Investment Advice Diploma

Securities
Edition 12, October 2021

This workbook relates to syllabus

version 12.1 and will cover examinations from
31 December 2021 to 30 December 2022
Welcome to the Chartered Institute for Securities & Investment’s Securities study material.

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

Published by:
Chartered Institute for Securities & Investment
© Chartered Institute for Securities & Investment 2021
20 Fenchurch Street
London
EC3M 3BY
Tel: +44 20 7645 0600
Fax: +44 20 7645 0601
Email: [email protected]
www.cisi.org/qualifications

Author:
Kevin Petley, Chartered FCSI
Reviewers:
JB Beckett, Chartered MCSI
Kim Holding, Chartered MCSI

This is an educational workbook only and the Chartered Institute for Securities & Investment accepts no
responsibility for persons undertaking trading or investments in whatever form.

While every effort has been made to ensure its accuracy, no responsibility for loss occasioned to any
person acting or refraining from action as a result of any material in this publication can be accepted by
the publisher or authors.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or
transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise
without the prior permission of the copyright owner.

Warning: any unauthorised act in relation to all or any part of the material in this publication may result in
both a civil claim for damages and criminal prosecution.

A learning map, which contains the full syllabus, appears at the end of this workbook. The syllabus
can also be viewed on cisi.org and is also available by contacting the Customer Support Centre on +44
20 7645 0777. Please note that the examination is based upon the syllabus. Candidates are reminded
to check the Candidate Update area details (cisi.org/candidateupdate) on a regular basis for updates
as a result of industry change(s) that could affect their examination. Please note that, as part of exam
security, hand-held calculators are not allowed in CISI exam venues. Candidates must use the onscreen
calculator for all CISI CBT exams in all languages in the UK and internationally.

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.

Workbook version: 12.1 (October 2021)

Learning and Professional Development with the CISI

The Chartered Institute for Securities & Investment is the leading professional body for those who work in,
or aspire to work in, the investment sector, and we are passionately committed to enhancing knowledge,
skills and integrity – the three pillars of professionalism at the heart of our Chartered body.

CISI examinations are used extensively by firms to meet the requirements of government regulators.
Besides the regulators in the UK, where the CISI head office is based, CISI examinations are recognised by
a wide range of governments and their regulators, from Singapore to Dubai and the US. Around 50,000
examinations are taken each year, and it is compulsory for candidates to use CISI workbooks to prepare for
CISI examinations so that they have the best chance of success. Our workbooks are normally revised every
year by experts who themselves work in the industry and also by our Accredited Training Partners, who
offer training and elearning to help prepare candidates for the examinations. Information for candidates is
also posted on a special area of our website: cisi.org/candidateupdate.

This workbook not only provides a thorough preparation for the examination it refers to, it is also a
valuable desktop reference for practitioners, and studying from it counts towards your Continuing
Professional Development (CPD). Mock examination papers, for most of our titles, will be made available
on our website, as an additional revision tool.

CISI examination candidates are automatically registered, without additional charge, as student members
for one year (should they not be members of the CISI already), and this enables you to use a vast range
of online resources, including CISI TV, free of any additional charge. The CISI has more than 40,000
members, and nearly half of them have already completed relevant qualifications and transferred to a core
membership grade.

Completing a higher level examination enables you to progress even more quickly towards personal
Chartered status, the pinnacle of professionalism in the CISI. You will find more information about the next
steps for this at the end of this workbook.
Cash, Money Markets and the Foreign Exchange Market . . . . . . . . . . . 1

1
Fixed-Income Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

2
Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119

3
Collective Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207

4
Settlement, Safe Custody and Prime Brokerage . . . . . . . . . . . . . . . . . 243

5
Securities Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277

6
Portfolio Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325

7
Investment Selection and Administration. . . . . . . . . . . . . . . . . . . . . 413

8
Glossary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459

Multiple Choice Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469

Syllabus Learning Map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505

It is estimated that this workbook will require approximately 140 hours of study time.

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

Need more support to pass your exam?

See our section on Accredited Training Providers.

Want to leave feedback?

Please email your comments to [email protected]
 1
Chapter One

Cash, Money Markets and

the Foreign Exchange
(FX) Market
1. Cash Instruments and Markets 3

2. Foreign Exchange (FX) Instruments and Markets 16

This syllabus area will provide approximately 7 of the 80 examination questions

2
 Cash, Money Markets and the Foreign Exchange (FX) Market

1. Cash Instruments and Markets

1
1.1 Cash Deposit Accounts

Learning Objective
1.1.1 Be able to analyse the main investment characteristics, behaviours and risks of cash deposit
accounts: deposit-taking institutions and credit risk assessment; term, notice, liquidity and
access; fixed and variable rates of interest; inflation; statutory protection; foreign currency
deposits; structured deposits

1.1.1 Characteristics of Cash Deposit Accounts

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

The main characteristics of cash deposits are:

• The return simply comprises interest income with no potential for capital growth.
• The amount invested is repaid in full at the end of the investment term.

1.1.2 Deposit-Taking Institutions

Deposit-taking institutions that accept and manage deposits and make loans in the UK are primarily
banks (often known as retail or high street banks), building societies, credit unions, trust companies,
mortgage loan companies and money market mutual funds. Some ‘digital only’ or ‘virtual’ challenger
banks also offer interest-bearing accounts.

In the UK, an authorised deposit-taking institution is a deposit-taker within the meaning of Section 31 of
the Financial Services and Markets Act (FSMA) 2000.

1.1.3 Term, Notice, Liquidity and Access

There are various different ways of making a deposit and they can vary in relation to the term of the
deposit, the period of notice which is required to withdraw the deposit and hence the liquidity of the
deposit and one’s access to it. The term reflects the amount of time for which the lender commits the
cash to the deposit-taking institution. As a general rule of thumb, the longer the lender is willing to grant
the deposit without seeking withdrawal, the higher the rate of interest which will be paid.

Under some arrangements the depositor may be required to give notice of intent to withdraw, and, if the
withdrawal takes place prior to a pre-agreed term with the deposit-taker, a penalty for early withdrawal
or redemption may be applied.

Liquidity, in this context, is essentially the speed and ease with which the deposit instrument can be
converted into cash.

3
1.1.4 Fixed and Variable Rates of Interest
The interest rate applied to the deposit is usually:

• a flat rate or an effective rate (an effective rate, also known as an annual equivalent rate (AER), is
when interest is compounded more frequently than once a year)
• fixed or variable
• paid gross of tax, and
• dependent upon its term and/or notice required by the depositor – fixed-term deposits are usually
subject to penalties if an early withdrawal is made.

Fixed-term deposits can also be made in the interbank market. The interbank market originally served
the short-term deposit and borrowing needs of the commercial banks, but it has since been tapped by
institutional investors and large corporates with short-term cash surpluses or borrowing needs in excess
of £0.5 million. The term of deposits made on the interbank market can range from overnight to one
year, with deposit rates being paid on a simple basis at the London Interbank Bid Rate (LIBID) and short-
term borrowing being charged at the London Interbank Offered Rate (LIBOR). LIBOR is scheduled to be
replaced with a substitute benchmark – Sterling Overnight Index Average (SONIA) for sterling by 2022.

The Bank of England (BoE) and the Financial Conduct Authority (FCA) are working with market
participants to catalyse a transition to the Secured Overnight Financing Rate (SOFR) by June 30 2023.

1.1.5 Certificates of Deposit (CDs)

Certificates of deposit (CDs) are negotiable bearer securities issued by commercial banks in exchange
for fixed-term deposits, with a fixed-term and a fixed-rate of interest, set marginally below that for an
equivalent bank time deposit. The holder can either retain the CD until maturity, or realise the security
in the money market whenever access to the money is required. CDs can be issued with terms of up to
five years.

As they are a fixed-interest security, the price will fluctuate with the competitiveness of the interest
rate compared to the prevailing yields (see chapter 2, section 1.3).

1.1.6 Cash Individual Savings Accounts (ISAs)

An individual savings account (ISA) is a tax-free wrapper in which money can be held to protect it
from income and capital gains tax (CGT). Anyone who is aged 16 or over, and resident in the UK for tax
purposes, can invest in a cash ISA. However, accounts must be opened in a single name only. See chapter
8, section 3.3.4 for the current limits.

1.1.7 Money Market Funds

These are managed funds that invest in short-term, low-risk credit securities. They aim to achieve
maximum returns while minimising credit, market and liquidity risks. They typically invest in assets such
as government securities, short-term bonds, commercial paper (CP), repurchase agreements or even
other money market funds.

4
 Cash, Money Markets and the Foreign Exchange (FX) Market

1.1.8 Inflation

1
Inflation is a measure of the rate of change in the general level of prices in an economy. While more
commonly in economic history there has been a trend towards increasing prices, there have been
times, including periods during 2020, when the general level of prices has declined, which is known as
deflation.

Increasing prices lead to erosion in the purchasing power of money, especially for those whose incomes
are fixed or rise at a slower pace than the rate of the price increases. Controlling inflation is a prime
focus of economic policy and, in the specific case of savings in the form of cash deposits, the presence
of inflation must be factored into the real rate of return after allowing for inflation. If the inflation rate
exceeds the nominal interest rate, the real interest rate is actually negative.

Real interest rates are calculated as follows:

Real interest rate = ([1 + Nominal interest rate] / [1 + Inflation rate]) – 1

So, the real return takes into account the inflation rate.

The best known measure of inflation in the UK is the retail prices index (RPI). Originally launched
in 1947, this measures the rate at which the prices of a representative basket of goods and services
purchased by the average UK household change over the course of a month. The consumer prices
index (CPI) is also used. See also chapter 2, section 1.4.1.

1.1.9 Statutory Protection

All retail cash deposits placed with licensed deposit-taking institutions in the UK are covered by the
FCA’s Financial Services Compensation Scheme (FSCS). The maximum level of compensation is £85,000
for single-name bank accounts, and £170,000 for joint accounts. The £85,000 figure represents the
sterling equivalent of €100,000, as required by the recast Deposit Guarantee Schemes Directive.

The FSCS will provide a £1 million protection limit for temporary high balances, for a maximum of 12
months, held with an individual’s bank, building society or credit union if it fails.

1.1.10 Foreign Currency Deposits

If cash is deposited in a foreign currency account, depositors should also consider the following:

• The costs of currency conversion and the potential exchange rate risks if sterling deposits cannot
be accepted.
• The creditworthiness of the banking system and the chosen deposit-taking institution, whether a
depositors’ protection scheme exists and whether there is any statutory protection.
• The tax treatment of interest applied to the deposit.
• Whether the deposit will be subject to any exchange controls that may restrict access to the money
and its ultimate repatriation.

5
1.1.11 Structured Deposits
Structured cash deposits are offered by banks, building societies and National Savings & Investments
(NS&I). The rate of return is generally based on the performance of a stock market index or other
benchmark. If the market falls, there is generally no return at all but the amount of capital invested is
protected as per any other savings account. These products can be sold as ISAs or as growth plans or
bonds.

When the investor buys a structured deposit, they agree to tie up their money for a set time – often five
or six years – in return for a lump sum at maturity. Unlike many other investment products, structured
deposits guarantee that the initial investment will be returned at maturity, irrespective of how the
benchmark performs.

Structured deposits are also sometimes referred to as guaranteed equity bonds (GEBS).

The variable return is also usually dependent on a cap which limits the amount of the return, or a
participation rate that specifies that only some of the investment can participate in the potential gains.

Example 1
A two-year structured deposit of £100,000 is entered into with a 10% cap.

The benchmark index has risen by 30% at maturity.

The income is based on 10% or £10,000.

Example 2
A two-year structured deposit of £100,000 is entered into with a participation rate of 50%.

The benchmark index has risen by 30% at maturity.

The income is based on 50% of the deposit that earns the index growth (or £50,000 at 30%) which is
£15,000.

It should be understood that while these products offer stock market exposure with a guarantee
that investors receive their initial investment, irrespective of how the index performs, the income will
generally be lower than direct stock market investment, for example, through an ISA tracker fund.

If a structured deposit is made, for example, through a bank or insurance company and that bank or
insurance company buys some complex underlying investments from one or more other companies,
there is a risk that if any of the other companies fail, the structured deposit could fail to return the
invested amount or provide the promised return.

6
 Cash, Money Markets and the Foreign Exchange (FX) Market

1.2 Treasury Bills

1
Learning Objective
1.1.2 Be able to analyse the main investment characteristics, behaviours and risks of Treasury
bills: purpose and method of issue; minimum denomination; normal life; zero coupon and
redemption at par; market access, trading and settlement

UK Treasury bills, or T-bills as they are commonly known, are short-term loan instruments, guaranteed by
the UK government, with a maturity date of less than one year at issue. Generally, they are issued with
either one month (28 days), three months (91 days) or six months (182 days) to redemption, with the
three-month T-bill the most common. There are also 12-month bills (up to 364 days), although to date
no 12-month tenders have been held. They pay no coupon, and consequently are issued at a discount to
their nominal value, the discount representing the return available to the investor.

The UK Debt Management Office (DMO) is the agency that issues and services the UK government’s
borrowing. Sterling Treasury bills form an important constituent in the DMO’s Exchequer cash
management operations and an intrinsic component in the UK government’s stock of marketable debt
instruments, alongside gilts. Since they are guaranteed by the government, Treasury bills provide a
very secure investment for market participants with short-term investment horizons. The return on a
Treasury bill is wholly dependent upon the price paid, and the way to calculate the effective yield can be
seen in section 1.2.3.

Unlike gilts, which the DMO uses for long-term public financing needs, Treasury bills are used as
a monetary policy instrument to absorb excess liquidity in the money markets, so as to maintain
short-term money market rates, or the price of money, as close as possible to base rate. These activities
are sometimes referred to as open market operations and are similar to those practised by the Federal
Reserve system in the US.

In essence, Treasury bills do not pay coupons but are redeemed at par.

1.2.1 Treasury Bill Issuance

Since April 1998, the issuance of Treasury bills has been handled by the DMO on behalf of HM Treasury.
The DMO took over debt issuance from the BoE following the transfer of responsibility for setting
interest rates from HM Treasury to the Bank in May 1997.

UK Treasury bills are issued at weekly auctions, known as tenders, held by the DMO at the end of the
week (usually a Friday). These tenders are open to bids from a group of eligible bidders which include
all of the major banks. The bids are tendered competitively. Only those bidding at a high enough price
will be allocated any Treasury bills, and they will pay the price that they bid. The bids must be for a
minimum of £500,000 nominal of the Treasury bills, and above this level bids must be made in multiples
of £50,000. In subsequent trading, the minimum denomination of Treasury bills is £25,000.

Treasury bills require settlement on the following business day. Members of the public wishing to
purchase Treasury bills at the tenders must do so through one of the Treasury bill primary participants.

7
1.2.2 Primary Participants
Treasury bill primary participants are banks that have agreed to bid at Treasury bill tenders on behalf
of investors. They are registered financial institutions that are regulated by the FCA and the Prudential
Regulation Authority (PRA) and are subject to their rules and guidance in their activities. These firms
also provide secondary market dealing levels for Treasury bills.

A list of banks that act as Treasury bill primary participants can be found in chapter 2, section 4.1.4.

1.2.3 Calculating Yields on Treasury Bills

The principal measures used to calculate the effective yield on Treasury bills are as follows:

Discount rate = 100 – Discounted value

100 x Days/365

The yield of a Treasury bill can be derived by using the following formula:

100 – Discounted value

Yield =
  Discounted value x Days/365

As an example consider the yield of a Treasury bill issued at 98 for 91 days:

Interest rate or yield = 100 – 98 = 0.0819 or 8.19%

98 x 91/365

1.2.4 General Collateral Sale and Repurchase Agreements (GC Repo)

One of the cornerstones for determining the prevailing rates in the money markets, which act as a
guideline to the yields which should be available from the DMO Treasury bill auctions, is the GC repo
rate, which is explained below.

Gilt sale and repurchase (gilt repo) transactions involve the temporary exchange of cash and gilts
between two parties. They are a means of short-term borrowing using gilts as collateral. The lender of
funds holds gilts as collateral, so is protected in the event of default by the borrower. General collateral
(GC) repo rates refer to the rates for repurchase agreements in which any gilt may be used as collateral.
Hence, GC repo rates should in principle be close to true risk-free rates.

Repo contracts are actively traded for maturities out to one year. The rates prevailing on these contracts
are very similar to conventional gilts of comparable maturity.

8
 Cash, Money Markets and the Foreign Exchange (FX) Market

1.2.5 Market Access and Current Pricing and Yield for Treasury Bills

1
The reference prices for UK Treasury bills are published by the DMO at the end of each business day.
They are based on a money market yield-to-maturity calculation priced around prevailing GC repo rates,
as explained above, adjusted by a spread reflecting recent Treasury bill tender results and, if applicable,
any specific supply and demand factors.

These reference prices provide indicative mid-prices for the purpose of valuation of collateral transfers
and are not intended to represent market prices at which the securities can be traded.

It is important to note that, in determining the yield on Treasury bills in the UK, the day count convention
is Actual/365. Most other markets use the convention of Actual/360.

1.3 Commercial Paper

Learning Objective
1.1.3 Be able to analyse the main investment characteristics, behaviours and risks of commercial
paper: purpose and method of issue; maturity; discounted security; unsecured and secured;
asset-backed; credit rating; market access, trading and settlement

1.3.1 Commercial Paper (CP)

Commercial paper (CP) is unsecured short-term promissory notes issued primarily by corporations,
although there are also municipal (local) and sovereign issuers. It represents the largest segment of
the money market. The vast majority is issued as discount instruments in bearer form. In the US, terms
rarely exceed 270 days, since this exempts the paper from registration under the Securities Act of 1933.
Outside the US, the term for CP can be as long as one year, but it is typical in all territories for the term to
be between one and three months.

Yields are quoted on a discount basis. Virtually all countries use the Actual/360 convention, except
the UK, which uses the Actual/365 convention. CP is the corporate equivalent of a Treasury bill. Large
companies issue CP to assist in the management of their liquidity. Rather than borrowing directly from
banks, these large entities run CP programmes that are placed with institutional investors.

The various companies’ CP is differentiated by credit ratings – when the large credit rating agencies
assess the stability of the issuer.

1.3.2 Asset-Backed Commercial Paper (ABCP)

Although the standard vanilla form of CP is unsecured, there are asset-backed versions as well. An asset-
backed commercial paper (ABCP) is a short-term investment vehicle with a maturity that is typically
between 90 and 180 days. The security itself will be issued by a bank or other financial institution, and
the notes are backed by physical assets such as trade receivables or commercial property or even credit
card receivables.

9
Finance companies will typically provide consumers with home loans, unsecured personal loans and
retail automobile loans. These receivables are then used by the finance company as collateral for raising
money in the CP market. Some finance companies are wholly owned subsidiaries of industrial firms that
provide financing for purchases of the parent firm’s products.

1.3.3 CP Issuance
CP issuance and marketability tends to be deeper and more prevalent in the US than in Europe and, in
recent times since the banking crisis of 2008, the market has been somewhat subdued. It was not until
the 1980s that CP was first issued outside the US, reflecting a global trend towards disintermediation of
banks.

Historically, the market for CP first developed in the US during the 19th century. The fractured, localised
banking industry was ill-equipped to meet the liquidity needs of emerging industrial corporations. If
a business was unable to secure loans from local banks, it might raise the funds by issuing promissory
notes in New York or Boston. Very likely, the purchaser would be a bank in one of those financial centres,
so CP was a vehicle for raising short-term funds out-of-state in the absence of cross-state banking.

In the 20th century, consumer finance companies turned to CP to finance their lending to purchasers
of automobiles, appliances and other consumer products. General Motors Acceptance Corporation
(GMAC) was a pioneer in such issuances. Today, finance companies issue a significant proportion of CP.

There are two methods of issuing CP. Larger issuers, especially finance companies, have the market
presence to issue their paper directly to investors, including buy-and-hold investors such as money
market funds. Their paper is called direct paper. Direct issuers of CP usually are financial companies that
have frequent and sizeable borrowing needs and find it more economical to sell paper without the use
of an intermediary.

Alternatively, issuers can sell the paper to a dealer, who then sells the paper in the market, in which case
the paper is called dealer paper. The dealer market for CP involves large securities firms and subsidiaries
of bank holding companies.

Unlike bonds or other forms of long-term indebtedness, a CP issuance is not all brought to market at
once. Instead, an issuer will maintain an ongoing CP programme. It advertises the rates at which it is
willing to issue paper for various terms, so buyers can purchase the paper whenever they have funds to
invest.

1.3.4 Secondary Market

There is an inactive secondary market for CP, but dealers will make a market in paper they issue. Direct
issuers will generally honour requests to repay CP early. Some do so at principal plus accrued interest;
others credit interest based on the rate the investor would have received if they had purchased the
paper with a term equal to their actual holding period.

10
 Cash, Money Markets and the Foreign Exchange (FX) Market

1.3.5 Credit Rating of CP

1
CP entails credit risk, and programmes are rated by the major rating agencies. Because CP is a rolling
form of debt, with new issues generally funding the retirement of old issues, the main risk is that the
issuer will not be able to issue new CP. This is called ‘rollover risk’.

Issuers of CP may obtain credit enhancements for their programmes. These may include instruments
such as a letter of credit or a third-party guarantee or insurance contract provided by another financial
institution.

The table below summarises the credit ratings assigned to commercial paper by Moody’s, Standard &
Poor’s (S&P) and Fitch Ratings inc.

CP Credit Ratings

Moody's S&P’s Fitch

Superior P1 A1+ or A1 F1+ or F1
Satisfactory P2 A2 F2
Adequate P3 A3 F3
Speculative NP B or C F4
Defaulted NP D F5

CP will offer yields above the equivalent rates available from Treasury bills. This is due both to their
credit risk and the fact that interest from Treasury bills may have tax advantages. For example, in the US,
interest on Treasury bills is not taxed at the state and local level. In the US, the Federal Reserve reports
the previous day’s average rates on CP for several maturities and types of issuers. These CP rates are a
standard index used as a basis in various interest rate swaps and other derivatives.

CP Following the Financial Crisis of 2007–08

During Q4 2008, the CP and asset-backed paper sectors of the money markets became effectively
frozen as there was no liquidity in the marketplace. Banks were unwilling to accept any collateral other
than government paper, because of fears as to the solvency of the issuers of CP. The BoE, as lender of
last resort, had to intermediate in the money market and accept a wider variety of collateral – such as
CP – than it had previously been willing to accept, as security for providing short-term liquidity to the
commercial banks and other institutions which required cash and liquidity for their ongoing operations.

11
1.4 Repurchase Agreements or Repos

Learning Objective
1.1.4 Be able to analyse the main investment characteristics, behaviours and risks of repurchase
agreements: purpose; sale and repurchase at agreed price, rate and date; tri-party repos;
documentation

The term repo stands for a sale and repurchase agreement, and is similar to a secured loan.

One party agrees to sell securities, for example gilts, to the other and receives collateral of, say, cash to
secure the loan. At the same time the parties agree to repurchase the same or equivalent securities at
a specific price in the future. At that point, the securities are returned by the borrower and the lender
returns the collateral. The cost of this secured finance is given by the difference between the sale and
repurchase price of these bonds and is known as the repo rate.

A reverse repo is simply the same repurchase agreement from the buyer’s viewpoint, not the seller’s.
Hence, the seller executing the transaction would describe it as a repo, while the buyer in the same
transaction would describe it a reverse repo. So repo and reverse repo are exactly the same kind of
transaction, just described from opposite viewpoints.

The purpose of the repo market as implemented by central banks, such as the BoE and the European
Central Bank (ECB), is to provide or remove liquidity from the money markets.

If the central bank wishes to increase the money supply, it will enter into repo agreements as the reverse
repo participant, with other money market institutions such as banks being the repo participant. As the
reverse repo participant, the central bank will provide cash for the collateral provided under the repo.

In contrast, if the central bank wishes to drain liquidity from the money markets, then it will use repo
transactions. This time the central bank will be the repo participant, initially selling instruments and,
therefore, withdrawing cash from the system.

1.4.1 Tri-Party Repos

In the case of a tri-party repo, a custodian bank or clearing organisation acts as an intermediary between
the two parties to the repurchase or repo agreement outlined above.

The tri-party agent is responsible for the administration of the transaction including collateral allocation,
the marking to market, and, when required, the substitution of collateral. The lender and the borrower
of cash both enter into tri-party transactions in order to avoid the administrative burden of the simpler
form of bilateral repos. Moreover, there is an added element of security in a tri-party repo because the
collateral is being held by an agent and the counterparty risk is reduced.

12
 Cash, Money Markets and the Foreign Exchange (FX) Market

1.4.2 Repos and Monetary Policy

1
The BoE is a principal participant in the repo market and will accept qualifying collateral – Treasury bills,
for example – as part of a repurchase agreement. In fact, the widely reported base rate is the repo rate
currently in effect with the BoE and other financial institutions in the money markets, and it is the rate
which is fixed by the Monetary Policy Committee (MPC) of the BoE at its regular meetings.

It is worth observing that a consequence of the liquidity crisis, which arose in 2007–08, is that central
banks in general, especially the Federal Reserve in the US and the BoE in the UK, have relaxed the
requirements on the quality of the collateral which is acceptable under a repo agreement with the
central bank. Commercial banks were permitted to use many kinds of asset-backed securities, which had
previously been considered to be below the acceptable standards in terms of credit risk and quality, in
their repo agreements with central banks. This was one method used by central banks and policymakers
to provide greater financial liquidity during the banking crisis.

1.4.3 Repo Market Illustration

The following diagram illustrates the principal characteristics of a repo agreement.

Repo Sells gilts

Start
Date
Participant A Participant B
Receives cash

Monetary value at start of

repo is transferred to A

Repo Buys back gilts

End
Date
Participant A Pays cash Participant B
plus interest

Monetary value at end of

repo is transferred to B

Diagrammatically, both parts of the repo transaction are agreed between the participants at the
outset: Participant A has entered into a repo transaction; Participant B has entered into a reverse repo
agreement. The amount of cash paid over by Participant B at the start of the repo will be less than
the amount paid over to Participant B at the end of the repo period. The difference between the two
amounts, expressed as a percentage, is the effective interest rate on the repo transaction. It is usually
referred to as the repo rate.

13
The cash transaction results in transfer of money to the borrower in exchange for legal transfer of
the security to the lender, while the promise to repurchase – known as a forward contract – ensures
repayment of the loan to the lender and return of the collateral of the borrower. The difference between
the price which is laid out in the forward contract committing the borrower to repurchase is known
as the forward price. The difference between it and the spot price provides, in similar fashion to the
discounting mechanism, the implicit rate of interest on the loan, and the settlement date stipulated in
the forward contract is the maturity date of the loan.

The obvious benefit to Participant A in the above example is that A is able to raise finance against
the security of the gilts that it holds – potentially a relatively cheap source of short-term finance. If
Participant B is considered a conventional bank simply providing finance, then the benefit of using
the repo is the security gained by holding the gilts. However, Participant B may be a gilt-edged market
maker (GEMM) that has sold gilts that it does not hold. The repo transaction enables the GEMM to access
the gilts that it requires to meet its settlement obligations. In this way, gilt repos facilitate the smooth
running of the secondary market in gilts.

The smooth running of the gilts market is further assisted by the DMO’s standing repo facility. This
enables any GEMM or other DMO counterparty to enter into a reverse repo arrangement with the DMO,
perhaps to cover a short position in gilts. They must first sign the relevant documentation provided by
the DMO and then are able to request any amount of a gilt above £5 million nominal. This facility is for
next-day settlement, and the facility can be rolled forwards for up to two weeks. The DMO does charge
a slightly higher than normal repo rate for firms accessing the standing repo facility. Although the gilt
market has been used as an example, it should be noted that the use of repos is an important liquidity
provider for debt markets as a whole.

1.4.4 Risks of a Repo

From the point of view of the lender, a repo is a simple loan transaction. They lend their surplus cash in
return for interest, and have the support of collateral by the holding of the bond during the life of the
contract. However, as with any collateralised loan, there are three types of primary risk.

• Legal risk – the agreement that is made is a legal document and as such there are potential legal
issues which could arise as in the case of any contractual claim, although the likelihood of this when
standardised documentation is used is minimal.
• Counterparty/credit risk – there is a creditworthiness risk as in all dealings with counterparties.
However, this risk is minimised in the repo transaction by the passing of collateral and, in this sense,
the lender then faces the second element of risk.
• Market and collateral risk – this risk arises from the fact that the underlying assets provided as
collateral may deteriorate to such an extent that, should the counterparty fail on the repayment
date, then the lender will be left with insufficient collateral compared to the amount of the loan.
To cover this third risk element, repo arrangements allow for margin calls to be made against the
borrower in the form of initial margin and variation margin.

14
 Cash, Money Markets and the Foreign Exchange (FX) Market

Initial and Variation Margin

1
The initial margin or haircut will be taken as a reduction in the amount of money lent against the bond.
As a result, the amount lent will seldom be 100% of the value of the bond. The scale of this initial haircut
will be influenced by such factors as the quality of the collateral, the quality of the counterparty and the
term of the repo.

Variation margin will allow for the collateral to be marked-to-market throughout the term of the repo.
This may be on a daily basis or it may be at specific dates throughout the term. Many agreements will
specify a frequency of marking-to-market and, within this, a minimum level of variation necessary to
initiate the margin call. As a result, when the collateral falls in value by only a small amount, no additional
margin is required to be put up, reducing the transaction costs.

The availability of variation margin obviously reduces the level of market risk that exists on repo
transactions. While there is still counterparty risk, the variation margin should ensure that the collateral
more than repays the principal of the loan.

Case Study: Repo 105

In 2001, a new accounting standard in the US, Statement of Financial Accounting Standards (SFAS) 140,
offered an opportunity to change the terms of the repo market in favour of banks. In the past, these deals
were booked as only temporary, because of the short-term nature of the funding, so the assets did not
actually leave the banks’ balance sheets. However, the relaxing of the rules went far enough that some
have questioned whether the use of a particular provision known as Repo 105 can be used to mislead
market participants as to the fairness of a company’s financial position when it uses a repo procedure in
a certain manner.

In 2008, just before Lehman Brothers filed for bankruptcy, it transferred $50.38 billion in a Repo 105
arrangement, reducing its leverage from 13.9% to 12.1%.

Anton Valukas of Jenner & Block, who was appointed as examiner by the judge handling Lehman’s
bankruptcy, said:

‘Unable to find a United States law firm that would provide it with an opinion letter permitting the
the true sale accounting treatment under US law, Lehman conducted its Repo 105 programme under
the aegis of an opinion letter to the Linklaters law firm in London’.

A 2,200-page report, authored by Valukas, into the collapse of Lehman reveals that the firm used balance
sheet manipulation in the form of the accounting practice known as Repo 105 without telling investors
or regulators, which had the effect of making the business appear healthier than it actually was. Lehman
initially had sought legal clearance from an American law firm to permit Repo 105 transactions but was
denied. It then sought advice from Linklaters in London, which said that the deals were possible under
English law.

In the run-up to a reporting period, Lehman would enter an arrangement to sell and then repurchase
financial assets. Normally, such deals are accounted as transactions, but by adding a cash element
Lehman was able to call them sales. The bank’s balance sheet, therefore, could be pumped up with cash
from the sale and would also reduce its borrowings. At the beginning of a new quarter, Lehman would
borrow more money and repurchase the assets to put them back on its balance sheet.

15
The assets were transferred through Lehman’s London operations so that the Repo 105 deals could
be conducted under English law. Under Repo 105, banks could book the transactions as sales because
banks had to take a bigger loss on the value of the assets in return for the loan. While the terms might
have been less favourable on the face of it, the benefit was considerable. Banks hold capital against
their assets to cover possible losses from loans. Removing some of those loans from the balance sheet
boosted the amount of capital banks held against their remaining assets, making them appear financially
stronger than if the loans were still on the balance sheet.

2. Foreign Exchange (FX) Instruments and Markets

2.1 Overview

Learning Objective
1.2.1 Understand the role, structure and main characteristics of the foreign exchange market: OTC
market; quotes, spreads and exchange rate information; market participants and access to
markets; volume, volatility and liquidity; risk mitigation: rollovers and stop losses; regulatory/
supervisory environment

The foreign exchange market (or forex or FX) is the collective way of describing all the transactions
in which national currencies are exchanged for others, anywhere in the world. The forex market is an
example of a decentralised market, in that it is distributed throughout the world from different trading
terminals and there are no central trading exchanges as in the trading of stocks at the London Stock
Exchange (LSE) or the New York Stock Exchange (NYSE).

The FX market is purely an over-the-counter (OTC) market, conducted electronically through platforms
including those referred to as electronic communications networks (ECNs). It bears a strong resemblance
to the decentralised OTC dealer networks which exist for the trading of most bonds and derivatives.
However, the forex market is dominated by the banks and there are no formal market makers as such
but rather banks which act as dealers. Also, unlike a typical domestic OTC market which is organised
around the opening hours of the domestic stock exchange, the forex market, being decentralised and
truly global, trades 24 hours a day, five days a week, closing effectively after the conclusion of trading in
North America on a Friday and reopening with the onset of trading in Asia on Monday.

2.1.1 Quotes, Spreads and Exchange Rate Information

All foreign exchange quotations involve specifying an exchange rate/relationship between two
currencies. As a general rule of thumb, exchange rates around the world are often quoted against the US
dollar. However a great amount of trading takes place between currencies which do not include the US
dollar. Technically speaking, a cross rate is any foreign currency rate that does not include the US dollar.
For example, the Great Britain pound/Japanese yen (GBP/JPY) is a cross rate.

16
 Cash, Money Markets and the Foreign Exchange (FX) Market

A currency pair is the quotation of the relative value of a currency unit against the unit of another

1
currency in the FX market. The currency that is used as the reference is called the base currency or
transaction currency, and the currency that is quoted in relation to it is called the counter currency or
quote currency.

Currency pairs are written by concatenating currency codes, which are formalised in ISO 4217, of
the base currency and the counter currency, separating them with a slash character. Often the slash
character is omitted. A widely traded currency pair is the relation of the euro against the US dollar,
designated as EUR/USD. The quotation EUR/USD 1.2500 means that one euro is exchanged for 1.2500
US dollars.

The most traded currency pairs in the world are called the majors. They involve the euro (EUR), US dollar
(USD), Japanese yen (JPY), pound sterling (GBP), Australian dollar (AUD), New Zealand dollar (NZD),
Canadian dollar (CAD) and Swiss franc (CHF).

In everyday foreign exchange market trading and news reporting, the currency pairs are often referred
to by nicknames. These are often reminiscent of national or geographic connotations. The GBP/USD
pairing is known by traders as cable, which has its origins from the time when a communications cable
under the Atlantic Ocean synchronised the GBP/USD quote between the London and New York markets.
The following nicknames are also common: fiber for EUR/USD, chunnel for EUR/GBP, loonie for USD/CAD,
aussie for AUD/USD, geppie for GBP/JPY, and kiwi for the New Zealand NZD/USD pairings.

Currencies are traded in fixed contract sizes, specifically called lot sizes, or multiples thereof. The
standard lot size is 100,000 units of the base currency. Retail brokerage firms also offer 10,000 units or
mini-lots.

Leverage is widely employed in forex trading and it is not uncommon for brokerage accounts to offer
leverage of up to 200:1, which can be quite dangerous for the retail investor considering the volatility of
many currency pairs.

Both spot and forward rates are quoted by dealers in the form of a buying rate (the bid) and a selling rate
(the offer). The officially quoted rate is a spot price. In a trading market, however, currencies are offered
for sale at an offering price, the ask price. Traders looking to buy a position seek to do so at their bid
price, which is always lower or equal to the asking price. This price differential is known as the spread.
For example, if the quotation of EUR/USD is 1.1207/1.1209, then the spread is USD 0.0002, or 2 pips. In
general, markets with high liquidity exhibit smaller spreads than less frequently traded markets.

The spread offered to a retail customer with an account at a brokerage firm, rather than a large
international forex market maker, is larger and varies between brokerages. Brokerages typically increase
the spread they receive from their market providers, as compensation for their service to the end
customer, rather than charge a transaction fee. A bureau de change which is used for some retail foreign
exchange transactions will usually have extremely wide spreads and using a high street bank to convert
currencies is not recommended, as the spreads/commissions can be quite exorbitant in comparison to
the rates available to a professional. There are FX dealers who will provide much better rates to retail
customers who need foreign currency for large international purchases/transactions.

17
2.1.2 Main Characteristics of the FX Market
FX is by far the largest type of capital market in the world, in terms of cash value traded, and includes
trading between large banks, central banks, currency speculators, multinational corporations, hedge
funds, governments and other institutions.

The Bank for International Settlements (BIS) provides the most useful information on the size and
turnover of the global forex market. It has conducted a triennial survey every three years since
April 1989, with the most recent having been conducted in April 2019, with the results published in
September 2019. The results of the latest survey can be found on the BIS’s website (bis.org).

It can be seen from these surveys that London continues to be the dominant centre for FX transactions
and the substantial increase in FX trading since 2007 owes much to the increasing importance of the
speculative and trading activity of other institutions, in addition to the large banks which continue to be
the main participants.

2.1.3 Volatility, Volume and Liquidity

The volume of transactions is quite staggering, with an estimated $8.21 trillion in nominal amounts
traded daily. Just as with derivatives, the nominal amount traded is somewhat misleading, since the
speculative activity in forex is focused on the amount that is traded at the margin. In other words, if one
places an order to sell $1 million to purchase £600,000 but only holds the position for a few hours (or
minutes) there is a sense in which the nominal amounts are not really exchanged, but, just as in the case
of a swap or contract for difference (CFD), it is the marginal difference which is really being traded or is
at risk.

Nonetheless, the FX market is extremely liquid and, in the case of major currency pairs such as the EUR/
USD, there is great depth to trading within the interbank market. Some other currency pairs, involving
more exotic or less traded currencies such as the Hungarian forint, will obviously be far less liquid, with
much wider spreads between the bid and the ask than for EUR/USD or GBP/USD.

FX markets can be extremely volatile at times, especially when the markets in other asset classes are
acting in an erratic manner.

The most volatile periods for forex trading are often seen in conjunction with the release of key economic
data. The US Labour Department issues its monthly employment data, more commonly known as the
Non-Farm Payroll (NFP) report, on the first Friday of each month at 08:30 Eastern time, and this can often
be a major mover of foreign exchange rates.

Other economic events which can strongly impact the FX market are releases of inflation data, gross
domestic product (GDP) data and retail sales data from major government organisations such as the
Office for National Statistics (ONS) in the UK, and Eurostat, which provides economic data for the EU.
Also important to the sudden movements of exchange rates are the results of auctions of government
securities and any changes in short-term rates announced by central banks.

18
 Cash, Money Markets and the Foreign Exchange (FX) Market

2.1.4 Risk Mitigation: Rollovers

1
The spot rate is the current market price, also called the benchmark price. Spot transactions do not
require immediate settlement, or payment on the spot. The settlement date, or value date, is the second
business day after the deal date (or trade date) on which the transaction is agreed to by the two traders.
The two-day period provides time to confirm the agreement and arrange the clearing and necessary
debiting and crediting of bank accounts in various international locations.

Rollover is the process of extending the settlement date of an open position in forex. In most currency
trades, a trader is required to take delivery of the currency two days after the transaction date. However,
by rolling over the position – simultaneously closing the existing position at the daily close rate and
re-entering at the new opening rate the next trading day – the trader artificially extends the settlement
period by one day.

Often referred to as tomorrow next, rollover is useful in FX because many traders have no intention of
taking delivery of the currency they buy. Rather, they want to profit from changes in the exchange rates.
Since every forex trade is transacted by borrowing one country’s currency to buy another, receiving
and paying interest is a regular occurrence. At the close of every trading day, a trader who took a long
position in a high-yielding currency relative to the currency that they borrowed will receive an amount
of interest in their account. Conversely, a trader will need to pay interest if the currency they borrow has
a higher interest rate relative to the currency that they purchase.

2.1.5 Risk Mitigation: Stop Losses

In trading foreign exchange, or any instrument for that matter, if one is using proper risk management
techniques, it is customary to establish what is called a stop loss for the position taken. This will provide
a safety mechanism so that, if the trade turns adversely against the trader, the position will be exited at
a pre-determined level.

As an example, let us suppose that an investor has a bullish view on sterling versus the US dollar. The
investor purchases a lot at the spot rate of $1.33 with an expectation that the rate will move to $1.34 in
a short time frame. However, if sterling suddenly starts to drop against the US dollar, perhaps following
some unexpected poor economic news in the UK, then a stop loss level set at $1.32 will get the investor
out of the trade with a loss of only one cent. If there was no stop loss in place and sterling dropped
precipitously, given the leverage levels used in forex trading, it is easy to lose large sums of money
quickly.

There is one important proviso regarding stop losses, however. Even if one sets a stop loss level at $1.38,
as in the example provided, there is no guarantee that the trade will actually be executed at this level.
Depending on the type of order placed and the access that the investor has, if sterling were to drop
quickly in a relatively illiquid market environment, an order might be filled at, say, $1.3760 after the stop
loss level was triggered. This problem with risk management of trading positions is not confined to the
forex market but can be seen across most asset classes including trading in equities, stock index futures
and commodities.

19
2.1.6 The Regulatory Environment
In view of the global reach of the forex market, the regulations covering it, such as they are, will tend to
be regulations relating to the manner in which brokerages operate in different jurisdictions.

The following is a list of some of the regulatory bodies that have regulatory authority and powers within
various jurisdictions.

The Financial Conduct Authority (FCA)

The FCA is an independent non-governmental body, which replaced the Financial Services Authority
(FSA) in April 2013. It has statutory powers provided by the Financial Services and Markets Act 2000.
The FCA regulates the financial services sector in the UK. It has regulation-making, investigatory and
enforcement powers. The FCA is obliged to have regard to the principles of good regulation.

The Prudential Regulation Authority (PRA)

The PRA was formed under the Financial Services Act (2012) and is part of the BoE. It is also one of the
successors to the FSA. Its responsibility is the prudential regulation and supervision of banks, building
societies, insurance companies and larger financial investment firms. The PRA’s main objectives are
to promote the financial safety of these firms and (mainly for insurance companies) to contribute to
ensuring adequate protection for consumers/policy holders.

The National Futures Association (NFA)

The NFA is a self-regulatory organisation for the US futures industry; its purpose is to safeguard market
integrity and protect investors in US derivatives, particularly forex derivatives, by implementing
regulations. Membership of the NFA is mandatory for any futures or forex broker operating in the US. It
is an independent regulatory body, with no ties to any specific marketplace.

The Commodity Futures Trading Commission (CFTC)

Created by Congress, the CFTC was formed in 1974 as an independent agency with the mandate to
issue forex regulations for financial markets in the US. Its regulations encourage competitiveness and
efficiency in the US forex markets and protect market participants against any abusive forex trading
practices.

Various National Authorities

Each country has its own national body for regulating its financial service industry. These are the bodies
that decide on forex regulations, which should ensure that dealers/brokers are obliged to operate in
accordance with that country’s forex trading regulations.

20
 Cash, Money Markets and the Foreign Exchange (FX) Market

2.2 Spot FX Prices

1
Learning Objective
1.2.2 Understand the determinants of spot foreign exchange prices: currency demand –
transactional and speculative; economic variables; cross-border trading of financial assets;
interest rates; free, pegged and managed rates

2.2.1 Currency Demand

The users of the FX market fall into two broad camps:

• Transactional – settling accounts for international trade.

• Speculative – including arbitrageurs and financial engineers using derivatives.

2.2.2 International Trade

FX transactions are partly driven by international trade. Trade can be in either goods or services. Using
the wider definition of trade, to include financial services and financial instruments such as bonds, helps
to explain the bulk of the transactional component to the movements in exchange rates.

From a traditional product perspective, if for example a Japanese company sells goods to a US customer,
they might invoice the transaction in US dollars. These dollars will need to be exchanged for Japanese
yen by the Japanese company and this will require an FX transaction. The Japanese company may not be
expecting to receive the dollars for a month after submission of the invoice. This gives them two choices:

• they can wait until they receive the dollars and then execute a spot transaction, or
• they can enter into a forward transaction to sell the dollars for yen in a month’s time. This will provide
them with certainty as to the number of yen they will receive and assist in their budgeting efforts.

In this section, the discussion will be confined to the spot market. Spot FX dealings are those which
occur with immediate effect where the transaction is settled with reference to the actual or real-time
pricing of foreign currencies in the highly liquid FX market.

2.2.3 Speculation in the FX Market

Speculative transactions are another major factor which account for FX transactions. If an investor thinks
that the US dollar is likely to weaken against the euro, they will buy the euro from the proceeds of selling
dollars in either the spot or forward market and will profit if they are correct.

Other ways in which the FX market provides speculative opportunities are in relation to very small
arbitrage opportunities related to interest rate differentials between two or more countries. Other
speculative activities in FX are related to complex derivative products and swaps created through
financial engineering. Although they will be more focused on the forward market in FX, they will impact
the spot market.

21
2.2.4 The Spot FX Market
In the spot market, the base currency is usually the US dollar. However, when sterling is quoted against
the US dollar, sterling is the base currency and the US dollar is the quoted currency. So, £1 is quoted in
terms of its value in dollars rather than $1 being quoted in terms of its value in pounds.

Speculators and traders in currencies can participate in the forex market by opening accounts with
brokers who will enable them to do one or more of the following:

• trade in the spot market with or without leverage

• trade in the futures markets for currencies which are listed on some futures exchanges, eg, the
Chicago Mercantile Exchange (CME)
• trade via a derivative such as an exchange-traded fund or via a spread betting instrument.

The convention in the spot market is for the exchange rate to be quoted as a mid-rate and then a bid-
offer spread around this mid-rate. The mid-rate is the mid-point between the bid and offer prices.

2.2.5 Economic Variables and Global Capital Flows

When looking at the fundamental factors which help to determine exchange rates, the demand and
supply considerations which arise through international trade and to some extent speculation will be
much influenced by macroeconomic factors within both the world economy and the economies of the
two countries for which a particular exchange rate is being determined. The key factors are as follows.

World Demand and Global GDP

During recessions and periods of slow economic growth, there will be less international trade, as was the
experience in 2009 in the aftermath of the 2007–08 banking crisis. This will tend to affect all countries
and, thus, not greatly influence any specific currency.

Safe-Haven Currencies
During times of economic and financial stress, the US dollar, Swiss franc and Japanese yen have proven
to be the most sought-after currencies. It is also fair to say that the so-called commodity currencies, such
as the Australian and Canadian dollar, will tend to fall in value against the US dollar, especially as the
demand for commodities falls and as these currencies are seen as less safe.

Debt/GDP Ratios
Global capital flows for the purchase of government debt are increasingly affecting global exchange
rates. Those countries or currency unions, in the case of the eurozone, where the public debt/GDP is
relatively high will, on the whole, attract less capital for their respective bond markets and the currencies
will underperform those countries with lower debt/GDP ratios. This is more complex than it appears, as
a country like the UK which has a high debt/GDP ratio also has a separate currency which it can manage
internally, whereas a country like Germany which has a lower debt/GDP ratio is part of the eurozone and
has seen the value of its currency – the euro – fall more with respect to the dollar as a result of the high
debt/GDP ratios of its other eurozone partners.

22
 Cash, Money Markets and the Foreign Exchange (FX) Market

Interest Rates and the Carry Trade

1
One of the principal driving factors for speculative capital flows is to exploit interest rate differentials
between countries. This has given rise to what is called the forex carry trade. In essence, large
institutional investors such as hedge funds will borrow funds in a currency where there is a relatively
low borrowing rate, eg, the yen, and will invest those funds, after converting to another currency such
as Australian dollars, where there is a higher rate of interest available for short-term deposits. The spread
between the borrowing cost and the interest-earning rates motivates the trades, but this will also affect
the cross rates.

Economic Growth and Outlook

Capital flows are a primary determinant of exchange rates, decisions made by investors regarding the
attractiveness of investments in international equities and fixed-income investments. If an individual
economy reveals positive economic fundamentals, such as a relatively high rate of annual GDP growth,
low inflation and stable monetary policy, this will prove more attractive to foreign investors than those
economies which are stagnating and where there is a much more uncertain economic outlook.

Capital Account Flows

There are considerable imbalances in the global trade of goods and services, with many nations
running large deficits on their visible trade accounts (ie, the trade in products) and having to export
more invisibles (eg, financial services) while attracting capital flows from the large surplus nations. The
trading relationship between China and the US provides a good illustration of this. In 2016, their trade
deficit between was $347 billion, with similar amounts having been seen for several years. In order to
finance these persistent deficits, the US has had to export a huge supply of US Treasury securities to the
Chinese central bank (the People’s Bank of China (PBOC)), and these appear on the capital account of the
balance of payments between China and the US. Although China has been reducing its exposure to US
Treasuries of late, according to some estimates, the PBOC owns over $1 trillion of US government bonds
and agency securities, ie, government-sponsored enterprise (GSE) obligations.

2.2.6 Determination of Exchange Rates

Free Floating
The FX system which has emerged, for much of the global economy, has some elements of management
of rates by central banks and governments, but is largely a system which is described as free floating.

• Pure free float is when no government intervention takes place and only market force rates
determine exchange rates.
• The present-day system is largely based upon the activities of the large banks and other institutions
which are conducting transactions between themselves in the forex market.
• The central banks can issue policy statements and from time to time may intervene directly into the
market to buy or sell their currency or another currency from their reserves.
• Central banks will attempt to guide the markets with respect to determining factors such as interest
rates, trade policies and other capital market incentives.

In contrast to (more or less) freely floating exchange rates, there are alternative models which have been
used historically and which could conceivably reappear in the future.

23
Managed Floating
• If market forces are interspersed with intervention by government via central banks, the term used
is managed floating.
• To keep a currency within specified bands, interest rates can be manipulated to induce foreigners to
either buy or sell the currency.
• Exchange controls can be applied – ranging from direct controls on the flow of currency to
withholding taxes and export controls.
• Retaliation and administration costs/losses from speculation are big costs involved in interventionism.

Fixed Exchange Rates (Pegged)

The post-1945 era saw a period of rigid fixed exchange rates in which no floating was permitted. There
was a rigid regulation of market forces to ensure that currencies were pegged. This was less arduous in
that era, as there was so much less free movement of capital around the globe than there is today.

• Under this fixed rate regime all central banks cooperated to achieve fixed rates.
• Sometimes, if market forces become too misaligned countries are forced into devaluations or
revaluations.
• Sterling was devalued on 19 September 1949, as the pound/dollar rate was reduced by 30%, from
US$4.03 to US$2.80.
• In the mid-1960s the pound came under renewed pressure, since the exchange rate against the
dollar was considered too high. In the summer of 1966, with the value of the pound falling in the
currency markets, exchange controls were tightened by the Wilson government.
• Among the measures, tourists were banned from taking more than £50 out of the country, until the
restriction was lifted in 1970.
• The pound was eventually devalued by 14.3% to US$2.41 in November 1967.
• Since then the currency has floated with respect to the US dollar.

Consequences of Floating Exchange Rates

• Free floating allows for natural adjustments to disequilibrium in the balance of payments.
• Market forces eventually become so overwhelming that governments cannot control the exchange
rate.
• Having to maintain a fixed rate of exchange gets in the way of other government objectives.
• Raising interest rates to protect a fixed rate of exchange may be unhelpful from other monetary and
fiscal perspectives – as it was in the UK in September 1992.

The Euro
In a referendum in June 2016, the UK voted to leave the EU (Brexit). Article 50 is part of European law,
provided for in the 2009 Treaty of Lisbon which made provision for any country that wishes to exit the
EU. On 28 March 2017, the UK Prime Minister signed a letter invoking Article 50 which was submitted on
29 March 2017 to the EU. The UK officially left the EU in January 2020 and since then most EU Regulations
impacting financial services have been carried over into UK law.

24
 Cash, Money Markets and the Foreign Exchange (FX) Market

An issue for the UK in relation to its FX rate policy is the status of sterling with regard to the trading

1
currency of what have been its most important trading partners in the eurozone – the euro.

• The euro is the official currency of many of the EU member states known as the ‘eurozone’.
• The euro is the single currency for more than 300 million people in Europe.
• Including areas using currencies pegged to the euro, the euro affects more than 480 million people.
• The euro was introduced to world financial markets as an accounting currency in 1999 and launched
as physical coins and banknotes in 2002. All EU member states are eligible to join if they comply with
certain monetary requirements, and eventual use of the euro is mandatory for all new EU members.
• Among EU countries that are not using the euro are Denmark and Sweden
• The euro is managed and administered by the Frankfurt-based ECB and the European System of
Central Banks (ESCB) (composed of the central banks of its member states).
• As an independent central bank, the ECB has sole authority to set monetary policy. The ESCB
participates in the printing, minting and distribution of notes and coins in all member states, and
also the operation of the eurozone payment systems.

Reserve Currencies
• The euro is widely perceived to be one of two, or perhaps three, major global reserve currencies,
making inroads on the widely used US dollar, which has historically been used by commercial
and central banks worldwide as a stable reserve on which to ensure their liquidity and facilitate
international transactions.
• A currency is attractive for foreign transactions when it demonstrates a proven track record of
stability, a well-developed financial market to dispose of the currency in, and proven acceptability to
others. While the euro has made substantial progress towards achieving these features, there are a
few challenges that undermine the ascension of the euro as a major reserve currency.
• The Chinese renminbi (RMB), also referred to as the Yuan (CNY), is one of the world’s reserve
currencies and was pegged to the US dollar until 2005. Since 2012, RMB has been allowed to float
but within a narrow margin set by a basket of global currencies.

2.3 Forward Exchange Rates

Learning Objective
1.2.3 Be able to calculate forward foreign exchange rates by adding or subtracting forward
adjustments; interest rate parity
1.2.4 Be able to analyse how foreign exchange contracts can be used to buy or sell currency relating
to overseas investments or to hedge non-domestic currency exposure: spot contracts; forward
contracts; currency futures; currency options; non-deliverable forwards

2.3.1 Quoting Forward Exchange Rates

When considering a quotation for a currency pair, it is important to distinguish between the base
currency and the quote currency. Interpreting an FX quote should follow two simple rules: the currency
first quoted is the base currency and this is followed by the quote currency; the second rule is that the
value of the base currency is always equal to one. For example, if the spot FX quote is for USD/CAD and
the rate quoted is 1.3085 (on the bid), this shows that one can sell one US dollar to purchase 1.3085
Canadian dollars in the spot market.

25
Many FX pairs are quoted with the US dollar as the base currency, but there are three important
exceptions which are for sterling (GBP), the Australian dollar (AUD), and for the euro (EUR), when it is
customary for these three currencies to be the base currency in each quotation and the US dollar is the
quote currency.

For example, in the case of GBP/USD, the base currency is GBP or sterling and the quote currency is the
US dollar.

One further convention to note is that it is customary in the FX market to specify a quotation to four
decimal places (in most cases with the exception of quotations which involve the Japanese yen) and the
smallest unit to four decimal places is referred to as a pip or point. For example, the difference between
a spot quotation of £1 = $1.3160 and £1 = $1.3220 is 60 pips.

A simple rule is that all exchange rates in the forex market are expressed using the following:

Base currency/quote currency = Bid/ask

Example
A spot quotation for GBP/USD of £1 = $1.3220/24 shows the bid/offer spread (with a four pip spread
between the bid/offer). The bid is the price at which one can sell the base currency and the offer is the
price at which one can buy the base currency. So, a US dollar-based investor (the quote currency in this
instance) will need to pay $1.3224 (the offer price) to purchase £1, and will receive $1.3220 (the bid
price) if selling £1 in exchange for dollars.

2.3.2 Interest Rate Parity

The concept of interest rate parity in determining the exchange rate between currencies arises from one
of the cornerstone ideas in financial theory, which is that of rational pricing and the notion of arbitrage.

Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free
price of the asset as any deviation from this price will be arbitraged away.

Arbitrage is the practice of taking advantage of a pricing anomaly between securities that are trading
in two (or possibly more) markets. One market can be the physical or underlying market; the other can
often be a derivative market.

When a mismatch or anomaly can be exploited (ie, after transaction costs, storage costs, transport costs
and dividends), the arbitrageur locks in a risk-free profit. In general terms, arbitrage ensures that the law
of one price will prevail. Interest rate parity results from recognising a possible arbitrage condition and
arbitraging it away.

Consider the returns from borrowing in one currency, exchanging that currency for another currency
and investing in interest-bearing instruments of the second currency, while simultaneously purchasing
futures contracts to convert the currency back at the end of the investment period. Under the
assumption of arbitrage, the returns available should be equal to the returns from purchasing and
holding similar interest-bearing instruments of the first currency.

26
 Cash, Money Markets and the Foreign Exchange (FX) Market

If the returns are different, investors could theoretically arbitrage and make risk-free returns. Interest rate

1
parity says that the spot and future prices for currency trades incorporate any interest rate differentials
between the two currencies.

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 simply
given by the differential between their respective nominal interest rates over the term being considered.
The relationship is purely mathematical and has nothing to do with market expectations.

The idea behind this relationship is embodied in the principle of interest rate parity and is expressed as
follows:

Forward rate for GBP/USD = £ Spot rate X

  [ ( 1 + US $ Short-term interest rate)
(1 + UK £ Short-term interest rate)
[

Example
The GBP/USD spot exchange rate = 1.3220. If the three-month interest rate for the UK is 4.88% and for
the US, 3.20%, what will the three-month forward exchange rate be?

As the three-month interest rates are quoted on a per annum basis, they must be divided by four
to obtain the rate of interest that will be payable (%) over three months (it could also be calculated
according to the more complex market convention of using actual days or 30/360 days for each month.
See chapter 2, section 6.6.3 for day count conventions):

Sterling: 4.88%/4 = 1.22%

Dollar: 3.20%/4 = 0.8%

Applying the interest rate parity formula:

Forward rate for GBP/USD = $1.3220 X

   
(1 + 0.008)
(1 + 0.012) [ [ = $1.3165

The forward exchange rate in the above example of $1.3165 is lower than the spot exchange rate of
$1.3220. That is, in three months’ time, £1 will buy $1.3165, or $0.0055 fewer dollars than is available at
the spot rate (ie, the difference is 55 pips). If this relationship did not exist, then an arbitrage opportunity
would arise between the spot and forward rates.

It is important to realise that the forward rate calculated under the notion of arbitrage and interest rate
parity is not a forecast of what the rate of exchange will actually be in three months. The actual rate will
vary according to all of the factors which influence exchange rates in the forex market. The three-month
forward rate in this example is simply a mathematically derived rate resulting from the interest rate
differentials prevailing between the two currencies being exchanged.

27
2.4 Currency Contracts: Spot, Forward and Future
Foreign currency risk can be reduced, though not completely eliminated, by employing the following
hedging instruments or strategies:

• spot contracts
• forward contracts
• foreign currency options
• foreign currency futures, and
• currency swaps.

2.4.1 FX Transactions
In conducting FX transactions, there are several ways to proceed depending on the purpose of the
transaction. The purposes include the purchase of a foreign asset by an investor, the settlement of an
international trade in merchandise or services, the need to hedge an investment or the need to lock in
a particular exchange rate for a future purchase at a price which is known and can be specified today.

2.4.2 Spot Contracts

If one requires immediacy in the transaction the most appropriate form of transaction will
involve entering into a spot contract. The term spot is used in a number of markets as well as
the FX market and refers to the current price of an asset which can normally be obtained in
real time. In the interbank forex market, which trades 24 hours a day, it is always possible to find the
exact pricing on a foreign exchange by regarding the prices prevailing at the time of inquiry. Other
markets where spot prices are used are in the commodities area, where, for example, the spot price of
gold is determined at a fixing each day in London. Crude oil is also often quoted on a spot basis.

A typical euro/US dollar (EUR/USD) spot quote might look something like this:

EUR/USD spot rate = 1.1360/1.1365

Conventionally, the quote might be simplified as simply 60/65, since FX traders are more focused on the
pip values at the end of the quote rather than the big figure values, which are less likely to be changing
so rapidly during daily trading.

The bid is the price at which one can sell the base currency and the offer is the price at which one can
buy the base currency. So, in the example just cited, a dollar-based investor (the quote currency in this
instance) needs to pay $1.1365 (the offer price) to purchase one euro, and will receive $1.1360 (the bid
price) if selling one euro in exchange for US dollars. The difference between the buyer’s and seller’s rates
is generally referred to as the bid-offer spread. It enables the bank offering the deals to make money.

Entering into a spot contract can be done with a bank and there may be commissions and transfer
charges involved. Settlement will normally be executed within a maximum of 48 hours, at which time
the foreign currency funds are available. Speculators in the forex market will often use spot prices for
trading purposes, and in the very active interbank market the bid/ask spreads may be tighter than those
shown in the above example.

28
 Cash, Money Markets and the Foreign Exchange (FX) Market

2.4.3 Forward Contracts

1
The forward market is almost exactly the same as the spot market, except that currency deals are agreed
for a future date, but at a rate of exchange fixed now. These rates of exchange are not directly quoted.
Instead, quotes on the forward market state how much must be added to, or subtracted from, the
present spot rate.

For example, the three-month GBP/USD quote might be:

spot $1.3055–$1.3145
three-month forward $1.00–0.97c pm

pm stands for premium. It is used when the dollar is going to be more expensive relative to sterling in
the future. It is deducted from the quoted spot rate in order to arrive at the forward rate. £1 will buy
fewer dollars in three months’ time and, if you have dollars in three months’ time, the bank will sell you
more sterling per dollar than they will now. The premium is quoted in cents, unlike the spot rate, which is
quoted in dollars. So, 1.00 pm is a premium of 1 cent or 0.01 dollars (100 pips), and 0.97 pm is a premium
of 0.97 cents or 0.0097 dollars (97 pips).

The three-month forward quote is, therefore: $1.2955–$1.3048.

Alternatively the three-month forward rate may exhibit a discount, rather than a premium, for example:

spot $1.3055–$1.3145
three-month forward 0.79–0.82c dis

‘dis’ stands for discount. The discount is used when the dollar is going to be cheaper relative to sterling
in the future. It needs to be added to the quoted spot rate to arrive at the forward rate. £1 will buy more
dollars in three months’ time and, if you have dollars in three months’ time, the bank will sell you less
sterling per dollar than they will now. The three-month forward quote is therefore:

three-month forward $1.3134–$1.3227

The logic is that the forward rate will always exhibit a wider spread than the spot rate.

A variant of the forward contract is a non-deliverable forward (NDF). As the name suggests, the
contract does not result in the exchange of notional currencies. It is usually a short-term forward
contract where the counterparties agree to take the opposite sides of a currency trade, at a set notional
amount and exchange rate. At maturity, the profit/loss is calculated by taking the difference between
the contracted exchange rate and the spot rate.

It is estimated that more than 60% of NDFs are traded for speculation purposes with the main base
currencies being the US dollar or euro.

29
2.4.4 Currency Futures Contracts
The interbank market has grown enormously since the abandonment of the fixed exchange rate regime
in the early 1970s. The major FX players are the multinational banks, and the OTC market in forex dealing
is the largest capital market by far in operation on a daily basis, with trillions of dollars in nominal terms
traded each day.

Most of the transactions which take place will be within the interbank market and will employ either
spot contracts, forward contracts or swap arrangements. There are, however, futures contracts, which
can also be used in FX, and these can be useful in relation to hedging.

A futures contract is an exchange-traded transaction where a standardised asset – such as 100 barrels of
West Texas Intermediate crude oil, a stipulated monetary value of a stock index such as the S&P 500, or
a stipulated amount of a foreign currency – is traded for delivery at a pre-determined date in the future
at a price which is established at the time at which the futures trade takes place. The buyer of the futures
contract agrees to take delivery, or, as is much more common, make a cash settlement for the item
traded at a future date, whereas the seller of the contract agrees to deliver the item traded, or again, as
is much more common, to make a cash settlement which covers the difference between the spot price
prevailing for that item in the marketplace at the time of the delivery versus the price agreed at the time
at which the parties entered the futures contract.

Currency futures were first created at the Chicago Mercantile Exchange (CME) in 1972, less than one year
after the system of fixed exchange rates was abandoned along with the gold standard. The International
Monetary Market (IMM), a division of the CME, was launched and trading began in seven currency
futures in May 1972. Other futures exchanges that trade currency futures are NYSE Liffe, the Tokyo
Financial Exchange and the Intercontinental Exchange (ICE).

As with other futures and options, the conventional maturity dates are the IMM dates, namely the third
Wednesday in March, June, September and December.

Futures contracts can be used to hedge against FX risk. If an investor will receive a payment
denominated in a foreign currency on some future date, that investor can lock in the current exchange
rate by entering into an offsetting currency futures position that expires on the date that the payment
should be received.

Example
A US-based investor expects to receive €1,000,000 on 1 December. The current exchange rate implied by
the futures is $1.2/€. One can lock in this exchange rate by selling €1,000,000 worth of futures contracts
expiring on 1 December. By doing so, the investor has guaranteed an exchange rate of $1.2/€ regardless
of exchange rate fluctuations in the meantime.

Currency futures can also be used to speculate as the following example shows.

30
 Cash, Money Markets and the Foreign Exchange (FX) Market

Example

1
A speculator buys ten September CME Euro FX Futures, at $1.2713/€. At the end of the day, the futures
close at $1.2784/€. The change in price is $0.0071/€. As each contract is equivalent to €125,000, and the
speculator has ten contracts, their profit is $8,875. Being an exchange-traded contract the settlement
takes place immediately.

One of the drawbacks of the above examples is that the timing and the amounts of futures contracts, as
they are standardised, do not provide for the kind of customisation which many investors and merchants
require when wanting to engage in a foreign currency transaction.

2.4.5 Currency Swaps (Foreign Exchange Swap, Forex Swap, or FX

Swap)
A short-term currency swap is a contract that commits two parties to exchange pre-agreed foreign
currency amounts now and to re-exchange them back at a given future date (the maturity date).

One currency is defined as the primary currency, and most deals are structured so that the nominal
value of the primary currency exchanged on the two dates is equal. The other currency is the secondary
currency, and the nominal value of this exchanged on the two dates is a function of the spot rate and the
swap market forward rate.

The terms ‘buyer’ and ‘seller’ relate to these swap arrangements from the point of view of the primary
currency cash flows at inception. The buyer is the person who, at inception, purchases the primary
currency (selling the secondary currency). The seller is the individual who, at inception, sells the primary
currency (buying the secondary currency).

From a diagrammatic perspective, the following example shows a simple short-term currency swap
involving sterling and the US dollar. The buyer is the purchaser of the primary currency, which is the US
dollar in this instance, and the seller is the seller of the dollars and the purchaser of the agreed amounts
of sterling.

31
 Buyer Seller

Buy $1.5m Primary Currency

Inception Inception

Sell £1m Secondary Currency

Sell $1.5m Primary Currency

Maturity Maturity

Buy £0.9m Secondary Currency

2.4.6 Synthetic Agreement for Forward Exchange (SAFE)

A SAFE is a variation on the short-term currency swap, in which there is no actual exchange of principal
at inception or at maturity, the arrangement being a CFD based on notional cash sums. In this case, large
notional sums may be referenced in the swap agreement but the resulting cash flow may be relatively
small, especially if there has been only a slight variation between the rates at the time of inception and
at the time of maturity.

When the two parties agree to execute a SAFE, they agree the exchange rates at which the notional deals
will be executed at inception and maturity. At maturity, one party pays to the other the difference in the
value of the secondary currency between the rate originally contracted and the rate actually prevailing.
In essence this is exactly how a CFD for any asset purchase works, including equity CFDs.

2.4.7 Currency Options Contracts

A currency option is a form of contract which confers the right but not the obligation for the purchaser
of the option to buy or sell a currency at a pre-agreed exchange rate on a specified date which is
established at the time when the contract is agreed. The execution of the contract results in a forex
option trade.

Most of the FX option volume is traded OTC and is lightly regulated, but a fraction is traded on exchanges
like the International Securities Exchange (ISE), the Philadelphia Stock Exchange (PHLX), or the CME for
options on futures contracts.

32
 Cash, Money Markets and the Foreign Exchange (FX) Market

Example

1
It is conventional for forex quotes to be made to four decimal places. For example, even if the rate of
exchange between sterling and the dollar was exactly £1 = $2 the convention is that the mid-rate (ie, the
mid-point between the bid and the ask) should be quoted as £1:$2.0000.

A GBP/USD FX option might be specified by a contract giving the owner the right, but not the obligation,
to sell £1,000,000 and buy $2,000,000 in three months’ time. In this case the pre-agreed exchange rate,
or strike price, is 2.0000 USD per GBP (or 0.5000 GBP per USD) and the notionals are £1,000,000 and
$2,000,000.

This type of contract is both a call on dollars and a put on sterling, and is often called a GBP/USD put
by market participants, as it is a put on the exchange rate; it could equally be called a USD/GBP call, but
market convention is quote GBP/USD (USD per GBP).

Let us assume that the rate is 1.9000 or lower than 2.0000 in three months’ time, meaning that the dollar
is stronger than the rate stipulated in the option (and the pound is weaker). The option will be exercised,
allowing the owner to sell GBP at 2.0000 and immediately buy it back in the spot market at 1.9000.

The result of this exercise of the option is that a profit of (2.0000 GBP/USD–1.9000 GBP/USD) x 1,000,000
GBP = 100,000 USD can be made in the process. From a sterling perspective, this will amount to
$100,000/1.9000 = 52,631.58 GBP.

33
 End of Chapter Questions

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

1. What are the age and residency requirements in order to invest in a cash individual savings account
(ISA)?
Answer reference: Section 1.1.6

2. Provide a simple formula which illustrates how to determine the real interest rate available as a
return from holding a security.
Answer reference: Section 1.1.8

3. What is the current level of protection provided to depositors at UK-licensed, deposit-taking

institutions and where is this level stipulated?
Answer reference: Section 1.1.9

4. What is the key characteristic and purpose of a gilt repo?

Answer reference: Sections 1.2.4 and 1.4

5. What does the term ‘cross rate’ in the foreign exchange market, when used in its precise sense,
mean?
Answer reference: Section 2.1.1

6. Explain what is meant by rolling over a position in the foreign exchange (FX) market.
Answer reference: Section 2.1.4

7. Explain what is meant by the term ‘managed floating’ in relation to exchange rates and give an
example of when that mechanism has been used.
Answer reference: Section 2.2.6

8. If the sterling/US dollar spot exchange rate is $1.3500, and the three-month interest rate for the UK
is 1.35% and for the US, 0.65%, what will the three-month forward exchange rate be?
Answer reference: Section 2.3.2

9. If the three-month rate of interest is lower in the eurozone than in the US, would the EUR/USD
forward rate be higher or lower than the spot rate?
Answer reference: Section 2.3.2

10. If the spot rate for sterling against the US dollar is $1.3420–$1.3426, and a three-month discount of
0.57c–0.63c is quoted, then what would be the quotation for the three-month forward exchange?
Answer reference: Section 2.4.3

34
Chapter Two

2
Fixed-Income Securities
1. Fixed-Income Securities 37

2. Corporate Debt 57

3. Eurobonds 63

4. Issuing Fixed-Income Securities 66

5. Fixed-Income Markets and Trade Execution 75

6. Present Value, Yield and Conversion Calculations 88

This syllabus area will provide approximately 20 of the 80 examination questions

36
 Fixed-Income Securities

1. Fixed-Income Securities

1.1 Characteristics of Fixed-Income Securities

2
Learning Objective
2.1.1 Understand the main characteristics of fixed-income securities: short-, medium- and long-
dated; dual-dated; floating rate; zero coupon; use of ratings; credit enhancements
2.1.2 Understand the main risks of fixed-income securities: the impact of ratings; the concept of risk-
free; currency, credit and inflation risks

Fixed-income securities (or bonds) are effectively loans with the features of most of this type of
instrument being as follows:

• Maturity date – fixed-income securities are usually established for an agreed period of time and the
issuer will repay (redeem) the loan at maturity.
• Interest – fixed-income securities will usually pay a fixed or variable rate of interest to the
bondholders on set dates (often half yearly or quarterly) for the period of the loan.

These features are consistent among most bonds, whether the issuers are governments, municipal
authorities, other public bodies or corporates.

1.1.1 Short-, Medium- and Long-Dated Bonds

In many bond markets, the instruments are subdivided or categorised based on the period of time that
remains until the bond matures:

A typical classification is as follows:

• Short – less than seven years to redemption.

• Medium – between seven and 15 years to redemption.
• Long – over 15 years to redemption.

However, the ranges in some countries can be different. For example, in the US, government bonds are
classed as short-term (one to five years), medium-term (six to 12 years) and long-term (greater than 12
years).

Dual-Dated Gilts
Some fixed-interest securities have two specified redemption dates and the issuer can choose to repay
the bond at any point between the two dates. The maturity classification applied to dual-dated gilts is
short-, medium- or long-dated, depending upon the time remaining to the later of the two dates.

37
Example
5% DEF plc 2023–27 corporate bond enables the issuer to choose to redeem the bond at the earliest
in 2023 and at any time up to the later date of 2027. What would make the issuer redeem early or late?

The answer may depend upon the interest rates at the time. If, in 2023, the interest rate that the issuer
has to pay to provide the funds for redemption is only 4%, then it will redeem at the earliest point –
saving 1% pa. In contrast, if the interest rate is greater than 5%, the issuer would not redeem, potentially,
until it was forced to in 2027.

1.1.2 Fixed- or Floating-Rate Bonds

With many bonds, such as government bonds, the periodic coupon payment is usually a fixed amount
which is established at the time of issue.

Government-sponsored entities, such as the Federal National Mortgage Association (Fannie Mae) in
the US, have been issuers of floating rate bonds, where the coupon rate varies. The rate is adjusted in
line with published, market interest rates. The published interest rates that are normally used are based
on the LIBOR. LIBOR is the average rate at which banks in London offer loans to other banks. LIBOR
was previously published by the British Bankers’ Association (BBA) using quotes provided by a panel of
banks.

In 2013, however, following a LIBOR-fixing scandal that came to prominence in 2012–13 when several
banks received large fines, individual traders were put on trial, and a criminal investigation into LIBOR
manipulation was carried out by the UK Serious Fraud Office, with NYSE Euronext being awarded
the contract by the FCA to take over and reform the running of LIBOR. From early 2014, LIBOR was
calculated by an entity owned by NYSE Euronext, but following the takeover of NYSE Euronext by
the Intercontinental Exchange (ICE), the entity is now called ICE Benchmark Administration ltd and is
overseen by the FCA.

Immediately after 31 December 2021, the sterling, euro, Swiss franc and Japanese yen settings, and
the one-week and two-month US dollar settings will cease to be provided and will be replaced by
alternative benchmark rates. Immediately after 30 June 2023, the remaining US dollar settings will cease
to be provided.

Sterling LIBOR will be replaced by the Sterling Overnight Index Average (SONIA) and US dollar LIBOR
replaced by the Secured Overnight Financing Rate (SOFR).

Floating rate notes (FRNs) typically add a margin to the LIBOR rate, measured in basis points (bps), with
each basis point representing one hundredth of 1%. A corporate issuer may offer floating rate bonds
to investors at three-month sterling LIBOR plus 75 basis points. If LIBOR is at 4%, the coupon paid will
be 4.75%, with the additional 75 basis points compensating the investor for the higher risk of payment
default.

38
 Fixed-Income Securities

1.1.3 Zero Coupon Bonds (ZCBs)

A zero coupon bond (ZCB) is, as the name suggests, a bond which has a single repayment amount,
which is received at the end of the term without any interim coupon payments. Its yield is calculated
through assessing the rate of return between the eventual payment and the discounted amount which

2
is paid for the bond at the time of issue or purchase.

1.1.4 Credit Ratings

Bondholders face the risk that the issuer of the bond may default on its obligation to pay interest and/or
the principal amount upon maturity. The risk of default is referred to as credit risk and can be assessed in
terms of the probability that an issuer will default on some, or all, of its payment obligations, resulting in
a loss to the bondholder. There are several independent credit rating agencies that assess and report on
this degree of likelihood. Three companies in particular are heavily relied on and their ratings therefore
affect the price of the bonds (see also section 6.2.2 of this chapter).

The three main credit rating agencies that provide these ratings, independent of one another, are
Moody’s, Standard & Poor’s (S&P) and Fitch Ratings. 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, speculative or junk bonds. Investment grade issues offer the greatest safety and
liquidity.

The three rating agencies use similar methods to rate issuers and individual bond issues. They assess
whether the cash flow generated by the borrower will comfortably service and, ultimately, repay the debt.
The table below provides an abridged version of the credit ratings available from the three agencies.

Risk Moody’s S&P Fitch Ratings

Investment Grade Aaa to Baa3 AAA to BBB– AAA to BBB–
Speculative Grade Ba1 to B3 BB+ to B– BB+ to B–
High Likelihood of Bankruptcy Caa to Ca CCC to C CCC to C
Bankrupt or in Default C D D

Credit enhancement is often a key part of the securitisation transaction when issuing securities that are
backed by assets, such as loans (see also section 6.2.5 of this chapter).

1.1.5 Credit Rating Agencies

Many governments have the highest credit ratings of those issued by the big three global credit rating
agencies. The highest rating for both S&P and Fitch Ratings is AAA, while the highest rating for Moody’s
is Aaa.

In recent years, the UK, Norwegian and German governments, among others, have enjoyed the highest
credit rating available from these agencies. However, in June 2016, after the result of the EU Referendum,
the UK had its credit rating outlook cut to negative by Moody’s who stated that the result would herald

39
‘a prolonged period of uncertainty’. Moody’s was the first ratings agency to take concrete action after the
Brexit vote. While traditionally the UK often enjoyed a AAA status, at the time of writing (June 2021),
the UK rating stood at AA with S&P (with a stable outlook) AA- with Fitch (with a negative outlook), and
Aa3 with Moody’s (also with a stable outlook). The cutting of a credit rating makes it more expensive for
governments to raise money with their sovereign bond issues, as it will require higher coupon payments
to attract investors who perceive more risk in a lower-rated government bond.

1.1.6 Risk Free

Government bonds have historically been described as risk free, since the assumption is made that
governments do not default on their debt. While this has been largely true, there have been academic
studies by Harvard professor Stephen Rogoff which illustrate that many governments have either
defaulted or partially defaulted on their obligations.

In recent times, with concerns about the possible default of the government debt of eurozone countries,
the issue has been raised that there is a difference between sovereign borrowers that can pay back debt
by simply issuing more of their own currency, and those which cannot. The US and UK are able to print
more sterling and dollars in order to service their debts, whereas eurozone countries are not in that
position: they cannot print more euros as that role is restricted to the European Central Bank (ECB).

Printing more currency to service debts is only done in extreme circumstances, and it may have unwanted
consequences, such as provoking a currency crisis, but from a theoretical point of view the facility of
printing more money provides a slightly unorthodox reassurance that most government debt is risk-free.

1.1.7 Index-Linked Bonds

Index-linked bonds (such as index-linked gilts and US Treasury Inflation-Protected Securities (TIPS))
differ from conventional bonds in that the coupon payments and the principal are adjusted in line with
a published index of price inflation. This means that both the coupons and the principal on redemption
paid by these bonds are adjusted to take account of inflation since the bond’s issue. Assuming inflation
is positive, the nominal amount outstanding of an index-linked bond is less than the redemption value
that the government will pay on maturity.

Because these bonds are uplifted by increases in the relevant price index, they are effectively inflation-
proof. In times of inflation, they will increase in price and preserve the purchasing power of the
investment. In a period of zero inflation, index-linked bonds will pay the coupon rate with no uplift and
simply pay back the nominal value at maturity.

The UK offers a number of index-linked gilts, as do a number of other governments including the US,
France, Germany and Japan.

40
 Fixed-Income Securities

2
Source: https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/czbh/mm23

1.2 Characteristics of Government Bonds

Learning Objective
2.2.1 Understand the main investment characteristics, behaviours and risks of government debt (for
example, USA, Germany, Japan and the UK)

1.2.1 Governments Bonds

Government bonds are dominant in the bond markets, with most modern governments running a
budget deficit leading to the large-scale issuance of bonds. Sometimes, the secondary market is run on
stock exchanges (as in Germany and the UK) and sometimes outside stock exchanges (as in the US). Like
any type of bond, government bonds have the exposure to risk.

Credit risk is the risk of a default of the issuer. Some regard them as near risk-free as a government has
various ways in which to raise money to continue to pay interest and make repayment at maturity.
However, historically, government defaults have been known, eg, Russia in 1998 and Argentina
numerous times since 2001.

For holders of a bond denominated in a currency of a different country, currency risk presents itself as
there is a risk that the value of the currency repaid will be less than the investors’ own currency. Most
bonds, apart from those that are index-linked, also carry inflation risk which is the risk that the value of
the funds paid as interest or at maturity will decline in real terms over time.

41
US
In the US, the Treasury issues government bonds known as Treasury bills and Treasury notes. There are
also TIPS. The management of government debt is the responsibility of the Bureau of the Fiscal Service.

US Treasury securities are extremely liquid and all trade on the secondary market. The US Treasury
ten-year note is widely quoted and acts as a benchmark when evaluating the performance of US
government stocks.

Germany
The German Federal Government issues bonds called Bunds (from Bundesanleihen). Maturities generally
range from two to 30 years. Index-linked German government bonds have been added recently to bond
market offerings.

German bonds are considered a benchmark in Europe and of being of the highest quality despite the
introduction of the euro. They are auctioned in the primary market and traded in the secondary market
on various German exchanges.

Japan
Japanese Government Bonds (JGBs) are issued by the Ministry of Finance in Japan and play a huge role
in the financial securities market in Japan. They are the most popular market for government bond
dealers across Asia and its ten-year bond is one of the most price-tracked across the globe.

JGBs are issued with a range of two to 40 years, with the ten-year bond usually providing a benchmark to
establish the level of demand for other JGBs, such as 20- and 30-year bonds. Japan is regularly regarded
as a stable bond issuer with JGBs regularly used as a safer haven in times of turbulence. The secondary
bond market is split between trading on the stock exchange and transactions that are made over-the-
counter (OTC). OTC is the dominant trading method. However, two-year, five-year, ten-year, 20-year,
30-year and 40-year fixed-rate JGBs are listed on the stock exchanges in Tokyo and Nagoya.

UK
Bonds issued, serviced and managed by the UK's Debt Management Office (DMO) on behalf of the UK
Treasury are known as gilts. Like other bonds, UK gilts are issued with a given nominal value that will be
repaid at the bond’s redemption date and a coupon rate representing the percentage of the nominal
value that will be paid to the holder of the bond each year. Obviously, different gilts have different
redemption dates and the coupon is payable at different points of the year (generally at semi-annual
intervals). Older issues are named Treasury or exchequer stocks while newer issues are known as
Treasury gilts. Those that are index linked are known as index-linked gilts.

Typically, UK gilts have maturities stretching much further into the future than other European
government bonds, which has influenced the development of pension and life insurance markets in the
respective countries.

42
 Fixed-Income Securities

Example
Gilts are denoted by their coupon rate and their redemption date, for example 6% Treasury Stock 2028.
The coupon indicates the cash payment per £100 nominal value that the holder will receive each year.

2
This payment is made in two equal semi-annual payments on fixed dates, six months apart. An investor
holding £1,000 nominal of 6% Treasury Stock 2028 will receive two coupon payments each year of £30
each, on 7 June and 7 December, until the repayment of the £1,000 on 7 December 2028.

1.2.2 Term of Government Debt

Government debt, such as UK gilts, can be divided into three broad classes:

• short-, medium- and long-dated

• dual dated
• undated (the last remaining undated bonds in the UK gilt category were redeemed on 5 July 2015.
This concluded a process first initiated by the Chancellor of the Exchequer in October 2014 against
the backdrop of prevailing historically low long gilt yields).

1.2.3 Separate Trading of Registered Interest and Principal (STRIP)

Some of the UK gilt issuance can be stripped into individual cash flows, ie, the periodic coupon payments
as well as the eventual repayment of the principal. All of these cash flows can be traded separately as
zero coupon gilts or gilt strips.

As an example, a ten-year gilt can be stripped to make 21 separate securities: 20 strips based on the
coupons, which are entitled to just one of the half-yearly interest payments; and one strip entitled to the
redemption payment at the end of the ten years.

As each ZCB is purchased at a discount to this redemption value, the entire return is in the form of
a capital gain. A STRIP can be used both as a portfolio management tool and as a personal financial
planning tool. The redemption proceeds from these bonds, each with their own unique redemption
date, can be used to coincide with specific future liabilities or known future payments.

1.3 Interest Rates and Government Bond Prices

Learning Objective
2.2.2 Understand the relationship between interest rates and bond prices: yield (flat yield and yield
to maturity); interest payable; accrued interest (clean and dirty prices); effect of changes in
interest rates

Because many bonds usually have semi-annual coupons (eg, as with gilts), the semi-annual cash flows
should be discounted at the semi-annual rate. The market convention for gilts is to quote the annual
yield by simply doubling the semi-annual figure.

43
Bonds, most of which have definite schedules of cash flow values with precise timings as to when
they will be paid out, are ideally suited to the application of discounted cash flow (DCF) evaluation
techniques.

1.3.1 Discounted Cash Flow (DCF)

The formula for a DCF evaluation is as follows:

   C1 + C2 + C3   F
PV = +...+
(1+r/cf )1 (1+r/cf )2 (1+r/cf )3    (1+r/cf )n

where:
PV = present value of the bond
C = coupon amount paid on the bond
cf = frequency of the coupon payment on an annual basis, eg, semi-annual payments equal 2
r = assumed discount rate (compounded in accordance with the frequency of payments of the
coupon and compounding)
F = face value or redemption amount of the bond
n = the number of time periods until the bond matures

The formula adds together the present value of all of the coupon payments, discounted in accordance
with the annual rate of interest (compounded at the frequency rate), and the redemption amount is also
discounted in similar fashion.

1.3.2 DCF and Gross Redemption Yield (GRY)

To state it quite simply, a yield of a bond is a measure of percentage return (the return versus the cost of
the bond). The gross redemption yield (GRY) or yield to maturity (YTM) represents the total return from
a bond, after considering the price paid, all of the coupon payments and the repayment of the principal.
Unlike flat yield, which is a rather simplistic measure, the GRY is the benchmark used in the markets
for measuring the so-called yield of a bond. Calculating the GRY is best understood by referencing the
discounted cash flow method outlined in section 1.3.1.

The following table shows a hypothetical UK government bond which has a maturity of five years with
the first coupon payment of 2.5% (ie, half of the quoted annual coupon rate) being paid in August
2019, and continuing until February 2024 when the bond will be redeemed at its face value. The tabular
layout uses the DCF approach to illustrate the exact nature of the cash flows. For simplification the GRY
is assumed to be the same as the nominal yield resulting in a value/current price that would be at par.

44
 Fixed-Income Securities

Bond Pricing – Discounted Cash Flow Evaluation

Gross Redemption Yield
Bond Price £100.00 5.00%
– GRY

2
Face Value £100.00 Coupon Frequency 2
Coupon
5.00%
Rate
Life in
5
Years
PV Cash Flows
Period Date Cash Flow (excluding purchase
amount)
Discounted Cash
Flow = Nominal
Calendar Date when
Nominal Cash Flow Cash Flow/
Cash Flow is Paid
[(1+YTM/Coupon
Frequency)^Period]
0 –£100.00
1 15 August 2019 £2.50 £2.44
2 15 February 2020 £2.50 £2.38
3 15 August 2020 £2.50 £2.32
4 15 February 2021 £2.50 £2.26
5 15 August 2021 £2.50 £2.21
6 15 February 2022 £2.50 £2.16
7 15 August 2022 £2.50 £2.10
8 15 February 2023 £2.50 £2.05
9 15 August 2023 £2.50 £2.00
10 15 February 2024 £2.50 £1.95
10 15 February 2024 £100.00 £78.12
Total £25.00 £100.00
Sum of Present Values of Coupon Payments £21.88
Discounted Value (ie, PV) of Face Value £78.12
Total Sums Received at Present Value £100.00

The manner in which the table is laid out shows the initial outlay of £100 at time 0 followed by the ten
semi-annual payments of £2.50 and the redemption amount being paid at period ten, ie, after five years.
What is useful about this manner of presentation is that the present value of all coupon payments can
be seen in isolation from the present value of the redemption value.

45
The nominal value of the coupon payment is, as expected, £25, ie, five years times £5; and with a 5%
discount factor the present value of the coupon payments is £21.88; and the present value of the
redemption amount when received five years hence is £78.12.

As one would expect, exactly the same result can be obtained by evaluating the price of the bond using
an annuity discount factor with the appropriate values shown in the table. The advantage of using
this approach is that there is less need to calculate all of the separate cash flow amounts but rather
the present values of all the coupons can be calculated in one step followed by the calculation of the
present values of the redemption amount.

Estimating
Annual Desired
Current 5.00% 5.00%
GRY Yield
Bond Price

Discount
Semi-Annual Cash Flow Present
Discount Factor Factor at
Cash Flows in £ Value
Desired Yield
10 £2.50 [1/0.025] x [1–(1/1.025^10)] = 8.75 8.75 £21.88
10 £100.00 [1/1.025^10] = 0.78 0.78 £78.12
Bond Price £100.00

The next diagram will provide a useful insight into what can happen to bonds of long duration during
periods of inflation when, as interest rates rise, investors will demand a much higher GRY and this could
be considerably higher than the nominal interest rate paid out by the bond through its coupons.

Estimating
Annual Desired
Current 5.00% 10.00%
GRY Yield
Bond Price

Discount
Semi-Annual Cash Present
Discount Factor Factor at
Cash Flows Flow in £ Value
Desired Yield
20 £2.50 [1/0.05] x [1–(1/1.050^20)] = 12.46 12.46 £31.16
20 £100.00 [1/1.050^20] = 0.38 0.38 £37.69
Bond Price £68.85

The above bond would exemplify a 5% gilt with ten years’ maturity issued with a 5% nominal yield
but where the GRY or desired yield to maturity has risen to 10% and the bond’s price in the secondary
market would have to fall to £68.85.

The value of a bond has two elements: the underlying capital value of the bond itself (the clean price
which is quoted) and the coupon that it is accruing over time (accrued interest). Each coupon is
distributed as income to people who are registered as at the ex-div date (which for gilts is normally
seven business days prior to payment date).

46
 Fixed-Income Securities

The dirty price calculated above using DCF is the price that is paid for a bond, which combines these
two elements. Consequently, ignoring all other factors that might affect the price, a dirty price will rise
gradually as the coupon builds up, and then fall back as the stock is either marked ex-div or pays the
dividend.

2
The dirty price of a bond will decrease on the days coupons are paid, resulting in a saw-tooth pattern
for the bond value. This is because there will be one less future cash flow (ie, the coupon payment just
received) at that point.
Bond Price

Coupon
t

st

st

t
res

es
e re

ere
Amount

er
n te

I nt

I nt

I nt
gI

ing

ing

ing
uin

ru
ru
ru
cr

c
c
c

Ac
Ac
Ac
Ac

Interest Interest Interest

Paid Paid Paid
Flat
Price ½ 1 1½

To separate out the effect of the coupon payments, the accrued interest between coupon dates is
subtracted from the value determined by the dirty price to arrive at the clean price.

The clean price more closely reflects changes in value due to issuer risk and changes in the structure
of interest rates. Its graph is smoother than that of the dirty price. Use of the clean price also serves to
differentiate interest income (based on the coupon rate) from trading profit and loss.

It is market practice to quote bonds on a clean-price basis. When a bond settles, the accrued interest is
added to the value based on the clean price to reflect the full market value.

Historically, investors, rather than claiming the coupon, could sell the bond at the high price just prior to
the payment of the coupon, and this gain was free of tax. This process was known as bond washing. In
1986, the UK moved to a system of clean pricing that separates the two elements. Under clean pricing,
whenever an investor purchases a bond, they pay the quoted price (the clean price), which represents
the capital value of the underlying bond with an allowance made for the interest element, allowing the
two elements (income and gain) to be taxed separately.

47
1.3.3 Cum Interest Bargains
A purchase made before the ex-div date is referred to as a cum div bargain. In this situation, the buyer of
the bond will be the holder on the next ex-interest date and will therefore receive the full coupon for the
period. The seller, however, has held the bond for part of this period and is therefore entitled to a part of
that coupon. To account for this, the purchaser of the bond must compensate the seller for the coupon
which they have earned.

Last Coupon Next Coupon

Purchase

The purchaser will therefore pay the clean price plus the interest from the last payment date up to the
purchase date. On the next payment date, the holder will receive the whole of the interest for the six
months. However, on a net basis, they will only have received the interest for the period of ownership.

The formula used by the DMO in the gilts market is as follows.

   Days
Dirty price = Clean price  +  Period’s coupons  X
Days in period

where:
Days = number of days from the day after the last coupon payment date up to, and
including, the settlement day
Days in period = number of days from the last coupon payment date up to and including the
calendar day before the next coupon

Example
For a particular gilt, the coupons are paid on 1 April and 1 October of each year. On 10 July, an investor
buys £10,000 nominal of Treasury 8% @ 101.50 for settlement on 11 July. The following are the steps
required in the calculations of the clean and dirty pricing.

April From last coupon (inclusive) 29 30

May 31 31
June 30 30
July To settlement date (inclusive) 11 31
August 31
September 30
Totals 101 183

Clean Price £10,000 @ 101.50 £10,150.00

Accrued Interest (£10,000 x 4%) x 101/183 £220.77
Dirty Price £10,370.77

48
 Fixed-Income Securities

1.3.4 Summary of Influences on Bond Prices

The previous scenarios illustrate two key features of bond pricing:

• There is an inverse relationship between bond prices and interest rates, ie, as market interest rates

2
rise, or specifically the required yield from investors rises, so the present or market value of a bond
will fall (and vice versa).
• When the coupon rate on the bond is equal to the prevailing interest rate (or desired yield), the bond
will be valued at par, as illustrated above when interest rates are at 5%.

These two features are vital for understanding the way in which bond pricing works, and students should
familiarise themselves with the reasoning behind them.

In most cases, the income (coupon) from a bond remains the same throughout its life. However, during
the life of the bond, there are many factors, especially inflation and the changes in the interest rate
environment, that can make it more or less attractive to investors. These factors lead to the alteration in
price of bonds.

The inverse relationship means that if investors see interest rates rising, the prices of bonds will fall.
The reason for this can be seen if we appreciate that investors will require a particular level of return,
depending upon rates of interest generally. If interest rates rise, investors’ required rate of return rises.
This means that they will be prepared to pay less for a particular bond with a fixed coupon rate than they
were prepared to pay previously. If interest rates generally fall, investors will be prepared to pay more for
a fixed-rate bond than previously, and bond prices will tend to rise.

Investors will generally require a higher return if the expected rate of inflation rises. Therefore, prices of
fixed-rate bonds will tend to fall with rising expectations of inflation. However, index-linked bonds have
a return that is linked to the inflation rate, with the result that the price of index-linked stock will tend to
rise when higher inflation is expected.

1.4 Index-Linked Debt

Learning Objective
2.2.3 Understand the main investment characteristics, behaviours and risks of index-linked debt:
retail prices and consumer prices indices as measures of inflation; process of index linking;
indexing effects on price, interest and redemption; return during a period of zero inflation;
harmonised price index

1.4.1 The Retail Prices Index (RPI) and Consumer Prices Index (CPI)
The retail prices index (RPI) has historically been the main inflation index used in the UK. The RPI is
calculated by looking at the prices of a basket of more than 700 goods and services. The prices are then
weighted to reflect the average household’s consumption patterns, so those important items on which
more money is spent get a higher weighting than peripheral items.

49
The index itself is based on movements in prices since a particular base period. Markets concentrate
on inflation indices as they are a good indicator of the level of inflation and, consequently, government
reaction to it. They also signal the need for potential increases in the yield paid on bonds in order to
compensate for the erosion of real returns.

Two more refined measures were introduced in the 1990s.

• RPIX – excludes the impact of mortgages.

• RPIY – excludes mortgages and indirect charges (VAT and local authority taxes).

Historically, the RPIX was used by the government in specifying its inflation target at a level of 2.5%. In
December 2003, the Chancellor of the Exchequer changed the UK inflation target to a new base, the
Harmonised Index of Consumer Prices (HICP) which, in the UK, has subsequently been renamed
the consumer prices index (CPI). The level of the new CPI inflation target for the BoE’s Monetary Policy
Committee was set at 2% from 10 December 2003. HICPs were originally developed in the EU to assess
whether prospective members of the European Monetary Union (EMU) would pass the required
inflation-convergence criterion; they then graduated to acting as the measure of inflation used by the
ECB to assess price stability in the eurozone area.

Like the RPI, the CPI is calculated each month by taking a sample of goods and services that a typical
household might buy, including food, heating, household goods and travel. There are significant
differences, however, between the CPI and the RPI. The CPI excludes a number of items that are
included in the RPI, mainly related to housing. These include council tax and a range of owner-occupier
housing costs such as mortgage interest payments, house depreciation, buildings insurance and estate
agency fees. The CPI covers all private households, whereas the RPI excludes the top 4% by income and
pensioner households who derive at least three-quarters of their income from state benefits. The CPI
also includes residents of student hostels and foreign visitors to the UK. It also covers some items that
are not in the RPI, such as unit trust and stockbrokers’ fees, university accommodation fees and foreign
students’ university tuition fees.

50
 Fixed-Income Securities

2
Source: https://www.inflationarypressure.com/

Although, in most cases, the same underlying price data is used to calculate the two indices, there are
some specific differences in price measurement. The two indices are also calculated differently. The
CPI uses the geometric mean to combine prices within each expenditure category, whereas the RPI
uses arithmetic means. The different techniques used to combine individual prices in the two indices
tend to reduce CPI inflation relative to RPIX; this is known as the formula effect. When the Chancellor
announced the changeover in target measure, the annual rate of RPIX exceeded the CPI by more
than 1%.

In November 2020, the UK Government announced that index-linked gilts, from 2030, will no longer be
linked to the RPI rather to the newer CPI that also includes housing costs, known as the CPIH. The CPIH
is regarded as the UK’s leading measure of inflation and is the same as the CPI except that it includes
owner occupiers’ housing (OOH) costs.

51
1.4.2 Index-Linked Issues
With an index-linked gilt (ILG), all cash returns – both interest payments and redemption proceeds – vary
with inflation following the issue reference date. Index-linked gilts use the RPI to calculate the inflation,
as the following illustration shows.

Example
A 5% semi-annual ILG which was issued several years previously has just paid a coupon. The RPI at the
issue reference date stood at 100. The RPI at the reference date for the coupon just paid stood at 150. To
determine the proper pricing of this ILG at the time of the last payment, it is necessary to undertake a
more detailed examination of the cash flows and appropriate discounting factors to apply.

If the RPI was still at 100, ie, there had been no inflation, the coupon and redemption proceeds would
be as follows:

• The coupon value will be £2.50 (£100 × 5% × ½).

• The redemption proceeds will be £100.00.

However, the current RPI value of 150 shows there has been 50% inflation since issue and, therefore, the
coupon amount and the redemption amounts will have to be adjusted.

• The adjusted coupon value will be £2.50 x 150/100 = £3.75.

• The adjusted redemption amount will be £100 x 150/100 = £150.

So, for all ILGs, there needs to be a reference date for measuring the RPI value which is to be used. That
reference date was historically eight months prior to the related cash flow, but for issues since June 2005
this was reduced to three months. For more recently issued ILGs, the appropriate values are as follows:

• The issue reference date is three months prior to issue.

• The reference date for any coupon is three months prior to its payment date.
• The reference date for the redemption proceeds is three months prior to redemption.

As the base index figure is the one three months prior to the issue date, and the final reference rate is
the index value three months prior to redemption, the holder is compensated for inflation for the three
months prior to the issue, but exposed to inflation for the last three months. It is, therefore, true to say
that holders are not guaranteed a real rate of return in any period, owing to the time lag involved.

52
 Fixed-Income Securities

Example
The following table considers a 5% ILG issued several years ago which is redeemable in 2½ years. The
RPI for the issue reference date was 100, and the RPI for the last coupon (just paid) was 150. Inflation

2
has recently been running at 3% every six months and is expected to continue at this level. Bondholders
require a return of 5% every six months.

The task is to calculate the price of the gilt in the secondary market at present.

Original
Current
RPI at Semi- Future Semi-Annual Desired
100 Inflation
Issue Annual Coupon Yield
Rate
Coupon
Current 2.5 x 150/100 =
150 £2.50 3% 10.00%
RPI £3.75
Semi- Discount
Annual Inflation Cash Flow Discount Factor at Present
Cash Adjusted in £ Factor Desired Value
Flows Yield
1 £3.75 x 1.031 £3.86 [1/1.05]1 0.95 £3.68
2 £3.75 x 1.032 £3.98 [1/1.05]2 0.91 £3.61
3 £3.75 x 1.033 £4.10 [1/1.05]3 0.86 £3.54
4 £3.75 x 1.03⁴ £4.22 [1/1.05]⁴ 0.82 £3.47
£153.75 x
5 £178.24 [1/1.05]⁵ 0.78 £139.65
1.03⁵
Bond Price £153.95

The coupon will need to be adjusted from its issue value of £2.50 to £3.75 to reflect the change in the
RPI from 100 to 150. Using similar reasoning, the redemption amount of the bond will also have to be
adjusted to £150 – and this is shown in the left-hand column of the table where the final payment will
need to be the adjusted coupon of £3.75 + adjusted redemption value of £150, ie, the final payment will
need to be £153.75.

The second column shows how these new base amounts as of the evaluation task have themselves to be
adjusted in nominal terms by uplifting them each six months by the level of inflation expected. So each
value has to be raised by 1.03 on a compounding basis.

Having performed that task, we can then apply the standard discounting factor to these nominal cash
flows by discounting on a compounding basis at 5% per semi-annual period.

An alternative approach is to discount the real (pre-inflation) flows at real rates.

53
The required nominal return every six months is 5%, though 2% of this will be satisfied by appreciation
in the cash flow values due to inflation. The real required return is provided by the Fisher relationship:

(1+r) = (1+i)(1+R)

where:

r = the monetary or nominal rate (5%)

i = inflation rate (3%)
R = real rate of return

Therefore: 1.05 = 1.03(1 + R)

1 + R = 1.019
R = 0.019 (or 1.9%)

Original Semi-Annual Current Future Semi-

RPI at Issue 100
Coupon Inflation Rate Annual Coupon
2.5 x 150/100 =
Current RPI 150 £2.50 3%
£3.75
Desired Semi-Annual Discount
5.00% 1.94%
Coupon Factor
Semi- Discount
Cash Flow Discount Present
Annual Factor at
in £ Factor Value
Cash Flows Desired Yield
[1/0.019] x [1–(1/1.019)⁵]
5 £3.75 4.73 £17.71
= 4.73
5 £150.00 [1/1.019⁵] = 0.91 0.91 £136.25
Bond Price £153.95

1.4.3 Summary of Index-Linked Debt

Ignoring the minor impact of the time lag, because index-linked bonds are uplifted by increases in the
relevant price index, they are effectively inflation-proof. In times of inflation, they will increase in price
and preserve the purchasing power of the investment.

In a period of zero inflation, index-linked bonds will pay the coupon rate with no uplift and simply pay
back the nominal value at maturity.

54
 Fixed-Income Securities

1.5 Other Governmental and Authority Debt

Learning Objective

2
2.2.4 Understand the main issuers and characteristics of supranational and public authority debt

1.5.1 Supranationals
Supranational bonds are issued by supranational organisations, such as the World Bank, the European
Investment Bank and the Asian Development Bank. The World Bank has raised money through
issuing bonds and, in 2009, following discussion among the G20 nations, the board of directors of
the International Monetary Fund (IMF) decided to approve the issuance of bonds to the lender’s 186
members for the first time.

The funds were needed for additional sources to lend during the global recession. According to a report
from Bloomberg:

The IMF board made the decision (to issue the bonds) on 1 July 2009, in a vote, and did not place a
limit on the note sales. The bonds are part of a wider effort to seek $500 billion in new funding as the
lender helps countries from Iceland to Pakistan combat the global financial crisis.
The securities, the culmination of months of talks between the fund and its members, will offer the
largest emerging-market nations a new way of making IMF contributions, while they seek greater say
at the fund. China, Brazil and Russia have favoured the bonds, instead of regular contributions, as
they wrangle with other members over redistributing the IMF’s voting power.

ECB and IMF Assistance

In response to the euro crisis, several EU member states, including Ireland, Greece and Portugal, have
found themselves in a position where they have needed to secure multi-billion euro funding from the
ECB and the IMF. Governments in these countries have been forced to enter into austerity programmes
in exchange for these massive cash injections.

In June 2011, the GRY on ten-year Greek government bonds climbed to almost 30%, indicating that the
markets believed there was a very high likelihood that the Greek government would eventually have to
restructure its debt or possibly experience an outright default. By the summer of 2015, Greece’s national
debt was €320 billion and the country had an S&P credit rating of CCC–. As of June 2021, it stands at BB-
with a positive outlook.

1.5.2 Government-Sponsored Enterprises (GSEs) or Agencies

Government-sponsored enterprises (GSEs) or agencies issue bonds, known as agency bonds, for
particular purposes. These are common in the US, where examples include the Federal Home Loan Banks
(FHLB), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation (FHLMC) – also known as Freddie Mac – which was created in 1970. Along with other GSEs,
the rationale for Fannie Mae and Freddie Mac as set up by the US Congress, was to buy mortgages in

55
the secondary market, pool them, and sell them as mortgage-backed securities to investors on the open
market.

The nature of the government guarantee for the obligations of GSEs was put in the spotlight during
the global banking crisis of 2008. Whereas GSE obligations had previously been issued with an implied
federal guarantee, this became explicit as GSEs have, since 2008, come under the direct conservatorship
of the US Treasury. The public underwriting of the entire liabilities of the GSEs is now measured in
hundreds of billions of dollars.

1.5.3 Local Government and Municipalities

In the UK, local government accounts for about 25% of UK public spending. A large proportion of this is
funded through the central government block grant, allocated on the basis of a complex formula which
determines each authority’s grant-related expenditure (GRE) level.

Local authority bonds in the UK were once used to build the civic infrastructure and utilities, and they
were a common source of public finance until the 1980s, when the central government began the era of
constraining local financial independence and increasing centralised economic control.

Recently, there have been some developments suggesting that local authorities may be seeking to issue
further bonds in the future. An important precedent was set in 2006 whereby the Treasury authorised
Transport for London (itself a local authority in legal terms) to issue, eventually, £600 million of bonds,
as part of its borrowings to improve transport infrastructure. There was a good reaction from investors
to the issue.

Many sub-sovereign, provincial, state and local authorities issue bonds. In the US, state and local
government bonds are known as municipal bonds, and municipalities in the US issue these bonds to
finance local borrowing. These bonds are often tax-efficient, particularly for investors who reside in that
municipality.

US municipal bonds are usually guaranteed by a third party, known in the market as a monoline
insurer, and the bonds’ credit quality may be enhanced by this guarantee, enabling the municipality to
secure funds on more advantageous terms. This relies on the monoline insurers having a strong credit
rating and some of the well-known monoline insurers in the US extended their activities to provide a
range of far riskier guarantees for asset-backed securities, which has resulted in them losing their own
investment grade ratings.

56
 Fixed-Income Securities

2. Corporate Debt

Learning Objective

2
2.3.1 Understand the main investment characteristics, behaviours and risks of corporate debt:
financial institutions and special purpose vehicles; fixed and floating charges; debentures;
types of asset-backed securities; mortgage-backed securities; securitisation process; roles of
participants

2.1 Secured Debt

Corporate debt is simply money that is borrowed by a company that has to be repaid. Generally,
corporate debt also requires servicing by making regular interest payments. Corporate debt can be
subdivided into money borrowed from banks via loans and overdrafts, and directly from investors in the
form of IOU instruments, typically debentures or, as they are more commonly known, bonds.

Debt finance can be less expensive than equity finance, ie, issuing shares, because investing in debt
finance is less risky than investing in the equity of the same company. The interest on debt has to be
paid before dividends, so there is more certainty to the investor in corporate debt rather than corporate
equity. Additionally, if the firm were to go into liquidation, the holders of debt finance are paid back
before the shareholders receive anything.

However, raising money via debt finance does present dangers to the issuing company. The lenders are
often able to claim some or all of the assets of the firm in the event of non-compliance with the terms of
the loan. For instance, a bank providing mortgage finance is technically able to seize property assets of a
firm if there is any default, and not necessarily an outright bankruptcy of the company. For a corporation
the power to borrow needs to be laid out in the Articles of Association, and the decision about taking on
new debts is taken by the board of directors and may have to be agreed at an annual general meeting
(AGM) of the company’s shareholders.

2.1.1 Financial Institutions and Special Purpose Vehicles (SPVs)

Like other companies or corporates, financial institutions issue bonds to finance borrowing. These
financial institutions also arrange borrowing for themselves and others by creating special purpose
vehicles (SPVs) to enable money to be raised that does not appear within the accounts of that entity.
This type of finance is often described as off-balance sheet finance, because it does not appear in the
statement of financial position/balance sheet that forms part of a company’s accounts.

2.1.2 Fixed and Floating Charges

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).

57
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.

Domestic corporate bonds are usually secured on the company’s assets by way of a fixed or a floating
charge. A fixed charge is a legal charge, or mortgage, specifically placed upon one or a number of the
company’s fixed, or permanent, assets. A floating charge, however, places a more general charge on
those assets that continually flow through the business and whose composition is constantly changing,
such as the issuing company’s stock-in-trade.

It is important to note that, unlike with a fixed charge, a company may not be inhibited from disposing
of any specific assets if its borrowing is only subject to a floating charge. The floating charge may simply
cover whatever the company has in its possession at any time and, unless itemised in an addendum to a
floating charge, no sale or disposition is excluded.

In liquidations, fixed charges have priority over floating charges.

Fixed and floating charges need to be registered, and this is usually done through a debenture trustee.

2.1.3 Debentures
In relation to UK securities, a debenture is a long-term debt instrument issued by a corporation, which
is backed by specific collateral or assets of the borrower. This collateral may be in the form of a fixed
charge over a particular asset, such as machinery, or based on a floating charge, where the assets are
not individually specified but cover the other assets which are not subject to a fixed charge. Somewhat
surprisingly, the convention in the US is more or less the converse, as a debenture is not secured but
traditionally backed by those assets which have not been pledged otherwise. While it may be considered
in a certain sense as unsecured debt, it does come with the non-specific backing of the creditworthiness
and reputation of the debenture issuer.

In both the US and the UK, debentures are usually issued by large, financially strong companies with
excellent bond ratings. The debenture is documented by an agreement called an indenture.

The holder of a debenture issue in the UK has an advantage in the case of liquidation because particular
assets of the company have been identified as collateral for the debt instrument. Debentures are thus a
debt instrument which provide greater security to the lender than holding an unsecured bond or loan.

2.1.4 Asset-Backed Securities (ABSs)

ABSs are bonds that are backed by a particular pool of assets. These assets can take several forms,
such as mortgage loans, credit card receivables or car loans. ABSs have been used in the financing of
entertainment properties, such as on the future royalties from music-publishing interests.

The assets provide the bondholders’ security, since the cash generated from them is used to service
the bonds (pay the interest), and to repay the principal sum at maturity. Such arrangements are often
referred to as the securitisation of assets.

58
 Fixed-Income Securities

Securitisation reflects the fact that the resulting financial instruments used to obtain funds from the
investors are considered, from a legal and trading point of view, as securities.

Diagrammatically:

2
Pool of assets,
Bonds that are
eg, mortgage loans,
sold to a variety of
credit card receivables,
investors
car loans

provide the backing for...

Mortgage-backed securities (MBSs) are one example of ABSs. They are created from mortgage loans
made by financial institutions like banks and building societies. MBSs are bonds that are created when
a group of mortgage loans are packaged (or pooled) for sale to investors. As the underlying mortgage
loans are paid off by the homeowners, the investors receive payments of interest and principal.

The MBS market began in the US, where the majority of issues are made by (or guaranteed by) an agency
of the US government. The Government National Mortgage Association (commonly referred to as Ginnie
Mae), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation (Freddie Mac) are the major issuers. These agencies buy qualifying mortgage loans, or
guarantee pools of such loans originated by financial institutions, securitise the loans and issue bonds.
Some private institutions, such as financial institutions and house builders, issue their own mortgage-
backed securities.

MBS issues are often sub-divided into a variety of classes (or tranches), each tranche having a particular
priority in relation to interest and principal payments. Typically, as the underlying payments on the
mortgage loans are collected, the interest on all tranches of the bonds is paid first. As loans are repaid,
the principal is paid back to the first tranche of bondholders, then the second tranche, third tranche and
so on. Such arrangements will create different risk profiles and repayment schedules for each tranche,
enabling the appropriate securities to be held according to the needs of the investor. Traditionally, the
investors in such securities have been institutional investors, such as insurance companies and pension
funds, although some now attract the more sophisticated individual investor.

Investors in ABSs have recourse to the pool of assets, although there may be an order of priority
between investors in different tranches of the issue. The precise payment dates for interest and principal
will be dependent on the anticipated and actual payment stream generated by the underlying assets
and the needs of investors. ABSs based on a pool of mortgage loans are likely to be longer-dated than
those based on a pool of credit card receivables. Within these constraints, the issuers of ABSs do create a
variety of tranches to appeal to the differing maturity and risk appetites of investors.

59
Many ABSs utilise an SPV in order to lessen the default risk investors face when investing in the securities.
This SPV is often a trust; the originator of the assets, such as the bank granting the mortgage loans, sells
the loans to the SPV and the SPV issues the asset-backed bonds. This serves two purposes:

1. The SPV is a separate entity from the originator of the assets, so the assets leave the originator’s
financial statements, to be replaced by the cash from the SPV. As already mentioned, this is often
described as an off-balance-sheet arrangement, because the assets have left the originator’s
balance sheet.
2. The SPV is a stand-alone entity, so if the originator of the assets suffers bankruptcy the SPV remains
intact, with the pool of assets available to service the bonds. This is often described as bankruptcy
remote and enhances the creditworthiness of ABSs, potentially giving them a higher rating than the
originator of the assets.

Diagrammatically:

Investors

(2) Asset-
(1) Pool of Investors
Originator of backed
assets
the assets, eg, SPV bonds
passed
mortgage bank sold to
to SPV Investors
investors

(3) Cash paid to originator Investors

The Securitisation Process

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

For securitisation issues, the complex nature of the instruments means that the credit rating agencies
consider the following:

• The credit quality of the securitised assets, focusing on the effect of worst case stress scenarios.
• Legal and regulatory issues and, in particular, whether the securitised assets have been appropriately
isolated from the bankruptcy or insolvency risk of any entities that participate in the transaction.
• Payment structures and how cash flows from the securitised assets are dealt with.
• Operational and administrative risks associated with the company responsible for managing the
securitised assets.
• Counterparty risk arising from the ability of third parties to meet obligations, such as financial
guarantees, bank liquidity or credit support facilities, letters of credit, and interest rate and currency
swaps.

60
 Fixed-Income Securities

2.1.5 Roles of Participants

The principal participants with regard to corporate debt are the issuer, the underwriter who is
responsible for issuing bonds into the primary market, the debenture trustee and brokers/dealers who
are involved in maintaining and making a secondary market for the bonds issued. Bonds can trade

2
on traditional exchanges, such as the LSE, but also on numerous decentralised electronic networks of
dealers and bond-trading platforms, a number of which are global in their coverage.

2.2 Unsecured Debt

Learning Objective
2.3.2 Understand the main investment characteristics, behaviours and risks of the main types of
unsecured debt: income bonds; subordinated; high yield; convertible bonds; contingent
convertible bonds

2.2.1 Income Bonds

Income bonds are the most junior of all bonds. Their payments are made only after the issuer earns a
certain amount of income. The issuer is not bound to make interest payments on a timely or regular
basis if the minimum income amount is not earned. The investor is aware of the risks involved and may
be willing to invest in these bonds if there is an attractive coupon rate or high GRY.

2.2.2 Subordinated Debt

Subordinated debt is not secured and the lenders have agreed that, if the company fails, they will only
be reimbursed when other creditors have been paid back, and then only if there is enough money left
over. Interest payments on subordinated borrowings will be higher than those on equivalent unsecured
borrowings that are not subordinated, because of the additional default risk faced by subordinated
lenders.

It should be noted that all three of the main categories of debt – senior, subordinated and junior – can
themselves contain sub-categories, such as senior secured, senior unsecured, senior subordinated
and junior subordinated. In practice, the credit rating agencies (CRAs) look at debt structures in these
narrower terms. Seniority can be contractual as the result of the terms of the issue, or based on the
corporate structure of the issuer.

2.2.3 Subordinated Loan Stock

This is a loan stock issued by a company that ranks above its preference shares but below its unsecured
creditors in the event of the company’s liquidation.

61
2.2.4 Permanent Interest-Bearing Securities (PIBSs)
• PIBSs are irredeemable fixed-interest securities issued by mutual building societies.
• PIBSs pay relatively high semi-annual coupons and potentially offer attractive returns. Interest is
paid gross, which means that PIBSs are attractive to zero-rate taxpayers and those who have some
means of sheltering the gross payment. However, this income is non-cumulative and PIBS holders
rank behind all other creditors in the event of liquidation.
• When the building society has demutualised, its PIBSs are reclassified as perpetual subordinated
bonds (PSBs). Both PIBSs and PSBs can be traded on the LSE.
• The liquidity of PIBS is generally not considered to be high and they tend to have a wide bid-offer
spread.

2.2.5 High-Yield Bonds

Customarily participants in the markets regard all debt that does not have an investment grade,
according to the above table, as speculative, and sometimes refer to this as junk debt. Bonds with a
grade below BBB–, using S&P’s rating system, are also typically known as high-yield bonds, as they will
require issuers to provide a high coupon to the bond in order to compensate investors for the higher
credit risk associated with the inferior credit rating.

In the 1980s, Michael Milken was a pioneer of the use of junk bonds as a way of financing new
companies or companies which had a track record of credit problems. Although his demise from the
world of finance was linked to an abusive mode of operation with high-yielding debt, which also added
some stigma to the term junk, there is no inherent obstacle to capital markets issuing and raising money
by using high-yielding debt instruments. The market should know how to price in the additional risk of
the issue including the amount of the coupon.

Bonds known as 'fallen angels' have seen their former investment-grade rating reduced to junk bond
status. Following this, they may issue high-yield debt which may become appealing if the long-term
outlook of the business is strong or if the net assets of the business or cash flow easily outweigh the debt
servicing cost or borrowings outstanding.

2.2.6 Convertible Bonds

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

Convertible bonds are often deployed as a form of deferred share. Issuers expect them to be converted
into equity at the conversion date. Convertibles have some of the characteristics of bonds, responding
to changes in interest rates, and some of the characteristics of shares, responding to share price
movements of the company issuing the convertible.

By convention, the right is normally to convert the debt into the ordinary shares of the company in a
given conversion ratio – for example, £100 nominal is converted into 30 shares (a conversion ratio of 30).
The conversion right may exist for a period of time during the bond’s life (the conversion window), or
may only be available on maturity.

62
 Fixed-Income Securities

2.2.7 Contingent Convertible Bonds (CoCos)

Contingent convertible bonds (also known as CoCos) are very similar to traditional convertible bonds.
The key difference is that a price is set, which the underlying equity share price must reach before
conversion can take place (ie, conversion is contingent on the ordinary shares attaining a certain market

2
price over a specified period of time).

They are also quite useful to the banking industry, where CoCos can be issued whereby conversion
happens when an uplift in the percentage of capital is required in order for the bank to remain solvent.
Thus, conversion into shares is automatic if the specified capital ratio is likely to be breached.

3. Eurobonds

Learning Objective
2.4.1 Understand the main investment characteristics, behaviours and risks of eurobonds: types
of issuer: sovereign, supranational and corporate; types of eurobond: straight, FRN/VRN,
subordinated, asset-backed, convertible; international bank syndicate issuance; immobilisation
in depositories; continuous pure bearer instrument: implications for interest and capital
repayment; accrued interest, ex-interest date

Essentially, eurobonds are international bond issues. They are a way for an organisation to issue
debt without being restricted to its own domestic market. They are usually issued by a syndicate of
international banks.

Generally, eurobonds are in bearer form. The bearer has all the rights attached to ownership.

Eurobonds are issued internationally, outside any particular jurisdiction, and as such they are largely free
of national regulation. For example, a US dollar eurobond can be issued anywhere in the world, outside
the US. Eurobonds are usually administered by a custodian who is responsible for arranging interest
payments and the repayment of principal at the bond’s maturity. Eurobond interest is usually paid gross
of withholding tax.

3.1 Types of Eurobonds

Most eurobonds are bought by major institutions looking for a sound long-term investment delivering a
fixed rate of return. Eurobond prices in the secondary market tend to be less sensitive than a company’s
shares to changes in its commercial performance or business prospects. Instead, eurobond prices are
more sensitive to wider economic shifts, such as changes in interest rates and currency fluctuations.

A London listing of a eurobond consists of admission to listing by the FCA – and admission to trading on
a recognised investment exchange (RIE) such as the LSE.

Typically, eurobonds pay coupons gross and usually annually.

63
The investment banks that originate eurobond issues have been innovative in their structure to
accommodate the needs of issuers and investors. Accordingly, there are many different flavours for
eurobonds. The basic forms are:

• straight or bullet bonds

• floating rate notes/variable rate notes
• subordinated
• asset-backed, and
• convertible.

Straight, fixed-coupon eurobonds or bullet bonds normally pay the coupons once a year. Additionally,
there are some straight zero coupon eurobonds.

Floating rate eurobonds (variable rate) are bonds where the coupon rate varies. The rate is adjusted in
line with published market interest rates. The published interest rates that are normally used are based
on LIBOR or Euribor. The LIBOR is the average rate at which banks in London offer loans to other banks.
The Euribor is the average interest rate at which a panel of more than 50 European banks borrow funds
from one another. Both LIBOR and Euribor rates are published for various maturities of up to one year.

Typically for an FRN, a margin is added to the reference rate, measured in basis points, each basis point
representing one hundredth of 1%. A eurobond issuer may offer floating rate bonds to investors at
three-month sterling LIBOR plus 75 basis points. If LIBOR is at 4%, then the coupon paid will be 4.75%,
with the additional 75 basis points compensating the investor for the higher risk of payment default.

• Subordinated eurobonds – have a junior or inferior status within the capital structure hierarchy
and have greater risk than a senior or secured note.
• Asset-backed eurobonds – where a specific asset or item of collateral has been pledged by the
issuer as security for the bond.
• Convertible eurobond issues – where the issuer has granted certain rights to the holder to convert
the bond into equity of the issuer according to the terms of the offering prospectus.

As far as the FCA is concerned, issuers of convertible bonds and bonds with equity warrants must also
include more detailed disclosures in order to gain admission to trading on the LSE. The additional
disclosures include the following:

• Profit and loss accounts, statements of financial position and cash flow statements for the last three
years and, where appropriate, an interim statement.
• Information on the shares into which the bonds are convertible.
• Information on the issuer’s directors, including their aggregate remuneration and their total interest
in the issuer’s shares.

64
 Fixed-Income Securities

3.2 Immobilisation
As bearer documents, it is important that eurobonds are kept safe. This is often achieved by holding the
bonds in depositories, particularly those maintained by Euroclear and Clearstream. Eurobonds which are
deposited at the clearing house are described as being immobilised. Immobilised means that the bonds

2
are safely held with a reputable depository and a buyer is likely to retain the bonds in their immobilised
form. As the eurobond market has grown, a self-regulatory organisation was been formed to oversee the
market and its participants – the International Capital Market Association (ICMA).

Settlement and accrued interest conventions have been established for the secondary market.
Settlement is on a T+2 basis and, historically, accrued interest has been calculated on the basis of 30
days per month and 360 days per year (30/360 basis). However, more recently issued eurobonds that are
in currencies other than the US dollar tend to use the actual/actual day count convention.

3.3 Dealing and Settlement

There is no formal marketplace for eurobond trading, although several exchanges can provide a listing
for major issues. The market is electronic, with telephone contact between the main investment houses
primarily based in London. The market is regulated by ICMA, which operates rules regulating the
conduct of these dealers.

Settlement is carried out by two independent clearing houses, Euroclear and Clearstream. Remember
that the important feature about the registers maintained by these two clearing houses is that they
are not normally available to any governmental authority, thereby preserving the bearer nature of the
documents. The methods of eurobond issuance are similar to those of corporate bond issues in the
domestic markets. A disposal of a eurobond is usually assessed for capital gains tax (CGT) in the same
way as other CGT-eligible financial instruments.

3.4 Interest Payments on Eurobonds

Eurobonds usually pay interest gross. The buyer is responsible for paying any tax due.

3.5 Accrued Interest on Eurobonds

Accrued interest is the portion of coupon interest applicable to a bond, should it be traded between
two coupon dates. Accrued interest is either cum interest or ex-interest. The terms ex-dividend and
ex-coupon are often used and have the same meaning in respect of bonds.

'Cum interest' means 'with interest' and is the portion of accrued interest between settlement date and
the last coupon date. It is payable by an investor to the previous investor as the new investor is obviously
not entitled to the full coupon, as they have not held it for the full period. 'Ex-interest' means 'without
interest' and is the portion of coupon interest between settlement date and the next coupon date. It is
payable by the previous investor to the new investor when bonds transacted are settled after the book
closing date, but before coupon date. In this circumstance it is assumed that the new investor will have
insufficient time to register the bond and therefore the previous investor receives the full coupon and
pays the portion of interest due to the new owner of the bond.

65
 4. Issuing Fixed-Income Securities

Learning Objective
2.5.1 Understand the responsibilities and processes of the UK Debt Management Office in relation
to the management and issue of UK government debt: gilts; Treasury bills; primary market
makers: gilt-edged market makers (GEMMs); intermediaries: inter-dealer brokers (IDBs)

4.1 The UK Debt Management Office (DMO)

4.1.1 Participants in the Government Bond Markets

In addition to the government’s issuing agency, the Debt Management Office (DMO) itself, there are
three major groups of participants that facilitate deals in the government bond markets:

• Primary dealers – such as gilt-edged market makers (GEMMs).

• Broker-dealers.
• Inter-dealer brokers.

4.1.2 The Issuing Agency – the Role of the DMO

The DMO is the issuing agency for the UK government. It is an executive agency of the Treasury, making
new issues of UK government securities (gilt-edged securities or gilts). Once issued, the secondary market
for dealing in gilts is overseen by two bodies, the DMO and the LSE. The main responsibility of the DMO is
to ensure that the government is able to borrow the money it requires to fund the public sector net cash
requirement (PSNCR). Issues by the DMO may be for a new gilt with a coupon/maturity dissimilar to any
existing issues.

Currently, the DMO believes that the range of issues in the market is, if anything, too large and may lead
to excessive fragmentation of supply and demand. In order to avoid this problem, the DMO may issue
a tranche of an existing stock. This entails issuing a given amount of nominal value on exactly similar
terms to an existing gilt.

The DMO refers to this as opening up an existing gilt. The advantages of tranches are that they avoid
adding further complexity to the gilts market and increase the liquidity of current issues. When a
tranche is issued, it may be identified by the letter A in order to indicate that, when the tranche is issued,
a full coupon may not be paid on the next payment date, to reflect the fact that the gilt has only been an
issue for part of the coupon period. A small tranche may be referred to as a tranchette.

The DMO is the body that enables certain LSE member firms to act as primary dealers, known as GEMMs.
It then leaves it to the LSE to prescribe rules that apply when dealing takes place.

66
 Fixed-Income Securities

4.1.3 Primary Issuance: Auctions and Tenders

The DMO can use a variety of methods for gilt issuance. The most commonly used is the auction method,
when the DMO announces the auction, receives bids and allocates the gilts to those that bid highest, at
the price they bid. GEMMs are expected to bid for gilts when the DMO makes a new issue, and the DMO

2
reserves the right to take the gilts onto its own books if the auction is not fully taken up.

A tender is an alternative method to an auction and is best explained using the following examples.

Example: Auction
The DMO auctions the proposed issuance on the basis of the bids received. The GEMMs place bids for
the gilt and the successful bidders pay the price at which they bid.

Let us suppose the auction is for £1 million nominal. The bids from the GEMMs are as follows:

• A offers to buy £0.5 million nominal and is willing to pay £101.50 for every £100 nominal.
• B offers to buy £0.5 million nominal and is willing to pay £100.75 for every £100 nominal.
• C offers to buy £0.5 million nominal and is willing to pay £100.50 for every £100 nominal.

The auction results in A and B being awarded the gilts for the prices that they bid and, since the whole
issuance has been bought by A and B, there is nothing left for C.

Example: Tender
Let us suppose the DMO tender process is for £1 million nominal and the DMO has set a minimum price
of £100 for each £100 nominal. The bids from the GEMMs are exactly as before:

• A offers to buy £0.5 million nominal and is willing to pay £101.50 for every £100 nominal.
• B offers to buy £0.5 million nominal and is willing to pay £100.75 for every £100 nominal.
• C offers to buy £0.5 million nominal and is willing to pay £100.50 for every £100 nominal.

In this instance, A and B are awarded the gilts, but both pay the lower price of £100.75, which is
effectively the highest price at which all the gilts can be sold. The C bid, as before, fails to get any fill as
the price offered is below the price at which £1 million can be cleared.

One of the metrics which is used to judge the success of a government auction is the bid-to-cover
ratio, which is used to express the demand for a particular security during offerings and auctions. It is
computed in two ways: either the number of bids received is divided by the number of bids accepted;
or the total amount of the bids is used instead. It is a metric which is especially followed by financial
analysts in the sale of US Treasury bonds and is becoming more of a focus in the DMO’s auctions as well.

In general terms, the simple point that needs to be made is that the higher the bid-to-cover ratio
in an auction, the higher the demand. A ratio above 2.0 indicates a successful auction comprised of
aggressive bids. A low ratio is an indication of a disappointing auction, often marked by a wide spread
in the yields bid.

67
Example
Consider the following scenario where the DMO is seeking to raise £10 billion in ten-year notes with a
4.125% coupon. In order to keep the example simple, the aggregate number of bids received (which
would have been expressed in price terms) will have equated to the following yields shown below:

• £4.00 billion at 4.115%.

• £4.50 billion at 4.120%.
• £3.50 billion at 4.125%.
• £3.75 billion at 4.135%.
• £3.75 billion at 4.140%.

The total of all bids is £19.5 billion and the number of bids placed, where the prices provided by bidders
will have equated to a yield at least equivalent to the required coupon value, is in excess of the £10
billion on offer. In such a scenario, the bid-to-cover ratio can be stated as 1.95 which is a satisfactory
auction result.

Either new issues or tranches of existing stock can be sold by way of an auction. Running alongside each
competitive auction are non-competitive bids, when investors can apply for up to £500,000 of nominal
value. Applicants through non-competitive bids will receive the gilts they applied for, at a weighted
average of accepted prices in the auction. This enables smaller investors to participate in the primary
market for gilts, while avoiding the necessity of determining an appropriate price.

4.1.4 Treasury Bill Issuance

Alongside gilts, sterling Treasury bills form an important constituent in the DMO’s exchequer cash
management operations and an intrinsic component in the UK government’s stock of marketable debt
instruments. Treasury bills are zero coupon eligible debt securities and the DMO financing remit from
the government includes a target end-year Treasury bill total.

Treasury bills are routinely issued at weekly tenders, held by the DMO on the last business day of each
week (ie, usually on Fridays), for settlement on the following business day. Treasury bills can be issued
with maturities of one month (approximately 28 days), three months (approximately 91 days), six months
(approximately 182 days) or 12 months (up to 364 days), although to date no 12-month tenders have been
held. Members of the public wishing to purchase Treasury bills at the tenders will have to do so through
one of the Treasury bill primary participants and purchase a minimum of £500,000 nominal of bills.

As of June 2021, the following banks act as Treasury bill primary participants:

• Banco Santander SA, London Branch.

• Bank of America Merrill Lynch International.
• Barclays Bank plc.
• BNP Paribas.
• Citigroup Global Markets ltd.
• Credit Agricole Corporate & Investment Bank.
• Credit Suisse Securities (Europe) ltd.
• Danske Bank A/S, London Branch.

68
 Fixed-Income Securities

• Deutsche Bank, London Branch.

• Goldman Sachs International.
• HSBC Bank London.
• Investec Bank plc.

2
• Jefferies International ltd.
• JP Morgan Securities plc.
• King and Shaxson ltd.
• Lloyds Bank Corporate Markets plc.
• Mitsubishi UFJ Securities International plc.
• Morgan Stanley & Co International ltd London.
• NatWest Markets plc.
• Nomura International.
• Royal Bank of Canada.
• Scotiabank.
• The Toronto Dominion Bank (London Branch).
• UBS AG (London Branch).

Source: UK Debt Management Office

In addition to primary participants, direct bidding by telephone in Treasury bill tenders is open to the
following other eligible participants:

• DMO cash management counterparties – who can bid on existing direct dealing lines.
• A limited range of wholesale market participants who have established a relationship with the DMO.

The operational format of Treasury bill tenders is as follows:

• All bids must be received by 11.00am (London time) on the day of the tender.
• All bids must be made (on a money market yield basis) to three decimal places.
• Bids at tenders must be for a minimum of £500,000 nominal of bills.
• The minimum issuance denomination of Treasury bills will be £25,000.

TreasuryDirect, an internet-based platform, is also available through which individuals can buy and hold
all of Treasury’s marketable issues available to the general public, as well as savings bonds. TreasuryDirect
does not offer savings bonds or the four-week bill, seven-year note, 30-year Treasury inflation-protected
securities (TIPS) or 30-year bond.

4.1.5 Interim Funding or Taps

The government’s current principal method of funding is through regular competitive auctions.
However, the government may still wish to issue smaller quantities of stock to improve liquidity or
improve market efficiency. In such situations, the DMO will sell smaller quantities of stock to investors
via the GEMMs.

When tapping stock into secondary markets in this way, it will often be a tranche of existing stock, or
a tranchette if a relatively small amount. Alternatively, it could be as a result of a failed auction when
the DMO has not received sufficient applications to account for the nominal value on offer. In such a
situation, the remaining stock will be available 'on tap' from the DMO.

69
4.1.6 Gilt-Edged Market Makers (GEMMs)
The GEMM, once vetted by the DMO and registered as a GEMM with the LSE, becomes a primary dealer
and is required to provide two-way quotes to customers (clients known directly to them) and other
member firms of the LSE throughout the normal trading day. There is no requirement to use a particular
system like those run by the LSE for making those quotes available to clients, and GEMMs are free to
choose how to disseminate their prices.

The obligations of a GEMM can be summarised as follows:

• To make effective two-way prices to customers on demand, up to a size agreed with the DMO,
thereby providing liquidity for customers wishing to trade.
• To participate actively in the DMO’s gilt issuance programme, broadly by bidding competitively in
all auctions and achieving allocations commensurate with their secondary market share – effectively
informally agreeing to underwrite gilt auctions.
• To provide information to the DMO on closing prices, market conditions and the GEMM’s positions
and turnover.

The privileges of GEMM status include:

• exclusive rights to competitive telephone bidding at gilt auctions and other DMO operations, either
for the GEMM’s own account or on behalf of clients
• an exclusive facility to trade as a counterparty of the DMO in any of its secondary market operations,
and
• exclusive access to gilt inter-dealer broker (IDB) screens.

A firm can register as a GEMM to provide quotes in either:

• all gilt-edged securities, or

• gilt-edged securities excluding index-linked gilts, or
• index-linked gilts only.

There are exceptions to the requirement to provide quotes to customers, including the members of the
LSE. The obligation does not include quoting to other GEMMs, fixed-interest market makers or gilt inter-
dealer brokers.

As of June 2021, the following are registered as GEMMs:

• Banco Santander SA, London Branch.

• Barclays Bank plc†.
• BNP Paribas (London Branch).
• Citigroup Global Markets ltd.
• Deutsche Bank AG (London Branch).
• Goldman Sachs International.
• HSBC Bank PLC†.
• Jefferies International ltd*.
• JP Morgan Securities plc.
• Lloyds Bank Corporate Markets plc.
• Merrill Lynch International.

70
 Fixed-Income Securities

• Morgan Stanley & Co. International plc.

• NatWest Markets plc†.
• Nomura International plc.
• Royal Bank of Canada Europe ltd.

2
• The Toronto-Dominion Bank (London Branch)*.
• UBS AG (London Branch).
• Winterflood Securities ltd†*.
† STRIPS market participant
* Retail GEMM

Source: UK Debt Management Office

4.1.7 Broker-Dealers
These are non-GEMM LSE member firms that are able to buy or sell gilts as principal (dealer) or as agent
(broker). When acting as a broker, the broker-dealer will be bound by the LSE’s best execution rule, ie, to
get the best available price at the time.

When seeking a quote from a GEMM, the broker-dealer must identify at the outset if the deal is a small
one, defined as less than £1 million nominal.

4.1.8 Gilt Inter-Dealer Brokers

Gilt inter-dealer brokers arrange deals between gilt-edged market makers anonymously. They are not
allowed to take principal positions, and the identity of the market makers using the service remains
anonymous at all times. The IDB will act as agent, but settle the transaction as if it were the principal.
The IDB is only allowed to act as a broker between GEMMs, and has to be a separate company and not a
division of a broker-dealer.

4.1.9 Standing Repo Facility

The smooth running of the gilts market is further assisted by the DMO’s standing repo facility. This
enables any GEMM, or other DMO counterparty, to enter into a reverse repo arrangement with the DMO,
perhaps to cover a short position in gilts. This facility is for next-day settlement, and the facility can be
rolled forward for up to two weeks. The DMO does charge a slightly higher than normal repo rate for
firms accessing the standing repo facility.

71
4.2 Bond Pricing Benchmarks

Learning Objective
2.5.2 Understand the main bond pricing benchmarks and how they are applied to new bond issues:
spread over government bond benchmark; spread over/under inter-bank benchmarks; spread
over/under swap

4.2.1 Spreads
Financial analysts and investment professionals pay close attention to spreads in the bond markets. A
spread is simply the difference between the yield available on one instrument and the yield available
elsewhere. It is usually expressed in basis points.

A basis point is equal to 0.01%, which means that a 100 basis point uplift or premium is equal to 1%.

Spreads are commonly expressed as spreads over government bonds. For example, if a ten-year
corporate bond is yielding 6% and the equivalent ten-year gilt is yielding 4.2%, the spread over the
government bond is 6% – 4.2% = 1.8% or 180 basis points. This spread will vary, mainly as a result of the
relative risk of the corporate bond compared to the gilt, so for a riskier corporate issuer the spread will
be greater.

4.2.2 Benchmarks
At times of financial stress, such as during the banking crisis in the autumn of 2008, the spread between
LIBOR and the applicable base rates can widen dramatically, which in this instance reflected the
incapacity or unwillingness of banks to engage in normal money market activities.

Spreads are tracked by many market data vendors including Bloomberg and Markit. Indeed, the latter
company has played a pioneering role in creating numerous benchmarks and indices for the credit
markets which enable all kinds of spreads to be calculated and compared.

The use of a particular pricing benchmark is generally determined by the type of debt asset class. Also,
specific features of a bond can mean that pricing off a benchmark security/rate becomes more difficult.
For example, a ten-year corporate bond with a put/call feature is unlikely to price off the ten-year gilt but
rather a benchmark curve, as the estimate of the maturity of the corporate bond is unlikely to coincide
with the specific maturity of the given gilt because of the put/call feature. (Pricing off simply means the
price/value of one thing – here a bond – being determined from the price/value of something else –
here another bond.)

4.2.3 Spread Over/Under Swap Rates

There is a very active market in exchanging floating rates for fixed rates in the so-called swaps market.
Credit default swaps (CDSs), which are a form of insurance against the risk of borrowers defaulting on
their debt, are some of the most actively traded instruments in the capital markets. The rates available

72
 Fixed-Income Securities

on various swaps – both for corporate credits and also sovereign credits – are also used as benchmarks
against which to benchmark the yield available on any specific security.

The swap spread is the difference between the ten-year Treasury and the swap rate, which is the fixed

2
rate on a LIBOR-based interest rate swap. Under normal market conditions, the ten-year Treasury yield
will be lower than the swap rate, reflecting the credit quality of the US government versus that of the
participants in the interbank credit markets.

In general terms, the swap spread is defined as the difference between the swap rate and yield of
(on-the-run) government bonds of equal maturity. On-the-run means the most recent issuance of a US
Treasury bond or UK gilt.

4.2.4 Swap Spread Inversion

In the spring of 2010, a rare occurrence took place in the US markets, when the ten-year swap spread
inverted. It was also reported by the Financial Times that, in the UK, the spread to gilts inverted in
December of that year.

One explanation provided for this unusual inversion focuses on the concern over the magnitude of
government borrowing. The reasoning provided is that pension funds, for example, are matching assets
and liabilities synthetically – ie, receiving a fixed rate through a swap contract rather than by purchasing
bonds. This could plausibly reflect concern over the supply deluge in government bonds and the effect
this will have on yields.

4.3 Issuance of Fixed-Income Securities

Learning Objective
2.5.3 Understand the purpose, structure and process of the main methods of origination and
issuance and their implications for issuers and investors: scheduled funding programmes and
opportunistic issuance (eg, MTN); auction/tender; reverse inquiry (under MTN)

4.3.1 Scheduled Funding and Opportunistic Issuance

Traditionally, borrowing money via a bond issue was sensible only when large sums of money were
being raised in a single capital-raising transaction. The sums had to be large enough to make the costs
involved in issuance worthwhile. The details of the bond would be established, including its coupon and
maturity, and the bonds would be marketed to potential investors. The investors would either be invited
to bid for the bonds in an auction-type process, or a tender method was adopted (see section 4.1.3).

The rather rigorous requirements that were traditional in bond issuance, for example in the US, meant
that it was awkward and expensive to regularly raise bond finance, because each bond issue had to be
separately registered with the financial regulator – in the US, the Securities and Exchange Commission
(SEC). Because many issuers, particularly companies, needed to borrow money regularly in line with the

73
developments of their business, they tended to prefer to set up scheduled funding programmes with
their banks under which they looked to borrow money, instead of issuing bonds.

However, a US innovation was introduced that has been subsequently adopted in many other jurisdictions
which enables bond financing to be much more flexible. A process known as 'shelf registration' was
introduced that enabled a single registration to be used for a number of bond issues over a period of up
to two years. As detailed below, shelf registration has been heavily used in the medium-term note (MTN)
market, for bonds with generally two to ten years between issue and maturity. Shelf registration introduced
flexibility to the bond market, allowing companies to issue smaller batches of bonds with the coupons and
maturity varying according to market demand at the time.

4.3.2 Medium-Term Notes (MTNs)

MTNs are a form of corporate debt financing. They originated in the 1970s in the US when auto finance
companies, and especially General Motors Acceptance Corporation (GMAC), started issuing debt securities
with maturities falling between those of commercial paper and corporate bonds. The goal was to achieve
better asset-liability management (ALM) for their auto loan books. The debt securities required registration
with the SEC just like corporate bonds. However, such registrations are expensive and time-consuming. As
the auto finance companies wanted to make frequent small issuances to satisfy their evolving ALM needs,
they needed a streamlined issuance process.

In 1982, the SEC adopted Rule 415, which launched today’s MTN market. This allows issuers to
continually offer MTNs to investors. The MTNs must be registered, but registration is required only once
every two years. During those two years, the issuer is free to modify the MTNs’ nominal yield or term, as
the issuer’s needs or market demand require. The process is called shelf registration, and it makes MTNs
resemble commercial paper. Differences are that MTNs have longer terms, are registered with the SEC
and are usually coupon-bearing instruments, as opposed to discount instruments.

4.3.3 Shelf Registration in the UK

The shelf registration system also exists in the UK. It allows an issuer listed on the Official List of the FCA
to produce, on an annual basis, a document (shelf document) which contains most of the information
required in listing particulars. The FCA publishes the shelf document on its website. If, during the next
12 months, the issuer wishes to issue and list further shares or debt securities, all that is necessary is
the publication and circulation of a short document (issue note) containing the information required
to complete the listing particulars and update the shelf document in respect of the issue in question.
Similar systems operate in many other countries, for example the US, Canada, Japan, France, Spain and
Belgium.

A shelf document can be produced at any time during the year, although there are likely to be
considerable cost savings if an issuer does it in conjunction with the production of its annual report and
accounts. The shelf document will remain current until the earliest of:

• the publication of the issuer’s next audited annual report and accounts
• 12 months from the date the shelf document is published on the website (being the maximum
period under European law)
• the date the shelf document is removed from the website at the written request of the
issuer.4.3.4 Characteristics of the MTN Market
74
 Fixed-Income Securities

An issuer will generally engage two or more dealers to offer the MTNs on a best efforts basis. Through
those dealers, the issuer advertises a rate schedule indicating nominal yields available for various terms
up to ten years. The issuer changes its rates depending on market conditions and its immediate need for
funds. At times, it may temporarily suspend issuing notes. If an investor is interested in purchasing notes

2
at the offered rates, it contacts one of the dealers, who arranges the transaction. Should an investor
want to buy notes for a term or nominal yield not offered, it may place a request through one of the
dealers. If the issuer finds the request appealing, it may accept the proposed terms. This process is called
a reverse inquiry, and it accounts for a considerable fraction of MTN issuances.

Because MTNs entail credit risk, they are rated just like corporate bonds. The vast majority of issues are
rated BBB– or better.

There is a secondary market for MTNs supported by issuing dealers. If a dealer buys notes held by an
investor, the dealer may try to resell the notes or hold them in their own inventory.

Traditionally, MTNs were issued as senior unsecured debt securities paying a fixed coupon for terms of
between 270 days and ten years. Today, MTNs are structured in many ways. Even the name ‘medium-
term note’ has become a bit of a misnomer. The market is not defined by the instruments’ terms so much
as it is by shelf registration. Shelf-registered securities have been issued with terms of as much as 30
years, and they are called MTNs. There are floating rate MTNs. Some structures have coupons linked to
equity or commodity indexes. Securitisations are also issued as MTNs. One appeal of the market is the
flexibility it affords.

5. Fixed-Income Markets and Trade Execution

5.1 Government Bond Markets

Learning Objective
2.6.1 Understand the role, structure and characteristics of government bond markets in the
developed markets of the USA, Germany, Japan and the UK, including: market environment:
relative importance of exchange versus OTC trading versus organised trading facilities (OTFs);
participants – primary dealers, broker dealers and inter-dealer brokers; access considerations;
regulatory/supervisory environment

A government bond is one issued by a national government denominated in the country’s own
currency. As an example, in the US, Treasury securities are denominated in US dollars. The first-ever
government bond was issued by the English government in 1693 to raise money to fund a war against
France. Germany’s federal government issues bonds known as Bunds. The word Bund in German is short
for Bundesanleihe, meaning federal bond. The Government of Japan issues bonds commonly known as
Japanese Government bonds (JGBs).

Government bonds are usually referred to as risk-free bonds because the government can raise taxes to
redeem the bond at maturity. Some counter examples do exist when a government has defaulted on its

75
domestic currency debt, such as Russia in 1998 (the rouble crisis), though this is relatively rare. In this
instance, the term risk-free means free of credit risk. However, other risks still exist, such as currency risk
for foreign investors. Secondly, there is inflation risk, in that the principal repaid at maturity will have less
purchasing power than anticipated, if inflation turns out to be higher than expected. Many governments
issue inflation-indexed bonds, which should protect investors against inflation risk.

The most common process of issuing corporate bonds is through underwriting. In underwriting, one
or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and
re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end
investors. However, government bonds are instead typically auctioned. The way in which auctions are
conducted by the UK's DMO was covered in section 4.1.3.

Most government bond trades take place between firms in the OTC market (off-exchange). With
the introduction of the second Markets in Financial Instruments Directive (MiFID II) in January 2018,
a new type of trading venue, known as an organised trading facility (OTF), was introduced. An
OTF is a multilateral system that is not a regulated market or a multilateral trading facility (MTF).
It allows multiple third-party buying and selling interests in bonds, structured finance products,
emission allowances or derivatives to be traded; equities cannot be traded through an OTF. An OTF
is an investment service of an authorised investment firm and, therefore, the operation of an OTF is a
regulated activity that requires authorisation.

The Sovereign Debt Crisis

The financial crisis saw a widening of bond yield spreads and extreme sovereign bond price volatility,
particularly in those countries who have received ECB/IMF bail outs. Also resulting from the crisis, was an
unprecedented increase in gilt issuance levels by the UK’s DMO. Programmes of quantitative easing (QE)
have been introduced by many global central banks to attempt to stimulate national economies. This
involves the central bank buying large amounts of financial assets from commercial banks and other
private institutions in an attempt to improve money supply.

5.1.1 Conduct of US Treasury Auctions

To finance the public debt of the US, the US Treasury sells bills, notes, bonds, and Treasury Inflation
Protected Securities (TIPS) to institutional and individual investors through public auctions. Treasury
auctions occur regularly and have a set schedule; the current pattern involves more than 250 auctions
taking place each year.

There are three steps to an auction: announcement of the auction; bidding (which is conducted through
the Treasury’s designated primary dealer network); and issuance of the purchased securities.

76
 Fixed-Income Securities

Auction Announcements
The auction announcement details are as follows:

• Amount of the security being offered.

2
• Auction date.
• Issue date.
• Maturity date.
• Terms and conditions of the offering.
• Non-competitive and competitive bidding close times.

Bidding in Auctions and the Role of Primary Dealers

The bidding process for auctions of US Treasury securities is dominated by the primary dealer network.
As of June 2021, there were 24 large financial institutions, such as banks and several foreign investment
banks, designated as primary dealers by the US Treasury. Primary dealers not only participate actively
in the auction of US Treasury securities but are required to make bids or offers when the Fed conducts
open market operations (see chapter 1, section 1.2). Between them, these primary dealers purchase the
vast majority of the US Treasury securities sold at auction and resell them to other institutions, such as
pension funds and the public.

When participating in an auction there are two bidding options – competitive and non-competitive.

• Competitive bidding – limited to 35% of the offering amount for each bidder, and a bidder specifies
the rate or yield that is acceptable.
• Non-competitive bidding – limited to purchases of $5 million per auction. With a non-competitive
bid, a bidder agrees to accept the rate or yield determined at auction. Bidding limits apply
cumulatively to all methods that are used for bidding in a single auction.

At the close of an auction, the Treasury accepts all non-competitive bids that comply with the auction
rules and then accepts competitive bids in ascending order in terms of their rate or yield until the
quantity of accepted bids reaches the offering amount.

On issue day, the Treasury delivers securities to bidders who were successfully awarded them in a
particular auction. In exchange, the Treasury charges the accounts of those bidders for payment of the
securities.

5.1.2 The Regulatory Environment

The issuance of government bonds, the procedures and protocols for their auction and the conducting
of trade in the secondary market are subject to the full force of regulators, as government bond markets
must be seen to be transparent and not open to abuse.

There have been well-known cases when dealers have been suspended and fined with substantial
penalties for engaging in abusive actions during the auction of government bonds. In the US in 1991,
a trader with Salomon Brothers was caught submitting false bids to the US Treasury, in an attempt
to purchase more Treasury bonds than permitted by one buyer, between December 1990 and May
1991. Salomon was fined $290 million, the largest fine ever levied on an investment bank at the time,
weakening it and eventually leading to its acquisition by Travelers Group.

77
Other malpractices have occurred in other markets, and the actions taken by regulators are often
harsh to discourage others from violating the strict procedures that need to be followed with the issue
and trading of government bonds. China has moved to regulate bond market makers who have long
provided unregulated critical services. Dealers can now apply for promotion to formal market-making
status. By the end of 2014, it was reported that China’s interbank market had outstanding bonds worth
nearly 30 trillion yuan ($4.8 trillion). The move will see the exchange monitor and supervise quotations
by market makers.

In June 2017, it was reported that the Chinese corporate bond market issuance had hit a low, with many
bonds maturing. In addition, market circumstances had dissuaded new issuance. In 2018–19, more than
$1 trillion of local bonds matured and it became increasingly expensive for companies to roll over their
borrowings. In addition, yields on AAA-rated bonds have doubled and companies defaulted on 39.2
billion yuan ($5.8 billion) of domestic bonds in the first four months of 2019 which was 3.4 times the
total for the same period in 2018.

Over the first four months of 2021, Chinese bond defaults rose by over 70% to USD 18 billion, mainly
in the areas of real estate, aviation and electronics. 37% of these defaults were linked to the Chinese
conglomerate – the HNA Group.

Despite this, Chinese corporate bond issuance increased in Q1 2021, with the trend continuing in April,
indicating an improving investor sentiment.

5.1.3 Emerging Bond Markets

Learning Objective
2.6.2 Understand the differences between the developed markets and the emerging economies

Emerging market countries often have economies that are less diverse and mature than developed
economies. Bonds in emerging markets are issued by the governments or corporations of the world’s
less-developed nations. Bonds from such countries are generally regarded as much higher risk. Some of
the reasons for this are:

• greater likelihood of economic swings

• common political upheaval
• government interference
• taxation on foreign investment
• less liquidity
• less stable political systems, and
• greater market volatility.

On top of this, trading markets can be less efficient and emerging market bonds are often lower-rated
and not as financially secure as those with higher credit ratings from more developed nations. These
bonds tend to have higher yields in order to attract investment and are often regarded as highly
speculative and considered a longer-term investment that is not suitable for those with an investment
aim to preserve capital.

78
 Fixed-Income Securities

However, since the 1990s, emerging market debt has evolved from being a very volatile asset class to a
much more mature segment of global markets.

Many emerging countries have enjoyed greater political stability and manageable levels of government

2
debt. While many emerging market investors and fund managers will invest in such bonds, ETFs can
also provide exposure to the emerging bond markets, both corporate and government.

Bonds of emerging markets can help to make a portfolio more diverse as price movements in bond
markets in developed countries do not necessarily correlate to moves in emerging markets. Holdings in
both sectors can produce very different investment returns.

A large number of emerging nations now issue debt. Of the countries issuing debt, among the most
prominent are the following:

• Europe – Bulgaria, Hungary, Russia, Serbia and Ukraine.

• Asia – China, India, Indonesia, Malaysia, Philippines and Vietnam.
• Latin America – Argentina, Brazil, Chile, Colombia, Dominican Republic, El Salvador, Mexico,
Panama, Peru, Uruguay and Venezuela.
• Middle East/Africa – Egypt, Ghana, Iraq, Ivory Coast, Lebanon, Morocco, South Africa and Turkey.

Historical Events
The emerging country bond market throughout modern day history has generally been a very small part
of the overall global debt market. Primary issuance was quite a rare occurrence and generally small in size.

Despite the emergence of less developed bond markets as a key part of global financial markets, the fact
is that they have been more prone to crises than developed markets. Examples of such crises are:

• 1994 economic crisis in Mexico – caused by an unexpected and sudden devaluation of Mexico’s
currency, the Mexican peso.
• 1997 Asian financial crisis – compounded by global fears of contagion across the world.
• 1998–2002 Argentine depression – the economy shrank by 28%, the government fell and
defaulted on its debt.
• 1998 Russian financial crisis – caused by declining productivity and a high artificial exchange rate.
• 2011 euro sovereign debt crisis – particularly affecting Portugal, Ireland, Greece and Spain and
three Icelandic banks who defaulted. Greece was subsequently downgraded to an emerging market
in 2013.

79
5.2 The Global Strips Market

Learning Objective
2.6.3 Understand the purpose and key features of the global strip market: result of stripping a bond;
zero coupon securities; access considerations

5.2.1 Overview of Bond Stripping

Stripping a bond involves the separation of each of the cash flows arising from ownership of a bond
during its lifetime. A bond will generate a coupon payment, most frequently on a semi-annual basis
throughout its lifetime, and will also pay out the redemption amount of the bond on the final maturity
date. The deconstruction of these individual payments can be considered as providing several new
securities, each of which can be held and traded by investors.

The term 'stripping' arises from separate trading of registered interest and principal of securities
(STRIPS). In effect, as suggested in the previous paragraph, stripping a bond involves trading the
interest (each individual coupon) and the principal (the nominal value) separately. Each strip forms
the equivalent of a ZCB. It will trade at a discount to its face value, with the size of the discount being
determined by prevailing interest rates and time.

A STRIPS market has been developed in the UK within the gilts market. Only those gilts that have been
designated by the DMO as strippable are eligible for the STRIPS market, not all gilts. Those gilts that
are stripped have separate registered entries for each of the individual cash flows that enable different
owners to hold each individual strip, and this facilitates the trading of the individual strips. Only GEMMs,
the BoE and the Treasury are able to strip gilts.

The US Treasury market also has a well-developed STRIPS market, with a wide variety of bonds of
different maturities with different coupons available for stripping. The secondary market for the zero
coupon instruments resulting from the stripping process is very active.

As an example, a ten-year gilt can be stripped to make 21 separate securities: 20 strips based on the
semi-annual coupons, which are entitled to one of the half-yearly interest payments; and one strip
entitled to the redemption payment at the end of the ten years. This process of stripping enables
different owners to hold each individual strip, with a view to achieving more precisely an investment
objective than available by holding the original bond with all of the cash flows associated with it during
its lifetime.

Let us consider a simpler example of a stripped bond and, as illustrated in the diagram, we shall consider
a two-year gilt with a nominal or face value of £10 million and a coupon of 6%.

There will be four separate payments of £300,000 paid in coupons, and after two years, the £10 million
will be redeemed. The cash flows can be considered independently as laid out in the following diagram.

80
 Fixed-Income Securities

6% £10m 2-year gilt

2
Coup
o ns Principal
£300,000
payable in six
months
£300,000
payable in 12 £10m payable
months in two years
£300,000
payable in 18
months
£300,000
payable in 24
months

Assuming that the gilt shown above has been designated by the DMO as strippable, each of the
individual cash flows generated can be registered separately with the DMO and traded independently
of the other strips that result from the bond’s decomposition. As in the US, the secondary STRIPS market
also facilitates the trading of the individual strips.

5.2.2 Benefit of a Stripped Bond to Investors

The key benefit of STRIPS is that investors can precisely match their liabilities, removing any reinvestment
risk that is normally faced when covering liabilities with coupon-paying bonds. The nature of the
reinvestment risk arises because, in a volatile interest rate environment, the returns available at the time
of receiving a coupon payment may not have the desired long-term yield-to-maturity characteristics
required by an investor, such as a pension fund. Furthermore, investors in government bond STRIPS from
countries like the US and the UK need not worry about the risk that the issuer of the bonds will default.

Example
An investor wants to fund the repayment of the principal on a £5 million mortgage, due to be paid in five
years’ time. Using gilts, there are three major choices:

1. The investor could buy a £5 million nominal coupon-paying gilt, but the coupons on this would
mean that it would generate more than £5 million.

2. The investor could buy less than £5 million nominal, attempting to arrive at £5 million in five years.
However, they will have to estimate how the coupons over the life of the bond could be reinvested
and what rate of return they will provide. The investor’s estimate could well be wrong.

3. The investor could buy a £5 million strip. This will precisely meet their needs.

81
5.2.3 Pricing a Zero Coupon Bond (ZCB)
As indicated, a stripped bond effectively can be considered as a series of separate zero coupon bonds
(ZCBs). The table below shows how to value the final redemption payment for a five-year strip which
pays out no coupons, as these have been stripped and sold separately. The required yield-to-maturity
(YTM) in this case is 10% and this will require that the final ZCB consisting of the redemption amount
will have to be discounted as shown in the table, using the semi-annual convention in the gilt market of
discounting at 5% twice annually. The ZCB with a five-year term priced to realise a YTM of 10% will have
to trade at £61.39.

Estimating
Annual
Current 0.00% Desired Yield 10.00%
Coupon
Bond Price
Semi-
Cash Flow Discount Factor Present
Annual Cash Discount Factor
in £ at Desired Yield Value
Flows

0 £0.00 [1/0.05] x [1–(1/1.050^0)] = 20 0.00 £0.00

10 £100.00 [1/1.050^10] = 0.61 0.61 £61.39

Bond Price £61.39

5.2.4 Minimum Units for Stripping and Reconstitution in the UK Gilts

Market
For each strippable stock there will be a minimum amount below which the system will not accept
a strip request. The need for this arises because nominal holdings of a gilt, whether of an unstripped
bond or a strip, must be in multiples of one penny. This implies that, for example, at least £4 of a bond
will need to be stripped if the annual interest payable is, say, 7½%, because each six-month coupon will
be denominated in ¼ percentage points (in this case a coupon of 3¾%). In the same way, the minimum
strippable amount of a 7¼% stock will need to be £8, and of a 71/8% stock £16.

The system also needs minimum units for the strippability of stock in amounts above the minimum
and for a minimum re-constitutable amount. For example, for a 7¼% gilt it will not be possible to
reconstitute to, say, an amount of £500, as the necessary coupon strips will be £18.125p and, thus, not
in whole pence.

Unless otherwise stated at the time of issue, the minimum strippable amount for a gilt is £10,000
nominal, which will be increased in multiples of £10,000 (ie, gilts will be strippable in amounts of
£10,000, £20,000, £30,000 and so on). Similarly, the minimum reconstitutable amount of a strippable gilt
will be £10,000 of the gilt being reconstituted, again unless otherwise stated at the time of issue.

82
 Fixed-Income Securities

5.3 Global Corporate Bond Markets

Learning Objective

2
2.6.4 Understand the role, structure and characteristics of global corporate bond markets:
decentralised dealer markets and dealer provision of liquidity; relationship between bond and
equity markets; bond pools of liquidity (including OTFs) versus centralised exchanges; access
considerations; regulatory/supervisory environment

5.3.1 The Impact of Default Risk on Bond Prices

In the corporate bond market, unlike the government bond markets where it is assumed that most
sovereign borrowers will not default, the determination of the likelihood that a corporate borrower may
default is a vital part in the pricing mechanism for corporate bonds.

The price of a corporate bond will be influenced by the prices (and inversely the yields) on an equivalent
government bond. However, the corporate bond’s price will be subject to a discount to represent the
risk that the corporate may default compared to the default risk-free nature of the government bond.
Credit-rating agencies provide a rating system for corporate bonds. See sections 6.1 and 6.2.

5.3.2 The Relationship between Bond and Equity Markets

The primary difference between the corporate bond market and the equity market relates to the nature
of the security being traded. A corporate bond usually has a specified income stream in the form of
coupon payments, which will be paid to the holder of the bond, and a bondholder has a more senior
claim against the assets of the issuer in the case of a bankruptcy or restructuring.

Investors in equities may receive a dividend payment from the corporation, but this is less certain and
can fluctuate. Indeed, less mature companies may not even pay a dividend. The equity holder also has
a greater risk that, if the corporation which has issued the shares becomes insolvent or undergoes a
restructuring, there may be insufficient assets to be liquidated or reorganised and then distributed to
shareholders. In such instances, shareholders may find that their equity stakes in a corporation have
little or no residual value.

5.3.3 The Equity Risk Premium

The reason behind this premium stems from the risk-return trade-off, in which a higher rate of return is
required to entice investors to take on riskier investments. As already explained, the risk-free rate in the
market is often quoted as the rate on longer-term government bonds, which are considered risk free
because of the low chance that the government will default on its loans. Investment grade bonds, ie,
those rated BBB– and above by S&P and Fitch, and Baa3 for Moody's, are considered to be relatively low
in risk and are of greater appeal to a conservative investor. On the other hand, an investment in stocks
is far less guaranteed, as companies regularly suffer downturns or go out of business. If the return on a
stock is 15% and the risk-free rate over the same period is 7%, the equity risk premium will be 8% for this
stock over that period of time.

83
5.3.4 The Decentralised Dealer Market for Bonds
The primary function and role of market makers in corporate bonds is to provide liquidity to the
marketplace and to act as a facilitator or agent in trades between the principals. Dealers are those that
have been appointed by the corporate issuer to act as distributors on their behalf in the issuance and
underwriting of bond issues. There is often a combination of such roles by large financial institutions.

Unlike the traditional centralised stock exchanges for dealing in equities, a decentralised dealer market
structure is one that enables investors to buy and sell without a centralised location. In a decentralised
market, the technical infrastructure provides traders and investors with access to various bid/ask prices
and allows them to deal directly with other traders/dealers rather than through a central exchange.

The FX market is an example of a decentralised market because there is no single exchange or physical
location where traders/investors have to conduct their buying and selling activities. Trades can be
conducted via an interbank/dealer network that is geographically distributed. The trading in corporate
bonds is also conducted through a decentralised dealer network that can provide pools of liquidity for
the conduct of trade between buyers and sellers without the requirement of all trades to be cleared
through an exchange.

As mentioned in section 5.1, MiFID II introduced OTFs. These allow multiple third-party buying and
selling interests in non-equity instruments, including bonds, as a service of an already authorised
investment firm. OTFs are subject to the same transparency requirements that apply to regulated
markets and MTFs.

5.3.5 The Regulatory/Supervisory Environment

FCA Regulations
All authorised dealer firms, and all of the individuals employed within them in the UK, are subject to all
of the rules and regulations of the FCA.

The supervisory approach of the UK regulator has changed dramatically as a result of the banking crisis
of 2007–08. The risks of discipline and criminal prosecution resulting from violation of FCA regulations by
somebody who is FCA-authorised, or is an approved person at an FCA-authorised firm, are greater now
than previously.

The FCA now has a credible deterrence policy, which includes enforcing search warrants and carrying
out arrests as appropriate, seeking custodial sentences and imposing larger fines. In 2019, the FCA
imposed fines totalling over £392 million and over £192 million in 2020.

Furthermore, while the FCA (as the FSA) previously focused on firms, it is now concentrating on
disciplinary action against individuals who are approved persons at authorised firms, and individuals
who are fulfilling a role which requires FCA-approved person status. Approved persons include directors,
senior management, compliance officers and those in customer-facing roles at an FCA-authorised firm.
The regime has recently been extended to any person who exercises significant influence over the
regulated firm whether in the UK or overseas, including those at a parent company who have decision-
making power over the actions of the authorised firm.

84
 Fixed-Income Securities

It has also been extended to include proprietary traders who are likely to exert significant influence,
on the basis that they can commit the regulated firm. Approved persons have a contract with the FCA,
which has its own code of conduct and principles to follow. They can be disciplined by the FCA for
breaches of these, with penalties including a public reprimand (which has associated reputation issues)

2
and/or a fine, or a prohibition order, which prevents the individual from acting in the financial services
sector.

LSE Regulations
In addition to the decentralised dealer network model, there is trading of bonds on the LSE. This trading
is subject to the rules and regulations of the exchange.

The complete rules and conditions for listing securities in London are set out in the Listing Rules and
in the Admission and Disclosure Standards. The Listing Rules are maintained by the FCA, whereas the
Admission and Disclosure Standards are maintained by the LSE.

The FCA and the LSE have a statutory obligation to protect all investors on an ongoing basis and to
maintain a fair and orderly market. To fulfil this obligation, the FCA requires all issuers of eurobonds
listed in London to meet a number of continuing obligations.

Issuers of London-listed securities have the ongoing obligation to disclose to the investor community
any information deemed to be price-sensitive, which must be disseminated to the market via a
regulatory information service such as the LSE’s Regulatory News Services (RNS).

International Capital Market Association (ICMA)

Most new eurobond issues are placed by an international securities house, appointed by the issuer to
act as the lead manager to the issue. This lead manager will then form a syndicate of other securities
houses through which the bonds will be marketed and sold to their respective clients.

Once issued, trading takes place OTC between ICMA dealers, rather than being conducted on a physical
exchange. ICMA dealers will, upon request, quote a two-way price for a specific transaction in a particular
issue, although, as most issues tend to be held until maturity, the secondary market is relatively illiquid.

5.4 Bond Pricing and Yield Quotations

Learning Objective
2.6.5 Understand the different quotation methods and the circumstances in which they are used:
yield; spread; price

There are two major elements of a quote for a bond: the price and, as a result of the price, the yield.
Most investment managers will be looking for bonds with particular yields and maturity dates, and
by using the relatively simple mathematics which underlies bond pricing (at least for relatively simple
bond issues) it is possible to determine with precision how much a bond which meets their requirement
should be priced at and at what price it should be trading in the secondary market.

85
5.4.1 Spreads
When dealing in corporate bonds, or across different bond markets (such as different countries’
government bonds), traders and researchers will also be looking at the yield spreads that are available
and anticipating changes in those spreads.

Many different factors, including global credit market liquidity, macroeconomic factors within the
world economy and their influence on capital markets as well as issuer-specific considerations, will
be taken into account in the pricing of bonds. The use of spreads to other issues will play a major part
in such pricing (see section 4.2), along with judgements about credit quality and the future course of
inflation, as well as monetary policy and the direction of interest rates. Also relevant is the term structure
of interest rates, which is often called the yield curve, and which reveals the different yields across a
spectrum of different maturities, ranging from the yield available on three-month Treasury bills all the
way out to the yield on 30-year bonds (or even longer in the case of some government issues).

5.4.2 Spreads in the Government Bond Market

At present, with so many governments having to issue very large quantities of bonds to finance public
deficits there is a competition for capital, and investors will allocate funds according to the relative yields
available from different governments and by assessing the appeal of the bonds of different issuers in
relation to yields being offered by benchmark issuers.

To cite one example which has become very widely quoted in regard to the difficulties faced by several
member states within the eurozone, the spread between the bonds of the troubled states, such as
Greece, Portugal and Spain, with German bunds of similar maturity (typically the ten-year maturity) are
quoted in the financial media. The bund is considered to be the safest government bond issued by any
EU member state, and Germany has an AAA rating from the credit rating agencies.

In the summer of 2011, both S&P and Fitch cut their credit rating for Greece to CCC, which was the
lowest grade possible prior to default; Moody’s had the rating at Ca, which was its second lowest.

The spreads between a ten-year bund and a similar maturity issue from the Greek government had
surpassed 2,500 basis points. With the ten-year bund yielding below 2% pa (June 2012), the equivalent
Greek bond was effectively yielding more than 27% pa.

The excessive size of the spread reflected the fact that private sector banks and other financial
institutions had no appetite or demand for the bonds issued by the Greek government, while many
market participants believed that they would default.

5.4.3 Key Bond Quotation Characteristics

Quoted Price
The quoted price shows the current market value of the bond. Both the bid price and the ask price
should be included to provide the spread between the two. The price that the buyer is willing to pay
is the bid price. The ask price is the amount a seller is willing to let go of the bond for. The size of the
spread will reflect the liquidity of the bond.

86
 Fixed-Income Securities

The price quotation will, with one important exception, be expressed in 1/100th of a point or basis
point. The price can be thought of as referencing a nominal or principal amount of £100 (or other unit of
currency). A quote, for example, of 105 shows that the bond has a current price which is five points or 5%
above its principal nominal value, or the par value which will be paid at redemption.

2
US Treasury issues follow a few quirky conventions. Prices are given as percentages of face value, with
fractions like 1/32 as the last digits, not decimals. For example, a bond quote for the US ten-year note
may show that the price has risen by 8/32 to sell for 108 22/32. The quote can easily be converted to the
more standard system of pricing in 1/100 of a unit (effectively a basis point). The rise of 8/32 is equivalent
to 25 basis points or ¼ of a point, and the price of the bond at 108 22/32 can be simply expressed as
108.6875.

Coupon
This tells you the percentage of the principal amount or par that will be paid annually. A coupon of 5%
means that, for a bond with a £1,000 par value, £50 will be paid annually. The quote should indicate the
frequency of coupon payment. Semi-annual coupon payments are standard for most global government
issues, including the US and UK, but annual payments are to be found with German bunds and are also
standard in the eurobond market.

Maturity
This is the date when the principal amount will be repaid. A ten-year bond will be redeemed ten years
from the issue date and will include a last coupon payment as well as the repayment of the principal.

Current Yield
The current yield or flat yield is the coupon rate divided by the bond’s current price (see section 6.4.1). It
does not include the timing of the payments of coupons and does not reflect the internal rate of return
of all of the payments to be made during the lifetime of the bond.

Yield and price are inversely proportional to each other. As a simple rule of thumb, if the current price of
the bond is higher than the par value, the yield is lower than the coupon, and, if the current price of the
bond is lower than the par value, the required yield is higher than the coupon value.

Gross Redemption Yield (GRY)/Yield to Maturity (YTM)

The convention in the US bond market is to quote the GRY as the key characteristic of a bond’s current
market value. The YTM is also known as the gross redemption yield (GRY) and, in essence, it represents
the rate of return, expressed in the form of an annualised percentage rate, if one were to hold on to the
bond until maturity and receive all of the coupons and the redemption of principal. See section 6.4.2.

One key assumption of the GRY calculation, which in fact makes it unrealistic, is that one is able to
continually reinvest all the interest payments received at the same yield throughout. It also takes into
account any profit or loss incurred due to the current price of the bond being over or under par. A
discounted cash flow (DCF) procedure is the appropriate method for determining the appropriate price
to pay for a bond which has a known maturity date and fixed regular coupon payments. See sections
1.3.1 and 1.3.2.

87
The pricing of bonds or notes is more complex when they have floating rate coupons, or embedded
options, such as the ability of the issuer to call the bond before it reaches maturity, or when they have
been issued with step-up coupons, ie, the amount of the coupon steps up by a specified amount
during the lifetime of the bond. This is found in bonds issued by the government of India, for example.
However, all approaches use the underlying principle of DCF, which is to determine the net present
value of future income streams by reference to a required yield in annual percentage terms, and then
use this percentage as the rate of discounting the cash flows.

Yield to worst (YTW) is another factor, often considered when trading in the bond market. YTW
represents the overall return on investment if all market factors perform in the most negative manner
possible, ie, the worst case scenario. In calculating YTW, it is assumed that the current prevailing interest
rate will remain unchanged. Put simply, it is the lowest potential yield that can be received on a bond
without the issuer actually defaulting.

Miscellaneous
More specifics about individual bonds are identified in shorthand. 'M' means matured bonds and 'cld'
means called. Some bond quotations will include the credit rating of the company selling the bond as
well as indicating whether the bond is callable or not. Callable bonds can be redeemed earlier than the
maturity date.

6. Present Value, Yield and Conversion Calculations

6.1 Credit Ratings and Debt Seniority

Learning Objective
2.7.1 Understand the purpose, influence and limitations of global credit rating agencies, debt
seniority and ranking in cases of default/ bankruptcy: senior; subordinated; mezzanine;
payment in kind (PIK); tiers of bank debt

6.1.1 Credit Ratings

A credit rating estimates the creditworthiness of an individual, corporation or even a country. Leaving
aside the case of credit ratings for individuals, in the world of corporate and sovereign credits (ie,
the creditworthiness of governments), a rating is an evaluation made by credit-rating agencies of a
borrower’s overall credit history. It provides a classification system, enabling a lender or investor to
estimate the probability of the issuer of a credit, such as a bond, being able to make repayment in
accordance with the terms of the borrowing, or more specifically the offering prospectus for a bond
issuance. An inferior credit rating indicates a higher risk of defaulting on a loan, and investors will want
to be compensated for this additional risk by higher interest rates and other provisions, or they may
simply be unwilling to purchase the bonds being offered by the issuer.

88
 Fixed-Income Securities

Although the three major rating agencies – Standard & Poor's (shortened to S&P) Moody’s Investors
Service (known simply as Moody's) and Fitch Ratings inc (known as Fitch) – use similar methods to rate
issuers and individual bond issues, essentially by assessing whether the cash flow likely to be generated
by the borrower will comfortably service and ultimately repay its debts, the rating each gives often differs,

2
though not usually significantly so.

As a reminder, 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.
Further detail on credit ratings available from the three agencies is provided in section 6.2.

Issues such as ABSs are credit enhanced in some way to gain a higher credit rating. The simplest method
of achieving this is through some form of insurance scheme that will pay out should the pool of assets
be insufficient to service or repay the debt.

6.1.2 The Seniority Structure of Debt

Debt issued by companies can come in a variety of forms including bonds and bank borrowing. When
there are multiple forms (or tiers) of debt, the issuer will have to establish an order as to which debt
will be serviced and the so-called seniority within the entity’s capital structure in the event of financial
difficulties leading to a restructuring or liquidation.

In broad terms, the seniority of debt falls into three main headings: senior; subordinated; and mezzanine
and payment in kind (PIK).

Senior
Senior debt is a class of corporate debt that has priority with respect to interest and principal over other
classes of debt and over all classes of equity by the same issuer.

Senior debt is often secured by collateral on which the lender has put in place a first lien or charge.
Usually this covers all the assets of a corporation and is often used for revolving credit lines. Senior debt
has priority for repayment in a debt restructuring or the winding-up of a company.

However, in various jurisdictions and under exceptional circumstances, notwithstanding the nominal
label given to senior debt, there can be special dispensations which might subordinate the claims of
holders of senior debt. Holders of particular tranches of debt which may have been designated and sold
as senior debt may find that other claimants have super-senior claims.

As an example, in 2008, the Washington Mutual Bank was seized by the Federal Deposit Insurance
Corporation (FDIC) in the US, and, under an agreement between the FDIC and JPMorgan Chase, all of
the assets and most of the Washington Mutual Bank’s liabilities (including deposits, covered bonds and
other secured debt) were assumed by J.P. Morgan. However, other debt claims, including unsecured
senior debt, were not. By doing this, the FDIC effectively subordinated the unsecured senior debt to
them, thereby fully protecting depositors while also eliminating any potential deposit insurance liability
to the FDIC itself. In this and similar cases, specific regulatory and oversight powers can lead to senior
lenders being subordinated in potentially unexpected ways.

89
Furthermore, in US Chapter 11 bankruptcies, new lenders can come in to fund the continuing operation
of companies and be granted status as super-senior to other (even senior-secured) lenders. This
so-called debtor-in-possession status also applies in other jurisdictions, including France.

Subordinated
Subordinated debt or bond-holders have accepted that their claim to the issuer’s assets ranks below
that of the senior debt in the event of a liquidation. As a result of accepting a greater risk than the senior
debt, the subordinated borrowing will be entitled to a higher rate of interest than that available on the
senior debt.

Tiers of Bank Capital

Capital in banks is vital as it provides the safety net for depositors when things go wrong. As a result,
international standards for capital at banks have been issued via the Bank for International Settlements
(BIS) in Basel for some time. The requirements are referred to as Basel Accords, since they are reached by
committee under the auspices of the BIS.

The different levels of capital defined by the Basel Accords are commonly referred to as tiers 1 and 2, with
tier 2 subdivided into upper tier 2 and lower tier 2. It is within tier 2 that debt instruments can appear.

Tier 1 is the bank’s core capital and includes capital that has no contractual obligations to pay dividends
or interest. This is typically the ordinary shares/common stock and the retained earnings that have
been accumulated. It also includes any preferred stock/preference shares that are perpetual and are
not cumulative. Upper tier 2 includes cumulative preferred stock/preference shares and any perpetual
subordinated debt that is either able to be deferred or able to be converted into equity if required.
The recent description for such instruments is contingent convertibles or CoCos, because they may be
treated as equity in the event of the bank facing serious problems.

Lower tier 2 capital includes other subordinated debt that stands below other debt holders, in particular
the bank’s depositors, in the event of the bank being closed down and wound up.

Mezzanine and PIK

The mezzanine level of debt, if it exists at all, will be even riskier than the subordinated debt. It will rank
below other forms of debt, but above the equity in a liquidation. As the most risky debt, the mezzanine
debt will offer a higher rate of interest than the subordinated and senior levels of debt. Interest on
mezzanine debt is not always paid fully in cash. Interest can be split into a portion that is paid in cash
and a portion that is instead added to the amount owed. This latter portion is known as a payment in
kind (PIK). Some mezzanine debt pays no cash interest at all and instead all of the interest is rolled up to
become an increased amount owed. These notes are often referred to as PIK notes. PIK notes are a little
like ZCBs in that they free the issuer from the need to service the borrowing with cash until the notes/
bonds reach maturity.

It should be noted that each of the three main categories can themselves contain sub-categories such as
senior secured, senior unsecured, senior subordinated and junior subordinated. In practice, the various
rating agencies look at debt structures in these narrower terms. Seniority can be contractual as the
result of the terms of the issue, or based on the corporate structure of the issuer.

90
 Fixed-Income Securities

6.2 Credit Ratings

Learning Objective

2
2.7.2 Be able to analyse sovereign, government and corporate credit ratings from an investment
perspective: main rating agencies; country rating factors; debt instrument rating factors;
investment and sub-investment grades; use of credit enhancements; impact of grading
changes; considerations when using credit rating agencies

6.2.1 Credit Risk

We have already noted in various contexts that the credit risk for bonds – the probability of an issuer
defaulting on their payment obligations and the extent of the resulting loss – can be assessed by
reference to the independent credit ratings given to most bond issues.

6.2.2 Global Credit Rating Agencies

The three most prominent global credit-rating agencies that provide credit ratings (Standard & Poor’s,
Moody’s and Fitch) carry on business across the world and all have major operations in New York,
London and Tokyo. The credit rating agencies are paid by the debt issuer and offer different types of
rating services: public ratings; private ratings for internal or regulatory purposes; shadow ratings – again
for private consumption – and model-based ratings. Each kind involves differing degrees of evaluation.

In the case of Standard & Poor’s, the agency is a division of the US publishing company McGraw-Hill,
which trades on the NYSE under the symbol MHP. Moody’s is also an NYSE-listed company, trading under
the symbol MCO, and among its major shareholders is the renowned investor Warren Buffett. Fitch
Ratings inc is headquartered in New York and London and is part of the Fitch Group.

The best known and largest of the three agencies, S&P, states that its mission is, ‘to provide investors who
want to make better informed investment decisions with market intelligence in the form of credit ratings,
indices, investment research and risk evaluations and solutions'. Standard & Poor’s is also widely known for
maintaining one of the most widely followed indices of large-cap American stocks: the S&P 500.

The rating agencies, which have been the subject of much criticism and scrutiny in the wake of the
collapse of the mortgage-backed securities market in 2007–08, have an unusual relationship with the
principal participants in bond markets. On the one hand, their ratings are used by buyers of bonds,
such as pension funds and other asset management companies, and are regarded as independent and
objectively determined; on the other hand, their instruction and appointment come from the seller of
the bonds.

As was seen in cases which have been the focus of testimony before the US Congress, there are grounds
for believing that the manner in which the agencies are commissioned by and paid by bond issuers
provides a reasonable question as to the reliability and independence of the assessments made. In the
corporate debt market, this is far more of an issue than in the case of the credit ratings provided for
sovereign and government bonds, when the agencies are acting as free agents.

91
The following table provides a complete listing of the ratings grades used by the three main credit
-rating agencies, and a brief description of each category and the implications for investors who are
seeking knowledge regarding risk and as a way of assisting in determining the appropriate prices at
which bonds of each category should trade in the secondary markets for such issues.

Bond Credit Ratings

Description Moody’s Standard & Poor’s Fitch Ratings
Investment Grade
Prime Aaa AAA AAA
High grade Aa1, Aa2, Aa3 AA+, AA, AA– AA+, AA, AA–
Upper medium grade A1, A2, A3 A+, A, A– A+, A, A–
Lower medium grade Baa1, Baa2, Baa3 BBB+, BBB, BBB– BBB+, BBB, BBB–
Non-Investment Grade
Speculative Ba1, Ba2, Ba3 BB+, BB, BB– BB+, BB, BB–
Highly speculative B1, B2, B3 B+, B, B– B+, B, B–
Substantial risks Caa1 CCC+ CCC
Extremely speculative Caa2 CCC C
In default with little prospect
Caa3, Ca CCC–, CC, C CCC
for recovery
In default C D D

The highest-grade corporate bonds are known as AAA or Aaa, and these are bonds that the three
agencies have deemed the least likely to fail. Lower-grade corporate bonds are perceived as more likely
to default, when the borrower will have to entice lenders with a higher coupon payment and higher
yield to maturity. Indeed, bonds with a rating below BBB– (in the case of Standard and Poor’s and Fitch
Ratings), or Baa3 (in the case of Moody’s) are often referred to as junk bonds or speculative bonds which
are non-investment grade.

Since the financial crisis, the effectiveness of credit-rating agencies has come under scrutiny. Flaws in
the system were apparent during the sub-prime mortgage crisis in 2007 where many credit ratings of
highly rated securities were questioned because of insufficient collateral tied to the underlying loans,
which many claim should have been factored into the overall ratings.

92
 Fixed-Income Securities

Other considerations when using a ratings agency are as follows:

• Of the 150 or so worldwide credit rating agencies, only a few are considered to be major. Thus, there
is often a market view that there is a lack of competition with the three dominant players possessing

2
the lion’s share of influence.
• There may be perceived conflicts of interest as the rating agencies receive fees from the companies
whose structures they rate, putting pressure on the agency not to upset the company. Critics would
assert that this perceived conflict could lead to overly high ratings.

6.2.3 Country-Rating Factors

The cutting of a credit rating makes it more expensive for governments to raise money with their
sovereign bond issues, as they require higher coupon payments to attract investors who perceive more
risk, for example, in an Irish government bond than a US Treasury one.

The list below shows the kinds of factors or indicators which credit-rating agencies employ to determine
a country’s credit rating. By scoring these factors and calculating an overall score, each country’s
sovereign debt can be graded.

• Debt profile (foreign exchange reserves, debt-service ratio and absolute level of debt).
• Banking/financial stability.
• Balance of payments/current account.
• Government fiscal policy.
• GDP growth.
• Governance (regulatory regime, rule of law, corruption, transparency).
• Political system.
• National security (external threats, internal strife, terrorism).
• Export profile (growth, diversity).

The increasingly important derivatives markets, which are constantly pricing sovereign credit default swap
rates, are also becoming a major influence on the way in which markets trade government debt.

93
 Country Currency Currency GDP Sovereign Ten-year World Euler GDP
volatility change growth credit sovereign Bank DB Hermes $ per
vs Euro vs euro in rating bond score rating person
1 year yields
Lower Higher Higher Higher Lower Higher AA Higher
better better better better better better best, D better
worst
Albania 8.3% -1.2% -10.3% 35 NA 67.7 D 5,352
Armenia 13.0% -7.8% -13.7% 16 NA 74.5 D 4,622
Austria -10.4% 96 -0.4% 78.7 AA 50,277
Belarus 41.5% -26.2% -0.2% 28 N/A 74.3 D 6,663
Bosnia & 2.4% 0.0% 2.1% 27 N/A 65.4 D 6,073
Herzegovina
Botswana 17.8% -11.0% -24.8% 70 4.5% 66.2 B 7,961
Bulgaria 1.8% 0.0% -10.0% 60 0.4% 72 B 9,738
Colombia 26.9% -16.4% -14.9% 57 5.1% 70.1 A 6,432
Czech 12.0% -5.4% -8.7% 83 0.8% 76.3 A 23,101
Republic
Denmark 1.4% 0.3% -6.8% 100 -0.4% 85.3 AA 59,822
Estonia -5.6% 83 N/A 80.6 AA 23,660
France -13.8% 92 -0.3% 76.8 AA 40,494
Finland -6.4% 96 -0.4% 80.2 AA 48,685
Georgia 29.9% -17.0% -12.3% 45 N/A 83.7 D 4,789
Germany -11.3% 100 -0.6% 79.7 AA 46,259
Indonesia 21.3% -11.1% -4.2% 60 6.9% 69.6 B 4,136
Ireland -3.0% 78 -0.18% 79.6 A 78,661
Italy -17.7% 61 0.9% 72.9 A 33,189
Kazakhstan 25.2% -15.1% -1.8% 56 N/A 79.6 D 9,731
Kenya 18.8% -10.5% 1.1% 33 11.7% 73.2 C 1,816
Kosovo -9.3% N/A N/A 73.2 N/A 4,417

94
 Fixed-Income Securities

Country Currency Currency GDP Sovereign Ten-year World Euler GDP

volatility change growth credit sovereign Bank DB Hermes $ per
vs Euro vs euro in rating bond score rating person
1 year yields

2
Lower Higher Higher Higher Lower Higher AA Higher
better better better better better better best, D better
worst
Latvia -8.9% 73 0.6% 80.3 BB 17,836
Lithuania -4.2% 75 0.3% 81.6 BB 19,455
Mexico 36.1% -18.4% -18.7% 60 5.8% 72.4 BB 10,118
Moldova 6.0% -2.3% -14.0% 25 NA 74.4 D 4,498
Namibia 33.3% -16.5% -11.1% 45 10.7% 61.4 C 4,957
Netherlands -9.4% 100 -0.43% 76.1 AA 52,448
Nigeria 18.4% -11.3% -6.1% 30 7.74% 56.9 D 2,230
North 2.3% 0.0% -12.7% 45 N/A 80.7 C 6,093
Macedonia
Phillipines 7.2% -0.1% -16.5% 61 3.0% 62.8 B 3,485
Poland 9.4% -4.7% -8.2% 71 1.3% 76.4 BB 15,595
Romania 3.0% -2.4% -10.5% 55 3.5% 73.3 B 12,919
Russian 36.7% -23.4% -8.0% 55 6.3% 78.2 C 11,585
Federation
Slovakia -12.1% 76 -0.25% 75.6 A 19,329
South Africa 32.8% -16.7% -17.1% 46 9.5% 67 C 6,001
Spain -21.5% 71 0.3% 77.9 A 29,613
Turkey 46.3% -31.7% -9.9% 36 12.9% 76.8 C 9,042
Ukraine 29.9% -18.4% -11.4% 26 14.1% 70.2 D 3,592
UK 13.6% -2.4% -21.5% 91 0.2% 83.5 AA 42,300
Vietnam 10.8% -6.0% 0.4% 43 2.7% 69.8 C 2,715
Zambia 65.0% -38.4% -2.1% 30 34.0% 66.9 D 1,291

95
6.2.4 Debt Instrument-Rating Factors
The financial obligation to which a rating refers is usually a bond or similar debt instrument. The company
wishing to raise money by issuing a bond relies on an independently verified credit rating to inform
potential investors regarding the relative ability of the company to meet its financial commitments. The
agencies themselves make it clear that they are not in the business of recommending the purchase or
sale of any security, but address only credit risk.

There are two types of issue credit ratings, dependent upon the length of time for which the financial
obligation is issued. There are long-term-issue credit ratings and short-term-issue credit ratings, each
with their own set of standards. The latter relate to obligations which are originally established with
a maturity of less than 365 days (and to short-term features of longer-term bonds). Ratings may be
public or private. They provide opinions, not recommendations, and are derived from both audited and
unaudited information.

It is important to appreciate that credit ratings are tailored to particular sectors. Ratings should be
comparable across different sectors, but a rating may serve a very specific purpose in, say, the banking
or insurance sectors; for example, assessing the likelihood of a bank running into serious financial
difficulty requiring support, and whether it will get external support in such an event. Obviously, this has
no equivalent outside the financial sector.

The credit rating for a particular instrument is not meant to be a recommendation to an investor to buy,
sell or hold onto the instrument. That is a decision for individual investors based on their appetite for
risk. The debt instruments with the lowest credit ratings will carry the highest levels of potential reward
but also the highest level of risk of default by the borrower, so the investor will have to balance risk
against potential reward.

6.2.5 The Use of Credit Enhancements

Credit enhancement is often a key part of the securitisation transaction when issuing securities that
are backed by assets, such as loans. However, the credit crisis of 2007–2008 discredited the process of
credit enhancement of structured securities as a financial practice as the risk was not assessed correctly
and defaults began to rise. If the credit rating had been properly assessed and higher interest rates
assigned to structured securities, the crisis might have been averted. Credit enhancements include
excess spreads, over-collateralisation and the use of reserve accounts as well as other external credit
enhancement techniques detailed below.

Excess Spread
The excess spread is the difference between the interest rate received on the underlying collateral and
the coupon on the issued security. It is, typically, one of the first defences against loss. Even if some of
the underlying loan payments are late or default, the coupon payment can still be made.

Over-Collateralisation (OC)
Over-collateralisation (OC) is a commonly used form of credit enhancement. With this support structure,
the face value of the underlying loan portfolio is larger than the security it backs. Thus, the issued
security is over-collateralised.

96
 Fixed-Income Securities

In this manner, even if some of the payments from the underlying loans are late or default, principal and
interest payments on the ABS can still be made. In the mortgage market the over-collateralised loans
might not work well when the value of the collateral kept as part of the loan that is the real estate itself
starts depreciating in value.

2
Reserve Account
A reserve account is created to reimburse the issuing trust for losses up to the amount allocated for the
reserve. To increase credit support, the reserve account will often be non-declining throughout the life
of the security, meaning that the account will increase proportionally up to some specified level as the
outstanding debt is paid off.

6.2.6 External Credit Enhancement

Surety Bonds
Surety bonds are insurance policies that reimburse the ABS for any losses. They are external forms of
credit enhancement. ABSs paired with surety bonds have ratings that are the same as that of the surety
bond’s issuer. By law, surety companies cannot provide a bond as a form of a credit enhancement
guarantee.

Letter of Credit (LOC)

With a LOC, a financial institution – usually a bank – is paid a fee to provide a specified cash amount
to reimburse the ABS-issuing trust for any cash shortfalls from the collateral, up to the required credit
support amount.

LOCs are becoming less common forms of credit enhancement, as much of their appeal was lost when
the rating agencies downgraded the long-term debt of several LOC-provider banks in the early 1990s.

Wrapped Securities
A wrapped security is insured or guaranteed by a third party. A third party or, in some cases, the parent
company of the ABS issuer may provide a promise to reimburse the trust for losses up to a specified
amount. Deals can also include agreements to advance principal and interest or to buy back any
defaulted loans. The third-party guarantees are typically provided by AAA-rated financial guarantors or
monoline insurance companies.

6.3 Factors Influencing Bond Prices

Learning Objective
2.7.3 Be able to analyse the factors that influence bond pricing: credit rating; default risk; impact of
interest rates; market liquidity; inflation

6.3.1 Credit Rating

Bondholders face the risk that the issuer of the bond might default on their obligation to pay interest
and the principal amount at redemption. As seen, this so-called credit risk – the probability of an issuer
97
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.

6.3.2 Interest Rate Risk

Probably the most important risk to a bondholder is the impact of changing interest rates, because of
the method of discounting future cash flows at the prevailing rate of interest to calculate the net present
value of the bond’s cash flow and thereby arrive at the current bond price. In simple terms, it can be said
that as the interest rate or discount rate increases in determining the present value of the bond’s cash
flows so the current price of the bond will decrease. There is an inverse relationship between the price of
a bond with a fixed coupon and the prevailing rate of interest.

For example, a bond issued with a 5% coupon will be less desirable as interest rates increase and further
bonds are issued with higher coupon rates – for example, issued with 6% coupons. In simple terms, the
price of the bond obtainable in the secondary market will have to decline so that the YTM for the 5%
bond becomes equal to the YTM for the 6% bond: the manner in which the lower coupon bond remains
competitive in YTM is by having a lower current price. Duration and modified duration (volatility) are the
means of measuring this risk more precisely. Convexity is a measure that is used to explain the sensitivity
of a bond’s price to changes in the discount rate.

6.3.3 Inflation Risk

Inflation risk is linked to interest rate risk, as interest rates have to rise to compensate bondholders for
declines in the purchasing power of money.

6.3.4 Market Liquidity Risk

The ease with which an issue can be sold in the market will affect the investor’s perception of the risk
of holding a bond. Smaller issues especially are subject to this risk. In certain markets, the volume of
trading tends to concentrate into the benchmark stocks, or the on-the-run stocks, especially in the
government bonds market, thereby rendering most other issues illiquid. Other bonds become subject
to seasoning as the initial liquidity dries up and the bonds are purchased by investors who wish to hold
them to maturity.

The difficulties that can arise in the liquidity and trading conditions of bonds were especially acute
during the 1998 crisis, which began with the default by Russia on its bonds and led to the collapse of
Long-Term Capital Management (LTCM) – a major fund that specialised in the trading of fixed-income
instruments and various arbitrage strategies.

One of the difficulties that arose during this crisis was the mispricing in the US Treasury market where
the most recently issued long-term bond, which is known as the on-the-run bond, trades at a premium
to those bonds which had been issued previously and which are known as off-the-run. If investors have
a preference, during a crisis, for the most liquid instruments, they may hoard the on-the-run bonds
and force their price to be out of normal alignment with similar bonds which have a slightly different

98
 Fixed-Income Securities

maturity date. This can result in a breakdown in complex strategies designed to exploit the spreads or
price differences across the yield spectrum.

6.3.5 Issue-Specific Risk

2
This may arise from factors specific to the bond issue which tend to either increase or decrease the risk,
eg, issuer options such as the right to call for early redemption or possibly, holder options.

6.3.6 Fiscal Risk

This represents risk that withholding taxes will be increased. For foreign bonds, there is also the risk
of the imposition of capital controls locking an investor’s money into the market. For an investor
purchasing overseas or international bonds denominated in a currency other than that of the borrower’s
domestic currency or currency of account, there is obviously also a currency risk.

6.3.7 Macroeconomic Factors Affecting Bond Prices and Yields

A major driver of bond prices is the prevailing interest rate and expectations of interest rates to come.
Yields required by bond investors are a reflection of their interest rate expectations. For example, if
interest rates are expected to rise, bond prices will fall to bring the yields up to appropriate levels to
reflect the interest rate increases. To remain competitive, equities prices will also suffer.

The interest rate itself is heavily impacted by inflationary expectations. Simplistically, if inflation is
expected to be 4% pa, the interest rate will have to be greater than this in order to provide the investor
with any real return. The interest rate might stand at 7% pa. If economic news suggests that inflation
is likely to increase further, to, say, 6%, then the interest rate will increase too, perhaps up to 9%. The
reverse will be true if inflation is expected to fall.

Technically, the interest rate referred to in the preceding paragraphs is the nominal interest rate. The
nominal rate is the interest rate including inflation. The interest rate excluding inflation is generally
referred to as the real interest rate.

6.3.8 Summary of Factors Influencing Bond Prices

The factors that influence the prices of bonds can be sub-divided into two:

• Specific issuer factors.

• Macroeconomic or market factors.

The characteristics of a particular issue and the quality of the issuer encompass the following:

• Issuer’s current credit rating (which itself will reflect the issuer’s specific prospects) that highlights
the issuer’s default risk.
• The structure and seniority of the particular issue – for example, the bonds may be of high or low
priority in the event of default by the issuer and may be structured in a way that gives the bonds
particular priority in relation to particular assets (such as mortgage-backed bonds).

99
• The above aspects, combined with prevailing yields available on other benchmark bonds (such as
government issues in the same currency, with similar redemption dates), will determine the required
YTM and, therefore, the appropriate price.
• Liquidity – the more liquid bonds tend to be more expensive, encompassing a liquidity premium
and having lower bid/offer spreads.

6.4 Valuation of Fixed-Income Securities

Learning Objective
2.7.4 Be able to analyse fixed-income securities using the following valuation measures and
understand the benefits and limitations of using them: flat yield; yield to maturity; nominal
and real return; gross redemption yield (using internal rate of return); net redemption yield;
modified duration

In bond markets, the single most important measure of return is the bond yield. There are, however,
several different yield measures which can be calculated, each having its own uses and limitations. For
each of these measures, we need to know the following:

• How is the measure calculated?

• How useful is this measure?
• What are the limitations of this measure?

6.4.1 Flat Yield

The simplest measure of the return used in the market is the flat (interest or running) yield. This measure
looks at the annual cash return (coupon) generated by an investment as a percentage of the cash price.
In simple terms, it provides the regular annual return that is generated on the money invested.

The calculation of the flat or running yield is provided by this formula.

Flat yield = Annual coupon rate X 100

Market price

For example, the flat yield on a 5% gilt, redeeming in six years and priced at £104.40, will be (5/104.40)
x 100 = 4.79%.

The flat yield only considers the coupon and ignores the existence of any capital gain (or loss) through
to redemption. As such, it is best suited to short-term investors in the bond, rather than those investors
that might hold the bond through to its maturity and benefit from the gain (or suffer from the loss) at
maturity. Using the flat yield, it is simple to see how a change in interest rates will impact bond prices. If
interest rates increase, investors will want an equivalent increase in the yield on their bonds. However,
because the coupon is fixed for most bonds, the only way that the yield can increase is for the price to
fall. This is the inverse relationship between interest rates and bond prices.

When interest rates rise, bond prices fall and vice versa.

100
 Fixed-Income Securities

The flat yield for an 8% annual coupon bond redeemable at par in four years can be calculated as follows
if the current price is £98.60:

Flat yield = 8.00 = 0.081136 or 8.11%

98.6

2
Uses
This measure assesses the annual income return only and is the most appropriate measure when the
bond under consideration is an irredeemable, which pays a perpetual coupon but no redemption
amount. Alternatively, the flat or running yield can be useful if the focus is on the short-term cash
returns that the investment will generate.

Limitations
There are three key drawbacks for using flat yield as a robust measure in assessing bond returns.

Since it only measures the coupon flows and ignores the redemption flows, when applicable, it is giving
an incomplete perspective on the actual returns from the bond. A bond which has been purchased at a
price away from redemption will be significantly undervalued when the par value is excluded from the
calculation. The calculation completely ignores the timing of any cash flows and, because there is no
discounted cash flow analysis, the time value of money is completely overlooked.

Negative Yields
In May 2020, gilts were sold by the UK government for the first time with a negative yield. This meant
that investors were effectively paying for the privilege of lending money to the UK Government. The
three-year bond, maturing in 2023, raised $3.75 billion with a yield of -0.003%. The bond’s coupon is
0.75% annually, but the premium over par means that investors will receive back less than they paid.

Negative interest rates have been a key feature in many parts of the world for some time. Investors that
purchase bonds with negative yields typically include insurance companies, pension funds and fund
managers whose asset allocation rules necessitate them having to invest certain percentages of funds
into bonds.

With floating rate notes, the return in any one period will vary with interest rates. If the coupon is not
a constant, then using a flat yield basis for measuring returns becomes an arbitrary matter of selecting
which coupon amount, among many possible values, to use for the calculation. For these reasons, the
flat yield is not a very useful measure.

101
6.4.2 Gross Redemption Yield (GRY)/Yield to Maturity (YTM)
The gross redemption yield (GRY) for a bond is also known as the yield to maturity (YTM). The GRY for
a bond is the internal rate of return (IRR) of the bond. The IRR is simply the discount rate that, when
applied to the future cash flows of the bond, produces the current price of that bond. Expressed in its
simplest form, the GRY is the IRR of:

• the dirty price paid to buy the bond

• the gross coupons received to redemption
• the final redemption proceeds.

The mathematical formulation is:

Coupont Redemption
GRY = r =

∑ (1+r)t
+
(1+r)n

where:
r = the yield to maturity, expressed as a decimal
t = the time period after which the cash flow arises
n = the time period at redemption

The GRY is a much fuller measure of yield because it takes both the coupons and any gain (or loss)
through to maturity into account. As such, it is more appropriate for long-term investors than the flat
yield. In particular, because it ignores the impact of any taxation (hence gross redemption yield), this
measure of return is useful for non-taxpaying, long-term investors such as pension funds and charities.
The GRY is the IRR of the bond. The IRR is simply the discount rate that, when applied to the future cash
flows of the bond, produces the current price of that bond.

Mathematical Formulations

Price of bond where the GRY is r =

∑ Coupont
(1+r)t
+
Redemption
(1+r)n

Coupon1 Coupon2 Coupon3 Cn+R

Price of bond where the GRY is r = + + +…+
(1+r) (1+r)2 (1+r)3 (1+r)n

where:

r = the redemption amount

n = the number of years to maturity
t = the time period after which the cash flow arises

102
 Fixed-Income Securities

Unfortunately neither of these formulae can be solved algebraically (except in very rare circumstances)
and therefore the process of interpolation represents the only practical method.

Interpolation Approach

2
The interpolation approach is based on the fact that there is an inverse relationship between yields and
bond prices, ie, as yields rise, bond prices fall, and vice versa. In order to calculate the GRY, we select
two interest rates and calculate the net present value of the bond cash flows at each of these two rates.
These calculations establish two reference points in terms of values and rates, which can be used to
determine a linear relationship between changes in the bond price and changes in interest rates. The
following two tables show how we can establish two reference points with regard to homing in on the
actual IRR by using the simple annual discounted cash flow approach for the bond considered earlier
(8% annual coupon, four years to maturity, priced at 98.60). Let us first determine the net present value
(NPV) of all the cash flow with an assumed GRY of 7% and deduct the current market price in the cash
flow calculation.

Annual
8.00% Assumed GRY 7.00%
Coupon
Discount Factor
Annual Cash Flows Cash Flow in £ Discount Factor Present Value
at Desired Yield
Current Bond Price –98.6
1 £8.00 [1/1.07]1 0.93 £7.48
2 £8.00 [1/1.07]2 0.87 £6.99
3 £8.00 [1/1.07]3 0.82 £6.53
4 £108.00 [1/1.07]⁴ 0.76 £82.39
Difference from
£4.79
Bond Price

This provides us with a reference point at 7%, so let us also get a reference point in terms of the NPV of
the cash flows with an assumed GRY of 11%.

Annual
8.00% Assumed GRY 11.00%
Coupon
Discount Factor
Annual Cash Flows Cash Flow in £ Discount Factor Present Value
at Desired Yield
Current Bond Price –98.6
1 £8.00 [1/1.11]1 0.90 £7.21
2 £8.00 [1/1.11]2 0.81 £6.49
3 £8.00 [1/1.11]3 0.73 £5.85
4 £108.00 [1/1.11]⁴ 0.66 £71.14
Difference from
–£7.91
Bond Price

103
With this approach we are in the first instance assuming that there is a linear relationship between the
NPVs and the GRY, so, having established two reference points, we are able to draw a line through both
the points. This can be seen from the diagram below.

£10.00
Net Present Value

£0.00
0.07 0.08 0.09 0.1 0.11 0.12

– £10.00
GRY

Even though the true relationship between bond prices and interest rates is not linear, using this
approach provides us with a much greater sense of where the approximate range is to refine our
exploration of the intervals and continue with the process of interpolation. From the graph above, it
would seem that the more approximate interval is close to 8.5%.

The following table shows the annuity formula for discounting cash flows, and here we have selected
the two much closer reference points, which are an assumed GRY of 25 basis points below the 8.5% level
that the previous reasoning brought us towards, and 25 basis points above that level.

104
 Fixed-Income Securities

Annual
8.00% Assumed GRY 8.25%
Coupon
Timing of Discount Factor
Cash Flow in £ Discount Factor Present Value

2
Cash Flows at Desired Yield
Current
–98.6
Bond Price

Redemption
£8.00
1  

0.0825 [
1–
1

1.08254
[ = 3.2938 3.2938 £26.35

£100.00 1 0.7283 £72.83

in Year 4
= 0.7283
1.08254 Difference
from Bond £0.58
Price

Assumed GRY 8.75%

Timing of Discount Factor
Cash Flow in £ Discount Factor Present Value
Cash Flows at Desired Yield
Current
–98.6
Bond Price

4 £8.00
1  

0.0875 [ 1–
1

1.08754
[ = 3.2576
3.2576 £26.06

1
Redemption
£100.00 = 0.7150 0.7150 £71.50
in Year 4 1.08754
Difference
from Bond –£1.04
Price

Conclusion
We have found that the rate of 8.25% is too low and 8.75% is too high, hence the GRY must lie between
these two points. The total range of values covered as a result of this 0.5% (8.75% – 8.25%) yield
difference is a value of £1.62 (£0.58 + £1.04). In other words, we need to move so far from 8.25% towards
8.75% that we eradicate £0.58 of this £1.62.

The GRY is, therefore, 8.25% + (58p/162p x 0.5%) = 8.25 + 0.179 = 8.429%.

The actual GRY is 8.428%. Hence this calculation has proved to be accurate to about one hundredth of
a basis point.

105
6.4.3 Net Redemption Yield (NRY)
The net redemption yield (NRY) is very similar to the GRY, in that it takes both the annual coupons
and the profit (or loss) made through to maturity into account. The NRY, however, considers
after-tax cash flows rather than the gross cash flows. As a result, it is a useful measure for
tax-paying, long-term investors.

The coupon received from gilts is generally taxable, but any gain made on redemption (or subsequent
sale) is not taxable. This makes gilts with a low coupon attractive to higher-rate taxpayers, as the price
will be lower than par, resulting in a substantial part of the return coming in the form of a tax-free capital
gain.

The net redemption yield for individual investors can be formulated as follows in two different formulae.

Price = ∑ Ct (1 – Tp)

(1+r)t
+
R

(1+r)n

where: Tp = personal tax rate

The formula cannot be solved algebraically, and to calculate the IRR for NRY, an interpolation approach
represents the only practical method.

As each individual has a different tax position, the NRY will obviously be different for different individuals.
The market convention is to compute the NRY at assumed levels of personal tax such as 40%.

The net redemption yield can, therefore, be calculated as the IRR of the:

• dirty price paid to buy the bond

• net coupons received to redemption (net of the appropriate rate of tax)
• final redemption proceeds which are paid gross.

It will be useful to continue with the bond example which we have analysed throughout this section,
which is an 8% annual coupon bond with a price of £98.60, and four years to maturity, assuming a 40%
level of tax.

Previously when considering the GRY we used the interpolation method with two reference points
determined by homing in on the likely interval for the GRY, which would produce an NPV of zero for
the cash flows. Let us simplify matters and look at two reference points for this analysis – the first
at 5%, which is approximately 60% of 8.25% (our lower reference point from before) and an upper
reference yield of 5.5% – since we do not know more exactly what interval may be covered and a 0.5%
interpolation interval should still deliver quite satisfactory results, as was seen when calculating the GRY.

The table below again uses the annuity discount factor, and the two assumed GRY rates have been
entered for the two scenarios. The important modification that has been made to the cash flows is that
the 8% coupon has been netted to a 4.8% coupon, although the redemption amount of the bond –
which is not subject to tax – has been left at its gross value – also its par value of £100.

106
 Fixed-Income Securities

Annual
8.00% Assumed GRY 5.00%
Coupon
Discount
Timing of

2
Cash Flow in £ Discount Factor Factor at Present Value
Cash Flows
Desired Yield
Current
–98.6
Bond Price

4 £4.80
0.05 [
1   1
1–
1.054
[ = 3.5460 3.5460 £17.02

Redemption
£100.00 1 0.8227 £82.27
in Year 4
= 0.8227
1.054 Difference
from Bond £0.69
Price

Assumed GRY 5.50%

Discount
Timing of
Cash Flow in £ Discount Factor Factor at Present Value
Cash Flows
Desired Yield
Current
–98.6
Bond Price

4 £4.80
1  

0.055
1–
[ 1

1.0554
= 3.5052
[ 3.5052 £16.82

Redemption 1
£100.00 0.8072 £80.72
in Year 4 = 0.8072
1.0554 Difference
from Bond –£1.05
Price

As can be seen from the above analysis of the cash flows, the GRY rate of 5% is too low and 5.5% is too
high, hence the GRY must lie between these two points.

The total range of values covered as a result of this 0.5% (5.5% – 5%) yield difference is a value of £1.74
(£0.69 + £1.05). To follow the method of interpolation we need to move so far from 5% towards 5.5%
that we extinguish £0.69 of this £1.74 interval.

The GRY is, therefore, 5% + (69p/174p x 0.5%) = 5.00 + 0.19828 = 5.198%.

107
The actual GRY (which will deliver a zero NPV) is 5.197%, hence this calculation has proved to be
accurate to within a single basis point. Since the beginning of the 1996–97 tax year, the tax treatment of
the income and gain elements of the return on a bond have been harmonised for corporate investors, ie,
both are taxed as income.

As a result, ignoring the time delay on the payment of the tax, the NRY for a corporate investor can be
calculated according to the following simple formula:

NRY = GRY x (1 – Tc )

where: Tc is the corporate tax rate

Uses of NRY
Since it is based on discounted cash flow techniques, the NRY measure overcomes the major deficiencies
highlighted in relation to the flat yield and the GRY. It considers all cash returns and their tax implications
for the investor.

Limitations of NRY
The limitations of NRY are as for GRY. Specifically, it only represents the net return that will be achieved
if interest rates to maturity remain constant throughout the holding period.

6.4.4 Macaulay Duration

For bonds, cash flows at different points in time have different sensitivities to rate movements (different
risks). A bond may be thought of as an amalgamation of differently timed cash flows, each with their
own sensitivity. Hence, the sensitivity of a bond to changes in rates must be a weighted average of
the sensitivities of the individual cash flows. This is a bond’s duration. Duration is an estimate of the
weighted average length of time to the receipt of a bond’s benefits (coupon and redemption value), the
weightings being the present value of the benefits involved.

This concept can be illustrated diagrammatically.

Final
Coupon
plus
Capital

First Second Third Fourth

Coupon Coupon Coupon Coupon Present Values

Actual Cash Paid

The fulcrum or point of balance in the diagram represents the duration of the bond.

108
 Fixed-Income Securities

In terms of a mathematical formula this can be expressed as follows:

Macaulay Duration (D) = (t x PVt)

∑

2
     Price

(1 x PV1) + (2 x PV2) + (3 x PV3) +...+ (n x PVn)

Macaulay Duration (D) =
Price
where:

PVt = present value of cash flow in period t (discounted using the redemption yield)
n = number of periods to maturity

The table below shows the calculation for a five-year bond with a 7% coupon and a required yield to
maturity or GRY of 8%.

Calculation of Macaulay Duration

Gross Redemption Yield
Bond Price £96.01 8.00%
(GRY)
Face Value £100.00 Coupon Frequency 1
Coupon
7.00%
Rate
Life in
5
Years
Period Cash Flow PV Cash Flow Duration Calculation
Cash Flow/[(1+GRY/Coupon
PV Cash Flow x Period
Frequency)^Period]
1 £7.00 £6.48 £6.48
2 £7.00 £6.00 £12.00
3 £7.00 £5.56 £16.67
4 £7.00 £5.15 £20.58
5 £107.00 £72.82 £364.11
Totals £96.01 £419.85

Macaulay Duration £419.85/£96.01 4.373

Duration is one of the most useful ways of assessing the risk of holding a bond, as the higher the
duration of the bond, the higher its risk or sensitivity to interest rates.

As a measure of relative risk for a bond, it is just as valuable as knowing the beta for a share.

109
Duration needs to be determined for a portfolio of bonds in order to establish a bond fund-management
strategy called immunisation. See chapter 7, sections 5.4 and 7.7. The basic features of sensitivity to
interest rate risk are all mirrored in the duration calculation.

• Longer-dated bonds will have longer durations.

• Lower-coupon bonds will have longer durations. The ultimate low-coupon bond is a zero coupon
bond where the duration will be the maturity.
• Lower yields will give higher durations. In this case, the present value of flows in the future will fall if
the yield increases, moving the point of balance towards the present day, therefore shortening the
duration.

The duration of a bond will shorten as the lifespan of the bond decays. However, the rate of their decay
will not be the same.

As was seen in the previous example, a five-year bond with a 7% annual coupon and a GRY or YTM of 8%
has a Macaulay Duration of 4.373 years. Let us now examine what will happen for that same bond after
another year has elapsed, and when the bond will only have a remaining life of four years. As can be seen
in the table below, assuming again the same expectation with respect to the GRY or yield to maturity,
the result of the new calculation for duration is now the equivalent of 3.617 years.

Calculation of Macaulay Duration

Gross Redemption Yield
Bond Price £96.69 8.00%
(GRY)
Face Value £100.00 Coupon Frequency 1
Coupon
7.00%
Rate
Life in
5
Years
Period Cash Flow PV Cash Flow Duration Calculation
Cash Flow/[(1+GRY/Coupon
PV Cash Flow* Period
Frequency)^Period]
1 £7.00 £6.48 £6.48
2 £7.00 £6.00 £12.00
3 £7.00 £5.56 £16.67
4 £107.00 £78.65 £314.59
5 £0.00 £0.00 £0.00
Totals £96.69 £349.75

Macaulay Duration
£349.75/£96.69 3.617
(Years)

110
 Fixed-Income Securities

The lifespan of the bond will have decayed by a full year, but the duration by only 0.756 of a year.

Modified Duration
At the same time as the Macaulay Duration was being promoted as a means of expressing the sensitivity

2
of a bond to movements in the interest rate, J. R. Hicks, an economist at Cambridge in the 1930s,
developed a formula to explain the impact of yield changes on price. Not surprisingly, the two measures
are linked.

Hicks’ basic proposition was that the change in yield multiplied by this sensitivity measure will give the
resultant percentage change in the bond’s price, ie, the volatility gives the percentage change in price
per unit change in yield.

Modified duration is the percentage change in the price of a bond arising from a 1% change in yields.
The formula may be derived through the use of calculus, specifically differentiation of the price equation
with respect to yields.

Fortunately, there is an easier definition, specifically:

–Macaulay Duration
Modified Duration/Volatility =
1 + GRY

The use of modified duration is to provide a first estimate of the change in the price of a bond that will
result from a given change in yields. Returning to the earlier example of a five-year bond with a 7%
annual coupon, a GRY/YTM of 8% and a Macaulay Duration of 4.373 years, if the required yield were to
increase by 1% the price of the bond would fall by 4.0491%, from the modified duration formula:

Modified Duration = –4.373/(1.08) = –4.0491

6.5 Investment Perspective of Bonds

Learning Objective
2.7.5 Be able to analyse the specific features of bonds from an investment perspective: coupon and
payment date; maturity date; embedded put or call options; convertible bonds; exchangeable
bonds

The term ‘fixed income’ is given to securities that pay a pre-specified or fixed return, in the form of capital
and income. Following the more widely adopted usage, such securities are also collectively called bonds.

Bonds can be considered to be a contractual asset with claims on a series of cash flows which are
committed by the issuer to the purchaser. Another way of expressing this same idea is to call them
negotiable instruments. Such instruments, or, more simply stated, paper can be bought and sold, traded
in a marketplace where there can be differences of opinion about their risk and reward characteristics.
Bonds issued by large governments – sovereign issuance – tend to be highly liquid, ie, very easy to buy
or sell, whereas certain corporate bonds can be far less liquid and may have to be held to maturity by
the initial buyer.

111
6.5.1 The History of Bonds
Historically, bonds began as very simple negotiable debt instruments, paying a fixed coupon for a
specified period, then being redeemed at face value. The term ‘straight bond’ was, and still is, used to
describe the plain vanilla version of bonds with the simplest characteristics. Traditionally, bonds were
seen as being investment vehicles for very cautious investors, and the term widows and orphans has
sometimes been applied to the kinds of individuals for which fixed-interest securities were deemed to
be most suitable.

The 1970s was a period during which there were several momentous changes in the world’s financial
system, which included the abandonment of convertibility of dollars into gold, the end of the era of
fixed exchange rates, the emergence of serious inflation which required continuing adjustments of
interest rates, the development of the euro currency markets (ie, the market in dollar and other currency
assets not based in their home jurisdiction) and the beginnings of innovations in financial markets
including financial futures, swaps and other derivatives. The volatility in interest rates and currencies
enabled global bond markets to emerge from the shadows during the mid-1970s and since then they
have become, over the past few decades, more complex investments with many variations on the basic
straight bond theme.

6.5.2 Maturity Date

The maturity date is the point at which the nominal value of the bond is repaid. For example, an issue
may have a maturity date of 15 February 2022, which is the date on which the redemption of the
principal will take place or the bond has reached its maturity. There is a secondary market for many
bonds which means that they can be sold prior to that date, but the true redemption will only take place
on the date of maturity. However, as bonds have become more complex, there are now a number of
variations which need to be considered. These can be classified as follows:

Irredeemable/Perpetual Bonds
With irredeemable/perpetual or undated bonds, there is no maturity date. The issuer is under no
obligation to redeem the principal sum, but they may have the right to do so if desired. With these
bonds, the coupon will be paid into perpetuity.

Redeemable Bonds
The majority of bond issues are redeemable with a single date at which the nominal value is repaid.

Occasionally, the issuer may be given the right to repay the bond at an earlier date, or a range of
earlier dates. Such bonds are known as callable bonds, because the issuer has the right to call the
bond back and redeem it early. Simplistically, the bond issuer is likely to call the bond back when the
cost of replacement finance is cheaper than the interest rate being paid on the callable bond. The UK
government has issued a particular type of callable bond known as a double-dated gilt. These gilts
are issued with two maturity dates and the government (via the DMO) can give notice and choose to
redeem these gilts on any day between the first and final maturity dates.

In contrast to callable bonds, some issuers give the holders of their bonds the right to sell their bonds
back to the issuer, prior to maturity. These are referred to as putable bonds.

112
 Fixed-Income Securities

6.5.3 Coupons
While there is a variety of bond known as zero coupon bonds which are issued at a discount to their
face value and do not pay out coupons, the vast majority of bonds are issued with a periodic payment
obligation embedded in the instrument. These periodic payments are known as coupon payments.

2
The basis for the determination of the bond coupon is set before issue, although this does not mean that
the value is known at that date. While the vast majority of bonds issued are straights (ie, a fixed coupon),
there are a number of variants on this theme. Some bonds have coupons which vary with economic
factors, some are index-linked to protect the bondholder from inflation, and some have more esoteric
features which can alter the amount of the coupon payment based upon other factors. In essence,
the majority of bonds are issued with a predetermined value for the coupon, but many are subject to
variability in the amount of the coupon payment to be made.

One example of coupons that are subject to some variability is the floating rate bond, when the coupons
are typically linked to a reference interest rate at the time, such as LIBOR. Clearly if LIBOR increases, the
coupons will increase and vice versa for falls in LIBOR.

Another example is an index-linked bond when the coupons and usually the principal are increased by
reference to an index of inflation, such as the RPI.

However the amount is calculated, the full coupon for the period will be paid to the holder of the
bond on the ex-coupon date. The category of pre-determined coupons includes the vast majority of
bonds. On these bonds, the gross annual coupon (ie, the amount due to be paid in a one-year period,
irrespective of the frequency of payment) is specified as a percentage of the nominal value of the bond.

How often the coupon is paid is determined at issue. The frequency is typically every six months or
once each year. Occasionally, coupons are paid quarterly, rather than annually or semi-annually. The
frequency tends to be consistent in certain sectors of the bond market. For example, the UK, US,
Japanese and Italian government bonds tend to pay coupons semi-annually. The government bonds
issued by Germany and France and most other eurobonds tend to pay coupons annually.

6.5.4 Redemption at Maturity

Most bonds are redeemed, but there are a few variations to be aware of. The vast majority of bonds are
redeemed in cash at maturity. This redemption may be either:

• At par value – redeemed at the nominal value of the bond at the redemption date.
• At a premium – redeemed at a specified premium above the nominal value of the bond at the
redemption date.

Other variations exist when, instead of obliging the issuer to repay cash at the maturity date, the bond
may offer the holder the choice between normal cash redemption proceeds and some other asset, such
as an alternative bond of a later maturity or shares issued by a corporation.

113
6.5.5 Embedded Options
Embedded options are sometimes a part of a bond’s characteristics. An embedded option is a part of the
formal structure of the bond that gives either the bondholder or the issuer the right to take some action
against the other party.

There are several types of options that can be embedded. Some common types of bonds with embedded
options include callable bonds, putable bonds, convertible bonds and exchangeable bonds.

Callable Bond
A callable bond, which is also known as a redeemable bond, allows the issuer to retain the privilege of
redeeming the bond at some point before the bond reaches the date of maturity. If the bond contains
such an option, on the call date(s), the issuer has the right, but not the obligation, to buy back the bonds
from the bondholders at a defined call price.

The call price will usually exceed the par or issue price. In certain cases, mainly in the high-yield debt
market, there can be a substantial call premium.

Thus, the issuer has an option, for which it pays in the form of a higher coupon rate. If interest rates in
the market have gone down by the time of the call date, the issuer will be able to refinance its debt at a
cheaper level and so will be incentivised to call the bonds it originally issued.

The largest market for callable bonds is that of issues from the GSEs in the US, such as Fannie Mae and
Freddie Mac, which own mortgages and issue mortgage-backed securities (see sections 1.5.2 and 2.1.4
of this chapter). In the US, mortgages are usually fixed-rate, and can be prepaid early without cost, which
has given rise to a highly developed mortgage refinancing market. If adjustable rates on mortgages go
down, a lot of home-owners will refinance at a lower rate, which will result in the GSEs seeing a loss in
assets. By issuing a large number of callable bonds, they have a natural hedge, as they can then call their
own issues and refinance at a lower rate.

The price behaviour of a callable bond is the opposite of that of putable bond. Since call options and put
options are not mutually exclusive, a bond may have both options embedded.

Price of callable bond = Price of straight bond – Price of call option

• The price of a callable bond is always lower than the price of a straight bond because the call option
adds value to an issuer.
• The yield on a callable bond is higher than the yield on a straight bond.

Putable Bond
The putable bond or put bond is a combination of a straight bond and embedded put option. The
holder of the putable bond has the right, but not the obligation, to demand early repayment of the
principal. The put option is usually exercisable on specified dates.

This type of bond protects investors: if interest rates rise after bond purchase, the future value of coupon
payments will become less valuable. Therefore, investors sell their bonds back to the issuer and may
lend the proceeds elsewhere at a higher rate. Bondholders are ready to pay for such protection by
accepting a lower yield relative to that of a straight bond.

114
 Fixed-Income Securities

Of course, if an issuer has a severe liquidity crisis, it may be incapable of paying for the bonds when
the investors wish. The investors also cannot sell back the bond at any time, rather on specified dates.
However, they will still be ahead of holders of non-putable bonds, who may have no more right than
timely payment of interest and principal (which could perhaps be many years to get all their money

2
back).

The price behaviour of putable bonds is the opposite of that of a callable bond.

Price of putable bond = Price of straight bond + Price of put option

• The price of a putable bond is always higher than the price of a straight bond because the put option
adds value to an investor.
• The yield on a putable bond is lower than the yield on a straight bond.

Convertible Bonds
A convertible note (or, if it has a maturity of greater than ten years, a convertible debenture) is a type of
bond that the holder can convert into shares of common stock in the issuing company or cash of equal
value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features. Although it
typically has a low coupon rate, the instrument carries additional value through the option to convert
the bond to stock, and thereby participate in further growth in the company’s equity value. The investor
receives the potential upside of conversion into equity while protecting the downside with cash flow
from the coupon payments.

From the issuer’s perspective, the key benefit of raising money by selling convertible bonds is a reduced
cash interest payment. However, in exchange for the benefit of reduced interest payments, the value
of shareholders’ equity is reduced due to the stock dilution expected when bondholders convert their
bonds into new shares.

Exchangeable Bonds (XBs)

An exchangeable bond (or XB) is a straight bond with an embedded option to exchange the bond for
the stock of a company other than the issuer (usually a subsidiary or company in which the issuer owns
a stake) at some future date and under prescribed conditions. An exchangeable bond is different from
a convertible bond as the convertible only gives the holder the option to convert bonds directly into
shares of the issuer.

The pricing of an exchangeable bond is similar to that of a convertible bond, splitting it into a straight
debt part and an embedded option part and valuing the two separately.

Price of exchangeable bond = Price of straight bond + Price of option to exchange

• The price of an exchangeable bond is always higher than the price of a straight bond because the
option to exchange adds value to an investor.
• The yield on an exchangeable bond is lower than the yield on a straight bond.

115
6.6 Present Value, Yield and Conversion Calculations

Learning Objective
2.7.6 Be able to calculate and interpret: simple interest income on corporate debt; conversion
premiums on convertible bonds; flat yield; accrued interest (given details of the day count
conventions)

6.6.1 Simple Interest Income on Corporate Debt

The simplest measure of the return on a corporate bond used is the flat (interest or running) yield. This
measure looks at the annual cash return (coupon) generated by an investment as a percentage of the
cash price. See section 6.4.1 for the formula for its calculation and a discussion of its limitations.

6.6.2 Conversion Premiums on Convertible Bonds

A convertible bond gives the holder the right, but not the obligation, to convert into a predetermined
number of ordinary shares of the issuer. Given this choice, the holder will choose to convert into shares
if, at maturity, the value of the shares they can convert into exceeds the redemption value of the bond.
Because there is this upside potential to the value of a convertible bond if the share price rises, and
the downside protection of the redemption value if the shares do not perform well, convertible bonds
generally trade at a premium to their share value.

Example
A convertible bond issued by XYZ plc is trading at £114. It offers the holder the option of converting
£100 nominal into 25 ordinary shares of the company. These shares are currently trading at £3.90. We
need to calculate the share value of the conversion choice which is, for £100 nominal, equal to 25 times
£3.90 or £97.50. The bond is currently trading at £114 so the premium at present is £114–£97.50 =
£16.50. It is common to express the premium as a percentage of the conversion value so this convertible
has a premium of £16.50/£97.50 or 16.9%.

Convertible bonds enable the holder to exploit the growth potential in the equity while retaining the
safety net of the bond. Therefore, convertible bonds trade at a premium to the value of the shares they
can convert into. If there were no premium, there would be an arbitrage opportunity for investors to
buy the shares more cheaply via the convertible than in the equity market. Usually, convertible bonds
are issued where the price of each share is set at the outset and that price will be adjusted to take into
account any subsequent bonus or rights issues. Given the share price, it is simple to calculate the
conversion ratio – the number of shares that each £100 of nominal value of the bonds can convert into.

Nominal value
Conversion ratio =
Conversion price of shares

If the issuing company has a 1-for-1 bonus issue, then the conversion price will halve and the conversion
ratio will double.

116
 Fixed-Income Securities

6.6.3 Flat Yield and Accrued Interest

Accrued interest is the interest that has been earned, but not paid, and is calculated by the following
formula:

2
Number of days since last payment
Accrued interest = Interest payment x
Number of days between payments

Calculating the Purchase Price for a Bond with Accrued Interest

You purchase a corporate bond with a settlement date on 15 September with a face value of £1,000
and a nominal yield of 8%, that has a listed price of 100 8/32 and that pays interest semi-annually on 15
February and 15 August. How much must you pay assuming an actual/actual convention?

The semi-annual interest payment is £40 and there were 31 days since the last interest payment on
15 August. If the settlement date fell on an interest payment date, the bond price will equal the listed
price: 100.25% x £1,000.00 = £1,002.50 (8/32 = 1/4 = 0.25, so 100 8/32 = 100.25% of par value). Since the
settlement date was 31 days after the last payment date, accrued interest must be added. Using the
above formula, with 184 days between coupon payments, we find that:

Accrued interest = 40 x 31/184 = £6.74

Therefore, the actual purchase price for the bond will be £1,002.50 + £6.74 = £1,009.24.

Day Count Conventions

Common day count conventions that affect the accrued interest calculation are:

• Actual/360 (days per month, days per year) – the period 1 February to 1 April is considered to be
59 days (28 days for February, plus 31 days for March) divided by 360.
• 30/360 – each month is treated as having 30 days, so a period from 1 February to 1 April is considered
to be 60 days. The year is considered to have 360 days. This convention is frequently chosen for ease
of calculation: the payments tend to be regular and at predictable amounts.
• Actual/365 – each month is treated normally, and the year is assumed to have 365 days, regardless
of leap year status. For example, a period from 1 February to 1 April is considered to be 59 days. This
convention results in periods having slightly different lengths.
• Actual/Actual (ACT/ACT) (1) – each month is treated normally, and the year has the usual number
of days. For example, a period from 1 February to 1 April is considered to be 59 days. In this
convention, leap years do affect the final result.
• Actual/Actual (ACT/ACT) (2) – each month is treated normally, and the year is the number of days
in the current coupon period multiplied by the number of coupons in a year, eg, if the coupon is
payable 1 February and 1 August then on 1 April the number of days in the year is 362, ie, 181 (the
number of days between 1 February and 1 August) x 2 (semi-annual).

117
 End of Chapter Questions

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

1. What is the defining characteristic of a dual-dated gilt?

Answer reference: Section 1.1.1

2. How does the clean price of a bond differ from the dirty price?
Answer reference: Section 1.3.2

3. If the prevailing rates of interest are rising, what will be the effect on bond prices?
Explain your answer.
Answer reference: Section 1.3.4

4. How does the calculation of the retail prices index and the consumer prices index differ?
Answer reference: Section 1.4.1

5. Explain the difference between a fixed and floating charge in relation to a corporate bond or
debenture and indicate which will have priority in a liquidation.
Answer reference: Sections 2.1.2 and 2.1.3

6. What are PIBSs and why might they be attractive to investors?

Answer reference: Section 2.2.4

7. Name three of the five basic forms of eurobond issues?

Answer reference: Section 3.1

8. If a ten-year corporate bond is yielding 5% and the equivalent ten-year gilt is yielding 3.3%, what is
the spread expressed in basis points?
Answer reference: Section 4.2.1

9. What is the key benefit of STRIPS?

Answer reference: Section 5.2.2

10. For the three main credit ratings agencies, there are two classifications which represent the lowest
form of investment grade debt. What are those classifications, and which agencies issue them?
Answer reference: Section 6.2.2

118
Chapter Three

Equities

3
1. Characteristics of Equities 121

2. Issuing Equity Securities 128

3. Equity Markets and Trade Execution 146

4. Mandatory and Optional Corporate Actions 186

5. Corporate Actions and Share Dilution 192

6. Warrants and Contracts for Difference (CFDs) 196

This syllabus area will provide approximately 20 of the 80 examination questions

120
 Equities

1. Characteristics of Equities

1.1 Equity and Share Capital

Learning Objective

3
3.1.1 Understand the main investment characteristics, behaviours and risks of different classes of
equity: ordinary, cumulative, participating, redeemable and convertible preference shares;
voting rights, voting and non-voting shares; ranking for dividends; ranking in liquidation

An equity or stock represents a unit of ownership in a company. Shares are issued by stock corporations
or associations limited by shares and traded on the stock exchange where, on a continuous basis, prices
are calculated by matching demand and supply.

The bearer or owner of a share (the shareholder) owns part of the company’s capital stock, indicated
either as a percentage of the total share capital or as a par value that is printed on the share certificate.

Basic shareholder rights include the right to:

• attend annual general meetings (AGMs) and extraordinary general meetings (EGMs)
• vote at the AGM
• receive a share of the company’s profits, and
• subscribe to new shares.

Shares are classified according to various criteria, such as the way in which the capital stock is divided up
and the rights attached to the shares.

• Par value shares versus no-par-value shares – a par value share states a fixed amount of the
capital stock; no-par-value shares place a value in the share based on (perhaps just a percentage of )
the capital stock of a company.
• Bearer shares versus registered shares – the owner of a registered share is named in a company’s
shareholder record. Registered shares with restricted transferability are a particular type of equity
because the transfer of ownership is subject to approval by the stock corporation. As far as bearer
shares (see section 1.1.5) are concerned, the shareholder right is merely bound to the ownership of
the share.
• Ordinary shares versus preferred shares – unlike ordinary shares, preferred shares do not carry
voting rights. Instead, preferred shares usually take precedence over ordinary shares when it comes
to the distribution of profits and liquidation proceeds of a stock corporation.

1.1.1 Ordinary Shares

Ordinary shares are by far the most common security representing ownership in a company. Holders of
ordinary shares exercise control by electing a board of directors and voting on company policy. Ordinary
shareholders occupy the lowest tier of the capital structure of a company: in the event of liquidation,
ordinary shareholders have rights to a company’s assets only after bondholders, preference shareholders
and other debt holders have been paid in full. The ordinary shareholders of a company, therefore, take
the greatest risk.

121
If the company is sufficiently profitable, the ordinary shareholders may receive dividends. Dividends for
ordinary shareholders are proposed by the directors and generally ratified by the shareholders at the
AGM. However, the ordinary shareholders will only receive a dividend after any preference dividends
have been paid.

Each ordinary share is typically given the right to vote at AGMs and general meetings, although
sometimes voting rights are restricted to certain classes of ordinary shares. Such different classes of
shares (often called A ordinary and B ordinary shares) are created to separate ownership and control.

Each shareholder has the right to vote at both an AGM and general meetings but may, if they so wish,
appoint a third party, or proxy, to vote on their behalf. A proxy may be an individual or group of
individuals appointed by the board of directors of the company to formally represent the shareholders
who send in proxy requests and to vote the represented shares in accordance with the shareholders’
instructions.

Each ordinary share has a nominal value which represents the minimum amount that the company
must receive from subscribers on the issue of the shares. Occasionally, the company may not demand
all of the nominal value at issue; the shares are then referred to as being partly paid. At a later date, the
company will call on the shareholders to pay the remaining nominal value.

Non-Voting Ordinary Shares

When companies wish to raise finance from people other than the existing shareholders without
diluting the control of the existing shareholders, they may issue non-voting shares.

These shares are identical in all respects to ordinary shares except that they carry no voting rights (called
NV or A shares) or restricted voting rights (RV shares).

Such shares offer no greater return (they receive the same ordinary dividend), though the shareholder
faces a much higher risk since they cannot influence the operations of the company. As a result, it is
becoming increasingly difficult for companies to raise new capital by issuing non-voting shares.

Redeemable Ordinary Shares

Since the Companies Act 1985, companies have been allowed to issue redeemable ordinary shares,
providing that they also have shares in issue that are not redeemable. See section 1.1.3 for a definition
of redeemable. The company may now also purchase its own shares subject to satisfying a number of
conditions.

1.1.2 Deferred Shares

Deferred shares are shares that do not rank for a dividend until a particular circumstance is satisfied,
typically either until:

• the ordinary dividends have reached a predetermined level, or

• a specified period after the issue.

122
 Equities

1.1.3 Types of Preference Shares

Preference, or preferred, shares can come in a variety of forms.

Cumulative Preference Shares

A cumulative preference shareholder will not only be paid this year’s dividend before any ordinary
shareholders’ dividends, but will also receive any unpaid dividends from previous years. If the dividend

3
on a cumulative preference share is not paid in any one year, it must be accumulated and paid later;
that is, it should be accrued in the accounts even if the company cannot afford to pay it this year. This
accumulated liability must be paid off in full in later years before any ordinary dividend can be paid.

Redeemable Preference Shares

Redeemable preference shares are preference shares that enable the company to buy back the
shares from the shareholder at an agreed price in the future. The money provided by the preference
shareholders can be repaid, removing any obligation the firm has to them.

Redeemable preference shares are repayable either at a predetermined price, which is normally quoted
as being at a premium above their nominal value, or on the occurrence of a predetermined event or
date. As such, the shares represent a temporary source of financing for the company that will rank for
dividends for a short period of time and then be repaid. The shares, from the company’s perspective, are
similar to debt.

Participating Preference Shares

One drawback of preference shares, when compared with ordinary shares, is that if the company starts
to generate large profits the ordinary shareholders will often see their dividends rise, whereas the
preference shareholders still get a fixed level of dividend. To counter this, some preference shares offer
the opportunity to participate in higher distributions.

As noted above, preference shares usually carry a fixed dividend, representing their full annual return
entitlement. Participating preference shares will receive this fixed dividend plus an additional dividend,
which is usually a proportion of any ordinary dividend declared. As such, they participate more in the
risks and rewards of ownership of the company.

Convertible Preference Shares

Up to the date of conversion, a convertible preference share offers the shareholder all the normal risks
and returns associated with preference shares, ie, fixed dividend returns and preferential rights to
any capital repayment. On reaching the date of conversion, the shareholders will have the option of
converting the preference shares into ordinary shares or taking a predetermined cash alternative.

Convertible preference shares will have a specified conversion ratio which sets out how many convertible
shares can be converted into one ordinary share. As a result, a conversion premium or discount can be
calculated.

If it is at a discount, the convertible is a less expensive way of buying into the ordinary shares than
buying these shares directly. This happens when the price of the convertible has lagged behind the rise
in the ordinary share price or offers a relatively less attractive rate of dividend. The opposite is true if the
convertible stands at a premium.

123
The conversion premium/discount is calculated as follows:

[(Conversion Ratio x Market Price of Convertible Shares / Market Price of Ordinary Shares) – 1] x 100

The conversion ratio in the formula refers to the number of convertible preference shares that have to
be converted into one ordinary share. The calculation and its use can be seen by the following example.

Example
A company has issued 7% cumulative redeemable preference shares at 110p. They are currently priced
at 125p per share and can be converted into the company’s ordinary shares at the rate of five preference
shares for one ordinary share.

If the ordinary shares are priced at 600p, the conversion premium or discount is calculated as follows:

[(5 x 125 / 600) – 1] x 100 = 4.2%

The result shows that the convertible shares are at a premium to the ordinary shares and so buying
the convertible preference shares is a more expensive route than buying the ordinary shares directly.
However, the fixed rate of dividend currently being paid on the preference shares may be sufficiently
attractive when compared to that being paid on the ordinary shares to justify the premium.

The fact that the shares are at a premium also indicates that it will not be worth exercising the option to
convert into ordinary shares. This can be seen by simply comparing the respective values of the shares
as follows:

Shares Number of Shares Price Market Value

Convertible Preference Shares 5 1.25 6.25
Ordinary Shares 1 6.00 6.00

1.1.4 Rankings for Dividends and Liquidation

Preference shares are less risky than ordinary shares, but also potentially less profitable. Holders
generally do not have the right to vote on company affairs, but they are entitled to receive a fixed
dividend each year (as long as the company feels they have sufficient profits). These dividends must be
paid before any dividends to ordinary shareholders, hence the term preference. Although preference
shares tend to be non-voting, it is common for preference shareholders to become entitled to vote in
the event of no dividend being paid for a substantial period of time.

Preferred shares are the first class of equity to participate in any liquidation proceeds. For that reason,
preferred shares are usually the security of choice for many venture capital investors. Essentially, they
adopt a last in, first out philosophy respecting repayment of capital at liquidation.

Venture capital investors may also be provided with different classes of preference shares which
command a liquidation preference of two or three times their initial capital before other share classes
can participate in any liquidation proceeds. The ordinary shareholders rank last in the event of a
company liquidation.

124
 Equities

1.1.5 Bearer and Registered Shares

In general, a bearer instrument is a document that indicates that the bearer of the document has title
to property, such as shares or bonds. Bearer instruments differ from normal registered instruments, in
that no records are kept of who owns the underlying property or of the transactions involving transfer
of ownership. Whoever physically holds bearer shares is the owner of the claims that are entailed
even though the name of that owner does not have to be registered. This means that not only can the

3
ownership of a company be hidden, it can be transferred at will without this being known, without
stamp duty or capital gains being paid, and without any organisation dealing with the company being
any the wiser. Money laundering regulation becomes virtually impossible in such circumstances.

Bearer shares are accordingly useful for investors and corporate officers who wish to retain anonymity,
although ownership is extremely difficult to recover in event of loss or theft.

Usually, the legal shareholders of a limited company are those persons whose names appear on the
corporation’s official shareholders’ list, or register. These shareholders may or may not be issued a
tangible stock certificate which they may possess. A common stock certificate will bear the name of the
shareholder, and how many shares of stock the certificate represents. It will contain other information
such as the name of the company, any par value the shares have and, most importantly, whether there
are restrictions on the transfer of the shares.

Although, traditionally, there were not many UK companies that issued bearer shares, they were
abolished in February 2016 in order to improve the transparency of company ownership.

1.2 Depositary Receipts

Learning Objective
3.1.2 Understand the purpose, main investment characteristics, behaviours and risks of depositary
receipts: American depositary receipts; global depositary receipts; beneficial ownership rights;
structure; unsponsored and sponsored programmes; transferability

1.2.1 American Depositary Receipts (ADRs)

American depositary receipts (ADRs) were introduced in 1927 and were originally designed to enable
US investors to hold overseas shares without the high dealing costs and settlement delays associated
with overseas equity transactions.

An ADR is dollar-denominated and issued in bearer form, with a depository bank as the registered
shareholder. ADRs confer the same shareholder rights as if the shares had been purchased directly. The
depository bank makes arrangements for issues such as the payment of dividends, also denominated
in US dollars, and voting via a proxy at shareholder meetings. The beneficial owner of the underlying
shares may cancel the ADR at any time and become the registered owner of the shares.

125
The US is a huge pool of potential investment and so ADRs enable non-US companies to attract US
investors to raise funds. ADRs are listed and freely traded on the NYSE and NASDAQ. An ADR market also
exists on the LSE.

Each ADR has a particular number of underlying shares or is represented by a fraction of an underlying
share. For example, Sanofi (the French Pharmaceutical and Biotech company) is listed in France and New
York. There are separate ADRs in existence for the ordinary shares. Each ADR represents two individual
Ord shares. ADRs give investors a simple, reliable and cost-efficient way to invest in other markets and
avoid high dealing and settlement costs. Other well-known companies, such as BP, Nokia, and Vodafone
have issued ADRs.

1.2.2 Global Depositary Receipts (GDRs)

Depositary receipts (DRs) issued outside the US are termed global depositary receipts (GDRs). These
have been issued since 1990 and are traded on many exchanges. Increasingly, depositary receipts are
issued by Asian and emerging market issuers.

For example, over 400 GDRs from over 44 countries are quoted and traded on a section of the LSE and
are settled in US dollars through Euroclear or the DTCC Depository Bank. Both Euroclear and DTCC will
collect the dividend on the underlying share and then convert this into payments that can be paid out
to the GDR holders. Any voting rights are exercised through the Depository Bank, but GDR holders are
not able to take up rights issues; instead these are sold and the cash distributed.

Both ADRs and GDRs are negotiable certificates evidencing ownership of shares in a corporation from
a country outside the US. Each DR has a particular number of underlying shares, or is represented by a
fraction of an underlying share.

1.2.3 Creation and Structure of Depositary Receipts

DRs are typically created (or sponsored) by the foreign corporation (Sanofi in the above example).
They will liaise with an investment bank regarding the precise structure of the DR, such as the number
or fraction of shares represented by each DR. A depository bank will then accept a certain number of
underlying shares from the issuer, create the DRs to represent the shares and make these DRs available
to the US, and potentially other investors, probably via local brokers.

126
 Equities

This creation process for an ADR is illustrated by the following diagram:

(2) Issuer supplies the underlying shares to

the depository bank

3
Issuer Depository Bank

US Investors
(1) Issuer liaises
with investment
bank over the
structure of
the ADR
(3) The depository bank sells the
programme
ADRs to US investors
(via US brokers)

Investment Bank

(4) Cash proceeds are paid to the issuer

One characteristic of DRs that must also be considered is pre-release trading (or grey market trading).
When a DR is being created, the depository bank receives notification that, in the future, the shares will
be placed on deposit. As long as the depository bank holds cash collateral, even though the shares are
not yet on deposit, the depository bank can create and sell the receipt (the DR) at this time. Effectively,
investors are buying a receipt that entitles them to all the benefits of a share that will, in the future, be
held on deposit for them. The DR can be treated in this way for up to three months before the actual
purchase of the underlying shares.

The shares underlying the DR are registered in the name of the depository bank, with the DRs themselves
transferable as bearer securities. The DRs are typically quoted and traded in US dollars and are governed
by the trading and settlement procedures of the market on which they are traded.

The depository bank acts as a go-between for the investor and the company. When the company pays
a dividend, it is paid in the company’s domestic currency to the bank, which then converts the dividend
into dollars and passes it on to the DR holders. US investors, therefore, need not concern themselves
with currency movements. Furthermore, when a DR holder decides to sell, the DRs will be sold on in
dollars.

This removal of the need for any currency transactions for the US investor is a key attraction of the DR.
DR holders are entitled to vote, just like ordinary shareholders, except that the votes will be exercised via
the depository bank.

127
If the DR represents a UK company’s shares, there are tax ramifications in the form of stamp duty. The
UK tax authority, Her Majesty’s Revenue & Customs (HMRC) levies this tax on share purchases, at 0.5% of
the price paid to purchase shares. However, because DRs may trade outside the UK, in the US, there is
no stamp duty charged on the purchase of a DR. Instead, HMRC charges a one-off fee for stamp duty of
1.5% when the DR is created.

If an investor wants to sell their DRs, they can do so either by selling them to another investor as a DR,
or by selling the underlying shares in the home market of the company concerned. The latter route will
involve cancelling the DR by delivering the certificates to the depository bank. The depository bank will
then release the appropriate number of shares in accordance with the instructions received.

The logistics of settling transactions and then arranging for custody of the securities purchased can
be fraught with difficulty. In addition, property rights are not as well defined as in developed nations.
However, these problems can be mitigated by using GDRs.

Unsponsored ADRs are issued by a depository bank with no involvement by the issuer. Certain
shareholder benefits may not apply to these instruments, which are largely traded OTC.

2. Issuing Equity Securities

2.1 Overview of Security Issuance

Learning Objective
3.2.1 Understand the purpose and key features of the following: primary issues; secondary issues;
issuing, listing and quotation; dual listings; cross listings; delisting (cancelling)

Recognised stock exchanges, such as the London Stock Exchange (LSE) in the UK and the New York Stock
Exchange (NYSE) in the US, are marketplaces for issuing securities and then facilitating the trading of
those securities via the trading and market-making activities of their member firms. All stock exchanges
provide both a primary and a secondary market.

2.1.1 Primary Issues

The primary market, or the new issues market, is where securities are issued for the first time. The
primary markets exist to enable issuers of securities, such as companies, to raise capital, and enable the
surplus funds held by potential investors to be matched with the investment opportunities the issuers
offer. It is a crucial source of funding.

The terminology often used is that companies float on the stock exchange when they first access
the primary market. The process that the companies go through when they float is often called the
initial public offering (IPO). Companies can use a variety of ways to achieve flotation, such as offers
for investors to subscribe for their shares (offers for subscription). Offers can be underwritten by an

128
 Equities

investment bank or else the shares sold in an offering may be sold on a best efforts basis by the manager
of the IPO. There are no guarantees that an IPO will succeed in selling all of the shares being offered, and,
if markets are going through periods of adversity and turmoil, it is common for an IPO to be withdrawn.

A large IPO is usually underwritten by a syndicate of investment banks led by one or more major
investment banks (known as lead underwriter or lead manager). Upon selling the shares, the
underwriters keep a commission based on a percentage of the value of the shares sold (called the gross

3
spread). Usually, the lead underwriters, ie, the underwriters selling the largest proportions of the IPO,
take the highest commissions – up to 8% in some cases.

The secondary market, not to be confused with secondary issuance, is where existing securities are
traded between investors, and the stock exchanges provide a variety of systems to assist in this, such
as the LSE’s SETS system that is used to trade the largest companies’ shares. These systems provide
investors with liquidity, giving them the ability to sell their securities if they wish. The secondary market
activity also results in the ongoing provision of liquidity to investors via the exchange’s member firms.
Each jurisdiction has its own rules and regulations for companies seeking a listing plus continuing
obligations for those already listed. In the UK, there is the FCA and in the US, the Securities and Exchange
Commission (SEC). For further details, see section 2.2.2.

A special purpose acquisitions company (SPAC) is a company with no commercial buying or selling
operations. The company is set up by investors solely to raise capital through an IPO, which it eventually
uses to acquire another existing company. SPACs have become increasingly popular in recent years, as
seen in 2020 when SPACs raised $82 billion in the US.

2.1.2 Secondary Issues

Secondary issuances or secondary public offerings of shares are often referred to as a follow-on offering
as they refer to an issuance of stock subsequent to the company’s IPO. A follow-on offering can be either
of two types (or a mixture of both): dilutive and non-dilutive (as rights issue). Furthermore, it could be a
cash issue or a capital increase in return for stock. A secondary offering is an offering of securities by a
shareholder of the company (as opposed to the company itself, which is a primary offering).

In the case of some offerings, there can be a hybrid offering amalgamating both primary and secondary
issuance. For example, Google’s IPO included both a primary offering (issuance of Google stock by
Google) and a secondary offering (sale of Google stock held by shareholders, including the founders).

In the case of the dilutive offering, a company’s board of directors agrees to increase the share float for
the purpose of selling more equity in the company. The proceeds from the secondary offering might
be used to pay off some debt or used for needed company expansion. When new shares are created
and then sold by the company, the number of shares outstanding increases and this causes dilution of
earnings on a per share basis. Usually, the gain of cash inflow from the sale is strategic and is considered
positive for the longer-term goals of the company and its shareholders.

The non-dilutive type of follow-on offering is when privately held shares are offered for sale by company
directors or other insiders (such as venture capitalists) who may be looking to diversify their holdings.
Because no new shares are created, the offering is not dilutive to existing shareholders, but the proceeds
from the sale do not benefit the company in any way. As with an IPO, the investment banks who are
serving as underwriters of the follow-on offering will often be offered the use of a greenshoe or over-
allotment option by the selling company.
129
2.1.3 Issuing, Listing and Quotation
To offer shares for sale to the public via an IPO, a UK company must be a public limited company (plc).
The kinds of IPOs that can be conducted and the listing requirements of the exchanges vary, and in the
case of a large corporation, the most likely route for a UK company is to seek a full listing on the Main
Market of the LSE. If the company is smaller or has less of a trading track record, it may join the LSE’s less
closely regulated alternative investment market (AIM) (see section 2.3.5).

Companies seeking a full listing on the LSE have to meet stringent entry criteria, known as the Listing
Rules, administered by the FCA. The requirements are detailed in section 2.3.4.

The advantages to a company of obtaining a full listing include:

• raising its public profile

• increasing the liquidity and marketability of its shares so that they can be more easily traded, and
• gaining easier and less expensive access to new capital.

The disadvantages, however, include:

• the costs and increased accountability associated with obtaining and maintaining a full listing as a
result of greater disclosure and compliance requirements
• relinquishing an element of control, and
• becoming a potential takeover target.

Once a company has undertaken a listed offering, its share prices will be quoted in the normal fashion
for all listed companies, ie, with a bid and ask quotation, and the shares can be traded on a variety of
platforms.

Delisting (Cancelling)
Delisting is really the opposite of listing and means that the listed security is removed from the
exchange’s official list. Delisting can be voluntary or involuntary and can be for a variety of reasons. Such
reasons are:

• failure to meet the listing regulations or requirements of the exchange. Listing requirements include
minimum share prices, certain financial ratios and minimum sales levels
• the company goes out of business
• the company declares bankruptcy
• the company has become a private company (eg, resulting from a management buy out) after a
merger or acquisition
• the company wishes to reduce or remove an element of its regular reporting requirements, or
• the company no longer seeks a listing because of factors such as low volumes on the exchange on
which it is listed or for financial reasons, eg, to save on listing fees.

It is not always the case that companies who are delisted are bankrupt. Some delisted shares continue
trading OTC.

130
 Equities

2.1.4 Dual Listing

Dual listing refers to the fact that many securities are listed on more than one exchange. This can be
the case when a company’s shares are listed and traded internationally both on the LSE and the NYSE,
such as in the case of BP, Vodafone and HSBC. Dual listing can also refer to stocks trading on more than
one exchange within the same jurisdiction. Many stocks are traded on the NYSE and on one or more
of the regional exchanges – for example, the common stock of General Motors. Although dual listing

3
theoretically should improve the liquidity of a stock, thereby benefiting investors, most dual-listed
securities trade chiefly on one exchange.

One consequence of a dual listing for multinational corporations is in reference to the Sarbanes-Oxley
Act (often referred to as SOX). Passed in 2002 by the US Congress, the Act’s objective is ‘to protect
investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities
laws, and for other purposes’. It applies to US public companies and their global subsidiaries, and to
foreign companies that have shares listed on US stock exchanges. As a result of their dual listing, SOX,
therefore, applies to some of the UK’s largest companies by market capitalisation, such as BP, HSBC,
Prudential, Royal Dutch Shell and Vodafone, as well as many other international companies.

With dual listing, there are two legal companies acting as one, and their shares list and trade as those
legal companies.

2.1.5 Cross Listing

The practice of cross listing involves an issuer listing its shares in more than one market and in addition
to being listed on its own domestic exchange, ie, it is where the same shares are listed in more than one
country.

Many cross-listed securities have their prices quoted in different currencies, eg, GBP in London and EUR
in Paris. Prices, therefore, are subject to exchange rate fluctuation, as well as local market price formation
from natural supply and demand. Sometimes, small differences can exist between the prices of both
markets (taking into account the exchange rate), but this is usually very small, momentary and quickly
arbitraged away.

Some high frequency traders employ trading algorithms that look to profit from such differences by
buying in one market and selling in another. For some securities, however, there may be delays in
settlement due to re-registration of the bought security to settle the sale and thus settlement risk arises,
even though both securities are technically identical and fungible.

There are some advantages for a company to cross list, including a lower cost of finance in capital raising,
improved liquidity and the local labour market advantage of creating improved visibility and perception
of the company/brand. Additionally, companies may perhaps introduce share option schemes for the
benefit of employees in these local markets.

The main disadvantage, of course, is cost to the issuer as each listing will have its own reporting and
disclosure obligations, as well as additional fees for listing.

131
2.2 The Regulatory Framework

Learning Objective
3.2.2 Understand the main regulatory, supervisory and trade body framework supporting UK
financial markets: Companies Acts; the Financial Conduct Authority (FCA); HM Treasury;
Payment Systems Regulator; the Panel on Takeovers and Mergers (POTAM); exchange
membership and rules; relevant trade associations and professional bodies

The regulatory framework that underlies the way that the financial markets operate, in general in the UK,
and the LSE in particular, includes oversight and compliance with the following fundamental principles:

• Company law – in particular, the various Companies Acts and especially the Companies Act 2006.
• Regulations and requirements of the Financial Conduct Authority (FCA).
• Supervision and vigilance by HM Treasury.
• The Panel on Takeovers and Mergers (POTAM).
• Rules of membership laid down by exchanges such as the LSE rule book.

The Companies Acts detail requirements for companies generally, such as the requirement to prepare
annual accounts, the need to have accounts audited and for AGMs. Of particular significance to the
LSE are the Companies Act requirements necessary to enable a company to be a plc, since one of the
requirements for a company to be listed and traded on the exchange is that the company is a plc. There
have been many versions of the Companies Act over the years, but the one which received royal assent
in November 2006 provided, at the time, a complete overhaul of the previously enacted legislation.

The 2006 Act contains 1,300 sections, 16 schedules and covers many of the key areas including:

• company names
• Memorandum of Association
• Articles of Association
• share capital and maintenance of capital
• meetings
• communication with shareholders
• directors’ duties
• company secretary and company records, and
• annual reports and accounts.

2.2.1 The Financial Conduct Authority (FCA)

The FCA has to give its recognition before an exchange is allowed to operate in the UK. It has granted
recognition to the LSE and, by virtue of this recognition, the exchange is described as a recognised
investment exchange (RIE). In granting recognition, the FCA assesses whether the exchange has
sufficient systems and controls to run a market. Furthermore, the FCA lays down the detailed rules that
have to be met before companies are admitted to the official list that enables their shares to be traded
on the exchange.

132
 Equities

2.2.2 Listing in the UK

The FCA is responsible for setting and administering the listing requirements and continuing obligations
for plcs seeking and obtaining a full listing on the LSE. The FCA, when the FSA, was appointed as the
listing authority in May 2000.

Each jurisdiction has its own rules and regulations for companies seeking a listing, plus continuing
obligations for those already listed. The FCA is the ‘competent authority for listing’ – making the decisions

3
as to which companies’ shares and bonds (including gilts) can be admitted to be traded on the LSE. It is
the FCA that sets the rules relating to becoming listed on the LSE, including the implementation of any
relevant EU directives. The LSE is responsible for the operation of the exchange, including the trading of
the securities on the secondary market, although the FCA can suspend the listing of particular securities
and, therefore, remove their secondary market trading activity on the exchange.

In a similar way in the US, the SEC requires companies seeking a listing on the US exchanges (such as
Euronext and Nasdaq) to register certain details with the SEC first. Once listed, companies are then
required to file regular reports with the SEC, particularly in relation to their trading performance and
financial situation.

2.2.3 HM Treasury
Her Majesty’s Treasury (commonly known as HM Treasury) is the economics and finance ministry, with
overall responsibility for fiscal policy, as well as providing a supervisory role for the entire financial
framework in the UK. The department of government is headed by the Chancellor of the Exchequer.

2.2.4 The Chancellor of the Exchequer

The Chancellor of the Exchequer is the title held by the British Cabinet minister who is responsible for
all economic and financial matters, controls HM Treasury and plays a role akin to the posts of Minister
of Finance or Secretary of the Treasury in other nations. The position is considered one of the four Great
Offices of State in the UK, and in recent times, has come to be the most powerful office in British politics
after the Prime Minister.

HM Treasury administers the sanctions regime in the UK. In 2011, sanctions were applied against the
government of Libya and, in addition to sanctions being applied against Al-Qaeda and the Taliban
regimes, there are sanctions which have also been applied against, among others, persons associated
with Burma, the Democratic Republic of the Congo, Iraq, Ivory Coast, Lebanon, Russia, Sudan, Zimbabwe
and, more recently, North Korea. The main instrument for administering financial sanctions is the
publication of a consolidated list of financial sanctions targets which is used by banks and other financial
institutions to scan their customer databases and discover financial assets controlled by those who are
the targets of the sanctions and, typically, freeze any funds.

2.2.5 The Panel on Takeovers and Mergers (POTAM)

The UK supervisory authority that carries out the regulatory functions required under the EU Takeover
Directive is the Panel on Takeovers and Mergers (the Panel or POTAM).

133
The Panel’s requirements are set out in a code that consists of six general principles and a number of
detailed rules. The Code is designed principally to ensure that shareholders are treated fairly and are
not denied an opportunity to decide on the merits of a takeover. Furthermore, the Code ensures that
shareholders of the same class are afforded equivalent treatment by an offeror. In short, the Code
provides an orderly framework within which takeovers are conducted and is designed to assist in
promoting the integrity of the financial markets.

The Code is not concerned with the financial or commercial advantages or disadvantages of a takeover.
These are matters for the company and its shareholders. Nor is the Code concerned with competition
policy, which is the responsibility of government and other bodies. Each of the six general principles is
reproduced below, and it is useful to be able to review the principles to appreciate fully the spirit of the
Code. At its broadest, the Code simply requires fair play between all interested parties.

1. All holders of the securities of an offeree company of the same class must be afforded equivalent
treatment; moreover, if a person acquires control of a company, the other holders must be protected.
2. The holders of the securities of an offeree company must have sufficient time and information
to enable them to reach a properly informed decision on the bid; where it advises the holders of
securities, the board of the offeree company must give its views on the implementation of the bid
on employment, conditions of employment and the locations of the company’s places of business.
3. The board of an offeree company must act in the best interests of the company as a whole and must
not deny the holders of securities the opportunity to decide on the merits of the bid.
4. False markets must not be created in the securities of the offeree company, or the offeror company
or of any other company concerned by the bid in such a way that the rise or fall of the prices of the
securities becomes artificial and the normal functioning of the markets is distorted.
5. An offeror must announce a bid only after ensuring that they can fulfil in full any cash consideration,
if such is offered, and after taking all reasonable measures to secure the implementation of any other
type of consideration.
6. An offeree company must not be hindered in the conduct of its affairs for longer than is reasonable
by a bid for its securities.

2.2.6 Trade Associations and Professional Bodies

The British Bankers’ Association (BBA)
The BBA is the leading association for the UK banking and financial services sector, speaking for over 200
banking members from 50 countries on the full range of UK or international banking issues.

The BBA website states:

'We have the largest and most comprehensive policy resources for banks in the UK and represent our
members domestically, in Europe and on the global stage. Our network also includes over 80 of the
world’s leading financial and professional services organisations. Our members manage more than
£7 trillion in UK banking assets, employ nearly half a million individuals nationally, contribute over
£60 billion to the UK economy each year and lend over £150 billion to UK businesses'.

134
 Equities

The Investment Association (IA)

The IA is the trade body for the UK’s £7.7 trillion asset management industry. Its stated purpose,
according to its website, is: ‘to support and promote a commercially successful and growing UK investment
management industry as we seek to improve the financial outcomes for customers – savers and investors’.

The Chartered Institute for Securities & Investment (CISI)

The CISI website states: ‘The Chartered Institute for Securities & Investment is the largest and most widely

3
respected professional body for those who work in the securities and investment industry in the UK and in a
growing number of major financial centres round the world’.

Evolved from the LSE, the CISI has more than 45,000 members and sets over 40,000 examinations
covering a range of vocational qualifications.

The CISI’s charitable objectives are to:

• promote, for the public benefit, the advancement and dissemination of knowledge in the field of
securities and investments
• develop high ethical standards for practitioners in securities and investments and to promote such
standards in the UK and overseas, and
• act as an authoritative body for the purpose of consultation and research in matters of education
and public interest concerning investment in securities.

The Personal Investment Management & Financial Advice Association (PIMFA)

On 1 June 2017, the Association of Professional Financial Advisers (APFA) merged with the Wealth
Management Association (WMA) to form the Personal Investment Management & Financial Advice
Association (PIMFA).

The mission of PIMFA is to ‘create an optimal operating environment so that member firms can focus on
delivering the best service to clients and providing responsible stewardship for their long-term savings and
investments’.

2.2.7 The Payment Systems Regulator (PSR)

The Payment Systems Regulator (PSR) is an independent economic regulator that came into force on 1
April 2015. The PSR is a subsidiary of the FCA but has its own statutory objectives, managing director and
board. It is funded by the payments industry and is accountable to the UK Parliament. Payment systems
are a key component of the financial system in the UK and they handle £75 trillion payments annually.

The PSR’s statutory objectives are summarised as follows:

• to ensure that payment systems are operated and developed in a way that considers and promotes
the interests of all the businesses and consumers that use them
• to promote effective competition in the markets for payment systems and services (between
operators, PSPs and infrastructure providers), and
• to promote the development of, and innovation in, payment systems, in particular the infrastructure
used to operate those systems.

135
The PSR will liaise with payment system operators (cards and interbank), payment service providers,
including banks and building societies, infrastructure providers and businesses that rely on these
systems. It also works with industry bodies and consumer groups. One of its key purposes is to use its
powers where it feels that the payment systems industry is failing to provide adequate competition and
provide greater benefits for businesses or consumers. Among other powers are giving directions to take
action and requiring operators to provide direct access to payment systems.

2.3 The London Stock Exchange (LSE)

Learning Objective
3.2.3 Understand the structure of the UK exchanges, the types of securities traded on their markets,
and the criteria and processes for companies seeking admission: London Stock Exchange Main
Market; high-growth segment; AIM; Aquis; market participants; implications for investors

The LSE began life in 1773 when traders who regularly met to buy and sell the shares of joint stock
companies in Jonathan’s Coffee House voted to change the name of the coffee house to that of the
LSE. The LSE is Europe’s largest stock exchange, accounting for over 35% of European stock market
capitalisation, about 10% of world stock market value and over 50% of foreign equity trading on world
stock exchanges. In the rapidly changing financial markets, the LSE has to continue evolving to adapt to
the new platforms and technologies of a very competitive global marketplace.

The LSE is a recognised investment exchange (RIE) and, as such, is responsible for:

• providing a primary and secondary market for equities and fixed-interest securities
• supervising its member firms
• regulating the markets it operates
• recording all transactions, or bargains, executed on the exchange, and
• disseminating price-sensitive company information received by its regulatory news service (RNS)
and distributed through commercial quote vendors, also known as secondary information providers
(SIPs).

The LSE operates both a primary and secondary market. In its guise as a primary market, the LSE will
provide facilities for new issuance of securities by existing listed companies and new companies which
have satisfied the listing criteria detailed in section 2.3.4.

In its capacity as a secondary market, the role which comprises the majority of its day-to-day activities,
the LSE provides a marketplace, nowadays exclusively an electronic market, for the dealing (trading) of
a variety of securities.

The LSE provides real-time market information to various organisations around the world which
subscribe to the data feeds and trading facilities of the firm. The LSE’s website outlines the following
three key considerations regarding membership of the exchange.

136
 Equities

2.3.1 Eligibility for Membership

Membership is available to investment firms and credit institutions authorised in the European Economic
Area (EEA). Other non-EEA-regulated companies/institutions may be eligible. Members may also be
eligible for stamp duty reserve tax (SDRT) exemption and may apply for this as part of their application.

2.3.2 Connectivity

3
Member firms can connect directly to the exchange’s markets. The exchange offers several types of
connectivity options with varying levels of management and performance. These range from full
host-to-host solutions to vendor access network (VAN) connections. Each firm will have different
requirements and the LSE can help them choose the right form of access for their firm.

2.3.3 Clearing and Settlement

Firms that choose to connect directly to the exchange need to have in place appropriate clearing and
settlement arrangements. Members of the LSE benefit from an efficient and competitive clearing and
settlement infrastructure across its domestic and international markets.

The major securities which are traded daily on the LSE are:

• shares of domestic plcs which are of two main varieties:

• companies with a full listing, and
• usually, smaller UK plcs are admitted to AIM.
• exchange-traded funds (ETFs) and other new investment products
• international equities
• domestic corporate bonds
• UK Treasury issuance including gilts
• local authority fixed-interest securities, and
• international bonds including eurobonds.

2.3.4 Full Listing

Companies seeking a full listing on the LSE have to meet stringent entry criteria. These criteria are
known as the Listing Rules and are administered by the FCA.

The Listing Rules include the following requirements:

• The market value of the company’s issued share capital, or market capitalisation, must be at least
£700,000, of which no less than 25% must be made freely available to the investing public to ensure
an active market in the shares. This 25% is known as the free float.
• The market value of any company bond issues must be at least £200,000. Should a company bring
both debt and equity to the market, the total value must therefore be at least £900,000.
• All securities issued by the company must be freely transferable, that is, third-party approval to deal
in these securities must not be required.
• Any subsequent issue of ordinary shares or of securities that can be converted into the company’s
ordinary shares must be made to existing shareholders first unless the shareholders pass a special
resolution to forgo their pre-emption right.

137
• No one shareholder can hold 30% or more of the company’s ordinary voting shares.
• The company must have at least three years of audited accounts.
• The company must publish a statement showing that it believes it has sufficient working capital to
last at least the next 12 months.
• The company’s directors must have appropriate expertise and experience for managing the
business.

UK and European high-growth companies that do not meet all of the eligibility criteria to join the
premium segment of the main market can seek admission to the high-growth segment (HGS) of the
main market. HGS provides medium- and large-sized high-growth companies with an additional route
to the main market, to raise capital and to use the public market as a platform to build their business.
Companies applying for a listing on the HGS must demonstrate growth in revenues of at least 20% over
a three-year period prior to admission and must have at least 10% of the number of securities admitted
in public hands with a value of at least £30 million (the majority of which must be raised at admission).

2.3.5 AIM
Gaining admission to AIM is far less demanding than obtaining a full listing, as a minimum market
capitalisation, free float and past trading record are not required.

Most AIM companies tend to be those in the early stages of development, typically operating in
growth industries or in niche sectors, with a view to applying for a full listing once they become more
established.

The criteria to be satisfied to gain admission to AIM include:

• The company will have to appoint a nominated adviser (NOMAD) to advise the directors of their
responsibilities in complying with AIM rules. The NOMAD will also have to advise the firm on how to
prepare a prospectus that accompanies the company’s application for admission to AIM.
• The company will also have to appoint a nominated broker to make a market and facilitate trading
in the company’s shares, as well as provide ongoing information about the company to interested
parties.

2.3.6 Continuing Obligations

Once companies have obtained a listing, they are subject to a strict set of rules and regulations set by
the FCA known as continuing obligations.

Among other things, these require a company to promptly make all price-sensitive information public
and issue the annual and interim reports and accounts to shareholders within a set time frame. AIM
companies must publish accounts in accordance with the UK Generally Accepted Accounting Principles
(GAAP) – audited annual accounts within six months of the financial year-end, and half-yearly reports
within three months of the period to which they relate.

138
 Equities

The Brexit transition period ended at 11pm on 31 December 2020 and the UK’s onshored EU legislation
now applies. ‘Onshoring’ was the process of amending EU legislation and regulatory requirements
so that they work in a UK-only context, including directly applicable EU legislation such as the EU
Regulations and Decisions that form part of UK law by virtue of the European Union (Withdrawal) Act
2018, now that the Brexit transition period has ended.

Price-sensitive information is information which would be expected to move the company’s share price

3
in a material way once in the public domain. This includes releasing details of any significant change to
a company’s current or forecasted trading prospects, dividend announcements, directors’ dealings and
any notifiable interests in the company’s shares.

A notifiable interest is when a shareholder or any parties connected to the shareholder has at least a
3% interest in the nominal value of the company’s voting share capital. When that is the case, they must
inform the company of their interest within two business days. From July 2016, the EU’s Market Abuse
Regulation (MAR) restricted all employees and directors from using inside information when dealing in
the company’s shares. MAR also imposed additional restrictions on directors and persons discharging
managerial responsibilities (PDMRs).

2.3.7 Market Participants

LSE membership consists of all major multinational banks as well as smaller boutique private client
banks, brokers, dealers, market makers, clearing firms and other financial intermediaries.

Historically, the main buyers and sellers responsible for the bulk of trading activities on the LSE were
high net worth individual investors and corporate investors who were investing in the shares and bonds
of other companies. In more recent times, participation in the daily activities of the LSE, in common
with all financial markets, is overwhelmingly conducted by institutional investors such as pension funds,
index funds, exchange-traded funds, hedge funds, investor groups, banks and other miscellaneous
financial institutions.

2.3.8 Aquis Exchange

Aquis Exchange is authorised and regulated by the FCA in the UK and AMF (Autorité des Marchés
Financiers) in France. It operates as a multilateral trading facility (MTF) in the UK under the name Aquis
Exchange UK and in the EU as Aquis Exchange Europe.

In March 2020, the FCA approved Aquis Exchange’s acquisition of the NEX exchange from CME. Aquis
operates order books and offers pan-European equities trading. It does not permit aggressive non-client
proprietary trading. Aquis offers a subscription-based pricing model and charges according to usage,
which Aquis cites as having the potential to significantly reduce the cost of trading.

139
2.4 Listing Securities without a Prospectus

Learning Objective
3.2.4 Understand the process of issuing securities in the UK with or without a prospectus: Prospectus
Directive (PD) or equivalent where applicable; eligibility and registration criteria for natural
persons and small and medium-sized enterprises (SMEs)

For most public offerings of securities, a vital prerequisite is a prospectus or offering document which
the issuer has to make available to all prospective investors and the exchanges upon which it intends to
list its securities. Such a prospectus has to fully disclose all of the pertinent details regarding the offering
including a detailed business plan, an explanation of how the proceeds from the offering will be used,
details of all owners/directors of the entity, and, most importantly, a comprehensive disclosure of all of
the risks associated with the investment.

There are, however, offerings of securities which are made, not to the general public, but to a subset of
so-called sophisticated investors, where the rigorous kinds of disclosures that have to be made in an IPO
prospectus can be avoided.

2.4.1 Prospectus Directive (PD)

Under the Market in Financial Instruments Directive (MiFID), which were coordinated among members
of the EU, provisions have been allowed for offerings which can be made to a restricted class of investors
in Europe when a formal prospectus is not statutorily required.

The Prospectus Regulations 2005, implementing the EU Prospectus Directive 2003/71/EC, were made
on 26 May 2005. The Statutory Instrument (No. 1433) was laid before Parliament on 27 May 2005. The
Prospectus Directive (PD) sets out the initial disclosure obligations for issuers of securities that are
offered to the public or admitted to trading on a regulated market in the EU. It provides a passport for
issuers, which in turn enables them to raise capital across the EU on the basis of a single prospectus.

The rules apply to prospectuses for public offers of securities and admission of securities to trading on a
regulated market. The following are the key provisions:

• Prospectus requirements – prescribing the contents and format of prospectuses; allowing issuers
to incorporate by reference; allowing the use of three-part prospectuses; setting out the exemptions
from the requirement to produce prospectuses.
• Approval and publication of prospectus – setting out procedures for the approval of prospectuses
and how and where they must be published.
• Passport rights – introducing administrative measures to facilitate the passporting of prospectuses
on a pan-European basis, making it easier for companies to raise capital across Europe.
• Third country issuers – prospectuses drawn up under a third country’s law can be treated as
equivalent to directive requirements. This will be determined on a case-by-case basis.
• Other provisions – requiring issuers to produce annual information updates and the establishment
of a qualified investor register.

140
 Equities

One very significant provision of the PD, as implemented in the UK, is that issuers/offerors are exempt
from the obligation to produce a prospectus where offers of securities are made only to qualified
investors (QIs).

The PD was repealed on 21 July 2019 by the Prospectus Regulation ((EU) 2017/1129). The review of the
PD was a key strategic priority for the European Commission (EC). With effect from January 2021, the UK
has its own prospectus regime which largely retains the requirements of the EU Prospectus Regulation,

3
but with some changes to reflect the UK’ s EU departure.

The main requirements of the revised Regulation include:

• Simplified Disclosure Regime – a new regime to assist small growth companies plus a simplified
disclosure regime for companies seeking to raise further capital.
• Universal Registration Document (URD) – a new form of shelf registration mechanism for regular
issuers of securities.
• Wholesale Disclosure Regime – permits a reduced standard of disclosure for prospectuses
prepared by issuers for admissions to trading of non-equity securities.
• Risk Factors – issuers will need to limit the risk factors in a prospectus to 15.
• Requirements for Prospectus Summaries – requirements for summaries to be included.

2.4.2 Qualified Investors (QIs)

A QI, in relation to an offer of transferable securities, would usually have to be deemed, under MiFID, to
be a professional client, have agreed to be treated as a professional client or be an eligible counterparty.
QIs include investment institutions, certain small and medium-sized entities (SMEs) and natural persons
meeting prescribed criteria.

Taxation Issues for a Qualified Investor Scheme (QIS)

A qualified investor scheme (QIS) is a type of authorised investment fund (AIF) which is subject to
regulation by the FCA. The general treatment of investors in an AIF is designed to recognise that
they have bought units in a pooled investment scheme where the investors have no control over the
decisions of the fund manager about when and what investments to buy and sell. Instead of being
charged a tax on their share of the income and gains of the scheme, they are liable to tax (income tax or
corporation tax) on the distributions they receive and to CGT (or to corporation tax on chargeable gains)
on the gains made when they sell their units. This treats their holding of units in a fund (that is, units in
an AIF or shares in an open-ended investment company (OEIC)) in a similar way to a holding of shares
in a normal company.

141
2.5 Initial Public Offering (IPO)

Learning Objective
3.2.5 Understand the purpose, structure and stages of an initial public offering (IPO) and the role
of the origination team: structure – base deal plus greenshoe; stages of an IPO; underwritten
versus best efforts; principles and process of price stabilisation
3.2.6 Understand the benefits for the issuer and investors of the different processes used in an IPO

For the issuer the key benefits of an IPO over other capital-raising methods are that IPOs can raise
substantial sums of capital and create a great deal of publicity for the issuing companies. The money
raised in the form of an IPO is known as risk capital and the company assets are not encumbered or
hypothecated in the same manner as they would be if the capital were raised from a debt offering.

For investors, the benefit of buying shares in a new issue is that, providing that they have conducted
adequate due diligence (ie, fully researched the business plans and risk disclosures in the offering
document), they can diversify their existing holdings with the shares of a new company which may, over
time, become very successful.

The early stage investors who purchased shares in the IPOs of companies such as Microsoft, Intel, Apple
and Google could have amassed fortunes if they had retained their shares. The extraordinary capital
gains seen in the shares of such companies represents one of the most exciting opportunities for returns
in the financial markets.

Of course, not all IPOs will be such success stories. A company may only perform in a mediocre fashion
following an IPO, and, as was seen during the dot com mania of the late 1990s, many internet ventures,
with little or no revenues, were taken to market in a bubble-like mania of IPOs and many of these
companies have subsequently disappeared. Others were absorbed by acquiring companies, and, in
many cases, the purchasers of shares in an IPO were eventually issued shares in the company which
acquired the original issuers. In some cases, the returns from these acquisitions have also produced
extraordinary returns.

However, the May 2012 IPO for Facebook saw the market price of the shares lose over a quarter of its
IPO value in under a month and, by three months, the price was less than half of its IPO value. However,
there was a subsequent improvement in the trading price during the second half of 2012, throughout
2013, and in the first half of 2014, where it often significantly outperformed a rising market. At the time
of writing (June 2021), the share price was around $330, over eight times the IPO price of $38.

2.5.1 The Origination Team

Deciding to list (or float) securities on a stock exchange is a significant decision for a company to take.
Flotations have both pros and cons. The fact that the company can gain access to capital and enable its
shares to be readily marketable are often-quoted positives. The most often-quoted negatives are that
the original owners may well lose control of the company, and that the ongoing disclosure requirements,
and attention paid to the company after listing are much greater than previously.

142
 Equities

Once the decision has been made to list, the company will need to find and appoint a sponsor. The
sponsor is likely to be an investment bank, a stockbroking firm or a professional services firm such as
an accountancy practice. The role of the sponsor includes assessing the company’s suitability for listing
and the best method of bringing the company to the market, and coordinating the production of the
prospectus. This is a detailed document about the company, including financial information, enabling
prospective investors to decide on the merits of the company’s shares.

3
The sponsor is only part of the origination team helping the company in the flotation. In addition to the
sponsor, the issuing company will appoint a variety of other advisers, such as reporting accountants,
legal advisers, public relations (PR) consultants and a corporate broker. The reporting accountants will
attest to the validity of the financial information provided in the prospectus and the legal advisers will
make sure that all relevant matters are covered in the prospectus and the statements made are justified.
The combination of the reporting accountants and the legal advisers is said to be providing due
diligence for the prospectus – making sure the document is accurate and complies with the regulations.

A PR consultant is generally appointed to optimise the positive public perception of the company and
its products and services in the run-up to listing.

Finally, the origination team may require a corporate broker to ensure that there is a market in the
company’s shares, to facilitate trading in those shares and to provide ongoing information about the
company to interested parties. This role will most likely be provided by the sponsor if the sponsor is an
investment bank or stockbroking firm.

2.5.2 Structure of the Offering

Let us take as an illustration of how the IPO is structured in the case of a relatively new technology
company which intends to sell one million shares of its stock in a public offering through an investment
banking firm (or group of firms, known as a syndicate) whom the company has chosen to be the
offering’s underwriter(s).

The underwriters function as the broker of these shares and find willing buyers among their clients.
A price for the shares is determined by agreement between the sellers (the company’s owners and
directors) and the buyers (the underwriters and their clients). A part of the responsibility of the lead
underwriter in running a successful offering is to help ensure that, once the shares begin to trade
publicly, they do not trade below the offering price. When a public offering trades below its offering
price, it is said that the offering broke issue or broke syndicate bid. This creates the perception of an
unstable or undesirable offering, which can lead to further selling and hesitant buying of the shares. To
manage this possible situation, the underwriter initially oversells (shorts) to their clients the offering by
an additional 15% of the offering size. In our example, then, the underwriter will sell 1.15 million shares
of stock to their clients.

Now, when the offering is priced and those 1.15 million shares are effective (become eligible for public
trading), the underwriter is able to support and stabilise the offering price bid (which is also known as
the syndicate bid) by buying back the extra 15% of shares (150,000 shares in this example) in the market
at or below the offer price. They are able to do this without having to assume the market risk of being
long this extra 15% of shares in their own account, as they are simply covering (closing out) their 15%
oversell short.

143
An IPO is usually structured with a base number of shares that the company is planning to issue.
However, the issuing company may also reserve the right to increase the number of shares that it issues
if significant levels of demand would remain unsatisfied if only the base number of shares were issued.
The option to increase the number of shares is referred to as a greenshoe option. A greenshoe option is
a clause contained in the underwriting agreement of an IPO. The greenshoe option, also often referred
to as an over-allotment provision, allows the underwriting syndicate to buy up to an additional 15%
of the shares at the offering price if public demand for the shares exceeds expectations and the stock
trades above its offering price.

The mechanism by which the greenshoe option works to provide stability and liquidity to a public
offering can be illustrated by continuing with the example outlined above, but assuming in this case
that the offering has such strong demand (as was the case for a number of the dot com IPOs of the
1990s) that the price of the stock immediately goes up and stays above the offering price.

Under this scenario, the underwriter is left having oversold the offering by 15% and is now technically
short those shares. If they were to buy back that 15% of shares, they would be buying back those shares
at a higher price than they sold them at, and would incur a loss on the transaction.

This is when the over-allotment (greenshoe) option comes into play: the company grants the
underwriters the option to take from the company up to 15% of shares additional to the original offering
size at the offering price. A reverse greenshoe allows underwriters to sell shares back to the issuer in
order to support the secondary market price following the IPO, if the price falls. The underwriter can
purchase shares in the secondary market and sell them back to the issuer, thus helping to stabilise the
price.

If the underwriters were able to buy back all of their oversold shares at the offering price in support of
the deal, they would not need to exercise any of the greenshoe. But if they were only able to buy back
some of the shares before the stock went higher, then they would exercise a partial greenshoe for the
rest of the shares. If they were not able to buy back any of the oversold 15% of shares at the offering
price (syndicate bid) because the stock immediately went and stayed up, then they would be able to
completely cover their 15% short position by exercising the full greenshoe.

2.5.3 The Stages of an IPO

There are three broad stages to an IPO:

• The decision – the issuing company (in conjunction with its advisers, particularly the investment
bank) makes a decision to raise capital via an IPO. This will involve careful consideration of the pros
and cons of a public offer.
• The preparation of the prospectus – this is the necessary document that must accompany an IPO,
involving the whole team of advisers, including the investment bank, reporting accountants and
legal advisers. In the US, a prospectus has to be filed with the SEC and must strictly follow prescribed
procedures and full risk disclosures in accordance with regulations covering new issues. In the UK,
similar policies are in place and regulated by the FCA.
• The sale of securities – the investment bank will lead-manage the sale and may well establish a
syndicate of co-managers to assist in selling the securities to their clients.

144
 Equities

2.5.4 Underwritten Versus Best Efforts

Underwriting an offer is generally the responsibility of the investment bank(s) and they typically
arrange firm underwriting where there are guarantees in place to buy the securities. An IPO is said to
be underwritten when there is a firm undertaking by the investment bank(s) that are conducting the
offering that all of the offering will be fully subscribed. In other words, the underwriting bank(s) will
guarantee that any shortfall by subscribers will be purchased by the bank(s) for their own account.

3
Investment banks may not provide a firm undertaking to place all of the securities on behalf of their
clients. Instead, the lead underwriter along with the co-managers of the offer may provide a best efforts
underwriting, in which they will do their best to sell the shares involved in the offering but where
there is no formal guarantee that this will be achieved. In practice, this means that the managers of
the underwriting are not committing to purchase any unplaced securities for their own account in an
unconditional manner. However, by an underwriter and the co-managers inserting the best efforts
conditionality, should there be a failure to fully complete a sale of the offering, there is a risk to the
underwriter of reputational damage and not being invited to participate in future IPOs.

2.5.5 Price Stabilisation

Stabilisation is the process whereby, to prevent a substantial fall in the value of securities when a large
number of new securities are issued, the lead manager of the issue agrees to support the price by buying
back the newly issued securities in the market if the market price falls below a certain predefined level.
This is done in an attempt to give the market a reasonable chance to adjust to the increased number of
securities that have become available, by stabilising the price at which they are traded.

By increasing the demand for the securities in the market at the same time as more securities become
available, the price should remain more stable. This will mean the issuing company’s securities appear
less volatile, and existing investors will be less likely to begin panic selling and creating a downward
spiral in the security’s price. The securities that are bought back by the lead manager of the issue will
then be sold back into the market over time.

Due to the need to maintain an orderly market, and to protect it from market abuse, there are strict rules
laid down by regulators regarding stabilisation practices. For example, the FCA restricts the stabilisation
period and requires disclosure to the market that stabilisation is happening, and that the market price
may not be representative because of the stabilisation activities.

145
 3. Equity Markets and Trade Execution

3.1 Trade Execution and Reporting

Learning Objective
3.3.1 Apply fundamental UK regulatory requirements with regard to trade execution and reporting:
best execution; aggregation and allocation; management of conflicts of interest and
prohibition of front running

3.1.1 Best Execution

The best execution provisions are contained in the section of the FCA Handbook which is known as
the Conduct of Business Sourcebook (COBS). The provisions apply to firms executing client orders, to
portfolio managers and to firms who receive and transmit client orders.

The initial provisions for implementation of best execution by the FCA followed in the wake of the
Markets in Financial Instruments Directive (MiFID) which, among other provisions, introduced unified
European requirements for the best execution of client orders in all MiFID financial instruments. The
MiFID draft implementing measures (published by the EC on 6 February 2006) imposed requirements
on investment firms providing the service of portfolio management or the reception and transmission
of orders for execution.

In 2006, under FSA (now FCA) rules then prevailing, a firm that executed transactions could agree with its
intermediate customers (including expert private customers classified as intermediate customers) that it
did not have to provide best execution. Exclusions from best execution were provided for certain spread
betting, venture capital and stock lending activities. In contrast, MiFID did not provide a mechanism for
member states to exempt particular products or activities from best execution requirements. The FCA
(while known as the FSA) subsequently amended the best execution provisions applicable in the UK to
reflect the comprehensive requirements stipulated by MiFID.

The overarching best execution principle requires firms to take all reasonable steps to obtain the
best possible result for their clients, taking into account a range of execution factors, when executing
client orders or placing orders with (or transmitting orders to) other entities to execute. Firms are now
required to comply with more detailed rules relating to arrangements and policies, disclosure, consent,
demonstrating compliance and monitoring and review.

In a press release available from the FCA website released at around the time of the publication of the
MiFID in 2006, the FCA Director for Conduct of Business Standards commented as follows:

'Our policy on best execution is designed to ensure that customers get a good deal. Standards are
set in relation to price and other aspects of an order to ensure that firms execute dealing instructions
as well as they are able. This is an important consumer protection measure, particularly for retail
customers who do not have access to the same information as market professionals and who
therefore find it difficult to judge the quality of price that a firm has obtained.

146
 Equities

We recognise that markets are developing in ways that are making the existing rules increasingly
difficult to interpret, not least the development of new electronic trading venues that offer a wider
choice of execution options and possibly lower costs of trading. We are taking a fresh look at our
policy and seeking the views of a wide range of firms, consumers and other interested parties'.

The FCA (as the FSA) then published a discussion paper in connection with the review of its guidelines
on best execution which set out a number of issues for debate. These issues on which it sought feedback

3
from the financial services sector can be summarised as follows:

Referencing a Benchmark
The FCA (as the FSA) raised questions about the use of a price benchmark as the best way of encouraging
firms to achieve the best price. In the UK equity market, for example, a price benchmark (the SETS price
on the LSE) is used as a reference against which best execution can be assessed.

Greater Disclosure of Execution Policies

The FCA (as the FSA) considered the merit of greater disclosure to customers of a firm’s execution policy
(that is, how firms execute orders and which execution venues are used). This helps consumers make
more informed choices when selecting firms and may also facilitate competition between firms. It also
enables journalists and other commentators to publish analyses comparing the execution capability
between firms.

Trade Venue Execution Quality

The FCA (as the FSA) raised the possibility of requiring execution venues to publish data on execution
quality in order to provide information to enable firms to select appropriate places for order execution.
Data on volumes, prices, spreads and other relevant information, published in a standard format, could
facilitate comparisons of execution performance.

Minimum Venue Access

The FCA (as the FSA) considered whether it should require firms to have access to a minimum number of
execution venues in order to ensure that firms obtain an acceptable price.

Trade-off Between Price and Timeliness of Execution

The FCA (as the FSA) considered to what extent there should be a trade-off between price and other
elements of an order, such as timely execution or settlement constraints. Should, for example, the
researching of the best price be sacrificed in the interests of speedy execution?

Execution in OTC Markets

The FCA (as the FSA) also considered the application of best execution in markets other than equities,
especially OTC markets such as derivative markets.

Current Position for Best Execution

Following a detailed examination of the issues discussed above, the FCA (as the FSA) developed its
current policy approach to this area and introduced amendments to Section 11.2 of COBS during 2011.

147
Some relevant details include the following:

• In order to comply with the obligation to act in accordance with the best interests of its clients when
it places an order with, or transmits an order to, another entity for execution, a firm must take all
reasonable steps to obtain the best possible result for its clients, taking into account the execution
factors. The relative importance of these factors must be determined by reference to the execution
criteria and, for retail clients, to the requirement to determine the best possible result in terms of the
total consideration.
• A firm satisfies its obligation to act in accordance with the best interests of its clients, and is not
required to take the steps mentioned above, to the extent that it follows specific instructions from
its client when placing an order with, or transmitting an order to, another entity for execution.
• A firm must monitor the effectiveness of its order execution arrangements and execution policy in
order to identify and, when appropriate, correct any deficiencies. In particular, it must assess on a
regular basis whether the execution venues included in the order execution policy provide the best
possible result for the client or whether it needs to make changes to its execution arrangements. The
firm must notify clients of any material changes to its order execution arrangements or execution
policy.
• A firm must, when providing the service of portfolio management or, for a management company,
collective portfolio management, comply with the obligation to act in accordance with the best
interests of its clients when placing orders with other entities for execution that result from decisions
by the firm to deal in financial instruments on behalf of its client.

3.1.2 Aggregation and Allocation

The FCA guidance is that orders for customers may only be aggregated when this is in the overall best
interests of those customers. In addition, the FCA imposes the requirement that customers must be
made aware that the aggregation may operate on some occasions to their disadvantage. Firms must
also consider the provisions of rules on best execution and timely allocation when aggregating orders,
together with any further requirements laid down by the LSE.

The FCA’s General Principles require regulated firms to implement procedures and arrangements which
provide for the prompt, fair and expeditious execution of customers’ orders relative to the trading
interests of the firm.

As an example of the implementation of this guidance, one well-known brokerage firm states that it
does not undertake to carry out (a customer’s) order or a transaction for its own account in aggregation
with another client order, unless it has satisfied the following conditions:

• It is unlikely that the aggregation of orders and transactions will work overall to the disadvantage of
any client whose order is to be aggregated.
• It has been disclosed to each client whose order is to be aggregated that the effect of aggregation
may work to its disadvantage in relation to a particular order.
• It has established and effectively implemented an order allocation policy. This policy should provide
in sufficiently precise terms for the fair allocation of aggregated orders and transactions, including
how the volume and price of orders determines allocations and the treatment of partial executions.

When a firm aggregates a client order with one or more other orders and the aggregated order is
partially executed, it will further allocate the related trades according to this order allocation policy.

148
 Equities

3.1.3 Front Running and Conflicts of Interest

Front running is a practice in which a trader takes a position to capitalise on advance knowledge of a
sale that is expected to influence the price of stocks or commodities.

Large-scale criticisms of the manner in which financial securities firms on both side of the Atlantic are
allowed to act as both a principal and agent in trading securities focus on the inherent conflict of interest
which this dual role creates. This more serious criticism suggests that it is not just individual traders who

3
may front-run on the basis of prior knowledge, but investment banks as a whole.

If an investment bank acts both as an agent/broker for customers who are engaging in trading/
investment decisions and placing orders with the investment bank, while at the same conducting
trading for its own account through its proprietary trading desk, the allegation is that there is a great
temptation for the prop trading desk to front-run the customer’s order.

Let us consider an example to illustrate how this might happen.

Example
An investment bank has, as a client, a large pension fund which makes periodic adjustments to its
holdings. The pension fund will tend to trade in large-sized orders known as block trades.

The pension fund decides to purchase a large block of several million shares in ABC Telcom plc and
places instructions with the customer execution desk of the investment bank.

Meanwhile, the bank’s proprietary trading desk, which is operating with the bank’s own capital and
running a P&L for its own trading activities, could become aware of this instruction to a separate
department, and will then have the possibility of acting on this prior knowledge that a large buy order
for Vodafone shares is about to enter the market. The bank’s own proprietary trading desk could then
get ahead of, or front-run, this large buy order and take a position in the stock itself before the large
trade is made public.

As there will be a tendency for a large buy order to move the price up, even by a couple of pennies, the
bank could realise a quick profit from acting ahead of the order being entered into the marketplace.

The traditional rejoinder to this suggestion is that large institutions operate with Chinese walls, which
separate the different functions within the institutions, and that the confidentiality and observance of
secrecy by different divisions of the firm will ensure that this does not create a conflict of interest for the
institutions.

Under Section 118 of the UK Financial Services and Markets Act 2000, money managers are barred from
trading on the kind of information just presented in the above illustration.

Front running can also be considered as a form of insider trading and/or market abuse.

149
The following broad guidelines have been considered by the FCA (as the FSA) to address the general
issue of potential conflicts of interest, insider trading and the more specific example of front running
in conjunction with the execution of specific trades. The FCA has guidelines covering what is called PA
Dealing – which covers dealing for the personal accounts of individual traders/money managers.

The following guidelines are suggested for good practice:

• Trading should not be allowed by analysts until seven to ten days after research is published by a
registered firm.
• Staff should be required to hold stock for a minimum of one month.
• Staff should be required to sign a form confirming that they do not have any inside information.
• Funds needed for stock for staff have to be provided up front.
• No short selling is allowed.
• Written permission from the CEO or compliance manager is required when trading in-house stocks
and dealing is not allowed when the firm holds principal positions.
• A blanket ban for corporate finance staff on trading in-house stocks.
• PA trading conducted in batch sessions (three times a day), therefore reducing the risk of
front running.

3.2 The Main Trading Venues

Learning Objective
3.3.2 Understand the key features of the main trading venues: regulated and designated investment
exchanges; recognised overseas investment exchanges; whether quote- or order- driven; main
types of order – limit, market, fill or kill, execute and eliminate, iceberg, named; liquidity and
transparency

3.2.1 Recognised Investment Exchanges (RIEs)

The FCA recognises and supervises a number of recognised investment exchanges (RIEs) and recognised
clearing houses (RCHs) under the Financial Services and Markets Act 2000 (FSMA).

Recognition gives an exemption from the need to be authorised to carry on regulated activities in
the UK. To be recognised, RIEs and RCHs must comply with the recognition requirements laid down in
the Financial Services and Markets Act 2000 (Recognition Requirement for Investment Exchanges and
Clearing Houses) Regulations 2001.

RIEs, in their capacity as market operators, may operate regulated markets and multilateral trading
facilities (see section 3.3).

The following is a list of regulated markets operated by RIEs:

• Cboe Europe Equities Regulated Market

• Euronext – Euronext London
• ICE Futures Europe
• NEX Exchange

150
 Equities

• London Stock Exchange (LSE)

• London Metal Exchange, and
• International Property Securities Exchange (IPSX).

3.2.2 Recognised Overseas Investment Exchanges (ROIEs)

The FCA has recognised and supervises a number of recognised overseas investment exchanges (ROIEs):

3
• Australian Securities Exchange ltd
• Borsa Italiana SpA
• Börse Frankfurt Zertifikate AG
• Cboe Europe BV
• Chicago Board of Trade (CBOT)
• The Chicago Mercantile Exchange (CME)
• Commodity Exchange inc (COMEX)
• Deutsche Börse AG
• EUREX Frankfurt AG
• Euronext Amsterdam NV
• Euronext Paris SA
• European Energy Exchange AG
• ICE Endex Markets BV
• ICE Futures US, inc
• MTS SpA
• NASDAQ OMX Oslo ASA
• The Nasdaq Stock Market llc
• New York Mercantile Exchange inc. (NYMEX inc)
• Singapore Exchange Derivatives Trading ltd
• Singapore Exchange Securities Trading ltd
• SIX Swiss Exchange AG

3.2.3 Designated Investment Exchanges (DIEs)

An investment exchange which does not carry on a regulated activity in the UK and is not a regulated
market may apply to the FCA to be included on its list of designated investment exchanges. Before
adding an investment exchange to the list of designated investment exchanges, the FCA will look at
whether the investment exchange provides an appropriate degree of protection for consumers. The
FCA will also undertake a public consultation prior to adding the investment exchange to the list of
designated investment exchanges.

Designation allows firms to treat transactions effected on a designated investment exchange in the
same way as they would treat transactions effected on a RIE.

Current DIEs recognised by the FCA are:

• American Stock Exchange

• Australian Stock Exchange
• Bermuda Stock Exchange
• Bolsa Mexicana de Valores

151
• Bourse de Montreal inc
• Channel Islands Stock Exchange
• Chicago Board of Trade
• Chicago Board Options Exchange
• Chicago Stock Exchange
• Coffee, Sugar and Cocoa Exchange, inc
• Euronext Amsterdam Commodities Market
• Hong Kong Exchanges and Clearing ltd
• International Securities Market Association
• Johannesburg Stock Exchange
• Kansas City Board of Trade
• Korea Stock Exchange
• MidAmerica Commodity Exchange
• Minneapolis Grain Exchange
• New York Cotton Exchange
• New York Futures Exchange
• New York Stock Exchange (NYSE)
• New Zealand Stock Exchange (NZX)
• Osaka Securities Exchange
• Pacific Exchange
• Philadelphia Stock Exchange
• Singapore Exchange
• South African Futures Exchange
• Tokyo International Financial Futures Exchange
• Tokyo Stock Exchange
• Toronto Stock Exchange.

3.2.4 Trading Systems

Trading systems provided by exchanges around the world can be classified on the basis of the type of
trading they offer. Broadly, trading systems are either quote-driven or order-driven. The difference in
the manner of operation is described below.

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. The buying price
is the bid and the selling price is the offer. Market makers make a profit, or turn, through this price
spread. Although this practice is outdated in many respects, many practitioners argue that quote-driven
systems provide liquidity to the market when trading would otherwise dry up. Nasdaq and the LSE’s
SEAQ trading systems are two of the last remaining examples of quote-driven equity trading systems,
although market makers can display both quotes and orders in Nasdaq.

Order-Driven Systems
On order-driven systems, the investors (or agents acting on their behalf ) indicate how many securities
they want to buy or sell, and at what price. The system then simply brings together the buyers and
sellers. Order-driven systems are very common in the equity markets, where the NYSE, the Tokyo Stock
Exchange (TSE) and the LSE’s Stock Exchange Electronic Trading Service (SETS) are all examples of order-
driven equity markets.

152
 Equities

Hybrid Market
From 2007, most NYSE-listed securities could be traded via a hybrid system. Orders can be sent for
immediate electronic execution or directed to the market floor for auction. Market makers can also
display both quotes and orders in Nasdaq.

3.2.5 Liquidity and Transparency

3
The traditional classifications between quote-driven and order-driven systems are beginning to lose
their sharp focus with the advent of several innovative approaches to the kinds of software platforms
which are now being employed to host trading activities. There are initiatives and technologies provided
by systems such as the LSE’s Turquoise system and by the NYSE/Arca systems which actively reward
member firms for liquidity provisioning. The following press release from NYSE Euronext summarises
the key issues for innovative forms of market making which are, in turn, creating a new breed of
electronic market-making firms known for their (sometimes controversial) use of what are known as
high frequency trading (HFT) algorithms.

'The New York Stock Exchange (NYSE) and NYSE Arca, units of NYSE Euronext (NYX), today announced
new transaction pricing, effective March 1, 2009, pending SEC filing. The NYSE fee change will include
customer rebates for adding liquidity while continuing to offer the lowest transaction fees for taking
liquidity in NYSE-listed securities among the major market centers. The fee change is expected to
be rolled out in conjunction with significant NYSE execution speed improvements. The NYSE Arca
fee change raises the rebate for active traders in Tape A (NYSE-listed) and Tape C (Nasdaq-listed)
securities, as well as a higher rebate on Mid-Point Passive Liquidity (MPL) orders for all customers
in all securities. Together, the dual-exchange model of the NYSE and NYSE Arca deliver the best rate
combination among major exchanges and superior liquidity when trading NYSE-listed securities, in
addition to the lowest take fee on NYSE and highest rebate on NYSE Arca.
In addition, NYSE Euronext’s Global Multi-Platform Incentive Program offers additional savings
to active global customers trading on the NYSE, NYSE Arca and Euronext markets. The program
provides rebates for customers with a specified average daily volume'.

Other developments, which are also features of the Turquoise system, have encouraged the development
of dark pools of liquidity in which there is, by design, little or no transparency provided to the general
investment community for large-scale trading activities (see section 3.3.4).

3.2.6 Order Book and Order Types

Outside the realm of dark pools, and still transparent to market participants, is the constantly updated
flow of orders that await matching and which constitute the so-called order book. The buy side of the
order book lists orders to buy, and the sell side of the order book lists orders to sell. New sell orders
entered into the system potentially match existing orders on the buy side. New buy orders potentially
match existing sell side orders in the order book. Increasingly trading systems are run electronically,
allowing participants to trade via computer screens. However, there are notable exceptions – for
example, the NYSE still retains a physical trading floor where buyers and sellers gather to trade.

153
Examples of Common Order Types
• Limit orders have a price limit and a time limit. For example, a limit order may state ‘sell 1,000 shares
at 360p by next Tuesday’. Any time limit up to a maximum of 90 days can be put on these orders. If no
time limit is placed on the order, it will expire at the end of the day that it is entered. Limit orders can
be partially filled, and it is only limit orders that are displayed on the SETS order book.
• Iceberg orders are a particular type of limit order. They enable a market participant with a
particularly large order to partially hide the size of their order from the market and reduce the
market impact that the large order might otherwise have. The term iceberg comes from the fact that
just the top part of the order is on view (the peak of the iceberg), and the rest is hidden (the bulk of
the iceberg is below the water). Once the top part of the order is executed, the system automatically
brings the next tranche of the iceberg order onto the order book. This process continues until the
whole of the iceberg order has been executed, or the time limit for the order expires.
• At market (also known as at best) orders can only be input during automatic execution and have no
specified price. The order will fill as much as possible at any available price and the remainder will be
cancelled; it does not wait on the order book to match against later orders.
• Execute and eliminate orders can only be entered during automatic execution. As with the at best
order, this type will execute as much of the trade as possible and cancel the rest. However, unlike
an at best order, this order type has a specified price and will not execute at a price worse than that
specified.
• Fill or kill orders can only be entered during automatic execution. They normally have a specified
price (although they can be entered without one) and either the entire order will be immediately
filled at a price at least as good as that specified, or the entire order will be cancelled (ie, if there are
not enough orders at the price specified or better).
• A market order is a buy or sell order that is to be executed immediately at prevailing market price.
Providing that there are available buyers and sellers, market orders are executed. The purpose of
these order types is to achieve execution rather than specifying a price, which means the order
giver cedes any real control over the price that will be achieved. The order can be executed with a
number of different ‘fills’ being split across more than one order book counterparty. There may also
be different prices for each fill.

Named Order
The International Order Book (IOB) is an order-driven trading service primarily for depositary receipts
of international securities. It operates in a similar way to SETS, and has the facility for inputting orders
that are not anonymous. Such orders are commonly referred to as named orders and are placed by LSE
member firms dealing in a principal capacity and wanting to display their willingness to deal on the
order book. The acronym that identifies the firm appears next to their order on the IOB.

3.2.7 The Role of Market Makers

Some of an exchange’s member firms have chosen to take on the special responsibilities of a market
maker. When a firm acts as a market maker it stands ready to provide a source of liquidity to certain
sections of the market such as the LSE’s SETSqx system. By being prepared to provide a bid for shares
that third parties want to sell and an ask for parties that want to buy shares, at any time, the market
maker smoothes out the more erratic price movements that can occur without this additional source of
market liquidity.

154
 Equities

To become a market maker a member firm must apply to the stock exchange, giving details of the
securities in which it has chosen to deal. It must provide prices at which it is willing to buy and sell a
minimum number of its chosen shares throughout the course of the trading day.

Because some of the exchange systems rely on market makers to honour their commitments, the
exchange closely vets firms before allowing them to quote prices to investors. In return for agreeing
to take on these extra responsibilities, market makers hope to enjoy the benefits of a steady stream of

3
business, from broker-dealers and from other investors.

3.2.8 Stock Borrowing and Lending Intermediaries (SBLIs)

Another key contributing factor to the liquidity and transparency of exchanges is the role taken by
stock borrowing and lending intermediaries (SBLIs). These are firms that arrange for one party (perhaps
a market making member firm) to borrow shares from another party (perhaps a long-term holder of
shares, like a pension fund). This may arise because the market maker has sold shares it does not own –
known as selling short.

By borrowing shares, the market maker can satisfy the need to deliver the shares. After an agreed period,
the borrower will return an equivalent number of the same shares to the lender. The borrower is charged
a fee for arranging the transaction (paid to the SBLI), and for borrowing the shares (paid to the lender).
During the period of the loan, the lender retains all the benefits of owning the shares (such as dividends)
except the voting rights. Transparency requirements are now in force which require the full disclosure of
stock borrowing and lending.

3.3 Alternative Trading Venues

Learning Objective
3.3.3 Understand the key features of alternative trading venues: multilateral trading facilities (MTFs);
organised trading facilities (OTFs); systematic internalisers; dark pools

Keeping abreast of developments in the various trading platforms in use in today’s financial markets
is a daunting challenge. There is a constant drive towards new IT architectures and new software
technologies, which means that the pace of innovation and the changes in the actual systems in effect
will have a tendency to make textbooks such as this outdated in relatively short timeframes.

In understanding the evolution of trading platforms from the more conventional systems which were in
place up until the mid-1990s, and which many non-professionals today still envisage as the model for
workflow in markets, it is important to take a brief historical perspective.

In 1998, the SEC in the US authorised the introduction of electronic communication networks (ECNs).
In essence, an ECN is a computerised trading platform which allows trading of various financial assets,
primarily equities and currencies, to take place away from a specific venue such as a stock exchange.
The primary motivation for the SEC to authorise the introduction of ECNs was to increase competition
among trading firms by lowering transaction costs, giving clients full access to their order books, and
offering order-matching outside of traditional exchange hours.

155
Since an ECN exists as a large number of networked computers/workstations, it effectively has no centre
or physical location but rather is decentralised and virtual. ECNs are sometimes also referred to as
alternative trading networks or venues. The term venue has to be understood in a metaphorical sense,
since a network is accessible from anywhere through an IT infrastructure and there is no specific place
where trades are executed.

Alternative trading systems (ATSs) have come to play a dominant role in public markets for accessing
liquidity. The most popular among varieties of ATSs are ECNs and crossing networks.

An example of an ECN is Bloomberg’s TradeBook which, according to its website, describes its mission
as follows:

'...(we) believe that traders equipped with advanced algorithms to manage complexity and supported
by analytics to provide the right market insights can achieve superior executions. We partner with our
clients to develop technology and services that give them better control of their transactions and
keep them more informed of market opportunities'.

Examples of crossing networks are Liquidnet and Posit. Liquidnet, which has a presence in Europe and in
Asian markets, provides not only a crossing network, but is also a major provider, among others, of dark
pools of liquidity. In essence, the idea with dark pools is that automated platforms offer the opportunity
to match off exchange with other buyers and sellers, without showing the available liquidity to
the market. This innovation in market technology has significant consequences with respect to the
transparency of trading in publicly-listed securities (see section 3.3.4).

As a way of demonstrating the manner in which innovations in alternative trading systems have
transformed the modus operandi of today’s financial markets it is worth considering Better Alternative
Trading System (BATS), a Kansas-based company that was founded only in June 2005, and which has
become the third-largest exchange in the world by volume behind the NYSE and Nasdaq. The founder
and CEO of BATS provided testimony, in June 2010, to the SEC Commission on market structure, which
looked into the highly unusual trading activity that took place in US markets on 9 May 2010. During a
ten-minute interval, the Dow Jones Industrial Average (DJIA) index dropped by 1,000 points and the
S&P 500 dropped by almost 100 points. Although the markets quickly recovered a substantial portion
of these abrupt losses, the incident has become known as the Flash Crash. Some market observers
have interpreted the incident as a warning signal that highly automated markets with high-frequency
algorithmic trading are potentially hazardous. The following excerpt from the testimony conveys the
essential characteristics of modern electronic markets:

'Nearly all equity trading in the US today is automated in some fashion and can exhibit characteristics
that fall under the umbrella label of high-frequency trading. These characteristics include direct
access to a market, the sending of a large number of orders into the market, orders generated by
computer algorithms, trading through a co-located broker, or subscribing to an exchange’s direct
data feed. Future regulations targeted in this area should take into account that the phrase high
frequency more broadly describes the state of our market than it does any particular segment of
trading participants'.

It should be expected that the implementation of similar technologies to those prevalent in the US
today will become widespread within Europe – indeed, BATS has already developed a substantial
presence in the UK equity markets.

156
 Equities

In addition to the absorption of new trading technologies, European markets and exchanges are still in
the process of implementing all of the changes associated with MiFID initiatives. MiFID expressed the
goal of improving pre-trade and post-trade transparency. With regard to pre-trade transparency the
requirement was that operators of continuous order-matching systems must make aggregated order
information on liquid shares available at the five best price levels on the buy and sell side; for quote-
driven markets, the best bids and offers of market makers must be made available. In regard to post-
trade transparency the requirement was that firms must publish the price, volume and time of all trades

3
in listed shares, even if executed outside of a regulated market, unless certain requirements are met to
allow for deferred publication.

Although MiFID was intended to increase transparency for prices, in fact the fragmentation of trading
venues has had an unanticipated effect. Where once a financial institution was able to see information
from just one or two exchanges, it now has the possibility (and in some cases the obligation) to collect
information from a multitude of multilateral trading facilities, systematic internalisers and other
exchanges from around the EEA. The overall result of all of these developments is a need for ever-faster
and more efficient technologies to process the amount of information that is available from so many
diverse trading venues in order for investors to benefit from the transparency that MiFID wished to
introduce.

3.3.1 Multilateral Trading Facilities (MTFs)

An MTF is a system that brings together multiple parties (eg, retail investors or other investment firms)
that are interested in buying and selling financial instruments and enables them to do so. These systems
can be crossing networks, or matching engines that are operated by an investment firm or a market
operator. Instruments may include shares, bonds and derivatives. This is done within the MTF operator’s
system.

An example of an equities-trading platform which captures the key characteristics of an MTF is

Turquoise, which has been adopted by the LSE as pivotal to its new trade execution platform. Turquoise
was originally created by a consortium of nine major investment banks and is a hybrid system that
allows trading both on and off traditional exchanges. Turquoise has been majority-owned by the LSE
Group since February 2010. Turquoise gives customers access to pan-European and US equity trading
in more than 4,300 securities. Unique functionality in Turquoise’s integrated book combines visible and
non-displayed orders to deliver increased likelihood of execution and price improvement.

One of the aims of MiFID was to promote competition between traditional exchanges and other trading
systems. Regulated market status is still viewed by many as the gold standard trading venue. However,
the distinction between regulated markets and MTFs is nowadays arguably rather blurred to the
extent that this view ceases to make a great deal of commercial sense. Regulatory standards for MTFs
and regulated markets are broadly the same in areas such as transparency and market abuse. Banks
and large institutions have backed the MTFs both through their custom and increasingly, as seen in
the example of Turquoise, through involvement in actually establishing them. Many banks and large
institutions see MTFs as an opportunity for forcing recognised exchanges to lower their fees. The trend
towards increasing market fragmentation is unlikely to be halted unless there is a change of policy on
the part of financial regulators.

157
MTF Documentation
Usually an MTF will have a members’ agreement which incorporates all of the rules to which the member
signs up to with the MTF. Usually there is no flexibility to negotiate these rules, so it is necessary to be
pretty clear on what is being signed up for. Normally the agreement gives the MTF discretion to cancel
trades, suspend trading and amend the rules, as well as giving it a broad indemnity.

Best Execution
The ability to access sources of liquidity other than merely a single exchange is of particular significance
to achieving the MiFID obligation for best execution. While the requirement to obtain the best result for
clients on a consistent basis does not necessarily mandate access to all venues, it is likely to mean that
trading houses will require access to at least the larger MTFs in addition to the exchanges themselves.

3.3.2 Organised Trading Facilities (OTFs)

With the implementation of MiFID II in January 2018, a new type of trading venue was introduced –
the organised trading facility (OTF). As mentioned earlier, an OTF is a multilateral system that is not
a regulated market, nor an MTF. It allows multiple third-party buying and selling interests in bonds,
structured finance products, emission allowances or derivatives to be traded. Equities cannot be traded
through an OTF. An OTF is a service of an authorised investment firm, and the operator of an OTF is not
permitted to trade against its own proprietary capital.

3.3.3 Systematic Internalisers (SIs)

A systematic internaliser (SI) is, in broad terms, an investment firm making markets outside a regulated
market or an MTF. The firm executes orders from its clients against its own book or against orders from
other clients. MiFID treats systematic internalisers as mini-exchanges. For example, they are subject to
the same pre-trade and post-trade transparency requirements.

3.3.4 Dark Pools of Liquidity

Dark pools refer to the non-displayed or hidden nature of the buy and sell orders that reside in a crossing
platform. The term 'dark liquidity' can also be applied to all forms of non-displayed liquidity such as the
order blotters of buy-side dealing desks.

One investment manager has described the appeals of dark liquidity pools as follows:

'A dark pool is a very simple way you can hopefully capture lots of liquidity and achieve a large
proportion of your order being executed without displaying anything to the market'.

In the US, the influx of crossing networks and alternative venues, and the rapid adoption of electronic
trading technologies, has been driving the growth of dark pools for several years. Dark pools are
primarily a US phenomenon, with more than 50 estimated to exist in the US and only a small number
operating in Europe. However, the fragmentation of the market, which has been largely encouraged
by the MiFID directives as well as the technological ‘arms race’ is responsible for the emergence of dark
pools in Europe.

158
 Equities

According to UBS ‘there are only two crossing networks outside of the exchanges in Europe – ITG and
Liquidnet’. But there is dark liquidity. One area is through the exchanges having iceberg orders, where
people may have a lot more to trade than is displayed on the screen at any time. The biggest sources of
dark liquidity are within the investment banks and major brokers.

3.3.5 Summary of MTFs and Dark Pools

3
By making use of certain waivers for pre-trade transparency under MiFID, dark pools and MTFs are
allowing institutions to execute large volume trades away from the visible order book. As there is no
pre-trade transparency, there is no visible price formation. This is essentially what makes them dark.

The large transaction size waiver on which the majority of trades in dark pools will rely is, in relative
terms, not actually that large. The effect of the waiver therefore means that large institutions are
increasingly able to conduct the majority of their trades in the dark through the new MTFs. There are a
number of different models on which dark pool MTFs are based. While certain models offer a basic dark
matching facility, certain systems provide a pass-through function that allows a user to send an order
through to a light venue. For instance, the order can be passed through to a standard MTF or exchange
if it cannot be filled in the dark pool. Brokers are now allowing combined access to liquidity in light and
dark pools. This method of combined access ties in with the best execution obligations of both buy and
sell side market participants.

Looking at the benefits that a dark pool may offer, users are likely to cite key advantages such as reducing
the market impact of large orders, securing more favourable security pricing (by crossing orders at the
mid-price) and lower execution costs.

3.4 High Frequency Trading (HFT)

Learning Objective
3.3.4 Understand algorithmic trading: reasons; high frequency trading (HFT); potential
consequences for the market (eg, flash crashes, increased liquidity, increased volume, illusion
of volume)

High frequency trading (HFT) is the use of technologically advanced tools and algorithms to trade
financial instruments. The key differences between HFT and traditional forms of trading are:

• in HFT, trading takes place solely through computer algorithms, and

• orders are processed by HFT firms and positions are opened and closed within seconds and fractions
of seconds (eg, microseconds/one millionth of a second).

3.4.1 How can High Frequency Traders make Profits?

Many HFT firms try to catch momentary moves in everything from stocks to currencies between
different trading platforms. This has essentially similar characteristics to traditional arbitraging when
firms take advantage of short-term market gyrations. Their algorithms will seek temporary inefficiencies
in the market and trade so that they can make money before the brief distortions go away, ie, they will
buy at a lower price in one market and sell at a higher price in another in identical or similar instruments.
159
Market making and liquidity provision also form part of HFT strategies that involve placing a limit order
to sell (or offer) or a buy limit order (or bid) in order to collect the bid-offer spread. By doing so, market
makers become counterparty to incoming market orders. This role has been traditionally fulfilled by
specialist firms, once known as stock jobbers.

3.4.2 The Effect of HFT on the Markets

Some institutional investors and market participants have voiced concerns that HFT increases the
cost of investing and damages the markets. Others suggest that HFT creates more accurate and faster
securities pricing, narrows bid-offer spreads, lowers volatility and adds liquidity to markets, and thus
benefits investors. The matter has been the subject of great debate. It is possible for HFTs to trade a
single stock hundreds of times in less than a minute. Concerns have been raised that this creates the
illusion of liquidity in a particular stock without there actually being any demand or settlement. It has
been suggested that this, in turn, could attract interest and investment from traditional investors.

Regulators claim that HFT may have caused volatility during the ‘flash crash’ on 6 May 2010, when the
Dow Jones Industrial Average (DJIA) fell by about 1000 points (about 9%) and then recovered much of
that fall within a few minutes. It was the highest ever one-day fall intraday in DJIA history. In July 2011,
a report was issued by the International Organisation of Securities Commissions (IOSCO). The report
commented that while ‘algorithms and HFT technology have been used by market participants to manage
their trading and risk, their usage was also clearly a contributing factor in the flash crash event of 6 May 2010’.

Algorithmic behaviour is becoming increasingly faster and more complex. This makes it often extremely
difficult to make sense of trading patterns. Media reports have cited flash spoofs that last a fraction of a
second and are designed to seek a reaction from other algos. These have been termed ‘predatory algos’.

Other causes that have been cited include a large E-mini S&P 500 seller that set off a chain of events
triggering the flash crash, and a large purchase of S&P 500 Index put options by a hedge fund shortly
before the crash. Whatever the reason, the HFT debate continues.

Several European regulators have proposed curtailing or banning HFT due to concerns about it causing
volatility. It is estimated that in 2015 in the US, HFT trading accounted for around 50% of all equity
trading volumes, down from as high as 73% in 2009, although it is now thought to be much lower than
50%. Among some of the largest HFT firms in the US are Virtu Financial, Jump Trading and Citadel llc.

3.5 Characteristics of Dividend Payments

Learning Objective
3.3.5 Understand the concepts of trading cum, ex, special cum and special ex: the meaning of books
closed, ex-div and cum div, cum, special ex, special cum, and ex rights; effect of late registration

Dividends have many dates associated with them, and some of them have multiple names. For example,
the books closed date is also known as the date of record or record date.

160
 Equities

3.5.1 Declaration Date

The declaration date is the date the company’s board of directors announces the company will pay a
dividend to its shareholders. This is the day on which the dividend goes on the company’s financial
statements as a liability that must be paid. It is also when the board announces the book closing date.

3.5.2 Ex-Dividend Date

3
The ex-dividend date is the day by which you must have purchased the stock to receive the dividend.
The ex-dividend date is different from the books closed date because it takes two to three days to be
officially recognised as a shareholder. After this date, anyone who purchases the stock is not entitled to
receive the dividend. Typically, the stock’s price will be decreased by the amount of the dividend after
this date because a new investor will not receive the payment.

3.5.3 Books Closed Date/Record Date

The books closed or record date for a dividend is the day by which you must be registered as an owner
of the stock to receive the dividend. On this day, a record is taken of all the owners of the company and
how many shares they own so the company knows whom to pay the dividend to on the payment date.
It typically takes two days to become registered as a shareholder of a company, so this is not the last day
to buy the stock; that is the ex-dividend date.

3.5.4 Payment Date

The payment date is the day on which you receive your dividend. The payment date is usually about
three weeks after the books closed date. Dividends are typically paid in cash, but they also can be paid
in stock or property.

Normally, a company’s shares are quoted cum-dividend (cd). This means that buyers of the shares have
the right to the next dividend paid by the company. However, there are brief periods when the share
becomes ex-dividend, meaning that it is sold without the right to receive the next dividend payment.
The ex-dividend period occurs around the time of a dividend payment.

The sequence of events, based upon the dates described above, which leads up to the dividend
payment is as follows.

• Dividend declared – on this date, the company announces its intention to pay a specified dividend
on a specified future date. The declaration must occur at least three clear business days before the
ex-dividend date.
• Ex-dividend date – the ex-dividend date is invariably the first Thursday that falls at least three clear
business days after the day that the dividend was declared.
• Record or books closed date – the record, or books closed date is the date on which a copy of the
shareholders’ register is taken. The people on the share register at the end of this day will be paid
the next dividend. The books closed date is the business day after the ex-dividend date. Because the
ex-dividend date is a Thursday, the books closed date is usually a Friday, except when the Friday is a
public holiday, in which case the books closed date is the next available business day.

161
• Dividend paid – the dividend is paid to those shareholders who were on the register on the record/
books closed date.

3.5.5 Ex-Dividend Period

The period from the ex-dividend date up to the dividend payment date is known as the ex-dividend
period. Throughout this period the shares trade without entitlement to the next dividend.

The relationship between the ex-dividend date and the books closed date is explained as follows. Since the
equity settlement process takes two business days, for a new shareholder to appear on the register on the
Friday they would have to buy the shares by Wednesday at the latest. Wednesday is the last day when the
shares trade cum-dividend, because new shareholders will be reflected in the register before the end of
the books closed date. A new shareholder buying their shares on the Thursday will not be entered into the
register until the following week – too late for the books closed date and therefore ex-dividend.

On the Thursday, when the shares first trade without the dividend (ex-dividend), the share price will fall
to reflect the fact that if an investor buys the share they will not be entitled to the impending dividend.

At all times other than during ex-dividend periods, shares trade cum dividend – ie, if an investor
purchases shares at this time, they will be entitled to all the future dividends paid by the company for as
long as they keep the share.

During the ex-dividend period, it is possible to arrange a special cum trade. That is where, by special
arrangement, the buyer of the share during the ex-dividend period does receive the next dividend.
These trades can be done up to and including the day before the dividend payment date, but not on or
after the dividend payment date.

In a similar manner to a special cum trade, an investor can also arrange a special ex trade. This is only
possible in the ten business days before the ex-date. If an investor buys a share during the cum-dividend
period, but buys it special-ex, they will not receive the next dividend.

Using special cum or special ex transactions enables the sellers or buyers to avoid the receipt of a
dividend – essentially deciding whether or not they want to collect their right to the dividend. During
the period when the LSE allows such trading, it effectively allows the right to the dividend to be traded.
The motivation for investors buying or selling with or without the dividend entitlement tends to be
related to tax: dividend income is normally subject to income tax, so selling the right to the dividend
may avoid some income tax.

3.5.6 Late Registration

The inherent disadvantage of special cum trades and special ex trades is that they may potentially result
in dividends from the company being paid to the wrong person.

If a trade settles later than the schedule prescribed, this could result in late registration and would mean
that the correct owner is not reflected in the shareholders’ register on the books closed date. As such,
the dividend paid out will not be to the actual owner of the shares. In such situations, it is the broker
acting for the buyers (or seller, as appropriate) that will need to make a claim for the dividend.

162
 Equities

3.6 Developed and Emerging Markets

Learning Objective
3.3.6 Apply knowledge of the key differences between international markets; regulatory and
supervisory environment; corporate governance; liquidity and transparency; access and
relative cost of trading

3
3.6.1 Overview
The emergence of vitally important new markets and dynamic emerging economies has been very
much a feature of the investment landscape of the last 20 years or so. Many investors nowadays are
focused on opportunities provided by the non-traditional markets of the developed world and are
looking increasingly at investing substantial portions of an investment portfolio in emerging market
assets.

The classification and categorisation schemes for investment markets are made by several of the main
financial information providers including the FTSE Group, Dow Jones and Standard & Poor’s.

The FTSE Group, an independent company which originated as a joint venture between the Financial
Times and the LSE, has, in addition to maintaining the FTSE 100 Index, also developed a system for
classifying the world’s markets according to certain categories.

Developed Countries
The following countries are classified by the FTSE as developed countries: Australia, Austria, Belgium,
Canada, Denmark, Finland, France, Germany, Hong Kong, Luxembourg, Ireland, Israel, Italy, Japan,
the Netherlands, New Zealand, Norway, Poland, Portugal, Singapore, South Korea, Spain, Sweden,
Switzerland, the UK and the US.

Developed countries have all met criteria adopted by the FTSE under the following categories:

• They are high-income economies (as measured by the World Bank gross national income (GNI) per
capita rating.
• Market and regulatory environment:
• formal stock market regulatory authorities actively monitor market (eg, SEC, FCA, SFC)
• fair and non-prejudicial treatment of minority shareholders
• no or selective incidence of foreign ownership restrictions
• no objections or significant restrictions or penalties applied on the repatriation of capital
• free and well-developed equity market
• free and well-developed foreign exchange market
• no or simple registration process for foreign investors.
• Custody and settlement:
• settlement – rare incidence of failed trades
• custody – sufficient competition to ensure high-quality custodian services
• clearing and settlement – T+2, T+3 or shorter, T+7 or shorter for frontier markets (see below)
• stock lending is permitted
• settlement – free delivery available
• custody – omnibus account facilities available to international investors.
163
• Dealing landscape:
• brokerage – sufficient competition to ensure high quality broker services
• liquidity – sufficient broad market liquidity to support sizeable global investment
• transaction costs – implicit and explicit costs to be reasonable and competitive
• short sales permitted
• off-exchange transactions permitted
• efficient trading mechanism
• transparency – market depth information/visibility and timely trade reporting process.
• Derivatives:
• developed derivatives markets.
• Size of market:
• market capitalisation
• total number of listed companies.

Advanced Emerging Countries

The following countries are classified by the FTSE as advanced emerging countries: Brazil, Czech
Republic, Greece, Hungary, Malaysia, Mexico, South Africa, Taiwan, Thailand and Turkey.

Secondary Emerging Countries

The following countries are classified by the FTSE as secondary emerging countries: Chile, China,
Columbia, Egypt, India, Indonesia, Kuwait, Pakistan, Peru, the Philippines, Qatar, Russia, Saudi Arabia and
the UAE.

Frontier Markets
The term ‘frontier markets’ is commonly used to describe the equity markets of the smaller and less
accessible, but still investable, countries of the developing world. The frontier or pre-emerging equity
markets are typically pursued by investors seeking high long-run return potential as well as low
correlations with other markets. The implication of a country being labelled as frontier, or pre-emerging,
is that the market is less liquid and significantly less correlated with developed and even traditional
emerging markets.

MSCI World Index

The MSCI World Index is a stock market index of over 1,650 world stocks. It is maintained by MSCI inc.,
formerly Morgan Stanley Capital International, and is often used as a common benchmark for world or
global stock funds.

The index includes a collection of stocks of all the developed markets in the world, as defined by MSCI.
The index includes securities from over 20 countries but excludes stocks from emerging economies,
making it less worldwide than the name suggests. A related index, the MSCI All Country World Index
(ACWI), incorporated both developed and emerging countries.

164
 Equities

3.6.2 UK
The Global Financial Centres Index (GFCI) is an annual survey of the leading financial centres in the
world. The GFCI makes the point that ‘London and New York are still leading the field in 1st and 2nd place
respectively. They remain the only two truly global centres’.

London Stock Exchange (LSE)

3
Normal continuous trading sessions are from 8.00am to 4.30pm every day of the week except Saturdays,
Sundays and holidays declared by the exchange in advance.

The LSE operates in the following primary areas:

• Equity markets and primary issuance – the LSE enables companies from around the world to raise
capital. There are four primary markets: the Main Market, the Alternative Investment Market (AIM),
the Professional Securities Market (PSM) and the Specialist Fund Market (SFM).
• Trading services – the LSE provides an active and liquid secondary highly active market for trading
in a range of securities, including UK and international equities, debt, covered warrants, exchange-
traded funds (ETFs), exchange-traded commodities (ETCs), real estate investment trusts (REITs),
fixed interest, and depositary receipts.

Regulatory Structure of the UK Market

The main regulatory, supervisory and trade body frameworks supporting the UK financial markets are:

• Companies Acts – the Companies Acts detail the requirements for companies generally, such as the
requirement to prepare annual accounts, have accounts audited and for annual general meetings.
Of particular significance to the LSE are the Companies Acts requirements to enable a company to
be a plc, since one of the requirements for a company to be listed and traded on the LSE is that the
company is a plc.
• Financial Conduct Authority (FCA) – the FCA has to give its recognition before an exchange is
allowed to operate in the UK. It has granted recognition to the LSE and, by virtue of this recognition,
the exchange is described as a recognised investment exchange (RIE). In granting recognition, the
FCA assesses whether the exchange has sufficient systems and controls to run a market. Furthermore,
the FCA lays down the detailed rules that have to be met before companies are admitted to the
official list that enables their shares to be traded on the exchange. In April 2013, banking supervisory
functions that were performed by the FSA were taken over by the Prudential Regulation Authority.
• The FCA is responsible for setting and administering the listing requirements and continuing
obligations for plcs seeking and obtaining a full list on the LSE. The FSA (now the FCA) was appointed
as the listing authority in May 2000 and is the ‘competent authority for listing’ – making the decisions
as to which companies’ shares and bonds (including gilts) can be admitted to be traded on the LSE.
It is the FCA that sets the rules relating to becoming listed on the LSE, including the implementation
of any relevant EU directives. The rules are contained in a rulebook called the Listing Rules. The
LSE is responsible for the operation of the exchange, including the trading of the securities on the
secondary market, although the FCA can suspend the listing of particular securities and therefore
remove their secondary market trading activity on the exchange.

165
• Her Majesty’s Treasury – Her Majesty’s Treasury (HM Treasury) is the UK’s economics and finance
ministry, with overall responsibility for fiscal policy as well as providing a supervisory role for the
entire financial framework in the UK. The department of government is headed by the Chancellor of
the Exchequer.
• Panel on Takeovers and Mergers (POTAM) – the UK supervisory authority that carries out the
regulatory functions required under the EU Takeover Directive is the Panel on Takeovers and
Mergers (the Panel or POTAM). The Panel’s requirements are set out in a Code that consists of six
general principles, and a number of detailed rules. The Code is designed principally to ensure that
shareholders are treated fairly and are not denied an opportunity to decide on the merits of a
takeover. Furthermore, the Code ensures that shareholders of the same class are afforded equivalent
treatment by an offeror. In short, the Code provides an orderly framework within which takeovers
are conducted, and is designed to assist in promoting the integrity of the financial markets.

Corporate Governance in the UK

In addition to the regulatory framework outlined in the previous paragraphs, there have been several
initiatives in the UK in recent years to improve corporate governance in relation to financial services.

In general terms, the term ‘corporate governance’ describes the processes, customs, policies, laws
and institutions affecting the way a corporation (or company) is directed, administered or controlled.
Corporate governance also includes the relationships between the many stakeholders involved and the
goals at which the corporation is aiming.

An important theme of corporate governance is the nature and extent of accountability of particular
individuals in the organisation, and mechanisms that try to reduce or eliminate conflicts of interest
between the different stakeholders within a corporation (especially where stakeholders may have
conflicts of a principal/agent nature). For example, the chief executive of a company has a duty to
shareholders to maximise the returns available to the owners of the corporation, but also has a stake in
securing the best possible remuneration for themselves.

An example of how this type of conflict can be addressed through corporate governance regulation is
the requirement that all large corporations must have a remuneration committee which should consist
of, at least, some independent directors who can monitor those circumstances in which the executives
of a company may decide to put their own interests ahead of the interests of the shareholders or other
stakeholders.

The FCA requires companies to disclose in their annual reports both how they have applied principles
of good governance and whether they have complied with the provisions of its code of best practice.

Numerous committees have reported, and from their recommendations a Corporate Governance
Code (the 'Code') has been drawn up by the FCA. The Code is derived from the recommendations of
the Greenbury, Cadbury and Higgs committee reports and, in particular, was much influenced by the
final report of the Hampel Committee in 1998. After the financial crisis of 2007–08, the Walker Review
published a report on the banking industry that also made recommendations for other industries. Paul
Myners also completed two major reviews of the roles of institutional investors for the Treasury. An
updated version of the Code was issued in 2010.

166
 Equities

The Code was updated again in 2018 for the purpose of placing greater emphasis on relationships
between companies, shareholders and stakeholders. It also promotes the importance of establishing
a corporate culture that is aligned with the company purpose and business strategy, while promoting
integrity and valuing diversity.

The key issues of the Corporate Governance Code are:

3
• Every listed company should be headed by an effective board, which should lead and control the
company.
• The board should meet regularly.
• Directors should bring independent judgement to bear on issues of strategy.
• No one individual should have unfettered powers of decision.
• A decision to combine the posts of chairman and chief executive officer in one person should be
publicly explained.
• There should be a strong and independent non-executive element on the board.
• The board should have a balance of executive and non-executive directors so that no small group of
individuals can dominate the board’s decision-taking.
• There should be a formal and transparent procedure for the appointment of new directors.
• All directors should submit themselves for re-election at least every three years.

There are also provisions concerning directors’ remuneration:

• Levels of remuneration should be sufficient to attract and retain directors needed to run the
company successfully.
• Remuneration should be structured to link rewards to corporate and individual performance.
• Remuneration committees should be responsible for this and should only include non-executive
directors.
• There should be an objective of having service contracts with notice periods of a maximum of one
year.
• The annual report should contain a statement of remuneration policy and details of the remuneration
of each director.

3.6.3 US
Since nearly 16% (after adjusting for purchasing power parity) of global GDP is accounted for by the
US, it is no surprise that two of its many exchanges, the NYSE and Nasdaq, comprise almost half of the
world’s total stock exchange activity. As well as trading domestic US stocks, these exchanges are also
involved in the trading of shares in major international companies.

The NYSE is the largest and most liquid stock exchange in the world as measured by domestic market
capitalisation, and is significantly larger than any other exchange worldwide. Although it trails Nasdaq
for the number of companies quoted on it, it is still larger in terms of the value of shares traded. The
NYSE trades in a continuous auction format. Member firms act as auctioneers in an open outcry auction
market environment, in order to bring buyers and sellers together and to manage the actual auction.
This makes it highly unusual in world stock markets but, as more than 50% of its order flow is now
delivered to the floor electronically, there are proposals to adopt a hybrid structure combining elements
of open outcry and electronic markets.

167
Nasdaq is an electronic stock exchange with over 3,000 companies listed on it. It is the third-largest
stock exchange by market capitalisation and has the second-largest trading volume. There are a variety
of companies traded on the exchange, but it is well known for being a high-tech exchange. Many of
the companies listed on it are telecoms, media or technology companies; it is typically home to many
new, high-growth and volatile stocks. Although it is an electronic exchange, trades are still undertaken
through market makers who make a book in specific stocks, so that when a broker wants to purchase
shares they do so directly from the market maker.

The main depository in the US is the Depository Trust Company (DTC), which is responsible for corporate
stocks and bonds, municipal bonds and money market instruments. The Federal Reserve Bank is still the
depository for most US government bonds and securities. Transfer of securities held by DTC is by book
entry, although shareholders have the right to request a physical certificate in many cases. However,
about 85% of all shares are immobilised at DTC, and efforts are under way in the US to eliminate the
requirement to issue physical certificates at the state level.

US equities settle at T+2, while US government fixed-income stocks settle at T+1. Corporate, municipal
and other fixed-income trades settle at T+2.

There are three levels of circuit breaker that can result in trading halts in the US. These are enacted if the
S&P500 falls by 7%, 13% or 20%. These circuit breakers are a key control put in place to limit sharp sell-
offs and halt trading for a set period of time.

Regulatory Environment in the US

The principal financial regulators and policy makers in the US market are as follows, with a brief
description of each:

• Securities and Exchange Commission (SEC) – the SEC has a role analogous to the FCA in the UK.
The SEC requires companies seeking a listing on the US exchanges to register with the SEC first.
Once listed, companies are then required to file regular reports with the SEC, particularly in relation
to their trading performance and financial situation.
• Commodity Futures Trade Commission (CFTC) – the role of the CFTC, which is an independent
agency, is to protect market users and the public from fraud, manipulation and abusive practices
related to the sale of commodity and financial futures and options, and to foster open, competitive
and financially sound futures and option markets.
• Federal Reserve System (‘The Fed’) – similar to the Bank of England it is the central bank of the US
and has very broad powers with relation to monetary policy.
• Federal Deposit Insurance Corporation (FDIC) – the FDIC is a government agency which is
responsible for administering the underwriting of customer deposits in the banking system and the
winding up or resolution of failed banks.
• Office of the Comptroller of the Currency (OCC) – established by the National Currency Act of
1863, the OCC serves to charter, regulate, and supervise all national banks and the federal branches
and agencies of foreign banks in the US.

168
 Equities

3.6.4 Japan
The Tokyo Stock Exchange (TSE) is one of five exchanges in Japan and is one of the more important
world exchanges.

The TSE uses an electronic, continuous auction system of trading. This means that brokers place orders
online and, when a buy and sell price match, the trade is automatically executed. Deals are made directly
between buyer and seller, rather than through a market maker. The TSE uses price controls so that the

3
price of a stock cannot rise above or fall below a certain point throughout the day. These controls are
used to prevent dramatic swings in prices that may lead to market uncertainty or stock crashes. If a
major swing in price occurs, the exchange can stop trading on that stock for a specified period of time.
In 2013, the TSE became the world’s third-largest exchange by listed companies after it and the Osaka
Securities Exchange merged their cash-equity trading platforms.

The Japan Securities Depository Centre (JASDEC) acts as the central securities depository (CSD) for
equities. The Bank of Japan (BOJ) provides the central clearing system and depository for Japanese
government bonds (JGBs) and Treasury bills.

Settlement within JASDEC is by book entry transfer, but without the simultaneous transfer of cash.
However, these movements are coordinated through the TSE.

The settlement cycle of Japanese government bonds (JGBs) shortened to T+1 from T+2 in 2018; and for
both equities and other fixed-income trades to T+2 from T+3 in 2019.

Regulation
The Financial Services Agency (FSA) is a Japanese government organisation responsible for overseeing
banking, securities and exchange, and insurance in order to ensure the stability of the financial system
of Japan. The agency operates with a commissioner and reports to the Minister of Finance (Japan). It
oversees the Securities and Exchange Surveillance Commission and the Certified Public Accountants
and Auditing Oversight Board.

3.6.5 Germany
Deutsche Börse is the main German exchange and provides services that include securities and
derivatives trading, transaction settlement, the provision of market information, as well as the
development and operation of electronic trading systems.

The cash market comprises both floor trading and a fully electronic trading system. Both platforms
provide efficient trading and optimum liquidity.

Xetra is Deutsche Börse’s electronic trading system for the cash market and matches buy and sell orders
from licensed traders in a central, fully electronic order book. In May 2011, floor trading at the Frankfurt
Stock Exchange migrated to Xetra technology. The new Xetra Specialist trading model combines the
advantages of fully electronic trading – especially in the speed of order execution – with the benefits
of trading through specialists who ensure that equities remain liquid and continually tradeable. The
machine fixes the price, the specialists supervise it; investors benefit from faster order processing.

169
Deutsche Börse also owns the international central securities depository Clearstream, which provides
integrated banking, custody and settlement services for the trading of fixed-interest securities and
shares. Clearstream Banking Frankfurt (CBF) performs clearing and settlement for the German market. At
the end of March 2003, Eurex Clearing AG (part of the Deutsche Börse group) took on the role of CCP for
German stocks traded on Xetra and held in collective safe custody.

Both equities and bonds have a T+2 settlement cycle. Transfer is by book entry via one of two settlement
processes, the Cascade system for domestic business, and through Clearstream for international users.

Regulation
The Federal Financial Supervisory Authority, better known by its abbreviation BaFin, is the financial
regulatory authority for Germany. It is an independent federal institution with headquarters in Bonn
and Frankfurt and falls under the supervision of the Federal Ministry of Finance. BaFin supervises about
2,700 banks, 800 financial services institutions and over 700 insurance undertakings.

3.6.6 Developing Markets

Although most overseas investment held by UK investors is in developed equity markets, emerging
markets represent a rapidly increasingly proportion of UK overseas investment. The term ‘emerging
market’ can be defined in various ways:

• markets in countries classified by the World Bank as low or middle income, and
• markets with a stock market capitalisation of less than 2% of the total world market capitalisation.

The attractions of investing in emerging markets comprise:

• Rapid economic growth – developing nations tend to grow at faster rates of economic growth than
developed nations, as they attempt to catch up with rich country living standards by developing
their infrastructure and financial systems. This process is assisted by domestic saving rates being
generally higher than in developed nations and the embracing of world trade and foreign direct
investment. Rapid economic growth tends to translate into rapid profits-growth.
• Low correlation of returns – emerging markets offer significant diversification benefits when held
with developed market investments, owing to the historically low correlation of returns between
emerging and developed markets. There is a notion that the BRIC economies have de-coupled with
the developed markets, but this is highly debatable as it still appears to be the case that, as a result
of financial contagion, adverse developments in the US market especially, or even the plight of the
euro currency, will cause disruptions to the BRIC markets (see section 3.6.7) as well as those in the
developed economies.
• Access to exchange-traded funds (ETFs) – many of the emerging markets, including the BRIC markets,
are now easily accessible to investors through a variety of ETFs which either track the MSCI indices for
the major geographical regions or provide more specialised baskets of assets for certain regions.
• Inefficient pricing – traditionally, emerging markets were not as well researched as their developed
counterparts, and pricing anomalies and inefficiencies were to be found. The increased interest in
the BRIC economies suggests that much of this alleged benefit may be disappearing.

170
 Equities

However, there can be significant drawbacks to investing in emerging markets:

• Lack of transparency – the quality and transparency of information is generally lower than for
developed nations, while accounting and other standards are generally not as comprehensive or as
rigorously applied.
• Lax regulation – regulation is generally more lax in emerging than in developed markets, and
incidents of insider trading and fraud by local investors more prevalent. Corporate governance also

3
tends to be lacking.
• Volatility – emerging market performances have been more volatile than those of developed
markets, owing to factors such as developing nations being less politically stable and more
susceptible to banking and other financial crises (although it should be noted the 2007-08 crisis was
primarily a crisis in the developed world).
• Settlement and custodial problems – the logistics of settling transactions and then arranging for
custody of the securities purchased can be fraught with difficulty. In addition, property rights are
not as well defined as in developed nations. However, these problems can be mitigated by using
global depositary receipts (GDRs) (see section 1.2.2).
• Liquidity – as emerging markets are less liquid, or more concentrated, than their developed
counterparts, investments in these markets tend not to be as readily marketable and, therefore, tend
to trade on wider spreads. In times of financial stress, it may be very difficult to exit certain assets
where there is no active market.
• Currencies – emerging market currencies tend to be less stable than those of developed nations and
periodically succumb to crises resulting from sudden significant outflows of overseas investor capital.
• Controls on foreign ownership – some developing nations impose restrictions on foreign
ownership of particular industries.
• Taxation – emerging market returns may be subject to local taxes that may not be reclaimable
under double taxation treaties.
• Repatriation – there may be severe problems in repatriating capital and/or income from
investments made in some emerging markets.

3.6.7 BRIC Markets

BRIC is an acronym that refers to the economies of Brazil, Russia, India and China. The four countries
combined currently account for more than a quarter of the world’s land area and more than 40% of the
world’s population. The acronym has been prominently used by the investment bank Goldman Sachs
since 2001. Goldman Sachs argued that, since the BRICs are developing rapidly, by 2050 their combined
economies could eclipse the combined economies of the current richest countries of the world. The way
momentum for growth in the world economy is shifting is also reflected in the political structures that
are emerging. Previously, the semi-annual G8 summits and meetings of the respective finance ministers
were the pivotal meetings for global policy coordination. However, the G20 summits, which include all
of the BRIC economies as well as those of the existing G8 and nations such as Mexico and South Korea,
are now becoming as important as, if not more so than, the G8 gatherings.

On 16 June 2009, the leaders of the BRIC countries held their first summit in Yekaterinburg, and issued
a declaration calling for the establishment of a multi-polar world order. Part of the discussions among
the BRIC nations have included calls for less reliance on the US dollar as the global reserve currency, and
there have been discussions about creating a new global unit of account similar to the special drawing
rights (SDRs) of the IMF. The BRIC nations are becoming increasingly significant contributors to the IMF
and are demanding a stronger representation in the formation of international monetary policy (to the
extent that there is such a policy).

171
Investing in the BRIC Economies
Certain collective investment vehicles are available to investors who wish to have investment exposure
to the BRIC economies, including specialised unit trusts and ETFs. For example, some ETFs that allow
exposure to the BRIC markets are available on the NYSE/Arca platform. One fund, BKF, holds assets from
all of the BRIC countries, and another, EWZ, reflects the MSCI Brazilian index. A third fund, iPath, provides
exposure to a broad selection of Indian equities by tracking the MSCI India index.

3.7 Fluctuations in Equity Market Prices

Learning Objective
3.3.7 Be able to assess how the following factors influence equity markets and equity valuation:
trading volume and liquidity of domestic and international securities markets; relationship
between cash and derivatives markets and the effect of timed events; market consensus and
analyst opinion; changes to the economic outlook; implications of foreign exchange

The prices of equities, in common with most asset classes, move continually during trading hours.

3.7.1 Liquidity
The liquidity of an asset is determined by how easily it can be bought and sold, and how quick it
can be converted into cash. This factor is extremely relevant when portfolio planning and selecting
investments with a view to selling them at a point in the future to realise cash. There are two sources
of risk connected with asset values. There is market risk (of asset value) and liquidity risk which is the
uncertainty of the ability to liquidate the asset when required.

Investors will differ as to their valuations of security prices based on different time horizons, different
economic outlooks and different vested interests, and their differing demand and supply criteria affect
the price. For markets to work properly there need to be disagreements, different time horizons among
the participants and different agendas and priorities. While some investors and traders think that an
asset is worth buying at a specified price, there must be others who, for various reasons, think that it is
worth selling at that same price.

The two most common frameworks for financial markets are the open outcry model and the electronic
order book; in both cases, for sustained trading to take place, there needs to be a fragmentation of
opinions. Assuming that there are a dedicated group of traders that want to trade a particular asset,
the more evenly divided opinions are, regarding the suitability of the current price, the more liquid the
market will be.

In very liquid markets, buying and selling preferences will show a high degree of non-alignment.
Trading stances will be dispersed and there will be no obvious internal coherence to them. But, when
the fragmentation is replaced by a near-consensus view among traders, the liquidity evaporates and
markets are prone to behaving in erratic ways: sometimes dramatic price swings and crashes can result.

172
 Equities

3.7.2 The Relationship Between Cash and Derivatives Markets

Some of the most actively traded derivative instruments are stock index futures. The contract for the S&P
500, which has two versions – a fully blown contract and what is called the E-mini version (see below) –
are probably the most traded index future in the world. The cash index which underlies this derivative
– the Standard & Poor’s 500 Index – consists of many of the largest capitalisation issues which trade
on the US exchanges NYSE and Nasdaq. Fund managers and traders desire exposure to this index for

3
numerous purposes, both as an indirect investment through the purchase of an index proxy such as the
popular exchange-traded fund SPY, or through a position in futures contracts.

The motivation could be to gain long exposure to this broad-based index of multinational equities and/
or as a hedging instrument for a portfolio of direct holdings in equities. In the UK, there is a futures
contract which tracks the FTSE 100, and there are also similar instruments that trade globally on the CME
Globex electronic trading platform, and which track among others, the Nikkei 225 Index in Japan and
the Xetra Dax Index in Germany.

Stock index futures, including the S&P futures, are popular because they trade 24 hours a day and allow
traders and brokers to gauge the futures level before the actual stock markets open for trading. This
gives a sense of where the market is likely to head at the start of trading.

The common characteristic of stock index futures contracts is that they have quarterly expirations.
For example, if one wants to purchase the Mini S&P 500 contract (ie, take a long position) one could
purchase the September 2010 futures contract. This contract has the following specification. The larger
full version of the S&P 500 contract is five times the size of the E-mini contract described below.

Mini S&P 500 Futures

Mini S&P 500 futures are legally binding agreements to buy or sell the cash value of the S&P 500 Index
at a specific future date. The contracts are valued at $50 x the futures price. For example, if the Mini S&P
500 futures price is at 920.00, the value of the contract is $46,000 ($50 x 920.00).

The minimum price movement of the futures or options contracts is called a tick. The tick value is 0.25
index points, or $12.50 per contract. This means that if the futures contract moves by the minimum price
increment (one tick), say, from 920.00 to 920.25, a long (buying) position will be credited $12.50; a short
(selling) position will be debited $12.50.

All futures positions (and all short option positions) require posting of a performance bond (or margin).
Positions are marked-to-market daily. Additional deposits into the margin account may be required
beyond the initial amount if the position moves against the investor.

Mini S&P 500 contracts are cash-settled, just like the standard S&P 500 futures; there is no delivery of the
individual stocks. Mini S&P 500 daily settlements and quarterly expirations use the exact same price as
the S&P 500. The same daily settlement prices allow E-mini contracts to benefit from the liquidity of the
S&P 500 futures.

Like the S&P 500, which is settled using a special opening quotation (SOQ), all Mini S&P 500 positions are
settled in cash to the same SOQ on the third Friday of the quarterly contract month.

173
Interaction Between Futures and Cash
Arbitrage opportunities arise if misalignments or discrepancies between the futures prices and the cash
prices on the S&P 500 arise. Indeed, programme trading is an arbitrage strategy which exists to exploit
these opportunities, which tend to be fairly small discrepancies and which therefore require very fast
executions to deliver profits.

The possibility of arbitrage and the fact that the futures contracts are very convenient for many
speculative purposes means that there is a real sense in which the action in the futures market can
tend to drive the price behaviour of the cash market. While this may seem like an aberration, in the
very complex and algorithmic nature of most cash market transactions today, the notion of the tail
(derivative) wagging the dog (underlying) is not so hard to contemplate.

The expirations of futures contracts can sometimes provide short-term volatility in the cash markets as
many large speculators and commercials (ie, investment banks) which are rolling over futures positions
will sometimes create whipsaw and turbulent market conditions. This situation is described by some in
the market as ‘witching’ and when contracts on futures, options on individual stocks, and options on
stock index futures occur (once each quarter) this phenomenon is referred to as ‘triple witching’.

For long-term investors, these kinds of activities might be considered as examples of ‘noise’ in the
equity markets, however, the impact of the derivatives markets upon the cash market is often not as
uni-directional as some commentators and textbooks imply. Rather than the derivative deriving its value
from the behaviour of the underlying cash instrument, the situation can often be better understood
from the converse perspective.

3.7.3 Market Consensus

Because it is unquantifiable and generally misunderstood by most traders and investors, psychology is
the often overlooked intangible aspect of trading.

In relation to trading and investing, we can consider two very different approaches to psychology in
the markets: individual psychology and group psychology. Attempting to draw conclusions based on
the actions of crowd psychology (sometimes disparagingly referred to as ‘herd behaviour’) is done by
examining how the behaviour of investors en masse exerts an effect on stock prices.

The foundations of how crowd behaviour relates to investing have a long history. Speculative investors
will often buy particular shares, or even shares in general, in the hope of taking advantage of a rising
trend in prices. As more investors buy, prices are driven higher still and this may encourage still further
buying. The process cannot continue indefinitely and eventually the bubble will burst when prices fall
back and there is a sudden change in sentiment. The fall in prices can then be as steep as the original
rise and those who bought at the highest prices will suffer losses. Famous historical examples of bubbles
include the South Sea Bubble, the Dutch tulip mania and the dot com mania of the 1990s. When most
investors are in consensus and are driving the market in a particular direction, one naturally thinks that
the consensus will continue ad infinitum and that the best trading decision is to follow the crowd.

174
 Equities

However, it has been suggested that historical examples prove this to be a paradox. When driven
strongly by consensus, crowd behaviour is actually a contrary indicator. When the consensus of the
majority of investors or traders is strongest, the individual trader should do exactly the opposite of
what the crowd is doing. When the market is strongly bullish, according to the contrarian view it is more
prudent to short the market. When the consensus is bearish, it is time to get ready to buy.

Mass psychology may continue to drive the trend for a longer period of time. The question that is asked

3
by investors who subscribe to the notion that the consensus is wrong at important market turning
points is: how can one expect to identify the moment when the consensus indicator is strongest and
what is the best moment to make a contrary investment decision? The answer is, of course, that there is
no way of determining the timing or, for that matter, of empirically verifying that treating consensus as a
contrarian indicator actually results in profitable investment. Market consensus can be used only as one
clue that a trading/investment opportunity may be available. It may simply indicate that it is a good time
to apply more detailed analyses to particular stocks or currencies.

The second question is: how does one establish the market consensus? Several tools are used to
help investors roughly identify the consensus of the market. Most of these tools tabulate a numerical
consensus indicator on the basis of advisory opinions, signals from the press or even polling that is done
among investment managers.

• The Commitments of Traders (COT) Report was first published by the Commodity Futures Trading
Commission (CFTC) in 1962 for 13 agricultural commodities to inform the public about the current
conditions in futures market operations. The data was originally released just once a month, but
moved to once every week by the year 2000. Along with reporting more often, the COT report has
become more extensive and has expanded to include information on most futures contracts. Among
the information published is the positions of so-called ‘commercials’. These are entities involved in
the production, processing, or merchandising of a commodity, using futures contracts primarily for
hedging. ‘Non-commercials’ are traders, such as individual traders and large institutions, who use the
futures market for speculative purposes and meet the reportable requirements set forth by the CFTC.
• Advisory opinion – advisers can often take the form of newsletter writers or bloggers and web
commentators who provide opinions on the future direction of markets or individual stocks. Sources
such as Investor’s Intelligence and Market Vane, both active in the US, poll these newsletters to track
the bullishness or bearishness of market commentators and advisers. These polling opinion research
services have developed special numerical figures to analyse these newsletters/blogs and will
assign either a bullish or bearish value to each of the opinion letters. These services then tabulate
the overall bullishness or bearishness of their entire universe of advisers. When this numerical value
crosses a certain threshold, either a buy or a sell signal is issued. The signal is issued contrary to the
balance of advisory opinion.

Share prices can change as a result of information becoming available to investors about various
matters, including:

• the earnings prospects and asset values of individual companies

• the membership of the board
• adverse factors affecting companies, such as legal action against it, or action by a bank to call in loans
• industry and economy surveys, for example, about levels of retail sales, or productivity

175
• macroeconomic developments, for example, the expected level of interest rates, or where an
economy appears to be located in the business cycle
• changes in government policy, for example fiscal and monetary policy
• movements in other stock markets around the world, such as the US, China and Japan
• geopolitical developments including wars, and threats from terrorist groups.

Many companies aim to present a stable and steadily rising pattern of dividend payments from year
to year. Sharp changes from the usual pattern may be taken by investors as a signal of a change in the
company’s fortunes, which may cause a shift in the share price. One of the consequences of the global
banking crisis of 2008 and the ensuing economic downturn has been that many large organisations,
especially in the financial services sector, have either cut their dividends or suspended them entirely.
One further consequence of this development is that many institutional investors, such as pension
funds, will then sell the shares of companies which suspend dividends, creating a downward cycle in
share prices.

The large US bank Citigroup is an example of a company which has suspended payment of a dividend
and seen its share price move into low single digits with a corresponding 90% fall in its market
capitalisation. ‘Market capitalisation’ refers to the value that is placed on a company by multiplying the
outstanding equity of a company by its current share price. In some ways it is a flawed notion, since it
places a value on the entire company from the value of the marginal shares traded during a particular
session, which may have been particularly troubled by the overall market. This gives rise to the rather
perverse way in which the market capitalisation of equity markets has moved up and down during the
2008–09 banking crisis and subsequent market recovery by many trillions of dollars or pounds.

Investors will look for evidence of the quality of a company’s management, although such evidence
can be difficult to obtain in practice. Changes in board membership can affect investors’ assessment of
a company’s prospects and the share price may move as a result. If a director resigns, investors will be
interested in the reason for the resignation. If new directors are appointed, their experience and past
track record will be of interest.

The prices of some companies’ shares are affected more by the state of the economy than others.
For example, because house purchase decisions are influenced by mortgage rates, housebuilding
companies will be particularly sensitive to interest-rate changes. If people are moving house less as a
result of interest rate increases, businesses such as DIY and carpeting firms may also face a downturn in
demand and, therefore, earnings.

Given the increasing interdependence of national economies through globalisation of trade and capital
flows, share prices will be heavily affected by economic conditions around the world, particularly the
state of the economy in the world’s largest debtor nation, the US. Some studies have suggested that
the inter-linkage between global stock markets is becoming much more pronounced than it used to be.
Correlation analysis shows that there is a much greater degree of co-movement between indices in the
US, UK, Western Europe and Japan. Emerging markets are less correlated with the more mature market
economies and this has given rise to the de-coupling thesis, which suggests that the fortunes of the
newly emerging dynamic economies – sometimes called the BRIC countries (ie, Brazil, Russia, India and
China) – are less coupled with the fortunes of, say, the US economy than in previous eras. The evidence
on this hypothesis is far from convincing, however, as evidenced by the dramatic declines seen in all
global stock markets in late 2008 and early 2009.

176
 Equities

On a related theme, there is a strong influence between the state of the world economy and final
demand and the price levels of major commodities such as oil, copper, and other industrial metals. The
emerging markets are greatly influenced by the prices of commodities both as major consumers (in the
case of China) and as producers (in the case of Russia and Brazil).

In 2010, there was a notable change in the manner in which the credit ratings for sovereign debt had
a very large impact on the behaviour of asset markets and investor sentiment. The downgrading of

3
the debt of Greece to junk status – which was finally confirmed by the major agencies in June 2010,
although anticipated by money market participants well before that – had a major impact on the
European credit markets, the value of the euro currency and also, for a time, brought a sharp correction
in equity markets.

3.7.4 Impact of Exchange Rates

The impact that foreign exchange rate fluctuations can have on share prices and indices is regularly
seen with the FTSE 100 index. Many of the component companies of the index have large international
operations where profits are realised in US dollars. If the foreign exchange markets see a fall in the value
of sterling, the dollar revenues of these companies will be worth more. As a consequence, the FTSE 100
index can rise, even if all other factors are unchanged.

A good example of this concerns Brexit and the aftermath of the UK’s announcement in June 2016 of
its intention to leave the EU. Companies like GlaxoSmithKline saw their prospective overseas profits rise
significantly, when converted back to sterling. The anticipated increases in the companies’ revenues
caused their share prices to rise. In the month following the Brexit referendum, GlaxoSmithKline’s share
price saw a 23% rise.

In fact, in the three months following the referendum, the FTSE 100 rose by 10.4%, while in the same
period sterling fell 12.8% against the US dollar.

Another example of a currency influencing shares prices was seen following the US election in 2016.
During the month after Donald Trump’s election to president in November, the S&P 500 rose 10% to
new highs and the key reasons were the strength of the US dollar, as well as expectations of tax cuts
for corporates. Trump’s election policies raised expectations of inflation rate and interest rate rises. With
higher interest rates can come higher rates of return and a more attractive currency. If the US dollar is
likely to become stronger, then so can the earnings of US companies.

177
3.8 Stock Market Indices

Learning Objective
3.3.8 Understand the purpose, construction, application and influence of indices on equity markets:
market regional and country sectors; market capitalisation sub-sectors; free float and full
market capitalisation indices; fair value-adjusted indices

A stock market index is a method of measuring a section of the stock market. Many indices are cited by
news or financial services firms and are used as benchmarks, to measure the performance of portfolios
and to provide the general public with an easy overview of the state of equity investments. Their
methods of construction vary according to whether they are capitalisation-weighted or not.

There are various organisations which have become specialists in constructing equity indices and
managing their composition, making periodic adjustments and publishing the index data in real
time and on a historical basis. Standard & Poor’s is the manager of the S&P 500 Index and selects the
constituents of the index from the largest capitalisation issues which trade on US exchanges. It consists
of stocks from the NYSE and Nasdaq and there is an overlap with the constituents of the better-known
Dow Jones Industrial Average, which is maintained by the Dow Jones company, former owners of the
Wall Street Journal. In addition, the Russell Investment Group in the US is well known for maintaining
several indices of US stocks including the Russell 2000, which represents the smallest-capitalisation
issues trading in US markets and is often used as a benchmark for what are called micro-cap stocks.

In the UK, the best known index is the FTSE 100 Index, which consists straightforwardly of the one
hundred largest companies traded on the LSE as measured by market capitalisation. The index is
maintained by the FTSE Group, a UK provider of stock market indices and market data services, wholly
owned by the LSE, which originated as a joint venture between the Financial Times and the LSE. It is
calculated in real time and published every 15 seconds.

Index Name Composition Scope

Largest 100 UK companies listed on the LSE and UK and multinationals.
FTSE 100
measured by market capitalisation.
Dow Jones 30 large US companies selected by the editors of US-domiciled multinationals.
Industrial the Wall Street Journal.
Average (DJIA)
Nikkei Stock 225 large and regularly traded Japanese Japanese corporations.
225 companies traded.
50 companies listed on the Hong Stock Exchange Hong Kong/China.
Hang Seng selected on the basis of market value, turnover
and financial performance.
A family of indices, based around the DJ Stoxx Global developed markets.
Global 1800 Index that consists of the 600
DJ Stoxx largest-capitalisation companies from each of
the three regions – Europe, Americas and Asia/
Pacific.

178
 Equities

A market capitalisation-based index, including Global developed markets.

MSCI World companies from over 20 countries, totalling over
1,650 companies. See section 3.6.1.
FTSE Eurofirst 300 largest listed companies by market European-domiciled
300 capitalisation from across Europe. corporations.
A capitalisation-weighted measure of the 40 French-domiciled companies;
most significant values among the 100 highest about 45% of its listed shares

3
CAC 40 market caps on Euronext Paris. are owned by foreign investors,
more than any other main
European index.
DAX is the capitalisation-weighted blue chip German stocks.
Deutscher
index for the Frankfurt Stock Exchange. The DAX
Aktien IndeX
includes the 30 major German companies trading
(DAX)
on the Frankfurt Stock Exchange.
Standard & Poor’s manages the composition of US-traded stocks which are
S&P 500 the index. The 500 constituents are selected by multi-national companies
S&P from the largest-cap stocks traded in the US. operating in global markets.
The FTSE All-Share Index, originally known as the To qualify, companies must have
FTSE Actuaries All-Share Index, is a capitalisation- a full listing on the LSE with a
FTSE All-Share
weighted index, comprising around 600 of more sterling- or euro-dominated
than 2,000 companies traded on the LSE. price on SETS.
The Nasdaq Composite covers issues listed Since both US and non-US
on the Nasdaq stock market with over 3,000 companies are listed on the
Nasdaq
components. It is an indicator of the performance Nasdaq stock market, the index
Composite
of stocks of technology companies and growth is not exclusively a US index.
companies.
The Nasdaq-100 Index consists of the largest Does not contain financial
Nasdaq-100 non-financial companies listed on Nasdaq. It is a companies incorporated outside
modified market value-weighted index. the US.

FTSE 100 companies represent about 81% of the market capitalisation of the whole LSE. Trading lasts
from 8.00am to 4.29pm (when the closing auction starts), and closing values are taken at 4.35pm.

The previous table provides information on the composition and geographical scope of many of the
largest and best known global equity indices.

As previously outlined, the FTSE Group, which is the principal provider of index information for the UK
as well as many other regions of the world, uses a classification system for segmenting different markets
according to their state of development. See section 3.6.1. Other companies, such as Dow Jones, use
similar criteria for their classification systems.

179
3.8.1 National and Sector Indices
A national index represents the performance of the stock market of a given nation and reflects investor
sentiment on the state of its economy. The most regularly quoted market indices are national indices
composed of the stocks of large companies listed on a nation’s largest stock exchanges. The concept
may be extended well beyond an exchange.

The Wilshire 5000 Index, the original total market index, represents the stocks of nearly every publicly
traded company in the US, including all US stocks traded on the NYSE (but not ADRs or limited
partnerships) and the Nasdaq Biotechnology Index, which consists of over 150 securities of Nasdaq-
listed companies in the biotechnology or pharmaceuticals industries. The Russell Investment Group, as
previously mentioned, also maintains dozens of indices covering different sectors within the US market.

More specialised indices exist tracking the performance of specific sectors of the market. Some examples
include the Wilshire US REIT which tracks more than 100 American real estate investment trusts (REITs) and
the Morgan Stanley Biotech Index, which consists of 36 American firms in the biotechnology industry.

Some indices, such as the S&P 500, have multiple versions. These versions can differ based on how the
index components are weighted and on how dividends are accounted for. For example, there are three
versions of the S&P 500 Index: price return, which only considers the price of the components; total
return, which accounts for dividend reinvestment; and net total return, which accounts for dividend
reinvestment after the deduction of a withholding tax. As another example, the Wilshire 4500 and
Wilshire 5000 indices have five versions each: full capitalisation total return; full capitalisation price;
float-adjusted total return; float-adjusted price and equal weight. The difference between the full
capitalisation, float-adjusted, and equal weight versions is in how index components are weighted.

3.8.2 The Construction of Indices and Weighting

Construction of an index usually involves the total market capitalisation of the companies weighted by
their effect on the index, so the larger stocks will make more of a difference to the index as compared to
a smaller market cap company.

Price-Weighted
However, there is one major exception to this method of construction and calculation which is the Dow
Jones Industrial Average (DJIA). Since it is such a widely quoted index, and since it is not capitalisation-
weighted, it is worth considering the method of calculation.

The sum of the prices of all 30 DJIA stocks is divided by the Dow divisor. The divisor is adjusted in case
of stock splits, spinoffs or similar structural changes, to ensure that such events do not in themselves
alter the numerical value of the DJIA. Early on, the initial divisor was composed of the original number
of component companies. This made the DJIA at first a simple arithmetic average. The present divisor,
after many adjustments, is less than one (meaning the index is larger than the sum of the prices of the
components).

180
 Equities

That is:
∑p
DJIA =
   d
where:

∑= sum
p = the prices of the component stocks

3
d = the Dow divisor

Events like stock splits or changes in the list of the companies composing the index alter the sum of the
component prices. In these cases, in order to avoid discontinuity in the index, the Dow divisor is updated
so that the quotations right before and after the event coincide:

∑pold ∑pnew
DJLA = =
dold dnew

The Dow Divisor was 0.1519 in June 2021. Every $1 change in price in a particular stock within the
average equates to a 6.5839 (or 1 ÷ 0.1519) point movement.

The DJIA is often criticised for being a price-weighted average, which gives higher-priced stocks more
influence over the average than their lower-priced counterparts but takes no account of the relative
industry size or market capitalisation of the components. For example, a $1 increase in a lower-priced
stock can be negated by a $1 decrease in a much higher-priced stock, even though the lower-priced
stock experienced a larger percentage change. In addition, a $1 move in the smallest component of the
DJIA has the same effect as a $1 move in the largest component of the average. Many critics of the DJIA
recommend the float-adjusted market-value-weighted S&P 500 or the Wilshire 5000 as better indicators
of the US stock market.

Float-Adjusted Market Capitalisation Method

This is also called the free-float method. The basic formula for any index is (be it capitalisation-weighted
or any other stock index) is:

Index level= ∑(price of stock x number of shares) x free-float factor/index divisor

The free-float adjustment factor represents the proportion of shares that is floated as a percentage of
issued shares and then is rounded up to the nearest multiple of 5% for calculation purposes. To find the
free-float capitalisation of a company, first find its market cap (number of outstanding shares x share
price) then multiply its free-float factor.

The free-float method, therefore, does not include restricted stocks, such as those held by company
insiders. Traditionally, capitalisation- or share-weighted indices all had a full weighting, ie, all
outstanding shares were included.

181
Many of them have changed to a float-adjusted weighting, which has some variations as explained as
follows:

• Actual free float – the number of freely tradable shares available, expressed in percentage terms
after deducting the portion classified as restricted holdings from the shares in issue.
• Investible market capitalisation – the company’s market capitalisation is used to calculate the
index value. It may differ from the full market capitalisation, due to the application of free-float
restrictions, capping weight, style weight or basket weight.

All FTSE equity index constituents are fully free-float-adjusted in accordance with FTSE’s index rules,
to reflect the actual availability of stock in the market for public investment. Each FTSE constituent
weighting is adjusted to reflect restricted shareholdings and foreign ownership to ensure an accurate
representation of investable market capitalisation.

Total Return Index

An index that calculates the performance of a group of stocks assuming that dividends are re-invested
into the index constituents. For the purposes of index calculation, the value of the dividends is re-invested
in the index on the ex-dividend date. Total return index data is not available at the stock level.

Fair Value-Adjusted Index

In the futures market, fair value is the equilibrium price for a futures contract. This is equal to the spot
price after taking into account compounded interest (and dividends lost because the investor owns the
futures contract rather than the physical stocks) over a certain period of time. In relation to an index,
fair value is the forward value (at the time of a futures contract expiration) of an index spot price, where
compounding takes into account time to expiration and dividends lost due to holding index futures
rather than underlying stocks. If the fair value before the open is lower than the futures contract price,
you may expect that a market index will go higher after the opening bell.

Calculation of fair value for futures contracts on equity indices is a feature of arbitrage strategies.

3.9 Accounting for Corporate Actions

Learning Objective
3.4.1 Understand the purpose and structure of corporate actions and their implications for investors:
stock capitalisation or consolidation; stock and cash dividends; rights issues; open offers, offers
for subscription and offers for sale; placings

There are more than 150 different types of corporate action, but for present purposes it will only be
necessary to consider some of the principal ones that are often encountered by investors.

3.9.1 Dividend Payments

The payment of dividends represents a share in the profits made by a company that are paid to a
shareholder as a return for providing its risk capital.

182
 Equities

Dividends are usually paid twice a year and are expressed in pence per share. Interim dividends are paid
in the second half of a company’s accounting period, while final dividends, usually the larger of the two
payments, are paid after the end of the company’s accounting year.

It is up to the company’s directors to determine the amount of any dividend to be paid, if any, and their
decision needs to be ratified by the shareholders at the AGM. Although shareholders can vote for the
final dividend to be paid at or below its proposed rate, they cannot vote for it to be increased above this

3
level.

Once a dividend has been declared, the company’s shares are traded on an ex-dividend (xd) basis
until the dividend is paid, typically six weeks after the announcement. Shares purchased during this
ex-dividend period do not entitle the new shareholder to this next dividend payment.

At the election of the board of directors, a company may decide to pay a dividend by issuing new shares
to the current shareholders of record, known as a scrip dividend. This will be dilutive for the company
and may be done to conserve cash. In the summer of 2010, when BP was facing mounting pressure from
the US government to suspend payments of a cash dividend until the full costs of the oil spillage in the
Gulf of Mexico were known, one of the options considered by the company was to pay a dividend in
newly issued shares of BP.

3.9.2 Final Redemption

A final redemption involves the repayment in full of a debt security at the maturity date stated in the
terms and conditions of an issue.

3.9.3 Warrant Exercise

Warrants give a holder the right to buy a prespecified number of a company’s ordinary shares, at a preset
price, on or before a pre-determined date. Warrant exercise relates to the act of exercising, or buying, the
shares over which the warrant confers a right.

3.9.4 Bonus (Capitalisation/Scrip) Issue

A bonus issue, also referred to as a capitalisation issue or scrip issue, is when a company issues
further units of a security to existing holders based on the holdings of each member on record date.
A company quite simply converts its reserves, which may have arisen from issuing new shares in the
past at a premium to their nominal value or from the accumulation of undistributed past profits, into
new ordinary shares. These shares rank pari passu with those already in issue and are distributed to the
company’s ordinary shareholders in proportion to their existing shareholdings free of charge.

Rationale for Bonus Issues

Occasionally, a company may issue new shares to its shareholders without raising further capital, often
as a public relations exercise to accompany news of a recent success or as a means to make its shares
more marketable.

183
Once a UK company’s share price starts trading well into double figures, its marketability starts to suffer
as investors shy away from the shares. Therefore, a reduction in a company’s share price as a result
of a bonus issue usually has the effect of increasing the marketability of its shares and often raises
expectations of higher future dividends. This, in turn, usually results in the share price settling above its
new theoretical level and the company’s market capitalisation increasing slightly.

3.9.5 Subdivision (Stock Split)

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

3.9.6 Consolidation (Reverse Split)

This covers the case when a company decides to decrease the number of issued securities, for example,
by consolidating every four shares currently existing into one share of four times the nominal amount.
This is often undertaken by a company if its listed share price falls below a certain threshold amount.
A reverse split was undertaken by AIG following its share price collapse and the takeover of 80% of its
equity by the US federal government. The reverse split, which took effect on 1 July 2009, was a 1:20 split
and applies to the public float which is still traded on the NYSE.

3.9.7 Rights Issue

When a company wishes to raise further equity capital, whether to finance expansion, develop a new
product or replace existing borrowings, it can make a rights issue to its existing ordinary shareholders.

The rights issue is accompanied by a prospectus, which outlines the purpose of the capital-raising
exercise, but it does not require an advertisement of the issue to be placed in the national press.

New shares are offered in proportion to each shareholder’s existing shareholding, usually at a price
deeply discounted to that prevailing in the market to ensure that the issue will be fully subscribed and
often to avoid the cost of underwriting the shares. The number of new shares issued and the price of
these shares will be determined by the amount of capital to be raised. This price, however, must be
above the nominal value of the shares already in issue.

The choices open to shareholders under a rights issue are:

• take up the rights in full by purchasing all of the shares offered

• sell the rights
• sell a sufficient proportion of the rights to take up the balance, or
• take no action and allow the rights to lapse.

With regard to lapsed rights, the following circumstances then apply. Rights issues are usually
underwritten by a third party and, in the case that shareholders do not take up their total entitlements,
the third party will take up, or underwrite, the remaining rights and then sell all the new ordinary shares
received. Any premium (positive difference) over the sale price of the ordinary shares and the take-up
price will then be distributed to those shareholders who did not either sell or take up their rights.

184
 Equities

If no premium was attained during the sale of new ordinary shares sold by the underwriters, no lapsed
rights proceeds will be distributed and nil-paid shares will be removed from the client’s accounts with
no associated value.

3.9.8 Open Offer, Offer for Subscription and Offer for Sale
An open offer is similar to a rights issue, in that shareholders are entitled to buy newly-issued shares

3
in proportion to their existing holdings. Unlike a rights issue, however, an open offer does not allow
shareholders to sell the right to subscribe to shares. Under an open offer the shareholders have an
entitlement rather than a tradeable right to subscribe to new shares. For this reason, an open offer is
sometimes called an entitlement issue.

Any entitlement that is not taken up is simply allowed to lapse, or the shares are sold to another party
with no compensation to the original shareholder for the loss in value of their holding that results from
the dilution that comes from the new issue.

As with a rights issue, the price of the offer is likely to be at a discount to the current share price and the
effect of the open offer on the price is calculated in essentially the same way.

An offer for sale is a public invitation by a sponsoring intermediary, such as an investment bank acting
as an underwriter or issue manager.

An offer for subscription, or direct offer, is a public invitation by the issuing company itself. The offer can
be made at a price that is fixed in advance or it can be by tender where investors state the price they are
prepared to pay. After all bids are received, a strike price is set which all investors must pay.

3.9.9 Placing
In placing its shares, a company simply markets the issue directly to a broker, an issuing house or other
financial institution, which in turn places the shares to selected clients. A placing is also known as
selective placing.

A company may undertake a placing to raise additional finance by placing new shares in the market
rather than by making a rights issue, and this requires the shareholders to firstly pass a special resolution
to forgo their pre-emption rights.

A placing is the least expensive IPO method, as the prospectus accompanying the issue is less detailed
than that required for the other two methods and no underwriting or advertising is required. If the
company is seeking a full listing, the issue must still be advertised in the national press.

A placing is the preferred new issue route for most AIM companies.

3.9.10 Placing with Clawback

If a company makes a placing with clawback, new shares are placed with institutions only after they
have been offered to existing shareholders. Depending on the take up of these new shares by existing
shareholders, the allocation to these institutions may be clawed back, or made on a pro rata basis.

185
 4. Mandatory and Optional Corporate Actions

Learning Objective

3.4.2 Be able to calculate the theoretical effect on the issuer’s share price of the following mandatory
and optional corporate actions: bonus/scrip; consolidation; rights issues

4.1 The Effect of Corporate Actions on Share Price

A corporate action can be simply defined as any event that brings material change to a company and
affects its stakeholders. This includes shareholders, both common and preferred, as well as bondholders.
These events are generally approved by the company’s board of directors, and in certain circumstances,
the shareholders are permitted to vote on proposed corporate actions.

Splits, dividends, mergers, acquisitions and spin-offs are all examples of corporate actions. Bondholders
are also subject to the effects of corporate actions. For example, if interest rates fall sharply, a company
may call in bonds and pay off existing bondholders, then issue new debt at lower interest rates.

Certain kinds of corporate action will bring direct change to a company’s capitalisation structure and
impact its stock price. Some examples are bonus issues, stock splits, reverse splits, acquisitions, rights
issues and spin-offs. Some of these types of actions will be considered in this section.

4.2 Bonus, Scrip or Capitalisation Issue

A scrip issue is also known as a bonus or capitalisation issue. One factor which can lead to a scrip or
bonus issue is when a company transfers profits to a fund called its capital redemption reserve and uses
it to issue bonus shares to the members in proportion to their existing holdings.

A scrip or bonus issue can reduce the amount of money available for paying dividends, so the term
‘bonus’ is not always appropriate. That is why the term ‘capitalisation of reserves’ is sometimes used. A
company can also use a capitalisation issue to credit partly paid shares with further amounts to make
them paid up. This is explained in the table below.

The following table shows the impact of a one for three scrip issue on a company. The company
started with 750,000 £1 ordinary shares in issue and net assets valued at £2.25 million, so the market
capitalisation of the company is £2.25 million. A transfer of £0.25 million from retained profits to the
share capital account is required to cover the scrip issue.

When the market capitalisation of £2.25 million is divided by this enlarged number of one million shares,
the resultant share price is £2.25 per share. Therefore, the impact of the scrip issue has been to reduce
the share price from £3.00 to £2.25.

186
 Equities

Bonus, Scrip or Capitalisation

Impact on the Accounts (all amounts in £’000s)
Before Issue After
Net assets 2,250 2,250
Issued share capital

3
750,000 £1 ordinary shares 750
1,000
250,000 ordinary shares 250
Share premium 1,000 1,000
Retained profit 500 (250) 250
Totals 2,250 0 2,250
Impact on the Share Price
Shares (’000s) Price £ Value (£’000s)
Before 750 3.00 2,250
Scrip issue 250
After 1,000 2,250

4.3 Share Split

The reduction in the share price as a result of a bonus issue may have its advantages, but it also has
disadvantages. If share prices are falling, it may result in the price dropping below the nominal value,
which under corporate law will prevent a company from raising finance by issuing more shares. An
alternative way of lowering the price per share but avoiding this problem is to undertake a split. A
share split is achieved by dividing the existing share capital into a larger number of shares with a lower
nominal value per share, even though the overall nominal value of all the shares will remain the same.

Example
Consider the case of a company which has issued one million ordinary shares at £1 nominal value but
wishes now to reduce the price of its shares by replacing that issue with a new issue of 2.5 million shares
at a nominal value of 40p. The results can be seen on the simplified section of the statement of financial
position as follows. In effect, the company is engaging in a 5:2 stock split. Before the new issue the
shares are trading at £3 each. The example below illustrates the changes in the capital structure and the
impact on the share price of a split issue along the lines just described.

187
 Share Split
Impact on the Accounts (all amounts in £’000s)
Before Issue After
Net assets 2,000 2,000
Share capital
1m £1 ordinary shares 1,000 (1,000)
2.5m 40p ordinary shares 1,000 1,000
Share premium 500 500
Profit and loss 500 500
Totals 2,000 0 2,000
Impact on the Share Price
Shares (’000s) Price £ Value (£’000s)
Before 1,000 3.00 3,000
Split issue 1,500
After 2,500 3,000
Market price for shares £1.20

In terms of market capitalisation, it can be seen that the price per share will drop to 120p per share. The
prior market capitalisation was £3 million based on one million shares, but there are now 2.5 million
shares issued and the market price for the shares is therefore £3 million/2.5 million shares. The new
share price of 120p is considerably above the new nominal value of 40p per share. Hence, this will not
cause any problems in issuing new shares.

Although both a capitalisation and a share split appear to be the same in many ways, it is important
to note the difference in terms. For example, a three-for-one capitalisation will result in shareholders
having three additional shares for each share held, whereas a three-for-one stock split will result in each
share becoming three shares.

To summarise, the results of each are as follows:

• Three-for-one capitalistion – the holder of one share now has four shares.
• Three-for-one stock split – the holder of one share now has three shares.

Capitalisation is more associated with the UK market, and the stock split more so with the US market.

188
 Equities

4.4 Consolidation (Reverse Split)

A reverse stock split, or consolidation, reduces the number of shares and increases the share price
proportionately. For example, if you own 10,000 shares of a company and it declares a one-for-ten
reverse split, you will own a total of 1,000 shares after the split. A reverse stock split has no effect on the
value of what shareholders own. Companies often split their stock when they believe the price of their
stock is too low to attract investors to buy their stock. Some reverse stock splits cause small shareholders

3
to be ‘cashed out’ so that they no longer own the company’s shares.

Example
A company has decided to issue half a million new shares with a nominal value of £2 each to replace its
one million existing shares with a nominal value of £1 each. The reverse split is in effect a one-for-two
split. The company’s share capital remains the same at £1 million, but the stock price has effectively
doubled as there are now only half the shares outstanding compared to those before the reverse split.

Reverse Split
Impact on the Accounts (all amounts in £’000s)
Before Issue After
Net assets 2,000 2,000
Share capital
1m £1 ordinary shares 1,000 (1,000)
0.5m £2.00 ordinary shares 1,000 1,000
Share premium 500 500
Profit and loss 500 500
Totals 2,000 0 2,000
Impact on the Share Price
Shares Value
Price £
(’000s) (£’000s)
Before 1,000 3.00 3,000
Consolidation or reverse split (500)
After 500 3,000
Market price for shares £6.00

189
4.5 Rights Issue
A rights issue is an issue of new shares whereby a company wishes to raise additional cash from existing
shareholders by offering new shares at a discount to the current market price. With a rights issue of
shares, existing shareholders are given the right, or strictly speaking the first refusal, to buy new shares
that the company is issuing.

Example
To illustrate the impact on the share price for a company which undertakes a rights issue, the following
are the key variables.

• Prior to the rights issue, the company has issued one million shares with a nominal value of £1 each.
The par value is the nominal value which has been determined by an issuing company as a minimum
price.
• The share premium account shows a balance of £0.5 million. The share premium account of a
company is the capital that a company raises upon issuing shares that is in excess of the nominal
value of the shares.
• The company wishes to raise new capital for expansion and undertakes a one-for-four rights issue at
a price of 160p in order to raise £400,000.
• The company’s accounts before the rights issue show that net assets are £2 million and retained
profits are £0.5 million.
• The market price of the shares prior to the rights offering is 300p per share.

What is the impact on the accounts and the theoretical market price per share of this issue?

A one-for-four rights issue means that for every four shares previously in existence, one new share will
be issued. In our example, one million shares were previously in issue, and 250,000 new shares will be
issued at a price of 160p in order to raise the £400,000 cash required.

In terms of the accounts, the 250,000 new share issue will increase the share capital to 1.25 million
shares, the profit and loss will remain unchanged but the share premium account will need to be
adjusted. The reason for this adjustment is that for the £400,000 raised, each of the 250,000 new shares
can be issued at the nominal value of £1 but the additional £150,000 raised in excess of the nominal or
face value of the shares is allocated to the share premium account as indicated in the simple statement
of financial position perspective in the table below.

The total capitalisation of the company will have increased to £2.4 million and can be broken down
according to the upper part of the table which reflects the rights issue from an accounting perspective.

The impact on the share price can be seen from the calculation of the theoretical market price in the
lower part of the table. The price for the shares should have fallen from 300p per share before the rights
issue to 272p after the issue to reflect the new capitalisation divided by the greater number of shares
now outstanding.

190
 Equities

Rights Issue
Impact on the Accounts (all amounts in £’000s)
Before Issue After
Net assets 2,000 400 2,400
Share capital

3
1m £1 ordinary shares 1,000 250 1,250
Share premium 500 150 650
Profit and loss 500 500
Totals 2,000 400 2,400
Impact on the Share Price
Shares (’000s) Price £ Value (£’000s)
Before 1,000 3.00 3,000
Rights issue 250 1.60 400
After 1,250 3,400
Market price for shares £2.72

Another perspective on this can be seen simply by looking at the following formula, which only requires
knowledge of the share price before the rights issue and the actual terms of the rights issue. The formula
for the theoretical ex-rights price is as follows:

[ No. of Shares Held Cum-Rights +

x
Cum-Rights Share Price
No. of Rights Allocated
x
Rights Issue Price
Total No. of Shares Held Assuming Rights Exercised ]
This is easily demonstrated in the following table based on the example above, which leads to the same
theoretical ex-rights price of 272p per share.

Number of Price per Total Value of

Description
Shares Share (pence) Holdings (pence)
Shares held cum-rights 4 300 1,200
Rights allocated – new share entitlement 1 160 160
Post rights issue assuming rights taken up 5 1,360
Theoretical ex-rights price = 1,360/5 272

191
 5. Corporate Actions and Share Dilution

Learning Objective
3.4.3 Be able to analyse the following in respect of corporate actions: rationale offered by the
company; the dilution effect on profitability and reported financials; the effect of share
buybacks

5.1 Overview
Corporate actions are multi-faceted, but those which are of most relevance to financial analysts and
investors are those which will impact the capital structure of the corporation.

One of the most important metrics for any company is the determination of the company’s earnings per
share or EPS. In arriving at the EPS, most concern will be in respect to the denominator or divisor of the
equation, ie, the number of ordinary shares which are outstanding. If there have been no changes in the
capital structure during the course of a year there should be no problems in simply stating the number
of shares outstanding as of the year-end and using this as the denominator. However, if there have been
modifications to the capital outstanding during the course of the year as a result of a corporate action,
then pro rata adjustments to the number to reflect the changes in capitalisation will be required. The
purpose of the adjustments will be:

• To ensure the EPS ratio for the current year is valid by comparing the full year’s earnings to the
representative number of shares in issue during the year, not simply the number of shares in issue
at the year-end. For example, the value for the number of shares outstanding will be distorted by an
issuance of new shares close to the preparation of year-end statements.
• In order to provide a consistent historical view of a company’s accounts and profitability trends, it
is important to ensure that the previous year's earnings per share figures have been calculated on a
similar basis. In order for this to take place, it will often be necessary to re-state a previous year’s EPS
figures.

The following are the principal kinds of corporate actions, the rationale behind them, and their impact
on capitalisation are also outlined.

5.2 Rights Issue

A rights issue is a corporate action designed to raise additional capital under a secondary market offering
of shares. With the issued rights, existing shareholders have the privilege to buy a specified number of
new shares from the firm at a specified price within a specified time. A rights issue is in contrast to an
initial public offering (primary market offering), when shares are issued to the general public for the first
time.

A rights issue is directly offered to all shareholders of record, or through broker dealers of record and may
be exercised in full or partially. Subscription rights may either be transferable, allowing the subscription
right-holder to sell them privately, on the open market or not at all. The company receives shareholders’
money in exchange for shares, meaning a rights issue is a source of capital.

192
 Equities

There are various reasons why companies may elect to undertake a rights issue. They may have
problems raising capital through borrowing or issuance of debentures, or they may prefer to avoid high
interest charges on loans or high coupons in conjunction with a bond issuance.

Several leading banks had to undertake rights issues both in the UK and elsewhere to rebuild their Tier
1 capital following the drastic fall in property prices in 2007–08 and the write-down of many of their
assets. Tier 1 capital is a key measure of a bank’s reserves as defined first in Basel 1.

3
In May 2010, Prudential Insurance announced plans for the biggest rights issue in UK history to raise
£14.5 billion to buy AIA Group – the Asian arm of US insurer AIG. Under the proposal, every shareholder
was entitled to buy 11 new shares for every two existing ones, at an issue price of 104p, which was an
80% discount to the price of the shares at the time of the announcement. The terms of the offer meant
that an existing shareholder could either buy the full entitlement of shares, sell part of the entitlement
and use the resulting money to pay for the balance or sell the entitlement. Shareholders who did
anything other than take up their full entitlement would see their existing shareholding diluted, or
reduced in value. The rights issue met such opposition from institutional shareholders in the UK that it
was subsequently withdrawn and the company decided to abandon the acquisition.

5.2.1 New Share Issue to Acquire a Subsidiary

If shares are issued as part of the consideration to acquire a subsidiary, the treatment is exactly the same
as a full price issue.

From the date when the subsidiary is acquired it will be necessary to consolidate into the group
accounts the profit of the subsidiary. In other words, from the date of acquisition the enlarged group’s
earnings will rise by the earnings generated by the subsidiary.

It will be necessary to apply a weighted average number to the shares as and when they were issued
and, therefore, outstanding.

5.3 Bonus Issues and Share Splits

A bonus share is a free share of stock given to current/existing shareholders in a company, based upon
the number of shares that the shareholder already owns at the time of the announcement of the bonus.
While the issue of bonus shares increases the total number of shares issued and owned, it does not
increase the value of the company. Although the total number of issued shares increases, the ratio of the
number of shares held by each shareholder remains constant.

A bonus issue does not raise any new cash and therefore will not generate any new earnings.

From a statement of financial position perspective a bonus issue has the effect of increasing share capital
and reducing reserves, ie, restructuring shareholders’ funds. It does not change the total shareholders’
funds or total net assets.

From an operational viewpoint, these bonus shares may as well have been issued at the same time as
the underlying shares on which they are now being paid.

193
In terms of accounting procedure, the best way to think about a bonus issue is to backdate the bonus
issue and in effect imagine that those shares had always been in issue. Similar considerations apply in
the case of a share split – for example, all existing shareholders are given another share in a two-for-one
split – so following such an event there are a greater number of shares outstanding, but, since the split
was on a pro bono basis, no new finance has been raised. The main reason for a bonus issuance or share
split is that the price of the existing share has become unwieldy.

During the 1990s internet and technology boom, many Nasdaq companies such as Intel, Apple and
Amazon saw their share prices increase by several orders of magnitude and the companies decided that
the share prices had become too high for the average retail investor. A company would undertake, for
example, a three-for-one split which would mean that, after the bonus issue (or split), all the existing
investors would have three shares for every one share before the split. So if the share price had risen to
$150 before the split, after the split or bonus issue the share price would have dropped to $50 per share.

A pure bonus issue will require an adjustment to be made to the number of shares previously in issue by
use of the bonus or split fraction as follows.

Number of shares after the issue

Number of shares before the issue

The alternative to the splits discussed above is the corporate action of a reverse split. In this case, a
company will announce that it will be reducing the number of shares outstanding but that the reduction
will be applied across the board to all current shareholders so that the number of shares outstanding
is adjusted for each individual shareholder. Following a reverse split, while the earnings per share (EPS)
will have risen, all things being equal, the entitlement or claim to a specific portion of the company’s
earnings by any shareholder will remain the same.

In essence, a split or reverse split in the number of a company’s shares outstanding will affect the EPS
for the individual shares. However, it will not affect the market capitalisation of the company. Moreover,
it will not affect the claims to participate in a different portion of the earnings of the company for the
current shareholders, since their revised holding will only entitle them to the same portion of the
earnings prior to the split or reverse split. If they have more shares as in the case of a split, the individual
shares will have a lower EPS, but when added together, and with the earnings as the same numerator
as before, their holding will entitle them to the same share of the company’s earning before the split.
If an investor has fewer shares, as in the case of a reverse split, the individual shares held will now have
a higher EPS, but the investor’s new holding, given that total earnings have remained the same, means
that their entitlement will still be to the same share or portion of the company’s earnings as before.

The reasons for undertaking a reverse split are usually the converse of those for a split. The company may
consider that the price of its shares is too low and, therefore, wants to boost the price by withdrawing a
large number of outstanding shares.

This can also be undertaken for listing purposes where, for example, the NYSE does not allow stocks
below a trading price of one dollar to be listed. Also, for institutional investors many are not allowed
to purchase stocks that are priced below a minimum amount. This is more typically the case in the
US, where share prices tend to have higher nominal amounts. The typical price for a US share is
approximately $40 and it is not permitted for many investment managers to buy shares that are priced
below $5, or sometimes even higher thresholds.

194
 Equities

Example
In the aftermath of the collapse of Lehman Brothers and the CDO market in 2008, AIG’s board of directors
decided that the company should undertake a reverse split in July 2009. The split was a 1:20 split which
meant that each shareholder exchanged 20 of the old shares for one new share.

Before the split, the shares had traded below $2 for much of the year, weighed down by the company’s
nearly $100 billion in losses in the previous year and a taxpayer bailout that left the US government

3
owning almost an 80% stake in the company. In August 2012, the shares of AIG were trading at
approximately $34.

5.4 Share Buybacks

A share repurchase, or share buyback, is usually a positive event for shareholders. It usually involves
a company buying back its own shares through the stock market or by way of a tender offer to
shareholders. The repurchased shares are often absorbed into the company which has the effect of
reducing the number of outstanding shares or market capitalisation. As this happens, shareholders have
a relatively larger stake in the company as there are fewer shares in issue on which the company returns
profits in the form of dividends.

From the issuer’s perspective, a buyback is often regarded as a good use of its capital and, indeed, can
create a positive opinion of the company by the markets as it is seen to be heavily investing in itself.

Buybacks have the effect of reducing the size of the assets on the statement of financial position so,
naturally, return on assets increases because the return is compared to a lower capital base. Another
effect is that return on equity increases for a similar reason – because there is less equity outstanding.
This also means that the price/earnings ratio will increase – there are fewer shares in issue with the same
earnings.

Issuers who operate employee share schemes can use buybacks to reduce or eliminate the diluting
effect that these options have over time. Employee share schemes increase the amount of shares in
issue and would have the opposite effect on key metrics as a buyback. Therefore, buybacks can negate
the effect of the employee share scheme and retain equilibrium.

5.5 Post-Statement of Financial Position Events

The basic EPS is required to be altered to incorporate the effect of certain share issues on the number of
ordinary shares when the issue occurs between the statement of financial position date and the date on
which the accounts are approved.

When the company undertakes a bonus issue, share split or consolidation, or when there is a bonus
element to another issue (eg, rights issue), the number of shares must include the extra shares now in
issue after the event.

In the case of an issue that impacts on earnings, such as a rights issue, only those shares that have no
earnings impact should be included in the EPS calculation. For a rights issue, this would be just the
bonus element.

195
5.6 Diluted Earnings Per Share (EPS)
The purpose of publishing a diluted EPS figure is to warn shareholders of potential future changes in
the EPS figure as a result of events that hypothetically may have taken place. The reason why the term
‘hypothetically’ is used in this context is because there is only a possibility – legally certain rights have
been granted which could be exercised and require further issues of shares – and the prudent method
of accounting is to assume, from the point of view of share dilution, the worst-case scenario.

There are two possible factors that could cause share dilution and which need to be covered in the
method of conservatively calculating a true and accurate picture of the EPS. A company may have either
or both of the following kinds of securities outstanding:

• convertible loan stock or convertible preference shares

• options or warrants.

Each of these circumstances may potentially result in more shares being issued and thereby qualifying
for a dividend in future years, which will have the material effect of diluting the current EPS. The diluted
EPS figure is a theoretical calculation based on assumptions about the future (which may or may not
actually take place) and it is considered of such importance to the reader of the accounts and a potential
investor that its calculation and disclosure is required by IAS 33 – earnings per share (FRS 22 in the UK).
IAS 33 requires the disclosure of basic and diluted EPS on the face of the statement of profit and loss,
both for net profit or loss for the period and profit or loss for continuing operations. Any additional
information, such as alternative methods of calculating the EPS, can only be disclosed by way of a
note to the accounts. A note needs to be included in the accounts detailing the basis upon which the
calculations are done, specifically the earnings figure used and the number of shares figure used within
the calculation, both for the year in question and the comparative year.

6. Warrants and Contracts for Difference (CFDs)

6.1 Warrants

Learning Objective
3.5.1 Be able to analyse the main purposes, characteristics, behaviours and relative risk and return of
warrants and covered warrants: benefit to the issuing company; right to subscribe for capital;
effect on price of maturity and the underlying security; exercise and expiry; calculation of the
conversion premium on a warrant

A warrant gives the right to the holder to buy shares from the company that issued the warrant at a
specified price on or before a specified date. Essentially, a warrant is very similar to a call option, which
gives the right to buy a share. Warrants have all the characteristics of call options, such as volatility,
risk and valuation factors. The major difference is that warrants are issued by and exercisable on the
company, which will issue new shares on exercise. Traded and traditional options are issued by investors
and relate to shares already in issue; their exercise does not result in new shares being issued.

196
 Equities

6.1.1 Company
Advantages to a Company of Issuing Warrants
• Raising immediate cash without the need to finance dividend payments to new shares.
• Increasing the attraction of a debt issue. Many warrants are attached to a debt issue, giving debt
investors the added attraction of an equity kicker. This will translate into lower required yields on the
debt, meaning that the initial financial burden on the company is lower.

3
• After the debt is issued, the warrants are usually detached from the debt and traded separately in the
marketplace. There is a secondary market for some of the more attractive and liquid warrants.
• If the company believes that its own share price will fall, then any warrants issued are unlikely to
be exercised. This means that the company will receive the money on issue of the warrants, but
anticipates that it will not have to issue any new shares.

Disadvantages to the Company of Issuing Warrants

If and when the warrant is exercised:

• New shares must be issued by the company, potentially at a significant discount to the then share
price.
• The required dividend payments in total may increase dramatically if the share price is not to be
adversely affected.

6.1.2 Investors
Advantages to Investors
• A geared investment in a company’s shares, being a cheaper alternative to buying the share itself,
much in the same way as for a call option.
• The buyer of a warrant does not suffer from the decay of time premium in the same manner as the
buyer of a call option.
• A way of securing an income yield while keeping open the possibility of high equity performance,
through buying debt plus warrants from the company. This is similar to the principle of buying a
convertible debt issue.

Disadvantages to Investors
• As a geared investment, percentage losses can be extreme if the share underperforms.
• The risk of a takeover. If a company is taken over, it is often the case that the exercise date of the
warrants will be accelerated to the takeover date. This will destroy any time value in the warrant,
meaning that an investor could suffer a serious loss. If the warrant is out-of-the-money, having just
been issued for example, then it may become worthless.

6.1.3 Additional Factors when Considering an Investment in Warrants

Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to
pay lower interest rates or dividends. They can be used to enhance the yield of the bond, and make it
more attractive to potential buyers. Warrants can also be used in private equity deals. Frequently these
warrants are detachable, and can be sold independently of the bond or stock.

197
Note that a warrant-holder will not be affected by bonus issues or rights issues because the terms of the
warrant will adjust in the same way as the terms of options contracts.

Warrants have similar characteristics to those of other equity derivatives, such as options – for instance:

• Exercising – a warrant is exercised when the holder informs the issuer of their intention to purchase
the shares underlying the warrant.
• Premium – a warrant’s premium represents how much extra has to be paid for shares when buying
them through the warrant as compared to buying them in the regular way.
• Gearing (leverage) – a warrant’s gearing is the way to ascertain how much more exposure the
investor has to the underlying shares using the warrant as compared to the exposure if they were
buying shares through the market.
• Expiration date – this is the date the warrant expires. If the investor plans on exercising the warrant,
they must do so before the expiration date. The more time remaining until expiry, the more time
for the underlying security to appreciate, which in turn will increase the price of the warrant (unless
it depreciates). Therefore, the expiration date is the date on which the right to exercise no longer
exists.

6.1.4 Secondary Market

Sometimes, the issuer will try to establish a market for the warrant and register it with a listed
exchange. In this case, the price can be obtained from a broker. But often, warrants are privately held
or not registered, which makes their prices less obvious. Unregistered warrant transactions can still
be facilitated between accredited parties, and in fact several secondary markets have been formed to
provide liquidity for these investments.

6.1.5 Comparison with Call Options

Warrants are much like call options, will often confer the same rights as an equity option, and can even
be traded in secondary markets. However, warrants have several key differences:

• Warrants are issued by private parties, typically the corporation on which a warrant is based, rather
than a public options exchange.
• Warrants issued by the company itself are dilutive. When the warrant issued by the company is
exercised, the company issues new shares of stock, so the number of outstanding shares increases.
When a call option is exercised, the owner of the call option receives an existing share from an
assigned call writer (except in the case of employee stock options, when new shares are created and
issued by the company upon exercise).
• Unlike common stock shares outstanding, warrants do not have voting rights.
• A warrant’s lifetime is measured in years (as long as 15 years), while options are typically measured in
months. Even long-term equity anticipation securities (LEAPS), the longest stock options available,
tend to expire in two or three years. Upon expiration, the warrants are worthless if not exercised,
unless the price of the common stock is greater than the exercised price.
• Warrants are not standardised like exchange-listed options. They are considered over-the-counter
instruments, and thus are usually only traded by financial institutions with the capacity to settle and
clear these types of transactions.

198
 Equities

Example
Warrants are available in a (fictional) investment company, Carmerside Investment Trust. Carmerside
Investment Trust shares are currently trading at 77p each, and warrants are available giving the investor
the right to buy shares at £1 each, up until 2028. The warrants are trading at 4p each.

In the above example, the warrant’s expiry date is in 2028 and its exercise price is 100p.

3
What are the advantages to Carmerside Investment Trust that persuade it to issue warrants? Clearly, the
sale of warrants for cash will raise money for the company, and if the warrants are exercised then further
capital will be raised by the company. Similarly to call options, holding the warrant does not entitle the
investor to receive dividends or to vote at company meetings, so the capital raised until the warrant is
exercised could be considered as free. Obviously warrants offer a highly geared investment opportunity
for the investor, and warrants are often issued alongside other investments, rather than sold in their own
right.

Example
ABC plc is attempting to raise finance by issuing bonds. Its advisers inform the company that it could
issue bonds paying a coupon of 6% pa, or lower this to 5% pa if it were to give away a single warrant
with each £100 nominal of the bonds. The warrants are detachable from the bonds. In other words, the
investors could decide to sell their warrants or keep them, regardless of whether they retain the bonds.

Traditional warrants are issued in conjunction with a bond (known as a warrant-linked bond), and
represent the right to acquire shares in the entity issuing the bond. In other words, the writer of a
traditional warrant is also the issuer of the underlying instrument. Warrants issued in this way make the
bond issue more attractive and can reduce the interest rate that must be offered in order to sell the bond
issue.

6.1.6 Warrant Price Behaviour

Warrants (including covered warrants, see section 6.1.8) are highly-geared investments. A modest outlay
can result in a large gain, but the investor can lose everything. Their value is driven by the length of time
for which they are valid (their maturity or period until expiry) and the value of the underlying security.

Comparison of Warrants
There is a relatively simple method of looking at the price of one warrant relative to other warrants
– using a conversion premium. The conversion premium is the price of the warrant plus the exercise
price required to buy the underlying share, less the prevailing share price. For example, calculating the
conversion premium for the Carmerside Investment Trust encountered above:

Warrant price = 4p
Plus exercise price = 100p
Less share price = 77p
Conversion premium = 27p

Note that if the resulting figure were a negative, the warrant would be trading at a conversion discount.

199
Valuation of Warrants
Since a warrant has the same commercial effect for the investor as an option, its valuation can be
achieved in the same way, eg, through use of the binomial model or the Black-Scholes model.

In undertaking this, however, we need to consider the differences between an option and a warrant:
specifically that, when a warrant is exercised, new shares are issued by the company, diluting the value
of the shares in existence.

The value of a warrant can therefore be established as follows:

A
Warrant value = x Number of shares
1+q

where:

A = value of an equivalent option derived from a suitable option pricing model

q = percentage increase in the number of shares in issue once the warrant is exercised (expressed as
a decimal)

6.1.7 Warrant Premium and Gearing

The warrant premium is the amount by which the warrant price plus the exercise price exceeds the share
price. This is also the time value of the warrant expressed as a percentage of the share price.

Warrant Premium =
[(Warrant Price + Exercise Price – Current Share Price)/Current Share Price] x 100

Options are highly geared investments. The same is true for warrants. The warrant gearing ratio indicates
how highly geared the warrant is, and it is calculated as follows:

Share Price
Gearing Ratio = x 100%
Warrant Price

Warrant A Warrant B

Issuer XYZ plc XYZ plc

Share Price 180 180

Exercise Price 100 300

Expiry Date 2029 2029

Price of Warrant 160 30

Gearing Ratio 112.50% 600.00%

200
 Equities

Warrant A is considered to be deeply in-the-money (ie, the exercise price is lower than the share price),
and Warrant B is deeply out-of-the-money. The price of Warrant A is consequently much higher and will
almost certainly be exercised and has in effect become like a share. If the share price moves to 181p, then
the warrant price will probably move to 161p. It is not a highly geared investment, and investing in the
warrant will give around the same percentage returns as investing in the share itself.

The situation with Warrant B is very different. A change in the share price from 180p to 181p is unlikely to

3
affect the value of the warrant significantly. If the share price rises significantly, however, then the price
of the warrant could also rise significantly, giving a very high percentage return on the initial investment.
Warrant B is much more highly geared than Warrant A.

6.1.8 Covered Warrants

Covered warrants are warrants based on an underlying share or index which are issued by a financial
institution, such as an investment bank, rather than by a corporate issuer. The warrant is called ‘covered’
because the issuing institution will hold the underlying asset, to cover its exposure. From an investor’s
perspective the purchase of covered warrants is a speculative and risky investment, although significant
profits can be earned due to the gearing or leverage effect of warrants.

Covered warrants are priced according to a calculation of their fair value rather than on the basis of supply
and demand. The cost of the warrants is called the premium (which represents the maximum potential
loss to the holder). They are exercised at the exercise price, and expire at the expiry or expiration date.

Call warrants give a right to buy at a specified price within a specified time period, while put warrants
give a right to sell at a specified price within a specified time period. A call warrant may be purchased as
a bet on the price of the underlying asset rising, while a put warrant may be bought as a bet on the price
falling. Covered warrants typically have a life of six to twelve months at issue, although this may be up to
five years.

Example
The ordinary shares of X plc trade at 120p currently (at 15 June). An investor who believes the price will
rise may be able to buy a call warrant to buy at 150p by, say, 30 September. This warrant might be priced
at, say, 5p for each share. If the X plc share price rises to 160p, the warrant can be excised for a profit since
160p–150p = 10p proceeds, compared with the cost of 5p. If the share price does not reach 150p by 30
September, the warrant will be worthless on expiry.

A put warrant to sell X plc at 100p by 30 September could be exercised if the share price of X plc falls
below 100p. The profit on exercise will depend on how far below 100p the price falls, less the initial
warrant cost.

Covered warrants can be sold on in the market before being exercised, in which case part of their value
will be the time value attributable to the hope that the warrant can eventually be exercised at a profit.
Covered warrants are available on the LSE, covering a range of blue chip and mid-cap shares and indices.
Covered warrants have also even been available for house price indices.

201
6.1.9 Warrant Pricing
A puzzle for investors might be how a warrant price is actually arrived at, because the forces of supply
and demand take a back seat. Ordinarily, for equities and for traditional listed warrants, the price is
purely a function of the demand from buyers and the supply from sellers.

For covered warrants, it is different. The issuer will usually be the sole market maker (or committed
principal), who is obliged to make a two-way price in the warrant throughout the trading day. And
supply and demand are, most of the time, only tangential factors in setting the price. Instead, computers
use algorithms to move the price automatically in relation to the changes in the underlying asset. There
are too many warrants to price manually, and because covered warrants are a synthetic creation there is
no need to balance supply and demand because the quantity in the market is more fluid.

Some potential issues relating to conflicts of interest can arise. What is to stop the issuer from fixing
the price to the detriment of investors? What is to stop the issuer from widening the dealing spread to
prevent sensible dealing during times of financial stress? And how are the prices really determined?

The single market-maker model, where only the issuer makes a price in its warrants, is a tried and tested
approach in overseas warrants markets, and it works well without abuse. Competition occurs across
warrants rather than within each individual security.

It is also reputational. On a popular security, warrants may be issued by several issuers, all competing for
business. If one has a price which is less favourable than the others, it will very quickly become apparent
in the market – good sources of electronic information make the process of comparison quick and
efficient – and that issuer will lose out on trade.

The twin forces of inter-warrant competition and reputation work to ensure an orderly and fairly priced
market for investors.

6.2 Contracts For Difference (CFDs)

Learning Objective
3.5.2 Be able to analyse the main characteristics of contracts for difference (CFDs); types and
availability of CFDs; CFD providers – market maker versus direct market access; margin; market,
liquidation and counterparty risks; size of CFD market and impact on total market activity;
differences in pricing, valuing and trading CFDs compared to direct investment; differences in
pricing, valuing and trading CFDs compared to spread bets

Contracts for difference (CFDs) were originally developed in the early 1990s in London and were based
on a similar structure to an equity swap. Essentially, a swap is a general term for a contractual asset when
payments on one or both sides to the agreement – called counterparties – are linked to the performance
of an underlying asset such as an equity index.

The motivation for developing equity swaps and, in turn, CFDs has been guided by several different
factors including the desire to avoid stamp duty and, in some instances, withholding taxes and also to
obtain leverage and enjoy the returns from ownership without actually owning equity.

202
 Equities

Equity swaps and customised CFDs are used by hedge funds and institutional investors to hedge their
exposure to equities in a cost-effective way. Along with futures and options, contracts for difference
come under the FCA’s definition of derivatives.

CFDs are different from traditional cash-traded instruments (such as equities, bonds, commodities and
currencies) in that they do not confer ownership of the underlying asset. Investors can take positions
on the price of a great number of different instruments. The price of the CFD tracks the price of the

3
underlying asset, and so the holder of a CFD benefits from, or loses because of, the price movement
in the stock, bond, currency, commodity or index. But the CFD holder does not take ownership of the
underlying asset.

CFDs are margin-traded, meaning that the investor does not have to deposit the full value of the
underlying asset with the CFD provider.

CFDs allow the investor to benefit from downward movements in a share or other price if they choose.
This has the effect of adopting a position of ‘short selling’ the stock. This flexibility, and the possibility of
margin trading, means that CFDs can be used either for hedging or speculation.

To understand how CFDs work, it is helpful to consider how the company offering the CFD is able to pay
an investor whose CFD has resulted in a price movement that is favourable for the investor. A broker
offering CFDs may seek to hedge its own liability to pay out for price movements in the stock concerned,
by buying a matching quantity of the stock in the market. The broker is likely to have customers
adopting long and short positions so these can be netted out, and the degree to which the company has
to hedge will be reduced.

The costs of CFDs comprise a cost built into the spread of the CFD price, together with a funding charge.
CFDs have the advantage that there is no stamp duty or stamp duty reserve tax (SDRT) to pay, although
the holder will be liable to capital gains tax (CGT).

CFD contracts are subject to a daily financing charge, usually applied at a previously agreed rate linked
to LIBOR. The parties to a CFD pay to finance long positions and may receive funding on short positions
in lieu of deferring sale proceeds. The contracts are settled for the cash differential between the price of
the opening and closing trades.

CFDs are subject to a commission charge on equities that is a percentage of the size of the position for
each trade. Alternatively, an investor can opt to trade with a market maker, forgoing commissions at the
expense of a larger bid/offer spread on the instrument.

Investors in CFDs are required to maintain a certain amount of margin as defined by the brokerage –
usually ranging from 1% to 30%. One advantage to investors of not having to put up as collateral the
full notional value of the CFD is that a given quantity of capital can control a larger position, amplifying
the potential for profit or loss, ie, the investment is geared. On the other hand, a leveraged position
in a volatile CFD can expose the buyer to a margin call in a downturn, which often leads to losing a
substantial part of the assets (or having the CFD position automatically closed out). As with many
leveraged products, maximum exposure is not limited to the initial investment, and it is possible to lose
more than one put in. These risks are typically mitigated through use of stop loss orders and other risk-
reduction strategies.

203
Example
Suppose you wish to buy 1,000 shares of XYZ at £12 each. In a normal non-margin broker account you
would need to have an initial cash deposit or balance of £12,000. Using CFDs, trading on a 5% margin,
you will only need an initial deposit of £600.

An example is the easiest way to show the use of leverage.

If you had £600 to invest, and wished to purchase XYZ shares at £12 and sell them at £13, a standard
trade would look as follows:

BUY: 50 x £12 = £600

SELL: 50 x £13 = £650

PROFIT = £50 or £50/£600 = 8.33%

Using leverage, the above transaction with CFDs is possible:

BUY: 1,000 x £12 = £600 (5% deposit) + £11,400 (95% borrowed funds)

SELL: 1,000 x £13 = £13,000

PROFIT = £1,000 or £1,000/600 = 167%

The profit received after using leverage was far greater – in fact, 20 times greater – than without using
leverage, ie, the borrowing of 95% of the contract amount. Clearly, though, the losses are also magnified
to the same extent when using leverage.

CFDs allow a trader to go short or long on any position using a margin. There are always two types of
margin with a CFD trade:

• Initial margin – the initial margin for shares of individual companies is normally between 5% and
30%. For exchange-traded funds, stock indices and foreign exchange, where relatively less risk of
volatility is perceived by CFD brokers, the initial margin can be as low as 1% and more typically at 5%.
In the case of the example above, we saw that this would be 5% of the contract price.
• Variable margin – the CFD will be marked-to-market at currently prevailing prices and if the position
has moved beyond the amount taken as initial margin – eg, the position has moved adversely – the
additional margin required to support the borrowing (in the example, at 95% for XYZ) will have to be
deposited or available in the current balance of the customer’s cash account.

Regulatory Restrictions
In 2019, following consultation feedback, the FCA confirmed new rules restricting the sale, marketing
and distribution of CFDs and CFD-like options to retail customers.

6.2.1 Market and Risk

The CFD market in the UK is operated by numerous large brokerages including such firms as IG Markets,
City Index and MF Global. As brokers, these are the companies which create and package the CFD
arrangements and which effectively become the counterparties to the trades with principal customers.

204
 Equities

It is incumbent on the broker offering the CFD to assure itself that the customer has sufficient collateral,
and is sufficiently aware of the risks of trading CFDs that offer a high degree of leverage. Risk warnings
are prominently displayed on all advertising and web pages. The FCA stipulates that CFD providers must
assess the suitability and appropriateness of CFDs for each new client, based on their experience; CFD
providers must also provide a risk warning document to all new CFD clients.

There have been some publicised cases in which a CFD customer has been unable to meet a margin

3
call for substantial losses resulting from a trade which turned out to be ill-conceived, and this raises the
possibility that the CFD broker that took the other side of the trade could potentially have liquidity/
solvency problems. If a CFD broker suffers difficulties in honouring its contracts with customers it will
also suffer immediate reputational damage and, while the customers may have collateral at risk their
losses will be confined to the marginal sums involved in CFD trading rather than the nominal sums (ie,
the total size of the trade as opposed to the amount of margin required to control that position size).

6.2.2 The Size of the CFD Market

CFDs have proven to be a very successful innovation in financial markets and their development was
spearheaded in the UK. CFDs have become ubiquitous in most European markets. Surprisingly, even at
present, there is no comparable product sold domestically in the US, which has been attributed to a lack
of clarity as to which US regulatory agency should provide supervision for these instruments.

It has been estimated that CFD trading in the UK has accounted for approximately 50% of all London
equity trading. This percentage is, if anything, likely to increase, as both professional and retail investors
have demonstrated a strong interest in the features of the products which have been described above.

6.2.3 CFDs and Spread Bets

CFDs and spread bets allow investors to do similar things; however, CFDs differ from spread bets in one
crucial respect – tax. While a spread bet offers tax-free gains, a CFD does not. CGT applies to profits on
CFDs – and investors can use capital losses on CFDs to reduce future CGT bills.

Furthermore, spread bets are essentially bets made with a bookmaker such as IG Index, and the
bookmaker will try to make its money on the spread between bid and offer prices, just like a market
maker in the equity markets. In contrast, CFDs can be matching trades on what is essentially an order-
driven system that may make them more cost-effective.

CFDs may also attract a financing charge if they are held over time, which does not apply to spread bets.

As a general rule, CFDs are more appropriate for more experienced participants taking larger positions,
such as day traders and institutions like hedge funds, while spread bets tend to be more appropriate for
trades undertaken by less sophisticated individuals.

205
 End of Chapter Questions

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

1. What does the term 'cumulative' entail when applied to the preference shares of a company?
Answer reference: Section 1.1.3

2. If shares issued as part of a public offering include a certain block of shares from company directors
or venture capitalists, are those shares dilutive or non-dilutive?
Answer reference: Section 2.1.2

3. What is the minimum market capitalisation requirement (ie, shares held by the public) for a
company to be admitted for a listing on the London Stock Exchange's high-growth segment?
Answer reference: Section 2.3.4

4. With respect to a London Stock Exchange-listed company, what is a notifiable interest?

Answer reference: Section 2.3.6

5. Which provision of MiFID enables the issuance of securities to qualified investors without
the rigorous disclosure requirements of a full-blown public offering?
Answer reference: Section 2.4.1

6. What is meant by the term 'greenshoe option' in regard to a public offering of securities?
Answer reference: Section 2.5.2

7. What does the term 'front running' mean in regard to the activities of brokers and other financial
intermediaries?
Answer reference: Section 3.1.3

8. What is an iceberg order?

Answer reference: Section 3.2.6

9. What strategies do high-frequency traders use to generate profits?

Answer reference: Section 3.4.1

10. Which organisation in the UK makes decisions as to which companies’ shares and bonds (including
gilts) can be admitted to be traded on the London Stock Exchange?
Answer reference: Section 3.6.2

206
Chapter Four

Collective Investments
1. Collective Investment Funds and Companies 209

4
2. Retail-Structured Products 228

3. Analysis of Collective Investments 233

This syllabus area will provide approximately 8 of the 80 examination questions

208
 Collective Investments

1. Collective Investment Funds and Companies

1.1 Unit Trusts

Learning Objective
4.1.2 Be able to analyse the key features, accessibility, risks, charges, valuation and yield
characteristics of unit trusts

4
A unit trust is a professionally managed collective investment fund. Unit trusts have been available in the
UK since the 1930s.

• Investors can buy units, each of which represents a specified fraction of the trust.
• The trust holds a portfolio of securities.
• The assets of the trust are held by trustees and are invested by managers.
• The investor incurs annual management charges and possibly also an initial charge.

An authorised unit trust (AUT) must be constituted by a trust deed made between the manager and the
trustee.

The basic principle with AUTs is that there is a single type of undivided unit. This is modified where
there are both income units (paying a distribution to unitholders) and accumulation units (rolling up
income into the capital value of the units). As with an open-ended investment company (OEIC), if the
fund manager wishes to market the unit trust in other member states of the EU, the manager may apply
for certification under the Undertakings for Collective Investment in Transferable Securities (UCITS)
Directive.

1.1.1 Trustees and Trust Deed

1. Trustees of a unit trust must be authorised by the FCA and fully independent of the trust manager.
2. The primary duty of the trustees is to protect the interests of the unitholders.
3. The investor in a unit trust owns the underlying value of shares based on the proportion of the units
held. They are effectively the beneficiary of the trust.
4. The trust deed of each unit trust must clearly state its investment strategy and objectives, so that
investors can determine the suitability of each trust.
5. The limits and allowable investment areas for a unit trust fund are also laid out in the trust deed
together with the investment objectives.

1.1.2 The Role of the Manager

The manager must also be authorised by the FCA and the role covers:

• marketing the unit trust

• managing the assets in accordance with the trust deed
• maintaining a record of units for inspection by the trustees
• supplying other information relating to the investments under the unit trust as requested
• informing the FCA of any breaches of regulations.

209
1.1.3 Buying and Selling Units
Units in unit trusts can be purchased in a number of ways: for example, via a newspaper advertisement,
over the phone or over the internet. These methods will generally require payment with the order,
or some form of guarantee of payment. A contract note will be produced and sent to the investor as
evidence of the purchase.

Investors can sell their units through the same source that they purchased them, or can contact the fund
managers directly, for example by telephone.

Liquidity Risk
Liquidity risk is a financial risk concerning how easily a security or financial asset (including investment
funds) can be traded quickly, especially when selling an asset to realise cash. It also refers to the ability
to sell an asset without impacting the market price.

For investment funds, liquidity is generally seen as the ability for the fund to fulfil redemption orders as
requested. Authorised funds and those that are less complex would generally carry less liquidity risk – ie,
if an asset has a lack of liquidity depth, there is a risk that the price will move significantly, eg, a sale is
attempted.

1.1.4 Unit Trust Pricing

The calculation of buying and selling prices take place at the valuation point, which is at a particular
time each day. The fund is valued on the basis of the net value of the constituent assets. Most unit trusts
use dual pricing, and a typical spread between buying and selling prices in the market will be in the
range of 5–7%. Some fund managers, however, use single pricing, in which case there is the same price
quoted for buying and selling units, with any charges being separately disclosed.

Offer Basis and Bid Basis

If the market is moving upwards, it is likely that investors will be buying. In these circumstances,
managers can move the spread to the top of the range. This effectively means that the offer price being
paid by investors will be at the highest level allowed by the FCA’s rules and increases the price for
buyers. However, it also increases the price for sellers of units, who get a price of 5–7% below the offer
price. When this happens, prices are said to be on an offer basis.

If the market is moving downwards, it is likely that investors will be selling. In these circumstances,
managers can move the spread to the bottom of the range. This effectively means that the buying price
being paid will be the lowest bid price allowed under the FCA’s rules (the cancellation price) and reduces
the price for sellers. However, it also reduces the price for buyers of units, who get a price of 5–7% above
the cancellation price. When this happens, prices are said to be on a bid basis.

Historic Pricing and Forward Pricing

Prices can be set on a historic or forward pricing basis. If the price the investor pays is based on the
previous valuation point, the pricing is described as historic. All units purchased up to the valuation
point on the following day will be at the same, previous price. If the investor pays a price based on the
next valuation point, it is called forward pricing. All units purchased up to the next valuation point will
be at that price.

210
 Collective Investments

Each system has merits. With historic pricing the investor knows the price they will pay for units, but
the value of the underlying securities may not be reflected in the price paid. This is good if prices have
moved up, but bad if they have moved down. Investors find future pricing confusing, as it is not possible
to determine in advance the price they will pay, but the price will be more reflective of the underlying
value of the securities.

On a historic pricing basis, the manager creates units at the valuation point, according to the amount of
sales expected up to the next valuation point. If sales exceed expected levels, the manager must either
move to forward pricing or risk loss of money for the fund, if there is an unfavourable price movement.

4
On a forward pricing basis, the manager must create units at the valuation point sufficient to cover
transactions since the last valuation point.

A manager using the historic pricing basis must move to a forward pricing basis if the value of the fund
is believed to have changed by 2% or more since the last valuation and if the investor requests forward
pricing.

1.1.5 Charges
Generally speaking, the charges on a unit trust can be taken in three ways: an initial charge which is made
up front, an annual management charge made periodically and an exit charge levied when the investor
sells. Whatever charges are made must be explicitly detailed in the trust deed and documentation. The
documents should provide details of both the current charges and the extent to which the manager can
change them.

The upfront initial charge is added to the buying price incurred by the investor. Initial charges tend to be
higher on actively managed funds, often in the range of 3.0% to 6.5%. Lower initial charges are typically
levied on index trackers. Some managers will discount their initial charges for direct sales including
those made over the internet. It is not unusual for those managers that charge low or zero initial
charges to make exit charges when the investor sells units. Over time, an increasing number of UK fund
managers are abolishing initial charges in their aim to become more cost competitive against tracker
funds and exchange-traded funds (ETFs).

If they apply, exit charges are generally only made when the investor sells within a set period of time,
such as the first three or five years. Furthermore, these exit charges tend to be made on a sliding scale
with a more substantial charge made for those exiting earlier than those exiting later. Both the set
period and the sliding scale reflect the fact that, if the investor holds the unit for longer, the manager
will benefit from the regular annual management charges that effectively reduces the need for the exit
charge.

The annual management charge is generally levied at a rate of 0.5–1.5% of the underlying fund. Like the
initial charge, the annual management charge will typically be lower for trusts that are cheaper to run,
such as index trackers, and higher for more labour-intensive actively-managed funds.

The FCA’s rules permit performance-related charges. These may be based on growth of the fund or
outperformance of the fund’s standard benchmark. The basis of the charges must be disclosed in the
fund prospectus and key features document.

211
On 31 December 2012, the Retail Distribution Review (RDR), which is designed to give consumers greater
confidence and trust in the retail financial services market, including greater transparency of fees and
commissions, came into force. Following this, the market has seen fee margins being compressed across
the industry with some fund managers innovating lower cost products.

1.1.6 Unauthorised Unit Trusts

In order to be marketed to the public, a unit trust must be authorised by the FCA. This has a direct
impact on the taxation of the fund, in that authorisation is a requirement for the trust to be treated as
exempt from CGT.

Unauthorised unit trusts are used for specific applications such as enterprise zone property holdings
(see section 1.4.3), where they are not marketed directly to the public, and these are subject to income
tax and CGT within the fund. Investors are liable to any additional income tax and CGT on disposal.

There is a further exempt type of unauthorised unit trust that may be used as investments for pensions
and registered charities. Exempt unit trusts are free of CGT on disposals within the fund and are subject
to income tax rather than corporation tax.

1.2 Investment Companies

Learning Objective
4.1.1 Be able to analyse the key features, accessibility, risks, charges, valuation and yield
characteristics of open-ended investment companies (OEICs)/investment companies with
variable capital (ICVCs)/SICAVS

1.2.1 Open-Ended Investment Companies (OEICs)

Open-ended investment companies (OEICs) are a type of open-ended collective investment formed as a
corporation under the Open-Ended Investment Companies Regulations of the UK. They are pronounced
‘oiks’ and are also known as investment companies with variable capital (ICVCs). The terms ICVC and
OEIC are used interchangeably, with different investment managers favouring one over the other. A
variant of the name is also SICAV, which is an acronym for société d’investissement à capital variable.
Translated to English, it becomes investment company with variable capital (ICVC).

An open-ended fund, such as an OEIC or unit trust, is one where the company or trust can create new
shares or units when new investors subscribe and can cancel shares or units when investors cash in their
holdings. In the case of a closed-ended fund, such as an investment trust, the number of shares in
issue is fixed and new investors buy shares from existing holders of the shares who wish to sell.

In 1997, new regulations provided for the incorporation in the UK of OEICs that fall within the scope of
the UCITS Directive. This means they can invest only in transferable securities (eg, listed securities, other
collective investment schemes, certificates of deposit). UCITS schemes must be open-ended. UCITS
certification allows the fund to be marketed throughout the European Economic Area (EEA).

212
 Collective Investments

With the implementation of FSMA 2000, the range of UK-authorised OEICs was extended to be similar to
that of unit trusts (see section 1.1), including money market funds and property funds.

Unit trusts and OEICs are authorised investment funds (AIFs) – often collectively referred to simply as
funds. The FCA’s Collective Investment Schemes Sourcebook (COLL) rules apply to OEICs as well as unit
trusts. OEICs can be set up as UCITS retail schemes or non-UCITS retail schemes, or set up for qualified
investors (QIs).

As stated above, OEICs and unit trusts are similar in that they are both types of open-ended collective
investments. However, with a unit trust, the units held provide beneficial ownership of the underlying

4
trust assets, whereas a share in an OEIC entitles the holder to a share in the profits of the OEIC. The value
of the share will be determined by the net asset value (NAV) of the underlying investments. For example,
if the underlying investments are valued at £125,000,000 and there are 100,000,000 shares in issue, the
NAV of each share is £1.25. The open-ended nature of an OEIC means that it cannot trade at a discount
to NAV, as an investment trust can (see section 1.3) .

The holder of a share in an OEIC can sell back the share to the company in any period specified in the
prospectus.

An OEIC may take the form of an umbrella fund, with a number of separately priced sub-funds adopting
different investment strategies or denominated in different currencies. Each sub-fund will have a
separate client register and asset pool.

Classes of shares within an OEIC may include income shares, which pay a dividend, and accumulation
shares, in which income is not paid out and all income received is instead added to net assets.

The Structure of OEICs

OEICs are similar to investment trusts (see section 1.3) and different from unit trusts in that both have
corporate structures. The objective of the company in each case is to make a profit for shareholders by
investing in the shares of other companies. They differ in that an investment trust is a closed-ended
investment and an OEIC is open-ended.

An OEIC has an authorised corporate director (ACD), who may be the only director. The responsibilities
of the ACD include the day-to-day management of the fund. It must also have a depository. This a
firm (usually a bank) authorised by the FCA, independent of the OEIC or ICVC and of its directors. The
depository has legal title to the OEIC investments and is responsible for their safe custody.

The depository can appoint sub-custodians to take custody of the assets but will remain ultimately
responsible. The depository also has responsibility for ensuring compliance with the key regulatory
requirements.

The ACD and the depository must be regulated by the FCA, and approved as authorised persons. FCA
rules cover the sales and marketing of OEICs and there are cancellation rules.

213
Pricing, Buying and Selling
The shares in the OEIC express the entitlement of the shareholders to a share in the profits of the
underlying fund which, like a unit trust, is valued on a net asset value basis. Unlike most companies,
where there are a limited number of shares available in each company and a shareholder must sell their
share before another can buy, an OEIC is open-ended, so the number of shares in issue can be increased
or reduced to satisfy the demands of the investors.

OEICs are single-priced instruments, which means that there is no bid/offer spread. The buying
price reflects the value of the underlying shares, with any initial charge reflecting dealing costs and
management expenses being disclosed separately. Costs of creation of the fund may be met by the
fund.

When the investor wishes to sell OEIC shares, the ACD will buy them. The money value on sale will be
based on the single price less a deduction for the dealing charges. The ACD may choose to run a box.
Shares sold back to the ACD will be kept and reissued to investors, reducing the need for creation and
cancellation of shares.

Advantages of OEICs for the Investor

• As for unit trusts, the general advantages of collective investment vehicles apply to OEICs.
• Like unit trusts, there is a wide range of types of fund available.
• The introduction of OEICs was expected to lead to a reduction in costs for the investor and
transparency of charges. At the same time, there is no dilution in investor protection.
• The charges with OEICs may be lower than for unit trusts, particularly in respect of cost of entry
(setting up) and exit (encashing the investment) due to single pricing.
• Annual management costs are not set out as a separate charge as with unit trusts.

1.3 Investment Trusts

Learning Objective
4.1.3 Be able to analyse the key features, accessibility, risks, tax treatment, charges, valuation and
yield characteristics of investment trusts

Investment trusts have a long history in the UK. The F&C Investment Trust (formerly The Foreign and
Colonial Investment Trust) was the first to be founded in 1868 with the aim of ‘giving the investor of
moderate means the same advantage as the large capitalist’. Today it invests in more than 450 different
companies in several different countries.

The company’s stated aim is as follows:

‘The objective of the trust is to secure long-term growth in capital and income through a policy of
investing primarily in an internationally diversified portfolio of publicly listed equities, as well as
unlisted securities and private equity, with the use of gearing’.

214
 Collective Investments

The trust is benchmarked against a composite index of 40% FTSE All-Share Index/60% FTSE All World
ex-UK. In general, investment trusts provide a way for the small investor to have some exposure to
investments in overseas stocks that it would be impractical for the investor to buy individually.

1.3.1 What is an Investment Trust?

An investment trust is a form of collective investment, pooling the funds of many investors and
spreading their investments across a diversified range of securities. Despite its name, it is a company,
not a trust in the legal sense of the term. Investment trusts are plcs listed on the LSE. Whereas other
companies may make their profit from providing goods and services, an investment trust makes its

4
profit solely from investments. The investor who buys shares in the investment trust hopes for dividends
and capital growth in the value of the shares.

Investment trusts are managed by professional fund managers who select and manage the stocks in the
trust’s portfolio. Investment trusts are generally accessible to the individual investor, although shares in
investment trusts are also widely held by institutional investors such as pension funds.

1.3.2 Comparison with Unit Trusts and OEICs

Investment trusts have wider investment freedom than unit trusts and OEICs/ICVCs. They can:

• invest in unquoted private companies as well as quoted companies, and

• provide venture capital to new companies or companies requiring new funds for expansion.

The corporate structure of an investment trust gives it a further advantage over unit trusts and OEICs,
because it can raise money more freely to help it to achieve its objectives. Unit trusts’ and OEICs’ powers
to borrow are more limited. The ability to borrow allows an investment trust to leverage returns for the
investor. Such gearing will also increase the volatility of returns.

Unlike unit trusts and OEICs, investment trusts are closed-ended investments. This means that the
number of shares in issue is not affected by the day-to-day purchases and sales by investors, which
allows the managers to take a long-term view of the investments of the trust. With an open-ended
scheme such as a unit trust or an OEIC, if there are more sales of units or shares by investors than
purchases, the number of units reduces and the fund must pay out cash. As a result, the managers may
need to sell investments even though it may not be the best time to do so from a strategic and long-
term viewpoint.

The price of shares of the investment trust rises and falls according to demand and supply, and not
directly in line with the values of the underlying investments. In this way, investment trust prices can
have greater volatility than unit trusts and OEICs, whose unit prices are directly related to the market
values of the underlying investments.

Because prices are dependent on supply and demand, the price of the shares can be lower than the
net asset value (NAV) of the share. When the prices of the trust’s share are below the NAV, investors can
buy investment trusts at a discount, while the income produced by the portfolio is based on the market
value of the underlying investments. The income yield is, therefore, enhanced.

215
Charges incurred on investment trust holdings can be compared with the alternatives. Some unit trusts
and OEICs have initial charges of around 5%. Initial charges may be much lower than this (at around
0.25%) for some investment trust savings schemes. However, there may be charges imposed when
selling investment trust holdings.

1.3.3 Management
As a company, an investment trust has a board of directors. The objective of a company is to invest
the money of the shareholders according to an investment strategy. Such a strategy and the decision
making which flows from it may be formulated by the directors (in a self-managed trust), or it may be
delegated to an external fund management company.

1.3.4 Regulatory Aspects

An investment trust is a listed company, governed by the Companies Act and Stock Exchange
regulations. As with other companies, it is bound by the rules set out in its Memorandum and Articles of
Association, which are set up when the company is formed.

An investment trust is also subject to the rules of the FCA, the overall regulator of the financial services
sector in the UK.

The following principles set down by the FCA apply to a company that seeks to apply for a listing as an
investment trust:

• The investment managers must have adequate experience.

• An adequate spread of investment risk must be maintained.
• The investment trust must not control, seek to control or actively manage companies in which it
invests.
• The board of the investment trust must be free to act independently of its management.
• The investment trust must seek approval by HMRC (under s.842, Income and Corporation Taxes Act
1988 (ICTA 1988)).
• The trust itself does not have direct dealings with the public. If the management company offers
the shares of the trust for sale to the public through a savings scheme, then the company must be
authorised by the FCA to carry on investment business under the Financial Services and Markets Act
2000.

1.3.5 Buying and Selling Shares in Investment Trusts

Shares in investment trusts can be bought through a stockbroker, who is likely to charge the same
level of commission as for other equities. When a broker is not providing any advice and is providing an
execution-only service, then commission may be as low as 0.5%, or £10 per deal. Stamp duty is payable
at 0.5% of the purchase consideration.

If the broker is providing an advisory service, then commission will be higher, eg, 1.5% or 2% of the
purchase consideration. Some brokers provide discretionary investment trust management services for
individuals with larger sums to invest. The broker will select trusts that meet the investor’s investment
objectives and will charge an annual management fee in addition to dealing charges.

216
 Collective Investments

An investor can usually deal through the investment trust managers instead of through a broker, and
may incur lower charges by doing so.

Small investors who do not have an account with a broker may prefer to deal through the managers.
However, the managers may only deal on a daily basis, while a broker will be able to quote an up-to-the-
minute price and a deal can be made instantly by telephone.

1.3.6 Investment Trust Share Pricing

The quotation of the price of investment trust shares is similar to that for equities generally, and a dealer

4
will give two prices:

• The higher price is the offer price, at which an investor can buy the shares.
• The lower price is the bid price, at which a holder of the shares can sell.

In a price quote in the financial media a single price may be given: this will typically be the mid-market
price, between the offer and bid prices. The difference between the offer price and the bid price is the
spread.

1.3.7 Savings and Investment Schemes

The major trust management groups also operate regular savings schemes, through which an investor
can make monthly investments.

• Drip-feeding an investment through such a scheme takes advantage of pound cost averaging with
regular fixed investments. Fewer units are bought when the units are relatively expensive. More
units are bought when unit prices are lower.
• Typically, such schemes will have a minimum investment of £25 or £50 per month.
• Charges are typically in the range of 0.25% to 1% of the initial investment. Dealing may be at no
extra charge.
• Dividend reinvestment may be available as an option for investors who do not require income, in
which case their dividends are converted into new shares.
• A low-cost share exchange service is offered by some investment trust groups, enabling investors to
realise their existing equity investments and to be given investment trust shares in return.

217
1.4 Real Estate Investment Trusts (REITs)

Learning Objective
4.1.4 Be able to compare and contrast the key features, accessibility, risks, tax treatment, charges,
valuation and yield characteristics of real estate investment trusts (REITs) with property
authorised investment funds (PAIFs)

1.4.1 Key Features of REITs

Real estate investment trusts (REITs) were first formed in the US, where the name originated. Other
countries, including Japan, the Netherlands and France, now have their own versions of REITs. The UK
introduced its version in January 2007.

Tax-transparent property investment vehicles, such as REITs, distribute nearly all of their taxable income
to investors. Provided they do this, the vehicles are granted exemption from capital gains tax and from
corporate taxes. Investors pay tax on the dividends and capital growth at their own marginal tax rates,
thus avoiding the double taxation that would otherwise affect investors in UK property companies.

In order to qualify as a REIT, a company must meet certain conditions:

• The company must be a UK-resident, closed-ended company and have its shares listed or admitted
to trading on a qualifying stock exchange (which includes the London Stock Exchange (LSE), Tokyo
Stock Exchange (TSE) and the AIM).The shares in the company must not be ‘closely held’, which
means that no one person (individual or corporate) should hold more than 10% of the shares.
• The property-letting business, which will be tax-exempt, must be effectively ring-fenced from any
other activities and should comprise at least 75% of the overall company, with regard to both its
assets and its total income.
• A minimum of 90% of the REIT’s profits from the ring-fenced letting business must be distributed to
investors.
• The REIT is required to withhold basic rate tax on the distribution of profits paid to investors.
• The distributions are taxed as property income at the holder’s marginal rate.
• The company will be subject to an interest-cover test on the ring-fenced part of its business, a
measure of the affordability of any loans.
• Other distributions will be taxed in the same way as normal dividends.
• The ratio of interest on loans to fund the tax-exempt property business to rental income must be
less than 1.25:1.

It is possible to hold REITs within ISAs, child trust funds (CTFs) and Junior ISAs (JISAs). UK property
companies are able to choose to convert to become REITs. The conversion charge for companies wishing
to become REITs in the UK is 2% of the market value of the properties concerned. The charge can be
spread on a graduating basis over four years.

A property company converting to REIT status will benefit from the tax exemption and should be better
able to raise funds through the stock market. This is because many property companies currently trade
at discount to net asset value, partly as a result of double taxation suppressing the value of the shares. A
more tax-efficient vehicle should help to correct this anomaly.

218
 Collective Investments

1.4.2 Property Authorised Investment Funds (PAIFs)

A property authorised investment fund (PAIF) is a tax-efficient investment vehicle. The funds are able to
pay dividends free of income and corporation tax if the monies derive from rental income. PAIFs were
introduced by HMRC in 2008 and have been relatively slow to become a popular alternative to existing
differing fund structures but offer a means of accessing returns from real estate portfolios that are
professionally managed.

PAIFs invest in property directly or by buying shareholdings in property companies.

4
Before PAIFs were introduced, property funds were established as unit trusts, whereby 20% of income
from rental payments had to be withheld. PAIFs taxation is more akin to how an individual would be
taxed as a holder of an underlying asset. Some of the benefactors of this new taxation regime include
tax-exempt UK investors, charities and pension schemes.

The key features of a PAIF are:

• The taxation obligation is of the investor rather than the fund itself.
• Distribution income is classed as either income from property, interest from cash or dividend income
and are applied according to the type of distribution.
• Property income and capital gains (within the fund) are corporation tax exempt.
• Individuals who do not invest through an ISA or SIPP will receive all distributions free of income tax.
• Effectively, investors have the same tax treatment with PAIFs as they have with an ordinary dividend.
• PAIFs must be established as an OEIC as well as being authorised by the FCA.

There are also HMRC rules regarding the diversity of ownership and also some corporate ownership
restrictions. At least 60% annual fund profits and at least 60% total fund asset value must relate to direct
property investments or shares in REITs.

1.4.3 Enterprise Zone Property

In the UK, enterprise zones were introduced by the Thatcher government in 1979. They were urban
areas, usually suffering from widespread job losses and capital flight, which were granted freedom from
normal planning controls with a ten-year relief from local rates. 11 enterprise zones were established in
1980 and a further 13 in 1982. They varied from inner cities to areas of post-industrial dereliction.

Expenditure on industrial and commercial buildings in an enterprise zone qualifies as a 100% deduction
against the investor’s income. The investor can make a direct investment or via a unit trust. The
advantage of the unit trust is a lower initial investment and a spread of properties. Nevertheless, there is
typically a high risk within the fund.

An individual who invests in such a unit trust is treated as if they have incurred a proportion of the trust’s
expenditure on enterprise zone property and they will qualify for industrial buildings allowances. These
allowances can be set against other income for tax purposes.

219
1.5 Exchange-Traded Products (ETPs)

Learning Objective
4.1.5 Be able to analyse the key features, accessibility, risks, charges, valuation and yield
characteristics of the main types of exchange-traded products (ETPs)

An exchange-traded product (ETP) is an investment fund with specified objectives which is traded on
many global stock exchanges in the same manner as a typical stock for a corporation. An ETP holds
assets such as stocks or bonds and trades at approximately the same price as the net asset value (NAV)
of its underlying assets over the course of the trading day.

Among the different kinds of ETP, the best known are ETFs, which will often track an index, such as the
S&P 500 or the FTSE 100.

In general, ETPs can be attractive as investment vehicles because of their low costs, tax-efficiency, and
stock-like features.

1.5.1 Different Kinds of ETPs

Exchange-Traded Funds (ETFs)
Only authorised participants (typically, large institutional investors) actually buy or sell shares of an ETF
directly from/to the fund manager, and then only in creation units (large blocks of tens of thousands of
ETF shares), which are usually exchanged in-kind with baskets of the underlying securities. Authorised
participants may wish to invest in the ETF’s shares long term, but usually act as market makers on the
open market, using their ability to exchange creation units with their underlying securities to provide
liquidity of the ETF shares and help ensure that their intra-day market price approximates to the net
asset value of the underlying assets. Other investors, such as individuals using a retail broker, trade ETF
shares via a secondary market, such as the NYSE/Arca Exchange in the US.

Closed-ended funds are not usually considered to be ETFs, even though they are funds and are
traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs
traditionally have been index funds, but in 2008 the US Securities and Exchange Commission (SEC)
began to authorise the creation of actively managed ETFs.

A popular ETF innovation in recent years has been the leveraged ETF which makes use of derivatives to
further leverage the returns of a basket or index. Leveraged ETFs are available for most major indices and
aim to create two or four times the return of its underlying index. However, there is some controversy
surrounding the products as they carry higher risk, borrowing issues and often index tracking error.

Synthetic ETFs also come with considerable risk. They attempt to replicate the performance of key
indices by using derivatives to track the index rather than owning the component shares. They are also
known as swaps-based exchange-traded funds.

220
 Collective Investments

Exchange-Traded Notes (ETNs)

An exchange-traded note (ETN) is a senior, unsecured, unsubordinated debt security issued by an
underwriting bank. Similar to other debt securities, ETNs have a maturity date and are backed only
by the credit of the issuer. When an investor buys an ETN, the underwriting bank promises to pay the
amount reflected in the index, minus fees upon maturity. Thus, an ETN has an additional risk compared
to an ETF – upon any reduction of credit ratings or if the underwriting bank goes bankrupt, the value of
the ETN will be eroded.

Though linked to the performance of a market benchmark, ETNs are not equities or index funds, but

4
they do share several characteristics of the latter. Similar to equities, they are traded on an exchange and
can be shorted. Similar to index funds, they are linked to the return of a benchmark index but, like debt
securities, ETNs do not actually own anything they are tracking.

The first ETN, marketed as the iPath Exchange-Traded Notes, was issued by Barclays Bank plc on 12 June
2006. ETNs may be liquidated before their maturity by trading them on an exchange or by redeeming a
large block of securities directly to the issuing bank. The redemption is typically on a weekly basis and a
redemption charge may apply, subject to the procedures described in the relevant prospectus.

Since ETNs are unsecured, unsubordinated debts, they are not rated, but are backed by the credit of
underwriting banks. Like other debt securities, ETNs do not have voting rights but, unlike other debt
securities, interest is not paid during the term of most ETNs.

Exchange-Traded Commodities (ETCs)

Exchange-traded commodities (ETCs) are investment vehicles that track the performance of an
underlying commodity index, including total return indices based on a single commodity. Similar to
ETFs and traded and settled exactly like normal shares on their own dedicated segment, ETCs have
market maker support with guaranteed liquidity, enabling investors to gain exposure to commodities,
on-exchange, during market hours.

Most ETCs implement a futures trading strategy, which may produce results quite different from owning
the commodity. In the case of many commodity funds, they simply roll so-called ‘front-month’ futures
contracts from month to month. This gives exposure to the commodity, but subjects the investor to risks
involved in different prices along the term structure of futures contracts, which may include additional
costs as the expiring contracts have to be rolled forward.

In addition to investment vehicles that track commodities, there are also ETPs that provide exposure to
FX spot rate changes and local institutional interest rates.

Leveraged ETFs
Leveraged exchange-traded funds are a specialised type of ETF that attempt to achieve returns that are
more sensitive to market movements than non-leveraged ETFs. Leveraged index ETFs are often marketed
as bull or bear funds. A leveraged bull ETF fund might, for example, attempt to achieve daily returns that
are 2x or 3x more pronounced than an index such as the FTSE 100 or the S&P 500. A leveraged inverse
(bear) ETF fund will attempt to achieve returns that are –2x or –3x the daily index return, meaning that it
will gain double or triple the loss of the market. Leveraged ETFs require the use of financial engineering
techniques, including the use of equity swaps, derivatives and rebalancing, to achieve the desired return.

221
1.5.2 Trading Features of an ETP
The range of ETPs available to investors is now very diverse and provides investors with a real alternative
to more traditional funds.

One of the key features of an ETP is that, since they are listed securities and trade in the same manner
as shares, the pricing takes place in real time and the funds can be bought or sold at all times when
the markets are open. This is unlike the position with many types of collective investment vehicles,
such as unit trusts and other investment funds, where the pricing of the fund based on the NAV of
the constituents is computed at the end of each day and where the ability to transact is also limited
to certain prescribed times. For investors and traders who want to be able to react quickly to market
movements, and have immediate pricing and settlement for their positions (subject only to the normal
settlement period for any listed share), ETP products are preferable to the more traditional structured
investment products.

Another feature of ETPs is that investors and traders can use limit orders and stop loss orders in a similar
fashion to the way in which equities are traded, and which, again, are not features available in the
trading of shares of traditional unit trusts or mutual funds.

One can purchase an ETP which has been designed and constructed to track a general stock index,
such as the S&P 500 (SPY) or the Nasdaq 100 Index (QQQ), or indices for market sectors (eg, industrials,
financials), geographical regions, currencies, commodities such as gold, silver, copper and oil, and even
certain managed funds with objectives and management criteria laid out in an offering prospectus.

Another reason which has led to the increasing popularity of ETPs is that many of them are offered as
inverse funds, which means that they are constructed in a manner so that the ETF has either outright
short positions in the underlying instruments for the sector or derivatives that provide a synthetic short
position for that sector. Accordingly, an investor who buys or takes a long position in such an inverse
fund is effectively short the sector or index-designated and will benefit from a downward movement
in that particular sector or index. This feature makes it easier for many investors to take a short position
rather than having to borrow stock from a brokerage.

For example, if one has a bearish view on the direction of the S&P 500 Index, it is possible to purchase
an ETF which trades on the NYSE/Arca Exchange under the symbol SDS, which is known as UltraShort
S&P500 ProShares fund, and this fund will return twice the inverse return of a long position in the S&P
500 Index. In essence, the mechanics for many kinds of inverse ETFs are that one buys (or goes long) the
ETF and this will profit as the sector or index goes down.

ETPs are also available to track the performance of various fixed-income instruments such as US Treasury
bonds, and of indices that track high-yield bonds and other corporate bonds. Again these can be used to
take a long position on higher yields, in effect to be short the bond on a price basis. One well-known ETF,
traded in the US under the symbol TBT, tracks the yield on US Treasury bonds of 20 years plus maturity.
The fund moves in line with the real-time yields of the long end of the US Treasury curve and therefore
the fund moves inversely to the price of such US Treasury bonds.

222
 Collective Investments

1.5.3 Charges and Taxation

Many ETP products are managed by large financial intermediaries (including Barclays and JPMorgan
Chase) and the fees and charges are very competitive and often considerably lower than those applied
to more traditionally managed funds. Also, no stamp duty is applied to purchases of ETPs available from
UK exchanges as they are domiciled outside the UK in such centres as Dublin or Jersey.

1.5.4 Tracking Methods

While the operation, marketing and construction of an ETP requires skills on the part of the ETP

4
management company, many funds are in effect tracker funds and therefore have to reflect the
composition of a reference index or commodity. There are different ways to achieve this, some of which
are discussed more fully in chapter 7, section 7.5, but in summary the main methods are:

• Full replication – this is an approach whereby the fund attempts to mirror the index by holding
shares in exactly the same proportions as in the index itself.
• Stratified sampling – this involves choosing investments that are representative of the index in
similar manner to the manner in which statisticians conduct surveys on a sampling which reflects
the stratification of an entire population. For example, if a sector makes up 16% of the index, then
16% of shares in that sector will be held, even though the proportions of individual companies
in the index may not be matched. The expectation is that, with stratified sampling, overall the
tracking error or departure from the index will be relatively low. The amount of trading of shares
required should be lower than with full replication, since the fund will not need to track every single
constituent of an index. This should reduce transaction costs and, therefore, will help to avoid such
costs eroding overall performance.
• Optimisation – this is a computer-based modelling technique which aims to approximate to the
index through a complex statistical analysis based on past performance. The constituent companies
in indices such as the FTSE 100 Index are reviewed from time to time, and some companies will
usually drop out while others will join.

The large amounts of funds invested in tracker funds can have a distorting effect on the market for
example, if many tracker funds buy a particular share at the point when it is included in the index.
Undoubtedly, inclusion in an index can be beneficial to the price of a share, while exclusion may be a
factor causing a share to receive less attention from investors and to fall out of favour.

1.6 Non-Mainstream Pooled Investments (NMPIs)

Learning Objective
4.1.6 Be able to analyse the key features, accessibility, charges, valuation and yield characteristics of
the main types of non-mainstream pooled investments (NMPI)

1.6.1 Overview
In June 2013, the FCA published its statement on ‘restrictions on the retail distribution of unregulated
collective investment schemes and close substitutes’.

223
The FCA identified a number of issues concerning the distribution of high-risk, complex investments.
From 1 January 2014, they ordered the cessation of the promotion of unregulated collective investment
schemes (UCISs) and similar or equivalent pooled vehicles to ordinary retail investors. The FCA
introduced new rules which introduced the instrument type non-mainstream pooled investments
(NMPIs).

1.6.2 Types of NMPIs

Any of the following can be an NMPI:

• a unit in an unregulated CIS

• a unit in a qualified investor scheme (a type of UK-authorised CIS)
• a security issued by a special purpose vehicle
• a traded life policy investment, and
• rights to, or interests in, these types of investments.

1.6.3 Risks and Suitability

The FCA has publicly stated that it does not believe that NMPIs are likely to be suitable for retail investors
of ordinary wealth or sophistication and has suggested that they should be excluded from the relevant
market when a firm is dealing with such clients. NMPIs are collective investment schemes (CISs) that are
not authorised or regulated in the UK. The feature of these schemes is that they have few regulatory
rules and constraints on the types of instruments they invest in, and so can invest in highly speculative,
complex or non-traditional assets and be highly geared. They may also be dependent on just a single
asset.

Other risks are:

• the fund’s assets may be speculative, illiquid and difficult to value

• the fund’s terms and conditions may be very complex
• their structures can often carry governance risks because they are potentially less regulated.

1.6.4 Charges and Tax

Many NMPIs will not be subject to the rules governing the disclosure of fees and charges. The taxation
rules in respect of these products are not likely to be of concern to most individuals as firms are not
allowed to market them to retail clients. For other investors, the taxation requirements are likely to vary
from product to product and according to the type of non-retail investor.

1.7 Money Market Funds

1.7.1 Overview
A money market fund is a form of collective investment vehicle which specialises in investing in short-
term, low-risk credit securities. The funds offered can be tailored for both the institutional market and
the retail market, are often structured in the form of an OEIC, and their aim is to achieve maximum

224
 Collective Investments

returns while minimising credit, market and liquidity risks. They typically invest in assets such as
government securities, short-term bonds, commercial paper, repurchase agreements or even other
money market funds.

The rates paid should reflect wholesale money market rates represented by LIBOR – established daily as
a summary of actual rates offered in the money market between banks.

1.7.2 Cash and Near-Cash Instruments

Cash deposits can be categorised as follows:

4
• short-term tactical cash
• longer-term strategic cash and near-cash instruments, or
• enhanced cash.

Cash balances can be held on a high-interest-bearing overnight deposit facility with a leading highly
rated bank. They can also include overnight money market instruments such as very short-term Treasury
bills.

Investments are made in cash and near-cash facilities or in funds which hold high-quality short-term
bonds and money market instruments. Generally there is no requirement to commit capital for any
set period. The money market fund may stipulate whether its holding are in short-term government
securities only, such as 30- and 90-day Treasury bills, which are assumed to be risk-free, or whether it
has exposure to non-government issues. The latter class could be in holdings of AAA corporate paper
but in uncertain times this may be deemed to have more risk than government securities only. In the
US, money market funds may also be marketed as having holdings in municipal bonds which offer
exemption from federal income tax.

Enhanced cash funds will typically invest some of their portfolio in the same assets as money market
funds, but others in riskier, higher-yielding, less liquid assets such as:

• lower-rated bonds
• longer maturity bonds
• foreign currency-denominated debt
• asset-backed commercial paper (ABCP)
• mortgage-backed securities (MBSs), and
• structured investment vehicles (SIVs).

As can be seen from the list above, the enhanced cash instruments which reach out for higher yield by
investing in much riskier and less liquid securities have been responsible for some significant problems
for certain of the more aggressive money market funds. In fact several funds offering exposure to
enhanced cash should not properly be considered as money market funds at all, and some have gone
out of business.

225
1.7.3 Institutional Money Market Funds
Money market funds have been available in the US since they were approved under the Investment
Company Act of 1940, and they are important providers of liquidity to financial intermediaries.

Institutional money market funds are high-minimum-investment, low-expense share classes which are
marketed to corporations, governments or fiduciaries. They are often set up so that money is swept to
them overnight from a company’s main operating accounts.

In the US, the largest institutional money fund is the JPMorgan Prime Money Market Fund, with over
US$100 billion in assets.

1.7.4 Retail Money Market Funds

Retail money market funds are offered primarily to individuals. In the UK, there are many providers of
money market funds for retail clients, and one such offering from HSBC is outlined in the details given
below:

• The term of a deposit can be tailored to a client’s individual needs and a specific rate of return can
be customised for each client.
• The minimum required deposit is £50,000.
• Deposits can be accepted on a fixed-term or notice basis.
• Monthly interest option available for all call/notice accounts, and for fixed-term accounts of six
months and above.
• Deposits can be viewed through personal internet banking, which includes transfer functionality for
all call/notice accounts.

Fixed-term Call/Notice
Minimum Balance £50,000 £250,000 £50,000
Term Seven days to five Overnight to six Immediate (Call), seven or 14 days, one,
years days three, or six months.
Maximum Balance No limit No limit
Minimum Additions Not allowed £1,000
Withdrawals Not permitted before expiry of term Minimum £1,000 (provided minimum
balance is maintained)
Interest Rate Fixed for term Variable

1.7.5 Risks in Money Market Funds

Reserve Primary Fund
In September 2008, at the height of the banking crisis, the oldest money-market fund in the US, the $60
billion Reserve Primary Fund, ‘broke the buck’. The term meant that it would return less than investors
had put in (97 cents in the dollar, in this case). Reserve Primary was holding $785 million of Lehman
Brothers debt, which had to be written down to zero after the bank went into bankruptcy.

226
 Collective Investments

Threadneedle UK Money Securities Fund

In October 2009, Threadneedle UK Money Securities Fund began closure proceedings following
approval from the FSA and shareholders. It cited the fact that:

‘The main reason for the closure is because the fund continued to suffer redemptions while no
improvement in its performance was expected. We thought it was fairer to remaining shareholders
to liquidate the fund in an orderly way. The market for mortgage-backed securities (MBSs) and asset-
backed securities (ABSs) became illiquid and we were unable to buy securities which were once an
integral part of the investment strategy of the fund. All clients have been advised of the closure’.

4
According to Trustnet data, over one year to 2 October 2009 the fund made total returns of –20%, in
contrast to the sector average return of 0.7%. Over three and five years the fund returned –21.8% and
–16.2% in contrast to the sector averages of 8% and 14.7%.

The fund had 40% of its investments in floating rate notes – issued by companies to raise money on the
financial markets – and included investments in derivatives of these instruments such as collateralised
loan obligations.

Threadneedle added:

‘The fund’s underperformance is attributable to some degree to its holdings in floating rate notes
(FRNs) which have been marked down during the credit crunch. In September 2007, FRNs constituted
just over 40% of the fund’s total holding. The whole range of the FRN market has been affected by the
credit crunch’.

1.7.6 Money Market Fund Dealing

Although money market funds can have different underlying structures, the method of dealing is
similar to the purchase of shares in a unit trust or other collective investment fund. Before making a
subscription, a potential investor must open a shareholder account with the company operating the
money market fund.

The managers of the fund will require an original complete share purchase agreement form and
documentation required to discharge the manager’s duties in respect of any anti-money laundering
laws and/or other regulations applicable.

Shareholders will normally be able to redeem all or some of their shares on any business day at the last
calculated NAV per share.

227
 2. Retail-Structured Products

Learning Objective
4.2.1 Be able to analyse the key features, accessibility, risks, valuation and yield characteristics of
the main types of retail structured products and investment notes (capital protected, autocall,
buffer zone): structure; income and capital growth; investment risk and return; counterparty
risk; expenses; capital protection.

A retail structured product, often known as a market-linked product, is an embodiment or ‘packaging’

of an investment strategy based on derivatives, such as a single security, a basket of securities, options,
indices, commodities, debt issuances and/or foreign currencies and swaps. The heterogeneous nature of
structured products available illustrates the fact that there is no single uniform definition of a structured
product.

Structured products were created to meet specific needs that cannot be met from the standardised
financial instruments available in the markets. They can be used as an alternative to a direct investment,
as part of the asset allocation process to reduce risk exposure of a portfolio or to utilise the current
market trend.

In the US, the Securities and Exchange Commission (SEC), Rule 434, defines structured securities as:

‘Securities whose cash flow characteristics depend upon one or more indices or that have embedded
forwards or options or securities where an investor’s investment return and the issuer’s payment
obligations are contingent on, or highly sensitive to, changes in the value of underlying assets,
indices, interest rates or cash flows’.

2.1 Retail-Structured Products in the UK

Until recently, the UK structured retail product market was quite small relative to UK markets for other
retail investment products. However, following the tumultuous conditions in traditional markets during
2007–08, UK consumers have begun to look to products that offer the potential for capital growth,
including products with the significant added feature of capital protection.

2.2 Capital or Principal Guarantee

A feature of some structured products is a principal guarantee function (often referred to as capital
protected), which offers protection of principal if held to maturity. However, the nature of the guarantee
has to be clearly understood as it almost certainly will not be analogous to the FSCS guarantee, of up
to £85,000, on a deposit at an authorised deposit-taker in the UK. The following illustration will help to
properly qualify the nature of the guarantee.

228
 Collective Investments

Example
Let us consider an example of how this might work and the risk/reward to the retail investor.

An investor pays £1,000 for an equity-linked note or structured product, perhaps on the advice of an IFA,
which is structured or financially engineered by and issued by an investment bank and marketed by a
consumer-facing financial services firm.

The product provides the investor with the following:

• A guarantee that the £1,000 will be repaid after five years. This can be called the principal guarantee

4
or capital protection.
• The investor will benefit from one half of the returns from the FTSE 100 Index during the five-year
period. This can be called the equity index linkage.

The engineering could be relatively simple and work as follows. Part of the purchase value is used to buy
a zero coupon bond or strip with a redemption value of £1,000 in five years. If the zero coupon bond is
priced to yield 5% to maturity, the amount required will be £783.53 and this can be straightforwardly
calculated as £1,000/(1.05^5).

With the net balance of the purchase amount – and the fees earned can be quite considerable for these
products – the bank’s structuring team could purchase options, warrants or even agree an equity swap
with a counterparty, in order to deliver the 50% returns on the FTSE 100 Index which will deliver the
required equity index linkage.

Theoretically, an investor could package such a simple product themselves, but the market access,
knowledge, costs and transaction volume requirements of many options and swaps are beyond many
individual investors. The package is sold as a capital-guaranteed product but, even though the ZCB
or STRIP is a risk-free government bond, the retail purchaser will not take physical possession of that,
but rather have it as a component in the packaging performed by the product structuring agent. If
the packager were to default, as did Lehman Brothers, which packaged several products like this, the
purchaser’s guarantee may not be nearly as risk-free as was portrayed in the offering document.

2.3 Autocalls and Buffer Zone Features

Most structured investments fall into one of three categories, each with its own risk/return profile:

• principal-protected
• buffer-zone, and
• return-enhanced.

As shown in the previous section, principal-protected investments offer the full downside protection of
a bond while having the upside potential of a typical equity investment. Investors, typically, give up a
portion of the equity appreciation in exchange for principal protection.

These are often of interest to clients wishing to participate in some of the more volatile asset classes or
emerging markets, but who are unwilling to risk their principal or who may have long-term financial
obligations.

229
Generally, investors will receive 100% of the principal amount of their notes if they are held to maturity,
regardless of the performance of the underlying investment. Maturities generally range from five
to seven years, and investors should be willing to hold the investments to maturity. Buffer-zone
investments, in exchange for risking principal, offer investors greater upside potential relative to a fully
principal-protected investment. In general, buffer-zone investments can be structured to have a shorter
maturity than principal-protected investments, often in a two- to four-year span.

These investments may be of interest to clients with a range-bound view – those who are comfortable
taking some downside risk but would like a ‘buffer’ to mitigate potential losses. Buffer-zone investments
do not guarantee return of principal. These investments will be fully exposed to any decline in the
underlying investment below the buffer zone.

In exchange for accepting full downside exposure in the underlying investment, a return-enhanced
investment offers leveraged equity returns, up to a pre-specified maximum. These products are often of
interest to clients with an appetite for risk. If an investor believes that near-term market returns are likely
to be flat or slightly up, a return-enhanced investment may be an investment vehicle to consider. A key
example is a structured product which includes an ‘autocall’ feature.

Autocalls, also known as ‘kick-out plans’, have captured a large part of the structured product market
in recent years. Product-providers use them to offer higher payoffs than other structured products
that automatically run to a full term. Autocalls pay out a defined return providing that a predefined
event takes place. A simple FTSE-based product may offer 10% per annum if the index rises by a set
amount from its initial starting point. If the trigger event occurs, the plan terminates early and returns
investor cash plus the offered coupon. Should the trigger not occur, the plan keeps going to subsequent
trigger anniversaries until kick-out conditions are met, rolling up coupons as it goes. If the plan reaches
maturity, it pays out the cumulative coupons and returns the initial investment.

Many current products are based on single index structures that kick out if the market is flat or higher
than its strike rate on each anniversary. Even if plans do not kick out on an anniversary, investors should
remember they have not necessarily lost an annual coupon, merely rolled it up.

Some of these products have capital-at-risk structures, typically losing money if the FTSE index has
fallen 50% or further from its strike level.

2.4 Investment Risk and Return

The main type of investment risk associated with retail structured products is that they can involve a
loss of principal due to market movements which have not been anticipated or hedged adequately by
the person(s) responsible for structuring the product. For example, in the case of a structured product
which has a component that is linked to the performance of an index or other instrument, the price
paid within the structured product could, under certain circumstances, suffer a similar fate to that of
an option element which, if it fails to reach its strike price (or target), can effectively become worthless
upon expiration.

The failure of a component within a structured product to perform in accordance with the manner
prescribed in the structuring could lead to a partial or complete loss of that portion of the investment,
plus whatever expenses might have been incurred in the implementation of that failed component.

230
 Collective Investments

It is not always easy to determine exactly how much potential for loss of capital may be entailed. The
returns from some structured products can be substantial, as they may depend on unlikely outcomes
for which the assessment of the risk/reward trade-off is inefficient. However, the general rule is that the
more uncertain the outcome in relation to returns, the more risk that is taken by the investor.

A second kind of risk involves the possibility of default by the issuer of the product or any counterparty
which is contractually obligated to perform in a specified manner. For UK retail investors, there
was a significant impact, involving complete or partial failure of capital protection, of a number of
structured products where that capital protection wholly or partially comprised debt assets issued
by Lehman Brothers’ European or offshore subsidiaries. In the case of a principal-protected product,

4
these products are not always insured by a statutory body such as the FDIC in the US or the Financial
Services Compensation Scheme (FSCS) in the UK. To spell this out clearly, one should consider the
following warning from the FCA with regard to structured investment products. They ‘carry a greater risk
of capital loss than deposits. Most structured investment products do not have FSCS coverage, and, while the
probability of counterparty failure may be low, this means the impact of a default could be catastrophic for
a customer (up to 100% loss of capital)’. Some structured products of a once-solvent company have been
known to trade in a secondary market for as low as pence in the pound.

Another risky instrument is known as a precipice bond, which is marketed as a high-income investment,
advertising double-digit returns. What is often less clear in promotional literature is the propensity for
capital loss as the products offer no, or little, capital protection. This can mean that while the income is
high for maybe three to five years, the initial capital is eroded.

2.4.1 Suitability
Of course, structured products can offer tax efficiency and other benefits but there is an obligation to
ensure that they are suitable for a client. Under the FCA’s suitability rules, a firm must obtain information
concerning the client in order to adequately assess their investment objectives, financial situation and
knowledge and experience. They must ask the client to provide information about their knowledge
and experience in potential investments so the firm can determine whether a product or service is
appropriate for the client. The danger is that a client may invest in a structured product without an
understanding of the structure or possibly the actual risks. The product may not be consistent with the
risk profile or investment objectives of the client.

Things to consider when assessing suitability of a structured product are as follows:

• As described in section 2.4, capital risk and the ability of the product provider to repay at the end of
the fixed term.
• How much of the capital is protected or guaranteed.
• Whether the risk behind the structured product is akin to a similar risk which is already a part of the
client’s existing investments. The instrument may look different but the market risk may be very
similar.
• Taxation would need to be planned for carefully, as some products have an early repayment
mechanism built in that could mean the client unexpectedly breaching tax allowance thresholds in
the year.

231
2.5 Accessibility
Interest in structured investment products has been growing in recent years and high net worth investors
now use structured products as way of portfolio diversification. Structured products are also available
at the mass retail level, particularly in Europe, where national post offices, and even supermarkets, sell
investments in these to their customers.

Structured products are by nature heterogeneous – as a large number of derivatives can be used – but
can broadly be classified under the following categories:

• Interest rate-linked notes and deposits.

• Equity-linked notes and deposits.
• FX and commodity-linked notes and deposits.
• Hybrid-linked notes and deposits.
• Credit-linked notes and deposits.
• Market-linked notes and deposits.

The fees payable for these products will be higher than for many simpler and direct holdings of assets,
reflecting the fact that some high-margin packaging skills are required. The fee structure should be
transparent and laid out clearly in the offering documentation. In addition, an IFA may be rewarded with
a significant commission arrangement for introducing a client to a structured investment product.

2.6 Summary of Benefits and Disadvantages

The benefits of structured products may include:

• Principal protection from the issuer, but caution is advised as outlined above, as they are not covered
under the FSCS scheme.
• They can provide a tax-efficient access to fully taxable investments. Structured products are
normally created so as to ensure the proceeds returned at maturity are categorised as capital gains
rather than income.
• Enhanced returns within an investment. The ingenuity that is used to create structured products can
sometimes be very rewarding. In addition, the returns available may provide diversification within a
portfolio consisting primarily of more mainstream assets. In other words, the correlation with other
market instruments may be low.
• Reduced volatility (or risk) within an investment. Some of the ingenuity that is involved in crafting
and structuring the products can be used to smooth returns, which may make them more appealing
to retail investors who do not like the drawdowns and volatility associated with direct holdings in
equities, for example.
• Some structured funds may be located offshore, in other words, not within the jurisdiction of the UK.

Disadvantages of structured products may include:

• Credit risk – structured products are unsecured debt from investment banks and, as the case of
Lehman Brothers shows, the possibility exists of a complete loss of capital either permanently or
until the administration process is completed, which may take years to work out.
• Lack of liquidity – structured products rarely trade after issuance and someone who wants or needs
to sell a structured product before maturity should expect to sell it at a significant discount.

232
 Collective Investments

• No daily pricing – structured products are priced on a matrix, not at NAV. Matrix pricing is
essentially a best-guess approach, and the lack of pricing transparency can make it very hard for
present valuation purposes.
• Highly complex – the complexity of the return calculations means few truly understand how the
structured product will perform relative to simply owning the underlying asset.

3. Analysis of Collective Investments

4
Learning Objective
4.3.1 Be able to analyse the factors to take into account when selecting collective investments:
quality of firm, management team and administration; investment mandate – scope, controls,
restrictions and review process; investment strategy; exposure, allocation, valuation and
quality of holdings; prospects for capital growth and income; asset cover and redemption
yield; track record compared with appropriate peer universe and market indices; tax treatment;
key person risk and how this is managed by a firm; shareholder base; measures to prevent price
exploitation by dominant investors; liquidity, trading access and price stability; suitability

A collective investment vehicle is a way of investing money with other people to participate in a wider
range of investments than those feasible for most individual investors, and to share the costs of doing
so. Terminology varies with country, but collective investment schemes (CISs) are often referred to as
investment funds, managed funds, unit trusts (in the US these are commonly called mutual funds) or
simply funds. Large markets have developed around collective investment, and these account for a
substantial portion of all trading on major stock exchanges.

Collective investments are marketed with a wide range of investment aims, either targeting specific
geographical regions (eg, emerging markets) or specified sectors (eg, biotechnology). There is often a
bias towards the domestic market to reflect national self-interest and the lack of currency risk. Funds are
often selected on the basis of these specified investment aims, their past investment performance and
other factors such as fees.

The type of investors in collective investments vary considerably according to the type of fund. Types of
collective investment vehicles include:

• unit trusts
• open-ended investment companies (OEICs)
• offshore funds
• exchange-traded funds (ETFs)
• hedge funds
• investment trusts, including split capital investment trusts
• venture capital trusts, and
• structured investment funds.

With so many products on offer, there are many factors to be taken into account when selecting a
collective investment, some of which are covered in the following sections.

233
3.1 Quality of Firm and Management Team
For funds that fall under the jurisdiction of the UK authorities, the manager(s) must be authorised by the
FCA. They are responsible for the operation of the funds.

A fund manager with a good past performance record may be able to repeat the performance in the
future. It should be noted that past performance is not an indicator of future performance. There is also
no assurance that a fund with a successful manager will be able to retain the services of the manager
over extended periods.

3.1.1 Key Person Risk (KPR)

One important risk for investors in certain high-profile funds relates to the possible loss of a key
manager. The manager may be lured away by higher compensation from a competitor, may go out on
their own to start a new fund, or may be required to leave a firm for violation of FCA rules.

Firms which rely heavily on the input of a star manager can find themselves subject to large-scale
redemptions if the manager leaves. This can lead to loss of capital, the possible recall of any borrowed
funds and reputational damage. Fund management companies have devoted considerable resources
to reduce the impact of senior figures. Paying the key managers more, insuring against executives’
departure and inventing quant systems to do away with manager decisions altogether are just some of
the tactics that have been used.

From the short-term perspective, the loss of a key manager may cause a lot of disruption to a firm,
although the more diversified the team of professionals within the fund as well as the more diversified
the investment strategy, the less likely that reputational damage will be lasting. Perhaps the biggest risk
is in hiring a top manager, paying them too much and then finding that the manager fails to consistently
deliver above-average returns.

3.2 Administration
The back-office functions of collective investment vehicles, which refer to the administration and
reporting to clients, are sometimes a major source of differentiation from the client’s perspective. With
many funds to choose from, and often very little in terms of performance differentiation, the funds
which have the best methods of communicating with clients and following the best procedures with
respect to administration will have a competitive edge.

3.3 Investment Mandate

The mandate of a collective investment vehicle is a statement of its aims, the limits within which it is
supposed to invest, and the investment policy it should follow. A fund mandate will typically define:

• the aim of the fund (eg, to generate dividend income or long-term growth)
• the type of strategy it will follow (which will tend to follow from the above)
• what regions it will invest in (UK, Europe, emerging markets)
• what sectors it will invest in
• what types of securities it will invest in (equities, bonds, or derivatives)

234
 Collective Investments

• whether the fund will short sell and whether it will be hedged
• whether it will be geared and to what extent
• a benchmark index that the fund aims to beat (or match if it is a tracker fund)
• the maximum error in tracking the benchmark.

Fund mandates are set by the fund management company, but publicised so that investors can choose
a fund that suits their requirements.

There are also legal limits on how some types of investment vehicle can invest.

4
3.4 Investment Strategy
The Investment Association (IA), the body that represents the UK investment management industry, has
published a classification system for the investment strategies. These are broadly followed by the major
collective investment vehicles – unit trusts and OEICs. The following diagram shows the groupings of
funds in the IA classifications.

The groups correspond to broadly different investment objectives.

• Some income funds principally target immediate income, while others aim to achieve growing
income.
• Growth funds which mainly target capital growth or total return are distinguished from those that
are designed for capital protection.
• Specialist funds cover other, more niche areas of investment.

The IA classifications above are based on broad criteria. Within particular categories such as UK All
Companies, there will be some funds focusing on mainstream blue chip stocks, some funds investing in
recovery stocks and some funds concentrating on special situations such as companies that are rich in
cash relative to their share price.

235
 IA Sector Classification Schematic

Primary Outcome

Capital
Growth Income Specialist
Protection

Cash/Liquidity Capital
Protection
Targeted
Fixed Absolute
Fixed Income Return
Income
Asset Class

Equity Equity Specialist

Equity Equity
Growth Income Volatility
Managed
Mixed Mixed
Mixed/
Asset Asset
Multi Asset
Growth Income

Specialist
Other Other Unclassified

• UK All Cos • Mixed Investment • UK Equity • ST Money • UK Direct

• UK Smaller Cos 0–35% Shares Income Market Property
• Japan • Mixed Investment • Global • STD Money • Property
• Japanese Smaller 20–60% Shares Equity Market Other
Cos • Mixed Investment Income • Specialist
• Asia Pac inc Japan 40–85% Shares
• Asia Pac ex Japan • Flexible
• China/Greater Investment
China
• UK Gilts • UK Equity • Technology and
• North America
• UK Index-Linked and Bond Telecommunications
• North American
Gilts Income
Smaller Cos
• £ Corp Bond
• Europe ex UK
• £ Strategic Bond
• Europe inc UK
• £ High Yield
• European Smaller
• Global Bonds
Cos
• Global Emerging
• Global
Markets Bond
• Global Emerging
Markets

Source: The Investment Association

236
 Collective Investments

Within the specified IA categories of funds are the following types of fund for which there is not a
separate classification:

• Index-tracking funds which track a share index such as the FTSE 100 Index rather than being
actively managed by fund managers.
• Ethical funds which aim to satisfy the criteria of some investors who only wish to invest in companies
whom they consider to be ethical. For example, there are some investors who do not wish to invest
in tobacco companies or companies that have dealings with certain foreign jurisdictions or who may
employ labour in developing world countries under relatively poor working conditions.

4
3.5 Asset Allocation
The asset allocation of the fund will be decided by the management team and there is scope for a fair
degree of discretion. However, if the mandate or trust deed for the fund is very specific then there will
be fewer degrees of freedom for the class of assets and individual securities that the manager can select
for the fund. The assessment of the fund by the trustees and the reporting of the list of assets to fund
participants will provide a means of ascertaining whether the fund is being managed in accordance
with its stated strategy and the domain of permissible assets.

3.6 Valuation and Quality of Holdings

The NAV of a collective investment scheme is calculated by reference to the total value of the fund’s
portfolio (its assets) less its accrued liabilities (money owed to lending banks, fees owed to investment
managers and service providers and other liabilities).

The portfolio’s assets are generally valued by objective criteria established at the outset of the fund.
When assets are traded on a securities exchange or cleared through a clearing firm, the most common
method of valuation is to use the market value of the assets in the portfolio (using, for example, the
closing bid price or last traded price). The value of over-the-counter (OTC) derivatives may be provided
by the counterparty to the derivative, who may be trading similar derivatives with other parties. Where
there is no objective method of calculating the value of an asset, the fund manager’s own valuation
methods subject to a fund’s directors or trustees is usually used.

The last issue raised in the valuation techniques is very relevant to the quality of the assets under
management. Some funds have made investments in assets for which there may be illiquid markets,
for example complex asset-backed securities, which not only hinders the mark-to-market valuation
methodology but can also prove to be a major problem if the fund has to liquidate holdings following
client redemptions in adverse market conditions. It is certainly not fair to conclude that assets which do
not trade in liquid markets suffer from inferior quality. However, the percentage of such assets should be
relatively small in a fund where the shareholders or participants can exit the fund at short notice. This is
less of a problem for some hedge funds, which have ‘gating’ provisions that allow the fund manager to
suspend redemptions in adverse market conditions.

237
3.7 Prospects for Capital Growth and Income
The table of fund classification in section 3.4 illustrates that investors have the choice between funds
that are primarily focused on capital growth and those which are mainly focused on income. There are
also funds of a hybrid nature which attempt to provide both.

Certain objectives will be more suited to different kinds of investor profiles and will not only include
the investor’s needs for income on a current basis but also will depend on their appetite for risk and
their investment horizons. As a simple rule of thumb, for those investors who have a low propensity
to liquidate their holdings in a short time-frame and who do not require a steady stream of income,
the focus on more adventurous asset classes such as emerging markets and equity investments in
technology funds may offer the highest long-term prospects for capital gains. For an investor that is
looking for current yield or income, the most appropriate kinds of collective investment vehicles are
those focused on fixed-income securities and high dividend stocks such as utility companies.

3.8 Asset Cover and Redemption Yield

A split capital investment trust (split) is a type of investment trust which issues different classes of share
to give the investor a choice of shares to match their needs. Most splits have a limited life determined at
launch, known as the wind-up date. Typically, the life of a split capital trust is five to ten years.

Split capital trusts will have at least two classes of share, and other varieties include:

• Zero dividend preference shares – no dividends, only capital growth at a pre-established

redemption price (assuming sufficient assets).
• Income shares – entitled to most (or all) of the income generated from the assets of a trust until the
wind-up date, with some capital protection.
• Annuity income shares – very high and rising yield, but virtually no capital protection.
• Ordinary income shares (income and residual capital shares) – a high income and a share of the
remaining assets of the trust after prior-ranking shares.
• Capital shares – entitled to most (or all) of the remaining assets after prior-ranking share classes
have been paid; very high risk.

Capital shares, if issued by a split capital trust, are the most risky, whereas zero dividend preference
shares have conventionally been the most popular, although in recent years their popularity has been
declining relative to newer CISs.

Zeros are the lowest risk class of share issued by split capital trusts because, as preference shares, they
have a higher priority over the assets of the underlying trust than other types of shareholder. Zeros
have no right to receive a dividend but instead are paid a predetermined maturity price at a specified
redemption date, providing that the trust has sufficient assets to fund this.

Providing that a trust has sufficient assets to meet the redemption price payable to zero shareholders,
the return is predictable, as is the timing of when an investor will realise their gain. As all the return
comes in the form of capital, zeros are also very tax-efficient for those investors who are unlikely to
exceed their annual capital gains tax allowance. For these reasons, zeros were once a popular tool for
school fees and retirement planning.

238
 Collective Investments

The question that should be first and foremost in any investor’s mind is: what is the potential for this
zero not to pay out its stated redemption price? There are a number of financial ratios that can be used
to analyse zeros but essentially each stock should be assessed on three criteria: hurdle rate/asset cover;
portfolio quality; and gearing.

• Firstly, a trust which already has sufficient assets to fully fund the redemption price to the zero
shareholders is lower-risk than one which still needs to appreciate in the remaining time before
maturity.
• Secondly, gearing is an important factor to consider since financial institutions who have loaned
money to the trust have a higher priority over the assets in the event of a wind-up than all types of

4
shareholder.
• Thirdly, the quality of the underlying portfolio is important. A trust may have sufficient asset cover to
meet the full redemption price of the zero shareholders, but if the underlying portfolio is volatile or
comprises specialist types of investments this undoubtedly puts the zeros more at risk than a trust
invested in a portfolio of mainstream shares that will be easy to sell in the event of a wind-up.

There can be potential to make relatively high returns at the more speculative end of the zero market,
where trusts may not yet have sufficient asset cover to meet their zero redemption prices. Returns from
the higher-quality zeros which have sufficient asset care are still sufficiently attractive for much less risk.
Gross redemption yields on quality zero funds are currently higher than prevailing gilt yields, and also
attractive compared to yields on UK equities which are riskier.

3.9 Benchmark Comparisons

Funds usually choose an index to be their performance benchmark. The index will match the region or
sector in which the fund invests. A British technology fund might choose one of the Techmark indices,
whereas an emerging markets fund may choose one of the MSCI indices.

The use of indices as benchmarks is one of the reasons why so many different indices exist: they need to
match the variety of funds. Even so, some funds and portfolios are better served by using a composite
of several indices.

One danger this brings is that it tempts managers to track their benchmark index (and thus avoid the
risk of underperforming) rather than genuinely trying to beat it: supposedly actively managed funds
thus become closet trackers.

Indices are not perfect benchmarks for performance measurement. Limitations include the range
available (although this can be overcome by using synthetic indices specially calculated for a specific
portfolio). Another problem is that changes in composition introduce a form of survivorship bias.
This is the tendency for failed companies to be excluded from performance studies because they no
longer exist. It often causes the results of studies to skew higher because only companies which were
successful enough to survive until the end of the period are included. For example, a fund company’s
roster of funds today will include only those that are successful now. Many losing funds are closed and
merged into other funds to hide poor performance.

239
3.10 Undertakings for Collective Investment in Transferable
Securities (UCITS)
UCITS are not a separate type of investment, but a classification for existing investments such as unit
trusts that can be marketed throughout the EEA.

UCITS were created as a result of the UCITS Directive introduced by the Council for the European
Communities on 20 December 1985. The idea of the directive was that it would introduce a framework
under which a fund management group could market a fund domiciled within one member state to
investors resident in another member state. Under the framework, a manager of a mutual fund certified
as a UCITS in its country of domicile may not be refused permission to market the fund in another
member state providing that it complies with local marketing requirements. Note that when the UK
finalises its withdrawal agreement with the EU, UK-domiciled UCITS funds will likely no longer be able
to be passported. For a fund to continue to be marketed in this way, it may have to re-domicile to an EU
member state, such as Ireland.

The directive does not cover closed-ended funds (such as UK investment trusts), and UCITS funds cannot
hold commodities or property.

A fund is authorised by the regulatory authority of its domicile and it is granted a UCITS certificate.
Application is then made to the regulatory authority of other member states in which the provider
wishes to market the fund. After two months the fund may be marketed.

3.11 Uses of Offshore Funds

Offshore-pooled investments may be useful for those who require a wider choice of funds than is
available onshore. Offshore funds are particularly attractive to investors who wish to use currency funds
or hedge funds. A fixed-interest fund with distributor status may be useful for a non-taxpayer. Earnings
from the offshore fund will be invested in a fixed-interest fund which is rolling up tax-free and can pay
out a gross dividend.

Within a non-distributor fund, the taxpayer will pay no tax while the income is rolling up. If a currently
higher-rate taxpayer can take encashment when they will be a basic rate taxpayer later, this would be
advantageous. A non-distributor fund may also be useful for a UK resident who is anticipating retiring
abroad. Earnings can be rolled up and encashed when the taxpayer is no longer a UK resident and
subject to UK tax.

3.12 Passporting
EEA financial services firms established in any EEA member state can use the EU’s passporting regime
to establish a branch or provide services in another EU state (before Brexit this regime also included
the UK). The passporting regime also allowed EEA-based investment funds to be marketed in the UK.
As part of the UK’s preparations for Brexit, the UK Government established the temporary marketing
permissions regime (TMPR) for EEA-based investment funds to continue to be marketed in the UK in the
same manner as they were before the end of 2020, subject to having notified the FCA before the end of
2020. They can do this for a limited period while seeking UK recognition to continue to market in the UK.

240
 Collective Investments

3.13 Tax Treatment

In the UK, unit trusts and OEICs can be held in the tax-advantaged wrapper of an individual savings
account (ISA) or an existing personal equity plan (PEP). On 6 April 2008, PEP accounts automatically
became stocks and shares ISAs.

Most collective investment vehicles can also be a constituent of a self-invested pension plan (SIPP),
which provides shelter from current taxation within a self-managed pension scheme.

3.14 Liquidity, Trading Access and Price Stability

4
Units in unit trusts and OEICs are priced by the manager based on net asset value. The valuation point will
be at a particular time each day and the pricing could be on a forward or historical basis. Furthermore,
pricing could be provided on a single price basis (especially for OEICs) or a dual-priced basis, when units
may be priced at a bid or offer basis. Dealing is with the manager of the scheme.

In contrast, closed-ended vehicles like investment trusts are priced based on supply and demand factors
and are purchased or sold through stockbrokers on stock exchanges just like other listed equities. As a
result, the traded price could be different to net asset value, exhibiting either a discount or a premium.

Exchange-traded funds are effectively hybrids. They are exchange-traded and open-ended, so the
possibility of creating more shares, or exchanging shares for the underlying constituents should mean
that the price is at, or close to the NAV.

3.15 Suitability
An investment firm always has an obligation to ensure that it makes an assessment of suitability when
selecting investments on behalf of a client. A firm is required to assess the client’s:

• investment objectives
• financial situation, and
• knowledge and experience.

It is also incumbent on the firm to assess the nature of the investment, its risks and benefits, and whether
the provider is an organisation to which it believes it is appropriate to entrust its client’s assets.

241
 End of Chapter Questions

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

1. How and when are the units within a unit trust valued and priced?
Answer reference: Section 1.1.4

2. What is an alternative and more commonly used name for an investment company with variable
capital (ICVC)?
Answer reference: Section 1.2.1

3. Describe the main characteristics of an investment trust and how they are accessible to the single
investor.
Answer reference: Section 1.3.1

4. What is the difference between an open-ended fund and a closed-ended fund?

Answer reference: Section 1.3.2

5. At what times of the day can one purchase an exchange-traded product (ETP)?
Answer reference: Section 1.5.2

6. What is an inverse exchange-traded fund (ETF) and why would one decide to invest in such an
instrument?
Answer reference: Section 1.5.2

7. What risk feature of retail-structured products was exemplified by the collapse of Lehman Brothers
in 2008?
Answer reference: Section 2.2

8. What is meant by the term ‘survivorship bias’?

Answer reference: Section 3.9

9. What are passporting rights with respect to the operation of multi-national collective investment
vehicles?
Answer reference: Section 3.12

10. When selecting investments on behalf of a client, what is an investment firm required to assess?
Answer reference: Section 3.15

242
Chapter Five

Settlement, Safe Custody

and Prime Brokerage

5
1. Clearing, Settlement and Safe Custody 245

2. Prime Brokerage and Equity Finance 268

This syllabus area will provide approximately 7 of the 80 examination questions

244
 Settlement, Safe Custody and Prime Brokerage

1. Clearing, Settlement and Safe Custody

1.1 Settlement of Trades

Learning Objective
5.1.1 Understand how fixed income, equity, money market and foreign exchange transactions are
cleared and settled in the UK, Germany, US and Japan: principles of delivery versus payment
(DvP) and free delivery; trade confirmation process; settlement periods; international central
securities depositories (ICSDs) – Euroclear and Clearstream; international exchanges

5
Settlement occurs after a deal has been executed. At its simplest, settlement refers to the transfer
of ownership from the seller of the investment to the buyer, combined with the transfer of the cash
consideration from the buyer to the seller.

The settlement process consists of several key stages, collectively described as clearing and settlement:

• Confirmation of the terms of the deal or trade by the participants.

• Clearance – the calculation of the obligations of the deal participants, the money to be paid and the
securities to be transferred.
• Settlement – the final transfer of the securities (delivery, which is almost exclusively electronic
delivery rather than transfer of physical documents, although the latter can still be stipulated) in
exchange for the final transfer of funds (payment – also made electronically).

1.1.1 Traditional versus Electronic Settlement

Traditionally, securities settlement involved the physical movement of paper instruments, or certificates
and transfer forms. Payment was usually made by cheque, which introduced an element of risk and
delay into the process of fully resolving and settling a transaction. It was also risky, inasmuch as paper
instruments, certificates and transfer forms were relatively easy to lose, steal, and forge.

The electronic settlement system came about largely as a result of Clearance and Settlement Systems in
the World’s Securities Markets, a major report in 1989 by the Washington-based think tank, the Group of
Thirty (G30). This report made nine recommendations with a view to achieving more efficient settlement.
This was followed up in 2003 with a second report, called Clearing and Settlement: A Plan of Action.

Electronic settlement takes place between participants to the system. If a non-participant wishes to
settle its interests, it must do so through a participant acting as a custodian. The interests of participants
are recorded by credit entries in securities accounts, maintained in their names by the operator of the
system. This permits both quick and efficient settlement by removing the need for paperwork, and
the synchronisation of the delivery of securities with the payment of a corresponding cash sum, called
delivery versus payment (DvP).

In any situation, the seller of a security is unlikely to be willing to hand over legal title to that security
unless they are sure that the cash is flowing in the opposite direction. Similarly, the buyer is unlikely
to be willing to hand over the cash without being sure that the legal ownership is passing in the other
direction, known as cash against delivery (CAD).

245
There are two basic elements to the settlement of trades that can differ across different instruments
and/or markets: timing and the settlement system that is used.

• Timing of settlement – this is normally based on a set number of business days after the trade is
executed, known as rolling settlement.
• Settlement system used – there are a variety of settlement systems that are used in particular
markets. For example, the majority of transactions in UK and Irish equities are settled via an
electronic settlement facility called CREST. CREST is a computer system that settles transactions
in shares, gilts and corporate bonds, primarily on behalf of the London Stock Exchange (LSE). It
is owned and operated by a company that is part of the Euroclear group of companies, called
Euroclear UK & Ireland (EUI). EUI has the status of a recognised clearing house (RCH) and, as such, it
is regulated by the PRA.

Dematerialisation involves dispensing of paper instruments and certificates altogether. Dematerialised

securities exist only in the form of electronic records. The legal impact of dematerialisation differs in
relation to bearer and registered securities respectively. The financial instruments settled by CREST are
dematerialised.

1.1.2 Summary of the UK Settlement System

The CREST system clears a deal or trade by matching the settlement details provided by the buyer and
the seller. The transaction is then settled when CREST updates the register of the relevant company,
instructing it to transfer the shares to the buyer, and at the same time instructing the buyer’s bank to
transfer the appropriate amount of money to the seller’s bank account.

To complete the settlement of a trade, CREST simultaneously:

• Updates the register of shareholders – CREST maintains the so-called operator register for UK
companies’ dematerialised shareholdings.
• Issues a payment obligation – CREST sends an instruction to the buyer’s payment bank to pay for
the shares.
• Issues a receipt notification – CREST notifies the seller’s payment bank to expect payment.

If a trading system provides a central counterparty (CCP) to the trades (such as LCH ltd for trades on
SETS), it is the CCP that assumes responsibility for settling the transaction with each counterparty. The
buyer and seller remain anonymous to each other.

CCP services are available in a range of markets in order to mitigate risks, such as credit risk. The
European Market Infrastructure Regulation (EMIR) establishes a set of common organisational, conduct
of business and prudential standards for CCPs with activities in EU member states.

For SETS trades, CREST gives the option to LSE member firms to settle with LCH ltd or SIX x-clear AG
as counterparty on a gross basis or on a net basis. If a firm has 20 orders executed in the same security
through SETS, they can either settle 20 trades with LCH ltd or SIX x-clear AG (settling gross), or choose to
have all 20 trades netted so that the firm just settles a single transaction with LCH ltd or SIX x-clear AG.
SIX x-clear is the clearing subsidiary of Swiss group SIX Securities Services.

246
 Settlement, Safe Custody and Prime Brokerage

Brexit
A consequence of Brexit is that CREST, as a central securities depository (CSD), is no longer authorised
in Ireland. As a result, Ireland’s listed securities have migrated to Euroclear Bank, the international CSD,
which will provide a replacement holding and settlement system for securities of Irish companies listed
or quoted on Euronext Dublin and/or the LSE. The transition took place in March 2021.

1.1.3 Settlement Period

The settlement period (the time between the trade and the transfer of money and registration) for UK
equities moved from a T+3 basis to a T+2 basis on 6 October 2014. ‘T’ is the trade date and ‘2’ is the
number of business days after the trade date that the cash changes hands and the shares’ registered title
changes.

5
In other words, if a trade is executed on a Wednesday, the cash and registered title will change two
business days later, on the Friday. Alternatively, should the trade be executed on a Thursday, it will be
the following Monday that settlement will occur. This is referred to by the LSE as standard settlement.
Standard settlement applies to all deals automatically executed on an LSE trading system, such as SETS.

The move to T+2 was in advance of the deadline of 1 January 2015 in the proposed EU Central Securities
Depositories Regulation (CSDR), which aimed to harmonise the settlement period for all European
securities settlement. The legislation required full alignment of settlement periods across EEA countries
(plus Switzerland) to T+2.

Among the key advantages of a shorter settlement cycle are:

• a reduction in risk
• a shorter period of providing margin for CCP clearing positions
• for investors, transactions will be concluded within a shorter period of time meaning that investors
will receive securities (buyers) and cash (sellers) a day earlier.

247
1.1.4 Global Settlement Systems and Periods
The following table provides an overview of the settlement systems in the UK, EU, the US and Japan.

Country/Region Instruments Settled Settlement Period System Name

Listed equities and
T+2 CREST
corporate bonds
UK
Government bonds T+1 (cash
CREST
(gilts) settlement)
Listed equities T+2 Clearstream
EU
Clearstream/
International bonds T+2
Euroclear
Depository Trust
Company and
National Services
Listed equities T+2
Clearing Corporation,
both subsidiaries of
US DTCC
Fixed Income
Clearing Corporation
Government bonds T+1 (FICC), a subsidiary
of Depository Trust &
Clearing Corporation
Japan Securities
Listed equities and
Japan T+2* Depository Center
convertible bonds
(JASDEC)

* Japan changed to T+2 from T+3 for both equities and fixed-income trades in July 2019. Japan also
recently shortened the settlement cycle of Japanese government bonds (JGBs) to T+1 from T+2.

1.1.5 Central Securities Depositories (CSDs)

Functions of a CSD
• Safekeeping – securities may be in dematerialised form, book-entry only form (with one or more
global certificates) or in physical form immobilised within the CSD.
• Deposit and withdrawal – supporting deposits and withdrawals involves the relationship between
the transfer agent and/or issuers and the CSD. It also covers the CSD’s role within the underwriting
process or listing of new issues in a market.
• Dividend, interest and principal processing, as well as corporate actions including proxy voting.
• Paying and transfer agents, as well as issuers are involved in these processes, depending on the
level of services provided by the CSD and its relationship with these entities.
• Other services – CSDs offer additional services aside from those considered core services. These
include securities lending and borrowing, matching, and repo settlement.

248
 Settlement, Safe Custody and Prime Brokerage

The Depository Trust & Clearing Corporation (DTCC)

The Depository Trust & Clearing Corporation (DTCC), based in New York, is the world’s largest
post-trade financial services company. The DTCC was established in 1999 to provide an efficient and safe
way for buyers and sellers of securities to make their exchange, and thus clear and settle transactions. It
also provides custody of securities.

Through its subsidiaries, the DTCC provides clearance, settlement and information services for equities,
corporate and municipal bonds, unit investment trusts, government and mortgage-backed securities,
money market instruments and over-the-counter (OTC) derivatives.

Japan Securities Depository Center (JASDEC)

The Japan Securities Depository Center (JASDEC), the central depository for Japan’s stock market, has

5
been a leading advocate in educating Japanese investors about the benefits of dematerialisation and
ensuring a seamless transition to a paperless environment.

1.1.6 International Central Securities Depositories (ICSDs)

An ICSD’s role is to settle international transactions. There are two ICSDs globally, Clearstream
International (previously known as Cedel) and Euroclear. Both were established in the early 1970s to
provide an efficient settlement environment for the then nascent eurobond market. Both have a joint
arrangement with so-called ‘common depositories’ in multiple countries to allow them to move securities
between clients in both organisations on a book-based basis. In addition to the ICSD functionality, both
organisations also provide international custody and settlement services in international securities and
in various domestic securities, usually through direct or indirect (through local agents) links to local
central securities depositories (CSDs).

In this activity, they are joined by two other CSDs, SIX SIS (a subsidiary of SIX Securities Services) and the
DTCC.

1.2 Settlement Risk

Learning Objective
5.1.2 Understand how settlement risk arises, its impact on trading and the investment process and
how it can be mitigated: underlying risks: default, credit and liquidity; relative likelihood of
settlement-based risks in developed and emerging markets; effect of DvP and straight-through
processing (STP) automated systems; risk mitigation within markets and firms; continuous
linked settlement

Settlement risk is the risk that a settlement in a transfer system does not take place as expected. Generally,
this happens because one party defaults on its clearing obligations to one or more counterparties. As
such, settlement risk comprises both credit and liquidity risks.

• Credit risk arises when a counterparty cannot meet an obligation for the full value on the due date
or thereafter because it is insolvent.

249
• Liquidity risk refers to the risk that a counterparty will not settle for the full value at the due date
but could do so at some unspecified time thereafter, causing the party which did not receive its
expected payment to finance the shortfall at short notice.

Sometimes, a counterparty may withhold payment even if it is not insolvent (causing the original party
to scramble around for funds), so liquidity risk can be present without being accompanied by credit
risk. Unsurprisingly, such settlement-based risks are considerably more likely to be an issue in emerging
markets than in the developed markets where sophisticated systems are utilised.

Example: Herstatt Risk

The best known example of settlement risk is the failure of a small German bank, Bankhaus Herstatt
in 1974. The firm’s banking licence was withdrawn, and it was ordered into liquidation during the
banking day, but after the close of the German interbank payments system. Some of Herstatt Bank’s
counterparties had irrevocably paid Deutschmarks to the bank during the day but before the banking
licence was withdrawn. They had done so in good faith, believing they would receive US dollars later the
same day in New York. Following the loss of its banking licence, Herstatt’s New York correspondent bank
suspended all outgoing US dollar payments from Herstatt’s account.

In addition, banks had entered into forward trades that were not yet due for settlement, and some lost
money replacing the contracts. In short, there were serious repercussions in the foreign exchange market
after the Bankhaus Herstatt default, and the intra-day settlement risk highlighted has subsequently
been termed Herstatt risk.

Herstatt risk has arisen in similar circumstances, and not just in the settlement of foreign exchange
transaction. The collapse of US investment bank Drexel Burnham Lambert in 1990, Bank of Credit and
Commerce International (BCCI) in 1991, Barings in 1995, Long-Term Capital Management (LTCM) in 1998
and Lehman Brothers and AIG in 2008, have all provided similar ingredients to that found for Herstatt
risk. The common thread to such settlement failures arises when parties are relying on the simultaneity in
processing of payments and, for reasons of default, illiquidity or even criminality, one side of the settlement
does not perform.

Examples: LTCM and Lehman Brothers

LTCM was bailed out by a consortium of 14 banks, under the supervision of the Federal Reserve Bank of
New York, in 1998 after being caught in a cash flow crisis when economic shocks resulted in excessive
mark-to-market losses and margin calls. The fund was engaged in complex arbitrage strategies in the
fixed-income market and, partly precipitated by a default in Russian bonds in August of 1998, many of
its positions became extremely illiquid and it was not able to fund its positions. Without the intervention
of the US central bank, obligations involving billions of dollars owed to counterparties would have
failed, raising the prospect of financial systemic risk.

The story of LTCM’s collapse, which incidentally had two Nobel laureates as part of its advisory team, can
be found in an excellent book on the subject, When Genius Failed by Roger Lowenstein.

In September 2008, Lehman Brothers, one of the five largest investment banks at the time, collapsed
after the US Treasury and Federal Reserve decided not to rescue the firm, following a collapse in
confidence by the clients of the firm. The firm was unable to meet margin calls, could not find funding in
the repo market and the share price collapsed. Despite efforts at the eleventh hour to find some means
of rescue, the firm declared Chapter 11 in the US and was subsequently liquidated.

250
 Settlement, Safe Custody and Prime Brokerage

The failure of the firm resulted in many trades, swaps and obligations of the firm failing to be honoured
and many disputes about whether trades had been settled or not. The lawsuits and damage from the
firm’s collapse was a far more dramatic example than the LTCM episode of the systemic risk posed by
the failure of a major hub in a highly interconnected global system. Counterparty risk is deemed to pose
such a threat to the financial system that financial regulators are considering the replacement of the
traditional methods of OTC settlement – which was the nature of many of the transactions of both LTCM
and Lehman Brothers – by central counterparty mechanisms such as the clearing house systems used at
futures exchanges.

1.2.1 The Committee on Payment and Settlement Systems (CPSS)

The Committee on Payment and Settlement Systems (CPSS) is part of the BIS and is a standard-setting

5
body for payment and securities settlement systems. It also serves as a forum for central banks to
monitor and analyse developments in domestic payment, settlement and clearing systems as well as in
cross-border and multicurrency settlement schemes.

From a historical perspective, following the Herstatt incident, a report prepared by the CPSS recognised
the gravity of settlement risk in the foreign exchange markets. It made the point that without adequate
safeguards, and since a bank’s maximum foreign exchange settlement exposure could equal or even
surpass the amount receivable for three days’ worth of trades at any point in time, the amount at risk to
even a single counterparty could exceed a bank’s capital.

The stock market crashes of 1987 (when the Dow Jones Industrial Average fell by 22% in a single day on
19 October) prompted regulators to review securities settlement procedures with a view to reducing
or eliminating principal risk. The CPSS concluded that the best way of eliminating principal risk was the
creation of DvP systems.

1.2.2 The Effect of Delivery versus Payment (DvP) and Straight-

Through Processing (STP) Automated Systems
DvP is a sale transaction of negotiable securities (in exchange for cash payment) that can be instructed
to a settlement agent using SWIFT Message Type MT 543. Use of such standard message types is
intended to reduce risk in the settlement of a financial transaction, and enable automatic processing.
Ideally, title to an asset and payment are exchanged simultaneously. Such simultaneity is often the case
when a central depository system is available such as Euroclear or the US Depository Trust & Clearing
Corporation.

Three main types of DvP systems are in use:

• Systems that settle transfer instructions for both securities and funds on a trade-by-trade (gross)
basis, with final (unconditional) transfer of securities from the seller to the buyer (delivery) occurring
at the same time as final transfer of funds from the buyer to the seller (payment).
• Systems that settle securities transfer instructions on a gross basis with final transfer of securities
from the seller to the buyer (delivery) occurring throughout the processing cycle, but settle funds
transfer instructions on a net basis, with final transfer of funds from the buyer to the seller (payment)
occurring at the end of the processing cycle.

251
• Systems that settle transfer instructions for both securities and funds on a net basis, with final
transfers of both securities and funds occurring at the end of the processing cycle.

Straight-Through Processing (STP)

STP has been deemed as best practice for settlement but has not been implemented comprehensively in
trade settlement. The goal is that the entire trade process for capital markets and payment transactions
be conducted electronically without the need for re-keying or manual intervention, subject to legal and
regulatory restrictions.

Currently, the entire trade life cycle, from initiation to settlement is commonly referred to as T+2
processing. Industry practitioners viewed STP as meaning at least same-day settlement or faster, ideally
minutes or even seconds. The goal was to minimise settlement risk for the execution of a trade and
its settlement and clearing to occur simultaneously. However, for this to be achieved, multiple market
participants must realise high levels of STP. In particular, transaction data needs to be made available on
a just-in-time basis, which is a considerably harder goal to achieve for the financial services community
than the application of STP alone.

Some industry analysts believe that STP is not an achievable goal, in the sense that firms are unlikely
to find the cost/benefit justification for reaching 100% automation. Instead they promote the idea of
improving levels of internal STP within a firm, while encouraging groups of firms to work together to
improve the quality of the automation of transaction information between themselves, either bilaterally
or as a community of users (external STP). Other analysts, however, believe that STP will be achieved
with the emergence of business process interoperability.

1.2.3 Continuous Linked Settlement (CLS)

CLS is a process by which most of the world’s largest banks manage settlement of foreign exchange
among themselves (and their customers and other third parties). The process is managed by CLS Group
Holdings and regulated by the Federal Reserve Board of New York. Since it began operations, CLS has
rapidly become the market standard for foreign exchange settlement between major banks.

Eighteen currencies are currently eligible for CLS settlement. They are: US dollar, euro, UK pound,
Japanese yen, Swiss franc, Canadian dollar, Australian dollar, Swedish krona, Danish krone, Norwegian
krone, Hungarian forint, the Singapore dollar, the Hong Kong dollar, the New Zealand dollar, the Korean
won, the South African rand, the Israeli shekel and the Mexican peso.

CLS settles transactions on a payment versus payment (PvP) basis which means that the two parties to
a foreign exchange transaction will buy and sell the respective currencies exchanged and the payments
made will occur simultaneously. The CLS settlement process is focused on a five-hour window each
business day from 7.00am to 12.00 midday in Central European Time (CET). This window was created to
provide an overlap across the business days in all parts of the world and facilitate global trading.

By 6.30am CET the settlement members must submit their settlement instructions for transactions to
settle that day. At 6.30am each settlement member receives a schedule of what monies need to be paid
in that day. From 7.00am the settlement members pay in the net funds that are due to settle in each
currency to their central banks, and CLS will then begin to attempt to settle deals. In the event that CLS
Bank’s strict settlement criteria are not met for each side of a trade, then no funds are exchanged. This

252
 Settlement, Safe Custody and Prime Brokerage

achieves the payment versus payment system that removes the Herstatt risk. Those trades that can be
settled are settled and money is paid out via the central banks.

As outlined above, the payments made to CLS Bank are made via the central banks. In the UK, both
sterling and euro payments are made via the Clearing House Automated Payment System (CHAPS).
CHAPS is the electronic transfer system for sending payments between banks that operates in
partnership with the Bank of England.

1.3 Financial Transaction Taxes (Stamp Duty and Stamp Duty

Reserve Tax (SDRT))

5
Learning Objective
5.1.3 Understand which transactions may be subject to or exempt from financial transaction taxes

Stamp duty is a transaction tax payable on documents that transfer certain kinds of property by the
purchaser of that property. If property can be handed over – for example, an item of furniture – there is
no charge to stamp duty, because there is no document executed on which to charge the duty.

Some properties, such as houses, land and shares in a company, can only be transferred in a prescribed
legal form. Legislation requires that documents transferring ownership or title to a property which is
liable to stamp duty may not be registered or used unless they have been duly stamped. Since owners
need to be able to demonstrate their title to property, they are effectively required to have their
document stamped if they want it to be recognised as their own.

There are different rates of transaction tax for shares and for other property. Stamp duty on share
transfers is charged to the purchaser at 0.5% of the price (excluding any commissions payable to the
stockbroker), with no threshold. Normally there is no charge on the issue, as distinct from the transfer,
of shares. Stamp duty is rounded up to the next £5. However, there is a charge of 1.5% made on the
creation of a bearer share, and on the transfer of shares into a depositary receipt such as an ADR,
because subsequent transfers will not attract stamp duty.

Stamp duty depends upon there being a document to stamp. It cannot be used for paperless transactions
or when ownership is in dematerialised form. Another transaction tax, stamp duty reserve tax (SDRT),
was, therefore, introduced to cater for the paperless transfer of shares through settlement systems such
as CREST. SDRT applies in place of stamp duty when the agreement is not completed by an instrument
of transfer (ie, a document, the stock transfer form). The SDRT regulations impose an obligation on the
operator of CREST (Euroclear UK & Ireland) to collect SDRT on transfers going through the system.

Ultimate liability for paying SDRT falls upon the purchaser or transferee. However, unlike stamp duty,
there is an overlying concept of accountable person (which arises under the SDRT Regulations 1986). In
general terms, the accountable person rules are designed to place the primary reporting and payment
obligations upon an involved financial intermediary, such as a broker. In many cases, typically those
involving on-market sales of listed shares, such an intermediary will be accountable (although the
accountable person will recover from the liable person any SDRT paid on that person’s behalf ).

253
The tax is charged at 0.5% on the consideration given for the transfer, payable by the purchaser. Unlike
stamp duty, there is no rounding to the next £5, and it is charged to the penny.

1.3.1 Securities Exempt from Financial Transaction Taxes

Gilts and bonds are not liable to transaction tax unless they are equity-related, for example, convertible
into equity. Gifts are not liable to transaction tax, since there is no consideration paid on the transactions.
Non-convertible bonds, are also exempt and there is an exemption for stamp duty on certificated shares
up to and including trades of £1,000. Certain shares traded on AIM and ISDX markets are also exempt
from transaction tax.

According to Schedule 15 of the Finance Act of 1999, which relates to the application of the duty for
bearer instruments, the following are relevant exemptions from stamp duty:

• renounceable letters of allotment, and

• letters of rights or other similar instruments when the rights under the letter or other instrument are
renounceable not later than six months after its issue.

Also exempt are certain specified instruments relating to non-sterling stock.

Stamp duty is also not chargeable under Schedule 15 on the issue of an instrument which relates to
stock expressed:

• in a currency other than sterling

• in units of account defined by reference to more than one currency (whether or not including
sterling), or
• on the transfer of the stock constituted by or transferable by means of any such instrument.

The following table illustrates the differences between the application of transaction taxes.

254
 Settlement, Safe Custody and Prime Brokerage

Stamp Duty Stamp Duty Reserve Tax

Non-certificated shares in dematerialised form

Shares bought and sold on same day.

No entry required in register
Payable by
the buyer or Shares with paper certification New issues in renounceable form such as
transferee allotment letters under a rights offering

Share options

Convertible loan stock

Rate 0.5% rounded up to the next £5 0.5% rounded to nearest penny

5
Intermediaries, such as LSE member firms
Persons
exempt Registered charities
from either CISs
tax
Those receiving shares as gifts

Gilts

Non-convertible bonds (loan stock) denominated in sterling

Instruments Bearer stocks

exempt
Foreign registered stocks
from either
tax New issues of securities (via rights offering) to existing owners

CFDs and some derivatives

Exchange-traded funds available through UK exchanges

Holdings in CISs are exempt only if the scheme is a bond or gilt fund (of the sort previously falling within
Section 101 of the Finance Act 1980). This includes funds which invest in foreign bonds as well as those
investing in UK bonds, but is restricted to authorised funds. Direct investments are exempt if they are
neither:

• investments the transfers of which would be liable to ad valorem stamp duty, nor
• chargeable securities for the purposes of SDRT.

For example, gilts, commercial paper and other exempt loan capital are exempt, whereas UK shares or
interests in UK land are not.

A unit under a unit trust scheme or a share in a foreign mutual fund is treated as capital stock of a
company formed or established in the territory by the law of which the scheme or fund is governed, and
as such is not subject to SDRT. A ‘foreign mutual fund’ means a fund administered under arrangements
governed by the law of a territory outside the UK under which subscribers to the fund are entitled
to participate in, or receive payments by reference to, profits or income arising to the fund from the
acquisition, holding, management or disposal of investments.

255
Derivatives are exempt investments only if they relate wholly to exempt investments. So, for example,
an index-tracking derivative will only be exempt if the index or indices concerned do not include any
non-exempt investments.

Contracts for difference (CFDs), which are becoming widely used by investors as a way of participating
in markets through a derivative rather than through the direct ownership of an underlying security,
are exempt from SDRT. For example, if one purchases a CFD to support a particular view on the future
direction of an individual equity or the FTSE 100 Index product, that CFD instrument is exempt from SDRT.

Cash or other funds held for day-to-day management do not count as investments.

1.3.2 Purchasers Exempt from Transaction Taxes

There are also exemptions from transaction taxes for purchases by registered charities, on-exchange
stock lending transactions, gifts and purchases by LSE member firms (who are granted intermediary
status) and the clearing house.

1.4 Safe Custody

Learning Objective
5.1.4 Understand the principles of safe custody, the roles of the different types of custodian and how
client assets are protected: global; regional; local; subcustodians; clearing and settlement agents

1.4.1 Services Provided by Custodians

When an institutional investor invests in securities, it will commonly employ the services of a custodian
to administer these securities by:

• providing safekeeping of the investor’s assets in the local market

• making appropriate arrangements for delivery and receipt of cash and securities to support
settlement of the investor’s trading activities in that market
• providing market information to the investor on developments and reforms within that market
• collecting dividend income, interest paid on debt securities and other income payments in the local
market
• managing the client’s cash flows
• monitoring and managing entitlements through corporate actions and voting rights held by the
investor in the local market
• managing tax reclaims and other tax services in the local market
• ensuring that securities are registered and that transfer of legal title on securities transactions
proceeds effectively, and
• ensuring that reporting obligations to the regulatory authorities, and to other relevant bodies, are
discharged effectively.

256
 Settlement, Safe Custody and Prime Brokerage

1.4.2 The Role and Responsibility of a Custodian

The primary responsibility of the custodian is to ensure that the client’s assets are fully protected at all
times. Hence, it must provide robust safekeeping facilities for all valuables and documentation, ensuring
that investments are only released from the custodian’s care in accordance with authorised instructions
from the client.

Importantly, the client’s assets must be properly segregated from those of the custodian, and appropriate
legal arrangements must be in place to ensure that financial or external shock to the custodian does not
expose the client’s assets to claims from creditors or any other party.

1.4.3 Global, Local or Regional Custody

5
An investor faces choices in selecting custody arrangements in regard to a portfolio of global assets. The
possible paths can be summarised as follows:

• Appointing a local custodian in each market in which they invest (often referred to as direct custody
arrangements).
• Appointing a global custodian to manage custody arrangements across the full range of foreign
markets in which they have invested assets.
• Making arrangements to settle trades and hold securities and cash with a CSD within each market,
or use an ICSD.

Global Custodian
A global custodian provides investment administration for investor clients, including processing cross-
border securities trades and keeping financial assets secure (ie, providing safe custody) outside of the
country where the investor is located.

The term ‘global custody’ came into common usage in the financial services world in the mid-1970s,
when the Employee Retirement Income Security Act (ERISA) was passed in the US. This legislation
was designed to increase the protection given to US pension fund investors. The Act specified that US
pension funds could not act as custodians of the assets held in their own funds; instead, these assets had
to be held in the safekeeping of another bank. ERISA went further, to specify that only a US bank could
provide custody services for a US pension fund.

Subsequently, the use of the term ‘global custody’ has evolved to refer a broader set of responsibilities,
encompassing settlement, safekeeping, cash management, record-keeping and asset-servicing (for
example, collecting dividend payments on shares and interest on bonds, reclaiming withholding tax,
advising investor clients on their electing on corporate actions entitlements) and providing market
information. Some investors may also use their global custodians to provide a wider suite of services,
including investment accounting, treasury and FX, securities lending and borrowing, collateral
management, and performance- and risk-analysis on the investor’s portfolio.

Some global custodians maintain an extensive network of branches globally and can meet the local
custody needs of their investor clients by employing their own branches as local custody providers. Citi
Transaction Services (part of Citigroup), for example, is the trusted custodian of over $21 trillion in assets
under custody, and has a network which spans 106 markets, of which 60 are proprietary endpoints.

257
In locations where a global custodian does not have its own branch, or in situations when it may find
advantage by looking outside of its proprietary branch network, a global custodian may appoint an
external agent bank to provide local custody services. For example, in a number of markets, Citi does not
feel that there is a sound economic rationale for maintaining its own branches, and it employs external
agents to act as its subcustodian in these markets. Similarly, investment banks and global broker-dealers
(eg, Morgan Stanley, Goldman Sachs and UBS) will also typically employ a network of agent banks to
meet their needs for clearing, settlement, asset-servicing and cash management in markets around the
world where they have investment activities.

A subcustodian is, therefore, employed by a global custodian as its local agent to provide settlement and
custody services for assets that it holds on behalf of investor clients in a foreign market. A subcustodian
effectively serves as the eyes and ears of the global custodian in the local market, providing a range of
clearing, settlement and asset servicing duties. It will also typically provide market information relating
to developments in the local market, and will lobby the market authorities for reforms that will make the
market more appealing and an efficient target for foreign investment.

In summary, when selecting a subcustodian, a global custodian may appoint:

• one of its own branches, when this option is available

• a local agent bank that specialises in providing subcustody in the market concerned, or
• a regional provider that can offer subcustody across a range of markets in a region.

Local Custodian
Agent banks that specialise in providing subcustody in their home market are sometimes known as
single-market providers. Stiff competition from larger regional or global competitors has meant that
these are becoming a dying breed. However, some continue to win business in their local markets, often
combining this service with offering global custody or master custody for institutional investors in their
home markets. Examples include MUFG Bank, Mizuho Bank and Sumitomo Mitsui Banking Corporation
in Japan, Maybank in Malaysia, and United Overseas Bank in Singapore.

A principal selling point is that they are local market specialists. They remain focused on their local
business without spreading their attentions broadly across a wide range of markets. A local specialist
bank may be attractive in a market in which local practices tend to differ markedly from global standards,
or where a provider’s long-standing relationship with the local regulatory authorities and/or political
elite leaves it particularly well placed to lobby for reforms on behalf of its cross-border clients.

Reciprocal arrangements may be influential in shaping the appointment of a local provider in some
instances. Under such an arrangement, a global custodian (A) may appoint the local provider (B) to
deliver subcustody in its local market (market B). In return, the custodian (A) may offer subcustody in its
own home market (market A) for pension and insurance funds in market B that use provider B as their
global custodian.

In summary, the strengths of a local custodian may include that they:

• are country specialists

• can be the ‘eyes and ears’ of a global custodian or broker-dealer in the local market
• will have regular dealings with financial authorities and local politicians, and may be well placed to
lobby for reforms that will improve the efficiency of the local market

258
 Settlement, Safe Custody and Prime Brokerage

• have expert knowledge of local market practice, language and culture, and
• may offer opportunities for reciprocal business.

A local custody bank may have the following disadvantages when compared with a regional custodian:

• Their credit rating may not match up to requirements laid down by some global custodians or global
broker-dealers.
• They cannot leverage developments in technology and client service across multiple markets
(unlike a regional custodian). Hence product and technology development may lag behind the
regional custodians with which it competes.
• They may not be able to offer the price discounts that can be extended by regional custodians
offering custody services across multiple markets.

5
Regional Custodian
A regional custodian is able to provide agent bank services across multiple markets in a region. For
example, Standard Chartered Bank and HSBC have both been offering regional custody and clearing
in the Asia-Pacific and South Asian region for many years, competing with Citi and some strong single-
market providers for business in this region. In Central and Eastern Europe, Bank Austria Creditanstalt/
Unicredit Group, Deutsche Bank, ING Group, Raiffeisen Zentralbank Österreich and Citi each offer a
regional clearing and custody service. In Central and South America, Citi and Itaú Unibanco (the Brazilian
bank that purchased Bank Boston’s established regional custody service) offer regional custody, in
competition in selected markets with HSBC, Santander and Deutsche Bank.

Employing a regional custodian may offer a range of advantages to global custodian or global broker-
dealer clients:

• Its credit rating may be higher than that of a single-market custodian.

• It can cross-fertilise good practice across multiple markets. Lessons learned in one market may be
applied, when appropriate, across other markets in its regional offering.
• It can leverage innovation in technology, product development and client service across multiple
markets, delivering economies of scale.
• It can offer standardised reporting, management information systems and market information
across multiple markets in its regional offering.
• Economies of scale may support delivery of some or all product lines from a regional processing
centre, offering potential cost savings and efficiency benefits.
• Its size and regional importance, plus the strength of its global client base, may allow a regional
custodian to exert considerable leverage on local regulators, political authorities and infrastructure
providers. This may be important in lobbying for reforms that support greater efficiency and security
for foreign investors in that market.
• A global client may be able to secure price discounts by using a regional custodian across multiple
markets.

In some situations, a regional provider may have certain disadvantages when compared with a local
custody bank:

• A regional custodian’s product offering may be less well attuned to local market practice, service
culture and investor needs than a well-established local provider.

259
• A regional custodian may spread its focus across a wider range of clients and a wider range of
markets than a single-market provider. Hence, a cross-border client may not receive the same level
of attention, or the same degree of individualised service, as may be extended by a local custodian.
• Some regional custodians may lack the long track record, customer base and goodwill held by some
local custodians in their own market.

1.4.4 Custody Agreements

Standard Custody Agreement
In order to formalise the custody arrangements outlined above, it is standard for the institutional
investor and the global custodian to sign a custody agreement that details:

• the legal conditions under which the investor’s assets are held by the global custodian, and are
protected and segregated from the assets of the global custodian
• the responsibilities and obligations required of the global custodian under the custody relationship,
and
• authority for the custodian to accept instructions from fund managers, when an institutional
investor employs investment managers to manage assets on its behalf.

The global custodian will negotiate a separate custody agreement with each institutional investor
that it conducts business with. Given that these institutions may have markedly different investment
strategies, allocating their assets across a different range of markets and investment instruments, the
structure and content of the legal agreement may differ significantly from client to client.

A custody agreement is likely to address the following issues:

• The method through which the client’s assets are received and held by the global custodian.
• Reporting obligations and deadlines.
• Guidelines for use of CSDs and other relevant use of financial infrastructure.
• Business contingency plans to cope with systemic malfunction or disaster.
• Liability in contract and claims for damages.
• Standards of service and care required under the custody relationship.
• A list of persons authorised to give instructions.
• Actions to be taken in response to instructions and actions to be taken without instructions.

Institutional investors and global custodians are required to adhere to the legal framework prevailing in
the countries in which assets are invested.

The custody agreement will typically include provision on the part of the investor to conduct periodic
reviews of the custodian’s internal control environment, in order to ensure that it has effective
procedures in place to monitor and manage risk. These controls should ensure that the investor’s assets
are held securely and that procedures for accepting, and acting on, authorised instructions are in place.

The custody agreement will commonly detail the level of indemnity that the global custodian will
provide to the client in instances of error or negligence on its own part or on the part of subcustodians
that it employs. It will also define the level of indemnity, if at all, that it will provide to clients against
catastrophic events, default by a CSD or clearing house, theft or fraud, and a wide range of other
contingencies.

260
 Settlement, Safe Custody and Prime Brokerage

Subcustody Agreement
When the global custodian employs a subcustodian to provide custody on its behalf in a foreign market,
it will sign a legal agreement with the subcustody provider that will detail:

• the legal conditions under which client assets are held by the sub-custodian, and are protected and
segregated from the assets of the subcustodian
• the responsibilities and obligations required of the subcustodian by the global custodian under the
custody relationship.

Subcustodians, global custodians and their foreign investor clients are bound by the legal regulations
prevailing in the overseas market. Hence, while many provisions of the subcustodian agreement will
resemble those appearing in the investor-global custodian agreement outlined above, these provisions
will be amended in certain instances to comply with local regulatory requirements and legal practice.

5
Service Level Agreement (SLA)
Detailed specifications pertaining to the standards of service required by an investor from its custodian
are spelt out in a service level agreement. This lays down required standards for service areas including:

• Record-keeping and maintenance of accurate and up-to-date documentation.

• Settlement on both recognised exchanges and in OTC markets.
• Communication and reporting.
• Processing of corporate actions – eg, rights issues and other capitalisation matters.
• Income-processing, for example from dividends and coupon payments.
• Tax services.
• Cash management.
• Management information systems.
• Stock lending and borrowing.
• Market information and market knowledge.
• Standards of service expected from account officers and relationship managers that represent
primary points of contact with the investor.

1.4.5 Selecting a Custodian

When selecting a global custodian, an institutional investor will typically invite statements of interest
from suitable candidates. The investor may ask for further detail of services offered by applicants via
a request for information (RFI). Eligible candidates will typically then be asked to complete a detailed
request for proposal (RFP) submission as a preliminary stage in the appointment process. An RFP is a
tendering process for buyers of global financial services.

Although the size and scope of the RFP will vary slightly from client to client, it will generally be a
lengthy questionnaire, requesting background information on the custodian’s staffing and IT capacity,
its track record and experience in the custody area, the strength of its existing client base and assets
under custody, its creditworthiness and its record of recent losses.

The RFP should be viewed as an early stage in the selection process, rather than a selection process in
its own right. Typically, it will be used to screen out candidates that do not meet the client’s selection
criteria, and then to provide a springboard for further investigation at a subsequent site visit and/or
interview stage.

261
1.4.6 Regulation and Legislation Affecting Custodians
Legislation governing the responsibilities held by pension fund trustees and other fiduciaries can
be important in shaping the procedures through which custodians are appointed and standards of
service monitored. For example, standards of fiducial conduct laid down in the US in Section 404 of
the Employment Retirement Income Security Act of 1974 (ERISA) or the 1995 UK Pensions Act require
pension fund trustees to be directly responsible for the appointment of custodians. This makes trustees
liable for civil penalties if they rely on the skill or judgement of any person who is appointed (other
than by the trustees) to exercise a prescribed function. To put it simply, this requires that pension
fund trustees should have a direct legal relationship with their custodian, not an indirect one via the
investment manager or any other appointed intermediary. Trustees must take full responsibility for
appointing and monitoring the actions of custodians acting on behalf of their fund.

In their capacity as fiduciaries, pension fund trustees are generally required to uphold the following
prudential standards:

• They must demonstrate that they have the necessary familiarity with the structure and aims of their
pension scheme and have an appropriate level of training and skill to carry out their responsibilities
to scheme members effectively.
• Fiduciaries have a responsibility to monitor and review the tasks that they delegate to third parties
(including custodians and investment management companies) in order to ensure that these tasks
are discharged effectively.
• The duty of loyalty demands that trustees administer their pension scheme solely in the best
interests of the scheme members.
• Trustees must avoid undue risk in the way that they manage scheme assets and appoint
intermediaries to manage or administer scheme assets on the scheme’s behalf.

Also, legislation guiding safekeeping of client assets typically requires that a firm that holds safe custody
investments with a custodian must have effective and transparent procedures in place for custodian
selection and for monitoring performance. The frequency of these risk reviews should be dependent on
the nature of the market and the type of services that the custodian delivers to the client.

1.5 Registered Title

Learning Objective
5.1.5 Understand the implications of registered title for certificated and uncertificated holdings:
registered title versus unregistered (bearer); legal title; beneficial interest; right to participate in
corporate actions

1.5.1 Registered Title

In regard to a trade involving UK shares, settlement must involve communicating the change in
ownership to the company registrar. This is because the issuing company maintains a register listing all
of its shareholders. Whenever shares are bought or sold, a mechanism is required to make the company
registrar aware of the change required to the register.

262
 Settlement, Safe Custody and Prime Brokerage

So, ‘registered title’ simply means ownership that is backed by registration. In terms of share ownership,
registered title gives shareholders the right to vote on important company matters, to claim dividends
on their shares, and to participate in other corporate actions such as rights issues. Registered title can
apply equally to holdings which are certificated, ie, where there is a paper instrument which underlies
the holding, or, as is increasingly the case, to uncertificated holdings which are often commonly known
as paperless. When shares are bought and sold, it is the company registrar who is responsible for
updating the register of members and giving the new owner registered title.

1.5.2 Bearer Shares or Unregistered Title

A bearer share or security is an ownership certificate which is not registered in any name. As with
other bearer securities, bearer stock is a negotiable certificate that can be transferred between owners

5
without endorsement. Bearer stock is popular in Europe but not in the US. Eurobonds and ADRs have
traditionally been issued as bearer securities and, in most cases, a register of the owners of these
instruments is not maintained by the issuers.

If an issuer of securities does not maintain a register, all of the securities issues are described as
unregistered or bearer securities. Proof of ownership and the right to transfer the security will depend
on physically handing over the shares and executing any other documentation to affect the validity
of a transfer of ownership. However, no formal registration with the issuer of the security is required.
Many short-term instruments which are issued in the money markets, such as commercial paper and
bills of exchange, will tend to be issued in bearer form. Bunds, which are long-term fixed-income debt
instruments issued by the German government, are also bearer instruments.

Owners of bearer instruments will usually place these for safekeeping with a custodian or nominee,
who will also take on the responsibility of collecting dividends or coupon income as appropriate. The
obligation for disclosure of the formal ownership of bearer securities can become an issue if there are
grounds to suspect that there has been any criminal wrongdoing or tax evasion on the part of the actual
owner of a bearer security. The default position is that the information regarding the actual owner
should be treated as a matter of confidentiality, unless the actual owner consents to declaration of this
information.

The key characteristics of bearer securities are:

• Bearer securities are easier to transfer since there is no register.

• Transfer of ownership is normally as simple as the physical transfer of certificates of ownership.

However, this does raise a few problems:

• It is difficult for the authorities to monitor ownership, making them attractive investments for
money launderers.
• The issuing company has difficulty knowing to whom dividend or interest payments should be sent.
• The actual physical security of the certificates is of greater importance and can increase the cost of
holding the investment.

263
1.5.3 Legal Title
To have legal title means having clear and enforceable ownership of an asset or property.

The term ‘title’ can be defined more specifically as having the legal rights of ownership, possession and
custody, evidenced by a legal document (instrument) such as a bill of sale, certificate of title or title deed.
Legal title empowers its holder to control and dispose of the property, and serves as a link between the
title holder and the property itself.

In law, to prove the ownership of an asset or property requires the ability to be able to show legal title
to that asset, and this is usually provided by a legal document, which establishes unequivocally that
the rights of ownership have been conveyed or transferred to the person who claims ownership. This
also provides the simple answer that legal title is a valid and enforceable claim to ownership. To provide
an example, from a legal perspective, of how title is transferred, it is worth considering the transfer of
ownership into a trust. Under a bare trust arrangement, as with any trust, assets are transferred into
trust by the settlor. At this point the settlor gives up the legal title to the assets. They cease to be their
property, and instead become the property of the trust.

1.5.4 Beneficial Ownership or Interest

The case of transfer to a trust was cited above but the case of a nominee or custodian having legal title
to an asset which is held on behalf of the actual owner serves to highlight the difference between legal
title and beneficial ownership.

Large institutions as a matter of course, as well as smaller investors by choice, will often want to avoid
the administrative tasks connected with registered title of shares and other investments. If an investor
wishes to retain the right to participate in all corporate actions but, for whatever reason, does not want
to be the registered owner of a security, the appropriate vehicle and legal form to use is for the investor
to appoint a nominee to hold the securities.

The nominee – often a stockbroker or custodian – takes the registered title to the shares and all the
responsibilities that go with it but the nominee’s client retains the benefits of ownership, mainly the
dividends and capital growth. It is the client that ultimately receives all of the income generated by
the shares. The nominee is referred to as the legal owner of the shares and the client is known as the
beneficial owner.

The beneficial owner who has appointed a nominee or custodian to hold the registered title of a security
will, as a result of the ‘pass-through’ arrangements incorporated in the custodian or nominee agreement,
be entitled to receive dividends arising for that security, coupon payments or entitlements under rights
issues and other capitalisation issues and, in general, have all of the benefits and obligations of the
corporate actions undertaken by the issuer of the security.

264
 Settlement, Safe Custody and Prime Brokerage

1.6 Nominees

Learning Objective
5.1.6 Understand the characteristics of nominees: designated nominee accounts; pooled nominee
accounts; corporate nominees; details in share register; legal and beneficial ownership

1.6.1 Background
UK company law prevents registrars and companies from recognising anyone other than the name on
register or, in the case of a corporation, its duly appointed attorney. Institutional investors employing

5
professional investment management firms to manage their assets are highly unlikely to hold these
securities in their own name (‘name on register’). The reason for this is simple. The person whose name
appears on the share register receives every piece of documentation sent out by the company and is
obliged to sign all share transfers and other relevant forms such as instructions for rights issues and
other corporate events.

To ensure safe custody of assets and remove this administrative burden from the investor, thus allowing
the speedy processing of transfers, institutional (and, increasingly, private client) shareholdings are held
in the names of nominee companies.

Nominee arrangements have long been established as the mechanism by which asset managers and
custodians can process transactions on behalf of their clients. Given that many investment management
firms outsource some or all of their investment administration activities to specialist custodians, the
vast majority of institutional shareholdings in fact now reside in nominee accounts overseen by these
specialist custodians.

As far as the company is concerned, the nominee name appearing on its share register is the legal owner
of the shares for the purposes of benefits and for voting. However, as explained in section 1.5, beneficial
ownership continues to reside with the underlying client.

It is this separation of ownership which allows the custodians, under proper client authorities, to transfer
shares to meet market transactions and to conduct other functions without the registrar requiring sight
of the signature or seal of the underlying client.

Registrars cannot recognise a trust as the beneficial owner of shares, so, in order to look beyond the
legal ownership of any holding, the registrar can issue at any time a notice under Section 793 of the
Companies Acts. This will require the nominee company to disclose the name of the beneficial owner of
the shares, so that at least the company may be aware for whom the nominee is acting.

A notice issued under Section 793 of the Companies Acts (which came into force on 20 January 2007
and replaced the Section 212 notice under the Companies Act 1985) allows a public company to issue
a notice requiring a person it knows, or has reasonable cause to believe, has an interest in its shares (or
to have had an interest in the previous three years) to confirm or deny the fact, and, if the former, to
disclose certain information about the interest, including information about any other person with an
interest in the shares.

265
1.6.2 Types of Nominee Companies
Nominees can be classified into three types:

• Pooled (or omnibus) – whereby individual clients are grouped together within a single nominee
registration
• Designated – where the nominee name includes unique identifiers for each individual client,
eg, XYZ Nominees Account 1, Account 2, Account 3, and so on
• Sole – where a single nominee name is used for a specific client, eg, ABC Pension Fund
Nominees ltd.

It is now generally accepted that there are no real advantages from a security point of view as to
which type of nominee arrangement is used to register the shares. However, how the shareholdings
are registered is of vital importance when it comes to voting. Clients brought together with others in
a pooled nominee have no visibility to the company; it is the single nominee name, covering multiple
clients, which the company recognises. Importantly, from a voting perspective, it is therefore only
the single bulk nominee who is entitled to vote. No separate entitlement accrues from the registrar’s
standpoint to each individual client making up the total holding.

Another disadvantage of the use of a nominee is that some companies offer their shareholders certain
perks, such as discounts on their products. By using a nominee (either a designated or a pooled
structure), the shareholder perks may not be available to the individual investor. This is simply because
the stockbrokers may be unwilling to undertake the necessary administration to facilitate the provision
of these perks.

One reason for registering shares in a designated or sole nominee name would be if the underlying
investor required dividends to be mandated to a particular bank account, rather than being collected
by the custodian, in which case registration in an omnibus account would not be practical. Both
designation and individual registration, as opposed to a pooled account, can help with some aspects of
auditing, and either affords a good control mechanism when identical trades may have been executed
for different clients (for example on the same date, for the same number of shares and for the same
settlement consideration).

One reason frequently cited by custodians for insisting on pooled nominee arrangements is the vexed
question of costs. However, operating a designated nominee account should give rise to few additional
costs from the custodian’s point of view, as the existing nominee name can easily be used with the
addition of a unique designation. While there may be a slight increase in the receipt of Section 793
requests and a small amount of extra work involved, for example in the receipt of separate income
payments, the actual procedures are identical and should be capable of being easily absorbed into the
existing administration and processing routines.

If the client insists on using a sole nominee name to register the shareholdings, this might involve
some costs for the custodian connected with the establishment of a nameplate nominee company, the
requisite appointment of directors and the completion of annual returns. The custodian may seek to
pass these comparatively meagre costs on to the client, but more usually they will be absorbed within
the standard custody tariff.

266
 Settlement, Safe Custody and Prime Brokerage

Neither of these two nominee approaches are likely to give rise to additional transaction charges
imposed on the custodian by CREST, the UK’s electronic share settlement system, as individual sales and
purchases are relayed across the system regardless of how the assets are registered. One area where
additional transactions may occur, giving rise to additional costs, is in respect of securities lending.

However, the CREST charges for such transactions are reasonably low and a client would need to
undertake a lot of loans and recalls for these transaction charges to become a significant amount. Such
small additional amounts need to be seen against the typical custody tariff for UK securities of around
one basis point (0.01%) of the value of assets under custody and a further charge of approximately £20
for each trade settled. Also, in the case of securities lending, the custodian usually retains a share of the
extra income generated. This is often around 30%, again drawing any additional transaction costs in
respect of loan movements created by a separately registered or designated nominee account.

5
1.6.3 Corporate Nominee
A corporate nominee (alternatively referred to as a corporate sponsored nominee) is when the issuing
company itself provides a facility for its smaller shareholders to hold their shares within a single
corporate nominee.

The corporate nominee is a halfway house between the pooled and the designated nominee structures
offered by stockbrokers. It will result in a single entry for all the shareholders together in the company’s
register (like the pooled nominee) but beneath this the issuing company (or its registrar) will be aware of
the individual holdings that make up the nominee. In a similar way to the designated nominee structure,
the company will be able to forward separate dividend payments to each of the individual shareholders,
as well as voting rights and other potential shareholder perks.

Shares held within a corporate nominee in dematerialised form enable quick and easy transfer through
CREST.

1.6.4 The Share Register

Shares in the UK are held in registered form. This means that the certificate is simply evidence of
ownership. The proof that counts is the name and address held on the company’s share register. There is
a statutory requirement for a minimum of one shareholder and for the details of shareholders to be put
on public record.

Upon incorporating a company (be it a new or ready-made shelf company or a tailor-made company),
one can either act as a shareholder in one’s own name, or a financial services firm equipped to handle
incorporations or a custodian can provide a nominee shareholder, with a view to securing corporate
privacy.

In other words, for the purpose of privacy, some clients do not wish to be identified as shareholders of
the companies that they have set up and will therefore wish to appoint nominee shareholders. These
nominee shareholders will hold the shares on trust for the beneficial owners and only they will be
identified on the register of shareholders.

267
Each nominee shareholder appointed will sign a declaration of trust to the beneficial owner that they
are holding the shares on behalf of the beneficial owner and will return the shares into the name of the
beneficial owner or will transfer them to another party as requested. A nominee shareholder is normally
a company created for the purpose of holding shares and other securities on behalf of investors.

1.6.5 Summary
Custodians and their nominees now control the majority of share registrations for institutional investors,
even for clients who may not have directly appointed custodians, but whose asset management firms
have outsourced their investment administration to these providers.

Custodians uniquely identify their clients’ holdings by segregating these in their computer systems, as it
is largely these systems that drive the calculation and application of dividends and other entitlements.
However, this segregation is not the same as having an individually identifiable holding for a particular
client on company share registers.

It is largely impractical for an institutional investor to achieve ‘name on register’, so the recognised
practice is to use nominee names whereby the custodian, or other duly authorised agent, is legally
entitled to perform the transfer and administration of the assets on behalf of, and under the authority of,
the underlying beneficial owner.

Many custodians prefer to pool all their clients into one single nominee registration but this does remove
the visibility of the underlying investor and makes individual client voting much more cumbersome.
Clients can request their custodian to adopt an individual registration solely for their particular
shareholdings. Typically this takes the form of a standard nominee name with a unique designation for
each client. The costs of such separate registration and its ongoing maintenance are minimal relative to
overall custody and securities lending charges and are often absorbed by the custodians.

2. Prime Brokerage and Equity Finance

2.1 Stock Lending

Learning Objective
5.2.1 Understand the purpose, requirements and implications of securities lending: benefits and
risks for borrowers and lenders; function of market makers, intermediaries and custodians;
effect on the lender’s rights; effect on corporate action activity; collateral; potential risks of lack
of consolidated disclosure by funds

Stock lending is the temporary transfer of securities by a lender to a borrower with agreement by the
borrower to return equivalent securities to the lender at a pre-agreed time.

268
 Settlement, Safe Custody and Prime Brokerage

There are two main motivations for stock lending: securities-driven, and cash-driven. In securities-driven
transactions, borrowing firms seek specific securities (equities or bonds), perhaps to facilitate their
trading operations. In cash-driven trades, the lender is able to increase the returns on an underlying
portfolio by receiving a fee for making its investments available to the borrower. Such transactions may
boost overall income returns, enhancing, for example, returns on a pension fund.

The terms of the securities loan will be governed by a securities lending agreement, which requires that
the borrower provide the lender with collateral in the form of cash, government securities, or a letter
of credit of value equal to or greater than the loaned securities. As payment for the loan, the parties
negotiate a fee, quoted as an annualised percentage of the value of the loaned securities. If the agreed
form of collateral is cash, then the fee may be quoted as a rebate, meaning that the lender will earn all
of the interest which accrues on the cash collateral, and will ‘rebate’ an agreed rate of interest to the
borrower.

5
Securities lending covers all sorts of securities including equities, government bonds and corporate
debt obligations. Securities lenders, often simply called ‘sec lenders’, are institutions which have access
to lendable securities. This can be asset managers, who have many securities under management,
custodian banks holding securities for third parties, or third-party lenders who access securities
automatically via the asset-holder’s custodian.

2.1.1 Benefits of Stock Lending

The initial driver for the securities lending business was to cover settlement failure. If one party failed
to deliver stock to you, it could mean that you were unable to deliver stock that you have already sold
to another party. In order to avoid the costs and penalties that can arise from settlement failure, stock
could be borrowed at a fee and delivered to the second party. When your initial stock finally arrived (or
was obtained from another source) the lender would receive back the same number of shares in the
security they lent.

More recently, the principal reason for borrowing a security is to cover a short position. As you are
obliged to deliver the security, you will have to borrow it. At the end of the agreement, you will have to
return an equivalent security to the lender. Equivalent in this context means fungible, ie, the securities
have to be completely interchangeable. Compare this with lending a ten-euro note: you do not expect
exactly the same note back, as any ten-euro note will do.

Securities lending and borrowing is often required, by matter of law, in order to engage in short selling.
In fact, regulations enacted in 2008 in the US, Australia and the UK, among other jurisdictions, required
that, before short sales were executed for specific stocks, the sellers first pre-borrow shares in those
issues. There is an ongoing debate among global policy makers and regulators about how to impose
new restrictions on short selling, and Germany took a unilateral step in banning the naked short selling
of CDSs (ie, where the short seller had no interest in the underlying security for the credit default
swap) in June 2010, during a period of turbulence for the eurozone. The Short Selling Regulation (SSR)
provides EU regulators and the FCA with the power to apply short- or long-term bans on short sales in
shares, and certain other financial instruments and this was utilised in various jurisdictions during the
COVID-19 pandemic.

269
The FCA lists the following positive aspects of stock lending in its guidance to the investment
community:

• It can increase the liquidity of the securities market by allowing securities to be borrowed
temporarily, thus reducing the potential for failed settlements and the penalties this may incur.
• It can provide extra security to lenders through the collateralisation of a loan.
• It can support many trading and investment strategies that otherwise would be extremely difficult
to execute.
• It allows investors to earn income by lending their securities on to third parties.
• It facilitates the hedging and arbitraging of price differentials.

2.1.2 Risks of Stock Lending

Many feel that securities lending could aid market manipulation through short selling, which can
potentially influence market prices. Short selling as such is not wrong (although market manipulation
certainly is) and stock lending can assist those that have sold stock short, thus adding liquidity to the
market.

As already noted, the debate about the merits and validity of short selling is sometimes emotionally
charged and often features in the rhetoric of politicians in populist attacks on the financial services
sector. It probably is fair to say that for most investment professionals who actually work in the financial
markets the notion that short selling in itself is an abusive practice is not palatable. There may be times
when the activity can be disruptive, but markets have a tendency to overreact in either direction, and
the periodic focus given to short selling when a market is moving down should be counterbalanced
by the tendency for markets to become too frothy and for long investors to become exuberant when
markets are rising.

Another alleged potential abuse is that of tax evasion. However, the act of stock lending itself does not
lead to tax evasion.

In the UK, those involved in securities lending will generally be supervised by the FCA. They will be
subject to the FCA’s Handbook, including the inter-professional conduct chapter of the Market Conduct
Sourcebook, and also subject to the provisions of the Financial Services and Markets Act on, among
other things, market abuse. They will also have regard to the provisions of the Stock Borrowing and
Lending Code, produced by the Stock Lending and Borrowing Committee, a committee of market
participants, chaired by the Bank of England and including a representative of the FCA.

Archegos Capital Management, on 26 March 2021, defaulted on margin calls from several global
investment banks. The firm had large, concentrated positions in ViacomCBS, Baidu, Vipshop, Farfetch,
and other companies, and used swaps rather than common stock to stealthily amass huge positions.
Like derivatives, short sales are also largely excluded from the need to disclose large holdings, while
if it had transacted in regular stocks it would have had to. The fund was also heavily leveraged and
transacted business with several banks which were thought to be unaware of Archegos’ large positions.

The SEC requires certain institutional investment managers to file a Form 13F, disclosing the names,
shares, and fair market value of certain securities over which the managers exercise control, but total
return swaps are not on the list of securities required to be disclosed. However, some reports have
suggested that Archegos-owned equities were in sufficient amounts that meant they should have
indeed filed a 13F.

270
 Settlement, Safe Custody and Prime Brokerage

As a result of exposure to Archegos, in April 2021, Credit Suisse reported losses of $5.5 billion, Morgan
Stanley nearly $1 billion, Japan’s Nomura Holdings $2 billion (later revised to $2.85billion) and UBS
Group AG $774 million – all in connection with Archegos’ failure.

As a result of this event, SEC officials are exploring how to increase transparency for the types of activity
that caused Archegos to default.

2.1.3 Legalities
Securities lending is legal and clearly regulated in most of the world’s major securities markets.
Most markets mandate that the borrowing of securities be conducted only for specifically permitted
purposes, which generally include to:

5
• facilitate settlement of a trade
• facilitate delivery of a short sale
• finance the security, or
• facilitate a loan to another borrower who is motivated by one of these permitted purposes.

Parties to a stock-lending transaction generally operate under a legal agreement, such as the Global
Master Securities Lending Agreement (GMSLA), which sets out the obligations of the borrower and
lender. The GMSLA was developed as a market standard for securities lending, drafted with a view
to compliance with English law and covers the matters which a legal agreement ought to cover for
securities lending transactions. The agreement is kept under review and amendments are periodically
made, although parties to an existing agreement need to agree that those amendments do apply.

2.1.4 Effect on a Lender’s Rights and Corporate Actions

When a security is loaned, the title of the security transfers to the borrower. This means that the
borrower has the advantages of holding the security, just as though they owned it – they can even lend
the securities on to another party. Specifically, the borrower will receive all coupon and/or dividend
payments, and any other rights such as voting rights. In most cases, these dividends or coupons must
be passed back to the lender in the form of what is referred to as a manufactured dividend. If the lender
wants to exercise its right to vote it should recall the stock in good time so that a proxy voting form can
be completed and returned to the registrar by the required deadline.

Similar issues are involved in other corporate actions such as a capitalisation issue. Technically the
consequences arising from any corporate action, such as a capitalisation matter or rights issue, by
the issuer of a security that has been lent to another would prima facie be to the benefit/cost of the
borrower. It is customary that these costs/benefits should flow back to the lender, and the exact manner
in which this will be implemented should be reflected in the securities lending agreement.

The term ‘securities lending’ is sometimes used erroneously as a synonym of ‘stock loan’. The latter term is
used in private hedged portfolio stock collateralised loan arrangements, where the underlying securities
are hedged so as to convert the variable asset to a relatively stable asset against which a usually non-
recourse or limited recourse loan can be placed.

271
2.1.5 Tax Consequences of Stock Lending
The tax position in relation to stock lending is complex and varies from country to country. If in doubt
those involved in stock lending should obtain professional advice from their tax specialist.

2.1.6 Collateral – Stock Lending versus Repo

While stock lending and sale/repurchase agreements (repos) are similar, the difference is that a stock
lender charges a fee to the borrower, whereas a repo counterparty pays (or receives) a rate of interest.

Example
A large pension fund manager with a position in a particular stock agrees that the security can be
borrowed by a securities lender. The securities lender, a prime broker or investment bank, will then allow
a hedge fund client to borrow the stock and sell it short. The short seller would like to buy the stock back
at a lower price and realise a profit when returning the security to the broker from whom it has been
borrowed.

Once the shares are borrowed and sold, cash is generated from selling the stock. That cash would
become collateral for the borrower. The cash value of the collateral is marked-to-market on a daily basis
so that it exceeds the value of the loan by at least 2%. The pension fund manager has access to the cash
for overnight investment and this enables the pension fund to maintain a long position in the stock. The
pension fund manager is able to earn additional income from lending the stock, and the hedge fund
manager is able, providing that their call that the price of the security is going to decline is correct, to
profit from the short sale. In addition, the prime broker earns a spread from facilitating the transaction
and also by providing this prime brokerage service to the hedge fund client.

2.1.7 Money Markets Committee

The Money Markets Committee (MMC) is a senior-level forum for market participants and the relevant
UK public authorities to discuss issues concerning the UK unsecured deposits and funding market, the
securities lending market and the repo market.

The MMC is chaired by the Bank of England (BoE). The Committee meets quarterly and also has two
permanent sub-committees: the UK Money Markets Code Sub-Committee and the Securities Lending
Committee

The objectives of the Money Markets Committee are:

1. to discuss important domestic and global market or structural developments affecting the UK
money-, repo- and securities-lending markets
2. where appropriate, to propose responses to any issues identified
3. to aid understanding and enhance monitoring of the functioning of the UK money markets
4. to endorse and facilitate continuing market-wide adoption of the UK Money Markets Code, a
voluntary code of good practice for the money and securities financing markets
5. to identify and address any high-level issues concerning contingency planning in the UK money
markets and payment systems, having regard to international developments.

272
 Settlement, Safe Custody and Prime Brokerage

International Securities Lending Association (ISLA)

The international trade organisation for the securities lending industry is the International Securities
Lending Association (ISLA).

2.2 Prime Broker Services

Learning Objective
5.2.2 Understand the purpose and main types of prime broker equity finance services and their
impact on securities markets: securities lending and borrowing; leveraged trade execution;
cash management; core settlement; custody; rehypothecation; repurchase agreements;
collateralised borrowing; tri-party repos; synthetic financing

5
Prime brokerage is the term given to a collection of services provided by investment banks to their
hedge fund clients and other asset management boutique firms.

Hedge funds are investment funds that are typically only open to a limited range of investors. They
tend to follow complex investment strategies, often involving derivatives. However, among the more
straightforward strategies adopted is the equity long/short strategy. This involves taking both long
positions in equities (in other words buying shares) and, at the same time, committing to sell equities
that are not held by the fund (described as selling short).

The hope is that the gain in one half of the strategy (the long or the short) will more than cover the loss
(or ‘hedge’) on the other half of the strategy (the short or the long). Selling short inevitably means that
the fund will need to borrow the securities it has sold until the position is unwound.

Whereas the managers of a hedge fund or alternative asset management vehicle are primarily concerned
with formulating and executing investment strategies, the actual execution and administration of the
fund’s account is usually left to the prime broker, which has the expertise and organisational systems
to offer more specialised and supportive services, and can also assist in providing additional credit and
financing facilities to the client funds.

The typical services that are provided by a prime broker include the following.

2.2.1 Securities Lending and Borrowing

Prime brokers can arrange for the appropriate shares to be borrowed to cover the hedge fund’s short
positions, and also use the fund’s long positions to lend to others and provide additional returns to the
fund as a result.

2.2.2 Leveraged Trade Execution

Many hedge funds will wish to use leverage in executing certain strategies, and in order to do so they
will often use the margin facilities provided by a prime broker. The broker will operate the margin
account in accordance with an underlying security arrangement in which the fund pledges collateral,
which may be financed via a repo, or where the margin account is subject to the constraints of mark-to-
market on a regular basis.

273
With the latter, if the fund’s marks fall below a certain stipulated threshold, the fund will be required
to provide more collateral to the prime broker or the broker is entitled to start liquidating investment
positions held by the fund in order to restore the margin account to an acceptable level of leverage as
agreed in the security agreement.

2.2.3 Cash Management

Prime brokers will also use opportunities that they have available to maximise the return that is
generated from any unfettered cash which is held by the fund and which has not been used as collateral
for a repo or in a margin account.

2.2.4 Core Settlement

The prime broker will take the necessary steps to make sure that any securities purchased become the
property of the fund and the appropriate cash is received in a timely manner for any sales made of the
fund’s securities.

2.2.5 Custody
The prime broker may provide the services of a custodian, ie, registering and keeping safe the securities
held by the fund, and processing any corporate actions promptly and in accordance with the fund’s
wishes. Sometimes this role will be handled by a separate custodian.

2.2.6 Rehypothecation
In addition to holding collateral and having a charge over the fund’s portfolio, the prime broker might
also require a right to re-charge, dispose of or otherwise use the customer’s assets which are subject
to the security, including disposing of them to a third party. This is commonly described as a right of
rehypothecation. When assets have been rehypothecated, they become the property of the prime
broker as and when the prime broker uses them in this way, for instance by depositing rehypothecated
securities with a third-party financier to obtain cheaper funding, or by lending the securities to another
client.

2.2.7 Repurchase Agreements

Repurchase agreements (or repos) are essentially when the prime broker arranges the sale of securities
owned by the fund for cash, while agreeing to buy back the equivalent securities later for a slightly
inflated price. The increase in price is effectively the borrowing cost of the cash, and is often referred to
as the repo rate.

In the case of a tri-party repo, a custodian bank or clearing organisation acts as an intermediary between
the two parties to the repurchase or repo agreement outlined above. The tri-party agent is responsible
for the administration of the transaction including collateral allocation, the marking-to-market, and,
when required, the substitution of collateral. The lender and the borrower of cash both enter into tri-
party transactions in order to avoid the administrative burden of the simpler form of bilateral repos.
Moreover, there is an added element of security in a tri-party repo because the collateral is being held by
an agent and the counterparty risk is reduced.

274
 Settlement, Safe Custody and Prime Brokerage

2.2.8 Collateralised Borrowing

Prime brokers advance cash to the customer against the security of a first fixed charge over the
customer’s portfolio. In the event of the customer’s default, this gives the prime broker a right of
recourse against the charged assets for the amounts owing to it. The availability of the portfolio as
collateral in this way should enable the bank to provide loans at more competitive rates than is the case
with an unsecured loan.

2.2.9 Synthetic Financing

This is when the prime broker will create exposure to particular securities by using derivatives, such
as swaps, rather than directly buying and holding the securities themselves. This route is generally
substantially cheaper than outright purchases.

275
 End of Chapter Questions

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

1. What is the settlement period for exchange-listed equities in Germany?

Answer reference: Section 1.1.4

2. What body does the acronym JASDEC refer to and what is its function?
Answer reference: Section 1.1.5

3. In relation to settlement of securities transactions, what is liquidity risk?

Answer reference: Section 1.2

4. What is the function of the Committee on Payment and Settlement Systems?

Answer reference: Section 1.2.1

5. What is the goal of straight-through processing (STP) in trade settlements?

Answer reference: Section 1.2.2

6. What is the principal reason behind the difference between stamp duty and stamp duty reserve
tax?
Answer reference: Section 1.3

7. Are trades using contracts for difference (CFDs) subject to stamp duty or stamp duty reserve tax?
Answer reference: Section 1.3.1

8. Provide at least one reason why a local custodian may be preferred by a client to a regional
custodian.
Answer reference: Section 1.4.3

9. When investors elect to have a nominee or custodian hold the registered title to securities that
they own, how does it affect their right to the benefits of dividends and other corporate actions?
Answer reference: Section 1.5.4

10. What is the difference between a repo and a tri-party repo?

Answer reference: Section 2.2.7

276
Chapter Six

Securities Analysis
1. Statements of Financial Position 279

2. Environmental, Social and Governance (ESG) 321

This syllabus area will provide approximately 6 of the 80 examination questions

6
278
 Securities Analysis

1. Statements of Financial Position

1.1 Balance Sheets

Learning Objective
6.1.1 Understand the purpose, structure and relevance to investors of statements of financial
position

1.1.1 Statement of Financial Position

A company’s statement of financial position (balance sheet) is a snapshot of its overall financial position
at a particular moment in time. The construction of the statement of financial position is underpinned

6
by the accounting equation assets equals liabilities plus equity and its presentation is split into two
halves that must always balance each other exactly. The key information that it provides to shareholders,
customers and other interested parties is what the company owns (its assets), what the company owes
to others (its liabilities or creditors) and the extent to which shareholders are providing finance to the
company (the equity).

Note that the Revised Accounting Standards of the International Accounting Standards Board (IAS 1: The
Presentation of Financial Statements) provide new terminology for the term balance sheet which is now
the statement of financial position.

The statement of financial position should reflect all of the reporting company’s assets and liabilities
but, over the years, companies and their advisers often developed creative structures to enable items to
remain off-balance sheet rather than on-balance sheet. The International Accounting Standards Board
(IASB) and the adoption of its accounting standards should ensure that everything that should appear on
the statement of financial position is categorised as such, and those items that are legitimately not assets
or liabilities of the company should remain off-balance sheet (off the statement of financial position).

The typical format of a statement of financial position, with example figures, is provided on the next
page for a fictitious company called XYZ plc. There will be further discussion of the actual performance of
this company in this chapter and we shall look at separate entries on the statement of financial position,
statement of profit and loss and statement of cash flows for XYZ plc. In sections 1.4, 1.5 and 1.6, we will
examine certain financial ratios, using key information available in a company’s financial statements,
to facilitate financial ratio analysis which, in turn, provides useful guidance to investors when they are
deciding where to allocate investment funds.

The statement of financial position of XYZ plc is drawn up as of 31 December 2018, which is in accordance
with its fiscal year, ie, the annual period selected for its accounts. In the case of XYZ plc, the fiscal year
also coincides with the calendar year, but this is not a necessary requirement as companies may elect a
different annual period from the calendar year to use as their fiscal year.

279
 XYZ plc Statement of Financial Position as at 31 December 2020

All amounts are in £000s

Assets
Non-current assets
Property, plant and equipment 8,900
Intangible assets 2,100
Investments 300
Total non-current assets 11,300
Current assets
Inventories 3,600
Accounts receivable 2,600
Short-term investments 120
Cash 860
Total current assets 7,180
Total assets 18,480
Non-current liabilities
Bank loans 1,780
Finance leases 1,120
Provisions for re-organisation 145
Total non-current liabilities –3,045
Current liabilities
Accounts payable 5,140
Finance lease current obligation 130
Bank overdraft 1,080
Tax 1,110
Total current liabilities –7,460
Net assets 7,975
Capital
Share capital – 5 million £1 ordinary shares 5,000
Share capital – preference shares 890
Share premium account 330
Revaluation reserve 380
Retained earnings 1,375
Shareholders’ funds 7,975

280
 Securities Analysis

The statement of financial position is shown in a format prescribed by the Companies Acts for the
statement of financial positions of plcs. Although not seen in the example, the format requires the
previous year’s comparative statement of financial position numbers to be set out alongside those of the
current year, and for a numerical reference to be inserted in the notes column to support explanatory
notes to the various statement of financial position items.

1.1.2 The Structure of a Statement of Financial Position

Assets
An asset is anything that is owned and controlled by the company and confers the right to future
economic benefits. Statement of financial position assets are categorised as either non-current assets or
current assets.

Non-current assets are those in long-term, continuing use by the company. They represent the major
investments from which the company hopes to make money. Non-current assets are categorised as:

6
• tangible, or
• intangible.

A company’s tangible non-current assets are those that have physical substance, such as land and
buildings and plant and machinery. Tangible non-current assets are initially recorded in the statement
of financial position at their actual cost or book value. However, in order to reflect the fact that the asset
will generate benefits for the company over several accounting periods, not just in the accounting
period in which it is purchased, all tangible non-current assets with a limited economic life are required
to be depreciated. The concept of depreciation will be covered in more detail later in this section.

IAS 16 allows a choice of accounting. Under the cost model, the asset continues to be carried at cost.
Under the alternative revaluation model the asset can be carried at a revalued amount, with revaluation
required to be carried out at regular intervals.

Intangible non-current assets are those assets that, although without physical substance, can be
separately identified and are capable of being sold. Ownership of an intangible non-current asset
confers rights known as intellectual property. These rights give a company a competitive advantage
over its peers and commonly include brand names, patents, trademarks, capitalised development costs
and purchased goodwill.

Purchased goodwill arises when the consideration, or price, paid by an acquiring company for a target
company exceeds the fair value of the target company’s separable, or individually identifiable, net
assets. This is not necessarily the same as the book, or statement of financial position, value of these net
assets:

Purchased Goodwill =
(Price Paid for Company – Fair Value of Separable Net Tangible and Intangible Assets)

Purchased goodwill is capitalised and included in the statement of financial position. Once capitalised,
it cannot be revalued.

281
Fixed-asset investments are typically long-term investments held in other companies. They are initially
recorded in the statement of financial position at cost, and then subsequently revalued (or marked-
to-market) at their fair value at each period end. Any gains or losses are reflected directly in the equity
section of the statement of financial position and disclosed in the statement of changes in equity.
However, if they suffer an impairment in value, then such a fall is charged to the statement of profit and
loss.

If the shareholding represents at least 20% of the issued share capital of the company in which the
investment is held, or if the investing company exercises significant influence over the management
policies of the other, then the investing company is subject to additional reporting requirements.

Current assets are those assets purchased with the intention of resale or conversion into cash, usually
within a 12-month period. They include stocks (or inventories) of finished goods and work in progress,
the debtor balances that arise from the company providing its customers with credit (trade receivables)
and any short-term investments held. Current assets also include cash balances held by the company
and prepayments. Prepayments are simply when the company has prepaid an expense, as illustrated by
the following example:

Example
ABC plc draws up its statement of financial position on 31 December each year. Just prior to the year end
ABC pays £25,000 to its landlord for the next three months’ rental on its offices (to the end of March in
the next calendar year).

This £25,000 is not an expense for the current year – it represents a prepayment towards the following
year’s expenses and is, therefore, shown as a prepayment within current assets in ABC’s statement of
financial position.

Current assets are listed in the statement of financial position in ascending order of liquidity, and appear
in the statement of financial position at the lower of cost or net realisable value (NRV).

Net Realisable Value (NRV)

NRV is defined as the estimated selling price of each stock item, less any further costs to be incurred
in both bringing the stock, work in progress or raw materials into a saleable condition, including any
associated selling and marketing costs.

Therefore, if for reasons such as obsolescence the NRV of the stock has fallen below cost, the item must
be written down to this NRV for statement of financial position purposes.

Determining what constitutes cost should be relatively straightforward, unless the company purchases
vast quantities of stock in different batches throughout its accounting period, making the identification
of individual items or lines of stock particularly difficult when attempting to match sales against
purchases.

282
 Securities Analysis

In such instances, cost can be determined by making an assumption about the way stock flows through
the business. Companies can account for their stock on one of three bases:

• First in first out (FIFO) – FIFO assumes that the stock first purchased by the business is the first to be
sold. Therefore, the value of the closing stock at the end of the accounting period is given by the cost
of the most recent stock purchased. This produces a closing stock figure in the statement of financial
position that closely resembles the current market value of the stock. It also results in the highest
reported profit figure of the three bases in times of rising prices.
• Last in first out (LIFO) – LIFO assumes that the most recent stock purchased by the company is the
first to be sold. IAS 2 does not permit the use of LIFO since, in times of rising prices, the statement of
financial position value of closing stock will be that of the stock first purchased and will therefore not
resemble current prices. It also produces the lowest reported profit figure of the three bases.
• Weighted average cost (WAC) – WAC values closing stock at the weighted average cost of stock
purchased throughout the accounting period. This method produces a closing stock figure and a
reported profit between that of the FIFO and LIFO methods.

6
Depreciation and Amortisation
Depreciation is applied to tangible non-current assets, such as plant and machinery. An annual
depreciation charge is made in the year’s statement of profit and loss. The depreciation charge allocates
the fall in the book value of the asset over its useful economic life. This requirement does not, however,
apply to freehold land and non-current asset investments which, by not having a limited economic life,
are not usually depreciated.

By reducing the book value of tangible non-current assets over their useful economic lives, depreciation
matches the cost of the asset against the periods from which the company benefits from its use.

On occasion, tangible assets such as land are not depreciated but periodically revalued. This is done
on the basis of providing the user of the accounts with a truer and fairer view of the assets, or capital,
employed by the company. To preserve the accounting equation (total assets = equity + liabilities), the
increase in the asset’s value arising on revaluation is transferred to a revaluation reserve, which forms
part of the equity.

Closely linked to the idea of depreciating the value of a tangible asset over its useful economic life is the
potential need for intangible assets to be amortised over their useful economic lives. Amortisation, like
depreciation, is simply a book entry whose impact is felt in the company’s reported income and financial
position but which does not impact its cash position.

Liabilities
A liability is an obligation to transfer future economic benefits as a result of past transactions or events;
more simply, it could be described as money owed to someone else. Liabilities are categorised according
to whether they are to be paid within, or after more than, one year.

Non-current liabilities comprise the company’s borrowing not repayable within the next 12 months.
This could include bond issues as well as longer-term bank borrowing. In addition, there is a separate
sub-heading for those liabilities that have resulted from past events or transactions and for which
there is an obligation to make a payment, but the exact amount or timing of the expenditure has yet
to be established. These are commonly referred to as provisions. Provisions may arise as a result of the
company undergoing a restructuring, for example.

283
Given the uncertainty surrounding the extent of such liabilities, companies are required to create a
realistic and prudent estimate of the monetary amount of the obligation, once they are committed
to taking a certain course of action. Current liabilities include the amount the company owes to its
suppliers, or trade payables, as a result of buying goods and/or services on credit, any bank overdraft,
and any other payables such as tax, that are due within 12 months of the statement of financial position.

Equity
Equity is referred to in a number of ways, such as shareholders’ funds, owners’ equity or capital. Equity
usually consists of three sub-elements: share capital, capital reserves and revenue reserves. Additionally,
when group accounts are presented, there may be minority interests within the group equity figure.

• Authorised and issued share capital – as a company is created, the share capital with which the
company proposes to be registered, and the division of that share capital into shares of a fixed
amount, is decided upon. This capital amount is known as the authorised share capital and acts as
a ceiling on the amount of shares that can be issued, although it can subsequently be increased by
the passing of an ordinary resolution at a company meeting. The issued share capital is the actual
number of shares that are in issue at any point in time.
• Share capital – this is the nominal value of equity and preference share capital the company has in
issue and has called up. This may differ from the amount of share capital the company is authorised
to issue as contained in its constitutional documents. The company may have only called up some
of its share capital and may not have issued all of the share capital that is authorised. Under the
Companies Act 2006, the requirement to have an authorised share capital has been removed.
Instead, directors can be authorised by the Articles or by a resolution to allot shares up to a
maximum amount and for a limited period.
• Capital reserves – capital reserves include the revaluation reserve, share premium reserve and
capital redemption reserve.
• The revaluation reserve arises from the upward revaluation of tangible and intangible assets.
• The share premium reserve arises from issuing shares at a price above their nominal value.
• The capital redemption reserve is created when a company redeems, or buys back, its shares
and makes a transfer from its revenue reserves to its capital reserves, equal to the nominal value
of the shares redeemed.
Capital reserves are not distributable to the company’s shareholders as apart from forming part of
the company’s capital base, they represent unrealised profits, though they can be converted into a
bonus issue of ordinary shares.
• Retained earnings – retained earnings is a revenue reserve and represents the accumulation of
the company’s distributable profits that have not been distributed to the company’s shareholders
as dividends, or transferred to a capital reserve, but have been retained in the business. Retained
earnings should not be confused with the amount of cash the company holds, which is sometimes
simply referred to as the notion that ‘profit is not cash’.
• Minority interests – these arise when a parent company controls one or more subsidiary
companies, but does not own all of the share capital. The equity attributable to the remaining
shareholders is the minority interests and this is reflected in the statement of financial position.

In total, equity is the sum of the called-up share capital, all the capital reserves and the revenue reserves:

Equity = Share Capital + Reserves

284
 Securities Analysis

1.1.3 The Relevance of the Statement of Financial Position to Investors

Prospective investors will make use of all of a company’s accounts and financial statements to assess the
viability of investing in a business. In addition, financial institutions such as commercial banks, credit
ratings agencies and investment banks will also pay particular attention to a company’s statement of
financial position, in order to decide whether to provide working capital in the form of a revolving credit
facility or overdraft, or when evaluating whether to facilitate the issuance of debt instruments such as
debentures to finance expansion and other significant expenditures.

As part of the exercise of due diligence by any potential investor in a solicitation for loan stock or bonds by a
company, the statement of financial position will be one of the key documents to assess the overall financial
soundness of a potential purchase of such securities.

In addition to the specific information made available by a company’s statement of financial position,
IAS 1 requires companies to present a separate Statement of Changes in Equity (SOCE) as one of the
components of financial statements. Companies are obliged to provide details of transactions with

6
owners, showing separately contributions by and distributions to owners and changes in ownership
interests in subsidiaries that do not result in a loss of control. For small- and medium-size enterprises
(SMEs), the SOCE should show all changes in equity including:

• total comprehensive income

• owners’ investments
• dividends
• owners’ withdrawals of capital, and
• treasury share transactions.

A vital consideration for any investor or lender is the relative size of shareholders’ equity compared
to debt, as this provides insight about how a company is financing its operations. Large short-term
liabilities, for example, increase a company’s sensitivity to interest rate changes and also influence
the credit rating which is granted to a company by a credit-rating agency. Credit-rating agencies will
in fact be one of the principal users of corporate statement of financial position information, and the
ratings which are provided to the investment community will have a major impact on to what extent
the company is perceived as a credit risk and consequently the terms that need to be provided by the
company (ie, the amount of the coupon payment) in a bond offering.

The assets portion of the statement of financial position can contain large amounts of intangible
assets. Assets such as goodwill are also worth close examination by investors since, if they become
disproportionate when compared to other current and long-term assets, this could be a warning that
there are other issues which require closer attention.

The notes (or footnotes) to the statement of financial position and to the other financial statements
are part of the financial statements. The notes inform the readers about such things as significant
accounting policies, commitments made by the company, and potential liabilities and potential losses.
The notes contain information that is critical to properly understanding and analysing a company’s
financial statements.

285
Some of the more pertinent details that an investor would want to examine in the notes to the financial
statements are the following:

• Companies are required to disclose the accounting policies that have been used to present the
company’s financial condition and results. Disclosure of any items which are extraordinary will take
on special significance. The comments will also provide insight into the quality of judgements of
the key management team, including any specific comments from the managing director/chief
executive officer as well as the chairman of the board.
• Footnotes will provide detailed information about the company’s current and deferred income
taxes.
• Footnotes need to disclose the company’s pension plans and other retirement or post-employment
benefit programmes. The notes contain specific information about the assets and costs of these
programmes, and indicate whether the plans are adequately funded.
• The notes also contain information about stock options granted to officers and employees, including
the method of accounting for stock-based compensation and the effect of the method on reported
results.

All of these items, as well as the statement from the chairman of the board will be scrutinised carefully
by the investment community to determine how willing they are to purchase securities from the issuer,
and on what terms such securities should be offered.

Additionally, investors will want to examine the external auditor’s report and any comments or
qualifications to the financial statements, as these could, if they are not routine, be a warning that there
may be deeper issues that require further investigation.

1.1.4 Trend Analysis

Financial ratios are examined in section 1.4 of this chapter. Ratios which measure liquidity, asset
turnover and dividend cover are based upon quantitative information about a company which is found
in its financial statements, including the statement of financial position.

Over and beyond ratio analysis, there is considerable benefit to be gained from what can be called trend
analysis. In this case the current statement of financial position, for example, is compared to those for
the preceding years, often five, with a view to establishing the trends of the data and to provide early
indicators for investors to changes which might be a cause for concern.

One technique for examining trends is known as common-size analysis. Common-size analysis (also
called vertical analysis) expresses each line item on a single year’s statement of financial position as a
percentage of one line item, which is referred to as a base amount. The base amount for the statement
of financial position is usually total assets (which is the same number as total liabilities plus stockholders’
equity) and for the statement of profit and loss it is usually net sales or revenues.

By comparing two or more years of common-size statements, changes in the mixture of assets, liabilities
and equity become evident. On the statement of profit and loss (see section 1.2), changes in the mix of
revenues and in the spending for different types of expenses can be identified.

The common-size statement is a valuable tool for identifying changes in the way in which assets
employed are financed and the breakdown of the assets employed.

286
 Securities Analysis

Statement of Financial Position Summary for XYZ plc

2016 2017 2018 2019 2020
£000s £000s £000s £000s £000s
Assets
Non-current assets 400 500 520 600 550
Current assets 420 460 530 660 650
Total 820 960 1,050 1,260 1,200
Financing
Share capital 200 200 210 300 400
Capital reserves 120 130 160 200 220
Retained earnings 216 340 300 310 330

6
Loans 50 150 150 150 50
Current liabilities 234 140 230 300 200
Total 820 960 1,050 1,260 1,200

Figures used are for illustrative purposes only.

The table above shows a summary statement of financial position for XYZ plc as of five year-ends.
It provides a high-level overview of the financial state of the company but the interpretation of the
numbers in each column is facilitated by a comparison of each row of the table to the two base amounts
of the total for each year of the assets and the total for each year of the liabilities. In this manner the
breakdown or composition of the assets and liabilities and financing becomes more readily apparent.

For example, we can see that, in 2017, XYZ plc took an additional £100,000 loan, and that in 2020,
the loan was paid back, essentially through the issue of new share capital. It can also be more clearly
seen, in the common-size statement which is calculated from the previous table, and which follows,
that the company is experiencing a steady decline in the ratio of non-current assets to the total assets
throughout the period.

287
 Common-Size Statement of Financial Position Summary for XYZ plc
2016 2017 2018 2019 2020
Percentages
Assets
Non-current assets 49% 52% 50% 48% 46%
Current assets 51% 48% 50% 52% 54%
Total 100% 100% 100% 100% 100%
Financing
Share capital 24% 21% 20% 24% 33%
Capital reserves 15% 14% 15% 16% 18%
Retained earnings 26% 35% 29% 25% 28%
Loans 6% 16% 14% 12% 4%
Current liabilities 29% 15% 22% 24% 17%
Total 100% 100% 100% 100% 100%

In 2016, the company’s loan amount of £50,000 represented just 6% of its liabilities/financing, whereas
after taking the loan of £100,000 in 2017, this ratio jumped to 16% of the company’s liabilities. When
the £100,000 of new shares were issued, and added to the share capital of the company in 2020, the
proceeds were used to pay back the loan and the ratio of loans to total financings dropped back to 4%,
indicating that the coverage has less leverage or gearing on its statement of financial position.

In summary, the trends that are discernible using the above approach will reveal what is happening
beneath the surface of the day-to-day operations of a company. By performing such an analysis, it
is possible to have much greater insight into a company’s financial position than is accessible from
consideration of just one year’s statement of profit and loss, useful as that is.

1.2 Statement of Profit and Loss

Learning Objective
6.1.2 Understand the purpose, structure and relevance to investors of statements of profit and loss

1.2.1 The Purpose of a Statement of Profit and Loss

The statement of profit and loss (income statement) summarises the amount of income earned by a
company, and the expenditure incurred by that company, over the accounting period. The purpose of
the statement of profit and loss is to detail how much profit (or loss) has been earned as a result of the
company’s ongoing operations. As a result, the statement of profit and loss is often referred to as the
profit and loss account. However, since the statement of profit and loss is constructed on an accruals
basis, rather than a cash basis, profit must not be confused with the company’s cash position.

288
 Securities Analysis

In accordance with the statement of financial position, the format of the statement of profit and loss
is governed by the Companies Acts and its construction is underpinned by accounting standards and
industry best practice.

Additionally, IAS 1 has brought about changes to the statement of profit and loss. The amendment
requires companies to present other comprehensive income items such as revaluation gains and losses,
and actuarial gains and losses, as well as the usual statement of profit and loss items, on the face of the
primary financial statements. IAS 1 allows this information to be presented either in one statement of
comprehensive income or in two separate statements: a statement of profit and loss and a statement of
comprehensive income.

The amount of profit earned over an accounting period has an impact on the company’s ability to pay
dividends and how much can be retained to finance the growth of the business from internal resources.

There are different ways of presenting a statement of profit and loss and there is no uniform agreement
as to which is the preferred method. In essence the two-column approach, which is shown in the

6
example statement of profit and loss for XYZ plc on the next page, is the most common format, although
there are variations as to exactly the format followed.

In the following example, the statement shows the most recent set of results for fiscal year 2018 and
alongside, for comparative purposes and to make the data more useful for investors who are looking
at the underlying trends of the business (as discussed later in this section), the comparable figures for
the year ending 2017 are shown. Also presented in this format are, for each line item, the percentage of
the amount shown in relation to the total revenue or turnover of the business, which enables the reader
to discern any notable shifts or changes in the broad categories of expenditures and other variables
displayed.

289
 Statement of Profit and Loss for XYZ plc as at 31 December 2020
All figures are in £000s except per share earnings
% of % of
2019 2020
revenue revenue
Revenue 65,690 66,478
Cost of sales (46,310) (47,375)
Gross profit 19,380 30% 19,103 29%
Distribution costs (8,090) 12% 13%
Administration (7,800) 12% (8,333) 12%
Loss on disposal of plant (1,309) 2% (7,956) 0%
Operating costs (17,199) 26% (16,289) 25%
Operating profit 2,181 3% 2,814 4%
Financial Income
Income from affiliate 206 200
Interest receivable 350 123
Interest payable (1,530) (1,561)
Profit before taxation 1,207 2% 1,577 2%
Taxation (422) 35% (522) 35%
Profit after taxation 785 1% 1,025 2%
Preference share dividends (124) (126)
Profit attributable to the group 661 898
Dividends
Ordinary 349 356
Earnings per share 13.21 17.97
Dividend per share 6.98 7.12

1.2.2 The Structure of a Statement of Profit and Loss

Revenue
The statement of profit and loss starts with one of the most important things in any company’s accounts:
its sales revenues. In accounts, sales revenues are generally referred to as revenue, or sometimes
turnover. It is simply everything that the company has sold during the year, regardless of whether it has
received the cash or not. For a manufacturer, revenue is the sales of the products that it has made. For
a company in the service industry, it is the consulting fees earned or perhaps commissions earned on
financial transactions.

290
 Securities Analysis

Revenue is calculated on an accruals basis and represents sales generated over the accounting period
regardless of whether cash has been received. However, since there are no prescriptive rules as to when
revenue should be recognised in the profit and loss account, this leaves scope for subjective judgement.

IAS 18 prescribes the accounting treatment for revenue arising from certain types of transactions and
events, essentially only allowing recognition of revenues when appropriate. Revenue is recognised in the
statement of profit and loss when it meets the following criteria:

• It is probable that any future economic benefit associated with the item of revenue will flow to the
company.
• The amount of revenue can be measured with reliability.

The IASB has published guidance on when revenue from the sale of goods, rendering of services and
interest, royalties and dividends should be recognised.

Revenue arising from the sale of goods should be recognised when all of the following criteria have been

6
satisfied:

• The seller has transferred to the buyer the significant risks and rewards of ownership.
• The seller retains neither continuing managerial involvement to the degree usually associated with
ownership nor effective control over the goods sold.
• The amount of revenue can be measured reliably.
• It is probable that the economic benefits associated with the transaction will flow to the seller.
• The costs incurred or to be incurred in respect of the transaction can be measured reliably.

For revenue arising from the rendering of services, revenue should be recognised based on the stage of
completion of the transaction, providing that all of the following criteria are met:

• The amount of revenue can be measured reliably.

• It is probable that the economic benefits will flow to the seller.
• The stage of completion at the statement of financial position date can be measured reliably.
• The costs incurred, or to be incurred, in respect of the transaction can be measured reliably.

When the criteria are not met, revenue should be recognised only to the extent of the expenses that are
recoverable.

For interest, royalties and dividends, revenue should be recognised as follows:

• Interest – on a time proportion basis that takes into account the effective yield.
• Royalties – on an accruals basis.
• Dividends – when the shareholder’s right to receive payment is established.

Cost of Sales
Cost of sales = [Opening stock (if any) + Purchases – Closing stock]

The cost of sales is arrived at by adding purchases of stock made during the accounting period, again by
applying accruals rather than cash accounting, to the opening stock for the period, and deducting from
this the value of the stock that remains in the business at the end of the accounting period.

291
The opening stock figure used in this calculation will necessarily be the same as the closing stock figure
that appears in the current assets section of the statement of financial position from the previous
accounting period.

Gross Profit
The gross profit figure is simply the revenue less the cost of sales.

Operating Profit
Operating profit is also referred to as profit on operating activities. It is the gross profit, less other
operating expenses, that the company has incurred. These other operating expenses might include costs
incurred distributing products (distribution costs) and administrative expenses such as management
salaries, auditors’ fees and legal fees. Administrative expenses also include depreciation and amortisation
charges. Additional items may be separately disclosed before arriving at operating profit, such as
the profit or loss made on selling a non-current asset. When a non-current asset, such as an item of
machinery, is disposed of at a price significantly different from its statement of financial position value,
the profit or loss when compared to this net book value (NBV) should be separately disclosed if material
to the information conveyed by the accounts.

Operating profit is the profit before considering finance costs (interest) and any tax payable. It can be
described as profit before interest and tax (PBIT).

Finance Costs/Finance Income

Finance costs are generally the interest that the company has incurred on its borrowings. That may be in
the form of bonds or may be bank loans and overdrafts. Finance income is typically the interest earned
on surplus funds, such as from deposit accounts.

Profit Before Tax

This is the profit made by the company in the period, before considering any tax that may be payable on
that profit.

Corporation Tax Payable

This is simply the corporation tax charge that the company has incurred for the period.

Net Income
Net income is the company’s total earnings or profit. In the UK it is also referred to as profit after tax.

It is calculated by taking the total revenues adjusted for the cost of business, interest, taxes, depreciation
and other expenses. The net income is the profit that is attributable to the shareholders of the company
and is stated before the deduction of any dividends because dividends are an appropriation of profit and
are at the discretion of the company directors.

The net income is added to the retained earnings in the statement of financial position and disclosed
within the statement of changes in equity. It is also within this statement that the dividends paid during
the year are deducted from the retained earnings. As will be seen in section 1.3, dividends paid are also
disclosed in the statement of cash flows.

292
 Securities Analysis

Earnings Per Share (EPS)

EPS is one of the most important figures for investors and financial analysts and is reflected at the
bottom of the statement of profit and loss, in pence. EPS is the amount of profit after tax that has been
earned per ordinary share. EPS is calculated as follows:

Net Income for the Financial Year

EPS =
Number of Ordinary Shares in Issue

Dividends
Some, or all, of the profit for the financial year can be distributed as dividends. Dividends to any
preference shareholders are paid out first, followed by dividends to ordinary shareholders at an amount
set by the board and expressed as a number of pence per share. The dividends for most listed companies
are paid in two instalments: an interim dividend paid after the half-year stage and a final proposed
dividend paid after the accounts have been approved. The dividends are shown in the accounts in a note
that reconciles the movement in equity from one statement of financial position to another.

6
Provisions and Exceptional Items
IAS 37 details how provisions should be recognised and measured and requires that sufficient
information is disclosed in the notes to the financial statements to enable users to understand their
nature, timing and amount. The key principle is that a provision should be recognised only when there
is a liability resulting from past events where payment is probable, and the amount can be estimated
reliably.

IAS 1 does not actually use the term ‘exceptional item’. However, the term is widely used in accounting.
Essentially, the idea behind classifying an item as exceptional is to remove the distorting influence of any
large one-off items on reported profit so that users of the accounts may establish trends in profitability
between successive accounting periods and derive a true and fair view of the company’s results.

IAS 1 acknowledges that, due to the effects of a company’s various activities, transactions and other
events that differ in frequency, potential for gain or loss and predictability, disclosing the components
of financial performance assists in understanding that performance and making future projections. In
other words, if an item is exceptional, it should be separately disclosed.

An exceptional item could be the profit made on selling a significant fixed asset or the loss on selling
an unprofitable operation. These profits and losses only represent book profits and losses rather than
actual cash profits and losses. We will return to this point when considering statements of cash flows in
section 1.3.

Exceptional profits are added to, and exceptional losses deducted from, operating profit in arriving at
the company’s profit before taxation.

Capital Versus Revenue Expenditure

Money spent by a company will usually fall into one of two possible forms: capital expenditure or
revenue expenditure.

293
Capital expenditure is money spent to buy non-current assets, such as plant, property and equipment.
It is reflected on the statement of financial position. Revenue expenditure is money spent that
immediately impacts the statement of profit and loss. Examples of revenue expenditure include wages
paid to staff, rent paid on property, and professional fees, such as audit fees.

1.2.3 The Relevance of the Statement of Profit and Loss to Investors

For obvious reasons, a company’s statement of profit and loss will be a main focus of attention to
the investment community, as it directly reflects the performance level of the company from current
operations. Moreover, analysis of the items in the statement of profit and loss reveals not only the size of
a company’s profit or losses, but also considerable details on the quality of its income and expenditures.

Investors will want to look closely at the breakdown of expenditures to see if there are signs that
the company’s management is overspending, especially in relation to previously released targets or
forecasts from previous financial statements.

The gross profit margin, ie, the percentage of gross profit to turnover or total revenues, may provide
further insights. A change that sees gross profit margin increase might be due to the company becoming
dominant, enabling it to increase the sales price and/or decrease the prices it is paying its suppliers. A
decrease in gross profit margin might arise because the company is facing increased competition and
has been forced to lower its sales prices and/or pay more to its suppliers. Alternatively, it may be a
strategic decision by the company to pursue market share.

The key figure which will be examined by investors and analysts is the EPS figure, as this will provide
guidance to the marketplace as to the company’s valuation. Analysts will want to see whether the
company’s EPS shows it to be performing in line with the applicable price/earnings (P/E) multiples for
the sector in which the company operates, and, if not, one would want to understand the reasons for
outperformance or underperformance. Detailed examination and analysis of the statement of profit and
loss may reveal whether there are unusual or exceptional circumstances that would explain a higher or
lower multiple than that which was expected from the company.

There are no absolute rules of reference for deciding how to evaluate a company’s EPS. Rather the figure
should be seen in the context of previous performance by the company. Companies have very different
business models. Some companies are suppliers of merchandise to mass markets, while others occupy
more specialised niches.

Some companies are keen to have a very large share of the available market in the product/service
which they supply, and work on the principle of low margins and high volume. Other companies may
prefer the converse model of having a high margin and relatively low volume. All of this needs to be
taken into consideration when assessing a company’s performance as revealed in its statement of profit
and loss.

Different sectors of the marketplace will have different P/E multiples and it is not easy to compare
company performances across different sectors. Also to be factored into the assessment is the fact that
to a large extent all companies will have earnings and costs which will fluctuate depending on economic
factors such as whether GDP is growing or contracting, on exchange rates, and in most general terms on
the state of the economy.

294
 Securities Analysis

1.2.4 Statement of Profit and Loss – Trend Analysis

In similar fashion to the approach used in consideration of the common-size technique for trend
analysis of a company’s statement of financial position, seen in section 1.1.4, a similar approach can be
taken with respect to the statement of profit and loss. Key performance metrics are not considered in
annual isolation but within the context of a broader time frame – perhaps five years, which is a widely
used frame of reference in the investment world.

The table below provides some highlights from the statement of profit and loss of a company over a
five-year period. The top line of the table reflects the gross revenues and shows that, in the period under
consideration, the revenues doubled to the point where, for year-end 2020, the company had annual
revenues of £1.6 million.

2016 2017 2018 2019 2020

£000s £000s £000s £000s £000s

6
Gross revenue 800 880 1040 1280 1600
Gross profit 140 170 200 210 240
Gross margin 18% 19% 19% 16% 15%
Profit before tax 130 160 180 200 220
Profit margin 16% 18% 17% 16% 14%
Dividends 4 5 6 7 10

The second line of the table indicates the monetary amount of gross profit being made in each year.
Below that there is a percentage figure showing the gross margin achieved in each of the five years and,
as can be seen, the company is in the somewhat concerning condition where, despite the impressive
growth in top-line revenue, the amount of gross profit as a percentage of revenue is declining. From
2018 to 2020, for example, the gross margin has dropped from 19% to 15%.

A somewhat similar decline in an important ratio is seen in the line for the profit margin for the company
(ie, profit before tax divided by revenues). The final line shows that the company has decided, not
through any logic of necessity but circumstance, to boost its annual dividend to shareholders by 150%
during the same period that its sales have doubled.

2016 2017 2018 2019 2020

£000s £000s £000s £000s £000s
Gross revenue 100 110 130 160 200
Gross profit 100 121 143 150 171
Gross margin 100 110 110 94 86
Profit before tax 100 123 138 154 169
Profit margin 100 112 107 96 85
Dividends 100 125 150 175 250

295
The table above provides a trend analysis for the previous set of data and makes it even easier to
conduct a proper comparison of key parameters and track down areas of concern or merit. The 2016
levels for each of the six variables are used as the base amounts and an index value has been created for
each of the subsequent years, with 2016 values set at an index value of 100.

It can be seen that the revenues have doubled and that the profit before tax has expanded by 69% (ie,
from 100 to 169). It is also clear that the increase in the index level of gross profit has failed to match that
seen on the top-line revenue.

One useful feature of the above way of presenting the data is that ratio values or percentages can
themselves be expressed in terms of index values. The gross margin has in fact declined from 110 in
2017 to 86 in 2020, and the net profit margin has declined to 85% of what it was in 2016. Clearly the
company is in a position where its expanding share of a market is leading to higher turnover but the
underlying profitability is deteriorating, which would call for a detailed analysis of its cost structure and,
in particular, its marginal costs. One final point is well demonstrated by the fact that the dividends have
increased by 150%, which is above the rate of growth of turnover and considerably beyond the rate of
growth in profitability.

Gross Revenue Growth 2016 2017 2018 2019 2020

A 100 110 130 160 200
B 100 140 200 220 250

Company 2017 2018 2019 2020

A 10.0% 18.2% 23.1% 25.0%
B 40.0% 42.9% 10.0% 13.6%

The table above focuses just on the revenue growth of two companies and uses a combination of the
index-based approach discussed previously with a simple expression of the percentage change for each
company.

Company A is the same company which was examined in more detail previously and the gross revenue
index levels have been included from 2016 to 2020. Company B is another company where similar
index values are available but we are not given access to the underlying data, so it may well be that the
two firms are of quite different orders of magnitude. But for the purposes of trend analysis this can be
overlooked by simply tracking the year-over-year percentage changes of each company.

The bottom two rows of the table above indicate the rates of growth of companies A and B from 2017
onwards. The 2016 figures are set aside since we are considering a progression from a starting year.
What can be clearly seen from the percentage changes is that the rates of growth are very different.
Company A is growing at an expanding rate, whereas company B is more erratic, and after two years of
strong growth its rate of growth in the most recent two-year period is substantially slower.

296
 Securities Analysis

1.3 Statement of Cash Flows

Learning Objective
6.1.3 Understand the purpose, structure and relevance to investors of statements of cash flows

1.3.1 The Purpose of the Statement of Cash Flows

A statement of cash flows (as it is now known in accordance with the IAS 1 Revised) is required by
accounting standard IAS 7. The statement of cash flows is basically a summary of all the payments and
receipts that have occurred over the course of the year, the total reflecting the inflow (or outflow) of
cash over the year.

The principal features of a statement of cash flows, and the purposes behind it, are as follows:

6
• Removal of accruals, or amounts payable and receivable, from the income statement so that these
amounts may be accounted for on a cash paid and received basis. The removal of accruals allows the
actual cash available to a company at any point in time to be more precisely determined.
• Adjustment for statement of financial position items such as an increase in the value of a company’s
stock or accounts receivable (also often referred to as debtors) or a decrease in accounts payable
(also often referred to a creditors), all of which increase reported profit but do not impact cash.
• Adding back non-cash items, such as depreciation charges, amortisation and book losses from
the sale of fixed assets, while deducting book profits from fixed-asset disposals recorded in the
statement of profit and loss, which impact recorded profit but not the company’s cash position.
• Bringing in changes in statement of financial position items that impact the company’s cash
position, such as finance raised and repaid over the accounting period and fixed assets bought and
sold. While these items are not readily accessible from an examination of a company’s profit and loss
accounts, the financial statement of cash flows may also contribute significantly to the company’s
current cash holdings.

Analysis of the statement of cash flows shows that it is important that a company generate positive
cash flow at the operating level, otherwise it will become reliant upon fixed-asset sales and borrowing
facilities to finance its day-to-day operations.

A company’s survival and future prosperity is also dependent upon it replacing its fixed assets to remain
competitive. However, these assets must be financed with capital of a similar duration to the economic
life and payback pattern of the asset; otherwise the company will have insufficient funds to finance its
operating activities. The statement of cash flows will also identify this.

1.3.2 The Structure of Statements of Cash Flows

IAS 7 regarding statement of cash flows requires a company’s cash flows to be broken down into three
particular headings:

1. Operating cash flow – operating activities is the cash that has been generated from the trading
activities of the company, excluding financing cost (interest).

297
2. Investment or enterprise cash flow – investing activities details the investment income (dividends
and interest) that has been received in the form of cash during the year and the cash paid to
purchase new non-current assets less the cash received from the sale of non-current assets during
the year.
3. Financing cash flow – financing activities includes the cash spent during the year on paying
dividends to shareholders and the cash raised from issuing shares or borrowing on a long-term
basis, less the cash spent repaying debt or buying back shares.

When all three sections of the statement of cash flows are consolidated, the resultant total should
explain the changes in cash (and cash equivalents) between the statement of financial position.

In order to establish the cash generated from the operating activities figure in the statement of cash
flows – essentially the company’s operating cash flow – IAS 7 allows one of two alternative presentations
on the face of the cash flow statement.

Of the two methods, the first is the direct method, where the cash received from customers and paid to
suppliers and employees is shown. Alternatively, the indirect method is where reconciliation is shown
between the company’s other financial disclosures, primarily those found in the statement of financial
position and the cash generated from operations in the statement of cash flows. This reconciliation
requires the following adjustments to be made to the operating profit figure:

• Non-cash charges such as the depreciation of tangible fixed assets and the amortisation of
intangible assets must be added back, as these do not represent an outflow of cash.
• Any increase in debtors or stock or decrease in short-term creditors over the accounting period must
be subtracted, as these all increase reported profit but do not increase cash.
• Any decrease in debtors or stock or increase in short-term creditors over the accounting period must
be added, as these all decrease reported profit but do not decrease cash.

298
 Securities Analysis

Operating Statement of Cash Flows for XYZ plc for Year Ending 31 December 2020
All figures are in £ sterling
Net income after tax 240,000
Other additions to cash
Depreciation and amortisation 35,000
Decrease in accounts receivable 17,000
Decrease in inventory
Decrease in other current assets 19,000
Increase in accounts payable 26,000
Increase in accrued expenses
Increase in other current liabilities

6
Total additions to cash from operations 97,000
Subtractions from cash
Increase in accounts receivable
Increase in inventory (33,000)
Increase in other current assets
Decrease in accounts payable
Decrease in accrued expenses (19,000)
Decrease in other current liabilities (23,000)
Total subtractions from cash from operations (75,000) (75,000)
Total operating cash flow 262,000

Figures used are for illustrative purposes only.

The Structure of the Operating Statements of Cash Flows

The statement provided above shows an example of using the indirect method for preparing the
operating statement of cash flows and each item will be explained briefly:

Additions to Cash
• Depreciation and amortisation – depreciation is not a cash expense; it is added back into net
income for calculating cash flow.
• Decrease in accounts receivable – if accounts receivable decrease, more cash has entered the
company from customers paying off their accounts – the amount by which accounts receivable has
decreased is an addition to cash.
• Decrease in inventory – a decrease in inventory signals that a company has spent less money to
purchase more raw materials. The decrease in the value of inventory is an addition to cash.
• Decrease in other current assets – similar reasoning to above for other current assets.

299
• Increase in accounts payable – if accounts payable increases it suggests more cash has been
retained by the company through not paying some bills. The amount by which accounts payable has
increased is an addition to cash.
• Increase in accrued expenses – for example deferring payment of some salaries will add to cash.
• Increase in other current liabilities – similar reasoning to above for increase in taxes payable.

Subtractions from Cash

• Increase in accounts receivable – if accounts receivable increases less cash has entered the
company from customers paying their accounts. The amount by which accounts receivable has
increased is a subtraction of cash.
• Increase in inventory – an increase in inventory signals that a company has spent more money
to purchase more raw materials. If the inventory was paid with cash, the increase in the value of
inventory is a subtraction of cash.
• Increase in other current assets – similar reasoning to above for other current assets.
• Decrease in accounts payable – if accounts payable decreases it suggests more cash has been used
by the company to pay its bills. The amount by which accounts payable decreased is a subtraction
from cash.
• Decrease in accrued expense – for example an increase in prepaid expenses results in a subtraction
of cash.
• Decrease in other current liabilities – similar reasoning to above for decrease in taxes payable.

The simple formula to arrive at the total operating cash flow is:

Net income after tax

+ Total additions to cash from operations
– Total subtractions from cash from operations

The following table shows the additional items that are required in addition to the operating statement
of cash flows and includes both the activities of investments, sometimes called the enterprise statement
of cash flows, and the financing statement of cash flows.

300
 Securities Analysis

Statement of Cash Flows for XYZ plc for Year Ending 31 December 2020
All figures are in £ sterling
Total Operating Cash Flow 262,000
Investment/Capital Expenditures
Additions to cash from investments
Decrease in fixed assets 150,000
Decrease in notes receivable 12,000
Decrease in securities investments
Decrease in intangible non-current assets
Total additions to cash from investments 162,000
Subtractions from cash for investments

6
Increase in fixed assets
Increase in notes receivable
Increase in securities investments –64,000
Increase in intangible non-current assets –250,000
Total subtractions from cash for investments (314,000)
Total enterprise cash flow 110,000
Financing Activities
Additions to cash from financing
Increase in borrowings 50,000
Increase capital stock –
Total additions to cash from financing 50,000
Subtractions from cash for financing
Decrease in borrowings
Decrease in capital stock –
Total subtractions from cash for financing –
Total equity cash flow 160,000
Subtractions from Cash for Dividends
Dividends paid (100,000)
Total free cash flow 60,000
Cash at beginning of period 450,000
Cash at end of period 510,000

Figures used are for illustrative purposes only.

301
The Structure of the Investment or Enterprise Statement of Cash Flows
Here is a brief description of the net result to the cash position of a company from its investment
and capital expenditures, or, as is it is sometimes referred to, especially in the US, the enterprise cash
flow statement. The statement can be compiled by reference to the changes from year to year in the
company’s statement of financial position.

Additions to Cash from Investments

• Decrease in fixed assets – sale of a building will lead to an addition to cash.
• Decrease in notes receivable – a reduction in notes receivable indicates that cash will have been
received.
• Decrease in securities, investments – securities will have been sold thereby raising cash.
• Decrease in intangible, non-current assets – sale of a patent or copyright will lead to an addition
of cash.

Subtractions from Cash from Investments

• Increase in fixed assets – purchase of a building will lead to a subtraction from cash.
• Increase in notes receivable – an increase in notes receivable indicates that cash has not been
received.
• Increase in securities investments – securities will have been purchased thereby reducing cash.
• Increase in intangible non-current assets – purchase of a copyright will lead to a reduction of
cash.

The Structure of the Financing Activities Statement of Cash Flows

Additions to Cash from Financing
• Increase in borrowings – additional net borrowing will lead to an addition of cash.
• Increase capital stock – additional net equity capital paid in will lead to an addition of cash.

Subtractions from Cash for Financing

• Decrease in borrowings – net reduction in borrowing will lead to a subtraction of cash.
• Decrease capital stock – retirement of net equity capital paid in will lead to a subtraction of cash.
• Subtractions from cash for dividends – dividends paid out will lead to a subtraction of cash.

The final line of the table shows the total free cash flow for the company:

Total Free Cash Flow = Total Equity Cash Flow – Dividends Paid Out

1.3.3 The Relevance of the Statement of Cash Flows to Investors

As listed companies typically use accrual accounting, the statements of profit and loss released each
quarter by a company will not necessarily reflect changes in their cash positions. If one has invested
in a company, or is contemplating an investment, one of the crucial considerations will be whether
the company has sufficient cash on hand to meet its obligations or whether it is likely to face a cash
crunch in which it could be forced to sell assets under duress or have to seek emergency funding under
disadvantageous conditions.

302
 Securities Analysis

While a company may be earning a profit from an accounting perspective, it may, during the quarter,
actually end up with less cash than when it started the quarter. Even profitable companies can fail to
adequately manage their cash flow, which is why the statement of cash flows is vitally important; it helps
investors see if a company is having trouble with its cash position.

Investors will use the statement of cash flows in a variety of ways:

• Cash from operating activities is compared to the company’s net income. If the cash from operating
activities is consistently greater than the net income, the company’s net income or earnings are said
to be of a high quality. If the cash from operating activities is less than net income, a warning to
investors should be raised as to why the reported net income is not turning into cash.
• Many investors have the view that cash is king. If a company is consistently generating more cash
than it is using, the company could increase its dividend, buy back some of its stock, reduce its
debt or acquire another company. All of these are perceived to be good for shareholder value. On
the contrary, if a company is lacking cash and faces momentary bouts of illiquidity, then there may
eventually be questions raised as to its ability to survive and its solvency.

6
• The methods of common sizing discussed in the previous two sections can also be applied to a
company’s statement of cash flows. For example, the financing activities revealed in the financing
statement of cash flows can throw further light on the gearing position of the company, as all of the
financing debits and credits to the cash account will be viewable in one place.

In summary, the casualties of a recession, such as that seen during 2020, are not always easy to identify
ahead of time and may not be readily discernible from financial statements. Many economists and
analysts have suggested that in the last quarter of 2008 it was as if the world economy fell off a cliff.
The track record for investment analysts in anticipating the demise of institutions such as major banks,
insurance companies and large manufacturers, even from a detailed perusal of financial statements has
historically not been very good.

The most common malaise for business failures, both during a recession and in more normal economic
circumstances, is the inability of firms to realise cash from operations to meet their unavoidable
obligations. Liquidity in the capital markets, in the most general and systemic sense of the term and not
just in the more literal sense of immediate access to raise cash, is at its lowest when it is most needed.

1.4 Financial Ratios

Learning Objective
6.1.4 Be able to analyse securities using the following financial ratios: liquidity; asset turnover;
gearing

1.4.1 Liquidity Ratios

Financial analysts often distinguish between solvency and liquidity. In essence, the solvency of a
company relates to its long-term position with respect to its assets and liabilities, and its commitments
to finance its statement of financial position. Liquidity issues are more concerned with the short-term
operating issues of a business and concern its ability to meet its ongoing cash requirements.

303
Liquidity ratios aim to establish the following:

• Does a company have the resources to meet its operating requirements from its working capital on
a timely basis?
• Can a company actually realise those resources quickly enough? In other words, does it have
sufficient ability to raise cash when required, to pay off the liabilities as they fall due?

Liquidity ratios are relatively simple tools and arguably lack real sophistication, but they are useful for
showing trends and are frequently used in loan agreements.

Working Capital Ratio or Current Ratio

The purpose of the working capital ratio or current ratio is to determine if the current assets recoverable
within one year are sufficient to cover the liabilities that fall due within one year.

Current assets normally refers to those assets that are recoverable within one year. However, it could be
the case that some receivables are recoverable after more than one year. This fact would then have to be
noted in the company’s accounts.

Current ratio = Current assets

Current liabilities

This ratio indicates whether a company has enough short-term assets to cover its short-term debt.
Anything below 1.0 indicates negative working capital. Anything over 2.0 means that the company is
not investing excess assets in the most productive and yield-generating fashion. Most analysts believe
that a ratio between 1.2 and 2.0 is desirable. However, the circumstances of every business vary and one
should consider how different businesses operate before making a judgement about what should be an
appropriate benchmark ratio.

A stronger ratio indicates a better ability to meet ongoing and unexpected bills, thereby taking the
pressure off cash flow. Being in a liquid position can also have advantages such as being able to
negotiate cash discounts with suppliers.

A weaker ratio may indicate that the business is having greater difficulties meeting its short-term
commitments and that additional working capital support is required. Having to pay bills before
payments are received may be the issue, in which case an overdraft could assist. Alternatively, building
up a reserve of cash investments may create a sound working capital buffer. Some practical problems
arise when calculating or using the current ratio:

• Overdrafts will be included within current liabilities but in practice are frequently payable after more
than one year. Banks often allow companies to extend overdrafts for several years.
• Although inventory is contained within current assets on the statement of financial position of
a company and is therefore assumed to be convertible into cash within one year this may not
necessarily be the case. In periods of recession there may be no easy way to obtain liquidity from
inventory other than through a sale at very distressed prices.
• The ratio fails to take into account the timing of cash flows within the period. It might be the case
that all the liabilities are payable in very short order, whereas many of the assets are only recoverable
in 12 months’ time.

304
 Securities Analysis

• The ratio is static in that it reflects values at a point in time, ie, when the statement of financial
position was drawn up. It is possible for a company to ‘window dress’ its accounts on that date so
that its ability to meet its obligations is seen in the most favourable light.

In order to alleviate the criticism that the current ratio is static a modified form of the ratio is often
advised. The working capital turnover ratio is also referred to as the net sales to working capital. It
indicates a company’s effectiveness in using its working capital.

Working capital turnover ratio is calculated as follows:

Net annual sales

Working capital turnover ratio =
Average amount of working capital during the same 12-month period

For example, if a company’s net sales for the year 2019 were £2,400,000, and its average amount of
working capital during 2020 was £400,000, its working capital turnover ratio was:

6
£2,400,000
= 6.0
£400,000

Note that working capital itself is defined as the total amount of current assets minus the total amount
of current liabilities. As indicated above, you should use the average amount of working capital for the
year of the net sales. As with most financial ratios, you should compare the working capital turnover
ratio to other companies in the same industry and to the same company’s past and planned working
capital turnover ratio.

1.4.2 Quick Ratio or Acid Test Ratio

The quick ratio is an adaptation of the current ratio designed to remove the problem of inventory and is
alternatively called the acid test ratio or liquid ratio. The term ‘acid test’ comes from the way gold miners
would test whether their findings were real gold nuggets. Unlike other metals, gold does not corrode in
acid; if the nugget did not dissolve when submerged in acid, it was said to have ‘passed the acid test’. If a
company’s financial statements pass the figurative acid test, this is indicative of its financial well-being.

Acid Test Ratio = Current Assets – Inventory

Current Liabilities

The acid test measures the ability of a company to use its near-cash or ‘quick’ assets to immediately
extinguish or retire its current liabilities. Quick assets include those current assets that can be quickly
converted to cash at close to their book values.

An alternative formulation for the ratio can be expressed more specifically as follows:

Acid Test Ratio = Cash + Marketable Securities + Accounts Receivable

  Current Liabilities

305
The acid test ratio, since it excludes the value of inventory, is therefore a more stringent test than the
working capital ratio. It indicates whether a firm has enough short-term assets to cover its immediate
liabilities without selling inventory.

Generally, the acid test ratio should be 1:1 or better; however, this varies widely by industry. If a company
has a ratio of less than 1, this does not necessarily mean that it is insolvent and unable to pay off its
liabilities. Depending on the type of business, however, it may be a sign of liquidity problems.

One useful metric to look for is to see if the acid test ratio is much lower than the working capital ratio. If
this is the case it means that current assets are highly dependent on inventory. Retail stores are examples
of this type of business, which also helps to explain why many retailers fall victim to recessions.

1.4.3 Gearing Ratios

Financial analysts are keen to examine the gearing ratios for businesses as they consider the capital
structure of a company and the relationship between its borrowings and shareholders’ funds, which are
not an immediate obligation of a company.

The use of gearing or financial leverage is found in many businesses and, in particular, the financial
services sector. For obvious reasons, a very high level of gearing can bring with it much greater levels of
financial risk.

The simplest and most direct way to think about gearing and leverage is in relation to the position of
a house purchaser, who makes a down-payment to purchase a home from their own savings and then
borrows (or finances) the rest of the purchase from a mortgage lender.

Example
An individual buys a £100,000 house with a £75,000 mortgage and £25,000 of their own cash. Let us
examine the impact of the change in home prices under two different possible scenarios:

• The house price has doubled – a 100% increase. The individual has made a money gain of £175,000
on what was effectively a £25,000 investment. Even though the purchaser will have been responsible
for other cash outlays, to keep matters simple the return would be £175,000/£25,000, ie, a 700%
return.
• The house price has halved – a 50% decrease. With the house now only worth £50,000 the individual
has lost £50,000 on their £25,000 investment which equates to a 200% loss.

The scale of the gains and losses for the purchaser of property with a standard mortgage which
involves relatively modest gearing can be substantial. It is not difficult to see how much more drastic
the amplification of gains and losses will be with much smaller down-payments and much larger
mortgages, which of course leads to much greater gearing.

306
 Securities Analysis

Operational Gearing
Operational gearing is a measure of operational risk, ie, risk to the operating profit figure. It assesses the
levels of variable and fixed operating costs in the business.

• Variable costs are costs whose level varies directly with the level of output, eg, raw material costs.
Hence if sales increase or decrease then variable costs increase/decrease.
• Fixed costs are costs whose level remains constant regardless of output levels, eg, rent, rates,
depreciation.

The greater the level of fixed costs in the business, the greater the variation in the profit figure as a result
of revenue changes.

In the table below, there are two companies which have very similar characteristics, except that
Company A has fixed costs of £30,000 and Company B has fixed costs of £50,000. Both companies are
operating at a level of 10,000 units of output per year and both have the same sales revenue per unit, ie,

6
price of their product, and both have variable costs of £11 per unit.

Gearing Company A Company B

Output (units) 10,000 10,000
Sales revenue (per unit) £20 £200,000 £200,000
Variable costs (per unit) £11 –£110,000 –£110,000
Contribution £9 £90,000 £90,000
Fixed costs –£30,000 –£50,000
Profit before tax £60,000 £40,000
Operational gearing ratio 1.50 2.25

The difference between the unit revenue and the unit variable cost is £9 and is known as the contribution.
This is the amount that the company has to pay towards or contribute to paying for its fixed costs before
it is able to determine its profit before tax.

Company A with a lower fixed cost is able to have a profit of £60,000 whereas B, which has higher
fixed costs, is able to have a profit before tax of £40,000. The operational gearing ratio is determined
for Company A from the formula provided above as (£200,000 – £110,000)/£60,000 = 1.5, whereas for
Company B the values are (£200,000 – £110,000)/£40,000 = 2.25.

Company B, with relatively higher fixed costs compared to Company A, is said to have high operational
gearing. In general terms, a company where the fixed costs are higher as a percentage of total costs will
experience a higher operational gearing ratio. One of the consequences of the gearing ratio is that a
company with a higher gearing ratio will see greater sensitivity in its profit ratio to sales in the case of
changes in the level of output and overall revenue.

307
Adjusting Output for Company A 75% 100% 125%
Output (units) 7,500 10,000 12,500
Sales revenue (per unit) £20 £150,000 £200,000 £250,000
Variable costs (per unit) £11 –£82,500 –£110,000 –£137,500
Contribution £9 £67,500 £90,000 £112,500
Fixed costs –£30,000 –£30,000 –£30,000 –£30,000
Profit before tax £37,500 £60,000 £82,500
Operational gearing ratio 1.50
Ratio of profit to normal output 0.625 1.000 1.375

In the table above, it can be seen that the output level for Company A has been decreased by 25% (ie,
the 75% level from the previous normal output level of 10,000 units remains at the previous level and
then is increased by 25%).

The effect of the operational gearing ratio can be translated into the effect on the profit before tax, as
shown by the fact that, for the 7,500 units of output, the profit is reduced by the percentage reduction in
output multiplied by the gearing ratio, ie, –25% x 1.5 = –37.5%, and for an increase in output of 25% the
profit is increased by +25% x 1.5 = +37.5%.

Adjusting Output for Company B 75% 100% 125%

Output (units) 7,500 10 000 12,500
Sales revenue (per unit) £20 £150,000 £200,000 £250,000
Variable costs (per unit) £11 –£82,500 –£110,000 –£137,500
Contribution £9 £67,500 £90,000 £112,500
Fixed costs –£50,000 –£50,000 –£50,000 –£50,000
Profit before tax £17,500 £40,000 £62,500
Operational gearing ratio 2.25
Ratio of profit to normal output 0.438 1.000 1.563

As can be seen in the table above, for Company B, with the higher gearing ratio, the changes to profit
resulting from scaling the output up and down are more severe, with a ±56.3% change to the normal
profit level from the scaling.

In order to apply this technique, one will be required to have a detailed knowledge of the company’s
cost structure and to be able to correctly delineate fixed and variable costs. This information is not
usually included in the published company accounts. It may be possible to break these down from a
more detailed examination of the statement of profit and loss.

Operational gearing is a key factor to consider in evaluating a business and its sensitivity to changes in
demand for its products. Businesses with high contribution levels will generally be more robust in being
able to withstand declines in their demand and output, and capital-intensive businesses will also have
relatively high fixed costs due to the depreciation of their non-current assets.

308
 Securities Analysis

1.5 Profitability Ratios

Learning Objective
6.1.5 Be able to analyse securities using the following profitability ratios: net profit margin;
operating profit margin; equity multiplier; return on capital employed

1.5.1 Gross, Net and Operating Profit Margins

Profitability ratios look at the percentage return that the company generates relative to its revenues.

The gross profit looks at the percentage of revenues that the company earns after considering just the
costs of sales. In accounting terminology, cost of sales is sometimes referred to as cost of goods sold.

6
The operating profit margin and net profit margin look at the percentage of revenues that the
company earns after considering cost of sales and other operating costs (such as distribution costs and
administrative expenses). Clearly, all other things being equal, a greater profit margin is preferable to
a lesser profit margin. Operating margin will take into account a wider range of variable costs, such as
wages, and while it does not include interest charges, net profit margin does.

The figures for the profitability ratios are drawn from the statement of profit and loss. The formulae for
the profitability ratios are:

Gross profit margin (%) = (Gross profit/revenues) x 100

Operating profit margin (%) = (Operating profit/revenues) x 100
Net profit margin (%) = (Net profit less interest/revenues) x 100

1.5.2 Equity Multiplier

The equity multiplier is a measure of financial gearing or leverage for a business; indeed, it is sometimes
known as the financial leverage ratio.

The method of calculating the ratio is simply equal to:

Total assets
Total equity (ie, shareholders’ funds)

The numerator of the above ratio is the sum of the total assets of an enterprise and will be equivalent
to the addition of all of the debt on the statement of financial position plus the total equity. The
denominator will be equivalent to the total equity – in other words, the shareholders’ funds. The
denominator of the ratio is thus confined to equity, and it is the numerator which will capture any debt
financing.

309
The higher the ratio, the more the enterprise is relying on debt instruments such as bonds and/or loans
in order to finance and run the day-to-day operations of the business. The lower the ratio, the less the
enterprise is relying on such debt to finance its operations. In the limiting case when the enterprise has
no debt financing, the ratio would be equal to 1.0. When there is debt financing within a business, the
ratio will be greater than 1.0 and will provide an indication of leverage, with higher values suggesting
that the company is more highly geared or leveraged.

To the extent that the ratio is higher than would be customarily found for similar companies within
specific market sectors, this will indicate increased risk that the company might encounter difficulties in
servicing the obligations to its debt holders.

1.5.3 Return on Capital Employed (ROCE)

This is widely seen as the best ratio for measuring overall management performance, in relation to the
capital that has been paid into the business.

The amount of capital employed is the equity plus the long-term debt. This is the money that the
company holds from shareholders and debt providers, and it is from this money that the management
should be able to generate profits. Effectively, the ROCE gives a yield for the entire company. It compares
the money invested in the company with the generated return. This annual return can then be compared
to other companies, or to less risky investments.

In summary, the key features of ROCE are:

• It looks at what returns have been generated from the total capital employed in a company including
debt as well as equity.
• It expresses the income generated by the company’s activities as a percentage of its total capital.
• This percentage result can then be used to compare the returns generated to the cost of borrowing,
establish trends across accounting periods and make comparisons with other companies.

The simple formula for ROCE is as follows:

ROCE = Profit before Interest and Tax X 100 = x%

Capital Employed

The component parts of capital employed are shown below in an expanded version of the formula:

ROCE = Profit Before Interest and Tax X 100 = x%

Equity + Long-term liabilities + Short-term interest bearing liabilities

The capital employed should include the short-term interest bearing borrowings that the company has
in its statement of financial position, as well as the long-term liabilities. This is because borrowing, for
example, in the form of a bond issue, will eventually become payable in less than one year, and will be
classified as a current liability before it is repaid. If this borrowing was not included in capital employed
when it became short term, this would fail to reflect the reality of the company’s debts. The short-term
nature of the liability is simply a temporary phenomenon; after all, to repay the short-term borrowing,
the company will probably need to issue a new bond that will be classified as a long-term liability in the
statement of financial position.

310
 Securities Analysis

It should be noted that the result can be distorted in the following circumstances:

• The raising of new finance at the end of the accounting period, as this will increase the capital
employed but will not affect the profit figure used in the equation.
• The revaluation of fixed assets during the accounting period, as this will increase the amount
of capital employed, while also reducing the reported profit by increasing the depreciation charge.
• The acquisition of a subsidiary at the end of the accounting period, as the capital employed
will increase but there will not be any post-acquisition profits from the subsidiary to bring into the
consolidated profit and loss account.

1.5.4 Net Asset Turnover and Profitability

Net asset turnover looks at the relationship between sales and the capital employed in a business
describing how efficiently a company generates sales by looking at how hard the assets are working.

The relationship between ROCE and net asset turnover is shown in the following example.

6
Example
XYZ plc has annual sales of £5 million, a trading profit of £1.5 million and the following items on its
statement of financial position:

Share Capital: £1.0m

Reserves: £5.0m
Loans: £1.0m
Overdraft: £0.5m

The ROCE and net asset turnover can be calculated as follows:

Profit Before Interest and Tax £1.5m

ROCE = = X 100 = 20%
Capital Employed £1m + £5m + £1m + £0.5m

Net Asset Turnover = Turnover (Sales) = £5m = 0.66 times

Capital Employed £7.5m

311
1.6 Investor Ratios

Learning Objective
6.1.6 Be able to analyse securities using the following investor ratios: earnings per share; price/
earnings (both historic and prospective); dividend yield; dividend cover; interest cover

1.6.1 Earnings Per Share (EPS)

The earnings per share (EPS) ratio is one of the most useful and often-cited ratios used in the investment
world. It is used universally and more or less has the same meaning in most jurisdictions but is one
ratio for which there are prescribed rules in the UK regarding its calculation. These are laid out in IAS 33,
which basically defines the EPS as follows:

EPS = Net Profit or Loss Attributable to Ordinary Shareholders

Average Weighted Number of Ordinary Shares Outstanding in Period

Example
Let us suppose that we can determine from the financial statements of XYZ plc that the net profit
attributable to the group (which is after the deduction of preference share dividends) was £898,000 in
2020, and the number of ordinary shares outstanding during the period was five million.
It is straightforward to calculate that the EPS for 2020 is equal to 18p.

The EPS ratio is expressed in pence and reveals how much profit was made during the year that is
available to be paid out to each shareholder.

As such a useful figure for investors, earnings are often divided into the current share price to assess
how many times the EPS must be paid to buy a share – in effect, how expensive (or cheap) those shares
are. This is called the price/earnings (P/E) ratio, and it measures how highly investors value a company
as a multiple of its profits. While this ratio is very widely used, and is discussed in the next section, there
are alternative measures which some analysts prefer and consider as more satisfactory for making
comparisons with regard to profitability and in the process of corporate valuation.

One such ratio is known as the EV/EBITDA ratio, for which the numerator, EV, represents the enterprise
value or the market value of a company’s debt plus the market value of its equity. The denominator of
the ratio represents a value known as EBITDA, which is an acronym for earnings before interest, tax,
depreciation and amortisation.

Some would argue that EBITDA is a preferable metric for a company’s earnings than simply earnings
before interest and tax (EBIT), which is used in the more straightforward calculation of the P/E ratio.
However, others would contend that EBITDA is a non-GAAP measure which allows too much discretion
in what is included and excluded in the calculation.

312
 Securities Analysis

As with all financial analysis, it is important to know what basis has been used for determining
profitability or valuation for two companies when drawing any comparative conclusions. There are
several variations on the basic theme of the earnings per share ratio, for example to include expected
growth multiples, but the plain vanilla version from which they derive is EPS.

The metric is so widely followed that market analysts will use, for example, the EPS of the FTSE 100 or
the Standard & Poor’s 500 Index in the US (S&P 500) as a critical variable in determining whether stock
markets are fairly priced, overpriced or underpriced in comparison to historical norms.

1.6.2 Price/Earnings Ratio

There are various P/E ratios: historic, sometimes referred to as ‘trailing’, and also prospective or forward
P/Es. The simple general purpose formula, as mentioned above, is:

P/E Ratio = Price per share

6
Annual earnings per share

In the equation above, the price per share in the numerator is the market price of a single share of the
stock. The earnings per share, shown in the denominator of the formula, depends on the type of P/E
under consideration – whether historic or forward-looking.

• Trailing P/E (also referred to as P/E) – earnings per share is the net income of the company for the
most recent 12-month period, divided by number of shares outstanding. This is the most common
meaning of ‘P/E’ if no other qualifier is specified. Four quarterly earnings reports are used and
earnings per share is updated quarterly. Note, companies individually choose their financial year so
the schedule of updates will vary.
• Trailing P/E from continued operations – instead of net income, this version of the P/E ratio uses
operating earnings, which exclude earnings from discontinued operations, extraordinary items (eg,
one-off windfalls and write-downs) or accounting changes.
• Forward P/E or estimated P/E – instead of net income from historic earnings (ie, those already
achieved), this version of the P/E ratio uses estimated net earnings over the next 12 months.
Estimates are typically derived as the mean of a select group of analysts. In times of rapid economic
dislocation, such estimates become less relevant as new economic data is published and/or the
basis of the analysts’ forecasts becomes obsolete, and they may quickly adjust their forecasts.

The P/E ratio can alternatively be calculated by dividing the company’s market capitalisation by its total
annual earnings. For example, if the stock of XYZ plc is trading at £2.50 and the earnings per share for
the most recent 12-month period is 18p, then XYZ’s stock has a P/E ratio of 13.9.

Expressed in different terms, a purchaser of XYZ’s stock is paying almost £14 for every pound of earnings.
Companies with losses (negative earnings) or no profit have an undefined P/E ratio (usually shown as
not applicable or N/A); sometimes, however, a negative P/E ratio may be shown.

By comparing price and earnings per share for a company, one can analyse the market’s stock valuation
of a company and its shares relative to the income the company is actually generating. Stocks with
higher (and/or more certain) forecast earnings growth will usually have a higher P/E, and those
expected to have lower (and/or riskier) earnings growth will in most cases have a lower P/E. Investors
can, therefore, use the P/E ratio to compare the value of stocks.

313
If one stock has a P/E twice that of another stock, all things being equal (especially the earnings growth
rate), it is a less attractive investment. Companies are rarely equal, however, and comparisons between
industries, companies and time periods may be misleading. See section 1.7.

According to research conducted by Professor Robert Shiller, who is the Arthur M. Okun Professor of
Economics Yale University, the average P/E ratio, since 1900, for the S&P 500 Index has ranged from 4.78
in December 1920 to 44.20 in December 1999, with an arithmetic mean of 16.36 and a median of 15.73.

The average P/E of the market varies in relation with, among other factors, expected growth of earnings,
expected stability of earnings, expected inflation and yields of competing investments. Another
important benchmark for comparing P/E ratios historically for the broad market is in comparison to the
risk-free rate of return, ie, the return from three-month Treasury bills. The argument is often made by
financial analysts that the lower the risk-free rate of return, the higher the P/E multiple should be, which
given the unusually low interest rates prevailing globally in 2020 might suggest that there is actually no
overvaluation of the S&P 500. But this is debatable, and the problem with all such valuation benchmarks
is that they cannot anticipate the manner in which market prices will develop in response to uncertain
future events.

1.6.3 Dividend Yield

The dividend yield of an ordinary share is calculated as follows:

Dividend Yield = Dividend per Share

Current Market Price per Share

In the case of XYZ plc, let us suppose that the dividend paid for each ordinary share in 2020 was 7p.
Assuming the share price, as before, to be £2.50, the dividend yield is £0.07/£2.50 = 2.8%.

Long-term investors in equities will be much influenced by the dividends paid out by a company, as this
is a vital part of the total return from holding equities. The income stream from ordinary shares via the
payment of dividends, however, cannot be relied upon in the way in which the dividend income from
either a bond or preferred stock can be. Alternatively, a higher dividend yield could be indicative of a
company with strong cash flows and/or low capital expenditure, whereby excess cash is paid out to
investors.

An issuer of a bond or preferred share is obliged to pay the dividend or coupon payment specified in
the offering prospectus, whereas the decision as to whether to pay a dividend, and, if so, how much, is
entirely at the discretion of the board of directors of the company. As an ordinary shareholder one is not
guaranteed that there will be a dividend at all, nor is there a specific amount that can be relied upon
for companies that have historically paid dividends. During the economic downturn of 2007–08, many
companies abandoned the payment of dividends completely or reduced the amounts paid substantially.

It is also worth mentioning that many new companies and companies that are still at the stage of rapid
growth may decide not to pay a dividend, as their shareholders might feel that the funds paid out in
dividends could be better invested in further growth of the business through retained earnings.

314
 Securities Analysis

There is not an obvious relationship between the dividend yield and the perception of the company
in the marketplace. A high dividend yield could arise because a company has elected to pay a high
dividend amount per share or it could also arise, as is often the case, because the shares are currently
valued by the market at a low multiple to earnings and dividends. This could be because investors are
risk-averse or believe that the market prospects in general are unfavourable.

In more general terms, the case could be made that, if investors believe a company has good growth
prospects and is attractive this will tend to increase the share price and reduce the yield. From this
perspective, there is also some value in the observation that companies with high P/E ratios tend to
have low dividend yields and vice versa.

1.6.4 Dividend/Interest Cover

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

6
Earnings per share
Dividend cover =
Dividend per share

From the statement of profit and loss of XYZ plc in 2020, it can be seen that the earnings per share
were 18p and the dividend per share was 7p, which means that the dividend cover was: £0.18 ÷ £0.07
= 2.6 times. An unusually high dividend cover implies that the company is retaining the majority of its
earnings, presumably with the intention of reinvesting to generate growth. As suggested, this is often
true for companies which are still in a high growth phase, rather than more mature companies, which
are sometimes referred to as cash cows.

Generally speaking, a ratio of two times or higher is considered safe – in the sense that the company
can well afford the dividend – and for a ratio lower than 1.5 there has to be some question as to how
sustainable the current dividend may be. If the ratio is lower than 1, the company is using its retained
earnings from a previous year to pay this year’s dividend and this is a cause for investor concern. The
company is then said to be paying an uncovered dividend.

In a similar way to dividend cover, the interest coverage ratio is used to calculate how likely it is that a
company can pay interest on its outstanding debt.

The interest coverage ratio is calculated by dividing the company’s Earnings Before Interest and Taxes
(EBIT) by the due interest.

Interest Coverage Ratio = EBIT

Interest Expense

If the ratio is 1.5 or less, the company’s ability to meet interest expenses may be in doubt.

315
1.7 Performing Financial Analysis

Learning Objective
6.1.7 Understand the main advantages and challenges of performing financial analysis: comparing
companies in different countries and sectors; comparing different companies within the same
sector; over-reliance on historical information; benefits and limitations of relying on third-party
research; comparing companies that use different accounting standards

1.7.1 The Benefits and Limitations of Financial Analysis

Financial analysis of a company’s accounting statements and the use of a wide array of financial ratios
bring to light useful and insightful ways to understand how a business works, whether it is working well
and how it compares it with its peers and competitors. The kind of analysis that has been examined is
the daily preoccupation of many analysts employed in the financial services whose role it is to advise
companies and investors, potential or current, on the manner in which a company is operating.

Company owners and managers can benefit greatly from using these techniques to understand better
their performance and how it might be improved. As most companies will be keen to show their
performance to the financial community in the best possible light, there is often considerable effort
employed to ensure that the ratios and metrics displayed will not disappoint investors.

The principal ratios used in financial analysis are concerned with liquidity, gearing and profitability, but
there are other, more esoteric ones as well. It should be said that there is often a rather loose definition
attached to some of the components that should be included in the calculation of the ratios and they
can also vary from one jurisdiction to another.

The mechanics for calculating dividend cover, for example, and dilution for EPS, can vary from one side of
the Atlantic to the other. Hardly any financial ratios have exact definitions, and are therefore susceptible
to different methods of calculation and interpretation. For example, analysts will have quite different
opinions on what ROCE exactly measures. To some extent it depends on how the analyst calculated the
value and, for example, whether or not it was decided to include bank overdrafts.

Notwithstanding the methodological inexactitude, financial ratios are a very valuable tool. In particular,
if they are compiled consistently for the same company on a regular basis they are very useful when
looking for trends or discontinuities from one year to the next. Changes in the financial ratios will
help to draw attention to where problems of efficiency or liquidity issues may be about to manifest
themselves. Once a problem or point of concern is identified, one needs to look behind the ratio to find
out what might be emerging problems in the underlying business fundamentals. In other words, in
order to properly evaluate the trends and ratios described above, it is necessary to go on to consider the
particular circumstances of the business.

316
 Securities Analysis

Comparing Companies in Different Sectors

Companies have very different business models. A business model describes the key strategic direction
of a company – its business philosophy – and there can be many different paths that lead to success.
Some companies are suppliers of merchandise to mass markets, while others occupy more specialised
niches. Some companies are keen to have a very large share of the available market in the product/
service which they supply, and work on the principle of low margins and high volume. Other companies
may prefer the converse model of having a high margin and relatively low volume.

In making comparison between companies in general, it is vital to consider the most appropriate
criteria to use in terms of financial ratio analysis, and not simply to take any ratio indiscriminately for
comparative purposes and draw what will almost certainly be misleading conclusions.

Accounting Policies
The accounting policies adopted by a company can significantly impact its ratios and also can introduce
a range of problems for comparison between different firms operating in different sectors of the

6
economy and even more for international comparisons. For example, if non-current assets are revalued,
then depreciation charges will be higher. Hence, profits will be lower but, on the statement of financial
position, more non-current assets mean a higher capital employed figure. In consequence, the return
on capital employed will be reduced (lower profits divided by higher capital employed). Thus, ratios
can be significantly different if they are drawn from financial statements prepared under different sets
of accounting standards, such as globally accepted International Financial Reporting Standards (IFRSs)
versus US Standards.

In comparing two companies where one does revalue non-current assets and one does not, or in
comparing one company to another where non-current assets have been revalued in between, it has to
be expected that there will be a distortion between the ratios as a result of this accounting policy.

Comparing P/E Multiples

By comparing price and EPS for a company, one can analyse the market’s stock valuation of a company
and its shares relative to the income the company is actually generating. Stocks with higher (and/or
more certain) forecast earnings growth will usually have a higher P/E and those expected to have lower
(and/or riskier) earnings growth will, in most cases, have a lower P/E.

Investors can use the P/E ratio to compare the relative valuations of stocks. As stated in section 1.6.2, too
simplistically, one might claim that, if one stock has a P/E twice that of another stock, all things being
equal, it is a less attractive investment. Companies are rarely equal, however, and comparisons between
industries, companies and time periods can be very misleading.

In general terms, companies which are in sectors of the economy where relatively high growth levels are
expected – such as high technology – will have higher P/E ratios than those in sectors such as utilities or
car manufacturing. Companies in different sectors of the economy will also tend to exhibit generically
contrasting P/E ratios. This will itself be largely based upon the market’s expectations as to future earnings
growth in different sectors. For example, a relatively young technology company which has bright
prospects will often be rewarded by investors with a relatively high P/E ratio as the earnings are expected
to grow dynamically.

317
On the other hand, a mature utility company which has fairly predictable future earnings potential will tend
to have a relatively lower P/E ratio based on more conservative growth estimations. Only if one were to
compare two companies from the same high growth sector – such as biotechnology – and one had a P/E
ratio of 20 and the other a P/E of 12 might it be reasonable to conclude that the former was more attractive,
as the market’s expectations for it were higher.

Comparing P/E ratios for companies in very different sectors of the economy is therefore not advisable,
and even comparing the P/E ratios for companies across borders can be very misleading, owing to
the different GAAP regimes. One factor which can influence any cross-border comparison between
companies is the interest rate environment as well as the annual rate of inflation in the respective
national economy. If short-term interest rates are relatively low, and inflation is considered to be benign,
a larger P/E ratio is supportable as there is less competition for equities coming from the income
obtainable from fixed-income securities and vice versa. Also relevant to such comparisons are local cost
structures for companies in general, the role of capital markets in capital formation, the extent of the
role of government and the financial regulatory environment.

Caution in general is suggested when using the P/E ratio unless it is for highly comparable businesses in
the same jurisdiction.

Another useful application of the P/E ratio is to consider the relationship between the P/E ratio on an
individual company’s security and the P/E ratio of the stock market average or of the sector average.
Some investors will be attracted to companies with a low P/E ratio as it suggests that the company
may be undervalued. Once again this needs to be placed into the context of which sector a possible
acquisition candidate occupies – so, for example, a company interested in taking over a technology
company will almost certainly have to pay an above-average market P/E multiple but will look for one
that is still attractively priced within that sector of the market.

Window-Dressing
One of the recurring comments made in the qualifications expressed regarding the interpretation
of financial analysis relates to the timing of events recorded on a company’s statement of financial
position. If an event, eg, the issuance of new shares, takes place towards the end of a fiscal year, then the
correct approach is to use a technique to weight the event appropriately so that the impact of the event
is spread out over the year.

More deliberate efforts can be made by companies to portray their accounts in the best light
possible and these are sometimes included under the heading of ‘window-dressing’. Window-dressing
transactions can be defined as transactions intended to mislead the user of the accounts. Another term
which is sometimes used in this regard is the tendency to use ‘cosmetic accounting techniques’ to cover
up the blemishes that would otherwise be apparent.

Window-dressing and cosmetic accounting can be more or less innocent and more or less dangerous for
the unwary. It can also lead to a distorted view of relative performance between companies, whether in
the same sector or jurisdiction, or for international comparisons. A common cause of distortion arises
because several ratios are calculated with reference to a year-end statement of financial position figure
only.

318
 Securities Analysis

Ideally one should compare full year’s transaction to a representative balance throughout the year. In
assessing true profitability, one should compare the full year’s profits to a representative amount of
capital employed to get the most accurate and reliable measure of the return on capital employed.

Comparing Like with Like

When using financial ratios therefore, it is imperative to compare like with like. As previously discussed,
the kind of depreciation methods used should be consistent and there is little value in comparing the
inventory turnover ratios for a supermarket with those for a high-end retail boutique.

If one is considering the payables payment period, it is most useful to compare the invoiced payables to
the invoiced cost of sales.

Also, when calculating profit margins, it is more reliable and accurate to compare the profit to the
revenue that has generated that profit.

6
Overreliance on Historic Information
A common criticism that is made about financial analysis and then decision-making, and about the
kinds of interpretation that can be drawn with respect to ratio analysis, is that, necessarily, all of the data
that has informed the present ratios will be historic – ie, in assessing profitability, the analyst will be
using revenues and costs and other pertinent data from the past.

While such data will have value with respect to future forecasts and can be used as a foundation for
making comparisons across different companies, the key to the successful management of business is
the ability of the management team to handle the unexpected, deal with contingencies and navigate
their way through the uncertainties and risks that arise in a fast-changing business environment.

The global banking crisis revealed to the world that the issue of liquidity for the financial services sector
had been vastly underrated. Banks that had operated for many years with very high gearing were
suddenly exposed as having taken very large risks with respect to their liquidity. The business models
of funding long-term obligations with short-term capital from previously highly liquid money markets
turned out to have been a mirage.

In general terms, the liquidity of any business depends to a large extent on the macro monetary
environment. In addition, it is useful to consider the benchmarks or norms which prevail among the
competitors and peer group for the sector of business in which the particular firm operates.

To take one example from the field of credit rating, the analysis which was performed by rating agencies
and regulators in assessing the risks of collateralised debt obligations (CDOs) and other mortgage-backed
securities (MBSs) was, as subsequent case studies and testimony have revealed, based on a study of
property prices over a relatively short time-frame. One could make the case both that the sample period
proved to be too short and that the modelling of a coordinated decline in housing prices had not been
properly undertaken because the analysts were too focused on the most recent historic data.

319
Similar risks can arise for a business when the expectation is that the future will largely resemble the
recent past, but developments in business processes, the burnout of demand for products which easily
become outmoded and the constant risk of disruptive innovations suggests that no business can
become overly reliant upon the continuation of trends which have been present in the past. The area of
business process re-engineering (ie, the continuing need for innovation and adaptation to new practices
in the way that business is conducted) is very active, and so are the threats to existing businesses from
brand new competitors with lower cost bases and better products and services.

1.7.2 The Benefits and Limitations of Relying on Third-Party Research

Many companies provide specialised research services for the macro economy and for particular
sectors of the economy. For example, companies such as Ovum Research provide in-depth analysis of
the global telecommunications industry and detailed knowledge of all of the major participants in this
marketplace. They provide industry forecasts and can be engaged by specific businesses to undertake
more detailed research on a custom basis.

In the financial services sector, there is a plethora of advisory and research organisations which examine
the state of:

• public finances – eg, the Institute for Fiscal Studies (IFS)

• the state of the housing market – eg, Nationwide Building Society
• the state of the retail industry – eg, the British Retail Consortium.

The principal benefit to be derived from the work of such third-party research firms is that there is a
depth of knowledge and expertise within such firms and organisations which can provide authoritative
and useful information to both business managers and the investment community.

There can also be considerable limitations as to the value of such research. Firstly, the organisation
which is providing the reports may have a hidden agenda or in the worst case a conflict of interest. For
example, the research firm may be trying to ingratiate itself with, or already have a relationship with, a
particular company, and may present information in a biased fashion. Furthermore, some research firms
have a vested interest in only presenting positive information that will enhance their likelihood of being
seen as supportive to a particular sector and more deserving of fees from potential clients.

The last issue raises the risk that the third parties may not be as independent as one would expect or
require. The case of the credit-rating agencies comes to mind again. When the issuer of a bond or security
engages a credit-rating firm to assess the credit risk of a security it is planning to issue, there is a prima
facie concern that the agency will want to please the issuer. After all the issuer is paying the agency,
rather than having proper diligence for the buyers of the securities who ultimately (and unwisely) use
the ratings prepared by the agencies to determine the riskiness of the security. The fact that so many
MBSs were issued with AAA ratings and turned out in some cases to be practically worthless provides
a clear illustration of the possible conflict of interest issues, and also on the unreliability of some third-
party research.

320
 Securities Analysis

1.7.3 Summary
When considering financial ratios for the purposes of comparative analysis, the aim should always be to
compare like with like, to apply the correct perspective on financings and changes in capital structure
during the period under investigation, to take into account the different business models and P/E
multiples applicable to different sectors of the economy, the rate of change in key levels of financial
performance, and, in general, to have a cautious view to over-reaching with the conclusions that one
reaches from that analysis.

2. Environmental, Social and Governance (ESG)

Learning Objective

6
6.2.1 Understand the main factors taken into account when conducting an analysis of
Environmental, Social and Governance (ESG) risks and opportunities

Environmental, Social, and Governance (ESG) refers to a set of standards for companies to comply
with. It enables socially conscious investors to effectively screen any intended investments before
trading. ESG has become an increasingly popular approach for potential investors to consider
environmental, social, and governance factors when deciding which companies they might want to
invest in. ESG investing is sometimes referred to as:

• responsible investing
• impact investing
• sustainable investing, or
• socially responsible investing.

ESG criteria allows investors to examine a broad range of company behaviour that can be defined in
three categories:

Environmental
Environmental standards may include how a company uses energy, how it deals with waste and
pollution, consideration and treatment of animals and its approach to conservation of natural resource,
as well as how it manages environmental issues. An example would be an environmental management
system which can be certified under ISO 14001 (International Organization for Standardization) which
sets out the criteria.

Social
Social factors look at how a company conducts its relationships with:

• Employees.
• Suppliers.
• Customers.
• Communities in which it operates.

321
For example, does the company donate funds to help the local community or allow and encourage its
staff to engage in community related volunteer work? Social criteria looks at the company’s business
relationships. For employees, do the working conditions prioritise health and safety issues?

An example would be a ‘sweatshop’ that might have working conditions that are very poor and/or
socially and legally unacceptable.

Governance
Governance looks at its leadership and running of the company and will include examination of factors
such as:

• Executive remuneration.
• Shareholders’ rights.
• Internal controls.
• Audits.
• Board nomination process.

Governance issues may include whether a company employs high standard accounting methods or
whether shareholders are afforded the chance to vote on key issues. Potential investors may want to
examine how the board handles such issues as conflict of interest.

The Increasing Focus on ESG

Many collective investment schemes (CISs), exchange-traded funds (ETFs), brokers and some robo-
advisors promote products that incorporate some ESG criteria. This can assist investors in avoiding
uninformed investment where the company might, because of their behaviour and practices, pose a
large financial risk or engage in activities that conflict with the investor’s own values and beliefs.

We are living in an environment where people are increasingly concerned about the global environment
– especially younger investors. There is an increasing desire to invest in companies that employ practices
that match their own standards and beliefs, and this will include individual pension investments. While
factors such as yield, performance and risk are important factors when deciding upon an investment,
ESG factors are increasingly affecting investment selection as a key criterion.

By definition, ESG involves investing in companies with sustainable business practices on the expectation
that such companies have higher investment potential. Theoretically, the application of ESG criteria
should, therefore, help to reduce risk. According to research carried out by MSCI, companies with high
ESG ratings have historically demonstrated lower levels of systematic risk, less volatile earnings, and less
systematic volatility, along with lower costs of capital compared with their low ESG-rated counterparts.

Greenwashing
Many companies have been criticised for simply labelling themselves as ‘green’ but not following
through with their pledges – this is known as ‘greenwashing’. This is the practice of companies making
misleading environmental claims for marketing purposes with the aim of improving their reputation
to attract environmentally and socially aware consumers, employees and investors, thereby increasing
profits.

322
 Securities Analysis

The origins of ESG can likely be traced back to the mid-18th century and the moral teachings of religious
groups such as the Quakers, who used their influence in early UK banking to discourage investment in
activities like slavery, alcohol and gambling.

ESG and Legislation

The European Securities and Markets Authority (ESMA) has set up a Coordination Network on
Sustainability which engages with national competent authorities to develop policies for the inclusion
of sustainability considerations in financial regulation and law.

In April 2019, ESMA issued a Consultation Paper which highlights proposed measures for the adoption
of sustainability factors and risks that UCITS and AIF managers should adopt into the management of
the organisation.

A month later, ESMA issued a paper of technical advice to the European Commission on possible
initiatives to deal with sustainable factors within the investment industry, going as far as to recommend

6
integrating new requirements into existing legislation such as:

• The Markets in Financial Instruments Directive II (MiFID II)

• Undertakings in Collective Investment in Transferable Securities (UCITS) Directive (investment
funds), and
• The Alternative Investment Fund Managers Directive (AIFMD).

The recommendations will oblige fund management companies to incorporate sustainability factors
and risks into areas of its business such as:

• Resourcing.
• Senior management oversight responsibility.
• Organisational structure.
• Investment due diligence.
• Conflicts of interest.
• Risk management.

In July 2019, ESMA issued another technical advice paper focussed on sustainability considerations
for the credit rating industry and its disclosure requirements. ESMA has confirmed that credit rating
agencies use different methods to consider ESG factors across asset types.

The Future for ESG

It is expected that ESMA will next consult on the draft implementing measures for the purpose of
integrating ESG into financial services regulation across the EU, making compliance mandatory.

As compliance with new directives and regulations is achieved in the industry, investors will be able to
be well informed on ESG factors for investments.

323
 End of Chapter Questions

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

1. Previously known as the balance sheet, what is the taxonomy which has been adopted by
the Revised Accounting Standards (IAS 1) and is the use of this new terminology mandatory?
Answer reference: Section 1.1.1

2. What is meant by the term ‘purchased goodwill’?

Answer reference: Section 1.1.2

3. What is the purpose of common-size analysis with respect to a company’s financial statements?
Answer reference: Section 1.1.4

4. How is earnings per share (EPS) calculated?

Answer reference: Section 1.2.2

5. If a company’s accounts show a decrease in accounts receivable, how will this impact its
statement of cash flows?
Answer reference: Section 1.3.2

6. In relation to the gearing of a company and its cost structure and revenues, what is the value
known as the contribution?
Answer reference: Section 1.4.3

7. Explain what is meant by dividend cover and provide a simple formula for how it is calculated.
Answer reference: Section 1.6.4

8. In contrasting the price/earnings (P/E) ratios of a long-established utility company and a relatively
new technology company, which would be expected to have the higher ratio and why would you
expect this to be the case?
Answer reference: Section 1.7.1

9. What are some of the limitations of relying on third-party research?

Answer reference: Section 1.7.2

10. What factors are considered important within ESG?

Answer reference: Section 2

324
Chapter Seven

Portfolio Construction
1. Market Information and Research 327

2. Influencing Factors 338

3. Securities and Derivatives Markets 347

4. Portfolio Risk 365

5. Mitigating Portfolio Risk 369

7
6. Key Approaches to Investment Allocation 376

7. Cash, Bond and Equity Portfolio Management 385

8. Evaluation of Portfolio Risk and Return 399

This syllabus area will provide approximately 8 of the 80 examination questions

326
 Portfolio Construction

1. Market Information and Research

1.1 Economic and Financial Communications

Learning Objective
7.1.1 Understand the use of regulatory, economic and financial communications: primary and
secondary information providers; government resources and statistics; broker research and
distributor information; regulatory resources

Financial communications and reports from numerous bodies, both in the private and public sector,
are a vital part of the tools required for the research and analysis functions that are crucial to
decision-making about investment strategies and asset allocation. The data needed by an investment
manager can be sourced from the following broad categories:

• Primary and secondary information providers (news services) – eg, Bloomberg, Thomson
Reuters, Consumer News and Business Channel (CNBC).

7
• Government resources and statistics – the Office for National Statistics (ONS) and the Bank of
England (BoE).
• Broker research and distributor information – eg, market commentary and analysis from major
investment banks, such as Goldman Sachs and Morgan Stanley.
• Desk research – secondary source research and analysis by an investment fund management team.
• Regulatory resources where relevant – eg, communications from the Financial Conduct Authority
(FCA).

1.1.1 Primary and Secondary Information Providers (News Services)

The major providers of financial news include the following companies:

Bloomberg
Bloomberg is a privately held financial software, news and data company. According to a market survey
by the New York Times it has a one-third share of the market for financial information services. Bloomberg
was founded by Michael Bloomberg in 1981 with a 30% ownership investment by Merrill Lynch. The
company provides financial software tools such as analytics and equity trading platforms, data services
and news to financial companies and organisations around the world through the Bloomberg Terminal,
its core money-generating product. Bloomberg has grown to include a global news service, including
television, radio, the internet and printed publications.

Thomson Reuters (TR)

Thomson Reuters (TR) is an information company created by the Canadian company Thomson
Corporation’s purchase of Reuters in April 2008. Thomson Reuters shares are listed on the Toronto Stock
Exchange (TSE) and the NYSE. According to a New York Times survey, TR also has approximately one-third
of the market for financial information services. The company has launched a television service called
Insider and is very visible on the internet as a major source of financial and non-financial news coverage.

327
CNBC
CNBC is a satellite and cable television business news channel in the US, owned and operated by NBC
Universal. The network and its international spin-offs cover business headlines and provide live coverage
of financial markets. The combined reach of CNBC and its siblings is 390 million viewers around the
world. It is headquartered in New Jersey and has a European headquarters in London.

A competitor of CNBC in rolling business news coverage is the Fox Business News Network which is part
of News Corporation, owned partly by the Murdoch family, which also owns the Wall Street Journal.

Financial Times and Wall Street Journal

Two online publications are also widely followed by global investors and there are of course many other
newspapers which provide detailed coverage of financial matters both in the UK and around the world.

The Financial Times reports business, and features share and financial product listings. The FT is usually
in two sections; the first section covers national and international news, the second company and
markets news.

The Wall Street Journal is an English-language international daily newspaper published by Dow Jones &
Company, a division of News Corporation, in New York City, with Asian and European editions.

1.1.2 Official Sources

Office for National Statistics (ONS)
The principal source for economic data on the UK economy is the ONS. The ONS produces and publishes
a wide range of information about Britain that can be used for social and economic policy making.
Much of the data on which policy makers depend is produced by the ONS through a combination of a
decennial population census, samples and surveys and analysis of data generated by businesses and
organisations such as the National Health Service and the register of births, marriages and deaths.

Arguably the most important set of data which is released periodically by the ONS relates to UK gross
domestic product (GDP). This measure is reported in essentially two formats showing the percentage
change within the most recent quarter of reference and also the current quarter’s relationship to the
same period one year ago.

In addition to the GDP data, other widely followed economic data published by the ONS relate to
inflation – the consumer prices index (CPI) and the different flavours of the retail prices index (RPI and
RPIX), employment data, balance of trade data and other demographic data.

Bank of England (BoE)

The Financial Stability Report is published half-yearly by bank staff under the guidance of the Bank’s
Financial Stability Executive Board. It aims to identify the major downside risks to the UK financial
system and thereby help financial firms, authorities and the wider public in managing and preparing for
these risks.

The Report starts with an overview of key developments affecting the UK financial system. This is
followed by four sections:

328
 Portfolio Construction

1. Global financial environment.

2. Short-term risks to financial stability.
3. Medium-term risks to financial stability.
4. Prospects for financial stability.

1.1.3 Broker Research

Securities research is a discipline within the financial services sector. Securities research professionals
are known most generally as analysts, research analysts, or securities analysts. Securities analysts are
commonly divided between the two basic kinds of securities: equity analysts (researching stocks and
their issuers) and fixed-interest analysts (researching bond issuers). However, there are some analysts
who cover all of the securities of a particular issuer, stocks and bonds alike.

Securities analysts are usually further subdivided by industry specialisation (or sectors). Among the
industries with the most analyst coverage are technology, financial services, energy, software and
retailing. Fixed-income analysts are also often subdivided, with specialised analyst coverage for
convertible bonds, high-yield bonds, distressed securities and other financial products.

7
Securities analysts communicate to investors, through research reports and commentary, insights
regarding the value, risk and volatility of a covered security, and thus assist investors to decide whether
to buy, hold, sell, sell short or simply avoid the security in question or derivative securities. Securities
analysts review periodic financial disclosures of the issuers (as required by the LSE and FCA in the UK
and the SEC in the US) and other relevant companies, read industry news and use trading history and
industry information databases. Their work may include interviewing managers and customers of the
companies they follow.

Those analysts who are engaged by a brokerage firm are usually referred to as sell-side analysts. This
differentiates them from buy-side analysts, who are engaged by asset management firms as part of their
research efforts before they buy securities rather than sell them.

1.1.4 Regulatory Resources

The main source of information reflecting changes in financial regulations which need to be complied
within the financial services sector in the UK are those which originate within the FCA. These can start
out as consultation papers but may then become official rule changes and will appear in the FCA
Handbook.

In addition, it is worth monitoring the FCA website for general regulatory developments, disciplinary
actions, money laundering issues and other developments.

Other areas where potential changes in regulations may be relevant arise from changes in listing
requirements from the FCA, changes affecting takeover regulation from the Panel on Takeovers and
Mergers (PTM or POTAM or just the Takeover Panel) and changes in legislation affecting companies in
general which will eventually be incorporated into updates of the Companies Acts.

329
1.2 Research and Reports

Learning Objective
7.1.2 Understand the different types and uses of research and reports: fundamental analysis;
technical analysis; fund analysis; fund rating agencies and screening software; broker and
distributor reports; sector-specific reports

1.2.1 Fundamental Analysis

Fundamental analysis involves the financial analysis of a company’s published accounts, along with an
analysis of its management, markets and competitive position. It is a technique that is used to determine
the value of a security by focusing on the underlying factors that affect a company’s business.

Fundamental analysis looks at both quantitative factors, such as the numerical results of the analysis of
a company and the market it operates in, and qualitative factors, such as the quality of the company’s
management, the value of its brand, and areas such as patents and proprietary technology.

The assumption behind fundamental analysis is that the market does not always value securities
correctly in the short term, and that by identifying the intrinsic value of a company, securities can
be bought at a discount and that the investment will pay off over time once the market realises the
fundamental value of a company.

Companies generate a significant amount of financial data, and so fundamental analysis seeks to extract
meaningful data about a company.

In addition to this quantitative data, fundamental analysis also assesses a wide range of other qualitative
factors such as:

• a company’s business model

• its competitive position
• the quality and experience of its management team
• how the company is managed, the transparency of available financial data and its approach to
corporate governance, and
• the industry in which it operates, its market share and its competitive position relative to its peers.

1.2.2 Technical Analysis

Technical analysis also seeks to evaluate the value of a company, but, instead of analysing a company’s
intrinsic value and prospects, it uses historical price and volume data to assess and estimate where
the price of a security or market will move in the future. In essence, technical analysts use different
quantitative and statistical tools to analyse time-series data of asset prices and other characteristics,
with a view to discerning recurrences of similar price-development patterns or chart formations.

330
 Portfolio Construction

The assumptions underlying technical analysis are that:

• the market discounts everything

• prices move in trends, and
• history tends to repeat itself.

Technical analysis uses charts of price movements, along with technical indicators and oscillators,
to identify patterns that can suggest future price movements. It is therefore unconcerned whether a
security is undervalued and simply concerns itself with future price movements.

One of the most important concepts in technical analysis is trend. Trends can, however, be difficult to
identify, as prices do not move in a straight line, and so technical analysis identifies series of highs or
lows that take place to identify the direction of movements. These are classified as uptrend, downtrend
and sideways movements.

The following diagram seeks to explain this by describing a simple uptrend.

7
3

1
4

Point 1 on the chart reflects the first high and point 2 the subsequent low and so on. For it to be an
uptrend, each successive low must be higher than the previous low point, otherwise it is referred to as a
reversal. The same principle applies for downtrends.

Along with direction, technical analysis will also classify trends based on time. Primary movements are
long-term price trends, which can last a number of years. Primary movements in the broader market
are known as bull and bear markets, a bull market being a rising market and a bear market a falling
market. Primary movements consist of a number of secondary movements, each of which can last for
up to a couple of months, which, in turn, comprise a number of tertiary, or day-to-day movements. The
results of technical analysis are displayed on charts that graphically represent price movements.

After plotting historical price movements, a trendline is added to clearly show the direction of the trend
and to show reversals.

331
The trendline can then be analysed to provide further indicators of potential price movement. The
diagram below shows an upward trend line, which is drawn at the lows of the upward trend and which
represents the support line for a stock as it moves from progressive highs to lows.

Price

Time

This type of trendline helps traders to anticipate the point at which a stock’s price will begin moving
upwards again. Similarly, a downward trendline is drawn at the highs of the downward trend. This line
represents the resistance level that a stock faces every time the price moves from a low to a high.

There are a variety of different charts that can be used to depict price movements; some of the main
types of chart are:

• Line charts are where the price of an asset, or security, over time is simply plotted using a single
line. Each point on the line represents the security’s closing price. However, in order to establish an
underlying trend, chartists often employ what are known as moving averages so as to smooth out
extreme price movements. Rather than plot each closing price on the chart, each point on the chart
instead represents the arithmetic mean of the security’s price over a specific number of days. 10, 50,
100 and 200 moving day averages are commonly used.
• Point and figure charts record significant price movements in vertical columns by using a series of
Xs to denote significant up moves and Os to represent significant down moves, without employing a
uniform timescale. Whenever there is a change in the direction of the security’s price, a new column
is started.
• Bar charts join the highest and lowest price levels attained by a security over a specified time period
by a vertical line. This time scale can range from a single day to a few months. When the chosen time
period is one trading day, a horizontal line representing the closing price on the day intersects this
vertical line.
• Candlestick charts – closely linked to bar charts, these again link the security’s highest and lowest
prices by a vertical line but employ horizontal lines to mark both the opening and closing prices for
each trading day. If the closing price exceeds the opening price on the day the body of the candle is
left clear while, if the opposite is true, it is shaded.

332
 Portfolio Construction

Technical analysis also uses lines on charts which form a channel, which is where two trendlines are
added to indicate levels of support and resistance which respectively connect the series of price lows
and price highs. Users of technical analysis will expect a security to trade between these two levels until
it breaks out, when it can be expected to make a sharp move in the direction of the break. If a support
level is broken, this provides a sell signal, while the breaking of a resistance level, as the price of the asset
gathers momentum, indicates a buying opportunity.

An example of such a breakout pattern is the one in the diagram below, where there has been an
upward breakout above the price resistance line. With respect to such channels, it is often observed that
price movements become progressively less volatile, and when there is a breakout, in either direction,
the price movement can then be quite dramatic.

Price

7
Time

Other continuation patterns include the rectangle and the flag.

Chartists typically use what are known as relative-strength charts to confirm breakouts from
continuation patterns. Relative strength charts simply depict the price performance of a security relative
to the broader market. If the relative performance of the security improves against the broader market
then this may confirm that a suspected breakout on the upside has or is about to occur. However,
acknowledging that prices do not always move in the same direction and trends eventually cease,
technical analysts also look to identify what are known as reversal patterns, or sell signals.

333
Probably the most famous of these is the head and shoulders reversal pattern, which is shown below.

Price Head

Left Shoulder Right Shoulder

Neckline

Time

A head and shoulders reversal pattern arises when a price movement causes the right shoulder to
breach the neckline – the resistance level – indicating the prospect of a sustained fall in the price of the
security.

1.2.3 The Difference between Fundamental and Technical Analysis

Fundamental and technical analysis are the two main methodologies used for investment analysis and,
as you can see from comparing their key characteristics, they differ widely in their approaches.

The principal differences between them can be summarised as follows:

• Analysing financial statements versus charts

• At a basic level, fundamental analysis involves the analysis of the company’s balance sheet, cash
flow statement and income statement.
• Technical analysis considers that there is no need to do this, as a company’s fundamentals are
all accounted for in the price and the information needed can be found in the company’s charts.
• Time horizon
• Fundamental analysis takes a relatively long-term approach to investment.
• Technical analysis uses chart data over a much shorter time-frame of weeks, days and even
minutes.
• Investing versus trading
• Fundamental analysis is used to make long-term investment decisions.
• Technical analysis is used to determine short-term trading decisions.

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

334
 Portfolio Construction

1.2.4 Fund Analysis

The IA has published a classification system for the diverse array of funds available to UK investors
including unit trusts and OEICs. The diagram in chapter 4, section 3.4, shows the IA classifications.

The groups correspond to broadly different investment objectives.

• Some income funds principally target immediate income, while others aim to achieve growing
income.
• Growth funds, which mainly target capital growth or total return, are distinguished from those that
are designed for capital protection.
• Specialist funds cover other more niche areas of investment.

Specialist fund-rating companies provide many valuable reports and surveys of the huge number of
investment funds that are available globally.

In the US, and increasingly in Europe, fund-ratings providers, such as Morningstar, Fitch Ratings and
Fund House, provide extensive research on mutual funds and other collective investment vehicles.
Trustnet provides a similar and comprehensive service for UK-based investors.

7
These services allow an investor to review the performance of funds from many different perspectives,
eg, total return, P/E ratios and dividend growth. It is possible to screen the databases which are
accessible on the websites of these companies for a fund which matches the criteria which one specifies.
For example, if one wants to invest in a fund which has exposure to Asian equities excluding Japan,
where the fund manager has been running the fund for at least three years and where the standard
deviation of the returns over the last five years has been below a specified amount, this can be achieved
by using the Morningstar and Trustnet platforms. Similar screening facilities are supplied at no charge by
companies such as Yahoo and MSN, but usually the databases are confined to single shares rather than
funds.

The following screenshot shows the manner in which a user can search for funds listed by Morningstar
which have a specific rating, as explained on the right-hand side of the image, and then to be more
specific with the other screening criteria, including the capacity to filter out results which have failed to
generate returns over (say) three years above a threshold amount supplied by the user.

335
Quantitative Versus Qualitative Fund Analysis
Quantitative analysis involves metrics such as comparing the performance of specific funds with the
overall market performance or the difference between a fund’s performance and a given benchmark.
Qualitative analysis differs in that it is more subjective and considers metrics such as fund managers’
skills and expertise and the relative position of the fund compared to one’s view of the market’s future
direction. Typically, a mixture of both quantitative and qualitative analysis will provide the optimum
position.

1.2.5 Broker and Distributor Reports

All major investment banks and brokers publish research reports on numerous matters which are of
interest to investors and fund managers.

These research reports may only be made available to clients of the firm, but are sometimes placed
in the public domain. These reports may cover macro-analysis, eg, a broker’s analyst may be showing
research and evidence for the prospects for growth in the US economy over the next year, or they may
be at the micro-level, examining the prospects for specific companies. The material covered by brokers
can include companies which are clients of the broker and also those which are not. Indeed some
brokers will publish research reports and offer ratings, ie, buy, sell or hold, on their competitors.

1.2.6 Sector-Specific Reports

In addition to the fund ratings agencies mentioned in chapter 2, section 1.1.6, there are numerous other
investment research firms which provide specialised information on specific sectors of the market, as
well an overview of sector performance in general.

336
 Portfolio Construction

As an example, the table below shows the performance of the eleven S&P 500 sectors.

The 2018 Sector Reclassification

As of September 2018, the S&P 500 was divided into 11 sectors, as follows, with their respective
weightings by market capitalisation. The following are the weightings as of January 2021:

• Communication Services: 10.8%

• Consumer Discretionary: 12.7%
• Consumer Staples: 6.6%
• Energy: 2.38%
• Financials: 10.31%
• Health Care: 13.4%
• Industrials: 8.5%
• Information Technology: 27.65%
• Materials: 2.65%
• Real Estate: 2.48%
• Utilities: 2.7%

7
Here is the performance of the sectors over the past ten years:

Abbrev. Sector Index Annual Best Worst

COND S&P 500 Consumer Discretionary Index 13.05% 43.1% –33.5%
CONS S&P 500 Consumer Staples Index 10.40% 27.6% –15.4%

ENRS S&P 500 Energy Index 0.86% 34.4% –34.9%

FINL S&P 500 Financials Index 3.13% 35.6% –55.3%

HLTH S&P 500 Healthcare Index 11.0% 41.5% –22.8%

INDU S&P 500 Industrials Index 8.95% 40.7% –39.9%
INFT S&P 500 Information Technology Index 15.21% 61.7% –43.1%
MATR S&P 500 Materials Index 8.49% 48.6% –45.7%
REAL S&P 500 Real Estate Index 5.38% 32.3% –42.3%
TELS S&P 500 Communication Services index 8.92% 32.7% –30.5%
UTIL S&P 500 Utilities Index 8.75% 29.0% –29.0%
S&P S&P 500 Index 9.88% 32.4% –37.0%

Source: Annual S&P Sector Performance (Novel Investor)

337
 2. Influencing Factors

Learning Objective
7.1.3 Be able to assess key factors that influence markets and sectors: responses to change and
uncertainty; volume, liquidity and nature of trading activity in domestic and overseas markets;
publication of announcements, research and ratings

2.1 Responses to Change and Uncertainty

It is an adage among investment professionals that markets hate uncertainty. Uncertainty is effectively
a synonym for risk, as risk arises from the uncertainty of outcomes. As investors, each time we decide to
purchase a security or invest in an opportunity, the outcome is uncertain in the same way that any future
event is.

2.2 Volume and Liquidity

The presence or absence of liquidity in financial markets is one of the most important conditions for
transactions to take place.

Economists have really not provided a satisfactory account of liquidity, but rather assume that it will be
present in markets. The term refers to the depth of interest from both buyers and sellers for a security
and if, as occurs from time to time – as in Q4 2020 – there is an absence of interest from buyers in many
securities, a market will become lopsided and the desire by many to sell their shares and bonds at the
same time causes disorderly market behaviour and results in rather sudden and abrupt drops in prices
of securities.

In its more extreme form this can be referred to as a market crash. The classic example of such an event
took place in October 1987, when global markets dropped precipitously and the NYSE fell by more than
20% in a single session on Monday 19 October of that year, with other indices such as the LSE registering
similar falls. The vital role of liquidity has been touched upon and it is worth pointing to the different
motives of the investor and the speculator or trader. The investor, such as a pension fund or unit trust
manager, may be purchasing (or selling) securities as part of a long-term portfolio management
exercise. The speculator or trader may be interested in trying to profit from short-term movements in
the prices of securities without the intention of holding the securities for an extended period.

Speculators and traders help to provide liquidity to a market which would see less activity if it were just
long-term investors that were conducting the activity. Trading activities create larger volumes in the
markets, and thereby enhance the ability of the long-term investors and allocators of capital to buy and
sell without moving the market excessively. This is a somewhat controversial topic, as there are some
who would argue that the activity of speculators, rather than providing greater liquidity and acting as a
way of smoothing price fluctuations, may actually lead to larger moves in prices or volatility, which has
the consequence of destabilising markets.

338
 Portfolio Construction

2.3 Global Movements

There is growing evidence that, in the highly inter-connected web of markets and the macro or global
investment strategies followed by large investment banks and asset managers, the degree to which
major global asset classes reveal a high degree of co-movement or correlation is indicative of ‘big
picture’ investment strategies, which are based on inter-market strategies. Although spelling out such
inter-market strategies goes beyond the syllabus of this course, the inter-linked nature of alignments in
foreign exchange, global equity indices, energy products and commodities in general can be fascinating
to study.

There are observable relationships between the movements of, for example, the Australian dollar versus
the Japanese yen, which is an example of the forex carry trade and the general appetite for riskier assets.
The forex carry trade arises from the notion that, if a large hedge fund or investment bank can borrow
capital in yen from Japanese sources at short-term rates that are less than 20 basis points (in general,
such rates are only available to the best rated entities, eg, major investment banks) and use the proceeds
to purchase Australian government securities yielding (say) 5%, there will not only be profits to be made
from the simple arbitrage but consequences for the exchange rates as well. Capital flows into Australian
government securities, with repo agreements then put in place, may then be associated with other
strategies to invest in other products such as commodities, often with considerable leverage, and such

7
strategies are followed by major funds and the proprietary trading desks of the large investment banks.

The consequences can be seen each day in the manner in which certain asset classes will move together
depending on the degree of risk that the short-term trading desks are willing to take. For example, and
to engage in simplification, following the 2007–08 banking crisis and the sovereign debt problems
within the eurozone, it is possible to discern a clear pattern whereby, when markets become more
anxious, there is a movement towards the US dollar and Japanese yen (which causes an ‘unwinding’ of
the short-term carry trades) and away from the euro and the so-called commodity currencies such as the
Australian and Canadian dollar. Investors/traders will also purchase US Treasury instruments and shun
the emerging markets and commodities.

Example of a Carry Trade

An investor decides to invest in a 12-month euro position @ 2%: €1,000,000 against GBP @ 1.3111:

Buy €1,000,000 @ 1.3111 = £762,718. GBP is borrowed at the rate of 1%. 12 months later, sterling has
dropped by 10% against the euro and the investor sells back the euro at the new rate of 1.1800.

Sell €1,000,000 @ 1.1800 = £847,457:

The loan is repaid leaving profit of £84,739 (£847,457 – £762,718).

The interest earned is 2% on €1,000,000 = €20,000 (or £16,949 @ the new rate 1.1800).

The interest payable is 1% on £762,718 = £7,627.

The total profit in the carry trade is, therefore:

Foreign exchange profit + interest earned – interest payable:

Therefore, total profit is: £84,739 + £16,949 – £7,627 = £94,061.

339
On the contrary, when there is more of an appetite for buying riskier assets, the converse will tend to be
the case. Capital will move away from the safe harbour of the US dollar and US Treasuries, global equity
indices will tend to move higher, the commodity currencies will often move up sharply against the dollar
and the emerging markets will see capital inflows.

Many of these movements will be of short-term duration, but it is also possible to discern similar
dynamics at work with respect to global asset allocation decision-making.

2.4 Market Abuse Regime

On 1 July 2005, the Financial Services and Markets Act 2000 (Market Abuse) Regulations 2005 came into
force in order to implement the European Commission (EC) Directive on Insider Dealing and Market
Manipulation (Market Abuse). The Market Abuse Directive (MAD) was a key element of the EU Financial
Services Action Plan and introduced a common EU approach for preventing and detecting market abuse
and ensuring a proper flow of information to the market.

The Market Abuse Regulation (MAR) took effect across the EU on 3 July 2016 and superseded the MAD.
The MAR, in many ways, is similar to the former UK regime, but expands the scope of market abuse and
introduces extra requirements for issuers and the way they operate. The UK has amended primary and
secondary legislation to ensure it complies with, and is compatible with, the MAR.

The MAR defines market abuse as follows:

‘Market abuse is a concept that encompasses unlawful behaviour in the financial markets and,
for the purposes of this Regulation, it should be understood to consist of insider dealing, unlawful
disclosure of inside information and market manipulation. Such behaviour prevents full and proper
market transparency, which is a prerequisite for trading for all economic actors in integrated financial
markets’.

Specifically, four types of behaviour are prohibited:

1. Engaging or attempting to engage in insider dealing.

2. Recommending that another person engage in insider dealing, or inducing another person to
engage in insider dealing.
3. Unlawfully disclosing inside information.
4. Engaging, or attempting to engage, in market manipulation.

The MAR applies to financial instruments:

1. admitted to trading on a regulated market, or for which a request for admission to trading on a
regulated market has been made
2. traded on a multilateral trading facility (MTF), admitted to trading on an MTF, or for which a request
for admission to trading on an MTF has been made
3. traded on an organised trading facility (OTF), and
4. not covered by points (1), (2) or (3), the price or value of which depends on, or has an effect on, the
price or value of a financial instrument referred to in those points, including, but not limited to, credit
default swaps and contracts for difference.

340
 Portfolio Construction

The UK market abuse regime applies not only to the regulated sector, but also to the public at large, and
sanctions may be imposed following a finding of severe market abuse. Offenders may face unlimited
financial penalties and, if they work in the financial services sector, they could lose their livelihoods by
having their authorisation/approval withdrawn or a prohibition order made against them.

The Markets in Financial Instruments Regulation (MiFIR), which has applied since January 2018, adds
further requirements to the existing regime that compels firms to report transactions and plays a key
role in the FCA’s market abuse monitoring work. The FCA takes a serious view of firms which fail to
report transactions in line with its rules or those who do not have in place adequate internal transaction
reporting procedures and systems. Even in cases of market misconduct, which do not necessarily fall
within the definition of civil market abuse, the FCA can still take action against a firm or individual (if
they are authorised to conduct investment business) based on a breach of its principles in the FCA
Handbook.

2.4.1 Insider Dealing

The first type of behaviour categorised as market abuse is insider dealing. This occurs where an insider
deals or attempts to deal in a qualifying or related investment on the basis of inside information relating

7
to the investment in question. This sits alongside the existing offence of criminal insider dealing which is
an offence under Part V of the Criminal Justice Act 1993.

An insider can be defined as any person who has inside information as a result of:

• their membership of an administrative, management or supervisory body of an issuer of qualifying

investments
• their holding in the capital of an issuer of qualifying investments
• having access to the information through the exercise of their employment, profession or duties
• their criminal activity, and
• other means which they know or could reasonably be expected to know.

The definition of inside information is broadly unchanged in the MAR, but is wider in scope in order to
capture inside information for spot commodity contracts. In the MAR, inside information includes the
following four key characteristics:

1. Information of a precise nature.

2. Information which has not been made public.
3. Information relating, directly or indirectly, to one or more issuers or to one or more financial
instruments.
4. Information which, if it were made public, would be likely to have a significant effect on the prices of
those financial instruments or on the price of related derivative financial instruments.

There is a separate definition of inside information for persons charged with the execution of orders (ie,
traders and market makers) and a further definition for emission allowances and auction products based
on these.

Front running is also classified as market abuse (ie, purchasing shares for a trader’s own benefit on the
basis of, and ahead of, orders from investors in order to benefit from an anticipated impact on prices).

341
2.4.2 Improper Disclosure
The second type of behaviour categorised as market abuse is improper disclosure. This occurs where
an insider discloses inside information to another person otherwise than in the proper performance of
their employment, profession or duties (this is commonly referred to as tipping off ).

According to the FCA, certain factors are to be taken into account in determining whether or not
disclosure is made by a person in the proper performance of their employment, profession or duties.
These include whether the disclosure is:

• permitted by FCA rules, the rules of a prescribed market, or the Takeover Code, or
• accompanied by the imposition of confidentiality requirements upon the person to whom the
disclosure is made and is reasonable, and is to enable a person to perform the proper functions of
their employment, profession or duties.

2.4.3 Misuse of Information

Market abuse can also arise from the misuse of information. This occurs where behaviour is:

• based on information which is not generally available to those using the market but which, if
available to a regular user of the market, would be, or would be likely to be, regarded by them as
relevant when deciding the terms on which transactions and qualifying investments should be
effected, or
• is likely to be regarded by a regular user of the market as a failure on the part of the person
concerned to observe the standard of behaviour reasonably expected of the person in their position
in relation to the market.

A regular user is defined, in relation to a particular market, as a reasonable person who regularly deals
on that market in investments of the kind in question.

An example of this behaviour is when an employee of a company informs a friend over lunch that the
company has received a takeover offer and the friend then places a spread bet with a bookmaker that
the same company will be the subject of a bid within a week. Note that the person making the bet is
guilty of misuse of information, but is not guilty of insider dealing as they are not dealing in qualifying
investments, which is a requirement of the insider-dealing behaviour.

2.4.4 Manipulating Transactions

Market abuse can arise from manipulating transactions which occur when the behaviour consists of
effecting transactions or orders to trade (other than for legitimate reasons and in conformity with
accepted market practices on the relevant market) which:

• give, or are likely to give, a false or misleading impression as to the supply of, or demand for, or as
to the price of, one or more qualifying investments (for example, entering orders onto an electronic
trading system at prices which are higher than the previous bid or lower than the previous offer and
withdrawing them before they are executed in order to give a misleading impression that there is
demand for, or supply of, the qualifying investment at that price), and

342
 Portfolio Construction

• secure the price of one or more such investments at an abnormal or artificial level (for example,
trading on one market or trading platform with a view to improperly influencing the price of the
same or related investments that are traded on another prescribed market).

An abusive squeeze is considered by the FCA to be a manipulating transaction. For example, a trader
with a long position in bond futures buys or borrows a large amount of the cheapest-to-deliver bonds
and either refuses to relend those bonds or will only lend them to parties the trader believes will not
relend to the market. The purpose is to position the price at which those with short positions have
to deliver to satisfy their obligations at a materially higher level, making the trader a profit from their
original position.

Criminal market manipulation is an offence under Sections 89–91 of the Financial Services Act 2012.

The MAR defines and prohibits market manipulation and has been extended to capture attempted
manipulation, benchmarks and, in some situations, spot commodity contracts.

2.4.5 Manipulating Devices

7
Manipulating devices consists of effecting transactions or orders to trade which employ fictitious
devices or any other form of deception or contrivance. An example of this is taking advantage of
occasional or regular access to traditional or electronic media by voicing an opinion about qualifying
investments while having previously taken positions on the investments and subsequently profiting
from the impact of the opinions voiced on the price of that instrument without having simultaneously
disclosed that conflict of interest to the public in a proper and effective way.

‘Pump and dump’ (ie, taking a long position in an investment and then disseminating misleading positive
information about that investment with a view to increasing its price) and trash and cash (ie, taking a
short position in an investment and then disseminating misleading negative information about that
investment with a view to driving down its price) are both considered by the FCA to be manipulating
devices within the meaning of civil market abuse.

2.4.6 Dissemination
The sixth type of behaviour amounting to market abuse is dissemination. This consists of the
dissemination of information by any means which gives, or is likely to give, a false or misleading
impression, as to a qualifying investment, by a person who knew, or could reasonably be expected to
have known, that the information was false or misleading.

An example of behaviour which, in the opinion of the FCA, falls within this category, is knowingly
or recklessly spreading false and misleading information about a qualifying investment through the
media. An example of the prohibited behaviour is the posting of information which contains false or
misleading statements about a qualifying investment on an internet bulletin board or in a chat room in
circumstances where the person knows that the information is false or misleading.

343
2.4.7 Misleading Behaviour or Distortion
The final type of behaviour amounting to market abuse is misleading behaviour or distortion, to the
extent that it is not covered under the previous headings. This occurs when behaviour is likely to:

• give a regular user of the market a false and misleading impression as to the supply of, demand for
or price or value of qualifying investments (misleading behaviour)
• be regarded by a regular user of the market as behaviour that will distort, or is likely to distort, the
market in such an investment (distortion), or
• be regarded by a regular user of the market as a failure on the part of the person concerned to
observe the standard of behaviour reasonably expected of a person in their position in relation to
the market.

2.4.8 Penalties for Market Abuse

If the FCA is satisfied that a person is engaging in, or has engaged in, market abuse, or has required or
encouraged another person to do so, it may:

• impose an unlimited civil fine

• make a public statement that the person has engaged in market abuse
• apply to the court for an injunction to restrain threatened or continued market abuse
• require a person to disgorge profits made or losses avoided as a result of market abuse, or
• require the payment of compensation to victims.

In some cases, the FCA may rely on individual recognised investment exchanges (RIEs) to take action
and the FCA has agreed operating arrangements with such RIEs in relation to market conduct for this
purpose.

2.4.9 Suspicious Transaction Reporting

The UK requirement for financial intermediaries involves the reporting of transactions giving rise to
suspicions of market abuse. An FCA-authorised firm which arranges or executes a transaction with,
or for, a client in a qualifying investment admitted to trading on a prescribed market, and which has
reasonable grounds to suspect that the transaction may constitute market abuse, is required to notify
the FCA without delay.

2.4.10 The London Stock Exchange (LSE) and Market Abuse

With the advent of the Markets in Financial Instruments Directive (MiFID), which has led to an expansion
in the scope for off-exchange trading (see section 3 of this chapter), the role of the major stock
exchanges to monitor the full range of MTFs has arguably diminished, which impairs the LSE’s ability
to monitor practices in accordance with the MAD. However, the MAR applies to financial instruments
admitted to all MTFs, as well as regulated markets. Accordingly, the MAR now applies to the AIM (as an
MTF) and other MTFs that admit to trading UK instruments that are also listed on the LSE.

344
 Portfolio Construction

2.5 The Panel on Takeovers and Mergers (the Takeover Panel

or POTAM)
The UK supervisory authority that carries out the regulatory functions required under the EU Takeover
Directive is the Panel on Takeovers and Mergers (the PTM or POTAM).

The Panel’s requirements are set out in a Code that consists of six general principles and a number of
detailed rules.

The Code is designed principally to ensure that shareholders are treated fairly and are not denied an
opportunity to decide on the merits of a takeover. Furthermore, the Code ensures that shareholders of
the same class are afforded equivalent treatment by an offeror. In short, the Code provides an orderly
framework within which takeovers are conducted, and is designed to assist in promoting the integrity
of the financial markets.

The European Takeovers Directive mandates that the Panel is put on a statutory footing. This was
completed in the Companies Act 2006. Whenever a transaction is made on the LSE or other London-
based exchange that is greater than £10,000, the details of the transaction get passed on to the panel for
their evaluation, and a levy is charged of (currently) £1.00 on the transaction, which goes to the panel as

7
payment (known as the PTM levy).

2.6 Publication of Announcements, Research and Ratings

From a short-term perspective, capital markets are highly sensitive to the publication of certain
information. Among the announcements that are most likely to have an impact on market behaviour
and settlement are the following.

2.6.1 Economic Data

The Office for National Statistics (ONS) in the UK publishes key economic reports regarding the labour
market, inflation (CPI and RPI data) and the rate of growth or decline in GDP. All of these reports are
subjected to detailed scrutiny and markets will often react to the data.

The key issue with respect to such data releases is the degree to which the published data has already
been discounted by market participants. In other words, traders and investors will form opinions about
the level of inflation before the actual release of the monthly CPI data and only if the numbers presented
are notably out of alignment with the expectations will the market react strongly. The market is alleged
to be a forward-looking discounting mechanism and as part of its pricing it will attempt to anticipate the
direction of the major macroeconomic variables.

In the US, the monthly report from the Department of Labour on Non-Farm Payrolls is one of the most
widely followed by market participants across the globe, as it provides one of the best indicators of
the state of the US economy. Traders and investors use the data to make forward forecasts about the
prospects for GDP growth and inflation and how this may affect the interest rate decisions by the
Federal Reserve.

345
2.6.2 Central Bank Policy Announcements
Each month the Monetary Policy Committee (MPC) of the Bank of England meets to review the short-
term interest rate policy – the repo rate – which is best suited to the current economic environment in
the UK.

Market participants watch the announcements about rates very closely. Unexpected moves in interest
rates, both upwards and downwards, have a large impact across all major asset classes. Bond prices
respond well to reductions in short-term rates, sterling may suffer if the rate available for short-term
sterling deposits is reduced, and the FTSE 100 will tend to move upwards on rate reductions. The
opposite reactions tend to be seen on a rate increase, and more so if the rate hike was unexpected or
more than had been expected.

The release of the minutes of each MPC meeting, which are usually published a few weeks after the
actual meeting, are also of interest to the markets. The comments expressed by the committee members
will be analysed carefully for any indications that monetary policy may be about to change.

Very similar issues arise in the case of the deliberations of the US central bank, the Federal Reserve. Since
the US is the largest single economy (about 15% of world GDP) and the US dollar is the global reserve
currency, the decisions about interest rates applicable on US dollar deposits/loans will have a greater
impact on global capital markets than any other. However, in the current market environment, investors
also pay particular attention to the activities of the Chinese government and its monetary policy, as well
as the Chinese participation in the US Treasury market.

2.6.3 Credit Rating Announcements

During 2010, global capital markets became increasingly anxious about sovereign debt, and this was
reflected in the enormous increase in the use of credit default swaps (CDSs) on individual sovereign
borrowers. The decisions made by the major credit rating agencies to downgrade the debt of a
particular sovereign issuer (such as happened to Greece, Ireland and Spain) can cause a ‘flight to safety’
as investors dump bonds from such issuers and seek out the safe haven of US Treasury bonds, and to
some extent gilts. Even the announcement that a country is being put on credit watch by an agency will
have a large impact in a market which is anxious about the levels of public debt in many nations.

2.6.4 Research Reports

The reports issued by brokerage firms and investment banks may have large macro-implications for
markets in general, but will more often involve a particular sector or even a particular company’s
securities. The downgrade of a company’s earnings outlook, which may have been triggered by the
company’s own announcements and forward-looking statements or even an unexpected comment on a
conference call with investors, can often see a company’s shares tumble.

If Goldman Sachs or J.P. Morgan tips a particular share for whatever reason, the price of that share is
likely to rise. Once again this may be caused by buying or simply by the market makers pushing up the
price in anticipation of likely buying.

346
 Portfolio Construction

2.6.5 Political Announcements

Some political announcements, especially relating to fiscal policy, also have the capacity to cause
significant movements in markets. The recent series of announcements from governments regarding
financial regulations and policies towards the banking system have introduced uncertainty into the
future prospects for the banking sector. As another example of the impact of political statements on
markets, in the summer of 2010, the announcements from President Obama regarding the horrendous
oil spill in the Gulf of Mexico and the need for BP to be held fully accountable for the costs resulting from
the damage done – both direct and indirect – saw the market capitalisation of BP fall by more than 50%
since the oil spill occurred in April 2010.

3. Securities and Derivatives Markets

Learning Objective
7.1.4 Be able to assess the interactive relationship between the securities and derivatives markets,

7
and the impact of related events on markets
7.1.5 Be able to assess the interactive relationship between different forms of fixed-interest
securities and the impact of related events on markets

3.1 Derivatives and Underlying Securities

The financial markets have seen a constant stream of innovations in recent years and many of these
are based on derivatives. In its simplest form a derivative is a security which is based upon or derived
from another asset such as an individual equity, an equity index, a commodity or a financial instrument
such as a gilt (or, in the US, a Treasury bond) or a foreign exchange rate. By its nature a derivative is a
contractual asset which is traded actively, some more than others, and the valuation of the derivative is
largely, if not completely, influenced by price movements in the underlying asset (often simply called
the ‘underlying’). In addition to price changes of the underlying, other variables, such as interest rates
and price volatility (ie, variability in the price behaviour), will also be factored into the pricing and
valuation of derivatives.

It is important to distinguish between those derivatives which are standardised and traded on public
exchanges, and those which are customised and traded in private markets or over-the-counter (OTC).
There are well known examples of both. Futures, for example, are standardised contracts requiring
the delivery of some standard item within specific time frames and in standardised quantities. They are
traded on exchanges such as the Chicago Mercantile Exchange (CME) and the London Metal Exchange
(LME).

The trades are settled via clearing houses and the trading volumes and price behaviour are fully
transparent and reported each day in the financial media. On the other hand, trading in credit default
swaps (CDSs) is not conducted on public exchanges where clearing houses clear all of the trades, but
rather they are agreements between two counterparties where the transaction takes place in an OTC

347
marketplace, which could be facilitated by a swap dealer or broker. Such transactions are subject to
counterparty risk, ie, when one or either party to such an OTC agreement could potentially default on
its obligations, whereas futures contracts are cleared by a centralised clearing exchange and the risk of
default is therefore transferred to a clearing house.

In this section, we shall be looking at three kinds of derivatives:

• Options – these are available on most asset classes, eg, equities and bonds. Options can even be
written on futures.
• Forwards – this is a customised contract usually with a bank to buy or sell a specific item, which is
often a foreign currency, for future delivery but at a rate and under terms which are agreed at the
outset of entering into the contract.
• Futures – these are essentially standardised contracts to buy and sell a certain asset at a specified
price with a delivery at some point in the future.

3.2 Options

3.2.1 Key Features

An option is a contract that confers upon the buyer the right, but not the obligation, to buy or sell an
asset at a given price on or before a given date.

• The right to buy is known as a call option.

• The right to sell is known as a put option.
• The rights to buy (call) or sell (put) are held by the person buying the option, who is known as the
holder.
• The person selling an option is known as a writer.
• The price at which the holder can buy or sell is the exercise price or strike price.

The following diagram shows the structure of an option agreement between the buyer or holder of an
option and the seller or writer of an option.

348
 Portfolio Construction

Exercise Price

Underlying Asset

Call

HOLDER Premium WRITER

Put

Underlying Asset

Exercise Price

7
The premium is the cost of an option. It is paid by the holder and received by the writer. The holder is
obliged to pay the premium, even if they do not exercise the option.

Depending on the option specification, the premium may be paid upon the purchase of the option (up
front) or upon exercise of the option (on close).

In return for receiving the premium, the writer agrees to fulfil the terms of the contract, which of course
are different for calls and puts.

Call writers agree to deliver the asset underlying the contract if ‘called upon’ to do so. When options
holders wish to take up their rights under the contract, they are said to exercise the contract. For a call,
this means that the writer must deliver the underlying asset for which they will receive the fixed amount
of cash stipulated in the original contract.

Put writers agree that the asset can be ‘put upon’ them, ie, if the contract is exercised by the holder,
the writer must pay the fixed amount of cash stipulated in the contract and receive delivery of the
underlying asset.

The date on which an option comes to the end of its life is known as its expiry date. The expiry date is
the last day on which the option may be exercised or traded. After this date the option disappears and
cannot be traded or exercised.

There are four basic options trades, as follows:

• Buying a call option.

• Selling a call option.
• Buying a put option.
• Selling a put option.

349
Options are available in a range of different exercise styles, which are specified when the options are
traded. There are four potential styles.

• American-style options – in which the option can be exercised by the holder at any time after the
option has been purchased.
• European-style options – when the option can only be exercised on its expiry date.
• Asian-style options – when the option is exercised at the average underlying price over a set
period of time. Traded average price options (TAPOs) are similar. These are fixed strike price, but are
exercised against an average underlying price.
• Bermudan option – when the option can be exercised at a set number of dates.

A person describing an option will specify its:

• underlying asset (eg, gold, per ounce)

• expiry date (eg, May)
• exercise price (eg, $850), and
• call/put.

3.2.2 Buying an Option for Speculation

A speculator anticipating a rise in the price of gold could straightforwardly buy gold for immediate
delivery and store it safely with a view to selling for a profit once the price has risen. Let us assume that
the spot price of gold is $1,200 per ounce and that the speculator decides to purchase 100 ounces for a
total expenditure of $120,000.

An alternative way to speculate that the price of gold is going to increase is to purchase an option –
specifically, an option that gives the right, but not the obligation, for a period of three months to buy
gold at a price of $1,200 per ounce. The purchaser of this option might have to pay $10 per ounce for the
option at present if the spot price is at $1,200 per ounce. This would be referred to as an at-the-money
option as the price for the underlying asset has the same value as the exercise price of $1,200 per ounce.

Theoretically, at-the-money options are priced on their time value premium only because at the present
time the option has no intrinsic value. If the option exercise price was $1,190 per ounce, and the spot
price was $1,200 per ounce, the option would have an intrinsic value of $10 per ounce in addition to the
time value, so the price would, for simplicity, be equal to $20 per ounce.

The more deeply in-the-money the option is, the higher the price will be, to reflect the fact that there is
substantial intrinsic value to the option. If the option were deeply out-of-the-money, for example, with
an exercise price of $1,250 per ounce, there would be zero intrinsic value and the time premium would
be the only value to be determined for this option which, on the surface at least, would not have a high
likelihood of being exercised with a profit unless gold were to exceed $1,250 per ounce during the
holding period of the option.

350
 Portfolio Construction

Remember that an option is a contract for a future delivery, so the only money to be invested at this
point is the sum of $10 per ounce. A standard, exchange-cleared options contract would be for the
purchase of 100 ounces, so the cost at the outset would be $1,000. It is now apparent that one of the
main features of purchasing an option is that it requires substantially less outlay than purchasing the
underlying asset.

If, three months later, as expected by the speculator, the price of gold has risen quite sharply from $1,200
per ounce to $1,300 per ounce, we can consider the effect on the two possible ways that the speculator
could have decided to proceed:

• buying physical gold from a bullion dealer, or

• buying an option to purchase gold.

The person who bought 100 ounces of gold from the bullion dealer at $1,200 would have made a profit
of $100 per ounce and therefore a total profit of 100 x 100 = $10,000.

Now, let us look at the profit for the options buyer. Three months ago, the speculator entered into a
contract that gave them the right, but not the obligation, to buy gold at $1,200 per ounce and, when
purchased, that right cost just $10 per ounce.

7
With gold now trading at $1,300, the right to buy at $1,200 must be worth at least $100 – the difference
between the current price and the stated price in the contract.

The return to the option buyer is the difference between the $130,000, which the 100 ounces are
currently worth in the spot market, and the $120,000 the buyer would pay to exercise the option, minus
the $1,000 which was the price to purchase the option, in other words $9,000.

On an investment of $10 per ounce, a $90 profit has been achieved. In percentage terms, this profit is
spectacularly greater than on the conventional purchase and sale of the physical commodity or asset.
This is not even taking into account any costs of carry or storage for the buyer of physical bullion.

Options are tradeable instruments. It is not necessary for the underlying asset to be delivered or
received. What more commonly occurs is that options are bought and sold. Thus, an option bought at
$10 could be sold to the market at $100, realising a $90 profit, with the investor never having had any
intention of buying the underlying asset. Options are used both for speculation and for hedging.

3.3 Forwards
A forward contract is very similar to that of a future (see section 3.4) in that it is an agreement to buy
or sell a specific quantity of a specified asset on a fixed future date at a price agreed today. However, a
forward contract is a customised OTC contract, whereas a future is standardised and exchange-traded.
The differences between futures and forward contracts are summarised in the following table.

351
 Attribute Futures Forward Contracts
How are they Traded on public exchanges, eg,
Over-the-counter (OTC)
traded? CME, NYMEX
Standardised, eg, the following
is the specification for crude oil
Customised and the full specification is
Quality futures traded on the NYMEX
provided in the contract
– 1,000 barrels of West Texas
Intermediate Crude Oil
Standard fixed dates, eg, S&P 500
Delivery
Index futures available for March, Bespoke (as specified in the contract)
dates
June, September and December
Liquidity/ Most futures markets are very Market may lack liquidity and there can be
ability to liquid and contracts can be traded bouts of systemic problems where trading
close out before delivery is required becomes very difficult
Most futures contracts are settled
Settlement in cash or rolled forward prior to Bespoke (as specified in the contract)
actual delivery
Counterparty None, owing to the workings of Default risk exists – if a counterparty
risk the clearing and settlement system becomes insolvent, eg, Lehman Brothers
Costs are customised for the purpose
Costs/margin Relatively low initial costs (margin) at hand and, depending on the
sophistication, may be high
In the US, regulation is from the
CFTC. In the UK, the FCA is the
Regulation Less regulated
main regulatory authority of
commodities and futures trade

3.4 Futures
A futures contract is an agreement to buy or sell a standard quantity of a specified asset on a fixed future
date, at a price agreed today.

• Standardised quantity – exchange-traded futures are traded in standardised parcels known as

contracts. For example, a futures contract on lead might be for 25 tonnes of the metal, or a currency
future might be for €20,000. The purpose of this standardisation is so that buyers and sellers are
clear about the quantity that will be delivered. If you sold one lead future, you would know that
you were obliged to sell 25 tonnes of lead. Futures are only traded in whole numbers of contracts.
This limitation is one of the factors which favours swaps as an attractive alternative to using futures
contracts. But on the other hand, futures contracts have the benefit that they are exchange-cleared,
which removes the counterparty risk element in a swap.
• Homogeneous and specified asset – all futures contracts are governed by their contract
specifications, and legal documents set out in detail the size of each contract, when delivery is to
take place, and what exactly is to be delivered. For example, in the crude oil futures market, the
contract which is actively traded on the NYMEX in New York calls for delivery of oil in terms of West
Texas Intermediate Crude, whereas the contracts traded in the London market call for delivery in
terms of Brent Crude.

352
 Portfolio Construction

• Fixed future date – the delivery of futures contracts takes place on a specified date(s) known as
delivery day(s). This is when buyers exchange money for goods with sellers. Futures have finite life
spans so that, once the last trading day has passed, it is impossible to trade the futures for that date.
At any one time, a range of delivery months may be traded and, as one delivery day passes, a new
date is introduced. Contracts may be rolled over from one expiry date to another by settling the
current contract and moving into a new futures contract with later expiration.
• Price agreed today – many people, from farmers to fund managers, use futures because they
provide certainty or a reduction of risk. Futures are tradeable, so, although the contract obligates
the buyer to buy and the seller to sell, these obligations can be offset by undertaking an equal and
opposite trade in the market. For example, let us suppose a farmer has sold a September wheat
future at £120 per tonne. If, subsequently, they decide they do not wish to sell their wheat but
would prefer to use the grain to feed their cattle, they would simply buy a September future at the
then prevailing price. Their original sold position is now offset by a bought position, leaving them
with no outstanding delivery obligations. This offsetting is common in future markets, and very few
contracts run through to delivery.

There are two parties to a futures contract – a buyer and a seller – whose respective obligations are as
follows:

7
• The buyer of a future enters into an obligation to buy.
• The seller of a future is under an obligation to sell.

As well as futures in commodities and metals, there are also futures based on financial instruments,
prices or indices. Financial futures contracts commonly used include:

• FTSE 100 Index Future.

• S&P 500 Index Future.
• Three-Month Sterling Future.
• UK Gilt Future.
• US Treasury Bond Future.
• Universal Stock Futures.

3.4.1 Tick Size and Value

With all futures contracts the tick is a fundamental concept, which needs to be clearly understood, to see
how the instruments change in value and how the contractual commitment that is undertaken by both
parties to the contract changes.

• The tick size is the smallest permitted quote movement on one contract.
• The tick value is the change in the value of one contract, if there is a one-tick change in the quote.

Let us begin by examining one of the most actively traded futures contracts on a daily basis, which is the
S&P 500 index futures contract, traded at the Chicago Mercantile Exchange (CME).

The contract size for this index future is equal to $250 multiplied by the value of the index. So, if the
index is trading at 1600, the value of the contract is $400,000. The tick size for this contract is 0.10 of the
index, so a sequence of prices traded for the future might be quoted in similar fashion to the following:
1599.70, 1599.80, 1599.90, 1600.00.

353
The value associated with each tick will be $25. This enables us to calculate our futures dealing profit or
loss by using the following formula:

Profit = Quote change in ticks x Tick value x Number of contracts

So if, for example, a speculator buys two contracts of the S&P 500 at 1599.1 and sells those two contracts
shortly after at 1600 exactly, the profit would be:

Profit = 90 bps/0.10 = 9 ticks x $25 x 2 contracts = $900

3.4.2 Hedging with Futures

Futures can be used both for speculation and for hedging. As an example, the FTSE 100 Index Future
fixes the price at which the underlying index may be bought or sold at a specific future date. We may use
this contract to gain exposure to, or hedge exposure against, the index, ie, the stock market in general.

Unit of Trade
Unit of trade = Index value × £10

That is, a contract can be valued by multiplying the index value by £10. If, for example, the index stood
at 6800, then one contract would have a value of 6800 × £10 = £68,000.

Under these circumstances we can consider the perspective of the speculator and the hedger. Either
person may buy – or take a long position in – the index future, or may wish to sell – or take a short
position in – the index future.

A speculator who believes that the FTSE 100 is about to move upwards could gain long exposure to the
index by buying a single futures contract, which would in effect give the speculator £68,000 of exposure
to the market. Another speculator who believes that the FTSE 100 is going to go down might decide to
sell – or go short of – the index as a result of selling a single futures contract, which would mean that
they would be short of £68,000 worth of the index and would profit if the market falls.

In contrast to the pure speculator, who is really interested in following hunches about the future
direction of the index and is attempting to benefit from making the right call and going either long or
short, a hedger is someone who already has a stake in the market and is looking to hedge their risk by
having an offsetting position in the futures market. If by chance someone owned exactly £68,000-worth
of stocks which were representative of the index and that person became nervous that the market is
about to go down, then selling a single futures contract would provide an offset or hedge to the loss of
value of the actual holdings of equities.

Delivery
This contract is cash-settled. That is, rather than the two parties exchanging the underlying asset and the
pre-agreed price at the delivery date, they simply settle up by the payment from one to the other of the
difference in value.

354
 Portfolio Construction

Quotation
The quote given is in index points.

Tick
The tick size – the smallest permitted quote movement – is 0.5 index points. The tick value is £5.00, ie,
0.5 × £10.

Example
We are managing a £31 million pension fund portfolio and we believe that the market is about to fall.
The index and the future currently stand at 6200. The alternatives are: sell the portfolio and move into
cash/bonds – this will avoid the market fall, but will clearly incur massive dealing costs; or set up a short
hedge using the futures contract.

Short hedge

The future is quoted at 6200, hence each contract will hedge £62,000 (6200 x £10) of our exposure.
To hedge the full portfolio, we will therefore need, quite conveniently, exactly 500 contracts

7
(£31 million ÷ £62,000).

Let us now consider what our position is if the market (and the futures contract) falls 200 points.

Cash position

Old portfolio value £31,000,000

New portfolio value = £31,000,000 x 6000/6200 = £30,000,000
Loss = £1,000,000

Futures position

Sold index at 6200

Bought index to close position at 6000
Points gain: 200 = 400 ticks

Hence, the total profit on our 500 contracts sold short will be:

Profit = Ticks × Tick value × Number of contracts = 400 × £5.00 × 500 = £1,000,000

The profit on the short futures position exactly cancels the loss on the portfolio and hence represents a
good hedging strategy.

In the case presented, there was an exact match because the size of the portfolio and the value of the
index produce an integer value for the number of contracts required for hedging purposes. If a fractional
value is obtained when dividing the size of the portfolio by the current size of the contract (based upon
the actual FTSE 100 index value), then the number can be rounded down to the nearest integer and the
hedge will not be a 100% match, but will still provide an effective way of allowing the portfolio manager
to shelter the portfolio from adverse movements in the overall market.

355
Hedge Ratio
One assumption we have made here is that our pension fund portfolio is only as volatile as the index,
ie, it has ß = 1. Beta (ß) measures the amount of fluctuation of one variable against another. If this is
not the case, then we may need to sell more or fewer contracts to achieve the hedge. The important
determinant is the relative volatility.

By definition, the futures contract has a ß = 1. If the portfolio has a ß = 1.3, then a 1% change in the index
will cause a 1% change in the value of a future but a 1.3% change in the portfolio value. We will therefore
need 1.3 times as many futures contracts to provide sufficient profit to cancel any losses suffered in the
portfolio.

When we hedge with futures, we should follow the formula below for determining how many contracts
will be required to ensure that the hedging reflects the relative volatilities of the portfolio and the
underlying instrument upon which the futures contract is based.

Hedging required number of contracts = Portfolio value X h

Futures value

where:
h is the hedge ratio, which reflects the relative volatilities of the portfolio and the hedging
instrument

In the case of hedging a portfolio against the FTSE contract the value for h – the hedge ratio – is simply
found by using the beta value of the portfolio.

Volatility of the Portfolio –ßp

h = = = –ßp since ßf = 1
Volatility of the Futures Contract ßf

3.5 Credit Default Swaps (CDSs)

A CDS is a credit derivative contract between two counterparties. The buyer makes periodic payments to
the seller, and in return receives a payoff if an underlying financial instrument defaults.

As an example, imagine that an investor buys a CDS from ABC investment bank where the reference
entity is XYZ ltd, which is a company which has a non-investment grade rating from the major ratings
agencies. The investor will make regular payments to ABC bank, and if XYZ ltd defaults on its debt the
investor will receive a one-off payment from ABC bank and the CDS contract is terminated. A default
could be more specifically defined but generally means that a coupon payment has been missed and
the company has failed to make good on the payment during a pre-determined grace period.

The investor may or may not actually own any of XYZ ltd’s debt. If the investor does, the CDS can be
thought of as hedging or protection. But investors can also buy CDS contracts referencing the debt of
a company without actually owning any of it. This is known as having a naked CDS position and will
be done for speculative purposes, to bet against the solvency of XYZ ltd in a gamble to make money
if it fails, or perhaps to hedge investments in other companies whose trading performance might be
dependent on the fortunes of XYZ ltd.

356
 Portfolio Construction

If XYZ ltd defaults, one of two things can happen:

• The investor delivers a defaulted asset to the bank for a payment of the par value. This is known as
physical settlement.
• The bank pays the investor the difference between the par value and the market price of a specified
debt obligation, ie, there is usually some recovery value and not all value will be destroyed for a
bondholder. This is known as cash settlement and is clearly the method which will be followed if the
investor has a naked CDS position and does not in fact own any of the bonds which have defaulted.

The CDS is quoted in terms of a spread, and this is the annual amount the protection buyer must pay the
protection seller over the length of the contract, expressed as a percentage of the notional amount. For
example, if the CDS spread for XYZ ltd was 50 basis points, or 0.5%, then an investor buying $10 million-
worth of protection from the bank selling the protection will have to pay the bank $50,000 per year.
These payments will continue until either the CDS contract expires or XYZ ltd defaults.

If the maturity of two CDSs is the same, then a company associated with a higher CDS spread is
considered by the markets to be more likely to default since a higher fee is being charged to protect
against this happening. This is very similar to the notion of an insurance premium being commensurate
with the likelihood of the event being insured against actually occurring. However, their factors such as

7
liquidity and the estimated loss should a default occur will make comparison less straightforward.

Credit spread rates and credit ratings of the underlying or reference obligations are considered among
money managers to be the best indicators of the likelihood of sellers of CDSs to have to perform under
these contracts. In fact, in the money markets, the CDS spread rates have become some of the most
widely followed of market barometers.

It is also worth mentioning the CDS market in sovereign credit risk. This market considers the possibility
of a sovereign borrower – such as the UK government or the US government – defaulting on its
obligations. Surprisingly, during the financial crisis of 2008–09 there had been periods when the CDS
spread on US Treasuries was higher than the spread quoted on the fast food chain McDonald’s.

3.5.1 Speculation
CDSs allow investors to speculate on changes in CDS spreads of single names or on changes in market
indices such as the North American CDX Index or the European iTraxx Index. Or, an investor might
believe that an entity’s CDS spreads are either too high or too low relative to the entity’s bond yields,
and attempt to profit from that view by entering into a trade, known as a basis trade, which combines a
CDS with a cash bond and an interest rate swap.

An investor might have reasons to speculate on an entity’s credit quality, since in most circumstances a
CDS spread will increase as creditworthiness declines, and diminish as creditworthiness increases. The
investor might therefore buy CDS protection on a company in order to speculate that the company
is about to default. Alternatively, the investor might sell protection if they think that the company’s
creditworthiness might improve.

357
Using as an example the scenario involving XYZ ltd, let us examine how a hedge fund could profit from
a default by XYZ ltd on its debt. The hedge fund buys $10 million worth of CDS protection for two years
from ABC Bank at a spread of 500 basis points (ie, 5%) pa.

• If XYZ ltd does indeed default after, say, one year, then the hedge fund will have paid $500,000 to
the bank, but will then receive $10 million (assuming zero recovery rate, and that the bank remains
solvent), thereby making a profit. The bank, prima facie, will incur a $9.5 million loss unless it has laid
off or offset its outright exposure before the default. ABC Bank could, for example, have taken out a
counterbalancing CDS with another financial institution.
• However, if XYZ ltd does not default, then the CDS contract will run for two years, and the hedge
fund will have ended up paying $1 million, without any return, thereby making a loss.

Note that there is a third possibility in the above scenario; the hedge fund could decide to liquidate its
position after a certain period of time in an attempt to lock in its gains or losses. For example:

• After one year, the market now considers XYZ ltd more likely to default, so its CDS spread has
widened from 500 to 1,500 basis points. The hedge fund may choose to sell $10 million-worth of
protection for one year to ABC Bank (or another bank) at this higher rate. Therefore, over the two
years, the hedge fund will pay the bank 2 x 5% x $10 million = $1 million, but will receive 1 x 15% x
$10 million = $1.5 million, giving a total profit of $500,000 (assuming XYZ ltd does not default during
the second year).
• In an alternative scenario, after one year, the market now considers XYZ ltd much less likely to default,
so its CDS spread has tightened from 500 to 250 basis points. Again, the hedge fund may choose to
sell $10 million-worth of protection for one year to ABC Bank at this lower spread. Therefore, over
the two years the hedge fund will pay the bank 2 x 5% x $10 million = $1 million, but will receive 1 x
2.5% x $10 million = $250,000, giving a total loss of $750,000 (again assuming that XYZ ltd does not
default during the second year). This loss is smaller than the $1 million loss that would have occurred
if the second transaction had not been entered into.

Transactions such as these do not even have to be entered into over the long term. CDS spreads can
widen by a few basis points over the course of one day. The hedge fund could have entered into an
offsetting contract immediately and made a small profit over the life of the two CDS contracts.

3.5.2 Hedging
CDSs are often used to manage the credit risk (ie, the risk of default) which arises from holding debt.
Typically, the holder of a corporate bond, for example, may hedge their exposure by entering into a CDS
contract as the buyer of protection. If the bond goes into default, the proceeds from the CDS contract
will cancel out the losses on the underlying bond.

Example
A pension fund owns $10 million of a five-year bond issued by XYZ ltd. In order to manage the risk of
losing money if the company defaults on its debt, the pension fund buys a CDS from Derivative Bank in
a notional amount of $10 million. The CDS trades at 200 basis points (200 basis points = 2.00%). In return
for this credit protection, the pension fund pays 2% of $10 million ($200,000) pa in quarterly instalments
of $50,000 to Derivative Bank.

358
 Portfolio Construction

• If XYZ ltd does not default on its bond payments, the pension fund makes quarterly payments to
Derivative Bank for five years and receives its $10 million back after five years from XYZ ltd. Though
the protection payments totalling $1 million reduce investment returns for the pension fund, its risk
of loss due to a default on the bond have been eliminated. The hedge achieved its purpose.
• If XYZ ltd defaults on its debt three years into the CDS contract, the pension fund will stop paying
the quarterly premium, and Derivative Bank will ensure that the pension fund is refunded for its loss
of $10 million. The pension fund still loses the $600,000 it has paid over three years, but without the
CDS contract it would have lost the entire $10 million.

3.5.3 Current Issues

There is ongoing debate concerning the possibility of limiting so-called naked CDSs. A naked CDS is one
when the buyer has no risk exposure to the underlying entity. Hence, naked CDSs do not hedge risk per
se, but are mere speculative bets that actually create risk.

Some suggest that buyers be required to have a stake, or element of risk exposure, in the underlying
entity that the CDS pays out on. In June 2010, the German government decided to impose a ban on the

7
use of naked CDSs in Germany.

Others suggest that a mere partial stake in the underlying risk is insufficient, and insist that buyer protection
be limited to insurable risk; that is, the actual value of the capital-at-risk in the underlying entity. This means
the CDS buyer would have to own the bond or loan that triggers a payout on default.

Still others, also calling for the outright ban of naked CDSs, claim that it is poor public policy to provide
financial incentive to one party which pays off only when some other party suffers a loss – the argument
being that it is foolish to incentivise the first party to nefariously intervene in the affairs of the second
party so as to cause, or to contribute to loss.

In 2012, the EU banned uncovered or naked positions in sovereign CDSs.

3.6 Fixed-Interest Securities and Spreads

As previously discussed, there are numerous forms of fixed-interest securities, and these cover a wide
range, from sovereign issues such as the gilts issued by the UK government, the Treasury bonds issued
by the US government and the bunds from the German government all the way across the spectrum to
high-yield securities for relatively high-risk corporations which are somewhat disparagingly called junk
bonds.

Fund managers will almost invariably want to have a sizeable portion of their portfolio allocated to
fixed-income securities, and they could include those just mentioned as well as selections from the
variety of investment grade corporate bonds, which are available from many issuers throughout global
capital markets.

Much attention is placed by asset managers on the relationships which exist between the different kinds
of fixed-interest securities, and much of this analysis is based upon what are commonly called spread
relationships.

359
Spreads can exist between the same genre of fixed-interest security, for example, between different
maturities of that security, the most obvious example being the relationship between government
bonds of different maturities. On the other hand, there are many kinds of spreads, involving different
securities from different issuers with contrasting credit qualities, and these are analysed and followed
closely by asset allocators.

3.6.1 Types of Spread

The four broad kinds of spreads which are most relevant to asset managers fall into the following
categories:

1. Term spreads.
2. Default spreads.
3. Credit quality spreads.
4. Sovereign spreads.

Term Spreads
The term spread is the difference between the yields of long- and short-dated bonds. The yield spread
between a two-year note or gilt and a ten-year gilt is often used for the purpose of UK investors. The key
value which is used for calculating the spreads is the gross redemption yield (GRY) (sometimes called,
especially in the US, the yield to maturity).

The GRY of a two-year note can be expressed in basis points. For example, a two-year note which has
a GRY of 1.5% can be quoted as being a yield of 150 basis points. Let us say that the GRY on a ten-year
gilt is quoted at 3.5% or 350 basis points; then the 2/10 spread can be stated simply as the difference
between the two yields, in this case simply as 200 basis points.

There are many reasons why following this particular spread can be advisable for investment managers.
Some reasons have to do with the ability to trade the spread. For example, if one believes that the spread
is going to widen to (say) 250 basis points, the asset manager could decide to have long positions in the
two-year note and short positions in the ten-year gilt. Most likely the widening of the spread is based
upon an increase in yield in the ten-year leg of the spread, and an increase in yield will result from a
decrease in the price, which will benefit someone who has taken a short position in the ten-year leg of
the spread.

All that matters is that the differential or spread moves in accordance with the anticipation of a widening
of the spread and the trade can be profitable.

In general terms, the term structure of interest rates, or yield curve, is often regarded as a leading
indicator of economic activity, or at least captures the market’s perception of the future rate of economic
activity. In the growth part of an economic cycle, 2/10 spread measure tends to be more positive, with
an upward-sloping yield curve with long-bond yields exceeding short-bond yields. This spread will often
exceed 200 basis points and could go much higher depending on the overall level of interest rates. At
the onset of a recession, the 2/10 measure tends to flatten and can even become negative if the yield
curve inverts.

360
 Portfolio Construction

The 2/10 spread can, with some allowance for other factors relating to the role of the public finances,
therefore be used to predict the position in the economic cycle and what kind of interest rate
environment lies ahead.

Careful analysis of the term spread can also be used to determine when a yield curve ride may be most
beneficial and to undertake spread trades or engage in a form of trading activity known as ‘riding the
yield curve’, which is covered in section 7.6.1.

Default Spreads
The default spread is the difference between the yields of investment grade corporate bonds and gilts.

In assessing the overall investment risk from a credit perspective of fixed-interest securities in general,
it is customary to compare the gross redemption yield on a ten-year investment grade bond – perhaps
limited to those of A– and above – with the GRY of a ten-year gilt. For a US-based investor, the
comparison will be between an investment grade corporate bond and the yield to maturity on a ten-
year US Treasury note.

As seen above, it is customary to quote this spread in basis points, and the prevailing level of this spread

7
can provide a good barometer of the market’s perceptions regarding the overall creditworthiness of the
corporate sector.

Government bonds are assumed in most financial theory to be risk-free, and, if the spread between the
yield on a ten-year government bond and the equivalent yield for a ten-year corporate bond is relatively
speaking rather low or narrow, then this low spread will reflect the perception that the corporate fixed-
interest sector is not considered to be at much risk.

In other words, in a buoyant economy, the default spread tends to narrow, whereas in a recession the
spread tends to widen. This widening can be especially acute during times of financial crisis such as were
seen in Q4 2008.

As before, the default spread can, if used judiciously, be helpful in predicting the position in the
economic cycle for market timing purposes.

Credit Quality Spreads

Another variation on this theme is to consider the spread between high-yield bonds and investment
grade corporate bonds, or the spread between so-called ‘junk bonds’ and gilts.

As an example, let us suppose that the typical GRY for a AAA corporate bond is quoted at 5% and the
average GRY for a high-yield corporate is quoted at 8%; then the yield spread for investment grade to
junk can be quoted as 300 basis points. As an alternative approach, the spread can be quoted between
the GRY for high-yield corporates and government bonds of similar maturities.

During the financial crisis of 2008, there were two factors at work which caused the spread between
high-yield and government bonds to widen rather dramatically. At the height of the banking crisis
in 2008, there was considerable anxiety among asset managers about the possibility of bankruptcies
and economic dislocation in general. This anxiety produced a flight to safety in which asset managers
sold many assets that were perceived to be of inferior quality and invested the proceeds from such
liquidations into government securities.

361
For example, at the end of 2008, the GRY on the US ten-year Treasury note was barely 2% or 200 basis
points (similarly, extremely low yields were seen on gilts, bunds and in most government bond markets),
while the typical yield on a junk bond reached up into the mid-teens. In such circumstances, the spread
between government and junk widened substantially from a more typical value of 200/300 basis points
to as high as 1,500 basis points.

Admittedly, there were some very extreme spreads between many kinds of fixed-interest securities
during the 2008 crisis, and many astute investors and traders decided to purchase those securities
which were very much out of favour as they anticipated that, given an eventual return to more normal
circumstances, the spreads would revert back to their more typical levels. By purchasing out-of-favour
speculative and non-investment grade corporate bonds during the early part of 2009, many fund
managers were able to make huge profits when the liquidity of the corporate bond markets returned to
more normal conditions.

Another feature of this spread relationship to observe is that the yields on government bonds will tend
to increase when there is less anxiety about systematic (and systemic) risk and less desire to seek out the
safe haven of gilts and Treasury securities.

Sovereign Spreads
There is one further type of spread which is becoming increasingly important for investment managers
to follow, and this one relates to the difference between the yields available on the government bonds
of different sovereigns. This has become especially significant since 2010 when there have been much-
publicised difficulties for peripheral states in the eurozone countries in terms of their creditworthiness.
Beginning in 2010, the government of Greece had to be assisted with borrowings in excess of €100
billion in order to stave off insolvency. This was followed shortly thereafter by the governments of
Ireland and Portugal.

In the summer of 2011, the Greek government was subject to emergency funding by the IMF and the
EU, as it was unable to raise any capital from private investors in the capital markets and had to rely on
continual funding provided by the European Central Bank (ECB). The GRY on ten-year Greek government
bonds climbed to almost 30% during June 2011, indicating that the markets believed there was a very
high likelihood that the Greek government would eventually have to restructure its debt or possibly
experience an outright default.

By the summer of 2015, Greece’s national debt was €320 billion, and it had a credit rating of CCC– from
S&P.

Historically, several governments have defaulted on their debt obligations, with Argentina and Russia
being two of the most notable.

One method for determining the creditworthiness of different sovereign issues is by quoting the spread
between the issues of governments which are perceived by the markets as being extremely low risk,
ie, AAA-rated sovereigns, and the yields of more problematic sovereigns. During the crisis of 2010–11,
among the peripheral states, the most commonly quoted spread was between the ten-year yield on (say)
Greek, Irish or Portuguese debt and the yield on the ten-year bund from Germany, which is considered
to be the safest government issue in the eurozone (and even one of the safest credits available globally).

362
 Portfolio Construction

So when the ten-year bund yielded 300 basis points and the yield on Irish bonds was 13% or 14%, there
was a 1,100 basis point spread between these two sovereign issues.

Factors which will affect sovereign spreads are clearly related to macroeconomic circumstances in the
various economies and, specifically, the differences in such factors as GDP growth rates, the level of
public finance deficits and the competitiveness of the two economies for which the spread is quoted.
Again looking at Greece, the debt/GDP ratio exceeds 150%. In comparison with Germany, Greece has an
unattractive cost structure within its economy, too large a public sector and a failure to collect taxation
revenues to assist in financing its large obligations to the public sector.

The credit-rating agencies have been very active during the crisis in the eurozone in monitoring the
creditworthiness of sovereign borrowers. Many states have suffered serious downgrades as the agencies
have become very focused on the high levels of public sector debt, weak tax revenues and very slow
economic growth.

While Greece dropped to a CCC-, it was then upgraded to a CCC+ in July 2015 after agreeing to a series
of concessions to obtain short-term financing from other European nations to assist meeting debt
payments, restructuring debts and implementing austerity measures. In 2018, Greece’s credit rating was

7
upgraded by S&P in April 2021 to BB, with a positive outlook by Moody’s in November 2020 to Ba3 (each
with a stable outlook), and in April 2020 by Fitch to BB- with a stable outlook.

Also troubling is the fact that many other European governments have been placed on alert by the
agencies with negative outlooks. As a consequence, large private sector investors – mainly the large
banks, insurance companies and pension funds – have either decided not to buy the debt of those
sovereigns which are seen to be at risk, or are demanding very substantial yields, ie, high interest
coupons, to compensate them for the possibility of restructurings or default. This makes any new debt
more expensive to service for the sovereign borrower.

In addition, the market for sovereign CDSs has been extremely active, with many fund managers
deciding to either hedge or insure against default on existing exposure to sovereign credit risk, or
to speculate on widening or narrowing of spreads, even if they have no actual cash positions in the
underlying sovereign debt market to protect.

3.6.2 The Impact of Related Events to Spreads between Fixed-Interest

Securities
For a fund manager, the impact of many kinds of events will lead to asset reallocations among different
securities in general, and more specifically to the mix they hold of different fixed-interest securities.
Such reallocations are often referred to as policy switching.

Some of the factors which will instigate policy switches can be summarised as follows.

Changes in Interest Rates

Intuitions about the future direction of interest rates, and market timing in general, is one of the primary
factors that will encourage fund managers to switch between different bonds. Switching from low-
duration to high-duration bonds if interest rates are expected to fall is an example of a policy switch
which will cause spreads to change.

363
Changes in the Structure of the Yield Curve
Normally, the yield curve is a smooth relationship between yield and maturity. Often, however, there
may be humps or dips in the curve. If the humps or dips are expected to disappear, then the prices of the
bonds on the hump can be expected to rise (and their yield fall correspondingly), and the prices of the
bonds in the dips can be expected to fall (and their yields correspondingly rise). A policy switch would
involve the purchase of the high-yield bond and the sale of the low-yield bond.

Expectations about the Future Shape of the Yield Curve

A downward-sloping or inverted curve suggests that markets believe that rates will fall. In the inverse
pattern to that when expectations are for higher rates in the future, if the expectation is for lower rates
in the future, bond purchases will be keen to lock in higher coupons now as the expectation is that
coupons will decline in the future.

A flat yield curve suggests that the market thinks that rates will not materially change in the future.

Changes in Bond Quality Ratings

A bond whose credit quality rating as, for example, rated by Standard & Poor’s or Moody’s is expected
to fall will drop in price. To prevent a capital loss, it can be switched for a bond whose quality rating
is expected to rise or remain unchanged. This is an uncertain process and often there are no advance
warnings of the re-rating of credit by the major rating agencies.

Changes in Sector Relationships

An example of a change in sector relationships is a change in taxes between two sectors. For example,
one sector may have withholding taxes on coupon payments, eg, domestic bonds, whereas another, eg,
eurobonds, may not.

Anticipation of Monetary Policy

The only point on the yield curve which can be fixed is immediate short-term rates, set by intervention
of the Bank of England or other central banks through operations in the money markets.

If short-term interest rates are deliberately being moved higher by the Bank, the market’s expectation
may well be that eventually this will lead to a downward-sloping yield curve, referred to as an ‘inverted’
curve. This reflects the market’s expectations that the Bank may be trying to arrest inflationary pressures
in the economy. If the market believes that inflation will rise in the future, then the yields on longer-
dated gilts will have to rise in order to compensate investors for the fall in the real value of their money.

The expectation of inflation is more of a problem with the long end, rather than the short end, owing
to the greater sensitivity to interest rates of longer-duration fixed-interest instruments. Once again, this
will be reflected in the 2/10 spread referred to in section 3.6.1.

3.6.3 Summary
The financial markets have become very sophisticated in analysing the co-movements of yields and
interest rates across a wide spectrum of fixed-income instruments. Many spreads are quoted in real
time in the money markets, and the manner in which other sectors of capital markets respond to these

364
 Portfolio Construction

changes in spreads has led to increasingly coordinated movements across multiple asset classes. Many
market observers and sophisticated investors have observed that the manner in which many assets
behave in reaction to changing financial spreads has introduced a new kind of risk dynamic into asset
management.

As with many other kinds of relationships, the influence is best seen as a two-way feedback loop in which
changed circumstances in one sector of the market – for example a ratings downgrade for a sovereign
state – will lead to a widening of spreads in many other parts of the market. As governments have
undertaken to protect their banking systems from critical points of failure, there has been a blurring of
the distinction between the creditworthiness of sovereigns, banks and private sector corporations.

4. Portfolio Risk

Learning Objective
7.2.1 Understand the main types of portfolio risk and their implications for investors: systemic

7
risk; market/systematic risk – asset price volatility, currency, interest rates, commodity price
volatility; non-systematic risk; liquidity, credit and default risk

4.1 An Overview of Portfolio Risk

Risks and reward are important aspects of investment decisions. Risk and potential reward are generally
positively correlated: investments with a higher potential return generally carry a higher risk of loss.
High-risk investments generally have potential for a higher reward, plus a greater possibility of loss.
Low-risk investments generally have a lower reward, with a lower possibility of loss.

Risk arises from the uncertainty of outcomes. Each time, as an investor, that we decide to purchase a
security, or invest in an opportunity, the outcome is uncertain in the same manner that exists for any
future event. We are concerned that we might incur a loss if we have miscalculated the opportunity or
that we may not realise, fully or even partially, the expected return.

At the macro level, we may be concerned about the risks of market crashes, terrorist incidents that
cause markets to plunge and other critical events. All of these contribute to the potential for profit
from investment and speculation, but also to the accompanying uneasiness that we all feel about
the possibility of losses or adverse consequences from our investment or speculation activities. The
prevalence of uncertainty in the outlook for financial assets reflects a major part of our general notion
of risk.

Another form of risk which concerns investors is the risk relating to the volatility of asset prices. While it
is commonplace and to be expected for the prices of assets to fluctuate on a day-to-day basis, there are
periods when markets exhibit a high degree of variability in price behaviour. Financial analysts use the
statistical value known as standard deviation, as a way of quantifying this variability of prices around
their mean price, which is used as a metric for volatility, and the larger the standard deviation value (ie,
the higher the asset price volatility), the more investors perceive the riskiness of holding financial assets.

365
4.2 Systemic Risk
Systemic risk is sometimes erroneously referred to as ‘systematic risk’. The latter term has quite a specific
meaning in financial theory and is a cornerstone of the capital asset pricing model (CAPM), where it
refers to what might better be described as market risk or more specifically non-diversifiable risk. See
section 4.3. Systemic risk is the risk of collapse of the entire financial system or entire market, as opposed
to risk associated with any one individual entity, group or component of the financial system.

To say that the entire financial system might collapse may have appeared fanciful – a scenario conjured
up by a febrile and apocalyptic imagination – until relatively recently. But in the second half of 2008,
when major financial institutions such as Lehman Brothers, AIG, Fannie Mae and Freddie Mac effectively
went bankrupt or entered the conservatorship of the US government, the spectre of a financial
meltdown became more credible. Central bankers, including the Governor of the Bank of England, have
since gone on record since to describe how close the world’s financial system came to a total collapse.

One of the characteristics and vulnerabilities of the financial system which was exposed as a result of
the crisis in asset-backed finance in 2007–08 were the interdependencies in the credit markets and
banking system, where the failure of a single entity or cluster of entities had the potential to cause a
cascading failure, which could potentially have bankrupted or brought down the entire system, causing
widespread panic and chaos in the capital markets.

Insurance is often difficult to obtain against systemic risks because of the inability of any counterparty to
accept the risk or mitigate against it, because, by definition, there is likely to be no (or very few) solvent
counterparties in the event of a systemic crisis. In the same way, it is difficult to obtain insurance for life
or property in the event of nuclear war.

The essence of systemic risk is that it is highly dependent on the correlation of losses. Under normal
market conditions, many asset classes and individual securities will show a significant degree of
independence of co-movement. In other words their price action will be weakly correlated. When,
however, markets become subject to financial contagion and panic, there is a tendency for most assets
and securities to become much more highly correlated. In fact, the correlation can approach unity
as their price behaviour will tend towards a uniform direction, ie, downwards, and, because of the
interdependencies between market participants, an event triggering systemic risk is much more difficult
to evaluate than specific risk.

For instance, while econometric estimates and expectation proxies in business-cycle research led to a
considerable improvement in forecasting recessions, good analysis on systemic risk protection is often
hard to obtain, since interdependencies and counterparty risk in financial markets play a crucial role
in times of systemic stress, and the interaction between interdependent market players is extremely
difficult (or impossible) to model accurately. If one bank goes bankrupt and sells all its assets, the drop in
asset prices may induce liquidity problems in other banks, leading to a general banking panic.

One concern is the potential fragility of liquidity – the ability to raise cash through selling securities – in
highly leveraged financial markets. If major market participants, including investment banks, hedge
funds and other institutions, are trading with high degrees of leverage, in other words, at levels far in
excess of their actual capital bases, then the failure of one participant to settle trades (as in the case of
AIG) may deprive others of liquidity, and through a domino effect expose the whole market to systemic
risk.

366
 Portfolio Construction

One of the functions of the Bank of England in the UK is to act as the lender of last resort in times of
financial panic and to ensure that the money markets can still function when there is a systemic risk to
the market. The Bank acted as lender of last resort to Northern Rock when it got into difficulties during
2007, and there was effectively a ‘run on the bank’, with depositors queuing to withdraw deposits from
branches of the bank. The Bank of England has provided even more extensive support to the money
markets since the financial crisis of Q4 2008 and has undertaken massive injections of liquidity and
quantitative easing to facilitate the functioning of the banking system and credit market.

4.3 Market (Systematic) and Diversifiable Risk

Market or systematic risk (as opposed to systemic risk) will be primarily influenced by macroeconomic
conditions but will also reflect the conditions and liquidity within the financial system at large. Unlike
systemic risk, when there could be financial contagion and ultimately a failure of the whole system, the
definition of market or systematic risk is that risk which cannot be avoided as the risk affects the market
as a whole. For the typical investor, however, it can be reduced by using a process of asset selection
guided by diversification across numerous securities.

By spreading the investments made in a portfolio over several different securities, from different asset

7
classes (eg, stocks, bonds and commodities), it is possible to get more or less the same returns that
any one of them can offer but with a much lower risk since, though one may become worthless, it is
unlikely that they will all do so simultaneously. This process, of spreading asset selection over many
classes of securities, is known as diversification, and when performed skilfully it can reduce risk without
necessarily reducing returns.

Not all risk can be diversified away. Systematic or market risk cannot be diversified away by holding a
range of investments within one particular market such as equities. If the global economy is performing
poorly and share prices generally are falling and returns are declining, then a wide and diversified
portfolio of shares is very likely to fall in line with the wider market. The risk of this happening affects
the whole market. An investor with limited funds to invest can achieve a high degree of diversification
across asset classes by investing in collective funds such as unit trusts and investment trusts, and this
can reduce non-systematic, specific risk to very low levels. However, it cannot be eliminated.

The risk that can be diversified away is that relating to specific or particular investments. This kind of risk
is called non-systematic or unsystematic risk as well as specific risk. In the case of an equity investment,
the company concerned might, for example, lose a major customer or it might suffer a loss in its share of
sales in its particular market. Such events can adversely affect the share price of that particular company.

4.4 Asset Price Volatility

As mentioned in the overview above, financial theory tends to focus on a more restrictive and
quantitative notion of risk which concerns the variability of returns in a market. The standard deviation
of the returns of asset prices is the principal metric used by financial analysts using modern portfolio
theory (MPT) and the CAPM. The simple notion is that investors will seek out those assets and securities
which deliver the highest rate of return which is commensurate with a given level of risk – and where
risk is equated with the standard deviation of the returns from that asset.

367
4.5 Other Types of Risk
There are a number of risks faced by investors that are difficult to avoid, some of which are outlined
below.

4.5.1 Inflation Risk

Inflation will erode returns or purchasing power and, even if the investor has taken account of inflation
in their analysis, the actual and expected inflation may be different from that assumed in calculating
expected returns.

4.5.2 Interest Rate Risk

Changes in interest rates will affect prices, therefore interest rate risk might be considered a subcategory
of market risk.

In addition, there are a number of risks specific to particular companies or sectors, which can be avoided
by diversification or by ignoring an investment altogether.

4.5.3 Exchange Rate Risk

Any investor who purchases securities which are denominated in a foreign currency may suffer (or
benefit) from changes in the exchange rates between the home or base currency or the other currency.
In addition, one has to consider the risk that one’s base or home currency may fall against other
currencies, thereby diminishing one’s purchasing power for global assets.

4.5.4 Default Risk

An investor may find that a company from which they have purchased a security could become insolvent
due to a harsh operating environment, high levels of borrowing, poor management or other financial
miscalculations. Fixed-income investors, who purchase the bonds of companies, have some access to
alerts of possible credit defaults through the credit rating agencies.

4.5.5 Liquidity Risk

The assumption is usually made that large capital markets such as the LSE and the NYSE provide liquidity
for investors to easily sell a security with a narrow spread between the ask and the bid prices. During
stressful periods this liquidity can diminish, and it can become much harder to readily sell a security. In
extreme cases a market can effectively seize up or, to use a more consistent metaphor, its liquidity can
evaporate. There may be an almost complete absence of bids for securities and meanwhile anxious asset
managers are being forced to sell securities to raise cash for redemptions, and this can lead to a free-fall
in asset prices resulting in market crashes.

368
 Portfolio Construction

5. Mitigating Portfolio Risk

Learning Objective
7.2.2 Understand the core principles used to help mitigate portfolio risk: correlation; diversification;
active and passive strategies; hedging and immunisation

5.1 Correlation
From an investment perspective, the statistical notion of correlation is fundamental to portfolio theory.
The very simplest idea is that, if one is seeking diversification in the holdings of a portfolio, one would
like to have, say, two assets where there is a low degree of association between the movements in price
and returns of each asset. The degree of association can also be expressed in terms of the extent to
which directional changes in each asset’s returns, or their co-movement, are related.

If assets A and B have a tendency to react to the same kinds of business conditions in a very simple and

7
predictable manner, they could be said to be strongly correlated. Let us assume that a certain kind of
regular release of economic data (eg, the monthly CPI data) is announced and company A’s shares move
up by 3% and company B’s shares move up by 2.5% when the data is below expectations, and that the
inverse pattern of price movement is seen when the data is above expectations. In such a case there is a
strong correlation between the movements (or changes) in the performance returns of A and B, and this
is expressed as strong positive correlation.

The following two diagrams will demonstrate how the monthly returns for two assets can be correlated
either negatively or positively and also how this can be plotted on a scatter diagram to illustrate the
degree to which there is a strong linear trend in place between the pairs of values recorded at each time
that the returns are calculated.

Strong Positive Correlation

Month Asset A Return Asset B Return

1 2.0% 3.0%
2 3.0% 5.0%
3 –1.0% –1.5%
4 12.0% 8.0%
5 7.0% 4.0%
6 –5.0% –7.5%
Correlation Coefficient 0.92

369
 12.0%

8.0%

4.0%
0.0%
–6.0% –4.0% –2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%
–4.0%
–8.0%
–12.0%

In the table above, the returns on the assets over a six-month period are shown and it will be seen that
there is a strong tendency of the returns to move together in a close association. This has resulted in a
coefficient of correlation between the returns for A and B of 0.92, which indicates a strongly positive
correlation.

There is strong correlation because there is close degree of co-movement in the returns and the
relationship is one of positive correlation because not only are the magnitudes of the changes in returns
similar but the sign of the changes track each other, ie, when A is going up so is B, and when A is going
down so is B. The chart plots these pairs of monthly values and a linear trend line (or linear regression)
has been shown. In cases of high correlation the points on the scatter graph will tend to be close to the
trendline.

Strong Negative Correlation

Month Asset A Return Asset B Return

1 2.0% –3.0%
2 3.0% –5.0%
3 –1.0% 1.5%
4 12.0% –8.0%
5 7.0% –4.0%
6 –5.0% 7.5%
Correlation Coefficient –0.92

370
 Portfolio Construction

12.0%

8.0%
4.0%
0.0%
–6.0% –4.0% –2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%
–4.0%

–8.0%

–12.0%

The chart above shows almost exactly the same as the previous chart except that the signs of the
changes in returns have been reversed. The magnitudes of the changes have not been changed, which
has also resulted in high correlation of the values, but this time there is an inverse relationship between

7
the returns of A and B. For example when, in month 6, A has a negative return of 5%, the return for B is
positive 7.5%.

The diagram below the chart reveals that the relationship is one of strong correlation in that most of the
points are close to the trendline but that this line is downward-sloping and also that the coefficient of
correlation is –0.92. This is an example of strong negative correlation.

Weak Positive Correlation

Month Asset A Return Asset B Return

1 2.0% 7.0%
2 3.0% 7.0%
3 –1.0% –5.5%
4 12.0% 3.0%
5 7.0% 2.0%
6 –5.0% –1.5%
Correlation Coefficient 0.13

371
 8.0%

4.0%

0.0%
–6.0% –4.0% –2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%

–4.0%

–8.0%

The situation in the above diagram shows that there is much weaker correlation between the returns of
assets A and B, as expressed in the lower coefficient value of 0.13. The relationship is still one of positive
correlation, but the strength of the association is weaker. Diagrammatically, this can be seen on the
scatter graph by the fact that the distances from each point of data are much further away from the
trendline than seen in the previous two diagrams.

Summary
The above results demonstrate that there are really two dimensions to the correlation coefficient. The
first is the magnitude of correlation, and the second is the sign.

The limiting cases for the coefficient of correlation are –1, which would be perfect negative correlation,
and +1, which would be perfect positive correlation. The closer that the actual value is to either of the
limiting cases, the stronger the correlation is, so 0.92 and –0.92 are both very strong correlations, but
one is positive and the other negative.

The example which provided a positive correlation coefficient of 0.13 still indicates a degree of
correlation but it is clearly weaker than for the other two cases examined.

Theoretically, the limiting case of no correlation would be where the coefficient had a value of zero.
In practice, it would be highly unlikely to find such a relationship between the returns for two assets,
as it would suggest that they move entirely independently of each other. From a macroeconomic
perspective, it can be estimated that the same types of large-scale business conditions will impact all
assets in a somewhat coordinated fashion, even if it is a loose and inverse one, and the notion of two
assets taking completely uncorrelated paths in their returns is not likely to be found in the actual world.

Any elementary text in statistics will make the point that high levels of correlation do not imply that
there is a causal relationship between the two variables. Sales of sun protection lotion and snake bites
are correlated in the US but there is no causal link – they are related via a third variable – the incidence
of extremely hot weather.

372
 Portfolio Construction

Not only does previously observed correlation have no predictive capacity, but the correlation between
returns from two financial assets over time can be highly unstable.

The use of correlation measurements is becoming increasingly a part of financial engineering and
underlies several fairly complex strategies which are being practised in the financial markets today by
so-called algorithmic trading.

The coefficient of correlation as used in finance is usually squared to form a value known as the
coefficient of determination or R².

5.2 Diversification of Returns

The explanation of correlation given above will help to guide our intuitions with respect to the benefits
of diversification and how they follow the observed correlations seen above.

In the first case, cited above, of high positive correlation, ie, 0.92, it can be stated that, to a large degree,
the performance of the two assets track each other, or experience the same degree of change and
movement, to an extent of about 92%. A portfolio with equal amounts of asset A and B in it will have a

7
tendency to perform not dissimilarly from a portfolio which has either 100% A or 100% B in it.

From this can be inferred the simple notion that diversification will be better achieved when the degree
of correlation is lower, subject to further refinements which will be seen below.

Consider a portfolio which had 50% of A and B but where the returns were highly negatively correlated,
ie, –0.92. The issue now is that the inverse nature of the returns will tend to cancel each other out. As a
position in asset A was improving and contributing profit towards the overall portfolio, this gain would
be almost entirely (or about 92%) offset by a corresponding loss in asset B.

The relationship depicted in the table, where the degree of correlation is 0.13, is the more promising
to investigate for the purposes of diversification, because there is a lower matching of the returns and
more likelihood that gains in one will not very closely resemble (either directly or inversely) the returns
in the other asset.

5.2.1 Combining Assets and Calculating Portfolio Standard Deviation

The key formula for calculating the standard deviation for a two-asset portfolio is shown below.
(Portfolios involving more than two assets require a more complex version.)

Variance of portfolio = pa2*σa2+pb2* σb2 +2*pa*pb*σa*σb*Cor(ab)

where:
pa = proportion of the portfolio allocated to security A
pb = proportion of the portfolio allocated to security B
σ² = variance of the security
Cor = coefficient of correlation between the expected returns of A and B
σ = standard deviation of the security

373
The above formula can be applied to the previous assets A and B which had a correlation coefficient of
0.13.

By combining Assets A and B into a portfolio with a ratio of 50:50, the standard deviation of the portfolio
has been reduced to a value below that for holding either 100% of asset A or 100% of asset B. The actual
monetary returns for each of A, B and A&B are also shown with the compounded monthly returns being
given as well.

Monthly Returns Ratio A:B

Month Asset A Asset B Portfolio A&B 0.5
1 2.0% 7.0% 4.5%
2 3.0% 7.0% 5.0%
3 –1.0% –5.5% –3.3%
4 12.0% 3.0% 7.5%
5 7.0% 2.0% 4.5%
6 –5.0% –1.5% –3.3%
Correlation Coefficient Cor(ab) 0.13
Portfolios Showing Compounded Returns
Variance of Portfolio = Month Portfolio Portfolio Portfolio
pa2xσa2+pb2x σb2 +2xpaxpbxσaxσbxCor(ab) A B A&B
0 £100.00 £100.00 £100.00
Proportion of Portfolio Invested in
50% 1 £102.00 £107.00 £104.50
A – pa
Proportion of Portfolio Invested in
50% 2 £105.06 £114.49 £109.73
B – pb
Standard Deviation Asset A σa 5.4% 3 £104.01 £108.19 £106.10
Standard Deviation Asset B σb 4.5% 4 £116.49 £111.44 £114.06
Standard Deviation Portfolio A&B 3.7% 5 £124.64 £113.67 £119.19
6 £118.41 £111.96 £115.26
Compound
18.41% 11.96% 15.26%
Return

From the above it can be seen that a combination of A&B provides a six-month compounded return of
15.26% and a standard deviation of 3.7%, and this illustrates the benefit of diversification when there is
relatively weak correlation between the assets.

5.3 Active and Passive Management Strategies

Active fund managers are those who use discretion as to the timing of investments and asset allocation
decisions and may change the composition of a portfolio on a regular basis. The underlying assumption
is that the fund manager’s expertise will enhance the overall return of the fund.

374
 Portfolio Construction

Active fund management rests on the notion that markets are not correctly explained by the efficient
markets hypothesis (EMH) and that mispricing of securities not only exists but that it can be identified
and exploited. A skilful fund manager will be able to identify such opportunities and purchase or sell
the mispriced security and derive a profit when the mispricing is eliminated. A less skilful manager
may suffer from not recognising such mispricing or be poor at timing the asset allocation decisions. As
a matter of fact, which is somewhat awkward for active fund managers, research has shown that the
average fund manager will underperform a simple index-tracking strategy.

Passive investment management aims to provide an appropriate level of return for a fund that is
commensurate with a simple buy-and-hold strategy for a broad cross-section of the market. Passive
management often takes the form of index tracking, in which the funds are simply used to replicate the
constituents of a broad market index such as the FTSE 100 index or the S&P 500 index in the US. More
specialised tracker funds can also be linked to the performance of securities in emerging markets, and
to specific industry sectors.

Increasingly, the proliferation of ETFs allows investors to purchase shares in a fund which trades actively
on a major exchange and which provides exposure to certain kinds of securities and when the minimal
management fees are incorporated into the actual price of the shares of the ETF. The benefit to an
investor of purchasing such ETFs is that there is usually a high degree of liquidity, the asset values of the

7
fund constituents as well as the price of the ETF shares is updated on a real-time basis, and the costs for
the packaging of the securities are minimal.

Passive fund management is consistent with the idea that markets are efficient and that no mispricing
exists. If the EMH is an accurate account of the way that capital markets work, then there is no benefit to
be had from active trading. Such trading will simply incur dealing and management costs for no benefit.
Investors who do not believe that they can identify active fund managers whom they are confident can
produce returns above the level of charges for active management will often elect to invest in passive
funds or index trackers.

5.4 Immunisation
Passive bond strategies are employed either when the market is believed to be efficient, in which case a
buy-and-hold strategy is used, or when a bond portfolio is constructed around the necessity of meeting
a future liability fixed in nominal terms. Immunisation is a passive management technique employed by
those bond portfolio managers with known future liability to meet. An immunised bond portfolio is one
that is insulated from the effect of future interest rate changes.

Immunisation can be performed by using either of two techniques: cash-matching or duration-based

immunisation.

• Cash-matching involves constructing a bond portfolio whose coupon and redemption payment
cash flows are synchronised to match those of the liabilities to be met.
• Duration-based immunisation involves constructing a bond portfolio with the same initial value
as the present value of the liability it is designed to meet and the same duration as this liability. A
portfolio that contains bonds that are closely aligned in this way is known as a bullet portfolio.

375
Alternatively, a barbell strategy can be adopted. If a bullet portfolio holds bonds with durations as
close as possible to ten years to match a liability with a ten-year duration, a barbell strategy may be to
hold bonds with a duration of five and 15 years. Barbell portfolios necessarily require more frequent
rebalancing than bullet portfolios.

5.5 Hedging
The risks that are inevitable when investing in shares, bonds and money market instruments can be
mitigated, but not entirely removed by, hedging. Hedging can be difficult to implement and becomes
mathematically intensive, especially when the investment portfolio contains complex instruments.
Also, hedging strategies will have a cost that inevitably impacts investment performance. Hedging is
usually achieved by using derivatives such as options, futures and forwards.

• Buying put options on investments held will enable the investor to remove the risk of a fall in value,
but the investor will have to pay a premium to buy the options.
• Futures, such as stock index futures, as seen in section 3.4, can be used to hedge against equity
prices falling – but the future will remove any upside as well as downside.
• Forwards, such as currency forwards, could be used to eliminate exchange-rate risk – but, like
futures, the upside potential will be lost in order to hedge against the downside risk.

6. Key Approaches to Investment Allocation

Learning Objective
7.2.3 Understand the key approaches to investment allocation for bond, equity and multi-asset
portfolios: asset class; geographical area; currency; issuer; sector; maturity

Top-down active portfolio management involves considering the big picture first (asset allocation) by
assessing the prospects for each of the main asset classes within each of the world’s major investment
regions, against the backdrop of the world economic, political and social environment. Once the asset
allocation has been decided upon, the next step is to consider the prospects for those sectors within
the various asset classes, eg, equities, bonds, commodities and derivatives. Sector-selection decisions
in equity markets are usually made with reference to the weighting each sector assumes within the
benchmark index against which the performance in that market is to be assessed. The final stage of the
process is deciding upon which specific issuers should be selected within the favoured sectors.

6.1 Asset Allocation

Within larger portfolio management organisations, asset allocation and top-down strategy are usually
determined on a monthly basis by an asset allocation committee. The committee draws upon forecasts
of risk and return for each asset class and correlations between these returns. It is at this stage of the
top-down process that quantitative models are often used, in conjunction with more conventional
fundamental analysis, to assist in determining which geographical areas and asset classes are most likely
to produce the most attractive risk-adjusted returns, taking full account of the client’s mandate.

376
 Portfolio Construction

Most asset allocation decisions, whether for institutional or retail portfolios, are made with reference to
the peer group median asset allocation. This is known as ‘asset allocation by consensus’ and is undertaken
to minimise the risk of underperforming the peer group. When deciding if and to what extent certain
markets and asset classes should be over- or under-weighted, most portfolio managers set tracking
error, or standard deviation of return, parameters against peer group median asset allocations.

Finally, a decision on whether to hedge market and/or currency risks must be taken.

Over the long term, some academic studies have concluded that the skills in decision-making with
regard to asset allocation can account for over 90% of the variation in returns for pension fund managers.

6.2 Geographical Area

Many investors wish to seek out opportunities in international markets and there are many investment
products now available, including a wide range of ETFs, which enable professional and retail investors to
gain exposure to specific geographical regions and even specific country funds.

Diversification is a primary reason to invest in overseas markets. More specifically, it is prudent to own

7
assets in countries whose economies have different attributes from the domestic market of the investor.
A service-based economy has different attributes from a commodity-based economy; exporting surplus
nations differ from importing surplus nations; economies with large public deficits (eg, the US, the UK
and Japan) can be contrasted with those with large surpluses (eg, China). These different attributes can
help to alleviate the coincidence of the timing of the economic cycles in these respective countries.
In turn this may result in the fact that the respective stock market cycles are unlikely to be largely
correlated with the business cycle in the investor’s domestic market.

Whatever countries are selected for inclusion in a portfolio strategy should be blended in consistently
with the required attributes. An investor who favours commodity-based economies will want exposure
to such countries as Australia, Canada, Russia and South Africa. Another investor, who may want
exposure to the semiconductor industry or computer hardware, may want to own a fund which
specialises in South Korea or Taiwan or Asia, possibly excluding Japan. (Some ETFs are structured in such
a manner that one can have exposure to most of the Asian markets but not Japan, because its economy
is considered by many investors to be a special case based upon the massive decline in Japanese
equities since 1990.)

6.2.1 Emerging Markets

Many enthusiasts for investing in emerging markets such as the BRIC nations (Brazil, Russia, India and
China) like to point to the much greater rate of economic growth in such nations compared to the rates
currently seen in the US and most of Europe. This has also given rise to the notion that the emerging
markets have become decoupled from the economic cycles that manifest themselves in the developed
world. While it is certainly the case that China and India, especially, have rates of GDP growth that
western countries are unlikely to see in the foreseeable future, it must also be recalled that when the
banking crisis occurred in 2007–8 some of the hardest-hit markets were the emerging ones.

377
One barometer to use for this is to consider the Hong Kong market, which is part of the emerging world
but which has well-established and very liquid capital markets. From the onset of the financial crisis in
the summer of 2007 the Hang Seng Index (as well as the Shanghai Index) experienced a drop of more
than 60%, which was considerably in excess of the decline seen in the US and Europe. A similar situation
has also been seen in 2020–21 due to the coronavirus (COVID-19) pandemic. The vaccine rollouts have
been generally slower in the developing markets, while the likes of the UK, Europe and the US are
leading the way in the recovery.

One other statistic is worth contemplating with regard to the notion that China in particular may be able
to lead the world out of its current anaemic growth rates because of the dynamism of its economy. The
IMF has estimated that the People’s Republic of China is now the second-largest economy in the world (if
the EU is not considered as a bloc) and has an annual GDP of about $14 trillion. However, to keep things
in perspective, in 2016 this was about 40% of the total world GDP. By comparison, if one takes the US and
all of the EU countries together, they account for about 50% of world GDP.

Undoubtedly, exposure to the emerging markets should be a part of most investment strategies, except
for the risk-averse, and in general terms a good spread of assets across many geographical regions will
provide a degree of diversification. But even this last comment needs to be qualified, as the degree of
diversification appears, from some correlation studies by quant funds, to be diminishing.

6.2.2 Currency
Foreign currencies are an asset class in their own right, and not just as a medium of exchange for
purchasing other assets. The volume of transactions that take place each day in the FX market makes
this market by far the largest section of the capital markets.

The decision by an investor to purchase a large holding of, for example, Australian dollars, by selling US
dollars, is an example of speculation perhaps, but is it any more of a speculation than the decision to
purchase shares in a company or the bonds issued by a government such as Ireland or Spain? All of the
examples cited have risks associated with them but all also have potentially large returns as well. As can
be seen in the previous chart, the Australian dollar dropped 0% from buying US dollar-denominated
assets in March 2009.

378
 Portfolio Construction

Australian dollar
almost at parity
with US dollar in
July 2008

Australian dollar at
trough in banking

7
crisis at 0.60c in
October 2008

As can be seen from the chart above, the Australian dollar dropped by about 40% from having almost
reached parity (ie, $1USD = $1AUD) in July 2008 to about 60 cents against the US dollar at the end of
October 2008. What is also interesting about the chart is that it very closely resembles the chart for many
global equity indices, including the S&P 500 and the FTSE 100. In fact, the S&P 500 lost almost exactly
40% during the comparable period to that shown on the above chart.

The question to ask is whether it was riskier to hold stocks in July 2008, or Australian dollars? Moreover,
would it have been an equally good decision to have bought Australian dollars in March 2009 or to have
bought stocks in the S&P 500 or FTSE 100?

The returns on both from buying at the trough of the financial crisis of 2008 would be remarkably similar.
So, an investor who sold the US dollar and bought Australian dollars in March 2009 would have had a
return in US dollar terms of about 30% from March 2009 until March 2010. This example also illustrates
how important it is to form a frame of reference for an investor. For example, an investor based in
Australia, whose currency of account for investment purposes is, let us say, the Australian dollar, would
have actually lost about 30% from buying US dollar-denominated assets in March 2009.

The more traditional explanations that are given when discussing currencies relate to the importance of
hedging, but in light of the previous discussion it is vital to consider what the basis is that one is using
for the hedge. To finish with the example from above, the Australian investor who might have decided
to purchase an ETF for an emerging market but decided to hedge that ETF against the US dollar would,
if the hedge had worked effectively, have lost the same amount as if they had purchased US dollars
outright.

379
Hedging Foreign Currency Risk
Foreign currency risk can be reduced, though not completely eliminated, by employing the hedging
instruments or strategies such as:

• forward contracts
• back-to-back loans
• foreign currency options
• foreign currency futures, or
• currency swaps.

Short-Term Currency Swaps for Speculation

A currency swap is another method, along with vehicles such as futures, options and forward
agreements, which will enable a speculator to speculate on the future directions of two key variables in
the foreign exchange market:

• forward exchange-rate spreads

• the changes in interest rate differentials between the prevailing short-term base rates in each of the
countries of the currency pair.

In terms of a swap transaction involving a currency pair, the buyer gains and a seller loses when
the primary currency interest rate increases relative to the secondary currency interest rate. More
specifically, it is the ratio between the two rates which is paramount – if the ratio increases from the
perspective of the primary currency, the buyer of the primary currency will gain and the seller of the
secondary currency will lose.

The swap structure can be demonstrated by the following scenario, in which a speculator enters a swap
transaction, buying $5 million in the belief that US interest rates will increase in the near future relative
to UK rates. The short-term rates applicable at the time of entering the swap are 2.5% for US dollars and
4% for sterling.

Let us assume that, for the sake of simplicity, within the next trading session US rates move up 50 basis
points to 3% and UK rates are adjusted downwards by 50 basis points to 3.5%. Also, for simplicity, we
shall assume that there has been no underlying change to the spot rate. The table below indicates the
mechanics of this swap arrangement and demonstrates how this arrangement proves to be profitable
to the speculator.

380
 Portfolio Construction

USD GBP

Initial Three-Month Interest Rates

2.50% 4.00%

Current spot rate

1.6450
GBP/USD

Three-month forward
1.6450 x [(1+0.025/4)/(1+0.040/4)] 1.6389
GBP/USD

Actual Transactions

Spot Market These two Zero cash

$5,000,000 £3,039,514
Buy USD and sell sterling notional flow at
deals will inception
Swap Market (inception) effectively
$5,000,000 £3,039,514 cancel each
Sell USD and buy sterling

7
other

Swap Market (three-

month values) $5,000,000 £3,050,841 Cash flows at maturity
Sell USD and buy sterling

Profitable Short-Term Speculation on Direction of Interest Rates in the US and UK

Overnight changes to interest rates 3.00% 3.50%

Three-month forward GBP/USD 1.6450 x [(1+0.030/4)/(1+0.035/4)] 1.6430

Swap market with three-month Cash flows

$5,000,000 £3,043,285
values at maturity

Profit for speculator £3,050,841 – £3,043,285 £7,556 Profit

The speculator can now close out their swap position with a forward exchange contract buying $5
million in three months for £3,043,285, realising a sterling profit of £7,556 (£3,050,841 – £3,043,285)
at maturity. In other words, the buyer of the primary currency – the US dollar in this transaction – has
shown a profit of £7,556 in sterling terms, and this is equivalent to the loss endured by the seller of the
secondary currency, ie, sterling.

However, the speculator or trader might have been incorrect in the assumption that US rates were
headed upwards relative to sterling rates and in fact the short-term rates have realigned themselves as
follows:

381
 Unprofitable Short-Term Speculation on Direction of Interest Rates in the US and UK
Overnight changes to interest rates 2.00% 4.00%
Three-month forward GBP/USD 1.6450 x [(1.020/4)/(1.040/4)] 1.6369

Cash flows
Swap market with three-month values $5,000,000 £3,054,636
at maturity

Loss for speculator £3,050,841 – £3,054,636 –£3,795 Loss

In this case, the buyer of the primary currency – US dollars – has sustained a loss in sterling terms of
£3,795, which is of course the gain experienced by the seller of sterling being the secondary currency to
the swap arrangement.

6.3 Sector Selection

As stated in section 6.1, a top-down approach to portfolio management is one in which the major asset
allocation decisions are based on first selecting asset classes which are in accordance with the objectives
and constraints of the fund, as stated in the mandate or prospectus. Thereafter, sectors are selected, and
then individual securities are selected to fit within this very structured approach.

When a top-down approach is adopted, investment management therefore involves the following
activities in the sequence below:

• Asset allocation.
• Market timing or tactical asset allocation.
• Sector selection.
• Stock selection (see section 7.1 of this chapter).

Once the asset allocation has been decided upon, top-down managers then consider the prospects
for those sectors within their favoured equity markets. Sector-selection decisions in equity markets are
usually made with reference to the weighting each sector assumes within the index against which the
performance in that market is to be assessed.

Given the strong interrelationship between economics and investment, however, the sector selection
process is also heavily influenced by economic factors, notably where in the economic cycle the
economy is currently positioned.

382
 Portfolio Construction

The investment clock below describes the interrelationship between the economic cycle and various
sectors:

7
However, the clock assumes that the portfolio manager knows exactly where in the economic cycle
the economy is positioned and the extent to which each market sector is operationally geared to the
cycle. Moreover, the investment clock does not provide any latitude for unanticipated events that may,
through a change in the risk appetite of investors, spark a sudden flight from equities to government
bond markets, for example, or change the course that the economic cycle takes. Finally, each economic
cycle is different and investors’ behaviour may not be the same as that demonstrated in previous cycles.

6.4 Issuer Selection

The final stage of the top-down process is deciding upon which stocks should be selected within the
favoured sectors. A combination of fundamental and technical analysis (see section 1.2) will typically be
used in arriving at the final decision.

In order to outperform a pre-determined benchmark, usually a market index, the active portfolio
manager must be prepared to assume an element of tracking error, more commonly known as active
risk, relative to the benchmark index to be outperformed. Active risk arises from holding securities in
the actively managed portfolio in differing proportions from that in which they are weighted within the
benchmark index. The higher the level of active risk, the greater the chance of outperformance, though
the probability of underperformance is also increased.

383
It should be noted that top-down active management, as its name suggests, is an ongoing and dynamic
process. As economic, political and social factors change, so do asset allocation, sector and stock
selection.

A bottom-up approach to asset allocation also focuses on the unique attractions of individual securities
and the characteristics of the issuer.

The considerations in the case of an equity investment will be the P/E multiple for the issuer, the P/E
multiples for competitors, the rate of earnings-growth and other financial ratios relating to profitability
and gearing. All of these were examined in chapter 6, section 1. In the case of considering a bond
purchase, the investor will want to examine the credit ratings reported by the major credit rating
agencies, the spreads between the issuer’s bonds and other benchmarks such as government issues of
similar maturity.

In addition, there are opportunistic factors to consider in evaluating the attractiveness of an individual
issuer of securities. Although the health and prospects for the world economy and markets in general
are taken into account, these are secondary to factors such as whether a particular company is, for
instance, a possible takeover target or is about to launch an innovative product.

6.5 Maturity
The ongoing fluctuation of interest rates poses a particular problem for fund managers with a portfolio
of bonds because of the reinvestment risk. However, by using an approach based upon bond duration-
matching or immunisation, it is possible to maintain a steady return over a specific time horizon,
irrespective of any changes in the interest rate. In the frequently found case where we need to match a
set of cash outflows as our liabilities, a bond portfolio with the same duration as the liabilities should be
constructed.

See section 7.7.1 for an explanation of duration matching.

The process of immunisation requires the fund manager to purchase a portfolio of bonds with a duration
equal to the liabilities that need to be matched. Through immunisation the fund manager can guarantee
that the bond portfolio will earn the gross redemption yield, since any alteration in capital value of the
bonds will be balanced by the reinvestment gain or loss.

384
 Portfolio Construction

7. Cash, Bond and Equity Portfolio Management

Learning Objective
7.2.4 Understand the main aims and investment characteristics of the main cash, bond and equity
portfolio management strategies and styles: indexing/passive management; active/market
timing, including high-conviction style; passive-active combinations; smart indexing; growth
versus income; market capitalisation; liability driven; immunisation; long, short and leveraged;
issuer and sector-specific; contrarian; quantitative; growth versus value investing

7.1 Active Equity Selection Strategies

Stock selection, or stock picking, is important whenever the fund managers are prepared to accept the
overall consensus for the market as a whole, but believe that certain individual securities are mispriced.

• An overpriced security is one that has an expected return that is less than should be expected on a
risk-adjusted basis.

7
• An underpriced security has an expected return that is more on a risk-adjusted basis than would be
expected.

Active stock selection can involve the application of various fundamental, technical or quantitative
techniques.

In terms of the capital asset pricing model (CAPM), which is a methodology for valuing securities in
reference to the overall market or what can be called the securities market line (SML), a security is said to
be mispriced if it has a non-zero alpha value.

The objective of a stock picker is to pick portfolios of securities with positive alpha. In terms of active
stock selection the manager will try to construct portfolios of securities that will have a more than
proportionate weighting of the underpriced or positive alpha securities, and a correspondingly less
than proportionate weighting of the overpriced securities which are exhibiting negative alpha.

7.2 Value Investing and Growth Investing

Value investing and growth investing represent two alternative approaches to investment decision-
making and asset selection.

With value investment, the method is to screen the market for shares that are outstandingly cheap
in relation to their chosen yardsticks. Key ratios include the relationship of the share price to assets,
earnings and dividends. Value investing seeks to identify those established companies, usually cyclical
in nature, that have been ignored by the market but look set for recovery. The value investor seeks to
buy stocks in distressed conditions in the hope that their price will return to reflect their intrinsic value,
or net worth.

A focus on recovery potential, rather than earnings growth, differentiates value investing from growth
investing, as does a belief that individual securities eventually revert to a fundamental or intrinsic value.
This is known as reversion to the mean.

385
In contrast to growth stocks, true value stocks also offer the investor a considerable safety margin against
the share price falling further, because of their characteristically high dividend yield and relatively stable
earnings.

Benjamin Graham, the founder of value investing, set up certain criteria for selecting ‘bargain issues’.
The investor sells the shares once they have reached their price target because they have no reason to
continue holding them as they cease to provide good value. Warren Buffett, who has become one of
the wealthiest people in the US, is a follower of Benjamin Graham and there are a number of other fund
managers that follow the value investment philosophy.

The growth investment philosophy, on the other hand, aims to buy growth stocks early.

Growth investment managers are screening the universe of stocks for the following:

• Fast-growing markets, especially if there are barriers to entry for competitors.

• Sectors in which both unit sales and earnings are rising due to growth in market size/share.
• A company in which sales and earnings rise higher in each business cycle.
• Good margins and above-average earnings growth.
• Good management, strong research, valuable patents, sound finances, a good location.

7.2.1 Growth at a Reasonable Price (GARP)

Value investing and growth investing are sometimes seen as being at the opposite ends of a spectrum.
Value investors may buy any shares that are priced inexpensively, even if the company’s growth
prospects are poor. On the other hand, growth investors may buy shares of companies that are growing
rapidly without regard to how high a P/E multiple the shares might already command. At its most
aggressive, growth investing simply focuses on those companies whose share price has been on a
rising trend and continues to gather momentum as an ever increasing number of investors jump on the
bandwagon. This is referred to as momentum investing.

Growth at a reasonable price (GARP) aims to reconcile these two approaches. It provides a framework
for value investors who do not want to miss out on today’s most promising growth opportunities. And
it affords the growth-orientated investor a tool to help determine when a high P/E becomes too high.

True growth stocks are those that are able to differentiate their product or service from their industry
peers so as to command a competitive advantage. This results in an ability to produce high-quality and
above-average earnings growth, as these earnings can be insulated from the business cycle. A growth
stock can also be one that has yet to gain market prominence but has the potential to do so: growth
managers are always on the lookout for the next Microsoft.

The key to growth investing is to rigorously forecast future earnings growth and to avoid those
companies susceptible to issuing profits warnings. A growth stock trading on a high P/E ratio will be
savagely marked down by the market if it fails to meet earnings expectations.

GARP is based on the principle that any P/E ratio is reasonable if it is equal to or less than the company’s
annual rate of earnings growth. This is known as the PEG and can be illustrated by the simple example
that one should be willing to accept a P/E multiple of up to 15 if the company’s earnings are growing at
an annual rate of at least 15%.

386
 Portfolio Construction

7.3 Quantitative Funds

Quantitative analysis involves using mathematical models to price and manage complex derivatives
products, and statistical models to determine which shares are relatively expensive and which are
relatively cheap.

Quantitative analysis aims to find market inefficiencies and exploit this using computer technology to
swiftly execute trades. Exploiting mispricing may involve only tiny differences, so leverage is often used
to increase returns.

Quants-based investors use specialised systems platforms to develop financial models using stochastic
calculus. Quantitative models follow a precise set of rules to determine when to trade to take advantage
of any mispricing opportunities. Speed of execution of each trade is also very important to investors
using electronic platforms and quants-based systems.

Quants-based funds account for a significant proportion of hedge funds, and the growth of more
sophisticated investment strategies has fuelled the adoption of quantitative investment analysis. The
growth of quants funds has, however, meant that the models used by many funds are directing funds
into the same positions. Some analysts have blamed part of the market upheaval during the credit

7
crunch on the pack mentality of quantitative computer models used by hedge funds.

Since, in a quantitative (quant) fund, the stock selection process is driven by computer models, there
is no place for a manager’s judgement based on fundamental analysis. Instead, the fund manager uses
predetermined or preset models to undertake this stock selection process. Such models sometimes rely
on ideas such as portfolio theory, CAPM, the dividend valuation model and options pricing techniques –
ie, fundamental evaluation tools – in order to determine which stocks to hold and in what proportions.
Sometimes the models are more based on the identification of patterns, in conjunction with technical
analysis.

Typical strategies of quant funds include:

• growth strategies
• value strategies
• statistical arbitrage strategies
• correlation strategies
• long/short equity strategies, and
• dispersion strategies.

It has been observed that quant funds tend to perform better in market downturns, whereas more
fundamental funds perform better in upswings.

Quant funds, based on correlations and exploiting convergence or mean reversion strategies, assume
that the historical statistical relationships between stocks will continue into the future, which clearly
may not hold true.

387
7.3.1 Combined Approach
Many investment management houses use a combined approach, with fundamental analysis and
quantitative analysis dictating the markets and stocks which they wish to buy, and technical analysis
being used to determine the timing of entry into the market place. As already noted, increasing numbers
of fund managers are becoming familiar with technical analysis since, if sufficient numbers do believe
the technical analysts, then the markets will have a tendency to move in line with the anticipations of
technically focused traders.

7.4 Buy-and-Hold
A buy-and-hold strategy involves buying a portfolio of securities and holding them for a long period
of time, with only minor and infrequent adjustments to the portfolio over time. Under this strategy,
investments bought now are held indefinitely, or, if they have fixed maturities, held until maturity and
then replaced with similar ones.

Despite the long-term tendency of equities to outperform other assets, the following is taken from
an article which appeared in the New York Times in February 2009 and reflects the relatively dire
performance of equities during the 1998–2008 period.

‘In the last 82 years – the history of the Standard & Poor’s 500 – the stock market has been through
one Great Depression and numerous recessions. It has experienced bubbles and busts, bull markets
and bear markets. But it has never seen a ten-year stretch as bad as the one that ended last month.

Over the ten years through January, an investor holding the stocks in the S&P’s 500 Stock Index, and
reinvesting the dividends, would have lost about 5.1% a year after adjusting for inflation, as is shown
in the following chart’.

Worst Decade Yet

Annual total return of Standard & Poor’s 500 Stock Index, adjusted for inflation, over ten-year periods
on date shown.

‘Figures are based on the total return of the S&P 500, with dividends reinvested, adjusted for the
change in the Consumer Prices Index (CPI). Figures are not reduced for either transaction costs or
taxes, and thus overstate what the average investor would be likely to receive. Figures assume the CPI
will be unchanged for January’.

Source: Standard & Poor’s, Bloomberg, Bureau of Labor Statistics via Haver Analytics

388
 Portfolio Construction

What lessons are there for investors seeking exposure to equities? One point is that spreading investment
over a period can reduce some of the effects of market volatility. If, instead of a single investment of, say,
£10,000 made in 1999 when the US and UK stock markets were at their peak an investor had invested
perhaps £2,000 per year over the next ten years, the principle of cost averaging would have lessened the
impact of poor returns for equities in recent years.

Buying and holding equities or even index-tracker products such as one based on the FTSE 100 is being
questioned by more financial analysts in the light of the more recent data.

7.5 Indexation
There is a variant to the buy-and-hold strategy that eliminates the diversifiable risk and effectively
replicates the performance of a market index, and this is known as index-matching or indexation.

There are several different ways of proceeding with respect to indexation, explored below, but the most
fundamental one is to decide on the appropriate index for the client, as there are many different market
indices available. An investor may want exposure to large-cap UK stocks, in which case the FTSE 100 is
the obvious index to select. Alternatively the investor may be more interested in the large cap stocks

7
which are primarily US-based and for this area the Standard & Poor’s 500 Index would be one of the most
appropriate indices. As the name suggests, the UK index consists of 100 large-cap stocks whereas its
most closely matched US counterpart comprises 500 different companies.

7.5.1 Duplication or Complete Indexation

The duplication of an index by holding all of its constituents is also known as complete indexation or full
replication. The requirement is to match exactly the underlying components of the relevant index and
as such this can often be complex and expensive. For example, the FTSE All-Share Index contains several
hundred securities weighted according to their relative market proportions. To construct a portfolio of
all these securities with the same proportions as the index would involve extremely high commissions
and dealing costs.

Although the large world indices are relatively stable in terms of their constituents, there is a need from
time to time to make changes and modify the components. In the case of the US S&P 500, Standard &
Poor’s will make periodic adjustments to the constituents in light of changes in the ownership of certain
companies, eg, a company may have been taken over by another. Also, the custodians of indices will
periodically have to remove some stocks from an index if the market capitalisation falls below a certain
threshold level, and then they will substitute another company which has grown in stature and market
capitalisation to qualify for entry to the index.

If a fund manager is replicating such an index, where modifications are being made from time to time,
then all of the changes and rebalancing will need to be made to the replica and this will involve dealing
costs and commissions as well as dealing spreads. The manner of rebalancing is more critical in the
case of an index like the S&P 500 which is market cap weighted, rather than in the case of the Dow
Jones Industrial Average which is a simple average of the 30 constituent stocks and where there is not a
balancing in the composition of the index based on market capitalisation.

389
A bond index fund will be even more complex and expensive to replicate. With the passage of time
the average maturity of a bond index will decline, and to replace those bonds which are reaching
redemption with suitable alternatives and preserve the duration characteristics of the bond fund is a
particularly challenging undertaking.

In general terms, duplication or complete indexation is often not practical, and therefore alternative
strategies designed to emulate the index’s performance are used.

Smart Indexing
Smart indexing involves a different strategy, while still using an index, like the S&P 500 Index, and
requires having a more balanced weighting across many different sectors. Indices, on their own, can
be heavily weighted towards certain sectors. For example, the S&P 500 has a higher weighting in
technology and healthcare and a lesser weighting in utilities. There are several smart ETFs that became
popular after the financial crisis and bear market; these ETFs can be based on an index like the S&P 500,
but not as a base index. The index components may have different weightings to create better balance.
This type of strategy is regarded as active investing or management, with an objective of creating
superior returns than for passively managed index trackers or funds.

7.5.2 Stratified Sampling

As in statistical theory, the use of stratified sampling involves the selection of a sample of securities from
the total population comprising the index. The sample should be stratified so that it is representative of
the primary characteristics of the whole population, ie, the total population of the index constituents
can be divided into sectors in the case of equities and into different maturities in the case of bonds. A
cross-section of securities is then selected from each sector with the intention that the sample exhibits
the highest correlation to the sector’s overall return and likewise that there is a strongly correlated fit
between the returns from the sample and those from the entire populations of the assets in the index.

This procedure limits the initial transaction costs and subsequent rebalancing costs, but increases the
risks of tracking errors, ie, the difference between the fund’s return and the return on the market index.

7.5.3 Factor-Matching
Factor-matching involves the construction of an index fund using securities selected on the basis
of specifically chosen factors or risk characteristics. If the first risk factor required is that the sample
matches the level of systematic (market) risk, then the selected portfolio will need to be chosen to have
the same level of beta as the market. Other factors may be sector breakdown, dividend pattern, firm size
or financial structure, eg, gearing ratio.

The selected index fund will be a subset of the available securities within the whole index that matched
the market in terms of the required factor(s) and have the highest overall correlation with the market.

390
 Portfolio Construction

7.5.4 Co-Mingling
Co-mingling involves the use of co-mingled funds, such as unit trusts or investment trusts, rather than
the explicit formation of an index fund. Co-mingling may be especially suitable for clients with relatively
small portfolios and may provide an acceptable compromise between the transaction costs of complete
indexation and the tracking error of stratified sampling.

7.5.5 Summary and Conclusion

The desire to replicate the performance of an index with a subset or sample is prone to tracking errors. In
other words, when the index is changed in some fashion, for example to remove certain securities which
may have been taken over or which have fallen below the market capitalisation threshold and then to
include some new entrants, the replication format used may no longer be suitable.

If the sample was based upon stratification and reflection of the sector composition of the index, the
removal of one or two key securities from a sector could have quite a pronounced effect on the sample
which was set up to emulate the previous composition of the index by sector. The replication may need
to be quite significant in terms of changing the constituents of the sample or replica to reflect again the
stratification of the whole index.

7
Another problem arises when the constituents of an index are changed. When the announcement of a
change is made, the price of the security being deleted tends to fall, while the price of the security being
added tends to rise. Fund managers are then forced to take a loss on some of their holdings as they eject
them from their surrogate portfolio and to pay over the odds for the additions, where the prices will fall
back over time after the index has settled down again. These effects can cause major tracking errors
between index funds and the index itself.

In general terms, over the longer term there is an expectation that the fund will underperform the index,
ie, suffer a tracking error.

Apart from the transaction costs involved in setting up and rebalancing, there are other problems
associated with running an index fund. The most important of these concerns income payments on the
securities. The total return on an index may include not only capital gains but also income in the form of
dividend or coupon payments. In order to match the performance of the index in terms of income, the
index fund needs to have the same pattern of income payments as the index. It will also have to make
the same reinvestment assumptions. Unless complete indexation has been undertaken, it is unlikely
that an index fund will exactly replicate the income pattern of the index.

In addition, the index may assume that gross income payments are reinvested without cost back into
the index on the day each security becomes ex-div. In practice, however, this assumption can be violated
for the following reasons:

• The dividend or coupon payment is not made until an average of six weeks after the ex-div date.
• The payment is received net of tax.
• There are dealing costs of reinvesting income payments.
• The income payments on different securities may be fairly small and it may not be worthwhile
investing such small sums on the days they are received.

391
Indexation is, however, a popular form of fund management. It attempts to avoid, as far as possible,
decisions about selection and timing of investment, yet it is not purely passive. At the very least, the
choice of index and the reinvestment of income involve active intervention.

Indexation is normally used in conjunction with other active methods whereby there is an indexed core
fund with actively managed peripheral funds, again with the objective of enhancing the overall return
of the fund. This is called ‘core-satellite management’.

7.6 Active Bond Selection Strategies

As with an equities portfolio, a bond portfolio will be actively managed whenever there are mispriced
bonds available. Active bond portfolio management operates around the activities of security selection
and market timing. However, there is a difference between active share selection and active bond
selection. Most equity managers engage in security selection, whereas most bond managers engage in
market timing.

A bond picker will construct a portfolio of bonds that, in comparison with the market portfolio, has less
than proportionate weightings in the overpriced bonds and more than proportionate weightings in the
underpriced bonds.

A market timer engages in active management when they do not accept the consensus market portfolio
and is either more bullish or more bearish than the market. Expectations of interest rate changes are
therefore a crucial input into successful market timing. A bond market timer is interested in adjusting
the relative duration of their portfolio over time. Market timing with bonds is sometimes called duration
switching.

High-conviction investing usually involves selecting a small amount of highly rated securities (maybe
20–30) that are considered to be blue chip, with a strong competitive position and good market share.
Other characteristics might be a cash-rich business, predictable future cash flows and being run by
stringent, honest and trustworthy management.

If the fund manager is expecting a bull market because they are expecting a fall in the general level of
interest rates, they may want to increase the duration of their portfolio by replacing low-duration bonds
with high-duration bonds. If the fund manager is expecting a bear market because they are expecting a
rise in the level of interest rates, they may want to reduce the duration of their portfolio.

Active bond portfolio management is generally not as profitable as active share portfolio management.
There are several reasons for this:

• There are more shares traded than bonds in the UK.

• The most liquid bonds are UK government bonds that have only certain maturities.
• The volatility of bond prices is generally much lower than that of shares, hence fewer opportunities
for substantial mispricing of bonds exists.
• With only a few bonds suitable for active trading, the portfolio consisting of these bonds will be
relatively undiversified.
• The cost of active bond portfolio management can be reduced using futures and options.

392
 Portfolio Construction

7.6.1 Riding the Yield Curve

‘Riding the yield curve’ is a valid strategy when the yield curve is upward sloping. If this is the case,
then an investment manager can buy bonds with maturities in excess of their investment horizon. They
proceed to hold the bonds until the end of their investment period and then sell them. If the yield curve
has not shifted during that period, the investment manager will have generated higher returns than if
they had bought bonds with the same maturity as their investment horizon.

This follows because, as the time to maturity declines, the yield to maturity falls and the price of the
bond rises, thereby generating a capital gain (hence, the term ‘yield curve ride’). These gains will be
higher than those available if bonds with the same maturity as the investment horizon are used,
because the maturity value of the latter bonds is fixed.

The following scenario provides an opportunity to ride the yield curve as the term structure of interest
rates is upward-sloping, showing that longer-dated instruments are yielding more than shorter-dated
instruments. To keep the example simple we shall assume that the two instruments are zero-coupon
Treasury notes with one and two years remaining to maturity. The current yield curve reveals that a one-
year note will have a yield to maturity of 8%, whereas a two-year note will have a yield to maturity of 9%.
Since there are no coupons, all of this is effected in the current price of the bond.

7
Zero Coupon Time Left to Yield to Maturity as Formula Price of Bond
Treasury Bond Maturity per the Yield Curve
A 1 8.00% 100/108^1 92.59
B 2 9.00% 100/109^2 84.17

If the fund manager buys the one-year ZCB and holds it for one year until redemption, the return will be
exactly as provided for by the yield curve, ie, 8%.

r = 100 – 92.59 = 8%
92.59

Since this is a zero-coupon held to maturity, the risk is zero.

The alternative scenario is to buy the two-year note and hold it for one year and sell it then as a zero
coupon with one year remaining. The return available then is as follows:

r = 92.59 – 84.17 = 10.00%

84.17

The return can again be determined from the holding-period return calculation, though an assumption
is required regarding the selling price in one year. The risk this time is not zero, as the fund manager is
exposed to movements in the yield curve. The yield curve ride is a strategy by which investors take on
some risk in order to enhance returns.

During Q3 2019, the financial markets experienced a situation caused by investors having concerns over
the long-term view of the global economy. This was accompanied by a change to the shape and slope
of the bond yield curve.

393
History shows that if markets expect that the economy is going to slow down, there is an expectation
that interest rates will start to fall over time which is a common response to try and stimulate growth.
Consequently, longer-term investment looks to the higher interest being offered before yields start to
decline, creating significant demand for longer dated bonds. As this happens, long-term bond yields fall
below those of shorter-dated bonds. As a result, an inverted yield curve can present.

An inverted yield curve is accepted as a key forecaster of economic slowdown or even global recessions.
It has been a reliable predictor of a coming recession. In the last seven global recessions, the spread
between three-month US paper and ten-year treasuries had become inverted.

7.6.2 Bond Switching

There are valid reasons for bond portfolio adjustments involving the purchase and sale of bonds, ie,
bond switching or swapping. There are two main classes of bond switches:

• anomaly switches, and

• policy switches.

Anomaly Switching
An anomaly switch is a switch between two bonds with very similar characteristics, but whose prices or
yields are out of line with each other.

• Substitution switching – this involves switching between two bonds that are similar in terms of
maturity, coupon and quality rating and every other characteristic, but which differ in terms of price
and yield. Since two similar bonds should trade at the same price and yield, this circumstance results
in an arbitrage between the expensive bond being sold and the cheap bond being purchased. If
the coupon and maturity of the two bonds are similar, then a substitution swap involves a one-for-
one exchange of bonds. However, if there are substantial differences in coupon or maturity, then
the duration of the two bonds will differ. This will lead to different responses if the general level
of interest rates changes during the life of the switch. It will therefore be necessary to weight the
switch in such a way that it is hedged from changes in the level of interest rates.
• A pure yield pickup switch involves the sale of a bond that has a given yield to maturity and the
purchase of a similar bond with a greater yield to maturity. With this switch, there is no expectation
of any yield or price correction, so no reverse transaction will need to take place at a later date, as
may be the case with a substitution switch.

Policy Switching
A policy switch is a switch between two dissimilar bonds, which is designed to take advantage of an
anticipated change in:

• interest rates
• the term structure of interest rates, ie, the yield curve
• possible changes in the bond credit rating from the major rating agencies, or
• sector relationships.

Such changes can lead to a change in the relative prices and yields of the two bonds. Policy switches
involve greater expected returns, but also greater potential risks, than anomaly switches.

394
 Portfolio Construction

Inter-Market Spread Switch

There is also a third kind of bond-switch. When it is believed that the difference in the yield being
offered between corporate bonds and comparable gilts, for example, is excessive given the perceived
risk differential between these two markets, an inter-market spread switch will be undertaken from the
gilt to the corporate bond market. Conversely, if an event that lowers the risk appetite of bond investors
is expected to result in a flight to quality, gilts will be purchased in favour of corporate bonds. Active
management policies are also employed in which it is believed the market’s view on future interest rate
movements, implied by the yield curve, is incorrect or has failed to be anticipated.

Reasons for Bond Switching

• Changes in interest rates – intuitions about the future direction of interest rates, and market timing
in general, is one of the primary factors that will encourage fund managers to switch between
different bonds. Switching from low-duration to high-duration bonds if interest rates are expected
to fall is an example of a policy switch.
• Changes in the structure of the yield curve – normally, the yield curve is a smooth relationship
between yield and maturity. Occasionally, however, there may be humps or dips in the curve. If the
humps or dips are expected to disappear, then the prices of the bonds on the hump can be expected

7
to rise (and their yield fall correspondingly), and the prices of the bonds in the dips can be expected
to fall (and their yields correspondingly rise). A policy switch involves the purchase of the high-yield
bond and the sale of the low-yield bond. Another example of a policy switch resulting from changes
in the structure of the yield curve is the bridge swap. As a result of an abnormal distortion in the yield
curve, perhaps due to very high demand for bonds of a specific maturity, there may be exploitable
opportunities from a form of arbitrage between different sections of the yield curve. As an example,
suppose that eight- and ten-year bonds are selling at lower yields and higher prices than the nine-
year bond. A bridge swap involves selling the eight and ten-year bonds and buying nine-year bonds.
• Changes in bond quality ratings – a bond whose quality rating is expected to fall will fall in price.
To prevent a capital loss, it can be switched for a bond whose quality rating is expected to rise or
remain unchanged. This is an uncertain process and often there are no advance warnings of the
re-rating of credits by the major rating agencies.
• Changes in sector relationships – a change in sector relationships is a change in taxes between
two sectors: one sector may have withholding taxes on coupon payments, eg, domestic bonds,
whereas another, eg, eurobonds, may not.

7.7 Passive Bond Selection Strategies

There are three types of passive bond selection strategy suitable for the management of the bond
element of the portfolios.

7.7.1 Duration Matching or Immunisation

The ongoing fluctuation of interest rates poses a particular problem for fund managers with a portfolio
of bonds because of the reinvestment risk. However, by using an approach based upon bond duration,
matching or immunisation, it is possible to maintain a steady return over a specific time horizon,
irrespective of any changes in the interest rate. In the frequently found case where we need to match a
set of cash outflows as our liabilities a bond portfolio with the same duration as the liabilities should be
constructed.

395
Suppose that a bond is purchased with a yield of 10%. Interest rates fall to 7%. Consequently, the current
price of the bond will rise. However, the overall return on the bond will fall, as it is now only possible to
reinvest the coupons received at the rate of 7%. As the bond approaches maturity, this fall in the return
will become greater as the reinvestment loss outweighs the gain (which will fall as the bond moves to
redemption and the price pulls to redemption at its face value). Under this scenario, the overall return
from the investment will fail to realise the quoted yield of 10%.

The same is true of the opposite situation when interest rates rise and bond prices fall. The downward
adjustment in the bond’s current price will diminish as the bond approaches maturity and the bond
pulls to redemption. The coupons will have been reinvested at a higher rate, therefore generating
greater returns. Under this scenario, the overall return from the investment will have outperformed the
quoted yield of 10%.

Reinvestment loss
becomes greater

Capital gain
diminishes

Duration of the bond Time

Yield is not an effective measure of the anticipated return on a bond if it is held to maturity precisely
because it assumes reinvestment at the same rate as the yield.

Duration matching or immunisation relies on the fact that these two effects (price and reinvestment) are
balanced at the point of duration, the weighted average life of the bond. If a bond is held to its duration
and not its maturity, the return can be guaranteed.

The diagram in chapter 2, section 6.4.4, illustrates the concept behind the bond duration as it shows the
pivot point where each of the cash flows from coupons have to be weighted in relationship to the larger
cash flow at the time of redemption when the last coupon is also accompanied by the repayment of the
principal or face value of the bond.

396
 Portfolio Construction

Liability-Driven Immunisation
The primary factor which can introduce risk into the simplified approach to immunisation outlined will
be caused by non-parallel shifts in the yield curve.

The above example of immunisation showed that it works for parallel shifts in the yield curve, ie, the
reinvestment rate fell equivalently on each coupon for each maturity. If this does not happen, then
matching the duration of the investment to the liability horizon no longer guarantees immunisation.
As is often the case, a non-parallel shift in the yield curve will lead to the income component and the
capital component changing in value by differing amounts.

This risk is reduced if the durations and convexities of the individual bonds in the immunising portfolio
are close to that of the liability, ie, a focused portfolio. In this case, the non-parallel yield curve shift will
affect the individual bonds and the liability in similar ways.

Rebalancing
Immunisation is not a passive approach to fund management because the portfolio will require a
continual rebalancing. The initial bonds are selected on the grounds of their duration values. However,

7
duration erodes over time and, owing to immunisation risk, new bonds will have to be purchased in
order to match the liability.

One possible way around this is to immunise the portfolio using zero coupon bonds. The advantage
of zero coupon bonds is that their duration will change in line with time and, therefore, the portfolio
will not require a constant rebalancing. However, this type of immunisation will be efficient only for
institutional investors. Private investors would have to pay income tax on the notional income received.
Even for institutional investors, disadvantage with using zero coupon instruments is that they are not
readily available for certain categories of bonds. The strips market for government securities is active
and a wide variety of zero coupon bonds are available, but this is not true of the corporate market.

7.7.2 Cash Flow-Matching (or Dedication)

Cash flow-matching is a much simpler approach to portfolio management. The approach is simply to
purchase bonds whose redemption proceeds will meet a liability of the fund as it falls due.

Under the concept of matching, bonds are purchased to match the liabilities of the fund. Starting
with the final liability, a bond (Bond 1) is purchased whose final coupon and redemption proceeds will
extinguish the liability.

Turning next to the penultimate liability, in part this may be satisfied by the coupon flows arising from
Bond 1, any remaining liability being matched against the final coupon and redemption value of a
second bond (Bond 2).

This process is continued for each liability, ensuring that bonds are purchased whose final coupon and
redemption values extinguish the net liabilities of the fund as and when they occur.

397
 Liability 4 Liability 3 Liability 2 Liability 1

Bond 4

Bond 3

Bond 2

Bond 1

Example

Maturity Years Coupon % Redemption Payment

1 8.35 108.35
2 7.7 107.70
3 7.14 107.14

A fund has to meet liabilities of £1,500 arising at the end of each of the next three years. There are three
bonds available and their details are revealed in the table above. The right-hand column indicates the
combined final coupon payment and the redemption of the face value of the bond, assumed to be £100.

Construct a portfolio to achieve cash matching the annual £1,500 liability.

Cash Flows
Number of
Coupon Principal Maturity Year 1 £ Year 2 £ Year 3 £
Bonds
14 7.14 100 3 100 100 1,500
13 7.70 100 2 100 1,400
12 8.35 100 1 1,300
1,500 1,500 1,500

The approach outlined in this example is a simple buy-and-hold strategy and as such does not require
a regular rebalancing. In practice, it is unlikely that bonds exist with exactly appropriate maturity dates
and coupons but, intuitively, it is easier to understand.

398
 Portfolio Construction

7.7.3 Combination Matching (or Horizon Matching)

Combination matching is a mixture of the above two approaches to managed bonds. It is possible to
construct a portfolio where, for example, the cash flow matches the liabilities for the next four quarters
but is then immunised for the remaining investment horizon. At the end of the four quarters, the
portfolio is rebalanced to cash-flow-match over the subsequent four quarters and is again immunised
for the remaining period. This combination approach is also known as horizon matching, and can be
reiterated at different intervals in order to meet the long-term liabilities of the fund.

8. Evaluation of Portfolio Risk and Return

Learning Objective
7.2.5 Understand how portfolio risk and return are evaluated using the following measures: holding-
period return; money-weighted return; time-weighted return; total return and its components;
standard deviation; value at risk; volatility; covariance and correlation; risk-adjusted returns (eg,

7
Sharpe ratio); benchmarking; alpha; beta
Candidates will not be expected to undertake the calculation of any variables mentioned in
this Learning Objective.

8.1 Holding-Period Return and Total Return

For any investment there is a basic pattern which can be thought of at its simplest in the form of a cost/
benefit analysis. There will be costs for making the investment, which could be a single one-off outlay at
the inception, or a continuing obligation to fund further costs through the lifetime of the investment. In
return there will be a series of incoming cash flows which are the benefits side of the investment.

In its simplest form, the performance of a portfolio of investments can be measured by regarding all of
the incoming cash flows in the form of dividends or coupon payments and also factor in capital growth
(final market value less initial value) and express these items which could be called the total return as
a percentage of the initial amount invested. This gives rise to the core concept of the holding-period
return. By calculation of the percentage holding-period return for any investment it becomes possible
to compare the relative performance of a variety of investments of different sizes and with different
objectives and characteristics. The percentage holding-period return is the gain during the period held
(money received less cost) divided by the initial cost:

(D+Ve – Vs)
rp = x 100%
  Vs

where:

rp = holding-period return
D = any returns paid out from the investment/portfolio at the end of the period
Vs = the initial cost at the start of the holding-period
Ve = the value of the investment at the end of the holding-period
399
Comparison of Two Investments
Investment A costs £1,000 and at the end of six months returns £50, before being sold for £1,200. How
can it be compared with investment B, bought at £500, held for one year and then sold for £800 with no
income paid out?

Holding-period return for Investment A:

Using this equation, the holding-period returns for Investment A can be calculated as follows.

(D+Ve – Vs)
rp = x 100%
  Vs

rp = (50+1,200 – 1,000) x 100%

1,000

rp = 25% in six months

Holding-period return for Investment B:

Using this equation, the holding-period returns for Investment B can be calculated as follows.

(D+Ve – Vs)
rp = x 100%
  Vs

rp = (0+800 – 500) x 100%

500

rp = 60% in one year

The holding-period returns of A and B are not yet directly comparable, since B was invested for twice as
long as A. When A was sold, the proceeds could have been reinvested for another six months, but we do
not know what return would have been available to the investor at that time.

To compare the returns, they must be for a standard period. This is achieved by using the equivalent
period interest rate formula to annualise the returns as follows:

Investment A: rp = 25% in six months

Annualising this return, we use the formula:

1+r = (1+R)n

1+r = (1+0.25)2 = 1.5625

r = 0.5625 or 56.25% pa

400
 Portfolio Construction

Investment B: rp = 60% pa

As a result of converting both returns to a common base of an annual return there is now a standardised
measure of return, the annualised holding-period return.

So far so good, but this simple kind of measurement is not useful when there is a need to factor in the
calculation of the return significant cash inflows or outflows from the fund during the period. This can be
demonstrated by considering another simple example.

A fund has a value at inception of £5 million, and halfway through the period it has the same value and a
further £5 million is deposited. At the end of the period it is worth £10 million, no dividends having been
paid. What is the fund’s performance?

Using our equation above, we have:

(D+Ve – Vs)
rp = x 100%
  Vs

7
rp = (0+£10m – £5m) x 100%
£5m

= +100%

But this seems to be patently false, since the fund has generated no return whatsoever. The terminal
value of the fund is simply the sum of what was initially held, plus the funds added. There has been no
growth or positive return generated. The shortcomings of the simple holding-period return calculation
can be dealt with by looking at the fund returns over each sub-period where there are no outflows or
inflows and then amalgamating them. In the above simple example, the first sub-period starts at £5
million and ends at £5 million, so the return is zero. This is amalgamated with the second sub-period that
starts at £10 million and ends at £10 million so is again zero. The amalgamated return is the expected
value of zero per cent.

This simple approach is, therefore, insufficient. In addition to the initial outlay or the value of the fund at
inception, it is necessary to account for the deposits and withdrawals that occur during the period over
which the performance is being measured.

8.2 Standard Deviation

To measure the degree of variability of an investment, we can use either:

• The standard deviation, which is conventionally denoted in statistics by sigma or σ.

• The variance, which is usually denoted as sigma squared or σ².

In making the calculations each possible return, Ri, occurs with probability p, and the expected
(arithmetic mean) return is denoted by Re.

401
In essence, the variance is calculated first by subtracting Re from each of the Ri values. This will lead
to positive and negative percentages. Since we are concerned about the magnitude of the difference
rather than the sign of the difference, each of these differences are squared.

The resulting squared amounts are then multiplied by the probability of each return, p. The sum of the
squared differences weighted according to their probability is known as the variance and the square
root of the variance is known as the standard deviation. The standard deviation has the advantage that
it is expressed in the same units as the returns (% in the example above), whereas the variance is in the
original units squared.

For some calculations in portfolio theory, it will be necessary to use the variance rather than the standard
deviation, but in discussions of risk in financial theory it is more common to use the standard deviation.

There are two formulae for the standard deviation. The first is where the variability of an entire
population is being calculated and, as can be seen, the denominator of the equation is equal to n – the
number of items being analysed. The second formula is more conventionally used for a sample, rather
than the entire population, and the denominator used is n – 1. For calculations of large sets of data the
difference is minimal.

Standard deviation of entire population = σ = Σp(Ri – Re)2

         n

Σp(Ri – Re)2
Standard deviation of population sample = σ =
   n–1

In order to illustrate the standard deviation of returns, an example will be followed.

The table below shows the four expected (possible) outcomes from an investment requiring an initial
outlay of £1,000 as surmised by an investor.

Starting Balance £1,000 Expected Return

Probability End Balance Return
20% £1,000 0.0% 0.0%
15% £1,100 10.0% 1.5%
35% £1,180 18.0% 6.3%
30% £1,200 20.0% 6.0%
100% 13.8%

Examining the matrix, it is possible to see that the expected return is simply the sum of the expected
returns multiplied in each case by the likelihood (as estimated) of that outcome. The result is a weighted
return where the probability is used to weight each of the expected returns. It is important that the
probabilities sum to 100%, so if there is uncertainty about any outcome it is better to include it under
the zero return item.

Once the expected return has been calculated, it is necessary to consider the variability of the outcomes
as included in the table and these are expressed as probabilities. Determining the risk of an investment
requires an assessment of the mean of the returns and the variability of the returns (or the dispersion of
the outcomes). We need to determine the mean value and the standard deviation of the returns.

402
 Portfolio Construction

Value At Risk (VAR)

To measure the degree of financial or market risk being endured within a firm or an investment, we
can use value at risk (VAR). It is a widely used risk measure of the risk of loss on a particular portfolio of
financial instruments.

For the given portfolio, time horizon, and probability, the VAR is defined as a threshold loss value. This
assumes mark-to-market pricing, normal markets and no trading within the portfolio. VAR is measured
in three components:

1. The amount of potential loss.

2. The time frame.
3. The probability that amount of loss will happen.

A simple example is a fund manager who determines that on their portfolio there is a 10% probability
one-day VAR of £50 million. This implies that there is a 10% probability that the fund manager or their
firm could lose more than £50 million on any given day. Therefore, a £50 million loss could be expected
to occur every ten days given that the portfolio has a 10% probability.

7
It should be noted that VAR measures just one aspect of market risk. It cannot be used on its own as a
reliable measure of capital adequacy.

8.2.1 Arithmetic Mean

The most commonly used measure of expected return is the arithmetic mean, the calculation of which
reflects the values and probabilities of the various possible returns. The arithmetic mean may be
described mathematically as:

Arithmetic mean = r = Σpr

where:

r = expected return
p = probability attached to a particular outcome or return
r = percentage return

The arithmetic mean is the most appropriate measure when assessing the expected return in any one
year. However, it is less appropriate when assessing the average annual return from an accumulated
total over several years. For illustration, assume that there has been a 20% return over a four-year period.
It would not be appropriate to say that the mean return is 5% pa (the arithmetic mean 20%/4) since this
ignores the compounding of those earlier returns. The more appropriate measure is be the geometric
mean, which reflects the compounding. The geometric mean deals with compounding situations, and
the formula and calculation techniques are similar to those used in the DCF techniques (see chapter 2,
section 1.2).

403
 Starting Balance £1,000 Expected Ri – Re (Ri – Re)2 p*(Ri – Re)2
Probability End Balance Return Return %
20% £1,000 0.0% 0.0% –13.8% 1.90% 0.380%
15% £1,100 10.0% 1.5% –3.8% 0.14% 0.021%
35% £1,180 18.0% 6.3% 4.2% 0.18% 0.063%
30% £1,200 20.0% 6.0% 6.2% 0.38% 0.114%
100% Expected Return Re 13.8% 0.578%
Variance = σ2 0.578%
Standard Deviation = √σ2 7.60%

The table is a continuation of the earlier tabulation of the expected returns based on a simple probability
calculation. The extension to the table shows the results in the three right-hand columns:

1. Subtracting the expected return Re from each of the returns Ri.

2. The squaring of the number determined above – so that each becomes a positive value.
3. The result from the above multiplied by each of the probabilities.

The sum of the last column is equal to the variance and the square root of the variance is the standard
deviation.

8.2.2 Interpretation of the Result

It can be seen from the above that an investor contemplating whether to invest in the project has an
expected return of 13.8% with a standard deviation of the returns of 7.60%. Let us also assume that the
investor has a cost of capital of 10% pa. It is clear that the expected return does exceed the current cost
of capital, but how should the investor take account of the variability, or the standard deviation, ie, the
risk? How can the investor relate the risk and return?

One thing which can be said at this preliminary stage is that, other things being equal, the higher the
standard deviation of the returns, the greater the risk. So, if an investor is faced with two projects, both
of which delivered the same expected return, and one has a much greater standard deviation than the
other, the investor will seek out the one with the smaller standard deviation. In very simple terms the
typical (rational) investor will perform a trade-off between the expected return and the amount of risk (ie,
how large is the standard deviation of the returns) and choose the one with the more favourable ratio.

To answer this question more deeply, however, it is necessary to venture into some elementary statistical
theory and make references to the normal distribution. In order to make this as concrete as possible and
not too theoretical, the discussion will allow us to examine the returns for an investor in the broad-based
FTSE 100 Index during the year ending on 1 June 2009. We shall take the closing price of the index at the
beginning of each month and calculate the percentage increase from month to month.

The following table shows the method for calculating the standard deviation of the monthly changes.

404
 Portfolio Construction

FTSE 100 Monthly Changes

Date Close Percentage Deviation Mean Squared Deviation
Change
01/05/2008 6053.5
02/06/2008 5625.9 –7.1% –4.7% 0.2%
01/07/2008 5411.9 –3.8% –1.4% 0.0%
01/08/2008 5636.6 4.2% 6.5% 0.4%
01/09/2008 4902.5 –13.0% –10.6% 1.1%
01/10/2008 4377.3 –10.7% –8.3% 0.7%
03/11/2008 4288.0 –2.0% 0.3% 0.0%
01/12/2008 4434.2 3.4% 5.8% 0.3%
02/01/2008 4149.6 –6.4% –4.0% 0.2%
02/02/2009 3830.1 –7.7% –5.3% 0.3%
02/03/2009 3926.1 2.5% 4.9% 0.2%
01/04/2009 4243.7 8.1% 10.5% 1.1%
01/05/2009 4417.9 4.1% 6.5% 0.4%

7
Statistical Value Greek Letter Value
Mean Monthly Change µ –2.37%
Variance = Sum of Squared Deviations/12 σ2 0.42%
Standard Deviation = √Variance σ 6.48%

The table above actually includes 13 values, with May 2008 being inserted only in order to determine
the percentage difference for the first reference value which is for June 2008.

The percentage changes are simply determined by the formula:

Close in current month – 1 X 100%

Close in previous month

In time series analysis, this value is sometimes called the first order difference and can be calculated
using a logarithmic approach in which case it is known as the log difference, but for simplicity the simple
percentage changes have been used in what follows. The arithmetic mean value or average monthly
change is simply the sum of the monthly changes divided by the number of values – in this case 12. It
is usually denoted by the Greek letter μ. As can be seen from the table the average monthly difference
during the one-year period is –2.37%, which reflects the significant decline in equity prices in the UK and
globally during the period.

It should be commented that this period which has been examined in the table shows some of the more
extreme behaviour of financial markets from a historical perspective. For the FTSE 100 during the period
examined, the standard deviation value of 6.48% for monthly returns observed is, from a historical point
of view, abnormally high. However the general theoretical implications of taking the observations of
mean and standard deviation and applying them to a forecast of risk and return are equally as applicable
for more extreme financial periods as well as more normal circumstances.

405
Indeed, one could make the case that financial market analysts had underestimated the degree of
systematic or market risk prior to the more extreme periods seen in the second half of 2008 and until
2009. The monthly changes have been illustrated in the column graph below and, as revealed, the back-
to-back losses of 10% plus in each of September and October 2008 are quite exceptional.

Monthly Returns for FTSE 100

1 June 2008 – 1 June 2009
10.00%

5.00%

0.00%
Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May
08 08 08 08 08 08 08 09 09 09 09 09
–5.00%

–10.00%

–15.00%

The diagram above shows the considerable variability in the monthly returns of the FTSE 100 Index
during a very troubled financial period. The degree of variability seen on the diagram from month
to month is more in the order of magnitude of a year to year chart in more normal times and helps
to address the underlying question of the riskiness of an investment. If one had taken a short-term
investment view and decided to buy stocks in the FTSE 100 in August 2008, within two months the
investment would have lost about 25% of its value. This is clearly a highly unusual situation which
coincided with the worst financial crisis in recent history.

8.3 Volatility
There are many different opinions on what constitutes the best measurement of volatility, starting with
the simplest, which is the variance in the returns of an asset, or more commonly the standard deviation
in the returns. We have seen how the variability of returns in the FTSE 100 Index during 2008 would have
impacted a portfolio manager with exposure to the stocks in this index.

From a macroeconomic perspective there are ways of measuring the degree of volatility across a broad
range of asset classes, and one of the more useful is the Chicago Board Options Exchange’s (CBOE’s)
Volatility Index, or VIX. It is fortunate that detailed daily records of the value of this index have been kept
since 1990 so it is possible to take a good look, for a substantial period, at what has happened to the
market’s own perception of its likely volatility and risk.

406
 Portfolio Construction

Implied volatility has to be distinguished from the actual observed variance in the returns that we
just mentioned, and which is usually referred to as historical volatility. Implied volatility is the market’s
perception, at the time, of the likely variation in returns as expressed in the prices of options (which
incorporate a variable premium value).

The following chart shows the monthly values of the CBOE Volatility Index for the period from 1990 until
2020. As can be seen immediately, the VIX As can be seen immediately, the VIX is itself highly volatile,
showing that perceptions about the future course of volatility are subject to profound and dramatic
changes depending on the prevailing market conditions, contemporaneous news events and crises.

7
Source: https://www.macrotrends.net/2603/vix-volatility-index-historical-chart

The peak in 2008–09 shows the extreme nature of the panic surrounding the global banking crisis
of 2008, when market traders were assuming an implied volatility of up to 90% at its peak and a
considerable period when the readings were above 40%. The more recent spike in 2019–20 coincides
with the beginning of the COVID-19 pandemic.

8.4 Beta, Covariance and Correlation

Standard deviation has been shown to be one of the key metrics in portfolio theory to measure risk but
there is another important notion, which is sometimes confused with volatility, but which provides a
different view of the risk of holding an asset.

407
The concept which plays a key role in modern portfolio theory is known as beta. Beta measures the
extent to which the price movements in a particular asset are either in line with the price movements
of a broad index or benchmark – such as the FTSE 100 or S&P 500 – or else exceed or are less than the
benchmark.

In other words, beta is a measure of the average historic sensitivity of a fund’s returns compared to the
broader market. For example, a value of 1 indicates that the fund has, on average, moved in line with the
general market movements.

• If the stock’s beta is 1, then the stock has the same volatility as the market as a whole, ie, will be
expected to move in line with the market as a whole.
• If it has a beta of greater than 1, then the stock will be expected to move more than the market as a
whole.
• If a stock has a beta of 1.5, then it has 50% greater volatility than the market portfolio, ie, can be
expected to move half as much again as the market. A beta of 1.5 means that the fund has moved by
an average of 1.5% for every 1% market movement. A beta value of 2 for an individual UK security that
has been benchmarked against the FTSE 100 means that the movements of the security should be
expected to be twice that of the index. So if the index were to rise by 10% the security will be expected
to rise by 20% and if the index were to fall by 5% then the security would be expected to fall by 10%.
• If it has a beta of less than 1, the stock is less volatile than the market as a whole, so a stock with a
beta of 0.7 will be expected to move 30% less than the market as whole. This is sometimes referred
to as acting defensively to general market moves.

Understanding the beta of a fund will, therefore, give an indication of how an asset of a fund may
perform in certain market conditions. When allied with the risk tolerance of a client, its value can be
seen. An asset with a high beta is potentially unsuitable for a risk-averse investor, whereas one that has
acted in line with market movements or defensively may be more appropriate.

Covariance is a statistical measure of the relationship between two variables such as share prices. The
covariance between two shares is calculated by multiplying the standard deviation of the first by the
standard deviation of the second share and then by the correlation coefficient. A positive covariance
between the returns of A and B means they have moved in the same direction, while a negative
covariance means they have moved inversely. The larger the covariance, the greater the historic joint
movements of the two securities in the same direction.

From this the following conclusions can be drawn:

• Although it is perfectly possible for two combinations of two different securities to have the same
correlation coefficient as one another, each may have a different covariance, owing to the differences
in the individual standard deviations of the constituent securities.
• A security with a high standard deviation in isolation does not necessarily have a high covariance
with other shares. If it has a low correlation with the other shares in a portfolio then, despite its high
standard deviation, its inclusion in the portfolio may reduce overall portfolio risk.
• Portfolios designed to minimise risk should contain securities as negatively correlated with each
other as possible and with low standard deviations to minimise the covariance.

To calculate the beta of an investment we need to know the systematic risk element of the investment.
Systematic risk is that part of the total risk that is related to movements in the market portfolio.

408
 Portfolio Construction

The correlation coefficient between two investment opportunities is a measure of this relationship and
hence can be included in the derivation approach to beta.

σs = σi Cor(im)

where: σs = investment’s systematic risk

σi = investment’s total risk (systematic and unsystematic)
Cor(im) = correlation coefficient between the investment’s returns and the market as a
whole, for which one can use an appropriate benchmark such as the returns
on the FTSE 100

For instance, if an investment is perfectly correlated with the market, then all of its risk will be systematic
σs = σi. However, if an investment is uncorrelated to the market, then its systematic risk will be zero and
all of its risk will be unsystematic.

σs σi Cor(im) σi σmCor(im)
ß = and from σs = Cor(im) = ß = =
σm σm σm2

7
If the covariance or correlation coefficient between the investment and the market can be established,
the beta can be calculated. Alternatively, if we establish the systematic risk, we can establish the beta.

8.5 Risk-Adjusted Returns and Performance Ratios

Once one has calculated the returns from a portfolio, it is very useful, in assessing the amount of risk
borne by the investor or fund manager, to compare the portfolio’s performance against the market as a
whole or against other portfolios. This requires the use of risk-adjusted performance measurements, of
which there are a number of methods in use including the following:

• Sharpe ratio.
• Sortino ratio.
• Jensen measure.
• Information ratio.
• Alpha.

We shall consider the most widely used by portfolio managers to benchmark their performance. It is
known as the Sharpe ratio and is named after William Sharpe, a Nobel laureate in economics who is
Emeritus Professor of Finance at Stanford University, who devised the measure.

The simplest method to calculate the Sharpe ratio is to deduct the risk-free rate of return from the
compounded annual growth rate (CAGR) and divide the result by the annualised standard deviation of
the returns.

So the formula is simply:

[CAGR – RFR] / Annualised Standard Deviation of Returns

409
There is a slightly different approach, which is to deduct the average monthly return at the risk-free T-bill
rate from the average monthly return and divide the result by the monthly standard deviation of the
returns. Once that figure is obtained the result is again multiplied by the square root of 12. The alternate
formula is simply:

{[Average Monthly Return – Average RFR]/ STD of Monthly Returns} x 12^0.5

Now that we know how to calculate the ratio, we should briefly explore the significance of this value
that was first proposed by Sharpe. The assumption behind the calculation and the reason why the
standard deviation is used as the denominator to the equation is that, since investors prefer a smooth
ride to a bumpy one, the higher the standard deviation, the lower will be the Sharpe ratio. Accordingly,
high Sharpe ratios are to be preferred and positive values are obviously better than negative values,
reflecting the fact that returns are positive. Obviously, the denominator of the equation will always be a
positive value.

As an aside, we should note that many analysts compute the Sharpe ratio using arithmetic returns.
However, the geometric mean is a more accurate measure of average performance for time series data,
as the following example shows. For example, if one has returns of +50% and –50% in two periods, then
the arithmetic mean is zero, which does not correctly reflect the fact that 100 became 150 and then
75. The geometric mean, which is –13.4%, is the correct measure to use. For investment returns in the
10–15% range, the arithmetic returns are about 2% above the geometric returns.

There are a few other factors that need to be noted about the simple formula for the Sharpe ratio. Since
the denominator of the formula is the standard deviation of the returns, the ratio becomes numerically
very unstable at extremes, or in other words when the denominator is close to zero.

The second and major problem relates to the actual sequence of returns and the different equity curves
associated with them. An equity curve tracks the actual rise and fall of equity in a fund or traces out
the development through time of the P&L. Dramatically different equity curves in a portfolio will not
be captured by the mean and standard deviations when looked at retroactively to compute the Sharpe
ratio.

Therefore, depending on the exact time frame of reference, the Sharpe ratio is the same in all three
instances – the actual sequence of returns, an ascending sort of those same returns and also a
descending sort of the sequence. What this illustrates is that the Sharpe ratio is essentially insensitive to
the clustering of returns.

This is a serious limitation of the value, because an investor will be seriously perturbed by the extreme
equity curves that could be witnessed if there were a cluster of losing months in a returns schedule.
Because of the calculation mode that underlies averages and standard deviations this clustering of
losing months will no longer be apparent on a retrospective basis, although at the time the volatility
would have felt much worse than the Sharpe ratio suggests.

There is one further limitation of the procedure for calculating the Sharpe ratio, which is that the
simple standard deviation or variability of the returns includes not only the months when returns are
negative but also those when returns are positive. The presence of a number of months with superior
returns in an otherwise typically positive period of performance will increase the standard deviation
but for reasons that, hopefully, the investor will not find unattractive. Risk is asymmetrical, and we

410
 Portfolio Construction

tend to equate negative or adverse returns as problematic, whereas the Sharpe ratio penalises the
fund manager who happens to show superior performance with higher variability caused by a higher
frequency of big winners. This limitation was the inspiration for the Sortino ratio – which is beyond the
scope of the current syllabus.

Alpha is a risk-adjusted performance measure using the volatility of a portfolio, and compares its risk-
adjusted performance to the benchmark index. The alpha is the measure of the portfolios over and
above the return from the benchmark index.

8.6 Time-Weighted and Money-Weighted Returns

Time-weighted returns and money-weighted returns are a way to measure the performance/rate of
return but by using different methods and criteria (the formulae for calculating these types of returns
are outside the scope of this workbook due to their complexity). The main difference between the two is
that time-weighted return ignores the effect of cash inflows and outflows during the calculation period.

• Time-Weighted Return (TWR) – a TWR is unaffected by withdrawals or contributions, but measures

the compound rate of return for one investment over a set time period. When calculating a time-

7
weighted rate of return, the effect of varying cash inflows is eliminated, so the calculation effectively
compares a single investment at the start of the measured period and then measures the profit or
loss at the end of the period.
With TWR, the total measurement period is divided into several sub-periods. Each sub-period
will end and be priced as an inflow or outflow occurs, or can be end of month or end of quarter,
depending on the requirements of the manager. The rate of return then takes the compounded
time-weighted rate for each sub-period, and calculates the average returns for the measurement
period. TWR is the preferred industry standard because of the ‘smoothing effect’ of the calculation.
• Money-Weighted Return (MWR) – the MWR can be used to evaluate the performance of a single
investment or an entire portfolio. Its name derives from it being based on the amount of money
within an account. In calculating the MWR, the inflows and outflows are taken into account and,
whatever factor is required to make the two sides equal, is the rate of return for the investment. A
MWR is relative to the length of the period in which a person has invested their capital. MWRs are
largely focused on the timing of inflows and outflows of cash. Unlike TWRs, MWRs measure the rate
of return based on the same rate of return being earned during each sub-period.

411
 End of Chapter Questions

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

1. What is the primary purpose of the Financial Stability Report which is published twice annually by the
Bank of England?
Answer reference: Section 1.1.2

2. What is a candlestick chart and which type of market analyst would be most associated with such a
chart?
Answer reference: Section 1.2.2

3. What market abuse is referred to by the term ‘pump and dump’?

Answer reference: Section 2.4.5

4. What is the primary objective of the Panel on Takeovers and Mergers?

Answer reference: Section 2.5

5. What is the meaning of underlying with respect to financial derivatives?

Answer reference: Section 3.1

6. What is an American-style put option?

Answer reference: Section 3.2.1

7. A portfolio manager is holding long positions in UK equities with a current value of £10 million
and largely replicates the weightings of the FTSE 100 Index. How many FTSE 100 contracts
should be sold to provide a suitable hedge if the FTSE 100 Index currently has a value of 6200?
Answer reference: Section 3.4.2

8. What is meant by the term ‘diversifiable’ or ‘non-systematic risk’?

Answer reference: Section 4.3

9. If the returns of two assets have a correlation coefficient of 0.8 and are combined in equal proportions
in Portfolio A, and two other assets with returns which have a correlation coefficient of 0.3 are
similarly placed in Portfolio B, which portfolio would you expect to exhibit the most diversification?
Answer reference: Sections 5.1 and 5.2

10. Explain why advocates of the efficient markets hypothesis favour a passive approach to portfolio
management rather than an active one.
Answer reference: Section 5.3

412
Chapter Eight

Investment Selection and

Administration
1. Client Investment Profiles 415

2. Strategy Selection 423

3. Investment Selection and Suitability 433

4. Managing a Client Portfolio 438

5. Changes that can Affect a Client Portfolio 444

8
This syllabus area will provide approximately 4 of the 80 examination questions
414
 Investment Selection and Administration

1. Client Investment Profiles

Learning Objective
8.1.1 Apply a range of essential information and factors to form the basis of appropriate investment
selection and suitability: financial needs, preferences and expectations; income and lifestyle –
current and anticipated; attitude to risk/capacity for loss; level of knowledge and experience of
investing; existing debts and investments

1.1 Attitude to Risk and Investment Expertise

The risk tolerance 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 the selection of investment
products. A client needs to have a very clear understanding of their own tolerance to risk, as it is essential
to choosing the right investment objectives.

Amongst the methods of assessment which can be developed by firms in order to evaluate an individual’s
risk profile, a questionnaire is common and useful. Questions asked to assess an individual’s risk profile
might include the following examples.

8
• How long do you expect to leave your investment in place until you sell it?
• Which outcome is most important to you from an investment portfolio? (Choose one.)
• Preserving capital
• Generating income
• Long-term growth and capital gains
• Which of the following asset classes have you owned previously or do you now own?
• Bank or building society deposit account
• Government stocks (gilts)
• Unit trusts or open-ended investment companies (OEICs)
• Investment trusts
• Individual company shares
• Which of the following best describes your main objective in investing? (Choose one.)
• The education of my children
• Savings
• Capital growth and returns
• My retirement
• To leave money in my will
• How large is your investment plan in proportion to your total savings?
• Less than 10%
• Between 10% and 20%
• Between 20% and 30%
• Between 30% and 40%
• Above 40%

415
Attitude to risk, and its definitions, are themes that financial services companies constantly revisit. The
reason for this is simple: namely that they want to be able to categorise a client into a risk category and
then be able to say which of their products are suitable for clients with that risk profile. Definitions of
risk profiles are imprecise and there are no agreed classifications, but an overall approach could include:

• No risk – the client is not prepared to accept any fall in the value of their investments. Appropriate
investments may be cash-type assets or short-dated government bonds priced below par.
• Low risk – the client is cautious and prepared to accept some value fluctuation in return for
long-term growth but will invest mainly in secure investments.
• Medium risk – the client will have some cash and bond investments but will have a fair proportion
in direct or indirect equity investments and, potentially, some in high-risk funds.
• High risk – the client is able to keep cash reserves to the minimum, will hold mainstream and
secondary equities and be prepared to accept derivatives and other high-risk investments.

Academic research has suggested that risk tolerance can be broken down into two main areas:

• ability to take risk, or risk capacity, and

• willingness to take risk, or risk attitude.

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, risk attitude is subjective and has more to do with
an individual’s psychological make-up than their financial circumstances. Some clients view market
volatility as an opportunity, while for others such volatility will cause distress (see section 1.4 for more
coverage of capacity for loss).

Objective Factors
There are a number of objective factors that can be established that will help define a client’s ability to
take risk, including:

• Timescale – the timescale over which a client may be able to invest will determine both what
products are suitable and what risk should be adopted. For example, there would be little
justification in selecting a high-risk investment for funds that are held to meet a liability that is due
in 12 months’ time. By contrast, someone in their 30s choosing to invest for retirement is aiming for
long-term growth, and higher-risk investments would then be suitable. As a result, the acceptable
level of risk is likely to vary from scenario to scenario.
• Commitments – family commitments are likely to have a significant impact on a client’s risk
profile. For example, if a client needs to support elderly relatives, or children through university,
this will have a determining influence on what risk they can assume. While by nature they may
be adventurous investors, they will want to meet their obligations, and this will make higher-risk
investments less suitable.
• Wealth – wealth will clearly be an important influence on the risk that can be assumed. A client with
few assets can little afford to lose them, while ones whose immediate financial priorities are covered
may be able to accept greater risk.
• Life cycle – stage of life is equally important. 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 to see their funds grow. As retirement approaches, this will change as the client seeks to lock
in the growth that has been made and, once they retire, they will be looking for investments that will
provide a secure income that they can live on.

416
 Investment Selection and Administration

• Age – the age of the client will often be used in conjunction with the above factors to determine
acceptable levels of risk, as some of the above examples have already shown.
• Health – the client’s health status will need to be established: that is, whether they are in good health
or have any serious medical conditions that may influence their investment objectives and attitude
to risk. An individual in good health, who comes from a family that traditionally lives until a very old
age, will certainly want to plan for the long term, and planning for income well into retirement may
well be very high on their list of priorities. This may influence the investment strategy selected, as
there may be a need to generate a growing level of income for many years, implying the need for a
higher exposure to equities and the growing dividend stream they provide. At the other end of the
spectrum, a client may be in poor health, and this may drive an investment strategy to produce a
more immediate income. This will then influence the asset allocation strategy adopted, and sway
weightings away from equities to cash and fixed-income instruments. A client’s health may also
influence their attitude to risk.

Subjective Factors
Subjective factors enable an adviser to try and establish a client’s willingness to take risks – their ‘risk
attitude’. A client’s attitudes and experiences must play a large part in the decision-making process. A
client may well be financially able to invest in higher-risk products, and these may well suit their needs,
but, if they are cautious by nature, they may well find the uncertainties of holding volatile investments
unsettling, and both the adviser and the client may have to accept that lower-risk investments and
returns must be selected.

8
When attempting to determine a client’s willingness to take risks, areas that can be considered include:

• A client’s level of financial knowledge – generally speaking, investors who are more knowledgeable
about financial matters are more willing to accept investment risk. This level of understanding does
still need, however, to be tested against their willingness to tolerate differing levels of losses.
• A client’s comfort with a level of risk – some individuals have a psychological make-up that
enables them to take risks more freely than others, and see such risks as opportunities.
• A client’s preferred investment choice – risk attitude can also be gauged by assessing a client’s
normal preferences for different types of investments, such as the relative safety of a bank account
versus the potential risk of stocks and shares.
• A client’s approach to bad decisions – 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,
wrong. 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.

Attempting to fully understand a client’s risk attitude requires skill and experience, but we can enhance
the classifications that we have used so far as suggested below.

417
 Classification Characteristics
Typically have very low levels of knowledge about financial matters and
very limited interest in keeping up to date with financial issues.
Have little experience of investment beyond bank and savings accounts.
Very cautious
Prefer knowing that their capital is safe rather than seeking high returns.
investors
Are not comfortable with investing in the stock market.
Can take a long time to make up their mind on financial matters and can
often regret decisions that turn out badly.
Typically have low levels of knowledge about financial matters and limited
interest in keeping up to date with financial issues.
May have some limited experience of investment products, but will be
more familiar with savings accounts than other types of investments.
Do not like to take risks with their investments. They would prefer to keep
Cautious investors
their money in the bank, but would be willing to invest in other types of
investments if they were likely to be better for the longer term.
Prefer certain outcomes to gambles.
Can take a relatively long time to make up their mind on financial matters
and can often suffer from regret when decisions turn out badly.
Typically have low to moderate levels of knowledge about financial matters
and limited interest in keeping up to date with financial issues.
Have some experience of investment products but are more familiar with
Moderately savings accounts.
cautious investors Are uncomfortable taking risks but willing to do so to a limited extent,
realising that risky investments are likely to be better for longer-term
returns.
Prefer certain outcomes and take a long time to make up their minds.
Typically have moderate levels of knowledge about financial matters but
will take some time to stay up to date with financial matters.
May have experience of investment products containing equities and
bonds.
Understand they have to take risks in order to achieve their long-term
Balanced investors
goals. Willing to take risks with at least part of their available assets.
Usually prepared to give up a certain outcome providing that the rewards
are high enough.
Can usually make up their minds quickly enough but may still suffer from
regret at bad decisions.

418
 Investment Selection and Administration

Classification Characteristics
Typically have moderate to high levels of financial knowledge and usually
keep up to date with financial matters.
Are usually fairly experienced investors who have used a range of
Moderately investment products in the past.
adventurous Are willing to take investment risk and understand this is crucial to
investors generating long-term returns. Are willing to take risk with a substantial
proportion of their available assets.
Will usually make their mind up quickly and are able to accept that
occasional poor outcomes are a necessary part of long-term investment.
Have high levels of financial knowledge and keep up to date.
Will usually be experienced investors who have used a range of investment
products and may have taken an active approach to managing their
investments.
Adventurous
investors Will readily take investment risk and understand this is crucial to
generating long-term returns. Willing to take risks with most of their
available assets.
Will usually make their mind up quickly and are able to accept that

8
occasional poor outcomes are a necessary part of long-term investment.
Have high levels of financial knowledge and a keen interest in financial
matters.
Have substantial amounts of investment experience and will typically have
been active in managing their investments.
Very adventurous Looking for the highest possible returns on their assets and willing to take
investors considerable amounts of risk to achieve this. Willing to take risks with all of
their available assets.
Have firm views on investment and will make up their minds on financial
matters quickly. Do not suffer from regret, and accept occasional poor
outcomes without much difficulty.

1.2 Financial Needs, Preferences and Expectations

Any individual is likely to have a number of objectives for which some financial provision may be
required. We have seen that at the start of the financial planning process the client’s general attitude to
risk and objective risk tolerance should be established; however, an important refinement of this is that
a client’s general view of risk does not mean that the same attitude to risk should necessarily be applied
to all of the individual’s objectives.

419
An individual may have investments that they wish to use for specific purposes or objectives and for
which they cannot easily afford to bear a great degree of shortfall risk. In such cases, they may wish
to choose low-risk investments, so that they can be reasonably certain that their objective will be
achievable by the desired date. The same individual might have other discretionary possibilities in mind
for which they are prepared to tolerate a higher level of risk. The objective may be seen as less essential
to the individual, and may be something that the person accepts that they will have to do without if
investment returns are not sufficient.

Of course, every investor is different, and the ways in which people rank their objectives and their risk
tolerance in relation to different objectives vary. For one person, having enough money to spend on a
comfortable home may take a higher priority than having the funds to travel widely. Another person
may treat travelling as a higher priority than spending on a home.

In general, the objectives that an individual sees as having the highest priority are those for which
they will want to take the lowest risk if they are investing to achieve those objectives. Lower-priority
objectives can generally be more easily forgone if investments suffer losses.

1.3 Current and Anticipated Lifestyle

1.3.1 Occupation, Earnings and Other Income Sources

Clearly, it will be necessary to establish what the client’s income is, from whatever sources it arises. If
generating a particular level of income is important to the client, it will obviously be essential. It will be
equally relevant if the client is uninterested in income-generation, as it will be needed to establish the
client’s tax position.

However, the client’s occupation may be a relevant factor for investment decisions in other, less obvious
ways. Firstly, the client’s occupation or business will give a good indication of their experience in business
matters, which may be relevant when judging the suitability of a particular type of investment that
carries greater risk and when the firm is required to assess the client’s experience before recommending
it.

Establishing the client’s occupation may also lead the adviser to realise that there may be issues with
dealing in certain stocks if the client holds a senior position in a company. In such a position, the client
and firm face the risk of dealing on inside information. They will need to ensure that arrangements are
put in place to request permission to trade, avoid closed dealing periods and ensure that any trading
takes place in a manner that places neither the firm nor the client at risk.

A client may also potentially be a politician or hold a senior position which is in the public spotlight.
When that is the case, they often need to distance themselves from any investment decision-making so
that there can be no accusation of them exploiting their position or knowledge. In such cases, it is often
common to establish a blind trust, where all investment decisions are taken on a totally discretionary
basis and where the client is deliberately kept unaware of trading decisions or their rationale.

When the client is in business, the adviser will want to understand the client’s plans for the business and
any funds that may be forthcoming immediately or in the future that might affect the investment plans
that the adviser will draw up.

420
 Investment Selection and Administration

1.3.2 Present and Anticipated Outgoings

The client’s outgoings need to be understood in conjunction with their income, when it is necessary to
look at budgeting, planning to meet certain liabilities or generating a specific income return.

Depending upon the client’s priorities, information about both their present and anticipated future
outgoings may be needed. This may be necessary, for example, if the investment plan involves
generating a certain income in retirement. Any cash funding requirements, such as the need to fund
school fees or university education, will particularly need to be understood so that the requirement to
provide the necessary cash can be factored into the investment strategy.

1.3.3 Pension Arrangements

The pension arrangements the client has made will need to be closely linked to the investment strategy
that is adopted both for retirement and other financial objectives.

The availability of tax exemptions for pension contributions may influence the choice of investments
and so clearly needs to be factored in at this stage.

1.3.4 Assets and Liabilities

8
Full details of the client’s existing assets and liabilities will need to be known. Note that as part of the
anti-money laundering checks that the adviser will need to undertake, the source of the client’s funds
will need to be established.

As well as obtaining details of the client’s assets, the adviser should also look to establish:

• the location of the assets and whether any investments are held in a nominee account
• the tax treatment of each of the assets
• whether any investments are held in a tax wrapper
• acquisition costs for any quoted investments held, including any calculations needed for assessing
any liability to capital gains tax
• details of any early encashment penalties.

The information needed will vary by type of asset.

Details should be established of any liabilities that the client has, and whether these are covered by any
protection products.

1.3.5 Potential Inheritances

The client should be asked to provide details of any potential inheritances they may receive and of
any trusts where they are beneficiaries. This will be relevant if the amounts due to be inherited might
influence the investment strategy adopted. For example, a client may be due to inherit a substantial
sum from elderly parents and so may be able to take a view that their investments should be directed to
outright growth.

421
1.3.6 Wealth and Investment Exposure
When considering a client’s investment profile, their existing wealth is clearly an important consideration.
If there is an excess of capital to invest, then clearly it is sensible for the individual to take steps to make
the best use of that capital.

It is possible, although not generally advisable, for someone with little wealth to gain exposure to
investment markets, for example by borrowing money to invest, or by using investments such as
derivatives or spread betting to gain a greater exposure than the individual’s free resources.

When investing in risky assets such as equities, a good principle is the often-stated one that someone
should only invest what they can afford to lose. Someone who borrows to invest without having other
capital to back it up if things go wrong has the problem that they may end up with liabilities in excess
of their assets.

An investor who uses instruments such as derivatives to increase their exposure should maintain other
accessible resources (eg, cash on deposit) that can be used to meet losses that may arise. Clearly, it is
also important that they understand the risks they are undertaking.

There continues to be an increased regulatory focus on derivatives in recent years with extra regulations
being introduced. For example, the European Market Infrastructure Regulation (EMIR) implemented a
range of new measures for clearing and reporting to address the way in which the risks associated with
derivative activity are managed and addressed. These measures have been amended, added to and
developed over time to address new risks as they arise.

1.4 Capacity for Loss

As part of assessing a client’s appetite for risk, it is necessary to be aware of the client’s capacity for loss,
which is considered to be part of the suitability assessment.

This can prove difficult when a client actually believes that they have unlimited capacity for loss.
However, the client will not necessarily take into account everything that must be considered and,
therefore, the client’s opinion on potential loss is somewhat different to capacity for loss.

A firm must collect and properly account for all the information relevant to assessing the risk a customer
is willing and, more importantly, is able, to take. A firm should ideally use one procedure to assess the
customer’s attitude to risk and a separate process to assess the capacity for loss, ensuring both are
appropriately considered as part of the suitability. Even when a firm uses a risk-profiling tool, it cannot
always easily determine the customer’s capacity for loss.

As part of the assessment, the firm will need to know what debts the client has, and what the retirement
plans of the client are, taking into account their age and any future capital needs.

422
 Investment Selection and Administration

2. Strategy Selection

Learning Objective
8.1.2 Be able to analyse and select strategies suitable for the client’s aims and objectives in terms
of: investment horizon; current and future potential for growth and yield; requirement for
capital protection; protection against inflation; liquidity, trading and ongoing management;
mandatory or voluntary investment restrictions; impact of fees and charges; ethical/
Environmental, Social and Governance (ESG) considerations

2.1 Capital Protection, Growth and Yield

Having collected all of the core information needed about the client, the adviser can then turn to
agreeing their investment objectives.

In collecting the information above, the adviser will have started to build a picture of the client’s needs.
They should be able to classify these needs along the lines of the following:

• maximising future growth

• protecting the real value of capital
• generating an essential level of income, and

8
• protecting against future events.

The adviser will want to convert this into an understandable investment objective and will use
classifications such as income, income and growth, growth, and outright growth. The purpose of this is
so that there can be a common understanding of what the client is trying to achieve. Typical financial
objectives include:

• Income – the client is seeking a higher level of current income at the expense of potential future
growth of capital.
• Income and growth – the client needs a certain amount of current income but also wants to invest
to achieve potential future growth in income and capital.
• Growth – the client is not seeking any particular level of income and their primary objective is
capital appreciation.
• Outright growth – the client is seeking maximum return through a broad range of investment
strategies which generally involve a high level of risk.

Once the client’s investment objectives have been agreed, the adviser needs to look at developing an
investment strategy that can be used to achieve these objectives. In developing an investment strategy,
the adviser will need to determine the following:

• time horizons
• risk tolerance
• investment preferences (see section 1.4 of this chapter)
• liquidity requirements, and
• tax status.

423
2.1.1 Time Horizon
One of the most important issues to clarify within an investor’s profile is their holding period or, in other
words, the period for which they are committed to a particular investment programme. The phrase ‘time
horizon’ refers to the period over which a client can consider investing their funds. Definitions of time
horizons vary, but short term is usually considered to be from one to four years, while medium term
refers to a period from five to ten years and long term is considered to be for a period of ten years or
more.

As an investment manager, it is essential to understand the time horizons over which a client is able
and willing to invest, as these will also have a clear impact on the selection and construction of an
investment portfolio.

The effect of the investment timescale is particularly important for equity or equity-backed investments.
Over short-term horizons, ie, less than five years, the returns from equities have often been negative but
over very long-term horizons equities have usually shown a relatively high return which exceeds that
of most other asset classes. Therefore, if an individual is only seeking to invest over a period of a few
months, at the end of which they wish to redeem their investment, then it is inadvisable to invest the
money in higher-risk investments such as equities as, given the volatility of equity returns there is an
uncomfortably high probability that any investments made in equities for a short timescale may have to
be liquidated at a loss. If there are known liabilities that may arise in future years, conservative standards
suggest investing an appropriate amount in bonds that are due to mature near the time needed so that
there is certainty of the availability of funds.

There is a wide range of available investment opportunities, and to understand which might be
suitable for a client, an adviser needs to start by understanding what the client’s investment or financial
objectives are.

2.1.2 Liquidity Requirements

Liquidity refers to the amount of funds a client might need both in the short and long term. When
constructing an investment portfolio, it is essential that an emergency cash reserve is put to one side
that the client can access without having to disturb longer-term investments.

A client may have known liabilities that will arise in the future which will need to be planned for, and it
will be necessary to factor in how the client will raise funds when needed. Markets can be volatile and
so the investment strategy needs to take account of ensuring that funds can be readily realised without
having to sell shares at depressed prices. With the need for liquidity in mind, it is wise for an investor to
have sufficient funds held on deposit at any time to meet likely cash needs.

However, keeping funds liquid brings the benefit of accessibility but there is a trade-off in terms of
returns: the most liquid investments, such as cash or instant access accounts, will have relatively lower
returns than other assets. The lower the client’s liquidity requirements and the longer their timescale,
the greater will be the choice of assets appropriate to meet the client’s investment objective. The need
for high liquidity, allied to a short timescale, demands that the client should invest in lower-risk assets
such as cash and short-dated bonds, which offer a potentially lower return than equities.

424
 Investment Selection and Administration

In planning terms, the adviser should agree with the client how much of a cash reserve should be held.
Recognising the long-term nature of investment, this should represent their expected cash needs over,
say, three to five years. This should then be supplemented by ensuring that the portfolio will contain
investments that are readily realisable in the event of an emergency and which otherwise will be
available to top up the cash reserve in future years.

This could be achieved, for example by using a bond ladder, which involves buying securities with
a range of different maturities. Building a laddered portfolio involves buying a range of bonds that
mature in, say, three, five, seven and ten years’ time. As each matures, funds can become available for the
investor to withdraw or can be reinvested in later maturities. See chapter 7, section 7.7.

Alternatively, structured products such as guaranteed capital growth bonds could meet the same
objective, subject to establishing a spread of providers and checking the counterparty risk involved. See
chapter 4, section 2.

2.1.3 Tax Status

Establishing the client’s tax position is essential so that their investments can be organised in such a way
that the returns attract the least tax possible. This requires the investment manager to be aware of what
taxes may affect the investor, such as taxes on any income arising or on any capital gains, how these are
calculated and what allowances may be available.

8
An adviser will also need to establish the client’s residence and domicile status, as these will impact how
any investments are structured. Residence is a key part of the UK tax code, and the manner in which a
taxpayer qualifies as either ordinarily resident or even non-resident will substantially affect the amount
of income tax and capital gains tax for which they are liable.

In the tax year 2021–22, individuals are taxed at the marginal rate of 45% on their taxable income in
excess of £150,000 pa. Accordingly, such clients may have a preference for investments which can be
taxed at the much lower rate for capital gains, which can vary between 10% and 28%, depending on
whether the gains are on residential property or other chargeable assets, whether the individual is a
basic rate or higher/additional rate taxpayer and also whether the taxpayer can qualify for entrepreneurs’
relief.

Consideration also needs to be given to any tax that may be deducted on investments that may be
selected for the client, for example, income tax that may have been deducted from a distribution from a
collective investment scheme.

When managing tax implications for a client, it is important to appreciate the difference between
tax evasion and tax avoidance. Tax evasion is a financial crime and is illegal, while tax avoidance is
organising your affairs within the rules so that you pay the least tax possible. The latter is a responsibility
of the adviser when they are undertaking financial planning.

The adviser will, therefore, need to establish:

• the client’s residence and domicile position

• the client’s income tax position

425
• how tax will affect any investment income
• any tax allowances which can be utilised
• how capital gains tax will affect any gains or losses made
• any capital gains tax allowances which can be utilised
• eligibility for any tax-free accounts, and
• opportunities for and the desirability of deferring any tax due.

2.2 Protection Against Inflation

Inflation can be one of the most important obstacles to successful investing because the real value of
the income flow from investments such as bonds and equities, as well as the long-term value of capital,
is eroded by the effects of inflation and the decline in the purchasing power of the wealth that is created.

Controlling inflation is the prime focus of economic policy in most countries, as the economic costs
inflation imposes on society are far-reaching. While there are many negative consequences, the two
which are most pertinent for the typical investor are:

• Inflation reduces the spending power of those dependent on fixed incomes such as pensions or
fixed-coupon investments such as a typical corporate bond.
• Individuals are not rewarded for saving. This occurs when the inflation rate exceeds the nominal
interest rate. That is, the real interest rate is negative. Real interest rates are calculated as follows:

Real interest rate = ([1 + nominal interest rate] / [1 + inflation rate]) – 1

So, the real return takes into account the inflation rate and in times of excessive inflation the real returns
available may well become negative.

In addition to the specific impact of inflation on returns just discussed, the broader macroeconomic
problems associated with periods of high inflation are well illustrated by the difficulties faced by
investors during the 1970s around the world. This was a period of extremely high inflation, fuelled by
surging commodity prices, especially crude oil, which in turn led to demands from organised labour for
higher wages, which in turn pushed up the costs to producers of goods and services, who in turn pushed
on these additional costs to end consumers in the form of higher prices. A vicious circle was created
which required very drastic increases in short-term interest rates at the end of the 1970s. The base rates
in the US and UK were approximately 20% as the 1980s began. This caused widespread distress for asset
prices. The 1970s was one of the worst on record for global stock market returns.

Inflation will also have negative implications for holders of bonds and fixed-income instruments. A
major driver of bond prices is the prevailing interest rate and expectations of interest rates to come.
Yields required by bond investors are a reflection of their interest rate expectations, which in turn will
be largely influenced by expectations about inflation. For example, if inflation and interest rates are
expected to rise, bond prices will fall to bring the yields up to appropriate levels to reflect the interest
rate increases. To remain competitive, equities prices will also suffer.

426
 Investment Selection and Administration

The interest rate itself is heavily impacted by inflationary expectations. Simplistically, if inflation is
expected to be at 4% pa, the interest rate will have to be greater than this in order to provide the investor
with any real return. The interest rate might stand at 7% pa. If economic news suggests that inflation is
likely to increase further, to say 6%, then the interest rate will increase too, perhaps up to 9%. The reverse
is true if inflation is expected to fall.

There are several investments that can be used if an investor is concerned to protect against the effects
of inflation. For example, index-linked bonds are ones where the coupon and the redemption amount
are increased by the amount of inflation over the life of the bond. The amount of inflation uplift is
determined by changes in the retail prices index (RPI). As with conventional gilts, investors receive two
interest payments a year and they get a redemption payment based on the nominal or face value of their
gilt holding. However, these payments are adjusted to take account of inflation since the gilt was issued.

Over time, successful companies should achieve a rise in both profits and dividend payments to
shareholders. This tends to be rewarded by existing shareholders and new investors placing a higher
value on the price of the shares. If the annual dividend increases are in excess of the annual inflation rate
over a sustained period of time, the share price and dividend receipts may well act as a healthy hedge
against inflation.

One final consideration for investors during periods of inflation is to consider making gold and other
commodities a part of their core portfolio holdings. Gold has traditionally been seen as not only a hedge

8
against inflation but also a protection against the debasement of paper assets, which partly arises
from inflation but might also arise from profligate government policies. Commodities such as energy
products and industrial metals will also tend to have a negative correlation with more mainstream assets
and should be relatively good performers during periods of inflation.

2.3 Mandatory and Voluntary Investment Restrictions

The regulatory framework adopted in the market needs to be adhered to. For collective investment
schemes (CISs) in the UK, there are certain investments which some funds may not be permitted to
invest in. Equally, a trust deed may exist which binds the fund manager to invest in certain securities and
the manager must comply. When there is no trust deed, the provisions of the Trustee Act 2000 apply in
the UK.

Some investors prefer to either exclude certain areas of the investment spectrum from their portfolios
or concentrate solely on a particular investment theme or require the portfolio to be constructed in
accordance with Islamic principles, ie, their religious beliefs and values about what is right and ethical
versus what is wrong and unethical and this will lead to conclusions about what is acceptable and
unacceptable business practice.

2.4 Trading and Ongoing Management

The issues an investment adviser faces when taking over an existing portfolio and reconstructing it are
similar to those involved when constructing an entirely new portfolio. A full profiling of the client’s needs
will be required to determine the need for accessibility and liquidity, income needs, attitude to risk,
timescale, tax position and any ethical preferences.

427
2.4.1 Liquidity and Accessibility
There are several meanings attributed to liquidity but specifically for many clients the key issue will
be how readily the asset can be converted into cash. However, another liquidity requirement, which is
particularly important for large funds that have a need to trade in large deal sizes, has to do with whether
the asset can be traded in substantial quantities without the transaction causing disproportionately
large changes in the price at which the trades occur.

In addition to liquidity issues, some investments are constrained in their accessibility and require long-
term commitments by the investor. In some cases, the investment cannot be realised early even if the
investor wishes it. Also, early redemption may be possible, but at the expense of a penalty or a significant
reduction in returns.

It is sometimes possible to sell an investment before maturity on the open market, as for example with
traded endowment policies. Although this should achieve a higher price than surrendering the policy
to the insurance company, there is still likely to be a loss in the rate of return compared with retaining
the investment until maturity. As a rule of thumb, it is prudent to avoid the premature redemption or in
a worst-case scenario distressed selling of investments, and good planning should seek to alleviate the
need for this.

2.4.2 Trading Frequency

From the point of view of professional ethics for fund managers it is deemed to be part of their code
of conduct that they do not engage in ‘churning’ a client’s investments. This is excessive trading or
switching investments on behalf of clients often, with a view to generating fee income for the fund
manager or associated brokerage firms.

There may also be tax penalties if investments are disposed of. For property, shares and collective
investments not sheltered within an ISA, or other tax wrapper, there may be a capital gains tax (CGT)
charge. Encashment of a life assurance investment bond may create a chargeable event, resulting in a
possible higher rate tax liability.

2.4.3 Impact of Fees and Charges

The fees paid for investment management services will vary widely depending on the kinds of
arrangements and vehicles which an investor selects. These could range from the fees often charged by
hedge funds, which are known by the 2/20 rule (ie, 2% is paid annually to a hedge fund manager by its
investors as an overall management charge and 20% of profits are paid as an incentive or bonus fee), to
the very low management fees which are embedded in the purchase of an exchange-traded fund.

For many traditional funds, the annual management charges will generally range between 0.25% and
1.5% of the fund’s total value.

Certain other costs, such as auditors’ fees, custody fees, directors’ remuneration, secretarial costs
and marketing costs, may be charged in addition. They will normally be charged against the income
generated. Such charges will normally be disclosed.

428
 Investment Selection and Administration

There are also charges that are external to the fund which the investor may incur. These can be briefly
summarised as follows:

• Dealing charges, including commission and 0.5% stamp duty, are payable to the broker carrying out
the transaction.
• The spread is the difference between buying and selling prices, as set by market makers.
• Product wrapper charges, usually administration charges, may be charged by the manager of a
wrapper such as an ISA used to hold the investment in the collective fund.
• Charges for advice may be incurred in addition if the investor takes financial advice.
• An up front initial commission may be paid to an IFA, and there may also be a periodic trail
commission payable to the adviser.
• Some advisers may agree to rebate part or all of the commission received against fees for advice.

The Financial Conduct Authority’s (FCA’s) Asset Management Market Study

In 2019, the FCA published new rules and guidance to improve the quality of the information available
to consumers about the funds they invest in. The FCA’s Asset Management Market study presented
evidence of weak price competition in many areas of the asset management industry. This meant lower
returns for savers, pensioners and other investors. The FCA has acted to tackle such issues.

The new rules and guidance are set out below:

8
• Set out how fund managers should describe fund objectives and investment policies to make them
more useful to investors.
• Require fund managers to explain why or how their funds use benchmarks or, if they do not use a
benchmark, how investors should assess the performance of a fund.
• Require fund managers who use benchmarks to reference them consistently across the fund’s
documents.
• Require fund managers who present a fund’s past performance to do so against each benchmark
used as a constraint on portfolio construction or as a performance target.
• Clarify that where a performance fee is specified in the prospectus, it must be calculated based on
the scheme’s performance after the deduction of all other fees.

Also, as a response of the Asset Management Market Study, in late November 2018, the Cost Transparency
Initiative was launched as an independent group working to improve cost and charges transparency for
institutional investors.

2.5 Clients’ Preferences and Ethical/ESG Investing

An adviser will need to establish whether the client has any specific investment preferences that
must be taken account of within the investment strategy. These may take the form of restrictions or a
requirement to follow a particular investment theme. Some investors may wish to impose restrictions on
what should be bought and sold within their portfolio. For example, they may impose a restriction that
a particular holding must not be disposed of, or they may prefer to exclude certain investment sectors
from their portfolios, such as armaments or tobacco.

429
Alternatively, a client may want to concentrate solely on a particular investment theme, such as ethical
and socially responsible investment, or may require the portfolio to be constructed in accordance with
religious principles.

Some investors wish to support ethical and ESG issues and they can accomplish their objectives by
selecting ethical investments or following the principles of socially responsible investing (SRI). There
are funds, often referred to generically as ‘ethical funds’, that screen investments on ethical, social or
environmental criteria, and an investment adviser’s task is to present the relevant information on such
funds being considered to the client. Certain funds focus on a particular theme, such as renewable
energy or public transport.

It may be that an investor wishes to concentrate on including positive ethical or SRI criteria, or
alternatively that they wish to exclude certain investments based upon the application of exclusion or
negative criteria – or, as is often the case, a mixture of both (positive and negative screening). Ethical
and SRI funds are often referred to as being various shades of green: light, medium or dark green, with
dark green funds applying the strictest exclusion criteria.

There are two principal SRI approaches: ethical investing and sustainability investing, both of which are
considered below.

Ethical funds, occasionally referred to as dark green funds, apply strictly ethical criteria, and are
constructed to avoid those areas of investment that are considered to have significant adverse effects
on people, animals or the environment. This they do by screening potential investments against
negative, or avoidance, criteria. In addition to those exclusions which are applied in the light green
funds, exposure to oil, pharmaceuticals and banking is severely limited. Dark green funds with strict
ethical screening may limit their performance by excluding whole industry sectors, for example gas
and oil companies, from investment. Companies with poor management-employer relations or with
evidence of excessive profits and/or tax avoidance schemes may be excluded. As a screening exercise
combined with conventional portfolio management techniques, the strong ethical beliefs that underpin
these funds typically result in a concentration of smaller company holdings and volatile performance,
though much depends on the criteria applied by individual funds.

Sustainability funds are those that focus on the concept of sustainable development, concentrating on
those companies that tackle or pre-empt environmental issues head-on. Unlike ethical investing funds,
sustainability funds, sometimes known as light green funds, are flexible in their approach to selecting
investments. Sustainability fund managers can implement this approach in two ways:

• Positive sector selection – selecting those companies that operate in sectors likely to benefit from
the global shift to more socially and environmentally sustainable forms of economic activity, such as
renewable energy sources. This approach is known as ‘investing in industries of the future’ and gives
a strong bias towards growth-orientated sectors.
• Choosing the best of sector – companies are often selected for the environmental leadership they
demonstrate in their sector, regardless of whether they fail the negative criteria applied by ethical
investing funds. For instance, an oil company which is repositioning itself as an energy business
focusing on renewable energy opportunities would probably be considered for inclusion in a
sustainability fund but would be excluded from an ethical fund.

430
 Investment Selection and Administration

With the growing trend among institutional investors for encouraging companies to focus on their
social responsibilities, sustainability-investing research teams enter into constructive dialogue with
companies to encourage the adoption of social and environmental policies and practices so that they
may be considered for inclusion in a sustainability investment portfolio. For example, engagement
funds are managed with a view to positively screening investments that promote ethical and socially
responsible behaviour. They might, for example, include companies which move and dispose of
waste responsibly. Another criterion which is followed for this category of funds is to seek out those
which follow sustainable development policies. A consequence of this may also be that the candidate
companies will be more pragmatic in balancing their costs and profits, which could lead them to be
more cost-efficient and avoid creating cost externalities, ie, those which are ultimately borne by society
in general.

Light green funds may invest in larger companies, mainly in Western Europe and North America, thus
tending to reduce risks often associated with investing in smaller companies and also in jurisdictions,
where, for example, there may be an absence of legislation to protect against exploitation of child labour.
Light green funds will usually permit investments in oil companies and refiners, pharmaceuticals and
banks, but will usually prohibit investments in companies producing tobacco products, environmental
exploitation, armaments, animal testing or companies with poor human rights records.

Medium green funds will tend to apply stricter criteria than light green, but still permit some exposure
to oil exploration and refining, banking and the pharmaceuticals sector.

8
Integrating social and environmental analysis into the stock selection process is necessarily more
research-intensive than that employed by ethical investing funds and dictates the need for a substantial
research capability. Moreover, in addition to adopting this more pragmatic approach to stock selection,
which results in the construction of better-diversified portfolios, sustainability funds also require each
of their holdings to meet certain financial criteria, principally the ability to generate an acceptable level
of investment return.

Typically, financial, environmental and social criteria are given equal prominence in company
performance ratings by sustainability-investing research teams. This is known as the triple bottom line.

The following are some examples of features that an investor may wish to encourage or to avoid.

431
 Encourage Avoid
Animal welfare Alcohol
Community relations Animal testing and intensive farming
Companies with good employee records Armaments
Disaster relief Companies with bad employee records
Education and training Deforestation
Food retailers with bad policies (eg, fast
Energy conservation and efficiency
food, high salt, high sugar)
Environmental technology Gambling
Equal opportunities Genetic research
Firms with environmental aims Human rights abuse
Food retailers with good policies (eg, organic, Fairtrade) Land abuse
Forestry Military
Healthcare sector Motor industries
Healthy eating Nuclear power
Land use Oil companies
Plant welfare Oppressive regimes
Pollution control Ozone depletion
Positive products and services Pesticides
Public transport Political donors
Recycling Polluters
Renewable energy projects Pornography
Waste management Tobacco
Water management Water pollution

The consumer website, Vigeo Eiris (www.vigeo-eiris.com), provides a database of green and ethical funds
in the UK. It also provides detailed information on ethical investment strategies as well as screening
criteria. In 2001, the FTSE developed an index series, FTSE4Good, which measures the performance of
companies that focus on responsible investments.

Environmental, Social and Governance (ESG)

Environmental, Social, and Governance (ESG) refers to a set of standards for companies to comply with.
It enables socially conscious investors to effectively screen any intended investments before trading.
ESG has become an increasingly popular approach for potential investors to consider environmental,
social, and governance factors when deciding which companies they might want to invest in.

432
 Investment Selection and Administration

ESG investing focuses on a company’s behaviours in three important areas. For example, many investors
will want to make investments in companies that treat their employees positively. In addition, matters
such as a company’s leadership practices, remuneration to staff and shareholder rights are often
important to ESG investors. The three categories are:

• Environmental standards may include how a company uses energy, how it deals with waste and
pollution, consideration and treatment of animals and its approach to conservation of natural
resource, as well as how it manages environmental issues.
• Social factors look at how a company conducts its relationships with employees, suppliers,
customers and communities in which it operates.
• Governance looks at its leadership and running of the company and will include examination of
factors such as staff and executive remuneration, shareholder’s rights, internal controls and audits.

3. Investment Selection and Suitability

Learning Objective

8
8.1.3 Be able to analyse and select investments suitable for a particular portfolio strategy: direct
holdings, indirect holdings and combinations, including structured products; role of
derivatives, including CFDs; impact on client objectives and priorities; diversification; cash,
deposits accounts and money market funds

3.1 Direct and Indirect Investments

Appreciating the need to diversify and having regard to the client’s objectives and risk profile, it is
unlikely that a single investment fund or one security will meet the client’s requirements. Therefore, the
portfolio manager needs to decide how to approach the selection of suitable investments for inclusion
in the client’s portfolio.

The choices can be summarised into three broad strategic approaches based upon the inclusion of the
following broad kinds of asset classes:

• direct holdings
• indirect holdings, and
• combinations of direct and indirect holdings.

433
3.1.1 Direct Holdings
Direct holdings refer to the purchase of the fundamental kinds of financial assets and securities such as
cash, equities, bonds, property, currencies and even physical commodities (although these may be held
indirectly through a futures contract). These holdings are also sometimes known as forming part of the
cash market, although that is a misnomer in many respects, since they are not to be considered in the
same manner that a cash deposit or certificate of deposit is an asset. The use of the term ‘cash’ or direct
holding is mainly used to distinguish this class of assets from derivatives, which are instruments that
derive their value from the underlying cash market securities.

3.1.2 Indirect Holdings

Indirect holdings refer to the assets which an investor may have within a portfolio where the constituents
from the first class of direct holdings may be themselves held within some form of structured instrument.
A structured product is a pre-packaged strategy which can be based on a single security, a basket of
securities, property, options, commodities, debt issuance or foreign currencies. It can also be a unit trust,
an OEIC, an exchange-traded fund (ETF) or a more complex type of structure (possibly using derivatives).
Structured products were originally designed to meet more bespoke requirements that cannot be
fulfilled from more traditional and standardised instruments.

As well as holdings which are indirectly held through the intermediation of another financial entity
which has packaged and managed the holdings, the most obvious other form of indirect holding is a
derivative such as a futures contract, an option, a swap arrangement or a contracts for difference.

3.1.3 Combinations of Direct and Indirect Holdings

Neither of the above two categories are, of course, mutually exclusive, and many investment strategies
will involve holding a combination of both.

3.2 Balance of Investments

Prudent selection and allocation between the two categories may result in a more balanced portfolio
and one which may contain hedges against risk, exposure to a wider and less correlated group of assets
and opportunities for returns which can consistently outperform the market.

Alpha is a term and quantitative measure which is used by fund managers to identify the extent to
which a portfolio strategy outperforms a benchmark index. Successful fund managers are looking to
achieve positive alpha at a minimum but are even more concerned to deliver positive absolute returns
rather than simply returns which are relatively better than the overall market.

434
 Investment Selection and Administration

It is not very reassuring for an investor to be told, as was the case in 2008, that their portfolio
outperformed the market, since general market returns for that year were spectacularly poor. A relative
return of 5% specified in reference to the total return for the S&P 500 for 2008 would still have meant
that an investor would have lost, by the end of 2008, approximately 32% of the capital with which they
started the year.

One of the real challenges which faces an investment manager who is focused primarily on equities,
when selecting the appropriate strategy, is to find ways of avoiding these large losses which occur
periodically (the total return for the S&P 500 in 2002 was also strongly negative with a –22% loss) but
not at the expense of forsaking the years when the overall equities market is performing well as it did in
2003, with a total return for the S&P 500 of more than 28% and, more recently in 2019, when there was a
total return of 31.5% and 18.4% in 2020.

The methods used by fund managers to formulate strategies for delivering optimal returns for a
given level of risk are at the cornerstone of portfolio construction methodologies. They can involve
quite sophisticated financial modelling and quantitative analysis, but ultimately depend on the good
judgement exercised by the fund manager in selecting the best strategy.

The different strategies employed will differ essentially according to the asset allocation strategy which
is employed.

8
3.2.1 Asset Allocation
Asset allocation involves considering the big picture first by assessing the prospects for each of the main
asset classes within each of the world’s major investment regions against the backdrop of the world
economic, political and social environment.

Top-Down and Bottom-Up Approaches to Asset Allocation

It is not easy to generalise about the different approaches that are taken by fund managers in terms of
broad strategy. However, some funds are run on the basis of investing in the most appealing countries
or asset classes. Thereafter, individual securities are selected to fit within this very structured approach.
This is described as the top-down approach.

In contrast, a bottom-up approach will examine the fundamental characteristics of many individual
stocks and the portfolio will be constructed from those which best satisfy the fund’s objectives and
constraints. This approach is appropriate when the manager is more concerned with the merits of
individual securities, and the resulting combination and the broad characteristics of the portfolio will
tend to emerge from the constituents rather than having been engineered or assembled from the top-
down approach.

See chapter 7, section 6, for more on these strategies.

Diversification by Asset Class

This is achieved by holding a combination of different kinds of asset within a portfolio, possibly spread
across cash, fixed-interest securities, equity investments, property-based investments, and other assets.

435
• Cash can be useful as an emergency fund or for instantly accessible money. At times when the
future for interest rates is uncertain, it may be wise to hold some cash in variable rate deposits in
the hope of a rate rise, and some in fixed-rate deposits as a hedge against a possible fall in the rate.
• Fixed-interest securities, such as government bonds, National Savings & Investment certificates
and guaranteed income bonds give a secure income and known redemption value at a fixed future
date.
• Equities can be used to produce a potentially increasing dividend income and capital growth.
For example, a share yielding 3% income plus capital growth of 6% gives an overall return of 9%
compared with a building society deposit account yielding, say, 3%.
• Collective investments such as unit trusts, investment trusts or unit-linked insurance products
spread the risk still further. In this case, the client is participating in a pool of shares. They may choose
a fund investing in a number of different economies, thereby reducing risk still further. Pooled
investments may be a sensible method of obtaining exposure to some of the less sophisticated
world markets where there is a high risk in holding one company’s shares.
• The use of property, whether residential or commercial, and other types of assets such as antiques,
coins or stamps, might help to spread risk further.

Diversification within Asset Classes

An investor can diversify a portfolio by holding a variety of investments within the particular asset types
held. This may be achieved by holding various fixed-interest securities, by holding equities in a number
of different companies, by spreading investments across different industry sectors and geographical
markets, and by holding a number of different properties or property-based investments.

A portfolio that includes a collection of securities will be less exposed to any loss arising from one of the
securities. Using a spread of shares across different sectors of the market can also reduce risk. In this way
there is a reduced concentration of capital in any one sector.

Diversification across different markets can also be achieved within an asset class. For example, a
portfolio of shares or equity-based collective investments may be spread across different national
markets and regions, perhaps with holdings in Asia as well as North America, Europe and the UK. Gaining
exposure to particular markets can be relatively difficult. For example, until recently there have been
relatively few investment vehicles providing exposure to China, although new collective investments
(such as ETFs based on the shares in an index) covering China have increasingly become available.

Sometimes a client will have a large holding in one share, perhaps because of an inheritance or as the
result of a share option scheme. Such a client should be made aware of the potential risk of such a large
holding.

Although different economies and stock markets influence each other, there are differences in how well
different regions and national markets perform. Different economies will be at different stages of the
business cycle than others at any particular time. On the same principle as that of different companies’
shares, a portfolio spread across different markets or regions of the world will be less exposed to poor
performance of a particular economy such as the UK.

Diversification by Manager
Diversifying risk across different funds with different managers reduces the risks from a manager
performing poorly. This is one of the attractions of manager of manager and fund of fund structures.

436
 Investment Selection and Administration

Summary of Strategic Allocation

Strategic asset allocation, as outlined above, represents what is sometimes referred to as the core
holdings that a fund should operate within over the longer term, in order to satisfy its objectives and
constraints. The strategic asset allocation is based on long-run estimates of capital market conditions
and is often, either explicitly or implicitly, based on the assumption of the efficient markets hypothesis
(EMH) that there are no real benefits to be gained from attempting to ‘time’ the market and to engage in
a proactive approach to asset selection.

Many clients and fund managers, as is evident from their manner of operation, also include a focus
on shorter-term and tactical decision-making with respect to portfolio construction. There are a
variety of techniques employed by many fund managers which reveal that, even though the fund may
have a commitment to a core strategy and core holdings, there are a number of initiatives of a more
opportunistic nature that supplement these core holdings. Sometimes, these activities are described as
making adjustments to a satellite holding of the portfolio.

3.2.2 Market Timing

Market timing is a form of tactical asset allocation involving the short-term variation of the asset
allocation of the fund in order to take advantage of market changes or fluctuations.

Market timing is, then, the variation of the asset allocation of the fund in anticipation of market

8
movements. It involves adjusting the sensitivity of the portfolio to anticipated market changes. A fund
manager engages in market timing when they do not agree with the consensus about the market, ie, they
are more bullish or more bearish than the market, and may rebalance their portfolio to take advantage of
this view.

If a pension fund has regular inflows from its clients, the investment manager may decide to either invest
those inflows immediately or passively, or perhaps engage in a form of market timing, by holding on to
the inflows and entering the market at what, in the opinion of the fund manager based upon a market
outlook, is a more favourable time. If the proceeds are put to work immediately, the fund will benefit
from pound cost averaging, ie, the purchases are made at both the peaks and troughs throughout the
year, and the fund acquires the investments at the average cost for the year.

If the deployment of the funds is delayed and the fund manager retains these funds as cash until the
most suitable time from a market timing perspective, the returns from such opportunistic deployments
may be more advantageous.

Some studies have shown that the asset allocation decision (market timing) has a greater impact on
performance than stock selection for most funds, especially international funds where the correlations
between markets are low. This finding suggests it is not optimal to adopt a passive approach to
investment management, such as a simple buy-and-hold strategy for a benchmark index (see chapter 7,
section 7.4) with no attempt to second guess the timing of short-term entry and exit points.

437
3.3 Cash Deposits
The most tangible forms of money are banknotes and coins. Keeping money under the mattress (or
in a safe) as notes and coins is one option for someone with savings. However, inflation will erode the
purchasing power of the money, and no interest will be earned. There is also the risk of loss or theft. An
alternative is to deposit the money with a sound financial institution such as a bank.

The key reasons for holding money as cash deposits are security, accessibility and liquidity. Accounts for
holding cash deposits are generally characterised by a high level of security. Capital is very unlikely to
be lost, at least in money terms. As already mentioned, there is a deposit insurance scheme in effect in
the UK which protects savings up to a limit of £85,000; similar deposit insurance schemes exist in the US
and the EU.

The purchasing power of capital held on deposit will, however, still be eroded by inflation. To offset this,
there is the reward of any interest receivable, and the rate of interest may exceed inflation, resulting in a
real rate of return for the investor.

An important advantage of cash deposits held in instant access accounts is their liquidity. Every investor
may need cash at short notice, and so should plan to hold some cash on deposit to meet possible
needs and emergencies. A cash deposit account can serve as a vehicle for reaching a savings target, for
example, when saving for the cost of a major purchase, or for the deposit on a house.

One risk from investing in certain kinds of products, which are marketed as certificates of deposit (CD)
by banks, is that the investor is locked in at a fixed rate for fixed terms, when it might be possible to
obtain more attractive rates for other investment products. This is part of the interest rate risk which all
investment products have to contend with when interest rates are fluctuating.

The capital on a deposit investment is secure in that the original capital is returned when the deposit is
withdrawn or the account matures, subject to any penalties which will have been made explicit in the
terms and conditions of the account.

3.3.1 The Risk of Cash Deposits

While it is generally assumed that there is no capital risk for the depositor up to the limits provided
for under the deposit insurance arrangements which are in place in the UK, there have been historical
precedents for complete losses when a deposit-taker fails and goes into liquidation. This happened with
the Bank of Credit and Commerce International, which collapsed in 1991. Prior to the financial crisis in
2008, several large local authorities in the UK had placed deposits with Icelandic banks via accounts in
the Isle of Man, and for some time these funds appeared to be in jeopardy. However, the vast majority of
this cash has subsequently been recovered.

438
 Investment Selection and Administration

Under current statutes, if a UK deposit-taking institution fails, the depositor will have recourse to the
Financial Services Compensation Scheme (FSCS), which is administered by the FCA. The FSCS is a
statutory fund of last resort set up under the Financial Services and Markets Act 2000 to compensate
customers of authorised financial services firms in the event of their insolvency. The scheme covers
deposits, insurance policies, insurance brokering, investments, mortgages and mortgage arrangements.
Although there are various provisions for non-cash deposits, the key provision in effect at present under
this scheme for the protection of cash deposits is that 100% of the first £85,000 is guaranteed by the FSCS.
For deposit claims against firms declared in default, the maximum level of compensation is also £85,000
(changed from £50,000 in April 2019).

3.3.2 Spreading Risk Across Different Deposit-Takers

The ceiling on compensation available through the FSCS leads some investors to consider spreading
their capital among a number of banks and building societies in order to reduce the overall default risk.
The benefit of spreading the risk in this way should be weighed against the possible disadvantage of
lower rates of interest that may be earned, because of the investor missing out on higher rates offered
for larger deposits.

3.3.3 Principal Deposit-Takers

Commercial Banks

8
Banks are listed as public limited companies and owned by their shareholders. Increasingly, governments
are now becoming large shareholders in what were previously private banks. For example, the UK
government holds over 70% of the equity of Royal Bank of Scotland.

Building Societies
A building society is a mutual organisation, owned by its members. The members are the holders of savings
accounts – often called share accounts – and borrowers. Members of the society have voting rights.

National Savings & Investments (NS&I)

Deposits held with NS&I are guaranteed by the government and therefore can be considered to be
completely secure. As a government department, NS&I is not a licensed deposit-taker as banks and
building societies are.

Supervision of the prudential soundness of banks and building societies is the responsibility of the
Prudential Regulation Authority (PRA).

Deposit Account Types

As the name implies, an instant access account allows the investor immediate access to funds. Most
investors will want to keep some funds available on instant access, for emergency purposes. There can
sometimes be certain restrictions within certain kinds of account. For example, an account might allow
only two withdrawals per year.

439
With a notice account, the investor must give, for example, 30-, 60- or 90-days’ notice of withdrawal
unless they wish to lose interest. There may be a higher rate of interest available to compensate for
the requirement to give notice. However, the investor should be careful to weigh the advantage of any
higher-rate offered against the disadvantage of the loss of liquidity and the costs of penalties if the
money needs to be withdrawn earlier than planned. Interest paid monthly will generally be slightly
lower than on an instant or notice account which pays interest annually because of the increased
frequency of payment of interest. When interest is credited month after month, then the interest itself
will begin to earn interest as soon as it is credited.

Example
An account pays interest at an annual rate of 3.6%. Interest is credited monthly.

3.6%/12 = 0.3% will be paid monthly

The annualised rate of interest is:

100 × ((1 + 0.036/12)12 – 1) = 100 × ((1.003)12 – 1) = 100 × (1.0366 – 1) = 3.66%

This shows that the account pays the same return as an annual interest account paying 3.66%.

Time deposits or term accounts offer investors terms that involve tying up the deposit for a fixed period,
often at fixed rates. The period may range from seven days to several years, and there may be a fairly
high minimum for such arrangements. Time deposits may be offered as bonds. The bond offer may be
open for a specified period, or the deposit-taker may reserve the right to withdraw the offer at any time.
The bond could run for a fixed term: one, two, three, four or five years, with severely restricted access
subject to a penalty, or no access at all. Interest may be tiered. For example, a five-year ‘step-up bond’
may offer a gross rate of interest of 3.0% in year one, 3.25% in year two, 3.50% in year three, rising to
4.0% in year four and a final 4.5% in year five.

3.3.4 The Tax Treatment of Cash Deposits

A UK resident is subject to tax on bank and building society deposits in the tax year in which the interest
is paid at one of the following rates:

• Basic rate taxpayers – eligible for the £1,000 tax-free savings allowance. Those with a total income
up to £46,350 a year are eligible for the £1,000 tax-free savings allowance.
• Higher-rate/additional rate taxpayers – eligible for a £500 tax-free savings allowance.

Since April 2016, banks and building societies have stopped automatically taking 20% in income tax
from the interest earned on non-ISA savings.

The ISA Wrapper

There have been several schemes instigated by the UK government to encourage private savings, which
essentially provide tax relief or a shelter from taxation for savings that fall within the limits specified in
current legislation.

440
 Investment Selection and Administration

Cash ISAs are savings accounts where the interest is not taxed, but there is a limit to how much can be
inserted into such a wrapper account. Each tax year, everyone over the age of 16 for cash ISAs, or 18 for
stocks & shares ISAs has an ISA allowance which sets the maximum that can be saved within the tax-free
wrapper for that tax year.

In 2021–22, the ISA limit is £20,000. New subscriptions can be split in any proportion between a cash ISA
and a stocks and shares ISA.

As of April 2021, the main types of ISAs are as follows:

1. The most common is the cash ISA which includes deposits with banks and building societies and
some cash-type products. Cash ISAs are the tax-free equivalent of traditional savings accounts.
2. The stocks & shares ISA can hold most fixed-interest securities and virtually all unit trusts, investment
trusts and OEICs, except cash-like and limited redemption funds. They also include life assurance
policies (but not pensions) which, before 2005–06, formed a separate component.
3. The Innovative Finance ISA covers peer-to-peer lending where lenders are matched with borrowers
so that each enjoys better rates. Those lending through peer-to-peer platforms receive their interest
tax-free.
4. The Lifetime ISA is available to those under the age of 40 and contributions of up to £4,000 can be
made in each tax year. The government will add a 25% bonus on these contributions at the end of
the tax year, meaning that people who save the maximum each year will receive a £1,000 bonus
each year from the government.

8
In addition, there is also the Junior ISA (JISA), which is available to all UK-resident children (aged under
18) who do not have a child trust fund, and a Flexible ISA, whereby savers may replace money that they
have withdrawn during the tax year without reducing that year’s allowance. Contributions of up to
£9,000 a year (for 2021–22) can be made into a JISA. Any savings or investments must be made by the
end of the tax year on 5 April.

Investors are also allowed to transfer shares into a stocks & shares ISA which they have received from
approved profit-sharing schemes, share incentive plans or Save As You Earn (SAYE) share options. They
have to transfer such shares at market value within 90 days of receipt. The value of these transfers
reduces the remaining ISA subscription balance available to the investor for that year.

Investors can transfer an existing ISA from one manager to another manager, providing that the
receiving manager is prepared to accept it. Transfers of previous years’ subscriptions can be in whole or
just in part. Transfers of the same year’s subscriptions, however, must be for the full amount.

Investors can also transfer their savings between stocks & shares ISAs and cash ISAs and vice versa. From
April 2016, individuals are able to withdraw money from their cash ISA and replace it in the year without
it counting towards their annual ISA subscription limit for that year.

3.3.5 Money Market Accounts

Some banks offer the facility to make money market deposits for periods ranging from overnight to five
years. A bank can offer interest at a rate that is personal to the investor, based on current money market
rates. Some banks offer money market deposits either for a fixed term with fixed interest, or on a notice
basis with variable interest.

441
A call account will allow the investor to access their money by the following day. This is close to the
terms of an instant access account. The principle of a fixed interest rate for a specified period is the
same as for term deposits, but the use of the term ‘money market deposit’ usually implies that a tailored
arrangement is made to meet a particular investor’s needs.

Money market deposits can be appropriate for investors with a larger sum to invest – for example,
proceeds from a house sale pending a later house purchase.

Money market accounts offer the depositor access to rates offered by the wholesale money market,
typically through the treasury department of their clearing or merchant bank. The rates paid should
reflect wholesale money market rates represented by LIBOR – established daily as a summary of actual
rates offered in the money market between banks.

Money market deposits offer certain advantages:

• Responsiveness – they respond immediately to changes in interest rates – good when interest rates
are rising.
• Flexibility – the length of a money market deposit – its term – can be chosen from a day up to about
a year (some banks offer longer periods).
• Higher Return – money market rates should generally be higher than deposit account rates offered
by the same bank.
• Convenience – once the money market account is set up, a telephone call can establish, change or
end a placement.
• Control – rolling over your money market deposit means that the deposit can be automatically
renewed each time it matures; this can include the interest accrued. This is particularly useful if you
expect to need the savings at short notice, but do not know when.

There are certain disadvantages to money market deposits:

• Commissions – money market commissions charged by banks appear to vary significantly. The
money market rate offered by one bank need not be the same as that offered by another. Daily rates
are decreasingly being published on the web, so it is difficult to compare the money market rates
from different banks.
• Competitiveness – money market rates can seem unattractive when compared with other forms of
deposits, from instant access deposit accounts to savings bonds, offered by other institutions.

Minimum money market deposits can range from £25,000 to £50,000.

3.3.6 Private Banking

Private banks, as distinct from high street banks, are also able to provide a range of cash deposit services
for their clients as well as wealth management, estate planning, tax planning, insurance, lending and
lines of credit. Private banking can be onshore and offshore. Although both are largely the preserve of
wealthy individuals, offshore banking means banking under a different financial regulatory regime to
the one in place in a person’s home country. Offshore banking also refers to the breadth of investment
opportunities available under these different countries’ regimes. The distinction between private and
retail banks is gradually diminishing as private banks reduce their investment thresholds in order to
compete for providing banking services to high net worth individuals.

442
 Investment Selection and Administration

3.4 The Use of Derivatives

The table below shows, in simplified form, how a fund manager may make short-term and tactical
adjustments to a portfolio to take advantage of expectations about the near-term outlook for the overall
market and specific asset classes. The bottom row of the table shows the manner in which derivatives
can be used as part of a portfolio management strategy, which can be seen as part strategic asset
allocation and part tactical.

Market Outlook
Portfolio Components
Bullish Bearish
Equity Component More exposure to high beta stocks Exposure to lower beta stocks
Fixed-Income Component More exposure to longer duration bonds Exposure to shorter duration
bonds
Tactical/Satellite Holdings Move into higher risk assets, eg, Reduce/eliminate holdings
emerging markets of higher risk assets, eg,
emerging markets
Derivatives Purchase of stock index futures and call Sale of stock index futures and
options purchase of put options

3.4.1 Portfolio Insurance

8
Portfolio insurance (also referred to as hedging) is a technique for limiting the potential loss on a
portfolio using derivatives, at the expense of giving up some of the potential profits. The approach
is based on options theory, when the holder of a call option has unlimited exposure to any potential
profits, but limited exposure to losses. As an alternative, one could consider the purchase of put options
when the fund manager has the right, but not the obligation, to put a stock or instrument to the option
seller at a specified price that may, in the case of a substantial fall in the value of the asset be at a much
higher price than the current trading price. This acts like a form of insurance.

CFDs and futures can also be used as a useful form of portfolio insurance. Although hedging minimises
risk, the cost of such insurance needs to be taken into account as it also reduces the profit potential of
the portfolio. With CFDs, the margined nature of the product increases the cost daily which, over time,
can erode the value of the insurance/hedge.

There are various ways in which such portfolio insurance may be implemented, although they all involve
reducing the exposure to markets as they fall. To simply set the stage we can consider the following
example of the purchase of a call option.

Example
In the following payoff chart, there is a stock which has a current price of £32.23 and an investor decides
to purchase an out-of-the-money option with an exercise price of £35. The option has no intrinsic value
because the current stock price is below that of the exercise price. The option has six months before
expiration, so effectively the option buyer is paying for what is called the time premium of the option, ie,
£5 in this case. This premium is based on the notion that during the six months leading up to expiration
the stock will fluctuate and, if the investor’s expectation is that the stock will be trading above £40 (ie,
the £35 exercise price plus the cost of the option) either at or before expiration, the premium is worth
paying for the right to call away the stock from the option seller or writer.

443
 The diagram shows that the option buyer – once the premium has been factored into the calculation –
will only experience a profitable payoff if the stock sells above £40. After this, the returns to the option
buyer show a substantial return, owing to the inherent gearing of the option instrument.

Payoff Diagram on a Call Option

Current Stock Price = £32.23
Strike Price of Option = £35.00
Price of the Option = £5.00
Stock Price Payoff Net Payoff
£20.00 £0.00 –£5.00
£25.00 £0.00 –£5.00
£30.00 £0.00 –£5.00
£35.00 £0.00 –£5.00
£40.00 £5.00 £0.00
£45.00 £10.00 £5.00
£50.00 £15.00 £10.00
£55.00 £20.00 £15.00
£60.00 £25.00 £20.00

£25.00
Net Payoff
£20.00

£15.00
Payoff Value

£10.00

£5.00

£0.00
£20.00 £25.00 £30.00 £35.00 £40.00 £45.00 £50.00 £55.00 £60.00
–£5.00

–£10.00
Price at Expiration

444
 Investment Selection and Administration

4. Managing a Client Portfolio

Learning Objective
8.2.1 Apply key elements involved in managing a client portfolio: systematic and compliant
approach to client portfolio monitoring, review, reporting and management; selection of
appropriate benchmarks to include: market and specialist indices; total return and maximum
drawdown; arrangements for client communication

4.1 Systematic Approach to Client Portfolio Monitoring

A key requirement for an investment fund management team is the provision of current, reliable
and useful reporting on the current state of a client’s portfolio. Issuance of statements showing the
deployment of funds and the returns currently achieved as well as historical summaries is just the basic
requirement.

Given the complex nature of the investment possibilities available in the capital markets, and the fact
that clients may have exposure to different currencies, derivatives, hedge instruments and diverse asset
classes, then the task of presenting this information to a client becomes a major challenge for good

8
investment managers.

The most appropriate method for client communication is for information to be made available to clients
on a current, probably real-time, basis via the internet. Many fund managers will provide clients with a
monitoring facility, which enables them to inspect their portfolio performance, at least in summary
form, via web-based portals. Clearly the fund manager should be using state-of-the-art information
technology and reporting software to generate timely information to a client.

In addition, clients may need to receive periodic hard copy documents outlining portfolio performance,
as well as other material relating to compliance and taxation-related matters. Professional advisers of
the client may often be the recipients of this information, so that other financial management matters
can be co-ordinated with investment management. The issuance of hard copy statements is often a
formality, however, as the client will require more immediate information than something which is out
of date as soon as it is printed.

IT systems are a part of the systematic nature of portfolio reporting and in addition the fund manager
will need to ensure that other relevant contextual information is provided to assist the client in making
the best use of the information being provided. References to standard portfolio metrics should be
included in the reports issued to clients. The already mentioned key ratios, such as the Sharpe ratio (see
chapter 7, section 8.5), will inform the client as to the risk/reward ratio of the portfolio. The investment
skills and judgments of fund managers are in fact largely determined by the manner in which their
performance is calibrated by such ratios.

Meetings with clients should also be held periodically and at the specific request of the client.

445
4.2 Compliance and Portfolio Management
Portfolio management should address issues of compliance. The actual execution of the portfolio
management strategy should be monitored regularly to ensure satisfactory progress against stated
objectives, costs/charges and performance criteria.

Part of the investment management function is to regularly review the appropriateness and effectiveness
of measures to manage risks.

Relevant documentation, registrations and other matters of compliance with legislation, reporting and
taxation-related matters should be considered as vital to the portfolio monitoring process. In addition
the portfolio manager and their team need to keep abreast of all relevant changes in legislation and
rules from financial regulators in order to ensure that they are complying with the most current methods
of reporting and following industry best practice.

4.3 Appraising Portfolio Performance

From portfolio construction theory, it is generally accepted that a time-weighted measure of returns is
the most suitable for determining the returns achieved from an investment. The next challenge is to find
a way of deciding how good a return that actually is. In other words, a benchmark should be referenced
to which comparisons of the returns achieved can be referenced. For example, is a return of 15% good
or poor?

Different performance appraisal criteria can be employed in answering this question and they centre on
issues concerned with absolute performance and relative performance.

4.3.1 Absolute Performance

Absolute performance measures aim to establish whether the total return is at a level which is
commensurate with the total risk experienced. The basis of most finance theory is that investors are
rational and risk-averse; accordingly it is appropriate to determine whether they are being adequately
compensated by way of absolute return for that absolute risk.

Methods available for this purpose include the following:

• Comparison of total returns to a peer group.

• Comparison of total returns to a customised benchmark index.
• Comparison of total returns to the capital market line or the securities market line.
• Excess return per unit risk measures, determining how well the excess absolute return over the risk-
free rate compensates for the total risk.

4.3.2 Relative Performance

Relative performance measures may be appropriate when the investment strategy is to outperform a
specific index or peer group. In this case, it will be the excess return and risk in comparison to the index
that will be relevant. Almost by definition, this is best achieved by considering excess return per unit risk
measure.

446
 Investment Selection and Administration

4.4 Benchmarking

4.4.1 Peer-Group or Customised Benchmarking

Portfolio performance may be measured by reference to a relevant peer group. The peer group will be
portfolio or fund managers who are also responsible for the full range of management decisions (asset
allocation and stock selection) for a portfolio or fund with similar objectives and constraints. With peer
group benchmarking the fund management objectives may be defined as, say, ‘outperform the peer
group median performance’.

Peer-group benchmarking has been criticised as tending to produce asset allocation decisions based
simply on what other funds are doing, rather than on the needs of the fund involved. A peer-group
benchmark does not show whether a portfolio manager is performing well in absolute terms. If all of the
peer group are poor managers, the portfolio manager may be top of the peer group but still be showing
poor absolute performance.

An alternative to peer-group benchmarking is customised benchmarking. This is appropriate when the

asset allocation decision and stock selection decisions are separated, and the asset allocation decision
taken by the trustee, say, with the stock selection decisions being taken by managers.

The manager’s performance can then be assessed by reference to an appropriate index or customised

8
benchmark based on the assets under their management. Using this approach, the selection of the index
is an important decision: is that index suitable for satisfying the fund’s liability-matching objectives?
Setting the limits for any permitted divergence from that index is also highly important. If these limits
are tight, then the fund becomes a pseudo-tracker, and the investor is then paying active management
fees when the true style is passive.

4.4.2 The Myners Report and Benchmarking

The Myners Report of 2001 examined these benchmarking issues, among others, especially in the
context of assessing pension fund performance. As a result of the weaknesses of the peer group
approach, the review concluded that this was inappropriate for managing pension funds.

The review recommended a customised benchmarking approach under which the fund should consider:

• the suitability of any index benchmarks in achieving the fund objectives, and
• each asset class whether active or passive management is most appropriate.

When fund managers believe that active management has the potential to achieve higher returns, they
should:

• set divergence limits for fund managers to operate within

• set challenging targets and risk controls for outperformance against the index, allowing sufficient
freedom for genuine active management to occur, and
• encourage an active management approach to be undertaken with conviction.

447
4.4.3 Benchmark Index
In order to assess how well a portfolio manager is performing, we can use a yardstick such as a benchmark
index for comparison. Once we have determined an appropriate benchmark, we can compare whether
the manager outperformed, matched or underperformed.

Some issues that would arise in selecting a benchmark are as follows:

• Appropriateness of the benchmark or index to the preferences of the fund (eg, a UK blue chip
portfolio might utilise the FTSE 100 Index).
• Appropriate to the currency of the portfolio – if the portfolio is US dollar-based, then the
performance of the US dollar against a range of currencies should be referenced. There is a US Dollar
Index which is a weighted index of the dollar against other major currencies, and there are futures
contracts based upon this index which can be used for hedging and benchmarking purposes.
• Is the benchmark itself an investable item, ie, is it composed of investments that could conceivably
be held in the portfolio?
• Is the benchmark easily measurable, ie, can the return be calculated on a frequent basis as required?
• Is the benchmark representative of achievable performance, ie, is it an arithmetic weighted
composition?
• Does the benchmark reflect the total return – in other words does it not only refer to the price value
of an index or indices but also take into account income as well as capital growth?

4.4.4 Appraisal Using Benchmarks

Once we have established a suitable benchmark, we can appraise the portfolio manager’s performance
by reference to it. The benchmark performance can be calculated as the weighted average of the
holding period returns on the relevant benchmark indices.

Example
Take as an illustration a situation where a pension fund manager has a portfolio with an initial value of
£100 million. The company for whom the fund is run is internationally based, with 75% of its employees
in the UK and 25% in the US. As such, it requires a corresponding international investment strategy
concentrating on a diversified spread of shares.

The company feels that the manager should be able to at least match the following two indices on the
relevant portions of the fund.

• FTSE 100 Index on the UK portion

• S&P 500 Index on the US portion.

The values on these indices at the start and end of the year were as follows:

Portfolio £m FTSE Index S&P 500 Index

End of year 117 6957 1775
Start of year 100 6000 1500
Annual return 17.00% 15.95% 18.33%

448
 Investment Selection and Administration

The fund had a capital value of £117 million at the end of the year, there having been no cash inflows
and outflows during the year.

What return has the fund manager achieved? What return has the benchmark portfolio achieved? Also,
has the fund manager achieved their target of at least matching the benchmark?

Since there have been no cash inflows/outflows during the year, we can use the simple holding period
return formula to assess the portfolio performance, giving:

(D+Ve) – Vs
rp = x 100%
  Vs
where:

rp = holding period return

D = any returns paid out from the investment/portfolio at the end of the period
Vs = the initial cost at the start of the holding period
Ve = the value of the investment at the end of the holding period

In the illustration, we are considering there are no outflows, so effectively D is 0.

The return for the portfolio can be simply calculated as follows:

rp = (0+£117m) – £100m x 100% = +17%

8
£100m

The benchmark performances are as follows:

FTSE 100:

rp = 6957 – 6000 x 100% = +15.95%

6000

S&P 500:

rp = 1775 – 1500 x 100% = +18.33%

1500

The initial assumption is that the pension fund manager allocates the fund between shares selected
within the UK market and the US market in the same ratio as the beneficiaries of the fund, ie, 75% is
allocated to UK shares and 25% is allocated to US shares.

Portfolio £m FTSE Index S&P 500 Index

End of year 117 6957 1775
Start of year 100 6000 1500
Annual return 17.00% 15.95% 18.33%
Weighting between UK/US assets 75/25 75% 25%
Weighted returns of benchmarks 11.96% 4.58%
Weighted average 16.54%
Portfolio performance compared to benchmarks 17.00% – 16.54% 0.46%

449
The weighted average return as shown in the table is r = (0.75 × 15.95%) + (0.25 × 18.33%) = 16.54%.

The fund has delivered a return of 17% and the weighted returns from the two appropriate benchmarks
shows a return of 16.54%. From this, it can be concluded that the pension fund manager has
outperformed the benchmarks by 0.46%.

It must be noted that this conclusion is only valid so long as the total return achieved was at no higher a
level of risk than that of the underlying index. If the fund’s return had been achieved by taking more risk
(ie, higher standard deviations in the returns) than the weighted standard deviation of the applicable
benchmarks the conclusion of manager outperformance would not be valid.

4.5 Total Return and Maximum Drawdown

Total return is a measure of investment performance that includes the change in price of the asset plus
any other income (including dividends, interest and capital gains distributions). It is assumed that all
income is reinvested over the period. The calculation of total return is expressed as a percentage of the
initial asset value.

For example, long-term investors in equities will be much influenced by the dividends paid out by a
company, as this is a vital part of the total return from holding equities.

Drawdown is the name given to the distance between troughs and peaks when looking at a timeline of
the P&L at different periods when it is measured. A monthly sampling of returns could be depicted as an
equity curve, with peaks and troughs as the curve moves up and down. The maximum drawdown will
be the distance from the highest level of account equity (the ‘high-water mark’) to the lowest trough
in the equity curve. The maximum drawdown is a key variable used by portfolio managers and is not
adequately addressed by some measures of risk/return and portfolio theory.

5. Changes that can Affect a Client Portfolio

Learning Objective
8.2.2 Understand how changes can affect the management of a client portfolio: client
circumstances; financial environment; new products and services available; administrative
changes or difficulties; investment-related changes (eg, credit rating, corporate actions);
portfolio rebalancing; benchmark review; changing regulatory environment

5.1 Client Circumstances

Clearly, before advising any client, an adviser or fund manager must be aware of that client’s various
needs, preferences, expectations and financial situation.

The circumstances of the client are, however, subject to change over time. Sometimes, these changes
can be anticipated and sometimes they will be almost completely unexpected.

450
 Investment Selection and Administration

As we saw in sections 1 and 2, the basic information about a client’s circumstances that needs to be
captured can be broken down into the following:

• personal and financial details

• objectives
• risk tolerance
• liquidity and time horizons
• tax status, and
• investment preferences.

Changes can take place in any one of these items.

For example, it may happen that if a client loses a regular source of income, even temporarily, there
may be a need to liquidate a part of their holdings in order to raise cash. To the extent that the current
portfolio has an adequate allocation of cash and short-term money market instruments available (which
it should, if the financial planning has been done properly), this may not present any immediate issues.
Obviously, liquidating a part of a portfolio will alter the balance of the remaining assets and will require
a rebalancing exercise to be performed at some future point in time.

If the client’s need for cash is in excess of the current allocation of very liquid instruments, then the
need to liquidate longer-term and perhaps less liquid holdings within the portfolio may be more
consequential. The redemption of certain instruments may attract penalties and charges; the need to

8
liquidate equities at a time when the overall market is performing poorly could lead to capital losses
and loss of future dividend income; and if there are derivatives in a portfolio which have been used for
tactical asset allocation then the timing of the exit from derivatives contracts can be very sensitive and
could trigger premature losses which would not have arisen if the instruments were held to maturity.

5.2 The Financial Environment

The changes which can take place in the overall financial environment, and which will affect the current
asset allocation strategy, can be quite drastic, as was evidenced by the broad market developments
that began in 2007 and which reached a climax (at least from our current perspective) in the latter
part of 2008. The impact of large scale macroeconomic factors, such as the abrupt drop in GDP and
employment which followed the banking crisis of 2007–8, has had an impact on many clients’ individual
circumstances. There will be some clients who have been faced with loss of employment income as
discussed above, but the largest capacity for damage is to overall investor sentiment and the general
appetite for risk. In 2020–21, we have seen reductions in returns for clients seeking an income due to
global dividend cuts, while at the same time, interest rates have been persistently low.

It is fair to say that many investors are now more risk-averse than at any time in the last 25 years, and
perhaps a case could be made that one would need to return to the 1930s to find a parallel era. On the
one hand, this has meant that many investors will have altered their attitude towards holding assets
they perceive to be too risky. On the other hand, there are many who think more opportunistically and
saw the large drop in asset prices in late 2008 and early 2009 as an excellent buying opportunity. Indeed,
those who bought equities and many kinds of riskier bonds such as ‘junk’ bonds in the spring of 2009
were very well rewarded.

451
Another issue to consider is that adverse market conditions can present major profit opportunities for
some investors. Hedge funds which operate with net short strategies delivered some extraordinary
returns during 2008, if they were correctly positioned. To cite one example, John Paulson, the
owner of a US-based hedge fund which used swap agreements (a form of derivative), which
benefited from the fall in mortgage-backed securities (MBSs) and their offshoots, is estimated to
have personally made more than $3 billion in 2008 from correctly anticipating the collapse of the
MBS market.

5.3 Availability of New Products and Services

Financial innovation over the last 20–30 years has been extraordinary. This has been especially the case
in terms of the products that are now available to investors such as CFDs, ETFs, new kinds of collective
investment vehicles and the proliferation of derivatives, including credit default swaps (CDSs) and other
asset-backed securities.

Although derivatives are not suitable for many portfolios, their proliferation reflects the way in which
the investment landscape is changing radically. Among the different kinds of services available now
to investors are many kinds of hedge funds and alternative asset management companies which
provide non-traditional ways of investing. The availability of such a diversified offering of products and
services is transforming the whole nature of the securities industry. These changes question some of the
underlying theories of investment and asset allocation and certainly require of professionals working in
financial services that they constantly re-educate themselves on the conditions and products of their
business.

The need for prudence and skill in investment decision-making is perhaps more than ever at a
premium, and this is also leading to new attitudes towards allocation, the need for greater flexibility
and pragmatism and also the possibility of fundamental changes in the regulation of the domestic and
global financial environment.

5.4 Administrative Changes

The innovations just discussed, as well as the changes in the operational side of the securities industry
– including new multilateral trading facilities, regulatory changes such as the dismantling of the FSA
in April 2013, and the removal of the banking supervision function to the Bank of England – continues
to impose a severe burden on the compliance and fund administration functions within investment
management. Brexit has led to many regulatory changes since the end of the transition period and
further regulatory divergence between the UK and the EU can be expected in the coming months and
years.

At the same time, there are pressures on fund managers from competitors, and caused by poor
performance, to cut fees and charges. The expectation is that there will need to be quite radical back
office changes at many investment firms.

452
 Investment Selection and Administration

5.5 Credit Rating Changes

Credit ratings for corporate borrowers are regularly reviewed and are often revised in the light of
changed economic conditions and/or changes in the outlook for an industry or the issuer’s specific
circumstances. Rating agencies will signal they are considering a rating change by placing the security
on CreditWatch (S&P), Under Review (Moody’s) or on Rating Watch (Fitch).

Most revisions result in credit downgrades rather than upgrades. The price change resulting from a
credit downgrade is usually much greater than for an upgrade, given that the price of a bond can fall all
the way to zero, whereas there is a limit to how high a bond’s price can rise.

The bond issues of many large telecoms companies, as a result of taking on large amounts of additional
debt to finance their acquisition of third generation (3G) telecoms licences in 2000, suffered severe
credit downgrades and, as a consequence, experienced an indiscriminate marking down in the prices of
their bond issues.

5.6 Corporate Actions

Corporate actions such as a rights issue will impact the pricing of securities and, in certain circumstances,
the decision by a company to engage in a secondary offering or proposal to alter its capital structure
may trigger a major response from the markets. Under these circumstances a decision may be made to

8
change a portfolio holding in the wake of the proposed corporate action.

As an example, the Financial Times published the following report in May 2010 in reference to a proposed
rights issue by the UK-based Prudential Insurance which had to be aborted:

‘Prudential was forced to abandon the launch of its $21 billion rights issue in a deeply embarrassing
move that could prove the last straw for some investors wavering over the British life assurer’s $35.5
billion takeover of AIG’s Asian arm. The Pru delayed its fundraising and canned its prospectus at
the last minute after failing to convince UK regulators that it would have enough capital after the
takeover, with up to $3 billion of AIA’s capital base locked into several Asian countries.

The company insisted that the timetable for its deal remained on track and people close to the Pru
were hopeful that the Financial Services Authority’s concerns could be satisfied within a couple of
days. However, others said that the Pru had a much deeper problem with the regulator. The FSA
was concerned that it would not have proper oversight of a company heavily biased towards Asia,
they suggested. It was also worried about another complex cross-border deal going badly wrong
following RBS’s disastrous acquisition of the Dutch bank ABN Amro in 2007.

The FSA wants the Pru to hold a lot more capital’, said one person involved’.

453
5.7 Portfolio Rebalancing
If a portfolio has to be rebalanced following a significant development either in relation to client
circumstances or to changes in the financial environment, the proper approach for an investment
manager is to rethink the entire asset allocation strategy. Rather than making piecemeal changes and
attempting to reimplement a revised version of the previous allocation strategy, it would be preferable
to devise a new strategic allocation which takes into account the new circumstances. This could even
lead to a reclassification of the investor’s profile and risk tolerance characteristics.

There are other circumstances, of a more routine nature, when a portfolio manager will rebalance a
portfolio, and to some extent the reasons why a portfolio manager may wish to rebalance are closely
related to market timing and active management strategies, such as bond switching, or bond swapping.

5.8 Benchmark Reviews

Once a portfolio has been constructed, the portfolio manager and client need to agree on a realistic
benchmark against which the performance of the portfolio can be judged. The choice of benchmark will
depend on the precise asset split adopted and should be compatible with the risk and expected return
profile of the portfolio. When an index is used, this should represent a feasible investment alternative to
the portfolio constructed. As an example, if the portfolio consists largely of small and micro-cap stocks
with a US bias, the appropriate benchmark index to use would be the Russell 2000 Index.

Portfolio performance is rarely measured in absolute terms but in relative terms against a pre-
determined benchmark and against the peer group (see section 4.4). In addition, indexed portfolios are
also evaluated against the size of their tracking error, or how closely the portfolio has tracked the chosen
index.

It is essential that the portfolio manager and client agree on the frequency with which the portfolio
is reviewed, not only to monitor the portfolio’s performance but also to ensure that it still meets the
client’s objectives and is correctly positioned given prevailing market conditions.

5.9 The Changing Regulatory Environment

The pace of change within the financial services sector is seemingly relentless, with the financial
crisis of recent times serving to exacerbate the amount of new regulation and all that it brings for
firms, regulators and, indeed, consumers. The financial services regulatory environment is seeing an
unprecedented amount of regulatory reform across the EU and in financial centres globally. Regulated
entities within financial services sectors are of course expected to keep pace with this level of change,
much of which is being imposed as EU Directives and/or Regulations.

454
 Investment Selection and Administration

MiFID in 2007 was, in many ways, the first step to creating a more harmonised financial services
environment in Europe. This has now been revised with the new rules imposed by MiFID II and the
Markets in Financial Instruments Regulation (MiFIR), which is an extension of MiFID, and went live in
January 2018. This affected all stages of the life cycle of transactions as well as many consumer and firm-
related post-trade requirements. MiFID II and MiFIR represent an overhaul of the existing rules and also
expand the scope of instruments and firms.

The new legislation not only focuses on trading venues for financial instruments but also on regulating
the operation of these venues. It significantly applies to regulated entities’ systems, processes and
oversight/governance, and it is likely that very few firms involved in the securities industry escaped
at least some impact for procedures, systems, policies, operations, oversight and reporting. The new
rules again focus on greater investor protection, harmonisation of regulation across the EU, enhanced
competition, greater supervisory oversight and powers for regulators and an enhanced supervisory role
for the European Securities and Markets Authority (ESMA) across all European states.

The increasing cost of compliance is (and will no doubt continue to be) a much-debated subject. The
continuous enhanced focus on regulatory compliance/risk (and its associated costs) can become
difficult for some institutions, with firms being expected to demonstrate full compliance in an extremely
complex regulatory environment. Fines for non-compliance, incomplete or poorly reported data
and, of course, market abuse can pose a significant financial risk and often, more worryingly, a major
reputational risk for firms.

8
One fact that the majority of senior industry practitioners are likely to agree upon (if asked) is the
certainty of a continued flow of substantial regulatory change that is unlikely to abate significantly in
the foreseeable future.

Financial Technology – Fintech

Financial technology (Fintech) is now a familiar term used when describing new technology that is
constantly seeking ways to improve and automate the financial services sector.

Fintech initiatives range from the development and use of cryptocurrencies to capital market
infrastructure, for example, in the execution of trades, clearing of traded positions, as well as data
analytics and regulatory services.

Although the term ‘Fintech’ is an umbrella term, its impact covers a huge variety of services and
operations.

New technologies that have already made significant inroads and are the most active areas of Fintech
innovation include or are centred on the following business areas:

• predictive behavioural analytics

• risk management
• cryptocurrency and digital cash (eg, Bitcoin)
• Regtech, which assists financial service firms meet the ever demanding industry compliance rules
and regulations. Areas such as Know Your Customer (KYC) and anti-money laundering (AML) have
gained particular focus. Financial services are among the most heavily regulated sectors in the world
• blockchain technology which uses a distributed ledger to maintain maintain records across a
network of computers without the need for a central register or database/ledger

455
• smart contracts, using computers programs and algorithms, automatically execute contracts
between buyers and sellers
• cybersecurity in response to increasingly sophisticated cybercrime
• robo-advisers are types of automated financial advisers that provide financial advice or discretionary
investment management with little need for humans. They can provide electronic financial advice
based on formulae or algorithms.

Whatever sector of the financial services sector one belongs to, the use of Fintech is sure to continue to
revolutionise many of the traditional human and manually-based functions.

456
 Investment Selection and Administration

End of Chapter Questions

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

1. What are the two main areas that risk tolerance can be broken down into?
Answer reference: Section 1.1

2. In reviewing a client’s investment profile, why is a greater exposure to assets which provide the
possibility of capital gains more appropriate for a younger investor rather than an older investor?
Answer reference: Section 2.1.1

3. What is the difference between tax evasion and tax avoidance?

Answer reference: Section 2.1.3

4. Explain the key benefit of an index-linked gilt.

Answer reference: Section 2.2

5. In the context of ethical/sustainable and responsible investing explain the difference between
negative screening and positive screening.

8
Answer reference: Section 2.5

6. What is an indirect holding as opposed to a direct holding in a portfolio?

Answer reference: Sections 3.1.1 and 3.1.2

7. What is market timing?

Answer reference: Section 3.2.2

8. Distinguish between absolute and relative performance.

Answer reference: Sections 4.3.1 and 4.3.2

9. What are three issues that would arise when selecting a benchmark?
Answer reference: Section 4.4.3

10. Explain what is meant by the maximum drawdown sustained by a portfolio.

Answer reference: Section 4.5

457
458
Glossary
460
 Glossary

Active Management Arbitrage

A type of investment approach employed to The process of deriving a risk-free profit by
generate returns in excess of an investment simultaneously buying and selling the same
benchmark index. Active management is employed asset in two related markets where a pricing
to exploit pricing anomalies in those securities anomaly exists.
markets that are believed to be subject to
mispricing by utilising fundamental analysis and/ Asset Allocation
or technical analysis to assist in the forecasting of The process of deciding on the division of a
future events and the timing of purchases and portfolio’s assets between asset classes and
sales of securities. geographically before deciding upon which
particular securities to buy.
Alpha
Auction
The return from a security or a portfolio in excess
of a risk-adjusted benchmark return. System used to issue securities where the
successful applicants pay the price that they
Alternative Investment Market (AIM) bid. Examples of its use include the UK Debt
Management Office (DMO) when it issues gilts.
The London Stock Exchange’s (LSE’s) market often
Auctions are also used by the London Stock
used for smaller UK public limited companies.
Exchange to establish prices, such as opening
AIM has less demanding admission requirements
and closing options on SETS.
and places less onerous continuing obligation
requirements upon those companies admitted
Authorisation
to the market than those applying for a full list
on the LSE. Required status in the UK for firms that want to
provide certain financial services – examples
American Depositary Receipt (ADR) include collective investment vehicles that want
to advertise their fund to retail investors.
An ADR is a security that represents securities of
a non-US company that trades in the US financial
Authorised Corporate Director (ACD)
markets.
Fund manager for an open-ended investment
Amortisation company (OEIC).
The depreciation charge applied in company
Bank of England (BoE)
accounts against capitalised intangible assets.
The UK’s central bank.
Annual General Meeting (AGM)
Base Currency
The annual meeting of directors and ordinary
shareholders of a company. All companies The currency against which the value of a quoted
are obliged to hold an AGM at which the currency is expressed. The base currency is
shareholders receive the company’s report and currency X for the X/Y exchange rate.
accounts and have the opportunity to vote on
Bear Market
the appointment of the company’s directors and
auditors and the payment of a final dividend A negative move in a securities market,
recommended by the directors. Also referred conventionally defined as a 20%+ decline. The
to as an Annual General Assembly in some duration of the market move is immaterial.
jurisdictions.

461
Bearer Securities Capitalisation Issue
Those whose ownership is evidenced by the Another term for a bonus or scrip issue.
mere possession of a certificate. Ownership can,
therefore, pass from hand to hand without any Central Bank
formalities. Central banks typically have responsibility for
setting a country’s or a region’s short-term
Beneficiaries interest rate, controlling the money supply,
The beneficial owners of trust property. acting as banker and lender of last resort to the
banking system and managing the national debt.
Beta
The relationship between the returns on a stock Clean Price
and returns on the market. Beta is a measure of The quoted price of a bond. The clean price
the systematic risk of a security or a portfolio excludes accrued interest to be added or to be
in comparison to the market as a whole. In deducted, as appropriate.
futures markets, beta measures the amount of
fluctuation of one variable against another, so Closed-Ended
is used to determine the number of contracts Organisations such as companies which are a
required to hedge a portfolio. fixed size as determined by their share capital.
Commonly used to distinguish investment trusts
Bid Price (closed-ended) from unit trusts and OEICs (open-
Bond and share prices are quoted as bid and ended).
offer. The bid is the lower of the two prices and is
the one that would be offered to the seller. Commercial Paper (CP)
Money market instrument issued by large
Bonus Issue (Capitalisation) corporates.
The free issue of new ordinary shares to a
company’s ordinary shareholders, in proportion Commission
to their existing shareholdings through the Charges for acting as agent or broker.
conversion, or capitalisation, of the company’s
reserves. By proportionately reducing the market Commodity
value of each existing share, a bonus issue makes Items including sugar, wheat, oil and copper.
the shares more marketable. Also known as a Derivatives of commodities are traded on
capitalisation issue or scrip issue. exchanges (eg, oil futures on ICE Futures).

Broker-Dealer Consumer Prices Index (CPI)

A London Stock Exchange (LSE) member firm Index that measures the movement of prices
that can act in a dual capacity both as a broker faced by a typical consumer.
acting on behalf of clients and as a dealer dealing
Contract
in securities on their own account.
For derivatives, a contract is the minimum,
Bull Market standard unit of trading.
A rising securities market, conventionally defined
Convertible Bond
as a 20%+ rise from a prior low. The duration of
the market move is immaterial. A bond which is convertible, usually at the
investor’s choice, into a certain number of the
issuing company’s shares.

462
 Glossary

Coupon Dow Jones Industrial Average (DJIA)

The regular amount of interest paid on a bond. Major share index in the USA, based on the prices
of 30 major US listed company shares.
CREST
Electronic settlement system used to settle Environmental, Social, and Governance (ESG)
transactions for shares, gilts and corporate A set of factors to be considered when measuring
bonds, particularly on behalf of the London the sustainability and ethical impact of an
Stock Exchange. investment in a company.

Cum Dividend (cd) Equities

The period during which the purchase of Another name for shares.
shares or bonds on which a dividend or coupon
payment has been declared, entitles the new Eurobond
holder to this next dividend or interest. See also This is an interest-bearing security issued
Ex-Dividend (xd). internationally. More strictly a eurobond is an
international bond issue denominated in a
Debt Management Office (DMO) currency different from that of the financial
Agency responsible for issuing gilts on behalf of centre(s) in which it is issued. Most eurobonds are
the UK Treasury. issued in bearer form through bank syndicates.

Dematerialised European Securities and Markets Authority

System where securities are held electronically (ESMA)
without certificates. European Union financial regulatory institution
and European Supervisory Authority located in
Derivatives Paris.
Instruments where the price or value is derived
from another underlying asset. Examples include Exchange Rate
options, futures and swaps. The rate at which one currency can be exchanged
for another.
Dirty Price
The price of a bond inclusive of accrued interest Ex-Dividend (xd)
or exclusive of interest to be deducted, as The period during which the purchase of shares
appropriate. or bonds (on which a dividend or coupon
payment has been declared) does not entitle
Diversification the new holder to this next dividend or interest
Investment strategy that involves spreading risk payment.
by investing in a range of investments.
Exercise
Dividend Take up the right to buy or sell the underlying
Distribution of profits by a company to asset in an option.
shareholders.
Exercise Price
Dividend Yield The price at which the right conferred by a
The dividend as a percentage of current share warrant or an option can be exercised by the
price. holder against the writer.

463
Financial Conduct Authority (FCA) FTSE All Share Index
One of the two regulators of the financial services An index comprising about 98% of LSE-listed
sector in the UK. shares by market capitalisation.

Fiscal Year Fund Manager

This is the period for reporting, alternatively Firm or person that makes investment decisions
referred to as a financial year. The term is on behalf of clients.
particularly used by the tax authorities for a
period of assessment for tax purposes. Future
An agreement to buy or sell an item at a future
Fixed-Interest Security date, at a price agreed today. Differs from a
A tradeable negotiable instrument, issued by a forward in that it is a standardised contract
borrower for a fixed term, during which a regular traded on an exchange.
and predetermined fixed rate of interest based
upon a nominal value is paid to the holder until it Global Master Securities Lending Agreement
is redeemed and the principal is repaid. (GMSLA)
Parties to a stock lending transaction generally
Floating Rate Notes (FRNs) operate under a legal agreement, such as the
Debt securities issued with a coupon periodically GMSLA, which sets out the obligations of the
referenced to a benchmark interest rate. borrower and lender.

Forex Gross Domestic Product (GDP)

Abbreviation for foreign exchange. A measure of a country’s output.

Forward Gross Redemption Yield (GRY)

A derivatives contract that creates a legally The annual compound return from holding
binding obligation between two parties for one a bond to maturity taking into account both
to buy and the other to sell a pre-specified interest payments and any capital gain or loss at
amount of an asset at a pre-specified price on a maturity. Also referred to as the yield to maturity
pre-specified future date. Forward contracts are (YTM). The GRY or YTM is the internal rate of
commonly entered into in the foreign exchange return on the bond based on its trading price.
market. As individually negotiated contracts,
forwards are not traded on a derivatives Harmonised Index of Consumer Prices (HICP)
exchange. European equivalent of the consumer prices
index (CPI) in the UK.
Forward Exchange Rate
An exchange rate set today, embodied in a Hedging
forward contract, that will apply to a foreign A technique employed to reduce the impact of
exchange transaction at a pre-specified point in adverse price movements on financial assets
the future. held.

FTSE 100 High Frequency Trading (HFT)

Main UK share index of the 100 largest High frequency trading involves the sending
listed company shares measured by market of a large number of orders into the market,
capitalisation. Also referred to as the ‘Footsie’. generated by computer algorithms.

464
 Glossary

ICE Futures Europe Investment Trust

The UK’s principal derivatives exchange for Despite the name, an investment trust is a
trading financial and soft commodity derivatives company, not a trust, which invests in a diversified
products. Owned by The Intercontinental range of investments. A type of closed-ended
Exchange Group (ICE) inc. Was formerly known as investment fund.
the London International Financial Futures and
Options Exchange (LIFFE). LIBOR Rates
Immediately after 31 December 2021, sterling
Index-Linked Gilts euro, Swiss franc and Japanese yen settings, and
Gilts whose principal and interest payments are the one-week and two-month US dollar settings
linked to the retail prices index (RPI). will cease to be provided and will be replaced by
alternative benchmark rates.
Inflation
A persistent increase in the general level of Immediately after 30 June 2023, the remaining
prices. Usually established by reference to US dollar settings will cease to be provided.
consumer prices and the CPI.
Sterling LIBOR will be replaced by SONIA,
Initial Public Offering (IPO) (Sterling Overnight Index Average) and US Dollar
LIBOR replaced by SOFR (Secured Overnight
A new issue of ordinary shares that sees the
Financing Rate).
company gain a stock market listing for the first
time, whether made by an offer for sale, an offer
Limit Order
for subscription or a placing.
An order placed on a market (such as the London
Insider Dealing/Trading Stock Exchange’s SETS system) which specifies
the highest price it will pay (for a buy order) or
Criminal offence by people in possession of
the lowest price it will accept (for a sell order).
unpublished price-sensitive information from an
inside source who deal, advise others to deal or
Liquidity
pass the information on.
Ease with which an item can be traded on the
Intercontinental Exchange (ICE) market. Liquid markets are also described as
‘deep’.
Operates regulated global futures exchanges and
over-the-counter (OTC) markets for agricultural,
Liquidity Risk
energy, equity index and currency contracts, as
well as credit derivatives. The risk that an item, such as a financial
instrument, may be difficult to sell at a reasonable
Investment Bank price.
Firms that specialise in advising companies on
Listing
M&A (mergers and acquisitions), and corporate
finance matters such as raising debt and equity. Companies whose securities are listed are
The larger investment banks are also heavily available to be traded on an exchange, such as
involved in trading financial instruments. the London Stock Exchange.

Investment Company with Variable Capital London Stock Exchange (LSE)

(ICVC)
The main UK market for securities.
Alternative term for an OEIC.

465
Long Position Nominal Value
The position following the purchase of a security The amount on a bond that will be repaid
or buying a derivative. on maturity. Also known as face or par value.
Also applied to shares in some jurisdictions and
Market representing the minimum that the shares are
All exchanges are markets – electronic or physical issued for.
meeting places where assets are bought or sold.
Non-Deliverable Forward (NDF)
Market Capitalisation A short-term forward contract that does not
The total market value of a company’s shares or result in the exchange of notional currencies.
other securities in issue. Market capitalisation is Instead, upon maturity, the profit/loss between
calculated by multiplying the number of shares parties is calculated by taking the difference
or other securities a company has in issue by the between the contracted exchange rate and the
market price of those shares or securities. spot rate.

Market Maker Offer Price

A stock exchange member firm registered to Bond and share prices are quoted as bid and
quote prices and trade shares throughout the offer. The offer is the higher of the two prices and
trading day (such as the LSE’s mandatory quote is the one that would be paid by a buyer.
period).
Open-Ended
Maturity Type of investment, such as OEICs or unit trusts,
Date when the principal on a bond is repaid. which can expand without limit.

Monetary Policy Committee (MPC) Open-Ended Investment Company (OEIC)

Committee run by the Bank of England that sets Collective investment vehicle similar to a
UK interest rates. unit trust. Alternatively described as an ICVC
(investment company with variable capital).
Multilateral Trading Facilities (MTFs)
Systems that bring together multiple parties Option
that are interested in buying and selling financial A derivative giving the buyer the right, but not
instruments including shares, bonds and the obligation, to buy or sell an asset in the
derivatives. future.

Nasdaq Organised Trading Facilities (OTFs)

The second-largest stock exchange in the US. A multilateral system that is not a regulated
Nasdaq lists certain US and international stocks market or a multilateral trading facility (MTF). It
and provides a screen-based quote-driven allows multiple third-party buying and selling
secondary market that links buyers and sellers interests in bonds, structured finance products,
worldwide. Nasdaq tends to specialise in the emission allowances or derivatives to be traded.
shares of technology companies. Equities cannot be traded through an OTF.

Nikkei 225 Over-the-Counter (OTC) Derivatives

The main Japanese share index, comprising 225 Derivatives that are not traded on a derivatives
blue-chip companies that are listed on the Tokyo exchange.
Stock Exchange.

466
 Glossary

Passive Management Registrar

In contrast to active management, passive The official who maintains the share register on
management is an investment approach that behalf of a company.
does not aspire to create a return in excess of a
benchmark index. The approach often involves Repo
tracking the benchmark index. The sale and repurchase of securities between
two parties: both the sale and the repurchase
Pre-Emption Rights agreement are made at the same time, with the
The rights accorded to ordinary shareholders purchase price and date fixed in advance.
to subscribe for new ordinary shares issued
by the company in proportion to their current Resolution
shareholding. Proposal on which shareholders vote.

Preference Share Retail Prices Index (RPI)

Shares which usually pay fixed dividends but do Index that measures the movement of prices
not have voting rights. Preference shares have faced by retail consumers in the UK.
preference over ordinary shares in relation to the
payment of dividends and in default situations. Rights Issue
The issue of new ordinary shares to a company’s
Primary Market shareholders in proportion to each shareholder’s
Also known as the new issues market, the primary existing holding. The issue is made in accordance
market is where securities are issued for the first with the shareholders’ pre-emptive rights and the
time, for example an IPO. new shares are usually offered at a discounted
price to that prevailing in the market. This means
Proxy that the rights have a value, and can be traded
Appointee who votes on a shareholder’s behalf ‘nil paid’.
at company meetings.
RPIX
Prudential Regulation Authority (PRA) UK index that shows the underlying rate of
One of the two regulators of the financial services inflation, excluding the impact of mortgage
sector in the UK. payments.

Quote-Driven Scrip Issue

Dealing system driven by market makers quote Another term for a bonus or capitalisation issue.
buying and selling prices.
Secondary Market
Real Estate Investment Trust (REIT) Marketplace for trading in existing securities.
An investment trust that specialises in investing
in commercial property. Share Buyback
The purchase and typically the cancellation by a
Redemption company of a proportion of its ordinary shares.
The repayment of principal to the holder of a
redeemable security.

467
Share Capital Treasury Bills
The nominal value of a company’s equity or Short-term (often three months) borrowings of
ordinary shares. A company’s authorised the government. Issued at a discount to the
share capital is the nominal value of equity nominal value at which they will mature. Traded
the company may issue, while the issued share in the money market.
capital is that which the company has issued. The
term share capital is often extended to include a T+2
company’s preference shares. The two-day rolling settlement period over
which all equity deals executed on the LSE SETS
Share Split/Stock Split are settled. This is also a standard settlement
A method by which a company can reduce the period for many international equity markets.
market price of its shares to make them more
marketable without capitalising its reserves. A Two-Way Price
share split simply entails the company reducing Prices quoted by a market maker at which they
the nominal value of each of its shares in issue are willing to buy (bid) and sell (offer).
while maintaining the overall nominal value of
its share capital. A share split should have the Underlying
same impact on a company’s share price as a Asset from which a derivative is derived.
bonus issue.
Unit Trust
Short Position
A vehicle whereby money from investors is
The position following the sale of a security not pooled together and invested collectively on
owned or selling a derivative. their behalf. Unit trusts are open-ended vehicles.
Special Purpose Vehicle (SPV)
Yield
Bankruptcy remote, off-balance sheet vehicle set
Income from an investment expressed as a
up for a particular purpose such as buying assets
percentage of the current price.
from the originator and issuing asset-backed
securities. Yield Curve

Special Resolution The depiction of the relationship between the

yields and the maturity of bonds of the same
Proposal put to shareholders requiring 75% of
type.
the votes cast in order to be accepted.

Swap
An over-the-counter (OTC) derivative whereby
two parties exchange a series of periodic
payments based on a notional principal amount
over an agreed term. Swaps can take a number
of forms including interest rate swaps, currency
swaps, credit default swaps and equity swaps.

Takeover
When one company buys more than 50% of the
shares of another (UK).

468
Multiple Choice
Questions
470
 Multiple Choice Questions

The following questions have been compiled to reflect as closely as possible the standard that you will
experience in your examination. Please note, however, that they are not actual exam questions. As part
of exam security, hand-held calculators are not allowed in CISI exam venues. Candidates must use the
onscreen calculator for all CISI CBT exams in all languages in the UK and internationally.

1. How does a subdivision or stock split work and how does it affect its current investors’ holdings in
the company?
A. It decreases the number of shares issued, helping its price to regain a previous level. It has no
immediate effect on current investors’ holdings
B. It increases the number of shares issued, reducing the price. While it has no monetary effect
on current investor’s holdings, they are diluted
C. It increases the number of shares, by issuing new shares to investors at their current price,
increasing their holdings
D. It increases the number of shares issued, reducing their price. It has no effect on current
investor’s holdings

2. Under rules imposed by MiFID and MiFIR, how are FCA-regulated firms obliged to assist in
preventing and detecting market abuse?
A. By deterring clients from trading in financial instruments that are currently the subject of
regulatory scrutiny
B. By making transaction reports to the FCA on a timely basis
C. By ensuring that all dealing staff and investment managers gain a relevant trading qualification
covering market abuse
D. By installing surveillance systems in order to perform routine tests against order book
execution and order data

3. In a company’s statement of financial position, which of the following category of asset is

depreciated over time?
A. All investments, in order to represent their current market value
B. All tangible assets, since they have a limited life that is useful to the company
C. All non-tangible, non-current assets, since their values change each year
D. Tangible non-current assets with a limited life, to reflect their value over their useful life

471
4. In relation to the production of statements of profit and loss, under the International Accounting
Standards (IAS), what two choices do firms have?
A. Produce a statement of the amount of gross income or two separate statements showing
income and expenditure separately
B. Produce a statement of comprehensive income or in two separate statements showing
income and comprehensive income
C. Produce statements detailing the profits over the accounting period or two separate
summaries of earned and unearned income
D. Produce a statement of income and expenditure or two statements showing net income and
expenditure separately

5. Which of the following retail structured investment products will be attractive to an investor who
is willing to trade some potential gains for reduced capital risk. Why?
A. A buffer zone investment, since it provides full capital protection should the market move
beyond a predetermined range over the investment life span, in exchange for a slightly
reduced return
B. Auto-call investments, since they include a number of opt-out levels, which allow investors an
early redemption option, with full capital protection, should specific events or triggers occur
C. Principal-protection investments, since they provide full capital protection, for a reduced
return, allowing investors to participate in more volatile assets and emerging markets
D. Principal-protection auto-call investments, since they provide both full capital protection, as
well as no counterparty risk, with pre-set exit levels, for a reduced return, that increases the
longer it is held

6. Which of the following best describes how a forward exchange rate is determined and its
relationship to the spot exchange rate?
A. Managed float, keeps currencies within a specific trading range, which determines the limits
of all forward rates
B. Market expectations, most market makers include rate forecasts as part of their forward
exchange rate quotes
C. Free floating, a combination of interest rate differentials, trade policies and major economic
factors determine both spot and forward quotes
D. Interest rate parity, the simply mathematical difference between the two currencies’ nominal
interest rates

7. Which market practice has been cited by the FCA as providing increased liquidity for the specific
securities involved, as well as proving support for a wide range of trading strategies that would be
difficult to execute without it?
A. A pooled nominee
B. Registered title
C. Stock lending
D. Reverse repurchase agreements

472
 Multiple Choice Questions

8. In what way can contingent convertible bonds be beneficial to the banking industry?
A. Conversion of such bonds can create an uplift in issuer’s capital
B. They are accepted as grade 1 collateral by the Bank of England
C. They can be readily exchanged for the equivalent in deferred equity capital in order to improve
the asset value
D. Banks are able to use them as off balance sheet assets that can be brought into the main asset
value calculations as required by the Bank of England

9. Which of the following is the best example of how a portfolio manager can limit potential losses on
portfolios by giving up some of the potential profits?
A. By using derivatives as insurance
B. By implementing a programme of product diversification
C. By intense strategic asset allocation
D. By setting stop loss limits on all investments

10 . Which of the following describes a key way to limit the risk of an open foreign exchange position?
A. By rolling over the position’s settlement date for a few days, to reduce any delivery risk
B. By setting a stop-loss price, at which the position will be closed, if the rate moves against the
position
C. By borrowing lower interest rate currencies, when rolling over a position, to reduce any costs
D. By setting a price at which the position will be closed, to ensure that you will not miss taking
profit

11. Which of the following best describes how Her Majesty’s Revenue and Customs (HMRC) collects
transfer taxes in relation to the majority of UK equity trades?
A. Through the stamping of share transfers at local stamp offices at which the submitting firm
declares a stamp duty charge based on 1% of the consideration of the transaction
B. Through the collection, by means of a stamp duty reserve tax (SDRT) charge of 1.5%,
automatically applied by the CREST system on all equity purchases
C. The stamp duty of 0.25% is collected based on consideration input by both the selling and
buying counterparties within CREST
D. SDRT of 0.5% is collected though CREST based on the input of accountable persons who act as
collectors of duty on purchases

473
12. One of the key characteristics of an open-ended investment company (OEIC) that is attractive to
most investors is:
A. Since they are open-ended, they cannot trade at a discount to their net asset value (NAV)
B. Their structure allows them to invest in only one fund at a time, to limit any risks, such as
foreign exchange (FX) risk
C. They are closed-ended, therefore can trade at a discount or premium to their NAV
D. Since they do not have any dealing charges, their bid-offer spread can be wide when liquidity
is limited

13 . A key part of issuing medium term notes and bonds in the UK market is by using a shelf registration.
This allows a borrower to issue new debt using this documentation for how long?
A. Until the publication of the issuer’s next audited annual report and accounts
B. When the amount of debt issued reaches the document’s pre-determined limit
C. For a period of up to two years, as long as the issuer reports a profit
D. Once the pre-determined number of issues has been reached

14. What did the Investment Association (IA) publish for investment strategies?
A) A classification system
B) A benchmark indexing table
C) A list of Ethical/ESG funds
D) CGT Indexation tables

15. In relation to market abuse, which of the following best describes dissemination?
A. Deliberately posting misleading information through the media in order to affect the market
price of an instrument
B. Giving non-public information to another individual which, if acted upon, could generate
profits when made public
C. Using member access to an electronic order book and inputting a series of fictitious orders to
create an appearance of high liquidity and volume
D. Dealing for one’s personal account in advance of a large order already received from a client
which is expected to move the share price in the market

474
 Multiple Choice Questions

16. A company is pursuing a strategy of increasing market share by reducing sales prices. The change
in which of the following is most likely to reveal the change?
A. Asset turnover
B. Earnings per share
C. Profit before taxes
D. Gross profit margin

17. Why can it be difficult for analysts and researchers when undertaking financial analysis of issuers
who operate in different sectors of the economy?
A. Because they are likely to encounter differing accounting policies and standards
B. Because most analysts develop expertise in a solitary area of the market and become known
for such concentrated expertise; diversifying is often seen as diluting this focused excellence
C. Because government and government agencies produce financial statistics and economic
measures that are not compatible with cross-sector correlation
D. Because multinationals tend to adopt the standards of their most liquid and profitable market
which leads to an extremely diverse range of global economic principles

18. What is regarded as the primary objective of the Sarbanes-Oxley Act of 2002?
A. To protect investors by improving the accuracy and reliability of corporate disclosures made
pursuant to the securities laws and for other purposes
B. To ensure the fair and orderly conduct of financial markets as protection for underlying
investors, consumers and market members
C. For investment advisers, portfolio managers and financial intermediaries to make full
disclosures of risks and fees in relation to promotions, marketing and offers for sale
D. For financial markets to ensure both pre- and post-trade transparency of listed instruments
unless certain predefined waivers are necessitated by liquidity constraints

19. For investment trusts regulated by the Financial Conduct Authority (FCA), which of the following is
true in relation to the underlying holdings within the fund?
A. The investment trust must not control, seek to control or actively manage companies in which
it invests
B. It must not hold a single asset if it represents greater than 1.25% of the total fund for a period
of longer than 12 months
C. It must submit a statement of underlying holdings to the Panel on Takeovers and Mergers
(POTAM) at least quarterly
D. It must evoke best practice to avoid shareholder conflict in respect of investments which may
be considered unethical

475
20. The type of risk that is defined as wide-spread and that can affect all markets, that cannot be
completely eliminated through diversification, is known as:
A. Global
B. Market
C. Default
D. Liquidity

21. When a company issues shares that are entitled to receive a fixed annual dividend and an
additional payment, which is a proportion of the ordinary share’s dividend in very profitable years,
these shares are known as:
A. Deferred preference shares
B. Cumulative preference shares
C. Registered bearer shares
D. Participating preference shares

22. Most convertible bonds pay a lower coupon than similar bonds. The reason for this is that investors
find which of the following characteristics attractive?
A. They are secured and therefore are backed by specific assets
B. They have a third-party guarantee, usually by a bank or fund
C. They include an option to convert the debt into the issuer’s shares
D. They are always senior and secured debt, with a higher credit rating

23. Which entity has published a classification system for the significant range of funds available to UK
investors?
A. The Investment Association (IA)
B. The Bank of England
C. Her Majesty’s Revenue and Customs (HMRC)
D. The Association of Private Client Investment Managers and Stockbrokers

24 . The euro debt market crisis is a good example of investors taking positions based on which type of
trading strategy spread?
A. Credit quality spreads
B. Default spreads
C. Sovereign spreads
D. Currency spreads

476
 Multiple Choice Questions

25. What is meant by systemic risk?

A. The risk that an instrument’s liquidity may diminish during periods of market stress
B. The risk that a company in which an investment has been made could become insolvent due
to a harsh operating environment
C. The risk that affects overall prices of markets and indices influenced by macroeconomic
conditions
D. The risk of collapse of the entire financial system or entire market

26. Which of the following objective factors is an indication that an investor will accept higher risk
investments?
A. Those with specific commitments to meet
B. One with limited assets and few liabilities
C. A younger person planning for retirement
D. One with a specific investment timescale and goal

27. In what way do shareholders gain eligibility to vote on important company matters and to receive
dividends via direct communication with the company’s appointed registrar?
A. By securing beneficial ownership
B. By placing an order to purchase an equity which is immediately executed
C. By securing legal registered title
D. By having physical possession of the registered certificates of legal title

28. Which of the following is deemed to be a main reason for establishing a liquidity ratio?
A. To establish whether a company has the resources to meet its operating requirements from its
working capital in a reasonable time period
B. To evaluate the effect of bank overdrafts on the cash assets and whether any have been
extended by the bank and included as current liabilities
C. To perform an analysis of the financial viability of stated bond assets, because some accounting
professionals prefer to include them as creditors, especially for lower grade corporates
D. To compare liabilities against readily realisable assets and to determine whether a struggling
company is still liquid

29. A preference shareholder can often be disadvantaged because, as a company starts to make large
profits, the ordinary shareholders may see dividends rise, with the preference still paying the initial
fixed rate. What class of share can mitigate this?
A. Debentures
B. Participating preference shares
C. Class A consolidated loan shares
D. Convertible preference shares

477
30. The Financial Conduct Authority (FCA) and most financial regulators require all large banks and
brokers to establish which of the following, to ensure that none of its traders are able to benefit
from front running any client orders and to avoid any conflict of interest between any of its
different departments?
A. Aggregated orders
B. Chinese wall
C. Allocation priority policy
D. No proprietary trading

31. A standard service level agreement with a custodian will typically contain which one of the
following?
A. Communication and reporting
B. Reporting obligations and deadlines
C. The method through which the client’s assets are received and held by the global custodian
D. A list of persons authorised to give instructions

32. Why is the gross redemption yield (GRY) considered to be an ideal way of truly representing the
return on a bond investment?
A. It includes the three key factors of price paid, all of the coupon payments and the repayment
of the principal
B. As well as taking into account actual return, it includes a formula for comparing the return
against benchmark rate such as the retail prices index (RPI)
C. It includes a comparison against other benchmark bonds and thus provides a true rate of
return against the overall bond markets
D. It provides a real return compared to LIBOR, Euribor and a basket of other major global interest
rates

33. Which of the following is most likely to be a non-dilutive follow-on share offering?
A. When shares are offered by company’s directors and other insiders who hold these shares and
who will directly benefit by receiving the proceeds
B. When new shares are offered by a company for specific investment goals or to finance a
takeover/merger
C. When shares are offered by the company to its directors to ensure that the company remains
independent or for specific investment goals
D. When new shares are offered by a company that will be traded on at least two different
exchanges within the same regulatory jurisdiction

478
 Multiple Choice Questions

34. Which of the following statements describing a bond’s price and yield quotations is true?
A. Traders use the yield curve as a measure of the returns and liquidity of bonds with the same
maturity of different issuers
B. They move in opposite directions, meaning that as a bond’s price falls, its yield will rise,
reflecting the fact that the coupon payment does not change
C. Every bond’s coupon represents the percentage of the principal amount or par that will be
paid on a quarterly basis
D. They move in the same direction, reflecting the bond’s basic credit standing, but their relative
spreads usually lag behind

35. Both fundamental and technical analysis are useful in evaluating securities and potential
investments. Which of the following best describes how they are used by investors?
A. Fundamental analysis is more popular with day traders, while technical analysis is used by
those who take a longer-term view
B. Technical analysis focuses on the trends in a company’s financial reports, while fundamental
analysis is more concerned with market trends
C. Both monitor the trading volume of a security and occasionally make adjustments when
liquidity is considered to be limited
D. Technical analysis uses price data that are more short-term time-frame, while fundamental
analysis is more longer term

36. Which of the following best describes the liquidity risk aspect in the settlement process?
A. It is when a counterparty is unable to meet all of its payment obligations in full on any specific
due date
B. It is when tight market conditions result in wide price spreads and limited trading amounts for
an asset on any specific due date
C. It is when a counterparty is declared insolvent after it has received several payments and it is
restricted from fulfilling its payments
D. It is when a counterparty has to finance any delivery failure by a counterparty at short notice

37 . An investor holds a number of convertible bonds in a portfolio. Which of the following has the
most valuable/highest conversion premium?
I – ABC plc trading at £107, £100 converts to 50 shares, which are trading at £1.85
II – EXE plc trading at £127, £100 converts to 45 shares, which are trading at £2.95
III – XYZ plc trading at £128, £100 converts to 320 shares, which are trading at 33p
IV – GHG plc trading at £111, £100 converts to 50 shares, which are trading at 1.80p

A. GHG plc which has a conversion premium of 23.3%

B. XYZ plc which has a conversion premium of £21.60
C. ABC plc which has a conversion premium of 24.50%
D. EXE plc which has a conversion premium of £22.25

479
38. In relation to tracking methods employed by exchange-traded funds (ETFs), which of the following
best explains the benefits of stratified sampling?
A. It enables the fund to reduce tracking errors and dealing costs
B. It ensures that the fund and the indices are 100% correlated and eliminates tracking errors
C. It enables the fund to replicate an index by using derivatives only and reduces brokers’
commission
D. It enables the fund managers to create an ETF from a sample of companies with dividend
reinvestment plans (DRIPs) which allows the fund to accumulate shares, while distributing
cash in lieu to holders

39. Which of the following is the best description of benchmarking?

A. The monitoring of the overall performance of a portfolio by comparison to a peer group
B. The setting of realistic targets for profits upon each asset purchase
C. The financial analysis and comparative analysis of direct products sectors
D. The plotting of prices of identical assets trading on multiple regulated markets and multilateral
trading facilities (MTFs)

40. Which of the following best describes the way that pension fund trustees are expected to uphold
prudential standards?
A. The duty of governance demands that trustees execute transactions in financial instruments
in the best interests of the scheme members and in accordance with markets in financial
instruments directive (MiFID)
B. Trustees must qualify targeted risk in the way that they manage members’ assets or administer
monies deposited with a third party
C. They must demonstrate that they have the necessary familiarity with the structure and aims
of their pension scheme and have an appropriate level of training and skill to carry out their
responsibilities to scheme members effectively
D. Senior scheme members have a responsibility to monitor and review the tasks delegated to
the trustees in order to ensure that these tasks are discharged effectively, including, but not
limited to, trading in financial instruments and depositing the scheme’s assets with any third
party

41. Securities analysts and investors use a company’s liquidity ratio to establish which of the
following?
A. Whether it has access to sufficient cash to meet its ongoing liabilities
B. The company’s capital ratio measured relative to its sector
C. How the company’s profit margin measures relative to its competitors
D. Whether it has sufficient ongoing cash to meet its long-term liabilities

480
 Multiple Choice Questions

42. One of the key approaches to asset selection is the bottom-up approach; which of the following
best describes this method?
A. Taking the opposite view of the current market and taking advantage of any price drop to
increase holdings in specific assets
B. Choosing individual assets whose characteristics meet the fund/investors’ goals and constraints
C. Buying specific assets at regular intervals, to avoid peaks and troughs in price throughout the
investment year
D. Selecting the types of assets and specific markets that meet the selected criteria, before
buying individual securities

43. What is the main reason why central banks use repos?
A. To control money supply
B. To assist in collateralising banks
C. To prop up base interest rates in times of economic slowdown
D. To enhance revenue generation from pools of under-utilised balance sheet assets

44. Which key figure, used by financial analysts, is derived from dividing a company’s net income for
the financial year by the number of shares in issue?
A. Net yield
B. Return on capital employed
C. Earnings per share
D. Net revenue ratio

45. The Financial Services and Markets Act 2000 (FSMA 2000) extended the range of UK-authorised
open-ended investment companies (OEICs) to include property funds and what other type of
funds?
A. Money market
B. Property
C. Corporate bond
D. Leveraged

46. Which of the following is the best description of subordinated eurobonds?

A. They have an inferior ranking within the capital structure hierarchy and have a greater risk
than a senior or secured note
B. They have a semi-superior status within the capital structure hierarchy and have greater risk
than a senior note but less than a secured note
C. The have the lowest ranking within the capital structure hierarchy and are effectively zero
coupon bonds, rarely paying interest
D. They are bonds where the coupon rate varies according to ability to pay and thus have an
inferior ranking within the capital structure hierarchy but have the same market risk as a
senior note

481
47. Which of the following best describes the purpose of a dividend cover calculation?
A. It establishes whether an issuer of asset-backed securities has enough earned revenue to
enable it to maintain its interest payments to holders
B. It attempts to assess the likelihood of the current net dividend paid to shareholders being
maintained by using the earnings per share (EPS)
C. It measures the cash assets against dividend forecasting to predict future dividend yields
D. It is a direct ratio of gross dividend versus EPS

48 . One way that a central bank can reduce or drain liquidity from the money markets is to:
A. Enter into a repurchase agreement as the reverse repo participant
B. Reduce the minimum balance requirement
C. Enter into a repurchase agreement as the repo participant
D. Use a tri-party repurchase agreement

49. Which of the following is the best description of a SAFE?

A. A contract which gives the right to the instrument purchaser (but not the obligation) to buy or
sell a currency at a pre-agreed forex rate on a set date
B. A contract that commits two parties to exchange pre-agreed amounts of foreign currency
immediately and then re-exchange them at a given maturity date
C. A contract where there is no exchange of principal monies at the outset or at maturity. The
arrangement is a contract for difference based on notional cash sums
D. An exchange-traded contract where a stipulated amount of a foreign currency is traded for
delivery at a pre-determined future date at a price agreed at the outset

50. For what purpose were harmonised indices of consumer prices (HICPs) initially used in the EU?
A. To assist the European Central Bank (ECB) in settling fiscal policy
B. To establish whether prospective members of the European Monetary Union would meet the
required inflation criterion
C. To assist in the setting of the ECB base rate for the euro as the rate is strongly correlated with
eurozone inflation
D. As a benchmark rate to establish whether eurozone countries were meeting inflation targets
both individually and by region

51. Which of the following financial instruments was introduced in the last 25 years and what is a key
advantage of them?
A. Exchange-traded funds – no stamp duty reserve tax (SDRT) on purchase
B. Split unit trusts – diversify the investment
C. Restricted for dividend equities – allow a lower entry price
D. Dual-listed securities – improve liquidity and price stability

482
 Multiple Choice Questions

52. Why are a company and listed security removed from an exchange’s official list involuntarily?
A. The company’s shares have fallen significantly in price beyond its banding
B. The company’s shares have experienced low volumes
C. The company has voted at an annual general meeting (AGM) to change its capital structure
D. The company has failed to meet the listing regulations

53. Which of the following describes how an open-ended investment company (OEIC) umbrella fund
manages its client register?
A. It has a separate register for each sub-fund
B. All sub-funds within the umbrella are consolidated into a single register
C. Each sub fund is split further into currencies, each with its own register
D. A register is created for each currency, so it often has one or more sub-funds within it

54. Within a statement of profit and loss, under International Accounting Standards Board (IASB)
published guidance, when is revenue from dividends recognised?
A. When the shareholder’s right to receive payment is established
B. When confirmation is received from the bank that funds have cleared
C. On the official pay date of the dividend
D. On the ex-dividend date as determined by the market

55. If a CREST member trades 20 times on SETS in the same security, what are the minimum
and maximum number of non-partial settlements that could take place through the central
counterparty?
A. 1 and 20
B. 0 and 20
C. 1 and 1
D. 0 and 1

56. There is a statutory protection, offered to savers as high as £1,000,000 which can apply to balances
in building societies, banks or credit unions if the entity fails. However, the standard protection
is usually a maximum of £85,000. What is the key factor that makes the protection the higher
amount?
A. The high account balance is temporary
B. The amount must have been constant for at least 18 months
C. The money is held for charitable purposes
D. The funds are held in escrow to the order of a third party

483
57. What key factor in relation to money market deposits and interest rates can represent a key
advantage to investors?
A. They respond immediately to interest rate changes
B. The commission rates charged across different banks are usually consistent
C. They offer better rates than cash deposits and savings bonds
D. The rates are always higher than London Inter-bank Offered Rate (LIBOR)

58. Which of the following applies to commercial paper issued in the UK but not usually to commercial
paper issued elsewhere?
A. The issue must be fully backed by cash or near-cash
B. Yields are quoted on a 365-day basis
C. The term is restricted to 270 days
D. They can only be marketed to professional investors

59. For mortgage-backed securities (MBSs) issued in the US, what is meant by tranches and what is
their purpose?
A. Each tranche represents a particular status with the eventual principal payment being
distributed according to the priority of the tranche
B. Each tranche represents a separate issue and fund raising and is redeemed and prioritised with
the closest redemption first
C. Each tranche has a different subscriber level with initial tranches being placed to large
institutions and the final tranche, being the residue, offered generally to retail investors
D. An MBS is generally sold in five tranches. The first is sold at a higher price, the second the next
highest, etc, and this dictates the repayment priority at redemption due date

60. Open-ended investment companies (OEICs) need to appoint an authorised corporate director
(ACD). Which of the following summarises the ACD’s main role?
A. To audit the accounts of the OEIC and associated funds
B. To keep the unit holders regularly briefed on the fund’s performance
C. Day-to-day management of the fund
D. Oversight of the investment manager and depositary

61. In what way do high frequency traders help with proper price formation and transparency in
relation to securities that are cross-listed?
A. Their arbitrage techniques generally lead to price consistency, eroding away small differences
B. Each trader is required to make markets in any venue it has access to under market rules
C. Traders offer plenty of liquidity and supply in otherwise illiquid securities whose trading
volume would be very low
D. A high frequency trader who trades in the same securities in different locations and currencies
has to publicly quote prices and size for both

484
 Multiple Choice Questions

62. Which of the following investment sectors is likely to be avoided by a sustainability investing
research team?
A. Forestry
B. Public transport
C. Land use
D. Pesticides

63. How does the Central Securities Depositories Regulation (CSDR) aims to improve the cost and risk
for those who use central counterparty clearing houses (CCPs)?
A. It enables non-clearing members (NCMs) to bypass general clearing members (GCMs) and
settle directly with the CCP
B. It results in a shorter time period of having to put up margin on open positions
C. It imposes stricter credit checks on GCMs and NCMs
D. It enables members to opt into settlement netting

64. The Payment Systems Regulator (PSR) is an independent economic regulator and has its own
statutory objectives. How is it funded and who is it accountable to?
A. It is funded by the payments industry and is accountable to the UK Parliament
B. It is funded by government grant and reports to the Exchequer
C. It is funded as part of the Financial Conduct Authority’s (FCA’s) financial accounts and also
reports to it
D. It is funded by industry donations and has no direct accountability

65. Under which circumstances would a permanent interest-bearing security become a perpetual
subordinated bond?
A. Directly following a partial default and rating downgrade
B. When the instrument has been delisted
C. When the issuing building society has demutualised
D. After a merger or demerger approved at an annual general meeting (AGM)

66. Most structured products will naturally fall into one of three categories, with each having a specific
risk/return profile. These are principal-protected, buffer-zone and which other?
A. Endowment ring-fenced
B. Capital-focused
C. Return-enhanced
D. Income-tax efficient

485
67. Fundamental analysis involves financial analysis of a company’s published accounts and
incorporates what two factors?
A. Forecasted and projected
B. Quantitative and qualitative
C. Appreciation and depreciation
D. Systemic and systematic

68. How does the CREST system assist in effecting the correct legal ownership status for share
transactions in UK-registered equities?
A. It ensures that actual bank-to-bank settlement follows legal registration
B. It communicates electronically with registrars
C. It guarantees the financial settlement of both the buyer and the seller
D. It acts as the legal operator register

69. In respect of establishing an investor’s profile, which of the following is the most accurate
description of time horizon?
A. The time between investing and an expected change in financial circumstances, eg, collecting
a pension
B. The forecasted future value of purchased investments taking into account all known factors
C. The time period over which an investor considers investing
D. The future value of benchmark indices given present financial condition and historical
volatility

70. What specific aspect of a special purpose vehicle (SPV) makes it different from debt issued directly
from the entity and, indeed, is the reason for them?
A. It reduces the liability of the issuer in the event of insolvency
B. It does not appear in the balance sheet of the entity
C. SPV-issued debt is subject to a lower level of regulatory oversight
D. SPVs can be marketed to retail investors while self-issued debt cannot be

71. The Panel on Takeovers and Mergers (POTAM) requirements for holders of the same security
during a takeover offer situation specify that all shareholders:
A. Must be treated in the same way as each other
B. Must eventually accept an unconditional offer
C. Must accept the offer using only electronic means
D. Must be sent details of the offer simultaneously

486
 Multiple Choice Questions

72. Which of the following is a key difference between the settlement of UK equities compared to UK
gilts?
A. The equity settlement period is a day longer
B. CREST settles equities while Euroclear settles gilts
C. Equities require legal registration, gilts do not
D. Equities can be central counterparty (CCP)-cleared, gilts cannot

73. What is the reason depreciation cannot be applied to freehold land?

A. Its value can appreciate as well as depreciate
B. Freehold land is already afforded stamp duty reliefs
C. It does not have a limited economic life
D. Freehold land is usually purchased to build on and improve

74. Money market funds (MMFs) should pay interest at a rate represented by London Inter-bank
Offered Rate (LIBOR). Which of the following best describes how LIBOR is established?
A. A calculation based on actual rates offered in the money market between banks
B. The base rate plus or minus the premium on overnight deposit bank rates, averaged
C. It is the base deposit rate, used by the Debt Management Office (DMO) and calculated across
various sectors by the Bank of England
D. It is the average two-day deposit rate announced by the seven largest lenders by loan value

75. Which aspect of a Treasury bill makes it very different from a regular gilt, certificate of deposit or
other money market instrument?
A. They are fully index-linked
B. There is no maturity date
C. There are no income payments
D. They cannot be traded

76. What is depicted using a point and figure chart for price movement?
A. Those movements that are significant
B. A geographical comparison between countries
C. A sectorised summary across similar businesses
D. Those that have moved against predictions

487
77. What aspect of contingent convertible capital instruments (CoCos) make them a different
instrument to traditional convertible bonds and which part of the industry finds them useful in
uplifting capital ratios?
A. They are convertible into a higher-yielding bond. The higher-yield bond is used by stock
borrowers
B. They are convertible only upon the expiry date and are automatically exercised if at a premium.
They are used extensively by money brokers
C. They can be exercised only when a certain price level is reached for the underlying equity and
can be beneficial for banks
D. They can be converted, when the price of the equity rises over four different subsequent
quarters, into cash, usually by investment funds

78. In comparing fundamental and technical analysis, what is the distinguishing factor in relation to
time horizon?
A. Fundamental analysis uses other similar analysis for a longer-term focus while technical looks
at shorter but less predictive data
B. Technical analysis produces a more factual-based result while fundamental is a more predictive
result using time factors
C. Technical analysis focuses on the most recent data while fundamental has a more historic
approach
D. Fundamental uses a long-term approach to investment while technical uses shorter-term data

79. How can the real returns on investments in highly credit rated, fixed rate securities become
negative?
A. When the price of the investment erodes the coupon value
B. When the inflation rate exceeds the coupon
C. When the accrued interest is deducted upon purchase during the initial investment
D. When the capital gain on a zero coupon bond does not bring the return to par

80. Which of the following best describes the characteristics of a certificate of deposit?
A. Negotiable bearer instrument with fixed rate
B. Tax-free wrapper in a single name
C. Benchmarked to London Inter-bank Offered Rate (LIBOR) and short term
D. Interest-bearing variable-rate investment

488
 Multiple Choice Questions

Answers to Multiple Choice Questions

1. D Chapter 3, Section 3.9.5

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

2. B Chapter 7, Section 2.4

Both MiFID and MiFIR impose requirements on firms to report transactions. Transaction Reports play
a key role in the FCA’s market abuse monitoring work. The FCA takes a serious view of firms which fail
to report transactions in line with its rules or which do not have in place adequate internal transaction
reporting procedures and systems.

3. D Chapter 6, Section 1.1.2

Tangible non-current assets are initially recorded in the statement of financial position at their actual
cost or book value. However, in order to reflect the fact that the asset will generate benefits for the
company over several accounting periods, not just in the accounting period in which it is purchased, all
tangible non-current assets with a limited economic life are required to be depreciated.

Depreciation is applied to tangible non-current assets such as plant and machinery. An annual
depreciation charge is made in the year’s statement of profit and loss. The depreciation charge allocates
the fall in the book value of the asset over its useful economic life.

4. B Chapter 6, Section 1.2.1

IAS 1 has brought about changes to the statement of profit and loss. The amendment requires
companies to present other comprehensive income items such as revaluation gains and losses, and
actuarial gains and losses, as well as the usual statement of profit and loss items, on the face of the
primary financial statements. IAS 1 allows this information to be presented either on one statement
of comprehensive income or on two separate statements: a statement of profit and loss (income
statement) and a statement of comprehensive income.

5. C Chapter 4, Section 2.3

Principal-protected investments offer the full downside protection of a bond while having the upside
potential of a typical equity investment. Investors typically give up a portion of the equity appreciation
in exchange for principal protection.

These are often of interest to clients wishing to participate in some of the more volatile asset classes or
emerging markets, but who are unwilling to risk their principal or who may have long-term financial
obligations. Generally, investors will receive 100% of the principal amount of their notes if they are held
to maturity, regardless of the performance of the underlying investment. Maturities generally range
from five to seven years, and investors should be willing to hold the investments to maturity.

489
6. D Chapter 1, Section 2.3.2
The relationship between the spot exchange rate and forward exchange rate for two currencies is
simply given by the differential between their respective nominal interest rates over the term being
considered. The relationship is purely mathematical and has nothing to do with market expectations.

7. C Chapter 5, Section 2.1.1

The FCA lists the following positive aspects of stock lending in its guidance to the investment
community:

• It can increase the liquidity of the securities market by allowing securities to be borrowed
temporarily, thus reducing the potential for failed settlements and the penalties this may incur.
• It can provide extra security to lenders through the collateralisation of a loan.
• It can support many trading and investment strategies that otherwise would be extremely difficult
to execute.
• It allows investors to earn income by lending their securities on to third parties.
• It facilitates the hedging and arbitraging of price differentials.

8. A Chapter 2, Section 2.2.7

They are also quite useful to the banking industry, where contingent convertible bonds can be issued
whereby conversion happens when an uplift in the percentage of capital is required in order for the
bank to remain solvent.

9. A Chapter 8, Section 3.4.1

Portfolio insurance (also referred to as hedging) is a technique for limiting the potential loss on a
portfolio using derivatives, at the expense of giving up some of the potential profits. The approach
is based on options theory, where the holder of a call option has unlimited exposure to any potential
profits, but limited exposure to losses. As an alternative, one could consider the purchase of put options
where the fund manager has the right, but not the obligation, to put a stock or instrument to the option
seller at a specified price that may, in the case of a substantial fall in the value of the asset, be at a much
higher price than the current trading price. This acts like a form of insurance. CFDs and futures can
also be used as a useful form of portfolio insurance. Although hedging minimises risk, the cost of such
insurance needs to be taken into account as it also reduces the profit potential of the portfolio. With
CFDs, the margined nature of the product increases the cost daily which, over time, can erode the value
of the insurance/hedge.

10. B Chapter 1, Section 2.1.5

In trading foreign exchange, or any instrument for that matter, if one is using proper risk management
techniques it is customary to establish what is called a stop loss for the position taken. This will provide a
safety mechanism so that, if the trade turns adversely against the trader, then the position will be exited
at a pre-determined level.

490
 Multiple Choice Questions

11. D Chapter 5, Section 1.3

The SDRT regulations impose an obligation on the operator of CREST (Euroclear UK & Ireland) to collect
SDRT on transfers going through the system.

Ultimate liability for paying SDRT falls upon the purchaser or transferee. However, unlike stamp duty,
there is an overlying concept of accountable persons (which arises under the SDRT Regulations 1986). In
general terms, the accountable person rules are designed to place the primary reporting and payment
obligations upon an involved financial intermediary, such as a broker. In many cases, typically those
involving on-market sales of listed shares, such an intermediary will be accountable (although the
accountable person will recover from the liable person any SDRT paid on that person’s behalf).

The tax is charged at 0.5% on the consideration given for the transfer, payable by the purchaser. Unlike
stamp duty, there is no rounding to the next £5, and it is charged to the penny.

12. A Chapter 4, Section 1.2.1

The value of an OEIC’s share is determined by the net asset value (NAV) of its underlying investments.
For example, if the underlying investments are valued at £125,000,000 and there are 100,000,000 shares
in issue, the NAV of each share is £1.25. The open-ended nature of an OEIC means that it cannot trade at
a discount to NAV, as an investment trust can.

13. A Chapter 2, Section 4.3.3

A shelf document can be produced at any time during the year, although there are likely to be
considerable cost savings if an issuer does it in conjunction with the production of its annual report and
accounts. The shelf document will remain current until the earliest of:

• the publication of the issuer’s next audited annual report and accounts
• 12 months from the date the shelf document is published on the website (being the maximum
period under European law)
• the date the shelf document is removed from the website at the written request of the issuer.

The shelf document must be formally approved by the UK Listing Authority before publication, and
registered.

14. A Chapter 4, Section 3.4

The Investment Association (IA), the body that represents the UK investment management industry, has
published a classification system for the investment strategies. These are broadly followed by the major
collective investment vehicles – unit trusts and OEICs. The IA classifications are based on broad criteria.
Within particular categories such as UK All Companies, there will be some funds focusing on mainstream
blue chip stocks, some funds investing in recovery stocks and some funds concentrating on special
situations such as companies that are rich in cash relative to their share price.

491
15. A Chapter 7, Section 2.4.6
The sixth type of behaviour amounting to market abuse is dissemination, which consists of the
dissemination of information by any means which gives, or is likely to give, a false or misleading
impression, as to a qualifying investment, by a person who knew or could reasonably be expected to
have known that the information was false or misleading.

An example of behaviour which, in the opinion of the FCA falls within this category, is knowingly
or recklessly spreading false and leading information about a qualifying investment through the
media. An example of the prohibited behaviour is the posting of information which contains false or
misleading statements about a qualifying investment on an internet bulletin board or in a chat room in
circumstances where the person knows that the information is false or misleading.

16. D Chapter 6, Section 1.2.3

Gross profit margin, the percentage of gross profit to turnover or total revenues, will fall as the company
lowers its sales prices but still faces similar costs. The impact on asset turnover, profit before taxes and
earnings per share, will depend on how many more sales the company manages to achieve as a result
of the strategy.

17. A Chapter 6, Section 1.7.1

The accounting policies adopted by a company can significantly impact its ratios and can also introduce
a range of problems for comparison between different firms operating in different sectors of the
economy and even more for international comparisons. For example, if non-current assets are revalued,
depreciation charges will be higher. Hence, profits will be lower but, on the statement of financial
position, more non-current assets mean a higher capital employed figure. In consequence, the return on
capital employed will be reduced (lower profits divided by higher capital employed).

In comparing two companies where one revalues non-current assets and the other does not, or in
comparing one company to another where non-current assets have been revalued in between, it has to
be expected that there will be a distortion between the ratios as a result of this accounting policy.

18. A Chapter 3, Section 2.1.4

One consequence of a dual listing for multi-national corporations is in reference to the Sarbanes-Oxley
Act (often referred to as SOX). Passed in 2002 by the US Congress, the Act’s objective is ‘to protect
investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities
laws, and for other purposes’. It applies to US public companies and their global subsidiaries, and to
foreign companies that have shares listed on US stock exchanges. As a result of their dual listing,
SOX therefore applies to some of the UK’s largest companies by market capitalisation, such as British
Petroleum, HSBC, Prudential, Royal Dutch Shell and Vodafone, as well as many other international
companies.

492
 Multiple Choice Questions

19. A Chapter 4, Section 1.3.4

The following principles, set down by the FCA, apply to a company that seeks to apply for a listing as an
investment trust:

• The investment managers must have adequate experience.

• An adequate spread of investment risk must be maintained.
• The investment trust must not control, seek to control or actively manage companies in which it
invests.
• The board of the investment trust must be free to act independently of its management.
• The investment trust must seek approval by HMRC (under s.842, Income and Corporation Taxes Act
1988 (ICTA 1988)).
• The trust itself does not have direct dealings with the public. If the management company offers
the shares of the trust for sale to the public through a savings scheme, then the company must be
authorised by the FCA to carry on investment business under the Financial Services and Markets Act
2000.

20. B Chapter 7, Section 4.3

Not all risk can be diversified away. Systematic or market risk cannot be diversified away by holding a
range of investments within one particular market such as equities. If the global economy is performing
poorly and share prices generally are falling and returns are declining, a wide and diversified portfolio
of shares is very likely to fall in line with the wider market. The risk of this happening affects the whole
market. An investor with limited funds to invest can achieve a high degree of diversification across asset
classes by investing in collective funds such as unit trusts and investment trusts, and this can reduce
non-systematic, specific risk to very low levels. However, it cannot be eliminated.

21. D Chapter 3, Section 1.1.3

One drawback of preference shares, when compared with ordinary shares, is that if the company starts
to generate large profits the ordinary shareholders will often see their dividends rise, whereas the
preference shareholders still get a fixed level of dividend. To counter this, some preference shares offer
the opportunity to participate in higher distributions.

Preference shares usually carry a fixed dividend, representing their full annual return entitlement.
Participating preference shares will receive this fixed dividend plus an additional dividend, which is
usually a proportion of any ordinary dividend declared. As such, they participate more in the risks and
rewards of ownership of the company.

22. C Chapter 2, Section 2.2.6

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

493
23. A Chapter 7, Section 1.2.4
The Investment Association has published a classification system for the diverse array of funds available to UK
investors including unit trusts and OEICs.

The groups correspond to broadly different investment objectives.

• Some income funds principally target immediate income, while others aim to achieve growing income.
• Growth funds, which mainly target capital growth or total return, are distinguished from those that are
designed for capital protection.
• Specialist funds cover other more niche areas of investment.

24. C Chapter 7, Section 3.6.1

Sovereign spreads are one further type of spread which is becoming increasingly important for
investment managers to follow, and this one relates to the difference between the yields available on
the government bonds of different sovereigns. This has become especially significant since 2010 when
there have been much publicised difficulties for peripheral states in the eurozone countries in terms of
their creditworthiness.

Factors which will affect sovereign spreads are clearly related to macroeconomic circumstances in the
various economies and, specifically, the differences in such factors as GDP growth rates, the level of
public finance deficits and the competitiveness of the two economies for which the spread is quoted.

25. D Chapter 7, Section 4.2

Systemic risk is sometimes erroneously referred to as systematic risk. The latter term has quite a specific
meaning in financial theory and is a cornerstone of the capital asset pricing model (CAPM), where it
refers to what might better be described as market risk or more specifically non-diversifiable risk.

Systemic risk is the risk of collapse of the entire financial system or entire market, as opposed to risk
associated with any one individual entity, group or component of the financial system.

To say that the entire financial system might collapse may have appeared fanciful until relatively
recently. But in the second half of 2008, when major financial institutions such as Lehman Brothers,
AIG, Fannie Mae and Freddie Mac effectively went bankrupt or entered conservatorship of the US
government, the spectre of a financial meltdown became more credible. Central bankers, including the
Governor of the Bank of England, have since gone on record to describe how close the world’s financial
system came to total collapse.

26. C Chapter 8, Section 1.1

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

494
 Multiple Choice Questions

27. C Chapter 5, Section 1.5.1

Registered title simply means ownership that is backed by registration. In terms of share ownership,
registered title gives shareholders the right to vote on important company matters, to claim dividends
on their shares, and to participate in other corporate actions such as rights issues.

28. A Chapter 6, Section 1.4.1

Financial analysts often distinguish between solvency and liquidity. In essence, the solvency of a
company relates to its long-term position with respect to its assets and liabilities, and its commitments
to finance its statement of financial position. Liquidity issues are more concerned with the short-term
operating issues of a business and concern its ability to meet its ongoing cash requirements.

29. B Chapter 3, Section 1.1.3

One drawback of preference shares when compared with ordinary shares is that if the company starts
to generate large profits, the ordinary shareholders will often see their dividends rise, whereas the
preference shareholders still get a fixed level of dividend. To counter this, some preference shares offer
the opportunity to participate in higher distributions.

30. B Chapter 3, Section 3.1.3

The traditional rejoinder to this suggestion is that large institutions operate with Chinese walls which
separate the different functions within them and that the confidentiality and observance of secrecy by
different divisions of the firm will ensure that this does not create a conflict of interest for the institution.

31. A Chapter 5, Section 1.4.4

Detailed specifications pertaining to the standards of service required by an investor from its custodian
are spelt out in a service level agreement. This lays down required standards for service areas including
the following:

• Record-keeping and maintenance of accurate and up-to-date documentation.

• Settlement on both recognised exchanges and in OTC markets.
• Communication and reporting.
• Processing of corporate actions, eg, rights issues and other capitalisation matters.
• Income-processing, for example from dividends and coupon payments.
• Tax services.
• Cash management.
• Management information systems.
• Stock lending and borrowing.
• Market information and market knowledge.
• Standards of service expected from account officers and relationship managers that represent
primary points of contact with the investor.

495
A custody agreement is likely to address the following issues:

• The method through which the client’s assets are received and held by the global custodian.
• Reporting obligations and deadlines.
• Guidelines for use of CSDs and other relevant use of financial infrastructure.
• Business contingency plans to cope with systemic malfunction or disaster.
• Liability in contract and claims for damages.
• Standards of service and care required under the custody relationship.
• A list of persons authorised to give instructions.
• Actions to be taken in response to instructions and actions to be taken without instructions.

32. A Chapter 2, Section 1.3.2

The GRY or yield to maturity of a bond represents the total return from a bond, after considering the
price paid, all of the coupon payments and the repayment of the principal. Unlike flat yield, which is a
rather simplistic measure, the yield to maturity is the benchmark used in the markets for measuring the
so-called yield of a bond.

33. A Chapter 3, Section 2.1.2

The non-dilutive type of follow-on offering is when privately held shares are offered for sale by company
directors or other insiders (such as venture capitalists) who may be looking to diversify their holdings.
Because no new shares are created, the offering is not dilutive to existing shareholders. However, the
proceeds from the sale do not flow into the company.

34. B Chapter 2, Section 5.4.3

Yield and price are inversely proportional to each other. As a simple rule of thumb, if the current price of
the bond is higher than the par value, the yield is lower than the coupon, and, if the current price of the
bond is lower than the par value, the required yield is higher than the coupon value.

35. D Chapter 7, Section 1.2.3

The principal differences between fundamental and technical analysis can be summarised as follows:

• Analysing financial statements versus charts – at a basic level, fundamental analysis involves the
analysis of the company’s balance sheet, cash flow statement and income statement. Technical
analysis considers that there is no need to do this, as a company’s fundamentals are all accounted
for in the price and the information needed can be found in the company’s charts.
• Time horizon – fundamental analysis takes a relatively long-term approach to investment. Technical
analysis uses chart data over a much shorter time-frame of weeks, days and even minutes.
• Investing versus trading – fundamental analysis is used to make long-term investment decisions.
Technical analysis is used to determine short-term trading decisions.

36. D Chapter 5, Section 1.2

Liquidity risk refers to the risk that a counterparty will not settle for the full value at the due date, but
could do so at some unspecified time thereafter, causing the party which did not receive its expected
payment to finance the shortfall at short notice.

496
 Multiple Choice Questions

37. A Chapter 2, Section 6.6.2

Convertible bonds enable the holder to exploit the growth potential in the equity while retaining the
safety net of the bond. It is for this reason that convertible bonds trade at a premium to the value of the
shares they can convert into. If there were no premium, there would be an arbitrage opportunity for
investors to buy the shares more cheaply via the convertible than in the equity market.

It is common to express the premium as a percentage of the conversion value so this convertible has a
premium of £16.50/£97.50 or 16.9%.

38. A Chapter 4, Section 1.5.4

Stratified sampling involves choosing investments that are representative of the index in similar manner
to the manner in which statisticians conduct surveys on a sampling which reflects the stratification of an
entire population. For example, if a sector makes up 16% of the index, 16% of shares in that sector will
be held, even though the proportions of individual companies in the index may not be matched. The
expectation is that, with stratified sampling, overall the tracking error or departure from the index will
be relatively low. The amount of trading of shares required should be lower than with full replication,
since the fund will not need to track every single constituent of an index. This should reduce transaction
costs and therefore help to avoid such costs eroding overall performance.

39. A Chapter 8, Section 4.4.1

Portfolio performance may be measured by reference to a relevant peer group.

The peer group will be portfolio or fund managers who are also responsible for the full range of
management decisions (asset allocation and stock selection) for a portfolio or fund with similar
objectives and constraints. With peer group benchmarking, the fund management objectives may be
defined as, for example, ‘to outperform the peer group median performance’.

Peer group benchmarking has been criticised as tending to produce asset allocation decisions based
simply on what other funds are doing, rather than on the needs of the fund involved.

A peer group benchmark does not show whether a portfolio manager is performing well in absolute
terms. If all of the peer group are poor managers, they may be at the top of the peer group, but still be
showing poor absolute performance.

40. C Chapter 5, Section 1.4.6

In their capacity as fiduciaries, pension fund trustees are generally required to uphold the following
prudential standards:

• They must demonstrate that they have the necessary familiarity with the structure and aims of their
pension scheme and have an appropriate level of training and skill to carry out their responsibilities
to scheme members effectively.
• Fiduciaries have a responsibility to monitor and review the tasks that they delegate to third parties
(including custodians and investment management companies) in order to ensure that these tasks
are discharged effectively.

497
• The duty of loyalty demands that trustees administer their pension scheme solely in the best
interests of the scheme members.
• Trustees must avoid undue risk in the way that they manage scheme assets and appoint
intermediaries to manage or administer scheme assets on the scheme’s behalf.

41. A Chapter 6, Section 1.4.1

Liquidity ratios aim to establish the following:

• Does a company have the resources to meet its operating requirements from its working capital on
a timely basis?
• Can a company actually realise those resources quickly enough? In other words does it have
sufficient ability to raise cash when required, to pay off the liabilities as they fall due?

42. B Chapter 8, Section 3.2.1

A bottom-up approach will examine the fundamental characteristics of many individual stocks and the
portfolio will be constructed from those which best satisfy the fund’s objectives and constraints. This
approach is appropriate when the manager is more concerned with the merits of individual securities
and the resulting combination and the broad characteristics of the portfolio will tend to emerge from
the constituents rather than having been engineered or assembled from the top-down approach.

43. A Chapter 1, Section 1.4

The purpose of the repo market as implemented by central banks, such as the Bank of England and the
European Central Bank, is to provide or remove liquidity from the money markets. If the central bank
wishes to increase the money supply, it will enter into repo agreements as the reverse repo participant,
with other money market institutions such as banks being the repo participant. In contrast, if the central
bank wishes to drain liquidity from the money markets then it will use repo transactions. This time the
central bank will be the repo participant, initially selling instruments and therefore withdrawing cash
from the system.

44. C Chapter 6, Section 1.2.2

Earnings Per Share (EPS) is one of the most important figures for investors and financial analysts and is
reflected at the bottom of the statement of profit and loss, in pence. EPS is the amount of profit after tax
that has been earned per ordinary share. EPS is calculated as follows:

Net Income for the financial year

EPS =
Number of ordinary shares in issue

45. A Chapter 4, Section 1.2.1

With the implementation of the Financial Services and Markets Act 2000 (FSMA 2000), the range of
UK-authorised OEICs was extended to be similar to that of unit trusts, including money market funds
and property funds.

498
 Multiple Choice Questions

46. A Chapter 2, Section 3.1

Subordinated eurobonds, as with subordinated notes in general, are ones which have a junior or inferior
status within the capital structure hierarchy and have greater risk than a senior or secured note.

47. B Chapter 6, Section 1.6.4

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

Earnings per share

Dividend cover =
Net dividend per share

48. C Chapter 1, Section 1.4

The purpose of the repo market as implemented by central banks, such as the Bank of England and
the European Central Bank, is to provide or remove liquidity from the money markets. If the central
bank wishes to increase the money supply, it will enter into repo agreements with other money market
institutions, such as banks, as the reverse repo participant, providing cash for the collateral provided
under the repo. If the central bank wishes to drain liquidity it will use a repo mechanism with the central
bank acting as the repo participant.

49. C Chapter 1, Section 2.4.6

A synthetic agreement for forward exchange (SAFE) is a variation on the short-term currency swap, in
which there is no actual exchange of principal at inception or at maturity, the arrangement being a CFD
based on notional cash sums. In this case large notional sums may be referenced in the swap agreement
but the resulting cash flow may be relatively small, especially if there has been only a slight variation
between the rates at the time of inception and at the time of maturity.

When the two parties agree to execute a SAFE, they agree the exchange rates at which the notional
deals will be executed at inception and maturity. At maturity, one party pays to the other the difference
in the value of the secondary currency between the rate originally contracted and the rate actually
prevailing. In essence this is exactly how a CFD for any asset purchase works, including equity CFDs.

50. B Chapter 2, Section 1.4.1

HICPs were originally developed in the EU to assess whether prospective members of the European
Monetary Union would pass the required inflation-convergence criterion; they then graduated to acting
as the measure of inflation used by the ECB to assess price stability in the euro area.

51. A Chapter 8, Section 5.3

Financial innovation over the last 20 years has been extraordinary. This has been especially the case in
terms of the products that are now available to investors, such as CFDs, ETFs, new kinds of collective
investment vehicles and the proliferation of derivatives including CDSs and other asset-backed
securities.

499
52. D Chapter 3, Section 2.1.3
Delisting can be voluntary or involuntary and can be for a variety of reasons. Such reasons are:

• failure to meet the listing regulations or requirements of the exchange. Listing requirements include
minimum share prices, certain financial ratios and minimum sales levels
• the company goes out of business
• the company declares bankruptcy
• the company has become a private company (eg, resulting from a management buy out) after a
merger or acquisition
• the company wishes to reduce or remove an element of its regular reporting requirements
• the company no longer seeks a listing because of factors such as low volumes on the exchange on
which it is listed or for financial reasons, eg, to save on listing fees.

53. A Chapter 4, Section 1.2.1

An OEIC may take the form of an umbrella fund, with a number of separately priced sub-funds adopting
different investment strategies or denominated in different currencies. All sub-funds will have a
separate client register and asset pool.

54. A Chapter 6, Section 1.2.2

For interest, royalties and dividends, revenue should be recognised as follows:

• Interest – on a time proportion basis that takes into account the effective yield.
• Royalties – on an accruals basis.
• Dividends – when the shareholders’ right to receive payment is established.

55. A Chapter 5, Section 1.1.2

For SETS trades, CREST provides the option to LSE member firms to settle with LCH ltd or SIX x-clear AG
as counterparty on a gross basis or on a net basis. If a firm has 20 orders executed in the same security
through SETS, they can either settle 20 trades with LCH.Clearnet or SIX x-clear AG (settling gross), or
choose to have all 20 trades netted so that the firm just settles a single transaction.

56. A Chapter 1, Section 1.1.9

The FSCS will provide a £1 million protection limit for temporary high balances held with an individual’s
bank, building society or credit union if it fails.

57. A Chapter 8, Section 3.3.5

Money market deposits respond immediately to changes in interest rates – good when interest rates are
rising.

58. B Chapter 1, Section 1.3.1

Commercial Paper (CP) yields are quoted on a discount basis. Virtually all countries use an actual/360
basis, except the UK, which uses an actual/365 basis.

500
 Multiple Choice Questions

59. A Chapter 2, Section 2.1.4

Mortgage-backed securities issues are often sub-divided into a variety of classes (or tranches), each
tranche having a particular priority in relation to interest and principal payments. Typically, as the
underlying payments on the mortgage loans are collected, the interest on all tranches of the bonds
is paid first. As loans are repaid, the principal is paid back to the first tranche of bondholders, then the
second tranche, third tranche and so on.

60. C Chapter 4, Section 1.2.1

An OEIC has an authorised corporate director (ACD), who may be the only director. The responsibilities
of the ACD include the day-to-day management of the fund.

61. A Chapter 3, Section 2.1.5

Prices are subject to exchange rate fluctuation, as well as local market price formation from natural
supply and demand. Sometimes, small differences can exist between the prices of both markets
(taking into account the exchange rate) but this is usually very small, momentary and is usually quickly
arbitraged away. Some high frequency traders (HFTs) will employ trading algorithms looking to trade
across markets.

62. D Chapter 8, Section 2.5

Sustainability funds are those that focus on the concept of sustainable development, concentrating
on those companies that tackle or pre-empt environmental issues head-on. Unlike ethical investing
funds, sustainability funds, sometimes known as light green funds, are flexible in their approach to
selecting investments. The following are some examples of features that an investor may wish to avoid:
pesticides, land abuse, deforestation, polluters and genetic research.

63. B Chapter 5, Section 1.1.3

The move to T+2 was proposed by the EU Central Securities Depositories Regulation (CSDR), which
requires the alignment of settlement periods within the EU and EEA countries.

Among the key advantages of a shorter settlement cycle is a shorter period of providing margin for CCP
clearing positions.

64. A Chapter 3, Section 2.2.7

The PSR is a subsidiary of the FCA but has its own statutory objectives, managing director and board. It
is funded by the payments industry and is accountable to the UK Parliament.

65. C Chapter 2, Section 2.2.4

When the building society has demutualised, its PIBSs are reclassified as perpetual subordinated bonds
(PSBs). Both PIBSs and PSBs can be traded on the LSE.

501
66. C Chapter 4, Section 2.3
Most structured investments fall into one of three categories, each with its own risk/return profile:

• principal-protected
• buffer-zone
• return-enhanced.

67. B Chapter 7, Section 1.2.1

Fundamental analysis looks at both quantitative factors, such as the numerical results of the analysis of
a company and the market it operates in, and qualitative factors, such as the quality of the company’s
management, the value of its brand, and areas such as patents and proprietary technology.

68. D Chapter 5, Section: 1.1.2

CREST updates the register of shareholders – it maintains the so-called operator register for UK
companies’ dematerialised shareholdings.

69. C Chapter 8, Section: 2.1.1

Time horizon refers to the period over which a client can consider investing their funds.

70. B Chapter 2, Section 2.1.1

Like other companies or corporates, financial institutions issue bonds to finance borrowing. These
financial institutions also arrange borrowing for themselves and others by creating special purpose
vehicles (SPVs) to enable money to be raised that does not appear within the accounts of that entity.
This type of finance is often described as off-balance-sheet finance, because it does not appear in the
balance sheet that forms part of the company’s accounts.

71. A Chapter 3, Section 2.2.5

All holders of the securities of an offeree company of the same class must be afforded equivalent
treatment.

72. A Chapter 5, Section 1.1.4

The settlement period for UK equities is T+2, while for UK gilts it is T+1.

73. C Chapter 6, Section 1.1.2

Depreciation is applied to tangible non-current assets, such as plant and machinery. This requirement
does not, however, apply to freehold land and non-current asset investments which, by not having a
limited economic life, are not usually depreciated.

502
 Multiple Choice Questions

74. A Chapter 4, Section 2.7.1

The rates paid on MMFs should reflect wholesale money market rates represented by LIBOR – established
daily as a summary of actual rates offered in the money market between banks.

75. C Chapter 1, Section 1.2

UK Treasury bills are short-term loan instruments, guaranteed by the UK government, with a maturity
date of less than one year at issue. They pay no coupon, and consequently are issued at a discount to
their nominal value, the discount representing the return available to the investor.

76. A Chapter 7, Section 1.2.2

Point and figure charts record significant price movements in vertical columns by using a series of Xs to
denote significant up moves and Os to represent significant down moves, without employing a uniform
timescale. Whenever there is a change in the direction of the security’s price, a new column is started.

77. C Chapter 2, Section 2.2.7

Contingent convertible bonds are convertible bonds where a price is set, which the underlying equity
share price must reach before conversion can take place. They are also quite useful to the banking
industry, where contingent convertible bonds can be issued whereby conversion happens when uplift
in the percentage of capital is required in order for the bank to remain solvent. Thus, conversion into
shares is automatic if the specified capital ratio is likely to be breached.

78. D Chapter 7, Section 1.2.3

Fundamental and technical analyses are the two main methodologies used for investment analysis.
Fundamental analysis takes a relatively long-term approach to investment. Technical analysis uses chart
data over a much shorter time frame of weeks, days and even minutes.

79. B Chapter 8, Section 2.2

The real return takes into account the inflation rate and in times of excessive inflation the real returns
available may well become negative.

80. A Chapter 1, Section 1.1.5

Certificates of deposit (CDs) are negotiable bearer securities issued by commercial banks in exchange
for fixed-term deposits, with a fixed term and a fixed rate of interest, set marginally below that for an
equivalent bank time deposit.

503
504
Syllabus Learning Map
506
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section

Element 1 Cash, Money Markets and the Foreign Exchange Market Chapter 1
Cash Instruments and Markets
1.1
On completion, the candidate should be able to:
Be able to analyse the main investment characteristics, behaviours
and risks of cash deposit accounts:
• deposit-taking institutions and credit risk assessment
• term, notice, liquidity and access
1.1.1 • fixed and variable rates of interest 1.1
• inflation
• statutory protection
• foreign currency deposits
• structured deposits
Be able to analyse the main investment characteristics, behaviours
and risks of Treasury bills:
• purpose and method of issue
1.1.2 • minimum denomination 1.2
• normal life
• zero coupon and redemption at par
• market access, trading and settlement
Be able to analyse the main investment characteristics, behaviours
and risks of commercial paper:
• purpose and method of issue
• maturity
1.1.3 • discounted security 1.3
• unsecured and secured
• asset-backed
• credit rating
• market access, trading and settlement
Be able to analyse the main investment characteristics, behaviours
and risks of repurchase agreements:
• purpose
1.1.4 1.4
• sale and repurchase at agreed price, rate and date
• tri-party repos
• documentation
Foreign Exchange Instruments and Markets
1.2
On completion, the candidate should be able to:
Understand the role, structure and main characteristics of the foreign
exchange market:
• OTC market
• quotes, spreads and exchange rate information
1.2.1 2.1
• market participants and access to markets
• volume, volatility and liquidity
• risk mitigation: rollovers and stop losses
• regulatory/supervisory environment

507
 Syllabus Unit/ Chapter/
Element Section
Understand the determinants of spot foreign exchange prices:
• currency demand – transactional and speculative
• economic variables
1.2.2 2.2
• cross-border trading of financial assets
• interest rates
• free, pegged and managed rates
Be able to calculate forward foreign exchange rates using:
1.2.3 • adding or subtracting forward adjustments 2.3
• Interest rate parity
Be able to analyse how foreign exchange contracts can be used to
buy or sell currency relating to overseas investments or to hedge non-
domestic currency exposure:
• spot contracts
1.2.4 2.3
• forward contracts
• currency futures
• currency options
• non-deliverable forwards

Element 2 Fixed-Income Securities Chapter 2

Characteristics of Fixed-Income Securities
2.1
On completion, the candidate should be able to:
Understand the main characteristics of fixed-income securities:
• short-, medium- and long-dated
• dual-dated
2.1.1 • Floating rate 1.1
• zero coupon
• use of ratings
• credit enhancements
Understand the main risks of fixed-income securities:
• the impact of ratings
2.1.2 1.1
• the concept of risk-free
• currency, credit and inflation risks
Characteristics of Sovereign and Government Bonds
2.2
On completion, the candidate should be able to:
Understand the main investment characteristics, behaviours and risks
2.2.1 1.2
government debt (for example, Germany, Japan, the UK and the US)
Understand the relationship between interest rates and bond prices:
• yield (flat yield and yield to maturity)
2.2.2 • interest payable 1.3
• accrued interest (clean and dirty prices)
• effect of changes in interest rates

508
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Understand the main investment characteristics, behaviours and risks
of index-linked debt:
• retail prices and consumer prices indices as measures of inflation
• consumer prices index
2.2.3 1.4
• process of index linking
• indexing effects on price, interest and redemption
• return during a period of zero inflation
• harmonised price index
Understand the main issuers and characteristics of supranational and
2.2.4 1.5
public authority debt
Characteristics of Corporate Debt
2.3
On completion, the candidate should be able to:
Understand the main investment characteristics, behaviours and risks
of corporate debt:
• financial institutions and special purpose vehicles
• fixed and floating charges
2.3.1 • debentures 2
• types of asset-backed securities
• mortgage-backed securities
• securitisation process
• roles of participants
Understand the main investment characteristics, behaviours and risks
of the main types of unsecured debt:
• income bonds
2.3.2 • subordinated 2.2
• high yield
• convertible bonds
• contingent convertible bonds
Characteristics of Eurobonds
2.4
On completion, the candidate should be able to:
Understand the main investment characteristics, behaviours and risks
of eurobonds:
• types of issuer: sovereign, supranational and corporate
• types of eurobond: straight, FRN/VRN, subordinated, asset-backed,
convertible
2.4.1 3
• international bank syndicate issuance
• immobilisation in depositories
• continuous pure bearer instrument: implications for interest and
capital repayment
• accrued interest, ex-interest date

509
 Syllabus Unit/ Chapter/
Element Section
Issuing Fixed-Income Securities
2.5
On completion, the candidate should be able to:
Understand the responsibilities and processes of the UK Debt
Management Office in relation to the management and issue of UK
government debt:
2.5.1 • gilts 4
• Treasury bills
• primary market makers: gilt edged market makers (GEMMs)
• intermediaries: inter-dealer brokers (IDBs)
Understand the main bond pricing benchmarks and how they are
applied to new bond issues:
2.5.2 • spread over government bond benchmark 4.2
• spread over/under inter-bank benchmarks
• spread over/under swap
Understand the purpose, structure and process of the main methods
of origination and issuance and their implications for issuers and
investors:
2.5.3 • scheduled funding programmes and opportunistic issuance 4.3
(eg, MTN)
• auction/tender
• reverse inquiry (under MTN)
Fixed-Income Markets and Trade Execution
2.6
On completion, the candidate should be able to:
Understand the role, structure and characteristics of government
bond markets in the developed markets of the UK, Germany, Japan
and the US, including:
• market environment: relative importance of exchange versus OTC
2.6.1 trading versus organised trading facilities (OTFs) 5.1
• participants – primary dealers, broker dealers and inter-dealer
brokers
• access considerations
• regulatory/supervisory environment
Understand the differences between the developed markets and the
2.6.2 5.1.6
emerging economies
Understand the purpose and key features of the global strip market:
• result of stripping a bond
2.6.3 5.2
• zero coupon securities
• access considerations

510
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Understand the role, structure and characteristics of global corporate
bond markets:
• decentralised dealer markets and dealer provision of liquidity
• relationship between bond and equity markets
2.6.4 • bond pools of liquidity (including OTFs) versus centralised 5.3
exchanges
• access considerations
• regulatory/supervisory environment
• ICMA and other relevant trade associations:
Understand the different quotation methods, and the circumstances
in which they are used
2.6.5 • yield 5.4
• spread
• price
Valuation of Fixed-Income Securities
2.7
On completion, the candidate should be able to:
Understand the purpose, influence and limitations of global credit
rating agencies, debt seniority and ranking in cases of default/
bankruptcy:
• senior
2.7.1 6.1
• subordinated
• mezzanine
• payment in kind (PIK)
• tiers of bank debt
Be able to analyse sovereign, government and corporate credit ratings
from an investment perspective:
• main rating agencies
• country rating factors
2.7.2 • debt instrument rating factors 6.2
• investment and sub-investment grades
• use of credit enhancements
• impact of grading changes
• considerations when using credit rating agencies
Be able to analyse the factors that influence bond pricing:
• credit rating
• default risk
2.7.3 6.3
• impact of interest rates
• market liquidity
• inflation

511
 Syllabus Unit/ Chapter/
Element Section
Be able to analyse fixed-income securities using the following
valuation measures and understand the benefits and limitations of
using them:
• flat yield
2.7.4 • yield to maturity 6.4
• nominal and real return
• gross redemption yield (using internal rate of return)
• net redemption yield
• modified duration
Be able to analyse the specific features of bonds from an investment
perspective:
• coupon and payment date
2.7.5 • maturity date 6.5
• embedded put or call options
• convertible bonds
• exchangeable bonds
Be able to calculate and interpret:
• simple interest income on corporate debt
2.7.6 • conversion premiums on convertible bonds 6.6
• flat yield
• accrued interest (given details of the day count conventions)

Element 3 Equities Chapter 3

Characteristics of Equities
3.1
On completion, the candidate should be able to:
Understand the main investment characteristics, behaviours and risks
of different classes of equity:
• ordinary, cumulative, participating, redeemable and convertible
3.1.1 preference shares 1.1
• voting rights, voting and non-voting shares
• ranking for dividends
• ranking in liquidation
Understand the purpose, main investment characteristics, behaviours
and risks of depositary receipts:
• American depositary receipts
• global depositary receipts
3.1.2 1.2
• beneficial ownership rights
• structure
• unsponsored and sponsored programmes
• transferability

512
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Issuing Equity Securities
3.2
On completion, the candidate should be able to:
Understand the purpose and key features of the following:
• primary issues
• secondary issues
3.2.1 • issuing, listing and quotation 2.1
• dual listings
• cross listings
• delisting (cancelling)
Understand the main regulatory, supervisory and trade body
framework supporting UK financial markets:
• Companies Acts
• The Financial Conduct Authority (FCA) and UK Listing Authority
(UKLA)
3.2.2 2.2
• HM Treasury
• Payment Systems Regulator
• The Panel on Takeovers and Mergers (POTAM)
• exchange membership and rules
• relevant trade associations and professional bodies
Understand the structure of the UK exchanges, the types of securities
traded on their markets, and the criteria and processes for companies
seeking admission:
• London Stock Exchange Main Market
3.2.3 • high-growth segment 2.3
• AIM
• Aquis
• market participants
• implications for investors
Understand the process of issuing securities in the UK with or without
a prospectus:
3.2.4 • Prospectus Directive (PD) or equivalent where applicable 2.4
• eligibility and registration criteria for natural persons and small
and medium-sized enterprises (SMEs)
Understand the purpose, structure and stages of an initial public
offering (IPO) and the role of the origination team
• structure – base deal plus greenshoe
3.2.5 2.5
• stages of an IPO
• underwritten versus best efforts
• principles and process of price stabilisation
Understand the benefits for the issuer and investors of the different
3.2.6 2.5
processes used in an IPO

513
 Syllabus Unit/ Chapter/
Element Section
Equity Markets and Trade Execution
3.3
On completion, the candidate should be able to:
Apply fundamental UK regulatory requirements with regard to trade
execution and reporting:
• best execution
3.3.1 3.1
• aggregation and allocation
• management of conflicts of interests and prohibition of front
running
Understand the key features of the main trading venues:
• regulated and designated investment exchanges
• recognised overseas investment exchanges
3.3.2 • whether quote- or order-driven 3.2
• main types of order – limit, market, fill or kill, execute and
eliminate, iceberg, named
• liquidity and transparency
Understand the key features of alternative trading venues:
• multilateral trading facilities (MTFs)
3.3.3 • organised trading facilities (OTFs) 3.3
• systematic internalisers
• dark pools
Understand algorithmic trading:
• reasons
3.3.4 • high frequency trading 3.4
• potential consequences for the market (eg, flash crashes, increased
liquidity, increased volume, illusion of volume)
Understand the concepts of trading cum, ex, special cum and special
ex:
3.3.5 • the meaning of books closed, ex-div and cum div, cum, special ex, 3.5
special cum and ex rights
• effect of late registration
Apply knowledge of the key differences between international
markets:
• regulatory and supervisory environment
3.3.6 3.6
• corporate governance
• liquidity and transparency
• access and relative cost of trading
Be able to assess how the following factors influence equity markets
and equity valuation:
• trading volume and liquidity of domestic and international
securities markets
3.3.7 • relationship between cash and derivatives markets and the effect 3.7
of timed events
• market consensus and analyst opinion
• changes to the economic outlook
• implications of foreign exchange

514
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Understand the purpose, construction, application and influence of
indices on equity markets:
• market regional and country sectors
3.3.8 3.8
• market capitalisation sub-sectors
• free float and full market capitalisation indices
• fair value-adjusted indices
Accounting for Corporate Actions
3.4
On completion, the candidate should be able to:
Understand the purpose and structure of corporate actions and their
implications for investors:
• stock capitalisation or consolidation
3.4.1 • stock and cash dividends 2.1
• rights issues
• open offers, offers for subscription and offers for sale
• placings
Be able to calculate the theoretical effect on the issuer’s share price of
the following mandatory and optional corporate actions:
3.4.2 • bonus/scrip 2.2
• consolidation
• rights issues
Be able to analyse the following in respect of corporate actions:
• rationale offered by the company
3.4.3 2.3
• the dilution effect on profitability and reported financials
• the effect of share buybacks
Warrants and Contracts for Difference
3.5
On completion, the candidate should be able to:
Be able to analyse the main purposes, characteristics, behaviours and
relative risk and return of warrants and covered warrants:
• benefit to the issuing company
3.5.1 • right to subscribe for capital 4.1
• effect on price of maturity and the underlying security
• exercise and expiry
• calculation of the conversion premium on a warrant
Be able to analyse the main characteristics of contracts for difference
(CFDs):
• types and availability of CFDs
• CFD providers – market maker versus direct market access
• margin
3.5.2 • market, liquidation and counterparty risks 4.2
• size of CFD market and impact on total market activity
• differences in pricing, valuing and trading CFDs compared to
direct investment
• differences in pricing, valuing and trading CFDs compared to
spread bets

515
 Syllabus Unit/ Chapter/
Element Section

Element 4 Collective Investments Chapter 4

Characteristics of Collective Investment Funds and Companies
4.1
On completion, the candidate should be able to:
Be able to analyse the key features, accessibility, risks, charges,
valuation and yield characteristics of open-ended investment
4.1.1 1.2
companies (OEICs)/investment companies with variable capital
(ICVCs)/SICAVs
Be able to analyse the key features, accessibility, risks, charges,
4.1.2 1.1
valuation and yield characteristics of unit trusts
Be able to analyse the key features, accessibility, risks, charges,
4.1.3 1.3
valuation and yield characteristics of investment trusts
Be able to compare and contrast the key features, accessibility, risks,
4.1.4 charges, valuation and yield characteristics of real estate investment 1.4
trusts (REITs) with property authorised investment funds (PAIFs)
Be able to analyse the key features, accessibility, risks, charges,
4.1.5 valuation and yield characteristics of the main types of exchange- 1.5
traded products (ETPs)
Be able to analyse the key features, accessibility, risks, charges,
4.1.6 valuation and yield characteristics of the main types of non- 1.6
mainstream pooled investments (NMPI)
Structured Products
4.2
On completion, the candidate should be able to:
Be able to analyse the key features, accessibility, risks, valuation and
yield characteristics of the main types of retail structured products and
investment notes (capital protected, autocall, buffer zone):
• structure
4.2.1 • income and capital growth 2
• investment risk and return
• counterparty risk
• expenses
• capital protection

516
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Analysis of Collective Investments
4.3
On completion, the candidate should be able to:
Be able to analyse the factors to take into account when selecting
collective investments:
• quality of firm, management team and administration
• investment mandate – scope, controls, restrictions and review
process
• investment strategy
• exposure, allocation, valuation and quality of holdings
• prospects for capital growth and income
4.3.1 3
• asset cover and redemption yield
• track record compared with appropriate peer universe and market
indices
• key person risk and how this is managed by a firm
• shareholder base
• measures to prevent price exploitation by dominant investors
• liquidity, trading access and price stability
• suitability

Element 5 Settlement, Safe Custody and Prime Brokerage Chapter 5

Clearing, Settlement and Safe Custody
5.1
On completion, the candidate should be able to:
Understand how fixed income, equity, money market and foreign
exchange transactions are cleared and settled in the UK, Germany, US
and Japan:
• principles of delivery versus payment (DvP) and free delivery
5.1.1 • trade confirmation process 1
• settlement periods
• international central securities depositories (ICSDs) – Euroclear
and Clearstream
• international exchanges
Understand how settlement risk arises, its impact on trading and the
investment process and how it can be mitigated:
• underlying risks: default, credit and liquidity
• relative likelihood of settlement-based risks in developed and
5.1.2 emerging markets 1.2
• effect of DvP and straight-through processing (STP) automated
systems
• risk mitigation within markets and firms
• continuous linked settlement
Understand which transactions may be subject to or exempt from
5.1.3 1.3
financial transaction taxes

517
Syllabus Unit/ Chapter/
Element Section
Understand the principles of safe custody, the roles of the different
types of custodian and how client assets are protected:
• global
5.1.4 • regional 1.4
• local
• sub-custodians
• clearing and settlement agents
Understand the implications of registered title for certificated and
uncertificated holdings:
• registered title versus unregistered (bearer)
5.1.5 1.5
• legal title
• beneficial interest
• right to participate in corporate actions
Understand the characteristics of nominees:
• designated nominee accounts
• pooled nominee accounts
5.1.6 1.6
• corporate nominees
• details in share register
• legal and beneficial ownership
Prime Brokerage and Equity Finance
5.2
On completion, the candidate should be able to:
Understand the purpose, requirements and implications of securities
lending:
• benefits and risks for borrowers and lenders
• function of market makers, intermediaries and custodians
5.2.1 2.1
• effect on the lender’s rights
• effect on corporate action activity
• collateral
• potential risks of lack of consolidated disclosure by funds

518
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Understand the purpose and main types of prime broker equity
finance services and their impact on securities markets:
• securities lending and borrowing
• leveraged trade execution
• cash management
• core settlement
5.2.2 2.2
• custody
• rehypothecation
• repurchase agreements
• collateralised borrowing
• tri-party repos
• synthetic financing

Element 6 Securities Analysis Chapter 6

Financial Statement Analysis
6.1
On completion, the candidate should be able to:
Understand the purpose, structure and relevance to investors of
6.1.1 1.1
statements of financial position
Understand the purpose, structure and relevance to investors of
6.1.2 1.2
statements of profit and loss
Understand the purpose, structure and relevance to investors of
6.1.3 1.3
statements of cash flows
Be able to analyse securities using the following financial ratios:
• liquidity
6.1.4 1.4
• asset turnover
• gearing
Be able to analyse securities using the following profitability ratios:
• net profit margin
6.1.5 • operating profit margin 1.5
• equity multiplier
• return on capital employed
Be able to analyse securities using the following investor ratios:
• earnings per share
• price/earnings (both historic and prospective)
6.1.6 1.6
• dividend yield
• dividend cover
• interest cover

519
 Syllabus Unit/ Chapter/
Element Section
Understand the main advantages and challenges of performing
financial analysis:
• comparing companies in different countries and sectors
6.1.7 • comparing different companies within the same sector 1.7
• over-reliance on historical information
• benefits and limitations of relying on third-party research
• comparing companies that use different accounting standards
Environmental, Social and Governance (ESG)
6.2
On completion, the candidate should:
Understand the main factors taken into account when conducting
6.2.1 an analysis of Environmental, Social and Governance (ESG) risks and
opportunities
Element 7 Portfolio Construction Chapter 7
Market Information and Research
7.1
On completion, the candidate should be able to:
Understand the use of regulatory, economic and financial
communications:
• primary and secondary information providers
7.1.1 1.1
• government resources and statistics
• broker research and distributor information
• regulatory resources
Understand the different types and uses of research and reports:
• fundamental analysis
• technical analysis
7.1.2 • fund analysis 1.2
• fund rating agencies and screening software
• broker and distributor reports
• sector-specific reports
Be able to assess key factors that influence markets and sectors:
• responses to change and uncertainty
7.1.3 • volume, liquidity and nature of trading activity in domestic and 2
overseas markets
• publication of announcements, research and ratings
Be able to assess the interactive relationship between the securities
7.1.4 3
and derivatives markets, and the impact of related events on markets
Be able to assess the interactive relationship between different forms
7.1.5 3
of fixed-interest securities and the impact of related events on markets
Portfolio Construction
7.2
On completion, the candidate should be able to:

520
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Understand the main types of portfolio risk and their implications for
investors:
• systemic risk
7.2.1 • market/systematic risk – asset price volatility, currency, interest 4
rates, commodity price volatility
• non-systematic risk
• liquidity, credit and default risk
Understand the core principles used to help mitigate portfolio risk:
• correlation
7.2.2 • diversification 5
• active and passive strategies
• hedging and immunisation
Understand the key approaches to investment allocation for bond,
equity and multi-asset portfolios:
• asset class
• geographical area
7.2.3 6
• currency
• issuer
• sector
• maturity
Understand the main aims and investment characteristics of the main
cash, bond and equity portfolio management strategies and styles:
• indexing/passive management
• active/market timing including High Conviction style
• passive-active combinations
• smart indexing
• growth versus income
7.2.4 • market capitalisation 7
• liability driven
• immunisation
• long, short and leveraged
• issuer and sector-specific
• contrarian
• quantitative
• growth versus value investing

521
 Syllabus Unit/ Chapter/
Element Section
Understand how portfolio risk and return are evaluated using the
following measures:
• holding-period return
• money-weighted return
• time-weighted return
• total return and its components
• standard deviation
• value at risk
7.2.5 8
• volatility
• covariance and correlation
• risk-adjusted returns (eg, Sharpe ratio)
• benchmarking
• alpha
• beta
Candidates will not be expected to undertake the calculation of any
variables mentioned in this Learning Objective.

Element 8 Investment Selection and Administration Chapter 8

Investment Selection and Suitability
8.1
On completion, the candidate should be able to:
Apply a range of essential information and factors to form the basis of
appropriate investment selection and suitability:
• financial needs, preferences and expectations
8.1.1 • income and lifestyle – current and anticipated 1
• attitude to risk/capacity for loss
• level of knowledge and experience of investing
• existing debts and investments
Be able to analyse and select strategies suitable for the client’s aims
and objectives in terms of:
• investment horizon
• current and future potential for growth and yield
• requirement for capital protection
8.1.2 2
• protection against inflation
• liquidity, trading and ongoing management
• mandatory or voluntary investment restrictions
• impact of fees and charges
• ethical/Environmental, Social and Governance (ESG) considerations

522
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Be able to analyse and select investments suitable for a particular
portfolio strategy:
• direct holdings, indirect holdings and combinations, including
structured products
8.1.3 3
• role of derivatives, including CFDs
• impact on client objectives and priorities
• diversification
• cash, deposits, accounts and money market funds
Administration and Maintenance
8.2
On completion, the candidate should be able to:
Apply key elements involved in managing a client portfolio:
• systematic and compliant approach to client portfolio monitoring,
review, reporting and management
8.2.1 4
• selection of appropriate benchmarks to include: market and
specialist indices; total return and maximum drawdown
• arrangements for client communication
Understand how changes can affect the management of a client
portfolio:
• client circumstances
• financial environment
• new products and services available
8.2.2 5
• administrative changes or difficulties
• investment-related changes (eg, credit rating, corporate actions)
• portfolio rebalancing
• benchmark review
• changing regulatory environment

523
 Examination Specification
Each examination paper is constructed from a specification that determines the weightings that will be
given to each element. The specification is given below.

It is important to note that the numbers quoted may vary slightly from examination to examination as
there is some flexibility to ensure that each examination has a consistent level of difficulty. However, the
number of questions tested in each element should not change by more than plus or minus 2.

Element Number Element Questions

1 Cash, Money Markets and the Foreign Exchange Market 5
2 Fixed-Income Securities 20
3 Equities 20
4 Collective Investments 8
5 Settlement, Safe Custody and Prime Brokerage 7
6 Securities Analysis 8
7 Portfolio Construction 8
8 Investment Selection and Administration 4
Total 80

524
CISI Chartered MCSI Membership can work for you...

Studying for a CISI qualification is hard work and we’re

sure you’re putting in plenty of hours, but don’t lose sight
of your goal!

This is just the first step in your career; there is much more to
achieve!

The securities and investments sector attracts ambitious and

driven individuals. You’re probably one yourself and that’s
great, but on the other hand you’re almost certainly surrounded
by lots of other people with similar ambitions.

So how can you stay one step ahead during these uncertain
times?

Entry Criteria for Chartered MCSI Membership

As an ACSI and MCSI candidate, you can upgrade your membership status to Chartered MCSI. There are
a number of ways of gaining the CISI Chartered MCSI membership.

A straightforward route requires candidates to have:

• a minimum of one year’s ACSI or MCSI membership;
• passed a full Diploma; Certificate in Private Client Investment Advice & Management or Masters in
Wealth Management award;
• passed IntegrityMatters with an A grade; and
• successfully logged and certified 12 months’ CPD under the CISI’s CPD Scheme.

Alternatively, experienced-based candidates are required to have:

• a minimum of one year’s ACSI membership;
• passed IntegrityMatters with an A grade; and
• successfully logged and certified six years’ CPD under the CISI’s CPD Scheme.

Joining Fee: Current Grade of Membership Grade of Chartership Upgrade Cost

ACSI Chartered MCSI £85.00
MCSI Chartered MCSI £30.00

By belonging to a Chartered professional body, members will benefit from enhanced status in the
industry and the wider community. Members will be part of an organisation which holds the respect of
government and the financial services sector, and can communicate with the public on a whole new level.
There will be little doubt in consumers’ minds that chartered members of the CISI are highly regarded
and qualified professionals and, as a consequence, will be required to act as such.

The Chartered MCSI designation will provide you with full access to all member benefits,
including Professional Refresher where there are currently over 100 modules available
on subjects including Anti-Money Laundering, Information Security & Data Protection,
Integrity & Ethics, and the UK Bribery Act. CISI TV is also available to members, allowing
you to catch up on the latest CISI events, whilst earning valuable CPD.
Revision Express

You’ve bought the workbook... now test your knowledge before your exam.

Revision Express is an engaging online study tool to be used in conjunction with most CISI workbooks.

Key Features of Revision Express:

• Questions throughout to reaffirm understanding of the subject
• Special end-of-module practice exam to reflect as closely as possible the standard you will experience
in your exam (please note, however, they are not the CISI exam questions themselves)
• Extensive glossary of terms
• Allows you to study whenever you like, and on any device

IMPORTANT: The questions contained in Revision Express products are designed as aids to revision, and
should not be seen in any way as mock exams.

Price per Revision Express module: £35

Price when purchased with the corresponding CISI workbook: £108 (normal price: £119)

To purchase Revision Express:

call our Customer Support Centre on:

+44 20 7645 0777

or visit the CISI’s online bookshop at:

cisi.org/bookshop

For more information on our elearning products, contact our Customer Support Centre on +44 20 7645
0777, or visit our website at cisi.org/elearning
Professional Refresher

Self-testing elearning modules to refresh your

knowledge, meet regulatory and firm requirements,
and earn CPD.

Professional Refresher is a training solution to help you

remain up-to-date with industry developments, maintain
regulatory compliance and demonstrate continuing
learning.

This popular online learning tool allows self-administered

refresher testing on a variety of topics, including the latest
regulatory changes.

There are over 120 modules available which address UK and international issues. Modules are reviewed
by practitioners frequently and new ones are added to the suite on a regular basis.

Benefits to firms:
• Learning and testing can form part of business T&C programme
• Learning and testing kept up-to-date and accurate by the CISI
• Relevant and useful – devised by industry practitioners
• Access to individual results available as part of management overview facility, ‘Super User’
• Records of staff training can be produced for internal use and external audits
• Cost-effective – no additional charge for CISI members
• Available for non-members to purchase

Benefits to individuals:
• Comprehensive selection of topics across sectors
• Modules are regularly refreshed and updated by industry experts
• New modules added regularly
• Free for members
• Successfully passed modules are recorded in your CPD log as active learning
• Counts as structured learning for RDR purposes
• On completion of a module, a certificate can be printed out for your own records

The full suite of Professional Refresher modules is free to CISI members, or £250 for non-members.
Modules are also available individually. To view a full list of Professional Refresher modules visit:

cisi.org/refresher

If you or your firm would like to find out more, contact our Client Relationship Management team:

+ 44 20 7645 0670
[email protected]

For more information on our elearning products, contact our Customer Support Centre on +44 20 7645
0777, or visit our website at cisi.org/refresher
 s
to b e r
ee m
Fr me
SI
CI

cisi.org/refresher
Feedback to the CISI
Have you found this workbook to be a valuable aid to your studies? We would like your views, so please
email us at [email protected] with any thoughts, ideas or comments.

Accredited Training Partners

Support for exam students studying for the Chartered Institute for Securities & Investment (CISI)
qualifications is provided by several Accredited Training Partners (ATPs), including Fitch Learning and
BPP. The CISI’s ATPs offer a range of face-to-face training courses, distance learning programmes, their
own learning resources and study packs which have been accredited by the CISI. The CISI works in close
collaboration with its ATPs to ensure they are kept informed of changes to CISI exams so they can build
them into their own courses and study packs.

CISI Workbook Specialists Wanted

Workbook Authors
Experienced freelance authors with finance experience, and who have published work in their area of
specialism, are sought. Responsibilities include:
• Updating workbooks in line with new syllabuses and any industry developments
• Ensuring that the syllabus is fully covered

Workbook Reviewers
Individuals with a high-level knowledge of the subject area are sought. Responsibilities include:
• Highlighting any inconsistencies against the syllabus
• Assessing the author’s interpretation of the workbook

Workbook Technical Reviewers

Technical reviewers to provide a detailed review of the workbook and bring the review comments to the
panel. Responsibilities include:
• Cross-checking the workbook against the syllabus
• Ensuring sufficient coverage of each learning objective

Workbook Proofreaders
Proofreaders are needed to proof workbooks both grammatically and also in terms of the format and
layout. Responsibilities include:
• Checking for spelling and grammar mistakes
• Checking for formatting inconsistencies

If you are interested in becoming a CISI external specialist call:

+44 20 7645 0609

or email:
[email protected]

For bookings, orders, membership and general enquiries please contact our Customer Support Centre
on +44 20 7645 0777, or visit our website at cisi.org