Active fund management
To begin with, we need to make a distinction between mutual funds that are managed and
those that are indexed. The former are actively managed by an individual manager, comanagers, or a team of managers. The index funds are passively managed, which means that
their portfolios mirror the components of a market index. For example, the well-known
Vanguard 500 Index fund is invested in the 500 stocks of Standard & Poor's 500 Index on a
market capitalization basis.
Swensen, and a high percentage of investment professionals, find index investing compelling
for the following reasons:
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Simplicity. Broad-based market index funds make asset allocation and diversification easy.
Management quality. The passive nature of indexing eliminates any concerns about human
error or management tenure.
Low portfolio turnover. Less buying and selling of securities means lower costs and fewer tax
consequences.
Low operational expenses. Indexing is considerably less expensive than active fund
management.
Asset bloat. Portfolio size is not a concern with index funds.
Performance. It is a matter of record that index funds have outperformed the majority of
managed funds over a variety of time periods.
•
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.
•
Aim to beat the market
•
Selectivity
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High turnover, high cost strategy.
It is worth remembering that despite their impressive long-term records, even top-rated fund
managers can have bad years. Such an occurrence is little cause to abandon a fund run by a
highly respected manager. Typically, managers will stick to their fundamental strategies and
not be swayed to experiment with tactics geared to improving results over the short term.
This type of posture best serves the long-term interests of fund investors.
Active management: Advantages
Expert analysis — seasoned money managers make informed decisions based on experience,
judgment, and prevailing market trends.
Possibility of higher-than-index returns — managers aim to beat the performance of the
index.
Defensive measures — managers can make changes if they believe the market may take a
downturn.
Active management: Disadvantages
Higher fees and operating expenses.
Mistakes may happen — there is always the risk that managers may make unwise choices on
behalf of investors, which could reduce returns.
Style issues may interfere with performance — At any given time, a manager's style may be
in or out of favour with the market, which could reduce returns.
Passive management: Advantages
Low operating expenses.
No action required — There is no decision-making required by the manager or the investor.
Passive management: Disadvantages
Performance is dictated by the index — investors must be satisfied with market returns
because that is the best any index fund can do.
Lack of control — managers cannot take action. Index fund managers are usually prohibited
from using defensive measures, such as moving out of stocks, if they think stock prices are
going to decline
Arbitrage Pricing Theory
Difference between this, three/ four factor and CAPM. And the assumptions which underpin
them?
Unexpected returns or impacts which will impact he stock due tp ‘general news’ eg interest
rates are accounted for by APT( multi factor model). Thus allows a number of factors to
affect the rate of return of a security believing …..An equities return depends upon how
investment reacts to a set of individual macro - economic factors ( as measured by the betas )
and the risk premium associated with each of them. changes in inflation, shape of yield
curve, industrial production, default - risk premium, real interest rate, personal consumption,
money supply, unemployment, political, Footsie, etc.
Therefore more accurate however Difficult to identify factors and measure investment's
changes in sensitivity to each and the risk of these factors.
Whereas CAPM (single factor model) only considers the covariance between the return of the
share and the return of the market portfolio.
Crucial assumption of APT
specific risk is uncorrelated across different securities
Riskless arbitrage opportunities will be eliminated immediately
Does not require any assumptions about utility theory
Does not assume that mean and variance of a portfolio are the only two elements in an
investor’s objective function
People prefer wealth to no wealth!
People are risk- averse
Investors can assess an investment's risk factor(s) numerically
Advantage of APT over CAPM
Unlike CAPM does not assume single-period horizon
does not assume no taxes
does not assume lending/borrowing at
risk-free rate by investors
does not assume investors select equities on basis of
means and variances.
There is less empirical evidence on APT than CAPM as a newer model.
Explains the pricing of securities in relation to each other rather than the market portfolio
Chaos Theory
Forecasts of economists of limited empirical validity
Capital market theory based on:
Rational Investors ( investors require mean/variance efficiency; assess potential returns by
probabilistic weighting that generates expected returns; risk is standard deviation of return;
investors want highest return for given level of risk and are risk averse ) and Efficient
Markets ( prices reflect all public information; changes in price are not related; value is
determined by the consensus of a large number of fundamental analysts )
chaos theory is an attempt to see and understand the underlying order of complex systems
that may appear to be without order at first glance.
Related to financial markets, proponents of chaos theory believe that price is the very last
thing to change for a stock, bond, or some other security. Price changes can be determined
through stringent mathematical equations predicting the following factors:
1) A trader's own personal motives, needs, desires, hopes, fears and beliefs are complex and
nonlinear.
2) Volume changes
3) Acceleration of the changes
4) Momentum behind the changes
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Every event is the result of literally thousands of different variables interacting, and
Changing just one of those variables (even a seemingly insignificant one) can cause
events to unfold in an entirely different way
Random Walks ( returns follow a random walk; probability distribution is approximately
normal ; distribution of returns has a finite mean and variance )
but
nature abhors equilibrium
free market economies evolve
time is a variable like any other
stock market is non - linear and dynamic and thus we should expect:
long-term correlations and trends ( feedback effects )
Erratic markets under certain conditions and at certain times
A time series of returns that, at smaller increments of time, will still look the same and will
have similar statistical characteristics ( fractals )
Less reliable forecast the further out we look ( sensitive dependence on initial conditions )
Sporadic occurrence of crashes indicates markets are not rational
Eg Bubble effect - crash emphasises the bursting aspect of the previous unsustainable rise
Deterministic chaos ‘ unpredictable behaviour governed by rules
Stochastic = random; lawless and irregular, ruled by chance, Chaos = lawless behaviour
governed by law
The outcome of not or of doing something will have consequences (butterfly effect)
Comparison of Newtonian and chaos science compared
Newtonian
Chaos
Order and regularity
Disorder and irregularity
Predictable results
Unpredictable results
- deterministic
- probabilistic
Ruled by law
Ruled by chance and simple
rules
Future determined by the past
Future cannot be determined
the past
Simple, modular systems, linear
Complex, non-linear systems
ie directly proportional
Very simple to calculate
Not proportional so difficult
to calculate
Discovered 300 years ago
Discovered 30 years ago
eg the Solar System
eg population growth cycles
Orderly motion eg the tides
Disorderly motion eg the
a fluid under the daily influence
weather - a turbulent fluid,
of sea and moon
unpredictable, with numerous
unquantifiable influences
Reductionist approach
Holistic, global approach
( Source Bernice Cohen The Edge of Chaos )
Collaterised Debt Obligations
An investment-grade security backed by a pool of bonds, loans and other assets. CDOs do not
specialize in one type of debt but are often non-mortgage loans or bonds. these different types
of debt are often referred to as 'tranches' or 'slices'. Each slice has a different maturity and risk
associated with it. The higher the risk, the more the CDO pays.
In simplest terms, a CDO
is an arrangement that raises money primarily by issuing its own bonds and then invests the
proceeds in a portfolio of bonds, loans, or similar assets. Payments on the portfolio are the
main
source of funds for repaying the CDO's own securities.
Most CDOs have actively managed portfolios. A typical deal has a manager (i.e., a
management
company) that collects fees for managing the portfolio – again similar to a mutual fund.
However, a
small proportion of CDOs has static, unmanaged portfolios. Those deals resemble oldfashioned unit
investment trusts.
But, there are lots of details and other features. For example, a standard feature of virtually all
CDOs
is "credit tranching." Credit tranching refers to creating multiple classes (or "tranches") of
securities,
each of which has a different seniority relative to the others.1
For example, a CDO might issue four classes of securities designated as (1) senior debt,
(2) mezzanine debt, (3) subordinate debt, and (4) equity. Each class protects the ones senior
to it
from losses on the underlying portfolio. The sponsor of a CDO usually sets the size of the
senior
class so that it can attain triple-A ratings. Likewise, the sponsor generally designs the other
classes
so that they achieve successively lower ratings. In a way, the rating agencies are really the
ones who
determine the sizes of the classes for a given portfolio.
Companies have different reasons for creating or sponsoring CDOs. For example, some
CDOs are
created by investment advisory firms (i.e., money management firms). Such a firm earns fees
based
on the amount of assets that it manages. By creating a CDO, the firm can increase its income
by
increasing its assets under management.
Other CDOs are created by banks as a way to remove assets from their balance sheets. A
bank can
remove assets from its balance sheet by creating a CDO and transferring assets to the CDO's
portfolio. Such a CDO is called a balance sheet CDO. Removing assets from its balance
sheet can
be advantageous for a bank when it calculates its regulatory capital requirement.
A CDO is basically a promise to pay cash flows to investors in a prescribed sequence, based
on how much cash flow the CDO collects from the pool of bonds or other assets it owns. If
the cash collected is insufficient to pay all investors those in the junior tranches suffer losses
first. Junior tranches offer higher coupon payments or lower prices to compensate for
additional default risk
Valued on a mark to market basis. Market value dropped dramatically during 2007-8 as many
had been issued on sub-prime mortgages.
Negative;
Assumptions about correlation have a strong effect on the predicted credit quality of a CDO.
A few
years ago, many of the outstanding CDOs performed much worse than the rating agencies
and other
market participants had predicted. Some professionals now feel that wrong assumptions about
correlation were the cause of the inaccurate predictions. Following the wave of poor CDO
performance, each of the rating agencies modified its CDO rating approach to place greater
emphasis on correlation.
Life cycle of CDO
It is useful to view a CDO as having a lifecycle that consists of several phases.
The first phase is the ramp-up phase, when the manager uses the proceeds from issuing the
CDO to purchase the initial portfolio. The CDO's governing documents generally specify
parameters for the initial portfolio but not the exact composition. For example, the terms of
the CDO might require that the initial portfolio have a minimum average rating, a minimum
average yield, a maximum average maturity, and a minimum degree of diversification.
During the ramp-up phase, the manger must select assets so that the portfolio satisfies all the
parameters.5
The second phase is the revolving period, during which the manager actively manages the
portfolio
and reinvests cash flow from the portfolio. The reinvestment phase allows a CDO to remain
outstanding – without amortization of the CDO's own bonds – even though the assets in the
underlying portfolio reach their maturity dates.
The third period is the amortization phase. During the amortization phase, the manager stops
reinvesting cash flow from the portfolio. Instead, the manager must apply the cash flow
toward
repaying the CDO's debt securities.
A manager generally is required to follow certain rules in managing the portfolio. The rules
protect
investors by somewhat limiting the manager's discretion. For example, one rule might require
the
manager to maintain the average yield or spread on the managed assets above a certain level.
Another rule might require the manager to maintain the average maturity of the assets within
a certain
range.
Way they are constructed:
A special purpose entity is designed to acquire a portfolio of assets ( these are normally
mortgage-backed securities, commercial real estate bonds and corporate loans ).
The SPE issues bonds to investors in exchange for cash which is used to buy the portfolio of
underlying assets.
For an investor the risk and return depends on how the tranches are defined and only
indirectly on the underlying assets. The originators of the underlying assets can pass credit
risk onto other institutions
Issuer of the CDO is normally an investment bank who earns commission at the time of issue
and management fees during the CDO’s life.
Cash flow CDOs focus primarily on managing the credit quality of the underlying portfolio.
Market value CDOs attempt to enhance investor returns through the more frequent and
profitable sale of collateral assets looking for capital gains.
Arbitrage transactions for both types account for 86% of CDOs and attempt to capture for
equity investors the spread between high yielding assets and the lower yielding liabilities
represented by the rated bonds.
Balance sheet transactions are motivated by the issuing institutions’ desire to remove loans
and other assets from their balance sheets to reduce credit risk.
In some CDOs the underlying portfolio is composed of credit
default swaps7 (CDS) rather than bonds or loans. Because CDS
permit "synthetic" exposure to credit risk, a CDO backed by CDS is
called a synthetic CDO. By contrast, a CDO backed by ordinary
bonds or loans is called a cash CDO. Synthetic CDOs recently
have become very popular, especially in Europe.
Synthetic CDOs gain credit exposure to a portfolio of fixed income assets through the use of
credit default swaps.
Participants in CDOs:
Investors – can get better yields than on corporate bonds. Senior tranche holders include
banks, insurance companies and investment funds. Junior tranche holders include hedge
funds, wealthy investors and banks
Underwriter. Normally an investment bank is structures debt and equity tranches. Works with
credit rating agencies to gain the desired rating for each tranche. Creates the special purpose
vehicle, prices the CDOs and places the tranches with investors.
Asset Manager – concerned with the construction and maintenance of the CDO portfolio
Trustee and collateral administrator – holds the title to the assets of the CDO for investors.
Performs compliance tests
Accountants – hired by underwriting form to perform due diligence on the CDOs portfolio of
debt securities
Lawyers – ensure compliance with securities laws and negotiate and draft the transaction
documents
CAPM
The general idea behind CAPM is that investors need to be compensated in two ways: time
value of money and risk. The time value of money is represented by the risk-free (rf) rate in
the formula and compensates the investors for placing money in any investment over a period
of time. The other half of the formula represents risk and calculates the amount of
compensation the investor needs for taking on additional risk. This is calculated by taking a
risk measure (beta) that compares the returns of the asset to the market over a period of time
and to the market premium (Rm-rf).
The CAPM says that the expected return of a security or a portfolio equals the rate on a riskfree security plus a risk premium. If this expected return does not meet or beat the required
return, then the investment should not be undertaken. The security market line plots the
results of the CAPM for all different risks (betas).
Shortcomings of CAPM
The model does not appear to adequately explain the variation in stock returns. Empirical
studies show that low beta stocks may offer higher returns than the model would predict.
Some data to this effect was presented as early as a 1969 conference in Buffalo, New York in
a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is itself
rational (which saves the efficient markets hypothesis but makes CAPM wrong), or it is
irrational (which saves CAPM, but makes EMH wrong – indeed, this possibility makes
volatility arbitrage a strategy for reliably beating the market).
The model assumes that investors demand higher returns in exchange for higher risk. It does
not allow for investors who will accept lower returns for higher risk. Casino gamblers clearly
pay for risk, and it is possible that some stock traders will pay for risk as well.
The model assumes that all investors agree about the risk and expected return of all assets.
(Homogeneous expectations assumption)
The model assumes that there are no taxes or transaction costs, although this assumption may
be relaxed with more complicated versions of the model.
The model assumes that asset returns are normally distributed, random variables. There is
significant evidence that equity and other markets are complex, chaotic systems. As a result,
large swings (3 to 6 standard deviations from the mean) occur in the market more frequently
than the normal distribution assumption would expect. These swings can greatly impact an
asset's value.
The market portfolio consists of all assets in all markets, where each asset is weighted by its
market capitalization. This assumes no preference between markets and assets for individual
investors, and that investors choose assets solely as a function of their risk-return profile. It
also assumes that all assets are infinitely divisible as to the amount which may be held or
transacted.
The market portfolio should in theory include all types of assets that are held by anyone as an
investment (including works of art, real estate, human capital...) In practice, such a market
portfolio is unobservable and people usually substitute a stock index as a proxy for the true
market portfolio. Unfortunately, it has been shown that this substitution is not innocuous and
can lead to false inferences as to the validity of the CAPM, and it has been said that due to
the inobservability of the true market portfolio, the CAPM might not be empirically testable.
This was presented in greater depth in a paper by Richard Roll in 1977, and is generally
referred to as Roll's Critique. Theories such as the Arbitrage Pricing Theory (APT) have since
been formulated to circumvent this problem.
Differences Vs Apt, 3/4 factor model? And the assumptions which underpin them?
Risk and retun of 2 asset portfolio
Sharpe, jenson, sortino, treynor. X2
Contracts for Difference
Understanding of?
Difference between this and exchange traded fund?
Definition of 'Exchange-Traded Fund - ETF'
A security that tracks an index, a commodity or a basket of assets like an index fund, but
trades like a stock on an exchange. ETFs experience price changes throughout the day as they
are bought and sold.
Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated
every day like a mutual fund does.
By owning an ETF, you get the diversification of an index fund as well as the ability to sell
short, buy on margin and purchase as little as one share. Another advantage is that the
expense ratios for most ETFs are lower than those of the average mutual fund. When buying
and selling ETFs, you have to pay the same commission to your broker that you'd pay on any
regular order.
One of the most widely known ETFs is called the Spider (SPDR), which tracks the S&P 500
index
Etf vs cfd
Exchange traded funds, or ETFs as they are commonly known, have been much vaunted as
the ideal investment and trading vehicle since their inception. In their simplest form, they are
just like other funds such as mutual funds with the exception that they are traded on an
exchange, hence the name. This means they can vary in price during the day, just like shares,
and can be used by a trader to squeeze out a profit on a short-term basis. However, as funds
they are also suitable for longer-term investment, and can be based on many different
underlying goods, such as stock indices, commodities, bonds, currencies, etc.
While frequently you may buy, or go long, in an exchange traded fund, they can also be used
for short positions. For instance you can find ETFs that behave inversely to indices, going up
in value when the index goes down. ETFs are also available in a form that multiplies the
difference, going up twice as much as an index goes up for example. This makes them very
flexible for many people.
Contracts for difference, or CFDs, on the other hand have been around for even fewer years
than exchange traded funds, but are also available to be traded on many different underlying
markets. CFDs allow you to contract to receive or pay the difference in price over time of the
underlying financial instruments, taken from when you open your trade to when you liquidate
your contract. You benefit to the extent a stockholder or owner would from an increase in
price, but without buying the underlying goods.
But when you come to compare CFDs with ETFs, you will find that there are many
differences. CFDs are a derivative, giving you substantial gearing of your investment, which
means you can control and profit from the change in price of a much higher value of security
than you could buy with the same money. Typically you will only have to pay 5% to 10% of
the value of the underlying. While some ETF's can manipulate the paybacks, they are not
leveraged as such, and you need to pay the full price for them.
The other difference, arising from this, is that CFDs are subject to interest charges for the
period that you hold them. Because they are a margined product, you are also open to the
broker requesting more money from you, a margin call, if the value falls. He has to do this to
protect his interests from you defaulting on the debt. If you have an active interest in trading,
and intend to take profitable positions, then the leverage of CFDs far outweighs these
disadvantages when compared to ETF's.
Corporate bonds
•
Investing in corporate bonds gives a return composed of:
•
a)
•
b)
The capital gain or loss made when you sell it or the loan is repaid by the
issuer.
•
The yield to maturity
•
Annual rate of return you would expect to get if you held the investment until the
loan/bond was redeemed or repaid and is represented by the IRR of the bond's
future cash flows up to maturity.
•
Shorter - term maturity bonds have a lower yield and longer-term maturity
bonds have a higher yield
•
•
Floating rate notes
These are bonds where the coupon is not fixed, but based on a reference rate, typically
LIBOR. They do not exhibit the same degree of interest rate sensitivity as
conventional bonds. The majority of floating rate loans (FRNs) will be issued with
maturities between two and ten years and will be senior debt. However, there is a
The coupon rate
•
•
•
•
class of perpetual FRNs which you may encounter from time to time of which the
majority are subordinated debt (rank below other debt owed by the issuer in the event
of default).
Convertible bonds
These are bonds where the holder may convert his redemption proceeds into the
equity of the issuing company. These are known as "equity convertibles" and can
offer a combination of yield and growth for investors. These instruments may see
their price driven higher by a rise in the company's equity. Risk, however, is generally
higher.
In some cases, bonds may be issued with the option to convert into other bonds. These
are a rather different kettle of fish and should not be confused with the "equity
convertibles" above.
Subordinated bonds
The majority of bonds issued are "senior debt", meaning that the holder has a priority
claim on the company's assets, ahead of that of the shareholders. Some bonds are
issued with "subordinated" status. This means that the buyer of the bonds accepts a
lower claim on the company's assets, below the senior debt holders, but above the
equity holders. Because of the additional risk, a higher yield will be offered.
Pros of bonds (gov and commercial)
Security
The risk of the UK or other major governments being unable to repay their debts is low and
government bonds should be considered superior in credit quality to a bank deposit in theory.
In practice though the Government underwrites bank deposits putting them on a par. High
grade multi-national government agencies (such as the World Bank) also offer an extremely
safe home for the investor holding bonds to maturity. Of course, not all bonds are issued by
governments. Many bonds are issued by companies and other organisations whose ability to
service the debt may be less certain. However, even corporate debt can be considered a safer
investment than the company’s equity. In the event of bankruptcy, bondholders are ranked
above shareholders in their claim on the company’s assets. However, if the company can't
meet its obligations to bondholders, their capital and income is at risk.
Return of capital
Bonds also differ from equities in one other very important aspect. In order to realise your
profit (or loss) on an equity, you are wholly dependent on the ability to sell the instrument
back to the market. When an investor buys a bond, the redemption date and value is fixed in
advance. Assuming the issuer is able to repay, the investor’s reliance on the uncertainties of
future market sentiment or liquidity is reduced.
Income
With an ageing population requiring an ongoing income, amongst a balanced portfolio, bonds
can add a degree of reliable income to a portfolio. Income available from bonds is generally
higher than that available from equities. Also, future income payments are a relatively known
quantity, unlike dividends from equities, which may be reduced or withheld entirely in times
of low profitability. This generally makes bonds a good choice for investors who wish
to shelter future income over a defined period of time. With bonds paying annually, semi-
annually or sometimes quarterly, a carefully chosen bond portfolio with multiple holdings
can produce a reliable monthly income. Remember also that most bonds pay their coupons
gross, without withholding tax. Investors can take advantage of this by holding qualifying
bonds within an ISA, producing a tax free income. Remember tax rules can change and the
reliefs depend on your personal circumstances.
Diversification
A well managed portfolio should contain a variety of different assets classes. Equities,
government bonds, index-linked bonds, corporate bonds, and alternative assets all have their
role to play. This simple approach of diversifying a portfolio is one of the most effective
strategies for reducing risk. In certain economic scenarios, such as a recession, some bonds
will offer a shelter against falling share prices.
Interest rates
When an investor buys a fixed coupon bond, he or she locks in interest rates for a defined
period. If interest rates rise, the income from a bond becomes less attractive and the market
value of the bond will fall. Falling interest rates will cause the market value of the bond to
rise. Investors who buy bonds in falling interest rate scenarios will receive the double benefit
of a secure income and capital appreciation of their asset. Investors must note that interest
rates are at an all time low and are likely to rise from here.
Speculation
Any financial instrument offers the potential to speculate on future price movements, and
bonds are no exception. Liquid government bonds are often used by traders speculating on
future interest rates while corporate bonds can see sharp price movements from changes in
the perceived credit quality of the issuer
Risks for corporate bonds
Market risk
The investor buys an asset at price "X". This price will then fluctuate from day to day
according to the balance of supply and demand in the market, creating a paper profit or loss.
Thus, if the investor needs to sell the asset before maturity to raise funds, he faces a risk of
capital loss.
Issue-specific risk
Many bonds are issued with imbedded features such as "calls", which enable the issuer to
repay the debt ahead of schedule. This can be disadvantageous to the holder. However, such
features are clearly laid out in the bond prospectus, so careful investors can either avoid such
issues, or make contingency plans. If you are unsure of the suitability of an investment please
seek advice.
Event and other risks
This encompasses a variety of "operational" hazards such as a shift to an unfavourable or
punitive tax treatment, remember tax rules can change and any reliefs depend on your
personal circumstances. These types of risk can be reduced through careful planning and
monitoring. Next we have "event risk". An example of this would be the issuer of the bond
becoming the target of a leveraged buyout - a buyout where by the company taking over the
issuer is buying with the use of debt, increasing the degree of risk of lending money to the
company. Finally, we add to this list the risk of inflation, which can devalue the asset or
portfolio over time.
Default Risk has been discussed above but there are also other risks for which corporate
bondholders expect to be compensated by credit spread. This is, for example why the Option
Adjusted Spread on a Ginnie Mae MBS will usually be higher than zero to the Treasury
curve.
-Credit Spread Risk. The risk that the credit spread of a bond (extra yield to compensate
investors for taking default risk), which is inherent in the fixed coupon, becomes insufficient
compensation for default risk that has later deteriorated. As the coupon is fixed the only way
the credit spread can readjust to new circumstances is by the market price of the bond falling
and the yield rising to such a level that an appropriate credit spread is offered.
-Interest Rate Risk. The level of Yields generally in a bond market, as expressed by
Government Bond Yields, may change and thus bring about changes in the market value of
Fixed-Coupon bonds so that their Yield to Maturity adjusts to newly appropriate levels.
-Liquidity Risk. There may not be a continuous secondary market for a bond, thus leaving an
investor with difficulty in selling at, or even near to, a fair price. This particular risk could
become more severe in developing market, where a large amount of junk bonds belong, such
as China, Vietnam, Indonesia, etc.[3]
-Supply Risk. Heavy issuance of new bonds similar to the one held may depress their prices.
-Inflation Risk. Inflation reduces the real value of future fixed cash flows. An anticipation of
inflation, or higher inflation, may depress prices immediately.
-Tax Change Risk. Unanticipated changes in taxation may adversely impact the value of a
bond to investors and consequently its immediate market value.
Credit Default Swaps
A CDS is an agreement that the seller of the CDS will compensate the buyer in the event of a
loan default. The buyer of the CDS makes a series of quarterly payments in arrears ( the CDS
‘fee’ or spread’ ) to the seller until maturity and , in exchange, receives the par value of the
bond if the bond defaults with the buyer transferring ownership to the seller.
CDS — Credit Default Swaps7
A CDS is a contract between two parties in which one buys
credit protection from the other. In some respects, a CDS is similar to an insurance policy that
covers credit risk. For example, party X might purchase protection from party Y covering the
credit risk of Acme Corporation. X is the
protection buyer and Y is the protection seller. Acme is the reference entity under the
contract. X agrees to pay Y a periodic fee during the term of the contract unless and until a
credit event occurs. A credit event could be Acme's
bankruptcy or a default on its financial obligations. Some CDS also include "debt
restructurings" as credit events, but that
feature introduces complications and opportunities for disputes. If a credit event occurs, Y
has to pay X the amount specified in the contract. In some contracts, the amount that Y must
pay is determined by the decline in the price of Acme's
debt securities following the credit event. Such an arrangement is called cash settlement of
the contract. In other cases, X delivers an eligible Acme bond to Y, for which Y must pay
par. That kind of settlement arrangement is called
physical settlement. A CDS has a "notional amount," which defines the maximum
dollar level of exposure under the contract. A CDS also has a specified term, which defines
the time limit of exposure. So, X
and Y might enter into a 5-year, $10 million CDS that references Acme. The notional amount
is $10 million and the term is five years. If a credit event occurs during the 5-year term, Y
would have to pay X. In a cash settlement scenario,
the payment amount would be $10 million times the percentage decline in the price of
specified Acme bonds. In a
physical settlement scenario, X would purchase Acme bonds in the open market (probably at
low prices reflecting the
company's distressed condition) and deliver them to Y, who would have to pay $10 million
for them.
Unless Y (the protection seller) has a very high credit rating, X (the protection buyer)
generally will require Y to post collateral
as security for its obligation to pay if a credit event occurs. However, the amount of collateral
that Y would have to provide
would be substantially less than the full notional amount of the CDS.
Selling protection through a CDS involves taking risk that is similar to owning a regular bond
of the reference entity.
However, selling protection does not require an initial principal investment (and collateral
requirements are not as large as the
principal investment would be). Thus, CDS provide a way for a company to amplify its
exposure to credit risk for a given
level of capital commitment. Accordingly, CDS are sometimes described as facilitating
leveraged credit exposure.
Buying protection through a CDS is like a short position in the reference entity's bonds.
However, actually taking a short
position in a corporate bond is often impractical. CDS allow market participants to express a
negative outlook on a
reference entity. Corporations and sovereign governments are the most common reference
entities for CDS. However, CDS can be constructed with ABS or MBS as the "reference
obligations." In fact, it is even possible to make a CDS where the reference obligation is a
tranche of a CDO.
Although CDS appear somewhat similar to insurance policies, they are not regulated as
insurance policies. A protection
buyer is not required to have any economic stake in a reference entity in order to purchase
protection. Indeed, both
a protection buyer and a protection seller may enter into a CDS for purely speculative
reasons. Even so, because a CDS
is a kind of derivative, it is not considered to be gambling and is not covered by State gaming
laws.
CDSs have existed since the early 1990s.
Not exchange traded, most are documented using standard forms produced by the
International Swaps and Derivatives Association. There is no required reporting of
transactions to a government agency and thus there is a lack of transparency which is
potentially dangerous.
Most CDSs are in the $10-$20million range with a typical maturity of five years. A default is
a ‘credit event’ and includes failure to pay, restructuring and bankruptcy or a drop in the
borrower’s credit rating.
Investors can buy and sell protection without owning the debt of the reference entity. These
are known as ‘naked credit default swaps ‘ which allow traders to speculate on the
creditworthiness of reference entities. CDSs can be used to create synthetic long and short
positions in the reference entity ie underlying bond. This happens in the majority of cases.
The seller does not have to be a regulated entity, maintain any reserves to pay off buyers (
although most are banks with capital adequacy requirements ).
Most important difference between CDSs and insurance is that insurance provides an
indemnity against losses suffered by the policy holder but CDSs provide and equal payout to
all holders, calculated using an agreed market wide method.
The pricing of CDSs is derived from financial models and arbitrage relationships with other
market instruments such as loans and bonds.
Counterparty risk. The buyer takes the risk the seller may default. The seller takes the risk the
buyer may default on the contract, depriving the seller of a revenue stream. A seller normally
buys offsetting protection from another party so hedging the exposure. If the buyer drops out
the seller unwinds the hedge transaction or sells a new CDS to a third party. This could be at
a lower price than the original and could involve a loss to the seller.
There can be liquidity risk. Margin calls may need to be made.
CDS spreads increase as credit-worthiness declines and vice-versa.
Often used for speculation. They have been accused of making the Greek Financial crisis
worse.
Credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series
of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a
bond or loan) goes into default or on the occurrence of a specified credit event (for example
bankruptcy or restructuring).
Credit Default Swaps can be bought by any (relatively sophisticated) investor;
It is not necessary for the buyer to own the underlying credit instrument.
Lowers borrowing costs
Hedges risk
Credit Rating Agencies
Credit quality is a measure of the issuer’s ability to service and repay its debt. In the case of
Gilts, and other high-quality government debt, they are given the highest level of credit
rating. Investors may have their own knowledge and views on a company’s ability to repay
debt or, alternatively, they can view the credit rating assigned to issuers by several of the
credit rating agencies. Credit agencies deploy considerable resources to assess both the issuer
and the individual bond. It is in the interest of bond issuers to obtain these ratings. That said,
it is the company itself which pays the ratings agency to rate their bonds and that does create
a potential conflict of interest. There are two main international credit ratings agencies,
namely Moody's and Standard & Poor’s.
Credit ratings are the criteria used by most banks and fund managers when establishing the
suitability of a bond as an investment but, remember, situations change quickly, and so can
credit ratings. You can look up the rating of most bond issuers on the Moodysand Standard &
Poors websites. Much research on this subject is also conducted by broking houses and
investment banks, as well as some good up & coming independent analysts. However it is
worth bearing in mind that movements in the issuers share and bond prices will usually occur
prior to any change in the credit rating.
Here is Standard & Poor’s definition of the ratings it awards to organisations issuing bonds (a
conversion table for Moody’s and S&P is shown on the right):
Standard &
Poor's
Moody's
AAA
Aaa
AA+
Aa1
AA
Aa2
AA-
Aa3
A+
A1
A
A2
A-
A3
BBB+
Baa1
BBB
Baa2
BBB-
Baa3
BB+
Ba1
BB
Ba2
B
Ba3
AAA Extremely strong capacity to meet its financial commitments. AAA is the highest issuer
credit rating by Standard & Poor’s.
AA Very strong capacity to meet its financial commitments. It differs from the highest rated
obligors only in small degrees.
A Strong capacity to meet its financial commitments, but is somewhat more susceptible to the
adverse effects of changes in circumstances and economic conditions than obligors in higherrated categories.
BBB Adequate capacity to meet its financial commitments. However, adverse economic
conditions or changing circumstances are more likely to lead to a weakened capacity of the
obligor to meet its financial commitments.
The above credit ratings are known as ‘investment-grade debt’. As a rule of thumb, investors
managing portfolios where the risk must be minimised, and security of income and capital is
paramount, will restrict themselves to bonds rated AAA and AA, with perhaps a few single A
investments. Consider also a bond’s credit history. Has the rating improved or declined over
time? Bonds subject to a potential re-rating will be on ‘credit watch”.
Below BBB Bonds rated below BBB are known as ‘non-investment grade’, ‘high yield’ or,
less charitably, as ‘junk’ bonds. These bonds are of a more speculative nature, and imply a
certain degree of risk. In view of this, the incremental yield available on the instrument must
be adequate to compensate the investor for this risk. Standard & Poor’s gives the following
definitions for non-investment grade debt.
BB Less vulnerable in the near term than other lower-rated obligors. However, it faces major
ongoing uncertainties and exposure to adverse business, financial, or economic conditions
that could lead to the obligor’s inadequate capacity to meet its financial commitments.
B More vulnerable than the obligors rated BB, but the obligor currently has the capacity to
meet its financial commitments. Adverse business, financial, or economic conditions will
likely impair the obligor’s capacity or willingness to meet its financial commitments.
CCC Currently vulnerable, and is dependent upon favourable business, financial, and
economic conditions to meet its financial commitments.
CC Currently highly vulnerable.
C May be used to cover a situation where a bankruptcy petition has been filed or similar
action taken, but payments on this obligation are being continued. C ratings will also be
assigned to a preferred stock issue in arrears on dividends or sinking fund payments, but that
is currently paying.
Plus (+) or minus (-) The ratings from AA to CCC may be modified by the addition of a plus
or minus sign to show relative standing within the major rating categories.
Types of issuer
Before we go on to look at some examples of individual bonds and their credit ratings, it is
worth considering the different classes of issuer that one might be likely to come across in the
Sterling bonds markets:
As a rule of thumb, the bonds with the least risk of default are the high quality sovereign
issuers such as the UK and the larger and wealthier European countries. The risk of default*
for bonds issued by these countries can be assumed to be low, and less than the risk from a
bank deposit. Ranking alongside these are the Supranationals, these being agencies such as
the World Bank and the European Investment Bank which are supported by their sovereign
members.
Second to this are the second-line countries, and those experiencing some economic
difficulty. Here we would give Italy and Japan as two examples. While these countries do not
quite have the economic strength of some of their peers, this type of debt should not be
confused with emerging market bonds, which carries a much higher degree of risk.
Finally we have Corporate Bonds. These are bonds issued by corporations, typically large
quoted companies. The life of a company is full of ups and downs and it is fair to say that in
most cases corporate bonds carry a greater risk than those issued by major governments or
banks. Factors affecting a company's credit rating include cash flow, profitability, asset
valuations and unforeseen events such as legal action, a takeover or a change of the trading
environment. The yield on these bonds will normally be greater than that available on bank
debt.
Other types of issuers: There are numerous bonds issued to fund mortgage loans, credit card
loans and other more complex financial transactions. These types of bonds, often known as
mortgage-backed securities (MBS) and asset-backed securities (ABS) are not generally
available to the investing public in the UK. The credit quality of these can vary and investors
should be sure of their suitability before buying.
*Note: risk of default should not be confused with market risk, or price volatility. A bond can
be 100% guaranteed by all the governments in the world and still experience price swings
between issuance and redemption, typically driven by changing interest rate volatility.
Some sample issuers and their ratings
Here we have taken a few of the popular issuers:
AAA
Germany and France. Supranational agencies such as the World Bank (also know as the
IBRD). UK Gilts continue to enjoy a 'AAA' status, although this is under review at the time
of writing.
AA
Sovereigns such as Japan (AA-). A few high quality banks and corporates.
A
Good quality corporates such as Tesco (A-). Lower rated banks.
BBB
More speculative corporates such as Marks & Spencer (BBB-) and British Telecom ( BBB•
Credit rated – junk bonds to AAA ( Investment grade AAA,AA+,AA,AA-,A+,A,BBB+,BBB,BBB- . Non- investment grade ( high yield ) BB+,BB,BB,B+,CCC+,CCC,CCC-,CC,SD,D)
•
AAA
supranational
•
AA
international banks
•
A
Strong covenants
•
BBB
Adequate protection
•
BB or B
•
CCC or below in danger of default
•
Lower the quality of the bond, higher the yield expected to compensate for the risk
•
Rerating ( downwards ) can be critical for company and government
•
Ability to get fixed rather than floating debt
Speculative
Credit rating is;
•
A forward-looking opinion of relative creditworthiness
•
A key component in pricing debt
•
Typically: higher rating = lower default risk = lower cost of capital
•
Rating scale runs from “AAA” (highest) to “D” (lowest; indicates default)
A Credit rating is not:
 A recommendation to purchase, sell or hold a particular security
 A comment on the liquidity of the instrument or any other element affecting the
suitability of the investment for an investor, including interest rate, currency and
prepayment risk
 An audit of the obligor’s financials or operations
How having the grades help;
 Ratings agencies…
…express an opinion regarding how likely a borrower (“Issuer”) will or will not keep its
promise to repay its debts.
…“keep score” by using a consistent set of grades (“ratings”) reflecting an opinion –that can
then be compared across industries and around the world.
…tell everyone who uses ratings what they mean and how they are assigned.
As long as they maintain the values of;
Independence
Quality and analytical rigor
Integrity
Openness and transparency
Adds value for;
Investors through giving a benchmark
Issuers, increasing their acceptance on debt markets, they can estimate the cost of debt,
expands their accesaability and creditability and can be compared to others

For a country rating, these are considered; politics

economics

liquidity and international investment position

fiscal performance

monetary flexibility
Current Events
Cameron vetoed the new treaty, saving the city and the rating of UK
The desion made have helped to protect it fall under these catagories;
POLITICS: the Government has a majority able to take difficult decisions
ECONOMICS: the cuts in the public sector i.e. implementing those measures in a recession
period was difficult and unpopular, but necessary
LIQUIDITY/INTERNATIONAL INVESTMENT: maintained level of financial commitment
FISCAL FLEXIBILITY: it tried to contained the debt burden, and to reduce it in the
forthcoming years
MONETARY FLEXIBILITY: the Bank of England provided it with the QE and QE2
Maintaining the AAA will allow the UK to continue to borrow money on the international
market at a cheap rate i.e. currently around 2,7% for a 3 year bond and 3.75% for a 10 year
bond. The Government took measures that should help the recovery, however just yesterday
news indicated that unemployment is rising and there is no growth forecasted for 2012.
Unfortunately for the UK, the solutions to its problems do not depend exclusively by internal
decisions.
Black swan theory - was developed by Nassim Nicholas Taleb (2007) to explain:

The disproportionate role of high-impact, hard to predict, and rare events that are
beyond the realm of normal expectations in history, science, finance and technology
Evaluate the term credit crunch, appraise the effects on global markets. ? x2
Highlight and apprasise the most momentus events since 2007
Discretionary stockbroker service
An order giving a broker the ability to decide when to buy/sell securities at the best possible
price for the customer. Some discretionary orders place restrictive terms to limit the amount
of discretion the broker has.
When placing a discretion order, the investor is giving limited discretion to the broker and
allowing for the timing of buying/selling to be decided by the trader.
Discretionary dealing is another service of the stock broker where the broker is responsible
for all the dealings and decision making in the market on his client's behalf.
There are three types of stock brokers:



Full Service Broker
Discount Broker
Direct-Access Broker
A full-service broker generally provides their clients with various financial services
depending on the requirements of the clients. The services provided by them may be
investment research advice, retirement planning and tax planning. A discount broker executes
the client's instruction by buying or selling the stocks, but refrains from offering any kind of
investment or financial advice. The direct access brokers are those who make the client's
trade directly with electronic communication networks (ECN's) making the trading much
faster.
Duration
•
Duration measures the sensitivity of the coupon and maturity of a gilt to changes in
interest rates. Duration is equivalent to the average life of the bond.
•
The greater the duration, the more sensitive it is to changes in interest rates.
•
Investor can:
•
Quantify the interest rate risk of any bond portfolio in a single number and thus work
out how to hedge that risk through bond futures etc
•
Can work out how much a particular bond price will move for a given change in
interest rates
Efficient Markets Hypothesis
 A very important aspect of financial markets is:
 The degree to which an investor can rely on the stock market being able to correctly
value a company's shares
 In an efficient capital market share prices rationally reflect available information
 Errors made in pricing shares are unbiased
 Price deviations from true value are random
Types of efficiency
 Operational – cost, sped and reliability of transactions in shares
 Allocational – scarce resources are allocated where they are most productive
 Pricing ( EMH ) – and investor can earn a risk-adjusted return as prices move
instantaneously and in an unbiased manner to any news
Levels of efficiey
 1.
Weak efficiency.
This implies that share prices fully reflect and information that may be
obtained from studying and analysing past movements in the share price. This form of
efficiency is tested by examining whether current changes in security prices are
related to past changes. Changes in prices appear to follow a random walk, with an
upward drift
 2.
Semi - strong efficiency
This implies that share prices fully reflect all the relevant, publicly disclosed
information that is known about the company and its share values. This is tested by
examining whether information revealed in a public announcement is incorporated in
security prices instantaneously or over time. Studies focusing on price changes on the
days announcements are made have revealed that information was incorporated in
prices on the same day.
 3.
Strong efficiency
This implies that share prices reflect all relevant information about their value,
even though some of that information may not have been publicly disclosed.
Investigations as to whether insiders can profit from inside information suggest that
indeed they can and strong-form efficiency does not hold
Assumptions of EMH
Rational investors outweigh irrational investors
 Rational investors have adequate funds ( from having money or being able to borrow
it ).Should be able to sell short ie borrow shares and sell them
 Information is available instantaneously to many investors and rational investors use
it to assess share pries and make a profit
 Rational investors do not believe the markets are efficient
 Transaction costs, market impact effects and required compensation for risk are not
large enough to deter prices at trading at close to fundamental value ( market impact
effects are the effects of an individual investors sales and purchases on the share price
)
Benefits in having efficient market = To encourage share buying
 To give correct signals to company managers
 To help allocate resources
 The Efficient Markets Hypothesis holds that a stock market is efficient if the market
price of a company's shares or bonds rapidly and correctly reflects all relevant
information as it becomes available. If this is true, under or over valued shares would
not exist.
 It is important to the financial manager that this is so. When decisions are made,
intended to increase shareholder wealth, the implications of the decision should be
signalled to them through a rising share price.
 In addition, CAPM and portfolio theory could not be relied on if the market is
inefficient - diversification would be useless because the optimal portfolio would be
achieved by investing in bargain shares that give higher returns than they should,
given their level of risk.
 Another implication of inefficiency would be that it would be virtually impossible for
managers to take rational investment decisions and use the best available foregone
rate of return to use as their discount rate.
 a)
If the market is weakly efficient, technical analysis is worthless - the
prediction of future share prices from past movements would be impossible.
 b)
If the market is semi - strong efficient technical analysis and fundamental
analysis are both worthless. However good a fundamental analyst is, the information's
implications are already impounded in the share price.
 c)
If the market is strongly efficient, one could not profit from inside information
because the share price reflects all relevant information about the company whether
public knowledge or not.
The major anomalies which have been uncovered by these studies are that there is a size effect ie
small companies have outperformed large ones, a price earnings ratio effect whereby it seems that
companies with low price earnings ratios give higher returns than those with high PE ratios, a price
to book value effect whereby companies with a low price to book value ratio have shown excess
returns and a variety of seasonal and calendar effects.
Appraise EMH and any anomalies found by researchers? X2
And any abnormaities in capital market price behaviour x3?
Critically appraise the EMH?
Ethical investment
Understanding of Islamic finance, approaches, impact on fund performance?
What is ment by ethical investment, approaches to it by fund managers and impact on
performance?
Demonstrate understanding of Islamic finance and its priciples that underpin financial
products? X2
Understanding of the term socially responcible investment and range of strats used in these
funds?
Evaluate range of approaches that fund managers running wthical funds can use when
investing in firms?
•
Ilamic finance = Invest in ‘permissible ( Halal) activities by permissable means
•
Lending of money for predetermined return
( riba ) expressly forbidden
•
May not invest in corporations involved with alcohol, gambling or usury transactions
•
Principle of risk sharing contracts with borrowers
•
Forbidden to make money on money thus only make a profit through assets
•
Reason - interest ( Riba ) is prohibited
•
Debt can only arise as a consequence of a sale
•
Ownership is the absolute nucleus of Islamic Finance - if you don’t take the risk you
cannot have the benefit.Thus cannot earn interest or be required to pay interest in
loans.
•
100% capital risk weighted as opposed to standard 50%
•
Stamp duty an issue as were paying double but this was abolished in the UK in
December 2003
Futures
A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset),
such as a physical commodity or a financial instrument, at a predetermined future date and
price. Futures contracts detail the quality and quantity of the underlying asset; they are
standardized to facilitate trading on a futures exchange. Some futures contracts may call for
physical delivery of the asset, while others are settled in cash. The futures markets are
characterized by the ability to use very high leverage relative to stock markets.
Futures can be used either to hedge or to speculate on the price movement of the underlying
asset. For example, a producer of corn could use futures to lock in a certain price and reduce
risk (hedge). On the other hand, anybody could speculate on the price movement of corn by
going long or short using futures.
The primary difference between options and futures is that options give the holder the right to
buy or sell the underlying asset at expiration, while the holder of a futures contract
is obligated to fulfill the terms of his/her contract.
In real life, the actual delivery rate of the underlying goods specified in futures contracts is
very low. This is a result of the fact that the hedging or speculating benefits of the contracts
can be had largely without actually holding the contract until expiry and delivering the
good(s). For example, if you were long in a futures contract, you could go short in the same
type of contract to offset your position. This serves to exit your position, much like selling a
stock in the equity markets would close a trade.
In finance, a futures contract is a standardized contract between two parties to exchange a
specified asset of standardized quantity and quality for a price agreed today (the futures
price or the strike price) with delivery occurring at a specified future date, the delivery date.
The contracts are traded on a futures exchange. The party agreeing to buy the underlying
asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to
sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology
reflects the expectations of the parties -- the buyer hopes or expects that the asset price is
going to increase, while the seller hopes or expects that it will decrease.
In many cases, the underlying asset to a futures contract may not be
traditional commodities at all – that is, for financial futures the underlying asset or item can
be currencies, securities orfinancial instruments and intangible assets or referenced items
such as stock indexes and interest rates.
While the futures contract specifies a trade taking place in the future, the purpose of the
futures exchange institution is to act as intermediary and minimize the risk of default by
either party. Thus the exchange requires both parties to put up an initial amount of cash,
the margin. Additionally, since the futures price will generally change daily, the difference in
the prior agreed-upon price and the daily futures price is settled daily also.
Unlike an option, both parties of a futures contract must fulfill the contract on the delivery
date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures
contract, then cash is transferred from the futures trader who sustained a loss to the one who
made a profit. To exit the commitment prior to the settlement date, the holder of a
futures position can close out its contract obligations by taking the opposite position on
another futures contract on the same asset and settlement date. The difference in futures
prices is then a profit or loss.
Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in
the underlying asset (which could include an intangible such as an index or interest rate) and
are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit
by predicting market moves and opening a derivative contract related to the asset "on paper",
while they have no practical use for or intent to actually take or make delivery of the
underlying asset. In other words, the investor is seeking exposure to the asset in a long futures
or the opposite effect via a short futures contract.
[edit]Hedgers
Hedgers typically include producers and consumers of a commodity or the owner of an asset
or assets subject to certain influences such as an interest rate.
For example, in traditional commodity markets, farmers often sell futures contracts for the
crops and livestock they produce to guarantee a certain price, making it easier for them to
plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that
they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest
rate swapsor equity derivative products will use financial futures or equity index futures to
reduce or remove the risk on the swap.
Those that buy or sell commodity futures need to be careful. If a company buys contracts
hedging against price increases, but in fact the market price of the commodity is substantially
lower at time of delivery, they could find themselves disasterously non-competitive.
[edit]Speculators
Speculators typically fall into three categories: position traders, day traders, and swing traders
(swing trading), though many hybrid types and unique styles exist. With many investors
pouring into the futures markets in recent years controversy has risen about whether
speculators are responsible for increased volatility in commodities like oil, and experts are
divided on the matter. [7]
An example that has both hedge and speculative notions involves a mutual fund or separately
managed account whose investment objective is to track the performance of a stock index
such as the S&P 500 stock index. The Portfolio manager often "equitizes" cash inflows in an
easy and cost effective manner by investing in (opening long) S&P 500 stock index futures.
This gains the portfolio exposure to the index which is consistent with the fund or account
investment objective without having to buy an appropriate proportion of each of the
individual 500 stocks just yet. This also preserves balanced diversification, maintains a higher
degree of the percent of assets invested in the market and helps reduce tracking error in the
performance of the fund/account. When it is economically feasible (an efficient amount of
shares of every individual position within the fund or account can be purchased), the portfolio
manager can close the contract and make purchases of each individual stock.
The social utility of futures markets is considered to be mainly in the transfer of risk, and
increased liquidity between traders with different risk and time preferences, from a hedger to
a speculator, for example.
[edit]Options on futures
In many cases, options are traded on futures, sometimes called simply "futures options".
A put is the option to sell a futures contract, and a call is the option to buy a futures contract.
For both, the option strike price is the specified futures price at which the future is traded if
the option is exercised. Futures are often used since they are delta one instruments. Calls and
options on futures may be priced similarly to those on traded assets by using an extension of
the Black-Scholes formula, namely Black's formula for futures.
Investors can either take on the role of option seller/option writer or the option buyer. Option
sellers are generally seen as taking on more risk because they are contractually obligated to
take the opposite futures position if the options buyer exercises his or her right to the futures
position specified in the option. The price of an option is determined by supply and demand
principles and consists of the option premium, or the price paid to the option seller for
offering the option and taking on risk. [8]
For hedging or speculation
Defenitiion of and why used by hegers, speculators, arbitridgers, businesses and fund
managers?
Why it is difficult to achieve a perfect hedge using future contracts?
Defininition
 Financial contract is a legally binding agreement to make or take delivery of a
standard quantity of a specific asset, at a future date, and at a price agreed between
the parties through an organised exchange.
 Main characteristics of these contracts
Locked into the agreed unit price for contract
Changes in future prices result in profits or losses
agreement between seller and buyer
seller (short) delivers to buyer (long)
specified quantity of an identified
commodity Eg Comex gold future 100 ounces of gold bullion with fineness of
0.999
fixed time in the future
agreed price
on designated contract market ie commodity futures exchange
minimal transaction costs
liquidity
electronic trading
types
 Commodity
Includes:
bonds
stock indices
bank deposits
foreign currency
agricultural products
energy products
precious metals
 Financial futures
Includes:
stock indices
universal stock futures
bonds
gilts
interest rates
swaps
Benefits of using futures
Fast and efficient
leave portfolio undisturbed
Low execution risk
Liquidity
Low Cost
 Derivative is type of future ?? isit?- Definition
A derivative instrument is one whose performance is based ( or derived ) on the
behaviour of the price of an underlying asset ( often simply known as the underlying ). The
underlying asset itself does not need to be bought or sold. A premium may be due.
 Examples of derivative products and their underlying commodities
Derivative
Underlying asset
Currency options
Foreign Exchange
Interest rate swaps
Government Bonds eg Gilts
Interest Rate futures
Implied forward interest rates
Total return swaps
Credit Risk
 But financial futures are independent of the underlying cash market ie Stock Index
Futures
 Faster and cheaper to take position in futures market than position in underlying spot
market.
 Commission smaller
 Bid – ask spread smaller
 Futures prices respond to new information more quickly
 Hedgers
To reduce an already existing risk, Price discovery
 Speculators Buy and sell to make a profit, not reduce risk,
Facilitate hedging,
Ensure
accurate pricing, Maintain price stability ( will buy in a
falling market and
sell in a rising one )
 Arbitrageurs Make profits from relative mispricing,
liquid, Ensure accurate pricing, Enhance price stability
Help make markets
 Private Clients
eg individuals with funds under management to enhance their
yield or for speculative purposes. less costly way of achieving required returns
Uses for derivatives.
 Take on credit risk without the loan
 Protect against currency devaluation
 Protect stock market portfolio from downturn in the market
 Take a view on upswing of an index
 Insure against changes in interest rates
 Enhance the yield on a non performing investment
Gilts
Definition
Bonds that are issued by the British government and generally considered low risk. Gilts are
the U.K. equivalent to U.S. Treasury securities. The name originates from the original British
government certificates that had gilded edges.
India's government securities are also called gilts because of the country's history as a British
colony.
Index-linked gilts, which represent a substantial proportion of all U.K. gilts, are indexed to
inflation, similar to Treasury Inflation Protected Securities in the United States. Bonds issued
by blue-chip companies that are considered to be similarly high-quality and low-risk, are
called gilt-edged securities. The primary purchasers of gilts are pension funds and life
insurers.
Conventional Gilts
The majority of Gilts are of a conventional nature, paying a fixed coupon (generally twice a
year) and maturing at a set date. The life of these instruments will vary from a few months to
as much as forty years. The most popular Gilts for private investors are maturities between
two and ten years. Some Gilts have more complex features such as "calls", which enable the
government to pay off the debt ahead of time. Before purchasing a Gilt, it is worth checking
the full details of the issue. Please note, prospectuses for Gilt issues can be obtained at the
website of the government’s Debt Management Office.
Index-linked Gilts
These were first issued in 1981. Rather than pay a fixed coupon and amount on redemption
Index-linked Gilts differ from conventional Gilts in that the semi-annual coupon payments
and the principal are indexed to the UK Retail Prices Index (RPI). It is worth noting that there
is a time lag on the RPI used to calculate the coupon and redemption period, however these
instruments do offer a shelter against inflation.Because of the inflation-linking aspect of these
bonds, Index Linked Gilts may show a wider movement of price over time.
Undated or perpetual Gilts
These differ from conventional Gilts as they have no set maturity date. They may (or may
not!) be paid back at a time of the government's choosing.
Because of this the holder is reliant on the market price to liquidate his investment, and as
such they should be viewed as more risky than conventional Gilts. The most well known
amongst this group is the UK 3.5% War Loan.
These instruments are more volatile than conventional Gilts (which inevitably trend towards
par).
Gilts can be bought, held, and sold just like shares, although far fewer private investors ever
do so.
Most online brokers enable you to buy and sell gilts for their normal trading fee, and the
bid/offer spread is usually reasonable. (Most investors will want to hold their gilts to
maturity, anyway, so won’t need to worry about selling).
Alternatively you can buy gilts from the government’s Debt Management Office. You’ll still
be charged a fee, and you have to trade by post and pay by cheque, and take whatever price is
prevailing for your gilts on the day, all of which is a faff. The dealing fees can be cheaper in
some cases, though.
To determine which gilts you want to buy, you can use various online resources to find
out bond prices and yields.
There’s no real difference between the different fixed term, fixed rate gilts except their price,
their coupon (and hence their running yield), and the time until maturity
Advantages of buying gilts directly
 You don’t pay annual management fees to a fund manager. After your initial trading
costs, there’s no more fees to pay (assuming you hold the gilt to maturity).
 You know exactly what income you’ll get every year from your gilts.
 You can ignore capital fluctuations, knowing you’ll get back the par value of the gilt if
you hold it to maturity.
 You can construct your own ‘ladder’ of gilts2, to smooth out the impact of varying rates in
the market.
 Individual gilts are free from capital gains tax (even outside of an ISA).
Disadvantage of buying gilts directly
 You’ll have to do your homework to understand the gilt market.
 Your gilts will rise and fall in value every day – perhaps markedly in the case of longdated gilts.
 You’ll need a reasonable sum if you want to create a nice spread of gilts.3.
 As your gilts mature you’ll need to spend time researching and buying new holdings.
 You may be tempted to try to trade your gilts for capital gains, which is not advisable if
you’re holding them for another purpose such as diversification.
 Only gilts with five or more years left to run when you buy can be held in an ISA.
Gilts: The basics
If you buy a gilt when it’s issued for exactly its nominal value and hold it to itsredemption
date, you know exactly how much money you’ll get over the years.
 You’ll be paid the interest rate (the coupon) every year plus you’ll be repaid the nominal
value of the gilt when it matures.
For instance, a gilt called Treasury 5 pc ’30 will pay £5 a year until 2030 for every £100
nominal (also called the face or par value) that you buy and hold.
Gilts are generally sold by the government for a little more or less than their nominal value,
however.

The price investors pay for new gilts is determined by an auction. This means they may
pay more or less than the nominal value (say £101 or £99), which reflects the annual yield
they’re demanding for holding the gilts.
 If investors pay more than the nominal value to own the gilt, they’re accepting a lower
yield. And vice-versa.
 The coupon payment is split across two payments a year.
When the redemption date is reached, the government pays you back the nominal value of the
gilt. This makes it almost impossible to lose money with gilts in cash terms, provided you
hold until redemption and the government doesn’t default, though inflation can easily erode
your real returns.
Note that this doesn’t mean you’ll necessarily get back what you paid for your gilts. You
might pay £105 in the open market, and receive just £100 back when the gilt is redeemed.
However this capital loss will have been taken into account by the market and reflected in the
income you’ve received for holding the gilt. This total return is the key.
Gilts are traded, which introduces risk
Once issued by The Treasury, gilts can be bought and sold on the secondary market until they
mature, just like shares and other securities.
An easy way to think of how their price fluctuates is to imagine what you’d pay to own the
aforementioned War Loan 3 1/2 pc:
 What would you pay if interest rates on savings were 6%?
 What would you pay if interest rates on savings were 2%?
All things being equal, an investor would obviously pay more for a 3.5% coupon when
interest rates on cash are lower than that, and substantially less when interest rates on cash are
higher.
The investor’s calculation is complicated by the fact that an undated gilt is never redeemed.
This means his view of interest rates (and inflation, and UK solvency) must extend far into
the future.
Dated gilts are less risky investments. You know you’re going to get the nominal value back
(not the price you paid, remember!) when they are redeemed, regardless of how their price
fluctuates in-between. This makes it possible to calculate a yield to redemption, which takes
into account both the annual coupon you’ll be paid for owning the gilt, and the capital gain or
loss you’ll make when the gilt is redeemed.
This assumes you hold the gilt until it’s redeemed, of course. If you sell it before then, you
might make a trading gain or loss.
You don’t have to calculate redemption yields and so on for yourself. Prices and yields are
listed in newspapers like the Financial Times, and on websites like Fixed Income Investor.
A few other useful things to know about gilts

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
The interest payment from gilts is treated as taxable income.
Any capital gains that arise from disposing of gilts are tax-free.
You can buy gilts directly through your broker or invest via a fund.
Gilts can go in an ISA provided you buy them with five years until redemption.
Index-linked gilts are a special kind that offer inflation-proofing. Both the coupon and the
principal payment are adjusted in line with RPI. You might not get much on top of that
though, depending on the mood of investors when you buy.
For investment same as equity.
Evaluate investing in gilts instead of equity?
Appraise investment in one of these?
Appraise the differences between corporate bonds and gilts? And as a possible investment x2
Calculate approximate flat and redemption yields on treasury bill.?
Outline the main features of gilts, disuinish them from coporate bonds? & evaluate.
•
Liquidity = Nearest to cash of any instrument Cash settlement = t + 1 (next business
day)
•
DMO offers to switch a nominal amount of one gilt for another to build up other more
liquid strippable gilts.
•
Opportunity to switch form less liquid gilt without incurring transaction costs.
Interest paid 1/2 yearly ( except 2 1/2 % Consols ) but accrues daily
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Core safety and income element
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Pre-ordained income producers
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Provides balance to portfolio
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Index linked issues – insurance policy
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Secure
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High value
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Low volatility
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High turnover
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Index - linked rate of interest and capital repayment linked to rate of inflation as
measured by the Retail Prices Index of 8 months ago
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Affected by ; Supply and Demand
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Vary with actual yields available in money markets
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Interest rates - when fall gilts prices rise and vice versa
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Inflation - when rises gilt prices fall
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International Markets eg weak sterling = weak prices
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Anticipation of changes ie future expectations of interest rates and inflation:
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Believe interest rates will fall
-
buy gilts
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Believe interest rates will rise
-
sell gilts
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Index - linked - believe inflation will rise – buy
Taxation
•
Taxed in year interest received ( as income tax )
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Interest paid gross either reclaim / take no action / incur a further liability
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Basic rate taxpayer 20%, higher rate taxpayer 40%, additional rate taxpaper 50%
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Free of Capital Gains Tax but cannot use to gains to offset losses
No stamp duty
Dealing via computer share is cheaper than stock broker
Clean Price = dirty price – accrued interest
•
Issue of new gilts - Private investors must spend at least £3,000 and must be part of an
Approved Group of Investors
As gilts only open to big players? Could instead invest in gilt funds
The first choice with a gilt fund is whether to go with a passive gilt fund or an actively
managed one.
Buying a gilt ETF is a very easy way to diversify your portfolio. The iShares IGLT exchange
traded fund, which holds a wide basket of gilts, is a good option.
Alternatively, there are plenty of managed gilt funds about, although you need to read the
descriptions carefully to see exactly what they invest in. Many bond funds use words like
‘strategic’ and ‘alpha’ to muddy the waters; it’s too easy to discover what you thought was a
UK gilt fund buying Indonesian government bonds, so be sure to read the small print.
As ever, the ETF option beats the managed funds on the all-important cost criteria. After
trading fees to buy the ETF, the annual charge is just 0.2% a year.
Managed gilt funds in contrast charge big upfront fees (which can be sidestepped by using a
fund supermarket) and up to 1% a year in total expenses, which is a huge amount out of your
return when yields are low.
Active gilt funds also differ in performance due to their managers’ attempts to trade gilts for a
profit, with some beating the market and some lagging. As usual, there’s no sure way to
know which funds will do well in advance.
Advantages of investing in a gilt fund
 It’s a one-shot asset allocation decision.
 You don’t have to learn about gilts, but can instead leave it to the professionals.
 Your fund will invest across a range of maturities, and this diversification should provide
a reasonable buffer against big valuation moves.
 An active gilt fund manager may also use derivatives and the like to further reduce
volatility in the fund.
 You can hold your gilt fund in an ISA.
Disadvantages of investing in a gilt fund
 The diversification of your fund will not stop its value rising and falling entirely, and
since it’s open-ended there’s no guarantee whether or when you’ll get back what you put
in. (Compare that with a fixed term gilt that redeems at par).
 Annual costs. Even the 0.2% TER of the iShares ETF isn’t negligible in an era when
yields are in the 3.5% range. As for 1% a year, ouch!
 If you choose an active fund, its return may lag the gilt market if the manager misjudges
things. You might want to invest in a couple of different funds to spread this risk.
 There’s (a very small) additional risk of fraud or similar if you invest via a fund manager,
versus holding the gilts yourself.
 Gilt funds are liable to capital gains tax (if held outside of an ISA).
SHOULD I INVEST IN GILT FUNDS?
To invest successfully in gilt funds, it is essential to watch the economic indicators that can
predict the decrease in interest rates. Some essential factors leading to interest rate reduction
are higher inflation, reduction in IIP (Index of Industrial Production), slow GDP growth and
likelihood of reduction in corporate earnings. Also consider your capacity to take risk, goal
and fund’s track record. Don’t be swayed by only returns, as you may end up suffering
losses.
I think most people who read Monevator are capable of buying and holding gilts directly,
whether they buy via their online broker or the DMO.
And in most cases, I think buying gilts directly is the preferable route, too. It’s usually
cheaper, and you can lock in the interest rate you’ll be paid for each issue, which is one big
advantage of owning gilts in the first place.
You also know when you’ll get your money back – and how much you’ll get. This is handy if
you know you’ll need a particular amount of money for some specific future use, such as
paying Jemima’s university fees.
But pure passive investors shouldn’t sweat about taking the gilt ETF route. Funds are also the
best choice if you’re too lazy or busy to dedicate time to your gilt portfolio.
The good news is that whether you buy gilts directly or invest in a gilt fund, you’ll get
roughly the same diversification benefits. So the decision as to how to invest really comes
down to which advantages outweigh the disadvantages for you.
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
Investing via the internet
The internet has changed the trading and investing landscape by providing greater access to
information, new technology and cheaper commission rates. This has also contributed to the
acceleration of globalization. With the current bidding wars going on between rival
exchanges, this is set to continue as exchange agreements facilitate access and the creation of
new products.
•
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.
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Management of the investment portfolio to achieve the desired level of risk or partial
or total elimination of a risk by some compensating action. Thus hedgers are
interested in reducing a risk they already face.
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Risks can be hedged via options, futures, financial futures, forward contracts, swaps
etc.
Reduction of risk is achieved by the establishment of a position in the futures market
which is equal and opposite to that in the underlying cash market.
Insurance / laying-off bets / hedging.
COST of hedging
CASH FLOW planning
FOCUS of attention
Management of RISK
Not a speculative activity
Hedging within an investment portfolio.
Hedging for commercial reasons.
Hedging in the financial market place.
LONG POSITION
Position of owning a good that you plan to sell in the future
SHORT POSITION
Position of expecting to purchase the good in the future
Rise in price Fall in price
gain if long, loss if short
loss if long, gain if short
GENERAL HEDGING APPLICATIONS
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CASH MARKET EXPOSURES
-
banks/securities houses
funds
OTC EXPOSURES
-
forward rate agreements
swaps
caps/ collars, floors
CASH FLOW MANAGEMENT
-
ASSET ALLOCATION
buy futures
-
sell/buy futures
PORTFOLIO INSURANCE
-
buy puts
RETURN ENHANCEMENT
-
sell calls/puts
SHORT AND LONG HEDGES
Raw Material
Uncertainty about sale price of a future crop at time of
harvest.
Accept
risk of a variable income or
sell crop forward as a SHORT HEDGE
farmer is selling the crop she does not yet have.
Production
Uncertainty about purchase price of raw material at time when it will
be needed. Accept risk of variable cost or
buy raw materials forward as a LONG HEDGE
producer buying the materials he does not yet need.
Speculators
Wish to take a position in the market - are betting that price will go up or that it will go down.
Use forwards and options
short hedges > long hedges
futures price will fall so speculator steps in and buys
long in anticipation of a profit.
short hedges < long hedges
futures price will rise so speculator steps in and sells
short in anticipation of a profit.
Spot
price for immediate delivery.
Like gilts "pull to maturity", as date of delivery gets
closer, the forward price moves closer to the spot
price.
Usual practice is for supplier of raw materials to buy
an equal and opposite future and then sell the crop
Arbitrageurs
spot.
Lock into a riskless profit by entering simultaneously into transactions in two or more
markets eg see the futures price of an asset getting out of line with the cash price will take
offsetting positions in the two markets to lock in a profit
Investment Trust Companies
Evaluate the benefits of collective investments?
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.
Main Market and AIM listings
Appraise difference between main market and alternative market listing?
NewBuy 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
if
CALL
-
RIGHT TO BUY
PUT
-
RIGHT TO SELL
equity price
rises then option price
rises
exercise price
‘
falls
interest rate
‘
rises
time to expire
equity volatility
For hedging or speculation
‘
rises
‘
rises
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
SN(d1) - X e-rft.N(d2)
PV of call option
=
PV
=
present value ie current price of option
N(d)
=
cumulative normal probability function.
X
=
exercise price
e
=
exponential, 2.71828
t
=
time to expiry of option ( years )
S
=
current price of equity
rf
=
risk-free rate of interest
d1
=
ln (S/X) + ( rf +
2
/2) t
t
d2
=
ln
d1 -
t
=
volatility of the share price ( standard deviation )
=
natural log
d1 and d2 represent Z values under the normal curve ( see table 1 )
N ( d1 ) and N ( d2 ) are cumulative probabilities thus add 0.5
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
Example of valuing a call option ( c )
Data about the shares of Wimborne plc is given below:
S
=
102
X
=
100
T
=
90 days
r
=
5%
d1
=
ln (102/100 ) + ( 0.05 + 0.22/2 ) 0.2465

0.20 x  0.2465
d2
=
0.3732
=
0.3732 - 0.2 x  0.2465
=
0.2739
N (d1 ) = 0.5 + 0.1443
=
0.6443
N ( d2 )
= 0.5 + 0.1064
=
0.6064
c
=
(102 x 0.6443 ) – (100 x e - 0.05 x 0.2465 x 0.6064 )
=
65.72 - 59.9
=
5.82
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.
5.
6.
Interest rates are known and constant
No early exercise ( European )
No dividends
Put Call Parity Equation
Four basic financial securities out of which all other investments can be constructed
Investing in shares ( S )
Investing in risk- free bonds ( B )
Investing in call options in the shares ( C )
Investing in put options in the shares ( P )
S
+
P
=
B
+
C
=
X
Put - Call Parity Theorem states that
S
+
P
-
C
where X is exercise price of the option
eg
Buy a share in XYZ
Buy a put option in XYZ
Sell a call option in XYZ
XYZ plc have a market price of £2, the call and the put options have and exercise price of £2
and one year to maturity. Risk free rate of interest is 8%
In one years time the price is £2.50
Value of share
2.50
Value of put option
0
Value of call option
(50 )
Net value
2.00
Exercise price of the option
2.00
Exercise price of the option
=
S+(x-S)-0
In one years time the price is £1.50
Value of share
1.50
Value of put option
50
Value of call option
0
Net value
Net value
S+P-C
Value of portfolio at expiry date is 0
thus PV
=
X ( 1 +Rf ) -t
Pv
=
200 ( 1 + 0.8 ) -1
=
185
PV
S
+ P - C=
X ( 1 +Rf ) -t
= +X
Rearranging
S
-
X ( 1 +Rf ) -t
=
C-P
=
15
Inserting current data
200
-
185
Value of put option should be 15p less than that of the call
Thus the value of the put option is:
P
=
C
+
X ( 1 +Rf ) -t
-
S
Value of put option in Wimborne plc using same data from call example
X ( 1 +Rf ) -t
P
=
C
+
-
S
P
=
5.82
+ 100 ( 1 + 0.05 ) -0.2465 - 102
=
5.82 + 98.8 - 102
=
2.62
Number of contracts = N(d1 ) is the ‘hedge ratio’ or delta risk of the option
The higher the delta risk value the more the value of the option is affected by changes in the
value of the underlying shares and vice versa
The hedge ratio is the number of call options that need to be sold to provide a risk free hedge
against a shareholding
Example
Paul owns 10,000 shares in BT. The delta value N (d1) of the option is 0.4. Option contracts
are for 1000 shares. How many contracts does he need for a risk free hedge?
Number of contracts =
Number of shares
Delta of Option x size of contract
=
10000
0.4 x 1000
=
25
Graph the profile option and net position between two prices? x2
Hedge ratio
c
=
mcu + ( 1-m ) cd
1+r
where
m
=
1+r-D
U-D
r
=
risk free rate of interest
c
=
value of call
m and ( 1 - m )
=
proportions
cu
=
pay off to higher price
cd
=
pay off to lower price
D
=
dividend yield
Hedge ratio
=
Number of shares bought
Number of calls sold
Assumptions of model
The distribution of the share prices is a multiplicative binomial
The U and D multipliers ( and thus the variances of the returns ) were the same in all periods
No transactions costs so a riskless hedge can be established for each period between the
option and the asset at no sunk cost
The correct combination of the asset and the portfolio would form a risk free portfolio
The return on that portfolio must be at the risk free rate
The implication is an option is only worth the present value of its expected pay off
Problem – considerable computer time needed to use model!
For every option there is an option price at which, given the probable distribution of equity
prices at maturity, the expected profit to both the buyer and the writer is equal to zero.
(Option strategies not covered in the slide 14.)
Active Fund Management
Demonstrate understanding of this?
Active - Attempt to achieve portfolio returns more than equal with risk, either by forecasting
broad market trends or by identifying particular mis-priced sectors of a market or securities in
a market.
Passive Fund Management
•
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
M 65
F 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, 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 The Greeks
•
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
Gamma
Measures the change in delta when a small change in the underlying asset occurs
Theta
Measures an option's loss in value due to time decay
Vega
Measures the change in option price as a result of change in volatility of the underlying
security.
Demonstrate understanding of the Greeks? X2
Understanding of the following terms ;delta, gamma, theta, vega?
THE GREEKS
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?
0.8 X + 0.5Y =
1.2X + 1.5Y =
0.7 (1)
1.3 (2)
Solve the simultaneous equation
Multiply (1 ) by 3 and subtract (2)
Three and Four Factor models
 3 = 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 equal-weighted 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 one- year 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 Trusts
Appraise investment in one of these? And for jounior?
Unit and investment trusts are for savings
•
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
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
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
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
Basis risk
£12.50
 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 exposure
nominal value of contract
Hedge ratio
 (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
KLM plc
451,250
1.0
432,500
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