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CISI Chartered Wealth Manager

Financial MarketsExam Practice Workbook ANSWERS (Chapters 1-10)

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Section A exam style questionsChapter 1

Question 1

Explain the four factors of production within an economy. (5 marks)

ANSWER:

Land

Land is the economic resource encompassing natural resources found within an economy. This resource includes timber, land, fisheries, farms and other similar natural resources. Land is usually a limited resource for many economies. Although some natural resources, such as timber, food and animals, are renewable, the physical land is usually a fixed resource. Nations must carefully use their land resource by creating a mix of natural and industrial uses. Using land for industrial purposes allows nations to improve the production processes for turning natural resources into consumer goods.

Labour

Labour represents the human capital available to transform raw or national resources into consumer goods. Human capital includes all able-bodied individuals capable of working in the economy and providing various services to other individuals or businesses. This factor of production is a flexible resource as workers can be allocated to different areas of the economy for producing consumer goods or services. Human capital can also be improved through training or educating workers to complete technical functions or business tasks when working with other economic resources.

Capital

Capital has two economic definitions as a factor of production. Capital can represent the monetary resources companies use to purchase natural resources, land and other capital goods. Monetary resources flow through an economy as individuals buy and sell resources to individuals and businesses. Capital also represents the major physical assets individuals and companies use when producing goods or services. These assets include buildings, production facilities, equipment, vehicles and other similar items. Individuals may create their own capital production resources, purchase them from another individual or business or lease them for a specific amount of time from individuals or other businesses.


Section A exam style questions

Chapter 1 continued/…

Entrepreneurship

Entrepreneurship is considered a factor of production because economic resources can exist in an economy and not be transformed into consumer goods. Entrepreneurs usually have an idea for creating a valuable good or service and assume the risk involved with transforming economic resources into consumer products. Entrepreneurship is also considered a factor of production since someone must complete the managerial functions of gathering, allocating and distributing economic resources or consumer products to individuals and other businesses in the economy.

Question 2

In the context of the foreign exchange markets, describe the factors that affect the demand for Sterling. (5 marks)

ANSWER:

Foreigners will need sterling to pay for exports of UK goods to overseas markets.

Overseas investors will want to invest capital in the UK. Speculation – if currency is expected to increase relative to one or

more other currencies. Currency rate management activities of central banks including the

Bank of England. Demand will be downward-sloping with respect to price – less demand

for exports and less interest from foreign investors as sterling advances relative to other currencies.




Question 3

Keynesian economists put forward two potential causes of inflation. One is cost push inflation.

a) State the other main cause and describe how it applies in favourable economic conditions.

b) Explain why your answer in a) above is unlikely to apply in recessionary economic conditions.

c) Explain giving your reasons, two factors that are particularly significant to cost push inflation.

(5 marks)

ANSWER:

a) The other main cause is demand-pull inflation.

This is the result of excessive levels of aggregate demand in the economy. It is more likely to occur in boom periods when unemployment is low and spending is high. Firms are likely to react to increased demand by raising prices if they are at full capacity. There will be a fast growth of demand for credit and borrowing and high levels of consumer spending. If this is a national phenomenon demand-pull inflation is created.

b) This is unlikely to occur during a recession. Recessions are characterised by low levels of national output. In a recession, unemployment increases and most firms operate with spare capacity. If firms have spare capacity available it is assumed they will respond to an increase in spending/demand by producing more rather than increasing prices.

They will also run down stocks in the first instance before they rebuild stock.In a recession even a large increase in spending/demand is unlikely to create demand-pull inflation. Increases are likely to produce substantial benefits for the economy. As firms expand to meet growing levels of spending and demand national output rises. Unemployment may fall as employers take on new staff to cope with growing orders.

There are huge difficulties here in timing etc and moving out of a recession can quickly lead to rampant demand pull inflation.




c) The two particularly significant factors/components are salary/wage increasesand rising raw material prices.

Salary/wage increases are likely to be a factor, if they rise faster then productivity gains. It is their relative increases in relation to any productivity gains that are being made that are important.

If unit costs increase cost-push pressures make products/services more expensive.

If raw material prices increase then so will production costs.

If a firm imports from abroad they are at risk of suffering from the world situation regarding commodity price fluctuations (external commodity price shocks).

As costs increase eventually the price to the consumer will increase (food prices are a good recent example) as companies will pass costs on to maintain profit margins.

Under both factors product costs increase and there is the further danger ofrising inflationary expectations.




Question 4

List six factors that can shift the position of the supply curve. (5 marks)

ANSWER:

Any six of the following:

Future price expectations of the good in question. Production costs – land, labour, capital, raw materials, energy etc. Price of other goods – especially substitutes. Business objectives. Movement in the exchange rate/interest rates. Changes in production technology. Government taxes. Changes in climate/weather conditions/seasonal variations. Profitability of alternatives. Number of suppliers/competition/mergers and acquisitions/market

power etc. Disasters/natural catastrophes. Skill shortages. Legal, political, institutional environment/regulation/price controls. Subsidies.




Question 5

a) Briefly explain price elasticity of demand (PED)

b) Where prices are rising and demand is falling, what would PEDs of -0.4 and -1.5 respectively indicate?

(5 marks)

ANSWER:

a) Elasticity of demand measures the sensitivity or responsiveness of the market to a change in price.

The simple calculation is:

% change in quantity demanded% change in price

The result will give us an indication about the effect of the price change on profit.

Price reductions do not always lead to increased profits. Price rises do not always lead to reduced profits either. There are also other factors to consider such as cost of production, economies of scale, distribution costs, cost of substitutes, competition, trends, product lifecycle, customer perception of quality etc.

b) With a PED of -0.4, Demand is inelastic. The percentage change in demand is less than the percentage change in price. This indicates a small sensitivity to the price change. Demand has reduced but not to the extent that positive growth has been eliminated.

With a PED of -1.5, Demand is elastic. The price increase will lead to a greater percentage drop in demand. Price rises will lead to reduced profits.



Chapters 2 and 3

Question 6

Explain the following methods of depreciation:

a) Straight line method

b) Reducing balance method

ANSWER:

a) Straight-line depreciation is the simplest and most often used method. In this method, the company estimates the salvage value (scrap value) of the asset at the end of the period during which it will be used to generate revenues (useful life). (The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero or even negative. Salvage value is also known as scrap value or residual value.) The company will then charge the same amount to depreciation each year over that period, until the value shown for the asset has reduced from the original cost to the salvage value.

Straight line depreciation = Cost – scrap (residual) value / Useful economic life in years.

b) In this method, the annual deprecation is based on a percentage of the asset's net book value (i.e. what the asset is worth in the firm's accounts). The net book value of an asset is calculated as follows:

Net book value = original cost - accumulated depreciation

As the deprecation charged against an asset builds up over time, the net book value of an asset would decrease. Therefore, although the percentage used in this method remains constant, the depreciation charge (in £) will become smaller, the longer the asset is held.

This method is also known as the diminishing or declining balance method.

The percentage rates chosen for reducing balance may seem as if they are chose randomly, without any real explanation. There is a formula which takes into account the cost, the scrap value, the expected lifespan of the assets. not a requirement of the course for you to know the formula and it is, without any doubt, one of the most complicated formulas you would be likely to see.

5 maximum



Chapters 2 and 3 continued/…

Question 7

Apparently very profitable companies can become bankrupt. Explain how the profit figure is affected by cashflow considerations. (5 marks)

ANSWER:

The profit figure arrived at in the profit and loss account is used to calculate the tax payable by the company on its operating activities for that particular year. It will reflect allowable deductions for example depreciation and amortisation charges. The profit figure will also be derived on an accruals basis which means that revenue and expenditure are recognised when they are earned or incurred and not when the cash is received or paid out. 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.

The logic of adding a cash flow statement to a set of financial statements is that it enables the readers of the accounts to clearly see how cash has been generated and/or used over the course of the year.

As such, the cash flow statement will not only include operating activities but also investing activities and financing activities.

This is felt to provide 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 balance sheet.




Question 8

Discuss the usefulness of ratio analysis in ascertaining the growth prospects of a company. (5 marks)

ANSWER:

Answer should discuss benefits of providing quantitative measures of company performance in different areas such as profitability, gearing, liquidity, operational efficiency which combined can provide an overall picture of the health and prospects of the company. Analysis helps to provide a consistent approach which allows for year on year comparison as well as comparison with peers in the sector.

Downsides include:

Profitability - no account taken of future economic events, management changes etc.

Liquidity - no account taken of macro-economic environment Accounting policies - differ. Can therefore have impact upon ratios Window dressing - putting figures in best light Circular transactions - e.g. to create extra revenue but which have no

validity Bed and breakfast transactions - e.g. sell before year end, but then buy

back after year end. Distortions - e.g. use of year-end balance to analyse full year’s transactions

or not comparing like with like.



Chapter 4

Question 9

a) Define and explain the meaning of AER.

b) F pays 1.2% net half yearly, fixed for three years. G pays 8.0% net at the end of three years. Calculate the AER for F and G to two decimal places and state which provides the better return.

c) H pays 2.5% net interest annually. Calculate the net return for a higher rate (not additional rate) taxpayer.

ANSWER:

a) AER (annualized equivalent rate) is the notional compound annual rate for products where interest is paid more or less frequently than once a year (equivalent to APR with borrowing).

b) F: [(1.012)2 – 1] x 100 = 2.41%, G [(1.08)1/3 – 1] x 100 = 2.60%

G provides the better return.

c) H: 2.5% x 100/80 x 60/100 = 1.875%



Chapters 5 and 6

Question 10

Explain how the “expectations theory” is used in the bond markets. (5 marks)

ANSWER: Answer could cover the following, although this is not necessarily a definitive answer

The shape of the yield curve varies according to investor’s expectations of future interest rates.

A steep upward sloping curve suggests investors expect rates to rise in the future.

Buyers of bonds will defer purchase of longer dated securities as they will expect to receive higher coupons in the future.

A downward sloping curve or inverted curve suggests that markets believe that rates will fall.

Bond purchases will be keen to lock in higher coupons now as the expectation is that coupons will decline in the future.

A flat yield curve suggests that the market thinks that rates will not material change in the future.

Question 11

4. Explain the relationship between the spot and the forward rate of a corporate bond (5 marks)

ANSWER: The spot rate is the rate of interest that can be agreed today for a loan

such as a corporate bond from today over a fixed period. A forward rate is the rate of interest that can be agreed today for a loan

from one future date to another. There is a relationship between spot and forward rates. If we are given

a spot rate for any period of time, we can derive the associated forward rates. Similarly, if we are given the forward rates, we can use them to calculate the associated spot rates.

For example, a 2 year spot rate is the sum of the current one year spot rate multiplied by the one year rate in one year’s time (forward rate).

Forward rates therefore equate to the term structure in spot rates.



Chapters 7 to 9

Question 12

Freya, who has experience of using derivatives, has bought a holding of 10,000 shares in ADG at 914p and expects the share price to improve over the next three months. She is concerned however, about economic uncertainty and is considering a hedge strategy to limit any potential loss.

ADG share price 914p

ADG Sept 908 european call option 22p

ADG Sept 908 european put option 14p

a) Which option and how many contracts should she buy? Calculate the cost, excluding expenses

b) If the share price is 902p when the options expire, calculate the profit or loss of the option strategy.

c) Assuming Freya wishes to continue holding on to the same number of shares in ADG, what further costs could she incur by exercising the put option at expiry?

(5 marks)

ANSWER: a) Freya would need to buy 10 contracts of the put option to hedge her position The cost would be 10,000 x 0.14 = £1,400 excluding expenses

b) The share price at the expiry date is 6p below the strike price, so the options have a loss of (14p – 6p) x 10,000 = £800.

c) If Freya wants to continue holding the shares, she should consider the extra costs involved by exercising the put option.

Firstly, there will be the costs of exercising the put and delivery of the shares.

Secondly, she will have to repurchase the shares at market price with associated stamp duty and commission costs. She may want to consider selling the options before the expiry date to avoid this secondary cost.



Chapters 7 to 9 continued/…

Question 13

“A warrant is much like a call traded option, often conferring the same rights and features.” Discuss the accuracy of this statement. (5 marks)

ANSWER: The statement is correct to the extent that a warrant is much like an

option conferring the same rights as an equity call option. It may even be traded on the secondary market. However, warrants have a number of real differences.

They are issued by private parties rather than a public options exchange.

Warrants issued by the company itself are dilutive. When a company issued warrant is exercised, the company issues new shares, so the number of outstanding shares increases. When a call option is exercised, the call option owner receives an existing share from the call writer.

Unlike common stock shares outstanding, warrants confer no voting rights.

Warrants are OTC instruments and are only traded by financial institutions with the capacity to settle and clear these types of transactions. Warrants are not standardized contracts unlike traded options.

A warrant’s lifetime is measure in years while options are typically measured in months.

Maximum 5




Question 14

Outline the tax reliefs and incentives available as a result of investing into an Enterprise Investment Scheme (EIS). (5 marks)

ANSWER:Tax reliefs and incentives of Enterprise Investment Schemes

Income tax relief of 30% of investments up to £1 million (2018/19). Relief will be withdrawn if the EIS shares are disposed of within three years

Capital gains from elsewhere can be deferred without limit if reinvested into an EIS within a period beginning one year before and ending three years after the disposal giving rise to the gain. On disposal of the EIS shares, the deferred gain will become chargeable to capital gains tax (CGT) unless re-invested to a new EIS

Gains arising from contributions to an EIS that qualified for income tax relief will be exempt from CGT as long as they are held for three years.

Capital losses made in EIS can be offset against other income or gains in the year of disposal (subject to minimum three year holding period).

Income from dividends arising is subject to income tax in the normal way

Subject to two-year ownership period, assets will receive 100% inheritance tax Business Property Relief.



Chapter 10

Question 15

Explain the dealing and settlement system for Eurobonds. (5 marks)

ANSWER:

Answer could cover the following but marks would be awarded for all correct aspects being explained.

There is no formal market place for eurobond trading. The market is based on electronic and telephone contact between the main investment houses which are primarily based in London.

The market is regulated by the International Capital Market Association (ICMA), which operates rules regulating the conduct of dealers in the market place.

Settlement is conducted for the market by two independent clearing houses, Euroclear and Clearstream which immobilise the bonds in their vaults and then operate electronic registers of ownership.

Settlement in the eurobond market is based on a T+2 day settlement system. The important feature about the registers maintained by the two clearing houses is that they are not normally available to any governmental authority, thereby preserving the bearer nature of the documents.

The methods of eurobond issuance are identical to those of corporate bond issues in the domestic markets.




Question 16

Briefly describe the obligations and privileges of a Gilt Edged Market Maker (GEMM). (5 marks)

ANSWER:

The privileges of a GEMM include: Executive rights to competitive bidding at gilt auctions and other DMO

operations, either for the GEMM’s own account or on behalf of clients. An exclusive facility to trade as a counterparty of the DMO in any of its

secondary market operations. Exclusive access to gilt Inter Dealer Broker (IDB) screens.

The obligations of a GEMM include: To make effective 2 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 all gilt auctions.

To provide information to the DMO on closing prices, market conditions and the GEMM’s positions and turnover.




Question 17

Outline the rationale and the key features of American and Global Depository Receipts (ADRs, GDRs).

ANSWER:

American (ADR) and Global (GDR) Depository Receipts are bearer receipts

ADRs enable trading in UK securities in the USA without changing the registered ownership in the UK

Shares in a UK company are purchased in the market and then transferred to a holding bank

The bank issues a receipt which indicates that shares are under its control

ADRs are denominated in dollars and dividends are converted by the US holding bank to dollars

They are exempt from stamp duty after creation They also trade in London GDRs are depository receipts created outside the USA, although also

usually priced in dollars; for foreign companies on London and Luxembourg stock exchanges; settled on Clearnet or Clearstream


Section B exam style questions

Chapter 1Question 1 a) It has been argued that excess money supply can cause inflation. Discuss the arguments between Keynesian and monetarist economists. (16 marks)

ANSWER:

Keynesian Economics - BackgroundJohn Maynard Keynes (1883–1946) was an economist at the University of Cambridge and then a government consultant whose ideas, now called Keynesian economics, had a major impact on modern economic and political theory as well as on many governments’ fiscal policies.

One of the principal differences between the Keynesian approach to economics and the classical school is that, unlike the adherents to laissez faire economics which stems from the classical theory discussed, Keynes advocated an active and interventionist role for governments in the conduct of economic affairs.

During the 1930s Great Depression era, it became more self-evident, in Keynes’s view, that there was a fallacy in the foundations of the classical theory which presumed that markets left to their own devices would reach, through the ‘laws’ of supply and demand, an optimal equilibrium level of economic activity.

The fact that the world economy had fallen into a major slump with levels of unemployment in many economies, especially the US, around 20% and the lack of any willingness by firms to undertake investment where high risk of failure was perceived, was something that the classical economists could neither explain nor for which they could find an appropriate remedy.

Keynes proposed that governments should use fiscal and monetary measures to aim to mitigate the adverse effects of economic recessions, depressions and booms. In his magnum opus, The General Theory of Employment, Interest, and Money, published in 1936, Keynes laid the foundation for a new kind of macro-economic policy role for governments. In essence, the policy which governments were urged to follow was that running public deficits, ie, where government expenditure exceeded government revenues, was a ‘remedy’ for economies that experienced a persistent state of under utilisation of resources.




Question 1 continued/…Instead of the prevailing view amongst classical economists that the government should strive to balance its budget and leave the free market to allocate the factors of production in a manner unfettered by government policy, it was Keynes’s insistence that governments must on occasion spend more than they would be collecting through taxation.Some of the theoretical background to the Keynesian view is required to appreciate the radical nature of his thinking and the manner in which it differed from the views on the role of free markets and equilibrium which were promulgated by the classical economists. the main motivations behind

Keynesianism was to address the shortcoming of the classical view and its manifest failure to explain and provide the necessary policy objectives to move the world economy out of the Great Depression of the 1930s. Keynes advocated in his seminal work ‘The General Theory of Employment’ that governments had to play a far more interventionist role in the economy and that this role should be primarily implemented through fiscal policy. In essence, the revival of Keynesian thinking amongst economists and policy makers following the near financial meltdown of 2008 and the subsequent global recession stems from the view that governments have to inject stimulus into the economy to boost demand for economic activity and that this requires the governments to engage in fiscal stimulus (as well as using supporting monetary policy as well).

Governments in the UK, US and other major economies are confronting the growing unemployment and drop in demand for goods and services by increasing their public expenditures and by running fiscal deficits. That is, they are allowing the public deficits – the difference between tax revenues and public expenditures – to rise. Some commentators are becoming increasingly anxious that the size of deficits in the public finances are unsustainable and could be sowing seeds for a crisis in the public finances of certain economies.

The government’s current borrowing requirement is the Keynesians believe vital to stimulate the economy and to increase final aggregate demand and are less concerned about the size of the PSNCR than the risk of a deflationary spiral which could potentially lead again to the levels of unemployment seen in the 1930s. On the other hand, the monetarists believe that, in the longer term, the creation of such massive deficits and borrowing by the central government runs the risk of higher inflation after the recovery and higher interest rates to pay for the deficit, which will also impact on the private sector’s appetite for capital investments.




Question 1 continued/…

Milton Friedman (1912–2006), an American economist, was a keen opponent of the Keynesian view of macro-economics and was a passionate advocate of laissez faire capitalism. Based at the University of Chicago he attracted a school of macro-economic thought in contradistinction to the Keynesians, which is known as the Chicago school or monetarism.

In his seminal work Capitalism and Freedom (1962) he emphasised that the role of government should be restrained and kept to a minimum in a free market in order to create political and social freedom.

In 1976, he won the Nobel Prize for his achievements in the fields of consumption analysis, monetary history and theory. His criticism of

Keynesianism stemmed from his passionate belief that free-market forces will lead to the correct allocation of resources.

Friedman argued that Keynesian theory tampered with the market’s efficiency and that it distorted the true nature of supply and demand.

Friedman distinguished between nominal income and real incomes – the former are not a true reflection of purchasing power as they can be eroded by the effect of inflation,

Friedman, who was very proactive during the 1970s and 1980s, believed that the acute inflation experienced during that period was attributable to too much government intervention in the economy, which was inspired by Keynesian theory. His primary criticism suggested that by manipulating aggregate demand in the fashion described previously and by also boosting the money supply, Keynesian economics resulted in stagflation, the combination of low growth and high inflation that developed economies suffered in the early 1970s.

Inflation and the Money SupplyThe Chicago school of monetarism maintain that there is a close and stable link between inflation and the money supply. Inflation results from, and can only be regulated by, controlling the amount of money injected into the national economy by central banks.

Friedman seriously questioned the use of fiscal policy as a tool of demand management; and held the view that the government’s role in the guidance of the economy should be severely restricted.





Friedman was a keen student of economic history and wrote extensively on the subject of the 1930s Depression, which he called the Great Contraction. He argued that it had been caused by an ordinary financial shock whose duration and seriousness were greatly increased by the subsequent contraction of the money supply caused by the misguided policies of the directors of the Federal Reserve, the US central bank. Most recently the current chairman of the Federal Reserve, Ben Bernanke, also a student of the 1930s, has published materials agreeing with Friedman on this diagnosis of the mistaken policy of money supply tightness during that period.

In more recent years during the 1980s under both President Reagan and Prime Minister Thatcher monetarism gained the upper hand over Keynesian thinking. However, as the world has entered a period of serious recession, the Keynesian view of the need for strong fiscal stimulus, in addition to a very easy monetary policy has come back to the foreground of economic policy. During 2009, and for many economies continuing in 2010 (and into 2013 in some countries), governments and central banks provided large boosts to the money supply and operating with extraordinarily low rates of interest designed to stimulate business investment and boost the level of economic activity from depressed levels.

Monetarism is fundamentally a restatement of classical economic doctrine. It is based firmly on the belief that free markets provide the only sound basis on which markets can do their job properly of determining resource allocation.

However, within this, it is not as dogmatic as classical economics, in believing that markets will not automatically work, and it offers a number of more pragmatic steps to achieve long-run equilibrium.

Monetarism focuses on the impact of inflation as a distorting influence in the market place. Inflation must be eradicated before any other economic problems can be solved.

Quantity Theory of MoneyThe following equation is known as the quantity theory of money or sometimes as the Fisher equation and was proposed by an economist Irving Fisher in the early 20th century and subsequently became a foundation stone of the work of the great advocate of monetarism Milton Friedman.





Quantity theory of money is MV = PTWhere:• M = the money supply (the stock of money)• V = the velocity of circulation• P = the average price of a transaction in a period• T = the number of transactions that takes place in a period example.

Assume that M equals £5 million and that the following transactions of a typical consumer are representative for the economy as a whole.

The consumer buys £5 of goods from a retailer and the retailer then spends this £5 on two types of products or services for herself, eg, a newspaper and a cup of coffee. The original purchase of £5 has effectively paid for a total of £10 of goods. The expenditure has led to three separate transactions and the velocity of circulation can be simply measured as £10 ÷ £5 or 2.

The number of transactions that have taken place in this simplified model is three and if this typical pattern was extrapolated to all consumers the total number of transactions, T, that would take place during a week, would be 3 million.

The average value of the transactions, P, would be:£(5 + 2.5 + 2.5)/3 = £10/3

Putting the figures together in the quantity theory of money equation we would have the following:£ 5,000,000 x 2 = £10/3 3,000,000 or simply £10,000,000 = £10,000,000/3

As it stands, the theory does not appear to reveal too much beyond the fact that money spent in a period must equal the receipts during that same period.

Where the theory becomes more valuable is in an examination of the parameters to the equation.





Monetarists, like Friedman argued that the velocity of circulation V of the equation tends to be fairly stable over time. However that notion has become increasingly suspect as many economists believe that in the global recession of 2009 the speed of transactions and the velocity of circulation of money have experienced a notable decline. Anyway, to pursue the monetarist’s proposition, their view regarding T is that this will be subject to slow and incremental growth as the productive capacity of the economy expands gradually. So, if both V and T, from their perspective, are relatively stable the relationship between M and P must be the most critical to determining the level of prices.

In essence, the key idea of monetarism is that excessive growth in the money supply, brought about by excessive intervention of governments within the economy will cause inflation. This leads to one of the principal areas of difference between monetarists and

Keynesians in their view of the role of government stimulus, and it arose especially according to Friedman in regard to the explanations and remedies proposed for unemployment. In particular, monetarists have a view on what they refer to as natural unemployment.

Summary of Monetarism and its differences from Keynesianism• Monetarists believe that governments should respect the view that market forces left to their own devices will lead to the most benign economy.• Monetarists are anti-interventionist in the Keynesian sense.• Monetarists have a definition of full employment that allows for the existence of a certain level of unemployment – called natural unemployment.• For Keynesians, monetary policy is really a by-product of, and consequential to, measures that are aimed at demand management.• For monetarists, it means controlling the supply of money with a view to restraining inflation.1• Keynesians argue that governments cannot really control the money supply – the money markets and the banks are the primary vehicles for creating credit and efforts to control this process are often ineffective.• Monetarists favour setting targets for M0 and M4 (discussed in Section 1.3) and monitoring the rate of change in the quantity of money.• Monetarists believe that inflation is caused by excessive growth in the money supply and that the cure for inflation is simple – control the money supply. In controlling money supply, inflation will automatically be brought under control.• In its purest form, monetarism exists solely to control money supply, with everything else being left to laissez faire market forces to bring the economy back to balance.





b) If a government accepts Keynes’ view on tax and spending in a recession, discuss the likely effect on bond prices and interest rates. (4 marks)

ANSWER: What Keynes says – government intervention in market borrow more

than raised etc could mention laffer curve interest rates will have to rise (see Greece etc as examples) and fixed bond prices will fall. Could also mention alternative effect eg via QE.



Question 2

‘The aim of a mixed economy, is to try to achieve the strength and dynamism of the free market, whilst avoiding the problems created by market failure.’With reference to the above statement, explain, with appropriate examples:

a) the ways in which a free market can provide strength and dynamism; (7marks)

b) the ways in which a free market can suffer from market failure; (7 marks)

c) how Governments intervene to control free markets and correct market failure (6 marks)

ANSWER:

a) The psychological ‘needs of people’ means a striving for material

improvement and satisfaction of enhanced needs. The free market best meets these.

A free market can mean a dynamic and enterprising economy with free exchanges between individuals. This often leads to economic growth and development and increases in individual incomes. Absolute poverty is better eliminated; there is increased scope for innovation, less need for government intervention and consequently lower taxes.

Individual entrepreneurs flourish, because they are theoretically efficiency maximisers, driven by profit motivation.

Competition, productivity gains and the introduction of new products is essential as consumers will search for the lowest costs producing maximum convenience/satisfaction etc.

Larger companies can produce significant innovation change often through a ‘blockbuster’ innovation/invention and also make incremental improvements. They can also be far more administratively efficient than non-profit bureaucracies.

There is a drive to innovation simply to stay in business. Consumers will not purchase obsolescent goods or services.

Research and development/improved processes and technological change are all clear features.

Flexible labour markets respond to changed market conditions. Global free trade is encouraged on the basis of competitive advantage

with different countries/regions exploiting respective advantages. Complex financial systems arise to ensure funds are available and

investments made and rewarded. (Max 7marks)





b) There can be significant market failure within free market economies Free market economies can fail to deliver efficient or optimal

allocations of resources Economic and social welfare concepts are not maximised in terms of

outcomes or indeed ignored. Concepts of fairness and social justice sit uneasily in free markets

The return to entrepreneurs will usually exceed that of economic and social welfare concepts but it may be that inadvertently the entrepreneur produces greater benefits for society than themselves.

Economic efficiency is often not maximised Information/knowledge is limited on an individual/company basis so

free market operators can be unaware of potential gains/opportunities to be made e.g. potential detrimental results for consumers

Various external factors (externalities) can diminish or obliterate individual gain so these are unacceptable losses to society e.g. pollution

Public goods/merit goods may not be supplied at all or under-supplied with de-merit goods over supplied

Perfect competition may not be the result of a free market. Monopolies and oligopolies can arise with potential detrimental effect for consumers

Factors of production can in fact be immobile under a free market economy congregating to low risk lowest common denominator activities e.g. hundreds of satellite TV channels many near identical

Not react well to shocks to the market e.g. terrorist attacks. Some government intervention to rectify such problems often required.

(Max 7marks)

c) Given the nature of free markets all this is of course to be expected

and therefore, governments need to intervene to control free markets to correct such failures and loss of efficiency. They will also pursue social engineering in the form of fairer income/wealth distribution.

Governments therefore try to avoid the free market problems using a variety of techniques and approaches including regulation, taxes/subsidies, competition policies, provision of public and merit goods and various forms of change via social engineering such as health promotion, discouraging certain behaviours etc. (Max 6 marks)




Question 3

a) Detail the various theories that attempt to describe the term structure of interest rates and the shape of the ‘normal’ yield curve. Comment on the market conditions when the inverted yield curve may occur. (10 marks)

ANSWER:

Normal shape of the yield curve is upward sloping curve (yields of longer maturities are higher than those of shorter maturities). Several theories are put forward to explain its shape.

Examples of theories: Expectations theory postulates that you would earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year later compared to buying a two-year bond today. This theory is sometimes used to explain the yield curve but has proven inaccurate in practice as interest rates tend to remain flat when the yield curve is normal. In other words, expectations theory often overstates future short-term interest rates.

Another term-structure theory, preferred habitat theory, expands on expectations theory to explain why longer-term bonds tend to pay more interest than two shorter-term bonds that add up to the same maturity. It says that investors prefer short-term bonds and are only interested in longer-term bonds if they pay a risk premium. While expectations theory assumes that investors only care about yield, preferred habitat theory assumes they care about maturity as well as yield.

Discussion along these lines (also Liquidity Preference Theory) and supporting graphs were expected. Inverted yield curve (downward sloping) normally occurs before the start of the recession period.





b) “Inflation is the one form of taxation that can be imposed without legislation” (Milton Friedman, 1912-2006).

Discuss the implications of this statement, and in particular explain what strategies investors might pursue to protect investment portfolios against the impact of high inflation. (10 marks)

ANSWER:

Inflation is an increase in the general level of prices over time in an economy.

The rate of inflation is measured as the annual change in consumer prices. A modest rate of inflation alongside growing profitability is probably good for an economy as it encourages investors to invest and provides incentives for firms to grow. However, a high rate of inflation is a problem as it reduces the purchasing power of money and gives rise to distortions in the economy (such as the inflation tax), income distribution effects, and uncertainty.

Milton Friedman argued that “inflation is the one form of taxation that can be imposed without legislation”, giving rise to a debate in the US around of the issue of taxation without legislation. Effectively, inflation reduces the spending power of people in the same manner as a tax, but without the ability to vote on this as it is more of a phenomenon than a conscious policy decision. In terms of wages, given that there are tax thresholds which do not always rise in line with inflation, workers may find that in times of higher inflation their tax liabilities increase at the same time that inflation is eroding this purchasing power.

In terms of investors, inflation leads to the erosion of returns: Fixed income investors are hit particularly badly as they will find their

interest receipts often do not keep up with inflation, thereby reducing real returns or even rendering them effectively negative;

The returns generated on equities will be worth less in terms of their purchasing power;

Companies may decide to postpone investment in new projects in times of higher inflation due to uncertainty regarding real returns.

The strategies which investors might pursue to protect investment portfolios against the impact of high inflation might include: investing in commodities such as gold which tend to perform well in times of higher inflation as investors move into less conventional assets;





An investment in certain industries which performs well in times of higher inflation (due to their ability to pass on costs) such as oil and gas or extractive industries;

A focus on equities which benefit from the exchange rate depreciation associated with higher inflation such as those companies with a significant focus on exports;

A move into property-related investments such as direct investment in property or indirect investment through REITs (as property prices tend to rise in an inflationary environment);

Gearing up the investment portfolio as in times of high inflation lenders tend to lose whilst borrowers gain (the latter are repaying ‘cheaper’ pounds);

Investment in index-linked investments of various types such as index-linked bonds.

Section B exam style questionsChapters 2 and 3


Question 4Jump Street Security Services Plc is a growing Company who have had the following results over the past two years.

2017 2016

Turnover 13,290 8,630 Cost of Sales 7,974 4,487Gross Profit 5,316 4,143Marketing and distribution costs 2,525 1,467Administration expenses 1,196 690Other operating costs 797 432Operating Profit 798 1,554Interest payable 535 297Profit before tax 263 1,257Tax 53 252Profit for the year 210 1,005Dividends 84 402Retained profit 126 603

Balance sheet as at 31st December 2017 2016

Fixed Assets Tangible Assets 6,652 5,332

Current Assets Inventory 2,856 1,151Debtors 3,404 1,625Cash & bank 91 338

Current Liabilities Creditors (falling due within one year) 4,787 2,446

Net current assets 1,564 668

Total Assets less current liabilities 8,216 6,000

Non current liabilities Creditors (due after one year) Loans 4,890 2,800

Net Assets 3,326 3,200

Capital & Reserves Called up share capital (£1 each) 2,400 2,400Profit & Loss account 926 800

Equity Shareholders’ Funds 3,326 3,200





a) To be able to evaluate the company as a potential investment, you have been asked to calculate, for both years, the ratios which will permit you to comment on Jump Street’s prospects in the following areas:

i) Profitability (3 marks) ii) Liquidity (3 marks) iii) Asset efficiency (3 marks) iv) Gearing (3 marks)

Can include any of the following ratios to cover the four areas required, although many other ratios would be acceptable.

2017 2016Return on investment 9.7 25.9Gross profit 40 48Net profit 6 18Return on equity 6.3 31.4Earnings per share 8.8 41.9Acid test ratio 0.73 0.8Debt ratio 37.6 33.1Inventory turnover 2.8 3.9Interest cover 1.5 5.2Dividend cover 2.5 2.5





b) Using your calculations above, plus any other calculations you wish to make, comment on Jump Street’s overall prospects as an investment stock and recommend whether it should be given a rating of buy hold or sell by a stock market analyst. (8 marks)

The comments will depend upon the calculations made (and mistakes made in part a) should not be punished in part b) if used correctly) but the following would be a potential answer:

Profitability – deteriorated Liquidity – has gone down, acid test ratio of less than one. Inventory has increased. Asset efficiency – asset turnover has fallen so it takes over 4 months now to sell the inventory as opposed to 3 last year. Gearing – Substantially increased borrowings

Overall not very positive

You could estimate the share price from the book value / NAV which gives £1.39 per share. With earnings per share of 8.75p that gives a P/E ratio of 15.9. Comments could be made about looking at the average for the sector and commenting on whether this is high or low and the implications. The question described the company as a growing company but this does not appear to be rated as a growth stock.

(Total 20 marks)



Chapters 4, to 9

Question 5

Your client, Paddy Windsor, has an equity portfolio valued at £2m under your advisory management, which is invested as follows:

80% in individual ‘blue chip’ UK equities (with a beta of 1.2)

20% in an i-share ETF investing in the S&P 500.

Paddy has made substantial gains on his portfolio since investing just after the credit crisis. Whilst in the long term he is happy to continue his exposure to these markets he is very concerned about a potential drop in the value of either or both indices between now and the end of the year. He asks for your advice as follows:

a) A friend of his said that he should use options contracts possibly combining contracts to achieve his objective of protecting his downside in the short term. Explain three ways in which he could hedge against a fall in the market before the end of the year and draw payoff diagrams showing how these combine with a long portfolio of shares. (15 marks)

Answer

The client has an exposure to two different indices so would need to hedge each part separately.

Would need to use equity index options

In view of the beta, he would need to buy 20% more contracts to hedge his downside

For the S&P 500 he could use a leveraged short ETF instead of using an option but this would be more expensive than an option

(Max 3 marks)





Being Long a Protective Put

The client could purchase equity index put options with a December exercise date

The options would gain value if the index level fell below the exercise price

If the market fell this would limit the downside to the cost of the premiums

If the market rose the client is still exposed to the indices so would just give away the option premiums

American option would give more optionality than a European

Diagram with put option, long portfolio and combined payout

(Max 4 marks)

Bear spread with calls

Moderately bearish strategy

Write a low strike call and buy a high strike call

Downside is not limited but fall in index will be softened by the difference in premiums

Still retains exposure to upside

Diagram with options, long portfolio and combined payout

(Max 4 marks)





Bear spread with puts

Moderately bearish strategy

Write a low strike put and buy a high strike put

Downside is not limited but fall in index will be softened by difference in strike prices less loss on premiums

Still retains exposure to upside but loses difference in premiums

Diagram with options, long portfolio and combined payout

(Max 4 marks)

b) Another friend suggested that he uses equity futures or forward contracts instead. He says ‘to be frank, I am now totally confused as to the difference between the two and he lost me completely when he said I had the choice of going long or short”. Explain to Mr Windsor how these derivatives work and the considerations he needs to bear in mind in terms of the relative riskiness, the type and number of contracts required. (5 marks)

Answer

Futures – traded, set dates, fixed contract sizes, settlement through LCH clearnet, liquid

Forwards – over the counter, flexible, more risky (counterparty risk), less liquid

Long = obligation to buy underlying at a specified time for a specified price

Short = obligation to sell underlying at a specified time for a specified price

Index futures are cash settled not physically settled (contract for difference)

Value of 1 contract = number of points (say 7,000 x £10 per point) = £70,000

No of contracts required = value of portfolio / £70,000

Hedging ratio = beta x number of contracts (as above)




Question 6You run a gilt and corporate bond investment portfolio for your client, Mrs Harper. She has stated a preference to invest in a fixed interest security that can take advantage of rising market conditions. You have suggested that a convertible bond may provide this and Mrs Harper would like more details.

a) Explain what the advantages and disadvantages of such a bond may be to her as an investor. (6 marks)

ANSWER

Advantages The holder has the security of a fixed income instrument, offering

downside protection even if the shares fall in value and the opportunity to benefit if the shares perform well.

Convertibles rank above shares in priority on liquidation. Convertibles usually offer higher yields than the underlying shares. Convertible bonds tend to be very marketable compared to non-

convertible issues.

Disadvantages Although offering higher yields than the underlying shares, convertibles

usually offer lower yields than equivalent straight bonds. The attractiveness of a convertible may be tainted by issuer call

options. If anticipated share growth is not achieved, the holder will have

sacrificed yield for no benefit.





b) In terms of pricing convertible bonds, explain the following:

(i) Cross over method based on income crossover (5 marks)(ii) Option / warrant pricing method (4 marks)

ANSWER

(i) The crossover method is a technique used to approximate the relative attractiveness of a convertible and its underlying equity. This estimates the date on which the rising common stock dividend will equal the convertible coupon. It is appropriate when there is no pre-determined conversion date, but instead the holders have a choice of dates on which conversion can occur and a likely date of conversion needs to be established.

The crossover method assumes the conversion takes place when the income that would be expected as dividends from the shares obtained exceeds the interest from the debt. Therefore, it is also known as the income-based approach.

The positive difference between the income earned from a bond’s coupon and the alternative dividend (increased at an assumed growth rate) is assessed. This is known as the income pick up. All the time the bond coupon remains positive to the dividend income, it should be retained. At the point where the cash value of the dividend earnings has risen above the level of the cash income from the coupon, it would make sense to convert to ordinary shares.

When we add together the discounted pickup income (at the required rate of return) prior to conversion, we calculate its present value. This can be added to the value of converting the security into ordinary shares at the time of issue using the nominal value conversion of “n” shares at current share price.

5 maximum



Chapters 4, 5 and 6 continued/…


(ii) The real nature of a convertible is a combination of two separate instruments: a low-coupon bond and an option or warrant to buy an the underlying equity of the issuing company. A possibly more appropriate method of valuing a convertible would be to use option, and warrant, pricing techniques.

The value of the option or warrant will be determined by a number of factors:

Exercise price of the option. Actual price of the underlying share. Expectations regarding volatility in the price of the underlying share. Time to expiry of the option. Interest rates. Whether a dividend will be paid on the share in the option period.

An example of this technique: a convertible at expiry date that can either be converted into shares with a value of £120 or redeemed for cash of £100. Clearly, the total value of the convertible is £120. Thisis made up of its value as straight debt (£100) plus the value of the option to convert into equity, which must be worth an additional £20.

Since the option is at its expiry date, there is no time value, and the whole of the £20 is intrinsic value. Intrinsic value is the difference between the market price of the shares (£120) and the exercise price of the option (£20). In the case of a convertible, the exercise price of the option is the lost proceeds from holding the instrument as straight debt – in other words, £100.

The absolute floor value of the convertible prior to conversion will be the higher of:

value of the plain vanilla bond (disregarding the conversion right), and value of the bond – the number of shares that could be obtained at

their current market price.





c) Now that her portfolio has reached a substantial size, Mrs Harper is concerned about sudden market movements and the impact they could have on the portfolio value. Explain how traded gilt futures contracts can be used to address this issue and any adjustment she may need to make in order to ensure the correct number of contracts are effected. (5 marks)

ANSWER

The gilt futures contract is a standardised contract that will provide a “tick value” for each basis point change in price of the underlying during the term of the contract. It is a contract backed by physical delivery of the appropriate gilts if held to expiry. A list of suitable gilts that can be delivered by gilt futures sellers is provided for each contract. These will have a conversion factor to adjust the price differential between the gilt futures and the underlying.

For the purposes of managing her portfolio against price drops in the underlying assets, Mrs Harper should be selling gilt futures. This will enable her to be compensated for price drops in the underlying market.

She will have to make initial margin payments to the clearing house to enter into the contracts. There will also be the need to make variation margin payments.

She will have to realise that if the market moves in the opposite way, she will need to make margin payments to the buyer of the contracts (via the clearing house). This provides for unlimited risk on the gilt futures contract. However, the contract can be settled before expiry for cash and her position will be backed (at least partially) by her underlying portfolio.

Mrs Harper can sell the right number of gilt futures contracts to match the risks in her portfolio by adjusting them by a hedge ratio of portfolio risk (duration) relative to contract risk (duration).




Question 7

a) Discuss how companies can use interest rate and / or currency swap agreements in order to benefit from changing market conditions. (10 marks)

b) Your client John Smith, has asked you to provide advice on his portfolio of equities. He wishes to invest in some overseas markets. A friend has suggested he can access these markets more effectively using an equity index swap agreement. Explain in detail the use of an equity index swap including its benefits and pitfalls. (10 marks)

(Total 20 marks) ANSWERa) An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular principal amount. However, in an interest rate swap, the principal amount is not actually exchanged. In an interest rate swap, the principal amount is the same for both sides of the currency and a fixed payment is frequently exchanged for a floating payment that is linked to an interest rate, which is usually LIBOR.

A currency swap involves the exchange of both the principal and the interest rate in one currency for the same in another currency. The exchange of principal is done at market rates and is usually the same for both the inception and maturity of the contract.

In general, both interest rate and currency swaps have the same benefits for a company. Essentially, these derivatives help to limit or manage exposure to fluctuations in interest rates or to acquire a lower interest rate than a company would otherwise be able to obtain. Swaps are often used because a domestic firm can usually receive better rates than a foreign firm (competitive advantage).

For example, suppose company A is located in the U.S. and company B is located in England. Company A needs to take out a loan denominated in British pounds and company B needs to take out a loan denominated in U.S. dollars. These two companies can engage in a swap in order to take advantage of the fact that each company has better rates in its respective country. These two companies could receive interest rate savings by combining the privileged access they have in their own markets.





Swaps also help companies hedge against interest rate exposure by reducing the uncertainty of future cash flows. Swapping allows companies to revise their debt conditions to take advantage of current or expected future market conditions. As a result of these advantages, currency and interest rate swaps are used as financial tools to lower the amount needed to service a debt.

Currency and interest rate swaps allow companies to take advantage of the global markets more efficiently by bringing together two parties that have an advantage in different markets. Although there is some risk associated with the possibility that the other party will fail to meet its obligations, the benefits that a company receives from participating in a swap far outweigh the costs.

10 maximum

b) An equity index return swap is an agreement between two parties to swap two sets of cash flows on pre-specified dates over an agreed number of years.

One party could agree to pay an interest payment - usually at a rate based on LIBOR – while the other part agrees to pay the total return on an equity or equity index. Investors, who are seeking a straightforward way to gain exposure to an asset class such as an index or sector portfolio in a cost efficient manner, use swaps.

Investors who seek exposure to an index have several alternatives to pursue. First, they could buy the entire index such as the S&P 500. This would entail buying shares of each company in the index and then adjusting the portfolio each time the index changes and as new money flows into the fund. This can become costly. One alternative is to use the equity index swap. The investor can arrange for an S&P 500 swap, paying for the swap on an agreed upon interest rate. In return, the investor receives the return on the S&P 500 index for the stated period of the swap, say five years. The investor receives the capital gains and income distributions from the S&P 500 on a monthly basis. Then, he or she pays interest to the counterparty at the agreed upon rate.

Equity swaps have tax advantages as well. Investors can structure a swap to spread out capital gains over a predetermined number of years in return for paying interest at a fixed rate.

Index return swaps offer investors another tool to tailor the timing of investing events and to gain exposure to selected sectors or regions without committing to buying shares in the index.





A downside will be when the index turns against the investor. If the index has fallen, the investor would have to usually pay the counterparty the amount of depreciation as well as the interest obligation. In addition, it may be difficult to get out of the swap deal prior to the end of its term without significant compensation being paid. Finally, counterparty risk will need to be considered.




Question 8ACE Pension Fund Managers are investigating whether or not to buy some shares in BBB plc. You have to advise them about the price which should be paid for the shares based upon the following information:

BBB plc Income Statement (Profit and Loss) as at 31 October

£mTurnover 30Profit before interest and tax 18.3Interest (2)Profit before tax 16.3Net profit after tax 13.45Preference dividend 2Ordinary dividend 8Retained profit 3.45

Balance sheet as at 31 OctoberCost (£m) Depreciation (£m) Net Value (£m)

Long-term Assets Land 20 4 16Plant and equipment 9.6 7.35 2.25Other fixed assets 18 12 6Total 24.25

Current AssetsStock 4Debtors 3.2Bank 5Total 12.2

Current LiabilitiesCreditors (6.1)Dividend (8)Tax (2.85)Interest on loans (2)Preference Dividend (2)Total (20.95)Net current assets (8.75)

Long-term liabilitiesLoan stock (5.6)Total Net Assets 9.9

Financed byOrd 5p shares 1.9Preference shares 5Retained profit 3Shareholders’ funds 9.9




Question 8 coninued/…

The P/E in the FT is 14:1 (sector average is 8:1) and the dividend yield in the FT at 31 October was 5%. Shareholders want a return of 9% per annum. In the 6 months interim accounts for the start of the next year (dated 30 April), the following data was noted as having changed on the balance sheet:

£(m) – nowOther Fixed Assets 8Plant and Equipment 1.3Creditors 6.3Dividend 0Preference Dividend 0Bank 1.4

(a) Calculate the share price using the following methods:(i) The net asset value method (as at 30 April) (5 marks)(ii) The dividend valuation model (assuming holding the share indefinitely (2 marks)(iii) The Price Earnings Ratio (2 marks)(iv) The dividend growth model assuming a constant growth rate of 3% (3 marks)(v) The dividend yield (as at 31 October) (2 marks)





ANSWER:

(a) (i)

Balance sheet as at 30 AprilCost (£m) Depreciation (£m) Net Value (£m)

Long-term Assets Land 20 4 16Plant and equipment 1.3Other fixed assets 8Total 25.30

Current AssetsStock 4Debtors 3.2Bank 1.4Total 8.60

Current LiabilitiesCreditors (6.3)Dividend (0)Tax (2.85)Interest on loans (2)Preference Dividend (0)Total (11.15)Net current assets (2.55)

Long-term liabilitiesLoan stock (5.6)Total Net Assets 17.15

Financed byOrd 5p shares 1.9Preference shares 5Retained profit 10.25Shareholders’ funds 17.15

The number of shares is £1.9m divided by 5p = 38m shares. Net asset per share is £17.15m / 38m shares = £0.451 or 45.1p





(ii) Dividend valuation model

£8m / 38m shares = 21p dividend per share. Required return is 9%Implied share price is 0.21 / 0.09 = £2.33

(iii) PE Ratio

P/E = 14:1Net profit after tax (year to 31 October) is £13.45mNumber of share is 38mEPS = 13.45m/38m = £0.354 or 35.4p Implied share price is 35.4p x 14 = £4.99

(iv) Dividend growth model:

Dividend is 21pAnnual growth of 3%Share price is: Next dividend / R – g) = 21p x 1.03 / (0.09 – 0.03) = £0.2163 / 0.06 = £3.60

(v) Yield is 5%

5% = £0.21 / share priceShare price based on yield = £4.20

(b) What would be the required selling price of the share if it is to be sold after 3 years (using the dividend yield price calculation in (v) above) as the purchase price? (6 marks)

ANSWER:Assume share price is £4.20 form part (v) above and dividend is 21p. Required return is 9%

0.21 / 1.09 = 0.1930.21 / 1.09^2 = 0.1770.21 / 1.09^3 = 0.162E3 (Balance) / 1.09^3 = 3.668

Total is £4.20Ie PV of E3 is £3.668Therefore TV at t=3 is £3.668 x 1.09^3 = £4.750

SECTION C Exam style questions


Chapters 1 to 10 (in no particular order)

Answer ALL parts of the question in this section.

Question 1

Mr Mooneyhas asked you for some advice. He has some knowledge of investments (he has a well-diversified UK equity portfolio worth £8m) but is now considering using derivatives as part of his investment portfolio. He is worried that the market may suffer in the short to medium term following the UK’s decision to leave the European Union (Brexit).

a) Illustrate how an Equity Swap could work for him, including any factors he should be aware of. (15 marks)

ANSWER:

a) Answer could cover some of the following

An equity swap is a swap agreement where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future.

The two cash flows are usually referred to as legs of the swap; one of these legs is usually pegged to a floating rate such as LIBOR. This leg is also commonly referred to as the floating leg. The other leg of the swap is based on the performance of either a share of stock or a specified stock market index such as the FTSE 100 or the S&P 500. This leg is commonly referred to as the equity leg.

Most equity swaps involve a floating leg vs an equity leg, although some exist with two equity legs. Parties may agree to make periodic payments or a single payment at the maturity of the swap (bullet swap), the simplest case.

Example of a simple index swap where you swap £8,000,000 – the notional amount – at FTSE index return against £8,000,000 at LIBOR. In this case, you will pay (to Counterparty B) any percentage rise in the FTSE on the £8,000,000 notional as well as all pro rated dividends received during the period and would receive from Party B LIBOR applied to the £8,000,000 notional. You could assume that the swap has quarterly reset dates.

You are paying the fixed leg (FTSE) and Counterparty B is paying the floating leg, (LIBOR).

Section C exam style questions




The simple structure can be seen in the following diagram and the more detailed analysis of the cash flows involved can be seen in tabular form. (Candidate can show diagram here)

As the swap relates to total return, the dividends earned on the FTSE 100 index also need to be exchanged. Of course, UK dividends accrue unevenly throughout the year, and the terms of the swap would need to specify whether interest is earned on dividends paid within the quarter.

If the floating-rate payment required from them had been earned from a LIBOR-like return on the floating-rate deposits held in their own portfolio then the payment will effectively be a wash against what those assets would have earned them anyway.

However there is an opportunity cost to be considered by you, and it may be that you would be willing to entertain a different strategy for earning on those assets; you may be willing to take some additional credit risk with your floating-rate assets, and this could allow those deposits to earn more than LIBOR and the difference between the commitment to pay LIBOR and the actual interest earned would add another component of the risk/reward pay-off obtainable under the swap agreement.

The nature of an equity or equity index-based swap, at least in its simplest form, exposes parties to the fact that the total return on the FTSE during any reset period could of course be net negative.

From your perspective, an equity swap, similar to the one just analysed, may hold certain advantages over either a physically constructed fund with all of the constituent equities, or one available from using futures contracts.

Equity Swaps for Speculation and HedgingCounterparties can use swaps to either gain or hedge their own exposure to physical equities.The opportunities for swap counterparties to run a matched book in equity swaps are limited because, while the index funds are naturally receivers of index returns, there are fewer parties who would have an obvious interest in wanting to pay equity returns on an extended basis.There may therefore be a fundamental mismatch in the motivations and incentives of different market participants which could inhibit the development of equity index swaps.





b) As an alternative, he wonders if a Contract For Difference (CFD) could be used. Explain to him how it could work. (5 marks)

Answer:

Answer would cover the main points which could include

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, contracts for difference (CFDs) come under the FCA’s definition of derivatives. It has been estimated that CFD trading in the UK now accounts for approximately 50% of all London equity trading.

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 etc. 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.

CFDs allow the investor to benefit from downward movements in a share or other price if they choose. This has the effect of adopting a position of short selling the stock. This flexibility, and the possibility of margin trading, means that CFDs can be used flexibly either for hedging or speculation.

To understand how CFDs work, it is helpful to consider how the company offering the CFD is able to pay an investor whose CFD has resulted in a price movement that is favourable for the investor.

A broker offering CFDs may seek to hedge its own liability to pay out for price movements in the stock concerned by buying a matching quantity of the stock in the market. The broker is likely to have customers adopting long and short positions so these can be netted out and the degree to which the company has to hedge will be reduced.





The costs of CFDs comprise a cost built into the spread of the CFD price, together with a funding charge. CFDs have the advantage that there is no stamp duty or stamp duty reserve tax (SDRT) to pay, although the holder will be liable to capital gains tax on gains.

CFD contracts are subject to a daily financing charge, usually applied at a previously agreed rate linked to LIBOR. The parties to a CFD pay to finance long positions and may receive funding on short positions in lieu of deferring sale proceeds. The contracts are settled for the cash differential between the price of the opening and closing trades.

CFDs are subject to a commission charge on equities that is a percentage of the size of the position for each trade. Alternatively, an investor can opt to trade with a market maker, foregoing commissions at the expense of a larger bid/offer spread on the instrument. Investors in CFDs are required to maintain a certain amount of margin as defined by the brokerage – usually ranging from 1% to 30%. One advantage to investors of not having to put up as collateral the full notional value of the CFD is that a given quantity of capital can control a larger position, amplifying the potential for profit or loss. On the other hand, a leveraged position in a volatile CFD can expose the buyer to a margin call in a downturn, which often leads to losing a substantial part of the assets.

As with many leveraged products, maximum exposure is not limited to the initial investment; it is possible to lose more than one put in. These risks are typically mitigated through use of stop orders and other risk-reduction strategies.

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 a margin call in a downturn, which often leads to losing a substantial part of the assets.

As with many leveraged products, maximum exposure is not limited to the initial investment; it is possible to lose more than one put in. These risks are typically mitigated through use of stop orders and other risk-reduction strategies.ILLUSTRATION





Suppose you wish to buy 1,000 shares of Glaxo Smith Kline (GSK) at £15 each. In a normal non-margin broker account you would need to have an initial cash deposit or balance of £15,000.

Using CFDs, trading on a 5% margin, you would only need an initial deposit of £750.

An example is the easiest way to show the use of leverage.

If you had £750 to invest, and wished to purchase GSK at £15 and sell at £16, a standard trade would look as follows:BUY: 50 x £15 = £750SELL: 50 x £16 = £800PROFIT = £50 or £50/£750 = 6.66%

Using leverage, the above transaction with CFDs would be possible:BUY: 1,000 x £15 = £750 (5% deposit) + £14,200 (95% borrowed funds)SELL: 1,000 x £16 = £16,000PROFIT = £1,000 or £1,000/750 or 133%

Profit received after using leverage was far greater, in fact 20 times greater than without using leverage, ie, the borrowing of 95% of the contract amount.

Clearly though the losses are also magnified to the same extent when using leverage.

CFDs allow a trader to go short or long on any position using 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 case of GSK, we saw that this would be 5% of the contract price.

Variable MarginThe CFD will be marked to the market at currently prevailing prices and if the position has moved beyond the amount taken as initial margin – eg, the position has moved adversely – the additional margin required to support the borrowing at 95% for GSK will have to be deposited or available in the current balance of the customer’s cash account.





c) Although he has identified potential instability after Brexit as possibly affecting his portfolio, he also wishes to understand what else can cause the markets and shares (and thus his share portfolio) to move significantly.

Discuss the factors that in your opinion are likely to cause significant movements to stock markets and share prices. (10 marks)

Answer:

Answer could be quite wide ranging with generic headings or more specific with actual factors. Reference should be made potential impact and why.

NB influence of Algorithmic trading, Economic factors etc can also be includedPrices of equities, in common with most asset classes, move continually during trading hours.

Investors will differ as to their valuations of security prices based on different time horizons, different economic outlooks and different vested interests.

For markets to work properly there need to be disagreements, different time horizons among the participants and different agendas and priorities. While some traders think that an asset is worth buying at a specified price there must be others who, for various reasons, think that it is worth selling at that same price. The two most common frameworks for financial markets are the open-outcry model and the electronic order book and, in both cases, for sustained trading to take place there needs to be a fragmentation of opinions.

Assuming that there are a dedicated group of traders that want to trade a particular asset, the more evenly divided opinions are regarding the suitability of the current price the more liquid the market will be.

In very liquid markets, buying and selling preferences will show a high degree of nonalignment.

Trading stances will be dispersed and there will no obvious internal coherence to them. But when the fragmentation is replaced by a near-consensus view among traders the liquidity evaporates and markets are prone to behaving in erratic and sometimes dramatic price swings and crashes can result.





Share prices can change as a result of information becoming available to investors about various matters, including:

• The earnings prospects and asset values of individual companies.• The membership of the Board.• Adverse factors affecting companies, such as legal action against it, or action by a bank to call in loans.• Industry and economy surveys, for example about levels of retail sales, or productivity.• Macro-economic developments, for example: the expected level of interest rates, or where an economy appears to be located in the business cycle. (this can be expanded and discussed in detail)• Changes in government policy, for example fiscal and monetary policy.• Movements in other stock markets around the world, such as the US, China and Japan.• Geo-political developments including wars, and threats from terrorist groups, etc.

Many companies aim to present a stable and steadily rising pattern of dividend payments from year to year. Sharp changes from the usual pattern may be taken by investors as a signal of a change in the company’s fortunes, which may cause a shift in the share price.

One of the consequences of the global banking crisis of 2008 and the ensuing economic downturn was that many large organisations, especially in the financial services industry, has either to cut their dividends or suspend them entirely. One further consequence of this type of development is that many institutional investors such as pension funds will then sell the shares of companies which suspend dividends creating a downward cycle in share prices. The large US bank Citigroup is an example of a company which suspended payment of a dividend and saw its share price move into low single digits with a corresponding 90% fall in its market capitalisation.

Market capitalisation refers to the value that is placed on a company by multiplying the outstanding equity of a company by its current share price. In some ways it is a flawed notion since it places a value on the entire company from the value of the marginal shares traded during a particular session, which may have been particularly troubled by the overall market.





This gives rise to the rather perverse way in which the market capitalisation of equity markets moved up and down during the 2008/09 banking crisis and subsequent market recovery by many trillions of dollars or pounds.Investors will look for evidence of the quality of a company’s management, although such evidence can be difficult to obtain in practice.

Changes in board membership can affect investors’ assessment of a company’s prospects and the share price may move as a result. If a director resigns, investors will be interested in the reason for the resignation. If new directors are appointed, their experience and past track record will be of interest.

The prices of some companies’ shares are affected more by the state of the economy than others. For example, because house purchase decisions are influenced by mortgage rates, house building companies will be particularly sensitive to interest rate changes. If people are moving house less as a result of interest rate increases, businesses such as DIY (do-ityourself) and carpeting may also face a downturn in demand and therefore earnings.

Given the increasing interdependence of national economies through globalisation of trade and capital flows, share prices will be heavily affected by economic conditions around the world, particularly the state of the economy in the world’s largest debtor nation, the US.

Some recent studies have suggested that the inter-linkage between global stock markets is becoming much more pronounced than it used to be. Correlation analysis shows that there is a much greater degree of co-movement between indices in the US, UK, western Europe and Japan.

Emerging markets are less correlated with the more mature market economies and this has given rise to the de-coupling thesis which suggests that the fortunes of the newly emerging dynamic economies – sometimes called the BRIC countries (ie, Brazil, Russia, India and China) – are less coupled with the fortunes of say the US economy than in previous eras. The evidence on this hypothesis is far from convincing however as evidenced by the dramatic declines seen in all global stock markets in late 2008 and early 2009.

On a related theme there is a strong influence between the state of the world economy and final demand and the price levels of major commodities such as oil, copper, and other industrial metals. The emerging markets are greatly influenced by the prices of commodities both as major consumers (in the case of China) and as producers (in the case of Russia and Brazil).





Speculative motives will also be a major factor influencing share prices and indeed the prices of commodities and other assets. Speculative investors will often buy particular shares, or even shares in general, in the hope of taking advantage of a rising trend in prices. As more investors buy, prices are driven higher still and this may encourage still further buying. The process cannot continue indefinitely and eventually the ‘bubble’ may burst when prices fall back and there is a sudden change in sentiment.

The fall in prices can then be as steep as the original rise and those who bought at the highest prices will suffer losses.

d) What other tools are available to him to address his specific worries? (10 marks)

Answer:Answer could cover a wide variety of areas for exampleFuturesOptionsCovered WarrantsWarrantsSell, invest in a risk free bond & buy callOption strategies (various)It required an explanation of the tool in some detail AND then how it meets Mr Provan’s concerns eg buying a call does not meet his needs (unless for example you add selling his portfolio, at a cost, and investing it elsewhere.)This question allowed candidates to show knowledge and understanding and use their own comprehension.

(Total 40 marks)




Question 2

Answer ALL parts of the question in this section.

9. Mr Smith is seeking to diversify his holdings away from UK listed equities by investing in commercial property and a hedge fund.

He is interested in a Real Estate Investment Trust (REIT), LLPC plc and a hedge fund, Stratosphere Capital Ltd.

Stratosphere Capital Ltd is a hedge fund with two classes of shares, each with a different charging structure as shown in Table 1 below.

Share class Initial charge % Annual management charge %

Performance fee

A 0 2 15% of gross return

B 5 0.5 20% of gross return over 4%

a) Explain the tax advantages that a REIT enjoys compared to a UK company that invests in property without a REIT status. (6 marks)

ANSWER:Income arising from the ring fenced; property rental is not subject to corporation tax. Non-REITs pay corporation tax on rental income less expenses.

Capital gains arising from the property business; No corporation tax; provided held for three years. Non-REITs pay corporation tax on capital gains.





b) List and briefly explain the new or increased risks that LLPC plc may face at a time when the economy is in recession. (6 marks)

ANSWER:It is hard to value properties as markets are volatile.There may be problems with tenant defaults.Debt repayments may become an issue if high.Hard to find tenants.Property values and rent incomes may drop.Property may be difficult to sell.

c) Other than taxation, what are the advantages of investing in property via a REIT rather than directly owning property. (4 marks)

ANSWER: Any four from:Less timing consuming and expensive managementLower costs of sale and purchasesGreater diversification possibilities for lower investment levelsExpertise of fund managerAccessible to smaller investorsMore liquid.





d) i) From the information provided in the Table above, calculate, showing all your workings the net return after two years (in percentage terms) if share class B achieves a gross return of 10% in the first year and 15% in year two. (6 marks)

ANSWER:

YR 1 100 x 95% (5% initial charge) x 99.5% (0.5% AMC) x 110% (performance) x 98.8% (20% x [10%-4%]) performance fee = £102.73

YR 2 102.73 x 99.5% x 115% x 97.8% (20% x [15% - 4%]) = £114.96

Net return = 14.96%.

ii) State the factors Mr Smith should take into consideration when choosing which share class to invest in. (2 marks)

ANSWER:Length of time he wishes to hold shares.Expected return.





e) State the advantages and disadvantages of investing in a fund of funds investing in the hedge fund sector (8 marks)

ANSWER:

AdvantagesThe fund of funds will invest in a variety of hedge funds, allowing the investor to diversify.A fund of funds provides easy access to investors who may be otherwise unable to use hedge funds.There may also be the opportunity to invest in funds that have otherwise closed to new investors.The manager of the fund of funds will have more expertise than the investor. He will have better access to information and will be more experienced in the due diligence required prior to investing in a hedge fund. FOFs typically can charge 1.5% management fees plus 10% performance fees. 7DisadvantagesIf a listed investment trust structure is used, the ‘management’ of the discount to NAV can become a headache for the fund sponsor/management group.Less visibility of underlying investment funds. Typically a ‘fund of funds’ merely reports its top 10 holdings.Low possibility of interaction between the investor and the underlying hedge fund manager.

f) Identify and briefly explain four ways that Mr Smith could protect his existing equity portfolio against a fall in the FTSE 100 index. (8 marks)

ANSWER: Sell futuresBuy put optionsUse CFDs / spread betting of FTSE 100Short exchange traded fund.

Must have accurate explanation of workings of each option to obtain full marks.

(Total 40 marks)


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