Hedge Funds
Generally, a hedge fund is a lightly regulated private investment fund often characterized by
unconventional investment strategies and often making use of legal structures (sometimes offshore)
to mitigate the effects of local regulation and tax regimes. In contrast to regular investment funds,
which are usually limited to only being able to "go long" (buy) instruments such as bonds, equities or
money market instruments, hedge funds also have the ability to "short" (sell) instruments which
they believe will fall in price. In this way, hedge funds are able to create more complex investment
structures which can, for example, profit in times of market volatility, or even in a falling market.
They are primarily organized as limited partnerships, and previously were often simply called
"limited partnerships" and were grouped with other similar partnerships such as those that invested
in oil development. Hedge funds are normally open to institutional or otherwise accredited
investors.
Critically appraise hedge funds?
Understanding of? X2
For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to
sophisticated investors. In the U.S., laws require that the majority of investors in the fund
be accredited. That is, they must earn a minimum amount of money annually and have a net worth
of more than $1 million, along with a significant amount of investment knowledge. You can think of
hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments
are pooled and professionally managed, but differ in that the fund has far more flexibility in its
investment strategies.
It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal
of most hedge funds is to maximize return on investment. The name is mostly historical, as the first
hedge funds tried to hedge against the downside risk of a bear market by shorting the market
(mutual funds generally can't enter into short positions as one of their primary goals). Nowadays,
hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just
"hedge risk". In fact, because hedge fund managers make speculative investments, these funds can
carry more risk than the overall market.
Hedge funds embrace a wide variety of skills and strategies, generally grouped under the four
following headings:




Long/short equity - they aim to profit from superior research and stock picking skills by
buying the best ideas and reducing the resulting stock market exposure by shorting (selling
stocks they do not own) those they believe will perform less well.
Relative value - typically they use computer systems to calculate the "fair" value of one asset
relative to another and then shorting the more expensive asset and buying the cheaper one.
Event-driven - they seek investment opportunities surrounding corporate events, for
example, investing in bankrupt or merging companies.
Trading strategies - for example, taking positions on the direction of markets, currencies and
commodities.
So, hedge fund managers are essentially a group of active investment managers who invest in a
variety of asset classes, with the licence to invest in a very flexible way.
Despite having a large concentration of investment expertise, hedge funds can still lose money for
themselves and their clients, or provide just rather disappointing returns, so choosing the right ones
is key. As noted earlier, the return from a given hedge fund manager is largely driven by the
manager's ability or skill.
Also, many hedge funds restrict how much money they will take on so they can sensibly manage the
funds they already have, and it is not uncommon for the most skilled (and hence desirable)
managers to be closed to new investors.
They can charge very high fees, which can be high enough to erode any out-performance achieved
by the manager, so due care is advised when selecting them.
Most hedge funds are domiciled offshore for tax reasons. But if the managements who actually run
the business are based in the UK then they should be subject to full regulation by the Financial
Services Authority.
Advantages
Hedge Funds Reduce Your Risk

Potential to reduce overall portfolio risk through an additional asset class
Hedge funds represent a different way of managing money with generally low correlations
to equity and debt investments. Adding them to a portfolio of stocks and bonds is likely to
reduce overall portfolio risk.

Potential to provide returns in both up and down markets
Hedge funds are designed for the potential to achieve the positive returns in all market
environments.

Potential for superior risk-adjusted performance



Specialized managers are focused on very precise areas of expertise
Greater freedom and flexibility to take advanatage of investment opportunities than
mutual fund managers
Broader range of financial instruments at disposal

Focused on absolute vs. relative performance
Hedge fund managers are only concerned with generating positive returns, as opposed to
benchmarking their performance against an equity index that could end up in a negative
postion.

Hedge fund managers are paid by performance
Hedge fund managers' interests are aligned with those of the investor, often with the
managers' own capital invested.

Sophisticated solution
Recognized by pension funds, banks, insurance companies and sophisticated investors as a
way to reduce portfolio volatility and potentially enhance returns.
o Many hedge fund strategies have the ability to generate positive returns in both
rising and falling equity and bond markets.
o Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and
volatility and increases returns.
o Huge variety of hedge fund investment styles - many uncorrelated with each other provides investors with a wide choice of hedge fund strategies to meet their
investment objectives.
o Hedge funds provide an ideal long-term investment solution, eliminating the need to
correctly time entry and exit from markets.
o Adding hedge funds to an investment portfolio provides diversification not
otherwise available in traditional investing.
Or in other words…
(1) reduce portfolio volatility risk,
(2) enhance portfolio returns in economic environments in which traditional stock and bond
investments offer limited opportunities, and
(3) participate in a wide variety of new financial products and markets not available in traditional
investor products.
Disadvantages




Only the wealthiest individuals can participate in hedge funds
Hedge funds are extremely risky and millions of dollars can be lost in the blink of an eye
The performance fee for the investment manager may encourage them to take bigger risks
with your money
There are very few government regulations overseeing hedge fund investments
Investing via the internet
•
Internet has increased information flow and content. And thus boosted the level of private
investors.
•
Reduction of trading costs (internet) and consolidation of execution only stockbrokers.
With the advent of the internet, investors can now enter orders directly online, or even trade with
other investors via electronic communication networks (ECN). Some orders entered online are still
routed through the broker allowing agents to approve or monitor the trades. This step assists in the
protection of both the client and brokerage firm from unlawful or incorrect trades which could affect
the client’s portfolio or the broker’s license.
Online brokers are most often referred to as discount brokers, due to their lower fees as opposed to
full service brokers who also give advice to clients.
Junior ISAs
Advice on weather a good investment?

Available for people under 18 who were born before 1.9.2002 or after 2.1.11

Cash or stocks and shares

Maximum input £3,600 per annum

Difference with Adult ISA is cannot leave an ISA with one issuer and open a new one with
another provider in the next tax year. The account has to be fully transferred and the old
account closed.

Savers can move money between a junior cash ISA and junior investment ISA freely

Index linked from 2018

Money can be taken out at 18
If close ISA cannot open another with another provider until next tax year. Can switch providers eg
can move from cash to stocks and shares ISA but if leave cash in stocks and shares ISA it will be
taxed.
CAT Standards Introduced by government to regulate and attract investors to cash ISAs
Charges – no one off charges
Access – minimum transaction size < £10
Terms – Interest payable no more than 2% less than bank base rate
Children cannot have a junior isa if they are eligible for child trust fund from government.

Open to children born between 1.9.02 – 2.1.11

Government put in money when account opened ( either £250 or £500 ) and again when
child reached 7. Children eligible for CTFs cannot have a Junior ISA.

Annual savings limit now also £3,600

Money can be invested in cash or shares

Index –linked from 2013

Money can be taken out at 18
Only the providers can switch money from one provider to another otherwise it counts as a
withdrawal.
The accounts offer parents a tax-free way to save for children who don't have a Child Trust Fund.
Junior ISAs are long-term tax-free savings accounts for children.
Your child can have a Junior ISA if they:



are under 18
live in the UK
do not already have a Child Trust Fund account
Each child can have one cash and one ‘stocks and shares’ Junior ISA at any one time.
Anybody can put money into a Junior ISA. The total limit for payments into Junior ISAs is £3,600 in
each tax year. There will be no tax to pay on any interest or gains.
The money in a Junior ISA belongs to the child, but they can’t take the money out until they are
18. They can then decide what they want to do with it. If the child chooses not to take the money
out, the Junior ISA will automatically become an ISA.
Tax-efficient - proceeds are free of income tax and capital gains tax. Of course, tax advantages
depend on individual circumstances and the tax treatment of the Junior ISA may change in the
future.
Includes an Annual Management Charge of 1.5%
Risks
Because the money is invested in stocks and shares, its value can go down as well as up
- There is a chance that the child may get back less than was invested
- Over time, the cost of living will generally rise, reducing the real value of any investment growth.
This means that the child may not be able to buy as much in the future with the proceeds of the
investment as they could do today
- If you decide to cancel and the value of the investment has fallen, the amount returned may be less
than the amount invested
- If the value of the account falls shortly before the child wants or needs to withdraw the money, it
could mean that they do not have enough money to meet their needs
- The tax advantages of the Junior ISA may change in the future. If this happens, the potential growth
of the account will be reduced
Main Market and AIM listings
Appraise difference between main market and alternative market listing?
The Main Market is London’s flagship market for larger, more established companies, and is home to
some of the world’s largest and most well-known companies.
AIM is London Stock Exchange’s (the ‘Exchange’s’) market for smaller and growing companies.
Launched in 1995, it is now firmly established as a leading growth market with the critical mass to
provide firms from a wide range of countries and sectors with access to a diverse set of investors,
who genuinely understand the needs of entrepreneurial businesses. AIM serves as a mechanism for
companies seeking access to capital to realise their growth and innovation potential and since launch
has helped over 3,100 companies raise over £67 billion through new and further capital raisings. AIM
plays a vital role in the funding environment for small and medium-sized enterprises as they develop
their businesses
AIM is a sub-market of the London Stock Exchange, allowing smaller companies to float shares with
a more flexible regulatory system than is applicable to the main market.
Some companies have since moved on to join the Main Market, although in the last few years,
significantly more companies transferred from the Main Market to the AIM (The AIM has significant
tax advantages for investors, as well as less regulatory burden for the companies themselves)
.
New Buy and right-to-buy discount schemes
Options
A LEGALLY BINDING CONTRACT WHICH IS A RIGHT BUT NOT AN OBLIGATION TO DELIVER / TAKE DELIVERY
OF A FIXED QUALITY AND QUANTITY OF AN UNDERLYING ASSET AT A FIXED PRICE AT OR BEFORE A SPECIFIC
DATE IN THE FUTURE
CALL
-
RIGHT TO BUY
PUT
-
RIGHT TO SELL
if equity price rises then option price rises
exercise price
falls
interest rate
rises
time to expire
rises
equity volatility
rises
For hedging or speculation
Blacks scholes – call and put option?
X4
BLACK & SCHOLES OPTION VALUATION MODEL
Payment of dividend affects the share price and thus the value of the share option
Buy a share at the current price are buying ‘cum div’
Share price should fall once dividend is paid and ex div price is cum div - dividend
Need to use adjusted share price before using model
Find present value of dividend due - use continuous discounting
Adjust the share price
NB This model is for European options and ignores dividends.
The model can be adapted for American options ( such as those traded on LIFFE ) and to include
prospective dividends
Assumptions of the model
1. Asset price follows a lognormal distribution so that returns are normally distributed
2. Time value of returns is known and directly proportional to the passage of time
3. No transaction costs so that a riskless hedge may continuously be established between the
option and the asset at no sunk cost
4. Interest rates are known and constant
5. No early exercise ( European )
6. No dividends
Passive Fund Management
Passive management (also called passive investing) is a financial strategy in which an investor (or a
fund manager) invests in accordance with a pre-determined strategy that doesn't entail any
forecasting (e.g., any use of market timing or stock picking would not qualify as passive
management). The idea is to minimize investing fees and to avoid the adverse consequences of
failing to correctly anticipate the future. The most popular method is to mimic the performance of
an externally specified index.
Passive management is most common on the equity market, where index funds track a stock market
index, but it is becoming more common in other investment types, including bonds, commodities
and hedge funds.[2]
The concept of passive management is counterintuitive to many investors.[2] The rationale
behind indexing stems from five concepts of financial economics[2]:
1. In the long term, the average investor will have an average before-costs performance equal
to the market average. Therefore the average investor will benefit more from reducing
investment costs than from trying to beat the average.[3][4]
2. The efficient-market hypothesis postulates that equilibrium market prices fully reflect all
available information, or to the extent there is some information not reflected, there is
nothing that can be done to exploit that fact. It is widely interpreted as suggesting that it is
impossible to systematically "beat the market" through active management,[5] although this
is not a correct interpretation of the hypothesis in its weak form. Stronger forms of the
hypothesis are controversial, and there is some debatable evidence against it in its weak
form too. For further information see behavioural finance.
3. The principal–agent problem: an investor (the principal) who allocates money to a portfolio
manager (the agent) must properly give incentives to the manager to run the portfolio in
accordance with the investor's risk/return appetite, and must monitor the manager's
performance.[6]
4. The capital asset pricing model (CAPM) and related portfolio separation theorems, which
imply that, in equilibrium, all investors will hold a mixture of the market portfolio and a
riskless asset. That is, under suitable conditions, a fund indexed to "the market" is the only
fund investors need.[2]
Investment Selection - Passive Strategies
Passive investing presents some obvious advantages that are often publicized by indexing
supporters.
Low cost - offers an incremental advantage that is both meaningful and certain. An active
manager has to add enough value to overcome the cost disadvantage.
Reduced uncertainty of decision errors – investors are exposed to market risk simply by
being invested. Reaching for returns in excess of those provided by the market brings about
the additional risk of selecting the wrong investments.
Style consistency – If the appropriate indexes are selected, indexing, at least in theory,
allows investors to control their overall allocation. Investors could only do this effectively
through successful tactical allocation. There are no guarantees they will succeed.
Tax efficiency - Indexing is generally regarded as more tax efficient, though it is mostly the
case for larger-cap indexes that are fairly stable and involve less trading. In smaller-cap
indexes, where successful stocks grow in size and leave the index, tax liabilities resulting
from more frequent rebalancing’s quickly accumulate.
•
Understanding of the term?
•
Active - Attempt to achieve portfolio returns more than commensurate with risk, either by
forecasting broad market trends or by identifying particular mis-priced sectors of a market
or securities in a market.
•
Passive – Buying a well-diversified portfolio to represent a broad-based market index
without attempting to search out mis-priced securities.
Passive managers assume:

Market does not misprice securities or assets or

Market does misprice securities and assets but managers unable to take advantage of
mispricing
Pensions
Difference between defined benefit and defined contribution pension scheme. Why shift away from
defined benefit? X4
State pension
Male 65 , Female 60 but 65 by 2018
December 2018 – April 2020 66
April 2034 – 36 67
April 2044 – 46 68
1.
Basic April 2012/13 max £107.45 pw single person,
2.
Additional, based on SERPS (1978) (max. just over £100 )
(State Earnings-Related Pension Scheme). Replaced from April 2002 by State Second Pension
( SP2 ).
Earnings related scheme – higher benefits for lower paid
Not available to the self-employed
The Pensions Act 2007 and the Pensions Act (Northern Ireland) 2008 provide for the abolition of
contracting out on a money-purchase (defined-contribution) basis. The aim is to introduce this
change in April 2012. Once this takes effect, individuals will no longer be able to contract out of the
State Second Pension through:


a money-purchase (defined-contribution) occupational pension scheme; or
a personal pension or a stakeholder pension.
If you are already contracted out through either type of scheme, you will:



be able to continue to make your own contributions to the scheme;
be able to continue to benefit from any employer contributions to the scheme; but
no longer be able to benefit from any rebate of National Insurance contributions
Contracting out through an occupational salary-related (defined-benefit) scheme will continue to be
allowed, but from 2012 cannot contract out through a money – purchase (defined contribution)
occupational scheme, a personal pension or stakeholder pension. If previously contracted out via
these will be brought back automatically in to additional State Pension
3.
Can contract out of SP2 by personal pension or membership of occupational scheme.
Pension can be enhanced by additional Personal Pension Plans (PPPs) or Additional Voluntary
Contributions (AVCs), or Free Standing Additional Voluntary Contributions (FSAVCs).
Occupational Pension schemes
Can take tax free lump sum on retirement
Death in service benefits
Provision for widow(er) and dependants
Defined benefit – benefits related to earnings at retirement and length of service. Maximum benefit
2/3 of final salary (most schemes 80ths . Risk on employer.
Defined contribution – benefits linked to fund value, levels of contribution made, and retirement age
and investment success. Risk on employee.
Minimum funding requirement for defined benefit schemes (value of assets must not be less than
value of liabilities )
Executive Pension Plans ( EPPs )
Small self - administered schemes ( SSASs)
Self-Invested Personal Pensions ( SIPPS )
Over 100,000 SIPPS
Available to employed and self-employed
Wide range of investment opportunities
Income drawdown ie income can be paid directly from SIPP rather than having to buy an annuity
Sliding scale of contributions
Eg 46 – 50 can pay 25% of earnings subject to max earnings .
From April 10 max personal contribution £255,000 or 1 x salary (whichever is the lower )
Lifetime allowance £1.8m ( pay extra tax if exceeded )
Can invest in:

Stocks and Shares

Units Trusts ITCs and OEICS

Insurance Company funds

Commercial property

Art, antiques
Benefits taken between 50 and 75. Up to 25% cash sum, free of tax

maximum benefits

lump sum on retirement
Employers can "contract-out" of SP2 and replace it with a Personal Pension Plan. (PPP)
employee (contracted out)
remain in scheme or PPP
employee (contracted in)
SP2 or PPP
employee, no employer scheme SP2 or PPP
Personal Pensions
self-employed
PPP
Contribution levels limited to % of Net Relevant Earnings (depending on age)
Can be drawn between 50 and 75
Max tax free cash 25% of accumulated fund
AVCs and FSAVCs
Pay up to % chosen of salary. Used not to be able to take lump sum out of AVC fund but now can
take 25% as lump sum.
Lifetime allowance 12/13 £1.8m. If exceeded as pension or lump sum extra charges
Pensions crisis
‘Time Bomb’
Demographics
Complicated and rigid structure of pensions regime
Public indifference
Equity collapse
Greed of fund management
Defined benefit schemes a rarity
What is government doing ( see below on latest pensions bill )
Proposals from National Association of Pension Funds to replace state pensions with Citizens’
pension
Pension fund collective deficits of private sector final salary schemes £175bn in July 2009
In 2007 the 7,800 schemes had surplus of £12bn
In spring 2009 823 ( 11% ) in surplus – in March 2008 it was 3,000
End Feb 2012 £222bn in deficit
5,235 in deficit 1,197 in surplus
Stock of assets needed to pay all pensions rose by 35% in 2011 to £1.264 trillion
Reasons
-
International credit crunch
-
Worldwide economic slowdown
-
Slump in share prices
-
Poorer returns on bonds
-
Cost of paying out pensions exceeds assets
Woolworths pension deficit before keeled over £147 million. Called on Pension Protection Fund
Marks and Spencer closed final salary scheme to new joiners in 2002
Aviva scheme closed etc etc
Hutton report
Has recommended all public sector final salary schemes reduced to
‘ career average’
Pensions Act 1995
Changes with effect from 1.4.97

Pensions regulator replaced Occupational Pensions Board

Compensation scheme ( fraud etc )

Final salary pensions schemes subject to MFR

Pension rights considered in divorce settlements

New contracting out test

Phasing of pension age starts at 2010

Schemes to have third of trustees appointed by members

Trustees to appoint an actuary and auditor

All schemes to provide equal access and benefits
Stakeholder Pensions

Available from April 2001

Low charges

Available to any UK resident under 75

Meant for people who do not have access to occupational pension or good value personal
pension

Available from financial services companies

No need for employed earnings

Low cost – max annual charge 1%

Extra services and charges not provided for by law must be optional

Contributions of as little as £20 (which can be paid weekly, monthly or at less regular intervals )

Maximum contribution greater of £3,600 and existing personal pension limits but no greater
than £3600

Contributions made net of basic rate tax

Benefits similar to current personal pensions

Cannot draw on it until at least 50 or when retire

Employers have to have scheme for 5 or more employees
Pension Bill - published on 12.2.04
Part of wider programme of pension reform
Better deal for people who choose to draw their state pension later
Establishes Pension Protection Fund for members of private sector defined benefit schemes and
final salary schemes
New compensation scheme – Pension Protection Fund
Run by board with chairman and directors
Provides compensation if company with defines benefit pension scheme becomes insolvent and
pension fund not sufficiently funded

100% for people of pension age

90% for people below that age subject to an overall benefit cap

Indexation of pensions

Survivor’s benefits
PPF board took over responsibilities of Pensions Compensation Board
Funded through a levy on private sector defined benefit schemes
Three parts to levy:

Pension protection

Administration

Fraud compensation
Pensions regulator to be appointed with powers to tackle underfunding
Pro-active approach focussing on fraud and mal-administration
Given powers to gather, retain and share relevant administration + providing information education
and assistance
Power to collect, retain and disclose information
Pensions simplification from 5.4.06 ( announced March 04 )
Single regime to replace current 8 ones
Pension lifetime allowance and pension personal allowance introduced – pension savings of £1.5
million benefit from tax relief. Charge of 25% above that
Minimum retirement age from 2010 55 ( is 50 )
Trivial pensions
All schemes can take 25% of final value as cash including AVCs and FSAVCs
6.4.06 = A-Day
Retirement age raised from 50 to 55 by April 2010
Contributions lower of annual salary or £255,000
Single lifetime allowance of £ 1.8m ( back down to £1.5m by 2012 ) – if pension fund value exceeds
this will be taxed on excess at 55%
Can take 1% of £1.5m in cash – 25% of which will be tax free ( aged 60 – 75)
No need to take an annuity
Option of Alternative Secured Income ( can pass any unused income on after death )
Limited period annuity ( lasts for five years then must take out another )
Value Protected Annuity ( lower income but pays unused amounts to heirs )
Annuity protection lump sum benefit
Pensions Act 2007
Personal accounts – additional state pension system for employees who cannot join an employer
scheme
Duty on every employer to provide good quality pensions
Automatic enrolment and compulsory employer contributions on existing company employer
schemes from 2012. Employees pay 4%, employers 1% and government 1%
Idea is to encourage savings from low to moderate earners
Government want to reduce income tax relief on pensions to around £30-40,000 ( from £225,000 as
now )
Coalition’s intention to repeal annuitisation legislation
Auto- enrolment
From October 2012 employers will enrol workers into a workplace pension if:
Not already in a pension
Aged 22 or over
Under State Pension Age
Earn more than £7,475 per annum
Work in the UK
Employers will contribute starting from 1% going up to 3% over next few years
Minimum to be contributed by employee starts at 2% and will increase to 8% over next few years
Percentages apply to ‘qualifying earnings ‘ between 5,035 and £33,540
Performance Measurement
however simplistic and ignores timing.
Profit and loss on the hedge and the hedge efficiency ratio? And its % and how successful it is? X3
Portfolio Theory
By combining shares together can reduce business risk, but never market risk.
Only diversify using shares with less than hugh positive positive correlation.
Most desireable portfolios producing a higher level of return for a given level of risk are located
along the efficient fountier.
Sharpe, traynor, differential return and jenson ratios?
CAPM vs APT & 3/4FACTOR M?
REITS
What benefits should derive from this?
Outline its main features and evaluate wether should invest?
Term Structure of Interest Rates
•
Implies that the expected rate of inflation determines expected future interest rates
•
( 1 + expected future spot interest rate ) = ( 1 + expected future interest rate ) x ( 1+
expected rate of inflation )
•
A rising yield curve implies rising future inflation rates
•
A falling yield curve implies falling inflation
•
A flat yield curve implies stable inflation
•
Taxes and transaction costs, however, are practical problems for the theory
The Greeks
Demonstrate understanding of the Greeks? X2 Understanding of the following terms ;delta,
gamma, theta, vega?
Describe certain sensitivities of options with regard to movements in the underlying instruments
Delta
Rate of change in option price for a 1p change in the underlying share price.
Measures the sensitivity of an option to share price movements.
Useful for creating a portfolio which minimises exposure to share price movements and predicting
how premiums will change for a given share price change.
Range of 0 to +1/-1
Positive for calls
Negative for puts
Increases as option moves into-the-money : close to 1
Decreases as option moves out-of-the-money: close to 0
At-the- money: approx 0.5
Changes as time value declines
In the money increases as option nears expiry
Out of the money decreases as option nears expiry
In terms of BSOPM
= N(d1) for a call
= N(d2) for a put
Delta = Change in option price
Change in share price
Eg Share price falls 1p
Put option price rises 0.625p
Own 5000 shares
Delta
=
-0.625 =
-0.625
1.000
Hedge ratio =
1
=
1.6
0.625
Number of contracts required to hedge position thus 8
1p share price fall on 5,000 shares = -£50
Profit on 8 contracts = 8 x 6.25p = £50
Hedging a long position in stock requires the establishment of a negative delta.
Can be done by buying puts or writing calls
Gamma 
Rate of change of the delta in relation to a movement in the underlying share price.
Shows how the time exposure of an options position insofar as it indicates how frequently a hedged
position may have to be rehedged.
Declines for in and out of the money options as expiry approaches
Increases for at the money options as expiry approaches
Theta 
Rate of change of an option premium with respect to time.
The theta of an option increases as expiry approaches and is greates for at-the-money options
Vega/Kappa
Rate of change of the option price with respect to the volatility of the underlying share.
Positive for calls and puts
Greatest for at-the-money options
Zero for deep in-or far out-of-the-money options
Hedging option sensitivities
Gamma and Vega can only be hedged by other option positions
Each Greek that is hedged requires at least one additional hedging instrument
Hedging positions for Gamma and Vega must be two options positions different from the one being
hedged.
Can use option positions to hedge Gamma and Vega and take a position
in the underlying asset ( or future ) to hedge the Delta.
Eg Option Z has a gamma of 0.7 and a Vega of 1.3.
You write the option and thus the Gamma is -0.7 and the Vega - 1.3.
You decide to hedge option Z with:
Option X
Gamma 0.8
Vega 1.2
Option Y
Gamma 0.5
Vega 1.5
How much of each do you need?
X + 0.5Y =
0.7 (1)
1.2X + 1.5Y
=
1.3 (2)
Solve the simultaneous equation
Multiply (1 ) by 3 and subtract (2)
Three and Four Factor models
3 factor model = Fama and French 1992 Published in Journal of Financial Economics
Five common risk factors in the returns on stocks and bonds
Three stock market factors:

Overall market factor

Firm size

Book- to market equity
Two bond factors:

Maturity

Default risks
The five factors seem to explain average returns on stocks and bonds.
In this model, as well as being influenced by the general risk premium for shares ( rm – rf ), the
average small share is more risky than the average large stock and gives and additional premium
SMB. In addition, a share with a high balance sheet ( book ) value per share relative to the market
price of share is more risky than that with a low value and is more risky and also offers a further risk
premium ( HML ).
4= Mark Cahart 1997 Journal of Finance
Common factors in stock returns and investment expenses almost completely explain persistence in
equity mutual funds’ mean and risk-adjusted returns. These results do not ‘support the existence of
skilled or informed mutual fund managers ‘ ( Cahart )
The research was carried out using monthly returns from 1,892mutual funds between January 1962
and December 1993.
His model was the same as Fama’s and French’s with the addition of PR1YRt. This is the equalweighted average of firms with the 30% eleven-month returns lagged one month or one year
momentum in stock returns.
He found that the returns on the top decile funds are strongly positively correlated with the oneyear momentum factor, while the returns on the bottom decile are strongly negatively correlated
with the one year momentum factor.
He found that buying last year’s top-decile mutual funds and selling last year’s bottom – decile funds
yielded 8% per annum.
Differences in the market value and momentum of stocks were 4.6%, expense ratios 0.7% and
transaction costs 1%
His conclusion for investors was:

Avoid funds with persistently poor performance

Funds with high returns last year have higher than average expected returns the following
year but not thereafter

Expense ratios, transaction costs and load fees all have a direct, negative impact on
performance.
Differences between This vs CAPM, APT? and also the assumption which underpin them
Unit and investment trusts are for:
•
Instant diversification
•
Monthly savings
•
Pound cost averaging
•
Tax reporting eased
•
Fund handles admin
•
Many funds available
•
Liquid
•
Give it to an active manager to run a separate fund for you
•
Run by stockbroker
•
Charges are high
Unit Trusts
Unit Trusts lets you put your money together with other investors’ to buy a wider range of
investments than you would be able to achieve on your own.
Unit trusts are open-ended investments; therefore the underlying value of the assets is always
directly represented by the total number of units issued multiplied by the unit price less the
transaction or management fee charged and any other associated costs. Each fund has a specified
investment objective to determine the management aims and limitations.





The fund manager runs the trust for profit.
The trustees ensure the fund manager keeps to the fund's investment objective and
safeguards the trust assets.
The unit holders have the rights to the trust assets.
The distributors allow the unit holders to transact in the fund manager's unit trusts
The registrars are usually engaged by the fund manager and generally act as a middleman
between the fund manager and various other stakeholders.
Types of Unit Trusts
1. Index-tracker unit trust which follows the performance of a particular stock market – in the
UK or abroad – with low management fees.
2. Actively managed unit trust where investments are chosen by professional fund managers
who constantly monitor companies, economic conditions and markets.
3. Income unit trust which aims for regular income rather than growth.
4. Multi Manager unit trust where you can aim for growth, income or a balance of both by
investing in several funds at the same time through one simple fund-of-funds investment.
5. Our Ethical unit trust which only invests in socially responsible companies.
6. Our Cash unit trust. The cash investment fund is available as a unit trust investment, but not
as an ISA. Our Cash fund isn’t a deposit account and your capital isn’t guaranteed.
Risk
Unit Trusts and Open-Ended Investment Companies (OEICs) are a good way for smaller investors to
enjoy the power of big institutional investors, putting their money into a variety of assets that could
offset some of the risk.
Your money is put into a fund, along with money from other investors. This pooled fund is then
invested across many different investments by a fund manager
Please remember though that the value of an investment may fluctuate and is therefore not
guaranteed. You may not get back the full amount of your original investment.
Tax
With a Unit Trust or OEIC your money is pooled with other investors' money and can be invested in a
range of sectors and assets such as stocks and shares, bonds or property.

Dividend income from OEICS and unit trusts invested in shares
If your fund is invested in shares then any dividend income that is paid to you (or
accumulated within the fund if it is reinvested) carries a 10% tax credit. If you are a basic
rate or non taxpayer, there is no further income tax liability. Higher rate taxpayers have a
total liability of 32.5% on dividend income and the tax credit reduces this to 22.5%, while the
additional rate taxpayers have a total liability of 42.5% reduced to 32.5% after tax credit is
applied.

Higher rate taxpayer example
This is how the tax works for a higher rate taxpayer.
o
o
o
o
Net dividend is £90.
Gross dividend is £100 (includes the 10% tax credit).
Less 32.5% (£32.50) higher rate tax on the gross amount of £100 equals a net
dividend of £67.50.
Tax due is £32.50, less 10% tax credit (£10) equals £22.50.
Interest from fixed interest funds
Any interest paid out from fixed interest funds (these are funds that invest for example in
corporate bonds and gilts, or cash) is treated differently to income from funds invested in
shares.
Income is paid net of 20% tax. So for example if interest of £100 had been generated, you
would receive a net payment of £80.

Capital gains tax
No capital gains tax is paid on the growth in your money from the investments held within
the fund, but when you sell, you may have to pay capital gains tax.
Bear in mind that you have a personal capital gains tax allowance that can help you limit any
potential tax liability. After 23 June 2010 the rate of tax that applies on any gain over your
allowance is either 18% or 28% depending on your taxable income.

Accumulated income
Accumulated income is interest or dividend payments which are not taken but instead
reinvested into your fund. Even though they are reinvested they still count as income and
are subject to the same tax rules as for dividend income and interest.
Access to Funds
You can withdraw your money from a unit trust with us at any time because there’s no minimum
holding period.
Charges for investment trusts are typically lower than for unit trusts and Oeics, primarily because
there is no commission to salesmen. But when it comes to buying a unit trust or Oeic it usually
means the investor has to pay an upfront charge of anything up to 5%. Around 3% of that is likely to
go to the adviser.
Annual charges for unit trusts are typically 1.5% to 2%, of which half a percentage point usually goes
as an annual 'trail' commission to the salesmen for ongoing advice - even in cases where the ongoing
advice never materialises. However, if you pay your adviser by fees instead of commission this is not
an issue.
Potential for growth



You can invest an unlimited amount in a unit trust, but you won’t get the tax advantages of
an ISA.
You can invest up to £50,000 online, today.
Minimum investment - £500 lump sum or £50 monthly.
What's the difference between a unit trust and an OEIC?
Although fundamentally they offer the same benefits, there are a few key differences between Unit
Trusts and OEICs:



Unit Trusts issue units, while OEICs issue shares.
Unit Trusts generally have two prices: a bid price at which you sell and an offer price at
which you buy. OEICs have one price, called the single price at which you buy and sell. Note:
Prudential Unit Trusts have only one unit price.
Both Unit Trusts and OEICs are overseen by an independent body. For Unit Trusts this is
called the Trustee and for OEICs it is the Depositary.
Investment Trusts
The easiest way to understand investment trusts is to think of them as a company. This is because
that is exactly what they are. Just like any other company, they issue shares to raise money from
shareholders and then invest that money. The difference between investment trusts and normal
'trading' companies is that they invest their money in the shares of other companies, rather than in
physical assets such as factories or mobile phone networks. Since they are like a company, they are
also able to borrow money to invest (which is not allowed for unit trusts or OEICs
Investment trusts are often referred to as 'closed-end funds'. Like ordinary companies, they have a
set number of shares in existence (although they do occasionally issue more or buy some back). So if
you want to buy shares in an investment trust you usually have to buy them from someone who's
already got some. You can either buy them through a stockbroker, or through one of the many
savings schemes set up by the investment trust companies themselves. In contrast, unit trusts and
OEICs are 'open-ended funds' so, as we saw in the previous article, if you want to buy into one they
simply create new units with the money you've provided.
Split Capital Investment Trusts (Splits)
Splits issue 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.
Every Split Capital Trust will have at least two classes of share:
In order of (typical) priority and increasing risk





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 (AKA Income & Residual Capital shares): a high income and a share
of the remaining assets of the trust after prior ranking shares
Capital shares: entitled most (or all) of the remaining assets after prior ranking share classes
have been paid; very high risk
The type of share invested in is ranked in a predetermined order of priority, which becomes
important when the trust reaches its wind-up date. If the Split has acquired any debt, debentures or
loan stock, then this is paid out first, before any shareholders. Next in line to be repaid are Zero
Dividend Preference shares, followed by any Income shares and then Capital. Although this order of
priority is the most common way shares are paid out at the wind-up date, it may alter slightly from
trust to trust.
Splits may also issue Packaged Units combining certain classes of share, usually reflecting the share
classes in the trust usually in the same ratio. This makes them essentially the same investment as an
ordinary share in a conventional Investment Trust.[7][8]
Taxation
Provided that it is approved by HM Revenue & Customs,[9] an investment trust is taxed in the
normal way on its investment income, but its capital gains are not taxed. This avoids the double
taxation which would otherwise arise when shareholders sell their shares in the investment trust
and are taxed on their gains.
An approved investment trust must



be resident in the United Kingdom
derive most of its income from investments
distribute at least 85% of its investment income as dividends (unless prohibited by company
law)
The company must not hold more than 15% of its investments in any single company (except
another investment trust); must not be empowered to distribute capital gains as dividends to
shareholders, and must not be a close company.
Risk
Exposure to the stock market
They invest in a number of different companies – diversified risk
Investment trusts are riskier than unit trusts because their shares can trade at a premium or
discount to the value of the assets they hold, known as the net asset value
Access to funds
Unlike unit trusts or OEICs, you don’t have to pay commission
Instant access to funds
Summary

Unit Trusts – Authorised by the FSA, managed by the Manager, and the under the
supervision of the trustee who holds the assets. Regulated by Trust Deed.
Many U/T’s have been converted to OEICs.
OEICs – Authorised by the FSA, managed by the Authorised Corporate Director, and under
the supervision of the Depositary who holds the assets.
The Depositary ensures the Authorised Corporate Director (ACD) acts in
accordance with the prospectus and the relevant regulations from the FSA.
Investment Trusts – Governed by the Companies Act and the listing rules of the Stock
Exchange, as well as subject to Inland Revenue approval. Under the supervision of the
directors.
pricing
Unit trusts – Usually dual priced daily at underlying NAV by the Manager, reflecting the cost
including Stamp Duty of buying securities in the cancellation price. May be initial charges –
Bid/Offer spread including commissions and charges 5%.
OEIC – Single (mid) priced daily by the ACD at underlying NAV. May be subject to a dilution
levy to protect the interests of existing investors. Similar charging structure to U/T’s Bid/Offer 5%.
Investment Trusts – Daily stock exchange prices available at bid and offer (spread
typically1%-2%) through a broker: broker commission and 0.5% stamp duty may be added
expense. The price depends on supply and demand for shares and is thus not defined as
equal to the underlying NAV.
Structure
Unit trusts
 Borrowing restricted to 10% of the value of the fund on a temporary basis.
 Units are all equal, accumulation and income units are possible.
OEIC
 Borrowing restricted to 10% of the value of the fund on a temporary basis.
 Different share classes are possible, generally reflecting different lower fee levels for
large investments. Accumulation and income shares are possible.
Investment Trusts
 Borrowing governed by the Memorandum and Articles of Association but unlimited
in theory and are often long term.
 Ordinary shares are most common. Split capital trusts have more than one type of
share which have different rights set out in the articles of association.
Pros and cons
Unit trusts & OEICs
Asset value
 The size of the fund will grow or diminish depending on the demand for its shares.
The NAV will always reflect the value of the underlying assets.
 Open-ended funds have to be managed so as to enable assets to be realised as
required to meet selling pressure.
Charging Structure
 Generally, OEIC’s and U/T’s AMC’s are +1.25% and front end charges of 5%.
Reflect the fact that the manager pays more in advertising, marketing,
printing and price publication costs.
Higher charges impact on performance returns.
Investment Trusts
 As there are only a fixed number of shares, the market price is usually different from
the value of the underlying assets.
Market price > NAV = Premium
Market Price < NAV = Discount
 The premium or discount can widen or narrow depending on market sentiment.
Therefore, the value of an investor’s share is not solely dependent on the skill of the
investment trust’s manager!
Gearing
 Enable trusts to create added value when equity markets are rising by comparison to
U/Ts & OEICs, which cannot borrow freely.
 If equity markets rise, IT’s with higher gearing will offer the prospect of higher gains.
Vice-versa in falling markets – Higher risk.
Charging/fees
Lower fees reflect the efficiency of managing large, stable funds
Collective investment scheme regulation - What are they?
 Portfolio of risky assets
 Offer stock market exposure
 Designed to facilitate pooled investment
 Able to be purchased at low quantities
Benefit to the Investor
 Investors are able to diversify risk
 Avoid paying Capital Gains Tax
 Improve investment timing
ISA
Tax
You pay no personal income tax or capital gains tax on any growth in an ISA, or when you take your
money out. You can save up to £11,280 per person in the 2012/13 tax year in an ISA. Find out more
about ISAs.
If you invest in a stocks and shares ISA, any dividends you receive are paid net, with a 10% tax credit.
There is no further tax liability.
Please be aware that the impact of taxation (and any tax reliefs) depends on individual
circumstances. Information about tax rules is based upon our current understanding, and is liable to
change in the future.
How many contracts are needed for a risk free hedge?
What is the % return on their investment given … x3 and value the market value of the plc? X2 how
much money will need to be moved into the company from other investment ? xx2 (contract for
difference?)
Analyse farmas discomposition. X2 and use it to calculate client risk, market timing, diversable risk,
pure selectivity.
Basis risk and how it can be managed. X3
Return on portfolio and move some from treasury bills into company how many should be moved?
Knowledge of farmas deconomposition? X2
What if the value of a stock future to be settled in 10 days.. (duration)
Capital markets pricing market behaviour x2.threory.
What benefits should drvive from SEPA
Understanding of the term collective investments?
Understanding of the term private equity and issues which can arise when used to buy firms?
Undertsnading of the term asset allocation?
Saving = returns are secondary to capital and safety growth.
Investment = lump some or monthy amount for income or capital growth long term.
Income tax= 20% from 8,105-35,000, 40% from 35,001+
Dividends tax = 10% from 10600 higher =32.5%
Capital gain = from 10,600 18%
Inheritance = 40% over £325,000
Benefits of cash = liquidity – immediate redemption and no loss of interest in normal savings a/c.
Essential part of any portofolio, non- marketable, almost zero risk. Negative of cash = no interest,
high interest accounts may have 90 days notice, interest is subject to income tax.
(only protected up to 85,000 per provider eg sanandeer not Bradford and bingley and alliance and
lecter)
4% half-yearly=
(1 + 0.04)2 - 1 = 0.0816 or 8.16% per annum
2% quarterly=
(1 + 0.02)4 - 1 = 0.0824 or 8.24% per annum
•
gilt Ex div ( 7 days before coupon date and thus interest paid ) interest belongs to seller and
thus price paid = gilt price - accrued interest otherwise Price paid = gilt price + accrued
interest
flat yield = Measures the return from income as a % of the price
•
Market price will vary according to level of interest paid and length of time to redemption/
•
Flat yield ( also known as interest yield/running yield )
•
= ( coupon yield /clean price ) * 100
•
Example
•
Calculate the flat yield of 5 ¾% Treasury 2011 price 106.04
•
£5.75 per annum is paid for every £100 nominal bought
•
but paid £106.04 per £100 so flat yield
= ( 5.75/106.04 ) x 100 = 5.42%
Redemption yield
•
Example
•
Calculate the approximate redemption yield on Tr 8pc 2018 125.73
•
Assume gilt redeemed end of September 2020 and today 1st October 2011.
•
Find flat yield first
( 8/125.73) * 100 = 6.36%
•
RY
=
6.36 + { 100 – 125.73 x 100 }
9 x 125.73
=
4.066%
•
Calculation assumes all income is re-invested at the redemption yield
•
As coupon paid twice a year:
•
Effective annual yield
•
= ( 1 + bond equivalent yield )2 – 1
•
2
•
Which measure should investors use?
•
If holding till maturity......redemption yield
For short-term.......................flat yield
QE, interest rate swaps, eurobonds.
Private equity -
Just equity – income tax and dividend 10/32.5%
•
Why buy ordinary shares?
•
To obtain income from dividends ( normally 2 per annum - interim and final )
•
To obtain capital gains from rises in the share price between buying and selling
•
Very liquid market but transaction costs. Stamp duty 0.5% on purchases
•
Dividend paid twice yearly
•
The higher the dividend the higher the share price
•
Investors needing a regular income will pay more for high yielding shares
•
The value of a dividend this year is worth more than those in the future as there is more
certainty of receiving it
•
Dividends are easier to predict than capital gains
Private equity
•
PE managers invest their own money
•
Favourable tax legislation
•
Were paying 10% on part of their earnings, interest 40% and dividends 25%
•
CGT now 18%
•
Leverage from banks but credit squeeze forcing a rethink of strategy
•
Attracts high-calibre individuals because of possibility of enormous rewards
•
Focus on three to five year horizons
•
Buys to sell later
•
Need for more transparency about deals
•
Unaccountable
•
Unregulated
•
Threaten stability of financial markets
•
Can add no value and carry excessive charges
•
Need for more disclosure
•
Industry has threatened to move offshore
Tick value basis point –

Basis point is 1/100 of one percent as is smallest permissable movement in interest rates

Traded in £500,000 size contracts

Contract covers 3 months

Minimum price movement Tick = 0.01%

Tick value = £500,000 x 0.0001 x ¼

Contract traded on LIFFE CONNECT

Contract profits or losses

Buy 5 contracts at 151.04

Sell 5 contracts at 155.04

Price movements 400

Profit 5 x 400 x £12.50 =£25,000
=
£12.50
Basis risk

Basis gives the ever-changing relationship between spot and futures prices.

At maturity, the futures and spot price converges on spot

If future closed out early, changes in spot price will not match
change in futures price

Simple and precise hedge ratios
Hedge ratio

=
(simple)
nominal value of contract
Hedge ratio

nominal value of exposure
=
(precise)
nominal value of exposure
nominal value of contract
x relative volatility

Relative volatility
= how much movement there is in prices
Calculated by 
Buying contracts to hedge = eg

Mr Pizza owns the shares listed below and is worried that the stock index is going to fall. He
decides to hedge against this a stock index futures contract. How should he proceed?
Share
Value of shares£
Share Beta
Market exposure£
ABC plc 531,250
1.1
584,375
EFG plc 600,000
1.2
720,000
HIJ plc 432,500
1.0
432,500
KLM plc 451,250
0.8
361,000
2,097,875
The FTSE 100 stands at 4000. Futures index is 4040.
Each contract thus worth £10 x 4000 = £40,000 worth of stock
Contracts required = £2,097,875/£40,000
=
52.45 contracts = 52 contracts
He would sell 52 contracts and close by buying out later
The above used the spot index – this is used when the futures contracts are to be
held to their maturity date.
If futures contracts are likely to be closed out quickly, use futures index. Assume
‘quickly’ means in less than three weeks time.
Investment in non listed goods (chattels) eg art

Advantages
pleasure
use
tax

Disadvantages storage
insurance
valuation
forgeries
SEPA
What is it?
Single Euro Payments Area
Covers 27EU countries + Iceland, Liechtenstien, Norway and
Switzerland
Electronic euro payments made across the euro area ( bank
transfer/debit/credit card/direct debit ) become as easy as domestic
payments.
Adoption of common processes and systems
Eg UK citizen with home in Spain can pay for groceries using UK bank
account, using debit card.
Companies will not need to set up accounts in each country of business
Benefits to business and consumers
Should iron out local market distortions
So far 4,000 banks signed up ( 50% of total in region but 80% of
transactions)
28.1.08 credit transactions covered, but direct debit since 2009
Consumers can use domestic banks or internet providers anywhere in
Eurozone. Should force down prices.
Liqidity preference on desiion on bond or gilt
•
Lack of uncertainty about the future and thus investors prefer liquidity to retain flexibility
•
Investors will prefer bonds with a shorter maturity and will take a lower yield
•
Borrowers will prefer bonds with a longer maturity and will pay a higher yield
•
Liquidity preference theory states that the liquidity preferences of investors and borrowers
will tend to bias longer - term bond yields upwards
•
Segmented markets
Redemption yields of bonds of differing maturities vary not because of future interest/
inflation rate expectations or liquidity premiums but because some investors only want to invest
short-term and others long-terms. The same goes for borrowers. Specific interest rates are required
and therefore the yield curve is a function of supply and demand in the market place. This will
enable some investors to make arbitrage profits