Capital Markets Programme

Securities
Edition 16, January 2021

This workbook relates to syllabus

version 20.0 and will cover examinations from
22 March 2021 to 21 March 2022
Welcome to the Chartered Institute for Securities & Investment’s Securities study material.

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

Published by:
Chartered Institute for Securities & Investment
© Chartered Institute for Securities & Investment 2021
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www.cisi.org/qualifications

Author:
Martin Mitchell FCSI
Reviewers:
Christopher Grune
Julie Petrera, MBA (FS)

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can also be viewed on cisi.org and is also available by contacting the Customer Support Centre on +44 20
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result of industry change(s) that could affect their examination.

The questions contained in this workbook are designed as an aid to revision of different areas of the
syllabus and to help you consolidate your learning chapter by chapter.

Workbook version: 16.1 (January 2021)

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The Financial Services Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1
Asset Classes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

2
Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

3
Primary Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

4
Secondary Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

5
Corporate Actions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163

6
Clearing and Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191

7
Accounting Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219

8
Risk and Reward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259

9
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293

Multiple Choice Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303

Syllabus Learning Map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335

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

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

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

The Financial Services

Sector
1. Introduction 3

2. Professional and Retail Business 5

3. Participants – Retail Sector 9

4. Participants – Wholesale Sector 12

This syllabus area will provide approximately 3 of the 100 examination questions
2
 The Financial Services Sector

1. Introduction

1
The financial services sector in developed countries is a major contributor to their economies. This is
particularly true in long-standing financial centres, such as New York, Boston, London and Tokyo, the
increasingly significant Chinese cities of Shanghai and Hong Kong, and the European hub of Frankfurt
among others. Financial services provide considerable employment and overseas earnings, as well as
vital functions that enable businesses to raise finance, grow and prosper.

Fundamentally, financial services provide the link between organisations needing capital and those
with capital available for investment. For example, an organisation needing capital may be a growing
company and the capital may be provided by individuals saving for their retirement in a pension fund.
It is the financial services sector that channels money invested to those organisations that need it, and
provides execution, payment, advisory and management services.

Financial services are constantly evolving, and it is vital for anyone working, or aspiring to work, in
this sector to keep pace with changes and developments. At the time of writing, there are continuing
major political developments and a global Coronavirus pandemic which is having massive economic
consequences. Additionally, the US continues its trade stand-off with China, the UK is finally leaving the
European Union (EU), and stubbornly low inflation persists despite minimal interest rates. Any increase
in the barriers to trade will inevitably impact businesses, not least those international banks and other
financial services entities looking towards Asia for growth. Brexit will result in some financial services
activities moving away from London, spurring the growth of financial centres within the EU, such as
Amsterdam, Dublin, Frankfurt and Paris.

Stock markets and investment instruments are not unique to one country, and there is increasing
similarity in the instruments that are traded on all world markets and in the way that trading and
settlement systems operate and are developing.

With this background, therefore, it is important to understand the core role that the financial services
profession undertakes within the economy and the key institutions that make up the global financial
services sector. However, the basic building blocks need to be clarified first – in particular, equities and
bonds.

1.1 Equities and Bonds

Learning Objective
1.1.4 Know the basic differences between equities and bonds

Traditionally, the assets available in the financial markets focused on the two major types of securities
– equities and bonds. In essence, equities are shares that represent an ownership stake (or ‘equity’) in
a company. Bonds, on the other hand, represent debt. Bonds are similar to an IOU (I owe you) – where
an issuer, such as a company or government, borrows a sum of money in exchange for a debt security,
known as a bond. The bond is the contractual agreement that sets out the terms of the loan including
the rate of interest, term of the bond, and an agreement to repay the principal amount of the bond at a
set date in the future.

3
As global markets have developed, participants have started to look at, and invest or speculate in, other
asset classes, in addition to equities and bonds. These include foreign currencies, depository receipts,
rights, warrants, commodities and real estate.

This workbook will provide further detail on equities, bonds and other securities.

However, before moving forward, it is useful to explain some terminology and outline the essential
differences between investing in bonds and investing in equities.

Bond investors:

• lend money to the issuer in return for an agreed rate of interest

• have an agreed date on which the principal loaned will be repaid
• will be paid ahead of shareholders if the issuer becomes insolvent
• may have legal recourse against the issuer of the bond if the interest on the bond is not paid
• may have legal recourse against the issuer of the bond if repayment does not occur.

Investors in equities hold a stake in a company. Each share represents a portion of the company, and
usually entitles the holder to one vote per share. Equities have different names in different parts of the
world. For example, in North America, equities are sometimes referred to as stocks, while in many other
parts of the world, equities are referred to as shares.

Equity investors:

• purchase a small portion, or share, of a company

• cannot be certain the value of the company will increase
• cannot be certain of the amount of dividend payments that they will receive or if they will receive
dividends at all
• can suffer a total loss of investment if the company collapses
• are re-paid after bondholders and other creditors in the event of issuer insolvency
• may have voting rights to influence decisions made by the company.

Securities, like equities and bonds, take one of two main forms – registered or bearer – and the form
determines how an investor proves ownership of a particular investment. Bearer certificates, as their
name suggests, mean that the person that bears (or holds) them has title to them, like banknotes. In
comparison, registered certificates require that the holder’s ownership is recorded in a register as the
owner (or title-holder) of the investment. The certificate itself is less important.

Example
An investor owns 100 shares in a global retailer in registered form. If a burglar breaks into the investor’s
house and steals the share certificates, can the burglar pretend that they own the shares and sell them?

Fortunately, the answer is no.

The answer to the above example is no because most shares around the world are held in registered
form. This means that the certificate is simply evidence of ownership. Indeed, with the advent of
technology, it is becoming increasingly rare to find share certificates at all – shares are usually held
electronically rather than physically. The proof that really counts is the name and address held on the
company’s stockholder register.

4
 The Financial Services Sector

Some securities come in bearer form and, unlike registered securities, the physical possession of the

1
certificate is the proof of ownership. Bearer securities are easier to transfer as there is no register and
they can simply be handed over. However, this does raise some issues including the following:

• It is difficult for the authorities to monitor ownership, making them attractive investments for
money launderers.
• The issuing organisation has difficulty knowing to whom dividends or interest payments are to be
sent.
• Physical security of the certificates is of greater importance and can increase the cost of holding the
investment. If, in the example above, the shares stolen were in bearer form, then the burglar would
be able to sell them.

It is important to note that many bearer securities are held in central securities depositories (CSDs), such
as Euroclear and Clearstream, and are technically referred to as ‘immobilised’. This removes the worry
about physical security, makes it easier for the issuer to pay any income due and also lessens the risk of
inappropriate use because the CSDs will be communicating with financial services regulators. Examples
of securities that are usually held in bearer form are eurobonds and American depositary receipts
(ADRs) (both are further detailed in chapter 2).

2. Professional and Retail Business

Learning Objective
1.1.1 Know the differences between retail and professional businesses, including: their clients;
equity markets; bond markets; foreign exchange markets

Within the financial services sector, there are two distinct subsectors – the wholesale sector and the
retail sector. The wholesale sector is also often referred to as the professional sector or institutional
sector. It is the business-to-business (B2B) area where both sides of a transaction are businesses, not
individuals.

The activities that make up the wholesale sector include:

• equity markets – the trading of shares

• bond markets – the trading of government, supranational or corporate debt
• foreign exchange – the trading of currencies
• derivatives – the trading of options, swaps, futures, forwards and other instruments like contracts
for difference (CFDs) and ‘exotic’ derivatives.
• insurance markets – major corporate insurance (including professional indemnity), reinsurance,
captive insurance and risk-sharing insurance
• fund management – managing the investment portfolios of collective investment schemes
(CISs), pension funds and insurance funds. This includes ‘alternative’ investments generally only
available to institutions or other large investors, such as hedge funds and private equity funds.
• investment banking – banking services tailored to organisations, such as undertaking mergers and
acquisitions, marketing and underwriting new issues of securities for raising capital, equity and fixed
income trading, OTC derivatives trading.

5
 • custodian banking – providing services to asset managers involving the safekeeping of assets, the
administration of the underlying investments, settlement, corporate actions and other specialised
activities. Custodian relationships are generally necessary for access to international markets.

By contrast, the retail sector focuses on services provided to personal customers/individuals. It is

business-to-consumer (B2C) and includes:

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

2.1 Equity Markets

Equity markets are the best-known financial markets and facilitate the trading of shares in quoted
companies. The participants in equity markets include both institutional and individual investors, but
are comprised primarily of institutional investors, such as asset managers, who trade the shares held in
their clients’ funds, and insurance companies. The trades they undertake are arranged by stockbrokers
(often simply referred to as brokers). The arranged trade will often involve purchasing from, or selling
to, a bank which is acting as a dealer or, in some cases, a market maker. As larger banks provide their
clients with the capacity to both arrange and to buy equities from them, or sell equities to them, the
banks are often termed brokers/dealers.

The World Federation of Exchanges provides data from the global stock exchanges. As illustrated in the
following graph, total market capitalisation was almost US$90 trillion at the end of June 2020 (note
that not all stock exchanges provide data to the World Federation of Exchanges so actual figures will be
higher). Global market capitalisation is the total value of shares listed on the world’s stock exchanges.

Market Capitalisation
50 100
45 90
40 80
Regional values, USD trillion

Total value, USD trillion

35 70
30 60
25 50
20 40
15 30
10 20
5 10
0 0
2016 2017 2018 2019 2020
Total APAC EMEA Americas

Source: World Federation of Exchanges

6
 The Financial Services Sector

• The New York Stock Exchange (NYSE) is the largest exchange in the world and had a domestic

1
market capitalisation of US$21.0 trillion as at the end of March 2020 (domestic market capitalisation
is the value of shares listed on an individual exchange).
• The other major US market, Nasdaq, was ranked as the second largest, with a domestic market
capitalisation of US$17.5 trillion, meaning that the two New York exchanges account for more than
one third of all exchange business.
• The next four largest exchanges in the world by market capitalisation at the end of March 2020
were all in Asia – Shanghai ($6.33 trillion), Japan Exchange Group, which includes the Tokyo Stock
Exchange ($5.9 trillion), Hong Kong ($5.49 trillion) and Shenzen ($4.76 trillion).
• In Europe, the largest exchanges are the London Stock Exchange (LSE), Euronext, Deutsche Börse’s
Frankfurt Stock Exchange (FSE) and the SIX Swiss Exchange.
• The Toronto Stock Exchange (TSX) in Canada is one of the ten largest exchanges in the world, and
the Bombay, Australian and Korean exchanges are in the top 15. The Bombay Stock Exchange (BSE),
although not largest in terms of market capitalisation, has the most companies listed on it compared
to any other exchange in the world.
• The Saudi Stock Exchange (Tadawul) is a recent addition to the world’s top ten by domestic market
capitalisation sine the addition of the massive oil company Aramco.
• Many African countries have stock exchanges; the largest include South Africa’s Johannesburg Stock
Exchange (JSE), Morocco’s Bourse de Casablanca, the Egyptian Exchange (EGX), the Nigerian Stock
Exchange (NSE), the Nairobi Securities Exchange and the Ghana Stock Exchange (GSE).
• Other large exchanges include B3 (Brasil Bolsa Bacao) and the Indonesia Stock Exchange, which as of
March 2020 had a market capitalisation of $763.5 billion and $417.1 billion respectively. Numerous
smaller exchanges also exist in other regions, such as Central Asia; the Kazakhstan Stock Exchange
and the Tashkent Stock Exchange (Uzbekistan) are two examples.

Source: World Federation of Exchanges

Rivals to traditional stock exchanges have also arisen with the development of technology and
communication networks known as multilateral trading facilities (MTFs) in Europe and alternative
trading systems (ATSs) in the US. MTFs and ATSs are systems that bring together multiple parties that
are interested in buying and selling financial instruments such as shares. These systems are also known
as crossing networks or matching engines, and are provided by either an investment firm or another
market operator. In addition, inter-dealer brokers (IDBs) or other intermediaries may operate their own
proprietary trade platforms, sometimes called ‘dark pools’ or electronic communications networks
(ECNs) which also compete with exchanges for trading volume. New trade aggregation systems are
also being required by regulators for previously over-the-counter (OTC) markets, eg, swap execution
facilities (SEFs), though some of these may be run by traditional securities exchanges and provide new
sources of business rather than competition.

7
2.2 Bond Markets
Although less frequently reported on than equity markets, bond markets are larger both in size
and value of trading. As with equities, the major participants include the investors (particularly the
institutions such as the funds run by asset managers and insurers) generally undertaking deals with the
dealers (or traders) at the large banks. However, in contrast to equities, little dealing is done via stock
exchange systems, with the majority of trades taking place away from the exchanges in OTC trades.
Furthermore, the volume of bond trading is lower, as most trades tend to be very large when compared
to equity market trades. The amounts outstanding on the global bond market are more than US$100
trillion. Domestic bond markets account for around three quarters of the total and international bonds
for the remainder.

Source: Bank for International Settlements

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

2.3 Foreign Exchange (FX) Markets

Foreign exchange (FX) markets are the largest of all financial markets, with average daily turnover in
excess of US$5 trillion.

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

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

As FX is an OTC market, meaning one where brokers/dealers negotiate directly with one another, there
is no central exchange or clearing house. Instead, FX trading is distributed among major financial
centres. One minor exception is that there are some FX futures and options contracts which are traded
on some of the exchanges.

The Bank for International Settlements (BIS) releases figures on the composition of the FX market every
three years. The latest report for 2019 shows that market activity has become ever more concentrated in
a handful of global centres. As you can see in the chart below, FX transactions are concentrated in five
countries/regions, with the UK as the main global centre:

8
 The Financial Services Sector

1
Others 20.7%
UK 43.1%

Japan 4.5%
Hong Kong 7.6%
Singapore 7.6%

US 16.5%

Source: Bank for International Settlements

3. Participants – Retail Sector

Learning Objective
1.1.2 Know the role of the following within the retail sector of the financial services markets: banks;
pension funds; insurance companies; investment services; financial planning and advice

The following sections provide descriptions and roles of some of the main participants in the financial
services sector that serve retail customers.

3.1 Retail Banks

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

Historically, these banks tended to operate predominantly through a network of physical branches
and telephone banking but, increasingly, they are operating through internet- and application-based
services.

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

3.2 Pension Funds

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

9
Pension funds are large, long-term investors in shares, bonds and cash. Some also invest in physical
assets, like property. To meet their aim of providing a pension on retirement, the sums of money
invested in pension funds are substantial.

3.3 Insurance Companies

One of the key functions of financial services is to effectively manage risks. Insurance companies provide
life products, which pay a named beneficiary when the insured dies, and general insurance, which
covers risks arising from incidents, such as accidents and theft (eg, motor insurance and household
insurance). Insurance companies are also important providers of pension products.

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

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

3.4 Investment Services

Individuals may want to deploy their savings in financial assets, such as shares and bonds, however,
investing savings can be complex and time-consuming. Specialists, therefore, have emerged to provide
services around the investments for customers, generally for a fee.

When the customers are individuals (retail), the typical investment services will help them select the
right investments, arrange their purchase (and subsequent sale), keep the investments under review
and collect any income from them. These activities need to be reported to the customers on a regular
basis.

The providers of these services include the retail banks as well as stockbrokers. Traditionally, stockbrokers
arranged trades in financial instruments on behalf of their clients, which include investment institutions,
fund managers and private clients. Today, many of these are institutional brokers operating in the
wholesale or professional market and making their money by using their discretion and skill to execute
large trades for their clients. Others are execution-only brokers who give no advice, but simply offer
trading services to retail clients. These firms earn their profits by charging commissions on transactions.

A growing area for providing retail investment advice is ‘robo-advisors’. These are often smaller,
IT-focused firms which create algorithms to provide automated investment advice at a relatively low
fee. These are sometimes subsidiaries of traditional financial institutions or of large technology firms.

10
 The Financial Services Sector

3.5 Financial Planning and Wealth Management

1
Stockbrokers also traditionally advised investors about which shares, bonds or funds they should buy
and the services they offered expanded to include investment management and wealth management
services. As a result, many stockbrokers now offer wealth management services to their clients and so
are referred to as wealth managers. These wealth management firms can be independent companies,
but some are divisions of larger entities, such as banks or insurance companies. They earn their profits
by charging fees for their advice and commissions on transactions. They may also look after client assets
and charge custody and portfolio management fees.

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

Financial planning goes beyond investment management. The process involves defining, quantifying
and qualifying goals and objectives, coming up with possible strategies to meet those goals, and
objectives, analysing the different strategies and then recommending and implementing the most
appropriate strategy for that client. In addition to investment management, other core topics that are
addressed include financial management and budgeting, retirement planning, risk management or
insurance planning, tax planning and estate planning. Financial planning addresses and integrates all
components of the client’s financial life.

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

Such advisers are considered ‘fiduciaries’. A fiduciary is defined as a person or organisation that acts on
behalf of others and puts their clients’ interests ahead of their own, with the objective of maintaining
good faith and trust. A fiduciary differs from other less formal types of consultants and or advisers in that
an adviser who is a fiduciary is both ethically and legally bound to put the client first.

11
 4. Participants – Wholesale Sector

Learning Objective
1.1.3 Know the role of the following within the wholesale sector of the financial services markets:
investment banks; fund managers; stockbrokers; custodians

The following sections provide descriptions and outline the roles of some of the main participants
within the financial services sector that specialise in providing services to the professional/wholesale
sector.

4.1 Investment Banks

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

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

• Corporate finance and advisory work, normally in connection with new issues of securities to raise
finance, mergers and acquisitions. This can include underwriting or bookrunning issues of securities
for public listing or via private placement.
• Banking, for governments, institutions and companies.
• Treasury dealing for corporate clients in foreign currencies, with financial engineering services to
protect them from interest rate and exchange rate fluctuations.
• Investment management for sizeable investors, such as corporate pension funds, charities and
private clients. This may be either via direct investment for the wealthier, or by way of investment
funds.
• Securities trading in equities, bonds and derivatives, and the provision of broking and distribution
facilities.
• Creation of and dealing in structured products, complex instruments which often combine several
types of other securities or currencies to meet a specific hedging or investment need for clients.

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

12
 The Financial Services Sector

4.2 Fund Managers

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

The US is the largest centre globally for fund management, followed by the UK, which is the biggest in
Europe.

Fund managers, also known as investment or asset managers, run portfolios of investments for others.
They invest money held by institutions, such as pension funds and insurance companies, as well as for
CISs, such as US mutual funds and Europe’s unit trusts and investment companies with variable capital
(ICVCs), and portfolios for wealthier individuals. Some are organisations that focus solely on this activity;
others are divisions of larger entities, such as insurance companies or banks.

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

Fund managers charge their clients for managing their money; these charges are often based on a small
percentage of the value of the fund being managed.

Other areas of fund management include the provision of investment management services to
institutional entities, such as companies, charities and local government authorities.

4.3 Stockbrokers
As already seen in the previous section, stockbrokers arrange trades in financial instruments on behalf
of their clients, which include institutional brokers operating in the wholesale or professional market
and making their money by using their discretion and skill to execute large trades for their clients. A
number of these stockbroking activities are undertaken by divisions of large investment banks rather
than independent entities and, like retail stockbrokers, they earn revenue by charging commissions on
the transactions they arrange.

13
4.4 Custodian Banks
Custodians are banks that specialise in safe custody services, looking after portfolios of shares and
bonds on behalf of others, such as fund managers, pension funds and insurance companies.

The core activities they undertake include:

• holding assets in safekeeping, such as equities and bonds

• arranging settlement of any purchases and sales of securities
• processing corporate actions, including collecting income from assets, namely dividends in the case
of equities and coupons in the case of bonds
• providing information on the underlying companies and their annual general meetings (AGMs)
• managing cash transactions
• performing FX transactions when required
• larger custodians often have an international network of country branches or affiliated local custody
firms, thereby enabling access to foreign markets
• providing regular reporting on all their activities to their clients.

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

14
 The Financial Services Sector

End of Chapter Questions

1
1. List the essential differences between equities and bonds.
Answer reference: Section 1.1

2. What is a bearer certificate?

Answer reference: Section 1.1

3. Where are bearer securities typically held and ‘immobilised’?

Answer reference: Section 1.1

4. What is the professional sector?

Answer reference: Section 2

5. Which are the largest stock exchanges in the world by market capitalisation?
Answer reference: Section 2.1

6. What is considered the largest of the financial markets?

Answer reference: Section 2.3

7. Where are the main global centres for foreign exchange trading?
Answer reference: Section 2.3

8. Which of the following are considered to be active primarily in the retail sector or the wholesale
sector?
• Insurance companies
• Investment banks
• Stockbrokers
• Pension funds
• Financial planners
Answer reference: Sections 3 and 4

9. What services are typically provided by investment banks?

Answer reference: Section 4.1

10. What services do custodian banks provide?

Answer reference: Section 4.4

15
16
Chapter Two

2
Asset Classes
1. Equities 19

2. Debt Instruments 23

3. Government Debt 37

4. Corporate Debt 46

5. Cash Assets 56

6. Eurobonds 61

7. Other Securities 63

8. Foreign Exchange (FX) 69

9. Collective Investment Schemes (CISs) 77

10. Structured Products 89

This syllabus area will provide approximately 27 of the 100 examination questions
18
 Asset Classes

1. Equities

Learning Objective

2
2.2.1 Understand the advantages and disadvantages to issuers and investors of the following
investments and their principal features and characteristics: ordinary shares; non-voting shares;
redeemable shares; partly paid shares and calls; and in respect of these, the generally accepted
practice regarding ranking for dividends and voting rights

Equities can be divided into two categories – ordinary shares and preference shares. In the US, the first
category – ordinary shares – is termed common stock, and the second – preference shares – is termed
preferred stock. This workbook will generally use the terms ordinary shares and preference shares,
although concepts mentioned in relation to ordinary shares can be considered to apply to what the
US would describe as common stock, and concepts mentioned in relation to preference shares can be
considered to apply to preferred stock.

Every company has ordinary shares in issue. In addition to the ordinary shares, some companies also
issue preference shares (or ‘preferred shares’ in the US). The vast majority of businesses, especially small
and medium-sized firms which are formed as corporations, issue shares which are unlisted or privately
held. The following discussion, especially with respect to ordinary shares, will be focused on those which
are listed on a public exchange.

The performance of ordinary shares is closely tied to the fortunes of the company. Holders of ordinary
shares have the right to vote on key decisions and receive dividends. Some companies issue more than
one class of ordinary shares (perhaps distinguished as A ordinary shares and B ordinary shares) and one
class may have more voting rights than the other. Occasionally, one class of shares may not have any
voting rights at all; these shares are described as non-voting shares.

Example
Alphabet inc is one of the world’s largest companies and owns Google. At the time of writing, Alphabet
has three classes of shares in issue:

• 300,221 shares of Class A Common Stock – each share has one vote.
• 46,302 shares of Class B Common Stock – each share has ten votes (these shares are owned primarily
by the Google founders, and retaining them enables them to retain control of operations and
decisions).
• 334,692 shares of Class C Capital Stock – each share has no voting rights at all.

Source: Alphabet Quarterly Filing (10-Q) June 2020

Redeemable shares are relatively unusual. They are shares offered by a company to shareholders that
may be bought back by the company at its election. Companies are permitted to issue ordinary shares
that can be redeemed, as long as conventional non-redeemable ordinary shares are also in issue.

19
Preference shares are, typically, slightly less risky than ordinary shares of the same company and,
therefore, potentially less profitable to invest in. They carry less risk due to the dividend policy and they
rank above ordinary shares in the event of bankruptcy. Holders of preference shares generally do not
have the right to vote on company affairs, but they are typically entitled to receive a fixed dividend
each year (as long as the company feels it has sufficient profits). These dividends must be paid before
any dividends are paid to ordinary shareholders, hence the term preference or preferred. Although
preference shares tend to be non-voting, it is common for preference shareholders to become entitled to
vote in the event of no dividend being paid for a substantial period of time. Precisely how long the period
needs to be to make it substantial will be detailed in the company’s constitution. Preference shares are
sometimes referred to as ‘hybrid’ securities as they have some characteristics like bonds (a fixed amount
of payment each year) and some like equities (they are shares).

As stated, companies have an obligation to pay dividends to preference shareholders before they pay a
dividend, if any, to the ordinary shareholders.

In the case of a liquidation, priority would be given first to debtholders. Once the obligations to
debtholders have been discharged, preference shareholders take priority over the ordinary shareholders.

1.1 Features of Ordinary Shares

It is the common stockholders or ordinary shareholders of a company that face the greatest risk. If the
company is liquidated, they will only receive a payout if there is money remaining after satisfying all of
the other claims from creditors, bondholders and preference shareholders. Furthermore, the value of
ordinary shares can decline if the demand for shares declines. Ordinary shareholders may end up selling
their shares for less than they paid for them. Their maximum loss is 100% of the purchase price plus the
commission paid.

However, if the company is sufficiently profitable, the ordinary shareholders may receive dividends.
Dividends for ordinary shareholders are proposed by the directors and generally ratified by the
shareholders at the annual general meeting (AGM). However, the ordinary shareholders will only receive
a dividend after any preference dividends have been paid. In addition to the potential for dividend
payments, ordinary shares can increase in value as the demand for shares increases. It is expected
that a firm which is profitable will retain some of the profit (‘retained earnings’) to invest in assets or
build up cash balances to enable the business to grow. Accordingly, ordinary shares, which represent a
fractional ownership stake, should over time be worth more. Although broad fluctuations in the equities
market create risk, an ordinary shareholder could sell ordinary shares in the market for greater than they
originally paid for them, thereby realising a profit or capital gain. The maximum gain is theoretically
unlimited.

Each ordinary share is typically given the right to vote at AGMs and extraordinary general meetings
(EGMs), although sometimes voting rights are restricted to certain classes of ordinary shares. Such
different classes of shares (often called A and B ordinary shares) are created to separate ownership
and control, such as with Google/Alphabet, where the founders retain control, and as illustrated in the
following example where the founders cede control.

20
 Asset Classes

Example
As seen, Alphabet inc has three classes of common stock, two classes of which are traded:

Class A shares give one vote per share, are traded under the ticker GOOGL and the price at the time of

2
writing (October 2020) was $1,563.19.

Class B shares give ten votes per share, they are not traded and are mainly held by the founders of
Google.

Class C shares give no votes per share, are traded under the ticker GOOG and the price at the time of
writing (October 2020) was $1,566.56.

Given that, as at the end of June 2020, there were the following numbers of shares in issue, the control is
seen to still reside with the founder members who hold a comfortable majority of the votes.

Class A shares: 300,221 shares with one vote per share = 300,221 votes

Class B shares: 46,302 shares with ten votes per share = 463,020 votes

Class C shares: 334,692 shares with no votes per share = 0 votes

Total votes = 763,241

Proportion of votes held by the B shareholders (mainly the founders) = 463,020/763,241 = 60.66%

Source: Alphabet Quarterly Filing (10-Q) June 2020

If they do have voting shares, each shareholder may, if they so wish, appoint a third party, or proxy,
to vote on their behalf. A proxy may be an individual or group of individuals appointed by the board
of directors of the company to represent the shareholders who send in proxy requests, to vote the
represented shares in accordance with the shareholders’ instructions.

In many jurisdictions, each ordinary share has a nominal value (also known as par value or face value)
which represents the minimum amount that the company must receive from subscribers on the issue of
the shares. Occasionally, the company may not demand all of the nominal value at issue, with the shares
then referred to as being partly paid. At some later date, the company will call on the shareholders to
pay the remaining nominal value and make the shares fully paid.

Most ordinary shares are registered, meaning that the issuing company maintains a register of who
holds the shares. This contrasts with bearer instruments when the issuer does not maintain a register –
they can be transferred to other investors by simply handing over the certificate. For registered shares,
a transfer requires a change of entry in the shareholders’ register.

21
1.2 Types of Preference Share

Learning Objective
2.2.2 Understand the advantages and disadvantages to issuers and investors of the following classes
of preference/preferred shares and their principal characteristics: cumulative; participating;
redeemable; convertible; zero coupon

Preference shares can come in a variety of forms.

• Cumulative – a cumulative preference shareholder will not only be paid this year’s dividend before
any ordinary shareholders’ dividends are paid, but also any unpaid dividends from previous years.
Non-cumulative shares, on the other hand, would forfeit dividends not paid in the previous period.
• Participating – one drawback of preference shares when compared to ordinary shares is that, if the
company starts to generate large profits, the ordinary shareholders will often see their dividends
rise, whereas the preference shareholders still get a fixed level of dividend. To counter this, some
preference shares offer the opportunity to participate in higher distributions. Participating shares
can also participate in additional distributions in the event of liquidation. While all preferred
shareholders rank above common shareholders, participating shareholders are entitled to more
money if there are additional funds available after all other preferred shareholders are paid, as if
they are also common shareholders.
• Redeemable – these are preference shares that enable the company to buy back the shares from
the shareholder at an agreed price in the future. The shares, from the company’s perspective, are
similar to debt. The money provided by the preference shareholders can be repaid, removing any
obligation the firm has to them.
• Convertible – in this case, the preference shareholder has the right, but not the obligation, to
convert the preference shares into a predetermined number of ordinary shares, eg, perhaps one
preference share may be converted into two ordinary shares. This is another method of avoiding the
lack of upside potential in the preference shares, compared to ordinary shares.
• Zero coupon – these are preference shares that pay no dividend, but offer an upside to the
shareholder in that they redeem at a price above that at which they are issued.

Note that any one particular preference share can exhibit more than one of these features.

While they convey certain protections, such as a fixed dividend as long as the company is profitable and
priority in the bankruptcy chain, preferred shares often are less liquid and are not actively monitored
or easily purchasable by investors. This may lead to regular preferred shares (without some of the
enhancements listed above) to underperform ordinary shares in a rising market.

22
 Asset Classes

2. Debt Instruments

2.1 Features and Characteristics

2
Learning Objective
2.3.1 Know the principal features and characteristics of debt instruments (fixed interest, floating rate
and index linked)

As outlined in chapter 1, a bond is essentially an I owe you (IOU) issued by an organisation (the borrower,
or issuer), in return for money lent to it.

The nominal value (or par value) of a bond is the amount that the borrower will pay back to the holder
of the bond on maturity.

The issuer of a bond is important in determining the return the buyer will demand. If the company or
government issuing a bond is considered high-risk – being more likely to fail to make the contractual
coupon payments or principal repayment – it will need to offer a high rate of interest on the bond to
attract investors. Some of the most significant issuers of bonds are governments; examples include
the US government’s Treasuries, Japanese government bonds (JGBs), Germany’s bunds and the UK
government’s gilts.

The redemption date of a bond is the date on which the borrower agrees to pay back the nominal value
of the bond. It is also referred to as the date on which the bond matures, ie, the maturity date.

A bond’s coupon is the interest rate that the borrower pays to the bondholder. Usually, this is expressed
as a fixed percentage of the nominal value (known as fixed interest). In diagrammatic form:

A Bond

I owe you: Nominal or par value

$100
Redemption or maturity date
To be repaid in 3 years’ time

Interest of 5% to be paid each year

Coupon
Issued by: Treasury
Issuer

23
As will be detailed in section 4.2 of this chapter, some bonds state the coupon by reference to a
published interest rate, such as the London Interbank Offered Rate (LIBOR), and reset the coupon
paid when the published interest rate changes. These are known as ‘floating rate’ bonds, and are often
called floating rate notes, (FRNs). There are also bonds that adjust both the coupon and the principal
amount repaid at maturity by reference to the prevailing rate of inflation. Such bonds are referred to
as ‘index-linked’ because their returns are linked to an inflationary index, such as the consumer prices
index (CPI).

2.2 Yields

Learning Objective
2.3.2 Understand the uses and limitations of the following: flat yield; gross redemption yield (using
internal rate of return); net redemption yield; modified duration in the calculation of price
change

The yield is a measure of the percentage return that an investment provides. For a bond, there are three
potential ways yields can be calculated: the flat yield (also known as the interest or running yield), the
gross redemption yield (GRY) that is commonly also referred to as the yield to maturity (YTM), and the
net redemption yield (NRY).

2.2.1 Flat Yield

The flat yield only considers the coupon and ignores the existence of any capital gain (or loss) if the
bond is held through to redemption. As such, it only reflects one aspect of the return (the coupon) and
ignores any gain (or loss) that will arise if the bond is held through to maturity.

The calculation of the flat yield is as follows:

Flat yield = (annual coupon/price) x 100

For example, the flat yield on a 5% gilt, redeeming in six years and priced at £104.40, is:

(5/104.40) x 100 = 4.79%

Exercise 1
a. Calculate the flat yield on a 4% gilt, redeeming in eight years and priced at £98.90
b. Calculate the flat yield on a 7% gilt, redeeming in three years and priced at £108.60

The answers can be found at the end of this chapter.

24
 Asset Classes

Using the flat yield, it is simple to see how a change in interest rates will impact bond prices. If interest
rates increase, investors will want an equivalent increase in the yield on their bonds. However, because
the coupon is fixed for most bonds, the only way that the yield can increase is for the price to fall. This
causes the inverse relationship between interest rates and bond prices. When interest rates rise, bond

2
prices fall and vice versa.

2.2.2 Gross Redemption Yield (GRY)/Yield To Maturity (YTM)

The GRY is a fuller measure of yield than the flat yield, because it takes both the coupons and any gain
(or loss) through to maturity into account – hence its alternative name ‘yield to maturity’ or just YTM.
Because it considers the gain or loss if the bond is held until it matures, it presents a more complete
picture of the return than the flat yield. However, it does ignore the impact of any taxation (hence the
‘gross’ in GRY), so this measure of return is especially useful for non-tax-paying long-term investors such
as pension funds and charities.

The calculation of the GRY utilises the approach covered in Section 2.6 of this chapter to arrive at the
present value of a bond. It is the internal rate of return (IRR) of the bond. The IRR is simply the discount
rate that, when applied to the future cash flows of the bond, produces the current price of that bond.

Example
Assume that there is a US Government bond known as a 5% Treasury Note and that it will be repaid in
exactly five years’ time. Its current price is $115, and so if an investor buys $10,000 nominal of the bond
today, it will cost $11,500, excluding brokers’ costs. The annual interest payments will amount to $500,
so its flat yield [(500/11,500) x 100] is currently 4.35%.

In five years’ time, however, the investor is only going to receive $10,000 when the bond is redeemed,
and so will make a loss of $1,500 over the period. If an investor were simply to look at the flat yield, it
would give a misleading indication of the true return that they were earning. The true yield needs to
take account of this loss to redemption and this is the purpose of the redemption yield.

Very simply, the investor needs to write off that loss over the five-year period of the bond, let us say at
the approximate rate of $300 per annum, so the annual return that the investor is receiving is actually
closer to $200 – the annual interest of $500 less the $300 written off. If you recalculate the flat yield
using this $200 as the interest, the return reduces to 1.74%.

The GRY, then, gives a more accurate indication of the return that the investor receives, and can be used
to compare the yields from different bonds to identify which is offering the best return.

Example
The following data gives the prices of two US Government bonds that are both due to be repaid in 2027.
Consider the data and identify which is producing the best overall return assuming that the investor will
hold the bonds until redemption.

25
 Stock Name Redemption Price Flat Yield GRY
7.625% Treasury 2027 150.04 5.08% 2.139%
6.875% Treasury 2027 144.46 4.76% 2.191%

As can be seen, although the first bond appears to be the more attractive on the basis of flat yield, the
GRY shows it will in fact produce a poorer overall return to the investor if held to maturity. An investor
concerned with maximising their overall return will clearly pick the second.

2.2.3 Net Redemption Yield (NRY)

The NRY is similar to the GRY in that it takes both the annual coupons and the profit (or loss) made
through to maturity into account. However, it looks at the after-tax cash flows rather than the gross cash
flows and, as a result, is a useful measure for tax-paying investors investors planning to hold their bonds
through to maturity.

2.2.4 Modified Duration

It is clear that, if interest rates rise, the price of fixed-rate debt instruments (eg, most government bonds,
including gilts and many corporate debt issues) falls, and vice versa.

If an investor thinks that interest rates are going to fall in the future, then investing in fixed-interest
securities is a good idea because, if the investor is correct, their price will rise.

However, some fixed-interest securities will be more responsive to a movement in interest rates than
others. They will all rise in value when interest rates fall, but some will probably rise by more than others.
The ones that rise the most are the more volatile securities.

All other things being equal, a lower-coupon bond will be more volatile to a change in interest rates
than a higher-coupon bond. Similarly, all other things being equal, a longer-dated bond will be more
responsive than a shorter-dated bond.

To identify which bonds are more volatile, volatility measures can be used.

The one measure of volatility required for this examination is modified duration.

The modified duration of a particular debt instrument shows the expected change in its price, given
a specified change in interest rates. The higher the modified duration, the more the price of that
instrument will move. The modified duration is the approximate percentage change in the price of a
bond brought about by a 1% change in the interest rate.

26
 Asset Classes

Example
If a government bond is priced at $95.84, and its modified duration is 1.02, what is the effect on the price
after an increase in interest rates by one percentage point?

2
If interest rates rise by one percentage point, the bond’s price will fall by 1.02/100 x $95.84 = $0.98.

If interest rates rise by one half of a percentage point, the bond’s price will fall by 1.02/100 x $95.84 x 0.5
= $0.49.

2.3 Interest and Conversion Premium Calculations

Learning Objective
2.3.3 Be able to calculate: simple interest income on corporate debt; conversion premiums on
convertible bonds and whether it is worth converting; flat yield; accrued interest (given details
of the day count conventions)

2.3.1 Interest on Corporate Debt

Corporate debt – the borrowing of a company – requires servicing by making regular interest payments.
Interest on bonds is calculated by reference to the coupon rate, coupon frequency and nominal value.
The flat yield is calculated using the coupon rate and the bond’s price.

Example
XYZ inc has issued bonds paying an annual 8% coupon and maturing in 2030. The bonds are currently
priced at 156, meaning investors have to pay $156 for each $100 of nominal value.

If an investor buys $5,000 nominal value, the bonds will cost $7,800 ($5,000 x 156/100).

The interest income for the investor each year will be the nominal value multiplied by the coupon rate
– $5,000 x 8% = $400 (the current price of the bond is not relevant in this calculation). If the interest was
paid semi-annually, then the annual payment would be split into two portions of $200 ($400/2) every
six months.

The flat yield for the investor is the coupon rate divided by the price expressed as a percentage, ie,
(8/156) x 100 = 5.13%.

2.3.2 Convertible Bonds

Some corporates issue bonds with conversion rights, known as convertible bonds. Convertible bonds
give the holder of the bond the right, but not the obligation, to convert the bond into a predetermined
number of ordinary shares of the issuer. Given this choice, the holder will choose to convert into shares
if, at maturity, the value of the shares they can convert into exceeds the redemption value of the bond.

27
Because there is this potential advantage to the value of a convertible bond if the share price rises,
and the downside protection provided by the redemption value if the shares do not perform well,
convertible bonds generally trade at a premium to their share value. The calculation of the premium is
shown by the following example.

Example
A convertible bond issued by XYZ inc is trading at $142.5. It offers the holder the option of converting
$1,000 nominal into three shares. The shares of XYZ inc are currently trading at $380. To calculate the
premium, first work out the share value of the conversion choice.

For $1,000 nominal value, that is $380 x 3 shares = $1,140.

The bond is trading at $142.5 ($1,000 nominal costs $1,425), and so the premium in absolute terms is
1,425 – 1,140 = $285 per $1,000 nominal.

It is more usual to express it as a percentage of the conversion value:

(285/1,140) x 100 = 25%

Exercise 2
The convertible bonds issued by ABC plc are trading at £110. Each £100 nominal value offers the holder
the option of converting into 15 ordinary ABC shares. The ordinary shares of ABC are currently trading at
£6.40. What is the conversion premium, expressed in percentage terms?

The answer can be found at the end of this chapter.

Convertible bonds enable the holder to exploit the growth potential in the equity, while retaining the
safety net of the bond. It is for this reason that convertible bonds trade at a premium to the value of
the shares they can convert into. If there were no premium, there would be an arbitrage opportunity
for investors to buy the shares more cheaply via the convertible than in the equity market. Usually,
convertible bonds are issued where the price of each share is set at the outset, and that price will be
adjusted to take into account any subsequent bonus or rights issues. Given the share price, it is simple
to calculate the conversion ratio – the number of shares that each £100 of nominal value of the bonds
can convert into.

Nominal value
Conversion ratio =
  Conversion price of shares

Example
£100 nominal value of a convertible bond is able to convert into shares at £4.46 each.

The conversion ratio is £100/£4.46 = 22.42 shares

If the issuing company had a 1-for-1 bonus issue, then the conversion price would halve, and the
conversion ratio would double.

28
 Asset Classes

2.3.3 Flat Yield Calculation

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

2
money invested.

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

Annual Coupon Rate

Flat Yield (%) = x 100
Market Price

The flat yield only considers the coupon and ignores the existence of any capital gain (or loss) through to
redemption. As such, it is better suited to short-term investors in the bond, rather than those investors
that might hold the bond through to its maturity and benefit from the gain (or suffer from the loss) at
maturity.

Limitations of Flat Yield

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

• Since it only measures the coupon flows and ignores the redemption flows, it often gives an
incomplete picture of the actual returns from the bond. A bond that has been purchased at a price
that is below the redemption value will be significantly undervalued because the redemption gain is
excluded from the calculation. The opposite is also true when a bond is purchased at a price above
the redemption value.
• The calculation completely ignores the timing of any cash flows and, because there is no discounted
cash flow analysis, the time value of money is completely overlooked.
• If the bond is a floating-rate note (FRN), the return in any one period will vary with interest rates.
If the coupon is not a constant, using a flat-yield basis for measuring returns becomes an arbitrary
matter of selecting which coupon amount among many possible values to use for the calculation.

2.3.4 Accrued Interest

Listed bond prices are flat prices, which do not include accrued interest. The flat price is alternatively
referred to as the clean price. Most bonds pay interest semi-annually. For settlement dates when
interest is paid, the bond price is equal to the flat price. Between payment dates, however, the actual
price paid for the bond will be the flat price plus the accrued interest.

Accrued interest is the interest that has been earned, but not paid, and is calculated by the following
formula:

Number of days since last payment

Accrued interest = Coupon payment x
Number of days between payments

29
The following graphic shows how the dirty price (ie, the clean price plus accrued interest) of a bond
fluctuates over the lifetime of the bond, in this case two years. The assumption made is that the flat
price remains constant over the two years; however, in reality, it will probably fluctuate with interest
rates and because of other factors. The flat price is what is listed in bond tables for prices. The accrued
interest must be calculated according to the formula above. Note that the bond price steadily increases
each day until reaching a peak the day before an interest payment, then drops to minimum immediately
following the payment.
Bond Price

Coupon
Amount
st

st

st

t
es
ere
ere

ere

er
Int

Int
Int

Int
ing

ing

ing
ing

cru
cru
cru
cru

Ac
Ac
Ac
Ac

Interest Interest Interest

Paid Paid Paid

Flat
Price ½ 1 1½

Calculating the Purchase Price for a Bond with Accrued Interest

Example
An investor purchases a corporate bond with a settlement date on 15 September with a face value
of $1,000 and a nominal yield of 8%, which has a listed price of 100.25, and which pays interest semi-
annually on 15 February and 15 August. How much should the investor pay for the bond, or in other
words what is its dirty price?

The semi-annual interest payment is $40 and there were 31 days since the last interest payment on
15 August. Assuming the settlement date fell on an interest payment date, the bond price would equal
the listed price: 100.25 x $1,000.00 = $1,002.50.

Since the settlement date was 31 days after the last payment date, accrued interest must be added.
Using the above formula, with 184 days between coupon payments, we find that:
31
Accrued Interest = $40 x = $6.74
184
Therefore, the actual purchase price for the bond will be $1,002.50 + $6.74 = $1,009.24.

30
 Asset Classes

Day Count Conventions

Historically, different day count conventions have evolved in calculating accrued interest to take into
account the fact that fixed-income securities have different coupon payment date characteristics, and
to address issues related to the vagaries of the calendar system. The Julian calendar has uneven-length

2
months and also has leap years, when once every four years there are 366 days to a year rather than 365.
This has given rise to a number of different ways of counting the intervals between payments and even
the length in days of the year assumed in the calculations.

There is no central authority defining day count conventions, so there is no standard terminology.
Certain terms, such as 30/360, actual/actual (ACT/ACT), and money market basis must be understood
in the context of the particular market. There has also been a move towards convergence in the
marketplace, which has resulted in the number of conventions in use being reduced.

In the example just cited, the day count is what can be called actual/actual, since the exact number of
days between coupons and the actual days since the last payment have been used.

Common day count conventions that affect the accrued interest calculation are:

• ACT/360 (days per month, days per year) – each month is treated normally and the year is
assumed to be 360 days, eg, the period from 1 February 2020 to 1 April 2020 is considered to be 59
days divided by 360 (even in instances like this one, when the year is actually a leap year). ACT/360
counts are used for US Treasury bills and money market instruments.
• 30/360 – each month is treated as having 30 days, so the period from 1 February 2020 to 1 April 2020
is considered to be 60 days. The year is considered to have 360 days (again, even in instances when
the year is a leap year). This convention is frequently chosen for ease of calculation: the payments
tend to be regular and at predictable amounts. 30/360 counts are used by US agency and corporate
issuers and eurobonds.
• ACT/365 – each month is treated normally, with the year assumed to be 365 days, regardless of
leap year status. So, despite 2020 being a leap year, the period from 1 February 2020 to 1 April 2020
is still considered to be 59 days. This convention results in periods having slightly different lengths
compared to the 30/360 basis.
• ACT/ACT – each month is treated normally, and the year has the actual number of days, eg, the
period from 1 February 2020 to 1 April 2020 is considered to be 60 days and the year is 366 days in
length. In this convention, leap years do affect the final result. If the period was 1 February 2021 to 1
April 2021, then the period is 59 days (as 2021 is not a leap year) and the year is 365 days long. ACT/
ACT counts are used by the US Treasury and for UK gilts.

31
2.4 Spreads and Pricing Benchmarks

Learning Objective
2.3.4 Understand the concept of spreads: spread over a government bond benchmark; spread over/
under swap

Commentators often refer to spreads in the bond markets. A spread is simply the difference between
the yields on two debt instruments, usually expressed in basis points, with each basis point representing
1/100 of 1%. For example, if the yield on Bond A is 5.5%, and the yield on Bond B is 5%, the spread is
5.5–5 = 0.5%, or 50 basis points. Spreads are used to compare instruments against one another or to a
benchmark, such as government bond yields or swap rates. The spread between a given debt instrument
and a benchmark represents the risk of the holding compared with that of the comparison. In general,
the greater the difference in the risks of the comparables, the larger the spread.

The comparison tends to be against one of two yields:

1. Government bond yields – benchmarks for corporate bonds are generally selected according to
market convention; typically, the most recently issued government bond closest to the maturity
of the corporate bond is selected as a benchmark. Gilts, bunds and US Treasuries are the reference
securities in the UK, Europe and the US, respectively.
2. Swap rates – there is a very active market in exchanging floating rates for fixed rates in the so-called
swaps market. The rates available on swaps are also used as benchmarks against which to judge yields.

The spreads on a particular instrument could be above or below benchmarks as shown in the following
example:

Example
UBX inc is a well-established and highly rated company. It has bonds in issue that expire in approximately
ten years and are currently yielding 3.40%. Comparative government bonds (based on the ten-year
Treasury bond) are yielding 3.15%, and the ten-year swaps rate is 3.20%. Three-month LIBOR is 3.54%.

The spreads can be summarised as follows:

• UBX bonds spread above government bonds = 25 basis points (3.40%–3.15%).

• UBX spread under LIBOR = 14 basis points (3.54%–3.40%).
• UBX bonds spread over swap rates = 20 basis points (3.40%–3.20%).

Spreads will vary, mainly as a result of the relative risk of the corporate bond compared to the
government or the financial institutions providing the swaps. For a riskier corporate issuer, the spread
will be greater.

32
 Asset Classes

2.5 The Yield Curve

Learning Objective

2
2.3.5 Understand the role of the yield curve and the relationship between price and yield with
reference to the yield curve (normal and inverted)

In many government bond markets there are a range of government bonds available with various
periods until maturity. By plotting the GRYs of these gilts on a graph, with yields on the Y axis and time
to maturity on the X axis, a pattern emerges. The line of best fit across these points is the yield curve.
It shows the yields available to investors in government bonds over different time horizons. The yield
curve is a visual representation of what is known as the term structure of interest rates – the relationship
between yields on financial instruments from the same issuer, but with different periods (terms) to
maturity.

The yield curve provides a useful tool for comparison – eg, if ten-year gilts yield 4%, then a ten-year
corporate bond should provide a higher yield to compensate investors for the additional default risk
they face.

2.5.1 The Normal Yield Curve

Typically, the shape of the yield curve is upward-sloping to the right, as shown in the following diagram:

Gross redemption yield (GRY)

Term to maturity (years)

This is known as the normal yield curve, and its shape captures the fact that investors have a liquidity
preference: they prefer more rather than less liquidity. As a result of this, they are willing to accept a
lower yield on more liquid, short-dated government bonds, and demand a higher yield on less liquid,
longer-dated government bonds. In other words, given the same coupon rate, the price of a short-dated
government bond will be higher than that of a longer-dated government bond, resulting in a higher
yield for the longer-dated instrument than the equivalent shorter-dated instrument.

33
2.5.2 The Inverted Yield Curve
Occasionally, the yield curve may not exhibit its normal, upward-sloping to the right shape. Instead, it
might be downward-sloping to the right, known as the ‘inverted yield curve’.

Gross redemption yield (GRY)

Term to maturity (years)

Clearly, in an inverted yield curve scenario, yields available on short-term government bonds exceed
those available on long-term government bonds. This occurs when there is an expectation of a
significant reduction in interest rates at some stage in the future. The consequence of this is that, when
investing in longer-term instruments that will be outstanding when the interest rates fall, the investor
is willing to accept a lower yield. For shorter-term instruments that will not be outstanding when the
interest rate falls, the investor is demanding a higher yield. The existence of an inverted yield curve does
not remove any liquidity preference, but the impact of the anticipated interest rate fall outweighs the
effect of the liquidity preference. Because an inverted yield curve implies the market expects rates to fall
(which happens when governments ease monetary conditions or there is weaker demand for credit),
this is often interpreted as a forecast for slowing economic conditions or an impending recession.

2.5.3 Negative Yields

Learning Objective
2.3.7 Understand the implications of negative interest rates for the bond market

Anaemic growth has been a feature for the developed world since the global financial crisis of 2007–08.
A lowering of the interest rate paid by central banks on the funds deposited by banks has not had
the desired economic impact. As a result, an increasing number of central banks (notably Denmark,
Sweden, Japan and the European Central Bank) have started to experiment with negative interest rates.
This involves the banks having to pay to leave their excess cash with the central bank, which should
encourage them to lend out the funds instead, boosting the economy.

34
 Asset Classes

This is a logical extension to the accepted monetary policy that to grow the economy requires a cut in
interest rates. It recognises that where interest rates are close to or at zero, the next move should be into
the negative. If the policy moved beyond the banks and into the general economy, then the negative
interest rates should give consumers and businesses an incentive to spend or invest money rather than

2
leave it in their bank accounts, where there is need to pay to keep it there and the value is further eroded
by inflation.

However, there are concerns regarding negative rates which perhaps explain why they have not been
more widely adopted. Negative interest rates on bank deposits would give savers an incentive to switch
out of deposits into holding cash. This would see the savings move out of the banking system. If banks
were to try to keep hold of the deposits by not charging the negative rates, then profitability will suffer.
This could have an adverse impact on the stability of the financial system.

The debate surrounding negative interest rates in banking has not prevented the emergence of
negative yields in the bond markets.

At the time of writing (October 2020) a substantial quantity of government bonds are priced to produce
a negative yield. In other words, investors are essentially willing to pay certain governments for the
privilege of lending money to them.

Example
As of 3 December 2020, the 0.25% coupon ten-year German bund that matures in 2030 was trading
at 105.49. So, investors at that price pay €5.49 more than the €100 nominal that will be returned in
approximately ten years, and over that period, the investor will receive just €2.50 in coupons (0.25% x
€100 x 10 years), ignoring any time value. At the time of writing, the yield to maturity was minus 0.55%.

Why is this the case? There is so much uncertainty and worry about the future macroeconomic outlook,
with Brexit rapidly approaching, the ongoing global pandemic, an increasing number of populist
governments being elected in places like Austria and Italy, and central banks seemingly unable to find
the answer to the economic problems faced. The result is that investors are desperate for a safe place for
their funds. So much so, that they are willing to accept a loss on their money (the negative yield) to keep
it secure with the German government.

2.5.4 Inflation and the Yield Curve

Nominal yields are drawn from conventional debt instruments and include investors’ anticipation of
inflation. However, in addition to nominal yield curves, real yield curves can be observed from the
yields on instruments that already include an uplift for inflation within their returns, such as the UK’s
index-linked gilts and the US Treasury Inflation Protected Securities (TIPS). The difference between
nominal yields and real yields reveals the term structure of inflation – the expectations for inflation in
the future that are currently captured within bond prices.

35
Generally, if inflation is expected to increase, then the yields demanded by investors need to reward
them for the anticipated inflation – so yields and the yield curve would be expected to rise. However,
when the central bank, such as the US Federal Reserve or the UK’s Bank of England (BoE), is concerned
about inflationary pressures and increases short-term interest rates to counter the danger, the impact
on medium- and long-dated bonds can be that the yields fall. This is because the investors have
confidence that, in the medium term, inflationary pressures will be removed by the pre-emptive actions
of the central bank.

2.6 The Present Value of a Bond

Learning Objective
2.3.6 Be able to calculate the present value of a bond (maximum two years) with annual coupon and
interest income

Money has a time value. That is, money deposited today will attract a rate of interest over the term
it is invested. For example, $100 invested today, at an annual rate of interest of 5%, becomes $105 in
one year’s time. The addition of this interest to the original sum invested acts as compensation to the
depositor for forgoing $100 of consumption for one year.

The time value of money can also be illustrated by expressing the value of a sum receivable in the future
in terms of its value today, again by taking account of the prevailing rate of interest. This is known as
the sum’s present value. So, $100 receivable in one year’s time, given an interest rate of 5%, will be
worth $100/1.05 = $95.24 today, in present value terms. This process of establishing present values is
known as discounting, the interest rate in the calculation acting as the discount rate. In other words, the
value today, or the present value, of a lump sum due to be received on a specified future date can be
established by discounting this amount by the prevailing rate of interest.

To arrive at the present value of a single sum, receivable after n years, when the prevailing rate of
interest is r, simply multiply the lump sum by the following:

1/(1 + r)n

Referring back to the earlier example, $100 receivable in one year’s time, given an interest rate of 5%,
will have a present value of:

$100 x 1/(1+r)n = $100 x 1/(1+0.05)1 = $100 x 1/1.05 = $100 x 0.9524 = $95.24

If $100 was due to be received in two years’ time, then the present value will be:

$100 x 1/(1+r)2 = $100 x 1/(1.05)2 = $100 x 1/1.1025 = $100 x 0.907 = $90.70

Present value calculations can also be used to derive the price of a bond, given the appropriate rate of
interest and the cash flows.

36
 Asset Classes

Example
Imagine $1,000 nominal of a two-year bond paying annual coupons of 10%. Given an appropriate rate
of interest, the sum of the present values will provide the logical price for the bond.

2
Using an interest rate of 5% pa, the following present values emerge:

Time Cash flow Discount factor Present value

End of year one $100 1/1.05 95.24
End of year two $1,100 1/1.052 997.73
Sum of the individual present values = price of the bond $1,092.97

Exercise 3
What is the price of the same two-year 10% coupon-paying bond if interest rates are:

a. 6%?
b. 4%?

The answers can be found at the end of this chapter.

3. Government Debt
Most developed countries have active markets for bonds issued by their government, eg, Treasuries
issued by the US Government and gilts issued by the UK Government. They are issued to cover the
government’s borrowing needs through the Bureau of the Fiscal Service in the US and the Debt
Management Office (DMO) in the UK, respectively.

As with other bonds, government bonds are issued with a given nominal value that will be repaid at the
bond’s redemption date, and a coupon rate representing the percentage of the nominal value that will
be paid to the holder of the bond each year. Obviously different government bonds can have different
redemption dates, and the coupon is payable at different points of the year (although it is generally at
semi-annual intervals).

Example
Government bonds are denoted by their coupon rate and their redemption date, for example, the US
3% Treasury Bond 2047. The coupon indicates the cash payment per $100 nominal value that the holder
will receive each year. This payment is made in two equal semi-annual payments on fixed dates, six
months apart. An investor holding $1,000 nominal of 3% Treasury Bond 2047 will receive a total coupon
of $30 each year, split into two payments of $15 each on 15 May and 15 November, until the repayment
of the $1,000 on 15 May 2047.

37
3.1 Interest Rates and Accrued Interest

Learning Objective
2.4.1 Understand the following features and characteristics of conventional government debt:
redemption price; interest payable; accrued interest; effect of changes in interest rates;
concept of risk-free

All government bonds specify a redemption value (the nominal value of the bond) that will be repaid at
the end of the bond’s life and a coupon. The coupon is the amount of interest paid to the holder of the
bond each year.

Government bonds are typically quoted on the basis of the price a buyer would pay for 100 units of the
currency’s nominal value.

Example
For example, a UK gilt 6% Treasury 2028 might be trading at 145, so a buyer will have to pay £145 for
each £100 nominal value. Why would the buyer be willing to pay more than £100? The answer lies in
the available interest rate across the financial markets. If the interest rate available on deposited funds
is lower than the coupon rate on the gilt, then that gilt will be a relatively attractive investment and its
price will be pushed upwards until the return it offers is in line with other investments.

This is an example of the inverse relationship between interest rates and bond prices.

As interest rates across the financial markets decrease, the quoted price of government bonds will
increase. Conversely, if interest rates increase, the quoted price of government bonds will decrease. In
summary, there is an inverse relationship between government bond prices and interest rates.

The coupons on government bonds are paid to the registered holder of the gilt at each coupon payment
date. However, because of the possibility of ownership changes just before the coupon payment date,
there is a period prior to each coupon payment date when a bond is dealt without entitlement to the
impending coupon payment. Despite the instrument being a bond, this is known as the ex-dividend
period. This period is short, for example for most gilts it is seven working days prior to the coupon
payment date. For the remainder of the time the gilt is described as trading cum-dividend.

The government bond markets are the facilities that enable investors to buy and sell bonds issued by
the relevant government. They are important as they are the benchmark bonds on which the return
provided by other bonds is judged.

For example, the yield available on US Treasuries is considered the risk-free rate for dollar-denominated
bonds. After all, it is the US Government that ultimately controls the printing of dollars, and so US
Treasuries are effectively credit risk-free. The risk-free rate represents the minimum amount an investor
would accept to invest any money and the investor would always want compensation of an amount
greater than the risk-free rate when accepting any risk at all. If a 15-year Treasury bond was trading at a
price to produce a 2% yield, a 15-year dollar-denominated corporate bond would be expected to yield
2% plus a margin to cover the increased credit risk that the corporate borrower presents.

38
 Asset Classes

3.2 Inflation-Protected Securities

Learning Objective

2
2.4.2 Understand the following features and characteristics of index-linked debt: index-linking;
inflation – effects and measurement; effect of the index on price, interest and redemption;
return during a period of zero inflation or deflation

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

Example
Index-linking US TIPS
With US TIPS, the index-linking is achieved by adjusting the principal outstanding on the bond using
the CPI. If the CPI is positive, there is inflation and the principal increases. If the CPI is negative, there is
deflation and the principal decreases. The coupon paid on the US TIPS is based on the fixed coupon set
at issue multiplied by the adjusted principal. When TIPS mature, the investor is paid the greater of the
adjusted principal and the original principal.

Example
UK Index-Linked Gilts
The older RPI inflation measure is still being used for UK index-linked gilts rather than the CPI. This is
because the RPI was contained in the prospectuses of older index-linked issues and consultation with
the industry indicated a preference for its continued use.

To calculate the inflation adjustment for a coupon payment, two index figures are required: that applicable
to the bond when it was originally issued, and that relating to the point at which interest is paid. For UK
gilts, the RPI figures used were originally those applicable eight months before the relevant dates (eg,
for a December coupon, the previous April RPI data was used). This indexation lag was shortened for
index-linked gilts issued after 2005 to just three months and it is this method for index-linking gilts that is
explained below.

Time
Coupon 1 Coupon 2 Coupon 3 Coupon 4
and repayment
of principal

39
An index ratio is used to calculate the coupon payments and the redemption payment. The index ratio
for each index-linked gilt measures the growth in the RPI since the gilt was first issued. For a given date,
it is the ratio of the reference RPI applicable to that date divided by the reference RPI applicable to the
original issue date of the gilt.

The reference RPI for the first calendar day of any month is the RPI for the month three months earlier
(for example, the reference RPI for 1 June is the RPI for March and for the 1 July it is the RPI for April).
The reference RPI for any other day in the month is calculated by linear interpolation between the
reference RPI applicable to the first calendar day of the month in which the day falls and the reference
RPI applicable to the first calendar day of the month immediately following.

The nominal amount of the index-linked gilt is uplifted by the index ratio to give an updated principal.
This principal is then used to generate the coupon payable by multiplying by the coupon percentage.
The coupon payments on an index-linked gilt that pays coupons half-yearly are based on the stated
coupon divided by two and multiplied by the nominal value uplifted by the relevant index ratio. The
redemption payment is based on the nominal value uplifted by the index ratio that applies at the point
of redemption, namely the RPI three months prior to redemption divided by the RPI three months prior
to the gilt’s issue date.

For example, a 2% Index-Linked Gilt 2035 pays semi-annual coupons on 26 January and 26 June each
year. An investor holding £20,000 nominal will receive 2% x 6/12 of £20,000 x index ratio each half-
year. At the redemption date in 2035, the investor will receive £20,000 uplifted by the index ratio that
captures the RPI increases since issue.

Because these bonds are uplifted by increases in the relevant price index, they are effectively inflation-
proof. In times of inflation, they will increase in price and preserve the purchasing power of the
investment.

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

In periods of deflation (negative inflation, with prices persistently falling), some sovereign index-linked
bonds (eg, in the US and France) have a ‘deflation floor’, with the issuer guaranteeing that the redemption
payment will not be less than the original par value. However, there is no deflation floor for the UK’s
index-linked gilts, where the possibility exists of returning less than the nominal value at redemption.

3.2.2 Inflation
Inflation can be one of the most significant obstacles to successful investing because the real value
of the income flow from investments, such as bonds and equities, as well as the long-term value of
capital, is eroded by the effects of inflation and the decline in the purchasing power of the wealth that
is created.Controlling inflation is the prime focus of economic policy in most countries, as the economic
costs inflation imposes on society are far-reaching. While there are many negative consequences, the
two which are most pertinent for the typical investor are that:

• inflation reduces the spending power of those dependent on fixed incomes, such as pensions or
fixed-coupon investments, including conventional bonds
• individuals may not be rewarded for saving; this occurs when the inflation rate exceeds the nominal
interest rate, ie, when the real interest rate is negative.

40
 Asset Classes

Real interest rates are calculated as follows:

Real interest rate = [(1 + nominal interest rate) / (1 + inflation rate)] – 1

So, the real return takes into account the inflation rate and in times of excessive inflation the real returns

2
available may well become negative.

In addition to the specific impact of inflation on returns mentioned, the broader macroeconomic
problems associated with periods of high inflation are well illustrated by the difficulties faced by
investors during the 1970s. This was a period of extremely high inflation, fuelled by surging commodity
prices, especially crude oil, which led to demands from organised labour for higher wages. This pushed
up the costs for producers of goods and services who, in turn, pushed on these additional costs to end-
consumers in the form of higher prices. A vicious circle was created which required very drastic increases
in short-term interest rates at the end of the 1970s – the base rates in the US and UK were approximately
20% as the 1980s began – and this caused widespread distress for asset prices. The 1970s was one of the
worst periods on record for global stock market returns.

Inflation will also have negative implications for holders of bonds and fixed-income instruments. A
major driver of bond prices is the prevailing interest rate and expectations of interest rates to come.
Yields required by bond investors are a reflection of their interest rate expectations, which, in turn, will
be largely influenced by expectations about inflation. For example, if inflation and interest rates are
expected to rise, bond prices will fall to bring the yields up to appropriate levels to reflect the interest
rate increases. To remain competitive, equities prices would also suffer.

In more recent periods, particularly in Western developed markets, central banks have been concerned
with a lack of inflation, or deflation. Deflation effectively increases debt burdens, so governments and
corporations with high levels of borrowings will struggle to repay these in a deflationary environment.
Also, central banks often see a low level of positive inflation as important to an expanding economy.

3.2.3 Consumer Price Indices

Index-linked bonds are ones where the coupon and the redemption amount are increased by the
amount of inflation over the life of the bond. The amount of inflation uplift is determined by changes in
the index that reflect the rate at which prices faced by individuals (consumers) are increasing – generally
referred to as consumer price indices.

The markets pay attention to consumer price indices because they are good indicators of the level of
inflation and, consequently, government reaction to it. These indices also signal the need for increases
in the yield paid on bonds in order to compensate for the erosion of real returns.

Example – Inflation Measures in the UK

Historically, the measure used in the UK was the RPI, which calculated the prices of a basket of over 300
goods. The prices were weighted to reflect an average household’s consumption patterns – those items
on which a lot of money was spent received a higher weighting than peripheral items. The index itself
was based on movements in price when compared against a base period.

41
In 2003, the Chancellor of the Exchequer began using a new target for inflation, the harmonised index
of consumer prices (HICP), which was renamed the consumer prices index (CPI). The level of the
new CPI-based inflation target for the BoE’s Monetary Policy Committee (MPC) was set at 2% from 10
December 2003.

The CPI is calculated each month by looking at the goods and services that a typical household might
buy, including food, heating, household goods and travel costs.

Producer prices indices (PPIs) measure inflationary pressures at an earlier stage in the production
process. PPIs include input price indices that measure the change in prices going into the production
process, including raw materials and other inputs. Changes in commodity prices will directly affect
this number. There are also output or factory gate indices that measure the changes in the price of
goods as they leave the production process and enter the retail sector. There is obviously a very strong
relationship with input price variation.

Historically, any changes in raw material prices had tended to pass on through the production process
and result in higher retail prices. However, in recent years, the generally low level of inflation, coupled
with the more competitive nature of the labour market, has made it increasingly difficult for producers
to pass on price increases. Consumers have grown used to stable prices, and appear to be unable to
force their wages up in order to compensate for the higher prices.

Summary of Inflation Measures in the UK

The main measures of inflation used in the UK are:

• Consumer Prices Index (CPI) – based on an EU-wide formula that was originally called the HICP,
allowing direct comparison of the inflation rate in the UK against that in the rest of Europe. CPI at 2%
is the current target for the BoE’s MPC.
• Retail Prices Index (RPI) – an average measure of change in the prices of goods and services. Once
published, it is never revised.
• Producer Prices Index (PPI) – this is based on measuring inflation further up the supply chain at the
wholesale level, including ‘factory gate’ inflation.

3.3 Separate Trading of Registered Interest and Principal of

Securities (STRIPS)

Learning Objective
2.4.3 Understand the purpose and characteristics of the strip market: advantages, disadvantages
and uses; result of stripping and reconstituting a bond; zero coupon securities

Zero coupon bonds (ZCBs) pay no interest; instead, they promise to pay just the nominal value at
redemption. As there is no other possible form of return, investors will pay less than the nominal value
when they buy ZCBs, with their return coming in the form of the difference between the price they pay
for the bond and the amount they receive when the bond is redeemed. The bond is said to be issued at
a discount to its face value, with the discount providing all of the return on a ZCB.

42
 Asset Classes

STRIPS is an acronym of Separate Trading of Registered Interest and Principal of Securities. Stripping
a bond involves trading the interest (each individual coupon) and the principal (the nominal value)
separately. Each individual strip forms the equivalent of a ZCB. Each strip will trade at a discount to its
face value, with the size of the discount being determined by prevailing interest rates and time.

2
To illustrate how STRIPS work, a ten-year US Treasury note (T-note) can be stripped to make 21 separate
securities: 20 STRIPS based on the coupons, which are entitled to just one of the half-yearly interest
payments; and one strip entitled to the redemption payment at the end of the ten years. Similarly, a
two-year, semi-annual coupon-paying UK gilt could be used to create five individual securities, one for
each of the four remaining coupon payments and one for the principal payment to be paid in two years.

6% £10m two-year gilt

Coup
ons
Principal
£300,000
payable in £300,000
six months payable in 12
months
£10m
£300,000 payable in
payable in 18 two years
months

£300,000
payable in 24
months

STRIPS markets have been developed in US Treasuries and in the UK gilts market. US financial institutions
are able to create STRIPS from US T-notes and bonds, including TIPS. In the UK, only those gilts that
have been designated by the DMO as strippable are eligible for the STRIPS market, not all gilts. Those
gilts that are stripped have separate registered entries for each of the individual cash flows that enable
different owners to hold each individual strip, and facilitate the trading of the individual STRIPS. It is only
gilt-edged market makers (GEMMs), the BoE or the UK Treasury that are able to strip gilts.

The key advantage of STRIPS is that investors can precisely match their liabilities, removing any
reinvestment risk.

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

1. The investor could buy a $5 million nominal coupon-paying Treasury with five years remaining to
maturity, but the coupons on this will mean that it will generate more than $5 million.

43
2. The investor could buy less than $5 million nominal, attempting to arrive at $5 million in five years.
However, the investor will have to estimate how the coupons over the life of the bond can be
reinvested and what rate of return they will provide – the estimate could well be wrong.
3. The investor could buy a five-year out $5 million strip (essentially this is a manufactured zero coupon
bond). This would precisely meet the need.

As seen in the example above, STRIPS can meet the liabilities of the investor precisely, removing
any reinvestment risk that is normally faced when covering liabilities with coupon-paying bonds.
Furthermore, investors in government bond STRIPS have few worries about the risk that the issuer of the
bonds will default – for example, liabilities of the US and UK Governments are generally considered to
be virtually free of any default risk (also known as credit risk).

As with STRIPS, it is only GEMMs, Her Majesty’s Treasury and the BoE that are allowed to reconstitute
stripped gilts. There is no requirement for the participant wanting to reconstitute STRIPS into a gilt
to have all of the individual strips in relation to that particular gilt. ‘Reconstitution’ is, effectively,
exchanging STRIPS for a conventional gilt, with the UK DMO as the counterparty to the deal.

3.4 International Government Bonds

Learning Objective
2.4.4 Understand the characteristics and differences between government bonds in developed,
emerging and frontier markets: settlement periods; coupon payment frequency; terms and
maturities; currency, credit and inflation risks

The following table highlights the way government bonds are referred to and classified across the major
economies of the world, and the settlement period for any market transactions that may take place after
the bonds are issued.

The coupon payment is the periodic payment that is made by the bond issuer to the bondholder,
and the maturity represents the time period during which the coupon payments will be paid, at the
conclusion of which the principal amount of the bond will be repaid to the holder.

44
 Asset Classes

Coupon Settlement
Country Name Maturity
Frequency Period
Over 10 years

2
Treasury bonds The longest maturity
Semi-annual T+1
(T-bonds) is for 30 years and is
US known as the long bond.
Treasury notes (T-notes) Semi-annual 2–10 years T+1
Treasury bills (T-bills) No coupon paid Less than 1 year Trade date
0–7 years remaining –
‘short-dated’
7–15 years remaining –
UK Gilts Semi-annual T+1
‘medium-dated’
15 years and over
remaining – ‘long-dated’
France OAT Annual 2–50 years T+2
Bund Annual Over 10 years
Germany Bobl Annual 5 years T+2
Schatz Annual Up to 2 years

Japanese Government Various maturities from

Japan Semi-annual T+1
Bond (JGB) 2–40 years

Outside of the developed markets, many sovereign states are considered to be ‘emerging’ or ‘frontier’
markets in relation to government bonds. Examples include much of South East Asia, the Middle East,
Sub-Saharan Africa and South America. It is argued that well-functioning bond markets would help
sustain economic stability, in particular, the ability to weather financial crises by providing funding
sources for these countries to finance fiscal stimulus packages.

Additionally, the development of bond markets can improve the intermediation of savings. Government
bond markets are an effective way to intermediate capital savers with capital users, particularly if they
also spur the development of a corporate bond market.

The last 30 years or so have also seen major increases in the issuance of government bonds by
emerging markets, both in US dollar denominations and each government’s currency. Traditionally,
the major emerging markets were captured in the acronym ‘BRIC’ – Brazil, Russia, India and China – and
it has since been broadened to include countries such as South Africa, Indonesia, Mexico, Turkey and
Malaysia. Those countries with less developed markets and systems than the emerging markets are
often classified as ‘frontier’ markets. Examples of frontier markets include Bangladesh, Bahrain, Nigeria,
Mauritius and Sri Lanka.

45
The risks of investing in emerging or even frontier market government bonds include the standard risks
that accompany all debt issues, such as the variables of the issuer’s economic or financial performance
and the ability of the issuer to meet payment obligations. These risks are heightened due to the
potential political and economic volatility of these developing nations which could increase the risk of
default (credit risk) and also allow inflation to take hold.

Emerging and frontier market government bonds also pose other cross-border risks, as a result of
exchange rate fluctuations and currency devaluations. If a bond is issued in the local currency, the
exchange rate of the investor’s home currency versus that currency can positively or negatively affect
yield. Investors wanting to reduce this currency risk need to avoid bonds that are denominated in the
local currency and select US dollar-denominated bonds instead.

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

Debt finance is less expensive than equity finance because investing in debt finance is less risky than
investing in the equity of the same company. The interest on debt has to be paid before dividends, so
there is more certainty for the lenders than the equity investors. Additionally, if the firm were to go into
liquidation, the holders of debt finance would be paid back before the shareholders received anything.

For investors in bonds, firms like Standard & Poor’s (S&P) capture the comparative riskiness of the issuer
and the bond in their credit ratings.

However, raising money via debt finance does present dangers to the issuing company. The lenders are
often able to claim some or all of the assets of the firm in the event of non-compliance with the terms
of the loan – in the same way that a bank providing consumer mortgage finance would be able to claim
the property as security against the loan. In addition, unlike common dividends, the interest on bonds
must be paid, using up a portion of the available cash flow, otherwise the company will default and
enter bankruptcy. This reduces the firm’s ability to weather temporary downturns in its business or the
broader economy.

4.1 Secured Debt

Learning Objective
2.5.1 Understand the principal features and uses of secured debt: fixed charges and floating charges;
asset-backed securities; mortgage-backed securities; covered bonds; securitisation process;
role of the trustee, when involved; different tiers of bank debt

Investors in corporate debt face the risk that the issuer will not be able to pay the interest and/or the
principal amount. When this happens, it is known as default.
46
 Asset Classes

One way for the corporate borrower to lessen the risk of default is to issue secured debt, when the debt
offers assets of the company as a guarantee. There are two ways of doing this:

• fixed charge – the debt carries a fixed charge over a particular company asset, eg, a building
floating charge – the debt is secured against a group of the company’s assets; in the event of

2
•
default, a floating charge crystallises over the available assets.

Bonds issued with a fixed charge are generally referred to as debentures.

4.1.1 Asset-Backed Securities (ABSs)

Asset-backed securities (ABSs) are bonds that are backed by a particular pool of assets. These assets
can take several forms, such as mortgage loans, credit card receivables and car loans. Major banks, such
as Citigroup, Bank of America and JP Morgan Chase, commonly securitise the amounts owed by their
customers on their credit cards.

The assets provide the bondholders’ security, since the cash generated from them is used to service
the bonds (pay the interest), and to repay the principal sum at maturity. Such arrangements are often
referred to as the securitisation of assets. The name ‘securitisation’ reflects the fact that the resulting
financial instruments used to obtain funds from the investors are considered, from a legal and trading
point of view, as securities.

Diagrammatically:

Pool of assets, Bonds that

eg, mortgage loans, are sold
credit card receivables, to a variety
or car loans of investors

Provide the backing for

4.1.2 Mortgage-Backed Securities (MBSs)

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

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

47
As with other ABSs, MBS issues are often subdivided into a variety of classes (or tranches), each tranche
having a specific priority in relation to interest and principal payments. Typically, as the underlying
payments on the mortgage loans are collected, the interest on all tranches of the bonds is paid first. As
loans are repaid, the principal is first paid back to the first tranche of bondholders, then the second tranche,
third tranche, and so on. Such arrangements will create different risk profiles and repayment schedules
for each tranche, enabling the appropriate securities to be held according to the needs of the investor.
Traditionally, the investors in such securities were institutional investors, like insurance companies and
pension funds, although they now also include the more sophisticated individual investor.

4.1.3 Further Details in Relation to ABSs

The investors in ABSs have recourse to the pool of assets, although there may be an order of priority
between investors in different tranches of the issue.

The precise payment dates for interest and principal are dependent on the anticipated and actual
payment stream generated by the underlying assets and the needs of investors. ABSs based on a pool
of mortgage loans are likely to be longer-dated than those based on a pool of credit card receivables.
Within these constraints, the issuers of ABSs create a variety of tranches to appeal to the differing
maturity and risk appetites of investors.

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

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

Diagrammatically:

Investors

(1) Pool (2) Asset-

Originator of of assets backed
Investors
the assets, eg, passed SPV bonds
mortgage bank to SPV sold to
investors
Investors
(3) Cash paid to
originator
Investors

48
 Asset Classes

In instances when no SPV is created, the asset-backed bonds are simply referred to as ‘covered bonds’,
referring to the pool of assets that provide the ‘cover’ to the bondholder. So, with covered bonds, the
assets are retained on the balance sheet of the issuing entity, such as a bank, rather than transferred
to an SPV. Indeed, when an SPV is used and the assets become distressed, or if there is no market for

2
determining the value of the assets held in the SPV, as was the case during the sub-prime crisis of 2007–
08, the originator of the securitisation instruments may decide to transfer the troubled assets back on to
its balance sheet to become covered bonds.

4.1.4 Covered Bonds

Covered bonds are senior secured debt securities of a regulated financial institution, such as a bank. As
with other forms of secured debt, if the issuing bank defaults, the collateral is used to cover any shortfall
in payments due from the bank. An additional feature of covered bonds is that, as long as the collateral
is sufficient, they continue to be paid according to their original schedule after default. Covered bonds
are a form of asset-backed bond with the pool of assets providing the ‘cover’ to the bondholder.

With European covered bonds, the assets are typically retained on the balance sheet of the issuing
entity, such as a bank, rather than transferred to an SPV. In other parts of the world, such as the US,
an SPV structure is still used for covered bonds as existing legislation does not facilitate more direct
issuance.

Interestingly, when an off-balance-sheet SPV has been used, and the assets become distressed, or if
there is no market for determining the value of the assets held in the SPV (as was the case during the
sub-prime crisis of 2007–08), some originators of the securitisation instruments decided to transfer the
troubled assets back on to their balance sheets to become covered bonds.

4.1.5 The Role of the Trustee in Secured Debt

Trustee for Secured Debt Issues
The terminology for secured debt varies globally, in particular the term ‘debenture’. In the UK, a secured
debt transaction is called a debenture, whereas in the US the term debenture generally refers to a loan
agreement with no security at all. In the US, the term ABS is more commonly used for secured issues.

When a corporation either in the UK or US issues secured debt to a large number of persons, it is
invariably the case that a trustee will be appointed.

The mechanics of this process are that, under the terms of the trust deed, the property of the company
is mortgaged to the holders of the securities to secure the payment of the money owing. However, there
is a contract or deed of trust put in place between the company and the trustees. The trustee holds the
benefit of the covenant by the company to repay the monies on trust for the holders of the securities.

Under English law, the trustee has wide discretionary powers, whereas under US law its responsibilities
are usually clearly defined. The main trustee roles for a UK debenture trustee are:

• Note trustee – is appointed to represent the interests of holders of the securities, while providing
guidance to the issuer.

49
• Security trustee – for issues secured by a pledge of securities or other properties, the security
is charged in favour of the trustee for the benefit of the various secured parties. The governing
documents dictate the order of priority of payments among the entitled parties.
• Share trustee – holds the shares in an issuing SPV in order to ensure off-balance-sheet treatment
for the originator of the transaction. Sometimes these SPVs are domiciled in offshore jurisdictions.
• Successor trustee – this role played by a trustee is provided for banks which need to resign
because of conflicts of interest (especially in connection with defaulted or bankrupt issues) or when
work requirements exceed the bank’s capacity.

Benefits of a Trust Deed

The security and all enforcement powers in respect of the trust deed are vested in the trustee as a single
entity acting on behalf of all the holders of securities. This enables a coherent enforcement procedure,
rather than a series of disparate actions by different holders of securities. This is an advantage to the
individual holders as it ensures organised action and parity of treatment. The trust deed would usually
provide that all holders are paid proportionately, and a single action by the trustee prevents some
holders recovering and not others. It is also an advantage to the company as it means it does not have to
defend a series of actions for what might be a trifling breach of any one provision.

Costs
Administration and enforcement by the trustee will be less costly than numerous parties dealing with
the company.

Representation of the Interests of the Bondholders

To make bonds a more marketable security, a trustee is assigned to represent the interests of the
bondholders. The corporate trustee is usually a bank or a trust company, and, although the trustee is
paid by the issuing corporation, it represents the interests of the bondholders.

Before marketing a bond, the issuer, often using the corporate trustee as its agent, will engage the
services of a credit rating agency to assess the creditworthiness of the issuer and the likelihood that
all of the terms of the securities offering are likely to be fulfilled. This engagement is to represent the
interest of the bondholders, but there is cause for a potential conflict of interest, as the credit rating
agency will be paid by the issuer, while its ratings are provided to advise the bondholders of the security
risk of the offering. Credit ratings agencies will never specifically recommend any particular offering, but
the ratings which are provided are relied upon by many investors.

The corporate trustee must keep track of all bonds sold, verifying that the amount issued is not greater
than what is stated in the indenture and making sure that the corporation complies with all covenants –
which are the terms of the indenture – while the bond issue is outstanding.

For instance, the indenture may stipulate that the corporation maintains a certain percentage of assets
over liabilities, or that the corporation does not take on too much debt. Adherence to the covenants of
the indenture is one of the principal roles of the trustee.

The trustee may either provide services for the payment of interest and the cash management function,
or it may appoint a separate custodian for the purpose.

50
 Asset Classes

4.1.6 Tiers of debt

When a company raises money by borrowing from a variety of sources, such as issuing bonds and
borrowing from banks, it is vital that the lenders understand their seniority relative to the others. In
other words, who is entitled to repayment first. Obviously, this is particularly acute if the borrowing

2
company is in financial difficulty. Broadly, borrowing is divided into three levels or ‘tiers’ – senior, sub-
ordinated and mezzanine. Any or all of these could be in the form of bonds or loans, and the typical
characteristics of each is as follows:

Senior Debt
As the name suggests, this debt ranks above all other debt and equity capital in the business. It will
be repaid before any of the other tiers of lender receive anything. Senior debt often has to meet strict
covenants, including meeting or exceeding certain minimum financial ratios, and it may be secured
against specific assets of the company. It will have the lowest interest rate of all the tiers since, from the
lender’s perspective, it is more secure.

Subordinated Debt
Again, as suggested by the name, this debt ranks behind senior debt – it is subordinated to senior debt
– in the event that the company is liquidated. The requirements of the subordinated debt are generally
less stringent than senior debt, and, since subordinated debt gives the lender less security than senior
debt, the interest rate is higher.

Mezzanine Debt
Any mezzanine debt is usually high-risk subordinated debt, ranking behind senior debt and unsecured
debt. To reflect the risk, the interest on mezzanine debt tends to be much higher than subordinated debt.
Indeed, some or all of the interest might not be paid in cash and is added to the principal outstanding
instead. This rolled up interest is often described as ‘payment in kind’ interest, or PIK. Sometimes the
mezzanine debt will also include warrants or options so that the lender can participate in equity returns.

4.2 Unsecured Debt

Learning Objective
2.5.2 Understand the principal features and uses of unsecured debt: subordinated; guaranteed;
convertible bonds

Unsecured debt is not secured against any of the company’s assets, so the holder has no special
protection against default. To compensate the holder for the additional risk, the coupon on an
unsecured bond, or the interest on unsecured bank borrowing, will be higher than on equivalent
secured borrowings.

51
Subordinated debt is typically unsecured and the lenders have agreed that, if the company fails, they
will only be repaid once other creditors have been repaid, if there is enough money left over. Unsecured
debtholders, however, would still be repaid prior to shareholders, as ‘lenders’ are always repaid before
‘owners’ in an insolvency. As seen, interest payments on subordinated borrowings will be higher than
those on equivalent unsecured borrowings that are not subordinated. This is simply because of the
additional default risk faced by subordinated lenders.

Guaranteed debt is when a guarantee is provided by someone other than the issuer. The guarantor is
typically the parent company, or another company in the same group of companies as the issuer.

Convertible bonds give the holder of the bond the right, but not the obligation, to convert into a
predetermined number of ordinary shares of the issuer.

The following table summarises the characteristics of subordinated, guaranteed and convertible bonds
as compared to an unsecured bond issued by the same company:

Subordinated bond Guaranteed bond Convertible bond

No difference: typically 2–30 years to maturity. In frontier and emerging markets,
seven years for an unsecured corporate bond issuance would be considered long
Normal life
term and fairly high risk. Companies do often issue medium-term notes (MTNs), of
two–seven year tenors.

Ranking in a Alongside other Alongside other unsecured

Below unsecured bonds
liquidation unsecured bonds bonds

Risk dependent upon

Risk and Greater risk of default, the guarantor’s own No difference from
rating so a lower credit rating financial standing, so unsecured bonds
a higher credit rating

Potentially lower due to

Likely to be higher than Likely to be lower due
Coupon the upside potential of the
unsecured bonds to the guarantee
share price

Upside potential of the

Attractive regulatory Guarantor is lowering shares restricts the cost of
Benefits to
treatment for financial the cost of the debt the debt and the possibility
the issuer
institution issuers finance of conversion lowers the risk
of eventual repayment

Fixed-coupon bonds are issued with a fixed rate of coupon. If interest rates rise, the fixed coupon
becomes less attractive and the price of the bond falls. The opposite is true of an interest rate fall. As for
government bonds, the interest is always calculated by reference to the nominal value of the bond, so a
$1,000 nominal 5% ABC corporate bond will pay $50 pa to the holder.

52
 Asset Classes

Floating rate bonds or notes are bonds when the coupon rate varies. The rate is adjusted in line with
published, market interest rates. The published interest rates that are normally used are based on LIBOR.
There are a number of LIBORs published each day for different currencies and different periods, such as
three-month US dollar LIBOR and six-month sterling LIBOR. LIBORs reflect the average rates at which

2
banks in London offer loans to other banks. Until 2014, LIBORs were published by the UK’s British Bankers’
Association (BBA), using quotes provided by a panel of banks; however, after regulatory investigations
discovered that LIBORs were being manipulated by a number of those banks, the UK regulator, the
Financial Conduct Authority (FCA), concluded that the administrator of LIBOR required regulatory
authorisation. LIBORs are now calculated by Intercontinental Exchange Benchmark Administration ltd
and are regulated by the FCA. They are often referred to as ICE LIBORs, as the calculation is made by a
company within the Intercontinental Exchange group (ICE).

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

4.3 Credit Ratings

Learning Objective
2.5.3 Understand the principal features and uses of credit ratings: rating agencies; impact on
price; uses and risks of credit enhancements; difference between investment grade and sub-
investment grade bonds; limitations

Bondholders face the risk that the issuer of the bond might default on their obligation to pay interest
and the principal amount at redemption. This so-called credit risk or default risk – the probability of an
issuer defaulting on their payment obligations and the extent of the resulting loss – can be assessed by
reference to the independent credit ratings given to most bond issues.

There are a significant number of credit ratings agencies around the world, some of whom specialise
in particular regions or particular types of company. However, the three most prominent agencies
that provide these ratings are S&P, Moody’s and Fitch Ratings inc. Bond issues subject to credit ratings
can be divided into two distinct categories: those accorded an investment grade rating and those
categorised as non-investment grade or speculative. The latter are also known as high-yield or junk
bonds. Investment grade issues offer the greatest liquidity and security, meaning the issuer is likely to
meet both interest and principal repayments. In exchange for this assurance, however, they typically
pay lower interest rates. Bonds with lower credit ratings tend to pay higher coupons to compensate for
the higher risk that investors take by investing in them. Further, if ratings change, the price of bonds
which have already been issued will be adjusted to reflect the fact that they have become more, or less,
attractive to investors. The change in price will alter the effective return on the bonds. The following
table provides a comprehensive survey of the credit ratings available from the three agencies.

53
Although the three rating agencies use similar methods to rate issuers and individual bond issues,
essentially by assessing whether the cash flow likely to be generated by the borrower will comfortably
service, and ultimately repay, its debts, the rating each gives sometimes differs, though not usually
significantly so.

There are also credit-rating agencies which specialise in particular regions. They typically offer wider
coverage within their region, particularly of corporate issuers, than the major agencies. Examples
include the Japan Credit Rating Agency (JCR) and Global Credit Ratings (GCR) in Africa.

54
 Asset Classes

Moody’s Standard and Poor’s Fitch

Long- Short- Long- Short- Long- Short-
term term term term term term

2
Aaa AAA AAA Prime
Aa1 AA+ AA+
A-1+ F1+
Aa2 AA AA High grade
P-1
Aa3 AA- AA-
A1 A+ A+ Upper medium
A-1 F1
A2 A A grade

A3 A- A-
P-2 A-2 F2
Baa1 BBB+ BBB+ Lower medium
Baa2 BBB BBB grade
P-3 A-3 F3
Baa3 BBB- BBB-
Ba1 BB+ BB+
Non-investment
Ba2 BB BB
grade speculative
Ba3 BB- BB-
B B
B1 B+ B+
B2 B B Highly speculative
B3 B- B-
Caa1 CCC+ Substantial risks
Extremely
Caa2 Not speculative
prime C
CCC- In default with
Caa3 CCC C little prospect for
recovery
In default with
Ca CC little prospect for
recovery
C / D
/ D D / In default
/ D

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

55
In 2007–08, the global financial crisis arose in part from highly leveraged and opaque ABSs such as
MBSs. The credit-rating agencies were criticised for the generous ratings they had attached to some
of these securities. As a result, regulatory oversight of the credit-ratings agencies has subsequently
increased substantially.

5. Cash Assets
Cash assets embrace the market involving cash deposits and short-term instruments that are issued
with less than one year to maturity. It is alternatively referred to as the money market. Over and above
cash deposits, the two prime examples of money market instruments are T-bills issued by governments
and commercial paper (CP) issued by companies.

5.1 Cash Deposits

Learning Objective
2.1.1 Understand the uses, advantages and disadvantages of holding cash deposits

Almost all investors keep at least part of their wealth in cash assets, which are often deposited with a
bank or other savings institution to earn interest.

Cash deposits comprise accounts held with banks or other savings institutions. They are held by a
wide variety of depositors – from retail investors through to companies, governments and financial
institutions.

The main characteristics of cash deposits are:

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

The interest rate paid on deposits may vary between institutions, as well as with the amount of money
deposited and the time for which the money is tied up.

• Large deposits are more economical for a bank to process and will earn a better rate.
• Fixed-term accounts involve the investor tying up their money for a fixed period of time, such as
one, two or three years, or when a fixed period of notice has to be given, such as 30 days, 60 days
or 90 days. In exchange for tying up their funds for these periods, the investor will demand a higher
rate of interest than would be available on accounts that permit immediate access.
• Instant-access deposit accounts typically earn the lowest rates of interest of the various deposit
accounts available.
• Current accounts (known in the US as checking accounts) will generate an even lower rate, and
sometimes pay no interest at all.

56
 Asset Classes

Generally, interest received by an individual is subject to income tax. In many countries, tax is deducted
at source – that is, by the deposit-taker before paying the interest to the depositor. The headline rate of
interest quoted by deposit-takers, before deduction of tax, is referred to as gross interest, and the rate of
interest after tax is deducted is referred to as net interest.

2
Advantages and Disadvantages
There are a number of advantages to investing in cash:

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

Investing in cash does have some serious drawbacks, however, including the following:

• Banks and savings institutions are of varying creditworthiness and the risk that they may default
needs to be assessed and taken into account.
• Inflation reduces the real return that is being earned on cash deposits and often the after-tax return
can be negative.
• Interest rates vary, and so the returns from cash-based deposits will also vary.

Although banks and other savings institutions are licensed, monitored and regulated, it is still
possible that such institutions might fail, as was seen in the aftermath of the financial crisis. Deposits
are, therefore, often protected by a government-sponsored compensation scheme. This will repay
any deposited money lost, typically up to a set maximum, due to the collapse of a bank or savings
institution. The sum is generally fixed so as to be of meaningful protection to most retail investors,
although it would be of less help to very substantial depositors.

When cash is deposited overseas, depositors should also consider:

• the costs of currency conversion and the potential exchange rate risks if the deposit is not made in
the investor’s home currency
• the creditworthiness of the banking system and the chosen deposit-taking institution, and whether
a depositors’ protection scheme exists and if non-residents are protected under it; not every country
operates one, and so the onus is on the investor or their adviser to check
• the tax treatment applied to the interest on the deposit
• whether the deposit will be subject to any exchange controls that may restrict access to the money
and its ultimate repatriation.

57
5.2 Treasury Bills (T-bills)

Learning Objective
2.1.2 Understand the features and characteristics of Treasury bills: issuer; purpose of issue; minimum
denomination; normal life; no coupon and redemption at par

As well as issuing bonds to fund the government’s long-term borrowing needs, treasury departments
or ministries of finance in various countries must also manage the liquidity needs of the central
government. This is done primarily through issuing short-term IOUs known as Treasury bills (T-bills).

T-bills are short-term loan instruments, issued and guaranteed by the government, with maturity dates
ranging between one and 12 months. For example, the US issues T-bills weekly, with maturities of
four weeks, 13 weeks, 26 weeks and 52 weeks. T-bills pay no coupon and, consequently, are issued at
a discount to their nominal value, with the difference between the par value (maturity value) and the
discount value (purchase price) representing the return to the investor.

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

Since they are guaranteed by the government, T-bills provide a very secure investment for market
participants with short-term investment horizons, and this type of instrument often represents a risk-
free investment. The return on a T-bill is wholly dependent upon the price paid.

Example
If a purchaser paid $990,000 for $1,000,000 nominal of a 13-week US T-bill, the return will be the gain
made of $10,000. As a percentage of invested funds, the return is: $10,000/$990,000 x 100 = 1.01% over
approximately three months.

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 Asset Classes

5.3 Commercial Paper (CP)

Learning Objective

2
2.1.3 Know the principal features and uses of commercial paper: issuers, including CP programmes;
investors; discount security; unsecured; asset-backed; rating; normal life, method of issuance;
role of dealer

CP is an unsecured short-term promissory note issued primarily by corporations, although there are also
municipal and sovereign issuers. It represents the largest segment of the money market through banks.
CP is the corporate equivalent of a government’s T-bill. It is issued at a discount to its nominal value and
can have a maturity of up to one year in Europe and 270 days in the US; however, it is common to find in
both territories that CP will be issued for three months.

Large companies issue CP to assist in the management of their liquidity. Rather than borrowing directly
from banks, these large entities run CP programmes that are placed with institutional investors.

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

Asset-backed CP is a short-term investment vehicle with a maturity that is typically between 90 and 180
days. The security itself will be issued by a bank or other financial institution, and the notes are backed
by assets, such as receivables. Finance companies will typically provide consumers with home loans,
unsecured personal loans and retail automobile loans. These receivables are then used by the finance
company as collateral for raising money in the CP market. Some finance companies are specialist firms
that provide financing for purchases of another firm’s products. For example, the major activity of
Ally Financial inc (formerly the General Motors Acceptance Corporation (GMAC)) is the financing of
purchases and leases of General Motors’ vehicles by dealers and consumers.

It is perhaps important to mention that a missed payment by an issuer of a CP for as little as one day can
lead to bankruptcy proceedings. Issuers take great care to repay the principal on the due day.

5.3.1 Commercial Paper Issuance and the Role of Dealers

There are two methods of issuing CP. The issuer can market the securities directly to a buy-and-hold
investor as with most money market funds. Alternatively, it can sell the paper to a dealer, who then sells
the paper in the market. The dealer market for CP involves large investment banks and other financial
services firms, such as bond dealers.

Unlike bonds or other forms of long-term indebtedness, a CP issuance is not all brought to market at
once. Instead, an issuer will maintain an ongoing CP programme. It advertises the rates at which it is
willing to issue paper for various terms, so buyers can purchase the paper whenever they have funds
to invest. Programmes may be promoted by dealers, in which case the paper is called dealer paper.
Larger issuers, especially finance companies, have the market presence to issue their paper directly to
investors. Their paper is called direct paper.

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Direct issuers of CP are usually financial companies that have frequent and sizeable borrowing needs
and find it more economical to sell paper without the use of an intermediary. In the US, direct issuers
save a dealer fee of approximately five basis points, or 0.05% annualised, which translates to $50,000 on
every $100 million outstanding. This saving compensates for the cost of maintaining a permanent sales
staff to market the paper. Dealer fees tend to be lower outside the US.

CP entails credit risk, and programmes are rated by the major rating agencies. Because CP is a rolling
form of debt, with new issues generally funding the retirement of old issues, the main risk is that the
issuer will not be able to issue new CP. This is called refinancing or rollover risk. Many issuers obtain
credit enhancements for their programmes. These may include a line of credit or other alternative
sources of financing.

5.4 Repo Markets

Learning Objective
2.1.4 Understand the basic purpose and characteristics of the repo markets: repo; reverse repo;
documentation; benefits of the repo market

A repo is a sale and repurchase agreement. It is legally binding for both buyer and seller. For example, a
government bond repo is a contract in which the seller of government bonds agrees to buy them back
at a future specified time and price. In effect, a government bond repo is a means of borrowing using
the bond as security, as illustrated in the following diagram:

sells government
bonds
Repo start date Participant Participant
A B
$ start

buys back
government bonds
Repo end date Participant Participant
A B
$ end

In the above diagram, both parts of the repo transaction are agreed between the participants at the
outset: Participant A has entered into a repo transaction, Participant B has entered into a reverse repo
agreement.

The amount of cash paid over by Participant B at the start of the repo will be less than the amount paid
over to Participant B at the end of the repo period. The difference between the two amounts, expressed
as a percentage, is the effective interest rate on the repo transaction. It is usually referred to as the repo
rate.

60
 Asset Classes

The obvious benefit to Participant A is that they are able to raise finance against the security of the bonds
that they hold – potentially a relatively cheap source of short-term finance. If Participant B is considered
a conventional bank simply providing finance, then the benefit of using the repo is the security gained
by holding the bonds. However, Participant B may be a market-making firm that has sold government

2
bonds that it does not hold. The repo transaction enables the market-making firm to access the bonds
that it requires to meet its settlement obligations. In this way, the government bond repo facilitates the
smooth running of the secondary market in the bonds.

In the UK, the smooth running of the gilts market is further assisted by the DMO’s standing repo facility.
This enables any GEMM, or other DMO counterparty, to enter into a reverse repo arrangement with
the DMO, perhaps to cover a short position in gilts. They must first sign the relevant documentation
provided by the DMO and then are able to request any amount of a gilt above £5 million nominal. This
facility is for next-day settlement, and the facility can be rolled forwards for up to two weeks. The DMO
does charge a slightly higher than normal repo rate for firms accessing the standing repo facility.

Although the government bond and gilts market has been used as an example, it should be noted that
the use of repos is an important liquidity provider for the debt markets as a whole. The term ‘reverse
repo’ is used for the transactions taken on the opposite side of the repo. A reverse repo is, therefore, the
equivalent of a short-term secured loan.

6. Eurobonds

Learning Objective
2.6.1 Understand the principal features and uses of eurobonds: issuing process; bearer; immobilised
in depositories; accrued interest; ex-interest date; interest payments

Eurobonds are bonds that are issued and sold outside of their home country (the currency of issue does
not need to be the euro). They can be issued in any currency as long as it is different to the currency of
the place from which they are issued. For example, a eurobond issued in the UK would be in a currency
other than pound sterling, such as the euro or the US dollar, and a eurobond issued in Germany would
be in a currency other than the euro, such as the US dollar or the Japanese yen. Eurobonds provide a
way for organisations to issue debt without being restricted to their own domestic market, and provide
investors access and an opportunity to invest in markets and currencies outside their home countries.
The way eurobonds are issued is, broadly, as follows:

1. The issuer appoints a lead manager – the issuer of a eurobond will appoint, and work with,
an investment bank that will act as lead manager to the issue. The issuer and lead manager will
together establish details of the proposed issue, crucially including the maturity and coupon. The
lead manager will, for a fee, underwrite and guarantee that the bonds will raise a certain amount.
2. The lead manager establishes a syndicate – for a sizeable eurobond issue, the lead manager will
establish a syndicate of banks, each agreeing to sell the eurobonds to their client base and accepting
responsibility for a proportion of both the issue and the underwriting.
3. The syndicate distributes to its client base – the eurobonds are sold to the clients of the syndicate
of banks and the issuer.

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It is unusual for eurobond issuers to keep a record of the holders of their bonds; the certificates
themselves are all that is needed to prove ownership. This is the concept of bearer documents, when
the holder of the certificates (the bearer) has all the rights attached to ownership. Eurobonds are issued
in bearer form and, because they are issued internationally, they are largely free of national regulation.
Eurobonds have been innovative in their structure to accommodate the needs of issuers and investors.
The absence of national regulation means that eurobonds can pay interest gross, making the buyer
responsible for paying their own tax and avoiding withholding tax (WHT) (tax being withheld at source
in the country of origin). There are plain vanilla, fixed-coupon bonds that normally pay the coupons
once a year. Additionally, there are ZCBs and other forms of eurobond, such as floating-rate bonds and
bonds with coupons that increase over time (stepped bonds).

Initially, eurobonds were aimed at wealthy individuals, but as the market has grown they have
increasingly become investments held by institutional investors.

As bearer documents, it is important that eurobonds are kept safe, and this is often achieved by holding
the bonds in depositaries, particularly those maintained by Euroclear and Clearstream. When the bonds
are deposited in these organisations they are described as being immobilised. Immobilisation does not
mean that the bonds cannot be transferred in secondary market transactions, it simply means that the
bonds are safely held within a reputable depositary and a buyer is likely to retain the bonds in their
immobilised form.

As the eurobond market has grown, a self-regulatory organisation has been formed that oversees the
market and its participants – the International Capital Market Association (ICMA).

Settlement and accrued interest conventions have been established for the secondary market.
Settlement is on a T+2 basis and accrued interest is calculated on the basis of 30 days per month and
360 days per year (30/360 basis).

The following table highlights the major features of eurobonds:

Feature Detail
Form Bearer
Interest payments Gross
Tax Taxable but untaxed at source
Trades matched through TRAX system
Trades settled through Euroclear or Clearstream
Settlement period Trade day plus two (T+2)
Trading mechanism Over-the-counter (OTC)

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 Asset Classes

7. Other Securities

7.1 Depositary Receipts (DRs)

2
Learning Objective
2.7.1 Know the principal features and characteristics of depositary receipts: American depositary
receipts; global depositary receipts; means of creation including pre-release facility;
registration; rights attached; dividends; exchange for underlying shares

Depositary receipts (DRs) come in two broad forms – American depositary receipts (ADRs) and global
depositary receipts (GDRs).

The US is a huge pool of potential investment. Therefore, substantial non-US companies may want to
attract US investors to raise funds. ADRs facilitate this process; indeed, they were created to make it
easier for Americans to invest in overseas companies. GDRs are depositary receipts that are identical to
ADRs, except that they are marketed to appeal to a broader base of investors, some of whom may be
based outside the US.

Both ADRs and GDRs are negotiable certificates evidencing ownership of shares in a corporation from
a country outside the US. Each DR has a particular number of underlying shares, or is represented by a
fraction of an underlying share.

Examples
Volkswagen AG (the motor vehicle manufacturer) is listed in Frankfurt. It has two classes of shares listed
– ordinary shares and preference shares. There are separate ADRs in existence for the ordinary shares
and preference shares. Each ADR represents 0.2 individual Volkswagen shares.

The Indian consulting and IT services giant Infosys has ADRs traded on the New York Stock Exchange
(NYSE) and each ADR represents a single share in Infosys ltd.

GDRs work in exactly the same way as ADRs, except that the target investors are not in the US, but in
other parts of the world. For example, the Indian conglomerate Reliance Industries ltd is listed on the
Bombay Stock Exchange in Mumbai, India, but also has GDRs available and traded in London – each
Reliance GDR represents two underlying Reliance shares.

DRs are typically created (or sponsored) by the foreign corporation (Volkswagen, Infosys and Reliance
Industries in the above examples). They will liaise with an investment bank regarding the precise
structure of the DR, such as the number or fraction of shares represented by each DR. A depository bank
will then accept a certain number of underlying shares from the issuer, create the DRs to represent the
shares and make these DRs available to US and/or other investors, probably via local brokers.

63
The creation process for an ADR is illustrated by the following diagram:

(2) Issuer supplies the underlying

shares to the depository bank

Issuer Depository Bank

US
Investors
(1) Issuer liaises
with investment (3) Depository bank sells the ADRs
bank over to US investors via US brokers)
structure
of the ADR
programme

Investment
Bank

(4) Cash proceeds are paid over to the issuer

One characteristic of DRs that must also be considered is pre-release or grey market trading. When
a DR is being created, the depository bank receives notification that, in the future, the shares will be
placed on deposit. As long as it holds cash collateral, even though the shares are not yet on deposit, the
depository bank can create and sell the receipt (the DR) at this time. Effectively, investors are buying
a receipt that entitles them to all the benefits of a share that will, in the future, be held on deposit
for them. The DR can be treated in this way for up to three months before the actual purchase of the
underlying shares.

The shares underlying the DR are registered in the name of the depository bank, with the DRs themselves
transferable as bearer securities. DRs are typically quoted and traded in US dollars and are governed by
the trading and settlement procedures of the market on which they are traded.

The depository bank acts as a go-between for the investor and the company. When the company pays
a dividend, it is paid in the company’s domestic currency to the depository bank. In an ADR, the bank
will then convert the dividend into dollars and pass it on to the ADR holders. The US investors therefore
need not concern themselves with currency movements. Furthermore, when an ADR holder decides to
sell, the ADRs will be sold on in dollars. This removal of the need for any currency transactions for the US
investor is a key attraction of the ADR.

DR holders are entitled to vote, just like ordinary shareholders, only the votes will be exercised via the
depository bank.

If the DR represents a UK company’s shares, there are tax ramifications. The UK tax authority, HM
Revenue & Customs (HMRC) levies a tax known as stamp duty on share purchases, at 0.5% of the price
paid to purchase shares.

However, because DRs may trade outside the UK, for example, in the US, no stamp duty is charged on the
purchase of a DR. Instead, HMRC charges a one-off fee for stamp duty of 1.5%, when the DR is created.

64
 Asset Classes

If an investor wants to sell their DRs, they can do so either by selling them to another investor as a DR,
or by selling the underlying shares in the home market of the company concerned. The latter route will
involve cancelling the DR by delivering the certificates to the depository bank. The depository bank will
then release the appropriate number of shares in accordance with the instructions received. GDRs are

2
generally convertible into the local shares. This may appeal to investors, particularly in emerging market
companies, in situations where the GDR liquidity diminishes after listing, while the local share is more
actively traded.

7.2 Warrants

Learning Objective
2.7.2 Know the rights, uses and differences between warrants and covered warrants

Traditionally, a warrant is an instrument issued by a company that allows the holder to subscribe for
shares in that company at a fixed price over a fixed period. A typical warrant may have a life of several
years.

Warrants are listed and traded on stock exchanges. If the holder decides to exercise, the company will
issue new shares.

Example
Warrants are available in a (fictional) investment company, Cambridge Investment Trust plc. Cambridge
Investment Trust shares are currently trading at 77p each, and warrants are available, giving the warrant
owner the right, but not the obligation, to buy shares at £1 each, up until 2020. The warrants are trading
at 4p each.

In the above example, the warrant’s expiry date is in 2020 and its exercise price is 100p.

What are the advantages to a company, such as the one encountered above, that persuade it to issue
warrants? Clearly, the sale of warrants for cash will raise money for the company, and, if the warrants are
exercised, then further capital will be raised by the company. Holding the warrant does not entitle the
investor to receive dividends or to vote at company meetings, so the capital raised until the warrant is
exercised could be considered as free.

Obviously warrants offer a highly geared investment opportunity for the investor, and they are often
issued alongside other investments, rather than sold in their own right.

Example
CBC plc is attempting to raise finance by issuing bonds. Their advisers inform them that they could issue
bonds paying a coupon of 6% pa, or lower it to 5% pa if they give away a single warrant with each £100
nominal of the bonds. The warrants are detachable from the bonds – in other words, the investors could
decide to sell their warrants or keep them, regardless of whether they retain the bonds.

65
Another type of warrant is a covered warrant. These are warrants issued by firms (usually investment
banks), rather than the company whose shares the warrant enables the investor to buy. They are offered
in the form of call warrants (giving the investor the right to buy), or put warrants (giving the investor the
right to sell). In the UK, covered warrants are traded on the London Stock Exchange (LSE).

7.2.1 Warrant Price Behaviour

Warrants (including covered warrants) are highly geared investments. A modest outlay can result in a
large gain, but the investor can lose the value of their entire stake in the warrant. Their value is driven
by the length of time for which they are valid (their maturity or period until expiry) and the value of the
underlying security.

There is a relatively simple method of looking at the price of one warrant relative to other warrants –
using the conversion premium. This is the price of the warrant plus the exercise price required to buy
the underlying share, less the prevailing share price.

Example
For example, calculating the conversion premium for the Cambridge Investment Trust warrants in the
example above involves the:

Warrant price = 4p

Plus exercise price = 100p

Less share price = 77p

Conversion premium = 27p

Note that if the resultant figure were a negative, the warrant would be trading at a conversion discount.

7.3 Property

Learning Objective
2.7.3 Understand the risks and rewards involved in investment in property and the differences
between the different investment routes: direct investment; real estate investment trusts;
open-ended collective funds

Property as an asset class has certain distinguishing features:

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

• Valuation is subjective, as property is not traded in a centralised marketplace, and continuous and
reliable price data is not available.
• Property is subject to complex legal considerations and high transaction costs upon transfer.

66
 Asset Classes

• It is relatively illiquid as a result of not being instantly tradeable.

• It is also illiquid because it is often indivisible: the investor generally has to sell all of the property or
nothing at all. It is not generally feasible for a commercial property investor to sell, for example, one
factory unit out of an entire block (or at least, to do so would be commercially unattractive) – and a

2
residential property owner cannot sell a spare bedroom to raise a little cash.
• Since property can only be purchased in discrete and sizeable units, individual transactions tend to
be large, making diversification difficult.
• The supply of land is finite and its availability can be further restricted by legislation and local
planning regulations. Therefore, price is predominantly determined by changes in demand.

Property or real estate can be subdivided into two types – residential and commercial. Residential
property is where people live, whereas commercial property is used for business purposes; commercial
property includes shops and offices, industrial premises and farmland.

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

Residential Property Commercial Property

Range of investment
opportunities, including Size of investment required means direct
Direct investment second homes, holiday investment in commercial property is limited to
homes and buy-to-let property companies and institutional investors
property
Typically short renewable Long-term contracts with periods commonly in
Tenancies
leases excess of five years
Repairs Landlord is responsible Tenant is usually responsible
Largely linked to capital Significant component is income return from
Returns
– increase in house prices rental income

As an asset class, property has, at times, provided positive real long-term returns allied to low volatility
and a reliable stream of income. An exposure to property can provide diversification benefits owing to
its low correlation with both traditional and alternative asset classes.

Many private investors have chosen to become involved in the property market through buying-to-
let or simply by purchasing a second home. Other investors wanting to include property within a
diversified portfolio generally seek indirect exposure, either via a mutual fund or shares in publicly-
quoted property companies. Either method adds real estate exposure to a portfolio, which is often seen
as a hedge to other asset classes. It adds an additional element of diversification, and can provide stable
income in the form of rent. Real estate returns often move in different directions (or at different speeds)
than other investments in capital markets.

On the other hand, real estate is illiquid – even when purchased within a mutual fund. Real estate
investments cannot be readily realised. During the financial crisis of 2007–08, property prices fell and,
as investors started to cash in their holdings, property funds brought in measures to stem outflows, in
some cases imposing 12-month moratoria on redemptions.

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However, property can be subject to prolonged downturns and its lack of liquidity, significant
maintenance costs, high transaction costs on transfer and the risk of having commercial property
with no tenant (and, therefore, no rental income) really only makes commercial property suitable as
an investment for long-term investing institutions, such as pension funds. The availability of indirect
investment via shares in companies or stakes in collective funds, however, makes a diversified property
portfolio more accessible to individual investors.

7.3.1 Real Estate Investment Trusts (REITs)

Real estate investment trusts (REITs) are well established in countries such as the UK, US, Australia,
Canada, France and Japan. They are listed investment companies that pool investors’ funds to invest in
commercial and possibly residential property.

One of the main features of REITs is that they provide access to property returns without the previous
disadvantage of double taxation. Until recently, when an investor held property company shares, not
only would the company pay corporation tax, but the investor would be liable to tax on dividends and
any growth. Under the rules for REITs, no corporation tax is payable, provided that certain conditions are
met and distributions are instead taxable on the investor.

Broadly, tax-exempt business conditions are the following:

• The property rental business carried on by a UK REIT must contain at least three single rental
properties. These can be commercial or residential, and a property includes each separately rented
unit in a multi-let property, but must not involve a property representing more than 40% of the total
value of the property rental business
• For each accounting period, the REIT must distribute at least 90% of its property rental business
profits by way of dividend.

Certain countries have different classifications for REITs, for example development and income REITS,
which are structured to cater for investors in early stage and construction period investments or more
mature cash flow-generative portfolios of properties.

REITs give investors access to professional property investment and may provide them with new
opportunities, such as the ability to invest in commercial property. This allows them to diversify the risk
of holding direct property investments.

REITs also remove a further risk from holding direct property, namely liquidity risk, or the risk that
the investment will not be able to be readily realised. REITs are closed-ended funds quoted on stock
exchanges, and shares in REITs are bought and sold in the same way as other listed company shares.

7.3.2 Open-Ended Funds

Open-ended funds are collective funds pooling the money of investors to buy portfolios of investments,
such as stocks or bonds. In return for their money, the investors are given units in the fund. The funds
are open-ended because they can grow by selling more units or shrink by buying back and cancelling
units. This gives the fund the attraction of liquidity.

68
 Asset Classes

However, this process works less well for funds investing in physical property. Individual properties
take time to sell, sales prices can suffer cyclical downturns and properties are usually indivisible – it is
the case of selling the whole property or none at all. As such, open-ended funds investing in property
may need to resort to redemption moratoria. This means that investors cannot sell back their units for a

2
period, or an extended redemption period, meaning that they have to be more patient than usual and
may need to wait months before receiving the proceed of the sale of units.

8. Foreign Exchange (FX)

8.1 Introduction

Learning Objective
2.8.1 Know the principal features and uses of spot, forward and cross rates: quotation as bid-offer
spreads; forwards quoted as bid-offer margins against the spot; quotation of cross rates

The foreign exchange (‘forex’ or ‘FX’) market is the collective way of describing all the transactions in
which one currency is exchanged for another, anywhere in the world. There is no physical exchange for
the currency market in London; it is purely OTC and dominated by the banks.

There are two types of transaction conducted on the FX market:

1. Spot transactions are immediate currency deals that are settled within two working days.
2. A forward transaction involves currency deals that are agreed for a future date at a rate of exchange
fixed now.

Both spot and forward rates are quoted by dealers in the form of a buying rate (the bid) and a selling rate
(the offer). The spread between these two prices enables the FX dealer to make a profit.

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

First, FX transactions are driven by international trade. If a Japanese company sells goods to a US
customer, it might invoice the transaction in US dollars. These dollars will need to be exchanged for
Japanese yen by the Japanese company and this is the FX transaction. The Japanese company may not
be expecting to receive the dollars for a month after submission of the invoice. This gives it two choices:

1. It can wait until it receives the dollars and then execute a spot transaction.
2. It can enter into a forward transaction to sell the dollars for yen in a month’s time. This will provide it
with certainty as to the amount of yen it will receive and assist in its budgeting efforts.

69
The second reason for FX transactions is speculation. If an investor feels that the US dollar is likely to
weaken against the euro, they can buy euros in either the spot or forward market to profit if they are
right.

Trading of foreign currencies is always done in pairs. These are currency pairs when one currency is
bought and the other is sold, and the prices at which these take place make up the exchange rate.
When the exchange rate is being quoted, the name of the currency is abbreviated to a three-character
reference.

The most commonly quoted currency pairs and their three-character references are:

• US dollar and Japanese yen (USD/JPY)

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

When currencies are quoted, the first currency is the base currency and the second is the counter or
quote currency. The base currency is always equal to one unit of that currency, in other words, one
pound, one dollar or one euro. For example, say the EUR:USD exchange rate is 1:1.1229, this means that
€1 is worth $1.1229.

When currency pairs are quoted, a market maker or foreign exchange trader will quote a bid and an ask
price. Staying with the example of the EUR/USD, the quote might be 1.1228/30. So if you want to buy
€100,000 then you will need to pay the higher of the two prices and deliver $112,300; if you want to sell
€100,000 then you get the lower of the two prices and receive $112,280.

Generally, exchange rates around the world are quoted against the US dollar. A cross rate is any foreign
currency rate that does not include the US dollar, eg, GBP/JPY is a cross rate, with the exception of GBP
and EUR. Obviously a cross rate will be of particular interest to companies doing international business
between the constituent countries, eg, a UK company selling goods or services to Japanese consumers,
and receiving payment in yen.

8.2 Spot and Forward Transactions

Learning Objective
2.8.2 Be able to calculate spot and forward settlement prices using: adding or subtracting forward
adjustments; interest rate parity

A typical sterling/dollar spot quote might look something like this:

GBP/USD spot rate 1.3055–1.3145

• Buyer’s rate: £1 buys $1.3055.

• Seller’s rate: $1.3145 buys £1.

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 Asset Classes

The buyer’s rate and seller’s rate refer to buying and selling dollars respectively. The difference between
the buyer’s and seller’s rates is generally referred to as the bid-offer spread. It enables the bank offering
the deals to make money.

2
How much will an investor receive if the above spot rate is applied? If the investor wants to sell $50,000
for pounds sterling, they will receive £38,037. This is based on the seller’s rate of $1.3145:£1.

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

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

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

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

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

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

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

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

three-month forward $1.3134–$1.3227

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

8.2.1 Interest Rate Parity

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

71
Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free
price of the asset, as any deviation from this price will be ‘arbitraged away’.

Arbitrage is the practice of taking advantage of a pricing anomaly between securities that are trading
in two (or possibly more) markets. One market can be the physical or underlying market; the other can
often be a derivative market. When a mismatch or anomaly can be exploited (ie, after transaction costs,
storage costs, transport costs and dividends), the arbitrageur ‘locks in’ a risk-free profit. In general terms,
arbitrage ensures that the law of one price will prevail.

Interest rate parity results from recognising a possible arbitrage condition and arbitraging it away.

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

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

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

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

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

Forward rate for GBP/USD = £ Spot rate x

  [ ( 1+US $ Short-term interest rate)
(1+UK £ Short-term interest rate)
[
Example
The GBP/USD spot exchange rate = 1.5220. If the three-month interest rate for the UK is 4.88% and for
the US, 3.20%, what will the three-month forward exchange rate be?

As the three-month interest rates are quoted on a per annum basis, they must be divided by four to
obtain the rate of interest that will be payable (%) over three months:

Sterling: 4.88%/4 = 1.22%

Dollar: 3.20%/4 = 0.8%

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 Asset Classes

Applying the interest rate parity formula:

Forward rate for GBP/USD = $1.5220 x

   
(1+0.008)
(1+0.0122)
= $1.5157
[ [

2
The forward exchange rate in the example of $1.5157 is lower than the spot exchange rate of $1.5220.
That is, in three months’ time, £1 will buy $1.5157 or $0.0063 fewer dollars than is available at the spot
rate (ie, the difference is 63 pips).

If this relationship did not exist, then an arbitrage opportunity would arise between the spot and
forward rates.

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

8.3 Factors Affecting Foreign Exchange Rates

Learning Objective
2.8.3 Understand the factors that affect foreign exchange rates: freely floating exchange rates;
purchasing power parity; currency demand and supply

Historically, exchange rates were fixed as part of the 1944 Bretton Woods agreement and not subject to
market forces. Resetting or changing these exchange rates took place, as it did in the UK in the 1960s, by
a formal devaluation whereby the rates which had been set in 1944 were modified. The UK Government
undertook a devaluation of the pound against the dollar from £1= $2.80 to £1= $2.40 in 1968.

The era of fixed exchange rates came to an end during the 1970s, largely as a result of a currency crisis
for the US dollar and the end of the official convertibility of currencies into gold, which was abandoned
in August 1971. There have been attempts by governments to reintroduce managed exchange rates
but these efforts have essentially failed, and the current regime of freely floating exchange rates is now
accepted as the only feasible way for the FX market to function effectively.

There are exceptions to floating currencies; for example, some Middle Eastern countries, such as Saudi
Arabia and the UAE, peg their currencies to the US dollar, and China pegs its currency to a basket of
other currencies including the US dollar. A more strict version of a peg is currency board, where there
are reserve requirements to ensure the peg holds. Hong Kong has such a system. Other countries which
moderately restrict inflows and outflows and where the central bank plays a key role in allocating the
supply of hard currency for imports and other international transactions often have parallel exchange
rates; Nigeria is an example. When the unofficial rate moves too far away from the official rate, a
devaluation can occur.

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Questions regarding the determination of the FX rates by the markets comes down to several related
issues concerning the demand and supply for individual currencies, monetary and interest rate policy,
issues relating to purchasing power parity (PPP), and speculation.

8.3.1 Purchasing Power Parity (PPP)

In the short term, it appears that the primary factors affecting the manner in which market participants
decide on the appropriate exchange rates are those of supply and demand and, to a greater or lesser
extent, market sentiment.

Purchasing power parity (PPP) theory concerns the rate to which exchange rates should tend to move
over the long term. PPP theory predicts that amounts of different currencies (at current exchange rates)
should have equal purchasing power.

The concept of PPP can be appreciated by considering an example.

Example
If a basket of goods costs £100 in London and the same basket of goods costs $200 in New York, the PPP
theory predicts that the exchange rate between the two countries will be £1 = $2.

If two economies experience differing rates of inflation then, over time, the exchange rate will tend to
alter in the direction of restoring PPP.

If, after a number of years, the basket of goods now costs £150 in London due to the impact of inflation
on UK prices and yet it only rises to $210 in New York, this suggests that the exchange rate between the
two currencies should now be £1 = $1.40: there should have been a decline in the value of sterling.

PPP has some plausibility over the long term and gives an underlying theme to the FX markets. If one
economy consistently has an inflation rate in excess of its competitors, then its currency will deteriorate
against its trading partners.

Factors Affecting the Supply and Demand for a Currency

The following is a list of factors that affect the supply and demand for a particular currency, using the US
dollar as an example:

Factors Affecting the Demand for US Dollars

• Overseas operators needing US dollars to pay for exports of US goods to overseas markets now or
in the future.
• Overseas investors wanting to invest capital in the US will increase demand, whereas investors
wanting to divest, or reduce their holdings in the US, will decrease demand.
• Speculation – if the US dollar is expected to increase relative to one or more other currencies,
speculators will buy US dollars ahead of the increase.
• Currency rate management activities of central banks, including the Federal Reserve.
• Demand will be downward-sloping with respect to price – less demand for exports and less interest
from overseas investors as the US dollar advances relative to other currencies.

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 Asset Classes

Factors Affecting the Supply of US Dollars

• When US importers purchase overseas currencies to pay for imported goods arriving in the US, they
are increasing the supply of US dollars into the markets.
• US residents wishing to invest in overseas assets will have to sell US dollars to buy overseas currency.

2
• Speculation – if the US dollar is expected to decrease relative to one or more other currencies,
speculators will sell US dollars.
• The Federal Reserve may sell the domestic currency to purchase additional overseas currency
reserves in order to influence the exchange rate as part of macroeconomic policy.
• Supply will be upward-sloping with respect to price.

8.3.2 Foreign Currency Trading and Speculation

Learning Objective
2.8.4 Understand the factors that affect foreign exchange trading and speculation

While the previous discussion has focused on the underlying economic and fundamental factors which
influence exchange rates, there is no question that the FX market is also one where there is a huge
amount of speculative trading activity. Much of this trading is conducted by the large banks, which are
the dominant players in the OTC market for FX.

The volume of transactions has been estimated by the Bank for International Settlements (BIS) at
approximately $6.6 trillion in nominal amounts traded daily. However, as with derivatives, the nominal
amount traded is somewhat misleading since the speculative activity in FX is focused on the amount
that is traded at the margin. In other words, if someone places an order to sell $1 million to purchase
£600,000, but only holds the position for a few hours or minutes, there is a sense in which the nominal
amounts are not really exchanged; it is the marginal difference which is really being traded or at risk.

According to the BIS, the most widely traded currency pair is the USD/EUR, which represents just under
one quarter of all trades. The FX market is extremely liquid and, for large deals, it is always open. There
is great depth of trading and, therefore, narrow spreads between buying and selling prices for the
commonly quoted and frequently traded currencies like the EUR/USD. Other currency pairs, however,
involving more exotic or less-traded currencies such as the Hungarian forint, will be much less liquid,
resulting in much wider spreads between the bid and ask prices.

FX markets can be extremely volatile at times, especially when the markets in other asset classes are
acting in an erratic manner. There is a fascinating correlation between certain currency pairs and equity
markets and some of this is explicable by reference to the carry trade. In essence, the carry trade in FX
involves the borrowing of funds in a currency where the rate of interest is relatively low – examples
are the Japanese yen and the Swiss franc – and then the purchase of securities, often government
bonds, which have a relatively high yield, such as short-term instruments available from the Australian
government.

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The more volatile periods for FX trading are often seen when central bank officials (such as the Federal
Reserve chairman) talk to the press or release minutes of meetings. Any hint of a change in central bank
policy will tend to impact the FX rates. Another key mover of FX rates is when the US Labour Department
issues its monthly employment data, more commonly known as the Non-Farms Payroll (NFP) report, on
the first Friday of each month at 8:30 Eastern time.

Other economic events which can strongly impact the FX market are releases of inflation data, gross
domestic product (GDP) data, and retail sales data from major government organisations, such as the
Office for National Statistics (ONS) in the UK and Eurostat which provides economic data for the EU.
Also important to the sudden movements of exchange rates are the results of auctions of government
securities and any changes in short-term rates announced by central banks. Currencies of emerging
markets countries may also be strongly influenced by heightened political risk, for example, around
election periods or if one country is experiencing tensions with its neighbors.

8.3.3 Cryptocurrencies

Learning Objective
2.8.5 Know the characteristics of cryptocurrencies

The wake of the global financial crisis of 2007–08 saw the creation of cryptocurrencies as a way for
individuals to control their own money without having to rely on companies, banks or governments.
At the time, blame for the financial crisis was primarily attributed to the imprudent actions of bankers
and politicians. Many individuals were, therefore, upset by the way in which they had to implicitly trust
banks and governments with their hard-earned money.

Cryptocurrencies are virtual or electronic currencies which (as their name suggests) use encryption
technology, to control the amount of currency issued as well as to record ownership and payments. The
first established cryptocurrency – Bitcoin – was created in 2009; today, about 3,000 cryptocurrencies are
available. Investors wishing to participate in the cryptocurrencies market must first set up a digital wallet.
Here they may securely store their coins or tokens, which they may acquire in one of the following ways:

• purchasing them in exchange for fiat currencies (transaction)

• earning them, for example, by publishing blog posts on platforms that pay users in cryptocurrency,
or
• through mining (cryptomining) by solving mathematical problems to generate new cryptographic
keys.

While cryptocurrencies may go up in value, they are high-risk and speculative, so it is important that
investors understand the risks before they start trading:

• Volatility – it is not uncommon for the value of cryptocurrencies to fluctuate by hundreds, or even
thousands, of US dollars. This can be driven by many factors including varying perceptions of its
intrinsic value as a store of value, unexpected changes in market sentiment, and security breaches.
• Decentralised – many cryptocurrencies are decentralised networks, whereby investors deal directly
with each other, rather than operating from within a centralised exchange. While this allows users
to eliminate any counterparty risk linked to a centralised exchange, volumes and liquidity are low.

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 Asset Classes

• Unregulated – cryptocurrencies are largely unregulated by both governments and central banks.
That said, the growth of the cryptocurrencies market for financial transactions has led to discussions
about ways in which regulation could be introduced.
• They are not reserve-backed – while traditional currencies are backed by the government that

2
issued them, cryptocurrencies are typically not backed by any tangible assets.
• Scalability – mining is energy intensive, requiring extensive computer resources.
• They are susceptible to human error, technical glitches and hacking – in December 2017, for
example, a hacker stole 4,700 Bitcoins (worth approximately $64 million at the time), when the
cryptocurrency’s price was hitting record highs of around $20,000 per coin.

9. Collective Investment Schemes (CISs)

A collective investment is a way of investing money with other people to participate in a wider range
of investments than those feasible for most individual investors, and to share the costs of doing
so. Terminology varies with country, but collective investments are often referred to as investment
funds, managed funds, mutual funds or simply funds. Across the world large markets have developed
around collective investment, and these account for a substantial portion of all trading on major stock
exchanges.

Collective investments are promoted with a wide range of investment aims either targeting specific
geographic regions (eg, emerging Europe) or specified themes (eg, technology). Depending on the
country, there is normally a bias towards the domestic market to reflect national self-interest as
perceived by policymakers, familiarity, and the lack of currency risk. Funds are often selected on the
basis of these specified investment aims, as well as their past investment performance and other factors,
such as fees.

9.1 Regulated and Unregulated Collective Investment Schemes

(UCISs)

Learning Objective
2.9.1 Understand the differences between regulated and unregulated collective investment
schemes and their advantages and disadvantages to the issuer and investor

Financial services regulations in certain jurisdictions tend to include particular requirements that need
to be met before a CIS can be marketed to retail investors. These requirements aim to make sure that
retail investors do not become involved in inappropriate schemes, such as ones that are excessively
complex or risky. In the UK, schemes meeting the requirements to enable them to be marketed to retail
investors are referred to as regulated schemes, and those that do not meet the requirements and cannot
be marketed to retail investors are referred to as unregulated schemes.

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Definition of a CIS
The definition of a CIS as given by the International Organization of Securities Commissions (IOSCO),
and which is used by many international organisations, is that a CIS is an instrument that:

• invests in transferable securities

• is publicly marketed, and
• is open-ended.

It is typical to distinguish two types of CIS:

• Regulated CISs that are either authorised by the local financial regulator or, if they are from outside
the country, are recognised by the local financial regulator. Recognition generally enables overseas
CISs to be marketed to the public in the country concerned and the financial regulator will only
recognise an overseas scheme if certain specified criteria are met.
• Unregulated collective investment schemes (UCISs) are schemes that are not authorised or
recognised by the local financial regulator.

UCISs are described as unregulated because they are not subject to the same restrictions as regulated
CISs (eg, in terms of who their potential clients can be and how they are run). Schemes that are
not authorised or recognised are subject to marketing restrictions, particularly in relation to retail
investors. UCISs are generally regarded as being characterised by a high degree of volatility, illiquidity,
operating with high levels of leverage, or all of these and, therefore, are usually regarded as speculative
investments. This means that, in practice, they are rarely regarded as suitable for more than a small
proportion of an investor’s portfolio. The schemes can offer exotic investments, such as golf courses
in Mexico, forests in Brazil or off-plan property in Eastern European countries, and some not so exotic
investments, such as wine in France.

9.1.1 The Risks of Unregulated Collective Investment Schemes (UCISs)

As with most other investments, a client investing in a UCIS could lose some or all of their principal
investment. However, this risk is likely to be particularly relevant to UCISs. UCISs frequently invest in
assets that are not available to regulated CISs (for example, because they are riskier or less liquid), or
are structured in a way that is different from regulated CISs. Unlike regulated CISs, UCISs are often not
subject to investment and borrowing restrictions aimed at ensuring a prudent spread of risk. As a result,
UCISs are generally considered to be a high-risk investment and firms should always ensure that clients
fully understand, and are financially able to assume, the associated risks before investing.

Typical risks encountered in an individual UCIS are likely to include the following:

• Liquidity – most unregulated investments will not offer daily liquidity. It is normal for investors
wishing to redeem their investment to need to serve notice of their intention and for the redemption
to take effect at the next available redemption date – typically at the end of the month in which
notice is served. The investment will be sold at the price prevailing at the end of the following
month and the realisation value returned to the investor approximately 14 days later. It can be seen,
therefore, that the elapsed time from serving notice to receiving the proceeds can be up to two and
a half months.

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 Asset Classes

• Fixed- or long-term commitment – mainly due to the liquidity constraints set out above,
investment must be regarded at the outset as long-term.
• There is no guarantee of capital or income return – while this represents a risk, it is not necessarily
significantly different to the risk associated with a regulated investment.

2
• High charges – some unregulated investments may have higher administration charges associated
with them. This can only be determined on an individual fund basis. Some unregulated investments
include a performance fee for the manager if they exceed a specified benchmark. It is usual, in these
cases, for there also to be a high-water mark which means that if the price of the investment falls in a
year only to rise again in the next, the manager will not become eligible to receive an additional fee,
until the previous maximum fund price is surpassed.
• Gearing – this means that the fund can borrow money to enhance the total funds available to it
for investment. If the fund goes up in value (and the capital value of the loan remains static) this
can lead to a higher multiple of gains (net of interest charges) being available for distribution to
the investors. The risk is that in the event of a loss in the value of the fund’s assets, this can lead to
a higher multiple of loss to the investor, because the loan will still require repayment in its entirety
before the net asset value (NAV) can be attributed to the investors. Note that gearing is referred to
as leverage in the US.
• Currency/geopolitical – an offshore investment may have a base currency other than the investor’s
home currency. For example, if the investor was from the US, this means that there is currency
exposure in the translation of value back into US dollars from whatever the base currency is.
If, during the period of investment, the base currency strengthens against the US dollar, this is
advantageous to the investor, and vice-versa. Similarly, investing offshore may expose the investor
to parts of the world which are less politically stable.
• Single asset – an unregulated investment may represent a single project, the success of which is
dependent upon certain criteria. This may be deemed high-risk.

9.2 Open-Ended and Closed-Ended CISs

Learning Objective
2.9.2 Understand the differences between open-ended and closed-ended collective investment
schemes and their advantages and disadvantages to the issuer and investor
2.9.3 Understand the circumstances under which a collective investment scheme may be exchange-
traded or offered by a fund manager
2.9.4 Understand the circumstances where a collective investment scheme would be issued under a
deed of trust and where it may be company- or private equity-based

As well as distinguishing between regulated and unregulated CISs, funds can also be subdivided based
on their legal structure and the way the scheme operates. A major subdivision is between schemes that
are open-ended and ones that are closed-ended.

An open-ended fund is an investment fund that can issue and redeem shares or units in the scheme
at any time. Each investor has a pro rata proportion of the underlying portfolio and so will participate
in any growth of the fund. The value of each share or unit is in proportion to the total value of the
underlying investment portfolio.

79
If investors wish to invest in an open-ended fund, they approach the fund directly and provide the
money they wish to invest. The fund can create new shares or units in response to this demand, issuing
new shares or units to the investor at a price based on the value of the underlying portfolio. If investors
decide to sell, they again approach the fund, which will redeem the shares or units and pay the investor
the value, again based on the value of the underlying portfolio.

An open-ended fund can, therefore, expand and contract in size based on investor demand, which is
why it is referred to as open-ended. Key examples of open-ended funds around the world include US
mutual funds, the UK’s open-ended investment companies (OEICs) and mainland Europe’s sociétés
d’investissement à capital variable (SICAVs).

A closed-ended investment company is another form of investment fund. When a closed-ended

investment company is first established, a set number of shares are issued to the investing public, and
these shares are then subsequently traded on a stock market. Investors wanting to then buy shares do so
on the stock market from investors who are willing to sell. The capital of the fund is, therefore, fixed, and
does not expand or contract in the way that an open-ended fund’s capital does. For this reason, they are
referred to as closed-ended funds. Traditionally, such funds have been referred to as investment trusts
although, increasingly, they are also referred to as investment companies.

9.2.1 Open-Ended Vehicles

Before looking at the relative advantages and disadvantages of open-ended and closed-ended CISs, it is
important to see the more detailed mechanics behind each of them. There are two major forms of open-
ended schemes – unit trusts and OEICs.

Unit Trusts
A unit trust is a professionally managed collective investment fund.

• Investors can buy units, each of which represents a specified fraction of the trust.
• The trust holds a portfolio of securities.
• The assets of the trust are held by trustees and are invested by managers.
• The investor incurs annual management charges and possibly also an initial charge.

An authorised unit trust (AUT) is essentially a unit trust that is allowed to be marketed to the investing
public, and must be constituted by a trust deed made between the manager and the trustee.

The Role of the Trustees

The primary duty of the trustees is to protect the interests of the unitholders. The investors in a unit trust
own the underlying value of shares based on the proportion of the units held. They are effectively the
beneficiaries of the trust. The following requirements apply in the UK in relation to trustees and the trust
deeds of AUTs:

1. Trustees of a unit trust must be authorised by the FCA and be fully independent of the trust manager.
2. Trustees are required to have capital in excess of £4 million and, for this reason, are normally large
financial institutions, such as banks or insurance companies.

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 Asset Classes

3. The trust deed of each unit trust must clearly state its investment strategy and objectives, so that
investors can determine the suitability of each trust.
4. The limits and allowable investment areas for a unit trust fund are also laid out in the trust deed
together with the investment objectives.

2
The Role of the Manager
In the UK, the manager of an AUT must also be authorised by the FCA. The role of the fund manager
covers:

• marketing the unit trust

• managing the assets in accordance with the trust deed
• maintaining a record of units for inspection by the trustees
• supplying other information relating to the investments under the unit trust as requested
• informing the FCA of any breaches of regulations while the manager is running the trust.

Buying and Selling Units

Units in AUTs can be purchased in a number of ways; for example, via a newspaper advertisement, over
the phone or over the internet. These methods will generally require payment with the order, or some
form of guarantee of payment. A contract note will be produced and sent to the investor as evidence of
the purchase.

Investors can sell their units via the same source that they purchased them, or can contact the fund
managers direct, for example by telephone.

Unit Trust Pricing

The calculation of buying and selling prices will take place at the valuation point, which is at a particular
time each day. The fund is valued on the basis of the net value of the constituent assets and a typical
spread between buying and selling prices in the market will be in the range of 5%-7%.

Some fund managers use single pricing, in which case there is the same price quoted for buying and
selling units, with any charges being separately disclosed.

Charges
The charges on a unit trust can be taken in three ways – an initial charge which is made upfront, an
annual management charge made periodically and an exit charge levied when the investor sells.
Whatever charges are made must be explicitly detailed in the trust deed and documentation. The
documents should provide details of both the current charges and the extent to which the manager can
change them.

The upfront initial charge is added to the buying price incurred by the investor. Initial charges tend to
be higher on actively managed funds, often in the range of 3–6.5%. Lower initial charges are typically
levied on index trackers. Some managers will discount their initial charges for direct sales including sales
made over the internet. It is not unusual for those managers that charge low or zero initial charges to
make exit charges when the investor sells units.

81
When they apply, exit charges are generally only made when the investor sells within a set period of
time, such as the first three or five years. Furthermore, these exit charges tend to be made on a sliding
scale with a more substantial charge made for those exiting earlier than those exiting later. Both the set
period and the sliding scale reflect the fact that, if the investor holds the unit for longer, the manager
will benefit from the regular annual management charges that effectively reduces the need for the exit
charge.

The annual management charge is generally levied at a rate of 0.5–1.5% of the underlying fund. Like the
initial charge, the annual management charge will typically be lower for trusts that are cheaper to run,
such as index trackers, and higher for more labour-intensive actively managed funds.

Open-Ended Investment Companies (OEICs)

Open-ended investment companies (OEICs) are a type of open-ended collective investment formed
as a corporation under the Open-Ended Investment Companies Regulations of the United Kingdom.
Pronounced ‘oiks’, they are also known as ICVCs, which is an acronym for investment companies with
variable capital. The terms ICVC and OEIC are used interchangeably, with different investment managers
favouring one over the other.

A share in an OEIC entitles the holder to a share of the profits of the OEIC, and the value of the share will
be determined by the value of the underlying investments. For example, if the underlying investments
are valued at £125,000,000 and there are 100,000,000 shares in issue, the net asset value (NAV) of each
share is £1.25.

Holders of shares in an OEIC can sell them back to the company, resulting in the number of shares issued
by the OEIC reducing. Similarly, new or existing investors can buy new shares from the OEIC, resulting in
the number of shares issued by the OEIC increasing. In both cases, the price at which the deal is done is
based on the NAV of the shares.

An OEIC may take the form of an umbrella fund with a number of separately priced sub-funds, adopting
different investment strategies or denominated in different currencies. Each sub-fund will have a
separate client register and asset pool.

Classes of shares within an OEIC may include income shares, which pay a dividend; and accumulation
shares, in which income is not paid out and all income received is added to net assets.

As the name suggests, OEICs are companies with corporate structures. They differ from other companies
in that they have the flexibility to issue and redeem their shares on an ongoing basis.

9.2.2 Investment Trusts

Investment trusts began in the UK and the Foreign & Colonial Investment Trust was the first to be
founded in 1868 with the aim of ‘giving the investor of moderate means the same advantage as the large
capitalist’. Today, the Foreign & Colonial Investment Trust invests in more than 600 different companies
in 35 countries and investment trust vehicles are found in many developed markets.

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 Asset Classes

In general, investment trusts provide a way for the small investor to have some exposure to investments
in very large portfolios of assets, primarily equities, which are impractical for the investor to buy
individually.

2
Investment trusts are a form of collective investment, pooling the funds of many investors and spreading
their investments across a diversified range of securities.

Investment trusts are managed by professional fund managers who select and manage the stocks in the
trust’s portfolio. Investment trusts are generally accessible to the individual investor, although shares in
investment trusts are also widely held by institutional investors, such as pension funds.

Despite their name, investment trusts are not trusts but are companies. However, whereas other
companies may make their profit from providing goods and services, an investment trust makes its
profit solely from investments. Like most investors, investors who buy shares in an investment trust
hope for dividends and capital growth.

Buying and Selling Shares in Investment Trusts

Prices
The quotation of the price of investment trust shares is similar to that for equities generally, and a dealer
will give two prices:

• The higher price is the offer price, at which an investor can buy the shares.
• The lower price is the bid price, at which a holder of the shares can sell.

In a price quote in the financial media, a single price may be given: this will typically be the mid-market
price, between the offer and bid prices.

The difference between the offer price and the bid price is the spread.

Shares in investment trusts can be bought through a stockbroker, who is likely to charge the same
level of commission as for other equities. If a broker is not providing any advice and is providing an
execution-only service, then commission may be as low as 0.5%, or a minimum commission of around
$7.50 per deal. If the broker is providing an advisory service, commission will be higher, for example,
1.5% or 2% of the purchase consideration.

Net Asset Value (NAV)

The NAV is essentially the net worth of an investment trust company’s equity capital and is calculated
from adding together the following:

• the value of the trust’s listed investments at mid-market prices

• the value of its unlisted investments at the directors’ valuation
• cash and other net current assets.

The company’s liabilities are deducted from this figure, including any issued preference capital at
nominal value. The resulting figure is the asset value for the ordinary shareholders of the company.
Dividing by the number of shares gives the NAV per share. The valuation may be carried out monthly,
weekly or daily.

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By way of illustration, the NAV of an investment trust with assets worth $10 million, and with liabilities
of $4 million, is $6 million ($10m – $4m). The NAV per share is the NAV divided by the number of shares
outstanding. Assuming this investment trust has 12 million ordinary shares outstanding, the NAV per
share is calculated as: $6 million ÷ 12 million shares = 50c per share. Most investment trusts operate at a
discount to NAV. The level of premium or discount relates to the demand for shares, and any factor that
influences demand will affect it.

Example
Neil Woodford is one of Britain’s best-known fund managers. After leaving Invesco Perpetual, he
established Woodford Investment Management and, in 2015, launched an investment trust – Woodford
Patient Capital Trust plc. As can be seen from the chart below, initial investor excitement resulted
in levels of demand that saw the trust trade at a premium to NAV. However, that soon turned into
a widening discount due to poorly performing investments, adverse publicity and ongoing worries
concerning future performance that reduced demand. This culminated in the investment trust
switching fund manager, from Woodford Investment Management to Schroders and being renamed
the Schroder UK Public Private Trust in late 2019. At the time of writing (October 2020), the trust is still
trading at a discount to its NAV.

Share Price and NAV – Schroder UK Public Private Trust (formerly Woodford Patient Capital Trust)

GBp
Price 48.44
100

80

60

40

20

Oct Jan Apr Jul Oct

Source: Hargreaves Lansdown

9.2.3 Comparison Between Open-Ended and Closed-Ended Funds

Generally, closed-ended investment trusts have wider investment freedom than authorised open-ended
investment funds, such as unit trusts and OEICs. Unlike authorised OEICs, closed-ended investment
trusts can:

• invest in unquoted private companies as well as quoted companies

• provide venture capital to new companies or companies requiring new funds for expansion.
• borrow money to help them achieve their objectives. Authorised open-ended collective schemes’
powers to borrow are more limited. The ability to borrow allows an investment trust to leverage
returns for the investor. Such gearing also increases the volatility of returns.

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 Asset Classes

As seen, in an open-ended fund, new shares or units can be created when new investors subscribe
and shares or units can be cancelled when investors cash in their holdings. In the case of closed-ended
funds, such as closed-ended investment companies, new investors have to buy from existing holders of
the shares who wish to sell.

2
As closed-ended vehicles, the number of shares in issue in an investment trust is not affected by the
day-to-day purchases and sales by investors, which allow the managers to take a long-term view of the
investments of the trust. With an open-ended scheme, such as an OEIC, if there are more sales of units
or shares by investors than purchases, the number of units reduces and the fund must pay out cash. As
a result, the managers may need to sell investments, even though it may not be the best time to do so
from a strategic and long-term viewpoint.

Being closed-ended also means that the prices of shares of an investment trust rise and fall according
to the demand for, and the supply of, the shares of the investment trust, and not necessarily directly in
line with the values of the underlying investments. In this way, investment trust prices can have greater
volatility than OEICs, where the share prices are directly related to the market values of the underlying
investments.

It is also the case for investment trusts that as prices are dependent on supply and demand, the price of
the shares can be lower than the NAV per share. This means investors can buy investment trust shares at
a discount, while the income produced by the portfolio is based on the market value of the underlying
investments. The income yield is, therefore, enhanced.

9.2.4 Exchange-Traded Funds (ETFs)

Exchange-traded funds (ETFs) are investment funds that are similar to both typical company shares and
CISs. They resemble shares in that they trade in real time on stock markets all over the world, and are like
CISs in that they contain a basket of investments, such as equities or bonds, that are bought and sold by
a manager. ETFs are generally passively managed.

Only authorised participants (typically large institutional investors) actually buy or sell shares of an ETF
directly from/to the fund manager, and then only in creation units – large blocks of tens of thousands of
ETF shares – which are usually exchanged in kind with baskets of the underlying securities. Authorised
participants may wish to invest in the ETF shares long-term, but usually act as market makers on the
open market, using their ability to exchange creation units with their underlying securities to provide
liquidity of the ETF shares and help ensure that their intra-day market price approximates to the NAV
of the underlying assets. Other investors, such as individuals using a retail broker, trade ETF shares via a
secondary market such as the NYSE/Arca exchange in the US, or the LSE in the UK.

While ETFs are relatively new (available in the US since 1993 and in Europe since 1999), they have quickly
become a very popular investment option for both individual and institutional investors. They are also
well-established in the international market, likely due to the vast investor interest in international
investing via funds. Most ETFs were initially index-tracking funds, however, in 2008, the US Securities
and Exchange Commission (SEC) authorised the creation of actively managed ETFs.

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Trading Features of an ETF
The selection of ETFs available is now very diverse and provides investors with a real alternative to
some of the more traditional funds. One of the key features of ETFs is that pricing takes place in real
time and the funds can be bought or sold anytime the markets are open. This is unlike the position with
many types of collective investment vehicles, such as unit trusts and other investment funds, where the
pricing is only computed at the end of each day. For investors and traders who want to be able to react
quickly to market movements and have immediate pricing and settlement for their positions (subject
only to the normal settlement period for any listed share), the variety of ETF products is often preferable
to the more traditional structured investment products.

Available ETFs include those that have been designed and constructed to track popular stock indices,
such as the S&P 500 (SPY) Nasdaq Powershares, which tracks the Nasdaq 100 Index (QQQ), or indices
for market sectors (eg, industrials and financials), geographical regions, currencies, commodities
such as gold, silver, copper and oil, and even certain managed funds (active ETFs) with objectives and
management criteria laid out in an offering prospectus.

ETFs are also available to track the performance of various fixed-income instruments, such as US
T-bonds or indices which track high-yield bonds and other corporate bonds. Again, these can be used
to take a long position on higher yields, in effect to be short the bond on a price basis. One well-known
ETF, traded in the US under the symbol TBT, tracks the yield on US T-bonds of 20 years plus maturity. The
fund moves in line with the real-time yields of the long end of the US Treasury curve, and therefore the
fund moves inversely to the price of such US T-bonds.

Charges and Taxation

Many ETF products are managed by large financial intermediaries, including BlackRock, State Street
Vanguard and JP Morgan Chase, and the fees and charges are very competitive and often considerably
lower than those applied for more traditionally managed funds.

Tracking Impact
While the operation, marketing and construction of an ETF requires skills on the part of the ETF
management company, many funds are in effect tracker funds and therefore have to reflect the
composition of a reference index or commodity.

The large amounts of funds invested in tracker funds can have a distorting effect on the market, for
example if many tracker funds buy a particular share at the point when it is included in the index.
Undoubtedly, inclusion in an index can be beneficial to the price of a share, while exclusion may be a
factor causing a share to receive less attention from investors and to fall out of favour.

Physical Versus Synthetic ETFs

When tracking an index, the providers of ETFs can use either physical or synthetic replication to ensure
their ETFs mimic their designated indices as accurately as possible.

86
 Asset Classes

Physical replication means the ETF will buy and own most or all of an index’s constituents in order to
replicate the index’s performance. Despite being simple and transparent, since physical replication
involves buying and selling index components, this strategy is inherently labour-intensive and costly.
These additional costs are ultimately passed along to investors in the form of higher charges.

2
In contrast, synthetic replication involves the ETF provider entering into a contract with a counterparty
(typically a bank) to deliver the return of the fund’s benchmark index in exchange for a fee. This swap
contract means that, for example, an equity ETF will not actually hold any stocks at all. Instead, it will
have a contractual relationship with the counterparty bank. This may generally reduce costs and any
possibility of tracking error, but it increases risk for investors. This is because there is a danger of the
counterparty being unable to honour its obligation under the contract, known as counterparty risk.

Exchange-traded notes (ETNs) trade similarly to ETFs and also often track indices, but are created
differently. These are structured investment products and are senior debt notes typically issued by
major banks. They, therefore, also entail counterparty credit risk and may also have different tax
consequences than investments into ETFs.

As the wide variety of exchange-traded products grows, certain funds have grown in size due to large
retail and institutional interest and are heavily traded. Some ETFs hold derivatives and offer large
amounts of leverage, attempting to track the underlying index returns at a ratio of 2x or even 3x.

Although ETF shares tend to be extremely liquid during exchange trading hours, the underlying holdings
can be very illiquid or traded OTC. This creates the risk that if there are large fund flows (particularly in
the case of large-scale redemptions), the authorised participants and fund managers may not able to
exit the underlying holdings in a timely fashion or without a large price impact. Examples of this would
be corporate bonds (particularly non-investment grade issues) or some smaller international equity
markets.

9.2.5 Specialist Funds

Closed-ended funds can also be set up to invest in areas such as private equity, property or infrastructure.
These vehicles essentially turn illiquid assets, or assets that investors would find difficult to invest in,
into liquid investments that are available to institutional and retail investors. These are also classed as
alternative assets.

Typically, these are long-term investment strategies and so the closed-end nature of the structure
is more appropriate to their needs. This can have advantages for a fund in that it does not need to
realise assets at possibly distressed prices to meet investor redemptions. It may require investors to
commit their money for long periods of time so that the planned investments have time to deliver their
expected returns.

Closed-ended companies may not be traded on a stock market and so periodic redemptions may be
made available to offer investors a way to realise all or part of their investment.

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Private Equity
Private equity investment is usually structured as a limited partnership arrangement and looks to target
institutional investors and only the wealthiest private investors. Access to private equity is possible,
however, for ordinary investors through listed, closed-ended funds.

Private equity firms invest in other businesses and then try to maximise their returns by exiting the
company at a profit.

There are a number of further factors to consider with regard to private equity funds:

• Private equity funds are a specialist and widely varied sector. Some hold direct investments in
companies and others do so indirectly through investment in other funds.
• Private equity funds make money by investing in businesses that need access to growth capital or
that need overhauling. The types and spread of investments they hold need to be analysed, along
with any commitments they may have to provide further capital.
• They will often use high levels of debt and so are exposed to interest rate rises and credit squeezes.
Funds will look to take their profit by a trade sale or flotation and so their planned exit route needs
evaluation.
• Private equity is highly correlated with the economic cycle and realising a profit can be problematic.
Given the timescales needed for such investments to work, the sale can occur at a time when there is
little market interest in a strategic sale or flotation. The disposal of a private equity stake is known as
an ‘exit’ and is typically opportunistic, making the timing and price realised unpredictable.
• In stable economic environments, the drivers of outperformance and the ability to exit investments
are in place. In such scenarios, discounts can be expected to narrow while, once the economic
environment deteriorates, discounts will widen.
• The size of fund also varies widely and the market capitalisation of the fund needs to be judged in
terms of the level of liquidity that is present and whether this would present any issues when buying
or trying to realise the investment.

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 Asset Classes

10. Structured Products

Learning Objectives

2
2.10.1 Know the key features of structured products: definition; uses and benefits

10.1 Key Features

Structured products (often referred to interchangeably as structured investment products, or SIPs)
are investments which provide a return based on the performance of an underlying asset, such as an
equity index. Mainly issued by banks and insurance companies, the precise terms of each structured
product will vary and these products may be referred to by a variety of names, including growth bonds,
certificates and investment notes. Typically, they are designed for investors who are prepared to invest
for a fixed period, and who also want some degree of protection over their initial capital.

In general, structured products share the following features:

• they either offer income or growth

• they have defined returns and defined risks
• returns are linked to one or more defined external measures, such as the S&P 500 or any other
equities index, gold prices and oil prices
• they run for a defined term, typically at least 18 months but not more than seven years.

All of these products are designed to run to maturity, at which point the issuer of the product will aim to
return the initial investment/deposit amount, along with the underlying linked asset’s gain.

Structured products can be separated into two major sub-categories: structured deposits and structured
investments.

• Structured deposits are cash-based products but can only be offered by banks which are able
to accept deposits. They are designed to return at least the initial amount deposited at the end
of the product’s life. Depositors are likely to have more protection over their money than normal
investments. For example, UK investors in these types of deposit-based products benefit from the
Financial Services Compensation Scheme’s (FSCS’s) deposit insurance. It is this key aspect that
differentiates this form of structured product from investment-based products. The underlying
asset in structured deposits is a cash deposit, and the returns may be linked to the performance of
another asset, such as the FTSE 100 Index or the gold price performance between the date when the
structured deposit is set up and its end date.
• Structured investments are typically further sub-divided into principal-protected investment
products and capital at risk investment products (often referred to as structured capital at risk
products (SCaRPs)). A structured investment product is generally a pre-packaged investment,
which is based on derivatives, a single security, a basket of securities, options, indices, commodities
or foreign currencies. They are, primarily, innovations designed to fulfil customised return/risk
objectives. The variety of possibilities just described is demonstrative of the fact that there is no
single, uniform definition of a structured product.

89
A feature of some structured products is a principal guarantee function which offers protection of the
principal, if held to maturity. These capital-protected structured products are designed to return the
original capital even if the underlying linked measure underperforms. However, despite the common
usage of the term ‘guarantee’, it is important to appreciate that, unlike deposit-based products, the
investment-based category of structured products do not draw any benefit from deposit protection
schemes in the event of the issuing bank or insurer defaulting.

Capital at risk varieties of investment-based structured products offer high returns if the linked index
measure outperforms. However, they can generate losses at maturity if the underlying index they are
linked to underperforms badly. This is often referred to as a ‘soft floor’ – the investor will get most or all
of their money back as long as the underlying index does not fall by more than a certain proportion. If
the index does fall by more than the ‘soft floor’, the investor will suffer the full loss.

An interesting example of a structured capital at risk product is the so-called ‘precipice bond’. A
precipice bond is an investment that will pay an attractive level of income over a set period, eg, 10%
per annum over three years. However, the ‘precipice’ is that if a reference index, such as a stock market
index, falls by more than a certain level over that period, the capital will suffer an equivalent loss. These
bonds were widely mis-sold to private investors with the advisers focusing on the level of ‘guaranteed’
income without highlighting the potential danger to the capital invested.

Uses and Benefits

Structured products are created to meet the specific needs of high net worth individuals (HNWIs)
and general retail investors that cannot be met by standardised financial instruments available in the
markets. As seen, the features of each individual structured product can differ markedly, however,
benefits can include:

• potential protection of initial capital investment

• enhanced returns and reduced volatility
• access to different asset classes
• reduced risk.

Structured products are generally used either to provide access to stock market growth with capital
protection or exposure to an asset, such as gold or currencies, that would not easily be achievable from
direct investment.

10.2 Components of a Structured Product

Learning Objectives
2.10.2 Know the components of structured products

Structured products are created by combining underlying assets, such as bonds, with derivatives, that
might be based on shares, indices, currencies or commodities. This combination can create structures
that have significant risk/return and cost-saving advantages compared to what might otherwise be
obtainable in the market, as illustrated in the following example.

90
 Asset Classes

Example
A structured product might combine two elements: a bond (that protects the investor’s principal) makes
up most of the investment (typically 80%), and the rest of the investor’s money is put into a derivative.

2
As the investment bond element in the structured product can be designed to give a return that
equals the initial investment (as long as the investor keeps the product until maturity), the principal
will be protected. The derivative element offers the potential to achieve higher returns based on the
performance of an underlying index or asset.

10.3 Pay-Out Structures

Learning Objectives
2.10.3 Know pay-out structures of structured products: callable; range accruals payoff; averaging
value; lookback; cash or nothing payoff; quantity adjusting (Quantos)

The potential pay-out structures available in structured products are best explored by looking at
examples. Four examples follow – first a structured deposit, and then three variants of structured
investment products.

Example
The rules for a structured deposit lasting three years might be as follows for an investment of $1,000.

• If the S&P 500 is higher at the end of the three years than it was at the beginning, the depositor gets
the original investment back plus interest equal to 100% of the growth in the index.
• If the S&P 500 is lower or the same at the end of three years than it was at the beginning, the
depositor only gets the original investment back.

As seen, structured deposits can offer the possibility of achieving a stock market return without risking
the capital loss that could be suffered from a direct investment in shares.

However, it is important to bear in mind that:

• the depositor might get less interest than that available on an ordinary savings account over the
period, or no interest at all
• investing in shares instead would potentially benefit from a rise in the stock market index (share
prices), and would also usually generate income in the form of dividend payments.

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Example
1. Capital at risk structured investment product

A so-called ‘accelerated tracker’ might provide for the investor to participate in 200% of the growth
of an index over a five-year period. If an investor buys $1,000 of the structured product, and the index
it is based on has grown by 10% at the end of the five years, the investor will receive back the initial
investment of $1,000 plus 200% of the growth, which amounts to $200 – that is, 10% of $1,000 or $100
growth x 200% = $200. If the final value of the underlying index was, say, 10% less than the issue price,
the investor will receive back the initial price of $1,000 less the change in the underlying index – 10% or
$100 – which amounts to $900.

The investor will surrender any right to the underlying income stream from the asset in exchange for
the right to participate in any performance. Also, as shown by the impact of an index fall, this structured
product is a capital at risk product.

2. Capital-protected structured investment product

A capital-protected tracker, as the name suggests, allows investors to gain some exposure to the growth
of an underlying asset or index, while providing protection for the capital invested.

For example, an instrument might be issued to track the performance of the S&P 500 Index over a six-
year period and provide participation of 110% of any growth but with 100% capital protection. If the
S&P 500 Index is at a higher level at maturity, the investor will receive back the initial price plus 110% of
the growth over that period. If the index is lower than at the start, the capital protection means that the
investor will receive back the initial investment.

3. Capital at risk with a buffer structured investment product

The rules for a structured investment lasting five years might be as follows for an investment of $1,000:

• If the S&P 500 is higher at the end of the five years than it was at the beginning, the investor gets
the original investment back plus an extra 30% – a total of $1,300.
• If the S&P 500 is at the same level or lower than it was at the beginning, but is less than 50%
lower, the investor gets the original investment of $1,000 back but nothing extra.
• If the S&P 500 has fallen by 50% or more, the amount of the investor’s original investment is cut
by the same percentage – so if the S&P 500 has fallen by 60%, the investor only gets 40% of the
money back – a total of $400.

Other structured investments might let the investor take a regular income and whether or not the
original investment is returned in full may depend on how the stock market index or other measure has
performed.

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 Asset Classes

Amongst the many features that might be included are the following:

• Structured products can be callable. This is where the product will mature early as soon as the
underlying asset (such as the stock market index) breaches a certain level on a pre-defined
observation date. This is often described as the investor being ‘kicked out’ and receiving the initial

2
investment and (potentially) a return.
• Structured products can include a payoff that is based on the underlying asset remaining within a
certain range on set dates. As long as the underlying does remain within the range, then the pre-
determined income or growth will accrue and be paid out, typically at maturity. This is known as a
‘range accruals payoff’.
• Averaging value structured products. Some structured products determine the return based on the
average level of the underlying asset over the life of the product rather than the value at maturity.
This feature can be useful in that it protects the investor against a temporary, short-term fall in the
underlying around maturity, but can also mean that the full gain in the value of the underlying might
not be realised.
• Some structured products incorporate a ‘lookback’ feature that gives the investor the ability to
realise the returns based on the highest percentage rise of the underlying over the period of the
structured product, rather than the maturity value or the average value.
• Cash or nothing payoff structured products have a return that either paid or not, depending on a
particular event linked to the reference underlying asset. A straightforward example is a product
with payment of the investor’s capital at maturity and a fixed payment if the underlying is above the
target level (usually the initial level) at maturity. If this does not occur, then only the capital is repaid.
• Quantity adjusting (quantos) structured products are designed to protect the investor against
adverse currency movements when the underlying is denominated in a foreign currency. These
products have a built in currency hedge that removes foreign currency fluctuations.

10.4 Risks

Learning Objectives
2.10.4 Know the risks associated with structured products: credit risk; income risk; pay-out structure
risk; market risk; liquidity risk; currency risk; option risk; call risk; counterparty risk

There can be multiple risks faced by investors in structured products, perhaps most obviously in relation
to the possibility of the counterparty to the investor collapsing. Despite banks selling structured
products where they often mention, and offer, either total or partial ‘capital protection’, this does not
necessarily mean that the investor’s money is completely safe. If the product is a structured deposit,
there is the potential of a deposit protection scheme for the banking industry which provides protection
in the event of a particular bank collapsing. However, for structured investment products, there will be
no such safety net.

93
There is a credit risk, or counterparty risk in that the protection of the principal will depend upon the
creditworthiness of the counterparty providing the protection guarantee. Even though the cash flows
and the principal in a structured product may come from a stable investment (eg, a bond), the products
themselves are legally considered to be the issuer’s liability.

Often, the products are created, and sold, by large global financial institutions and investment banks
whose own credit rating may be less than the underlying assets held. If the issuer goes bust, then the
product’s principal-protected guarantee may not apply and the capital will be at risk. Several firms that
issued structured products (including Lehman Brothers) went into administration or bankruptcy during
the financial crisis and could not meet their obligations. Investors in structured products had to wait,
along with bondholders, to recover their funds invested with the banks who offered such products.

• Principal protection will depend upon the creditworthiness of the counterparty providing the
protection guarantee. Even though the cash flows and the principal in a structured product may
come from a stable investment (eg, a bond), the products themselves are legally considered to be
the issuer’s liability.
• The fees payable for these products will be higher than for many simpler products or via holding the
assets directly.
• The structured products may utilise a complex set of instruments or illiquid derivatives. The pricing
of such products may, therefore, not be very transparent to the investor, particularly in times of high
market volatility. This was a problem cited by investors in credit derivatives and mortgage-backed
securities (MBSs) around the time of the financial crisis.
• The product will have to be held to maturity to secure any gains, unless it is a listed structured
product. Even with listed structured products, the sale of a structured product before maturity is
likely to be at a significant discount.

Furthermore, the fees payable for these products will be higher than for many simpler products or via
holding the assets directly.

The structured products may utilise a complex set of instruments, illiquid securities or custom-created
OTC derivatives. The cash flows and pricing of such products may, therefore, not be very transparent to
the investor, particularly in times of high market volatility. Often the only source of periodic pricing of
an SIP is provided by the manufacturer itself so there may be conflicts of interest. These were some of
the problems cited by investors in credit derivatives and mortgage-backed securities (MBSs) around the
time of the financial crisis.

Example
Bitcoin-linked note

Another example of a structured product could be a EUR five-year Bitcoin-Gold Switcher Note. The
investor receives 6% pa in euros and at maturity receives the principal (€100 face value per note) plus
the higher of the double the compounded Bitcoin or gold bullion return at the end of the period. If a
loss has been incurred, it will be deducted from the principle up to the full amount so possibly 100%
of the face value. The note pays a much higher than market interest rate to entice investors, however
they bear substantial risk at redemption. Such a structure would provide income and substantial upside,
while effectively offering a limited risk means of investing in two types of assets which are often seen as
alternatives to traditional central bank-controlled currencies.

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 Asset Classes

Let us consider two scenarios. Assuming that upon purchase the gold spot price is $1,800 per ouce
and Bitcoin is $19,000, after five years gold price is $2,200 and BTC is trading at $12,000. The investor
would receive the 6% annual interest paid in euro and at maturity would receive the final 6% coupon
plus €144.44 for a total of €150.44. The increase over face value represents twice (2x) the 22.22% return

2
on gold, while BTC suffered a loss over the period. Alternatively, if after five years, gold has fallen to
$500 per ouce and BTC has fallen to $8,000, the investor would receive the final 6% coupon but no
principal, reflecting the fact that both gold and BTC have lost more than 50% over the period leading
to a complete loss of the face value of the notes. The total return on the notes would be –30.2%, still an
improvement compared to investing directly in the assets, due to the relatively high coupon rate which
mitigates the loss on the two ‘switching’ assets.

For less visibly traded and little-known SIPs, investors should enquire on a number of points before
investing. For example, how much of the instrument has been issued? Are institutions invested in it or
only retail and smaller investors? Is the product issued by the firm selling it or is it part of a syndicate?
Are there any firms involved in its creation and sale which are not highly regarded? How creditworthy is
the issuer/manufacturer?

Structured investment products can offer extremely customised risk-return payoffs and access to
exposure in many assets not offered by traditional securities markets, but the many disadvantages or
specific risks must be carefully considered to determine suitability.

Exercise Answers

Exercise 1
a. Calculate the flat yield on a 4% gilt, redeeming in eight years and priced at £98.90.
(4/98.90) x 100 = 4.04%

b. Calculate the flat yield on a 7% gilt, redeeming in three years and priced at £108.60.
(7/108.60) x 100 = 6.45%

Exercise 2
The share value of the conversion choice is currently 15 x £6.40 = £96.
The bond is trading at £110, so the premium is £14 per £100 nominal value.
Expressed as a percentage: 14/96 x 100 = 14.6%.

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Exercise 3
a.

Time Cash flow Discount factor Present value

End of year one $100 1/1.06 94.33
End of year two $1,100 1/1.062 978.99
Sum of the individual present values = price of the bond $1,073.33

b.

Time Cash flow Discount factor Present value

End of year one $100 1/1.04 96.15
End of year two $1,100 1/1.042 1,017. 01
Sum of the individual present values = price of the bond $1,113.16

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 Asset Classes

End of Chapter Questions

1. What is the key difference between an ordinary share and a bearer instrument?

2
Answer reference: Section 1.1

2. What are the four types of preference share?

Answer reference: Section 1.2

3. What is the date on which a borrower agrees to pay back the nominal value of a bond known as?
Answer reference: Section 2.1

4. What are three drawbacks in using flat yield as a robust measure in assessing bond returns?
Answer reference: Section 2.3.3

5. What is an index ratio used for?

Answer reference: Section 3.2.1

6. What are two of the serious drawbacks with investing in cash?

Answer reference: Section 5.1

7. How do global depositary receipts differ from American depositary receipts?

Answer reference: Section 7.1

8. What are the two types of transaction conducted on the FX market and how do they differ?
Answer reference: Section 8.1

9. Name four typical risks encountered in an individual UCIS.

Answer reference: Section 9.1.1

10. Which type of investment trust can invest in unquoted private companies as well as quoted
companies?
Answer reference: Section 9.2.3

97
98
Chapter Three

Markets

3
1. The Primary and Secondary Markets 101

This syllabus area will provide approximately 1 of the 100 examination questions
100
 Markets

1. The Primary and Secondary Markets

Learning Objective
3.1.1 Know the principal characteristics of, and the differences between, the primary and secondary
markets. In particular: uses of primary and secondary markets; users of the primary and

3
secondary markets; the role of the governing authority

Stock exchanges are organised marketplaces for issuing securities and then trading those securities via
their members. All stock exchanges provide both a primary and a secondary market.

1. The primary market, or the new issues market, is where securities are issued for the first time. The
primary markets exist to enable issuers of securities, particularly companies, to raise capital, and to
enable the surplus funds held by potential investors to be matched with investment opportunities
the issuers offer. It is a crucial source of funding. The terminology often used when companies raise
capital on a stock exchange is that they access the primary market and float. The process that the
companies go through when they float is often called the initial public offering (IPO). Companies
can use a variety of ways to achieve this flotation, such as offers for investors to subscribe for their
shares (offers for subscription).
2. The secondary market is where existing securities are traded between investors. Stock exchanges
and other trading venues, such as multilateral trading facilities (MTFs), provide systems to assist in
this. These systems provide investors with liquidity, giving them the ability to sell their securities if
they wish. Trading activity in the secondary market also results in the ongoing provision of buy and
sell prices to investors via the exchange’s member firms of stockbrokers and investment banks.

1.1 Users of Primary Markets

Issuers of new securities, such as corporations engaging in IPOs or follow-on offerings, as well as the
issuers of certain kinds of debt instruments, are the main suppliers of new securities in the primary
markets.

The main purchasers of newly-issued securities are large institutional investors, such as pension funds,
insurance companies and collective investment vehicles, such as exchange-traded funds (ETFs) and
mutual funds, who buy the securities being offered on behalf of their clients, who are primarily members
of the general public.

1.2 Users of Secondary Markets

In the secondary market, where existing securities are bought and sold throughout the daily trading
sessions, there will be a variety of participants. In addition to the previously mentioned institutional
investors engaged in the purchase of newly issued securities, these same institutions will, as a result of
changes in their asset allocation decision-making, be engaged in selling previously owned securities
within their portfolio and, in turn, adding other securities which have previously been available on the
secondary market. The constant shifting of priorities in portfolio allocation constitutes a large part of the
transactional volume which arises each day, for example, in the activities of the London Stock Exchange
(LSE) and the New York Stock Exchange (NYSE).

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Also the secondary markets will be used by short-term speculators and traders who may hold securities
for very short periods – perhaps seconds, minutes or hours – when the motivation is to attempt to make
profits from anticipating the direction of short-term price changes in the variety of securities which are
available for trade in the secondary markets.

Members of the general public also access shares on the secondary market through stockbrokers and
through direct investing platforms. Both buyers and sellers of existing shares and debt instruments are
trading in the secondary market.

Increasingly, the principal users of secondary markets are various funds and trading vehicles which
engage in automated trading strategies that are triggered by computer-programmed algorithms. These
algorithmic trading strategies can be very short-term, perhaps involving buying one minute, and selling
the next, and trigger automatically executed trades on multiple occasions each day. When the objective
is to exploit transitory price discrepancies, such strategies are referred to as high-frequency trading
(HFT).

1.3 Motivations for the Use of Primary and Secondary

Markets
The principal reason behind the primary markets is for issuers, like companies, to raise capital by
accessing the substantial market made up of potential investors. The issuers might want to raise capital
for a variety of purposes, such as business expansion or acquisitions, and the buyers of the offerings may
want to allocate their capital across what they perceive as attractive investment opportunities.

It is not always the issuer that receives the proceeds of the shares sold in an IPO. It is often the case that
some, or all, of the shares being sold are already in existence and the recipients of the proceeds of the
IPO sale are the selling shareholders. This is illustrated by the IPO of Saudi Aramco that saw a substantial
stake sold by the Saudi Arabian government.

Example
Saudi Aramco is often discussed as one of the world’s biggest companies. As it approached its IPO in
December 2019, it was considered by many to be worth approximately $2 trillion. Prior to going public,
the oil giant was 100% owned by the Saudi Arabian state. As part of ‘Vision 2030’, the Saudi government
is investing heavily and moving away from its over-reliance on oil. So, it sold around 1.7% of Saudi
Aramco in an IPO which raised around $29.4 billion – money that will enable significant government
spending to rebalance the economy in line with its vision for the future.

In general terms, buyers of the securities in an IPO have longer-term investment objectives. However,
some activity in the primary market – such as when there is a highly publicised IPO – may be for short-
term speculative purposes. The manner in which some buyers of newly-issued securities buy a new
offering, and then, in the midst of some rather exaggerated market excitement about the new issue, sell
it shortly afterwards, is known as flipping, an extreme form of short-term trading.

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 Markets

When the promoters or underwriters (see chapter 4) of an IPO receives orders for more shares than are
being sold, the offering is said to be ‘oversubscribed’ and, in this case, the initial trades in the secondary
market may be significantly higher than the price set for the IPO.

The principal use and benefit of secondary markets is that they provide a liquid environment within
which owners of securities can sell a current holding and where willing buyers can purchase existing
securities. The larger capitalisation issues are usually bought and sold in substantial amounts during

3
each trading session and the spread, ie, the difference between the price that the securities are being
offered at – or the ask price – and the price at which buyers are prepared to buy these securities – the
bid price – is narrow. One characteristic of a liquid market is that spreads are narrow. Another feature
which provides for more liquidity is the activity of speculators – including HFT activities – where the
continuous buying and selling of securities with very short-term holding period horizons provides a
depth to the secondary market, which would not be available if the secondary market only existed for
institutions seeking longer-term investment reallocations.

1.4 The Role of the Governing Authority

Each jurisdiction has its own governing rules and regulations for companies seeking a listing,
and continuing obligations for those already listed. For example, the UK has the United Kingdom
Listing Authority (UKLA) which is a division of the Financial Conduct Authority (FCA). The formal
description of the UKLA is that it is the competent authority for listing – making the decisions
as to which companies’ shares and bonds (including UK government bonds or gilts) can be
admitted to be traded on the LSE. The rules are contained in a rule book called the Listing Rules
(www.handbook.fca.org.uk/handbook/LR.pdf).

The UKLA sets the rules relating to becoming listed on the LSE, including the implementation of any
relevant EU directives. The LSE is responsible for the operation of the exchange, including the trading
of the securities on the secondary market, although the UKLA can suspend the listing of particular
securities and, therefore, remove their secondary market trading activity on the exchange.

Developed markets generally have a similar structure to the UK. The US Securities and Exchange
Commission (SEC) requires companies seeking a listing on the US exchanges, such as the NYSE and
Nasdaq, to register certain details with the SEC first. Once listed, companies are then required to file
regular reports with the SEC, particularly in relation to their trading performance and financial situation.

In China, the relevant regulator for new listings is the China Securities Regulatory Commission (CSRC),
although the exchanges themselves (the Shanghai and Shenzhen stock exchanges) also have significant
authority over new issues.

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 End of Chapter Questions

1. What is the definition of the primary market?

Answer reference: Section 1

2. What is an IPO?
Answer reference: Section 1

3. Where might secondary trading take place?

Answer reference: Section 1

4. Who are the main investors in newly issued securities?

Answer reference: Section 1.1

5. What will asset allocation changes result in?

Answer reference: Section 1.2

6. Why would an investor in the secondary market employ HFT?

Answer reference: Section 1.2

7. What is the main motivation for issuers in the primary market?

Answer reference: Section 1.3

8. What is the benefit of the secondary market?

Answer reference: Section 1.3

9. Who is the governing authority for listing in the UK?

Answer reference: Section 1.4

10. Who is the governing authority for listing in the US?

Answer reference: Section 1.4

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Chapter Four

Primary Markets

4
1. Types of Offer 107

2. Participants in an Equity Offering Securities 115

3. Stock Exchanges 119

4. Bond Offerings 123

This syllabus area will provide approximately 14 of the 100 examination questions
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 Primary Markets

1. Types of Offer

1.1 Initial Public Offerings (IPOs)

Learning Objective
4.1.1 Understand the use of an initial public offering: why would a company choose an IPO; structure
of an IPO – base deal plus greenshoe; stages of an IPO; underwritten versus best efforts

4
An IPO is the initial public offering of a company’s shares which, until the IPO, were privately owned (and
controlled) by a small group of investors. The owners prior to the IPO are likely to include the founders
of the company and/or relatives or close acquaintances and early stage investors, such as private
equity (PE) or venture capital (VC) funds. By issuing company shares via an IPO, which is also known as
‘going public’, the original owners are giving up a substantial amount of control, as the new owners,
shareholders, will not only own stock in the company, but will also have voting rights. These rights will
enable the new shareholders to be included in decision-making procedures and to elect the board of
directors. It is possible that public shareholders may have different interests from the existing owners,
as owners of listed shares are usually most interested in an increased share price. Furthermore, they can
sell their shares on the market and the existing owners will lose control over who becomes a shareholder
(and, therefore, a decision-maker) in the future.

The key advantages of IPOs over other capital-raising methods are that IPOs can raise substantial sums
of capital and create a great deal of publicity for the issuing companies. The money raised in the form of
an IPO is known as risk capital and the company assets are not encumbered or hypothecated in the same
manner as they would be if the capital were raised from a debt offering.

An IPO is usually structured with a base number of shares that the company is planning to issue.
However, the issuing company may also reserve the right to increase the number of shares it issues, if
significant levels of demand would remain unsatisfied if only the base number of shares were issued. The
option to increase the number of shares by a pre-set maximum is referred to as a greenshoe, or an over-
allotment clause. The terms of the clause are included in the underwriting documents.

There are three broad stages to an IPO:

1. The decision – the issuing company (in conjunction with its advisers, particularly an investment
bank) makes a decision to raise capital via an IPO. This will involve careful consideration of the pros
and cons of a public offer.
2. The preparation of the prospectus – the act of preparing this official document that outlines the
terms of the IPO involves the whole team of advisers, including the investment bank, reporting
accountants and legal advisers.
3. The sale of securities – the investment bank will lead-manage the sale and may well establish a
syndicate of co-managers to assist in selling the securities to its clients.

107
The underwriting of the offer is generally the responsibility of the investment bank or banks that
manage the sale. Often the bank (or banks) arranges ‘firm’ underwriting when there are guarantees in
place to buy the securities. Sometimes, the investment banks may not provide a firm undertaking for all
of the securities. Instead, the lead underwriter, along with the co-managers of the offer, may provide a
‘best efforts’ underwriting, in which they will do their best to sell the shares involved in the offering but
where there is no formal guarantee that this will be achieved. In practice, this means that the managers
of the underwriting are not committing to purchase any unplaced securities for their own account in an
unconditional manner. By an underwriter and the co-managers inserting the best efforts conditionality,
should there be a failure to fully complete a sale of the offering, the underwriter will avoid the immediate
monetary loss that purchasing the shares would entail. However, the result might be that the underwriter
will suffer reputational damage and become less likely to be invited to participate in future IPOs.

Example
Saudi Aramco: The world’s biggest IPO

The world’s biggest ever IPO occurred in December 2019 – it was the initial public offer of the Saudi
Arabia oil giant Saudi Aramco.

Decision – the sale of a stake in state-owned Aramco initially targeted selling 5% of the company to a
combination of local and global investors. With an estimated value of the company of $2 trillion, a 5%
stake would raise around $100 billion. The decision was supported by a group of ‘joint financial advisors’
that consisted of seven international banks (Citigroup, Credit Suisse, Goldman Sachs, HSBC, JPMorgan,
Merrill Lynch/Bank of America and Morgan Stanley) and two local banks (NCB Capital and Samba).

Prospectus – a huge document of over 250 pages, excluding the financial statements and appendices,
was produced in conjunction with a large panel of banks, local and international law firms and two firms
of accountants (EY acting as financial due diligence advisor and PwC as independent auditor).

Sale of securities – after scaling back some of the international ambitions, the IPO mainly targeted local
and regional investors with a base number of 3 billion shares, representing 1.5% of the issued share
capital. A group of 25 banks acted as underwriters, and the shares were sold at SAR 32 each ($8.53),
raising around $25.6 billion for the selling shareholder, the Saudi government.

1.2 Follow-on Offerings

Learning Objective
4.1.2 Understand the use of follow-on offerings: why would a company choose a follow-on
offering; structure of a follow-on – base deal plus greenshoe; stages of a follow-on offering;
underwritten versus best efforts

An already listed company looking to raise more capital can choose to go through a follow-on offering.
A follow-on offering is alternatively referred to as a secondary offer. Clearly, issuing more shares in a
follow-on offering will only be considered if the equity markets are sufficiently robust. In a bear market,
there is unlikely to be sufficient demand for the shares at the price the issuing company wants.

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 Primary Markets

Like an IPO, a follow-on offering will be structured with a base number of shares that the company
is planning to issue. Again, the issuing company may also retain a greenshoe option to increase the
number of shares that it issues, if significant levels of demand would otherwise remain unsatisfied.

A secondary offering will inevitably be quicker, easier and cheaper than an IPO, simply because the
company has been through the stages before in its IPO. The broad stages of a follow-on offer are the
same as an IPO:

1. The decision.
2. The preparation of the prospectus – this should be relatively easy, since the issuing company has

4
prepared a prospectus before, when it first became a listed entity.
3. The sale of securities – as in an IPO, the appointed investment bank will lead-manage the sale and
may well establish a syndicate of co-managers to assist in selling the securities to its clients.

As with an IPO, the follow-on offering may also be underwritten, with a potential combination of firm
underwriting by the investment bank(s) and best efforts underwriting by other banks and stockbroking
firms.

As with an IPO, a follow-on offering is said to be underwritten when there is a firm undertaking by the
investment bank(s) that is conducting the offering that all of the offering will be fully subscribed. In
other words, the underwriting bank(s) will guarantee that any shortfall by subscribers will be purchased
by the bank(s) for its own account.

A best efforts agreement provides no such guarantee. In this case, the underwriting bank(s) agrees to
use its best efforts to sell as much of an issue as possible to the public. If the underwriter is unable to sell
all of the offering because of adverse market conditions, they do not take responsibility for placing any
of the unsold inventory. Arrangements that are made on a best efforts basis are often found with high-
risk securities.

1.3 Offers for Sale

Learning Objective
4.1.3 Understand the use of offers for sale: why would a company choose an offer for sale; structure
of an offer for sale; stages of an offer for sale; tenders, strike price, who may receive an
allotment, who is involved in the offer process

Offers for sale are the most common way of achieving a listing. The company seeking to sell the shares
approaches an issuing house (usually an investment bank) that specialises in approaching potential
shareholders and preparing the necessary documentation. The issuing company sells its shares to the
issuing house (usually an investment bank), which then invites applications from the public at a slightly
higher price than the issuing house has paid and on the basis of a detailed prospectus, known as the
offer document. For a company applying for a full listing, this provides comprehensive information
about the company and its directors and how the proceeds from the share issue will be applied. This
document must be prepared by the company’s directors and assessed by their sponsor to satisfy the
regulatory authorities of the company’s suitability to obtain a full listing.

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Diagrammatically:

Company

Shares £

Issuing House

£ £
Shares Shares Shares Shares
£ £

Investor Investor Investor Investor

1 2 3 4

Offers for sale do not necessarily require the company to create new shares specifically for the share
issue. Indeed, offers for sale are often used by a company’s founders to release part, or all, of their
equity stake in their company, and have also been the preferred route for government privatisation
programmes, when former nationalised companies have been sold to the public. In both cases, existing
shareholdings are disposed of, rather than new shares created, in order to obtain a listing.

An offer for sale can be made on either a fixed- or a tender-price basis:

Fixed-price offer – when a fixed-price offer is made, the price is usually fixed just below that at which
it is believed the issue should be fully subscribed, so as to encourage an active secondary market in the
shares. Subscribers to a fixed-price issue apply for the number of shares they wish to purchase at this
fixed price. If the offer is oversubscribed, as it nearly always is, given the favourable pricing formula,
then shares are allotted either by scaling down each application or by satisfying a randomly chosen
proportion of the applications in full. The precise method used will be detailed in the offer document.

Tender offer – given the judgement required in setting the price at a level that does not lead to the
issue being excessively oversubscribed but which leads to a successful new issue, and the fact that
market sentiment can and often does change between the announcement of the IPO and the end of
the offer period, offers for sale can be made on a tender basis when the issuer does not stipulate a fixed
price for the shares but invites tenders for the issue, usually by setting a minimum tender price. Investors
state the number of shares they wish to purchase and state the price per share they are prepared to pay.

Once the offer is closed, a single strike price can then be determined by the issuing house or by the
company, as appropriate, to satisfy all applications tendered at, or above, this price.

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 Primary Markets

Although this auctioning process is the more efficient way of allocating shares and maximising the
proceeds from a share issue, tender offers are also more complex to administer and, as such, tend to be
outnumbered by fixed-price offers.

1.3.1 Over-allotment Options

An allotment provision used in an IPO that has become almost standard in the case of new offerings
undertaken by US investment banks is the greenshoe. It is known as the greenshoe option because
the term comes from a company founded in 1919 as Green Shoe Manufacturing Company, now called
Stride Rite Corporation, which was the first company to be permitted to use this practice in an offering.

4
More properly known by its legal title as an over-allotment option, the greenshoe provision gives the
underwriters of an IPO the right to sell up to an additional 15% of the original number of shares at
the IPO price in a registered securities offering, if demand for the securities is in excess of the original
amount offered. It is used as a tool in providing price stabilisation and a successful execution of the
offering on behalf of the issuer. In essence, it is one strategy that underwriters have developed which
enables them to smooth out price fluctuations if demand surges on the one hand, and to help support
the IPO if there are adverse market conditions.

The way a greenshoe operates is best illustrated by the following simplified example:

Example
ABC is a company planning an IPO and using the services of an investment bank. The number of shares
to be sold is initially agreed to be 100,000. The investment bank is also granted an over-allotment option
(the greenshoe) that enables it to buy a further 15,000 shares from ABC if demand is sufficient.

During book-building, the investment bank finds buyers for 115,000 shares rather than just 100,000. On
the day following listing, if the price of the shares holds at the listing price or higher, the investment
bank simply exercises the over-allotment option to cover the additional 15,000 shares sold.

In contrast, if ABC shares struggle to stay at the listing price and fall in the immediate aftermarket, the
investment bank can buy back 15,000 shares to help support the price. If it does this, the over-allotment
option will not be exercised.

By using the over-allotment provision, the issuer may ensure a more successful marketing and
distribution of the offering. However, some issuers have refrained from providing their underwriters
with a greenshoe option.

Example
Saudi Aramco: Greenshoe in the world’s biggest IPO

As seen, the world’s biggest was the IPO of the Saudi Arabia oil giant Saudi Aramco in December 2019.
The IPO consisted of a base number of 3 billion shares, representing 1.5% of the issued share capital, but
the banks were given the option to sell a further 15% (450 million shares). This greenshoe option was
exercised, with the IPO overall proceeds increasing from the initial $25.6 billion to approximately $29.4
billion.

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1.4 Selective Marketing and Placing

Learning Objective
4.1.4 Understand the basic process and uses of selective marketing and placing: advantages to the
issuing company; what is a placing; what is selective marketing; how is a placing achieved; how
is selective marketing achieved

In placing its shares, a company simply markets the issue directly to a broker, an issuing house or other
financial institution, which in turn places the shares with selected clients. Although the least democratic
of the three IPO methods, given that the general public does not initially have access to the issue, a
placing is the least expensive, as the prospectus accompanying the issue is less detailed than that
required for the other two methods and no underwriting is required.

Placings can be used for IPOs but also for secondary (or follow-on) issues. If the company is based in a
jurisdiction that gives shareholders pre-emptive rights, a resolution at a shareholders’ meeting will be
required to enable the placing to happen.

A placing is often referred to as a selective marketing, because the intermediary is selecting the clients
to whom the offer is directed.

Diagrammatically:

Company

Shares £

Issuing House

£ £
Shares Shares Shares Shares
£ £

Selected Selected Selected Selected

Client Client Client Client
1 2 3 4

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 Primary Markets

1.4.1 Private Placements

For most public offerings of securities a vital prerequisite is a prospectus or offering document which
the issuer has to make available to all prospective investors and the exchanges upon which it intends
to list its securities. The prospectus has to fully disclose all the pertinent details regarding the offering,
including a detailed business plan, an explanation of how the proceeds from the offering will be used,
details of all owners/directors of the entity, and most importantly a comprehensive disclosure of all of
the risks associated with the investment.

A special provision exists for offerings marketed to a restricted class of investors, known as either

4
sophisticated, qualified or accredited investors. These investors, and the investment banks who advise
them, are able to purchase investments through which a formal prospectus is either not issued, or when
the regular disclosure requirements associated with issuing shares are far less onerous than those which
would be required for a public offering.

The specific requirements for this type of offering in the EU are outlined in the Prospectus Directive (PD).
In the US, the SEC also has special provisions for these so-called private placements. The most frequently
used exemption is Regulation D (often shorted to ‘Reg D’).

1.5 Introductions

Learning Objective
4.1.5 Understand the use of introductions: why would a company undertake an introduction;
structure of an introduction; stages of an introduction

An introduction is not actually an issue at all. It is used by a company that wishes to become listed
in order to gain access to the secondary market that an exchange will provide. Listing by way of
introduction is fairly common on many emerging market exchanges.

An introduction is unusual because most companies use listing as an opportunity to raise extra funds
and some companies are forced to issue more shares to comply with regulations that typically require
a minimum percentage of shares to be held by people other than the founders and other significant
shareholders.

An introduction is used by a company that does not need to raise extra capital through share issues, but
wishes to gain the extra liquidity in its shares that a listing provides. This might be a company that is
already listed on another, overseas stock exchange, a new company formed from two previously listed
companies that have merged, or a demutualised organisation.

As an introduction does not raise funds, it is not a marketing operation in the same way as an offer for
sale, offer for subscription or placing.

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1.6 Exchangeable/Convertible Bond Offerings

Learning Objective
4.1.6 Understand the use of exchangeable/convertible bond offerings: the difference between
exchangeable and convertible bonds; structure of an offering – base deal plus greenshoe;
stages of an offering; underwritten versus best efforts

Exchangeable bonds and convertible bonds are similar instruments – they both can be described as
hybrid instruments, with characteristics of both equities and bonds. A convertible bond is a bond,
paying a coupon and with a nominal value to be repaid on maturity, that offers the holder of the bond
the right to convert the bond into a set number of ordinary shares of the company that issued the bond.

Example
XYZ plc issues convertible bonds paying a 6% annual coupon and redeeming in five years’ time. The
holder of the convertible can choose to convert £100 nominal value of the bonds into 25 XYZ plc shares
at redemption.

The holder of the bonds will convert as long as the shares are trading at more than £4 each (£100
divided by 25 shares) at the redemption date. Say the shares are trading at £4.60 each at redemption, by
converting the bondholder will get 25 x £4.60 = £115 worth of securities. This is preferable to the £100
alternative.

An exchangeable bond is also a bond that pays a coupon and has a set redemption date. Like a
convertible, it gives the holder the right to exchange the bond for a set number of shares, but these
shares are not those of the bond issuer, but of another company’s shares that are held by the issuer.

Example
A listed company holds ABC plc shares and issues exchangeable bonds paying a 6% annual coupon
and redeeming in five years’ time. The holder of the exchangeable bonds can choose to convert £100
nominal value of the bonds into 20 ABC shares at redemption.

Clearly the holder of the bonds will exchange as long as the ABC shares are trading at more than £5 each
(£100 divided by 20) at the redemption date.

The holder of either a convertible or an exchangeable bond has the safety of coupons and repayment,
combined with the potential upside of equity growth. Both types of bond will enable the issuer to
raise borrowed funds more cheaply, because the bonds have the upside potential of the conversion/
exchange into shares.

The structure of an offering of a convertible or exchangeable bond mirrors that of equities – the issuer
will set a base amount of bonds it wishes to issue and perhaps retain a greenshoe, reserving the right to
issue more if demand is strong.

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 Primary Markets

The stages of the convertible/exchangeable offer are the same as an IPO:

1. The decision – the issuing company (in conjunction with its advisers, particularly an investment
bank) makes a decision to raise capital via a convertible/exchangeable instrument. This will involve
careful consideration of the pros and cons of issuing such an instrument.
2. The preparation of the prospectus – the act of preparing the official document that outlines the
terms of the convertible/exchangeable instrument.
3. The sale of securities – the investment bank will manage the sale of the convertibles/exchangeables
and may establish a syndicate of co-managers to assist in selling the securities to its clients.

4
As with an IPO, the offer may also be underwritten, with a potential combination of firm underwriting
by the investment bank(s) and best efforts underwriting by clients of the investment bank(s) such as
stockbroking firms.

2. Participants in an Equity Offering Securities

Deciding to list (or float) securities on a stock exchange, such as the New York Stock Exchange (NYSE),
the London Stock Exchange (LSE), or any of a host of other exchanges worldwide, is a significant decision
for a company to take. Flotations have both pros and cons – the fact that the company can gain access
to capital and enable its shares to be readily marketable are often-quoted positives. The most often-
quoted negatives are the fact that the original owners may well lose control of the company and that
the ongoing disclosure and attention paid to the company after listing is much greater than previously.

2.1 Listing Advisers and Continuing Obligations

Learning Objective
4.2.2 Know the role of advisers: listing agent; corporate broker; nominated advisor (nomad)
4.2.3 Know the issuer’s obligations: corporate governance; reporting

In order to have its securities listed, the company concerned will have to find and appoint certain
advisers. The precise requirements and roles are laid down in the local regulations that apply to the
particular exchange. Generally, the advisers will include both a listing agent at the IPO stage and a
corporate broker to act for the company both at the IPO and afterwards.

Once the decision has been made to list, the company will have to find and appoint a listing agent,
alternatively referred to as a sponsor. The sponsor is likely to be an investment bank, a stockbroking
firm or a professional services firm such as an accountancy practice. The role of the sponsor includes
assessing the company’s suitability for listing, the best method of bringing the company to the market,
and coordinating the production of the prospectus. The prospectus is a detailed document about the
company, including financial information that should enable prospective investors to decide on the
merits of the company’s shares. In certain markets, such as the London Stock Exchange’s AIM, the listing
agent or sponsor is referred to as the nominated advisor or ‘nomad’). The particular responsibilities of
the ‘nomad’ on the LSE’s AIM are detailed in section 3.1 of this chapter.

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The sponsor is only part of the origination team helping the company in the flotation. In addition to the
sponsor, the issuing company will appoint a variety of other advisers, such as reporting accountants,
legal advisers, public relations (PR) consultants and a corporate broker.

The reporting accountants (also sometimes referred to as the ‘public auditors’) will attest to the validity
of the financial information provided in the prospectus. The legal advisers will make sure that all relevant
matters are covered in the prospectus and that the statements made are justified. The combination of
the reporting accountants and the legal advisers is said to be providing due diligence for the prospectus
– making sure the document is accurate and complies with the regulations.

A PR consultant is generally appointed to optimise the positive public perception of the company and
its products and services in the run-up to listing.

Finally, the origination team is likely to include a corporate broker, who may be the same firm as the listing
agent. The responsibilities of the corporate broker are to act as an interface between the company on the
one hand, and the stock market and investors in the company’s securities on the other. In particular, the
corporate broker advises the company on market conditions – the way existing and potential investors
are viewing the company in relation to its peers, and the general direction of the market.

An issuer that is planning to have its securities listed will have to accept certain obligations. Like the
requirements for advisers, the precise obligations can vary across jurisdictions, but they always include
obligations in relation to good corporate governance and regular reporting.

Corporate governance is the way a company (the corporate) manages and controls its activities (governs
itself). Corporate governance is often described as the set of laws, rules, customs and both external and
internal policies that guide how a company is directed and managed. In particular, it is expected (and,
in some jurisdictions, required) that the listed companies have put in place appropriate corporate and
management structures. Examples include reducing the influence of a single individual by splitting
the roles of chairman and chief executive of the company, appointing a reasonable proportion of non-
executive directors (NEDs) to the board, and having a suitably qualified finance director.

Reporting requirements are designed to make sure that existing and potential investors are kept
informed of progress and developments at the listed company. It is particularly important that
financial information is provided regularly and that the information is reliable, and so listed companies
are generally required to provide audited annual accounts; and less detailed half-yearly, or perhaps
quarterly, reports.

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2.2 The Syndicate Group

Learning Objective
4.2.1 Understand the role of the syndicate group: different roles within a syndicate: book runner,
co-lead; co-manager; marketing and book-building

For large listings, when the issuing company is planning to issue substantial quantities of shares to
interested investors, the sponsor will gather together a syndicate of investment banks and stockbrokers

4
to market the share issue to their clients. These clients may be a mixture of both institutional clients
(such as insurance companies and asset management firms) and retail clients. The sponsor will generally
act as the lead manager of the syndicate, appointing a host of co-managers to assist. Sometimes, the
issue may be large enough to warrant the appointment of more than one lead manager, perhaps with
each co-lead manager taking responsibility for particular geographical areas – for example, one lead
manager for Europe, another for the US.

The process of finding buyers for the issuing company’s shares is known as bookbuilding, and the lead
managers coordinate the overall level of demand across the syndicate. This role is commonly referred to
as that of the book runner.

During the book-building, the syndicate will gather the willingness of investors to purchase the shares,
which will be sensitive to the price at which the shares are sold. Usually, the book-building begins with
an indicative range of prices; the finalisation of the price will come just prior to listing. This is illustrated
in the following example.

Example
Cauldron Stanley is a large investment bank. It is acting as lead manager and sponsor for a new issue of
shares for a client, Wizard Enterprises plc, which is looking to raise several billion pounds. Because of the
size of the issue, Cauldron Stanley sets up a syndicate of ten investment banks to assist in the marketing
and act as co-managers.

The syndicate initially markets the shares at an indicative price range of £2 to £2.20 each. The strength
of demand is strong so that, as listing approaches, the final price is set at the top of the range, at £2.20
per share.

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2.3 Underwriting

Learning Objective
4.2.4 Understand the purpose and practice of underwriting, rights and responsibilities of the
underwriter: benefits to the issuing company; risks and rewards to the underwriter

In circumstances where a company is attempting to sell shares to the investing public, there is a danger
that the demand is not sufficient, perhaps because of a general fall in share prices near to the flotation
date. This could lead to the flotation failing, so it is usual to underwrite new issues of shares. Underwriting
is agreeing with financial institutions, such as banks, insurance companies and asset managers, that, if
the demand is insufficient, the financial institutions will buy the shares. Effectively, underwriting creates
an insurance policy that the issue will happen because, in the worst case, the underwriters (the financial
institutions that have agreed to underwrite the offer) will buy the shares. The underwriters also work
closely with the issuing company, prior to an offering period, to determine demand for the shares, to
help determine an appropriate share price for the listing and in the distribution of the shares to their
network of institutional or retail clients.

In such circumstances, the price at which the underwriters guarantee to buy is generally at a discount to
the share price at which the shares are offered to the public, eg, shares offered to the public at £5 each
might be underwritten at £4.75 each.

The benefits to the issuing company of an underwriting arrangement are obvious – the sale of the
shares and minimum proceeds are guaranteed. For the underwriters, the risk is that they may end up
buying shares for more than they are worth. However, in return for accepting this risk, the underwriters
will be paid fees, regardless of whether or not there is a lack of demand for the shares from the public.

2.4 Stabilisation

Learning Objective
4.2.5 Understand stabilisation and its purpose: governing principles and regulation with regard to
stabilisation activity; who is involved in stabilisation; what does stabilisation achieve; benefits
to the issuing company and investors

Stabilisation is the process whereby, to prevent a substantial fall in the value of securities when a large
number of new securities are issued, the lead manager of the issue agrees to support the price by buying
back the newly issued securities in the market if the market price falls below a certain predefined level.
This is done in an attempt to give the market a reasonable chance to adjust to the increased number of
securities that have become available, by stabilising the price at which they are traded.

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By increasing the demand for the securities in the market at the same time as more securities become
available, the price should remain more stable. This will mean the issuing company’s securities appear
less volatile, and existing investors will be less likely to begin panic-selling, creating a downward spiral
in the security’s price. The securities that are bought back by the lead manager of the issue will then be
sold back into the market over time.

An alternative way of stabilising the price of shares after an IPO is to use a greenshoe option.

There are strict rules laid down by regulators regarding stabilisation practices. For example, the UK’s FCA
requires disclosure to the market that stabilisation is happening, and that the market price may not be

4
a representative one because of the stabilisation activities. Prices can also be stabilised by exchanges
using circuit breakers to temporarily suspend trading in periods of volatility.

3. Stock Exchanges

Learning Objective
4.3.1 Know the role of stock exchanges and their regulatory frameworks

The basic role of a stock exchange is to facilitate the secondary market trading of listed securities. Buyers
and sellers trade with one another over the exchange, and supply and demand for the listed securities
determines the price. Investments traded on exchanges can include common or preference shares, ETFs,
bonds and options. The participants include individuals, institutional investors, such as asset managers,
and insurance companies. Trades are arranged by stockbrokers (brokers) and the arranged trades will
often involve purchasing from, or selling to, a bank which is acting as a dealer or, in some cases, a market
maker. The larger banks that provide their clients with the capacity to both arrange and deal are often
termed broker/dealers.

There are major exchanges in each of the world’s financial centres, and their regulatory frameworks are
all broadly similar in that they must:

• determine which securities can be traded, most obviously laying down conditions that must be
satisfied before an issuing company is ‘quoted’ on the exchange
• lay down rules and regulations for subsequent trading of those securities by the participants
(‘members’) using the exchange.

Generally speaking, the regulatory framework that surrounds initial/primary and secondary markets in
securities consists of three strands – the law, the requirements of the local regulator and the rules of the
stock exchange itself. To illustrate the interaction of these three strands, it is instructive to look at the
framework that has developed in the UK.

Illustration – The Regulatory Framework Surrounding the LSE

The regulatory framework that lies behind the way that the LSE operates includes three major
constituents: the law (in particular the UK Companies Act), the requirements of the FCA and the rules laid
down by the exchange itself (in its rule book).

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The Companies Act details the requirements for companies generally, such as the requirement to prepare
annual accounts, to have accounts audited and for annual general meetings (AGMs). Of particular
significance to the LSE are the Companies Act requirements to enable a company to be a plc, since one
of the requirements for a company to be listed and traded on the exchange is that the company is a plc.

The FCA has to give its recognition before an exchange is allowed to operate in the UK. It has granted
recognition to the LSE and, by virtue of this recognition, the exchange is described as a recognised
investment exchange (RIE). In granting recognition, the FCA assesses whether the exchange has
sufficient systems and controls to run a market. Furthermore, the FCA (through its division; the UK Listing
Authority (UKLA)) lays down the detailed rules that have to be met before companies are admitted to the
Official List that enables their shares to be traded on the exchange.

The LSE also has its own rules in relation to who can access its systems and become members of the
exchange, as well as how those members must behave when trading on the exchange.

3.1 Admission Criteria for Listing

Learning Objective
4.3.2 Understand the purpose of admission criteria for main markets and how they can differ from
other markets listing smaller companies: appointment of advisers and brokers; transferability
of shares; trading record; amount raised; percentage in public hands; shareholder approval;
market capitalisation; costs

Listing securities, such as a company’s shares, is typically a two-stage process that aims to make sure
potential investors have relevant and reliable information about the securities and their issuer, and that
there are likely to be sufficient securities available to make them relatively easy to buy and sell.

The first stage usually involves the filing of a prospectus with the regulator that contains information
about the securities’ issuer, its history, financial situation and its operations. This will be coordinated by
a sponsor (generally an investment bank) and supported by reporting accountants vetting the numbers
and legal advisers ensuring the sponsor has discharged its legal responsibilities. The prospectus is filed
and made available to interested investors (the public).

The second stage is an application to the stock exchange to have the securities traded. The exchange
will want to see that there is at least a minimum number of shares held by persons other than the issuing
company’s directors and other dominant investors (a sufficient ‘free float’) and that there are investment
banks willing to buy and sell the securities once listed.

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It is common in developed markets around the world to have more than one market for company
securities: a major or main market for securities issued by the bigger, well-established companies, and
a junior market for securities issued by smaller, less well-known companies. Examples include the UK
and Hong Kong. In the UK, the LSE has established two markets for company securities: the Official
List and AIM (which originally stood for ‘Alternative Investment Market’). The Official (or full) List is the
senior market and is often referred to as the Main Market. Entry rules are stringent, ensuring that only
companies of a high quality can be involved. AIM was created with less stringent admission requirements
to provide a market for smaller, less well-established companies. In Hong Kong, the senior and junior
markets are referred to as the Main Board and the Growth Enterprise Market. The latter captures the
logic of providing a facility for trading smaller companies’ shares, where entry requirements are less

4
stringent. It is a fact that small companies can, if they are successful, grow very quickly and provide
extremely attractive returns to their early-stage investors.

The following outlines how the Main Market admission requirements typically differ from those of the
junior/growth market using the UK as an example.

The UK Main Market versus the Junior Market

The Main Market in the UK is typically referred to as the Official List and the criteria for admission to the
Official List are set out in the Listing Rules – a rule book is maintained by the UKLA, itself a division of the
regulator, the FCA.

The UKLA actually has two sets of requirements that may be met by an applicant to be admitted to
the Official List. The first is the so-called Standard Listing, with the requirements derived from the EU,
and the second is the so-called Premium Listing, which has further requirements over and above the
European minimum. Only equity shares are eligible for Premium Listing, so issuers of other securities,
such as bonds, can only seek a Standard Listing.

The main requirements contained in the Listing Rules for admission to a Premium Listing are:

• Every company applying for a listing must be duly incorporated (UK companies need to be plcs),
and must be represented by a sponsor (alternatively referred to as a listing agent), which will usually
be an investment bank, stockbroker, law firm or accountancy practice. The sponsor provides a link
between the company and the UKLA, guiding the company through the listing process.
• The expected market capitalisation of the company should be at least £700,000 for the company’s
shares to be listed.
• The company should have a trading record of at least three years.
• At least 25% of the company’s shares should be in public hands, or be available for public
purchase. The term ‘public’ excludes directors and their associates and anyone who holds 5%
or more of the shares.
• The company and its advisers must publish a prospectus, a detailed document providing potential
investors with the information required to make an informed decision on the company and its shares.
• The company must restrict its ability to issue warrants to no more than 20% of the issued share capital.
• Listing is not free, and a further requirement before a company’s shares can be admitted is that the
appropriate fee has been paid.

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For issuers listing debt securities, where the Premium Listing is not available, the requirements for
Standard Listing include that the aggregate market value of the debt securities should be at least
£200,000.

Once listed, companies are expected to fulfil certain continuing obligations: they are obliged to issue a
half-yearly report in addition to annual accounts, and they have to notify the market of any new, price-
sensitive information.

The UK’s Junior Market: AIM

In contrast to the Official List, to which access is via application to the UKLA and the UKLA’s Listing Rules
must be complied with, AIM companies’ application and regulations are set by the LSE. AIM companies
are usually smaller than their fully listed counterparts, and the rules governing their listing are much less
stringent. For example, there is no restriction on market value, percentage of shares in public hands or
trading history.

Among the more important rules for the AIM is the requirement that AIM companies need to have a
nominated adviser. The nominated adviser is often referred to as the ‘nomad’ and is typically a firm of
stockbrokers or accountants or an investment bank. Each nomad needs to be approved by the LSE for
assessing the appropriateness of the applicant for AIM, and for guiding and advising AIM companies on
their responsibilities under the rules of the market that have been laid down by the LSE.

The main requirements for a company’s shares to be admitted to the AIM are twofold:

1. That there is no restriction on the transferability of the shares.

2. That the AIM company appoints two experts to assist it:
a. the nominated adviser – as seen, the nomad can be thought of as an exchange expert, advising
the company on all aspects of AIM Listing Rules and compliance
b. the broker – AIM companies’ shares are usually less liquid than those of fully listed companies; it
is the broker’s job to ensure that there is a market in the company’s shares, to facilitate trading
in those shares and to provide ongoing information about the company to interested parties.

As with the Official List, the LSE imposes similar continuing obligations on AIM companies. There are
also certain other aspects in relation to AIM companies and their broker and nominated adviser:

• The broker and adviser can be the same firm; they are often firms of stockbrokers or accountants.
• If a company ceases, at any time, to have a broker or adviser, then the firm’s shares are suspended
from trading.
• If the company is without a broker or adviser for a period of one month it is removed from AIM.

Similar structures exist elsewhere in Europe, with two paths open to companies wishing to access
the primary market for capital – through markets regulated by the EU and through markets that are
regulated by the exchanges themselves. An important example is Frankfurt in Germany.

Example
On the Frankfurt Stock Exchange (FWB), a listing in the EU-regulated market can be in the General
Standard segment or in the Prime Standard segment. The market that the Frankfurt exchange itself
regulates includes the Scale segment.

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General Standard
The General Standard segment is primarily intended for medium-sized and large corporations who
seek to address national investors and want to use a cost-effective listing for that purpose. It has the
following key conditions:

• Valid and audited securities prospectus, satisfying the requirements of the Federal Financial
Supervisory Authority (BaFin).
• Reporting history dating back at least three years.
• Probable total price value of at least €1.25 million.
• Number of shares admitted to trading to be at least 10,000.

4
• Free-float to be at least 25%.

Prime Standard
The Prime Standard is considered to be the premium segment for raising equity with ongoing
requirements that exceed those of the General Standard. The Prime Standard sets the very highest
transparency requirements of all segments in the Frankfurt Stock Exchange and, indeed, in all of Europe.
The additional admission follow-up duties for the Prime Standard stand out not only for the higher
transparency yardstick but also because the requirements always have to be met in English. The Prime
Standard is, therefore, an attractive choice for issuers who want to appeal to international investors.

Scale
Scale for equities is the segment for small and medium-sized enterprises (SMEs). It targets German and
European SMEs seeking capital for growth.

4. Bond Offerings

4.1 Types of Issuer

Learning Objective
4.4.1 Know the different types of issuer: supranationals; governments; agency; municipal; corporate;
financial institutions and special purpose vehicles

Bonds are essentially IOU (I owe you) instruments that specify a face value, coupon rate and redemption
date. They are issued by a variety of organisations including:

• Supranationals – organisations like the World Bank raise money through issuing bonds.
• Governments – most governments have a requirement to borrow money at some stage, and the
long-term borrowing is generally financed by bond issues, such as UK gilts and US Treasury bonds.
• Agencies – agencies (often backed by the government) issue bonds for particular purposes. These
are common in the US, where examples include the Federal National Mortgage Association (‘Fannie
Mae’), created to provide mortgage finance for the disadvantaged, and the Student Loan Marketing
Association (‘Sallie Mae’) created to finance student education.

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• Municipalities – municipalities in the US issue municipal bonds to finance local borrowing. These
municipal bonds are often tax-efficient, particularly for investors who reside in that municipality.
Municipal bonds are usually guaranteed by a third party, known in the US market as a monoline
insurer, and their credit quality may be enhanced by such a guarantee, which enables the
municipality to secure funds on more advantageous terms.
• Corporates – large companies often use bonds, including convertible bonds to lower their
borrowing rate, to finance their capital expenditure needs to finance borrowing needs.
• Financial institutions and special purpose vehicles (SPVs) – like other corporates, financial
institutions issue bonds to finance borrowing. These financial institutions also arrange borrowing for
themselves and others by creating SPVs to enable money to be raised that does not appear within
the accounts of that entity. This type of finance is often described as off-balance-sheet finance
because it does not appear in the balance sheet that forms of part of the company’s accounts.

The use of SPVs continues to be popular in the asset-backed securities markets.

4.2 Bond Issuance

Learning Objective
4.4.2 Know the methods of issuance: scheduled funding programmes and opportunistic issuance,
eg, medium-term notes (MTNs); auction/tender; reverse inquiry (under MTN)

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

Example
The Debt Management Office (DMO) is the part of the UK Treasury that oversees gilt issues. It uses
a number of different issue methods, depending on the circumstances. Most commonly used is the
auction method, when the DMO announces the auction, receives bids and allocates the gilts to those
that bid highest, at the price they bid. Gilt-edged market makers (GEMMs) are expected to bid for gilts
when the DMO makes a new issue, and the DMO reserves the right to take the gilts onto its own books if
the auction is not fully taken up. Applicants bid for the gilt and successful bidders pay the price at which
they bid.

Imagine an auction is for £1m nominal.

• A offers to buy £0.5m nominal, willing to pay £101.50 for every £100 nominal.
• B offers to buy £0.5m nominal, willing to pay £100.75 for every £100 nominal.
• C offers to buy £0.5m nominal, willing to pay £100.50 for every £100 nominal.

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A and B are awarded the gilts for the prices that they bid and there is nothing left for C.

Up until 1987, instead of the auction method, the tender method was standard, when all bidders paid a
common strike price. In a tender, a minimum price is set by the DMO and investors make bids. The gilts
are awarded at the highest price at which they can all be sold.

Imagine the auction is for £1 million nominal and the minimum price is £100 for £100 nominal. The bids
submitted are:

• A offers to buy £0.5 million nominal, paying £101.50 for every £100 nominal.
• B offers to buy £0.5 million nominal, paying £100.75 for every £100 nominal.

4
• C offers to buy £0.5 million nominal, paying £100.50 for every £100 nominal.

In this instance, A and B are awarded the gilts, but both pay the lower price: £100.75 (the highest price
at which all the gilts could be sold).

As many issuers, particularly companies, needed to borrow money regularly in line with the
developments of their business, they tended to prefer to set up scheduled programmes with their banks
under which they would be able to borrow money, instead of issuing bonds.

However, a US innovation has been introduced that has been subsequently adopted in many other
jurisdictions which enables bond financing to be much more flexible. Traditionally, it was awkward and
expensive to regularly raise bond finance because each bond issue had to be separately registered with
the financial regulator (the SEC in the US). A process known as ‘shelf registration’ was introduced that
enabled a single registration to be used for a number of bond issues over a period of up to two years.
This has been heavily used in the medium-term note (MTN) market for bonds with generally two to ten
years between issue and maturity. Shelf registration introduced flexibility to the bond market, allowing
companies to issue smaller batches of bonds, with the coupons and maturity varying according to
market demand at the time.

The process involves the bond issuer finding two or more dealers that are willing to offer their services
to market the bonds to their clients on a best efforts basis. The issuer will then issue bonds as and when
the money is required, with coupon rates and maturity in accordance with market demand. Indeed, it is
not unusual for some MTNs to be issued in response to an enquiry from clients of the dealers that want a
particular maturity and coupon. These are termed reverse inquiries in the US, and the issuer can decide
whether to accept the terms and issue the bonds or not.

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4.3 The Role of the Origination Team

Learning Objective
4.4.3 Understand the role of the origination team including: pitching; indicative bid; mandate
announcement; credit rating; roadshow; listing; syndication

Many of the activities in originating bond issues are similar to those in originating equity issues,
particularly if the bonds are going to be listed and therefore need a prospectus. In such cases, there will
be a whole origination team involving the issuer, its investment bank, reporting accountants, legal and
PR advisers.

A typical new issue of bonds could contain any, or all, of the following stages:

1. Pitching – the issuer of the bonds will need to decide that a bond issue is appropriate and which
investment bank(s) it wants to assist in the issue. The final decision will be dependent upon an
assessment of the qualities of the potential banks. A final decision is usually made on the basis of a
presentation (pitch) made by the banks, to the issuer.
2. Indicative bid – during the pitching stage, the banks will detail their views of how much finance the
issuer is likely to raise given the terms of the bond issue.
3. Mandate announcement – once the issuer has decided upon the bank(s) to raise the finance on its
behalf, it will announce the names of the banks that have been given the mandate to arrange the
issue on its behalf.
4. Credit rating – given by one of the credit-rating agencies or an investment bank, this will be vital
to the amount of finance that can be raised. The details of the proposed terms and conditions
of the bond will have to be provided to get a credit rating, and there may be a need for credit
enhancements, such as insurance, to enable a higher rating to be achieved. Many larger institutions,
particularly pension funds or endowments may be constrained according to how much they can
invest in lower-rated bonds.
5. Roadshow – once the bank running the issue has been appointed, it will arrange and run a series of
visits to the potential buyers of the bonds. This is commonly described as the roadshow, because it
involves travelling around a number of major financial centres to see the key investors.
6. Listing – if the bond is to be listed it will need a prospectus to submit to the relevant listing authority.
7. Syndication – for larger bond issues there will be a number of banks acting for the issuer, described
as a lead manager (the primary contact with the issuer) and the other co-managers that will sell
into their particular client base, perhaps based on geographical regions. The total of all the banks
involved is the syndicate.

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End of Chapter Questions

1. What are the three broad stages to an initial public offering (IPO)?
Answer reference: Section 1.1

2. How does a tender offer differ from a fixed-price offer for sale?
Answer reference: Section 1.3

3. What is a greenshoe provision and what is the issue limit under this provision?

4
Answer reference: Section 1.3.1

4. What is a placing?
Answer reference: Section 1.4

5. How does a convertible bond differ from an exchangeable bond?

Answer reference: Section 1.6

6. What is the role of the listing agent or sponsor in an intial public offering (IPO)?
Answer reference: Section 2.1

7. What requires UK issuers to prepare annual audited accounts and hold annual general
meetings (AGMs)?
Answer reference: Section 3

8. For how long must a company applying for a Premium Listing in the UK have a trading record?
Answer reference: Section 3.1

9. What is a shelf registration?

Answer reference: Section 4.2

10. What is a reverse inquiry in relation to medium-term notes?

Answer reference: Section 4.2

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128
Chapter Five

Secondary Markets
1. Trading Venues 131

2. Methods of Trading and Participants 135

5
3. Stock Exchanges 140

4. Indices 145

5. Government Bonds 152

6. Corporate Bond Markets 156

7. Dealing Methods 158

This syllabus area will provide approximately 15 of the 100 examination questions
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 Secondary Markets

1. Trading Venues

Learning Objective
5.1.1 Understand the main characteristics and practices in the developed markets
5.1.2 Understand the main characteristics and practices in the emerging and frontier markets
5.1.3 Understand the purpose, role and main features of stock exchanges generally. In particular:
scope; provision of liquidity; price formation; brokers versus dealers
5.1.4 Understand the purpose, role and main features of alternative trading venues: off-exchange
trades; dark pools; OTC; private transactions; multilateral trading facilities

5
1.1 Developed Markets
Trading venues facilitate the purchase and sale of listed equities and have traditionally been dominated
by national stock exchanges, including the New York Stock Exchange (NYSE) in the US, the UK’s London
Stock Exchange (LSE), Germany’s Frankfurt Stock Exchange (FWB) and Japan’s Tokyo Stock Exchange
(TSE). Typically, these exchanges started out as meeting places, where buyers and sellers would gather
to carry out deals, and gradually developed to become regulated entities where one investor’s wish to
buy is matched with another investor’s wish to sell via middlemen (the brokers).

Examples of how many stock exchanges began as informal gatherings of traders are the Amex where
stocks were traded on the curb on Broad Street, as well as the Nairobi Securities Exchange whose
predecessor was the lounge of the Stanley Hotel. Later, once they moved to dedicated premises,
many securities exchanges utilised writing on chalk or marker boards to a room full of brokers in
order to disseminate quotes. Unsurprisingly, these exchanges have taken advantage of huge strides in
technology to introduce electronic systems that match orders efficiently and effectively. Also note that,
although many exchanges began only trading equities and were called ‘stock’ exchanges, most have
gradually introduced new products such as corporate bonds, options or ETFs and some have formally
changed their name to reflect this, going by the term ‘securities’ exchange.

Stock exchanges offer membership to investment banks and firms of stockbrokers. Becoming a member
of an exchange enables these banks and stockbrokers to be involved in secondary market trades. As a
consequence of the ongoing activities of the major participants in the secondary market – institutional
investors, banks, and speculators – these exchanges provide liquidity to existing and potential investors,
enabling existing investors to sell their securities and allowing potential investors to become actual
investors by purchasing securities. Furthermore, because these exchanges aggregate and integrate
the trading activity on their systems as well as some alternative venues, the prices at which trades are
executed is the market price at any given time. This is described as the price formation process, and
sometimes markets are characterised as price discovery mechanisms.

Brokers arrange deals for their clients, as well as potentially giving advice to their clients, as to which
securities they should buy, sell or retain. In return for arranging (and potentially advising), the brokers
will earn a commission that is typically calculated as a set percentage of the value of the deal. Acting as
a broker is often described as dealing as agent. The broker never actually buys or sells securities – the
broker is simply an agent that facilitates the transaction(s) between two parties. Firms of stockbrokers
tend to act as brokers on the stock exchanges.

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Dealers, in contrast to brokers, actually buy or sell securities. If a client wants to sell shares, a dealer may
buy those shares from the client; if another client wants to buy shares, a dealer may sell those shares
to the client. Acting as a dealer is often described as dealing as principal, because the dealer is taking a
principal position by either buying or selling the securities. It is the investment banks that tend to act as
dealers on the stock exchanges.

Firms, such as investment banks, that are involved in both acting as agent (broking) and as principal
(dealing), are often described as broker-dealers.

However, over recent decades, the equity markets in the developed world have seen a proliferation of
venues beyond the single national exchange. A number of developed markets now have a multitude of
regulated exchanges, plus a variety of so-called alternative trading systems (ATSs), including firms
(such as investment banks) that internalise their customers’ trades by executing them against other
customers’ trades or the firm’s own inventory.

Example
The US is the largest developed market in the world and its equity trading venues include the following:

• 23 registered ‘national securities exchanges’ including the two dominant exchanges, Nasdaq and
the NYSE
• more than 40 alternative trading systems, including those operated by investment banks, such as
Goldman Sachs, Morgan Stanley, UBS and Bank of America Merrill Lynch.

The same variety of venues for trading equities exists in developed markets elsewhere in the world
although, sometimes, the terminology differs a little, such as that introduced in the EU.

Example
In Europe, the terminology used was originally introduced by the Markets in Financial Instruments
Directive (MiFID). It distinguished three venues for trading equities:

1. Regulated markets – these are basically stock exchanges.

2. Multilateral trading facilities (MTFs) – these are systems other than regulated markets that are
operated and/or managed by a market operator which bring together multiple third-party buying
and selling interests in financial instruments (such as shares) in a way that results in a contract.
3. Systematic internalisers (SIs) – these are investment firms (such as investment banks) which, on an
organised, frequent, systematic and substantial basis, deal on their own account when executing
client orders outside other markets.

A second Markets in Financial Instruments Directive (MiFID II) was subsequently introduced in early
2018 that added a fourth type of venue – the organised trading facility (OTF). This venue type is for
instruments other than equities, such as bonds or derivatives, where multiple third-party buying and
selling interests are able to interact in a way that results in a contract.

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Over-the-counter (OTC) is the term given to trading which is conducted by networks of dealers and
when the trading is not coordinated or subject to the formal procedures and standardised formats of an
exchange.

Dark pool is the term that refers to a trading system where stocks are traded without the order price
being displayed until after the trade is complete. The term ‘dark’ is used to describe the fact that order
price information cannot be seen. Trading undertaken in dark pools is commonly described as dark
liquidity. The opposite of dark pools are known as ‘lit pools’.

One investment manager has described the appeal of dark liquidity pools as follows ‘a dark pool is a
way you can hopefully capture lots of liquidity and achieve a large proportion of your order being executed
without displaying anything to the market’.

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In the US, the dark pools are a form of what are referred to as ATSs and, in Europe, they are a form of
multilateral trading facility (MTF).

Private transactions are those offerings of securities which are made, not to the general public, but to a
subset of so-called sophisticated investors, when the same rigorous kinds of disclosures that have to be
made in an initial public offering (IPO) prospectus (sometimes known in the US as a red herring) can be
avoided.

In the US, the Securities and Exchange Commission (SEC) has special provisions for what are termed
private placements. A private placement (or non-public offering) is a funding round of securities which
are sold without an IPO, and without the formality of an approved prospectus, usually to a small number
of chosen private investors.

Although these placements are subject to the Securities Act of 1933, the securities offered do not
have to be registered with the SEC if the issuance of the securities conforms to an exemption from
registrations as set forth in the Rules known as Regulation D. Private placements may typically consist
of stocks, shares of common stock or preferred stock or other forms of membership interests, warrants
or promissory notes (including convertible promissory notes), and purchasers are often institutional
investors such as banks, insurance companies and pension funds.

Private placements are commonly used by growing businesses in their early stages, such as many
technology businesses that require substantial amounts of cash as they develop their business model
and scale in advance of an IPO. The various rounds of equity funding are often given alphabetic
characters – eg, equity funding stage A or B – as illustrated in the following example.

Example
WeWork has established itself as a unique and modern office space provider and filed for an IPO in the
US in mid-2019. The planned IPO did not go ahead, partly because the valuation placed on the business
was deemed insufficient given the amounts paid for WeWork shares in the numerous privately placed
funding rounds prior to the filing. At the time of writing (October 2020), WeWork is struggling to survive
in the face of the Coronavirus pandemic which is seeing employees increasingly working from home,
therefore reducing demand for office space.

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Here is a brief summary of the various funding rounds for WeWork:

Equity Funding Round Date(s) Amount raised ($m)

Series A Apr 2009 17.5
Series B Nov 2010 41.0
Series C Jul 2011 156.4
Series D May 2012 and Dec 2014 397.6
Series E Jun 2015 742.5
Series F Jul 2015 750.0
Series G Aug 2017 and May 2019 875.0

1.2 Emerging and Frontier Markets

Less developed markets around the world, including those classified as emerging and frontier markets,
tend not to have reached the same degree of sophistication as developed markets. Most of the equity
trading in these markets takes place through stock exchanges. Frontier markets are considered to be
even less well developed (eg, less sophisticated, and generally smaller and less liquid) than the larger
emerging markets, so are sometimes called ‘pre-emerging’.

Example
The Stock Exchange of Thailand
Originally incorporated in 1974, the Stock Exchange of Thailand’s primary role is to serve as the centre
for the trading of listed securities and to provide systems needed to facilitate securities trading.

The Stock Exchange of Thailand’s core operations include listing securities, the supervision of
information, disclosures by listed companies, oversight of securities trading, monitoring member
companies involved in trading securities, as well as dissemination of information and educating
investors.

China provides a good example of an equity market that quickly became very sophisticated – partly
because of China’s rapid development and the size of its economy.

Example
China’s equity market is relatively young and includes the Shanghai Stock Exchange (SSE) and the
Shenzhen Stock Exchange (SZSE), both of which only began trading in 1990. In less than three decades,
the SSE became the fourth largest exchange in the world, with a market capitalisation of over $5 trillion.
The SSE lists China’s most prominent large-cap companies, such as state-owned enterprises (SOEs),
banks and energy firms, while the SZSE lists mainly small- and mid-cap firms. In addition to listing on
mainland markets, the largest Chinese firms and SOEs also list on the Hong Kong Stock Exchange (HKEX).

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China’s market structure is unusual in that there are multiple share classes. Historically, regulators
restricted foreigners’ access to mainland markets, depriving investors of the significant growth
opportunities associated with China’s emergence onto the global stage. The gradual loosening of these
controls has resulted in the presence of different share classes, most notably A-shares and H-shares.

A-shares are traded on the mainland exchanges and are gradually being opened up to enable purchase
by overseas investors under an approved quota system. H-shares are mainland Chinese companies
listed in Hong Kong and are available to, and popular with, global investors. Although the H-share
universe consists of a more limited number of companies than on the mainland exchanges, international
investors prefer the more familiar legal and market framework in Hong Kong.

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2. Methods of Trading and Participants

2.1 Quote-Driven Versus Order-Driven Systems

Learning Objective
5.2.1 Understand the differences between quote-driven and order-driven markets and how they operate

Trading systems provided by exchanges around the world can be classified on the basis of the type of
trading they offer. Broadly, systems are either quote-driven or order-driven:

• Quote-driven systems – market makers agree to buy and sell at least a set minimum number of
shares at quoted prices. The buying price is the bid and the selling price is the offer. The prime
example of a quote-driven equity trading system is Nasdaq in the US.
• Order-driven systems – the investors (or agents acting on their behalf) indicate how many
securities they want to buy or sell, and at what price. The system then simply brings together the
buyers and sellers. Order-driven systems are very common in the equity markets – the NYSE, the TSE
and trading in the shares of the largest companies on the LSE are all examples of order-driven equity
markets.

The presence of market makers on quote-driven systems provides liquidity that might be lacking on an
order-driven system. Market makers are required to quote two-way prices, resulting in an ability for
trades to be executed. In contrast, an order-driven system can lack liquidity, since transactions can only
be matched against other orders – if there are insufficient orders, trades cannot be matched.

The orders that await matching are included in the so-called ‘order book’. The buy side of the order book
lists orders to buy, and the sell side of the order book lists orders to sell. New sell orders entered into
the system potentially match existing orders on the buy side. New buy orders potentially match existing
sell-side orders in the order book.

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Generally, trading systems are run electronically, allowing participants to trade via computer screens.
Until March 2020, the NYSE was a notable exception, still retaining a physical trading floor where buyers
and sellers gather to trade in an open-outcry manner in addition to the electronic system. Due to the
COVID-19 pandemic, the floor was temporarily closed, sending all employees to work remotely for
the first time. It did subsequently re-open, but only for floor brokers. Most of the NYSE workers have
continued to, or returned to, working remotely. While the floor is a tradition, it is not necessary. All
regulatory obligations can be fulfilled electronically.

Some trading systems combine features of both order-driven and quote-driven systems – these are
referred to as hybrid systems and include the LSE’s Stock Exchange Electronic Trading Service – quotes
and crosses (SETSqx).

2.2 Participants

Learning Objective
5.2.2 Know the functions and obligations of: market makers; broker-dealers; inter-dealer brokers;
systematic internalisers

Member firms of an exchange can act in two different capacities or roles – as a principal and as an agent.
This does not preclude an individual firm from acting in both capacities; at times it may be acting as an
agent and at others it may be acting as a principal.

When a firm is acting as a principal it is essentially buying shares for its own account, in the hope of the
shares increasing in value before it sells them, or, in the case of a short transaction, selling borrowed
shares at a higher price at the time of borrowing than the price it has to pay when it wishes to replace
or cover. Market makers also hope to, on average, profit from buying at the bid and selling at the offer.
Firms acting in this way can also be described as performing their function as dealers and, in more
specialised cases, as outlined below, as market makers.

When a firm is acting as an agent, it is essentially arranging and making deals on behalf of other third
parties, and it makes money, when acting in this capacity, by charging a commission on the deal. This
agency role is commonly described as acting as a broker. For instance, when acting as an agent or
broker a firm will receive orders to buy and sell equities on behalf of its clients and find matches for the
trades that its clients want to make. In return for these services, brokers charge commission.

If a firm decides to focus only on acting as a principal it is known simply as a dealer, and some exchange
member firms may choose simply to buy and sell equities for their own account. Most exchange
members, however, are broker-dealers. This means they have the dual capacity to either arrange deals
(acting as a broker), or to buy and sell shares for themselves (acting as a dealer).

Some of an exchange’s member firms may choose to take on the special responsibilities of a market
maker. When a firm acts as a market maker, it stands ready to provide a source of liquidity to certain
sections of the market. By being prepared to provide a bid for shares that third parties want to sell and
an ask for parties that want to buy shares at any time, the market maker smooths out the more erratic
price movements that can occur without this additional source of market liquidity.

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To become a market maker a member firm must apply to the stock exchange, giving details of the
securities in which it has chosen to deal. It must provide prices at which it is willing to buy and sell a
minimum number of its chosen shares throughout the course of the trading day. Because some of the
exchange systems rely on market makers to honour their commitments, the exchange closely vets
firms before allowing them to quote prices to investors. In return for agreeing to take on these extra
responsibilities, market makers hope to enjoy the benefits of a steady stream of business, from broker-
dealers and from other investors.

An inter-dealer broker (IDB) is an exchange member firm that has registered with the exchange to act
as an agent between dealers (such as market makers). When one dealer trades with another, it often
prefers its identity to remain a secret. This is the key benefit of using an IDB. The IDB is acting as agent
for the dealer but settles any transactions as if it were principal in order to preserve the anonymity of the
dealer. An IDB is not allowed to take principal positions, and it has to be a separate firm, not a division

5
of another broker-dealer.

The term ’systematic internaliser’ was introduced by the EU Markets in Financial Instruments Directive
(MiFID). It is an investment firm (such as an investment bank) which, on an organised, frequent,
systematic and substantial basis, deals on its own account when executing client orders instead of
placing the orders elsewhere.

2.3 Algorithmic Trading

Learning Objective
5.2.3 Understand algorithmic trading: reasons; consequences of high frequency trading; types of
company that pursue this strategy; latency/co-location

As exchanges have become increasingly computer-driven, and other electronic venues, such as MTFs,
have become part of the financial services infrastructure, a new form of trading has evolved.

Variously known as algorithmic trading, automated trading, black-box trading, quant trading or simply
algo-trading, it relies on computer systems to buy shares automatically when predefined market
conditions are met. Algorithmic trading is, in essence, automated trading by computers which are
programmed to take certain actions in response to varying market data. Market-predicting algorithms
are created in order to find potential trades and then execute them. These algorithms are continually
evolving through artificial intelligence and the sophisticated uses of statistics.

The key reasons that are advanced for the popularity of algorithmic trading are as follows:

• Removing the emotion of trading – since entry and exit rules are predefined and incorporated in
the algorithm, there is no opportunity for the trader to divert from the plan or to overtrade.
• Preservation of discipline – since trades are automated, the strategy will be consistently
maintained, regardless of market volatility.

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• Speed, accuracy and reduced costs – automated algorithmic trading will be executed quicker
than other forms of order. Furthermore, the use of the algorithm removes the danger of inaccurate
details being manually entered and, without any need for human intervention, the orders are
likely to be cheaper to execute. However, if there is a data error or a glitch in the algo, large losses
can quickly accumulate due to the relative lack of oversight and often rapid-fire trading style of
automated trading.

One major sub-category of algorithmic trading is high frequency trading (HFT) which involves the use
of powerful computers that are programmed to transmit orders based on algorithms. These algorithms
will respond extremely rapidly to market movements and, because the computers are usually located
physically closely to those of the exchange, the orders will arrive ahead of other conventional orders.
The high-frequency traders will enter into hundreds, or even thousands, of small orders in this way and
will then reverse the deals (so if the initial deals were to buy, they will sell or vice versa) to make a ‘turn’
on each. The amount of money made on each deal might be very small, but because of the quantity
of deals being done, the high-frequency trader can make a lot of money very quickly. Estimates for
exchanges puts the proportion of trading by high frequency traders at 50% or more.

Potential criticisms of HFT include seeing the traders as ‘vultures’ exploiting the genuine, longer-term
investors and, given their dominance of market turnover, the impact they can have on pricing. The
impact on pricing can be substantial, as was exhibited in the so-called ‘flash crash’ that hit the US
markets on 6 May 2010. On that day, stock prices fell rapidly, with around 600 points being wiped off the
Dow Jones Industrial Average (DJIA) in five minutes, only to recover again around 20 minutes later.
An official report from the SEC and the Commodity Futures Trading Commission (CFTC) put most of the
blame for the volatility on high-frequency traders’ algorithms. The initial impact came from movements
in the Standard & Poor’s (S&P) futures market and spilled over into the wider stock market with the high-
frequency traders aggressively selling. After the Chicago Mercantile Exchange (CME) paused trading in
the S&P futures by triggering a circuit breaker, prices stabilised and then recovered almost as quickly as
the losses had crystallised minutes earlier.

Another ‘mini’ flash crash occurred in the US market on 23 April 2013 in response to a hoax Twitter
posting about an attack on the White House and an injury to President Obama. The DJIA fell about
130 points and then rapidly recovered. Again some commentators placed the blame for the excessive
volatility on the algorithms of the high-frequency traders.

HFT has been criticised for the systemic risks that it can create. In the event of extreme price movements
on one exchange, the arbitrage trades automatically placed by the high-frequency traders can rapidly
spread the price movements to other exchanges where the same, or related, instruments are traded.

Another criticism of HFT is that many of the strategies used are, in effect, forms of market manipulation.
An example would be where an algorithm maintains a series of offers just above the market, but
instantly withdraws them when a market order to buy is entered. The investor would end up buying at a
much higher price than they expected. The algorithm could then enter a series of bids near the market
and hope to exit in the same way, earning a relatively riskless profit in a sideways-trading market. Such
a strategy, in addition, to being possibly unethical and in violation of exchange rules, would only be
available to HFT-style traders due to the speed required.

The original operators of the HFT algorithms were small, specialist firms; their success has attracted
others, including hedge funds and the large investment banks.

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Key to many HFTs is reducing the level of latency. Simplistically, latency is the time taken to interact with
the market. If latency can be lowered, it could give the trader the ability to act on market information
more quickly than others and generate profits as a result. Shaving microseconds from the time to act on
new information can provide competitive advantage.

One factor that can assist in minimising latency is co-location. Co-location involves the trader using
brokers with servers physically close to those of the exchange, often in the same data centre. This will
minimise the data transmission time for orders to reach the exchanges servers.

2.4 Prime Broker Services

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Learning Objective
5.2.4 Know the main services provided by an equity and fixed-income prime broker, including:
securities lending and borrowing; leverage trade execution; cash management; core
settlement; custody; rehypothecation

Prime brokerage is the term given to a collection of services provided by investment banks to their
hedge fund clients. The typical services that are provided by a prime broker include the following:

1. Securities lending and borrowing – eg, to cover short positions in a hedge fund’s long/short
strategy.
2. Leveraged trade execution – undertaking trades on the fund’s behalf that are partly financed by
borrowed funds, essentially providing margin for conducting trades.
3. Cash management – maximising the return that is generated from cash held by the fund.
4. Core settlement – taking the necessary steps to make sure that any securities purchased become
the property of the fund, and that the appropriate cash is received for any sales made of the fund’s
securities in a timely manner.
5. Custody – keeping safe the securities held by the fund and processing any corporate actions
promptly and in accordance with its targets.
6. Rehypothecation – in addition to holding collateral and having a charge over the fund’s portfolio,
the prime broker might also require a right to re-charge, dispose of, or otherwise use the customer’s
assets which are subject to the security, including disposing of them to a third-party. This is
commonly described as a ‘right of rehypothecation’. When assets have been rehypothecated, they
become the property of the prime broker as and when the prime broker uses them in this way, for
instance, by depositing rehypothecated securities with a third-party financier to obtain cheaper
funding or by lending the securities to another client.
7. Access to OTC markets – either serving as the counterparty, or finding a third party to take the
other side to non-exchange instruments such as swaps and structured products.

In addition to these transaction-related services, the prime broker would also be expected to offer all
the other typical services of an investment bank, such as providing research, invitations to roadshows/
deal presentations, arranging meetings with strategists, analysts and company management, and any
other services generally provided to their institutional clients.

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 3. Stock Exchanges

3.1 Rules and Procedures

Learning Objective
5.3.1 Understand the rules, procedures and requirements applying to dealing through stock
exchanges’ bespoke electronic systems and hybrid trading systems relating to: order book
features; order management; limitations and benefits of trading through bespoke systems;
right to call a halt in trading; liquidity; market makers

Most stock exchanges operate electronic order-driven systems that automatically match orders to buy
and sell equities.

Such systems are centred on an electronic order book into which member firms submit their orders to
buy and sell equities and, when there are orders that can be matched, the system automatically brings
them together.

3.1.1 The Order Book

In the order book, orders are given priority first by price and then by time.

The electronic screen reflecting the order book for the shares of the fictional company ABC plc might
look something like this:

Company: ABC
Orders to buy Orders to sell
Volume Price Volume Price
10,000 315 4,000 316
2,000 315 12,000 317
4,000 314 14,000 318
8,000 313 3,000 318
5,000 312 5,000 319
5,000 311 5,000 319

The order priority adopted is by price first, and then time. The best buy and sell prices are always at
the top of the two columns of orders and will be executed first. In the case of the buy orders, this is the
highest-priced order (315 in the above example, where the order to buy 10,000 shares must have been
entered into the system before the order to buy 2,000 shares).

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In the case of the sell orders, this is the lowest-priced order (316 in the above example). Below the best-
priced orders, all the other orders are displayed, giving an immediate picture of the depth of liquidity on
the order book.

Essentially, the way that this system works is that exchange members have access to the order book and
can enter orders electronically. If a firm of brokers enters a sell order on behalf of a client for up to 12,000
shares in ABC at the best available price, the order will be executed by the system by matching with
the best buy orders (10,000 and 2,000 shares). The matched order will proceed to settlement at 315 per
share and be immediately revealed to the market in terms of size (12,000 shares) and price (315).

3.1.2 Opening Auctions and Automatic Execution

At the start of each day’s trading, an opening price is often established using an auction process.

5
Typically, this sees member firms entering orders in the period leading up to the auction. In this period,
no trading takes place.

The auction itself uses an uncrossing algorithm through which those orders that overlap on the order
book are executed at the single price that maximises the number of shares traded. Simultaneously, the
opening price for the security is calculated. Once the opening auction is complete, automatic execution
commences. As orders are entered on to the system, the exchange’s system tries to match them. If the
exchange system finds a buyer and seller with agreeable prices and volumes, the trade is automatically
executed.

During the trading day, there is typically a possibility of an interruption to this automatic execution of
orders. If the price of a trade is more than the price tolerance level away from the previous trade price,
an automatic execution is suspended for a period to allow investors time to react to large price changes.
The price tolerance level is typically set at between 5% and 25%, depending upon the exchange and the
share concerned.

3.1.3 Viewing the Order Book

Any market participant can view the exchange’s order book for a particular security (by looking at a
Bloomberg screen, for example). However, membership of the exchange is required to interact with the
order book. It is for brokers and dealers only.

The exchange typically reserves the right to prohibit any transaction from being dealt on-exchange
for any reason. This is referred to as a trading halt, and often arises from the suspension of a security’s
listing.

If a security is suspended, permission is required from the exchange before a member firm can affect a
transaction in that security. The length of the trading halt is at the discretion of the exchange. Trades
that have occurred but have not yet settled at the time of suspension are settled as normal.

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3.2 Order Types

Learning Objective
5.3.2 Understand the following order types and their differences: market; limit; fill or kill; all or none;
execute and eliminate; iceberg; multiple fills

There are a number of types of order that can be entered onto a stock exchange’s bespoke order-driven
system, and each will be treated slightly differently. The following outlines and explains the major order
types.

1. Limit orders have a price limit and a time limit, eg, a limit order may state: ‘sell 1,000 shares at 360 by
next Tuesday’ and the system will attempt to sell these shares at a price no worse than 360 by next
Tuesday. Limit orders can be partially filled, and it is only limit orders that are displayed on the order
book. Typically, and if no time limit is specified, limit orders are good only for the day on which they
are ordered.
2. Iceberg orders are a particular type of limit order. They enable a market participant with a
particularly large order to partially hide the size of their order from the market and reduce the
market impact that the large order might otherwise have. The term comes from the fact that just the
top part of the order is on view (the peak of the iceberg); the rest is hidden (the bulk of the iceberg
is below the water). Once the top part of the order is executed, the system automatically brings the
next tranche of the iceberg order on to the order book. This process continues until the whole of the
iceberg order has been executed, or the time limit for the order expires.
3. Market orders do not specify a price. They are submitted to the order book to deal in a specified
number of shares. Market orders are typically entered any time throughout the trading session, but
variations include market-on-open (MOO) or market-on-close (MOC ).
4. Execute and eliminate orders will execute as much of the trade as possible and cancel the rest.
However, unlike an at best order, this order type has a specified price and will not execute at a price
worse than that specified.
5. Fill or kill orders normally have a specified price (although they can be entered without one) and
either the entire order will be immediately filled at a price at least as good as that specified, or the
entire order will be cancelled (ie, if there are not enough orders at the price specified or better).
6. All-or-none orders are the same as fill or kill orders except that, if the order cannot be executed
immediately, all-or-none orders will not be cancelled until the end of the trading day when the
market closes.

If the order placed on the system does not perfectly match an equal and opposite order, then it may be
subject to what are known as ‘multiple fills’. For example, a market order to buy 5,000 shares may be
satisfied against a number of sell orders, say, a limit order to sell 1,000 shares at $20.00 or better, another
to sell 2,500 shares at $20.02 or better, and a third to sell 1,500 shares at $20.03 or better. The buy order
has been filled by three individual deals (a multiple fill) and will pay a weighted average price of just less
than $20.02.

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Number of shares Price per share ($) Number x price ($)

1,000 20.00 20,000
2,500 20.02 50,050
1,500 20.03 30,045
5,000 100,095
Weighted average price paid =100,095/5,000 = $20.019

3.3 The Central Counterparty (CCP)

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Learning Objective
5.3.3 Understand the operation, purpose, benefits and limitations of using a central counterparty

Most stock exchanges utilise a central counterparty (CCP); the impact of a CCP is best illustrated by way
of an example:

Example
A trade is executed on an exchange’s order book that involves A agreeing to sell shares to B. The CCP
steps in between the two parties and two new obligations replace the initial obligation of A to sell
to B. The two obligations are for A to sell to the CCP and then for the CCP to sell to B. This transfer of
obligation is known as ‘novation’.

If either of the two parties to this transaction (A or B) were to default, it would no longer affect the other
party, as they no longer have a contract with each other. It would only impact the CCP.

The use of a central counterparty provides certain benefits to market participants, particularly:

• Reduced counterparty risk – the risk that the other side of the transaction will default is reduced
because it is replaced by the CCP, which is invariably well-capitalised and has an insurance policy in
place lessening the risk of default. This reduces the risk of systemic collapse of the financial system.
• Providing total anonymity – both sides of the trade do not discover who the original counterparty
was.
• Reduced administration – all trades are settled with the CCP, rather than a variety of counterparties,
improving operational efficiency.
• Facilitating netting of transactions – because all the trades are with a single CCP, receipts and
payments for transactions in the same share that settle on the same day can be netted against each
other.
• Improved prices – because more participants are willing to transact anonymously, it is argued that
a CCP results in improvements in price.

The CCP typically charges a flat fee to both parties for fulfilling its role and also requires margin payments
(similar to derivatives margin) to reduce its potential loss, should one party default.

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3.4 Costs of Trading

Learning Objective
5.3.4 Understand the concept of stamp duties and other transaction taxes and costs on securities
trades and the potential for their variation between types of security

Whenever a trade is undertaken in a security, be it a share or a bond, there will be costs. There are what
might be described as tacit fees in the difference between the bid and offer prices: if an investor buys
shares and pays the offer price, that investor would only be able to sell the shares at the lower bid price.
There is also the dealing cost in the form of commission that needs to be paid to the broker arranging
the transaction, but in particular environments there may be additional costs as outlined below:

• Broker’s commission – commission is typically based on a set percentage of the value of the
securities being purchased or sold. The precise percentage varies by broker and market, but it is
generally at least 0.5% of the value of the securities traded. It will invariably be higher when the
broker is providing the client with research and advice, with these so-called full service brokers likely
to charge a higher percentage of perhaps 1.5%. If the broker is offering little or no investment advice,
perhaps providing their services over the internet, the firm is described as a discount broker and the
fees will be lower. Both types of broker are likely to have a minimum charge that will apply if the
value of the securities traded is small. This might be $7.50 or equivalent for a discount broker and
perhaps £19.95 for a full service broker.
• Account fees – brokers also tend to charge account fees to their ongoing customers, although a
number of brokers will waive these fees where the client undertakes more than a minimum number
of trades during a particular period, such as a quarter or a year. These fees typically are charged
to cover the various administrative costs of maintaining the account, such as providing account
statements and custody charges.
• Exchange fees, regulatory fees, clearing fees, taxes/duties – there are typically minor charges
that are either subsumed within the brokers’ commissions, or added separately to cover the
charges the stock exchange makes per transaction, charges to contribute to the clearing system,
and, in many jurisdictions, some form of tax such as the UK’s stamp duty or stamp duty reserve tax.
Since the financial crisis of 2007–08, there has been an ongoing debate about taxing the financial
services profession, generally through a financial transactions tax, to provide for the costs to the
taxpayer of bailing out banks. Further charges are also commonly made to contribute to other
regulatory matters, like overseeing the conduct of takeovers and mergers or providing an investors’
compensation scheme if a broker were to go bust.

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4. Indices

Learning Objective
5.4.1 Know how different indices are created and their purpose: types of index; purpose of weighted
indices; purpose of unweighted indices; sector versus national indices; price return, total return
and net total return indices; the implications of free-float on market capitalisation

4.1 Stock Market Indices

A stock market index is a method of measuring the performance of a section of the stock market which

5
is segmented to represent a particular group. The group might be the largest companies listed on
the market, or perhaps a group of companies that all operate in a similar industry. Many indices are
cited by news or financial services firms and are used as benchmarks to measure the performance of
portfolios and to provide the general public with an easy overview of the state of equity investments.
Their methods of construction may vary according to whether they are capitalisation-weighted or not.
Capitalisation-weighted refers to market capitalisation which is the number of shares in issue multiplied
by the price per share.

There are various organisations that have become specialists in constructing and maintaining equity
indices. This includes managing their composition, making periodic adjustments and making index
data public in real time and on a historical basis. For example, Standard & Poor’s (S&P), a well-known
credit ratings agency in the US, is the manager of the S&P 500 index. This index represents 500 American
companies with a market capitalisation of at least 8.2 billion. Although it represents 500 companies, it is
made up of 505 stocks, since some companies have multiple share classes included. S&P 500 companies
trade on the NYSE and the Nasdaq, and include most of the largest companies in the US. The index is
weighted by free-float market capitalisation, so larger companies impact the index value more than
smaller ones. The S&P 500 is referenced as a benchmark for comparison against other markets or
investments within the US, or globally. The Dow Jones Industrial Average (DJIA), also known as ‘the Dow’,
is another example of a US index. The DJIA, however, is made up of only 30 companies that trade on US
exchanges: either the NYSE or Nasdaq. The Dow is one of the oldest and most-referenced stock market
indices in the world. In addition, the FTSE Russell organisation in the US is well known for maintaining
several indices of US stocks, including the Russell 2000, which represents a diversified group of small
capitalisation issues trading in US markets. MSCI is another provider of global indices which is used heavily
by institutional investors for benchmarking performance.

The Nikkei 225 is the premier index of Japanese stocks. It has been calculated for more than 60 years and
consists of 225 stocks in the first section of the Tokyo Stock Exchange. The constituents are reviewed
at the beginning of October each year, based on two factors: liquidity and sector balance. The TOPIX is
another widely referenced index, which is a capitalisation-weighted index of all the companies on the
Tokyo Stock Exchange’s large company board – First Section).

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In the UK, the best-known index is the FTSE (Footsie) 100 index, which consists of the 100 largest
companies traded on the LSE as measured by market capitalisation. FTSE 100 companies represent
about 81% of the market capitalisation of the whole of the LSE. The index, maintained by the FTSE
Group, is calculated in real time while the LSE is open for trading and published every 15 seconds. The
FTSE Group is a subsidiary of the London Stock Exchange Group (LSEG), as is FTSE Russell in the UK.

The FTSE 100 started at a base level of 1000 points in January 1984, meaning that the value of the
100 constituent companies at that time equated to 1000 index points. As the value of the constituent
companies increases (or decreases), the FTSE 100 increases (or decreases). So, if the value of the
constituents grew by 10% in the first nine months following the index publication date, the index would
have risen to 1100 index points.

All countries with active stock exchanges have indices that provide a quick and simple way of assessing
whether the stock prices are moving up or down. The following table provides information on the
composition and geographical scope of many of the largest and best-known global equity indices:

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 Secondary Markets

Index name Geographical scope Composition

Largest 100 UK companies
FTSE 100 UK and multinationals listed on the LSE as measured
by market capitalisation
30 large US companies
selected by a committee that
DJIA US-domiciled multinationals
includes the managing editor
of the Wall Street Journal
225 large and regularly traded
Nikkei Stock Japanese companies traded
Japanese corporations
225 on the Tokyo Stock Exchange

5
(TSE)
50 companies listed on the
Hong Kong Stock Exchange
Hang Seng Hong Kong/China selected on the basis of
market value, turnover and
financial performance
A family of indices, based
around the STOXX Global
1800 index that consists of 600
STOXX Global developed markets of the largest capitalisation
companies from each of
three regions – Europe, the
Americas and Asia/Pacific
A market capitalisation-based
index including companies
MSCI World Global developed markets from 23 countries, totalling
approximately 1,700
companies
The 300 largest listed
FTSE Eurofirst companies by market
European-domiciled corporations
300 capitalisation from across
Europe

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 Index name Composition Geographical scope
Cotation A capitalisation-weighted
French-domiciled companies;
Assistée en measure of the 40 most
approximately 45% of its listed shares are
Continu significant values among the
owned by foreign investors, more than any
(CAC) 40 100 highest market caps on
other main European index
(CAC quarante) Euronext Paris
Deutscher The base date for the DAX is 30 December The DAX includes the 30 major
Aktien IndeX 1987 and it was started from a base value of German companies trading on
(DAX) 1,000. The Xetra system calculates the index the Frankfurt Stock Exchange
Standard & Poor’s manages
the composition of the index.
US-traded stocks which are multinational The 500 constituents are
S&P 500
companies operating in global markets selected by S&P from the
largest cap stocks traded in
the US
The FTSE All-Share index,
originally known as the FTSE
To qualify, companies must have a full
Actuaries All-Share index, is a
listing on the LSE with a sterling- or euro-
FTSE All-Share capitalisation-weighted index,
dominated price on the Stock Exchange
comprising around 600 of
Electronic Trading Service (SETS)
more than 2,000 companies
traded on the LSE
Covers issues listed on the
Nasdaq stock market, with
over 3,200 components, of
Nasdaq which around 300 are non-
Since both US and non-US companies are
Composite US stocks. It is an indicator of
listed on the Nasdaq stock market, the
the performance of stocks of
index is not exclusively a US index
technology companies and
growth companies
Consists of the largest non-
Does not contain financial companies, and
financial companies listed on
Nasdaq 100 includes companies incorporated outside
the Nasdaq. It is a modified
the US
market value-weighted index
Named after the close to
5,000 shares it contained on
launch in 1974, the Wilshire
Contains all US-headquartered equities with 5000 contains all US equity
Wilshire 5000
readily available prices securities with readily
available price data. It is
capitalisation-weighted and
measures total return

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 Secondary Markets

4.2 National and Sector Indices

A national index represents the performance of the stock market of a given nation and reflects investor
sentiment on the state of its economy.

The most regularly quoted market indices are national indices, composed of the stocks of large
companies listed on a nation’s largest stock exchanges. The concept may be extended well beyond an
exchange.

For example, the Wilshire 5000 Index, the original total market index, represents the stocks of nearly
every publicly traded company in the US, including all US stocks traded on the NYSE (but not American
depositary receipts or limited partnerships) and Nasdaq.

5
More specialised indices exist which track the performance of specific sectors of the market. Examples
include the FTSE EPRA/NAREIT for real estate and the Nasdaq Biotechnology Index for the biotechnology
industry.

4.3 Construction of Indices and Weighting

The construction of an index usually involves the total market capitalisation of the companies weighted
by their effect on the index, so the larger stocks make a greater difference to the index than the
smaller market cap companies. However, the one major exception to this method of construction and
calculation is the DJIA which is price-weighted rather than market capitalisation-weighted. Since it is
such a widely quoted index, it is worth considering the method of calculation.

The sum of the prices of all 30 DJIA stocks is divided by the Dow Divisor. The divisor is adjusted in case of
stock splits, spin-offs or similar structural changes, to ensure that such events do not alter the numerical
value of the DJIA. Early on, the initial divisor was composed of the original number of component
companies, which made the DJIA at first a simple arithmetic average. The present divisor, after many
adjustments, is less than one, meaning the index is larger than the sum of the prices of the components.

That is:
∑p
DJIA =
d
where:

p = the prices of the component stocks.

d = the Dow divisor.

Events, such as stock splits or changes in the list of companies composing the index, will alter the sum
of the component prices. In these cases, in order to avoid discontinuity in the index, the Dow Divisor is
updated to instantly capture the effect of any events as soon as they occur. The value of the Dow Divisor
is altered so that the quotations right before and after the event coincide:

∑pold ∑pnew
DJIA = =
dold dnew

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The DJIA is often criticised for being a price-weighted average, which gives higher-priced stocks more
influence over the average than their lower-priced counterparts, but takes no account of the relative
industry size or market capitalisation of the components. For example, a $1 increase in a lower-priced
stock can be negated by a $1 decrease in a much higher-priced stock, even though the lower-priced stock
experienced a larger percentage change. In addition, a $1 move in the smallest component of the DJIA
has the same effect as a $1 move in the largest component of the average. At the time of writing, United
Health Group and Home Depot are among the highest-priced stocks in the average and, therefore, have
a large influence on it. Alternatively, Cisco Systems and Walgreens Boots Alliance are among the lowest-
priced stocks in the average and hold the least amount of sway in the price movement. Many critics of
the DJIA therefore recommend the float-adjusted market value-weighted S&P 500 or the Wilshire 5000 as
better indicators of the US stock market.

All FTSE Equity Index constituents are fully free-float-adjusted, in accordance with the FTSE’s Index
rules, to reflect the actual availability of stock in the market for public investment. Each FTSE constituent
weighting is adjusted to reflect restricted shareholdings and foreign ownership, so as to ensure an
accurate representation of investable market capitalisation.

4.4 Total Return Index

A total return index is one that calculates the performance of a group of stocks, assuming that dividends
are reinvested into the index constituents. For the purposes of index calculation, the value of the
dividends is reinvested in the index on the ex-dividend date.

Some indices, such as the S&P 500, have multiple versions. These versions can differ, based on how the
index components are weighted and on how dividends are accounted for. For example, there are three
versions of the S&P 500 Index:

• price return, which measures the price performance and, therefore, disregards income from
dividends
• total return (also sometimes called ‘gross’), which measures the performance of both price return
and dividend reinvestment, and
• net total return, which accounts for dividend reinvestment after the deduction of a withholding tax.

4.5 Free-Float and Market Capitalisation

The free-float of a public company is an estimate of the proportion of shares that are not held by
large owners and that are not stock with sales restrictions (restricted stock that cannot be sold until it
becomes unrestricted stock).

The free-float or a public float is usually defined as being all shares held by investors other than:

• shares held by owners owning 5% or more of all shares (those could be government holdings,
institutional investors, strategic shareholders, founders, executives, and other insiders’ holdings)
• restricted stocks (granted to executives who can be, but do not have to be, registered insiders)
• insider holdings (it is assumed that insiders hold stock for the very long term).

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 Secondary Markets

4.5.1 Free-Float Factor

For most market capitalisation-weighted indices, the total market capitalisation of a company is
included, irrespective of who is actually holding the shares and whether they are freely available for
trading.

The free-float factor represents the proportion of shares that is free-floated as a percentage of issued
shares and is then typically rounded to the nearest multiple of 5% for calculation purposes. For example,
a constituent security with a free float of 23.2% will be included in the index at 25% of its total market
capitalisation. To find the free-float capitalisation of a company, first find its market cap (number
of outstanding shares x share price) then multiply by its free-float factor. More recently, a free-float
adjustment factor has been introduced into the calculations of many major global equity indices.

5
A free-float adjustment factor is introduced into the calculations of most of the major global equity
indices.

Example
Saudi Arabia’s Tadawul All Share Index (TASI) is a market cap-weighted index of all of the companies
traded on the Saudi Stock Exchange. This includes the chemicals giant Saudi Basic Industries
Corporation (SABIC) that has 3 billion shares in issue trading at around SAR 90 each (at the time of
writing). This gives a market cap for SABIC of approximately SAR 270 billion. However, mainly due to a
70% controlling stake held by Saudi Aramco, only around 22% of the shares are freely floating, so the
free-float adjustment applied to the index’s calculation hugely reduces SABIC’s influence.

In essence, free-float market cap equates to the total value of buying all the shares of a particular
company which are traded in the open market.

The free-float method is seen as a better way of calculating market capitalisation, because it provides a
more accurate reflection of market movements and is more representative of the investable universe.
When using a free-float methodology, the resulting market capitalisation is smaller than the full market
capitalisation method. This is useful for performance measurement, as it provides a benchmark more
closely related to what money managers can actually buy.

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 5. Government Bonds

Learning Objective
5.5.1 Know the functions, obligations and benefits of the following in relation to government bonds:
primary dealers; broker-dealers; inter-dealer brokers; government issuing authorities

5.1 Participants in Government Bond Markets

In addition to the government itself, there are four major groups of participants that facilitate deals in
the government bond markets:

1. The government’s issuing agency.

2. Primary dealers – such as gilt-edged market makers (GEMMs) in the UK.
3. Broker-dealers.
4. Inter-dealer brokers.

The roles of these participants will be illustrated in a series of examples covering UK, US, Japanese and
eurozone government bond markets.

Government Issues in the UK

Issuing Agency
The Debt Management Office (DMO) is the issuing agency for the UK government in respect of its
government bonds. It is an executive agency of the UK Treasury, making new issues of UK government
securities, which are known as ‘gilt-edged securities’ or just ‘gilts’. Once issued, the secondary market for
dealing in gilts is overseen by two bodies, the DMO and the LSE.

It is the DMO that enables certain LSE member firms to act as primary dealers, known as gilt-edged
market makers or simply GEMMs. The DMO then leaves it to the LSE to prescribe rules that apply when
dealing takes place.

Gilt-Edged Market Makers (GEMMs)

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

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 Secondary Markets

The obligations of a GEMM can be summarised as follows:

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

The privileges of GEMM status include:

• exclusive rights to competitively bid directly with the DMO at gilt auctions and other DMO
operations, either for the GEMM’s own account or on behalf of clients

5
• an exclusive facility to trade as a counterparty of the DMO in any of its secondary market operations
• exclusive access to the services of gilt inter-dealer brokers (IDBs).

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

• all gilt-edged securities, or

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

There are exceptions to the requirement to provide two-way quotes to customers. In particular the
obligation does not include quoting to other GEMMs or gilt IDBs.

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

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

Gilt Inter-Dealer Brokers (IDBs)

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

Government Issues in the US

The Treasury Department conducts auctions and direct sales of US Government securities. As with the
DMO in the UK, it conducts auctions on a regular basis and appoints primary dealers, which include the
major investment banks as conduits in the auction process to place bids and to buy the issue on behalf
of their clients or for their own account.

The New York branch of the Federal Reserve also serves an important role, both as a regulator of banks
which serve as primary dealers and, since the financial crisis in 2008, purchasing from the primary
dealers as part of quantitative easing (QE) activities.

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The US government securities are typically issued in one of three forms – bills, notes and bonds – that
differ in the length of time between issue and maturity:

• Treasury bills (T-bills) are issued for terms less than a year.
• Treasury notes (T-notes) are issued for terms of two, three, five, seven and ten years.
• Treasury bonds (T-bonds) are issued for terms of 30 years.

T-bills are issued in regular auctions with maturity dates of 28 days (or four weeks, about a month), 91
days (or 13 weeks, about three months), 182 days (or 26 weeks, about six months), and 364 days (or 52
weeks, about one year). T-bills are sold by single price auctions held weekly.

During periods when Treasury cash balances are particularly low, the Treasury may sell cash management
bills (or CMBs). These are sold at a discount and by auction just like weekly T-bills. They differ in that they
are irregular in amount; term (often less than 21 days); and day of the week for auction, issuance, and
maturity. When CMBs mature on the same day as a regular weekly bill, usually Thursday, they are said to
be on-cycle.

T-notes and T-bonds pay interest every six months until they mature. T-bonds have the longest maturity
of 30 years. Both T-notes and T-bonds are issued by auction.

For T-notes, two-year notes, three-year notes, five-year notes, and seven-year notes are auctioned every
month. Ten-year notes are auctioned at original issue in February, May, August, and November, with
reopenings in January, March, April, June, July, September, October and December. In a reopening,
additional amounts of a previously issued security are auctioned. Reopened securities have the same
maturity date and interest rate as the original securities.

For T-bonds, original issue auctions take place in February, May, August, and November, and reopening
auctions in the other eight months.

Government Issues in Japan

Japanese Government bonds (JGBs) are issued by the Ministry of Finance (MoF) and, as the name
implies, they are the bonds issued by the government, which is responsible for interest and principal
payments. Interest is paid every six months, and principal is repaid at maturity.

JGBs are available with various maturity periods. Coupon-bearing bonds, which feature semi-annual
interest payment and principal payment at maturity, have maturities of two, five, five (for retail
investors), ten, ten (inflation-indexed), ten (for retail investors), 15 (floating rate), 20, 30 and 40 years.

The Japanese Government also offers a separate strips programme.

Government Issues in the Eurozone

The eurozone consists of the 19 states which have adopted the euro as their currency and for whom
their monetary policy is determined by monthly meetings of the European Central Bank (ECB). Each of
the member states issues government bonds which have the credit rating associated with the country
of issue rather than the eurozone as a whole. In the syllabus, the focus is on Germany and France.

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 Secondary Markets

German Government securities offer original maturities ranging from three months to 30 years. In the
money market segment, the Federal Government issues Treasury discount paper (Bubills) with maturities
of six and 12 months. The offering of capital market products begins with Federal Treasury notes
(Schatz) with a maturity of two years, followed by five-year Federal notes (Bobls) (Bundesobligationen)
and Federal bonds (Bunds) with maturities of ten and 30 years.

The German Federal Government usually places single issues by auction. Only credit institutions
domiciled in an EU member state can be members of the auction group and participate directly in these
auctions. The Bund uses a multiple price auction procedure. In other words, bids for Bunds, Bobls and
Schatz accepted by the government are allocated at the price quoted in the respective bid and are not
settled at a uniform price. Bids priced above the lowest accepted price are allotted in full, while bids
priced below the lowest accepted price receive no allotment. Non-competitive bids are allotted at the
weighted average price of the accepted price bids. The government reserves the right to reallot the

5
bids at the lowest accepted price as well as the non-competitive bids, eg, to allot them only at a certain
percentage rate. The same procedure is applied on a yield basis for Bubills.

To remain a member of the auction group, a credit institution must subscribe to at least 0.05% of the
total issuance allotted at the auctions in a calendar year, weighted according to maturity. Members who
do not reach the required minimum allotment drop out of the auction group Bund issues. There are no
other requirements placed on the members of the auction group.

French Government securities consist of Obligations Assimilable du Trésor (OATs) and Bons du Trésor à
Taux Fixe et à Intérêts Précomptés (BTFs).

OATs are the government’s medium and long-term debt instruments with maturities from 2–50 years.
Most OATs are fixed-rate bonds redeemable on maturity. Longer term OATs, with a maturity that
exceeds eight years, are auctioned on the first Thursday of each month. Medium-term OATS and index-
linked OATS are auctioned on the third Thursday of each month.

The French Treasury (Agence France Tresor) previously had a separate category of medium-term
Bons du Trésor à Taux Fixe et à Intérêts Annuels (BTANs), which represented medium-term government
debt. The maturity of BTANs was either two or five years, however, the French Treasury streamlined its
classification to just OATs and BTFs, and the last BTAN matured in late 2017.

BTFs, or negotiable fixed-rate discount T-bills, are the government’s cash management instrument.
They are used to cover short-term fluctuations in the government’s cash position (less than one year),
mainly due to differences in the pace with which revenues are collected and expenses are paid and in
the debt amortisation schedule. On issue, BTFs have a maturity of less than one year. They are auctioned
every Monday.

The principal method of issuing French Government securities is the bid price system where participants
compete in the auction, on an equal footing, through a transparent system of open bidding according
to a planned issuance programme.

In the bid price system the highest bids are first served, followed by lower bids and so on, up to Agency
France Trésor’s target amount. Participants pay different prices, precisely reflecting their bids. Only
institutions affiliated to Euroclear France and holding accounts with the Banque de France are eligible
to bid.

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 6. Corporate Bond Markets

6.1 Characteristics

Learning Objective
5.6.1 Understand the characteristics of corporate bond markets: decentralised dealer markets and
dealer provision of liquidity; the impact of default risk on prices; the differences between
bond and equity markets; dealers rather than market makers; bond pools of liquidity versus
centralised equity exchange; relevance of the retail bond market

The price of a corporate bond is based on the equivalent government bond, less a discount to represent
the risk that the corporate may default, compared with the default risk-free nature of the government
bond. Unlike the market for equities, the method of dealing in corporate bonds tends to be away from
the major exchanges in what is commonly described as a decentralised dealer market. The dealers
provide liquidity by being willing to buy or sell the bonds. The systems that the dealers use to display
their willingness to deal are numerous, with each being described as a separate pool of liquidity.

6.1.1 Default
In the corporate bond market, unlike the government bond markets where it is often assumed that no
sovereign borrower will default, the determination of the likelihood that a corporate borrower may
default is a vital part of the pricing mechanism.

6.1.2 Differences between Equity and Bond Markets

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

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

6.1.3 Markets and Dealers of Corporate Bonds

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

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 Secondary Markets

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

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

6.1.4 Retail Bond Market

5
Although most trading of bonds is done by institutional investors through a decentralised network of
dealers, there is also an active retail market provided by stock exchanges. An example of this is the LSE’s
Order Book for Retail Bonds (ORB).

Example
The ORB is an order-driven trading service offering access to a selected number of gilts, supranational
and UK corporate bonds. Trading is available in more than 60 gilts and over 100 corporate bonds on an
electronic order-driven system with continuous two-way pricing provided by market makers.

An example of a retail corporate bond is as follows:

Bond issuer: HSBC – the global bank.

Maturity date: 22 August 2033.
Coupon: 5.375% fixed.

Issuers are able to issue bonds via the ORB, which can provide an attractive alternative source of finance
for the issuers wanting to raise relatively modest amounts of capital. Issue sizes tend to vary from as
little as £20 million up to £300 million, and the minimum denominations that investors can trade are
typically £1,000. The HSBC bond outlined above was a £196 million issue and can be traded in minimum
denominations of £1,000.

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 7. Dealing Methods

Learning Objective
5.7.1 Know the different trading methods for bonds: OTC inter-dealer voice trading; inter-dealer
electronic market; OTC customer-to-dealer voice trading; customer-to-dealer electronic
market; on-exchange trading

7.1 Trading Methods for Bonds

Bond trading, including both corporate and government bonds, is either conducted between dealers,
some of which is arranged by IDBs, or between dealers and their customers, like asset managers.

Dealer-to-dealer trading can occur in three ways:

• Direct telephone contact.

• Indirect via an IDB voice-broking the deal.
• Via an electronic market, known as an electronic trading platform, such as MTS Cash or BrokerTec.

Dealer-to-customer trading is done either by voice trading between the two parties, or via an electronic
platform, such as TradeWeb, MTS BondVision or proprietary single-dealer systems developed by some
of the larger banks. Other platforms were developed by financial information vendors or independent
brokerages and dark pool providers, for example Bloomberg ALLQ, Liquidnet and MarketAxess.

A relatively small proportion of corporate bond dealing takes place via stock exchanges.

7.2 Trends in Trading Methods

Learning Objective
5.7.2 Understand the different trends between trading methods: characteristics of electronic
trading; OTC; exchange-traded; price-driven via inter-dealer brokers (IDBs) – dealer-to-dealer;
request for quote (RFQ) – customer-to-dealer

Traditionally, most trading in fixed-income instruments had been undertaken over-the-counter

(OTC) by dealers at large banks buying from, or selling to, clients that they had managed to establish
relationships with. The deals were mostly arranged over the telephone, with clients often ringing more
than one dealer in an attempt to find the most advantageous price. When dealers wanted to trade with
other dealers, the typical method was to speak to a ‘voice broker’ at an inter-dealer broking firm, who
would arrange deals with other dealers.

As technology has improved, electronic trading has become much more important, particularly for the
more liquid government bonds like US Treasuries, European sovereign bonds and JGBs. It is in these
markets where inter-dealer platforms like MTS Cash and, BrokerTec have removed the need for voice
brokers and replaced them with electronic trading.

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 Secondary Markets

Similarly, much of the dealer-to-customer trading in the more liquid bonds migrated to either single-
dealer platforms run by individual banks, or multi-dealer platforms, such as Tradeweb Markets and MTS
BondVision. However, electronic trading volumes of bonds through single-dealer platforms struggled
to recover after the 2008 financial crisis, with banks much less willing to use valuable capital-taking
positions in the bond market. In response, the multi-dealer platforms have expanded and some have
tried to create competitive advantage by introducing or enhancing value-added services such as
straight-through processing (STP), and expanding into OTC derivatives.

The dealer-to-customer systems typically operate on a request for quote (RFQ) basis. Investors will
request quotes from a number of dealers’ platforms simultaneously. Dealers respond to such requests
very quickly and trades can be executed electronically. These RFQ systems are a significant improvement
over voice communication in terms of ease and speed of trading. RFQ systems also bring dealers into
direct competition with each other which should deliver price improvement for investors.

5
7.3 Factors that Influence Bond Pricing

Learning Objective
5.7.3 Know the factors that influence bond prices: issuer factors: yield to maturity, seniority,
structure, technical factors, credit rating; market factors; benchmark bonds; liquidity premiums
for highly traded bond issues; indicative pricing versus firm two-way quotes; availability of
a liquid repo market and the difficulty in offering illiquid bonds; inability to borrow or cover
shorts

Broadly, the factors that influence the prices of bonds can be subdivided into two: issuer factors and
market factors.

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

• Issuer’s current credit rating (which itself will reflect the issuer’s specific prospects and highlight the
issuer’s default risk).
• The structure and seniority of the particular issue, for example, the bonds may be high- or low-
priority in the event of default by the issuer and may be structured in a way that gives the bonds
particular priority in relation to particular assets (such as mortgage-backed bonds).
• The above aspects, combined with prevailing yields available on other benchmark bonds (such
as government issues in the same currency, with similar redemption dates), will determine the
required yield to maturity (YTM) and, therefore, the appropriate price.

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Market Factors
Additionally, market factors that influence bond pricing will include the following:

• Liquidity – the more liquid bonds tend to be more expensive, encompassing a liquidity premium
and having narrower bid/offer spreads.
• Method of trading – some bonds attract firm quotes while others are traded with indicative quotes
only; the precise price will only be arrived at by negotiation.
• Ability to borrow – bonds with active repo markets, and the ability to cover short positions
relatively easily, will inevitably react more quickly to underlying interest rate changes and therefore
yield changes.

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

One of the difficulties that arose during this crisis was the mispricing in the US Treasury market, where
the most recently issued long-term bond, known as the on-the-run bond, trades at a premium to
those bonds which had been issued previously and which are known as off-the-run. If investors have a
preference, during a crisis, for the most liquid instruments, they may hoard the on-the-run bonds and
force their price to be out of normal alignment with similar bonds which have slightly different maturity
dates. This can result in a breakdown in complex strategies designed to exploit the spreads or price
differences across the yield spectrum.

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 Secondary Markets

End of Chapter Questions

1. What is a dark pool?

Answer reference: Section 1.1

2. How does order-driven trading differ from quote-driven trading?

Answer reference: Section 2.1

3. What is a broker-dealer?
Answer reference: Section 2.2

4. What is a prime broker?

5
Answer reference: Section 2.4

5. What priority is normally given to orders on an exchange’s order book?

Answer reference: Section 3.1.1

6. What is an iceberg order?

Answer reference: Section 3.2

7. What benefits do central counterparties bring to market participants?

Answer reference: Section 3.3

8. How many companies are included in the Dow Jones Industrial Average (DJIA) and what markets
does it represent?
Answer reference: Section 4.1

9. What are the four types of participants that facilitate deals in the government bond markets?
Answer reference: Section 5.1

10. What is the typical method of trading corporate bonds?

Answer reference: Sections 6.1 and 7

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162
Chapter Six

Corporate Actions
1. Income Events 165

2. Capital Events 168

3. Capital Raising Events 175

6
4. Share Capital and Changes to Share Ownership 184

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

Corporate actions are events that are instituted by an issuer of securities, such as a company with
shares in issue or an organisation with bonds in issue, that directly impact those securities. Perhaps
the most obvious examples are when a company pays a dividend to its shareholders or a coupon to its
bondholders. These are referred to as income events. Other corporate actions include those that bring
about changes to the share capital of a company (capital events and capital raising events), such as
when the company gives away new shares to existing shareholders for nothing (scrip issues), or offers
new shares to existing shareholders at a discounted price (rights issues).

1. Income Events

Learning Objective
6.1.1 Understand the main types of dividends and bond coupon payments: characteristics; benefits

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to the investor; benefits to the issuing company

The two major classes of securities are equities and bonds; while bondholders will receive income in the
form of coupon payments, equity holders might receive income in the form of dividends from the issuer.

1.1 Bonds
Interest income from bonds is generally more predictable than dividend income from equities. The
contractual nature of a bond’s coupon means that the investor knows in advance how much income
is expected and when it will be paid, based on the coupon rate, payment frequency and the nominal
value of the bond. Most bonds pay coupons either semi-annually or annually, and the coupon is a fixed
percentage that is set when the bond is issued.

An additional benefit for the investor could be that sometimes a bond pays attractive coupons relative to
the prevailing interest rate because interest rates have fallen since the bond was issued. This also leads to
an appreciation in the bond’s market price. If investors buy or sell bonds on the secondary market, they
can also calculate accrued interest, which enables them to know exactly how much income has accrued
by any date.

The issuer of fixed-coupon bonds has the benefit of predictability too – knowing how much and how
often the coupons need to be paid and how much capital must be repaid to the bondholder at the
bond’s maturity. An additional benefit for the issuer may arise when interest rates have generally risen
and it managed to lock in an attractively low coupon when the bond was issued.

Awkwardness in the usually straightforward income events for bonds can arise in two situations –
when the bonds are floating-rate notes (FRNs) and when the issuer is having difficulty in meeting the
contractual payment of the coupons due to profitability and cash flow constraints.

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FRNs specify a coupon based on a published rate of interest, usually based on a margin above one
of the London Interbank Offered Rates, LIBORs, or Eurozone equivalents, EURIBOR or more recently
introduced reference rates like the Secured Overnight Financing Rate (SOFR). This clearly removes some
of the predictability in the amount for both the investor in the bond and the issuer, as it will vary with
changes in the level of the reference interest rate. It is also common for FRNs to have income events
more regularly than most other bonds by paying quarterly coupons. By way of an example, below are
some extracts from an FRN issued by the international bank, Standard Chartered.

Example
Standard Chartered
• In common with a number of large banks, Standard Chartered has perpetual floating rate bonds in
issue.
• At the end of 2018, Standard Chartered had $600m nominal of callable floating rate senior notes in
issue, maturing in 2023. The bonds pay an annual coupon of 3-month US dollar LIBOR plus 1.150%.

The second potential issue that impacts the usual predictability of a bond’s income events is where the
issuer gets into difficulty and cannot meet the contractual coupon payment. This is clearly more likely
if the bonds are lower on the credit rating scale – perhaps classified as ‘junk’ or in other words, below
investment grade.

1.2 Equities
The income from equities in the form of dividends is typically much less predictable than the income
from bonds. Company dividends are generally variable in amount and will be dependent upon the
profitability and cash flow generation of the issuer. That said, many larger, established and listed
companies offer predictability in terms of both the frequency with which dividends are paid (for
example, US companies tend to pay dividends quarterly), and the amount. This is because most
companies do all they can to at least maintain the dividends paid per share from one year to the next.
A pattern of growing dividends from year to year would be even better. This is clearly illustrated in the
following example for the US-listed oil company, ExxonMobil.

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 Corporate Actions

Example
ExxonMobil Dividend Information
Latest announced dividend payment:

Rate Ex-dividend date Record date Payment date

$0.87/share 10 November 2020 12 November 2020 10 December 2020

ExxonMobil dividends per common share:

2020 2019 2018 2017 2016 2015 2014 2013 2012

Q1 0.87 0.82 0.77 0.75 0.73 0.69 0.63 0.57 0.47
Q2 0.87 0.87 0.82 0.77 0.75 0.7 0.69 0.63 0.57

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Q3 0.87 0.87 0.82 0.77 0.75 0.73 0.69 0.63 0.57
Q4 0.87 0.87 0.82 0.77 0.75 0.73 0.69 0.63 0.57
Total $3.48 $3.43 $3.23 $3.06 $2.98 $2.88 $2.70 $2.46 $2.18

ExxonMobil’s dividend payments to shareholders have grown at an average annual rate of 6.4% over the
last 38 years.

Source: Exxon Mobil

The benefits to the investors in equity from dividend income events are that the dividends tend to be
predictable in terms of frequency and the amount can show some upside potential when the issuer
does well.

The benefits to the issuer of equity financing include that the company can reduce, or even stop, the
payment of dividends in times of lower profitability and/or the need to conserve cash.

Preference shares are often described as a hybrid instrument because they are essentially a halfway
house between equities and bonds. The income events for preference shares are dividend payments,
but the rate of dividend will be specified in advance in a similar way to the coupons on a bond. This will
increase the predictability of income events for the investor compared with conventional equity. As
preference shares are a form of equity, the issuer will retain the flexibility to stop paying dividends in
times of stress. This option is not available for the contractual coupons on a bond.

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 2. Capital Events

2.1 Bond Repayments

Learning Objective
6.2.1 Know the main types of bond repayment events: bullet maturities; callable and puttable
bonds; sinking funds

A capital event for a bond involves the repayment of the principal borrowed. In the UK and the US, this
usually occurs as a single lump-sum repayment of the entire principal at the maturity date specified in
the bond’s contractual term. This is often described as a bullet payment. Therefore, it is bonds which are
structured to be repaid once that are referred to as bullet issues. Alternatively, non-bullet issues would
repay the principal over a series of payments, rather than in a lump sum. Since the issuer is required to
make a large payment on a single date, often far in the future, bullet issue bonds are considered to be
riskier than non-bullet bonds. Because bullet issues are riskier, they usually pay a higher rate of interest
to compensate the lender.

A variation on the single bullet maturity is the sinking fund. A sinking fund involves the issuer setting
aside a certain amount of funds toward the maturity repayment each year. The money is often paid to a
separate trustee, who will either hold the money until the scheduled maturity date, or buy back bonds in
the open market if they are trading below par. The sinking fund reduces the risk that the issuer will not
have sufficient funds to repay the entire principal on the maturity date.

Example
The Zambian government has established a sinking fund for repayment of two sovereign eurobonds.

Zambia issued its debut bond of US$750 million in 2012 and this was followed by another US$1 billion
bond in 2014. The two bonds are expected to mature in 2022 and 2024 respectively, with concerns that
the country may not be able to repay the funds due to economic challenges.

Chief Government Spokesperson, Chishimba Kambwili, said in a statement released after a Cabinet
meeting that ‘cabinet approved the establishment of the sinking fund which was expected to run over nine
years and will help to ensure accumulation of resources for the repayment of the bonds at maturity’.

However, the Zambian government began speaking with creditors about restructuring its foreign debt
in early 2020, causing the 2024 bond to trade as low as 30 cents on the dollar. In October 2020, a missed
coupon payment triggered a one-month grace period which lapsed in November of that year. The issues
are now in default and discussions between the government of Zambia and international creditors are
ongoing.

A sinking fund approach may be combined with a bond issue that is callable. A callable bond is one
where the issuer has the right, at specified points during the bond’s life, to redeem some, or all, of the
bonds at a pre-agreed amount, often at par value. Obviously, a call provision will give the issuer the
ability to redeem a bond early if it is relatively expensive.

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 Corporate Actions

In contrast, some bonds are issued with put provisions. These putable bonds give the bond investors the
flexibility to require the bonds to be redeemed early, after giving the issuer due notice.

2.2 Equity Capital Events

Learning Objective
6.2.2 Understand the characteristics and rationale for capital restructuring events and the effect on
the company’s accounts: bonus issues; stock splits; reverse stock splits

In this section, three types of capital events for equities will be considered that do not involve any
money flowing between the equity investor and the company. All three – bonus issues, stock splits and
reverse stock splits – are undertaken to restructure the equity section of the company’s accounts and,
more importantly, change the price at which the shares in the company trade.

6
2.2.1 Bonus Issues
A bonus issue is where a company issues new shares to its shareholders for no consideration or pro bono,
raising no further capital. This corporate action is referred to in one of three ways – as a bonus issue, a
scrip issue or a capitalisation issue. The reasons for doing this vary; sometimes it is as a public relations
exercise to accompany news of a recent success or, more likely, it is simply as a means of reducing the
current market price to make its shares more marketable.

It will have an impact on the way shareholders’ funds are shown in the company’s accounts, usually by
converting undistributable capital reserves into share capital. A company simply converts its reserves,
which may have arisen from issuing new shares in the past at a premium to their nominal value and/
or from the accumulation of undistributed past profits, into new shares. These new shares rank equally
with those already in issue and are distributed to the company’s shareholders in proportion to their
existing shareholdings, free of charge.

Although as a result of the bonus issue the nominal value of the company’s share capital will increase
proportionately to the number of new shares issued, the net worth or intrinsic value of the business
should remain the same. However, given that the company’s earnings, or profits, and dividends will
now be spread over a wider share capital base, the company’s earnings per share (EPS) and dividends
per share (DPS) should fall proportionately with the number of new shares in issue. This should result in
the market price of the shares reducing by the same proportion, thereby leaving the company’s overall
market capitalisation unchanged.

Traditionally, once a UK company’s share price starts trading well into double figures in pounds sterling,
or, in the US, once the market price exceeds $200, it is felt that marketability starts to suffer as investors
shy away from the shares they consider excessively expensive. Therefore, a reduction in a company’s
share price as a result of a bonus issue usually has the effect of increasing the marketability of its shares.
It can also raise expectations of higher future dividends. This, in turn, might result in the share price
settling above its new theoretical level and the company’s market capitalisation increasing slightly.

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2.2.2 Stock Splits and Reverse Stock Splits
An alternative to a bonus issue as a way of reducing a share price is to have a subdivision or stock split,
whereby each share is split into a number of shares. The reason a company would do this is that the share
price has become too high, which impacts investor access and liquidity. For example, a company with
shares having a nominal value of US$500 each and a market price of US$1,000 may have a split whereby
each share is divided into five shares, each with a nominal value of US$100. In theory, the market price of
each new share should be US$200 (US$1,000 ÷ 5). This is termed a ‘5-for-1 split’.

There is little difference between a bonus issue and a stock split in terms of the impact on the share
price, but the way the two impact the accounts of the company is different. A bonus issue will increase
the share capital line reflected in the accounts, with a corresponding movement from reserves. A stock
split will not alter the share capital line – it will be the same total amount but will be subdivided into a
larger number of shares, each with a smaller nominal value.

By way of an example, the following is an extract from a CNN article that followed a stock split by
technology giant Apple in 2014.

Example
Apple Just Got ‘Cheaper’. Will You Buy?
Apple is about to split its stock. A share of Apple worth about $647.50 will become seven shares at around
$92.50.

Apple is the most valuable company in the world. Many consumers use (and love) its products. Yet for average
investors, the stock has often been too expensive to touch.

You could buy a 16GB iPad Air with Wi-Fi and standard cellular connections for $629 – and that costs less
than one share of Apple. But that just changed.

A share of Apple went from costing $645.57 (as of Friday’s closing price) to about $92.44 – give or take a
few cents. That is because the company did what is known as a stock split. It issued more shares to existing
investors in order to bring down the price of the stock.

Current shareholders received seven shares of Apple for each one they owned. As a result, the stock price is
one-seventh of where it used to be.

It is important to note that if you already owned Apple, nothing really changed. You just have more stock at a
lower price. The value of your investment – and the market value of Apple – stays the same.

So why is Apple doing this? Companies with stock prices above $100 often decide to split their stock to try and
lure more individual investors.

A reverse split, or consolidation, is the opposite of a split: shares are combined or consolidated. For
example, a company with a share price of US$0.10 may consolidate ten shares into one. The market price
of each new share should then be US$1 (US$0.10 x 10). A company may do this if the share price has
fallen to a low level and it wishes to make its shares more marketable. The impact on the share capital
in the company’s accounts will be similar to a stock split in that the total will remain the same, but the
subdivision will be into a smaller number of shares each with a larger nominal value.

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 Corporate Actions

2.3 Impact of Capital Restructuring Events on the Share Price

Learning Objective
6.2.3 Be able to calculate the impact of bonus issues, stock splits and reverse stock splits on the
share price

The following table shows the impact of a 1-for-3 scrip issue on a company. The company started with
750,000 $1 shares in issue trading at $3 each, so the market capitalisation of the company is 750,000 x
$3 = $2.25 million. The $3 price is generally referred to as the cum bonus price (also known as cum scrip
or cum capitalisation). It is the price including the forthcoming bonus before the issue has happened.
Assuming the financial statement of the company reflects this market capitalisation, the company
will have net assets of $2.25 million. A transfer of $0.25 million from retained profits to the share
capital account is required to cover the 250,000 shares given away in the scrip issue. When the market

6
capitalisation of $2.25 million is divided by this enlarged number of 1 million shares, the resulting share
price is $2.25. So, the impact of the scrip issue has been to reduce the share price from $3.00 to $2.25.
The $2.25 is the theoretical ex-bonus price that is expected after the issue. It is theoretical because it
assumes nothing else has altered in the market for the shares. In reality, market movements may not
mean that this is the actual resulting share price after the bonus issue.

Bonus, Scrip or Capitalisation

Impact on the accounts (all amounts in $000)
Before Issue After
Net assets 2,250 2,250
Issued share capital
1m $1 shares 750 250 1,000
Retained profit 1,500 (250) 1,250
Totals 2,250 0 2,250
Impact on the share price
Shares (000) Price $ Value ($000)
Before 750 3.00 2,250
Scrip issue 250
After 1,000 2,250
Market price for shares 2.25

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An alternative way of calculating the theoretical ex-bonus price of the shares is to consider a shareholder
that holds the minimum number of shares to qualify for the bonus issue – in this case three shares.
As the table below shows, the shareholder started with three shares each worth $3, so the portfolio
was worth $9. Since no cash has flowed into the company, after the free share has been received the
portfolio should still be worth $9. Now, the shareholder has four shares, so the theoretical ex-bonus
price is $9 divided by 4 = $2.25.

Number of shares Price per share Total value of holding

Before 3 $3 $9
Bonus 1 Nil Nil impact
After 4 $9/4 = $2.25 $9

Example
XYZ makes a bonus issue to its shareholders on a 1-for-4 basis to coincide with the launch of a new
product. Prior to the announcement of the issue, the company’s shares traded at $2.00 per share. If
the company had 1 million shares in issue, each with a nominal value of $0.25 in issue prior to the
announcement, calculate:

• the number of shares and the nominal value of the company’s share capital immediately before and
immediately after the announcement
• the new theoretical market price for the shares
• the market capitalisation of the company immediately before and immediately after the
announcement based on the pre-existing share price and the new theoretical market price.

Solution

Number of shares
• Immediately before = 1m.
• Afterwards, with one new share given away for every four = 1m + 0.25m = 1.25m

Nominal value of the company’s share capital

• Immediately before = 1m x $0.25 = $250,000.
• Immediately after = 1.25m x $0.25 = $312,500.

Theoretical market price after the bonus issue

The theoretical market price will be $2.00 x (4/5) = $1.60.

Using the alternative approach considering the minimum number of shares to qualify for the bonus –
here, four shares:

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 Corporate Actions

Number of shares Price per share Total value of holding

Before 4 $2 $8
Bonus 1 Nil Nil impact
After 5 $8/5 = $1.60 $8

Market capitalisation
• Immediately before = 1m x $2.00 = $2m.
• Immediately after = 1.25m x $1.60 = $2m.

The alternative way of lowering the price per share, but avoiding this problem, is to undertake a split. A
stock split is achieved by dividing the existing share capital into a larger number of shares with a lower
nominal value per share. The lower price should make the shares more accessible for investors and so

6
therefore increase trading activity and liquidity for existing and prospective shareholders.

Example – Stock Split

A company has issued 1 million shares at $1 nominal or par value but now wishes to reduce the price
of its shares by replacing that issue with a new issue of 5 million shares at a nominal value of $0.20. The
results can be seen on the simplified section of the financial statement as follows. In effect, the company
is engaging in a 5:1 stock split. Before the split, assume the shares are trading at $3 each.

Stock split
Impact on the accounts (all amounts in $000)
Before Issue After
Net assets 2,000 2,000
Share capital
1m $1 shares 1,000 (1,000)
5m $0.20 shares 1,000 1,000
Reserves – retained profits 1,000 1,000
Totals 2,000 0 2,000
Impact on the share price
Shares (000) Price $ Value ($000)
Before 1,000 3.00 3,000
Split issue 4,000
After 5,000 3,000

Market price for shares 0.60

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It can be seen that the price per share will drop to $0.60. In essence, each individual $1 nominal share
has been split into five shares, each with a nominal value of $0.20. Therefore, the share price will
theoretically fall to one fifth of the $3, that is $0.60.

The prior market capitalisation was $3 million based on 1 million shares but there are now 5 million
shares issued and the market price for the shares is, therefore, $3 million divided by 5 million shares.
The new market price for the shares of $0.60 is above the new nominal value of $0.20 per share, so the
company would not encounter any problem in issuing these new shares with this nominal value.

In contrast, a reverse stock split entails consolidating the existing share capital into a smaller number of
shares with a higher nominal value per share. The result should be a higher price per share.

Example – Reverse Stock Split

A company has issued 4 million shares at a nominal value of $1 but now wishes to increase the price of
its shares by replacing that issue with a new issue of 2 million shares at a nominal value of $2. The results
can be seen on the simplified section of the financial statement as follows. In effect, the company is
engaging in a 1:2 reverse stock split. Before the reverse split, assume the shares are trading at $1.20 each.

Reverse stock split

Impact on the accounts (all amounts in $000)
Before Issue After
Net assets 5,000 5,000
Share capital
4 million $1 shares 4,000 (4,000)
2 million $2 shares 4,000 4,000
Reserves – retained profits 1,000 1,000
Totals 5,000 0 5,000
Impact on the share price
Shares (000) Price $ Value ($000)
Before 4,000 1.20 4,800
Reverse split issue 2,000
After 2,000 4,800

Market price for shares 2.40

It can be seen that the price per share will rise to $2.40. In essence, each individual $1 nominal value
share has been amalgamated into a single $2 nominal value share. Therefore, the share price will
theoretically increase to twice the original share price of $1.20, that is $2.40.

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The prior market capitalisation was $4.8 million based on 4 million shares, but there are now only 2
million shares in issue and the market price for the shares is, therefore, $4.8 million divided by 2 million
shares. The new market price of the shares is $2.40.

Exercise 1
a. A company has a 1-for-1 bonus issue. What is the ex-bonus price (the price after the issue) if the
cum-bonus price (the price before the issue) is $10? Here is a blank table to help:

Number of shares Price per share Total value of holding

Before
Bonus
After

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b. What difference would it make if the shares were split with two shares replacing each previous
share?
c. What difference would it make if a reverse stock split was carried out, with every five original shares
becoming a single new share?

The answers to this exercise can be found at the end of this chapter.

3. Capital Raising Events

3.1 Rights Issues

Learning Objective
6.3.1 Understand the characteristics of rights issues: reasons for a rights issue; pre-emptive rights;
structure of rights issue; stages of rights issue; trading nil-paid
6.3.2 Be able to calculate: the impact of a rights issue on the share price; the maximum nil paid
rights to be sold to take up the balance at nil cost; the value of nil paid rights

Before considering rights issues, it is important to consider the concept of pre-emptive rights. Pre-
emptive rights are legally required in many jurisdictions around the world and give existing shareholders
the right to subscribe for new shares. What this means is that, unless the shareholders agree to permit
the company to issue shares to others, they will be given the option to subscribe for any new share
offering before it is offered to the wider public. The purpose of this is to ensure that the level of influence
or control that a shareholder has is not diluted by any issue without that shareholder’s prior knowledge
and agreement.

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Example of Dilution
Suppose an investor holds 400 shares out of a total of 10,000 shares in XYZ plc, a 4% stake in the
company. XYZ then decides to issue 10,000 further shares. That means that there are now 20,000 shares
in issue. The investor’s original 400 shares now represents a 2% stake rather than a 4% stake. This is
dilution.

The existence of pre-emption rights means that listed companies cannot issue equity shares,
convertibles or warrants for cash, other than to the current equity shareholders of the company, except
with the prior approval of the current shareholders in a shareholders’ meeting. Jurisdictions, typically,
require a special resolution from shareholders before allowing new shares to be allotted in cash to
anyone other than the existing shareholders in proportion to their existing holding.

However, it is quite common to see the waiving of pre-emption rights as a proposed special resolution at
the annual general meetings (AGMs) of listed companies, although best practice is to limit such issuance
to 5% in any single year unless there is an identified purpose for the issue detailed in the resolution.

Example – Pre-emptive Rights

Investor X holds 400 ordinary shares of the 10,000 issued ordinary shares in ABC plc. Investor X,
therefore, owns 4% of ABC plc.

If ABC plc planned to increase the number of issued ordinary shares by allowing investors to subscribe
for 10,000 new ordinary shares, Investor X has the pre-emptive right to be offered 4% of the new shares,
ie, another 400 shares. This would enable Investor X to retain their 4% ownership of the enlarged
company.

In summary:

Before the issue Further issue After the issue

Investor X 400 (4%) 400 800 (4%)
Other shareholders 9,600 (96%) 9,600 19,200 (96%)
Total 10,000 (100%) 10,000 20,000 (100%)

A rights issue is one method by which a company can raise additional capital, complying with pre-
emptive rights, with existing shareholders having the right to subscribe for new shares.

A rights issue is an offer by a company of new shares for cash to the existing shareholders in proportion
to their existing holding. The shares are usually priced at a discount to the current market price. The
holder of the right, as the name suggests, has the right, but not the obligation, to purchase additional
shares directly from the company at the discounted price. The right will have an expiry date, after which
it will no longer be valid. Rights are short-term privileges and can be traded, usually on the exchange on
which the company is listed, until they expire.

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A rights issue is an attractive way for a company to raise new finance for the following reasons:

• There is no dilution of shareholders’ interest, ie, someone who held 20% of the shares before the
issue will hold 20% after (assuming they take up their rights).
• The issue is at a discount to the current market price to make it attractive.
• Existing ordinary shareholders of a company will receive a provisional allotment of new shares. After
being granted such an allotment, each may decide to exercise the rights to add to their holding, but
there is no obligation to take up the offer.
• A shareholder who does not want to subscribe more cash and take up their rights can sell them,
receiving cash as payment for the dilution of interest that they will suffer.
• Such issues are generally underwritten to cater for those individuals who do not want to exercise
their rights, thus the company can be sure of raising all the finance it requires.
• In essence, a rights issue is a way of avoiding the negative effects of dilution on shareholders.

The rationale for a rights issue could be to fund expansion, perhaps to take over a rival or to diversify into
a new business area, or to raise more capital to enable the issuer to survive. Existing shareholders receive

6
a provisional allotment letter, which tells them how many shares they are entitled to and what the price
will be.

Existing shareholders do not have to participate in the rights issue but can sell the rights nil-paid, either
in part or in full. A fuller discussion of the method of calculating the nil-paid value is discussed below,
but the essential feature is that the issuer provides the current shareholders with a transferable security
(known as a provisional allotment letter) which can be sold to other investors.

By way of an example, the UK-listed engineering group Rolls Royce announced a rights issue to raise
around £2 billion in October 2020 as part of a number of measures to enable it to survive the Coronavirus
pandemic:

Example – Rolls Royce plc – Extracts from Rights Issue Booklet – 01 October 2020
We were pleased that in February 2020 we were able to report to you, our shareholders, that the group
had delivered strong progress in 2019 and that we had started 2020 with real momentum. The sudden
and material effect of the COVID-19 pandemic has had a significant impact on the commercial aviation
industry. This has resulted in a sharp deterioration in the group’s financial performance, particularly in
our Civil Aerospace business. There is considerable uncertainty about the precise pace of the industry
recovery and the possibility of delays remains a risk. In response we have taken, or are committed to
undertake, a number of significant actions in order to strengthen our financial position and seek to
ensure we can deliver improved future returns.

We have recently announced that we would like to do a rights issue as one of these measures. The
rights issue, along with the other measures we are putting in place, will mean we can restore financial
performance in order to improve returns and build a more resilient and more appropriate balance sheet;
drive growth and maximise value from our existing capabilities; and position the group to benefit from
new technologies, with a focus on sustainable power.

In this rights issue, you get the right to buy ten new shares for every three shares you already own, at a
price of 32p per new share.

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3.1.1 Mechanics of a Rights Issue
New shares are offered in proportion to each shareholder’s existing shareholding, usually at a price
deeply discounted to that prevailing in the market, to ensure that the issue will be fully subscribed and
sometimes to reduce, or even avoid, the cost of underwriting the shares. The number of new shares
issued and the price of these shares will be determined by the amount of capital to be raised.

The right to participate in such an issue is only conferred upon those shareholders who hold the issuing
company’s shares cum-rights – that is, those who hold the company’s shares before trading in the shares
is conducted on an ex-rights, or without-rights, basis. The ex-rights period begins on, or shortly after,
the day on which the rights issue announcement is made and runs for a further period, tending to be
a minimum of ten business days, through to the acceptance date, the date by which the shareholder
should have decided whether or not to take up these new shares.

Those entitled to participate in the rights issues are advised of their entitlement by means of a
provisional allotment letter. The provisional allotment letter is renounceable and transferable and it sets
out the shareholder’s existing shareholding, the rights allotted over the new shares and the acceptance
date. The ex-rights period begins on the day after the allotment letter is posted.

As these new shares rank equally, or pari passu, with the existing shares in issue, once the existing shares
are declared ex-rights, the market price should fall to reflect the dilution effect that the new shares will
have on the prevailing share price. The price to which the shares should fall is termed the theoretical
ex-rights price, and its method of calculation is as follows:

[( ) ( )]
No. shares held cum-rights No. rights allocated
x + x
cum-rights share price rights issue price

Total no. shares held assuming rights exercised

The difference between the theoretical ex-rights price and the rights issue price is known as the nil-paid
value, and the calculation and significance of this will be illustrated in the following sections.

As noted above, shareholders typically have a minimum of ten business days to decide how to react to
the announcement following receipt of the provisional allotment letter and must choose between one
of the four following courses of action:

• Option One – Take up the rights in full

Take up the rights in full by purchasing all of the shares offered. To take up the rights in full, the
shareholder simply sends the company the provisional allotment letter, with a cheque, by the due
date.
• Option Two – Sell the rights nil-paid in full
If a shareholder entitled to take up the rights issue decides not to, they can sell the rights to these
new shares nil-paid. The purchaser of the nil-paid rights will be able to take up the shares at the
discounted price. Essentially they have a short-dated option on these new shares that can only be
exercised, or traded, during the three-week ex-rights period. To sell the rights nil-paid in full the
shareholder must sign the form of renunciation on the reverse of the provisional allotment letter and
send it to their broker by the due date.

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 Corporate Actions

• Option Three – Sell part of rights nil-paid to preserve current stake without dilution
The shareholder can sell sufficient of the rights nil-paid to finance the take-up of the remaining
rights. This course of action would be taken by a shareholder wishing to retain their shareholding
in the company but without any desire to invest any further capital at this stage. When selling
the rights nil-paid in part, the shareholder does exactly the same as when selling them in full but
requests that their broker split the allotment letter in accordance with the number of rights sold and
those to be taken up. One of the split allotment letters will go to the purchaser of the rights, and the
other to the original shareholder.
• Option Four – Take no action
Any shareholder not taking any action by the acceptance date stipulated in the provisional
allotment letter will automatically have their rights sold nil-paid. The proceeds, less any expenses
incurred by the company, are then distributed to all such shareholders on a pro rata basis. For the
smaller shareholder not wishing to increase their shareholding in the company, this is often the
most economical way to proceed.

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3.1.2 Impact of a Rights Issue on the Share Price
To illustrate the impact on the share price for a company which undertakes a rights issue, the following
are the key variables in the example discussed below:

• Prior to the rights issue the company has 1 million shares in issue with a nominal value of £1.00
each. The nominal value is also referred to as the par value – it is the minimum price that the issuing
company must receive when issuing shares.
• The share premium account (sometimes termed additional paid-in capital) shows a balance of £0.5
million. The share premium account is the capital that a company raises upon issuing shares that is
in excess of the nominal value of the shares.
• The company wishes to raise new capital for expansion and undertakes a 1-for-4 rights issue at a
price of £1.50 in order to raise £375,000.
• The company’s accounts before the rights issue show that net assets are £2 million and retained
profits are £0.5 million.
• The market price of the shares prior to the rights offering is £3.00 per share.

What is the impact on the accounts and the theoretical market price per share of this issue?

A 1-for-4 rights issue means that for every four shares previously in existence, one new share will be
issued. In our example, 1 million shares were previously in issue, so 250,000 new shares will be issued at
a price of £1.50 in order to raise the £375,000 cash required.

In terms of the accounts, the 250,000 new share issue will increase the share capital to 1.25 million
shares, the retained profit (retained earnings) will remain unchanged but the share premium account
will need to be adjusted. The reason for this adjustment is that for the £375,000 raised, each of the
250,000 new shares can be issued at the nominal value of £1 but the additional £125,000 raised in excess
of the nominal value of the shares is allocated to the share premium account as indicated in the simple
balance sheet perspective in the table below.

The total capitalisation of the company will have increased to £2.375 million and can be broken down
according to the upper part of the table which reflects the rights issue from an accounting perspective.

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The impact on the share price can be seen from the calculation of the theoretical market price in the
lower part of the table. The price for the shares should have fallen from £3.00 per share before the rights
issue to £2.70 after the issue to reflect the new capitalisation divided by the greater number of shares
now outstanding.

Rights issue
Impact on the accounts (all amounts in £'000s)
Before Issue After
Net assets 2,000 375 2,375
Share capital
1m £1 ordinary shares 1,000 250 1,250
Share premium 500 125 625
Retained profit 500 500
Totals 2,000 375 2,375
Impact on the share price
Shares ('000s) Price £ Value (£'000s)
Before 1,000 3.00 3,000
Rights issue 250 1.50 375
After 1,250 3,375

Market price for shares 2.70

Another perspective on this can be seen simply by looking at the following formula, which only requires
knowledge of the share price before the rights issue and the actual terms of the rights issue.

The formula for the theoretical ex-rights price is as follows:

[( ) ( )]
No. shares held cum-rights No. rights allocated
x + x
cum-rights share price rights issue price

Total no. shares held assuming rights exercised

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 Corporate Actions

Total value
Number of Price per
Description of holdings
shares share (pence)
(pence)
Shares held cum-rights 4 300 1,200
Rights allocated – new share entitlement 1 150 150
Post rights issue assuming rights taken up 5 1,350
Theoretical ex-rights price =1,350/5 270

Exercise 2
A company’s shares are currently trading at $5.00 each. The company announces a 1-for-3 rights issue at
$3.00 per share. What is the theoretical ex-rights price? Here is a blank table to help:

6
Number of shares Price per share Total value of holding
Before
Bonus
After

The answer to this exercise can be found at the end of this chapter.

3.1.3 Nil-Paid Value

The nil-paid rights is the theoretical value of the right to buy a share in a rights issue. This is calculated by
comparing the theoretical ex-rights price to the price of exercising the right.

As can be seen, it is straightforward to substitute the following values using the minimum number of
shares required to qualify for the rights issue (in this case four shares) from the company provided above:

Number of shares held cum-rights = 4

Cum rights share price = £3.00
Number of rights allocated = 1
Rights issue price = £1.50
Total shares assuming rights exercised = 5
Solving = {[4 x £3.00] + [1 x £1.50]}/5 = £13.50/5 = £2.70

Given this example, the price of each nil-paid right should be calculated from the ex-rights share price –
price of the new shares = 270p – 150p = 120p.

Obviously, it would not be rational to pay more than 120p for the right to purchase a new share for 150p
when the ex-rights price of the existing shares in issue is 270p.

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Exercise 3
A company’s shares are currently trading at $8.00 each. The company announces a 1-for-6 rights issue at
$4.50 per share. What is the nil-paid value? Here is a blank table to help:

Number of shares Price per share Total value of holding

Before
Bonus
After

The answer to this exercise can be found at the end of this chapter.

3.1.4 Selling Some Rights to Take Up Others (‘Swallowing the Tail’)

As discussed in the preceding section, the third possibility for a shareholder in a rights issue (instead of
exercising their rights, or selling all of their rights nil-paid) is the situation when investors can choose to
sell some of their entitlement and use the cash raised to take up the rest of the offer. In effect, they can
buy a sufficient number of shares in the offering to utilise the cash they receive from selling a proportion
of their rights entitlement nil paid. They do not invest any additional funds into the business.

The number of nil-paid rights to be sold to take up the balance at nil cost is given by the equation:

Issue price of new shares x number of shares allocated

Theoretical ex-rights price

As nil-paid rights cannot be sold in fractions, the number must be rounded up to the nearest integer or
whole number value.

The actual process of selling some rights to use the proceeds to buy the remaining rights without having
to invest any new proceeds is sometimes known as ‘swallowing the tail’ and can be demonstrated in the
following table which is expanded from the one shown earlier. The table assumes the investor’s current
holdings, cum-rights, is 2,000 shares, and all of the information is the same as contained in the rights issue
case study discussed, that is a 1 for 4 rights issue at an exercise price of 150p and a cum-rights share price
of 300p.

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Price
Total value
Number per
Description of holdings
of shares share
(£)
(pence)
Shares held cum-rights 2,000 300 6,000.00
Rights allocated – new share entitlement 500 150 750.00
Post rights issue assuming rights taken up 2,500 6,750.00
Theoretical ex-rights price = 675,000/2,500 270
Nil-paid rights value = 270 – 150 120
No. of nil-paid rights to be sold* 278
Amount raised from selling nil rights = 278 x 120 333.60
Number of rights taken up = 500 – 278 222

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Cost of purchasing rights = 222 x 150 333.00
Gain/(loss) from financing to preserve current stake 0.60
Total value of shares post rights = (2,000 + 222) x £2.70 5,999.40
Total value of position post rights 6,000.00
Net change in position 0.00

* Number of shares to be sold is calculated by taking the issue price of the new shares (here £1.50)
multiplied by the number of shares allocated (here 500) and dividing the result by the theoretical
ex-rights price (here £2.70). The result is 277.7778, rounded to the nearest whole number = 278.

As can be seen from the bottom row, the net change in the investor’s position is zero, ignoring
transaction costs. By selling 278 nil-paid rights and using the proceeds to purchase 222 new shares,
accompanied by the tiny cash gain of 60p on the proceeds, the investor is in the same position as before
the rights issue (in terms of money invested in the business) but now holds an additional 222 shares at
no additional cost.

Exercise 4
A company’s shares are currently trading at $5.00 each. The company announces a 1 for 3 rights issue
at $3.00 per share. For a shareholder with 3,000 shares, how many shares should be sold nil-paid to
‘swallow the tail’?

The answer to this exercise can be found at the end of this chapter.

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 4. Share Capital and Changes to Share Ownership

4.1 Share Buybacks

Learning Objective
6.4.1 Understand why share buybacks are undertaken: governing regulation: resolution at AGM;
limits on percentage of shares and price; use of company’s own money; key aspects of share
buybacks – criteria to comply with: different structures regarding block trades; accelerated
book build – best efforts basis; accelerated book build – back stop price; bought deal

A share buyback occurs when a company decides to use cash to repurchase shares from existing
shareholders. There are two common scenarios where share buybacks may be considered worthwhile:

1. When the company has reduced its activities (perhaps having sold a major part of its business) and
has surplus cash to return to shareholders.
2. When the company wants to reorganise its capital structure to include more debt and less equity. In
these circumstances the company can borrow money (by issuing bonds or from banks), and use it to
buy back and therefore reduce the number of shares it has in issue.

There are restrictions on a company’s ability to buy back its own shares, partly to prevent shareholders
from being unfairly preferred to creditors, and partly to make sure that the company has gained approval
to buy back from its own shareholders. To prevent unfair prejudice against the creditors, regulation
limits the monetary value that can be used to repurchase shares in a given year. For example, in the UK,
there are various accounting tests that need to be satisfied to prevent erosion of what is referred to as
the creditors’ buffer. In simple terms, the creditors’ buffer is the money originally paid into the company
as capital.

Approval from shareholders generally requires a resolution at the AGM to grant permission to buy shares
back. In the AGM, the shareholders will also set the limit on the percentage of shares to be purchased
and the price paid to those shareholders that sell. The limit must be within that outline by the regulator.
The actual mechanics of undertaking a share buyback, once regulatory and shareholder approval has
been gained, can follow a variety of forms, such as:

• Block trades – when an investment bank acting for the company will seek to do a small number of
large trades with investors, perhaps through an exchange.
• Accelerated book build – the investment bank will contact a number of institutions, investors in
the company, seeking their willingness to sell at particular price points. If the buyback is sufficiently
large to require a syndicate (a group of dealers buying back shares, rather than just one), some of
the more junior members may only be willing to be involved on a best efforts basis, and the whole
syndicate will have a price which it cannot go above (the back-stop price). A best efforts basis means
that the dealer(s) will attempt to buy back shares, but do not guarantee any financial compensation,
and cannot be held liable if they fail to meet the targeted number of shares they are seeking to
buy. This is the opposite of a bought deal, in which the underwriter(s) actually purchase the shares
themselves and then attempt to resell them to clients. If all of the inventory bought in a bought deal
is not sold, the investment bank(s) guarantee the numbers of shares they will buy at an agreed price.

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4.2 Stakebuilding

Learning Objective
6.4.2 Understand how and why stakebuilding is used: strategic versus acquisition; direct versus
indirect: direct – outright purchase, ie, dawn raid; indirect – CFDs; disclosure thresholds,
including mandatory takeover threshold

A stake is simply a shareholding, and many investors buy stakes in companies simply for the investment
potential. Sometimes, however, stakes are built in companies for reasons over and above the simple
investment potential.

Strategic stakes may be accumulated in order to prevent a company being taken over by a competitor
and to influence the company concerned. This may be in order to protect supplies. The company may be

6
a key supplier of raw materials to the strategic stakeholder, without which the strategic stakeholder may
have difficulty obtaining the quantity and quality of raw materials it seeks.

Another example would be where a stake is accumulated in the hope of bringing about an acquisition.
An acquisition of another company is achieved by purchasing more than 50% of the shares, and thereby
gaining control of the votes and the company. It is usual to talk in terms of the acquiring company being
the predator or offeror and the company being acquired as the target or offeree.

A predator is unlikely to want the market to be aware of its intentions, as this might increase the price it
has to pay to acquire shares in the target company. The predator might decide to launch a ‘dawn raid’ –
purchasing a large number of shares as soon as the market opens, or at least over a short period of time
before their intentions become clear.

Another possibility for keeping stakebuilding more secretive is to build a stake in an ‘indirect’ way.
Instead of buying shares in another entity directly, the stake could be established by acquiring contracts
for difference (CFDs). A CFD on a share is an agreement between the buyer and seller to exchange the
difference in the current value of the share and its value at the end of the contract. If the difference is
positive, the seller pays the buyer; if it is negative, the buyer pays the seller. CFDs enable participants to
get the economic exposure of owning a stake in another entity in a less visible and potentially leveraged
way.

However, for a potential predator building a stake in order to eventually acquire a target company, or
anyone else building a significant stake, there are generally certain regulatory restrictions.

Example – Stakebuilding Restrictions in the UK

First, as a stake becomes more significant, there are disclosure requirements. In the UK these disclosure
requirements are contained within the FCA’s Disclosure and Transparency Rules. An investor is judged to
have a notifiable interest in a public company if they hold 3% or more of its shares. At this point they are
obliged to inform the company of their holding. Once the investor’s holding is above 3%, they must also
inform the company if it rises or falls through a whole percentage point.

Indirect exposure to shares acquired under other financial instruments that have a similar economic
effect, such as CFDs are included in these disclosure requirements.

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The second regulatory restriction, and in addition to the rules relating to notification and disclosure of
significant shareholdings, is the rules laid down by the Panel on Takeovers and Mergers (POTAM or PTM)
in the UK that apply to stakebuilding during the course of a takeover bid. Under PTM rules, a mandatory
offer is required if any person either:

• acquires shares that take their holding to 30% or more of the voting rights of the target company, or
• increases their holding from a starting point of 30% or more, but less than 50%.

If a mandatory bid is required, the consideration offered must be in the form of cash, or there must
be a cash alternative. The cash offer must not be less than the highest price paid by the offeror in the
previous 12 months.

There are some exceptions to this rule, the main one being for additions to the offeror’s stake during the
course of a formal offer. In any other instances the PTM’s permission is required to acquire shares that
breach the rule.

During the course of an offer, dealings in relevant securities by the offeror or the offeree company, or any
associates, for their own account must be publicly disclosed. The requirement is that disclosure must be
made to the Panel and a Regulatory Information Service (RIS) (such as the LSE’s Regulatory News Service
(RNS)) by noon on the business day following the transaction.

Relevant securities are the shares of the offeror and offeree, and any derivatives such as options on these
shares.

Additionally, PTM rules require that anyone holding more than 1% (before or after the transaction) of
the offeree or offeror company shares must disclose any further transactions (excluding acceptance of
the offer itself ) to the PTM and an RIS by noon on the next business day.

4.3 Takeovers and Mergers

Learning Objective
6.4.3 Know the characteristics of takeovers and mergers

Companies seeking to expand can grow organically or by purchasing or partnering with other existing
companies. In the UK, purchases are often referred to as takeovers or mergers. In the US, the term
‘takeover’ is often referred to as an acquisition, and the initials ‘M&A’ are often used to describe a merger
and/or acquisition or any blending of two existing companies. In both countries, the terms ‘takeover/
acquisition’ and ‘merger’ are often used interchangeably in the press, however there is a difference
between the two.

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 Corporate Actions

A takeover or acquisition occurs if one company buys a majority of the shares of another company;
it gains control over the other company and is, therefore, termed the parent company, while the other
company is its subsidiary. This takeover could be ‘friendly’ because the directors of the target company
are positive about the merits of the takeover and recommend their shareholders accept it. Alternatively,
it could be ‘hostile’ because the directors of the target company recommend rejecting the offer,
perhaps because the amounts being offered are considered too low. Clearly, the shareholders of the
target company could choose to accept or reject the takeover bid regardless of what their directors are
recommending. Hostile takeover bids can be successful and friendly takeover bids can sometimes be
unsuccessful. An example of an attempted takeover that was unsuccessful was Kraft Heinz, attempting
to purchase Unilever in 2017. Unilever directors warned shareholders that the offer made by Kraft Heinz
undervalued the company and that it would result in job cuts in Europe. European shareholders did not
support the takeover.

In a successful takeover, the predator company will buy more than 50% of the shares of the target
company. When the predator holds more than half of the shares of the target company, the predator is

6
described as having gained control of the target company. Usually, the predator company will look to
buy all, or almost all, of the shares in the target company, perhaps for cash, perhaps using its own shares,
or even using a mixture of cash and shares.

Merger is the term reserved for the situation where two companies of a similar size come together to
form a larger, merged entity. In a merger it is usual for one company to exchange new shares for the
shares of the other. As a result, the two companies effectively come together to form a bigger entity
under the joint ownership of the two original groups of shareholders. Often, companies that merge
will include both of the original company names in the new company name to demonstrate that both
brands hold value. Examples include Disney Pixar, JP Morgan Chase and ExxonMobil.

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 Exercise Answers
Exercise 1
a. Bonus issue

Number of shares Price per share Total value of holding

Before 1 $10.00 $10.00

Bonus 1 $0.00 $0.00

After 2 $10/2 = $5 $10.00

The theoretical ex-bonus price would be $5.

b. Share Split
If the shares were split into two, the impact would be the same. The price after the split would be half of
the price before = $10/2 = $5.

c. Reverse Share Split

If there was a reverse share split, and five original shares become one new share, the per share price
would rise. The new shares will theoretically be worth five times the previous value: 5 x $10 = $50.

Exercise 2

Number of shares Price per share Total value of holding

Before 3 $5.00 $15.00

Bonus 1 $3.00 $3.00

After 4 $18.00/4 = $4.50 $18.00

The theoretical ex-rights price is $18.00 divided by 4 = $4.50.

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 Corporate Actions

Exercise 3

Number of shares Price per share Total value of holding

Before 6 $8.00 $48.00

Bonus 1 $4.50 $4.50

After 7 $52.50/7 = $7.50 $52.50

The nil-paid value is the theoretical ex-rights price of $7.50 less the rights price of $4.50 = $3.00.

Exercise 4

6
Number of shares Price per share Total value of holding

Before 3 $5.00 $15.00

Bonus 1 $3.00 $3.00

After 4 $18.00/4 = $4.50 $18.00

The theoretical ex-rights price is $18.00 divided by 4 = $4.50.

The number of shares to be sold is given by:

(Issue price of new shares x number of shares allocated)/theoretical ex-rights price =

3 x 1000/4.50 = 666.66.

Rounded up to 667 shares sold at the nil-paid value of (4.50-3.00) = 1.50 generates $1,000.50.

That would leave 333 shares to be taken up that will cost 333 x $3 = $999.

The shareholder will be left with an additional $1.50 ($1,000.50 – $999.00).

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 End of Chapter Questions

1. What is a bonus issue?

Answer reference: Section 2.2.1

2. What is a stock split and how does it differ from a scrip issue?
Answer reference: Section 2.2.2

3. Why would a company want to split its shares, or undertake a scrip issue that will result in the share
price going down?
Answer reference: Section 2.3

4. What is dilution in the context of a shareholding?

Answer reference: Section 3.1

5. What is a rights issue?

Answer reference: Section 3.1

6. What options exist for a shareholder when a company has a rights issue?
Answer reference: Section 3.1.1

7. Explain nil-paid value in the context of rights issues.

Answer reference: Section 3.1.3

8. Why might a company buy back its own shares?

Answer reference: Section 4.1

9. What are the two main restrictions that companies face when they are considering buying back
some of their own shares?
Answer reference: Section 4.1

10. What is the difference between a takeover and a merger?

Answer reference: Section 4.3

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Chapter Seven

Clearing and Settlement

1. Introduction to Settlement Systems 193

2. Settlement Models 195

3. Custody 199

4. Registered Title 203

5. Designated and Pooled Nominees 204

7
6. Cum- and Ex-Dividend 207

7. Continuous Linked Settlement (CLS) 208

8. Distributed Ledger Technology 210

9. Stock Borrowing and Lending 211

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

1. Introduction to Settlement Systems

Learning Objective
7.1.1 Understand the main stages of clearing and settlement

Settlement occurs after a deal has been executed. While the change in legal ownership is immediate,
the transfer of securities from the seller and the payment from the buyer takes some time. The process
consists of several key stages, collectively described as clearing and settlement:

• Pre-settlement and clearing – as soon as a trade has been executed, a number of procedures and
checks must be conducted before settlement can be completed. These include matching the trade
instructions supplied by each counterparty to ensure that the details they have supplied for the
trade correspond. It also involves conducting checks to ensure that the seller has sufficient securities
to deliver and that the buyer has sufficient funds to cover the purchase cost.
• Settlement – the process through which legal title (ie, ownership) of a security is transferred from
seller to buyer in exchange for the equivalent value in cash. Usually, these two transfers should occur

7
simultaneously.
• Post-settlement – this entails the management of failed transactions and the subsequent
accounting of trades.

When a trade has been executed, a key step in the management of risk in the post-execution, pre-
settlement stage is for the two sides to the trade to compare trade details, and to eliminate any
mismatches, prior to the exchange of cash and securities. This is broadly called the ‘trade confirmation”
step.

The matching of the buyer’s and seller’s trade data is typically conducted at two levels:

1. Trading counterparties compare trade details – this may take place bilaterally, via matching facilities
extended by the securities settlement system (at the central securities depository (CSD) for example),
or via a third-party central matching facility that will compare trade details electronically and issue a
report on matching status (ie, whether matched or unmatched). Trades conducted via an electronic
order book will effectively be auto-matched – matching engine software is integrated into the
electronic order management technology that will provide automated matching of buyers’ and
sellers’ orders in the order book. For centrally cleared transactions, matched instructions may be
forwarded to the central counterparty (CCP) for clearing (see below).
2. Custodians acting on behalf of the buyer and seller will compare settlement instructions in order to
identify potential mismatches prior to the settlement date.

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

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Specifically, the clearing process includes:

• recording key trade information so that counterparties can agree on its terms
• formalising the legal obligation between counterparties
• matching and confirming trade details
• agreeing procedures for settling the transaction
• calculating settlement obligations and sending out settlement instructions to the brokers,
custodians and the CSD
• managing margin and making margin calls; this relates to collateral paid to the clearing agent by
counterparties to guarantee their positions against default up to settlement.

Trades may be cleared bilaterally between the trading counterparties or via a CCP that interposes itself
between buyer and seller. When trades are cleared bilaterally, each trading party bears a direct credit
risk against each counterparty that it trades with.

CCP services are available in a range of markets in order to mitigate this risk. For example, LCH, a multi-
asset class clearing house with divisions in both the UK (LCH ltd), and France (LCH SA), provides CCP
services for equities traded on both the LSE and the Euronext European markets. Similar CCP services
are provided by the LCH Group in other markets such as SwapClear for OTC interest rate swaps, and
CDSClear for credit default swaps (CDSs).

In the US, two major subsidiaries of the Depository Trust and Clearing Corporation (DTCC) provide
clearing services. The National Securities Clearing Corporation (NSCC) provides these services for US
equities trades and the Fixed Income Clearing Corporation (FICC) for US fixed income transactions.

Eurex Clearing AG, which is part of Deutsche Börse Group, is another significant CCP service provider,
that deals with German equities and derivatives. The CME Group in the US also provides clearing services
for certain OTC trades such as interest rate swaps and foreign exchange transactions.

There are two further basic elements to the settlement of trades that can differ across different
instruments and/or markets:

• Timing of settlement – the length of time it takes for a trade to settle is based on the trade date plus
a set number of business days after the trade is executed. This is sometimes called the processing
cycle. Settlement length is usually expressed as T (trade date) + the number of days, for example, T+2
means transaction date plus two business days. Settlement timing differs across different countries/
exchanges and can differ within the same country/exchange by type of security.
• Structure of the settlement system – the Bank for International Settlements (BIS) has identified
three common structural approaches/models for linking delivery and payment in a securities
settlement system that are all typically described as achieving delivery versus payment (DvP). These
are described in detail in the following section.

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2. Settlement Models

Learning Objective
7.1.2 Understand the concept of DvP and the main differences between DvP models 1 to 3 as
defined by the BIS

As mentioned, DvP is delivery versus payment and the concept is that, after agreeing a deal, the two
parties concerned, for example, the buyer of shares and the seller of those shares, both face risks. The
seller faces the risk that the buyer may not pay for the shares and the buyer faces the risk that the seller
may not pass over ownership of the shares. A system that guarantees DvP will remove those risks by only
transferring ownership of the shares when the payment is certain, and only making the payment when
the transfer of ownership is certain. The BIS identifies the following three models for DvP settlement
systems:

• Model 1 – systems that settle transfer instructions for both securities and funds on a trade-by-trade
(gross) basis, with final (unconditional) transfer of securities from the seller to the buyer (delivery)

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occurring at the same time as final transfer of funds from the buyer to the seller (payment).
• Model 2 – systems that settle securities transfer instructions on a gross basis, with final transfer
of securities from the seller to the buyer (delivery) occurring throughout the processing cycle, but
settle funds transfer instructions on a net basis, with final transfer of funds from the buyer to the
seller (payment) occurring at the end of the processing cycle.
• Model 3 – systems that settle transfer instructions for both securities and funds on a net basis, with
final transfers of both securities and funds occurring at the end of the processing cycle.

2.1 BIS Model 1: Gross, Simultaneous Settlements of

Securities and Funds Transfers
The essential characteristic of model 1 systems is the simultaneous settlement of individual securities
transfer instructions and associated funds transfer instructions. The system typically maintains both
securities and funds accounts for participants and makes all transfers by book entry.

An against-payment transfer instruction is settled by simultaneously debiting the seller’s securities

account, crediting the buyer’s securities account, debiting the buyer’s funds account and crediting the
seller’s funds account. All transfers are final (irrevocable and unconditional) transfers at the time the
debits and credits are posted to the securities and funds accounts. Overdrafts (negative balances) on
securities accounts are prohibited. Funds account overdrafts are allowed in most model 1 systems, and
an instruction to transfer securities against payment would not be executed either if the seller had an
insufficient securities balance or if the buyer had an insufficient funds balance or overdraft facility.

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Model 1 systems may require participants to maintain substantial money balances to ensure the
completion of settlements, especially if participants are unable to adjust their money (or securities)
balances during the processing cycle, or if the volume and value of transfers are relatively large. If
balances cannot be adjusted during the processing cycle, participants must maintain balances sufficient
not only to cover the net value of all funds debits and credits on the settlement date, but also to
cover the largest debit balance during processing. The magnitude of the largest debit balance during
processing can be very difficult to predict with any precision. Even if the debit balance after processing
was known with certainty, the largest debit balance during processing could be considerably larger
because the order in which transfers occur is determined by the availability of securities balances and
cannot be predicted in advance. If participants do not maintain substantial money balances, and are
unable to adjust their money balances during the processing cycle, high rates of failed transactions
are likely to result in a model 1 system. In an extreme case, a high fail rate could escalate to a gridlock
situation in which very few, if any, transactions could be completed on the settlement date.

Furthermore, if funds accounts are held by another entity, a communications link must be established
between the operator of the securities transfer system and the other entity to provide the securities
transfer system with real-time information on the completion of funds transfers.

The system may also allow participants to make free transfers, that is, transfers of securities without a
corresponding transfer of funds, or free payments, that is, transfers of funds without a corresponding
transfer of securities.

To avoid high fail rates, model 1 systems frequently employ some type of queue management technique
and may also offer securities lending facilities. The system must also make decisions about the treatment
of transfer orders that cannot be executed because of insufficient securities or money balances. The
options available depend critically on whether participants are able to interact with the system during
the processing cycle. If so, responsibility for queue management might be left to the participants.

Counterparties to a failed transaction could be promptly notified and given the opportunity to borrow
the securities or funds necessary to allow execution of the instruction. The system could repeatedly
recycle instructions on a simple first-in, first-out basis until participants had taken the steps necessary to
allow execution.

In some model 1 systems, however, transfers are executed during one or more batch-processing
cycles in which participants have no opportunity to adjust their securities or money balances to make
completion possible. Such systems typically employ complex chaining procedures that manipulate the
order in which transfer instructions are executed so as to maximise the number or value of securities
transferred and correspondingly minimise the number and value of failed transactions.

These systems may also offer automatic securities lending programmes, that is, programmes in which
participants may pre-authorise the lending of available securities to other participants that have
insufficient securities balances to allow execution of their transfer instructions.

Model 1 is primarily used in Europe and Eurasia, eg, the UK’s CREST system.

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Example
The majority of transactions in UK equities are settled via an electronic settlement facility called CREST.

CREST is a computer system that settles transactions in shares, gilts and corporate bonds, primarily on
behalf of the London Stock Exchange (LSE). It is owned and operated by a company that is part of the
Euroclear group of companies, called Euroclear UK & Ireland ltd.

The financial instruments settled by CREST are dematerialised: instead of using paper share certificates,
the underlying company uses an electronic entry in its register of shareholders. This allows transactions
in shares to be settled electronically.

CREST clears the trade by matching the settlement details provided by the buyer and the seller. The
transaction is then settled when CREST updates the register of the relevant company, to transfer the
shares to the buyer, and at the same time instructs the buyer’s bank to transfer the appropriate amount
of money to the seller’s bank account.

In summary, to complete the settlement of a trade, CREST simultaneously:

• updates the register of shareholders – CREST maintains the so-called ‘operator register’ for UK
companies’ dematerialised shareholdings

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• issues a payment obligation – CREST sends an instruction to the buyer’s payment bank to pay for
the shares
• issues a receipt notification – CREST notifies the seller’s payment bank to expect payment.

If a trading system provides a CCP to the trades (such as LCH ltd), it is the CCP that assumes responsibility
for settling the transaction with each counterparty. The buyer and seller remain anonymous to each
other.

For frequently traded, listed company share trades, CREST gives the option to LSE member firms to
settle with LCH ltd’s EquityClear on a gross basis or on a net basis. To illustrate this, if a firm has 20 orders
executed in the same security through the Stock Exchange Electronic Trading Service (SETS), it could
choose to either settle 20 trades with LCH ltd (settling on a gross basis), or choose to have all 20 trades
netted so that the firm just settles a single transaction with LCH ltd (settling on a net basis).

The settlement period (the time between the trade and the transfer of money and registration) for UK
equities (and most other developed equities markets) is on a T+2 basis, where ‘T’ is the trade date and
‘2’ is the number of business days after the trade date that the cash changes hands and the shares’
registered title changes. In other words, if a trade is executed on a Tuesday, the cash and registered
title will change two business days later, on the Thursday. So, if the trade is executed on a Thursday,
settlement will occur on the following Monday.

2.2 BIS Model 2: Gross Settlements of Securities Transfers

Followed by Net Settlement of Funds Transfers
The essential characteristic of the model 2 system is that securities transfers are settled on a trade-for-
trade (gross) basis throughout the processing cycle, while funds transfers are settled on a net basis at
the end of the processing cycle. The system maintains securities accounts for participants, but funds
accounts are generally held by another entity, either a commercial bank or the central bank.

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Securities are transferred by book entry, that is, by debiting the seller’s securities account and crediting
the buyer’s securities account. These transfers are final at the instant the entries are made on the system’s
books. The corresponding funds transfers are irrevocable but not final. During the processing cycle the
system calculates running balances of funds debits and credits. The running balances are settled at the
end of the processing cycle when the net debit positions and net credit positions are posted on the
books of the commercial bank or central bank that maintains the funds accounts.

Settlement of funds transfers may occur once a day or several times a day. Thus, final transfer of securities
(delivery) precedes final transfer of funds (payment). Like model 1 systems, model 2 systems typically
prohibit participants from overdrawing securities accounts but funds overdrafts are tacitly allowed since
the running balances are permitted to be net debit balances. A securities transfer instruction is rejected
if, and only if, sufficient securities are not available in the seller’s account.

Without additional safeguards, model 2 systems would expose sellers of securities to the risk that
they do not get the funds to which they are entitled. However, by allowing participants to settle funds
transfer instructions on a net basis, the frequency of failed transactions is reduced, limiting the potential
for fails to exacerbate such risks to participants.

Nonetheless, failed transactions would occur in the case of insufficient securities balances. Thus,
queuing arrangements need to be developed, although they generally do not need to be as complex as
in a model 1 system. Still, the system must decide whether to depart from first-in, first-out processing of
securities transfer instructions and adopt more complex procedures that maximise the number or value
of transfers completed.

Operators of model 2 systems have recognised the dangers inherent in allowing delivery prior to
payment, and these systems are designed to provide strong assurances that sellers will receive payment
for securities delivered. In most cases, an assured payment system is utilised, that is, a system in which
the seller delivers securities in exchange for an irrevocable commitment from the buyer’s bank to make
payment to the seller’s bank at the end of the processing cycle.

Model 2 is the settlement system that predominates globally, particularly in the US. Furthermore, since
it is probably the easiest model in which to realise liquidity efficiencies, it is particularly popular in the
emerging markets of Latin America, Africa and the Middle East.

2.3 BIS Model 3: Simultaneous Net Settlement of Securities

and Funds Transfers
The essential characteristic of model 3 systems is the simultaneous net settlement of both securities
and funds transfer instructions. Settlement may occur once a day or at several times during the day. The
system maintains securities accounts for participants. Funds accounts may be maintained by a separate
entity, either a commercial bank or a central bank. Securities are transferred by book entry, that is, by
debiting the seller’s securities account and crediting the buyer’s securities account.

During a processing cycle, running balances of debits and credits to funds and securities accounts are
calculated, and in some systems this information may be made available to participants. However, book-
entry transfers of securities do not occur until the end of the processing cycle.

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The obligation of the seller’s bank in the event of failure of the buyer’s bank is a matter of negotiation
between the seller’s bank and the seller. In some cases, the seller’s bank may guarantee that the seller
will receive payment even if the buyer’s bank fails. If a participant has insufficient balances, it may
be notified and given an opportunity to obtain the necessary funds or securities. If, and only if, all
participants in net debit positions have sufficient balances of funds and securities, final transfers of the
net securities balances and net funds balances are executed.

Model 3 systems can achieve, and most do achieve, DvP and, therefore, eliminate the risk of the seller not
receiving their money. The exceptions involve systems that in certain circumstances allow provisional
securities transfers to become final prior to the settlement of funds transfers.

DvP model 3 has the advantage of reducing both the funds and securities liquidity requirements within
the settlement systems, but can potentially create large liquidity exposures if a participant fails to settle
its net funds debit position, in which case some or all of the defaulting participant’s transfers may have
to be unwound.

3. Custody

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Learning Objective
7.1.3 Know the concept of custody and the roles of the different types of custodian: global; regional;
local; sub-custodian

3.1 Services Provided by Custodians

A custodian is a reputable (usually large) third-party firm or company that holds securities or other
assets that belong to an investment institution for safekeeping and/or security. The custodian can hold
either physical or electronic assets.

Custodians provide additional services to their clients, including:

• providing safekeeping of the investor’s assets in the local market

• maintaining lists of inventory
• verifying trade details against securities available for sale from that institution
• making appropriate arrangements for delivery and receipt of cash and securities to supoort
settlement of the investor’s trading activities in that market
• ensuring that securities are registered and that transfer of legal title on securities transactions
proceeds effectively
• providing market information to the investor on developments and reforms within that market
• collecting dividend income, interest paid on debt securities and other income payments in the local
market
• managing the client’s cash flows
• monitoring and managing entitlements through corporate actions and voting rights held by the
investor in the local market

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• managing tax reclaims and other tax services in the local market
• ensuring that reporting obligations to the regulatory authorities, and to other relevant bodies, are
discharged effectively.

3.2 The Role and Responsibility of a Custodian

The primary responsibility of the custodian is to ensure that the client’s assets are fully protected at all
times. Hence, it must provide robust safekeeping facilities for all valuables and documentation, ensuring
that investments are only released from its care in accordance with authorised instructions from the
client.

Importantly, the client’s assets must be properly segregated from those of the custodian and appropriate
legal arrangements must be in place to ensure that financial or external shock to the custodian does not
expose the client’s assets to claims from creditors or any other party.

3.3 Types of Custodian

An investor faces choices in selecting custody arrangements with regard to a portfolio of global assets.
The possible paths can be summarised as follows:

• Appointing a local custodian in each market in which they invest (often referred to as direct custody
arrangements).
• Appointing a global custodian to manage custody arrangements across the full range of foreign
markets in which they have invested assets.
• Making arrangements to settle trades and hold securities and cash with a CSD within each market,
or to go via an international central securities depository (ICSD).

3.3.1 Global Custody

A global custodian provides investment administration for investor clients, including processing cross-
border securities trades and keeping financial assets secure (ie, providing safe custody) outside the
country where the investor is located.

The term ‘global custody’ came into common usage in the financial services world in the mid-1970s,
when the Employee Retirement Income Security Act (ERISA) was passed in the US. This legislation
was designed to increase the protection given to US pension fund investors. The Act specified that US
pension funds could not act as custodians of the assets held in their own funds. Instead, these assets had
to be held in the safekeeping of another bank. ERISA went further, to specify that only a US bank could
provide custody services for a US pension fund.

Subsequently, use of the term global custody has evolved to refer to a broader set of responsibilities,
encompassing settlement, safekeeping, cash management, record-keeping and asset servicing (eg,
collecting dividend payments on shares and interest on bonds, reclaiming withheld taxes and advising
investor clients on their electing on corporate actions entitlements), and providing market information.
Some investors may also use their global custodians to provide a wider suite of services, including
investment accounting and valuation reporting, treasury and foreign exchange, securities lending and
borrowing, collateral management, and performance and risk analysis on the investor’s portfolio.

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Some global custodians maintain an extensive network of branches globally and can meet the local
custody needs of their investor clients by employing their own branches as local custody providers.
Citigroup’s custody business, for example, maintains a proprietary branch network covering 50 markets.
Consequently, when Citigroup is acting as global custodian for an investor client, it may opt to use its
own branch to provide local custody in many locations where the investor holds assets.

3.3.2 Sub-Custody
A sub-custodian is employed by a global custodian as its local agent to provide settlement and custody
services for assets that it holds on behalf of investor clients in a foreign market. A sub-custodian
effectively serves as the eyes and ears of the global custodian in the local market, providing a range of
clearing, settlement and asset servicing duties. It will also typically provide market information relating
to developments in the local market, and will lobby the market authorities for reforms that will make the
market more appealing and an efficient target for foreign investment.

In selecting a sub-custodian, a global custodian may:

• appoint one of its own branches, in cases when this option is available

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• appoint a local agent bank that specialises in providing sub-custody in the market concerned
• appoint a regional provider that can offer sub-custody to the global custodian across a range of
markets in a region or globally.

A good example of a custodian that offers global services by selecting local specialists is the US bank
Brown Brothers Harriman. It adopts a ‘non-captive sub-custodian bank strategy…independently selecting
banks that are determined to be the best and most trusted service providers in each market’.

Local Custodian
Agent banks that specialise in providing sub-custody in their home market are sometimes known as
single market providers. Stiff competition from larger regional or global competitors has meant that
these are becoming a dying breed. However, some continue to win business in their local markets, often
combining this service with offering global custody or master custody for institutional investors in their
home markets. Examples include Bank of Tokyo-Mitsubishi UFJ, Mizuho Bank and Sumitomo Mitsui
Banking Corporation in Japan, Maybank in Malaysia and United Overseas Bank in Singapore.

A principal selling point is that they are local market specialists. Hence, they can remain focused on
their local business, without spreading their attentions broadly across a wide range of markets. A local
specialist bank may be attractive in a market in which local practices tend to differ markedly from global
standards, or where a provider’s long-standing relationship with the local regulatory authorities and/or
political elite leaves it particularly well placed to lobby for reforms on behalf of its cross-border clients.
Local specialist banks may also be the only viable option in many smaller markets where regional or
global banks find providing custody services uneconomical.

Reciprocal arrangements may be influential in shaping the appointment of a local provider in some
instances. Under such an arrangement, a global custodian (A) may appoint the local provider (B) to
deliver sub-custody in its local market (market B). In return, the custodian (A) may offer sub-custody in
its own home market (market A) for pension and insurance funds in market B that use provider B as their
global custodian.

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In summary, the strengths of a local custodian may include the following:

• They are country specialists.

• They can be the eyes and ears of the global custodian or broker-dealer in the local market.
• They will have regular dealings with financial authorities and local politicians – they may be well
placed to lobby for reforms that will improve the efficiency of the local market.
• They have expert knowledge of local market practice, language and culture.
• They may offer opportunities for reciprocal business.

A local custody bank may be perceived to have the following disadvantages when compared with a
regional custodian:

• Their credit rating may not meet requirements laid down by some global custodians or global
broker-dealers.
• They cannot leverage developments in technology and client service across multiple markets
(unlike a regional custodian) – hence product and technology development may lag behind the
regional custodians that they compete with.
• They may not be able to offer the price discounts that can be extended by regional custodians
offering custody services across multiple markets.

Regional Custodian
A regional custodian is able to provide agent bank services across multiple markets in a region.

For example, Standard Chartered Bank and HSBC have both been offering regional custody and
clearing in the Asia-Pacific and South Asian region for many years, competing with Citigroup and some
strong single market providers for business in this region. In Central and Eastern Europe, Bank Austria
(subsidiary of the Unicredit Group), Deutsche Bank, Raiffeisen Bank International and Citigroup each
offer a regional clearing and custody service. In Central and South America, Citigroup and Brazil’s Itau
Unibanco offer regional custody, in competition in selected markets with HSBC, Bank Santander and
Deutsche Bank. In Africa, Standard Chartered and Standard Bank of South Africa offer sub-custodian
services across many countries on the continent.

Employing a regional custodian may offer a range of advantages to global custodian or global
broker-dealer clients:

• Its credit rating may be higher than that of a single market custodian.
• It can cross-fertilise good practice across multiple markets – lessons learned in one market may be
applied, when appropriate, across other markets in its regional offering.
• It can leverage innovation in technology, product development and client service across multiple
markets – delivering economies of scale.
• It can offer standardised reporting, management information systems and market information
across multiple markets in its regional offering.
• Economies of scale may support delivery of some or all product lines from a regional processing
centre – offering potential cost savings and efficiency benefits.
• Its size and regional importance, plus the strength of its global client base, may allow a regional
custodian to exert considerable leverage on local regulators, political authorities and infrastructure
providers. This may be important in lobbying for reforms that support greater efficiency and security
for foreign investors in that market.

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• A global client may be able to secure price discounts by using a regional custodian across multiple
markets.

In some situations, a regional provider may be perceived to have certain disadvantages when compared
with a local custody bank:

• A regional custodian’s product offering may be less well attuned to local market practice, service
culture and investor needs than that of a well-established local provider.
• A regional custodian may spread its focus across a wider range of clients and a wider range of
markets than a single market provider. Hence, a cross-border client may not receive the same level
of attention, and the same degree of individualised service, as may be extended by a local custodian.
• Some regional custodians may lack the long track record, customer base and goodwill held by some
local custodians in their own market.

4. Registered Title

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Learning Objective
7.1.4 Understand the implications of registered title: registered title versus unregistered (bearer);
legal title; beneficial interest; voting rights; right to participate in corporate actions

Generally, when settling trade involving shares, settlement must involve communicating the change
in ownership to the company registrar. The issuing company maintains a register listing all of its
shareholders and their legal addresses. Whenever shares are bought or sold, the company registrar is
responsible for updating the register of members and addresses and giving the new owner registered
title. Most shares issued today are issued in registered form.

Shares that are not registered are described as bearer shares, which means that the person holding the
shares is the owner and there are no records to confirm or contradict this. Bearer shares are, therefore,
like cash, in that if they are given away, lost or stolen, the person who physically has them in hand is able
to benefit from their monetary value and any associated voting rights.

Registered title, therefore, means ownership that is backed by registration, whereas bearer form
means in possession of the physical share certificates without any underlying register entry. Either the
registered or bearer holder can sell the shares, will receive dividends if any are paid, can vote where
applicable, and may participate in other corporate actions, such as rights issues.

Busy shareholders often want to avoid the administrative tasks connected with registered title, so
they choose to appoint their stockbroker, or another professional, to act as a nominee. The nominee
takes the registered title to the shares and all the responsibilities that go with it, but the nominee’s
client retains beneficial ownership. The beneficial owner receives dividends and is entitled to any other
‘benefits’ of the shares such as the ability to vote or participate in other corporate actions. The nominee
is, however, the legal owner. The legal owner has the title of the shares, but has no rights to any of the
benefits of owning the shares.

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 5. Designated and Pooled Nominees

Learning Objective
7.1.5 Understand the basics of designated and pooled nominee accounts and their uses, and the
concept of corporate nominees: designated nominee accounts; pooled nominee accounts;
details in share register; function of corporate nominees; legal ownership; beneficial
ownership; effect on shareholder rights of using a nominee

5.1 The Share Register

When shares are held in registered form, any share certificate is simply evidence of ownership. The proof
that counts is the name and address held on the company’s share register.

5.2 Nominees
Upon the incorporation of a company (be it a new or ready-made shelf company or a tailor-made
company), the investor can either act as a shareholder in their own name, or a financial services firm
equipped to handle incorporations, or a custodian can provide them with a nominee shareholder.
These nominee shareholders will hold the shares in trust for the beneficial owners, and it is the nominee
shareholders that are identified on the register of shareholders.

Each nominee shareholder appointed will sign a declaration of trust to the beneficial owner that they
are holding the shares on behalf of the beneficial owner and will return the shares into the name of the
beneficial owner or will transfer them to another party as requested. A nominee shareholder is normally
a company created for the purpose of holding shares and other securities on behalf of investors.

Institutional investors employing professional investment management firms to manage their assets
are highly unlikely to hold these securities in their own name (name on register). The reason for this is
simple: the person whose name appears on the share register receives every piece of documentation
sent out by the company and is obliged to sign all share transfers and other relevant forms such as
instructions for rights issues and other corporate events. To ensure safe custody of assets and remove this
administrative burden from the investor, thus allowing the speedy processing of transfers, institutional
(and, increasingly, private client) shareholdings are held in the names of ‘nominee’ companies.

Nominee companies have long been established as the mechanism by which asset managers and
custodians can process transactions on behalf of their clients. Given that many investment management
firms have outsourced some or all of their investment administration activities to the specialist
custodians, the vast majority of institutional shareholdings in fact now reside in nominee accounts
overseen by those specialist custodians.

As far as the company is concerned, the nominee name appearing on its share register is the legal owner
of the shares for the purposes of benefits and for voting. However, beneficial ownership continues to
reside with the underlying client, who is entitled to receive dividends and the capital growth of the
shares but does not retain the automatic right to attend company meetings.

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It is this separation of ownership which allows the custodians, under proper client authorities, to transfer
shares to meet market transactions and to conduct other functions, without the registrar requiring sight
of the signature or seal of the underlying client.

5.3 Types of Nominee Companies

Nominee companies can be classified into three types:

• Pooled (often termed ‘omnibus’ or ‘commingled’), whereby individual clients are grouped together
within a single nominee registration.
• Designated (sometimes termed ‘numbered accounts’), where the nominee name includes unique
identifiers for each individual client, eg, XYZ Nominees Account 1, Account 2, Account 3.
• Sole, where a single nominee name is used for a specific client, eg, ABC Pension Fund Nominees ltd.

How the shareholdings are registered is of vital importance when it comes to voting.

It is now generally accepted that there are no real advantages, from a security point of view, no matter
which type of nominee arrangement is used to register the shares. However, clients brought together
with others in a pooled nominee have no visibility to the company: it is the single nominee name,

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covering multiple clients, which the company recognises. Importantly, from a voting perspective it is
only the single bulk nominee that is entitled to vote; no separate entitlement accrues from the registrar’s
standpoint to each individual client making up the total holding.

Some companies offer their shareholders certain benefits, such as discounts on their products. By using
a nominee (either a designated or a pooled structure), the shareholder benefits may not be available
to the individual investor. This is simply because the stockbrokers may be unwilling to undertake the
necessary administration to facilitate the provision of these benefits.

One reason for registering shares in a designated or sole nominee name would be that, if the underlying
investor requires dividends to be mandated to a particular bank account rather than being collected by
the custodian, registration in an omnibus account is not practicable.

Designation or individual registration can also help some aspects of auditing and it affords a good
control mechanism when identical bargains may have been executed for different clients (for example
on the same date, for the same number of shares and for the same settlement consideration).

One reason frequently cited by custodians for insisting on pooled nominee arrangements is the vexed
question of costs. Operating a designated nominee account should give rise to few additional costs
from the custodian’s point of view, as the existing nominee name can easily be used, with the addition
of a unique designation. While there may be a small amount of extra work involved, eg, in the receipt of
separate income payments, the actual procedures are identical and should be capable of being easily
absorbed into the existing administration and processing routines.

If the client insists on using a sole nominee name to register the shareholdings, this may involve some
costs for the custodian connected with the establishment of a nameplate nominee company, the
requisite appointment of directors and the completion of annual returns. The custodian may seek to pass
these comparatively meagre costs on to the client, but more usually they will be absorbed within the
standard custody tariff.

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5.4 The Corporate Nominee
A corporate nominee (alternatively referred to as a corporate sponsored nominee) is when the issuing
company itself provides a facility for its smaller shareholders to hold their shares within a single
corporate nominee.

The corporate nominee is a halfway house between the pooled and the designated nominee structures
offered by stockbrokers. It will result in a single entry for all the shareholders together in the company’s
register (like the pooled nominee) but beneath this the issuing company (or its registrar) will be aware of
the individual holdings that make up the nominee. In a similar way to the designated nominee structure,
the company will be able to forward separate dividend payments to each of the individual shareholders,
as well as voting rights and other potential shareholder perks. Shares held within a corporate nominee in
dematerialised form enable quick and easy transfer through the settlement system.

5.5 Summary
Custodians and their nominees now control the majority of share registrations for institutional investors,
even for clients who may not have directly appointed custodians but whose asset management firms
have outsourced their investment administration to these providers.

Custodians uniquely identify their clients’ holdings by segregating these in their computer systems, as it
is largely these systems which drive the calculation and application of dividends and other entitlements.
However, this segregation is not the same as having an individually identifiable holding for a particular
client on company share registers.

It is largely impractical for an institutional investor to achieve name on register, so the recognised
practice is to use nominee names whereby the custodian, or other duly authorised agent, is legally
entitled to perform the transfer and administration of the assets on behalf of, and under the authority of,
the underlying beneficial owner.

Many custodians prefer to pool all their clients into one single nominee registration, known as an
omnibus account. However, this does remove the visibility of the underlying investor and makes
individual client voting much more cumbersome. Either omnibus or numbered accounts will often, at
least temporarily, obscure the true ownership. Many high profile institutions, for various reasons, may
not want to quickly publicise that they are accumulating a stake in a given company.

Clients can request their custodian to adopt an individual registration solely for their particular
shareholdings. Typically this takes the form of a standard nominee name with a unique designation for
each client. The costs of such separate registration and its ongoing maintenance are minimal, relative to
overall custody and securities lending charges and are often absorbed by the custodians.

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6. Cum- and Ex-Dividend

Learning Objective
7.1.6 Understand the concepts, requirements, benefits and disadvantages of deals executed cum,
ex, special cum and special ex: timetable; effect of deals on the underlying right; effect on the
share price before and after a dividend; the meaning of ‘books closed’, ‘ex-div’ and ‘cum div’,
cum and ex-rights; effect of late registration; benefits that may be achieved; disadvantages/
risks; when dealing is permitted

Cum-dividend means ‘with the dividend’. Shares are normally traded cum-dividend, meaning that
buyers of the shares have the right to the next dividend paid by the company. However, there are brief
periods when the share becomes ex-dividend, meaning that they would be sold without the right to
receive the next dividend payment. The ex-dividend period occurs in the period just prior to a dividend
payment, as detailed below.

The sequence of events that is typically adopted in the developed markets leading up to the dividend

7
payment is as follows:

1. Dividend declared – on this date, the company announces its intention to pay a specified dividend
on a specified future date. The declaration usually occurs well before this date (perhaps a month or
two earlier).
2. Record or books-closed date – the record, or books-closed date is the date on which a copy of the
shareholders’ register is taken. The people on the share register at the end of this day will be paid the
next dividend. In many markets, the books-closed date is normally a Friday, except where the Friday
is a public holiday, in which case the books-closed date is the next available business day.
3. Ex-dividend date – the ex-dividend date is typically a Thursday: the business day before the record
date.
4. Dividend paid – this date is determined by the company, and is typically within 30 business days of
the record date. The dividend is paid to those shareholders who were on the register on the record/
books-closed date.
5. Ex-dividend period – the period from the ex-dividend date up to the dividend payment date is
the ex-dividend period. Throughout this period the shares trade without entitlement to the next
dividend.

The relationship between the ex-dividend date and the books-closed date is easily explained. Since
the equity settlement process in most equity markets takes two business days, for a new shareholder
to appear on the register on the Friday they would have to buy the shares on Wednesday at the latest.
Wednesday is the last day when the shares trade cum-dividend, because new shareholders will be
reflected in the register before the end of the books-closed date. A new shareholder buying their shares
on the Thursday will not be entered into the register until the following week – too late for the books-
closed date and therefore ex-dividend.

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On the Thursday when the shares first trade without the dividend (ex-dividend), the share price will fall
to reflect the fact that if an investor buys the share he will not be entitled to the impending dividend.

At all times other than during ex-dividend periods, shares trade cum-dividend, ie, if an investor
purchases shares at this time, they will be entitled to all of the future dividends paid by the company for
as long as they keep the shares. During the ex-dividend period, it is possible to arrange a special cum-
trade. That is when, by special arrangement, the buyer of the share during the ex-dividend period does
receive the next dividend. These trades can be executed up to and including the day before the dividend
payment date, but not on or after the dividend payment date.

In a similar manner to a special cum-trade, an investor can also arrange a special ex trade. This is
generally only possible in the ten business days before the ex-date. If an investor buys a share during the
cum-dividend period, but buys it special ex, they will not receive the next dividend. Using special cum
or special ex transactions enables the sellers or buyers to avoid the receipt of a dividend – essentially
deciding whether or not they want to collect their right to the dividend. The motivation for investors
buying or selling with or without the dividend entitlement tends to be related to tax. Dividend income is
normally subject to income tax, so selling the right to the dividend may avoid some income tax.

The inherent disadvantage of special cum trades and special ex trades is that they will, potentially, result
in dividends from the company being paid to the wrong person. Equally a trade that settles later than
usual could mean that the correct owner is not reflected in the shareholders’ register on the books-
closed date – and the dividend is paid by the company to the wrong person. In such situations, it is the
broker acting for the buyers (or seller, as appropriate) that will need to make a claim for the dividend.

In such situations, if the dividend was paid to the wrong person in a special cum-trade, then it is the
broker acting for the buyers that should make a claim for the dividend. In contrast, when the dividend
has been paid to the wrong person, following a special ex trade, it is the seller’s broker who will have to
make the claim for their client to receive their rightful dividend payment.

7. Continuous Linked Settlement (CLS)

Learning Objective
7.1.7 Understand what continuous linked settlement (CLS) is and its purpose: the settlement of
currencies across time zones; receiving and matching instructions; advantages; how it reduces
settlement risk (Herstatt risk)

As international trade and investment has increased, so has the foreign exchange (FX) market. The
average daily volume in the global FX market, and related markets, has grown enormously and was
reported to be approximately US$6.6 trillion in 2019 by the BIS (the most recent of the BIS triennial
surveys published at the time of writing).

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Continuous linked settlement (CLS) is a process by which most of the world’s largest banks manage FX
settlement among themselves (and their customers and other third parties). The process is managed by
CLS Group Holdings and regulated by the Federal Reserve Board of New York.

CLS settles transactions on a payment versus payment (PvP) basis. The two parties to an FX transaction
will buy and sell the respective currencies exchanged and the payments made will occur simultaneously.
Unless such simultaneity in payments is ensured, there is a possibility of settlement risk which is also
often referred to as Herstatt risk. Before the establishment of CLS, FX transactions were settled by each
side of a trade making separate payments. The risks implicit in this approach became clear in 1974,
when the German banking regulators withdrew the banking licence of Bankhaus Herstatt, putting it into
liquidation at the close of business on 26 June. Bankhaus Herstatt had been active in the FX markets
and had received currency from counterparties during the day, but had not yet made any payments,
when its licence was withdrawn and it was declared bankrupt. Several banks had irrevocably paid over
deutschmarks to Herstatt during the day, but had not received the anticipated currency in exchange.
In addition, banks had entered into forward trades that were not yet due for settlement, and some lost
money replacing the contracts. In short, there were serious repercussions in the FX market after the
Bankhaus Herstatt default, thus the intra-day settlement risk highlighted was thereafter termed Herstatt
risk.

7
The result was the impetus to set up a more robust and reliable system that ensured payment from one
party was only made if there was a payment coming in the opposite direction to fulfil the other side of
the FX deal – PvP. CLS was the result that solved the PVP problem, despite the counterparties potentially
being in different parts of the world and time zones.

The CLS process is focused on a five-hour window each business day from 7.00am to 12 midday in
Central European Time (CET). This window was created to provide an overlap across the business days in
all parts of the world and facilitate global trading.

By 6.30am CET, the settlement members must submit their settlement instructions for transactions to
settle that day. At 6.30am, each settlement member receives a schedule of what monies need to be paid
in that day. From 7.00am, the settlement members pay in the net funds that are due to settle in each
currency to their central banks, and CLS will then begin to attempt to settle deals. In the event that CLS
Bank’s strict settlement criteria are not met for each side of a trade, then no funds are exchanged. This
achieves the PvP system that removes the so-called Herstatt risk. Those trades that can be settled are
settled and money is paid out via the central banks.

As outlined above, the payments made to CLS Bank are made via the central banks.

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 8. Distributed Ledger Technology

Learning Objective
7.1.8 Know the application of distributed ledger technology

Distributed ledger technology (DLT) is, in simple terms, the replacement of one, centralised ledger of
transactions with a decentralised network of computers all holding copies of exactly the same ledger.
The computers are often referred to as ‘nodes’ and any changes to the ledger must to be done by
consensus. Consensus is typically achieved using a ‘consensus algorithm’ – a process used to achieve
agreement.

The distributed ledger could be open to any participant, and described as ‘public’, or it could be
restricted to a selected group of participants and ‘private’.

Blockchain is an example of DLT and is commonly associated with the cryptocurrency Bitcoin. Bitcoin is
a public system that uses blockchain DLT and a consensus algorithm based on proof of work.

Amongst the advantages of DLT are that it should:

• Produce a trustworthy and reliable record, since consensus is required for any changes.
• Prevent a single point of failure (in one of the nodes) from creating a wider problem because of all
the remaining nodes hold copies of the valid ledger.
• Be very difficult to hack, because of the use of multiple nodes.
• Remove the costs and delays caused by the need to maintain and update a single, central database.

The above advantages make it clear that DLT could be adopted to settle trades and there is much
excitement about how this could speed up settlement and reduce settlement costs. For example, it
is being actively investigated by the Australian Securities Exchange (ASX) to update and replace the
current CHESS system of settlement.

Additionally, some countries are exploring the creation of digital versions of their national currency with
an associated underlying ledger system, which will facilitate use in international trade.

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9. Stock Borrowing and Lending

Learning Objective
7.2.1 Know the uses of, requirements and implications of stock lending: what is stock lending; stock
lending versus repo; purpose for the borrower; purpose for the lender; risk
7.2.2 Understand the function of stock borrowing and lending intermediaries (SBLIs), including:
use of custodian banks; administration, including collateral; regulation; effect on the lender’s
rights; lender retains the right to sell

Stock lending is the temporary transfer of securities, by a lender to a borrower, with agreement by the
borrower to return equivalent securities to the lender at a pre-agreed time. It is commonly seen in the
more developed markets where liquidity is greatest and regulations easily allow for shorting.

There are two main motivations for stock lending: securities-driven, and cash-driven. In securities-driven
transactions, borrowing firms seek specific securities (equities or bonds), perhaps to facilitate their

7
trading operations. In the cash-driven trades, the lender is able to increase the returns on an underlying
portfolio, by receiving a fee for making its investments available to the borrower. Such transactions may
boost overall income returns, enhancing, for example, returns on a pension fund.

The terms of the securities loan will be governed by a securities lending agreement, which requires that
the borrower provide the lender with collateral, in the form of cash, government securities, or a letter
of credit of value equal to or greater than the loaned securities. As payment for the loan, the parties
negotiate a fee, quoted as an annualised percentage of the value of the loaned securities. If the agreed
form of collateral is cash, then the fee may be quoted as a rebate, meaning that the lender will earn all of
the interest that accrues on the cash collateral, and will rebate an agreed rate of interest to the borrower.

9.1 Benefits of Stock Lending

The initial driver for the securities lending business was to cover settlement failure. If one party fails to
deliver stock to another on time, it can render that party unable to deliver the stock it has already sold
onto another (third) party. To avoid the costs and penalties associated with settlement failure, stock can
be borrowed for a fee in order to meet a delivery commitment. Once the original stock finally arrives (or
is obtained from another source), the borrower can return the same number of shares to the lender that
were originally borrowed.

So, the principal reason for borrowing securities is to cover a short position. As borrowers are sometimes
obliged to deliver the securities they do not hold, they will have to borrow them. At the end of the
agreement, they have to return the equivalent quantity of securities to the lender. ‘Equivalent’, in
this context, means fungible, ie, the securities must be completely interchangeable. This is similar to
lending a €10 note – the lender does not expect that specific €10 note back; instead, any €10 note, or a
combination of money equal to €10, will suffice.

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Securities lending and borrowing is often required, by matter of law, in order to engage in short selling.
In fact, regulations enacted in 2008 in the US, Australia and the UK, among other jurisdictions, required
that, before short sales were executed for specific stocks, especially banks and financial services
companies, the sellers first pre-borrowed shares in those issues.

There is an ongoing debate among global policymakers and regulators about how to impose new
restrictions on short selling and in June 2010, during a period of turbulence for the eurozone, Germany
took a unilateral step in banning the naked short selling of CDSs (ie, when the short seller had no
interest in the underlying security for the CDS).

The following are generally considered to be positive aspects of stock lending:

• It can increase the liquidity of the securities market by allowing securities to be borrowed
temporarily, thus reducing the potential for failed settlements and the penalties this may incur.
• It can provide extra security to lenders through the collateralisation of a loan.
• It can support many trading and investment strategies that otherwise would be extremely difficult
to execute.
• It allows investors to earn income by lending their securities on to third parties.
• It facilitates the hedging and arbitraging of price differentials, therefore helping improve market
efficiency.

9.2 Risks of Stock Lending

Many feel that securities lending can aid market manipulation through short selling, which can potentially
influence market prices. Short selling itself is not wrong, but market manipulation certainly is.

The debate about the merits and validity of short selling is sometimes emotion-charged, and features
in the rhetoric of politicians in populist attacks on the financial services profession. It is probably fair to
say that for most investment professionals who actually work in the financial markets, the notion that
short selling in itself is an abusive practice is not palatable. There may be times when the activity can be
disruptive, but markets have a tendency to overreact in either direction and the periodic focus given to
short selling when a market is moving down should be counterbalanced by the tendency for markets to
become too frothy and for long investors to become exuberant when markets are going up.

Furthermore, while securities lending may be a useful tool, it presents associated risks to both the
borrower and the lender. The securities on loan, or the collateral, may not be returned on the agreed
date, whether because of settlement delays or liquidity problems in the market concerned or the more
intimidating prospect of counterparty default or legal challenge. Those securities will then need to be
acquired in the market, potentially at a high cost.

In order to mitigate the risk of such failures, lenders are advised to employ a range of precautions to
ensure the safe return of the securities and to ensure that the loss is fully compensated in the event that
the securities are not returned. These include:

• employing detailed credit evaluations on the borrower

• setting limits on the lender’s credit exposure to any individual borrower
• collateralising loan exposures against cash or securities (the lender will decide what quality of
collateral it will accept)

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• marking exposures and collateral to market (ie, ensuring that exposures and collateral are valued at
current market prices) on a daily basis and making margin calls to bring collateral and exposure into
line
• employing master legal agreements that set out clear legal parameters that dictate the structure
and process of the lending arrangements, and how the lender will be compensated in the event of
default or systemic crisis.

When collateral is taken in securities lending arrangements, its value will typically exceed the market
value of the borrowed assets by an agreed percentage, known as a ‘haircut’. This protects the lender
from adverse price movements of the collateral held.

To summarise, as with the use of derivatives, short selling is simply a tool. When used improperly, such
as with too much leverage, it can create problems for its users. Without these tools, markets would be
unable to represent fair value or provide the functionality, eg, hedging, required for smooth operation.

9.3 Stock Borrowing and Lending Intermediaries (SBLIs)

Securities lending has increasingly become a volume business which has encouraged the proliferation

7
of various specialist intermediaries to undertake principal and/or agency roles in this field. These stock
borrowing and lending intermediaries (SBLIs) provide a service in separating out the underlying owners
of securities – which are typically large pension funds or insurance companies – from those who would
be borrowers of those securities, typically hedge funds and other asset managers, and liaising with both
sides. The economy of scale offered by SBLIs in pooling together securities of different clients has also
enabled smaller asset holders to participate in this market.

Asset managers and custodian banks have added securities lending to the other services they offer.
Owners and SBLIs will often split revenues from securities lending at commercial rates. The split will be
determined by many factors, including the service level and provision by the agent of any risk mitigation,
such as an indemnity. Securities lending is often part of a much bigger relationship and therefore the
split negotiation can become part of a bundled approach to the pricing of a wide range of services.

9.3.1 Custodian Banks

Since custody is a highly competitive business, for many providers it is often run as a loss-making
activity. Supplementing their custodian role by acting as an SBLI can add a new level of revenue
generation for custodian banks. Many large custodian banks have therefore added securities lending to
their core custody businesses.

From the perspective of the custodian, the advantages of acting as an SBLI are that they already have:

• an existing banking relationship with their customers

• investment in technology and global coverage of markets arising from their custody businesses
• the ability to pool assets from many smaller underlying funds, insulating borrowers from the
administrative inconvenience of dealing with many small funds
• experience in local operations in developing as well as developed markets
• the capability to provide indemnities and manage cash collateral efficiently.

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9.3.2 Administration
For SBLIs, it is important that there is adequate documentation in place with borrowing counterparties,
which sets out the terms and conditions of the service being provided and the risks involved.

If assets are pooled within an SBLI, the SBLI must ensure that only assets belonging to customers who
have consented to securities lending are lent out. The SBLI should maintain a separate account or be
able to demonstrate that it maintains adequate systems to differentiate between the safe custody
investments of those customers who have not consented to stock lending activity and those that have
consented.

If collateral is required from the borrower, the SBLI must consider whether that collateral should be
provided in advance of the lending, given the risks of the transaction and normal practice in the relevant
market. The level and type of collateral should take account of the creditworthiness of the borrower and
the risks associated with the collateral being offered.

Cash or assets held in favour of a customer for stock lending activity must be held in accordance with
the appropriate custody rules. This includes dividends, stock lending fees and any other payments
received in relation to stock lending.

9.4 Legalities
Securities lending is legal and clearly regulated in most of the world’s major securities markets.
Most markets mandate that the borrowing of securities be conducted only for specifically permitted
purposes, which generally include to:

• facilitate settlement of a trade

• facilitate delivery of a short sale
• finance the security, or
• facilitate a loan to another borrower who is motivated by one of these permitted purposes.

Effect on a Lender’s Rights and Corporate Actions

When a security is loaned, the title of the security transfers to the borrower. This means that the
borrower has the advantages of holding the security, just as though they owned it. Specifically, the
borrower will receive all coupon and/or dividend payments, and any other rights such as voting rights.
These dividends or coupons must be passed back to the lender in the form of what is referred to as a
manufactured dividend.

If the lender wants to exercise its right to vote, it should recall the stock in good time so that a proxy
voting form can be completed and returned to the registrar by the required deadline. Similar issues are
involved in other corporate actions such as capitalisation issues. Technically, the consequences arising
from any corporate action by the issuer of a security, such as a capitalisation or rights issue, when that
security has been lent to another would, prima facie, be to the benefit/cost of the borrower. Under the
terms of the loan, it is customary that these costs/benefits flow back to the lender, and the exact manner
in which this is implemented should be reflected in the securities lending agreement.

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The parties to a stock-lending transaction generally operate under a legal agreement, which sets out
the obligations of the borrower and lender. In securities lending, the lender effectively retains all the
benefits of ownership. The borrower can use the securities as required – perhaps by lending them on to
another party – but is liable to the lender for all the benefits such as dividends, interest and stock splits.

The Global Master Securities Lending Agreement (GMSLA) has been developed as a market standard for
securities lending. It covers the matters which a legal agreement ought to cover for securities lending
transactions. This agreement is kept under review, and amendments are made from time to time,
although parties to an existing agreement will need to agree that any amendments will apply to their
agreement.

Stock Lending Versus Repo

Stock lending and sale/repurchase agreements (repos) are similar; however, the key difference is that
a stock lender charges a fee to the borrower, whereas a repo counterparty pays (or receives) a rate of
interest.

A repurchase agreement, or repo, is a method of secured lending, whereby securities are sold to a
counterparty against payment of cash and then repurchased at a later date, with interest being paid to

7
the cash lender. A repo may be employed, for example, to raise the funds necessary to cover the cash
leg of a securities transaction. This mode of financing will typically be cheaper than seeking unsecured
funding and may be particularly well suited for trading companies that hold a large inventory of stock
that may otherwise be unutilised.

For the cash borrower, a key feature of repo transaction is that it provides a method of funding that
is significantly cheaper than borrowing on an unsecured basis. The cash lender receives securities as
collateral throughout the loan period and is free to utilise these securities if the cash borrower fails to
repay cash plus interest (or cash plus fee) to the lender.

For the cash lender, a repo provides an avenue through which it can generate income on its cash
balance. Although it could potentially earn more income by lending this cash on an unsecured basis, a
repo affords additional security to the lender by ensuring that it holds collateral that it will inherit if the
borrowing counterparty defaults on its obligations.

The collateral will be marked-to-market on a daily basis throughout the repo period to reflect current
market rates. If the value of the collateral rises or falls outside of a pre-agreed band (known as the
variation margin), a margin call will be made (ie, collateral is requested from, or returned to, the lender)
to ensure that the value of the collateral remains aligned to the cash sum borrowed through the repo
agreement.

The types of securities that will be acceptable as collateral will usually be dependent on the risk appetite
of the collateral-taker (ie, the cash lender). Government debt securities (German bunds, UK gilts, US
Treasuries and other selected G10 government bonds) typically represent premium-quality collateral.
However, each collateral-taker will apply its own collateral eligibility criteria when specifying the types
of collateral that it will accept in repo transactions and other forms of secured lending. These criteria
may include asset type, credit rating of issuer, currency, duration and average daily traded volume (ie, a
measure of the security’s liquidity).

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Some collateral-takers will be willing to accept lower-quality collateral in repo arrangements. The
motivation for doing so is twofold:

1. Accepting lower-quality collateral will typically yield a better return for the collateral-taker (the
lender).
2. Top-grade collateral (eg, high-quality government debt, such as German bunds) is often in short
supply and may be expensive to borrow.

As such, some counterparties may accept asset-backed securities (ABSs), high-grade corporate debt
and, in some instances, equities as collateral. Traditionally, because of their inherent volatility, equities
have represented a small portion of the tri-party repo market.

Lenders can specify their eligibility criteria for collateral that they are willing to accept.

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End of Chapter Questions

1. What are the three stages of clearing and settlement?

Answer reference: Section 1

2. What are the three models for delivery versus payment (DvP) settlement systems identified by the
Bank for International Settlements (BIS)?
Answer reference: Section 2

3. What is regarded as the primary role of a custodian?

Answer reference: Section 3.2

4. What is sub-custody and why is it used?

Answer reference: Section 3.3.2

5. What is meant if a person owns registered title to an asset?

Answer reference: Section 4

7
6. Who is the legal owner of the shares if held by a nominee company?
Answer reference: Section 5.2

7. What is meant by a ‘pooled nominee’?

Answer reference: Section 5.3

8. What is the date on which a copy of the shareholders’ register is taken known as?
Answer reference: Section 6

9. What is Herstatt risk and how is it eliminated by continuous linked settlement (CLS)?
Answer reference: Section 7

10. Who has the right to vote when stock is loaned?

Answer reference: Section 8.4

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Chapter Eight

Accounting Analysis
1. Basic Principles 221

2. The Statement of Financial Position 225

3. The Income Statement 231

4. The Statement of Cash Flows 236

5. Additional Information 243

6. Financial Statement Analysis 244

8
This syllabus area will provide approximately 14 of the 100 examination questions
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 Accounting Analysis

1. Basic Principles

1.1 The Purpose of Financial Statements

Learning Objective
8.1.1 Understand the purpose and uses of financial statements

Accounting can be defined as the recording, measuring and reporting of economic events, or activities,
to interested parties in a usable form. It is about providing information relating to the financial and
economic activities of a business in the form of a set of accounts. This set of accounts is alternatively
referred to as the financial statements of the business.

Accounting information must be prepared and produced in the form of financial statements to provide
stakeholders with information about the company in a standard format. This enables stakeholders to
objectively compare the information against previous periods (quarters, half-years or years) for the
same company, as well as against other companies, particularly competitors in the same industry.
Stakeholders include owners, creditors, prospective investors, employees, financial analysts and
institutional investors, stock exchanges, as well as governments, consumers and environmental groups.

8
The directors of a company are required to prepare financial statements and make other disclosures
within an annual report and accounts. These set out the results of the company’s activities during its
most recent accounting period and its financial position as at the end of the period. The accounting
period typically spans a 12-month period.

Broadly, these financial statements comprise three major statements:

1. The statement of financial position/balance sheet – this provides a snapshot of the company’s
financial position as of a given date, usually the company’s accounting year-end. It has three main
sections – assets, equity and liabilities. The assets are owned by the company, the liabilities are owed
by the company to others, and the equity is the total capital amount that the shareholders have
contributed and are due. The assets are listed on one side of the balance sheet and the liabilities and
shareholders’ equity are on the opposite side. The two sides of the sheet must balance each other
(assets = equity + liabilities), which is why this was traditionally referred to as the balance sheet.
More recently, however, it has been referred to as the statement of financial position.
2. The income statement – this summarises income (or revenue) that is earned and the expenses that
are incurred by the company over the accounting period. Broadly, it is a summary of the trading
activities of the company over the year. If income exceeds expenses, the company has made a profit;
if expenses exceed income, the company has incurred a loss. The income statement is sometimes
referred to as the profit and loss statement.

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The income statement links the company’s previous statement of financial position with its current one.
This relationship is depicted below.

Statement of Statement of
Company Founded Financial Position (1) Financial Position (2)

Income earned/ Income earned/

expenses incurred expenses incurred

Income Income
Statement (1) Statement (2)

Accounting Period (1) Accounting Period (2)

3. A cash flow statement – this statement identifies how much cash the company generated over the
accounting period and how much cash has been spent. The statement divides the sources and uses
of cash into cash flow from operating, investing and financing activities. The total of the net cash
flows from the three activities is the change in the company’s cash from one accounting period to
the next. The cash flow statement is also referred to as a statement of cash flows.

Additional disclosures and notes to financial statements – in addition to the three accounting
statements mentioned above that must be generated each year or accounting period, companies also
provide additional disclosures such as a statement of comprehensive income, a statement of changes
in equity and notes that explain the company’s accounting policies and provide additional information
to both aid understanding and help a stakeholder to compare figures from previous years and other
companies’ financial statements.

The information contained in the company’s report and accounts is also required to be independently
verified, or audited. An audit is an independent assessment of the company’s accounts that have
been prepared by the directors. This audit is concluded with an auditor’s report to the members, or
shareholders, of the company confirming whether or not the accounts give a true and fair view of the
company’s activities and financial position and whether they have been prepared in accordance with
the law and other regulations. If they have, an unqualified audit report is issued. If they have not the
auditor must issue a qualified report and state the reason for this qualification.

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 Accounting Analysis

1.2 Accounting Regulations

Learning Objective
8.1.2 Understand the requirements for companies and groups to prepare accounts in accordance
with applicable accounting standards and the difficulties encountered when comparing
companies using different standards: accounting principles; International Financial Reporting
Standards; International Accounting Standards

The form and content of all company financial statements and their respective disclosures are prescribed
by the law and by mandatory accounting standards set by the accountancy profession. Accounting
standards are authoritative statements of how particular types of transaction and other events should
be reflected in financial statements.

The combination of accounting regulations is often referred to as the generally accepted accounting
principles (GAAP). There are efforts being made to harmonise GAAP throughout the world, spearheaded
by the International Accounting Standards Board (IASB). The IASB is an independent, privately funded
accounting standard-setter based in London. The board members include a chair and an internationally
diverse set of members with a variety of functional backgrounds. To ensure a broad international
diversity, there will normally be members from:

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• the Asia/Oceania region
• Europe
• North America
• Africa, and
• South America.

The IASB is committed to developing, in the public interest, a single set of high-quality, understandable
and enforceable global accounting standards that require transparent and comparable information
in general purpose financial statements. In addition, the IASB cooperates with national accounting
standard-setters to achieve convergence in accounting standards around the world.

Standards issued by the IASB are designated International Financial Reporting Standards (IFRSs).
There were also standards issued by the IASB’s predecessor (the International Accounting Standards
Committee) that continue to be designated International Accounting Standards (IASs). The IASB has
retained the IASs and also issues IFRSs.

Many developed countries require the IASB’s standards to be used for listed companies; however,
the US still retains its own US GAAP that is gradually converging with IFRSs. Until fully converged,
companies’ financial statements prepared under IFRSs will vary to some extent with the US GAAP. This
means it is not simply the case of judging whether one company has performed better than another by
looking at the amount of profit made by a European-listed company using IFRSs and a US competitor
preparing accounts under US GAAP – adjustments are required to make the accounting principles
adopted compatible.

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1.3 Group Versus Company Accounts

Learning Objective
8.1.3 Understand the differences between group accounts and company accounts and why
companies are required to prepare group accounts (candidates should understand the
concept of goodwill and minority interests but will not be required to calculate them)

If a company invests in another company, all that appears in the accounts of the investing company is
the original cost of the investment (in the statement of financial position), and the dividends received (if
there are any) appear in the investing company’s income statement.

This treatment is fine when the investment is a small minority shareholding in another company.
However, in instances when the investment is so significant that the investing company controls
the other company, another accounting treatment is required – the preparation of group financial
statements (known as group accounts or consolidated financial statements). The investing company is
described as the parent and the company or companies that the parent company controls are described
as subsidiaries. As long as a parent/subsidiary relationship exists, the parent company should prepare
and present a set of group accounts in addition to its individual company financial statements.

These group accounts present the financial statements as if the parent and the subsidiaries were a
single entity, rather than distinct individual companies. This entails the addition of the assets of the
parent plus all of the subsidiaries’ assets to arrive at the group assets, and similar additions to arrive at
the group’s liabilities, revenues, expenses and cash flows.

Two particular issues can crop up when amalgamating the figures for the parent company and its
subsidiaries:

1. Goodwill – when presenting the group accounts as a single entity, the assets and liabilities of the
subsidiaries are added to those of the parent company. This replaces the original cost of investment
in the group statement of financial position. If the cost of investment exceeded the net assets (assets
less liabilities) of the subsidiary, the excess is described as goodwill and appears as an asset in the
consolidated statement of financial position in the group accounts.
2. Non-controlling interests – in circumstances when the parent company owns a majority of the
shares in a subsidiary, but not all of the shares, there will be non-controlling interests. These non-
controlling interests used to be referred to as minority interests. For example, if a parent owned
75% of the shares of a subsidiary, the non-controlling interest would be 25%; if it owned 51% of the
shares, the non-controlling interest would be 49%. As the presentation of the group accounts adds
together all of the assets and liabilities of the subsidiaries, it includes some net assets that belong
to the non-controlling interests. These are reflected by detailing the extent to which the net assets
and net income belong to the non-controlling interests in the consolidated statement of financial
position and the group income statement.

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 Accounting Analysis

2. The Statement of Financial Position

2.1 Purpose, Format and Main Contents

Learning Objective
8.2.1 Know the purpose of the statement of financial position, its format and main contents

The statement of financial position, or balance sheet, is a snapshot of a company’s financial position
at a particular moment, usually a company’s quarter end or year end. It is divided in two, and the two
sides must always balance each other exactly, hence the term ‘balance sheet’. The key information it
provides to stakeholders is what the company owns (its assets), what the company owes (its liabilities),
and the extent to which shareholders are financing the company (the shareholders’ equity). The assets
and liabilities are also divided into current (due within one year) and non-current, to provide additional
context as to how liquid or permanent the assets are, and how immediately the liabilities are due.

The balance sheet should reflect all of the reporting company’s assets and liabilities, but over time
companies and their advisers developed creative structures to enable items to remain off-balance-sheet
rather than on-balance-sheet. The IASB and the adoption of its accounting standards should ensure that

8
everything that should appear on the balance sheet is categorised as on-balance-sheet, and those items
that are legitimately not assets or liabilities of the company should remain off-balance-sheet.

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The typical format of a statement of financial position, with example figures, is provided below, followed
by an explanation of each of the headings:

Example statement of financial position as at 31 December 2020

€000
Assets
Non-current assets
Property, plant and equipment 8,900
Intangible assets 2,100
Investments 300
11,300
Current assets
Inventories 3,600
Trade and other receivables 2,600
Prepayments 120
Cash 860
7,180
Total assets 18,480

Equity and liabilities

Capital and reserves
Share capital – 10m 50c ordinary shares 5,000
Share capital – preference shares 100
Share premium account 120
Revaluation reserve 180
Retained earnings 6,880
Total equity 12,280
Non-current liabilities
Bank loans 2,000
Provisions 2,000

Current liabilities
Trade and other payables 2,200

Total liabilities 6,200

Total equity and liabilities 18,480

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 Accounting Analysis

2.2 Assets
An asset is anything that is owned and controlled by the company and confers the right to future
economic benefits. Statement of financial position assets are categorised as either non-current assets
or current assets.

2.2.1 Non-Current Assets

Non-current assets are those in long-term, continuing use by the company. They represent the major
investments from which the company hopes to make money. Non-current assets are categorised as:

• tangible, or
• intangible.

Tangible Non-Current Assets

A company’s tangible non-current assets are those that have physical substance, such as land and
buildings and plant and machinery, and indeed are often referred to as plant, property and equipment
(PPE). Tangible non-current assets are initially recorded in the statement of financial position at their
actual cost, or book value. However, in order to reflect the fact that the asset will generate benefits
for the company over several accounting periods, not just in the accounting period in which it was
purchased, all tangible non-current assets with a limited economic life are required to be depreciated.

8
The concept of depreciation will be covered in more detail in section 2.3.

Intangible Non-Current Assets

Intangible non-current assets are those assets that are expected to generate economic benefits over
a number of accounting periods but are without physical substance. These often take the form of
intellectual property and can give a company a competitive advantage over its peers. Commonly
quoted examples include computer software, patents, trademarks, capitalised development costs and
purchased goodwill.

Purchased goodwill arises in group accounts when the consideration, or price, paid by an acquiring
company for a target subsidiary company, exceeds the fair value of the target’s separable, or individually
identifiable, net assets. This is not necessarily the same as the book, or statement of financial position,
value of these net assets.

Non-Current Investments
Non-current investments include investible assets, such as equity investments or investments in debt
instruments in other companies, that will not be sold, or will not mature within the next year. They
are recorded in the statement of financial position at cost, less any impairment to their value, where
applicable.

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2.2.2 Current Assets
Current assets are those assets purchased with the intention of resale or conversion into cash, usually
within a 12-month period. They include stocks (or inventories) of finished goods and work in progress,
the debtor balances that arise from the company providing its customers with credit (trade receivables),
and any short-term investments held. Current assets also include cash balances held by the company
and prepayments. Prepayments are simply when the company has prepaid an expense, as illustrated by
the following example:

Example
A company, XYZ, draws up its statement of financial position on 31 December each year. Just prior to
the year-end, XYZ pays €25,000 to its landlord for the next three months’ rental on its offices (to the end
of March in the next calendar year).

This €25,000 is not an expense for the current year – it represents a prepayment towards the following
year’s expenses and is, therefore, shown as a prepayment within current assets in XYZ’s statement of
financial position.

Current assets are typically listed in the statement of financial position in ascending order of liquidity
and appear in the statement of financial position at the lower of cost or net realisable value (NRV).

Sometimes the distinction between current and non-current assets does not appear on the face of
the balance sheet, with the split between the two only appearing in the notes to the accounts. As an
example, agricultural firms often amalgamate both current and non-current ‘biological assets’ on their
balance sheets. Firms in particular industries occasionally have reporting customs which differ from the
majority of firms, so an understanding of the individual company and the sector/industry it operates in
can be important.

2.3 Depreciation and Amortisation

Learning Objective
8.2.2 Understand the concept of depreciation and amortisation

Depreciation is applied to tangible, non-current assets, such as plant equipment and machinery. These
assets wear out over time, and lose their usefulness, speed or efficiency, which decreases their value.
The logging of that decrease in value over time on a financial statement is called ‘depreciation’. This
requirement does not, however, apply to freehold land and non-current asset investments which, not
having a limited economic life, are not usually depreciated.

Depreciation and amortisation are costs and are, therefore, recorded as expenses on each year’s
income statement of comprehensive income, because using up the value of the asset, like equipment,
is considered a cost of performing business, just as wages being paid to employees are.

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 Accounting Analysis

To calculate the annual depreciation charge to be applied to a tangible asset, the difference between
its cost and estimated disposal value, termed the depreciable amount, must first be established. This
value is then written off, over the asset’s useful economic life, by employing the most appropriate
depreciation method. The most common depreciation method is the straight line method. The straight
line method simply spreads the depreciable amount equally over the economic life of the asset. The
straight line method is given by the following formula:

(cost – disposal value)

Straight line depreciation =
      useful economic life in years

One thing to recognise about the annual depreciation charge is that it is an accounting book entry, or
a non-cash charge. That is, no cash flows from the business as a result of making the charge: it is simply
an accounting entry made against the income statement to reflect the estimated cost of resources used
over an accounting period. The statement of financial position value of the asset is given by its cost,
less the accumulated depreciation to date, and is termed the net book value (NBV). This NBV does not
necessarily equal the market value of the asset.

Example
Depreciation
A machine purchased for €25,000 has an estimated useful economic life of six years and an estimated

8
disposal value after six years of €1,000. Calculate the depreciation that should be charged to this asset
and its NBV in years one to six, using the straight line depreciation method.

Solution

Straight depreciation
(cost – disposal value)
Straight line depreciation =
   useful economic life (years)

(€25,000 – €1,000)
= = €4,000 pa
  6

Year Opening net book value Depreciation Closing net book value
1 25,000 4,000 21,000
2 21,000 4,000 17,000
3 17,000 4,000 13,000
4 13,000 4,000 9,000
5 9,000 4,000 5,000
6 5,000 4,000 1,000

By reducing the book value of tangible non-current assets over their useful economic lives, depreciation
matches the cost of the asset against the periods from which the company benefits from its use.

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On occasion, tangible assets, such as land, are not depreciated but periodically revalued. This is done
on the basis of providing the user of the accounts with a truer and fairer view of the assets, or capital,
employed by the company. To ensure the statement of financial position still balances (total assets =
equity and liabilities), the increase in the asset’s value arising on revaluation is reflected in a revaluation
reserve, which forms part of the equity.

Closely linked to the idea of depreciating the value of a tangible asset over its useful economic life is the
potential need for intangible assets to be amortised over their useful economic lives. Amortisation, like
depreciation, is simply a book entry whose impact is felt in the company’s reported income and financial
position but does not impact its cash position. Most intangible assets are amortised each year. Examples
of intangible assets include software, patents and licences held by the company.

Purchased goodwill is accounted for in a slightly different manner to most other intangible non-current
assets. Purchased goodwill is capitalised and included in the statement of financial position; it is not
amortised and, once capitalised, cannot be revalued but may suffer impairment in value.

2.4 Equity

Learning Objective
8.2.3 Understand the difference between share capital, capital reserves and revenue reserves

Equity is referred to in a number of ways, such as shareholders’ funds, owners’ equity or capital. Equity
usually consists of three sub-elements: share capital, capital reserves and revenue reserves. Additionally,
when group accounts are presented, there may be minority or non-controlling interests within the
group equity figure.

• Share capital – this is the nominal value of equity and preference share capital the company has in
issue and has called up.
• Capital reserves – capital reserves include revaluation reserves and the share premium account.
The revaluation reserve arises from the upward revaluation of non-current assets, and the share
premium reserve arises when the company issues shares at a price above their nominal value.
Capital reserves are not distributable to the company’s shareholders in the form of dividends, as
they form part of the company’s capital base, although they can be converted into a bonus issue of
ordinary shares.
• Revenue reserves – the major revenue reserve is the accumulated retained earnings of the
company. This represents the accumulation of the company’s distributable profits that have not
been paid to the company’s shareholders as dividends, but have been retained in the business.
The retained earnings should not be confused with the amount of cash the company holds or with
the income statement that shows how the retained, or undistributed, profit in a single accounting
period was arrived at.
• Non-controlling interests – these arise when a parent company controls one or more subsidiary
companies, but does not own all of the share capital. The equity attributable to the remaining
shareholders is the non-controlling interests and this is reflected in the statement of financial
position within the equity section.

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 Accounting Analysis

In total, equity is the sum of the called-up share capital, all of the capital reserves and the revenue
reserves:

Equity = share capital + reserves

2.5 Liabilities

Learning Objective
8.2.4 Know how loans and indebtedness are included within a statement of financial position

A liability is an obligation to transfer future economic benefits as a result of past transactions or

events; more simply, it could be described as money owed to someone else. Liabilities are categorised
according to whether they are to be paid within, or after more than, one year:

• Non-current liabilities – this comprises the company’s borrowing not repayable within the next 12
months. This could include bond issues as well as longer-term bank borrowing. Other types of long-
term obligations, such as long-term lease payments due would also be included in this section of
the balance sheet. In addition, there is a separate subheading for those liabilities that have resulted
from past events or transactions and for which there is an obligation to make a payment, but the

8
exact amount or timing of the expenditure has yet to be established. These are commonly referred
to as provisions. Such provisions may arise as a result of the company undergoing a restructuring,
for example. Given the uncertainty surrounding the extent of such liabilities, companies are
required to create a realistic and prudent estimate of the monetary amount of the obligation, once
it is committed to taking a certain course of action.
• Current liabilities – this includes the amount the company owes to its suppliers, or trade payables,
as a result of buying goods and/or services on credit, any bank overdraft, and any other payables,
such as tax, that fall due for payment within 12 months of the date of the statement of financial
position.

3. The Income Statement

3.1 Purpose and Contents

Learning Objective
8.3.1 Know the purpose of the income statement, its format and main contents

The income statement summarises the company’s income earned and expenditure incurred over the
accounting period. The income statement is alternatively referred to as the statement of profit and
loss. The function of this financial statement is to detail how much profit has been earned and how the
company’s reported profit (or loss) was arrived at.

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The amount of profit earned over the accounting period will impact the company’s ability to pay
dividends and how much can be retained to finance the growth of the business from internal resources.

Like the statement of financial position, the format of the income statement is governed by the law
and underpinned by the requirements of various accounting standards. The following table shows a
simplified example of an income statement. Under IFRSs, there is some flexibility about the precise
format that is presented.

Example income statement for the year ending 31 December 2020

Notes 2020 2019
€000 €000
Revenue 9,500 8,750
Cost of sales (7,000) (6,600)
Gross profit 2,500 2,150
Distribution costs (110) (90)
Administrative expenses (30) (20)
Loss on disposal of plant (260)
Operating profit 2,100 2,040
Financial costs (230) (250)
Financial income 120 112
Profit before taxation 1,990 1,902
Taxation (555) (548)
Net income 1,435 1,354
Earnings per share (cents) 16.1c 15.9c

3.1.1 Revenue
The income statement starts with one of the most important things in any company’s accounts: its sales
revenues. In accounts, sales revenues are generally referred to as revenue, or sometimes turnover. It is
simply everything that the company has sold during the year, regardless of whether it has received the
cash or not. For a manufacturer, revenue is the sales of the products that it has made. For a company
in the service industry, it is the consulting fees earned, or perhaps commissions earned on financial
transactions.

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 Accounting Analysis

3.1.2 Costs of Sales

The costs of sales are the costs to the company of generating the sales made in the financial year. These
items are also sometimes known as the cost of goods sold (COGS). They, typically, include the costs
directly associated with producing the goods that are sold, such as of the raw materials used to make a
product and the costs of converting those raw materials into their finished state, including the wages of
the staff making the products. COGS does not include indirect expenses such as the costs of distribution
or selling the goods that are sold.

3.1.3 Gross Profit

Total sales, less the costs of those sales, results in the gross profit for the year.

3.1.4 Operating Profit

Operating profit is also referred to as profit on operating activities. It is the gross profit, less other
operating expenses that the company has incurred. These other operating expenses might include costs
incurred distributing products (distribution costs) and administrative expenses such as management
salaries, auditors’ fees and legal fees. Administrative expenses would also include depreciation and
amortisation charges. Additional items may be separately disclosed before arriving at operating profit,
such as the profit or loss made on selling a non-current asset. When a non-current asset, such as an item

8
of machinery, is disposed of at a price significantly different from its statement of financial position
value, the profit or loss when compared to this NBV should be separately disclosed if material to the
information conveyed by the accounts.

Operating profit is the profit before considering finance costs (interest) and any tax payable – so it
can also be described as profit before interest and tax (PBIT) or earnings before interest and tax (EBIT).
To reach a number more closely equating the net cash generated by the company’s operations,
depreciation and amortisation are often added back to derive earnings before interest, taxes,
depreciation and amortisation (EBITDA). This number is often useful for determining how much debt a
company can sustain.

3.1.5 Finance Costs/Finance Income

Finance costs are generally the interest that the company has incurred on its borrowings – that may be
in the form of bonds or may be bank loans and overdrafts.

Finance income is typically the interest earned on surplus funds, such as from deposit accounts.

3.1.6 Profit Before Tax

This is the profit made by the company in the period, before considering any tax that may be payable on
that profit.

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3.1.7 Corporation Tax Payable
This is simply the corporation tax charge that the company has incurred for the period.

3.1.8 Net Income

Once tax and financing costs have been deducted, the income statement reaches a vital figure: net
income, net profit or the profit for the period. Net income reflects all of the revenues earned during
the period, less all of the expenditures incurred. This net income is also the profit attributable to the
shareholders of the company because, in theory, it could all be distributed to shareholders as dividends.

3.1.9 Earnings Per Share (EPS)

This is an important figure for readers of the financial statements as it displays the company’s profit
expressed on a per-share basis. This is always reflected at the bottom of the income statement. Earnings
per share (EPS) is the amount of profit after tax that has been earned per ordinary share. EPS is calculated
as follows:

Net income for the financial year – Dividends on preferred shares

EPS =
  Number of ordinary shares in issue

3.1.10 Dividends
Some, or all, of the profit for the financial year can be distributed as dividends. Dividends to any
preference shareholders are paid out first, followed by dividends to ordinary shareholders at an amount
set by the board. The dividends for most listed companies are either paid in two or four instalments:
either a single interim dividend paid after the half-year stage or three quarterly dividends, and a final
dividend to be paid after the accounts have been approved.

The dividends are shown in the accounts in another of the required disclosures under the IFRS – the
statement of changes in equity – that reconciles the movement in equity from one statement of financial
position to another.

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 Accounting Analysis

Example statement of changes in equity for the year ending 31 December 2020
Ord Pref Share
Revaluation Retained
share share premium Total
reserve earnings
capital capital account
As at 1 January
4,470 100 100 5,040 9,710
2019
Gain on
80 80
revaluation
Issue of shares 530 120 650
Net income for
1,435 1,435
the year
Preference
(5) (5)
dividends paid
Ordinary
(400) (400)
dividends paid
As at 31
December 5,000 100 120 180 6,070 11,470
2019

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3.2 Capital Versus Revenue Expenditure

Learning Objective
8.3.2 Understand the difference between capital and revenue expenditure

Money spent by a company will usually fall into one of two possible forms: capital expenditure or
revenue expenditure.

• Capital expenditure is money spent to buy non-current assets, such as PPE. It is reflected on the
statement of financial position.
• Revenue expenditure is money spent that immediately impacts the income statement. Examples
of revenue expenditure include wages paid to staff, rent paid on property and professional fees, like
audit fees.

4. The Statement of Cash Flows

4.1 Purpose of the Statement of Cash Flows

Learning Objective
8.4.1 Know the purpose of the cash flow statement and its format as set out in IAS 7

The statement of cash flows or, as it is often termed, the cash flow statement, is basically a summary of
all the payments and receipts that have occurred over the course of the year, the total reflecting the
inflow (or outflow) of cash over the year.

A statement of cash flows is required by accounting standard IAS 7.

The logic of adding a cash flow statement to a set of financial statements is that it enables the readers
of the accounts to see clearly how cash has been generated and/or used over the course of the year.
This is considered to provide relatively easily understood information to the users of the accounts that
supplements the performance figures provided by the income statement, and the statement of financial
position given by the statement of financial position.

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 Accounting Analysis

IAS 7 cash flow statements require a company’s cash flows to be broken down into particular headings,
as illustrated in the following example:

Example cash flow statement for the year ending 31 December 2020

Operating activities
Cash receipts from customers 4,528
Cash paid to suppliers and employees (2,441)
Cash generated from operations 2,527
Tax paid –
Interest paid (150)
Net cash from operating activities 4,464

Investing activities
Interest received 80
Dividends received 40

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Purchase of plant, property and equipment (1,890)
Proceeds on sale of investments 120
Net cash used in investing activities (1,650)

Financing activities
Dividends paid (435)
Repayments of borrowings (200)
Proceeds on issue of shares 650
Net cash generated from financing activities 15

Net increase in cash and cash equivalents 2,829

Cash and cash equivalents at the beginning of the
425
year
Cash and cash equivalents at the end of the year 3,254

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Looking at the key cash flow statement headings in turn:

• Operating activities is the cash that has been generated from the trading activities of the company,
excluding financing cost (interest).
• Investing activities details the investment income (dividends and interest) that has been received
in the form of cash during the year, the cash paid to purchase new non-current assets and any cash
received from the sale of non-current assets and investments during the year.
• Financing activities includes the cash spent during the year on paying dividends to shareholders,
borrowing on a long-term basis or the cash raised from issuing shares, less the cash spent repaying
debt or buying back shares.

The resultant total should explain the changes in cash (and cash equivalents) between the statement
of financial positions. Many short-term investments are classified as cash equivalents, such as Treasury
bills (T-bills).

4.2 Profit Versus Cash

Learning Objective
8.4.2 Understand the difference between profit and cash and their impact on the long-term future
of the business

Profit appears in the income statement and is the excess of revenues earned over the period, over the
expenses incurred in that same period. Obviously, generating profits is necessary for the long-term
survival of any business, although companies can (and many do) exhibit losses for a number of years.
Without profit, that business is unlikely to survive indefinitely.

The extent to which a company has generated (or used up) cash is detailed in the cash flow statement.
Cash is generated when cash received exceeds cash paid out, and cash is used up when the cash paid
out exceeds the cash received. Cash is often described as the lifeblood of the company. Without it, the
company will not survive. If a company does not have the cash to pay a liability when it is due, there is a
possibility of the company being forced to close down.

When comparing profit against cash, there are some key differences. Because profit is based on
revenues earned, not cash received, there is a possibility that the two figures for a company could be
very different. For example, a company may make sales on credit and, therefore, recognise the revenues
at the point of sale in the income statement. The cash for those sales could be received significantly
later.

Similarly, profit is based on expenditure incurred, not cash paid, and there can be significant differences
between the two. A key example of the potential for difference is in the different treatments of the
purchase of a non-current tangible asset, like a machine. In the income statement, the impact will be a
gradual expense incurred each year for the depreciation of the machine. In the cash flow statement, the
full cost will be paid in cash at the time of purchase.

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 Accounting Analysis

Example operating cash flow statement for year ending 31 December 2020
All figures are in €
Net income after tax 240,000
Other additions to cash
Depreciation
Depreciation is not a cash expense; it is added
and 35,000
back into net income for calculating cash flow
amortisation
If accounts receivable decreases, then more
Decrease cash has entered the company from customers
in accounts 17,000 paying off their accounts – the amount by which
receivable accounts receivable has decreased is an addition
to cash
A decrease in inventory signals that a company
Decrease in has spent less money to purchase more raw
inventory materials. The decrease in the value of inventory
is an addition to cash
Decrease in
Similar reasoning to above for other current
other current 19,000
assets
assets

8
If accounts payable increases it suggests more
Increase in cash has been retained by the company through
accounts 26,000 not paying some bills – the amount by which
payable accounts payable has increased is an addition to
cash
Increase
For example, deferring payment of some salaries
in accrued
will add to cash
expenses
Increase in other Similar reasoning to above for increase in taxes
current liabilities payable
Total additions to cash from
97,000
operations
Subtractions
from cash
If accounts receivable increases, then less cash
Increase in
has entered the company from customers paying
accounts
their accounts – the amount by which accounts
receivable
receivable has increased is a subtraction of cash
An increase in inventory signals that a company
has spent more money to purchase more raw
Increase in
–33,000 materials. If the inventory was paid with cash, the
inventory
increase in the value of inventory is a subtraction
of cash

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 Increase in other
Similar reasoning to above for other current assets
current assets
If accounts payable decreases it suggests more
Decrease
cash has been used by the company to pay its
in accounts
bills – the amount by which accounts payable
payable
decreased is a subtraction from cash
Decrease
For example, an increase in prepaid expenses
in accrued –19,000
results in a subtraction of cash
expenses
Decrease in
Similar reasoning to above for decrease in taxes
other current –23,000
payable
liabilities
Total subtractions from cash
–75,000
from operations
= net income after tax + total additions to cash
Total operating cash flow 262,000 from operations + total subtractions from cash
from operations

4.3 Free Cash Flow

Learning Objective
8.4.3 Understand the purpose of free cash flow and the difference between enterprise cash flow and
equity cash flow

There is no single definition of free cash flow. Logically, it perhaps should be drawn from the cash flow
statement and represent the amount of cash that has been generated and that the company can choose
what to do with. This might be the operating cash flow less the extent to which the company has to
spend cash to maintain the operating capacity of the business. It is the latter figure that is difficult to
isolate, and is likely to be a subjective judgement by the user of the accounts. The resultant figure might
be adjusted further depending on whether the calculation is for free cash flow to the firm (enterprise
cash flow), or just free cash flow to the shareholders (equity cash flow). This will be explored in more
detail below.

Because of the difficulty in arriving at free cash flow from the cash flow statement, many users calculate
a free cash flow figure from the income statement. This is generally arrived at by taking the net income
from the income statement, adding back the charges for depreciation and amortisation and deducting
capital expenditure. The capital expenditure is used as a best estimate of the capital spend required to
maintain the operating capacity of the business. The use of the income statement figure for operating
cash flow presents a smoother, potentially more representative figure for cash generation than the
figure in the cash flow statement as it removes the inconsistencies that payments in advance or in
arrears create.

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 Accounting Analysis

As well as there being two potentially different sources for free cash flow (the cash flow statement or the
income statement), there are further adjustments that might be made depending on whether the free
cash flow is being calculated for the whole enterprise (the enterprise cash flow) or is being calculated for
the equity holders only (the equity cash flow).

The enterprise cash flow is the free cash flow before considering payments made to any of the providers
of finance to the firm. The providers of finance to the firm are both the lenders and the equity holders.
The enterprise cash flow will, therefore, be the free cash flow before considering any financing costs.

In contrast, the equity cash flow is the free cash flow to the shareholders, so it will be after any financing
costs to the lenders, but before any dividend payments to the shareholders.

Example cash flow statement for year ending 31 December 2020

All figures are in €
= net income after tax + total additions to
Total operating cash flow 262,000 cash from operations + total subtractions
from cash from operations
Investment/capital expenditures
Additions to cash from investments

8
Decrease in plant,
The sale of a building, for example, will
property and 150,000
lead to an addition to cash
equipment
Decrease in notes A reduction in notes receivable indicates
12,000
receivable that cash will have been received
Decrease in
Securities will have been sold thereby
securities,
raising cash
investments
Decrease in
Sale of a patent or copyright will lead to
intangible, non-
an addition of cash
current assets
Total additions to cash from
162,000
investments
Subtractions from cash for investments
Increase in plant,
Purchase of a building will lead to a
property and
subtraction from cash
equipment
Increase in notes An increase in notes receivable indicates
receivable that cash has not yet been received
Increase in securities, Securities will have been purchased
–64,000
investments thereby reducing cash
Increase in intangible, Purchase of a copyright will lead to a
–250,000
non-current assets reduction of cash

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 Total subtractions from cash for
–314,000
investments
= total operating cash flow + additions
to cash from capital investments –
Total enterprise cash flow 110,000
subtractions from cash from capital
investments
Financing activities
Additions to cash from financing
Increase in Additional net borrowing will lead to an
50,000
borrowings addition of cash
Increase in capital Additional net equity capital paid in will
stock lead to an addition of cash
Total additions to cash from financing 50,000
Subtractions from cash for financing
Decrease in Net reduction in borrowing will lead to a
borrowings subtraction of cash
Retirement of net equity capital paid in,
Decrease in capital
such as share buybacks, will lead to a
stock
subtraction of cash
Total subtractions from cash for
financing
= total enterprise cash flow + additions
Total equity cash flow 160,000 to cash from financing + subtractions
from cash from financing
Subtractions from cash for dividends
Dividends paid –100,000
= total equity cash flow – dividends paid
Total free cash flow 60,000
out

Cash at beginning of
450,000
period
Cash at end of period 510,000

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 Accounting Analysis

5. Additional Information

Learning Objective
8.5.1 Know additional information that can be used to analyse company performance contained
within: the annual report; auditor’s report

The financial statements are often referred to as the accounts, and they provide important information
for a variety of users, including existing and potential investors, as well as many other interested parties,
including lenders to the company. Each year listed companies publish their financial statements within
a larger document – the annual report and accounts. As the name suggests, in addition to the financial
statements, this document also includes other information that may be helpful to the many interested
parties. To illustrate this, here are the contents of a typical annual reports and accounts along with
explanations and some suggestions as to how they might be of use in analysing corporate performance:

• Strategic report:
• This is where the directors of the company (particularly the chairman and the CEO) report on
the strategy that the company has adopted, including any major plans for the future. This can
be helpful for users of the accounts in clarifying how the company is delivering value now, and
outlining how it hopes this will develop over the coming years.

8
• Stakeholder review:
• Typically this section of the annual report looks at the major stakeholders (including customers,
employees, society in general, the environment and shareholders) and the way the company
is looking after their interests. Like the strategic review, it provides context in terms of
performance and also some information that may be of particular interest to those aiming for
socially responsible investing.
• Financial review:
• Here, the CFO will outline the performance based on a variety of metrics, including many of the
accounting ratios that will be considered in the next section. There also tends to be an outline
of the key risks faced by the business. Again, this will provide analytical context as well as useful
insight as to why profitability and liquidity might have changed from previous periods, and how
it might develop in future periods.
• Governance report:
• This sub-section will outline how the company runs the business responsibly and effectively
including individual reports from sub-committees of the board such as the audit committee.
The audit committee contributes to auditor independence – it is a group of non-executive
directors responsible for the appointment, compensation and oversight of the work of the
external auditor. Interested stakeholders often want to assess how the company is run and
should gain confidence from a well-governed company.
• Directors’ remuneration:
• How the directors are rewarded is something investors should want to know. Investors want to
see directors appropriately rewarded for positive performance and not remunerated excessively
in times of poor performance. The ideal here is goal congruence, where the directors have a
remuneration scheme that aligns their motivations in the same direction as the stakeholders,
particularly the shareholders.

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• Financial statements including:
• Independent auditor’s report
– This is vital. It is where the independent auditor’s report give an opinion on whether the
financial statements have been properly prepared and present a true and fair view. If the auditor
does not believe this to be the case, then the opinion is ‘qualified’ in some way. If the auditor
does believe the accounts present a true and fair view, then the report is said to be ‘unqualified’.
Users of the accounts want to have confidence in the numbers being presented, and an
independent auditor’s unqualified opinion adds credibility and confidence to the reported
performance.
• Accounts and notes:
• Much of the coverage in the chapter so far has concentrated on what is included in the section
of the annual report and accounts. In particular, this is where the income statement, statement
of financial position and cash flow statement are presented, along with supporting detail in the
so-called ‘notes to the accounts’. The use of these in analysing performance is detailed in the
following section.
• Shareholder information:
• The annual report incudes a section that provides a summary of information likely to be of
interest to the shareholders. It will detail the share price and dividend history to give the existing
and potential investors useful insight into capital gains and income that the company has
delivered to date.

6. Financial Statement Analysis

Learning Objective
8.6.1 Understand the importance of analysing financial statements in context for an informed
assessment
8.6.2 Understand the relationship between share price and financial statement information
8.6.3 Understand the purpose of ratio analysis and its limitations

6.1 Introduction
The three principal financial statements and associated explanatory notes published by companies
in their report and accounts furnish the user with a considerable amount of information. To assess a
company, the financial statements are vital. They will be able to answer key questions such as ‘is the
company profitable?’, and, if so, how the company’s profitability compares to earlier years and other
similar (and, therefore, comparable) companies. The statement of financial position can be utilised to
assess the assets the company owns, and the various liabilities it owes to others. The cashflow statement
can be used to assess how much cash is being used up and generated by the business.

However, in addition to looking at the financial statements as presented, users tend to use the accounts
to provide the inputs into ratios which can reveal trends and consolidate the information into a more
readily usable form.

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 Accounting Analysis

Ratios are commonly employed by analysts to assess the prospects for a particular company and,
therefore, the investment potential of the shares of that company, as well as assisting other interested
parties in assessing the company such as the board, suppliers, competitors and employees.

The purpose of ratio analysis is:

1. To assist in assessing business performance, by identifying meaningful relationships between

numbers contained within company financial statements, that may not be immediately apparent.
Although there are no statutory rules as to how ratios should be calculated, there should be logic in
the numbers being related to each other.
2. To summarise financial information into an easily understandable form.
3. To identify trends, strengths and weaknesses by comparing the ratios to those of the same company
in prior periods, other similar companies, sector averages and market averages.

However, ratio analysis does have its limitations:

1. As financial statements contain historic data, ratios are not predictive; indeed, occasionally, historic
figures can be restated in later periods, making comparison difficult.
2. The use of alternative accounting methods and differences in international accounting practices
may make it difficult to draw comparisons.
3. Significant judgement is needed when performing ratio analysis, which naturally leads to
divergence.

8
The first limitation noted above is worth exploring further, in particular, the fact that financial statements
present data from the past – historic data. It is this that is perhaps the main reason for the relationship
between the financial statements and the underlying share price of the company not being predictable
and straightforward. Share prices are driven by supply and demand factors, and, although an important
information source, the publication of financial statements does not always have a predictable impact
on the share price. The financial statements are simply telling investors what has happened in the
past, and do not necessarily change investor predictions of the future. This is illustrated in the fictional
example below:

Example
Mirage inc reported its latest annual reports that showed net income up 10% from a year earlier and an
increase in its final dividend of 12% to 30c per share. Mirage shares rose just 2% as investors had been
anticipating more growth in revenues from new markets and were disappointed to see revenues barely
bigger than a year earlier.

The above example shows that the share price reflects what investors believe is going to happen, and
if the financial statements change the investors’ view, then the share price will react to that changed
view. A substantial driver of share prices is anticipated performance and the publication of financial
statements can disappoint (as above) because the reported numbers, although positive, are not as
positive as the investors expected. Similarly, financial statements can, and often do, lead to share price
increases because they exceed expectation. This might be because of profits that are bigger than the
investors expected, or because anticipated falls in profits are not as bad as investors were expecting.

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The following section includes the various ratios required for the examination, including an explanation
of each of the key subsets of the ratios and the formulae so that the candidate can also calculate the
specified ratios.

6.2 Return and Profitability Ratios

Learning Objective
8.6.4 Be able to calculate the following key ratios: profitability ratios (gross profit and operating
profit margins), asset management ratios (turnover)
8.6.5 Be able to calculate the following key ratios: return on capital employed (ROCE), return on
assets (ROA), return on shareholders’ equity (ROE)

6.2.1 Return and Profitability Ratios Explained

Profitability ratios are a representation of the percentage return that the company generates relative to
its revenues. The gross profit is the percentage of revenues that the company earns after considering the
costs of sales. The operating profit margin portrays the percentage of revenues that the company earns
after considering costs of sales and other operating costs (such as distribution costs and administrative
expenses). The net profit margin is the percentage of revenues that the company earns after considering
all costs (both operating and finance costs). Clearly, all other things being equal, a greater profit margin
is preferable to a lesser profit margin.

There are a number of possible measures of return on capital employed (ROCE) widely seen as the best
ratio for measuring overall management performance, in relation to the capital that has been paid into
the business. It looks at the amount of return (profit) that is being generated as a percentage of the
finance put into the business (the capital employed). The amount of capital employed is the equity plus
the long-term debt. This is the money that the company holds from shareholders and debt providers,
and it is from this money that the management should be able to generate profits. Many commentators
refer to return on capital employed (ROCE) as the return on assets (ROA) since the capital employed in
the business is, by definition, equivalent to the net assets being used by the business.

A further measure of return is the return on shareholders’ equity (ROE) which looks at the net income
generated as a percentage of the equity financing the business.

6.2.2 Return and Profitability Ratios: Calculations

Effectively, the ROCE gives a yield for the entire company. It compares the money invested in the
company with the generated return. This annual return can then be compared to other companies, or
less risky investments.

The formula is:

Operating profit x 100

ROCE =
Capital employed

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 Accounting Analysis

where operating profit is the profit before financing and tax on the income statement, and capital
employed is the total for equity on the statement of financial position, plus the total for non-current
liabilities from the statement of financial position.

Using the example accounts encountered earlier:

ROCE = 2,100 / (12,280 + 4,000) x 100 = 12.9%

The formula for return on assets is:

ROA = Operating profit x 100

Total net assets

where operating profit is the profit before financing and tax on the income statement, and total net
assets is the non-current assets plus the current assets, less the current liabilities. It gives exactly the
same result as the ROCE:

Using the example accounts encountered earlier:

ROA = 2,100 / (11,300 + 7,180 - 2,200) x 100 = 12.9%

8
The formula for return on shareholders’ equity is:

ROE = Net income x 100

Shareholders’ equity

where net income is taken from the foot of the income statement and shareholders’ equity is the total
from the equity section of the statement of financial position.

Using the example accounts encountered earlier:

ROE = 1,435 / 12,280 x 100 = 11.7%

The figures for the profitability ratios are drawn from the income statement. The formulae for the
profitability ratios are:

Gross profit margin (%) = (Gross profit / Revenues) x 100

Operating profit margin (%) = (Operating profit / Revenues) x 100

Using the example from earlier:

Gross profit margin (%) = (2,500 / 9,500) x 100 = 26.3%

Operating profit margin (%) = (2,100 / 9,500) x 100 = 22.1%

247
The operating profit margin can also be used in conjunction with a ratio called ‘asset turnover’ to
provide a breakdown of the ROCE and ROA ratio.

Asset turnover is calculated by taking the annual revenues (the turnover of the business) and dividing it
by the total net assets in the business. It gives a result expressed as a ‘number of times’ and reflects the
amount of activity generated from the assets:

Asset turnover (number of times) = Revenues / Total net assets

Using the example from earlier:

Asset turnover (number of times) = 9,500 / 16,280 = 0.58 times

The larger the asset turnover, the more use the company is getting from the assets. If asset turnover is
combined with the operating profit margin, the result is the ROCE/ROA:

Operating profit margin x asset turnover = ROCE or ROA

Operating profit margin (%) = (2,100 / 9,500) x 100 = 22.1%

Asset turnover (number of times) = 9,500 / 16,280 = 0.58 times

22.1% x 0.58 = 12.9%

6.3 Financial Gearing Ratios

Learning Objective
8.6.4 Be able to calculate the following ratios: debt ratios
8.6.6 Be able to calculate the following financial gearing ratios: investors’ debt to equity ratio; net
debt to equity ratio; interest cover

6.3.1 Financial Gearing Ratios Explained

Financial gearing is a measure of risk arising from the company’s debt. Financial gearing is also called
‘financial leverage’, and the ratios are also referred to as ‘financial leverage ratios’ or ‘debt ratios’.
Financial gearing or leverage is determined by examining the amount of a company’s financing that
comes from debt, and the amount that comes from shareholders’ funds or equity – the debt to equity
ratio.

The higher the proportion of debt finance, the higher the risk that the company will not be able to meet
its financing commitments. This is because interest on debt must be paid every year and the debt must
be repaid at some point, whereas dividends on shares need only be paid in profitable years and share
capital never has to be repaid.

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 Accounting Analysis

It is the inability to service and repay debt that brings about company failure. However, high levels of
borrowing in some circumstances can be positive for the shareholders because, if the debt interest is
fixed, what is left after paying debt interest is the entitlement of the equity holders so, in years when the
firm earns substantial returns, all of the excess belongs to the equity holders.

Whether debt levels are excessive is a matter of judgement, but gearing ratios tend to look at the total
debt compared to equity. Sometimes this ratio may be less useful because, as well as holding substantial
amounts of debt, the company also holds substantial cash and short-term investments that could be
used to repay the debt – it is in these circumstances when net debt to equity is used.

Another way to assess whether debt levels are excessive is to look at the extent to which profits are
being made to cover the interest burden on that debt – the interest cover.

6.3.2 Financial Gearing Ratios: Calculations

Debt to Equity = Debt/Equity
Both figures for debt and equity are drawn from the statement of financial position of a company.
All non-current liabilities are generally considered to be debt, and the total of the equity portion of
the statement of financial position is considered to be equity. The ratio is either stated as a simple
proportion: debt to equity is 0.6; or, as a percentage: debt is 60% of the equity.

8
Using the example encountered earlier:

Debt to equity = 2,000 / 12,280 = 0.163 or 16.3%

Net Debt to Equity = (Debt less cash and short-term investments)/Equity

Net debt is simply the debt as in the debt-to-equity ratio, less the cash and short-term investments that
are within the current assets on the statement of financial position.

Using the example:

Net debt to equity = (2,000 – 860) / 12,280 = 0.093 or 9.3%

Interest Cover = Operating Profit/Interest Costs

Interest cover figures are drawn from the income statement. The operating profit is simply divided by
the interest costs (the financing costs line on the income statement).

Using the example:

Interest cover = 2,100 / 230 = 9.13 times

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6.4 Liquidity Ratios

Learning Objective
8.6.4 Be able to calculate the following ratios: liquidity ratios (current, quick/acid test)

A company’s survival is dependent upon both its profitability and its ability to generate sufficient cash
to support its day-to-day operations. This ability to pay its liabilities as they become due is known as
liquidity, and it can be assessed by using the current ratio and the quick or acid test ratio.

6.4.1 Current Ratio

The current ratio uses numbers from the statement of financial position and simply divides a company’s
current assets by its current liabilities as follows:

Current ratio = current assets / current liabilities

The higher the result, the more readily a company should be able to meet its liabilities that are becoming
due and still fund its ongoing operations.

Using the earlier example:

Current ratio = current assets / current liabilities = 7,180 / 2,200 = 3.26

6.4.2 Quick Ratio (Acid Test)

The quick ratio is also known as the acid test. It excludes inventory from the calculation of current assets,
as inventory is potentially not liquid, to give a tighter measure of a company’s ability to meet a sudden
cash call. Its formula is:

Quick ratio = (current assets – inventory) / current liabilities

For most industries, a ratio of more than one will indicate that a company has sufficient short-term
assets to cover its short-term liabilities. If it is less than one, it may indicate the need to raise new finance.

From the earlier example:

Quick ratio = (current assets – inventory) / current liabilities = (7,180 – 3,600)/ 2,200 = 1.63

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 Accounting Analysis

6.5 Investors’ Ratios

Learning Objective
8.6.7 Be able to calculate the following investors’ ratios: earnings per share (including diluted
earnings per share); price earnings ratio (both historic and prospective); gross dividend yield;
gross dividend cover
8.6.8 Be able to calculate the following investors’ ratios: enterprise value to EBIT; enterprise value to
EBITDA

Existing and potential investors look at a variety of ratios to assess whether or not a company is likely to
be a good investment. These ratios look to establish how:

• expensive the shares are, in order to reach a conclusion on the likelihood of capital growth
• much in dividends the shares pay, and how easily the company is able to bear the payment of those
dividends, to reach a conclusion on the income those shares are likely to generate.

6.5.1 Earnings Per Share (EPS)

The EPS ratio is one of the most useful and often-cited ratios used in the investment world. It is used

8
universally and more or less has the same meaning in most jurisdictions, but is one ratio for which there
are prescribed rules regarding its calculation. These are laid out in IAS 33, which essentially defines the
EPS as follows:

EPS = Net profit or loss attributable to ordinary shareholders

Average weighted number of ordinary shares outstanding in a period

The EPS reveals how much profit was made during the year that is available to be paid out to each share.
As a figure for profit per share, it can be divided into the current share price to assess how many times
the profit per share must be paid to buy a share – in effect, how expensive (or cheap) those shares are.
This is the price earnings ratio (P/E).

Furthermore, investors are particularly interested in the earnings each share will generate in the future,
rather than how much they have generated in the past. As a result, stockbrokers’ research departments
will endeavour to anticipate what the EPS will be – the prospective EPS – rather than what the EPS was
in the last reported set of results – the historic EPS.

To calculate the EPS, simply divide the value of net income or earnings (which is the net income for the
financial year) by the number of ordinary shares in issue.

Net income for the financial year – Dividends on preferred shares

EPS =
Number of ordinary shares in issue

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Note that if the company has preference shares in issue, the earnings are after the preference
shareholders’ dividend but before the ordinary shareholders’ dividend. For a group of companies
preparing consolidated accounts, the earning line will also be after any non-controlling interests.
Non-controlling interests used to be known as ‘minority interests’ and are the profits that belong to
shareholders of any subsidiary companies that are not shareholders in the parent company.

The following illustration shows how to calculate the earnings per share.

Illustration
XYZ has net income or earnings of €898,000 for its most recent fiscal year and, at the time of preparing
the EPS estimate, has 5 million outstanding ordinary shares.

The EPS is €898,000/5,000,000 shares = 18c per share.

6.5.2 Diluted Earnings Per Share

The purpose of publishing a separate figure for diluted EPS is to warn shareholders of potential future
changes in the EPS figure as a result of events that actually may have, or theoretically could take place.

The EPS, as defined in section 6.5.1, is potentially misleading if the company has substantial quantities of
instruments in issue that are convertible into shares. These may be convertible bonds or share options
issued to the senior management of the company. If the EPS is calculated in the usual way – by simply
dividing the net income for the period by the number of issued shares – the users of the accounts are
not incorporating the impact that convertible instruments may have – in particular their dilutive impact
on the EPS. The issuance of more shares will mean a lower EPS. As a result, for companies with significant
convertible instruments in issue, an adjusted figure for the EPS is required to be disclosed that takes this
into account. This ratio is called the diluted EPS.

The reason why the term theoretically is used in this context is because there is only a possibility –
legally certain rights have been granted which could be exercised and require further issues of shares
– and the prudent method of accounting is to assume, from the point of view of share dilution, the worst
case scenario.

There are two broad forms of securities that could cause share dilution and which need to be
incorporated into calculating a diluted EPS. A company may have either or both of the following kinds
of securities outstanding:

• issued convertible loan stock or convertible preference shares

• issued options or warrants.

Each of these circumstances may potentially result in more shares being issued, and thereby qualifying
for a dividend in future years, which may have a material effect in diluting the current EPS.

The diluted EPS figure is considered of such importance to the reader of the accounts, and a potential
investor, that its calculation and disclosure is required by IAS 33 – Earnings Per Share.

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 Accounting Analysis

The following illustration for the same imaginary company shows how to calculate the diluted EPS.

Illustration
The debt financing of XYZ at the year-end includes €250,000 of 10% convertible loan stock, which was
issued some years earlier. The terms of conversion for every €100 nominal value of loan stock is for
115 ordinary shares, and the convertible stockholders have not taken the option of converting, so the
€250,000 of convertible loan stock is still in issue at year-end.

Basic earnings for the year to 31 December is €898,000.

If the convertible loan stock had been converted, interest would have been saved of €250,000 @ 10% =
€25,000.

However, assuming a corporation tax rate of 30% this would have increased the tax payable by €25,000
x 30% = €7,500.

So, the fully diluted earnings, assuming the conversion had occurred = (€898,000 + €25,000 – €7,500) =
€915,500.

Number of shares pre-dilution for the period = 5,000,000.

8
The option remains for the loan stock to be converted at a rate of 115 shares. So, the maximum number
of new ordinary shares that could be issued is [250,000 / 100] x 115 = 287,500 shares.

So, the fully diluted number of ordinary shares = 5,287,500.

Pre-dilution, the basic EPS is €898,000 / 5,000,000 shares = 18c per share.

The fully diluted EPS is €915,500 / 5,287,500 shares = 17.3c.

6.5.3 Price Earnings (P/E) Ratio

The price earnings (P/E) ratio is calculated as follows:

Current market price per share

P/E Ratio =
Earnings per share

Let us suppose that the ordinary shares for a company are currently trading at €2.50 per share and that
the EPS is 20c: the P/E ratio is €2.50/€0.20 = 12.5.

The P/E ratio can be thought of as the number of years of earnings at the current level to generate the
share price, and in this case it is 12.5 years.

The price per share in the numerator is the market price of a single share of the stock. The EPS in the
denominator of the formula can vary according to the type of P/E that is being offered for consideration.

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Essentially, analysts will tend to look at two types of earnings for the denominator – backward-looking
and forward-looking. Forward-looking EPS requires forecasting, which can be unreliable and is often
based on a company’s own projections.

Trailing (P/E)
Also known as P/E trailing twelve months (ttm), or last twelve months (ltm), this is the backward-looking
version that has already been described in the formula. It can be updated between annual reports
using half-yearly or quarterly figures and it is customary in the analyst community to take for earnings
the net income of the company for the most recent 12-month period divided by the number of shares
outstanding. This is the most common meaning of P/E if no other qualifier is specified.

Forward P/E
This is also known as P/E or estimated P/E, and is based on estimation of net earnings over the next 12
months. Estimates are typically derived as the mean of a select group of analysts, the average of which
is often called the ‘consensus estimate’. In times of rapid economic dislocation, such estimates become
less relevant as the macroenvironment changes (eg, new economic data is published and/or the basis of
the analysts’ forecasts becomes obsolete) occur ahead of the analysts adjusting their forecasts.

Companies with losses (negative earnings) or no profit have an undefined P/E ratio (usually shown as
not applicable (N/A)).

Illustration
Continuing with the illustration from above of XYZ, if the ordinary shares are currently trading at €1.60
each, and there is a forecast EPS for the next fiscal year for XYZ of 17 cents per share, the P/E ratios for
the company will be as follows:

Historic P/E = 160 / 18 = 8.89 (this is based on the pre-diluted EPS of 18 cents)

Prospective P/E = 160 / 17 = 9.41 (this is based on the forecast EPS of 17 cents)

Uses of the P/E Ratio

By comparing price and EPS, one can analyse the market’s stock valuation of a company and its shares,
relative to the income the company is actually generating. Stocks with higher (and/or more certain)
forecast earnings growth will usually have a higher P/E, and those expected to have lower (and/or
riskier) earnings growth will, in most cases, have a lower P/E.

Investors can use the P/E ratio to compare the relative valuations of stocks. If one stock has a P/E twice
that of another stock, all things being equal, it is a less attractive investment. However, companies are
rarely equal and comparisons between industries, companies, and time periods can be misleading.

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 Accounting Analysis

P/E ratios are closely followed by the investment community and financial analysts. Indeed, the P/E
ratios of stock market indices or averages are often used to determine whether or not the overall market
is considered to be expensive, is priced in line with historical norms, or is cheap. For example, in the
US the S&P 500 Index has a mean historical P/E ratio, over the last 50 years, of approximately 18, but
has fluctuated rather considerably from that mean. When analysing the ratio it is customary to use the
last 12 months of earnings of the constituent stocks of the index, and this is referred to as the trailing
average.

Companies in different sectors of the economy will also tend to exhibit different P/E ratios. This will itself
be largely based upon the market’s expectations as to future earnings growth in different sectors. For
example, a relatively young technology company which has bright prospects will often be rewarded by
investors with a relatively high P/E ratio as the earnings are expected to grow dynamically. On the other
hand, a mature utility company which has fairly predictable future earnings potential will tend to have a
relatively lower P/E ratio based on more conservative growth estimations.

At times during the recession in the early 1980s, the trailing P/E ratio for the S&P Index reached below
eight and, in the early part of 2000 just prior to the collapse of the dot com stocks, the P/E ratio reached
above 40, measured on a trailing 12-month basis.

One factor which can influence the criterion used to assess whether the overall market is overpriced,
fairly priced or underpriced is the interest rate environment as well as the annual rate of inflation.

8
During periods when short-term interest rates are relatively low, and inflation is considered to be
benign, a larger P/E ratio is supportable as there is less competition for equities coming from the income
obtainable from fixed-income securities and vice versa. Another way to look at this is that low interest
rates will lower the discount factor for future cash flows, thereby increasing the net present value of an
investment in the firm.

Another useful application of the P/E ratio is to consider the relationship between it on an individual
company’s security and the P/E ratio of the stock market average or of the sector average. Some
investors will be attracted to companies with a low P/E ratio as it suggests that the company may be
undervalued.

6.5.4 Enterprise Value (EV) to Earnings Before Interest and Tax (EBIT)
This ratio consists of two other metrics – enterprise value (EV), and EBIT (earnings before interest and
tax).

EV is a measure of a company’s value and is often used as an alternative to straightforward market

capitalisation. A firm’s EV is calculated as its market capitalisation plus all of its outstanding debt,
minority interests and preferred shares, minus all of the cash and cash equivalents.

From a slightly different perspective, EV is the sum of the claims of all of a company’s security holders,
which includes all of the debt holders, preferred shareholders, minority shareholders, common equity
holders, and others. EV is one of the fundamental metrics used in business valuation, financial modelling,
accounting and portfolio analysis.

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A simplified and intuitive way to understand EV is to consider it as the cost of purchasing an entire
business. If you settle with all the security holders, you have essentially purchased the company at its EV.

EBIT is the same as profit before interest and tax (PBIT) and is another fairly widely used indicator of a
company’s financial performance, calculated as:

EBIT = Revenue less expenses (excluding tax and interest)

Comparison of EV/EBIT with P/E Ratio

Price earnings ratios provide a measure of the expensiveness, or cheapness, of a particular company’s
shares. As an alternative, EV multiples look at the whole company, incorporating both the equity and
the debt. Simplistically, the smaller the EV to EBIT, the cheaper the company is, which could highlight a
buying opportunity for investors.

6.5.5 Enterprise Value (EV) to Earnings Before Interest, Tax,

Depreciation and Amortisation (EBITDA)
This ratio, once again, is used as a measure of the relative expensiveness (or cheapness) of a business
and also uses the EV as the numerator in the ratio.

EBITDA is essentially income before interest and tax, but with depreciation, and amortisation
reversed and added back. It can be considered as a simplistic operating cash flow from the business,
as depreciation and amortisation do not involve the movement of cash. However, it must be clearly
understood that this is a non-GAAP measure. This means that companies can, and often do change the
items included in their EBITDA calculation from one reporting period to the next.

Care must be taken as EBITDA does not truly represent cash earnings: it leaves out the cash required to
fund working capital and the replacement of old equipment, which can be significant.

EBITDA = Revenue less expenses (excluding tax, interest, depreciation and amortisation)

6.5.6 Gross Dividend Yield

The gross dividend yield expresses the total dividends per share paid out over the last year as a
percentage of the current share price.

To calculate gross dividend yield, simply divide the dividend per share by the current share price and
multiply it by 100:

Dividend
Gross dividend yield = x 100
Current share price
For XYZ, let us assume that the board of directors decides to distribute €400,000 to shareholders in the
form of a dividend and retain the rest of net income on its statement of financial position. The dividend
per share will be €400,000 divided by five million shares = 8c.

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 Accounting Analysis

The gross dividend yield will be:

8
Gross dividend yield = x 100 = 5%
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A high yield may indicate that the share price is relatively low in comparison with the return it offers.
This suggests that the market does not have confidence that the dividends paid in the past will continue
to be paid in the future. Conversely, a low dividend yield indicates high market confidence in the
company’s ability to increase dividends.

6.5.7 Gross Dividend Cover

The dividend cover can be used to assess how well a company covered its dividend payout with the
profits it made. In other words, how easy was it for the company to pay these dividends?

Dividend cover compares the earnings of the company (net income in relation to the year’s activity)
with the dividends paid in the year. This also reveals the proportion of profits that were reinvested in the
company. If dividend cover was two times, then half of the profits are paid out to shareholders and half
are retained.

A dividend cover of less than one is known as an uncovered dividend, meaning the year’s profits were
not enough to cover the dividend.

8
To calculate the dividend cover for XYZ, take the company’s EPS and divide it by the dividends per share:

EPS
Dividend cover =
Dividends per share

Using the figures from above, the dividend cover for XYZ will be 18 / 8 = 2.25 times.

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 End of Chapter Questions

1. What is the alternative name for the financial accounts of a business?

Answer reference: Section 1.1

2. What is the basic description of a statement of financial position?

Answer reference: Section 2.1

3. What is meant by non-current assets?

Answer reference: Section 2.2.1

4. What is meant by intangible non-current assets?

Answer reference: Section 2.2.1

5. What is depreciation generally applied to?

Answer reference: Section 2.3

6. What are the two typical types of capital reserves and how do they arise?
Answer reference: Section 2.4

7. How does a minority interest arise?

Answer reference: Section 2.4

8. What is the purpose of an income statement?

Answer reference: Section 3.1

9. What is meant by operating profit?

Answer reference: Section 3.1.4

10. How is the dividend yield calculated?

Answer reference: Section 6.5.6

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Chapter Nine

Risk and Reward

1. Investment Management 261

2. Institutional Investment Advice 287

This syllabus area will provide approximately 11 of the 100 examination questions

9
260
 Risk and Reward

1. Investment Management

1.1 Risk and Reward

Learning Objective
9.1.1 Know the basics of risk and reward: assessment of returns; types of risk; quantifying risk

In general terms, when choosing between investments across the various asset classes, the returns
achieved will depend on a variety of factors, including how the economy in general performs, what
events are taking place in the geographical location of the investment (political, economic) and how the
sector of the economy in which the company operates behaves. The decisions which need to be made
with respect to investment management are very much concerned with a balancing (or, as it is sometimes
expressed, a trade-off) between the likely rewards and potential returns from the chosen investment
given the associated risks, and then considering the impact of those risks on the overall portfolio.

Let us consider the situation of a fund manager who is concerned about how the economy will behave
and is trying to put together an overall assessment of the expected returns (ERs) on a portfolio of
investments depending upon the future growth of the economy. In the illustration below, the economic
outlook is quite uncertain.

The table shows three different scenarios with their association probabilities and ERs. The first row of the

9
table considers that the economy will be in a recession with overall contraction. The fund manager gives
that a probability of 20% and a return for that scenario of negative 10% for the assets under consideration.
The second scenario is for a growth rate between just above zero up to 3% pa (based upon gross domestic
product (GDP) for example) and this is assumed to have a 50% probability with an associated annual
return of 8%. The most upbeat scenario is for growth above 3% and the fund manager’s assessment is that
there is a 30% probability of this and an appealing 15% return for this scenario.

Future Growth Probability (P) Scenario Probability Scenario Probability

of Economy Return (SR) x Scenario Variance (SV) x Scenario
Return (SR–ER)2 Variance
(P x SR) (P x SV)

Contraction <
20% –10.0% –2.0% 0.027225 0.005445
0%

> 0% Growth
50% 8.0% 4.0% 0.000225 0.0001125
< 3%

Growth > 3% 30% 15.0% 4.5% 0.007225 0.0021675

Expected
100% 6.5% σ2 0.77%
Return (ER)

Standard
σ 8.79%
Deviation √σ2

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The overall ER from these scenarios is calculated by taking the probability of each and multiplying that
by the scenario return (SR) and summing the results. Under the conditions in the table, the expected
return is 6.5%.

The manner in which the risks are associated with the different scenarios can be determined by
calculating the variance. The variance measures the extent to which returns ‘vary’ from the average (or
expected) return. As can be seen from the right-hand column of the table, the total of each variance can
be calculated and, from this, we can derive the standard deviation. The standard deviation is the square
root of variance, and is used as a statistical measure of risk that depicts the likely variation from ER levels.

In essence, the cornerstones of investment theory require calculations similar to the above in many
instances. First, what is the expected return? Often based upon a probability study, and, just as
important, what is the notion of the risk associated with achieving that return? From the point of view
of investment management, the risk reflects the variability or deviation of the likely returns from the ER
and reflects the uncertainty of the likely outcomes.

1.1.1 Types of Risk

Risk arises from the uncertainty of outcomes. Each time an investor decides to purchase a security or
invest in an opportunity, the outcome is uncertain in the same way that any future event is. The investor
may incur a loss if the opportunity has been miscalculated, if an unforeseen impact arises, or they may
not realise, fully or even partially, the ER.

At the macro level, investors may be concerned about the risks of market crashes, terrorist incidents
that cause markets to plunge and other critical events. At the micro level, investors are concerned
with internal or external events that may impact the company (or the creditworthiness/solvency of the
company) invested in. All of these contribute to the potential for profit from investment and speculation
and the accompanying uneasiness felt about the possibility of losses or adverse consequences from
investment or speculative activities. This is the general notion of risk.

There are a number of types of risk faced by investors that are difficult to avoid, and the main categories
can be identified in overview under the following headings.

Market or Systematic Risk

This is the risk that the overall market in general, or the relevant part of the capital markets for investors
wanting exposure to specific sectors, will rise or fall, as economic conditions and other market factors
change. This may affect returns over a period of time, or it may have a more immediate impact if an
investor buys at the top of the market or sells at the bottom. Because all securities are part of some
broad asset class and this grouping is often the primary driver of returns, this type of risk is difficult to
avoid.

Inflation Risk
Inflation will erode returns or purchasing power and even if the investor has taken account of inflation
in their analysis the actual and expected inflation may be different from that assumed in calculating ERs.

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 Risk and Reward

Interest Rate Risk

Changes in interest rates will affect prices; this is possibly a sub-category of market risk. The amount of
the change in price is related to the term to maturity and the coupon rate; therefore, those investments
with longer terms to maturity and lower coupon rates are more susceptible to interest rate risk. There
may be some overlap between different types of risks, for example, higher inflation tends to push
interest rates higher.

Reinvestment Risk
Changes in interest rates can also impact investments in reinvestment. Reinvestment risk is the risk that
an investor cannot invest maturing assets at the same rate as originally obtained. If interest rates fall
during the term of an investment, matured assets will have to be invested at a lower rate.

Exchange Rate Risk

Any investor who purchases securities which are denominated in a foreign currency may suffer (or
benefit) from changes in the exchange rates between the home or base currency or the other currency.
In addition, it is important to consider the risk that an investor’s base or home currency may fall against
other currencies, thereby diminishing the purchasing power for global assets.

Political and Legal Risk

In addition to currencies changing, the political or legal landscape of an overseas country can impact
investments made abroad. These could include regulatory or tax changes, or actions taken by the
local central bank, that could significantly affect the value, marketability or after-tax return on certain

9
investments.

Default Risk
An investor may find that a company from which they have purchased a security could become
insolvent due to a harsh operating environment, high levels of borrowing, poor management and other
financial miscalculations. Fixed-income investors, who purchase the bonds of companies, have some
access to alerts of possible credit defaults through the credit ratings agencies, such as Standard & Poor’s
(S&P), Moody’s and Fitch Ratings.

Liquidity Risk
The risk that an investor will not be able to obtain the price they want for a security when buying or
selling due to limited quantity or trading activity. Generally, the larger capital markets, such as those of
New York, London and Tokyo, among others, provide sufficient liquidity for investors to sell a security
easily with a narrow spread between the ask and the bid prices. During stressful periods, however, this
liquidity can diminish and it can become much harder to sell a security readily. Liquidity risk is also
significant in smaller and more illiquid markets, where it may take weeks to exit a large investment
holding and it may be difficult to achieve market price.

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1.1.2 Quantifying Risk
How can we quantify the risk and expected return of any investment?

In order to assess the risk and expected returns from particular opportunities, an investor needs
to conduct an analysis of the forecasts for the economy and the forecasts for particular companies
and/or sectors and undertake a risk analysis of the possible outcomes, and their likelihood, which could
adversely affect these forecasts.

This can be summarised as both forward- and backward-looking:

• Forward-looking forecasts and probabilities assess the likelihood of each possible state of the
world occurring and estimate the returns and values arising given that particular outcome.
• Backward-looking analyses tend to study historically observed returns and associated frequencies
on the assumption that this past data will be representative of the future.

In both cases, assessing the likelihood or probability of certain outcomes becomes the central task and
it is necessary to consider the probability of returns and their associated risks from a broad perspective.
Risk and reward are important aspects of investment decisions. Risk and potential reward are generally
positively correlated: investments with a higher potential return generally carry a higher risk of loss.
High-risk investments generally have potential for a higher reward, plus a greater possibility of loss.
Low-risk investments generally have a lower reward, with a lower possibility of loss.

1.2 Equities

Learning Objective
9.1.2 Understand the risk and reward of investment in equities: risk profile; effect of long-term
investment; can offer income and capital appreciation; purpose and use of dividends

Equities are shares in companies that give the investor an ownership stake in the company, alongside
the attraction of limited liability. If the issuing company collapses, the shareholders’ loss is simply the
amount paid for the shares. As a part-owner of the company, the investor has the opportunity to share
in the company’s profits and vote at general meetings. Indeed, most investors are attracted to equities
in the hope that the value of the shares increases (capital appreciation), and this may be combined with
income in the form of regular, and perhaps increasing, dividends.

Risk Profile for Equities

Equity investments are generally considered to be risky, relative to other investments, such as bonds
and money market instruments. Medium levels of risk are attached to larger, well-established company
shares, and high levels of risk attached to smaller company shares and start-up company shares.
However, equity investments offer the potential to deliver high returns if held long term.

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 Risk and Reward

Equity Risk Premium

For equity investors there is an equity risk premium, which effectively is a higher rate of return that
is required to entice investors to take on the risk of owning shares or equity, as opposed to holding a
more secure asset such as a bond. If one is seeking the most secure form of investment this will usually
be available in the form of a government bond or short-term instrument. The risk-free rate is the rate
on government bonds and short-term debts, because of the low chance that the government will
default on its loans. An investment in stocks or equities has far more risk associated with it, as it is a non-
secured asset and companies can suffer from adverse business conditions or go bankrupt, in which case
shareholders often receive no residual value.

As an example, if the total return on a stock is 10% over a given period and the risk-free rate over the
same period is 4%, the equity-risk premium is 6%.

1.3 Money Market Instruments

Learning Objective
9.1.3 Understand the risk and reward of investment in money market instruments: risk profile; use as
short-term investment

For investment horizons that are very short (eg, the next six months rather than the next 20 years), there
is the potential for investors to keep their funds in cash and place them on interest-earning deposit, or

9
to invest in short-term money market instruments, like Treasury bills (T-bills). These investments are
low-risk, relatively secure and deliver income, but provide little scope for capital growth. For investors
that do not want their money tied up for long periods, however, the predictable value and liquidity of
these short-term investments is important.

Prices of money market instruments fluctuate and can, in moments of financial crisis, become quite
erratic. Many investors will want to hold the shortest-term instruments from the most secure issuers,
such as T-bills, during periods when the money markets are not functioning normally. During the
financial crisis, which became especially acute in September and October of 2008, many institutions
wanted to replace all of their other money market holdings with the shortest-duration T-bills. This can
have the perverse consequence, on extreme occasions, of making such instruments, which are priced
on a discount basis, yield a negative return or at a rate which is far below that which would normally
be expected. The desire to move into such short-term paper during moments of crisis is referred to as a
flight to safety.

While some institutional investors, such as pension funds, seek out longer-dated maturities in fixed-
income markets, there are many that prefer shorter- and medium-term assets. There is often a trade-off
and calculation to be made between the value of a long-term income stream from such instruments
versus the greater volatility in the prevailing prices of longer-dated paper.

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1.4 Debt Instruments

Learning Objective
9.1.4 Understand the risk/reward of investments in debt (fixed-interest, floating-rate and index-
linked): compared to equities; effect of holding to maturity; can combine low risk and certain
return; can provide a fixed income; inflation risk; interest rate risk; default risk

Bonds are generally described as ‘fixed interest’ or ‘fixed income’, meaning there is a contractually fixed
rate of return to the investor. In most instances, this contractually fixed rate is also a fixed percentage
(such as 5%), but in other (less common) instances, it is fixed by reference to a published interest rate
(such as LIBOR plus 0.5%). The latter is said to have a ‘floating’ rate of coupon because the LIBOR rate can,
and does, vary over time. Bonds are predominantly issued by companies, governments, government
agencies, state-owned enterprises, and supranationals, such as the World Bank, the Asian Infrastructure
Investment Bank (AIIB) and the African Development Bank (AfDB).

Their attractiveness to investors is driven by the fixed income that they offer from regular, pre-
determined coupons, combined with the relative certainty of the principal amount to be repaid at
redemption.

As mentioned above, the coupons can be fixed (at a percentage of nominal value), they can float
depending upon a published interest rate. Traditionally, the rates used have been the London Interbank
Offered Rates (LIBORs), however, after scandals involving attempted manipulation of LIBOR, it is
gradually being replaced. For example, in the US, the alternative proposed is the Secured Overnight
Finance Rate (SOFR). SOFR is based on the cost of borrowing cash overnight, collateralised by US
Treasury securities. In the UK, the Sterling Overnight Index Average (Sonia) has been proposed as the
primary interest rate benchmark in sterling markets. Sonia is based on actual transactions and represents
the average interest rate that banks pay to borrow sterling overnight from other financial institutions.

Coupons can also can be tied to inflation by being index-linked (eg, to the consumer prices index (CPI)).
The principal amount paid at maturity is generally the par or nominal value, although with index-linked
bonds it will be uplifted for inflation. Bonds are generally less risky than equities, but offer less potential
for substantial returns. Indeed, for highly rated bonds, where the risk of default is low, investors can
be virtually certain of the yield that their investment will deliver, as long as they hold their bonds to
maturity. If the bonds are sold before they reach maturity, however, there is a danger that their market
value may be below their nominal value, bringing about a capital loss and the potential to impact the
investor’s yield adversely.

As explained, interest rate risk is the risk that an interest rate movement brings about an adverse
movement in the value of an investment. It is particularly acute when the investment is a fixed-interest
bond and the interest rate rises. Because of the inverse relationship between bonds and interest rates,
the value of the bond will fall. Interest rate risk is largely removed if the bond is floating-rate, since the
coupon will be reset in line with the higher market interest rate.

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 Risk and Reward

Inflation risk arises when inflation is more substantial than the investor expected, and the value of
the investments held may fall. Generally, bonds will suffer because the fixed cash payments that they
deliver are less valuable. Floating-rate bonds will suffer less because the higher inflation will bring about
a higher interest rate, but the real value of the principal at redemption will fall. Inflation-protected
securities will not suffer. The coupon and the principal are linked to a measure of inflation (eg, increases
in the CPI) so the investor will not lose out.

In contrast to debt instruments, equities and property cope reasonably well with unexpected inflation.
Companies are able to increase their prices and deliver larger dividends, and the property market as a
whole tends to reflect the inflationary increases.

Investors in bonds face default risk. This is the risk of the issuer defaulting on their payment obligations.
The probability of default (often referred to as credit risk) is measured by various independent credit
rating agencies, mainly S&P, Moody’s and Fitch Ratings. These rating agencies divide issuers into
two distinct classes: investment grade (alternatively referred to as prime) and sub-investment grade
(alternatively referred to as speculative, non-prime or junk).

The largest three international rating agencies apply similar criteria to assess whether the issuer will
be able to service the required payments on the debt. The bonds are then categorised according to
their reliability, payment history and current financial situation. Triple A is the best and the next best is
double A (although the rating agencies can have lesser notches such as pluses and minuses).

Very few organisations, except a very select group of companies, some western governments and
supranational agencies, have triple A ratings, but most large companies boast an investment grade

9
rating. An investment grade rating is one that is at least BBB (from S&P or Fitch Ratings), or at least Baa
from Moody’s. Issues of bonds categorised as sub-investment grade are alternatively known as junk
bonds because of the high levels of credit risk.

Governments may have different ratings for local currency debt and for debt in international currencies.
Their ratings may be better in a local currency as they can print more of the local currency, if needed, to
repay the debt.

In emerging and frontier markets including in Africa, investors in corporate and other local bonds may
look for ratings by local or specialist credit rating agencies.

If the rating agencies downgrade the issuer of a bond, potential investors will look to compensate for the
increased risk by demanding a greater yield on the issuer’s bonds. This will inevitably result in a lower
price for the bond. Some issuers of bonds utilise credit enhancements to enable their bonds to be rated
more highly by the credit rating agencies. Examples of credit enhancements are bonds guaranteed by
another group company, or bonds with a fixed charge over particular assets. Some African corporate,
infrastructure and other bonds also get credit enhancement in the form of an international or other
leading bank or agency which guarantees some or all of the repayments on the bonds. Investors may
also be offered insurance against specific risks, such as political risk (see below), by a specialised insurer.

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1.5 Overseas Equities and Bonds

Learning Objective
9.1.5 Understand risk profile of investment in overseas shares and debt: country risk; exchange rate
risk

To lessen the risk that a particular company, or issuer of a bond, delivers poor returns due to problems
in the domestic economy, investors can invest in overseas companies’ equities, or overseas bond issues.
Like domestic equities and bonds, these overseas investments may offer the possibilities of income and
capital appreciation.

However, the investor may be less knowledgeable about the overseas company/issuer and there may be
particular idiosyncrasies in some overseas markets; for example, local custodians may not be required to
give the holder access to corporate actions.

Currency (or Exchange Rate) Risk

These overseas investments are also higher-risk than their domestic equivalents because of the
additional risk that is created by the possibility of exchange rates moving against the investor.
Depending on the direction of the move in exchange rates, the investor could lose (or gain) more
than just the value of change in price in the home currency. While this is most prevalent in overseas
investments, it can also be problematic if the investment is in a company that is based in the home
market but that has substantial overseas business interests.

Political or Legal Risk

Investments abroad are also exposed to any changes to the political or legal landscape where they are
made – such changes could affect the economy where investments are made or could be particular
to overseas investors. For example, a government could prevent pension funds from holding certain
classes of securities, apply or alter withholding tax rates on interest paid to foreign investors or change
tax exempt status to taxable status. All of these events would impact the returns (and, therefore, add
risk) to investors abroad. Imposition of capital controls, a situation where a government restricts flows
of foreign currency into and out of the country, overlaps with both foreign exchange and political risk.

1.6 Types of Investment Risk

Learning Objective
9.1.6 Understand the risks facing the investor: specific/unsystematic; market/systematic; interest
rate risk; inflation risk

Risk can be categorised in a number of different ways, but the overriding rule for investment is that the
potential for spectacular return can only arise if the investor takes a large amount of risk: the risk-return
relationship.

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 Risk and Reward

Market (or Systematic) Risk

This is the risk that the whole market moves in a particular direction. It is typically applied to equities and
brought about by economic and political factors. It cannot be diversified away. For example, political
crises or general recessions will tend to bring about falls in the market value of all shares, although they
may affect different company shares to different degrees. Market risk can also be affected by events in
other apparently unrelated markets, for instance if international investors decide the time is right to
move funds from emerging stock markets into the most developed markets, such as the US and UK.

Specific (or Unsystematic) Risk

This is the risk that something adverse impacts the value of a particular investment, but the adverse
impact is not market-wide. An obvious example is a company’s management making some sort of
error – perhaps producing a defective product with resultant impact on profits and customer goodwill.
Specific risk can be diversified away by holding many investments.

Interest Rate Risk

As seen earlier in this chapter, changes in interest rates will affect prices, and interest rate risk is in
essence a sub category of market risk.

Inflation Risk
Inflation risk is possibly another sub category of market risk. Inflation will erode returns and, even if
the investor has taken account of inflation in their analysis, the actual and expected inflation may be
different from that assumed in calculating expected returns.

9
1.7 Correlation and Diversification

Learning Objective
9.1.7 Understand how to optimise the risk/reward relationship through the use of: correlation;
diversification; use of different asset classes

Investors generally choose to avoid unnecessary risk in their portfolios by holding appropriate
proportions of each class of investment. The more conservative investor will hold a greater proportion
of low-risk bonds and money market instruments. These lower-risk investments are likely to give rise
to lower, but more predictable, returns. The more adventurous investor will hold a greater proportion
of medium- and high-risk equity investments, because higher risk means greater potential for higher
returns. Essentially, the choice of investments is driven by the investor’s attitude to risk and the fact that
there is a trade-off between risk and return.

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However, diversification can remove some of the market risk without having to remove all high-risk
investments from a portfolio. This is done by combining securities that are not perfectly positively
correlated into a portfolio, which will remove some of the unsystematic risk in that portfolio.
Unsystematic risk affects certain sectors of the market, but not the market as a whole. So, by reducing
the concentration in certain sectors (with diversification), the portfolio risk will be reduced with the
addition of additional uncorrelated securities.

Risk

Market Risk

5 10 15 20
Number of Different Companies

For example, an investor’s portfolio might contain high-risk equity investments but as the portfolio
diversifies, ie, as the investor includes a wider range of companies’ shares, risk diminishes, because
unexpected losses made on one investment are offset by unexpected gains on another.

1.7.1 Correlation
From an investment perspective the statistical notion of correlation is fundamental to portfolio theory.
The very simplest idea is that, if one is seeking diversification in the holdings of a portfolio, one would
like to have, say, two assets where there is a low degree of association between the movements in price
and returns of each asset. The degree of association can also be expressed in terms of the extent to
which directional changes in each asset’s returns, or their co-movement, are related.

If assets A and B have a tendency to react to the same kinds of business conditions in a very simple and
predictable manner they could be said to be strongly correlated. Let us assume that a certain kind of
regular release of economic data (for example the monthly CPI data) is announced and company A’s
shares move up by 3% and company B’s shares move up by 2.5% when the data is below expectations,
and that the inverse pattern of price movement is seen when the data is above expectations. In such a
case there is a strong correlation between the movements (or changes) in the performance returns of A
and B and this is expressed as strong positive correlation.

1.7.2 Diversification
Diversification benefits are maximised by holding investments with uncorrelated returns (when the
returns do not tend to move in the same direction and to the same degree). It is not necessary for the
investments to be wholly negatively correlated, as combinations of investments that are positively
correlated do still provide diversification benefits. It is only a combination of investments that are
perfectly positively correlated that will offer no diversification benefits.

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However, diversification cannot remove all of the risk. There are certain things, such as economic
news, that tend to impact the whole market. The risk that can be removed is known as the specific or
unsystematic risk, and the risk that cannot be diversified away is the market or systematic risk.

Diversification by Asset Class

This is achieved by holding a combination of different kinds of asset within a portfolio, possibly spread
across cash, fixed-interest securities, equity investments, property-based investments, and other assets.

Cash can be useful as an emergency fund or for instantly accessible money. At times when the future for
interest rates is uncertain, it may be wise to hold some cash in variable-rate deposits, in the hope of a
rate rise, and some in fixed-rate deposits as a hedge against a possible fall in the rate.

Fixed-interest securities, such as government bonds, give a secure income and known redemption
value at a fixed future date.

Equities can be used to produce a potentially increasing dividend income and capital growth. For
example, a share yielding 3% income plus capital growth of 6% gives an overall return of 9% compared
with a bank deposit account yielding, say, 4%.

Collective investments, such as mutual funds, spread the risk still further. In this case, the client is
participating in a pool of investments. The client may choose a fund investing in a number of different
economies, thereby reducing risk still further. Pooled investments may be a sensible method of
obtaining exposure to some of the lesser understood world markets where there is a high risk in holding
just one company’s shares. The use of property, whether residential or commercial and other types of

9
assets such as antiques, coins or stamps might help to spread risk further.

Diversification by Maturity
Fixed-income securities can be diversified by maturity date. This strategy is known as ‘laddering’. As
discussed, reinvestment risk is related to the fact that the prevailing interest rate may have changed at
the maturity date of various fixed-income instruments. Therefore, spreading maturities across a period
of time will potentially reduce risk (reinvestment risk) for a fixed-income portfolio.

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1.8 Active and Passive Investment Management
Methodologies

Learning Objective
9.1.8 Understand active investment management methodologies and strategies, and their
advantages and disadvantages

1.8.1 Active Management

Active management (also called ‘active investing’) refers to a method of portfolio management where
the manager’s strategy is designed to outperform the returns available from an investment benchmark
index. For example, an active portfolio manager focused on investing in large-cap UK equities will be
seeking to realise returns superior to those available from a simple method/strategy of buying and
holding all of the constituents of the FTSE 100.

It is worth pointing out that purchasing a simple derivative, such as a FTSE 100 futures contract, will not
reflect the total returns available to an investor in the actual index, as it will only capture changes in the
price level of the index and not the dividend income. More complex derivative products can emulate the
total returns without requiring an outright purchase of all 100 stocks in the index.

Active portfolio managers can use various strategies to construct their portfolios with a view to superior
performance than that available from index tracking. For example, the manager could focus on selecting
securities based on research and quantitative analysis focused on measures such as P/E ratios and price
earnings growth (PEG) ratios, sector investments that attempt to anticipate long-term macro-economic
trends (such as a focus on energy or technology stocks), and purchasing stocks of companies that are
temporarily out of favour or selling at a discount to their intrinsic value. Certain actively managed funds
will also pursue more specialised strategies, such as merger arbitrage, option writing, and forms of
statistical arbitrage, involving more exotic securities, such as derivatives and convertible securities.

The effectiveness of an actively managed investment portfolio will clearly depend on the skill (or
good fortune) of the manager and research staff. In reality, the majority of actively managed funds
rarely outperform their index counterparts over an extended period of time, assuming that they are
benchmarked correctly. For example, research covering managed active funds established in the US
(mostly retail US equity and global equity in the form of Standard & Poor’s Index Versus Active (SPIVA)
scorecards), demonstrates that only a minority of actively managed mutual funds have gains better
than the S&P Index benchmark. As the time period for comparison increases, the percentage of actively
managed funds whose gains exceed the S&P benchmark declines further.

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1.8.2 Advantages of Active Management

The primary attraction of active management is that it allows selection of a variety of investments
instead of investing in the market as a whole. Investors may have a number of reasons for not wanting
to simply track an index. They may, for example, be sceptical of the efficient market hypothesis (EMH), or
believe that some market segments are less efficient than others. They may also want to reduce volatility
by investing in less risky, high-quality companies, rather than in the market as a whole, even at the cost
of slightly lower returns. Conversely, some investors may want to take on additional risk in exchange for
the opportunity of obtaining higher-than-market returns. Investments that are not highly correlated to
the market are useful as a portfolio diversifier and may reduce overall portfolio volatility.

Some investors may also wish to follow a strategy that avoids or underweights certain industries
compared to the market as a whole, for instance, an employee of a high-technology growth company
who receives company stock or stock options as a benefit might prefer not to have additional funds
invested in the same industry.

1.8.3 Disadvantages of Active Management

The most obvious disadvantage of active management is that the fund manager may make bad
investment choices or follow an unsound theory in managing the portfolio. The fees associated with
active management are also higher than those associated with passive management, even if frequent
trading is not undertaken. Those who are considering investing in an actively managed fund should
evaluate the fund’s prospectus carefully.

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Active fund management strategies that involve frequent trading generate higher transaction costs
which diminish the fund’s return. In addition, the short-term capital gains resulting from frequent trades
often have an unfavourable income tax impact when such funds are held in a taxable account.

More specialised tracker funds can also be linked to the performance of securities in emerging markets,
specific industry sectors and ‘smart beta’. Increasingly the proliferation of exchange-traded funds
(ETFs), allows investors to purchase shares in a fund which trades actively on a major exchange and
which provides exposure to certain kinds of securities and where the minimal management fees are
incorporated into the actual price of the shares of the ETF. The benefits to an investor purchasing such
ETFs is that there is usually a high degree of liquidity, the asset values of the fund constituents as well
as the price of the ETF shares are updated on a real-time basis, and the costs for the packaging of the
securities are minimal.

When the assortment of assets of an actively managed fund becomes too large, it inevitably begins to
take on index-like characteristics as it must invest in an increasingly broad selection of securities which
will tend to perform exactly in line with the overall market. In such a situation, the fund becomes a
pseudo-tracker, and an investor in the fund is paying active management fees when the actual style is
effectively passive. This last factor is why some fund managers close their funds to new investors after
the fund reaches a certain size, so that they can avoid having to be so broadly diversified as to deviate
from their original selection criteria underlying their active strategic focus.

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1.8.4 Active Management with Manager Participation
One meaning sometimes given to active management is when the managers/directors have a vested
interest in the success of the fund. Many funds do not have either the manager or directors with an
equity stake in the fund that the manager is running. In contrast, private equity funds and hedge funds
often provide real active management. In private equity, this is because there are usually only a small
number of shareholders in the privately owned companies, and a significant stakeholder like the private
equity fund will contribute to the strategic decisions. In hedge funds, it is usual to see and expect the
managers to include their own money in the fund.

The advantage to an investor in a fund where the management is personally at risk by holding a stake in
the fund under management is that the manager’s interests will be aligned with those of the investors.
The manager has what is known as ‘skin in the game’.

1.8.5 Active Bond Strategies

Generally speaking, active strategies are used by those portfolio managers who believe the bond market
is not perfectly efficient and therefore is subject to mispricing. If a bond is considered mispriced, then
active management strategies can be employed to capitalise upon this perceived pricing anomaly.

Bond switching, or bond swapping, is used by those portfolio managers who believe they can
outperform a buy-and-hold passive policy, by actively exchanging bonds perceived to be overpriced for
those perceived to be underpriced. The success of this approach partly depends on whether the target
bonds and other bonds are actively traded in the secondary market and whether they are accurately
priced.

Bond switching takes three forms:

• Anomaly switching – this involves moving between two bonds similar in all respects apart from the
yield and price on which each trades. This pricing anomaly is exploited by switching away from the
more to the less highly priced bond.
• Policy switching – when an interest rate cut is expected but not implied by the yield curve, shorter-
dated, low-duration bonds are sold in favour of longer-dated, high-duration bonds. By pre-empting
the rate cut, the holder can subsequently benefit from the greater price volatility of the latter bonds.
• Inter-market spread switch – when it is believed that the difference in the yield being offered
between corporate bonds and comparable government bonds, for example, is excessive given
the perceived risk differential between these two markets, an inter-market spread switch will be
undertaken from the gilt to the corporate bond market. Conversely, if an event that lowers the risk
appetite of bond investors is expected to result in a flight to quality, government bonds will be
purchased in favour of corporate bonds.

Active management policies are also employed if it is believed the market’s view on future interest rate
movements, implied by the yield curve, are incorrect or have failed to be anticipated. This is known as
‘market timing’.

Riding the yield curve is an active bond strategy that does not involve seeking out price anomalies, but
instead takes advantage of an upward-sloping yield curve.

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Example
If a portfolio manager has a two-year investment horizon then a bond with a two-year maturity could
be purchased and held until redemption. Alternatively, if the yield curve is upward-sloping and the
manager expects it to remain upward-sloping without any intervening or anticipated interest rate rises
over the next two years, a five-year bond could be purchased, and sold two years later when the bond
has a remaining life of three years.

As long as the yield curve remains static over this period, the manager could generate a better return
than would have been generated by purchasing a two-year maturity bond.

1.9 Passive Management

Learning Objective
9.1.9 Understand passive investment management methodologies and strategies and their
advantages and disadvantages

Passive managers are those that do not aspire to create a return in excess of a benchmark index. They
often follow exactly the course just outlined and invest in an index fund or derivative that replicates as
closely as possible the investment weighting and returns of a selected benchmark index, such as the
FTSE 100 in the UK market or, if they seek to match the returns of the US market, they may invest in

9
an instrument which exactly tracks the total returns of the S&P 500 Index. Investments which track a
specific index are also available for many emerging markets, including South Africa, Egypt and Nigeria
in Africa; India, China, Indonesia, Philippines, Sri Lanka and Vietnam in Asia; and Mexico, Brazil, Peru and
Chile in Latin America.

1.9.1 Advantages of Passive Management

To a large extent, the advantages and disadvantages of a passive approach to portfolio management
will tend to be the converse of the respective positions with respect to active management that have
just been covered.

Indeed, the most frequently cited advantage of a passive approach to asset management is that the
performance of the fund is not dependent on the manager’s ability to make investment choices which,
it is contended by the active manager, will outperform the broad market, but which in fact may well
prove not to be the case and will lead to a less rewarding performance than simply investing in a tracker
fund.

Subscribers to the EMH will tend to favour the use of index trackers if they are seeking out a risk/reward
ratio which is in accordance with the overall performance of the market. By investing in a fund which
tracks a broad benchmark, such as the S&P 500 Index or FTSE 100 Index, the investor is only exposed to
the systematic risk within the market and can avoid the risks (and potential rewards) of non-systematic
risk.

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Several research studies have provided evidence that the majority of actively managed large- and mid-
cap stock funds in the US have failed to outperform their passive index counterparts.

Investors in a passively managed fund can also avoid incurring the fees associated with active
management. A passive fund management strategy can avoid the frequent trading which is more likely
under an active management approach, and transaction costs will be lower which, relatively speaking,
will enhance the fund’s return. Also, a strategy of buy-and-hold, which is typically the outcome of a
passive strategy, is far less likely to incur frequent short-term capital gains resulting from the greater
focus on short-term trading activities of active management, and to that extent will also be able to avoid
the unfavourable income tax impact when such funds are held in a taxable account.

Another significant advantage of a passive management style is the fact that the total expense ratio
will be considerably lower than for many actively managed funds, such as hedge funds which operate
with fees charged for funds under management and also incentive fees. With regard to unit trusts and
mutual funds, it is also the case that index tracker funds will have lower expense ratios and, somewhat
ironically, they may not differ significantly in their performance and fund composition from the actively
managed funds. As mentioned, this can arise when the asset composition of an actively managed fund
becomes so large that it begins to take on index-like characteristics. In such cases, the actively managed
fund, while it may not have set out with the intention, becomes, in effect, a closet index tracker.

Passive management has recently become more appealing to a broad range of investors because
innovative investment products, introduced in recent years, now allow investors to invest in sector
trackers and so-called smart beta ETFs (further considered below). For example, specialised ETFs can
be linked to the performance of securities in emerging markets and specific industry sectors or use
alternative index construction methods taking in factors other than market capitalisation, such as
equal weighting, cash flow and profitability. Increasingly, the proliferation of ETFs allows investors to
purchase shares in a fund which trades regularly on a major exchange and which provides exposure to
certain kinds of securities with minimal management fees.

1.9.2 Disadvantages of Passive Management

Disadvantages of passive management include the fact that performance is always dictated by a
benchmark or index, meaning that investors must be satisfied with the index returns. In addition, the
inherent lack of control dictated by being passive prevents defensive measures if it appears that a
certain class of asset prices, specifically equities, may be heading for turbulent trading conditions and
possible capital losses.

The investor in a passively managed fund should only expect to realise similar returns to those that
are available from the index upon which the passively managed fund is based. So, while the investor’s
returns will be acceptable from a relative perspective, ie, they will be highly correlated with the market
return, they may still be unacceptable from an absolute perspective in the sense that losses will arise if
the market sustains losses.

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The main disadvantage of passive management is that it lacks the potential to generate alpha, eg,
excess or above-market returns. The investor in a passively managed fund forgoes the opportunity to
have exposure to a variety of investments which could outperform a broad benchmark index and which
may have other desirable attributes providing diversification and lower correlation elements than
simply investing in the market as a whole.

Investors may have a variety of reasons for not wanting to simply track an index. Those opposed to
passive management may have serious reservations regarding the validity of the EMH and believe that
some market segments are more efficient in creating profits than others. They may also want to reduce
volatility by investing in less risky, high-quality companies rather than in the market as a whole, even
at the cost of slightly lower returns. Conversely, some investors may want to take on additional risk
in exchange for the opportunity of obtaining higher-than-market returns, and such investors will be
willing to seek out higher beta stocks (by definition a broad benchmark-based portfolio should have a
beta of approximately one) in exchange for the possibility of above-average potential gains (and losses).
Investments that are not highly correlated to the market, eg, certain commodities such as gold, are
useful as a portfolio diversifier and may reduce overall portfolio volatility.

Some investors may also wish to follow a strategy that avoids or underweights certain industries
compared to the market as a whole, as part of a deliberate diversification strategy. For example,
someone employed in the financial services profession whose own compensation is closely tied to
company stock or the stock options of their employer may prefer not to have any additional funds
invested in the same sector.

Investors in many African and Asian markets may not have options to track the market indices,
particularly countries where creation of securities exchanges is a recent development or the markets

9
are too illiquid to attract index providers. Such examples include Francophone West Africa (BRVM
exchange) and Rwanda, or Myanmar and Bangladesh in Asia. Such markets still tend to be dominated
by direct, private investing (such as private equity). In addition, a fund manager may not be willing to
invest in some shares that are not often traded as they may not be able to sell their holdings quickly
or for the market price. As a result, active investment is the usual strategy, particularly for institutional
investors into the smaller emerging or pre-emerging (frontier) markets.

1.9.3 Smart Beta

Beta is a measure of the sensitivity of an investment’s movements in relation to the overall market. The
market has a beta of precisely one, and an index that tracks the market exactly would also have a beta
of one. A security with a beta greater than one would be more volatile (risky) than the overall market,
and a beta with less than one would be less volatile (risky). However, tracking a market capitalisation-
weighted index has the inherent disadvantage of going overweight in those stocks that are overvalued,
and underweight in those stocks that are undervalued. Smart beta is a potential solution to this.

Smart beta is the term for an investment strategy that does not use the traditional market capitalisation
weighting system, but instead uses alternative weighting systems, for example weighting constituents
equally, or based on dividends paid, sales revenues or cash flow generation. Smart beta can be thought
of as taking the key advantage of active investment management by introducing the possibility of
outperformance, and combining it with the key advantages of passive index tracking by creating a well-
diversified portfolio at a lower cost than active management.

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Two similar concepts to smart beta which have become increasingly popular in the ETF space are hedge
fund replication strategies and factor investing. Such funds mimic either particular hedge fund strategies
(eg, long-short equities) or gain exposure to cheaper (value), smaller (small-cap) companies via a
systematic or rules-based approach. These funds essentially attempt to provide the outperformance of
active management with lower fees and greater transparency.

1.9.4 Passive Bond Strategies

Passive bond strategies are employed either when the market is believed to be efficient, in which case a
buy-and-hold strategy is used, or when a bond portfolio is constructed around meeting a future liability
fixed in nominal terms.

Immunisation is a passive management technique employed by those bond portfolio managers with a
known future liability to meet. An immunised bond portfolio is one that is insulated from the effect of
future interest rate changes.

Immunisation can be performed by using either of the following techniques.

• Cash matching involves constructing a bond portfolio whose coupon and redemption payment
cash flows are synchronised to match those of the liabilities to be met.
• Duration-based immunisation involves constructing a bond portfolio with the same initial value
as the present value of the liability it is designed to meet and the same duration as this liability. A
portfolio that contains bonds that are closely aligned in this way is known as a bullet portfolio.

Alternatively, a barbell strategy can be adopted. If a bullet portfolio holds bonds with durations as
close as possible to ten years to match a liability with ten-year duration, a barbell strategy may be to
hold bonds with a durations of five and 15 years. Barbell portfolios necessarily require more frequent
rebalancing than bullet portfolios.

Finally, a ladder portfolio is one constructed around equal amounts invested in bonds with different
durations. So, for a liability with a ten-year duration, an appropriate ladder strategy may be to hold equal
amounts in bonds with a one-year duration, two-year duration and so on right through to 20 years.

1.9.5 Management Strategy and the Efficient Markets Hypothesis (EMH)

The efficient markets hypothesis (EMH) is an investment theory stating that it is impossible to beat the
market because stock market efficiency causes existing share prices to always incorporate and reflect all
relevant information. According to the EMH, this means that stocks always trade at their fair value on
stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks
for inflated prices. As such, it should be impossible to outperform the overall market through expert
stock selection, technical analysis or market timing, and the only way an investor can possibly obtain
higher returns is by purchasing riskier investments.

Passive fund management is consistent with the idea that markets are efficient and that no mispricing
exists. If the EMH is an accurate account of the way that capital markets work, then there is no benefit to
be had from active trading. Such trading will simply incur dealing and management costs for no benefit.
Investors who do not believe that they can identify active fund managers who they are confident can
produce returns above the level of charges for active management will often elect to invest in passive
funds or index trackers.

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An active manager will try to achieve the desired goal of outperforming a designated benchmark by
seeking out market inefficiencies and by purchasing securities that are undervalued, or by short-selling
securities that are overvalued. Either of these methods may be used alone or in combination. Depending
on the goals of the specific investment portfolio, active fund management may also serve to create less
volatility (or risk) than the benchmark index. The reduction of risk may be instead of, or in addition to,
the goal of creating an investment return greater than the benchmark.

Note that market participants subscribe to different forms of EMH. The view that no one can, over the
long term, beat the broad market is termed strong form EMH. Many active fund managers acknowledge
that while information travels quickly and the financial markets are extremely competitive, the weak
form of EMH may apply. Weak form EMH recognises that differences in the spread of information
(particularly through proprietary research) ) can offer advantages, and the fact that trading or structural
costs may make some strategies profitable for some traders but not for others.

1.10 ESG Investing

Learning Objective
9.1.10 Know the role of ESG investment

ESG stands for environmental, social and governance, and ESG investing refers to the level to which
these factors are considered in selecting and managing investments. ESG investing has become

9
increasingly important over the recent years. ESG investing is also known as responsible investing (RI),
socially responsible investing (SRI) or sustainable investing. In all cases, investors and managers consider
factors beyond only risk and return when making investment decisions. This can be done by avoiding,
limiting or screening certain investments, or divesting of existing holdings, to ensure they meet certain
pre-determined thresholds of environment, social or government responsibility.

Examples of what might be taken into account by an ESG investor include the following:

• Environmental criteria:
• How much energy the company uses, and how responsible it is in conserving energy.
• Whether the company minimises waste and pollution.
• The conservation efforts of the company and the impact it has on the natural world.
• The company’s view on, and efforts to manage, climate change.
• Social criteria:
• The extent to which the company supports its local community.
• Charitable contributions made by the company.
• The values encouraged and required throughout the company’s supply chain.
• Whether the health and safety of the workforce is held in high regard.
• Governance criteria:
• The diversity of the company’s management and board of directors.
• The balance between executive directors and non-executives.
• The level of transparency the company provides, beyond simple statutory reporting.
• The values and ethical expectations placed on the staff, particularly the senior management.

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The obvious reason for including such criteria in the selection of investments is that increasing numbers
of investors feels they are important. They have the environmental and social conscience to want to
support the more responsible companies. They might want to avoid certain types of company that
are engaged in what they feel is inappropriate because of the environmental or social harm it might
cause. Companies involved in natural resource extraction, tobacco, gambling or the production of
armaments might be good examples. In fact, because it is one of the largest carbon emission producers
among energy sources, coal mining and coal-fired powerplant companies have suffered a reduction in
investment from many global institutions. Furthermore, it is distinctly possible that selecting companies
with the right ESG criteria could result in a portfolio of shares in companies that last longer and perform
better over the medium and long term.

The extent to which an investment is ESG responsible or compliant can be measured in a variety of ways.
There are a variety of rating systems that rate companies and investments on sustainability including
the Bloomberg Barclays MSCI Socially Responsible (SRI) Index, the Jantzi Social Index and Sustainalytics.
The approaches used, however, are fragmented. There is not yet a globally agreed upon method to
measure and compare these across countries. Further, there is a danger, however, that companies might
engage in practices that make them appear to be better governed, more socially and environmentally
responsible than they really are. This might be done to attract and retain investment. Such practices are
often referred to as ‘greenwashing’ and, until ESG criteria become universally agreed, measurable and
standardised such practices might continue.

1.11 Hedging

Learning Objective
9.1.11 Know the role of hedging in the management of investment risk and how to achieve it: futures;
options; CFDs

The risks that are inevitable when investing in shares, bonds and money market instruments can be
largely removed by entering into hedging. Unfortunately, the hedging strategies will have a cost that
inevitably impacts investment performance.

Hedging is the attempt to reduce risk, usually achieved by using derivatives, for example, options,
futures and forwards. The objective is to buy or sell derivatives that reduce the exposure to market
fluctuations that would take place in the portfolio. This is done by taking the opposite position of what
is in the portfolio with the derivative. For example, buying put options (the right to sell) on investments
held in the portfolio will enable the investor to remove the risk of a fall in value. However, the investor
will have to pay a premium to buy the options.

Futures, such as stock index futures, can be used to hedge against equity prices falling – but the future
will remove any upside as well as downside.

Forwards can also be used to reduce risk. Currency forwards could be used to eliminate exchange rate
risk – but, like futures, the upside potential will be lost in order to hedge against the downside risk.
Furthermore, currency forwards are usually only available for currencies where the foreign exchange
market is very active and there are few exchange control restrictions.

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Example
Hedging exchange rate risk in Africa

Currency forwards, which are usually traded over-the-counter (OTC), are available for the South African
rand (ZAR) and international currencies. The Johannesburg Stock Exchange (JSE) trades currency futures
and options, including products that track the ZAR exchange rate to the US dollar, the Great British
pound, the euro and the Botswana pula (BWP). The Central Bank of Nigeria started the trading of foreign
currency futures contracts settled in the Nigerian naira (NGN) on the FMDQ OTC securities exchange.

1.11.1 Hedging with Futures Contracts

One of the most commonly used techniques for hedging a portfolio is through selling futures contracts
to control the level of exposure arising from the ownership of equities.

Example
A UK-based pension fund which has a large exposure to large-capitalisation equities traded on the
London Stock Exchange (LSE) could use the FTSE 100 futures contract as a hedging instrument

Calculating the number of futures contracts to sell for hedging purposes can be a formidable challenge.
The simplest case is when the cash portfolio has similar characteristics to an available futures contract
such as the FTSE 100 contract. In such a case, one simply divides the cash value of the portfolio by the
nominal size of the futures contract and then sells that number of contracts. If the extent to which the

9
cash portfolio moves in relation to the benchmark index, which is known as the portfolio’s beta, can be
measured with some precision, then the number of contracts sold needs to be prorated by the ratio
between the portfolio’s beta and the beta of the index which, since it is the benchmark reference, is
given a beta value of one.

If, for example, the market value-weighted average beta of the portfolio was 1.20, then the pension fund
would sell the appropriate nominal value of futures contracts, multiplied by 1.20, to reflect the fact that
the actual holdings are more volatile than the hedging instrument.

The use of futures has the advantages of lower cost, greater efficiency and less portfolio disruption. The
shortcomings of selling futures contracts are as follows.

The exact risk characteristics, ie, the beta value of the portfolio, may not be emulated by the performance
of any index or instrument which is available as a futures contract. For example, a portfolio which has
a combination of small-capitalisation stocks and emerging market exchange-traded funds will be
difficult to hedge by selling a broad-based futures contract on, say, the FTSE 100 index or the S&P 500.
Furthermore, futures contracts are not available on all markets, for example they are not available on
many African and emerging Asian markets.

Also, the key issue is one of knowing when to enter the futures hedge trade and when to exit the trade.
If the short sale of an index future is not settled before the market has completed a correction and is
starting to rise again, the continued ownership of a short position in an index futures position will offset
the gains being made in the cash portfolio.

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There are also operational and regulatory considerations to implementing a futures hedge. Separate
accounts will generally be required in addition to those used to trade cash securities. To ensure the
portfolio is protected, the futures position must be rolled forward prior to contract expiration. Also,
depending on the fund vehicle and type of client, there may be restrictions on the use of derivatives.

1.11.2 Hedging with Options

An alternative way of implementing a hedge strategy for a fund manager or other investors is to continue
to hold the investments, such as individual equities, in the portfolio, and to purchase put options on
those positions (or on an index where the performance of an index closely matches the overall portfolio).
Remember that a put option, when purchased, gives the owner the right, but not the obligation to sell
the underlying equities at a predetermined price. This combination of owning, or being long on both the
investment(s) and the puts enables the holder to continue to participate in any upside potential of the
investments, while enjoying the right to sell the investment at the predetermined price (as set out in the
put contract) if the investments do not perform. This provides the protection from excessive loss, which is
the primary objective of hedging. The fund manager will cap his or her loss at the strike price less the cost
to purchase the put option contracts.

Being long a put option is thus motivated by a view that an asset’s price will fall; it is a hedging move or
can be used as an outright bearish strategy, which will enable the option buyer to benefit should the
price of the underlying instrument or equity fall.

On the other side of the trade, the seller is said to be ‘short’ the put option and expects the market to
either rise or not fall sufficiently for the option to be exercised. Known as the ‘writer’, the seller seeks for
the option not to be exercised and to profit from the premium paid by the buyer.

Example – Hedging with a Put Option

Assume that in December an investor holds 1,000 shares in XYZ, the current price is $110 and the
investor has a bearish view of the price development in the intermediate term – let us assume six
months forward in June. The investor can buy put options in XYZ with a strike of $110, an expiry of June
and a premium of $6. This means that they have the right (but not the obligation) to sell the XYZ shares
for $110 in June.

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Model of Option Payoffs and Profits Action Buy Put

Exercise Price 110.00 Premium Paid 6.00 Strategy Long

Option Payoffs and Profits

12.00
8.00
4.00
Profit/Loss

0.00
100 105 110 115 120 125 130 135
–4.00
–8.00
–12.00
Stock Price at Maturity in Dollars
Option Profit

Stock 95 100 105 110 115 120 125 130 135

Intrinsic
15.00 10.00 5.00 0.00 0.00 0.00 0.00 0.00 0.00
Value
Profit/Loss 9.00 4.00 –1.00 –6.00 –6.00 –6.00 –6.00 –6.00 –6.00

9
The break-even point for this option is calculated by deducting the premium from the exercise price, eg,
$110 – $6 = $104. The premium needs to be recovered before any profit or hedge protection is made.

However, the maximum profit will occur if the share price falls to zero, meaning that the shares
can (theoretically) be bought for nothing and sold for $110. With the premium of $6 deducted, the
maximum profit will be $104, the same as the break-even point.

In a hedging exercise, it must obviously be recalled that the profit seen from this option payoff diagram
is only going to cover the losses which are incurred from holding the underlying shares of XYZ. But the
option does provide the portfolio manager with protection all the way down to the worst-case scenario
of the shares going to zero.

The risks taken by the purchaser of a put option are limited to the premium paid and this is illustrated in
the diagram as the extended horizontal line showing a return of minus six dollars per share.

The motivation behind buying a put option will be to protect against a fall in the share price. The holder
of a put obtains the right, but not the obligation, to sell at a fixed price. The value of this right will
become increasingly valuable as the asset price falls. The greatest profit that will arise from buying a put
will be achieved if the asset price falls to zero.

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The purchase of put options is an added expense for a fund manager and, in the nature of all options
contracts, the premium paid for the put option is known as a wasting asset as it is subject to decay as the
expiration of the option period approaches. If a fund manager wishes to continue to protect a portfolio
with put options, which have definite maturity dates, then a process of rolling over the options contracts
can be employed. This will further add to the costs, and the least advantageous position from the point
of view of the overall returns to the fund manager is the situation when portfolio insurance has been
purchased through extended use of put options, the cash value of the portfolio continues to rise as the
insurance is not required, and the cost of the premiums has to be charged against the earnings of the
cash portfolio.

Hedging with options, in addition to the cost, will also involve the same operational and regulatory
considerations as with futures.

1.11.3 Hedging with Contracts for Differences (CFDs)

Contracts for differences (CFDs) were originally developed in the early 1990s and were initially used by
institutional investors to hedge their exposure to stocks in a cost-effective way.

CFDs are different from traditional cash-traded instruments (such as equities, bonds, commodities and
currencies) in that they do not confer ownership of the underlying asset. Investors can take positions on
the price of a great number of different instruments.

Along with futures and options, CFDs are derivatives. The price of the CFD tracks the price of the
underlying asset, and so the holder of a CFD benefits, or loses, from the price movement in the stock,
bond, currency, commodity or index. But the CFD holder does not take ownership of the underlying
asset.

CFDs are margin-traded, meaning that the investor does not have to deposit the full value of the
underlying asset with the CFD provider. Thus, an investor or fund manager can use CFDs to buy
exposure to market movements, using only a fraction of the capital they would require in the cash
market. The investor then has a geared position relative to the capital deposited.

Since CFDs allow an investor to benefit from downward movements in an equity position or index,
they are useful for hedging purposes. They enable the fund manager to retain a position in the cash
instrument but have a derivative position which is equivalent to that of short-selling the stock. This
flexibility, and the possibility of margin trading, means that CFDs can be used flexibly either for hedging
or speculation.

The costs of CFDs comprise commissions for each deal, plus a cost built into the spread of the CFD price,
together with a funding/financing charge. CFD contracts are subject to a daily financing charge, usually
applied at a previously agreed rate linked to a published interest rate like LIBOR. The parties to a CFD pay
to finance long positions and may receive funding on short positions in lieu of deferring sale proceeds.
The contracts are settled for the cash differential between the price of the opening and closing trades.

CFDs are subject to a commission charge on equities that is a percentage of the size of the position for
each trade.

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 Risk and Reward

Investors in CFDs are required to maintain a certain amount of margin as defined by the brokerage –
usually ranging from 1% to 30%. One advantage to investors of not having to put up as collateral the
full notional value of the CFD is that a given quantity of capital can control a larger position, amplifying
the potential for profit or loss. On the other hand, a leveraged position in a volatile CFD can expose the
buyer to further margin calls in a downturn, which will fund what may crystallise as a substantial loss.

As with many leveraged products, maximum exposure is not limited to the initial investment; it is
possible that an investor loses more than the margin put in, with additional money paid in the form of
subsequent ‘margin calls’ to cover losses.

Example
Suppose you wish to hedge 10,000 shares in XYZ plc which are held in a portfolio and are currently
trading at 99p each. CFDs are available at a quoted price of 98.5p/99.5p. To achieve this hedge you
could sell the equivalent of 10,000 shares locking in the current CFD price of 98.5p, and then if the price
declines the returns from the CFD position will be similar to those available if you had a short position in
the stock selling 10,000 shares for 98.5p each – a total position of £9,850.

Using CFDs, assuming a 5% margin, you will only need an initial deposit of £492.50 (£9,850 x 5%). As
the price decreases, the returns from the CFD will compensate for the loss incurred on the actual long
holding of the stock.

Assume a month later the price of XYZ plc shares has declined to 84p, and the CFDs are now quoted
at 83.5p/84.5p. The loss on the shares within the portfolio amounts to £1,500. Initially they were worth
10,000 x 99p = £9,900 and now they are only worth 10,000 x 84p = £8,400.

9
The gain on the CFDs (before considering any commissions on the sale and purchase and ignoring any
funding charges) is £1,400. The CFDs were initially sold for 10,000 x 98.5p = £9,850 and then bought for
10,000 x 84.5p = £8,450.

So, ignoring funding charges and commissions, the hedge had managed to remove £1,400 of the £1,500
loss on the shares. Given that this is a short sale, the funding charges can be considered negligible.
Commissions would be payable on the initial sale of CFDs and the subsequent purchase of CFDs at
say 0.15%, so in total would be £27.45 (£9,850 x 0.15%) + (£8,450 x 0.15%). So overall, the hedge is
marginally less efficient, but still very worthwhile. However, it is important to emphasise that had the
shares risen over the period, the CFD hedge would have lost money, removed the gain on the portfolio
and (after costs) turned it into a net loss.

CFDs allow a trader to go short or long on any position using margin. There are always two types of
margin with a CFD trade:

• Initial margin – normally between 5% and 30% for shares/stocks and 1% for indices and foreign
exchange. In the above example, 5% of the contract price was assumed.
• Variation or maintenance margin – the CFD will be marked to the market at currently prevailing
prices and if the position has moved beyond the amount taken as initial margin – ie, the position has
moved adversely – additional margin would be required. This is termed variation or maintenance
margin.

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1.12 Company Liquidations

Learning Objective
9.1.12 Understand the general concept of ranking in respect of shares and corporate bonds in the
event of a company’s liquidation

In the case of the winding-up or liquidation of a company, the priority and manner in which the owners
of different tiers of the capital structure of that company are dealt with is referred to as the liquidation
ranking.

The basic rule is that all shareholders or equity participants are subordinate to debt holders. There are
separate provisions for the priority of debt holders, based upon the seniority of the debt, whether there
is a fixed charge associated with the debt or a floating charge, and other covenants that were granted
at the time of debt issuance.

Once the obligations to the debt holders have been discharged, preference shareholders will take
priority over the ordinary shareholders in a liquidation. From the proceeds following a liquidation event
(which may be defined to include events other than the winding-up of the company), the preference
shareholders will receive the par value of their shares before there is any distribution to the ordinary
shareholders. There is one further consideration which relates to the issuance of preference shares
as part of early-stage or venture funding of a start-up company; this is often referred to as liquidation
preference.

The liquidation preference is the amount that must be paid to the preference shareholders, such
as venture capital or angel investors, before distributions may be made to common stockholders.
The liquidation preference is payable on either the liquidation of a company, asset sale, merger,
consolidation or any other reorganisation resulting in the change of control of the start-up. It is usually
expressed as a multiple of the original purchase price of the preference shares, such as 2x. Thus, if the
purchase price of the preferred is $2 per share, a liquidation preference of 2x will be $4 per share. In
effect, the preference shareholders will receive twice the nominal value of their shares upon liquidation
before the proceeds (if any) are distributed to the ordinary shareholders.

1.12.1 Debt Seniority

Debt issued by companies can come in a variety of forms including bonds and bank borrowing. When
there are multiple forms of debt, the issuer will have to establish some sort of order as to which debt will
be serviced and repaid first, in the event of the company’s encountering financial difficulties. In broad
terms, the seniority of the debt falls into three main headings:

• Senior – senior debt or bonds have a claim that is above that of the more junior forms of borrowing
and the equity of the issuer in the event of liquidation.
• Subordinated – subordinated debt or bondholders have accepted that their claim to the issuer’s
assets ranks below that of the senior debt in the event of a liquidation. As a result of accepting a
greater risk than the senior debt, the subordinated borrowing will be entitled to a greater rate of
interest than that available on the senior debt.

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 Risk and Reward

• Mezzanine and payment-in-kind (PIK) – the mezzanine level of debt, if it exists at all, will be even
more risky than the subordinated debt. It will rank below other forms of debt but above the equity
in a liquidation. As the most risky debt, the mezzanine debt will offer a greater rate of interest than
the subordinated and senior levels of debt. Mezzanine borrowing can be raised in a variety of ways:
• One example of mezzanine level finance is the issue of payment-in-kind (PIK) notes. PIK notes
are bonds that typically have a quoted coupon rate, but the coupons are not paid in cash until
the bond matures. The coupons are effectively rolled up over the life of the PIK notes.
• Mezzanine debt may also have a convertibility clause if not paid according to schedule or
included in order to lower the interest rate for what would otherwise create a high financing
expense for the issuer.

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

2. Institutional Investment Advice

2.1 Institutional Client Profiles

Learning Objective

9
9.2.1 Know the requirements of different institutional investors: pension funds; life and general
insurance funds; hedge funds; regulated mutual funds; banks; ESG funds

2.1.1 Institutional Investors

There are a number of institutional investors, including pension funds, the providers of life assurance,
the providers of general insurance and banks.

Pension funds are set up with the aim of providing retirement funds for the beneficiaries. They may be
sponsored by an employer, be solely dependent on contributions from the workforce, or a combination
of the two. Pension funds tend to be approved by tax authorities and can then accumulate income and
capital gains tax-free. The money in the fund is invested by fund managers and, because pension funds
have a relatively long investment horizon, they can take risks and have traditionally tended to invest
heavily in equities.

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Example
Local institutional investors, especially pension funds, are increasingly important in African capital
markets. In some countries, including South Africa, Namibia, Kenya and Botswana, pension funds were
established many years ago and are large in relation to the size of the market. They invest in higher-risk
securities, such as equities, and even into some infrastructure projects in a similar manner to pension
funds in developed markets. In other countries, such as Nigeria, Ghana and Tanzania, pension funds are
growing fast – sometimes by over 30% a year – driven by new legislation which encourages workers and
employers to contribute.

Research suggests pension fund assets in Africa totalled $372 billion in 2016, of which almost 95%
was concentrated in five countries (in descending order): South Africa, Nigeria, Kenya, Namibia and
Botswana. This included large funds, such as the Government Employees Pension Fund (GEPF) in
South Africa, the National Social Security Fund (NSSF) in Kenya, the Government Institutions Pension
Fund (GIPF) in Namibia and the Botswana Public Officers Pension Fund (BPOPF). At the time of writing
(December 2020), pension fund assets under management across Africa exceeded $1 trillion.

Pension funds can be divided into two broad classes: those that define the benefits they will pay
out (defined benefit schemes or final salary schemes), and those where the benefit is driven by the
contributions made and the investment performance (defined contribution schemes). These are often
referred to in shorthand as ‘DB’ or ‘DC’ schemes. Life assurance business arises from insurance contracts
written by an insurance company on the life of an individual. They mainly comprise:

• term assurance policies which, in exchange for a regular premium, only pay out if the individual
dies before the end of a set policy term
• whole of life policies which simply pay out on death in exchange for regular premiums
• endowment policies which are term assurance policies with a significant investment element that
depends on the performance of the insurance company’s fund
• single premium life assurance bonds which are single premium endowments; again they have a
significant investment element.

Like pension funds, because of the long-term nature of life assurance business, the funds tend to be
willing to invest in higher-risk investments involving a heavy weighting in equity investments. Unlike
pension funds, the income and the gains made within life assurance funds are typically subject to tax.

General insurance is when insurance is written by an insurance company against short-term personal
and commercial risks, such as car or household contents insurance. Because of the short-term nature of
the liabilities, the funds from the premiums tend to be invested in low-risk, liquid, short-term assets such
as money market instruments. Like life assurance funds, general insurance funds are subject to tax on
the income and gains within the fund.

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 Risk and Reward

If banks hold surplus cash at the end of each business day, they will place the funds on deposit with
other banks (in the interbank market) and invest in eligible money market instruments (such as Treasury
bills and commercial paper (CP)) – relatively risk-free investments to cover the short-term nature of the
banks’ liabilities to depositors. In the UK, the Bank of England (BoE) will accept what are described as
an ‘eligible’ money market instrument as collateral against loans. An eligible money market instrument
means that the BoE will accept it as collateral against loans. As with insurance companies, banks are
taxed on income and gains they generate from their investments.

The following table provides a summary of the key distinctions and similarities across the institutional
investors:

Proportion Proportion of
Investment Relative risk
Institution of equity money market
horizon profile
investments investments
Pension fund Long-term* High Low High
Life assurance fund Long-term High Low High
General insurance
Short-term Low High Low
fund
Bank Short-term Low High Low

* Clearly, this depends on the maturity profile of the pension scheme; a scheme with the bulk of
members nearing retirement would take a shorter-term view.

9
2.1.2 Regulated Mutual Funds
Diversification of shareholdings reduces risk, but for a private client with a relatively modest amount
to invest this would be prohibitively expensive. One way of avoiding the high cost of investing in many
different companies is to invest in a pooled fund where a fund manager handles the money of a group
of investors. As a result, the portfolio is conveniently and cheaply diversified.

These pooled funds or collective investment vehicles are either regulated or unregulated. This refers
to authorisation by the regulator, such as the Securities and Exchange Commission (SEC) in the US,
or financial regulators in any other part of the world. So, regulated or unregulated funds can also be
referred to as authorised or unauthorised. Regulated or authorised schemes can be freely marketed;
unregulated or unauthorised schemes cannot be freely marketed.

An unauthorised collective investment scheme can still be marketed but with restrictions, eg, only to
relatively large customers, more sophisticated investors or those who already hold such an investment.
If investors show that they have good knowledge of investment markets and/or substantial resources
at their disposal so that their risk is more widely spread, then they are called sophisticated and high net
worth individuals (HNWIs). Their advisers can introduce them to more risky investments, such as hedge
funds. In addition, a regulator may require that only investment advisors who are registered with them
can market to the public in that country and that only regulated funds may be marketed.

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2.1.3 Hedge Funds
Hedge funds are unauthorised investment vehicles that are not subject to the same regulatory oversight as
other pooled funds. This enables hedge funds to invest in a wide variety of investments in different markets,
and to employ high-risk strategies, including gearing with derivatives and seeking arbitrage opportunities.
One example includes going long in some investments and short in others (a long/short strategy).

Unlike most of the conventional collective investment vehicles that are restricted to a long-only investment
strategy, hedge funds can be more flexible and take substantial short positions.

Due to their unauthorised nature, nothing prevents hedge funds from borrowing money and gearing
up the returns for their shareholders. Indeed, many hedge funds have substantial amounts of borrowed
funds and are highly geared.

The objective of hedge funds is to produce positive returns, no matter what the general market is doing.
Their name reflects the fact that, when combined with more conventional investing strategies, the
positive returns generated by hedge funds will reduce the risk of the overall portfolio falling in value in
adverse market conditions.

As hedge funds are not authorised, they cannot be freely marketed. They also do not have to report
pricing or holdings to investors as frequently as authorised funds. This, combined with the requirement
to invest substantial minimum amounts, means that hedge funds tend to be accessible only to
institutional investors and high net worth individuals who have the experience and capital to accept the
associated risks.

2.1.4 ESG Funds

We encountered the idea of investing in accordance with environmental, social and governance (ESG)
criteria earlier in this chapter. Unsurprisingly, many fund management companies have launched funds
that capitalise on the popularity of sustainable investments enabling investors to easily gain access
to an ESG responsible portfolio. The investments in such funds are restricted to those that meet the
fund manager’s stated criteria. These will assess, for equity investment, whether the company is caring
for the planet (such as minimising carbon emissions), protecting society (such as offering equal job
opportunities) and is soundly-run (such as effectively tying executive remuneration to performance).

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 Risk and Reward

2.2 Regulatory Information and Financial Communications

Learning Objective
9.2.2 Understand the need for the publication of regulatory information and financial communications
and the types of entity through which publication is achieved: PIPs; RNS; SIPs; Bloomberg;
Reuters; analyst research

Listed companies that have their shares traded on exchanges need to keep market participants posted
on any price-sensitive information that may arise. For example, if a company has won a significant, new
contract or simply announced its most recent set of results, it needs to inform the market participants
in an orderly manner. In Europe, this is a requirement of the European Union’s (EU’s) Transparency
Directive, and companies typically satisfy this by notifying primary information providers (PIPs). An
example of a primary information provider is the LSE’s Regulatory New Service (RNS).

Example
RNS is a leading service for regulatory news announcements in the UK. It helps companies and their
intermediaries fulfil their UK, and other global, regulatory disclosure obligations in an efficient manner.

Almost 300,000 announcements are processed by RNS each year, with over 70% of all regulatory and
potentially price-sensitive UK company announcements originating from RNS. Releasing announcements
through RNS ensures company information is distributed immediately and accurately. Announcements
are visible on over two million market professional terminals, databases and financial websites across

9
the world, including key vendor services, such as Refinitiv (formerly Thomson Reuters), Bloomberg and
the Dow Jones.

In summary, PIPs simply offer a service that receives regulatory information from listed companies,
processes that information and disseminates it by circulating it to secondary information providers
(SIPs). Examples of SIPs include those key vendors mentioned above: Bloomberg, Refinitiv and the
Dow Jones. The SIPs, in turn, disseminate the information to the wider financial community, such as
stockbrokers and research analysts.

The information that reaches the financial community via the PIPs and SIPs is used to inform and update
research reports written by research analysts that comment on the likely future movements in the
companies’ share prices.

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 End of Chapter Questions

1. What is liquidity risk?

Answer reference: Section 1.1.1

2. What is meant by backward-looking analyses?

Answer reference: Section 1.1.2

3. What is the equity risk premium?

Answer reference: Section 1.2

4. What is meant by strongly correlated assets?

Answer reference: Section 1.7.1

5. How do active and passive investment methodologies differ?

Answer reference: Sections 1.8 and 1.9

6. What is ESG investing

Answer reference: Section 1.10

7. What is the motivation for buying an equity put option when holding the underlying
shares?
Answer reference: Section 1.11.2

8. Who takes priority in a company liquidation?

Answer reference: Section 1.11.2

9. What are the three main types of debt seniority?

Answer reference: Section 1.12.1

10. What is the basic definition of a hedge fund?

Answer reference: Section 2.1.3

11. What are PIPs and what service do they offer?

Answer reference: Section 2.2

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Glossary
294
 Glossary

Active Management Amortisation

A type of investment approach employed to The depreciation charge applied in company
generate returns in excess of an investment accounts against capitalised intangible assets.
benchmark index. Active management is
employed to exploit pricing anomalies in those Annual General Meeting (AGM)
securities markets that are believed to be The annual meeting of directors and ordinary
subject to mispricing by utilising fundamental shareholders of a company. All companies are
analysis and/or technical analysis to assist in the obliged to hold an AGM at which the shareholders
forecasting of future events and the timing of receive the company’s report and accounts and
purchases and sales of securities. have the opportunity to vote on the appointment
of the company’s directors and auditors and
Acquisition the payment of a final dividend recommended
by the directors. Also referred to as an Annual
An acquisition is the term that is typically used General Assembly in some jurisdictions.
when one company buys another for cash,
or where the company being purchased is Arbitrage
significantly smaller than the predator company
The process of deriving a risk-free profit by
that buys it. Rather than the two initial groups
simultaneously buying and selling the same
of shareholders coming together in a merger
asset in two related markets where a pricing
of their interests, the shareholders of the target
anomaly exists.
either accept cash and lose their involvement in
the new combination, or play a much reduced Asset Allocation
role in the new combination.
The process of deciding on the division of a
portfolio’s assets between asset classes and
AIM
geographically before deciding upon which
The London Stock Exchange’s (LSE’s) market
particular securities to buy.
for smaller UK public limited companies (plcs).
AIM has less demanding admission requirements Auction
and places less onerous continuing obligation
System used to issue securities where the
requirements upon those companies admitted
successful applicants pay the price that they
to the market than those applying for a full list
bid. Examples of its use include the UK Debt
on the LSE.
Management Office (DMO) when it issues gilts.
Auctions are also used by the LSE to establish
Alpha
prices, such as opening and closing auctions on
The return from a security or a portfolio in excess
SETS.
of a risk-adjusted benchmark return.
Base Currency
Alternative Trading Systems (ATSs)
The currency against which the value of a quoted
An ATS is a platform for trading that is not a
currency is expressed. The base currency is
recognised stock exchange.
currency X for the X/Y exchange rate.

American Depositary Receipt (ADR)

Bear Market
An ADR is a security that represents securities of
A negative move in a securities market,
a non-US company that trades in the US financial
conventionally defined as a 20%+ decline. The
markets.
duration of the market move is immaterial.

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Bearer Securities Circuit Breaker
Those whose ownership is evidenced by the An automated suspension of trading on an
mere possession of a certificate. Ownership can, exchange when prices move by more than a
therefore, pass from hand to hand without any predetermined amount to enable market
formalities. participants to reflect and prevent panic buying
or selling.
Beta
The relationship between the returns on a stock Clean Price
and returns on the market. Beta is a measure of The quoted price of a bond. The clean price
the systematic risk of a security or a portfolio in excludes accrued interest to be added or to be
comparison to the market as a whole. deducted, as appropriate.

Bonds Closed-Ended
Securities issued by an organisation, such as a Organisations such as companies which are a
government or corporation. Bonds pay regular fixed size as determined by their share capital.
interest and repay their principal or face value at Commonly used to distinguish investment trusts
maturity. One of the most common underlying (closed-ended) from unit trusts and OEICs (open-
assets for derivative contracts. ended).

Bonus Issue Collective Investment Scheme (CIS)

The free issue of new ordinary shares to a A CIS is essentially a way of investing money
company’s ordinary shareholders, in proportion with other people to participate in a wider range
to their existing shareholdings through the of investments than those feasible for most
conversion, or capitalisation, of the company’s individual investors, and to share the costs of
reserves. By proportionately reducing the market doing so. Terminology varies by country, but
value of each existing share, a bonus issue makes collective investments are often referred to as
the shares more marketable. Also known as a investment funds, managed funds, mutual funds
capitalisation issue or scrip issue. or simply funds.

Broker-Dealer Commercial Paper (CP)

An exchange member firm that can act in a dual Money market instrument issued by large
capacity both as a broker acting on behalf of corporates.
clients and as a dealer dealing in securities on
their own account. Commission
Charges for acting as agent or broker.
Captive Insurance
The creation of a specialist insurance entity to Commodity
provide insurance to other companies within the
Items including sugar, wheat, oil and copper.
same group.
Derivatives of commodities are traded on
Central Bank exchanges (eg, oil futures on ICE Futures).

Central banks typically have responsibility for

Consumer Prices Index (CPI)
setting a country’s or a region’s short-term
Index that measures the movement of prices
interest rate, controlling the money supply,
faced by a typical consumer.
acting as banker and lender of last resort to the
banking system and managing the national debt.

296
 Glossary

Convertible Bond Derivatives

A bond which is convertible, usually at the Instruments where the price or value is derived
investor’s choice, into a certain number of the from another underlying asset. Examples include
issuing company’s shares. options, futures and swaps.

Correlation Dirty Price

A statistical measure of how two securities move The price of a bond inclusive of accrued interest
in relation to each other. or exclusive of interest to be deducted, as
appropriate.
Coupon
The regular amount of interest paid on a bond. Diversification
Investment strategy that involves spreading risk
CREST by investing in a range of investments.
Electronic settlement system used to settle
transactions for shares, gilts and corporate Dividend
bonds, particularly on behalf of the LSE. Distribution of profits by a company to
shareholders.
Cum-Dividend
The way a financial instrument is described when Dow Jones Industrial Average (DJIA)
the buyer will be entitled to the next dividend Major share index in the US, based on the prices
(on a share) or coupon (on a bond). of 30 major US-listed company shares.

Dark Pool Equities

A dark pool is a form of alternative trading Another name for shares.
system which provides little or no transparency
about the prices and trades executed within it. Eurobond
An interest-bearing security that is issued
Debt Management Office (DMO) internationally. More precisely, a eurobond is
Agency responsible for issuing gilts on behalf of an international bond issue denominated in a
the UK Treasury. currency different from that of the financial
centre(s) in which the bond is issued. Most
Dematerialised eurobonds are issued in bearer form through
System where securities are held electronically bank syndicates.
without certificates.
Euronext
Depreciation European stock exchange network formed by
Depreciation is accounting for the using up of the merger of the Paris, Brussels, Amsterdam and
a tangible non-current asset like an industrial Lisbon exchanges.
machine. Over the expected useful life of the
asset (say, the next five years), a particular Exchange Rate
percentage of the asset’s cost is allocated to the The rate at which one currency can be exchanged
income statement to represent the charge for for another.
usage of the asset.

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Ex-Dividend Forward
The period during which the purchase of shares A derivatives contract that creates a legally binding
or bonds (on which a dividend or coupon obligation between two parties for one to buy
payment has been declared) does not entitle and the other to sell a pre-specified amount of an
the new holder to this next dividend or interest asset, at a pre-specified price, on a pre-specified
payment. future date. Forward contracts are commonly
entered into in the foreign exchange market. As
Exercise Price individually negotiated contracts, forwards are
The price at which the right conferred by a not traded on a derivatives exchange.
warrant or an option can be exercised by the
holder against the writer. FTSE 100
Main UK share index of the 100 largest
Fiscal Years listed company shares measured by market
These are the periods for reporting, alternatively capitalisation. Also referred to as the ‘Footsie’.
referred to as financial years. The term is
particularly used by the tax authorities for Fund Manager
periods of assessment for tax purposes. Firm or person that makes investment decisions
on behalf of clients.
Fixed-Interest Security
A tradeable negotiable instrument, issued by a Future
borrower for a fixed term, during which a regular An agreement to buy or sell an item at a future
and predetermined fixed rate of interest based date, at a price agreed today. Differs from a
upon a nominal value is paid to the holder until it forward in that it is a standardised contract
is redeemed and the principal is repaid. traded on an exchange.

Flipping Greenshoe Option

Typically used in the context of an initial public An over-allotment option giving the underwriters
offering (IPO), flipping is where the shares are of an IPO the right to sell additional securities in
purchased with the intention of immediately an offering, if demand for the securities is in
selling them at a higher price. Flipping is only excess of the original amount offered. It is a
successful if the share price rises above the IPO strategy that underwriters have developed which
price. enables them to smooth out price fluctuations if
demand surges on the one hand, and to help
Floating-Rate Note (FRN) support the IPO if there are adverse market
A debt security issued with a coupon periodically conditions.
referenced to a benchmark interest rate, such as
LIBOR. Grey Market Trading
Also known as ‘pre-release’, grey market trading is
Forex (FX) the purchase and sale of an instrument before its
Abbreviation for foreign exchange. formal release into the market. A key example is
a depository bank selling an American depositary
receipt (ADR) in the three-month period up to its
creation.

298
 Glossary

Gross Domestic Product (GDP) Investment Bank

A measure of a country’s output. Firms that specialise in advising companies on
mergers and acquisitions (M&A), and corporate
Gross Redemption Yield (GRY) finance matters such as raising debt and equity.
The annual compound return from holding The larger investment banks are also heavily
a bond to maturity taking into account both involved in trading financial instruments.
interest payments and any capital gain or loss at
maturity. Also referred to as the yield to maturity Investment Trust
(YTM). The GRY or YTM is the internal rate of Despite the name, an investment trust
return on the bond based on its trading price. is a company, not a trust, which invests in a
diversified range of investments.
Harmonised Index of Consumer Prices (HICP)
The way the consumer prices index in the EU was Liquidity
originally described. Ease with which an item can be traded on the
market. Liquid markets are also described as
Hedging ‘deep’.
A technique employed to reduce the impact of
adverse price movements on financial assets Liquidity Risk
held. The risk that an item, such as a financial instrument,
may be difficult to sell at a reasonable price.
Index-Linked Gilts
Gilts whose principal and interest payments are Listing
linked to the retail prices index (RPI). An example Companies whose securities are listed are
of an inflation-protected security. available to be traded on an exchange.

Inflation London Interbank Offered Rate (LIBOR)

A persistent increase in the general level of prices. Benchmark money market interest rates
Usually established by reference to consumer published for a number of different currencies
prices and the CPI. over a range of periods. LIBOR, which is the
rate at which funds in a particular currency and
Initial Public Offering (IPO) for a particular maturity, are available to one
A new issue of ordinary shares that sees the bank from other banks. LIBORs are gathered and
company gain a stock market listing for the first published on a daily basis.
time, whether made by an offer for sale, an offer
for subscription or a placing. Long Position
The position following the purchase of a security
Introduction or buying a derivative.
In the context of a listing or IPO, an introduction
is a company applying for, and gaining a listing Market Capitalisation
for its securities on a stock market, without The total market value of a company’s shares or
raising any funds. other securities in issue. Market capitalisation is
calculated by multiplying the number of shares
or other securities a company has in issue by the
market price of those shares or securities.

299
Market Maker Offer Price
A stock exchange member firm registered to Bond and share prices are quoted as bid and
quote prices and trade shares throughout the offer. The offer is the higher of the two prices and
trading day (such as the LSE’s mandatory quote is the one that would be paid by a buyer.
period).
Open-Ended
Maturity Type of investment, such as OEICs or unit trusts,
Date when the principal on a bond is repaid. which can expand without limit.

Merger Option
A merger is the term used when two companies A derivative giving the buyer the right, but not
of similar size come together to form a single, the obligation, to buy or sell an asset in the
combined entity. This is typically achieved by a future.
share for share exchange.
Ordinary Share
Monetary Policy Committee (MPC) Alternatively referred to as common stock,
Committee run by the Bank of England that sets persons owning ordinary shares (ordinary
UK interest rates. shareholders) are the owners of the company.
They tend to benefit when a company does
Multilateral Trading Facilities (MTFs) well from a combination of the value of the
shares increasing (capital gains) and the receipt
Systems that bring together multiple parties
of income, in the form of variable dividends.
that are interested in buying and selling financial
instruments including shares, bonds and
Over-the-Counter (OTC)
derivatives.
Transactions between banks and their
Net Redemption Yield (NRY) counterparties not on a recognised exchange.

Similar to the GRY in that it takes both the annual Passive Management
coupons and the profit (or loss) made through to
In contrast to active management, passive
maturity into account, however, the NRY looks
management is an investment approach that
at the after-tax cash flows rather than the gross
does not aspire to create a return in excess of a
cash flows. As a result, it is a useful measure for
benchmark index. The approach often involves
tax-paying, long-term investors.
tracking the benchmark index.
Nominal Value
Pre-Emption Rights
The amount on a bond that will be repaid on
The rights accorded to ordinary shareholders
maturity, sometimes known as the face or par
to subscribe for new ordinary shares issued
value. Also applied to shares in some jurisdictions
by the company in proportion to their current
and representing the minimum that the shares
shareholding.
are issued for.
Preference Share
Nominee
Shares which usually pay fixed dividends but do
A nominee is the party holding legal ownership
not have voting rights. Preference shares have
of securities, such as shares, on behalf of another
preference over ordinary shares in relation to the
beneficial owner.
payment of dividends and in default situations.

300
 Glossary

Premium Repo
An excess amount being paid, such as the excess The sale and repurchase of securities between
paid for a convertible bond over the market value two parties: both the sale and the repurchase
of the underlying shares it can be converted into. agreement are made at the same time, with the
The term is also used for the amount of cash purchase price and date fixed in advance.
paid by the holder of an option or warrant to the
writer in exchange for conferring a right. Retail Prices Index (RPI)
The RPI is a historic measure of inflation faced by
Producer Prices Indices (PPI) consumers. It has subsequently been superseded
A producer price index (PPI) is an inflation index by the Consumer Prices Index (CPI), but is still
that measures price changes faced by producers, used for some purposes, such as the calculation
rather than consumers. An increase or decrease of the uplift for some index-linked gilts.
in the PPI is thought to be a precursor to an
increase or decrease in the CPI. Rights Issue
The issue of new ordinary shares to a company’s
Prospectus
shareholders, in proportion to each shareholder’s
A detailed document about a company that existing holding. The issue is made in accordance
is issuing securities. If it relates to an IPO, it with the shareholders’ pre-emptive rights and the
will include all of the information to enable new shares are usually offered at a discounted
prospective investors to decide on the merit of price to that prevailing in the market. This means
the company’s shares. that the rights have a value, and can be traded
‘nil-paid’.
Proxy
Appointee who votes on a shareholder’s behalf Scrip Issue
at company meetings. Another term for a bonus or capitalisation issue.

Real Estate Investment Trust (REIT) Share Buyback

An investment trust that specialises in investing The purchase and, typically, the cancellation by
in commercial property. a company of a proportion of its ordinary shares.

Redemption Share Capital

The repayment of principal to the holder of a The nominal value of a company’s equity or
redeemable security. ordinary shares. A company’s authorised
share capital is the nominal value of equity
Registrar
the company may issue, while the issued share
The official who maintains the share register on capital is that which the company has issued. The
behalf of a company. term share capital is often extended to include a
company’s preference shares.
Reinsurance
Insurance purchased by an insurer against the Short Position
risks that it may have to pay out on the policies it The position following the sale of a security not
has underwritten. Effectively enables insurers to owned, or selling a derivative.
transfer some of their risks to other insurers.

301
Special Purpose Vehicle (SPV) Two-Way Price
Bankruptcy-remote, off-balance-sheet vehicle set Prices quoted by a market maker at which they
up for a particular purpose such as buying assets are willing to buy (bid) and sell (offer).
from the originator and issuing asset-backed
securities (ABSs). Underwriting
When financial institutions, such as banks,
Special Resolution insurers and asset managers, agree to buy
Proposal put to shareholders requiring 75% of securities being issued (for example, in an IPO) if
the votes cast in order to be accepted. demand is otherwise insufficient.

Stock Split Unit Trust

A method by which a company can reduce the A vehicle whereby money from investors is
market price of its shares to make them more pooled together and invested collectively on
marketable without capitalising its reserves. A their behalf. Unit trusts are open-ended vehicles.
share split simply entails the company reducing
the nominal value of each of its shares in issue Yield
while maintaining the overall nominal value of its Income from an investment expressed as a
share capital. A share split should have the same percentage of the current price.
impact on a company’s share price as a bonus
issue. Yield Curve
The depiction of the relationship between the
Swap yields and the maturity of bonds of the same
An over-the-counter (OTC) derivative whereby type.
two parties exchange a series of periodic
payments based on a notional principal amount Zero Coupon Bonds (ZCBs)
over an agreed term. Swaps can take a number Bonds issued at a discount to their nominal
of forms including interest rate swaps, currency value that do not pay a coupon but which are
swaps, credit default swaps (CDSs) and equity redeemed at par on a pre-specified future date.
swaps.

Takeover
A takeover is the term used when one company
(the predator) takes over another company (the
target) by buying the majority of the target
company’s shares. Takeovers can be friendly
(where the directors of the target support the
takeover bid), or hostile (where the directors of
the target do not support the takeover bid).

Treasury Bills (T-bills)

Short-term (often three months) borrowings of
the government. Issued at a discount to the
nominal value at which they will mature. Traded
in the money market.

302
Multiple Choice
Questions
304
 Multiple Choice Questions

1. A bond with a 4% coupon, redeemable in five years’ time, is currently trading at 105. Which of the
following is most accurate in terms of the limitation of using the flat yield to assess whether or not
to invest in this bond?
A. The flat yield includes the annualised gain through to redemption of the bond
B. The flat yield includes the annualised loss through to redemption of the bond
C. The flat yield ignores the gain through to redemption
D. The flat yield ignores the loss through to redemption

2. Which best describes the purpose of stabilisation in the conduct of an initial public offering (IPO)?
A. To coordinate the marketing activities of the origination syndicate so that they are not
disjointed
B. To ensure that pension funds are treated equally in the numbers of shares offered to them in
an initial public offering
C. To ensure that the prices of the new issue increase after the initial public offering
D. To prevent a substantial fall in the value of securities by buying back securities in the market

3. The risk-free rate of return is best described as the rate of return:

A. offered by large corporations which have no previous history of default
B. on government bonds and short-term debts
C. from a well-diversified and balanced portfolio
D. on any investment with a AAA rating (or equivalent) from all three large credit rating agencies

4. What is the maximum period during which a special ex trade can normally be transacted and who
is entitled to receive the dividend?
A. In the two business days before the ex-dividend date with the seller entitled to the dividend
B. In the two business days before the ex-dividend date with the buyer entitled to the dividend
C. In the ten business days before the ex-dividend date with the buyer entitled to the dividend
D. In the ten business days before the ex-dividend date with the seller entitled to the dividend

5. The exchange rate on which of the following currency pairs is considered a cross rate?
A. The British pound and the Swiss franc
B. The British pound and the US dollar
C. The US dollar and the Australian dollar
D. The Swiss franc and the US dollar

305
6. How does continuous linked settlement (CLS) reduce the settlement risk for foreign exchange
transactions?
A. By adopting a PvP system
B. By collecting margin from both participants to a trade
C. By requiring collateral in the form of investment grade bonds
D. By only allowing the biggest banks to participate

7. Which of the following best distinguishes the operations of the New York Stock Exchange (NYSE)
and the London Stock Exchange (LSE)?
A. The NYSE is the US listing authority, the LSE is not the UK’s listing authority
B. The LSE is primarily quote-driven, the NYSE is primarily order-driven
C. Only the NYSE operates an open-outcry system
D. The presence of dark pools as off-exchange facilities are only provided by the NYSE

8. If interest rates were to rise in the UK, what would one expect to be the effect on the price and yield
of gilts?
A. Price and yield would remain the same
B. Price would fall and yield would rise
C. Price would fall and yield would fall
D. Price would rise and yield would fall

9. Which of the following ranks lowest in the order of priority in a liquidation?

A. Senior debt
B. Preferred shares
C. Payment-in-kind (PIK) debt
D. Subordinated debt

10. All of the following are true of the foreign exchange market, except:
A. banks are the major market participants
B. spot and forward contracts are available
C. central bank authorisation is required for the acquisition of foreign currencies by local
residents
D. deals for delayed settlement are allowed

11. Which of the following measures is used as a target for the UK Monetary Policy Committee in
relation to inflation?
A. Retail Prices Index
B. Retail Prices Index excluding mortgage payments
C. Producer Prices Index
D. Consumer Prices Index

306
 Multiple Choice Questions

12. Under Financial Conduct Authority (FCA) regulations, which of the following is the level at which
an investor is first judged to have a notifiable interest in a public company? If they hold voting
rights that amount to:
A. 1%
B. 3%
C. 5%
D. 9.9%

13. Which of the following types of fund typically sees the manager hold a stake in the fund?
A. Pension fund
B. Insurance fund
C. Mutual fund
D. Hedge fund

14. Which of the following best describes the action that an investor should take in relation to a rights
issue if they want to retain influence over the company at the same level?
A. Take up the rights in full
B. Sell the rights nil-paid
C. Sell part of the rights nil-paid and use the proceeds to buy shares
D. Take no action

15. £100 nominal of a convertible loan stock carries the right to convert into 50 ordinary shares. The
current market price of the convertible is £107 and the ordinary share price is £1.85. The conversion
premium is therefore:
A. 15.7%
B. 16.2%
C. 10.1%
D. 13.5%

16. US Treasury-issued long bonds have maturities of:

A. 10 years
B. 15 years
C. 20 years
D. 30 years

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17. Which type of security has the characteristic that it is an anonymous, freely transferable share
certificate?
A. A bearer share
B. A preference shareholder’s certificate
C. An accumulation share
D. A share that pays dividends quarterly

18. Private placements which are allowed to proceed without a full prospectus can only be made
available to which of the following types of investors?
A. Member firms of the local stock exchange
B. Pension funds
C. Hedge funds
D. Qualified investors

19. Which of the following best describes the income statement?

A. A summary statement of generation and spending of cash over the accounting period
B. A summary of the income earned and expenses incurred over the accounting period
C. A report from the directors regarding their forecast of the expected revenues in the next fiscal
year
D. A snapshot of the financial position as at the year-end

20. What is the present value of a 4% annual coupon-paying $100 nominal bond with two years to
maturity, with a prevailing discount rate of 1%?
A. $98.73
B. $100
C. $105.91
D. $104.12

21. Which of the following best describes the STRIPS market? It is the market for:
A. zero coupon bonds
B. bonds trading cum interest/dividend
C. bonds trading ex interest/dividend
D. the individual cash flows on a government bond

22. How does a regulated fund differ from an unregulated fund?

A. Only regulated funds are legal
B. Only regulated funds can be marketed
C. Unregulated funds have marketing restrictions
D. Unregulated funds are run by unauthorised persons

308
 Multiple Choice Questions

23. Which of the following order types used for exchange order books provides some of the
characteristics now demanded by users of dark pools?
A. Limit order
B. Iceberg order
C. Fill or kill order
D. Execute and eliminate order

24. A fund wants to invest in bonds that are relatively risky to capture as high a yield as possible, but
does not want to venture into ‘junk’ bond territory. Which of the following credit ratings is likely to
be most attractive?
A. A+
B. A–
C. BBB–
D. BB+

25. A summary statement of payments and receipts over an accounting period is:
A. a statement of cash flows
B. a statement of financial position
C. a report from the directors regarding the financial prospects for the company
D. an income statement

26. What term is given to the risk that the overall market in general will rise or fall as economic
conditions and other market factors change?
A. Systemic risk
B. Systematic risk
C. Liquidity risk
D. Inflation risk

27. What is a special purpose vehicle (SPV)?

A. A totally separate ‘off-balance-sheet’ entity which does not require the guarantee of the
asset’s originator
B. A vehicle which is created offshore to avoid corporate taxation
C. A special investment vehicle which is underwritten by a sovereign guarantee
D. An ‘off-balance-sheet’ entity which would be legally required to be taken back on to the
originator’s balance sheet in the case of the assets becoming distressed

309
28. All of the following would be considered examples of capital expenditure, except:
A. money spent to buy a non-current asset
B. the purchase of a new office building
C. the purchase of copyrights from another company
D. a payment to an investment bank for advice on an acquisition

29. XYZ announces a 1 for 4 rights issue. The cum-rights share price is $4.50 and the right enables
shares to be purchased at $3.20 each. What is the theoretical ex-rights price?
A. $1.04
B. $1.30
C. $4.24
D. $12.80

30. If an investor wishes to avoid the administrative tasks involved with share registration and transfers
title to a nominee, which of the following is true?
A. The nominee becomes the beneficial owner while the investor retains legal ownership
B. The nominee or custodian will become the beneficial owner of the shares
C. The nominee will become the legal owner of the shares and keep all dividends
D. The nominee will become the legal owner but the investor will remain as the beneficial owner
and be entitled to receive all dividends

31. In an underwriting event, where share demand is insufficient and there are more shares issued
than there is demand for, what happens to ensure the issue is still successful?
A. The issue will be cancelled
B. The issuer will issue shares and then buy its own shares back
C. The financial institution responsible for distributing the shares (underwriter) will buy them
D. The regulator will buy them and attempt to re-sell them at a later date

32. Which of the following correctly identifies the longest-term debt instrument issued by the German
Government?
A. German Treasury note
B. Schatz
C. Bund
D. Eurobond

310
 Multiple Choice Questions

33. All of the following major stock indices are capitalisation-weighted, except the:
A. FTSE 100 Index
B. Standard & Poor’s 500 Index
C. Dow Jones Industrial Average
D. Nasdaq Composite Index

34. Which entity is responsible for determining the maturities of debt issued by the UK Government
and its date of issuance?
A. Bank of England
B. Debt Management Office
C. HM Revenue & Customs
D. Financial Conduct Authority

35. Which of the following arranges deals in investments for retail investors without giving any advice?
A. Investment banks
B. Insurance companies
C. Execution-only stockbrokers
D. Wealth managers

36. An inability for investors to sell a security easily, with a wide spread between bid and ask, is best
described as which of the following?
A. Liquidity risk
B. Default risk
C. Inflation risk
D. Market risk

37. Which of the following would be a reason for holding shares in a designated rather than a pooled
nominee account?
A. The shareholder retains the right to vote
B. The shareholder requires any dividends to be mandated to a particular bank account
C. Shareholder benefits are made available to the investor with a designated account
D. Transaction charges are lower for a designated account

38. Which of the following ratios effectively provides a yield for the whole company being analysed?
A. Return on capital employed
B. Debt to equity
C. Enterprise value to EBIT
D. Gross dividend yield

311
39. Which of the following best describes the purpose of the primary market?
A. To allow providers of capital to purchase new securities which are made available from new
issuers
B. To allow institutional investors to buy shares that they have not previously owned
C. To allow speculators and traders to provide liquidity for those requiring large-scale portfolio
rebalancing
D. To allow the calculation of the daily value of the stock indices

40. Which of the following measures of profit is stated after deduction of only the cost of goods sold?
A. Gross profit
B. Operating profit
C. Revenue
D. Net income

41. Which of the following combinations of two shares in a portfolio will give zero diversification
benefits? Two shares that are:
A. perfectly positively correlated
B. perfectly negatively correlated
C. positively correlated
D. negatively correlated

42. Which of the following holds ownership via a nominee name with a unique identifier for each
individual client?
A. Pooled nominee
B. Omnibus nominee
C. Designated nominee
D. Sole nominee

43. Which of the following clearing and settlement models involves gross settlement of securities
followed by net settlement of funds?
A. BIS model 1
B. BIS model 2
C. BIS model 3
D. The sub-custodian model

312
 Multiple Choice Questions

44. Which of the following best describes the straight line method of depreciation?
A. An annual charge equal to the cost of a non-current asset
B. An annual charge to match the cost of a non-current asset in equal amounts over its useful
economic life
C. An annual payment made into a deposit account to cover the deterioration in the performance
of a company’s asset
D. An annual charge to represent the opportunity cost of the loss of interest as a result of
purchasing a non-current asset

45. Agreeing procedures for settling a transaction typically forms part of which stage of the clearing
and settlement process?
A. Matching
B. Clearing
C. Settlement
D. Post-settlement

46. Which of the following types of corporate debt is likely to offer the highest rate of interest?
A. Senior unsecured
B. Mezzanine
C. Senior secured
D. Subordinated

47. Which of the following would form part of a passive rather than an active portfolio management
strategy?
A. Short-selling securities that are overvalued
B. Hedging an existing holding using an over-the-counter (OTC) forward to take advantage of
price movements outside normal trading hours
C. Selecting securities based on quantitative research and the P/E ratios of companies within
selected sectors
D. Buying index-based equity derivatives to emulate the FTSE 100

48. Which of the following measures is the same as the internal rate of return of a bond?
A. Modified duration
B. Convexity
C. Flat yield
D. Gross redemption yield

313
49. Which of the following is the standard settlement timetable for equity transactions in most
developed markets?
A. T+1
B. T+2
C. T+3
D. T+5

50. Becker inc shares are trading at 90 cents. Becker decides to undertake a reverse stock split with
each share representing six previously existing shares. What is the new share price likely to be?
A. $0.15
B. $1.50
C. $5.40
D. $36.00

51. Which of the following is a passive strategy for investing in bonds to meet a future liability?
A. Riding the yield curve
B. Anomaly switching
C. Policy switching
D. Barbell strategy

52. An investment bank is organising the execution of client orders on its own account on a frequent,
systematic and substantial basis. How would the investment bank be described under MiFID?
A. A regulated market
B. A multilateral trading facility
C. A national securities exchange
D. A systematic internaliser

53. If demand for a new issue is insufficient, who typically buys the remaining shares?
A. The issuing company
B. The lead manager
C. The underwriter
D. The secondary market
54. A company has a 1-for-3 rights issue at £2.00 per share. Immediately before the announcement the
share price was £6. What is the nil-paid value of the rights?
A. £2
B. £3
C. £5
D. £6

314
 Multiple Choice Questions

55. How frequently are coupons paid on German Government bunds?

A. Never
B. Quarterly
C. Semi-annually
D. Annually

56. The following are reasons for scrip issues, except:

A. raising money for acquisitions
B. as a public relations exercise
C. to reduce the current market price
D. to tidy up shareholders’ funds

57. The following are terms used to describe off-exchange trading venues where stocks are traded in
large quantities without prices being displayed until after the trade is done, except:
A. Dark pools
B. ATSs
C. MTFs
D. MiFIDs

58. When the yield curve is described as inverted, which of the following is most likely to be true?
A. Long-term corporate bonds are yielding less than the equivalent government bonds
B. Short-term corporate bonds are yielding less than the equivalent government bonds
C. Long-term government bond yields are higher than short-term government bond yields
D. Short-term bond government yields are higher than long-term government bond yields

59. How does the majority of corporate bond secondary market trading take place?
A. Stock exchange order-driven system
B. Stock exchange quote-driven system
C. Decentralised dealer market
D. The original issuers of the bonds

60. A medium-term note that is sold to an investor after the investor requests a certain quantity and
price is generally referred to as:
A. selective marketing
B. a reverse inquiry
C. an auction
D. a tender offer

315
61. If a company writes an option to issue more than a base number of shares in an initial public
offering (IPO), it is usually called which one of the following?
A. Greenshoe
B. Follow-on
C. Underwriting
D. Syndication

62. Which government issues BTFs into its money markets?

A. UK
B. Germany
C. US
D. France

63. Which of the following is a cash flow that impacts the equity, but not the enterprise?
A. Sale of a building
B. Receipts from customers
C. Purchase of an intangible
D. Payment of interest on borrowings

64. A hybrid system:

A. includes both buy and sell orders
B. trades both bonds and equities
C. involves investment banks and fund managers
D. combines quote-driven and order-driven trading

65. Which of the following best describes the dirty price of a bond?
A. The price quoted in the market
B. The price that ignores any accrued interest
C. The price that includes any accrued interest
D. The par value of the bond

66. A bond issued by VPN plc pays a 4% coupon and redeems in five years. It also provides the holder
with the right, but not the obligation, to hand back the bond and accept five shares in DEF plc
instead. How would the bond be best described?
A. A convertible bond
B. An exchangeable bond
C. A preferred equity
D. A bond with warrants attached

316
 Multiple Choice Questions

67. Which of the following is generally considered to be most risky?

A. Small company shares

B. Large company shares
C. Bonds
D. Money market instruments

68. A preference share that will carry forward the right to dividends unpaid and can also be bought
back by the issuing company at particular times, is best described as:
A. cumulative and convertible
B. cumulative and participating
C. cumulative and redeemable
D. convertible and participating

69. Which of the following is most involved in the due diligence of the prospectus for a new issue of
shares?
A. The corporate broker
B. The PR consultant
C. The reporting accountants
D. The non-executive director

70. What particular issue only crops up in a set of accounts for a group of companies?
A. Goodwill
B. Intangible assets
C. Receivables from other companies
D. Payables to other companies

71. The lowest yielding bonds are likely to come from an issuer rated at:
A. Baa3
B. Caa1
C. Ba1
D. Ba3

72. A client of a stockbroking firm is considering purchasing shares in an already listed company for
the first time. The purchase will most likely be made:
A. in the primary market
B. in the secondary market
C. from the company
D. from the stockbroking firm

317
73. A company has a 1-for-5 rights issue at £3.00 per share. Immediately before the announcement the
share price was £6.00. What is the theoretical ex-rights price?
A. £2.50
B. £3.00
C. £5.50
D. £6.00

74. Which of the following is the name of the German Government bond that is issued with a five-year
maturity?
A. OAT
B. BTAN
C. Bund
D. Bobl

75. Which of the following best describes stabilisation?

A. Supporting the price of newly issued securities in the aftermarket
B. Keeping the price of securities at the same level
C. Preventing shares from being removed from the stock market index
D. Selecting a variety of shares from the same industry in a portfolio

76. Dale inc shares are currently trading at $120 each. Dale decides it is appropriate to split the shares
on the basis of three new shares for each share. What is the most likely resultant share price?
A. $30
B. $36
C. $40
D. $360

77. Which of the following US equity indices would give more influence to a higher-priced stock,
regardless of that stock’s market capitalisation?
A. DJIA
B. S&P 500
C. Nasdaq Composite
D. Wilshire 5000

78. Which of the following is true of a trade executed via an inter-dealer broker (IDB)?
A. The deal price is never revealed
B. The deal is always done via a dark pool
C. The deal is settled as if the IDB was the principal
D. The deal involves a large-cap stock

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 Multiple Choice Questions

79. A company has two types of share in issue: ‘A’ and ‘B’ shares. Both classes of share have voting
rights and the right to receive dividends determined by the company. Neither share type has
a fixed entitlement to dividends and both classes rank equally in respect of dividend payment
priority. The ‘A’ shares are entitled to ten votes per share and the ‘B’ shares are entitled to one vote
per share. How would the two shares best be described?
A. As types of ordinary share
B. As types of preference share
C. The ‘A’ shares as preference shares and the ‘B’ shares as ordinary shares
D. The ‘B’ shares as preference shares and the ‘A’ shares as ordinary shares

80. What is the term typically used for an issue of securities that involves marketing to a preselected
group of potential investors, rather than investors generally?
A. Follow-on offer
B. IPO
C. Greenshoe
D. Placing

81. Spencer plc’s 4% ten-year bonds are yielding a 45 basis points spread over the relevant ten-year
government bond that is yielding 3.80%. Ten-year swaps are currently 4.15%. What are Spencer’s
bonds yielding in relation to swaps?
A. Plus 10 basis points
B. Minus 15 basis points
C. Plus 25 basis points
D. Plus 60 basis points

82. The allocation of the estimated cost of an intangible asset as it is used up over its useful economic
life is known as which of the following?
A. Amortisation
B. Depreciation
C. Revaluation
D. Owners’ equity

83. If bond A has a significantly higher modified duration than bond B, which of the following is true?
A. Bond A has a higher coupon than bond B
B. Bond A has a shorter maturity than bond B
C. Bond A has a higher credit rating than bond B
D. Bond A is more responsive to interest rate changes than bond B

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84. A fund manager wishing to hedge exposure to risk arising from long equity positions is most likely
to do which of the following?
A. Buy futures contracts
B. Buy put options
C. Buy call options
D. Effectively buy using CFDs

85. How is cash at the bank normally classified within a company’s statement of financial position?
A. As a non-current asset
B. As a current asset
C. As a liability
D. As part of equity

86. Which of the following types of organisation typically offers corporate finance advice, securities
trading and merger and acquisition assistance?
A. Wealth managers
B. Financial planners
C. Investment banks
D. Custodian banks

87. In a large new listing, which of the following is the term for the firm that book builds?
A. Syndicate
B. Lead manager
C. Issuer
D. Primary adviser

88. A company has reduced its activities and wants to reorganise its capital structure to include more
debt and less equity. Which of the following corporate actions is likely to be most appropriate?
A. Share buyback
B. Rights issue
C. Bonus issue
D. Placing

89. Which of the following is the type of order that does not specify a price?
A. Market order
B. Limit order
C. Iceberg order
D. Execute and eliminate order

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 Multiple Choice Questions

90. Which of the following best describes the features of subordinated debt?
A. The yields are higher than senior debt, the bonds rank above equity in a liquidation
B. The yields are lower than senior debt, the bonds rank above equity in a liquidation
C. The yields are higher than senior debt, the bonds rank below equity in a liquidation
D. The yields are lower than senior debt, the bonds rank below equity in a liquidation

91. What is the normal priority that is given to orders on an order-driven trading system?
A. Price and then time
B. Time and then price
C. Quantity and then price
D. Frequency and then price

92. The foreign exchange market is best described as which of the following?
A. An over-the-counter market, with no central exchange or clearing house
B. An exchange-driven market, centred in London, New York and Hong Kong
C. A market exclusively provided by a small number of major multinational banks
D. A market that only trades the major currencies – the US dollar, euro, sterling and the yen

93. Under an offer for sale agreement, what party is responsible for soliciting potential investors for
the new issue?
A. The issuer
B. The issuing house
C. The company’s board of directors
D. The regulatory authority

94. Which of the following institutional investors is most likely to hold the highest proportion of
money market instruments in its portfolio?
A. General insurance fund
B. Defined benefit pension fund
C. Defined contribution fund
D. Life assurance fund

95. All of the following are expenses charged in the income statement, except:
A. corporation tax
B. costs of sales
C. finance costs
D. dividends

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96. A share premium account is classed within what sub-element of equity?
A. Share capital
B. Capital reserves
C. Revenue reserves
D. Minority interests

97. Combining securities with a less than perfect positive correlation in a portfolio will remove some of
which of the following risks?
A. Unsystematic risk
B. Market risk
C. Systematic risk
D. Political risk

98. All of the following are headings within a cash flow statement under IAS 7, except:
A. operating activities
B. investing activities
C. financing activities
D. depreciating activities

99. A company applies for a listing and becomes listed without selling any shares in the primary or
secondary markets. How is this process typically described?
A. Placing
B. Reverse takeover
C. Over-allotment
D. Introduction

100. All of the following are generally viewed as key benefits of utilising a central counterparty, except:
A. providing anonymity
B. avoiding the need for exchange membership
C. facilitating netting
D. reducing administration

322
 Multiple Choice Questions

Answers to Multiple Choice Questions

1. D Chapter 2, Section 2.2.1

The buyer of this bond will suffer a loss through to redemption since the price at 105 is above par.
However, the flat yield ignores the loss since it just takes into account the coupon divided by the price.

2. D Chapter 4, Section 2.4

To prevent a substantial fall in the value of securities when a large number of new securities are issued,
the lead manager of the issue agrees to support the price by buying back the newly issued securities in
the market if they should drop below an agreed-upon minimum price.

3. B Chapter 2, Section 3.1

In standard financial theory it is the rate of return on government bonds and short-term debts because
of the low chance that governments will default on their loans.

4. D Chapter 7, Section 6
A special cum-trade can be arranged any time during the ex-dividend period. A special ex-trade,
however, is generally only possible in the ten business days before the ex-date.

5. A Chapter 2, Section 8.1

A cross rate is between two currencies that do not include the US dollar.

6. A Chapter 7, Section 7
CLS adopts a system known as payment versus payment.

7. C Chapter 5, Section 2.1

The trading floor at the London Stock Exchange has been closed for decades. A relatively minor part of
trading on the NYSE is still operated on an open-outcry basis in Wall Street.

8. B Chapter 2, Section 2.2.1

An interest rate rise will mean that the yield on bonds will need to rise too, and the change in yield is
brought about by a reduction in the price of the bond.

9. B Chapter 9, Section 1.11

Preferred shares will rank above ordinary/common shares but below forms of debt in a liquidation.

10. C Chapter 2, Section 8

There is no requirement for central bank authorisation. For example, anyone can buy or sell currencies
at a foreign exchange booth in an airport.

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11. D Chapter 2, Section 3.2.3
In December 2003, the UK’s Chancellor of the Exchequer changed the inflation target to a new base, the
harmonised index of consumer prices (HICP), which has since been renamed the consumer prices index
(CPI).

12. B Chapter 6, Section 4.2

Notifiable interests in the UK begin at 3% or more of the voting rights.

13. D Chapter 9, Section 1.8.4

Both hedge funds and private equity funds typically see the management having stakes to provide ‘skin
in the game’.

14. A Chapter 6, Section 3.1

The investor would have to buy all of their rights in order to retain the same percentage in the enlarged
share capital.

15. A Chapter 2, Section 2.3.2

To calculate the premium, take the value of the bond (£107) and divide it by the value of the shares the
bond could be converted into, ie, (50 x 185p) = £92.50. The answer is therefore 107 divided by 92.50
which is 1.157, so the bond is worth 1.157 times the value of the shares into which it could be converted:
a 15.7% premium.

16. D Chapter 2, Section 3.4

The US long bond has a maturity of 30 years.

17. A Chapter 7, Section 4

Since the issuer maintains no register for bearer shares, it does not record the seller or the buyer.

18. D Chapter 4, Section 1.4.1

Private placements can only be made available to ‘qualified investors’ as specified by the financial
services regulator.

19. B Chapter 8, Section 1.1

The income statement summarises the income earned and expenses incurred over the accounting
period.

20. C Chapter 2, Section 2.6

Y1 = 100 x 4% x (1 ÷ 1.01) = 3.96
Y2 = 104 x (1 ÷ 1.01²) = 101.95
Present value = 3.96 + 101.95 = 105.91

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 Multiple Choice Questions

21. D Chapter 2, Section 3.3

STRIPS is an acronym for Separate Trading of Registered Interest and Principal of Securities and enables
a bond’s individual cash flows – the coupons and the principal – to be traded separately.

22. C Chapter 2, Section 9.1

Authorisation by the regulator removes some of the marketing restrictions that apply to an unregulated
or unauthorised fund. Both regulated and unregulated funds are legal, and tend to be run by authorised
persons.

23. B Chapter 5, Section 3.2

Iceberg orders enable a market participant with a particularly large order to partially hide the size of
their order from the market and reduce the market impact that the large order might otherwise have.

24. C Chapter 2, Section 4.3

The minimum acceptable investment grade from S&P and Fitch is BBB–, and BB+ is below investment
grade.

25. A Chapter 8, Section 4.1

The summary statement of payments and receipts over an accounting period is known as the statement
of cash flows.

26. B Chapter 9, Section 1.6

Systematic risk or market risk is the risk that the overall market will rise or fall, as economic conditions
and other market factors change.

27. A Chapter 2, Section 4.1.3

There is normally no legal requirement for the originator to support the assets in an SPV. However,
when the assets become distressed, or if there is no market for determining the value of the assets held
in the SPV, as was the case during the ‘sub-prime’ crisis of 2007/8, the originators of the securitisation
instruments have occasionally chosen to fully transfer the troubled assets on to their primary balance
sheets for reputational reasons.

28. D Chapter 8, Section 3.2

The payment to the investment bank would be considered as professional fees and not part of the
capital expenditure which would be incurred in an acquisition. The consideration paid to the acquired
company for an acquisition would, however, be a capital expenditure.

29. C Chapter 6, Section 3.1.2

Theoretical ex-rights price = (4 x 4.50) + (1 x 3.20) ÷ 5 = $4.24.

30. D Chapter 7, Section 4

The nominee will become the legal owner but the investor will remain as the beneficial owner of the
shares and be entitled to receive all dividends.

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31. C Chapter 4, Section 2.3
Essentially, underwriting is the issuer agreeing with the financial institution underwriting the offer
(bank, insurance company) that, if the demand for shares is insufficient, the underwriter will buy the
shares.

32. C Chapter 2, Section 3.4

A Bund is the longest-term debt instrument issued by the German Government.

33. C Chapter 5, Section 4.3

The Dow Jones Industrial Average is not capitalisation-weighted and as an example of a price-weighted
average it gives higher-priced stocks more influence than their lower-priced counterparts.

34. B Chapter 4, Section 4.2

The Debt Management Office, which is an executive agency of HM Treasury, is responsible for deciding
on what are the most appropriate maturities for gilts and their dates of issuance.

35. C Chapter 1, Section 3

Execution-only brokers give no advice, but simply offer trading services to retail clients. They earn their
profits by charging commissions on the transactions arranged.

36. A Chapter 9, Section 1.1.1

Liquidity risk is the inability to sell easily with the market displaying a wide spread between buying and
selling prices.

37. B Chapter 7, Section 5

One reason for registering shares in a designated or sole nominee name would be to enable the
underlying investor to have dividends mandated to a particular bank account rather than collected by
the custodian.

38. A Chapter 8, Section 5.2.2

It is the ROCE that effectively provides a yield – operating profit expressed as a percentage of capital.

39. A Chapter 3, Section 1

The primary market allows providers of capital to purchase new securities, usually conducted through
IPOs, which are made available from new issuers of securities.

40. A Chapter 8, Section 3.1.3

Gross profit is the profit after deducting the cost of sales or the cost of goods sold.

41. A Chapter 9, Section 1.7.2

Combining perfectly positively correlated investments gives no diversification benefits.

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 Multiple Choice Questions

42. C Chapter 7, Section 5.3

It is the designated nominee that involves a unique identifier rather than the actual client name (which
is used in the sole nominee).

43. B Chapter 7, Section 2.2

The three BIS models all provide delivery versus payment terms. Model 1 involves gross simultaneous
settlements of securities and funds, Model 2 gross settlement of securities transfers followed by net
settlement of funds and Model 3 simultaneous net transfers of securities and funds. There is no sub-
custodian model for clearing and settlement.

44. B Chapter 8, Section 2.3

Straight line depreciation is an annual charge to match the cost of a non-current asset and which is
applied in equal amounts over the useful economic life of the asset.

45. B Chapter 7, Section 1

Agreeing procedures for settling a transaction is one part of the clearing process, alongside matching
and confirming details.

46. B Chapter 9, Section 1.11.1

Mezzanine debt, including PIK notes, ranks below other forms of debt but above equity in the event
of a liquidation. As the most risky debt, it will offer a greater rate of interest than the subordinated and
senior levels of debt.

47. D Chapter 9, Section 1.9

Passive management requires the construction of an equity portfolio to track, or mimic, the performance
of a recognised equity index. Using index-based derivatives can emulate the total returns without
requiring an outright purchase of all of the stocks in the index.

48. D Chapter 2, Section 2.2.2

The gross redemption yield provides the ‘internal rate of return’ of the bond. The internal rate of return
is simply the discount rate that, when applied to the future cash flows of the bond, produces the current
price of that bond.

49. B Chapter 7, Section 2.1

In most developed equities markets, the settlement of equity trades is T+2.

50. C Chapter 6, Section 2.3

Since 6 x 90 cents shares form each new share, the new share price should be $5.40.

51. D Chapter 9, Section 1.9.4

A barbell strategy is a passive strategy that involves creating a portfolio containing bonds with durations
either side of the future liability.

327
52. D Chapter 5, Section 1.1
Under MiFID, systematic internalisers are investment firms that execute client orders on their own
account on a frequent, systematic and substantial basis.

53. C Chapter 4, Section 1.1

It is usual for new issues to be underwritten. The underwriter will then buy any unsold shares at a
contracted price which may be at a discount to the offer price.

54. B Chapter 6, Section 3.1.3

Number of shares Value Portfolio value

Starting minimum number of shares
3 £6 £18
at the cum-rights price
Rights share at exercise price 1 £2 £2
Resultant portfolio at average,
4 £5 £20
ex-rights price

Nil-paid value = theoretical ex-rights price less exercise price = £5 – £2 = £3

55. D Chapter 2, Section 3.4

German bunds pay coupons once per year.

56. A Chapter 6, Section 2.2.1

A scrip issue, also known as a bonus issue or capitalisation issue, involves giving shares away for nothing.
Scrip issues will not raise any money.

57. D Chapter 5, Section 1.1

Dark pools are a form of multilateral trading facility and, in Europe, are commonly referred to as
alternative trading systems (ATSs). MiFID is an EU directive.

58. D Chapter 2, Section 2.5.2

The inverted yield curve is where long-term government bond yields are lower than short-term
government bond yields and so the yield curve slopes downwards to the right.

59. C Chapter 5, Section 6.1.3

Secondary market trading of corporate bonds takes place away from the stock exchanges via a
decentralised dealer system.

60. B Chapter 4, Section 4.2

A reverse inquiry is used to describe the situation where a request from an investor results in the issuing
company creating new securities (such as medium-term notes).

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 Multiple Choice Questions

61. A Chapter 4, Section 1.1

The greenshoe is where the issuing company writes an option to increase the number of shares it issues
above a base level. This is in order to stabilise the price in the aftermarket.

62. D Chapter 5, Section 5.1

BTFs are French. The UK has Treasury bills, the US has T-bills and Germany has Bubills.

63. D Chapter 8, Section 4.3

Enterprise cash flow is the cash flow to all of the providers of capital (debt and equity). It does not
include cash flows from, or to, the debt holders.

64. D Chapter 5, Section 2.1

Hybrid trading systems are those that combine both order-driven and quote-driven elements.

65. C Chapter 2, Section 2.3.4

The dirty price of a bond can be best described as the price that includes any accrued interest.

66. B Chapter 4, Section 1.6

An exchangeable bond is able to be exchanged for shares in a company that is not the issuer of the
bond.

67. A Chapter 9, Section 1.2

Equities are generally considered more risky than bonds and money market instruments, and smaller
company shares are more risky than larger, more established company shares.

68. C Chapter 2, Section 1.2

Cumulative preference shares accumulate unpaid dividends and being redeemable means that the
issuer has the right to buy the shares back at a specific point (or points) in the future.

69. C Chapter 4, Section 2.1

The reporting accountants will be attesting to the validity of the financial information contained within
the prospectus. Alongside the legal advisers, it is the reporting accountants that provide the due
diligence.

70. A Chapter 8, Section 1.3

Goodwill only ever appears as an asset in a set of group accounts.

71. A Chapter 2, Section 4.3

All of the credit ratings given are from Moody’s, and the best of the given ratings is Baa3 (Moody’s
lowest investment grade rating). Bonds issued from a company rating at investment grade, rather than
junk, are likely to provide a lower yield.

329
72. B Chapter 2, Section 1
Shares purchased in companies that are already listed are typically arranged by stockbrokers and
purchased from other investors who are willing to sell in the secondary market.

73. C Chapter 6, Section 3.1.2

Number of shares Value Portfolio value

Starting minimum number of shares
5 £6 £30
at the cum-rights price
Rights share at exercise price 1 £3 £3
Resultant portfolio at average,
6 £5.50 £33
ex-rights price

74. D Chapter 2, Section 3.4

The Bobl is issued with a five-year maturity. Bunds are longer-dated German government bonds and
OATs and BTANs are French Government bonds.

75. A Chapter 4, Section 2.4

Stabilisation is the process of supporting the price of newly issued securities, usually by the lead
manager, for a short period after the issue.

76. C Chapter 6, Section 2.3

If shares were trading at $120, a stock split of three new shares for each share would most likely give a
resultant share price of $40.

77. A Chapter 5, Section 4.3

The Dow Jones Industrial Average is price-weighted rather than market-capitalisation-weighted. A
price-weighted average gives higher-priced stocks more influence over the average than their lower-
priced counterparts, but takes no account of the relative market capitalisation of the components. All of
the other options are market-capitalisation-weighted indices.

78. C Chapter 5, Section 2.2

Inter-dealer brokers act as agent for dealers but keep the identities secret by settling as if the IDB was
the principal to the deal.

79. A Chapter 2, Section 1

Although relatively unusual, some companies issue different classes of ordinary shares with the primary
difference being that one class has more voting rights than the other.

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 Multiple Choice Questions

80. D Chapter 4, Section 1.4

A placing is alternatively referred to as a selective marketing. It is where the securities are only offered to
a preselected group of potential investors and not investors in general.

81. A Chapter 2, Section 2.4

Spencer’s bonds are yielding 3.80% + 0.45% = 4.25% which is 10 basis points (0.10%) above the 4.15%
swap rate.

82. A Chapter 8, Section 2.3

The annual expense for using up a non-current asset is termed depreciation if the asset is tangible, and
amortisation if the asset is intangible.

83. D Chapter 2, Section 2.2.4

Modified duration provides the approximate price movement brought about by an interest rate change.

84. B Chapter 9, Section 1.10

Buying futures contracts, call options or buying via CFDs would increase risk by adding more long
positions. Buying put options would reduce the risk.

85. B Chapter 8, Section 2.1

Cash is classified as a current asset within the balance sheet.

86. C Chapter 1, Section 4.1

Investment banks tend to specialise in corporate finance, securities trading and mergers and
acquisitions.

87. B Chapter 4, Section 2.2

The lead manager of the syndicate will coordinate the overall level of demand and allocate buyers – a
process known as bookbuilding.

88. A Chapter 6, Section 4.1

Share buybacks (a company using its own money to buy back shares from existing investors) are typical
in two situations – when the company has reduced its activities (perhaps having sold a major part of its
business) and has surplus cash to return to shareholders, and when the company wants to reorganise its
capital structure to include more debt and less equity.

89. A Chapter 5, Section 3.2

Market orders execute at the market price and do not need to specify a price.

331
90. A Chapter 2, Section 4.2
Subordinated debt is more risky than senior debt, so it will have a higher yield. All bonds rank above
equity in a liquidation.

91. A Chapter 5, Section 3.1.1

Order-driven systems give priority to price first, followed by the time at which the order was submitted.

92. A Chapter 1, Section 2.3

The foreign exchange market is an over-the-counter market with brokers/dealers negotiating directly
with one another. It is distributed among all of the major financial centres and includes thousands of
banks and many currencies.

93. B Chapter 4, Section 1.3

The issuer (the company seeking the offer) approaches the issuing house, ie, the investment bank,
which will approach potential shareholders to distribute the offer. The investment bank will sell the
shares to the public for slightly higher than the price they receive from the issuer. The spread represents
their compensation for distributing the issue.

94. A Chapter 9, Section 2.1.1

General insurance is short-term in nature, so tends to hold the greater proportion of money market
instruments.

95. D Chapter 8, Section 3.1.10

Dividends are not charged within the income statement. Instead, they are shown in the statement of
changes in equity that reconciles the movement in equity from one balance sheet to another.

96. B Chapter 8, Section 2.4

Share premium accounts arise where shares are sold by a company above their nominal value. The
excess is treated as a capital reserve.

97. A Chapter 9, Section 1.7

Less than perfect positive correlation between securities in a portfolio will reduce the unsystematic risk.

98. D Chapter 8, Section 4.1

The cash flow statement is split into three headings: cash from operating activities, investing and
financing. Depreciation is not a cash flow.

99. D Chapter 4, Section 1.5

An introduction is where a company that already meets the requirements for listing becomes listed
without selling any shares.

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 Multiple Choice Questions

100. B Chapter 5, Section 3.3

The existence of a central counterparty does not impact the need for brokers and dealers to be members
of the exchange. A central counterparty does provide anonymity to both sides of the trade, facilitate
netting of transactions in the same security and reduce administration by always settling with the same
(central) counterparty.

333
334
Syllabus Learning Map
336
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section

Element 1 The Financial Services Sector Chapter 1

The Financial Services Sector
1.1
On completion, the candidate should:
know the differences between retail and professional businesses,
including:
• their clients
1.1.1 2
• equity markets
• bond markets
• foreign exchange markets
know the role of the following within the retail sector of the financial
services markets:
• banks
1.1.2 • pension funds 3
• insurance companies
• investment services
• financial planning and advice
know the role of the following within the wholesale sector of the
financial services markets:
• investment banks
1.1.3 4
• fund managers
• stockbrokers
• custodians
1.1.4 know the basic differences between equities and bonds 1.1

Element 2 Asset Classes Chapter 2

Cash Assets
2.1
On completion, the candidate should:
understand the uses, advantages and disadvantages of holding cash
2.1.1 5.1
deposits
understand the features and characteristics of Treasury bills:
• issuer
• purpose of issue
2.1.2 5.2
• minimum denomination
• normal life
• no coupon and redemption at par
know the principal features and uses of commercial paper:
• issuers, including CP programmes
• investors
• discount security
• unsecured
2.1.3 5.3
• asset-backed
• rating
• normal life
• method of issuance
• role of dealer

337
 Syllabus Unit/ Chapter/
Element Section
understand the basic purpose and characteristics of the repo markets:
• repo
2.1.4 • reverse repo 5.4
• documentation
• benefits of the repo market
Shares
2.2
On completion, the candidate should:
Understand the advantages and disadvantages to issuers and
investors of the following investments and their principal features
and characteristics:
• ordinary shares
2.2.1 • non-voting shares 1
• redeemable shares
• partly paid shares and calls
• and, in respect of these, the generally accepted practice
regarding ranking for dividends and voting rights
understand the advantages and disadvantages to issuers and
investors of the following classes of preference/preferred shares and
their principal characteristics:
• cumulative
2.2.2 1.2
• participating
• redeemable
• convertible
• zero coupon preference shares
Debt Instruments
2.3
On completion, the candidate should:
know the principal features and characteristics of debt instruments
2.3.1 2.1
(fixed interest, floating rate and index-linked)
understand the uses and limitations of the following:
• flat yield
2.3.2 • gross redemption yield (using internal rate of return) 2.2
• net redemption yield
• modified duration in the calculation of price change
be able to calculate:
• simple interest income on corporate debt
• conversion premiums on convertible bonds and whether it is
2.3.3 2.3
worth converting
• flat yield
• accrued interest (given details of the day count conventions)
understand the concept of spreads:
2.3.4 • spread over a government bond benchmark 2.4
• spread over/under swap
understand the role of the yield curve and the relationship between
2.3.5 2.5
price and yield with reference to the yield curve (normal and inverted)

338
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
be able to calculate the present value of a bond (maximum two years)
2.3.6 2.6
with annual coupon and interest income
understand the implications of negative interest rates for the bond
2.3.7 2.5.3
market
Government Debt
2.4
On completion, the candidate should:
understand the following features and characteristics of conventional
government debt:
• redemption price
2.4.1 • interest payable 3.1
• accrued interest
• effect of changes in interest rates
• concept of risk-free
understand the following features and characteristics of index-linked
debt:
• index-linking
2.4.2 3.2
• inflation – effects and measurement
• effect of the index on price, interest and redemption
• return during a period of zero inflation or deflation
understand the purpose and characteristics of the strip market:
• advantages, disadvantages and uses
2.4.3 3.3
• result of stripping and reconstituting a bond
• zero coupon securities
understand the characteristics and differences between government
bonds in developed, emerging and frontier markets:
• settlement periods
2.4.4 3.4
• coupon payment frequency
• terms and maturities
• currency, credit and inflation risks
Corporate Debt
2.5
On completion, the candidate should:
understand the principal features and uses of secured debt:
• fixed charges and floating charges
• asset-backed securities
• mortgage-backed securities
2.5.1 4.1
• covered bonds
• securitisation process
• role of the trustee, when involved
• different tiers of bank debt
understand the principal features and uses of unsecured debt:
• subordinated
2.5.2 4.2
• guaranteed
• convertible bonds

339
 Syllabus Unit/ Chapter/
Element Section
understand the principal features and uses of credit ratings:
• rating agencies
• impact on price
2.5.3 • uses and risks of credit enhancements 4.3
• difference between investment grade and sub-investment grade
bonds
• limitations
Eurobonds
2.6
On completion, the candidate should:
understand the principal features and uses of eurobonds:
• issuing process
• bearer
2.6.1 • immobilised in depositories 6
• accrued interest
• ex-interest date
• interest payments
Other Securities
2.7
On completion, the candidate should:
know the principal features and characteristics of depositary receipts:
• American depositary receipts
• global depositary receipts
• means of creation including pre-release facility
2.7.1 7.1
• registration
• rights attached
• dividends
• exchange for underlying shares
know the rights, uses and differences between warrants and covered
2.7.2 7.2
warrants
understand the risks and rewards involved in investment in property
and the differences between the different investment routes:
2.7.3 • direct investment 7.3
• Real Estate Investment Trusts
• open-ended collective funds
Foreign Exchange
2.8
On completion, the candidate should:
know the principal features and uses of spot, forward and cross rates:
• quotation as bid-offer spreads
2.8.1 8.1
• forwards quoted as bid-offer margins against the spot
• quotation of cross rates
be able to calculate spot and forward settlement prices using:
2.8.2 • adding or subtracting forward adjustments 8.2
• interest rate parity

340
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
understand the factors that affect foreign exchange rates:
• freely floating exchange rates
2.8.3 8.3
• purchasing power parity
• currency demand and supply
understand the factors that affect foreign exchange trading and
2.8.4 8.3.2
speculation
2.8.5 know the characteristics of cryptocurrencies 8.3.3
Collective Investments
2.9
On completion, the candidate should:
understand the differences between regulated and unregulated
2.9.1 collective investment schemes and their advantages and 9.1
disadvantages to the issuer and investor
understand the differences between open-ended and closed-
2.9.2 ended collective investment schemes and their advantages and 9.2
disadvantages to the issuer and investor
understand the circumstances under which a collective investment
2.9.3 9.2
scheme may be exchange-traded or offered by a fund manager
understand the circumstances where a collective investment scheme
2.9.4 would be issued under a deed of trust and where it may be company 9.2
or private equity based
Structured Products
2.10
On completion, the candidate should:
know the key features of structured products:
2.10.1 • definition 10
• uses and benefits
2.10.2 Know the components of structured products 10.2
know pay-out structures of structured products:
• callable
• range accruals payoff
2.10.3 • averaging value 10.3
• lookback
• cash or nothing payoff
• quantity adjusting (Quantos)
know the risks associated with structured products:
• credit risk
• income risk
• pay-out structure risk
• market risk
2.10.4 10.4
• liquidity risk
• currency risk
• option risk
• call risk
• counterparty risk

341
 Syllabus Unit/ Chapter/
Element Section
Element 3 Markets Chapter 3
Principal Characteristics
3.1
On completion, the candidate should:
know the principal characteristics of, and the differences between,
the primary and secondary markets. In particular:
3.1.1 • uses of primary and secondary markets 1
• users of primary and secondary markets
• the role of the governing authority

Element 4 Primary Markets Chapter 4

Types of Offer
4.1
On completion, the candidate should:
understand the use of an initial public offering:
• why would a company choose an IPO
4.1.1 • structure of an IPO – base deal plus greenshoe 1.1
• stages of an IPO
• underwritten versus best efforts
understand the use of follow-on offerings:
• why would a company choose a follow-on offering
4.1.2 • structure of a follow-on – base deal plus greenshoe 1.2
• stages of a follow-on offering
• underwritten versus best efforts
understand the use of offers for sale:
• why would a company choose an offer for sale
• structure of an offer for sale
4.1.3 1.3
• stages of an offer for sale
• tenders, strike price, who may receive an allotment, who is
involved in the offer process
understand the basic process and uses of selective marketing and
placing:
• advantages to the issuing company
4.1.4 • what is a placing 1.4
• what is selective marketing
• how is a placing achieved
• how is selective marketing achieved
understand the use of introductions:
• why would a company undertake an introduction
4.1.5 1.5
• structure of an introduction
• stages of an introduction
understand the use of exchangeable/convertible bond offerings:
• the difference between exchangeable and convertible bonds
4.1.6 • structure of an offering – base deal plus greenshoe 1.6
• stages of an offering
• underwritten versus best efforts

342
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Participants Involved with Equity Offerings
4.2
On completion, the candidate should:
understand the role of the syndicate group:
• different roles within a syndicate:
• bookrunner
4.2.1 2.2
• co-lead
• co-manager
• marketing and book building
know the role of advisers:
• listing agent
4.2.2 2.1
• corporate broker
• nominated advisor (nomad)
know the issuer’s obligations:
4.2.3 • corporate governance 2.1
• reporting
understand the purpose and practice of underwriting, rights and
• responsibilities of the underwriter:
4.2.4 2.3
• benefits to the issuing company
• risks and rewards to the underwriter
understand stabilisation and its purpose:
• governing principles and regulation with regard to stabilisation
activity
4.2.5 2.4
• who is involved in stabilisation
• what does stabilisation achieve
• benefits to the issuing company and investors
Stock Exchanges
4.3
On completion, the candidate should:
4.3.1 know the role of stock exchanges and their regulatory frameworks 3
understand the purpose of admission criteria for main markets and
how they can differ from other markets listing smaller companies:
• appointment of advisers and brokers
• transferability of shares
• trading record
4.3.2 3.1
• amount raised
• percentage in public hands
• shareholder approval
• market capitalisation
• costs

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 Syllabus Unit/ Chapter/
Element Section
Bond Offerings
4.4
On completion, the candidate should:
know the different types of issuer:
• supranationals
• governments
4.4.1 • agency 4.1
• municipal
• corporate
• financial institutions and special purpose vehicles
know the methods of issuance:
• scheduled funding programmes and opportunistic issuance,
4.4.2 eg, medium-term notes (MTNs) 4.2
• auction/tender
• reverse inquiry (under MTN)
understand the role of the origination team including:
• pitching
• indicative bid
• mandate announcement
4.4.3 4.3
• credit rating
• roadshow
• listing
• syndication

Element 5 Secondary Markets Chapter 5

Trading Venues
5.1
On completion, the candidate should:
understand the main characteristics and practices in the developed
5.1.1 1
markets
understand the main characteristics and practices in the emerging
5.1.2 1
and frontier markets
understand the purpose, role and main features of stock exchanges
generally. In particular:
• scope
5.1.3 1
• provision of liquidity
• price formation
• brokers versus dealers
understand the purpose, role and main features of alternative trading
venues:
• off-exchange trades
5.1.4 • dark pools 1
• OTC
• private transactions
• multilateral trading facilities

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Syllabus Unit/ Chapter/

Element Section
Methods of Trading and Participants
5.2
On completion, the candidate should:
understand the differences between quote-driven and order-driven
5.2.1 2.1
markets and how they operate
know the functions and obligations of:
• market makers
5.2.2 • broker-dealers 2.2
• inter-dealer brokers
• systematic internalisers
understand algorithmic trading:
• reasons
5.2.3 • consequences of high frequency trading 2.3
• types of company that pursue this strategy
• latency/co-location
understand the main services provided by an equity and fixed income
prime broker, including:
• securities lending and borrowing
• leverage trade execution
5.2.4 2.4
• cash management
• core settlement
• custody
• rehypothecation
Stock Exchanges
5.3
On completion, the candidate should:
understand the rules, procedures and requirements applying to
dealing through the Stock Exchanges’ bespoke electronic systems
and hybrid trading systems relating to:
• order book features
5.3.1 • order management 3.1
• limitations and benefits of trading through bespoke systems
• right to call a halt in trading
• liquidity
• market makers
understand the following order types and their differences:
• market
• limit
• fill or kill
5.3.2 3.2
• all or none
• execute and eliminate
• iceberg
• multiple fills
understand the operation, purpose, benefits and limitations of using
5.3.3 3.3
a central counterparty
understand the concept of stamp duties and other transaction taxes
5.3.4 and costs on securities trades and the potential for their variation 3.4
between types of security

345
 Syllabus Unit/ Chapter/
Element Section
Indices
5.4
On completion, the candidate should:
know how different indices are created and their purpose:
• types of index
• purpose of weighted indices
5.4.1 • purpose of unweighted indices 4
• sector versus national indices
• price return, total return and net total return indices
• the implications of free float on market capitalisation
Government Bonds
5.5
On completion, the candidate should:
know the functions, obligations and benefits of the following in
relation to government bonds:
• primary dealers
5.5.1 5
• broker-dealers
• inter-dealer brokers
• government issuing authorities
Corporate Bond Markets
5.6
On completion, the candidate should:
understand the characteristics of corporate bond markets:
• decentralised dealer markets and dealer provision of liquidity
• the impact of default risk on prices
5.6.1 • the differences between bond and equity markets 6.1
• dealers rather than market makers
• bond pools of liquidity versus centralised equity exchange
• relevance of the retail bond market
Dealing Methods
5.7
On completion, the candidate should:
know the different trading methods for bonds:
• OTC inter-dealer voice trading
• inter-dealer electronic market
5.7.1 7
• OTC customer-to-dealer voice trading
• customer-to-dealer electronic market
• on-exchange trading
understand the different trends between trading methods:
• characteristics of electronic trading:
• OTC
5.7.2 7.2
• exchange-traded
• price-driven via inter-dealer brokers (IDBs) – dealer-to-dealer
• request for quote (RFQ) – customer-to-dealer

346
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
know the factors that influence bond prices:
• issuer factors:
• yield to maturity
• seniority
• structure
• technical factors
• credit rating
5.7.3 7.3
• market factors
• benchmark bonds
• liquidity premiums for highly traded bond issues
• indicative pricing versus firm two-way quotes
• availability of a liquid repo market and the difficulty in offering
illiquid bonds
• inability to borrow or cover shorts

Element 6 Corporate Actions Chapter 6

Income Events
6.1
On completion, the candidate should:
understand the main types of dividends and bond coupon payments:
• characteristics
6.1.1 1
• benefits to the investor
• benefits to the issuing company
Capital Events
6.2
On completion, the candidate should:
know the main types of bond repayment events:
• bullet maturities
6.2.1 2.1
• callable and puttable bonds
• sinking funds
understand the characteristics and rationale for capital restructuring
events and the effect on the company’s accounts:
6.2.2 • bonus issues 2.2
• stock splits
• reverse stock splits
be able to calculate the impact of bonus issues, stock splits and
6.2.3 2.3
reverse stock splits on the share price
Capital Raising Events
6.3
On completion, the candidate should:
understand the characteristics of rights issues:
• reasons for a rights issue
• pre-emptive rights
6.3.1 3.1
• structure of rights issue
• stages of rights issue
• trading nil paid

347
Syllabus Unit/ Chapter/
Element Section
be able to calculate:
• the impact of a rights issue on the share price
6.3.2 • the maximum nil paid rights to be sold to take up the balance at 3.1
nil cost
• the value of nil paid rights
Share Capital and Changes to Share Ownership
6.4
On completion, the candidate should:
understand why share buybacks are undertaken:
• governing regulation:
• resolution at AGM
• limits on percentage of shares and price
• use of company’s own money
6.4.1 4.1
• key aspects of share buybacks – criteria to comply with
• different structures regarding block trades
• accelerated book build – best efforts basis
• accelerated book build – back stop price
• bought deal
understand how and why stake building is used:
• strategic versus acquisition
• direct versus indirect:
6.4.2 4.2
• direct – outright purchase, ie, dawn raid
• indirect – CFDs
• disclosure thresholds, including mandatory takeover threshold
6.4.3 know the characteristics of takeovers and mergers 4.3

Element 7 Clearing and Settlement Chapter 7

Activities
7.1
On completion, the candidate should:
7.1.1 understand the main stages of clearing and settlement 1
understand the concept of DvP and the main differences between
7.1.2 2
DvP models 1 to 3 as defined by the BIS
know the concept of custody and the roles of the different types of
custodian:
• global
7.1.3 3
• regional
• local
• sub-custodian
understand the implications of registered title:
• registered title versus unregistered (bearer)
• legal title
7.1.4 4
• beneficial interest
• voting rights
• right to participate in corporate actions

348
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
understand the basics of designated and pooled nominee accounts
and their uses, and the concept of corporate nominees:
• designated nominee accounts
• pooled nominee accounts
7.1.5 • details in share register 5
• function of corporate nominees
• legal ownership
• beneficial ownership
• effect on shareholder rights of using a nominee
understand the concepts, requirements, benefits and disadvantages
of deals executed cum, ex, special cum and special ex:
• timetable
• effect of deals on the underlying right
• effect on the share price before and after a dividend
7.1.6 • the meaning of ‘books closed’, ‘ex-div’ and ‘cum div’, cum and 6
ex-rights
• effect of late registration
• benefits that may be achieved
• disadvantages/risks
• when dealing is permitted
understand what continuous linked settlement (CLS) is and its
purpose:
• the settlement of currencies across time zones
7.1.7 7
• receiving and matching instructions
• advantages
• how it reduces settlement risk (Herstatt risk)
7.1.8 know the application of distributed ledger technology 8
Stock Borrowing and Lending
7.2
On completion, the candidate should:
know the uses of, requirements and implications of stock lending:
• what is stock lending
• stock lending versus repo
7.2.1 9
• purpose for the borrower
• purpose for the lender
• risk
understand the function of stock borrowing and lending
intermediaries (SBLIs), including:
• use of custodian banks
7.2.2 • administration, including collateral 9
• regulation
• effect on the lender’s rights
• lender retains the right to sell

349
 Syllabus Unit/ Chapter/
Element Section

Element 8 Accounting Analysis Chapter 8

Basic principles
8.1
On completion, the candidate should:
8.1.1 understand the purpose and uses of financial statements 1.1
understand the requirements for companies and groups to prepare
accounts in accordance with applicable accounting standards and
the difficulties encountered when comparing companies using
8.1.2 different standards: 1.2
• accounting principles
• International Financial Reporting Standards
• International Accounting Standards
understand the differences between group accounts and company
accounts and why companies are required to prepare group accounts
8.1.3 1.3
(candidates should understand the concept of goodwill and minority
interests but will not be required to calculate them)
Statements of Financial Position
8.2
On completion, the candidate should:
know the purpose of the statement of financial position, its format
8.2.1 2.1
and main contents
8.2.2 understand the concept of depreciation and amortisation 2.3
understand the difference between share capital, capital reserves and
8.2.3 2.4
revenue reserves
know how loans and indebtedness are included within a statement of
8.2.4 2.5
financial position
Income Statement
8.3
On completion, the candidate should:
know the purpose of the income statement, its format and main
8.3.1 3.1
contents
8.3.2 understand the difference between capital and revenue expenditure 3.2
Cash Flow Statement
8.4
On completion, the candidate should:
know the purpose of the cash flow statement and its format as set out
8.4.1 4.1
in IAS 7
understand the difference between profit and cash and their impact
8.4.2 4.2
on the long-term future of the business
understand the purpose of free cash flow and the difference between
8.4.3 4.3
enterprise cash flow and equity cash flow
8.5 Additional Information
know additional information that can be used to analyse company
performance contained within:
8.5.1 5
• the annual report
• auditor’s report

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 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Financial Statements Analysis
8.6
On completion, the candidate should:
understand the importance of analysing financial statements in
8.6.1 6
context for an informed assessment
understand the relationship between share price and financial
8.6.2 6
statement information
8.6.3 understand the purpose of ratio analysis and its limitations 6
be able to calculate the following ratios:
• profitability ratios (gross profit and operating profit margins)
8.6.4 • liquidity ratios (current ratio, quick/acid test) 6.2, 6.3, 6.4
• debt ratios
• asset management ratios (turnover)
be able to calculate the following key ratios:
• return on capital employed (ROCE)
8.6.5 6.2
• return on assets (ROA)
• return on shareholders equity (ROE)
be able to calculate the following financial gearing ratios:
• investors’ debt to equity ratio
8.6.6 6.3
• net debt to equity ratio
• interest cover
be able to calculate the following investors’ ratios:
• earnings per share (including diluted earnings per share)
8.6.7 • price earnings ratio (both historic and prospective) 6.5
• gross dividend yield
• gross dividend cover
be able to calculate the following investors’ ratios:
8.6.8 • enterprise value to EBIT 6.5
• enterprise value to EBITDA

Element 9 Risk and Reward Chapter 9

Investment Management
9.1
On completion, the candidate should:
know the basics of risk and reward:
• assessment of returns
9.1.1 1.1
• types of risk
• quantifying risk
understand the risk and reward of investment in equities:
• risk profile
9.1.2 • effect of long-term investment 1.2
• can offer income and capital appreciation
• purpose and use of dividends

351
 Syllabus Unit/ Chapter/
Element Section
understand the risk and reward of investment in money market
instruments:
9.1.3 1.3
• risk profile
• use as short-term investment
understand the risk/reward of investments in debt (fixed-interest,
floating-rate and index-linked):
• compared to equities
• effect of holding to maturity
9.1.4 • can combine low risk and certain return 1.4
• can provide a fixed income
• inflation risk
• interest rate risk
• default risk
understand risk profile of investment in overseas shares and debt:
9.1.5 • country risk 1.5
• exchange rate risk
understand the risks facing the investor:
• specific/unsystematic
9.1.6 • market/systematic 1.6
• interest rate risk
• inflation risk
understand how to optimise the risk/reward relationship through the
use of:
9.1.7 • correlation 1.7
• diversification
• use of different asset classes
understand active investment management methodologies and
9.1.8 1.8
strategies, and their advantages and disadvantages
understand passive investment management methodologies and
9.1.9 1.9
strategies and their advantages and disadvantages
9.1.10 know the role of ESG investment 1.10
know the role of hedging in the management of investment risk and
how to achieve it:
9.1.11 • futures 1.11
• options
• CFDs
understand the general concept of ranking in respect of shares and
9.1.12 1.12
corporate bonds in the event of a company’s liquidation

352
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Institutional Investment Advice
9.2
On completion, the candidate should:
know the requirements of different institutional investors:
• pension funds
• life and general insurance funds
9.2.1 • hedge funds 2.1
• regulated mutual funds
• banks
• ESG funds
understand the need for the publication of regulatory information
and financial communications and the types of entity through which
publication is achieved:
• PIPs:
9.2.2 • RNS 2.2
• SIPs:
• Bloomberg
• Reuters
• analyst research

353
 Examination Specification
Each examination paper is constructed from a specification that determines the weightings that will be
given to each element. The specification is given below.

It is important to note that the numbers quoted may vary slightly from examination to examination as
there is some flexibility to ensure that each examination has a consistent level of difficulty. However, the
number of questions tested in each element should not change by more than plus or minus 2.

Element Number Element Questions

1 The Financial Services Sector 3
2 Asset Classes 27
3 Markets 1
4 Primary Markets 14
5 Secondary Markets 15
6 Corporate Actions 7
7 Clearing and Settlement 8
8 Accounting Analysis 14
9 Risk and Reward 11
    Total 100

354
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