. Starting with ordered raw data, the steps you should take in making these calculations manually are as follows: 1. obtain the arithmetic mean; 2. obtain the set of deviations from the mean; 3. square each deviation; 4. divide the sum of the squared deviations by the number of observations to obtain the population variance or by the number of observations minus one to obtain the sample variance; 5. take the square root of the variance in each case to obtain the standard deviation. Using the ordered raw data above and adopting these steps, the variances and standard deviations are obtained as follows: Value (x)

1 1 2 2 3 5 5 5 6 6 6 7 10 10 10 12 14 20 20 20 45 Σx = 210; n = 21 Mean (x) = Σx/n =210/21 = 10

(x – x ) (subtract each value x in column 1 from the mean of 10) -9 -9 -8 -8 -7 -5 -5 -5 -4 -4 -4 -3 0 0 0 2 4 10 10 10 35 Σ(x - x) = 0

(x – x )2 (square each of the (x – x ) differences in column 3 otherwise the minus differences will offset the plus differences) 81 81 64 64 49 25 25 25 16 16 16 9 0 0 0 4 16 100 100 100 1225 Σ(x - x)2 = 2016

Population variance (σ2) = Σ(x - x )2 = 2016 = 96 n 21 Population standard deviation (σ) = √variance = √96 = 9.8 Sample variance (σ2) = Σ(x - x )2 = 2016 = 100.8 n-1 20 Sample standard deviation (s) = √variance = √100.8 = 10.04

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By tabulating this raw data into a frequency distribution, the variance and standard deviation are calculated in a similar fashion as follows: Value (x)

Frequency (f)

fx

1 2 3 5 6 7 10 12 14 20 45 Total

2 2 2 4 1 3 3 15 3 18 1 7 3 30 1 12 1 14 3 60 1 45 Σf = 21 Σfx = 210 Mean (x) = Σfx/Σf =210/21 = 10

(x – x ) (subtract each value x in column 1 from the mean of 10) -9 -8 -7 -5 -4 -3 0 2 4 10 35 -

(x – x )2 (square each of the (x – x ) differences in column 4) 81 64 49 25 16 9 0 4 16 100 1225 -

f(x – x )2 multiply each of the (x – x )2 differences in column 5 by the frequencies in column 2) 162 128 49 75 48 9 0 4 16 300 1225 Σf(x – x)2 = 2106

Population variance (σ2) = Σf (x - x )2 = 2016 = 96 Σf

21

Population standard deviation (σ) = √variance = √96 = 9.8 Sample variance (σ2) = Σf (x - x )2 = 2016 = 100.8 Σf - 1

20

Sample standard deviation (σ) = √variance = √100.8 = 10.04 It should come as no surprise that the solutions for the raw data and frequency distributions are identical as the same data has been used in both cases. So what information do these measures of dispersion convey about the distribution being considered and how can they be used as a predictive tool? Well, as mentioned earlier, both the variance and standard deviation draw on the mean’s characteristic of being that value from which the sum of the differences, or deviations, of all other items in the distribution equal zero. The variance is the average of the sum of the squared deviations from the mean, whilst the standard deviation, as the square root of the variance, represents the average amount by which the values in the distribution deviate from the mean. As most aspects of finance tend to draw on the standard deviation rather than the variance when calculating dispersion from the mean, we will concentrate on the former both as a measure of dispersion and as a way of predicting future values from current and past distributions.

68.26%

-3σ

-2σ

-1σ

+1σ

+2σ

+3σ

95.5% 99.75%

Figure 8: A Normal Distribution International Certificate in Investment Management

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You may recall that where data is normally distributed about the mean, this can be depicted graphically as a symmetrical, continuous, bell shaped normal curve. This normal curve has the following qualities: 1. Approximately 2/3rds (68.26%) of observations, or items, in the distribution will be within one standard deviation either side of the mean, 2. Approximately 95.5% of observations will be within two standard deviations either side of the mean, and 3. Approximately 99.75% of observations will be within three standard deviations either side of the mean. Therefore, if the above distribution represents a normally distributed population of hypothetical real annual equity investment returns with a mean return of 10% and a standard deviation of 9.8%, it can be inferred that about two-thirds of returns over this period have been within 9.8% of the 10% mean return. That is, on about two-thirds of occasions annual real returns have varied between 0.2% and 19.8%. On 95.5% of occasions, they have been between - 9.6% and 29.6% and on 99.75% of occasions between - 19.4% and 39.4%. Notice how the standard deviation adopts the same unit of measurement as the mean. This provides some indication of the riskiness, or volatility, of the hypothetical real returns from equities over this period. However, these findings are based on the assumption that these returns are normally distributed around the mean, which they are not. As the calculation of the mean and standard deviation in this distribution have been skewed, or distorted, by the extreme value of 45% and the three 20% returns, these normal distribution values cannot be rigidly applied to this particular distribution. In fact, this distribution, as with most long run distributions of equity returns, is 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. As inferred earlier, measures of central tendency and dispersion can also be used to predict future values from current and past distributions, again by making the assumption that these returns are normally distributed but also that the past is a carbon copy of the future. This is known as meanvariance analysis. The most likely future outcome or expected return, is given by the mean of these past returns, whilst the risk attached to this expected outcome, is given by the variance or, more usually, by the standard deviation of these returns. So, assuming the distribution used above is a normal distribution, it can be inferred that the most likely future, or expected, return will be the mean of 10% whilst there is approximately a two-thirds probability of the return being between 0.2% and 19.8%. Alternatively, it could be said that in two years out of three, the return is expected to be between 0.2% and 19.8%. Example Based on past observations, security A and security B have the following expected returns attached to the probable economic outlook. Economic Outlook Description Probability Recession 0.2 Trend growth 0.5 Boom 0.3

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Security A rA (return % pa) 20 30 10

Security B rB (return % pa) -20 60 90

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The probabilities are future estimates and the expected returns have been derived from the returns that were achieved in the past. Assuming that these returns represent the population, calculate the expected return for each security and the risk, or standard deviation, associated with that return, and state which is the riskier security if held in isolation. Solution Security A

Scenario 1 Scenario 2 Scenario 3

rA

pA

20 30 10

0.2 0.5 0.3 1.0

Expected return e(rA) (multiply the returns in column 1 by the probability of returns and establish the expected return, or mean, by summing the numbers below) 4 15 3 22

rA –e(rA) (subtract the expected return of 22% from the returns in column 1)

[rA –e(rA)]2 (square the difference in column 4 to ensure the pluses do not offset the minuses)

Variance p[rA –e(rA)]2 (attach the probabilities to the resulting variances of returns)

-2 8 -12

4 64 144

0.8 32 43.2 76

e(rA) (mean) = 22% Standard deviation (σA) = √variance (σA2) = √76 = 8.72% So, based on past observations, security A is expected to: 1. Produce a return of 22%; with 2. A 68% or 2/3rds probability (one standard deviation) of the return being within 22% +/- 8.72%, ie, 13.28% to 30.72%; 3. A 95.5% probability of the return being within 22% +/- (2 x 8.72%), ie, 4.56% to 39.44%; and 4. A 99.75% probability of the range of returns extending from - 4.16% to 48.16%. There remains a 0.25% probability of the return being less than 10% or greater than 52%. Turning to security B: Security B Scenario 1 Scenario 2 Scenario 3

rB - 20 60 90

pB 0.2 0.5 0.3 1.0

e(rB) -4 30 27 53

rB – e(rB) - 73 7 37

[rB – e(rB)]2 5329 49 1369

p[rB – e(rB)]2 1065.8 24.5 410.7 1501.0

e(rB) = 53% σB = √σB2 = √1501 = 38.74%

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e(r) B

A

O σ

Figure 9: Expected Return and Risk So, security B has the higher expected return but also has the greatest risk attached to that return. Once again, however, there are limitations to this analysis: principally that a normal distribution is assumed and that the past is a guide to the future.

1.4

Diversification

LEARNING OBJECTIVES 2.1.4

Understand the correlation between two variables and the interpretation of the data

2.1.5

Understand the covariance between two variables and the interpretation of the data

2.1.6

Understand the use of regression analysis to quantify the relationship between two variables and interpretation of the data

“Money is like muck, not good except it be spread” Francis Bacon The risk of holding securities A and B in isolation is given by their respective standard deviation of returns. However, by combining these two assets in varying proportions to create a two stock portfolio, the portfolio’s standard deviation of return will, in all but a single case, be lower than the weighted average sum of the standard deviations of these two individual securities. The weightings are given by the proportion of the portfolio held in security A and that held in security B, where the weighting of A = (1 - weighting of B). This reduction in risk for a given level of expected return is known as diversification.

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Quantifying Diversification To quantify the diversification potential of combining securities when constructing a portfolio, two concepts are used: 1. Correlation, and 2. Covariance.

Correlation 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. That is, risk reduction is achieved by combining assets whose returns have not moved in perfect step, or are not perfectly positively correlated, with one another. When combined as a portfolio, the risk associated with security A and security B’s individual returns, quantified by their individual standard deviations, is secondary to the correlation of their individual returns. Just because two shares have high individual standard deviations doesn’t necessarily mean that when combined they will create a similarly risky portfolio. In fact, the lower the correlation of these returns, the greater the portfolio’s diversification and the lower the level of total risk associated with any given level of expected return.

The Correlation Coefficient The correlation coefficient (ρ) is calculated in much the same way as a regression between two variables when employing regression analysis. In quantifying the degree of correlation between individual security returns, r varies between -1 where there is a perfectly negative correlation between returns from two securities and +1 for a perfectly positive correlation. 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. Where there is no predictable common movement between security returns, there is said to be zero or imperfect correlation. Although the correlation coefficient given this scenario is zero, there are still diversification benefits from combining securities that give this result. 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 correlation, as with the results of regression analysis, does not prove that a cause-and-effect or, indeed, that a steady relationship exists between two variables. Correlations can arise from pure chance.

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ns of retur n io t la e r sing cor B Decrea

e(rAB) e(rB)

e(rAB1)

ρ AB

=-1

ρ AB

e(rA)

O

=0

ρ AB

=+1

A

σAB1 σA

σB

σAB

Figure 10: Correlation The above diagram shows how the combined risk and expected return of holding securities A and B in differing proportions varies according to the correlation of their returns. For instance, if rAB = 0, then both a higher expected return and lower total risk could be achieved by holding a portfolio comprising mostly security A with a small holding in security B, than by holding this same total amount in security A alone. In practice, however, as a result of correlations being dynamic and the possibility that the correlation may have resulted by chance, past correlation coefficients of investment returns are rarely a perfect guide to the future. The covariance The covariance (cov) also quantifies the extent to which the returns from securities A and B have varied with each other and is given by the equation: CovAB = ρAB x σA x σB Assuming the returns from securities A and B (considered in Section 1.3 above) are mildly negatively correlated with ρAB = -0.225, then: CovAB = -0.225 x 8.72 x 38.74 = -76 A positive covariance between the returns of A and B means they have moved in the same direction whilst a negative covariance means they have moved inversely. The larger the covariance the greater the historic joint movements of the two securities in the same direction. The covariance of 76 is relatively low and, therefore, indicates that a portfolio containing the two securities would be relatively well diversified; that is, there is a fair chance that if security A does badly, security B should do well.

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From the equation: CovAB = ρAB x σA x σB it can be seen that: ρ

AB = CovAB σA x σB

From these two equations, the following conclusions can be drawn: 1. Although it is perfectly possible for two combinations of two different securities to have the same correlation coefficient as one another, each may have a different covariance, owing to the differences in the individual standard deviations of the constituent securities. 2. A security with a high standard deviation in isolation does not necessarily have a high covariance with other shares. If it has a low correlation with the other shares in a portfolio then, despite its high standard deviation, its inclusion in the portfolio may reduce overall portfolio risk. 3. Portfolios designed to minimise risk should contain securities as negatively correlated with each other as possible and with low standard deviations to minimise the covariance. The covariance can be established without knowing the correlation coefficient. We know that the covariance establishes the extent to which security returns move in tandem under different scenarios. Formally put, the covariance between the returns of two securities is the summed average, or expected value, of the product of each security’s deviation of returns from its expected return under different scenarios. In other words, if one security’s return at one point in time differs from its expected return, what is likely to happen to the return of the other security relative to its expected return at that same point in time? With reference to the tables which established security A’s and security B’s expected returns and standard deviations, take each row of the ρA column for security A, multiply by the same row of the rA - e(rA) column for security A, multiply this by the same for security B and then sum these products. The covariance of the returns between security A and security B is, therefore: CovAB = Σ{ρscenario n x [rA - e(rA)] x [rB - e(rB)]} CovAB = 0.2(-2 x -73) + 0.5(8 x 7) + 0.3(-12 x 37) CovAB = -76 You will notice that by applying the formula ρAB = CovAB / σA x σB that ρ

AB =

-76 8.72 x 38.74

= -0.225

Where the observed returns are given rather than the probabilities of occurrence, the covariance formula becomes: CovAB = Σ{[rA-e(rA)][rB-e(rB)]} n

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A more detailed examination of how the correlation and covariance between two variables is calculated is set out in Appendix 1 for those of you who wish to further your understanding of these concepts.

2. FINANCIAL MATHEMATICS 2.1

Introduction

Money has a time value. That is, money deposited today will attract a rate of interest over the term it is invested. So, £100 invested today at an annual rate of interest of 5% becomes £105 in one year’s time. The addition of this interest to the original sum invested acts as compensation to the depositor for forgoing £100 of consumption, for one year. The time value of money can also be illustrated by expressing the value of a sum receivable in the future in terms of its value today, again by taking account of the prevailing rate of interest. This is known as the sum’s present value. So, £100 receivable in one year’s time, given an interest rate of 5%, will be worth £100/1.05 = £95.24 today in present value terms. This process of establishing present values is known as discounting; the interest rate in the calculation acting as the discount rate. Discounting can also be used to establish what sum needs to be invested today to realise a target final sum on a pre-specified future date, given a known interest rate. So, £95.24 invested today at 5% for one year will result in a future value of £95.24 x 1.05 = £100. We will come back to each of these calculations throughout this section.

2.2

Simple and compound interest

LEARNING OBJECTIVES 2.2.2

Be able to calculate the future value of lump sums and regular payments

Interest, whether payable or receivable, can be calculated on either a simple or compound basis. Whereas simple interest is calculated only on the original capital sum, compound interest is calculated on the original capital sum plus accumulated interest to date. Simple interest Simple Interest = Principal x Rate x Time or I = p x r x t where: I = simple interest which is the total amount of interest paid p = initial sum invested or borrowed (also called the principal). r = rate of interest to be expressed as a decimal fraction ie, 12% use 0.12 in the calculation t = number of years. Example One: If £200 is invested at a rate of 7% for two years, the simple interest calculation is: I = £200 x 0.07 x 2 = £28.00.

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Example Two: If £300 is invested at a rate of 5% for 60 days, the simple interest calculation is: I = £300 x 0.05 x 60/365 = £2.47 (rounded to two decimal places). Leap years are handled according to a number of different conventions. In general, the UK and Japan use a 365 day interest year (even in a leap year). Some European countries and the USA use a 360 day interest year. For the purposes of this course, leap years will be ignored and a 365 day year will be assumed. To calculate the future value (FV) of a lump sum invested at a rate of interest (r) applied on a simple interest basis over a defined number of years (t), the following formula should be used: FV = initial sum invested x [1 + (r x t)] = p + p x r x t So, if £100 is invested at a 5% simple rate of interest over two years, the future value of this sum will be: FV = £100 x [1 + (0.05 x 2)] = £100 x 1.10 = £110.00

Compound Interest Albert Einstein is quoted as saying “the most powerful force in the universe is compound interest.” When money is invested it earns interest. As long as this interest is not withdrawn, compound interest will be paid on the original investment and past interest earned. The longer and more frequent the period of compounding, the greater the growth in interest payments. Note that annual compounding is the most common period used. FV = p x (1+r/n)nt FV =future value of the initial investment (p) p = initial sum invested or borrowed (also called the principal). r = rate of interest to be expressed as a decimal fraction ie, 12% use 0.12 in the calculation. n = number of compounding periods per year. t = number of years. Example One: If £100 is invested at 5% over two years with annual compounding, the future value is: FV = £100 x (1.05)2 = £110.25 That is, at the end of year one the £100 becomes £100 x 1.05 = £105. 1.05 is then applied to £105 to become £105 x 1.05 = £110.25 at the end of year two. To raise a number to the power of n, you need to use the ^ key on your calculator. In establishing the terminal, or future, value of this £100 then, a geometric progression has been employed. Example Two: If £2,000 is invested at 5% over two years with interest reinvested each month, the future value at the end of the two year period is: FV = £2,000 x ( 1 + 0.05 / 12 ) 12 x 2 = £2,000 x ( 1.004167 ) 24 =£2,209.88

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Example Three: If £2,000 is invested at 5% over two years with interest reinvested each month, the future value at the end of the two year period is: FV = £2,000 x (1 + 0.05 / 12 )12 x 2 = £2,000 x (1.004167)24 = £2,209.88 For the remainder of this chapter, we will focus on the use of compound interest.

2.3

Annualised compound returns

LEARNING OBJECTIVES 2.2.1

Be able to calculate the present value of lump sums and regular payments, annuities and perpetuities

2.2.2

Be able to calculate the future value of lump sums and regular payments

If you have already established what final amount is to be received from investing a lump sum over a defined period, or have a target final sum in mind, and wish to calculate the compound annual rate of growth achieved or required over the term of the investment, then this can be derived in one of three ways: 1. Annualised return = [n√(final sum/amount invested) - 1] x 100, or 2. Annualised return = [(final sum/amount invested)1/n - 1)] x 100, or 3. Annualised return = ([1 + (growth/amount invested)]1/n - 1) x 100 1/n is simply another way of calculating n√, the nth root of a number. To find the nth root of a value or to raise a number to the power of 1/n, you should use the ^ key on your calculator, placing (1 n) after ^. You may recall from earlier that the resulting number is the geometric mean. Example If £5,000 invested over 10 years with interest payable annually on a compound basis grows to £10,000, what is the compound annual rate of return? Annualised return = [(final sum/amount invested)1/n - 1] x 100 Annualised return = [(10,000/5,000)1/10 - 1] x 100 Annualised return = [(10,000/5,000)0.1 - 1] x 100 = 7.177% To check this answer, simply apply this compound annual rate to £5,000 over 10 years using the formula: FVn = initial sum invested x (1 + r)n FV10 = £5,000 x (1.07177)10 = £10,000

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As noted earlier in the chapter, you should use the geometric mean rather than the arithmetic mean when calculating the annual compound rate of growth of an investment over a period of time. For example, if £100 grows at the end of the year to £110 and then falls back to £100 at the end of year 2, despite a zero rate of growth, the arithmetic mean = 10% - 9.1% = 0.45% per annum. 2 The following example applies what has been covered so far. Example £4,500 was invested at a variable interest rate compounded annually. In years one and two the investment attracted a rate of interest of 5% per annum, in year three, 6% and in year four, 3%. Calculate: i. The value of the investment as at the end of year four, and ii. The compound annualised return. Solution i. FV4 = £4,500 x (1.05)2 x (1.06) x (1.03) = £5,417 ii. Compound annualised return = [(5,417/4,500)1/4 - 1] x 100 = [(5,417/4,500)0.25 - 1] x 100 = 4.75%

To check the answer, use the future value formula: FV4 = £4,500 x 1.04754 = £5,417

Effective Interest Rates Deposit interest rates, rather than being compounded annually, are often compounded on either a monthly, quarterly or semi-annual basis. However, two rates are usually quoted by deposit taking institutions. These are a flat rate, or annual rate of interest, and an effective rate, also known as an annual equivalent rate (AER). The effective annual rate of interest = [(1 + r/f)f - 1] where r = flat rate of interest and f = frequency of compounding during the year. The greater the frequency with which interest is compounded during the year, the higher the effective interest rate. Example If the quoted flat rate is 10% per annum, what is the effective annual interest rate if interest is compounded: i. Monthly ii. Quarterly

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Solution i. The effective annual rate of interest = [(1 + r/f)f - 1] = [(1 + 0.1/12)12 - 1] = 10.47% ii. The effective annual rate of interest = [(1 + 0.1/4)4 - 1] = 10.38% Example A three month Treasury Bill has a new issue price of £98.40 per £100 nominal. In three months time, the bill will be redeemed at £100. Calculate the effective annual rate of return if the bill is purchased at issue and held to redemption.

Solution Gain to redemption = redemption value - issue price Gain to redemption = £100 - £98.40 = £1.60 Effective annual gain = £1.60 x 4 = £6.40 Flat annual interest rate = £6.40/£98.40 = 6.5% Effective annual rate of interest = [(1 + r/f)f - 1] = [(1 + 0.065/4)4 - 1] = 6.66% Alternatively, you could use the formula: Annual rate of return = [1 + (quarterly gain/amount invested)]f - 1) Annual rate of return = [1 + (1.60/98.40)]4 - 1) = 6.66% To establish the future value of an invested lump sum where interest is compounded more frequently than once per annum, the following formula should be applied: FVn = initial sum invested x [(1 + r/f)f x n] Example £1,000 is invested for two years at a quoted flat rate of 10% per annum. Calculate the future value of this sum if interest is compounded: i. Monthly ii. Quarterly Solution i. FVn = initial sum invested x [(1 + r/f)f x n] So, FV2 = £1,000 x [(1 + 0.1/12)12 x 2] = £1,220.39 ii. FV2 = £1,000 x [(1 + 0.1/4)4 x 2] = £1,218.40

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Applying Compound Interest to Regular Payments So far we have concentrated on establishing the final value of invested lump sums when compound interest is applied. We now move on to looking at how final values are established when a series of equal payments are invested either at the start or the end of each year. The former payments are known as being made in advance whilst the latter are termed as being made in arrears.

If investing at the start of each year, then

[

]

FVn = regular payment x { (1 + r)n+1 - 1 - 1} r

Example £100 is invested at the start of each year for five years at a fixed rate of interest of 6% per annum compounded annually. What will the accumulated value of these series of payments be at the end of the five year period? Solution

[

]

FV5 = £100 x { 1.066 - 1 - 1} = £597.53. To check this answer: 0.06

[

]

If investing at the end of each year, then FVn = regular payment x (1 + r)n - 1 r

Example £100 is invested at the end of each year for five years at a fixed rate of interest of 6% per annum compounded annually. What will the accumulated value of these series of payments be at the end of the five year period? Solution

[

]

FV5 = £100 x 1.065 - 1 = £563.71 0.06

Note The difference between this final sum and that above where each payment had been made at the start of the year = £597.53 - £563.71 = £33.82. This difference is solely accounted for by one earlier payment being invested over the entire five year period, ie, (£100 x 1.065)- £100 = £33.82.

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2.4

Discounting

LEARNING OBJECTIVES 2.2.1

Be able to calculate the present value of lump sums and regular payments, annuities and perpetuities

2.2.4

Understand the importance of selecting an appropriate discount rate for discounting cash flows

As stated in the introduction to this section, the value today, or the present value of a lump sum due to be received on a specified future date can be established by discounting this amount by the prevailing rate of interest. Assuming compound interest, the present value formula = 1/(1 + r)n or (1 + r)-n where r is the discount rate and n is the number years into the future when the lump sum is due to be received. The discount rate is usually based on the prevailing risk free rate of interest though an adjustment is typically made for the risk associated with the investment. This is known as the risk premium. We come back to this later in the chapter. What we will be considering from hereon are collectively known as discounted cash flow (DCF) techniques. So referring back to our original example, £100 receivable in 1 year’s time, given a prevailing rate of interest of 5% would have a present value of: £100 x 1/(1 + r)n = £100 x 1/1.05 = £100 x 0.9524 = £95.24 This 0.9524 is known as the discount factor. If £100 was due to be received in two years time, then the present value of this sum would be: £100 x 1/1.052 = £100 x 0.907 = £90.70 whilst if received in three year’s time, the present value would equal: £100 x 1/1.053 = £100 x 0.8638 = £86.38 Discounting can also be used to calculate the lump sum that needs to be invested today to accumulate a target final lump sum at a certain time in the future, given a known interest rate. Example How much would you need to invest today to accumulate £5,340 in five years time if the compound rate of interest is fixed at 5.5% per annum for the five year term? Solution The present value of a future lump sum = 1/(1 + r)n

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So, the present value of £5,340 = £5,340 x 1/(1 + 0.055)5 = £4,085.82. Therefore, £4,085.82 should be invested today at 5.5% per annum compound if £5,340 is to be realised in five years time. The future value formula confirms this: FV5 = initial sum invested x (1 + r)5 = £4,085 x 1.0555 = £5,340

Taking this one stage further, present value formulae can also be used to establish the value today of receiving a series of future regular payments, from an annuity for example. From what we have just covered, we know that if £100 was received at the end of years one, two and three given a 5% rate of interest, then the collective present value of these series of sums would be £272.32. The derivation of this sum is shown in the table below. Year 1 2 3 Total

Cash flow (£) 100 100 100

Discount factor @ 5% 0.9524 0.9070 0.8638 2.7232

Present value (£) 95.24 90.70 86.38 272.32

However, this same answer could have been arrived at without having to establish the present value of each cash flow, but by adopting another formula. As with compounding, the formula used depends upon whether the amounts are received at the beginning or at the end of each year. For payments received in arrears, ie, at the end of each year as above, the formula is:

[

]

Present value of future paymentsarrears = annuity x 1- (1 + r)-n or r

= annuity x 1/r [1- 1/(1 + r)n]

Remember (1 + r)-n is simply 1/(1 + r)n So, the present value of the above amounts received in arrears: = £100 x 1/0.05 [1- 1/1.053] = £100 x 2.7232 = £272.32 2.7232 is known as the annuity discount factor.

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For payments received in advance, ie, at the beginning of each year, the formula is: Present value of future paymentsadvance = annuity x {1 + [1- (1 + r)-(n -1)]} or r

= annuity x {1 + (1/r [1- 1/(1 + r)(n -1)])}

So, for the above example, the present value of these amounts received in advance would be: Annuity x {1 + (1/r [1- 1/(1 + r)(n -1)])} = £100 x {1 + (1/0.05 [1- 1/1.052])} = £100 x 2.8594 = £285.94 The difference between these two present values of £285.94 and £272.32, ie, £13.62, is accounted for by the first payment of £100 in the latter example being received at the beginning of the year, ie, today, and, therefore, not requiring discounting, and the final payment of £100 received in the former example being discounted to £86.38. The discounted values of £95.24 and £90.70 are common to both calculations. You will have noticed that as present value formulae express future cash flows in today’s terms, the comparison of competing investments of equal risk with the same start date but with different future cash flow timings and/or amounts is made possible. These formulae can also be used to calculate the sum to be invested today to provide for a level annuity. That is, a series of future equal payments to be received either at the start or end of each year for a set period assuming that the fund, from which these are paid, will attract a fixed rate of interest on its outstanding amount and be run down to zero by the end of the period. Example How much needs to be invested today to provide a level annuity that pays £400 at the end of each of the next five years given a compound interest rate of 6% per annum, assuming that the annuity fund is run down to zero at the end of the five year period? Solution Present value of future payments = annuity x 1/r [1- 1/(1 + r)n]

So, present value of future payments = £400 x 1/0.06 [1- 1/(1.06)5] = £400 x 4.2124 = £1,684.96 So, if £1684.95 was invested at the beginning of the five year period at a fixed rate of interest of 6% per annum with payments of £400 being made from this sum plus accumulated interest at the end of each of the next five years, the fund would be run down to zero. The table below confirms this.

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Sum @ start of year (£) 1684.96 1386.05 1069.21 733.36 377.36

Apply interest @ 6% (ie, x 1.06) (£) 1786.05 1469.21 1133.36 777.36 400.00

Annuity (£)

Sum @ end of year (£) 1386.05 1069.21 733.36 377.36 -

(400) (400) (400) (400) (400)

However, what if the payments from the annuity were not due to be received at the end of years one and two but from the end of year three? This being the case you would need to make the following calculations using the data from the above example: Period Years 1- 5

Discount factor calculation 1

Years 1 - 2

1

1

/0.06 [1- /(1.06) 5]

Discount factor @ 6% 4.2124

1

(1.8334)

/0.06 [1- /(1.06) 2]

2.379

By deducting the two year annuity discount factor from the five year annuity discount factor and applying the resulting factor of 2.379 to £400, the present value of these three remaining payments becomes £951.60. Alternatively, it could be said that £951.60 is the amount that needs to be invested today to provide this annuity. This is confirmed in the table below. Start of year 1 2 3 4 5

Sum @ start of year (£) 951.60 1008.70 1069.22 733.37 377.37

Apply interest @ 6% (£) 1008.70 1069.22 1133.37 773.37 400.00

Annuity (£) (400) (400) (400)

Sum @ end of year 1008.70 1069.22 733.37 377.37 -

Perpetuities If a series of equal payments are to be paid or received indefinitely (or in practice beyond 50 years) at the end of each year, starting in one year’s time, then the present value of this series of cash flows is given by the formula: annuity x 1/r Example If £1,000 per annum is to be received at the end of each year in perpetuity, given a compound rate of interest of 5%, what is the present value of these cash flows? £1,000 x 1/0.05 = £20,000 However, if this series of £1,000 cash flows were to be received at the start of each year, then the formula would change to: annuity + (annuity x 1/r) = £1,000 + (£1,000 x 1/0.05) = £21,000. International Certificate in Investment Management

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2.5

Calculating Real Returns

Depositing a sum of money at an 8% rate of interest is more attractive when inflation is running at 2% than at 4%. As a lower rate of inflation has a lesser impact on the nominal rate of return than a higher rate, a higher real, or inflation-adjusted, return results. The real return is given by: Real return = {[(1 + nominal return)n/(1 + inflation rate)n] - 1} x 100 To establish the compound annual real rate of return, having arrived at the total real return, the following formula is applied: Compound annual real return = [(1 + real return)1/n - 1] x 100 Example If a lump sum was invested for two years at 8.2% applied on a compound basis when the inflation rate in year one was 2% and in year two, 4%, what would the compound annual real rate of return be? Solution Real return = {[(1 + nominal return)n/(1 + inflation rate)n] - 1} x 100 So, [1.0822/(1.02 x 1.04)] - 1 = 10.36% (versus the nominal return of 1.0822 = 17.07%) Compound annual real rate of return = [(1 + real return)1/n - 1] x 100 = [1.10361/2 - 1] x 100 = [1.10360.5 - 1] x 100 = 5.05% Example If an investor’s portfolio has grown from £50,000 to £77,000 in five years, over which time inflation has averaged 2%, what is the real compound annual growth rate? Solution Annualised return = [(final sum/amount invested)1/n - 1)] x 100 = [(77,000/50,000)0.2 - 1)] x 100 = 9.02%

Real annual return = [(1.0902/1.02) - 1] x 100 = 6.88%

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2.6 Investment Project Appraisal LEARNING OBJECTIVES 2.2.3

Be able to calculate simple and compound interest, discounted cash flows (DCFs), net present values (NPV), internal rates of return (IRR) and interpret the data

2.2.4

Understand the importance of selecting an appropriate discount rate for discounting cash flows

Discounted cash flow (DCF) techniques can be used as means to appraise the undertaking of business investment projects, such as whether a company should expand by acquiring additional capacity. Often faced with a number of alternative courses of action, company management must decide which of these alternatives will maximise profit or some other corporate objective. Obviously, it is imperative that the correct course of action is taken as once an investment is made, the success of the business will inevitably be dependent upon on the profitable utilisation of the assets purchased and the cash flows they generate. DCF techniques, by discounting a project’s expected cash outflows, principally the initial investment made, and comparing these to the present value of the expected cash inflows, or revenues, derive what is known as the project’s net present value (NPV). Only if the NPV is positive should the project be undertaken or at least considered, as a positive NPV shows that the project is expected to generate a surplus in present value terms having taken account of the amounts invested and all costs associated with the project. Example X plc is considering undertaking Project Y. Project Y requires an initial outlay of £5.5m at the start of year one but is expected to generate annual revenues of £1.25m at the end of years one to eight. If the discount rate is 15.5%, should the project be considered for implementation? Solution Period Start year 1 End of years 1 – 8 NPV

Cash flow (£000) (5500) 1250

Discount factor 1 1 1 /0.155 [1- /1.155 8] = 4.4145

Discounted cash flow (£000) (5500) 5518 18

As the project has a positive NPV, albeit marginal when compared to the initial outlay of £18,000, it should be considered for implementation. However, when establishing the NPV of a project it is essential that the correct discount rate is used.

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The Weighted Average Cost of Capital (WACC) The rate of interest, or discount rate, used to establish the NPV of a project’s anticipated cash flows must be chosen with great care. Use too high a discount rate and what could have been a profitable project with a positive NPV may end up being rejected, use too low an interest rate and an ultimately unprofitable project may result. Despite the UK having experienced a low inflation and interest rate environment for nearly a decade, many companies still persist in using too high a discount rate to appraise projects to the detriment of their own operations and the wider economy. The relationship between NPV and the discount rate is depicted in the diagram below. Net present value

+NPV

O

Discount rate

-NPV

Figure 11: NPV and the discount rate

When undertaking a project assumed to be of an equivalent risk to its existing operations, a company will typically employ its WACC as the discount rate. WACC can be defined as the average cost of servicing a company’s long term sources of finance. These long term sources comprise a company’s equity capital, or ordinary shares, and loan capital or debt. To arrive at a company’s WACC, the cost of these two sources of finance are individually calculated and then combined, each source being accorded a weight in the WACC calculation, based on their respective market values as a proportion of their combined market value. WACC = (cost of equity x market value of equity) + (cost of debt x market value of debt) market value of equity and debt

market value of equity and debt

The cost of equity finance is calculated as the opportunity cost of investing in a company’s equity rather than a risk-free asset, such as a government security. For this calculation, we use what is known as the Capital Asset Pricing Model (CAPM) formula. CAPM is examined in more detail in Chapter 9. The cost of equity = Rf + βi [E(Rm) - Rf] where: Rf is the risk-free return

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[E(Rm) - Rf] is the additional return expected from holding risky equities rather than a risk-free asset, commonly known as the ex ante equity risk premium (ERP) βi is the specific risk of investing in this particular company. βi is known as the company’s beta.

The cost of debt is given by: rate of interest paid on debt × (1 - corporation tax rate) × 100 As debt interest payments are eligible for corporation tax relief, the interest rate is adjusted by (1 corporation tax rate). An example should bring all of the above together. Example The long term capital structure of X plc is as follows: Capital Structure 100,000 ordinary shares £100,000 nominal 12% loan stock Total

Market value (£000) 1,400 100 1,500

The risk-free rate of return (Rf) is 6%, the equity risk premium is 5% and the company’s beta is 2. X plc’s post-tax cost of debt finance is 8.4%. Calculate X plc’s WACC. Solution Cost of equity = 0.06 + 2[0.05] = 16% X plc’s WACC =

{[

] [

0.16 x 1400 + 0.084 x 100 1500

1500

]}

x 100 = 15.5%

Therefore, 15.5% is the discount rate that should be applied by X plc when appraising investment projects assuming they are of equivalent risk to those currently undertaken. The importance of knowing a company’s WACC is further considered in Chapter 7 when looking at shareholder valuation models.

The Internal Rate of Return (IRR) We saw that by applying a discount rate of 15.5% to project Y’s anticipated cash flows, the result was a positive NPV of £18,000. This implies that the project should return in excess of 15.5% over the term of the project if the cashflow estimates prove correct. However, the cashflows associated with any prospective project are just estimates and the cost of capital used may not always accurately reflect the riskiness of the project. Therefore, it is useful to establish what the breakeven rate of return is, or that discount rate which implies an NPV of zero. This rate of return is called the internal rate of return (IRR) or DCF yield.

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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, by assuming a linear relationship between discount rates and the resultant NPVs, 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, by employing the following formula: Approximate IRR = [r1 + {[+NPV/+NPV - (-NPV)] x (r2 - r1)}] x 100

where r1 is the lower discount rate that produces a positive NPV and r2 the higher discount rate that results in the negative NPV. Net present value

IRR

+NPV

Discount rate

O

true relationship

-NPV relationship assumed by interpolation

Figure 12: NPV and the IRR

However, as this formula treats the relationship between the discount rate and NPV as linear rather than as the convex relationship depicted earlier, its accuracy is reliant upon the two discount rates used being as close together as possible to minimise the deviation between the approximated and true IRR. Relating this back to Project Y, if a discount rate of 16% is applied to the project’s anticipated cash flows then this should, given the marginally positive NPV associated with a 15.5% discount rate, result in a negative NPV. The table below demonstrates this. Period Start year 1 Years 1 – 8 NPV

84

Cash flow (£000) (5500) 1250

Discount factor 1 1

1

/0.16 [1- /1.16 8] = 4.3436

Discounted cash flow (£000) (5500) 5430 (70)

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By interpolating between these two discount rates we can establish the approximate IRR: [r1 + {[+NPV/+NPV - (-NPV)] x (r2 - r1)}] x 100 = [0.155 + {[18/(18 + 70)] x (0.16 - 0.155)}] x 100 = 15.6% As this IRR is greater than X Ltd’s WACC, X Ltd will consider accepting the project. This is consistent with the positive NPV we derived from using a 15.5% discount rate. Applying a 15.6% discount rate to the above cash flows should produce an NPV close to zero. Period Start year 1 Years 1 – 8

Cash flow (£000) (5500) 1250

NPV

Discount factor 1 1

1

/0.156 [1- /1.156 8] = 4.4002

Discounted cash flow (£000) (5500) 5500 0

NPV versus IRR Competing projects are usually ranked in ascending order of their respective NPVs rather than the size of their IRRs. Although a positive NPV will always result in an IRR greater than the discount rate used to discount the project’s cash flows, NPV provides a superior means of ranking projects owing to a limiting assumption made within the IRR calculation. Rather than treating funds generated in excess of the breakeven point as being reinvested at the discount rate, it assumes they are reinvested at the IRR. Conceptually this is incorrect. (This is revisited in Chapter 4 when considering the calculation of bond yields.) Therefore, IRR should only be used as a way of establishing the breakeven rate of return for investment projects. Multiple IRRs will also exist for projects whose cash flows change direction more than once.

Further Considerations When Using DCF Techniques 1. Forecasting errors. The initial investment and any subsequent costs and/or the anticipated revenues may be incorrectly forecast. 2. Government policy. Government policy has been ignored in the above analysis. However, a change in tax policies and/or legislation may impact the project either positively or negatively. 3. Inflation. Inflation has also been ignored. However, if expected inflation is incorporated into the analysis then the project’s cash flows must be expressed in current prices, or in real terms, if they are to be discounted by a real, or inflation-adjusted, discount rate. 4. Assessing the risk of the project. Depending on its exact nature, acceptance of a project can increase or, indeed, reduce the risk attached to a company’s existing operations. This must be taken into account when choosing the discount rate.

Concluding comments At the beginning of this chapter, it was emphasised that becoming familiar with information sources and being able to assimilate and interpret data, particularly numerical data, is imperative if informed investment decisions are to be made and investment opportunities are to be capitalised upon. This chapter, having considered a wide range of statistical and mathematic methods and techniques in some detail, provides the basis for those sections within Chapters 4, 7, 9 and 10 where the risks and rewards, valuation and performance of securities and portfolios are assessed. International Certificate in Investment Management

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REGULATION

1. 2.

3

CORPORATE GOVERNANCE OVERSEAS REGULATORS

89 93

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1. CORPORATE GOVERNANCE LEARNING OBJECTIVES 1.1 Corporate Governance 3.1.1

know the origins and nature of Corporate Governance

3.1.2

know the Corporate Governance mechanisms available to stakeholders to exercise their rights

3.1.3

understand the role of auditors and non-executive directors

3.1.4

know the implications of the Sarbanes-Oxley Act and its main provisions

3.2.2

know the impact of high profile failures on the various markets, participants and regulation of them

A company is a separate legal entity distinct from its shareholder owners. As the day-to-day running of a company, rather than being in the hands of the company’s shareholders, is the responsibility of the company’s executive directors, appointed by the shareholders, there is also a separation of ownership and control. The executive directors, or Board, are ultimately accountable to the company’s shareholders for their actions in carrying out their stewardship function. Therefore, a mechanism is needed to ensure that companies are run in the best long term interests of their shareholders. This mechanism is known as corporate governance. Corporate governance is concerned with the creation of shareholder value through the transparent disclosure of a company’s activities to its shareholders, director accountability and two-way communication between the Board and the company’s shareholders.

The legal duties of directors 1. Fiduciary duties: Directors must act in good faith and in the interests of the company as a whole. For instance, directors must give equal consideration to all shareholders, they must not use their position to make private profits at the company's expense and substantial deals with the company must be approved by shareholders at a general meeting. 2. Statutory duties: Directors are personally responsible for ensuring that the company complies with company law. Directors also have to comply with other laws. For example, they must comply with employment law in dealing with employees and take reasonable care to ensure the health and safety of employees. Directors can be held personally liable for losses resulting from acts or omissions, eg, the committing of illegal acts, and can be held jointly and severally liable for the consequences of acting collectively in breach of their responsibilities. Directors may also be disqualified from acting in the capacity of a director and some actions could result in criminal convictions. Directors will also be required to: • act within their powers; • exercise independent judgement; • exercise reasonable care, skill and diligence; • avoid conflicts of interest; • not accept benefits from third parties; and • declare an interest in a proposed transaction with the company. International Certificate in Investment Management

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The Code of Best Practice Following the collapse of a number of leading companies, as a result of corporate mismanagement in the late 1980s, a committee chaired by Sir Adrian Cadbury issued a report and the Cadbury Code in 1992. The main recommendations of the Cadbury report emphasised the need to ensure a balance of power and division of responsibility between the chairman and chief executive at executive Board level and the appointment of non-executive directors (NEDs) to provide an independent check on the conduct and remuneration of the executive directors and to act as advisors to the Board. Most NEDs have a background in business and/or politics. Quite uniquely, corporate Boards in the UK assume a single tier structure in that no statutory distinction is made between executive and non-executive directors, though the latter have no day-to-day management responsibility. Whilst the executive company chairman assumes responsibility for running the Board, it is the chief executive that is ultimately responsible for the company’s day-to-day operations. The Greenbury Report soon followed the Cadbury report, in 1995, with recommendations on the structure and disclosure of executive director remuneration, whilst the Hampel Committee, reporting a year later, continued the work of Cadbury but with a broader remit. In 1998, the Committee on Corporate Governance drew on the findings of these three committees publishing the Combined Code on Corporate Governance, which has since became known as the Combined Code or the Code of Best Practice. The main provisions of the Combined Code, which are embodied within the Financial Services Authority’s (FSA) listing requirements applying to all public limited companies (plcs) quoted on the London Stock Exchange (LSE), are: 1. There must be a clear separation of the roles and division of responsibility between the chairman and chief executive and a balance between the number of executive and NEDs to ensure a democratic decision making process. 2. Director remuneration should be partly linked to the company’s and the director’s performance, should not be set by the director themselves and should not be excessive in the circumstances. 3. Directors should actively enter into two-way communication with shareholders. 4. Shareholders should be presented with a realistic assessment of the company’s financial position and future prospects and be informed of the company’s system of internal controls. Following the loss of investor and public confidence arising from a number of corporate governance abuses, the near failure of Equitable Life and Marconi plc in the UK and the Enron debacle in the US, the role of the NED has come under closer scrutiny as have the number of non-executive directorships held simultaneously by individuals, given the apparent failings of each company’s NEDs in these dramatic cases. Other high-profile examples of poor corporate governance include: 1. National Australia Bank: In 2004, the bank was involved in a $360 million AUD currency trading scandal due to management failing to supervise and monitor their employees correctly. 2. In 1995, Britain’s Barings Bank collapsed due to the failure of management to monitor staff, in particular Nick Leeson, in their derivatives trading activities in Singapore. One of the most remarkable facts was that Leeson at one point sold options worth approximately $7 billion USD without anyone in the London office questioning the trade. Consequently, in May 2002 the UK government appointed former investment banker, Derek Higgs, to report on the independence, responsibilities and effectiveness of NEDs and how their role may be strengthened.

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The Higgs Report, published in January 2003, recommends a strengthening of corporate governance in UK company boardrooms. This it does through several key recommendations: • NEDs should be drawn from a wider pool of talent than is currently the case. • To ensure that NEDs are truly independent of the executive board, a former employee of the company should not become a NED of the company until five years have elapsed since the date of their departure. In addition, NEDs should typically serve no more than two three-year terms with the same company. A NED should not be considered independent after 10 years. • At least half of a company’s board should comprise truly independent NEDs led by a senior independent director (SID). The senior independent director should: • attend management meetings with shareholders to learn of shareholders’ concerns and communicate their views of the company to the other NEDs; and • act as a conduit for shareholders to raise issues, which have failed to be resolved by the chairman or chief executive in the first instance. In addition, the review recommends that: • The chief executive of a company should not then become its chairman as to do so may result in the chairman competing with the incoming chief executive for the board’s allegiance. • No individual should act as chairman for more than one company and no full-time executive director should accept more than one non-executive directorship. Although the Higgs Report has received broad support from key industry associations such as the NAPF and IMA, it has been heavily criticised by the CBI. This criticism has mainly come from company chairmen concerned that the role of the senior independent director will undermine their position and divide a company’s board. Following the Financial Reporting Council’s (see Chapter 6) brief consultation process on Higgs’ recommendations amongst interested parties, these recommendations have since been incorporated into a revised Code of Best Practice. As with all other aspects of the code, companies are subject to the “comply or explain” protocol that underpins UK corporate governance. The momentum built up by the UK corporate governance movement since the early 1990s is fast approaching the level of shareholder activism in the US. This has been evidenced by the action taken by institutional shareholders in 2004 in preventing Michael Green from assuming the role of chairman of the merged ITV companies and Sir Ian Prosser taking up the chairmanship of Sainsburys. Moreover, recent research conducted by Deutsche Bank has found that those companies that best meet the criteria established under 50 corporate governance standards tend to significantly outperform those that don’t.

The Role of the Auditor An auditor is a firm of accountants appointed by a company’s executive directors - the appointment being ratified by the company’s shareholders - to carry out an independent assessment of the company’s accounts prepared by the directors. Following the unearthing of significant accounting frauds at Enron and WorldCom in the US and the widespread manipulation of companies’ reported profits, the role of the auditor, has, like that of the NED, also come under the microscope on both sides of the Atlantic. Although auditors in the UK are not required to actively detect fraud, they are required to report to the company’s shareholders, via an auditor’s report, on whether or not the company’s accounts give a true and fair view of the company’s activities and financial position and

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whether they have been prepared in accordance with the Companies Acts and mandatory accounting standards. The auditor’s report is considered in more detail in Chapter 6. To ensure the independence of a company’s auditors from the company’s management and, therefore, safeguard the integrity of the company’s financial accounts, Sir Robert Smith was commissioned by the government to report on how such independence could be preserved. Publishing his report on the same day as the Higgs Review, the Smith Report recommends that such independence could best be assured by modifying the structure and role of company audit committees, whose principal function is to advise the company’s board on the appointment and remuneration of auditors. Smith recommends that the audit committee should: • include at least three NEDs; • monitor the integrity of financial statements; • review internal controls and internal and external auditors; • take an adversarial approach towards company management if it discovers misleading financial reporting. Like the Higgs Review, the Smith Report has also been integrated within the revised Code of Best Practice.

Sarbanes-Oxley Act 2002 After a series of financial scandals, the USA government introduced the Sarbanes-Oxley Act in 2002. The Act’s objective is “to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes”. It applies to USA public companies and their global subsidiaries. It also applies to foreign companies that have shares listed on USA stock exchanges. The Sarbanes-Oxley Act is often referred to as SOX, SarbOx or SOA. The Act covers a wide range of corporate governance issues and some of these include: • The chief executive and chief financial officers must certify the accuracy of the corporation’s annual and quarterly Stock Exchange Commission reports. They are then personally responsible for the information and certifying false accounts can lead to a criminal prosecution and imprisonment. • All off-balance sheet transactions and material relationships must be disclosed. • The company must state whether it has adopted a code of ethics for its senior financial officers. • Personal loans to officers or directors are forbidden. • Greater protection for “whistleblowers”. • The need for auditable business processes and communication. • Companies are prohibited from receiving non-audit services from their existing auditor. • New measures to prevent conflicts of interest between securities analysts and investment banks.

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2. OVERSEAS REGULATORS LEARNING OBJECTIVES 3.2.1

know the primary function of the following bodies in the regulation of the financial services industry: Securities and Exchange Commission (SEC); Financial Services Authority (FSA); Japan Financial Services Agency (JFSA); European Union (EU); International Organisation of Securities Commissions (IOSCO)

2.1 Securities and Exchange Commission (SEC) The SEC is the USA’s financial services market regulator. It monitors securities exchanges, brokers, dealers, investment advisors and mutual funds. The SEC aims to ensure that market-related information is disclosed to the investment community in a fair and timely manner. It also enforces laws to prevent investors suffering from unfair trading practices and insider trading.

2.2 Financial Services Authority (FSA) The FSA is the regulator for the financial services industry in the UK. It has four statutory objectives: 1. Promote and educate the public to aid their understanding of the financial system. 2. Secure consumer protection. 3. Reduce financial crime 4. Maintain public confidence of the high standards set for the financial services industry.

2.3 Japan Financial Services Agency (JFSA) The Financial Services Agency is a government regulator that is responsible for ensuring the stability of the Japanese financial services market. It is responsible for monitoring insurance companies, securities exchanges, banking and other market participants. It is also involved in establishing business accounting standards and supervising certified public accountants and auditing firms. The agency reports to the Minister of Financial Services.

2.4 European Union (EU) The European Commission is currently working towards strengthening and consolidating the laws for financial services across the European Union. Currently there is no single regulator for the financial services industry and each country has their own set of rules and regulations.

2.5 International Organisation of Securities Commissions (IOSCO) IOSCO was established in 1983 and aims to establish high regulatory standards across the world for the securities industry. The membership of this organisaction collectively regulates 90% of the worlds’s securities markets. It is considered to be one of the most influential forums for regulators.

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ASSET CLASSES

1. 2. 3. 4. 5. 6.

EQUITIES FIXED INTEREST CASH AND MONEY MARKET INSTRUMENTS DERIVATIVES PROPERTY ALTERNATIVE INVESTMENTS

97 112 138 141 175 178

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1. EQUITIES “March is one of the most dangerous months to buy stocks. The others are June, January, September, April, November, May, October, July, December, August and February.” Mark Twain

1.1

Introduction

A company’s share capital can be broadly divided into two distinct classes of share: ordinary shares and preference shares.

1.2

Ordinary Shares

LEARNING OBJECTIVES 4.1.1

Know the characteristics and risks of different classes of share capital (preference shares, ordinary shares), shareholder rights and priority for dividends and capital repayment for both private and public companies

Purchasing a company’s ordinary shares confers an equity interest in the company. That is, a direct stake is taken in the company’s fortunes. As such, a company’s ordinary share capital is also known as its risk capital given that ordinary shareholders are always the last in line to be paid an income and the last to be repaid their capital in the event of the company’s liquidation. Only after all other claims on the company’s resources, such as those from bondholders and preferential creditors, have been satisfied are its equity shareholders rewarded or recompensed. Over the longer term, however, ordinary shareholders have been handsomely rewarded for assuming this equity risk though in the short term have generally experienced a greater volatility in their returns than any of the other main asset types. As mentioned in Chapter 3, a company is a separate legal entity distinct from its owners. Therefore, a company’s ordinary shareholders have no personal liability for the company’s debts. This gives rise to the concept of limited liability. That is, each shareholder’s liability only extends to any outstanding payment on the nominal value of the company’s shares held if issued partly paid. The nominal value of a share is only of legal significance and simply requires that all ordinary shares issued by a company are set at or above this price. A 25p nominal value is fairly common. Most ordinary shares in issue are irredeemable, in that there is not usually any pre-specified provision for their repurchase by the company. This and other aspects of UK company law are defined within the Companies Acts. These establish the framework within which all companies in the UK must operate.

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Shareholder Rights Ordinary shareholders are entitled to a number of rights. These are specified in a company’s Articles of Association, which govern the company’s internal constitution. That is, they define the relationship between the company and its members, or shareholders, and the rights of the company’s shareholders between themselves. The rights attaching to a company’s issued ordinary share capital include a right to: 1. Share in the profits of the company through the payment of dividends. Each equity share has an equal right to share in this distribution of a company’s profits. This is what is meant by the term equity. However, the company’s directors are not obliged to pay dividends on a regular basis: payment is very much based upon their discretion. This is considered in more detail below. 2. Receive a copy of the company’s annual and interim report and accounts, their content and the timescale within which they are issued being defined by the Companies Acts. 3. Be notified in advance of all company meetings and to attend and vote on resolutions put by the directors at these meetings. 4. Subscribe for new ordinary shares issued to raise additional capital before they are offered to outside investors. These are known as pre-emption rights. Shareholder’s pre-emption rights can be waived by special resolution.

Types of Ordinary Share In addition to conventional ordinary shares, which confer voting and the other rights considered above to the company’s ordinary shareholders, other types of ordinary shares, albeit rarities, exist: 1. Non-voting shares. Aside from not carrying any voting rights, non-voting shares, designated either as A or B shares, rank equally alongside other ordinary shares in all respects. However, not being as valuable as those shares that carry voting rights in a takeover situation, non-voting shares usually trade at a discount to their voting counterparts. Although now prevented from issuing new non-voting shares by the LSE, a number of prominent companies still have non-voting shares in issue. 2. Redeemable shares. Companies are permitted to issue ordinary shares that can be redeemed, or bought back, by the company so long as conventional non-redeemable ordinary shares are also in issue. 3. Deferred shares. A company’s original promoters, in order to retain an element of control over the company when additional equity finance is raised, may issue deferred, or founder’s, shares that confer enhanced voting rights. As a quid pro quo to other equity shareholders, these shares typically defer the right to a dividend for a set period.

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1.3

Preference Shares

LEARNING OBJECTIVES 4.1.1

Know the characteristics and risks of different classes of share capital (preference shares, ordinary shares), shareholder rights and priority for dividends and capital repayment for both private and public companies

4.1.2

Know the main characteristics and reasons for issuing convertible preference shares

4.1.3

Be able to calculate a conversion premium or discount on a convertible preference share

In addition to ordinary shares, companies can also issue preference shares. Although the interests of preference shareholders rank below that of a company’s bondholders and preferential creditors, 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. Consequently, preference shareholders are usually only entitled to a fixed rate of dividend and with the single exception detailed below are not given any voting rights. This fixed rate of dividend is expressed as a percentage of each share’s nominal value in net, or after tax, terms. So, a 6% preference share with a nominal value of £1, would pay a net annual dividend of 6p per share.

Types of Preference Share Most preference shares in issue are cumulative. That is, unless they are designated as noncumulative, preference shareholders are entitled to receive all dividend arrears from prior years before the company can pay its ordinary shareholders a dividend. However, the payment of dividends on preference shares is again very much at the discretion of the company’s directors. If any preference dividends remain outstanding preference shareholders can often assume the same voting rights as ordinary shareholders. Any such rights will be detailed in the company’s Articles of Association. Variations on conventional preference shares include: 1. 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 prespecified level. 2. Redeemable preference shares. These are issued with a predetermined redemption price and date. Some redeemable preference shares are issued as convertible preference shares. 3. 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 predetermined 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. Once again, the rights attaching to each type of share will be detailed in the company’s Articles of Association.

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Convertible preference shares Convertible preference shares are usually issued by: 1. The bidding company in a company takeover as consideration to the target company’s shareholders, so as to defer the dilution, or expansion, of the bidder’s ordinary share capital. 2. Companies in difficulty undergoing a capital restructuring to its creditors in exchange for waiving outstanding debts. In both cases, the convertible preference shareholders can ultimately share in the issuing company’s fortunes whilst enjoying a fixed rate of dividend in the meantime. The reasons for issuing convertible preference shares and their underlying mechanics are very similar to that of convertible loan stock considered in the Fixed Interest securities section of this chapter. Given the terms on which convertible preference shares may be converted into the issuing company’s ordinary shares, a conversion premium or discount can be established by using the following equation: Conversion premium/discount = [(conversion ratio x market price of convertible/market price of equity shares) - 1] x 100 where the conversion ratio is the rate at which the convertible can be exchanged for equity shares. If the price of the convertible given the conversion ratio is lower than, or stands at a discount to, the price of the equity shares then the convertible is a less expensive way of buying into the issuing company’s ordinary shares than buying these shares directly. This happens when the price of the convertible has lagged the rise in the ordinary share price and/or offers a relatively less attractive rate of dividend. The opposite is true if the convertible stands at a premium. Example A company has issued 7% cumulative redeemable preference shares at 110p. They are currently priced at 125p per share and can be converted into the company’s ordinary shares at the rate of 5 preference shares for 1 ordinary share. If ordinary shares = 600p, what is the conversion premium or discount? Solution Conversion premium = [(5 x 125/600) - 1] x 100 = 4.2%. Therefore, buying the convertible preference shares is a more expensive route into the issuing company’s ordinary shares than buying the shares directly. However, the fixed rate of dividend currently being paid on the preference shares may be sufficiently attractive when compared to that being paid on the ordinary shares to justify the premium. For the remainder of this section we will focus solely on ordinary shares.

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1.4

Public Limited Companies (PLCs)

LEARNING OBJECTIVES 4.1.5

Know the principal purpose and requirements of the listing rules

4.1.14

Know the means by which companies communicate price sensitive information, the nature of such information and the primary information providers

In the UK there are two types of company: private limited companies and public limited companies (plcs). Only plcs are permitted to issue shares to the public and have their shares publicly traded on a stock exchange, though very few plcs take advantage of this. Those in the UK that do, either obtain a full listing on the LSE or gain admittance to the LSE’s Alternative Investment Market (AIM). Chapter 5 details the structure and dealing and settlement systems of these stock exchanges as well as those of competing mechanisms. Private limited companies seeking a full listing on the LSE must first meet the stringent entry criteria, or Listing Rules, detailed in the Purple Book and administered by the FSA in its capacity as the UK Listing Authority (UKLA).

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1.5

Share Issues

LEARNING OBJECTIVES 4.1.4

Understand the main characteristics of GDRs and ADRs

4.1.6

Understand the different new issue methods (see the syllabus learning map at the back of this book for the full version of this learning objective)

4.1.7

Know the main mandatory corporate actions (see the syllabus learning map at the back of this book for the full version of this learning objective)

4.1.8

Know the main optional corporate actions (see the syllabus learning map at the back of this book for the full version of this learning objective)

4.1.9

Know the difference between optional and mandatory corporate actions

4.1.10

Understand the reasons for capitalisation and rights issues and the options available to the shareholder when a rights issue is made

4.1.11

Be able to calculate the effect of capitalisation and rights issues on the issuer's share price

New issue methods “Most new issues are sold under favourable market conditions - which means favourable for the seller and, consequently, less favourable for the buyer.” Benjamin Graham A plc applying for a full listing to have its shares traded on the LSE must first make at least 25% of its ordinary shares available on the LSE’s primary market, to ensure an active market in its shares, via one of four permissible floatation methods, detailed below. AIM companies, however, not being subject to any free float criteria can issue as much or as little of their share capital as they wish. Those companies that seek to raise capital through their listing or admission can do so through an initial public offering (IPO) of ordinary shares either by making an offer for sale, an offer for subscription or a placing. These are termed marketing operations. Those companies applying for a full listing that simply wish to increase the marketability of its shares, however, would choose the fourth route to the primary market by making an introduction. 1. An offer for sale. By adopting this IPO method, the issuing company sells its shares to an issuing house, which then invites applications from the public at a slightly higher price than that paid by the issuing house and on the basis of a detailed prospectus, known as the offer document. For a company applying for a full listing, this provides comprehensive information about the company and its directors and how the proceeds from the share issue will be applied. This document must be prepared by the company’s directors and assessed by an independent sponsor, such as a solicitor or accountant, to satisfy the UKLA of the company’s suitability to obtain a full listing. In addition, a letter from the company’s sponsor to the UKLA confirming the adequacy of the company’s day-to-day, or working, capital must accompany the prospectus whilst an advertisement detailing the floatation, known as a formal notice, must be placed in a national newspaper.

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Companies applying for admission to AIM, however, are subject to much less onerous requirements. Regardless of the IPO method adopted, the company’s directors in conjunction with the company’s nominated adviser, must simply provide a prospectus to accompany the share issue. Although this contains less detail than that for a full list IPO, it must incorporate a warning to investors of the potential risks associated with investing in smaller company shares. An advertisement need not be placed in a national newspaper. Offers for sale do not necessarily require the company to create new shares specifically for the share issue. Indeed, offers for sale are often used by a company’s founders to release part or all of their equity stake in their company and have also been the preferred route for government privatisation programmes, where former nationalised monopolies have been sold to the public. In both cases existing shareholdings are disposed of, rather than new shares being created, in order to obtain a listing. 2. An offer for subscription. Rarely used today, this IPO method requires the company to offer its new shares directly to the public, again by issuing a detailed prospectus and placing an advertisement in the national press when a full listing is sought. In so doing, the company arranges for an issuing house to underwrite the share issue, in exchange for a small commission, so that in the event of the issue being under subscribed, the underwriter will take up the remaining shares. Usually the issuing company will only commit to the issue if a minimum subscription level has been reached. An offer for sale or an offer for subscription can be made on either a fixed or a tender price basis. Fixed price offer When a fixed price offer is made, the price is usually fixed just below that at which it is believed the issue should be fully subscribed, so as to encourage an active secondary market, or after market, in the shares. A secondary market is one in which securities already in issue trade. Generally speaking, in the absence of a liquid and well regulated secondary market, an active primary market could not exist, as investors would be reluctant to purchase new securities that they may subsequently find difficult to trade. Similarly, any relaxation of the primary market admittance and issue criteria would adversely impact on the liquidity of the secondary market. This is considered in Chapter 5. Subscribers to a fixed price issue apply for the number of shares they wish to purchase at this fixed price. If the offer is oversubscribed, as it nearly always is given the favourable pricing formula, then shares are allotted either by scaling down each application or by satisfying a randomly chosen proportion of the applications in full. The precise method used will be detailed in the offer document. Tender offer However, given the judgement required in setting the price at a level that does not lead to the issue being excessively oversubscribed but which leads to a successful new issue and the fact that market sentiment can and does often change between the announcement of the IPO and the end of the offer period, offers for sale and offers for subscription can be made on a tender basis. By not stipulating a fixed price for the shares but by inviting tenders for the issue, usually by setting a minimum tender price, investors subscribe for the number of shares they wish to purchase and state the price per share they are prepared to pay. Once the offer is closed, a single strike price can then be determined by the issuing house or by the company, as appropriate, to satisfy all applications tendered at or above this price. As with a fixed price offer, this single strike price is typically set at a level just below that required for the entire share issue to be taken up, again to ensure an active secondary market in the shares. Although this auctioning process is the more efficient way of allocating shares and maximising the proceeds from a share issue, tender offers are also more complex to administer and, as such, tend to be outnumbered by fixed price offers.

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3. A placing. In placing its shares, 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 also known as selective placing. Although the least democratic of the three IPO methods, given that the general public does not initially have access to the issue, a placing is the least expensive as the prospectus accompanying the issue is less detailed than that required for the other two methods and no underwriting or advertising is required. However, if made in respect of a full listing, the issue must still be advertised in the national press. Placings are the preferred new issue route for most AIM companies. 4. An introduction. An introduction is not really an IPO in the true sense as no capital is raised. A LSE listing via an introduction is potentially available to those companies already quoted on another, overseas, stock exchange, typically multinationals, wishing to expand their shareholder base and to larger UK plcs that simply require a listing to improve the marketability of their shares, as a result of a demutualisation for example. Demutualisation is the process whereby a mutual organisation, such as a building society or a life assurance company, becomes a plc. Although in both cases, neither company has any immediate requirements for raising capital, by making their shares more marketable they facilitate future capital raising requirements.

American Depository Receipts (ADRs) and Global Depository Receipts (GDRs) Introduced in 1927, an ADR is a dollar denominated negotiable certificate issued by a depository bank in respect of non-US listed shares that have been lodged with the bank. ADRs are listed and freely traded on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX) and NASDAQ. The NYSE and NASDAQ are discussed in Chapter 5. An ADR market also exists on the LSE: ADR prices being quoted on the LSE SEAQ trading system, also discussed in Chapter 5. ADRs were originally designed to enable US investors to hold overseas shares without the high dealing costs and settlement delays associated with overseas equity transactions though have since been used by UK institutional investors wishing to purchase UK-listed shares. The reason for doing this is to avoid the stamp duty that would be payable if these shares were purchased in London. Stamp duty is discussed in Chapter 5. Although issued in bearer form with the depository bank as the registered shareholder, or legal owner, of the underlying securities, ADRs confer the same shareholder rights on the ADR holder, known as the beneficial owner, as if the shares had been purchased directly. Arrangements for issues such as the payment of dividends, also denominated in US dollars, and voting via a proxy at shareholder meetings are detailed on the ADR certificate, as, indeed, are the duties of the depository bank. The beneficial owner of the underlying shares may cancel the ADR at any time and become the registered owner of the shares. Those ADRs that represent the equity of those companies that actively participate in the ADR creation process and meet the costs involved, such as the stamp duty that is payable upon their creation, are known as sponsored issues. All other issues are known as unsponsored issues. Up to 20% of a company’s voting share capital may be converted into ADRs. Many UK companies have used ADR issues as a means by which to raise capital. ADRs are not the only type of depository receipts that may be issued. Those issued outside of the US are termed Global Depository Receipts (GDRs). GDRs have been issued since 1990 and are traded on many exchanges including the LSE. Increasingly depository receipts are issued by Asian and emerging market issuers.

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Corporate Actions Corporate actions are categorised as either mandatory, optional or mandatory with options. Mandatory corporate actions are those that must be applied by companies across all shareholders of a particular class. For instance, once approved, a dividend must be paid to all of a company’s ordinary shareholders. However, an optional corporate action is one where some shareholders may choose to proceed but others may not. For example, deciding upon whether to accept the terms of a takeover bid. Finally, a corporate action that is mandatory with options is best described as one when something will happen but the shareholders have a range of options: when a rights issue is announced for instance. The main optional corporate actions comprise: • Warrant Exercise; • Placing with Clawback; and • Rights Issue Call.

Warrant Exercise Warrants are negotiable securities issued by plcs, often with the company’s ordinary shares, and confer a right, rather than place an obligation, on the holder to buy a pre-specified number of the company’s ordinary shares at a preset price on or before a predetermined date. Warrant exercise relates to the act of exercising, or buying, the shares over which the warrant confers a right. Warrants will only be exercised if profitable to do so. Warrants are considered in more detail later in the derivatives section of this chapter.

Placing With Clawback Placing with clawback relates to placings, which are covered in the following section.

Rights Issue Call Rights issue call relates to rights issues, which are covered in the following section.

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Share Issues to Existing Shareholders As mentioned earlier, once listed or admitted to AIM, plcs are required to offer any subsequent issues of ordinary shares, or those of securities that are potentially convertible into the latter, initially to their shareholders, if the intention is to raise additional finance. This is to prevent the dilution of existing shareholdings in the company. You may recall these are known as shareholders pre-emption rights. As well as issuing shares to raise additional capital, however, companies also occasionally issue shares for other reasons. This section looks firstly at the former category, which comprises rights issues and placings, and then the latter, comprising bonus issues and stock splits. 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. 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, usually at a price deeply 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. The offer to the shareholder to take up these shares - being an optional corporate action - is purely at the option of the shareholder and is termed a rights issue call. The right to participate in such an issue is only conferred upon those shareholders who hold the issuing company’s shares cum-rights (cr). That is, those who hold the company’s shares before trading in the shares is conducted on an ex-rights (xr), or without rights, basis. The ex-rights period begins on or shortly after the day on which the rights issue announcement is made and runs for a further three weeks through to the acceptance date, the date by which the shareholder should have decided whether or not to take up these new shares. This means that if a shareholder entitled to take up the rights issue sells part or all of their shareholding in the company during this ex-rights period then the selling shareholder retains their pre-emption rights over this particular issue. Those entitled to participate in the rights issues are advised of their entitlement by means of a provisional allotment letter. This sets out the shareholder’s existing shareholding, the rights allotted over the new shares and the acceptance date. The ex-rights period begins on the day after which the allotment letter is posted. As these new shares rank equally, or pari passu, with the existing shares in issue, once the existing shares are declared xr, the market price should fall to reflect the dilution effect that the new shares will have on the prevailing share price. The price to which the shares should fall is termed the theoretical ex-rights (xr) price, and is calculated as follows: Theoretical xr price = [(No. shares held cum-rights x cum-rights share price) + (No. rights allocated x rights issue price)] Total no. shares held assuming rights exercised Example A rights issue is announced on a one for four basis at 200p when the cum-rights share price stood at 350p. Calculate the theoretical ex-rights price.

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Solution Number of shares held 4 existing 1 new 5 post rights

Price per share (p)

Total value of holding (p)

350 200

1400 200 1600

The theoretical ex-rights price = 1600/5 = 320p The reason for this price being referred to as theoretical is because it ignores shareholder reaction and market sentiment towards the rights issue. Sometimes the share price will settle above this level if the shareholders believe a highly satisfactory return will be achieved on the capital raised whilst at other times a rights issue may meet with a lukewarm reception with not all shareholders wanting or being able to take up their rights in full. Therefore, the ex-rights price will fall below this theoretical level. As noted above, shareholders have three weeks to decide how to react to the announcement following receipt of the provisional allotment letter and prospectus and must choose between one of the four following courses of action: i. Take up the rights in full by purchasing all of the shares offered. To take up the rights in full, the shareholder simply sends the company the provisional allotment letter with a cheque by the due date. ii. Sell the rights nil paid in full. If a shareholder entitled to take up the rights issue decides not to, then they can sell the rights to these new shares nil paid. Nil paid rights are essentially a short dated option on these new shares and can only be exercised or traded during the, three week, ex-rights period. Options are considered in the derivatives section of this chapter. Given the above example, the price of each nil paid right = ex-rights share price - price of the new shares = 320p - 200p = 120p. Obviously, it would not be rational to pay more than 120p for the right to purchase a new share for 200p when the ex-rights price of the existing shares in issue is 320p. However, once again market sentiment and other considerations can influence the price of these nil paid rights. As an option on these new shares, nil paid rights are geared to the company’s share price. By gearing it is meant that if the price of the shares rises by 10p then so should the price of the nil paid rights. In the above example, the shares are geared by a factor of 320/120 = 2.67. So, whereas a 10p rise in the ex-rights share price represents a 10/320 x 100 = 3.125% increase, for the nil paid rights this translates into an 10/120 x 100 = 8.33% increase, or a percentage rise 2.67 times as great. To sell the rights nil paid in full, the shareholder must sign the form of renunciation on the reverse of the provisional allotment letter and send this to their broker by the due date. iii. Sell sufficient rights nil paid to finance the take up of the remaining rights. This course of action would be taken by a shareholder wishing to retain their shareholding in the company but without any desire to invest any further capital at this stage. Using the example above, if a shareholder with, say, 2,000 shares and, therefore, a right to take up 500 shares via the rights issue, sold 313 nil paid rights at 120p, the £375.60 raised would be sufficient to take up the remaining 500 minus 313, or 187 shares at 200p, ie, £374.

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The number of nil paid rights to be sold is given by the equation: issue price of new shares/ ex-rights price of existing shares x number of shares allotted = 200/320 x 500 = 312.5 nil paid rights As nil paid rights cannot be sold in fractions, this is rounded up to 313. When selling the rights nil paid in part, the shareholder does exactly the same as when selling them in full but requests that their broker split the allotment letter in accordance with the number of rights sold and those to be taken up. One of the split allotment letters will go to the purchaser of the rights and the other to the original shareholder. iv. Take no action. Any shareholder not taking any action by the acceptance date stipulated in the provisional allotment letter will automatically have their rights sold nil paid. The proceeds, less any expenses incurred by the company, are then distributed to all such shareholders on a pro rata basis. For the smaller shareholder not wishing to increase their shareholding in the company, this is often the most economic way to proceed. 2. Placing. If additional finance is to be raised by a company by placing new shares in the market rather than by making a rights issue to its existing shareholders, then the shareholders must first pass a special resolution to forgo their pre-emption rights. These secondary placings have several merits for the company over rights issues: i. A limited prospectus is required. ii. The issue does not need to be underwritten (though neither does a rights issue priced at a deep discount to the cum-rights share price). iii. The shares are usually priced at only a slight discount to the prevailing share price, thereby reducing the number of shares that need to be issued. iv. The company receives the proceeds from the issue far more quickly. If a company makes a placing with clawback, new shares are placed with institutions only after they have been offered to existing shareholders. Depending on the take up of these new shares by existing shareholders, the allocation to these institutions may be clawed back, or made on a pro rata basis. 3. Bonus/scrip issue. Occasionally a company may issue new shares to its shareholders without raising further capital, often as a public relations exercise to accompany news of a recent success or as a means to make its shares more marketable. Such issues are known as bonus, scrip or capitalisation issues. A company quite simply converts its reserves, which may have arisen from issuing new shares in the past at a premium to their nominal value and/or from the accumulation of undistributed past profits, into new ordinary shares. These shares rank pari passu with those already in issue and are distributed to the company’s ordinary shareholders in proportion to their existing shareholdings free of charge. Although as a result of the bonus issue, the nominal value of the company’s share capital will increase proportionately to the number of new shares issued, the net worth or intrinsic value of the business should remain the same. However, given that the company’s earnings, or profits, and dividends will now be spread over a wider share capital base, the company’s earnings per share (EPS) and dividends per share (DPS) should fall proportionately with the number of new shares in issue. This should result in the market price of the shares reducing by this same proportion, thereby leaving the company’s market capitalisation unchanged.

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Example Z plc makes a bonus issue to its shareholders on a one for four basis to coincide with the launch of its new product. Prior to the announcement of the issue, the company’s ordinary shares traded at 200p per share. If the company had 1m ordinary shares each with a nominal value of 25p in issue prior to the announcement, calculate: i. The nominal value of the company’s share capital immediately before and immediately after the announcement; ii. The new theoretical market price for the shares; and iii. The market capitalisation of the company immediately before and immediately after the announcement based on the pre-existing share price and the new theoretical market price. Solution i. Nominal value of the company’s share capital a. Immediately before = 1m x 25p = £250,000 b. Immediately after = 1m x 5/4 x 25p = £312,500 ii. Theoretical market price = 200p x 4/5 = 160p iii. Market capitalisation a. Immediately before = 1m x 200p = £2m b. Immediately after = 1m x 5/4 x 160p = £2m However, in contrast to the US, once a UK company’s share price starts trading well into double figures, its marketability starts to suffer as investors shy away from the shares. Therefore, a reduction in a company’s share price as a result of a bonus issue usually has the affect 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. This was strongly in evidence at the height of the boom in dot com shares when dot com bonus issues met with an almost euphoric response from the market. 4. Consolidation. A consolidation is where a company increases the nominal value of each of its shares in issue whilst maintaining the overall nominal value of its share capital. For instance, if a company has 1m shares in issue each with a nominal value of £1, it can simply increase the nominal value per share to £2 and reduce the number of shares in issue to 500,000. A consolidation is the exact opposite of a share split (please see below). 5. Subdivision/stock split. A company can also reduce the market price of its shares to make them more marketable without capitalising its reserves by undertaking a stock split. A stock split simply entails the company reducing the nominal value of each of its shares in issue whilst maintaining the overall nominal value of its share capital. For instance, if the company has 1m shares in issue each with a nominal value of £1, it can simply split each share into four, each share now having a nominal value of 25p. Although the total nominal value of the shares in issue remains unchanged, the overall market capitalisation of the company should increase as its shares become more marketable. Other things being equal, the effect of a stock split on the share price should be the same as for a bonus issue.

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1.6

Dividends

LEARNING OBJECTIVES 4.1.12

Know the reasons for companies paying dividends, how dividend policy is determined and the practical constraints on paying dividends

The return from ordinary shares comprises capital growth and dividend income. Although the contribution of dividends to equity returns has diminished in recent years, mainly as a result of changes in the UK tax system that begun in 1997, historically strong dividend growth has been the main attraction for many equity investors and has proved to be the most important determinant of returns over the longer term. In fact between 1900 and 2000, a UK equity portfolio with dividends reinvested would have grown to a sum 100 times greater than one where they hadn’t been. Therefore, the importance of dividends can never be underestimated. Of all the asset types, or asset classes, equities still provide the most consistent and stable income stream. Moreover, dividends can also be used in conjunction with the DCF techniques we considered in Chapter 2 to establish the value of a company’s ordinary shares. This we look at in Chapter 7. Dividends are usually paid twice a year and are expressed in pence per share. Interim dividends are paid in the second half of a company’s accounting period whilst final dividends, usually the larger of the two payments, are paid after the end of the company’s accounting year. As the final dividend is decided upon by the company’s directors and voted upon by the shareholders at the AGM, it is often paid the day after the meeting. Although shareholders can vote for the final dividend to be paid at or below its proposed rate, they cannot vote for it to be increased above this level. The Companies Acts restrict the amount that can be paid by a plc as dividends to its ordinary shareholders to the company’s, post tax, distributable profit and that retained within its revenue reserves from prior years. Aside from supplementing a company’s distributable profit in lean years, these revenue reserves are used by most companies as their principal means of financing operations and expanding the business. Once a dividend has been declared, the company’s shares are traded on an ex-dividend (xd) basis until the dividend is paid, typically six weeks after the announcement. Shares purchased during this ex-dividend period, do not entitle the new shareholder to this next dividend payment. The factors that determine a company’s dividend policy comprise: 1. The amount of cash being generated by the company and the competing demands placed upon this cash generation. So as to retain cash within the business, many companies provide shareholders with the option of taking additional new shares in the company in lieu of a cash dividend. However, following tax changes made in 1999, these scrip dividends are no longer as tax efficient to companies or as cost efficient to shareholders as they used to be. Shareholders in receipt of scrip dividends are taxed in exactly the same way as if they received a cash dividend. The taxation of dividends is covered in Chapter 8. 2. The level of the company’s current year distributable profit and that retained from prior years.

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3. The directors’ policy on dividend growth. The rate of growth in the level of dividend declared typically acts as a signal to the market of the directors’ optimism or pessimism surrounding the company’s medium term prospects and long term health. A reduction in a company’s trend, or long term, dividend growth rate, or, worse still, an absolute cut in the dividend per share (DPS), predictably results in a decline in the share price. The potential impact that the rate of dividend growth has on a company’s share price is considered in Chapter 7.

1.7

Share Buybacks

LEARNING OBJECTIVES 4.1.13

Know the reasons for companies buying back their own shares

Although most ordinary shares in issue are irredeemable, an increasing trend amongst UK companies began to surface towards the end of the 1990s in buying back their own shares. The same changes to the UK tax system, referred to earlier, that began taking place in 1997, made it more tax efficient for companies, and more beneficial for their institutional shareholders, for any cash surpluses to be used to buy back and cancel a proportion of their ordinary shares rather than to pay enhanced dividends, subject to the permission of the High Court and agreement from HMRC. Share buybacks cannot, however, replace dividends as means of distributing cash to shareholders. Apart from share capital being finite and buybacks not providing shareholders with the same regular and reasonably predictable income flow that dividends typically provide, such an arrangement would not be permitted by HMRC. By reducing the number of shares in issue, so the company’s EPS will increase, and so in turn may its stock market rating. Alternatively, a company may decide to enhance its EPS by replacing part of its share capital with a bond issue. As mentioned in Chapter 2, bond interest being tax-deductible, unlike equity dividends, should lower the company’s WACC and benefit its remaining ordinary shareholders. However, as we explain in the section on fixed interest securities, replacing equity with debt finance increases the company’s gearing and, therefore, the risk attached to the company’s shares.

Concluding Comments Over the longer term, equities have consistently outperformed all of the other main asset types and have delivered superior real returns under almost all economic conditions. Strong long term dividend growth has also served to provide the most stable and consistent income stream of all the asset classes. However, equity investment has many inherent risks and can suffer prolonged downturns in the short to medium term.

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2. FIXED INTEREST 2.1

Introduction

LEARNING OBJECTIVES 4.2.1

Know the structure, characteristics and risks of the different types of fixed interest securities

A fixed interest security can be defined as a tradeable 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. Fixed interest securities are commonly termed bonds, stock and debt. Each of the, above, italicised terms are defined below: 1. Negotiable instrument. Bonds are negotiable instruments in that ownership of the security can pass freely from one party to another. This makes bonds tradeable. 2. Borrower. Bonds can be issued by a wide range of borrowers, including supranationals, such as the IMF, governments, government agencies, local authorities and companies, in a variety of different forms. 3. Fixed rate of interest. Most bonds are issued with a predetermined fixed rate of interest, known as the bond’s coupon. This can be expressed either in nominal terms or, in the case of indexlinked bonds, in real terms, and is usually paid semi-annually. However, some bonds are issued with variable, or floating, coupons whilst others are issued without any coupon at all. 4. Nominal value. Also known as the par value. 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 or at a premium to par. Bonds are also traded and reference is made to bond holdings on the basis of nominal, 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. 5. Holder. The holder is the owner of the bond, title to which is usually evidenced by a certificate. Most bonds issued in the UK are individually registered in the holder’s name and, therefore, require the completion and registration of a stock transfer form (STF) for ownership to pass between one party and another. Most overseas and international bond issues, however, are made in bearer form. That is, rather than being formerly registered in the name of the holder, ownership is confirmed by the mere possession of a certificate. Ownership can, therefore, pass from hand to hand without any formalities. 6. Redeemed. Most bonds have a fixed redemption date upon which the bond matures and the underlying principal, known as the redemption payment, is returned to the holder by the issuer. 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. 7. Principal. As mentioned in (6), the principal is the redemption payment made by the issuer to the holder of the bond at maturity. This sum is usually the nominal, or par, value.

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2.2

Types of Bond

LEARNING OBJECTIVES 4.2.1

Know the structure, characteristics and risks of the different types of fixed interest securities

4.2.2

Know the characteristics and reasons for issuing convertible bonds

4.2.3

Be able to calculate a conversion premium on a convertible bond

4.2.9

Know the characteristics and uses of strips and repos

Bonds are usually classified according to the issuer, their structure or defining characteristics and the market into which they are issued: 1. Most bonds are issued by governments and supranationals, known collectively as sovereign borrowers, companies and, to a lesser extent, local authorities. 2. Bond structures can range from conventional, or straight, issues that meet with the definition considered at the very start of this section, through to those that have evolved as a result of the significant amount of innovation that has taken place in bond markets in recent years. The innovative features and structures that now increasingly characterise many bond issues include many of the features noted earlier, such as those being issued: a. With index linked coupon payments and redemption proceeds. b. Without coupon payments. These zero coupon bonds (ZCBs) are issued at a discount to nominal value but are redeemed at par, thereby providing their entire return as capital gain. c. With conversion rights. These convertible bonds may 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. d. With floating rather than fixed coupons. These are termed floating rate notes (FRNs). e. With provisions for early redemption. These early redemption provisions are known as call and put provisions. If a call provision is granted to the issuer, the bond is a callable bond, whereas if a put provision is conferred upon the holder it is a putable bond. Bond issues with call provisions entitle the issuer to redeem the issue earlier than the stated redemption date on advantageous terms, typically at a predetermined price. This has the effect of placing a ceiling on any upward movement in the bond’s price, thereby making these bonds less attractive than those that do not contain such provisions. 3. Bonds can be issued into the issuer’s own domestic bond market, internationally in one or across a range of bond, or debt, markets.

Government Bonds Bonds which are issued by a government are usually referred to as (credit risk) free bonds. This is because the government can repay the debt by raising taxes or issuing more money. However, government bonds may still have currency and inflation risk. Some of the main issuers include:

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Country Japan

Currency Yen

USA

US Dollar

Name Japanese Government Bond (JGBs) US Treasuries

France

Euro

OATs

Germany

Euro

Bunds

England

Sterling

GILTS

Issuer Ministry of Finance Bureau of the Public Debt Agence France Trésor Finanzagentur GmbH UK Debt Management Office

Gilt STRIPS Since 1997 certain gilts have been available to trade as STRIPS (Separate Trading of Registered Interest and Principal). A stripped gilt is one that is separated into its component coupon payments and its redemption payment. Each of these payments can then be separately traded as a zero coupon bond (ZCB) with a known nominal redemption value. As each ZCB is purchased at a discount to this redemption value, the entire return is in the form of a capital gain. Conventional gilts with interest payment dates of 7 June and 7 December, index linked gilts and rump gilts are all potentially strippable. Apart from adding to the liquidity of the gilt market, STRIPS can be used both as a portfolio management and as a personal financial planning tool given that the redemption proceeds from these ZCBs, each with their own unique redemption date, can be used to coincide with specific future liabilities or known future payments.

Eurobonds Eurobonds are large international bond issues made by supranationals, governments and larger, usually multinational, companies. The Eurobond market developed in the early 1970s to accommodate the recycling of substantial OPEC US dollar revenues from Middle East oil sales at a time when US financial institutions were subject to a ceiling on the rate of interest that could be paid on dollar deposits. Since then it has grown exponentially into the world’s largest market for longer term capital, as a result of the corresponding growth in world trade and even more significant growth in international capital flows, with most of the activity being concentrated in London, UK. Often issued in a number of financial centres simultaneously, the one defining characteristic of Eurobonds is that they are denominated in a currency different from that of the financial centre or centres in which they are issued. In this respect the term Eurobond is a bit of a misnomer as Eurobond issues and the currencies in which they are denominated are not restricted to those of European financial centres or countries. The euro prefix simply originates from the depositing of US dollars in the European Eurodollar market and has been applied to the Eurobond market since. So, a Eurosterling bond issue is one denominated in sterling and issued outside of the UK, though not necessarily in a European financial centre.

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Eurobonds issued by companies typically do not provide any underlying collateral, or security, to the bondholders but are almost always credit rated by a credit rating agency. Credit ratings are covered later in this section. To prevent the interests of these bondholders being subordinated, or made inferior, to those of any subsequent bond issues the company makes, a negative pledge clause will be provided by the company. This prevents the company subsequently making any secured bond issues, or issues which confer greater seniority or entitlement to the company’s assets in the event of its liquidation, unless an equivalent level of security is provided to existing bondholders. As discussed below, given that most issues made in the UK domestic corporate bond market require some kind of security to be offered to bondholders, Eurobond issuers are effectively prevented from using this market. However, the reasons for tapping the Eurobond rather than the UK domestic bond market for such companies are sufficiently powerful to overcome this impediment, since the Eurobond market offers: 1. A choice of innovative products to more exactly meet issuers needs; 2. The ability to tap potential lenders internationally rather than just domestically; 3. Anonymity to investors, issues being made in bearer form; 4. Gross interest payments to investors; 5. Lower funding costs due to the competitive nature and greater liquidity of the market; 6. The ability to make bond issues at short notice; and 7. Less regulation and disclosure. Eurobonds can assume a wide range of innovative structures. Although most are issued as conventional bonds, or straights,with a fixed nominal value, fixed coupon and known redemption date, other common structures include: 1. Floating-rate notes (FRNs). The coupon on FRNs is referenced to a key money market rate of interest, such as the London Interbank Offered Rate (LIBOR), and paid at a fixed margin above this rate. FRNs can also employ caps and collars, which place parameters on the movement of this fixed-rate and often incorporate a droplock facility whereby the FRN converts into a fixed rate bond upon the floating coupon falling to a pre-specified level. 2. Zero coupon bonds (ZCBs). As noted earlier, these are issued at a discount to their redemption value and provide a return in the form of capital gain. However, because they are issued at a deep discount to their redemption value, this gain is taxed as income and not capital in the hands of the holder. 3. Convertible bonds. These can be converted into another of the issuer’s securities. 4. Dual currency bonds. These are issued in a different currency to that in which the coupons and redemption proceeds are paid.

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Domestic Corporate Bonds 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 corporate bond market. Domestic corporate bonds are usually categorised as either debentures or as loan stock. Debentures are bonds secured on the issuing company’s assets by way of a fixed or a floating charge. A fixed charge is a legal charge, or mortgage, specifically placed upon one or a 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. The type of security provided by a debenture issue, along with all other of the issue’s terms and any covenants which must be observed by the issuer, is incorporated into a trust deed or an indenture; the company’s compliance with which is overseen by an independent trustee appointed by the company. If any of these terms or covenants is breached then the company will be held by trustee to be in default of its obligations and, in turn, has the right to appoint a receiver to realise the asset(s) subject to the charge. Typical terms and covenants contained in the indenture to a corporate bond issue include: 1. Details of the coupon and payment dates. Whereas dividend payments on equity and preference shares are made at the discretion of the company’s directors, failure to make interest payments on time constitutes default, as does a failure to make the final redemption payment on the due date. 2. Details of the type of charge and the asset(s) to which it relates. Only if an asset is subject to a fixed charge, must the company obtain the permission of the trustee before disposing of the asset. 3. Protective covenants. The issuing company may have limits placed upon future borrowing powers and the ranking of any subsequent debt so as not to compromise its ability to meet existing coupon and redemption payments. These covenants may also require the issuer not to breach pre-specified parameters for certain key financial ratios that provide evidence of the issuer’s ability to meet its contractual obligations. This type of covenant provides the bondholders with continued evidence of the company’s financial strength. Ratio analysis is covered in Chapter 7. 4. The rights of the trustee in the event of the company defaulting on the issue’s terms and breaching specified covenants. 5. How the issue is to be redeemed. As shown in the table below, those debentures with a fixed charge offer a greater level of security to bondholders than those subject to a floating charge in the event of the issuing company going into liquidation. That is, the former have a more senior ranking than the latter in the order of priority in which capital repayment is made.

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ORDER OF PRIORITY OF CAPITAL REPAYMENT IN THE EVENT OF LIQUIDATION • Debentures secured by a fixed charge; • Preferential creditors; • Debentures secured by a floating charge; • Unsecured creditors including loan stock; • Subordinated loan stock; • Preference shares; • Ordinary shares. Although most domestic bond issues require some form of security to be offered to bondholders, companies can make unsecured bond issues, known as loan stock. Being issued without any underlying collateral, however, means that loan stock ranks with the company’s other unsecured creditors in the event of the company’s liquidation, though its seniority, or ranking, can fall one notch to just above that of the company’s preference shareholders if issued as subordinated loan stock.

Convertible Loan Stock In addition to that issued with conventional bond characteristics, loan stock can also be issued with conversion rights into the issuing company’s ordinary shares on predetermined terms. With characteristics similar to that of convertible preference shares, convertible loan stock, if not converted, simply becomes a conventional dated fixed interest security. Being debt rather than equity, however, convertible loan stock places an obligation on the issuer to make pre-specified interest payments regardless of the company’s ability or desire to pay dividends. However, like all corporate bond issues, these interest payments can be offset against a company’s profits for corporation tax purposes. Moreover, the provision of conversion rights, or equity sweeteners, means the loan stock can be issued at a lower coupon than a comparable straight loan stock. Convertible loan stocks are usually issued for the following reasons: 1. The bidding company in a takeover wishing to defer the immediate dilution of the bidding company’s equity share capital, issues convertible loan stock as consideration to the target company’s shareholders. 2. A company seeking to raise capital but which does not have sufficient assets to offer as security for a debenture issue or is unable to make a rights issue as its share price has fallen below the nominal value of its shares. 3. A company undergoing a capital restructuring can issue convertible loan stock in exchange for other forms of issued capital or to its other creditors in lieu of outstanding debts. As with convertible preference shares, given the terms on which the convertible loan stock can be converted into the issuing company’s ordinary shares, a conversion premium or discount can be established:

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Conversion premium/discount = [(market price of convertible/market price of equity shares x conversion ratio) – 1] x 100 where the conversion ratio is the rate at which the convertible can be exchanged for equity shares. If the price of the convertible given the conversion terms is lower than, or stands at a discount to, the price of the equity shares then the convertible is a less expensive way of buying into the issuing company’s ordinary shares than buying these shares directly. This will occur when the price of the convertible has lagged the rise in the ordinary share price and/or offers a relatively less attractive income stream. It may be that the equity dividend has recently experienced strong growth. The opposite is true if the convertible stands at a premium. Example A company has issued 8% convertible loan stock at £100 nominal. This can be converted into the company’s ordinary shares at a rate of 18 ordinary shares for every £100 nominal of the loan stock. If the loan stock is priced at £120 and the ordinary shares are priced at 575p, what is the conversion premium or discount? Conversion premium = [(120/18 x 5.75) – 1] x 100 = 15.9% Therefore, buying the convertible preference shares is a more expensive route into the issuing company’s ordinary shares than buying the shares directly. However, the 8% coupon may be sufficiently attractive when compared to the ordinary share dividend and the anticipated dividend growth to justify the premium. 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.

Permanent Interest Bearing Securities (PIBs) PIBS are irredeemable fixed interest securities issued by mutual building societies. PIBS pay relatively high semi-annual coupons, net of basic rate income tax, and potentially offer attractive returns. However, this income is non-cumulative and PIB holders rank behind all other creditors in the event of liquidation. If the building society subsequently demutualises, its PIBS are reclassified as Perpetual Subordinated Bonds (PSBs). Both PIBS and PSBs can be traded on the LSE.

Issue and Redemption of Domestic Corporate Bonds Corporate bonds can be issued with either fixed or floating rate coupons. They can also be issued and redeemed at par or at a discount or premium to par in the same way as other bonds. The method by which the company intends to redeem its bond issue will be stated in the indenture governing the terms of the issue. Redemptions are usually financed by making another bond issue or very occasionally by raising equity finance. However, replacing debt, with its tax-deductible interest, with equity that pays dividends out of post tax profits, is not tax efficient and will result in the company’s equity being diluted, usually with an adverse impact on the EPS.

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Rather than raise additional finance at redemption, the issuing company also has the option of gradually redeeming the issue throughout the life of the bond. This it can do by either: 1. Incorporating a call provision within the terms of the issue so that a pre-specified percentage of the bond issue can be redeemed on a random basis, or 2. Voluntarily purchasing the bonds, if traded on the open market, at random. In addition: 1. A provision is often incorporated within the issue terms that may require the company to purchase the bonds if the price at which they trade in the market falls below par, or 2. The bond issue may contain a put provision that gives the holder the option to sell the bond back to the company under certain specified conditions.

2.3

Bond Yields

LEARNING OBJECTIVES 4.2.5

Understand what is meant by running yield, net redemption yield (NRY), gross redemption yield (GRY), duration

4.2.6

Be able to calculate running yields, net redemption yields (NRYs), gross redemption yields (GRYs), duration

4.2.7

Know the characteristics of the yield curve: normal; inverted

The return from bonds, like equities, comprises two elements: the income return and that from price, or capital, movements during the period the security is held. Obviously, if a bond is purchased when issued at par and held to redemption, then, assuming it is redeemed at par, the return will simply comprise the coupon payments received over the term of the bond. However, if a bond is not purchased at par and/or not held to redemption, then its return will also be determined by the difference between the price at which it was purchased and that at which it is subsequently sold or redeemed, as appropriate.

The Running Yield The simplest approach to establishing 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. Running yield = (coupon/clean price) x 100 So, a Treasury 6% 2008 (six years to maturity) issued and due to be redeemed at par and currently priced at 110 would have a running yield of: (6/110) x 100 = 5.45% However, the running yield ignores the difference between the current market price and the redemption value. To remedy this, the gross redemption yield (GRY) can be calculated.

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The Gross Redemption Yield (GRY) The simplest approach to calculating the gross redemption yield (GRY) is as follows: GRY = running yield + [{(par – market price)/number years to redemption}/market price] x 100 Using the same example as above: GRY = running yield + [{(100 – 110)/6}/110] x 100 = 5.45% + - 1.52% = 3.93% You will notice that the GRY, which calculates the average annual compound return from the bond if held to maturity, is lower than the running yield. The reason for this is that the market price is higher than the bond’s par value. Therefore, the bond will suffer a capital loss if held to maturity. If, however, the market price is below par, then the GRY would be greater than the running yield as a capital gain would be made if the bond was held to maturity. This method of calculating the GRY though is only an approximation since the formula: 1. Can only cope with fixed coupons paid annually, not semi-annual, floating or index linked coupons, and 2. Ignores the time value of money. The only accurate way to calculate a bond’s GRY is to employ the DCF techniques covered in Chapter 2. You may recall that the DCF yield or internal rate of return (IRR) is that which when applied to a project’s cash flows results in a net present value (NPV) of zero. That is, the IRR is the rate of return that a project needs to achieve in order to breakeven. Exactly the same principles are applied when establishing a bond’s GRY. The GRY is the IRR that equates the price of the bond to the present value of its cash flows, namely its coupon payments and final redemption payment. By employing the DCF techniques contained in Chapter 2, the theoretical price of a conventional fixed interest security with a known redemption date is given by the present value of its future cash flows: Theoretical bond price = C1/(1+r) + C2/(1+r)2 ....+ (Cn + R)/(1+r)n where C1 represents the first coupon payment, C2 the second and Cn the nth payment, R the redemption payment, n the term of the bond and r the discount rate applied to these cash flows. This discount rate is the rate of return, or yield, required by investors over the term of the bond. It is also the bond’s GRY. As can be seen from the equation, the higher the coupon, the greater the term to maturity, and the lower the discount rate applied, the higher the price of the bond.

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However, as we know, the only accurate way to establish an IRR is through a lengthy process of trial and error using a range of discount rates but an approximate IRR can be derived through interpolation. That is, by taking two discount rates, one that when applied to the bond’s cash flows produces a positive NPV and another, higher, discount rate that results in a negative NPV, and then finding the rate between them that produces a zero NPV. We also know that the accuracy of this method is reliant upon the two discount rates used being as close together as possible to minimise the deviation between the approximated and true IRR. Treating the above bond as paying coupons annually, we know that the approximate GRY is 3.93%. Therefore, if we discount the bond’s cash flows by, say, 3.8% and 4.2% we should arrive at a GRY very close to the true IRR. Discounting the bond’s cash flows at 3.8% gives: Period Start year 1 End of years 1 – 5

Cash flow (£) (110) 6

Year 6

100 + 6

Discount factor

Discounted cash flow (£) (110.00) 26.86

1 1 1 /0.038 [1- /1.038 5] = 4.4769 1

87.74

/1.038 6

NPV

4.60

Discounting the bond’s cash flows at 4.2%, however, gives: Period Start year 1 End of years 1 – 5

Cash flow (£) (110) 6

Year 6

106

Discount factor 1 1 1 /0.042 [1- /1.042 5] = 4.4269 1

Discounted cash flow (£) (110.00) 26.56 82.81

/1.042 6

NPV

(0.63)

Therefore, using the interpolation formula: GRY = [r1 + {[+NPV/+NPV – (-NPV)] x (r2 – r1)}] x 100 GRY = [0.038 + {[4.60/(4.60 + 0.63)] x (0.042– 0.038)}] x 100 = 4.15% Discounting the bond’s cash flows at 4.15% should provide an NPV close to zero: Period Start year 1 End of years 1 – 5

Cash flow (£) (110) 6

Year 6

106

NPV

Discount factor 1 1 1 /0.0415 [1- /1.0415 5] = 4.433 1

/1.0415 6

Discounted cash flow (£) (110.00) 26.60 83.05 (0.35)

This GRY of 4.15% compares with the 3.93% we obtained by using the approximation formula. Obviously, the greater the number of cash flows to be derived from the bond, the less accurate the former method of approximating the GRY will be.

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If the GRY for a semi-annual coupon bond is to be calculated, then each of the semi-annual coupons and the redemption payment would be discounted by a factor of 1/[1 + (r/2)]n, where n represents the semi-annual payment period in which the cash flow is received. Where the cash flows are of equal magnitude, the discount factor 1/(r/2)[1- 1/[1 + (r/2)]n] can be used.

The Net Redemption Yield (NRY) The NRY calculates the redemption yield of a bond net of the income tax payable on the coupons to be received. Exactly the same process is employed as when calculating the GRY, whether using the approximate or DCF approach, though the coupon flows are given by: Coupon x (1 – holder’s income tax rate) As the redemption proceeds from a gilt or QCB are free of all personal taxes, this payment does not need to be adjusted.

Assessing the GRY The GRY as a yield measure, however, has its drawbacks. Firstly, it assumes that the bond will be held to redemption. More fundamentally though, the GRY being an IRR is conceptually flawed. Relating this to what was covered in Chapter 2, implicit in the GRY calculation is the assumption that once a cash flow has been received it can be reinvested at the same rate of interest as the GRY. If, however, the prevailing market rate of interest is lower than the GRY, then the true annualised compound annual return from the bond will also be lower than that implied by the GRY. This inability to reinvest coupons at the same rate of interest as the GRY is known as reinvestment risk.

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2.4

The Term Structure of Interest Rates

LEARNING OBJECTIVES 4.2.8

Be able to calculate forward rates given two spot rates of different maturities

Interest rates change over time. They also differ with the term of the investment. That is, bonds of different maturities usually have different GRYs. This relationship between yield and maturity is known as the term structure of interest rates and can be illustrated graphically by a redemption yield curve, or yield curve, as it is more commonly known. Gross redemption yield (GRY)

Term to maturity (years)

Figure 1: Normal Yield Curve 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. The reason for this term structure can be explained by liquidity preference theory. This theory maintains that investors have a natural preference for short term investments, and, therefore, demand a liquidity premium or a higher rate of return the longer the term of the investment. The reasons for this are two-fold. Firstly, the longer capital is tied up the longer the investor must forgo the consumption of goods and services and, secondly, the longer the term of the investment, the greater the risk to the capital invested. From a borrower’s perspective, the ability to borrow longer-term finance is attractive in that it negates the risk associated with periodically refinancing shorter term borrowing at its maturity. For this reason, borrowers are generally prepared to pay a liquidity premium for longer term funds. This liquidity premium is dynamically determined by market forces, principally the ever-changing risk appetite of investors.

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The shape and level of the yield curve can also be explained by expectations theory, market segmentation and certain other factors. 1. Expectations Theory Expectations theory maintains that the difference between short and long term interest rates can be explained by the course that short term interest rates are expected to take over time. More specifically, it states that the long term interest rate is related to the short term interest rate by the geometric average of the current and expected future level of short term interest rates. This relationship gives rise to what are termed spot rates and forward rates. A spot rate is a compound annual fixed rate of interest that applies to an investment over a specific time period whereas a forward rate is the implied annual compound rate of interest that links one spot rate to another assuming no interest payments are made over the investment period. This relationship is best illustrated with an example. If £100 can be invested over one year at a spot rate of 6% per annum, then at the end of the year this investment would be worth £100 x 1.06 = £106. If this same £100 could be invested over two years at a spot rate of 7% per annum, then at the end of its term the £100 would have a value of £100 x 1.072 = £114.49. The interest rate that links these two spot rates is the forward rate. Therefore, the forward rate can be defined as that which links the final value of £106 in year one to £114.49 in year two: Forward rate between year one and year two (1f2) = (£114.49/£106) – 1 = 8% So, if £100 is invested over year one at 6% and is then invested over year two at 8%, then the value of the investment at the end of year two will be £106 x 1.08 = £114.49. This implies that if we know the one year interest rate is 6% and that interest rates between year one and year two are expected to rise from 6% to 8%, they will, taking a geometric mean, average 7% compound over the two year period. This 7% compound rate is the two year spot rate. Therefore, a two year bond should yield 7%. This is given by the following geometric progression: 1.06 x 1.08 = (1.07)2 So, the two year spot rate = [(1.06 x 1.08)1/2 –1] = 7% You will notice that the one year spot and forward rates are the same at 6%. If the spot rate for a three year investment is 8%, then the forward rate linking the two year to the three year spot rate, given a final sum in year three of £100 x 1.083 = £125.97 is: Forward rate between year two and year three (2f3) = (£125.97/£114.49) – 1 = 10% So, taking the geometric average of these forward rates, the three year spot rate or the yield on a three year bond of 8% is derived by the geometric progression: 1.06 x 1.08 x 1.10 = (1.08)3 So, the three year spot rate = [(1.06 x 1.08 x 1.10)1/3 -1] = 8%

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However, what is the forward rate linking the one year spot rate of 6% with the three year spot rate of 8%? Forward rate between year one and year three (1f3) = (£125.97/£106)1/2 – 1 = 9% You will notice that as the forward rate is an annualised compound rate of interest and a two year period is being considered, the equation has been raised to the power of ½. If the forward rate linking the spot rate in year one to, say, that in year five was being calculated then since four years are being considered the equation would be raised to the power of ¼ or 0.25. To confirm the answer is correct, if £100 is invested in year one at 6% and the resulting £106 is then invested over the next two years at 9%, then the final sum will be £106 x 1.092 = £125.97. The geometric progression here is: 1.06 x (1.09)2 = (1.08)3 So, the three year spot rate = [(1.06 x 1.09 x 1.09)1/3 -1] = 8% Again, despite the different approach, a three year spot rate of 8% has been derived. In conclusion then, if the short term rate of interest is expected to rise over time then the yield curve will display a positive slope; the slope being reinforced by the liquidity preference premium. If interest rates are expected to remain unchanged in the future, however, notwithstanding the effect of liquidity preference, then a flat yield curve will result whilst the expectation of short term interest rates falling, from what the market believes are unsustainably high levels, will result in a downward sloping, or inverted, yield curve.

GRY

Maturity

Figure 2: Inverted Yield Curve

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As discussed in Chapter 1, expectations of changes in short term interest rates are largely driven by inflation expectations. However, inflation expectations can also directly influence the yield on fixed interest securities as, with the exception of index-linked bonds, notwithstanding the eight month time lag, inflation erodes both the value of future coupon payments and that of the redemption payment. Therefore, if the holder is to be provided with a real rate of return, the GRY should exceed the average inflation rate that is expected to prevail over the term of the bond. In addition, the GRY must compensate the holder for the risk that their estimate of future inflation, given the past volatility of inflation rates, may be wrong. This is termed the inflation risk premium (IRP). The more volatile inflation has been in the recent past, the greater the IRP demanded by investors. There is also the premium required for the loss of liquidity, which as we know, varies with the marketability and term of the investment and the risk appetite of investors prevailing in the market. The GRY, or annualised total return on a bond if held to redemption, can, therefore, be expressed as: GRY = real return+ expected inflation + inflation risk premium + liquidity premium When choosing between conventional and comparable index linked gilts of the same term, investors must decide whether the yield differential between the real and nominal yield offered reflects their own expectations of inflation over the term of the bond. Breakeven inflation rate tables are available which state the rate of inflation at which the investor at current yields should be indifferent between these two bonds, given the effect of various tax rates on each of the bonds coupon payments. If the investor’s inflation expectations are below this breakeven inflation rate then the conventional gilt should be chosen over the index linked gilt and visa versa. 2. Market Segmentation Market segmentation is based upon the notion that a bond market is not homogeneous but can be divided up into distinct segments based upon term to maturity, with each segment operating as if a separate market subject to its own unique set of market conditions, independently of interest rate expectations. This, therefore, implies that the shape and level of the yield curve, as well as being determined by liquidity preference and interest rate expectations, also depends on demand and supply conditions in each of these segments. For instance, as short dated gilts are typically held by banks and longer dated gilt issues are favoured by those institutional investors with long term liabilities to meet, such as pension funds, if medium dated bonds have no natural demand, this can lead to a humped yield curve, subject, of course, to the amount of bond issuance being made into each of these segments. That is, medium dated bonds would offer higher GRYs than those of equivalent short or long dated bonds, as a result of an excess of supply over demand. GRY

Maturity

Figure 3: Humped Yield Curve

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The gilt yield curve is published in the Financial Times every Saturday, whilst current and historic yield curves can be obtained from Bloomberg.

2.5

Bond Risks

LEARNING OBJECTIVES 4.2.4

Know the main risks faced by bondholders

As you no doubt appreciate by now, there are a number of risks attached to holding bonds, some of which have already been considered, notably: 1. Early redemption risk. The risk that the issuer may invoke a call provision if the bond is callable; 2. Seniority risk. The seniority with which corporate debt is ranked in the event of the issuer’s liquidation; 3. Unanticipated inflation risk. Risk of inflation rising unexpectedly and its effect on real value of bond’s coupon payments and redemption payment; 4. Liquidity risk. Liquidity is the ease with which a security can be converted into cash. Any market with brisk two-way trade and narrow dealing spreads is said to be liquid. However, bonds such as rump gilts, most index linked gilts and those issues made by less well known, or less highly rated, issuers tend to suffer from illiquidity and can, therefore, be difficult to realise at short notice or can suffer wider than average dealing spreads. In addition, liquidity also depends on an asset’s term and the ever-changing risk appetite of investors. In addition, however, the following risks also need to be considered: 5. Exchange rate risk. Bonds denominated in a currency different to that of the investor’s home currency are potentially subject to adverse exchange rate movements. Therefore, any positive difference in yield offered by such bonds over that available from equivalent bonds denominated in domestic currency must at least compensate for any potential exchange rate loss the holder may suffer; 6. Credit risk. The credit risk, or 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. The three most prominent credit rating agencies that provide these ratings are Standard & Poor’s, Moody’s and Fitch. Independent credit rating agencies should be differentiated from independent fund rating agencies as the latter rate the past and future potential performance of investment funds rather than bond issues. 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 provides an abridged version of the credit ratings available from the three companies. Standard & Poor’s

Moody’s

Fitch

Investment grade

AAA to BBB -

Aaa to Baa3

AAA to BBB -

Non-investment grade

BB+ to C

Ba1 to C

BB+ to C

Already in default

D

-

DDD to D

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Although the three rating agencies use similar methods to rate issuers and individual bond issues, essentially by assessing whether the cash flow likely to be generated by the borrower will comfortably service, and ultimately repay its debts, 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. These terms are explained more fully in Chapter 6. Very few organisations, with the exception of supranational agencies, such as the World Bank, and most Western governments, are awarded a triple-A rating, though the bond issues of most large corporations boast an investment grade credit rating. However, 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. 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. The bond issues of many large telecom companies, as a result of taking on large amounts of additional debt to finance their acquisition of third generation (3G) telecom licences in 2000, suffered severe credit downgrades and, as a consequence, experienced an indiscriminate marking down in the prices of their bond issues. Although differences between the historic default rates of triple-A rated bonds, bonds that just meet the investment grade criteria and non-investment grade bonds have been quite marked, particularly during economic recessions, the longer term performance of the latter two categories, taken as a whole, has more than compensated investors for their increased risks of default. However, as intimated earlier, investors must also be compensated for differences in the liquidity and volatility of different issues, which like the credit risk premium are subject to the changing risk appetites of investors. Therefore, we can conclude that: Corporate bond GRY = government bond GRY+credit risk premium+liquidity and volatility risk premium

7. Interest rate risk. An inverse relationship exists between the price of bonds with fixed coupons and their corresponding yields. As yields rise, so prices fall and visa versa. Bond Yield

Bond Price

Figure 4: The Relationship Between Bond Prices and Bond Yields Bond yields can rise, and, therefore, prices can fall, as a result of a number of factors such as investors increased inflation expectations or a credit downgrading. However, the most likely cause of rising bond yields is an increase in the market rate of interest.

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For example, if a gilt is issued at par with a fixed coupon of 6% when market interest rates are 6% but interest rates then suddenly increase to 7%, the price of the bond would need to fall to below par in order for the yield to rise to compete with cash deposits paying 7% interest. Another way of looking at this is to say that the price of the bond will fall because the discount rate applied to each of its future cash flows, to establish its market price or NPV, will be higher than before. We know that the theoretical price of a conventional fixed interest security with a known redemption date is given by the present value of its future cashflows: Theoretical bond price = C1/(1+r) + C2/(1+r)2 ....+ (Cn + R)/(1+r)n where C1 represents the first coupon payment, C2 the second and Cn the nth payment, R the redemption payment, r the bond’s GRY, or the rate of return required by investors, and n the term of the bond. Therefore, one of the greatest risks to a bond’s price is a rise in yield resulting from change in the market rate of interest. The sensitivity of a bond’s price to a change in its yield provides a measure of the bond’s volatility and is determined by three factors: 1. The term to maturity. Longer dated bonds are more sensitive to changes in yield than shorter dated as there are a greater number of cash flows to be discounted by this higher yield. Based on this criteria undated bonds are the most volatile. An alternative way of looking at this is to say that as bonds approach maturity they have a greater pull towards their redemption value and are, therefore, less affected by interest rate changes. This is known as the pull to maturity. Bond Price ion mpt e d e ng r achi o r p Ap

Par Approaching rede mption

Term of maturity

Figure 5: The Pull to Maturity

This can also be explained by reference to the diagram below.

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Bond Yield

Short Dated Bond Price

Long Dated Bond Price

Figure 6: Long Dated Bond Prices are More Sensitive than Short Dated Bond Prices to Changes in Yield

2. The coupon. The lower the coupon the greater the bond’s sensitivity to changes in yield. Low coupon bonds have a greater concentration of their total cash flows weighted towards the redemption payment, which when discounted at the higher yield will have a more exaggerated effect on the bond’s price. Given this, index linked bonds are more sensitive to changes in yield than conventional fixed interest bonds of the same maturity. Not only do index linked bonds generally have lower coupons than their conventional counterparts but the index linking applied to the redemption payment is far greater than the combined index linking applied to the coupon payments. Zero coupon bonds (ZCBs), however, whose only cash flow is the redemption payment at maturity, are the most volatile based on this criteria. 3. The GRY. The lower the GRY the more sensitive the bond is to changes in yield for the same reasons outlined in (2). However, the question remains which of these factors has the greatest impact on determining the sensitivity of a bond’s price to changes in its yield? In other words, would a low coupon, low GRY short dated bond be more or less volatile than a high coupon, high GRY, long dated bond? In order to establish the relative volatility or interest rate risk of two or more bonds, a composite measure of bond volatility, that combines maturity, coupon and yield, can be used. This is known as Macaulay duration.

Macaulay Duration Macaulay duration, or duration as it is usually termed, is defined as the weighted average time, expressed in years, for the present value of a bond’s cash flows to be received. The formula for calculating the duration of a bond that pays annual coupons is given by: Duration =

Σ(t x PV)

NPV of bond’s cash flows where PV is the present value of each of the bond’s cashflows discounted by the bond’s GRY and t is the time period in which the cashflow is received. t is used to weight each of these cashflows. The concept is best explained by an example.

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Example Calculate the duration of a 7% semi-annual coupon bond with a GRY of 8% and a term of three years.

Time period (t) 1 2 3 4 5 6

Cash flow (£) 3.50 3.50 3.50 3.50 3.50 103.50 121.00

x discount factor 1 /1.04 1 /1.04 2 1 /1.04 3 1 /1.04 4 1 /1.04 5 1 /1.04 6

= present value (PV) (£) 3.37 3.23 3.11 2.99 2.88 81.80 97.38 = NPV

T x PV 3.37 6.46 9.33 11.96 14.40 490.80 Σ(t x PV) = 536.32

As the bond has semi-annual cash flows, each cash flow is discounted by a factor of 1/[1 + (r/2)]n . Once the present value of each cash flow has been established, each is multiplied by the time period (t) in which it is to be received. Duration =

Σ(t x PV) NPV of bond’s cash flows

Duration = (536.32/97.38) = 5.507 However, because the coupons in this example are paid semi-annually, rather than annually, the solution must be divided by two, otherwise the answer will be 5.5 years, a term which extends beyond the term of the bond. So, the duration = 5.507/2 = 2.754 years. This solution is illustrated in the diagram below.

£81.80 £3.37

£3.23

£3.11

£2.99

£2.88

DURATION OF BOND (2.754 YEARS) TERM OF BOND (3 YEARS)

Figure 7: Macaulay Duration This solution can be interpreted as saying that this bond at this point in time has the exact same sensitivity to changes in yield, or is equally as volatile, as a zero coupon bond (ZCB) with a 2.754 year life. It will also be more volatile than a bond with a lower duration but less volatile than a bond with a higher duration. In summary, the longer dated the bond, the lower its coupon and the lower its GRY, the greater its duration will be. International Certificate in Investment Management

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Modified duration Having calculated the bond’s Macaulay duration, the sensitivity of its price to changes in its yield can be quantified by calculating its modified duration (MD), by applying the following formula: MD = Macaulay duration/(1 + GRY) for a bond that pays annual coupons, and MD = Macaulay duration/[1 + (GRY/2)] for a bond with semi-annual coupons Applying this second formula to the above example: MD = Macaulay duration/[1 + (GRY/2)] = 2.754/[1 + (0.08/2)] = 2.648 As with Macaulay duration, the higher the modified duration, the greater the sensitivity of the bond price to changes in its yield. The 2.648 derived means that for a 1% change in yield, given the bond’s current price and yield, the price will change by 2.648%. So, given a bond price of £97.38, established in the above table, if the yield rises by 1% the price should fall to: £97.38 – (£97.38 x 0.02648) = £94.80 However, this is only an approximation. BOND PRICE £121

CONVEXITY EFFECTS

{ £97.38

{

GRY3

GRY 8%

GRY2

Figure 8: Modified Duration Whereas the relationship between price and yield is convex, that assumed by the above calculation is linear. This means that only small changes in yield can be translated into price changes with any reasonable degree of accuracy (in a similar way to which interpolation approximates the IRR). Moreover, as a result of this convex relationship, a 1% rise in yield will have a smaller impact on price than a 1% fall. That is, bond price effects are not symmetrical.

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The impact of assuming a linear relationship between changes in price and yield where a convex relationship exists is to understate the price rise resulting from falling yields and to overstate the price fall as a consequence of rising yields. These are termed convexity effects. Once again, the longer the term, the lower the coupon and the lower the GRY of the bond, the greater its convexity. The greater the bond’s convexity, the greater the price rise from a given fall in yield and the smaller the price fall from a given rise in yield. A high degree of convexity, ie, the more convex the curve, is a desirable feature for a bond to possess.

2.6

Repos

LEARNING OBJECTIVES 4.2.9

Know the characteristics and uses of strips and repos

Repos are the sale and repurchase of bonds between two parties. Repos are categorised into general repos and specific repos: 1. General repos. An example of a general repo would be when party A sells bonds to party B and undertakes to repurchase these or equivalent securities at a predetermined price on a prespecified future date. Essentially party A uses these bonds as collateral for raising finance. The cost of this secured finance, the repo rate, is given by the difference between the sale and repurchase price of these bonds. 2. Specific repos. A specific repo would be used if party B has sold a particular bond they did not own in belief that its price would fall and need to acquire temporary title to an identical security in order to settle this short sale. This they would do by buying this particular bond from party A, party A agreeing to repurchase the bond at a predetermined price on a pre-specified future date. Again, the repo rate is given by the difference in the sale and repurchase price but in this example party A can also obtain a return from investing the proceeds from party B until the bond is repurchased. A formal gilt repo market has existed in the UK since 1996 and, like the gilt STRIPS market, has served to increase the liquidity of the gilt market through increased turnover.

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2.7

Securitisation

LEARNING OBJECTIVES 4.2.10

Know the concept of securitisation

Securitisation is packaging the rights to the future revenue stream from a collection of assets into a bond issue. It was originally used in the US in the early 1970s to package future interest payments from a pool of mortgages, known as Collateralised Mortgage Obligations (CMOs) or mortgagebacked securities. Securitisation has since been extended to credit card debts and even to the future revenues to be derived from prominent rock musicians’ back catalogue sales. These are termed Asset Backed Securities (ABSs).

2.8

Bond Strategies

LEARNING OBJECTIVES 4.2.11

Know the main bond strategies: bond switching; riding the yield curve; immunisation; Barbell/Bullett/Ladder portfolios

Bonds can be managed along active or passive lines. Generally speaking, active based strategies are used by those portfolio managers who believe the bond market is not perfectly efficient and, therefore, subject to mispricing. An efficient market is one in which everything known or knowable about the asset or the market in which the asset trades is factored into the asset’s price. This is covered in more detail in Chapter 9. If a bond is considered mispriced, then active management strategies can be employed to capitalise upon this perceived pricing anomaly. Active management policies are also employed where it is believed the market’s view on future interest rate movements, implied by the yield curve, are incorrect or have failed to be anticipated. This is known as market timing. Passive bond strategies, however, 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.

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Active Bond Strategies 1. BOND SWITCHING Bond switching, or bond swapping, is used by those portfolio managers who believe they can outperform a buy-and-hold passive policy by actively exchanging bonds perceived to be overpriced for those perceived to be underpriced. Bond switching takes three forms: a. Anomaly switching. This 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. b. Policy switching. When an interest rate cut is expected but not implied by the yield curve, low duration bonds are sold in favour of those with high durations. By pre-empting the rate cut, the holder can subsequently benefit from the greater price volatility of the latter bonds. c. Intermarket spread switch. When it is believed that the difference in the yield being offered between corporate bonds and comparable gilts, for example, is excessive given the perceived risk differential between these two markets, an intermarket spread switch will be undertaken from the gilt to the corporate bond market. Conversely, if an event that lowers the risk appetite of bond investors is expected to result in a flight to quality, gilts would be purchased in favour of corporate bonds.

2. RIDING THE YIELD CURVE GRY A B

0

3

5

TERM TO MATURITY (YEARS)

Figure 9: Riding the Yield Curve Riding the yield curve is an active bond strategy that does not involve seeking out price anomalies but instead takes advantage of an upward sloping yield curve. If, for example, a portfolio manager has a two year investment horizon, a bond with a two year maturity could be purchased and held until redemption. Alternatively, if the yield curve is upward sloping and the manager expects it to remain upward sloping without any intervening or anticipated interest rate rises over the next two years, a five year bond, for example, could be purchased and sold two years later when the bond has a remaining life of three years. Assuming that the yield curve remains static over this period, the manager would move from point A to point B on the yield curve, benefiting from selling the bond at a higher price than that at which it was purchased as its GRY falls. However, this strategy is totally at odds with what the yield curve is implying about the future course of interest rates. International Certificate in Investment Management

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Example If a six month zero coupon bond (ZCB) is priced at £97.40 per £100 nominal and a 12 month ZCB at £94.20 per £100 nominal, what annualised percentage return could be obtained from purchasing a 12 month ZCB and selling it in six months time assuming the yield curve remains unchanged? Would such an active policy outperform a passive buy-and-hold policy? Solution By adopting this strategy of riding an upward sloping yield curve, the return = {1- [1 + ((97.4 – 94.2)/94.2)]2} x 100 = (1 - 1.0342) x 100= 6.9% The buy-and-hold policy would have produced a return = ((100 – 94.2)/94.2) x 100 = 6.16% Therefore, the active strategy would have outperformed the passive strategy. Note: You will not be required to calculate the result of basic riding the yield curve strategies in the examination.

Passive Bond Strategies IMMUNISATION Immunisation is a passive 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. Immunisation can be performed by using either of the following techniques: a. Cash matching. As its name suggests, cash matching, involves constructing a bond portfolio, whose coupon and redemption payment cash flows are synchronised to match those of the liabilities to be met. For instance, the Boots plc pension scheme in 2000 moved all of its assets into mainly long dated fixed interest securities so as to more accurately match the profile of its scheme members pension rights. Other large pension schemes have begun considering the wisdom of Boots’ strategy but are loathe to realise equity losses. This is covered in more detail in Chapter 9. Each bond within the portfolio is held until redemption. As intimated earlier, the availability of gilt STRIPS has facilitated cash matching. b. Duration based immunisation. This involves constructing a bond portfolio with: i. The same initial value as the present value of the liability it is designed to meet, and ii. The same duration as this liability. The duration of a bond portfolio is simply the value weighted average duration of each bond in the portfolio. Although described as a passive approach, duration based immunisation requires the portfolio to be rebalanced in response to the changing durations of the underlying bonds over the holding period. To reduce the frequency of this rebalancing, however, the portfolio should contain bonds whose individual durations are as closely aligned to the duration of the liability as possible. This is known as a bullet portfolio. For instance, if a bullet portfolio holds bonds with durations as close as possible to 10 years to match a liability with a 10 year duration, a barbell strategy may be to hold bonds with a durations of five and 15 years. Barbell portfolios necessarily require more frequent rebalancing than bullet portfolios. Finally, a ladder portfolio is one constructed around equal amounts invested in bonds with different durations. So, for a liability with a 10 year duration, an appropriate ladder strategy may be to hold equal amounts in bonds with a one year duration, two year duration right through to 20 years.

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Although, historically, bonds have underperformed equities by a significant margin over the longer term, in recent years this underperformance has been reversed, whilst the relative volatility of these returns has narrowed. This has mainly been as a result of the more stable economic environment and the pursuit of sensible macroeconomic policies as well as those other factors that conspired to invert the yield curve.

2.9

The Credit Rating Agencies

LEARNING OBJECTIVES 4.2.12

Know the role of ratings agencies: Fitch, Moody’s, Standard and Poor’s and the structure of their credit ratings

In addition to rating individual issues, the credit rating agencies also rate the creditworthiness of companies, institutions, international agencies and nations separately from the ratings applied to any debt they have issued and have also recently begun rating the ability of occupational pension funds to meet their obligations as they fall due. Credit rating agencies should be differentiated from their fund rating agencies as the latter rate the past and future potential performance of investment funds rather than bond issues, organisations and nation states. 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. The table on page 4-40 provides an abridged version of the credit ratings available from the three companies. These are very important as the higher the rating, the more cheaply an institution can raise funds. Although the three main rating agencies use similar methods to rate issuers and individual issues, essentially by assessing whether the cash flow likely to be generated by the borrower will comfortably service and ultimately repay its debts, the ratings often differs though not usually significantly. The scope of this analysis has recently been widened to take account of the size of the issuer’s pension scheme deficit and, following the collapse of Enron, the nature and extent of its offbalance sheet liabilities, as appropriate. Very few organisations, with the exception of supranational agencies, such as the World Bank, and most Western governments, are awarded a triple-A rating, though the bond issues of most large organisations boast an investment grade credit rating. However, 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. 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. S&P and Fitch have recently started assigning recovery ratings to bankrupt or insolvent borrowers that indicate likely recovery prospects.

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Nationally Recognised Statistical Rating Organisation (NRSRO) The three main credit rating agencies are known as nationally recognised statistical rating organisations (NRSRO) and are granted this quasi-official status by the Securities and Exchange Commission (SEC) in the US. Since NRSRO status was introduced in 1975, this has effectively restricted entry to the industry and, as a consequence, created a cartel for the big three agencies, though a fourth, Dominion Bond Ratings, was granted NRSRO status in February 2003. The credit agencies are also subject to the recently launched International Organisation of Securities Commissions (IOSCO) code of conduct, which requires the agencies to publish their own code of conduct and explain any areas in which they do not fulfill the requirements of the IOSCO code.

Concluding Comments Generally speaking, against the backdrop of a supportive economic environment, gilts and highly rated corporate bonds provide a high level of security, a reliable and relatively attractive flow of income allied to the prospect of capital gain if inflation and interest rates are low and falling. Most are readily marketable and shorter dated issues are subject to little interest rate risk. However, no protection is afforded to the investor in an economic environment characterised by high and rising inflation and interest rates, unless the bond is index linked or has a floating rate coupon, or against the increased risk of default on corporate debt if the economy moves into recession.

3. CASH AND MONEY MARKET INSTRUMENTS 3.1

Introduction

Whereas bond markets are populated by issuers and investors seeking to raise and invest capital over the medium to long term, cash investments are geared to short term liquidity management and providing a temporary safe haven for investment funds. Cash investments take two main forms: cash deposits and money market instruments.

3.2

Cash Deposits

LEARNING OBJECTIVES 4.3.1

Know the main characteristics and risks of cash deposits and money market instruments: Money Market Deposits; Certificates of deposit (CDs); Commercial Paper (CP); Treasury Bills

Cash deposits generally comprise bank, building society and National Savings products, all of which are targeted at retail investors, though companies and financial institutions make short term cash deposits with banks.

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The main characteristics of cash deposits are: 1. The return simply comprises interest income with no potential for capital growth. 2. The amount invested is repaid in full at the end of the investment term. The interest rate applied to the deposit is usually: 1. 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. This was covered in Chapter 2. 2. Fixed or variable. 3. Paid net or gross of tax. 4. Dependent upon its term and/or notice required by the depositor. Fixed term deposits are usually subject to penalties if an early withdrawal is made. All retail cash deposits placed with licensed deposit taking institutions in the UK are covered by the FSA’s Financial Services Compensation Scheme (FSCS) up to a maximum of £35,000. The maximum payment from the scheme is £31,700, being 100% of the first £2,000 plus 90% of the next £33,000 deposited with any one licensed deposit taking institution. Where cash is deposited overseas either onshore or offshore, depositors should also consider the following: 1. The costs of currency conversion and the potential exchange rate risks if sterling deposits cannot be accepted. 2. The creditworthiness of the banking system and the chosen deposit taking institution and whether a depositors’ protection scheme exists. 3. The tax treatment of interest applied to the deposit. 4. Whether the deposit will be subject to any exchange controls that may restrict access to the money and its ultimate repatriation.

3.3 Money Market Instruments LEARNING OBJECTIVES 4.3.1

Know the main characteristics and risks of cash deposits and money market instruments: Money Market Deposits; Certificates of deposit (CDs); Commercial Paper (CP); Treasury Bills

The money markets are the wholesale or institutional markets for cash and are characterised by the issue, trading and redemption of short dated negotiable securities usually with a maturity of up to one year, though typically three months. Due to the short term nature of the market most instruments are issued in bearer form and at a discount to par, to save on the administration associated with registration and the payment of interest. Although accessible to retail investors indirectly through collective investment funds, direct investment in money market instruments is often subject to a relatively high minimum subscription and, therefore, tends to be more suitable for institutional investors.

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The main securities comprise: 1. Certificates of Deposit (CDs). 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 maturity or realise the security in the money market whenever access to the money is required. However, being a fixed interest security the price will fluctuate with the competitiveness of the yield. By issuing a CD, the bank is able to keep the deposit on its books until the CD matures. CDs can be issued with terms of up to five years. 2. Commercial Paper (CP). Commercial Paper is the term used to describe the unsecured negotiable bearer securities, or short term promissory notes, that are issued by plcs with a full LSE listing. These securities are issued at a discount to par with a maturity of between eight and 365 days. Being redeemed at par, the return on Commercial Paper entirely comprises capital gain. Another short term financing instrument that can be issued by companies is a bill of exchange. A bill of exchange is essentially an invoice, for goods or services supplied, which states the amount and date by which this amount is due to be paid by the recipient of the transaction. Once the obligation to pay this amount by the due date is formally accepted by the party in receipt of these goods and services, the instrument becomes a negotiable bearer bill and can be traded at a discount to its face value until maturity. To minimise the credit risk associated with holding such a bill and to narrow the discount at which it can be sold, the issuer may obtain the formal acceptance of an eligible bank to guarantee the face value of the bill at maturity. 3. Treasury Bills (TBs). Treasury Bills are similar to Commercial Bills in that they are issued at a discount to par whilst being redeemed at their nominal value. However, they are issued weekly via a Bank of England auction, usually with a term of 91 days and a £100 redemption value, and are backed by the UK government. Treasury Bills are highly liquid and act as the benchmark risk free interest rate when assessing the returns potentially available on other asset types. This we come back to in Chapter 9. Rather than being issued to satisfy the government’s short term financing needs, however, Treasury Bills are used as a monetary policy instrument to absorb excess liquidity in the money markets so as to maintain short term money market rates, or the price of money, as close as possible to base rate. The annual yield on a 91 day Treasury Bill is calculated by the following formula: [(par value - issue price)/issue price] x 365/91 x 100 So, a 91 day Treasury Bill issued at £98.50 will have an annual yield of: 1 + [[(100 - 98.5)/98.5]4 - 1] x 100 = 6.2% In addition to holding these instruments, fixed term deposits can also be made in the Interbank market. The Interbank market originally served the short term deposit and borrowing needs of the commercial banks but has since been tapped by institutional investors and large corporates with short term cash surpluses or borrowing needs in excess of £0.5m. The term of deposits made on the Interbank market can range from overnight to one year with deposit rates being paid on a simple basis at LIBID - the London Interbank Bid Rate - and short term borrowing being charged at LIBOR - the London Interbank Offered Rate. The mean of these rates is LIMEAN, the London Interbank Mean Rate.

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Concluding Comments Cash deposits and money market instruments provide a low risk way to generate an income or capital return, as appropriate, whilst preserving the nominal value of the amount invested. They also provide a valuable role in times of market uncertainty. However, they are unsuitable for anything other than the short term as, historically, they have underperformed most other asset types over the medium to long term. Moreover, in the long term, the post-tax real return from cash has barely been positive.

4. DERIVATIVES 4.1

Introduction

A derivative instrument is one whose value is based on the price of an underlying asset. This asset could be a financial asset such as individual company shares, equity and bond indices, interest rates or currencies or a hard or soft commodity asset, such as silver or wheat. The underlying asset is often referred to as the cash market. Most derivatives take the form of either forwards, futures or options contracts, though others include warrants and swaps.

4.2 Forward and Futures Contracts LEARNING OBJECTIVES 4.4.1

Know the characteristics of futures

4.4.2

Understand the risk reward profile of buying and selling futures

4.4.6

Understand the geared nature of futures and options

4.4.8

Know the differences between forwards, futures and options

4.4.9

Know the differences between physically settled and cash settled derivatives and the role of the clearing houses

4.4.11

Know the characteristics of a contract for difference

Derivatives can be traced back to the Middle Ages. Drawing on the microeconomic principles covered in Chapter 1, farmers and merchants operating in near perfectly competitive agricultural markets, being price takers unable to influence the market price of produce come harvest time, needed a mechanism by which to guard, or hedge, against price fluctuations caused by glut and drought. So as 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 the commodity would be delivered between the farmer and merchant (the counterparties) at a prespecified future time. These early derivative contracts introduced an element of certainty into commerce.

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In the US mid-West grain markets of 19th century, these contracts gained immense popularity and led to the opening of the world’s first, and until very recently, largest, derivatives exchange - the Chicago Board of Trade (CBOT) - in 1848. 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. That is, the obligation written into the contract, to deliver or take delivery of a predetermined quantity and quality of grain at a pre-specified price, could be transferred to other parties before the stated delivery date. However, although these futures contracts were subsequently extended to a wide variety of commodity markets, and offered by an ever increasing number of derivative exchanges, 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 amongst an increasing number of derivatives exchanges, including the London International Financial Futures and Options Exchange (LIFFE). Subsequently LIFFE was acquired by a consortium of European exchanges called Euronext and is now referred to as Euronext.liffe. Derivatives then primarily provide a mechanism by which the price of assets or commodities can be traded in the future at a price fixed today without the full value of this transaction being exchanged or settled at the outset. Each of the contracts considered so far can be defined as follows: 1. Forward contracts. A forward contract is 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. In executing, or opening a position in, a forward contract, the buyer is said to go long of the contract whereas a seller is described as going short. Forward contracts are usually individually negotiated deals tailored to meet the exact needs of the counterparties. As such, they are rarely traded on a derivatives exchange, as to be tradable, assets require some sort of standardisation. Therefore, they are traded off exchange directly between the counterparties and are known as over-the-counter (OTC) derivatives. 2. Futures contracts. The definition of a futures contract is identical to that of a forward contract. However, there are two main differences between the two derivatives: a. Futures are traded on regulated derivatives exchanges with a central counterparty guaranteeing each trade registered on the exchange. As futures are traded on regulated derivatives exchanges they are known as exchange-traded derivatives. Increasingly, derivatives exchanges are moving away from being centralised market places, where trading is conducted on an exchange floor, to being decentralised, where trading is conducted remotely via electronic trading systems. Each derivatives exchange has a clearing house, which, amongst its other functions, acts as a central counterparty to each trade registered on the exchange. Trades are registered on the same day as they are executed. This ensures that in the event of a counterparty defaulting upon its obligations, the clearing house will honour the futures contract to which it is a party. The role of the London Clearing House (LCH), which acts on behalf of Euronext.liffe, is discussed below. b. Futures contracts are subject to detailed contract specifications determined by the exchange on which the future is traded so as to standardise the following: i. The quality of the asset to be delivered. ii. The notional value, or quantity, of the asset upon which the contract is based, and ultimately to be delivered if the contract is physically settled.

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iii. The tick size and tick value of the contract. The tick size is the minimum possible price movement of the contract. For instance, the Euronext.liffe FTSE 100 index future has a tick size of 0.5 index points. The tick value is the monetary value of one tick. For this contract it is £5. iv. The predetermined date(s) on which the underlying asset is to be delivered by the seller of the contract to the buyer in exchange for cash if physically settled, or the cash to be exchanged between the parties if cash settled. There are four things to mention about delivery: i. As intimated above, not all futures contracts require physical delivery of the underlying asset: some are settled between the counterparties by cash on the monetary gain or loss to date. These are known as contracts for differences (CFD). At no stage do the counterparties to a CFD exchange the notional value of the contract. Most Euronext.liffe financial futures contracts, with the main exception of Euronext.liffe Long Gilt Futures, are cash settled CFDs whereas most commodity based contracts are physically settled. ii. At any one point in time all Euronext.liffe financial futures contracts have three delivery dates from which to choose. At November 2001 these comprised delivery dates in December, March and June. Once the December 2001 contracts expired, contracts with September 2002 delivery dates became available. iii. Some physically settled futures contracts do not simply have a single delivery date but a delivery period during which the seller can make delivery to the buyer. Euronext.liffe Long Gilt Futures contracts, for instance, each have a delivery month at any point during which the seller can give notice to Euronext.liffe of an intention to deliver gilts to the buyer. iv. Very few futures contracts run to the delivery date as most are closed out prior to this point by entering into an equal and opposite transaction in a contract with the same specification and expiry date so as to offset the original open position. The process of closing out is considered later in this section.

4.3

The Clearing House

LEARNING OBJECTIVES 4.4.7

Understand the principles of margin

4.4.9

Know the differences between physically settled and cash settled derivatives and the role of the clearing houses

Clearing and settlement services are provided by a clearing house. Most clearing houses operate exclusively for a single exchange though several, such as the London Clearing House (LCH), act on behalf of a number of exchanges, ie, International Petroleum Exchange, London Metal Exchange and Euronext.liffe. The principal aims of a clearing house are to: 1. Provide an efficient and cost-effective clearing service to the clearing members of its member exchanges. An exchange clearing member is one who has authority to process, or clear, a derivatives trade once executed. Most clearing members also have the authority to execute derivatives trades but must hold an exchange-trading permit to do so.

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2. Some clearing houses also offer novation where they act as the central counterparty to all trades registered on a member exchange. For example, the LCH becomes the counterparty to each and every trade registered on a member exchange. Novation is the cancelling of the original contractual relationship between the counterparties to the trade at the point at which the trade is registered on the exchange and replacing this with a new contractual relationship between each counterparty and the LCH. By the LCH being the counterparty to each registered trade, anonymity is preserved between the original counterparties. Client A (seller)

Clearing member A

Client B (buyer)

Contractual relationship formed

Clearing member B

Trade novates to LCH

LCH

Figure 10: LCH as Central Counterparty As a central counterparty, the LCH ultimately acts as the guarantor to each registered trade executed on the exchange in the event of a counterparty defaulting. To minimise the risk of default, the LCH: a. Sets stringent clearing member admission and continuing obligation requirements. b. Requires collateral, or margin, to be deposited by exchange clearing members when futures positions are initially registered and then throughout the term of the contract on any losses accumulated whilst this position remains open. This margin takes two forms: i. Initial margin. This is payable by both exchange clearing members to the LCH, upon a futures contract being registered and usually represents between 2% and 5% of the transaction’s notional value, depending on prevailing market conditions. This sum covers the LCH against the most probable adverse one day price movement in the contract. Initial margin can be paid either in cash or in securities that are acceptable to the LCH and is returned once the contract has been settled between the parties or upon the contract being closing out. Cash deposited with the LCH earns interest daily at the London deposit rate. ii. Variation margin. As initial margin only potentially covers the LCH for a one day price movement in the contract, the profit and loss position of each party is calculated on a daily basis for the previous trading day and settled between the exchange clearing members in cash via the LCH each morning. This process of revaluing futures positions daily is known as marking to market. In addition, the existence of a central counterparty enables margin payments and receipts from multiple trades to be netted out.

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4.4

The Main Uses of Futures Contracts

“There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can” Mark Twain, Following the Equator It has become evident in what was originally discussed that derivatives have principally been used to oil the wheels of commerce by introducing an element of certainty into the price at which future transactions take place. Indeed, in the US there has been a requirement since 1974 that before any derivative can be traded on an exchange it must have an underlying economic purpose. Moreover, in a world characterised by rising volatility and increased uncertainty, stemming partly from the globalisation, or continued integration, of the world economy and financial markets, derivatives have become increasingly important as a means to hedge, or transfer, risk to those who wish to assume it. However, 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. Given that futures are highly geared instruments, if the market moves against the speculator though, losses can mount up very quickly. Indeed, following several high profile disasters involving derivatives, most nonpractitioners 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, or brisk two-way trade, in futures contracts, without speculators those wishing to use futures to hedge risk would be unable to do so. Within portfolio management, futures can be used for the following purposes: 1. Hedging. Hedging is a technique employed by portfolio managers to reduce the impact of adverse price movements in financial assets held within a portfolio by selling sufficient futures contracts. You may recall from Chapter 2, that another means of reducing risk is by diversifying the range of assets held within a portfolio. However, whether risk is reduced through hedging or diversification it can never be completely eliminated, unless, of course, in the case of diversification the asset returns within the portfolio are perfectly negatively correlated. 2. Anticipating future cash flows. Closely linked to this idea of hedging adverse price movements in assets already held is hedging a potential rise in the price of assets soon to be purchased. If a portfolio manager expects to receive a large inflow of cash to be invested in a particular asset, then futures can be used to offset the potentially increased cost of the asset when the cash flow is received. 3. Asset allocation. Asset allocation describes the way in which a portfolio’s assets have been invested both geographically and between the various asset classes. Changes to this asset mix, 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. Futures transactions can also easily be reversed. 4. Arbitrage. Arbitrage is the process of deriving a risk-free profit from simultaneously buying and selling the same asset in two different markets where an unexplained price difference, or pricing anomaly, exists. If the price of the derivative and underlying asset are out of line, then the portfolio manager may be able to profit from this pricing anomaly.

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4.5

Euronext.liffe Financial Futures Contracts

LEARNING OBJECTIVES 4.4.7

Understand the principles of margin

4.4.10

Know the main characteristics, contract specifications uses within investment management of Euronext.liffe (formerly LIFFE)

and

(see the syllabus learning map at the back of this book for the full version of this learning objective) 4.4.11

Know the characteristics of a contract for difference

4.4.12

Know the meaning of contango and backwardation

The main financial futures contracts traded on Euronext.liffe include: 1. FTSE 100 index future; 2. Long Gilt Futures 3. Short term interest rate (STIR) futures; 4. Universal stock futures. The underlying contract specifications of each will now be considered in turn though the FTSE 100 index future will also be used to further explain the mechanics of futures contracts in general and illustrate how each of the above uses for futures within portfolio management can be employed in practice.

Euronext.liffe FTSE 100 Index Future The FTSE 100 index future is based upon the FTSE 100 index, which derives its value from the share price performance of the UK’s top 100 companies. The future is priced in index points with a tick value of £5 per 0.5 of an index point for the purpose of calculating variation margin and at £10 per index point when establishing the contract’s notional value. So a contract priced at 5,000 index points would have a notional value of: Number of index points x value per index point 5,000 x £10 = £50,000 This is the maximum amount the buyer of the contract would lose if the FTSE 100 index fell to zero. Being a contract for differences (CFD) settled in cash, at no stage of the transaction from opening a position in the contract to the expiry date, or its prior closing out, would this notional value be exchanged between the counterparties. Instead, initial margin is payable by both parties to the LCH and daily profits and losses are settled in cash each morning via the LCH based on the price movement in the contract on the previous trading day. Hence the term, contract for differences.

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As to its mechanics, if you believe the FTSE 100 index will rise over the term of the contract, you buy, or go long of, the contract but go short if you believe the FTSE 100 will fall. This is illustrated in the diagram below. £

Long

Short

Profit

45°

45°

0

Loss

5,000

FTSE 100

Figure 11: FTSE 100 Index Futures Contracts So, if a contract is executed when the contract price is 5,000 index points and the FTSE 100 subsequently rises in value, the buyer will gain at the expense of the seller and visa versa if the FTSE 100 subsequently falls. You also will also notice that the gains are exactly mirrored by the losses in both cases. This is true of all futures transactions. Futures contracts, therefore, represent a zero sum game: for every winner there will be an equal and opposite loser. So if on the first trading day after executing the contract, the price rises to 5,050, the long position would have made 50 index points, or 100 ticks, of profit and the seller an equivalent loss. Therefore, 100 ticks at £5 per tick = £500 will pass as variation margin between the short position to the long position the following morning via the LCH. To simplify matters from hereon we will treat each index point as being worth £10, rather than two ticks each worth £5.

PRICING So how exactly is the contract priced? Well, the price of any futures contract will be determined by the number of orders placed to buy the contract and the number placed to sell at any point in time. As in any free market, price acts as the mechanism to bring demand and supply into equilibrium. Where there are more buyers than sellers of FTSE 100 index futures, this will have the effect of driving the contract price higher until sellers are attracted back into the market. Where there is an excess of sellers, the price will fall until a sufficient number of buyers come back into the market. Futures prices then can vary independently of the underlying asset, the FTSE 100 index in this particular case. However, the FTSE 100 index future contract price cannot deviate too far from the underlying FTSE 100 index as upon the delivery, or expiry, the price of the futures contract converges to that of the underlying FTSE 100. Therefore, any significant divergence between the two prices will present an arbitrage opportunity. International Certificate in Investment Management

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To obtain the price, or fair value, of the FTSE 100 index futures contract, the following equation should be applied: FTSE 100 index future fair value = FTSE 100 index + {FTSE 100 index x [(short term interest rate - FTSE 100 dividend yield) x remaining term of contract]} Example The FTSE 100 index currently stands at 4,000 and has a dividend yield of 2%. The three month money market interest rate is 5%. Calculate the fair value of a FTSE 100 index future that has 90 days remaining before expiry. FTSE 100

FTSE 100 Index Future

4,030 BASIS 4,000 FTSE 100 Index

Term of FTSE 100 Index Futures Contract

Expiry date

Figure 12: Pricing a FTSE 100 Index Future Solution FTSE 100 index future fair value = 4,000 + {4,000 x [(0.05 - 0.02) x 90/365]} = 4,030

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There are three points to note about the price that has been derived: 1. The FTSE 100 index future is simply another way of gaining exposure to the FTSE 100 index. However, whereas buying the underlying stocks in the FTSE 100 index entails making a capital outlay equal to the value of these underlying stocks, the FTSE 100 index future only requires the payment of initial margin upon opening a position in the contract. The cash that would otherwise have been used to purchase these stocks can, therefore, be invested in an interest bearing cash deposit over the term of the contract. The margin deposited similarly earns interest over this same term. The income return from purchasing the FTSE 100 index, however, is given by the dividend yield: the value of dividends from the index expressed as a percentage of the index value. Since the yield from investing in a cash deposit is usually higher than the dividend yield on the FTSE 100 index, the future usually has a higher price than the underlying index. 2. When the futures price is higher than that of the underlying asset, the market is said to be in contango. This is usual for a financial future. However, when the futures price is lower than that of the underlying asset, the market is in backwardation. 3. The difference between the futures price and that of the underlying cash market gives rise to the basis. In this example the basis is 37 index points. This is also known as the fair value premium when the market is in contango and a fair value discount when in backwardation. As the futures contract approaches expiry so this basis will narrow until the futures price converges with the FTSE 100 index on the delivery date. The basis can, of course, either widen or narrow in response to a change in interest rates and/or the dividend yield and market sentiment. However, if the basis moves for an unexplained reason, then arbitrage activity will bring it back into line. Any potential movement in the basis is known as basis risk. A futures contract can be closed out at any time by either party to crystallise a gain or limit a loss by entering into an equal and opposite transaction in a contract with the same specification and expiry date as that originally bought or sold, albeit at a different price. So, if a FTSE 100 index future had been bought at 4,030 and the contract price rose to 4,070, then the contract can be closed out before the delivery date by selling a FTSE 100 contract with the same delivery date at 4,070 to lock in this gain. Variation margin of 40 index points x £10 per point = £400 would have been paid by the original seller to the original buyer and the initial margin deposited with the LCH would be repaid as the original buyer now has a flat position in the contract. The original seller faced with the prospect of mounting losses could crystallise their position by buying a FTSE 100 index future at 4,070. In both cases, when one party closes out their position, the other party’s position remains open as the counterparty to each open position is the LCH.

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CLOSING OUT £ New Short Short

Long

PROFIT

0

LOSS

4,030

4,070

FTSE 100

Figure 13: Closing Out a FTSE 100 Index Future Using the FTSE 100 index future within portfolio management The FTSE 100 index future can be used within portfolio management for: 1. Hedging; 2. Anticipating future cash flows; 3. Asset allocation; 4. Arbitrage. 1. Hedging Before looking at a hedging example, it is useful to consider why FTSE 100 futures would be used in preference to selling the underlying portfolio if the expectation is for the FTSE 100 to fall. There are three reasons for this: a. The portfolio manager’s mandate may require equities to be held within the portfolio regardless of market conditions. b. Selling a large portfolio would: i. Move the price of the shares against the portfolio manager; ii. Take time; iii. Result in significant dealing costs. c. Futures markets: i. Being more liquid than securities markets, would not move the price of the transaction against the fund manager and would be completed more swiftly; ii. Incur lower dealing costs.

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Hedging Example If a portfolio manager wants to hedge a £1m FTSE 100 portfolio over the next three months against a market fall with the FTSE 100 at 4,000 and the future priced at 4,042, how many futures contracts would they need to buy or sell, assuming that the value of the portfolio moves in line with that of the FTSE 100 index? Solution The portfolio manager would need to sell: Portfolio value/

FTSE 100 futures contract value =

£1m/ 4,042 x £10

= 24.74 contracts However, since futures can only be dealt in whole contracts, 24.74 is rounded up to 25 contracts. Example 1 Given the above, what would be the net profit or loss if the FTSE 100 index fell to 3,900 taking the futures price to, say, 3,940? Solution The value of the portfolio would fall to: £1m x 3,900/4,000 = £975,000 This loss of £25,000 would be more than offset by the profit on the futures: = {[(4,042 - 3,940)] x £10 x 25} = £25,500 Therefore, the net position would be: £975,000 + £25,500 = £1,000,500 rather than the £1m the portfolio manager started with. If only 24 contracts had been purchased, the net result would have been £999,480. There are four reasons why hedging using futures is imperfect: 1. The calculation for determining the number of contracts to hedge an underlying asset is based on the futures price rather than on the price of the asset, or cash market. 2. The number of contracts sold is usually either rounded up or rounded down. 3. The basis is not constant and can temporarily move out of line. 4. The portfolio may not move in line with the market. This we consider in Chapter 9. Example 2 What if the FTSE 100 index didn’t fall but rose to 4,055 taking the futures price to, say, 4,100? Solution Although the value of the portfolio would have risen to £1m x 4,055/4,000 = £1,013,750, this increase would have been more than offset by the variation margin payable to the LCH for the [(4,100 - 4042)] = 58 index points loss = [58 x £10 x 25] = £14,500.

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Regardless of whether the FTSE 100 index rises or falls, by using FTSE 100 index futures to hedge the portfolio, the portfolio manager has essentially locked it into a FTSE 100 index value of about 4,000. This stands in contrast to when FTSE 100 index options are used. These are considered later in the Chapter. The futures hedge can, of course, be closed out at any time before expiry by buying 25 FTSE 100 index futures with the same delivery date to offset the original short position. 2. Anticipating Future Cash Flows If our portfolio manager expects to receive a cash inflow of £500,000 into their £1m FTSE 100 portfolio shortly and anticipates that the market will rise between now and then, they could buy sufficient FTSE 100 futures contracts to offset the increased cost of the FTSE 100 index shares when the cash flow is received. Assuming again that the FTSE 100 index is trading at 4,000 and the FTSE 100 index future at 4,042, the portfolio manager would buy: 500,000/ 4,042 x 10 = 12.37 contracts, rounded down to 12 contracts If the contracts are held to the delivery date and at this point the FTSE 100 index had risen to 4,500 - the futures price having converged to that of the FTSE 100 index - then the variation margin payable to the portfolio manager would be: [12 x (4,500 - 4,042) x £10] = £54,960 However, this sum which represents a 54,960/500,000 = 11% increase in the £500,000 would not fully offset the 12.5% rise in the FTSE 100 index, partly as a result of rounding down the number of contracts purchased but mainly because 42 index points has been lost over the term of the contract. This will be revisited when we consider the use of options. 3. Asset Allocation As noted earlier, using futures contracts to make portfolio asset allocation switches, whether geographic or between asset classes, is less expensive and more efficient than adjusting the underlying portfolio. For example, to increase exposure to the US equity market at the expense of UK equities, a fund manager would simply sell sufficient FTSE 100 futures to reduce the UK equity exposure and purchase sufficient S&P 500 futures without disturbing the underlying securities in the portfolio. The manager could then gradually close out these contracts as the UK shares in the portfolio are sold and US stocks are purchased. 4. Arbitrage The portfolio manager can generate additional capital profits for a portfolio by arbitraging any unexplained differences between what the basis should be and what it currently is. Once again, if the FTSE 100 index stands at 4,000 and the three month FTSE 100 index future at 4,050, when the fair value should be 4,042, a risk free profit can be made by borrowing funds at the prevailing three month money market rate of interest to purchase the FTSE 100 index at 4,000 whilst simultaneously selling the three month future at 4,050. If a sufficient number of arbitrageurs enter into this same transaction then the FTSE 100 index should be driven up and the future driven down until the fair value premium, or basis, comes back into line.

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Euronext.liffe Long Gilt Futures LIFFE long gilt futures contracts can be used within the portfolio management process in exactly the same way as FTSE 100 index futures contracts. These contracts differ from the FTSE 100 index contract, however, in that they are : i. Based on a notional gilt with a £100,000 nominal value and a 7% coupon. Each contract has a tick value of £10 per 0.01 movement in the contract price. 0.01 is known as 1 basis point (1bp). ii. Physically settled, rather than cash settled, if held until the delivery month and the seller, or short position, has given notice to LIFFE of its intention to deliver. The short position will then deliver gilts with a nominal value of £100,000 for each contract sold from an approved list to the buyer of the contract in exchange for a cash sum calculated by LIFFE, known as the invoicing amount. The mostly likely gilt to be delivered by the seller to the buyer from the approved list in each case is known as the cheapest to deliver (CTD) gilt. The price of the CTD gilt determines the price of the gilt future and ultimately the invoicing amount. If, however, the short position does not wish to go to delivery, they have until the last trading day in the delivery month to close out the contract. Although the long position also has the option of closing out their position on or before the last trading day, if they have no intention of taking delivery of the CTD gilt their position must be closed out three business days before the start of the delivery month to eliminate any possibility of being required to take delivery of the CTD gilt.

Euronext.liffe Short Term Interest Rate (STIR) Futures STIR futures are based on the British Bankers Association (BBA) LIBOR for three month sterling deposits. Each contract has a notional value of £500,000 with a tick value of £12.50 per 0.01 movement in the contract price. This tick value is derived from: £500,000 x 0.01% x 3/12 = £12.50 The contract is priced on the basis of 100 minus the three month interest rate. So, if the three month BBA LIBOR is 6%, the contract would be priced at 100 - 6 = 94. The contract can be used for both speculation and hedging. If a speculator believes that short term interest rates are heading higher then they would sell the contract as higher interest rates would cause the price of the contract to fall, in the same way that higher bond yields result in lower bond prices. If a hedger, however, having deposited cash at a short term money market rate fears that interest rates may fall, then they will buy the contract to guard against receiving a lower interest income. Once again, the activities of hedgers and speculators create a liquid two-way market in risk: the former transferring risk to the latter. Example 1 A portfolio manager has borrowed £1m temporarily for three months upon which interest is payable at LIBOR + 1%. LIBOR is currently 5.5%. The manager believes that interest rates may rise very soon and wants to guard against higher interest costs. At what price should these contracts be trading and how many contracts should the manager buy or sell? Solution The contract should be priced at 100 - 5.5 = 94.5 Number of contracts to be sold = £1m/£500,000 = 2 International Certificate in Investment Management

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Example 2 If the contract is currently priced at 94.5 and at expiry LIBOR has risen to 7%, will the portfolio manager be fully covered against rising interest costs? Solution 3 month interest costs when LIBOR is at 5.5%: £1m x 0.065 x 3/12 = £16,250 Three month interest costs when LIBOR is at 7%: £1m x 0.08 x 3/12 = £20,000 Increase in interest costs = £20,000 - £16,250 = £3,750 Gain on STIR futures contracts to offset increase in interest costs = 2 contracts x 150 ticks x £12.50 = £3,750 The portfolio manager will, therefore, be completely covered against rising interest costs.

Euronext.liffe Universal Stock Futures LIFFE universal stock futures are a recent innovation. Rather than enable portfolio managers to hedge the risk of an entire portfolio, they hedge the price risk associated with individual stocks held within a portfolio. However, they are currently limited to a selection of larger multinational companies. Each position taken in a contract is for 1,000 UK company shares or 100 US or European company shares. Universal stock futures are cash settled.

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4.6 Options LEARNING OBJECTIVES 4.4.3

Know the characteristics of options

4.4.4

Be able to calculate the outcome of basic option strategies and the potential risks and rewards of: buying calls; buying puts; selling calls; selling puts

4.4.5

Understand American and European exercise styles

4.4.6

Understand the geared nature of futures and options

4.4.8

Know the differences between forwards, futures and options

4.4.10

Know the main characteristics, contract specifications and uses within investment management of Euronext.liffe (formerly LIFFE) (see the syllabus learning map at the back of this book for the full version of this learning objective)

4.4.13

Know the meaning of in-the-money, at-the-money and out-of-the money in relation to options

4.4.14

Be able to calculate the time and intrinsic value of an option premium given the premium and the underlying price Know the factors that determine an option premium

4.4.15

So far we have restricted our analysis to futures contracts. We now move on to consider options contracts. Options, although traceable back to the Japanese rice markets and the Dutch Tulipmania of 17th century, didn’t really start to flourish until two US academics - Fischer Black and Myron Scholes produced the Black Scholes option pricing model in 1973. Until then, options contracts could not easily be priced which prevented them from being traded. This model, however, paved the way for the creation of standardised options contracts and the opening of the Chicago Board Options Exchange (CBOE) in the same year. This in turn led to an explosion in product innovation and the creation of other options exchanges, such as Euronext.liffe. Options can still be traded off-exchange, or over-the-counter (OTC), however, in much the same way as forward contracts, where the contract specification determined by the parties is bespoke.

The Underlying Mechanics An options contract can be defined as one that confers the right from one party to another to either buy or sell an asset at a pre-specified price on, and sometimes before, a pre-specified future date, in exchange for the payment of a premium. PREMIUM WRITER

HOLDER RIGHT

Figure 14

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The two parties to an options contract are the holder and the writer. The writer, or seller, 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 the following respect: a right is conferred in exchange for the payment of a premium. An option that confers the right to buy is a call option whereas one that confers the right to sell is a put option. 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. As the minimum value of an option is zero, 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. Most exchange-traded options can be exercised on or before the expiry date and are known as American style options. Options that can only be exercised by the holder on the expiry date are termed European style options. The pre-specified price stated in the contract is termed the strike price or exercise price. As only the writer has an obligation to deliver the asset to the holder of a call option at this exercise price if the option is exercised against them or take delivery from the holder of a put option if exercised against them, only the writer is required to make initial and variation margin payments to the clearing house of the member exchange upon which the option is written: the LCH for Euronext.liffe traded options for instance. However, as with most exchange-traded financial futures, 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: the cash difference again being determined by the tick value of the contract. The following diagrams illustrate these points.

PROFIT HOLDER 367.5 0 x = 4300 4667.5 -367.5

FTSE 100 Index WRITER

LOSS

Figure 15: FTSE 100 Index Call Option

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The above diagram considers the position of a holder and a writer of a Euronext.liffe FTSE 100 index call option, given a FTSE 100 index value of 4,300. The option, like its equivalent future, is cash settled and priced in index points at £10 per point, again with a tick value of £5 per 0.5 of an index point. As with all Euronext.liffe traded options it also offers the choice of three expiry dates via three separate contracts. In this example a three month call option is used. The holder of the FTSE 100 index call option believes that the index will rise over the term of the contract whilst the writer takes the view that the index will either remain static or will fall. The holder in order to acquire the right to buy the underlying FTSE 100 index at 4,300, in this example, must pay a premium of 367.5 index points to the writer. This immediately puts the holder into a loss position. However, once the FTSE 100 index rises beyond the exercise price, the holder starts to move towards the break even point of 4667.5. At 4,301, for instance, the holder could exercise the option requiring the writer to pay 1 index point at £10. However, given the premium paid of 367.5 index points, the holder’s loss would only have been reduced to 366.5 index points. At 4,302, the loss would reduce to 365.5 index points and so on until at 4667.5 the premium is completely covered. Beyond this point the holder moves into profit. The position of the writer exactly mirrors that of the holder. Options, like futures, are a zero sum game. At 4,301 the writer’s profit is reduced by 1 index point just as the holder’s loss is reduced by 1 index point. As the holder breaks even so does the writer and as the holder moves into profit so the writer starts to accrue losses at the same rate. The most the holder can lose is all or part of the premium paid to the writer if the FTSE 100 doesn’t reach the breakeven point whereas the call writer’s potential losses are unlimited above the breakeven point. Therefore, the premium received by the call writer must reflect the probable size of potential losses. This is exactly what the Black Scholes option pricing model aims to calculate. The writer can, however, close out their position at any time by entering into an equal and opposite transaction to their short position; that is by purchasing an option with the same contract specification and expiry date as that originally sold. By the writer closing out their position, the holder’s position remains open as the counterparty to the contract is not the writer but the LCH.

PROFIT

HOLDER

295.5

0

x =4300 4004.5

FTSE 100 Index

- 295.5 WRITER LOSS

Figure 16: FTSE 100 Index Put Option International Certificate in Investment Management

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The FTSE 100 index put option in this example confers the right on the holder to sell the FTSE 100 index to the writer at an exercise price of 4,300. Again, the FTSE 100 index stands at 4,300. By purchasing a three month put option, the holder takes the view that the index will fall over the option’s life whilst the writer believes the index will either remain static or rise. Given a premium of 295.5 index points, once the index reaches 4004.5, both the holder and writer are in a breakeven position. Beyond this point the holder begins to profit at the expense of the writer. At this point the writer may decide to close out their position. However, although the holder’s maximum loss is, once again, limited to the premium paid to the writer, the writer’s loss is not unlimited as the furthest the index can fall is to zero. Added to the fact that equity markets tend to rise more often than they fall, writing put options is generally a less risky activity than writing call options. This is reflected in the difference between the two premiums paid by the respective holders in the above examples.

Options on Futures Options that confer the right to buy or sell a futures contract, with a pre-specified delivery month, at a pre-determined strike price are called options on futures. Unlike other exchange-traded options, these specialist options, such the Euronext.liffe Option on Long Gilt Future, are, as with futures positions, marked to market daily between the two parties with variation margin payable via the exchange clearing house. As such, they do not require the holder to pay the writer a premium upon opening the position. However, if the holder exercises the option only then does the original premium become payable though this is netted out against the variation margin balances held by the clearing house. At this point, the holder assumes either a long or short futures position with a set delivery month.

Categorising Options Options are described as being either in-the-money (ITM), at-the-money (ATM) or out-of- themoney (OTM) depending on how the option’s exercise price compares with the price of the underlying asset, at any point in time during the option’s finite life. This is summarised in the table below. Call In-the-money (ITM) At-the-money (ATM) Out-of-the-money (OTM)

EA

Put E>A E=A E
where E = exercise price of option, and A = price of underlying asset The options used in the above examples were both ATM as their exercise prices of 4,300 coincided with the level of the FTSE 100 index in both instances. These terms, when applied to option premiums, give rise to what is known as intrinsic value and time value. Where an option is ITM, the option premium comprises intrinsic value and time value. However, ATM and OTM option premiums only comprise time value. The premiums, and a breakdown between intrinsic and time value, for a hypothetical Euronext.liffe February FTSE 100 index option with three exercise prices for each call and put is given below, this time based on the FTSE 100 index standing at 4,000.

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FTSE 100 index option (Euronext.liffe) (4000) £10 per full index point 3950 4000 4050 Call Put Call Put Call Put Feb 168½ 121½ 141 137 111 164½ EA E>A Intrinsic value 50 50 Time value 118½ 121½ 141 137 111 114½ ITM OTM ATM ATM OTM ITM

The 3,950 call is ITM as the exercise price is lower than the price of the underlying asset, the FTSE 100 index, by 50 index points. Of the 168½ index point premium, these 50 index points comprise the option’s intrinsic value. For an ITM option, this is the difference between the exercise price and the price of the underlying asset. If the call option is purchased and exercised today, 50 of the 168½ index point premium would be covered by virtue of the fact that the exercise price is below the current FTSE 100 index value to the tune of 50 index points. That is, the holder would be 118½ index points from the breakeven point. Another way of looking at this is to say that unless the premium for such an option was at least equal to 50 index points, an instant risk free profit could be made by purchasing the option and exercising it immediately. The 118½ index points that remain comprise the time value. The 3,950 put option, however, is OTM as selling the FTSE 100 at 3,950 when it stands at 4,000 is not an attractive proposition. Therefore, the option premium of 121½ index points is purely time value. Options cannot have negative intrinsic values. This position between the put and call reverses for the 4,050 exercise price. The time value that characterises an element of ITM premiums but the entire premium for ATM and OTM options represents the probability of the underlying asset price moving in the option holder’s favour during the term of the option. The table below shows that time value is higher for both calls and puts the longer the time the option has to expiry but rapidly diminishes as the expiry date approaches. The 3,950 calls, for instance, all have 50 index points of intrinsic value, but have an increasing amount of time value as the contract expiry date moves from February through to April. FTSE 100 index option (Euronext.liffe) (4000) £10 per full index point 3950 4000 4050 Call Put Call Put Call Put Feb 168½ 121½ 141 137 111 164½ Mar 249 177 217 ½ 198 186 218½ Apr 307½ 311½ 280 233½ 253 256 EA E>A ITM OTM ATM ATM OTM ITM

Option Gearing Much like futures, where only a fraction of the notional value of the contract is paid as margin, options by only requiring the holder to pay a premium, also provide an ideal means to speculate on asset price movements.

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This gearing effect, inherent in derivative products, can be illustrated by using individual Euronext.liffe equity options. These are available on 85 individual FTSE 100 companies. Each option contract confers a right over 1,000 company shares and is priced in pence per share. This premium, therefore, needs to be multiplied by 1,000. The tick value is 0.5p per share or £5 per contract. Again, three expiry dates are offered for each option. If exercised, equity options are physically settled. Example

ABC plc (105)

Euronext.liffe EQUITY OPTIONS Calls Puts Apr Jul Oct Apr 1 100 6 10½ 12 /2 1 110 1 51/2 8 6

Jul 31/2 81/2

Oct 51/2 101/2

Assume it is March and ABC plc’s share price is 105p. This makes the call options in ABC with a 100p exercise price ITM and those with a 110p exercise price OTM. The ABC April 100 call option is priced at 6p and the 110 at 1p. If you believe the share price of ABC between now and the expiry date in April is going to rise, which of the two options should you purchase? The former being ITM has intrinsic value. That is, 5p of the 6p premium is covered by the current share price being 5p higher than the 100p exercise price. The share price only has to rise marginally for the entire 6p to be covered. However, the call option with the 110p exercise price requires the share price to rise by at least 6p to 111p for the 1p premium to be covered. Therefore, the OTM option is the more risky of the two options. However, it also offers the greatest potential reward being more highly geared. To illustrate this assume that the ABC share price rises from 105p to 114p. If the shares, rather than an option, had been purchased, then the percentage return would be: (114 - 105)/

105 x 100 = 8.6%

However, if the April 100 call options had been purchased then the return would rise from 8.6% to: 114 - (100 + 6) = 8p profit but as the initial outlay was only 6p, 8/6 x 100 = 133% If the April 110 call options had been purchased though then the return would have further increased to: 114 - (110 + 1) = 3p profit but as the initial outlay was only 1p, 3/1 x 100 = 300%

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Option Pricing Option prices, or premiums, are determined by six factors. These are summarised for call and put options in the table below given an isolated increase in each of the factors detailed in the first column. An increase in the: Underlying asset price Exercise price Time to maturity Volatility of underlying asset price Income yield of underlying asset Short term interest rates

Call option Rise Fall Rise Rise Fall Rise

Put option Fall Rise Rise Rise Rise Fall

1. Underlying asset price. The higher the asset price the more valuable are call options and the less valuable are put options. 2. Exercise price. The higher the exercise price the less valuable are call options and the more valuable are put options. 3. Time to maturity. The longer the term of the option, the greater the chance of the option expiring ITM, therefore, the higher the time value and the higher the premium. 4. Volatility of the underlying asset price. The more volatile the price of the underlying asset, the greater the chance of the option expiring ITM, therefore, the higher the premium. 5. Income yield of the underlying asset. The greater the income yield of the underlying asset, the greater the sacrifice being made by the call option holder by not holding this asset but the greater the benefit to the put option holder. Therefore, the higher the income yield, the more valuable the put option and the less valuable the call option. 6. Short term interest rates. The higher the short term rate of interest the greater the interest income received by the call option holder on the cash not committed to buying the underlying asset. This makes call options more valuable. However, the outlay on a put option not earning this higher rate of interest makes put options less valuable. It should be noted that the income and interest rate effects on option prices are fairly minor in relation to the other factors.

Choices Available to Traded Option Holders Holders of European style traded options have three choices open to them: 1. Exercise the option at the expiry date if the option is ITM. 2. Sell the option before the expiry date. 3. Leave the option to expire worthless, if OTM. Holders of American style traded options can also exercise the option if ITM before the expiry date.

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Uses of Options Within Portfolio Management The main uses of options within portfolio management comprise: 1. Hedging. 2. Anticipating future cash flows. 3. Enhancing portfolio performance.

1. Hedging A UK equity portfolio can be hedged against adverse market movements by purchasing either Euronext.liffe FTSE 100 index put options or, where individual holdings are to be hedged, individual Euronext.liffe equity put options. Bond holdings within a portfolio can be hedged using Euronext.liffe options on bond futures. The motivation for hedging a portfolio using FTSE 100 index put options instead of realising the underlying holdings is the same as that for using FTSE 100 index futures. However, the one major difference to the outcome when using options rather than futures is that, by paying a premium for the right, rather than the obligation, to sell the portfolio, the portfolio manager is not locked into the FTSE 100 at any one level. Example The same portfolio manager as before has a FTSE 100 portfolio worth £1m and wishes to protect it against a sharp fall in the market. The FTSE 100 is currently at 4,000 and the manager wishes to provide the fund with downside protection should the market fall beyond 3950. Assume it is January and April 3950 puts are priced at 311.5 index points. The manager, therefore, buys: portfolio value/ £1m/ FTSE 100 index value x £10 = (4000 x £10) = 25 puts. You will notice that the FTSE 100 index level of 4,000 and not the put exercise price of 3,950 is used as the denominator. You may recall that with FTSE 100 index futures, the futures price rather than the FTSE 100 index is used as the denominator. This provides protection to the £1m portfolio below 3950 but not between 4,000 and 3950. The cost of the protection is given by: Premium in index points x £10 per index point x number of contracts 311.5 x £10 x 25 = £77,875 This premium is paid to the writer of the options. If the FTSE 100 falls to, say, 3000, the portfolio manager can exercise the puts against the put writer at 3,950. Assuming that the portfolio moves in line with the value of the FTSE 100 index the result is as follows:

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Portfolio value Hedge value Premium paid New portfolio value Difference in portfolio value

£1m x 3000 /4000 (3950 – 3000) x 25 x £10 25 x 311.5 x £10 £1m - £909,625

£ 750,000 £ 237,500 £( 77,875) £ 909,625 £( 90,375)

By not totally hedging the portfolio against a market fall from 4,000 and paying a premium for the 25 put options, the portfolio manager is out of pocket by £90,375. However, if the FTSE 100 had in fact risen rather than fallen, the manager could simply have left the option to expire worthless. In the FTSE 100 index futures example, the manager had effectively locked the portfolio into an index level of about 4,000 but did, of course, have the option of closing out this position if the index subsequently rose.

2. Anticipating Future Cash Flows Much as in the futures example, if the portfolio manager is expecting a large cash inflow to the portfolio in a rising market, call options can be purchased to offset the higher cost of the asset when the cash flow is received. This method is preferable to using futures for the following two reasons: i. Options, although usually purchased ATM for this purpose, more accurately reflect any rise in the underlying asset price once ITM than futures, given that futures are subject to basis risk and ultimately lose the basis as the futures price converges to the asset price at the delivery date. ii. If the market falls only the premium is lost whereas a long futures position must be closed out if losses are to be avoided.

3. Enhancing Portfolio Performance If a portfolio manager expects asset markets to be relatively static over the short to medium term, options can be employed to enhance the potential performance of a portfolio over this period in several ways. Depending on whether the portfolio is a regulated fund determines how options can be used. If a regulated fund, the manager can write covered calls. That is, write call options on assets already held in the portfolio. These are usually written OTM often at an exercise price equal to that at which the portfolio manager is looking to sell the asset.

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PROFIT

0 XC

Price of underlying asset

LOSS

profit/loss profile of written OTM call option profit/loss profile of underlying asset net profit/loss profile of underlying asset combined with written call option

Figure 17: Writing Covered Calls The net profit and loss profile of the underlying asset combined with the written call option illustrates how performance is enhanced by the option premium until just beyond where the price of the underlying asset equals the exercise price (XC). If the portfolio is not a regulated fund, however, the manager can enhance portfolio performance in a number of other ways.

Basic Option Strategies Two of the simplest ways of using options to enhance the performance of an unregulated fund is by speculating on price movements via purchased options and/or by writing naked options to generate additional income for the fund. Options are written naked when the underlying asset is not held. In addition, however, a number of strategies that require the use of two or more options can be employed. These are categorised as either combinations or as spreads.

1. Combinations Combinations require the simultaneous purchase or sale of both a put and call option on the same underlying asset, sometimes with different exercise prices but always with the same expiry dates. Examples include straddles and strangles, both of which seek to take advantage of either large price movements in the underlying asset, where a long position is taken in both the call and the put, or little or no price movement, where a short position is taken in each

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A. SHORT STRADDLE PROFIT

Maximum Profit

11

8

0 A Limited loss

X=200

B

Price of underlying asset Unlimited loss

LOSS

net profit/loss profile

Figure 18: Short Straddle A short straddle (see Figure 18) is used where it is believed the price of the underlying asset will trade within a narrow range over the term of the option contracts. This short straddle has been constructed by simultaneously writing a call option and a put option, both with an exercise price of 200 and the same expiry date. Both options are usually written ATM. If the options had been written at different exercise prices, with the call exercise price (XC) being higher than that of the put (XP), then a short strangle would have been constructed. This is shown in Figure 20. The premium for the purchased call in the short straddle is 11 whilst that for the purchased put is eight. The point of maximum profit for this short straddle is realised when the asset price is equal to the exercise price. At this point the profit is equal to the sum of the option premiums, ie, 19. The strategy breaks even firstly at point A where the sum of the two premiums is deducted from the exercise price and secondly at point B where they are added to the exercise price, ie, at 181 and 219. If the price of the underlying asset moves either side of these values, then losses begin to accrue and are potentially unlimited. In comparison with a short straddle, a short strangle (see Figure 20) presents the option writer with a lower risk, lower return strategy, as the breakeven points are further apart.

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B. LONG STRADDLE

PROFIT Unlimited profit

Limited profit

0 X

Price of underlying asset

Maximum Loss

LOSS

net profit/loss profile

Figure 19: Long Straddle A long straddle, as shown in Figure 19 above, takes the opposing view to a short straddle by taking advantage of potential price volatility in the underlying asset in either direction. A long straddle is constructed by simultaneously purchasing a call and put option with the same exercise price and expiry dates. If the purchased call option has a higher exercise price (XC) than the purchased put option (XP), then a long strangle is constructed, as shown in Figure 21 below. The point of maximum loss for the long straddle is incurred when the price of the underlying asset is equal to the exercise price. The breakeven points are established in the same way as for the short straddle. Beyond these breakeven points, however, profits are potentially unlimited. The long strangle provides a lower risk, lower return strategy for the option holder, as the breakeven points are further apart.

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C. SHORT STRANGLE

PROFIT Maximum profit

0

Xp

Limited loss

Xc

Price of underlying asset Unlimited loss

LOSS

Figure 20: Short Strangle

D. LONG STRANGLE

PROFIT

Unlimited profit

Limited profit

XC

Xp 0

Price of underlying asset Maximum loss

LOSS

Figure 21: Long Strangle

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2. Spreads Spreads require the simultaneous purchase of one or more options and the writing of another or several others on the same underlying asset with either different exercise prices and the same expiry date or the same exercise prices and different expiry dates. Four examples of such spreads are:

A. BEAR SPREAD

Maximum profit

XS

XL

Price of underlying asset Maximum loss

Figure 22: Bear Spread Bear and bull spreads are relatively cautious strategies involving the use of two options. Bear spreads are designed to moderately profit from a falling market. This involves simultaneously purchasing and writing put options on the same underlying asset with the same expiry date but with the purchased put option (XL) having a higher exercise price than that sold (XS). Writing an option lowers the net outlay. A bear spread can also be constructed by simultaneously purchasing and selling call options, again on the same asset with the same expiry dates with the purchased call (XL) having a higher exercise price than the written call (XS). In the strategy depicted, using put options the maximum loss is given by the net premium paid and the maximum profit by (XL- XS - net premium paid).

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B. BULL SPREAD Maximum profit

XL

Price of underlying asset

XS Maximum loss

Figure 23: Bull Spread Bull spreads are designed to benefit moderately from rising markets. Whether using calls or puts, the purchased option (XL) will have a lower exercise price than that sold (XS). Again, by writing an option, the net outlay is reduced. If call options are used, the maximum profit is capped at (XS - XL - net premium paid) and the maximum loss limited to the net premium paid.11

C. LONG BUTTERFLY SPREAD PROFIT Maximum profit

0

XL1 Maximum loss

XS

XL2 Maximum loss

Price of underlying asset

LOSS

Figure 24: Long Butterfly Spread

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Butterfly spreads are complex option strategies, involving the use of four options, designed to exploit either rising or falling volatility in the price of the underlying asset. A long butterfly spread benefits from a decrease in the volatility in the price of the underlying asset by simultaneously buying two calls or puts, one with a low (XL1) and one with a high (XL2) exercise price, whilst simultaneously selling two calls or puts with identical exercise prices (XS) between that of the two bought options. All four options have the same expiry date. Being a safer strategy to pursue than a short straddle or strangle, albeit a potentially less profitable one, if the resulting price volatility is greater than that expected then the loss is limited in both directions.

D. SHORT BUTTERFLY SPREAD

PROFIT

Maximum profit 0

XL

Xs1

Xs2

Maximum profit Price of underlying asset

Maximum loss LOSS

Figure 25: Short Butterfly Spread Short butterfly spreads take advantage of expected increases in the price volatility of the underlying asset by simultaneously writing two calls or puts, one with a low (XS1) and one with a high (XS2) exercise price, whilst simultaneously buying two calls with identical exercise prices (XL) between that of the two sold options. Again all four options have the same expiry date. The profit and loss trade off is again more cautious than that of a long straddle or strangle. Summary of derivative trades View Market to rise sharply Market to fall sharply Market to rise mildly Market to fall mildly Market volatility to rise but uncertain of direction Market volatility to fall

170

Derivative trade Buy a call/long future Buy a put/short future Bull spread Bear spread Long straddle/s trangle or short butterfly Short straddle/strangle or long butterfly

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4.7

Warrants

LEARNING OBJECTIVES 4.4.16

Know the main characteristics of a warrant

4.4.17

Be able to calculate a warrant conversion premium

4.4.18

Know the difference between warrants and covered warrants

Warrants are negotiable securities issued by plcs which confer a right on the holder to buy a certain number of the company’s ordinary shares at a preset price on or before a predetermined date. Although essentially long dated call options, warrants are traded on the LSE and if exercised result in the company issuing additional equity shares. The warrants market is relatively small, comprising around 250 issues. Warrants can be issued on a stand alone basis either to existing shareholders or to outside investors for cash, if the shareholders pass a special resolution, or can accompany loan stock issues to lower the coupon payable. Unlike convertible loan stock, however, the conversion right contained within the warrant is traded separately from the loan stock. Warrants can also be issued alongside new investment trust shares issues to act as sweeteners for prospective shareholders. Given the terms of the warrant issue, the conversion premium or discount can be calculated. This is, whether the warrants are a more or less expensive way into the shares than by purchasing the shares directly. Conversion premium/(discount) = [(NX + W)/NS -1] x 100 where N is the number of shares each warrant can subscribe for, S is the share price, W is the warrant price and X is the exercise price. Example A warrant that confers the right to subscribe for 1 ordinary share at 100p until 2007 is currently priced at 20p. Given that the current share price is 90p, calculate the conversion premium or discount. Solution Conversion premium/(discount) = [(100 + 20)/90 -1] x 100 = 33.33% The annualised conversion premium is (1.330.2 -1) x 100 = 5.87% However, this conversion premium does not tell the whole story. Since warrants like options are highly geared, especially in this case where the warrant is OTM, a rise in the share price, the underlying asset, will have a disproportionate effect on the warrant price. In fact, if the share price rises by more than 7.4% per annum, the warrant will return more than by holding the shares directly over this period, excluding dividends. Note: This 7.4% was calculated by using the formula:

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√

Breakeven rate of share price growth = n (NX/(NS - W)) -1

Covered Warrants Covered warrants, a form of “securitised derivative”, are similar to warrants issued by plcs except that they are issued by investment banks and can be used by investors to both gear and hedge their exposure to a range of shares, indices, commodities and interest rates. Although actively traded on the continent, these securitised derivatives are new to the UK having only been granted FSA approval to be traded on the LSE with effect from 1 August 2002. The LSE has, in turn, authorised four banks to issue and trade these instruments on a newly constructed trading platform, launched on 28 October 2002, though it is envisaged that most trades will be routed through private client stockbrokers. In addition, unlike conventional warrants, which often trade in illiquid markets, the issuing banks control the amount of liquidity and, hence, the issue and exit prices of these warrants in this specialist market.

4.8

Swaps

LEARNING OBJECTIVES 4.4.19

Know the basic structure of an Interest Rate Swap

4.4.20

Know the basic structure of a Currency Swap

4.4.21

Know the basic structure of an Equity Swap

So far the focus has been on exchange-traded derivatives rather than OTC or off-exchange derivatives. Despite the lack of a central counterparty and their illiquidity, OTC derivatives have nevertheless proved extremely popular for risk management, speculation and arbitrage principally because they are not standardised but constructed around the unique needs of users. The most significant growth in OTC derivatives has been experienced in the swaps market. Swaps are similar to futures in that they do not require a premium to be paid by one party to another and create an obligation between the parties. The swaps market is mainly populated by investment banks, securities houses, portfolio managers, supranationals and multinational companies. Swaps take many forms but can be broadly categorised as:

1. INTEREST RATE SWAPS (IRS) An 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. IRSs take two forms: i. Fixed rate into floating rate. This is commonly known as a coupon or vanilla swap. ii. One type of floating rate into another type of floating rate. This is termed a basis swap.

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IRSs are typically based on the principle of comparative advantage. This we considered in Chapter 1 when looking at international trade. For instance company Y has a AA credit rating and company Z has a BBB+ rating. Y wishes to borrow on a floating rate basis and Z on a fixed rate basis but both companies regard the cost of borrowing on their preferred bases as prohibitive. Each faces the following borrowing costs in the credit markets:

Fixed Floating Total difference

Company Y 7% LIBOR + 1/8

Company Z 9.75% LIBOR + 1 1/8

Difference 2.75% 1.00% 1.75%

Although company Y has an absolute advantage in borrowing on both a fixed and floating rate basis, company Z has a comparative advantage in borrowing on a floating basis. That is, the difference between the floating rate Z faces to that faced by company Y is less than the difference that exists between the two parties on a fixed rate basis. (Y, therefore, has a comparative advantage in borrowing on a fixed rate basis.) Where comparative advantage exists both parties can reduce their collective borrowing costs by entering into an interest rate swap. In this instance, Y and Z can share a total saving of 1.75% by entering into a vanilla swap. To do this each must borrow on the basis upon which they have comparative advantage. They must then decide exactly how this saving should be split. This is demonstrated below.

Original cost of borrowing Swap from Y to Z Swap from Z to Y Net interest payment Less: original cost of borrowing on preferred basis Saving

Company Y (7%) (LIBOR + 3/4%) 8.75% LIBOR – 1.0% (LIBOR + 1/8%)

Company Z LIBOR + 1 1/8% LIBOR + 3/4% (8.75%) 9.125% (9.75%)

1.125%

0.625%

In practice, the interest payment made by each party to an IRS is netted off. So, if LIBOR is 6%, Z will simply pay Y 8.75% minus 6.75% = 2%. Also an element of the 1.75% saving would be paid to an investment bank, known as a swap house, for matching the parties and assuming the counterparty risk.

2. 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 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.

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3. EQUITY SWAPS An equity swap is 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. Being cash settled, no principal is exchanged between the counterparties, only payments representing the servicing costs of the two sides of the transaction. 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 swap may be a vanilla swap based in a single currency or a cross-currency swap based in two different currencies. An example of a vanilla equity swap, based on a single currency, may be between the FTSE 100 index and a rate of interest based on LIBOR. This is equivalent to the party receiving the return on the FTSE 100 simply funding this equity exposure by drawing on a cash deposit. Alternatively, by using a cross-currency swap, exposure can be gained to a more esoteric overseas equity market again by swapping this return into a fixed or floating rate of interest.

EQUITY TOTAL RETURN SWAP HOUSE

PORTFOLIO MANAGER

INTEREST RATE

Figure 26: Equity Swap The advantages to a portfolio manager being in receipt of the cash flows from the equity exposure include: a. Gaining equity exposure without the costs associated with buying and holding equities. b. Facilitating index tracking. This is considered in Chapter 9. c. Facilitating access to illiquid markets that may be inaccessible to foreigners. d. 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, then the portfolio manager will be required to make both an interest payment and an additional payment in respect of this negative return. Equity swaps can also be used by portfolio managers wishing to gain exposure to another equity market at the expense of an existing exposure without realising an element of their underlying portfolio, as an alternative to using futures, by entering into an equity swap where both sides of the transaction require the payment of the total return from an equity index.

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5. PROPERTY 5.1

Introduction

LEARNING OBJECTIVES 4.5.2

Understand the characteristics of a property market and the differences between the property market, securities market and money market

Property as an asset class is quite unique in its distinguishing features: 1. It is heterogeneous in nature. 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. 2. Valuation is subjective as property, due to its heterogeneity, is not traded in a centralised market place and continuous and reliable price data is not available. 3. It is subject to complex legal considerations and high transactions costs upon transfer. 4. It is highly illiquid as a result of not being instantly tradeable. 5. It is not divisible. Since property can only be purchased in discrete units, diversification is made difficult. 6. 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.

5.2

Direct Property Investment

LEARNING OBJECTIVES 4.5.1

Know the direct and indirect means of investing in property: property investment trusts, property bonds, shares in property companies, pension holdings

In England and Wales, an interest in property can either take the form of a freehold or a leasehold interest.

1. 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.

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2. Leasehold The freeholder can create a lesser interest in the property known as a 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 sublease and act as the head lessee to a sub tenant. Once the lease has expired, the freeholder assumes full rights over the property unless the leaseholder has security of tenure conferred by statute. If so, the leaseholder can apply for the creation of a new lease. If the freeholder fails to create this lease, then this inaction may result in the freeholder being required by law to compensate the leaseholder. When assessing the investment potential of property, institutions take account of its location, condition and age as well as whether a freehold or leasehold interest is to be acquired. If the freehold is to be purchased and a leasehold interest subsequently created, then the present value of the rental income must be derived to determine the value of the property to the institution. If, however, a leasehold interest is to be acquired, then the frequency of rent reviews and responsibility for repairs and maintenance must also be established. Until April 2002, a system of five yearly upward only rent reviews was commonplace in the UK. However, since then, a new code of conduct drawn up by the property industry has created a considerable of amount of flexibility in the construction of rent review clauses in an era of low inflation. When making direct property investments, institutional investors tend to avoid residential housing given its political sensitivity and high maintenance costs. Instead they concentrate on the following property types: 1. Commercial property. Freehold and long leasehold interests in shops, shopping centres, offices, leisure complexes and hotels situated in prime locations are the most popular means of institutional direct investment in property. 2. Industrial. Institutions tend only to invest in those factories and warehouses that are less sensitive to the fortunes of the economic cycle and, therefore, less likely to suffer from obsolescence. 3. Farmland and woodland. Institutions tend to favour freehold over leasehold interests in farmland and indirect to direct management of the freehold. Investment in woodland, however, due to the characteristically long payback periods, is usually jointly undertaken with estate owners.

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5.3 Indirect Property Investment LEARNING OBJECTIVES 4.5.1

Know the direct and indirect means of investing in property: property investment trusts, property bonds, shares in property companies, pension holdings

Indirect exposure to property can be obtained through the following several investment media: 1. Enterprise Zone Trusts (EZTs). EZTs are unauthorised unit trusts that invest purely in commercial property situated in government designated enterprise zones. Although they are highly illiquid they do offer significant tax breaks. 2. Authorised property unit trusts and open-ended investment companies (OEICs). As authorised collective investment schemes, property unit trusts and OEICs must meet stringent diversification criteria when investing in property and property related assets, such as property company shares. 3. Specialist property investment trusts. Investment trusts are fully listed plcs that principally invest in equities, bonds, property and cash. Specialist property investment trusts, like their unit trust counterparts, invest in property both directly and indirectly and must also meet diversification criteria. 4. Real Estate Investment Trusts (REITs). REITs will be introduced from January 2007. The distribution requirement has been reduced from 95% to 90% of taxable profits. REITs have 12 months to make the distribution (originally it was proposed to be 6 months). 5. Property bonds. These are life assurance company single premium bonds that invest in specialist unitised property life funds. 6. Property company shares. The shares of property developers can be a useful way of gaining exposure to the fortunes of the property market. However, they are often difficult to value and tend to mirror the fortunes of the equity market rather than the property market. 7. Syndicated commercial property investment. Aimed at the higher net worth private investor, these relatively illiquid commercial property investments are offered by financial firms usually via tax efficient Small Self-Administered Pension Schemes (SSASs) and Self-Invested Personal Pensions (SIPPs).

Concluding Comments As an asset class, property has consistently provided positive real long term returns allied to low volatility and a reliable stream of income. 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 transactions costs on transfer only really make it suitable as an investment medium for long term investing institutions such as pension funds. The availability of indirect investment media, however, makes property a more accessible asset class to those portfolio managers running smaller diversified portfolios.

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6. ALTERNATIVE INVESTMENTS 6.1

Introduction

LEARNING OBJECTIVES 4.6.1

Know the main types and characteristics of alternative investments

Alternative investments are those which fall outside the traditional asset classes of equities, property, fixed interest, cash and money market instruments. Alternative investments are often physical assets which tend to be popular with collectors. However, they also have the potential to appreciate substantially in value. An advantage is that they are not exclusive to wealthy clients and due to the wide variety of options available, even modest investments are possible. The disadvantage is that they often suffer from illiquidity and can be difficult to sell quickly if funds are required for other purposes. They can also be difficult to value due to the size of the different markets. Prices can change rapidly as markets can are subject to trends and fashions. Alternative investments have always been popular with wealthy individuals. However, financial advisers generally do not recommend their clients hold more than 10% of their portfolio in alternative investments.

6.2

Types of Alternative Investments

Alternative investments include (but are not limited) to the following list: • Jewellery. • Antiques. • Books. • Art. • Classic cars. • Private equity. • Structured products. • Autographs. • Posters. • Coins. • Stamps (rare stamps were rated in the top 4 investments for the 20th century with annual returns of around 10% per annum). • Comic books. • Toys (worth 4 to 5 times more if in the original packaging).

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• Race horses (although more money is made from stud breeders). • Fine wine. • Precious metals. • Memorabilia.

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1. 2. 3. 4.

5

STOCK EXCHANGES DEALING AND TRADING INTERNATIONAL MARKETS FOREIGN EXCHANGE

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This syllabus area will provide approximately 12 of the 100 examination questions

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1. STOCK EXCHANGES 1.1

Introduction

Financial markets are best described by the functions they perform. The main functions of financial markets are to: 1. Raise capital for companies. This function is performed by stock exchanges. 2. Provide maturity transformation by channelling short term savings into longer term business investment. 3. Bring buyers and sellers together in highly organised marketplaces to reduce search and transaction costs and facilitate price discovery, so that securities and other assets can be valued objectively. This function is performed by stock and derivative exchanges and other market places. 4. Allocate capital efficiently from low growth to high growth areas. 5. Transfer risk from risk adverse to risk seeking investors. This was considered in Chapter 4 when looking at the activities of hedgers and speculators in derivative markets. This role is equally well performed by the insurance market, which underwrites the risk from a large number of insurance policies. It is not however a function of stock markets or stock exchanges. 6. Provide borrowing and lending facilities to match surplus funds with investment opportunities. This function is performed by banks and stock exchanges.

1.2

Stock exchanges

LEARNING OBJECTIVES 5.1.1

Understand the role of the exchanges for trading: shares; bonds; derivatives

5.1.2

Know why companies obtain listings on overseas stock exchanges

5.1.3

Know the role and responsibilities of the London Stock Exchange (LSE)

5.3.1

Know the main characteristics of the major stock exchanges for the following markets: UK

“Stock exchanges should realise that they are not some kind of institutional icon, but are just…like vegetable markets…with a pair of braces.” City Stockbroker A stock exchange is an organised market place for issuing and trading securities by members of that exchange. Each exchange has its own rules and regulations for companies seeking a listing and continuing obligations for those already listed. All stock exchanges provide both a primary and a secondary market.

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Primary markets exist to raise capital and enable surplus funds to be matched with investment opportunities whilst secondary markets allow the primary market to function efficiently by facilitating two-way trade in issued securities. Secondary markets, by injecting liquidity into what would otherwise be deemed illiquid long term investments, also reduce the cost of issuing securities in the primary, or new issue, market. However, these roles can only be performed efficiently if markets are provided with accurate and transparent information so that securities may be valued objectively and investors can make informed decisions. This is particularly important if capital is to be allocated efficiently from what are perceived to be low growth to high growth areas to the overall benefit of the economy. Indeed, a lack of transparency and an inability to interpret information correctly was evident from the way in which capital flowed from the so-called old economy to what was perceived as the new economy during the dot.com boom. We return to this point in Chapter 9. Historically, stock exchanges have operated as national monopolies from a central location, or physical market place, mainly catering for the needs of domestic investors and domestic issuers. As mainly mutually owned, or not-for-profit, organisations, many stock exchanges had become bureaucratic, parochial and resistant to change and ironically had restricted access to new capital to fund development, investment in new trading and settlement technology and facilitate expansion into new markets. However, recently, in an attempt to meet the challenges posed by competing trading systems and the globalisation of financial markets, in an increasingly price sensitive and competitive global market place, many have sought to become more dynamic and cost efficient and have strived to create new markets. Indeed, stock exchanges have been taking their lead from the radical changes recently undertaken in the derivatives markets. These have included abandoning restrictive mutual ownership by exchange members to become shareholder owned listed companies, operating as electronic trading networks, as the move to electronic trading has gathered pace, and creating new markets through strategic mergers and alliances with other exchanges. The motivation behind many of these mergers and alliances has been a realisation that financial markets have integrated to such a degree that the shares of most multinational companies, rather than just being listed on their domestic stock exchange, are instead listed on those stock exchanges that best reflect the global distribution and capital requirements of their business. Listing on an overseas stock exchange also enhances the liquidity and marketability of companies shares and can also build the company’s brand. In effect, a global capital market has been created through the globalisation of markets and economies.

The London Stock Exchange (LSE) The LSE began life in 1773 when traders who regularly met to buy and sell the shares of joint stock companies in Jonathan’s Coffee House voted to change the name of the coffee house to that of the London Stock Exchange. You will not be surprised to learn that many changes have taken place since then, mostly since 1986. The LSE is Europe’s largest stock exchange, accounting for over 35% of European stock market capitalisation, about 10% of world stock market value and over 50% of foreign equity trading on world stock exchanges. Despite this, the LSE continues to evolve in a very competitive global marketplace. In April 2001, in its drive to expand into new markets, the LSE launched its International Retail Service (IRS), making over 100 continental European and US stocks available to private client stock brokers via an informal dual listing.

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The LSE is a recognised investment exchange (RIE) and, as such, is responsible for: 1. Providing a primary and secondary market for equities and fixed interest securities. 2. Supervising its member firms. 3. Regulating the markets it operates. 4. Recording all transactions, or bargains, executed on the exchange. 5. Disseminating price sensitive company information received by its Regulatory News Service (RNS) and distributed through commercial quote vendors, also known as Secondary Information Providers (SIPs). As noted in Chapter 4, the LSE now competes with other Primary Information Providers (PIPs) in this respect. The LSE’s role as the UK Listing Authority (UKLA) passed to the Financial Services Authority (FSA) on 1 May 2000 once the LSE became a public limited company (plc). The LSE operates both a primary and secondary market for: 1. Domestic plcs. These include: a. Companies with a full listing, including those technology companies listed on techMARK. b. Smaller UK plcs admitted the AIM. c. Exchange-Traded Funds (ETFs) and other innovative investments on its extraMARK exchange. ETFs are considered in Chapter 9. 2. International equities. 3. Domestic bonds: a. Gilts. b. Local authority fixed interest securities. c. Corporate bonds. The role of the derivatives exchange was considered in Chapter 4.

1.3

Alternative Trading Systems

LEARNING OBJECTIVES 5.1.4

Understand the reasons for the emergence of alternative trading systems: Crossing networks and Electronic Communication Networks (ECNs)

1. Electronic Communications networks (ECNs) ECNs came into being following a US regulatory probe that unearthed pricing collusion amongst NASDAQ dealers in 1997. ECNs are private trading systems run in the US independently of public trading systems such as the NYSE and NASDAQ (please see Section 3 - International Markets for NASDAQ and NYSE). They allow investors to trade quickly and directly with each other for a flat fee with no spread and most provide trading facilities after hours for both private investors and institutions. Most have influential institutional backing and account for nearly 50% of trading in

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NASDAQ stocks. To trade on NASDAQ, ECNs must be certified with the US Securities and Exchange Council (SEC) and registered with NASDAQ. When an order is routed through an ECN it is posted electronically into the NASDAQ system as an ECN quote. The order can then be executed on NASDAQ or matched with another order through the ECN. ECNs rely on NASDAQ price data for trading to take place and fragment liquidity in the NASDAQ market by acting as a separate market in NASDAQ stocks. Although ECNs pose a competitive threat to other major exchanges, they must first obtain regulatory approval before they can trade the stocks listed on a regulated exchange. Whereas most are currently restricted to trading NASDAQ stocks only, one has already gained regulatory clearance from the SEC to become an exchange and is, therefore, able to trade NYSE listed stocks.

2. Crossing networks Crossing networks have been formed recently by global investment banks, which through their fund management subsidiaries, dominate the global demand for securities trading. Crossing networks enable fund managers to deal directly with each other, though like ECNs, they are reliant on stock exchanges to supply prices. One crossing network already has a turnover in the US equivalent to 3% of US stock exchange turnover and more than two-thirds of UK pension funds use their services.

2. DEALNG AND SETTLEMENT 2.1

Introduction

LEARNING OBJECTIVES 5.2.1

Know the differences between a primary market and a secondary market

5.2.2

Know the structure and operation of the primary and secondary markets

5.2.3

Know the features and differences of quote- and order-driven markets

A primary market is the market for new issues or initial public offerings (IPOs). As noted in Chapter 4, equity new issues can be made via an offer for sale, offer for subscription, placing, or if no new capital is to be raised, via an introduction. New equity issues have also started to be offered directly to investors via online investment banks. Secondary markets are those that permit the trading of securities already issued. This trading is conducted through trading systems broadly categorised as either: 1. Quote-driven, or 2. Order-driven.

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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. 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. An order driven market, however, is one that employs either an electronic order book such as the LSE’s SETS or an auction process such as that on the NYSE floor to match buyers with sellers. In both cases, buyers and sellers are matched in strict chronological order by price and the quantity of shares being traded and do not require market makers.

2.2

Transaction costs

LEARNING OBJECTIVES 5.2.4

Know the types of transaction costs incurred in dealing in different asset classes

Equities Dealing in equities on any stock market in the world will incur additional costs for investors. For example, in the UK share trading incurs the following costs: 1. Dealing spread. The size of the dealing spread, or the difference between bid and offer prices, will depend on how liquid the market for a particular share is. Trades executed on SETS do not suffer dealing spreads. 2. Commission. Although negotiable, a typically institutional bargain will attract commission at 0.2% of the value of the transaction. 3. Panel on Takeovers and Mergers (POTAM) levy. This levy of 100p is charged on all transactions over £10,000. 4. Stamp duty. All purchases of registered shares attract either stamp duty (SD) or stamp duty reserve tax (SDRT) at 0.5% of the transaction value. If the purchaser requires a share certificate to be issued then SD is rounded up to the nearest £5. Otherwise SDRT applies, which is charged to the nearest penny.

Bonds The vast majority of bonds are traded on the ‘over-the-counter’ market (as opposed to a centralised market such as a stock exchange). The transaction costs for a bond will depend on the market where it is bought or sold. It will also depend on the type and size of the bond. Bond dealers make their profits (or losses) by taking a spread between the buying and selling price.

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Property Investors in property typically have to pay additional costs which include stamp duty, real estate agent commission, mortgage costs, valuation costs, building inspection fees etc. If the property is to be rented out, there are property management fees, insurance, maintenance and rates bills which all need to be factored into the yield calculation.

Cash Generally speaking, there are very small or even no transaction costs for investing in term deposits or cash accounts. Some banks will charge account-keeping fees or penalty rates if a term deposit agreement is broken. Investors run the risk that the return on their investment does not keep up with inflation.

3. INTERNATIONAL MARKETS 3.1

Introduction

The list below gives the rankings of the world’s stock exchanges by market capitalisation. 1. New York Stock Exchange. 2. Tokyo Stock Exchange. 3. NASDAQ. 4. London Stock Exchange. 5. Euronext. 6. Toronto Stock Exchange. 7. Frankfurt Stock Exchange (Deutsche Börse). 8. Hong Kong Stock Exchange. 9. Milan Stock Exchange (Borsa Italiana). 10. Madrid Stock Exchange (BME Spanish Exchanges) 11. SWX Swiss Exchange Source: World Federation of Exchanges (February 2006).

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3.2

USA Markets

LEARNING OBJECTIVES 5.3.1

Know the main characteristics of the major stock exchanges for the following markets: USA

5.3.2

Know the settlement cycles for the following markets: USA

New York Stock Exchange (NYSE) Founded in 1792, the NYSE is the world’s largest marketplace for equities trading and is home to nearly 3,000 companies collectively worth in excess of US$15,000bn. Despite this, it remains one of the few remaining not-for-profit stock exchanges owned by its exchange members, though it will shortly be merging with Archipelago, an ECN, to become a listed exchange, and one of the few that still conducts trading on an exchange floor with a bell opening and closing the trading day. During trading hours, exchange members known as floor brokers, who own a seat on the trading floor, buy and sell shares on behalf of investors, though a few exchange members, known as floor traders, trade shares as principal, using their own capital. Each stock listed on the NYSE is allocated to a specialist, a broker who trades only in specific stocks at one of the exchange’s 17 trading posts. Floor brokers receive their orders from one of the 1,500 trading booths situated along the perimeter of the trading floor and take these to the appropriate specialist at their trading post to find the best price for each particular security. In this order driven market, the specialist acts as an auctioneer. At the start of the trading day, each specialist establishes a fair market price for each of their stocks based on supply and demand, then throughout the day quotes the current bids and offers for each stock to the floor brokers. Orders can also be sent electronically to a specialist through the superDOT system. Specialists, acting as agents to the floor brokers, either execute orders immediately at the best available price or when a stock reaches a limit price specified by the investor. In instances when there is a temporary shortage of buyers or sellers, NYSE specialists will buy or sell on their own account to restore an orderly two-way market. They are not, however, under the same obligation as LSE market makers to make a market in the shares regardless of market conditions. Settlement is made on a T+3 basis through the National Securities Clearing Corporation (NSCC). Investors can hold their shares either directly, through nominees or via the US Depository Trust Corporation (DTC).

NASDAQ (National Association of Securities Dealers Automated Quotations System) NASDAQ is a non-centralised screen based quote driven market. Since its inception in 1971, NASDAQ has operated through a sophisticated computer network linking buyers and sellers from around the world, rather than from a physical exchange floor.

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Essential to NASDAQ’s market structure are independent market makers who actively compete for retail and institutional investor orders by displaying continuous two-way price quotations in over 6,000 companies on a network of over 500,000 computer terminals worldwide. As companies in the US are not permitted to list on more than one domestic exchange, many technology companies choose to list on NASDAQ rather than the NYSE. NASDAQ trades are settled in exactly the same way and on the same basis as deals conducted on the NYSE.

3.3

European Markets (Excluding UK)

LEARNING OBJECTIVES 5.3.1

Know the main characteristics of the major stock exchanges for the following markets: France; Germany

5.3.2

Know the settlement cycles for the following markets: France; Germany

Euronext Euronext, the Paris, Amsterdam, Brussels and Lisbon exchange, is an order driven market. It employs an electronic order driven trading system and settles through Clearnet on a T+3 basis.

Deutsche Börse Based in Frankfurt, the recently floated Deutsche Börse is Europe’s 3rd largest and the world’s 12th largest stock exchange. Trading is conducted on exchange floors throughout Germany and via Xetra, an electronic order driven trading system. All trades are settled through Clearstream on a T+2 basis.

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3.4

Asian Markets

Tokyo Stock Exchange (TSE)

LEARNING OBJECTIVES 5.3.1

Know the main characteristics of the major stock exchanges for the following markets: Japan

5.3.2

Know the settlement cycles for the following markets: Japan

The TSE is an order driven market with dealing conducted on an exchange floor and through the CORES computer system. Settlement is on a T+3 basis through the Japan Securities Clearing Company (JSCC), which is wholly owned by the TSE. In contrast to most other developed equity markets, shares cannot be delivered outside of Japan and must be held for overseas investors by nominees or the Japan Securities Depository Centre (JASDEC). The Financial Services Agency (FSA) is the regulator for the Japanese market.

Chinese Stock Exchanges

LEARNING OBJECTIVES 5.3.3

Know the main characteristics of the following Asian and Middle East stock exchanges: China

5.3.4

Know the settlement cycles for the following Asian and Middle East markets: China

5.3.5

Know the characteristics of an emerging market

China has three main stock exchanges: 1. Shanghai Stock Exchange 2. Shenzhen Stock Exchange and 3. Hong Kong Stock Exchange. All three exchanges are governed by the China Securities Regulatory Commission(CSRC). Investors are restricted to the following catagories of shares: 1. “A” shares – Chinese nationals. However, Qualified Foreign Institutional Investors (QFII) are now able to trade. 2. “B” shares (on the SSE and SZSE) – Foreign investors (although Chinese nationals are able to trade). 3. “C” shares – State owned companies. 4. “H” shares – Traded on the SEHK. 5. “N” shares – Traded on the NYSE.

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1. Shanghai Stock Exchange (SSE) The SSE is an order-driven system that supports paperless trading. Orders can be placed at terminals at the SSE trading floor or from member firms. Settlement is on the basis of T+1 for A shares and T+3 for B shares. The central depository, registration and clearing is performed by the China Securities Central Clearing & Registration Corporation (CSCCRC).

2. Shenzhen Stock Exchange (SZSE) The SZSE is based in Shenzhen, China. Orders are processed directly from off-site terminals in member firms' offices. Settlement is on the basis of T+1 for A shares and T+3 for B shares. The central depository, registration and clearing is performed by the Shenzhen Depository and Clearing Corporation (SDCC).

3. Hong Kong Stock Exchange (SEHK) Hong Kong Exchanges and Clearing Limited owns the stock and futures exchange in Hong Kong. It also owns the related clearing houses ie, Hong Kong Securities Clearing Company Ltd, HKFE Clearing Corporation Ltd and the SEHK Options Clearing House Ltd. The stock exchange has an order-driven trading system. Orders can be placed at terminals in the the exchange or from member firms. Settlement is on the basis of T+2 for all shares. The Central Clearing Automated Settlement System (CCASS) is used for settlement.

Indian Stock Exchanges

LEARNING OBJECTIVES 5.3.3

Know the main characteristics of the following Asian and Middle East stock exchanges: India

5.3.4

Know the settlement cycles for the following Asian and Middle East markets: India

5.3.5

Know the characteristics of an emerging market

The Securities and Exchange Board of India is the main regulator for Indian markets. The two main stock exchanges in India are listed below.

1.

Bombay Stock Exchange Limited (BSE)

The BSE is the oldest stock exchange in Asia and is based in Mumbai, India. The Bank of India Shareholding Ltd (BOISL) undertakes clearing activities for the BSE. The company is a joint venture between the Bank of India and BSE. Settlement is on a T+2 basis for equities. The BSE Sensex (or BSE 30) is a commonly used market index.

2.

National Stock Exchange of India Ltd (NSE)

The NSE is India’s largest stock exchange and is the third largest stock exchange in the world in terms of transactions. Settlement is performed by the National Securities Clearing Corporation Ltd. (NSCCL), a wholly owned subsidiary of NSE, and is on a T+2 basis for equities.

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LEARNING OBJECTIVES 5.3.3

Know the main characteristics of the following Asian and Middle East stock exchanges: Dubai; Egypt; Saudi Arabia

5.3.4

Know the settlement cycles for the following Asian and Middle East markets: Dubai; Egypt; Saudi Arabia

5.3.5

Know the characteristics of an emerging market

Dubai Dubai has two stock exchanges: Dubai Financial Market (DFM), which opened in March 2000, and Dubai International Financial Exchange (DIFX), which opened in September 2005.

Dubai Financial Market (DFM) Dubai Financial Market is a public institution having its own independent corporate body. DFM operates as a secondary market for trading of securities issued by public shareholding companies, bonds issued by the Federal Government or any of the local governments and public institutions in the country, units of investment funds and any other financial instruments, local or foreign, which are accepted by the Market. DFM operates on an automated screen-based trading system and settlement occurs, electronically, on a T + 2 basis, via the Central Depository.

Dubai International Financial Exchange (DIFX) Dubai International Financial Exchange is based in the Dubai International Financial Centre which is a 110 acre free zone. The Dubai Financial Services Authority regulates the activities of the Exchange. Settlement is on the basis of T+3 and usually in USDs, with Standard Chartered Bank as it’s clearing bank.

Egypt: Cairo & Alexandria Stock Exchanges (CASE) Egypt has two stock exchanges: the Cairo Exchange, which was opened in 1903, and the Alexandria Exchange, which opened in 1888. Both use the same trading, clearing and settlement systems and have the same board of directors. The clearing and settlement system in Egypt is based upon delivery versus payment (DvP), whereby Misr for Clearing, Depository and Central Registry (MCDR) acts as the clearing house between the buying and selling member firms. The CASE 30 is a popular market index. Settlement is: • T+0 for securities traded by the Intra-day Trading System. • T+1 for government bonds that are traded through the Primary Dealers System. • T+2 for all other securities.

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Saudi Arabia The Saudia Arabian Stock Exchange (SSE) uses Tadawul (an electronic stock exchange system) for trading, clearing, settlement and depository operations. The system allows for real-time share trading and same-day settlement. The exchange is supervised by the Saudi Arabian Monetary Agency and is the largest exchange in the Arab region.

Summary of Overseas Equity Market Trading and Settlement Exchange

Trading method

NYSE

Order driven - exchange floor and superDOT Quote driven Order driven - exchange floor and CORES Order driven Order driven - exchange floor and Xetra

NASDAQ Tokyo Euronext Deutsche Börse

3.5

Standard settlement basis T+3

Clearing house

T+3 T+3

NSCC JSCC

T+3 T+2

Clearnet Clearstream

NSCC

Emerging Markets

LEARNING OBJECTIVES 5.3.5

Know the characteristics of an emerging market

There are many benefits to investing overseas. At a general level, these benefits arise from the fact that the world economy is not totally synchronised, most investment themes are global, many industries are either over or underrepresented in the UK and the UK equity market accounts for less than 10% of world stock market capitalisation. To be efficient then, a portfolio should be adequately diversified with no one geographical region or asset class monopolising it. Although most overseas investment held by UK investors is in developed equity markets, emerging markets represent a rapidly increasingly proportion of UK overseas investment. The term emerging market can be defined in various ways: • Markets in countries classified by the World Bank as low or middle income, and • Markets with a stock market capitalisation of less than 2% of the total world market capitalisation. The attractions of investing in emerging markets comprise: • Rapid economic growth. Developing nations tend to grow at faster rates of economic growth than developed nations as they attempt to catch up with rich country living standards by developing their infrastructure and financial systems. This process is assisted by domestic saving rates being generally higher than in developed nations and the embracing of world trade and foreign direct investment (FDI). Rapid economic growth tends to translate into rapid profits growth.

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• Low correlation of returns. Emerging markets offer significant diversification benefits when held with developed market investments, owing to the historically low correlation of returns between emerging and developed markets. • Attractive valuations. Emerging markets have historically traded at a discount to developed market valuations • Industry representation. Investors are able to gain exposure to industries not represented in developed nations. • Inefficient pricing. As emerging markets are not as well researched as their developed counterparts, pricing anomalies often appear. However, there are also significant drawbacks: • Lack of transparency. The quality and transparency of information is generally lower than for developed nations whilst accounting and other standards are generally not as comprehensive or as rigorously applied. • Regulation. Regulation is generally more lax in emerging than in developed markets and incidents of insider trading and fraud by local investors more prevalent. Corporate governance also tends to be lacking. • Volatility. Emerging market performances have been more volatile than that for developed markets owing to factors such as developing nations being less politically stable and more susceptible to banking and other financial crises. • Settlement and custodial problems. The logistics of settling transactions and then arranging for custody of the securities purchased can be fraught with difficulty. In addition, property rights are not as well defined as in developed nations. However, these problems can be mitigated by using Global Depositary Receipts (GDRs). • Liquidity. As emerging markets are less liquid, or more concentrated, than their developed counterparts, investments in these markets tend not to be as readily marketable and, therefore, tend to trade on wider spreads. • Currencies. Emerging market currencies tend to be less stable than those of developed nations and periodically succumb to crises resulting from sudden significant outflows of overseas investor capital. • Controls on foreign ownership. Some developing nations impose restrictions on foreign ownership of particular industries. • Taxation. Emerging market returns may be subject to local taxes that may not be reclaimable under double taxation treaties. • Repatriation. There may be severe problems in repatriating capital and/or income from investments made in some emerging markets.

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4. FOREIGN EXCHANGE LEARNING OBJECTIVES 5.4.5

4.1

Understand the reasons for changes in exchange rates

Introduction

An exchange rate is the price of one currency in terms of another. As mentioned in Chapter 1, under a system of floating exchange rates in a world where very few barriers impede the mobility of international capital flows, foreign direct and international portfolio investment are by far the most powerful determinant of exchange rates in the short to medium term: overwhelming those currency flows associated with international trade and central bank intervention. In fact, such has been the growth in the movement of international capital that over $1.9tn a day flows through world foreign exchange centres with over a third of this turnover passing through London alone. Following the introduction of euro notes and coins on 1 January 2002, the euro joined the US dollar and Japanese yen in becoming one of the world’s pre-eminent currencies. However the world’s most heavily traded currency remains the US dollar, the world’s premier reserve, or safe haven currency.

4.2

The Structure and Operation of the Foreign Exchange Market

LEARNING OBJECTIVES 5.4.1

Know the basic structure and operation of the foreign exchange market

5.4.2

Understand the difference between spot and forward exchange rates

The foreign exchange, or forex, 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 forex market does not have a centralised market place. 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 on either Reuters 2002, an automated broking system or via EBS, an electronic broking system. 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. When one currency is quoted in terms of another, the former is known as the base currency (X) and the latter the quoted currency (Y). The exchange rate given by X/Y represents the value of one unit of the base currency in terms of the quoted currency. In the spot market, the base currency is usually the US dollar ($). However, when sterling (£) is quoted against the $, £ is the base currency and the $ the quoted currency. So, £1 is quoted in terms of its value in dollars rather than $1 being quoted in terms of its value in pounds.

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The convention in the spot market is for the exchange rate to be quoted as a mid-rate and a bidoffer spread around this mid-rate. The mid-rate is the mid-point between the bid and offer prices. The bid price is the rate at which the quoted currency ($) can be purchased with the base currency (£) and the offer price the rate at which the quoted currency ($) can be sold in exchange for the base currency (£). So, if the spot $/£ exchange rate is quoted as $1.5223 and the bid-offer spread is quoted as 220-226, then the exchange rate would be $1.5220 - $1.5226. By knowing the rate at which sterling can be exchanged for dollars and dollars for, say, euros, the exchange rate between sterling and euros can be determined via the respective dollar exchange rates. Where an exchange rate is derived via the dollar, it is known as a cross rate. So, given the sterling/dollar exchange rate of $1.5220 - $1.5226 and a dollar/euro exchange rate of €1.1062 e0.1.1066, the sterling/euro exchange rate will be: £ bid rate = 1.5220 x e1.1062 = €1.6836 £ offer rate = 1.5226 x e1.1066 = €1.6849 That is, e1.6836 - €1.6849.

4.3

Parity Relationships

LEARNING OBJECTIVES 5.4.3

Be able to calculate forward exchange rates and parity relationships

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. 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. The demise of the US dollar, for instance, was regularly predicted during the middle to late 1990s and into the 2000s but remained buoyant despite the launch of the euro in 1999, the mild US economic recession in 2001 and the US current account deficit consistently recording new highs. Exchange rate forecasting can be guided by the following three parity relationships: 1. Purchasing Power Parity (PPP). 2. Interest Rate Parity. 3. International Fisher Effect. Each of these will now be examined.

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1. Purchasing Power Parity (PPP) PPP states that the price of homogeneous internationally traded goods in any two countries should be equated by the nominal exchange rate in the long run. The nominal exchange rate is that which we observe in the foreign currency markets between those two countries trading these goods. According to PPP, the nominal exchange rate between two countries should adjust to reflect the difference in their respective inflation rates, if the real exchange rate, or each country’s international competitiveness, is to remain constant. This is the idea behind the Economist’s BigMac index, detailed below. The real exchange rate is given by: Real exchange rate = UK price level x US$ US price level £ Therefore, if PPP holds in the long run, the relationship between successive spot exchange rates over time can be explained by inflation differentials between countries. This relationship can be summarised by the following equation: PPP = Spot £/$t1 = 1 + expected inflation rateus Spot £/$t0

1 + expected inflation rateuk

where spot £/$t0 is the spot rate today and spot £/$t1 the spot rate in 1 year’s time. So, assuming PPP holds and the inflation rate over the next year in the UK is expected to be 4% whilst that in the US is expected to be 3% and the current spot £/$ exchange rate is $1.5100, the spot exchange rate in one year’s time should be: Spot £/$t1 = 1.03 $1.5100

1.04

Therefore, spot £/$t1 = (1.5100 x 1.03)/1.04 = $1.4955 The Economist frequently tests whether nominal exchange rates reflect PPP by operating a BigMac index. After all, how many other goods can be purchased worldwide that are as homogeneous in nature? The idea is that the BigMac PPP should result in hamburgers costing the same in the US as anywhere else in the world when account is taken of the nominal exchange rate. However, based on this objective measure of PPP most currencies are either overvalued or more usually undervalued relative to the US dollar. This should not come as any great surprise given that PPP is a long run and not a short run proposition. Moreover, prices cannot always be compared on a like-for-like basis between countries so as to determine the appropriate nominal exchange rate as: 1. Not all goods represented in inflation indices are internationally traded; 2. Some internationally traded goods attract indirect taxes in certain countries but not others; and 3. Comparing inflation rates between countries is difficult as each adopts its own method of calculation.

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In addition, factors that can influence currency values in the short to medium term include: 1. Net international capital flows. In a world where very few barriers impede the mobility of international capital flows, foreign direct investment (FDI) and international portfolio investment are by far the most powerful determinants of exchange rates in the short to medium term. These capital flows gravitate to those countries or economic regions that offer the most profitable investment opportunities and accommodating attitude to outside capital. Such countries or regions are typically politically stable, have high and sustainable economic growth rates, stable and transparent macroeconomic policies and/or high real interest rates. Note that reference is made to the real and not to the nominal rate of interest. This is because if a country’s inflation rate is high relative to that of its trading partners, the currency’s potential to depreciate, in order to restore the country’s competitiveness, may more than offset the relatively attractive nominal interest rate being offered. The conclusion then is that high real rather than high nominal interest rates attract investors to a currency. 2. Net international trade flows. Dwarfed by the size of international capital flows, international trade flows tend to have a relatively muted effect on exchange rates. 3. Central bank intervention. Central banks often use their limited armoury of foreign currency reserves to influence the level of their domestic currency in the international currency markets. However, if private capital is flowing in the opposite direction, unilateral central bank intervention in the currency markets rarely achieves its desired effect for anything other than a very short period. When undertaken in concert with other central banks though, central bank intervention has proved very effective in influencing exchange rates. Central banks can also use short term interest rates to influence the exchange rate. However, a conflict often arises between using interest rates to influence the exchange rate so as to bring the trade balance back into equilibrium and using interest rates to regulate demand in the economy. For instance, if a country with strong domestic demand and a trade deficit is subject to a rising short term interest rate, engineered primarily to dampen inflationary pressures within the economy, this can have the effect of worsening the trade deficit. As we know, raising the real short term rate of interest will attract portfolio investment flows which serve to finance the trade deficit. However, these investment flows will also stimulate demand for the currency, thereby raising the nominal exchange rate. Other things being equal, this higher exchange rate should reduce the competitiveness and, therefore, dampen the demand for the country’s exports whilst increasing the competitiveness of imports, thereby worsening the trade deficit. If interest rates had instead been reduced in an attempt to lower the nominal exchange rate so as to improve the country’s trade position, then by leaving domestic demand unchecked, higher inflation would usually result.

2. Interest Rate Parity The only unbiased estimate of a currency’s future spot exchange rate can be obtained by establishing the forward exchange rate. This should not be confused with the forward rate considered earlier in this chapter when looking at the term structure of interest rates. The forward exchange rate is the exchange rate set today, embodied in a forward contract, that will apply to a foreign exchange transaction at some pre-specified point in the future: in three months time for instance. 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.

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The relationship between the spot exchange rate and forward exchange rate for two currencies is simply given by the differential between their respective nominal interest rates over the term being considered. The relationship is purely mathematical and has nothing to do with market expectations of the likely course that the exchange rate may take given knowledge of other factors. The idea behind this relationship is embodied in the principle of interest rate parity and is explained by the use of arbitrage pricing. As you may recall, arbitrage is the process of deriving a risk-free profit from simultaneously buying and selling the same asset in two different markets where an unexplained price difference, or pricing anomaly, exists. Before looking at how arbitrage pricing works in this instance, the relationship between the spot and forward exchange rate, as given by interest rate parity, is as follows: F£/$ = S£/$ x [(1 + R$)/(1 + R£)] where F£/$ is the forward exchange rate between sterling and the dollar, S£/$ the spot rate, R$ the $ nominal interest rate and R£ the £ nominal interest rate. This principle is best illustrated by an example. Example The £/$ spot exchange rate = 1.5220. If the three month interest rate for the UK is 4.88% and for the US, 3.20%, what will the three month forward exchange rate be? Solution As the three month interest rates are quoted on a per annum basis, they must be divided by four to obtain the rate of interest that would be payable (%) over three months: Sterling: 4.88%/4 = 1.22% Dollar: 3.20%/4 = 0.8% Applying the interest rate parity formula: F£/$ = S£/$ x [(1 + R$)/(1 + R£)] = $1.5220 x [1.008/1.0122] = $1.5157 The forward exchange rate of $1.5157 is lower than the spot exchange rate of $1.5220. That is, in three months time, £1 will buy $1.5220 minus $1.5157 = $0.0063 fewer dollars. The dollar will strengthen against sterling. The reason for this is due to three month interest rates in the UK being higher than that in the US. To explain. If £1 was invested over three months at 1.22% this would provide a terminal value of £1 x 1.0122 = £1.0122. Alternatively, if the £1 was converted into dollars at the spot exchange rate and this $1.5220 was invested at 0.8% over the three months then the terminal value would be $1.5220 x 1.008 = $1.5342. Therefore, in three months time £1.0122 will buy $1.5342. This implies that the spot exchange in three months time should be: S£/$ + 3 months = $1.5342/1.0122 = $1.5157. This is also the three month forward exchange rate.

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If this relationship did not exist, then an arbitrage opportunity would arise between the spot and forward rates. Ignoring the bid/offer spread, if $1.5220 is the spot rate, at which dollars can be exchanged for £1 today and $1.5100, rather than $1.5157, is the forward rate, then an arbitrage opportunity would arise and risk-free profit could be made by simultaneously: 1. Entering into a three month forward contract today to sell $1.5100 for £1 in three months time, whilst 2. Borrowing £1 today, at 1.22% over three months, and investing the $1.5220 into which the £1 is converted at 0.8% for three months. The £1 borrowed with interest at 1.22% over three months will amount to £1.012, whilst the $1.5220 at 0.8% over three months will have grown to $1.5342. This $1.5342 could be sold via the three month forward contract at a rate of £1/$1.5100, generating a sterling sum of $1.5342/$1.5100 x £1 = £1.016. This £1.016 could then be used to repay the £1.012, generating a profit = £1.012 - £1.016 = £0.004. 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. This is not to say, however, that the spot rate in three months time will be the same as the three month forward rate quoted today. The three month forward rate in this example is simply an unbiased, or mathematically based, estimate, or the best guess, of the spot rate in three months’ time.

Premiums and Discounts Where interest rates are higher in the base currency (£) than the quoted currency ($), a premium between the spot and forward exchange rate is said to arise. When the opposite is true, a discount arises. In the above example, as a result of three month interest rates in the UK being higher than that in the US, a premium arose. This premium was given by the difference between the spot and forward rates of $1.5220 - $1.5157 = $0.0063, though $ premiums and discounts are usually quoted in cents (c) rather than $s. Premiums are identified by the letters pm and discounts dis. As premiums imply that the quoted currency will strengthen over time, premiums are deducted from the spot exchange rate to derive the forward exchange rate whilst discounts, for the opposite reason, are added. Market convention is for the spot rate to be quoted with the premium or discount, rather than for the forward rate to be quoted. So, if the spot rate is $1.5220 - $1.5226 and a three month premium of 0.63c - 0.57c is quoted then the three month forward exchange rate will be: Spot exchange rate 3 months forward 3 month forward exchange rate

$1.5220 - $1.5226 0.63c - 0.57c pm $1.5157 - $1.5169

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3. International Fisher Effect The Fisher Effect states that nominal interest rates (R) in an economy fully reflect expected inflation. Extending this to the international economy, the International Fisher Effect states that in a world of perfect capital mobility, nominal interest rates (R) should take full account of expected inflation rates (ei) so that real interest rates (r) are equal worldwide. Any differences that existed would be arbitraged away. We know from Chapters 1 and 2 that: Real interest rate (r) = [1 + nominal interest rate (R)] -1 [1 + inflation rate (i)] So, changing actual inflation (i) to expected inflation (ei) and moving the -1 from the right to the left of the equation, gives: 1+r=1+R 1 + ei (Note: rearranging this equation to 1+R=(1+r)(1+ei) gives the Fisher Effect) If 1 + ruk = 1 + rus Then, the International Fisher Effect = 1 + Ruk = 1 + Rus 1 + eiuk

1 + eius

Example If inflation is expected to be 4% in the UK and 3% in the US, given a nominal rate of interest of 6% in the UK, calculate the nominal rate of interest in the US. Solution 1 + Ruk = 1 + Rus 1 + eiuk

1 + eius

So, 1 + Rus = [(1 + Ruk) x (1 + eius)]/(1 + eiuk) = (1.06 x 1.03)/1.04 So Rus = 1.05 - 1 = 5% Although the International Fisher Effect cannot be directly employed to act as an exchange rate estimating mechanism, it does act as a link between the other two parity relationships covered above. PPP provides the theoretical long term spot exchange rate based on inflation differentials whilst interest rate parity establishes the relationship between spot and forward exchange rates based on nominal interest rate differentials. The International Fisher Effect links the PPP inflation differential with the interest rate parity interest rate differential by stating that if real interest rates are equal worldwide then the inflation differential must equal the nominal interest rate differential between the two countries. This can be seen by rearranging 1 + Ruk = 1 + Rus to: 1 + eiuk

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1 + eius = 1 + Rus 1 + eiuk

1 + Ruk

As interest rate parity expresses the relationship between the forward and spot exchange rate as F£/$ = S£/$ x [(1 + R$)/(1 + R£)], this suggests that the forward exchange rate can be arrived at by either employing expected inflation rate or interest rate differentials. It also implies that there is a negative correlation between exchange rate movements and fixed interest securities, as yields are closely linked to interest rates and inflation. Similarly, the relationship between the future and current spot rate can be derived by employing either variable. However, just as PPP has its shortcomings so does the International Fisher Effect, principally because real interest rates worldwide are not equal due to: 1. Short term nominal interest rates being set by national central banks, not markets. 2. Different countries employing different methods of calculating inflation. 3. Impediments to international capital mobility.

4.4

Hedging Foreign Currency Exposure

LEARNING OBJECTIVES 5.4.4

Know the mechanisms through which currency exposure can be hedged

There are many benefits to investing in overseas assets, particularly overseas equities, owing to the positive diversification effects that result from: i. The generally low correlation of overseas equity returns to UK equity returns. ii. Economic cycles not being synchronised worldwide. iii. Exposure to industries that are not well represented in the UK. Exchange rate gains can be also be made. Against this, however, must be weighed potential disadvantages. These include: i. Political risks. ii. Difficulty in accessing information. iii. Possible exchange controls. iv. High transaction costs. v. Exchange rate losses. The one common denominator is currency risk. Currency risk can either augment or detract from the return generated by the asset.

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Example A £100 is invested in US equities at a spot exchange rate of $1.50. Over the next year the investment increases in value by 10%. Calculate the annual return in sterling terms, if the dollar based investment is converted back into sterling at a spot exchange rate of: a. $1.40 b. $1.70 Solution In dollar terms the investment has grown to $150 x 1.1 = $165 a. $165/1.40 = £117.86. Therefore, the annual return = [117.86/100] - 1 = 17.86% b. $165/1.70 = £97.06. Therefore, the annual return = [97.06/100] - 1 = -2.94% Example The price of an internationally-traded commodity is rising at 5% per annum in the UK, and 2% per annum in the USA. The spot exchange rate in one year's time is expected to be 1.00/1.61 (GBP/USD). If purchasing power parity holds, what is the current spot exchange rate? Solution a. If the commodity's value in USD is expected to rise by 2% per annum, then it's current value will be (100-2 = 98%) of the 1.61 USD ie, 0.98 x 1.61 = 1.5778 USD. b. If the commodity's value in GBP is expected to rise by 5% per annum, then its current value will be (100-5 = 95%) of 1.00 ie, 0.95 x 1.00 = 0.95 GBP. c. This means 0.95 GBP will give 1.5778 USD or using standard convention 1.00 GBP will give (1.5778 x 1.0 / 0.95 ) = 1.6608 USD. So the current spot exchange rate would be: 1.00/1.66 (GBP/USD). Foreign currency risk can be reduced, though not completely eliminated, by employing the following hedging instruments or strategies: 1. Forward contracts. 2. Back-to-back loans. 3. Foreign currency options. 4. Foreign currency futures. 5. Currency swaps. Concluding comments Exchange rate forecasting is an inexact science despite the existence of parity relationships and advances in forecasting techniques. Although when investing overseas, currency hedging should be considered, 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.

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ACCOUNTING

1. 2. 3. 4. 5.

BASIC PRINCIPLES BALANCE SHEET THE INCOME STATEMENT THE CASHFLOW STATEMENT CONSOLIDATED COMPANY REPORTS AND ACCOUNTS

207 214 224 229 233

This syllabus area will provide approximately 13 of the 100 examination questions

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1. BASIC PRINCIPLES 1.1

Introduction

Accounting is the recording, measuring and reporting of economic events, or activities, to interested parties in a readily useable form. The need for accounting information was stimulated by the emergence of the limited liability company in the 19th Century and the resulting separation of ownership and control. However, although companies initially provided accounting information to satisfy the informational needs of their shareholders and creditors, the form this information now takes and the way in which it is communicated must also meet the disparate informational needs of other parties with a legitimate interest in the company’s activities, performance and financial position. These other users include prospective investors, employees, financial analysts, institutional investment committees, as well as governmental, consumer and environmental groups. It is recommended that you obtain a set of company report and accounts, as these will assist your understanding of this chapter and of Chapter 7.

1.2

The Form and Content of Company Accounts

LEARNING OBJECTIVES 6.1.1

Know the legal requirements to prepare accounts and the differences between private and public company requirements

6.1.2

Know the fundamental accounting bases upon which company accounts are prepared (concepts of entity, going concern, prudence, matching, consistency and historic cost)

6.1.3

Know the function of the Accounting Standards Board (ASB) and International Accounting Standards Board (IASB)

6.1.4

Know the purpose of the International Financial Reporting Standards (IFRSs)

6.1.5

Understand the purpose of the auditors' report and the reasons why reports are modified

Under the Companies Acts, the directors of a company are legally required to prepare financial statements and make other disclosures within an annual report and accounts. 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 period. These financial statements and disclosures include the following: 1. A balance sheet. This provides a snapshot of the company’s financial position as at the company’s accounting year end by summarising the assets it owns and how they are financed at this one point in time. 2. An income statement. This statement summarises the trading activities, or revenue transactions, that have been undertaken by the company over its accounting period. Revenue transactions differ from capital transactions in that the latter represent capital expenditure that seeks to enhance the operational capacity of the business rather than the company’s immediate trading position.

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The income statement links the company’s previous balance sheet with its current one. This relationship is depicted below. COMPANY FOUNDED

BS1

BS2

REVENUE TRANSACTIONS

REVENUE TRANSACTIONS

Income statement1

Income statement2

Accounting period 1

Accounting period 2

Figure 1: Income Statements 3. Comparative figures from the previous year’s financial statements and explanatory notes to accompany individual balance sheet and income statement items. 4. Disclosure of the company’s accounting policies, or the basis on which the accounts have been prepared. 5. A directors’ report. Amongst other things, the directors’ report outlines the company’s principal activities and how each has performed over the accounting period. For example, it details any significant changes made to its fixed assets, ie, those it intends to retain in the business, and lists the names of its directors and any interests each has in the company. The amount of information contained in the company’s report and accounts and the requirement for its independent verification, or audit, depends upon whether the company is categorised by the Companies Acts as being: 1. A small, medium or larger private limited company (ltd), or 2. A public limited company (plc). To qualify as either a small or medium sized private limited company, at least two of the following three size criteria must not have been exceeded in the current and preceding accounting period:

Turnover Total assets Average number of employees

Small £5.6m £2.8m 50

Medium £22.8m £11.4m 250

If a company qualifies as either a small or medium sized company over two successive accounting periods, then it will automatically qualify as such in the accounting period that immediate follows.

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Small and medium sized private limited companies necessarily have less onerous reporting requirements placed upon them than their larger counterparts. In addition, those small companies with a turnover not exceeding £5.6m and assets not valued at more than £2.8m are not subject to an independent audit of their accounting information or required to publish an accompanying auditors’ report. The auditors’ report is considered below. However, those companies that do not meet the Companies Acts small private limited company criteria must, in addition to the other information detailed above, also publish a cash flow statement within their annual report and accounts. This financial statement identifies how a company’s financial resources have been generated over the accounting period and how they have been applied, or expended. The Companies Acts also require explanatory notes to the cash flow statement to appear in the company’s accounts.

Additional Reporting Requirements for Listed Companies In addition to the above requirements laid down by the Companies Acts, companies with a full LSE listing, regardless of size, must also incorporate the following within their annual report and accounts: 1. A statement of changes in equity. This financial statement details all profits made and losses incurred by the equity holders of the company over the accounting period, whether realised or not. It also reflects any dividends paid to the shareholders during the period. Since dividends paid to shareholders are an appropriation of profit rather than an expense against profit, dividends paid are not reflected in the income statement, but in the statement of changes in equity. Accounting standards allow the details to be presented as a ‘statement of recognised income and expenses’ instead of a full statement of changes in equity. 2. An operating and financial review (OFR) for reporting years beginning on or after 1 April 2005. This provides a narrative on the company’s performance and prospects consistent with the company’s accounts. 3. Additional disclosures required under the UKLA’s Listing Rules. You may recall, from Chapter 3, that one of these is whether the company has complied with the Code of Best Practice in discharging its corporate governance responsibilities during the accounting period and, from Chapter 4, whether the company has issued shares or warrants to investors other than its ordinary shareholders, following the passing of a special resolution. Many listed companies voluntarily provide additional information about their strategy, business performance and financial management. These are encapsulated in a Chairman’s statement, a Chief Executive’s Review and a Finance Director’s Report, respectively. Some now also provide a detailed environmental report of their activities. Listed companies must also publish a half yearly, or interim, set of report and accounts. Apart from not being subject to a full independent audit, they do not contain as much information about the company’s activities as the annual report and accounts.

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Accounting Regulations The form and content of all company financial statements and their respective disclosures are prescribed by the Companies Acts and mandatory accounting standards set by the accountancy profession. The latter comprise Statements of Standard Accounting Practice (SSAPs) and Financial Reporting Standards (FRSs) for unlisted UK companies. The setting of SSAPs was originally the responsibility of the Accounting Standards Committee (ASC). However, the ASC was superseded by the Accounting Standards Board (ASB) in 1990, whose role it has been to review and issue accounting standards as FRSs, rather than SSAPs, on behalf of the Financial Reporting Council (FRC). Today, SSAPs coexist with FRSs with some SSAPs having been replaced with FRSs.

International Accounting Standards Board (IASB) The international standard setting board aims to standardise the way accounts are presented regardless of the country in which they are produced. The International Accounting Standards Board was formed in 2001 to replace its predecessor the International Accounting Standards Committee (IASC), set up in 1973. The IASB issues the International Financial Reporting Standards (IFRS). Many of these standards were previously known as International Accounting Standards (IAS). However, in April 2001, the IASB changed the naming convention. Although new IAS are no longer published, they are still used if they have not been replaced by an IFRS. Some countries such as Australia, European Union, Russia and Turkey have already adopted the IFRS. Although the USA still has its own standards, it is working to harmonise these with the international standards. Currently there are more than 100 countries which have either adopted or modified the IFRS to become their national accounting standards. The IASC had issued a variety of standards, each designated as an “International Accounting Standard” (IAS 1, 2, etc), and these were inherited by the IASB in 2001. Subsequently the IASB has issued a number of standards itself, each designated as an “International Financial Reporting Standard” (IFRS 1, 2 etc). Collectively, IFRSs and IASs are referred to as international accounting standards. The main IASs and IFRSs and their application are considered throughout this chapter and Chapter 7. In addition to accounting standards, there is a guiding principle that overrides every other in the preparation of company accounts. This is the legal requirement under the Companies Acts for accounts to provide a true and fair view of the company’s results and financial position. Although not defined within the Acts, this principle allows directors to depart from mandatory disclosure requirements and accounting regulations if failure to do so would prevent a true and fair view from being given.

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The Main Accounting Standards Below are some of the main international accounting standards, each of which is considered within this chapter. IAS 1

Presentation of Financial Statements

IAS 2

Inventories

IAS 7

Cash Flow Statements

IAS 8

Accounting Policies, Changes in Accounting Estimates and Errors

IAS 10

Events after the Balance Sheet date

IAS 16

Property, Plant and Equipment

IAS 27

Consolidated and Separate Financial Statements

IAS 28

Investments in Associates

IAS 33

Earnings Per Share

IAS 36

Impairment of Assets

IAS 37

Provisions, Contingent Liabilities and Contingent Assets

IAS 38

Intangible Assets

IAS 40

Investment Properties

IFRS 3

Business Combinations

Fundamental Accounting Bases In general, financial statements are drawn up under the historic cost convention. This requires assets brought into the business and transactions made by the business to be recorded at their actual, or historic, cost so as to provide a consistent and objective basis on which to account for a company’s activities. In addition to applying the historic cost convention to company accounts, the Companies Act 1985 requires five fundamental accounting concepts to be applied in the preparation of the income statement and balance sheet. These are: 1. The going concern concept. This assumes that the company will continue to trade as going concern for the foreseeable future, unless there is evidence to the contrary. Therefore, the balance sheet must not record assets at their liquidation values. 2. The accruals concept. This requires the accounts to reflect revenues and expenses as they are earned and incurred. rather than when they are received and paid. 3. The prudence concept. Whilst revenues and profits must not be anticipated, foreseeable costs and losses must be provided for within the accounts. In the event of the prudence concept conflicting with the accruals concept, the former always prevails. 4. The consistency concept. Accounting treatments adopted in the accounts must be consistently applied between accounting periods and between similar items. 5. Non-aggregation, or ‘no-netting off’. When determining the aggregate amount of any item, the amount of each individual asset or liability that falls to be taken into account shall be determined separately. For example, if a firm had two bank accounts with different banks, one with a positive balance and another with an overdraft, they would be presented as asset and liability respectively, rather than being deducted from one another to arrive at a single net asset or liability.

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In addition to the Companies Acts, international accounting standards also provide some guidance on accounting concepts. IAS 1 ‘Presentation of Financial Statements’ sets out the overall framework for presenting financial statements including fundamental principles of going concern, consistency, accruals and materiality. The principle of materiality is that only ‘material’ items need to be considered. Material items are those items whose inclusion or exclusion would impact the user’s view of the accounts. IAS 1 also states that assets and liabilities, and income and expenses may not be offset unless offsetting is permitted or required by another international accounting standard.

The Auditors’ Report All companies, other than those small companies detailed earlier, 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. This audit is concluded with an auditors report to the members, or shareholders, of the company is giving 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 Companies Acts and mandatory accounting standards. If so, then an unqualified audit report is issued. If not, then the auditor must modify the report. These modified reports fall into three categories: 1. Disclaimer of opinion, where the auditor is unable to form an opinion owing to a considerable amount of uncertainty surrounding the outcome of a particular event, a court action against the company for instance, or 2. Adverse opinion, where the auditor disagrees with an accounting treatment or a view made in the statements, which the directors refuse to amend. 3. Qualification, where the auditor has material disagreement with the treatment adopted by the directors or a material uncertainty that limits the scope of the audit opinion. In either case, the effect of the disagreement or limit in scope is not so material to require an adverse or disclaimer of opinion. Medium sized private limited companies and those small private limited companies that are subject to an audit are required to publish an abridged auditors’ report termed a special auditors’ report.

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Summary of Reporting Requirements Reporting requirement Balance sheet Income Statement Directors report Cashflow statement Auditors report

Disclosure of accounting policies Explanatory notes Comparative figures Statement of changes in equity Disclosures required by UKLA Listed Rules

Private limited companies Small Medium Yes Yes Yes Yes

Large Yes Yes

plcs All Yes Yes

Yes No Special auditors report if above certain size and turnover Yes

Yes Yes Special auditors report

Yes Yes Yes

Yes Yes Yes

Yes

Yes

Yes

Yes Yes No

Yes Yes No

Yes Yes No

No

No

No

Yes Yes Listed plcs only Listed plcs only

Publishing and Filing Company Accounts Companies are subject to strict time limits within which their report and accounts must be published. Indeed, the Companies Acts specifically require private limited companies to publish their financial accounts within 10 months and plcs within seven months of their accounting year end. However, those plcs with a full LSE listing and which are, therefore, subject to the UKLA’s continuing obligations, must publish their report and accounts within six months of their accounting year end and produce a set of interim accounts within 90 days of the end of the half year. These statements must be presented at the company’s AGM and filed with the Registrar of Companies. Small and medium sized companies may file abbreviated accounts.

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2. BALANCE SHEET 2.1

Introduction

LEARNING OBJECTIVES 6.2.1

Know the purpose and main contents of the balance sheet

The balance sheet 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. The balance sheet is often described as being a photograph of the company’s financial position in that it doesn’t tell the user anything about the company either immediately before or immediately after the balance sheet date, only at this one point in time. The construction of the balance sheet is underpinned by the accounting equation: Assets = Liabilities plus Equity This can be further expanded to: fixed assets + current assets = current liabilities + long term borrowing + issued share capital + capital reserves + revenue reserves.

2.2

Format

LEARNING OBJECTIVES 6.2.1

Know the purpose and main contents of the balance sheet

The balance sheet of A plc is shown below in a format prescribed by the Companies Acts. Although not shown in the example, this 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.

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A plc Balance Sheet as at 31 December 2006 £'000 Assets Non-current assets Property, plant and equipment Intangible assets Investments available for sale Current assets Inventories Trade and other receivab les Investments held for trading Cash

8900 2100 300 11300 3600 2600 120 860 7180 18480

Total assets Equity and liabilities Capital and reserves Share capital - 50p ordinary shares Share capital - preference shares Share premium account Revaluation reserve Capital redemption reserve Retained earnings Total equity Non-current liabilities Bank loans

5000 100 120 100 80 6880 12280 2000 2000

Current liabilities Trade and other payables

4200 4200 6200 18480

Total liabilities Total equity and liabilities

2.3

2006

Assets

LEARNING OBJECTIVES 6.2.2

Understand how assets are classified and valued

6.2.3

Know the difference between capitalising costs and expensing costs

6.2.4

Know how goodwill and other intangible assets arise and are treated

6.2.5

Be able to calculate the different methods of depreciation and amortisation

An asset is anything that is owned and controlled by the company and confers the right to future economic benefits. Balance sheet assets are categorised as either fixed assets or current assets.

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1. Fixed Assets Fixed assets are alternatively called ‘non-current 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: 1. Tangible. 2. Intangible. 3. Investments.

Tangible Fixed Assets A company’s tangible fixed assets are those that have physical substance, such as land and buildings and plant and machinery. Tangible fixed assets are alternatively referred to as ‘property, plant and equipment’. In accordance with IAS 16 Property, Plant and Equipment and the historic cost convention, tangible fixed assets are initially recorded in the balance sheet at their actual cost. This actual cost includes any additional costs directly attributable in bringing the asset into its working condition, such as the delivery costs, installation costs, and other costs associated with financing the purchase of the asset. Since these costs are not expensed to the income statement in the accounting period in which they were incurred, but are included on the balance sheet as assets, they are known as capitalised costs. Subsequent to acquiring tangible fixed assets, IAS 16 allows a choice of accounting. Under the ‘cost model’, the asset continues to be carried at cost. Under the alternative ‘revaluation model’ the asset can be carried at a revalued amount, with revaluation required to be carried out at regular intervals. However, in order to reflect the fact that the asset will generate benefits for the company over several accounting periods, not just in the accounting period in which it is purchased, the Companies Acts and IAS 16 require all tangible fixed assets with a limited economic life, to be depreciated over this term. An annual depreciation charge is made to the income statement against the carrying value, of the asset over the asset’s useful economic life. This requirement does not necessarily apply to investment properties, which are covered by separate provisions contained within IAS 40 Investment Properties. Investment properties are properties that are not owneroccupied and are held to earn rentals or for capital appreciation, or both. When properties are classified as investment properties, they are measured at fair value instead of being subjected to depreciation charges. To calculate the annual depreciation charge to be applied to a tangible fixed asset, the difference between its carrying or ‘book’ value and estimated disposal value, termed the depreciable amount, must first be established. This value is then written off over the asset’s remaining useful economic life by employing the most appropriate depreciation method. The two most common depreciation methods comprise: 1. The straight line method, and 2. The reducing balance method.

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The straight line method is the simplest of the two methods as it simply spreads the depreciable amount equally over the useful economic life of the asset. The straight line method is given by the following formula: Straight line depreciation = (cost - disposal value)/remaining useful economic life (years) The reducing balance method, however, employs a more complex formula: Reducing balance depreciation % rate = [1 - {Disposal Value/Cost}1/E x 100 Economic Life.

where E = Useful

This method produces a depreciation percentage rate which, rather than being applied to the depreciable amount, is instead applied to book value of the asset. Although this results in a higher depreciation charge than the straight line method in the early years of the asset’s life but a lower charge in the later years, the total amount written off over the asset’s useful economic life, the depreciable amount, will be the same in both cases. One thing to recognise about the annual depreciation charge though is that it is an accounting book entry, or a non-cash charge. That is, no cash flows from the business as a result of making the charge: it is simply an accounting entry made as an expense in the income statement to reflect the estimated cost of resources employed over an accounting period. The balance sheet value of the asset is given by its book value less the accumulated depreciation to date and is termed the net book value (NBV). This NBV does not necessarily equal the market value of the fixed asset. Which of the depreciation methods is the more appropriate depends on the type of asset being depreciated and its use in the business. However, as the choice of method has obvious implications for both the reported profit and the financial position of the company, it should be chosen carefully. The argument in favour of using the reducing balance method over the straight line method though, is that as tangible fixed assets tend to confer the greatest benefits in the earliest years of their employment, these should be matched by a higher depreciation charge. The above points are best illustrated by using an example. Example A machine purchased for £24,500 has an estimated useful economic life of six years and an estimated disposal value after six years of £1,000. Calculate the depreciation that should be charged to this asset and its NBV in years one to six, using: 1. The straight line depreciation method. 2. The reducing balance depreciation method. Solution 1. Straight depreciation Straight line depreciation = (cost - disposal value)/useful economic life (years) = (£24,500 - £1,000)/6 = £3,916.67 per annum. The depreciation charge will be the same in years one to six.

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2. Reducing balance depreciation percentage rate = [1 - {£1,000/£24,500}1/6] x 100 = [1- 0.5868] x 100 = 0.4132 x 100 = 41.32% applied to the reducing value of the asset per annum. Please note, {£1,000/£24,500}1/6 can also be expressed as 6√{£1,000/£24,500}. Summary of the annual depreciation charges and NBV of the asset

Year 1 2 3 4 5 6 Total

Straight line method Depreciation NBV (£) charge (£) 3,916.67 20,583.33 3,916.67 16,666.66 3,916.67 12,749.99 3,916.67 8,833.32 3,916.67 4,916.65 3,916.67 998.98 23,500.02 -

Reducing balance method Depreciation NBV (£) charge (£) 10,123.40 14,376.60 5,940.41 8,436.19 3,485.83 4,950.35 2,045.48 2,904.87 1,200.29 1,704.58 704.33 1,000.25 23,499.75 -

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. Once a depreciation method has been chosen it must be consistently applied to both similar tangible fixed assets and between successive accounting periods. The method may only be changed in order to present a fairer view of the company’s results and financial position. A note to this effect must be disclosed in the company’s accounts. The useful economic life of tangible fixed assets needs to be reviewed at the end of each accounting period. If there are significant changes then the depreciation calculation needs to be modified. This is a simple calculation whereby the initial cost of the asset less total depreciation charged to date is then depreciated over the revised economic life. By reducing the book value of tangible fixed assets over their useful economic lives, depreciation broadly complies with two of the fundamental accounting concepts encountered earlier: 1. Going concern. Stating tangible fixed assets in the balance sheet at their NBV does not override the going concern concept. 2. Accruals. The cost of the fixed asset is written off over its useful economic life as the estimated benefits to flow from its use are received over several accounting periods, rather than solely in the accounting period in which the expenditure was made. In addition to depreciating fixed tangible assets, companies are also required to recognise any permanent decline, or diminution, in the value of their fixed assets. Under IAS 36 Impairment of Assets, the NBV of a tangible fixed asset must be written down, or written off in exceptional cases, if its value becomes impaired. Vodafone, for example, following an impairment review, wrote down the value of its telecom assets by £6bn in May 2002. Similarly MMO2, the former mobile telecoms operator of the BT Group, wrote down the value of its UK and German 3G licences by £5.9bn in May 2003, because of industry-wide delays in offering 3G services and the growing realisation that the provision of such services will not be as profitable as was originally thought. Such write-downs, like depreciation, are non-cash charges.

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On occasion, tangible fixed assets, such as land, are not depreciated because they are accounted for under the ‘revaluation model’ allowed under IAS 16. The standard requires revaluations to be carried out with sufficient regularity so that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date. This provides the user of the accounts with a truer and fairer view of the assets, or capital, employed by the company. To preserve the accounting equation, assets = liabilities plus equity, the increase in the asset’s value arising on revaluation is transferred to a revaluation reserve, which forms part of the equity section on the balance sheet.

Intangible Fixed Assets Intangible fixed assets are those assets that although without physical substance, can be separately identified and are capable of being realised. Ownership of an intangible fixed asset confers certain rights (eg, goodwill not really intellectual property more intangible asset’s). These rights give a company a competitive advantage over its peers and commonly include brand names, patents, trade marks and purchased goodwill. The accounting treatment of goodwill is detailed in IFRS 3 ‘Business Combinations’ and for other intangible fixed assets is prescribed by IAS 38 Intangible Assets. The main provisions of these standards are as follows: 1. Intangible fixed assets that have been purchased separately, such as brand names, are capitalised in the balance sheet at their cost of purchase. If purchased as the result of taking over another company, however, they can only be capitalised as a separately identifiable intangible fixed asset if their value can be reliably measured. Otherwise their value is subsumed within purchased goodwill. If capitalised, intangible fixed assets are accounted for like tangible fixed assets – either under the ‘cost model’ or the ‘revaluation model’. The equivalent of depreciation of tangible fixed assets is the ‘amortisation’ of intangible fixed assets. 2. Purchased goodwill arises when the consideration, or price, paid by the acquiring company for the target exceeds the fair value of the target’s separable, or individually identifiable, net assets. This is not necessarily the same as the book, or balance sheet, value of these net assets: purchased goodwill = (price paid for company - fair value of separable net tangible and intangible assets) Purchased goodwill is capitalised in the balance sheet and IFRS 3 then requires it to be held on the balance sheet and not subjected to regular amortisation charges. Instead, goodwill should be subjected to impairment reviews at least annually. 3. Intangible fixed assets that have been created internally by the company rather than being acquired, such as brand names, customer lists and the like, tend not to be capitalised in the balance sheet because their cost cannot be distinguished from the cost of developing the business as a whole. However, certain costs incurred by the company, rather than being written off against the company’s revenue in the income statement in the period in which they were incurred, can instead be capitalised as intangible fixed assets if it can be shown that a future benefit will arise from the expenditure. So as to meet with the accruals concept, this capitalised cost is then matched against the company’s revenue in subsequent accounting periods in line with the estimated flow of the expected future benefits to arise from the capitalised asset. Most notable amongst these is the capitalisation of development expenditure. Development expenditure is that made on the application of technical know-how that is expected to result in improved products or processes and ultimately increased profits for the company. International Certificate in Investment Management

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Although any expenditure devoted to research must be written off in the accounting period in which it is incurred, IAS 38 permits development expenditure to be capitalised after technical and commercial feasibility of the resulting product or service have been established.

Fixed Asset Investments Fixed asset investments are typically long term investments held in other companies. They are initially recorded in the balance sheet at cost, and then subsequently revalued to their fair value at each period end. Any gains or losses are reflected directly in the equity section of the balance sheet and disclosed in the statement of changes in equity. However, if they suffer an impairment in value, then such a fall is charged to the income statement. As detailed later in this chapter, if the shareholding represents at least 20% of the issued share capital of the company in which the investment is held, or if the investing company exercises significant influence over the management policies of the other, then the investing company is subject to additional reporting requirements.

2. Current Assets Current assets are those assets purchased with the intention of resale or conversion into cash, usually within a 12 month period. They are, therefore, known as revenue items and include stocks of goods, the debtor balances that arise from the company providing its customers with credit and any short term investments held. Current assets also include cash balances held by the company and pre-payments. Current assets are listed in the balance sheet in descending order of liquidity and typically appear in the balance sheet at the lower of: 1. Cost, or 2. Net realisable value (NRV). IAS 2 ‘Inventories’ expands upon this principle in relation to individual and groups of similar items of stock and work in progress held by the company. IAS 2 requires stock and work in progress to be stated in the balance sheet at the lower of: 1. Cost, defined as the cost of purchase plus any conversion costs incurred in bringing the stock item to its present location and condition, or 2. NRV, defined as the estimated selling price of each stock item less any further costs to be incurred in both bringing the stock, work in progress or raw materials into a saleable condition including any associated selling and marketing costs. Therefore, if for reasons such as obsolescence, the NRV of the stock has fallen below cost, the item must be written down to this NRV for balance sheet purposes. Determining what constitutes cost should be relatively straightforward unless the company purchases vast quantities of stock in different batches throughout its accounting period making the identification of individual items or lines of stock particularly difficult when attempting to match sales against purchases. In such instances, cost can be determined by making an assumption about the way stock flows through the business. Companies can account for their stock on one of three bases:

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1. First in first out (FIFO). FIFO assumes that the stock first purchased by the business is the first to be sold. Therefore, the value of the closing stock at the end of the accounting period is given by the cost of the most recent stock purchased. This produces a closing stock figure in the balance sheet that closely resembles the current market value of the stock. It also results in the highest reported profit figure of the three bases in times of rising prices. 2. Last in first out (LIFO). LIFO assumes that the most recent stock purchased by the company is the first to be sold. IAS 2 does not permit the use of LIFO since, in times of rising prices, the balance sheet value of closing stock will be that of the stock first purchased and will, therefore, not resemble current prices. It also produces the lowest reported profit figure of the three bases. 3. Weighted average cost (AVCO). AVCO values closing stock at the weighted average cost of stock purchased throughout the accounting period. This method produces a closing stock figure and a reported profit between that of the FIFO and LIFO methods. Again, these points are best illustrated by the use of an example: Example Z Ltd has started trading in electronic calculators. At the end of its first accounting period, Z Ltd had sold 1,500 calculators having purchased 1,750 calculators in two batches. In drawing up its accounts, Z Ltd applies the principles of IAS ‘Inventories’ to the calculators and accounts for its stock of calculators on a FIFO basis. At the end of the accounting period, it is estimated that the NRV of the stock of calculators is £1,350.

Stock of calculators

Number of calculators

Opening stock Batch 1 costs of purchase Batch 2 costs of purchase Stock sold Closing stock

1,000 750 (1,500) 250

Cost of purchase per calculator (£) 4 5 -

Cost of conversion per calculator (£) 1 1 -

Sales price per calculator (£)

8

In relation to the above data, what is the value of the closing stock of calculators? Solution Under IAS 2, closing stock is valued at the lower of cost or NRV. As the stock is accounted for on a FIFO basis, the closing stock of 250 calculators if valued at cost = [(£5 x 250) + (£1 x 250)] = £1,500. However, as the NRV is lower at £1,350, the balance sheet value will be £1,350.

NOTE If the stock had been accounted for on a LIFO basis, the closing stock of 250 items would have had a balance sheet value of [250 x (£4 + £1)] = £1,250, as this cost is lower than the NRV. We will return to IAS 2 when looking at the income statement.

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2.4

Liabilities

LEARNING OBJECTIVES 6.2.6

Know how liabilities are categorised

A liability is a present obligation to transfer future economic benefits as a result of past transactions or past events. Liabilities are categorised according to whether they are to fall due within or more than one year: 1. Current liabilities. This balance includes the amount the company owes to its suppliers, or trade creditors, as a result of buying goods and/or services on credit, any bank overdraft and any dividends and/or tax payable within 12 months of the balance sheet date. 2. Non-current liabilities or long-term liabilities. This comprises the company’s borrowing not repayable within the next 12 months. This could include debentures and/or loan stock issues as well as longer term bank borrowing. In addition, IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ creates a separate heading for provisions that have resulted from past events or transactions and for which there is an obligation to make a payment, but the exact amount or timing of the expenditure has yet to be established. Such provisions may arise as a result of the company undergoing a restructuring for example. Given the uncertainty surrounding the extent of such liabilities, IAS 37 requires the company to create a realistic and prudent estimate of the monetary amount of the obligation once it is committed to taking a certain course of action. Provisions cannot, however, be made in respect of possible but not probable, future obligations that may arise on the occurrence of a future event: customers making claims on goods sold with warranties for instance. Given the unpredictable nature of these so-called contingent liabilities, the company’s potential liability and the uncertainties surrounding this, where quantifiable, are instead disclosed by way of a note in the accounts.

2.5

Equity

LEARNING OBJECTIVES 6.2.7

Understand the difference between authorised and issued share capital and capital reserves and revenue reserves

CALLED UP SHARE CAPITAL This is the nominal value of equity and preference share capital the company has in issue. This may differ from the amount of share capital the company is authorised to issue as contained in its articles of association.

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CAPITAL RESERVES 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 from issuing shares at a price above their nominal value whilst 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, as suggested in Chapter 4, they can be converted into a bonus issue of ordinary shares.

RETAINED EARNINGS Retained earnings is a revenue reserve and represents the accumulation of the company’s distributable profits that have not been distributed to the company’s shareholders as dividends, or transferred to a capital reserve, but have been retained in the business. You should not confuse this balance with the amount of cash the company holds or with the income statement that shows how the retained, or undistributed, profit in a single accounting period was arrived at. You may recall, from earlier in this chapter, that the income statement reconciles the movement between successive balance sheets. However, in some instances this may also require the inclusion of the statement of changes in equity.

2.6

Events After the Balance Sheet Date

LEARNING OBJECTIVES 6.2.8

Know what contingent liabilities and post balance sheet events are

IAS 10 ‘Events after the Balance Sheet date’ provides for when there have been significant developments in the company’s fortunes between the balance sheet date and the directors approving and signing the accounts. If the development materially affects an item already recorded in the balance sheet, this is termed an adjusting event as the item in question must be adjusted to reflect this development: the impact of the liquidation of a major debtor on the debtors balance at the balance sheet date for example. However, when a significant development does not directly impact the pre-existing balance sheet, this is known as a non-adjusting event as only a note outlining the nature and impact of the event on the post balance sheet financial position of the company is required to be disclosed in the accounts.

2.7

Assessing the Balance Sheet

The balance sheet is constructed on the basis of the accounting equation, assets = equity plus liabilities, as at one particular point in time: the accounting year end. However, neither the balance sheet total of a company’s assets nor its equity represent the market value of the company at this or any other point in time. This can only be ascertained from the company’s market capitalisation, or the market value of its shares in issue, if traded.

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The construction of the balance sheet is a mixture of: 1. Historic cost; 2. Modified historic cost; and 3. Accruals. Although assets are brought into the balance sheet at their actual or historic cost, this book value is modified for fixed assets as a result of their revaluation, impairment, depreciation and amortisation and for current assets if their NRV falls below cost. Moreover, the balance sheet does not account for that most valuable of company assets - the knowledge, skills and loyalty of a company’s employees - even though this intangible asset can make the difference between a company success or failure. As for liabilities, subjective provisions often need to be made for future expenditure whenever uncertainty surrounds the exact extent of a company’s obligation to an outside party. Therefore, great care must be taken when assessing and evaluating a company’s balance sheet. This we consider further in Chapter 7.

3. THE INCOME STATEMENT 3.1

Introduction

LEARNING OBJECTIVES 6.3.1

Know the purpose and main contents of the income statement

The income statetment 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, 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: 1. Detail how the company’s reported profit was arrived at, and 2. 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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3.2

Format

LEARNING OBJECTIVES 6.3.1

Know the purpose and main contents of the income statement

Like the balance sheet, the format of the income statetment is governed by the Companies Acts and its construction underpinned by accounting standards. An example income statement and the related statement of changes in equity for A plc is shown below. As with the balance sheet, comparative numbers and explanatory notes must be provided. A plc Income Statement for the year end 31 December 2005 2005 £'000 9500 (7000) 2500 (110) (30) 2360 (260) 2100 30 90 (230) 1990 (555) 1435 14.3p

Revenue Cost of sales Gross profit Distribution costs Administrative expenses Operating profit Exceptional loss Income from fixed asset investments Interest receivable Interest payable Profit before taxation Taxation Net income Earnings per share (pence)

A plc Statement of chang es in equity for the year ended 31 December 2005

As at 1 January 2005 Gain on revaluation Issue of shares Net income for the year Preference dividends paid Ordinary dividends paid As at 31 December 2005

Ord Share Capital 4470

Pref Share Capital 100

530

5000

Share premium account 0

Revaluation Reserve 0 100

Capital redemption reserve 80

Retained earnings 5880

120

100

120

100

80

Total 10530 100 650

1435

1435

-5

-5

-430

-430

6880

12280

It is important to understand how each of the above levels of reported profit are derived.

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3.3

Profit

LEARNING OBJECTIVES 6.3.2

Know the basic concepts underlying revenue recognition

6.3.3

Know how expenses, provisions and dividends are accounted for

6.3.4

Be able to calculate the different levels of profit given revenue and different categories of cost

6.3.5

Know the difference between revenue and reserve accounting

Gross Profit Gross profit is calculated by deducting the cost of goods sold from revenue: Gross profit = revenue - cost of sales Revenue is calculated on an accruals basis and represents sales generated over the accounting period regardless of whether cash has been received. However, since there are no prescriptive rules as to when revenue should be recognised in the profit and loss account, this leaves scope for subjective judgement. During the dot.com boom of the late 1990s, a number of information technology companies generated considerable controversy by recognising revenue in their profit and loss accounts before completing contracts for the supply of software, which subsequently failed to be fulfilled. Many have since adopted more conservative revenue recognition policies. IAS 18 ‘Revenue’ prescribes the accounting treatment for revenue arising from certain types of transactions and events, essentially only allowing recognition of revenues when appropriate. Cost of sales = [opening stock (if any) + purchases - closing stock] The cost of sales is arrived at by adding purchases of stock made during the accounting period, again by applying accruals rather than cash accounting, 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. The opening stock figure used in this calculation will necessarily be the same as the closing stock figure that appears in the current assets section of the balance sheet from the previous accounting period. The above formulae are applied in the example below. This example, which employs the provisions of IAS 2 ‘Inventories’, was used earlier in the balance sheet section. Example Z Ltd has started trading in electronic calculators. At the end of its first accounting period, Z Ltd had sold 1,500 calculators having purchased 1,750 calculators in two batches. In drawing up its accounts, Z Ltd applies the principles of IAS 2 Inventories to the calculators and accounts for its stock of calculators on a FIFO basis. At the end of the accounting period, it is estimated that the NRV of the stock of calculators is $1,350.

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It was established that under IAS 2 closing stock is valued at the lower of cost or NRV. As the stock is accounted for on a FIFO basis, the closing stock of 250 calculators if valued at cost = [($5 x 250) + ($1 x 250)] = $1,500. However, as the NRV is lower at $1,350, the balance sheet value is $1,350. Given the value of the closing stock, the gross profit can be calculated. Gross profit = turnover - [opening stock + purchases - closing stock] Gross profit = (1,500 x $8) - [0 + (1,000 x ($4 + $1)) + (750 x ($5 + $1)) - $1,350] = $3,850

NOTE If the stock had been accounted for on a LIFO basis, the closing stock of 250 items would have had a balance sheet value of [250 x ($4 + $1)] = $1,250, as this cost is lower than the NRV. Therefore, the reported profit figure would have been (1,500 x $8) - [0 + (1,000 x ($4 + $1)) + (750 x ($5 + $1)) - $1,250] = $3,750.

Operating Profit Operating profit is stated after deducting distribution costs and administration expenses. Administration expenses usually include depreciation charges. Although not shown in the above income statement, IFRS 5 ‘Non-current assets held for sale and discontinued operations’ requires the company’s revenue and all items leading to and including the operating profit for the accounting period to be shown in respect of the company’s continuing, or ongoing operations, and separately for operations discontinued during the period.

Exceptional Items IAS 1 does not actually use the term exceptional item, however the term is widely used in accounting. Essentially, the idea behind classifying an item as exceptional is 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. IAS 1 acknowledges that, due to the effects of a company’s various activities, transactions and other events that differ in frequency, potential for gain or loss and predictability, disclosing the components of financial performance assists in understanding that performance and making future projections. In other words, if an item is exceptional, it should be separately disclosed. An exceptional item could be the profit made on selling a significant fixed asset or the loss on selling an unprofitable operation. These profits and losses only represent book profits and losses rather than actual cash profits and losses. We will return to this point when considering cashflow statements later in this chapter. Exceptional profits are added to, and exceptional losses deducted from, operating profit in arriving at the company’s profit before taxation.

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Profit Before Taxation In addition to exceptional items, net dividend income from long term investments made in other companies, gross interest receivable as well as gross interest payable must all be accounted for on an accruals rather than a cash paid and received basis, when moving between operating profit and profit before taxation.

Profit After Taxation A provisional estimate of the company’s corporation tax liability is deducted from profit before taxation to give profit after taxation. The calculation of corporation tax is considered in Chapter 8.

Net Income Net income is the company's total earnings or profit. In the UK it is also referred to as profit after tax. It is calculated by taking the total revenues adjusted for the cost of business, interest, taxes, depreciation and other expenses. The 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. The 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 in the chapter, dividends paid are also disclosed in the cashflow statement.

Earnings Per Share (EPS) The EPS is calculated as follows: EPS = profit for the financial year/number of ordinary share in issue IAS 33 Earnings Per Share standardises the calculation of EPS. This is considered in Chapter 7.

Reserve Accounting To ensure that the income statement gives a true and fair view, certain items are not accounted for through the income statement. Instead they are taken through ‘reserves’ and reflected in the statement of changes in equity. As well as dividends paid considered above, another example would be an upwards revaluation of a tangible fixed asset. This increase in value would be reflected in the balance sheet, but not disclosed in the income statement. It is because the asset has not actually been sold at that revalued amount, the gain is termed unrealised and is not included in the income statement. Furthermore, because such items are not shown in the income statement, but do impact the balance sheet assets, the way they are accounted for is termed ‘reserve accounting’. The following example consolidates what has been discussed.

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Example The following figures relate to B plc for the period ended 30 June 200X. Items Revenue Cost of sales Administrative expenses Exceptional loss Interest receivable Tax Ordinary Dividends paid

£000 5,105 2,750 645 1,308 213 184 252

With reference to the above income statement items, what is B plc’s operating profit and net income, respectively? Solution The operating profit is calculated by deducting the cost of sales and administrative expenses from revenue. This gives $1,710,000. The net income is $623,000. This is arrived at by deducting the exceptional loss and tax from operating profit and adding the interest receivable. Dividends do not enter into the calculation as they are an appropriation of profit.

4. THE CASHFLOW STATEMENT 4.1

Introduction

Cash is the life blood of any business. No matter how profitable the company, an inability to generate a sufficient amount of cash to sustain the business will compromise its chances of long term survival. It has been mentioned on several occasions that profit is not the same as cash since profit is arrived at through the use of accruals, rather than cash, accounting. Indeed, neither the most recent balance sheet nor income statement provide a clear indication of the impact events or transactions recorded in these statements have on the company’s cash position. Only when the most recent balance sheet is compared to that for the previous accounting period is some indication provided. Therefore, in order to establish whether the company has been cash generative or not, IAS 7 ‘Cashflow Statements’ requires companies to produce a cashflow statement. Cashflow statements seek to identify how a company’s cash has been generated over the accounting period and how it has been expended. They are constructed by: 1. 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. 2. Adjusting for balance sheet items such as an increase in the value a company’s stock or debtors or a decrease in creditors, all of which increase reported profit but do not impact cash. 3. 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. 4. 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. International Certificate in Investment Management

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The Cashflow Statement for A plc, based on the IAS 7 format, is given below. Although not shown, explanatory notes to the cashflow statement and comparatives are also required. As not all of the effects of accruals accounting can be stripped out from a company’s operating profit, the cashflow statement is a bit of a misnomer in that it contains a mixture of accruals, cash and credit, or fund, flows. Analysis of the cashflow statement shows that it is important that a company generates positive cashflow at the operating level otherwise it will become reliant upon fixed asset sales and borrowing facilities to finance its day-to-day operations. We will return to this point when considering ratio analysis in Chapter 7. A company’s survival and future prosperity is 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 cashflow statement will also identify this.

4.2

Format

LEARNING OBJECTIVES 6.4.1

Know the purpose and main contents of the cash flow statement

A plc Cashflow Statement for the year ended 31 December 2005 2005 Operating activities Cash receipts from customers Cash paid to suppliers and employees Cash generated from operations Tax paid Interest paid Net cash from operating activities

4528 (2001) 2527 (440) (150) 4464

Investing activities Interest received Dividends received Purchase of fixed assets Proceeds on sale of investments Net cash used in investing activities

80 40 (1890) 120 (1650)

Financing activities Dividends paid Repayments of borrowings Proceeds on issue of shares Net cash generated from financing activities

(435) (200) 650 15

Net increase in cash and cash equivalents Cash and cash equivalents at the beginning of the year Cash and cash equivalents at the end of the year

2829 425 3254

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Note that the amounts applied to the interest paid and received items may differ from their respective income statement totals. If the income statement total for interest payable were £230,000, and the actual interest paid was £150,000, this is £80,000 less than the income statement total. This implies that £80,000 has been accrued at the balance sheet date. Example Why should the interest payable in the income statement be recorded as £220,000 whilst the interest paid in the cashflow statement only equals £100,000? Because £120,000: A. has yet to be paid by the company B. is owed to the company C.has been capitalised D.is to be written off Solution A. The income statement applies the accruals concept when accounting for interest payments whilst the cashflow statement uses cash accounting. Therefore, the £120,000 difference is an accrual of interest due to be paid by the company. If the interest had been capitalised it would have appeared as a payment in the cashflow statements and as an asset in the balance sheet. Write-offs occur on items that are receivable rather than payable.

4.3

Calculating Net Cashflow from Operating Activities

LEARNING OBJECTIVES 6.4.2

Be able to calculate net cash flow from operations from operating profit

In order to establish the cash generated from operating activities figure in the cashflow statement essentially the company’s operating cashflow - IAS 7 allows one of two alternative presentations on the face of the cashflow statement. The preferred method is the direct method (shown in the above example) where the cash received from customers and paid to suppliers and employees are shown. Alternatively, the indirect method is where a reconciliation is shown between the company’s income statement’s operating profit and the cash generated from operations in the cashflow statement. This reconciliation requires the following adjustments to be made to the operating profit figure: 1. Non-cash charges such as the depreciation of tangible fixed assets and the amortisation of intangible assets must be added back as these do not represent an outflow of cash. 2. Any increase in debtors or stock or decrease in short term creditors over the accounting period must be subtracted as these all increase reported profit but do not increase cash. 3. Any decrease in debtors or stock or increase in short term creditors over the accounting period must be added as these all decrease reported profit but do not decrease cash.

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Example Given the income statement and balance sheet items below, how can the cash generated from operations figure of £2,527,000 in XYZ plc’s cashflow statement be reconciled with XYZ plc’s operating profit of £2,360,000?

Depreciation Goodwill amortisation Increase in stock Decrease in debtors Increase in creditors

£000 62 17 12 77 23

Solution

Operating profit Add: Depreciation Add: Goodwill amortisation Subtract: Increase in stock Add: Decrease in debtors Add: Increase in creditors Net cash inflow from operating activities

£000 2360 62 17 (12) 77 23 2527

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4.4

Interpreting Company Accounts

“Recessions catch what the auditors miss” J K Galbraith Although the limitations of the three principal accounting statements - the balance sheet, income statement and cashflow statement - have already been considered, the fraudulent accounting of activities at Enron and WorldCom further highlights the need to exercise caution when interpreting information contained in company accounts. Turning to the WorldCom debacle, for instance, in an attempt to flatter its bottom line and in flagrant breach of US GAAP (Generally Accepted Accounting Practice), the company capitalised US$3.8bn of expenses in its balance sheet rather than charging them to its income statement. In the UK, despite the need to comply with the Companies Acts and mandatory accounting standards, a certain amount of subjectivity is attached to the numbers appearing in audited company accounts. In particular, the debate surrounding revenue recognition, the capitalisation of costs in the balance sheet along with the many and various ways in which a company’s earnings can be calculated and presented (this is detailed in Chapter 7) has confirmed the view held by many that accounting is more of an art than a science. The impact of what is generally considered to be a deterioration in the quality of corporate reporting, at a time when the corporate community has come under greater scrutiny following a number of corporate governance abuses, has been to undermine investor confidence in company accounts which in turn has sparked a number of dramatic reforms throughout the accounting industry.

5. CONSOLIDATED COMPANY REPORT AND ACCOUNTS 5.1

Introduction

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, then this investment is recognised in company A’s balance sheet as either a: 1. Fixed asset investment at cost less any impairment to its value, or as a 2. Current asset at the lower of cost or NRV. In this instance NRV is the current market value. In both cases, any dividends received would be taken to the profit and loss account in arriving at profit on ordinary activities before taxation. If, however, this shareholding represents at least 20% of company B’s voting capital or company A is in a position to exert considerable influence over company B’s management, then company A is required to show the position of the combined entity in its balance sheet and profit and loss account.

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5.2

Subsidiaries

LEARNING OBJECTIVES 6.5.1

Know the basic principles of accounting: Associated Companies; Subsidiaries

When a company controls another company, it is known as a parent company with a subsidiary. The controlled entity is called the subsidiary company, and the controlling entity is called its parent (or the parent company). The most common way that control of a subsidiary is achieved is through the ownership of shares in the subsidiary by the parent. These shares give the parent the necessary votes 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. A subsidiary may itself have subsidiaries, and these, in turn, may have subsidiaries of their own. A parent and all its subsidiaries together are called a group of companies. 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. These accounts are alternatively termed ‘consolidated accounts’, and by amalgamating the assets and liabilities, the shareholders of the parent are clearly able to see all of the resources the group controls, and the liabilities the group owe to others. The vast majority of listed companies are parent companies that control one or more subsidiary companies. As a result, listed companies present group accounts to their shareholders. As stated above, a subsidiary is established when the parent company controls more than 50%. In instances where the parent has greater than 50%, but less than 100% of the shares of the subsidiary, the remaining shares are owned by persons other than 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 balance sheet as a separate entry within equity for the minority interests.

5.3

Equity Method of Accounting

IAS 28 ‘Investments in Associates’ prescribes the accounting treatment for fixed asset investments held in other companies where there is a 20% to 50% shareholding or the investing company participates in or exercises a significant influence over the management of the other company. The company in which the shareholding is held is known as an associate company and the method employed to account for the investment is termed the equity method of accounting.

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The equity method of accounting requires that if A has a 30% shareholding in B, for instance, then: i. 30% of company B’s post acquisition operating profit, interest payable, interest receivable and tax is added to company A’s respective income statement items in the consolidated income statement. Any dividends received by A from B do not, however, enter the consolidated income statement. Company B’s post acquisition profits are those that arise after A has taken a stake in B as an associated company. ii. 30% of the value of company B’s net assets and the value of any purchased goodwill that arose on making this investment in company B would appear in the consolidated balance sheet.

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INVESTMENT ANALYSIS

1. 2. 3.

FUNDAMENTAL AND TECHNICAL ANALYSIS YIELDS AND RATIOS VALUATIONS

239 244 258

This syllabus area will provide approximately 8 of the 100 examination questions

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1. FUNDAMENTAL AND TECHNICAL ANALYSIS 1.1

Introduction

“When the facts change, I change my mind.” John Maynard Keynes Second guessing financial markets is not easy. However, when making investment decisions, portfolio managers can employ a number of analytical techniques. These can be broadly categorised as either: 1. Technical analysis, or 2. Fundamental analysis.

1.2

Technical Analysis

LEARNING OBJECTIVES 7.1.1

Know the difference between fundamental and technical analysis

Technical analysts, or chartists, principally seek to establish price trends, whether in the broader market or for individual securities, when making investment decisions. Adopting the mantra the trend is your friend, chartists analyse charts of past price and volume movements and employ mechanical trading rules to take advantage of any perceived informational advantage conveyed by these charts. In order to assess whether a trend has been established, technical analysts divide price movements into three categories: 1. Primary movements; 2. Secondary movements; 3. Tertiary movements. Primary movements are long term price trends, which can last a number of years. Primary movements in the broader market are known as bull and bear markets: a bull market being a rising market and a bear market a falling market. Primary movements consist of a number of secondary movements, each of which can last for up to a couple of months, which in turn comprise a number of tertiary, or day-to-day movements.

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PRICE SECONDARY MOVEMENTS

CHANGE IN PRIMARY MOVEMENT

TERTIARY MOVEMENTS

PRIMARY MOVEMENT

TIME

Figure 1: Line Chart Price movements can be identified and evaluated through analysing various types of chart. These comprise: 1. Line charts, such as that depicted above, where the price of an asset, or security, over time is simply plotted using a single line. Each point on the line represents the security’s closing price. However, in order to establish an underlying trend, chartists often employ what are known as moving averages so as to smooth out extreme price movements. Rather than plot each closing price on the chart, each point on the chart instead represents the arithmetic mean of the security’s price over a specific number of days. 10, 50, 100 and 200 moving day averages are commonly used. 2. Point and figure charts. These record significant price movements in vertical columns by using a series of Xs to denote significant up moves and Os to represent significant down moves, without employing a uniform time scale. Whenever there is a change in the direction of the security’s price a new column is started.

PRICE

C C C C X C C C X C X 0 C C X 0 X 0 X C X 0 C 0 X 0 X X 0 X X 0 X

Figure 2: Point and Figure Chart

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3. Bar charts. Bar charts join the highest and lowest price levels attained by a security over a specified time period by a vertical line. This time scale can range from a single day to a few months. When the chosen time period is one trading day, a horizontal line representing the closing price on the day intersects this vertical line.

PRICE

TIME

Figure 3: Bar Chart 4. Candlestick charts. Closely linked to bar charts are candlestick charts. These again link the security’s highest and lowest prices by a vertical line but employ horizontal lines to mark both the opening and closing prices for each trading day. If the closing price exceeds the opening price on the day then the body of the candle is left clear, whilst if the opposite is true, it is shaded. PRICE

TIME

Figure 4: Candlestick Chart Technical analysis is based on the belief that although market prices at any one point in time reflect supply and demand, it is investor psychology that drives markets. More specifically, the price at which an investor purchases a security typically dictates the investor’s subsequent actions regarding this investment. This is known as anchoring.

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Given that most investors are averse to making losses, the purchase price of the security is likely to represent the minimum price at which that investor is subsequently prepared to sell the investment. If the price of the security subsequently falls, the investor is likely to hold onto their investment until the price recovers to its former level, at which point the investor is likely to sell. If this loss aversion principle is applied to other investors who invested in this same security at the same price and who also decide to sell once the price has recovered, this will have the effect of putting a ceiling on the price of the security in the short term. Technical analysts call this the resistance level. Similarly, if a large number of investors buy a security at a particular point in time and the price of that security subsequently rises and a profit is taken, they may be inclined to repeat the exercise if the price then falls back to what they originally paid for the investment. This original purchase price then creates a floor, or a support level. By noting the price at which high volumes of trading have occurred in a particular asset through the analysis of price and volume charts, support and resistance levels can then be established. If a support level is subsequently broken, this provides a sell signal whilst the breaking of a resistance level, as the price of the asset gathers momentum, indicates a buying opportunity. These are known as breakouts. Technical analysts also look for breakouts from continuation patterns. These price patterns, rather than representing a trend, indicate a consolidation of price movements. An example of a continuation pattern is the triangle. PRICE BREAKOUT

TIME

Figure 5: The Triangle Here price movements become progressively less volatile but often breakout in either direction in quite a spectacular fashion. Other continuation patterns include the rectangle and the flag. Chartists typically use what are known as relative strength charts to confirm breakouts from continuation patterns. Relative strength charts simply depict the price performance of a security relative to the broader market. If the relative performance of the security improves against the broader market then this may confirm that a suspected breakout on the upside has or is about to occur.

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However, acknowledging that prices do not always move in the same direction and trends eventually cease, technical analysts also look to identify what are known as reversal patterns, or sell signals. That is, momentum in asset prices can build up in both directions. Probably the most famous of these is the head and shoulders reversal pattern, depicted below. A head and shoulders reversal pattern arises when a price movement causes the right shoulder to breach the neckline, the resistance level, indicating the prospect of a sustained fall in the price of the security. Although in technical analysis the trend is your friend, the mantra is often suffixed with “trees don’t grow to the sky”. PRICE HEAD LEFT SHOULDER

RIGHT SHOULDER NECKLINE

TIME

Figure 6: Head and Shoulders Reversal Pattern Although technical analysis has become quite a sophisticated art and has attracted a significant following, it does have a number of drawbacks: principally that a trend can be interpreted in one of a number of ways and breakouts can often prove to be false dawns.

1.3

Fundamental Analysis

LEARNING OBJECTIVES 7.1.1

Know the difference between fundamental and technical analysis

By contrast, fundamental analysis seeks to establish the intrinsic or fundamental value of a security, or of the broader market, principally by calculating and interpreting a wide range of yields and ratios based on factors such as earnings and asset values as well as employing discounted cashflow (DCF) techniques in an attempt to judge whether the security or market is correctly valued. These techniques are considered below. Fundamental analysis also draws on quantitative techniques. These are mathematical and statistical techniques that seek to establish correlations between a range of variables and asset returns as well as analyse the trade off between risk and return for different asset classes. These techniques were introduced in Chapter 2 and are considered further in Chapter 9.

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Concluding Comments Although the approaches adopted by technical and fundamental analysis differ markedly, they should not be seen as being mutually exclusive techniques. Indeed, their differences make them complimentary. Used collectively, they can enhance the portfolio management decision making process.

2. YIELDS AND RATIOS 2.1

Introduction

The three principal financial statements and associated explanatory notes published by companies in their annual report give a considerable amount of information. As a result, ratio analysis is commonly used for three main reasons: 1. To assist in assessing business performance by identifying meaningful relationships between numbers contained within company financial statements that may not be immediately apparent. Although there are no statutory rules as to how ratios should be calculated, there should be logic in the numbers being related to each other. 2. To summarise financial information into an easily understandable form. 3. To identify trends, strengths and weaknesses. However, ratio analysis does have its limitations: 1. 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. 2. Despite accounting regulations, accounting data can be window dressed. 3. Ratios do not provide answers and are of limited value in isolation, but do prompt further investigation. 4. 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. However, because of a culture of innovation and enterprise, it may actually perform better and ultimately give a higher return on investment. 5.

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.

Accounting ratios can be categorised under four headings: 1. Profitability. These assess the effectiveness of a company’s management in employing the company’s assets profitability. 2. Profit Stability. These assess the risks attached to a company’s profits, or earnings. 3. Liquidity Management. These establish, in conjunction with the company’s cashflow statement and what is known as z-score analysis, the ability of the company to meet its liabilities as they fall due. 4. Operational Efficiency. These analyse a company’s cost control and productivity.

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Ratios for each of these four main categories will be calculated in respect of A plc’s financial statements produced in Chapter 6. These are reproduced at the end of this section for ease of reference.

2.2

Profitability Ratios

LEARNING OBJECTIVES 7.2.1

Be able to calculate Return on Equity (ROE)

7.2.2

Be able to calculate Return on Capital Employed (ROCE)

7.2.3

Be able to calculate asset turnover

7.2.4

Be able to calculate profit margin

1. RETURN ON EQUITY (ROE) ROE = net income - preference dividends/ordinary shareholders equity x 100

[

]

ROE = 1,435 - 5/(12,280 -100) x 100 = 11.74% ROE measures the percentage return a company has achieved on the book value of its ordinary shareholders’ equity. In other words the percentage return generated for its ordinary shareholders. Note that if there are any preference shares, then the nominal value of the company’s preference share capital is deducted from total equity to arrive at ordinary shareholders’ equity. The net income is reduced by any preference dividends that have been paid during the period to arrive at the net income attributable to the ordinary shareholders. Businesses that employ few tangible assets, known as people businesses, generally have a high ROE.

2. RETURN ON CAPITAL EMPLOYED (ROCE) ROCE = profit before interest payable and tax/capital employed x 100 ROCE = profit immediately before interest payable/(total assets - current liabilities + short term interest bearing borrowing) x 100 For a plc: ROCE = [2,220/(18,480 - 4,200)] x 100 = 15.55% Capital employed can also be defined as: (total equity + non-current liabilities + short-term interest bearing borrowing) ROCE is a key profitability measure as it provides the rate of return obtained on all sources of finance employed by the business, not just ordinary shareholders equity. This return necessarily includes profits and income derived from all aspects of a company’s operations. It can, therefore, be used for the purpose of establishing trends between accounting periods and between other companies in the industry.

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However, ROCE can be distorted by: i. The raising of new finance at the end of the accounting period as this will increase the capital employed denominator but will not affect the profit numerator in the equation. ii. The revaluation of fixed assets during the accounting period as this will increase the amount of capital employed whilst also reducing the reported profit by increasing the depreciation charge. iii. The acquisition of a subsidiary at the end of the accounting period in the group accounts as the capital employed in the consolidated balance sheet will increase by the net assets of the subsidiary company less the minority interests, if any, whereas there will not be any post acquisition profits from the subsidiary to bring into the consolidated profit and loss account. A more detailed analysis of ROCE can be undertaken by employing two secondary ratios: asset turnover and profit margin. Asset turnover measures how efficiently the company’s assets have been utilised over the accounting period whilst 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 relationship between ROCE and these two secondary ratios is given by the following formula: ROCE = asset turnover x profit margin. Asset turnover = revenue/capital employed = 9,500/14,280 = 0.665 per annum. Profit margin = profit per ROCE/revenue x 100 = 2,220/9,500 x 100 = 23.37%. ROCE = asset turnover x profit margin = 0.665 x 23.37% = 15.55%. Although the company has a low asset turnover, it has a high profit margin. This is characteristic of companies that operate in capital intensive industries. Those in high revenue businesses, such as food retailers, typically have low profit margins but a high asset turnover. The ROCE for a food retailer could well be: ROCE = asset turnover x profit margin = 7 x 2.117% = 14.82%. ROCE, therefore, makes inter-industry comparisons possible.

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2.3

Stability Ratios

LEARNING OBJECTIVES 7.2.5

Be able to calculate financial gearing

7.2.6

Be able to calculate interest cover

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 cyclical, or closely tied to the fortunes of the economic cycle. It also depends on the level of a company’s financial gearing, or capital structure. These ratios focus on the long-term sustainability of a company:

1. FINANCIAL GEARING A company’s financial gearing (alternatively termed ‘leverage’) describes its capital structure, or the ratio of debt to equity capital it employs. From the standpoint of a company’s shareholders, although debt finance can enhance the company’s earnings growth, being a more tax efficient and generally less expensive means of financing than equity capital, if excessive it can also lead to an extremely volatile earnings stream, given that debt interest must be paid regardless of the company’s profitability. Therefore, the higher a company’s financial gearing, the higher the potential risk to its shareholders, in terms of the quality and predictability of the company’s earnings, but the higher the potential reward assuming the business can earn a return on this capital in excess of its cost. Financial gearing is calculated by following formula: Financial gearing (debt to equity ratio) = (interest bearing debt + preference shares) ordinary shareholders equity

x 100

Preference shares are included in the numerator as preference share dividends also take priority over the payment of equity dividends. A plc’s debt to equity ratio =

(2,000 + 100) (12,280 - 100)

x 100 = 17.24%

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: Net financial gearing (net debt to equity ratio) =

(interest bearing debt - cash + preference shares) ordinary shareholders equity

x 100

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UK plcs are generally more conservative in employing debt finance within their capital structures than their US and continental Europe counterparts, though this does vary quite considerably across industries. Whereas the average UK non-financial company is 50% geared, those in the US and EU average 150% and 100% respectively. You may recall from Chapter 4, that the recent popularity of UK companies buying back a proportion of their ordinary shares, has had the effect of raising financial gearing levels.

2. 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. The effect of a company’s financial gearing policy on the profit and loss account is reflected in its interest cover: Interest cover =

profit before interest payable and tax interest payable

A plc’s interest cover=

2,220 230

= 9.65 times

A plc’s interest payments are nearly 10 times covered by its pre-tax profits. The higher a company’s interest cover, the greater the safety margin for its ordinary shareholders. However, this ratio 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. The interest cover calculation should also incorporate any capitalised interest on loans taken out to finance the purchase of fixed assets or the funding of development expenditure, for example, if the cover is not to be overstated. A plc’s high interest cover and its low financial gearing suggests, however, that the company has adequate scope to raise additional loan finance without dramatically impacting its ability to service such finance or compromise the quality of its earnings stream.

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2.4

Liquidity Management Ratios

LEARNING OBJECTIVES 7.2.7

Be able to calculate the working capital (current) ratio

7.2.8

Be able to calculate the liquidity (acid test) ratio

7.2.9

Be able to calculate debtor turnover

7.2.10

Be able to calculate creditor turnover

7.2.11

Be able to calculate stock turnover

7.2.12

Know the purpose of z score analysis

As mentioned in Chapter 6, a company’s survival is dependent upon both its profitability and an ability to generate sufficient cash to support its day-to-day operations. More specifically, a company’s short term, or working, capital must be sufficient to enable it to meet its liabilities as they fall due. Working capital is defined as the sum of a company’s current assets less its current liabilities. The working capital cycle is shown below.

INVENTORIES SALES

PURCHASES

TRADE RECEIVABLES

TRADE PAYABLES

CASH

Figure 7: The Working Capital Cycle Although a company will want to hold sufficient stock (an alternative term for inventories) to meet anticipated demand, at the same time it must ensure that it doesn’t tie up too many resources in this stock so as to compromise its profitability.

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1. WORKING CAPITAL RATIO Working capital ratio = current assets/current liabilities Given the above, generally speaking the working capital ratio should ideally be in the range 1.5 to 2 as this indicates a compromise between ensuring that a company’s current liabilities are more than covered by its current assets whilst not tying too much of the company’s resources in assets that detract from its profitability. Again, there are exceptions, such as food retailers, which survive on working capital ratios as low as 0.5. This is because food retailers tend to turn their stock over at a faster rate than they pay their creditors. To explain. If the balance sheet value of inventories represents, say, 15 days worth of carrots for which the food retailer receives 30 days trade credit from its suppliers, then the balance sheet value of stock at the end of the accounting period will be half that of the trade payables balance, notwithstanding the seasonality of the business. A plc’s working capital ratio = 7,180/4,200 = 1.71

2. LIQUIDITY RATIO As stock in many industries can suffer from a high rate of obsolescence and physical deterioration, the liquidity, or acid test, ratio excludes inventories from the working capital ratio in order to establish a company’s solvency, or ability to meet its current liabilities. Liquidity ratio = (current assets - inventories)/current liabilities For most industries a liquidity ratio of one is seen as the benchmark, though the food retail industry tends towards 0.3 as a result of it generally extending shorter payment terms to its trade receivables, such as they exist, than it receives from its trade payables. A plc’s liquidity ratio = (7,180 - 3,600)/4,200 = 0.85

3. DEBTOR TURNOVER RATIO If the company is to maintain sufficient working capital in the business for it to function efficiently, then it must ensure that the average period of credit it receives from its suppliers is at least as great as that which it extends to its customers. Sums of money receivable from customers are referred to either as trade receivables or as ‘debtors’. Sums payable to suppliers are referred to either as trade payables or ‘creditors’. Debtor turnover per annum = revenues/trade receivables A plc’s debtor turnover = 9,500/2,600 = 3.65 times per annum or 365/3.65 = 100 days.

4. CREDITOR TURNOVER RATIO Creditor turnover per annum = cost of sales/trade payables A plc’s creditor turnover = 7,000/4,200 = 1.67 per annum or 365/1.67 = 218 days.

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5. STOCK TURNOVER RATIO If obsolescence or physical deterioration in a company’s stock is rapid, it must be turned over at a similarly rapid rate. Stock turnover = cost of sales/inventories A plc’s stock turnover = 7,000/3,600 = 1.94 per annum or 365/1.94 = 188 days. The example below consolidates what has been covered so far. Example Why would you expect the working capital ratio for a large supermarket chain to be lower than that for a car manufacturer? Because typically in the food retail industry, unlike in the car manufacturing industry: I. Stock turns over at a faster rate than creditors are paid II. Debtors turn over at a faster rate than creditors are paid III.Stock is subject to obsolescence IV. Low profit margins are offset by high asset turnover A. I and II only B. I and III only C.II and IV only D.III and IV only Solution A. In the food retail industry, the average payment period received from suppliers typically exceeds the period during which stock is turned over by the business and the average payment period the business gives to its trade receivables. Consequently, stock and debtors balances in the balance sheet are relatively low in comparison to the creditors balance, giving rise to a low working capital ratio. Stock obsolescence is not exclusive to the food retail industry and does not explain the difference in inter-industry working capital ratios. Although the food retail industry has low profit margins and a high asset turnover, neither impacts directly on the working capital ratio, though the product of these two secondary ratios provides the ROCE.

6. Z-SCORE ANALYSIS Liquidity management ratios, when used in conjunction with a company’s cashflow statement, provide an indication of a company’s solvency, or ability to meet its debts as they fall due. As mentioned in Chapter 6, if a company is to remain solvent and prosper, it must be able to produce a positive cashflow from its operating activities. However, a generally more reliable way of establishing whether a company is dangerously close to becoming insolvent is by employing z-score analysis. z-score analysis is undertaken by business schools to determine the probability of a company going into liquidation by analysing such factors as the company’s gearing and sales mix and distilling these into a statistical z-score. If negative, this implies that a company’s insolvency is imminent. International Certificate in Investment Management

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Other danger signals include an increased use of leased assets and an over dependence on one customer.

2.5

Operational Efficiency Ratios

In order to quantify the operational efficiency of a company, ratios such as revenues or sales per employee, sales per square foot of retail space and administrative expenses as a percentage of revenues can be calculated. Many companies provide these and similar ratios, as a matter of course, in their annual reports and accounts. In addition, many also supply details of those less tangible factors in which they have a particularly enviable record such as employee retention and customer loyalty.

2.6

Earnings Per Share (EPS)

LEARNING OBJECTIVES 7.2.14

Be able to calculate earnings per share (EPS)

7.2.15

Be able to calculate earnings before interest, tax, depreciation, and amortisation (EBITDA)

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. The EPS formula is given by: EPS = net income - preference dividends/number of ordinary shares in issue A plc’s EPS = 1,435 - 5/10,000 = 14.3p The resulting figure is known as the basic EPS. IAS 33 ‘Earnings per share’ standardises the calculation of EPS to facilitate inter-company comparisons. In particular, if a company has issued ordinary shares during the accounting period, IAS 33 has a set treatment for adjusting the number of ordinary shares in the formula’s denominator depending on whether the share issue was made as a rights issue, bonus issue or as consideration for a company takeover. In addition, IAS 33 requires plcs to publish on the face of the profit and loss account: i. A comparative EPS figure for the previous accounting period, and ii. A diluted EPS figure where the company has deferred equity shares in issue on which a dividend has yet to be paid or any securities in issue that can potentially be converted into the company’s ordinary shares so diluting the company’s future earnings. These include convertible preference shares, convertible loan stock, warrants and options issued under a company share option scheme. These options are not to be confused with traded options.

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Earnings can also be analysed before making any financial, taxation and accounting charges through an EPS measure known as EBITDA. EBITDA is the mnemonic for Earnings Before Interest, Tax, Depreciation and Amortisation and provides a way for company earnings to be compared internationally as the earnings picture is not clouded by differences in accounting standards worldwide. A common method of calculating EBITDA is as follows: EBITDA = EBIT + Depreciation + Amortisation, where EBIT = Operating Income (or Operating Profit) EBITDA is used extensively as a measure of headline earnings by those telecom and technology companies, which are loss making under conventional criteria, given the considerable amounts of capital spending and number of takeovers many undertake. However, by not taking account of depreciation, amortisation and tax, EBITDA provides a misleading impression of the profitability of a business, typically producing a much larger and less volatile earnings figure than those earnings measures discussed above. For example, for the year to 31 March 2003, MMO2 posted EBITDA of £859m but reported a pre-tax loss of £10.2bn. In addition, the calculation of EBITDA is not governed by any accounting standard. Moreover, whilst EBITDA is often used as a proxy for net cash flow, it should not be used as a measure of the cash available to investors as from this cash flow the company must service its debt, invest in capital equipment and pay corporation tax.

2.7

Price Earnings Ratio (PER)

LEARNING OBJECTIVES 7.2.16

Be able to calculate historic and prospective price earnings ratios (PERs)

The Price Earnings Ratio (PER) provides an indication of how highly rated a company is in its ability to grow its earnings stream. The PER formula is given by: PER = share price/EPS Assuming a share price of 275p, A plc’s PER = 275p/14.3p = 19.23 The higher the PER, the higher the company’s perceived EPS growth prospects. What constitutes a high or low PER depends on the market or industry being considered. We look at the PER in more detail in the next section.

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2.8

Dividends

LEARNING OBJECTIVES 7.2.17

Be able to calculate dividend yields

7.2.18

Be able to calculate dividend cover

Company dividends streams, like earnings streams, send out an important signal to the market about a company’s ability to meet investors’ growth expectations. Much as when a company’s EPS fail to meet expectations or when an earnings stream becomes unduly volatile so an erratic dividend growth policy or a dividend cut can result in a company’s shares being de-rated by the market. Company dividend announcements are, therefore, as keenly anticipated as their EPS announcements. Dividends can be analysed in several ways: i. Dividend per share (DPS) DPS = Net ordinary dividend/

no. ordinary shares =

£430,000/ 10m = 4.3p

Dividends are paid to investors net of a 10% tax credit. ii. Dividend yield = net DPS/share price × 100 = 4.3p/275p × 100 = 1.56% Dividend yields if grossed up can be compared with other gross income yields, such as bond yields. Grossed up dividend yield = grossed up net DPS/share price × 100 where the grossed up net DPS = net DPS x 100/90 For A plc, grossed up dividend yield = 4.3p x 100/90 × 100 = 1.74% 275p During the late 1990s, dividend yields in the UK, although remaining higher than those in most other developed equity markets, fell dramatically as a result of: 1. Tax changes made in the 1997 Budget primarily to discourage companies from making high dividend payouts and to encourage the greater retention of earnings. That is, to encourage lower payout ratios and higher retention ratios. 2. The greater use of share buybacks rather than dividends to return surplus cash to shareholders. 3. Share prices rising at a faster rate than dividend growth. Whereas PERs provide a measure of EPS growth expectations, dividend yields provide an indication of a company’s perceived ability to grow its dividends. A low dividend yield implies high dividend growth whereas the opposite is true of a high dividend yield. However, since entering the new millennium, UK dividend yields have returned to their historic average level of about 4% as a result of dividends being broadly maintained by UK listed companies against the backdrop of falling share prices. iii. Dividend cover The extent to which a company distributes its earnings as dividends, or reinvests them in the business, is calculated by using the dividend cover formula. Dividend cover = EPS/net DPS

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A plc’s dividend cover = 14.3p/4.3p = 3.32 Dividend cover can be interpreted as follows: 1. The higher the dividend cover, the greater the retention ratio and the lower the payout ratio. 2. Dividend cover indicates how sustainable a company’s dividend policy is. For instance, if a company’s dividend cover is less than one, then the company is utilising prior year retained earnings to pay this year’s dividend. However, if greater than one, the company’s ability to maintain its most recent dividend, can be established by calculating the margin of safety, given by: (EPS - DPS)/ EPS x 100 So if A plc’s EPS fell by (14.3 - 4.3)/14.3 × 100 = 70%, its dividend could still be maintained. A large margin of safety also indicates the ability of the company to grow its future dividends, subject to the constraints covered in Chapter 4. iv. The present value of the flow of future dividends. This can be used to establish the theoretical, fundamental or intrinsic value of a share and is considered in the next section.

2.9

Price to Book (P/B) Ratio

LEARNING OBJECTIVES 7.2.19

Be able to calculate price to book ratios

The price to book (P/B) ratio measures the relationship between the company’s share price and the net book, or asset, value per share attributable to its ordinary shareholders. Net asset values (NAVs) are considered in more detail in the next section. P/B ratio = share price/net asset value (NAV) per share A plc’s P/B ratio = 275p/121.8p = 2.26 where NAV per share = assets - liabilities - preference shares/number of shares in issue A plc’s NAV per share = (£18.48m - £6.2m - £0.1m)/10m = 121.8p per share Growth shares, companies perceived by investors to have above average growth potential, typically have high P/B ratios, whereas the opposite is true of those believed to have below average growth prospects. These are known as value shares.

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A PLC’S FINANCIAL STATEMENTS A plc Balance Sheet as at 31 December 2006 £'000 Assets Non-current assets Property, plant and equipment Intangible assets Investments available for sale Current assets Inventories Trade and other recei vables Investments held for trading Cash Total assets Equity and liabilities Capital and reserves Share capital - 50p ordinary shares Share capital - preference shares Share premium account Revaluation reserve Capital redemption reserve Retained earnings Total equity Non-current liabilities Bank loans Current liabilities Trade and other payables Total liabilities Total equity and liabiliti es

256

2006

8900 2100 300 11300 3600 2600 120 860 7180 18480

5000 100 120 100 80 6880 12280 2000 2000 4200 4200 6200 18480

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A plc Income Statement for the year end 31 December 2005 2005 £'000 9500 (7000) 2500 (110) (30) 2360 (260) 2100 30 90 (230) 1990 (555) 1435 14.3p

Revenue Cost of sales Gross profit Distribution costs Administrative expenses Operating profit Exceptional loss Income from fixed asset investments Interest receivable Interest payable Profit before taxation Taxation Net income Earnings per share (pence)

A plc Statement of changes in equity for the year ended 31 December 2005

As at 1 January 2005 Gain on revaluation Issue of shares Net income for the year Preference dividends paid Ordinary dividends paid As at 31 December 2005

Ord Share Capital 4470

Pref Share Capital 100

530

5000

Share premium account 0

Revaluation Reserve 0 100

Capital redemption reserve 80

Retained earnings 5880

120

100

120

100

80

Total 10530 100 650

1435

1435

-5

-5

-430

-430

6880

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A plc Cashflow Statement for the year ended 31 December 2005 2005 Operating activities Cash receipts from customers Cash paid to suppliers and employees Cash generated from operations Tax paid Interest paid Net cash from operating activities

4528 (2001) 2527 (440) (150) 4464

Investing activities Interest received Dividends received Purchase of fixed assets Proceeds on sale of investments Net cash used in investing activities

80 40 (1890) 120 (1650)

Financing activities Dividends paid Repayments of borrowings Proceeds on issue of shares Net cash generated from financing activities

(435) (200) 650 15

Net increase in cash and cash equivalents Cash and cash equivalents at the beginning of the year Cash and cash equivalents at the end of the year

2829 425 3254

3. VALUATION 3.1

Introduction

The final strand of fundamental analysis to be considered is that of equity valuation. Equities can be valued on four bases: 1. Dividend flows; 2. Earnings growth; 3. Net Asset Value (NAV); 4. Shareholder value added.

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3.2 Dividend Flows LEARNING OBJECTIVES 7.3.1

Be able to calculate equity valuations based on dividends: Gordon's Growth 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. That is, a company’s share price is viewed as a perpetuity, or a future flow of income. The discount rate used to obtain the present value of this dividend flow is that of investors’ required rate of return. This can be derived by adjusting the risk-free interest rate, given by a Treasury bill or a gilt, for the relative risk of the investment. This we consider in more detail in Chapter 9. If the dividend to be paid by the company is expected to remain constant, that is without any growth over time, the following formula is applied: Sxd = D/r where Sxd is the theoretical ex-dividend share price, D the most recent dividend paid and r the shareholders’ required rate of return. If the company’s shares are trading on a cum-dividend basis then the formula is modified to: Scd = D + D/r However, given typical shareholder expectations for steady dividend growth over time, a more realistic assumption to make is that future dividends will grow at a constant rate, g. This gives rise to Gordon’s growth model. The respective equations now become: Sxd = [D (1 + g)/(r - g)] Scd = D + [D (1 + g)/(r - g)] Example Calculate the theoretical cum-dividend share price of F plc given that it expects to increase its current annual dividend of 5 pence per share, about to be paid, by 6% per annum indefinitely. F plc’s shareholders’ required rate of return is 7%. Solution Theoretical cum-dividend share price = 5p + 5(1.06)/(0.07 - 0.06) = 535p

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3.3

Price Earnings Ratio (PER)

LEARNING OBJECTIVES 7.2.16

Be able to calculate historic and prospective price earnings ratios (PERs)

7.3.2

Be able to calculate equity valuations based on earnings: Price earnings ratios (PERs)

Assuming the stock market is an objective valuation mechanism, the ratio between a company’s share price and its EPS, the price earnings ratio (PER), provides an indication of how highly rated a company is in its ability to grow its earnings stream. The PER formula stated earlier, is given by: PER = share price/EPS Crudely speaking, the price earnings ratio (PER) is the number of years it would take for the current EPS to repay the share price, ignoring the time value of money. The higher the expected EPS growth, the faster the capital outlay on purchasing the share will be repaid, therefore, the higher the PER. However, the higher the PER, the greater the share price’s vulnerability to EPS growth not meeting the expectations reflected in the price. PERs can be calculated on either an historic basis, based on the most recent EPS, or a prospective basis, based on an expected EPS figure. When EPS is increasing, the historic PER should be higher than the prospective PER. PERs are generally highest at the start of an economic cycle when earnings are depressed, as the company’s share price reflects its future rather than current earnings prospects. However, PER multiples can expand in a dramatic fashion once the economic cycle is in full swing, as they did in 1987 and 1999, given the expectation of secular, or permanent, earnings growth: latterly as a result of a belief in the new paradigm. This was outlined in Chapter 1. Although PERs differ significantly between markets and industries, there could be several reasons why a company has a higher PER than its industry peers, apart from its shares simply being overpriced. These may include: 1. A greater perceived ability to grow its EPS more rapidly than its competitors. 2. Producing higher quality earnings than its peers. 3. Being a potential takeover target. 4. 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. As noted in Chapters 3 and 4 when considering equities, company takeovers are often funded with the issue of ordinary shares rather than cash where the PER multiple of the bidding company’s shares is greater than that of the target company’s shares.

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3.4

Net Asset Value (NAV)

LEARNING OBJECTIVES 7.3.3

Be able to calculate equity valuations based on assets: Net Asset Value

As noted earlier, a company’s net asset value (NAV) per share attributable to its ordinary shareholders is given by: NAV per share = (total assets - liabilities - preference shares)/number of shares in issue However, a company’s ordinary shares would normally be expected to trade at premium to their NAV, not least because of the internally generated goodwill attributable to the company’s management, market positioning and reputation that is not capitalised in the company’s balance sheet and the historic cost convention that underpins the preparation of financial statements. In the event of a takeover bid, unless the company is being bought for its assets by an asset stripper, any offer for the company’s shares is usually made at a premium to this NAV. That is not to say that the NAV represents the liquidation value of a company’s assets. It doesn’t, again as the result of the historic cost convention and, of course, the going concern concept. However, the NAV per share is useful for assessing the following: 1. The minimum price at which a company’s shares should theoretically trade. 2. The underlying value of a property company. 3. 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.

3.5

Shareholder Value Models

LEARNING OBJECTIVES 7.3.4

Know the basic concept behind shareholder value models: Economic Value Added (EVA); Market Value Added (MVA)

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, given by the company’s WACC. You may recall from Chapter 1 that in economic terms this excess return is defined as supernormal profit and arises as a result of a company’s dominant market position or some other competitive advantage the company may have over its industry peers.

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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 WACC multiplied by an adjusted net assets figure from the company’s balance sheet, termed invested capital: Net operating profit after tax - (WACC x invested capital) If positive, then value is being added. If negative, however, value is being destroyed. However, 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. A company’s MVA is the market’s assessment of the present value of the company’s future annual EVAs. A company’s MVA is derived from the following equation: market value of company’s equity + market value of company’s net debt = MVA + company’s invested capital Therefore: MVA = market value of company’s equity + market value of company’s net debt - company’s invested capital 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. Concluding comments “Nobody rings a bell at the top of the market.” Second guessing the equity market by employing technical and fundamental analysis can help in determining whether a company’s shares or the broader market are under or over priced or ready to break out from an established trading range but they are by no means a fail-safe way of investing. For instance, despite price earnings ratios rising in most western markets during the 1990s far in excess of previous highs, this did not prevent many of these markets reaching vertiginous levels. As many investors often find to their cost, markets can under and over shoot their true, or fundamental, values often for sustained periods of time.

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TAXATION

1. 2. 3.

8

BUSINESS TAX PERSONAL TAXES OVERSEAS TAXATION

265 266 268

This syllabus area will provide approximately 3 of the 100 examination questions

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INTRODUCTION “A good tax is one that is low, uniform and unavoidable” Nigel Lawson (Former Chancellor of the Exchequer) Once tax is brought into the equation, three factors need to be borne in mind: 1. It can make a substantial difference to the returns from an investment and complicate the investment decision making process. 2. Although it is important to maximise the use of tax allowances, exemptions and reliefs, investment decisions should never be based solely on the tax concessions offered. With certain exceptions, tax breaks are usually only given in exchange for accepting a higher level of risk. 3. It is important to understand the distinction between tax avoidance and tax evasion. Tax avoidance is the perfectly legitimate practice of saving tax through diligent tax planning. Tax evasion, whether failing to disclose the receipt of income or the making of a capital gain or falsifying a disclosure, is not.

1. BUSINESS TAX LEARNING OBJECTIVES 8.1.1

understand the application of the main business taxes: Business tax; Transaction tax (ie, Stamp Duty/Stamp Duty Reserve Tax; Tax on sales

8.1.2

know the purpose of tax-efficient incentive schemes sponsored by governments and supranational agencies (eg, International Monetary Fund)

In general, companies are required to pay corporation tax to their government which is dependent on the company’s profits, type of industry, location, ownership structure etc. They may aso be required to collect tax on behalf of the government. Examples include: state taxes, sales tax, goods and service tax, value-added tax, environmental tax etc. An example of corporate tax rates for various countries is listed below.

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Country UK

USA France Germany Japan Egypt Saudia Arabia China

India Dubai

Business Tax The main rate is 30% but is less for smaller companies. UK resident companies are subject to UK corporation tax on their worldwide profits, gains and income, however and wherever generated, whilst non-UK resident companies are only liable to UK corporation tax on profits generated in the UK. Main rate is 35% but this rate may be higher under certain circumstances. The corporate tax rate for most companies is 33.3%. Larger companies may pay an additional tax while smaller companies get reduced rates. From 1 January 2008, the corporate rate is expected to be reduced from approximately 38-40% down to 30%. The corporate tax rate is approximately 40% (but will depend on location.) Main rate is 20%. Egyptian companies are taxed on their world-wide income. Foreign companies are taxed on any income sourced from Egypt. Flat rate of 20% although some types of companies are required to pay more. For example companies in the natural gas business pay 30%. Chinese companies with less than 25% foreign investment are taxed at 33% (with some exceptions). Companies with at least 25% foreign investment are also taxed at 33% but are eligible for certain tax concessions depending on their location and industry. Other taxes that may also apply include: value added tax(VAT), land tax, stamp duty and consumption tax. Local companies pay 30% with a 10% surcharge and 2% for education. Foreign companies pay an effective rate of 41.82%. No federal level corporation tax (subject to various conditions).

Note: These rates are indicative and may be subject to change at short notice.

2. PERSONAL TAXES LEARNING OBJECTIVES 8.2.1

understand the direct and indirect taxes as they apply to individuals: Tax on income; Tax on capital gains; Estate tax; Transaction tax (Stamp Duty); Tax on sales

Personal tax is that paid by individuals based on their income. Sources of income can include salary and wages, royalties, tips, capital gains tax, interest, dividends, fringe benefits etc. Most countries have progressive tax rates where lower incomes are taxed at lower rates. A list of the personal tax rates in various countries is given below:

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Country UK USA France Germany Japan Egypt Saudia Arabia

China India Dubai

Personal Tax Progressive rates up to 40%. Progressive rates up to 35%. Progressive rates up to approximately 48%. Progressive rates up to 45%. Progressive rates up to 37% however there are local taxes that can raise this rate up to 50%. Progressive rates up to 20%. All citizens of Saudi Arabia and countries belonging to the Gulf Co-operation Council do not pay income tax but may be subject to zakat – a religious tax of 2.5%. All other citizens pay 20% tax. There is no VAT or sales tax in Saudi Arabia. Progressive rates up to 45%. Progressive rates up to a maximum rate of 33.66% In Dubai there are no personal taxes, capital gains tax or withholding tax. However, there are other indirect taxes such as import duty tax (approximately 10%), landlord taxes, hotel services/entertainment tax.

Note: These rates are indicative and may be subject to change at short notice.

There are many different types of business and personal taxes. These include Value Added Tax (VAT), Goods & Services Tax (GST), Sales Tax, Capital Gains Tax, Inheritance Tax, Stamp Duty, Environmental Levy etc. Every country has different rules and regulations associated with these taxes and the one certainty around these tax laws is that they will change - and often! Governments can also offer companies and individuals various tax concessions and incentives. For example, Shenzhen in China was one of the first Special Economic Zones established by the Chinese governement to encourage business development and trade. Furthermore, individuals in the UK get special tax concessions for investing in Individual Savings Accounts (ISAs) which are products designed to encourage individuals to save.

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3. OVERSEAS TAXATION LEARNING OBJECTIVES 8.3.1

know the principles of withholding tax

8.3.2

know the principles of double taxation relief (DTR)

For a UK-resident company overseas taxation can arise as a result of: 1. Profits generated overseas, whether or not these profits are repatriated. 2. The receipt of overseas dividend income.

3.1

Profits Generated Overseas

It was established earlier that UK-resident companies are subject to UK corporation tax on their worldwide profits. However, recognising that profits generated in another country will also be potentially liable to local taxes, one of the following reliefs will be granted: i. Double taxation relief (DTR), or ii. Unilateral tax relief. DTR prevents the same profits being taxed twice in the UK and the overseas territory. DTR arises as a result of the UK entering into bilateral agreements, known as Double Taxation Agreements (DTAs), with other countries. These ensure that UK company profits earned overseas in a country with which the UK has a DTA are not subject to UK corporation tax if the overseas tax rate applied to the company’s profits is equal to or greater than the UK corporation tax rate. If lower than the UK rate, then the difference between the two rates is payable to Her Majesty’s Revenue & Customs (HMRC) in the UK. Although the UK has more DTAs than any other country in the world, if a DTA does not exist with a particular country, then HMRC may unilaterally grant relief to ensure that the company pays tax at a rate at least equal to the UK corporation tax rate, but no higher than the overseas tax rate.

3.2

Receiving Overseas Dividend Income

Overseas dividend income upon being remitted to the UK is usually received net of the following taxes: 1. Overseas corporation tax, also known as underlying tax. 2. Withholding tax. Withholding tax is a tax deducted at source on dividend and interest income paid to non-resident investors to prevent tax evasion. Each country applies its own standard rate of withholding tax. Although UK companies in receipt of overseas dividend income from which withholding tax has been deducted can reclaim this withholding tax from HMRC via DTAs, this reclaim is subject to a maximum rate of relief. Therefore, any remainder must be reclaimed directly from the overseas tax authorities. Individual investors and investment funds in receipt of overseas dividend income can also reclaim withholding tax through the same process.

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1. 2. 3.

9

RISK AND RETURN THE ROLE OF THE PORTFOLIO MANAGER FUND CHARACTERISTICS

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This syllabus area will provide approximately 9 of the 100 examination questions

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1. RISK AND RETURN 1.1

Introduction

This section looks at the financial theory, which, over the past 50 years, has had a pronounced effect on the construction of investment portfolios.

1.2

Modern Portfolio Theory

LEARNING OBJECTIVES 9.1.1

Know the main principles of Modern Portfolio Theory (MPT) and the need for diversification

Modern Portfolio Theory (MPT), which originated from the work of US academic Harry Markowitz in 1952, introduced a whole new way of thinking about portfolio construction. In particular it introduced the concept of efficient, or diversified, portfolios. Markowitz’s main proposition was that rational risk averse investors, or wealth maximisers, who were assumed to select securities on the basis of the mean and standard deviation (σ) of their past returns, should combine these securities so as to reduce the combined variability of their future returns. You may recall, from Chapter 2, that selecting securities on the basis of the mean and standard deviation of past returns is termed the mean-variance approach to security selection. So whereas the risk associated with holding securities A and B in isolation is given by their respective standard deviation of returns, by combining these two assets in varying proportions to create a two stock portfolio, the total standard deviation of return (σρ) will be less than the weighted average sum of A’s and B’s individual standard deviations, assuming, of course, that their returns are anything other than perfectly positively correlated (σAB = +1):

σρ < (wA x σA) + (wB x σB), where the weighting of security A = 1 - weighting of security B. When combined in a portfolio, the individual standard deviations of the portfolio’s constituent stocks are secondary to the correlation of their individual returns in determining the portfolio’s total risk (σρ). The lower the correlation of these returns, the greater the portfolio’s diversification and, therefore, the lower the level of total risk (σρ) associated with any given level of expected return [E(Rρ)]. However, as we saw when looking at the calculation of the covariance of returns in Chapter 2, minimising risk also requires selecting portfolios of securities with low standard deviations. The portfolio’s expected return [E(Rρ)] is given by the weighted average of the individual expected returns of its constituent securities: E(Rρ) = [wA x E(RA)] + [wB x E(RB)]

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EXPECTED RETURN E(R)

RISK (σ)

Figure 1: The Efficient Frontier By plotting all combinations of securities held in different proportions on a chart that plots risk (σρ) against expected return [E(Rρ)], a convex curve known as an efficient frontier can be derived. The efficient frontier excludes portfolios containing perfectly positively and perfectly negatively correlated securities: the former because they are undesirable and the latter because they do not exist in practice. As its name suggests, the efficient frontier depicts those combinations of securities that represent efficient portfolios: those that offer the maximum expected return for any given level of risk. As to which of these portfolios will be selected by investors depends on each investor’s own risk and return criteria. This decision making process can be illustrated by employing indifference curves. D E(R)

E

C X

EFFICIENT FRONTIER Z

Y

σ

Figure 2: Choosing Between Efficient Portfolios

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A risk seeking investor would have an indifference curve similar to that of CD. That is, the risk seeking investor is willing to assume a considerable amount of additional risk in exchange for a slight increase in expected return. A risk averse investor, however, would have an indifference curve similar to that of XY for the opposite reason. The point at which each of these indifference curves is tangential to the efficient frontier determines which of the efficient portfolios is selected in each case. Although since its origins in the early 1950s, this basic portfolio selection model has been developed into more sophisticated models, such as the Capital Asset Pricing Model (CAPM) in the mid-1960s and Arbitrage Pricing Theory (APT) in the late 1970s, it remains the backbone of finance theory and practice. CAPM and APT are considered below.

1.3

Efficient Markets Hypothesis (EMH)

LEARNING OBJECTIVES 9.1.2

Know the main propositions and limitations of the Efficient Markets Hypothesis (EMH)

Another fundamental proposition of MPT, and one that has been vigorously debated since the early 1960s by academics and market practitioners alike, is the Efficient Markets Hypothesis (EMH). That is, whether or not markets and securities respond instantly and, indeed, rationally to price sensitive information and move independently of past trends. Those that do are known as price efficient markets. Behind the EMH lies 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.

ALL INFORMATION

PUBLICLY AVAILABLE NEW INFORMATION

PAST PRICES WEAK

SEMI-STRONG

STRONG

Figure 3: Type of Information Incorporated Into Market Prices

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Market efficiency can be analysed at three levels: 1. Weak form. A weak form price efficient market is one in which security prices fully reflect past share price and trading volume data. 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. 2. Semi-strong form. 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. Such markets are populated by a large number of market participants each of whom intensively researches the prospects for one or a number of securities traded in the market hoping to be the first to act upon the release of new publicly available information or capitalise upon the identification of a pricing anomaly. Ironically, by exhaustively researching the market, the activities of these investors, analysts and other City professionals make the market price efficient. This produces quite damning results for these market participants, as taken together, the weak and semi-strong forms of the EMH imply that in an efficiently priced market investors cannot consistently achieve superior risk-adjusted returns but can only outperform the market as a result of luck and/or taking high risks. Whereas a weak form efficient market destroys the basis upon which technical analysis is based, the value of fundamental analysis is nullified in a semistrong efficient market as the analysis of publicly known information does not convey any informational advantage. 3. Strong form. A strong form efficient market is one in which share prices reflect all available information, including privileged or, inside, information: that which is not publicly available and therefore, illegal to act upon. In a strong form efficient market, where everything about the market or an individual security is known or knowable, not even private information can help investors. So once again fundamental analysis is made redundant and outperformance can be only be achieved through luck and/or taking high risks. Obviously, once known to be subject to insider dealing, a market soon loses its liquidity. In conclusion then, the potential implications of a semi-strong form efficient market, where one cannot consistently outperform the market on a risk-adjusted basis regardless of whether technical and fundamental analysis is employed, has always loomed over the active portfolio management community, which seeks to do just that.

Evaluating the EMH 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, those that seek to outperform established market benchmarks through employing investment analysis, do so consistently. Less well developed and less actively researched equity markets, however, do not always exhibit semi-strong price efficiency and, therefore, provide an opportunity for active managers operating in these markets to outperform.

Limitations of the EMH Despite the broad price efficiency of western equity markets, pricing anomalies and trends do occasionally arise as a result of markets and individual securities under and over shooting their fundamental values. As a consequence, some active managers do outperform their respective benchmarks and often do so in quite a spectacular fashion.

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It could be argued that developed markets are largely price efficient but investors do not always invest in a rational fashion, thereby providing others with pricing anomalies to exploit. Indeed, this argument has recently given way to a new way of thinking about the determination of security pricing known as behavioural finance. Rather than making simplifying assumptions about the way in which investors approach investment, behavioural finance instead analyses the emotion and irrationality that often surrounds investment decision making, in order to explain the inconsistency of these pricing anomalies with the EMH. For instance, in blatant violation of the weak form of the EMH, 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. You may recall, from Chapter 7, that this forms the basis of technical analysis. The inability for all market participants to absorb and interpret information correctly given varying cognitive abilities and the way in which the information is presented may also explain why new information may not necessarily be factored into security prices instantaneously on every occasion. The behavioural finance literature also goes to great lengths to rationalise the actions, or “animal spirits” as Keynes described them, of investors in order to explain how and why stock market bubbles develop and eventually burst, a phenomenon which again stands at odds with the EMH. In short, the power of irrational thought and differing cognitive abilities should never be under estimated in financial markets. Finally, investors frequently deal in securities for reasons completely unrelated to investment considerations. For instance, investors may sell securities in order to raise cash at short notice to meet an unexpected liability or invest in a rising market simply because influential peers have advised them to do so or because a rising trend has been identified. This is known as momentum investing. Buying and selling in this fashion can result in securities losing touch with their fundamental or intrinsic values.

1.4

Capital Asset Pricing Model (CAPM)

LEARNING OBJECTIVES 9.1.3

Understand the assumptions underlying the construction of the Capital Asset Pricing Model (CAPM) and its limitations

9.1.4

Be able to apply the CAPM formula to equity portfolio selection decisions

INTRODUCTION The CAPM, introduced in the mid 1960s, extends Modern Portfolio Theory (MPT) by dividing the total risk, or the standard deviation (σ), of a security’s returns into two separate elements: 1. Unsystematic risk (σu), or company-specific risk: that which is peculiar to an individual company causing its shares to move independently of general market movements. Unsystematic risk can be diversified away by holding a large number of securities operating within different industry sectors, and 2. Systematic (σs) risk, which no matter how well diversified the portfolio, cannot be diversified away. Such risk stems from broad equity market movements, or market risk, which, in turn, mainly derives from changes in economic factors.

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This dichotomy is illustrated below. TOTAL RISK

UNSYSTEMATIC RISK

SYSTEMATIC RISK

NUMBER OF STOCKS IN PORTFOLIO

Figure 4: Portfolio Risk When CAPM was introduced, it was believed that by holding about 20 securities most of the unsystematic risk within a portfolio could be diversified away. However, since shares have generally become more highly correlated with each other it is now believed that nearer 50 shares would need to be held to achieve this same goal. The mathematical relationship between a security’s total risk and its systematic and unsystematic components is given by the equation:

σ2 = σs2 + σu2 where σ2 is the variance of the security’s returns, σs2 the security’s systematic risk squared and σu2 the security’s unsystematic risk squared. This can also be shown diagrammatically.

σ2 σS2

Figure 5

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The CAPM formula You may recall from Chapter 2 that the CAPM formula was used to derive the cost of a company’s equity capital. However, CAPM is principally concerned with quantifying the expected return on a security, invested within a well-diversified portfolio, over and above a risk-free rate, given the security’s systematic risk that cannot be diversified away. CAPM then, implies that investors will only be rewarded for their exposure to undiversifiable systematic risk and not for company specific risk, which can be diversified away when combined with other securities in a portfolio. CAPM is underpinned by the following formula: E(Ri) = Rf + βi [E(Rm) - Rf] where: E(Ri) = expected return on security i Rf

= expected return on a short term risk free asset, eg, a Treasury Bill (TB)

βi

= beta for security i

E(Rm)= expected return on the market The expression [E(Rm) - Rf] is known as the ex ante equity risk premium (ERP). This is the excess return investors require for assuming the market risk associated with holding a well diversified portfolio of equities [E(Rm)] rather than a risk free asset (Rf). This premium is influenced by how investors view the outlook for the stock market in the light of expected earnings and dividend growth and the position of the economic cycle.

Beta Beta (β) is a measure of the average historic sensitivity, or volatility, of a security’s returns to the variability of returns in the broader market, known as market risk, expressed as a proportion of this market risk. The beta of security i (βi ) can, therefore, be expressed as:

βi = σs/σm where, σs is security i’s systematic risk and σm market risk Restated, this equation gives: σs = βi x σm and explains the relationship between a security’s systematic risk and market risk. However, this systematic risk, σs = ρim x σi, where, ρim is the correlation coefficient between the returns of security i and those of the market and σi, the total risk, or standard deviation of returns, for security i. Therefore, βi = σs/σm = (ρim x σi)/σm

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Multiplying the equation by σm, gives:

βi = (ρim x σi x σm)/σm2 = Covim/Varm where, Covim is the covariance between the returns from security i and the market, and Varm, the variance of returns from the market. Individual security beta values are derived by running a regression between a security’s monthly percentage returns against that of the market, usually over a 36-month period. Plotted on a chart with the security’s percentage returns on the Y or vertical axis and the market’s percentage returns on the X or horizontal axis, the slope of the line that best fits this data is the security’s beta. The resulting beta value (β) indicates the following: i. β > 1 indicates historically that the security has on average acted aggressively to general market moves. A beta of 1.5, for instance, means the security has moved on average by 1.5% for every 1% market move. High beta stocks include high street retailers and banks. ii. β = 1 suggests that historically the security has on average moved in line with general market moves. iii. β < 1 but > 0 means the security has generally acted defensively to general market moves. Defensive stocks include utilities and food retailers. iv. β = 0 indicates that the security is uncorrelated with general market movements. This can mean one of two things: either the security is a risk free asset or the security’s risk is entirely unsystematic. v. β < 0 suggests that the security has moved in the opposite direction to market moves. If the security has a beta of - 0.9 for instance, it has fallen by 0.9% for every 1% up move in the market. The beta of a security is influenced by the issuing company’s financial and operational gearing. The securities of those companies that are highly financially and operationally geared and whose fortunes are, therefore, closely linked to the economic cycle are typically high beta stocks. When stocks are combined to form a diversified portfolio, the beta of the portfolio (βρ) is given by the weighted average beta of each stock in the portfolio:

βρ = Σ(wi x βi), where wi is the percentage weighting by market value of security i, and βi, the

beta of security i.

As in the CAPM world, systematic risk is the only risk that a security adds to the total risk of a diversified portfolio and each security’s systematic risk relative to the market is given by its beta, this makes intuitive sense.

Beta and Hedging You should note that where a portfolio has a beta other than one, this will have implications for hedging the portfolio against a fall in the broader equity market when using derivatives. If the portfolio has a beta of two for instance, then twice of many futures will need to be sold or twice as many put options purchased to provide the same protection as would be afforded to a portfolio with a beta of one.

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The Security Market Line (SML) The CAPM formula underpins what is known as the Security Market Line (SML).

UNDERVALUED SECURITIES

SML

E(RM) OVERVALUED SECURITIES RF

β=1

β

Figure 6: Security Market Line (SML) The SML is an upward sloping straight line that depicts a linear relationship between a security’s beta and its benchmark return, assuming the security is invested within a well diversified portfolio. This benchmark return comprises the return from a short dated risk-free (Rf) asset such as a Treasury bill, plus an equity risk premium for assuming market risk, the size of which is determined by the security’s beta. For a security with a beta of one, the expected return should be equal to that of the broader market. All efficiently priced securities held within well diversified portfolios lie on this line: those that do not are inefficiently priced. Those below the line are priced too high in that their expected return is below that required for their commensurate beta risk, whilst those above the line are priced too low and, therefore, offer a return in excess of that required. However, in a world where all investors have access to the same free information, these pricing anomalies should soon be arbitraged away, with each security trading on the SML. 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.

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Example As a portfolio manager familiar with CAPM, you know that the current risk free rate of return is 4% and the expected return on the market is 9%. Already holding a well-diversified portfolio, you are considering including investments X, Y and Z in this portfolio. These investments have the following characteristics: Investment X has an expected return of 5% and a CAPM beta of -0.2 Investment Y has an expected return of 8% and a CAPM beta of 0.9 Investment Z has an expected return of 10% and a CAPM beta of 1.1 Using CAPM as the sole means of evaluating these investments, which should be considered for inclusion in the portfolio? Solution Applying the CAPM formula [Rρ = Rf + ß(Rm - Rf)] to these three investments: 1. Investment X’s benchmark return = 0.04 - 0.2(0.09 - 0.04) = 3% 2. Investment Y’s benchmark return = 0.04 + 0.9(0.09 - 0.04) = 8.5% 3. Investment Z’s benchmark return = 0.04 + 1.1(0.09 - 0.04) = 9.5% As the expected return on X and Z is greater than that required under CAPM, ie, X and Z are positioned above the SML, whereas Y is positioned below, only X and Z should be considered for inclusion in the portfolio.

The Derivation of the SML The SML is simply an extension of Markowitz’s efficient frontier. As noted earlier, Markowitz’s efficient frontier represents those combinations of securities that provide the maximum expected return for a given level of risk (σρ). Each is an efficient portfolio. However, the decision of which efficient portfolio to choose is subjective and depends upon each investor’s attitude to risk as depicted by the shape and positioning of their indifference curves. CML

E(R)

M EFFICIENT FRONTIER

Rf

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By introducing the possibility of combining risk free assets with portfolios of risky stocks though, it can be shown that all investors would hold the same portfolio of stocks regardless of their attitude towards risk. This is depicted by the Capital Market Line (CML): an upward sloping straight line originating from Rf that is tangential to the efficient frontier at point M. M is known as the market portfolio as it is broadly representative of the entire market. Investors can operate anywhere they wish on the CML. Risk averse investors may wish to hold an element of their portfolio in a risk free asset and a proportion of the market portfolio whereas risk seeking investors may borrow at the risk free interest rate and gear their returns. So regardless of each investor’s appetite for risk, every investor will hold at least a proportion of the market portfolio, unless they are so risk averse that they simply hold risk free assets. The CML being superimposed on a chart that plots expected return against the total variability of returns (σ), provides an ideal benchmark against which to assess the forecasted return of a security being added to an undiversified portfolio: that is one which contains both systematic and unsystematic risk. However, if the security being evaluated is invested in a well diversified portfolio, one where the unsystematic risk has been diversified away, the SML, rather than the CML is used. The SML performs exactly the same role as the CML except that the SML plots the linear relationship between a security’s expected return and beta risk, rather than against its total variability of returns. As the additional risk brought by an individual security to a well diversified portfolio is simply its beta risk, then the SML provides a more accurate benchmark for the security’s expected return. The beta of the market portfolio is one. We will return to the CML and SML in Chapter 10 when looking at risk-adjusted equity portfolio returns.

CAPM Assumptions and Limitations CAPM’s underlying assumptions are as follows. Investors: i. Are infinite in number and, therefore, act as price takers rather than price setters; ii. Are rational and risk averse; iii. Hold well diversified portfolios; iv. Act on full and free information, have the same cognitive ability as one another to interpret this information no matter how it is presented, formulate views on risk and return in exactly the same way as each other and have the same future expectations; v. Make investment decisions based on mean variance analysis; vi. Can lend and borrow unlimited amounts at the risk free rate of interest; vii.Are not subject to transaction costs or taxes; viii.Have the same one-period time horizon.

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CAPM’s limitations are as follows: i. Many of the assumptions made above; ii. All relevant factors and inputs are assumed to remain constant over the investment horizon, such as the risk free rate of interest and the ex ante equity risk premium (ERP); iii. The model does not take account of practical constraints faced by portfolio managers, such as a fund’s liability structure, liquidity needs and investment time horizon; iv. The model assumes that a security’s risk and equity risk premium can be wholly explained by a single market beta; v. Betas are difficult to estimate, are based on historic observation and change over time as companies reinvent themselves. However, portfolio betas are more stable than individual security betas as changes in individual security betas within a portfolio tend to cancel each other out; vi. Research casts doubt on the link between security returns and their betas, as: a. Investors appear to be rewarded for more than their exposure to systematic risk, that is, exposure to some unsystematic risk appears to be rewarded; b. Beta fails to capture other elements of macroeconomic risk that impacts on share price performance.

1.5

Arbitrage Pricing Theory (APT)

LEARNING OBJECTIVES 9.1.5

Know the main: principles behind Arbitrage Pricing Theory (APT); differences between CAPM and APT

APT was developed in the late 1970s in response to CAPM’s main limitation that a single market beta is assumed to capture all factors that determine a security’s risk and expected return. APT, rather than relying on a single beta, adopts a more complex multi factor approach by: i. Seeking to capture exactly what factors determine security price movements by conducting regression analysis; ii. Applying a separate risk premium to each identified factor; iii. Applying a separate beta to each of these risk premia depending on a security’s sensitivity to each of these factors. Examples of factors that are employed by advocates of the APT approach include both industry related and more general macroeconomic variables such as anticipated changes in inflation, industrial production and the yield spread between investment grade and non-investment grade bonds.

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The expected return for a security i [E(Ri)] using the APT approach can be summarised as follows: E(Ri)= Rf + bi1P1 + bi2P2..... + binPn where: Rf = risk-free rate of interest bi1 = the sensitivity, or beta, of security i to factor 1, eg, bank base rate P1 = the risk premium, or extra expected return above the risk free rate, for one unit exposure to factor one APT’s underlying assumptions include: i. Securities markets are price efficient; ii. Investors seek to maximise their wealth, though do not necessarily select portfolios on the basis of mean variance analysis; iii. Investors can sell securities short. Short selling is selling securities you don’t own with the intention of buying them back at a lower price in order to settle and profit from the transaction; iv. Identified factors are uncorrelated with each other. APT is attractive in that it: i. Explains security performance more accurately than CAPM by using more than one beta factor; ii. Uses fewer assumptions than CAPM; iii. Enables portfolios to be constructed that either eliminate or gear their exposure to a particular factor. However, APT’s shortcomings include a reliance on: i. Identified factors being uncorrelated with each other; ii. Stable relationships being established between security returns and these identified factors.

2. THE ROLE OF THE PORTFOLIO MANAGER 2.1

Introduction

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” John Maynard Keynes As a portfolio manager it is important to understand the distinction between investment and speculation. Investment can be differentiated from speculation by the timeframe adopted and level of risk assumed by the investor. Investment is undertaken via a diversified portfolio of securities for the medium to long term whereas speculation is based on profiting from the short term price movements of individual price movements of securities or assets. Portfolio management is concerned with the former. International Certificate in Investment Management

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2.2 The Portfolio Management Process LEARNING OBJECTIVES 9.2.1

Understand the establishment of: relationships with clients; client objectives and risk profile including income and/or growth, time horizons, restrictions and liquidity; discretionary and non-discretionary portfolio management

9.2.2

Understand the establishment of the investment strategy (see the syllabus learning map at the back of this book for the full version of this learning objective)

9.2.3

Understand deciding on the benchmark and the basis for review

9.2.4

Understand the measurement and evaluation of performance and the purpose and requirements of annual and periodic reviews including client reporting

9.2.5

Understand the benefits of employing derivatives within the investment management process

Portfolio management is the management of an investment portfolio on behalf of a private client or institution with a primary focus on meeting the client’s investment objectives. Portfolio management can be conducted on either a: i. Discretionary basis, where the portfolio manager makes investment decisions within the parameters laid down by the client, or ii. Non-discretionary or advisory basis, where the client makes all of the investment decisions, with or without seeking advice from the portfolio manager. In both cases, the portfolio manager usually has the choice of investing directly in a range of asset classes and/or indirectly via investment funds.

The Role and Responsibilities of the Portfolio Manager The main responsibilities of the portfolio manager are to: i. Help clients decide on and prioritise objectives; ii. Document the client’s investment objectives and risk tolerance; iii. Determine and agree an appropriate investment strategy; iv. Act in the client’s best interest; v. Keep the portfolio under review; vi. Carry out any necessary administration and accounting.

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Stages of the Portfolio Management Process The portfolio management process can be divided into six distinct stages: 1. Determining the client’s requirements; 2. Formulating the investment strategy to meet the client’s objectives; 3. Agreeing the performance benchmark, frequency and basis of review; 4. Implementing the investment strategy by selecting suitable asset classes and/or collective investment funds; 5. Measuring and evaluating performance; 6. Revisiting the client’s objectives, revising the construction of the portfolio and/or the benchmark. Each of these will now be considered.

Stage 1: Determining the Client’s Requirements The asset split of the portfolio will be determined by the following client requirements: i. The investment objective The client’s investment objective overrides everything else. Typical objectives include: a. Maximising income, growth or total return. b. Maintaining the real value of capital. c. Outperforming a benchmark or peer group average. d. Meeting or matching future liabilities. This was considered in Chapter 4 when looking at passive bond management strategies. ii. Risk tolerance 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. iii. Liquidity requirements and time horizon The lower the client’s liquidity requirements and the longer their timescale, the greater the choice of assets available to the portfolio manager to meet the client’s investment objective. Whereas the need for high liquidity allied to a short timescale demands that the portfolio manager 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. It is important, however, that the client maintains sufficient liquidity to meet both known commitments and possible contingencies. iv. Tax status As for most investors, whether institutional or retail, capital gains are generally treated more favourably than income, the focus should be on those investments that produce capital growth rather than income, notwithstanding the client’s objectives and time horizon. v. 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: Socially Responsible Investment (SRI) for instance.

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Stage 2: Formulating the Investment Strategy to Meet the Client’s Objectives Appreciating the need to diversify and having regard to the client’s objectives, it is unlikely that a single investment fund or one security will meet the client’s requirements. Therefore, the portfolio manager needs to decide how to approach selecting suitable investments for inclusion in the client’s portfolio. In Chapter 4, when looking at bond management strategies, two broad approaches to bond portfolio management were considered: active and passive bond management. Active and passive strategies can also be applied to the management of equities.

Passive Management Whereas buy and hold and immunisation techniques are available to the passive bond portfolio manager, the two main passive portfolio management techniques employed by equity portfolio managers are simple buy and hold policies and index tracking. An equity buy and hold policy is the simplest and least expensive of the two strategies through portfolios constructed on a buy and hold basis are not necessarily well diversified. Index tracking, or indexation, however, necessitates the construction of an equity portfolio to track, or mimic, the performance of a recognised equity index. Indexation is undertaken on the assumption that securities markets are efficiently priced and cannot, therefore, be consistently outperformed. Consequently, no attempt is made to forecast future events or outperform the broader market. Indexation techniques originated in the US in the 1970s but have since become popular in the UK. Indexed portfolios are typically based upon a market capitalisation weighted index and employ one of three established tracking methods: 1. Full replication. This method requires each constituent of the index being tracked to be held in accordance with its index weighting. Although full replication is accurate, it is also the most expensive of the three methods so is only really suitable for large portfolios. 2. Stratified sampling. This requires a representative sample of securities from each sector of the index to be held. Although less expensive than full replication, the lack of statistical analysis renders this method subjective and potentially encourages biases towards those stocks with the best perceived prospects. 3. Optimisation. Optimisation is a lower cost though statistically more complex way of tracking an index than fully replicating it. Optimisation uses a sophisticated computer modelling technique to find a representative sample of those securities that mimic the broad characteristics of the index being tracked. This it does by adopting an APT type approach to security risk. The advantages of employing indexation are that: i. Relatively few active portfolio managers consistently outperform benchmark equity indices. ii. Once set up, passive portfolios are generally less expensive to run than active portfolios given a lower ratio of staff to funds managed and lower portfolio turnover. The disadvantages of adopting indexation, however, include: i. Performance is affected by the need to manage cashflows, rebalance the portfolio to replicate changes in index constituent weightings and adjust the portfolio for index promotions and demotions. Also most indices assume that dividends from constituent equities are reinvested on the ex-dividend (xd) date whereas a passive fund can only invest dividends when received, usually six weeks after the share has been declared xd.

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ii. Indexed portfolios cannot meet all investor objectives. iii. Indexed portfolios follow the index down in bear markets. iv. An index does not represent the least covariance portfolio. That is, equity indices do not lie on the efficient frontier as they are unable to assess how the inclusion of a stock to the index adds to or further diversifies the risk of the portfolio. Moreover, many indices are highly concentrated, being dominated by a few key industrial sectors.

Active Management Active equity management is employed for exactly the same reasons as active bond management: to exploit pricing anomalies in those securities markets that are perceived as being inefficiently priced. In contrast to passive equity management, active equity management seeks to outperform a predetermined benchmark over a specified time period by employing fundamental and/or technical analysis to assist in the forecasting of future events and the timing of purchases and sales of securities. As noted in Chapter 4, this is known as market timing. Actively managed portfolios can be constructed on either a top down or a bottom up basis. The top down approach is employed for internationally diversified portfolios whereas the bottom up method is adopted for those portfolios that focus on the investment opportunities offered by a particular country, investment region or investment theme. Whichever portfolio construction approach is employed, it is imperative that the portfolio is suitably positioned to reflect current market conditions as well as the outlook for world markets and the world economy.

Top Down Active Management Top down active management comprises three stages:

1. ASSET ALLOCATION Asset allocation is the result of top down portfolio managers considering the big picture first, 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. Within larger portfolio management organisations, this 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 against peer group median asset allocations, such as the WM or CAPS median asset allocation in the case of institutional mandates. Tracking error as well as WM and CAPS are covered in Chapter 10. As noted in Chapter 4, asset allocation decisions are increasingly being implemented through the use of futures contracts.

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Finally, the decision whether to hedge market and/or currency risks must taken. Over the long term, recent academic studies conclude that asset allocation accounts for over 90% of the variation in pension fund returns.

THE IMPORTANCE OF OVERSEAS DIVERSIFICATION To be efficient, a portfolio should be adequately diversified with no one geographical region or asset class monopolising it. There has always been a tendency for UK portfolio managers to focus primarily on UK bond and equity markets within internationally diversified portfolios, mainly because these are markets they can relate to and feel comfortable with, despite the fact that few multinational companies domiciled in the UK derive the majority of their revenues from the UK. They are also largely free of currency risk, though currency risk derives from a company’s multinational orientation. However, despite the increased globalisation of economies and markets, there are significant advantages to looking further a field to enhance the risk/return characteristics of any portfolio. As mentioned in previous chapters, the world economy is not totally synchronised, most investment themes are global, many industries are either under or over represented in the UK and the UK market only accounts for about 10% of world stock market capitalisation. Although, as noted, investing in overseas equities gives rise to currency risk, this is more than outweighed by the diversification benefits that arise from UK equity returns generally having a low correlation coefficient with many other equity markets. Currency risk can, of course, be hedged. The argument for globally diversified portfolios is further reinforced by the fact that the barriers and costs associated with international investing continue to decline whilst the quality of information flows increases. Moreover, investing overseas can also help to diversify away some of the systematic risk within the UK element of the portfolio.

ASSET ALLOCATION CONSTRAINTS When deciding on asset allocation policy, any constraints faced by the client must be taken into account. For a pension fund client, the following constraints may exist: i. Liability constraints. Defined benefit (DB) pension schemes (see Section 3.13 of this chapter) with imminently maturing liabilities will need to be invested in lower risk, lower return assets whilst less mature schemes will be able to take a longer term view on investment returns by investing a greater proportion of its portfolio in real assets, such as equities and property. ii. Cashflow constraints. A DB pension fund that does not benefit from positive cashflow, where contributions to the scheme are exceeded by pensions in payment, will be constrained in its ability to invest in real assets. iii. Legal constraints. These may also exist where a client’s investment policy is restricted by express conditions contained within a trust, such as the use of derivatives within the portfolio or being precluded from investing in high yield bonds. However, most trusts have wide ranging investment powers and those that were subject to the restrictions imposed by the Trustee Investment Act 1961 now have wider investment powers conferred to them under the Trustee Act 2000, as outlined in Chapter 3. iv. The introduction of accounting standards that require the recognition of any liability in relation to defined benefit schemes has reinforced the move by DB pension schemes away from volatile equities and into less volatile investments, such as bonds that more closely match scheme assets with scheme liabilities.

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v. Peer group benchmarking limits. As noted earlier, many pension funds set tracking error parameters against peer group median asset allocations.

2. SECTOR SELECTION Once asset allocation has been decided upon, top down managers then consider the prospects for those sectors within their favoured equity markets. 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.

Commodities and basic resources General industrial and capital spending equities (electrical, engineering, contractor, TMT)

Growth decelerates as interest rates rise to suppress inflation

Cyclical consumer equities (airlines, autos, general retailers, leisure)

Basic industry equities (chemicals, paper, steel)

Cash Defensive equities (food retailers, pharmaceuticals, tobacco, utilities) Recession Bear Market arket Bull m f o t r Sta Bonds Growth accelerates Interest rate as interest rates fall sensitive equities (bank, house-building)

End o f Bull mark et

Property

Exchange rate sensitive equities (exporters, multi-nationals)

Figure 8: The Investment Clock Given the strong interrelationship between economics and investment, however, the sector selection process is also heavily influenced by economic factors, notably where in the economic cycle the economy is currently positioned. Interestingly, for equities, economic growth is something of a double-edged sword in that strong growth should increase earnings but also raises the spectre of higher interest rates. The interrelationship between the stages of a conventional UK economic cycle and that of a conventional UK investment cycle is illustrated in the above investment clock. However, the clock assumes that the portfolio manager knows exactly where in the economic cycle the economy is positioned and the extent to which each market sector is operationally geared to the cycle. Moreover, the investment clock doesn’t provide any latitude for unanticipated events that may, through a change in the risk appetite of investors, spark a sudden flight from equities to government bond markets, for example, or change the course that the economic cycle takes. In addition to economics, the current popularity of particular investment themes may cause certain sectors to be over weighted relative to their weighting in the benchmark index. This was true of technology, media and telecom (TMT) stocks in 1999, for instance.

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3. STOCK SELECTION “Worldly wisdom teaches us that it is better for reputation to fail conventionally than to succeed unconventionally” John Maynard Keynes The final stage of the top down process is deciding upon which 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. In order to outperform a predetermined benchmark, usually a market index, the active portfolio manager must be prepared to assume an element of tracking error, more commonly known as active risk, relative to the benchmark index to be outperformed. Active risk arises from holding securities in the actively managed portfolio in differing proportions to that in which they are weighted within the benchmark index. The higher the level of active risk, the greater the chance of outperformance, though the probability of underperformance is also increased. This risk of underperforming the benchmark index by assuming active risk was dramatically illustrated in the court action brought against Merrill Lynch Investment Managers (MLIM) by Unilever in the High Court in 2001. MLIM, formerly Mercury Asset Management (MAM), had signed a contract with Unilever that set a target investment return for Unilever’s £1bn pension fund of 1% per annum, net of management fees, in excess of the FTSE All Share index with a 3% per annum underperformance limit. However, over the 15 months to 31 March 1998, MLIM underperformed the index by 10.5%: the worst recorded performance of the 1,600 pension funds monitored by performance measurement company, WM. Although the value of the fund rose in absolute terms, it had underperformed its peers and the All Share index in relative terms. Unilever brought an action to recover the performance that had been “lost” as a result of poor stock selection allied to a claim of negligence for failing to monitor the fund’s active risk more carefully. The case resulted in MLIM paying Unilever an undisclosed sum without admission of liability. Given the increased popularity of indexation as a result of the generally superior performance of index tracker portfolios in recent years, there has been a tendency for many active portfolio managers to manage by consensus, or limit tracking error, in order to minimise the possibility of underperforming their peers, especially those that adopt indexation. This has led to accusations of active managers running closet trackers. The outcome of the MLIM case may well exacerbate this trend.

Concluding Comments It should be noted that top down active management, as its name suggests, is an ongoing and dynamic process. As economic, political and social factors change so does asset allocation, sector and stock selection.

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Bottom Up Active Management A bottom up approach to active management describes one that focuses solely on the unique attractions of individual stocks. Although the health and prospects for the world economy and markets in general are taken into account, these are secondary to factors such as whether a particular company is a possible takeover target or is about to launch an innovative product, for instance. A true bottom up investment fund is characterised by significant tracking error as a result of assuming considerable active risk. However, many actively managed single country investment funds that hold large capitalisation stocks in proportions barely indistinguishable to that of the index they are benchmarked against have been accused of closet tracking. By closely tying their stock selection to the index they seek to outperform rather than evaluating stocks according to their risk and return characteristics and assessing the covariance of their returns with other stocks in the portfolio, such funds invariably produce poor performance, not least because of the high charges they make.

Investment Management Styles Active portfolio management, whether top down or bottom up, employs one of a number of distinctive investment styles when attempting to outperform a predetermined benchmark. The more popular investment styles employed by active portfolio managers are: 1. Growth investing; 2. Value investing; 3. Thematic investing; 4. Fashion led; and 5. Contrarian investing.

1. Growth Investing Growth investing is a relatively aggressive investment style. At its most aggressive, it simply focuses on those companies whose share price has been on a rising trend and continues to gather momentum as an ever increasing number of investors jump on the bandwagon. This was referred to earlier as momentum investing. Little, if any, attention is paid to the usually above average PER of such shares. In 1999 and early 2000, the focus of many momentum driven growth strategies was on TMT stocks. Buying growth at a reasonable price (GARP) investing is a less aggressive growth investment style as attention is centred on those companies which are perceived to offer above average earnings growth potential that has yet to be fully factored into the share price. True growth stocks, however, are those that are able to differentiate their product or service from their industry peers so as to command a competitive advantage and, that rare commodity in a low inflation environment, pricing power. This results in an ability to produce high quality and above average earnings growth as these earnings can be insulated from the business cycle. A growth stock can also be one that has yet to gain market prominence but has the potential to do so: growth managers are always on the look out for the next Microsoft.

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The key to growth investing is to rigorously forecast future earnings growth and to avoid those companies susceptible to issuing profits warnings. As noted in Chapter 7, a growth stock trading on a high PER will be savagely marked down by the market if its earnings expectations fail to be met.

2. Value Investing In contrast to growth investing, value investing seeks to identify those established companies, usually cyclical in nature, that have been ignored by the market but look set for recovery. Like a pawnbroker, the value investor seeks to buy stocks in distressed conditions in the hope that their price will return to reflect their intrinsic value, or net worth. A focus on recovery potential, rather than earnings growth, differentiates value investing from growth investing, as does a belief that individual securities eventually revert to a fundamental or intrinsic value. This is known as reversion to the mean. In contrast to growth stocks, true value stocks also offer the investor a considerable safety margin against the share price falling further, because of their characteristically high dividend yield and relatively stable earnings.

VALUE VERSUS GROWTH INVESTING The table below summarises the main differences between value and growth stocks and the approaches taken towards value and growth investing.

Approach taken Preferred market conditions Typical characteristics of value and growth stocks PER Dividend yield Operational gear ing Financial gearing P/B ratio Intellectual asset backing

Value Cautious Bear market but set to recover

Growth Adventurous Bull market gathering momentum

Low High High Low Low Low

High Low Low High High High

Value investing worked well in the UK in 1970s and 1980s but was largely discarded in favour of growth investing for most of the 1990s. In the 1970s and 1980s, value investors by focusing on those stocks underrated by the market, simply relied on many of these companies either being taken over by a competitor or a conglomerate or riding the next economic cycle upswing in an economy characterised by boom and bust, politically inspired economic policies and regular currency crises. Today, by way of contrast, against a more stable economic backdrop, it has become apparent that companies that have performed well in the past but whose fortunes have since been reversed do not necessarily recover their pre-eminence tomorrow.

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Indeed, once sterling exited the ERM in 1992, the changing characteristics of the UK economy, principally its ability to produce robust growth without accompanying inflation, began to favour growth investing. Whereas many value stocks rely on economic growth to generate inflation so as to enhance the issuing company’s pricing power, the classic growth stock can produce double-digit earnings growth in a low inflation environment, principally by offering a niche product or service and/or through establishing brand loyalty. However, since the demise of the TMT momentum driven market in March 2000, value and growth investing have vied for dominance, though value investing has proved to be the superior of the two competing investment styles to date, as it has been over the long term. All of this serves to show that no one investment style suits all market conditions and different styles require different investment expertise. Consequently, portfolio managers are increasingly positioning themselves as style neutral, preferring to alternate between growth and value investment styles according to prevailing economic and investment conditions. In today’s market, it pays to be pragmatic.

3. Thematic Investing Thematic investing typically focuses on specific industry sectors linked by a common investment opportunity, regardless of where in the world the sectors are located. This makes a great deal of sense in a world where many businesses operate globally and generate the majority of their revenue from outside the country in which their head office is situated. In other words, thematic investing is based on the premise that geography and company domicile as a basis for investing globally has become flawed. Such opportunities, or themes, are often driven by technological advancement, demographics or a change in government policy. For instance, an ageing world population will increasingly require the provision of private healthcare, a theme upon which pharmaceutical companies have capitalised globally. However, whereas some investment managers tend to concentrate on a single global investment theme or industry, others adopt a trans-sectoral, or multithemed, approach to thematic investment, recognising that companies do not always fit neatly into sectors. This latter approach is principally driven by those major global macroeconomic trends that are expected to lead to equity outperformance in the medium to long term. An example of a theme pursued within a multi-themed approach is to focus on those companies that stand to benefit from a disinflationary environment by virtue of possessing a unique competitive advantage, such as a strong and enduring brand. Having been introduced to the UK in the mid-1980s, thematic investing has become increasingly popular as world markets have become more closely correlated and investors seek both diversification away from general market trends and access to the next big global investment story. TMT was the global theme of 1999. Since then, Socially Responsible Investment (SRI) has become a popular investment theme. Thematic investing also relates to seeking out those sectors that would be expected to outperform at various stages of the economic cycle as illustrated by the investment clock earlier in this chapter.

4. Fashion Led Investing Fashion led investing is similar to a growth momentum style of investing in that it is assumed a particular trend or fashion will continue to provide outperformance of the broader market. However, fashions by definition soon go out of style. Investing in last year’s top performing stock, theme or market rarely produces a repeat performance the following year. Just compare the fortunes of TMT stocks in 1999 with 2000. International Certificate in Investment Management

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5. Contrarian Investing Contrarian investing is similar to value investing in that a position is taken against the market consensus. It may be that a company has suffered a short term setback and it is perceived that the market has overreacted to the bad news or that a share has simply been ignored by institutional investors because of its low market capitalisation. Contrarian investing, however, often takes the view that last year’s poor performer will be this year’s sought after stock. As with fashion led investing, adopting a mechanised approach to investment rarely produces the desired result.

COMBINING ACTIVE AND PASSIVE MANAGEMENT Having considered both active and passive management, it should be noted that active and passive investment 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 between 70% to 80% of the portfolio’s value, so as to minimise the risk of underperformance, and then fine tuning this core by investing the remaining 20% to 30% in a number of specialist actively managed funds or individual securities, with either a growth or income bias, to meet the client’s stated objective. These are known as the satellites. Institutional portfolios are increasingly employing private capital and hedge funds as satellites. These are considered in the Alternative Investment Strategies (AIS) section later in this chapter. The core can also be run on an enhanced index basis, whereby specialist investment management techniques are employed to add value to the indexed core. 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 are instead marginally over weighted or under weighted relative to the index based on their perceived prospects.

Stage 3: Agreeing the Performance Benchmark, Frequency and Basis of Review Once the portfolio has been constructed, the portfolio manager and client need to agree on a realistic benchmark against which the performance of the portfolio can be judged. The choice of benchmark will depend on the precise asset split adopted and should be compatible with the risk and expected return profile of the portfolio. Where an index is used, this should represent a feasible investment alternative to the portfolio constructed. We return to these points in Chapter 10 when looking at the evaluation of risk-adjusted returns. The performance of institutional portfolios is often benchmarked against the WM or CAPS median whilst private client portfolios are often benchmarked against the Association of Private Client Investment Managers and Stockbrokers (APCIMS) indices, though FTSE International and MSCI indices are also widely used in both cases.

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Stage 4: Implementing the Investment Strategy by Selecting Suitable Asset Classes and/or Funds Portfolios can be constructed using a combination of securities and/or investment funds. These investment funds may include: i. Authorised collective investment funds, notably unit trusts and OEICs; ii. Investment trusts; iii. Unauthorised collective investment funds, such as EZTs; iv. Offshore funds; v. Hedge funds; vi. Venture capital funds; vii.Venture Capital Trusts (VCTs); viii.Exchange Traded Funds (ETFs).

Stage 5: Measuring and Evaluating Performance Portfolio performance is rarely measured in absolute terms but in relative terms against the predetermined benchmark and against the peer group. In addition, indexed portfolios are also evaluated against the size of their tracking error, or how closely the portfolio has tracked the chosen index. Tracking error arises from both under performance and outperformance of the index being tracked. Performance attribution and measurement is covered in Chapter 10.

Stage 6: Revisiting the Client’s Objectives, Revising the Construction of the Portfolio and/or the Benchmark It is essential that the portfolio manager and client agree on the frequency with which the portfolio is reviewed, not only to monitor the portfolio’s performance but also to ensure that it still meets with the client’s objectives and is correctly positioned given prevailing market conditions. The main reasons for revising the portfolio’s construction and/or altering the agreed benchmark, include: i. The client’s objectives or circumstances have changed; ii. Investment conditions have changed; iii. Fundamental changes have been made to the tax system.

Concluding Comments Despite the useful theoretical framework provided by MPT, CAPM and APT, portfolio management in practice can perhaps best be described more as an art than a science, not least because the emotional needs of the client must be balanced against the uncertainties of financial markets and practical portfolio construction constraints. Rarely will a mechanised or purely mathematically approach to portfolio management work in practice, though mathematical models are often employed at certain of its defined stages.

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SOCIALLY RESPONSIBLE INVESTMENT (SRI) The UK’s first ethical fund was launched in 1984 to a muted response. However, after a slow start, the popularity of ethical investing, or making profit out of principles, soon gathered pace as public awareness of environmental issues grew and governments began to respond with a combination of environmental legislation and taxes. The growing interest in actively encouraging corporate social responsibility is now central to SRI: the phrase designed to describe the inclusion of social and environmental criteria in investment fund 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. Types of SRI approaches: 1. Ethical Investing 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. Screening research is provided by a number of commercial operations of which the Ethical Investment Research Service (EIRIS) set up to independently research corporate behaviour, is one of the best known. 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. 2. Sustainability Investing 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, pragmatic and proactive in their approach to selecting investments. Sustainability investors focus on those risks which most mainstream investors ignore. For instance, whilst 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 price 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: i. Positive sector selection. Positive sector selection is selecting those companies that operate in sectors likely to benefit from the global shift to more socially and environmentally sustainable forms of economic activity, such as renewable energy sources. This approach is known as investing in “industries of the future” and gives a strong bias towards growth oriented sectors. ii. Choosing the best of sector. Companies are often selected for the environmental leadership they demonstrate in their sector, regardless of whether they fail the negative criteria applied by ethical investing funds. For instance, an oil company which is repositioning itself as an energy business focussing on renewable energy opportunities, would probably be considered for inclusion in a sustainability fund but would be excluded from an ethical fund.

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Responsible Engagement With the growing trend amongst 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, which results in the construction of better diversified portfolios, sustainability funds also require each of their holdings to meet with certain financial criteria, principally the ability 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.

Recent Catalysts toFurther Encourage SRI Investing The move towards SRI investing was given further impetus in July 2000 when legislation came into force requiring pension fund trustees to disclose the extent to which they take account of ethical, social and environmental issues in their investment strategies. In addition, many companies now voluntarily produce an environmental or social report to accompany their annual report and accounts, which provides information as diverse as the extent of their greenhouse gas omissions to the number of employees dismissed during the year for unethical behaviour. Moreover, the Association of British Insurers (ABI) has recently issued guidelines requiring listed companies to spell out their attitude to corporate social responsibility issues in their report and accounts, as well as identify and disclose those social, environmental and ethical risks to their business. Research suggests that good corporate social responsibilities is linked to superior, long term business performance. Evidence of SRI investing having entered the mainstream, however, was provided by FTSE International launching its FTSE4Good indices in July 2001. These indices cover most sizeable companies around the world and set three global benchmarks against which companies are judged for inclusion. These indices are detailed in Chapter 10.

The Benefits of Employing Derivatives Within the Investment Management process As noted in Chapter 4, the benefits of using derivatives within the investment management process include: • hedging; • anticipating future cash flows; • asset allocation; • arbitrage; • enhancing portfolio performance; • facilitating access to illiquid or inaccessible markets.

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2.3 Conflict of Interest

LEARNING OBJECTIVES 9.2.6

Understand the issues associated with conflicts of interest and the duty to clients

The FSA has strict regulations regarding the fair treatment of clients, and all policies and procedures must by followed by law. Portfolio managers along with other involved parties, have a legal duty to disclose any material interest or conflict of interest when dealing on behalf of a client. They are also required to act honestly, fairly and in the best interests of their clients.

3. FUND CHARACTERISTICS 3.1

Introduction

As noted earlier, portfolio managers can construct portfolios both by investing directly in the main asset classes and by drawing on a wide range of investment funds. This section looks at the characteristics of these investment funds as well as those fund structures portfolio managers may themselves manage.

3.2

Insurance Companies

LEARNING OBJECTIVES 9.3.1

Know the main features and risk characteristics of the following: • Insurance Companies (life and general)

Insurance companies, like pension funds, are long term investing institutions and hold 20% of their assets in UK equities. Insurance companies write two main categories of business: 1. Life assurance business, and 2. General business.

1. LIFE ASSURANCE BUSINESS Life assurance policies are those written by an insurance company on an individual’s life. These mainly comprise: i. Term assurance policies, which in exchange for a regular premium, only pay out if the individual dies before the end of the set policy term.

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ii. Whole of life (WOL) policies, which having no set policy term pay out on the individual’s death at some stage in the future, again in exchange for a regular premium. iii. Endowment policies. These are term assurance policies with a significant investment element. This investment element can be invested in either the company’s with profit or unit linked life funds. iv. Single premium life assurance bonds. These are single premium WOL investment policies that can also be invested either in the company’s with profit or unit linked life funds but which only offer minimal life assurance. Due to the long term nature of life assurance business, life assurance premiums are heavily weighted towards equity investment. Life assurance business profits are subject to the standard corporation tax rules considered in Chapter 8.

2. GENERAL BUSINESS The general business of an insurance company comprises writing insurance against short term personal and commercial risks, typically over a 12 month period. Given the short term nature of these potential liabilities, general business policy premiums are mainly invested in liquid short term assets. Special rules are applied to the taxation of general insurance business.

3.3

Exchange-Traded Funds (ETFs)

LEARNING OBJECTIVES 9.3.1

Know the main features and risk characteristics of the following: • Exchange-Traded Funds (ETFs)

Exchange-Traded Funds (ETFs) are essentially open ended investment funds, principally designed to track the performance of a particular index, but which are listed and traded as quoted companies, with a transparent net asset value (NAV), on one of a number of stock exchanges around the world. These hybrid characteristics mean that investors can gain exposure to an entire index through the purchase of a single share. ETFs originated in the US in 1993 with the introduction of the Standard & Poors Depository Receipt (SPDR), or Spider as it has become more popularly known, and are listed and traded on the American Stock Exchange (AMEX). Tracking the S&P 500, this US dollar denominated product was initially targeted at institutional investors, though, like other ETFs, it has since evolved to vie for the attentions of institutional and retail investors alike, offering the same favourable terms to each.

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Although UK investors have had access to US and, more recently, to European listed ETFs since their inception, it wasn’t until April 2000 that the UK’s first ETF, based upon the FTSE 100 index, was introduced. ETFs in the UK are public limited companies (plcs) that are listed on the LSE’s extraMARK exchange, traded through SETS and settled on CREST. Unlike the shares issued by other plcs, however, purchases of LSE-listed ETFs are not directly subject to the usual 0.5% stamp duty, assuming the fund is domiciled outside of the UK; Ireland for instance. Also, in contrast to index tracker unit trust funds, ETFs are continuously priced on a real time basis, rather than a daily basis, thereby enabling investors to gain instant exposure at a known price to the fund at any time during the trading day. Despite this real time pricing, ETFs trade at or very near to their underlying net asset value (NAV) due to the unique way that ETF shares are created and redeemed. ETFs have other distinguishing features. These include being: • Based on a wide variety of benchmark equity indices as well as a range of sector and themespecific indices and industry baskets. Some are now even actively managed and fixed interest funds are envisaged. Inevitably, some ETFs are more liquid, or more easily tradeable, than others; • Transparent in that details of the fund’s holdings, NAV and price quotes can be accessed online; and • Subject to low expense ratios, management charges and bid/offer spreads, though these are dependent on the market index or sector being tracked and the latter on the liquidity of the fund. Moreover, no initial or exit charges are applied. ETF expenses are usually paid out of the fund’s dividend income. 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.

3.4

Venture Capital Trusts (VCTS)

LEARNING OBJECTIVES 9.3.1

Know the main features and risk characteristics of the following: • Venture Capital Trusts (VCTs)

VCTs are specialist investment trusts that mainly invest in the issue of new ordinary shares and loan stock by qualifying Enterprise Investment Scheme (EIS) companies.

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3.5

Venture Capital Funds (Limited Partnerships)

LEARNING OBJECTIVES 9.3.1

Know the main features and risk characteristics of the following: • Venture Capital Funds (limited partnerships)

Venture capital companies (VCCs) form limited partnerships that source private capital mainly from pension funds and wealthy individuals to finance business start ups and provide development capital to fast growing unquoted companies. Typically formed with a 10 year life, the venture capital company has full discretion over how the funds are invested within the partnership and will return the invested proceeds, less an annual management fee and a percentage of the profits made, to the partnership’s subscribers during this period.

3.6

Offshore Funds

LEARNING OBJECTIVES 9.3.1

Know the main features and risk characteristics of the following: • Offshore Funds

Offshore investment fund companies mainly market open-ended equity, fixed interest, money market and currency funds. Some closed ended investments are, however, offered by investment trust managers. The main offshore centres are the Channel Islands, the Isle of Man, Dublin, Luxembourg and Bermuda. Open ended offshore funds assume one of two structures: i. Distributor funds. Distributor funds are those that distribute at least 85% of their net investment income to unit holders or shareholders. Distributor status is applied for annually retrospectively from HMRC and, if granted, renders UK resident investors remitting income and capital gains back to the UK subject to the standard income tax and CGT rules. Growth oriented funds, whose gross investment income is no greater than 1% of their assets, can also apply for distributor status, even if this income is not distributed. ii. Non-distributor funds. Non-distributor funds are typically those that roll up their capital gains and income and are, therefore, not granted distributor status. UK resident investors are subject to income tax on all income and gains remitted back to the UK from non-distributor funds. The funds themselves are not subject to UK tax. The FSA recognises three types of offshore fund that may be freely marketed in the UK: i. Those that comply with the UCITS directive; ii. Designated territories funds domiciled in the Channel Islands, Isle of Man and Bermuda; iii. Funds domiciled outside of the designated territories but approved by the FSA on an individual basis. International Certificate in Investment Management

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Although offshore funds provide the UK investor with a greater choice than that available onshore and in some cases can prove more tax efficient, they generally attract higher charges than their onshore equivalents and suffer non-reclaimable withholding taxes.

3.7

Common Investment Funds

LEARNING OBJECTIVES 9.3.1

Know the main features and risk characteristics of the following: • Common Investment Funds

Common Investment Funds (CIFs) are collective investment schemes made available to charities registered with the Charity Commission in England and Wales. Charities exist for the relief of poverty, the advancement of education or religion and for purposes considered beneficial to the community. Charities are registered with the Charity Commission, whose functions are to establish and maintain a register of charities, promote the effective use of a charity’s resources and investigate abuses of a charity’s assets. CIFs are set up by the Charity Commission under the Charities Acts 1960 and 1993, though are not promoted by the Charity Commission to charities as being more suitable than any other investment vehicle. Although not authorised by the FSA, CIFs are similar in structure to authorised unit trusts in that they provide diversification and cost efficiency. Moreover, as they can be registered with the Charity Commission as charities in their own right, they can benefit from the tax exempt status enjoyed by charities. There are over 30 CIFs available with total assets under management of about £5bn.

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Alternative Investment Strategies (AISS) Against a background of closely correlated global equity markets and the expectation of lower nominal investment returns, many portfolio managers have begun to employ AIS within their portfolios. AIS invest in non-traditional assets (NTA) and comprise hedge funds and private capital.

3.8

Hedge Funds

LEARNING OBJECTIVES 9.3.1

Know the main features and risk characteristics of the following: • Hedge Funds

In the UK, the mere mention of hedge funds to some investment professionals often provokes an immediate and negative reaction given their reputation for being high risk. However, this perception stands at odds with the reality in most cases. In their true incarnation, hedge funds seek to eliminate or reduce market risk and capture returns through manager stock selection skill regardless of market conditions. This they do by combining long and short positions taken in a portfolio of carefully selected securities without predicting or relying on the direction of the broader market. That is, they hedge market risk. The concept of profiting regardless of directional market movements is core to the hedge fund concept. However, as with most simple concepts in finance, innovation has resulted in a number of complex hedge fund structures, many of which place a greater emphasis on producing highly geared returns than the control of market risk. Consequently, there is no simple definition of a hedge fund. The hedge fund concept can be traced back to an Australian American, Alfred Winslow Jones, who launched the world’s first hedge fund in 1949. Today, the hedge fund market is worth about US$1,000bn. About 90% of the 6,000 available hedge funds are based in the US, mainly in New York, with the remainder located in offshore financial centres. The main differences that exist between hedge funds, whose activities are unregulated, and conventional regulated investment funds comprise: 1. Structure. Most hedge funds are set up either as private partnerships in the US or as unauthorised collective investment schemes in offshore financial centres. An investment bank, known as a prime broker, typically provides the fund with trading and credit facilities as well as administrative support, whilst the fund management is usually conducted in a major financial centre such as London. 2. High investment entry levels. The minimum initial investment into a hedge fund ranges somewhere between US$100,000 and US$1m. Most hedge funds also impose a limit on the size to which they can grow so as to keep the fund nimble. The most successful funds have been known to close their doors to new investment within a matter of months after launch. 3. Investment flexibility. Being an unregulated investment medium, hedge funds have complete investment flexibility in terms of where, how and in what assets they decide to invest. In addition to being able to take long and short positions in securities, hedge funds also take positions in commodities, currencies and mortgage-backed securities. Moreover, as hedge funds do not tie

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their asset and sector allocations to those of their peers, they typically have more concentrated, or less well diversified, portfolios than regulated investment funds. 4. Gearing. Hedge funds can borrow and/or employ derivatives to potentially enhance returns through gearing. Regulated investment funds can only use derivatives for efficient portfolio management (EPM). 5. Low correlation to world securities markets. Despite the greater concentration of their portfolio holdings, hedge funds, when combined with conventional portfolios, usually provide additional diversification owing to their low correlation with world equity and bond market movements. However, the extent to which the inclusion of a hedge fund diversifies the risk of a portfolio containing traditional assets is wholly dependent upon the hedge fund’s chosen investment strategy. 6. Investment returns. Hedge funds are geared to absolute returns and the avoidance of losses whereas regulated investment funds focus on relative returns, typically against an index or peer group average. 7. Performance related fees. Hedge funds typically levy an annual management fee of 2% in addition to a performance related fee of about 20% if an absolute performance target in excess of the risk-free rate of return is met or exceeded and previous losses have been made good. Regulated investment funds are not permitted to charge performance related fees. 8. Manager investment. Hedge fund managers are further incentivised by being expected to invest some of their own wealth into the fund. This reinforces the alignment of manager and investor interests. 9. Accessibility. So as to maximise the manager’s investment freedom, most hedge funds impose an initial lock-in period of between one and three years before investors may deal in the hedge fund’s shares. Any dealing that subsequently takes place is then usually only permitted at the end of each month or quarter. It is also not uncommon for hedge fund assets to be priced monthly. As there is no universal definition of hedge funds, no one definitive classification system exists. Whilst many textbooks refer to four broad strategies or fund types - long/short equity, market neutral, event driven and global macro - others cover in excess of 30 strategies in this highly fragmented industry. However, hedge fund strategies can be broadly divided into non-directional, or market neutral, and directional strategies. Although both focus on producing positive absolute returns, the former seek to contain losses and reduce volatility by insulating manager stock selection skill from broad market movements whereas the latter typically employ high levels of gearing without hedging to reinforce a directional view on markets. Given the bewildering array of hedge fund structures, investment strategies and the general lack of accessibility and transparency associated with hedge fund investment, the introduction of funds of hedge funds (FOHFs) in the UK has both widened the appeal and accessibility of this non-traditional asset (NTA) class to retail and institutional investors alike, by assuming the substantial due diligence involved in selecting hedge funds. This process entails researching and monitoring individual manager strategies, investment styles, the degree of hedging and gearing employed, risk management processes and the consistency of performance. In addition, the suitability and compatibility of certain strategies and styles is assessed given the risk profile of the fund and the positioning of the investment cycle. This latter point is of particular importance as no style weathers all market conditions - a point that was discussed when looking at investment styles earlier in this chapter. Hedge funds are a useful addition to the portfolio construction process and are suitable for inclusion in most portfolios so long as a sensible balance between risk and reward is maintained and a high level of liquidity is not required.

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3.9

Private Equity Funds

LEARNING OBJECTIVES 9.3.1

Know the main features and risk characteristics of the following: • Private Equity Funds

Private equity is another non-traditional asset (NTA) class that has recently gained increased popularity amongst UK institutional investors, principally pension funds, notably because of its low correlation to broad equity market movements and the higher than average returns it has historically delivered. Providers of private equity comprise the subsidiaries of major banks as well as independent venture capital companies and limited partnerships. These institutions, in turn, typically source their capital from portfolio managers, pension funds and wealthy individuals. Private equity is a key source of funding for many companies and can take the form of equity, bond or mezzanine finance, the latter combining the characteristics of the former two. Start up finance and development capital is provided to small but potentially fast growing unquoted companies, with private capital investors reaping their reward from realising the often significant equity stake they take in the business through either a trade sale or upon the company floating its equity in the new issue market. Private equity is also used to finance management buyouts (MBOs) by incumbent managements, management buy-ins (MBIs) by outside managements, leveraged buyouts (LBOs) by specialist buyout funds, who then sell off the assets of the company bought out, and to facilitate public-to-private transactions, when listed companies wish to de-list and be put back into private hands. Given the specialist nature of each type of transaction, when investing in private equity, it is imperative that such investments are well diversified geographically, between industries and across differing stages of company development.

3.10 Multi-Manager Funds LEARNING OBJECTIVES 9.3.1

Know the main features and risk characteristics of the following: • Fund of Funds • Manager of Managers

The idea behind multi-manager funds is the recognition that no one fund manager or investment house has the expertise in all asset classes, geographic regions and investment styles. Hence by selecting multiple managers a degree of diversification is obtained and the “best” managers are selected. They are currently the fastest growing investment product in the UK. However the fees associated with these products tend to be higher due to the additional layer of management. The main types of multi-manager fund categories are: Fund of Funds and Manager of Managers.

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Fund of Funds (FoF) A fund of funds has one overall manager. It invests in a portfolio of other existing investment funds and seeks to harness the best investment manager talent available within a diversified portfolio. Most fund of funds are managed on an unfettered basis, in that the component funds are run by a number of managers external to the fund management group marketing the fund of funds. However, some are managed as a fettered product and are obligated to invest solely in funds run by the same management group as the fund.

Manager of Managers (MoM) A manager of managers fund does not invest in other existing retail collective investment schemes. Instead it entails the MoM fund arranging segregated mandates with individually chosen fund managers. Traditionally, these types of funds were only available to wealthy clients or institutions but they are increasingly being offered to retail investors. One disadvantage is that the initial investment required is usually substantially higher than that required for a fund of funds or other collective investment scheme.

3.11 Private Client Funds LEARNING OBJECTIVES 9.3.1

Know the main features and risk characteristics of the following: • Private Client Funds

Discretionary trading involves a client’s adviser or broker having the right to make investment decisions without consulting them. Note that a client mandate (with rules) would need to be put in place prior to any trading. With non-discretionary trading, the client has the final word on investment decisions. Private client funds are bespoke portfolios run on either a discretionary or advisory (nondiscretionary) basis for wealthy clients. The asset split of such portfolios are unique to each client.

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3.12 Collective Investment Funds LEARNING OBJECTIVES 9.3.1

Know the main features and risk characteristics of the following: • Investment Trusts • Unit Trusts • OEICs (ICVCs)

Collective investment funds pool the resources of a large number of investors to provide access to those geographical areas and asset classes that would otherwise be too costly, and in some instances too risky, to gain exposure to directly. The benefits of collective investment, therefore, include: i. Economies of scale; ii. Diversification; iii. Professional investment management. In the UK, collective investment funds comprise unit trusts, OEICs and investment trusts. Unit trusts and OEICs are known as collective investment schemes (CIS) or mutual funds.

1. Unit Trusts Unit trusts were first launched in the UK in 1931 and, until very recently with the introduction of OEICs, proved to be the UK’s most popular collective investment fund structure. Unit trusts have the following characteristics: a. They issue units. Each unit in the fund ranks equally with all others in issue and proportionately reflects the value of the fund’s underlying assets, or NAV. b. They are open ended. A unit trust can increase or decrease the number of units in issue depending upon whether or not investors, known as unit holders, are buying more units than they are selling, or redeeming. Whilst the issue of units adds to the fund’s assets, redemptions reduce the fund’s assets. No restrictions are imposed upon the buying and selling of units. c. They are governed by a trust deed. The trust deed sets out the fund’s objective, pricing and charging structures as well as the responsibilities of the parties to the trust, namely the unit trust manager and the trustee. The unit trust manager assumes responsibility for running the fund and selecting the fund’s investments as well as promoting the fund, whilst unit holders interests are protected by an independent trustee. The trustee, which is usually a third party bank or insurance company, is the registered owner of the fund’s assets and, therefore, oversees the management and the pricing of the trust. In addition, the trustee is responsible for maintaining a register of unit holders, issuing and redeeming units and distributing the fund’s income, if appropriate.

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d. Authorisation. Most unit trusts are authorised by the Financial Services Authority (FSA). FSA authorisation permits the fund to advertise to the public and exempts it from CGT on realised capital gains. Authorisation restricts the range of assets that can be held and requires the fund to meet stringent diversification rules. Authorised unit trusts can only borrow funds on a temporary basis and can only use derivatives for Efficient Portfolio Management (EPM). That is, to reduce the fund’s risk, cost and/or to enhance the fund’s income or capital at little or no risk to the fund. However, futures and options funds (FOFs) and geared futures and options funds (GFOFs) marketed in the UK (see fund types, below) and mixed funds introduced under the UCITS Product Directive (UCITS III) - detailed below - can use derivatives for investment purposes. FOFs and GFOFs, however, are subject to strict derivative investment limits whilst mixed funds must make detailed disclosure of their derivative investment strategies, techniques and risk controls. Unauthorised unit trusts, such as EZTs, are those run for tax exempt investors, such as pension funds and charities. e. They are dual priced. Units are purchased by investors at the offer price and sold at the bid price. The difference between these two prices, which are subject to FSA regulations, is known as the bid/offer spread. Unit trusts are priced daily in accordance with an FSA approved formula based on the value of the fund’s underlying assets, or NAV, at the daily valuation point. Mandatory single pricing for unit trusts is soon to be introduced. f. Categorisation. Unit trusts are categorised according to their investment objective rather than their investment style. That is, whether they are income or growth oriented, the asset classes they hold and where in the world they invest. In all, there are over 30 unit trust categories. These are determined by the Investment Managers Association (IMA), the investment management industry’s trade body, but are constantly evolving as new fund types are launched. g. Funds types. Some of the FSA unit trust categories include: 1. Securities funds; 2. Warrants funds; 3. Money market funds; 4. Futures and options funds; 5. Geared futures and options funds; 6. Fund of funds; 7. Property funds; 8. Feeder funds; 9. Mixed funds. The investment and diversification rules for each of these funds are detailed and beyond the scope of this syllabus. h. Taxation. As noted earlier, authorised unit trusts are exempt from CGT. They are, however, subject to corporation tax at 20% on any interest income or other UFII they receive from the securities they hold, net of their management expenses. UK dividend income though, being FII, is not subject to any further tax within the fund. Unit holders are potentially subject to CGT when disposing of their units and higher rate taxpayers to additional income tax on dividend and interest distributions and income directed by the unit holder to be accumulated within the fund, as detailed in Chapter 8.

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2. Open Ended Investment Companies (OEICs) OEICs were introduced in the UK in 1997 in response to the UK unit trust industry losing considerable market share in open ended investment funds to continental and offshore fund management centres. Overseas investors, which had become familiar with the OEIC structure, didn’t feel comfortable with an investment fund that was subject to UK trust law and was dual priced. In continental Europe, OEICs are often referred to as Investment Companies with Variable Capital (ICVC) or SICAV (Societe d’Investment a Capital Variable). OEICs are very similar to unit trusts in that they are also open ended funds and subject to comparable regulations. However, rather than adopting a trust structure, OEICs are limited companies that issue and redeem shares rather than units. Investors as shareholders are, therefore, entitled to attend and vote at an AGM. OEICs typically assume a so-called umbrella structure, within which the individual investment funds are known as sub-funds. These sub-funds can issue different classes of share, each with their own unique charging structure, and in a range of currencies. Also, rather than being dual priced, OEIC shares are single priced. The other differences that exist between unit trusts and OEICs are really a matter of semantics. An OEIC is run by an Authorised Corporate Director (ACD), whose responsibilities are broadly similar to that of a unit trust manager, whilst a depository, rather than a trustee, oversees the running and administration of the OEIC. OEICs are also classified alongside unit trusts by the IMA according to exactly the same criteria. However, FSA OEIC categories differ from their unit trust counterparts in that feeder funds are not a recognised OEIC fund type whilst umbrella funds containing securities sub-funds and/or warrants sub-funds are. OEICs are taxed in exactly the same way as unit trusts and OEIC shareholders in the same way as unit trust unit holders. Although over half of all UK mutual fund groups have converted their unit trusts into OEICs, many more are expected to continue this trend now that the UCITS Product Directive (UCITS III), detailed below, has been adopted by the FSA, within its collective investment schemes handbook, thereby permitting a wider range of OEICs and fund structures to be sold into the EU investment funds market.

THE UCITS DIRECTIVE The Undertakings for Collective Investments in Transferable Securities (UCITS) Directive was introduced in 1985 by the European parliament, to enable collective investment schemes (CIS) authorised in one EU member state to be freely marketed throughout the EU, so long as the marketing rules of the host state(s) were complied with. To comply with the provisions of the original UCITS Directive, a CIS must: 1. Be open ended, in that it can freely issue and redeem units or shares to and from investors; 2. Be a securities fund, warrants fund or an umbrella fund comprising either or both of these fund categories; 3. Meet certain EU-wide rules on structure, control and disclosure of information;

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4. Invest no more than 10% of its scheme property, or assets, in transferable securities not listed on an EU stock exchange; 5. Invest no more than 5% of its scheme property in any one company; and 6. Avoid direct investment in real estate, metals and commodity futures. In December 2001, the European parliament approved the European Undertakings for Collective Investments in Transferable Securities (UCITS) Amending Directives, comprising the Product Directive and the Management Directive. These are more commonly known collectively as UCITS III, respectively. 1. The Product Directive. The Product Directive, once implemented into member state national law - as it has been in the UK since 1 November 2002 - permits CIS operators, or UCITS management companies, to market a new category of CIS across the EU. This, so-called, “mixed fund” has much wider investment powers than those funds meeting the original UCITS criteria in that it permits investment in a broader range of financial instruments than was possible under the original UCITS Directive and enables the fund to hold a greater percentage of its resources in any one asset class than was previously allowed. Most notably, investment in derivatives is now permitted, though such investment requires the fund to make comprehensive disclosure of its investment strategy and risk monitoring techniques to investors. Funds marketed into other EU member states under the original directive will, for the time being, operate alongside the exporting of mixed funds under UCITS III, though, through a series of transitional measures, all existing UCITS funds categories must be converted to mixed funds by 13 February 2007. UCITS III may go some way to the UCITS Directive fulfilling its vision of creating truly panEuropean investment funds market notwithstanding the tax differences and differing regulations that continue to exist between most EU member states. 2. The Management Directive. The Management Directive enables UCITS management companies to extend their activities beyond managing UCITS-compliant CISs. They are permitted to provide services such as investment advice and administration to third parties in relation to CISs, for instance. Moreover, the directive also enables them to “passport” these other services across the European Economic Area (EEA) in a similar fashion to the “passporting” of investment services by EU investment firms under the Investment Services Directive (ISD) 1996. The EEA comprises those states that collectively constitute the European Free Trade Association (EFTA), namely the pre-accession 15 EU member states, Switzerland, Norway and Iceland. Services are “passported” under the ISD by either establishing a branch in another EEA country or by conducting business in the EEA on a cross border basis by setting up a computer network, for instance. The Management Directive also provides for new capital adequacy, or financial resources, requirements to be applied to UCITS management companies, so as to facilitate this “passporting”, and for the simplification of CIS prospectuses.

3. Investment Trusts Investment trusts are plcs listed on the LSE that issue shares. Despite having been introduced in the UK in 1868, they have not proved as popular as unit trusts and OEICs. In part this can be explained by investment trusts having a closed ended structure, or a fixed amount of share capital in issue. This share capital can only be increased through a special type of rights issue known as a C share issue. As a consequence, although each share in issue represents an equal share of the investment trust’s underlying assets, the share price can move independently of the value of these assets, like that of any other listed company. The share price will, therefore, trade at either a premium, or more commonly, a discount to its net asset value (NAV). Although discounts can narrow to the advantage of the shareholder, they can also widen.

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An investment trust’s NAV is calculated as follows: listed investments at mid-market price, plus unlisted investments valued by directors, plus cash and other assets, less nominal value of loans and preference shares An investment trust’s discount or premium is calculated as follows: [(NAV - share price)/NAV] x 100 However, having a closed ended structure also means not having to meet shareholder redemptions. Instead, shareholders must realise their investment through an LSE member firm like any other equity share. Therefore, the portfolio 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. Also, unlike open ended funds, investment trusts can permanently employ gearing to potentially enhance shareholder returns. As gearing, like discounts, can work to the advantage or to the detriment of the investor, this makes investment trusts a more riskier proposition than open ended funds. In order to gain authorisation, investment trusts must meet certain LSE and HMRC requirements. These include not having control over the companies in which they invest, deriving at least 70% of the fund’s income from shares and other securities and investing no more than 15% of the fund’s assets in any one company. Authorisation grants the investment trust exemption from CGT on realised capital gains though corporation tax remains payable on UFII, in the same way as for open ended funds. Investment trust investors are taxed in exactly the same way as their open ended counterparts. Investment trusts are categorised by the Association of Investment Trust Companies (AITC) according to their investment objective and can be marketed either as conventional funds or as split capital trusts with different classes of share capital in issue. In both cases, investors interests are protected by an independent Board of Directors, the continuing obligation requirements of the UKLA and the Companies Acts. The split capital investment trust industry came under attack in 2002 as a result of engaging in practices which led to collapsing asset values and the insolvency of several trusts. A common practice had been for these trusts to employ considerable amounts of bank debt so as to gear the capital and income performance of their underlying portfolios, which in the vast majority of cases mainly comprised the income shares of other split capital investment trusts. This “magic circle” of highly geared cross-shareholdings necessarily created a domino effect throughout the industry as the value of these portfolio assets fell against the backdrop of declining equity markets and bank debt covenants were broken. As a result, many split capital investment trusts were forced to restructure, repay bank debts and either cut or suspend dividend payments. A £144m compensation fund was set up for the investors who lost money as a result.

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3.13 Retirement Funds LEARNING OBJECTIVES 9.3.2

Know the main features and risk characteristics of retirement funds

Many western countries currently face the problem of a signicantly aging population and are encouraging citizens to set up their own retirement funds. Although most countries have some sort of public assistance for retirees, it is envisaged that due to the large number of elderly citizens it will place a heavy burden on the government’s funds. As a result, many countries such as Australia and Singapore have set up a compulsory pension system where a percentage of an employee’s salary must be paid into a retirement fund. There are usually tax advantages attached to retirement funds as the government attempts to encourage people to save for their retirement. Retirement funds typically have rules stating that investors cannot withdraw their money until they reach a certain age (usually their retirement age). This can present difficulties for investors if they require the funds earlier in life, for example to buy a house. Another disadvantage of retirement plans is that governments can and do change the rules relating to factors such as contribution limits, withdrawal age, taxation benefits, withdrawal methods (eg, annuity, cash) etc. Two of the most common types of retirement funds are Defined Benefit Schemes and Defined Contribution Schemes.

1. Defined Benefit (DB) Schemes DB, or final salary, pension schemes are those occupational pension schemes that provide guaranteed benefits for their scheme members. These benefits are based on the number of years each employee has been a member and their salary either at retirement or at the date of leaving the scheme sponsor’s employment. A common type of DB plan is a ‘Final Salary Plan’ which is based on the member’s final salary and the number of years they have worked. A pension or lump sum is then paid on retirement. The investment risk rests with the scheme sponsor (and not the scheme member).

2. Defined Contribution Plans In a defined contribution plan, the money to be invested is paid into an individual member’s account (in their name). The member carries the investment risk so that if, for example, their fund invests in UK equities and this asset class performs poorly, then the retirement benefits available will also be poor. In recent years, these types of plans have become much more common throughout the world, particularly in the USA and UK. Some examples include Individual Retirement Accounts (USA), 401(k) Plans (USA), Stakeholder Pensions (UK), SIPPS (UK) and PERCO (France).

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1. 2. 3.

10

PERFORMANCE BENCHMARKS PERFORMANCE ATTRIBUTION PERFORMANCE MEASUREMENT

315 325 327

This syllabus area will provide approximately 5 of the 100 examination questions

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1. PERFORMANCE BENCHMARKS 1.1

Introduction to performance benchmarks

When considering the stages of the portfolio management process in Chapter 9 the need to establish a realistic benchmark against which the performance of a portfolio can be judged once constructed, was briefly discussed. Depending on the objective and asset split of the portfolio, this benchmark can either take the form of an established index or a peer group average. Each of these will now be considered in turn.

1.2

Equity indices

LEARNING OBJECTIVES 10.1.3

Be able to calculate the main types of equity indices (arithmetic price and market value weighted and geometric unweighted)

Index numbers The ability to calculate and interpret index numbers is fundamental to the portfolio management process. Index numbers are a concise way of comparing the value of a variable between different points in time. They are calculated by selecting a period in time - the base period - and assigning an arbitrarily determined base value to the variable, typically one, 10 or 100 to keep matters simple. Subsequent index values of the variable can then be compared with this base value or any other subsequent value; these changes being expressed either in absolute or in percentage change terms. Index values then, given a sufficiently long history can provide an indication of whether a trend has been established or whether once established a trend has been bucked. The principles for calculating index numbers are perfectly general and can be applied to comparing the values of any variable. Index numbers are particularly useful, however, for calculating how the price of a basket comprising a number of different items has changed over time. These are known as composite indices. Composite indices, such as the RPI and the CPI, provide a concise summary of how these individual price movements over a particular time period impact on the general level of prices. Stock market, or equity, indices, like any other composite index number, are designed to provide a concise summary of the price movements of their underlying constituents. This they do by representing the collective diversity of individual share price movements. In addition, however, some equity indices also incorporate the reinvestment of dividends, into their index values to provide an index of total return: total return being equal to price movements plus this dividend income. There are now over 3,000 equity indices worldwide, some of which track the fortunes of a single market whilst others cover a particular region, sector or a range of markets.

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Most stock market indices have the following four uses: 1. To act as a market barometer. Most equity indices provide a comprehensive record of historic price movements, thereby facilitating the assessment of trends. Plotted graphically, these price movements may be of particular interest to technical analysts, or chartists, and momentum investors, by assisting the timing of security purchases and sales, or market timing. Technical analysis was covered in Chapter 7, whilst market timing and momentum investing were considered in Chapter 9. 2. To assist in performance measurement. Most equity indices can be used as performance benchmarks against which portfolio performance can be judged. 3. To act as the basis for index tracker funds, exchange-traded funds (ETFs), index derivatives and other index related products. 4. To support portfolio management research and asset allocation decisions. This was covered in Chapter 9. Stock market indices were originally designed to provide an impressionistic mood of the market and as such were not constructed in a particularly scientific manner. In recent years, however, index construction has become more of a science as performance measurement has come under increased scrutiny and the growth of index related products has necessitated the need for more representative measures of market movements with greater transparency surrounding their construction. Therefore, when constructing an equity index the following general considerations must be made: 1. What market, sector or combination of markets should be tracked? 2. What should be the basis of inclusion of constituents? 3. How should these constituents be weighted, if at all? 4. How should the price relatives of the individual index constituents be combined? 5. What rules should apply to changing index constituents? 6. Should the index only track price movements or should it also incorporate dividend income? Moreover, for an equity index to prove successful, it must ensure that: 1. It is relevant to investors’ needs; 2. It is capable of being replicated by a real world portfolio for performance measurement and index related product purposes; 3. Its constituents are not subject to any investment restrictions; that is, they should be capable of being held within a portfolio; 4. It is sufficiently broadly based; and 5. Its method of construction and calculation is transparent. One of the most fundamental aspects of equity index construction is deciding upon: 1. How to combine, or average, the relative prices of index constituents, and 2. Whether or not to employ a method of weighting. Equity indices can adopt either an arithmetic or geometric averaging process and apply an unweighted, price weighted or market value weighted methodology to the chosen averaging process. So far our analysis has been restricted to unweighted, quantity weighted and value weighted arithmetic index numbers.

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Most equity indices take one of the three following forms: 1. Price weighted arithmetic indices. These are constructed on the assumption that an equal number of shares are held in each of the underlying index constituents. However, as these equal holdings are weighted according to each constituent’s share price, those constituents with a high share price relative to that of other constituents, have a greater influence on the index value. The index is calculated by summing the total of each constituent’s share price and comparing this total to that of the base period. Although such indices are difficult to justify and interpret, the most famous of these is the Dow Jones Industrial Average (DJIA). 2. Unweighted geometric indices. These establish the geometric mean of the index constituent price relatives between time periods. The geometric mean is the nth root of the product of n constituents, where n = the number of index constituents. One of the few remaining examples of this type of index is the FT Ordinary Share Index, or FT30. 3. Market value weighted arithmetic indices. These are calculated in the same way as the value index considered earlier, by weighting each constituent share price by the corresponding number of shares in issue in that period and comparing this total to that of the base period. Examples of this type of composite index include the FTSE 100 and S&P 500. However, the value of a market capitalisation index as a performance measurement benchmark can be compromised if those index constituents that make significantly less than 100% of their equity available to the market are accorded a full market value index weighting. Not only will the restricted supply of a particular stock prevent a portfolio manager from holding a full weighting of the stock within their portfolio but the price of the constituent will be distorted given the need for index tracker funds in particular to hold the stock in accordance with its index weighting. Most of the established market capitalisation weighted index providers, such as FTSE International, Stoxx and MSCI, have, therefore, introduced restrictions on the weightings of those constituent companies with less than 100% free float by adopting free float capitalisation weighted indices. The following example illustrates how each of these different methods of averaging and weighting measure the same event differently. Period

to t1 t2

Stock X

Stock Y

Stock Z

(800 shares in issue)

(100 shares in issue)

(100 shares in issue)

100p 90p 100p

100p 105p 0p

100p 120p 100p

Price weighted arithmetic index 100 105 66.67

Unweighted geometric index 100 104.28 0

Market value weighted arithmetic index 100 94.5 90

Assume each index begins with base value = 100 in t0. This base value, as before, has been arbitrarily chosen.

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In period t1, X’s share price has fallen from 100p to 90p, whilst Y and Z’s share prices have risen from 100p to 105p and 120p, respectively. The number of shares in issue for all three constituents remain the same as in period t0. The three indices are calculated as follows: 1. Price weighted arithmetic index = [Σpt1/Σpt0] x base index value, when p = share price and t = time period = [(90 + 105 + 120)/(100 + 100 + 100)] x 100 = 105 2. Unweighted geometric index = n√ [product of current share prices/product of base shares prices] x base index value, where n = number of index constituents = [(90 x 105 x 120)/(100 x 100 x 100)]1/3 x 100 = 104.28 3. Market value weighted arithmetic index = (Σpt1qt1)/(Σpt0qt0) x base index value, where q = number of shares each constituent has in issue = [[(90 x 800) + (105 x 100) + (120 x 100]/[(100 x 800) + (100 x 100) + (100 x 100)]] x 100 = 94.5

In period t2, the indices become: 1. Price weighted arithmetic index = [(100 + 0 + 100)/(100 + 100 + 100)] x 100 = 66.67 2. Unweighted geometric index = [(100 x 0 x 100)/(100 x 100 x 100)]1/3 x 100 = 0 3. Market value weighted arithmetic index = [[(100 x 800) + (0 x 100) + (100 x 100)]/[(100 x 800) + (100 x 100) + (100 x 100)]] x 100 = 90

Comparison of Index Averaging Methods 1. Price weighted arithmetic indices. Despite their ease of calculation, these indices are influenced solely by the relative share prices of their underlying constituents; favouring highly priced shares over lowly priced. By ignoring the number of shares each constituent has in issue, unlike market value weighted arithmetic indices, changes in the value of price weighted arithmetic indices are unrepresentative of how the value of their constituent shares would change within a real world portfolio. This is particularly prominent in period t1 when a fall in the share price of X and a rise in the share prices of Y and Z result in the price weighted arithmetic index rising and the market value weighted index falling and in period t2 when the share price of Y falling to zero causes the former index to exaggerate the event. Therefore, these indices are of limited use as market barometers and as performance measurement benchmarks. 2. Unweighted geometric indices. This type of index has two main drawbacks: a. It always understates the price rises and overstates the price falls of constituents relative to that of a price weighted arithmetic index. b. It collapses if the price of an index constituent falls to zero.

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Given these shortcomings, unweighted geometric indices should not be used for performance measurement purposes or as a guide to broad market movements. 3. Market value weighted arithmetic indices. These indices, although subject to significant data requirements and more complex calculations than their peers, replicate the precise effect changing share values would have on a portfolio comprising the same underlying index constituents weighted in accordance with their relative market capitalisations. Moreover, most, unlike many price weighted arithmetic and unweighted geometric indices, have a broad coverage of the market being represented. They are, therefore, the most suitable type of index to assess market trends, act as performance benchmarks, provide a basis for pricing index relate products and support research and asset allocation decisions.

Index Changes Changes to equity indices encompass: 1. Index rebasing, and 2. Constituent changes.

Index Rebasing When an index is rebased the following formula is applied: Rebased index value = original index value x new base index value/index value when index rebased So, if the period t0 base value of 100 for each of the above indices is rebased to 120, then the above index values will become:

Period to t1 t2

Price weighted arithmetic index 120 126 80

Unweighted geometric index 120 125.1 0

Market value weighted arithmetic index 120 113.4 108

Constituent Changes Most indices have set criteria as to when incumbent constituents should be replaced. However, if the index is to continue to convey the same information as before the constituent change, then its value must remain unaltered at the time of the adjustment. Period

to t1 t2

Stock X

Stock Y

Stock Z

(800 shares in issue)

(100 shares in issue)

(100 shares in issue)

Price weighted arithmetic index

Unweighted geometric index

100p 90p 100p

100p 105p 0p

100p 120p 100p

100 105 66.67

100 104.28 0

Market value weighted arithmetic index 100 94.5 90

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Take the price weighted arithmetic index value in period t1 of 105. If share X was to be replaced by share A with 200 shares in issue and a share price of 120p, then for the price weighted arithmetic index to maintain its value of 105, that is to prevent the index value rising to: [(120 + 105 + 120)/(100 + 100 + 100)] x 100 = 115, a new divisor, or denominator, must replace the Σpt0 denominator, as follows: Old divisor = former Σpt1/t1 index value = [(90 + 105 + 120)/105] = 3 New divisor = old divisor x (new Σpt1/former Σpt1) New divisor = 3 x [(120 + 105 + 120)/(90 + 105 + 120)] = 3.286 By dividing the total of the new share prices, by the new divisor of 3.286, the price weighted arithmetic index remains at 105: [(120 + 105 + 120)/3.286] = 105 Index values calculated from period t1 onwards, will, therefore, draw on the following formula: [Σptn/3.286] where Σptn is the sum of the constituent share prices in period n. A similar adjustment would be made to the unweighted geometric and market value weighted indices though that made to the unweighted geometric index is not as complex as the process described above.

1.3

The Main Equity Indices

LEARNING OBJECTIVES 10.1.1

Know the main features of the named indices (see the syllabus learning map at the back of this book for the full version of this learning objective)

10.1.2

Know why free float indices were introduced

FTSE International Equity Indices FTSE International Limited produce a range of free float capitalisation weighted indices, each of which have stringent entry criteria for the inclusion of constituents. The free float restrictions are graduated and apply to all constituents whose free floats are less than 75% of their market capitalisation. FTSE index

FTSE 100 FTSE 250 FTSE 350 FTSE SmallCap FTSE All Share FTSE Fledgling

320

Constituents

The 100 largest companies The next 250 largest companies FTSE 100 + FTSE 250 FTSE All Share - FTSE 350 FTSE 100 + FTSE 250 + FTSE SmallCap Those that do not meet the size criteria for the FTSE All Share

Approximate percentage of FTSE All Share index 80% 15% 95% 5% 100% 1.5%

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1. FTSE All Share index. The All Share index provides the broadest measure of UK equity market performance. Introduced in 1962 with a base, or starting, value of 100, the All Share index contains around 700 companies and represents about 98% of the capitalisation of the UK equity market. It is an amalgamation of the FTSE 100 and FTSE 250 indices, which together comprise the FTSE 350, and the FTSE SmallCap index of around 400 stocks. The FTSE 350 is further sub divided into a 175 high yield stocks index and a 175 low yield stocks index. The former acts as a proxy for the performance of value stocks and the latter for growth stocks. The All Share index is also segmented into 10 industry sub-sectors which themselves are divided into a further 34 key industry sectors by the FTSE Actuaries Industry Classification Committee. You can locate these sectors on the back page of the Companies and Markets section of the Financial Times. Outside of the All Share index is the FTSE Fledgling index, introduced in 1995, that contains those companies whose market capitalisation is insufficient to gain entry to the FTSE SmallCap index. These companies account for about 1.5% of UK stock market capitalisation. There are also specialist indices such as the FTSE All-Small index which is an amalgamation of the SmallCap and Fledgling indices, the FTSE AIM which covers those companies admitted the Alternative Investment Market (AIM) and the FTSE techMARK 100 and FTSE techMARK All Share indices which represent those companies from Fledgling to FTSE 100 committed to technological innovation. The All Share index, in common with the other FTSE indices, is only published as a capital return index. However, total return data on all FTSE indices is made available. The value of the All Share index is calculated at the end of each trading day as well as intraday on a minute-by-minute basis. 2. FTSE 100 index. The Footsie, as it is colloquially known, was introduced on 3 January 1984 with a base value of 1000 and is the most widely monitored barometer of UK equity market sentiment. Computed on a real time basis (every 15 seconds), the FTSE 100 index comprises the 100 largest publicly quoted companies in the UK, many of which are multinationals, and represents about 80% of the All Share index by market capitalisation. The composition of the index is reviewed at the end of each quarter. Any FTSE 100 company that has fallen in value to 110th place or below in the All Share index is automatically replaced by a FTSE 250 constituent. 3. FTSE 250 index. Introduced in 1992 but with a 1985 base value of 1412.60, the FTSE 250 comprises those 250 companies that by market capitalisation are positioned directly beneath the FTSE 100. Like the FTSE 100, the FTSE 250 is also calculated on a real time basis (every 15 seconds). FTSE 250 companies account for about 15% of the All Share index. 4. FTSE SmallCap index. The SmallCap index was introduced in 1992 with a base value of 1363.79 and comprises approximately 350 stocks. SmallCap index constituents are reviewed annually by the FTSE Equity Indices Committee in conjunction with the FTSE Fledgling index, in a similar fashion to that of the FTSE 100 and FTSE 250 quarterly reshuffle, though the criteria is a little more complicated. As a result there could be more or less than 400 companies in the SmallCap index in successive years. The index is calculated at the end of each trading day as well as intraday on a minute-by-minute basis. 5. FTSE4Good indices. As noted in Chapter 9, the FTSE4Good indices were introduced in July 2001 to provide a benchmark against which to judge the performance of ethical and SRI portfolios. There are four indices representing the UK, US, European and global equity markets each of which is based upon selected constituents of existing FTSE International indices. As the index constituents are screened by EIRIS, the indices veer towards the ethical end of the green investment spectrum. FTSE International, in conjunction with EIRIS, judges companies for inclusion in each of these indices against best practice in three areas: i. upholding and supporting universal human rights; ii. working towards environmental sustainability; iii. developing positive relations with shareholders and customers.

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6. FTSE All World index. The FTSE All World index was launched on 30 June 2000. It is a US$ denominated index that monitors the performance of over 2,200 stocks in the equity markets of 48 countries and attempts to cover up to 90% of the free float capitalisation of each equity market it monitors. The index also compiles regional indices, indices for economic groups and industry sectors. Like the domestic FTSE International indices, it has stringent entry criteria.

Other Prominent Equity Indices 1. MSCI World index. The Morgan Stanley Capital International (MSCI) World index is a global index covering 1,700 stocks from 23 developed countries representing about 85% of the free float capitalisation of each market. Like the FTSE World index, it also comprises a series of country, industry and economic group indices. It is denominated in US$ but is also calculated in the local currencies of the 23 equity markets covered. 2. Dow Jones Industrial Average (DJIA) index. Introduced in 1897 with 12 constituents at a base value of 40, this price weighted arithmetic index has, since the late 1920s, had 30 constituents. Although not suitable for benchmarking purposes because of the significant drawbacks in its calculation and its narrow representation of the US equity market, it nonetheless remains the most popular measure of US equity market performance. 3. Standard & Poors (S&P) 500 index. The S&P 500 index comprises 500 of the most widely held NYSE listed companies and represents about 80% of NYSE market capitalisation. This market capitalisation weighted index was rebased in 1941 at an index value of 10. 4. DAX 30 index. The DAX 30 index contains the largest 30 German stocks by market capitalisation. It is a real time index and is uniquely calculated inclusive of reinvested income. 5. CAC 40 index. The CAC 40 index comprises the 40 largest French companies by market capitalisation and is calculated on a real time basis. 6. Nikkei Dow indices. The Nikkei 225 index is a price weighted arithmetic index of 225 Japanese companies that are considered representative of the Japanese equity market. The index was introduced in 1949 with a base value of 176.21. The Nikkei 300, introduced in 1993, however, being a market capitalisation weighted index is more suitable than the Nikkei 225 to act as a benchmark for performance measurement purposes. 7. Hang Seng index. The Hang Seng index contains approximately 38 companies listed on the Hong Kong Stock Exchange. It is a capitalisation-weighted index. 8. All Ordinaries (‘All Ords’). This index contains more than 300 Australian companies and measures the share price movements on a daily basis. The companies in the index have a market capitalisation of around 95% of all shares listed on the Australian Stock Exchange.

Limitations of Equity Indices for Performance Measurement Purposes All equity indices suffer from the following limitations as a performance measurement benchmarks: 1. Most only measure the change in constituent capital values, or price movements, rather than including the reinvestment of dividend income to measure the change in total return. Although FTSE International take dividend income into account in their total return indices, it is assumed that dividend payments are reinvested on the xd date rather than on the date when the dividend is actually paid. 2. All assume that the investor is fully invested in the constituent equities at all times. 3. All fail to reflect the cost of setting up and administering a portfolio and the impact of taxation on subsequent returns.

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4. All suffer from survivorship bias. At any point in time an index only contains and reflects the performance of those constituents that continue to meet its criteria rather than those that have left the index perhaps as a result of a decline in fortunes, merger or acquisition, even though those shares that have left the index may remain in a real world portfolio. 5. The combination and weighting of constituents in most indices rarely result in a low covariance portfolio. This point was explored in Chapter 9.

1.4

Bond Indices

FTSE Actuaries Government Securities indices The FTSE Actuaries Government Securities indices were introduced in 1977 and comprise price and yield indices for conventional and index-linked gilts across different maturities. Each index is weighted according to the market value of each constituent stock and is calculated daily. Although each price index can be individually used for performance measurement, taken together these price indices form a broad measure of gilt market performance in the All Stocks index.

Citi World Government Bond index The Citi World Government Bond index can be used as a benchmark against which to monitor and evaluate portfolios of government bonds held in the major government bond markets.

Other Bond Indices Corporate bond indices are compiled by investment banks such as Merrill Lynch and Goldman Sachs.

1.5 Peer Group Average Benchmarks LEARNING OBJECTIVES 10.1.4

Know the alternative ways of benchmarking: • Peer group average (WM and CAPS)

Rather than use an established index to benchmark portfolio performance, a peer group average is often employed. Owing to the asset allocation by consensus methodology adopted by most top down institutional portfolio managers in the running of pension fund portfolios, extensive use is made of the standardised benchmarks provided by: i. The WM company (WM), and ii. The Combined Actuarial Performance Service (CAPS). WM and CAPS provide, what are known as, universe returns for the pension fund industry: a universe being defined by pension funds of a particular size. These universe returns are calculated quarterly, from survey evidence received from pension fund managers, on both a median and weighted average basis, usually within six to eight weeks after the quarter end. This time delay is due to the amount of performance data that must be collected in order to calculate these peer group performance averages. International Certificate in Investment Management

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Portfolios run for retail clients, however, in addition to the indices detailed above and those provided by the Association of Private Client Investment Managers and Stockbrokers (APCIMS), often use peer group performance figures provided by Micropal and Hindsight. The APCIMS private investor indices are constructed in conjunction with FTSE International. They comprise a growth, balanced and income index, each of which is designed to provide investors with a benchmark against which to measure the performance of their portfolios. Each index has its own unique percentage weighting in the FTSE All Share index, FTSE All-World ex-UK index (priced in sterling), FTSE Gilts (All Stocks) index and in cash, represented by seven-day LIBOR minus 1%. These percentage weightings are reviewed by APCIMS survey evidence every six months. Where peer group average benchmarks are used, whether for institutional or retail portfolios, clients will usually wish to see evidence of consistent above average performance and in many cases first quartile performance. Average in this context is typically taken to be the median. Performance measurement statistics within a defined universe are also usually categorised into deciles and percentiles. These were considered in Chapter 2.

Peer Group Averages Versus Indices i. Continuous data. Indices calculated on a real time basis provide continuous data for performance measurement purposes whereas peer group average benchmarks are only published periodically and not always in a timely fashion. ii. Transparency. For WM and CAPS universe performance data, only at the time of publishing the performance figures for each universe are the benchmark weights applied to the average pension fund in each universe known for the previous quarter. Moreover, these benchmark asset allocation weights are only provided in respect of broad investment regions. No individual country weights or sector weightings are given. The composition of an index, by contrast, is totally transparent and known at any point in time. iii. Chain linking. The performance of indices can be chain linked, or reconciled, over time whereas WM and CAPS median performance data cannot. iv. Survivorship bias. Both indices and peer group average benchmarks in general suffer from survivorship bias.

1.6 Global Investment Performance Standards (GIPS) LEARNING OBJECTIVES 10.1.4

Know the alternative ways of benchmarking: • GIPS (Global Investment Performance Standards)

GIPS are not a way of benchmarking performance but are performance standards, developed by the Society of Investment Professionals, that set out global guidelines for the standardisation of the calculation and presentation of performance figures. As such, they represent a great leap forward for the performance measurement industry.

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2. PERFORMANCE ATTRIBUTION 2.1

Total Return

LEARNING OBJECTIVES 10.2.1

Understand total return and its components

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.

2.2 Performance Attribution LEARNING OBJECTIVES 10.2.2

Be able to calculate the deviations from a performance benchmark attributable to: actual vs relative performance; asset allocation; stock selection

Performance attribution is used to decompose the results of top down active portfolio management. It involves: i. Comparing a portfolio manager’s performance against an agreed benchmark, and ii. Attributing the resulting outperformance or underperformance to: a. the degree of asset allocation skill, that is whether the portfolio manager has invested in the right asset classes and in the right geographical regions; and/or b. the degree of stock selection skill, that is having decided upon the asset allocation, has the portfolio manager invested in the right sectors and stocks? To determine a fund manager’s asset allocation skill, you need to apply the following formula for each asset class: (fund value at start of period x portfolio manager asset class weightings x benchmark asset class returns) minus (fund value at start of period x benchmark asset class weightings x benchmark asset class returns) This isolates that part of the return attributable to diligent asset allocation by comparing the portfolio manager’s exposure to asset classes and geographical areas to that of the benchmark and then multiplying this difference by the benchmark returns. 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. International Certificate in Investment Management

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Example (1) Fund value at start of period Fund value at end of period Asset allocation and returns during period Fund asset allocation Benchmark asset allocation Benchmark returns

= £20m = £18.75m Equities %

Gilts %

75 50 - 10

25 50 -5

Given the fund and benchmark statistics above, what is the absolute outperformance or underperformance of the fund relative to the benchmark? Solution (1) Absolute outperformance or underperformance: Benchmark at end of period = [0.5 x £20m x (1 - 0.1)] + [0.5 x £20m x (1 - 0.05)] = £18.5m Fund value at end of period = £18.75m Fund outperformance = £18.75m - £18.5m = £0.25m Example (2) Given the fund and benchmark statistics above, calculate the absolute outperformance or underperformance of the fund relative to the benchmark attributable to asset allocation. Solution (2) The contribution of asset allocation to fund returns is established by applying the following formula to both the fund’s equity and gilt weightings and to the benchmark returns: (fund value at start of period x portfolio manager asset class weightings x benchmark asset class returns) minus (fund value at start of period x benchmark asset class weightings x benchmark asset class returns) However, as the value of the benchmark at the end of the period is already known, then a quicker way of establishing the out or under performance due to asset allocation is to apply the following formula: [fund value at start of period x fund equity weighting x benchmark equity return] + [fund value at start of period x fund gilt weighting x benchmark gilt return] - benchmark at end of period Performance attributable to asset allocation = [£20m x 0.75 x (1 - 0.1)] + [£20m x 0.25 x (1 - 0.05)] - £18.5m = £(0.25m) Poor asset allocation has caused the fund to under perform the benchmark by £0.25m. Example (3) Given the fund and benchmark statistics above, calculate the absolute contribution to performance attributable to stock selection. Solution (3) The fund value at the end of the period is £18.75m whilst the fund value attributable to asset allocation is £18.25m. Therefore, good stock selection has added £0.5m to performance.

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}

The outcome of this performance attribution is summarised in the diagram below. FUND VALUE AT START OF YEAR

}

OUTPERFORMANCE DUE TO STOCK SELECTION

£20m

FUND VALUE AT END OF YEAR

£18.75m

BENCHMARK

£18.50m

£18.25m

} }

ABSOLUTE LOSS IN VALUE OF FUND

NET OUTPERFORMANCE OF FUND UNDERPERFORMANCE DUE TO ASSET ALLOCATION

Figure 1: Outcome of Performance Attribution Summary

3. PERFORMANCE MEASUREMENT 3.1

Introduction

Fund performance can be measured in a number of ways. The two most common are: 1. Money weighted rate of return (MWRR), and 2. Time weighted rate of return (TWRR).

3.2 Money Weighted Rate of Return (MWRR) LEARNING OBJECTIVES 10.3.1

Be able to calculate the money weighted rates of return (MWRR)

The MWRR is the internal rate of return (IRR) that equates the value of a portfolio at the start of an investment period plus the net new capital invested during the investment period with the value of the portfolio at the end of the period. The MWRR, therefore, measures the fund growth resulting from both the underlying performance of the portfolio and the size and timing of cashflows to and from the fund over the period.

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To establish the IRR, you must solve the following equation for r, the simple rate of interest: [(V0 + C0) (1 + 2r)] + C1(1 + r) + C2 = V2 where: V0 = value of the portfolio in period t0 including any cashflow (C0) received in period t0 C1 = value of the cashflow received in period t1 C2 = value of the cashflow received in period t2 V2 = value of the portfolio in period t2 including any cash flow (C2) received in period t2. V0 + C0 is invested for two periods, hence (1 + 2r), whilst C1 is only invested for one period, hence (1+ r).

3.3 Time Weighted Rate of Return (TWRR) LEARNING OBJECTIVES 10.3.2

Be able to calculate the time weighted rates of return (TWRR)

As the distorting effects that cashflows have on portfolio performance are beyond the control of the portfolio manager, it makes sense to adopt a performance measure that eliminates them. This is exactly what the TWRR does. 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 cashflow. 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. The TWRR is given by the following formula: R = [(V1/(V0 + C0)) x (V2/(V1 + C1))]1/n - 1, where: V0 = value of the portfolio in period t0 before the receipt of cashflow C0 C0 = value of the cash flow, if any, received at the start of the period V1 = value of the portfolio immediately before the receipt of cashflow C1 in period t1 C1 = value of the cashflow received in period t1 V2 = value of the portfolio immediately before the receipt of any cashflow C2 in period t2 n = number of sub periods You may recognise the TWRR formula as being similar to that used in Chapter 2 to calculate an annual compound rate of growth or geometric mean.

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Example Time period t0 t1 t2

Portfolio value 10 20 30

Cash inflow 6 4 1

Calculate the money weighted rate of return (MWRR) and the time weighted rate of return (TWRR) for the above portfolio. Solution To obtain MWRR, solve for r. So, if 16 (1+2r) + 4 (1+r) + 1 = 31, then r = 27.8% TWRR = (20/16 x 30/24)1/2 -1 = 25% You will notice that the cash inflow C0 of six received in period t0 increases the initial portfolio value for both equations from 10 to 16. By contrast, cashflow C2 received by the portfolio in period t2, is treated differently by each of the two performance measures. Whereas both sides of the MWRR equation are increased by C2, the TWRR equation ignores the cashflow. Instead C2 will simply increase the TWRR portfolio starting value from 30 to 31 for the next investment period.

MWRR versus TWRR The data requirements, calculation differences and the interpretation of the MWRR and TWRR are summarised below.

Data requirements

Calculation differences

Interpreting the data

Money weighted rate of return Portfolio values at start and end of period Date and size of each capital cashflow Fund growth resulting from fund performance and size and timing of cashflows Not suitable for inter-fund performance comparisons

Time weighted rate of return Portfolio value immediately before each new cashflow Date and size of each capital cashflow Unitised fund performance unaffected by the size and timing of cashflows as equal weight placed upon each sub period rate of return Suitable for collective investment fund performance measurement

Example Why is the use of a time weighted rate of return (TWRR) preferable to using a money weighted rate of return (MWRR) when comparing the performance of two open ended investment companies (OEICs) over a period of time? Solution TWRRs calculate unitised fund performance rather than measure fund growth by eliminating the distorting timing effect of cashflows on portfolio performance and by placing equal weight on the size of cashflows to and from the portfolio and on the rates of return achieved in each sub period. Therefore, fund performance can be compared on a like-for-like basis. International Certificate in Investment Management

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3.4 Calculating Risk Adjusted Returns for Equity Portfolios LEARNING OBJECTIVES 10.3.3

Be able to calculate the risk-adjusted returns for equities: Sharpe; Treyno; Jensen

Having calculated a portfolio’s rate of return it makes intuitive sense to evaluate this performance on a risk-adjusted basis, given the various links between risk and return that have been established in Chapters 2 and 9. The risk-adjusted performance of actively managed equity portfolios can be evaluated using: 1. The Sharpe ratio. 2. The Treynor ratio. 3. The Jensen measure.

The Sharpe Ratio The Sharpe ratio = (Rp - Rf)/σp 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 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 Treynor Ratio The Treynor ratio = (Rp - Rf)/βp The Treynor ratio takes a similar approach to the Sharpe ratio but is calculated for a well diversified equity portfolio. As the portfolio’s return would have been generated only by the systemic risk it had assumed, the Treynor ratio, therefore, divides the portfolio’s return over and above the risk free interest rate by its CAPM beta. Once again, the higher the ratio, the greater the implied level of active management skill. Example (1) If an equity portfolio returns 15% given a beta of 1.2 and a standard deviation of 18% whilst the risk free rate of interest is 5%, calculate the: i. Sharpe ratio. ii. Treynor ratio. Solution (1) The Sharpe ratio = (Rp - Rf)/σp = 15 - 5/18 = 0.56

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The Treynor ratio = (Rp - Rf)/βp = 15 - 5/1.2 = 8.33 Example (2) Assuming the above portfolio is well diversified and a competing portfolio has a Sharpe ratio of 0.64 and a Treynor ratio of 7.33, which of the two portfolios has been better managed? Solution (2) As the appropriate measure of risk-adjusted returns for a well diversified portfolio is the Treynor ratio, the higher Treynor ratio of the original portfolio implies a superior risk-adjusted return. The 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 systematic risk as that assumed by the portfolio. That is, the CAPM benchmark beta is the same as that of the portfolio (bp). The Jensen measure = Rp - [Rf + βp(Rm - Rf)] 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 out or under performed the benchmark and is, therefore, positioned above or below the SML, respectively. The extent of any out or under performance is known as the portfolio’s alpha. 3.5 Calculating risk adjusted returns for bond portfolios Having considered the evaluation of risk-adjusted equity portfolio returns, we now turn briefly to the evaluation of risk-adjusted returns from bond portfolios. The simplest way of measuring the risk-adjusted performance of a bond portfolio is by dividing its return over and above the risk free interest rate by its duration relative to that of the broader bond market. This is summarised by the following formula: (Rp - Rf)/(durationp/durationm), where Rp is the return on the portfolio Rf is the risk free rate of return durationp is the Macaulay duration of the portfolio durationm is the Macaulay duration of the bond market.

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APPENDIX

1. 2. 2.

REGRESSION, CORRELATION AND COVARIANCE DATA FOR REGRESSION, CORRELATION AND COVARIANCE CALCULATIONS STANDARD DEVIATION CALCULATION FOR X AND Y

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1. REGRESSION, CORRELATION AND COVARIANCE The following observations were made on X (independent variable) and Y (dependent variable): X Y

0 2

1 3

2 6

3 8

4 9

5 11

1. Establish the equation that underlies the regression line (line of best fit) 2. Calculate the correlation coefficient between X and Y (ρXY) 3. Calculate the covariance of X and Y (covXY)

2. DATA FOR REGRESSION, CORRELATION AND COVARIANCE CALCULATIONS X

Y

0 1 2 3 4 5 ΣX=15 n=6 X=15/6 =2.5

2 3 6 8 9 11 ΣY=39 n=6 Y=39/6 =6.5

(X-X) -2.5 -1.5 -0.5 0.5 1.5 2.5 Σ(X-X)=0

(Y-Y) -4.5 -3.5 -0.5 1.5 2.5 4.5 Σ(Y-Y)=0

(X-X)(Y-Y) 11.25 5.25 0.25 0.75 3.75 11.25 Σ(X-X)(Y-Y) =32.5

X2

Y2 0 4 1 9 4 36 9 64 16 81 25 121 ΣX2=55 ΣY2=315

XY 0 3 12 24 36 55 ΣXY=130

1. The line of best fit is given by the equation: Y = a+bX where b = (nΣXY)-(ΣY)(ΣY) = (6 x 130)-(15 x 39) = 195 = 1.86 (6 x 55) - 152 105 (nΣX2) - (ΣX)2 and a = Y - bX = 6.5 - (1.86 x 2.5) = 1.85 So, Y = 1.85 + 1.86X This can be shown graphically: Y (dependent variable) Y = 11.15 12 11 10 9 8 7 6 5 4 3 2

Y = 1.85

1 0 0

1

2

3

4

5

6

7

8

9

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You will notice that the regression line intersects the y-axis at Y=1.85 even though it has been observed that when X=0, Y=2. This is because the line of best fit takes into account each observation, not just the extreme observations, when determining the minimum square of each of the vertical distances of these observations from the unique straight line. 2. The correlation coefficient between X and Y (PXY) PXY =

=

(nΣXY) - (ΣX)(ΣY) √[(nΣX2)-(ΣX)2][(nΣY2)-(ΣY)2] (6 x 130) - (15 x 39) √[(6 x 55) - 152] x [(6x315) - 392

= 195 = 0.99 196.8

There is almost a perfectly positive correlation between X and Y. 3. The covariance of X and Y(covXY): covXY = Σ(X-X)(Y-Y) = 32.5 = 5.42 n 6 This small positive covariance indicates that X and Y have moved in the same direction, as confirmed by their positive correlation, but due to both X and Y having low standard deviations relative to their respective means, their historic joint movements are small. This is demonstrated by the following equation: covXY = ρXYXσXXσY

5.42 = 0.99 x 1.71 x 3.2

3. STANDARD DEVIATION CALCULATION FOR X AND Y (X-X) -2.5 -1.5 -0.5 0.5 1.5 2.5 Σ(X-X)=0

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(X-X) 2 6.25 2.25 0.25 0.25 2.25 6.25 Σ(X-X) 2=17.5 σX2=17.5 /6=2.92 σX=√2.92=1.71

(Y-Y) -4.5 -3.5 -0.5 1.5 2.5 4.5 Σ(Y-Y)=0

(Y-Y) 2 20.25 12.25 0.25 2.25 6.25 20.25 Σ(Y-Y) 2=61.5 σY2=61.5 /6=10.25 σY=√10.25=3.2

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S N O TI IA EV BR AB

GLOSSARY Active management An investment approach employed to exploit pricing anomalies in those securities markets that are believed to be subject to mispricing by utilising fundamental and/or technical analysis to assist in the forecasting of future events and the timing of purchases and sales of securities. Also known as Market Timing. Active Risk The risk that arises from holding securities in an actively managed portfolio in different proportions to their weighting in a benchmark index. Also known as Tracking Error. Aggregate demand The total demand for goods and services within an economy. Aggregate supply The amount of output firms are prepared to supply in aggregate at each general price level in an economy, assuming the price of inputs to the production process are fixed, in order to meet aggregate demand. Alpha The return from a security or a portfolio in excess of a risk adjusted benchmark return. Also known as Jensen’s Alpha. Alternative Investment Alternative investments are those which fall outside the traditional asset classes of equities, property, fixed interest, cash and money market instruments. Alternative investments are often physical assets which tend to be popular with collectors. Alternative Investment Market (AIM) The London Stock Exchange’s (LSE) market for smaller UK public limited companies (plcs). AIM has less demanding admission requirements and places less onerous continuing obligation requirements upon those companies admitted to the market than those applying for a full list on the LSE. Amortisation The depreciation charge applied in company accounts against capitalised intangible assets. Annual equivalent rate (AER) See Effective Rate. Annual general meeting (AGM) The annual meeting of directors and ordinary shareholders of a company. All companies are obliged to hold an AGM at which the shareholders receive the company’s report and accounts and have the opportunity to vote on the appointment of the company’s directors and auditors and the payment of a final dividend recommended by the directors. Annuity An investment that provides a series of prespecified periodic payments over a specific term or until the occurrence of a prespecified event, eg death.

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Arbitrage The process of deriving a risk-free profit by simultaneously buying and selling the same asset in two related markets where a pricing anomaly exists. Arithmetic mean A measure of central tendency established by summing the observed values in a data distribution and dividing this sum by the number of observations. The arithmetic mean takes account of every value in the distribution. Articles of association The legal document which sets out the internal constitution of a company. Included within the articles will be details of shareholder voting rights and company borrowing powers. Asset allocation The process of investing an international portfolio’s assets geographically and between asset classes before deciding upon sector and stock selection. Association of British Insurers (ABI) The trade body that represents the interests of the UK insurance industry. Association of Investment Trust Companies (AITC) The trade body that exists to further the interests of the UK investment trust industry. Association of Private Client Investment Managers and Stockbrokers (APCIMS) The trade association that represents stockbrokers’ interests. Backwardation When the futures price stands at a discount to the price of the underlying asset. Balance of payments A summary of all economic transactions between one country and the rest of the world typically conducted over a calendar year. Base currency The currency against which the value of the quoted currency is expressed. The base currency would be currency X for the X/Y exchange rate. Basis The difference between the futures price and the price of the underlying asset. Bear market Conventionally defined as a 20%+ decline in a securities market. The duration of the market move is immaterial.

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Bearer securities Those whose ownership is evidenced by the mere possession of a certificate. Ownership can, therefore, pass from hand to hand without any formalities. Beneficiaries The beneficial owners of trust property. Beta The covariance between the returns from a security and those of the market relative to the variance of returns from the market. Bond See Fixed Interest Security. Bonus issue The free issue of new ordinary shares to a company’s ordinary shareholders in proportion to their existing shareholdings through the conversion, or capitalisation, of the company’s reserves. By proportionately reducing the market value of each existing share, a bonus issue makes the shares more marketable. Also known as a Capitalisation Issue or Scrip Issue. British Venture Capital Association (BVCA) The trade association that represents all principal sources of private and venture capital in the UK. Broker dealer A London Stock Exchange (LSE) member firm that can act in a dual capacity both as a broker acting on behalf of clients and as a dealer dealing in securities on their own account. Bull market A rising securities market. The duration of the market move is immaterial. Business cycle See Economic Cycle. Call option An option that confers a right on the holder to buy a specified amount of an asset at a prespecified price on or sometimes before a prespecified date. CapitALisation Issue See Bonus Issue. Central bank Those public institutions that operate at the heart of a nation’s financial system. Central banks typically have responsibility for setting a nation’s or a region’s short term interest rate, controlling the money supply, acting as banker and lender of last resort to the banking system and managing the national debt. They increasingly implement their policies independently of government control. The Bank of England is the UK’s central bank. Certificate of Deposit (CD) Negotiable bearer securities issued by commercial banks in exchange for fixed term deposits. International Certificate in Investment Management

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Ceteris paribus Other things being equal. In economics, the ceteris paribus caveat is used when considering the impact of a change in one factor or variable on another variable, market or the economy as a whole, holding all other factors constant. Clean price The quoted price of a Gilt. The clean price excludes accrued interest or interest to be deducted, as appropriate. Closing out The process of terminating an open position in a derivatives contract by entering into an equal and opposite transaction to that originally undertaken. Code of best practice See Combined Code. Combinations A strategy requiring the simultaneous purchase or sale of both a call and a put option on the same underlying asset, sometimes with different exercise prices but always with the same expiry dates. Combinations include straddles and strangles. Combined Code The code that embodies best corporate governance practice for all public limited companies (plcs) quoted on the London Stock Exchange (LSE). Also known as the Code of Best Practice. Commercial Paper (CP) Unsecured bearer securities issued at a discount to par by public limited companies (plcs) with a full listing on the London Stock Exchange (LSE). Commercial Paper does not pay coupons but is redeemed at par. Competition Commission The body to which a merger or takeover is referred for investigation by the Secretary of State for Trade and Industry in order to establish whether the combined entity would work against the public interest or would prove to be anti-competitive. Complement A good is a complement for another if a rise in the price of one results in a decrease in demand for the other. Complementary goods are typically purchased in conjunction with one another. Consumer Prices Index (CPI) Geometrically weighted inflation index targetted by the Monetary Policy Committee.

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Contango When the futures price stands at a premium to the price of the underlying asset. Continuous data Where numbers in a data series can assume any value. Convertible bonds Bonds issued with a right to convert into either another of the issuer’s bonds or, if issued by a company, the company’s equity, both on prespecified terms. Convertible loan stock Bonds issued with a right to convert into the issuing company’s equity on prespecified terms. Convertible preference shares Preference shares issued with a right to convert into the issuing company’s equity on prespecified terms. Convexity The non-symmetrical relationship that exists between a bond’s price and its yield. The more convex the bond, the greater the price rise for a fall in its yield and the smaller the price fall for a rise in its yield. Also see Modified Duration. Corporate governance The mechanism that seeks to ensure that companies are run in the best long term interests of their shareholders. Also see Combined Code. Correlation The degree of co-movement between two variables determined through regression analysis and quantified by the correlation coefficient. Correlation does not prove that a cause-and-effect or, indeed, a steady relationship exists between two variables as correlations can arise from pure chance. Coupon The predetermined rate of interest applying to a bond over its term expressed as a percentage of the bond’s nominal, or par, value. The coupon is usually a fixed rate of interest. Covariance The correlation coefficient between two variables multiplied by their individual standard deviations. Cross elasticity of demand (XED) The effect of a small percentage change in the price of a complement or substitute good on a complement or substitute. Discounted cash flow (DCF) yield See Internal Rate of Return (IRR). Deadweight loss A measure of the inefficient allocation of resources that results from a monopoly restricting output and raising price to maximise profit.

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Debenture A corporate bond issued in the domestic bond market and secured on the issuing company’s assets by way of a fixed or a floating charge. Demand curve The depiction of the quantity of a particular good or service consumers will buy at a given price. Plotted against price on the vertical axis and quantity on the horizontal axis, a demand curve slopes downward from left to right. Depreciation The charge applied in a company’s accounts against its tangible fixed assets to reflect the usage of these assets over the accounting period. Derivative An instrument whose value is based on the price of an underlying asset. Derivatives can be based on both financial and commodity assets. Dirty price The price of a Gilt inclusive of accrued interest or exclusive of interest to be deducted, as appropriate. Discount The difference in the Spot and Forward Exchange Rate that arises when interest rates in the quoted currency are higher than those in the base currency. Discount rate The rate of interest used to establish the present value of a sum of money receivable in the future. Discrete data Where numbers in a data series are restricted to specific values. Dividend The distribution of a proportion of a company’s distributable profit to its shareholders. Dividends are usually paid twice a year and are expressed in pence per share. Dow Jones Industrial Average (DJIA) A price weighted arithmetic index of 30 actively traded, and mainly industrial, US stocks. Duration The weighted average time, expressed in years, for the present value of a bond’s cash flows to be received. Also known as Macaulay Duration. Economic cycle The course an economy conventionally takes as economic growth fluctuates over time. Also known as the Business Cycle. Economic growth The growth of GDP or GNP expressed in real terms usually over the course of a calendar year. Often used as a barometer of an economy’s health.

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Economies of scale The resulting reduction in a firm’s unit costs as the firm’s productive capacity and output increases. Economies of scale are maximised and unit costs minimised at the Minimum Efficient Scale (MES) on a firm’s long term average total cost (LTATC) curve. Beyond this point diseconomies of scale set in. Effective rate The annualised compound rate of interest applied to a cash deposit. Also known as the Annual Equivalent Rate (AER). Efficient frontier A convex curve used in Modern Portfolio Theory that represents those efficient portfolios that offer the maximum expected return for any given level of risk. Efficient Markets Hypothesis (EMH) The proposition that everything that is publicly known about a particular stock or market should be instantaneously reflect in its price. As a result of active portfolio managers and other investment professionals exhaustively researching those securities traded in developed markets, the EMH argues that share prices move randomly and independently of past trends, in response to fresh information, which itself is released at random. Equilibrium A condition that describes a market in perfect balance, where demand is equal to supply. Equity That which confers a direct stake in a company’s fortunes. Also known as a company’s ordinary share capital. Eurobond International bond issues denominated in a currency different from that of the financial centre(s) in which they are issued. Most Eurobonds are issued in bearer form through bank syndicates. Euronext The Paris, Amsterdam and Brussels stock and derivatives exchange. European Monetary Union (EMU) The creation of a single European currency, the euro, and the European Central Bank (ECB), which sets monetary policy across the eurozone. Currently, 12 of the European Union’s (EU) 25 members participate in EMU. Exchange rate The price of one currency in terms of another. Ex-dividend (xd) The period during which the purchase of shares or bonds (on which a Dividend or Coupon payment has been declared) does not entitle the new holder to this next dividend or interest payment.

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Exercise price The price at which the right conferred by an Option can be exercised by the holder against the writer. Expectations theory The proposition that the difference between short and long term interest rates can be explained by the course short term interest rates are expected to take over time. Ex-rights (xr) The period during which the purchase of a company’s shares does not entitle the new shareholder to participate in a rights issue announced by the issuing company. Shares are usually traded ex-rights (xr) on or within a few days of the company making the rights issue announcement. Extraordinary General Meeting (EGM) A company meeting, other than an AGM, at which matters that urgently require a special resolution are put to the company’s shareholders. Fair value The theoretical price of a futures contract. Financial gearing The ratio of debt to equity employed by a company within its capital structure. Financial Services Authority (FSA) The UK regulator for financial services created by FSMA 2000. Fiscal policy The use of government spending, taxation and borrowing policies to either boost or restrain domestic demand in the economy so as to maintain full employment and price stability. Also known as Stabilisation Policy. Fixed interest security A tradeable 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. Flat rate The annual simple rate of interest applied to a cash deposit. Flat yield See Running Yield. Flight to quality The movement of capital to a safe haven during periods of market turmoil to avoid capital loss. Floating Rate Notes (FRNs) Debt securities issued with a coupon periodically referenced to a benchmark interest rate.

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Forward 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. Forward exchange rate An exchange rate set today, embodied in a forward contract, that will apply to a foreign exchange transaction at some pre-specified point in the future. Forward rate The implied annual compound rate of interest that links one spot rate to another assuming no interest payments are made over the investment period. Fractional reserve banking See Reserve Ratio. Frequency distribution Data either presented in tabulated form or diagrammatically, whether in ascending or descending order, where the observed frequency of occurrence is assigned to either individual values or groups of values within the distribution. Full employment level of output See Potential Output Level. Full listing Those public limited companies (plcs) admitted to the London Stock Exchange’s (LSE) official list. Companies seeking a full listing on the LSE must satisfy the UK Listing Authority’s (UKLA) stringent listing requirements and continuing obligations once listed. Fund of Funds A fund of funds is a multi-manager fund. It has one overall manager that invests in a portfolio of other existing investment funds and seeks to harness the best investment manager talent available within a diversified portfolio. Fund Managers Association (FMA) See Investment Managers Association (IMA). Fundamental analysis The calculation and interpretation of yields, ratios and discounted cash flows (DCFs) that seek to establish the intrinsic value of a security or the correct valuation of the broader market. The use of fundamental analysis is nullified by the semi-strong form of the Efficient Markets Hypothesis (EMH). Future 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. Futures contracts differ from forward contracts in that their contract specification is standardised so that they may be traded on a derivatives exchange. Future value The accumulated value of a sum of money invested today at a known rate of interest over a specific term. International Certificate in Investment Management

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Geometric mean A measure of central tendency established by taking the nth root of the product (multiplication) of n values. Geometric progression The product (multiplication) of n values. Gilts UK government securities issued primarily to finance government borrowing. See also Public Sector Net Cash Requirement (PSNCR). Gross domestic product (GDP) A measure of the level of activity within an economy. More precisely, GDP is the total market value of all final goods and services produced domestically in an economy typically during a calendar year. Gross national product (GNP) GDP at market prices plus net property income generated from overseas economies by UK factors of production. Gross redemption yield (GRY) The annual compound return from holding a bond to maturity taking into account both interest payments and any capital gain or loss at maturity. Also known as the Yield to Maturity (YTM). Hedging A technique employed to reduce the impact of adverse price movements in financial assets held. Immunisation Passive bond management techniques that comprise cash matching and duration based immunisation. Income elasticity of demand (YED) The effect of a small percentage change in income on the quantity of a good demanded. Index A single number that summarises the collective movement of certain variables at a point in time in relation to their average value on a base date or a single variable in relation to its base date value. Index linked gilts (ILGs) Gilts whose principal and interest payments are linked to the Retail Price Index (RPI) with an eight month time lag. Inflation The rate of change in the general price level or the erosion in the purchasing power of money. Inflation risk premium (IRP) The additional return demanded by bond investors based on the volatility of inflation in the recent past.

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Initial margin The collateral deposited by exchange clearing members with the clearing house when opening certain derivative transactions. Initial public offering (IPO) See New Issue. Interest rate parity The mathematical relationship that exists between the Spot and Forward Exchange Rate for two currencies. This is given by the differential between their respective nominal interest rates over the term being considered. Internal rate of return (IRR) The discount rate that when applied to a series of cash flows produces a net present value (NPV) of zero. Also known as the DCF Yield. International Fisher Effect The proposition that in a world of perfect capital mobility nominal interest rates should take full account of expected inflation rates so that real interest rates are equal worldwide. International Organisation of Securities Commissions (IOSCO) IOSCO aims to establish high regulatory standards across the world for the securities industry. The membership of this organisaction collectively regulates 90% of the worlds’s securities markets. Interpolation A method by which to establish an approximate Internal Rate of Return (IRR). Irredeemable security A security issued without a pre-specified redemption, or maturity, date. Issuing house An institution that facilitates the issue of securities. Japan Financial Services Agency (JFSA) The Financial Services Agency is a government regulator that is responsible for ensuring the stability of the Japanese financial services market. Jensen’s alpha See Alpha. Keynesians Those economists who believe that markets are slow to self correct and, therefore, advocate the use of fiscal policy to return the economy back to a full employment level of output. Kondratieff cycles Long term economic cycles of 50 years+ duration that result from innovation and investment in new technology.

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Liquidity The ease with which a security can be converted into cash. Liquidity is determined by the amount of two-way trade conducted in a security. Liquidity also describes that amount of an investor’s financial resources held in cash. Liquidity preference theory The proposition that investors have a natural preference for short term investments and, therefore, demand a liquidity premium in the form of a higher return the longer the term of the investment. Loan stock A corporate bond issued in the domestic bond market without any underlying collateral, or security. London Clearing House (LCH) The institution that clears and acts as central counterparty to all trades executed on member exchanges. London Interbank Offered Rate (LIBOR) A benchmark money market interest rate. London International Financial Futures and Options Exchange (euronext.liffe) The UK’s principal derivatives exchange for trading financial and soft commodity derivatives products. Since it was purchased by Euronext, LIFFE is commonly referred to as euronext.liffe. London Stock Exchange (LSE) The UK market for listing and trading domestic and international securities. Long position The position following the purchase of a security or buying a derivative. Macaulay duration See Duration. Macroeconomics The study of how the aggregation of decisions taken in individual markets determine variables such as national income, employment and inflation. Macroeconomics is also concerned with explaining the relationship between these variables, their rates of change over time and the impact of monetary and fiscal policy on the general level of economic activity. Manager of Managers Fund A manager of managers fund is a multi-manager fund. It does not invest in other existing retail collective investment schemes. Instead it entails the MoM fund arranging segregated mandates with individually chosen fund managers. Margin See Initial Margin and Variation Margin. Marginal cost (MC) The change in a firm’s total cost resulting from producing one additional unit of output.

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Marginal revenue (MR) The change in the total revenue generated by a firm from the sale of one additional unit of output. Market capitalisation The total market value of a company’s shares or other securities in issue. Market capitalisation is calculated by multiplying the number of shares or other securities a company has in issue by the market price of those shares or securities. Market segmentation The proposition that each bond market can be divided up into distinct segments based upon term to maturity with each segment operating as if it is a separate bond market operating independently of interest rate expectations. Market timing See Active Management. Marking to market The process of valuing a position taken in a securities or a derivatives market. Mean-variance analysis The use of past investment returns to predict the investment’s most likely future return and to quantify the risk attached to this expected return. Mean variance analysis underpins Modern Portfolio Theory (MPT). Median A measure of central tendency established by the middle value within an ordered distribution containing an odd number of observed values or the arithmetic mean of the middle two values in an ordered distribution containing an even number of values. Member firm A firm that is a member of a Stock Exchange or clearing house. Microeconomics Microeconomics is principally concerned with analysing the allocation of scarce resources within an economic system. That is, microeconomics is the study of the decisions made by individuals and firms in particular markets and how these interactions determine the relative prices and quantities of factors of production, goods and services demanded and supplied. Minimum Efficient Scale (MES) The level of production at which a firm’s long run average production costs are minimised and its economies of scale are maximised. Mode A measure of central tendency established by the value or values that occur most frequently within a data distribution. Modern Portfolio Theory (MPT) The proposition that investors will only choose to hold those diversified, or efficient, portfolios that lie on the efficient frontier.

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Modified duration (MD) A measure of the sensitivity of a bond’s price to changes in its yield. Modified duration approximates a bond’s convexity. Monetarists Those economists who believe that markets are self correcting, that the level of economic activity can be regulated by controlling the money supply and that fiscal policy is ineffective and possibly harmful as a macroeconomic policy tool. Also known as New Classical Economists. Monetary policy The setting of short term interest rates by a central bank in order to manage domestic demand and achieve price stability in the economy. Monetary policy is also known as Stabilisation Policy. Money Anything that is generally acceptable as a means of settling a debt. Money weighted rate of return (MWRR) The internal rate of return (IRR) that equates the value of a portfolio at the start of an investment period plus the net new capital invested during the investment period with the value of the portfolio at the end of this period. The MWRR, therefore, measures the fund growth resulting from both the underlying performance of the portfolio and the size and timing of cash flows to and from the fund over this period. Multi-Manager Funds A fund that offers a portfolio of separately managed funds. There are two main types: fund-of-funds and manager of managers. Multiplier The factor by which national income changes as a result of a unit change in aggregate demand. Myners Report The report commissioned by the UK government in November 2000 which comprehensively reviewed institutional investment in the UK. The report was formally entitled Institutional Investment in the UK: A Review. NASDAQ The second largest Stock Exchange in the US. NASDAQ lists certain US and international stocks and provides a screen based quote driven secondary market that links buyers and sellers worldwide. NASDAQ also operates a stock exchange in Europe (Nasdaq Europe). National Association of Pension Funds (NAPF) The trade body that represents the interests of the occupational pension scheme industry. National debt A government’s total outstanding borrowing resulting from financing successive budget deficits, mainly through the issue of government backed securities. Negotiable security A security whose ownership can pass freely from one party to another. Negotiable securities are, therefore, tradeable.

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Net present value (NPV) The result of subtracting the discounted, or present, value of a project’s expected cash outflows from the present value of its expected cash inflows. Net redemption yield (NRY) The annual compound return from holding a bond to maturity taking account of both the coupon payments net of income tax and the capital gain or loss to maturity. New Classical Economists See Monetarists. New issue A new issue of ordinary shares whether made by an offer for sale, an offer for subscription or a placing. Also known as an Initial Public Offering (IPO). New paradigm The term applied to an economy that can produce robust economic growth without accompanying inflation through the employment of productivity enhancing new technology. Nominal value The face or par value of a security. The nominal value is the price at which a bond is issued and usually redeemed and the price below which a company’s ordinary shares cannot be issued. Non-accelerating inflation rate of unemployment (NAIRU) That level of unemployment that is consistent with a stable inflation rate. Also known as the natural rate of unemployment or the vertical long run Phillip’s curve. Normal distribution A distribution whose values are evenly, or symmetrically, distributed about the arithmetic mean. Depicted graphically, a normal distribution is plotted as a symmetrical, continuous, bell shaped curve. Normal profit The required rate of return for a firm to remain in business taking account of all opportunity costs. OFEX A market for unquoted companies in the early stages of development. OFEX is short for off exchange. Opportunity cost The cost of foregoing the next best alternative course of action. In economics, costs are defined not as financial but as opportunity costs. Option A derivatives contract that confers the right from one party (the writer) to another (the holder) to either buy (call option) or sell (put option) an asset at a pre-specified price on, and sometimes before, a pre-specified future date, in exchange for the payment of a premium. Ordinary shares See Equity.

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Over-the-counter (OTC) derivatives Derivatives that are not traded on a derivatives exchange owing to their non-standardised contract specifications. Par value See Nominal Value. Pari passu Of equal ranking. New Ordinary Shares issued under a rights issue, for instance, rank pari passu with the company’s existing Ordinary Shares. Passive management An investment approach employed in those securities markets that are believed to be price efficient. The term also extends to passive bond management techniques collectively known as Immunisation. Permanent Interest Bearing Securities (PIBS) Irredeemable Fixed Interest Securities issued by mutual building societies. Known as Perpetual Subordinated Bonds (PSBs) if the building society demutualises. Perpetual Subordinated Bonds (PSBs) See Permanent Interest Bearing Securities (PIBS). Perpetuities An investment that provides an indefinite stream of equal prespecified periodic payments. Population A statistical term applied to a particular group where every member or constituent of the group is included. Portfolio Theory See Modern Portfolio Theory (MPT). Potential output level The sustainable level of output produced by an economy when all of its resources are productively employed. Also known as the Full Employment Level of Output. Pre-emption rights The rights accorded to ordinary shareholders under company law to subscribe for new ordinary shares issued by the company, in which they have the shareholding, for cash before the shares are offered to outside investors. Preference shares Those shares issued by a company that rank ahead of ordinary shares for the payment of dividends and for capital repayment in the event of the company going into liquidation. Premium The amount of cash paid by the holder of an option to the writer in exchange for conferring a right. Also the difference in the spot and forward exchange rate that arises when interest rates in the base currency are higher than those in the quoted currency.

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Present value The value of a sum of money receivable at a known future date expressed in terms of its value today. A present value is obtained by discounting the future sum by a known rate of interest. Price elasticity of demand (PED) The effect of a small percentage change in the price of a good on the quantity of the good demanded. PED is expressed as a figure between zero and infinity. Prima facie At first sight. For instance, a portfolio’s past performance provides prima facie evidence of a portfolio manager’s skill and investment style. Primary data Data commissioned for a specific purpose. Primary market The market for New Issues or Initial Public Offerings (IPOs). Production Possibility Frontier (PPF) The PPF depicts all feasible combinations of output that can be produced within an economy given the limit of its resources and production techniques. Provisional allotment letter That which is sent to those shareholders who are entitled to participate in a rights issue. The letter details the shareholder’s existing shareholding, their rights over the new shares allotted and the date(s) by which they must act. Public Sector Net Cash Requirement (PSNCR) The extent to which the UK government needs to borrow, mainly through the issue of government backed securities, to finance a budget deficit as a result of its spending exceeding tax revenue for the fiscal year. Pull to maturity A term used to explain why the price of short dated bonds are less affected by interest rate changes than that of long dated bonds. Purchasing power parity (PPP) The nominal exchange rate between two countries that reflects the difference in their respective rates of inflation. Put option An option that confers a right on the holder to sell a specified amount of an asset at a prespecified price on or sometimes before a prespecified date. Qualifying corporate bonds (QCBs) UK corporate bonds issued in sterling without conversion rights. QCBs are free of capital gains tax (CGT).

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Quantity Theory of Money A truism that formalises the relationship between the domestic money supply and the general price level. Quoted currency The currency whose value is expressed in terms of one unit of the base currency. The quoted currency would be currency Y for the X/Y exchange rate. Redeemable security A security issued with a known maturity, or redemption, date. Redemption The repayment of principal to the holder of a redeemable security. Regression analysis A statistical technique used to establish the degree of correlation that exists between two variables. Reinvestment risk The inability to reinvest coupons at the same rate of interest as the Gross Redemption Yield (GRY). This in turn makes the GRY conceptually flawed. Repo The sale and repurchase of bonds between two parties: the repurchase being made at a price and date fixed in advance. Repos are categorised into general repos and specific repos. Reserve ratio The proportion of deposits held by banks as reserves to meet depositor withdrawals and Bank of England credit control requirements. Resistance level A term used in Technical Analysis to describe the ceiling put on the price of a security resulting from persistent investor selling at that price level. Retail Price Index (RPI) An expenditure weighted measure of UK inflation based on a representative basket of goods and services purchased by an average UK household. Rights issue The issue of new ordinary shares to a company’s shareholders in proportion to each shareholder’s existing shareholding, usually at a price deeply discounted to that prevailing in the market. Also see Pre-emption Rights. Running yield The return from a bond calculated by expressing the coupon as a percentage of the clean price. Also known as the Flat Yield or interest yield. Sample A statistical term applied to a representative subset of a particular population. Samples enable inferences to be made about the population.

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Scrip issue See Bonus Issue. Secondary data Pre-existing data. Secondary market The market for trading securities already in issue. Securities and Exchange Commission (SEC) The SEC is the USA’s financial services market regulator. Securitisation The packaging of rights to the future revenue stream from a collection of assets into a bond issue. Settlor The creator of a trust. Share buyback The redemption and cancellation by a company of a proportion of its irredeemable ordinary shares subject to the permission of the High Court and agreement from HM Revenue & Customs. Share capital The Nominal Value of a company’s Equity or Ordinary Shares. A company’s authorised share capital is the Nominal Value of Equity the company may issue whilst issued share capital is that which the company has issued. The term share capital is often extended to include a company’s preference shares. Share split 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 nominal value of each of its shares in issue whilst maintaining the overall nominal value of its share capital. A share split should have the same impact on a company’s share price as a Bonus Issue. Short position The position following the sale of a security not owned or selling a derivative. Spot rate A compound annual fixed rate of interest that applies to an investment over a specific time period. Also see Forward Rate. Spreads A strategy requiring the simultaneous purchase of one or more options and the sale of another or several others on the same underlying asset with either different exercise prices and the same expiry date or the same exercise prices and different expiry dates. Spreads include bull spreads, bear spreads and butterfly spreads.

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Stabilisation Policy See Fiscal Policy and Monetary Policy. Standard deviation A measure of dispersion. In relation to the values within a distribution, the standard deviation is the square root of the distribution’s variance. Stock exchange An organised market place for issuing and trading securities by members of that exchange. Stock Exchange Alternative Trading SERVICE (SEATS Plus) The London Stock Exchange’s (LSE) electronic order driven bulletin board for trading less liquid securities, notably those fully listed or AIM shares with less than two registered market makers. Stock Exchange Automated Quotation (SEAQ) The London Stock Exchange’s (LSE) quote driven screen based trading system that displays firm bid and offer prices quoted by competing market makers during the mandatory quote period. Stock Exchange Electronic Trading SERVICE (SETS) The London Stock Exchange’s (LSE) screen based order driven trading system that electronically matches buy and sell orders input to the system. Only the most liquid securities in the UK equity market can be traded through SETS and all orders must be firm and not indicative, as once displayed an order must be capable of immediate execution. Strike price See Exercise Price. STRIPS The principal and interest payments of those designated Gilts that can be separately traded as Zero Coupon Bonds (ZCBs). STRIPS is the mnemonic for Separate Trading of Registered Interest and Principal. Subordinated loan stock Loan Stock issued by a company that ranks above its Preference Shares but below its unsecured creditors in the event of the company’s liquidation. Substitute A good is a substitute for another if a rise in the price of one results in an increase in demand for the other. As substitute goods perform a similar function to each other, they typically have a high price elasticity of demand. Supply curve The depiction of the quantity of a particular good or service firms are willing to supply at a given price. Plotted against price on the vertical axis and quantity on the horizontal axis, a supply curve slopes upward from left to right.

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Swap An Over the Counter (OTC) Derivative whereby two parties exchange a series of periodic payments based on a notional principal amount over an agreed term. Swaps can take the form of interest rate swaps, currency swaps and equity swaps. T+3 The three day rolling settlement period over which all deals executed on the London Stock Exchange’s (LSE) SETS are settled. TechMARK The London Stock Exchange (LSE) sub-market for those public limited companies (plcs) committed to technological innovation. Technical analysis The analysis of charts depicting past price and volume movements to determine the future course of a particular market or the price of an individual security. Technical analysis is nullified by the weak form of the Efficient Markets Hypothesis (EMH). Tick The minimum price movement of a derivatives contract as specified by the exchange on which the product is traded. Tick value The monetary value of one tick. Time value That element of an option premium that is not intrinsic value. The term time value also relates to a sum of money which, by taking account of a prevailing rate of interest and the term over which the sum is to be invested or received, can be expressed as either a future value or as a present value, respectively. Time weighted rate of return (TWRR) The unitised performance of a portfolio over an investment period that eliminates the distorting effect of cash flows. The TWRR is calculated by compounding the rates of return from each investment sub period, a sub-period being created whenever there is a movement of capital into or out of the portfolio. Tracking error See Active Risk. Treasury bills Short term government-backed securities issued at a discount to par via a weekly Bank of England auction. Treasury bills do not pay coupons but are redeemed at par. Trustees The legal owners of trust property who owe a duty of skill and care to the trust’s beneficiaries.

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UK Listing Authority (UKLA) The body responsible for setting and administering the listing requirements and continuing obligations for public limited companies (plcs) seeking and obtaining a full list on the London Stock Exchange (LSE). The Financial Services Authority (FSA) as appointed as the UKLA in May 2000. UndertakingS for Collective InvestmentS in Transferable Securities (UCITS) Directive An EU Directive originally introduced in 1985 but since revised to enable collective investment schemes (CISs) authorised in one EU member state to be freely marketed throughout the EU, subject to the marketing rules of the host state(s) and certain fund structure rules being complied with. Unemployment The percentage of the labour force registered as available to work at the current wage rate. Variance A measure of dispersion. In relation to the values within a distribution, the variance is the mean of the sum of the squared deviations from the distribution’s arithmetic mean. Variation margin The cash that passes between the exchange clearing members daily via the clearing house in settlement of the previous day’s price movement in an open derivatives contract. virt-x A pan-European stock exchange for the trading of blue chip shares. virt-x was formed by the amalgamation of the Tradepoint exchange and the Swiss stock exchange. Volatility A measure of the extent to which investment returns, asset prices and economic variables fluctuate. Volatility is measured by the standard deviation of these returns, prices and values. Warrants Negotiable securities issued by public limited companies (plcs) that confer a right on the holder to buy a certain number of the company’s ordinary shares on prespecified terms. Warrants are essentially long dated Call Options but are traded on a Stock Exchange rather than on a derivatives exchange. Weighted Average Cost of Capital (WACC) The average post-tax cost of servicing a company’s long term sources of finance. The WACC acts as the discount rate for establishing the Net Present Value (NPV) of investment projects of equivalent risk to those currently undertaken by the company. Yield curve The depiction of the relationship between the Gross Redemption Yields (GRYs) and the maturity of bonds of the same type. Yield to maturity (YTM) See Gross Redemption Yield (GRY).

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Zakat Depending on various conditions, some Muslims are required to pay 2.5% of their wealth to the Department of Zakat and Income Tax (DZIT). Zero coupon bonds (ZCBs) Bonds issued at a discount to their Nominal Value that do not pay a Coupon but which are redeemed at par on a prespecified future date.

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International Certificate in Investment Management SYLLABUS 1.0 / WORKBOOK EDITION 1 COMPARISON ELEMENT 1 ECONOMICS 1.1 Microeconomic Theory On completion, the candidate should: 1.1.1 understand how price is determined and the interaction of supply and demand 1.1.2 be able to calculate elasticities of demand 1.1.3 understand the theory of the firm: • profit maximisation • short and long run costs • increasing and diminishing returns to factors • economies and diseconomies of scale 1.1.4 understand firm and industry behaviour under perfect competition 1.1.5 understand firm and industry behaviour under monopoly and oligopoly 1.2 Macroeconomic Analysis On completion, the candidate should: 1.2.1 know how national income is determined, composed and measured in both an open and closed economy 1.2.2 know the stages of the economic cycle 1.2.3 understand the composition of the balance of payments and the factors behind and benefits of international trade and capital flows 1.2.4 know the nature, determination and measurement of the money supply 1.2.5 understand the role, basis and framework within which monetary and fiscal policy operate 1.2.6 know the role of central banks and of the major G8 central banks 1.2.7 know how inflation/deflation and unemployment are determined, measured and their inter-relationship ELEMENT 2 FINANCIAL MATHEMATICS AND STATISTICS 2.1 Statistics On completion, the candidate should: 2.1.1 understand where financial data may be sourced from and how it can be presented 2.1.2 be able to calculate the measures of central tendency: • arithmetic mean • geometric mean • median • mode 2.1.3 be able to calculate the measures of dispersion: • variance (sample/population) • standard deviation (sample/population) • range 2.1.4 understand the correlation between two variables and the interpretation of the data 2.1.5 understand the covariance between two variables and the interpretation of the data 2.1.6 understand the use of regression analysis to quantify the relationship between two variables and the interpretation of the data 2.2 Financial Mathematics On completion, the candidate should: 2.2.1 be able to calculate the present value of lump sums and regular payments, annuities and perpetuities 2.2.2 be able to calculate the future value of lump sums and regular payments 2.2.3 be able to calculate simple and compound interest, discounted cash flows (DCFs), net present values (NPV) and internal rates of return (IRR) and

CHAPTER/SECTION

Chapter 1, Section 1.2 Chapter 1, Section 1.3 Chapter 1, Section 1.4

Chapter 1, Section 1.6 Chapter 1, Section 1.7

Chapter 1, Section 2.2 Chapter 1, Section 2.3 Chapter 1, Section 2.8 Chapter 1, Section 2.5 Chapter 1, Section 2.5 Chapter 1, Section 2.10 Chapter 1, Sections 2.6, 2.7

Chapter 2, Section 1.2 Chapter 2, Section 1.3

Chapter 2, Section 1.3

Chapter 2, Section 1.4 Chapter 2, Section 1.4 Chapter 2, Section 1.4

Chapter 2, Sections 2.3, 2.4 Chapter 2, Sections 2.2, 2.3 Chapter 2, Section 2.6

SYLLABUS LEARNING MAP

International Certificate in Investment Management SYLLABUS 1.0 / WORKBOOK EDITION 1 COMPARISON interpret the data understand the importance of selecting an appropriate discount rate for discounting cash flows ELEMENT 3 INDUSTRY REGULATION 3.1 Corporate Governance On completion, the candidate should: 3.1.1 know the origins and nature of Corporate Governance 3.1.2 know the Corporate Governance mechanisms available to stakeholders to exercise their rights 3.1.3 understand the role of auditors and non-executive directors 3.1.4 know the implications of the Sarbanes-Oxley Act and its main provisions 3.2 Overseas Regulators On completion, the candidate should: 3.2.1 know the primary function of the following bodies in the regulation of the financial services industry: • Securities and Exchange Commission (SEC) • Financial Services Authority (FSA) • Japan Financial Services Agency (JFSA) • European Union (EU) • International Organisation of Securities Commissions (IOSCO) 3.2.2 know the impact of high profile failures on the various markets, participants and regulation of them: • Barings Bank • Enron • Equitable Life • National Australia Bank ELEMENT 4 ASSET CLASSES 4.1 Equities On completion, the candidate should: 4.1.1 know the characteristics and risks of different classes of share capital (preference shares, ordinary shares), shareholder rights and priority for dividends and capital repayment for both private and public companies 4.1.2 know the main characteristics and reasons for issuing convertible preference shares 4.1.3 be able to calculate a conversion premium or discount on a convertible preference share 4.1.4 understand the main characteristics of GDRs and ADRs 4.1.5 know the principal purpose and requirements of the listing rules 4.1.6 understand the different new issue methods: • offer for sale by subscription • offer for sale • placing 4.1.7 know the main mandatory corporate actions • bonus/scrip • consolidation • final redemption • subdivision/stock splits 4.1.8 know the main optional corporate actions • warrant exercise • placing with clawback • rights issue call

2.2.4

Chapter 2, Sections 2.4, 2.6

Chapter 3, Section 1 Chapter 3, Section 1 Chapter 3, Section 1 Chapter 3, Section 1

Chapter 3, Section 2

Chapter 3, Section 1

Chapter 4, Sections 1.2, 1.3

Chapter 4, Section 1.3 Chapter 4, Section 1.3 Chapter 4, Section 1.5 Chapter 4, Section 1.4 Chapter 4, Section 1.5

Chapter 4, Section 1.5

Chapter 4, Section 1.5

SYLLABUS LEARNING MAP

International Certificate in Investment Management SYLLABUS 1.0 / WORKBOOK EDITION 1 COMPARISON

4.1.9 know the difference between optional and mandatory corporate actions 4.1.10 understand the reasons for capitalisation and rights issues and the options

Chapter 4, Section 1.5 Chapter 4, Section 1.5

available to the shareholder when a rights issue is made

4.1.11 be able to calculate the effect of capitalisation and rights issues on the issuer’s share price 4.1.12 know the reasons for companies paying dividends, how dividend policy is determined and the practical constraints on paying dividends 4.1.13 know the reasons for companies buying back their own shares 4.1.14 know the means by which companies communicate price sensitive information, the nature of such information and the primary information providers 4.2 Fixed Interest On completion, the candidate should: 4.2.1 know the structure, characteristics and risks of the different types of fixed interest securities 4.2.2 know the characteristics and reasons for issuing convertible bonds 4.2.3 be able to calculate a conversion premium on a convertible bond 4.2.4 know the main risks faced by bondholders 4.2.5 understand what is meant by running yield, net redemption yield (NRY), gross redemption yield (GRY), duration 4.2.6 be able to calculate running yields, net redemption yields (NRYs), gross redemption yields (GRYs), duration 4.2.7 know the characteristics of the yield curve: • normal • inverted 4.2.8 be able to calculate forward rates given two spot rates of different maturities 4.2.9 know the characteristics and uses of strips and repos 4.2.10 know the concept of securitisation 4.2.11 know the main bond strategies: • bond switching • riding the yield curve • immunisation • Barbell/Bullet/Ladder portfolios 4.2.12 know the role of ratings agencies: Fitch, Moody’s, Standard & Poor’s and the structure of their credit ratings 4.3 Cash and Money Market Instruments On completion, the candidate should: 4.3.1 know the main characteristics and risks of cash deposits and money market instruments: • Money Market Deposits • Certificates of Deposit (CDs) • Commercial Paper (CP) • Treasury Bills 4.4 Derivatives On completion, the candidate should: 4.4.1 know the characteristics of futures 4.4.2 understand the risk reward profile of buying and selling futures 4.4.3 know the characteristics of options 4.4.4 be able to calculate the outcome of basic option strategies and the potential risks and rewards of each • buying calls • buying puts • selling calls

Chapter 4, Section 1.5 Chapter 4, Section 1.6 Chapter 4, Section 1.7 Chapter 4, Section 1.4

Chapter 4, Sections 2.1, 2.2 Chapter 4, Section 2.2 Chapter 4, Section 2.2 Chapter 4, Section 2.5 Chapter 4, Section 2.3 Chapter 4, Section 2.3 Chapter 4, Section 2.3

Chapter 4, Section 2.4 Chapter 4, Sections 2.2, 2.6 Chapter 4, Section 2.7 Chapter 4, Section 2.8

Chapter 4, Section 2.9

Chapter 4, Sections 3.2, 3.3

Chapter 4, Section 4.2 Chapter 4, Section 4.2 Chapter 4, Section 4.6 Chapter 4, Section 4.6

SYLLABUS LEARNING MAP

International Certificate in Investment Management SYLLABUS 1.0 / WORKBOOK EDITION 1 COMPARISON • selling puts understand American and European exercise styles understand the geared nature of futures and options understand the principles of margin know the differences between forwards, futures and options know the differences between physically settled and cash settled derivatives and the role of the clearing house 4.4.10 know the main characteristics, contract specifications and uses within investment management of Euronext.liffe (formerly LIFFE) • FTSE 100 index futures and options • Long Gilt futures • Short Term Interest Rate (STIR) futures • Universal Stock Futures • Individual equity options 4.4.11 know the characteristics of a contract for difference 4.4.12 know the meaning of contango and backwardation 4.4.13 know the meaning of in-the-money, at-the-money and out-of-the money in relation to options 4.4.14 be able to calculate the time and intrinsic value of an option premium given the premium and the underlying price 4.4.15 know the factors that determine an option premium 4.4.16 know the main characteristics of a warrant 4.4.17 be able to calculate a warrant conversion premium 4.4.18 know the difference between warrants and covered warrants 4.4.19 know the basic structure of an Interest Rate Swap 4.4.20 know the basic structure of a Currency Swap 4.4.21 know the basic structure of an Equity Swap 4.5 Property On completion, the candidate should: 4.5.1 know the direct and indirect means of investing in property, property investment trusts, property bonds, shares in property companies, pension holdings 4.5.2 understand the characteristics of a property market and the differences between the property market, securities market and money market 4.6 Alternative Investments On completion, the candidate should: 4.6.1 know the main types and characteristics of alternative investments: • commodities • private equity • structured products ELEMENT 5 FINANCIAL MARKETS 5.1 Exchanges On completion, the candidate should: 5.1.1 understand the role of the exchanges for trading: • shares • bonds • derivatives 5.1.2 know why companies obtain listings on overseas stock exchanges 5.1.3 know the role and responsibilities of the London Stock Exchange (LSE) 5.1.4 understand the reasons for the emergence of alternative trading systems: • Crossing networks and Electronic Communication Networks (ECNs)

4.4.5 4.4.6 4.4.7 4.4.8 4.4.9

Chapter 4, Section 4.6 Chapter 4, Sections 4.2, 4.6 Chapter 4, Sections 4.3, 4.5 Chapter 4, Sections 4.2, 4.6 Chapter 4, Sections 4.2, 4.3 Chapter 4, Sections 4.5, 4.6

Chapter 4, Sections 4.2, 4.5 Chapter 4, Section 4.5 Chapter 4, Section 4.6 Chapter 4, Section 4.6 Chapter 4, Section 4.6 Chapter 4, Section 4.7 Chapter 4, Section 4.7 Chapter 4, Section 4.7 Chapter 4, Section 4.8 Chapter 4, Section 4.8 Chapter 4, Section 4.8

Chapter 4, Sections 5.2, 5.3 Chapter 4, Section 5.1

Chapter 4, Section 6.1

Chapter 5, Section 1.2

Chapter 5, Section 1.2 Chapter 5, Section 1.2 Chapter 5, Section 1.3

SYLLABUS LEARNING MAP

International Certificate in Investment Management SYLLABUS 1.0 / WORKBOOK EDITION 1 COMPARISON 5.2 Dealing and Settlement On completion, the candidate should: 5.2.1 know the differences between a primary market and a secondary market 5.2.2 know the structure and operation of the primary and secondary markets for: • Government/local authority/supranational agencies • Corporate bonds • Eurobonds 5.2.3 know the features and differences of quote and order driven markets 5.2.4 know the types of transaction costs incurred in dealing in different asset classes 5.3 International Markets On completion, the candidate should: 5.3.1 know the main characteristics of the major stock exchanges for the following markets: USA, UK, Japan, France, Germany 5.3.2 know the settlement cycles for the following markets: USA, UK, Japan, France, Germany 5.3.3 know the main characteristics of the following Asian and Middle East stock exchanges: China, India, Dubai, Egypt, Saudi Arabia 5.3.4 know the settlement cycles for the following Asian and Middle East markets: China, India, Dubai, Egypt, Saudi Arabia 5.3.5 know the characteristics of an emerging market 5.4 Foreign Exchange On completion, the candidate should: 5.4.1 know the basic structure and operation of the foreign exchange market 5.4.2 understand the difference between spot and forward exchange rates 5.4.3 be able to calculate forward exchange rates and parity relationships 5.4.4 know the mechanisms through which currency exposure can be hedged 5.4.5 understand the reasons for changes in exchange rates ELEMENT 6 ACCOUNTING 6.1 Basic principles On completion, the candidate should: 6.1.1 know the legal requirements to prepare accounts and the differences between private and public company requirements 6.1.2 know the fundamental accounting bases upon which company accounts are prepared (concepts of entity, going concern, prudence, matching, consistency and historic cost) 6.1.3 know the function of the Accounting Standards Board (ASB) and International Accounting Standards Board (IASB) 6.1.4 know the purpose of the International Financial Reporting Standards (IFRSs) 6.1.5 understand the purpose of the auditors’ report and the reasons why reports are modified 6.2 Balance Sheet On completion, the candidate should: 6.2.1 know the purpose and main contents of the balance sheet 6.2.2 understand how assets are classified and valued 6.2.3 know the difference between capitalising costs and expensing costs 6.2.4 know how goodwill and other intangible assets arise and are treated 6.2.5 be able to calculate the different methods of depreciation and amortisation 6.2.6 know how liabilities are categorised 6.2.7 understand the difference between authorised and issued share capital and capital reserves and revenue reserves 6.2.8 know what contingent liabilities and post balance sheet events are 6.3 Income Statement

Chapter 5, Section 2.1 Chapter 5, Section 2.1

Chapter 5, Section 2.1 Chapter 5, Section 2.2

Chapter 5, Sections 1.2, 3.2, 3.3, 3.4 Chapter 5, Sections 3.2, 3.3, 3.4 Chapter 5, Section 3.4 Chapter 5, Section 3.4 Chapter 5, Sections 3.4, 3.5

Chapter 5, Section 4.2 Chapter 5, Section 4.2 Chapter 5, Section 4.3 Chapter 5, Section 4.4 Chapter 5, Section 4

Chapter 6, Section 1.1 Chapter 6, Section 1.1

Chapter 6, Section 1.1 Chapter 6, Section 1.1 Chapter 6, Section 1.1

Chapter 6, Sections 2.1, 2.2 Chapter 6, Section 2.3 Chapter 6, Section 2.3 Chapter 6, Section 2.3 Chapter 6, Section 2.3 Chapter 6, Section 2.4 Chapter 6, Section 2.5 Chapter 6, Section 2.6

SYLLABUS LEARNING MAP

International Certificate in Investment Management SYLLABUS 1.0 / WORKBOOK EDITION 1 COMPARISON On completion, the candidate should: 6.3.1 know the purpose and main contents of the income statement 6.3.2 know the basic concepts underlying revenue recognition 6.3.3 know how expenses, provisions and dividends are accounted for 6.3.4 be able to calculate the different levels of profit given revenue and different categories of cost 6.3.5 know the difference between revenue and reserve accounting 6.4 Cash Flow Statement On completion, the candidate should: 6.4.1 know the purpose and main contents of the cash flow statement 6.4.2 be able to calculate net cash flow from operations from operating profit 6.5 Consolidated Company Report and Accounts On completion, the candidate should: 6.5.1 know the basic principles of accounting for: • Associated Companies • Subsidiaries ELEMENT 7 INVESTMENT ANALYSIS 7.1 Fundamental and Technical Analysis On completion, the candidate should: 7.1.1 know the difference between fundamental and technical analysis 7.2 Yields and Ratios On completion, the candidate should: 7.2.1 be able to calculate Return on Equity (ROE) 7.2.2 be able to calculate Return on Capital Employed (ROCE) 7.2.3 be able to calculate asset turnover 7.2.4 be able to calculate profit margin 7.2.5 be able to calculate financial gearing 7.2.6 be able to calculate interest cover 7.2.7 be able to calculate the working capital (current) ratio 7.2.8 be able to calculate the liquidity (acid test) ratio 7.2.9 be able to calculate debtor turnover 7.2.10 be able to calculate creditor turnover 7.2.11 be able to calculate stock turnover 7.2.12 know the purpose of z score analysis 7.2.13 understand the difficulties in interpreting the key accounting ratios for: • companies in different industries • different companies within the same industry • the same company over successive accounting periods 7.2.14 be able to calculate earnings per share (EPS) 7.2.15 be able to calculate earnings before interest, tax, depreciation, and amortisation (EBITDA) 7.2.16 be able to calculate historic and prospective price earnings ratios (PERs) 7.2.17 be able to calculate dividend yields 7.2.18 be able to calculate dividend cover 7.2.19 be able to calculate price to book ratios 7.3 Valuation On completion, the candidate should: 7.3.1 be able to calculate equity valuations based on Dividends: Gordon’s Growth Model 7.3.2 be able to calculate equity valuations based on Earnings: Price earnings ratios (PERs)

Chapter 6, Sections 3.1, 3.2 Chapter 6, Section 3.3 Chapter 6, Section 3.3 Chapter 6, Section 3.3 Chapter 6, Section 3.3

Chapter 6, Section 4.2 Chapter 6, Section 4.3

Chapter 6, Section 5.2

Chapter 7, Sections 1.2, 1.3

Chapter 7, Section 2.2 Chapter 7, Section 2.2 Chapter 7, Section 2.2 Chapter 7, Section 2.2 Chapter 7, Section 2.3 Chapter 7, Section 2.3 Chapter 7, Section 2.4 Chapter 7, Section 2.4 Chapter 7, Section 2.4 Chapter 7, Section 2.4 Chapter 7, Section 2.4 Chapter 7, Section 2.4 Chapter 7, in general

Chapter 7, Section 2.6 Chapter 7, Section 2.6 Chapter 7, Sections 2.7, 3.3 Chapter 7, Section 2.8 Chapter 7, Section 2.8 Chapter 7, Section 2.9

Chapter 7, Section 3.2 Chapter 7, Section 3.3

SYLLABUS LEARNING MAP

International Certificate in Investment Management SYLLABUS 1.0 / WORKBOOK EDITION 1 COMPARISON

7.3.3

be able to calculate equity valuations based on Assets: - Net Asset Value 7.3.4 know the basic concept behind shareholder value models: • Economic Value Added (EVA) • Market Value Added (MVA) ELEMENT 8 TAXATION 8.1 Business Tax On completion, the candidate should: 8.1.1 understand the application of the main business taxes: • Business tax • Transaction tax (ie, Stamp Duty/Stamp Duty Reserve Tax) • Tax on sales 8.1.2 know the purpose of tax-efficient incentive schemes sponsored by governments and supranational agencies (eg, International Monetary Fund) 8.2 Personal Taxes On completion, the candidate should: 8.2.1 understand the direct and indirect taxes as they apply to individuals: • Tax on income • Tax on capital gains • Estate tax • Transaction tax (Stamp Duty) • Tax on Sales 8.3 Overseas Taxation On completion, the candidate should: 8.3.1 know the principles of withholding tax 8.3.2 know the principles of double taxation relief (DTR) ELEMENT 9 PORTFOLIO MANAGEMENT 9.1 Risk and Return On completion, the candidate should: 9.1.1 know the main principles of Modern Portfolio Theory (MPT) and the need for diversification 9.1.2 know the main propositions and limitations of the Efficient Markets Hypothesis (EMH) 9.1.3 understand the assumptions underlying the construction of the Capital Asset Pricing Model (CAPM) and its limitations 9.1.4 be able to apply the CAPM formula to equity portfolio selection decisions 9.1.5 know the main: • principles behind Arbitrage Pricing Theory (APT) • differences between CAPM and APT 9.2 The Role of the Portfolio Manager On completion, the candidate should: 9.2.1 understand the establishment of: • relationships with clients • client objectives and risk profile including income and/or growth, time horizons, restrictions and liquidity • discretionary and non-discretionary portfolio management 9.2.2 understand the establishment of the investment strategy • the difference between active and passive management • top down versus bottom up active management • investment styles • ethical, environmental and socially responsible investment • alternative investment strategies

Chapter 7, Section 3.4 Chapter 7, Section 3.5

Chapter 8, Section 1

Chapter 8, Section 1

Chapter 8, Section 2

Chapter 8, Section 3 Chapter 8, Section 3

Chapter 9, Section 1.2 Chapter 9, Section 1.3 Chapter 9, Section 1.4 Chapter 9, Section 1.4 Chapter 9, Section 1.5

Chapter 9, Section 2.2

Chapter 9, Section 2.2

SYLLABUS LEARNING MAP

International Certificate in Investment Management SYLLABUS 1.0 / WORKBOOK EDITION 1 COMPARISON

9.2.3 9.2.4

understand deciding on the benchmark and the basis for review understand the measurement and evaluation of performance and the purpose and requirements of annual and periodic reviews including client reporting 9.2.5 understand the benefits of employing derivatives within the investment management process 9.2.6 understand the issues associated with conflicts of interest and the duty to clients 9.3 Fund Characteristics On completion, the candidate should: 9.3.1 know the main features and risk characteristics of the following: • Private Client Funds • Investment Trusts • Unit Trusts • OEICs (ICVCs) • Insurance Companies (life and general) • Exchange-Traded Funds (ETFs) • Venture Capital Trusts (VCTs) • Venture Capital Funds (limited partnerships) • Offshore Funds • Common Investment Funds • Hedge Funds • Private Equity Funds • Fund of Funds • Manager of Managers 9.3.2 understand the main features and risk characteristics of retirement funds ELEMENT 10 PERFORMANCE MEASUREMENT 10.1 Performance Benchmarks On completion, the candidate should: 10.1.1 know the main features of: FTSE UK equity indices • FTSE All World index • FTSE Actuaries Government Securities indices • MSCI World index • Dow Jones Industrial Average index • S&P 500 index • DAX index • CAC 40 index • Nikkei Dow indices • Hang Seng • ASX 10.1.2 know why free float indices were introduced 10.1.3 be able to calculate the main types of equity indices (arithmetic price and market value weighted and geometric unweighted) 10.1.4 know the alternative ways of benchmarking: • GIPS (Global Investment Performance Standards) • Peer group average (WM and CAPS) 10.2 Performance Attribution On completion, the candidate should: 10.2.1 understand total return and its components 10.2.2 be able to calculate the deviations from a performance benchmark attributable to:

Chapter 9, Section 2.2 Chapter 9, Section 2.2 Chapter 9, Section 2.2 Chapter 9, Section 2.3

Chapter 9, Sections 3.2, 3.3, 3.4, 3.5, 3.6, 3.7, 3.8, 3.9, 3.10, 3.11, 3.12

Chapter 9, Section 3.13

Chapter 10, Section 1.3

Chapter 10, Section 1.3 Chapter 10, Section 1.2 Chapter 10, Sections 1.5, 1.6

Chapter 10, Section 2.1 Chapter 10, Section 2.2

SYLLABUS LEARNING MAP

International Certificate in Investment Management SYLLABUS 1.0 / WORKBOOK EDITION 1 COMPARISON • actual vs relative performance • asset allocation • stock selection 10.3 Performance Measures On completion, the candidate should: 10.3.1 be able to calculate the money weighted rates of return (MWRR) 10.3.2 be able to calculate the time weighted rates of return (TWRR) 10.3.3 be able to calculate the risk-adjusted returns for equities: • Sharpe • Treynor • Jensen

Chapter 10, Section 3.2 Chapter 10, Section 3.3 Chapter 10, Section 3.4

SYLLABUS LEARNING MAP

International Certificate in Investment Management SYLLABUS 1.0 / WORKBOOK EDITION 1 COMPARISON

ASSESSMENT STRUCTURE A 2 hour examination consisting of 100 multiple choice questions. Candidates may have, in addition to the assessed questions, a small number of trial questions that will not be separately identified and do not contribute to the result. Candidates will be given proportionately more time to complete the test. For example a 100 question exam may actually have up to 110 questions in total, the test will last a few minutes longer, but 10 of these will be trial unscored questions. SYLLABUS STRUCTURE The syllabus is divided into sections. These are divided into elements and the elements are made up of learning objectives. Each learning objective begins with one of the following prefixes: know, understand, be able to calculate or be able to apply. These words indicate the different levels of skill to be tested. Learning objectives prefixed: ‘Know’ - require candidates to recall information such as facts, rules and principles. ‘Understand’ - require candidates to demonstrate comprehension of an issue, fact, rule or principle. ‘Be able to calculate’ - require candidates to be able to use formulae to perform calculations ‘Be able to apply’ - require candidates to be able to apply their knowledge to a given set of circumstances in order to present a clear and detailed explanation of a situation, rule or principle. Where a learning objective refers to main or basic, this signifies that the candidate needs to be aware of the topic’s key principles rather than possessing an in-depth grasp of the topic. As this examination has a practical bias, candidates will be tested on topical investment issues detailed in the syllabus. Some topics may also be examined through the use of diagrams, charts and other pictorial representations and in the case of the accounting and investment analysis sections via a basic set of company accounts.

CANDIDATE UPDATE Candidates are reminded to check the 'Candidate Update' area of the Institute's website on a regular basis for updates resulting from industry changes that may affect their examination. (www.sii.org.uk)

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

Total LOs

Questions

1 2 3 4 5 6 7 8 9 10 TOTAL

12 10 6 51 18 21 24 5 13 9 169

8 7 4 31 12 13 8 3 9 5 100

SYLLABUS LEARNING MAP

International Certificate in Investment Management SYLLABUS 1.0 / WORKBOOK EDITION 1 COMPARISON

Candidates should adopt professional updating practices early in their training and learn to draw on many sources of technical advice. In particular, candidates should supplement their studies by reading the journals, reference sources and texts listed below. In the case of textbooks these can be expected to go beyond the requirements of the syllabus, but candidates may find this helpful as it will bring a different perspective to their studies. Periodicals The Economist Financial News Financial Times (particularly the weekend editions, and the financial sections of other newspapers) Investors Chronicle Investment Adviser Investment Week Money Management Professional Pensions The Wall Street Journal Europe Texts Economics: Begg, Fischer and Dornbusch; McGraw Hill Essential Quantitative Methods for Business Management and Finance: Oakeshott; Palgrave or Quantitative Methods for Business and Economics: Burton, Carol and Wall; FT Prentice Hall A Practitioner’s Guide to the City Code on Takeovers & Mergers; 2002-03 Button; City & Financial Publishing Investment Management: Lofthouse; Wiley Finance & Financial Markets; Pilbeam; Palgrave Interpreting Company Reports and Accounts: Holmes, Sugden & Gee; FT/ Prentice Hall Modern Portfolio Theory and Analysis: Elton and Gruber; John Wiley & Sons or Investments: Bodie, Kane, Marcus; McGraw Hill International The City: Inside the Great Expectation Machine (myth and reality in institutional investment and the stock market) by Tony Golding, published by FT Prentice Hall

Useful websites www.fsa.gov.uk www.hm-treasury.gov.uk www.hmrc.gov.uk www.dmo.gov.uk www.gad.gov.uk www.bankofengland.co.uk www.competition-commission.org.uk www.thetakeoverpanel.org.uk/ www.londonstockex.co.uk

SYLLABUS LEARNING MAP

International Certificate in Investment Management SYLLABUS 1.0 / WORKBOOK EDITION 1 COMPARISON www.liffe.com www.aca.org.uk www.abi.org.uk www.aitc.co.uk www.bvca.co.uk www.investmentuk.org www.apcims.co.uk Global business news websites: • CNN.com • S&P.com • FT.com • BusinessWeek.com • Efinancialnews.com

NEXT STEPS IAQTM Programme: Candidates who have passed three IAQ examinations achieve the IAQ Award and are eligible for Associate membership of the SII. Certificate Programme: Candidates who have passed two Certificate examinations achieve the SII Certificate Award and are eligible for Associate membership of the SII. Visit our website to learn about the numerous career benefits SII membership will bring: www.sii.org.uk After completing the IAQ or Certificate programmes, you are encouraged to progress your career by preparing for one or more of the SII Advanced examinations: • Advanced Operational Risk • Advanced Global Securities Operations • Advanced Investment Schemes Administration. You may also consider preparing for the SII Diploma qualification – the highest award for professionals in the securities and investment industry. To sit the Institute’s examinations or to purchase any of our publications please visit the our website at www.sii.org.uk or contact Client Services on 020 7645 0680. Details on all of these awards and further information can also be found on the Institute’s website. Candidates are reminded to check the ‘Content Update’ area of the Institute's website on a regular basis for updates that could affect their examination as a result of industry change.

SII Membership Progression

L E V E L 3 I A Q TM P R O G R A M M E The Investment Administration Qualification (IAQTM) is a practitioner led programme for administration and operations staff. It equips individuals with an overview of the nature of the financial services industry and its regulation as well as providing a detailed picture of their particular industry sector. The IAQ is awarded on the basis of passes in any three modules (or two modules plus one exemption). Module selection depends on each candidate’s individual circumstances, generally candidates fall into four groups: 1. Individuals presently in an overseeing role, working for a firm which is authorised and regulated by the FSA, are required to take the following modules recommended by the FSA: • Introduction to Securities & Investment • FSA Financial Regulation or Principles of Financial Regulation • A technical module relevant to the role. 2. Individuals working for a firm which is authorised and regulated by the FSA, who are not expected to take on an overseeing role, may, if their firm agrees, select any three modules. 3. Individuals working for a firm which is not authorised and regulated by the FSA, particularly in firms based offshore, may, if the firm agrees, select any three modules but are recommended to consider first passing Introduction to Securities & Investment and then selecting any two modules. 4. Individuals entering the IAQ examination privately are advised to take Introduction to Securities & Investment and FSA Financial Regulation (or Principles of Financial Regulation) as two of the three modules, but may select any three modules. All IAQ modules have been recognised by the Financial Services Skills Council for “overseeing” functions as defined by the FSA. For details of the “overseeing” categories for which the IAQ is recognised, please refer to the Financial Services Skills Council’s Appropriate Examinations list which can be found on their website (www.fssc.org.uk).

L E V E L 3 C E R T I F I C AT E I N I N V E S T M E N T S The Securities & Investment Institute Certificate in Investments (previously the Securities Institute Certificate) is a series of examinations designed to satisfy the Financial Services Skills Council’s examination requirements for advising on, and dealing in, securities and/or derivatives, and for managing investments. In order to be awarded the Securities qualification, candidates must pass two modules: • FSA Financial Regulation or Principles of Financial Regulation, and then one of: • Securities - a two-hour, 100 multiple-choice question examination. • Derivatives - a two-hour, 100 multiple-choice question examination. • Securities and Financial Derivatives - this examination consists of two sections: • Section 1 (Securities & Markets) is a 2 hour, 100 multiple choice question paper. • Section 2 (Financial Derivatives) is a 1 hour 24 minute, 70 multiple choice question paper. • Investment Management - a two-hour, 100 multiple-choice question examination. • Financial Derivatives Module* - a 1 hour 24 minute, 70 multiple choice question paper. (*If you have passed the Certificate in Securities and want to gain the Certificate in Securities and Financial Derivatives, you can do this through the Financial Derivatives Module. Please note that taking the Financial Derivatives Module after taking Unit 1 - Financial Regulation or Unit 6 - Principles of Financial Regulation does not lead to a Ceritificate). Candidates can sit the modules independently of each other and in either order.

SECURITIES & INVESTMENT INSTITUTE The Securities & Investment Institute is the professional body for qualified and experienced practitioners of good repute engaged in a wide range of securities and other financial services businesses. The Institute’s purpose is to promote high standards of personal integrity, business ethics and professional competence and to create opportunities for practitioners to meet for professional and social purposes. Please call 020 7645 0600 or visit www.sii.org.uk for more information.

ASSOCIATE STATUS Associate status is a professional designation offered by the Securities & Investment Institute in recognition of the achievement of a benchmark qualification. Through Associate status, the Institute offers practitioners the opportunity to meet regulatory requirements to maintain competence. Upon achieving the Investment Administration Qualification (IAQ) individuals become eligible for Associate status. The use of the designatory letters ‘ASI’ demonstrates a high level of competency within the financial services industry and a commitment to high standards and professional integrity. For further information please telephone the Membership Department on 020 7645 0650.

CONTINUING COMPETENCE On successful completion of the IAQ, and to meet regulatory requirements, individuals will be required to keep their industry knowledge up–to–date by undertaking Continuing Competence. The Institute offers an extensive range of courses, conferences and workshops which provide excellent opportunities to keep in touch with industry developments. Telephone our Client Services team on 020 7645 0680 for more information. Membership of the Institute provides access to a programme of free Continuing Professional Development (CPD) Events and information on a range of topics on the website. See the Membership section of our website (www.sii.org.uk) or telephone the Membership Department on 020 7645 0650.

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International Certificate in Investment Management

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