Investment Operations

Certificate

Introduction to
Securities & Investment
Edition 39, April 2023
This workbook relates to syllabus
version 23.0 and will cover exams from
1 August 2023 to 31 July 2024
Welcome to the Chartered Institute for Securities & Investment’s Introduction to Securities & Investment
study material.

This workbook has been written to prepare you for the Chartered Institute for Securities & Investment’s
Introduction to Securities & Investment examination.

Published by:
Chartered Institute for Securities & Investment
© Chartered Institute for Securities & Investment 2023
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Author:
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The questions contained in this workbook are designed as an aid to revision of different areas of the
syllabus and to help you consolidate your learning chapter by chapter.

Please note that, as part of exam security, hand-held calculators are not allowed in CISI exam venues.
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internationally.

Workbook version: 39.1 (April 2023)

ii
Important – Keep Informed on Changes to this Workbook and Examination Dates

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iii
iv
Introduction: The Financial Services Sector . . . . . . . . . . . . . . . . . 1

1
The workbook commences with an introduction to the financial services sector and
examines the role of the sector and the main participants that are seen in financial centres
around the globe.

The Economic Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

2
An appreciation of some key aspects of macroeconomics is essential to an
understanding of the environment in which investment services are delivered. This
chapter looks at some key measures of economic data and the role of central banks
in management of the economy.

Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

3
The workbook then moves on to examine some of the main asset classes in detail,
starting with equities. It begins with the features, benefits and risks of owning shares
or stocks, looks at corporate actions and some of the main world stock markets and
indices, and outlines the methods by which shares are traded and settled.

Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

4
A review of bonds follows which includes looking at the key characteristics and types
of government and corporate bonds and the risks and returns associated with them.

Other Markets and Investments . . . . . . . . . . . . . . . . . . . . . . . . 101

5
This chapter starts the review of financial assets and markets by looking at the
characteristics of cash deposits, the money markets, property and the foreign exchange
markets.

Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
6
Next there is a brief review of derivatives to provide an understanding of the key
features of futures, options and swaps and the terminology associated with them.

Investment Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

7

The workbook then turns to the major area of investment funds or mutual funds/
collective investment schemes. The chapter looks at open-ended and closed-ended
funds, exchange-traded funds and hedge funds, and how they are traded.

v
 Financial Services Regulation and Professional Integrity . . . . . . . . . 155
8

An understanding of regulation is essential in today’s investment industry.

This chapter provides an overview of international regulation and looks at specific
areas such as money laundering, insider trading and bribery as well as a section
on professional integrity and ethics.

Taxation, Investment Wrappers and Trusts . . . . . . . . . . . . . . . . . 177

9

Having reviewed the essential regulations covering the provision of financial services,
the workbook then moves on to look at the main types of investment wrappers
seen in the UK, including ISAs and pensions, and also looks at the principles of
taxation and the use of trusts.

Other Financial Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195

10

This chapter reviews other types of financial products which are available, including loans,
mortgages and protection products, such as life assurance.

Financial Advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11

209
The workbook concludes with a look at the main areas of financial advice, the financial
advice process and the legal concepts.

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235

Multiple Choice Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245

Syllabus Learning Map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

It is estimated that this workbook will require approximately 80 hours of study time.

What next?
See the back of this book for details of CISI membership.

Need more support to pass your exam?

See our section on Accredited Training Partners.

Want to leave feedback?

Please email your comments to [email protected]

vi
 Before you open Chapter 1
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ebook bw 18.indd 1 02/10/2018 12:01:33

 Chapter One

Introduction:
The Financial Services
Sector
1. Introduction 3

2. Professional and Retail Business 5

3. Participants 10

4. Investment Distribution Channels 16

This syllabus area will provide approximately 3 of the 50 examination questions

1
2
 Introduction: The Financial Services Sector

1. Introduction

1
The financial services sector is a major
contributor to the economies of developed
countries. In the UK, for example, the
activities of financial services firms provide
considerable employment as well as overseas
earnings for the economy.

The financial services sector also plays

another important role in the economy by
providing the link between organisations
needing capital (eg, a company seeking to
expand) and those with capital available
for investment (eg, individuals saving for
retirement via a pension fund). It is the
financial services sector that channels money
invested to those organisations that need it
whilst also providing execution, payment,
advisory and management services.

The financial services sector is constantly

evolving and it is vital for anyone working
in it, or aspiring to work in it, to keep pace
with these changes by scanning the news for
important developments.

A research briefing note for the UK Parliament,

issued in September 2022, emphasised the
importance of the financial services sector
to the UK economy1. It reported that in the
previous year, the sector contributed £173.6
billion to the UK economy, was the fourth
largest in the Organisation for Economic
Co-operation and Development (OECD) as a
proportion of national economic output, and
directly employed 1.1 million people.

However, UK exports of financial services to

the EU have fallen significantly since 2018.
Specifically, between 2018 and 2021, the
value of UK exports of financial services to
the EU fell by 19%, while exports of financial
services to non-EU countries grew by 4%.
Post Brexit, the EU stopped recognising UK

1 https://researchbriefings.files.parliament.uk/
documents/SN06193/SN06193.pdf

3
exchanges and trading venues as having the same supervisory powers as its own, which led to a shift
in share trading from London to other European cities. In the first quarter of 2022, the EU accounted for
34% of UK financial services exports and the US accounted for 31%.

A twice-yearly ranking of the competitiveness of financial markets ranked London second in the world
(see below) in March 2022.

Global Financial Centres Index

The Global Financial Centres Index is produced by China Development Institute (CDI) in Shenzhen in
conjunction with Z/Yen Partners in London2 and evaluates the rankings and future competitiveness of
major financial centres based on five areas of competitiveness – business environment, human capital,
infrastructure, financial sector development, and reputation. The Global Financial Centres Index 32
published in September 2022 included 119 financial centres and showed New York retained its number
one place in the rankings with London not far behind.

Top 5 Global Financial Centres

1 New York
2 London
3 Singapore
4 Hong Kong
5 San Francisco

In Western Europe, other financial centres ranking in the top 20 were – Paris (10th), Frankfurt (18th),
Amsterdam (19th) and Geneva (20th).
Stock markets and investment instruments are not unique to one country, and there is increasing
similarity in the instruments that are traded on all world markets and in the way that trading and
associated settlement systems are developing.

With this background, therefore, it is important to understand the core role that the financial services
sector undertakes within the economy and some of the key features of the global financial services
sector. This will be considered in the following sections.

2 Source: https://www.longfinance.net/media/documents/GFCI_32_Report_2022.09.22_v1.0_.pdf

4
 Introduction: The Financial Services Sector

2. Professional and Retail Business

1
Learning Objective

1.1.2 Know the function of and differences between retail and professional business and who the
main customers are in each case

Within the financial services sector, there are two distinct areas: the wholesale and retail sectors. The
wholesale sector is also sometimes referred to as the professional sector or institutional sector.

The activities that take place in wholesale financial markets are shown below and are expanded on in
sections 2.1 to 2.5.

The financial activities that make up the wholesale/professional sector include:

• equity markets – the trading of quoted or listed shares

• bond markets – the trading of government, supranational or corporate debt
• foreign exchange – the trading of currencies
• derivatives – the trading of options, swaps, futures and forwards, and
• insurance markets – major corporate insurance (including professional indemnity), reinsurance,
captive insurance and risk-sharing insurance.

Other activities that take place in the wholesale sector include:

• fund management – managing the invest­ ment portfolios of collective investment schemes,
pension funds and insurance funds
• investment banking – banking services tailored to organisations, eg, undertaking mergers and
acquisitions (M&A), equity trading, fixed-income trading and private equity, and
• custodian banking – provision of services to asset managers involving the safekeeping of
assets; the administration of the underlying investments; settlement; corporate actions and other
specialised activities.

By contrast, the retail sector focuses on services provided to personal customers:

• retail banking – the traditional range of current accounts, deposit accounts, lending and credit
cards
• insurance – the provision of a range of life assurance and protection solutions for areas such as
medical insurance, critical illness cover, motor insurance, property insurance, income protection and
mortgage protection
• pensions – the provision of investment accounts specifically designed to capture savings during a
person’s working life and provide benefits on retirement
• investment services – a range of invest­ment products and vehicles ranging from execution-only
stockbroking to full wealth management services and private banking, and
• financial planning and financial advice – helping individuals to understand and plan for their
financial future.

5
 2.1 Equity Markets
Equity markets is the name given to stock markets where the shares of companies such as Amazon,
Apple, Facebook and Netflix are traded. Equity markets are generally the best-known financial markets
and facilitate the trading of shares in quoted or listed companies.

The World Federation of Exchanges (WFE) provides data from the global stock exchanges. As illustrated
in the following graph, global market capitalisation was over US$102 trillion towards the end of 2022
(note that not all stock exchanges provide data to the World Federation of Exchanges, so actual figures
may well be higher). Global market capitalisation is the total value of shares quoted on the world’s stock
exchanges.

Market Capitalisation
120

100

80
USD Million

60

40

20

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022

Source: World Federation of Exchanges

At the time of writing (December 2022)3:

• The New York Stock Exchange (NYSE) was the largest exchange in the world and had a domestic
market capitalisation of over US$22 trillion (domestic market capitalisation is the value of shares
listed on an individual exchange).
• The other major US market, Nasdaq, was ranked as the second largest, with a domestic market
capitalisation of over US$17 trillion, meaning that the two New York exchanges account for a
significant proportion of all global exchange business.
• The Shanghai Stock Exchange (SSE) is the world’s third largest exchange, with a domestic
capitalisation of close to US$6 trillion.
• Euronext is the world’s fourth largest market and had a domestic market capitalisation of over US$5
trillion.
• In Europe, the largest exchanges are the London Stock Exchange (LSE), Euronext, SIX Swiss
Exchange and Deutsche Börse AG.

3 https://www.statista.com/topics/1009/global-stock-exchanges/#topicOverview

6
 Introduction: The Financial Services Sector

Rivals to traditional stock exchanges have also arisen with the development of technology and

1
communication networks known as multi­lateral trading facilities (MTFs). MTFs are systems that bring
together multiple parties that are interested in buying and selling financial instruments including shares,
bonds and derivatives. These systems are also known as crossing networks or matching engines that
are operated by an investment firm or another market operator.

We will look at equities and equity markets in more detail in chapter 3.

2.2 Bond Markets

Bond markets allow governments and companies to raise loans or debt finance directly from investors
and then facilitate the subsequent secondary trading of the debt securities created. Although less well
known than equity markets, bond markets are larger both in size and value of trading. However, the
volume of bond trading is lower, as most trades tend to be very large when compared to equity market
trades. The amounts outstanding on the global bond market are over US$128 trillion according to
data published by the International Capital Markets Association (ICMA). Sovereign, Supranational and
Agency (SSA) debt accounts for 68% of the global bond market whilst corporate bonds make up the
remaining 32%4.

The instruments traded range from domestic bonds issued by companies and governments, to
international bonds issued by companies, governments and by supranational agencies such as the
World Bank. Although the US has the largest bond market by some way, trading in international bonds
is predominantly undertaken in European markets.

We will look at bonds in more detail in chapter 4.

2.3 Foreign Exchange (FX) Markets

Foreign exchange (FX) markets are global and facilitate the trading of currencies as well as the
determination of exchange rates, ie, the price of one currency in terms of another. FX markets are the
largest of all financial markets, with average daily turnover of approximately US$7.5 trillion 3, a volume
5

30 times greater than daily global GDP.

The rate at which one currency is exchanged for another is determined by supply and demand. For
example, if there is strong demand from Japanese investors for US assets, such as property, bonds or
shares, the US dollar will rise in value.

There is an active FX market that enables governments, companies and individuals to deal with their
cash inflows and outflows denominated in overseas currencies. Historically, most FX deals were
arranged over the telephone. The market was provided by the major banks who each provided rates of
exchange at which they were willing to buy or sell currencies. However, with the advances in technology
and stricter banking regulation, electronic trading is becoming increasingly prevalent which, in turn, has
prompted a growth in remittance companies alongside established banks.

4 https://www.icmagroup.org/market-practice-and-regulatory-policy/secondary-markets/bond-market-size/
3 Source: Foreword: OTC foreign exchange and interest rate derivatives marketshttps://www.bis.org/publ/qtrpdf/r_
qt2212d.htm through the prism of the Triennial Survey (bis.org)

7
As FX is an over-the-counter (OTC) market, meaning one where brokers/dealers negotiate directly with
one another, there is no central exchange or clearing house. Instead, FX trading is distributed among
major financial centres.

The Bank for International Settlements (BIS) releases figures on the composition of the FX market every
three years. The latest report for 2022 4 shows that market activity remains ever more concentrated in a
6

handful of global centres. As you can see in the chart below, FX transactions are mainly concentrated in
five locations, with the UK as the main global centre.

Main Locations for FX Trading

Other
21.6%
UK
38.1%

Japan
4.4%
Hong Kong
SAR 7.1%

Singapore
9.4% US 19.4%

Source: Bank for International Settlements (http://stats.bis.org:8089/statx/srs/table/D11.2?c=&p=2022&

m=&f=xlsx)

2.4 Derivatives Markets

Derivatives markets trade a range of complex products based on underlying instruments that include
currencies, indices, interest rates, equities, commodities and credit risk. Futures and options are two of
the most well-known derivatives.

Derivatives based on these underlying elements are available on both the exchange-traded market and
the over-the-counter (OTC) market (see chapter 6, section 1.1). The largest of the exchange-traded
derivatives markets is the Chicago Mercantile Exchange (CME), while Europe dominates trading in the
OTC derivatives markets worldwide.

Interest rate derivatives contracts account for the vast majority of outstanding derivatives contracts,
mostly through interest rate swaps. In terms of currencies, the interest rate derivatives market is
dominated by the euro and the US dollar, which have accounted for most of the growth in this market
since 2001. The growth in the market came about as a reaction to the 2000–02 stock market crash as
traders sought to hedge their position against interest rate risk.

We will look in more detail at derivatives in chapter 6.

4 Source: https://www.bis.org/statistics/rpfx22_fx.pdf

8
 Introduction: The Financial Services Sector

2.5 Insurance Markets

1
Insurance markets specialise in the manage­ment of risk.

Globally, the US, China, Japan and the UK are the largest insurance markets. The following table shows
the top ten largest markets by insurance premiums according to a study by Swiss Re.

Five Largest Insurance Markets in 2020

Rank Country

1 US

2 China

3 Japan

4 UK

5 France

Source: https://www.swissre.com/institute/research/sigma-research/World-insurance-series.html

The market is led by a number of major players who dominate insurance activity in their sector or
region; some of the largest are China Life, Allianz and AXA.

Another well-known organisation is Lloyd’s (the world’s specialist insurance market and often referred
to as Lloyd’s of London); with a history dating back over 300 years, it is one of the largest insurance
organisations in the world. It is not an insurance company but a marketplace that brings together a
range of insurers, both individuals and companies, each of whom accepts insurance risks as a member
of one or more underwriting syndicates. A small number of individual members (traditionally known as
‘names’) are liable to the full extent of their private wealth to meet their insurance commitments, while
the corporate entities trade with limited liability. Lloyd’s names join together in syndicates and each
syndicate will ‘write insurance’, ie, take on all or part of an insurance risk. There are many syndicates,
and each name will belong to one or a number of these. Each syndicate hopes that premiums received
will exceed claims paid out, in which case each name will receive a share of profits (after deducting
administration expenses).

Lloyd’s insures specialist and complex risks in casualty, property, energy, motor, aviation, marine and
reinsurance. It has a reputation for innovation, for example, developing policies for aviation, burglary and
cybercrime, and is known across the world as the place to bring unusual, specialist and complicated risks.

Less well known to the general public is the reinsurance industry. Just as individuals use insurance to
protect against the risk of needing to make a claim, insurers protect themselves by using reinsurance
companies. An insurer may seek to hedge some of the risks associated with the insurance policies
it has written by laying off some of that risk with a reinsurer. The reinsurance contract can cover an
entire insurance portfolio or single risks; it may involve sharing all premiums and losses or just those
exceeding a threshold, and it can also cover large one-off risks, such as major construction, satellites or
large sporting events. Some of the largest reinsurers in the world are Munich Re, Swiss Re, Hannover Re,
Berkshire Hathaway and Lloyd’s of London.

9
3. Participants
Learning Objective

1.1.1 Know the role of the following within the financial services sector: retail banks; savings
institutions; investment banks; pension funds; insurance companies; fund managers;
stockbrokers; custodians; platforms; third-party admin­istrators (TPAs); industry trade and
professional bodies; peer-to-peer (P2P)/crowdfunding

The following sections provide descriptions of some of the main participants in the financial services
sector.

3.1 Retail Banks

Retail banks (or high street banks) provide services such as taking deposits from and lending funds to
retail customers, as well as providing payment and money transmission services. They may also provide
similar services to business customers.

Historically, these banks have tended to operate through a network of branches located on the high
street, although we have seen a rising number of branch closures in recent years as an increasing
number of customers move to online banking.

As well as providing traditional banking services, larger retail banks also offer other financial products
such as investments, pensions and insurance.

3.2 Savings Institutions

As well as retail banks, most countries also have savings institutions. Savings institutions originally
specialised in offering savings products to retail customers but now tend to offer a similar range of services
to those offered by banks.

In the UK, they are usually known as building societies. They were established in the 19th century when
small numbers of people would group together and pool their savings, allowing some members to build
or buy houses. Building societies are jointly owned by the individuals who have deposited money with
or borrowed money from them – the ‘members’. It is for this reason that such savings organisations are
often described as ‘mutual societies’.

Over the years, many smaller building societies have merged or been taken over by larger ones or
banks. In the late 1980s, legislation was introduced allowing building societies to become companies
– a process known as ‘demutualisation’. Some large building societies remain as mutuals, such as the
Nationwide Building Society. They continue to specialise in services for retail customers, especially the
provision of deposit accounts and mortgages.

Another UK example is National Savings & Investment (NS&I) which is the largest single savings
organisation in the UK and can trace its origins back over 150 years. It offers a range of savings products,
including premium savings bonds and national savings certificates, as well as traditional savings

10
 Introduction: The Financial Services Sector

products. It is operated by the government and so, when customers invest in NS&I products, they are

1
lending to the government. In return, the government pays interest or prizes for premium bonds and
offers 100% security on all deposits.

More recently, competition to traditional banks has emerged from ‘challenger banks’. These are smaller
banks, specialising in areas underserved by large, traditional banks, and which distinguish themselves
from historic banking by deploying modern financial technology with no community branches.

3.3 Peer-to-Peer (P2P) and Crowdfunding

A more recent development in the banking industry has been the emergence of competitors to the
traditional role of banks in the form of peer-to-peer (P2P) lending or crowdfunding.

In the traditional banking model, banks take in deposits on which they pay interest and then lend out
at a higher rate. The spread between the two is where they earn their profit. P2P lending cuts out the
banks, so borrowers often get slightly lower rates, while savers get far improved headline rates, with the
P2P firms themselves profiting via a fee.

In exchange for accepting greater risk, savers can earn higher returns which can be very useful in periods
of low interest rates. Available rates vary depending on the type of borrower that the P2P site lends to
and the risk the lender is prepared to accept. The deposit is lent out to individuals and businesses, but
it may take time before all of a large deposit is lent and interest is earned. No interest is paid while it is
waiting to be lent out. Immediate withdrawals are not always possible and, where they are, may take
time and incur a charge or a reduced interest rate.

Since April 2016, an Innovative Finance Individual Savings Account (ISA) has been available as an
investment option so that the P2P deposit can be sheltered in a tax-free wrapper.

Crowdfunding is the practice of funding a project or venture by raising small amounts of money from
a large number of people. Traditionally, financing a business, project or venture involved asking a few
people for large sums of money. Crowdfunding switches this idea around, using the internet to access
many potential funders.

Crowdfunding can take the following forms:

• A donation – people simply believe in the cause or innovation.

• Debt crowdfunding – investors receive their money back with interest.
• Equity crowdfunding – people invest in exchange for equity or shares in the venture.

3.4 Investment Banks

Investment banks provide advice and arrange finance for companies that want to float on a stock
market, raise additional finance by issuing further shares or bonds, and carry out mergers and
acquisitions. They also provide services for those who might want to invest in shares and bonds, for
example, pension funds and asset managers.

11
Typically, an investment banking group provides some or all of the following services, either in divisions
of the bank or in associated companies within the group:

• Corporate finance and advisory work, normally in connection with new issues of securities for
raising finance, takeovers, mergers and acquisitions.
• Banking for governments, institutions and companies.
• Treasury dealing for corporate clients in foreign currencies, with financial engineering services to
protect them from interest rate and exchange rate fluctuations.
• Investment management for sizeable investors, such as corporate pension funds, charities and
high net worth private clients. This may be either via direct investment for the wealthier, or by way
of collective investment schemes (CISs) (see chapter 7). In larger firms, the value of funds under
management runs into many billions of pounds.
• Securities trading in equities, bonds and derivatives, and the provision of broking and distribution
facilities.

Only a few investment banks provide services in all these areas. Most others tend to specialise to some
degree and concentrate on only a few product lines. A number of banks have diversified their range
of activities by developing businesses such as proprietary trading, servicing hedge funds, or making
private equity investments.

3.5 Pension Funds

Pension funds are one of the key ways by which individuals can make provision for retirement. There
is a variety of pension schemes available, ranging from those provided by employers to self-directed
schemes.

Pension funds are large, long-term investors in shares, bonds and cash. Some also invest in physical
assets, like property. To meet their aim of providing a pension on retirement, the sums of money
invested in pensions are substantial.

3.6 Insurance Companies

One of the key functions of the financial services sector is to ensure risks are managed effectively.
The insurance industry provides solutions for much more than the standard areas of life and general
insurance cover.

Protection planning is a key area of financial advice, and the insurance industry offers a wide range of
products to meet many potential scenarios. These products range from payment protection policies
designed to pay out in the event that an individual is unable to meet repayments on loans and
mortgages, to fleet insurance against the risk of an airline’s planes crashing (see chapter 10 for examples
of further types of products offered).

Insurance companies collect premiums in exchange for the cover provided. This premium income is
used to buy investments such as shares and bonds and as a result, the insurance industry is a major
player in the stock market. Insurance companies will subsequently realise these investments to pay any
claims that may arise on the various policies. The UK insurance industry is the largest in Europe and the
fourth largest in the world after the US, China and Japan.

12
 Introduction: The Financial Services Sector

3.7 Fund Managers

1
Fund management is the professional manage­ment of investment portfolios for a variety of institutions
and private investors.

The UK is the largest centre for fund manage­ment in Europe, second in size globally only to the US.
The fund management industry in the UK serves a large number of domestic and overseas clients and
attracts significant overseas funds. London is the leading inter­national centre for fund management.

Fund managers, also known as investment or asset managers, run portfolios of investments for others.
They invest money held by institutions, such as pension funds and insurance companies, as well as
for collective investment schemes (CISs), such as unit trusts and open-ended investment companies
(OEICs) for wealthier individuals. Some are organisations that focus solely on this activity; others are
divisions of larger entities, such as insurance companies or banks.

Fund management is also known as asset management or investment management.

Investment managers who buy and sell shares, bonds and other assets in order to increase the value
of their clients’ portfolios can con­veniently be subdivided into institu­tional and private client fund
managers. Institutional fund managers work on behalf of institutions, for example, investing money for
a company’s pension fund or an insurance company’s fund, or managing the investments in a unit trust.
Private client fund managers invest the money of relatively wealthy individuals. Institutional portfolios
are, unsurprisingly, usually larger than those of regular private clients.

Fund managers charge their clients for managing their money; their charges are often based on a small
percentage of the value of the fund being managed. Other areas of fund management include the
provision of investment management services to institutional entities, such as companies, charities and
local government authorities.

13
3.8 Stockbrokers and Wealth Managers
Traditionally, stockbrokers arranged trades in financial instruments on behalf of their clients, which
include investment institutions, fund managers and private clients. Today, most of these are institutional
brokers who make their money by using their discretion and skill to execute large trades in the market.
Others are execution-only brokers (see section 4.3) that offer trading services to retail clients. These
firms earn their profits by charging commissions on transactions.

Stockbrokers also advised investors about which shares, bonds or funds they should buy and the
services offered expanded to include investment management services and wealth management. As a
result, many stockbrokers now offer a range of wealth management services to their clients and so are
referred to as wealth managers. These wealth management firms can be independent companies, but
some are divisions of larger entities, such as investment or commercial banks. They earn their profits by
charging fees for their advice and commissions on transactions. Also, like fund managers, they may look
after client assets and charge custody and portfolio management fees.

3.9 Custodian Banks

Custodians are banks that specialise in safe custody services, looking after portfolios of shares and
bonds on behalf of others, such as fund managers, pension funds and insurance companies.

The core activities they undertake include:

• holding assets in safekeeping, such as equities and bonds

• arranging settlement of any purchases and sales of securities
• processing corporate actions, including collecting income from assets, namely dividends in the
case of equities and interest in the case of bonds
• providing information on the underlying companies and their annual general meetings (AGMs)
• managing cash transactions
• performing foreign exchange transactions when required, and
• providing regular reporting on all their activities to their clients.

Competition has driven down the charges that a custodian can make for its traditional custody services
and has resulted in consolidation within the industry. The custody business is now dominated by a small
number of global custodians, which are often divisions of investment banks.

3.10 Platforms
Platforms are online services used by intermediaries, such as independent financial advisers (IFAs), to
view and administer their clients’ investment portfolios.

They offer a range of tools which allow advisers to see and analyse a client’s overall portfolio and
to choose products for them. As well as providing facilities for investments to be bought and sold,
platforms generally arrange custody for clients’ assets. Examples of platforms include those offered by
Cofunds and Hargreaves Lansdown.

14
 Introduction: The Financial Services Sector

The term ‘platform’ refers to both wraps and fund supermarkets. These are similar, but while fund

1
supermarkets tend to offer wide ranges of unit trusts and OEICs, wraps often offer greater access to
other products too, such as ISAs, pension plans and insurance bonds. Wrap accounts enable advisers to
take a holistic view of the various assets that a client has in a variety of accounts. Advisers also benefit
from using wrap accounts to simplify and bring some level of automation to their back office using
internet technology.

Platform providers also make their services available direct to investors, and platforms earn their income
by charging for their services. The advantage of platforms for fund management groups is the ability of
the platform to distribute their products to financial advisers.

3.11 Third-Party Administrators (TPAs)

Third-party administrators (TPAs) undertake investment administration on behalf of other firms and
specialise in this area of the investment industry.

The number of TPA firms and the scale of their operations has grown with the increasing use of
outsourcing. The rationale behind outsourcing is that it enables a firm to focus on the core areas of its
business (for example, investment management and stock selection, or the provision of appropriate
financial planning) and fix its costs, and leaves a specialist firm to carry out the administrative functions,
which it can process more efficiently and cost effectively.

3.12 Trade and Professional Bodies

The investment industry is a dynamic, rapidly-changing business, and one that requires cooperation
between firms to ensure that the views of various industry sections are represented, especially to
government and regulators. The industry also facilitates and enables cross-firm developments to take
place to create an efficient market in which the firms can operate.

This is essentially the role of the numerous professional and trade bodies that exist across the world’s
financial markets. Some examples of such bodies include the following:

• Bonds – International Capital Market Association (ICMA).

• Derivatives – FIA Europe; International Swaps and Derivatives Association (ISDA).
• Fund managers – Investment Association (IA).
• Insurance companies – Association of British Insurers (ABI).
• Wealth management – Personal Investment Management and Financial Advice Association
(PIMFA, formerly the Wealth Management Association (WMA)).
• Banks – UK Finance represents nearly 300 of the leading firms providing finance, banking, markets
and payments-related services in, or from, the UK. UK Finance has been created by combining most
of the activities of the Asset Based Finance Association, the British Bankers’ Association, the Council
of Mortgage Lenders, Financial Fraud Action UK, Payments UK and the UK Cards Association.
• Investment funds – the Tax Incentivised Savings Association (TISA) is an industry-funded body
working to improve savings and investment schemes available to UK citizens; the Depositary and
Trustee Association (DATA) represents the industry views of depositaries of open-ended investment
companies (OEICs) and trustees of unit trusts within the UK.

15
4. Investment Distribution Channels
Learning Objective

1.1.3 Know the role of the following investment distribution channels: independent financial
adviser; restricted advice; execution-only; robo-advice
1.1.4 Know about the following themes: Fintech; environmental, social, and governance (ESG)

4.1 Financial Planning

Financial planning is a professional service available to individuals, their families and businesses, who
need objective assistance in organising their financial affairs to achieve their financial and lifestyle
objectives more easily.

Financial planning is clearly about financial matters, so it deals with money and assets that have
monetary value. Invariably this will involve looking at the current value of clients’ bank balances, any
loans, investments and other assets. It is also about planning, ie, defining, quantifying and qualifying
goals and objectives and then working out how those goals and objectives can be achieved. In order to
do this, it is vital that a client’s current financial status is known in detail.

Financial planning is ultimately about meeting a client’s financial and lifestyle objectives, not the
adviser’s objectives. Any advice should be relevant to the goals and objectives agreed. Financial
planning plays a significant role in helping individuals get the most out of their money. Careful planning
can help individuals define their goals and objectives, and work out how these may be achieved in the
future using available resources. Financial planning can look at all aspects of an individual’s financial
situation and may include tax planning, both during lifetime and on death, asset management, debt
management, retirement planning and personal risk management – protecting income and capital in
the event of illness and providing for dependants on death.

The Chartered Institute for Securities & Investment (CISI) offers qualifications and related products at all
levels for those working in, or looking for a career in, financial planning. Further details can be found on
the CISI’s website (www.cisi.org).

4.2 Financial Advisers

Financial advisers are professionals who offer advice on financial matters to their clients. Some
recommend suitable financial products from the whole of the market and others from a narrower range
of products.

Typically, a financial adviser will conduct a detailed survey of a client’s financial position, preferences
and objectives; this is sometimes known as a fact-find. The adviser will then suggest appropriate action
to meet the client’s objectives and, if necessary, recommend a suitable financial product to match the
client’s needs.

16
 Introduction: The Financial Services Sector

Investment firms must now clearly describe their services as either independent advice or restricted

1
advice. Firms that describe their advice as independent will have to ensure that they genuinely do
make their recommendations based on comprehensive and fair analysis of all products available in the
market, and provide unbiased, unrestricted advice. If a firm chooses to only give advice on its own range
of products – restricted advice – this will have to be made clear. Their activities are supervised by the
Financial Conduct Authority (FCA).

4.3 Execution-Only
A firm carries out transactions on an execution-only basis if a customer asks it to buy or sell a specific
investment product without having been prompted or advised by the firm. In such instances, customers
are responsible for their own decision about a product’s suitability.

The practice of execution-only sales is long-established. To ensure that firms operate within regulatory
guidelines they need to record and retain evidence in writing that the firm:

• gave no advice, and

• made it clear, at the time of the sale, that it was not responsible for assessing the product’s suitability.

4.4 Robo-Advice
Robo-advice is the application of technology to the process of providing financial advice, but without
the involvement of a financial adviser. A prospective investor enters data and financial information
about themselves, and the system then uses an algorithm to score the information and decide
what investments should be chosen. The system then presents the investment strategy, which is
usually passively focused around index funds or exchange-traded funds (ETFs), and allows easy
implementation.

Robo-advice can be fully automated or provide guidance and tools to enable investors to choose their
own solutions. The approach uses an asset and risk model, as well as the construction of risk-targeted
portfolios or funds to achieve a client’s objectives, and then the ongoing monitoring and rebalancing
against those objectives.

Robo-advice is already established in the US, with some of the industry’s largest players involved. More
providers are coming online in the UK to fill the gaps in the advice market and, particularly, for pensions
planning, as a result of major changes to how pension benefits can be taken (see chapter 9, section 4.2).

17
4.5 Financial Technology – Fintech
Financial technology, or Fintech, refers to the use of technology to enhance and deliver superior
financial service product offerings. The term describes a variety of financial activities; at its most basic,
we see and use Fintech in our daily lives in the form of internet banking or more recently mobile pay.
It is worth noting the importance that this development played during the coronavirus (COVID–19)
pandemic, when many retail outlets were only accepting contactless payment.

The emergence of Fintech has seen global financial firms rebrand their offering from that of a purely
financial firm to one that offers a product via the most technologically advanced methods. This is
important not only in terms of keeping pace with an ever-changing market but also in terms of winning
new business and being the first to market with new product offerings.

Fintech can be utilised by organisations in many ways including data collection, faster client on boarding,
data aggregation in portfolio construction and real-time pricing updates to name a few. In 2015–16, the
Financial Planning Standards Board (FPSB) examined how the advent of Fintech platforms and tools and
automated advice could shape the future of financial planning. Initially there was trepidation among
those financial professionals surveyed, however, a year later the response was more favourable and
Fintech was emerging as a trend which complimented existing service and product offerings.

In 2019, the Department for International Trade and the HM Treasury published the ‘UK FinTech: State
of the Nation’, a comprehensive summary of the UK’s Fintech industry. The document highlights the UK
Market as a forerunner in the Fintech sector. Contributing factors include the thriving ecosystem (an
area we will discuss in more detail under Environmental, Social and Governance (ESG) (section 4.6)) and
the quality of the workforce. The UK government says it is setting the global standard on innovation in
financial services.

It is also important to note the FCA’s proactive approach to the Fintech industry, an action that no
doubt has contributed to the UK’s global standing. In its infancy, the FCA identified the need to have a
dedicated team to allow innovators in the Fintech navigate the area of regulation. This was initially done
through the use of ‘robo’ advice and later evolved in the guise of the sandbox. The sandbox gives firms
the opportunity to test Fintech-related ideas with real customers in a controlled environment. Demand
for the sandbox initiative is high and it continues to evolve with the recent launch of the Green Fintech
Challenge.

4.6 Environmental, Social and Governance (ESG)

The emergence of a more conscious investor has contributed to the development of the latest theme
within the financial sector. ESG factors are used by these investors to determine if an investment suits
their objectives.

• Environmental factors include sustainability and climate change.

• Social factors and concerns include consumer protection and diversity.
• Governance factors and concerns include employee relations and management structures.

18
 Introduction: The Financial Services Sector

It is not only important for firms to ensure their product offering to their investors/consumers covers

1
ESG factors but it is also extremely important that firms looking to deal with other firms adopt this and
demonstrate this culture. For example, an investment firm which demonstrates a commitment to ESG
will not want to associate with an administration firm whose social environment could be called into
question.

Investors can utilise the services of an ESG rating agency in deciding which investments suit their
objectives. The rating agency will assign weightings to investments based on ESG factors, these weightings
will be used to determine a rating. MSCI is one such organisation that determines the ESG rating. A rules-
based methodology is used to identify industry leaders and those on the opposite end of the spectrum.
Companies are rated on a scale according to their ESG risk exposure and how it is perceived that those
risks are managed relative to industry peers. Such ratings allow ESG-conscious investors access to expert
industry insights similar to that of debt ratings when making investment decisions.

19
End of Chapter Questions
Think of an answer for each question and refer to the appropriate section for confirmation.

1. Name four main activities undertaken by the professional financial services sector and five
by the retail sector.
Answer Reference: Section 2

2. How does a mutual savings institution differ from a retail bank?

Answer Reference: Sections 3.1 and 3.2

3. How does peer-to-peer (P2P) lending differ from traditional banking?

Answer Reference: Section 3.3

4. What are the main types of services provided by investment banks?

Answer Reference: Section 3.4

5. What is protection planning, and what scenarios might necessitate the use of protection
policies?
Answer Reference: Section 3.6

6. What services does a custodian offer?

Answer Reference: Section 3.9

7. What is a platform and why might they be considered a useful distribution channel?
Answer Reference: Section 3.10

8. What is the role of a third-party administrator?

Answer Reference: Section 3.11

9. What are the two types of financial adviser, and how does the range of products they advise
on differ?
Answer Reference: Section 4.2

10. What records should be kept when a transaction is undertaken on an execution-only basis?
Answer Reference: Section 4.3

20
 Chapter Two

The Economic
Environment
1. Introduction 23

2. Factors Determining Economic Activity 23

3. The Economic Cycle and Economic Policy 26

4. Central Banks 29

5. Key Economic Indicators 35

This syllabus area will provide approximately 4 of the 50 examination questions

21
22
 The Economic Environment

1. Introduction
In this chapter, we turn to the broader economic
environment in which the financial services sector

2
operates.

First, we will look at how economic activity is

determined in various economic and political
systems, and the stages of the economic cycle.
Then, we will look at the role of the government
in determining economic policy as well as the role
of central banks in the economy.

The chapter concludes with an explanation of

some of the key economic measures that provide
an indication of the state of an economy.

2. Factors Determining
Economic Activity
Learning Objective

2.1.1 Know the factors which determine

the level of economic activity: state-
controlled economies; market
economies; mixed economies; open
economies

Every country has a set of characteristics, such as

natural resources and a skilled workforce, which
can influence their ability to grow their economy.

While it is not just economic factors that influence

economic development, they are important
for understanding the capacity or the ability of
an economy to develop on its own. There are
several factors affecting economic growth, and it
is helpful to split them into demand-side factors
(eg, consumer spending) and supply-side factors
(eg, productive capacity). Each factor influences
the available economic resources and growth
opportunities within a country.

23
Economic systems are the means by which countries determine how they will use these resources
to resolve the basic problem of what, how much, how, and for whom to produce. The main
types of economic systems are a state-controlled economy, a market economy and a mixed economy,
while an open economy refers to a country’s economic relationship with the rest of the world. Each of
these are considered below.

2.1 State-Controlled Economies

A state-controlled economy is one in which the state (in the form of the government) decides what is
produced and how it is distributed. It is also known as a planned economy or a command economy. The
best-known example of a state-controlled economy was the Soviet Union throughout most of the 20th
century.

Sometimes, these economies are referred to as ‘planned economies’, because the production and
allocation of resources is planned in advance rather than being allowed to respond to market forces.
The perceived advantage of a planned economy is suggested to be low levels of inequality and
unemployment, with the common good replacing profit as the primary incentive of production.
However, this may not be the case and large inequalities can arise, as seen in countries such as
Russia and Venezuela. The need for careful planning and control can bring about excessive layers of
bureaucracy and state control inevitably removes a great deal of individual choice.

These latter factors have contributed to the reform of many planned economies and the introduction of
more mixed economies (covered in more detail in section 2.3).

2.2 Market Economies

In a market economy, the forces of supply and demand determine how resources are allocated.

Businesses produce goods and services to meet the demand from consumers. The interaction of
demand from consumers and supply from businesses in the market will determine the market-clearing
price. This is the price that reflects the balance between what consumers will willingly pay for goods and
services and what suppliers will willingly accept for them. If there is oversupply, the price will be low and
some producers will leave the market. If there is undersupply, the price will be high, which will attract
new producers into the market.

There is a market not only for goods and services, but also for productive assets, such as capital goods
(eg, machinery), labour and money. For the labour market, it is the wage level that is effectively the
‘price’, and for the money market it is the interest rate.

People compete for jobs and companies compete for customers in a market economy. Scarce resources,
including skilled labour, such as a football player, or a financial asset, such as a share in a successful
company, will have a high value. In a market economy, competition means that inferior football players
and shares in unsuccessful companies will be much cheaper and ultimately competition could bring
about the collapse of the unsuccessful company, and result in the inferior football player searching for
an alternative career.

24
 The Economic Environment

2.3 Mixed Economies

A mixed economy combines a market economy with some element of state control. The vast majority of
economies are mixed to a greater or lesser extent.

2
While most of us would agree that unsuccessful companies should be allowed to fail, we generally feel
that the less able in society should be cushioned against the full force of the market economy.

In a mixed economy, the government will provide a welfare system to support the unemployed, the
infirm and the elderly, in tandem with the market-driven aspects of the economy. Governments will also
spend money running key areas such as defence, education, public transport, health and police services.

Governments raise finance for their public expenditure by:

• collecting taxes directly from wage-earners and companies

• collecting indirect taxes (eg, VAT and taxes on petrol, cigarettes and alcohol), and
• raising money through borrowing in the capital markets.

Civil servants, primarily working for the government to raise money and spend it, tend to be one of the
largest groups in the labour market. In the UK, it is the civil servants working for the Treasury who raise
money and allocate it to the ‘spending departments’, such as the National Health Service (NHS).

2.4 Open Economies

The term ‘open economy’ relates to a country’s economic relationship with outside countries. In an
open economy, there are few barriers to trade or controls over foreign exchange.

Although most western governments create barriers to protect their citizens against illegal drugs and
other dangers, they generally have policies to allow or encourage free trade.

From time to time, issues will arise when one country believes another is taking unfair advantage
of trade policies and employs some form of retaliatory action, possibly including the imposition of
sanctions as has been seen in the most recent trade wars between the US and China. When a country
prevents other countries from trading freely with it in order to preserve its domestic market, the practice
is usually referred to as protectionism.

The World Trade Organization (WTO) exists to promote the growth of free trade between economies. It
is, therefore, sometimes called upon to arbitrate when disputes arise. In addition to global agreements
on trade under WTO rules, there are many regional and bilateral trade agreements that go beyond
commitments made in the WTO that aim to increase trade and boost economic growth.

25
3. The Economic Cycle and Economic Policy
Learning Objective

2.1.2 Know the stages of the economic cycle and the role of government in determining: economic
policy; fiscal policy; monetary policy

Traditionally, the role of government has been to manage the economy through taxation and through
economic and monetary policy, and to ensure a fair society by the state provision of welfare and
benefits to those who meet certain criteria, while leaving business relatively free to address the
challenges and opportunities that arise.

Governments can use a variety of policies when attempting to reduce the impact of fluctuations in
economic activity. Collectively, these measures are known as stabilisation policies and are categorised
under the broad headings of fiscal policy and monetary policy. Fiscal policy involves making
adjustments using government spending and taxation, while monetary policy involves making
adjustments to interest rates and the money supply.

3.1 Macroeconomic Objectives

Macroeconomic policy is the management of the economy by government in such a way as to influence
the performance and behaviour of the economy as a whole. The main objectives are as follows:

• As far as possible, all factors of production, ie, land, labour capital

Full employment
and enterprise should be fully utilised.

Economic growth • Measured by increases in gross domestic product (GDP).

• Achieving price stability – typically, a rate of inflation of 2% is set

Low inflation
as a target.

Balance of payments • Deficits in external trade, with imports exceeding exports, might
equilibrium be damaging for the prospect of economic growth.

Simultaneous achievement of all four objectives is extremely difficult. For example, the balance of
payments tends to deteriorate as economic growth improves. This is because when growth is triggered
by an increase in aggregate demand, it often leads to an increase in imports as foreign goods are
bought by UK manufacturers and consumers.

3.2 Stages of the Economic Cycle

Over time, the level of economic activity within an economy tends to fluctuate as GDP increases and
decreases. The following diagram illustrates the four typical stages of the economic cycle, ie, peak,
contraction, trough and expansion:

26
 The Economic Environment

Level of National Economic Activity

2
• Peak – GDP is at its highest point. Any growth in output stops. This is the point at which GDP is
expected to decline, ie, contraction of the economy is expected.
• Contraction – this is the period over which GDP declines as economic activity slows. When there
are two consecutive quarters of declining GDP or ‘negative growth’, economists refer to this as a
recession.
• Trough – GDP is now at its lowest point. The contraction phase is over.
• Expansion – economic activity picks up and GDP begins growing once again. Early expansion
is usually characterised by a moderate increase in GDP whereas with late expansion, the rate of
increase is higher.

Section 5.2.2 will expand on this cycle.

27
3.3 Fiscal Policy
Fiscal policy is any action by the government to spend money, or to collect money in taxes, with the
purpose of influencing the condition of the economy. The government will use the following tools to
influence the level of spending in the economy:

• The budget – the government budget is a statement of public income and expenditure over a period
of one year. There will be a balanced budget where income equals expenditure, a deficit budget
where expenditure exceeds income, or a surplus budget where income exceeds expenditure. With
a budget deficit, ie, where public expenditure is more than public income, the government must
borrow to make up the difference. This is known as the public sector borrowing requirement (PSBR).
• Taxation – taxation can be direct, for example, PAYE tax levied on income, or indirect, eg, VAT
charged on goods and services. Through the taxation system, the government can influence the
level of spending in the economy. If the government were to reduce taxation and keep its own
spending constant, it would mean that firms and households would have more disposable income.
This is one method of stimulating demand. On the other hand, a government could reduce demand
by raising taxes or reducing its expenditure.

3.3.1 Implications of Fiscal Policy for Business

Planning
Since fiscal policy influences the level of aggregate demand in the economy, businesses need to
take this into account when planning output levels, future employment levels and also deciding on
investments. Planning will be much easier if government policy is stable.

Costs
Taxation, especially employers’ national insurance contributions, will affect total labour costs, hence
the ultimate cost for products and services. In addition, if indirect taxes such as VAT rise, the cost would
either have to be absorbed by the firm or passed on to the customer.

3.4 Monetary Policy

Monetary policy is the regulation of the economy through control of the monetary system by operating
on such variables as the money supply, the level of interest rates and the conditions for the availability
of credit. Monetary policy is generally concerned with the volume of money in circulation and the price
of money or the interest rate.

The Money Supply

The stock of money in the economy is believed to influence the volume of expenditure in the economy.
This, in turn, influences the level of output and prices. Under monetary policy, the government can target
the stock of money as an economic tool. Governments may decide to impose a ‘credit squeeze’ and
restrict credit lending to control the level of spending and reduce inflation. Alternatively, governments
may impose reserve requirements on banks, eg, a minimum cash reserve ratio.

28
 The Economic Environment

Interest Rates
Interest represents the price of money or the cost of borrowing. It is, therefore, assumed that there is
a direct relationship between the interest rate and the level of spending in the economy. An increase
in interest rates is thought to discourage spending in the economy and thereby reduce the level of

2
aggregate spending.

• Consumers would be encouraged to save with higher interest rates.

• Mortgage payments would rise, leaving less disposable income for homeowners.
• The higher cost of credit would deter borrowing and hence spending.
• The level of corporate investments would decline due to higher borrowing costs.
• The corporate sector may lose confidence in the economy and become pessimistic about future
prospects.

It has been argued, however, that a higher level of interest rates will not necessarily achieve the above.
Other effects of a high rate of interest need to be considered.

• Higher interest means greater interest income for savers. They may increase their spending.
• Demands for higher wages could arise out of the need to make higher mortgage payments.
• Higher interest rates attract capital inflows. This would lead to an appreciation in the exchange rate,
making imports cheaper and, thus, more attractive. This will contribute to the balance of payments
deficit.
• Lower demand could result in higher unemployment and lower tax income for the government.
Unemployment benefits may, therefore, increase.
• Low investment now would mean poor prospects for future economic growth.

4. Central Banks
Learning Objective

2.1.3 Know the function of central banks: the Bank of England including the Monetary Policy
Committee; the Federal Reserve; the European Central Bank

Rather than following one or another type of policy, most governments now adopt a pragmatic
approach to controlling the level of economic activity through a combination of fiscal and monetary
policy. In an increasingly integrated world, however, 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.

Governments typically implement their monetary policies using their central bank, and a consideration
of their role in this implementation is explained below.

29
4.1 The Role of Central Banks
Central banks operate at the very centre of a nation’s financial system. They are usually public bodies
but, increasingly they operate independently of government control or political interference. They
usually have some or all of the following responsibilities:

• Acting as banker to the banking system by accepting deposits from, and lending to, commercial
banks.
• Acting as banker to the government.
• Managing the national debt.
• Regulating the domestic banking system.
• Acting as lender of last resort in financial crises to prevent the systemic collapse of the banking
system.
• Setting the official short-term rate of interest.
• Controlling the money supply.
• Issuing notes and coins.
• Holding the nation’s gold and foreign currency reserves.
• Influencing the value of a nation’s currency through activities such as intervention in the currency
markets.
• Providing a depositors’ protection scheme for bank deposits.

4.2 Bank of England (BoE)

The Bank of England (BoE) is the central bank of the UK. It was founded in 1694 and its roles and
functions have evolved and changed over its 300-year-plus history. Since its foundation it has been the
government’s banker and, since the late 18th century, it has been banker to the banking system or, more
generally, the bankers’ bank. As well as providing banking services to its customers, the BoE manages
the UK’s foreign exchange and gold reserves.

The Bank has two core purposes – monetary stability and financial stability.

• Monetary stability means stable prices and confidence in the currency. Stable prices involve
meeting the government’s inflation target which, since November 2003 has been a rolling two-
year target of 2% for the consumer prices index (CPI). This it does by setting the base rate, the UK’s
administratively set short-term interest rate.
• Financial stability refers to detecting and reducing threats to the financial system as a whole. A
sound and stable financial system is important in its own right, and vital to the efficient conduct of
monetary policy.

It also undertakes the other typical responsibilities of a central bank with the exceptions of managing
the national debt and providing a depositors’ protection scheme. As we will see in section 4.2.3, these
are undertaken by separate agencies.

30
 The Economic Environment

4.2.1 Monetary Stability

The BoE is perhaps most visible to the general public through its banknotes and, since the late 1990s,
its interest rate decisions. The BoE has had a monopoly on the issue of banknotes in England and Wales

2
since the early 20th century. But it is only since 1997 that the BoE has had statutory responsibility for
setting the UK’s official interest rate.

Interest rate decisions are taken by the BoE’s Monetary Policy Committee (MPC). The MPC is made up
of nine members – the Governor of the BoE, the three Deputy Governors for Monetary Policy, Financial
Stability and Markets and Banking, the Chief Economist and four external members appointed directly
by the Chancellor. External members are appointed to make sure that the MPC benefits from the
thinking and expertise that exists outside of the BoE. A representative from HM Treasury also sits with
the MPC at its meetings. The Treasury representative can discuss policy issues but is not allowed to
vote. They are there to make sure that the MPC is fully briefed on fiscal policy developments and other
aspects of the government’s economic policy, and that the Chancellor is kept fully informed about
monetary policy. Each member of the MPC has expertise in the field of economics and monetary policy.
Members do not represent individual groups or areas – they are independent – and they serve fixed
terms, after which, they will either be replaced or reappointed.

The MPC’s primary focus is to ensure that inflation is kept within a government-set range, set each year
by the Chancellor of the Exchequer, to support the government’s economic objectives, including those
for growth and employment. The MPC does this by setting the base rate which is otherwise known as
the ‘official bank rate’. This is the MPC’s main policy instrument.

At its monthly meetings, the MPC must gauge all of those factors that can influence inflation over both
the short and medium term. These include the level of the exchange rate, the rate at which the economy
is growing, how much consumers are borrowing and spending, wage inflation, and any changes to
government spending and taxation plans. The MPC also has responsibility for formulating monetary
policy within the Bank and quantitative easing (QE), as described below.

When setting the base rate, the MPC must also be mindful of the impact any changes will have on the
sustainability of economic growth and employment in the UK and the time lag between a change in
rate and the effects it will have on the economy. Depending on the sector of the economy we are looking
at, this can be anything from a very short period of time (eg, credit card spending when consumers are
already stretched), to a year or more (businesses altering their investment and expansion plans).1

Quantitative Easing (QE)

Reactions to the Great Recession of 2008 saw governments across the world, including the UK, follow
a policy of reducing interest rates to counter the effect of a slowing global economy and the risks of
depression. When a central bank is concerned about the risks of very low inflation, it cuts the base rate
to reduce the cost of money and provide a stimulus to the economy.

The key difference in the last recession was that interest rates were reduced massively by central banks
in developed countries. When they are close to zero, central banks need an alternative policy instrument.
This is a process known as quantitative easing (QE). The objective of QE is to inject cash directly into the

1 Review the latest minutes from the MPC and identify their key decisions and observations at https://www.bankofengland.
co.uk/home/monetary-policy-report and select Monetary Policy Committee Minutes or the Monetary Policy Summary and
minutes of the Monetary Policy Committee.

31
economy to stimulate demand and return inflation to target. When QE was introduced in the UK, there
was a real concern about falling into a deflationary spiral, as the UK was in the midst of one of the worst
global recessions on record. With interest rates near to zero, and the economy stagnating, there was a
real risk of low inflation or even deflation. By injecting money directly into the economy and, therefore,
increasing spending, the aim was to push inflation back up towards the 2% target level.

QE involves the central bank creating money, which it then used to buy assets such as government
bonds and high-quality debt from private companies, resulting in more money in the wider economy.

Creating more money does not involve printing more banknotes. Instead, the central bank buys assets
from private sector institutions and credits the seller’s bank account, so the seller has more money in
their bank account, while the central bank holds assets as part of its reserves. The objective is to move
money out in the wider economy.

Injecting more money into the economy through the purchase of bonds can have a number of effects:

• The seller of the bonds ends up with more money and so may spend it, which will help boost growth.
• Alternatively, they may buy other assets instead, and in doing so, boost prices and provide liquidity
to other sectors of the economy, resulting in people feeling better off and so spending more.
• Buying assets means higher asset prices and lower yields, which brings down the cost of borrowing
for businesses and households, encouraging a further boost to spending.
• Banks find themselves holding more reserves, which might lead them to boost their lending to
consumers and business; again, borrowing increases and so does spending.

The theory is that the extra money works its way through the economy, resulting in higher spending
and therefore growth, or reducing the impact of recession and preventing the onset of a depression. It
is difficult to tell if QE has worked and, if it has, how well. However, economies that had programmes of
QE, such as the UK and the US, would appear to have fared better post-recession than those that did not.

The process of reversing or ‘unwinding’ QE, is known as quantitative tightening or QT. This is done by
the Bank either by stopping reinvestments or selling bonds and should have the effect of raising interest
rates and lowering inflation. The extent to which this occurs depends on economic circumstances and,
generally, both QE and QT are likely to be more powerful when markets are stressed.

4.2.2 Financial Stability

Since the financial crisis of 2007–08, the Bank’s role of protecting and enhancing the stability of the
financial system has gained greater emphasis and importance.

The purpose of preserving financial stability is to maintain the three vital functions which the financial
system performs in the economy:

• providing the main mechanism for paying for goods, services and financial assets
• intermediating between savers and borrowers, and channelling savings into investment via debt
and equity instruments, and
• insuring against and dispersing risk.

32
 The Economic Environment

In April 2013, the UK government brought in a major reform of the regulatory regime which significantly
increased and broadened the Bank’s role and responsibilities for financial stability. These changes are
a response to the weaknesses identified as a result of the financial crisis, of which perhaps the most
significant failing was that no single institution had the responsibility, authority or powers to oversee

2
the financial system as a whole.

In June 2011, the government announced details of its plans to establish a new committee at the BoE
– the Financial Policy Committee (FPC). The FPC is tasked with monitoring the stability and resilience
of the UK financial system and using its powers to tackle those risks. It also gives direction and
recommendations to the Prudential Regulation Authority (PRA) and Financial Conduct Authority
(FCA). The PRA is part of the BoE and has assumed responsibility for the supervision of banks and key
market infrastructure firms (such as the London Clearing House and Euroclear UK & Ireland).

The FPC has two key policy levers – its powers of direction and of recommendation. FPC directions
are binding instructions on the PRA and FCA who will then make banks, building societies and other
investment firms carry out the resulting actions. FPC recommendations can be on a ‘comply or explain’
basis to the regulators. This means that, if the regulators decide not to implement a comply or explain
recommendation, they are required to explain publicly their reasons for not doing so. The FPC can also
make general recommendations to other bodies.

4.2.3 Other Bank of England Responsibilities

In addition to these responsibilities, the Bank also assumes responsibility for all other traditional central
bank activities (listed in section 3.1), with the exception of managing the national debt and providing a
depositors’ protection scheme for bank deposits. Managing the national debt is undertaken by the Debt
Management Office (DMO), and operating the depositors’ protection scheme by the Financial Services
Compensation Scheme (FSCS).

4.3 Federal Reserve (Fed)

The Federal Reserve System in the US dates back to 1913. The Fed, as it is known, comprises 12 regional
Federal Reserve Banks, each of which monitors the activities of, and provides liquidity to, the banks in
its region.

Although free from political interference, the Fed is governed by a seven-strong board appointed by
the President of the US. This governing board, together with the presidents of five of the 12 Federal
Reserve Banks, makes up the Federal Open Market Committee (FOMC). The chairman of the FOMC, also
appointed by the US President, takes responsibility for the committee’s decisions, which are directed
towards its statutory duty of promoting price stability and sustainable economic growth. The FOMC
meets every six weeks or so to examine the latest economic data in order to gauge the health of the
economy and determine whether the economically sensitive Fed funds rate should be altered. In late
2015, it made the decision to raise interest rates for the first time since the 2008 financial crisis.

As lender of last resort to the US banking system, the Fed has rescued a number of US financial institutions
and markets from collapse during the financial crisis. In doing so, it has prevented widespread panic and
prevented systemic risk from spreading throughout the financial system (known as ‘contagion’).

33
4.4 European Central Bank (ECB)
Based in Frankfurt, the ECB assumed its central banking responsibilities upon the creation of the euro, on
1 January 1999. The ECB is principally responsible for setting monetary policy for the entire Eurozone, with
the objective of maintaining internal price stability. Its objective of keeping inflation, as defined by the
Consumer Price Index (CPI), ‘close to but below 2% in the medium term’ is achieved by influencing those factors
that may affect inflation, such as the external value of the euro and growth in the money supply.

The ECB sets its monetary policy through its president and council; the latter comprises the governors
of each of the Eurozone’s national central banks. Although the ECB acts independently of EU member
governments when implementing monetary policy, it has on occasion succumbed to political
persuasion. It used to be one of the few central banks that did not act as a lender of last resort to the
banking system, but that changed when the Eurozone crisis forced it to support banks and economies
in struggling European countries.

In 2014, the ECB was given a supervisory role to monitor the financial stability of banks in Eurozone states.
The Single Supervisory Mechanism (SSM) is a new framework for banking supervision in Europe and
comprises the ECB and national supervisory authorities of participating EU countries. Its main aims are to:

• ensure the safety and soundness of the European banking system, and
• increase financial integration and stability in Europe.

The SSM is an important milestone towards a banking union within the EU.

34
 The Economic Environment

5. Key Economic Indicators

Learning Objective

2
2.1.4 Understand the impact of the following economic data: gross domestic product (GDP); balance
of payments; budget deficit/surplus; level of unemployment; exchange rates; inflation/
deflation

As well as being essential to the management of the economy, indicators can provide investors with a
guide to the health of the economy and aid long-term investment decisions.

This section takes a closer look at several economic indicators, including:

• inflation as an indicator of how the overall process of goods and services in the economy are
changing
• gross domestic product (GDP) as a measure of economic activity
• economic growth and economic cycles
• the balance of payments as a summary of all the country’s transactions with the rest of the world
• the budget deficit and national debt, and
• unemployment and exchange rates.

5.1 Inflation
Inflation is a persistent increase in the general level of prices.

There are a number of reasons for prices to increase, such as excess demand in the economy, scarcity of
resources and key workers, or rapidly increasing government spending. Most Western governments seek to
control inflation at a level of about 2–3% pa without letting it get too high (or too low).

High levels of inflation can cause problems:

• Businesses have to continually update prices to keep pace with inflation.

• Employees find the real value of their salaries eroded.
• Those on fixed levels of income, such as pensioners, will suffer as the price increases are not matched
by increases in income.
• Exports may become less competitive.
• The real value of future pensions and investment income becomes difficult to assess, which might
act as a disincentive to save.

There are, however, some positive aspects to high levels of inflation:

• Rising house prices can contribute to a ‘feel-good’ factor (although this might contribute to further
inflation as house-owners become more eager to borrow and spend).
• Borrowers benefit, because the value of borrowers’ debt falls in real terms – ie, after adjusting for the
effect of inflation.
• Inflation also erodes the real value of a country’s national debt and can benefit an economy in
difficult times.

35
Deflation, by contrast, is defined as a general fall in price levels. Although not experienced as a worldwide
phenomenon since the 1930s, it has been seen more recently in many economies, including Japan, and
in Eurozone countries, such as Greece and, to a lesser extent, Spain.

While it may seem that lower prices would be a good thing, deflation can ripple through the economy,
such as when it causes high unemployment, and can turn a bad situation, such as a recession, into a
worse situation, such as a depression. Deflation can spiral where it creates a vicious circle of reduced
spending and a reluctance to borrow as the real burden of debt in an environment of falling prices
increases. Deflation can, then, become a self-reinforcing loop – falling prices create the circumstances
for prices to continue falling, leading to a depression.

It should be noted that falling prices are not necessarily a destructive force per se and, indeed, they
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.

5.1.1 Measuring Inflation

Consumer price indices measure changes in prices to estimate how the prices of goods and services
are changing over time. Over any given period, the price of some goods will rise and some will fall,
so inflation measures present a picture of what is happening with the average level of prices in the
economy. If inflation is rising, then this implies that, overall, the cost of goods and services is rising; this
equates to a fall in the purchasing power of money, ie, £1 now buys less than it did before.

People buy different things and use a variety of services, so estimates of inflation are based on typical
goods and services that a household consumes. In the UK, inflation measures are calculated by the Office
for National Statistics (ONS). The ONS publishes three main measures of inflation – the consumer price
index (CPI), the CPI including occupier’s housing costs (CPIH) and the retail price index (RPI) – which
is due to be phased out by 2030 due to shortcomings in the way it is calculated. The CPI and CPIH use
essentially the same data except for the inclusion of housing costs in the latter.

The way that the ONS calculates inflation is to collect price data on a typical ‘shopping basket’ of some
700 items from month to month. The content of the basket is fixed for a period of 12 months and
different weights are attached to various items in the basket reflecting their importance in a typical
household budget. The content and the weightings attached are reviewed regularly to ensure they
remain up to date.

To calculate changes in price, the ONS sets a base year for the total cost of the ‘shopping basket’ which
is then converted into an index of 100; for CPI and CPIH the base year is 2015. On a monthly basis, prices
are collected again and the cost of the basket is recalculated resulting in a revised index number; so, for
example, the CPI for November 2022 was 124.8. The following graph shows how this changed over the
12 months to November 2022.

36
 The Economic Environment

CPI Index

2
Source: Consumer price inflation, UK – Office for National Statistics

The annual rate of inflation is simply the percentage change in the latest index compared with the value
recorded 12 months previously. So, we can see that the CPI in November 2022 was 124.8 compared to
the November 2021 figure of 114.1, which represents a rise in prices, so the annual rate of inflation for
that 12-month period was 9.4%.

5.2 Measures of Economic Data

In addition to inflation measures, there are a number of other economic statistics carefully watched
by the government and by other market participants as potentially significant indicators of how the
economy is performing.

5.2.1 Gross Domestic Product (GDP)

At the very simplest level, an economy comprises two distinct groups: individuals and firms. Individuals
supply firms with the productive resources of the economy 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 what is known as the circular flow of income.

37
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, and
• by the value of total output generated by firms.

Gross domestic product (GDP) is the most commonly used measure of a country’s output. It measures
economic activity on an expenditure basis and is typically calculated quarterly as below:

Gross Domestic Product

consumer spending

plus government spending

plus investment

plus exports

less imports

equals GDP

38
 The Economic Environment

5.2.2 Economic Growth and the Economic Cycle

There are many sources from which economic growth can emanate, but in the long run, the rate of
sustainable growth (or trend rate of growth) ultimately depends on:

2
• the growth and productivity of the labour force
• the rate at which an economy efficiently channels its domestic savings and capital attracted from
overseas into new and innova­tive technology and replaces obsolescent capital equipment, and
• the extent to which an economy’s infra­structure is maintained and developed to cope with growing
transport, communication and energy needs.

In a mature economy, the labour force typically grows at about 1% pa, though in countries such as the
US, where immigrant labour is increasingly employed, the annual growth rate has been in excess of this.
Long-term productivity growth is dependent on factors such as education, training and the utilisation
of labour-saving new technology. Moreover, productivity gains are more difficult to extract in a post-
industrialised economy than in one with a large manufacturing base.

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

GDP Growth
Economic Peak
Expansion

Trend Growth

Economic Trough
Deceleration
Acceleration

Recession
Recovery

Boom

Time

39
The economic cycle can be illustrated by looking at what happened to the UK economy in the decade
following the recession of 2008. Since 1992, the size of the UK economy, measured by calculating the
total value of all the goods and services produced in the country, had been growing every quarter;
however, from April to June 2008, it began to fall. The economy continued to get smaller for five
successive quarters (as mentioned, two or more consecutive quarters of falling GDP is commonly called
a recession). The following chart shows this shrinking of the UK economy in 2008 and the five successive
quarters of lower GDP.

UK GDP 2008–10

Source: Office for National Statistics

Having shrunk by more than 6% between the first quarter of 2008 and the second quarter of 2009,
the UK economy took five years to return to the size it was prior to the recession. 2020 saw another
fall in GDP as the economic impact of the coronavirus (COVID-19) pandemic hit. Annual UK GDP in
2020 is estimated to have fallen by 9.4%. Note that estimates for GDP are subject to more uncertainty
than usual due to the challenges of collecting data during the pandemic and are likely to be revised in
subsequent releases.

40
 The Economic Environment

5.2.3 Balance of Payments

The balance of payments is a summary of all the transactions between the UK and the rest of the world.
If the UK imports more than it exports, there is a balance of payments deficit. If the UK exports more than

2
it imports, there is a balance of payments surplus. The main components of the balance of payments are
the trade balance, the current account and the capital account.

The trade balance comprises a visible trade balance – the difference between the value of imported and
exported goods, such as those arising from the trade of raw materials and manufactured goods; and an
invisible trade balance – the difference between the value of imported and exported services, arising
from services such as banking, financial services and tourism. If a country has a trade deficit in one of
these areas or overall, this means that it imports more than it exports, and, if it has a trade surplus, it
exports more than it imports.

The current account is used to calculate the total value of goods and services that flow into and out of a
country. The current account comprises the trade balance figures for the visibles and invisibles. To these
figures are added other receipts such as dividends from overseas assets and remittances from nationals
working abroad.

The results of the current account calculations provide details of the balance of trade a country has with
the rest of the world. Being a post-industrial economy, the UK typically runs a deficit on visible trade but
an invisible trade surplus. Also, because it is an open economy, imports and exports combined total over
50% of UK GDP.

The capital account records international capital transactions related to investment in business, real
estate, bonds and stocks. This includes transactions relating to the ownership of fixed assets and the
purchase and sale of domestic and foreign investment assets. These are usually divided into categories
such as foreign direct investment, when an overseas firm acquires a new plant or an existing business;
portfolio investment, which includes trading in stocks and bonds; and other investments, which include
transactions in currency and bank deposits.

For the balance of payments to balance, the current account must equal the capital 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.

A current account deficit resulting from a country 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
central bank intervention in the foreign currency market.

Having the right exchange rate is critical to the level of international trade undertaken, to a country’s
international competitiveness and, therefore, to its economic position. This can be understood by
looking at what happens if a country’s exchange rate alters.

• If the value of its currency rises, then exports will be less competitive unless producers reduce their
prices, and imports will be cheaper and, therefore, more competitive. The result will be either to
reduce a trade surplus or worsen a trade deficit.
• If its value falls against other currencies, then the reverse happens: exports will be cheaper in
foreign markets and, therefore, more competitive, and imports will be more expensive and less
competitive. A trade surplus or deficit will, therefore, see an improving position.

41
5.2.4 Budget Deficit and National Debt
A key function of government is to manage the public finances, and so a key economic indicator is the
level of public sector debt, or the national debt as it is more frequently referred to.

In the past, a state would incur budget deficits, usually as a result of military conflicts, and finance these
through taxation. In the UK, this changed in the late 1600s when the government’s need to finance
another war with France led to the creation of the Bank of England in 1694 and the first ever issue of
state public debt.

Following on from this, the early 1700s saw the emergence of banking and financial markets and the
ability to raise money by creating debt through the issue of bills and bonds and the beginning of the
national debt. Some key statistics from the ONS show how the national debt has grown since then:

• The national debt rose from £12 million in 1700 to £850 million by the end of the Napoleonic Wars
in 1815.
• The two world wars of the 20th century caused debt levels to rise, from £650 million in 1914 to £7.4
billion by 1919, and from £7.1 billion in 1939 to £24.7 billion in 1946.
• The period of relatively high inflation in the 1970s and 1980s saw debt rise from £33.1 billion in 1970
to £197.4 billion in 1988.
• The national debt has since continued to grow rapidly and exceeds £2 trillion following heavy
government spending to support the economy during the COVID-19 pandemic.

There are a wide number of measures used as key economic indicators, which can be quite confusing. Each
measures different sets of data, but essentially they fall into two main types:

• Government debt – essentially this is what the government owes. The most widely quoted is
public sector net debt.
• Budget deficit – essentially the shortfall between what the government receives in tax receipts and
what it spends. The most widely quoted is the Public Sector Net Cash Requirement (PSNCR).

Debt measures are also usually presented as a percentage of GDP, since comparisons over time need to
allow for effects such as inflation. Dividing by GDP is the conventional way of doing this.

The PSNCR is the difference each year between government expenditure and government income; the
latter mainly from taxes. In a buoyant economy, government spending tends to be less than income,
with substantial tax revenues generated from corporate profits and high levels of employment. This
enables the government to reduce public sector (ie, government) borrowing.

The reaction to the economic impact of the COVID-19 pandemic saw the government use fiscal policy
measures to mitigate some of the immediate economic disruption. This saw additional government
spending at a time when tax receipts were slowing due to lower economic activity linked to imposed
national lockdowns, leading to a growing budget deficit. This has pushed government borrowing to a
level not seen other than during the first and second world wars.

42
 The Economic Environment

If left unaddressed, high levels of public borrowing and debt risk undermining growth and economic
stability.

As mentioned earlier, excessive government spending, causing a growing PSNCR, has the potential to

2
bring about an increase in the rate of inflation.

5.2.5 Level of Unemployment

The extent to which those seeking employment cannot find work is an important indicator of the health
of the economy. There is always likely to be some unemployment in an economy – some people might
lack the right skills and/or live in employment black spots. Higher levels of unemployment indicate low
demand in the economy for goods and services produced and sold to consumers and therefore low
demand for people in the UK to provide them.

High unemployment levels will have a negative impact on the government’s finances. The government
will need to increase social security payments, and its income will decrease because of the lack of tax
revenues from the unemployed.

The following chart shows what happened to unemployment following the Great Recession in 2008.

Great Recession and Unemployment

Source: ONS

The financial crisis of 2008 had a significant impact on employment in the UK. As the economy got
smaller, unemployment rose and employers stopped hiring. By the end of 2011, almost 2.7 million
people were looking for work, and the quarterly unemployment rate reached 8.4%, the highest since
1995. Unemployment had returned to its pre-downturn rate at the end of 2015 and, since then, has
continued to fall – reaching a record low of 4.1% in the third quarter of 2017.

43
In 2020, the COVID-19 pandemic hit, leading to job losses and marked probably the sharpest
deterioration since the financial crisis over a decade ago. Labour market statistics, however, present a
confused picture of how the pandemic has affected employment in the UK as many people have been
furloughed. The unemployment rate reached 4.5% at the end of 2021 and decreased to 3.7% by the end
of 2022.

The pattern of employment is, however, undergoing rapid change in what is increasingly being
described as the ‘gig’ economy; this is one where temporary positions are common and organisations
contract with independent workers for short-term engagements as opposed to permanent jobs. This
has led to concerns that workers are classed as independent contractors and, therefore, have fewer
employment rights which is cutting the government’s tax ‘take’.

5.3 Exchange rates

An exchange rate can be described as the price of one currency in terms of another and is quoted for
pairs of currencies. If the exchange rate changes such that one currency A can buy more of currency B,
this shows an appreciation of currency A and a depreciation of currency B. Note that the mechanics of
exchange rates are covered elsewhere (chapter 5, section 5).

In this context, we are considering the effect that exchange rates have on an economy. Generally,
very volatile exchange rates (rates that are not stable and have large variations), create a great deal of
uncertainty and affect economic activity as well as investment decisions that involve foreign assets. For
example, an investor based in the UK may have property in the US, eg, a US dollar-denominated asset.
If the US dollar were to depreciate relative to sterling, the investor would experience a decrease in the
value of their asset even though property prices in the US may not have changed.

A significant factor that influences the volatility of exchange rates is the exchange rate regime that the
central bank follows. These vary widely, but two extremes are described below:

1. Fixed rate system – the exchange rate is pegged to a particular currency, eg, the US dollar or a
basket of currencies. To ensure that the rate stays ‘fixed’, the central bank will intervene in the
currency market to offset the natural forces of demand and supply by spending its foreign currency
reserves or buying foreign currency.
2. Floating rate system – the exchange rate is determined by the natural forces of demand and
supply. There is no intervention in the market by the central bank. This is sometimes referred to as a
‘free’ floating rate system.

Examples of exchange rate regimes that fall within the two extremes include the following:

• Target zone – similar to the fixed rate system, however, the exchange rate is managed within a
band (upper and lower limit). This means that the rate can fluctuate; the central bank will only
intervene if the upper or lower limits for the rate are breached.
• Crawling peg – similar to target zone, but with upper and lower limit bands gradually widening.
This system is generally used as a strategy for moving away from a fixed rate system.
• Managed float – this is also known as a ‘dirty’ float. With this system, the exchange rate is largely a
floating rate, but with occasional intervention from the central bank to alter the direction of the rate
or the speed with which the rate changes.

44
 The Economic Environment

End of Chapter Questions

Think of an answer for each question and refer to the appropriate section for confirmation.

2
1. What are the key differences between state-controlled and market economies?
Answer Reference: Sections 2.1 and 2.2

2. Which international organisation has the role of reducing trade barriers?

Answer Reference: Section 2.4

3. What is the primary role of the Monetary Policy Committee (MPC)?

Answer Reference: Section 4.2.1

4. What are the negative effects of inflation?

Answer Reference: Section 5.1

5. What are the principal differences between the CPI and CPIH?
Answer Reference: Section 5.1.1

6. What economic measure is used as an indicator of the health of the economy?

Answer Reference: Section 5.2.1

7. What does the balance of payments represent?

Answer Reference: Section 5.2.3

8. What is the potential impact of increasing levels of government spending on the PSNCR and
inflation?
Answer Reference: Section 5.2.4

9. What is the impact of high unemployment levels on the economy?

Answer Reference: Section 5.2.5

45
46
 Chapter Three

Equities
1. Introduction 49

2. Company Formation and Administration 49

3. Types of Equities 51

4. The Benefits of Owning Shares 54

5. The Risks of Owning Shares 59

6. Corporate Actions 61

7. Stock Exchanges 67

8. Stock Market Indices 70

9. Trading 72

10. Holding Title 76

11. Clearing and Central Counterparties 77

12. Settlement 78

This syllabus area will provide approximately 9 of the 50 examination questions

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48
 Equities

1. Introduction
In this chapter, we will look in detail at many of
the features of equities and how they are traded.

The chapter starts by explaining how a company is

formed. We then consider the features of equities,
the benefits and risks of owning shares and the
effect of corporate actions, before moving on to
the requirements for listing on a stock exchange,

3
looking at world stock exchanges and indices,
and then outlining how equities are traded and
settled.

2. Company Formation and

Administration
Learning Objective

3.1.1 Know how a company is formed and the

differ­ences between private and public
companies

2.1 Forming a Company

Many businesses, large and small, are set up as
companies.

To form a simple company is inexpensive

and requires the founders of the company to
complete a series of documents and lodge these
with the appropriate authority. In the UK, these
documents are required to be lodged with the
Registrar of Companies at Companies House.

To form a company, the following two docu­ments

are required:

• Memorandum of Association.
• Articles of Association.

The Memorandum of Association confirms the

subscribers’ intention to form a company under
the Companies Act 2006 and that they have

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agreed to become members of that company and to take at least one share each. It is a legal statement
signed by all initial shareholders agreeing to form the company. The Articles of Association detail the
relationship between the company and one of its key sources of finance; in other words, its owners. The
articles are written rules concerning the running of the company. They are agreed by the shareholders,
directors and the company secretary, and they include details such as shareholder rights, the frequency
of company meetings and the company’s borrowing powers.

Companies that were incorporated prior to the implementation of the Act often needed to update their
constitution to make it compliant with the provisions of the Act. For quoted companies, a shareholder
resolution needed to be passed that meets the standards of the UK Listing Authority (UKLA) which is
part of the primary markets function of the Financial Conduct Authority (FCA).

2.2 Private and Public Companies

Companies are usually established as either:

• private companies – such as ABC ltd, where ltd is short for ‘limited’. Such companies can have just
one shareholder, or
• public companies – such as XYZ plc, where plc stands for public limited company. Plcs must have a
minimum of two shareholders.

It is only plcs that are permitted to issue shares to the public. As a result, all listed companies are plcs,
but not all plcs are listed. It is perfectly possible for a company to ‘just be’ a plc, and not be listed on a
stock exchange. The global bank HSBC Holdings is a plc and is listed on a number of worldwide stock
exchanges including the London Stock Exchange (LSE), New York Stock Exchange (NYSE), Hong Kong
Exchanges and Clearing (HKEX), Paris Stock Exchange (Euronext) and the Bermuda Stock Exchange
(BSX). In contrast, Virgin Holdings, the business empire of Richard Branson, is a plc, but is not listed.

‘Limited’, whether as in ‘ltd’ or ‘plc’, means that the liability of shareholders for the debts of the company
is limited to the amount that they agreed to pay to the company on initial subscription.

Example
A UK company is created with a share capital of £100 which is made up of 100 ordinary £1 shares.

Assuming that each share is fully paid (see section 3.1), an initial shareholder who subscribes for 20
shares will pay £20.

In the event that the company goes bankrupt, the liability of that shareholder for the company’s
debts is limited to the amount they subscribed, that is, £20.

The position would be different if the shares were only partly paid. For example, the shares might
be ordinary £1 shares but only require 50p per share to be paid at the outset, the remainder being
payable at some future date. In the event of liquidation, the shareholder may be called on to
subscribe the balance to meet the company’s debts.

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 Equities

2.3 Company Meetings

Learning Objective

3.1.8 Know the purpose and format of annual general meetings

Public companies must hold annual general meetings (AGMs) at which the shareholders are given the
opportunity to question the directors about the company’s strategy and operations. Public companies
must hold an AGM within six months of the financial year-end.

3
The Companies Act provides shareholders with the right to attend, speak and vote at the AGM or to
appoint a proxy to vote (but not speak) on their behalf at the meeting.

The shareholders are also given the opportunity to vote on matters such as the appointment and
removal of directors and the payment of the final dividend recommended by the directors.

Most matters put to the shareholders are ordinary resolutions, requiring a simple majority of those
shareholders voting to be passed. Matters of major importance, such as a proposed change to the
company’s constitution, require a special resolution and at least 75% to vote in favour.

Shareholders can either vote in person, or have their vote registered at the meeting by completing a
proxy voting form, enabling someone else to register their vote on their behalf.

Companies may also hold other meetings during the year to deal with important issues, such as a
takeover or capital raising. These are known simply as general meetings. Until 2009, they were referred
to as extraordinary general meetings (EGMs), and you may come across that term as it is still often used
to differentiate between the two types of meeting.

3. Types of Equities
Learning Objective

3.1.2 Know the features and benefits of ordinary and preference shares: dividend; capital gain; share
benefits; right to subscribe for new shares; right to vote

The capital of a company is made up of a combination of borrowing and the money invested by its
owners. The long-term borrowings, or debt, of a company are usually referred to as bonds, and the
money invested by its owners as shares, stocks or equity. Shares are the equity capital of a company,
hence the reason they are referred to as equities. They may comprise ordinary shares and preference
shares.

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3.1 Ordinary Shares
Ordinary shares carry the full risk and reward of investing in a company. If a company does well, its
ordinary shareholders should do well. As the shareholders of the company, it is the ordinary shareholders
who vote ‘yes’ or ‘no’ to each resolution put forward by the company directors at company meetings.
For example, an offer to take over a company may be made and the directors may propose that it
is accepted but this will be subject to a vote by shareholders. If the shareholders vote ‘no’, then the
resolution will not be passed.

Ordinary shareholders share in the profits of the company by receiving dividends declared by the
company, which tend to be paid half-yearly or even quarterly. With the final dividend for the financial
year, the company directors will propose a dividend which will need to be ratified by the ordinary
shareholders before it is formally declared as payable. The amount of dividend paid will depend on how
well the company is doing. However, some companies pay large dividends and others none as they
plough all profits made back into their future growth.

If the company does badly, it is the ordinary shareholders that will suffer. If the company closes down,
often described as the company being ‘wound up’, the ordinary shareholders are paid last, after
everybody else. If there is nothing left, then the ordinary shareholders get nothing. If there is money
left after all creditors and preference shareholders have been paid, it all belongs to the ordinary
shareholders.

Some ordinary shares may be referred to as partly paid or contributing shares. This means that only part
of their nominal value has been paid up. For example, if a new company is established with an initial
capital of £100, this capital may be made up of 100 ordinary £1 shares. If the shareholders to whom these
shares are allocated have paid £1 per share in full, then the shares are termed fully paid. Alternatively,
the shareholders may contribute only half of the initial capital, say £50 in total, which would require a
payment of 50p per share, ie, one-half of the amount due. The shares would then be termed partly paid,
but the shareholder has an obligation to pay the remaining amount when called upon to do so by the
company.

3.2 Preference Shares

Some companies have preference shares as well as ordinary shares. The company’s internal rules (its
Articles of Association) set out the specific ways in which the preference shares differ from the ordinary
shares.

Preference shares are a hybrid security with elements of both debt and equity. Although they are
technically a form of equity invest­ment, they also have characteristics of debt, particularly in that they
pay a fixed income. Preference shareholders have legal priority (known as seniority) over ordinary
shareholders in respect of earnings and, in the event of bankruptcy, in respect of assets.

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 Equities

Normally, preference shares:

• are non-voting, except in certain special circumstances, such as when their dividends have not
been paid
• pay a fixed dividend each year, the amount being set when they are first issued and which has to be
paid before dividends on ordinary shares can be paid, and
• rank ahead of ordinary shares in terms of being paid back if the company is wound up.

Preference shares may be cumulative, non-cumulative, and/or participating.

3
If dividends cannot be paid in a particular year, perhaps because the company has insufficient profits,
preference shareholders would receive no dividend. However, if they were cumulative preference
shareholders, then the dividend entitlement accumulates. Assuming sufficient profits, the cumulative
preference shareholders will have the arrears of dividend paid in the subsequent year. If the shares were
non-cumulative, the dividend from the first year would be lost.

Participating preference shares entitle the holder to a basic dividend of, say, 3p a year, but the directors
can award a bigger dividend in a year when the profits exceed a certain level. In other words, the
preference shareholder can ‘participate’ in bumper profits.

Preference shares may also be convertible or redeemable.

Convertible preference shares carry an option to convert into the ordinary shares of the company at set
intervals and on pre-set terms.

Redeemable shares, as the name implies, have a date on which they may be redeemed; that is, the
nominal value of the shares will be paid back to the preference shareholder and the shares cancelled.

Example
Banks and other financial institutions are regular issuers of preference shares. So, for example, an
investor may have the following holding of a preference share issued by Standard Chartered – £1,000
Standard Chartered 73/8% non-cumulative irredeemable £1 preference shares.

This means the following:

• The investor will receive a fixed dividend of 73/8% each year which is payable in two equal
half-yearly instalments on 1 April and 1 November.
• The amount of the dividend is calculated by multiplying the nominal value of shares held (£1,000,
ie, 1,000 £1 preference shares) by the interest rate of 73/8% which gives a total annual dividend of
£73.75 gross which will be paid in two instalments.
• The dividend will be paid providing that the company makes sufficient profits, and has to be paid
before any dividend can be paid to ordinary shareholders.
• The term ‘non-cumulative’ means that, if the company does not make sufficient profits to pay the
dividend, then it is lost and the arrears are not carried forward.
• The term ‘irredeemable’ means that there is no fixed date for the shares to be repaid and the
capital would only be repaid in the event of the company being wound up. The amount the
investor would receive is the nominal value of the shares, in other words £1,000, and they would
be paid out before (in preference to) the ordinary shareholders.

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4. The Benefits of Owning Shares
Learning Objective

3.1.2 Know the features and benefits of ordinary and preference shares: dividend; capital gain; share
benefits; right to subscribe for new shares; right to vote
3.1.3 Be able to calculate the share dividend yield

Holding shares in a company is having an ownership stake in that company. Ownership carries certain
benefits and rights, and ordinary shareholders expect to be the major beneficiaries of a company’s
success.

As we will see in section 5, shares carry risks. As a reward for taking this risk, shareholders hope to benefit
from the success of the company. This reward or return can take one of the following forms.

4.1 Dividends
A dividend is the return that an investor gets for providing the risk capital for a business. Companies pay
dividends out of their profits, which form part of their distributable reserves. Distributable reserves are
the post-tax profits made over the life of a company, in excess of dividends paid.

Example
ABC plc was formed some years ago. Over the company’s life it has made £20 million in profits and
paid dividends of £13 million. Distributable reserves at the beginning of the year are, therefore, £7
million.

This year, ABC plc makes post-tax profits of £3 million and decides to pay a dividend of £1 million.

At the end of the year distributable reserves are:

Millions
Opening balance 7

Profit after tax for year 3

10
Dividend (1)
Closing balance 9

Despite only making £3 million in the current year, it would be perfectly legal for ABC plc to pay
dividends of more than £3 million, because it can use the undistributed profits from previous years.
This would be described as a naked or uncovered dividend, because the current year’s profits were
insufficient to fully cover the dividend. Companies occasionally do this, but it is obviously not possible
to maintain this long term.

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 Equities

Companies seek, if possible, to pay steadily growing dividends. A fall in dividend payments can lead
to a negative reaction among shareholders and a general fall in the willingness to hold the company’s
shares, or to provide additional capital.

4.1.1 Dividend Yield

Potential shareholders will compare the dividend paid on a company’s shares with the return on other
investments. These would include other shares, bonds and bank deposits. A comparison of returns is
facilitated by calculating the dividend yield, ie, the dividend as a percentage of the current share price.

3
Example
ABC plc has 20 million ordinary shares, each trading at £2.50. It pays out a total of £1 million in
dividends.

Its dividend yield is calculated by expressing the dividend as a percentage of the total value of the
company’s shares (the market capitalisation):

Dividend ( £1m )
× 100
Market capitalisation

So, the dividend yield is:

£1m / ( 20m × £2.50)  × 100 =

2%
 

Since ABC plc paid £1 million to shareholders of 20 million shares, the dividend yield can also be
calculated on a per-share basis.

The dividend per share is £1 million/20 million shares, ie, £0.05. So, £0.05/£2.50 (the share price) is
again 2%.

Some companies have a higher-than-average dividend yield, which may be for one of the following
reasons:

• The company is mature and continues to generate healthy levels of cash, but has limited growth
potential, perhaps because the government regulates its selling prices, and so surplus profits
are paid to shareholders in the form of higher dividends. Examples are utilities such as water or
electricity companies.
• The company has a low share price for some other reason, perhaps because it is, or is expected to
be, relatively unsuccessful; its comparatively high current dividend is, therefore, not expected to be
sustained and its share price is not expected to rise.

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In contrast, some companies might have dividend yields that are relatively low. This is generally because:

• the share price is high, because the company is viewed by investors as having high growth
prospects, and
• a large proportion of the profit being gen­erated by the company is being ploughed back into the
business, rather than being paid out as dividends.

4.2 Capital Gains

Capital gains can be made on shares if their prices increase over time. If an investor purchases a share
for £3 and two years later that share price has risen to £5, then the investor has made a £2 capital gain.

However, the shares need to be sold to realise any capital gains. If the investor does not sell the share,
then the gain is described as being unrealised, and they run the risk of the share price falling before they
realise the share and ‘bank’ the profits.

In the recent past, the long-term total financial return from UK equities has been fairly evenly split
between dividends and capital gain. Whereas dividends need to be reinvested in order to accumulate
wealth, capital gains simply build up.

4.3 Shareholder Benefits

Some companies provide perks to shareholders, such as a telecoms company offering its shareholders
a discounted price on their mobile phones or a shipping company offering cheap ferry tickets. Such
benefits can be a pleasant bonus for small investors, but are not normally a big factor in investment
decisions.

4.4 Shareholder Rights

4.4.1 Right to Subscribe for New Shares

Rights issues are one method by which a company can raise additional capital, with existing
shareholders having the right to subscribe for new shares (see section 6.2).

If a company were able to issue new shares to anyone, then existing shareholders could lose control of
the company, or at least see their share of ownership diluted. As a result, under UK legislation, existing
shareholders in UK companies are given pre-emptive rights to subscribe for new shares. What this
means is that, unless the shareholders agree to permit the company to issue shares to others, they must
be given the option to subscribe for any new share offering before it is offered to the wider public, and
in many cases they receive some compensation if they decide not to do so.

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 Equities

Pre-emptive rights are illustrated in the following example:

Example
An investor, Mr B, holds 20,000 ordinary shares of the 100,000 issued ordinary shares in ABC plc. He,
therefore, owns 20% of ABC plc.

If ABC plc planned to increase the number of issued ordinary shares, by allowing investors
to subscribe for 50,000 new ordinary shares, Mr B would be offered 20% of the new shares,
ie, 10,000. This would enable Mr B to retain his 20% ownership of the enlarged company.

3
In summary:

Before the issue

Mr B = 20,000 (20%)
Other shareholders = 80,000 (80%)
Total = 100,000 (100%)

New issue
Mr B = 20,000 (20%)
Other shareholders = 80,000 (80%)
Total = 100,000 (100%)

New issue
Mr B = nil
Other shareholders = 50,000
Total = 50,000

After the issue

Mr B = 20,000 (13.3%)
Other shareholders = 130,000 (86.7%)
Total = 150,000 (100%)

Mr B = 10,000
Other shareholders = 40,000
Total = 50,000

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 If this were not the case, Mr B’s stake in ABC plc would be diluted, as shown below:

Before the issue

Mr B = 20,000 (20%)
Other shareholders = 80,000 (80%)
Total = 100,000 (100%)

New issue
Mr B = nil
Other shareholders = 50,000
Total = 50,000

After the issue

Mr B = 20,000 (13.3%)
Other shareholders = 130,000 (86.7%)
Total = 150,000 (100%)

A rights issue is one method by which a company can raise additional capital, complying with pre-
emptive rights, with existing shareholders having the right to subscribe for new shares. The mechanics
of a rights issue will be looked at in section 6.2.

4.4.2 Right to Vote

Ordinary shareholders have the right to vote on matters presented to them at company meetings. This
would include the right to vote on proposed dividends and other matters, such as the appointment, or
reappointment, of directors.

The votes are normally allocated on the basis of 'one share = one vote'. The votes are cast in one of two
ways:

• The individual shareholder can attend the company meeting and vote.
• The individual shareholder can appoint someone else to vote on their behalf – this is commonly
referred to as voting by proxy.

However, some companies issue different share classes, for some of which voting rights are restricted
or non-existent. This allows some shareholders to control the company while only holding a small
proportion of the shares.

In practice, most shares these days are held in electronic form in stockbrokers’ or investment managers’
nominee accounts operated by nominee companies – these companies are used solely for holding
and administering shares and other investments. It does not trade, and so is described as ‘bankruptcy
remote’ as the chances of it going into liquidation are low. It is the nominee’s name that appears on the
record of ownership of the shares and so, if the shareholder wishes to vote, they will need to arrange for
the operator of the nominee account to vote on their behalf.

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 Equities

5. The Risks of Owning Shares

Learning Objective

3.1.4 Understand the advantages, disadvantages and risks associated with owning shares: price risk;
liquidity risk; issuer risk; foreign exchange risk

Shares are relatively high risk but have the potential for relatively high returns when a company is

3
successful. The main risks associated with holding shares can be classified under the following headings.

5.1 Market and Price Risk

Market risk is the risk that share prices in general might fall. Even though the company involved might
maintain dividend payments, investors could face a loss of capital.

Market-wide falls in equity prices occur, unfortunately, on a fairly frequent basis.

One example is when worldwide equities fell by nearly 20% on 19 October 1987, with some shares
falling by even more than this. That day is generally referred to as Black Monday when the Dow Jones
index fell by 22.3%, wiping US$500 billion off share prices.

Another instance of a market-wide fall in equity prices was the ‘dot-com’ bubble. The arrival of the
internet age sparked suggestions that a new economy was in development and led to a surge in internet
stocks. Many of these stocks were quoted on the NASDAQ exchange, whose index went from 600 to
5,000 by the year 2000. This led the Chairman of the Federal Reserve to describe investor behaviour
as ‘irrational exuberance’. In mid-2000s, reality started to settle in and the ‘dot-com’ bubble was firmly
popped, with the NASDAQ index crashing to below the 2000 mark.

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The subprime crisis and credit crunch brought about another fall in stock markets. In 2008, the NASDAQ
had its worst ever fall, declining by 40.54% over the year, the Dow Jones Industrial Average (DJIA) fell
33.84%, and the FTSE 100 tumbled 31% in the largest annual drop seen since its launch in 1984.

More recently, in the first part of 2020, equity markets worldwide fell as markets reacted to the
coronavirus (COVID-19) pandemic.

These examples clearly demonstrate the risks associated with equity investment from general price
collapses. In addition to these market-wide movements, any single company can experience dramatic
falls in its share price when it discloses bad news, such as the loss of a major contract.

Price risk varies between companies: volatile shares tend to exhibit more price risk than more ‘defensive’
shares, such as utility companies and general retailers.

5.2 Liquidity Risk

Liquidity risk is the risk that shares may be difficult to sell at a reasonable price or traded quickly enough
in the market to prevent a loss. It essentially occurs when there is difficulty in finding a counterparty
who is willing to trade in a share.

This typically occurs in respect of shares in ‘thinly traded’ companies – private companies, or those in
which there is not much trading activity. It can also happen, to a lesser degree, if share prices in general
are falling, in which case the spread between the bid price (the price at which dealers will buy shares)
and the offer price (the price at which dealers will sell shares) may widen.

Example
Prices for ABC plc shares might be 720–722p on a normal day.

To begin to see a capital gain, an investor who buys shares (at 722p) needs the price to rise so that the
bid (the price at which they could sell) has risen by more than 2p (eg, from 720 to 723p).

If there was a general market downturn, the dealer might widen the price spread to, say, 700–720 to
deter sellers. An investor wanting to sell would be forced to accept the much lower price.

Shares in smaller companies tend to have a greater liquidity risk than shares in larger companies –
smaller companies also tend to have a wider price spread than larger, more actively traded companies.

5.3 Issuer Risk

This is the risk that the issuing company collapses and the ordinary shares become worthless.

In general, it is very unlikely that larger, well-established companies would collapse, and the risk could
be seen, therefore, as insignificant. However, events such as the collapse of Northern Rock, HBOS,
Bradford & Bingley, Woolworths, Comet, BHS and Carillion show that the risk is a real and present one
and cannot be ignored. Shares in new companies, which have not yet managed to report profits, may
have substantial issuer risk.

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 Equities

5.4 Foreign Exchange Risk

Foreign exchange risk for investors can be indirect or direct. Indirect relates to investing in a company
that has earnings and operations overseas. Investors will be exposed to the risks associated with changes
in earnings as a result of this. The company itself may engage in hedging their exposure to foreign
currency risk. Direct foreign exchange risk for the investor relates to investing in shares denominated
in foreign currency. Because the relative value of currencies fluctuate, the sterling value of an equity
investment denominated in a foreign currency is subject to constant fluctuations. For example, a UK
investor holding US shares would see the sterling value of their holding fall if the dollar were to weaken
against the pound. Foreign exchange and examples of strategies that can be used to manage this risk

3
include forward and futures contracts which are covered in chapter 5.

6. Corporate Actions
Learning Objective

3.1.5 Know the definition of a corporate action and the difference between mandatory, voluntary
and mandatory with options including takeovers and mergers
3.1.6 Understand the following terms: bonus/scrip/capitalisation issues/stock splits/reverse stock
splits; rights issues; dividend payments; buybacks
3.1.7 Be able to calculate: theoretical ex-rights price; theoretical ex-bonus price

A corporate action occurs when a company does something that affects its shareholders or bondholders.
For example, most companies pay dividends to their shareholders twice a year.

Corporate actions can be classified into three types:

1. A mandatory corporate action is one mandated by the company, not requiring any intervention
from the shareholders or bondholders. The most obvious example of a mandatory corporate action
is the payment of a dividend, since all qualifying shareholders automatically receive the dividend.
2. A mandatory corporate action with options is an action that has some sort of default option that
will occur if the shareholder does not intervene. However, until the date at which the default option
occurs, the individual shareholders are given the choice to select another option. An example of a
mandatory with options corporate action is a rights issue (detailed below).
3. A voluntary corporate action is an action that requires the shareholder to make a decision. An
example is a takeover bid – if the company is being bid for, each individual shareholder will need to
choose whether to accept the offer or not.

This classification is the one that is used throughout Europe and by the international central securities
depositories Euroclear and Clearstream. It should be noted that, in the US, corporate actions are simply
divided into two classifications: voluntary and mandatory. The major difference between the two is
therefore the existence of the category of mandatory events with options. In the US, these types of
events are split into two or more different events that have to be processed.

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6.1 Securities Ratios
Before we look at various types of corporate action, it is necessary to know how the terms of a corporate
action such as a rights issue or bonus issue are expressed – a securities ratio.

When a corporate action is announced, the terms of the event will specify what is to happen. This could
be as simple as the amount of dividend that is to be paid per share. For other events, the terms will
announce how many new shares the holder is entitled to receive for each existing share that they hold.

So, for example, a company may announce a bonus issue whereby it gives new shares to its investors in
proportion to the shares they already hold. The terms of the bonus issue may be expressed as 1:4, which
means that the investor will receive one new share for each existing four shares held. This is the standard
approach used in European and Asian markets and can be simply remembered by always expressing the
terms as the investor will receive ‘X new shares for each Y existing shares’.

The approach differs in the US. Here, the first number in the securities ratio indicates the final holding
after the event; the second number is the original number of shares held. The above example expressed
in US terms would be 5:4. So, for example, if a US company announced a 5:4 bonus issue and the investor
held 10,000 shares, then the investor would end up with 12,500 shares.

6.2 Rights Issues

A company may wish to raise additional finance by issuing new shares. This might be to provide funds
for expansion, or to repay bank loans or bond finance. In such circumstances, a company may approach
its existing shareholders with a ‘cash call’ – they have already bought some shares in the company, so
would they like to buy some more?

UK company law gives a series of protections to existing shareholders. As already stated, they have pre-
emptive rights – the right to buy shares so that their proportionate holding is not diluted. A rights issue
can be defined as an offer of new shares to existing shareholders, pro rata to their initial holding. Since it
is an offer and the shareholders have a choice, rights issues are examples of a ‘mandatory with options’
type of corporate action.

As an example of a rights issue, the company might offer shareholders the right that for every two shares
owned, they can buy one more at a specified price that is at a discount to the current market price.

The initial response to the announcement of a planned rights issue will reflect the market’s view of the
scheme. If it is to finance expansion, and the strategy makes sense to the investors, the share price could
well rise. If investors have a very negative view of why a rights issue is being made (eg, to fund activities
that investors view negatively) and of what it says for the future of the company, the share price can fall
substantially.

The company and their investment banking advisers will, therefore, have to consider the numbers
carefully. If the price at which new shares are offered is too high, the cash call might flop. This would be
embarrassing – and potentially costly for any institution that has underwritten the issue. (Underwriters
of a share issue agree, for a fee, to buy any portion of the issue not taken up by shareholders at the issue

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price. The underwriters then sell the shares they have bought when market conditions seem opportune
to them, and may make a gain or a loss on this sale. The underwriters agree to buy the shares if no one
else will, and the company’s investment bank will probably underwrite some of the issue itself.)

This situation was seen during the financial crisis with HBOS, RBS and, more recently, with Keir Group,
when the price of shares on the open market fell below the discounted rights issue price. The rights
issues were flops, and the underwriters ended up having to take up the new shares.

Example

3
ABC plc has 100 million shares in issue, currently trading at £4.00 each.

To raise finance for expansion, it decides to offer its existing shareholders the right to buy one new
share for every four previously held. This would be described as a 1 for 4 rights issue (see section 6.1).

The price of the rights would be set at a discount to the prevailing market price at, say, £2.00.

Each shareholder is given choices as to how to proceed following a rights issue. For an individual
holding four shares in ABC plc, they could do the following:

• Take up the rights, by paying the £2.00 and increasing their holding in ABC plc to five shares.
• Sell the rights on to another investor. The rights entitlement is transferable (often described as
renounceable) and will have a value because it enables the purchase of a share at the discounted
price of £2.00.
• Do nothing. If the investor chooses this option, the company’s advisers will sell the rights at the
best available price and pass on the proceeds (after charges) to the shareholder.
• Alternatively, the investor could sell sufficient rights to raise cash and use this to take up the rest.
As an example, if an investor had a holding of, say, 4,000 shares then they would have the right to
buy 1,000. They could sell sufficient of the rights to raise cash and use this cash to take up the rest.

The share price of the investor’s existing shares will also adjust to reflect the additional shares that are
being issued. So, if the investor originally had four shares priced at £4 each, worth £16, and they can
acquire one new share at £2.00, on taking the rights up, the investor will have five shares worth £18
or £3.60 each.

The share price will, therefore, change to reflect the effect of the rights issue once the shares go
ex-rights (this is the point at which the shares and the rights are traded as two separate instruments).
The adjusted share price of £3.60 is known as the theoretical ex-rights price (TERP) – theoretical
because the actual price will also be determined by demand and supply.

The rights can be sold, and the price is known as the premium. In the example above, if the theoretical
ex-rights price is £3.60 and a new share can be acquired for £2.00, then the right to acquire one has a
value. That value is the premium and would be £1.60, although again the actual price would depend
upon demand and supply.

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6.3 Bonus Issues
A bonus issue (also known as a scrip or capitalisation issue) is a corporate action when the company
gives existing shareholders extra shares without their having to subscribe any further funds. The
company is simply increasing the number of shares held by each shareholder, and ‘capitalises’ earnings
by transfer to shareholders’ funds. It is a mandatory corporate action.

Example
XYZ plc’s shares currently trade at £15.00 each.

The company decided to make a 1 for 2 (1:2) bonus issue, giving each shareholder an additional share
for every two shares they currently hold.

The result is that a single shareholder who held two shares worth £30.00 now has three shares worth
the same amount in total. As the number of shares has increased, the share price decreases to £10.00.

The reason for making a bonus issue is to increase the liquidity of the company’s shares in the market
and to bring about a lower share price. The logic is that, if a company’s share price becomes too high, it
may be unattractive to investors. Traditionally, most large UK companies tried to keep their share prices
below £10, but that is less common today.

6.4 Stock Splits and Reverse Stock Splits

Similar to a capitalisation issue as described above, a stock split does not raise extra cash. It simply
involves the division of existing shares into smaller denominations, making the share capital more
marketable. For example, a company whose shares have a nominal value of £1 each but a market value
of £5 each may decide to split each £1 share into 5 shares of 20p each. The market value of each share
then becomes £1. The reverse might be appropriate where the market value of a company’s share is
very low. This is known as consolidation of shares or a reverse stock split.

6.5 Dividends
Dividends are an example of a mandatory corporate action and represent the part of a company’s profit
that is passed to its shareholders.

Dividends for many large UK companies are paid twice a year, with the first dividend being declared by
the directors and paid approximately halfway through the year (commonly referred to as the interim
dividend). The second dividend is paid after approval by shareholders at the company’s AGM, held after
the end of the company’s financial year, and is referred to as the final dividend for the year.

The amount paid per share depends on factors such as the overall profitability of the company and any
plans it might have for future expansion.

The individual shareholders will receive the dividends by cheque, or by the money being transferred
straight into their bank accounts or be paid through CREST (see section 12 for further detail on CREST).

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 Equities

A practical difficulty, especially in a large company, where shares change hands frequently, is
determining who is the correct person to receive dividends. The London Stock Exchange (LSE),
therefore, has procedures to minimise the extent that people receive dividends they are not
entitled to, or fail to receive the dividend to which they are entitled. The shares are bought
and sold with the right to receive the next declared dividend up to a date shortly before
the dividend payment is made. Up to that point, the shares are described as cum-dividend.
If the shares are purchased cum-dividend, the purchaser will receive the declared dividend. At a certain
point between the declaration date and the dividend payment date, the shares go ex-dividend (xd).
Buyers of shares when they are ex-dividend are not entitled to the declared dividend.

3
In October 2014, the standard settlement period across Europe for equity trades changed to T+2; this
means that a trade is settled two business days after it is executed so, for example, a trade executed on
Monday would settle on Wednesday. As a result, the dividend timetable also changed as the following
example illustrates.

Example
The sequence of events for a company listed on the LSE might be as follows:

ABC plc calculates its interim profits (for the six months to 30 June) and decides to pay a dividend of
8p per share. It announces (‘declares’) the dividend on 2 September and states that it will be due to
those shareholders who are entered on the shareholders’ register on Friday 4 October. (The actual
payment of the dividend will then be made to those shareholders at a later specified date.)

This latter date (always on a Friday) is variously known as the:

• record date
• register date, or
• books closed date.

Given the record date of Friday 4 October, the LSE sets the ex-dividend date as Thursday 3 October.

On this day, the shares will go ex-dividend and should fall in price by 8p. This is because new buyers
of ABC plc’s shares will not be entitled to the dividend.

Mistakes can happen. If an investor bought shares in ABC plc on 2 October, and for some reason the
trade did not settle on Friday 4 October, they would not receive the dividend. A dividend claim would
be made, and the buyer’s broker would then recover the money via the seller’s broker.

6.6 Takeovers and Mergers

Companies seeking to expand can grow either organically or by buying other companies. In a takeover,
which may be friendly or hostile, one company (the predator) seeks to acquire another company (the
target). When they acquire shares in the other company, they are under an obligation to report their
share purchases once they reach a certain percentage.

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In a successful takeover, the predator company will buy more than 50% of the shares of the target
company. When the predator holds more than half of the shares of the target company, the predator
is described as having ‘gained control’ of the target company. Usually, the predator company will look
to buy all of the shares in the target company, perhaps for cash, but usually using its own shares, or a
mixture of cash and shares.

A merger is a similar transaction when the two companies are of similar size and agree to merge their
interests. However, in a merger it is usual for one company to exchange new shares for the shares of the
other. As a result, the two companies effectively merge together to form a bigger entity.

The following table shows examples of some of the largest mergers and acquisitions (M&A) that have
taken place since 1998.

M&A Transactions Worldwide

Value (US$
Rank Date Acquirer Target Name
billions)

1 1999 Vodafone AirTouch plc Mannesmann AG 202.7

2 2000 America Online inc Time Warner 164.7

3 2013 Verizon Communications inc Verizon Wireless inc 130.2

4 2007 Shareholders (Spin out) Philip Morris Intl inc 107.6

5 2015 Anheuser-Busch Inbev SA/NV SABMiller plc 101.5

6 2007 RFS Holdings BV ABN-AMRO Holding NV 98.2

7 1999 Pfizer inc Warner-Lambert co 89.6

8 2017 Walt Disney co 21st Century Fox inc 84.2

9 2016 AT&T inc Time Warner inc 79.4

10 2019 Bristol-Myers Squibb co Celgene Corp 79.4

Source: IMAA

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 Equities

7. Stock Exchanges

7.1 Primary and Secondary Markets

Learning Objective

3.1.9 Know the function of a stock exchange: primary/secondary market; listing

3
When a company decides to seek a listing for its shares, the process is known by one of a number of
terms, namely:

• becoming listed or quoted

• floating on the stock market
• going public, or
• making an initial public offering (IPO).

Typically, a company making an IPO will have been in existence for many years, and will have grown to
a point where it wishes to expand further.

Other relevant terms are ‘primary market’ and ‘secondary market’. The term primary market refers
to the marketing of new shares in a company to investors for the first time. Once they have acquired
shares, an investor will at some point wish to dispose of some or all of their shares and will often do this
through a stock exchange. This latter process is referred to as dealing on the secondary market.

Primary markets exist to raise capital and enable surplus funds to be matched with investment
opportunities, while secondary markets allow the primary market to function efficiently by facilitating
two-way trade in issued securities.

7.2 Advantages and Disadvantages of Listing

The advantages and disadvantages to be considered carefully include the following:

Advantages
• Capital – an IPO provides the possibility of raising capital and, once listed, further offers of shares
are much easier to make. If the shares being offered to the public are those of the company’s
original founders, then the IPO offers them an exit route and a means to convert their holdings
into cash.
• Takeovers – a listed company could use its shares as payment to acquire the shares of other
companies as part of a takeover or merger.
• Status – being a listed company should help the business in marketing itself to customers, suppliers
and potential employees.
• Employees – stock options to key staff are a way of providing incentives and retaining employees,
and options to buy listed company shares that are easily sold in the market are even more attractive.

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Disadvantages
• Regulation – listed companies must gov­ern themselves in a more open way than private ones and
provide detailed and timely information on their financial situation and progress.
• Takeovers – listed companies are at risk of being taken over themselves.
• Short-termism – shareholders of listed companies tend to exert pressure on the company to reach
short-term goals, rather than be more patient and look for longer-term investment and growth.

7.2.1 Requirements for Listing on the LSE

In the UK, the responsibility for allowing a company to be listed on the LSE rests with a division of the UK
regulator, the Financial Conduct Authority (FCA). The division was known as the United Kingdom Listing
Authority (UKLA), but the FCA have indicated that they are in the process of gradually phasing out that
name and will instead refer to the FCA's 'primary market' functions. Note that the name may still appear
as it may be used by other entities.

LSE offers a choice of markets for listing equity shares and there are three different segments of the Main
Market: the Premium, Standard Main and High Growth segments which are each tailored to different
capital raising requirements. A listing on the LSE is often referred to as a full listing. This distinguishes
it from cases where companies are listed on AIM (previously referred to as the Alternative Investment
Market), where the requirements are less onerous (see section 7.2.2).

The FCA and LSE have a number of requirements for companies seeking a listing for their shares. These
are mainly aimed at making sure the company is sufficiently large and that it complies with the rules on
issues such as disclosure of important information, so that its shares may be held by members of the
public. The main requirements for a listing on premium and standard segments are as follows:

• The company must be a public limited company (plc).

• The company’s expected market capitalisation (the share price multiplied by the number of shares
in issue) must be at least £30 million.
• For a listing on the Premium Main Market, the company should have been trading for at least three
years and at least 75% of its business must be supported by a historic revenue-earning record for
that period.
• At least 10% of the company’s shares should be in public hands or available for purchase by the
public. The term ‘public’ excludes directors of the company and their associates, and significant
shareholders who hold 5% or more of the company’s shares.
• A trading company must demonstrate that it has sufficient working capital for the next 12 months.
• Once listed, companies are expected to fulfil rules known as the continuing obligations. For
example, they are obliged to issue a half-yearly report and to notify the market of any new
price-sensitive information.

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 Equities

7.2.2 AIM
Becoming a fully listed company is not open to all companies. Listed status is rightly reserved for large,
established companies. Smaller businesses have a range of alternative sources of finance for expansion,
including the private equity/venture capital industry and the AIM market.

AIM was established by the LSE as a junior market for younger, smaller companies. Such companies
apply to the LSE to join AIM, whereas full listing requires application to the FCA. The requirements for
a listing on AIM, in comparison to the requirements for a full listing, are shown in the following table.

3
AIM Full Listing

No trading history required; the company could be

Three years’ trading history is needed.
newly established.

No minimum market capitalisation required. £30m is the minimum market cap.

No requirement for a minimum proportion of the At least 10% of the shares must be held by
shares to be held by the ‘public’. outside investors.

A company wanting to gain admission to AIM is required to appoint a nominated adviser (NOMAD)
and a nominated broker. The role of the NOMAD is to advise the directors of their responsibilities
in complying with AIM rules and the content of the prospectus that accompanies the company’s
application for admission to AIM. The role of the nominated broker is to make a market and facilitate
trading in the company’s shares, as well as to provide ongoing information about the company to
interested parties.

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Certain rules are common to both AIM and fully listed companies. They must both release
price-sensitive information promptly and produce financial information at the half-yearly (interim) and
full year (final) stage.

8. Stock Market Indices

Learning Objective

3.1.10 Know the types and uses of the main global stock exchange indices

Markets worldwide compute one or more indices of prices of the shares of their country’s large
companies. These indices provide a snapshot of how share prices are progressing across the whole
group of constituent companies. They also provide a benchmark for investors, allowing them to assess
whether their portfolios of shares are outperforming or underperforming the market in general.

Additionally, in recent decades, many indices have provided the basis for derivatives contracts, such
as FTSE (pronounced footsie) Futures and FTSE Options. Indices also provide the basis for many tracker
products, such as exchange-traded funds (ETFs).

Generally, the constituents of these indices are the largest companies, ranked by their market value
or market capitalisation (market cap). However, there are also indices which track all constituents of a
market, or which focus specifically on a segment, eg, the smaller companies listed on that market.

As well as considering which market they are tracking, it is important to also understand how the index
has been calculated. Early indices, such as the DJIA, are price-weighted so that it is only the price of each
stock within the index that is considered when calculating the index. This means that no account is
taken of the relative size of a company contained within an index, and the share price movement of one
can therefore have a disproportionate effect on the index.

Following on from these earlier indices, broader-based indices were calculated based on a greater range
of shares and which also took into account the relative market capitalisation of each stock in the index to
give a more accurate indication of how the market was moving. This development process is ongoing,
and most market capitalisation-weighted indices have a further refinement in that they now take account
of the free-float capitalisation of their constituents. This float-adjusted calculation looks to exclude
shareholdings held by large investors and governments that are not readily available for trading.

An alternative method of calculating an index is the equal weighted methodology. An equal investment
in each stock in the index is assumed. This means that a percentage rise in the share price of any
constituent company will have an equal impact on the index as that in any other.

Some of the main indices that are regularly quoted in the financial press are shown in the table that
follows.

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 Equities

Region Country Index Name Index Type

Dow Jones Industrial Average (DJIA)

– provides a narrow view of the US stock Price-weighted
market

NASDAQ Composite – focuses on the

Americas US
shares traded on NASDAQ, including many Market Cap
technology companies

S&P 500 (Standard & Poor’s) – provides a

3
Market Cap
wider view of the US stock market

FTSE 100 – an index of the largest 100

UK Market Cap
companies

CAC 40 – represents the 40 most significant

France stocks among the 100 largest market caps Market Cap
Europe
on Euronext Paris

Xetra DAX – consisting of 30 major German

Germany companies trading on the Frankfurt Stock Market Cap
Exchange

Shanghai Stock Exchange (SSE)

Composite Index – reflects overall market
performance of companies listed on the SSE Market Cap
including stocks listed on China’s NASDAQ-
China style sci-tech innovation board

Shanghai Shenzhen CSI 300 Index –

replicates the performance of the top 300
Market Cap
A-share stocks quoted on the Shanghai and
Asia Pacific Shenzhen stock exchanges

Hang Seng – largest companies that trade

on the Hong Kong Exchange, covering
Hong Kong Market Cap
approximately 65% of its total market
capitalisation

Nikkei 225 – contains the 225 top-rated

Japan Japanese companies listed in the First Price-weighted
Section of the Tokyo Stock Exchange

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9. Trading
Learning Objective

3.1.11 Know how shares are traded: on-exchange/over-the-counter; multilateral trading facilities;
order-driven/quote-driven

Trading of shares and bonds takes place either on-exchange or off-exchange. As the name suggests,
on-exchange trading is when trading is conducted through a recognised stock exchange. Trades can,
however, be undertaken directly between market counterparties away from an exchange in which case
they are referred to as ‘over-the-counter’ trades.

Stock market trading is conducted through trading systems broadly categorised as either:

• quote-driven, or
• order-driven.

9.1 Quote-Driven Systems

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. Compared to electronic order-driven systems, many
practitioners argue that quote-driven systems provide liquidity to the market when trading would
otherwise dry up. The NASDAQ and the LSE’s Stock Exchange Automated Quotation (SEAQ) trading
systems are two examples of quote-driven equity trading systems.

An example of the LSE’s SEAQ trading screen is shown below:

Sector/segment of the
LSE trading system
where the stock is traded

Mid price of best bid/offer Volume-weighted average price

Yellow strip: best buy/sell

prices and corresponding
volume and number of
orders at that price

Market maker firm quotes

Source: London Stock Exchange

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 Equities

9.2 Order-Driven Systems

An order-driven market is one that employs either an electronic order book, such as the LSE’s
Stock Exchange Electronic Trading Service (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.

Most stock exchanges operate order-driven systems and how they operate can be seen by looking at
the LSE’s SETS system as an example.

3
Example – SETS
The LSE’s main trading platform is SETS, which is used to trade shares that are contained within the
FTSE All Share Index. It combines electronic order-driven trading with integrated market maker
liquidity provision, delivering guaran­teed two-way prices for the most liquid securities.

In this system, LSE member firms (investment banks and brokers) input orders via computer terminals.
These orders may be for the member firms themselves, or for their clients. Very simply, the way the
system operates is that these orders will be added to the ‘buy queue’ or the ‘sell queue’, or executed
immediately. Investors who add their order to the relevant queue are prepared to hold out for the price
they want.

Those seeking immediate execution will trade against the queue of buyers (if they are selling) or
against the sellers’ queue (if they are buying).

For a liquid stock, like Vodafone, there will be a ‘deep’ order book – the term ‘deep’ implies that there
are lots of orders waiting to be dealt on either side. The top of the queues might look like this:

Buy Queue Sell Queue

We will buy for at most We will sell for at least

7,000 shares £1.24 3,500 shares £1.25

5,150 shares £1.23 1,984 shares (2) £1.26

19,250 shares (1) £1.22 75,397 shares (2) £1.26

44,000 shares (1) £1.22 17,300 shares £1.27

Queue priority is given on the basis of price and then time. So, for the equally priced orders noted(1),
the order to buy 19,250 shares must have been placed before the 44,000 order – hence its position
higher up the queue. Similarly, for the orders noted(2), the order to sell 1,984 shares must have been
input before the order to sell 75,397 shares.

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 Cumulative volume Sector/segment
traded on and off of the LSE
order book during trading system
the current trading Volume-weighted VWAP for
where the stock
day average price (VWAP) automated trades
is traded
Last trade price
Volume of shares
traded automatically
(on book)

Yellow strip: best buy/sell

prices and corresponding
volume and number of
orders at that price

Market maker
executable
quotes

Source: London Stock Exchange

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 Equities

9.3 Retail Service Providers (RSPs)

Brokers providing services to retail clients utilise a trading approach known as the Retail Service
Provider (RSP) system. Firms, such as FIDESSA, provide RSP gateways that, on demand, harvest prices
from a broker-defined range of RSPs and respond to the broker with the best price available. The
system’s primary role is to provide electronic quotation and dealing facilities for retail stockbrokers and
it is a quote-driven system operated by UK market makers.

A client places an order with a stockbroker who then uses the system to connect to competing RSP
firms, requesting the most competitive quote for their client’s order. The broker then selects the most

3
competitive price, enabling clients to benefit from price competition and obtain best execution for
the client. RSPs run highly automated systems and up to 30 market makers may be competing for
each order. A key element of the model is the price calculation system used by RSP firms. Price data is
gathered electronically from different exchanges in order to build a consolidated view of the best bid
and offer prices and to quote competitive prices.

9.4 Other Trading Systems

The LSE also has other systems including:

• the Stock Exchange Electronic Trading Service – quotes and crosses (SETSqx) for less liquid
shares that are not traded on SETS
• SEAQ for fixed-interest securities and AIM stocks not traded on SETSqx, and
• the electronic order book for retail bonds (ORB), which offers continuous two-way pricing for trading
in UK gilts and retail-size corporate bonds.

As an alternative to trading on a stock exchange, trades can be conducted through multilateral trading
facilities (MTFs). MTFs, sometimes referred to as ‘alternative trading systems’, are non-exchange trading
venues which bring together buyers and sellers of securities.

Subscribers can post orders into the system and these will be communicated (typically, electronically
via an electronic communication network (ECN)) for other subscribers to view. Matched orders will then
proceed to execution. Examples of MTFs include Cboe Europe Equities and Turquoise.

A further alternative is for a firm to execute client trades against its own account – a role known as a
‘systematic internaliser’. Instead of sending orders to a stock exchange, it can match them with other
orders on its own book. This means it is able to compete directly with stock exchanges and automated
dealing systems, but it has to make such dealings transparent – ie, it has to show a price before a trade is
made and has to give information about the transaction, just like conventional trading exchanges, after
a trade is made.

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10. Holding Title
Learning Objective

3.1.12 Know the method of holding title and related terminology: registered and bearer; immobilised
and dematerialised

Shares can be issued in either registered or bearer form.

Holding shares in registered form involves the investor’s name being recorded on the share register
and, often, the investor being issued with a share certificate to reflect their ownership. However, many
companies which issue registered shares now do so on a non-certificated basis.

The alternative to holding shares in registered form is to hold bearer shares. As the name suggests,
the person who holds, or is the ‘bearer’ of, the shares is the owner. Ownership passes by transfer of
the share certificate to the new owner. This adds a degree of risk to holding shares in that loss of the
certificate might equal loss of the person’s investment. As a result, holding bearer shares is relatively
rare, especially in the UK. In addition, bearer shares are regarded unfavourably by the regulatory
authorities owing to the opportunities they offer for money laundering. Consequently, they are usually
immobilised in depositories such as Euroclear, or by their local country registries.

In all but a very few cases, a UK company is required to maintain a share register. This is simply a record
of all current shareholders in that company, and how many shares they each hold. The share register is
kept by the company registrar, who might be an employee of the company itself or a specialist firm of
registrars. An electronic register is also kept by CREST so that trades can be settled electronically.

When a shareholder sells some, or all, of their shareholding, there must be a mechanism for updating
the register to reflect the buyer and effect the change of ownership and for transferring the money to
the seller. This is required in order to settle the transaction – accordingly, it is described as settlement.

Historically, each shareholder also held a share certificate as evidence of the shares they owned. When
shares were sold, the seller sent their share certificate and a stock transfer form, providing details of the
new owner, to the company registrar. Acting on these documents, the registrar would delete the seller’s
name and insert the name of the buyer into the register. The registrar then issued a new certificate
to the buyer. This was commonly referred to as certificated settlement because the completion of a
transaction required the issue of a new share certificate.

Certificated settlement is cumbersome and inefficient, and most markets have moved to having a single
central securities depository which hold records of ownership, with transfer of ownership taking place
electronically. In the UK, settlement has moved to a paperless, dematerialised (or uncertificated) form
of settlement through a system called CREST (see section 12).

Further developments in settlement took place from October 2014 onwards when rules came in
requiring European markets to move to a standardised T+2 settlement period. This reduction in the
settlement period is intended to harmonise practices across Europe and help to reduce risk.

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 Equities

Some investors still hold physical share certificates and they have been unable to benefit from shorter
settlement periods. Settlement of these trades usually takes place at T+10 or a shorter period to allow
all of the paperwork to be completed. As part of the changes to settlement periods, there are separate
proposals to phase out the use of paper share certificates.

11. Clearing and Central Counterparties

Learning Objective

3
3.1.13 Understand the role of the central counterparty in clearing and settlement

Clearing is the process through which the obligations held by buyer and seller to a trade are defined and
legally formalised. In simple terms, this procedure establishes what each of the counterparties expects
to receive when the trade is settled. It also defines the obligations each must fulfil, in terms of delivering
securities or funds, for the trade to settle successfully.

Specifically, the clearing process includes the following:

• Recording key trade information so that counter­­parties can agree on the trade’s terms.
• Formalising the legal obligation between counterparties.
• Matching and confirming trade details.
• Agreeing procedures for settling the trans­action.
• Calculating settlement obligations and sending out settlement instructions to the brokers,
custodians and central securities depository (CSD).
• Managing margin and making margin calls. (Margin relates to collateral paid to the clearing agent
by counterparties to guarantee their positions against default up to settlement.)

Trades may be cleared and settled directly between the trading counterparties – known as bilateral
settlement. When trades are cleared bilaterally, each trading party bears a direct credit risk against
each counterparty that it trades with. Hence, it will typically bear direct liability for any losses incurred
through counterparty default.

The alternative is to clear trades using a central counterparty (CCP). A CCP interposes itself between the
counterparties to a trade, becoming the buyer to every seller and the seller to every buyer. As a result,
buyer and seller interact with the CCP and remain anonymous to one another. This process is known as
‘novation’.

Regulators are increasingly keen to promote the use of CCPs across a wide range of financial products.
While this does not eliminate the risk of institutions going into default, it does spread this risk across all
participants, and is making these risks progressively easier to monitor and regulate. The risk controls
extended by a CCP effectively provide an early warning system to financial regulators of impending
risks, and are an important tool in efforts to contain these risks within manageable limits. CCP services
have been introduced in a range of markets in order to mitigate this risk. For example, LCH.Clearnet
provides CCP services in the UK and Euronext European markets for trading in equity, derivatives and
energy products.

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12. Settlement
Learning Objective

3.1.14 Understand how settlement takes place: participants; process; settlement cycles

Settlement is the process through which legal title (ie, ownership) of a security is transferred from
seller to buyer in exchange for the equivalent value in cash. Ideally, these two transfers should occur
simultaneously, known as delivery versus payment (DvP).

CREST is the term that is commonly used to refer to the system operated by Euroclear UK & International,
the central securities depository for UK and Irish equities. Some of its key features are:

• holdings are uncertificated; that is, share certificates are not required to evidence transfer of
ownership
• there is real-time matching of trades
• settlement of transactions takes place in sterling, euros or dollars
• electronic transfer of title (ETT) (see below) takes place on settlement
• settlement generates guaranteed obligations to pay cash outside CREST
• coverage includes shares, corporate and government bonds and other securities held in registered
form
• a range of corporate actions is processed, including dividend distributions and rights issues, and
• it also provides a mechanism to facilitate the settlement of trades when the investor holds paper
share certificates.

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 Equities

12.1 Settlement in CREST

The diagram below illustrates how a sterling sale of UK-registered shares between two counterparties on
a recognised exchange is input, matched and settled in CREST.

Selling Member Buying Member

Stage 1
Trade Matching
Sell details Buy details

CREST

3
Stage 2
Selling Buying
Stock Settlement
Member’s AC Stock Member’s AC

Stage 3 Selling Buying

Cash Settlement Member’s CMA Cash Member’s CMA

Register updated

Stage 4
Register Update
Issuer register Bank account
updated transfer

Stage 1 – Trade Matching

• The buying and selling members input instructions in CREST detailing the terms of the agreed trade.
• CREST authenticates these instructions to check that they conform to the authentication procedures
stipulated by CREST. If the input data from both members matches, CREST creates a matching
transaction.

Stage 2 – Stock Settlement

• On the intended settlement date, CREST checks that the buying member has the funds, the selling
member has sufficient stock in its stock account and the buyer’s CREST settlement bank has sufficient
liquidity at the Bank of England to proceed to settlement of the transaction.
• If so, CREST moves the stock from the selling member’s account to the buying member’s account.

Stage 3 – Cash Settlement

• CREST also credits the cash memo account (CMA) of the selling member and debits the CMA of the
buying member, which simultaneously generates a settlement bank payment obligation of the
buying member’s settlement bank in favour of the Bank of England.
• The selling member’s settlement bank receives that payment in Bank of England funds immediately
upon the debit of the purchase price from the buying member’s CMA.

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Stage 4 – Register Update
• CREST then automatically updates its operator register of securities to effect the transfer of shares to
the buying member.
• Legal title to the shares passes at this point – ETT, as described earlier.
• This prompts the simultaneous generation by the CREST system of a registrar update request (RUR),
requiring the issuer to amend its record of uncertificated shares.

In practice, stages 2, 3 and 4 occur simultaneously.

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 Equities

End of Chapter Questions

Think of an answer for each question and refer to the appropriate section for confirmation.

1. What are the constitutional documents of a company more commonly known as?
Answer Reference: Section 2.1

2. When a shareholder appoints someone to vote on their behalf at a company meeting, what is
this referred to as?

3
Answer Reference: Sections 2.3 and 4.4.2

3. What are the features of a cumulative preference share?

Answer Reference: Section 3.2

4. Why might a company have a higher than average dividend yield?

Answer Reference: Section 4.1.1

5. What options are available to an investor in a rights issue?

Answer Reference: Section 6.2

6. Under what type of corporate action would an investor receive additional shares without
making any payment?
Answer Reference: Section 6.3

7. Which body is responsible for approving the listing of companies on the London Stock
Exchange?
Answer Reference: Section 7.2.1

8. What is the function of a stock market index?

Answer Reference: Section 8

9. The CAC 40 index relates to which market?

Answer Reference: Section 8

10. What is the key characteristic of an order-driven trading system?

Answer Reference: Section 9.2

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82
 Chapter Four

Bonds
1. Introduction 85

2. Characteristics of Bonds 85

3. Government Bonds 87

4. Corporate Bonds 88

5. Investing in Bonds 95

This syllabus area will provide approximately 7 of the 50 examination questions

83
84
 Bonds

1. Introduction
Although bonds do not often generate as much
media attention as shares, they are the larger
market of the two in terms of global investment
value.

Bonds are roughly equally split between

government and corporate bonds. Government
bonds are issued by national governments, and
by supranational agencies such as the European
Investment Bank (EIB) and the World Bank.

4
Corporate bonds are issued by companies, such
as the large banks and other large corporate
listed companies.

In this chapter, we will first look at the common

characteristics of bonds and then consider the
key features of both government and corporate
bonds.

2. Characteristics of Bonds
Learning Objective

4.1.1 Understand the characteristics and

terminology of bonds: coupon;
redemption; nominal value; yields

A bond is, very simply, a loan.

A company that needs to raise money to finance

an investment could borrow money from their
bank, or alternatively they could issue a bond to
raise the funds they need.

With a bond, an investor lends in return for the

promise to have the loan repaid on a fixed date
plus (usually) a series of interest payments. Bonds
are commonly referred to as loan stock, debt or
(in the case of those that pay fixed income) fixed-
interest securities.

85
The feature that distinguishes a bond from most loans is that a bond is tradable. Investors can buy and
sell bonds without the need to refer to the original borrower.

Although there are a wide variety of bonds in issue, they all share similar characteristics. These can be
described by looking at an example of a UK government bond and explaining what each of the terms
means.

To explain the terminology associated with bonds, we will assume that an investor has purchased a
holding of £10,000 nominal 0.375% Treasury stock 2030.

Nominal £10,000

Stock Treasury stock

Coupon 0.375%

Redemption date 2030

Price £100.70

Value £10,070.00

Each of the terms annotated above is explained below:

1. Nominal – this is the amount of stock purchased and should not be confused with the amount
invested or the cost of purchase. This is the amount on which interest will be paid and the amount
that will eventually be repaid. It is also known as the par or face value of the bond.
2. Stock – the name given to identify the stock.
3. 0.375% – this is the nominal interest rate payable on the stock, also known as the coupon. The rate
is quoted gross and will normally be paid in two separate and equal half-yearly interest payments.
The annual amount of interest paid is calculated by multiplying the nominal amount of stock held
by the coupon; that is, in this case, £10,000 times 0.375%.
4. 2030 – this is the year in which the stock will be repaid, known as the redemption date or maturity
date. Repayment will take place at the same time as the final interest payment. The amount repaid
will be the nominal amount of stock held; that is, £10,000.
5. Price – the convention in the bond markets is to quote prices per £100 nominal of stock. So, in this
example, the price is £100.70 for each £100 nominal of stock.
6. Value – this is calculated by taking the price per £100 nominal of stock and scaling up based on the
total nominal value held. In this example, the total nominal value is £10,000 and the price per £100
nominal value is £100.70. The total value is, therefore, £10,070.00, calculated as: (£10,000/£100) x
£100.70 = £10,070.00.

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 Bonds

3. Government Bonds
Learning Objective

4.2.1 Know the definition and features of government bonds: types

Governments issue bonds to finance their spending and investment plans, and to bridge the gap
between their actual spending and the tax alongside other forms of income that they receive. Issuance
of bonds is high when tax revenues are significantly lower than government spending.

Western governments are major borrowers of money, so the volume of government bonds in issue is

4
very large and forms a major part of the investment portfolio of many institutional investors (such as
pension funds and insurance companies).

UK government bonds are known as gilts. When physical certificates were issued, historically they used
to have a gold or gilt edge to them, hence they are known as gilts or gilt-edged stock. The bonds are
issued on behalf of the government by the Debt Management Office (DMO), an executive agency of HM
Treasury.

3.1 Types of Government Bonds

There are two main types of UK government bond in issue – conventional bonds and index-linked
bonds.

Conventional government bonds are instruments that carry a fixed coupon and a single repayment
date, such as the example used above of 0.375% Treasury stock 2030. Conventional bonds typically
represent around 75% of bonds in issue.

The coupon and redemption amount for index-linked bonds are increased by the amount of inflation
over its lifetime. An example is 0.125% Treasury index-linked stock 2029. When this stock was issued,
it carried a coupon of 0.125%, but this is uplifted by the amount of inflation at each interest payment.
Similarly, the amount that will be repaid in 2029 will also be adjusted in line with inflation.

Index-linked bonds are attractive in periods when a government’s control of inflation is uncertain
because they provide extra protection to the investor. They are also attractive as long-term investments,
eg, pension funds. Long-term investors need to invest their funds and know that the returns will
maintain their real value after inflation so that they can meet their obligations to pay pensions.

Conventional bonds can be stripped into their individual cash flows – that is, the coupon payments and
the bond repayment. ‘Stripping’ a gilt refers to breaking it down into its individual cash flows which
can be traded separately as zero coupon gilts. A three-year gilt will have seven individual cash flows:
six (semi-annual) coupon payments and the final maturity repayment. These are known as ‘gilt STRIPs’.

In the past, there have also been other types of government bonds, dual-dated and undated. Dual-dated
bonds carried a fixed coupon but showed two dates between which they can be repaid. The decision
as to when to repay is made by the government and depends on the prevailing rates of interest at that

87
time. The final gilt of this type, 12% Exchequer stock 2013–17, was redeemed on 12 December 2013.
There also used to be a limited number of government stocks which were irredeemable, ie, they had
no fixed repayment date. The last remaining ‘undated’ bonds in the UK gilt portfolio were redeemed in
2015.

4. Corporate Bonds
Learning Objective

4.3.1 Know the definitions and features of the following types of bonds: domestic; foreign;
eurobond; asset-backed securities including covered bonds; zero coupon; convertible;
preferred; floating rate notes; medium-term notes; permanent interest-bearing shares

A corporate bond is a bond that is issued by a company, as the name suggests.

The term is usually applied to longer-term debt instruments, with a maturity date of more than 12
months. The term commercial paper (CP) (see chapter 5, section 3) is used for instruments with a
shorter maturity. Only companies with high credit ratings (see section 5.3) can issue bonds with a
maturity greater than ten years at an acceptable cost.

Most corporate bonds are listed on stock exchanges, but the majority of trading in most developed
markets takes place in the over-the-counter (OTC) market – that is directly between market counterparties.

4.1 Features of Corporate Bonds

There is a wide variety of corporate bonds and they can often be differentiated by looking at some of
their key features, such as security, and redemption provisions.

4.1.1 Bond Security

When a company is seeking to raise new funds by way of a bond issue, it will often have to offer ‘security’
to provide the investor with some guarantee for the repayment of the bond. In this context, security
usually means some form of charge over the issuer’s assets (eg, its property or trade assets) so that, if the
issuer defaults, the bondholders have a claim on those assets before other creditors (and so can regard
their borrowings as safer than if there were no security).

In some cases, the security takes the form of a third-party guarantee – for example, a guarantee by a
bank that, if the issuer defaults, the bank will repay the bondholders.

The greater the security offered, the lower the cost of borrowing should be.

The security offered may be fixed or floating. Fixed security implies that specific assets (eg, a building)
of the company are charged as security for the loan. A floating charge means that the general assets of
the company are offered as security for the loan; this might include cash at the bank, trade debtors and
stock.

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 Bonds

4.1.2 Redemption Provisions

In some cases, a corporate bond will have a call provision, which gives the issuer the option to buy back
all or part of the issue before maturity.

This is attractive to the issuer as it gives it the option to refinance the bond (ie, replace it with one
at a lower rate of interest) when interest rates are lower than the coupon that is being paid. This is a
disadvantage to the investor, who will probably demand a higher yield as compensation.

Call provisions can take various forms. For example, there may be a requirement for the issuer to redeem
a specified amount at regular intervals. This is known as a sinking fund requirement.

Some bonds are also issued with put pro­visions, known as ‘puttable’ bonds. These give the bondholder

4
the right to require the issuer to redeem early, on a set date or between specific dates. This makes the
bond attractive to investors and may increase the chances of selling a bond issue in the first instance; it
does, however, increase the issuer’s risk that it will have to refinance the bond at an inconvenient time.
An example of a bond with a put provision is shown below in the section on medium-term notes.

4.2 Types of Corporate Bonds

The development of financial engineering techniques in banks around the world has resulted in a large
variety of corporate debt being issued and traded. Some of the main types are described below.

4.2.1 Medium-Term Notes (MTNs)

Medium-term notes (MTNs) are standard corporate bonds with maturities up to five years, though the
term is also applied to instruments with maturities as long as 30 years. Where they differ from other debt
instruments is that they are offered to investors continually over a period of time by an agent of the
issuer, instead of in a single tranche of one sizeable underwritten issue.

The market originated in the US to close the funding gap between CP and long-term bonds.

Example
An example of an MTN is one issued by Tesco. As part of a larger financing programme, it issued a
£200 million tranche of 6% sterling-denominated notes in 1999 which are repayable in 2029.

This bond contains an example of an investor put provision. It provides that, if there is a restructuring
event (which for this bond is if anyone becomes entitled to more than 50% of the voting rights in the
company) and this results in a rating downgrade, then holders of the bonds can give notice to Tesco
requiring it to redeem the bond at par together with any accrued interest.

89
4.2.2 Fixed-Rate Bonds
The key features of fixed-rate bonds have already been described in section 2. Essentially, they have
fixed coupons which are paid either half-yearly or annually and predetermined redemption dates.

4.2.3 Floating Rate Notes (FRNs)

Floating rate notes (FRNs) are usually referred to as FRNs and are bonds that have variable rates of
interest.

The rate of interest will be linked to a benchmark rate, such as the Sterling Overnight Index Average
(SONIA) in the UK and Secured Overnight Reference Rate (SOFR) in the US. SONIA is the rate of interest at
which banks will lend to one another in London and is the replacement for LIBOR, and is now often used
as a basis for financial instrument cash flows.

An FRN will usually pay interest at the benchmark rate plus a quoted margin or spread.

4.2.4 Permanent Interest-Bearing Shares (PIBS)

PIBS are a type of instrument that is peculiar to the UK sterling market. The term stands for permanent
interest-bearing shares and they are issued by building societies. They carry fixed coupons and are
irredeemable.

You should note that the name ‘shares’ is a misnomer. It is in fact a bond, pays interest, and is taxable as
such despite its name.

Example
An example of a PIBS is one issued by Coventry Building Society. In 2006, it issued a bond titled
6.092% Permanent Interest-Bearing Shares with a redemption date of 31 December 2099 – nearly 90
years away, hence why it qualifies as irredeemable.

We will look separately at some other types of bonds in the following sections.

4.2.5 Convertible Bonds

Convertible bonds are issued by companies. They give the investor holding the bond two possible
choices:

• to simply collect the interest payments and then the repayment of the bond on maturity, or
• to convert the bond into a predefined number of ordinary shares in the issuing company, on a set
date or dates, or between a range of set dates, prior to the bond’s maturity.

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 Bonds

The attractions to the investor are:

• If the company prospers, its share price will rise and, if it does so sufficiently, conversion may lead to
capital gains.
• If the company hits problems, the investor can retain the bond – interest will be earned and, as
bondholder, the investor will rank ahead of existing shareholders if the company goes bankrupt.
Of course, if the company were seriously insolvent and the bond were unsecured, the bondholder
might still not be repaid – but this is a possibility more remote than that of a full loss as a shareholder.

For the company, relatively cheap finance is acquired. Investors will pay a higher price for a bond that
is convertible because of the possibility of a capital gain. However, the prospect of dilution of current
shareholder interests, as convertible bondholders exercise their options, has to be borne in mind.

4
4.2.6 Preferred Bonds
Preferred bonds, also known as ‘preferreds’, have similar characteristics to shares and bonds and have
the potential to offer investors higher yields than holding the company’s ordinary shares or bonds.
They are essentially bonds that have equity-like features and are generally issued by large banks and
insurance companies. They are usually undated/perpetual and carry callable rights for the issuer within
the first five to ten years of issuance. A specific equity-like feature is the fact that these pay dividends
as opposed to coupons as with other bonds. Within the issuer’s capital structure, preferreds rank lower
than senior debt but higher than equity.

4.2.7 Zero Coupon Bonds (ZCBs)

A zero coupon bond (ZCB) is a bond that pays no interest. ‘Coupon’ is an alternative term for the
interest payment on a bond.

Example
Imagine that the issuer of a bond (Example plc) offered you the opportunity to purchase a bond with
the following features:

• €100 nominal value

• Issued today
• Redeems at its par value (that is, €100 nominal value) in five years
• Pays no interest.

Would you be interested in purchasing the bond? It is tempting to say no – who would want to buy a
bond that pays no interest?

However, there is no requirement to pay the par value – a logical investor would presumably be
happy to pay a lesser amount than the par value, for example €60. The difference between the price
paid of €60 and the par value of €100 recouped after five years would provide the investor with their
return of €40 over five years.

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The example shows why a zero coupon bond may be attractive. As the example illustrates, these zero
coupon bonds are issued at a discount to their par value and they repay, or redeem, at par value. All of
the return is provided in the form of capital growth rather than income and, as a result, it may be treated
differently for tax purposes.

4.3 Domestic and Foreign Bonds

Bonds can be categorised geographically. A domestic bond is issued by a domestic issuer into the
domestic market, for example, a UK company issuing bonds, denominated in sterling, to UK investors.

In contrast, a foreign bond is issued by an overseas entity into a domestic market and is denominated in
the domestic currency. Examples of a foreign bond are a German company issuing a sterling bond to UK
investors, or a US dollar bond issued in the US by a non-US company.

4.4 Eurobonds
Eurobonds are large international bond issues often made by governments and multinational
companies. The eurobond market developed in the early 1970s to accommodate the recycling of
substantial OPEC (Organization of the Petroleum Exporting Countries ) 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. Most of the activity is concentrated in London.

Often issued in a number of financial centres simultaneously, the 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. An example might be a German company issuing either a euro or a dollar or a sterling
bond to Japanese investors.

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. For
example, a dollar-denominated bond sold outside the US (designed to borrow US dollars circulating
outside the US) would typically be referred to as a eurodollar bond. 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 euro sterling bond issue is one denominated in sterling and issued outside
the UK, though not necessarily in a European financial centre.

Eurobonds issued by companies often do not provide any underlying collateral, or security, to the
bondholders but are almost always credit-rated by a credit rating agency (see section 5.3). To prevent
the interests of these bondholders being subordinated (made inferior) to those of any subsequent bond
issues, the company makes a ‘negative pledge’ clause. This prevents the company from subsequently
making any secured bond issues, or issues which confer greater seniority (ie, priority) or entitlement to
the company’s assets, in the event of its liquidation, unless an equivalent level of security is provided to
existing bondholders.

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 Bonds

The eurobond market offers a number of advantages over a domestic bond market that make it an
attractive way for companies to raise capital, including:

• a choice of innovative products to more precisely meet issuers’ needs

• the ability to reach potential lenders internationally rather than just domestically
• anonymity to investors as issues are made in bearer form
• gross interest payments to investors
• lower funding costs due to the competitive nature and greater liquidity of the market
• the ability to make bond issues at short notice, and
• less regulation and disclosure.

Most eurobonds are issued as conventional bonds (or ‘straights’), with a fixed nominal value, fixed
coupon and known redemption date. Other common types include floating rate notes, zero coupon

4
bonds, convertible bonds and dual-currency bonds – but they can also assume a wide range of other
innovative features.

Distinguishing Features of Domestic, Foreign and Eurobonds

Type of Bond Issuer Currency Market

Domestic bonds UK GBP UK

Foreign bonds UK USD US
GBP (or any currency other than USD
Eurobonds UK US
will be termed as eurobonds)

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4.5 Asset-Backed Securities (ABSs)
There is a large group of bonds that trade under the overall heading of asset-backed securities (ABSs).
These are bundled securities, so-called because they are marketable securities that result from the
bundling or packaging together of a set of non-marketable assets.

The assets in this pool, or bundle, range from mortgages and credit card debt to accounts receivable.
(‘Accounts receivable’ is money owed to a company by a customer for goods and services that they have
bought and is usually known as this once an invoice has been issued.)

The largest market is for mortgage-backed securities, whose cash flows are backed by the principal and
interest payments of a set of mortgages.

Mortgage-backed bonds are created by bundling together a set of mortgages and then issuing bonds
that are backed by these assets. These bonds are sold on to investors, who receive interest payments
until they are redeemed.

Creating a bond in this way is known as securitisation, and it began in the US in 1970 when the
government first issued mortgage certificates, a security representing owner­­ship of a pool of mortgages.

A significant advantage of ABSs is that they bring together a pool of financial assets that otherwise could
not easily be traded in their existing form. The pooling together of a large portfolio of these illiquid
assets converts them into instruments that may be offered and sold freely on the capital markets.

4.5.1 Covered Bonds

A variation on asset-backed bonds is covered bonds which are widely used in Europe.

These are issued by financial institutions and are corporate bonds that are backed by cash flows from a
pool of mortgages or public sector loans. The pool of assets provides ‘cover’ for the loan, hence the term
‘covered bond’.

They are similar in many ways to asset-backed securities, but the regulatory framework for covered
bonds is designed so that bonds that comply with those requirements are considered as particularly
safe investments. The main differences are:

• They remain on the issuer’s balance sheet.

• The asset pool must provide sufficient collateral to cover bondholder claims throughout the whole
term of the covered bond.
• Bondholders must have priority claim on the cover asset pool in case of default of the issuer.

Covered bonds are an important part of the financing of the mortgage and public sector markets in
Europe and represent a vital source of term funding for banks. A thriving covered bond market is seen
as essential for the future of the European banking sector and the ability of individuals to finance house
loans at a reasonable rate.

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 Bonds

5. Investing in Bonds

5.1 Advantages, Disadvantages and Risks

Learning Objective

4.4.1 Know the potential advantages and disadvantages of investing in different types of bonds

As one of the main asset classes, bonds clearly have a role to play in most portfolios.

4
5.1.1 Advantages
Their main advantages are:

• for fixed-interest bonds, a regular and certain flow of income

• for most bonds, a fixed maturity date (but there are bonds which have no redemption date, and
others which may be repaid on either of two dates or between two dates – some at the investor’s
option and some at the issuer’s option)
• a range of income yields to suit different investment and tax situations, and
• the relative security of capital for more highly rated bonds.

5.1.2 Disadvantages
Their main disadvantages are:

• the ‘real’ value of the income flow is eroded by the effects of inflation (except in the case of
index-linked bonds)
• bonds carry various elements of risk (see section 5.1.3).

5.1.3 Risks
As can be seen, there are a number of risks attached to holding bonds.

Corporate bonds generally have default risk (the possibility of an issuer defaulting on the payment of
interest or capital, eg, the company could go bust) and price risk.

Highly-rated government bonds are said to have only price risk, as there is little or no risk that the
government will fail to pay the interest or repay the capital on the bonds. However, recent turmoil in
government bond markets, such as fears that certain European governments were unable to meet their
obligations on these loans, resulted in the prices of their bonds falling significantly.

Price (or market) risk is of particular concern to bondholders, who are open to the effect of movements
in general interest rates, which can have a significant impact on the value of their holdings.

95
This is best explained by two simple examples.

Example
Interest rates are approximately 5%, and the government issues a bond with a coupon rate of 5%
interest. Three months later, interest rates have doubled to 10%. What will happen to the value of the
bond? The value of the bond will fall substantially. Its 5% interest is no longer attractive, so its resale
price will fall to compensate and to make the return it offers more competitive.

Example
Interest rates are approximately 5%, and the government issues a bond with a coupon rate of 5%
interest. Interest rates generally fall to 2.5%. What will happen to the value of the bond? The value
of the bond will rise substantially. Its 5% interest is very attractive, so its resale price will rise to
compensate and make the return it offers fall to more realistic levels.

With both of these examples, remember that it is the current value of the bond that is changing.
Changes in interest rates do not affect the amount payable at maturity, which will remain as the nominal
amount of the stock.

As the above examples illustrate, there is an inverse relationship between interest rates and bond prices:

• If interest rates increase, bond prices will decrease.

• If interest rates decrease, bond prices will increase.

Some of the other main risks associated with holding bonds are:

• Early redemption – the risk that the issuer may invoke a call provision (if the bond is callable).
• Seniority risk – the seniority with which corporate debt is ranked in the event of the issuer’s
liquidation. Debt with the highest seniority is repaid first in the event of liquidation; so debt with the
highest seniority has a greater chance of being repaid than debt with lower seniority. If the company
raises more borrowing and it is entitled to be repaid before the existing bonds, then the bonds have
suffered from seniority risk.
• Inflation risk – the risk of inflation rising unexpectedly and eroding the real value of the bond’s
coupon and redemption payment.
• Liquidity risk – liquidity is the ease with which a security can be converted into cash. Some bonds
are more easily sold at a fair market price than others.
• Exchange rate risk/foreign currency risk – bonds or coupon payments denominated in a currency
different from that of the investor’s home currency are potentially subject to adverse exchange rate
movements.

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 Bonds

5.2 Flat Yields

Learning Objective

4.4.2 Be able to calculate the flat yield of a bond

Yields are a measure of the returns to be earned on bonds. The coupon reflects the interest rate payable
on the nominal or principal amount. However, an investor will have paid a different amount to purchase
the bond, so a method of calculating the true return is needed.

The return, as a percentage of the cost price, which a bond offers is often referred to as the bond’s yield.
The interest paid on a bond as a percentage of its market price is referred to as the flat or running yield.

4
The flat yield is calculated by taking the annual coupon and dividing by the bond’s price and then
multiplying by 100 to obtain a percentage. The bond’s price is typically stated as the price payable to
purchase £100 nominal value. This is best illustrated by example:

Examples
1. A bond with a coupon of 1%, issued by XYZ plc, redeemable in 2030, is currently trading at £100
per £100 nominal. The flat yield is the coupon divided by the price expressed as a percentage, ie:
£1/£100 x 100 = 1%.
2. A bond with a coupon of 1.5%, issued by ABC plc, redeemable in 2030, is currently trading at
£98 per £100 nominal. So, an investor could buy £100 nominal value for £98. The flat yield is the
coupon divided by the price expressed as a percentage, ie, £1.50/£98 x 100 = 1.53%.
3. 0.375% Treasury stock 2030 is priced at £100.70. So an investor could buy £100 nominal value for
£100.70. The flat yield on this gilt is the coupon divided by the price, ie: £0.375/£100.70 x 100 =
0.372%.

The interest earned on a bond is only one part of its total return, however, as the investor may also
either make a capital gain or a loss on the bond if it is held until redemption. The redemption yield is a
measure that incorporates both the income and capital return – assuming the investor holds the bond
until its maturity – into one figure.

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5.3 Rating Agencies
Learning Objective

4.4.3 Understand the role of credit rating agencies and the differences between investment and
non-investment grades

Credit risk, or the probability of an issuer defaulting on their payment obligations, and the extent of the
resulting loss, can be assessed by reference to the independent credit ratings given to most bond issues.

There are more than 70 agencies throughout the world, and preferred agencies vary from country
to country. The three most prominent credit rating agencies that provide these ratings are Standard
& Poor’s; Moody’s; and Fitch Ratings. The table below shows the credit ratings available from each.
Standard & Poor’s and Fitch Ratings refine their ratings by adding a plus or minus sign to show relative
standing within a category, while Moody’s do the same by the addition of a 1, 2 or 3.

As can be seen, 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 – for the worst-rated – ‘junk’ bonds. Investment grade issues
offer the greatest liquidity and certainty of repayment.

Bonds will be assessed and given a credit rating when they are first issued and then reassessed if
circumstances change, so that their rating can be upgraded or downgraded with a consequent effect
on their price.

Bond Credit Ratings

Standard & Fitch

Credit Risk Moody’s
Poor’s Ratings
Investment Grade

Highest quality Aaa AAA AAA

High quality Very strong Aa AA AA

Upper medium grade Strong A A A

Medium grade Baa BBB BBB

Non-Investment Grade

Somewhat
Lower medium grade Ba BB BB
speculative
Low grade Speculative B B B

Poor quality May default Caa CCC CCC

Most speculative C CC CC
No interest being paid or bankruptcy petition filed C D C

In default C D D

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 Bonds

End of Chapter Questions

Think of an answer for each question and refer to the appropriate section for confirmation.

1. 4¾% Treasury Gilt 2030 is an example of which type of government bond?

Answer Reference: Section 3.1

2. Which type of government bond would you expect to be the most attractive during a period of
rising inflation?
Answer Reference: Section 3.1

3. What is the function of a call provision when attached to a bond?

4
Answer Reference: Section 4.1.2

4. What is the typical maturity period for a medium-term note (MTN)?

Answer Reference: Section 4.2.1

5. What options does a convertible bond give to an investor?

Answer Reference: Section 4.2.5

6. What type of bond does not pay interest?

Answer Reference: Section 4.2.7

7. Which types of assets might you see pooled together to provide the backing for an asset-
backed security (ABS)?
Answer Reference: Section 4.5

8. What will be the impact of a fall in interest rates on bond prices?

Answer Reference: Section 5.1.3

9. You have a holding of £1,000 Treasury 1.75% stock 2028 which is priced at £117. What is its
flat yield?
Answer Reference: Section 5.2

10. What credit rating should be looked for in a bond when seeking the greatest liquidity and
certainty of repayment?
Answer Reference: Section 5.3

99
100
 Chapter Five

Other Markets and

Investments
1. Introduction 103

2. Cash Deposits 103

3. Money Markets 106

4. Property 108

5. Foreign Exchange (FX) 110

This syllabus area will provide approximately 4 of the 50 examination questions

101
102
 Other Markets and Investments

1. Introduction
This chapter looks at cash deposits, the money
market, the property market and foreign exchange
(FX).

5
2. Cash Deposits
Learning Objective

5.1.1 Know the characteristics of fixed-term and

instant access deposit accounts

Nearly all investors keep at least part of their wealth

in the form of cash, which will be deposited with a
bank or other savings institution to earn interest.

Cash deposits comprise accounts held with banks or

other savings institutions, such as building societies.
They are held by a wide variety of depositors, from
retail investors, through to companies, governments
and financial institutions.

The main characteristics of cash deposits are:

• The return simply comprises interest income

with no potential for capital growth.
• The amount invested (the capital) is repaid in
full at the end of the investment term or when
withdrawn.

Some accounts are known as instant access and

the money can be withdrawn at any time, other
accounts are for a fixed term of a year or more, while
others require notice to be given before monies can
be withdrawn. The interest rate paid on deposits will
vary with the amount of money deposited and the
time for which the money is tied up. Large deposits
are more economical for a bank or building society
to process and will earn a better rate. The rate will
also vary because of competition, as deposit-taking
institutions will compete intensely with one another
to attract new deposits.

103
In the recent past, the interest rates payable have suffered as a result of monetary policy that saw
base rates fall as low as 0.1%. The result has been that the rates on offer from banks and other savings
institutions are at historic lows and, in some cases, negative interest rates are in place. Some banks pay
no interest to large companies and others are considering charging large companies for holding cash
with them as they cannot earn enough after costs to offer a return.

Any interest received is liable to income tax, but is now paid gross (without deduction of tax) to
investors. More detail on how interest is taxed can be found in chapter 9.

Until April 2016, interest used to be paid net of tax as deposit-takers were required to deduct tax before
it was paid to the depositor and then account for the tax to HM Revenue & Customs (HMRC). From
April 2016, however, there has been a new personal savings allowance to remove tax on up to £1,000
of savings income for basic rate taxpayers, and up to £500 for higher rate taxpayers. As part of this
change, since April 2016, banks and building societies have been required to stop automatically taking
20% in income tax from the interest earned on non-ISA savings.

2.1 Advantages and Disadvantages

Learning Objective

5.1.2 Know the advantages and disadvantages of investing in cash

There are a number of advantages to investing in cash:

• One of the key reasons for holding money in the form of cash deposits is liquidity. Liquidity is the
ease and speed with which an investment can be turned into cash to meet spending needs. Most
investors are likely to have a need for cash at short notice and so should plan to hold some cash on
deposit to meet possible needs and emergencies before considering other less liquid investments.
• The other main reasons for holding cash investments are as a savings vehicle and for the interest
return that can be earned on them.
• A further advantage is the relative safety that cash investments have and that they are not exposed
to market volatility, as is the case with other types of assets.

Although cash investments are relatively simple products, it does not follow that they are free of risks,
as bank failures in 2008 so clearly demonstrated. Investing in cash does have some serious drawbacks,
including:

• Deposit-taking institutions are of varying creditworthiness; the risk that they may default needs to
be assessed and taken into account.
• Inflation reduces the real return that is being earned on cash deposits and could mean the real
return after tax is negative.
• Interest rates vary and so the returns from cash-based deposits will also vary.
• There is a currency risk, and different regulatory regimes to take into account, where funds are
invested offshore or in a different currency.

As a result, when comparing available investment options, it is important to consider the risks that exist
as well as comparing the interest rates available.

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 Other Markets and Investments

Bank and building society deposits are usually protected by a compensation scheme. This will repay
any deposited money lost, up to a set maximum, as a result of the collapse of a bank or building society.
The sum is fixed so as to be of meaningful protection to most retail investors, although it would be of
less help to very substantial depositors. Although most cash products are not regulated, the Prudential
Regulatory Authority (PRA) does regulate banks and other deposit-takers, and depositors based in the
UK are covered by the Financial Services Compensation Scheme (FSCS). The FSCS provides protection
for the first £85,000 of deposits per person with an authorised institution.

5
2.2 Cryptocurrencies
Learning Objective

5.1.3 Know the differences between cryptocurrencies and fiat currencies

In this section, we look at cryptocurrencies and how they differ from traditional money.

Cryptocurrencies are a type of digital currency or asset that can be traded, stored and transferred
electronically. There is no single definition of cryptocurrencies, but one from the European regulatory
authorities is that they are a virtual currency that is represented by a digital record, is not issued
by a central bank or similar institution, is not a legally established currency and which, in some
circumstances, can be used as an alternative to money. Perhaps, the best known is Bitcoin which uses
blockchain technology to build a decentralised network that has no central trusted authority and which
is open to anyone to participate.

According to the Financial Conduct Authority (FCA), there are three main kinds of cryptoassets:

• Exchange tokens – such as Bitcoin and other cryptocurrencies.

• Security tokens – has features similar to general investments such as asset ownership rights,
entitlement to a share of future profits, repayment of a specific sum of money, or tradability.
• Utility tokens – gives access to services and products.

To look at fiat currency, we first need to look at what constitutes money. Throughout history, many
different things have been used as money, such as gold and silver. In the 16th century, goldsmiths
began storing gold coins for customers and issuing them with receipts, which could be converted back
into gold on demand. Over time, people started to use these receipts for making payments instead
of returning to the goldsmith to withdraw their gold when they needed to transact. As a result, these
receipts became a form of money themselves and forerunners of the banknotes used today. Banknotes,
until 1931, could have been exchanged on demand for the equivalent amount of gold that they
represented. Since then, banknotes became a form of ‘fiat money’ – money that is no longer convertible
into gold or any other asset. So, fiat money does not have any intrinsic value but is accepted because the
parties engaging in exchange agree on its value and because governments have established it as legal
tender. Economic theory holds that money serves three functions:

• a store of value
• a medium of exchange with which to make payments
• a unit of account with which to measure the value of any particular item that is for sale.

105
Meeting these economic definitions does not necessarily imply that an asset will be regarded as money
for legal or regulatory purposes. While cryptocurrencies can be used as a means of exchange, they are
not currently considered to be a currency or money, according to both the Bank of England (BoE) and
the G20 Finance Ministers and Central Bank Governors (FMCBGs). Their view is that they are too volatile
to be a good store of value, are not widely accepted as a means of exchange, and they are not used as a
unit of account.

3. Money Markets
Learning Objective

5.2.1 Know the difference between a capital market instrument and a money market instrument
5.2.2 Know the definition and features of the following: Treasury bill; commercial paper; certificate
of deposit; money market funds
5.2.3 Know the advantages and disadvantages of investing in money market instruments

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. These usually have a maturity of
up to one year, though three months or less is more typical. By contrast, the capital markets are the
long-term providers of finance for companies through investments either in bonds or shares.

Owing to the short-term nature of the money markets, most instruments are issued in bearer form
and at a discount to their face value to save on the administration associated with registration and the
payment of interest. Instruments used to be issued in bearer form (an explanation of ‘bearer’ can be
found in chapter 4, section 10), but it is now usual to issue them in electronic form to enable electronic
book transfer and custody of the securities.

Although they are accessible to retail investors indirectly through collective investment schemes, 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.

Both cash deposits and money market instruments provide a low-risk way to generate an income or
capital return, as appropriate, while preserving the nominal value of the amount invested. They also
play 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, returns from cash deposits, once tax and inflation have been
taken into account, have barely been positive.

The main types of UK money market instruments are:

• Treasury bills – these are issued weekly by the Debt Management Office (DMO) on behalf of the
Treasury. The money is used for the government’s short-term borrowing needs. Treasury bills are
non-interest-bearing instruments (sometimes referred to as ‘zero coupon’ instruments, see chapter
5, section 4.2.6). Instead of interest being paid out on them, they are normally issued at a discount
to par – ie, a price of less than £100 per £100 nominal (the amount of the Treasury bill that will be

106
 Other Markets and Investments

repaid on maturity) – and commonly redeem after one, three or six months. For example, a Treasury
bill might be issued for £999 and mature at £1,000 three months later. The investor’s return is the
difference between the £999 they paid, and the £1,000 they receive on the Treasury bill’s maturity.
• Certificates of deposit (CDs) – these are issued by banks in return for deposited money and are
tradeable on the money markets. Until the late 1960s, a rigidity in the interbank market meant
that deposits, once taken, could not be traded during their lifetime. To overcome this, CDs were
introduced which could be traded on a secondary market. By market convention, it is a short-term

5
marketable instrument with a maturity up to five years, although the vast majority are issued for
periods of less than six months. Interest can be at a fixed or variable rate, although they may also be
issued at a discount and without a coupon. Most sterling CDs are held by banks, building societies
and other money market participants.
• Commercial paper (CP) – this is the corporate equivalent of a Treasury bill. CP is issued by large
companies to meet their short-term borrowing needs. A company’s ability to issue CP is typically
agreed with banks in advance. For example, a company might agree with its bank to a programme
of £10 billion worth of CP. This would enable the company to issue various forms of CP with different
maturities (eg, one month, three months and six months) and possibly different currencies, to
investors. As with Treasury bills, CP is zero coupon and issued at a discount to its par value.

Settlement of money market instruments is typically achieved through CREST (this is the system used in
the UK to settle trades in shares and bonds) and they are commonly settled on the day of the trade or
the following business day.

As mentioned earlier, the money market is a highly professional market that is used by banks and
companies to manage their liquidity needs. It is not accessible by private investors, who instead need to
utilise either money market accounts offered by banks, or money market funds.

There is a range of money market funds available and they can offer some advantages over pure money
market accounts. There is the obvious advantage that the pooling of funds with other investors gives
the investor access to assets they would not otherwise be able to invest in. The returns on money market
funds should also be greater than a simple money market account offered by a bank. Placing funds in a
money market account means that the investor is exposed to the risk of that bank. By contrast, a money
market fund will invest in a range of instruments from many providers, and as long as they are AAA-
rated they can offer high security levels. A rating of AAA is the highest rating assigned by a credit rating
agency.

Under UK regulatory rules, money market funds may only invest in approved money market instruments
and deposits with credit institutions and meet other conditions on the structure of the underlying
portfolio.

The Investment Association (IA) introduced two money market sectors with effect from 1 January 2012.
These are based on the European definitions of money market funds that have been adopted by the
Financial Conduct Authority (FCA) – short-term money market funds and money market funds.

• Short-term money market funds can have a constant or a fluctuating net asset value (NAV). A
constant NAV face value means they should have an unchanging net asset value when income in
the fund is accrued daily and can either be paid out to the unitholder or used to purchase more units
in the scheme.
• Money market funds by contrast must have a fluctuating NAV.

107
Note that new EU-wide regulations have been implemented which will permit variations in the structure
of short-term money market funds; however, these are beyond the scope of this workbook.

It should be noted that money market funds may invest in instruments in which the capital is at risk
and so may not be suitable for many investors. In addition, money market funds may invest in assets
denominated in other currencies and so introduce exchange rate risk.

4. Property
Learning Objective

5.3.1 Know the characteristics of property investment: commercial/residential property; direct/

indirect investment
5.3.2 Know the potential advantages and disadvantages of investing in property

Property as an asset class is unique in its distinguishing features:

• Each individual property is unique in terms of location, structure and design.

• Valuation is subjective, as property is not traded in a centralised marketplace, and continuous and
reliable price data is not available.
• It is subject to complex legal considerations and high transaction costs upon transfer.
• It is relatively illiquid as a result of not being instantly tradeable.
• It is also illiquid in another sense: the investor generally has to sell all of the property or nothing at
all. It is not generally feasible for a commercial property investor to sell one flat out of an entire block
(or, at least, to do so would be commercially unattractive) – and a residential property owner cannot
sell their spare bedroom to raise a little cash!
• Since property can only be purchased in discrete and sizeable units, diversification is difficult.
• 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.

108
 Other Markets and Investments

What is also fundamentally different is the price. Only the largest investors, which generally means
institutional investors, can purchase sufficient properties to build a diversified portfolio. These tend to
avoid residential property (although some have diversified into sizeable residential property portfolios)
and instead they concentrate on commercial property, industrial property and farmland.

Some of the key differences between commercial and residential property are shown in the following
table.

5
Residential Property Commercial Property

Size of investment required means

Range of investment opportunities
Direct direct investment in commercial
including second homes, holiday
investment property is limited to property
homes and buy to let.
companies and institutional investors.

Long-term contracts with periods

Tenancies Typically, short renewable leases.
commonly in excess of ten years.

Repairs Landlord is responsible. Tenant is usually responsible.

Largely linked to increase in house Significant component is return from

Returns
prices. rental income.

As an asset class, direct investment in property has at times provided positive real long-term returns allied
to low volatility and a reliable stream of income. An exposure to property can provide diversification
benefits within a portfolio of investments owing to its low correlation with both traditional and alternative
asset classes. Many private investors have chosen to become involved in the property market through the
buy-to-let market.

However, property can be subject to prolonged downturns, and its lack of liquidity, significant
maintenance costs, high transaction costs on transfer and the risk of having commercial property with
no tenant (and, therefore, no rental income) makes commercial property suitable as an investment only
for long-term investing institutions such as pension funds.

Other investors wanting to include property within a diversified portfolio generally seek indirect
exposure via a mutual fund, property bonds issued by insurance companies, or shares in publicly
quoted property companies. The availability of indirect investment media makes property a more
accessible asset class to those running smaller, diversified portfolios.

The IA also has a sector covering funds that predominantly invest in property.

It needs to be remembered, however, that investing via a property fund does not always mean that an
investment can be readily realised. During 2008, property prices fell across the board and, as investors
started to encash holdings, property funds brought in measures to stem outflows and in some cases
imposed 12-month moratoria on encashments. A repeat of this was seen in subsequent years, including
2020, with funds imposing moratoriums due to a large stream of redemptions by investors.

109
5. Foreign Exchange (FX)
Learning Objective

5.4.1 Know the basic structure of the foreign exchange market including: currency quotes;
settlement; spot/forward; short-term currency swaps
5.4.2 Be able to calculate a forward exchange rate using interest rate parity formula

The FX market refers to the trading of one currency for another. It is by far the largest market in the
world.

Historically, currencies were backed by gold (as money had ‘intrinsic value’); this prevented the value
of money from being debased and inflation being triggered. This gold standard was replaced after the
Second World War by the Bretton Woods Agreement. This agreement aimed to prevent speculation in
currency markets, by fixing all currencies against the dollar and making the dollar convertible to gold
at a fixed rate of $35 per ounce. Under this system, countries were prohibited from devaluing their
currencies by more than 10%, which they might have been tempted to do in order to improve their
trade position.

The growth of international trade and increasing pressure for the movement of capital eventually
destabilised this agreement, and it was finally abandoned in the 1970s. Currencies were allowed to float
freely against one another, leading to the development of new financial instruments and speculation in
the currency markets.

Trading in currencies became 24-hour, as it could take place in the various time zones of Asia, Europe
and America. London, being placed between the Asian and American time zones, was well placed to
take advantage of this, and has grown to become the world’s largest FX market. Other large centres
include the US, Singapore, Hong Kong and Japan.

Trading of foreign currencies is always done in pairs. These are currency pairs when one currency is
bought and the other is sold, and the prices at which these take place make up the exchange rate. When
the exchange rate is being quoted, the name of the currency is abbreviated to a three-digit reference;
so, for example, sterling is abbreviated to GBP (for Great British pounds).

5.1 Currency Quotes

The most commonly quoted currency pairs are:

• US dollar and Japanese yen (USD/JPY)

• Euro and US dollar (EUR/USD)
• US dollar and Swiss franc (USD/CHF)
• British pound and US dollar (GBP/USD)
• Euro and British pound (EUR/GBP).

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 Other Markets and Investments

When currencies are quoted, the first currency is the base currency and the second is the counter or
quote currency. The base currency is always equal to one unit of that currency, in other words, one
pound, one dollar or one euro. For example, if the EUR/USD exchange rate is 1:1.1165, this means that
€1 is worth $1.1165.

When the exchange rate is ‘going up’, it means that the value of the base currency is rising relative to
the other currency and is referred to as currency strengthening; if the opposite is the case, the currency

5
is said to be weakening.

When currency pairs are quoted, a market maker or FX trader will quote a bid and ask price. Staying
with the example of the EUR/USD, the quote might be 1.1164/66 – notice that the euro is not mentioned,
as standard convention is that the base currency is always one unit. So, if you want to buy €100,000, you
will need to pay the higher of the two prices and deliver $111,660; if you want to sell €100,000, you get
the lower of the two prices and receive $111,640.

The FX market is renowned for being an over-the-counter (OTC) market, ie, one where brokers and
dealers negotiate directly with one another. The main participants are large international banks, which
continually provide the market with both bid (buy) and ask (sell) prices. Central banks are also major
participants in FX markets, which they use to try to control the money supply, inflation and interest
rates.

5.2 FX Transactions
There are several types of transactions and financial instruments commonly used:

• Spot transaction – the spot rate is the rate quoted by a bank for the exchange of one currency for
another with immediate effect. It is worth noting that, in many cases, spot trades are settled – that
is, the currencies actually change hands and arrive in recipients’ bank accounts – two business days
after the transaction date (T+2).
• Forward transaction – in this type of transaction, money does not actually change hands until
some agreed future date. A buyer and seller agree on an exchange rate for any date in the future, for
a fixed sum of money, and the transaction occurs on that date, regardless of what the market rates
are then. The duration of the trade can be a few days, months or years.
• Future – foreign currency futures are a standardised version of forward transactions that are traded
on derivatives exchanges for standard sizes and maturity dates. The average contract length is
roughly three months.
• Swap – the most common type of forward FX transaction is the currency swap. In a swap, two parties
exchange currencies for a certain length of time and agree to reverse the transaction at a later date.
These are not exchange-traded contracts and instead are negotiated individually between the
parties to a swap. They are a type of OTC derivative (see chapter 6).

Settlement is made through CLS Bank or the worldwide international banking system. CLS Bank is a
specialist bank, created in 2002. It is owned by many of the world’s largest financial institutions and is
used to settle FX transactions between member banks using a system called ‘payment-versus-payment’
(PvP). Member banks input their instructions for the buy and sell side of an FX transaction and, provided
the instructions agree and the necessary funds are held, the currencies are exchanged. FX trades can
also be settled directly by participants, as banks hold accounts with each other and their overseas
branches and subsidiaries through which settlement is made.

111
5.3 Forward Exchange Rates
A forward exchange contract is an agreement between two parties to either buy or sell foreign currency
at a fixed exchange rate for settlement at a future date. The forward exchange rate is the exchange
rate set today even though the transaction will not settle until some agreed point in the future, such as
in three months’ time.

The relationship between the spot exchange rate and forward exchange rate for two currencies is 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.

Example
To calculate a three-month forward rate for GBP/USD, we need the current spot rate and the three-
month interest rates in the UK and the US:

• The GBP/USD spot rate is 1.25.

• Three-month LIBOR rates are 0.50% in the UK and 1% in the US. As those interest rates are quoted
on an annual basis, we need to adjust them to quarterly.
• UK three-month rates are 0.50% ÷ 4 = 0.125%.
• US three-month rates are 1.00% ÷ 4 = 0.25%.

We can then calculate the forward rate using the interest rate parity formula:

 1 + quote currency short-term rate 

=
Forward rate spot rate ×  
 1 + base currency short-term rate 

Applying the formula, we can calculate the three-month forward rate as:

 1 + 0.0025 
Forward rate =
1.25 ×  =1.2516
 1 + 0.00125 

As interest rates in this example are higher than in the UK, the forward rate is higher. If it had been
lower, the forward rate would have been lower.

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 Other Markets and Investments

End of Chapter Questions

Think of an answer for each question and refer to the appropriate section for confirmation.

1. What is the maximum amount of compensation per person that would be payable by the
Financial Services Compensation Scheme (FSCS) in the event of the failure of a bank?
Answer Reference: Section 2.1

5
2. Economic theory holds that money should serve which three functions?
Answer Reference: Section 2.2

3. How is the return on a Treasury bill achieved?

Answer Reference: Section 3

4. What are the advantages and disadvantages of investing in property?

Answer Reference: Section 4

5. When will a spot foreign exchange (FX) trade settle?

Answer Reference: Section 5.2

113
114
 Chapter Six

Derivatives
1. An Overview of Derivatives 117

2. Futures 119

3. Options 121

4. Interest Rate Swaps 123

5. Credit Default Swaps (CDSs) 124

6. Derivatives and Commodity Markets 125

This syllabus area will provide approximately 4 of the 50 examination questions

115
116
 Derivatives

1. An Overview of Derivatives
Derivatives are not a new concept – they have
been around for hundreds of years. Their origins
can be traced back to agricultural markets, where
farmers needed a mechanism to guard against
price fluctuations caused by gluts of produce and
merchants wanted to guard against shortages that
might arise from periods of drought.

So, in order to fix the price of agricultural produce

in advance of harvest time, farmers and merchants
would enter into forward contracts. These set the
price at which a stated amount of a commodity
would be delivered between a farmer and a

6
merchant (now termed the ‘counterparties’ to the
trade) at a pre-specified future date.

These early derivative contracts introduced an

element of certainty into commerce and gained
immense popularity; they led to the opening of
the world’s first derivatives exchange in 1848, the
Chicago Board of Trade (CBOT).

Modern commodity markets have their roots in

this trading of agricultural products. Commodity
markets are where raw or primary products are
exchanged or traded on regulated exchanges. They
are bought and sold in standardised contracts – a
standardised contract is one where not only the
amount and timing of the contract conforms to the
exchange’s norm, but also the quality and form of
the underlying asset – for example, the dryness of
wheat or the purity of metals.

Commodities are sold by producers (eg, farmers,

mining companies and oil companies) and
purchased by consumers (eg, food manufacturers
and industrial goods manufacturers). Much of the
buying and selling is undertaken via commodity
derivatives, which also offer the ability for producers
and consumers to hedge their exposure to price
movements. However, there is also substantial
trading in commodities (and their derivatives)
undertaken by financial firms and speculators
seeking to make profits by correctly predicting
market movements.

117
Today, derivatives trading also takes place in financial instruments, indices, metals, energy and a wide
range of other assets.

The majority of derivatives take one of four forms: forwards, futures, options or swaps.

1.1 Uses of Derivatives

Learning Objective

6.1.1 Know the uses and application of derivatives

A derivative is a financial instrument whose price is based on the price of another asset, known as
the underlying asset or simply ‘the underlying’. This underlying asset could be a financial asset or a
commodity. Examples of financial assets include bonds, shares, stock market indices and interest rates;
for commodities they include oil, silver or wheat.

As we will see later in this chapter, the trading of derivatives can take place either directly between
counterparties or on an organised exchange. When trading takes place directly between counterparties
it is referred to as over-the-counter (OTC) trading, and where it takes place on an exchange, such as ICE
Europe, the derivatives are referred to as being exchange-traded.

Derivatives play a major role in the investment management of many large portfolios and funds, and are
used for hedging, anticipating future cash flows, asset allocation change and arbitrage. Each of these
uses is expanded on briefly below:

• Hedging is a technique employed by portfolio managers to reduce the impact of adverse price
movements on a portfolio’s value; this could be achieved by selling a sufficient number of futures
contracts or buying put options.
• Anticipating future cash flows – closely linked to the idea of hedging, 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 fix the price at which it will be bought and offset the risk that prices will have risen by the time the
cash flow is received.
• Asset allocation changes – changes to the asset allocation of a fund, whether to take advantage
of anticipated short-term directional market movements or to implement a change in strategy, can
be made more swiftly and less expensively using derivatives such as futures than by actually buying
and selling securities within the underlying portfolio.
• Arbitrage is the process of deriving a risk-free profit from simultaneously buying and selling the
same asset in two different markets, when a price difference between the two exists. If the price of
a derivative and its underlying asset are mismatched, then the portfolio manager may be able to
profit from this pricing anomaly.

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 Derivatives

2. Futures

2.1 Development of Futures

As mentioned above, the CBOT opened the world’s first derivatives exchange 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.

These futures contracts have subsequently been extended to a wide variety of commodities and many
other assets and are offered by an ever-increasing number of derivatives exchanges.

It was not 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 followed.

6
2.2 Definition and Function of a Future
Learning Objective

6.2.1 Know the definition and function of a future

Derivatives provide a mechanism by which the price of assets or commodities can be traded for future
settlement at a price agreed today without the full value of this transaction being exchanged or settled at
the outset.

A future is an agreement between a buyer and a seller. A futures contract is a legally binding obligation
between two parties:

• The buyer agrees to pay a prespecified amount for the delivery of a particular prespecified quantity
of an asset at a prespecified future date.
• The seller agrees to deliver the asset at the future date, in exchange for the prespecified amount of
money.

Example
A buyer might agree with a seller to pay US$50 per barrel for 1,000 barrels of crude oil in three
months’ time. The buyer might be an electricity-generating company wanting to fix the price it will
have to pay for the oil to use in its oil-fired power stations, and the seller might be an oil company
wanting to fix the sales price of some of its future oil production.

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A futures contract has two distinct features:

• It is exchange-traded – for example, on derivatives exchanges such as ICE Europe in London or the
Chicago Mercantile Exchange (CME) in the US.
• It is dealt on standardised terms – the exchange specifies the quality of the underlying asset,
the quantity underlying each contract, the future date and the delivery location – only the price is
open to negotiation. In the above example, the oil quality will be based on the oil field from which
it originates (eg, Brent crude – from the Brent oil field in the North Sea), the quantity is 1,000 barrels,
the date is three months ahead and the location might be the port of Rotterdam.

2.3 Futures Terminology

Learning Objective

6.4.1 Understand the following terms: long; short; open; close; holder; writing; premium;
covered; naked

Derivatives markets have specialised terminology that is important to understand.

Staying with the example above, the electricity company is the buyer of the contract, agreeing to
purchase 1,000 barrels of crude oil at US$50 per barrel for delivery in three months’ time. The buyer is
said to go long of the contract, while the seller (the oil company, in the above example) is described as
going short. Entering into the transaction is known as opening the trade and the eventual delivery of
the crude oil will close the trade.

The definitions of these key terms that the futures market uses are as follows:

• Long – the term used for the position taken by the buyer of the future. The person who is ‘long’ of
the contract is committed to buying the underlying asset at the pre-agreed price on the specified
future date.
• Short – the position taken by the seller of the future. The seller is committed to delivering the
underlying asset in exchange for the pre-agreed price on the specified future date.
• Open – the initial trade. A market participant ‘opens’ a trade when it first enters into a future. It
could be buying a future (opening a long position), or selling a future (opening a short position).
• Close – the physical assets underlying most futures that are opened do not end up being delivered:
they are ‘closed-out’ instead. For example, an opening buyer will almost invariably avoid delivery
by making a closing sale before the delivery date. If the buyer does not close-out, they will pay the
agreed sum and receive the underlying asset. This might be something the buyer is keen to avoid,
for example because the buyer is actually a financial institution simply speculating the price of the
underlying asset using futures.
• Covered – when the seller of the future has the underlying asset that will be needed if physical
delivery takes place.
• Naked – when the seller of the future does not have the asset that will be needed if physical delivery
of the underlying commodity is required. The risk could be unlimited.

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 Derivatives

3. Options
Learning Objective

6.3.1 Know the definition and function of an option

6.3.2 Understand the following terms: calls; puts
6.4.1 Understand the following terms: long; short; open; close; holder; writing; premium; covered;
naked

3.1 Development of Options

We now move on to consider options contracts. Options did not really start to flourish until two US
academics produced an option pricing model in 1973 that allowed them to be readily priced. This
paved the way for the creation of standardised options contracts and the opening of the Chicago Board

6
Options Exchange (CBOE) in the same year. This in turn led to an explosion in product innovation and
the creation of other options exchanges.

3.2 Definition and Function of an Option

An option gives a buyer the right, but not the obligation, to buy or sell a specified quantity of an
underlying asset at a pre-agreed exercise price, on or before a prespecified future date or between two
specified dates. The seller, in exchange for the payment of a premium, grants the option to the buyer.

A key difference between a future and an option is, therefore, that an option gives the right to buy or
sell, whereas a future is a legally binding obligation between counterparties.

When options are traded on an exchange, they will be in standardised sizes and terms. From time to
time, however, investors may wish to trade an option that is outside these standardised terms and they
will do so in the OTC market. Options can, therefore, also be traded off-exchange, or OTC, where the
contract specification determined by the parties is bespoke.

3.3 Options Terminology

There are two main classes of options:

• A call option is when the buyer has the right to buy the asset at the exercise price, if they choose to.
The seller is obliged to deliver if the buyer exercises the option.
• A put option is when the buyer has the right to sell the underlying asset at the exercise price. The
seller of the put option is obliged to take delivery and pay the exercise price, if the buyer exercises
the option.

The buyers of options are the owners of those options. They are also referred to as holders.

The sellers of options are referred to as the writers of those options. Their sale is also referred to as
‘taking for the call’ or ‘taking for the put’, depending on whether they receive a premium for selling a call
option or a put option.

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For exchange-traded contracts, both buyers and sellers settle the contract with a clearing house that is
part of the exchange, rather than with each other. The exchange needs to be able to settle bargains if
holders choose to exercise their rights to buy or sell. Since the exchange does not want to be a buyer
or seller of the underlying asset, it matches these transactions with deals placed by option writers who
have agreed to deliver or receive the matching underlying asset, if called upon to do so.

The premium is the money paid by the buyer/holder to the exchange (and then by the exchange to the
seller/writer) at the beginning of the option contract; it is not refundable.

Call Option Put Option

The holder has the right, but not the

The holder has the right, but not the
Holder obligation, to exercise the option to
obligation, to exercise the option to sell.
buy.

The writer received a premium from The writer received a premium from the
Writer
the holder and is obliged to sell. holder and is obliged to buy.

The following simplified example of an options contract is intended to assist in understanding the way
in which options contracts might be used.

Example
Suppose shares in Jersey plc are trading at 324p and an investor buys a 350p call for three months for
a premium of 42p. The investor, Frank, has the right to buy Jersey shares from the writer of the option
(another investor – Steve) at 350p if he chooses at the end of the next three months.

If Jersey shares are below 350p three months later, Frank will abandon the option.

If they rise to, say, 600p, Frank will contact Steve and either:

• exercise the option (buy the share at 350p and keep it, or sell it at 600p)
• persuade Steve to give him 600p – 350p = 250p to settle the transaction.

If Frank paid a premium of 42p to Steve, what is Frank’s maximum loss and what level does Jersey plc
have to reach for Frank to make a profit?

The most Frank can lose is 42p, the premium he has paid.

If the Jersey plc shares rise above 350p + 42p, or 392p, then Frank makes a profit. Frank’s potential
profit is unlimited.

If the shares rise to 351p then Frank would exercise his right to buy – better to make a penny and cut
his losses to 41p than lose the whole 42p.

The most Steve can gain is the premium, ie, 42p. Steve’s potential loss, however, is theoretically
unlimited, unless he actually holds the underlying shares.

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 Derivatives

Staying with that example, we can look at the terms ‘covered’ and ‘naked’ in relation to options. The
writer of the option is hoping that the investor will not exercise his right to buy the underlying shares
and then he can simply pocket the premium. This obviously presents a risk because if the price does rise
then the writer will need to find the shares to meet his obligation. He may not have the shares to deliver
and may have to buy these in the market, in which case his position is referred to as being naked (ie, he
does not have the underlying asset – the shares). Alternatively, he may hold the shares, and his position
would be referred to as covered.

4. Interest Rate Swaps

Learning Objective

6.6.1 Know the definition and function of an interest rate swap

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A swap is an agreement to exchange one set of cash flows for another. They are most commonly used to
switch financing from one currency to another or to replace floating interest with fixed interest.

Swaps are a form of OTC derivative and are negotiated between the parties to meet the different needs
of customers, so each tends to be unique.

Interest rate swaps are the most common form of swaps.

They involve an exchange of interest payments and are usually constructed, whereby one leg of the
swap is a payment of a fixed rate of interest and the other leg is a payment of a floating rate of interest.

They are often used to hedge exposure to interest rate changes and can be most easily appreciated by
looking at an example.

Example
Company A is embarking on a three-year project to build and equip a new manufacturing plant and
borrows funds to finance the cost. Because of its size and credit status, it has no choice but to borrow
at variable rates.

It can reasonably estimate what additional returns its new plant will generate but, because the
interest it is paying will be variable, it is exposed to the risk that the project may turn out to be
uneconomic if interest rates rise unexpectedly.

If the company could secure fixed-rate finance, it could remove the risk of interest rate variations and
more accurately predict the returns it can make from its investment.

To do this, Company A could enter into an interest rate swap with an investment bank. Under the
terms of the swap, Company A pays a fixed rate to the investment bank and in exchange receives
an amount of interest calculated on a variable rate. With the amount it receives from the investment
bank, it then has the funds to settle its variable-rate lending, even if rates increase. In this way, it has
hedged its concerns about interest rates rising.

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The two exchanges of cash flow are known as the legs of the swap and the amounts to be exchanged
are calculated by reference to a notional amount. The notional amount in the above example would be
the amount that Company A has borrowed to fund its project. It is referred to as the notional amount as
it is needed in order to calculate the amounts of interest due, but is never exchanged.

Typically, one party will pay an amount based on a fixed rate to the other party, who will pay back an
amount of interest that is variable and usually based on a market reference rate such as the Secured
Overnight Funding Rate (SOFR). The variable rate will usually be set as a market reference rate plus, say,
0.5%, and will be reset quarterly. The variable rate is often described as the floating rate.

5. Credit Default Swaps (CDSs)

Learning Objective

6.7.1 Know the definition and function of credit default swaps

In recent years, there has been significant growth in the use of credit derivatives, of which a credit
default swap (CDS) is just one example.

Credit derivatives are instruments whose value depends on agreed credit events relating to a third-party
company, for example, changes to the credit rating of that company, or an increase in that company’s
cost of funds in the market, or credit events relating to it. Credit events are typically defined as including
a material default, bankruptcy, a significant fall in an asset’s value, or debt restructuring, for a specified
reference asset.

The purpose of credit derivatives is to enable an organisation to protect itself against unwanted credit
exposure, by passing that exposure on to someone else. Credit derivatives can also be used to increase
credit exposure, in return for income.

Although a CDS has the word ‘swap’ in its name, it is not like other types of swaps, which are based
on the exchange of cash flows. A CDS is actually more like an option. In a CDS, the party buying credit
protection makes a periodic payment (or pays an up-front fee) to a second party, the seller. In return,
the buyer receives an agreed compensation if there is a credit event relating to some third party or
parties. If such a credit event occurs, the seller makes a predetermined payment to the buyer, and the
CDS then terminates. So, a CDS can be thought of as a type of insurance – in simple terms, the holder of
a bond (ie, the CDS buyer) can take out protection on the risk of the issuer of the bond (the debt issuer)
defaulting by paying a premium to a counterparty, the CDS seller. An investment fund might take out a
CDS to protect its holding of a bond in case of default, while other market participants might use one to
speculate on changes in credit rating.

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6. Derivatives and Commodity Markets

Learning Objective

6.5.1 Know the characteristics of the derivatives and commodity markets

As we saw earlier, a derivative is a financial instrument whose price is derived from that of another asset
(the other asset being known as the ‘underlying asset’, or sometimes ‘the underlying’ for short).

Derivatives are often thought of as dangerous instruments that are impenetrably complex. While
derivatives can be complex and present systemic risks, they are chiefly designed to be used to reduce
the risk faced by organisations and individuals, a process known as hedging. Equally, many derivatives
are not particularly complex.

6
As an example, imagine that you wanted to purchase a large amount of wheat from a wholesale
supplier. You contact the supplier and see that it will cost the sterling equivalent of $5 a bushel. But you
discover that the wheat is currently out of stock in the warehouse. However, you can sign a contract to
accept delivery of the wheat in one month’s time (when the stock will be replenished), and at that stage,
the store will charge $5 for each bushel you order now. If you sign, you have agreed to defer delivery for
one month – and you have purchased into a derivative.

The physical trading of commodities takes place side by side with the trading of derivatives. The
physical market concerns itself with procuring, transporting and consuming real commodities by the
shipload on a global basis. This trade is dominated by major international trading houses, governments,
and the major producers and consumers. The derivatives markets exist in parallel and serve to provide
a price-fixing mechanism whereby all stakeholders in the physical markets can hedge market price risk.

Another aspect of commodity markets, more recent in origin but highly developed, is the use of
commodities as an investment asset class in its own right.

6.1 Derivatives Markets

Broadly speaking, there are two distinct groups of derivatives, differentiated by how they are traded.
These are OTC derivatives and exchange-traded derivatives (ETDs).

OTC derivatives are negotiated and traded privately between parties without the use of an exchange.
Products such as interest rate swaps, forward rate agreements and other exotic derivatives are mainly
traded in this way.

The OTC market is the larger of the two in terms of value of contracts traded daily. Trading takes place
predominantly in Europe and, particularly, in the UK (note that there is considerable activity taking place
at the moment to move OTC trading on-exchange in response to regulatory concerns about the risks
posed by OTC derivative trading).

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ETDs are ones that have standardised features and can, therefore, be traded on an organised exchange,
such as single stock or index derivatives. The role of the exchange is to provide a marketplace for trading
to take place, but also to stand between each party to a trade to provide a guarantee that the trade
will eventually be settled. It does this by acting as an intermediary (central counterparty) for all trades
and by requiring participants to post a margin, which is a proportion of the value of the trade, for all
transactions that are entered into.

6.2 Physical Markets

There are a number of different commodity markets, which are differentiated by the commodity that is
traded. Some of the main ones are:

• agricultural markets
• base and precious metals
• energy markets
• power markets
• plastics markets
• emissions markets, and
• freight and shipping markets.

As an example, we will consider the features of the base and precious metals markets and energy
markets below.

Example
Base and Precious Metals

There are numerous metals produced worldwide and subsequently refined for use in a large variety
of products and processes.

As with all other commodity prices, metal prices are influenced by supply and demand.

The factors influencing supply include the availability of raw materials and the costs of extraction and
production.

Demand comes from underlying users of the commodity, eg, the demand for metals in rapidly
industrialising economies, including China and India. It also originates from investors such as hedge
funds which might buy metal futures in anticipation of excess demand, or incorporate commodities
into specific funds. Producers use the market for hedging their production. Traditionally, the price of
precious metals such as gold will rise in times of crisis – gold is often seen as a safe haven.

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 Derivatives

Example
Energy Markets

The energy market includes the market for oil (and other oil-based products like petroleum), natural
gas and coal.

Oil includes both crude oil and various ‘fractions’ produced as a result of the refining process, such as
naphtha, butane, kerosene, petrol and heating/gas oil.

Crude oil is defined by three primary factors:

• Field of origin, for example, Brent, West Texas Intermediate, Dubai.

• Density, ie, low density or ‘light’, high density or ‘heavy’.
• Sulphur content, ie, low sulphur (known as ‘sweet’) or high sulphur (known as ‘sour’).

Demand for oil and gas is ultimately driven by levels of consumption, which in turn is driven by

6
energy needs, eg, from manufacturing industry and transport. Supply of these commodities is finite,
and countries with surplus oil and gas reserves are able to export to those countries with insufficient
oil and gas to meet their requirements. In the past, oil producing countries that are members of the
Organization of Petroleum Exporting Countries (OPEC) would regularly restrict the supply of oil in
order to keep prices high or to drive them up. More recently, prices of oil have dropped significantly
due to a combination of oversupply and competition between oil-producing states.

6.3 Derivatives Exchanges

Details of some of the main derivatives exchanges in Europe are shown below.

ICE Futures Europe

In 2001, Euronext purchased a derivatives exchange in London called LIFFE (pronounced ‘life’) and
renamed it Euronext.liffe. LIFFE was originally an acronym for the London International Financial
Futures and Options Exchange, originally set up in 1982. It is now part of ICE following the takeover of
NYSE Euronext.

ICE Futures Europe is the main exchange for trading financial derivative products in the UK, including
futures and options on:

• interest rates and bonds

• equity indices (eg, FTSE)
• individual equities (eg, BP, HSBC).

It also trades derivatives on soft commodities, such as sugar, wheat and cocoa. Additionally, it also runs
futures and options markets in Amsterdam, Brussels, Lisbon and Paris.

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Eurex
Eurex is the world’s leading international derivatives exchange and is based in Frankfurt. Its principal
products are German bond futures and options, the most well-known of which are contracts on the
Bund (a German bond). It also trades index products for a range of European markets.

Eurex was created by Deutsche Börse AG and the Swiss Exchange. Trading is on the fully computerised
Eurex platform, and its members are linked to the Eurex system via a dedicated wide-area communications
network (WAN). This enables members from across Europe and the US to access Eurex outside
Switzerland and Germany.

Intercontinental Exchange (ICE)

Intercontinental Exchange (ICE) operates the electronic global futures and OTC marketplace for
trading energy commodity contracts. These contracts include crude oil and refined products, natural
gas, power and emissions.

The company’s regulated futures and options business, formerly known as the International Petroleum
Exchange (IPE), now operates under the name ICE Futures. ICE acquired the London-based energy
futures and options exchange in 2001 and completed the transition from open outcry to electronic
trading in April 2005.

ICE Futures Europe is the leading energy futures and options exchange and is a subsidiary of ICE. ICE’s
products include derivative contracts based on key energy commodities: crude oil and refined oil
products, such as heating oil and jet fuel and other products, like natural gas and electric power. With
the acquisition of LIFFE, its range of tradeable products expanded to include futures and options on
bonds, equities and indices.

ICE’s other markets are centred in North America and include trading of agricultural, currency and stock
index futures and options. It also took over NYSE Euronext and, as a result, by acquiring LIFFE, became
the world’s largest derivatives exchange operator.

London Metal Exchange (LME)

The London Metal Exchange (LME) is the world’s premier non-ferrous metals market and has been
operating for over 130 years. Although it is based in London, it is a global market with an international
membership and with more than 95% of its business coming from overseas.

Futures and options contracts are traded on a range of metals, including aluminium, copper, nickel, tin,
zinc and lead. More recently, it has also launched the world’s first futures contracts for plastics.

Trading on the LME takes place in three ways: through open outcry trading in the ‘ring’, through an
inter-office telephone market and through LME Select, the exchange’s electronic trading platform.

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6.4 Investing in Derivatives Markets

Learning Objective

6.5.2 Know the potential advantages and disadvantages of investing in the derivatives and
commodity markets

Having looked at various types of derivatives and their main uses, we can summarise some of the main
advantages and disadvantages of investing in derivatives.

Advantages
• Enables producers and consumers of goods to agree the price of a commodity today for future
delivery, which can remove the uncertainty of what price will be achieved for the producer and the
risk of lack of supply for the consumer.

6
• Enables investment firms to hedge the risk associated with a portfolio or an individual stock.
• Offers the ability to speculate on a wide range of assets and markets to make large bets on price
movements using the geared nature of derivatives.

Drawbacks and Risks

• Some types of derivatives investment can involve the investor losing more than their initial outlay
and, in some cases, facing potentially unlimited losses.
• Derivatives markets thrive on price volatility, meaning that professional investment skills and
experience are required.
• In the OTC markets, there is a risk that a counterparty may default on their obligations, and so it
requires great attention to detail in terms of counterparty risk assessment, documentation and the
taking of collateral.

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End of Chapter Questions
Think of an answer for each question and refer to the appropriate section for confirmation.

1. What are the main investment uses of derivatives?

Answer Reference: Section 1.1

2. What is the key difference between a future and an option?

Answer Reference: Sections 2.2 and 3.2

3. What is the position that the seller of a future adopts known as?
Answer Reference: Section 2.3

4. An investor who enters into a contract for the delivery of an asset in three months’ time is said
to have adopted what position?
Answer Reference: Section 2.3

5. What name is given to the seller of an option?

Answer Reference: Section 3.3

6. What type of option gives the holder the right to sell an asset?
Answer Reference: Section 3.3

7. What is the price paid for an option known as and who is it paid to?
Answer Reference: Section 3.3

8. What is an interest rate swap?

Answer Reference: Section 4

9. What are the main types of contract traded on the London Metal Exchange (LME) and Eurex?
Answer Reference: Section 6.3

10. What are the main advantages and disadvantages of investing in derivatives?
Answer Reference: Section 6.4

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 Chapter Seven

Investment Funds
1. Introduction 133

2. Unit Trusts 141

3. Open-Ended Investment Companies (OEICs) 142

4. Pricing, Dealing and Settlement 143

5. Investment Trusts 146

6. Exchange-Traded Funds (ETFs) 148

7. Summary: Comparison Between Investment Companies 150

8. Alternative Investment Funds (AIFs) 151

This syllabus area will provide approximately 6 of the 50 examination questions

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132
 Investment Funds

1. Introduction
The asset management industry forms a major
part of the UK’s financial services sector. It is
responsible for the investment management of
institutional and retail funds which, according
to the 2020–21 edition of Asset Management in
the UK, produced by the Investment Association
(IA), totalled £10 trillion, an increase of 6% year
on year.

The size and scale of the industry can be seen in

the regular reports issued by the IA, which is the
trade body for the UK-based asset management
industry. Its members manage a wide variety
of investment vehicles including authorised
investment funds, pension funds and stocks and
shares individual savings accounts (ISAs). Its role

7
is to represent the industry, principally to the
government and regulators, as well as to the
press and public, and to promote high standards.
The global nature of the industry can be seen in
the following headline figures, as reported by the
IA:

• The UK is the second-largest asset

management centre after the US and is the
largest centre for investment management in
Europe.
• The £10 trillion of assets managed by IA
members represents around 65% of the wider
UK investment management industry which
rose to an estimated £11.6 trillion in 2021, up
from £11 trillion in 2020.
• Almost half (46%) of total assets managed in
the UK are managed on behalf of overseas
clients. European clients continue to account
for the majority (59%) of overseas client
assets.

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How its member firms relate to the rest of the industry can be seen from the diagram below.

Source: Investment Association (IA)

1.1 Key Considerations

Before we consider the benefits of collective investment and the range of investment styles that are
available, we should first look at some of the key considerations that an individual should take into
account when determining where to invest and choosing between the types of investment funds that
are available.

Before making any investments, the investor should ensure they have sufficient cash resources and then
consider some of the following points:

• What am I investing for? The answer, be it retirement, to meet school fees or any other reason, will
give some direction to the type of investment that may be suitable.
• What amount of money will I need? An assessment of how much money will eventually be needed
determines how much will need to be invested to achieve that goal and whether this is affordable.
• Over what timescale do I want investment returns? This, along with the reason for investing, will
give the timescale over which investment needs to be made.
• What risks am I prepared to take? If an individual is going to invest, they will need to be prepared
to take some risk in the hope of greater reward. They must be prepared to see at least some fall in
the value of their investment without panicking, and be willing to hold on in the hope of future
gains. If they are not prepared to take any risk whatsoever, then investing in the stock market is not
the right option.
• What types of assets are right for me? Each type of asset carries risks and these need to be
understood so that the right type of asset can be selected that can meet the individual’s long-term
objective with an acceptable level of risk.
• How can I avoid risk? Risk cannot be totally avoided, but diversifying the range of assets held
reduces the risks that are faced.

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 Investment Funds

• What mix of investments is best suited to my objectives and attitude to risk? The right mix
of assets – cash, bonds, shares and property – that is best suited will depend on the individual’s
investment objective, their attitude to risk, and the timescale over which they are investing. The
mix will also need to change if the individual’s circumstances change and at the time when the
investment funds are needed approaches.
• Do I need income now or later? If income is taken to spend, then the investment will grow more
slowly, whereas if it is reinvested it will allow interest to be earned on interest, and this compounding
of interest will generate further growth.

The complexity means that some individuals are well advised to seek professional advice from qualified
financial advisers. This is only a brief consideration of some of the many questions that all individuals
need to consider both before investing and when reviewing existing investments (further coverage can
be found in chapter 11).

1.2 The Benefits of Collective Investment

Learning Objective

7
7.1.1 Understand the potential advantages, disadvantages and risks of collective investment

When investors decide to invest in a particular asset class, such as equities, there are two ways they can
do it – direct investment or indirect investment.

Direct investment is when an individual personally buys shares in a company, such as in British
Petroleum (BP), the oil giant. Indirect investment is when an individual buys a stake in an investment
fund, such as a mutual fund that invests in the shares of a range of different types of companies, perhaps
including BP.

Collective investment schemes (CISs) pool the resources of a large number of investors, with the aim of
pursuing a common investment objective.

This pooling of funds brings a number of benefits, including:

• economies of scale
• diversification
• access to professional investment management
• access to geographical markets, asset classes or investment strategies which might other­wise be
inaccessible to the individual investor
• in many cases, the benefit of regulatory oversight, and
• in some cases, tax deferral.

The value of shares and most other investments can fall as well as rise. Some might fall spectacularly,
for example, shares in a company that suddenly collapses, such as Northern Rock and Lehman Brothers,
or where a news event causes a significant fall in a share price, such as when the scandal concerning
exhaust emissions became public or the effect on the BP share price following the Deepwater Horizon
disaster. However, if an investor holds a diversified pool of investments in a portfolio, the risk of single
constituent investments falling spectacularly (such as the collapse of Thomas Cook in 2020) can

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normally be offset by outperformance on the part of other investments. In other words, risk is lessened
when the investor holds a diversified portfolio of investments (of course, the opportunity of a startling
outperformance is also diversified away – but many investors are happy with this if it reduces their risk
of total or significant loss).

However, an investor needs a substantial amount of money before they can create a diversified
portfolio of investments directly. If an investor has only £3,000 to invest and wants to buy the shares
of 30 different companies, each investment would be £100. This would result in a large amount of the
£3,000 being spent on commission, since there will be minimum commission rates of, say, £10 on each
purchase. Instead, an investment of £3,000 might go into a fund with, say, 80 different investments,
but, because the investment is being pooled with those of lots of other investors, the commission, as a
proportion of the fund, is very small.

A fund might be invested in shares from many different sectors; this achieves diversification from an
industry perspective (thereby reducing the risk of investing in a number of shares whose performance is
closely correlated). Alternatively it may invest in a variety of bonds or a mix of cash, equities, bonds and
property. Some collective investments put limited amounts of investment into bank deposits and even
into other collective investments.

The other main rationale for investing collectively is to access the investing skills of the fund manager.
Fund managers follow their chosen markets closely and will carefully consider what to buy and whether
to keep or sell their chosen investments. Few investors have the skill, time or inclination to do this as
effectively themselves.

However, fund managers do not manage portfolios for nothing. They might charge investors fees to
become involved in their collective investments (entry fees or initial charges) or to leave the collective
investment (exit charges) plus annual management fees. These fees are needed to cover the fund
managers’ salaries, technology, research, their dealing, settlement and risk management systems, and
to provide a profit. Equally, there is no guarantee of the investment performance of the fund or of how
it will perform in comparison to similar funds or benchmarks.

1.3 Investment Styles

Learning Objective

7.1.2 Know the difference between active and passive (eg, index) management

There is a wide range of funds with many different investment objectives and investment styles. Each of
these funds has an investment portfolio managed by a fund manager according to a clearly stated set
of objectives. An example of an objective might be to invest in the shares of UK companies with above-
average potential for capital growth and to outperform the FTSE All Share index. Other funds’ objectives
could be to maximise income or to achieve steady growth in capital and income.

In each case, it will also be made clear what the fund manager will invest in, ie, shares and/or bonds and/
or property and/or cash or money market instruments; and whether derivatives will be used to hedge
currency or other market risks.

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 Investment Funds

It is also important to understand the invest­ment style the fund manager adopts. This refers to the fund
manager’s approach to choosing investments and meeting the fund’s objectives. In this section, we will
look at the differences between active and passive management styles.

1.3.1 Active Management

Active management seeks to outperform a predetermined benchmark over a specified time period. It
does so by employing fundamental and technical analysis to assist in the forecasting of future events,
which may be economic or specific to a company, so as to determine the portfolio’s holdings and the
timing of purchases and sales. Actively managed funds usually have higher charges than passive funds.

Two commonly used terms in this context are ‘top down’ or ‘bottom up’. Top down means the manager
focuses on economic and industry trends rather than the prospects of particular companies. Bottom
up means that the analysis of a company’s net assets, future profitability and cash flow, and other
company-specific indicators, is a priority.

Included in the bottom-up approach is a range of investment styles:

7
• growth investing – which is picking the shares of companies that present oppor­tunities to grow
significantly in the long term
• value investing – which is picking the shares of companies that are undervalued relative to their
present and future profits or cash flows
• momentum investing – which is picking the shares whose share price is rising on the basis that this
rise will continue
• contrarian investing – the flip side of momentum investing, which involves picking shares that are
out of favour and may have ‘hidden’ value.

There is also a significant range of styles used by managers of hedge funds. Hedge funds are considered
in section 8.1.

1.3.2 Passive Management

Passive management is seen in those types of investment funds that are often described as index
tracker funds. Index-tracking, or indexation, involves constructing a portfolio in such a way that it will
track, or mimic, the performance of a recognised 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.

The advantages of employing indexation are as follows:

• Relatively few active portfolio managers consistently outperform benchmark equity indices.
• The fund’s charges will typically be significantly lower than actively managed funds.
• 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.

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The disadvantages of adopting indexation include the following:

• Performance is affected by the need to manage cash flows, rebalance the portfolio to replicate
changes in index-constituent weightings, and adjust the portfolio for stocks coming into, and falling
out of, the index. This can lead to tracking error when the performance does not match that of the
underlying index.
• Most indices reflect the effect of the value of dividends from constituent equities on the ex-dividend
date.
• Indexed portfolios may not meet all of an investor’s objectives.
• Indexed portfolios follow the index down in bear markets.

1.3.3 Combining Active and Passive Management

It should be noted that active and passive investment are not necessarily mutually exclusive and there
are investment strategies that incorporate both styles, known as core-satellite management.

One way in which this is achieved is by indexing, say, 70–80% of the portfolio’s value (the ‘core’), so as
to minimise the risk of underperformance, and then fine-tuning this by investing the remainder in a
number of specialist actively managed funds or individual securities. This is the ‘satellite’ element of the
fund.

Although passive funds generally track an index, there are funds that are described as ‘smart beta’.
Instead of tracking just an index, these funds will take into account other factors, such as value or
growth, when creating an index that they will track. It can be regarded as a mix of active and passive – it
follows an index, but is active because it also considers alternative factors.

1.4 Range of Funds Available

Learning Objective

7.1.4 Know the types of funds and how they are classified

There are almost 2,500 UK-domiciled authorised investment funds available to investors along with
even more EU-based ones and a wide range of ETFs and, unsurprisingly, a method of classifying them is
needed in order to allow investors to compare funds with similar objectives.

The IA is the trade body for the UK authorised open-ended funds industry; it maintains a system for
classifying funds. The Association of Investment Companies (AIC) occupies a similar role for investment
trusts (closed-ended companies).

The IA’s classification system contains a number of sectors that group similar funds and ETFs together
(ETFs were added in to the IA sectors in April 2021). Most sectors are broadly categorised between those
designed to provide ‘income’ and those designed to provide ‘growth’. Those funds that do not fall easily
under these headings are in other categories entitled capital protection, specialist funds, volatility-
managed, absolute/target return, and unclassified.

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Each of the sectors is made up of funds investing in similar asset categories, in the same stock market
sectors or in the same geographical region. So, for example, under the heading of funds principally
targeting income you will find sectors that include UK gilts, UK corporate bonds and global bonds. See
the following table for an example.

Example
A useful example of how the IA sectors work can be seen by looking at some bond fund sectors and
how the content of each differs.

Funds which invest at least 95% of their assets in sterling-denominated (or hedged
UK Gilts back to sterling) government-backed securities, with a rating the same as or higher
than that of the UK, with at least 80% invested in UK government securities (gilts).

Funds which invest at least 95% of their assets in sterling-denominated (or hedged
UK Index-
back to sterling) government-backed index-linked securities, with a rating the same

7
Linked Gilts
as or higher than that of the UK, with at least 80% invested in UK index-linked gilts.

Funds which invest at least 80% of their assets in sterling-denominated (or hedged
£ Corporate back to sterling), triple BBB-minus or above corporate bond securities (as measured
Bonds by Standard & Poor’s or an equivalent external rating agency). This excludes
convertibles, preference shares and permanent interest-bearing shares (PIBS).

Funds which invest at least 80% of their assets in sterling-denominated (or hedged
back to sterling) fixed-interest securities. This excludes convertibles, preference
shares and permanent interest-bearing shares (PIBS). At any point in time, the asset
£ Strategic
allocation of these funds could theoretically place the fund in one of the other fixed-
Bonds
interest sectors. The funds will remain in this sector on these occasions since it is
the manager’s stated intention to retain the right to invest across the sterling fixed-
interest credit risk spectrum.

Funds which invest at least 80% of their assets in sterling-denominated (or hedged
back to sterling) fixed-interest securities and at least 50% of their assets in below
£ High Yield BBB-minus fixed-interest securities (as measured by Standard & Poor’s or an
equivalent external rating agency), excluding convertibles, preference shares and
PIBS.

The sectors are aimed at the needs of the investor who has a desire to compare funds on a like-for-like
basis. Sector classification provides groups of similar funds whose performance can be readily compared
by an investor and their adviser.

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1.5 UCITS and NURS
Learning Objective

7.1.3 Know the purpose and principal features of UCITS/NURS

As you would expect, the investment industry has many regulations designed to protect investors.
Some of these regulations govern permissible investments and the documentation an investor can
expect to receive.

1.5.1 Undertakings for Collective Investments in Transferable Securities

(UCITS)
UCITS refers to a series of EU regulations (‘directives’) that were originally designed to facilitate the
promotion of funds to retail investors across the European Union (EU) and the European Economic Area
(EEA). A UCITS fund, therefore, complies with the requirements of these directives, no matter which EU
country it is established in.

The aim of the directives was to create a framework for cross-border sales of investment funds
throughout the EU, which would allow an investment fund to be sold throughout the EU, subject
to regulation by its home country regulator. The rationale was that allowing funds to be sold across
borders would reduce the costs involved and improve customer choice, while ensuring a level playing
field through common standards of investor protection.

Following the end of the Brexit transition period, UK fund management firms have lost their ability to
establish a fund in the UK as a UCITS fund and then sell the fund across Europe. As a result, many UK
fund management groups have set up subsidiaries in Luxembourg, Ireland and other countries so that
they can operate from there. Equally, EEA-based funds will encounter difficulties in selling their funds in
the UK.

The FCA intends to permit EEA UCITS funds to continue to be marketed to retail investors during a
temporary period before they require them to apply for recognition. The sheer numbers involved,
however, make individual recognition of funds impractical, and to address this, HM Treasury has
introduced an overseas fund regime which will allow the government to recognise another country’s
regime for funds which will then enable funds from those countries to access the UK market.

1.5.2 NURS
Funds can also be set up under NURS regulations. NURS stands for ‘non-UCITS retail schemes’ and these
are funds that are deemed by the UK regulator to be suitable for retail investors, but do not meet the
more prescriptive rules of the European UCITS Directive. These allow a greater range of investment
opportunities including direct investment in property. Many fund of funds have adopted NURS as this
allows the use of a much wider range of underlying investments.

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2. Unit Trusts
Learning Objective

7.2.1 Know the definition and legal structure of a unit trust

7.2.2 Know the roles of the manager and the trustee

A unit trust is a CIS in the form of a trust in which the trustee is the legal owner of the underlying assets
and the unitholders are the beneficial owners. It may be authorised or unauthorised.

Investors pay money into the trust in exchange for units. The money is invested in a diversified portfolio
of assets, usually consisting of shares or bonds or a mix of the two. If the diversified portfolio increases
in value, the value of the units will increase. Of course, there is a possibility that the portfolio might fall
in value, in which case the units will also decrease in value. The unit trust is often described as an open-
ended CIS because the trust can grow as more investors buy into the fund, or shrink as investors sell
units back to the fund and they are either cancelled or reissued to new investors.

7
The role of the unit trust manager is to decide, within the rules of the trust and the various regulations,
which invest­ments are included within the unit trust to meet its investment objectives. This will include
deciding what to buy and when to buy it, as well as what to sell and when to sell it. The unit trust
manager may (and commonly does) outsource this decision-making to a separate investment manager.

The manager also provides a market for the units, by dealing with investors who want to buy or sell
units. The manager also carries out the daily pricing of units, which is based on the net asset value (NAV)
of the underlying constituents.

Every unit trust must also appoint a trustee. The trustee is the legal owner of the assets in the trust,
holding the assets for the benefit of the underlying unit holders.

The trustee also protects the interests of the investors by, among other things, monitoring the actions
of the unit trust manager. Whenever new units are created for the trust, they are created by the trustee.
The trustees are organisations that the unit holders can ‘trust’ with their assets.

For authorised unit trusts (AUTs), the trustees are companies subject to special regulation – all part of
global banking groups.

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3. Open-Ended Investment Companies (OEICs)
Learning Objective

7.3.1 Know the definition and legal structure of an OEIC/ICVC/SICAV

7.3.2 Know the roles of the authorised corporate director and the depository

An open-ended investment company (OEIC) is another form of authorised CIS. OEICs are referred to
as investment companies with variable capital (ICVCs) by the FCA.

An ICVC commonly found in Western Europe is the Société d’Investissement à Capital Variable
(SICAV). Like a UK OEIC, it is an investment company with variable capital. SICAVs are typically set up in
Luxembourg by asset management firms so that they can be distributed to investors across Europe or
further afield.

An OEIC is a CIS structured as a company, with the investors holding shares.

The OEIC invests shareholders’ money in a diversified pool of investments. As their name suggests,
OEICs are companies, but they differ from conventional companies because they are established under
special legislation and not the Companies Acts. OEICs are not subject to share repurchase restrictions,
create new shares and redeem existing ones according to investor demand, unlike ordinary companies.
This means they are open ended in nature, just like unit trusts.

When an OEIC is set up, it is a requirement that an authorised corporate director (ACD) and a
depository are appointed. The ACD is responsible for the day-to-day management of the fund, including
managing the investments, valuing and pricing the fund, and dealing with investors. It may undertake
these activities itself or delegate them to specialist third parties. It is subject to the same requirements
as the manager of an AUT.

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 Investment Funds

The OEIC’s investments are held by an independent depository, responsible for looking after the
investments on behalf of the OEIC shareholders and overseeing the activities of the ACD. The depository
occupies a similar role to that of the trustee of an AUT and is subject to the same regulatory requirements.

The register of shareholders is maintained by the ACD.

4. Pricing, Dealing and Settlement

4.1 Pricing
Learning Objective

7.4.1 Know how unit trust units and OEIC shares are priced, bought and sold
7.4.2 Know how collectives are settled

7
The prices at which authorised unit trusts or OEICs are bought and sold are based on the value of the
fund’s underlying investments – the net asset value. The authorised fund manager is, however, given
the flexibility to quote prices, which can be either single-priced or dual-priced (although this decision
must be taken at the outset and the manager cannot switch between the two as and when it suits).

Single pricing refers to the use of the mid-market prices of the underlying assets to produce a single
price, while dual pricing involves using the market’s bid and offer prices of the underlying assets to
produce separate prices for buying and selling of shares/units in the fund. Traditionally, AUTs have
used dual pricing and OEICs have used single pricing. All funds now have a choice of which pricing
methodology they use; whichever is chosen must be disclosed in the prospectus.

When a fund is single-priced, with its underlying investments valued based on their mid-market value,
this method of pricing does not provide the ability to recoup dealing expenses and commissions within
the spread. Where necessary, such costs are recouped either by applying a separate charge, known
as a dilution levy, on purchases or redemptions, or by swinging the daily price to a dual-priced basis
depending on the ratio of buyers and sellers on any day. It is important to note that the initial charge
will be charged separately, whichever pricing method is used. The maximum price at which the fund
manager is able to sell new units is prescribed by the FCA. It is known as the maximum buying price and,
under dual pricing, comprises the creation price (ie, the price the manager must pay to the trustee to
create new units, which broadly consists of the value of the underlying investments and an allowance
for dealing costs) plus the fund manager’s initial charge.

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 Example
Value of the portfolio (at offer prices) divided by the number of units 100.00p

Add, allowance for dealing costs: brokerage at, say, ¼% 0.25p

Stamp duty at ½% 0.50p

Subtotal (= creation price) 100.75p

Add, fund manager’s initial charge at, say, 6.55% 6.55p

Maximum buying price 107.30p

The actual buying price does not have to be 107.30p and, because of the sensitivity of investors to
charges, the fund manager may feel that a lower price of, say, 103p per unit is more appropriate.

The price at which the fund manager will repurchase units is calculated in a similar manner. From
the investor’s viewpoint it is referred to as the selling price, and the minimum selling price is also the
cancellation price, ie, the price received from the fund by the manager when they cancel the units, using
as its starting point the value of the portfolio at bid prices. Again, the manager has flexibility about the
price that is set, subject to it being no less than the minimum selling price.

The prices of most individual funds are provided in broadsheet newspapers each day. The telephone
numbers and addresses of the fund managers are normally provided alongside the prices.

4.2 Charges
An investor in a CIS faces several charges, some of which will be explicit, such as the initial charge made
for the investment that we have already seen, and the annual management charge (AMC), which is
applied to cover the ongoing costs of the management and administration of the fund.

Other charges, however, will be less explicit, as they are incurred in the necessary management of the
fund, such as any audit costs for the fund. Managers of funds are entitled (under the terms of their
management agreements) to charge certain other costs to the fund. These include:

• brokers’ commission for trades undertaken

• legal and audit fees, and
• fees for specialist taxation advice.

The size of these other charges can have an impact on the performance of the fund.

UCITS funds are required to publish an ongoing charges figure (OCF) and quote this in the key investor
information document (KIID). It includes all types of expenses incurred by the UCITS, such as the costs
of the UCITS management company, the depositary, the custodian and any investment adviser. It
also includes costs for outsourced services as well as registration fees, regulatory and audit fees, and
payments to legal and professional advisers. However, it does not include any initial or exit charges or
any performance fees.

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 Investment Funds

Other funds may still publish a total expense ratio (TER). The TER consists of the AMC and other charges
such as the fees paid to the trustee, depositary, custodian, auditors and registrar. It also includes any
performance fees, although they may be shown in a separate field.

4.3 Dealing and Settlement

Investors can buy or sell units in a number of ways:

• directly with the fund manager (either by telephone, via the internet or by post)
• via their broker or financial adviser
• through a fund supermarket or platform.

Whether an investor wishes to buy or sell their units, they will be either bought from, or sold back to, the
authorised fund manager. There is no active secondary market in units or shares, except between the
investors (or their advisers/intermediaries) and the fund manager. The key point to note, therefore, is that
units in AUTs and shares in OEICs are bought from the managers themselves and not via a stock market.

A fund supermarket or platform is an organisation that specialises in offering investors easy access to

7
a range of unit trusts and OEICs from different providers. They are usually based around an internet
platform which takes the investor’s order and processes it on their behalf, usually at reduced, or nil,
commission rates. They offer online dealing, valuations, portfolio planning tools and access to key
features documents and illustrations. Investors can look at their various holdings in different funds in
one place, analyse their performance and easily make switches from one fund to another.

Settlement currently takes place directly with each fund group. For purchases, once the investment
has been made and the amount invested has been received, the fund group will record ownership of
the relevant number of units or shares in the fund’s share register. When the investor decides to sell,
they need to instruct the fund manager (or ask their adviser or the supermarket to instruct the fund
manager), who then has four days (T+4) from receipt of the instruction and necessary paperwork in
which to settle the sale and remit the proceeds to the investor. Traditionally, this instruction had to be
in writing but, since 2009, managers have been able to accept instruction via the internet or over the
telephone, using appropriate security checks.

When an order to buy or sell units is undertaken by an organisation that provides dealing services,
such as a fund supermarket, it is likely to use a systems platform to place those orders with the fund
management group.

One widely used system is EMX, which can be used by firms to enter customer orders, aggregate these
and then send them electronically to the fund group. The firm then receives an electronic confirmation
of receipt and, once the deal is traded at the next valuation point, EMX will send an electronic dealing
confirmation showing the price at which the deal was done.

EMX was taken over by Euroclear UK & International, the parent company that owns CREST, and it now
has an automated straight-through processing (STP) platform for fund dealing and settlement.

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5. Investment Trusts
Learning Objective

7.5.1 Know the characteristics of an investment trust: share classes; gearing; real estate investment
trusts (REITs)
7.5.2 Know the meaning of the discounts and premiums in relation to the pricing of investment
trusts
7.5.3 Know how investment trust shares are traded

Despite its name, an investment trust is actually a company, not a trust and is commonly referred to as
an investment trust company (ITC). It is a listed company and has directors and shareholders. However,
like a unit trust, an investment trust will invest in a diversified range of investments, allowing its
shareholders to diversify and lessen their risk.

When a new investment company is established and launched, it issues shares to new investors.
Unlike an authorised unit trust or OEIC, the number of shares is likely to remain fixed for many years.
As a result, these investment companies are closed-ended, in contrast with AUTs and OEICs which are
open-ended.

The cash from the primary issue of shares will be invested in a number of other investments, mainly the
shares of other companies. If the value of the investments grows, then the value of the investment trust
company’s shares should rise too.

5.1 Share Classes

Some investment companies have more than one type of share and, if this is the case, they are known
as split-capital investment trusts. For example, an investment trust might issue both ordinary shares and
preference shares.

Preference shares may be issued on different terms and may, for example, be issued as convertible
preference shares that are convertible into the ordinary shares or as zero dividend preference (ZDP)
shares. As the name suggests, ZDPs receive no dividends and the investor instead receives their return
via the difference in the price they paid and the amount they receive when the ZDP is repaid at a fixed
future date.

5.2 Real Estate Investment Trusts (REITs)

Real estate investment trusts (REITs) are investment companies that pool investors’ funds to
invest in commercial and, possibly, residential property. They became available to UK investors from
January 2007 and the main quoted property companies, such as Land Securities and British Land, have
converted to REIT status.

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 Investment Funds

One of the main features of REITs is that they provide access to property returns without the previous
disadvantage of double taxation. Prior to the introduction of REITs, when an investor held property
company shares, not only would the company pay corporation tax, but the investor would be liable to
income tax on any dividends and capital gains tax (CGT) on any growth. Under the rules, a REIT pays
no tax on property income or capital gains on property disposals, providing that at least 90% of that
income (after expenses) is distributed to shareholders each year. These property income distributions
are then taxed in the hands of the investor as if they had received that income directly themselves (ie, it
is not taxed as a dividend).

REITs may also be held in both individual savings accounts (ISAs) and self-invested personal pension
schemes (SIPPs).

REITs give investors access to professional property investment and provide new opportunities, such as
the ability to invest in commercial property. This allows investors to diversify the risk of holding direct
property investments. This type of investment trust company also removes a further risk from holding
direct property, namely liquidity risk or the risk that the investment will not be able to be readily realised.

REITs are closed-ended; like other investment trusts, they are quoted on the LSE and other trading

7
venues and dealt in the same way.

5.3 Gearing
In contrast with OEICs and authorised unit trusts, investment companies are allowed to borrow
more money on a long-term basis by taking out bank loans and/or issuing bonds. This can enable
them to invest the borrowed money in more stocks and shares – a process known as ‘gearing’. This
approach can improve returns when markets are rising, but when markets are falling it can exacerbate
losses. As a result, the greater the level of gearing used by an investment trust, the greater will be
the risk.

5.4 Pricing, Discounts and Premiums

The price of a share (except in the case of an OEIC share and a unit in an AUT, as we have seen) is what
someone is prepared to pay for it. The price of an investment trust share is no different.

The share price of an investment trust is thus arrived at in a very different way from the unit price of an
authorised unit trust or the share price of an OEIC.

Remember that units in an authorised unit trust are bought and sold by its fund manager at a price that
is based on the underlying value of the constituent investments. Similarly, shares in an OEIC are bought
and sold by the ACD, again at the value of the underlying investments. The share price of an investment
trust, however, is not necessarily the same as the value of the underlying investments. The value of
the underlying investments determined on a per share basis is referred to as the net asset value but,
because the share price is driven by supply and demand factors, it may be above or below the net asset
value (NAV).

• When the investment trust share price is above the NAV, it is said to be trading at a premium.
• When the investment trust share price is below the NAV, it is said to be trading at a discount.

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 Example
ABC Investment Trust shares are trading at £2.30. The NAV per share is £2.00. ABC Investment Trust
shares are trading at a premium. The premium is 15% of the underlying NAV.

Example
XYZ Investment Trust shares are trading at 95p. The NAV per share is £1.00. XYZ Investment Trust
shares are trading at a discount. The discount is 5% of the underlying NAV.

Investment trust company shares generally trade at a discount to their NAV, and the extent of the
discount is calculated daily and shown in the business pages of newspapers.

A number of factors contribute to the extent of the discount and it will vary across different investment
companies. Most importantly, the discount is a function of the market’s view of the quality of the
management of the investment portfolio, and its choice of underlying investments. A smaller discount
(or even a premium) will be displayed when investment trusts are nearing their winding-up, or about
to undergo some corporate activity such as a merger/takeover. (You should note that some, but not
all, investment trusts have a predetermined date at which the trust will be wound up and the assets
returned to the shareholders.)

5.5 Trading in Investment Trust Shares

In the same way as other listed company shares, shares in investment trust companies are bought and
sold on the LSE using the SETS trading system or via a retail service provider (RSP).

6. Exchange-Traded Funds (ETFs)

Learning Objective

7.6.1 Know the main characteristics of exchange-traded funds: trading; replication methods;
synthetic/non-synthetic

An exchange-traded fund (ETF) is an investment fund usually designed to track a particular index. This
is typically a stock market index, such as the FTSE 100. The investor buys shares in the ETF which are
quoted on the stock exchange, as with investment trusts. However, unlike investment trusts, ETFs are
open-ended funds. This means that, like OEICs, the fund gets bigger as more people invest and smaller
as people withdraw their money.

Assets under management in ETFs have grown at an amazing rate. A report by Ernst & Young showed
that assets under management were just $417 billion in 2005, but they had soared to $7 trillion by the
end of 2020 according to the Financial Times.

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 Investment Funds

ETFs use passive investment management which is a method of managing an investment portfolio
that seeks to match the performance of a broad-based market index. Its investment style is described
as passive because portfolio managers do not make decisions about which securities to buy and
sell; instead, they invest in the same securities that make up an index. It, therefore, seeks to hold a
portfolio that mirrors the index it is tracking and undertakes trading only to ensure that the portfolio’s
performance is in line with the index. Most index tracker funds are based on market capitalisation-
weighted indices, such as the FTSE 100 or S&P 500, where the largest stocks in the index by market
value have the biggest influence on the index’s value. The fund will seek to track the index using either
physical or synthetic replication.

Physical replication is the traditional form of index replication and is the one favoured by the largest and
long-established ETF providers. It employs 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 and so is only really suitable for large portfolios.
2. Stratified sampling – this method requires a representative sample of securities from each sector
of the index to be held. Although this method is less expensive, the lack of statistical analysis renders
it subjective and potentially encourages biases towards those stocks with the best perceived

7
prospects.
3. Optimisation – this method costs less than fully replicating the index tracked, but is statistically more
complex. Optimisation uses a sophisticated computer modelling technique to find a representative
sample of those securities which mimic the broad characteristics of the index tracked.

Synthetic replication involves the fund manager entering into a swap (an OTC derivative) with a market
counterparty to exchange the returns on the index for a payment. The advantage of this approach is
that responsibility for tracking the index performance is passed on to the swap provider and costs are
substantially lower. The downside is that the investor is exposed to counterparty risk, namely that the
swap provider fails to meet their obligations.

ETF shares may trade at a premium or discount to the underlying investments, but the difference is usually
minimal and the ETF share price essentially reflects the value of the investments in the fund. The investor’s
return is in the form of dividends paid by the ETF and the possibility of a capital gain (or loss) on sale.

In London, ETFs are traded on the London Stock Exchange (LSE). Shares in ETFs are bought and sold via
stockbrokers and exhibit the following charges:

• There is a spread between the price at which investors buy the shares and the price at which they
can sell them. This is usually very small, for example, just 0.1% or 0.2% for, say, an ETF tracking the
FTSE 100.
• An annual management charge is deducted from the fund. Typically, this is 0.5% or less.
• The investors pay a stockbroker’s commission when they buy and sell. However, unlike other shares,
there is no stamp duty (typically charged at 0.5%) to pay on purchases.

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7. Summary: Comparison Between Investment Companies
The following table summarises the main points about each type of CIS.

Investment Exchange-
Authorised
OEICs Trusts/ Traded Key Points
Unit Trusts
REITs Funds

Despite the name

‘investment trust’,
Legal Structure Trust Company Company Company only unit trusts are
truly structured as a
trust.
The companies that
Authorised
Authorised act as manager tend
Corporate Board of Management
Management Manager to be investment
Director Directors Company
(company) management
(company)
companies.
Supervision for open-
ended companies
Board of
Supervision Trustee Depository Depository (OEICs and ETFs)
Directors
is provided by a
depository.
In order to be listed
on the exchange,
Regulation FCA FCA UKLA FCA and UKLA companies have to
satisfy the UK Listing
Authority.
Only investment
Open- or
Open Open Closed Open trust companies are
closed-ended
closed-ended.
It is only investment
trust companies
Dependent Largely based
Single- or Single- or where the price can
Pricing on demand on net asset
dual-priced dual-priced exhibit a substantial
and supply value
discount or premium
to the NAV.
Trading for unit trust
Authorised and OEICs is with the
Authorised
Trading Corporate Stock Market Stock Market investment manager,
Manager
Director not on the stock
market.
Authorised Stock market-traded
Authorised
Settlement Corporate CREST CREST funds are settled via
Manager
Director CREST.

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 Investment Funds

8. Alternative Investment Funds (AIFs)

8.1 Hedge Funds

Learning Objective

7.7.1 Know the basic characteristics of hedge funds: risks; cost and liquidity; investment strategies

Hedge funds are reputed to be high risk. However, in some cases this perception stands at odds with
reality. In their original incarnation, hedge funds sought to eliminate or reduce market risk. That said,
there are now many different styles of hedge fund – some risk-averse, and some employing highly risky
strategies. It is, therefore, not wise to generalise about them.

The most obvious market risk is the risk that is faced by an investor in shares – as the broad market
moves down, the investor’s shares also fall in value.

Traditional absolute return hedge funds attempt to profit regardless of the general movements of the

7
market, by carefully selecting a combination of asset classes, including derivatives, and by holding both
long and short positions (a short position may be ‘naked’, ie, involve the selling of shares which the fund
does not at that time own in the hope of buying them back more cheaply if the market falls).

However, innovation has resulted in a wide range of complex hedge fund strategies, some of which
place a greater emphasis on producing highly geared returns than on controlling market risk.

Many hedge funds have high initial investment levels, meaning that access is effectively restricted to
wealthy investors and institutions. However, investors can also gain access to hedge funds through
funds of hedge funds.

The common aspects of hedge funds are the following:

• Structure – most hedge funds are established as unauthorised and, therefore, unregulated CISs,
meaning that they cannot be generally marketed to private individuals/retail investors because they
are considered too risky for the less financially sophisticated investor.
• High investment entry levels – most hedge funds require minimum investments in excess of
£500,000; some exceed £1 million.
• Investment flexibility – because of the lack of regulation, hedge funds are able to invest in
whatever assets they wish (subject to compliance with the restrictions in their constitutional
documents and prospectus). In addition to being able to take long and short positions in securities
such as shares and bonds, some take positions in commodities and currencies. Their investment
style is generally aimed at producing ‘absolute returns’ – positive returns regardless of the general
direction of market movements.
• Gearing – many hedge funds can borrow funds and use derivatives to potentially enhance their returns.
• Prime broker – hedge funds buy and sell investments from, borrow from and, often, entrust the
safekeeping of their assets to one main wholesale broker, called their prime broker.
• Liquidity – to maximise the hedge fund manager’s investment freedom, hedge funds usually impose an
initial ‘lock-in’ period of between one and three months before investors can sell on their investments.

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• Cost – hedge funds typically levy perfor­mance-related fees which the investor pays if certain
performance levels are achieved, otherwise paying a fee comparable to that charged by other
growth funds. Performance fees can be substantial, with 20% or more of the ‘net new highs’ (also
called the ‘high water mark’) being common.

8.2 Private Equity

Learning Objective

7.7.2 Know the basic characteristics of private equity: raising finance; realising capital gain

Private equity is medium- to long-term finance, provided in return for an equity stake in potentially
high-growth companies. It can take many forms, from providing venture capital to complete buy-outs.

For a firm, attracting private equity investment is very different from raising a loan from a lender. Private
equity is invested in exchange for a stake in a company and the investors’ returns are dependent on
the growth and profitability of the business. It, therefore, faces the risk of failure, just like the other
shareholders.

The private equity firm is rewarded by the company’s success, generally achieving its principal return
through realising a capital gain on exit. This may involve:

• the private equity firm selling its shares back to the management of the investee company
• the private equity firm selling the shares to another investor, such as another private equity firm
• a trade sale, which is the sale of company shares to another firm, or
• the company achieving a stock market listing.

Private equity firms raise their capital from a variety of sources, but mainly from large investing
institutions. These companies may be happy to entrust their money to the private equity firm because
of its expertise in finding businesses with good potential.

Few people or institutions can afford the risk of investing directly in individual buyouts and, instead,
use investment vehicles to achieve a diversification of risk. Traditionally, this was through investment
trusts, such as 3i or Electra Private Equity. Continued growth raised for this asset class, resulted in
alternative methods of raising investment. Private equity arrangements are now usually structured as
limited partnerships, with high minimum investment levels. As with hedge funds, there are generally
restrictions on when an investor can realise their investment.

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 Investment Funds

End of Chapter Questions

Think of an answer for each question and refer to the appropriate section for confirmation.

1. How can the pooling of funds via a collective investment scheme (CIS) benefit a retail investor?
Answer Reference: Section 1.2

2. What is an investment management approach that seeks to produce returns in line with an
index known as?
Answer Reference: Section 1.3.2

3. Why would a European investment fund seek Undertakings for Collective Investment in
Transferable Securities (UCITS) status?
Answer Reference: Section 1.5.1

4. How does the trading and settlement of an authorised unit trust (AUT) differ from that of an
exchange-traded fund (ETF)?
Answer Reference: Sections 2, 6 and 7

7
5. How do open-ended investment companies (OEICs) differ from conventional companies?
Answer Reference: Section 3

6. For which type of collective investment vehicle would the fund manager most likely quote bid
and offer prices?
Answer Reference: Section 4.1

7. What are some of the principal ways in which investment trusts differ from AUTs and OEICs?
Answer Reference: Sections 5 and 7

8. What is an open-ended type of investment vehicle that is traded on a stock exchange?

Answer Reference: Section 6

9. What type of investment vehicle makes extensive use of short positions?

Answer Reference: Section 8.1

10. What is the main way that private equity firms raise capital?
Answer Reference: Section 8.2

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154
 Chapter Eight

Financial Services
Regulation and
Professional Integrity
1. Financial Services Regulation 157

2. Financial Crime 163

3. Insider Dealing and Market Abuse 166

4. Data Protection 169

5. Complaints and Compensation 170

6. Integrity and Ethics in Professional Practice 172

This syllabus area will provide approximately 4 of the 50 examination questions

155
156
Financial Services Regulation and Professional Integrity

1. Financial Services
Regulation
An understanding of regulation is essential in
today’s investment world, and in this chapter
we will consider some of the key aspects of the
regulation of the financial services sector.

As this section considers UK regulation, much of the

material has been sourced from publications issued
by the UK’s regulators.

1.1 The Need for Regulation

Learning Objective

8.1.1 Know the UK regulatory environment

and role of the: government; regulatory
authorities

8
8.1.2 Understand the need for regulation and
the authorisation of firms

Effective financial markets are an essential part of

developed and developing economies. They fuel
economic development and aid wealth creation.
As a result, confidence and trust in these markets
is vital; loss of confidence and trust can result in an
adverse impact on customers and the economy.

The risk of monetary loss that can arise from dealing

in all types of financial transactions has meant that
financial markets have always been subject to the
need for rules and codes of conduct to protect
investors and the public.

As markets developed, there grew a need for

market participants to be able to set rules so that
there were agreed standards of behaviour, and
to provide a mechanism so that disputes could
be settled readily. This need developed into what
is known as self-regulation, when, for example, a
stock exchange, as well as providing a secondary
market for shares, would also set rules for its
members and police their implementation.

157
As markets, financial institutions and financial services developed, and the potential impact that they
could have on both the economy and society grew, self-regulation became increasingly untenable, and
most countries moved to a statutory approach and established their own regulatory bodies.

This required governments to become involved in the regulation of financial markets. The role of
the government is to establish the legal framework within which financial markets operate and how
supervision of markets and participants will take place.

Regulatory bodies are established by governments or other bodies sanctioned by governments to

oversee the functioning and fairness of financial markets and the firms that engage in financial activity.
The government delegates the responsibility for setting rules and supervising financial market activity
to these regulatory bodies and then oversees their effectiveness.

A key characteristic of financial markets is therefore a set of standards, rules and codes of conduct to
define standards of acceptable conduct by firms and individuals.

The main purposes and aims of regulation, in all markets globally, are to:

• maintain and promote the fairness, efficiency, competitiveness, transparency and orderliness of
markets
• promote understanding by the public of the operation and functioning of the financial services
sector
• provide protection for members of the public investing in or holding financial products
• minimise crime and misconduct in the sector
• reduce systemic risks, and
• assist in maintaining the market’s financial stability by taking appropriate steps.

The objectives and benefits of regulation are typically achieved through a combination of law and
regulation. Regulation is a combination of rules and standards generally covering matters such as
observing proper standards of market conduct, managing conflicts of interest, treating customers
fairly, and ensuring the suitability of customer advice. The objectives and benefits of regulation can be
summarised as follows:

• Increasing the confidence and trust in financial markets, systems and products.
• Establishing an environment to encourage economic development and wealth creation.
• Reducing the risk of market and system failures, including their economic consequences.
• Enhancing consumer protection by giving them the reassurance they need to save and invest.
• Reducing financial crime by ensuring that financial systems cannot easily be exploited.

1.1.1 UK Regulation
In the UK, the financial services sector underwent a radical change on 1 December 2001 when the
Financial Services and Markets Act 2000 (FSMA) came into force. Before FSMA, the various areas of
the sector were covered by a series of laws and the requirements of a mix of statutory and self-regulating
organisations, regarded by some as unnecessarily complex and confusing.

The key parties involved in financial regulation are the Financial Policy Committee (FPC), the Prudential
Regulation Authority (PRA) and the Financial Conduct Authority (FCA).

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 Financial Services Regulation and Professional Integrity

Financial Policy Committee (FPC)

This committee was established in the Bank of England (BoE), with responsibility for ‘macro-prudential’
regulation, or regulation of the stability and resilience of the financial system as a whole. Its role is:

‘Contributing to the Bank’s objective to protect and enhance financial stability, through identifying
and taking action to remove or reduce systemic risks, with a view to protecting and enhancing the
resilience of the UK financial system’.

The FPC has the power to make recommendations on a comply-or-explain basis to the PRA and the FCA;
that is, to comply with the recommendation as soon as practicable, or explain to the FPC, in writing and
in public, why they have not done so.

Prudential Regulation Authority (PRA)

The PRA is part of the BoE and is responsible for prudential regulation of financial firms that manage
significant risks on their balance sheets – in other words, it is responsible for the regulation and
supervision of ‘significant’ individual firms including all deposit-taking institutions, insurers and other
prudentially significant investment firms. The latter include the supervision of central counterparties and
securities settlement systems, and this responsibility sits alongside the BoE’s existing responsibilities for
overseeing recognised payment systems.

The PRA has a primary objective of enhancing financial stability by promoting the safety and soundness

8
of PRA-authorised firms in a way which minimises the disruption caused by any firms which do fail. In
fulfilling its objective, it will take an ‘intrusive’ approach to regulation and supervision.

The PRA is responsible for prudential supervision of those firms, but their day-to-day conduct is
supervised by the FCA. As a result, they are referred to as dual-regulated firms.

Financial Conduct Authority (FCA)

The FCA is responsible for the conduct of all firms and the prudential regulation of firms not supervised
by the PRA. The FCA focuses on the day-to-day regulation of all firms in retail and wholesale financial
markets, as well as the infrastructure that supports these markets. It has responsibility for the prudential
supervision of firms that do not fall under the PRA’s scope.

The FCA is responsible for:

• regulating standards of conduct in retail and wholesale markets

• supervising trading infrastructures that support those markets
• the prudential supervision of firms that are not PRA-regulated, and
• the functions of the UK Listing Authority (UKLA).

Its three statutory objectives are to:

• protect consumers
• enhance the integrity of the UK financial system, and
• help maintain competitive markets and promote effective competition in the interests of consumers.

159
These are supported by a set of principles of good regulation which the FCA must have regard to when
discharging its functions.

HM Treasury is responsible for oversight of how the FCA conducts its operations, and so the FCA is
accountable to Treasury ministers, and through them to Parliament.

1.1.2 Authorisation
FSMA makes it an offence for a firm to provide financial services in the UK without being authorised to
do so. There are certain exemptions from this requirement, for example for the BoE.

Authorisation is granted by the relevant regulator. Following the establishment of the FCA and the PRA
on 1 April 2013, solo-regulated firms need to be authorised by the FCA. However, other firms, known as
dual-regulated firms, are regulated by the FCA for the way they conduct their business and by the PRA
for prudential requirements and, therefore, require authorisation from both.

The regulator(s) looks at each applicant to assess whether the firm is fit and proper and meets
certain threshold conditions. Before granting authorisation, the regulator considers the company’s
management, its financial strength and the calibre of its staff. The latter is particularly important in
certain key roles, which the regulator refers to as senior management functions.

By only allowing fit and proper firms to be involved in the financial services sector, the regulator begins
to satisfy the statutory objectives of enhancing financial stability, enhancing the integrity of the financial
system and protecting consumers.

In addition to meeting the threshold conditions, the PRA has eight Fundamental Rules that apply to all
PRA-authorised firms and the FCA has 11 Principles for Businesses that apply to all firms; both are shown
in the table that follows. Both set out the fundamental obligations of financial services firms and it is
vital that boards and senior management understand these and the more detailed rules, and establish
within their firms a culture that supports adherence to the spirit and the letter of the requirements.

160
 Financial Services Regulation and Professional Integrity

• Fundamental Rule 1 – a firm must conduct its business with

integrity.
• Fundamental Rule 2 – a firm must conduct its business with due
skill, care and diligence.
• Fundamental Rule 3 – a firm must act in a prudent manner.
• Fundamental Rule 4 – a firm must at all times maintain adequate
financial resources.
• Fundamental Rule 5 – a firm must have effective risk strategies and
The PRA’s Fundamental risk management systems.
Rules • Fundamental Rule 6 – a firm must organise and control its affairs
responsibly and effectively.
• Fundamental Rule 7 – a firm must deal with its regulators in
an open and cooperative way, and must disclose to the PRA
appropriately anything relating to the firm of which the PRA would
reasonably expect notice.
• Fundamental Rule 8 – a firm must prepare for resolution so, if the
need arises, it can be resolved in an orderly manner with a minimum
disruption of critical services.

1. Integrity – a firm must conduct its business with integrity.

2. Skill, care and diligence – a firm must conduct its business with

8
due skill, care and diligence.
3. Management and control – a firm must take reasonable care to
organise and control its affairs responsibly and effectively, with
adequate risk management systems.
4. Financial prudence – a firm must maintain adequate financial
resources.
5. Market conduct – a firm must observe proper standards of market
conduct.
6. Customers’ interests – a firm must pay due regard to the interests
of its customers and treat them fairly.
7. Communications with clients – a firm must pay due regard to the
The FCA Principles for
information needs of its clients, and communicate information to
Businesses
them in a way which is clear, fair and not misleading.
8. Conflicts of interest – a firm must manage conflicts of interest
fairly, both between itself and its customers and between a
customer and another client.
9. Customers: relationships of trust – a firm must take reasonable
care to ensure the suitability of its advice and discretionary decisions
for any customer who is entitled to rely upon its judgment.
10. Clients’ assets – a firm must arrange adequate protection for
clients’ assets when it is responsible for them.
11. Relations with regulators – a firm must deal with its regulators in
an open and cooperative way, and must disclose to the appropriate
regulator appropriately anything relating to the firm of which that
regulator would reasonably expect notice.

161
It should be apparent from reading the above that a general overriding theme of ‘fair play’ runs through
the principles. This is coupled with a recognition that there is often an information imbalance between
the firm and its customers (since the firm is usually more expert in its products and services than its
customers are). This theme is reinforced through the FCA’s treating customers fairly (TCF) initiative and
the new Consumer Duty that sets higher and clearer standards of consumer protection. The FCA has
defined six consumer outcomes to explain to firms what it believes TCF should do for their consumers.
These are that:

1. consumers can be confident that they are dealing with firms where the fair treatment of customers
is central to the corporate culture
2. products and services marketed and sold in the retail market are designed to meet the needs of
identified consumer groups and are targeted accordingly
3. consumers are provided with clear information and are kept appropriately informed before, during
and after the point of sale
4. if consumers receive advice, the advice is suitable and takes account of their circumstances
5. consumers are provided with products that perform as firms have led them to expect, and the
associated service is both of an acceptable standard and as they have been led to expect, and
6. consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch
provider, submit a claim or make a complaint.

The New Consumer Duty

The new consumer duty finalised by the FCA in 2022 reflects a significant change and is frequently
described as TCF with teeth. The change is designed to set a higher standard than Principle 6 of the
Principles for Businesses. The concept is about focusing on consumer outcomes rather than processes
and will be implemented from 31 July 2023 – a new Consumer Principle will be added as Principle 12: ‘A
firm must act to deliver good outcomes for retail clients’.

According to the Consumer Duty Instrument FCA 2022/31, there will be a new PRIN 2A.2 which details
the following obligations:

• You must act in good faith towards retail customers. (Acting in good faith is a standard of conduct
characterised by honesty, fair and open dealing and acting consistently with the reasonable
expectations of retail customers).
• You must avoid causing foreseeable harm to retail customers.
• You must enable and support retail customers to pursue their financial objectives.

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 Financial Services Regulation and Professional Integrity

2. Financial Crime

2.1 Money Laundering

Learning Objective

8.2.1 Know what money laundering is, the stages involved and the related criminal offences

2.1.1 Definition and Stages of Money Laundering

Money laundering is the process of turning money that is derived from criminal activities – dirty money
– into money which appears to have been legitimately acquired and which can, therefore, be more
easily invested and spent.

Money laundering can take many forms, including:

• turning money acquired through criminal activity into clean money

• handling the proceeds of crimes such as theft, fraud and tax evasion
• handling stolen goods

8
• being directly involved with or facilitating the laundering of any criminal or terrorist property, and
• criminals investing the proceeds of their crimes in the whole range of financial products.

There are three stages to a money laundering operation:

• Placement – is the first stage and typically involves placing the criminally derived cash into some
form of bank or building society account.
• Layering – is the second stage and involves moving the money around in order to make it difficult
for the authorities to link the placed funds with the ultimate beneficiary of the money. Disguising
the original source of the funds might involve buying and selling foreign currencies, shares or bonds.
• Integration – is the third and final stage. At this stage, the layering has been successful and the
ultimate beneficiary appears to be holding legitimate funds (‘clean’ money rather than ‘dirty’
money). The money is integrated back into the financial system and dealt with as if it were legitimate.

Terrorist Financing
There can be considerable similarities between the movement of terrorist funds and the laundering
of criminal property. Because terrorist groups can have links with other criminal activities, there is
inevitably some overlap between anti-money laundering (AML) provisions and the rules designed
to prevent the financing of terrorist acts. However, the following are two major differences to note
between terrorist financing and other money laundering activities:

• Often, only quite small sums of money are required to commit terrorist acts, making identification
and tracking more difficult.
• If legitimate funds are used to fund terrorist activities, it is difficult to identify when the funds
become terrorist funds.

163
Terrorist organisations can, however, require significant funding, and will employ modern techniques
to manage the funds and transfer them between jurisdictions, hence the similarities with money
laundering.

2.2 Other Areas of Financial Crime

Learning Objective

8.2.2 Know how firms/individuals can be exploited as vehicles for financial crime: fraud; cybercrime;
terrorist financing; bribery

2.2.1 Fraud
Individuals and firms may unwittingly find themselves targeted by criminals and have to be aware
of this possibility, and areas that staff working in financial services need to be aware of is the theft of
customer data to facilitate identity fraud and cybercrime (note that terrorist financing was considered
earlier in section 2.1.1).

Identity fraud or identity theft is one of the fastest-growing types of fraud in the UK and elsewhere.

• Identity fraud is the use of a misappropriated identity in criminal activity, to obtain goods or
services by deception. This usually involves the use of stolen or forged identity documents such as a
passport or driving licence.
• Identity theft (also known as impersonation fraud) is the misappropriation of the identity (such
as the name, date of birth, current address or previous addresses) of another person, without their
knowledge or consent. These identity details are then used to obtain goods and services in that
person’s name.

A person’s identity (and their ability to prove it) is central to almost all commercial activity. Organisations
need to verify that the person applying for credit or investment services is who they say they are and
lives where they claim to live. The procedures used by organisations to check the information supplied
by customers help to detect and prevent most identity fraud. However, some fraudulent applications
are accepted due to the sophisticated techniques used by the fraudsters.

When opening accounts in banks and other financial organisations, criminals will use data from
legitimate persons to provide information for applications and other purposes which, when checked
against normal credit reference, postal and other databases, will seem to confirm the genuine nature of
the application.

Key to this is accessing what are known as ‘breeder’ documents. They allow those who possess them
to apply for or obtain other documentation and thus build up a profile or ‘history’ that can satisfy basic
customer due diligence (CDD) processes (processes to verify the identity of a client and verify that they
are indeed who they claim to be). The information may either be used quickly before the source of the
data is alerted or used, for example, as a facilitator for other identities so as not to alert the source.

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 Financial Services Regulation and Professional Integrity

2.2.2 Cybercrime
Cybercrime is another fast-growing area of crime.

Although there is no single universal definition of cybercrime, law enforcement generally makes a
distinction between two main types of internet-related crime:

1. Advanced cybercrime (or high-tech crime) – sophisticated attacks against computer hardware
and software.
2. Cyber-enabled crime – many ‘traditional’ crimes have taken a new turn with the advent of the
Internet, such as crimes against children, financial crimes and even terrorism.

In the past, cybercrime was committed mainly by individuals or small groups. Today, the authorities are
seeing highly complex cybercriminal networks bring together individuals from across the globe in real
time to commit crimes on an unprecedented scale. New trends in cybercrime are emerging all the time,
with estimated costs to the global economy running to billions of dollars.

Criminal organisations are turning increasingly to the internet to facilitate their activities and maximise
their profit in the shortest time. The crimes themselves are not necessarily new – such as theft, fraud,
illegal gambling, sale of fake medicines – but they are evolving in line with the opportunities presented
online and therefore becoming more widespread and damaging.

8
2.2.3 Bribery
A final area of consideration is the issue of bribery. The Bribery Act 2010 came into force in July 2011 as
part of a complete reform of corruption law to provide a modern and comprehensive scheme of bribery
offences that enable courts and prosecutors to respond more effectively to bribery at home or abroad.

The Bribery Act replaces offences at common law and under legislation dating back to the early 1900s.
Its key provisions are as follows:

• Two general offences are created covering the offering, promising or giving of an advantage, and
the requesting, agreeing to receive or accepting of an advantage.
• There is a discrete offence of bribery of a foreign public official to obtain or retain business or an
advantage in the conduct of business.
• A new offence is created, of failure by a commercial organisation to prevent a bribe being paid for
or on its behalf.

Bribery is a criminal offence and penalties include a maximum of ten years’ imprisonment, unlimited
fines, confiscation of proceeds, debarment from public sector contracts and director disqualification.

For companies, the most important point to note is that there is a new offence of failing to prevent
bribery, which does not require any corrupt intent. This offence will make it easier for the Serious
Fraud Office (SFO) to prosecute companies when bribery has occurred. The only defence available to a
commercial organisation charged with the corporate offence will be for the organisation to show that it
had adequate procedures in place to prevent an act of bribery being committed in connection with its
business. Employees need to be aware that although bribery may be seen as ‘normal’ in certain foreign
countries, it is still an offence under UK law.

165
3. Insider Dealing and Market Abuse
Learning Objective

8.3.1 Know the offences that constitute insider dealing and market abuse and the instruments
covered

3.1 Insider Dealing

When directors or employees of a listed company buy or sell shares in that company, there is a possibility
that they may be committing a criminal act – that of insider dealing.

For example, a director may be buying shares in the knowledge that the company’s last six months of
trade was better than the market expected. The director has the benefit of this information because
they are ‘inside’ the company. Under the Criminal Justice Act 1993, this would be a criminal offence
punishable by a fine and/or a jail term.

The instruments covered by the insider dealing legislation in the Criminal Justice Act are described as
‘securities’. For the purposes of this piece of law, securities are:

• shares
• bonds (includes government bonds and others issued by a company or a public sector body)
• warrants
• depositary receipts
• options (to acquire or dispose of securities)
• futures (to acquire or dispose of securities), and
• contracts for difference (based on securities, interest rates or share indices).

Note that the definition of ‘securities’ does not embrace commodities or derivatives on commodities
(such as options and futures on agricultural products, metals or energy products), or units/shares in
open-ended collective investment schemes (such as OEICs, unit trusts and SICAVs).

To be found guilty of insider dealing, the Criminal Justice Act 1993 defines who is deemed to be an
insider, what is deemed to be inside information and the situations that give rise to the offence.

Inside information is information that relates to particular securities or a particular issuer of securities
(and not to securities or securities issuers generally) and which:

• is specific or precise
• has not been made public, and
• if it were made public, would be likely to have a significant effect on the price of the securities.

This is generally referred to as unpublished price-sensitive information and the securities are referred to
as price-affected securities.

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 Financial Services Regulation and Professional Integrity

Information becomes public when it is published, for example, a UK-listed company publishing
price-sensitive news through the LSE’s Regulatory News Service. Information can be treated as public
even though it may be acquired only by persons exercising diligence or expertise (for example, by
careful analysis of published accounts, or by scouring a library).

A person has this price-sensitive information as an insider if they know that it is inside information from
an inside source. The person may have:

• gained the information through being a director, employee or shareholder of an issuer of securities
• gained access to the information by virtue of their employment, office or profession (for example,
the auditors to the company), or
• sourced the information from (1) or (2), either directly or indirectly.

The offence of insider dealing is committed when an insider acquires or disposes of price-affected
securities while in possession of unpublished price-sensitive information. It is also an offence to
encourage another person to deal in price-affected securities, or to disclose the information to another
person (other than in the proper performance of employment). The acquisition or disposal must occur
on a regulated market or through a professional intermediary.

3.2 Market Abuse

8
Market abuse may arise in circumstances where financial investors have been unreasonably
disadvantaged, directly or indirectly, by others who behave unlawfully. Certain types of behaviour, such
as insider dealing and market manipulation, can amount to market abuse.

Market abuse is a civil offence and can be subject to fines and sanctions by the regulator. Insider dealing
and market manipulation may also be a criminal offence and offences are prosecuted in the courts.

167
There are three market abuse behaviours specified in FCA rules – insider dealing, unlawful disclosure
of inside information and market manipulation. These behaviours are specifically prohibited, subject to
certain exemptions.

• Insider dealing arises when a person in possession of inside information

uses it to deal, or to attempt to deal or to recommend or induce another to
do so.
• Dealing includes acquiring or disposing of financial instruments to which
the inside information relates, as well as to cancelling or amending an
Insider dealing order that was made before having inside information in relation to that
instrument.
• A person using the recommendation or inducement will also be insider
dealing where they know, or ought to know, that the recommendation or
inducement is based on inside information.
• In the UK, the FCA judges what a reasonable person knows, or ought to
know, in such circumstances.

• The general disclosure obligation requires issuers to inform the public as

soon as possible about inside information which directly concerns them.
Where their securities are admitted to trading on a regulated market,
disclosure must also be made to the officially appointed central storage
Public mechanism.
disclosure • There is an obligation to prepare and maintain insider lists of any person
requirements with access to inside information.
• Directors and senior executives (and their closely associated persons) who
have regular access to inside information must notify both the issuer and
the FCA of every account transaction relating to the issuer’s shares, debt
instruments, derivatives or other linked financial instruments.

• Market manipulation is committed if a person carries out any of the

specified activities or behaviours which include:
• giving false or misleading signals about the supply of, demand for or price
of a financial instrument
• using fictitious devices or other deception or contrivance that is likely to
affect the price of financial instruments
Market • disseminating information which gives, or is likely to give, false or
manipulation misleading signals as to supply, demand or price of financial instruments;
or secures, or is likely to secure, their price at an abnormal or artificial
level, including circulating rumours knowing the information was false or
misleading, and
• certain other behaviours including collaborating to secure a dominant
position over the supply or demand for a financial instrument, or creating
other unfair trading conditions including by algorithmic and high-
frequency trading.

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4. Data Protection
Learning Objective

8.4.1 Know the impact of the Data Protection Act 2018 on firms’ activities

Customers routinely entrust financial firms with their important personal data; if this information falls
into criminal hands, fraudsters can attempt to undertake financial transactions in the customer’s name.
Firms must take special care of their customers’ personal data and comply with the data protection
regulations.

Whenever personal data is processed, collected, recorded, stored or disposed of, it must be done
within the terms of the data protection regulations. These and other information rights laws set out
an individual’s rights regarding their personal information, how organisations should carry out direct
marketing and how an individual can access information from public authorities.

In order to comply with the Data Protection Act, firms have a number of legal responsibilities, including:

• notifying the Information Commissioner’s Office (ICO) that they are processing information
• processing personal information in accordance with the data protection principles, and

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• answering subject-access requests received from individuals.

The regulations lay down data protection principles that set out the main responsibilities of
organisations. In summary, these require that personal data shall be:

• processed lawfully, fairly and in a transparent manner in relation to individuals

• collected for specified, explicit and legitimate purposes and not further processed in a manner that
is incompatible with those purposes
• adequate, relevant and limited to what is necessary in relation to the purposes for which it is
processed
• accurate and, where necessary, kept up to date; every reasonable step must be taken to ensure that
personal data that is inaccurate, having regard to the purposes for which it is processed, is erased or
rectified without delay
• kept in a form which permits identification of data subjects for no longer than it is necessary for the
purposes for which the personal data is processed, and
• processed in a manner that ensures appropriate security of the personal data, including protection
against unauthorised or unlawful processing and against accidental loss, destruction or damage,
using appropriate technical or organisational measures.

The regulations require personal data to be processed in a manner that ensures its security. This includes
protection against unauthorised or unlawful processing, and against accidental loss, destruction or
damage. It also requires that appropriate technical or organisational measures are used.

If a firm outsources, there are data protection implications. Firms must assess that the organisation can
carry out the work in a secure way, check that they are doing so and take proper security measures.
The firm must also have a written contract with the organisation, which lays down how it can use and
disclose the information entrusted to it.

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There are also rules where a data breach takes place. The rules place a duty on all organisations to report
certain types of data breach to the relevant supervisory authority. In some cases, organisations will also
have to report certain types of data breach to the individuals affected where it is likely to result in a high
risk to the rights and freedoms of individuals.

5. Complaints and Compensation

Learning Objective

8.5.1 Know the requirements for handling customer complaints, including the role of the Financial
Ombudsman Service

5.1 Complaints
It is almost inevitable that customers will raise complaints against a firm providing financial services.
Sometimes these complaints will be valid and sometimes not. The FCA requires authorised firms to
deal with complaints from eligible complainants promptly and fairly. Eligible complainants are, broadly,
individuals and small businesses. The FCA requires firms to have appropriate written procedures for
handling expressions of dissatisfaction from eligible complainants. However, the firm is able to apply
these procedures to other complainants as well, if it so chooses. These procedures should be followed
regardless of whether the complaint is oral or written and whether the complaint is justified or not, as
long as it relates to the firm’s provision of or failure to provide a financial service.

These internal complaints-handling procedures should provide for the receiving of complaints,
acknowledgement of complaints in a timely manner, responding to those complaints, appropriately
investigating the complaints and notifying the complainants of their right to go to the Financial
Ombudsman Service (FOS) when relevant. Among other requirements, the complaints-handling
procedures require the firm to issue its final response to the complainant within eight weeks of the date
of the original complaint and the complainant must be notified of their right to refer their complaint to
the FOS if they are dissatisfied with the firm’s response.

The internal complaints-handling procedures must make provision for the complaints to be investigated
by an employee of sufficient competence who was not directly involved in the matter that is the subject
of the complaint. The person charged with responding to the complaints must have the authority to
settle the complaint, including offering redress if appropriate, or should have access to someone with
the necessary authority.

The responses should adequately address the subject matter of the complaint and, when a complaint is
upheld, offer appropriate redress. If the firm decides that redress is appropriate, the firm must provide
the complainant with fair compensation for any acts or omissions for which it was responsible and
comply with any offer of redress the complainant accepts. Any redress for financial loss should include
consequential or prospective loss, in addition to actual loss.

The firm must take reasonable steps to ensure that all relevant employees (including any of the firm’s
appointed representatives) are aware of the firm’s complaints-handling procedures and endeavour to
act in accordance with these.

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5.2 The Financial Ombudsman Service (FOS)

The UK dispute resolution scheme is known as the Financial Ombudsman Service (FOS), and it is
designed to resolve complaints about financial services firms quickly and with minimum formality; it is
funded by industry contributions through levies and case fees. Eligible complainants are able to refer
complaints to the FOS if they are not satisfied with the response of a financial services firm.

The decision of the FOS is binding on firms, although not binding on the person making the complaint.
Under the legislation that established the FOS, financial services businesses are required to cooperate
with the ombudsman service and the ombudsman decision is final and binding on the business.

The Financial Ombudsman can require the firm to pay over money as a result of a complaint. This money
award against the firm will be of such amount that the Ombudsman considers to be fair compensation;
however, the sum cannot exceed £375,000. Where the decision is made to make a money award, the
Ombudsman can award compensation for financial loss, pain and suffering, damage to reputation and
distress or inconvenience.

Please visit the FOS website (www.financial-ombudsman.org.uk/publications/plan-budget.htm) and

take a look at their ‘plans for the year ahead’ to gain an idea of some of the areas that it deals with.

5.3 The Financial Services Compensation Scheme (FSCS)

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Learning Objective

8.5.2 Know the circumstances under which the Financial Services Compensation Scheme pays
compensation and the compensation payable for investment and deposit claims

The Financial Services Compensation Scheme (FSCS) has been established to pay compensation or
arrange continuing cover to eligible claimants in the event of a default by an authorised person or firm.
Default is, typically, the firm suffering insolvency. It is funded by compulsory financial services sector
contributions.

Eligible claimants are, broadly speaking, the less knowledgeable clients of the firm, such as individuals
and small organisations. These less knowledgeable clients are generally the firm’s ‘private customers’
and exclude the more knowledgeable ‘professional customers’. The scheme is similar to an insurance
policy that is paid for by all authorised firms and provides protection to some clients in the event of a
firm collapsing. The claims could come from money on deposit with a bank, or claims in connection with
investment business, such as the collapse of a fund manager or stockbroker.

The maximum level of compensation for claims against firms declared in default is 100% of the first
£85,000 per person per firm for investments, and £85,000 for bank deposits. There are different rules for
other financial products and services.

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6. Integrity and Ethics in Professional Practice
Learning Objective

8.1.3 Know the CISI’s Code of Conduct

8.1.4 Understand the key principles of professional integrity and ethical behaviour in financial
services

We are all faced with ethical choices on a regular basis, and doing the right thing is usually obvious.
Yet there have been many situations in the news over the years in which seemingly rational people have
behaved unethically.

Despite the strong relationship between the two, ethics should not be seen as a subset of regulation,
but as an important topic in its own right.

Many firms and individuals maintain the highest standards without feeling the need for a plethora of
formal policies and procedures documenting conformity with accepted ethical standards. Nevertheless,
it cannot be assumed that ethical awareness will be absorbed through a sort of process of osmosis.
Accordingly, if we are to achieve the highest standards of ethical behaviour in our industry, and in
industry more generally, it is sensible to consider how we can create a sense of ethical awareness.

If we accept that ethics is about both thinking and doing the right thing, then we should seek first
of all to instil the type of thinking which causes us, as a matter of habit, to reflect upon what we are
considering doing, or what we may be asked to do, before we carry it out.

There will often be situations, particularly at work, when we are faced with a decision where it is not
immediately obvious whether what we are being asked to do is actually right.

A simple checklist will help to decide. Is it:

• Open – is everyone whom your action or decision affects fully aware of it, or will they be made aware
of it?
• Honest – does it comply with applicable law or regulation?
• Transparent – is it clear to all parties involved what is happening/will happen?
• Fair – is the transaction or decision fair to everyone involved in it or affected by it?

A simple and often quoted test is whether you would be happy to appear in the media in connection
with, or in justification of, the transaction or decision.

6.1 Overview of FCA Rules on Individual Accountability

Senior managers of a financial services firm (eg, members of a firm’s senior management team, such
as the chief executive officer (CEO), the chief risk officer (CRO) and the chief finance officer (CFO)) have
an obligation to prevent regulatory breaches, but a senior manager will only be guilty of misconduct
if the FCA is able to demonstrate (ie, proves and it is accepted) that the senior manager failed to
take reasonable steps to prevent a regulatory breach from occurring. Although the burden of proof
rests with the FCA, senior managers are expected to be able to provide the FCA with evidence of any
reasonable steps they took when made aware of the breach. A set of Conduct Rules apply to all relevant

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employees based in the UK, or who deal with customers in the UK. This means that the Conduct Rules
cover all employees who are in a position to affect the FCA’s objectives. The Conduct Rules are, in effect,
designed to raise overall conduct standards in the industry and are presented below:

• Rule 1: You must act with integrity.

• Rule 2: You must act with due skill, care and diligence.
• Rule 3: You must be open and cooperative with the FCA, the PRA and other regulators.
• Rule 4: You must pay due regard to the interests of customers and treat them fairly.
• Rule 5: You must observe proper standards of market conduct.

Following the publication of the FCA’s Policy Statement, and final rules, on the Consumer Duty, the
following changes come into effect from 31 July 2023 relating to the Conduct Rules: Individuals working
for a firm who is subject to the ‘Consumer Duty’ requirements have a new Conduct Rule (Rule 6) for FCA
only firms – as noted above.

Senior managers must adhere to the Conduct Rules above and the following additional rules:

• You must take reasonable steps to ensure that the business of the firm for which you are responsible
is controlled effectively.
• You must take reasonable steps to ensure that the business of the firm for which you are responsible
complies with the relevant requirements and standards of the regulatory system.
• You must take reasonable steps to ensure that any delegation of your responsibilities is to an

8
appropriate person and that you oversee the discharge of the delegated responsibility effectively.
• You must disclose appropriately any information of which the FCA or PRA would reasonably expect
notice.

6.2 Chartered Institute for Securities & Investment (CISI) Code of

Conduct
For any industry in which trust is a central feature, demonstrable standards of practice and the means
to enforce them are a key requirement. Hence the proliferation of professional bodies in the fields of
health and wealth – areas in which consumers are more sensitive to performance and have higher
expectations than in many other fields.

Within financial services we have a structure where, in most countries, detailed and prescriptive
regulation is imposed by regulatory bodies. Nevertheless, profes­sional bodies operating in the field of
financial services have developed codes of conduct for their members.
The CISI has in place its own Code of Conduct. Its membership requires members to meet the standards
set out within the Institute’s Principles. These words are from the introduction:

‘Professionals within the securities and investment industry owe important duties to their clients, the
market, the industry and society at large. Where these duties are set out in law, or in regulation, the
professional must always comply with the requirements in an open and transparent manner.

Members of the Chartered Institute for Securities & Investment (CISI) are required to meet the
standards set out within the Institute’s Principles. These Principles […] impose an obligation on
members to act in a way beyond mere compliance and to support the underlying values of the
Institute’.

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They set out clearly the expectations upon members of the industry ‘to act in a way beyond mere
compliance’. In other words, we must understand the obligation upon us to act with integrity in all
aspects of our work and our professional relationships.

Principles Stakeholders

Personal Accountability – to strive to uphold the highest levels of personal Self, Clients,
and professional standards at all times, acting with integrity, honesty, due Regulators,
skill, care and diligence to avoid any acts, either in person, in a remote Colleagues, Market
working environment or digitally which may damage the reputation of your Participants, Firm,
organisation, your professional body or the financial services profession. Profession, Society

Client Focus – to put the interests of clients and customers first by treating
them fairly, being a good steward of their interests, never seeking personal
Clients
advantage from confidential information received and utilising client data
only for a defined purpose.

Conflict of Interest – being alert to, and actively manage, fairly and
effectively any personal or other conflicts of interest, obeying legislation and Clients, Market
complying with regulations to the best of your ability, ensuring you are open Participants,
and cooperative with all your regulators, challenging and reporting unlawful Regulators
or unethical behaviour.

Respect for Market Participants – to treat all counterparties and business

partners with respect, to observe proper standards of market integrity, good Clients, Market
practice, conduct and confidentiality required to maintain the highest level of Participants
mutual trust.

Professional Development – to strive continually for professional

Profession, Clients,
excellence, committing to Continuous Professional Development (CPD) and
Colleagues
promoting and supporting the development of others.

Aware of Capabilities – to decline to act on any matter about which you

are not competent or qualified unless you have access to such advice
Clients, Profession,
or assistance to carry out the work in a professional manner, taking into
Market Participants
account the nature of the individual mandates given by your customers and
counterparties.

Society, Colleagues,
Respect Others and the Environment – to treat everyone fairly and with Clients, Regulators,
respect, supporting opportunity for all, embracing diversity and inclusion and Market Participants,
ensuring that the environmental impact of your work is considered. Profession,
Professional Body

Speak Up & Listen Up – to be active in speaking up and encouraging

others to do so by listening up, promoting a safe environment for all and
Society, Colleagues
recognising the responsibilities you have to the communities in which you
operate.

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End of Chapter Questions

Think of an answer for each question and refer to the appropriate section for confirmation.

1. What is the rationale behind the checks that the Financial Conduct Authority (FCA) undertakes
to make sure that a firm is ‘fit and proper’ prior to authorisation?
Answer Reference: Section 1.1.3

2. What are the FCA’s 11 Principles for Businesses?

Answer Reference: Section 1.1.3

3. What are the three stages of the money laundering process?

Answer Reference: Section 2.1

4. What are the two major differences between money laundering and terrorist financing?
Answer Reference: Section 2.1

5. What is the difference between identity fraud and identity theft?

Answer Reference: Section 2.2

6. What is the corporate offence in relation to bribery, and what defence may be made when
charged with it?

8
Answer Reference: Section 2.2

7. What types of securities do the insider dealing rules apply to?

Answer Reference: Section 3.1

8. What types of behaviour might lead to a charge of market abuse?

Answer Reference: Section 3.2

9. What action should a firm take before it allows another firm to process customer data for it?
Answer Reference: Section 4

10. What is the name of the body that handles dispute resolution and complaints about financial
services firms?
Answer Reference: Sections 5.1 and 5.2

11. If an authorised firm were to become insolvent, who could an investor seek compensation
from?
Answer Reference: Section 5.3

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 Chapter Nine

Taxation, Investment
Wrappers and Trusts
1. Introduction 179

2. Taxation 179

3. Individual Savings Accounts (ISAs) 185

4. Pensions 187

5. Trusts 191

This syllabus area will provide approximately 4 of the 50 examination questions

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 Taxation, Investment Wrappers and Trusts

1. Introduction
In this chapter, we look at the main UK taxes
that apply to individuals, as well as some of the
investment wrappers that are available and their
tax attractiveness to investors. We conclude with
an overview of trusts and their uses.

2. Taxation
Learning Objective

9.1.1 Know the direct and indirect taxes

affecting individuals: income tax; capital
gains tax; inheritance tax; stamp duty;
corporation tax; state benefits/HMRC tax
credits; National Insurance; residency/
domicile
9.1.2 Know the main exemptions in respect of
the main personal taxes

9
In this section, we will review the main taxes that
affect private individuals, with a focus on the
impact of tax on investment income. There will
then be a brief review of corporation tax.

The main taxes that affect private investors are

income tax, capital gains tax (CGT), stamp duty and
inheritance tax (IHT).

2.1 Residency and Domicile

Each country has its own rules which determine
an individual’s liability to tax on income, gains
and on assets liable to IHT or a wealth tax.

2.1.1 Domicile
Domicile is the country that a person treats as
their permanent home, or lives in and has a
substantial connection with. Every person must
have a domicile; however, it is not possible at any
time to have more than one domicile.

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There are three types of domicile:

1. Domicile of origin – the domicile that every person acquires at birth.

2. Domicile of choice – this is acquired by a person residing in a country with the intention of
continuing to do so permanently or indefinitely.
3. Domicile of dependency – this arises in respect of children, married women and mentally
disordered persons. Their domicile will generally be the same as, and will change (if at all) in
accordance with, the domicile of the person on whom they are deemed to be legally dependent.

The concept of domicile is of considerable importance in a number of areas of law. It is the link between
a person and the legal system or rules that apply to matrimonial, legitimacy, succession and taxation
issues. Domicile and its related concepts are important as they help to determine:

• who has a right to inherit assets on death

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

2.1.2 Residency
An individual’s residency status is one of the factors that decides what tax is paid and on what types of
income and gains.

Definitions of residency vary from country to country. For individuals, physical residency is the most
important factor, but other factors such as property ownership or the availability of accommodation
can also be taken into account. The complexity of the rules surrounding residency means that
individuals who are not resident in a country for a complete tax year need to exercise particular care in
understanding the rules and ensuring that their visits do not exceed the maximum time permitted.

In the UK, residents normally pay UK tax on all their income, whether it is from the UK or abroad.
However, there are special rules for UK residents whose permanent home (domicile) is abroad and non-
residents only pay tax on their UK income – generally, they do not pay UK tax on their overseas income,
but the tax rules here are complex.

Whether a person is a UK resident usually depends on how many days they physically spend in the UK in
the tax year (6 April to 5 April the following year). You are automatically resident if either:

• you spent 183 or more days in the UK in the tax year, or

• your only home was in the UK – you must have owned, rented or lived in it for at least 91 days in total
– and you spent at least 30 days there in the tax year.

You are automatically non-resident if either:

• you spent fewer than 16 days in the UK (or 46 days if you have not been classed as UK resident for
the three previous tax years), or
• you work abroad full time (averaging at least 35 hours a week) and spent fewer than 91 days in the
UK, of which no more than 30 were spent working.

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2.2 Income Tax

Individuals are liable to income tax on their earnings and any interest or dividends that arise. Income is
classified into three types:

• Non-savings income – this category includes earnings from employment and pension income.
• Savings income – this includes interest from bank accounts and bonds.
• Dividend income – the final category includes dividends payable by companies and investment
funds.

Private investors are liable to pay tax on the income generated from their savings and investments.
In this context, taxable income includes interest on bank deposits, the dividends payable on shares,
income distributions paid by unit trusts and the interest on government stocks and corporate bonds.

Income from savings and investments is added to the investor’s other income, such as salary or pension,
and income tax is charged on the total amount after deducting the annual personal allowance (the
personal allowance applies up to an earnings limit of £100,000, after which it is gradually reduced). The
remaining income is grouped into bands and taxed at different rates.

There are a number of other deductions that an individual is allowed to make from gross income before
tax is payable; for example, subject to certain limitations, contributions made to a personal or corporate
pension scheme and charitable donations made by individuals on, or after, 6 April 2000.

Some income is tax free, including Premium Bond prizes, interest on national savings certificates, income
from individual savings accounts (ISAs), gambling and National Lottery wins, compensation for loss of

9
employment of up to £30,000 and statutory redundancy payments, and dividends on ordinary shares of
a venture capital trust (VCT).

2.2.1 Savings Interest

Interest income is referred to by HM Revenue & Customs (HMRC) as non-dividend savings income and
is taxed after earned income. Non-dividend savings income applies to UK and overseas savings income
from the following sources:

• interest from banks and building societies

• interest from gilts and corporate bonds
• purchased life annuities (income component)
• the taxable amount on deep-discounted securities (eg, zero coupon bonds)
• some distributions from unit trusts.

From 6 April 2016, a new personal savings allowance was introduced to remove tax on up to £1,000
of savings income for basic rate taxpayers and up to £500 for higher rate taxpayers. Additional rate
taxpayers do not receive an allowance.

How much tax is then due will depend upon what rate the investor pays tax at.

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2.2.2 Dividend Income
The taxation of dividends changed significantly from April 2016 when a dividend allowance was
introduced where a certain amount of dividend income is tax-exempt. The dividend allowance for
2023–24 is £1,000, and sums above that amount are taxed at 8.75% for basic rate taxpayers, 33.75% for
higher rate taxpayers and 39.35% for additional rate taxpayers.

2.2.3 National Insurance Contributions (NICs)

National Insurance contributions (NICs) build entitlement to certain UK social security benefits, including
the state pension. The type and level of NICs paid depend on how much people earn and whether they
are employed or self-employed. NICs cease in the year an individual reaches state pension age.

Employers are responsible for calculating, deducting and paying Class 1 primary NICs (employees’
contributions) to HMRC on behalf of all their employees (including directors) earning above the
earnings threshold; these must be deducted from their earnings. Employers also pay Class 1 secondary
NICs (employers’ contributions) for all employees earning above the earnings threshold.

2.2.4 State Benefits

State benefits are a mechanism to redistribute income to people on lower wages and their main purpose
is to help families on lower pay make ends meet. Although the criteria set out for who can claim benefits
tends to change regularly, they will generally fall into the following categories:

• if you are unemployed

• if you are on a low income
• if you are ill, disabled or injured
• if you have dependants
• if you are aged over 60
• if you are pregnant, or have recently had a baby.

There are a large number of benefits available depending upon someone’s personal circumstances and
the most well-known ones are Universal Credit (UC) and the Jobseeker’s Allowance (JSA).

Universal Credit is a benefit for working age people that replaced six different benefits – Income Support;
income-based Jobseeker’s Allowance (JSA); income-related Employment and Support Allowance (ESA);
Housing Benefit; Child Tax Credit; and the Working Tax Credit. If eligible, a single Universal Credit
payment is made monthly in England and Wales with a fortnightly option in Scotland and Northern
Ireland. A separate Jobseeker’s Allowance can be claimed if someone loses their job and is payable for a
period of up to six months. It can be claimed in addition to Universal Credit.

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2.3 Capital Gains Tax (CGT)

CGT is a tax levied on an increase in the capital value of an asset; you normally only pay CGT when
the asset is disposed of. For example, if an individual bought shares for £2,000 and later sold them for
£17,000, then that individual has made a capital gain of £15,000. CGT may be payable when an asset is
sold or disposed of which includes when you:

• sell, give away, exchange, or transfer – ‘dispose of’ – all or part of an asset
• receive a capital sum, such as an insurance payout for a damaged asset.

Most types of assets are liable to CGT and include items such as:

• shares
• unit trusts
• certain bonds, and
• property (except your main home, or principal private residence).

As you can see from the previous list, nearly all types of assets are caught by CGT.

There are, however, a number of notable exemptions:

• Although property is chargeable to CGT, any gain on the sale of your main home is exempt. For CGT
purposes, your main home is referred to as your ‘principal private residence’.
• Your car, and other personal possessions worth up to £6,000 each, such as jewellery or paintings.
• Gains on gilts and certain other sterling bonds, called ‘qualifying corporate bonds’.

9
• Gains on assets held in accounts that benefit from tax exemptions, such as an ISA, Junior ISA (JISA)
or approved pension.
• Betting, lottery or pools winnings.
• Transfers between spouses.

In addition, individuals have an annual tax-free allowance which is known as the annual exempt
amount, which allows them to make a certain amount of gains tax-free each year. Any net gains in
excess are chargeable as follows:

• 10% and 20% for individuals (the rate used will depend on the amount of their total taxable income
and gains)
• 18% and 28% for gains on the sale of residential properties
• 20% for trustees or personal representatives
• 10% for gains qualifying for business asset disposal relief (BADR).

2.4 Inheritance Tax (IHT)

IHT is usually paid on the estate that someone leaves when they die. It is also sometimes payable on
trusts or gifts made during someone’s lifetime.

IHT is based on the value of assets that are transferred during the individual’s lifetime or that are
remaining at death, known as the estate of the deceased. Each individual has a nil-rate band (NRB)
which is currently set at £325,000; and any transfers in excess of the NRB are then charged at 40%.

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The residence nil-rate band (RNRB) was introduced in April 2017 and is in addition to the NRB. To be
eligible, an individual must pass their home or a share of it to their children or grandchildren – this
includes stepchildren, adopted children and foster children, but not nieces, nephews or siblings.

Providing that certain conditions are met, the RNRB gives an additional allowance to be used to reduce
the IHT against that person’s home. The home allowance remains at £175,000 for 2023–24 and is frozen
at that level until 2025–26.

IHT is a complex area, but some of the major exemptions are:

• assets left to the deceased person’s spouse

• assets left to registered charities, and
• gifts made more than seven years before death can be exempt if certain conditions are met.

Since October 2007, it has also been possible to transfer any unused NRB from a late spouse or civil
partner to the second spouse or civil partner when they die. The percentage that is unused on the
first death can then be used to reduce the IHT liability on the second death and can increase the IHT
threshold of the second partner from £325,000 to as much as £650,000, depending on the circumstances
and the NRB upon the second partner’s death.

The Finance Act 2012 introduced a reduction in the rate of IHT from 40% to 36% where 10% or more of a
deceased person’s net estate (after deducting IHT exemptions, reliefs and the NRB) is left to charity. The
measure applies to deaths on or after 6 April 2012.

2.5 Stamp Duty

Stamp duty is a tax paid on UK share trades when a stock transfer form is used. Stamp duty reserve tax
(SDRT) is payable when an individual buys shares electronically and no stock transfer form is used. The
rate is 0.5% of the purchase price and is paid only by the purchaser.

There is no stamp duty payable on the purchase of most foreign shares, bonds, open-ended investment
companies (OEICs), unit trusts and exchange-traded funds (ETFs).

Stamp duty land tax (SDLT) is payable by the purchaser on purchases of land and property in the UK.
For most residential property, the amount due is a percentage of the purchase price. Since 1 April 2016,
individuals pay 3% on top of the normal SDLT rates if buying a new residential property means that they
own more than one property. In addition to the above, the 2020 Budget saw the introduction of a new
SDLT surcharge of 2% for non-UK resident buyers of property.

2.6 Value Added Tax (VAT)

VAT is chargeable by firms and individuals whose turnover exceeds a certain amount, when they supply
what are known as taxable goods or services. Although this affects all firms except those below the VAT
threshold, they are allowed to deduct tax they have paid on purchases, so reducing their liability.

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The standard rate of VAT is 20% and is relevant to a number of investment services. For example, fees
charged for providing an investment management service to an authorised unit trust (AUT) would be
VAT-exempt, while those charged to clients (eg, private individuals) would be VATable. There are also
exceptions when no VAT is payable, such as with broker’s commission for the execution of a stock
market trade.

2.7 Corporation Tax (CT)

Corporation tax (CT) is paid by limited companies and other bodies (including clubs and associations)
on their profits and gains. It is not paid by individuals in business as sole traders (ie, the self-employed),
as they are taxed on their earnings as income.

CT is charged for accounting periods. These are usually for one year, apart from in the year that the
company starts and ceases, and if there is a change of accounting date. If this spans a change in rate, the
period must be apportioned between the periods for each rate.

The tax is charged on the adjusted profit. This is the figure shown in the accounts as net profit before tax
and dividends. To this, various adjustments are made to bring the figure into line with tax law.

3. Individual Savings Accounts (ISAs)

Learning Objective

9
9.2.1 Know the definition of, and tax incentives provided by, ISAs
9.2.2 Know the main types of ISA available: cash ISA; stocks and shares ISA; Innovative ISA; Lifetime
ISA; Junior ISA

Individual savings accounts (ISAs) were set up by the government to encourage individual investment.
They were introduced in 1999 and have since been the main vehicle for saving and investing tax
efficiently. The particular incentive for investment is that the investments held within an ISA are free of
income tax and CGT.

An ISA itself is often referred to as an investment wrapper because it is essentially an account that holds
other savings and investments, such as deposits, shares, OEICs and unit trusts, and allows them to be
invested in a tax-efficient manner.

The ISA acts as a wrapper, shielding the return on savings and investments held in it from tax. Firms
offering investments in ISAs, such as banks, building societies and fund management companies, must
be approved by HM Revenue & Customs (HMRC). The approved entity is known as the ISA manager.
HMRC is also responsible for setting the detailed rules applicable to ISAs.

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3.1 Types of ISAs
The following table summarises the main types of ISAs.

Annual
Type Description Main Terms
Allowance

Cash ISA Savings account. £20,000 Tax-free interest. Available to over 16s.

Tax-free gains, no income tax on

Stocks and
Investment account. £20,000 dividends, tax-free interest. Must be over
Shares ISA
18 to open.

Innovative Peer-to-peer lending Tax-free interest. Must be over 18 to

£20,000
Finance ISA account. open.

Cash or stocks and

shares. 25% government top up (up to age 50).
Lifetime ISA Home deposit, £4,000 Tax-free interest. Only those aged 18–39
retirement savings or can open.
investment account.

Cash JISA – tax-free interest. Stocks and

shares JISA – tax-free gains, no income
Cash or stocks and tax on dividends, tax-free interest.
Junior ISA shares. Opened by parents or the child if 16 or
£9,000
(JISA) Savings or investment older. Managed by parent until child
account for under 18s. turns 16. No withdrawals until the child
is 18, at which point the ISA becomes an
adult ISA.

Tax-free interest with 25% government

Help to Buy Savings account for top-up. Closed to new entrants on 30
£2,400
ISA first-time buyers. November 2019, but remains open to
new contributions until 2029.

3.2 Eligibility
To be able to apply for an ISA, an investor must be able to meet eligibility rules on age (as in the table
above) and residence. The investor must be either of the following:

• A UK resident for tax purposes, or a non-resident UK Crown servant (or their spouse/civil partner),
subject to UK income tax on their overseas earnings.
• If an ISA holder ceases to be resident in the UK, they can keep the ISA and retain the tax benefits, but
cannot pay in any further money.

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ISAs cannot be assigned, put into trust or arranged on a joint basis. Investments must be made with the
investor’s own cash.

Note that having a JISA does not affect an individual’s entitlement to adult ISAs. It will be possible for
JISA holders to open adult cash ISAs from the age of 16, and JISA contributions will not impact upon
their adult ISA subscription limits.

Example
A person aged between 16 and 18 years old can hold a cash ISA, but cannot open a stocks and shares
ISA. They will be able to pay the maximum subscription into a cash ISA in addition to any amounts
that they pay into a JISA that they hold. So, in 2023–24, they could pay £9,000 into a JISA and £20,000
into a cash ISA.

3.3 Subscription
Subscription limits are set annually and are usually increased by the rate of inflation unless the
Chancellor announces a different rate at the budget. For the 2023–24 tax year, the ISA subscription limit
is £20,000. With reference to the table above, this means that:

• The whole allowance can be invested in a cash ISA or a stocks and shares ISA, or an innovative
finance ISA or any combination of these.
• Up to £4,000 of the annual subscription limit can be subscribed to a lifetime individual savings
account (LISA).

9
• An investor can invest in any combination of ISAs providing that the total subscriptions are within
the limits and the ‘one ISA of each type per tax year’ rule is met.

4. Pensions
Learning Objective

9.3.1 Know the benefits provided by pensions

9.3.2 Know the basic characteristics of the following: state pension scheme; occupational pension
schemes; personal pensions including self-invested personal pensions (SIPPs)

4.1 Retirement Planning

For many people their pension and their house are their main assets.

Pensions are becoming increasingly important as people live longer, and commentators speak of a
‘pensions time bomb’, when the pension provided by the state, the individuals and their employers will
be inadequate to meet needs in retirement. When the state pension was introduced in the UK, the initial
need was funding for the rare event of people living beyond the age of 65. Today this is very common.
As an example, it is predicted that by 2040 over 50% of the people in the UK will be over 65.

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4.2 Benefits
A pension is an investment fund where contributions are made, usually during the individual’s
working life, to provide a lump sum on retirement plus an annual pension payable thereafter. Pension
contributions are tax-effective, as tax relief is given on contributions.

Some of the main tax incentives of pensions include:

• Tax relief on contributions made by individuals and employers.

• Pension funds are not subject to income tax and CGT and so the pension fund can grow tax-free.
• The ability to take a pension from age 55 (it is due to increase to 57 from 2028).
• An option to take a tax-free lump sum at retirement.
• The option to include death benefits as part of the scheme.

These tax advantages were put in place by the government to encourage people to provide for their
own retirement. Pensions, however, are subject to income tax when they are received.

State pensions are provided out of current NICs, with no investment for future needs. This is a problem
as the dependency ratios – the potential support ratio which is the proportion of working people to
retired people – is forecast to fall from 4:1 in 2002 to 3:1 by 2030 and to 2.5:1 by 2050.

This means that by 2050 either each worker will have to support almost twice as many retired people, or
the support per head will need to fall substantially, or some combination of these changes.

As a result of these cost pressures, major changes were made to the state pension scheme:

• The age at which the state pension is payable is rising, such that the pension age for both men and
women is 65 (since 6 April 2018), ie, everyone will draw their pensions at the same age. Those born
after 6 October 1954, but before 6 April 1968, however, do not draw their pensions until the age
of 66. For those born after 1968, the pension age will increase from 66 to 67 and then to 68. It may
subsequently rise even further.
• The state pension used to be in two parts – a basic state pension and an additional state pension,
or state second pension (S2P). This has been replaced by a flat rate pension, although the amount
payable will depend on whether the individual has made sufficient NICs during their working life.

4.3 Occupational Pension Schemes

One of the earliest types of scheme supplementing state funding was the occupational pension scheme.
Occupational pension schemes are run by companies for their employees. In an occupational pension
scheme, the employer makes pension contributions on behalf of its workers.

The advantages of these schemes are:

• Employers must contribute to the fund (some pension schemes do not involve any contributions
from the employee – these are called non-contributory schemes).
• Running costs are often lower than for personal schemes and the costs are often met by the
employer.
• The employer must ensure the fund is well run, and for defined benefit schemes must make up any
shortfall in funding.

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The occupational pension scheme could take the form of a defined benefit scheme, also known as a
‘final salary scheme’, when the pension received is related to the number of years of service and the
individual’s final salary. For example, an occupational pension scheme might provide an employee
with 1/60th of their final salary for every year of service; the employee could then retire with an annual
pension the size of which was related to the number of years’ service.

Employers have generally stopped providing defined benefit schemes to new employees because of
rising life expectancies and volatile investment returns, and the implications these factors have on the
funding requirement for defined benefit schemes.

Instead, occupational pension schemes are now typically provided to new employees on a defined
contribution basis – where the size of the pension fund is driven by the contributions paid and the
investment performance of the fund. Under this type of scheme, an investment fund is built up and the
amount of pension that will be received at retirement will be determined by the value of the fund and
the amount of pension it can generate.

The higher cost of providing a defined benefit scheme is part of the reason why many companies have
closed their defined benefit schemes to new joiners and make only defined contribution schemes
available to staff. A key advantage of defined contribution schemes for employers over defined benefit
schemes is that poor investment performance is not the employer’s problem; it is the employee who will
end up with a smaller pension pot.

Occupational pension schemes are structured as trusts, with the investment portfolio managed by
professional asset managers. The asset managers are appointed by, and report to, the trustees of the

9
scheme. The trustees will typically include representatives from the company (eg, company directors) as
well as employee representatives.

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4.4 Private Pensions or Personal Pensions
Private pensions or personal pensions are individual pension plans. They are defined contribution
schemes that might be used by employees of companies that do not run their own scheme or when
employees opt out of the company scheme; or they might be used in addition to an existing pension
scheme; and they are also used by the self-employed.

Many employers actually organise group personal pension schemes for their employees, by arranging
the administration of these schemes with an insurance company or an asset management firm. Such
employers may also contribute to the personal pension schemes of their employees.

Employees and the self-employed who wish to provide for their pension and do not have access to
occupational schemes or employer-arranged personal pensions have to organise their own personal
pension schemes. These will often be arranged through an insurance company or an asset manager,
where the individual can choose from the variety of investment funds offered.

Individuals also have the option to run a self-invested personal pension (SIPP), commonly administered
by a stockbroker or IFA on their behalf. In a SIPP, it is the individual who decides which investments are
included in the scheme, subject to HMRC guidelines.

The schemes are approved by HMRC, which means that they are tax-exempt. The contributions are tax-
deductible and there is no tax either on investment income or capital gains.

In a private scheme, the key responsibility that lies with the individual is that the individual chooses the
investment fund in a scheme administered by an insurance company or asset manager, or the actual
investments in a SIPP. It is then up to the individual to monitor the performance of their investments
and assess whether it will be sufficient for their retirement needs.

4.5 Accessing Pensions

4.5.1 Pension Freedoms

In April 2015, the tax rules were changed and the advent of ‘pension freedoms’ gave people greater
access to their pensions. Members of defined contribution schemes can now access their pension pot
in different ways. People are no longer required to buy an annuity, although this option may still be the
best route for many. Instead, it is now possible for an individual to take their entire pension as a lump
sum at retirement age; although, if they choose to do this, only 25% will be tax free; tax will need to be
paid on the remaining 75%. Alternatively, they can select to take an adjustable income (drawdown),
take cash out in lump sums or a combination of the options.

In 2018, the FCA conducted a ‘Retirement Outcomes Review’ and found that around 33% of those
who did not seek financial advice before deciding on how to access their pension were holding cash
thus limiting their pension pot’s ability to earn a return. At the time, this concerned the FCA as the
review stated that over a twenty-year period, someone who wished to draw from their pension pot
could increase their expected annual income by as much as 37% if they invested in a range of assets
as opposed to holding cash. It was clear that there was insufficient engagement with deciding how to
invest funds that moved into drawdown and, as a result, the FCA intervened by introducing drawdown
investment pathways in 2021.

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4.5.2 Investment Pathways

Drawdown investment pathways, essentially retirement income choices, are off-the-shelf investment
products designed for those who wish to draw on their pension without paying for financial advice on
how the rest of the pension pot is invested. The four pathways are shown below:

• Investment pathway 1: I have no plan to touch my money in the next five years.
The associated investment strategy will aim for long-term, risk-controlled growth through a broad
range of assets.
• Investment pathway 2: I plan to use my money to set up a guaranteed income (annuity) within the
next five years.
The strategy here aims to preserve the annuity purchasing power of the pension pot.
• Investment pathway 3: I plan to start taking my money as long-term income in the next five years.
This strategy aims for capital growth with a long-term income target.
• Investment pathway 4: I plan to take out all my money in the next five years.
Capital preservation is the main aim here.

The main advantage of selecting one of the pathways above is that they are ready-made, quick to
arrange and they do not require financial advice. On the other hand, the biggest drawback is the fact
that these options are not tailored to the personal circumstances of the individual and do not take other
financial circumstances into account.

5. Trusts

9
Learning Objective

9.4.1 Know the features of the main trusts: discretionary; interest in possession; bare
9.4.2 Know the definition of the following terms: trustee; settlor; beneficiary
9.4.3 Know the main reasons for creating trusts

5.1 What is a Trust?

A trust is the legal means by which one person gives property to another person to look after on behalf
of yet another individual or a set of individuals.

Starting with the individuals involved, the person who creates the trust is known as the settlor.
The person they give the property to, to look after on behalf of others, is called the trustee, and the
individuals for whom it is intended are known as the beneficiaries.

5.2 Uses of Trusts

Trusts are widely used in estate and tax planning for high net worth individuals and are encountered
throughout retail investment firms from execution-only stockbrokers to private banks.

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Some of their main uses include:

• providing funds for a specific purpose, such as the maintenance of young children
• setting aside funds for disabled or incapacitated children in order to protect and provide for their
financial maintenance
• to reduce future inheritance tax liabilities by transferring assets into a trust and so out of the settlor’s
ownership, and
• separating out rights to income and capital so that, for example, the spouse of a second marriage
receives the income from an asset during their life and the capital passes on that person’s death to
the settlor’s children.

Trusts are also the underlying structure for many major investment vehicles, such as pension funds,
charities and unit trusts.

5.3 Types of Trusts

There are a number of different types of trust. The following are some of the main ones that are
encountered:

• Bare or absolute trusts – in which a trustee holds assets for one or more persons absolutely.
• Interest in possession trusts – in which a beneficiary has a right to the income of the trust during
their life and the capital passes to others on their death. These include life interest trusts.
• Discretionary trusts – in which the trustees have discretion over to whom the capital and income
is paid, within certain criteria.

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End of Chapter Questions

Think of an answer for each question and refer to the appropriate section for confirmation.

1. What rates of tax will be paid on a dividend by a higher rate taxpayer?

Answer Reference: Section 2.2.2

2. What assets are liable to capital gains tax (CGT)?

Answer Reference: Section 2.3

3. When does a liability to CGT arise?

Answer Reference: Section 2.3

4. How does the eligibility for an individual savings account (ISA) differ between a cash ISA and
a stocks and shares ISA?
Answer Reference: Section 3

5. What proportion of the annual ISA allowance can be invested in a cash ISA?
Answer Reference: Section 3

6. What happens to a Junior ISA (JISA) when the child turns 18?
Answer Reference: Section 3

9
7. When can a child take over management responsibility for their JISA?
Answer Reference: Section 3

8. What is the key difference between a defined benefit pension scheme and a defined contribution
pension scheme?
Answer Reference: Section 4.3

9. What is the type of trust in which a trustee holds assets for another person absolutely?
Answer Reference: Section 5.3

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 Chapter Ten

Other Financial Products

1. Loans 197

2. Property and Mortgages 201

3. Life Assurance 205

This syllabus area will provide approximately 3 of the 50 examination questions

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 Other Financial Products

1. Loans
Learning Objective

10.1.1 Know the differences between bank

loans, overdrafts and credit card
borrowing
10.1.4 Know the difference between secured
and unsecured borrowing

Individuals can borrow money from banks and

other lenders in three main ways:

• overdrafts
• credit card borrowing, and
• loans.

1.1 Overdrafts
When an individual draws out more money than
they hold in their current account, they become
overdrawn. Their account is described as being
‘in overdraft’. If the amount overdrawn is within
a limit previously agreed with the bank, the
overdraft is said to be authorised. If it has not

10
been previously agreed, or exceeds the agreed
limit, it is unauthorised.

Unauthorised overdrafts are very expensive,

usually incurring both a high rate of interest
on the borrowed money and a fee. The bank
may refuse to honour payments from an
unauthorised overdrawn account.

Authorised overdrafts agreed with the bank

in advance are charged interest at a lower
rate. Some banks allow small overdrafts without
charging fees to avoid infuriating a customer
who might be overdrawn by a relatively low
amount due to a mistiming between payments
in and out of their account.

Overdrafts are an expensive way of borrowing

money, and borrowers should try to restrict
their use to temporary periods and avoid
unauthorised overdrafts as far as possible.

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1.2 Credit Cards
Customers in the UK are very attached to their credit cards from savings institutions like banks and
building societies and other cards from retail stores known as store cards. In other countries, including
much of Europe, the use is much less widespread.

A wide variety of retail goods such as food, electrical goods, petrol and cinema tickets can be paid for
using a credit card. The retailer is paid by the credit card company for the goods sold; the credit card
company charges the retailer a percentage fee, but this enables the store to sell goods to customers
using their credit cards.

Customers are typically sent a monthly statement by the credit card company. Customers can then
choose to pay all the money owed to the credit card company, or just a percentage of the total sum
owed. Interest is charged on the balance owed by the customer.

Generally, the interest rate charged on credit cards is relatively high compared to other forms of
borrowing, including overdrafts. However, if a credit card customer pays the full balance each month,
they are borrowing interest-free. It is also common for credit card companies to offer 0% interest to new
customers for balances transferred from other cards and for new purchases for a set period, often six
months. However, these offers are often only available if a fee is paid.

1.3 Loans
Loans can be subdivided into two groups:

• secured loans, and

• unsecured loans.

Unsecured loans are typically used to purchase consumer goods. The lender will check the
creditworthiness of the borrower – assessing whether they can afford to repay the loan and interest
over the agreed term of, say, 48 months from their income given their existing outgoings.

The unsecured loan is not linked to the item that is purchased with the loan (in contrast to mortgages,
which are covered in section 2), so if the borrower defaults it can be difficult for the lender to enforce
repayment. The usual mechanism for the unsecured lender to enforce repayment is to start legal
proceedings to get the money back.

In contrast, if secured loans are not repaid, the lender can repossess the specific property which was the
security for the loan.

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Example
Jenny borrows £500,000 to buy a house.

The loan is secured on the property. Jenny loses her job and is unable to continue to meet the
repayments and interest.

As the loan is secured, the lender is able to take the house to recoup the money. If the lender takes
this route, the house will be sold and the lender will take the amount owed and give the rest, if any,
to Jenny.

As seen in this example, it is common for loans made to buy property to be secured. Such loans are
referred to as mortgages and the security provided to the lender means that the rate of interest is likely
to be lower than on other forms of borrowing, like overdrafts and unsecured loans.

1.3.1 Commercial Loans

Businesses will also need to borrow money from time to time, either through an overdraft or by longer-
term borrowing, when it is known as a commercial loan. A commercial loan is, typically, used to fund
major capital expenditure by a company and/or cover operational costs that the company cannot
immediately meet. As with other loans, the lender will assess the ability of the company to repay the
loan and whether it requires any security. Loans can be for various lengths of time, and interest rates
may be variable or fixed. Commercial mortgages are also available for property purchases.

1.4 Interest Rates

10
Learning Objective

10.1.2 Know the difference between the quoted interest rate on borrowing and the effective annual
rate of borrowing
10.1.3 Be able to calculate the effective annual rate of borrowing, given the quoted interest rate and
frequency of payment

The costs of borrowing vary depending on the form of borrowing, how long the money is required for,
the security offered and the amount borrowed.

Mortgages, secured on a house, are much cheaper than credit cards and authorised overdrafts.
Unauthorised overdrafts will incur even higher rates of interest plus charges. Borrowers also have to
grapple with the different rates quoted by lenders; loan companies traditionally quote flat rates that are
lower than the true rate or effective annual rate.

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 Example
The Moneybags Credit Card Company quotes its interest rate at 12% pa, charged on a quarterly basis.

The effective annual rate can be determined by taking the quoted rate and dividing by four (to
represent the quarterly charge). It is this rate that is applied to the amount borrowed on a quarterly
basis. 12% divided by 4 = 3%.

Imagine an individual borrows £100 on their Moneybags credit card. Assuming they make no
repayments for a year – how much will be owed?

At the end of the first quarter, £100 x 3% = £3 will be added to the balance outstanding, to make it
£103.At the end of the second quarter, interest will be due on both the original borrowing and the
interest. In other words there will be interest charged on the first quarter’s interest of £3, as well as the
£100 original borrowing. £103 x 3% = £3.09 will be added to make the outstanding balance £106.09.

At the end of the third quarter, interest will be charged at 3% on the amount outstanding (including
the first and second quarters’ interest). £106.09 x 3% = £3.18 will be added to make the outstanding
balance £109.27. At the end of the fourth quarter, interest will be charged at 3% on the amount
outstanding (including the first, second and third quarters’ interest). £109.27 x 3% = £3.28 will be
added to make the outstanding balance £112.55.

In total, the interest incurred on the £100 was £12.55 over the year. This is an effective annual rate of
12.55/100 x 100 = 12.55%.

There is a shortcut method to arrive at the effective annual rate seen above. It is simply to take the
quoted rate, divide by the appropriate frequency (four for quarterly, two for half-yearly, 12 for monthly)
and express the result as a decimal – in other words 3% will be expressed as 0.03, or 6% as 0.06. The
decimal is then added to 1, and multiplied by itself by the appropriate frequency. The result minus 1 and
then multiplied by 100 is the effective annual rate.

From the previous example:

• 12% divided by 4 = 3%, expressed as 0.03.

• 1 + 0.03 = 1.03.
• 1.034 = 1.03 x 1.03 x 1.03 x 1.03 = 1.1255.
• 1.1255 – 1 = 0.1255 x 100 = 12.55%.

This formula can also be applied to deposits to determine the effective annual rate of a deposit paying
interest at regular intervals.

To make comparisons easier, lenders must quote the true cost of borrowing, embracing the effective
annual rate and including any fees that are required to be paid by the borrower. This is known as the
annual percentage rate (APR). The additional fees that the lender adds to the cost of borrowing might
be, for example, loan arrangement fees.

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2. Property and Mortgages

Learning Objective

10.2.1 Understand the characteristics of the mortgage market: interest rates; loan to value
10.2.2 Know the definition of and types of mortgage: repayment; interest-only; offset

2.1 Characteristics of the Property Market

In the UK, the proportion of families who own, or are buying, their home is higher than in many other
countries in the EU. In the past, home ownership has been encouraged by the government, for example
by providing tax relief on mortgage interest payments, and encouraging local authority tenants to buy
their homes from their local council.

As well as buying their own home, some people have taken out second mortgages to buy holiday
homes in places like Cornwall, France and Spain, while others have taken out a ‘buy-to-let’ mortgage
loan with a view to letting a property out to tenants.

Because of the past performance of property prices, property came to be seen as a reasonably safe
investment. There is the additional attraction that any capital gains made on a home (‘principal private
residence’, according to the tax authorities) are not subject to capital gains tax (CGT, see chapter 9,
section 2.3). Any gain on a second home, however, is liable to CGT.

However, the costs of purchasing a property are substantial, embracing solicitors’ fees and stamp duty.

10
Each individual property is also unique, with no two properties the same, and the attractiveness or
otherwise is driven heavily by personal preference. As was seen by the last crash in the property market
during 2008–09, prices can fall as well as rise.

2.2 Mortgages
A mortgage is simply a secured loan, with the security taking the form of a property.

A mortgage is, typically, provided to finance the purchase of that property, and for most people their
main form of borrowing is the mortgage on their house or flat. Mortgages tend to be taken out over
a long term, with most at one time running for 20 or 25 years. Rising property prices, however, have
meant that mortgage terms have increased, with around 40% of them now having terms over 25 years,
and half of that figure having terms over 30 years.

Whether a mortgage is to buy a house or flat, or to ‘buy-to-let’, the factors considered by the lender
are much the same. The mortgage lender, such as the building society or bank, will consider each
application for a loan in terms of the credit risk – the risk of not being repaid the principal sum loaned
and the interest due.

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Applicants are assessed in terms of:

• income and security of employment – the amount borrowed will be based on a multiple of the
applicant’s income (the loan to income ratio), although this will be capped at 4½ times their income
• existing outgoings – for example, utility bills, other house­hold expenses and school fees. The lender
will undertake an affordability assessment to assess whether the applicant can afford the monthly
repayments
• future problems – the lender must look ahead and stress test the applicant’s ability to repay the
mortgage taking into account possible changes to their lifestyle, such as redundancy, starting a
family or having another child, or taking a career break
• the size of the loan in relation to the value of the property being purchased which is referred to as
the loan-to-value ratio.

A second mortgage is, sometimes, taken out on a single property. If the borrower defaults on their
borrowings, the first mortgage ranks ahead of the second one in terms of being repaid out of the
proceeds of the property sale.

2.3 Mortgage Interest Rates

There are four main methods by which the interest may be charged. These are:

• variable rate
• fixed rate
• capped rate, and
• tracker rate.

In a standard variable-rate mortgage, the borrower pays interest at a rate that varies with prevailing
interest rates. The lender’s standard variable rates will reflect increases or decreases in the rates set by
the Bank of England (BoE). Once they have entered into a variable rate mortgage, the borrower will
benefit from rates falling and remaining low, but will suffer the additional costs when rates increase.

In a fixed-rate mortgage, the borrower’s interest rate is set for an initial period, such as the first two or
five years. If interest rates rise, the borrower is protected from the higher rates throughout this period,
continuing to pay the lower, fixed rate of interest.

However, if rates fall, and perhaps stay low, the fixed-rate loan can only be cancelled if a redemption
penalty is paid. The penalty is calculated to recoup the loss suffered by the lender as a result of the
cancellation of the fixed-rate loan. It is common for fixed-rate borrowers to be required to remain with
the lender and pay interest at the lender’s standard variable rate for a couple of years after the fixed-rate
deal ends – commonly referred to as a ‘lock-in’ period.

Capped mortgages protect borrowers from rates rising above a particular rate – the ‘capped rate’. For
example, a mortgage might be taken out at 3%, with the interest rate based on the lender’s standard
variable rate, but with a cap at 4%. If prevailing rates fall to 2%, the borrower pays at that rate, but if rates
rise to 5%, the rate paid cannot rise above the cap, and is only 4%.

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A tracker mortgage is one that is linked to another rate such as the BoE base rate. The tracker rate will
be set at a percentage above the BoE base rate, say 1% above, and will then increase or decrease as base
rate changes, hence why it is called a tracker.

Lending institutions, sometimes, also attract borrowers by offering discounted rate mortgages. A 3%
loan might be discounted to 2% for the first three years. Such deals might attract ‘switchers’ – borrowers
who shop around and remortgage at a better rate; they may also be useful for first-time buyers as they
make the transition to home ownership with a relatively low but growing level of income.

2.4 Types of Mortgage

2.4.1 Repayment Mortgages

The most straightforward form of mortgage is a repayment mortgage. This is simply a mortgage in
which the borrower will make monthly payments to the lender, with each monthly payment comprising
both interest and capital.

Example
Mr Mullergee borrows £100,000 from XYZ Bank to finance the purchase of a flat on a repayment basis
over 25 years. Each month, he is required to pay £600 to XYZ Bank.

Mr Mullergee will pay in total £180,000 to XYZ Bank (£600 x 12 months x 25 years), a total of £80,000
interest over and above the capital borrowed of £100,000.

Each payment he makes will be allocated partly to interest and partly to capital. In the early years, the
payments are predominantly interest. Towards the middle of the term the capital begins to reduce

10
significantly, and at the end of the mortgage term the payments are predominantly capital.

The key advantage of a repayment mortgage over other forms of mortgage is that, as long as the
borrower meets the repayments each month, they are guaranteed to pay off the loan over the term of
the mortgage.

The main risks attached to a repayment mortgage from the borrower’s perspective are:

• The cost of servicing the loan could increase, when interest is charged at the lender’s standard
variable rate of interest. This rate of interest will increase if interest rates go up. Mortgage repayments
can rise significantly at the end of a fixed-rate deal when they revert to the standard variable rate.
• The borrower runs the risk of having the property repossessed if they fail to meet the repayments –
remember, the mortgage loan is secured on the underlying property.

These also apply to other forms of mortgage.

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2.4.2 Interest-Only Mortgages
As the name suggests, an interest-only mortgage requires the borrower to make interest payments to
the lender throughout the period of the loan. At the same time, the borrower generally puts money
aside each month, into some form of investment.

The borrower’s aim is for the investment to grow through regular contributions and investment returns
(such as dividends, interest and capital growth) so that at the end of the mortgage the accumulated
investment is sufficient to pay back the capital borrowed and perhaps offer some additional cash.

Example
Ms Ward borrows £100,000 from XYZ Bank to finance the purchase of a flat on an interest-only
basis over 25 years. Each month she is required to pay £420 interest to XYZ Bank. At the same time,
Ms Ward pays £180 each month into an investment fund run by an insurance company. At the end
of the 25-year period, Ms Ward hopes that the investment in the fund will have grown sufficiently to
repay the £100,000 loan from XYZ Bank and offer an additional lump sum.

The main risks attached to an interest-only mortgage from the borrower’s perspective are:

• Borrowers with interest-only mortgages still face the risks that repayment mortgage borrowers
face – namely that interest rates may increase and their property is at risk if they fail to keep up the
payments to the lender.
• There is also an additional risk that the investment might not grow sufficiently to pay the amount
owing on the mortgage. In the example above, there is nothing guaranteeing that, at the end of
the 25-year term, the investment in the fund will be worth £100,000 – indeed, it might be worth
considerably less.

Lenders must ensure that borrowers have robust investment plans in place to repay the mortgage.

2.4.3 Offset Mortgages

An offset mortgage is a simple concept which works on the basis that, for the calculation and charging
of interest, any mortgage is offset against, for example, any savings you may hold.

Example
Let us assume you have a mortgage of £100,000 and have a savings account with £8,000 and £2,000
in a current account. For the purpose of calculating interest, the £100,000 is offset by the £10,000
worth of savings, so in effect you only pay interest on £90,000 of your mortgage borrowing.

Obviously, you would not receive any interest on your savings.

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There are two main benefits to this approach:

• A higher-rate tax payer will not incur tax on any savings interest earned because it has been offset
against the mortgage borrowing.
• As interest is being paid on a slightly lower mortgage, it provides some flexibility to manage
finances, pay off the mortgage a little quicker and have more control.

3. Life Assurance
Learning Objective

10.3.1 Know the basic principles of life insurance and the definition of the following types of life
policy: term assurance; whole-of-life

A life policy is simply an insurance policy in which the event insured is a death. Such policies involve the
payment of premiums in exchange for life cover – a lump sum that is payable upon death.

Instead of paying a fixed sum on death, there are investment-based policies which may pay a sum
calculated as a guaranteed amount plus any profits made during the period between the policy being
taken out and the death of the insured. The total paid out, therefore, depends on the guaranteed sum,
the date of death and the investment performance of the fund.

There are two types of life cover we need to consider, namely whole-of-life assurance and term
assurance. A whole-of-life policy provides permanent cover, meaning that the sum assured will be paid
whenever death occurs, as opposed to if death occurs within the term of a term assurance policy.

10

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3.1 Whole-of-Life Assurance
There are three types of whole-of-life policy:

• non-profit that is for a guaranteed sum only

• with-profits which pays a guaranteed amount plus any profits made during the period between the
policy being taken out and death, and
• unit-linked policies in which the return will be directly related to the investment performance of
the units in the insurance company’s fund.

The reason for such policies being taken out is not normally just for the insured sum itself. Usually they
are bought as part of a protection planning exercise to provide a lump sum in the event of death to
pay off the principal in a mortgage or to provide funds to assist with the payment of any tax that might
become payable on death. They can serve two purposes, therefore, both protection and investment.

3.2 Term Assurance

Term assurance is a type of policy that pays out a lump sum in the event of death occurring within a
specified period.

Term assurance has a variety of uses, such as ensuring there are funds available to repay a mortgage in
case someone dies or providing a lump sum that can be used to generate income for a surviving partner
or to provide funds to pay any tax that might become payable on death.

When taking out life cover, the individual selects the amount that they wish to be paid out if the event
happens and the period that they want the cover to run for and whether the required cover is level,
increasing or decreasing. If, during the period when the cover is in place, they die, then a lump sum
will be paid out that equals the amount of life cover selected. With some policies, if an individual is
diagnosed as suffering from a terminal illness which is expected to cause death within 12 months of the
diagnosis, then the lump sum is payable at that point.

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 Other Financial Products

End of Chapter Questions

Think of an answer for each question and refer to the appropriate section for confirmation.

1. When can a lender repossess the specific property which was purchased with a loan?
Answer Reference: Section 1.3

2. How can the interest rates on different types of loans or accounts be readily compared?
Answer Reference: Section 1.4

3. Firm A charges interest annually at 6% on loans and Firm B charges interest quarterly at 6%
pa. Which is the more expensive?
Answer Reference: Section 1.4

4. A firm offers fixed–rate loans at 6% pa charged quarterly. Ignoring charges, what is the APR
on the loan?
Answer Reference: Section 1.4

5. An individual took out a second mortgage through a firm to finance the purchase of a second
home in Spain. It was secured on their property in the UK on which they had an existing
mortgage through another company. If the individual is unable to meet their outgoings, and
their UK property is repossessed, which mortgage will be repaid first?
Answer Reference: Section 2.2

6. What are the main differences between the different ways in which interest is calculated on
mortgages?
Answer Reference: Section 2.3

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7. What are the principal risks associated with interest–only mortgages?
Answer Reference: Section 2.4.2

8. What is the difference between whole-of-life assurance and term assurance?

Answer Reference: Section 3

9. What are the key differences between non-profit, with-profits and unit-linked life policies?
Answer Reference: Section 3.1

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208
 Chapter Eleven

Financial Advice
1. Financial Advice 211

2. Legal Concepts in Financial Advice 220

3. The Financial Advice Process 228

This syllabus area will provide approximately 2 of the 50 examination questions

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 Financial Advice

1. Financial Advice
Learning Objective

11.1.1 Understand the main areas of financial

advice: budgeting; protection;
borrowing; investment and saving;
later-life planning; estate planning; tax
planning and offshore considerations

Financial advice is the help given to an individual

when a financial adviser considers their financial
needs and recommends products to meet them.
This can be about an individual’s finances as a
whole, or just one particular need that they have.

Receiving financial advice often entails having a

face-to-face interview with an adviser, although
it can be received in other ways. In all cases,
the adviser should gather information about
the individual to find out their specific needs
and circumstances. The adviser can then use
this information to recommend that they buy
particular products; however, they must only
recommend products that are suitable for the
individual.

1.1 Budgeting

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Taking the time to manage your money better
can really pay off as it can help you to stay on
top of bills and save money each year. Budgeting
means an individual is:

• less likely to end up in debt

• less likely to be caught out by unexpected
costs
• more likely to have a good credit rating
• more likely to be accepted for a mortgage or
loan
• able to spot areas where they can make
savings, and
• able to save for planned spending or just for
the future.

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The first step to taking control of finances is to produce a budget, recording areas of income and
expenditure over a period of a year. If an individual is spending too much, it will help identify areas
where they can cut back. It should also highlight the major areas of expenditure, such as a mortgage,
where shopping around could reduce costs. Equally, it should highlight loans or money owed on credit
cards where it usually makes sense to pay off the debt that charges the highest rate of interest first.

Hopefully, as a result, savings goals can then be set, initially creating an emergency reserve for
unexpected bills and then, as savings grow, developing an investment plan or paying into a pension.

1.2 Borrowing
While few people can manage without borrowing, there are some steps that can be taken to keep it
under control. Key questions to ask yourself include the following:

• Do you need to spend the money?

• Do you have other ways of financing the purchase?
• Can you afford to pay back the money that you are planning to borrow?

Before borrowing, it would be wise to consider whether it is worth getting into debt for this purpose. A
good debt would be a sensible investment in a person’s financial future. It should leave them better off
in the long term, and it should not have a negative impact on their overall financial position. Bad debts
are those that drain their wealth, are not affordable and offer no real prospect of ‘paying for themselves’
in the future.

If someone definitely wants to borrow some money, and they are sure that they can repay it, there are
a number of key factors to consider. It is very important to work out how much they can afford to repay
each month, as this will affect which borrowing option is best for them. They should also make sure they
choose the right type of credit or loan for their situation; otherwise they could find themselves paying
more than they need to.

It is important to consider:

• the interest rate and the annual percentage rate (APR)

• how much will be repaid in total
• any penalties that may occur for missed or late payments, and
• the cost per week or per month and whether this might vary.

1.3 Protection
Financial stability and protection should be considered at some level by all consumers. The protection
required will of course depend on a number of circumstances including, for example, requirements
and available income. There are four main areas that might be in need of protection – family and
personal, mortgage, long-term care and business. Assessing what type of protection is required involves
the adviser exploring with the client what might happen and what the consequences might be. The
characteristics of some protection products are covered below.

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1.3.1 Critical Illness Insurance Cover

Critical illness cover is designed to pay a lump sum in the event that a person suffers from any one of a
wide range of critical illnesses. Some of the key features of such policies include the following:

• The critical illnesses covered will be clearly defined; illnesses resulting from activities such as war or
civil unrest will not be covered.
• Critical illness cover is usually available to those aged between 18 and 64 years of age and often
must end before an individual’s 70th birthday. It will pay out a lump sum if an individual is diagnosed
with a critical illness and will normally be tax free. The cover will then cease.
• Critical illness cover can usually be taken out on a level, decreasing or increasing cover basis and can
often be combined with other cover, such as life cover.

1.3.2 Income Protection Cover

Income protection insurance is designed to pay out an income benefit when a person is unable to work
for a prolonged period due to sickness or incapacity. Since this may need to be paid for a significant
period of time, the premiums are relatively expensive. Their use and value can be readily appreciated by
considering how a family would continue to pay its bills if the main income/earner were to fall ill. Some
of the key features of such policies include the following:

• The circumstances under which a benefit will be payable are clearly defined. The illness or injury
that an individual may suffer is referred to as ‘incapacity’, and the insurance policy will define what
constitutes this in relation to their occupation.
• The policy provides a regular income after a certain waiting period, known as the deferred period
(the longer the deferred period chosen, the lower the premiums will be). The income will generally
represent 50–75% of pre-tax earnings considering state benefits and the fact that the income from
the policy is not subject to tax. Payments will differ or cease on return to work.
• Once a claim is made, the insurance company may extend the deferred period or even decline the
claim. The claim will not be met if incapacity arises as a result of specific situations including, for

11
example, unreasonable failure to follow medical advice, alcohol or solvent abuse and intentional
self-inflicted injury.

1.3.3 Mortgage Payment Protection Cover

Mortgage payment protection is designed to ensure that the payments that are due for a mortgage
continue to be paid if the borrower is unable to work because of accident, sickness or unemployment.

It is designed to cover short-term problems, such as covering the costs if an individual loses their job
and until they find alternative work, rather than long-term benefits.

The same basic features as reviewed above under income protection cover will apply, along with the
following further considerations:

• The protection provided will be on a level basis, so regular reviews are needed so that the cover
reflects the payments due as mortgage interest rates change.
• The amount of benefit payable can be reduced to take account of income from other sources and
there may be limits on the maximum amounts that will be paid. As a result, the amount of benefit
paid may not cover the mortgage payments.

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1.3.4 Accident and Sickness Cover
Personal accident policies are generally taken out for annual periods and can provide for income or
lump sum payments in the event of an accident. Although they are relatively inexpensive, care needs to
be taken to look in detail at the exclusions and limits that apply. These may include the following:

• The amount of cover may be the lower of a set amount or a maximum percentage of the individual’s
gross monthly salary.
• The waiting period between when an individual becomes unable to work and when benefits start
may be 30 or 60 days.

The insurance company will assess eligibility at the time of the claim and may refuse a claim as a result
of pre-existing medical conditions even if they have been disclosed.

1.3.5 Household Cover

House and contents insurance are well-established products and are well understood by most
consumers, so these will only be covered briefly.

Key considerations include the following:

• Is the cover enough to pay for the complete rebuild of a home?

• To what extent are external features of a house covered, such as walls, gates, driveways and
pathways?
• What cover is there in case a neighbour sues you for your tree falling on their property or a similar
accident?
• What is the extent of cover for personal possessions?
• Is legal cover included?

1.3.6 Medical Insurance

Private medical insurance is obviously intended to cover the cost of medical and hospital expenses. It
may be taken out by individuals, or provided as part of an individual’s employment.

Some of the key features of such policies include the following:

• The costs that will be covered are usually closely defined.

• There will be limits on what will be paid out per claim, or even over a certain period such as a year.
• Standard care that can be dealt with by a person’s local doctor may not be included.
• Again, there will be exclusions such as for pre-existing conditions.

1.3.7 Long-Term Care

The purpose of long-term care cover is to provide the funds that will be needed in later life to meet the
cost of care. Simply considering the cost of nursing home care explains the need for such a policy, but
its value to an individual will depend on the amount of state funding for care costs that will be available.
Premiums will be expensive, reflecting the cost of care, and the benefit will normally be paid as an
income that can be used to cover the expenditure.

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1.3.8 Business Insurance

Business insurance protection can take many forms, and the two main types are liability insurance, such
as public liability insurance, and indemnity insurance. Some examples of its use are:

• providing indemnity cover for claims against the business for faulty work or goods
• protecting loans that have been taken out and secured against an individual’s assets
• providing an income if the owner is unable to work and the business ceases
• providing payments in the event of a key member of the business dying, to cover any impact on its
profits, or
• providing money in the event of death of a major shareholder or partner so that the remaining
shareholders can buy out their share and their estate can distribute the funds to their family.

1.4 Investment and Saving

If someone saves regularly, they will quickly find that their savings will add up and keep growing. This
is because each time any interest earned on money is paid into an account, it will start earning interest
too. This interest on interest is known as compound interest, and over the longer term it makes a big
difference as to how much savings are worth.

As an example, consider two separate investments of £1,000 that each earn 5% a year. In one, the
earnings are withdrawn each year and so the value of the investment remains the same, represented by
the flat line in the graph below. In the other, the interest is reinvested each year, as shown by the curved
upper line. As the reinvested earnings generate their own annual returns at 5%, the accumulated value
accelerates toward the end of the 20-year and 40-year periods.

Returns reinvested: £7,040

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Returns not reinvested: £1,000

0

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Key considerations when comparing returns on accounts include the following:

• Advertised rates do not always represent the true rate actually earned.
• Tax treatment may vary.
• There may be minimum or maximum investment amounts which may restrict the usefulness of an
account.
• Attractive accounts may only be available for funds that are new to that savings institution and not
from existing accounts with the same firm.
• There may be penalty charges if withdrawals are made or early encashment is needed, which will
reduce returns.
• High quoted returns may only last for a limited period, to be replaced by lower rates. Many top-of-
the-table rates include temporary bonuses for three, six or 12 months, after which time the accounts
often switch to uncompetitive rates.

Investing involves committing money into an investment vehicle in the hope of making a financial gain.
It is different from saving because it involves a greater level of risk, and there is no guarantee that you
will get your money back.

Investment products are for the longer term and are generally suitable if the individual already has
enough cash savings to keep them going for three to six months. Investments generally outperform
cash savings over the longer term but, as their value can rise and fall, investors have to be prepared to
take on some risk.

1.5 Later-Life Planning

As covered in chapter 9, people are living longer than ever. Due to medical advances and general
improvements in health, most people’s life expectancy has increased significantly over the last few
decades.

The bad news, however, is that to enjoy those extra years means needing a level of income that is
enough to fund the life style that people want. Being able to enjoy rather than endure retirement
requires individuals to plan and take action to achieve their objectives.

One simple way to estimate what size of retirement fund is needed is to determine what income needs
to be generated to fund the life style that someone wants in retirement. We then need to estimate the
return that this fund can generate.

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Example
Let us assume that someone is aged 25 and wants to know the size of retirement fund that they
need to build up for their retirement, which they expect to be at age 65. They estimate that they will
need to be able to generate a pension income of £25,000 from their accumulated savings at today’s
prices. They then need to decide what rate of return it is reasonable for the fund to generate; for this
example, we will assume that it can produce a return of 4% a year.

From this we can get a simple idea of what size of fund needs to be built up. The income of £25,000
represents 4% of the retirement fund, so the fund needed will be:

£25,000 ÷ 0.04 = £625,000

This gives a simple idea of what sum needs to be saved. The next step is then to work out how much
needs to be saved each year to try to achieve that goal.

The graph below shows the impact of saving £1,000 per year for different periods of time, assuming
an average rate of return of 5%. If someone could begin saving early for retirement, and then save for
40 years, this would generate a fund of about £126,840. Going back to our example, this would imply
needing to save an average of £5,000 per year which in the first years is probably unrealistic; this means
that later contributions need to be significantly higher to make up for the shortfall.

What you should also see is that delaying starting to save for ten years, and so only saving for 30 years,
means that the accumulated fund would only be worth £69,761. If saving for retirement is left even later,
then it will grow even less, meaning that more will have to be saved to achieve someone’s plans. Clearly,
the amount saved into a pension would not stay the same from year to year, and the return would vary,
but it does emphasise the power of compounding and the impact of delaying saving for retirement.

140,000

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120,000

100,000

80,000

60,000

40,000

20,000

0
10 years 20 years 25 years 30 years 35 years 40 years

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1.6 Estate Planning
Estate planning is concerned with making sure that a client takes appropriate steps to ensure that their
accumulated wealth passes to their intended beneficiaries, and in as tax-efficient a method as possible.

It can be a complex subject, but essentially involves determining who is to inherit the assets of the client
and what steps can be taken to reduce any estate taxes that will arise on the client’s death.

A key first step in estate planning is to assess the extent of a client’s assets and liabilities. These include
their property, savings and any investments, but it is also necessary to identify any other funds that
would become payable if the client were to die, such as the proceeds of any life assurance policies or the
payment of death benefits if the client is still working. The assessment of a client’s liabilities should also
take account of any protection policies that may be in place to meet that liability, such as a mortgage
protection policy.

This balance sheet can then be used to direct the client to consider three key areas:

• Whether they need to execute a power of attorney (POA) to protect their interests when they are
incapable of managing their affairs.
• Whom they wish to inherit their estate, and whether there are any specific gifts they wish to make
which should be expressed in a will.
• The extent of any liability to inheritance tax (IHT) that may arise, and whether action should be taken
to mitigate this.

A will is a legal document that specifies what is to happen to an individual’s assets on their death.
Obviously, where possible, the client should make a will in order to ensure that the assets of their estate
pass in accordance with their wishes, and should take specialist advice so that relevant laws are taken
into account.

If overseas assets are held, especially property, separate wills should be made in each country; generally,
these should be drafted by a specialist in the jurisdiction in question.

If no will is made, the legal system will determine who inherits. When a person dies without leaving
a will, they are described as having died intestate and a set of intestacy rules will determine who is
to inherit. These rules may well provide for the estate to pass in a way that the client would not have
intended.

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1.7 Tax Planning

The tax status of a client, and the taxes to which any investment income or gains will be subject, may
have a major impact on the choice of investments and investment strategy that is adopted. An adviser
will, therefore, need to establish the following:

• The client’s residency and domicile position.

• The client’s income tax position.
• How tax will affect any investment income.
• Any tax allowances which can be utilised.
• How tax will affect any gains or losses made.
• Eligibility for any tax-free accounts.
• Opportunities for deferring any tax due.

An adviser must establish the client’s residence and domicile status, as they may affect how any
investments are structured. Although tax rules vary from country to country, establishing the client’s
tax position is essential so that their investments can be organised in a way that attracts the least tax
possible on returns. This requires the adviser to be aware of what taxes may affect the client, such as
those on any income arising or on any capital gains, how these are calculated, and what allowances
may be available. It should also be remembered that tax legislation is constantly being reviewed and
updated, therefore future charges to taxation rules may render a tax-planning strategy ineffective.

Advisers also need to take care that any tax avoidance measures will stand up to scrutiny given the
increasing public disquiet of tax avoidance measures by companies and wealthy individuals.

Tax planning, also called ‘tax mitigation’, involves minimising tax liabilities in ways that are expressly
endorsed by tax legislation. By contrast, tax avoidance flouts the spirit of the law and is, therefore,
thought by some to be unacceptable, albeit not criminal in the way that tax evasion is.

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Tax Avoidance versus Tax Evasion

• Tax avoidance is, generally, the legal exploitation of the tax system to one’s
own advantage, to attempt to reduce the amount of tax that is payable by
Tax avoidance
means that are within the law, while making a full disclosure of the material
information to the tax authorities.

• By contrast, tax evasion is the general term for efforts by individuals,

Tax evasion companies, trusts and other entities to evade the payment of taxes by illegal
means.

While the difference between tax avoidance and tax evasion used to be simply expressed as the first
being legal and the second being illegal, public perceptions of what is acceptable tax avoidance are
leading the terms to be more carefully defined.

International cooperation is increasingly being used to improve the exchange of information between
countries in order to counter tax avoidance and evasion globally.

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1.8 Offshore Considerations
Each country has its own rules which determine an individual’s liability to tax on income, gains and on
assets liable to IHT or a wealth tax.

Most countries’ tax systems can be loosely categorised as either a worldwide- or territorial-based system
of taxation:

• Under a worldwide-based system of taxation, residents of that country are taxed on their worldwide
income and capital gains irrespective of where the income or gains arise. For example, the US has a
worldwide-based system of taxation, as does the UK, Australia, Germany, Italy and Japan.
• Under a territorial-based system of taxation, residents are taxed only on income and capital gains
arising in that country, and income and gains arising outside of that country are not liable to tax.
• Some countries that adopt a territorial-based system, however, extend the tax base of residents to
include overseas income and gains, but only if such income or gains are remitted to the country of
residence.

2. Legal Concepts in Financial Advice

Learning Objective

11.3.1 Understand the key legal concepts relating to: legal persons (wills/intestacy/personal
representatives/trustees/companies/limited liabilities/partnerships); contract, capacity to
contract; agency; real estate, personal property and joint ownership; powers of attorney;
insolvency and bankruptcy; identifying, reporting scams

The legal system in the UK has a significant impact on the provision of financial services. It is important,
therefore, to be aware of some of the main legal concepts and how these may affect the provision of
financial advice and services.

2.1 Legal Persons and Capacity

A legal person is an individual or an entity that is recognised as having legal rights and obligations, such
as having the ability to enter into contracts, to sue, and to be sued. Entities can take many forms, such as
companies, partnerships and trusts.

2.1.1 Individuals
Individuals acquire their status as legal persons when they are born, but their legal capacity to enter into
contracts or otherwise exercise their rights is limited in certain circumstances.

A person who is of age and of sound mind has the legal capacity to make their own choices and
decisions, and so they can enter into contracts providing that it is not illegal or void for reasons of public
policy. The relevance of this for financial services firms is that they can, for example, open accounts,
enter into agreements and give instructions to trade with individuals they know are of age and of sound
mind.

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Where someone is under the legal age, however, the position is different. In the UK, individuals under
18 are known as minors and they are able to enter into a contract under law; however, the contract
is binding on the adult, but it is voidable by the minor before they reach 18 and for a short time
afterwards. This means that the minor can enforce the contract, but can also terminate it if they wish,
subject to some exceptions. Once the minor reaches the age of 18, and ratifies the contract in some way,
it becomes legally binding on both parties. This legal position does not mean that banks do not offer
banking accounts to those under 18; it does mean, however, that they may put additional requirements
in place to protect themselves, especially where accounts are opened for children under 16.

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2.1.2 Attorneys and Deputies
A person who has legal capacity can authorise someone else to act for them by executing a power of
attorney which is a legal document that authorises someone to act on their behalf.

Ordinary Power of Attorney (OPA)

An ordinary power of attorney (OPA) authorises one or more persons, known as attorneys, to make
financial decisions on an individual’s behalf or to undertake specific actions. Individuals may use an
OPA for a number of reasons; for example, if they are out of the country and legal documents need
to be executed, or if they are in hospital and unable temporarily to look after their financial affairs.
It will usually end either at a specified time or upon the request of the donor at any time, and it will
automatically be revoked if the donor loses mental capacity. A bank or financial institution will need
to check the document to confirm their authority to act and confirm the attorney’s identity before
accepting any instructions.

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Lasting Power of Attorney (LPA)
If an individual wants someone to be able to act on their behalf, should there come a time when they
no longer have the mental capacity to make their own decisions, then they can execute a lasting power
of attorney (LPA). There are two types of LPA – one for financial decisions and one for health and care
decisions. Before it can be used, an LPA must be registered with the Office of the Public Guardian, and
a stamped copy of the LPA is then submitted to financial institutions to show that the attorney has the
authority to act on behalf of the donor.

Deputy Order
When someone becomes mentally incapable of managing their financial affairs, and they have not
made an LPA, a deputy needs to be appointed. This requires an application to the Court of Protection
to appoint a deputy to make ongoing decisions on behalf of that person. The Deputy Order will set out
the extent of the powers granted to the deputy, which might relate to finances or personal welfare.
This needs to be registered with banks and other financial institutions who will want to see the original
document, or an official copy certified by a solicitor.

2.1.3 Wills, Intestacy and Personal Representatives

Wills and Intestacy

A will is a legal document that tells the world what is to happen to an individual’s assets. Where possible,
the client should make a will in order to ensure that the assets of their estate pass in accordance with
their wishes, and should take specialist advice so that relevant laws are taken account of.

A will is generally regarded as essential for everyone, but particularly so in the case of a family with young
children, and in cases of second marriage. A family with young children needs to consider what would
happen to the children if their parents were unfortunate enough to be involved in a fatal accident. Who
would look after them, who would invest any money until they came of age and what would happen
if they needed some essential expenditure, such as the payment of school fees? A properly drafted will
should ensure that all of these points are provided for. In cases of second marriage, the partners may
wish their assets to be split in precise ways on the death of the survivor, and again, a carefully drafted
will can achieve this.

If overseas assets are held, especially property, separate wills should be made in each country, and
generally, this should be drafted by a specialist in the jurisdiction in question.

If no will is made, the legal system will determine who inherits. When a person dies without leaving a
will, they are described as having died intestate and a set of intestacy rules will determine who is to
inherit. These may well provide for the estate to pass in a way that the client would not have intended.

In some jurisdictions, it is not possible to make a will, and, where that is the case, consideration may be
given to an offshore trust.

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Personal Representatives
When a person dies, someone will need to collect in their assets, settle any debts and distribute the
balance to whoever is entitled to the remainder, ie, the beneficiaries. The person who is responsible for
administering the estate of the deceased is known as a personal representative and can be either an
executor or an administrator.

To be able to take control of the assets, the executor or administrator needs to be able to prove that
they have the authority to do so. They do this by applying for a grant of representation, which can be
either a grant of probate or a grant of letters of administration:

Personal representatives:

• Where the deceased leaves a will, they may appoint someone to deal with their affairs on death. This
person is known as the executor of the estate and they apply for a grant of probate.
• Where no will is left, then no executor is named or, if the named executor does not wish to act,
someone else needs to be appointed to deal with the deceased’s affairs. This person is known as the
administrator of the estate and they apply for a grant of letters of administration.

The grant of probate or grant of letters of administration is a legal document that bears the seal of the
court and formally confirms the appointment of the executor(s) or administrator(s). Once issued, the
grant is then registered with each financial institution and is official proof of the appointment of the
executor or administrator; it allows the firms to now take instructions from them as to how they wish to
deal with the assets.

2.1.4 Trusts
As we saw in section 5 of chapter 9, a trust is the legal means by which one person gives property to
another person to look after on behalf of yet another individual or a set of individuals. The person who
creates the trust is known as the settlor, the person they give the property to, to look after on behalf of

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others, is called the trustee, and the individuals for whom it is intended are known as the beneficiaries.

The terms of a trust are set out in a trust deed, which will also appoint the trustees and give them
powers to manage the trust and invest the assets. Assets are transferred into the trust; this involves the
trustees becoming the legal owners of the assets although they continue to hold these on the terms of
the trust and for the benefit of the beneficiaries.

As the trustees are responsible for managing the trust and are the legal owners of its assets, they have
the legal capacity to enter into contracts on behalf of the trust. A financial institution will, therefore,
need to see the trust deed and check the document to confirm the trustees’ authority to act and confirm
their identity before accepting any instructions.

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2.1.5 Companies
A company is a legal entity formed to conduct business or other activities in the name of its members.
Because it is incorporated, it has a legal personality distinct from those of its members.

A company is, therefore, a separate entity from its shareholders. It is a legal person in its own right, and
it is quite separate from those who own it (the shareholders) and those who run it (the directors).

A company operates through its directors who are empowered to run it and enter into contracts on its
behalf. A financial institution will, therefore, need to see the incorporation documents of the company
and satisfy itself that the person it is dealing with is a director or is authorised by the board of directors
to act.

2.1.6 Partnerships
A partnership exists when two or more persons commence in business together with a view to
making a profit. Certain persons are unable to form partnerships, including charities and not-for profit
organisations.

While there does not need to be any written agreement for a partnership to exist, there will normally
be a partnership agreement that takes the form of a deed setting out the way in which the partnership
will operate. The partners are at liberty to decide on the terms of their own relationship and may choose
almost any conditions they wish as long as they are agreed to by all of the partners.

There are three types of partnership in the UK, each defined by a different partnership act:

• Conventional partnership – this is not a separate legal entity from its owners. Partners are
responsible for their own and each other’s debts, and each partner can sue and be sued in their own
name. A partnership is unable to hold land and property in its name; instead, any contract is with the
individuals forming the partnership.
• Limited partnership – at least one partner must have unlimited liability, referred to as a general
partner, while the others have limited liability.
• Limited liability partnership (LLP) – this is a corporate version of a partnership. An LLP is a separate
legal entity to its members (the partners) and so may hold land and property in its name. LLPs have
designated partners who are the equivalent of company officers.

2.1.7 Agency
The law of agency refers to a set of rules designed to ensure the smooth functioning of businesses by
setting out the scope of the authority granted to an agent.

In a relationship between a principal and agent, the function of the agent is to create a contract between
the principal and third parties or to act as the representative of the principal in other ways.

A key point is the power of the agent to bind their principal in a contract which the agent makes on their
behalf, sometimes without the principal being aware that this is happening.

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If the agent exceeds this authority, then the principal will not be bound and the agent will be personally
liable to the third party for breach of warranty of authority. However, the common law may extend the
scope of the agent’s authority beyond this, to protect an innocent third party. The principal will then be
bound to the third party, but the principal can sue the agent for overstepping their actual authority, if it
is a breach of the agency contract.

2.2 Ownership of Property

The law in England and Wales recognises two types of property – real property and personal property.
The distinction arises for common law; however, modern laws continue to distinguish between the two,
and different laws apply to personal property than the ones applicable to real property.

Personal property includes possessions of any kind, as long as they are movable and owned by
someone. It includes tangible items, such as furniture and vehicles, and intangible items, such as bonds
and shares.

The key difference between personal property and real property is that real property is fixed
permanently to one location. This includes land and anything that is built on it. It also includes anything
that is growing on the land or under it. Examples include land, buildings, crops and mineral rights.

2.2.1 Joint Ownership

Where assets are held in joint names, the surviving joint owner takes the deceased’s share automatically.
The surviving joint owner needs to register the death certificate with the bank or other financial
institution; this should then transfer the asset into the sole name of the survivor.

Example
A husband and wife have joint savings accounts at the time the husband dies. The wife would need

11
to register her husband’s death certificate with each bank, who will then automatically transfer the
account into her name, and take her sole instructions on what is to happen to the account. It is not
necessary to produce a grant of probate or letters of administration.

There is an alternative type of joint ownership known as tenancy in common. This is where an asset (eg,
land or a bank account) is owned by one or more individuals who could own the asset in equal shares or
potentially in unequal shares.

The big difference with tenancy in common is that if one of the owners dies, their share of the property
does not automatically pass to the surviving owner; it would pass to whoever they specified in a will or,
if a will is not made, in accordance with the rules of intestacy.

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2.3 Insolvency and Bankruptcy
Insolvency is where the liabilities of a business or an individual (ie, what they owe) exceed their assets
(ie, what they own), or where they are unable to repay their debts as they fall due. Insolvency is a term
that is used to describe all types of financial failure (bankruptcy only applies to an individual, not a
partnership entity or a limited company).

An individual can be declared bankrupt if they owe more than £5,000 to any creditor. Bankruptcy usually
lasts for a year if the individual cooperates with the official receiver or their trustee in bankruptcy. It is
worth noting that, until you are made bankrupt, bailiffs can still call at your door to attempt to take
goods.

With companies, the two main processes encountered are liquidation and administration:

• A liquidation is the legal ending of a limited company. Following liquidation, a business will be
removed from the official Companies House register – a process known as being ‘struck off’; from this
point, that business ceases to legally exist. Both solvent and insolvent companies can be liquidated,
however, the process for doing so differs slightly for each. A liquidator will sell a business’s assets,
pay the firm’s creditors and distribute any remaining share capital to shareholders.
• Where a company is placed into administration, an insolvency practitioner or ‘administrator’ is
appointed to take control of the company. The administrator will devise a plan to either:
• restore the company’s viability while coming to an arrangement with its creditors, or
• realise the company’s assets to pay a particular creditor, or
• sell the business as a going concern on the basis that more money can be made from its assets than
if the firm was liquidated.

2.4 Identifying and Reporting Scams

Scams are schemes to con people out of their money. They can be by post, telephone, text message,
email or even in person.

There is widespread advice online on how to identify scams, and banks, for example, regularly make
their customers aware of what to look out for. Despite this, people are still being caught out by scams,
as they are becoming more and more sophisticated. Some basic precautions anyone can take are to be
suspicious of any contact that comes out of the blue, to never share personal details without confirming
who is asking for them, and not to click on links from unexpected contacts.

• Email scams are particularly rife. The recommended ways to identify a scam email include checking
the ‘from’ address, checking whether the greeting is what you would expect from that organisation,
checking the branding used in the email, checking for poor spelling, grammar and presentation,
and finding another way to check whether the sender is legitimate before clicking on any links or
responding.
• Fake websites can be difficult to spot, but some checks that can be made are checking the domain
name used and seeing if it has an extra word added to the name of the firm you are expecting to
deal with, looking for the padlock against a site’s name to see whether it is encrypted, being aware
of trust-mark labels as they are easy to fabricate, considering whether the low price being offered is
just trying to lure you, and taking time to browse the website to double check its content.

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• Telephone calls from scammers seem to be widespread, to say nothing of being annoying, and
although most people will hang up, it is easy to be caught out if it is something you are expecting or
purports to come from the police, another authority or a trusted company. Recommended ways to
deal with this are to hang up and find another way to contact that organisation, check whether it is
legitimate, and never disclose bank details or personal information unless you are absolutely sure of
who you are talking to.

Scams can affect many different types of people, and anyone who thinks they have been the victim
of a scam should report it to Action Fraud (actionfraud.police.uk). The Action Fraud website also has
extensive information on different types of fraud and the measures that individuals can take to protect
themselves. Some of the simple steps that they recommend to protect yourself include the following:

• Do not give any personal information (name, address, bank details, email address or phone number)
to organisations or people before verifying their credentials.
• Make sure your computer has up-to-date anti-virus software and a firewall installed. Ensure that
your browser is set to the highest level of security, and has monitoring to prevent malware issues
and computer crimes.
• Many frauds start with a phishing email. Remember that banks and financial institutions will not
send you an email asking you to click on a link and confirm your bank details. Do not trust such
emails, even if they look genuine. You can always call your bank using the phone number on a
genuine piece of correspondence or their website (typed directly into the address bar) to check if
you are not sure.
• Sign up to Verified by Visa or MasterCard Secure Code whenever you are given the option while
shopping online. This involves you registering a password with your card company and adds an
additional layer of security to online transactions with signed-up retailers.
• Destroy and preferably shred receipts with your card details on and post with your name and address
on. Identity fraudsters do not need much information in order to be able to clone your identity.
• If you receive bills, invoices or receipts for things that you have not bought, or financial institutions
you do not normally deal with contact you about outstanding debts, take action. Your identity may
have been stolen.

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• Be extremely wary of post, phone calls or emails offering you business deals out of the blue. If an
offer seems too good to be true, it probably is. Always question it.

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3. The Financial Advice Process
Learning Objective

11.2.1 Understand the key factors in the financial advice process: the client relationship; affordability,
suitability, attitude to risk; matching solutions with needs; use of communication skills in
giving advice; monitoring and reviewing clients’ circumstances; information given to clients;
consumer rights and remedies, including awareness of their limitations

The financial advice process has developed significantly over recent years to meet the higher standards
demanded in these days of increasing professionalism and regulatory scrutiny.

While an adviser needs to have a detailed understanding of the myriad of investment products and
solutions that are available in the market and of the tax implications of various investments, this
technical knowledge is only of value to the client if it is applied within a structured advice process,
taking the whole of the client’s circumstances into account in such a way that any recommendations are
suitable for their needs.

The financial planning process can be divided into five distinct stages:

1. Determine the client’s requirements.

2. Formulate the strategy to meet the client’s objectives.
3. Implement the strategy by selecting suitable products.
4. Revisit the recommended investments to ensure that they continue to meet the client’s needs.
5. Periodically revisit the client’s objectives and revise the strategy and products held, if needed.

3.1 Client Relationships and Communication Skills

The process above misses out a key step in the financial advice process, namely establishing an effective
relationship with the client that allows the adviser to gather all of the information needed for suitable
advice to be given, for the adviser to gain the trust of the client and for questions, explanations and
recommendations to be given in a clear and understandable manner. It is only by engaging the client
in the financial advice process and ensuring that they fully understand why information is needed and
why recommendations are being made that the best results can be obtained.

The nature of the relationship with a client will depend upon the service being provided. This can
range from providing the facilities to execute transactions without any advice, to ongoing relationships
that deal with selected financial areas only, are limited to investment management only, or extend to
in-depth wealth management or private banking. The client relationship can, therefore, be a one-off
service to satisfy a client’s needs, or a long-term relationship where the adviser plays a key role in the
client achieving their long-term financial objectives.

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Whatever the service, an adviser has a fiduciary duty to their client that requires them to observe the
highest standards of personal conduct, and to fully respect the confidence and trust implicit in that
relationship. The main responsibilities of the adviser can, therefore, be seen as:

• helping clients to decide on, and prioritise, objectives

• documenting the client’s investment objectives and risk tolerance
• determining, and agreeing, an appropriate investment strategy
• acting in the client’s best interests
• where agreed, keeping the products under review, and
• carrying out any necessary administration and accounting.

Most financial firms spend significant amounts of time and money on training their advisers in
communication techniques. Techniques that need to be honed include:

• establishing a rapport with the client

• making it clear early on what the purpose of any meeting with the client is
• explaining that the information collection exercise is to ensure the quality of the advice that will be
given
• using a mixture of open-ended and closed-ended questions to establish the information needed
• using everyday terminology and explaining jargon when it has to be used
• checking understanding
• establishing priorities and getting the client to confirm their agreement, and
• guiding and controlling the pace of any interviews with the client.

It is also about listening – the best financial advisers are the ones who listen to what the client wants,
establish rapport with them and then mutually agree what needs to be done.

At the end of the day, short-circuiting the process by not ascertaining all relevant information is alien to
any professional approach and is in fundamental contradiction to the adviser’s fiduciary duty and to all
regulation.

11
3.2 Matching Solutions with Needs
An adviser must ‘know’ the customer before being able to provide appropriate advice. It is essential to
establish the fullest details about the client – not only their assets and liabilities, but their life assurance
or protection products or arrangements that they may have in place. Their family circumstances, health
and future plans and expectations are equally important.

One of the Financial Conduct Authority’s (FCA’s) 11 Principles for Businesses requires a firm to
take reasonable care to ensure the suitability of its advice and discretionary decisions – Principle 9
Customers: Relationships of trust. To comply with this, a firm should obtain sufficient information
about its customers to enable it to meet its responsibility to give suitable advice. This requirement to
gather sufficient information about the customer is generally referred to as the ‘know your customer’
requirement.

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The purpose of gathering information about the client is clearly so that financial plans can be devised
and appropriate recommendations made. The types of information that should be gathered include:

• personal details – name, address, age, health, family and dependants

• financial details – income, outgoings, assets, liabilities, insurance and protection arrangements
• objectives – growth, protecting real value of capital, generating income, protecting against future
events
• risk tolerance – cautious, balanced, adventurous
• liquidity and time horizons – immediate needs, known future liabilities, need for an emergency
reserve
• tax status – income, capital gains, inheritance taxes, available allowances
• investment preferences – restrictions, ethical considerations.

Only when having completed this process can the adviser start on the next significant stage: to identify
potential solutions, and then match them to the client’s needs and demands. Firms must then ensure
that any recommendations they make are both suitable and appropriate. In order to do so, a firm should
ensure that the information they gather also includes details about:

• the client’s knowledge and experience in relation to the investment or service that will be considered
for recommendation, and
• the level of investment risk that the client can bear financially and whether that is consistent with
their investment objectives.

3.3 Attitude to Risk

A key element of the financial advice process is establishing the client’s risk profile.

Investment always involves a trade-off between risk and return. However, different people are prepared
to tolerate different levels of investment risk, and investment risk means different things to different
people. Variations in attitude arise because of individual differences in circumstances, experiences and
psychological makeup.

The client’s risk profile should be based on their risk tolerance, attitude to risk and capacity for loss.

Risk Assessment

This is a personality characteristic best described as a client’s willingness to

Risk tolerance accept a certain level of fluctuation in the value of their investments without
feeling an immediate desire to sell.

This represents the client’s personal opinion on the risks associated with making
Attitude to risk
an investment, based on their prior knowledge and experience.

This is the client’s ability to absorb any financial losses that might arise from
Capacity for loss
making a particular investment.

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The risk profile of a client will have a considerable impact on the financial planning strategy that an
adviser recommends. It will exhibit itself in the importance that is given to financial protection and in
what is an acceptable selection of investment products.

A client’s ability to take risk can be determined in an objective manner by assessing their wealth and
income relative to any liabilities. By contrast, their willingness to take risk is subjective and has more
to do with an individual’s psychological makeup than their financial circumstances. Some clients view
market volatility as an opportunity while, for others, such volatility would cause distress.

Examples of the objective and subjective factors that can be established that will help define a client’s
risk profile are shown below:

Examples of Objective Factors

• The timescale over which a client may be able to invest will determine both
Timescale
what products are suitable and what risk should be adopted.

• Family commitments are likely to have a significant impact on a client’s risk

Commitments
profile.

• A client with few assets can little afford to lose them, while those whose
Wealth
immediate financial priorities are covered may be able to accept greater risk.

• A client in their 30s or 40s who is investing for retirement will want to aim
for long-term growth and may be prepared to accept a higher risk in order
Life-cycle and
to see their funds grow.
age
• As retirement approaches, this will change as the client will be looking for
investments that will provide a secure income that they can live on.

Examples of Subjective Factors

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• Generally speaking, investors who are more knowledgeable about
A client’s level
financial matters are more willing to accept investment risk. This level
of financial
of understanding does still need, however, to be tested against their
knowledge willingness to tolerate differing levels of losses.

A client’s comfort
• Some individuals have a psychological makeup that enables them to take
with
risks more freely than others, and to see such risks as opportunities.
a level of risk

• Risk attitude can also be gauged by assessing a client’s normal preferences

A client’s preferred
for different types of investments, such as the relative safety of a bank
investment choice
account versus the potential risk of stocks and shares.

• This refers to how a client regrets certain investment decisions, and is the
negative emotion that arises from making a decision that is, after the fact,
A client’s approach wrong.
to bad decisions • Some clients can take the view that they assessed the opportunity fully
and therefore any loss is just a cost of investing. Others regret their wrong
decisions and therefore avoid similar scenarios in the future.

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Attempting to fully understand a client’s risk attitude requires skill and experience and establishing an
investor’s risk profile is not straightforward.

The key point is that the adviser needs to understand the client’s attitude to risk and the risk
characteristics of different assets and products if they are to match appropriate solutions with the
client’s needs.

3.4 Suitability and Affordability

When a firm proposes to offer investment advisory services or discretionary portfolio management, it
must first assess whether such services are suitable for a professional client or a retail client. If the firm
intends to offer other investment services (eg, trading derivatives such as contracts for difference), then
it must ensure that they are appropriate for the client.

In assessing the client’s knowledge and experience, the firm should gather information on:

• the types of services and transactions with which the client is familiar
• the nature, volume, frequency and time that the client has been involved in such services and
transactions, and
• the client’s level of education, profession or relevant former profession.

The general requirement is that the firm must take reasonable steps to ensure it makes no personal
recommendation to a client unless it is suitable for them. Suitability will have regard to the facts
disclosed by the client and other facts that the firm should reasonably be aware of.

Having assessed what services and products are suitable and appropriate, the firm should provide
the client with a report which should set out, among other things, why the firm has concluded that a
recommended transaction is suitable.

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3.5 Information Given to Clients

As well as acting in the client’s best interests, financial advisers also need to ensure that they provide
sufficient information about their firm and any proposed investments to the client.

The purpose of this duty to disclose material information is to ensure that the client has all the
information needed to ensure that they are in a position to make a full and informed decision about the
suitability of the recommendations being made.

What constitutes ‘material information’ will depend upon the investments and products being
recommended, but it would include areas such as charges, cancellation rights, early encashment
penalties, risk warnings and any special or non-standard terms. Examples of the scenarios in which
disclosure of material information may be relevant include financial planning reports and suitability
reports, key investor information documents (KIIDs) and simplified prospectuses for a mutual fund.

Where the firm will be providing ongoing services, it should provide details about how it will go about
managing the client’s money and the arrangements it will put in place for safeguarding the client’s
assets.

3.6 Consumer Rights

As in other areas of consumer law, the rights of a consumer in financial services are dictated by the terms
of the contract drawn up between the client and the financial institution. In addition, there are rules
surrounding unfair terms in contracts and on consumer credit and the right for customers to change
their mind. In certain circumstances, clients who are buying certain investment or insurance products or
services are entitled to a period of reflection during which they can decide whether or not to proceed
with their purchase. This period for reflection is known as the ‘cooling-off’ period. If a right to cancel is
provided to a client, the firm must give a clear and prominent notice in writing, either before or, if not
possible, immediately after the sale. They must inform the client of:

11
• the existence of the right to cancel or withdraw
• its duration
• the conditions for exercising it, including any amount the client may have to pay
• what happens if the client does not exercise the right, and
• any other practical details the client may need.

If the client exercises their right to cancel, the effect is that they withdraw from the contract which is
then terminated.

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End of Chapter Questions
Think of an answer for each question and refer to the appropriate section for confirmation.

1. What advantages can be expected when an individual undertakes a budgeting exercise?

Answer reference: Section 1.1

2. What are examples of good debts and bad debts?

Answer reference: Section 1.2

3. Which types of protection should a consumer who takes a mortgage consider?

Answer reference: Section 1.3.3 & 1.3.5

4. What is the difference between savings and investments?

Answer reference: Section 1.4

5. Why might a deputy act for an individual?

Answer reference: Section 2.1.2

6. How does joint tenancy differ from tenancy in common?

Answer reference: Section 2.2.1

7. What are the main stages of the financial advice process?

Answer reference: Section 3

8. Which one of the FCA’s 11 Principles for Businesses requires a firm to take reasonable care to
ensure the suitability of its advice?
Answer reference: Section 3.2

9. What is the difference between risk tolerance and capacity for loss?
Answer reference: Section 3.3

10. What is the purpose of the information that firms must provide to clients before they enter
into any contracts?
Answer reference: Section 3.5

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 Glossary
Glossary

235
Active Management Bank of England (BoE)
A type of investment approach employed to The UK’s central bank. Implements economic
generate returns in excess of the market. policy decided by the Treasury and determines
interest rates.
Additional Rate (of Income Tax)
Tax on top band of income, currently 45%. Basic Rate (of Income Tax)
Rate of tax (currently 20%) charged on income
Alternative Investment Market (AIM) that is below the higher-rate tax threshold.
Established by the London Stock Exchange (LSE).
It is the junior market for smaller company Beneficiaries
shares. The beneficial owners of trust property, or those
who inherit under a will.
Annual Equivalent Rate (AER)
The annualised compound rate of interest Bid Price
applied to a cash deposit or to a loan. Also Price at which dealers buy stock. It is also the
known as the Annual Effective Rate or Effective price quoted by unit trusts that are dual-priced
Annual Rate. for sales of units.

Annual General Meeting (AGM) Bonds

Yearly meeting of shareholders. Mainly used Interest-bearing securities which entitle holders
to vote on dividends, appoint directors and to annual interest and repayment at maturity.
approve financial statements. Commonly issued by both companies and
governments.
Articles of Association
The legal document which sets out the internal Bonus Issue
constitution of a company. Included within the A free issue of shares to existing shareholders.
Articles will be details of shareholder voting No money is paid. The share price falls pro rata.
rights and company borrowing powers. Also known as a capitalisation or scrip issue.

Authorisation CAC 40
Required status under FSMA for firms that wish Index of the prices of 40 major French company
to provide financial services. shares.

Authorised Corporate Director (ACD) Call Option

Fund manager for an OEIC. Option giving its buyer the right to buy an asset
at an agreed price.
Authorised Unit Trust (AUT)
Capital Gains Tax (CGT)
Unit trust which is freely marketable. Authorised
by the FCA. Tax payable by individuals on profit made on the
disposal of certain assets.
Balance of Payments
Central Bank
A summary of all the transactions between a
country and the rest of the world. The difference Central banks typically have responsibility for
between a country’s imports and exports. 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.

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 Glossary

Certificated CREST
Ownership (of shares) designated by certificate. Electronic settlement system used to hold stock
and settle transactions for UK and Irish shares.
Certificates of Deposit (CDs)
Certificates issued by a bank as evidence that Debt Management Office (DMO)
interest-bearing funds have been deposited with The agency responsible for issuing gilts on behalf
it. CDs are traded within the money market. of the Treasury.

Closed-Ended Defined Benefit

Organisations such as companies which are a Usually a workplace pension based on the
fixed size as determined by their share capital. individual’s salary and length of service.
Commonly used to distinguish investment trusts
(closed-ended) from unit trusts and OEICs (open- Defined Contribution
ended). A pension pot based on how much is paid in.

Closing Dematerialised (Form)

Reversing an original future position by, for System where securities are held electronically
example, selling what you have previously without certificates.
bought.
Derivatives
Commercial Paper (CP) Options, futures and swaps. Their price is derived
Money market instrument issued by large from an underlying asset.
corporates.
Dilution Levy
Commission An additional charge levied on investors buying
Charges for acting as agent or broker. or selling units in a single-priced fund to offset
any potential effect that large purchases or sales
Commodity can have on the value of the fund.
Items including sugar, wheat, oil and copper.
Derivatives of commodities are traded on Diversification
exchanges (eg, oil futures on ICE Futures). Investment strategy of spreading risk by
investing in a range of investments.
Contract
A standard unit of trading in derivatives. Dividend
Distribution of profits by a company.
Convertible Bond
A bond that is convertible, at the investor’s Dividend Yield
choice, into the same company’s shares. Most recent annual dividend expressed as a
percentage of current share price.
Coupon
Amount of interest paid on a bond. Dow Jones Industrial Average (DJIA)
Major share index in the USA, based on the prices
Credit Creation of 30 major company shares.
Expansion of loans which increases the money
supply.

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Dual Pricing Exchange-Traded Fund (ETF)
System in which a unit trust manager quotes two Type of collective investment scheme that
prices at which investors can sell and buy. is open-ended but traded on an investment
exchange, rather than directly with the fund’s
Economic Cycle managers.
The course an economy conventionally takes
as economic growth fluctuates over time. Also Ex-Dividend (xd)
known as the business cycle. The period during which the purchase of shares
or bonds (on which a dividend or coupon pay­
Economic Growth ment has been declared) does not entitle the
The growth of Gross Domestic Product (GDP) new holder to this next dividend or interest
expressed in real terms, usually over the course payment.
of a calendar year. Often used as a barometer of
an economy’s health. Exercise Price
The price at which the right conferred by an
Effective Annual Rate option can be exercised by the holder against
The annualised compound rate of interest the writer.
applied to a cash deposit or loan. Also known as
the Annual Equivalent Rate (AER). Financial Conduct Authority (FCA)
One of the bodies that replaced the FSA in
Equity
2013 and which is responsible for regulation of
Another name for shares. Can also be used to conduct in retail, as well as wholesale, financial
refer to the amount by which the value of a markets and the infrastructure that supports
house exceeds any mortgage or borrowings those markets.
secured on it.
Financial Services and Markets Act 2000
Eurobond (FSMA)
An interest-bearing security issued Legislation which provides the framework for
internationally. regulating financial services.

Euronext Fiscal Policy

European stock exchange network formed by The use of government spending, taxation and
the merger of the Paris, Brussels, Amsterdam and borrowing policies to either boost or restrain
(later) Lisbon exchanges. domestic demand in the economy so as to
maintain full employment and price stability.
European Securities and Markets Authority
(ESMA) Fit and Proper
Responsible for drafting, implementing and FSMA 2000 requires that every firm conducting
monitoring EU financial regulation. financial services business must be ‘fit and proper’.

Exchange Fixed-Interest Security

Marketplace for trading investments. A tradable negotiable instrument, issued by a
borrower for a fixed term, during which a regular
Exchange Rate
and predetermined fixed rate of interest, based
The rate at which one currency can be exchanged upon a nominal value, is paid to the holder until
for another. it is redeemed and the principal is repaid.

238
 Glossary

Floating Rate Notes (FRNs) Future

Debt securities issued with a coupon periodically An agreement to buy or sell an item at a future
referenced to a benchmark interest rate, such as date, at a price agreed today. Differs from a
LIBOR. forward in that it is a standardised amount
and, therefore, the contract can be traded on
Forward an exchange.
A derivatives contract that creates a legally
binding obligation between two parties for one Gilt-Edged Stock (Gilt)
to buy and the other to sell a prespecified UK government bond.
amount of an asset at a prespecified price
on a prespecified future date. As individually Gross Domestic Product (GDP)
negotiated contracts, forwards are not traded on A measure of a country’s output.
a derivatives exchange.
Hedging
Forward Exchange Rate A technique employed to reduce the impact
An exchange rate set today, embodied in a of adverse price movements in financial assets
forward contract, that will apply to a foreign held. Often uses derivatives to achieve this aim.
exchange transaction at some prespecified point
in the future. Higher Rate (of Income Tax)
Tax on the band of income above the basic rate
FTSE 100 and below the additional rate, currently 40%.
Main UK share index of 100 leading shares
(‘Footsie’). Holder
Investor who buys put or call options.
FTSE All Share Index
Index comprising around 98% of UK-listed shares Independent Financial Adviser (IFA)
by value. A financial adviser who is not tied to the
products of any one product provider and is
Full Listing duty-bound to give clients best advice and offer
Those public limited companies (plcs) admitted them the option of paying for advice. IFAs must
to the LSE’s official list. Companies seeking a establish the financial planning needs of their
full listing on the LSE must satisfy the UK Listing clients through a personal fact-find, and satisfy
Authority’s (UKLA) stringent listing requirements these needs with the most appropriate products
and continuing obligations once listed. offered in the marketplace.

Fund Manager Individual Savings Account (ISA)

Firm that invests money on behalf of clients. Accounts that benefit from tax advantages and
which can hold cash and stocks and shares.
Fund Supermarket
An internet-based service that provides a Inflation
convenient way of investing in collective An increase in the general level of prices.
investment funds by allowing a variety of funds
to be purchased from a number of different Inheritance Tax (IHT)
management groups in one place. Tax on the value of an estate when a person dies.

239
Initial Public Offering (IPO) Liquidity Risk
A new issue of ordinary shares, whether made The risk that shares may be difficult to sell at a
by an offer for sale, an offer for subscription or a reasonable price.
placing. Also known as a new issue.
Listing
Insider Dealing Companies whose securities are listed on the LSE
Criminal offence by people with unpublished and available to be traded.
price-sensitive information who deal, advise
others to deal or pass the information on. Lloyd’s of London
The world’s largest insurance market.
Integration
Third stage of money laundering. Loan Stock
A corporate bond issued in the domestic bond
Intercontinental Exchange (ICE) market without any underlying collateral, or
ICE operates regulated global futures exchanges security.
and over-the-counter (OTC) markets for
agricultural, energy, equity index and currency London Metal Exchange (LME)
contracts, as well as credit derivatives. ICE The market for trading in derivatives of certain
conducts its energy futures markets through ICE metals, such as copper, zinc and aluminium.
Futures Europe, which is based in London, and
also owns LIFFE. London Stock Exchange (LSE)
The main UK market for securities.
Investment Bank
Business that specialises in raising debt and Long Position
equity for companies. The position following the purchase of a security
or buying a derivative.
Investment Company with Variable Capital
(ICVC) Market
Alternative term for an OEIC. All exchanges are markets – electronic or physical
meeting places where assets are bought or sold.
Investment Trust
A company, not a trust, which invests in a Market Capitalisation
diversified range of investments. Total market value of a company’s shares. The
share price multiplied by the number of shares
Layering in issue.
Second stage in money laundering.
Market Maker
LIFFE An LSE member firm which is obliged to offer to
The UK’s principal derivatives exchange for buy and sell securities in which it is registered
trading financial and soft commodity derivatives throughout the mandatory quote period. In
products. Owned by Intercontinental Exchange return for providing this liquidity to the market,
(ICE). it can make its profits through the differences at
which it buys and sells.
Liquidity
The ease with which an item can be traded on the
market. Liquid markets are described as deep.

240
 Glossary

Maturity NASDAQ Composite

Date when the capital on a bond is repaid. NASDAQ stock index.

Memorandum of Association National Debt

The legal document that principally defines a A government’s total outstanding borrowing
company’s powers, or objects, and its relationship resulting from financing successive budget
with the outside world. deficits, mainly through the issue of government-
backed securities.
Merger
The combining of two or more companies into National Savings and Investments (NS&I)
one new entity. Government agency that provides investment
products for the retail market.
Mixed Economy
Economy which works through a combination of Nikkei 225
market forces and government involvement. The main Japanese share index.

Monetary Policy Nominal Value

The setting of short-term interest rates by a The amount of a bond that will be repaid on
central bank in order to manage domestic maturity. Also known as face or par value.
demand and achieve price stability in the
economy. Nominated Adviser (NOMAD)
Firm which advises AIM companies on their
Monetary Policy Committee (MPC) regulatory responsibilities.
Committee run by the Bank of England which
sets interest rates. Offer Price
Price at which dealers sell stock. It is also the
Multilateral Trading Facilities (MTFs) price quoted by unit trusts that are dual-priced
Systems that bring together multiple parties for purchases of units.
that are interested in buying and selling financial
instruments including shares, bonds and Open
derivatives. To initiate a transaction, eg, an opening purchase
or sale of a future. Normally reversed by a closing
Mutual Fund transaction.
A type of collective investment scheme found in
the US. Open Economy
Country with no restrictions on trading with
Names other countries.
Participants at Lloyd’s of London who form
syndicates to write insurance business. Both Open-Ended
individuals and companies can be names. Type of investment such as OEICs or unit trusts
which can expand without limit.
NASDAQ
National Association of Securities Dealers Open-Ended Investment Company (OEIC)
Automated Quotations. US market specialising Collective investment vehicle similar to a
in the shares of technology companies. unit trust. Alternatively described as an ICVC
(Investment Company with Variable Capital).

241
Open Outcry Primary Market
Trading system used by some derivatives The function of a stock exchange in bringing
exchanges. Participants stand on the floor of the new securities to the market and raising funds.
exchange and call out transactions they would
like to undertake. Protectionism
The economic policy of restraining trade
Option between countries by imposing methods such as
A derivative giving the buyer the right, but not tariffs and quotas on imported goods.
the obligation, to buy or sell an asset.
Proxy
Over-the-Counter (OTC) Derivatives Appointee who votes on a shareholder’s behalf
Derivatives that are not traded on a derivatives at company meetings.
exchange, owing to their non-standardised
contract specifications. Prudential Regulation
Prudential regulation rules require financial firms
Passive Management to hold sufficient capital and have adequate risk
An investment approach that aims to track the controls in place.
performance of a stock market index. Employed
in those securities markets that are believed to Prudential Regulation Authority (PRA)
be price-efficient. The UK body that is responsible for prudential
regulation of all deposit-taking institutions,
Personal Allowance insurers and investment banks.
Amount of income that each person can earn
each year tax-free. Public Sector Net Cash Requirement (PSNCR)
Borrowing needed to meet the shortfall of
Placement government revenue compared to government
First stage of money laundering. expenditure.

Platform Put Option

Platforms are online services such as fund Option where buyer has the right to sell an asset.
supermarkets and wraps that are used by
intermediaries to view and administer their Quote-Driven
investment clients’ portfolios. Dealing system driven by securities firms who
quote buying and selling prices.
Preference Share
Shares which pay fixed dividends. Do not have Real Estate Investment Trust (REIT)
voting rights, but do have priority over ordinary An investment trust that specialises in investing
shares in default situations. in commercial property.

Premium Redemption
The amount of cash paid by the holder of an The repayment of principal to the holder of a
option to the writer in exchange for conferring redeemable security.
a right.
Redemption Yield
Premium Bond A measure that incorporates both the income
National Savings & Investments bonds that pay and capital return – assuming the investor holds
prizes each month. Winnings are tax-free. the bond until its maturity – into one figure.

242
 Glossary

Registrar Short Position

The official of a company who maintains the The position following the sale of a security not
share register. owned, or selling a derivative.

Resolution Société d’Investissement à Capital Variable

Proposal on which shareholders vote. (SICAV)
Type of European collective investment scheme
Retail Bank that is open-ended.
Organisation that provides banking facilities to
individuals and small/medium businesses. Single Pricing
Refers to the use of the mid-market prices of the
Rights Issue underlying assets to produce a single price for
The issue of new ordinary shares to a company’s units/shares in collective investment schemes.
shareholders in proportion to each shareholder’s
existing shareholding, usually at a price deeply Special Resolution
discounted to that prevailing in the market. Proposal put to shareholders requiring 75% of
the votes cast.
Robo-Advice
The application of technology to the process Spread
of providing financial advice but without the Difference between a buying (bid) and selling
involvement of a financial adviser. (ask or offer) price.

Secondary Market Stamp Duty

Marketplace for trading in existing securities. Tax at ½% on the purchase of certain assets
including certificated securities.
Securities
Bonds and equities. Stamp Duty Land Tax (SDLT)
Tax charged on the purchase of properties and
Settlor land above a certain value.
The creator of a trust.
Stamp Duty Reserve Tax (SDRT)
Senior Managers Stamp duty levied at ½% on purchase of
Individuals holding certain positions that require dematerialised equities.
approval from the regulators.
State-Controlled Economy
Share Capital Country where all economic activity is controlled
The nominal value of a company’s equity or by the state.
ordinary shares. A company’s authorised share
capital is the nominal value of equity the Stock Exchange Automated Quotations
company may issue, while issued share capital (SEAQ)
is that which the company has issued. The term LSE screen display system where market makers
share capital is often extended to include a display the prices at which they are willing to
company’s preference shares. deal. Used mainly for fixed-income stocks and
small cap shares.

243
Stock Exchange Electronic Trading Service Treasury Bills
(SETS) Short-term (usually 90-day) borrowings of the UK
LSE’s electronic order-driven trading system. government. Issued at a discount to the nominal
value at which they will mature. Traded in the
Stock Exchange Electronic Trading Service – money market.
quotes and crosses (SETSqx)
A trading platform for securities less liquid than Trustees
those traded on SETS. It combines a periodic The legal owners of trust property who owe a
electronic auction book with stand-alone quote- duty of skill and care to the trust’s beneficiaries.
driven market making.
Two-Way Price
STRIPS Prices quoted by a market maker at which they
The principal and interest payments of those are willing to buy (bid) and sell (offer).
designated gilts that can be separately traded as
zero coupon bonds (ZCBs). STRIPS is the acronym Underlying
for Separate Trading of Registered Interest and Asset from which a derivative is derived.
Principal of Securities.
Unit Trust
Swap A system whereby money from investors is
An OTC derivative whereby two parties exchange pooled together and invested collectively on
a series of periodic payments based on a notional their behalf into an open-ended trust.
principal amount over an agreed term. Swaps
can take the form of interest rate swaps, currency Wrap
swaps or equity swaps. A type of fund platform that enables advisers to
take a holistic view of the various assets that a
Syndicate client has in a variety of accounts.
Lloyd’s names joining together to write insurance.
Writer
T+2 Party selling an option. The writers receive
The two-day rolling settlement period over premiums in exchange for taking the risk of
which all certificated deals executed on the LSE’s being exercised against.
SETS are settled.
Xetra DAX
Takeover German shares index, comprising 30 shares.
When one company buys more than 50% of the
shares of another. Yield
Income from an investment as a percentage of
Third-Party Administrator (TPA) the current price.
A firm that specialises in undertaking investment
administration for other firms. Zero Coupon Bond (ZCB)
Bonds issued at a discount to their nominal
Treasury value that do not pay a coupon but which are
Government department ultimately responsible redeemed at par on a prespecified future date.
for the regulation of the financial services sector.

244
 Multiple Choice
Multiple Choice
Questions
Questions

245
246
 Multiple Choice Questions

The following questions have been compiled to reflect as closely as possible the standard you will
experience in your examination. Please note, however, they are not the CISI examination questions
themselves.

Tick one answer for each question. When you have completed all questions, refer to the end of this
section for the answers.

1. Which of the following is a wholesale market activity associated with an investment bank?
A. Execution-only stockbroking
B. Life assurance
C. Mergers and acquisitions
D. Private banking

2. Holding assets in safe-keeping is one of the principal activities of:

A. a custodian bank
B. an international bank
C. an investment bank
D. a retail bank

3. An economy that is characterised by an absence of barriers to trade and controls over foreign
exchange is known as:
A. a market economy
B. a mixed economy
C. a state-controlled economy
D. an open economy

4. For those on a fixed income, high levels of inflation would normally:

A. allow them to save more
B. reduce their tax allowances
C. allow them to invest for longer periods
D. reduce the amount of goods they can buy

5. What is the definition of a country’s invisible trade balance?

A. International transactions related to the purchase and sale of domestic and foreign
investment assets
B. The difference between the value of imported and exported goods
C. The total value of goods and services that flow in and out of the country
D. The difference between the value of imported and exported services

247
6. Which organisation provides compensation in the event that a bank goes bust?
A. FCA
B. FOS
C. FSCS
D. PRA

7. Which of the following is a zero coupon instrument?

A. Certificates of deposit
B. Cash ISAs
C. Bank current accounts
D. Treasury bills

8. Which type of foreign exchange transaction would normally settle two days later?
A. Forward
B. Future
C. Spot
D. Swap

9. Energy commodity futures contracts are traded on which market?

A. LIFFE
B. Eurex
C. ICE Futures
D. LME

10. Which of the following markets would normally trade aluminium and tin derivatives?
A. LIFFE
B. ICE
C. LME
D. LSE

11. Which stock market index provides the widest view of the US stock market?
A. Dow Jones Industrial Average
B. NASDAQ Composite
C. Nikkei 225
D. S&P 500

248
 Multiple Choice Questions

12. The key difference between the primary market and the secondary market is that the primary
market:
A. relates to equities and the secondary market relates to bonds
B. covers regulated and protected activities and the secondary market covers unregulated and
unprotected activities
C. is where new shares are first issued and the secondary market is where existing shares are
subsequently traded
D. involves domestic trading and the secondary market involves overseas trading

13. In the event of a company going into liquidation, who would normally have the lowest priority
for payment?
A. Banks
B. Bondholders
C. Ordinary shareholders
D. Preference shareholders

14. What type of corporate action would have taken place if an existing shareholder purchased
new shares in the company, thereby increasing the total shares issued?
A. Bonus issue
B. Capitalisation issue
C. Rights issue
D. Scrip issue

15. The passing of a special resolution at a company meeting requires what MINIMUM percentage
of votes in favour?
A. 50
B. 75
C. 90
D. 100

16. What is the corporate equivalent of Treasury bills known as?

A. Supranational bonds
B. Commercial paper
C. Structured products
D. Certificates of deposit

17. Which of the following is a mandatory corporate action with options?

A. Bonus issue
B. Merger
C. Rights issue
D. Takeover

249
18. Which types of instrument would you expect to see traded on SETS?
A. Options
B. Futures
C. Unit trusts
D. FTSE 350 shares

19. A UK company has issued a fixed-coupon bond denominated in yen into the Japanese market
to make it attractive to Japanese investors. What type of bond is this known as?
A. Asset-backed bond
B. Eurobond
C. Foreign bond
D. Covered bond

20. Which type of bond gives the bondholder the right to require the issuer to repay it early?
A. Floating rate note
B. Convertible
C. Medium-term note
D. Puttable

21. You have a holding of £10,000 5% Treasury Gilt 2025 which is currently priced at 112 and on
which you receive half-yearly interest of £250. Which of the following is its flat yield?
A. 5.0%
B. 4.46%
C. 2.50%
D. 2.23%

22. If interest rates increase, what will be the effect on a 5% government bond?
A. Price will rise
B. Price will fall
C. Coupon will rise
D. Coupon will fall

23. Which of the following statements concerning call and put options is true?
A. The buyer of a call has the right to sell an asset
B. The buyer of a put has the right to buy an asset
C. The seller of a call has the right to sell an asset
D. The buyer of a call has the right to buy an asset

250
 Multiple Choice Questions

24. An investor who has entered into a contract which commits them to buying the underlying
asset at a future date is described as?
A. Seller
B. Long
C. Short
D. Writer

25. Which type of collective investment scheme would you expect to trade at a discount or
premium to its net asset value (NAV)?
A. Unit trust
B. ETF
C. Investment trust
D. OEIC

26. Which of the following types of collective investment scheme has traditionally been dual-
priced, but may now also use single pricing?
A. ETF
B. REIT
C. Investment trust
D. Unit trust

27. An investment fund which can be sold throughout the EU, subject to regulation by its home
country regulator, is known as:
A. an investment trust
B. an OEIC
C. a SICAV
D. a UCITS

28. The standard settlement period for the sale of a unit trust is which of the following?
A. T+1
B. T+3
C. T+4
D. T+5

29. What minimum percentage of profits, after expenses, must be distributed for a real estate
investment trust (REIT) to retain its tax status?
A. 90
B. 85
C. 75
D. 60

251
30. What type of investment vehicle would you expect to have the highest minimum investment
limit?
A. ETF
B. Hedge fund
C. Investment trust
D. SICAV

31. Which UK regulatory body is responsible for the supervision of investment exchanges and
other infrastructure that supports the markets?
A. FCA
B. FPC
C. FSA
D. PRA

32. A money launderer is actively switching monies between investment products. The stage of
money laundering relevant to these activities is known as:
A. investment
B. integration
C. layering
D. placement

33. Which of the following is least accurate in relation to terrorist financing?

A. Because terrorist groups can have links with other criminal activities, there can be overlap
between money laundering and terrorist financing rules
B. If legitimate funds are used to fund terrorist activities, it is difficult to identify when the funds
become terrorist funds
C. Often, only small sums of money are required to commit terrorist acts, therefore, making
tracking easy
D. Often, only small sums of money are required to commit terrorist acts, therefore, making
tracking more difficult

34. Insider dealing rules apply to which ONE of the following securities?
A. Commodity derivatives
B. OEIC shares
C. Government bonds
D. Unit trusts

35. What is the maximum payout that can be awarded by the Financial Ombudsman Service?
A. £50,000
B. £150,000
C. £250,000
D. £375,000

252
 Multiple Choice Questions

36. Behaviour likely to give a false or misleading impression of the supply, demand or value of the
investments deemed under the legislation to be qualifying, is most likely to constitute which of
the following offences?
A. Front running
B. Money laundering
C. Market abuse
D. Insider dealing

37. Which of the following assets is exempt from capital gains tax (CGT)?
A. Buy-to-let properties
B. Shares
C. UK government bonds
D. Unit trusts

38. What income tax will an additional rate taxpayer with an overall income of £250,000 per annum
pay on a UK dividend?
A. 8.75%
B. 33.75%
C. 39.35%
D. 45%

39. Sue, a higher rate taxpayer aged 43, receives £10,000 in dividend income. What rate of income
tax will she pay on her dividend income?
A. 8.75%
B. 20%
C. 33.75%
D. 39.35%

40. If an individual investor wishes to be able to manage the investments in a pension themselves,
which type of pension would be the most suitable?
A. SSAS
B. SIPP
C. Occupational pension
D. Stakeholder pension

41. The person who is responsible for administering the estate of the deceased is known as which
of the following?
A. Attorney
B. Deputy
C. Personal representative
D. Trustee

253
42. The individual charged with looking after the assets of a trust is known as the:
A. beneficiary
B. executor
C. settlor
D. trustee

43. You have a loan where interest is charged quarterly at 20% pa. What is the effective annual rate
of borrowing?
A. 21%
B. 21.18%
C. 21.35%
D. 21.55%

44. A policy that only pays out if death occurs during the term of the policy is:
A. an endowment plan
B. a term assurance
C. an income replacement plan
D. a whole-of-life assurance

45. Which of the following types of investment fund is most likely to utilise gearing?
A. ETF
B. Investment trust
C. OEIC
D. Unit trust

46. Which of the below would undertake the investment administration of other firms?
A. Trustee
B. Depository
C. Third Party Administrator
D. Sub Custodian

47. All of the following relate to residential property investment with the exception of which one?
A. Tenant is responsible for the property repairs
B. Landlord is responsible for the property
C. Typically short renewable leases
D. Range of Investment Opportunities including second dwellings and buy to let

254
 Multiple Choice Questions

48. What right does a participating preference share afford the holder?
A. Entitle the holder to a basic dividend
B. Afford the holder voting rights
C. Allow the shares to be converted to a bond certificate
D. Allow the holder the right to participate in day to day decisions in the firm

49. Which of the below does not characterise a covered bond?

A. The asset pool may be provided by a special purpose vehicle (SPV)
B. The asset pool must provide sufficient cover
C. There needs to be sufficient collateral only at the time the bond is issued
D. It remains on the issuer’s balance sheet

50. When a company is referred to as being struck off, it describes which of the following?
A. The managing director has been removed from their position a majority vote of the
shareholders
B. The company is placed into administration and an insolvency practitioner or ‘administrator’ is
appointed to take control of the company.
C. The company has been removed from the official companies house register
D. The company is being sold off as a going concern on the basis that more money can be made
from its assets then if it were liquidated.

255
Answers to Multiple Choice Questions

1. C Chapter 1, Section 3.4

Advice on mergers and acquisitions is a wholesale market activity provided by investment banks.

2. A Chapter 1, Section 3.9

The primary role of a custodian is the safe-keeping of assets.

3. D Chapter 2, Section 2.4

In an open economy, there are few barriers to trade or controls over foreign exchange.

4. D Chapter 2, Section 5.1

High levels of inflation mean that prices rise and so someone on a fixed income would be able to buy
fewer goods.

5. D Chapter 2, Section 5.2.3

The invisible trade balance is the difference between the value of imported and exported services. B is
known as the visible trade balance, C is the country’s current account, and A is the capital account.

6. C Chapter 5, Section 2.1

The Financial Services Compensation Scheme (FSCS) provides protection in the event of a deposit-
taking institution going bust.

7. D Chapter 5, Section 3
Treasury bills do not pay interest but instead are issued at a discount to par.

8. C Chapter 5, Section 5.2

The ‘spot rate’ is the rate quoted by a bank for the exchange of one currency for another with immediate
effect; however, spot trades are settled two business days after the transaction date.

9. C Chapter 6, Section 6.3

ICE operates the electronic global futures and OTC marketplace for trading energy commodity contracts.
These contracts include crude oil and refined products, natural gas, power and emissions.

10. C Chapter 6, Section 6.3

A range of metals including aluminium, copper, nickel, tin, zinc and lead are traded on the London Metal
Exchange (LME).

11. D Chapter 3, Section 8

The S&P 500 is generally regarded as providing the widest view of the US market compared to the Dow
Jones and the NASDAQ Composite.

256
 Multiple Choice Questions

12. C Chapter 3, Section 7.1

The primary market is where new shares in a company are marketed for the first time. When these shares
are subsequently resold, this is normally done on the secondary market.

13. C Chapter 3, Section 3.1

If the company closes down, often described as the company being ‘wound up’, the ordinary
shareholders are paid after everybody else.

14. C Chapter 3, Section 6.2

Under a rights issue, a shareholder is offered the right to subscribe for further ‘new’ shares at a fixed price
per share.

15. B Chapter 3, Section 2.3

Matters of major importance, such as a proposed change to the company’s constitution, require a
‘special resolution’ and at least 75% to vote in favour.

16. B Chapter 5, Section 3

Commercial paper (CP) is issued by companies and is effectively the corporate equivalent of a Treasury
bill.

17. C Chapter 3, Section 6.2

A rights issue is a mandatory with options type of corporate action.

18. D Chapter 3, Section 9.2

SETS is used to trade equity shares.

19. C Chapter 4, Section 4.3

A foreign bond is one issued by an overseas entity into a domestic market and is denominated in the
domestic currency.

20. D Chapter 4, Section 4.1.2

Puttable bonds give the bondholder the right to require the issuer to redeem early, on a set date or
between specific dates.

21. B Chapter 4, Section 5.2

The flat yield is calculated by taking the annual coupon and dividing by the bond’s price, and then
multiplying by 100 to obtain a percentage. So the calculation is 5/112 x 100 = 4.46%.

22. B Chapter 4, Section 5.1.3

Bonds have an inverse relationship with interest rates so if interest rates rise, then bond prices will fall.

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23. D Chapter 6, Section 3.3
A call option is when the buyer has the right to buy the asset at the exercise price, if they choose to. The
seller is obliged to deliver if the buyer exercises the option.

24. B Chapter 6, Section 2.3

A contract to buy an underlying asset at a future date is a future and the buyer is referred to as long.

25. C Chapter 7, Section 5.4

Investment trusts are structured and listed on a stock market as with any other type of share and able
to borrow money to gear up the portfolio. The share price, however, is not necessarily the same as the
value of the underlying investments (determined on a per share basis and referred to as the net asset
value). The share price could therefore trade at a premium or discount to the net asset value.

26. D Chapter 7, Section 4.1

Unit trusts have traditionally been dual priced, that is to quote separate prices for buying and selling the
units. They now have a choice whether to use dual or single pricing.

27. D Chapter 7, Section 1.5.1

The UCITS directives have been issued with the intention of creating a framework for cross-border sales
of investment funds throughout the EU. They allow an investment fund to be sold throughout the EU
subject to regulation by its home country regulator.

28. C Chapter 7, Section 4.3

Fund groups are required to settle sales within four days of the receipt of all required documentation.

29. A Chapter 7, Section 5.2

At least 90% of profits, after expenses, must be distributed to shareholders for a REIT to retain its tax
status.

30. B Chapter 7, Section 8.1

Hedge funds typically have high minimum investment levels, ranging from £50,000 to over £1 million in
some cases.

31. A Chapter 8, Section 1.1.1

The Financial Conduct Authority (FCA) is responsible for the regulation of all firms in retail and wholesale
financial markets, as well as the infrastructure that supports these markets. This includes supervision of
investment exchanges.

32. C Chapter 8, Section 2.1.1

Layering is the second stage and involves moving the money around in order to make it difficult for the
authorities to link the placed funds with the ultimate beneficiary of the money.

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 Multiple Choice Questions

33. D Chapter 8, Section 2.1.1

Often, only quite small sums of money are required to commit terrorist acts, therefore, making
identification and tracking more difficult.

34. C Chapter 8, Section 3.1

The instruments (securities) covered by the insider dealing legislation in the Criminal Justice Act include
government bonds, but does not embrace commodity derivatives, shares in OEICs or unit trusts.

35. D Chapter 8, Section 5.2

The Financial Ombudsman Service (FOS) can make an award against what it considers to be fair
compensation; however, the sum cannot exceed £375,000.

36. C Chapter 8, Section 3.2

Market abuse includes behaviour likely to give a false or misleading impression of the supply, demand
or value of qualifying investments.

37. C Chapter 9, Section 2.3

UK government bonds (gilts) are exempt from capital gains tax (CGT).

38. C Chapter 9, Section 2.2.2

Dividends are taxed at 8.75% for basic rate taxpayers, 33.75% for higher rate taxpayers and 39.35% for
additional rate taxpayers.

39. C Chapter 9, Section 2.2.2

The first £2,000 of dividend income in each tax year is tax-free. Sums above this will be taxed at 8.75% for
basic rate taxpayers, 33.75% for higher rate taxpayers and 39.35% for additional rate taxpayers.

40. B Chapter 9, Section 4.4

Individuals can manage the investments held within a self-invested personal pension (SIPP) subject to
HM Revenue & Customs (HMRC) guidelines.

41. C Chapter 11, Section 2.1.3

The person who is responsible for administering the estate of the deceased is known as a personal
representative and can be either an executor or an administrator.

42. D Chapter 9, Section 5.1

A settlor creates the trust and the person they give the property to, to look after for the beneficiaries is
the trustee.

43. D Chapter 10, Section 1.4

Interest will be charged on the outstanding balance at 5% per quarter so the effective annual rate is
[(1.05 x 1.05 x 1.05 x 1.05)] – 1 x 100 = 21.55%.

259
44. B Chapter 10, Section 3.2
Term assurance is designed to pay out only if death occurs within a specified period.

45. B Chapter 7, Section 5.3

One of the distinguishing features of an investment trust is its ability to borrow funds for investment; in
other words, to use gearing.

46. C Chapter 1, Section 3.11

Third-party administrators (TPAs) undertake investment administration on behalf of other firms, and
specialise in this area of the investment industry.

47. A Chapter 5, Section 4

Unlike Commercial property rental where the landlord is responsible for property repairs, the landlord
is responsible in the case of a residential property. This is a cost that should be factored into residential
property investment.

48. A Chapter 3, Section 3.2

Normally, preference shares: are non-voting, except in certain special circumstances, such as when
their dividends have not been paid pay a fixed dividend each year, the amount being set when they are
first issued and which has to be paid before dividends on ordinary shares can be paid, and rank ahead
of ordinary shares in terms of being paid back if the company is wound up. Preference shares may be
cumulative, non-cumulative, and/or participating.

49. A Chapter 4, Section 4.5.1

Covered Bonds are a variation on asset-backed bonds and are widely used in Europe. The regulatory
framework for covered bonds is designed so that bonds that comply with those requirements are
considered as particularly safe investments. Covered bonds must remain on the issuer’s balance sheet.
The asset pool must provide sufficient collateral to cover bondholder claims throughout the whole term
of the covered bond. Bondholders must have priority claim on the cover asset pool in case of default of
the issuer.

50. C Chapter 11, Section 2.3

A liquidation is the legal ending of a limited company. Following liquidation, a business will be removed
from the official Companies House register – a process known as being ‘struck off’; from this point, that
business ceases to legally exist. Both solvent and insolvent companies can be liquidated, however,
the process for doing so differs slightly for each. A liquidator will sell a business’s assets, pay the firm’s
creditors and distribute any remaining share capital to shareholders.

260
 Syllabus Learning Map
Syllabus learning Map

261
262
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section

Element 1 Introduction Chapter 1

The Financial Services Sector
1.1
On completion, the candidate should:
Know the role of the following within the financial services sector:
• retail banks
• savings institutions
• investment banks
• pension funds
• insurance companies
1.1.1 • fund managers 3
• stockbrokers
• custodians
• platforms
• third-party administrators (TPAs)
• industry trade and professional bodies
• peer-to-peer (P2P)/crowdfunding
Know the function of and differences between retail and professional
1.1.2 2
business and who the main customers are in each case
Know the role of the following investment distribution channels:
• independent financial adviser
1.1.3 • restricted advice 4
• execution-only
• robo-advice
Know about the following themes:
1.1.4 • fintech 4
• environmental, social, and governance (ESG)

Element 2 The Economic Environment Chapter 2

The Economic Environment
2.1
On completion, the candidate should:
Know the factors which determine the level of economic activity:
• state-controlled economies
2.1.1 • market economies 2
• mixed economies
• open economies
Know the stages of the economic cycle and the role of government in
determining:
2.1.2 • economic policy 3
• fiscal policy
• monetary policy
Know the function of central banks:
• the Bank of England including the Monetary Policy Committee
2.1.3 4
• the Federal Reserve
• the European Central Bank

263
 Syllabus Unit/ Chapter/
Element Section
Understand the impact of the following economic data:
• gross domestic product (GDP)
• balance of payments
2.1.4 • budget deficit/surplus 5
• level of unemployment
• exchange rates
• inflation/deflation

Element 3 Equities Chapter 3

Equities
3.1
On completion, the candidate should:
Know how a company is formed and the differences between private
3.1.1 2
and public companies
Know the features and benefits of ordinary and preference shares:
• dividend
• capital gain
3.1.2 3&4
• share benefits
• right to subscribe for new shares
• right to vote
3.1.3 Be able to calculate the share dividend yield 4
Understand the advantages, disadvantages and risks associated with
owning shares:
• price risk
3.1.4
• liquidity risk 5
• issuer risk
• foreign exchange risk
Know the definition of a corporate action and the difference between
3.1.5 mandatory, voluntary and mandatory with options including 6
takeovers and mergers
Understand the following terms:
• bonus/scrip/capitalisation issues/stock splits/reverse stock splits
• rights issues
3.1.6 6
• dividend payments
• buybacks
(may be tested by the use of a simple calculation)
Be able to calculate:
3.1.7 • theoretical ex-rights price 6
• theoretical ex-bonus price
3.1.8 Know the purpose and format of annual general meetings 2.3
Know the function of a stock exchange:
3.1.9 • primary/secondary market 7.1
• listing
3.1.10 Know the types and uses of the main global stock exchange indices 8

264
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Know how shares are traded:
• on-exchange/over-the-counter
3.1.11 9
• multilateral trading facilities
• order-driven/quote-driven
Know the method of holding title and related terminology: registered
3.1.12 10
and bearer; immobilised and dematerialised
Understand the role of the central counterparty in clearing and
3.1.13 11
settlement
Understand how settlement takes place:
• participants
3.1.14 12
• process
• settlement cycles

Element 4 Bonds Chapter 4

Characteristics
4.1
On completion, the candidate should:
Understand the characteristics and terminology of bonds:
• coupon
4.1.1 • redemption 2
• nominal value
• yields
Government Bonds
4.2
On completion, the candidate should:
Know the definition and features of government bonds:
4.2.1 3
• types
Corporate Bonds
4.3
On completion, the candidate should:
Know the definitions and features of the following types of bond:
• domestic
• foreign
• eurobond
• asset-backed securities including covered bonds
4.3.1 • zero coupon 4
• convertible
• preferred
• floating rate notes
• medium-term notes
• permanent interest-bearing shares
Bonds
4.4
On completion, the candidate should:
Know the potential advantages and disadvantages of investing in
4.4.1 5.1
different types of bonds
4.4.2 Be able to calculate the flat yield of a bond 5.2
Understand the role of credit rating agencies and the differences
4.4.3 5.3
between investment and non-investment grades

265
 Syllabus Unit/ Chapter/
Element Section

Element 5 Other Markets and Investments Chapter 5

Cash Deposits
5.1
On completion, the candidate should:
Know the characteristics of fixed-term and instant access deposit
5.1.1 2
accounts
5.1.2 Know the advantages and disadvantages of investing in cash 2.1
5.1.3 Know the differences between cryptocurrencies and fiat currencies 2.2
The Money Market
5.2
On completion, the candidate should:
Know the difference between a capital market instrument and a
5.2.1 3
money market instrument
Know the definition and features of the following:
• Treasury bill
5.2.2 • commercial paper 3
• certificate of deposit
• money market funds
Know the advantages and disadvantages of investing in money
5.2.3 3
market instruments
Property
5.3
On completion, the candidate should:
Know the characteristics of property investment:
5.3.1 • commercial/residential property 4
• direct/indirect investment
Know the potential advantages and disadvantages of investing in
5.3.2 4
property
Foreign Exchange Market
5.4
On completion, the candidate should:
Know the basic structure of the foreign exchange market including:
• currency quotes
5.4.1 • settlement 5
• spot/forward
• short-term currency swaps
Be able to calculate a forward exchange rate using interest rate parity
5.4.2 5
formula

Element 6 Derivatives Chapter 6

Derivatives Uses
6.1
On completion, the candidate should:
6.1.1 Know the uses and application of derivatives 1.1
Futures
6.2
On completion, the candidate should:
6.2.1 Know the definition and function of a future 2.2

266
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Options
6.3
On completion, the candidate should:
6.3.1 Know the definition and function of an option 3
Understand the following terms:
6.3.2 • calls 3
• puts
Terminology
6.4
On completion, the candidate should:
Understand the following terms:
• long
• short
• open
• close
6.4.1 • holder 2.3 & 3
• writing
• premium
• covered
• naked
Derivatives/Commodity Markets
6.5
On completion, the candidate should:
6.5.1 Know the characteristics of the derivatives and commodity markets 6
Know the potential advantages and disadvantages of investing in the
6.5.2 6.4
derivatives and commodity markets
Swaps
6.6
On completion, the candidate should:
6.6.1 Know the definition and function of an interest rate swap 4
Credit Default Swaps
6.7
On completion, the candidate should:
6.7.1 Know the definition and function of credit default swaps 5

Element 7 Investment Funds Chapter 7

Introduction
7.1
On completion, the candidate should:
Understand the potential advantages, disadvantages and risks of
7.1.1 1.2
collective investment
Know the difference between active and passive (eg, index)
7.1.2 1.3
management
7.1.3 Know the purpose and principal features of UCITS/NURS 1.5
7.1.4 Know the types of funds and how they are classified 1.4
Unit Trusts
7.2
On completion, the candidate should:
7.2.1 Know the definition and legal structure of a unit trust 2
7.2.2 Know the roles of the manager and the trustee 2

267
 Syllabus Unit/ Chapter/
Element Section
Open-Ended Investment Companies (OEICs)
7.3
On completion, the candidate should:
7.3.1 Know the definition and legal structure of an OEIC/ICVC/SICAV 3
Know the roles of the authorised corporate director and the
7.3.2 3
depository
Pricing, Dealing and Settling
7.4
On completion, the candidate should:
Know how unit trust units and OEIC shares are priced, bought and
7.4.1 4.1
sold
7.4.2 Know how collectives are settled 4.1
Investment Trusts
7.5
On completion, the candidate should:
Know the characteristics of an investment trust:
• share classes
7.5.1 5
• gearing
• real estate investment trusts (REITs)
Know the meaning of the discounts and premiums in relation to the
7.5.2 5
pricing of investment trusts
7.5.3 Know how investment trust shares are traded 5
Exchange-Traded Funds (ETFs)
7.6
On completion, the candidate should:
Know the main characteristics of exchange-traded funds:
• trading
7.6.1 6
• replication methods
• synthetic/non-synthetic
Alternative Investment Funds (AIFs)
7.7
On completion, the candidate should:
Know the basic characteristics of hedge funds:
• risks
7.7.1 8.1
• cost and liquidity
• investment strategies
Know the basic characteristics of private equity:
7.7.2 • raising finance 8.2
• realising capital gain

Element 8 Financial Services Regulation Chapter 8

Introduction
8.1
On completion, the candidate should:
Know the UK regulatory environment and role of the:
8.1.1 • government 1.1
• regulatory authorities
8.1.2 Understand the need for regulation and the authorisation of firms 1.1
8.1.3 Know the CISI’s Code of Conduct 6

268
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Understand the key principles of professional integrity and ethical
8.1.4 6
behaviour in financial services
Financial Crime
8.2
On completion, the candidate should:
Know what money laundering is, the stages involved and the related
8.2.1 2.1
criminal offences
Know how firms/individuals can be exploited as vehicles for financial
crime:
• fraud
8.2.2 2.2
• cybercrime
• terrorist financing
• bribery
Insider Dealing and Market Abuse
8.3
On completion, the candidate should:
Know the offences that constitute insider dealing and market abuse
8.3.1 3
and the instruments covered
Data Protection
8.4
On completion, the candidate should:
8.4.1 Know the impact of the Data Protection Act 2018 on firms’ activities 4
Complaints and Compensation
8.5
On completion, the candidate should:
Know the requirements for handling customer complaints, including
8.5.1 5
the role of the Financial Ombudsman Service
Know the circumstances under which the Financial Services
8.5.2 Compensation Scheme pays compensation and the compensation 5.3
payable for investment and deposit claims

Element 9 Taxation, Investment Wrappers and Trusts Chapter 9

Tax
9.1
On completion, the candidate should:
Know the direct and indirect taxes affecting individuals:
• income tax
• capital gains tax
• inheritance tax
9.1.1 • stamp duty 2
• corporation tax
• state benefits/HMRC tax credits
• National Insurance
• residency/domicile
9.1.2 Know the main exemptions in respect of the main personal taxes 2
Investment Wrappers
9.2
On completion, the candidate should:
9.2.1 Know the definition of, and tax incentives provided by, ISAs 3

269
 Syllabus Unit/ Chapter/
Element Section
Know the main types of ISA available:
• Cash ISA
• Stocks and shares ISA
9.2.2
• Innovative ISA 3
• Lifetime ISA
• Junior ISA
Pensions
9.3
On completion, the candidate should:
9.3.1 Know the benefits provided by pensions 4
Know the basic characteristics of the following:
• state pension scheme
9.3.2 • occupational pension schemes 4
• personal pensions including self-invested personal pensions
(SIPPs)
Trusts
9.4
On completion, the candidate should:
Know the features of the main trusts:
• discretionary
9.4.1 5
• interest in possession
• bare
Know the definition of the following terms:
• trustee
9.4.2 5
• settlor
• beneficiary
9.4.3 Know the main reasons for creating trusts 5

Element 10 Other Financial Products Chapter 10

Loans
10.1
On completion, the candidate should:
Know the differences between bank loans, overdrafts and credit card
10.1.1 1
borrowing
Know the difference between the quoted interest rate on borrowing
10.1.2 1.4
and the effective annual rate of borrowing
Be able to calculate the effective annual rate of borrowing, given the
10.1.3 1.4
quoted interest rate and frequency of payment
10.1.4 Know the difference between secured and unsecured borrowing 1
Mortgages
10.2
On completion, the candidate should:
Understand the characteristics of the mortgage market:
10.2.1 • interest rates 2
• loan to value
Know the definition of and types of mortgage:
• repayment
10.2.2 2
• interest-only
• offset

270
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Life Assurance
10.3
On completion, the candidate should:
Know the basic principles of life assurance and the definition of the
following types of life policy:
10.3.1 3
• term assurance
• whole-of-life

Element 11 Financial Advice Chapter 11

Areas of Financial Advice
11.1
On completion, the candidate should:
Understand the main areas of financial advice:
• budgeting
• protection
• borrowing
11.1.1 1
• investment and saving
• later-life planning
• estate planning
• tax planning and offshore considerations
The Process for Giving of Financial Advice
11.2
On completion, the candidate should:
Understand the key factors in the financial advice process:
• the client relationship
• affordability, suitability, attitude to risk
• matching solutions with needs
11.2.1 • use of communication skills in giving advice 3
• monitoring and reviewing clients’ circumstances
• information given to clients
• consumer rights and remedies, including awareness of their
limitations
Legal Concepts Relevant in Financial Advice
11.3
On completion, the candidate should:
Understand the key legal concepts relating to:
• legal persons (wills/intestacy/personal representatives/trustees/
companies/limited liabilities/partnerships)
• contract, capacity to contract
11.3.1 • agency 2
• real estate, personal property and joint ownership
• powers of attorney
• insolvency and bankruptcy
• identifying, reporting scams

271
Examination Specification
Each examination paper is constructed from a specification that determines the weightings that will be
given to each element. The specification is given below.

It is important to note that the numbers quoted may vary slightly from examination to examination as
there is some flexibility to ensure that each examination has a consistent level of difficulty. However, the
number of questions tested in each element should not change by more than plus or minus 2.

Element Number Element Questions

1 Introduction 3

2 The Economic Environment 4

3 Equities 9

4 Bonds 7

5 Other Markets and Investments 4

6 Derivatives 4

7 Investment Funds 6

8 Financial Services Regulation 4

9 Taxation, Investment Wrappers and Trusts 4

10 Other Financial Products 3

11 Financial Advice 2
    Total 50

272
Syllabus Learning Map

273
274
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