SII

International
Certificate in
Investment
Management
The Official Learning and Reference Manual
1st Edition, July 2007
This Workbook relates to syllabus version 1.0 and will cover examinations from
17th September 2007 to 30th April 2009.
PROFESSIONALISM INTEGRITY EXCELLENCE

INTERNATIONAL CERTIFICATE IN INVESTMENT MANAGEMENT
Welcome to the International Certificate in Investment Management study material for the Securities
& Investment Institute’s Certificate Programme. This manual has been written to prepare you for the
Securities & Investment Institute’s International Certificate in Investment Management examination.
PUBLISHED BY:
Securities & Investment Institute
© Securities & Investment Institute 2007
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London EC3M 1AE
Tel: 020 7645 0600
Fax: 020 7645 0601
This is an educational manual only and the Securities & Investment Institute accepts no responsibility
for persons undertaking trading or investments in whatever form.
While every effort has been made to ensure its accuracy, no responsibility for loss occasioned to any
person acting or refraining from action as a result of any material in this publication can be accepted by
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Warning: Any unauthorised act in relation to all or any part of the material in this publication may
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A Learning Map, which contains the full syllabus, appears at the end of this workbook. The syllabus can
also be viewed on the Institute’s website at www.sii.org.uk and is also available by contacting Client
Services on 020 7645 0680. Please note that the examination is based upon the syllabus. Candidates
are reminded to check the ‘Examination Content Update’ (ECU) area of the Institute's website
(www.sii.org.uk) on a regular basis for updates that could affect their examination as a result of
industry change.
The questions contained in this manual are designed as an aid to revision of different areas of the
syllabus and to help you consolidate your learning chapter by chapter. They should not be seen as a
'mock' examination or necessarily indicative of the level of the questions in the corresponding
examination.
Workbook version: 1.3 (August 2008)

FOREWORD
Learning and Professional Development with the SII
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For further details, please visit www.sii.org.uk
As a Professional Body, 35,000 SII members subscribe to the SII Code of Conduct and the SII
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development within the SIICPD scheme. To learn more about SII membership visit our
website at www.sii.org.uk
We hope that you will find this manual useful and interesting. Once you have completed it
you will find helpful suggestions on qualifications and membership progression with the SII.
Ruth Martin
Managing Director
CONTENTS
Chapter 1: Economics 1
Chapter 2: Financial Mathematics and Statistics 49
Chapter 3: Industry Regulation 87
Chapter 4: Asset Classes 95
Chapter 5: Financial Markets 181
Chapter 6: Accounting 205
Chapter 7: Investment Analysis 237
Chapter 8: Taxation 263
Chapter 9: Portfolio Management 269
Chapter 10: Performance Measurement 313
Appendix 333
Glossary 337
It is estimated that this workbook will require approximately 100 hours of study time.
ECONOMICS
1.
2.
MICROECONOMIC THEORY
MACROECONOMIC ANALYSIS
1 3
19
This syllabus area will provide approximately 8 of the 100 examination questions
International Certificate in Investment Management

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1. MICROECONOMIC THEORY
1.1 Introduction
The study of economics can be divided into two broad categories: microeconomics and
macroeconomics. Microeconomics, as its name suggests, is the smaller picture view of the
economy: that is, the study of the decisions made by individuals and firms in a particular market.
Macroeconomics, however, takes the bigger picture view by seeking to explain how, by aggregating
the resulting impact of these decisions on individual markets, variables such as national income,
employment and inflation are determined. We look at microeconomics first and macroeconomics in
Section 2 of this chapter. In both cases, we mainly take an intuitive rather than a mathematical or
algebraic approach to the subject. That is to say, we concentrate on the more practical aspects of
economics and those that relate most directly to the role of the portfolio manager, without delving
too deeply into the rigor underpinning many microeconomic and macroeconomic models. We also
apply the other things being equal caveat throughout the chapter. Therefore, when considering the
impact of a change in one factor or variable on another variable, market or the economy as a
whole, we assume all other variables remain constant, so that the effect of the change can be
isolated.
1.2 The Determination of Price and Output

LEARNING OBJECTIVES
1.1.1 Understand how price is determined and the
interaction of supply and demand
Price and output in the free market are determined by the interaction of demand and supply. That
is, the demand for goods and services from individuals, or consumers, and the supply of production
from firms. In effect, an auction process takes place in each market as profit-seeking firms strive to
satisfy customers' needs and desires, each buyer and seller being guided by their own self-interest.
This process was described by Adam Smith, the founding father of modern economics, as the
workings of the invisible hand.

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Price
P1
P2
Demand Curve
O
Q1 Q2
Quantity
Figure 1: The Demand Curve
The demand curve represents the quantity of a particular good consumers will buy at a given price.
Although termed a curve, it is usually depicted as a negatively sloped straight line; the negative slope
representing the inverse linear relationship between the price of a good and the quantity
demanded. This inverse relationship is shown in the above diagram. A change in the price of a good
then, generates movement along the demand curve. However, a change in anything other than a
change in the price of this particular good could be met by a parallel shift in the demand curve
either to the right or to the left. That is, a greater or lesser quantity of the good will be demanded
at each price level, respectively.
Price
Decrease Increase
in in
Demand Demand
P1
O Q0 Q1 Q2
Quantity
Figure 2: Shifts in the Demand Curve

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Such parallel shifts can result from:
1. The price of other goods changing. The direction of the shift depends on whether these other
goods are:
i. substitutes - products that may be purchased instead of the good in question, such as coffee
instead of tea; or
ii. complements - products that are typically purchased in conjunction with this particular
product - coffee and coffee-complement, for example.
If the price of tea rises, then the demand for coffee will increase at each price level, leading to the
coffee demand curve shifting to the right, such that quantity Q2 will be demanded at price P1.
Conversely, if the price of coffee-complement increases, so the demand for coffee will fall, resulting
in the demand curve shifting to the left; Q0 being demanded at P1.
2. Growth in consumers’ income. A rise in income should result in increased demand for the good
at each price level, ie, the demand curve shifting to the right, assuming the good is a normal
good. This is true of all luxury goods and some day-to-day necessities. However, if the good is an
inferior good, then the demand curve will shift to left in response to consumers moving away
from this product to another more desirable, or more innovative, product.
3. Changing consumer tastes. This can also result in the demand curve shifting to either the left or
right depending on whether or not the product is currently fashionable.
Price
Supply curve
P1
P2
Q2 Q1 Quantity
Figure 3: The Supply Curve
The supply curve depicts the amount of a particular good firms are prepared to supply at a given
price. Movement along the supply curve results in a greater quantity being supplied the higher the
price. However, once again, a change in anything other than a change in the price of the good could
result in the supply curve shifting to either the left or right.

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Price
S0 S1 S2
Decrease Increase
in supply in supply
P1
Q0 Q1 Q2 Quantity
Figure 4: Shifts in the Supply Curve
For instance, an increase in the cost of production resulting from rising resource prices will see the
supply curve shift to the left. Conversely, a more efficient production process resulting from utilising
new production technology or increased competition from new firms entering the industry will shift
the curve to the right.
Price
S1
Excess supply
}
P2
P1
D1
Q1 Q2 Quantity
Figure 5: Equilibrium

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The interaction of demand and supply will determine the quantity of the good and the price at
which it is to be supplied. This result is known as reaching a state of equilibrium. At this point
demand and supply are equal, with output Q1 being produced at price P1. P1 is known as the
market clearing price. If, for example, output Q2 had been produced rather than Q1, insufficient
demand for these goods at price P2 would have resulted in the building up of surplus stocks.
Production would have contracted until the price of these unsold stocks had been forced down to
the market clearing price of P1. Whether the goods in question are doughnuts or derivatives, the
price mechanism always brings supply and demand back into equilibrium when a market is allowed
to operate freely. This is known as Says Law: supply creates its own demand. You need look no
further than your local fruit and vegetable market to see the free market at its most efficient, with
transparent pricing equating supply and demand.
1.3 Elasticities of Demand

LEARNING OBJECTIVES
1.1.2 Be able to calculate elasticities of demand
Elasticity measures the sensitivity of the quantity of output demanded to changes in:
1. the price of the good;
2. the prices of substitutes and complements; and
3. consumers’ income.
Price Elasticity of Demand (PED)

The price elasticity of demand (PED) quantifies the extent to which the demand for a particular
good changes in proportion to small changes in its price. By knowing the PED of a product, firms
are able to calculate the impact a small price rise or price reduction will have on the total revenue
generated by the product. Total revenue is simply calculated by multiplying the quantity of the
product demanded by its price per unit.
Formally put, the PED = percentage change in quantity

small percentage change in price
So, for example, if a gadget is priced at £2, 1,000 units are sold. If, however, the price is reduced to
£1.90 per unit, 1,200 units would be sold. A 5% reduction in price, therefore, results in a 20%
increase in the volume of sales, thereby increasing total sales revenue from £2,000 (1,000 units x
£2) to £2,280 (1,200 units x £1.90).
The PED of a gadget, therefore = + 20% = -4

-5%

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The PED of -4 tells us that for a 5% reduction in price, the quantity demanded will increase at four
times the rate. The reason for the PED having a negative value is that, as we have seen, when price
falls so the quantity of a normal good demanded rises and visa versa. Where a percentage change in
price per unit results in a proportionately greater quantity demanded and, therefore, an increase in
total revenue, then demand for the good is said to be elastic. When the opposite is true, demand is
inelastic. So, ignoring the minus sign, demand is elastic when the PED is greater than one but less
than infinity and inelastic when less than one.
Price
infinite elasticity = -α
elastic demand > -1
-
}
unit elasticity = -1
inelastic demand < -1

+
- zero elasticity = 0
}
+
0 Quantity
- revenue lost from price reduction
+ revenue gained from price reduction
Figure 6: Price Elasticity of Demand (PED)
As the diagram above illustrates, linear demand curves are rarely elastic or inelastic along their
entire length as the PED falls as you move down the curve. At the two extremes of the linear
demand curve, however, you have the point of infinite elasticity where there is no demand for the
good and that of zero elasticity where a fixed quantity of the good is demanded with the price set at
zero. An infinitely elastic demand curve is perfectly elastic, or horizontal, along its entire length
whilst a demand curve with zero elasticity is perfectly inelastic, or vertical. The above diagram also
shows the point of unit elasticity, where the PED is equal to -1. As you move down the elastic
section of the demand curve towards this point, successive price decreases result in diminishing -
though still proportionately greater - quantity increases. This has the effect of slowing the rate at
which total revenue increases. Total revenue is maximised at the point of unit elasticity. Beyond this
point, however, total revenue decreases as on the inelastic part of the demand curve successive
price cuts result in proportionately and successively smaller quantity increases. The total revenue
pattern for a linear demand curve is shown below.

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Total
Revenue
Unit elasticity Inelastic

Elastic demand
demand
0 Q1 Quantity
Example
of total
revenue 0 50 100 180 280 360 400 360 280 180 100 50 0
pattern
Rate of total Total revenue Rate of total
revenue increase maximised revenue decrease
diminishing accelerating
Figure 7: Price Elasticity of Demand and Total Revenue
We will come back to this point shortly when looking at profit maximisation.
Knowing the PED for a good or service is particularly useful when a firm wishes to employ
discriminatory or differential pricing by segmenting the market for its product and charging each
market segment a different price. Rail companies, for instance, meet inelastic demand for peak
services with higher prices than for elastic off-peak travel. Larger multi-branded motor vehicle
manufacturers also operate discriminatory pricing through their various marques.
There are numerous factors that determine the PED for a good. These include:
i. Substitutes. In the short run, consumers may find it difficult to adjust their behaviour or spending
patterns in response to a price rise unless there is a viable alternative. A rise in the cost of peak
time train travel faced by city commuters illustrates this. However, if over time substitutes
become available, the demand for this good or service becomes increasingly price elastic. The
availability of choice alters spending patterns.
ii. The percentage of an individual’s total income, or budget, devoted to the good. Goods that
account for a small percentage of one’s income are usually price inelastic.
iii. Habit forming goods. Goods that can become addictive, such as tobacco, are also price inelastic.

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Cross Elasticities of Demand (XED)

As already mentioned, a change in the price of substitutes and complements for a good impact on
the quantity demanded and influence its PED. These so-called cross elasticities of demand (XED)
are positive for substitutes and negative for complements. So if the price of coffee rises, so the
demand for its substitute, tea, increases, resulting in a parallel shift to the right in the tea demand
curve.
The XED = percentage change in quantity

small percentage change in the price of a complement or substitute
Income Elasticity of Demand (YED)

The income elasticity of demand (YED) for a good is the percentage change in the quantity
demanded given a small change in income.
The YED = percentage change in quantity

small percentage change in income
As noted earlier, rising income results in increased demand for normal goods. Therefore, all normal
goods have a positive YED. This is represented by a parallel shift to the right in the demand curve.
You may recall that normal goods include luxuries and some necessities. By definition, luxury goods
have a YED of greater than one, in that as consumers’ income increases so the proportion of total
income spent on luxury items increases at a greater rate. The necessities of life, however, have a
YED of one or less. Some necessities have positive values, others negative. Those with negative
values are inferior goods. That is, goods that account for a smaller percentage of an individual’s
budget as their income rises. Product innovation often distinguishes a normal good from an inferior
good. For instance, rising income levels has seen a shift away from commoditised portable CD
players - once a luxury item - to technologically superior ipods.
Again, knowing the YED for a particular good or service helps firms plan for future production and
assists government in deciding how to raise revenue from applying indirect, or expenditure, taxes,
such as VAT, given forecasts of income growth.
1.4 The Theory of the Firm

LEARNING OBJECTIVES
1.1.3 Understand the theory of the firm
(see the syllabus learning map at the back of this book
for the full version of this learning objective)
In economics, a simplifying assumption is made that firms seek to maximise profits. Although firms
have other objectives, which we explore throughout this text, we will stay with this assumption for
the purpose of the foregoing analysis.
Firms maximise profit by equating marginal revenue (MR) to marginal cost (MC). That is, a firm will
manufacture units of a product until the extra, or marginal, revenue generated by the sale of one
additional unit equals the cost of producing this one additional unit.

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So, profits are maximised where: MR = MC
£
unit price elasticity
of demand
reducing price
for all output
Average revenue (AR)
Marginal Quantity
revenue
(MR)
Figure 8: Total Average and Marginal Revenue
Looking at the revenue side of the equation first, we know that the more units of a product we buy
from a firm, the lower the average price per unit we expect to pay. That is, the price per unit of all
output falls as the quantity demanded increases. This is depicted by the average revenue (AR)
curve, which is also the demand curve for the product. The progressively smaller additional amount
of revenue received from the sale of each additional unit of product as we move down the AR
curve is illustrated by the MR curve. You will notice that the slope of the MR curve is steeper than
that of the AR curve given this progressively smaller contribution made to total revenue as the sale
of units increases. MR will always be lower than AR. For example, if one gadget can be sold for £10,
the total revenue, average revenue and marginal revenue from selling this one unit is £10. However,
in order to sell a second unit, the price, or average revenue, must be reduced to, say, £9 per
gadget. Since the total revenue has increased from £10 to £18, the marginal revenue from this sale
is £8. If the sale of a third gadget requires the price to be reduced to £8 per unit, ie, average
revenue falls to £8 per unit, marginal revenue falls to £6.
At the point where the MR curve cuts the horizontal axis, any additional sales will detract from the
firm’s total revenue. By producing and selling quantity Q1, the firm maximises its revenue. You may
recall that at this point on the demand, or AR, curve there is unit price elasticity of demand for the
product. Below this point, the demand curve is inelastic, so any further fall in price resulting from
increasing sales of the product will reduce total revenue.

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Cost Short run marginal cost (SRMC)

C
decreasing
increasing returns
returns to
to labour
labour
Short run average total cost (SRATC)
B
Short run average variable cost (SRAVC)
A
O QO Quantity
Figure 9: Short Run Average and Marginal Costs
Moving now to the cost side of the equation. In economics, the treatment of costs is unique in three
respects. Firstly, costs are defined not as financial but as opportunity costs; that is, the cost of
foregoing the next best alternative course of action. Secondly, cost includes what is termed normal
profit, or the required rate of return for the firm to remain in business. Finally, economics
distinguishes between the short run and the long run when analysing the behaviour of costs.
In the short run, it is assumed that the stock of capital equipment available to each firm and its
efficiency in the production process is fixed. This gives rise to what is known as a fixed cost; fixed
because the cost will be incurred regardless of production. The only resources available in varying
quantities to the firm in the short run are labour and raw materials. Both, therefore, are variable
costs. In the short run, the SRATC faced by the firm in its production is given by the sum of this
fixed and variable cost divided by the number of units produced. The SRMC curve depicts the cost
to the firm of increasing its production by one additional unit of output. Therefore, in the same way
that MR is the increase in total revenue resulting from the sale of one additional gadget, so SRMC is
the increase in total cost resulting from the production of this additional unit.
As the amount of labour employed in the production process increases so the SRATC of producing
additional units falls, as a direct result of the fixed cost being spread over a greater number of units
and increasing returns to labour, or rising productivity. At output Q0, the optimal level of
production, SRATC is minimised. This is shown as point B. At this point, the SRMC curve cuts the
SRATC curve, as marginal cost and average total cost are now the same. However, beyond this level
of output, the marginal cost of producing one additional unit is greater than the average total cost of
producing Q0 plus this one additional unit, as shown by the SRMC curve rising above the SRATC
curve. This causes the SRATC curve to rise. The reason for this is that diminishing returns to labour
begin to set in as the increased use of labour becomes less productive given that the firm’s
productive capacity is constrained by a fixed amount of capital equipment.
Progressively, this effect begins to far outweigh that of spreading the fixed cost across a greater
amount of production, resulting in the slope of the rising SRATC curve becoming steeper.

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Finally, in the short run, each firm only needs to cover its variable costs of production with the
revenue generated by product sales when deciding whether or not to produce units, as the fixed
costs will be incurred regardless of any production decision. In this context, fixed costs are known
as sunk costs. Many large scale vehicle manufacturers are currently only covering their variable
costs. Any revenue generated over and above this level will, however, contribute towards meeting
these fixed costs. Given this, the firm’s supply curve is depicted as being between points A and C on
the SRMC curve.
Revenue,
cost SRMC
0 Qoptimal Quantity
MR
Figure 10: The Optimal Level of Output
As you may recall, a firm’s profits are maximised at that level of output where MR = MC. If, for
example, the MR from selling another gadget is £5 whereas the MC associated with producing this
extra unit is only £4, then the gadget should be produced and sold. Conversely, if the MR was £4
and the associated MC, £5, then it would not be in the firm’s interest to produce another gadget.
However, although in the short run the optimal level of output (Qoptimal) for a firm is given where
the MR and SRMC curves intersect, the firm will only make a profit at this level of output if its fixed
costs are being covered. If the firm is not covering all of its fixed costs at Qoptimal, it will continue
to produce gadgets in the short run so long as its can meet its variable costs at this level of
production.
In the long run all factors of production, or inputs to the production process, are variable. The long
run average total cost (LRATC) curve shows the minimum average cost way to produce different
levels of output given this flexibility. In effect, however, the long run is an amalgam of a series of
short runs, though without the capital constraints. This has the result that each point on the LRATC
curve will not necessarily correspond with the lowest point on each of the SRATC curves, where
the stock of capital equipment is fixed.
What differentiates the short run from the long run then is the length of time necessary for
adjustments to be made to each and every one of the factors of production used in the production
process. The question of how long is the long run remains, however. The economist John Maynard
Keynes once famously remarked that in the long run we are all dead!

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In the long run, the production process benefits from economies of scale as the firm’s productive
capacity increases. Note that the term economies of scale rather than simply increasing returns to
labour is used here, given the flexibility with which all factors of production can be employed.
Production costs are minimised on the LRATC curve at Q2, known as the minimum efficient scale
(MES). Beyond this point diseconomies of scale set in as management bureaucracy negatively
impacts the production process.
Cost
SRATC1
Diseconomies of scale
SRATC2
SRATC3
Long run average total
cost (LRATC)
Economies of
scale
Minimum efficient
scale (MES)
O Q2 Quantity
Figure 11: Long Run Average Total Cost (LRATC)
Finally, in the long run, unlike in the short run, all costs of production must be covered when making
the decision to produce output. Remember, so long as the revenue generated by product sales are
covering all costs, then the firm will be making a normal profit.
1.5 Industrial Structure
xit
ande
ry PERFECT
ent
s to COMPETITION
arrier Ability to
B MONOPOLISTIC influence
COMPETITION price
OLIGOPOLY
MONOPOLY
Number of firms in industry
Figure 12: Industrial structure

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The above diagram provides a simplified representation of different market structures. Although it
does not necessarily follow that in all industries the greater the number of firms, the more
competitive the industry, for the purposes of simplifying the analysis of firms’ production decisions
based on profit maximisation, it is a useful assumption to make.
At one extreme of the industrial structure spectrum lies the monopolist, the single supplier to an
entire industry in the enviable position of being able to set the market price and generate
supernormal profits. At the other extreme lies the perfectly competitive firm that operates within
an industry containing an infinite number of firms, each of which accepts the market price for a
homogeneous product set by the interaction of consumer demand for the industry’s total supply. In
the long run, perfectly competitive firms only generate normal profits. Positioned between these
two extreme industrial structures are two models of imperfect competition that represent the
majority of real world markets: oligopoly and monopolistic competition. An oligopoly exists where a
limited number of highly interdependent firms dominate an industry, typically through either implicit
or explicit collusion on price and output, whereas monopolistic competition is found in an industry
characterised by a large number of firms each of which produces a product that, although not
homogeneous in that each is subtly differentiated, is a close substitute for others produced within
the industry. Oligopolistic and monopolistically competitive firms, having some influence on their
own output and pricing decisions, generate profits somewhere between the normal and
supernormal levels mainly through subtle product differentiation, defensive advertising to increase
brand loyalty and so reduce the elasticity of demand for their product and through limited price
competition.
LRATC3
LRATC2
LRATC1
Demand curve
Quantity
Figure 13: Minimum Efficient Scale (MES)
There are a number of factors that determine industrial structure, the most important of which is
the size of each firm’s minimum efficient scale (MES) relative to the output of the industry in which
it operates. MES is, in turn, determined by the size and profile of the LRATC curve faced by firms in
the industry relative to the size of the market and so dictates how many firms each industry can
profitably support. This is shown in the diagram above. A perfectly competitive industry, for
instance, would be characterised by a large number of firms each with a MES representing a minute
fraction of the industry’s total output. This is shown by LRATC1.

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However, a so-called natural monopoly - one that benefits from significant economies of scale -
would have an enormous MES relative to the size of the market, as depicted by LRATC3. In this
case, the industry can only support a single firm profitably. Where firms in an industry face a LRATC
curve given by LRATC2, as no one firm can profitably supply the entire industry, an oligopoly would
form.
However, as many industries are populated with firms of varying sizes and cost bases and not all
firms operate at the lowest point of their LRATC curve, economists also use the 3-firm
concentration ratio to determine the structure of an industry. This they do by calculating the
percentage of industry output produced by the industry’s three largest firms. Whereas an oligopoly
will have a high concentration ratio, a perfectly competitive industry will have a particularly low
concentration ratio.
1.6 Perfect Competition

LEARNING OBJECTIVES
1.1.4 Understand firm and industry behaviour under
perfect competition
£ Marginal cost (MC)
Ps Average total cost (ATC)

SUPERNORMAL
PROFITS
Pp AR = MR
Average variable cost (AVC)
Qp Qs Quantity
Figure 14: A Perfectly Competitive Firm
Perfect competition is a theoretical representation of how a perfectly free market would operate
where no one buyer or seller is able to influence the price of a single homogeneous product.
Although impossible to fully replicate in practice, the market for grain comes close to meeting the
assumed characteristics of a perfectly competitive industry, as the actions of an individual grain
farmer or a grain merchant are unlikely to influence the market price of grain. Both, therefore, are
described as being price takers. The characteristics of a perfectly competitive industry are as
follows:
i. no one firm dominates the industry which contains an infinite number of firms;
ii. firms do not face any barriers to entry or exit from the industry;

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iii. a single homogeneous product is produced by all firms in the industry;
iv. there is a single market price at which all output produced by any one firm can be sold;
v. there are an infinite number of consumers who all face the same market price; and
vi. perfect information about the product, its price and each firm's output is freely available to all.
Given these assumptions, each firm in a perfectly competitive industry faces a horizontal, or
perfectly elastic, demand curve where average revenue (AR) is the same as the marginal revenue
(MR). Remember, a single price PP has been set by the interaction of industry supply and consumer
demand in the marketplace. Given that each firm’s output represents a minute fraction of total
industry output, their individual output decisions will not affect the industry price, so each firm can
sell as much or as little of their output as they wish at this price. To maximise profits, however, they
will set output at QP where MR = MC. At this point they are covering all of their costs and
generating normal profit. They are, therefore, in a state of equilibrium.
If, however, this single industry price rises, because of a reduction in industry supply for whatever
reason, to Ps, each firm would then produce quantity QS, generating supernormal profits in the
process. These supernormal profits are simply the revenue generated in excess of average total
costs at QS. However, this state of disequilibrium would not last for long, as other firms learning of
these supernormal profits, given freely available information, would be attracted to the market in
search of these excess returns. Inevitably, the resulting increase in supply would shift the industry
supply curve to the right, eventually driving the price back down to PP, eliminating the supernormal
profits in the process. Equilibrium will be restored once each firm is again producing at the point
where MR = MC.
1.7 Monopoly and Oligopoly

LEARNING OBJECTIVES
1.1.5 Understand firm and industry behaviour under
monopoly and oligoploy
£
CONSUMER
SURPLUS
Marginal cost (MC)

DEADWEIGHT
LOSS
Pm
SUPERNORMAL Average total cost (ATC)
PROFITS
PP
Average revenue (AR)
Qm QP Quantity
Marginal revenue (MR)
Figure 15: Monopoly

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The monopolist being an industry’s sole supplier, unlike a perfectly competitive firm, is able to set
rather than accept the market price for its output. Facing a demand curve represented by the
average revenue (AR) it receives for selling successive amounts of output, the monopolist, like any
other profit-maximising firm, sets its output where MR = MC. However, at output QM and price
PM, the monopolist not only maximises its profits but also generates sustainable supernormal
profits. You will also notice that the monopolist only operates at a single point on the elastic part of
the demand curve and does not have a supply curve. Moreover, the only time a monopolist would
change its output decision and move along the elastic part of the demand curve would be in
response to a shift in its MC curve. A shift to the right may be as a result of falling labour costs, for
instance. The socially desirable or optimum level of output QP, where a perfectly competitive firm
would produce if faced with this demand curve and the same cost structure, would never be
chosen by the monopolist as only normal profits would be generated at this point.
Given the monopolist’s ability to set price solely on the elastic part of the demand curve, it is in an
ideal position to engage in price discrimination and in same instances, perfect price discrimination;
that is, charge each and every customer a different price for its output so as to eliminate what is
known as consumer surplus. Consumer surplus arises where a firm, by setting a single price for its
output, forgoes the additional revenue that could have been generated by segmenting the market
for its product and charging each segment a different price.
Monopolies are usually the result of industries that require large scale capital investment to fully
exploit the enormous economies of scale on offer. These natural monopolies mainly comprise utility
companies that substantially invest in the nation's infrastructure. Some firms, however, gain
monopoly status through being the original innovator in what proves to be a growth industry - a
phenomenon known as first mover advantage - and retain this status by patenting the product or by
creating other barriers to entry. Some may prevent new firms from entering the industry by
engaging in anti-competitive behaviour such as creating products that can only be used in
conjunction with others that only they produce, or spending large sums on advertising to raise the
fixed costs of entering the industry.
Recognising the deadweight loss, or inefficient allocation of resources, that monopolies create by
restricting output and raising price above marginal cost, the price and output decisions of most
natural monopolies are now regulated or have been introduced to limited competition. Those
monopolies that operate in industries with limited economies of scale, however, can also be split up
into smaller and less dominant companies by the regulatory authorities. Controls also exist on
preventing monopolies being created through merger and takeover activity. This we investigate in
Chapter 3.
However, where a monopoly constantly faces the threat of new entrants to the industry and does
not have a significant cost or non-price advantage over these potential competitors, it may be
forced to revise its output and pricing decisions to stymie this threat. That is, it may be forced to
adopt limit pricing by setting a price below that which generates supernormal profits. As a new
entrant could produce output (QP - QM) profitably if covering its average total cost then so long as
the monopolist sets output so that price is below the level at which these costs are covered then it
will counter the threat of enticing new entrants to the industry and maintain its profits above the
normal level.

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2. MACROECONOMIC ANALYSIS
2.1 Introduction
Having considered the allocation of resources and the determination of price and output within
different industrial structures, we now turn to look at how key economic variables are determined
in the macroeconomy. As in the previous section, we take a mainly intuitive rather than a purely
mathematical or algebraic approach to the subject and apply the other things being equal caveat
when analysing the effect of a change in one variable or input on another or the economy as a
whole, again to isolate the effect of this change.
2.2 The Determination of National Income

LEARNING OBJECTIVES
1.2.1 Know how national income is determined, composed
and measured in both an open and closed economy
We saw in our analysis of microeconomics that at the very simplest level an economy comprises
two distinct groups or economic agents, individuals, or consumers, and firms. Individuals supply
firms with the productive resources of the economy - land, labour and capital - or the inputs to the
production process, in exchange for an income. In turn, these individuals use this income to buy the
entire output produced by firms employing these resources. This gives rise to the circular flow of
income. This economic activity can be measured in one of three ways: by the total income paid by
firms to individuals, by individuals total expenditure on firms’ output or by the value of total output
generated by firms. Each measure should produce the same answer in this simple economy.
However, as economies develop from simple agrarian barter based societies through to being
manufacturing based and finally services based, or post-industrial, economies with developed
monetary and financial systems, so this simple model of the economy becomes more complex.

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PAYMENT FOR INPUTS

TO PRODUCTION PROCESS
DIRECT
TAXATION DIRECT
CONSUMERS GOVERNMENT FIRMS
TRANSFER TAXATION
PAYMENTS
INDIRECT
TAXATION
GOVERNMENT
SPENDING
INCOME SPENT ON
DOMESTIC PRODUCTION
IMPORTS EXPORTS
SAVINGS OVERSEAS ECONOMIES INVESTMENT
FINANCIAL MARKETS
AND INSTITUTIONS
Figure 16: The Circular Flow of Income
In addition to individuals saving some of their income for future consumption and financial markets
and institutions channelling these savings to firms to invest in both new and replacement capital
equipment for future production as well as in stocks of finished goods and raw materials to meet
future consumer demand, government spending and taxation decisions along with international
trade also become an integral part of the economic system. Consequently, the circular flow
becomes subject to injections in the form of business investment, government spending and firms’
exports to overseas economies and leakages in the form of saving, taxation and imported goods and
services. Moreover, by engaging in international trade, an economy that could once be described as
closed becomes an open economy.
So long as total leakages are exactly counteracted by total injections in the circular flow, we can
imply that the difference between the amount that individuals are saving and firms are investing is
equal to the difference between what the government is spending and receiving in tax revenue plus
the difference between exports and imports. Therefore, any imbalance between what the
government is spending and receiving as tax revenue, for instance, must be met by an imbalance
between saving and investment and/or between exports and imports.
At a national level, the amount of economic activity within the circular flow is measured by the
National Income Accounts on either an income, expenditure or output basis and stated in terms of
Gross Domestic Product (GDP) or Gross National Income (GNI).

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GDP measures the total market value of all final goods and services produced domestically typically
during a calendar year. Market value is the value of output at current prices inclusive of indirect
taxes, such as VAT, whilst final output is defined as that purchased by the end user of a product or
service. This latter point is particularly important as national income accounting, by:
1. distinguishing between final goods and those intermediate products or inputs used in a prior
production process, and
2. employing the concept of value added,
avoids any double counting in the national accounts.
For instance, if a brick company produced £5m of bricks, having bought in £1m of clay from a clay-
extracting firm that owns the clay pits, the value added to the brick company’s final output would
be £4m. If a house builder then purchased these bricks to build houses subsequently sold for £10m,
a further £5m would be added to the national accounts that have already accounted for the £1m
and £4m. To summarise then, the UK’s GDP is calculated by measuring the income, expenditure or
output generated over the course of a calendar year from the production of finished goods and the
supply of services originating in the UK inclusive of indirect taxes. The citizenship or tax residency
of the individual or firm generating this output in the UK is immaterial. An outline of the
components comprising the income measure of GDP is shown below:
Income from employment

plus income from self-employment
plus gross trading profits of companies
plus gross trading surpluses of public corporations and general government enterprises
plus rental income
= GDP AT FACTOR COST
minus depreciation of the nation’s existing capital stock
= NET DOMESTIC PRODUCT AT FACTOR COST
An outline of the components comprising the expenditure measure of GDP is shown below:
Consumer spending (C)

plus business investment spending and investment in stocks (I)
plus government spending (G)
= TOTAL DOMESTIC EXPENDITURE
plus exported goods and services (X)
= TOTAL FINAL EXPENDITURE
minus imported goods and services (M)
= GDP AT MARKET PRICES (Y)
minus indirect taxes
plus subsidies
= GDP AT FACTOR COST
minus depreciation of the nation’s existing capital stock
= NET DOMESTIC PRODUCT AT FACTOR COST

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In a mature post-industrial economy such that in the UK or the US, consumer spending makes the
greatest contribution to GDP, accounting for around two-thirds of its total at market prices.
Government spending net of taxation, depending on the government’s fiscal policy stance, which
we will consider shortly, accounts for up to about 5% of GDP whilst business spending and net
trade typically represents up to one third of GDP at market prices.
What differentiates GDP from GNP is that GNP also includes the contribution made during the
calendar year to an economy’s circular flow by its nationals - both firms and individuals - based
overseas. This contribution is known as net property income and comprises wages, profits, interest
and dividends. GNP at market prices, therefore, is simply GDP at market prices plus net property
income generated from overseas economies by UK factors of production.
By dividing GDP (or GNP) by population, one obtains GDP (GNP) per head or GDP (GNP) per
capita. GDP per capita along with growth of GDP between calendar years, more commonly known
as economic growth, are used as barometers of national prosperity. However, whereas GDP and
GDP per capita are calculated at market prices, or in nominal terms, economic growth is always
expressed in real terms. The difference between real and nominal GDP is accounted for by a
broadly based measure of inflation known as the GDP deflator.
For instance, if a nation’s GDP in period t0 was £800bn but rose in period t1 to £850bn whilst the
index value (we look at index values in Chapter 10) of its GDP deflator in t0 was 140 but rose to
145 in t1, the GDP of £850bn expressed in real, or t0, terms would be:
£850bn x 140/145 = £820.7bn
A real increase in GDP from £800bn to £820.7bn, represents economic growth of:
(£820.7bn - £800bn)/
£800bn = 2.6% rather than nominal growth of
(£850bn - £800bn)/ (145 - 140)/
£800bn = 6.25% which includes inflation of 140
= 3.6% between t0 and t1. Inflation is considered later in this chapter.
Note: real growth does not equal nominal growth minus inflation. Rather real growth =
[ ]
(1 + nominal growth) - 1
(1 + inflation)
Economic growth as a barometer of national prosperity, or standard of living does, however, have
significant shortcomings:
1. The effects of economic growth may just benefit a narrow section of society rather than society
as a whole, depending on the composition and distribution of GDP;
2. GDP and, therefore, economic growth only capture those aspects of economic activity that are
measurable. Therefore, both fail to account for:
a. the undesirable side effects of economic activity, such as pollution and congestion;
b. non-marketable production such as DIY;
c. the, albeit subjective, value attributed to leisure activities;
d. economic activity in the so-called shadow economy, where, as a result of tax evasion,
certain activities go unrecorded. In the UK, this activity is estimated to equate to about 5%
of GDP, though in many other countries with mature economic systems, estimates as high
as 20% of GDP are not uncommon.

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As we shall see, although there are many sources from which economic growth can emanate, in the
long run the rate of sustainable or trend rate of growth ultimately depends on:
1. The growth and productivity of the labour force. In a mature economy, the labour force typically
grows at about 0.5% per annum, though in countries such as the USA where immigrant labour is
increasingly employed, the annual growth rate has been in excess of 1%. Long term productivity
growth is dependent on factors such as education and training and the utilisation of labour saving
new technology. Moreover, productivity gains are more difficult to extract in a post-industrialised
economy than one with a large manufacturing base. Since the early 1970s both the UK and USA
economies have been transformed into post-industrial economies. Long term productivity
growth in each has averaged about 1.25% and 1.75% per annum respectively.
2. The rate at which an economy efficiently channels its domestic savings and capital attracted from
overseas into new and innovative technology and replaces obsolescent capital equipment.
3. The extent to which an economy’s infrastructure is maintained and developed to cope with
growing transport, communication and energy needs.
Given these factors, the UK’s long term trend rate of economic growth has averaged a little over
2% per annum, whilst that of the USA has averaged nearly 3%. In developing economies, however,
which are operating at a lower level of GDP but with generally higher savings and investment rates
as a percentage GDP and more rapid growth in their labour forces than their more mature
counterparts, economic growth rates approaching 10% per annum are not uncommon. For
example, China is expected to grow around 8% per annum over the next few years and be one of
the fastest growing economies in the world. Dubai, India and Saudi Arabia are also currently
recording similar high rates of economic growth.
This trend rate of growth also defines an economy’s potential output level or full employment level
of output. That is, the sustainable level of output an economy can produce when all of its resources
are productively employed.
When an economy is growing in excess of its trend growth rate, actual output will exceed potential
output, often with inflationary consequences. However, when a country’s output contracts - that is,
when its economic growth rate turns negative for at least two consecutive calendar quarters - the
economy is said to be in recession, or entering a deflationary period, resulting in spare capacity and
unemployment. Unlike in microeconomics where the establishment of a market-clearing price in a
single market brings supply and demand into equilibrium, in macroeconomics the interaction of
individual markets and sectors may cause the economy to operate in a state of disequilibrium, often
for significant periods of time. This we consider when we examine fiscal and monetary policy.

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2.3 The Economic Cycle

LEARNING OBJECTIVES
1.2.2 Know the stages of the economic cycle
The fact that actual growth fluctuates and deviates from trend growth in the short term gives rise to
the economic cycle, or business cycle.
GDP GROWTH
ECONOMIC PEAK
EXPANSION
TREND GROWTH
0
ACCELERATION
DECELERATION
ECONOMIC TROUGH
RECESSION
RECOVERY
CONTRACTION
BOOM
TIME
Figure 17: The Economic Cycle
Economic cycles describe the course an economy conventionally takes, usually over a 7 to 10 year
period, as economic growth oscillates in a cyclical fashion. The length of a cycle is measured either
between successive economic peaks or between successive economic troughs. Although cycles
typically assume a recovery, acceleration, boom, overheating, deceleration and recession pattern, in
practice it is difficult to identify exactly when one stage ends and another begins and, indeed, to
quantify the duration of each stage. Moreover, whilst successive economic expansions have
increased in length, recessions have become shorter and generally less pronounced. According to a
recent Organisation for Economic Cooperation and Development (OECD) study, this smoothing
out of the economic cycle has been as a result of the growth of the service sector in those
developed economies that comprise the OECD; service sector output being much less volatile than
manufacturing output. It has also stemmed from the economic stability resulting from the successful
reduction in inflation, itself brought about by governments allowing their central banks to set an
independent monetary policy. Each of these points is considered shortly.

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What causes cycles has been the subject of much academic debate and literature. However, in a
post-industrial, or an increasingly service-based economy, such as the UK’s, individuals’ savings
decisions and firms’ decisions to invest in or disinvest of capital equipment and inventories are
thought to have a significant influence on the course the cycle takes as, indeed, are changes in
government fiscal policy and central bank monetary policy. Certainly in the recent past, the boom
stage of the cycle has been characterised by firms’ over investing in capital equipment and
inventories, this being financed through excessive borrowing, in an attempt to satisfy rising
consumer demand, itself financed by cheap and readily available credit and boom-inspired gains
made on financial and property assets. The catalyst for subsequent decelerations, however, has
typically been the adverse effect of rising interest rates - engineered to pre-empt or respond to the
resulting inflationary pressures arising from this excess demand - on heavily indebted firms and
consumers. As the cost of credit increases, consumers cut back on their spending, so causing firms
to reduce production and run down their existing inventories. Being left with spare productive
capacity, firms then have little incentive to invest in new capital equipment, especially when the cost
of finance has increased. A vicious circle can then develop as firms go bust, consumers lose their
jobs and demand decelerates, in stark contrast to the virtuous circle that develops during the boom
stage of the cycle. Once again, each of these points will be considered later in this chapter.
Where an economy is positioned in the economic cycle also determines the performance of the
various asset, or investment, classes. This is covered in Chapters 4 and 9.
Finally, empirical evidence shows that if the short term peaks and troughs of conventional cycles are
ignored, economic cycles of 50 years or so pervade economies. These Kondratieff cycles flow from
the benefits of innovation and investment in new technology.
2.4 Aggregate Demand and Aggregate Supply

Returning to the determination of national income, we saw from the expenditure method of
accounting for GDP at market prices (Y) that total spending or aggregate demand in the economy
originates from several sources, such that:
Y = C + I + G + (X - M)
We will now briefly consider each of these components, what influences them and what their
impact, both individually and collectively, is on the level of national income within a simple aggregate
demand model.
Consumer spending (C)

C is driven by:
a. the level of national income (Y);
b. consumer confidence;
c. actual and expected changes in the level of consumers’ wealth, known as wealth effects;
d. expectations of future income; and
e. the availability and cost of credit.

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Consumer spending
(C)
c(1-t)Y = slope of line
Consumption function = a+c (1 - t)Y
0
National income (Y)
Figure 18: The Consumption Function
The consumption function shows the planned level of consumer spending at each level of national
income, or GDP. You will notice, however, that this spending comprises two components: an
autonomous or fixed amount of spending that is independent of the national income level, shown by
the point at which the consumption function intersects with the vertical axis, representing spending
on necessities, and an amount that varies directly with GDP, denoted by c(1 - t)Y. This latter
element is known as the marginal propensity to consume (MPC) and determines what proportion
of consumers’ post-tax, or disposable, income is spent, rather than saved, on goods and services. ‘t’
is the rate of direct taxation imposed by the government. The steeper the slope of the consumption
function, the higher the MPC out of post-tax income. Necessarily, the marginal propensity to save
(MPS) is given by 1 - MPC.
Obviously, by incorporating factors that make this model dynamic such as consumer confidence -
itself determined by job security and employment prospects - changes in the level of wealth, the
availability and cost of borrowing and expectations of future income levels, so the relationship
between consumer spending and national income becomes more complex.
Knowing that consumer spending usually accounts for about two-thirds of demand in a mature
economy, its importance can never be overlooked. Therefore, if consumers decide to start saving
more and spending less, as a result of declining confidence for instance, this will impact adversely on
the demand for firms’ output, leading to a reduction in the demand by firms for labour and other
resources, which itself then results in a further decline in the demand for firms’ output and so on.
As we will see when considering fiscal policy, this spiralling deficiency in demand may eventually
require an element of government intervention to restore the economy to its potential or full
employment level of output.

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Business Investment (I)
I is the amount firms spend on capital equipment and stocks built up in anticipation of consumer
demand. I is determined by:
a. firms’ ability to invest given the level of their retained profits and the cost of external finance;
b. business confidence and expectations of future returns from this investment spending;
c. the rate of technological innovation; and
d. the rate at which the capital stock is depreciating.
Interest rate (r)
MEI = slope of line
0 Business investment spending (I)
Figure 19: The Investment Schedule
In a basic aggregate demand model, investment spending is assumed to be autonomous, or

independent, of the level of national income. The investment schedule, therefore, depicts the
relationship between the level of investment spending and the rate of interest for a given
expectation of future investment returns. This is known as the marginal efficiency of investment
(MEI). The steeper the slope of the investment schedule, the higher the marginal efficiency of
investment and, therefore, the more inelastic investment spending is in relation to the cost of
finance.
However, investment spending is also sensitive to an autonomous change in the demand for firms’
output, the rate of technological innovation and the rate of depreciation of the capital stock. A
change in any one of these variables will result in a shift in the investment schedule and, therefore,
to a greater or lesser amount of business investment being undertaken at each level of the interest
rate.
Government Spending (G)

An increase in government spending and/or a reduction in the level or rate of taxation can be used
to stimulate the level of demand in an economy in the short term. As with business investment
spending and that element of consumer spending that is considered autonomous, government
spending is assumed to be independent of the level of national income within a basic model of
aggregate demand.

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Government spending takes many forms. It includes infrastructure spending, spending on public
services and transfer, or benefit, payments to individuals. All but the latter are captured within the
national accounts. Government spending can be financed through a combination of direct and
indirect taxation and/or borrowing. Tax cuts, however, can be financed through borrowing and/or a
reduction in government spending. Collectively government spending, taxation and borrowing are
known as fiscal policy. When the government spends the same as it is receiving in tax revenue, it
runs a balanced budget. However, if it is receiving more in tax revenue than it is spending, then it is
running a budget surplus and a budget deficit if the opposite is true. The extent to which the
government needs to borrow to finance this deficit is given by the Public Sector Net Cash
Requirement (PSNCR). The financing of successive fiscal deficits gives rise to the national debt.
Fiscal policy has been an important feature of modern day economies, mainly being used to boost
deficient demand in an attempt to move the economy back to its full employment level of output.
Until the 1930s, economies had largely relied on market forces to achieve the potential or full
employment level of output; a point we will consider when looking at fiscal policy later in this
chapter. Suffice to say at this stage that the impact of an increase in government spending on the
level of national income is always greater than that of an equivalent tax cut, given that a proportion
of the latter is often saved or spent on imported goods whereas the former is injected directly to
the circular flow. The political impact of a tax cut though is often far greater.
Having considered three of the four components of aggregate demand - those that exist within a
closed economy - we now need to examine how they collectively impact the output of the
economy.
General
price
level (P)
Aggregate demand (AD)
O
National income (Y)
Figure 20: Aggregate Demand
This diagram is similar to that of the demand curve in microeconomics but differs in that it shows
the aggregate, or total, demand in the economy at each general, or average, price level as you move
along the AD curve. The AD curve is unpinned by the following equation:
Y = C + I + G, or
Y = [a + c(1 - t)Y] + I + G

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An autonomous change, or shift, in any one of the above sources of demand or spending will shift
the AD curve to the right if demand is increased or to the left if decreased. However this shift will
increase national income disproportionately. The reason for this is the existence of the multiplier.
If, for example, the government increased the level of its spending by £100m, thereby shifting the
AD curve to the right, the resulting increase in national income would be greater than £100m since
the recipients of this sum would then spend a proportion of it on other goods and services whilst
the recipients of that smaller sum would do the same. This process would continue until the
multiplier effect has worked itself throughout the economy.
The closed economy multiplier is given by:
1/
(1 - [MPC (1 - tax rate)])
You will notice that the multiplier only takes account of the one variable that is assumed to vary
directly with the level of national income, namely the marginal propensity to consume out of
disposable income: MPC (1 - tax rate).
Example
Introvasia has a MPS = 0.3 and a tax rate (t) = 0.2. What is the value of the economy’s multiplier?
Solution
MPC = 1 - MPS = 0.7
Multiplier = 1/(1 - [ 0.7 (1 - 0.2)]) = 2.27
So, an increase in G = 100, would result in national income increasing by 100 x 2.27 = 227, other
things being equal.
In a closed economy, this autonomous stimulus to demand could also have originated from an
increase in the level of business investment collectively undertaken by firms or through an
autonomous shift in the consumption function.
However, we haven’t yet considered the final component of aggregate demand - net exports - that
which makes a closed economy an open economy - and in particular its impact on the multiplier.
Net Trade (X - M)
Net trade represents the difference between the value of goods and services exported (X) and
those imported (M). By bringing net trade into the equation, depending upon whether the economy
is a net importer or net exporter, giving rise to a trade deficit and trade surplus respectively, the
position of the AD curve will be affected as the aggregate demand equation now becomes:
Y = C + I + G + (X - M)

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In simple aggregate demand models, exports are assumed to be autonomous of the level of
domestic national income; being determined instead by the level of national income within overseas
economies. Imports, however, are assumed to be directly related to the level of domestic national
income: this direct relationship being given by the marginal propensity to import goods and services
(MPM). As imports are a leakage from the circular flow of national income, the MPM will
necessarily dampen the value of the multiplier in an open economy.
The open economy multiplier is given by:
1/
{(1 - [MPC (1 - tax rate)]) + MPM}
As with the closed economy multiplier, only those variables that are assumed to vary directly with
national income are included.
Example
In Extrovasia, an open economy, the MPC is 0.7, t = 0.2 and MPM = 0.1. Calculate the open
economy multiplier.
Solution
Multiplier = 1/{(1 - [0.7 (1 - 0.2)]) + 0.1} = 1.85
So an increase in G = 100 would result in national income increasing by 100 x 1.85 = 185.
In an open economy, this autonomous stimulus to demand could have emanated from any other
autonomous shift in domestic spending or, indeed, an increase in the level of exports.
Having considered aggregate demand, we now turn to aggregate supply.
General
Long run aggregate supply (LRAS)
price
level
(P)
Short run aggregate supply (SRAS)
O YF National income (Y)
Figure 21: Aggregate Supply

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Aggregate supply quantifies the amount of output firms are prepared to supply at each general price
level, assuming the price of inputs to the production process are fixed. As in microeconomics, we
need to differentiate between the short and long run. The LRAS curve denotes the economy’s
potential or full employment level of output (Yf) given the amount of resources, available
technology and rate of productivity it can draw upon, whereas the SRAS curve is subject to
diminishing returns to labour as a consequence of a fixed capital stock. Shifts in the LRAS curve
follow from changes in the amount of available resources, technological innovation and the
efficiency of production techniques whereas changes in production costs, principally the wage rate,
and other factors that impact the production process in the short term - known as supply shocks -
will shift the SRAS curve.
Through the interaction of the AD and LRAS curves, we arrive at the economy’s full employment
equilibrium level of output and general price level. However, we know that short term fluctuations
in economic activity mean that the economy can operate in disequilibrium - that is, either above or
below its full employment level of output - often for significant periods of time. The aggregate
demand and supply framework can, therefore, be utilised to illustrate how different policy
prescriptions available to governments can be used in an attempt to bring aggregate demand and
supply back into equilibrium.
2.5 Fiscal and Monetary Policy

LEARNING OBJECTIVES
1.2.4 Know the nature, determination and measurement of
the money supply
1.2.5 Understand the role, basis and framework within which
monetary and fiscal policy operate
Governments can use a variety of policy instruments when attempting to reduce short term cyclical
fluctuations in economic activity so as to maintain the economy at or near its full employment level
of output. Collectively, these measures are known as stabilisation policies and are categorised under
the broad headings of fiscal policy and monetary policy. It should be noted that neither fiscal or
monetary policy alone can alter the level of economic activity in the long term. In the foregoing
analysis we will concentrate on the situation where output is below the full employment level, that
is where there is a deflationary gap, rather than when the opposite is true and an inflationary gap
exists.

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Fiscal policy
General
price level
(P) LRAS
SRAS1
A SRAS2
AD
Figure 22: Classical Economics
Applying microeconomic principles, classical economists believed that at the macroeconomic level,
if the economy was operating below the full employment level of output at point A, input prices,
principally wages, and the price of output would automatically fall to restore equilibrium at point B.
(Classical economics was founded by Adam Smith in the 18th century and is based upon the
premise that individuals, or economic agents, act rationally.)
However, prices and wages are rarely as flexible as this. In fact, they are often described as being
sticky, or resistant to downward pressure. Recognising this, the Keynesian economic revolution,
which originated during the Great Depression of the 1930s, marked a dramatic departure away
from the classical view of markets, notably labour markets, being self-correcting at the
macroeconomic level. Instead, government intervention, or demand management, was deemed
necessary to return the economy back to full employment. Stimulating deficient demand, rather
than supply, was considered the key to achieving full employment in the Keynesian world. As we
already know, this demand management, or fiscal policy, combines government spending, taxation
and borrowing policies.
However, demand management takes two forms:

1. A discretionary, or proactive, approach to demand management is that which is deliberately
implemented to either boost or restrain demand. The former is known as an expansionary fiscal
policy whilst the latter is referred to as a restrictive or tight fiscal policy.
2. A passive approach to demand management whereby spending on transfer, or social security,
payments automatically increases, and tax revenue decreases, as the economic cycle moves into
its recessionary phase. These are known as automatic or built-in stabilisers.

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Determining whether or not government is pursuing an expansionary or a restrictive fiscal policy is
not always easy. Although the existence of a budget deficit, or PSNCR, may imply that an
expansionary fiscal stance is being adopted, this deficit may simply be as a result of the economy
operating below its full employment level. So as to establish whether this deficit has been caused by
structural or cyclical factors and to determine the fiscal stance being taken, economists usually
calculate whether a budget deficit, budget surplus or balanced budget would result at current
government spending and tax rates if the economy was operating at full employment, rather than
below this level.
LRAS
General price
level (P)
SRAS
A
AD2
AD1
Figure 23: Keynesian Economics
The diagram above depicts the result of pursuing an expansionary fiscal policy when the economy is
operating at below full employment within a simple aggregate demand and supply framework.
Reinforced by the multiplier, this fiscal expansion shifts the AD curve from point A to point C,
thereby returning the economy to its full employment level of output, albeit at a higher general
price level. We will return to this latter point shortly when examining the relationship between
unemployment and inflation.
There are, however, three practical problems associated with fiscal policy:
1. Time-lags. The length of time that elapses between recognising the need for action - based on
economic data that is itself time-lagged - implementing the appropriate policy and the policy
impacting the economy can be considerable. So much so that these time-lags can render fiscal
policy a destabilising rather than stabilising influence, especially if fiscal policy is used excessively
in an attempt to fine tune demand as it used to be immediately before and after general elections.
2. Crowding out. If an expansionary fiscal policy is financed through borrowing, this borrowing will
increase the market rate of interest to the detriment of that element of business investment and
some consumer spending that would have been undertaken at the lower interest rate.
3. Higher future tax rates. Pursuing an expansionary fiscal policy may result in a higher future tax
burden being imposed on the economy.

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Although fiscal policy was used as the key policy instrument by successive governments between
the late 1930s and mid-1970s, during the early 1970s an economic condition known as stagflation -
a combination of rising unemployment and high rates of inflation - had begun to pervade the world
economy, despite the implementation of reactive Keynesian demand management policies to
counter this. Governments, therefore, began instead to adopt alternative policies developed by the
new classical economists, or monetarists.
Monetary Policy
Monetarists adopted the classical economic proposition that markets are essentially self-correcting,
taking the view that government intervention can prove to be a destabilising influence on the
economy in the short run. However, for markets to self-correct, monetarists recognised that the
distorting influence of inflation on the ability of the price mechanism to clear markets needed to be
controlled.
Monetarists believed that inflation and short run fluctuations in economic activity stemmed solely
from the growth and instability of the domestic money supply. This proposition was based on
Fisher’s Quantity Theory of Money, originally formulated in 1911. The Quantity Theory is given by:
MV = PY, where
M = the money supply; V = the velocity of circulation of money, or demand for money; P = the
average price level and Y = real GDP.
The Quantity Theory is a truism, or an identity, in that both sides of the equation measure the same
thing: nominal, or money, GDP. MV measures the money, or nominal, value of transactions within a
period - that is, the amount of money in the economy multiplied by the number of times it changes
hands - whilst PY denotes the total money value of output in the economy. By assuming that in the
short term both V and Y are either stable or at least change very slowly and in a predictable fashion
- we already know that Y does to a degree - a model was developed to explain inflation purely as a
result of increases in the money supply.
This theory basically states that an increase in the money supply (M) leads to price increases (P) of
the same proportion (ie, inflation).
After all, when the supply of any commodity increases, so its value decreases. Monetarists believed
that by limiting the rate of money supply growth to the trend rate of economic growth, stable
growth without inflation would be achieved and market forces could be left to bring the economy
back into full employment equilibrium. Discretionary fiscal policy, especially that financed through
borrowing, was actively discouraged as in addition to crowding out business investment,
unpredictable increases in the money supply would result.
However, as with Keynesian demand management, there are also several problems with the
monetarist proposition:
1. Defining the Money Supply

The money supply is the amount of money that exists in the economy at any point in time.
However, before the money supply can be quantified, the term money must be defined.

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Money is anything that is generally acceptable as a means of settling a debt. Money, therefore, must
fulfil several functions. Most importantly, it must overcome the problem of finding someone else
with matching trading requirements, known as the mutual coincidence of wants problem, and the
associated search costs encountered with exchange through a system of barter, by acting as an
acceptable medium of exchange. It must also act as a store of value for future consumption by
maintaining its purchasing power and provide a unit of account against which the price of goods and
services can be compared. To be acceptable, however, money must also be easily recognisable,
divisible, portable and durable. In a developed economy, money takes the form of fiat currency.
That is, currency that has no intrinsic value but which is demanded for what it can itself purchase.
As a result of the various forms that money can take in an economy with a sophisticated financial
system, it will probably come as no surprise that there is no single definition of the money supply.
Since 1976, several measures of the money supply have been defined and redefined in the UK.
However, only two measures remain: M0 and M4. M0, the monetary base, is the narrowest
measure of the two in that it only contains notes and coins in circulation and banks operational
deposits at the Bank of England - the UK’s central bank- whilst M4, the broadest measure, is
defined as M0 plus bank and building society deposits.
The definition of the money supply is further complicated by the existence of credit creation and
the money multiplier. As banks are only required to hold a small proportion of their deposits as
reserves to meet day-to-day withdrawals - known as the reserve ratio - they can lend out the
significant remainder, assuming that bank depositors’ required ratio of cash holdings to deposits
does not exceed this ratio. This is known as fractional reserve banking. As a sizeable proportion of
each loan made from bank deposits is redeposited and then extended as another loan, so credit is
created and the money supply expands.
The impact on the money supply can be quantified by multiplying the level of cash deposits in the
banking system by the money multiplier, which is given by:
1/
reserve ratio
So, a bank with $100,000 of cash deposits subject to a 10% reserve ratio will create loans of
$900,000 until a total of $100,000/0.1 = $1m of deposits are on the bank’s books with $100,000 of
cash being held to satisfy the reserve ratio requirement.
2. Controlling the Money Supply

Since the 1970s, the Bank of England has attempted to control the money supply through a variety
of monetary policy measures:
a. The imposition of qualitative and quantitative credit controls, changing the reserve ratio and
imposing special deposits on banks so as to restrict the ability of the banking system to create
credit, and
b. Setting the price of money - or base rate - through its operations in the money markets and repo
markets. This it does through injecting or withdrawing liquidity to or from the banking system by
either buying or selling short term bills or government bonds. We return to money markets and
repo markets in Chapter 4.
However, as a result of disintermediation and securitisation - the substitution by firms of raising

finance through the issue of securities rather than through bank loans - and a relatively price
inelastic demand for bank lending, monetary control has never proved totally effective.

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3. The Velocity of Circulation of Money

To compound this, the velocity of circulation of money, or the demand for money, is not stable or
predictable in the short run. This is mainly as a result of financial innovation, deregulation and
structural changes in financial markets as well as changes in the rate of inflation and rate of interest.
Therefore, changes in the money supply do not directly translate into changes in the price level.
4. Time-Lags
As with fiscal policy, considerable time-lags exist between recognising the need for action through
to the implementation of policy having an effect on the economy. Time-lags of up to 12 months
typically exist between the date of implementing monetary policy and its effect working through to
the economy.
As a consequence of these factors, formal control of the money supply in the UK was abandoned in
the late-1980s.
Concluding Comments
Arguably, governments’ failure to adopt the ideas of Keynesians and Monetarists to the letter when
formulating and implementing their policies probably explains why so many economic problems
failed to be solved or, in some cases, were exacerbated. Most governments now adopt a pragmatic
approach to controlling the level of economic activity through a combination of fiscal and monetary
policy, though in an increasingly integrated world, controlling the level of activity in an open
economy in isolation is difficult as financial markets rather than individual governments and central
banks tend to dictate economic policy.
2.6 Unemployment and Inflation

LEARNING OBJECTIVES
1.2.7 Know how inflation and unemployment are determined,
measured and their inter-relationship
Unemployment
Unemployment can be defined as the percentage of the labour force registered as available to work
at the current wage rate. In the market-clearing world of the classical economists, however, it was
believed that unemployment was purely voluntary; a consequence of workers demanding too high a
wage rate thereby pricing themselves out of a job. By accepting a lower wage rate, this voluntary
unemployment would disappear. In the Keynesian world of demand management though,
involuntary, rather than voluntary, unemployment was seen to exist as a result of deficient demand
and sticky prices and wage rates, resistant to downward pressure.

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There are, of course, many other reasons why unemployment exists, two of which are described
by structural unemployment and frictional unemployment. The former arises as a result of the
changing nature of the economy where certain skills in particular sectors of the economy become
redundant, whilst the latter is a consequence of workers being between jobs in the hope of securing
a higher wage rate for their skills.
The Trade off Between Unemployment and Inflation

Earlier, when considering the impact of Keynesian demand management policies in restoring the
economy to full employment, we saw that the general price level in the economy rose as a
consequence. Accepted as a side effect of fiscal policy, it became apparent that a trade off between
unemployment and inflation existed. This idea was formalised by a Keynesian economist, A W
Phillips in 1958, in what became known as the Phillips curve.
Inflation
rate (%)
O
Unemployment rate (U) %
Figure 24: The Phillips Curve
Representing an established empirical relationship between the rate of inflation - the rate at which
the general price level rises - and the rate of unemployment, the Phillips curve appeared to suggest
that it was possible to trade off a rate of inflation with a politically acceptable rate of involuntary
unemployment through the implementation of demand management policies. However, the
emergence of stagflation - the undesirable combination of stagnant or falling output and
employment allied to high and rising inflation - in the early 1970s put paid to this simple relationship.

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Inflation
Long run Phillips curve (NAIRU)
rate (%)
3
B C
O Unemployment rate (U) %

A
Short run Phillips curve2 (SRPC2)
Short run Phillips curve1 (SRPC1)
Figure 25: The Expectations Augmented Phillips Curve
The monetarists restated the Phillips curve relationship to explain the existence of stagflation by
introducing the concept of a natural rate of unemployment, or a non-accelerating inflation rate of
unemployment (NAIRU), and workers’ inflation expectations to the model. A distinction was also
made between short run and long run Phillips curves. Whereas the economy could operate
temporarily below its NAIRU on a short run Phillips curve, in the long run it would always move
along the vertical long run Phillips curve represented by its NAIRU. To explain, assume the
economy starts at point A where it is operating at its NAIRU, with 0% inflation. Workers
expectations of future inflation based on the recent past are also set at 0%. Aggregate demand is
then stimulated through government spending. A reduction in voluntary employment results as
firms, in response to increased orders for their output, raise their wage rates to attract workers.
This takes the economy to point B on SRPC1, where increased demand for employment and output
has resulted in inflation of, say, 3%, though workers inflation expectations remain at 0%. Those
workers attracted by the higher nominal wage rates on offer soon realise that the real value of
these wages is no greater than before, as a result of the increase in the general price level, and
decide to leave the labour market. Their failure to anticipate this higher inflation as the economy
moved towards point B had resulted from money illusion. With inflation expectations now set at
3%, however, the economy moves from SRPC1 to SRPC2 at point C, which coincides with the
LRPC or NAIRU.
Given the existence of NAIRU and inflation expectations, the monetarist model concludes that
discretionary demand management policies are ineffective in reducing unemployment for anything
other than short periods of time and ultimately result in higher prices.
NAIRU, which includes structural and frictional unemployment, can be reduced though through the
adoption of supply side policies, such as retraining those with redundant skills, reducing
employment taxes and providing less generous unemployment benefits. Moreover, it has been
argued by proponents of the new paradigm that technological innovation and its resulting
productivity gains has created a new economy that can operate at a higher employment level, or a
lower NAIRU, without accompanying inflation.

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Inflation
Inflation is the rate of change in the general price level or the erosion in the purchasing power of
money. During the late 1970s and early 1980s in the UK, given a high and rising inflation rate, there
was a marked policy shift away from targeting unemployment to making inflation the prime focus of
economic policy. Although unemployment results in a waste of economic resources as actual GDP
will be below potential GDP, from a political standpoint it tends not to be shared equally by society,
whereas the economic costs inflation imposes on society are considered more far reaching, for the
following reasons:
1. It hinders the ability of the price mechanism to clear markets.
2. It reduces the spending power of those dependent on fixed incomes.
3. Individuals are not rewarded for saving as borrowers gain at the expense of savers. This occurs
when the inflation rate exceeds the nominal interest rate. That is, the real interest rate is
negative. Real interest rates are calculated as follows:
Real interest rate = [1 + nominal interest rate] - 1

[1 + inflation rate]
4. It creates uncertainty leading to firms deferring investment decisions and consumers spending
decisions.
5. Time is spent guarding against inflation rather than being devoted to more productive means.
6. Exported goods and services become less competitive internationally.
It is important, however, to distinguish between inflation that can be anticipated and that which
cannot when assessing its costs. If inflation can be fully anticipated by society then its costs can be
minimised.
Inflation is typically categorised as either:

1. Cost-push inflation. If firms face increased costs and inelastic demand for their output, the
likelihood is these rising costs will be passed on to the end consumer. Consumers will in turn
demand higher wages from firms causing a wage price spiral to develop. This was certainly the
case following the oil price shocks of 1973 and 1980; or
2. Demand-pull inflation. When the economy is operating beyond its full employment level of
output, prices are pulled up as a result of an inflationary gap emerging. This excess demand can
often stem from the optimism that accompanies rising asset prices but has resulted on
innumerable occasions from politically inspired tax cuts.
Inflation can be measured in several ways. However, the two most widely monitored are:
1. retail prices; and
2. producer prices.
The most well recognised measure of inflation in the UK is the Retail Price Index (RPI). Originally
launched in 1947, this measures the rate at which the prices of a representative basket of goods and
services purchased by the average UK household - that is, excluding the top 4% of income earners
and pensioners - have changed over the course of a month. Needless to say, the composition and
weighting of the various goods and services in the basket has altered dramatically since its inception.

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There are a number of different RPI measures. The three most keenly observed are the headline
RPI, RPIX, which excludes mortgage interest payments, and RPIY, which further excludes VAT and
the council tax. The RPI indices are usually published within 2 weeks of the end of the month
covered. European Union (EU) countries, of which the UK is one, also each calculate a consumer
prices index (CPI) so that inflation rates can be compared between EU nations on a uniform basis.
The CPI differs from the RPIX both in its method of construction and in totally excluding owner-
occupied housing costs. We return to RPIX and CPI when looking at central banks later in this
chapter and index numbers in Chapter 10.
Inflation at the “factory gate” is measured by two Producer Price Indices (PPIs). These are usually
published at about the same time as the RPI indices. The input index measures the rate at which the
prices of raw materials and other inputs to production processes are increasing and the output
index how the prices of goods leaving factories are behaving. The producer price indices are a
useful indicator of inflationary pressures that may eventually feed through to RPIX.
2.7 Deflation
LEARNING OBJECTIVES
1.2.7 Know how deflation and unemployment are determined,
measured and their inter-relationship
Deflation is defined as a general fall in the price level. Although not experienced as a worldwide
phenomenon since the 1930s, deflation has been in evidence over the past 10 years in countries
such as Japan.
Deflation typically results from negative demand shocks, such as the bursting of the 1990s
technology bubble, and from excess capacity and production and, in turn, creates a vicious circle of
reduced spending and a reluctance to borrow as the real burden of debt in an environment of falling
prices, in stark contrast to that in a period of rising prices, increases. Although deflation posed a
threat to the world economy in 2003, this threat is now thought to have passed with the majority of
the world's central bankers now more concerned about the return of inflation.
It should be noted that falling prices are not necessarily a destructive force per se and, indeed, can
be beneficial if they are as a result of positive supply shocks, such as rising productivity growth and
greater price competition caused by the globalisation of the world economy and increased price
transparency.

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2.8 International Trade
LEARNING OBJECTIVES
1.2.3 Understand the composition of the balance of payments
and the factors behind and benefits of international
trade and capital flows
International trade is the exchange of goods and services between countries. It is conducted
because it confers the following benefits on those countries that participate in this exchange:
1. Specialisation. Economies of scale in the production of a particular good or provision of a
particular service can be fully exploited if the MES is not being achieved when producing solely
for the domestic market. Increased production levels can also take full advantage of and further
develop any particular skill possessed by the labour force, known as the division of labour.
This point can be taken one stage further. Even though a particular country, country A, may have
an absolute cost advantage, ie, is more efficient in the production or provision of two particular
goods or services over another nation, country B, there is still scope for A and B to collectively
benefit from international trade if each specialises solely in the provision of the good or service
where they have a comparative cost advantage. So, if A specialises in the provision of the good or
service where its absolute and comparative cost advantage over B is greatest whilst B
concentrates solely on the provision of the good or service where A’s cost advantage is smallest,
ie, where B’s comparative advantage is greatest, by trading each other’s production both can be
shown to be better off in terms of the positive impact this specialisation and trade has on their
respective GNPs. This is known as the law of comparative advantage.
2. Competition. Global competition in the provision of goods and services results in improved
choice and quality of products as well as more competitive prices and productivity improvements
in the industries concerned.
Despite the substantial benefits of conducting international trade free from any governmental
interference, governments often engage in protectionism, or the erection of trade barriers, in the
misguided belief that certain domestic industries, often those that are inefficiently run, should be
protected against global competition. This usually results in some sort of trade retaliation. However,
the General Agreement on Tariffs and Trade (GATT) of 1948, which created an international trade
organisation with responsibility for liberalising international trade, a role since assumed by the
World Trade Organisation (WTO), has led to a gradual reduction in these barriers to free trade.

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The Balance of Payments

The balance of payments is a summary of all economic transactions between one country and the
rest of the world typically conducted over a calendar year.
The main components of the balance of payments are as follows:

1. The trade balance. This comprises a visible trade balance - the difference between the value of
imported and exported goods and an invisible trade balance - the difference between the value of
imported and exported services. Being a post-industrial economy, the UK typically runs a deficit
on visible trade but an invisible trade surplus. Also, being an open economy, imports and exports
combined total over 50% of UK GDP.
2. The current account. The current account is equal to the trade balance less government transfer
payments to overseas economies plus the net flow of interest, profits and dividends derived from
net UK holdings of overseas assets. This latter net flow can be substantial given that the UK is
one of the world’s largest owners of overseas assets.
3. The financial account. This accounts for the net amount of long and short term capital that has
flowed between the UK and the rest of the world over the period. Long term capital flows are
known as foreign direct investment (FDI) and include the overseas expansion plans of
multinational companies, whether that results in the financing of a new plant or acquiring an
existing business. Short term capital flows, typically footloose movements of capital attracted by
potentially high short term returns, however, are termed portfolio investment.
For the balance of payments to balance, the current account must equal the financial account plus
or minus a balancing item - used to rectify the many errors in compiling the balance of payments -
plus or minus any change in central bank foreign currency reserves. We look at central banks, such
as the Bank of England, shortly.
Current Account = Financial Account +/- Balancing Item +/- Change in Central Bank foreign currency reserves
So a current account deficit resulting from the UK being a net importer of overseas goods and
services must be met by a net inflow of capital from overseas taking account of any measurement
errors and any Bank of England intervention in the foreign currency market. Central bank currency
intervention is considered in the next section.
2.9 Exchange Rates

An exchange rate is the price of one currency in terms of another.
Between 1945 and 1972, world currencies operated under the Bretton Woods fixed exchange rate
system. All currencies were formally linked to the US dollar, which was itself convertible into gold at
a fixed price. Although this fixed rate between world currencies and the dollar and the price of gold
could and did change with formal revaluations and devaluations, the system collapsed in the early
1970s and was replaced by a floating exchange rate system.
Under a floating exchange rate system, the exchange rate is set by the demand for and supply of a
currency against all others, though a currency’s value is often influenced by central bank
intervention in the currency markets. This is known as managed floating.

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Currencies can also operate within semi-fixed exchange rate systems such as the European
Exchange Rate Mechanism (ERM), of 1979 to 1998, whereby each currency within the system is
fixed against a central exchange rate but is permitted to deviate either side of this central rate by a
pre-specified percentage.
Although most world currencies currently operate within a system of managed floating, some
currencies remain formally pegged to the US dollar, whilst others are managed against a basket of
currencies - known as a crawling peg - or operate within regional fixed exchange rate systems.
The Effect of the Exchange Rate on International Competitiveness

In an open economy, such as the UK’s, where international trade accounts for a significant share of
GDP, having the “right” exchange rate is imperative. The example below illustrates how the
exchange rate impacts on the price and, therefore, the competitiveness of imports and exports of
goods and services.
Imported baseballs from the US £:$ exchange rate Exported cricket balls to the US
Cost in £ for $1 baseball Cost in $ for £1 cricket ball
£1.00 £1=$1 $1.00
£0.50 £1=$2 $2.00
£2.00 £1=$0.50 $0.50
Figure 26: The Importance of the Exchange Rate
Taking this one stage further, the overall effect of a change in the exchange rate on the UK trade
balance assuming that demand is price elastic and all other factors, such as productivity, are held
constant is as follows:
1. A rise in the nominal value of sterling will reduce a trade surplus or worsen a trade deficit as:
a. exports will be less competitive, unless UK exporters reduce their sterling prices; whereas
b. imports will be more competitive, unless exporters to the UK raise their prices.
2. A fall in the nominal value of sterling will increase a trade surplus or reduce a trade deficit as:
a. exports will be more competitive, unless UK exporters raise their sterling prices; whereas
b. imports will be less competitive, unless exporters to the UK reduce their prices.
By taking account of whether exporters and importers alter their prices when faced with a change
in the nominal exchange rate, we can establish whether a country’s overall international
competitiveness has improved or declined.
One way of establishing international competitiveness is by calculating the real exchange rate. The
UK’s real exchange rate relative to that of the USA can be formally stated as:
Real exchange rate = UK price level x USD

US price level £

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A rising real exchange rate signifies a reduction in international competitiveness. So, if UK inflation is
rising at a faster rate than in the USA without a compensating weakening of the nominal exchange
rate, so the UK’s international competitiveness declines. The precise effect on the trade balance
and the revenues of importing and exporting firms will, of course, also depend on factors such as
the price elasticities of these internationally traded goods and services, any productivity
improvements in those industries and the speed with which consumers substitute goods and
services when faced with a change in price. As consumers are typically slow to change their
spending patterns when faced with changing prices, the impact of a change in the real exchange rate
on the trade balance is never instantaneous.
In fact a weakening of the nominal exchange rate will immediately raise import prices whilst
reducing export prices, thereby worsening the trade balance. However once consumers adjust to
these new relative prices so the trade balance will improve. The trade balance, therefore, tends to
experience a J-curve effect.
We return to looking at exchange rates in Chapter 5.
2.10 Central Banks

LEARNING OBJECTIVES
1.2.6 Know the role of central banks and of the major G8
central banks
Central banks operate at the very centre of a nation’s financial system. Most are public bodies
though increasingly central banks operate independently of government control or political
interference and usually have the following responsibilities:
1. acting as banker to the banking system by accepting deposits from and lending to commercial
banks;
2. acting as banker to the government;
3. managing the national debt;
4. regulating the domestic banking system;
5. acting as lender of last resort to the banking system in financial crises to prevent the systematic
collapse of the banking system;
6. setting the official short term rate of interest;
7. controlling the money supply;
8. issuing notes and coins;
9. holding the nation’s gold and foreign currency reserves to defend and influence the value of a
nation’s currency through intervention in the currency markets; and
10.providing a depositors protection scheme for bank deposits.

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People’s Bank of China (PBC or PBoC)
China’s central bank was established in 1948. In 2003 the Standing Committee of the Tenth
National People’s Congress approved laws to strengthen the bank’s responsibility for financial
stability, monetary policy and managing financial risk.
Central Bank of the UAE (CBUAE)

The central bank was established in 1980. It’s head office is in Abu Dhabi, with five branches located
in Al Ain, Dubai, Fujairah, Ras Al Khaimah and Sharjah. Some of the main responsibilities of the
central bank include directing monetary, banking and credit policies, financial stability and
supervision of the banking system.
Central Bank of Egypt

Egypt’s central bank was established in 1961 and is based in Cairo. Some of the bank’s main
responsibities include controlling monetary, banking and credit policies, financial stability, issuing
currency and banking supervision.
European Central Bank (ECB)

The ECB is based in Frankfurt, Germany. It assumed its central banking responsibilities upon the
creation of the euro, on 1 January 1999. The euro has since been adopted by 12 of the 25 member
states of the European Union (EU), which have collectively created an economic region known as
the Eurozone. The ECB is principally responsible for setting monetary policy for the entire
Eurozone with the sole objective of maintaining internal price stability. Its objective of keeping
inflation (as defined by the Harmonised Consumer Prices index (HICP)) “close to but below 2% in
the medium term” is achieved by making reference to those factors, such as the external value of
the euro and growth in the money supply, that may influence inflation.
The ECB sets its monetary policy through its president and council, the latter comprising the
governors of each of the Eurozone’s national central banks. Although the ECB acts independently of
EU member governments when conducting monetary policy, it has on occasion succumbed to
political persuasion. It is also one of the few central banks that does not act as a lender of last resort
to the banking system.
Reserve Bank of India

The Reserve Bank of India was established in 1935 and is based in Mumbai. The main function of the
bank is to ensure monetary stability in India. It is also required to issue currency, manage foreign
exchange, and to regulate and supervise the financial system.
Bank of Japan (BOJ)

Japan’s central bank has a statutory duty to maintain price stability. It is also responsible for the
country’s monetary policy, issuing and managing the external value of the Japanese yen and acting as
lender of last resort to the Japanese banking system. Until very recently, the BOJ was also subject to
a degree of political interference.

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Saudia Arabian Monetary Agency (SAMA)

The central bank of the Kingdom of Saudi Arabia was established in 1952 and is based in Riyadh. It is
responsible for monetary policy, financial stability, issuing currency, acting as a banker to the
government and managing foreign exchange reserves.
Bank of England
The UK’s central bank was founded in 1694, originally as a commercial bank but was nationalised in
1946.
It wasn’t until 1997 that the Bank gained operational independence in setting UK monetary policy, in
line with that of most other developed nations, when the Bank of England’s Monetary Policy
Committee (MPC) was established.
Since November 2003, the MPC has been subject to meeting a rolling two year target of 2% for
the Consumer Prices Index (CPI) set by the Chancellor of the Exchequer. This it does by setting the
base rate, the UK’s administratively set short-term interest rate, and the MPC’s sole policy
instrument.
In addition to its short-term interest rate setting role, the Bank also assumes responsibility for all
other traditional central bank activities, with the exception of:
1. Supervising the banking system.
2. Managing the national debt. This is the responsibility of the Treasury.
3. Providing a depositors protection scheme for bank deposits. This is now provided by the FSA
through its Financial Services Compensation Scheme (FSCS).
Federal Reserve
The Federal Reserve System in the USA dates back to 1913. The Fed, as it is known, comprises 12
regional Federal Reserve Banks, each of whom monitors the activities of and provides liquidity to
the banks in their region. Although free from political interference, the Fed is governed by a seven-
strong board appointed by the President of the United States of America. This governing board in
addition to the presidents of 6 of the 12 Federal Reserve Banks make up the Federal Open Market
Committee (FOMC). The chairman of the FOMC, also appointed by the USA President, takes
responsibility for the committee’s decisions, which are directed towards the FOMC’s statutory duty
of promoting price stability and full employment.
The FOMC meets every six weeks or so to examine the latest economic data and the many
economic and financial indicators it monitors to gauge the health of the economy to determine
whether the economically sensitive Fed Funds rate should be altered in response to its findings.
Very occasionally it meets in emergency session as and when circumstances dictate.
As lender of last resort to the USA banking system, the Fed has, in recent years, rescued a number
of USA financial institutions and markets from collapse and prevented widespread panic, or
systematic risk, spreading throughout the financial system by judicious use of the Fed Funds rate.

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Economics - A Conclusion
Having read this chapter, you may have come to the conclusion that economics is very much an
inexact science as a result of:
1. the many interacting factors, relationships and destabilising influences that exist within and
outside of the domestic economy;
2. the fallibility of government and central bank policy instruments that seek to control economic
activity in the short term; and
3. the unpredictability of intangible factors such as business and consumer confidence.
With so many factors influencing the economy at any given time, it is almost impossible to establish
with any certainty the contribution or impact that any one factor or change in policy will have on
the economy. Indeed, much of what has been considered in this chapter has been on the basis of
applying the other things being equal caveat so as to isolate the effect of a change in one variable on
another. That is not to say that economics should be ignored or discarded. Indeed, so long as you
can accept its limitations, it can provide an invaluable framework for decision making within the
portfolio management process, especially in evaluating and assessing the desirability of competing
investment opportunities. This we consider in Chapters 4 and 9.

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48
FINANCIAL
MATHEMATICS
AND STATISTICS
1.
2.
STATISTICS
FINANCIAL MATHEMATICS
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1. STATISTICS
1.1 Introduction
The ability to source and interpret all kinds of information, both qualitative and quantitative, in a
timely fashion is key to the portfolio management process. However, since information, or data, can
be sourced from a variety of media, is presented in a wide range of formats and is not always in a
readily usable form, becoming familiar with information sources and being able to assimilate data is
imperative if informed investment decisions are to be made and investment opportunities are to be
capitalised upon.
1.2 Sourcing and Presenting Data

LEARNING OBJECTIVES
2.1.1 Understand where financial data may be sourced from
and how it can be presented
Data Sourcing
Although portfolio managers mainly rely on economic, financial and statistical information when
making investment decisions, social and demographic as well as scientific, legislative and market
research data are frequently drawn upon. Where such information pre-exists, it is termed
secondary data. Secondary data is available from and compiled by a diverse range of bodies and
institutions either with a particular user group in mind or for general consumption and typically
requires further analysis if each user is to maximise the value of the information contained within it.
Information or material that is specifically commissioned for a particular purpose, however, is
known as primary data and should satisfy the originator’s exact information needs. Increasingly, data
is being made available via electronic means, though paper based information IS still a key source.
Information sources relevant to the portfolio manager include:
1. Internet websites. These range from those that provide up-to-the-minute general and finance
news to those which provide access to comprehensive and more specialist economic, social,
demographic and industry information.
2. Commercial quote vendors that provide real time security pricing information as well as historic
security and economic data.
3. Company financial statements.
4. Share price charts.
5. Independent company analysis provided by specialist research consultancies and credit rating
agencies.
6. Authoritative in-depth analysis of financial, economic and social trends produced by government
statistical departments, central banks, international agencies such as the World Bank,
International Monetary Fund (IMF) and Organisation for Economic Cooperation and
Development (OECD), business schools and other academic research organisations.
7. Economic bulletins and financial reports.
8. Newspapers and other journals.

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When dealing with data, you must be able to distinguish whether the information relates to an
entire population or a sample of a population. Where a population is being considered then every
member of a particular group will be included in the analysis. A sample is a subset of the population
and is the group that will be examined.
It is often the case that populations become so large and cumbersome that using and making
inferences from samples is the only viable and cost effective means of analysing the population. The
larger this sample is, the more representative it will be of the population. This sample can either be
selected randomly from the population, in that each constituent has an equal chance or probability
of being included, or non-randomly if it is believed that by intervening in the selection process a
more representative sample of the population will be obtained.
From hereon we will be concentrating solely on numerical, or quantitative, data. Numerical data
can be categorised into that which is continuous, where numbers in a data series can assume any
value, or discrete, where the numbers in the data series are restricted to specific values, such as
whole numbers.
Data Presentation
Raw numerical data can be presented in a wide variety of tabulated and graphical formats to
enhance its informational value and ease of interpretation.
Tabulated Data
Tabulated numerical data often takes the form of a frequency distribution. A distribution is where
the observed numerical values of the subject or variable being considered are arranged in order of
their size or value. Take the example of the real annual percentage returns achieved by UK equities
over the past 100 years. This data can be presented in ascending order of returns with a frequency
of occurrence assigned either to each individual return or to a group of returns. Grouping, or
banding, of observed values is typically used when copious amounts of data need to be consolidated
so that the information can be conveyed in a more meaningful way. So the data may disclose that a
10.1% return has been achieved on two occasions, a 10.4% return on one occasion and an 11%
return on four occasions. Alternatively, a frequency of three could be assigned to a 10.1% to 10.5%
band of returns and four to a 10.6% to 11% band, or a frequency of seven to a larger 10.1% to
11% band. The width of the band, or interval, used will necessarily impact on the usefulness of the
data and should, therefore, be chosen carefully. By adding these frequencies together in ascending
order, a cumulative frequency distribution can be derived. From this, one can deduce what
percentage of returns are either equal to or less than a particular return so as to gain an insight to
the nature of UK equity returns over time.

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Graphical Data
Numerical data presented graphically, or pictorially, can often assist in interpreting the underlying
information. This is true of most tabulated data, especially the type of data we have just considered.
The more popular forms that graphically presented data can take, include:
1. line and scatter graphs and charts;
2. bar charts; and
3. pie charts.
y-axis
Dependent
variable
slope of line = b
O x-axis
Independent variable
Figure 1: Regression Analysis
Graphical presentation of data is particularly useful for when an apparent cause-and-effect, or

causal, relationship between two variables is being illustrated. By causal it is meant that one of the
variables is either thought or known to determine the other. The former is known as the
independent variable (X) and is plotted on the horizontal, or x-axis, of a graph, whilst the latter, the
dependent variable (Y), is scaled on the vertical, or y-axis. For instance, the annual rate of economic
growth over the past 100 years could be plotted against our real annual UK equity returns to see if
any apparent cause-and-effect relationship exists. In this instance, economic growth would act as
the independent variable whilst the equity returns would be the dependent variable, with a series of
points scattered between the two axes representing the observed co-movement between the two
variables. In order to quantify this apparent association between these two variables, a linear
relationship is established through regression analysis. To achieve this, regression analysis employs a
concept known as least squares regression, which by drawing on the data calculates the position of
a unique straight line that best represents, or best fits, the collective position of all of these points.
This it does by calculating how to collectively minimise the square of each of the vertical distances
of these points from a single straight line. The resulting line of best fit is underpinned by the
following equation:
Y = a + bX, where a = the value of Y when X = 0 and b = the rate at which Y increases
proportionately with X if a positive relationship exists or decreases if there is a negative
relationship, denoted by -bX. You may recall from Chapter 1 that the relationship between planned
consumer expenditure and disposable income, as encapsulated within the consumption function,
was given by a similar equation: C = a + c(1- t)Y.

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Drawing on the above diagram, a is where this unique straight line cuts the y-axis and b the slope of
this line. So if a = 5 and b = 0.8, then if X = 10, Y = 5 + 0.8 (10) = 13.
It should be noted, however, that regression analysis by itself does not prove causation. It is
perfectly possible that the relationship between the two variables is not causal but has arisen purely
by chance.
The derivation of the line of best fit is set out in Appendix 1 for those of you who wish to further
your understanding of this topic.
Arithmetic
scale
O Arithmetic scale
Figure 2:Accelerating rate of increase in dependent variable using arithmetic scale
Log scale
1000
100
10
O
Arithmetic scale
Figure 3: Accelerating rate of increase in dependent variable using semi-log scale

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When plotting data graphically, the scale of the axes used on the graph should be taken into
consideration if the data is to convey the right message to the user or be interpreted correctly. For
instance, if a logarithmic scale is used on the y-axis but a conventional arithmetic scale is used on the
x-axis, a so-called semi-log scale is created. A logarithmic scale is one whereby as you move up the
y-axis each successive value increases by a fixed multiple of the previous value. Therefore, a
concave relationship between two variables using an arithmetic scale, depicting an accelerating rate
of increase in the dependent variable in response to successive increases in the independent
variable, would, given a semi-log scale, be transformed into a linear relationship. The range and
spacing of the values used on each scale also affects the depicted relationship.
1.3 Measures of Central Tendency and Dispersion

LEARNING OBJECTIVES
2.1.2 Be able to calculate the measures of central tendency:
arithmetic mean; geometric mean; median; mode
Dealing mainly with raw numerical data or with ordered numerical distributions, you must be able
to make inferences about the data being considered and ideally use it to make predictions about the
population. Statistics makes this possible by drawing on what are known as measures of central
tendency and measures of dispersion. All of the following calculations can be performed quickly and
simply using a Casio fx-83 MS calculator.
Measures of central tendency establish a single number or value that is typical of the distribution.
That is, the value for which there is a tendency for the other values in the distribution to surround.
Measures of dispersion, however, quantify the extent to which these other values within the
distribution are spread around, or deviate from, this single number.
Measures of Central Tendency

The three most commonly used measures of central tendency are the arithmetic mean, median and
mode.
1. Arithmetic mean ( x ).The arithmetic mean is the most common and most familiar of the three
measures and for raw data is established by using the following formula: x = Σx/n, where Σx is the
sum (Σ) of each of the observed values (x) and n the number of observations, or items. Where data
has been collated as a frequency distribution, the mean ( x ) = Σfx/Σf, where f is the frequency with
which each value, or item, appears within the distribution. Where raw data has been tabulated into
a frequency distribution, n becomes Σf.
2. Median (xm). The median is the mid-point or middle value within an ordered distribution
containing an odd number of observed values or the arithmetic mean of the middle two values in an
ordered distribution containing an even number of values. So, within a distribution of 50 observed
values, the median will be the mean of the 25th and 26th value in this ordered sequence of numbers
whereas if the distribution contains 49 values, the median will be the 25th value in the sequence.
That is to say, 50% of the distribution’s values lie above this value whilst 50% lie below. This can be
summarised by using the following equation:

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x value = (n + 1)/ . Where there is a frequency distribution the median becomes the (Σf + 1)/
m 2 2
value.
3. Mode (xf). The mode is the value or values that occur most frequently in the distribution. That is,
more than one value can represent the mode of a distribution.
From what we know of these measures of central tendency, several conclusions can be drawn.
Firstly, whilst it is possible that both the mean and median may result in a number or value that isn’t
contained within the distribution, the mode will always be one or more of the observed values.
Secondly, only the mean will be influenced by any extreme values within the distribution as only the
mean takes every value into account; the median and mode do not.
Real annual percentage investment returns from UK equities over 16 years

Type of Distribution Symmetrical Negatively Skewed Positively Skewed
Return (% pa) Frequency Frequency Frequency
1 1 1 2
2 3 3 6
3 8 4 4
4 3 6 3
5 1 2 1
Total frequency ( Σf) 16 16 16
The relationship between the mean, median and mode depends on how evenly the values are
distributed within the sample or population. Given the hypothetical data above, we can illustrate
how the size and position of each of these three measures of central tendency compare given
distributions with the same minimum and maximum observed values but with different frequencies
assigned to each value within the distribution.
The relationship between the mean, median and mode (using continuous data)
Frequency
mean = median = mode
Ascending order of values
Figure 4: Symmetrical Distribution

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Frequency
mean<median<mode
Figure 5: Negatively Skewed Distribution

Frequency
mode<median<mean
Figure 6: Positively Skewed Distribution
Where the distribution is symmetrical - that is where the ordered data is normally distributed - the
three measures of central tendency will produce the same value, in this example, 3%. Each of these
measures is positioned at the peak of this symmetrical, continuous, bell shaped normal curve.
Where the data is asymmetrical, or skewed, however, each measure of central tendency will
produce a different value. For a negatively skewed distribution, where a larger number of observed
values are concentrated towards the higher end of the distribution, the mode, which always
pinpoints where a frequency distribution peaks, will be greater than median which will be greater
than the mean.

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The following calculations show this:
1. Mean ( x ) = Σfx/Σf = [(1 x 1%) + (3 x 2%) + (4 x 3%) + (6 x 4%) + (2 x 5%)]/16 = 3.3%.
2. Median (xm) = (Σf+1)/2 value = (16 + 1)/2 = 8.5th value = (3 + 4)/2 = 3.5%.
3. Mode (xf) = 4%.
For a positively skewed distribution, where a greater number of observed values are at the lower
end of the distribution, the ordering of the mean, median and mode are reversed:
1. Mean ( x ) = 2.7%.
2. Median (xm) = 2.5%.
3. Mode (xf) = 2%.
Although under most circumstances the mean tends to be a more stable measure of central
tendency than the median when moving between samples of a population, when distributions are
highly skewed with extreme values, such as the distribution of annual investment returns over long
time periods, or the distribution of household income, the median often provides a more
representative measure of central tendency. This quality is also possessed by the geometric mean.
(For instance, if an investment fund lost 60% of its value in year 1 but gained 30% in year 2 and
50% in year 3, its arithmetic mean performance would have been 6.67% even though it had lost
22% of its initial value over the 3 year period).
Geometric mean
The geometric mean ( x g) is established by taking the nth root of the product of n values (product
simply means multiplication), such that:
x g = n√(x1 x x2... x xn) = (x1 x x2... x xn)1/n, where x1 is the first value and xn the nth value.
(x1 x x2 ...x xn) is known as a geometric progression.
Example
What is the geometric mean of 1, 3, 5 and 10?
Solution
x g = (1 x 3 x 5 x 10)1/4 = 3.49
However, the geometric mean will always result in a number that is less than the arithmetic mean
( x ), considered to be the most representative measure of central tendency in most, though, not all
situations:
x = Σx/n = (1 + 3+ 5 + 10)/4 = 4.75

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Despite this shortcoming, geometric progressions and geometric means have a fundamental use in
portfolio management. Geometric progressions can be used to establish the compounded value of a
variable over time, with the geometric mean then being employed to determine the average
compound annual growth rate implied by this cumulative growth. This is covered more fully later in
the next section and in Chapter 4 when we look at fixed interest securities.
Measures of Dispersion
LEARNING OBJECTIVES
2.1.3 Be able to calculate the measures of dispersion:
variance (sample/population); standard deviation
(sample/population); range
The extent to which the observed values within a distribution deviate or are spread around this
average value, or central point, can be quantified through the use of dispersion measures. Intuitively
we should only be concerned with the dispersion of values that surround the mean and median as
the scatter of data around the mode, assuming of course that only one mode exists, provides little,
if any, useful information about the distribution.
To calculate the degree of dispersion around the mean, the variance or standard deviation of the
distribution must be established, whereas for the median, the range, interquartile range, deciles and
percentiles are typically determined.
Starting with dispersion around the median, as we know, the median represents the mid-point of an
ordered distribution of numerical values. So, given the distribution below of 21 discrete values in
ascending order, the median is the (21 + 1)/2 = 11th value, 6.
1,1,2,2,3,5,5,5,6,6,6,7,10,10,10,12,14,20,20,20,45
The first of the dispersion measures used with the median is the range. This simply deducts the
lowest value in the distribution from the highest value. Therefore, for the above distribution, we
arrive at 45 - 1 = 44. However, this number does not provide a great deal of information about the
other values that lie within this range unless the numbers are evenly distributed around the median,
which in the above example they are not. In fact, the distribution’s highest value severely distorts
the informational value of the range. To remedy this, the interquartile range can be employed. The
range is divided into four quarters or quartiles; in the same way that the median divides the
distribution into two halves. The interquartile range measures dispersion from the top of the first
quartile (Q1) to the top of the third quartile (Q3); that is the middle 50% range of values within the
distribution.
Given this distribution of 21 values placed in ascending order, Q1 will be the ¼ (n + 1) value = ¼
(21 + 1) = 5.5th value = (3 + 5)/2 = 4 and Q3 the ¾ (21 + 1) = 16.5th value = (12 + 14)/2 =
13. The interquartile range then = 13 - 4 = 9. This is a far more representative measure of
dispersion than the value of 44 given by the range. When data is presented in a frequency
distribution, Q1 would be given by the ¼ (Σf + 1) value and that of Q3 by the ¾ (Σf + 1) value.

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Deciles representing 1/10ths of the distribution and percentiles, 1/100ths are calculated in a similar
fashion. Indeed, the 25th percentile of a distribution defines Q1, the median the 50th percentile,
whilst the 75th percentile defines Q3. We will see in Chapter 10, how performance measurement
statistics are typically categorised into quartiles and often deciles and percentiles. The diagram
below summarises each of these measures.
Values arranged in ascending order

Minimum Maximum
value Interquartile range value
1/ of values 1/ of values 1/ of values 1/

4 4 4 4 of values
Q1 Q2 = Median Q3
= 25th percentile = 50th percentile = 75th percentile
Range
Figure 7: Measure of Dispersion Around the Median
Having considered those measures of dispersion that relate to the median, we now consider the
calculation of the variance (σ2) and standard deviation (s) around the arithmetic mean ( x ). As the
arithmetic mean takes account of every value within a distribution, unlike the median or mode, the
mean can be defined as that value where sum of the differences, or deviations, of the other items in
the distribution from this value will equal zero. Given that the mean of the distribution below is 10,
confirm to yourself that by subtracting each item from 10, the sum of the negative differences
cancel out the sum of the positive differences to produce zero.
1,1,2,2,3,5,5,5,6,6,6,7,10,10,10,12,14,20,20,20,45
The variance draws on this characteristic of the mean as it is defined as the arithmetic mean of the
sum of the squared deviations from the mean, whilst the standard deviation is the square root of
the variance. In effect, by taking the square root of the variance, the standard deviation represents
the average amount by which the values in the distribution deviate from the mean. All of this will
become clear shortly. Several formulae exist to calculate these two measures of dispersion. Which
of these is used depends on whether the distribution represents a population or a sample of the
population and whether the data is presented as ordered raw data, as above, or as a frequency
distribution.
When calculating the variance and standard deviation of ordered raw data, the following formulae
are employed:

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Population Formulae
Variance (σ2) = Σ(x - x )2
n
√( Σ(x - x )2
Standard deviation (σ) = √variance =
n )
Sample Formulae
Variance (σ2) = Σ(x - x )2
(n - 1)
√
Standard deviation (σ) = √variance = (Σ(x - x )2)
(n - 1)
Assuming, however, that the distribution data has been tabulated as a frequency distribution, the
formulae become:
Population Formulae
Variance (σ2) = Σf (x - x )2
Σf
√
Standard deviation (σ) = √variance = (Σf (x - x )2)
Σf
Sample Formulae
Variance (σ2) = Σf (x - x )2
(Σf - 1)
√
Standard deviation (σ) = √variance = (Σf (x - x )2)
(Σf - 1)
You will notice several differences between the ordered raw data and frequency distribution data
formulae. Firstly, the Σ in the numerator of the raw data equations becomes Σf in the frequency
distribution formulae numerators. Secondly, the n in the raw data population denominator and (n -
1) in the sample denominator changes to Σf and (Σf - 1) in the frequency distribution denominators,
respectively. You may recall that n is the total number of observations within a distribution of
ordered raw data whereas Σf is the sum total of frequencies in a frequency distribution. The reason
why - 1 appears in the denominator for both sample formulae is because the sample may not be
fully representative of the underlying population: the smaller the sample size the less representative
the sample is likely to be of the population. By subtracting one from the sum of the number of
observations (n) or frequencies (f), the greater the likelihood that the measure of dispersion
produced by the sample will be representative of the population. So, the smaller the sample size the
larger the variance and standard deviation. However, as the sample size approaches that of the
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Although the variances and standard deviations of both ordered raw and frequency distribution data
can be calculated quickly and easily by using the Casio fx-83MS calculator, it is useful to work
through their calculation manually. Starting with ordered raw data, the steps you should take in
making these
calculations manually are as follows:
1. obtain the arithmetic mean;
2. obtain the set of deviations from the mean;
3. square each deviation;
4. divide the sum of the squared deviations by the number of observations to obtain the population
variance or by the number of observations minus one to obtain the sample variance;
5. take the square root of the variance in each case to obtain the standard deviation.
Using the ordered raw data above and adopting these steps, the variances and standard deviations
are obtained as follows:
Value (x) (x – x ) (x – x )2
(subtract each (square each of the (x – x )
value x in differences in column 3 otherwise
column 1 from the minus differences will offset
the mean of 10) the plus differences)
1 -9 81
1 -9 81
2 -8 64
2 -8 64
3 -7 49
5 -5 25
5 -5 25
5 -5 25
6 -4 16
6 -4 16
6 -4 16
7 -3 9
10 0 0
10 0 0
10 0 0
12 2 4
14 4 16
20 10 100
20 10 100
20 10 100
45 35 1225
Σx = 210; n = 21 Σ(x - x) = 0 Σ(x - x)2 = 2016
Mean (x) = Σx/n =210/21 = 10
Population variance (σ2) = Σ(x - x )2 = 2016 = 96

n 21
Population standard deviation (σ) = √variance = √96 = 9.8
Sample variance (σ2) = Σ(x - x )2 = 2016 = 100.8

n-1 20
Sample standard deviation (s) = √variance = √100.8 = 10.04

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By tabulating this raw data into a frequency distribution, the variance and standard deviation are
calculated in a similar fashion as follows:
Value Frequency fx (x – x ) (x – x )2 f(x – x )2

(x) (f) (subtract (square each multiply each of the
each value x of the (x – x ) (x – x )2 differences in
in column 1 differences in column 5 by the
from the column 4) frequencies in
mean of 10) column 2)
1 2 2 -9 81 162
2 2 4 -8 64 128
3 1 3 -7 49 49
5 3 15 -5 25 75
6 3 18 -4 16 48
7 1 7 -3 9 9
10 3 30 0 0 0
12 1 12 2 4 4
14 1 14 4 16 16
20 3 60 10 100 300
45 1 45 35 1225 1225
Total Σf = 21 Σfx = 210 - - Σf(x – x)2 = 2106
Mean (x) = Σfx/Σf =210/21 = 10
Population variance (σ2) = Σf (x - x )2 = 2016 = 96

Σf 21
Population standard deviation (σ) = √variance = √96 = 9.8
Sample variance (σ2) = Σf (x - x )2 = 2016 = 100.8

Σf - 1 20
Sample standard deviation (σ) = √variance = √100.8 = 10.04
It should come as no surprise that the solutions for the raw data and frequency distributions are
identical as the same data has been used in both cases. So what information do these measures of
dispersion convey about the distribution being considered and how can they be used as a predictive
tool? Well, as mentioned earlier, both the variance and standard deviation draw on the mean’s
characteristic of being that value from which the sum of the differences, or deviations, of all other
items in the distribution equal zero. The variance is the average of the sum of the squared
deviations from the mean, whilst the standard deviation, as the square root of the variance,
represents the average amount by which the values in the distribution deviate from the mean. As
most aspects of finance tend to draw on the standard deviation rather than the variance when
calculating dispersion from the mean, we will concentrate on the former both as a measure of
dispersion and as a way of predicting future values from current and past distributions.
68.26%
-3σ -2σ -1σ +1σ +2σ +3σ

95.5%
99.75%
Figure 8: A Normal Distribution

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You may recall that where data is normally distributed about the mean, this can be depicted
graphically as a symmetrical, continuous, bell shaped normal curve. This normal curve has the
following qualities:
1. Approximately 2/3rds (68.26%) of observations, or items, in the distribution will be within one
standard deviation either side of the mean,
2. Approximately 95.5% of observations will be within two standard deviations either side of the
mean, and
3. Approximately 99.75% of observations will be within three standard deviations either side of the
mean.
Therefore, if the above distribution represents a normally distributed population of hypothetical

real annual equity investment returns with a mean return of 10% and a standard deviation of 9.8%,
it can be inferred that about two-thirds of returns over this period have been within 9.8% of the
10% mean return. That is, on about two-thirds of occasions annual real returns have varied
between 0.2% and 19.8%. On 95.5% of occasions, they have been between - 9.6% and 29.6%
and on 99.75% of occasions between - 19.4% and 39.4%. Notice how the standard deviation
adopts the same unit of measurement as the mean. This provides some indication of the riskiness,
or volatility, of the hypothetical real returns from equities over this period.
However, these findings are based on the assumption that these returns are normally distributed
around the mean, which they are not. As the calculation of the mean and standard deviation in this
distribution have been skewed, or distorted, by the extreme value of 45% and the three 20%
returns, these normal distribution values cannot be rigidly applied to this particular distribution. In
fact, this distribution, as with most long run distributions of equity returns, is positively skewed.
That is, equity markets produce more extreme positive and negative returns than should statistically
be the case - a phenomenon known as kurtosis - but these extreme positive values far outweigh the
negative ones.
As inferred earlier, measures of central tendency and dispersion can also be used to predict future
values from current and past distributions, again by making the assumption that these returns are
normally distributed but also that the past is a carbon copy of the future. This is known as mean-
variance analysis. The most likely future outcome or expected return, is given by the mean of these
past returns, whilst the risk attached to this expected outcome, is given by the variance or, more
usually, by the standard deviation of these returns. So, assuming the distribution used above is a
normal distribution, it can be inferred that the most likely future, or expected, return will be the
mean of 10% whilst there is approximately a two-thirds probability of the return being between
0.2% and 19.8%. Alternatively, it could be said that in two years out of three, the return is
expected to be between 0.2% and 19.8%.
Example
Based on past observations, security A and security B have the following expected returns attached
to the probable economic outlook.
Economic Outlook Security A Security B

Description Probability rA (return % pa) rB (return % pa)
Recession 0.2 20 -20
Trend growth 0.5 30 60
Boom 0.3 10 90

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The probabilities are future estimates and the expected returns have been derived from the returns
that were achieved in the past.
Assuming that these returns represent the population, calculate the expected return for each
security and the risk, or standard deviation, associated with that return, and state which is the
riskier security if held in isolation.
Solution
Security A
rA pA Expected return rA –e(rA) [rA –e(rA)]2 Variance
e(rA) (subtract the (square the p[rA –e(rA)]2
(multiply the returns in expected difference in (attach the
column 1 by the return of column 4 to probabilities
probability of returns and 22% from ensure the to the
establish the expected the returns pluses do resulting
return, or mean, by in column 1) not offset variances of
summing the numbers the minuses) returns)
below)
Scenario 1 20 0.2 4 -2 4 0.8
Scenario 2 30 0.5 15 8 64 32
Scenario 3 10 0.3 3 -12 144 43.2
1.0 22 76
e(rA) (mean) = 22%
Standard deviation (σA) = √variance (σA2) = √76 = 8.72%
So, based on past observations, security A is expected to:

1. Produce a return of 22%; with
2. A 68% or 2/3rds probability (one standard deviation) of the return being within 22% +/- 8.72%,
ie, 13.28% to 30.72%;
3. A 95.5% probability of the return being within 22% +/- (2 x 8.72%), ie, 4.56% to 39.44%; and
4. A 99.75% probability of the range of returns extending from - 4.16% to 48.16%.
There remains a 0.25% probability of the return being less than 10% or greater than 52%.
Turning to security B:
Security B
rB pB e(rB) rB – e(rB) [rB – e(rB)]2 p[rB – e(rB)]2
Scenario 1 - 20 0.2 -4 - 73 5329 1065.8
Scenario 2 60 0.5 30 7 49 24.5
Scenario 3 90 0.3 27 37 1369 410.7
1.0 53 1501.0
e(rB) = 53%
σB = √σB2 = √1501 = 38.74%

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e(r)
B
O
σ
Figure 9: Expected Return and Risk
So, security B has the higher expected return but also has the greatest risk attached to that return.
Once again, however, there are limitations to this analysis: principally that a normal distribution is
assumed and that the past is a guide to the future.
1.4 Diversification
LEARNING OBJECTIVES
2.1.4 Understand the correlation between two variables and
the interpretation of the data
2.1.5 Understand the covariance between two variables and
the interpretation of the data
2.1.6 Understand the use of regression analysis to quantify the
relationship between two variables and interpretation of the data
“Money is like muck, not good except it be spread”

Francis Bacon
The risk of holding securities A and B in isolation is given by their respective standard deviation of
returns. However, by combining these two assets in varying proportions to create a two stock
portfolio, the portfolio’s standard deviation of return will, in all but a single case, be lower than the
weighted average sum of the standard deviations of these two individual securities. The weightings
are given by the proportion of the portfolio held in security A and that held in security B, where the
weighting of A = (1 - weighting of B). This reduction in risk for a given level of expected return is
known as diversification.

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Quantifying Diversification
To quantify the diversification potential of combining securities when constructing a portfolio, two
concepts are used:
1. Correlation, and
2. Covariance.
Correlation
Diversification is achieved by combining securities whose returns ideally move in the opposite
direction to one another, or if in the same direction at least not to the same degree. That is, risk
reduction is achieved by combining assets whose returns have not moved in perfect step, or are not
perfectly positively correlated, with one another. When combined as a portfolio, the risk associated
with security A and security B’s individual returns, quantified by their individual standard deviations,
is secondary to the correlation of their individual returns. Just because two shares have high
individual standard deviations doesn’t necessarily mean that when combined they will create a
similarly risky portfolio. In fact, the lower the correlation of these returns, the greater the
portfolio’s diversification and the lower the level of total risk associated with any given level of
expected return.
The Correlation Coefficient

The correlation coefficient (ρ) is calculated in much the same way as a regression between two
variables when employing regression analysis. In quantifying the degree of correlation between
individual security returns, r varies between -1 where there is a perfectly negative correlation
between returns from two securities and +1 for a perfectly positive correlation. Only when
security returns are perfectly negatively correlated, in that they move in the opposite direction to
one another at all times and in the same proportion, can they be combined to produce a risk-free
return. Where there is no predictable common movement between security returns, there is said
to be zero or imperfect correlation. Although the correlation coefficient given this scenario is zero,
there are still diversification benefits from combining securities that give this result. In fact, a
perfectly positive correlation, when security returns move in the same direction and in perfect step
with each other, is the only instance when diversification benefits cannot be achieved.
It should be noted, however, that correlation, as with the results of regression analysis, does not
prove that a cause-and-effect or, indeed, that a steady relationship exists between two variables.
Correlations can arise from pure chance.

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ns
e(rAB)
lation of retur
re
sing cor
e(rB) Decrea B
ρ =-1
AB ρ =0 ρ
e(rAB1) AB AB =+1
e(rA) A
O σAB1 σA σB σAB
Figure 10: Correlation
The above diagram shows how the combined risk and expected return of holding securities A and B
in differing proportions varies according to the correlation of their returns. For instance, if rAB = 0,
then both a higher expected return and lower total risk could be achieved by holding a portfolio
comprising mostly security A with a small holding in security B, than by holding this same total
amount in security A alone.
In practice, however, as a result of correlations being dynamic and the possibility that the
correlation may have resulted by chance, past correlation coefficients of investment returns are
rarely a perfect guide to the future.
The covariance
The covariance (cov) also quantifies the extent to which the returns from securities A and B have
varied with each other and is given by the equation:
CovAB = ρAB x σA x σB
Assuming the returns from securities A and B (considered in Section 1.3 above) are mildly
negatively correlated with ρAB = -0.225, then:
CovAB = -0.225 x 8.72 x 38.74 = -76
A positive covariance between the returns of A and B means they have moved in the same direction
whilst a negative covariance means they have moved inversely. The larger the covariance the
greater the historic joint movements of the two securities in the same direction. The covariance of -
76 is relatively low and, therefore, indicates that a portfolio containing the two securities would be
relatively well diversified; that is, there is a fair chance that if security A does badly, security B should
do well.

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From the equation:
CovAB = ρAB x σA x σB
it can be seen that:
ρ
AB = CovAB
σA x σB
From these two equations, the following conclusions can be drawn:

1. Although it is perfectly possible for two combinations of two different securities to have the same
correlation coefficient as one another, each may have a different covariance, owing to the
differences in the individual standard deviations of the constituent securities.
2. A security with a high standard deviation in isolation does not necessarily have a high covariance
with other shares. If it has a low correlation with the other shares in a portfolio then, despite its
high standard deviation, its inclusion in the portfolio may reduce overall portfolio risk.
3. Portfolios designed to minimise risk should contain securities as negatively correlated with each
other as possible and with low standard deviations to minimise the covariance.
The covariance can be established without knowing the correlation coefficient. We know that the
covariance establishes the extent to which security returns move in tandem under different
scenarios. Formally put, the covariance between the returns of two securities is the summed
average, or expected value, of the product of each security’s deviation of returns from its expected
return under different scenarios. In other words, if one security’s return at one point in time differs
from its expected return, what is likely to happen to the return of the other security relative to its
expected return at that same point in time?
With reference to the tables which established security A’s and security B’s expected returns and
standard deviations, take each row of the ρA column for security A, multiply by the same row of
the rA - e(rA) column for security A, multiply this by the same for security B and then sum these
products. The covariance of the returns between security A and security B is, therefore:
CovAB = Σ{ρscenario n x [rA - e(rA)] x [rB - e(rB)]}
CovAB = 0.2(-2 x -73) + 0.5(8 x 7) + 0.3(-12 x 37)
CovAB = -76
You will notice that by applying the formula ρAB = CovAB / σA x σB that
ρ
AB = -76
8.72 x 38.74 = -0.225
Where the observed returns are given rather than the probabilities of occurrence, the covariance
formula becomes:
CovAB = Σ{[rA-e(rA)][rB-e(rB)]}
n

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A more detailed examination of how the correlation and covariance between two variables is
calculated is set out in Appendix 1 for those of you who wish to further your understanding of these
concepts.
2. FINANCIAL MATHEMATICS
2.1 Introduction
Money has a time value. That is, money deposited today will attract a rate of interest over the term
it is invested. So, £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. Discounting can also be used to establish what sum needs to be invested today to realise a
target final sum on a pre-specified future date, given a known interest rate. So, £95.24 invested
today at 5% for one year will result in a future value of £95.24 x 1.05 = £100. We will come back
to each of these calculations throughout this section.
2.2 Simple and compound interest

LEARNING OBJECTIVES
2.2.2 Be able to calculate the future value of lump sums
and regular payments
Interest, whether payable or receivable, can be calculated on either a simple or compound basis.
Whereas simple interest is calculated only on the original capital sum, compound interest is
calculated on the original capital sum plus accumulated interest to date.
Simple interest
Simple Interest = Principal x Rate x Time or I = p x r x t where:

I = simple interest which is the total amount of interest paid
p = initial sum invested or borrowed (also called the principal).
r = rate of interest to be expressed as a decimal fraction ie, 12% use 0.12 in the calculation
t = number of years.
Example One: If £200 is invested at a rate of 7% for two years, the simple interest calculation is:
I = £200 x 0.07 x 2 = £28.00.

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Example Two: If £300 is invested at a rate of 5% for 60 days, the simple interest calculation is: I =
£300 x 0.05 x 60/365 = £2.47 (rounded to two decimal places).
Leap years are handled according to a number of different conventions. In general, the UK and
Japan use a 365 day interest year (even in a leap year). Some European countries and the USA use
a 360 day interest year. For the purposes of this course, leap years will be ignored and a 365 day
year will be assumed.
To calculate the future value (FV) of a lump sum invested at a rate of interest (r) applied on a simple
interest basis over a defined number of years (t), the following formula should be used:
FV = initial sum invested x [1 + (r x t)] = p + p x r x t
So, if £100 is invested at a 5% simple rate of interest over two years, the future value of this sum
will be:
FV = £100 x [1 + (0.05 x 2)] = £100 x 1.10 = £110.00
Compound Interest
Albert Einstein is quoted as saying “the most powerful force in the universe is compound interest.”
When money is invested it earns interest. As long as this interest is not withdrawn, compound
interest will be paid on the original investment and past interest earned. The longer and more
frequent the period of compounding, the greater the growth in interest payments. Note that annual
compounding is the most common period used.
FV = p x (1+r/n)nt
FV =future value of the initial investment (p)
p = initial sum invested or borrowed (also called the principal).
r = rate of interest to be expressed as a decimal fraction ie, 12% use 0.12 in the calculation.
n = number of compounding periods per year.
t = number of years.
Example One: If £100 is invested at 5% over two years with annual compounding, the future value
is:
FV = £100 x (1.05)2 = £110.25
That is, at the end of year one the £100 becomes £100 x 1.05 = £105. 1.05 is then applied to £105
to become £105 x 1.05 = £110.25 at the end of year two. To raise a number to the power of n,
you need to use the ^ key on your calculator. In establishing the terminal, or future, value of this
£100 then, a geometric progression has been employed.
Example Two: If £2,000 is invested at 5% over two years with interest reinvested each month, the
future value at the end of the two year period is:
FV = £2,000 x ( 1 + 0.05 / 12 ) 12 x 2 = £2,000 x ( 1.004167 ) 24 =£2,209.88

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Example Three: If £2,000 is invested at 5% over two years with interest reinvested each month,
the future value at the end of the two year period is:
FV = £2,000 x (1 + 0.05 / 12 )12 x 2 = £2,000 x (1.004167)24 = £2,209.88
For the remainder of this chapter, we will focus on the use of compound interest.
2.3 Annualised compound returns

LEARNING OBJECTIVES
2.2.1 Be able to calculate the present value of lump sums and
regular payments, annuities and perpetuities
2.2.2 Be able to calculate the future value of lump sums and
regular payments
If you have already established what final amount is to be received from investing a lump sum over a
defined period, or have a target final sum in mind, and wish to calculate the compound annual rate
of growth achieved or required over the term of the investment, then this can be derived in one of
three ways:
1. Annualised return = [n√(final sum/amount invested) - 1] x 100, or
2. Annualised return = [(final sum/amount invested)1/n - 1)] x 100, or
3. Annualised return = ([1 + (growth/amount invested)]1/n - 1) x 100
1/n is simply another way of calculating n√, the nth root of a number. To find the nth root of a value
or to raise a number to the power of 1/n, you should use the ^ key on your calculator, placing (1
n) after ^. You may recall from earlier that the resulting number is the geometric mean.
Example
If £5,000 invested over 10 years with interest payable annually on a compound basis grows to
£10,000, what is the compound annual rate of return?
Annualised return = [(final sum/amount invested)1/n - 1] x 100
Annualised return = [(10,000/5,000)1/10 - 1] x 100
Annualised return = [(10,000/5,000)0.1 - 1] x 100 = 7.177%
To check this answer, simply apply this compound annual rate to £5,000 over 10 years using the
formula:
FVn = initial sum invested x (1 + r)n
FV10 = £5,000 x (1.07177)10 = £10,000

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As noted earlier in the chapter, you should use the geometric mean rather than the arithmetic mean
when calculating the annual compound rate of growth of an investment over a period of time. For
example, if £100 grows at the end of the year to £110 and then falls back to £100 at the end of year
2, despite a zero rate of growth, the arithmetic mean = 10% - 9.1% = 0.45% per annum.
2
The following example applies what has been covered so far.
Example
£4,500 was invested at a variable interest rate compounded annually. In years one and two the
investment attracted a rate of interest of 5% per annum, in year three, 6% and in year four, 3%.
Calculate:
i. The value of the investment as at the end of year four, and
ii. The compound annualised return.
Solution
i. FV4 = £4,500 x (1.05)2 x (1.06) x (1.03) = £5,417
ii. Compound annualised return = [(5,417/4,500)1/4 - 1] x 100
= [(5,417/4,500)0.25 - 1] x 100 = 4.75%
To check the answer, use the future value formula: FV4 = £4,500 x 1.04754
= £5,417
Effective Interest Rates

Deposit interest rates, rather than being compounded annually, are often compounded on either a
monthly, quarterly or semi-annual basis. However, two rates are usually quoted by deposit taking
institutions. These are a flat rate, or annual rate of interest, and an effective rate, also known as an
annual equivalent rate (AER).
The effective annual rate of interest = [(1 + r/f)f - 1]
where r = flat rate of interest and f = frequency of compounding during the year.
The greater the frequency with which interest is compounded during the year, the higher the
effective interest rate.
Example
If the quoted flat rate is 10% per annum, what is the effective annual interest rate if interest is
compounded:
i. Monthly
ii. Quarterly

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Solution
i. The effective annual rate of interest = [(1 + r/f)f - 1] = [(1 + 0.1/12)12 - 1]

= 10.47%
ii. The effective annual rate of interest = [(1 + 0.1/4)4 - 1] = 10.38%
Example
A three month Treasury Bill has a new issue price of £98.40 per £100 nominal. In three months
time, the bill will be redeemed at £100. Calculate the effective annual rate of return if the bill is
purchased at issue and held to redemption.
Solution
Gain to redemption = redemption value - issue price
Gain to redemption = £100 - £98.40 = £1.60
Effective annual gain = £1.60 x 4 = £6.40
Flat annual interest rate = £6.40/£98.40 = 6.5%
Effective annual rate of interest = [(1 + r/f)f - 1] = [(1 + 0.065/4)4 - 1] = 6.66%
Alternatively, you could use the formula:
Annual rate of return = [1 + (quarterly gain/amount invested)]f - 1)
Annual rate of return = [1 + (1.60/98.40)]4 - 1) = 6.66%
To establish the future value of an invested lump sum where interest is compounded more
frequently than once per annum, the following formula should be applied:
FVn = initial sum invested x [(1 + r/f)f x n]
Example
£1,000 is invested for two years at a quoted flat rate of 10% per annum. Calculate the future value
of this sum if interest is compounded:
i. Monthly
ii. Quarterly
Solution
i. FVn = initial sum invested x [(1 + r/f)f x n]
So, FV2 = £1,000 x [(1 + 0.1/12)12 x 2] = £1,220.39
ii. FV2 = £1,000 x [(1 + 0.1/4)4 x 2] = £1,218.40

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Applying Compound Interest to Regular Payments
So far we have concentrated on establishing the final value of invested lump sums when compound
interest is applied. We now move on to looking at how final values are established when a series of
equal payments are invested either at the start or the end of each year. The former payments are
known as being made in advance whilst the latter are termed as being made in arrears.
If investing at the start of each year, then
[
FVn = regular payment x { (1 + r)n+1 - 1 - 1}
r ]
Example
£100 is invested at the start of each year for five years at a fixed rate of interest of 6% per annum
compounded annually. What will the accumulated value of these series of payments be at the end of
the five year period?
Solution
[ ]
FV5 = £100 x { 1.066 - 1 - 1} = £597.53. To check this answer:
0.06
[
If investing at the end of each year, then FVn = regular payment x (1 + r)n - 1
r ]
Example
£100 is invested at the end of each year for five years at a fixed rate of interest of 6% per annum
compounded annually. What will the accumulated value of these series of payments be at the end of
the five year period?
Solution
[
FV5 = £100 x 1.065 - 1 = £563.71
0.06 ]
Note
The difference between this final sum and that above where each payment had been made at the
start of the year = £597.53 - £563.71 = £33.82. This difference is solely accounted for by one
earlier payment being invested over the entire five year period, ie, (£100 x 1.065)- £100 = £33.82.

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2.4 Discounting
LEARNING OBJECTIVES
2.2.1 Be able to calculate the present value of lump sums and
regular payments, annuities and perpetuities
2.2.4 Understand the importance of selecting an appropriate
discount rate for discounting cash flows
As stated in the introduction to this section, 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.
Assuming compound interest, the present value formula = 1/(1 + r)n or (1 + r)-n
where r is the discount rate and n is the number years into the future when the lump sum is due to
be received. The discount rate is usually based on the prevailing risk free rate of interest though an
adjustment is typically made for the risk associated with the investment. This is known as the risk
premium. We come back to this later in the chapter.
What we will be considering from hereon are collectively known as discounted cash flow (DCF)
techniques.
So referring back to our original example, £100 receivable in 1 year’s time, given a prevailing rate of
interest of 5% would have a present value of:
£100 x 1/(1 + r)n = £100 x 1/1.05 = £100 x 0.9524 = £95.24
This 0.9524 is known as the discount factor.
If £100 was due to be received in two years time, then the present value of this sum would be:
£100 x 1/1.052 = £100 x 0.907 = £90.70
whilst if received in three year’s time, the present value would equal:
£100 x 1/1.053 = £100 x 0.8638 = £86.38
Discounting can also be used to calculate the lump sum that needs to be invested today to
accumulate a target final lump sum at a certain time in the future, given a known interest rate.
Example
How much would you need to invest today to accumulate £5,340 in five years time if the
compound rate of interest is fixed at 5.5% per annum for the five year term?
Solution
The present value of a future lump sum = 1/(1 + r)n

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So, the present value of £5,340 = £5,340 x 1/(1 + 0.055)5 = £4,085.82.
Therefore, £4,085.82 should be invested today at 5.5% per annum compound if £5,340 is to be
realised in five years time.
The future value formula confirms this:
FV5 = initial sum invested x (1 + r)5 = £4,085 x 1.0555 = £5,340
Taking this one stage further, present value formulae can also be used to establish the value today of
receiving a series of future regular payments, from an annuity for example.
From what we have just covered, we know that if £100 was received at the end of years one, two
and three given a 5% rate of interest, then the collective present value of these series of sums
would be £272.32. The derivation of this sum is shown in the table below.
Year Cash flow (£) Discount factor @ 5% Present value (£)

1 100 0.9524 95.24
2 100 0.9070 90.70
3 100 0.8638 86.38
Total 2.7232 272.32
However, this same answer could have been arrived at without having to establish the present value
of each cash flow, but by adopting another formula. As with compounding, the formula used
depends upon whether the amounts are received at the beginning or at the end of each year.
For payments received in arrears, ie, at the end of each year as above, the formula is:
[
Present value of future paymentsarrears = annuity x 1- (1 + r)-n or
r ]
= annuity x 1/r [1- 1/(1 + r)n]
Remember (1 + r)-n is simply 1/(1 + r)n
So, the present value of the above amounts received in arrears:
= £100 x 1/0.05 [1- 1/1.053] = £100 x 2.7232 = £272.32
2.7232 is known as the annuity discount factor.

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For payments received in advance, ie, at the beginning of each year, the formula is:
Present value of future paymentsadvance = annuity x {1 + [1- (1 + r)-(n -1)]} or

r
= annuity x {1 + (1/r [1- 1/(1 + r)(n -1)])}
So, for the above example, the present value of these amounts received in advance would be:
Annuity x {1 + (1/r [1- 1/(1 + r)(n -1)])} = £100 x {1 + (1/0.05 [1- 1/1.052])}
= £100 x 2.8594 = £285.94
The difference between these two present values of £285.94 and £272.32, ie, £13.62, is accounted
for by the first payment of £100 in the latter example being received at the beginning of the year, ie,
today, and, therefore, not requiring discounting, and the final payment of £100 received in the
former example being discounted to £86.38. The discounted values of £95.24 and £90.70 are
common to both calculations.
You will have noticed that as present value formulae express future cash flows in today’s terms, the
comparison of competing investments of equal risk with the same start date but with different
future cash flow timings and/or amounts is made possible.
These formulae can also be used to calculate the sum to be invested today to provide for a level
annuity. That is, a series of future equal payments to be received either at the start or end of each
year for a set period assuming that the fund, from which these are paid, will attract a fixed rate of
interest on its outstanding amount and be run down to zero by the end of the period.
Example
How much needs to be invested today to provide a level annuity that pays £400 at the end of each
of the next five years given a compound interest rate of 6% per annum, assuming that the annuity
fund is run down to zero at the end of the five year period?
Solution
Present value of future payments = annuity x 1/r [1- 1/(1 + r)n]
So, present value of future payments = £400 x 1/0.06 [1- 1/(1.06)5]
= £400 x 4.2124 = £1,684.96
So, if £1684.95 was invested at the beginning of the five year period at a fixed rate of interest of 6%
per annum with payments of £400 being made from this sum plus accumulated interest at the end
of each of the next five years, the fund would be run down to zero. The table below confirms this.

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Sum @ start Apply interest @ Annuity (£) Sum @ end of
of year (£) 6% (ie, x 1.06) (£) year (£)
1684.96 1786.05 (400) 1386.05
1386.05 1469.21 (400) 1069.21
1069.21 1133.36 (400) 733.36
733.36 777.36 (400) 377.36
377.36 400.00 (400) -
However, what if the payments from the annuity were not due to be received at the end of years
one and two but from the end of year three? This being the case you would need to make the
following calculations using the data from the above example:
Period Discount factor calculation Discount factor @ 6%

1 1
Years 1- 5 /0.06 [1- /(1.06) 5] 4.2124
1 1
Years 1 - 2 /0.06 [1- /(1.06) 2] (1.8334)
2.379
By deducting the two year annuity discount factor from the five year annuity discount factor and
applying the resulting factor of 2.379 to £400, the present value of these three remaining payments
becomes £951.60. Alternatively, it could be said that £951.60 is the amount that needs to be
invested today to provide this annuity. This is confirmed in the table below.
Start of Sum @ start Apply interest Annuity (£) Sum @ end

year of year (£) @ 6% (£) of year
1 951.60 1008.70 - 1008.70
2 1008.70 1069.22 - 1069.22
3 1069.22 1133.37 (400) 733.37
4 733.37 773.37 (400) 377.37
5 377.37 400.00 (400) -
Perpetuities
If a series of equal payments are to be paid or received indefinitely (or in practice beyond 50 years)
at the end of each year, starting in one year’s time, then the present value of this series of cash
flows is given by the formula:
annuity x 1/r
Example
If £1,000 per annum is to be received at the end of each year in perpetuity, given a compound rate
of interest of 5%, what is the present value of these cash flows?
£1,000 x 1/0.05 = £20,000
However, if this series of £1,000 cash flows were to be received at the start of each year, then the
formula would change to:
annuity + (annuity x 1/r) = £1,000 + (£1,000 x 1/0.05) = £21,000.

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2.5 Calculating Real Returns

Depositing a sum of money at an 8% rate of interest is more attractive when inflation is running at
2% than at 4%. As a lower rate of inflation has a lesser impact on the nominal rate of return than a
higher rate, a higher real, or inflation-adjusted, return results. The real return is given by:
Real return = {[(1 + nominal return)n/(1 + inflation rate)n] - 1} x 100
To establish the compound annual real rate of return, having arrived at the total real return, the
following formula is applied:
Compound annual real return = [(1 + real return)1/n - 1] x 100
Example
If a lump sum was invested for two years at 8.2% applied on a compound basis when the inflation
rate in year one was 2% and in year two, 4%, what would the compound annual real rate of return
be?
Solution
Real return = {[(1 + nominal return)n/(1 + inflation rate)n] - 1} x 100
So, [1.0822/(1.02 x 1.04)] - 1 = 10.36% (versus the nominal return of 1.0822 = 17.07%)
Compound annual real rate of return = [(1 + real return)1/n - 1] x 100
= [1.10361/2 - 1] x 100 = [1.10360.5 - 1] x 100 = 5.05%
Example
If an investor’s portfolio has grown from £50,000 to £77,000 in five years, over which time inflation
has averaged 2%, what is the real compound annual growth rate?
Solution
Annualised return = [(final sum/amount invested)1/n - 1)] x 100
= [(77,000/50,000)0.2 - 1)] x 100 = 9.02%
Real annual return = [(1.0902/1.02) - 1] x 100 = 6.88%

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2.6 Investment Project Appraisal
LEARNING OBJECTIVES
2.2.3 Be able to calculate simple and compound interest,
discounted cash flows (DCFs), net present values (NPV),
internal rates of return (IRR) and interpret the data
2.2.4 Understand the importance of selecting an appropriate
discount rate for discounting cash flows
Discounted cash flow (DCF) techniques can be used as means to appraise the undertaking of
business investment projects, such as whether a company should expand by acquiring additional
capacity. Often faced with a number of alternative courses of action, company management must
decide which of these alternatives will maximise profit or some other corporate objective.
Obviously, it is imperative that the correct course of action is taken as once an investment is made,
the success of the business will inevitably be dependent upon on the profitable utilisation of the
assets purchased and the cash flows they generate.
DCF techniques, by discounting a project’s expected cash outflows, principally the initial investment
made, and comparing these to the present value of the expected cash inflows, or revenues, derive
what is known as the project’s net present value (NPV). Only if the NPV is positive should the
project be undertaken or at least considered, as a positive NPV shows that the project is expected
to generate a surplus in present value terms having taken account of the amounts invested and all
costs associated with the project.
Example
X plc is considering undertaking Project Y. Project Y requires an initial outlay of £5.5m at the start
of year one but is expected to generate annual revenues of £1.25m at the end of years one to eight.
If the discount rate is 15.5%, should the project be considered for implementation?
Solution
Period Cash flow Discount factor Discounted cash

(£000) flow (£000)
Start year 1 (5500) 1 (5500)
1 1
End of years 1 – 8 1250 /0.155 [1- /1.155 8] = 4.4145 5518
NPV 18
As the project has a positive NPV, albeit marginal when compared to the initial outlay of £18,000, it
should be considered for implementation.
However, when establishing the NPV of a project it is essential that the correct discount rate is
used.

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The Weighted Average Cost of Capital (WACC)

The rate of interest, or discount rate, used to establish the NPV of a project’s anticipated cash flows
must be chosen with great care. Use too high a discount rate and what could have been a profitable
project with a positive NPV may end up being rejected, use too low an interest rate and an
ultimately unprofitable project may result. Despite the UK having experienced a low inflation and
interest rate environment for nearly a decade, many companies still persist in using too high a
discount rate to appraise projects to the detriment of their own operations and the wider economy.
The relationship between NPV and the discount rate is depicted in the diagram below.
Net present value
+NPV
O Discount rate
-NPV
Figure 11: NPV and the discount rate
When undertaking a project assumed to be of an equivalent risk to its existing operations, a

company will typically employ its WACC as the discount rate.
WACC can be defined as the average cost of servicing a company’s long term sources of finance.
These long term sources comprise a company’s equity capital, or ordinary shares, and loan capital
or debt. To arrive at a company’s WACC, the cost of these two sources of finance are individually
calculated and then combined, each source being accorded a weight in the WACC calculation,
based on their respective market values as a proportion of their combined market value.
WACC = (cost of equity x market value of equity) + (cost of debt x market value of debt)
market value of equity and debt market value of equity and debt
The cost of equity finance is calculated as the opportunity cost of investing in a company’s equity
rather than a risk-free asset, such as a government security. For this calculation, we use what is
known as the Capital Asset Pricing Model (CAPM) formula. CAPM is examined in more detail in
Chapter 9.
The cost of equity = Rf + βi [E(Rm) - Rf] where:
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[E(Rm) - Rf] is the additional return expected from holding risky equities rather than a risk-free
asset, commonly known as the ex ante equity risk premium (ERP)
βi is the specific risk of investing in this particular company. βi is known as the company’s beta.
The cost of debt is given by:
rate of interest paid on debt × (1 - corporation tax rate) × 100
As debt interest payments are eligible for corporation tax relief, the interest rate is adjusted by (1 -
corporation tax rate).
An example should bring all of the above together.
Example
The long term capital structure of X plc is as follows:
Capital Structure Market value

(£000)
100,000 ordinary shares 1,400
£100,000 nominal 12% loan stock 100
Total 1,500
The risk-free rate of return (Rf) is 6%, the equity risk premium is 5% and the company’s beta is 2.
X plc’s post-tax cost of debt finance is 8.4%. Calculate X plc’s WACC.
Solution
Cost of equity = 0.06 + 2[0.05] = 16%
X plc’s WACC =
{[ ] [
0.16 x 1400 + 0.084 x 100
1500 1500 ]} x 100 = 15.5%
Therefore, 15.5% is the discount rate that should be applied by X plc when appraising investment
projects assuming they are of equivalent risk to those currently undertaken.
The importance of knowing a company’s WACC is further considered in Chapter 7 when looking at
shareholder valuation models.
The Internal Rate of Return (IRR)

We saw that by applying a discount rate of 15.5% to project Y’s anticipated cash flows, the result
was a positive NPV of £18,000. This implies that the project should return in excess of 15.5% over
the term of the project if the cashflow estimates prove correct. However, the cashflows associated
with any prospective project are just estimates and the cost of capital used may not always
accurately reflect the riskiness of the project. Therefore, it is useful to establish what the breakeven
rate of return is, or that discount rate which implies an NPV of zero. This rate of return is called the
internal rate of return (IRR) or DCF yield.

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As the only accurate way to establish this IRR is through a lengthy process of trial and error using a
range of discount rates, an approximate IRR is usually derived through a short cut methodology
known as interpolation. Interpolation, by assuming a linear relationship between discount rates and
the resultant NPVs, takes a lower discount rate that produces a positive NPV and a higher discount
rate that results in a negative NPV, and then finds the rate between them that produces a zero NPV,
by employing the following formula:
Approximate IRR = [r1 + {[+NPV/+NPV - (-NPV)] x (r2 - r1)}] x 100
where r1 is the lower discount rate that produces a positive NPV and r2 the higher discount rate
that results in the negative NPV.
Net present value
+NPV IRR
O Discount rate
-NPV true relationship
relationship
assumed by
interpolation
Figure 12: NPV and the IRR
However, as this formula treats the relationship between the discount rate and NPV as linear rather
than as the convex relationship depicted earlier, its accuracy is reliant upon the two discount rates
used being as close together as possible to minimise the deviation between the approximated and
true IRR.
Relating this back to Project Y, if a discount rate of 16% is applied to the project’s anticipated cash
flows then this should, given the marginally positive NPV associated with a 15.5% discount rate,
result in a negative NPV. The table below demonstrates this.

(£000) flow (£000)
Start year 1 (5500) 1 (5500)
1 1
Years 1 – 8 1250 /0.16 [1- /1.16 8] = 4.3436 5430
NPV (70)

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By interpolating between these two discount rates we can establish the approximate IRR:
[r1 + {[+NPV/+NPV - (-NPV)] x (r2 - r1)}] x 100
= [0.155 + {[18/(18 + 70)] x (0.16 - 0.155)}] x 100
= 15.6%
As this IRR is greater than X Ltd’s WACC, X Ltd will consider accepting the project. This is
consistent with the positive NPV we derived from using a 15.5% discount rate.
Applying a 15.6% discount rate to the above cash flows should produce an NPV close to zero.

(£000) flow (£000)
Start year 1 (5500) 1 (5500)
1 1
Years 1 – 8 1250 /0.156 [1- /1.156 8] = 4.4002 5500
NPV 0
NPV versus IRR

Competing projects are usually ranked in ascending order of their respective NPVs rather than the
size of their IRRs. Although a positive NPV will always result in an IRR greater than the discount rate
used to discount the project’s cash flows, NPV provides a superior means of ranking projects owing
to a limiting assumption made within the IRR calculation. Rather than treating funds generated in
excess of the breakeven point as being reinvested at the discount rate, it assumes they are
reinvested at the IRR. Conceptually this is incorrect. (This is revisited in Chapter 4 when
considering the calculation of bond yields.) Therefore, IRR should only be used as a way of
establishing the breakeven rate of return for investment projects. Multiple IRRs will also exist for
projects whose cash flows change direction more than once.
Further Considerations When Using DCF Techniques

1. Forecasting errors. The initial investment and any subsequent costs and/or the anticipated
revenues may be incorrectly forecast.
2. Government policy. Government policy has been ignored in the above analysis. However, a
change in tax policies and/or legislation may impact the project either positively or negatively.
3. Inflation. Inflation has also been ignored. However, if expected inflation is incorporated into the
analysis then the project’s cash flows must be expressed in current prices, or in real terms, if they
are to be discounted by a real, or inflation-adjusted, discount rate.
4. Assessing the risk of the project. Depending on its exact nature, acceptance of a project can
increase or, indeed, reduce the risk attached to a company’s existing operations. This must be
taken into account when choosing the discount rate.
Concluding comments
At the beginning of this chapter, it was emphasised that becoming familiar with information sources
and being able to assimilate and interpret data, particularly numerical data, is imperative if informed
investment decisions are to be made and investment opportunities are to be capitalised upon. This
chapter, having considered a wide range of statistical and mathematic methods and techniques in
some detail, provides the basis for those sections within Chapters 4, 7, 9 and 10 where the risks
and rewards, valuation and performance of securities and portfolios are assessed.

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REGULATION
1.
2.
CORPORATE GOVERNANCE
OVERSEAS REGULATORS
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1. CORPORATE GOVERNANCE
LEARNING
1.1 OBJECTIVES
Corporate Governance
3.1.1 know the origins and nature of Corporate Governance
3.1.2 know the Corporate Governance mechanisms
available to stakeholders to exercise their rights
3.1.3 understand the role of auditors and non-executive directors
3.1.4 know the implications of the Sarbanes-Oxley Act and its
main provisions
3.2.2 know the impact of high profile failures on the various
markets, participants and regulation of them
A company is a separate legal entity distinct from its shareholder owners. As the day-to-day running
of a company, rather than being in the hands of the company’s shareholders, is the responsibility of
the company’s executive directors, appointed by the shareholders, there is also a separation of
ownership and control. The executive directors, or Board, are ultimately accountable to the
company’s shareholders for their actions in carrying out their stewardship function. Therefore, a
mechanism is needed to ensure that companies are run in the best long term interests of their
shareholders. This mechanism is known as corporate governance. Corporate governance is
concerned with the creation of shareholder value through the transparent disclosure of a
company’s activities to its shareholders, director accountability and two-way communication
between the Board and the company’s shareholders.
The legal duties of directors

1. Fiduciary duties: Directors must act in good faith and in the interests of the company as a whole.
For instance, directors must give equal consideration to all shareholders, they must not use their
position to make private profits at the company's expense and substantial deals with the company
must be approved by shareholders at a general meeting.
2. Statutory duties: Directors are personally responsible for ensuring that the company complies
with company law. Directors also have to comply with other laws. For example, they must
comply with employment law in dealing with employees and take reasonable care to ensure the
health and safety of employees.
Directors can be held personally liable for losses resulting from acts or omissions, eg, the
committing of illegal acts, and can be held jointly and severally liable for the consequences of acting
collectively in breach of their responsibilities. Directors may also be disqualified from acting in the
capacity of a director and some actions could result in criminal convictions.
Directors will also be required to:

• act within their powers;
• exercise independent judgement;
• exercise reasonable care, skill and diligence;
• avoid conflicts of interest;
• not accept benefits from third parties; and
• declare an interest in a proposed transaction with the company.

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The Code of Best Practice

Following the collapse of a number of leading companies, as a result of corporate mismanagement
in the late 1980s, a committee chaired by Sir Adrian Cadbury issued a report and the Cadbury
Code in 1992. The main recommendations of the Cadbury report emphasised the need to ensure a
balance of power and division of responsibility between the chairman and chief executive at
executive Board level and the appointment of non-executive directors (NEDs) to provide an
independent check on the conduct and remuneration of the executive directors and to act as
advisors to the Board. Most NEDs have a background in business and/or politics. Quite uniquely,
corporate Boards in the UK assume a single tier structure in that no statutory distinction is made
between executive and non-executive directors, though the latter have no day-to-day management
responsibility. Whilst the executive company chairman assumes responsibility for running the Board,
it is the chief executive that is ultimately responsible for the company’s day-to-day operations.
The Greenbury Report soon followed the Cadbury report, in 1995, with recommendations on the
structure and disclosure of executive director remuneration, whilst the Hampel Committee,
reporting a year later, continued the work of Cadbury but with a broader remit. In 1998, the
Committee on Corporate Governance drew on the findings of these three committees publishing
the Combined Code on Corporate Governance, which has since became known as the Combined
Code or the Code of Best Practice.
The main provisions of the Combined Code, which are embodied within the Financial Services
Authority’s (FSA) listing requirements applying to all public limited companies (plcs) quoted on the
London Stock Exchange (LSE), are:
1. There must be a clear separation of the roles and division of responsibility between the chairman
and chief executive and a balance between the number of executive and NEDs to ensure a
democratic decision making process.
2. Director remuneration should be partly linked to the company’s and the director’s performance,
should not be set by the director themselves and should not be excessive in the circumstances.
3. Directors should actively enter into two-way communication with shareholders.
4. Shareholders should be presented with a realistic assessment of the company’s financial position
and future prospects and be informed of the company’s system of internal controls.
Following the loss of investor and public confidence arising from a number of corporate governance
abuses, the near failure of Equitable Life and Marconi plc in the UK and the Enron debacle in the
US, the role of the NED has come under closer scrutiny as have the number of non-executive
directorships held simultaneously by individuals, given the apparent failings of each company’s
NEDs in these dramatic cases.
Other high-profile examples of poor corporate governance include:

1. National Australia Bank: In 2004, the bank was involved in a $360 million AUD currency trading
scandal due to management failing to supervise and monitor their employees correctly.
2. In 1995, Britain’s Barings Bank collapsed due to the failure of management to monitor staff, in
particular Nick Leeson, in their derivatives trading activities in Singapore. One of the most
remarkable facts was that Leeson at one point sold options worth approximately $7 billion USD
without anyone in the London office questioning the trade.
Consequently, in May 2002 the UK government appointed former investment banker, Derek Higgs,
to report on the independence, responsibilities and effectiveness of NEDs and how their role may
be strengthened.
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The Higgs Report, published in January 2003, recommends a strengthening of corporate
governance in UK company boardrooms. This it does through several key recommendations:
• NEDs should be drawn from a wider pool of talent than is currently the case.
• To ensure that NEDs are truly independent of the executive board, a former employee of the
company should not become a NED of the company until five years have elapsed since the date
of their departure. In addition, NEDs should typically serve no more than two three-year terms
with the same company. A NED should not be considered independent after 10 years.
• At least half of a company’s board should comprise truly independent NEDs led by a senior
independent director (SID). The senior independent director should:
• attend management meetings with shareholders to learn of shareholders’ concerns and
communicate their views of the company to the other NEDs; and
• act as a conduit for shareholders to raise issues, which have failed to be resolved by the
chairman or chief executive in the first instance.
In addition, the review recommends that:

• The chief executive of a company should not then become its chairman as to do so may result in
the chairman competing with the incoming chief executive for the board’s allegiance.
• No individual should act as chairman for more than one company and no full-time executive
director should accept more than one non-executive directorship.
Although the Higgs Report has received broad support from key industry associations such as the
NAPF and IMA, it has been heavily criticised by the CBI. This criticism has mainly come from
company chairmen concerned that the role of the senior independent director will undermine their
position and divide a company’s board.
Following the Financial Reporting Council’s (see Chapter 6) brief consultation process on Higgs’
recommendations amongst interested parties, these recommendations have since been
incorporated into a revised Code of Best Practice. As with all other aspects of the code, companies
are subject to the “comply or explain” protocol that underpins UK corporate governance.
The momentum built up by the UK corporate governance movement since the early 1990s is fast
approaching the level of shareholder activism in the US. This has been evidenced by the action
taken by institutional shareholders in 2004 in preventing Michael Green from assuming the role of
chairman of the merged ITV companies and Sir Ian Prosser taking up the chairmanship of
Sainsburys. Moreover, recent research conducted by Deutsche Bank has found that those
companies that best meet the criteria established under 50 corporate governance standards tend to
significantly outperform those that don’t.
The Role of the Auditor

An auditor is a firm of accountants appointed by a company’s executive directors - the appointment
being ratified by the company’s shareholders - to carry out an independent assessment of the
company’s accounts prepared by the directors. Following the unearthing of significant accounting
frauds at Enron and WorldCom in the US and the widespread manipulation of companies’ reported
profits, the role of the auditor, has, like that of the NED, also come under the microscope on both
sides of the Atlantic. Although auditors in the UK are not required to actively detect fraud, they are
required to report to the company’s shareholders, via an auditor’s report, on whether or not the
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whether they have been prepared in accordance with the Companies Acts and mandatory
accounting standards. The auditor’s report is considered in more detail in Chapter 6.
To ensure the independence of a company’s auditors from the company’s management and,
therefore, safeguard the integrity of the company’s financial accounts, Sir Robert Smith was
commissioned by the government to report on how such independence could be preserved.
Publishing his report on the same day as the Higgs Review, the Smith Report recommends that such
independence could best be assured by modifying the structure and role of company audit
committees, whose principal function is to advise the company’s board on the appointment and
remuneration of auditors. Smith recommends that the audit committee should:
• include at least three NEDs;
• monitor the integrity of financial statements;
• review internal controls and internal and external auditors;
• take an adversarial approach towards company management if it discovers misleading financial
reporting.
Like the Higgs Review, the Smith Report has also been integrated within the revised Code of Best
Practice.
Sarbanes-Oxley Act 2002

After a series of financial scandals, the USA government introduced the
Sarbanes-Oxley Act in 2002. The Act’s objective is “to protect investors by improving the accuracy
and reliability of corporate disclosures made pursuant to the securities laws, and for other
purposes”. It applies to USA public companies and their global subsidiaries. It also applies to foreign
companies that have shares listed on USA stock exchanges. The Sarbanes-Oxley Act is often
referred to as SOX, SarbOx or SOA.
The Act covers a wide range of corporate governance issues and some of these include:
• The chief executive and chief financial officers must certify the accuracy of the corporation’s
annual and quarterly Stock Exchange Commission reports. They are then personally responsible
for the information and certifying false accounts can lead to a criminal prosecution and
imprisonment.
• All off-balance sheet transactions and material relationships must be disclosed.
• The company must state whether it has adopted a code of ethics for its senior financial officers.
• Personal loans to officers or directors are forbidden.
• Greater protection for “whistleblowers”.
• The need for auditable business processes and communication.
• Companies are prohibited from receiving non-audit services from their existing auditor.
• New measures to prevent conflicts of interest between securities analysts and investment banks.

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2. OVERSEAS REGULATORS
LEARNING OBJECTIVES
3.2.1 know the primary function of the following bodies in the
regulation of the financial services industry: Securities
and Exchange Commission (SEC); Financial Services
Authority (FSA); Japan Financial Services Agency (JFSA); European
Union (EU); International Organisation of Securities Commissions
(IOSCO)
2.1 Securities and Exchange Commission (SEC)

The SEC is the USA’s financial services market regulator. It monitors securities exchanges, brokers,
dealers, investment advisors and mutual funds. The SEC aims to ensure that market-related
information is disclosed to the investment community in a fair and timely manner. It also enforces
laws to prevent investors suffering from unfair trading practices and insider trading.
2.2 Financial Services Authority (FSA)

The FSA is the regulator for the financial services industry in the UK. It has four statutory objectives:
1. Promote and educate the public to aid their understanding of the financial system.
2. Secure consumer protection.
3. Reduce financial crime
4. Maintain public confidence of the high standards set for the financial services industry.
2.3 Japan Financial Services Agency (JFSA)

The Financial Services Agency is a government regulator that is responsible for ensuring the stability
of the Japanese financial services market. It is responsible for monitoring insurance companies,
securities exchanges, banking and other market participants. It is also involved in establishing
business accounting standards and supervising certified public accountants and auditing firms. The
agency reports to the Minister of Financial Services.
2.4 European Union (EU)

The European Commission is currently working towards strengthening and consolidating the laws
for financial services across the European Union. Currently there is no single regulator for the
financial services industry and each country has their own set of rules and regulations.
2.5 International Organisation of Securities Commissions (IOSCO)

IOSCO was established in 1983 and aims to establish high regulatory standards across the world for
the securities industry. The membership of this organisaction collectively regulates 90% of the
worlds’s securities markets. It is considered to be one of the most influential forums for regulators.

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CLASSES
1.
2.
3.
4.
EQUITIES
FIXED INTEREST
CASH AND MONEY MARKET INSTRUMENTS
DERIVATIVES
4 97
112
138
141
5. PROPERTY 175
6. ALTERNATIVE INVESTMENTS 178

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1. EQUITIES
“March is one of the most dangerous months to buy stocks. The others are June, January, September,
April, November, May, October, July, December, August and February.”
Mark Twain
1.1 Introduction
A company’s share capital can be broadly divided into two distinct classes of share: ordinary shares
and preference shares.
1.2 Ordinary Shares

LEARNING OBJECTIVES
4.1.1 Know the characteristics and risks of different classes
of share capital (preference shares, ordinary shares),
shareholder rights and priority for dividends and capital
repayment for both private and public companies
Purchasing a company’s ordinary shares confers an equity interest in the company. That is, a direct
stake is taken in the company’s fortunes. As such, a company’s ordinary share capital is also known
as its risk capital given that ordinary shareholders are always the last in line to be paid an income
and the last to be repaid their capital in the event of the company’s liquidation. Only after all other
claims on the company’s resources, such as those from bondholders and preferential creditors,
have been satisfied are its equity shareholders rewarded or recompensed. Over the longer term,
however, ordinary shareholders have been handsomely rewarded for assuming this equity risk
though in the short term have generally experienced a greater volatility in their returns than any of
the other main asset types.
As mentioned in Chapter 3, a company is a separate legal entity distinct from its owners. Therefore,
a company’s ordinary shareholders have no personal liability for the company’s debts. This gives
rise to the concept of limited liability. That is, each shareholder’s liability only extends to any
outstanding payment on the nominal value of the company’s shares held if issued partly paid. The
nominal value of a share is only of legal significance and simply requires that all ordinary shares
issued by a company are set at or above this price. A 25p nominal value is fairly common. Most
ordinary shares in issue are irredeemable, in that there is not usually any pre-specified provision for
their repurchase by the company. This and other aspects of UK company law are defined within the
Companies Acts. These establish the framework within which all companies in the UK must
operate.

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Shareholder Rights
Ordinary shareholders are entitled to a number of rights. These are specified in a company’s
Articles of Association, which govern the company’s internal constitution. That is, they define the
relationship between the company and its members, or shareholders, and the rights of the
company’s shareholders between themselves.
The rights attaching to a company’s issued ordinary share capital include a right to:
1. Share in the profits of the company through the payment of dividends. Each equity share has an
equal right to share in this distribution of a company’s profits. This is what is meant by the term
equity. However, the company’s directors are not obliged to pay dividends on a regular basis:
payment is very much based upon their discretion. This is considered in more detail below.
2. Receive a copy of the company’s annual and interim report and accounts, their content and the
timescale within which they are issued being defined by the Companies Acts.
3. Be notified in advance of all company meetings and to attend and vote on resolutions put by the
directors at these meetings.
4. Subscribe for new ordinary shares issued to raise additional capital before they are offered to
outside investors. These are known as pre-emption rights. Shareholder’s pre-emption rights can
be waived by special resolution.
Types of Ordinary Share

In addition to conventional ordinary shares, which confer voting and the other rights considered
above to the company’s ordinary shareholders, other types of ordinary shares, albeit rarities, exist:
1. Non-voting shares. Aside from not carrying any voting rights, non-voting shares, designated
either as A or B shares, rank equally alongside other ordinary shares in all respects. However, not
being as valuable as those shares that carry voting rights in a takeover situation, non-voting shares
usually trade at a discount to their voting counterparts. Although now prevented from issuing
new non-voting shares by the LSE, a number of prominent companies still have non-voting shares
in issue.
2. Redeemable shares. Companies are permitted to issue ordinary shares that can be redeemed, or
bought back, by the company so long as conventional non-redeemable ordinary shares are also in
issue.
3. Deferred shares. A company’s original promoters, in order to retain an element of control over
the company when additional equity finance is raised, may issue deferred, or founder’s, shares
that confer enhanced voting rights. As a quid pro quo to other equity shareholders, these shares
typically defer the right to a dividend for a set period.

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1.3 Preference Shares
LEARNING OBJECTIVES
4.1.1 Know the characteristics and risks of different classes of
share capital (preference shares, ordinary shares),
shareholder rights and priority for dividends and
capital repayment for both private and public companies
4.1.2 Know the main characteristics and reasons for issuing convertible
preference shares
4.1.3 Be able to calculate a conversion premium or discount on a
convertible preference share
In addition to ordinary shares, companies can also issue preference shares. Although the interests of
preference shareholders rank below that of a company’s bondholders and preferential creditors,
preference shares rank ahead of ordinary shares for the payment of dividends and for capital
repayment in the event of the company going into liquidation. Consequently, preference
shareholders are usually only entitled to a fixed rate of dividend and with the single exception
detailed below are not given any voting rights. This fixed rate of dividend is expressed as a
percentage of each share’s nominal value in net, or after tax, terms. So, a 6% preference share with
a nominal value of £1, would pay a net annual dividend of 6p per share.
Types of Preference Share

Most preference shares in issue are cumulative. That is, unless they are designated as non-
cumulative, preference shareholders are entitled to receive all dividend arrears from prior years
before the company can pay its ordinary shareholders a dividend. However, the payment of
dividends on preference shares is again very much at the discretion of the company’s directors. If
any preference dividends remain outstanding preference shareholders can often assume the same
voting rights as ordinary shareholders. Any such rights will be detailed in the company’s Articles of
Association. Variations on conventional preference shares include:
1. Participating preference shares. In addition to the right to a fixed dividend, these shares are also
entitled to participate in the company’s profits if the ordinary share dividend exceeds a pre-
specified level.
2. Redeemable preference shares. These are issued with a predetermined redemption price and
date. Some redeemable preference shares are issued as convertible preference shares.
3. Convertible preference shares. These preference shares as well as having a right to a fixed
dividend can be converted, by the preference shareholder, into the company’s ordinary shares at
a pre-specified price or rate on predetermined dates. If not converted, then the preference
shares simply continue to entitle the shareholder to the same fixed rate of dividend until the
stated redemption date.
Once again, the rights attaching to each type of share will be detailed in the company’s Articles of
Association.

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Convertible preference shares

Convertible preference shares are usually issued by:
1. The bidding company in a company takeover as consideration to the target company’s
shareholders, so as to defer the dilution, or expansion, of the bidder’s ordinary share capital.
2. Companies in difficulty undergoing a capital restructuring to its creditors in exchange for waiving
outstanding debts.
In both cases, the convertible preference shareholders can ultimately share in the issuing company’s
fortunes whilst enjoying a fixed rate of dividend in the meantime. The reasons for issuing
convertible preference shares and their underlying mechanics are very similar to that of convertible
loan stock considered in the Fixed Interest securities section of this chapter. Given the terms on
which convertible preference shares may be converted into the issuing company’s ordinary shares,
a conversion premium or discount can be established by using the following equation:
Conversion premium/discount =
[(conversion ratio x market price of convertible/market price of equity shares) - 1] x 100
where the conversion ratio is the rate at which the convertible can be exchanged for equity shares.
If the price of the convertible given the conversion ratio is lower than, or stands at a discount to,
the price of the equity shares then the convertible is a less expensive way of buying into the issuing
company’s ordinary shares than buying these shares directly. This happens when the price of the
convertible has lagged the rise in the ordinary share price and/or offers a relatively less attractive
rate of dividend. The opposite is true if the convertible stands at a premium.
Example
A company has issued 7% cumulative redeemable preference shares at 110p. They are currently
priced at 125p per share and can be converted into the company’s ordinary shares at the rate of 5
preference shares for 1 ordinary share. If ordinary shares = 600p, what is the conversion premium
or discount?
Solution
Conversion premium = [(5 x 125/600) - 1] x 100 = 4.2%.
Therefore, buying the convertible preference shares is a more expensive route into the issuing
company’s ordinary shares than buying the shares directly. However, the fixed rate of dividend
currently being paid on the preference shares may be sufficiently attractive when compared to that
being paid on the ordinary shares to justify the premium.
For the remainder of this section we will focus solely on ordinary shares.

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1.4 Public Limited Companies (PLCs)
LEARNING OBJECTIVES
4.1.5 Know the principal purpose and requirements of the
listing rules
4.1.14 Know the means by which companies communicate
price sensitive information, the nature of such information and the
primary information providers
In the UK there are two types of company: private limited companies and public limited companies
(plcs). Only plcs are permitted to issue shares to the public and have their shares publicly traded on
a stock exchange, though very few plcs take advantage of this. Those in the UK that do, either
obtain a full listing on the LSE or gain admittance to the LSE’s Alternative Investment Market (AIM).
Chapter 5 details the structure and dealing and settlement systems of these stock exchanges as well
as those of competing mechanisms.
Private limited companies seeking a full listing on the LSE must first meet the stringent entry
criteria, or Listing Rules, detailed in the Purple Book and administered by the FSA in its capacity as
the UK Listing Authority (UKLA).

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1.5 Share Issues
LEARNING OBJECTIVES
4.1.4 Understand the main characteristics of GDRs and ADRs
4.1.6 Understand the different new issue methods
(see the syllabus learning map at the back of this book for the full
version of this learning objective)
4.1.7 Know the main mandatory corporate actions
4.1.8 Know the main optional corporate actions
4.1.9 Know the difference between optional and mandatory corporate
actions
4.1.10 Understand the reasons for capitalisation and rights issues and the
options available to the shareholder when a rights issue is made
4.1.11 Be able to calculate the effect of capitalisation and rights issues on
the issuer's share price
New issue methods

“Most new issues are sold under favourable market conditions - which means favourable for the seller
and, consequently, less favourable for the buyer.”
Benjamin Graham
A plc applying for a full listing to have its shares traded on the LSE must first make at least 25% of
its ordinary shares available on the LSE’s primary market, to ensure an active market in its shares,
via one of four permissible floatation methods, detailed below. AIM companies, however, not being
subject to any free float criteria can issue as much or as little of their share capital as they wish.
Those companies that seek to raise capital through their listing or admission can do so through an
initial public offering (IPO) of ordinary shares either by making an offer for sale, an offer for
subscription or a placing. These are termed marketing operations.
Those companies applying for a full listing that simply wish to increase the marketability of its
shares, however, would choose the fourth route to the primary market by making an introduction.
1. An offer for sale. By adopting this IPO method, the issuing company sells its shares to an issuing
house, which then invites applications from the public at a slightly higher price than that paid by
the issuing house 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 an independent sponsor, such as a
solicitor or accountant, to satisfy the UKLA of the company’s suitability to obtain a full listing. In
addition, a letter from the company’s sponsor to the UKLA confirming the adequacy of the
company’s day-to-day, or working, capital must accompany the prospectus whilst an
advertisement detailing the floatation, known as a formal notice, must be placed in a national
newspaper.

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Companies applying for admission to AIM, however, are subject to much less onerous
requirements. Regardless of the IPO method adopted, the company’s directors in conjunction
with the company’s nominated adviser, must simply provide a prospectus to accompany the
share issue. Although this contains less detail than that for a full list IPO, it must incorporate a
warning to investors of the potential risks associated with investing in smaller company shares.
An advertisement need not be placed in a national newspaper.
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, where former nationalised monopolies have been sold to the public. In
both cases existing shareholdings are disposed of, rather than new shares being created, in order
to obtain a listing.
2. An offer for subscription. Rarely used today, this IPO method requires the company to offer its
new shares directly to the public, again by issuing a detailed prospectus and placing an
advertisement in the national press when a full listing is sought. In so doing, the company arranges
for an issuing house to underwrite the share issue, in exchange for a small commission, so that in
the event of the issue being under subscribed, the underwriter will take up the remaining shares.
Usually the issuing company will only commit to the issue if a minimum subscription level has
been reached.
An offer for sale or an offer for subscription 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, or after
market, in the shares. A secondary market is one in which securities already in issue trade.
Generally speaking, in the absence of a liquid and well regulated secondary market, an active
primary market could not exist, as investors would be reluctant to purchase new securities that
they may subsequently find difficult to trade. Similarly, any relaxation of the primary market
admittance and issue criteria would adversely impact on the liquidity of the secondary market.
This is considered in Chapter 5. 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
However, 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 does often change between the announcement of the IPO and the end
of the offer period, offers for sale and offers for subscription can be made on a tender basis. By
not stipulating a fixed price for the shares but by inviting tenders for the issue, usually by setting a
minimum tender price, investors subscribe for 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. As with a
fixed price offer, this single strike price is typically set at a level just below that required for the
entire share issue to be taken up, again to ensure an active secondary market in the shares.
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.

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3. A placing. In placing its shares, a company simply markets the issue directly to a broker, an issuing
house or other financial institution, which in turn places the shares to selected clients. A placing is
also known as selective placing. 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 or advertising is required. However, if made in respect of a full
listing, the issue must still be advertised in the national press.
Placings are the preferred new issue route for most AIM companies.
4. An introduction. An introduction is not really an IPO in the true sense as no capital is raised. A
LSE listing via an introduction is potentially available to those companies already quoted on
another, overseas, stock exchange, typically multinationals, wishing to expand their shareholder
base and to larger UK plcs that simply require a listing to improve the marketability of their
shares, as a result of a demutualisation for example. Demutualisation is the process whereby a
mutual organisation, such as a building society or a life assurance company, becomes a plc.
Although in both cases, neither company has any immediate requirements for raising capital, by
making their shares more marketable they facilitate future capital raising requirements.
American Depository Receipts (ADRs) and Global Depository Receipts (GDRs)

Introduced in 1927, an ADR is a dollar denominated negotiable certificate issued by a depository
bank in respect of non-US listed shares that have been lodged with the bank. ADRs are listed and
freely traded on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX) and
NASDAQ. The NYSE and NASDAQ are discussed in Chapter 5. An ADR market also exists on the
LSE: ADR prices being quoted on the LSE SEAQ trading system, also discussed in Chapter 5.
ADRs were originally designed to enable US investors to hold overseas shares without the high
dealing costs and settlement delays associated with overseas equity transactions though have since
been used by UK institutional investors wishing to purchase UK-listed shares. The reason for doing
this is to avoid the stamp duty that would be payable if these shares were purchased in London.
Stamp duty is discussed in Chapter 5. Although issued in bearer form with the depository bank as
the registered shareholder, or legal owner, of the underlying securities, ADRs confer the same
shareholder rights on the ADR holder, known as the beneficial owner, as if the shares had been
purchased directly. Arrangements for issues such as the payment of dividends, also denominated in
US dollars, and voting via a proxy at shareholder meetings are detailed on the ADR certificate, as,
indeed, are the duties of the depository bank. The beneficial owner of the underlying shares may
cancel the ADR at any time and become the registered owner of the shares.
Those ADRs that represent the equity of those companies that actively participate in the ADR
creation process and meet the costs involved, such as the stamp duty that is payable upon their
creation, are known as sponsored issues. All other issues are known as unsponsored issues. Up to
20% of a company’s voting share capital may be converted into ADRs. Many UK companies have
used ADR issues as a means by which to raise capital.
ADRs are not the only type of depository receipts that may be issued. Those issued outside of the
US are termed Global Depository Receipts (GDRs). GDRs have been issued since 1990 and are
traded on many exchanges including the LSE. Increasingly depository receipts are issued by Asian
and emerging market issuers.

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Corporate Actions
Corporate actions are categorised as either mandatory, optional or mandatory with options.
Mandatory corporate actions are those that must be applied by companies across all shareholders
of a particular class. For instance, once approved, a dividend must be paid to all of a company’s
ordinary shareholders. However, an optional corporate action is one where some shareholders may
choose to proceed but others may not. For example, deciding upon whether to accept the terms of
a takeover bid. Finally, a corporate action that is mandatory with options is best described as one
when something will happen but the shareholders have a range of options: when a rights issue is
announced for instance.
The main optional corporate actions comprise:

• Warrant Exercise;
• Placing with Clawback; and
• Rights Issue Call.
Warrant Exercise
Warrants are negotiable securities issued by plcs, often with the company’s ordinary shares, and
confer a right, rather than place an obligation, on the holder to buy a pre-specified number of the
company’s ordinary shares at a preset price on or before a predetermined date. Warrant exercise
relates to the act of exercising, or buying, the shares over which the warrant confers a right.
Warrants will only be exercised if profitable to do so. Warrants are considered in more detail later
in the derivatives section of this chapter.
Placing With Clawback

Placing with clawback relates to placings, which are covered in the following section.
Rights Issue Call

Rights issue call relates to rights issues, which are covered in the following section.

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Share Issues to Existing Shareholders

As mentioned earlier, once listed or admitted to AIM, plcs are required to offer any subsequent
issues of ordinary shares, or those of securities that are potentially convertible into the latter,
initially to their shareholders, if the intention is to raise additional finance. This is to prevent the
dilution of existing shareholdings in the company. You may recall these are known as shareholders
pre-emption rights. As well as issuing shares to raise additional capital, however, companies also
occasionally issue shares for other reasons. This section looks firstly at the former category, which
comprises rights issues and placings, and then the latter, comprising bonus issues and stock splits.
1. Rights issues. When a company wishes to raise further equity capital, whether to finance
expansion, develop a new product or replace existing borrowings, it can make a rights issue to its
existing ordinary shareholders. The rights issue is accompanied by a prospectus, which outlines
the purpose of the capital raising exercise, but does not require an advertisement of the issue to
be placed in the national press. New shares are offered in proportion to each shareholder’s
existing shareholding, usually at a price deeply discounted to that prevailing in the market to
ensure that the issue will be fully subscribed and often to avoid the cost of underwriting the
shares. The number of new shares issued and the price of these shares will be determined by the
amount of capital to be raised. This price, however, must be above the nominal value of the
shares already in issue. The offer to the shareholder to take up these shares - being an optional
corporate action - is purely at the option of the shareholder and is termed a rights issue call.
The right to participate in such an issue is only conferred upon those shareholders who hold the
issuing company’s shares cum-rights (cr). That is, those who hold the company’s shares before
trading in the shares is conducted on an ex-rights (xr), 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 three weeks through to the acceptance date, the date by which the
shareholder should have decided whether or not to take up these new shares. This means that if
a shareholder entitled to take up the rights issue sells part or all of their shareholding in the
company during this ex-rights period then the selling shareholder retains their pre-emption rights
over this particular issue.
Those entitled to participate in the rights issues are advised of their entitlement by means of a
provisional allotment letter. This 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 which 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 xr, 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 (xr) price, and is calculated as follows:
Theoretical xr price =
[(No. shares held cum-rights x cum-rights share price) + (No. rights allocated x rights issue price)]
Total no. shares held assuming rights exercised
Example
A rights issue is announced on a one for four basis at 200p when the cum-rights share price stood at
350p. Calculate the theoretical ex-rights price.

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Solution
Number of shares held Price per share (p) Total value of holding (p)
4 existing 350 1400
1 new 200 200
5 post rights 1600
The theoretical ex-rights price = 1600/5 = 320p
The reason for this price being referred to as theoretical is because it ignores shareholder reaction
and market sentiment towards the rights issue. Sometimes the share price will settle above this
level if the shareholders believe a highly satisfactory return will be achieved on the capital raised
whilst at other times a rights issue may meet with a lukewarm reception with not all shareholders
wanting or being able to take up their rights in full. Therefore, the ex-rights price will fall below this
theoretical level.
As noted above, shareholders have three weeks to decide how to react to the announcement
following receipt of the provisional allotment letter and prospectus and must choose between one
of the four following courses of action:
i. 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.
ii. Sell the rights nil paid in full. If a shareholder entitled to take up the rights issue decides not to,
then they can sell the rights to these new shares nil paid. Nil paid rights are essentially a short
dated option on these new shares and can only be exercised or traded during the, three week,
ex-rights period. Options are considered in the derivatives section of this chapter.
Given the above example, the price of each nil paid right =
ex-rights share price - price of the new shares = 320p - 200p = 120p.
Obviously, it would not be rational to pay more than 120p for the right to purchase a new share
for 200p when the ex-rights price of the existing shares in issue is 320p. However, once again
market sentiment and other considerations can influence the price of these nil paid rights. As an
option on these new shares, nil paid rights are geared to the company’s share price. By gearing it
is meant that if the price of the shares rises by 10p then so should the price of the nil paid rights.
In the above example, the shares are geared by a factor of 320/120 = 2.67.
So, whereas a 10p rise in the
ex-rights share price represents a 10/320 x 100 = 3.125% increase, for the nil paid rights this
translates into an 10/120 x 100 = 8.33% increase, or a percentage rise 2.67 times as great.
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 this to their broker by the due date.
iii. Sell sufficient 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. Using the example above, if a shareholder
with, say, 2,000 shares and, therefore, a right to take up 500 shares via the rights issue, sold 313
nil paid rights at 120p, the £375.60 raised would be sufficient to take up the remaining 500 minus
313, or 187 shares at 200p, ie, £374.

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The number of nil paid rights to be sold is given by the equation:

issue price of new shares/
ex-rights price of existing shares x number of shares allotted
= 200/320 x 500 = 312.5 nil paid rights

As nil paid rights cannot be sold in fractions, this is rounded up to 313.
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.
iv. 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 economic way to proceed.
2. Placing. If additional finance is to be raised by a company by placing new shares in the market
rather than by making a rights issue to its existing shareholders, then the shareholders must first
pass a special resolution to forgo their pre-emption rights. These secondary placings have several
merits for the company over rights issues:
i. A limited prospectus is required.
ii. The issue does not need to be underwritten (though neither does a rights issue priced at a
deep discount to the cum-rights share price).
iii. The shares are usually priced at only a slight discount to the prevailing share price, thereby
reducing the number of shares that need to be issued.
iv. The company receives the proceeds from the issue far more quickly.
If a company makes a placing with clawback, new shares are placed with institutions only after
they have been offered to existing shareholders. Depending on the take up of these new
shares by existing shareholders, the allocation to these institutions may be clawed back, or
made on a pro rata basis.
3. Bonus/scrip issue. Occasionally a company may issue new shares to its shareholders without
raising further capital, often as a public relations exercise to accompany news of a recent success
or as a means to make its shares more marketable. Such issues are known as bonus, scrip or
capitalisation issues. A company quite simply converts its reserves, which may have arisen from
issuing new shares in the past at a premium to their nominal value and/or from the accumulation
of undistributed past profits, into new ordinary shares. These shares rank pari passu with those
already in issue and are distributed to the company’s ordinary shareholders in proportion to their
existing shareholdings free of charge.
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 this same
proportion, thereby leaving the company’s market capitalisation unchanged.

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Example
Z plc makes a bonus issue to its shareholders on a one for four basis to coincide with the launch
of its new product. Prior to the announcement of the issue, the company’s ordinary shares
traded at 200p per share. If the company had 1m ordinary shares each with a nominal value of
25p in issue prior to the announcement, calculate:
i. The nominal value of the company’s share capital immediately before and immediately after
the announcement;
ii. The new theoretical market price for the shares; and
iii. 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
i. Nominal value of the company’s share capital
a. Immediately before = 1m x 25p = £250,000
b. Immediately after = 1m x 5/4 x 25p = £312,500
ii. Theoretical market price = 200p x 4/5 = 160p
iii. Market capitalisation
a. Immediately before = 1m x 200p = £2m
b. Immediately after = 1m x 5/4 x 160p = £2m
However, in contrast to the US, once a UK company’s share price starts trading well into double
figures, its marketability starts to suffer as investors shy away from the shares. Therefore, a
reduction in a company’s share price as a result of a bonus issue usually has the affect of
increasing the marketability of its shares and often raises expectations of higher future dividends.
This in turn usually results in the share price settling above its new theoretical level and the
company’s market capitalisation increasing slightly. This was strongly in evidence at the height of
the boom in dot com shares when dot com bonus issues met with an almost euphoric response
from the market.
4. Consolidation. A consolidation is where a company increases the nominal value of each of its
shares in issue whilst maintaining the overall nominal value of its share capital. For instance, if a
company has 1m shares in issue each with a nominal value of £1, it can simply increase the
nominal value per share to £2 and reduce the number of shares in issue to 500,000. A
consolidation is the exact opposite of a share split (please see below).
5. Subdivision/stock split. A company can also reduce the market price of its shares to make them
more marketable without capitalising its reserves by undertaking a stock split. A stock split simply
entails the company reducing the nominal value of each of its shares in issue whilst maintaining
the overall nominal value of its share capital. For instance, if the company has 1m shares in issue
each with a nominal value of £1, it can simply split each share into four, each share now having a
nominal value of 25p. Although the total nominal value of the shares in issue remains unchanged,
the overall market capitalisation of the company should increase as its shares become more
marketable. Other things being equal, the effect of a stock split on the share price should be the
same as for a bonus issue.

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1.6 Dividends
LEARNING OBJECTIVES
4.1.12 Know the reasons for companies paying dividends, how
dividend policy is determined and the practical
constraints on paying dividends
The return from ordinary shares comprises capital growth and dividend income. Although the
contribution of dividends to equity returns has diminished in recent years, mainly as a result of
changes in the UK tax system that begun in 1997, historically strong dividend growth has been the
main attraction for many equity investors and has proved to be the most important determinant of
returns over the longer term. In fact between 1900 and 2000, a UK equity portfolio with dividends
reinvested would have grown to a sum 100 times greater than one where they hadn’t been.
Therefore, the importance of dividends can never be underestimated. Of all the asset types, or
asset classes, equities still provide the most consistent and stable income stream. Moreover,
dividends can also be used in conjunction with the DCF techniques we considered in Chapter 2 to
establish the value of a company’s ordinary shares. This we look at in Chapter 7.
Dividends are usually paid twice a year and are expressed in pence per share. Interim dividends are
paid in the second half of a company’s accounting period whilst final dividends, usually the larger of
the two payments, are paid after the end of the company’s accounting year. As the final dividend is
decided upon by the company’s directors and voted upon by the shareholders at the AGM, it is
often paid the day after the meeting. Although shareholders can vote for the final dividend to be
paid at or below its proposed rate, they cannot vote for it to be increased above this level.
The Companies Acts restrict the amount that can be paid by a plc as dividends to its ordinary
shareholders to the company’s, post tax, distributable profit and that retained within its revenue
reserves from prior years. Aside from supplementing a company’s distributable profit in lean years,
these revenue reserves are used by most companies as their principal means of financing operations
and expanding the business.
Once a dividend has been declared, the company’s shares are traded on an ex-dividend (xd) basis
until the dividend is paid, typically six weeks after the announcement. Shares purchased during this
ex-dividend period, do not entitle the new shareholder to this next dividend payment.
The factors that determine a company’s dividend policy comprise:

1. The amount of cash being generated by the company and the competing demands placed upon
this cash generation. So as to retain cash within the business, many companies provide
shareholders with the option of taking additional new shares in the company in lieu of a cash
dividend. However, following tax changes made in 1999, these scrip dividends are no longer as
tax efficient to companies or as cost efficient to shareholders as they used to be. Shareholders in
receipt of scrip dividends are taxed in exactly the same way as if they received a cash dividend.
The taxation of dividends is covered in Chapter 8.
2. The level of the company’s current year distributable profit and that retained from prior years.

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3. The directors’ policy on dividend growth. The rate of growth in the level of dividend declared
typically acts as a signal to the market of the directors’ optimism or pessimism surrounding the
company’s medium term prospects and long term health. A reduction in a company’s trend, or
long term, dividend growth rate, or, worse still, an absolute cut in the dividend per share (DPS),
predictably results in a decline in the share price. The potential impact that the rate of dividend
growth has on a company’s share price is considered in Chapter 7.
1.7 Share Buybacks

LEARNING OBJECTIVES
4.1.13 Know the reasons for companies buying back their
own shares
Although most ordinary shares in issue are irredeemable, an increasing trend amongst UK
companies began to surface towards the end of the 1990s in buying back their own shares. The
same changes to the UK tax system, referred to earlier, that began taking place in 1997, made it
more tax efficient for companies, and more beneficial for their institutional shareholders, for any
cash surpluses to be used to buy back and cancel a proportion of their ordinary shares rather than
to pay enhanced dividends, subject to the permission of the High Court and agreement from
HMRC. Share buybacks cannot, however, replace dividends as means of distributing cash to
shareholders. Apart from share capital being finite and buybacks not providing shareholders with
the same regular and reasonably predictable income flow that dividends typically provide, such an
arrangement would not be permitted by HMRC.
By reducing the number of shares in issue, so the company’s EPS will increase, and so in turn may
its stock market rating. Alternatively, a company may decide to enhance its EPS by replacing part of
its share capital with a bond issue. As mentioned in Chapter 2, bond interest being tax-deductible,
unlike equity dividends, should lower the company’s WACC and benefit its remaining ordinary
shareholders. However, as we explain in the section on fixed interest securities, replacing equity
with debt finance increases the company’s gearing and, therefore, the risk attached to the
company’s shares.
Concluding Comments
Over the longer term, equities have consistently outperformed all of the other main asset types and
have delivered superior real returns under almost all economic conditions. Strong long term
dividend growth has also served to provide the most stable and consistent income stream of all the
asset classes. However, equity investment has many inherent risks and can suffer prolonged
downturns in the short to medium term.

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2. FIXED INTEREST
2.1 Introduction
LEARNING OBJECTIVES
4.2.1 Know the structure, characteristics and risks of the
different types of fixed interest securities
A fixed interest security can be defined as a tradeable negotiable instrument,issued by a borrower

for a fixed term, during which a regular and predetermined fixed rate of interest based upon a
nominal value is paid to the holder until it is redeemed and the principal is repaid. Fixed interest
securities are commonly termed bonds, stock and debt.
Each of the, above, italicised terms are defined below:

1. Negotiable instrument. Bonds are negotiable instruments in that ownership of the security can
pass freely from one party to another. This makes bonds tradeable.
2. Borrower. Bonds can be issued by a wide range of borrowers, including supranationals, such as
the IMF, governments, government agencies, local authorities and companies, in a variety of
different forms.
3. Fixed rate of interest. Most bonds are issued with a predetermined fixed rate of interest, known
as the bond’s coupon. This can be expressed either in nominal terms or, in the case of index-
linked bonds, in real terms, and is usually paid semi-annually. However, some bonds are issued
with variable, or floating, coupons whilst others are issued without any coupon at all.
4. Nominal value. Also known as the par value. In contrast to the nominal value of equity shares, a
bond’s nominal value is of practical significance as it is the price at which the bond is usually
issued and redeemed, though some issues are made and/or redeemed either at a discount or at a
premium to par. Bonds are also traded and reference is made to bond holdings on the basis of
nominal, rather than market, value. In addition, the coupon is expressed as a percentage of the
nominal value. So, a bond with a nominal value of £100 and a 7% coupon paid semi-annually
means the holder will receive £3.50 every six months.
5. Holder. The holder is the owner of the bond, title to which is usually evidenced by a certificate.
Most bonds issued in the UK are individually registered in the holder’s name and, therefore,
require the completion and registration of a stock transfer form (STF) for ownership to pass
between one party and another. Most overseas and international bond issues, however, are made
in bearer form. That is, rather than being formerly registered in the name of the holder,
ownership is confirmed by the mere possession of a certificate. Ownership can, therefore, pass
from hand to hand without any formalities.
6. Redeemed. Most bonds have a fixed redemption date upon which the bond matures and the
underlying principal, known as the redemption payment, is returned to the holder by the issuer.
Others are dual dated in that they have two redemption dates between which the bond is
redeemed by the issuer. Some bonds, however, are issued in irredeemable, or undated form, or
effectively become undated by virtue of the wording of their redemption terms.
7. Principal. As mentioned in (6), the principal is the redemption payment made by the issuer to the
holder of the bond at maturity. This sum is usually the nominal, or par, value.

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2.2 Types of Bond
LEARNING OBJECTIVES
4.2.1 Know the structure, characteristics and risks of the
different types of fixed interest securities
4.2.2 Know the characteristics and reasons for issuing
convertible bonds
4.2.3 Be able to calculate a conversion premium on a convertible bond
4.2.9 Know the characteristics and uses of strips and repos
Bonds are usually classified according to the issuer, their structure or defining characteristics and the
market into which they are issued:
1. Most bonds are issued by governments and supranationals, known collectively as sovereign
borrowers, companies and, to a lesser extent, local authorities.
2. Bond structures can range from conventional, or straight, issues that meet with the definition
considered at the very start of this section, through to those that have evolved as a result of the
significant amount of innovation that has taken place in bond markets in recent years. The
innovative features and structures that now increasingly characterise many bond issues include
many of the features noted earlier, such as those being issued:
a. With index linked coupon payments and redemption proceeds.
b. Without coupon payments. These zero coupon bonds (ZCBs) are issued at a discount to
nominal value but are redeemed at par, thereby providing their entire return as capital gain.
c. With conversion rights. These convertible bonds may confer a right on the holder to convert
into other bonds, or if issued by a company, into its ordinary shares, on pre-specified terms
and on predetermined dates.
d. With floating rather than fixed coupons. These are termed floating rate notes (FRNs).
e. With provisions for early redemption. These early redemption provisions are known as call
and put provisions. If a call provision is granted to the issuer, the bond is a callable bond,
whereas if a put provision is conferred upon the holder it is a putable bond. Bond issues with
call provisions entitle the issuer to redeem the issue earlier than the stated redemption date
on advantageous terms, typically at a predetermined price. This has the effect of placing a
ceiling on any upward movement in the bond’s price, thereby making these bonds less
attractive than those that do not contain such provisions.
3. Bonds can be issued into the issuer’s own domestic bond market, internationally in one or across
a range of bond, or debt, markets.
Government Bonds
Bonds which are issued by a government are usually referred to as (credit risk) free bonds. This is
because the government can repay the debt by raising taxes or issuing more money. However,
government bonds may still have currency and inflation risk. Some of the main issuers include:

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Country Currency Name Issuer

Japan Yen Japanese Ministry of
Government Finance
Bond (JGBs)
USA US Dollar US Treasuries Bureau of the
Public Debt
France Euro OATs Agence France
Trésor
Germany Euro Bunds Finanzagentur
GmbH
England Sterling GILTS UK Debt
Management
Office
Gilt STRIPS
Since 1997 certain gilts have been available to trade as STRIPS (Separate Trading of Registered
Interest and Principal). A stripped gilt is one that is separated into its component coupon payments
and its redemption payment. Each of these payments can then be separately traded as a zero
coupon bond (ZCB) with a known nominal redemption value. As each ZCB is purchased at a
discount to this redemption value, the entire return is in the form of a capital gain. Conventional
gilts with interest payment dates of 7 June and 7 December, index linked gilts and rump gilts are all
potentially strippable.
Apart from adding to the liquidity of the gilt market, STRIPS can be used both as a portfolio
management and as a personal financial planning tool given that the redemption proceeds from
these ZCBs, each with their own unique redemption date, can be used to coincide with specific
future liabilities or known future payments.
Eurobonds
Eurobonds are large international bond issues made by supranationals, governments and larger,
usually multinational, companies. The Eurobond market developed in the early 1970s to
accommodate the recycling of substantial OPEC US dollar revenues from Middle East oil sales at a
time when US financial institutions were subject to a ceiling on the rate of interest that could be
paid on dollar deposits. Since then it has grown exponentially into the world’s largest market for
longer term capital, as a result of the corresponding growth in world trade and even more
significant growth in international capital flows, with most of the activity being concentrated in
London, UK.
Often issued in a number of financial centres simultaneously, the one defining characteristic of
Eurobonds is that they are denominated in a currency different from that of the financial centre or
centres in which they are issued. In this respect the term Eurobond is a bit of a misnomer as
Eurobond issues and the currencies in which they are denominated are not restricted to those of
European financial centres or countries. The euro prefix simply originates from the depositing of US
dollars in the European Eurodollar market and has been applied to the Eurobond market since. So,
a Eurosterling bond issue is one denominated in sterling and issued outside of the UK, though not
necessarily in a European financial centre.

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Eurobonds issued by companies typically do not provide any underlying collateral, or security, to the
bondholders but are almost always credit rated by a credit rating agency. Credit ratings are covered
later in this section. To prevent the interests of these bondholders being subordinated, or made
inferior, to those of any subsequent bond issues the company makes, a negative pledge clause will
be provided by the company. This prevents the company subsequently making any secured bond
issues, or issues which confer greater seniority or entitlement to the company’s assets in the event
of its liquidation, unless an equivalent level of security is provided to existing bondholders. As
discussed below, given that most issues made in the UK domestic corporate bond market require
some kind of security to be offered to bondholders, Eurobond issuers are effectively prevented
from using this market. However, the reasons for tapping the Eurobond rather than the UK
domestic bond market for such companies are sufficiently powerful to overcome this impediment,
since the Eurobond market offers:
1. A choice of innovative products to more exactly meet issuers needs;
2. The ability to tap potential lenders internationally rather than just domestically;
3. Anonymity to investors, issues being made in bearer form;
4. Gross interest payments to investors;
5. Lower funding costs due to the competitive nature and greater liquidity of the market;
6. The ability to make bond issues at short notice; and
7. Less regulation and disclosure.
Eurobonds can assume a wide range of innovative structures. Although most are issued as
conventional bonds, or straights,with a fixed nominal value, fixed coupon and known redemption
date, other common structures include:
1. Floating-rate notes (FRNs). The coupon on FRNs is referenced to a key money market rate of
interest, such as the London Interbank Offered Rate (LIBOR), and paid at a fixed margin above
this rate. FRNs can also employ caps and collars, which place parameters on the movement of
this fixed-rate and often incorporate a droplock facility whereby the FRN converts into a fixed
rate bond upon the floating coupon falling to a pre-specified level.
2. Zero coupon bonds (ZCBs). As noted earlier, these are issued at a discount to their redemption
value and provide a return in the form of capital gain. However, because they are issued at a deep
discount to their redemption value, this gain is taxed as income and not capital in the hands of the
holder.
3. Convertible bonds. These can be converted into another of the issuer’s securities.
4. Dual currency bonds. These are issued in a different currency to that in which the coupons and
redemption proceeds are paid.

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Domestic Corporate Bonds

Although many companies are reliant upon short term bank borrowing and retained profits to
finance their operations, longer term finance can be obtained for expansion by issuing bonds in the
domestic corporate bond market.
Domestic corporate bonds are usually categorised as either debentures or as loan stock.
Debentures are bonds secured on the issuing company’s assets by way of a fixed or a floating
charge. A fixed charge is a legal charge, or mortgage, specifically placed upon one or a number of
the company’s fixed, or permanent, assets. A floating charge, however, places a more general
charge on those assets that continually flow through the business and whose composition is
constantly changing, such as the issuing company’s stock-in-trade. The type of security provided by
a debenture issue, along with all other of the issue’s terms and any covenants which must be
observed by the issuer, is incorporated into a trust deed or an indenture; the company’s compliance
with which is overseen by an independent trustee appointed by the company.
If any of these terms or covenants is breached then the company will be held by trustee to be in
default of its obligations and, in turn, has the right to appoint a receiver to realise the asset(s)
subject to the charge.
Typical terms and covenants contained in the indenture to a corporate bond issue include:
1. Details of the coupon and payment dates. Whereas dividend payments on equity and preference
shares are made at the discretion of the company’s directors, failure to make interest payments
on time constitutes default, as does a failure to make the final redemption payment on the due
date.
2. Details of the type of charge and the asset(s) to which it relates. Only if an asset is subject to a
fixed charge, must the company obtain the permission of the trustee before disposing of the
asset.
3. Protective covenants. The issuing company may have limits placed upon future borrowing
powers and the ranking of any subsequent debt so as not to compromise its ability to meet
existing coupon and redemption payments. These covenants may also require the issuer not to
breach pre-specified parameters for certain key financial ratios that provide evidence of the
issuer’s ability to meet its contractual obligations. This type of covenant provides the
bondholders with continued evidence of the company’s financial strength. Ratio analysis is
covered in Chapter 7.
4. The rights of the trustee in the event of the company defaulting on the issue’s terms and
breaching specified covenants.
5. How the issue is to be redeemed.
As shown in the table below, those debentures with a fixed charge offer a greater level of security
to bondholders than those subject to a floating charge in the event of the issuing company going
into liquidation. That is, the former have a more senior ranking than the latter in the order of
priority in which capital repayment is made.

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ORDER OF PRIORITY OF CAPITAL REPAYMENT IN THE EVENT OF LIQUIDATION
• Debentures secured by a fixed charge;
• Preferential creditors;
• Debentures secured by a floating charge;
• Unsecured creditors including loan stock;
• Subordinated loan stock;
• Preference shares;
• Ordinary shares.
Although most domestic bond issues require some form of security to be offered to bondholders,
companies can make unsecured bond issues, known as loan stock. Being issued without any
underlying collateral, however, means that loan stock ranks with the company’s other unsecured
creditors in the event of the company’s liquidation, though its seniority, or ranking, can fall one
notch to just above that of the company’s preference shareholders if issued as subordinated loan
stock.
Convertible Loan Stock

In addition to that issued with conventional bond characteristics, loan stock can also be issued with
conversion rights into the issuing company’s ordinary shares on predetermined terms. With
characteristics similar to that of convertible preference shares, convertible loan stock, if not
converted, simply becomes a conventional dated fixed interest security. Being debt rather than
equity, however, convertible loan stock places an obligation on the issuer to make pre-specified
interest payments regardless of the company’s ability or desire to pay dividends. However, like all
corporate bond issues, these interest payments can be offset against a company’s profits for
corporation tax purposes. Moreover, the provision of conversion rights, or equity sweeteners,
means the loan stock can be issued at a lower coupon than a comparable straight loan stock.
Convertible loan stocks are usually issued for the following reasons:
1. The bidding company in a takeover wishing to defer the immediate dilution of the bidding
company’s equity share capital, issues convertible loan stock as consideration to the target
company’s shareholders.
2. A company seeking to raise capital but which does not have sufficient assets to offer as security
for a debenture issue or is unable to make a rights issue as its share price has fallen below the
nominal value of its shares.
3. A company undergoing a capital restructuring can issue convertible loan stock in exchange for
other forms of issued capital or to its other creditors in lieu of outstanding debts.
As with convertible preference shares, given the terms on which the convertible loan stock can be
converted into the issuing company’s ordinary shares, a conversion premium or discount can be
established:

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Conversion premium/discount =
[(market price of convertible/market price of equity shares x conversion ratio) – 1] x 100
where the conversion ratio is the rate at which the convertible can be exchanged for equity shares.
If the price of the convertible given the conversion terms is lower than, or stands at a discount to,
the price of the equity shares then the convertible is a less expensive way of buying into the issuing
company’s ordinary shares than buying these shares directly. This will occur when the price of the
convertible has lagged the rise in the ordinary share price and/or offers a relatively less attractive
income stream. It may be that the equity dividend has recently experienced strong growth. The
opposite is true if the convertible stands at a premium.
Example
A company has issued 8% convertible loan stock at £100 nominal. This can be converted into the
company’s ordinary shares at a rate of 18 ordinary shares for every £100 nominal of the loan stock.
If the loan stock is priced at £120 and the ordinary shares are priced at 575p, what is the conversion
premium or discount?
Conversion premium = [(120/18 x 5.75) – 1] x 100 = 15.9%
Therefore, buying the convertible preference shares is a more expensive route into the issuing
company’s ordinary shares than buying the shares directly. However, the 8% coupon may be
sufficiently attractive when compared to the ordinary share dividend and the anticipated dividend
growth to justify the premium. The higher the premium, the more the convertible loan stock will
behave like a conventional stock whereas the lower the premium the nearer the loan stock will be
to conversion and, therefore, the closer its price movements will be to that of the company’s
equity.
Permanent Interest Bearing Securities (PIBs)

PIBS are irredeemable fixed interest securities issued by mutual building societies. PIBS pay
relatively high semi-annual coupons, net of basic rate income tax, and potentially offer attractive
returns. However, this income is non-cumulative and PIB holders rank behind all other creditors in
the event of liquidation. If the building society subsequently demutualises, its PIBS are reclassified as
Perpetual Subordinated Bonds (PSBs). Both PIBS and PSBs can be traded on the LSE.
Issue and Redemption of Domestic Corporate Bonds

Corporate bonds can be issued with either fixed or floating rate coupons. They can also be issued
and redeemed at par or at a discount or premium to par in the same way as other bonds.
The method by which the company intends to redeem its bond issue will be stated in the indenture
governing the terms of the issue. Redemptions are usually financed by making another bond issue or
very occasionally by raising equity finance. However, replacing debt, with its tax-deductible interest,
with equity that pays dividends out of post tax profits, is not tax efficient and will result in the
company’s equity being diluted, usually with an adverse impact on the EPS.

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Rather than raise additional finance at redemption, the issuing company also has the option of
gradually redeeming the issue throughout the life of the bond. This it can do by either:
1. Incorporating a call provision within the terms of the issue so that a
pre-specified percentage of the bond issue can be redeemed on a random basis, or
2. Voluntarily purchasing the bonds, if traded on the open market, at random.
In addition:
1. A provision is often incorporated within the issue terms that may require the company to
purchase the bonds if the price at which they trade in the market falls below par, or
2. The bond issue may contain a put provision that gives the holder the option to sell the bond back
to the company under certain specified conditions.
2.3 Bond Yields

LEARNING OBJECTIVES
4.2.5 Understand what is meant by running yield, net
redemption yield (NRY), gross redemption yield (GRY),
duration
4.2.6 Be able to calculate running yields, net redemption yields (NRYs),
gross redemption yields (GRYs), duration
4.2.7 Know the characteristics of the yield curve: normal; inverted
The return from bonds, like equities, comprises two elements: the income return and that from
price, or capital, movements during the period the security is held. Obviously, if a bond is purchased
when issued at par and held to redemption, then, assuming it is redeemed at par, the return will
simply comprise the coupon payments received over the term of the bond. However, if a bond is
not purchased at par and/or not held to redemption, then its return will also be determined by the
difference between the price at which it was purchased and that at which it is subsequently sold or
redeemed, as appropriate.
The Running Yield

The simplest approach to establishing the return from a bond is to calculate its running yield, also
known as the flat or interest yield. This expresses the coupon as a percentage of the market, or
clean, price of the bond.
Running yield = (coupon/clean price) x 100
So, a Treasury 6% 2008 (six years to maturity) issued and due to be redeemed at par and currently
priced at 110 would have a running yield of:
(6/110) x 100 = 5.45%
However, the running yield ignores the difference between the current market price and the
redemption value. To remedy this, the gross redemption yield (GRY) can be calculated.

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The Gross Redemption Yield (GRY)

The simplest approach to calculating the gross redemption yield (GRY) is as follows:
GRY =
running yield + [{(par – market price)/number years to redemption}/market price] x 100
Using the same example as above:
GRY = running yield + [{(100 – 110)/6}/110] x 100 = 5.45% + - 1.52% = 3.93%
You will notice that the GRY, which calculates the average annual compound return from the bond if
held to maturity, is lower than the running yield. The reason for this is that the market price is
higher than the bond’s par value. Therefore, the bond will suffer a capital loss if held to maturity. If,
however, the market price is below par, then the GRY would be greater than the running yield as a
capital gain would be made if the bond was held to maturity.
This method of calculating the GRY though is only an approximation since the formula:
1. Can only cope with fixed coupons paid annually, not semi-annual, floating or index linked
coupons, and
2. Ignores the time value of money.
The only accurate way to calculate a bond’s GRY is to employ the DCF techniques covered in
Chapter 2. You may recall that the DCF yield or internal rate of return (IRR) is that which when
applied to a project’s cash flows results in a net present value (NPV) of zero. That is, the IRR is the
rate of return that a project needs to achieve in order to breakeven. Exactly the same principles are
applied when establishing a bond’s GRY. The GRY is the IRR that equates the price of the bond to
the present value of its cash flows, namely its coupon payments and final redemption payment.
By employing the DCF techniques contained in Chapter 2, the theoretical price of a conventional
fixed interest security with a known redemption date is given by the present value of its future cash
flows:
Theoretical bond price = C1/(1+r) + C2/(1+r)2 ....+ (Cn + R)/(1+r)n
where C1 represents the first coupon payment, C2 the second and Cn the nth payment, R the
redemption payment, n the term of the bond and r the discount rate applied to these cash flows.
This discount rate is the rate of return, or yield, required by investors over the term of the bond. It
is also the bond’s GRY. As can be seen from the equation, the higher the coupon, the greater
the term to maturity, and the lower the discount rate applied, the higher the price of the
bond.

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However, as we know, the only accurate way to establish an IRR is through a lengthy process of trial
and error using a range of discount rates but an approximate IRR can be derived through
interpolation. That is, by taking two discount rates, one that when applied to the bond’s cash flows
produces a positive NPV and another, higher, discount rate that results in a negative NPV, and then
finding the rate between them that produces a zero NPV. We also know that the accuracy of this
method is reliant upon the two discount rates used being as close together as possible to minimise
the deviation between the approximated and true IRR.
Treating the above bond as paying coupons annually, we know that the approximate GRY is 3.93%.
Therefore, if we discount the bond’s cash flows by, say, 3.8% and 4.2% we should arrive at a GRY
very close to the true IRR.
Discounting the bond’s cash flows at 3.8% gives:
Period Cash flow Discount factor Discounted

(£) cash flow (£)
Start year 1 (110) 1 (110.00)
1 1
End of years 1 – 5 6 /0.038 [1- /1.038 5] = 4.4769 26.86
1
Year 6 100 + 6 /1.038 6 87.74
NPV 4.60
Discounting the bond’s cash flows at 4.2%, however, gives:
Period Cash Discount factor Discounted

flow (£) cash flow (£)
Start year 1 (110) 1 (110.00)
1 1
End of years 1 – 5 6 /0.042 [1- /1.042 5] = 4.4269 26.56
1
Year 6 106 /1.042 6 82.81
NPV (0.63)
Therefore, using the interpolation formula:
GRY = [r1 + {[+NPV/+NPV – (-NPV)] x (r2 – r1)}] x 100
GRY = [0.038 + {[4.60/(4.60 + 0.63)] x (0.042– 0.038)}] x 100 = 4.15%
Discounting the bond’s cash flows at 4.15% should provide an NPV close to zero:
Period Cash Discount factor Discounted

flow (£) cash flow (£)
Start year 1 (110) 1 (110.00)
1 1
End of years 1 – 5 6 /0.0415 [1- /1.0415 5] = 4.433 26.60
1
Year 6 106 /1.0415 6 83.05
NPV (0.35)
This GRY of 4.15% compares with the 3.93% we obtained by using the approximation formula.
Obviously, the greater the number of cash flows to be derived from the bond, the less accurate the
former method of approximating the GRY will be.

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If the GRY for a semi-annual coupon bond is to be calculated, then each of the semi-annual coupons
and the redemption payment would be discounted by a factor of 1/[1 + (r/2)]n, where n represents
the semi-annual payment period in which the cash flow is received. Where the cash flows are of
equal magnitude, the discount factor 1/(r/2)[1- 1/[1 + (r/2)]n] can be used.
The Net Redemption Yield (NRY)

The NRY calculates the redemption yield of a bond net of the income tax payable on the coupons
to be received. Exactly the same process is employed as when calculating the GRY, whether using
the approximate or DCF approach, though the coupon flows are given by:
Coupon x (1 – holder’s income tax rate)
As the redemption proceeds from a gilt or QCB are free of all personal taxes, this payment does
not need to be adjusted.
Assessing the GRY

The GRY as a yield measure, however, has its drawbacks. Firstly, it assumes that the bond will be
held to redemption. More fundamentally though, the GRY being an IRR is conceptually flawed.
Relating this to what was covered in Chapter 2, implicit in the GRY calculation is the assumption
that once a cash flow has been received it can be reinvested at the same rate of interest as the GRY.
If, however, the prevailing market rate of interest is lower than the GRY, then the true annualised
compound annual return from the bond will also be lower than that implied by the GRY. This
inability to reinvest coupons at the same rate of interest as the GRY is known as reinvestment risk.

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2.4 The Term Structure of Interest Rates
LEARNING OBJECTIVES
4.2.8 Be able to calculate forward rates given two spot rates
of different maturities
Interest rates change over time. They also differ with the term of the investment. That is, bonds of
different maturities usually have different GRYs. This relationship between yield and maturity is
known as the term structure of interest rates and can be illustrated graphically by a redemption
yield curve, or yield curve, as it is more commonly known.
Gross redemption yield (GRY)
Term to maturity (years)
Figure 1: Normal Yield Curve
Although yield curves can assume a range of different shapes, more often than not the yield curve is
described as being upward sloping, in that it displays a positive slope. This is known as a normal
yield curve as it depicts the commonly observed relationship of long term interest rates being
higher than short term interest rates. The reason for this term structure can be explained by
liquidity preference theory. This theory maintains that investors have a natural preference for short
term investments, and, therefore, demand a liquidity premium or a higher rate of return the longer
the term of the investment. The reasons for this are two-fold. Firstly, the longer capital is tied up
the longer the investor must forgo the consumption of goods and services and, secondly, the longer
the term of the investment, the greater the risk to the capital invested.
From a borrower’s perspective, the ability to borrow longer-term finance is attractive in that it
negates the risk associated with periodically refinancing shorter term borrowing at its maturity. For
this reason, borrowers are generally prepared to pay a liquidity premium for longer term funds.
This liquidity premium is dynamically determined by market forces, principally the ever-changing
risk appetite of investors.

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The shape and level of the yield curve can also be explained by expectations theory, market
segmentation and certain other factors.
1. Expectations Theory
Expectations theory maintains that the difference between short and long term interest rates can be
explained by the course that short term interest rates are expected to take over time. More
specifically, it states that the long term interest rate is related to the short term interest rate by the
geometric average of the current and expected future level of short term interest rates.
This relationship gives rise to what are termed spot rates and forward rates. A spot rate is a
compound annual fixed rate of interest that applies to an investment over a specific time period
whereas a forward rate is the implied annual compound rate of interest that links one spot rate to
another assuming no interest payments are made over the investment period. This relationship is
best illustrated with an example.
If £100 can be invested over one year at a spot rate of 6% per annum, then at the end of the year
this investment would be worth £100 x 1.06 = £106. If this same £100 could be invested over two
years at a spot rate of 7% per annum, then at the end of its term the £100 would have a value of
£100 x 1.072 = £114.49. The interest rate that links these two spot rates is the forward rate.
Therefore, the forward rate can be defined as that which links the final value of £106 in year one to
£114.49 in year two:
Forward rate between year one and year two (1f2) = (£114.49/£106) – 1 = 8%
So, if £100 is invested over year one at 6% and is then invested over year two at 8%, then the
value of the investment at the end of year two will be £106 x 1.08 = £114.49.
This implies that if we know the one year interest rate is 6% and that interest rates between year
one and year two are expected to rise from 6% to 8%, they will, taking a geometric mean, average
7% compound over the two year period. This 7% compound rate is the two year spot rate.
Therefore, a two year bond should yield 7%. This is given by the following geometric progression:
1.06 x 1.08 = (1.07)2
So, the two year spot rate = [(1.06 x 1.08)1/2 –1] = 7%
You will notice that the one year spot and forward rates are the same at 6%.
If the spot rate for a three year investment is 8%, then the forward rate linking the two year to the
three year spot rate, given a final sum in year three of £100 x 1.083 = £125.97 is:
Forward rate between year two and year three (2f3) = (£125.97/£114.49) – 1 = 10%
So, taking the geometric average of these forward rates, the three year spot rate or the yield on a
three year bond of 8% is derived by the geometric progression:
1.06 x 1.08 x 1.10 = (1.08)3
So, the three year spot rate = [(1.06 x 1.08 x 1.10)1/3 -1] = 8%

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However, what is the forward rate linking the one year spot rate of 6% with the three year spot
rate of 8%?
Forward rate between year one and year three (1f3) = (£125.97/£106)1/2 – 1 = 9%
You will notice that as the forward rate is an annualised compound rate of interest and a two year
period is being considered, the equation has been raised to the power of ½. If the forward rate
linking the spot rate in year one to, say, that in year five was being calculated then since four years
are being considered the equation would be raised to the power of ¼ or 0.25.
To confirm the answer is correct, if £100 is invested in year one at 6% and the resulting £106 is
then invested over the next two years at 9%, then the final sum will be £106 x 1.092 = £125.97.
The geometric progression here is:
1.06 x (1.09)2 = (1.08)3
So, the three year spot rate = [(1.06 x 1.09 x 1.09)1/3 -1] = 8%
Again, despite the different approach, a three year spot rate of 8% has been derived.
In conclusion then, if the short term rate of interest is expected to rise over time then the yield
curve will display a positive slope; the slope being reinforced by the liquidity preference premium. If
interest rates are expected to remain unchanged in the future, however, notwithstanding the effect
of liquidity preference, then a flat yield curve will result whilst the expectation of short term interest
rates falling, from what the market believes are unsustainably high levels, will result in a downward
sloping, or inverted, yield curve.
GRY
Maturity
Figure 2: Inverted Yield Curve

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As discussed in Chapter 1, expectations of changes in short term interest rates are largely driven by
inflation expectations. However, inflation expectations can also directly influence the yield on fixed
interest securities as, with the exception of index-linked bonds, notwithstanding the eight month
time lag, inflation erodes both the value of future coupon payments and that of the redemption
payment. Therefore, if the holder is to be provided with a real rate of return, the GRY should
exceed the average inflation rate that is expected to prevail over the term of the bond. In addition,
the GRY must compensate the holder for the risk that their estimate of future inflation, given the
past volatility of inflation rates, may be wrong. This is termed the inflation risk premium (IRP). The
more volatile inflation has been in the recent past, the greater the IRP demanded by investors.
There is also the premium required for the loss of liquidity, which as we know, varies with the
marketability and term of the investment and the risk appetite of investors prevailing in the market.
The GRY, or annualised total return on a bond if held to redemption, can, therefore, be expressed
as:
GRY = real return+ expected inflation + inflation risk premium + liquidity premium
When choosing between conventional and comparable index linked gilts of the same term,
investors must decide whether the yield differential between the real and nominal yield offered
reflects their own expectations of inflation over the term of the bond. Breakeven inflation rate
tables are available which state the rate of inflation at which the investor at current yields should be
indifferent between these two bonds, given the effect of various tax rates on each of the bonds
coupon payments. If the investor’s inflation expectations are below this breakeven inflation rate
then the conventional gilt should be chosen over the index linked gilt and visa versa.
2. Market Segmentation
Market segmentation is based upon the notion that a bond market is not homogeneous but can be
divided up into distinct segments based upon term to maturity, with each segment operating as if a
separate market subject to its own unique set of market conditions, independently of interest rate
expectations. This, therefore, implies that the shape and level of the yield curve, as well as being
determined by liquidity preference and interest rate expectations, also depends on demand and
supply conditions in each of these segments.
For instance, as short dated gilts are typically held by banks and longer dated gilt issues are favoured
by those institutional investors with long term liabilities to meet, such as pension funds, if medium
dated bonds have no natural demand, this can lead to a humped yield curve, subject, of course, to
the amount of bond issuance being made into each of these segments. That is, medium dated bonds
would offer higher GRYs than those of equivalent short or long dated bonds, as a result of an excess
of supply over demand.
GRY
Maturity
Figure 3: Humped Yield Curve

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The gilt yield curve is published in the Financial Times every Saturday, whilst current and historic
yield curves can be obtained from Bloomberg.
2.5 Bond Risks

LEARNING OBJECTIVES
4.2.4 Know the main risks faced by bondholders
As you no doubt appreciate by now, there are a number of risks attached to holding bonds, some of
which have already been considered, notably:
1. Early redemption risk. The risk that the issuer may invoke a call provision if the bond is callable;
2. Seniority risk. The seniority with which corporate debt is ranked in the event of the issuer’s
liquidation;
3. Unanticipated inflation risk. Risk of inflation rising unexpectedly and its effect on real value of
bond’s coupon payments and redemption payment;
4. Liquidity risk. Liquidity is the ease with which a security can be converted into cash. Any market
with brisk two-way trade and narrow dealing spreads is said to be liquid. However, bonds such as
rump gilts, most index linked gilts and those issues made by less well known, or less highly rated,
issuers tend to suffer from illiquidity and can, therefore, be difficult to realise at short notice or
can suffer wider than average dealing spreads. In addition, liquidity also depends on an asset’s
term and the ever-changing risk appetite of investors.
In addition, however, the following risks also need to be considered:

5. Exchange rate risk. Bonds denominated in a currency different to that of the investor’s home
currency are potentially subject to adverse exchange rate movements. Therefore, any positive
difference in yield offered by such bonds over that available from equivalent bonds denominated
in domestic currency must at least compensate for any potential exchange rate loss the holder
may suffer;
6. Credit risk. The credit risk, or 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. The three most prominent credit rating agencies that provide these
ratings are Standard & Poor’s, Moody’s and Fitch. Independent credit rating agencies should be
differentiated from independent fund rating agencies as the latter rate the past and future
potential performance of investment funds rather than bond issues. 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. The table below provides an
abridged version of the credit ratings available from the three companies.
Standard & Poor’s Moody’s Fitch

Investment grade AAA to BBB - Aaa to Baa3 AAA to BBB -
Non-investment grade BB+ to C Ba1 to C BB+ to C
Already in default D - DDD to D

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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 often differs though not
usually significantly so. The scope of this analysis has recently been widened to take account of the
size of an issuer's pension scheme deficit and, following the collapse of Enron, the nature and extent
of its off-balance sheet liabilities. These terms are explained more fully in Chapter 6.
Very few organisations, with the exception of supranational agencies, such as the World Bank, and
most Western governments, are awarded a triple-A rating, though the bond issues of most large
corporations boast an investment grade credit rating. However, ratings are regularly reviewed and
are often revised in the light of changed economic conditions and/or changes in the outlook for an
industry or the issuer’s specific circumstances. Most revisions result in credit downgrades rather
than upgrades. The price change resulting from a credit downgrade is usually much greater than for
an upgrade given that the price of a bond can fall all the way to zero, whereas there is a limit to how
high a bond's price can rise.
The bond issues of many large telecom companies, as a result of taking on large amounts of
additional debt to finance their acquisition of third generation (3G) telecom licences in 2000,
suffered severe credit downgrades and, as a consequence, experienced an indiscriminate marking
down in the prices of their bond issues.
Although differences between the historic default rates of triple-A rated bonds, bonds that just
meet the investment grade criteria and non-investment grade bonds have been quite marked,
particularly during economic recessions, the longer term performance of the latter two categories,
taken as a whole, has more than compensated investors for their increased risks of default.
However, as intimated earlier, investors must also be compensated for differences in the liquidity
and volatility of different issues, which like the credit risk premium are subject to the changing risk
appetites of investors. Therefore, we can conclude that:
Corporate bond GRY = government bond GRY+credit risk premium+liquidity and volatility risk premium
7. Interest rate risk. An inverse relationship exists between the price of bonds with fixed coupons
and their corresponding yields. As yields rise, so prices fall and visa versa.
Bond Yield
Bond Price
Figure 4: The Relationship Between Bond Prices and Bond Yields
Bond yields can rise, and, therefore, prices can fall, as a result of a number of factors such as
investors increased inflation expectations or a credit downgrading. However, the most likely
cause of rising bond yields is an increase in the market rate of interest.

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For example, if a gilt is issued at par with a fixed coupon of 6% when market interest rates are
6% but interest rates then suddenly increase to 7%, the price of the bond would need to fall to
below par in order for the yield to rise to compete with cash deposits paying 7% interest.
Another way of looking at this is to say that the price of the bond will fall because the discount
rate applied to each of its future cash flows, to establish its market price or NPV, will be higher
than before.
We know that the theoretical price of a conventional fixed interest security with a known
redemption date is given by the present value of its future cashflows:
Theoretical bond price = C1/(1+r) + C2/(1+r)2 ....+ (Cn + R)/(1+r)n
where C1 represents the first coupon payment, C2 the second and Cn the nth payment, R the
redemption payment, r the bond’s GRY, or the rate of return required by investors, and n the
term of the bond.
Therefore, one of the greatest risks to a bond’s price is a rise in yield resulting from change in the
market rate of interest.
The sensitivity of a bond’s price to a change in its yield provides a measure of the bond’s volatility
and is determined by three factors:
1. The term to maturity. Longer dated bonds are more sensitive to changes in yield than shorter
dated as there are a greater number of cash flows to be discounted by this higher yield. Based
on this criteria undated bonds are the most volatile. An alternative way of looking at this is to
say that as bonds approach maturity they have a greater pull towards their redemption value
and are, therefore, less affected by interest rate changes. This is known as the pull to maturity.
Bond Price
ion
edempt
ng r
proachi
Ap
Par
Approaching rede
mption
Term of maturity
Figure 5: The Pull to Maturity
This can also be explained by reference to the diagram below.

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Bond Yield
Short Dated Long Dated

Bond Price Bond Price
Figure 6: Long Dated Bond Prices are More Sensitive than Short Dated Bond
Prices to Changes in Yield
2. The coupon. The lower the coupon the greater the bond’s sensitivity to changes in yield. Low
coupon bonds have a greater concentration of their total cash flows weighted towards the
redemption payment, which when discounted at the higher yield will have a more exaggerated
effect on the bond’s price. Given this, index linked bonds are more sensitive to changes in yield
than conventional fixed interest bonds of the same maturity. Not only do index linked bonds
generally have lower coupons than their conventional counterparts but the index linking
applied to the redemption payment is far greater than the combined index linking applied to
the coupon payments.
Zero coupon bonds (ZCBs), however, whose only cash flow is the redemption payment at
maturity, are the most volatile based on this criteria.
3. The GRY. The lower the GRY the more sensitive the bond is to changes in yield for the same
reasons outlined in (2).
However, the question remains which of these factors has the greatest impact on determining the
sensitivity of a bond’s price to changes in its yield? In other words, would a low coupon, low GRY
short dated bond be more or less volatile than a high coupon, high GRY, long dated bond? In order
to establish the relative volatility or interest rate risk of two or more bonds, a composite measure
of bond volatility, that combines maturity, coupon and yield, can be used. This is known as Macaulay
duration.
Macaulay Duration
Macaulay duration, or duration as it is usually termed, is defined as the weighted average time,
expressed in years, for the present value of a bond’s cash flows to be received. The formula for
calculating the duration of a bond that pays annual coupons is given by:
Duration = Σ(t x PV)

NPV of bond’s cash flows
where PV is the present value of each of the bond’s cashflows discounted by the bond’s GRY and t
is the time period in which the cashflow is received. t is used to weight each of these cashflows.
The concept is best explained by an example.

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Example
Calculate the duration of a 7% semi-annual coupon bond with a GRY of 8% and a term of three
years.
Time Cash flow x discount = present value T x PV

period (t) (£) factor (PV) (£)
1
1 3.50 /1.04 3.37 3.37
1
2 3.50 /1.04 2 3.23 6.46
1
3 3.50 /1.04 3 3.11 9.33
1
4 3.50 /1.04 4 2.99 11.96
1
5 3.50 /1.04 5 2.88 14.40
1
6 103.50 /1.04 6 81.80 490.80
121.00 97.38 = NPV Σ(t x PV) = 536.32
As the bond has semi-annual cash flows, each cash flow is discounted by a factor of 1/[1 + (r/2)]n .
Once the present value of each cash flow has been established, each is multiplied by the time period
(t) in which it is to be received.
Duration = Σ(t x PV)

NPV of bond’s cash flows
Duration = (536.32/97.38) = 5.507
However, because the coupons in this example are paid semi-annually, rather than annually, the
solution must be divided by two, otherwise the answer will be 5.5 years, a term which extends
beyond the term of the bond.
So, the duration = 5.507/2 = 2.754 years. This solution is illustrated in the diagram below.
£81.80
£3.37 £3.23 £3.11 £2.99 £2.88
DURATION OF BOND (2.754 YEARS)
TERM OF BOND (3 YEARS)
Figure 7: Macaulay Duration
This solution can be interpreted as saying that this bond at this point in time has the exact same
sensitivity to changes in yield, or is equally as volatile, as a zero coupon bond (ZCB) with a 2.754
year life. It will also be more volatile than a bond with a lower duration but less volatile than a bond
with a higher duration.
In summary, the longer dated the bond, the lower its coupon and the lower its GRY, the
greater its duration will be.

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Modified duration
Having calculated the bond’s Macaulay duration, the sensitivity of its price to changes in its yield can
be quantified by calculating its modified duration (MD), by applying the following formula:
MD = Macaulay duration/(1 + GRY) for a bond that pays annual coupons, and
MD = Macaulay duration/[1 + (GRY/2)] for a bond with semi-annual coupons
Applying this second formula to the above example:
MD = Macaulay duration/[1 + (GRY/2)] = 2.754/[1 + (0.08/2)] = 2.648
As with Macaulay duration, the higher the modified duration, the greater the sensitivity of the bond
price to changes in its yield. The 2.648 derived means that for a 1% change in yield, given the
bond’s current price and yield, the price will change by 2.648%.
So, given a bond price of £97.38, established in the above table, if the yield rises by 1% the price
should fall to:
£97.38 – (£97.38 x 0.02648) = £94.80
However, this is only an approximation.
BOND PRICE
£121
CONVEXITY
EFFECTS
{
£97.38
GRY
GRY3 8% GRY2
Figure 8: Modified Duration
Whereas the relationship between price and yield is convex, that assumed by the above calculation
is linear. This means that only small changes in yield can be translated into price changes with any
reasonable degree of accuracy (in a similar way to which interpolation approximates the IRR).
Moreover, as a result of this convex relationship, a 1% rise in yield will have a smaller impact on
price than a 1% fall. That is, bond price effects are not symmetrical.

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The impact of assuming a linear relationship between changes in price and yield where a convex
relationship exists is to understate the price rise resulting from falling yields and to overstate the
price fall as a consequence of rising yields. These are termed convexity effects.
Once again, the longer the term, the lower the coupon and the lower the GRY of the bond, the
greater its convexity. The greater the bond’s convexity, the greater the price rise from a
given fall in yield and the smaller the price fall from a given rise in yield. A high degree of
convexity, ie, the more convex the curve, is a desirable feature for a bond to possess.
2.6 Repos
LEARNING OBJECTIVES
4.2.9 Know the characteristics and uses of strips and repos
Repos are the sale and repurchase of bonds between two parties. Repos are categorised into
general repos and specific repos:
1. General repos. An example of a general repo would be when party A sells bonds to party B and
undertakes to repurchase these or equivalent securities at a predetermined price on a pre-
specified future date. Essentially party A uses these bonds as collateral for raising finance. The
cost of this secured finance, the repo rate, is given by the difference between the sale and
repurchase price of these bonds.
2. Specific repos. A specific repo would be used if party B has sold a particular bond they did not
own in belief that its price would fall and need to acquire temporary title to an identical security
in order to settle this short sale. This they would do by buying this particular bond from party A,
party A agreeing to repurchase the bond at a predetermined price on a
pre-specified future date. Again, the repo rate is given by the difference in the sale and
repurchase price but in this example party A can also obtain a return from investing the proceeds
from party B until the bond is repurchased.
A formal gilt repo market has existed in the UK since 1996 and, like the gilt STRIPS market, has
served to increase the liquidity of the gilt market through increased turnover.

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2.7 Securitisation
LEARNING OBJECTIVES
4.2.10 Know the concept of securitisation
Securitisation is packaging the rights to the future revenue stream from a collection of assets into a
bond issue. It was originally used in the US in the early 1970s to package future interest payments
from a pool of mortgages, known as Collateralised Mortgage Obligations (CMOs) or mortgage-
backed securities. Securitisation has since been extended to credit card debts and even to the
future revenues to be derived from prominent rock musicians’ back catalogue sales. These are
termed Asset Backed Securities (ABSs).
2.8 Bond Strategies

LEARNING OBJECTIVES
4.2.11 Know the main bond strategies:
bond switching; riding the yield curve; immunisation;
Barbell/Bullett/Ladder portfolios
Bonds can be managed along active or passive lines. Generally speaking, active based strategies are
used by those portfolio managers who believe the bond market is not perfectly efficient and,
therefore, subject to mispricing. An efficient market is one in which everything known or knowable
about the asset or the market in which the asset trades is factored into the asset’s price. This is
covered in more detail in Chapter 9. If a bond is considered mispriced, then active management
strategies can be employed to capitalise upon this perceived pricing anomaly. Active management
policies are also employed where 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.
Passive bond strategies, however, 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.

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Active Bond Strategies
1. BOND SWITCHING
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.
Bond switching takes three forms:

a. 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.
b. Policy switching. When an interest rate cut is expected but not implied by the yield curve, low
duration bonds are sold in favour of those with high durations. By pre-empting the rate cut,
the holder can subsequently benefit from the greater price volatility of the latter bonds.
c. Intermarket spread switch. When it is believed that the difference in the yield being offered
between corporate bonds and comparable gilts, for example, is excessive given the perceived
risk differential between these two markets, an intermarket spread switch will be undertaken
from the gilt to the corporate bond market. Conversely, if an event that lowers the risk
appetite of bond investors is expected to result in a flight to quality, gilts would be purchased in
favour of corporate bonds.
2. RIDING THE YIELD CURVE

GRY
0 3 5 TERM TO MATURITY (YEARS)
Figure 9: Riding the Yield Curve
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. If, for example, a portfolio manager
has a two year investment horizon, 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, for example, could be purchased and sold two years later when the
bond has a remaining life of three years. Assuming that the yield curve remains static over this
period, the manager would move from point A to point B on the yield curve, benefiting from
selling the bond at a higher price than that at which it was purchased as its GRY falls. However,
this strategy is totally at odds with what the yield curve is implying about the future course of
interest rates.

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Example
If a six month zero coupon bond (ZCB) is priced at £97.40 per £100 nominal and a 12 month ZCB
at £94.20 per £100 nominal, what annualised percentage return could be obtained from purchasing
a 12 month ZCB and selling it in six months time assuming the yield curve remains unchanged?
Would such an active policy outperform a passive buy-and-hold policy?
Solution
By adopting this strategy of riding an upward sloping yield curve, the return
= {1- [1 + ((97.4 – 94.2)/94.2)]2} x 100 = (1 - 1.0342) x 100= 6.9%
The buy-and-hold policy would have produced a return =

((100 – 94.2)/94.2) x 100 = 6.16%
Therefore, the active strategy would have outperformed the passive strategy.
Note: You will not be required to calculate the result of basic riding the yield curve strategies in the
examination.
Passive Bond Strategies
IMMUNISATION
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:
a. Cash matching. As its name suggests, 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. For instance, the Boots plc pension scheme in 2000 moved all of its assets
into mainly long dated fixed interest securities so as to more accurately match the profile of its
scheme members pension rights. Other large pension schemes have begun considering the
wisdom of Boots’ strategy but are loathe to realise equity losses. This is covered in more detail in
Chapter 9. Each bond within the portfolio is held until redemption. As intimated earlier, the
availability of gilt STRIPS has facilitated cash matching.
b. Duration based immunisation. This involves constructing a bond portfolio with:
i. The same initial value as the present value of the liability it is designed to meet, and
ii. The same duration as this liability. The duration of a bond portfolio is simply the value
weighted average duration of each bond in the portfolio.
Although described as a passive approach, duration based immunisation requires the portfolio to be
rebalanced in response to the changing durations of the underlying bonds over the holding period.
To reduce the frequency of this rebalancing, however, the portfolio should contain bonds whose
individual durations are as closely aligned to the duration of the liability as possible. This is known as
a bullet portfolio. For instance, if a bullet portfolio holds bonds with durations as close as possible to
10 years to match a liability with a 10 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 10 year duration, an appropriate ladder
strategy may be to hold equal amounts in bonds with a one year duration, two year duration right
through to 20 years.

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Although, historically, bonds have underperformed equities by a significant margin over the longer
term, in recent years this underperformance has been reversed, whilst the relative volatility of these
returns has narrowed. This has mainly been as a result of the more stable economic environment
and the pursuit of sensible macroeconomic policies as well as those other factors that conspired to
invert the yield curve.
2.9 The Credit Rating Agencies
LEARNING OBJECTIVES
4.2.12 Know the role of ratings agencies: Fitch, Moody’s,
Standard and Poor’s and the structure of their credit
ratings
In addition to rating individual issues, the credit rating agencies also rate the creditworthiness of
companies, institutions, international agencies and nations separately from the ratings applied to any
debt they have issued and have also recently begun rating the ability of occupational pension funds
to meet their obligations as they fall due.
Credit rating agencies should be differentiated from their fund rating agencies as the latter rate the
past and future potential performance of investment funds rather than bond issues, organisations
and nation states.
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. The
table on page 4-40 provides an abridged version of the credit ratings available from the three
companies. These are very important as the higher the rating, the more cheaply an institution can
raise funds.
Although the three main rating agencies use similar methods to rate issuers and individual issues,
essentially by assessing whether the cash flow likely to be generated by the borrower will
comfortably service and ultimately repay its debts, the ratings often differs though not usually
significantly. The scope of this analysis has recently been widened to take account of the size of the
issuer’s pension scheme deficit and, following the collapse of Enron, the nature and extent of its off-
balance sheet liabilities, as appropriate.
Very few organisations, with the exception of supranational agencies, such as the World Bank, and
most Western governments, are awarded a triple-A rating, though the bond issues of most large
organisations boast an investment grade credit rating. However, ratings are regularly reviewed and
are often revised in the light of changed economic conditions and/or changes in the outlook for an
industry or the issuer’s specific circumstances. Most revisions result in credit downgrades rather
than upgrades. The price change resulting from a credit downgrade is usually much greater than for
an upgrade given that the price of a bond can fall all the way to zero, whereas there is a limit to how
high a bond’s price can rise. S&P and Fitch have recently started assigning recovery ratings to
bankrupt or insolvent borrowers that indicate likely recovery prospects.

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Nationally Recognised Statistical Rating Organisation (NRSRO)

The three main credit rating agencies are known as nationally recognised statistical rating
organisations (NRSRO) and are granted this quasi-official status by the Securities and Exchange
Commission (SEC) in the US. Since NRSRO status was introduced in 1975, this has effectively
restricted entry to the industry and, as a consequence, created a cartel for the big three agencies,
though a fourth, Dominion Bond Ratings, was granted NRSRO status in February 2003.
The credit agencies are also subject to the recently launched International Organisation of Securities
Commissions (IOSCO) code of conduct, which requires the agencies to publish their own code of
conduct and explain any areas in which they do not fulfill the requirements of the IOSCO code.
Concluding Comments
Generally speaking, against the backdrop of a supportive economic environment, gilts and highly
rated corporate bonds provide a high level of security, a reliable and relatively attractive flow of
income allied to the prospect of capital gain if inflation and interest rates are low and falling. Most
are readily marketable and shorter dated issues are subject to little interest rate risk. However, no
protection is afforded to the investor in an economic environment characterised by high and rising
inflation and interest rates, unless the bond is index linked or has a floating rate coupon, or against
the increased risk of default on corporate debt if the economy moves into recession.
3. CASH AND MONEY MARKET INSTRUMENTS
3.1 Introduction
Whereas bond markets are populated by issuers and investors seeking to raise and invest capital
over the medium to long term, cash investments are geared to short term liquidity management
and providing a temporary safe haven for investment funds. Cash investments take two main forms:
cash deposits and money market instruments.
3.2 Cash Deposits

LEARNING OBJECTIVES
4.3.1 Know the main characteristics and risks of cash deposits
and money market instruments: Money Market
Deposits; Certificates of deposit (CDs); Commercial
Paper (CP); Treasury Bills
Cash deposits generally comprise bank, building society and National Savings products, all of which
are targeted at retail investors, though companies and financial institutions make short term cash
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The main characteristics of cash deposits are:
1. The return simply comprises interest income with no potential for capital growth.
2. The amount invested is repaid in full at the end of the investment term.
The interest rate applied to the deposit is usually:

1. A flat rate or an effective rate. An effective rate, also known as an annual equivalent rate (AER), is
where interest is compounded more frequently than once a year. This was covered in Chapter 2.
2. Fixed or variable.
3. Paid net or gross of tax.
4. Dependent upon its term and/or notice required by the depositor. Fixed term deposits are
usually subject to penalties if an early withdrawal is made.
All retail cash deposits placed with licensed deposit taking institutions in the UK are covered by the
FSA’s Financial Services Compensation Scheme (FSCS) up to a maximum of £35,000. The maximum
payment from the scheme is £31,700, being 100% of the first £2,000 plus 90% of the next £33,000
deposited with any one licensed deposit taking institution.
Where cash is deposited overseas either onshore or offshore, depositors should also consider the
following:
1. The costs of currency conversion and the potential exchange rate risks if sterling deposits cannot
be accepted.
2. The creditworthiness of the banking system and the chosen deposit taking institution and
whether a depositors’ protection scheme exists.
3. The tax treatment of interest applied to the deposit.
4. Whether the deposit will be subject to any exchange controls that may restrict access to the
money and its ultimate repatriation.
3.3 Money Market Instruments

LEARNING OBJECTIVES
4.3.1 Know the main characteristics and risks of cash deposits
and money market instruments: Money Market
Deposits; Certificates of deposit (CDs); Commercial
Paper (CP); Treasury Bills
The money markets are the wholesale or institutional markets for cash and are characterised by the
issue, trading and redemption of short dated negotiable securities usually with a maturity of up to
one year, though typically three months. Due to the short term nature of the market most
instruments are issued in bearer form and at a discount to par, to save on the administration
associated with registration and the payment of interest. Although accessible to retail investors
indirectly through collective investment funds, direct investment in money market instruments is
often subject to a relatively high minimum subscription and, therefore, tends to be more suitable for
institutional investors.

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The main securities comprise:

1. Certificates of Deposit (CDs). CDs are negotiable bearer securities issued by commercial banks
in exchange for fixed term deposits. With a fixed term and a fixed rate of interest, set marginally
below that for an equivalent bank time deposit, the holder can either retain the CD until maturity
or realise the security in the money market whenever access to the money is required. However,
being a fixed interest security the price will fluctuate with the competitiveness of the yield. By
issuing a CD, the bank is able to keep the deposit on its books until the CD matures. CDs can be
issued with terms of up to five years.
2. Commercial Paper (CP). Commercial Paper is the term used to describe the unsecured
negotiable bearer securities, or short term promissory notes, that are issued by plcs with a full
LSE listing. These securities are issued at a discount to par with a maturity of between eight and
365 days. Being redeemed at par, the return on Commercial Paper entirely comprises capital
gain.
Another short term financing instrument that can be issued by companies is a bill of exchange. A
bill of exchange is essentially an invoice, for goods or services supplied, which states the amount
and date by which this amount is due to be paid by the recipient of the transaction. Once the
obligation to pay this amount by the due date is formally accepted by the party in receipt of these
goods and services, the instrument becomes a negotiable bearer bill and can be traded at a
discount to its face value until maturity. To minimise the credit risk associated with holding such a
bill and to narrow the discount at which it can be sold, the issuer may obtain the formal
acceptance of an eligible bank to guarantee the face value of the bill at maturity.
3. Treasury Bills (TBs). Treasury Bills are similar to Commercial Bills in that they are issued at a
discount to par whilst being redeemed at their nominal value. However, they are issued weekly
via a Bank of England auction, usually with a term of 91 days and a £100 redemption value, and
are backed by the UK government. Treasury Bills are highly liquid and act as the benchmark risk
free interest rate when assessing the returns potentially available on other asset types. This we
come back to in Chapter 9.
Rather than being issued to satisfy the government’s short term financing needs, however,
Treasury Bills are used as a monetary policy instrument to absorb excess liquidity in the money
markets so as to maintain short term money market rates, or the price of money, as close as
possible to base rate.
The annual yield on a 91 day Treasury Bill is calculated by the following formula:
[(par value - issue price)/issue price] x 365/91 x 100
So, a 91 day Treasury Bill issued at £98.50 will have an annual yield of:
1 + [[(100 - 98.5)/98.5]4 - 1] x 100 = 6.2%
In addition to holding these instruments, fixed term deposits can also be made in the Interbank
market. The Interbank market originally served the short term deposit and borrowing needs of the
commercial banks but has since been tapped by institutional investors and large corporates with
short term cash surpluses or borrowing needs in excess of £0.5m. The term of deposits made on
the Interbank market can range from overnight to one year with deposit rates being paid on a
simple basis at LIBID - the London Interbank Bid Rate - and short term borrowing being charged at
LIBOR - the London Interbank Offered Rate. The mean of these rates is LIMEAN, the London
Interbank Mean Rate.

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Concluding Comments
Cash deposits and money market instruments provide a low risk way to generate an income or
capital return, as appropriate, whilst preserving the nominal value of the amount invested. They also
provide a valuable role in times of market uncertainty. However, they are unsuitable for anything
other than the short term as, historically, they have underperformed most other asset types over
the medium to long term. Moreover, in the long term, the post-tax real return from cash has barely
been positive.
4. DERIVATIVES
4.1 Introduction
A derivative instrument is one whose value is based on the price of an underlying asset. This asset
could be a financial asset such as individual company shares, equity and bond indices, interest rates
or currencies or a hard or soft commodity asset, such as silver or wheat. The underlying asset is
often referred to as the cash market. Most derivatives take the form of either forwards, futures or
options contracts, though others include warrants and swaps.
4.2 Forward and Futures Contracts

LEARNING OBJECTIVES
4.4.1 Know the characteristics of futures
4.4.2 Understand the risk reward profile of buying and
selling futures
4.4.6 Understand the geared nature of futures and options
4.4.8 Know the differences between forwards, futures and options
4.4.9 Know the differences between physically settled and cash settled
derivatives and the role of the clearing houses
4.4.11 Know the characteristics of a contract for difference
Derivatives can be traced back to the Middle Ages. Drawing on the microeconomic principles
covered in Chapter 1, farmers and merchants operating in near perfectly competitive agricultural
markets, being price takers unable to influence the market price of produce come harvest time,
needed a mechanism by which to guard, or hedge, against price fluctuations caused by glut and
drought. So as to fix the price of agricultural produce in advance of harvest time, farmers and
merchants entered into forward contracts. These set the price at which a stated amount of the
commodity would be delivered between the farmer and merchant (the counterparties) at a pre-
specified future time. These early derivative contracts introduced an element of certainty into
commerce.

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In the US mid-West grain markets of 19th century, these contracts gained immense popularity and
led to the opening of the world’s first, and until very recently, largest, derivatives exchange - the
Chicago Board of Trade (CBOT) - in 1848. The exchange soon developed a futures contract that
enabled standardised qualities and quantities of grain to be traded for a fixed future price on a
stated delivery date. Unlike the forward contracts that preceded it, the futures contract could itself
be traded. That is, the obligation written into the contract, to deliver or take delivery of a
predetermined quantity and quality of grain at a pre-specified price, could be transferred to other
parties before the stated delivery date. However, although these futures contracts were
subsequently extended to a wide variety of commodity markets, and offered by an ever increasing
number of derivative exchanges, it wasn’t until 1975 that CBOT introduced the world’s first
financial futures contract. This set the scene for the exponential growth in product innovation and
the volume of futures trading that soon followed amongst an increasing number of derivatives
exchanges, including the London International Financial Futures and Options Exchange (LIFFE).
Subsequently LIFFE was acquired by a consortium of European exchanges called Euronext and is
now referred to as Euronext.liffe. Derivatives then primarily provide a mechanism by which the
price of assets or commodities can be traded in the future at a price fixed today without the full
value of this transaction being exchanged or settled at the outset.
Each of the contracts considered so far can be defined as follows:

1. Forward contracts. A forward contract is a legally binding obligation between two parties for one
to buy and the other to sell a pre-specified amount of an asset at a pre-specified price on a
pre-specified future date.
In executing, or opening a position in, a forward contract, the buyer is said to go long of the
contract whereas a seller is described as going short. Forward contracts are usually individually
negotiated deals tailored to meet the exact needs of the counterparties. As such, they are rarely
traded on a derivatives exchange, as to be tradable, assets require some sort of standardisation.
Therefore, they are traded off exchange directly between the counterparties and are known as
over-the-counter (OTC) derivatives.
2. Futures contracts. The definition of a futures contract is identical to that of a forward contract.
However, there are two main differences between the two derivatives:
a. Futures are traded on regulated derivatives exchanges with a central counterparty
guaranteeing each trade registered on the exchange.
As futures are traded on regulated derivatives exchanges they are known as
exchange-traded derivatives. Increasingly, derivatives exchanges are moving away from
being centralised market places, where trading is conducted on an exchange floor, to being
decentralised, where trading is conducted remotely via electronic trading systems. Each
derivatives exchange has a clearing house, which, amongst its other functions, acts as a
central counterparty to each trade registered on the exchange. Trades are registered on the
same day as they are executed. This ensures that in the event of a counterparty defaulting
upon its obligations, the clearing house will honour the futures contract to which it is a
party.
The role of the London Clearing House (LCH), which acts on behalf of Euronext.liffe, is
discussed below.
b. Futures contracts are subject to detailed contract specifications determined by the
exchange on which the future is traded so as to standardise the following:
i. The quality of the asset to be delivered.
ii. The notional value, or quantity, of the asset upon which the contract is based, and
ultimately to be delivered if the contract is physically settled.

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iii. The tick size and tick value of the contract. The tick size is the minimum possible price
movement of the contract. For instance, the Euronext.liffe FTSE 100 index future has a
tick size of 0.5 index points. The tick value is the monetary value of one tick. For this
contract it is £5.
iv. The predetermined date(s) on which the underlying asset is to be delivered by the seller
of the contract to the buyer in exchange for cash if physically settled, or the cash to be
exchanged between the parties if cash settled.
There are four things to mention about delivery:

i. As intimated above, not all futures contracts require physical delivery of the underlying
asset: some are settled between the counterparties by cash on the monetary gain or loss
to date. These are known as contracts for differences (CFD). At no stage do the
counterparties to a CFD exchange the notional value of the contract. Most Euronext.liffe
financial futures contracts, with the main exception of Euronext.liffe Long Gilt Futures,
are cash settled CFDs whereas most commodity based contracts are physically settled.
ii. At any one point in time all Euronext.liffe financial futures contracts have three delivery
dates from which to choose. At November 2001 these comprised delivery dates in
December, March and June. Once the December 2001 contracts expired, contracts with
September 2002 delivery dates became available.
iii. Some physically settled futures contracts do not simply have a single delivery date but a
delivery period during which the seller can make delivery to the buyer. Euronext.liffe
Long Gilt Futures contracts, for instance, each have a delivery month at any point during
which the seller can give notice to Euronext.liffe of an intention to deliver gilts to the
buyer.
iv. Very few futures contracts run to the delivery date as most are closed out prior to this
point by entering into an equal and opposite transaction in a contract with the same
specification and expiry date so as to offset the original open position. The process of
closing out is considered later in this section.
4.3 The Clearing House
LEARNING OBJECTIVES
4.4.7 Understand the principles of margin
4.4.9 Know the differences between physically settled and
cash settled derivatives and the role of the
clearing houses
Clearing and settlement services are provided by a clearing house. Most clearing houses operate
exclusively for a single exchange though several, such as the London Clearing House (LCH), act on
behalf of a number of exchanges, ie, International Petroleum Exchange, London Metal Exchange and
Euronext.liffe.
The principal aims of a clearing house are to:

1. Provide an efficient and cost-effective clearing service to the clearing members of its member
exchanges.
An exchange clearing member is one who has authority to process, or clear, a derivatives trade
once executed. Most clearing members also have the authority to execute derivatives trades but
must hold an exchange-trading permit to do so.

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2. Some clearing houses also offer novation where they act as the central counterparty to all trades
registered on a member exchange. For example, the LCH becomes the counterparty to each and
every trade registered on a member exchange. Novation is the cancelling of the original
contractual relationship between the counterparties to the trade at the point at which the trade
is registered on the exchange and replacing this with a new contractual relationship between
each counterparty and the LCH. By the LCH being the counterparty to each registered trade,
anonymity is preserved between the original counterparties.
Client A (seller) Client B (buyer)
Contractual relationship
Clearing member A Clearing member B
formed
Trade novates to LCH
LCH
Figure 10: LCH as Central Counterparty
As a central counterparty, the LCH ultimately acts as the guarantor to each registered trade
executed on the exchange in the event of a counterparty defaulting. To minimise the risk of default,
the LCH:
a. Sets stringent clearing member admission and continuing obligation requirements.
b. Requires collateral, or margin, to be deposited by exchange clearing members when futures
positions are initially registered and then throughout the term of the contract on any losses
accumulated whilst this position remains open. This margin takes two forms:
i. Initial margin. This is payable by both exchange clearing members to the LCH, upon a futures
contract being registered and usually represents between 2% and 5% of the transaction’s
notional value, depending on prevailing market conditions. This sum covers the LCH against
the most probable adverse one day price movement in the contract. Initial margin can be paid
either in cash or in securities that are acceptable to the LCH and is returned once the contract
has been settled between the parties or upon the contract being closing out. Cash deposited
with the LCH earns interest daily at the London deposit rate.
ii. Variation margin. As initial margin only potentially covers the LCH for a one day price
movement in the contract, the profit and loss position of each party is calculated on a daily
basis for the previous trading day and settled between the exchange clearing members in cash
via the LCH each morning. This process of revaluing futures positions daily is known as
marking to market.
In addition, the existence of a central counterparty enables margin payments and receipts from
multiple trades to be netted out.

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4.4 The Main Uses of Futures Contracts
“There are two times in a man’s life when he should not speculate: when he can’t afford it and when he
can”
Mark Twain, Following the Equator
It has become evident in what was originally discussed that derivatives have principally been used to
oil the wheels of commerce by introducing an element of certainty into the price at which future
transactions take place. Indeed, in the US there has been a requirement since 1974 that before any
derivative can be traded on an exchange it must have an underlying economic purpose. Moreover,
in a world characterised by rising volatility and increased uncertainty, stemming partly from the
globalisation, or continued integration, of the world economy and financial markets, derivatives
have become increasingly important as a means to hedge, or transfer, risk to those who wish to
assume it.
However, since only initial margin, and not the full notional value of the contract, is payable by the
counterparties at the point of opening their respective positions, futures provide an ideal means by
which to speculate on both rising and falling asset prices in a range of markets. Given that futures
are highly geared instruments, if the market moves against the speculator though, losses can mount
up very quickly. Indeed, following several high profile disasters involving derivatives, most non-
practitioners tend to think of futures solely as speculative instruments, used in the pursuit of making
quick profits, despite evidence to the contrary.
Whatever the perception, speculation per se should not be discouraged as, apart from adding to
market liquidity, or brisk two-way trade, in futures contracts, without speculators those wishing to
use futures to hedge risk would be unable to do so. Within portfolio management, futures can be
used for the following purposes:
1. Hedging. Hedging is a technique employed by portfolio managers to reduce the impact of
adverse price movements in financial assets held within a portfolio by selling sufficient futures
contracts. You may recall from Chapter 2, that another means of reducing risk is by diversifying
the range of assets held within a portfolio. However, whether risk is reduced through hedging or
diversification it can never be completely eliminated, unless, of course, in the case of
diversification the asset returns within the portfolio are perfectly negatively correlated.
2. Anticipating future cash flows. Closely linked to this idea of hedging adverse price movements in
assets already held is hedging a potential rise in the price of assets soon to be purchased. If a
portfolio manager expects to receive a large inflow of cash to be invested in a particular asset,
then futures can be used to offset the potentially increased cost of the asset when the cash flow
is received.
3. Asset allocation. Asset allocation describes the way in which a portfolio’s assets have been
invested both geographically and between the various asset classes. Changes to this asset mix,
whether to take advantage of anticipated short term directional market movements or to
implement a change in strategy, can be made more swiftly and less expensively using futures than
by adjusting the underlying portfolio. Futures transactions can also easily be reversed.
4. Arbitrage. Arbitrage is the process of deriving a risk-free profit from simultaneously buying and
selling the same asset in two different markets where an unexplained price difference, or pricing
anomaly, exists. If the price of the derivative and underlying asset are out of line, then the
portfolio manager may be able to profit from this pricing anomaly.

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4.5 Euronext.liffe Financial Futures Contracts

LEARNING OBJECTIVES
4.4.7 Understand the principles of margin
4.4.10 Know the main characteristics, contract specifications and
uses within investment management of Euronext.liffe
(formerly LIFFE)
4.4.11 Know the characteristics of a contract for difference
4.4.12 Know the meaning of contango and backwardation
The main financial futures contracts traded on Euronext.liffe include:

1. FTSE 100 index future;
2. Long Gilt Futures
3. Short term interest rate (STIR) futures;
4. Universal stock futures.
The underlying contract specifications of each will now be considered in turn though the FTSE 100
index future will also be used to further explain the mechanics of futures contracts in general and
illustrate how each of the above uses for futures within portfolio management can be employed in
practice.
Euronext.liffe FTSE 100 Index Future

The FTSE 100 index future is based upon the FTSE 100 index, which derives its value from the
share price performance of the UK’s top 100 companies. The future is priced in index points with a
tick value of £5 per 0.5 of an index point for the purpose of calculating variation margin and at £10
per index point when establishing the contract’s notional value.
So a contract priced at 5,000 index points would have a notional value of:
Number of index points x value per index point
5,000 x £10 = £50,000
This is the maximum amount the buyer of the contract would lose if the FTSE 100 index fell to
zero. Being a contract for differences (CFD) settled in cash, at no stage of the transaction from
opening a position in the contract to the expiry date, or its prior closing out, would this notional
value be exchanged between the counterparties. Instead, initial margin is payable by both parties to
the LCH and daily profits and losses are settled in cash each morning via the LCH based on the
price movement in the contract on the previous trading day. Hence the term, contract for
differences.

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As to its mechanics, if you believe the FTSE 100 index will rise over the term of the contract, you
buy, or go long of, the contract but go short if you believe the FTSE 100 will fall. This is illustrated in
the diagram below.
£ Short Long
Profit
45° 45°
0
Loss
5,000 FTSE 100
Figure 11: FTSE 100 Index Futures Contracts
So, if a contract is executed when the contract price is 5,000 index points and the FTSE 100
subsequently rises in value, the buyer will gain at the expense of the seller and visa versa if the FTSE
100 subsequently falls. You also will also notice that the gains are exactly mirrored by the losses in
both cases. This is true of all futures transactions. Futures contracts, therefore, represent a zero
sum game: for every winner there will be an equal and opposite loser. So if on the first trading day
after executing the contract, the price rises to 5,050, the long position would have made 50 index
points, or 100 ticks, of profit and the seller an equivalent loss.
Therefore, 100 ticks at £5 per tick = £500 will pass as variation margin between the short position
to the long position the following morning via the LCH. To simplify matters from hereon we will
treat each index point as being worth £10, rather than two ticks each worth £5.
PRICING
So how exactly is the contract priced? Well, the price of any futures contract will be determined by
the number of orders placed to buy the contract and the number placed to sell at any point in time.
As in any free market, price acts as the mechanism to bring demand and supply into equilibrium.
Where there are more buyers than sellers of FTSE 100 index futures, this will have the effect of
driving the contract price higher until sellers are attracted back into the market. Where there is an
excess of sellers, the price will fall until a sufficient number of buyers come back into the market.
Futures prices then can vary independently of the underlying asset, the FTSE 100 index in this
particular case. However, the FTSE 100 index future contract price cannot deviate too far from the
underlying FTSE 100 index as upon the delivery, or expiry, the price of the futures contract
converges to that of the underlying FTSE 100. Therefore, any significant divergence between the
two prices will present an arbitrage opportunity.

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To obtain the price, or fair value, of the FTSE 100 index futures contract, the following equation
should be applied:
FTSE 100 index future fair value =

FTSE 100 index + {FTSE 100 index x [(short term interest rate - FTSE 100 dividend yield) x
remaining term of contract]}
Example
The FTSE 100 index currently stands at 4,000 and has a dividend yield of 2%. The three month
money market interest rate is 5%. Calculate the fair value of a FTSE 100 index future that has 90
days remaining before expiry.
FTSE 100
FTSE 100 Index Future
4,030
BASIS
4,000
FTSE 100 Index
Expiry date
Term of FTSE 100 Index Futures Contract
Figure 12: Pricing a FTSE 100 Index Future
Solution
FTSE 100 index future fair value =
4,000 + {4,000 x [(0.05 - 0.02) x 90/365]} = 4,030

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There are three points to note about the price that has been derived:
1. The FTSE 100 index future is simply another way of gaining exposure to the FTSE 100 index.
However, whereas buying the underlying stocks in the FTSE 100 index entails making a capital
outlay equal to the value of these underlying stocks, the FTSE 100 index future only requires the
payment of initial margin upon opening a position in the contract. The cash that would otherwise
have been used to purchase these stocks can, therefore, be invested in an interest bearing cash
deposit over the term of the contract. The margin deposited similarly earns interest over this
same term. The income return from purchasing the FTSE 100 index, however, is given by the
dividend yield: the value of dividends from the index expressed as a percentage of the index
value. Since the yield from investing in a cash deposit is usually higher than the dividend yield on
the FTSE 100 index, the future usually has a higher price than the underlying index.
2. When the futures price is higher than that of the underlying asset, the market is said to be in
contango. This is usual for a financial future. However, when the futures price is lower than that
of the underlying asset, the market is in backwardation.
3. The difference between the futures price and that of the underlying cash market gives rise to the
basis. In this example the basis is 37 index points. This is also known as the fair value premium
when the market is in contango and a fair value discount when in backwardation. As the futures
contract approaches expiry so this basis will narrow until the futures price converges with the
FTSE 100 index on the delivery date. The basis can, of course, either widen or narrow in
response to a change in interest rates and/or the dividend yield and market sentiment. However,
if the basis moves for an unexplained reason, then arbitrage activity will bring it back into line.
Any potential movement in the basis is known as basis risk.
A futures contract can be closed out at any time by either party to crystallise a gain or limit a loss by
entering into an equal and opposite transaction in a contract with the same specification and expiry
date as that originally bought or sold, albeit at a different price. So, if a FTSE 100 index future had
been bought at 4,030 and the contract price rose to 4,070, then the contract can be closed out
before the delivery date by selling a FTSE 100 contract with the same delivery date at 4,070 to lock
in this gain. Variation margin of 40 index points x £10 per point = £400 would have been paid by
the original seller to the original buyer and the initial margin deposited with the LCH would be
repaid as the original buyer now has a flat position in the contract. The original seller faced with the
prospect of mounting losses could crystallise their position by buying a FTSE 100 index future at
4,070. In both cases, when one party closes out their position, the other party’s position remains
open as the counterparty to each open position is the LCH.

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CLOSING OUT
New Short
Short Long
PROFIT
LOSS
4,030 4,070 FTSE 100
Figure 13: Closing Out a FTSE 100 Index Future
Using the FTSE 100 index future within portfolio management
The FTSE 100 index future can be used within portfolio management for:
1. Hedging;
2. Anticipating future cash flows;
3. Asset allocation;
4. Arbitrage.
1. Hedging
Before looking at a hedging example, it is useful to consider why FTSE 100 futures would be used in
preference to selling the underlying portfolio if the expectation is for the FTSE 100 to fall. There are
three reasons for this:
a. The portfolio manager’s mandate may require equities to be held within the portfolio regardless
of market conditions.
b. Selling a large portfolio would:
i. Move the price of the shares against the portfolio manager;
ii. Take time;
iii. Result in significant dealing costs.
c. Futures markets:
i. Being more liquid than securities markets, would not move the price of the transaction against
the fund manager and would be completed more swiftly;
ii. Incur lower dealing costs.

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Hedging Example
If a portfolio manager wants to hedge a £1m FTSE 100 portfolio over the next three months against
a market fall with the FTSE 100 at 4,000 and the future priced at 4,042, how many futures
contracts would they need to buy or sell, assuming that the value of the portfolio moves in line with
that of the FTSE 100 index?
Solution
The portfolio manager would need to sell:
Portfolio value/ £1m/

FTSE 100 futures contract value = 4,042 x £10
= 24.74 contracts
However, since futures can only be dealt in whole contracts, 24.74 is rounded up to 25 contracts.
Example 1
Given the above, what would be the net profit or loss if the FTSE 100 index fell to 3,900 taking the
futures price to, say, 3,940?
Solution
The value of the portfolio would fall to:
£1m x 3,900/4,000 = £975,000
This loss of £25,000 would be more than offset by the profit on the futures:
= {[(4,042 - 3,940)] x £10 x 25} = £25,500
Therefore, the net position would be: £975,000 + £25,500 = £1,000,500 rather than the £1m the
portfolio manager started with. If only 24 contracts had been purchased, the net result would have
been £999,480.
There are four reasons why hedging using futures is imperfect:

1. The calculation for determining the number of contracts to hedge an underlying asset is based on
the futures price rather than on the price of the asset, or cash market.
2. The number of contracts sold is usually either rounded up or rounded down.
3. The basis is not constant and can temporarily move out of line.
4. The portfolio may not move in line with the market. This we consider in Chapter 9.
Example 2
What if the FTSE 100 index didn’t fall but rose to 4,055 taking the futures price to, say, 4,100?
Solution
Although the value of the portfolio would have risen to £1m x 4,055/4,000 = £1,013,750, this
increase would have been more than offset by the variation margin payable to the LCH for the
[(4,100 - 4042)] = 58 index points loss = [58 x £10 x 25] = £14,500.

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Regardless of whether the FTSE 100 index rises or falls, by using FTSE 100 index futures to hedge
the portfolio, the portfolio manager has essentially locked it into a FTSE 100 index value of about
4,000. This stands in contrast to when FTSE 100 index options are used. These are considered later
in the Chapter. The futures hedge can, of course, be closed out at any time before expiry by buying
25 FTSE 100 index futures with the same delivery date to offset the original short position.
2. Anticipating Future Cash Flows

If our portfolio manager expects to receive a cash inflow of £500,000 into their £1m FTSE 100
portfolio shortly and anticipates that the market will rise between now and then, they could buy
sufficient FTSE 100 futures contracts to offset the increased cost of the FTSE 100 index shares
when the cash flow is received.
Assuming again that the FTSE 100 index is trading at 4,000 and the FTSE 100 index future at 4,042,
the portfolio manager would buy:
500,000/
4,042 x 10 = 12.37 contracts, rounded down to 12 contracts
If the contracts are held to the delivery date and at this point the FTSE 100 index had risen to 4,500
- the futures price having converged to that of the FTSE 100 index - then the variation margin
payable to the portfolio manager would be:
[12 x (4,500 - 4,042) x £10] = £54,960
However, this sum which represents a 54,960/500,000 = 11% increase in the £500,000 would not
fully offset the 12.5% rise in the FTSE 100 index, partly as a result of rounding down the number of
contracts purchased but mainly because 42 index points has been lost over the term of the
contract. This will be revisited when we consider the use of options.
3. Asset Allocation
As noted earlier, using futures contracts to make portfolio asset allocation switches, whether
geographic or between asset classes, is less expensive and more efficient than adjusting the
underlying portfolio. For example, to increase exposure to the US equity market at the expense of
UK equities, a fund manager would simply sell sufficient FTSE 100 futures to reduce the UK equity
exposure and purchase sufficient S&P 500 futures without disturbing the underlying securities in the
portfolio. The manager could then gradually close out these contracts as the UK shares in the
portfolio are sold and US stocks are purchased.
4. Arbitrage
The portfolio manager can generate additional capital profits for a portfolio by arbitraging any
unexplained differences between what the basis should be and what it currently is.
Once again, if the FTSE 100 index stands at 4,000 and the three month FTSE 100 index future at
4,050, when the fair value should be 4,042, a risk free profit can be made by borrowing funds at the
prevailing three month money market rate of interest to purchase the FTSE 100 index at 4,000
whilst simultaneously selling the three month future at 4,050. If a sufficient number of arbitrageurs
enter into this same transaction then the FTSE 100 index should be driven up and the future driven
down until the fair value premium, or basis, comes back into line.

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Euronext.liffe Long Gilt Futures
LIFFE long gilt futures contracts can be used within the portfolio management process in exactly the
same way as FTSE 100 index futures contracts. These contracts differ from the FTSE 100 index
contract, however, in that they are :
i. Based on a notional gilt with a £100,000 nominal value and a 7% coupon. Each contract has a tick
value of £10 per 0.01 movement in the contract price. 0.01 is known as 1 basis point (1bp).
ii. Physically settled, rather than cash settled, if held until the delivery month and the seller, or short
position, has given notice to LIFFE of its intention to deliver. The short position will then deliver
gilts with a nominal value of £100,000 for each contract sold from an approved list to the buyer
of the contract in exchange for a cash sum calculated by LIFFE, known as the invoicing amount.
The mostly likely gilt to be delivered by the seller to the buyer from the approved list in each case is
known as the cheapest to deliver (CTD) gilt. The price of the CTD gilt determines the price of the
gilt future and ultimately the invoicing amount. If, however, the short position does not wish to go
to delivery, they have until the last trading day in the delivery month to close out the contract.
Although the long position also has the option of closing out their position on or before the last
trading day, if they have no intention of taking delivery of the CTD gilt their position must be closed
out three business days before the start of the delivery month to eliminate any possibility of being
required to take delivery of the CTD gilt.
Euronext.liffe Short Term Interest Rate (STIR) Futures

STIR futures are based on the British Bankers Association (BBA) LIBOR for three month sterling
deposits. Each contract has a notional value of £500,000 with a tick value of £12.50 per 0.01
movement in the contract price. This tick value is derived from:
£500,000 x 0.01% x 3/12 = £12.50
The contract is priced on the basis of 100 minus the three month interest rate. So, if the three
month BBA LIBOR is 6%, the contract would be priced at 100 - 6 = 94.
The contract can be used for both speculation and hedging. If a speculator believes that short term
interest rates are heading higher then they would sell the contract as higher interest rates would
cause the price of the contract to fall, in the same way that higher bond yields result in lower bond
prices. If a hedger, however, having deposited cash at a short term money market rate fears that
interest rates may fall, then they will buy the contract to guard against receiving a lower interest
income. Once again, the activities of hedgers and speculators create a liquid two-way market in
risk: the former transferring risk to the latter.
Example 1
A portfolio manager has borrowed £1m temporarily for three months upon which interest is
payable at LIBOR + 1%. LIBOR is currently 5.5%. The manager believes that interest rates may
rise very soon and wants to guard against higher interest costs. At what price should these
contracts be trading and how many contracts should the manager buy or sell?
Solution
The contract should be priced at 100 - 5.5 = 94.5
Number of contracts to be sold = £1m/£500,000 = 2

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Example 2
If the contract is currently priced at 94.5 and at expiry LIBOR has risen to 7%, will the portfolio
manager be fully covered against rising interest costs?
Solution
3 month interest costs when LIBOR is at 5.5%:
£1m x 0.065 x 3/12 = £16,250
Three month interest costs when LIBOR is at 7%:
£1m x 0.08 x 3/12 = £20,000
Increase in interest costs = £20,000 - £16,250 = £3,750
Gain on STIR futures contracts to offset increase in interest costs
= 2 contracts x 150 ticks x £12.50 = £3,750
The portfolio manager will, therefore, be completely covered against rising interest costs.
Euronext.liffe Universal Stock Futures

LIFFE universal stock futures are a recent innovation. Rather than enable portfolio managers to
hedge the risk of an entire portfolio, they hedge the price risk associated with individual stocks held
within a portfolio. However, they are currently limited to a selection of larger multinational
companies. Each position taken in a contract is for 1,000 UK company shares or 100 US or
European company shares. Universal stock futures are cash settled.

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4.6 Options
LEARNING OBJECTIVES
4.4.3 Know the characteristics of options
4.4.4 Be able to calculate the outcome of basic option
strategies and the potential risks and rewards of: buying
calls; buying puts; selling calls; selling puts
4.4.5 Understand American and European exercise styles
4.4.6 Understand the geared nature of futures and options
4.4.8 Know the differences between forwards, futures and options
4.4.10 Know the main characteristics, contract specifications and uses
within investment management of Euronext.liffe (formerly LIFFE)
4.4.13 Know the meaning of in-the-money, at-the-money and out-of-the
money in relation to options
4.4.14 Be able to calculate the time and intrinsic value of an option
premium given the premium and the underlying price
4.4.15 Know the factors that determine an option premium
So far we have restricted our analysis to futures contracts. We now move on to consider options
contracts.
Options, although traceable back to the Japanese rice markets and the Dutch Tulipmania of 17th
century, didn’t really start to flourish until two US academics - Fischer Black and Myron Scholes -
produced the Black Scholes option pricing model in 1973. Until then, options contracts could not
easily be priced which prevented them from being traded. This model, however, paved the way for
the creation of standardised options contracts and the opening of the Chicago Board Options
Exchange (CBOE) in the same year. This in turn led to an explosion in product innovation and the
creation of other options exchanges, such as Euronext.liffe.
Options can still be traded off-exchange, or over-the-counter (OTC), however, in much the same
way as forward contracts, where the contract specification determined by the parties is bespoke.
The Underlying Mechanics

An options contract can be defined as one that confers the right from one party to another to either
buy or sell an asset at a pre-specified price on, and sometimes before, a pre-specified future date, in
exchange for the payment of a premium.
PREMIUM
WRITER HOLDER
RIGHT
Figure 14

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The two parties to an options contract are the holder and the writer. The writer, or seller, confers
the right, rather than the obligation, to the holder to either buy or sell an asset at a pre-specified
price in exchange for the holder paying a premium for this right. This premium represents a fraction
of the cost of the asset or the notional value of the contract. Options, therefore, differ from futures
in the following respect: a right is conferred in exchange for the payment of a premium.
An option that confers the right to buy is a call option whereas one that confers the right to sell is a
put option. As the holder is in possession of a right, rather than an obligation, the holder does not
have to exercise this right if the transaction ultimately proves not to work in their favour. As the
minimum value of an option is zero, the option can simply be abandoned with the loss of the
premium paid. The writer, however, is obliged to satisfy this right if taken up, or exercised, against
them by the holder. Most exchange-traded options can be exercised on or before the expiry date
and are known as American style options. Options that can only be exercised by the holder on the
expiry date are termed European style options.
The pre-specified price stated in the contract is termed the strike price or exercise price. As only
the writer has an obligation to deliver the asset to the holder of a call option at this exercise price if
the option is exercised against them or take delivery from the holder of a put option if exercised
against them, only the writer is required to make initial and variation margin payments to the
clearing house of the member exchange upon which the option is written: the LCH for
Euronext.liffe traded options for instance.
However, as with most exchange-traded financial futures, most exchange-traded financial options
are cash settled rather than physically settled. Therefore, if exercised, the cash difference between
the exercise price of the option and that of the underlying asset, rather than the asset itself, passes
from the writer to the holder: the cash difference again being determined by the tick value of the
contract.
The following diagrams illustrate these points.
PROFIT
HOLDER
367.5
0
x = 4300 FTSE 100
4667.5 Index
-367.5
WRITER
LOSS
Figure 15: FTSE 100 Index Call Option

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The above diagram considers the position of a holder and a writer of a Euronext.liffe FTSE 100
index call option, given a FTSE 100 index value of 4,300. The option, like its equivalent future, is
cash settled and priced in index points at £10 per point, again with a tick value of £5 per 0.5 of an
index point. As with all Euronext.liffe traded options it also offers the choice of three expiry dates
via three separate contracts. In this example a three month call option is used. The holder of the
FTSE 100 index call option believes that the index will rise over the term of the contract whilst the
writer takes the view that the index will either remain static or will fall.
The holder in order to acquire the right to buy the underlying FTSE 100 index at 4,300, in this
example, must pay a premium of 367.5 index points to the writer. This immediately puts the holder
into a loss position. However, once the FTSE 100 index rises beyond the exercise price, the holder
starts to move towards the break even point of 4667.5. At 4,301, for instance, the holder could
exercise the option requiring the writer to pay 1 index point at £10. However, given the premium
paid of 367.5 index points, the holder’s loss would only have been reduced to 366.5 index points.
At 4,302, the loss would reduce to 365.5 index points and so on until at 4667.5 the premium is
completely covered. Beyond this point the holder moves into profit. The position of the writer
exactly mirrors that of the holder. Options, like futures, are a zero sum game. At 4,301 the writer’s
profit is reduced by 1 index point just as the holder’s loss is reduced by 1 index point. As the holder
breaks even so does the writer and as the holder moves into profit so the writer starts to accrue
losses at the same rate.
The most the holder can lose is all or part of the premium paid to the writer if the FTSE 100
doesn’t reach the breakeven point whereas the call writer’s potential losses are unlimited above the
breakeven point. Therefore, the premium received by the call writer must reflect the probable size
of potential losses. This is exactly what the Black Scholes option pricing model aims to calculate.
The writer can, however, close out their position at any time by entering into an equal and opposite
transaction to their short position; that is by purchasing an option with the same contract
specification and expiry date as that originally sold. By the writer closing out their position, the
holder’s position remains open as the counterparty to the contract is not the writer but the LCH.
PROFIT
HOLDER
295.5
0
x =4300 FTSE 100
Index
4004.5
- 295.5
WRITER
LOSS
Figure 16: FTSE 100 Index Put Option

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The FTSE 100 index put option in this example confers the right on the holder to sell the FTSE 100
index to the writer at an exercise price of 4,300. Again, the FTSE 100 index stands at 4,300. By
purchasing a three month put option, the holder takes the view that the index will fall over the
option’s life whilst the writer believes the index will either remain static or rise. Given a premium of
295.5 index points, once the index reaches 4004.5, both the holder and writer are in a breakeven
position. Beyond this point the holder begins to profit at the expense of the writer. At this point the
writer may decide to close out their position. However, although the holder’s maximum loss is,
once again, limited to the premium paid to the writer, the writer’s loss is not unlimited as the
furthest the index can fall is to zero. Added to the fact that equity markets tend to rise more often
than they fall, writing put options is generally a less risky activity than writing call options. This is
reflected in the difference between the two premiums paid by the respective holders in the above
examples.
Options on Futures
Options that confer the right to buy or sell a futures contract, with a pre-specified delivery month,
at a pre-determined strike price are called options on futures. Unlike other exchange-traded
options, these specialist options, such the Euronext.liffe Option on Long Gilt Future, are, as with
futures positions, marked to market daily between the two parties with variation margin payable via
the exchange clearing house. As such, they do not require the holder to pay the writer a premium
upon opening the position. However, if the holder exercises the option only then does the original
premium become payable though this is netted out against the variation margin balances held by the
clearing house. At this point, the holder assumes either a long or short futures position with a set
delivery month.
Categorising Options
Options are described as being either in-the-money (ITM), at-the-money (ATM) or out-of- the-
money (OTM) depending on how the option’s exercise price compares with the price of the
underlying asset, at any point in time during the option’s finite life. This is summarised in the table
below.
Call Put
In-the-money (ITM) E<A E>A
At-the-money (ATM) E=A E=A
Out-of-the-money (OTM) E>A E<A
where E = exercise price of option, and A = price of underlying asset
The options used in the above examples were both ATM as their exercise prices of 4,300 coincided
with the level of the FTSE 100 index in both instances.
These terms, when applied to option premiums, give rise to what is known as intrinsic value and
time value. Where an option is ITM, the option premium comprises intrinsic value and time value.
However, ATM and OTM option premiums only comprise time value. The premiums, and a
breakdown between intrinsic and time value, for a hypothetical Euronext.liffe February FTSE 100
index option with three exercise prices for each call and put is given below, this time based on the
FTSE 100 index standing at 4,000.

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FTSE 100 index option (Euronext.liffe) (4000) £10 per full index
point
3950 4000 4050
Call Put Call Put Call Put
Feb 168½ 121½ 141 137 111 164½
E<A E<A E=A E=A E>A E>A
Intrinsic value 50 - - - - 50
Time value 118½ 121½ 141 137 111 114½
ITM OTM ATM ATM OTM ITM
The 3,950 call is ITM as the exercise price is lower than the price of the underlying asset, the FTSE
100 index, by 50 index points. Of the 168½ index point premium, these 50 index points comprise
the option’s intrinsic value. For an ITM option, this is the difference between the exercise price and
the price of the underlying asset. If the call option is purchased and exercised today, 50 of the 168½
index point premium would be covered by virtue of the fact that the exercise price is below the
current FTSE 100 index value to the tune of 50 index points. That is, the holder would be 118½
index points from the breakeven point. Another way of looking at this is to say that unless the
premium for such an option was at least equal to 50 index points, an instant risk free profit could be
made by purchasing the option and exercising it immediately. The 118½ index points that remain
comprise the time value.
The 3,950 put option, however, is OTM as selling the FTSE 100 at 3,950 when it stands at 4,000 is
not an attractive proposition. Therefore, the option premium of 121½ index points is purely time
value. Options cannot have negative intrinsic values. This position between the put and call reverses
for the 4,050 exercise price.
The time value that characterises an element of ITM premiums but the entire premium for ATM
and OTM options represents the probability of the underlying asset price moving in the option
holder’s favour during the term of the option. The table below shows that time value is higher for
both calls and puts the longer the time the option has to expiry but rapidly diminishes as the expiry
date approaches. The 3,950 calls, for instance, all have 50 index points of intrinsic value, but have an
increasing amount of time value as the contract expiry date moves from February through to April.
FTSE 100 index option (Euronext.liffe) (4000) £10 per full index
point
3950 4000 4050
Call Put Call Put Call Put
Feb 168½ 121½ 141 137 111 164½
Mar 249 177 217 ½ 198 186 218½
Apr 307½ 311½ 280 233½ 253 256
E<A E<A E=A E=A E>A E>A
ITM OTM ATM ATM OTM ITM
Option Gearing
Much like futures, where only a fraction of the notional value of the contract is paid as margin,
options by only requiring the holder to pay a premium, also provide an ideal means to speculate on
asset price movements.

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This gearing effect, inherent in derivative products, can be illustrated by using individual
Euronext.liffe equity options. These are available on 85 individual FTSE 100 companies. Each option
contract confers a right over 1,000 company shares and is priced in pence per share. This premium,
therefore, needs to be multiplied by 1,000. The tick value is 0.5p per share or £5 per contract.
Again, three expiry dates are offered for each option. If exercised, equity options are physically
settled.
Example
Euronext.liffe EQUITY OPTIONS

Calls Puts
Apr Jul Oct Apr Jul Oct
1
ABC plc 100 6 10½ 12 /2 1 31/2 51/2
(105) 110 1 51/2 8 6 81/2 101/2
Assume it is March and ABC plc’s share price is 105p. This makes the call options in ABC with a
100p exercise price ITM and those with a 110p exercise price OTM. The ABC April 100 call option
is priced at 6p and the 110 at 1p. If you believe the share price of ABC between now and the expiry
date in April is going to rise, which of the two options should you purchase?
The former being ITM has intrinsic value. That is, 5p of the 6p premium is covered by the current
share price being 5p higher than the 100p exercise price. The share price only has to rise marginally
for the entire 6p to be covered. However, the call option with the 110p exercise price requires the
share price to rise by at least 6p to 111p for the 1p premium to be covered.
Therefore, the OTM option is the more risky of the two options. However, it also offers the
greatest potential reward being more highly geared.
To illustrate this assume that the ABC share price rises from 105p to 114p.
If the shares, rather than an option, had been purchased, then the percentage return would be:
(114 - 105)/
105 x 100 = 8.6%
However, if the April 100 call options had been purchased then the return would rise from 8.6%
to:
114 - (100 + 6) = 8p profit but as the initial outlay was only 6p, 8/6 x 100 = 133%
If the April 110 call options had been purchased though then the return would have further
increased to:
114 - (110 + 1) = 3p profit but as the initial outlay was only 1p, 3/1 x 100 = 300%

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Option Pricing
Option prices, or premiums, are determined by six factors. These are summarised for call and put
options in the table below given an isolated increase in each of the factors detailed in the first
column.
An increase in the: Call option Put option

Underlying asset price Rise Fall
Exercise price Fall Rise
Time to maturity Rise Rise
Volatility of underlying asset price Rise Rise
Income yield of underlying asset Fall Rise
Short term interest rates Rise Fall
1.
Underlying asset price. The higher the asset price the more valuable are call options and the less
valuable are put options.
2. Exercise price. The higher the exercise price the less valuable are call options and the more
valuable are put options.
3. Time to maturity. The longer the term of the option, the greater the chance of the option
expiring ITM, therefore, the higher the time value and the higher the premium.
4. Volatility of the underlying asset price. The more volatile the price of the underlying asset, the
greater the chance of the option expiring ITM, therefore, the higher the premium.
5. Income yield of the underlying asset. The greater the income yield of the underlying asset, the
greater the sacrifice being made by the call option holder by not holding this asset but the greater
the benefit to the put option holder. Therefore, the higher the income yield, the more valuable
the put option and the less valuable the call option.
6. Short term interest rates. The higher the short term rate of interest the greater the interest
income received by the call option holder on the cash not committed to buying the underlying
asset. This makes call options more valuable. However, the outlay on a put option not earning
this higher rate of interest makes put options less valuable.
It should be noted that the income and interest rate effects on option prices are fairly minor in
relation to the other factors.
Choices Available to Traded Option Holders

Holders of European style traded options have three choices open to them:
1. Exercise the option at the expiry date if the option is ITM.
2. Sell the option before the expiry date.
3. Leave the option to expire worthless, if OTM.
Holders of American style traded options can also exercise the option if ITM before the expiry date.

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Uses of Options Within Portfolio Management

The main uses of options within portfolio management comprise:
1. Hedging.
2. Anticipating future cash flows.
3. Enhancing portfolio performance.
1. Hedging
A UK equity portfolio can be hedged against adverse market movements by purchasing either
Euronext.liffe FTSE 100 index put options or, where individual holdings are to be hedged, individual
Euronext.liffe equity put options. Bond holdings within a portfolio can be hedged using
Euronext.liffe options on bond futures.
The motivation for hedging a portfolio using FTSE 100 index put options instead of realising the
underlying holdings is the same as that for using FTSE 100 index futures. However, the one major
difference to the outcome when using options rather than futures is that, by paying a premium for
the right, rather than the obligation, to sell the portfolio, the portfolio manager is not locked into
the FTSE 100 at any one level.
Example
The same portfolio manager as before has a FTSE 100 portfolio worth £1m and wishes to protect it
against a sharp fall in the market. The FTSE 100 is currently at 4,000 and the manager wishes to
provide the fund with downside protection should the market fall beyond 3950. Assume it is
January and April 3950 puts are priced at 311.5 index points. The manager, therefore, buys:
portfolio value/ £1m/

FTSE 100 index value x £10 = (4000 x £10) = 25 puts.
You will notice that the FTSE 100 index level of 4,000 and not the put exercise price of 3,950 is
used as the denominator. You may recall that with FTSE 100 index futures, the futures price rather
than the FTSE 100 index is used as the denominator.
This provides protection to the £1m portfolio below 3950 but not between 4,000 and 3950. The
cost of the protection is given by:
Premium in index points x £10 per index point x number of contracts
311.5 x £10 x 25 = £77,875
This premium is paid to the writer of the options.
If the FTSE 100 falls to, say, 3000, the portfolio manager can exercise the puts against the put writer
at 3,950. Assuming that the portfolio moves in line with the value of the FTSE 100 index the result
is as follows:

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Portfolio value £1m x 3000 /4000 £ 750,000
Hedge value (3950 – 3000) x 25 x £10 £ 237,500
Premium paid 25 x 311.5 x £10 £( 77,875)
New portfolio value £ 909,625
Difference in portfolio value £1m - £909,625 £( 90,375)
By not totally hedging the portfolio against a market fall from 4,000 and paying a premium for the
25 put options, the portfolio manager is out of pocket by £90,375.
However, if the FTSE 100 had in fact risen rather than fallen, the manager could simply have left the
option to expire worthless. In the FTSE 100 index futures example, the manager had effectively
locked the portfolio into an index level of about 4,000 but did, of course, have the option of closing
out this position if the index subsequently rose.
2. Anticipating Future Cash Flows

Much as in the futures example, if the portfolio manager is expecting a large cash inflow to the
portfolio in a rising market, call options can be purchased to offset the higher cost of the asset when
the cash flow is received. This method is preferable to using futures for the following two reasons:
i. Options, although usually purchased ATM for this purpose, more accurately reflect any rise in the
underlying asset price once ITM than futures, given that futures are subject to basis risk and
ultimately lose the basis as the futures price converges to the asset price at the delivery date.
ii. If the market falls only the premium is lost whereas a long futures position must be closed out if
losses are to be avoided.
3. Enhancing Portfolio Performance

If a portfolio manager expects asset markets to be relatively static over the short to medium term,
options can be employed to enhance the potential performance of a portfolio over this period in
several ways. Depending on whether the portfolio is a regulated fund determines how options can
be used. If a regulated fund, the manager can write covered calls. That is, write call options on
assets already held in the portfolio. These are usually written OTM often at an exercise price equal
to that at which the portfolio manager is looking to sell the asset.

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PROFIT
0
XC Price of underlying asset
LOSS
profit/loss profile of written OTM call option
profit/loss profile of underlying asset
net profit/loss profile of underlying asset combined with written call option
Figure 17: Writing Covered Calls
The net profit and loss profile of the underlying asset combined with the written call option
illustrates how performance is enhanced by the option premium until just beyond where the price
of the underlying asset equals the exercise price (XC).
If the portfolio is not a regulated fund, however, the manager can enhance portfolio performance in
a number of other ways.
Basic Option Strategies

Two of the simplest ways of using options to enhance the performance of an unregulated fund is by
speculating on price movements via purchased options and/or by writing naked options to generate
additional income for the fund. Options are written naked when the underlying asset is not held.
In addition, however, a number of strategies that require the use of two or more options can be
employed. These are categorised as either combinations or as spreads.
1. Combinations
Combinations require the simultaneous purchase or sale of both a put and call option on the same
underlying asset, sometimes with different exercise prices but always with the same expiry dates.
Examples include straddles and strangles, both of which seek to take advantage of either large price
movements in the underlying asset, where a long position is taken in both the call and the put, or
little or no price movement, where a short position is taken in each

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A. SHORT STRADDLE
PROFIT Maximum
Profit
11 8
0
A X=200 B Price of
underlying
Limited asset
loss Unlimited
loss
LOSS
net profit/loss profile
Figure 18: Short Straddle

A short straddle (see Figure 18) is used where it is believed the price of the underlying asset will
trade within a narrow range over the term of the option contracts. This short straddle has been
constructed by simultaneously writing a call option and a put option, both with an exercise price of
200 and the same expiry date. Both options are usually written ATM. If the options had been
written at different exercise prices, with the call exercise price (XC) being higher than that of the
put (XP), then a short strangle would have been constructed. This is shown in Figure 20.
The premium for the purchased call in the short straddle is 11 whilst that for the purchased put is
eight. The point of maximum profit for this short straddle is realised when the asset price is equal to
the exercise price. At this point the profit is equal to the sum of the option premiums, ie, 19. The
strategy breaks even firstly at point A where the sum of the two premiums is deducted from the
exercise price and secondly at point B where they are added to the exercise price, ie, at 181 and
219. If the price of the underlying asset moves either side of these values, then losses begin to
accrue and are potentially unlimited. In comparison with a short straddle, a short strangle (see
Figure 20) presents the option writer with a lower risk, lower return strategy, as the breakeven
points are further apart.

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B. LONG STRADDLE
PROFIT
Limited Unlimited
profit profit
0
X Price of
underlying asset
Maximum
LOSS Loss
net profit/loss profile
Figure 19: Long Straddle
A long straddle, as shown in Figure 19 above, takes the opposing view to a short straddle by taking
advantage of potential price volatility in the underlying asset in either direction. A long straddle is
constructed by simultaneously purchasing a call and put option with the same exercise price and
expiry dates. If the purchased call option has a higher exercise price (XC) than the purchased put
option (XP), then a long strangle is constructed, as shown in Figure 21 below.
The point of maximum loss for the long straddle is incurred when the price of the underlying asset
is equal to the exercise price. The breakeven points are established in the same way as for the short
straddle. Beyond these breakeven points, however, profits are potentially unlimited. The long
strangle provides a lower risk, lower return strategy for the option holder, as the breakeven points
are further apart.

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C. SHORT STRANGLE
PROFIT
Maximum profit
0 Xp Xc Price of
Limited underlying
loss asset
Unlimited
loss
LOSS
Figure 20: Short Strangle
D. LONG STRANGLE
Limited Unlimited
PROFIT profit profit
Xp XC
0
Price of
underlying
asset
Maximum loss
LOSS
Figure 21: Long Strangle

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2. Spreads
Spreads require the simultaneous purchase of one or more options and the writing of another or
several others on the same underlying asset with either different exercise prices and the same
expiry date or the same exercise prices and different expiry dates. Four examples of such spreads
are:
A. BEAR SPREAD
Maximum profit
Price of underlying
XS XL asset
Maximum loss
Figure 22: Bear Spread
Bear and bull spreads are relatively cautious strategies involving the use of two options.
Bear spreads are designed to moderately profit from a falling market. This involves simultaneously
purchasing and writing put options on the same underlying asset with the same expiry date but with
the purchased put option (XL) having a higher exercise price than that sold (XS). Writing an option
lowers the net outlay. A bear spread can also be constructed by simultaneously purchasing and
selling call options, again on the same asset with the same expiry dates with the purchased call (XL)
having a higher exercise price than the written call (XS). In the strategy depicted, using put options
the maximum loss is given by the net premium paid and the maximum profit by (XL- XS - net
premium paid).

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B. BULL SPREAD
Maximum
profit
XL
Price of
XS underlying asset
Maximum loss
Figure 23: Bull Spread
Bull spreads are designed to benefit moderately from rising markets. Whether using calls or puts,
the purchased option (XL) will have a lower exercise price than that sold (XS). Again, by writing an
option, the net outlay is reduced. If call options are used, the maximum profit is capped at (XS - XL
- net premium paid) and the maximum loss limited to the net premium paid.11
C. LONG BUTTERFLY SPREAD
PROFIT
Maximum profit
XL1 XS XL2
0 Price of
underlying
Maximum loss Maximum loss asset
LOSS
Figure 24: Long Butterfly Spread

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Butterfly spreads are complex option strategies, involving the use of four options, designed to
exploit either rising or falling volatility in the price of the underlying asset.
A long butterfly spread benefits from a decrease in the volatility in the price of the underlying asset
by simultaneously buying two calls or puts, one with a low (XL1) and one with a high (XL2)
exercise price, whilst simultaneously selling two calls or puts with identical exercise prices (XS)
between that of the two bought options. All four options have the same expiry date. Being a safer
strategy to pursue than a short straddle or strangle, albeit a potentially less profitable one, if the
resulting price volatility is greater than that expected then the loss is limited in both directions.
D. SHORT BUTTERFLY SPREAD
PROFIT
Maximum profit Maximum profit

Price of
0
Xs1 XL Xs2 underlying asset
Maximum loss
LOSS
Figure 25: Short Butterfly Spread
Short butterfly spreads take advantage of expected increases in the price volatility of the underlying
asset by simultaneously writing two calls or puts, one with a low (XS1) and one with a high (XS2)
exercise price, whilst simultaneously buying two calls with identical exercise prices (XL) between
that of the two sold options. Again all four options have the same expiry date. The profit and loss
trade off is again more cautious than that of a long straddle or strangle.
Summary of derivative trades
View Derivative trade

Market to rise sharply Buy a call/long future
Market to fall sharply Buy a put/short future
Market to rise mildly Bull spread
Market to fall mildly Bear spread
Market volatility to rise but Long straddle/s trangle or short
uncertain of direction butterfly
Market volatility to fall Short straddle/strangle or long butterfly

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4.7 Warrants
LEARNING OBJECTIVES
4.4.16 Know the main characteristics of a warrant
4.4.17 Be able to calculate a warrant conversion premium
4.4.18 Know the difference between warrants and covered warrants
Warrants are negotiable securities issued by plcs which confer a right on the holder to buy a certain
number of the company’s ordinary shares at a preset price on or before a predetermined date.
Although essentially long dated call options, warrants are traded on the LSE and if exercised result
in the company issuing additional equity shares. The warrants market is relatively small, comprising
around 250 issues.
Warrants can be issued on a stand alone basis either to existing shareholders or to outside investors
for cash, if the shareholders pass a special resolution, or can accompany loan stock issues to lower
the coupon payable. Unlike convertible loan stock, however, the conversion right contained within
the warrant is traded separately from the loan stock. Warrants can also be issued alongside new
investment trust shares issues to act as sweeteners for prospective shareholders.
Given the terms of the warrant issue, the conversion premium or discount can be calculated. This
is, whether the warrants are a more or less expensive way into the shares than by purchasing the
shares directly.
Conversion premium/(discount) = [(NX + W)/NS -1] x 100
where N is the number of shares each warrant can subscribe for, S is the share price, W is the
warrant price and X is the exercise price.
Example
A warrant that confers the right to subscribe for 1 ordinary share at 100p until 2007 is currently
priced at 20p. Given that the current share price is 90p, calculate the conversion premium or
discount.
Solution
Conversion premium/(discount) = [(100 + 20)/90 -1] x 100 = 33.33%
The annualised conversion premium is (1.330.2 -1) x 100 = 5.87%
However, this conversion premium does not tell the whole story. Since warrants like options are
highly geared, especially in this case where the warrant is OTM, a rise in the share price, the
underlying asset, will have a disproportionate effect on the warrant price. In fact, if the share price
rises by more than 7.4% per annum, the warrant will return more than by holding the shares
directly over this period, excluding dividends.
Note: This 7.4% was calculated by using the formula:

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√
Breakeven rate of share price growth = n (NX/(NS - W)) -1
Covered Warrants
Covered warrants, a form of “securitised derivative”, are similar to warrants issued by plcs except
that they are issued by investment banks and can be used by investors to both gear and hedge their
exposure to a range of shares, indices, commodities and interest rates. Although actively traded on
the continent, these securitised derivatives are new to the UK having only been granted FSA
approval to be traded on the LSE with effect from 1 August 2002. The LSE has, in turn, authorised
four banks to issue and trade these instruments on a newly constructed trading platform, launched
on 28 October 2002, though it is envisaged that most trades will be routed through private client
stockbrokers. In addition, unlike conventional warrants, which often trade in illiquid markets, the
issuing banks control the amount of liquidity and, hence, the issue and exit prices of these warrants
in this specialist market.
4.8 Swaps
LEARNING OBJECTIVES
4.4.19 Know the basic structure of an Interest Rate Swap
4.4.20 Know the basic structure of a Currency Swap
4.4.21 Know the basic structure of an Equity Swap
So far the focus has been on exchange-traded derivatives rather than OTC or
off-exchange derivatives. Despite the lack of a central counterparty and their illiquidity, OTC
derivatives have nevertheless proved extremely popular for risk management, speculation and
arbitrage principally because they are not standardised but constructed around the unique needs of
users. The most significant growth in OTC derivatives has been experienced in the swaps market.
Swaps are similar to futures in that they do not require a premium to be paid by one party to
another and create an obligation between the parties. The swaps market is mainly populated by
investment banks, securities houses, portfolio managers, supranationals and multinational
companies. Swaps take many forms but can be broadly categorised as:
1. INTEREST RATE SWAPS (IRS)

An IRS is an agreement between two parties to periodically exchange a series of interest payments
in the same currency to collectively reduce the cost of borrowing. Being cash settled CFDs, at no
stage in the transaction is the notional loan principal, upon which the swap is based, exchanged. IRSs
can be used for both new and existing borrowing for terms up to about 25 years.
IRSs take two forms:

i. Fixed rate into floating rate. This is commonly known as a coupon or vanilla swap.
ii. One type of floating rate into another type of floating rate. This is termed a basis swap.

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IRSs are typically based on the principle of comparative advantage. This we considered in Chapter 1
when looking at international trade. For instance company Y has a AA credit rating and company Z
has a BBB+ rating. Y wishes to borrow on a floating rate basis and Z on a fixed rate basis but both
companies regard the cost of borrowing on their preferred bases as prohibitive. Each faces the
following borrowing costs in the credit markets:
Company Y Company Z Difference

Fixed 7% 9.75% 2.75%
Floating LIBOR + 1/8 LIBOR + 1 1/8 1.00%
Total difference 1.75%
Although company Y has an absolute advantage in borrowing on both a fixed and floating rate basis,
company Z has a comparative advantage in borrowing on a floating basis. That is, the difference
between the floating rate Z faces to that faced by company Y is less than the difference that exists
between the two parties on a fixed rate basis. (Y, therefore, has a comparative advantage in
borrowing on a fixed rate basis.) Where comparative advantage exists both parties can reduce their
collective borrowing costs by entering into an interest rate swap. In this instance, Y and Z can share
a total saving of 1.75% by entering into a vanilla swap. To do this each must borrow on the basis
upon which they have comparative advantage. They must then decide exactly how this saving
should be split. This is demonstrated below.
Company Y Company Z
Original cost of borrowing (7%) LIBOR + 1 1/8%
Swap from Y to Z (LIBOR + 3/4%) LIBOR + 3/4%
Swap from Z to Y 8.75% (8.75%)
Net interest payment LIBOR – 1.0% 9.125%
Less: original cost of borrowing (LIBOR + 1/8%) (9.75%)
on preferred basis
Saving 1.125% 0.625%
In practice, the interest payment made by each party to an IRS is netted off. So, if LIBOR is 6%, Z
will simply pay Y 8.75% minus 6.75% = 2%. Also an element of the 1.75% saving would be paid
to an investment bank, known as a swap house, for matching the parties and assuming the
counterparty risk.
2. CURRENCY SWAPS
Currency swaps are simply interest rate swaps made in two different currencies that require an
exchange of the loan principal at the beginning and at the end of the swap period. The exchange
rate at which the loan principal is swapped is agreed at outset. As a result of this exchanging of
principal, the credit risks between the parties are higher than for a single currency interest rate
swap.
Currency swaps are mainly used as a hedging, or risk management, tool rather than for speculation
and arbitrage.

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3. EQUITY SWAPS
An equity swap is an agreement between two parties, an institutional investor and a bank for
instance, to exchange a series of periodic payments between one another based on a notional
principal amount. Being cash settled, no principal is exchanged between the counterparties, only
payments representing the servicing costs of the two sides of the transaction. One set of payments
is linked to the total return on an equity index, the other usually to a fixed or floating rate of
interest, though this can be the return on another equity index. The swap may be a vanilla swap
based in a single currency or a cross-currency swap based in two different currencies.
An example of a vanilla equity swap, based on a single currency, may be between the FTSE 100
index and a rate of interest based on LIBOR. This is equivalent to the party receiving the return on
the FTSE 100 simply funding this equity exposure by drawing on a cash deposit. Alternatively, by
using a cross-currency swap, exposure can be gained to a more esoteric overseas equity market
again by swapping this return into a fixed or floating rate of interest.
EQUITY TOTAL RETURN
PORTFOLIO SWAP
MANAGER HOUSE
INTEREST RATE
Figure 26: Equity Swap
The advantages to a portfolio manager being in receipt of the cash flows from the equity exposure
include:
a. Gaining equity exposure without the costs associated with buying and holding equities.
b. Facilitating index tracking. This is considered in Chapter 9.
c. Facilitating access to illiquid markets that may be inaccessible to foreigners.
d. Permitting a longer term exposure than would be possible using exchange-traded derivatives.
However, if the return on the equity index is negative in any period, then the portfolio manager will
be required to make both an interest payment and an additional payment in respect of this negative
return.
Equity swaps can also be used by portfolio managers wishing to gain exposure to another equity
market at the expense of an existing exposure without realising an element of their underlying
portfolio, as an alternative to using futures, by entering into an equity swap where both sides of the
transaction require the payment of the total return from an equity index.

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5. PROPERTY
5.1 Introduction
LEARNING OBJECTIVES
4.5.2 Understand the characteristics of a property market
and the differences between the property market,
securities market and money market
Property as an asset class is quite unique in its distinguishing features:

1. It is heterogeneous in nature. Given that each individual property is unique in terms of location,
structure and design, the property market can be segmented into an infinite number of individual
markets.
2. Valuation is subjective as property, due to its heterogeneity, is not traded in a centralised market
place and continuous and reliable price data is not available.
3. It is subject to complex legal considerations and high transactions costs upon transfer.
4. It is highly illiquid as a result of not being instantly tradeable.
5. It is not divisible. Since property can only be purchased in discrete units, diversification is made
difficult.
6. 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.
5.2 Direct Property Investment

LEARNING OBJECTIVES
4.5.1 Know the direct and indirect means of investing in
property: property investment trusts, property bonds,
shares in property companies, pension holdings
In England and Wales, an interest in property can either take the form of a freehold or a leasehold
interest.
1. Freehold
The freeholder of a property has the right to use or dispose of the property as they wish, albeit
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2. Leasehold
The freeholder can create a lesser interest in the property known as a leasehold interest. The
leaseholder, or tenant, to whom this interest is conferred, has the right to use the property for a
specific period subject to the terms of the lease and the payment of rent. Unless prevented from
doing so under the terms of the lease, the leaseholder can also create a sublease and act as the head
lessee to a sub tenant.
Once the lease has expired, the freeholder assumes full rights over the property unless the
leaseholder has security of tenure conferred by statute. If so, the leaseholder can apply for the
creation of a new lease. If the freeholder fails to create this lease, then this inaction may result in the
freeholder being required by law to compensate the leaseholder.
When assessing the investment potential of property, institutions take account of its location,
condition and age as well as whether a freehold or leasehold interest is to be acquired. If the
freehold is to be purchased and a leasehold interest subsequently created, then the present value of
the rental income must be derived to determine the value of the property to the institution.
If, however, a leasehold interest is to be acquired, then the frequency of rent reviews and
responsibility for repairs and maintenance must also be established. Until April 2002, a system of
five yearly upward only rent reviews was commonplace in the UK. However, since then, a new
code of conduct drawn up by the property industry has created a considerable of amount of
flexibility in the construction of rent review clauses in an era of low inflation.
When making direct property investments, institutional investors tend to avoid residential housing
given its political sensitivity and high maintenance costs. Instead they concentrate on the following
property types:
1. Commercial property. Freehold and long leasehold interests in shops, shopping centres, offices,
leisure complexes and hotels situated in prime locations are the most popular means of
institutional direct investment in property.
2. Industrial. Institutions tend only to invest in those factories and warehouses that are less sensitive
to the fortunes of the economic cycle and, therefore, less likely to suffer from obsolescence.
3. Farmland and woodland. Institutions tend to favour freehold over leasehold interests in farmland
and indirect to direct management of the freehold. Investment in woodland, however, due to the
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5.3 Indirect Property Investment
LEARNING OBJECTIVES
4.5.1 Know the direct and indirect means of investing in
property: property investment trusts, property bonds,
shares in property companies, pension holdings
Indirect exposure to property can be obtained through the following several investment media:
1. Enterprise Zone Trusts (EZTs). EZTs are unauthorised unit trusts that invest purely in commercial
property situated in government designated enterprise zones. Although they are highly illiquid
they do offer significant tax breaks.
2. Authorised property unit trusts and open-ended investment companies (OEICs). As authorised
collective investment schemes, property unit trusts and OEICs must meet stringent
diversification criteria when investing in property and property related assets, such as property
company shares.
3. Specialist property investment trusts. Investment trusts are fully listed plcs that principally invest
in equities, bonds, property and cash. Specialist property investment trusts, like their unit trust
counterparts, invest in property both directly and indirectly and must also meet diversification
criteria.
4. Real Estate Investment Trusts (REITs). REITs will be introduced from January 2007. The
distribution requirement has been reduced from 95% to 90% of taxable profits. REITs have 12
months to make the distribution (originally it was proposed to be 6 months).
5. Property bonds. These are life assurance company single premium bonds that invest in specialist
unitised property life funds.
6. Property company shares. The shares of property developers can be a useful way of gaining
exposure to the fortunes of the property market. However, they are often difficult to value and
tend to mirror the fortunes of the equity market rather than the property market.
7. Syndicated commercial property investment. Aimed at the higher net worth private investor,
these relatively illiquid commercial property investments are offered by financial firms usually via
tax efficient Small Self-Administered Pension Schemes (SSASs) and Self-Invested Personal
Pensions (SIPPs).
Concluding Comments
As an asset class, property has consistently 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. However,
property can be subject to prolonged downturns and, if invested in directly, its lack of liquidity and
high transactions costs on transfer only really make it suitable as an investment medium for long
term investing institutions such as pension funds. The availability of indirect investment media,
however, makes property a more accessible asset class to those portfolio managers running smaller
diversified portfolios.

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6. ALTERNATIVE INVESTMENTS
6.1 Introduction
LEARNING OBJECTIVES
4.6.1 Know the main types and characteristics of alternative
investments
Alternative investments are those which fall outside the traditional asset classes of equities,
property, fixed interest, cash and money market instruments. Alternative investments are often
physical assets which tend to be popular with collectors. However, they also have the potential to
appreciate substantially in value.
An advantage is that they are not exclusive to wealthy clients and due to the wide variety of options
available, even modest investments are possible. The disadvantage is that they often suffer from
illiquidity and can be difficult to sell quickly if funds are required for other purposes. They can also
be difficult to value due to the size of the different markets. Prices can change rapidly as markets
can are subject to trends and fashions.
Alternative investments have always been popular with wealthy individuals. However, financial
advisers generally do not recommend their clients hold more than 10% of their portfolio in
alternative investments.
6.2 Types of Alternative Investments

Alternative investments include (but are not limited) to the following list:
• Jewellery.
• Antiques.
• Books.
• Art.
• Classic cars.
• Private equity.
• Structured products.
• Autographs.
• Posters.
• Coins.
• Stamps (rare stamps were rated in the top 4 investments for the 20th century with annual
returns of around 10% per annum).
• Comic books.
• Toys (worth 4 to 5 times more if in the original packaging).

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• Race horses (although more money is made from stud breeders).
• Fine wine.
• Precious metals.
• Memorabilia.

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180
FINANCIAL
MARKETS
1.
2.
3.
STOCK EXCHANGES
DEALING AND TRADING
INTERNATIONAL MARKETS
5 183
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4. FOREIGN EXCHANGE 196

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1. STOCK EXCHANGES
1.1 Introduction
Financial markets are best described by the functions they perform.
The main functions of financial markets are to:

1. Raise capital for companies. This function is performed by stock exchanges.
2. Provide maturity transformation by channelling short term savings into longer term business
investment.
3. Bring buyers and sellers together in highly organised marketplaces to reduce search and
transaction costs and facilitate price discovery, so that securities and other assets can be valued
objectively. This function is performed by stock and derivative exchanges and other market
places.
4. Allocate capital efficiently from low growth to high growth areas.
5. Transfer risk from risk adverse to risk seeking investors. This was considered in Chapter 4 when
looking at the activities of hedgers and speculators in derivative markets. This role is equally well
performed by the insurance market, which underwrites the risk from a large number of
insurance policies. It is not however a function of stock markets or stock exchanges.
6. Provide borrowing and lending facilities to match surplus funds with investment opportunities.
This function is performed by banks and stock exchanges.
1.2 Stock exchanges
LEARNING OBJECTIVES
5.1.1 Understand the role of the exchanges for trading:
shares; bonds; derivatives
5.1.2 Know why companies obtain listings on overseas stock
exchanges
5.1.3 Know the role and responsibilities of the London Stock Exchange
(LSE)
5.3.1 Know the main characteristics of the major stock
exchanges for the following markets: UK
“Stock exchanges should realise that they are not some kind of institutional icon, but are just…like
vegetable markets…with a pair of braces.”
City Stockbroker
A stock exchange is an organised market place for issuing and trading securities by members of that
exchange. Each exchange has its own rules and regulations for companies seeking a listing and
continuing obligations for those already listed. All stock exchanges provide both a primary and a
secondary market.

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Primary markets exist to raise capital and enable surplus funds to be matched with investment
opportunities whilst secondary markets allow the primary market to function efficiently by
facilitating two-way trade in issued securities. Secondary markets, by injecting liquidity into what
would otherwise be deemed illiquid long term investments, also reduce the cost of issuing securities
in the primary, or new issue, market. However, these roles can only be performed efficiently if
markets are provided with accurate and transparent information so that securities may be valued
objectively and investors can make informed decisions. This is particularly important if capital is to
be allocated efficiently from what are perceived to be low growth to high growth areas to the
overall benefit of the economy. Indeed, a lack of transparency and an inability to interpret
information correctly was evident from the way in which capital flowed from the so-called old
economy to what was perceived as the new economy during the dot.com boom. We return to this
point in Chapter 9.
Historically, stock exchanges have operated as national monopolies from a central location, or
physical market place, mainly catering for the needs of domestic investors and domestic issuers. As
mainly mutually owned, or
not-for-profit, organisations, many stock exchanges had become bureaucratic, parochial and
resistant to change and ironically had restricted access to new capital to fund development,
investment in new trading and settlement technology and facilitate expansion into new markets.
However, recently, in an attempt to meet the challenges posed by competing trading systems and
the globalisation of financial markets, in an increasingly price sensitive and competitive global market
place, many have sought to become more dynamic and cost efficient and have strived to create new
markets. Indeed, stock exchanges have been taking their lead from the radical changes recently
undertaken in the derivatives markets. These have included abandoning restrictive mutual
ownership by exchange members to become shareholder owned listed companies, operating as
electronic trading networks, as the move to electronic trading has gathered pace, and creating new
markets through strategic mergers and alliances with other exchanges.
The motivation behind many of these mergers and alliances has been a realisation that financial
markets have integrated to such a degree that the shares of most multinational companies, rather
than just being listed on their domestic stock exchange, are instead listed on those stock exchanges
that best reflect the global distribution and capital requirements of their business. Listing on an
overseas stock exchange also enhances the liquidity and marketability of companies shares and can
also build the company’s brand. In effect, a global capital market has been created through the
globalisation of markets and economies.
The London Stock Exchange (LSE)

The LSE began life in 1773 when traders who regularly met to buy and sell the shares of joint stock
companies in Jonathan’s Coffee House voted to change the name of the coffee house to that of the
London Stock Exchange. You will not be surprised to learn that many changes have taken place
since then, mostly since 1986. The LSE is Europe’s largest stock exchange, accounting for over 35%
of European stock market capitalisation, about 10% of world stock market value and over 50% of
foreign equity trading on world stock exchanges. Despite this, the LSE continues to evolve in a very
competitive global marketplace. In April 2001, in its drive to expand into new markets, the LSE
launched its International Retail Service (IRS), making over 100 continental European and US stocks
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The LSE is a recognised investment exchange (RIE) and, as such, is responsible for:
1. Providing a primary and secondary market for equities and fixed interest securities.
2. Supervising its member firms.
3. Regulating the markets it operates.
4. Recording all transactions, or bargains, executed on the exchange.
5. Disseminating price sensitive company information received by its Regulatory News Service
(RNS) and distributed through commercial quote vendors, also known as Secondary Information
Providers (SIPs). As noted in Chapter 4, the LSE now competes with other Primary Information
Providers (PIPs) in this respect.
The LSE’s role as the UK Listing Authority (UKLA) passed to the Financial Services Authority (FSA)
on 1 May 2000 once the LSE became a public limited company (plc).
The LSE operates both a primary and secondary market for:

1. Domestic plcs. These include:
a. Companies with a full listing, including those technology companies listed on techMARK.
b. Smaller UK plcs admitted the AIM.
c. Exchange-Traded Funds (ETFs) and other innovative investments on its extraMARK exchange.
ETFs are considered in Chapter 9.
2. International equities.
3. Domestic bonds:
a. Gilts.
b. Local authority fixed interest securities.
c. Corporate bonds.
The role of the derivatives exchange was considered in Chapter 4.
1.3 Alternative Trading Systems

LEARNING OBJECTIVES
5.1.4 Understand the reasons for the emergence of
alternative trading systems: Crossing networks and
Electronic Communication Networks (ECNs)
1. Electronic Communications networks (ECNs)

ECNs came into being following a US regulatory probe that unearthed pricing collusion amongst
NASDAQ dealers in 1997. ECNs are private trading systems run in the US independently of public
trading systems such as the NYSE and NASDAQ (please see Section 3 - International Markets for
NASDAQ and NYSE). They allow investors to trade quickly and directly with each other for a flat
fee with no spread and most provide trading facilities after hours for both private investors and
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NASDAQ stocks. To trade on NASDAQ, ECNs must be certified with the US Securities and
Exchange Council (SEC) and registered with NASDAQ.
When an order is routed through an ECN it is posted electronically into the NASDAQ system as an
ECN quote. The order can then be executed on NASDAQ or matched with another order through
the ECN. ECNs rely on NASDAQ price data for trading to take place and fragment liquidity in the
NASDAQ market by acting as a separate market in NASDAQ stocks.
Although ECNs pose a competitive threat to other major exchanges, they must first obtain
regulatory approval before they can trade the stocks listed on a regulated exchange. Whereas most
are currently restricted to trading NASDAQ stocks only, one has already gained regulatory
clearance from the SEC to become an exchange and is, therefore, able to trade NYSE listed stocks.
2. Crossing networks
Crossing networks have been formed recently by global investment banks, which through their
fund management subsidiaries, dominate the global demand for securities trading. Crossing
networks enable fund managers to deal directly with each other, though like ECNs, they are reliant
on stock exchanges to supply prices. One crossing network already has a turnover in the US
equivalent to 3% of US stock exchange turnover and more than two-thirds of UK pension funds
use their services.
2. DEALNG AND SETTLEMENT
2.1 Introduction
LEARNING OBJECTIVES
5.2.1 Know the differences between a primary market and a
secondary market
5.2.2 Know the structure and operation of the primary and
secondary markets
5.2.3 Know the features and differences of quote- and order-driven
markets
A primary market is the market for new issues or initial public offerings (IPOs). As noted in Chapter
4, equity new issues can be made via an offer for sale, offer for subscription, placing, or if no new
capital is to be raised, via an introduction. New equity issues have also started to be offered directly
to investors via online investment banks.
Secondary markets are those that permit the trading of securities already issued. This trading is
conducted through trading systems broadly categorised as either:
1. Quote-driven, or
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Quote driven trading systems employ market makers to provide continuous two-way, or bid and
offer, prices during the trading day in particular securities regardless of market conditions. Market
makers make a profit, or turn, through this price spread. Although outdated in many respects, many
practitioners argue that quote driven systems provide liquidity to the market when trading would
otherwise dry up. The NASDAQ and the LSE’s SEAQ trading systems are two of the last remaining
examples of quote-driven equity trading systems.
An order driven market, however, is one that employs either an electronic order book such as the
LSE’s SETS or an auction process such as that on the NYSE floor to match buyers with sellers. In
both cases, buyers and sellers are matched in strict chronological order by price and the quantity of
shares being traded and do not require market makers.
2.2 Transaction costs

LEARNING OBJECTIVES
5.2.4 Know the types of transaction costs incurred in dealing
in different asset classes
Equities
Dealing in equities on any stock market in the world will incur additional costs for investors. For
example, in the UK share trading incurs the following costs:
1. Dealing spread. The size of the dealing spread, or the difference between bid and offer prices,
will depend on how liquid the market for a particular share is. Trades executed on SETS do not
suffer dealing spreads.
2. Commission. Although negotiable, a typically institutional bargain will attract commission at 0.2%
of the value of the transaction.
3. Panel on Takeovers and Mergers (POTAM) levy. This levy of 100p is charged on all transactions
over £10,000.
4. Stamp duty. All purchases of registered shares attract either stamp duty (SD) or stamp duty
reserve tax (SDRT) at 0.5% of the transaction value. If the purchaser requires a share certificate
to be issued then SD is rounded up to the nearest £5. Otherwise SDRT applies, which is charged
to the nearest penny.
Bonds
The vast majority of bonds are traded on the ‘over-the-counter’ market (as opposed to a
centralised market such as a stock exchange). The transaction costs for a bond will depend on the
market where it is bought or sold. It will also depend on the type and size of the bond. Bond
dealers make their profits (or losses) by taking a spread between the buying and selling price.

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Property
Investors in property typically have to pay additional costs which include stamp duty, real estate
agent commission, mortgage costs, valuation costs, building inspection fees etc. If the property is to
be rented out, there are property management fees, insurance, maintenance and rates bills which
all need to be factored into the yield calculation.
Cash
Generally speaking, there are very small or even no transaction costs for investing in term deposits
or cash accounts. Some banks will charge account-keeping fees or penalty rates if a term deposit
agreement is broken. Investors run the risk that the return on their investment does not keep up
with inflation.
3. INTERNATIONAL MARKETS
3.1 Introduction
The list below gives the rankings of the world’s stock exchanges by market capitalisation.
1. New York Stock Exchange.
2. Tokyo Stock Exchange.
3. NASDAQ.
4. London Stock Exchange.
5. Euronext.
6. Toronto Stock Exchange.
7. Frankfurt Stock Exchange (Deutsche Börse).
8. Hong Kong Stock Exchange.
9. Milan Stock Exchange (Borsa Italiana).
10. Madrid Stock Exchange (BME Spanish Exchanges)
11. SWX Swiss Exchange
Source: World Federation of Exchanges (February 2006).

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3.2 USA Markets
LEARNING OBJECTIVES
exchanges for the following markets: USA
5.3.2 Know the settlement cycles for the following
markets: USA
New York Stock Exchange (NYSE)

Founded in 1792, the NYSE is the world’s largest marketplace for equities trading and is home to
nearly 3,000 companies collectively worth in excess of US$15,000bn. Despite this, it remains one of
the few remaining not-for-profit stock exchanges owned by its exchange members, though it will
shortly be merging with Archipelago, an ECN, to become a listed exchange, and one of the few that
still conducts trading on an exchange floor with a bell opening and closing the trading day.
During trading hours, exchange members known as floor brokers, who own a seat on the trading
floor, buy and sell shares on behalf of investors, though a few exchange members, known as floor
traders, trade shares as principal, using their own capital. Each stock listed on the NYSE is allocated
to a specialist, a broker who trades only in specific stocks at one of the exchange’s 17 trading posts.
Floor brokers receive their orders from one of the 1,500 trading booths situated along the
perimeter of the trading floor and take these to the appropriate specialist at their trading post to
find the best price for each particular security.
In this order driven market, the specialist acts as an auctioneer. At the start of the trading day, each
specialist establishes a fair market price for each of their stocks based on supply and demand, then
throughout the day quotes the current bids and offers for each stock to the floor brokers. Orders
can also be sent electronically to a specialist through the superDOT system. Specialists, acting as
agents to the floor brokers, either execute orders immediately at the best available price or when a
stock reaches a limit price specified by the investor. In instances when there is a temporary shortage
of buyers or sellers, NYSE specialists will buy or sell on their own account to restore an orderly
two-way market. They are not, however, under the same obligation as LSE market makers to make
a market in the shares regardless of market conditions.
Settlement is made on a T+3 basis through the National Securities Clearing Corporation (NSCC).
Investors can hold their shares either directly, through nominees or via the US Depository Trust
Corporation (DTC).
NASDAQ (National Association of Securities Dealers Automated Quotations

System)
NASDAQ is a non-centralised screen based quote driven market. Since its inception in 1971,
NASDAQ has operated through a sophisticated computer network linking buyers and sellers from
around the world, rather than from a physical exchange floor.

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Essential to NASDAQ’s market structure are independent market makers who actively compete
for retail and institutional investor orders by displaying continuous two-way price quotations in over
6,000 companies on a network of over 500,000 computer terminals worldwide.
As companies in the US are not permitted to list on more than one domestic exchange, many
technology companies choose to list on NASDAQ rather than the NYSE.
NASDAQ trades are settled in exactly the same way and on the same basis as deals conducted on
the NYSE.
3.3 European Markets (Excluding UK)
LEARNING OBJECTIVES
exchanges for the following markets: France; Germany
markets: France; Germany
Euronext
Euronext, the Paris, Amsterdam, Brussels and Lisbon exchange, is an order driven market. It
employs an electronic order driven trading system and settles through Clearnet on a T+3 basis.
Deutsche Börse
Based in Frankfurt, the recently floated Deutsche Börse is Europe’s 3rd largest and the world’s 12th
largest stock exchange. Trading is conducted on exchange floors throughout Germany and via
Xetra, an electronic order driven trading system.
All trades are settled through Clearstream on a T+2 basis.

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3.4 Asian Markets
Tokyo Stock Exchange (TSE)
LEARNING OBJECTIVES
exchanges for the following markets: Japan
markets: Japan
The TSE is an order driven market with dealing conducted on an exchange floor and through the
CORES computer system. Settlement is on a T+3 basis through the Japan Securities Clearing
Company (JSCC), which is wholly owned by the TSE. In contrast to most other developed equity
markets, shares cannot be delivered outside of Japan and must be held for overseas investors by
nominees or the Japan Securities Depository Centre (JASDEC). The Financial Services Agency
(FSA) is the regulator for the Japanese market.
Chinese Stock Exchanges
LEARNING OBJECTIVES
5.3.3 Know the main characteristics of the following Asian and
Middle East stock exchanges: China
5.3.4 Know the settlement cycles for the following Asian and
Middle East markets: China
5.3.5 Know the characteristics of an emerging market
China has three main stock exchanges:

1. Shanghai Stock Exchange
2. Shenzhen Stock Exchange and
3. Hong Kong Stock Exchange. All three exchanges are governed by the China Securities Regulatory
Commission(CSRC).
Investors are restricted to the following catagories of shares:

1. “A” shares – Chinese nationals. However, Qualified Foreign Institutional Investors (QFII) are now
able to trade.
2. “B” shares (on the SSE and SZSE) – Foreign investors (although Chinese nationals are able to
trade).
3. “C” shares – State owned companies.
4. “H” shares – Traded on the SEHK.
5. “N” shares – Traded on the NYSE.

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1. Shanghai Stock Exchange (SSE)

The SSE is an order-driven system that supports paperless trading. Orders can be placed at
terminals at the SSE trading floor or from member firms. Settlement is on the basis of T+1 for A
shares and T+3 for B shares. The central depository, registration and clearing is performed by the
China Securities Central Clearing & Registration Corporation (CSCCRC).
2. Shenzhen Stock Exchange (SZSE)

The SZSE is based in Shenzhen, China. Orders are processed directly from off-site terminals in
member firms' offices. Settlement is on the basis of T+1 for A shares and T+3 for B shares. The
central depository, registration and clearing is performed by the Shenzhen Depository and Clearing
Corporation (SDCC).
3. Hong Kong Stock Exchange (SEHK)

Hong Kong Exchanges and Clearing Limited owns the stock and futures exchange in Hong Kong. It
also owns the related clearing houses ie, Hong Kong Securities Clearing Company Ltd, HKFE
Clearing Corporation Ltd and the SEHK Options Clearing House Ltd. The stock exchange has an
order-driven trading system. Orders can be placed at terminals in the the exchange or from
member firms. Settlement is on the basis of T+2 for all shares. The Central Clearing Automated
Settlement System (CCASS) is used for settlement.
Indian Stock Exchanges
LEARNING OBJECTIVES
Middle East stock exchanges: India
Middle East markets: India
The Securities and Exchange Board of India is the main regulator for Indian markets. The two main
stock exchanges in India are listed below.
1. Bombay Stock Exchange Limited (BSE)

The BSE is the oldest stock exchange in Asia and is based in Mumbai, India. The Bank of India
Shareholding Ltd (BOISL) undertakes clearing activities for the BSE. The company is a joint venture
between the Bank of India and BSE. Settlement is on a T+2 basis for equities. The BSE Sensex
(or BSE 30) is a commonly used market index.
2. National Stock Exchange of India Ltd (NSE)

The NSE is India’s largest stock exchange and is the third largest stock exchange in the world in
terms of transactions. Settlement is performed by the National Securities Clearing Corporation
Ltd. (NSCCL), a wholly owned subsidiary of NSE, and is on a T+2 basis for equities.

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LEARNING OBJECTIVES
Middle East stock exchanges: Dubai; Egypt; Saudi Arabia
Middle East markets: Dubai; Egypt; Saudi Arabia
Dubai
Dubai has two stock exchanges: Dubai Financial Market (DFM), which opened in March 2000, and
Dubai International Financial Exchange (DIFX), which opened in September 2005.
Dubai Financial Market (DFM)

Dubai Financial Market is a public institution having its own independent corporate body. DFM
operates as a secondary market for trading of securities issued by public shareholding companies,
bonds issued by the Federal Government or any of the local governments and public institutions in
the country, units of investment funds and any other financial instruments, local or foreign, which
are accepted by the Market.
DFM operates on an automated screen-based trading system and settlement occurs, electronically,
on a T + 2 basis, via the Central Depository.
Dubai International Financial Exchange (DIFX)

Dubai International Financial Exchange is based in the Dubai International Financial Centre which is
a 110 acre free zone. The Dubai Financial Services Authority regulates the activities of the
Exchange. Settlement is on the basis of T+3 and usually in USDs, with Standard Chartered Bank as
it’s clearing bank.
Egypt: Cairo & Alexandria Stock Exchanges (CASE)

Egypt has two stock exchanges: the Cairo Exchange, which was opened in 1903, and the Alexandria
Exchange, which opened in 1888. Both use the same trading, clearing and settlement systems and
have the same board of directors. The clearing and settlement system in Egypt is based upon
delivery versus payment (DvP), whereby Misr for Clearing, Depository and Central Registry
(MCDR) acts as the clearing house between the buying and selling member firms. The CASE 30 is a
popular market index.
Settlement is:
• T+0 for securities traded by the Intra-day Trading System.
• T+1 for government bonds that are traded through the Primary Dealers System.
• T+2 for all other securities.

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Saudi Arabia
The Saudia Arabian Stock Exchange (SSE) uses Tadawul (an electronic stock exchange system) for
trading, clearing, settlement and depository operations. The system allows for real-time share
trading and same-day settlement. The exchange is supervised by the Saudi Arabian Monetary
Agency and is the largest exchange in the Arab region.
Summary of Overseas Equity Market Trading and Settlement
Exchange Trading method Standard Clearing

settlement house
basis
NYSE Order driven - exchange T+3 NSCC
floor and superDOT
NASDAQ Quote driven T+3 NSCC
Tokyo Order driven - exchange T+3 JSCC
floor and CORES
Euronext Order driven T+3 Clearnet
Deutsche Börse Order driven - exchange T+2 Clearstream
floor and Xetra
3.5 Emerging Markets

LEARNING OBJECTIVES
There are many benefits to investing overseas. At a general level, these benefits arise from the fact
that the world economy is not totally synchronised, most investment themes are global, many
industries are either over or underrepresented in the UK and the UK equity market accounts for
less than 10% of world stock market capitalisation. To be efficient then, a portfolio should be
adequately diversified with no one geographical region or asset class monopolising it.
Although most overseas investment held by UK investors is in developed equity markets, emerging
markets represent a rapidly increasingly proportion of UK overseas investment. The term
emerging market can be defined in various ways:
• Markets in countries classified by the World Bank as low or middle income, and
• Markets with a stock market capitalisation of less than 2% of the total world market
capitalisation.
The attractions of investing in emerging markets comprise:

• Rapid economic growth. Developing nations tend to grow at faster rates of economic growth
than developed nations as they attempt to catch up with rich country living standards by
developing their infrastructure and financial systems. This process is assisted by domestic saving
rates being generally higher than in developed nations and the embracing of world trade and
foreign direct investment (FDI). Rapid economic growth tends to translate into rapid profits
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• Low correlation of returns. Emerging markets offer significant diversification benefits when held
with developed market investments, owing to the historically low correlation of returns between
emerging and developed markets.
• Attractive valuations. Emerging markets have historically traded at a discount to developed
market valuations
• Industry representation. Investors are able to gain exposure to industries not represented in
developed nations.
• Inefficient pricing. As emerging markets are not as well researched as their developed
counterparts, pricing anomalies often appear.
However, there are also significant drawbacks:

• Lack of transparency. The quality and transparency of information is generally lower than for
developed nations whilst accounting and other standards are generally not as comprehensive or
as rigorously applied.
• Regulation. Regulation is generally more lax in emerging than in developed markets and incidents
of insider trading and fraud by local investors more prevalent. Corporate governance also tends
to be lacking.
• Volatility. Emerging market performances have been more volatile than that for developed
markets owing to factors such as developing nations being less politically stable and more
susceptible to banking and other financial crises.
• Settlement and custodial problems. The logistics of settling transactions and then arranging for
custody of the securities purchased can be fraught with difficulty. In addition, property rights are
not as well defined as in developed nations. However, these problems can be mitigated by using
Global Depositary Receipts (GDRs).
• Liquidity. As emerging markets are less liquid, or more concentrated, than their developed
counterparts, investments in these markets tend not to be as readily marketable and, therefore,
tend to trade on wider spreads.
• Currencies. Emerging market currencies tend to be less stable than those of developed nations
and periodically succumb to crises resulting from sudden significant outflows of overseas investor
capital.
• Controls on foreign ownership. Some developing nations impose restrictions on foreign
ownership of particular industries.
• Taxation. Emerging market returns may be subject to local taxes that may not be reclaimable
under double taxation treaties.
• Repatriation. There may be severe problems in repatriating capital and/or income from
investments made in some emerging markets.

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4. FOREIGN EXCHANGE
LEARNING OBJECTIVES
5.4.5 Understand the reasons for changes in exchange rates
4.1 Introduction
An exchange rate is the price of one currency in terms of another. As mentioned in Chapter 1,
under a system of floating exchange rates in a world where very few barriers impede the mobility of
international capital flows, foreign direct and international portfolio investment are by far the most
powerful determinant of exchange rates in the short to medium term: overwhelming those
currency flows associated with international trade and central bank intervention. In fact, such has
been the growth in the movement of international capital that over $1.9tn a day flows through
world foreign exchange centres with over a third of this turnover passing through London alone.
Following the introduction of euro notes and coins on 1 January 2002, the euro joined the US dollar
and Japanese yen in becoming one of the world’s pre-eminent currencies. However the world’s
most heavily traded currency remains the US dollar, the world’s premier reserve, or safe haven
currency.
4.2 The Structure and Operation of the Foreign Exchange Market

LEARNING OBJECTIVES
5.4.1 Know the basic structure and operation of the foreign
exchange market
5.4.2 Understand the difference between spot and forward
exchange rates
The foreign exchange, or forex, market exists to serve a variety of needs from companies and
institutions purchasing overseas assets, denominated in currencies different to their own, to
satisfying the foreign currency needs of business travellers and holidaymakers. The forex market
does not have a centralised market place. Instead, it comprises an international network of major
banks each making a market in a range of currencies in a truly internationalised 24 hour market.
Each bank advertises its latest prices, or rates of exchange, through commercial quote vendors and
conducts deals on either Reuters 2002, an automated broking system or via EBS, an electronic
broking system. Deals struck in the spot market are for delivery and settlement two business days
after the date of the transaction: that is on a T+2 basis.
When one currency is quoted in terms of another, the former is known as the base currency (X)
and the latter the quoted currency (Y). The exchange rate given by X/Y represents the value of one
unit of the base currency in terms of the quoted currency. In the spot market, the base currency is
usually the US dollar ($). However, when sterling (£) is quoted against the $, £ is the base currency
and the $ the quoted currency. So, £1 is quoted in terms of its value in dollars rather than $1 being
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The convention in the spot market is for the exchange rate to be quoted as a mid-rate and a bid-
offer spread around this mid-rate. The mid-rate is the mid-point between the bid and offer prices.
The bid price is the rate at which the quoted currency ($) can be purchased with the base currency
(£) and the offer price the rate at which the quoted currency ($) can be sold in exchange for the
base currency (£). So, if the spot $/£ exchange rate is quoted as $1.5223 and the bid-offer spread is
quoted as 220-226, then the exchange rate would be $1.5220 - $1.5226.
By knowing the rate at which sterling can be exchanged for dollars and dollars for, say, euros, the
exchange rate between sterling and euros can be determined via the respective dollar exchange
rates. Where an exchange rate is derived via the dollar, it is known as a cross rate. So, given the
sterling/dollar exchange rate of $1.5220 - $1.5226 and a dollar/euro exchange rate of €1.1062 -
e0.1.1066, the sterling/euro exchange rate will be:
£ bid rate = 1.5220 x e1.1062 = €1.6836
£ offer rate = 1.5226 x e1.1066 = €1.6849
That is, e1.6836 - €1.6849.
4.3 Parity Relationships

LEARNING OBJECTIVES
5.4.3 Be able to calculate forward exchange rates and
parity relationships
The value of a currency could be described as a country’s share price, as its value tends to reflect
most aspects of a country’s fortunes. This makes currencies probably the most unpredictable of all
the asset classes and exchange rates one of the most difficult macroeconomic variables to forecast.
Although currencies very rarely go into terminal decline, they can under and overshoot their long
term fundamental values often for significant periods of time for a variety of economic and political
reasons and in response to fickle changes in market sentiment. Currency forecasting can, therefore,
be extremely hazardous. The demise of the US dollar, for instance, was regularly predicted during
the middle to late 1990s and into the 2000s but remained buoyant despite the launch of the euro in
1999, the mild US economic recession in 2001 and the US current account deficit consistently
recording new highs. Exchange rate forecasting can be guided by the following three parity
relationships:
1. Purchasing Power Parity (PPP).
2. Interest Rate Parity.
3. International Fisher Effect.
Each of these will now be examined.

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1. Purchasing Power Parity (PPP)

PPP states that the price of homogeneous internationally traded goods in any two countries should
be equated by the nominal exchange rate in the long run. The nominal exchange rate is that which
we observe in the foreign currency markets between those two countries trading these goods.
According to PPP, the nominal exchange rate between two countries should adjust to reflect the
difference in their respective inflation rates, if the real exchange rate, or each country’s international
competitiveness, is to remain constant. This is the idea behind the Economist’s BigMac index,
detailed below.
The real exchange rate is given by:
Real exchange rate = UK price level x US$

US price level £
Therefore, if PPP holds in the long run, the relationship between successive spot exchange rates
over time can be explained by inflation differentials between countries.
This relationship can be summarised by the following equation:
PPP = Spot £/$t1 = 1 + expected inflation rateus

Spot £/$t0 1 + expected inflation rateuk
where spot £/$t0 is the spot rate today and spot £/$t1 the spot rate in 1 year’s time.
So, assuming PPP holds and the inflation rate over the next year in the UK is expected to be 4%
whilst that in the US is expected to be 3% and the current spot £/$ exchange rate is $1.5100, the
spot exchange rate in one year’s time should be:
Spot £/$t1 = 1.03
$1.5100 1.04
Therefore, spot £/$t1 = (1.5100 x 1.03)/1.04 = $1.4955
The Economist frequently tests whether nominal exchange rates reflect PPP by operating a BigMac
index. After all, how many other goods can be purchased worldwide that are as homogeneous in
nature? The idea is that the BigMac PPP should result in hamburgers costing the same in the US as
anywhere else in the world when account is taken of the nominal exchange rate. However, based
on this objective measure of PPP most currencies are either overvalued or more usually
undervalued relative to the US dollar. This should not come as any great surprise given that PPP is a
long run and not a short run proposition.
Moreover, prices cannot always be compared on a like-for-like basis between countries so as to

determine the appropriate nominal exchange rate as:
1. Not all goods represented in inflation indices are internationally traded;
2. Some internationally traded goods attract indirect taxes in certain countries but not others; and
3. Comparing inflation rates between countries is difficult as each adopts its own method of
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In addition, factors that can influence currency values in the short to medium term include:
1. Net international capital flows. In a world where very few barriers impede the mobility of
international capital flows, foreign direct investment (FDI) and international portfolio investment
are by far the most powerful determinants of exchange rates in the short to medium term. These
capital flows gravitate to those countries or economic regions that offer the most profitable
investment opportunities and accommodating attitude to outside capital. Such countries or
regions are typically politically stable, have high and sustainable economic growth rates, stable
and transparent macroeconomic policies and/or high real interest rates. Note that reference is
made to the real and not to the nominal rate of interest. This is because if a country’s inflation
rate is high relative to that of its trading partners, the currency’s potential to depreciate, in order
to restore the country’s competitiveness, may more than offset the relatively attractive nominal
interest rate being offered. The conclusion then is that high real rather than high nominal interest
rates attract investors to a currency.
2. Net international trade flows. Dwarfed by the size of international capital flows, international
trade flows tend to have a relatively muted effect on exchange rates.
3. Central bank intervention. Central banks often use their limited armoury of foreign currency
reserves to influence the level of their domestic currency in the international currency markets.
However, if private capital is flowing in the opposite direction, unilateral central bank intervention
in the currency markets rarely achieves its desired effect for anything other than a very short
period. When undertaken in concert with other central banks though, central bank intervention
has proved very effective in influencing exchange rates.
Central banks can also use short term interest rates to influence the exchange rate. However, a
conflict often arises between using interest rates to influence the exchange rate so as to bring the
trade balance back into equilibrium and using interest rates to regulate demand in the economy. For
instance, if a country with strong domestic demand and a trade deficit is subject to a rising short
term interest rate, engineered primarily to dampen inflationary pressures within the economy, this
can have the effect of worsening the trade deficit. As we know, raising the real short term rate of
interest will attract portfolio investment flows which serve to finance the trade deficit. However,
these investment flows will also stimulate demand for the currency, thereby raising the nominal
exchange rate.
Other things being equal, this higher exchange rate should reduce the competitiveness and,
therefore, dampen the demand for the country’s exports whilst increasing the competitiveness of
imports, thereby worsening the trade deficit. If interest rates had instead been reduced in an
attempt to lower the nominal exchange rate so as to improve the country’s trade position, then by
leaving domestic demand unchecked, higher inflation would usually result.
2. Interest Rate Parity

The only unbiased estimate of a currency’s future spot exchange rate can be obtained by
establishing the forward exchange rate. This should not be confused with the forward rate
considered earlier in this chapter when looking at the term structure of interest rates. The forward
exchange rate is the exchange rate set today, embodied in a forward contract, that will apply to a
foreign exchange transaction at some pre-specified point in the future: in three months time for
instance.
A forward exchange contract is an agreement between two parties to either buy or sell foreign
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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
of the likely course that the exchange rate may take given knowledge of other factors.
The idea behind this relationship is embodied in the principle of interest rate parity and is explained
by the use of arbitrage pricing. As you may recall, arbitrage is the process of deriving a risk-free
profit from simultaneously buying and selling the same asset in two different markets where an
unexplained price difference, or pricing anomaly, exists. Before looking at how arbitrage pricing
works in this instance, the relationship between the spot and forward exchange rate, as given by
interest rate parity, is as follows:
F£/$ = S£/$ x [(1 + R$)/(1 + R£)]
where F£/$ is the forward exchange rate between sterling and the dollar, S£/$ the spot rate, R$ the
$ nominal interest rate and R£ the £ nominal interest rate. This principle is best illustrated by an
example.
Example
The £/$ 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?
Solution
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 would be payable (%) over three months:
Sterling: 4.88%/4 = 1.22%
Dollar: 3.20%/4 = 0.8%
Applying the interest rate parity formula:
F£/$ = S£/$ x [(1 + R$)/(1 + R£)] = $1.5220 x [1.008/1.0122] = $1.5157
The forward exchange rate of $1.5157 is lower than the spot exchange rate of $1.5220. That is, in
three months time, £1 will buy $1.5220 minus $1.5157 = $0.0063 fewer dollars. The dollar will
strengthen against sterling. The reason for this is due to three month interest rates in the UK being
higher than that in the US. To explain.
If £1 was invested over three months at 1.22% this would provide a terminal value of £1 x 1.0122
= £1.0122. Alternatively, if the £1 was converted into dollars at the spot exchange rate and this
$1.5220 was invested at 0.8% over the three months then the terminal value would be $1.5220 x
1.008 = $1.5342. Therefore, in three months time £1.0122 will buy $1.5342. This implies that the
spot exchange in three months time should be:
S£/$ + 3 months = $1.5342/1.0122 = $1.5157.
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If this relationship did not exist, then an arbitrage opportunity would arise between the spot and
forward rates. Ignoring the bid/offer spread, if $1.5220 is the spot rate, at which dollars can be
exchanged for £1 today and $1.5100, rather than $1.5157, is the forward rate, then an arbitrage
opportunity would arise and risk-free profit could be made by simultaneously:
1. Entering into a three month forward contract today to sell $1.5100 for £1 in three months time,
whilst
2. Borrowing £1 today, at 1.22% over three months, and investing the $1.5220 into which the £1 is
converted at 0.8% for three months.
The £1 borrowed with interest at 1.22% over three months will amount to £1.012, whilst the
$1.5220 at 0.8% over three months will have grown to $1.5342. This $1.5342 could be sold via
the three month forward contract at a rate of £1/$1.5100, generating a sterling sum of
$1.5342/$1.5100 x £1 = £1.016. This £1.016 could then be used to repay the £1.012, generating
a profit = £1.012 - £1.016 = £0.004.
Therefore, in order to prevent these arbitrage opportunities arising, the spot and forward exchange
rates must be linked by the interest rate parity principle or by arbitrage pricing. This is not to say,
however, that the spot rate in three months time will be the same as the three month forward rate
quoted today. The three month forward rate in this example is simply an unbiased, or
mathematically based, estimate, or the best guess, of the spot rate in three months’ time.
Premiums and Discounts

Where interest rates are higher in the base currency (£) than the quoted currency ($), a premium
between the spot and forward exchange rate is said to arise. When the opposite is true, a discount
arises.
In the above example, as a result of three month interest rates in the UK being higher than that in
the US, a premium arose. This premium was given by the difference between the spot and forward
rates of $1.5220 - $1.5157 = $0.0063, though $ premiums and discounts are usually quoted in
cents (c) rather than $s. Premiums are identified by the letters pm and discounts dis.
As premiums imply that the quoted currency will strengthen over time, premiums are deducted
from the spot exchange rate to derive the forward exchange rate whilst discounts, for the opposite
reason, are added. Market convention is for the spot rate to be quoted with the premium or
discount, rather than for the forward rate to be quoted.
So, if the spot rate is $1.5220 - $1.5226 and a three month premium of 0.63c - 0.57c is quoted then
the three month forward exchange rate will be:
Spot exchange rate $1.5220 - $1.5226

3 months forward 0.63c - 0.57c pm
3 month forward exchange rate $1.5157 - $1.5169

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3. International Fisher Effect

The Fisher Effect states that nominal interest rates (R) in an economy fully reflect expected inflation.
Extending this to the international economy, the International Fisher Effect states that in a world of
perfect capital mobility, nominal interest rates (R) should take full account of expected inflation rates
(ei) so that real interest rates (r) are equal worldwide. Any differences that existed would be
arbitraged away.
We know from Chapters 1 and 2 that:
Real interest rate (r) = [1 + nominal interest rate (R)] -1

[1 + inflation rate (i)]
So, changing actual inflation (i) to expected inflation (ei) and moving the -1 from the right to the left
of the equation, gives:
1+r=1+R
1 + ei
(Note: rearranging this equation to 1+R=(1+r)(1+ei) gives the Fisher Effect)
If 1 + ruk = 1 + rus
Then, the International Fisher Effect = 1 + Ruk = 1 + Rus

1 + eiuk 1 + eius
Example
If inflation is expected to be 4% in the UK and 3% in the US, given a nominal rate of interest of 6%
in the UK, calculate the nominal rate of interest in the US.
Solution
1 + Ruk = 1 + Rus
1 + eiuk 1 + eius
So, 1 + Rus = [(1 + Ruk) x (1 + eius)]/(1 + eiuk) = (1.06 x 1.03)/1.04
So Rus = 1.05 - 1 = 5%
Although the International Fisher Effect cannot be directly employed to act as an exchange rate
estimating mechanism, it does act as a link between the other two parity relationships covered
above. PPP provides the theoretical long term spot exchange rate based on inflation differentials
whilst interest rate parity establishes the relationship between spot and forward exchange rates
based on nominal interest rate differentials.
The International Fisher Effect links the PPP inflation differential with the interest rate parity
interest rate differential by stating that if real interest rates are equal worldwide then the inflation
differential must equal the nominal interest rate differential between the two countries.
This can be seen by rearranging 1 + Ruk = 1 + Rus to:

1 + eiuk 1 + eius

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1 + eius = 1 + Rus
1 + eiuk 1 + Ruk
As interest rate parity expresses the relationship between the forward and spot exchange rate as
F£/$ = S£/$ x [(1 + R$)/(1 + R£)], this suggests that the forward exchange rate can be arrived at
by either employing expected inflation rate or interest rate differentials. It also implies that there is
a negative correlation between exchange rate movements and fixed interest securities, as yields are
closely linked to interest rates and inflation. Similarly, the relationship between the future and
current spot rate can be derived by employing either variable.
However, just as PPP has its shortcomings so does the International Fisher Effect, principally
because real interest rates worldwide are not equal due to:
1. Short term nominal interest rates being set by national central banks, not markets.
2. Different countries employing different methods of calculating inflation.
3. Impediments to international capital mobility.
4.4 Hedging Foreign Currency Exposure

LEARNING OBJECTIVES
5.4.4 Know the mechanisms through which currency
exposure can be hedged
There are many benefits to investing in overseas assets, particularly overseas equities, owing to the
positive diversification effects that result from:
i. The generally low correlation of overseas equity returns to UK equity returns.
ii. Economic cycles not being synchronised worldwide.
iii. Exposure to industries that are not well represented in the UK.
Exchange rate gains can be also be made.
Against this, however, must be weighed potential disadvantages. These include:

i. Political risks.
ii. Difficulty in accessing information.
iii. Possible exchange controls.
iv. High transaction costs.
v. Exchange rate losses.
The one common denominator is currency risk. Currency risk can either augment or detract from
the return generated by the asset.

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Example
A £100 is invested in US equities at a spot exchange rate of $1.50. Over the next year the
investment increases in value by 10%. Calculate the annual return in sterling terms, if the dollar
based investment is converted back into sterling at a spot exchange rate of:
a. $1.40
b. $1.70
Solution
In dollar terms the investment has grown to $150 x 1.1 = $165
a. $165/1.40 = £117.86. Therefore, the annual return = [117.86/100] - 1 = 17.86%
b. $165/1.70 = £97.06. Therefore, the annual return = [97.06/100] - 1 = -2.94%
Example
The price of an internationally-traded commodity is rising at 5% per annum in the UK, and 2% per
annum in the USA. The spot exchange rate in one year's time is expected to be 1.00/1.61
(GBP/USD). If purchasing power parity holds, what is the current spot exchange rate?
Solution
a. If the commodity's value in USD is expected to rise by 2% per annum, then it's current value will
be (100-2 = 98%) of the 1.61 USD ie, 0.98 x 1.61 = 1.5778 USD.
b. If the commodity's value in GBP is expected to rise by 5% per annum, then its current value will
be (100-5 = 95%) of 1.00 ie, 0.95 x 1.00 = 0.95 GBP.
c. This means 0.95 GBP will give 1.5778 USD or using standard convention 1.00 GBP will give
(1.5778 x 1.0 / 0.95 ) = 1.6608 USD.
So the current spot exchange rate would be: 1.00/1.66 (GBP/USD).
Foreign currency risk can be reduced, though not completely eliminated, by employing the
following hedging instruments or strategies:
1. Forward contracts.
2. Back-to-back loans.
3. Foreign currency options.
4. Foreign currency futures.
5. Currency swaps.
Concluding comments
Exchange rate forecasting is an inexact science despite the existence of parity relationships and
advances in forecasting techniques. Although when investing overseas, currency hedging should be
considered, like any other form of hedging, the result is usually imperfect. Depending on the
method adopted, hedging strategies can also be costly to devise, time consuming and sometimes
inflexible. Indeed, research suggests that on balance hedging should be used when investing in
overseas bonds but generally avoided when investing in a diversified portfolio of overseas equities
denominated in a variety of currencies.

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ACCOUNTING
1.
2.
3.
4.
BASIC PRINCIPLES
BALANCE SHEET
THE INCOME STATEMENT
THE CASHFLOW STATEMENT
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214
224
229
5. CONSOLIDATED COMPANY REPORTS AND ACCOUNTS 233

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1. BASIC PRINCIPLES
1.1 Introduction
Accounting is the recording, measuring and reporting of economic events, or activities, to
interested parties in a readily useable form. The need for accounting information was stimulated by
the emergence of the limited liability company in the 19th Century and the resulting separation of
ownership and control. However, although companies initially provided accounting information to
satisfy the informational needs of their shareholders and creditors, the form this information now
takes and the way in which it is communicated must also meet the disparate informational needs of
other parties with a legitimate interest in the company’s activities, performance and financial
position. These other users include prospective investors, employees, financial analysts, institutional
investment committees, as well as governmental, consumer and environmental groups.
It is recommended that you obtain a set of company report and accounts, as these will assist your
understanding of this chapter and of Chapter 7.
1.2 The Form and Content of Company Accounts
LEARNING OBJECTIVES
6.1.1 Know the legal requirements to prepare accounts and
the differences between private and public company
requirements
6.1.2 Know the fundamental accounting bases upon which company
accounts are prepared (concepts of entity, going concern, prudence,
matching, consistency and historic cost)
6.1.3 Know the function of the Accounting Standards Board (ASB) and
International Accounting Standards Board (IASB)
6.1.4 Know the purpose of the International Financial Reporting
Standards (IFRSs)
6.1.5 Understand the purpose of the auditors' report and the reasons
why reports are modified
Under the Companies Acts, the directors of a company are legally 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. An accounting period typically spans a 12 month period.
These financial statements and disclosures include the following:

1. A balance sheet. This provides a snapshot of the company’s financial position as at the company’s
accounting year end by summarising the assets it owns and how they are financed at this one
point in time.
2. An income statement. This statement summarises the trading activities, or revenue transactions,
that have been undertaken by the company over its accounting period. Revenue transactions
differ from capital transactions in that the latter represent capital expenditure that seeks to
enhance the operational capacity of the business rather than the company’s immediate trading
position.

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The income statement links the company’s previous balance sheet with its current one. This
relationship is depicted below.
COMPANY BS1 BS2

FOUNDED
REVENUE TRANSACTIONS REVENUE TRANSACTIONS
Income statement1 Income statement2
Accounting period 1 Accounting period 2
Figure 1: Income Statements
3. Comparative figures from the previous year’s financial statements and explanatory notes to
accompany individual balance sheet and income statement items.
4. Disclosure of the company’s accounting policies, or the basis on which the accounts have been
prepared.
5. A directors’ report. Amongst other things, the directors’ report outlines the company’s principal
activities and how each has performed over the accounting period. For example, it details any
significant changes made to its fixed assets, ie, those it intends to retain in the business, and lists
the names of its directors and any interests each has in the company.
The amount of information contained in the company’s report and accounts and the requirement
for its independent verification, or audit, depends upon whether the company is categorised by the
Companies Acts as being:
1. A small, medium or larger private limited company (ltd), or
2. A public limited company (plc).
To qualify as either a small or medium sized private limited company, at least two of the following
three size criteria must not have been exceeded in the current and preceding accounting period:
Small Medium
Turnover £5.6m £22.8m
Total assets £2.8m £11.4m
Average number of employees 50 250
If a company qualifies as either a small or medium sized company over two successive accounting
periods, then it will automatically qualify as such in the accounting period that immediate follows.

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Small and medium sized private limited companies necessarily have less onerous reporting
requirements placed upon them than their larger counterparts. In addition, those small companies
with a turnover not exceeding £5.6m and assets not valued at more than £2.8m are not subject to
an independent audit of their accounting information or required to publish an accompanying
auditors’ report. The auditors’ report is considered below.
However, those companies that do not meet the Companies Acts small private limited company
criteria must, in addition to the other information detailed above, also publish a cash flow statement
within their annual report and accounts. This financial statement identifies how a company’s
financial resources have been generated over the accounting period and how they have been
applied, or expended. The Companies Acts also require explanatory notes to the cash flow
statement to appear in the company’s accounts.
Additional Reporting Requirements for Listed Companies

In addition to the above requirements laid down by the Companies Acts, companies with a full LSE
listing, regardless of size, must also incorporate the following within their annual report and
accounts:
1. A statement of changes in equity. This financial statement details all profits made and losses
incurred by the equity holders of the company over the accounting period, whether realised or
not. It also reflects any dividends paid to the shareholders during the period. Since dividends paid
to shareholders are an appropriation of profit rather than an expense against profit, dividends
paid are not reflected in the income statement, but in the statement of changes in equity.
Accounting standards allow the details to be presented as a ‘statement of recognised income and
expenses’ instead of a full statement of changes in equity.
2. An operating and financial review (OFR) for reporting years beginning on or after 1 April 2005.
This provides a narrative on the company’s performance and prospects consistent with the
company’s accounts.
3. Additional disclosures required under the UKLA’s Listing Rules. You may recall, from Chapter 3,
that one of these is whether the company has complied with the Code of Best Practice in
discharging its corporate governance responsibilities during the accounting period and, from
Chapter 4, whether the company has issued shares or warrants to investors other than its
ordinary shareholders, following the passing of a special resolution.
Many listed companies voluntarily provide additional information about their strategy, business
performance and financial management. These are encapsulated in a Chairman’s statement, a Chief
Executive’s Review and a Finance Director’s Report, respectively. Some now also provide a detailed
environmental report of their activities.
Listed companies must also publish a half yearly, or interim, set of report and accounts. Apart from
not being subject to a full independent audit, they do not contain as much information about the
company’s activities as the annual report and accounts.

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Accounting Regulations
The form and content of all company financial statements and their respective disclosures are
prescribed by the Companies Acts and mandatory accounting standards set by the accountancy
profession. The latter comprise Statements of Standard Accounting Practice (SSAPs) and Financial
Reporting Standards (FRSs) for unlisted UK companies. The setting of SSAPs was originally the
responsibility of the Accounting Standards Committee (ASC). However, the ASC was superseded
by the Accounting Standards Board (ASB) in 1990, whose role it has been to review and issue
accounting standards as FRSs, rather than SSAPs, on behalf of the Financial Reporting Council (FRC).
Today, SSAPs coexist with FRSs with some SSAPs having been replaced with FRSs.
International Accounting Standards Board (IASB)

The international standard setting board aims to standardise the way accounts are presented
regardless of the country in which they are produced. The International Accounting Standards
Board was formed in 2001 to replace its predecessor the International Accounting Standards
Committee (IASC), set up in 1973.
The IASB issues the International Financial Reporting Standards (IFRS). Many of these standards
were previously known as International Accounting Standards (IAS). However, in April 2001, the
IASB changed the naming convention. Although new IAS are no longer published, they are still used
if they have not been replaced by an IFRS.
Some countries such as Australia, European Union, Russia and Turkey have already adopted the
IFRS. Although the USA still has its own standards, it is working to harmonise these with the
international standards.
Currently there are more than 100 countries which have either adopted or modified the IFRS to
become their national accounting standards.
The IASC had issued a variety of standards, each designated as an “International Accounting
Standard” (IAS 1, 2, etc), and these were inherited by the IASB in 2001. Subsequently the IASB has
issued a number of standards itself, each designated as an “International Financial Reporting
Standard” (IFRS 1, 2 etc). Collectively, IFRSs and IASs are referred to as international accounting
standards.
The main IASs and IFRSs and their application are considered throughout this chapter and Chapter
7.
In addition to accounting standards, there is a guiding principle that overrides every other in the
preparation of company accounts. This is the legal requirement under the Companies Acts for
accounts to provide a true and fair view of the company’s results and financial position. Although
not defined within the Acts, this principle allows directors to depart from mandatory disclosure
requirements and accounting regulations if failure to do so would prevent a true and fair view from
being given.

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The Main Accounting Standards
Below are some of the main international accounting standards, each of which is considered within
this chapter.
IAS 1 Presentation of Financial Statements
IAS 2 Inventories
IAS 7 Cash Flow Statements
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
IAS 10 Events after the Balance Sheet date
IAS 16 Property, Plant and Equipment
IAS 27 Consolidated and Separate Financial Statements
IAS 28 Investments in Associates
IAS 33 Earnings Per Share
IAS 36 Impairment of Assets
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
IAS 38 Intangible Assets
IAS 40 Investment Properties
IFRS 3 Business Combinations
Fundamental Accounting Bases

In general, financial statements are drawn up under the historic cost convention. This requires
assets brought into the business and transactions made by the business to be recorded at their
actual, or historic, cost so as to provide a consistent and objective basis on which to account for a
company’s activities.
In addition to applying the historic cost convention to company accounts, the Companies Act 1985
requires five fundamental accounting concepts to be applied in the preparation of the income
statement and balance sheet. These are:
1. The going concern concept. This assumes that the company will continue to trade as going
concern for the foreseeable future, unless there is evidence to the contrary. Therefore, the
balance sheet must not record assets at their liquidation values.
2. The accruals concept. This requires the accounts to reflect revenues and expenses as they are
earned and incurred. rather than when they are received and paid.
3. The prudence concept. Whilst revenues and profits must not be anticipated, foreseeable costs
and losses must be provided for within the accounts. In the event of the prudence concept
conflicting with the accruals concept, the former always prevails.
4. The consistency concept. Accounting treatments adopted in the accounts must be consistently
applied between accounting periods and between similar items.
5. Non-aggregation, or ‘no-netting off’. When determining the aggregate amount of any item, the
amount of each individual asset or liability that falls to be taken into account shall be determined
separately. For example, if a firm had two bank accounts with different banks, one with a positive
balance and another with an overdraft, they would be presented as asset and liability respectively,
rather than being deducted from one another to arrive at a single net asset or liability.

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In addition to the Companies Acts, international accounting standards also provide some guidance
on accounting concepts.
IAS 1 ‘Presentation of Financial Statements’ sets out the overall framework for presenting financial
statements including fundamental principles of going concern, consistency, accruals and materiality.
The principle of materiality is that only ‘material’ items need to be considered. Material items are
those items whose inclusion or exclusion would impact the user’s view of the accounts.
IAS 1 also states that assets and liabilities, and income and expenses may not be offset unless
offsetting is permitted or required by another international accounting standard.
The Auditors’ Report

All companies, other than those small companies detailed earlier, whose accounts are subject to a
statutory independent audit must appoint, or reappoint, an auditor at the company’s AGM to carry
out an independent assessment of the company’s accounts prepared by the directors. This audit is
concluded with an auditors report to the members, or shareholders, of the company is giving an
opinion on 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 Companies Acts
and mandatory accounting standards. If so, then an unqualified audit report is issued. If not, then the
auditor must modify the report. These modified reports fall into three categories:
1. Disclaimer of opinion, where the auditor is unable to form an opinion owing to a considerable
amount of uncertainty surrounding the outcome of a particular event, a court action against the
company for instance, or
2. Adverse opinion, where the auditor disagrees with an accounting treatment or a view made in
the statements, which the directors refuse to amend.
3. Qualification, where the auditor has material disagreement with the treatment adopted by the
directors or a material uncertainty that limits the scope of the audit opinion. In either case, the
effect of the disagreement or limit in scope is not so material to require an adverse or disclaimer
of opinion.
Medium sized private limited companies and those small private limited companies that are subject
to an audit are required to publish an abridged auditors’ report termed a special auditors’ report.

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Summary of Reporting Requirements
Reporting Private limited companies plcs

requirement Small Medium Large All
Balance sheet Yes Yes Yes Yes
Income Yes Yes Yes Yes
Statement
Directors report Yes Yes Yes Yes
Cashflow statement No Yes Yes Yes
Auditors report Special auditors Special Yes Yes
report if above auditors
certain size and report
turnover
Disclosure of Yes Yes Yes Yes
accounting policies
Explanatory notes Yes Yes Yes Yes
Comparative figures Yes Yes Yes Yes
Statement of No No No Listed
changes in plcs
equity only
Disclosures required No No No Listed
by UKLA Listed plcs
Rules only
Publishing and Filing Company Accounts

Companies are subject to strict time limits within which their report and accounts must be
published. Indeed, the Companies Acts specifically require private limited companies to publish
their financial accounts within 10 months and plcs within seven months of their accounting year end.
However, those plcs with a full LSE listing and which are, therefore, subject to the UKLA’s
continuing obligations, must publish their report and accounts within six months of their accounting
year end and produce a set of interim accounts within 90 days of the end of the half year.
These statements must be presented at the company’s AGM and filed with the Registrar of
Companies. Small and medium sized companies may file abbreviated accounts.

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2. BALANCE SHEET
2.1 Introduction
LEARNING OBJECTIVES
6.2.1 Know the purpose and main contents of the
balance sheet
The balance sheet provides a snapshot of a company’s financial position as at its accounting year
end by summarising the assets it owns and how these are financed. The balance sheet is often
described as being a photograph of the company’s financial position in that it doesn’t tell the user
anything about the company either immediately before or immediately after the balance sheet date,
only at this one point in time. The construction of the balance sheet is underpinned by the
accounting equation:
Assets = Liabilities plus Equity
This can be further expanded to:
fixed assets + current assets = current liabilities + long term borrowing +

issued share capital + capital reserves + revenue reserves.
2.2 Format
LEARNING OBJECTIVES
balance sheet
The balance sheet of A plc is shown below in a format prescribed by the Companies Acts. Although
not shown in the example, this format requires the previous year’s comparative balance sheet
numbers to be set out alongside those of the current year and for a numerical reference to be
inserted in the notes column to support explanatory notes to the various balance sheet items.

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A plc Balance Sheet as at 31 December 2006 2006
£'000
Assets
Non-current assets
Property, plant and equipment 8900
Intangible assets 2100
Investments available for sale 300
11300
Current assets
Inventories 3600
Trade and other receivab les 2600
Investments held for trading 120
Cash 860
7180
Total assets 18480
Equity and liabilities

Capital and reserves
Share capital - 50p ordinary shares 5000
Share capital - preference shares 100
Share premium account 120
Revaluation reserve 100
Capital redemption reserve 80
Retained earnings 6880
Total equity 12280
Non-current liabilities
Bank loans 2000
2000
Current liabilities
Trade and other payables 4200
4200
Total liabilities 6200
Total equity and liabilities 18480
2.3 Assets
LEARNING OBJECTIVES
6.2.2 Understand how assets are classified and valued
6.2.3 Know the difference between capitalising costs and
expensing costs
6.2.4 Know how goodwill and other intangible assets arise and are
treated
6.2.5 Be able to calculate the different methods of depreciation and
amortisation
An asset is anything that is owned and controlled by the company and confers the right to future
economic benefits. Balance sheet assets are categorised as either fixed assets or current assets.

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1. Fixed Assets
Fixed assets are alternatively called ‘non-current assets’ or ‘long-lived assets’. They are those assets
used within the business to generate revenue on a continuing basis rather than being purchased for
immediate resale. They, therefore, represent capital expenditure made by the company. Fixed
assets are categorised as either:
1. Tangible.
2. Intangible.
3. Investments.
Tangible Fixed Assets

A company’s tangible fixed assets are those that have physical substance, such as land and buildings
and plant and machinery. Tangible fixed assets are alternatively referred to as ‘property, plant and
equipment’. In accordance with IAS 16 Property, Plant and Equipment and the historic cost
convention, tangible fixed assets are initially recorded in the balance sheet at their actual cost. This
actual cost includes any additional costs directly attributable in bringing the asset into its working
condition, such as the delivery costs, installation costs, and other costs associated with financing the
purchase of the asset. Since these costs are not expensed to the income statement in the
accounting period in which they were incurred, but are included on the balance sheet as assets,
they are known as capitalised costs.
Subsequent to acquiring tangible fixed assets, IAS 16 allows a choice of accounting. Under the ‘cost
model’, the asset continues to be carried at cost. Under the alternative ‘revaluation model’ the asset
can be carried at a revalued amount, with revaluation required to be carried out at regular intervals.
However, in order to reflect the fact that the asset will generate benefits for the company over
several accounting periods, not just in the accounting period in which it is purchased, the
Companies Acts and IAS 16 require all tangible fixed assets with a limited economic life, to be
depreciated over this term. An annual depreciation charge is made to the income statement against
the carrying value, of the asset over the asset’s useful economic life. This requirement does not
necessarily apply to investment properties, which are covered by separate provisions contained
within IAS 40 Investment Properties. Investment properties are properties that are not owner-
occupied and are held to earn rentals or for capital appreciation, or both. When properties are
classified as investment properties, they are measured at fair value instead of being subjected to
depreciation charges.
To calculate the annual depreciation charge to be applied to a tangible fixed asset, the difference
between its carrying or ‘book’ value and estimated disposal value, termed the depreciable amount,
must first be established. This value is then written off over the asset’s remaining useful economic
life by employing the most appropriate depreciation method. The two most common depreciation
methods comprise:
1. The straight line method, and
2. The reducing balance method.

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The straight line method is the simplest of the two methods as it simply spreads the depreciable
amount equally over the useful economic life of the asset. The straight line method is given by the
following formula:
Straight line depreciation = (cost - disposal value)/remaining useful economic life (years)
The reducing balance method, however, employs a more complex formula:
Reducing balance depreciation % rate = [1 - {Disposal Value/Cost}1/E x 100 where E = Useful

Economic Life.
This method produces a depreciation percentage rate which, rather than being applied to the
depreciable amount, is instead applied to book value of the asset. Although this results in a higher
depreciation charge than the straight line method in the early years of the asset’s life but a lower
charge in the later years, the total amount written off over the asset’s useful economic life, the
depreciable amount, will be the same in both cases.
One thing to recognise about the annual depreciation charge though 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 as an expense in the income statement to reflect the
estimated cost of resources employed over an accounting period. The balance sheet value of the
asset is given by its book value 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 fixed asset.
Which of the depreciation methods is the more appropriate depends on the type of asset being
depreciated and its use in the business. However, as the choice of method has obvious implications
for both the reported profit and the financial position of the company, it should be chosen carefully.
The argument in favour of using the reducing balance method over the straight line method though,
is that as tangible fixed assets tend to confer the greatest benefits in the earliest years of their
employment, these should be matched by a higher depreciation charge.
The above points are best illustrated by using an example.
Example
A machine purchased for £24,500 has an estimated useful economic life of six years and an
estimated 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:
1. The straight line depreciation method.
2. The reducing balance depreciation method.
Solution
1. Straight depreciation
Straight line depreciation = (cost - disposal value)/useful economic life (years)
= (£24,500 - £1,000)/6 = £3,916.67 per annum.
The depreciation charge will be the same in years one to six.

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2. Reducing balance depreciation percentage rate
= [1 - {£1,000/£24,500}1/6] x 100 = [1- 0.5868] x 100 = 0.4132 x 100
= 41.32% applied to the reducing value of the asset per annum.
Please note, {£1,000/£24,500}1/6 can also be expressed as 6√{£1,000/£24,500}.
Summary of the annual depreciation charges and NBV of the asset
Straight line method Reducing balance method

Year Depreciation NBV (£) Depreciation NBV (£)
charge (£) charge (£)
1 3,916.67 20,583.33 10,123.40 14,376.60
2 3,916.67 16,666.66 5,940.41 8,436.19
3 3,916.67 12,749.99 3,485.83 4,950.35
4 3,916.67 8,833.32 2,045.48 2,904.87
5 3,916.67 4,916.65 1,200.29 1,704.58
6 3,916.67 998.98 704.33 1,000.25
Total 23,500.02 - 23,499.75 -
NOTE
The minor differences between the numbers resulting from the two methods are due to rounding
up the straight line depreciation charge and rounding down the reducing balance percentage rate.
Once a depreciation method has been chosen it must be consistently applied to both similar
tangible fixed assets and between successive accounting periods. The method may only be changed
in order to present a fairer view of the company’s results and financial position. A note to this effect
must be disclosed in the company’s accounts. The useful economic life of tangible fixed assets needs
to be reviewed at the end of each accounting period. If there are significant changes then the
depreciation calculation needs to be modified. This is a simple calculation whereby the initial cost of
the asset less total depreciation charged to date is then depreciated over the revised economic life.
By reducing the book value of tangible fixed assets over their useful economic lives, depreciation
broadly complies with two of the fundamental accounting concepts encountered earlier:
1. Going concern. Stating tangible fixed assets in the balance sheet at their NBV does not override
the going concern concept.
2. Accruals. The cost of the fixed asset is written off over its useful economic life as the estimated
benefits to flow from its use are received over several accounting periods, rather than solely in
the accounting period in which the expenditure was made.
In addition to depreciating fixed tangible assets, companies are also required to recognise any
permanent decline, or diminution, in the value of their fixed assets. Under IAS 36 Impairment of
Assets, the NBV of a tangible fixed asset must be written down, or written off in exceptional cases,
if its value becomes impaired. Vodafone, for example, following an impairment review, wrote down
the value of its telecom assets by £6bn in May 2002. Similarly MMO2, the former mobile telecoms
operator of the BT Group, wrote down the value of its UK and German 3G licences by £5.9bn in
May 2003, because of industry-wide delays in offering 3G services and the growing realisation that
the provision of such services will not be as profitable as was originally thought. Such write-downs,
like depreciation, are non-cash charges.

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On occasion, tangible fixed assets, such as land, are not depreciated because they are accounted for
under the ‘revaluation model’ allowed under IAS 16. The standard requires revaluations to be
carried out with sufficient regularity so that the carrying amount does not differ materially from that
which would be determined using fair value at the balance sheet date. This provides the user of the
accounts with a truer and fairer view of the assets, or capital, employed by the company. To
preserve the accounting equation, assets = liabilities plus equity, the increase in the asset’s value
arising on revaluation is transferred to a revaluation reserve, which forms part of the equity section
on the balance sheet.
Intangible Fixed Assets

Intangible fixed assets are those assets that although without physical substance, can be separately
identified and are capable of being realised. Ownership of an intangible fixed asset confers certain
rights (eg, goodwill not really intellectual property more intangible asset’s). These rights give a
company a competitive advantage over its peers and commonly include brand names, patents, trade
marks and purchased goodwill.
The accounting treatment of goodwill is detailed in IFRS 3 ‘Business Combinations’ and for other
intangible fixed assets is prescribed by IAS 38 Intangible Assets. The main provisions of these
standards are as follows:
1. Intangible fixed assets that have been purchased separately, such as brand names, are capitalised
in the balance sheet at their cost of purchase. If purchased as the result of taking over another
company, however, they can only be capitalised as a separately identifiable intangible fixed asset if
their value can be reliably measured. Otherwise their value is subsumed within purchased
goodwill. If capitalised, intangible fixed assets are accounted for like tangible fixed assets – either
under the ‘cost model’ or the ‘revaluation model’. The equivalent of depreciation of tangible fixed
assets is the ‘amortisation’ of intangible fixed assets.
2. Purchased goodwill arises when the consideration, or price, paid by the acquiring company for
the target exceeds the fair value of the target’s separable, or individually identifiable, net assets.
This is not necessarily the same as the book, or balance sheet, value of these net assets:
purchased goodwill =
(price paid for company - fair value of separable net tangible and intangible assets)
Purchased goodwill is capitalised in the balance sheet and IFRS 3 then requires it to be held on
the balance sheet and not subjected to regular amortisation charges. Instead, goodwill should be
subjected to impairment reviews at least annually.
3. Intangible fixed assets that have been created internally by the company rather than being
acquired, such as brand names, customer lists and the like, tend not to be capitalised in the
balance sheet because their cost cannot be distinguished from the cost of developing the business
as a whole.
However, certain costs incurred by the company, rather than being written off against the
company’s revenue in the income statement in the period in which they were incurred, can instead
be capitalised as intangible fixed assets if it can be shown that a future benefit will arise from the
expenditure. So as to meet with the accruals concept, this capitalised cost is then matched against
the company’s revenue in subsequent accounting periods in line with the estimated flow of the
expected future benefits to arise from the capitalised asset. Most notable amongst these is the
capitalisation of development expenditure. Development expenditure is that made on the
application of technical know-how that is expected to result in improved products or processes and
ultimately increased profits for the company.

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Although any expenditure devoted to research must be written off in the accounting period in
which it is incurred, IAS 38 permits development expenditure to be capitalised after technical and
commercial feasibility of the resulting product or service have been established.
Fixed Asset Investments

Fixed asset investments are typically long term investments held in other companies. They are
initially recorded in the balance sheet at cost, and then subsequently revalued to their fair value at
each period end. Any gains or losses are reflected directly in the equity section of the balance sheet
and disclosed in the statement of changes in equity. However, if they suffer an impairment in value,
then such a fall is charged to the income statement.
As detailed later in this chapter, if the shareholding represents at least 20% of the issued share
capital of the company in which the investment is held, or if the investing company exercises
significant influence over the management policies of the other, then the investing company is
subject to additional reporting requirements.
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 are, therefore, known as revenue items and include stocks
of goods, the debtor balances that arise from the company providing its customers with credit and
any short term investments held. Current assets also include cash balances held by the company
and pre-payments. Current assets are listed in the balance sheet in descending order of liquidity and
typically appear in the balance sheet at the lower of:
1. Cost, or
2. Net realisable value (NRV).
IAS 2 ‘Inventories’ expands upon this principle in relation to individual and groups of similar items of
stock and work in progress held by the company. IAS 2 requires stock and work in progress to be
stated in the balance sheet at the lower of:
1. Cost, defined as the cost of purchase plus any conversion costs incurred in bringing the stock
item to its present location and condition, or
2. NRV, defined as the estimated selling price of each stock item less any further costs to be
incurred in both bringing the stock, work in progress or raw materials into a saleable condition
including any associated selling and marketing costs.
Therefore, if for reasons such as obsolescence, the NRV of the stock has fallen below cost, the item
must be written down to this NRV for balance sheet purposes.
Determining what constitutes cost should be relatively straightforward unless the company
purchases vast quantities of stock in different batches throughout its accounting period making the
identification of individual items or lines of stock particularly difficult when attempting to match
sales against purchases. In such instances, cost can be determined by making an assumption about
the way stock flows through the business. Companies can account for their stock on one of three
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1. First in first out (FIFO). FIFO assumes that the stock first purchased by the business is the first to
be sold. Therefore, the value of the closing stock at the end of the accounting period is given by
the cost of the most recent stock purchased. This produces a closing stock figure in the balance
sheet that closely resembles the current market value of the stock. It also results in the highest
reported profit figure of the three bases in times of rising prices.
2. Last in first out (LIFO). LIFO assumes that the most recent stock purchased by the company is
the first to be sold. IAS 2 does not permit the use of LIFO since, in times of rising prices, the
balance sheet value of closing stock will be that of the stock first purchased and will, therefore,
not resemble current prices. It also produces the lowest reported profit figure of the three bases.
3. Weighted average cost (AVCO). AVCO values closing stock at the weighted average cost of stock
purchased throughout the accounting period. This method produces a closing stock figure and a
reported profit between that of the FIFO and LIFO methods.
Again, these points are best illustrated by the use of an example:
Example
Z Ltd has started trading in electronic calculators. At the end of its first accounting period, Z Ltd
had sold 1,500 calculators having purchased 1,750 calculators in two batches. In drawing up its
accounts, Z Ltd applies the principles of IAS ‘Inventories’ to the calculators and accounts for its
stock of calculators on a FIFO basis. At the end of the accounting period, it is estimated that the
NRV of the stock of calculators is £1,350.
Stock of calculators Number of Cost of Cost of Sales price

calculators purchase per conversion per per
calculator (£) calculator (£) calculator (£)
Opening stock - - -
Batch 1 costs of purchase 1,000 4 1
Batch 2 costs of purchase 750 5 1
Stock sold (1,500) - 8
Closing stock 250 - -
In relation to the above data, what is the value of the closing stock of calculators?
Solution
Under IAS 2, closing stock is valued at the lower of cost or NRV. As the stock is accounted for on a
FIFO basis, the closing stock of 250 calculators if valued at cost = [(£5 x 250) + (£1 x 250)] =
£1,500. However, as the NRV is lower at £1,350, the balance sheet value will be £1,350.
NOTE
If the stock had been accounted for on a LIFO basis, the closing stock of 250 items would have had
a balance sheet value of [250 x (£4 + £1)] = £1,250, as this cost is lower than the NRV.
We will return to IAS 2 when looking at the income statement.

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2.4 Liabilities
LEARNING OBJECTIVES
6.2.6 Know how liabilities are categorised
A liability is a present obligation to transfer future economic benefits as a result of past transactions
or past events. Liabilities are categorised according to whether they are to fall due within or more
than one year:
1. Current liabilities. This balance includes the amount the company owes to its suppliers, or trade
creditors, as a result of buying goods and/or services on credit, any bank overdraft and any
dividends and/or tax payable within 12 months of the balance sheet date.
2. Non-current liabilities or long-term liabilities. This comprises the company’s borrowing not
repayable within the next 12 months. This could include debentures and/or loan stock issues as
well as longer term bank borrowing.
In addition, IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ creates a separate
heading for provisions that have resulted from past events or transactions and for which there is an
obligation to make a payment, but the exact amount or timing of the expenditure has yet to be
established. Such provisions may arise as a result of the company undergoing a restructuring for
example. Given the uncertainty surrounding the extent of such liabilities, IAS 37 requires the
company 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.
Provisions cannot, however, be made in respect of possible but not probable, future obligations that
may arise on the occurrence of a future event: customers making claims on goods sold with
warranties for instance. Given the unpredictable nature of these so-called contingent liabilities, the
company’s potential liability and the uncertainties surrounding this, where quantifiable, are instead
disclosed by way of a note in the accounts.
2.5 Equity
LEARNING OBJECTIVES
6.2.7 Understand the difference between authorised and
issued share capital and capital reserves and revenue
reserves
CALLED UP SHARE CAPITAL

This is the nominal value of equity and preference share capital the company has in issue. This may
differ from the amount of share capital the company is authorised to issue as contained in its articles
of association.

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CAPITAL RESERVES
Capital reserves include the revaluation reserve, share premium reserve and capital redemption
reserve. The revaluation reserve arises from the upward revaluation of fixed assets, both tangible
and intangible, the share premium reserve from issuing shares at a price above their nominal value
whilst the capital redemption reserve is created when a company redeems, or buys back, its shares
and makes a transfer from its revenue reserves to its capital reserves equal to the nominal value of
the shares redeemed. Capital reserves are not distributable to the company’s shareholders as apart
from forming part of the company’s capital base, they represent unrealised profits, though, as
suggested in Chapter 4, they can be converted into a bonus issue of ordinary shares.
RETAINED EARNINGS
Retained earnings is a revenue reserve and represents the accumulation of the company’s
distributable profits that have not been distributed to the company’s shareholders as dividends, or
transferred to a capital reserve, but have been retained in the business. You should not confuse this
balance 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.
You may recall, from earlier in this chapter, that the income statement reconciles the movement
between successive balance sheets. However, in some instances this may also require the inclusion
of the statement of changes in equity.
2.6 Events After the Balance Sheet Date

LEARNING OBJECTIVES
6.2.8 Know what contingent liabilities and post balance
sheet events are
IAS 10 ‘Events after the Balance Sheet date’ provides for when there have been significant
developments in the company’s fortunes between the balance sheet date and the directors
approving and signing the accounts. If the development materially affects an item already recorded
in the balance sheet, this is termed an adjusting event as the item in question must be adjusted to
reflect this development: the impact of the liquidation of a major debtor on the debtors balance at
the balance sheet date for example. However, when a significant development does not directly
impact the pre-existing balance sheet, this is known as a non-adjusting event as only a note outlining
the nature and impact of the event on the post balance sheet financial position of the company is
required to be disclosed in the accounts.
2.7 Assessing the Balance Sheet

The balance sheet is constructed on the basis of the accounting equation, assets = equity plus
liabilities, as at one particular point in time: the accounting year end. However, neither the balance
sheet total of a company’s assets nor its equity represent the market value of the company at this
or any other point in time. This can only be ascertained from the company’s market capitalisation,
or the market value of its shares in issue, if traded.

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The construction of the balance sheet is a mixture of:

1. Historic cost;
2. Modified historic cost; and
3. Accruals.
Although assets are brought into the balance sheet at their actual or historic cost, this book value is
modified for fixed assets as a result of their revaluation, impairment, depreciation and amortisation
and for current assets if their NRV falls below cost. Moreover, the balance sheet does not account
for that most valuable of company assets - the knowledge, skills and loyalty of a company’s
employees - even though this intangible asset can make the difference between a company success
or failure.
As for liabilities, subjective provisions often need to be made for future expenditure whenever
uncertainty surrounds the exact extent of a company’s obligation to an outside party.
Therefore, great care must be taken when assessing and evaluating a company’s balance sheet. This
we consider further in Chapter 7.
3. THE INCOME STATEMENT
3.1 Introduction
LEARNING OBJECTIVES
income statement
The income statetment summarises the company’s revenue transactions over the accounting
period to produce a profit or a loss. As a result, the income statement is often referred to as the
profit and loss account. However, being constructed on an accruals, rather than a cash basis, profit
must not be confused with the company’s cash position.
The two specific functions of this financial statement are to:

1. Detail how the company’s reported profit was arrived at, and
2. State how much profit has been earned and how it has been distributed. The amount of profit
earned over the accounting period will impact the company’s ability to pay dividends and its
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3.2 Format
LEARNING OBJECTIVES
income statement
Like the balance sheet, the format of the income statetment is governed by the Companies Acts
and its construction underpinned by accounting standards. An example income statement and the
related statement of changes in equity for A plc is shown below. As with the balance sheet,
comparative numbers and explanatory notes must be provided.
A plc Income Statement for the year end 31

December 2005
2005
£'000
Revenue 9500
Cost of sales (7000)
Gross profit 2500
Distribution costs (110)
Administrative expenses (30)
Operating profit 2360
Exceptional loss (260)
2100
Income from fixed asset investments 30
Interest receivable 90
Interest payable (230)
Profit before taxation 1990
Taxation (555)
Net income 1435
Earnings per share (pence) 14.3p
A plc Statement of chang es in equity for the year ended 31 December 2005
Ord Pref Share Capital

Share Share premium Revaluation redemption Retained
Capital Capital account Reserve reserve earnings Total
As at 1 January 2005 4470 100 0 0 80 5880 10530
Gain on revaluation 100 100
Issue of shares 530 120 650
Net income for the
year 1435 1435
Preference dividends
paid -5 -5
Ordinary dividends
paid -430 -430
As at 31 December
2005 5000 100 120 100 80 6880 12280
It is important to understand how each of the above levels of reported profit are derived.

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3.3 Profit
LEARNING OBJECTIVES
6.3.2 Know the basic concepts underlying revenue
recognition
6.3.3 Know how expenses, provisions and dividends are
accounted for
6.3.4 Be able to calculate the different levels of profit given revenue and
different categories of cost
6.3.5 Know the difference between revenue and reserve accounting
Gross Profit
Gross profit is calculated by deducting the cost of goods sold from revenue:
Gross profit = revenue - cost of sales
Revenue is calculated on an accruals basis and represents sales generated over the accounting
period regardless of whether cash has been received. However, since there are no prescriptive
rules as to when revenue should be recognised in the profit and loss account, this leaves scope for
subjective judgement. During the dot.com boom of the late 1990s, a number of information
technology companies generated considerable controversy by recognising revenue in their profit
and loss accounts before completing contracts for the supply of software, which subsequently failed
to be fulfilled. Many have since adopted more conservative revenue recognition policies. IAS 18
‘Revenue’ prescribes the accounting treatment for revenue arising from certain types of
transactions and events, essentially only allowing recognition of revenues when appropriate.
Cost of sales = [opening stock (if any) + purchases - closing stock]
The cost of sales is arrived at by adding purchases of stock made during the accounting period,
again by applying accruals rather than cash accounting, to the opening stock for the period and
deducting from this the value of the stock that remains in the business at the end of the accounting
period. The opening stock figure used in this calculation will necessarily be the same as the closing
stock figure that appears in the current assets section of the balance sheet from the previous
accounting period.
The above formulae are applied in the example below. This example, which employs the provisions
of IAS 2 ‘Inventories’, was used earlier in the balance sheet section.
Example
Z Ltd has started trading in electronic calculators. At the end of its first accounting period, Z Ltd
had sold 1,500 calculators having purchased 1,750 calculators in two batches. In drawing up its
accounts, Z Ltd applies the principles of IAS 2 Inventories to the calculators and accounts for its
stock of calculators on a FIFO basis. At the end of the accounting period, it is estimated that the
NRV of the stock of calculators is $1,350.

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It was established that under IAS 2 closing stock is valued at the lower of cost or NRV. As the stock
is accounted for on a FIFO basis, the closing stock of 250 calculators if valued at cost = [($5 x 250)
+ ($1 x 250)] = $1,500. However, as the NRV is lower at $1,350, the balance sheet value is
$1,350.
Given the value of the closing stock, the gross profit can be calculated.
Gross profit = turnover - [opening stock + purchases - closing stock]
Gross profit = (1,500 x $8) - [0 + (1,000 x ($4 + $1)) + (750 x ($5 + $1)) - $1,350] = $3,850
NOTE
If the stock had been accounted for on a LIFO basis, the closing stock of 250 items would have had
a balance sheet value of [250 x ($4 + $1)] = $1,250, as this cost is lower than the NRV. Therefore,
the reported profit figure would have been (1,500 x $8) - [0 + (1,000 x ($4 + $1)) + (750 x ($5 +
$1)) - $1,250] = $3,750.
Operating Profit
Operating profit is stated after deducting distribution costs and administration expenses.
Administration expenses usually include depreciation charges.
Although not shown in the above income statement, IFRS 5 ‘Non-current assets held for sale and
discontinued operations’ requires the company’s revenue and all items leading to and including the
operating profit for the accounting period to be shown in respect of the company’s continuing, or
ongoing operations, and separately for operations discontinued during the period.
Exceptional Items
IAS 1 does not actually use the term exceptional item, however the term is widely used in
accounting. Essentially, the idea behind classifying an item as exceptional is to remove the distorting
influence of any large one-off items on reported profit so that users of the accounts may establish
trends in profitability between successive accounting periods and derive a true and fair view of the
company’s results.
IAS 1 acknowledges that, due to the effects of a company’s various activities, transactions and other
events that differ in frequency, potential for gain or loss and predictability, disclosing the
components of financial performance assists in understanding that performance and making future
projections. In other words, if an item is exceptional, it should be separately disclosed.
An exceptional item could be the profit made on selling a significant fixed asset or the loss on selling
an unprofitable operation. These profits and losses only represent book profits and losses rather
than actual cash profits and losses. We will return to this point when considering cashflow
statements later in this chapter.
Exceptional profits are added to, and exceptional losses deducted from, operating profit in arriving
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Profit Before Taxation

In addition to exceptional items, net dividend income from long term investments made in other
companies, gross interest receivable as well as gross interest payable must all be accounted for on
an accruals rather than a cash paid and received basis, when moving between operating profit and
profit before taxation.
Profit After Taxation

A provisional estimate of the company’s corporation tax liability is deducted from profit before
taxation to give profit after taxation. The calculation of corporation tax is considered in Chapter 8.
Net Income
Net income is the company's total earnings or profit. In the UK it is also referred to as profit after
tax. It is calculated by taking the total revenues adjusted for the cost of business, interest, taxes,
depreciation and other expenses. The net income is the profit that is attributable to the
shareholders of the company, and is stated before the deduction of any dividends because dividends
are an appropriation of profit and are at the discretion of the company directors.
The net income is added to the retained earnings in the balance sheet and disclosed within the
statement of changes in equity. It is also within this statement that the dividends paid during the year
are deducted from the retained earnings. As we will see later in the chapter, dividends paid are also
disclosed in the cashflow statement.
Earnings Per Share (EPS)

The EPS is calculated as follows:
EPS = profit for the financial year/number of ordinary share in issue
IAS 33 Earnings Per Share standardises the calculation of EPS. This is considered in Chapter 7.
Reserve Accounting
To ensure that the income statement gives a true and fair view, certain items are not accounted for
through the income statement. Instead they are taken through ‘reserves’ and reflected in the
statement of changes in equity.
As well as dividends paid considered above, another example would be an upwards revaluation of a
tangible fixed asset. This increase in value would be reflected in the balance sheet, but not disclosed
in the income statement. It is because the asset has not actually been sold at that revalued amount,
the gain is termed unrealised and is not included in the income statement. Furthermore, because
such items are not shown in the income statement, but do impact the balance sheet assets, the way
they are accounted for is termed ‘reserve accounting’.
The following example consolidates what has been discussed.

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Example
The following figures relate to B plc for the period ended 30 June 200X.
Items £000
Revenue 5,105
Cost of sales 2,750
Administrative expenses 645
Exceptional loss 1,308
Tax 184
Ordinary Dividends paid 252
With reference to the above income statement items, what is B plc’s operating profit and net
income, respectively?
Solution
The operating profit is calculated by deducting the cost of sales and administrative expenses from
revenue. This gives $1,710,000. The net income is $623,000. This is arrived at by deducting the
exceptional loss and tax from operating profit and adding the interest receivable. Dividends do not
enter into the calculation as they are an appropriation of profit.
4. THE CASHFLOW STATEMENT
4.1 Introduction
Cash is the life blood of any business. No matter how profitable the company, an inability to
generate a sufficient amount of cash to sustain the business will compromise its chances of long
term survival.
It has been mentioned on several occasions that profit is not the same as cash since profit is arrived
at through the use of accruals, rather than cash, accounting. Indeed, neither the most recent
balance sheet nor income statement provide a clear indication of the impact events or transactions
recorded in these statements have on the company’s cash position. Only when the most recent
balance sheet is compared to that for the previous accounting period is some indication provided.
Therefore, in order to establish whether the company has been cash generative or not, IAS 7
‘Cashflow Statements’ requires companies to produce a cashflow statement.
Cashflow statements seek to identify how a company’s cash has been generated over the
accounting period and how it has been expended. They are constructed by:
1. Removing accruals, or amounts payable and receivable, from the income statement so that these
amounts may be accounted for on a cash paid and received basis.
2. Adjusting for balance sheet items such as an increase in the value a company’s stock or debtors
or a decrease in creditors, all of which increase reported profit but do not impact cash.
3. Adding back non-cash items, such as depreciation charges, amortisation and book losses from the
sale of fixed assets, whilst deducting book profits from fixed asset disposals recorded in the
income statement, which impact recorded profit but not the company’s cash position.
4. Bringing in changes in balance sheet items that impact the company’s cash position, such as
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The Cashflow Statement for A plc, based on the IAS 7 format, is given below. Although not shown,
explanatory notes to the cashflow statement and comparatives are also required.
As not all of the effects of accruals accounting can be stripped out from a company’s operating
profit, the cashflow statement is a bit of a misnomer in that it contains a mixture of accruals, cash
and credit, or fund, flows.
Analysis of the cashflow statement shows that it is important that a company generates positive
cashflow at the operating level otherwise it will become reliant upon fixed asset sales and
borrowing facilities to finance its day-to-day operations. We will return to this point when
considering ratio analysis in Chapter 7.
A company’s survival and future prosperity is also dependent upon it replacing its fixed assets to
remain competitive. However, these assets must be financed with capital of a similar duration to the
economic life and payback pattern of the asset, otherwise the company will have insufficient funds
to finance its operating activities. The cashflow statement will also identify this.
4.2 Format
LEARNING OBJECTIVES
6.4.1 Know the purpose and main contents of the cash
flow statement
A plc Cashflow Statement for the year ended 31 December 2005

2005
Operating activities
Cash receipts from customers 4528
Cash paid to suppliers and employees (2001)
Cash generated from operations 2527
Tax paid (440)
Interest paid (150)
Net cash from operating activities 4464
Investing activities
Interest received 80
Dividends received 40
Purchase of fixed assets (1890)
Proceeds on sale of investments 120
Net cash used in investing activities (1650)
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 2829

Cash and cash equivalents at the beginning of the year 425
Cash and cash equivalents at the end of the year 3254

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Note that the amounts applied to the interest paid and received items may differ from their
respective income statement totals. If the income statement total for interest payable were
£230,000, and the actual interest paid was £150,000, this is £80,000 less than the income statement
total. This implies that £80,000 has been accrued at the balance sheet date.
Example
Why should the interest payable in the income statement be recorded as £220,000 whilst the
interest paid in the cashflow statement only equals £100,000?
Because £120,000:
A. has yet to be paid by the company
B. is owed to the company
C.has been capitalised
D.is to be written off
Solution
A. The income statement applies the accruals concept when accounting for interest payments
whilst the cashflow statement uses cash accounting. Therefore, the £120,000 difference is an
accrual of interest due to be paid by the company. If the interest had been capitalised it would have
appeared as a payment in the cashflow statements and as an asset in the balance sheet. Write-offs
occur on items that are receivable rather than payable.
4.3 Calculating Net Cashflow from Operating Activities

LEARNING OBJECTIVES
6.4.2 Be able to calculate net cash flow from operations
from operating profit
In order to establish the cash generated from operating activities figure in the cashflow statement -
essentially the company’s operating cashflow - IAS 7 allows one of two alternative presentations on
the face of the cashflow statement. The preferred method is the direct method (shown in the
above example) where the cash received from customers and paid to suppliers and employees are
shown. Alternatively, the indirect method is where a reconciliation is shown between the
company’s income statement’s operating profit and the cash generated from operations in the
cashflow statement. This reconciliation requires the following adjustments to be made to the
operating profit figure:
1. Non-cash charges such as the depreciation of tangible fixed assets and the amortisation of
intangible assets must be added back as these do not represent an outflow of cash.
2. Any increase in debtors or stock or decrease in short term creditors over the accounting period
must be subtracted as these all increase reported profit but do not increase cash.
3. Any decrease in debtors or stock or increase in short term creditors over the accounting period
must be added as these all decrease reported profit but do not decrease cash.

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Example
Given the income statement and balance sheet items below, how can the cash generated from
operations figure of £2,527,000 in XYZ plc’s cashflow statement be reconciled with XYZ plc’s
operating profit of £2,360,000?
£000
Depreciation 62
Goodwill amortisation 17
Increase in stock 12
Decrease in debtors 77
Increase in creditors 23
Solution
£000
Add: Depreciation 62
Add: Goodwill amortisation 17
Subtract: Increase in stock (12)
Add: Decrease in debtors 77
Add: Increase in creditors 23
Net cash inflow from operating activities 2527

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4.4 Interpreting Company Accounts
“Recessions catch what the auditors miss”
J K Galbraith
Although the limitations of the three principal accounting statements - the balance sheet, income
statement and cashflow statement - have already been considered, the fraudulent accounting of
activities at Enron and WorldCom further highlights the need to exercise caution when interpreting
information contained in company accounts. Turning to the WorldCom debacle, for instance, in an
attempt to flatter its bottom line and in flagrant breach of US GAAP (Generally Accepted
Accounting Practice), the company capitalised US$3.8bn of expenses in its balance sheet rather than
charging them to its income statement.
In the UK, despite the need to comply with the Companies Acts and mandatory accounting
standards, a certain amount of subjectivity is attached to the numbers appearing in audited company
accounts. In particular, the debate surrounding revenue recognition, the capitalisation of costs in the
balance sheet along with the many and various ways in which a company’s earnings can be
calculated and presented (this is detailed in Chapter 7) has confirmed the view held by many that
accounting is more of an art than a science.
The impact of what is generally considered to be a deterioration in the quality of corporate

reporting, at a time when the corporate community has come under greater scrutiny following a
number of corporate governance abuses, has been to undermine investor confidence in company
accounts which in turn has sparked a number of dramatic reforms throughout the accounting
industry.
5. CONSOLIDATED COMPANY REPORT AND

ACCOUNTS
5.1 Introduction
If company A has less than a 20% holding in the voting share capital of company B and does not
exercise any significant influence over the operating policies of company B, then this investment is
recognised in company A’s balance sheet as either a:
1. Fixed asset investment at cost less any impairment to its value, or as a
2. Current asset at the lower of cost or NRV. In this instance NRV is the current market value.
In both cases, any dividends received would be taken to the profit and loss account in arriving at
profit on ordinary activities before taxation.
If, however, this shareholding represents at least 20% of company B’s voting capital or company A
is in a position to exert considerable influence over company B’s management, then company A is
required to show the position of the combined entity in its balance sheet and profit and loss
account.

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5.2 Subsidiaries
LEARNING OBJECTIVES
6.5.1 Know the basic principles of accounting: Associated
Companies; Subsidiaries
When a company controls another company, it is known as a parent company with a subsidiary. The
controlled entity is called the subsidiary company, and the controlling entity is called its parent (or
the parent company). The most common way that control of a subsidiary is achieved is through the
ownership of shares in the subsidiary by the parent. These shares give the parent the necessary
votes to determine the composition of the board of the subsidiary and so exercise control. This
gives rise to the common presumption that owning more than 50% of the shares is enough to
create a subsidiary.
A subsidiary may itself have subsidiaries, and these, in turn, may have subsidiaries of their own. A
parent and all its subsidiaries together are called a group of companies. To account for its control, a
parent company is required to present ‘group accounts’ that amalgamate the assets and liabilities of
the parent with those of its subsidiary companies. These accounts are alternatively termed
‘consolidated accounts’, and by amalgamating the assets and liabilities, the shareholders of the
parent are clearly able to see all of the resources the group controls, and the liabilities the group
owe to others.
The vast majority of listed companies are parent companies that control one or more subsidiary
companies. As a result, listed companies present group accounts to their shareholders.
As stated above, a subsidiary is established when the parent company controls more than 50%. In
instances where the parent has greater than 50%, but less than 100% of the shares of the
subsidiary, the remaining shares are owned by persons other than the parent and are known as the
‘minority interests’.
The percentage of the net income that is owned by the minority shareholders are shown as a
deduction at the foot of the group income statement. A similar adjustment is also made at the base
of the group balance sheet as a separate entry within equity for the minority interests.
5.3 Equity Method of Accounting

IAS 28 ‘Investments in Associates’ prescribes the accounting treatment for fixed asset investments
held in other companies where there is a 20% to 50% shareholding or the investing company
participates in or exercises a significant influence over the management of the other company.
The company in which the shareholding is held is known as an associate company and the method
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The equity method of accounting requires that if A has a 30% shareholding in B, for instance, then:
i. 30% of company B’s post acquisition operating profit, interest payable, interest receivable and
tax is added to company A’s respective income statement items in the consolidated income
statement. Any dividends received by A from B do not, however, enter the consolidated income
statement.
Company B’s post acquisition profits are those that arise after A has taken a stake in B as an
associated company.
ii. 30% of the value of company B’s net assets and the value of any purchased goodwill that arose
on making this investment in company B would appear in the consolidated balance sheet.

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236
INVESTMENT
ANALYSIS
1.
2.
3.
FUNDAMENTAL AND TECHNICAL ANALYSIS
YIELDS AND RATIOS
VALUATIONS
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1. FUNDAMENTAL AND TECHNICAL ANALYSIS
1.1 Introduction
“When the facts change, I change my mind.”
John Maynard Keynes
Second guessing financial markets is not easy. However, when making investment decisions,
portfolio managers can employ a number of analytical techniques. These can be broadly categorised
as either:
1. Technical analysis, or
2. Fundamental analysis.
1.2 Technical Analysis

LEARNING OBJECTIVES
7.1.1 Know the difference between fundamental and
technical analysis
Technical analysts, or chartists, principally seek to establish price trends, whether in the broader
market or for individual securities, when making investment decisions. Adopting the mantra the
trend is your friend, chartists analyse charts of past price and volume movements and employ
mechanical trading rules to take advantage of any perceived informational advantage conveyed by
these charts.
In order to assess whether a trend has been established, technical analysts divide price movements
into three categories:
1. Primary movements;
2. Secondary movements;
3. Tertiary movements.
Primary movements are long term price trends, which can last a number of years. Primary
movements in the broader market are known as bull and bear markets: a bull market being a rising
market and a bear market a falling market. Primary movements consist of a number of secondary
movements, each of which can last for up to a couple of months, which in turn comprise a number
of tertiary, or day-to-day movements.

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PRICE
SECONDARY MOVEMENTS CHANGE IN PRIMARY
MOVEMENT
TERTIARY
MOVEMENTS
PRIMARY
MOVEMENT
TIME
Figure 1: Line Chart
Price movements can be identified and evaluated through analysing various types of chart. These
comprise:
1. Line charts, such as that depicted above, where the price of an asset, or security, over time is
simply plotted using a single line. Each point on the line represents the security’s closing price.
However, in order to establish an underlying trend, chartists often employ what are known as
moving averages so as to smooth out extreme price movements. Rather than plot each closing
price on the chart, each point on the chart instead represents the arithmetic mean of the
security’s price over a specific number of days. 10, 50, 100 and 200 moving day averages are
commonly used.
2. Point and figure charts. These record significant price movements in vertical columns by using a
series of Xs to denote significant up moves and Os to represent significant down moves, without
employing a uniform time scale. Whenever there is a change in the direction of the security’s
price a new column is started.
PRICE
C C C C X C
C C X C X 0
C C X 0 X 0
X C X 0 C 0
X 0 X
X 0 X
X 0
X
Figure 2: Point and Figure Chart

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3. Bar charts. Bar charts join the highest and lowest price levels attained by a security over a
specified time period by a vertical line. This time scale can range from a single day to a few
months. When the chosen time period is one trading day, a horizontal line representing the
closing price on the day intersects this vertical line.
PRICE
TIME
Figure 3: Bar Chart
4. Candlestick charts. Closely linked to bar charts are candlestick charts. These again link the
security’s highest and lowest prices by a vertical line but employ horizontal lines to mark both
the opening and closing prices for each trading day. If the closing price exceeds the opening price
on the day then the body of the candle is left clear, whilst if the opposite is true, it is shaded.
PRICE
TIME
Figure 4: Candlestick Chart
Technical analysis is based on the belief that although market prices at any one point in time reflect
supply and demand, it is investor psychology that drives markets. More specifically, the price at
which an investor purchases a security typically dictates the investor’s subsequent actions regarding
this investment. This is known as anchoring.

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Given that most investors are averse to making losses, the purchase price of the security is likely to
represent the minimum price at which that investor is subsequently prepared to sell the investment.
If the price of the security subsequently falls, the investor is likely to hold onto their investment until
the price recovers to its former level, at which point the investor is likely to sell. If this loss aversion
principle is applied to other investors who invested in this same security at the same price and who
also decide to sell once the price has recovered, this will have the effect of putting a ceiling on the
price of the security in the short term. Technical analysts call this the resistance level. Similarly, if a
large number of investors buy a security at a particular point in time and the price of that security
subsequently rises and a profit is taken, they may be inclined to repeat the exercise if the price then
falls back to what they originally paid for the investment. This original purchase price then creates a
floor, or a support level.
By noting the price at which high volumes of trading have occurred in a particular asset through the
analysis of price and volume charts, support and resistance levels can then be established. If a
support level is subsequently broken, this provides a sell signal whilst the breaking of a resistance
level, as the price of the asset gathers momentum, indicates a buying opportunity. These are known
as breakouts.
Technical analysts also look for breakouts from continuation patterns. These price patterns, rather
than representing a trend, indicate a consolidation of price movements. An example of a
continuation pattern is the triangle.
PRICE
BREAKOUT
TIME
Figure 5: The Triangle
Here price movements become progressively less volatile but often breakout in either direction in
quite a spectacular fashion. Other continuation patterns include the rectangle and the flag.
Chartists typically use what are known as relative strength charts to confirm breakouts from
continuation patterns. Relative strength charts simply depict the price performance of a security
relative to the broader market. If the relative performance of the security improves against the
broader market then this may confirm that a suspected breakout on the upside has or is about to
occur.

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However, acknowledging that prices do not always move in the same direction and trends
eventually cease, technical analysts also look to identify what are known as reversal patterns, or sell
signals. That is, momentum in asset prices can build up in both directions. Probably the most
famous of these is the head and shoulders reversal pattern, depicted below. A head and shoulders
reversal pattern arises when a price movement causes the right shoulder to breach the neckline,
the resistance level, indicating the prospect of a sustained fall in the price of the security. Although in
technical analysis the trend is your friend, the mantra is often suffixed with “trees don’t grow to the
sky”.
PRICE
HEAD
LEFT SHOULDER RIGHT SHOULDER
NECKLINE
TIME
Figure 6: Head and Shoulders Reversal Pattern
Although technical analysis has become quite a sophisticated art and has attracted a significant
following, it does have a number of drawbacks: principally that a trend can be interpreted in one of
a number of ways and breakouts can often prove to be false dawns.
1.3 Fundamental Analysis

LEARNING OBJECTIVES
7.1.1 Know the difference between fundamental and
technical analysis
By contrast, fundamental analysis seeks to establish the intrinsic or fundamental value of a security,
or of the broader market, principally by calculating and interpreting a wide range of yields and ratios
based on factors such as earnings and asset values as well as employing discounted cashflow (DCF)
techniques in an attempt to judge whether the security or market is correctly valued. These
techniques are considered below.
Fundamental analysis also draws on quantitative techniques. These are mathematical and statistical
techniques that seek to establish correlations between a range of variables and asset returns as well
as analyse the trade off between risk and return for different asset classes. These techniques were
introduced in Chapter 2 and are considered further in Chapter 9.

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Concluding Comments
Although the approaches adopted by technical and fundamental analysis differ markedly, they should
not be seen as being mutually exclusive techniques. Indeed, their differences make them
complimentary. Used collectively, they can enhance the portfolio management decision making
process.
2. YIELDS AND RATIOS
2.1 Introduction
The three principal financial statements and associated explanatory notes published by companies in
their annual report give a considerable amount of information. As a result, ratio analysis is
commonly used for three main reasons:
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.
However, ratio analysis does have its limitations:

1. As financial statements contain historic data, ratios are not predictive. Past performance may give
no indication of future performance particularly for research and development companies which
may, for example, make a major discovery in medicine or technology.
2. Despite accounting regulations, accounting data can be window dressed.
3. Ratios do not provide answers and are of limited value in isolation, but do prompt further
investigation.
4. Different companies within the same industry may be at different stages of building their
business. For example, a new technology company may have very high levels of debt and limited
cash flow. It may have ratios which are poor compared with more established companies in the
same industry. However, because of a culture of innovation and enterprise, it may actually
perform better and ultimately give a higher return on investment.
5. Industry averages can also be misleading as they may be based on different accounting policies.
This can be a problem when comparing industries in different countries that have different
accounting standards.
Accounting ratios can be categorised under four headings:

1. Profitability. These assess the effectiveness of a company’s management in employing the
company’s assets profitability.
2. Profit Stability. These assess the risks attached to a company’s profits, or earnings.
3. Liquidity Management. These establish, in conjunction with the company’s cashflow statement
and what is known as z-score analysis, the ability of the company to meet its liabilities as they fall
due.
4. Operational Efficiency. These analyse a company’s cost control and productivity.

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Ratios for each of these four main categories will be calculated in respect of A plc’s financial
statements produced in Chapter 6. These are reproduced at the end of this section for ease of
reference.
2.2 Profitability Ratios

LEARNING OBJECTIVES
7.2.1 Be able to calculate Return on Equity (ROE)
7.2.2 Be able to calculate Return on Capital Employed
(ROCE)
7.2.3 Be able to calculate asset turnover
7.2.4 Be able to calculate profit margin
1. RETURN ON EQUITY (ROE)

ROE = net income - preference dividends/ordinary shareholders equity x 100
[ ]
ROE = 1,435 - 5/(12,280 -100) x 100 = 11.74%
ROE measures the percentage return a company has achieved on the book value of its ordinary
shareholders’ equity. In other words the percentage return generated for its ordinary shareholders.
Note that if there are any preference shares, then the nominal value of the company’s preference
share capital is deducted from total equity to arrive at ordinary shareholders’ equity. The net
income is reduced by any preference dividends that have been paid during the period to arrive at
the net income attributable to the ordinary shareholders. Businesses that employ few tangible
assets, known as people businesses, generally have a high ROE.
2. RETURN ON CAPITAL EMPLOYED (ROCE)

ROCE = profit before interest payable and tax/capital employed x 100
ROCE = profit immediately before interest payable/(total assets - current liabilities + short term
interest bearing borrowing) x 100
For a plc: ROCE = [2,220/(18,480 - 4,200)] x 100 = 15.55%
Capital employed can also be defined as:

(total equity + non-current liabilities + short-term interest bearing borrowing)
ROCE is a key profitability measure as it provides the rate of return obtained on all sources of
finance employed by the business, not just ordinary shareholders equity. This return necessarily
includes profits and income derived from all aspects of a company’s operations. It can, therefore, be
used for the purpose of establishing trends between accounting periods and between other
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However, ROCE can be distorted by:

i. The raising of new finance at the end of the accounting period as this will increase the capital
employed denominator but will not affect the profit numerator in the equation.
ii. The revaluation of fixed assets during the accounting period as this will increase the amount of
capital employed whilst also reducing the reported profit by increasing the depreciation charge.
iii. The acquisition of a subsidiary at the end of the accounting period in the group accounts as the
capital employed in the consolidated balance sheet will increase by the net assets of the
subsidiary company less the minority interests, if any, whereas there will not be any post
acquisition profits from the subsidiary to bring into the consolidated profit and loss account.
A more detailed analysis of ROCE can be undertaken by employing two secondary ratios: asset
turnover and profit margin. Asset turnover measures how efficiently the company’s assets have
been utilised over the accounting period whilst the company’s profit margin measures how effective
its price and cost management has been in the face of industry competition. High or improving
profit margins may, of course, attract other firms into the industry, depending on the existence of
industry barriers to entry, thereby driving down margins in the long run.
The relationship between ROCE and these two secondary ratios is given by the following formula:
ROCE = asset turnover x profit margin.
Asset turnover = revenue/capital employed = 9,500/14,280 = 0.665 per annum.
Profit margin = profit per ROCE/revenue x 100 = 2,220/9,500 x 100 = 23.37%.
ROCE = asset turnover x profit margin = 0.665 x 23.37% = 15.55%.
Although the company has a low asset turnover, it has a high profit margin. This is characteristic of
companies that operate in capital intensive industries. Those in high revenue businesses, such as
food retailers, typically have low profit margins but a high asset turnover. The ROCE for a food
retailer could well be:
ROCE = asset turnover x profit margin = 7 x 2.117% = 14.82%.
ROCE, therefore, makes inter-industry comparisons possible.

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2.3 Stability Ratios
LEARNING OBJECTIVES
7.2.5 Be able to calculate financial gearing
7.2.6 Be able to calculate interest cover
Investors prefer consistent earnings growth, or high quality earnings streams, to volatile and
unpredictable earnings. The quality of this earnings stream is dependent upon whether the
company’s business is cyclical, or closely tied to the fortunes of the economic cycle. It also depends
on the level of a company’s financial gearing, or capital structure.
These ratios focus on the long-term sustainability of a company:
1. FINANCIAL GEARING
A company’s financial gearing (alternatively termed ‘leverage’) describes its capital structure, or the
ratio of debt to equity capital it employs.
From the standpoint of a company’s shareholders, although debt finance can enhance the
company’s earnings growth, being a more tax efficient and generally less expensive means of
financing than equity capital, if excessive it can also lead to an extremely volatile earnings stream,
given that debt interest must be paid regardless of the company’s profitability. Therefore, the higher
a company’s financial gearing, the higher the potential risk to its shareholders, in terms of the quality
and predictability of the company’s earnings, but the higher the potential reward assuming the
business can earn a return on this capital in excess of its cost. Financial gearing is calculated by
following formula:
Financial gearing (debt to equity ratio)
= (interest bearing debt + preference shares) x 100

ordinary shareholders equity
Preference shares are included in the numerator as preference share dividends also take priority
over the payment of equity dividends.
A plc’s debt to equity ratio = (2,000 + 100) x 100 = 17.24%

(12,280 - 100)
A company’s financial gearing can also be expressed in net terms by taking into account any cash
held by the company, as this may potentially be available to repay some of the company’s debt:
Net financial gearing (net debt to equity ratio)
= (interest bearing debt - cash + preference shares) x 100

ordinary shareholders equity

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UK plcs are generally more conservative in employing debt finance within their capital structures
than their US and continental Europe counterparts, though this does vary quite considerably across
industries. Whereas the average UK non-financial company is 50% geared, those in the US and EU
average 150% and 100% respectively.
You may recall from Chapter 4, that the recent popularity of UK companies buying back a
proportion of their ordinary shares, has had the effect of raising financial gearing levels.
2. INTEREST COVER
Shareholders and prospective lenders to the company will also be interested in the company’s
ability to service, or pay the interest on, its interest bearing debt. The effect of a company’s financial
gearing policy on the profit and loss account is reflected in its interest cover:
Interest cover = profit before interest payable and tax

interest payable
A plc’s interest cover= 2,220 = 9.65 times

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A plc’s interest payments are nearly 10 times covered by its pre-tax profits.
The higher a company’s interest cover, the greater the safety margin for its ordinary shareholders.
However, this ratio requires careful interpretation as it is susceptible to changes in the company’s
capital structure and general interest rate movements, unless fixed rate finance or interest rate
hedging is employed. The interest cover calculation should also incorporate any capitalised interest
on loans taken out to finance the purchase of fixed assets or the funding of development
expenditure, for example, if the cover is not to be overstated.
A plc’s high interest cover and its low financial gearing suggests, however, that the company has
adequate scope to raise additional loan finance without dramatically impacting its ability to service
such finance or compromise the quality of its earnings stream.

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2.4 Liquidity Management Ratios
LEARNING OBJECTIVES
7.2.7 Be able to calculate the working capital (current) ratio
7.2.8 Be able to calculate the liquidity (acid test) ratio
7.2.9 Be able to calculate debtor turnover
7.2.10 Be able to calculate creditor turnover
7.2.11 Be able to calculate stock turnover
7.2.12 Know the purpose of z score analysis
As mentioned in Chapter 6, a company’s survival is dependent upon both its profitability and an
ability to generate sufficient cash to support its day-to-day operations. More specifically, a
company’s short term, or working, capital must be sufficient to enable it to meet its liabilities as
they fall due. Working capital is defined as the sum of a company’s current assets less its current
liabilities. The working capital cycle is shown below.
INVENTORIES
PURCHASES SALES
TRADE PAYABLES TRADE RECEIVABLES
CASH
Figure 7: The Working Capital Cycle
Although a company will want to hold sufficient stock (an alternative term for inventories) to meet
anticipated demand, at the same time it must ensure that it doesn’t tie up too many resources in
this stock so as to compromise its profitability.

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1. WORKING CAPITAL RATIO

Working capital ratio = current assets/current liabilities
Given the above, generally speaking the working capital ratio should ideally be in the range 1.5 to 2
as this indicates a compromise between ensuring that a company’s current liabilities are more than
covered by its current assets whilst not tying too much of the company’s resources in assets that
detract from its profitability. Again, there are exceptions, such as food retailers, which survive on
working capital ratios as low as 0.5. This is because food retailers tend to turn their stock over at a
faster rate than they pay their creditors. To explain.
If the balance sheet value of inventories represents, say, 15 days worth of carrots for which the food
retailer receives 30 days trade credit from its suppliers, then the balance sheet value of stock at the
end of the accounting period will be half that of the trade payables balance, notwithstanding the
seasonality of the business.
A plc’s working capital ratio = 7,180/4,200 = 1.71
2. LIQUIDITY RATIO
As stock in many industries can suffer from a high rate of obsolescence and physical deterioration,
the liquidity, or acid test, ratio excludes inventories from the working capital ratio in order to
establish a company’s solvency, or ability to meet its current liabilities.
Liquidity ratio = (current assets - inventories)/current liabilities
For most industries a liquidity ratio of one is seen as the benchmark, though the food retail industry
tends towards 0.3 as a result of it generally extending shorter payment terms to its trade
receivables, such as they exist, than it receives from its trade payables.
A plc’s liquidity ratio = (7,180 - 3,600)/4,200 = 0.85
3. DEBTOR TURNOVER RATIO

If the company is to maintain sufficient working capital in the business for it to function efficiently,
then it must ensure that the average period of credit it receives from its suppliers is at least as great
as that which it extends to its customers. Sums of money receivable from customers are referred to
either as trade receivables or as ‘debtors’. Sums payable to suppliers are referred to either as trade
payables or ‘creditors’.
Debtor turnover per annum = revenues/trade receivables
A plc’s debtor turnover = 9,500/2,600 = 3.65 times per annum or 365/3.65 = 100 days.
4. CREDITOR TURNOVER RATIO

Creditor turnover per annum = cost of sales/trade payables
A plc’s creditor turnover = 7,000/4,200 = 1.67 per annum or 365/1.67 = 218 days.

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5. STOCK TURNOVER RATIO
If obsolescence or physical deterioration in a company’s stock is rapid, it must be turned over at a
similarly rapid rate.
Stock turnover = cost of sales/inventories
A plc’s stock turnover = 7,000/3,600 = 1.94 per annum or 365/1.94 = 188 days.
The example below consolidates what has been covered so far.
Example
Why would you expect the working capital ratio for a large supermarket chain to be lower than that
for a car manufacturer?
Because typically in the food retail industry, unlike in the car manufacturing industry:
I. Stock turns over at a faster rate than creditors are paid
II. Debtors turn over at a faster rate than creditors are paid
III.Stock is subject to obsolescence
IV. Low profit margins are offset by high asset turnover
A. I and II only
B. I and III only
C.II and IV only
D.III and IV only
Solution
A. In the food retail industry, the average payment period received from suppliers typically exceeds
the period during which stock is turned over by the business and the average payment period the
business gives to its trade receivables. Consequently, stock and debtors balances in the balance
sheet are relatively low in comparison to the creditors balance, giving rise to a low working capital
ratio.
Stock obsolescence is not exclusive to the food retail industry and does not explain the difference in
inter-industry working capital ratios. Although the food retail industry has low profit margins and a
high asset turnover, neither impacts directly on the working capital ratio, though the product of
these two secondary ratios provides the ROCE.
6. Z-SCORE ANALYSIS
Liquidity management ratios, when used in conjunction with a company’s cashflow statement,
provide an indication of a company’s solvency, or ability to meet its debts as they fall due. As
mentioned in Chapter 6, if a company is to remain solvent and prosper, it must be able to produce a
positive cashflow from its operating activities. However, a generally more reliable way of
establishing whether a company is dangerously close to becoming insolvent is by employing z-score
analysis.
z-score analysis is undertaken by business schools to determine the probability of a company going
into liquidation by analysing such factors as the company’s gearing and sales mix and distilling these
into a statistical z-score. If negative, this implies that a company’s insolvency is imminent.

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Other danger signals include an increased use of leased assets and an over dependence on one
customer.
2.5 Operational Efficiency Ratios

In order to quantify the operational efficiency of a company, ratios such as revenues or sales per
employee, sales per square foot of retail space and administrative expenses as a percentage of
revenues can be calculated. Many companies provide these and similar ratios, as a matter of course,
in their annual reports and accounts. In addition, many also supply details of those less tangible
factors in which they have a particularly enviable record such as employee retention and customer
loyalty.
2.6 Earnings Per Share (EPS)

LEARNING OBJECTIVES
7.2.14 Be able to calculate earnings per share (EPS)
7.2.15 Be able to calculate earnings before interest, tax,
depreciation, and amortisation (EBITDA)
The quality of a company’s earnings stream and its ability to grow its EPS in a consistent manner are
probably the most important factors affecting the price of a company’s shares, not least because
earnings provide the ability to finance future operations and the means to pay dividends to
shareholders.
The EPS formula is given by:
EPS = net income - preference dividends/number of ordinary shares in issue
A plc’s EPS = 1,435 - 5/10,000 = 14.3p
The resulting figure is known as the basic EPS.
IAS 33 ‘Earnings per share’ standardises the calculation of EPS to facilitate inter-company
comparisons. In particular, if a company has issued ordinary shares during the accounting period,
IAS 33 has a set treatment for adjusting the number of ordinary shares in the formula’s denominator
depending on whether the share issue was made as a rights issue, bonus issue or as consideration
for a company takeover.
In addition, IAS 33 requires plcs to publish on the face of the profit and loss account:
i. A comparative EPS figure for the previous accounting period, and
ii. A diluted EPS figure where the company has deferred equity shares in issue on which a dividend
has yet to be paid or any securities in issue that can potentially be converted into the company’s
ordinary shares so diluting the company’s future earnings. These include convertible preference
shares, convertible loan stock, warrants and options issued under a company share option
scheme. These options are not to be confused with traded options.

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Earnings can also be analysed before making any financial, taxation and accounting charges through
an EPS measure known as EBITDA. EBITDA is the mnemonic for Earnings Before Interest, Tax,
Depreciation and Amortisation and provides a way for company earnings to be compared
internationally as the earnings picture is not clouded by differences in accounting standards
worldwide. A common method of calculating EBITDA is as follows:
EBITDA = EBIT + Depreciation + Amortisation, where EBIT = Operating Income (or Operating
Profit)
EBITDA is used extensively as a measure of headline earnings by those telecom and technology
companies, which are loss making under conventional criteria, given the considerable amounts of
capital spending and number of takeovers many undertake. However, by not taking account of
depreciation, amortisation and tax, EBITDA provides a misleading impression of the profitability of a
business, typically producing a much larger and less volatile earnings figure than those earnings
measures discussed above. For example, for the year to 31 March 2003, MMO2 posted EBITDA of
£859m but reported a pre-tax loss of £10.2bn. In addition, the calculation of EBITDA is not
governed by any accounting standard. Moreover, whilst EBITDA is often used as a proxy for net
cash flow, it should not be used as a measure of the cash available to investors as from this cash flow
the company must service its debt, invest in capital equipment and pay corporation tax.
2.7 Price Earnings Ratio (PER)

LEARNING OBJECTIVES
7.2.16 Be able to calculate historic and prospective price
earnings ratios (PERs)
The Price Earnings Ratio (PER) provides an indication of how highly rated a company is in its ability
to grow its earnings stream. The PER formula is given by:
PER = share price/EPS
Assuming a share price of 275p, A plc’s PER = 275p/14.3p = 19.23
The higher the PER, the higher the company’s perceived EPS growth prospects. What constitutes a
high or low PER depends on the market or industry being considered.
We look at the PER in more detail in the next section.

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2.8 Dividends
LEARNING OBJECTIVES
7.2.17 Be able to calculate dividend yields
7.2.18 Be able to calculate dividend cover
Company dividends streams, like earnings streams, send out an important signal to the market
about a company’s ability to meet investors’ growth expectations. Much as when a company’s EPS
fail to meet expectations or when an earnings stream becomes unduly volatile so an erratic dividend
growth policy or a dividend cut can result in a company’s shares being de-rated by the market.
Company dividend announcements are, therefore, as keenly anticipated as their EPS
announcements. Dividends can be analysed in several ways:
i. Dividend per share (DPS)
DPS = Net ordinary dividend/ no. ordinary shares =
£430,000/
10m = 4.3p
Dividends are paid to investors net of a 10% tax credit.
ii. Dividend yield = net DPS/share price × 100 = 4.3p/275p × 100 = 1.56%
Dividend yields if grossed up can be compared with other gross income yields, such as bond
yields.
Grossed up dividend yield = grossed up net DPS/share price × 100
where the grossed up net DPS = net DPS x 100/90
For A plc, grossed up dividend yield = 4.3p x 100/90 × 100 = 1.74%
275p
During the late 1990s, dividend yields in the UK, although remaining higher than those in most
other developed equity markets, fell dramatically as a result of:
1. Tax changes made in the 1997 Budget primarily to discourage companies from making high
dividend payouts and to encourage the greater retention of earnings. That is, to encourage lower
payout ratios and higher retention ratios.
2. The greater use of share buybacks rather than dividends to return surplus cash to shareholders.
3. Share prices rising at a faster rate than dividend growth.
Whereas PERs provide a measure of EPS growth expectations, dividend yields provide an indication
of a company’s perceived ability to grow its dividends. A low dividend yield implies high dividend
growth whereas the opposite is true of a high dividend yield. However, since entering the new
millennium, UK dividend yields have returned to their historic average level of about 4% as a result
of dividends being broadly maintained by UK listed companies against the backdrop of falling share
prices.
iii. Dividend cover
The extent to which a company distributes its earnings as dividends, or reinvests them in the
business, is calculated by using the dividend cover formula.
Dividend cover = EPS/net DPS

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A plc’s dividend cover = 14.3p/4.3p = 3.32
Dividend cover can be interpreted as follows:

1. The higher the dividend cover, the greater the retention ratio and the lower the payout ratio.
2. Dividend cover indicates how sustainable a company’s dividend policy is.
For instance, if a company’s dividend cover is less than one, then the company is utilising prior
year retained earnings to pay this year’s dividend. However, if greater than one, the company’s
ability to maintain its most recent dividend, can be established by calculating the margin of
safety, given by:
(EPS - DPS)/
EPS x 100
So if A plc’s EPS fell by (14.3 - 4.3)/14.3 × 100 = 70%, its dividend could still be maintained. A
large margin of safety also indicates the ability of the company to grow its future dividends,
subject to the constraints covered in Chapter 4.
iv. The present value of the flow of future dividends. This can be used to establish the theoretical,
fundamental or intrinsic value of a share and is considered in the next section.
2.9 Price to Book (P/B) Ratio

LEARNING OBJECTIVES
7.2.19 Be able to calculate price to book ratios
The price to book (P/B) ratio measures the relationship between the company’s share price and the
net book, or asset, value per share attributable to its ordinary shareholders. Net asset values
(NAVs) are considered in more detail in the next section.
P/B ratio = share price/net asset value (NAV) per share
A plc’s P/B ratio = 275p/121.8p = 2.26
where NAV per share = assets - liabilities - preference shares/number of shares in issue
A plc’s NAV per share = (£18.48m - £6.2m - £0.1m)/10m = 121.8p per share
Growth shares, companies perceived by investors to have above average growth potential, typically
have high P/B ratios, whereas the opposite is true of those believed to have below average growth
prospects. These are known as value shares.

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A PLC’S FINANCIAL STATEMENTS
A plc Balance Sheet as at 31 December 2006 2006

£'000
Assets
Non-current assets
Property, plant and equipment 8900
Intangible assets 2100
Investments available for sale 300
11300
Current assets
Inventories 3600
Trade and other recei vables 2600
Investments held for trading 120
Cash 860
7180
Total assets 18480
Equity and liabilities

Capital and reserves
Share capital - 50p ordinary shares 5000
Share capital - preference shares 100
Share premium account 120
Revaluation reserve 100
Capital redemption reserve 80
Retained earnings 6880
Total equity 12280
Non-current liabilities
Bank loans 2000
2000
Current liabilities
Trade and other payables 4200
4200
Total liabilities 6200
Total equity and liabiliti es 18480

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A plc Income Statement for the year end 31
December 2005
2005
£'000
Revenue 9500
Cost of sales (7000)
Gross profit 2500
Distribution costs (110)
Administrative expenses (30)
Exceptional loss (260)
2100
Income from fixed asset investments 30
Interest payable (230)
Profit before taxation 1990
Taxation (555)
Net income 1435
Earnings per share (pence) 14.3p
A plc Statement of changes in equity for the year ended 31 December 2005
Ord Pref Share Capital

Share Share premium Revaluation redemption Retained
Capital Capital account Reserve reserve earnings Total
As at 1 January 2005 4470 100 0 0 80 5880 10530
Gain on revaluation 100 100
Issue of shares 530 120 650
Net income for the
year 1435 1435
Preference dividends
paid -5 -5
Ordinary dividends
paid -430 -430
As at 31 December
2005 5000 100 120 100 80 6880 12280

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A plc Cashflow Statement for the year ended 31 December 2005

2005
Operating activities
Cash receipts from customers 4528
Cash paid to suppliers and employees (2001)
Cash generated from operations 2527
Tax paid (440)
Interest paid (150)
Net cash from operating activities 4464
Investing activities
Interest received 80
Dividends received 40
Purchase of fixed assets (1890)
Proceeds on sale of investments 120
Net cash used in investing activities (1650)
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 2829

Cash and cash equivalents at the beginning of the year 425
Cash and cash equivalents at the end of the year 3254
3. VALUATION
3.1 Introduction
The final strand of fundamental analysis to be considered is that of equity valuation. Equities can be
valued on four bases:
1. Dividend flows;
2. Earnings growth;
3. Net Asset Value (NAV);
4. Shareholder value added.

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3.2 Dividend Flows
LEARNING OBJECTIVES
7.3.1 Be able to calculate equity valuations based on
dividends: Gordon's Growth Model
The dividend valuation model applies a theoretical price to a company’s shares by discounting the
company’s expected flow of future dividends into infinity. That is, a company’s share price is viewed
as a perpetuity, or a future flow of income. The discount rate used to obtain the present value of
this dividend flow is that of investors’ required rate of return. This can be derived by adjusting the
risk-free interest rate, given by a Treasury bill or a gilt, for the relative risk of the investment. This
we consider in more detail in Chapter 9.
If the dividend to be paid by the company is expected to remain constant, that is without any
growth over time, the following formula is applied:
Sxd = D/r
where Sxd is the theoretical ex-dividend share price, D the most recent dividend paid and r the
shareholders’ required rate of return.
If the company’s shares are trading on a cum-dividend basis then the formula is modified to:
Scd = D + D/r
However, given typical shareholder expectations for steady dividend growth over time, a more
realistic assumption to make is that future dividends will grow at a constant rate, g. This gives rise to
Gordon’s growth model. The respective equations now become:
Sxd = [D (1 + g)/(r - g)]
Scd = D + [D (1 + g)/(r - g)]
Example
Calculate the theoretical cum-dividend share price of F plc given that it expects to increase its
current annual dividend of 5 pence per share, about to be paid, by 6% per annum indefinitely. F
plc’s shareholders’ required rate of return is 7%.
Solution
Theoretical cum-dividend share price = 5p + 5(1.06)/(0.07 - 0.06) = 535p

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3.3 Price Earnings Ratio (PER)

LEARNING OBJECTIVES
7.2.16 Be able to calculate historic and prospective price
earnings ratios (PERs)
7.3.2 Be able to calculate equity valuations based on earnings:
Price earnings ratios (PERs)
Assuming the stock market is an objective valuation mechanism, the ratio between a company’s
share price and its EPS, the price earnings ratio (PER), provides an indication of how highly rated a
company is in its ability to grow its earnings stream. The PER formula stated earlier, is given by:
PER = share price/EPS
Crudely speaking, the price earnings ratio (PER) is the number of years it would take for the current
EPS to repay the share price, ignoring the time value of money. The higher the expected EPS
growth, the faster the capital outlay on purchasing the share will be repaid, therefore, the higher
the PER. However, the higher the PER, the greater the share price’s vulnerability to EPS growth not
meeting the expectations reflected in the price.
PERs can be calculated on either an historic basis, based on the most recent EPS, or a prospective
basis, based on an expected EPS figure. When EPS is increasing, the historic PER should be higher
than the prospective PER.
PERs are generally highest at the start of an economic cycle when earnings are depressed, as the
company’s share price reflects its future rather than current earnings prospects. However, PER
multiples can expand in a dramatic fashion once the economic cycle is in full swing, as they did in
1987 and 1999, given the expectation of secular, or permanent, earnings growth: latterly as a result
of a belief in the new paradigm. This was outlined in Chapter 1.
Although PERs differ significantly between markets and industries, there could be several reasons
why a company has a higher PER than its industry peers, apart from its shares simply being
overpriced. These may include:
1. A greater perceived ability to grow its EPS more rapidly than its competitors.
2. Producing higher quality earnings than its peers.
3. Being a potential takeover target.
4. Experiencing a temporary fall in profits.
One way of establishing whether a company’s PER is justified is to divide it by a realistic estimate of
the company’s average earnings growth rate for the next five years. A number of less than one
indicates that the shares are potentially attractive.
As noted in Chapters 3 and 4 when considering equities, company takeovers are often funded with
the issue of ordinary shares rather than cash where the PER multiple of the bidding company’s
shares is greater than that of the target company’s shares.

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3.4 Net Asset Value (NAV)
LEARNING OBJECTIVES
7.3.3 Be able to calculate equity valuations based on assets:
Net Asset Value
As noted earlier, a company’s net asset value (NAV) per share attributable to its ordinary
shareholders is given by:
NAV per share = (total assets - liabilities - preference shares)/number of shares in issue
However, a company’s ordinary shares would normally be expected to trade at premium to their
NAV, not least because of the internally generated goodwill attributable to the company’s
management, market positioning and reputation that is not capitalised in the company’s balance
sheet and the historic cost convention that underpins the preparation of financial statements.
In the event of a takeover bid, unless the company is being bought for its assets by an asset stripper,
any offer for the company’s shares is usually made at a premium to this NAV. That is not to say that
the NAV represents the liquidation value of a company’s assets. It doesn’t, again as the result of the
historic cost convention and, of course, the going concern concept.
However, the NAV per share is useful for assessing the following:
1. The minimum price at which a company’s shares should theoretically trade.
2. The underlying value of a property company.
3. The underlying value of an investment trust; a plc that invests in other company and government
securities.
NAV per share is not useful for assessing the value of service or people oriented businesses that are
driven by intellectual, rather than physical, capital, because the former cannot be capitalised in the
balance sheet.
3.5 Shareholder Value Models

LEARNING OBJECTIVES
7.3.4 Know the basic concept behind shareholder value
models: Economic Value Added (EVA); Market Value
Added (MVA)
The approach taken by shareholder value models is to establish whether a company has the ability
to add value for its ordinary shareholders by earning returns on its assets in excess of the cost of
financing these assets, given by the company’s WACC. You may recall from Chapter 1 that in
economic terms this excess return is defined as supernormal profit and arises as a result of a
company’s dominant market position or some other competitive advantage the company may have
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Economic Value Added (EVA) is the most popular of these shareholder value approaches.
The EVA for any single accounting period is calculated by adjusting the operating profit in the
company’s income statement, mainly by adding back non-cash items, and subtracting from this the
company’s WACC multiplied by an adjusted net assets figure from the company’s balance sheet,
termed invested capital:
Net operating profit after tax - (WACC x invested capital)
If positive, then value is being added. If negative, however, value is being destroyed.
However, EVA:
• is based on accounting profits and accounting measures of capital employed;
• only measures value creation or destruction over one accounting period; and
• in isolation cannot establish whether a company's shares are overvalued or undervalued.
In order to determine whether a company's shares are correctly valued, the concept of Market
Value Added (MVA) needs to be employed.
A company’s MVA is the market’s assessment of the present value of the company’s future annual
EVAs. A company’s MVA is derived from the following equation:
market value of company’s equity + market value of company’s net debt

= MVA + company’s invested capital
Therefore:
MVA = market value of company’s equity + market value of company’s net debt
- company’s invested capital
Quite simply, if the present value of the company’s future annual EVAs discounted at the company’s
WACC is greater than that implied by the MVA, this implies that the company’s shares are
undervalued and vice versa if less than the MVA.
Like EVA, MVA also relies on accounting values to establish the invested capital figure and in
addition requires analysts to forecast EVAs several years into the future to determine whether the
resultant MVA is reasonable.
Concluding comments
“Nobody rings a bell at the top of the market.”
Second guessing the equity market by employing technical and fundamental analysis can help in
determining whether a company’s shares or the broader market are under or over priced or ready
to break out from an established trading range but they are by no means a fail-safe way of investing.
For instance, despite price earnings ratios rising in most western markets during the 1990s far in
excess of previous highs, this did not prevent many of these markets reaching vertiginous levels. As
many investors often find to their cost, markets can under and over shoot their true, or
fundamental, values often for sustained periods of time.

262
TAXATION
1.
2.
3.
BUSINESS TAX
PERSONAL TAXES
OVERSEAS TAXATION
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INTRODUCTION
“A good tax is one that is low, uniform and unavoidable”

Nigel Lawson
(Former Chancellor of the Exchequer)
Once tax is brought into the equation, three factors need to be borne in mind:
1. It can make a substantial difference to the returns from an investment and complicate the
investment decision making process.
2. Although it is important to maximise the use of tax allowances, exemptions and reliefs,
investment decisions should never be based solely on the tax concessions offered. With certain
exceptions, tax breaks are usually only given in exchange for accepting a higher level of risk.
3. It is important to understand the distinction between tax avoidance and tax evasion. Tax
avoidance is the perfectly legitimate practice of saving tax through diligent tax planning. Tax
evasion, whether failing to disclose the receipt of income or the making of a capital gain or
falsifying a disclosure, is not.
1. BUSINESS TAX
LEARNING OBJECTIVES
8.1.1 understand the application of the main business taxes:
Business tax; Transaction tax (ie, Stamp Duty/Stamp
Duty Reserve Tax; Tax on sales
8.1.2 know the purpose of tax-efficient incentive schemes sponsored by
governments and supranational agencies (eg, International
Monetary Fund)
In general, companies are required to pay corporation tax to their government which is dependent
on the company’s profits, type of industry, location, ownership structure etc. They may aso be
required to collect tax on behalf of the government. Examples include: state taxes, sales tax, goods
and service tax, value-added tax, environmental tax etc. An example of corporate tax rates for
various countries is listed below.

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Country Business Tax

UK The main rate is 30% but is less for smaller companies. UK resident companies are
subject to UK corporation tax on their worldwide profits, gains and income,
however and wherever generated, whilst non-UK resident companies are only
liable to UK corporation tax on profits generated in the UK.
USA Main rate is 35% but this rate may be higher under certain circumstances.
France The corporate tax rate for most companies is 33.3%. Larger companies may pay
an additional tax while smaller companies get reduced rates.
Germany From 1 January 2008, the corporate rate is expected to be reduced from
approximately 38-40% down to 30%.
Japan The corporate tax rate is approximately 40% (but will depend on location.)
Egypt Main rate is 20%. Egyptian companies are taxed on their world-wide income.
Foreign companies are taxed on any income sourced from Egypt.
Saudia Arabia Flat rate of 20% although some types of companies are required to pay more. For
example companies in the natural gas business pay 30%.
China Chinese companies with less than 25% foreign investment are taxed at 33% (with
some exceptions). Companies with at least 25% foreign investment are also taxed
at 33% but are eligible for certain tax concessions depending on their location and
industry. Other taxes that may also apply include: value added tax(VAT), land tax,
stamp duty and consumption tax.
India Local companies pay 30% with a 10% surcharge and 2% for education. Foreign
companies pay an effective rate of 41.82%.
Dubai No federal level corporation tax (subject to various conditions).
Note: These rates are indicative and may be subject to change at short notice.
2. PERSONAL TAXES
LEARNING OBJECTIVES
8.2.1 understand the direct and indirect taxes as they apply
to individuals: Tax on income; Tax on capital gains;
Estate tax; Transaction tax (Stamp Duty); Tax on sales
Personal tax is that paid by individuals based on their income. Sources of income can include salary
and wages, royalties, tips, capital gains tax, interest, dividends, fringe benefits etc. Most countries
have progressive tax rates where lower incomes are taxed at lower rates. A list of the personal tax
rates in various countries is given below:

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UK Progressive rates up to 40%.
USA Progressive rates up to 35%.
France Progressive rates up to approximately 48%.
Germany Progressive rates up to 45%.
Japan Progressive rates up to 37% however there are local taxes that can raise this rate
up to 50%.
Egypt Progressive rates up to 20%.
Saudia Arabia All citizens of Saudi Arabia and countries belonging to the Gulf Co-operation
Council do not pay income tax but may be subject to zakat – a religious tax of
2.5%. All other citizens pay 20% tax. There is no VAT or sales tax in Saudi Arabia.
China Progressive rates up to 45%.
India Progressive rates up to a maximum rate of 33.66%
Dubai In Dubai there are no personal taxes, capital gains tax or withholding tax.
However, there are other indirect taxes such as import duty tax (approximately
10%), landlord taxes, hotel services/entertainment tax.
Note: These rates are indicative and may be subject to change at short notice.
There are many different types of business and personal taxes. These include Value Added Tax
(VAT), Goods & Services Tax (GST), Sales Tax, Capital Gains Tax, Inheritance Tax, Stamp Duty,
Environmental Levy etc. Every country has different rules and regulations associated with these
taxes and the one certainty around these tax laws is that they will change - and often!
Governments can also offer companies and individuals various tax concessions and incentives. For
example, Shenzhen in China was one of the first Special Economic Zones established by the
Chinese governement to encourage business development and trade. Furthermore, individuals in
the UK get special tax concessions for investing in Individual Savings Accounts (ISAs) which are
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3. OVERSEAS TAXATION
LEARNING OBJECTIVES
8.3.1 know the principles of withholding tax
8.3.2 know the principles of double taxation relief (DTR)
For a UK-resident company overseas taxation can arise as a result of:

1. Profits generated overseas, whether or not these profits are repatriated.
2. The receipt of overseas dividend income.
3.1 Profits Generated Overseas

It was established earlier that UK-resident companies are subject to UK corporation tax on their
worldwide profits. However, recognising that profits generated in another country will also be
potentially liable to local taxes, one of the following reliefs will be granted:
i. Double taxation relief (DTR), or
ii. Unilateral tax relief.
DTR prevents the same profits being taxed twice in the UK and the overseas territory. DTR arises
as a result of the UK entering into bilateral agreements, known as Double Taxation Agreements
(DTAs), with other countries. These ensure that UK company profits earned overseas in a country
with which the UK has a DTA are not subject to UK corporation tax if the overseas tax rate applied
to the company’s profits is equal to or greater than the UK corporation tax rate. If lower than the
UK rate, then the difference between the two rates is payable to Her Majesty’s Revenue &
Customs (HMRC) in the UK.
Although the UK has more DTAs than any other country in the world, if a DTA does not exist with
a particular country, then HMRC may unilaterally grant relief to ensure that the company pays tax at
a rate at least equal to the UK corporation tax rate, but no higher than the overseas tax rate.
3.2 Receiving Overseas Dividend Income

Overseas dividend income upon being remitted to the UK is usually received net of the following
taxes:
1. Overseas corporation tax, also known as underlying tax.
2. Withholding tax.
Withholding tax is a tax deducted at source on dividend and interest income paid to non-resident
investors to prevent tax evasion. Each country applies its own standard rate of withholding tax.
Although UK companies in receipt of overseas dividend income from which withholding tax has
been deducted can reclaim this withholding tax from HMRC via DTAs, this reclaim is subject to a
maximum rate of relief. Therefore, any remainder must be reclaimed directly from the overseas tax
authorities. Individual investors and investment funds in receipt of overseas dividend income can
also reclaim withholding tax through the same process.

268
PORTFOLIO
MANAGEMENT
1.
2.
3.
RISK AND RETURN
THE ROLE OF THE PORTFOLIO MANAGER
FUND CHARACTERISTICS
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1. RISK AND RETURN
1.1 Introduction
This section looks at the financial theory, which, over the past 50 years, has had a pronounced
effect on the construction of investment portfolios.
1.2 Modern Portfolio Theory

LEARNING OBJECTIVES
9.1.1 Know the main principles of Modern Portfolio Theory
(MPT) and the need for diversification
Modern Portfolio Theory (MPT), which originated from the work of US academic Harry Markowitz
in 1952, introduced a whole new way of thinking about portfolio construction. In particular it
introduced the concept of efficient, or diversified, portfolios. Markowitz’s main proposition was that
rational risk averse investors, or wealth maximisers, who were assumed to select securities on the
basis of the mean and standard deviation (σ) of their past returns, should combine these securities
so as to reduce the combined variability of their future returns. You may recall, from Chapter 2,
that selecting securities on the basis of the mean and standard deviation of past returns is termed
the mean-variance approach to security selection.
So whereas the risk associated with holding securities A and B in isolation is given by their
respective standard deviation of returns, by combining these two assets in varying proportions to
create a two stock portfolio, the total standard deviation of return (σρ) will be less than the
weighted average sum of A’s and B’s individual standard deviations, assuming, of course, that their
returns are anything other than perfectly positively correlated (σAB = +1):
σρ < (wA x σA) + (wB x σB), where the weighting of security A = 1 - weighting of security B.
When combined in a portfolio, the individual standard deviations of the portfolio’s constituent
stocks are secondary to the correlation of their individual returns in determining the portfolio’s total
risk (σρ). The lower the correlation of these returns, the greater the portfolio’s diversification and,
therefore, the lower the level of total risk (σρ) associated with any given level of expected return
[E(Rρ)]. However, as we saw when looking at the calculation of the covariance of returns in
Chapter 2, minimising risk also requires selecting portfolios of securities with low standard
deviations.
The portfolio’s expected return [E(Rρ)] is given by the weighted average of the individual expected
returns of its constituent securities:
E(Rρ) = [wA x E(RA)] + [wB x E(RB)]

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EXPECTED
RETURN E(R)
RISK (σ)
Figure 1: The Efficient Frontier

By plotting all combinations of securities held in different proportions on a chart that plots risk (σρ)
against expected return [E(Rρ)], a convex curve known as an efficient frontier can be derived. The
efficient frontier excludes portfolios containing perfectly positively and perfectly negatively
correlated securities: the former because they are undesirable and the latter because they do not
exist in practice. As its name suggests, the efficient frontier depicts those combinations of securities
that represent efficient portfolios: those that offer the maximum expected return for any given level
of risk. As to which of these portfolios will be selected by investors depends on each investor’s own
risk and return criteria. This decision making process can be illustrated by employing indifference
curves.
D
E(R)
E
C
X
EFFICIENT
FRONTIER
σ
Figure 2: Choosing Between Efficient Portfolios

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A risk seeking investor would have an indifference curve similar to that of CD. That is, the risk
seeking investor is willing to assume a considerable amount of additional risk in exchange for a slight
increase in expected return. A risk averse investor, however, would have an indifference curve
similar to that of XY for the opposite reason. The point at which each of these indifference curves is
tangential to the efficient frontier determines which of the efficient portfolios is selected in each
case.
Although since its origins in the early 1950s, this basic portfolio selection model has been developed
into more sophisticated models, such as the Capital Asset Pricing Model (CAPM) in the mid-1960s
and Arbitrage Pricing Theory (APT) in the late 1970s, it remains the backbone of finance theory and
practice. CAPM and APT are considered below.
1.3 Efficient Markets Hypothesis (EMH)

LEARNING OBJECTIVES
9.1.2 Know the main propositions and limitations of the
Efficient Markets Hypothesis (EMH)
Another fundamental proposition of MPT, and one that has been vigorously debated since the early
1960s by academics and market practitioners alike, is the Efficient Markets Hypothesis (EMH). That
is, whether or not markets and securities respond instantly and, indeed, rationally to price sensitive
information and move independently of past trends. Those that do are known as price efficient
markets.
Behind the EMH lies a number of key assumptions that underpin most finance theory models. Aside
from investors being rational and risk averse, they are also assumed to possess a limitless capacity to
source and process freely available information accurately.
ALL
INFORMATION
PUBLICLY
AVAILABLE NEW
INFORMATION
PAST PRICES
WEAK SEMI-STRONG STRONG
Figure 3: Type of Information Incorporated Into Market Prices

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Market efficiency can be analysed at three levels:

1. Weak form. A weak form price efficient market is one in which security prices fully reflect past
share price and trading volume data. As a consequence, successive future share prices should
move independently of this past data in a random fashion, thereby nullifying any perceived
informational advantage from adopting technical analysis to analyse trends.
2. Semi-strong form. A semi-strong efficient market is one in which share prices reflect all publicly
available information and react instantaneously to the release of new information. Such markets
are populated by a large number of market participants each of whom intensively researches the
prospects for one or a number of securities traded in the market hoping to be the first to act
upon the release of new publicly available information or capitalise upon the identification of a
pricing anomaly. Ironically, by exhaustively researching the market, the activities of these
investors, analysts and other City professionals make the market price efficient.
This produces quite damning results for these market participants, as taken together, the weak
and semi-strong forms of the EMH imply that in an efficiently priced market investors cannot
consistently achieve superior risk-adjusted returns but can only outperform the market as a
result of luck and/or taking high risks. Whereas a weak form efficient market destroys the basis
upon which technical analysis is based, the value of fundamental analysis is nullified in a semi-
strong efficient market as the analysis of publicly known information does not convey any
informational advantage.
3. Strong form. A strong form efficient market is one in which share prices reflect all available
information, including privileged or, inside, information: that which is not publicly available and
therefore, illegal to act upon. In a strong form efficient market, where everything about the
market or an individual security is known or knowable, not even private information can help
investors. So once again fundamental analysis is made redundant and outperformance can be only
be achieved through luck and/or taking high risks. Obviously, once known to be subject to insider
dealing, a market soon loses its liquidity.
In conclusion then, the potential implications of a semi-strong form efficient market, where one
cannot consistently outperform the market on a risk-adjusted basis regardless of whether technical
and fundamental analysis is employed, has always loomed over the active portfolio management
community, which seeks to do just that.
Evaluating the EMH

Generally speaking, most established western equity markets are relatively price efficient. Although
testing for strong form efficiency is impossible, as inside information would be required, the most
conclusive evidence supporting the semi-strong efficient form of the EMH is that very few active
portfolio managers, those that seek to outperform established market benchmarks through
employing investment analysis, do so consistently.
Less well developed and less actively researched equity markets, however, do not always exhibit
semi-strong price efficiency and, therefore, provide an opportunity for active managers operating in
these markets to outperform.
Limitations of the EMH

Despite the broad price efficiency of western equity markets, pricing anomalies and trends do
occasionally arise as a result of markets and individual securities under and over shooting their
fundamental values. As a consequence, some active managers do outperform their respective
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It could be argued that developed markets are largely price efficient but investors do not always
invest in a rational fashion, thereby providing others with pricing anomalies to exploit. Indeed, this
argument has recently given way to a new way of thinking about the determination of security
pricing known as behavioural finance. Rather than making simplifying assumptions about the way in
which investors approach investment, behavioural finance instead analyses the emotion and
irrationality that often surrounds investment decision making, in order to explain the inconsistency
of these pricing anomalies with the EMH. For instance, in blatant violation of the weak form of the
EMH, investors frequently use past share price data, especially recent highs and lows and the price
they may have paid for a share, as anchors against which to judge the attractiveness of a particular
share price, which in turn influences their decision making. You may recall, from Chapter 7, that this
forms the basis of technical analysis. The inability for all market participants to absorb and interpret
information correctly given varying cognitive abilities and the way in which the information is
presented may also explain why new information may not necessarily be factored into security
prices instantaneously on every occasion. The behavioural finance literature also goes to great
lengths to rationalise the actions, or “animal spirits” as Keynes described them, of investors in order
to explain how and why stock market bubbles develop and eventually burst, a phenomenon which
again stands at odds with the EMH. In short, the power of irrational thought and differing cognitive
abilities should never be under estimated in financial markets.
Finally, investors frequently deal in securities for reasons completely unrelated to investment
considerations. For instance, investors may sell securities in order to raise cash at short notice to
meet an unexpected liability or invest in a rising market simply because influential peers have
advised them to do so or because a rising trend has been identified. This is known as momentum
investing. Buying and selling in this fashion can result in securities losing touch with their
fundamental or intrinsic values.
1.4 Capital Asset Pricing Model (CAPM)

LEARNING OBJECTIVES
9.1.3 Understand the assumptions underlying the
construction of the Capital Asset Pricing Model (CAPM)
and its limitations
9.1.4 Be able to apply the CAPM formula to equity portfolio
selection decisions
INTRODUCTION
The CAPM, introduced in the mid 1960s, extends Modern Portfolio Theory (MPT) by dividing the
total risk, or the standard deviation (σ), of a security’s returns into two separate elements:
1. Unsystematic risk (σu), or company-specific risk: that which is peculiar to an individual company
causing its shares to move independently of general market movements. Unsystematic risk can
be diversified away by holding a large number of securities operating within different industry
sectors, and
2. Systematic (σs) risk, which no matter how well diversified the portfolio, cannot be diversified
away. Such risk stems from broad equity market movements, or market risk, which, in turn,
mainly derives from changes in economic factors.

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This dichotomy is illustrated below.
TOTAL
RISK
UNSYSTEMATIC
RISK
SYSTEMATIC RISK
NUMBER OF STOCKS
IN PORTFOLIO
Figure 4: Portfolio Risk
When CAPM was introduced, it was believed that by holding about 20 securities most of the
unsystematic risk within a portfolio could be diversified away. However, since shares have generally
become more highly correlated with each other it is now believed that nearer 50 shares would
need to be held to achieve this same goal.
The mathematical relationship between a security’s total risk and its systematic and unsystematic
components is given by the equation:
σ2 = σs2 + σu2
where σ2 is the variance of the security’s returns, σs2 the security’s systematic risk squared and
σu2 the security’s unsystematic risk squared.
This can also be shown diagrammatically.
σ2
σS2
σu2
Figure 5

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The CAPM formula
You may recall from Chapter 2 that the CAPM formula was used to derive the cost of a company’s
equity capital. However, CAPM is principally concerned with quantifying the expected return on a
security, invested within a well-diversified portfolio, over and above a risk-free rate, given the
security’s systematic risk that cannot be diversified away. CAPM then, implies that investors will
only be rewarded for their exposure to undiversifiable systematic risk and not for company specific
risk, which can be diversified away when combined with other securities in a portfolio.
CAPM is underpinned by the following formula:
E(Ri) = Rf + βi [E(Rm) - Rf]
where:
E(Ri) = expected return on security i
Rf = expected return on a short term risk free asset, eg, a Treasury Bill (TB)
βi = beta for security i
E(Rm)= expected return on the market
The expression [E(Rm) - Rf] is known as the ex ante equity risk premium (ERP). This is the excess
return investors require for assuming the market risk associated with holding a well diversified
portfolio of equities [E(Rm)] rather than a risk free asset (Rf). This premium is influenced by how
investors view the outlook for the stock market in the light of expected earnings and dividend
growth and the position of the economic cycle.
Beta
Beta (β) is a measure of the average historic sensitivity, or volatility, of a security’s returns to the
variability of returns in the broader market, known as market risk, expressed as a proportion of this
market risk.
The beta of security i (βi ) can, therefore, be expressed as:
βi = σs/σm
where, σs is security i’s systematic risk and σm market risk
Restated, this equation gives: σs = βi x σm and explains the relationship between a security’s
systematic risk and market risk.
However, this systematic risk, σs = ρim x σi,
where, ρim is the correlation coefficient between the returns of security i and those of the market
and σi, the total risk, or standard deviation of returns, for security i.
Therefore, βi = σs/σm = (ρim x σi)/σm

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Multiplying the equation by σm, gives:
βi = (ρim x σi x σm)/σm2 = Covim/Varm
where, Covim is the covariance between the returns from security i and the market, and Varm, the
variance of returns from the market.
Individual security beta values are derived by running a regression between a security’s monthly
percentage returns against that of the market, usually over a 36-month period. Plotted on a chart
with the security’s percentage returns on the Y or vertical axis and the market’s percentage returns
on the X or horizontal axis, the slope of the line that best fits this data is the security’s beta.
The resulting beta value (β) indicates the following:

i. β > 1 indicates historically that the security has on average acted aggressively to general market
moves. A beta of 1.5, for instance, means the security has moved on average by 1.5% for every
1% market move. High beta stocks include high street retailers and banks.
ii. β = 1 suggests that historically the security has on average moved in line with general market
moves.
iii. β < 1 but > 0 means the security has generally acted defensively to general market moves.
Defensive stocks include utilities and food retailers.
iv. β = 0 indicates that the security is uncorrelated with general market movements. This can mean
one of two things: either the security is a risk free asset or the security’s risk is entirely
unsystematic.
v. β < 0 suggests that the security has moved in the opposite direction to market moves. If the
security has a beta of - 0.9 for instance, it has fallen by 0.9% for every 1% up move in the
market.
The beta of a security is influenced by the issuing company’s financial and operational gearing. The
securities of those companies that are highly financially and operationally geared and whose fortunes
are, therefore, closely linked to the economic cycle are typically high beta stocks.
When stocks are combined to form a diversified portfolio, the beta of the portfolio (βρ) is given by
the weighted average beta of each stock in the portfolio:
βρ = Σ(wi x βi), where wi is the percentage weighting by market value of security i, and βi, the
beta of security i.
As in the CAPM world, systematic risk is the only risk that a security adds to the total risk of a
diversified portfolio and each security’s systematic risk relative to the market is given by its beta,
this makes intuitive sense.
Beta and Hedging

You should note that where a portfolio has a beta other than one, this will have implications for
hedging the portfolio against a fall in the broader equity market when using derivatives. If the
portfolio has a beta of two for instance, then twice of many futures will need to be sold or twice as
many put options purchased to provide the same protection as would be afforded to a portfolio
with a beta of one.

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The Security Market Line (SML)
The CAPM formula underpins what is known as the Security Market Line (SML).
UNDERVALUED SML
SECURITIES
E(RM)
OVERVALUED
SECURITIES
RF
β=1 β
Figure 6: Security Market Line (SML)
The SML is an upward sloping straight line that depicts a linear relationship between a security’s
beta and its benchmark return, assuming the security is invested within a well diversified portfolio.
This benchmark return comprises the return from a short dated risk-free (Rf) asset such as a
Treasury bill, plus an equity risk premium for assuming market risk, the size of which is determined
by the security’s beta. For a security with a beta of one, the expected return should be equal to that
of the broader market.
All efficiently priced securities held within well diversified portfolios lie on this line: those that do
not are inefficiently priced. Those below the line are priced too high in that their expected return is
below that required for their commensurate beta risk, whilst those above the line are priced too
low and, therefore, offer a return in excess of that required. However, in a world where all
investors have access to the same free information, these pricing anomalies should soon be
arbitraged away, with each security trading on the SML.
CAPM, by providing a precise prediction of the relationship between a security’s risk and return,
therefore, provides a benchmark rate of return for evaluating investments against their forecasted
return.

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Example
As a portfolio manager familiar with CAPM, you know that the current risk free rate of return is
4% and the expected return on the market is 9%. Already holding a well-diversified portfolio, you
are considering including investments X, Y and Z in this portfolio. These investments have the
following characteristics:
Investment X has an expected return of 5% and a CAPM beta of -0.2
Investment Y has an expected return of 8% and a CAPM beta of 0.9
Investment Z has an expected return of 10% and a CAPM beta of 1.1
Using CAPM as the sole means of evaluating these investments, which should be considered for
inclusion in the portfolio?
Solution
Applying the CAPM formula [Rρ = Rf + ß(Rm - Rf)] to these three investments:
1. Investment X’s benchmark return = 0.04 - 0.2(0.09 - 0.04) = 3%
2. Investment Y’s benchmark return = 0.04 + 0.9(0.09 - 0.04) = 8.5%
3. Investment Z’s benchmark return = 0.04 + 1.1(0.09 - 0.04) = 9.5%
As the expected return on X and Z is greater than that required under CAPM, ie, X and Z are
positioned above the SML, whereas Y is positioned below, only X and Z should be considered for
inclusion in the portfolio.
The Derivation of the SML

The SML is simply an extension of Markowitz’s efficient frontier. As noted earlier, Markowitz’s
efficient frontier represents those combinations of securities that provide the maximum expected
return for a given level of risk (σρ). Each is an efficient portfolio. However, the decision of which
efficient portfolio to choose is subjective and depends upon each investor’s attitude to risk as
depicted by the shape and positioning of their indifference curves.
E(R) CML
EFFICIENT
FRONTIER
Rf
Figure 7 σ

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By introducing the possibility of combining risk free assets with portfolios of risky stocks though, it
can be shown that all investors would hold the same portfolio of stocks regardless of their attitude
towards risk. This is depicted by the Capital Market Line (CML): an upward sloping straight line
originating from Rf that is tangential to the efficient frontier at point M. M is known as the market
portfolio as it is broadly representative of the entire market. Investors can operate anywhere they
wish on the CML. Risk averse investors may wish to hold an element of their portfolio in a risk free
asset and a proportion of the market portfolio whereas risk seeking investors may borrow at the
risk free interest rate and gear their returns.
So regardless of each investor’s appetite for risk, every investor will hold at least a proportion of the
market portfolio, unless they are so risk averse that they simply hold risk free assets.
The CML being superimposed on a chart that plots expected return against the total variability of
returns (σ), provides an ideal benchmark against which to assess the forecasted return of a security
being added to an undiversified portfolio: that is one which contains both systematic and
unsystematic risk. However, if the security being evaluated is invested in a well diversified portfolio,
one where the unsystematic risk has been diversified away, the SML, rather than the CML is used.
The SML performs exactly the same role as the CML except that the SML plots the linear
relationship between a security’s expected return and beta risk, rather than against its total
variability of returns. As the additional risk brought by an individual security to a well diversified
portfolio is simply its beta risk, then the SML provides a more accurate benchmark for the
security’s expected return. The beta of the market portfolio is one.
We will return to the CML and SML in Chapter 10 when looking at risk-adjusted equity portfolio
returns.
CAPM Assumptions and Limitations

CAPM’s underlying assumptions are as follows. Investors:
i. Are infinite in number and, therefore, act as price takers rather than price setters;
ii. Are rational and risk averse;
iii. Hold well diversified portfolios;
iv. Act on full and free information, have the same cognitive ability as one another to interpret this
information no matter how it is presented, formulate views on risk and return in exactly the
same way as each other and have the same future expectations;
v. Make investment decisions based on mean variance analysis;
vi. Can lend and borrow unlimited amounts at the risk free rate of interest;
vii.Are not subject to transaction costs or taxes;
viii.Have the same one-period time horizon.

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CAPM’s limitations are as follows:

i. Many of the assumptions made above;
ii. All relevant factors and inputs are assumed to remain constant over the investment horizon, such
as the risk free rate of interest and the ex ante equity risk premium (ERP);
iii. The model does not take account of practical constraints faced by portfolio managers, such as a
fund’s liability structure, liquidity needs and investment time horizon;
iv. The model assumes that a security’s risk and equity risk premium can be wholly explained by a
single market beta;
v. Betas are difficult to estimate, are based on historic observation and change over time as
companies reinvent themselves. However, portfolio betas are more stable than individual security
betas as changes in individual security betas within a portfolio tend to cancel each other out;
vi. Research casts doubt on the link between security returns and their betas, as:
a. Investors appear to be rewarded for more than their exposure to systematic risk, that is,
exposure to some unsystematic risk appears to be rewarded;
b. Beta fails to capture other elements of macroeconomic risk that impacts on share price
performance.
1.5 Arbitrage Pricing Theory (APT)
LEARNING OBJECTIVES
9.1.5 Know the main: principles behind Arbitrage Pricing
Theory (APT); differences between CAPM and APT
APT was developed in the late 1970s in response to CAPM’s main limitation that a single market
beta is assumed to capture all factors that determine a security’s risk and expected return.
APT, rather than relying on a single beta, adopts a more complex multi factor approach by:
i. Seeking to capture exactly what factors determine security price movements by conducting
regression analysis;
ii. Applying a separate risk premium to each identified factor;
iii. Applying a separate beta to each of these risk premia depending on a security’s sensitivity to each
of these factors.
Examples of factors that are employed by advocates of the APT approach include both industry
related and more general macroeconomic variables such as anticipated changes in inflation,
industrial production and the yield spread between investment grade and non-investment grade
bonds.

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The expected return for a security i [E(Ri)] using the APT approach can be summarised as follows:
E(Ri)= Rf + bi1P1 + bi2P2..... + binPn
where:
Rf = risk-free rate of interest
bi1 = the sensitivity, or beta, of security i to factor 1, eg, bank base rate
P1 = the risk premium, or extra expected return above the risk free rate, for one unit exposure to
factor one
APT’s underlying assumptions include:

i. Securities markets are price efficient;
ii. Investors seek to maximise their wealth, though do not necessarily select portfolios on the basis
of mean variance analysis;
iii. Investors can sell securities short. Short selling is selling securities you don’t own with the
intention of buying them back at a lower price in order to settle and profit from the transaction;
iv. Identified factors are uncorrelated with each other.
APT is attractive in that it:

i. Explains security performance more accurately than CAPM by using more than one beta factor;
ii. Uses fewer assumptions than CAPM;
iii. Enables portfolios to be constructed that either eliminate or gear their exposure to a particular
factor.
However, APT’s shortcomings include a reliance on:

i. Identified factors being uncorrelated with each other;
ii. Stable relationships being established between security returns and these identified factors.
2. THE ROLE OF THE PORTFOLIO MANAGER
2.1 Introduction
“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious
when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a
country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”
John Maynard Keynes
As a portfolio manager it is important to understand the distinction between investment and

speculation. Investment can be differentiated from speculation by the timeframe adopted and level
of risk assumed by the investor. Investment is undertaken via a diversified portfolio of securities for
the medium to long term whereas speculation is based on profiting from the short term price
movements of individual price movements of securities or assets. Portfolio management is
concerned with the former.

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2.2 The Portfolio Management Process

LEARNING OBJECTIVES
9.2.1 Understand the establishment of: relationships with
clients; client objectives and risk profile including
income and/or growth, time horizons, restrictions and
liquidity; discretionary and non-discretionary portfolio
management
9.2.2 Understand the establishment of the investment strategy
9.2.3 Understand deciding on the benchmark and the basis for review
9.2.4 Understand the measurement and evaluation of performance and
the purpose and requirements of annual and periodic reviews
including client reporting
9.2.5 Understand the benefits of employing derivatives within the
investment management process
Portfolio management is the management of an investment portfolio on behalf of a private client or

institution with a primary focus on meeting the client’s investment objectives. Portfolio
management can be conducted on either a:
i. Discretionary basis, where the portfolio manager makes investment decisions within the
parameters laid down by the client, or
ii. Non-discretionary or advisory basis, where the client makes all of the investment decisions, with
or without seeking advice from the portfolio manager.
In both cases, the portfolio manager usually has the choice of investing directly in a range of asset
classes and/or indirectly via investment funds.
The Role and Responsibilities of the Portfolio Manager

The main responsibilities of the portfolio manager are to:
i. Help clients decide on and prioritise objectives;
ii. Document the client’s investment objectives and risk tolerance;
iii. Determine and agree an appropriate investment strategy;
iv. Act in the client’s best interest;
v. Keep the portfolio under review;
vi. Carry out any necessary administration and accounting.

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Stages of the Portfolio Management Process
The portfolio management process can be divided into six distinct stages:
1. Determining the client’s requirements;
2. Formulating the investment strategy to meet the client’s objectives;
3. Agreeing the performance benchmark, frequency and basis of review;
4. Implementing the investment strategy by selecting suitable asset classes and/or collective
investment funds;
5. Measuring and evaluating performance;
6. Revisiting the client’s objectives, revising the construction of the portfolio and/or the benchmark.
Each of these will now be considered.
Stage 1: Determining the Client’s Requirements

The asset split of the portfolio will be determined by the following client requirements:
i. The investment objective
The client’s investment objective overrides everything else. Typical objectives include:
a. Maximising income, growth or total return.
b. Maintaining the real value of capital.
c. Outperforming a benchmark or peer group average.
d. Meeting or matching future liabilities. This was considered in Chapter 4 when looking at
passive bond management strategies.
ii. Risk tolerance
Although risk is an emotive subject, establishing a client’s tolerance towards risk need not be
subjective. Indeed, an objective measure of a client’s risk tolerance is provided by the risks that
will need to be taken if the client’s stated investment objective is to be met. If the client believes
these risks are too great, then the client’s objective will need to be revised.
iii. Liquidity requirements and time horizon
The lower the client’s liquidity requirements and the longer their timescale, the greater the
choice of assets available to the portfolio manager to meet the client’s investment objective.
Whereas the need for high liquidity allied to a short timescale demands that the portfolio
manager should invest in lower risk assets such as cash and short dated bonds, which offer a
potentially lower return than equities, if the opposite is true the portfolio can be more
proportionately weighted towards equities. It is important, however, that the client maintains
sufficient liquidity to meet both known commitments and possible contingencies.
iv. Tax status
As for most investors, whether institutional or retail, capital gains are generally treated more
favourably than income, the focus should be on those investments that produce capital growth
rather than income, notwithstanding the client’s objectives and time horizon.
v. Investment preferences
Some investors prefer to either exclude certain areas of the investment spectrum from their
portfolios or concentrate solely on a particular investment theme: Socially Responsible
Investment (SRI) for instance.

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Stage 2: Formulating the Investment Strategy to Meet the Client’s Objectives

Appreciating the need to diversify and having regard to the client’s objectives, it is unlikely that a
single investment fund or one security will meet the client’s requirements. Therefore, the portfolio
manager needs to decide how to approach selecting suitable investments for inclusion in the client’s
portfolio. In Chapter 4, when looking at bond management strategies, two broad approaches to
bond portfolio management were considered: active and passive bond management. Active and
passive strategies can also be applied to the management of equities.
Passive Management
Whereas buy and hold and immunisation techniques are available to the passive bond portfolio
manager, the two main passive portfolio management techniques employed by equity portfolio
managers are simple buy and hold policies and index tracking.
An equity buy and hold policy is the simplest and least expensive of the two strategies through
portfolios constructed on a buy and hold basis are not necessarily well diversified.
Index tracking, or indexation, however, necessitates the construction of an equity portfolio to track,
or mimic, the performance of a recognised equity index. Indexation is undertaken on the
assumption that securities markets are efficiently priced and cannot, therefore, be consistently
outperformed. Consequently, no attempt is made to forecast future events or outperform the
broader market.
Indexation techniques originated in the US in the 1970s but have since become popular in the UK.
Indexed portfolios are typically based upon a market capitalisation weighted index and employ one
of three established tracking methods:
1. Full replication. This method requires each constituent of the index being tracked to be held in
accordance with its index weighting. Although full replication is accurate, it is also the most
expensive of the three methods so is only really suitable for large portfolios.
2. Stratified sampling. This requires a representative sample of securities from each sector of the
index to be held. Although less expensive than full replication, the lack of statistical analysis
renders this method subjective and potentially encourages biases towards those stocks with the
best perceived prospects.
3. Optimisation. Optimisation is a lower cost though statistically more complex way of tracking an
index than fully replicating it. Optimisation uses a sophisticated computer modelling technique to
find a representative sample of those securities that mimic the broad characteristics of the index
being tracked. This it does by adopting an APT type approach to security risk.
The advantages of employing indexation are that:

i. Relatively few active portfolio managers consistently outperform benchmark equity indices.
ii. Once set up, passive portfolios are generally less expensive to run than active portfolios given a
lower ratio of staff to funds managed and lower portfolio turnover.
The disadvantages of adopting indexation, however, include:

i. Performance is affected by the need to manage cashflows, rebalance the portfolio to replicate
changes in index constituent weightings and adjust the portfolio for index promotions and
demotions. Also most indices assume that dividends from constituent equities are reinvested on
the ex-dividend (xd) date whereas a passive fund can only invest dividends when received, usually
six weeks after the share has been declared xd.

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ii. Indexed portfolios cannot meet all investor objectives.
iii. Indexed portfolios follow the index down in bear markets.
iv. An index does not represent the least covariance portfolio. That is, equity indices do not lie on
the efficient frontier as they are unable to assess how the inclusion of a stock to the index adds to
or further diversifies the risk of the portfolio. Moreover, many indices are highly concentrated,
being dominated by a few key industrial sectors.
Active Management
Active equity management is employed for exactly the same reasons as active bond management:
to exploit pricing anomalies in those securities markets that are perceived as being inefficiently
priced. In contrast to passive equity management, active equity management seeks to outperform a
predetermined benchmark over a specified time period by employing fundamental and/or technical
analysis to assist in the forecasting of future events and the timing of purchases and sales of
securities. As noted in Chapter 4, this is known as market timing.
Actively managed portfolios can be constructed on either a top down or a bottom up basis. The top
down approach is employed for internationally diversified portfolios whereas the bottom up
method is adopted for those portfolios that focus on the investment opportunities offered by a
particular country, investment region or investment theme. Whichever portfolio construction
approach is employed, it is imperative that the portfolio is suitably positioned to reflect current
market conditions as well as the outlook for world markets and the world economy.
Top Down Active Management

Top down active management comprises three stages:
1. ASSET ALLOCATION
Asset allocation is the result of top down portfolio managers considering the big picture first, by
assessing the prospects for each of the main asset classes within each of the world’s major
investment regions against the backdrop of the world economic, political and social environment.
Within larger portfolio management organisations, this is usually determined on a monthly basis by
an asset allocation committee. The committee draws upon forecasts of risk and return for each
asset class and correlations between these returns. It is at this stage of the top down process that
quantitative models are often used, in conjunction with more conventional fundamental analysis, to
assist in determining which geographical areas and asset classes are most likely to produce the most
attractive risk-adjusted returns taking full account of the client’s mandate.
Most asset allocation decisions, whether for institutional or retail portfolios, are made with
reference to the peer group median asset allocation. This is known as asset allocation by consensus
and is undertaken to minimise the risk of underperforming the peer group. When deciding if and to
what extent certain markets and asset classes should be over or under weighted, most portfolio
managers set tracking error, or standard deviation of return, parameters against peer group median
asset allocations, such as the WM or CAPS median asset allocation in the case of institutional
mandates. Tracking error as well as WM and CAPS are covered in Chapter 10. As noted in Chapter
4, asset allocation decisions are increasingly being implemented through the use of futures
contracts.

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Finally, the decision whether to hedge market and/or currency risks must taken.
Over the long term, recent academic studies conclude that asset allocation accounts for over 90%
of the variation in pension fund returns.
THE IMPORTANCE OF OVERSEAS DIVERSIFICATION

To be efficient, a portfolio should be adequately diversified with no one geographical region or asset
class monopolising it. There has always been a tendency for UK portfolio managers to focus
primarily on UK bond and equity markets within internationally diversified portfolios, mainly
because these are markets they can relate to and feel comfortable with, despite the fact that few
multinational companies domiciled in the UK derive the majority of their revenues from the UK.
They are also largely free of currency risk, though currency risk derives from a company’s
multinational orientation.
However, despite the increased globalisation of economies and markets, there are significant
advantages to looking further a field to enhance the risk/return characteristics of any portfolio. As
mentioned in previous chapters, the world economy is not totally synchronised, most investment
themes are global, many industries are either under or over represented in the UK and the UK
market only accounts for about 10% of world stock market capitalisation. Although, as noted,
investing in overseas equities gives rise to currency risk, this is more than outweighed by the
diversification benefits that arise from UK equity returns generally having a low correlation
coefficient with many other equity markets. Currency risk can, of course, be hedged. The argument
for globally diversified portfolios is further reinforced by the fact that the barriers and costs
associated with international investing continue to decline whilst the quality of information flows
increases. Moreover, investing overseas can also help to diversify away some of the systematic risk
within the UK element of the portfolio.
ASSET ALLOCATION CONSTRAINTS

When deciding on asset allocation policy, any constraints faced by the client must be taken into
account. For a pension fund client, the following constraints may exist:
i. Liability constraints. Defined benefit (DB) pension schemes (see Section 3.13 of this chapter)
with imminently maturing liabilities will need to be invested in lower risk, lower return assets
whilst less mature schemes will be able to take a longer term view on investment returns by
investing a greater proportion of its portfolio in real assets, such as equities and property.
ii. Cashflow constraints. A DB pension fund that does not benefit from positive cashflow, where
contributions to the scheme are exceeded by pensions in payment, will be constrained in its
ability to invest in real assets.
iii. Legal constraints. These may also exist where a client’s investment policy is restricted by express
conditions contained within a trust, such as the use of derivatives within the portfolio or being
precluded from investing in high yield bonds. However, most trusts have wide ranging investment
powers and those that were subject to the restrictions imposed by the Trustee Investment Act
1961 now have wider investment powers conferred to them under the Trustee Act 2000, as
outlined in Chapter 3.
iv. The introduction of accounting standards that require the recognition of any liability in relation to
defined benefit schemes has reinforced the move by DB pension schemes away from volatile
equities and into less volatile investments, such as bonds that more closely match scheme assets
with scheme liabilities.

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v. Peer group benchmarking limits. As noted earlier, many pension funds set tracking error
parameters against peer group median asset allocations.
2. SECTOR SELECTION
Once asset allocation has been decided upon, top down managers then consider the prospects for
those sectors within their favoured equity markets. Sector selection decisions in equity markets are
usually made with reference to the weighting each sector assumes within the index against which
the performance in that market is to be assessed.
Commodities and
basic resources Cash
Property Defensive equities
General industrial Growth (food retailers,
et
mark
and capital spending decelerates pharmaceuticals,
equities (electrical, as interest Recession tobacco, utilities)
f Bull
engineering, rates rise to Bear Market

End o
contractor, TMT) suppress arket

inflation t o f Bull m
Star
Bonds
Growth accelerates
Cyclical consumer as interest rates fall Interest rate
equities (airlines, sensitive equities
autos, general (bank,
retailers, leisure) house-building)
Exchange rate sensitive

Basic industry equities equities (exporters,
(chemicals, paper, steel) multi-nationals)
Figure 8: The Investment Clock
Given the strong interrelationship between economics and investment, however, the sector
selection process is also heavily influenced by economic factors, notably where in the economic
cycle the economy is currently positioned. Interestingly, for equities, economic growth is something
of a double-edged sword in that strong growth should increase earnings but also raises the spectre
of higher interest rates. The interrelationship between the stages of a conventional UK economic
cycle and that of a conventional UK investment cycle is illustrated in the above investment clock.
However, the clock assumes that the portfolio manager knows exactly where in the economic cycle
the economy is positioned and the extent to which each market sector is operationally geared to
the cycle. Moreover, the investment clock doesn’t provide any latitude for unanticipated events that
may, through a change in the risk appetite of investors, spark a sudden flight from equities to
government bond markets, for example, or change the course that the economic cycle takes.
In addition to economics, the current popularity of particular investment themes may cause certain
sectors to be over weighted relative to their weighting in the benchmark index. This was true of
technology, media and telecom (TMT) stocks in 1999, for instance.

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3. STOCK SELECTION
“Worldly wisdom teaches us that it is better for reputation to fail conventionally than to succeed
unconventionally”
John Maynard Keynes
The final stage of the top down process is deciding upon which stocks should be selected within the
favoured sectors. A combination of fundamental and technical analysis will typically be used in
arriving at the final decision.
In order to outperform a predetermined benchmark, usually a market index, the active portfolio
manager must be prepared to assume an element of tracking error, more commonly known as
active risk, relative to the benchmark index to be outperformed. Active risk arises from holding
securities in the actively managed portfolio in differing proportions to that in which they are
weighted within the benchmark index. The higher the level of active risk, the greater the chance of
outperformance, though the probability of underperformance is also increased.
This risk of underperforming the benchmark index by assuming active risk was dramatically
illustrated in the court action brought against Merrill Lynch Investment Managers (MLIM) by
Unilever in the High Court in 2001. MLIM, formerly Mercury Asset Management (MAM), had
signed a contract with Unilever that set a target investment return for Unilever’s £1bn pension fund
of 1% per annum, net of management fees, in excess of the FTSE All Share index with a 3% per
annum underperformance limit. However, over the 15 months to 31 March 1998, MLIM
underperformed the index by 10.5%: the worst recorded performance of the 1,600 pension funds
monitored by performance measurement company, WM. Although the value of the fund rose in
absolute terms, it had underperformed its peers and the All Share index in relative terms. Unilever
brought an action to recover the performance that had been “lost” as a result of poor stock
selection allied to a claim of negligence for failing to monitor the fund’s active risk more carefully.
The case resulted in MLIM paying Unilever an undisclosed sum without admission of liability.
Given the increased popularity of indexation as a result of the generally superior performance of
index tracker portfolios in recent years, there has been a tendency for many active portfolio
managers to manage by consensus, or limit tracking error, in order to minimise the possibility of
underperforming their peers, especially those that adopt indexation. This has led to accusations of
active managers running closet trackers. The outcome of the MLIM case may well exacerbate this
trend.
Concluding Comments
It should be noted that top down active management, as its name suggests, is an ongoing and
dynamic process. As economic, political and social factors change so does asset allocation, sector
and stock selection.

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Bottom Up Active Management
A bottom up approach to active management describes one that focuses solely on the unique
attractions of individual stocks. Although the health and prospects for the world economy and
markets in general are taken into account, these are secondary to factors such as whether a
particular company is a possible takeover target or is about to launch an innovative product, for
instance. A true bottom up investment fund is characterised by significant tracking error as a result
of assuming considerable active risk.
However, many actively managed single country investment funds that hold large capitalisation
stocks in proportions barely indistinguishable to that of the index they are benchmarked against
have been accused of closet tracking. By closely tying their stock selection to the index they seek to
outperform rather than evaluating stocks according to their risk and return characteristics and
assessing the covariance of their returns with other stocks in the portfolio, such funds invariably
produce poor performance, not least because of the high charges they make.
Investment Management Styles

Active portfolio management, whether top down or bottom up, employs one of a number of
distinctive investment styles when attempting to outperform a predetermined benchmark.
The more popular investment styles employed by active portfolio managers are:
1. Growth investing;
2. Value investing;
3. Thematic investing;
4. Fashion led; and
5. Contrarian investing.
1. Growth Investing
Growth investing is a relatively aggressive investment style. At its most aggressive, it simply focuses
on those companies whose share price has been on a rising trend and continues to gather
momentum as an ever increasing number of investors jump on the bandwagon. This was referred
to earlier as momentum investing. Little, if any, attention is paid to the usually above average PER of
such shares. In 1999 and early 2000, the focus of many momentum driven growth strategies was on
TMT stocks.
Buying growth at a reasonable price (GARP) investing is a less aggressive growth investment style as
attention is centred on those companies which are perceived to offer above average earnings
growth potential that has yet to be fully factored into the share price.
True growth stocks, however, are those that are able to differentiate their product or service from
their industry peers so as to command a competitive advantage and, that rare commodity in a low
inflation environment, pricing power. This results in an ability to produce high quality and above
average earnings growth as these earnings can be insulated from the business cycle. A growth stock
can also be one that has yet to gain market prominence but has the potential to do so: growth
managers are always on the look out for the next Microsoft.

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The key to growth investing is to rigorously forecast future earnings growth and to avoid those
companies susceptible to issuing profits warnings. As noted in Chapter 7, a growth stock trading on
a high PER will be savagely marked down by the market if its earnings expectations fail to be met.
2. Value Investing
In contrast to growth investing, value investing seeks to identify those established companies,
usually cyclical in nature, that have been ignored by the market but look set for recovery. Like a
pawnbroker, the value investor seeks to buy stocks in distressed conditions in the hope that their
price will return to reflect their intrinsic value, or net worth. A focus on recovery potential, rather
than earnings growth, differentiates value investing from growth investing, as does a belief that
individual securities eventually revert to a fundamental or intrinsic value. This is known as reversion
to the mean. In contrast to growth stocks, true value stocks also offer the investor a considerable
safety margin against the share price falling further, because of their characteristically high dividend
yield and relatively stable earnings.
VALUE VERSUS GROWTH INVESTING

The table below summarises the main differences between value and growth stocks and the
approaches taken towards value and growth investing.
Value Growth
Approach taken Cautious Adventurous
Preferred market conditions Bear market but Bull market gathering
set to recover momentum
Typical characteristics of
value and growth stocks
PER Low High
Dividend yield High Low
Operational gear ing High Low
Financial gearing Low High
P/B ratio Low High
Intellectual asset backing Low High
Value investing worked well in the UK in 1970s and 1980s but was largely discarded in favour of
growth investing for most of the 1990s. In the 1970s and 1980s, value investors by focusing on
those stocks underrated by the market, simply relied on many of these companies either being
taken over by a competitor or a conglomerate or riding the next economic cycle upswing in an
economy characterised by boom and bust, politically inspired economic policies and regular
currency crises. Today, by way of contrast, against a more stable economic backdrop, it has become
apparent that companies that have performed well in the past but whose fortunes have since been
reversed do not necessarily recover their pre-eminence tomorrow.

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Indeed, once sterling exited the ERM in 1992, the changing characteristics of the UK economy,
principally its ability to produce robust growth without accompanying inflation, began to favour
growth investing. Whereas many value stocks rely on economic growth to generate inflation so as
to enhance the issuing company’s pricing power, the classic growth stock can produce double-digit
earnings growth in a low inflation environment, principally by offering a niche product or service
and/or through establishing brand loyalty. However, since the demise of the TMT momentum
driven market in March 2000, value and growth investing have vied for dominance, though value
investing has proved to be the superior of the two competing investment styles to date, as it has
been over the long term.
All of this serves to show that no one investment style suits all market conditions and different
styles require different investment expertise. Consequently, portfolio managers are increasingly
positioning themselves as style neutral, preferring to alternate between growth and value
investment styles according to prevailing economic and investment conditions. In today’s market, it
pays to be pragmatic.
3. Thematic Investing
Thematic investing typically focuses on specific industry sectors linked by a common investment
opportunity, regardless of where in the world the sectors are located. This makes a great deal of
sense in a world where many businesses operate globally and generate the majority of their revenue
from outside the country in which their head office is situated. In other words, thematic investing is
based on the premise that geography and company domicile as a basis for investing globally has
become flawed. Such opportunities, or themes, are often driven by technological advancement,
demographics or a change in government policy. For instance, an ageing world population will
increasingly require the provision of private healthcare, a theme upon which pharmaceutical
companies have capitalised globally. However, whereas some investment managers tend to
concentrate on a single global investment theme or industry, others adopt a trans-sectoral, or multi-
themed, approach to thematic investment, recognising that companies do not always fit neatly into
sectors. This latter approach is principally driven by those major global macroeconomic trends that
are expected to lead to equity outperformance in the medium to long term. An example of a theme
pursued within a multi-themed approach is to focus on those companies that stand to benefit from
a disinflationary environment by virtue of possessing a unique competitive advantage, such as a
strong and enduring brand.
Having been introduced to the UK in the mid-1980s, thematic investing has become increasingly
popular as world markets have become more closely correlated and investors seek both
diversification away from general market trends and access to the next big global investment story.
TMT was the global theme of 1999. Since then, Socially Responsible Investment (SRI) has become a
popular investment theme. Thematic investing also relates to seeking out those sectors that would
be expected to outperform at various stages of the economic cycle as illustrated by the investment
clock earlier in this chapter.
4. Fashion Led Investing

Fashion led investing is similar to a growth momentum style of investing in that it is assumed a
particular trend or fashion will continue to provide outperformance of the broader market.
However, fashions by definition soon go out of style. Investing in last year’s top performing stock,
theme or market rarely produces a repeat performance the following year. Just compare the
fortunes of TMT stocks in 1999 with 2000.

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5. Contrarian Investing
Contrarian investing is similar to value investing in that a position is taken against the market
consensus. It may be that a company has suffered a short term setback and it is perceived that the
market has overreacted to the bad news or that a share has simply been ignored by institutional
investors because of its low market capitalisation. Contrarian investing, however, often takes the
view that last year’s poor performer will be this year’s sought after stock. As with fashion led
investing, adopting a mechanised approach to investment rarely produces the desired result.
COMBINING ACTIVE AND PASSIVE MANAGEMENT

Having considered both active and passive management, it should be noted that active and passive
investment are not mutually exclusive. Index trackers and actively managed funds can be combined
in what is known as core-satellite management. This is achieved by indexing between 70% to 80%
of the portfolio’s value, so as to minimise the risk of underperformance, and then fine tuning this
core by investing the remaining 20% to 30% in a number of specialist actively managed funds or
individual securities, with either a growth or income bias, to meet the client’s stated objective.
These are known as the satellites.
Institutional portfolios are increasingly employing private capital and hedge funds as satellites. These
are considered in the Alternative Investment Strategies (AIS) section later in this chapter.
The core can also be run on an enhanced index basis, whereby specialist investment management
techniques are employed to add value to the indexed core. These include stock lending and
anticipating the entry and exit of constituents from the index being tracked.
In addition, indexation and active management can be combined within index tilts. Rather than hold
each index constituent in strict accordance with its index weighting, each are instead marginally
over weighted or under weighted relative to the index based on their perceived prospects.
Stage 3: Agreeing the Performance Benchmark, Frequency and Basis of Review

Once the portfolio has been constructed, the portfolio manager and client need to agree on a
realistic benchmark against which the performance of the portfolio can be judged. The choice of
benchmark will depend on the precise asset split adopted and should be compatible with the risk
and expected return profile of the portfolio. Where an index is used, this should represent a feasible
investment alternative to the portfolio constructed. We return to these points in Chapter 10 when
looking at the evaluation of risk-adjusted returns.
The performance of institutional portfolios is often benchmarked against the WM or CAPS median
whilst private client portfolios are often benchmarked against the Association of Private Client
Investment Managers and Stockbrokers (APCIMS) indices, though FTSE International and MSCI
indices are also widely used in both cases.

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Stage 4: Implementing the Investment Strategy by Selecting Suitable Asset
Classes and/or Funds
Portfolios can be constructed using a combination of securities and/or investment funds. These
investment funds may include:
i. Authorised collective investment funds, notably unit trusts and OEICs;
ii. Investment trusts;
iii. Unauthorised collective investment funds, such as EZTs;
iv. Offshore funds;
v. Hedge funds;
vi. Venture capital funds;
vii.Venture Capital Trusts (VCTs);
viii.Exchange Traded Funds (ETFs).
Stage 5: Measuring and Evaluating Performance

Portfolio performance is rarely measured in absolute terms but in relative terms against the
predetermined benchmark and against the peer group.
In addition, indexed portfolios are also evaluated against the size of their tracking error, or how
closely the portfolio has tracked the chosen index. Tracking error arises from both under
performance and outperformance of the index being tracked.
Performance attribution and measurement is covered in Chapter 10.
Stage 6: Revisiting the Client’s Objectives, Revising the Construction of the

Portfolio and/or the Benchmark
It is essential that the portfolio manager and client agree on the frequency with which the portfolio
is reviewed, not only to monitor the portfolio’s performance but also to ensure that it still meets
with the client’s objectives and is correctly positioned given prevailing market conditions.
The main reasons for revising the portfolio’s construction and/or altering the agreed benchmark,
include:
i. The client’s objectives or circumstances have changed;
ii. Investment conditions have changed;
iii. Fundamental changes have been made to the tax system.
Concluding Comments
Despite the useful theoretical framework provided by MPT, CAPM and APT, portfolio management
in practice can perhaps best be described more as an art than a science, not least because the
emotional needs of the client must be balanced against the uncertainties of financial markets and
practical portfolio construction constraints. Rarely will a mechanised or purely mathematically
approach to portfolio management work in practice, though mathematical models are often
employed at certain of its defined stages.

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SOCIALLY RESPONSIBLE INVESTMENT (SRI)

The UK’s first ethical fund was launched in 1984 to a muted response. However, after a slow start,
the popularity of ethical investing, or making profit out of principles, soon gathered pace as public
awareness of environmental issues grew and governments began to respond with a combination of
environmental legislation and taxes.
The growing interest in actively encouraging corporate social responsibility is now central to SRI:
the phrase designed to describe the inclusion of social and environmental criteria in investment fund
stock selection. Indeed, SRI funds have been at the forefront of an industry wide move to include
the analysis of the non-financial aspects of corporate performance, business risk and value creation
into the investment process.
Types of SRI approaches:

1. Ethical Investing
Ethical funds, occasionally referred to as dark green funds, are constructed to avoid those areas
of investment that are considered to have significant adverse effects on people, animals or the
environment. This they do by screening potential investments against negative, or avoidance,
criteria. Screening research is provided by a number of commercial operations of which the
Ethical Investment Research Service (EIRIS) set up to independently research corporate
behaviour, is one of the best known.
As a screening exercise combined with conventional portfolio management techniques, the
strong ethical beliefs that underpin these funds typically results in a concentration of smaller
company holdings and volatile performance, though much depends on the criteria applied by
individual funds.
2. Sustainability Investing
Sustainability funds are those that focus on the concept of sustainable development,
concentrating on those companies that tackle or pre-empt environmental issues head on. Unlike
ethical investing funds, sustainability funds, sometimes known as light green funds, are flexible,
pragmatic and proactive in their approach to selecting investments.
Sustainability investors focus on those risks which most mainstream investors ignore. For
instance, whilst most scientists and governments agree that the world’s carbon dioxide
absorption capacity is fast reaching critical levels, this risk appears not to have been factored into
the share price valuations of fossil fuel businesses. Factors such as these are critical in selecting
stocks for sustainability funds.
Sustainability fund managers can implement this approach in two ways:
i. Positive sector selection. Positive sector selection is selecting those companies that operate in
sectors likely to benefit from the global shift to more socially and environmentally sustainable
forms of economic activity, such as renewable energy sources. This approach is known as
investing in “industries of the future” and gives a strong bias towards growth oriented sectors.
ii. Choosing the best of sector. Companies are often selected for the environmental leadership
they demonstrate in their sector, regardless of whether they fail the negative criteria applied
by ethical investing funds. For instance, an oil company which is repositioning itself as an
energy business focussing on renewable energy opportunities, would probably be considered
for inclusion in a sustainability fund but would be excluded from an ethical fund.

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Responsible Engagement
With the growing trend amongst institutional investors of encouraging companies to focus on their
social responsibilities, sustainability investing research teams enter into constructive dialogue with
companies to encourage the adoption of social and environmental policies and practices so that
they may be considered for inclusion in a sustainability investment portfolio.
Integrating social and environmental analysis into the stock selection process is necessarily more
research intensive than that employed by ethical investing funds and dictates the need for a
substantial research capability. Moreover, in addition to adopting this more pragmatic approach to
stock selection, which results in the construction of better diversified portfolios, sustainability funds
also require each of their holdings to meet with certain financial criteria, principally the ability to
generate an acceptable level of investment return. Typically, financial, environmental and social
criteria are given equal prominence in company performance ratings by sustainability investing
research teams. This is known as the triple bottom line.
Recent Catalysts toFurther Encourage SRI Investing

The move towards SRI investing was given further impetus in July 2000 when legislation came into
force requiring pension fund trustees to disclose the extent to which they take account of ethical,
social and environmental issues in their investment strategies. In addition, many companies now
voluntarily produce an environmental or social report to accompany their annual report and
accounts, which provides information as diverse as the extent of their greenhouse gas omissions to
the number of employees dismissed during the year for unethical behaviour. Moreover, the
Association of British Insurers (ABI) has recently issued guidelines requiring listed companies to spell
out their attitude to corporate social responsibility issues in their report and accounts, as well as
identify and disclose those social, environmental and ethical risks to their business. Research
suggests that good corporate social responsibilities is linked to superior, long term business
performance.
Evidence of SRI investing having entered the mainstream, however, was provided by FTSE
International launching its FTSE4Good indices in July 2001. These indices cover most sizeable
companies around the world and set three global benchmarks against which companies are judged
for inclusion. These indices are detailed in Chapter 10.
The Benefits of Employing Derivatives Within the Investment Management

process
As noted in Chapter 4, the benefits of using derivatives within the investment management process
include:
• hedging;
• anticipating future cash flows;
• asset allocation;
• arbitrage;
• enhancing portfolio performance;
• facilitating access to illiquid or inaccessible markets.

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2.3 Conflict of Interest
LEARNING OBJECTIVES
9.2.6 Understand the issues associated with conflicts of
interest and the duty to clients
The FSA has strict regulations regarding the fair treatment of clients, and all policies and procedures
must by followed by law. Portfolio managers along with other involved parties, have a legal duty to
disclose any material interest or conflict of interest when dealing on behalf of a client. They are also
required to act honestly, fairly and in the best interests of their clients.
3. FUND CHARACTERISTICS
3.1 Introduction
As noted earlier, portfolio managers can construct portfolios both by investing directly in the main
asset classes and by drawing on a wide range of investment funds. This section looks at the
characteristics of these investment funds as well as those fund structures portfolio managers may
themselves manage.
3.2 Insurance Companies

LEARNING OBJECTIVES
9.3.1 Know the main features and risk characteristics of the
following:
• Insurance Companies (life and general)
Insurance companies, like pension funds, are long term investing institutions and hold 20% of their
assets in UK equities. Insurance companies write two main categories of business:
1. Life assurance business, and
2. General business.
1. LIFE ASSURANCE BUSINESS

Life assurance policies are those written by an insurance company on an individual’s life.
These mainly comprise:

i. Term assurance policies, which in exchange for a regular premium, only pay out if the individual
dies before the end of the set policy term.

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ii. Whole of life (WOL) policies, which having no set policy term pay out on the individual’s death at
some stage in the future, again in exchange for a regular premium.
iii. Endowment policies. These are term assurance policies with a significant investment element.
This investment element can be invested in either the company’s with profit or unit linked life
funds.
iv. Single premium life assurance bonds. These are single premium WOL investment policies that
can also be invested either in the company’s with profit or unit linked life funds but which only
offer minimal life assurance.
Due to the long term nature of life assurance business, life assurance premiums are heavily
weighted towards equity investment. Life assurance business profits are subject to the standard
corporation tax rules considered in Chapter 8.
2. GENERAL BUSINESS
The general business of an insurance company comprises writing insurance against short term
personal and commercial risks, typically over a 12 month period. Given the short term nature of
these potential liabilities, general business policy premiums are mainly invested in liquid short term
assets.
Special rules are applied to the taxation of general insurance business.
3.3 Exchange-Traded Funds (ETFs)

LEARNING OBJECTIVES
following:
• Exchange-Traded Funds (ETFs)
Exchange-Traded Funds (ETFs) are essentially open ended investment funds, principally designed to
track the performance of a particular index, but which are listed and traded as quoted companies,
with a transparent net asset value (NAV), on one of a number of stock exchanges around the world.
These hybrid characteristics mean that investors can gain exposure to an entire index through the
purchase of a single share. ETFs originated in the US in 1993 with the introduction of the Standard
& Poors Depository Receipt (SPDR), or Spider as it has become more popularly known, and are
listed and traded on the American Stock Exchange (AMEX). Tracking the S&P 500, this US dollar
denominated product was initially targeted at institutional investors, though, like other ETFs, it has
since evolved to vie for the attentions of institutional and retail investors alike, offering the same
favourable terms to each.

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Although UK investors have had access to US and, more recently, to European listed ETFs since
their inception, it wasn’t until April 2000 that the UK’s first ETF, based upon the FTSE 100 index,
was introduced. ETFs in the UK are public limited companies (plcs) that are listed on the LSE’s
extraMARK exchange, traded through SETS and settled on CREST. Unlike the shares issued by
other plcs, however, purchases of LSE-listed ETFs are not directly subject to the usual 0.5% stamp
duty, assuming the fund is domiciled outside of the UK; Ireland for instance. Also, in contrast to
index tracker unit trust funds, ETFs are continuously priced on a real time basis, rather than a daily
basis, thereby enabling investors to gain instant exposure at a known price to the fund at any time
during the trading day. Despite this real time pricing, ETFs trade at or very near to their underlying
net asset value (NAV) due to the unique way that ETF shares are created and redeemed.
ETFs have other distinguishing features. These include being:

• Based on a wide variety of benchmark equity indices as well as a range of sector and theme-
specific indices and industry baskets. Some are now even actively managed and fixed interest
funds are envisaged. Inevitably, some ETFs are more liquid, or more easily tradeable, than others;
• Transparent in that details of the fund’s holdings, NAV and price quotes can be accessed online;
and
• Subject to low expense ratios, management charges and bid/offer spreads, though these are
dependent on the market index or sector being tracked and the latter on the liquidity of the fund.
Moreover, no initial or exit charges are applied. ETF expenses are usually paid out of the fund’s
dividend income.
ETFs can be used by retail and institutional investors for a wide range of investment strategies,
including the construction of core-satellite portfolios, asset allocation and hedging.
3.4 Venture Capital Trusts (VCTS)

LEARNING OBJECTIVES
following:
• Venture Capital Trusts (VCTs)
VCTs are specialist investment trusts that mainly invest in the issue of new ordinary shares and loan
stock by qualifying Enterprise Investment Scheme (EIS) companies.

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3.5 Venture Capital Funds (Limited Partnerships)
LEARNING OBJECTIVES
following:
• Venture Capital Funds (limited partnerships)
Venture capital companies (VCCs) form limited partnerships that source private capital mainly from
pension funds and wealthy individuals to finance business start ups and provide development capital
to fast growing unquoted companies. Typically formed with a 10 year life, the venture capital
company has full discretion over how the funds are invested within the partnership and will return
the invested proceeds, less an annual management fee and a percentage of the profits made, to the
partnership’s subscribers during this period.
3.6 Offshore Funds

LEARNING OBJECTIVES
following:
• Offshore Funds
Offshore investment fund companies mainly market open-ended equity, fixed interest, money
market and currency funds. Some closed ended investments are, however, offered by investment
trust managers. The main offshore centres are the Channel Islands, the Isle of Man, Dublin,
Luxembourg and Bermuda.
Open ended offshore funds assume one of two structures:

i. Distributor funds. Distributor funds are those that distribute at least 85% of their net investment
income to unit holders or shareholders. Distributor status is applied for annually retrospectively
from HMRC and, if granted, renders UK resident investors remitting income and capital gains
back to the UK subject to the standard income tax and CGT rules. Growth oriented funds,
whose gross investment income is no greater than 1% of their assets, can also apply for
distributor status, even if this income is not distributed.
ii. Non-distributor funds. Non-distributor funds are typically those that roll up their capital gains and
income and are, therefore, not granted distributor status. UK resident investors are subject to
income tax on all income and gains remitted back to the UK from non-distributor funds.
The funds themselves are not subject to UK tax.
The FSA recognises three types of offshore fund that may be freely marketed in the UK:
i. Those that comply with the UCITS directive;
ii. Designated territories funds domiciled in the Channel Islands, Isle of Man and Bermuda;
iii. Funds domiciled outside of the designated territories but approved by the FSA on an individual
basis.

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Although offshore funds provide the UK investor with a greater choice than that available onshore
and in some cases can prove more tax efficient, they generally attract higher charges than their
onshore equivalents and suffer non-reclaimable withholding taxes.
3.7 Common Investment Funds

LEARNING OBJECTIVES
following:
• Common Investment Funds
Common Investment Funds (CIFs) are collective investment schemes made available to charities
registered with the Charity Commission in England and Wales. Charities exist for the relief of
poverty, the advancement of education or religion and for purposes considered beneficial to the
community. Charities are registered with the Charity Commission, whose functions are to establish
and maintain a register of charities, promote the effective use of a charity’s resources and
investigate abuses of a charity’s assets.
CIFs are set up by the Charity Commission under the Charities Acts 1960 and 1993, though are not
promoted by the Charity Commission to charities as being more suitable than any other investment
vehicle. Although not authorised by the FSA, CIFs are similar in structure to authorised unit trusts in
that they provide diversification and cost efficiency. Moreover, as they can be registered with the
Charity Commission as charities in their own right, they can benefit from the tax exempt status
enjoyed by charities. There are over 30 CIFs available with total assets under management of about
£5bn.

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Alternative Investment Strategies (AISS)
Against a background of closely correlated global equity markets and the expectation of lower
nominal investment returns, many portfolio managers have begun to employ AIS within their
portfolios. AIS invest in non-traditional assets (NTA) and comprise hedge funds and private capital.
3.8 Hedge Funds

LEARNING OBJECTIVES
following:
• Hedge Funds
In the UK, the mere mention of hedge funds to some investment professionals often provokes an
immediate and negative reaction given their reputation for being high risk. However, this perception
stands at odds with the reality in most cases.
In their true incarnation, hedge funds seek to eliminate or reduce market risk and capture returns
through manager stock selection skill regardless of market conditions. This they do by combining
long and short positions taken in a portfolio of carefully selected securities without predicting or
relying on the direction of the broader market. That is, they hedge market risk. The concept of
profiting regardless of directional market movements is core to the hedge fund concept. However,
as with most simple concepts in finance, innovation has resulted in a number of complex hedge fund
structures, many of which place a greater emphasis on producing highly geared returns than the
control of market risk. Consequently, there is no simple definition of a hedge fund.
The hedge fund concept can be traced back to an Australian American, Alfred Winslow Jones, who
launched the world’s first hedge fund in 1949. Today, the hedge fund market is worth about
US$1,000bn. About 90% of the 6,000 available hedge funds are based in the US, mainly in New
York, with the remainder located in offshore financial centres. The main differences that exist
between hedge funds, whose activities are unregulated, and conventional regulated investment
funds comprise:
1. Structure. Most hedge funds are set up either as private partnerships in the US or as
unauthorised collective investment schemes in offshore financial centres. An investment bank,
known as a prime broker, typically provides the fund with trading and credit facilities as well as
administrative support, whilst the fund management is usually conducted in a major financial
centre such as London.
2. High investment entry levels. The minimum initial investment into a hedge fund ranges
somewhere between US$100,000 and US$1m. Most hedge funds also impose a limit on the size
to which they can grow so as to keep the fund nimble. The most successful funds have been
known to close their doors to new investment within a matter of months after launch.
3. Investment flexibility. Being an unregulated investment medium, hedge funds have complete
investment flexibility in terms of where, how and in what assets they decide to invest. In addition
to being able to take long and short positions in securities, hedge funds also take positions in
commodities, currencies and mortgage-backed securities. Moreover, as hedge funds do not tie

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their asset and sector allocations to those of their peers, they typically have more concentrated,
or less well diversified, portfolios than regulated investment funds.
4. Gearing. Hedge funds can borrow and/or employ derivatives to potentially enhance returns
through gearing. Regulated investment funds can only use derivatives for efficient portfolio
management (EPM).
5. Low correlation to world securities markets. Despite the greater concentration of their portfolio
holdings, hedge funds, when combined with conventional portfolios, usually provide additional
diversification owing to their low correlation with world equity and bond market movements.
However, the extent to which the inclusion of a hedge fund diversifies the risk of a portfolio
containing traditional assets is wholly dependent upon the hedge fund’s chosen investment
strategy.
6. Investment returns. Hedge funds are geared to absolute returns and the avoidance of losses
whereas regulated investment funds focus on relative returns, typically against an index or peer
group average.
7. Performance related fees. Hedge funds typically levy an annual management fee of 2% in addition
to a performance related fee of about 20% if an absolute performance target in excess of the
risk-free rate of return is met or exceeded and previous losses have been made good. Regulated
investment funds are not permitted to charge performance related fees.
8. Manager investment. Hedge fund managers are further incentivised by being expected to invest
some of their own wealth into the fund. This reinforces the alignment of manager and investor
interests.
9. Accessibility. So as to maximise the manager’s investment freedom, most hedge funds impose an
initial lock-in period of between one and three years before investors may deal in the hedge
fund’s shares. Any dealing that subsequently takes place is then usually only permitted at the end
of each month or quarter. It is also not uncommon for hedge fund assets to be priced monthly.
As there is no universal definition of hedge funds, no one definitive classification system exists.
Whilst many textbooks refer to four broad strategies or fund types - long/short equity, market
neutral, event driven and global macro - others cover in excess of 30 strategies in this highly
fragmented industry. However, hedge fund strategies can be broadly divided into non-directional, or
market neutral, and directional strategies. Although both focus on producing positive absolute
returns, the former seek to contain losses and reduce volatility by insulating manager stock
selection skill from broad market movements whereas the latter typically employ high levels of
gearing without hedging to reinforce a directional view on markets.
Given the bewildering array of hedge fund structures, investment strategies and the general lack of
accessibility and transparency associated with hedge fund investment, the introduction of funds of
hedge funds (FOHFs) in the UK has both widened the appeal and accessibility of this non-traditional
asset (NTA) class to retail and institutional investors alike, by assuming the substantial due diligence
involved in selecting hedge funds. This process entails researching and monitoring individual
manager strategies, investment styles, the degree of hedging and gearing employed, risk
management processes and the consistency of performance. In addition, the suitability and
compatibility of certain strategies and styles is assessed given the risk profile of the fund and the
positioning of the investment cycle. This latter point is of particular importance as no style weathers
all market conditions - a point that was discussed when looking at investment styles earlier in this
chapter.
Hedge funds are a useful addition to the portfolio construction process and are suitable for inclusion
in most portfolios so long as a sensible balance between risk and reward is maintained and a high
level of liquidity is not required.
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3.9 Private Equity Funds
LEARNING OBJECTIVES
following:
• Private Equity Funds
Private equity is another non-traditional asset (NTA) class that has recently gained increased
popularity amongst UK institutional investors, principally pension funds, notably because of its low
correlation to broad equity market movements and the higher than average returns it has
historically delivered.
Providers of private equity comprise the subsidiaries of major banks as well as independent venture
capital companies and limited partnerships. These institutions, in turn, typically source their capital
from portfolio managers, pension funds and wealthy individuals.
Private equity is a key source of funding for many companies and can take the form of equity, bond
or mezzanine finance, the latter combining the characteristics of the former two. Start up finance
and development capital is provided to small but potentially fast growing unquoted companies, with
private capital investors reaping their reward from realising the often significant equity stake they
take in the business through either a trade sale or upon the company floating its equity in the new
issue market. Private equity is also used to finance management buyouts (MBOs) by incumbent
managements, management buy-ins (MBIs) by outside managements, leveraged buyouts (LBOs) by
specialist buyout funds, who then sell off the assets of the company bought out, and to facilitate
public-to-private transactions, when listed companies wish to de-list and be put back into private
hands.
Given the specialist nature of each type of transaction, when investing in private equity, it is
imperative that such investments are well diversified geographically, between industries and across
differing stages of company development.
3.10 Multi-Manager Funds

LEARNING OBJECTIVES
following:
• Fund of Funds
• Manager of Managers
The idea behind multi-manager funds is the recognition that no one fund manager or investment
house has the expertise in all asset classes, geographic regions and investment styles. Hence by
selecting multiple managers a degree of diversification is obtained and the “best” managers are
selected. They are currently the fastest growing investment product in the UK. However the fees
associated with these products tend to be higher due to the additional layer of management. The
main types of multi-manager fund categories are: Fund of Funds and Manager of Managers.

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Fund of Funds (FoF)

A fund of funds has one overall manager. It invests in a portfolio of other existing investment funds
and seeks to harness the best investment manager talent available within a diversified portfolio.
Most fund of funds are managed on an unfettered basis, in that the component funds are run by a
number of managers external to the fund management group marketing the fund of funds.
However, some are managed as a fettered product and are obligated to invest solely in funds run by
the same management group as the fund.
Manager of Managers (MoM)

A manager of managers fund does not invest in other existing retail collective investment schemes.
Instead it entails the MoM fund arranging segregated mandates with individually chosen fund
managers. Traditionally, these types of funds were only available to wealthy clients or institutions
but they are increasingly being offered to retail investors. One disadvantage is that the initial
investment required is usually substantially higher than that required for a fund of funds or other
collective investment scheme.
3.11 Private Client Funds

LEARNING OBJECTIVES
following:
• Private Client Funds
Discretionary trading involves a client’s adviser or broker having the right to make investment
decisions without consulting them. Note that a client mandate (with rules) would need to be put in
place prior to any trading. With non-discretionary trading, the client has the final word on
investment decisions.
Private client funds are bespoke portfolios run on either a discretionary or advisory (non-
discretionary) basis for wealthy clients. The asset split of such portfolios are unique to each client.

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3.12 Collective Investment Funds
LEARNING OBJECTIVES
following:
• Investment Trusts
• Unit Trusts
• OEICs (ICVCs)
Collective investment funds pool the resources of a large number of investors to provide access to
those geographical areas and asset classes that would otherwise be too costly, and in some
instances too risky, to gain exposure to directly.
The benefits of collective investment, therefore, include:

i. Economies of scale;
ii. Diversification;
iii. Professional investment management.
In the UK, collective investment funds comprise unit trusts, OEICs and investment trusts. Unit
trusts and OEICs are known as collective investment schemes (CIS) or mutual funds.
1. Unit Trusts
Unit trusts were first launched in the UK in 1931 and, until very recently with the introduction of
OEICs, proved to be the UK’s most popular collective investment fund structure.
Unit trusts have the following characteristics:

a. They issue units. Each unit in the fund ranks equally with all others in issue and
proportionately reflects the value of the fund’s underlying assets, or NAV.
b. They are open ended. A unit trust can increase or decrease the number of units in issue
depending upon whether or not investors, known as unit holders, are buying more units than
they are selling, or redeeming. Whilst the issue of units adds to the fund’s assets, redemptions
reduce the fund’s assets. No restrictions are imposed upon the buying and selling of units.
c. They are governed by a trust deed. The trust deed sets out the fund’s objective, pricing and
charging structures as well as the responsibilities of the parties to the trust, namely the unit
trust manager and the trustee. The unit trust manager assumes responsibility for running the
fund and selecting the fund’s investments as well as promoting the fund, whilst unit holders
interests are protected by an independent trustee. The trustee, which is usually a third party
bank or insurance company, is the registered owner of the fund’s assets and, therefore,
oversees the management and the pricing of the trust. In addition, the trustee is responsible
for maintaining a register of unit holders, issuing and redeeming units and distributing the
fund’s income, if appropriate.

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d. Authorisation. Most unit trusts are authorised by the Financial Services Authority (FSA). FSA
authorisation permits the fund to advertise to the public and exempts it from CGT on realised
capital gains. Authorisation restricts the range of assets that can be held and requires the fund
to meet stringent diversification rules. Authorised unit trusts can only borrow funds on a
temporary basis and can only use derivatives for Efficient Portfolio Management (EPM). That
is, to reduce the fund’s risk, cost and/or to enhance the fund’s income or capital at little or no
risk to the fund. However, futures and options funds (FOFs) and geared futures and options
funds (GFOFs) marketed in the UK (see fund types, below) and mixed funds introduced under
the UCITS Product Directive (UCITS III) - detailed below - can use derivatives for investment
purposes. FOFs and GFOFs, however, are subject to strict derivative investment limits whilst
mixed funds must make detailed disclosure of their derivative investment strategies,
techniques and risk controls.
Unauthorised unit trusts, such as EZTs, are those run for tax exempt investors, such as pension
funds and charities.
e. They are dual priced. Units are purchased by investors at the offer price and sold at the bid
price. The difference between these two prices, which are subject to FSA regulations, is
known as the bid/offer spread. Unit trusts are priced daily in accordance with an FSA approved
formula based on the value of the fund’s underlying assets, or NAV, at the daily valuation point.
Mandatory single pricing for unit trusts is soon to be introduced.
f. Categorisation. Unit trusts are categorised according to their investment objective rather than
their investment style. That is, whether they are income or growth oriented, the asset classes
they hold and where in the world they invest. In all, there are over 30 unit trust categories.
These are determined by the Investment Managers Association (IMA), the investment
management industry’s trade body, but are constantly evolving as new fund types are
launched.
g. Funds types. Some of the FSA unit trust categories include:
1. Securities funds;
2. Warrants funds;
3. Money market funds;
4. Futures and options funds;
5. Geared futures and options funds;
6. Fund of funds;
7. Property funds;
8. Feeder funds;
9. Mixed funds.
The investment and diversification rules for each of these funds are detailed and
beyond the scope of this syllabus.
h. Taxation. As noted earlier, authorised unit trusts are exempt from CGT. They are, however,
subject to corporation tax at 20% on any interest income or other UFII they receive from the
securities they hold, net of their management expenses. UK dividend income though, being FII,
is not subject to any further tax within the fund.
Unit holders are potentially subject to CGT when disposing of their units and higher rate
taxpayers to additional income tax on dividend and interest distributions and income directed
by the unit holder to be accumulated within the fund, as detailed in Chapter 8.

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2. Open Ended Investment Companies (OEICs)
OEICs were introduced in the UK in 1997 in response to the UK unit trust industry losing
considerable market share in open ended investment funds to continental and offshore fund
management centres. Overseas investors, which had become familiar with the OEIC structure,
didn’t feel comfortable with an investment fund that was subject to UK trust law and was dual
priced. In continental Europe, OEICs are often referred to as Investment Companies with Variable
Capital (ICVC) or SICAV (Societe d’Investment a Capital Variable).
OEICs are very similar to unit trusts in that they are also open ended funds and subject to
comparable regulations. However, rather than adopting a trust structure, OEICs are limited
companies that issue and redeem shares rather than units. Investors as shareholders are, therefore,
entitled to attend and vote at an AGM. OEICs typically assume a so-called umbrella structure,
within which the individual investment funds are known as sub-funds. These sub-funds can issue
different classes of share, each with their own unique charging structure, and in a range of
currencies. Also, rather than being dual priced, OEIC shares are single priced.
The other differences that exist between unit trusts and OEICs are really a matter of semantics. An
OEIC is run by an Authorised Corporate Director (ACD), whose responsibilities are broadly similar
to that of a unit trust manager, whilst a depository, rather than a trustee, oversees the running and
administration of the OEIC.
OEICs are also classified alongside unit trusts by the IMA according to exactly the same criteria.
However, FSA OEIC categories differ from their unit trust counterparts in that feeder funds are not
a recognised OEIC fund type whilst umbrella funds containing securities sub-funds and/or warrants
sub-funds are.
OEICs are taxed in exactly the same way as unit trusts and OEIC shareholders in the same way as
unit trust unit holders.
Although over half of all UK mutual fund groups have converted their unit trusts into OEICs, many
more are expected to continue this trend now that the UCITS Product Directive (UCITS III),
detailed below, has been adopted by the FSA, within its collective investment schemes handbook,
thereby permitting a wider range of OEICs and fund structures to be sold into the EU investment
funds market.
THE UCITS DIRECTIVE

The Undertakings for Collective Investments in Transferable Securities (UCITS) Directive was
introduced in 1985 by the European parliament, to enable collective investment schemes (CIS)
authorised in one EU member state to be freely marketed throughout the EU, so long as the
marketing rules of the host state(s) were complied with.
To comply with the provisions of the original UCITS Directive, a CIS must:
1. Be open ended, in that it can freely issue and redeem units or shares to and from investors;
2. Be a securities fund, warrants fund or an umbrella fund comprising either or both of these fund
categories;
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4. Invest no more than 10% of its scheme property, or assets, in transferable securities not listed on
an EU stock exchange;
5. Invest no more than 5% of its scheme property in any one company; and
6. Avoid direct investment in real estate, metals and commodity futures.
In December 2001, the European parliament approved the European Undertakings for Collective
Investments in Transferable Securities (UCITS) Amending Directives, comprising the Product
Directive and the Management Directive. These are more commonly known collectively as UCITS
III, respectively.
1. The Product Directive. The Product Directive, once implemented into member state national
law - as it has been in the UK since 1 November 2002 - permits CIS operators, or UCITS
management companies, to market a new category of CIS across the EU. This, so-called, “mixed
fund” has much wider investment powers than those funds meeting the original UCITS criteria in
that it permits investment in a broader range of financial instruments than was possible under the
original UCITS Directive and enables the fund to hold a greater percentage of its resources in any
one asset class than was previously allowed. Most notably, investment in derivatives is now
permitted, though such investment requires the fund to make comprehensive disclosure of its
investment strategy and risk monitoring techniques to investors. Funds marketed into other EU
member states under the original directive will, for the time being, operate alongside the
exporting of mixed funds under UCITS III, though, through a series of transitional measures, all
existing UCITS funds categories must be converted to mixed funds by 13 February 2007.
UCITS III may go some way to the UCITS Directive fulfilling its vision of creating truly pan-
European investment funds market notwithstanding the tax differences and differing regulations
that continue to exist between most EU member states.
2. The Management Directive. The Management Directive enables UCITS management companies
to extend their activities beyond managing UCITS-compliant CISs. They are permitted to provide
services such as investment advice and administration to third parties in relation to CISs, for
instance. Moreover, the directive also enables them to “passport” these other services across the
European Economic Area (EEA) in a similar fashion to the “passporting” of investment services
by EU investment firms under the Investment Services Directive (ISD) 1996. The EEA comprises
those states that collectively constitute the European Free Trade Association (EFTA), namely the
pre-accession 15 EU member states, Switzerland, Norway and Iceland.
Services are “passported” under the ISD by either establishing a branch in another EEA country
or by conducting business in the EEA on a cross border basis by setting up a computer network,
for instance. The Management Directive also provides for new capital adequacy, or financial
resources, requirements to be applied to UCITS management companies, so as to facilitate this
“passporting”, and for the simplification of CIS prospectuses.
3. Investment Trusts
Investment trusts are plcs listed on the LSE that issue shares. Despite having been introduced in the
UK in 1868, they have not proved as popular as unit trusts and OEICs. In part this can be explained
by investment trusts having a closed ended structure, or a fixed amount of share capital in issue.
This share capital can only be increased through a special type of rights issue known as a C share
issue. As a consequence, although each share in issue represents an equal share of the investment
trust’s underlying assets, the share price can move independently of the value of these assets, like
that of any other listed company. The share price will, therefore, trade at either a premium, or
more commonly, a discount to its net asset value (NAV). Although discounts can narrow to the
advantage of the shareholder, they can also widen.

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An investment trust’s NAV is calculated as follows:
listed investments at mid-market price, plus
unlisted investments valued by directors, plus
cash and other assets, less
nominal value of loans and preference shares
An investment trust’s discount or premium is calculated as follows:
[(NAV - share price)/NAV] x 100
However, having a closed ended structure also means not having to meet shareholder redemptions.
Instead, shareholders must realise their investment through an LSE member firm like any other
equity share. Therefore, the portfolio manager can take a longer term view when implementing
their investment policy than the manager of an open ended fund that must maintain an element of
liquidity to meet potential redemptions.
Also, unlike open ended funds, investment trusts can permanently employ gearing to potentially
enhance shareholder returns. As gearing, like discounts, can work to the advantage or to the
detriment of the investor, this makes investment trusts a more riskier proposition than open ended
funds.
In order to gain authorisation, investment trusts must meet certain LSE and HMRC requirements.
These include not having control over the companies in which they invest, deriving at least 70% of
the fund’s income from shares and other securities and investing no more than 15% of the fund’s
assets in any one company. Authorisation grants the investment trust exemption from CGT on
realised capital gains though corporation tax remains payable on UFII, in the same way as for open
ended funds. Investment trust investors are taxed in exactly the same way as their open ended
counterparts.
Investment trusts are categorised by the Association of Investment Trust Companies (AITC)
according to their investment objective and can be marketed either as conventional funds or as split
capital trusts with different classes of share capital in issue. In both cases, investors interests are
protected by an independent Board of Directors, the continuing obligation requirements of the
UKLA and the Companies Acts.
The split capital investment trust industry came under attack in 2002 as a result of engaging in
practices which led to collapsing asset values and the insolvency of several trusts. A common
practice had been for these trusts to employ considerable amounts of bank debt so as to gear the
capital and income performance of their underlying portfolios, which in the vast majority of cases
mainly comprised the income shares of other split capital investment trusts. This “magic circle” of
highly geared cross-shareholdings necessarily created a domino effect throughout the industry as
the value of these portfolio assets fell against the backdrop of declining equity markets and bank
debt covenants were broken. As a result, many split capital investment trusts were forced to
restructure, repay bank debts and either cut or suspend dividend payments. A £144m
compensation fund was set up for the investors who lost money as a result.

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3.13 Retirement Funds

LEARNING OBJECTIVES
9.3.2 Know the main features and risk characteristics of
retirement funds
Many western countries currently face the problem of a signicantly aging population and are
encouraging citizens to set up their own retirement funds. Although most countries have some sort
of public assistance for retirees, it is envisaged that due to the large number of elderly citizens it will
place a heavy burden on the government’s funds. As a result, many countries such as Australia and
Singapore have set up a compulsory pension system where a percentage of an employee’s salary
must be paid into a retirement fund. There are usually tax advantages attached to retirement funds
as the government attempts to encourage people to save for their retirement.
Retirement funds typically have rules stating that investors cannot withdraw their money until they
reach a certain age (usually their retirement age). This can present difficulties for investors if they
require the funds earlier in life, for example to buy a house. Another disadvantage of retirement
plans is that governments can and do change the rules relating to factors such as contribution limits,
withdrawal age, taxation benefits, withdrawal methods (eg, annuity, cash) etc.
Two of the most common types of retirement funds are Defined Benefit Schemes and Defined
Contribution Schemes.
1. Defined Benefit (DB) Schemes

DB, or final salary, pension schemes are those occupational pension schemes that provide
guaranteed benefits for their scheme members. These benefits are based on the number of years
each employee has been a member and their salary either at retirement or at the date of leaving the
scheme sponsor’s employment. A common type of DB plan is a ‘Final Salary Plan’ which is based on
the member’s final salary and the number of years they have worked. A pension or lump sum is
then paid on retirement. The investment risk rests with the scheme sponsor (and not the scheme
member).
2. Defined Contribution Plans

In a defined contribution plan, the money to be invested is paid into an individual member’s account
(in their name). The member carries the investment risk so that if, for example, their fund invests in
UK equities and this asset class performs poorly, then the retirement benefits available will also be
poor. In recent years, these types of plans have become much more common throughout the
world, particularly in the USA and UK.
Some examples include Individual Retirement Accounts (USA), 401(k) Plans (USA), Stakeholder
Pensions (UK), SIPPS (UK) and PERCO (France).

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1. PERFORMANCE BENCHMARKS
1.1 Introduction to performance benchmarks

When considering the stages of the portfolio management process in Chapter 9 the need to
establish a realistic benchmark against which the performance of a portfolio can be judged once
constructed, was briefly discussed. Depending on the objective and asset split of the portfolio, this
benchmark can either take the form of an established index or a peer group average.
Each of these will now be considered in turn.
1.2 Equity indices

LEARNING OBJECTIVES
10.1.3 Be able to calculate the main types of equity indices
(arithmetic price and market value weighted and
geometric unweighted)
Index numbers
The ability to calculate and interpret index numbers is fundamental to the portfolio management
process. Index numbers are a concise way of comparing the value of a variable between different
points in time. They are calculated by selecting a period in time - the base period - and assigning an
arbitrarily determined base value to the variable, typically one, 10 or 100 to keep matters simple.
Subsequent index values of the variable can then be compared with this base value or any other
subsequent value; these changes being expressed either in absolute or in percentage change terms.
Index values then, given a sufficiently long history can provide an indication of whether a trend has
been established or whether once established a trend has been bucked.
The principles for calculating index numbers are perfectly general and can be applied to comparing
the values of any variable. Index numbers are particularly useful, however, for calculating how the
price of a basket comprising a number of different items has changed over time. These are known
as composite indices. Composite indices, such as the RPI and the CPI, provide a concise summary
of how these individual price movements over a particular time period impact on the general level
of prices.
Stock market, or equity, indices, like any other composite index number, are designed to provide a
concise summary of the price movements of their underlying constituents. This they do by
representing the collective diversity of individual share price movements. In addition, however,
some equity indices also incorporate the reinvestment of dividends, into their index values to
provide an index of total return: total return being equal to price movements plus this dividend
income. There are now over 3,000 equity indices worldwide, some of which track the fortunes of a
single market whilst others cover a particular region, sector or a range of markets.

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Most stock market indices have the following four uses:

1. To act as a market barometer. Most equity indices provide a comprehensive record of historic
price movements, thereby facilitating the assessment of trends. Plotted graphically, these price
movements may be of particular interest to technical analysts, or chartists, and momentum
investors, by assisting the timing of security purchases and sales, or market timing. Technical
analysis was covered in Chapter 7, whilst market timing and momentum investing were
considered in Chapter 9.
2. To assist in performance measurement. Most equity indices can be used as performance
benchmarks against which portfolio performance can be judged.
3. To act as the basis for index tracker funds, exchange-traded funds (ETFs), index derivatives and
other index related products.
4. To support portfolio management research and asset allocation decisions. This was covered in
Chapter 9.
Stock market indices were originally designed to provide an impressionistic mood of the market and
as such were not constructed in a particularly scientific manner. In recent years, however, index
construction has become more of a science as performance measurement has come under
increased scrutiny and the growth of index related products has necessitated the need for more
representative measures of market movements with greater transparency surrounding their
construction. Therefore, when constructing an equity index the following general considerations
must be made:
1. What market, sector or combination of markets should be tracked?
2. What should be the basis of inclusion of constituents?
3. How should these constituents be weighted, if at all?
4. How should the price relatives of the individual index constituents be combined?
5. What rules should apply to changing index constituents?
6. Should the index only track price movements or should it also incorporate dividend income?
Moreover, for an equity index to prove successful, it must ensure that:

1. It is relevant to investors’ needs;
2. It is capable of being replicated by a real world portfolio for performance measurement and
index related product purposes;
3. Its constituents are not subject to any investment restrictions; that is, they should be capable of
being held within a portfolio;
4. It is sufficiently broadly based; and
5. Its method of construction and calculation is transparent.
One of the most fundamental aspects of equity index construction is deciding upon:
1. How to combine, or average, the relative prices of index constituents, and
2. Whether or not to employ a method of weighting.
Equity indices can adopt either an arithmetic or geometric averaging process and apply an
unweighted, price weighted or market value weighted methodology to the chosen averaging
process. So far our analysis has been restricted to unweighted, quantity weighted and value
weighted arithmetic index numbers.

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Most equity indices take one of the three following forms:
1. Price weighted arithmetic indices. These are constructed on the assumption that an equal
number of shares are held in each of the underlying index constituents. However, as these equal
holdings are weighted according to each constituent’s share price, those constituents with a high
share price relative to that of other constituents, have a greater influence on the index value. The
index is calculated by summing the total of each constituent’s share price and comparing this total
to that of the base period. Although such indices are difficult to justify and interpret, the most
famous of these is the Dow Jones Industrial Average (DJIA).
2. Unweighted geometric indices. These establish the geometric mean of the index constituent
price relatives between time periods. The geometric mean is the nth root of the product of n
constituents, where n = the number of index constituents. One of the few remaining examples
of this type of index is the FT Ordinary Share Index, or FT30.
3. Market value weighted arithmetic indices. These are calculated in the same way as the value
index considered earlier, by weighting each constituent share price by the corresponding number
of shares in issue in that period and comparing this total to that of the base period. Examples of
this type of composite index include the FTSE 100 and S&P 500.
However, the value of a market capitalisation index as a performance measurement benchmark
can be compromised if those index constituents that make significantly less than 100% of their
equity available to the market are accorded a full market value index weighting. Not only will the
restricted supply of a particular stock prevent a portfolio manager from holding a full weighting of
the stock within their portfolio but the price of the constituent will be distorted given the need
for index tracker funds in particular to hold the stock in accordance with its index weighting.
Most of the established market capitalisation weighted index providers, such as FTSE
International, Stoxx and MSCI, have, therefore, introduced restrictions on the weightings of
those constituent companies with less than 100% free float by adopting free float capitalisation
weighted indices.
The following example illustrates how each of these different methods of averaging and weighting
measure the same event differently.
Period Stock X Stock Y Stock Z Price Unweighted Market value

(800 shares (100 shares (100 shares weighted geometric weighted
in issue) in issue) in issue)
arithmetic index arithmetic
index index
to 100p 100p 100p 100 100 100
t1 90p 105p 120p 105 104.28 94.5
t2 100p 0p 100p 66.67 0 90
Assume each index begins with base value = 100 in t0. This base value, as before, has been
arbitrarily chosen.

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In period t1, X’s share price has fallen from 100p to 90p, whilst Y and Z’s share prices have risen
from 100p to 105p and 120p, respectively. The number of shares in issue for all three constituents
remain the same as in period t0. The three indices are calculated as follows:
1. Price weighted arithmetic index = [Σpt1/Σpt0] x base index value, when p = share price and t =
time period
= [(90 + 105 + 120)/(100 + 100 + 100)] x 100 = 105
2. Unweighted geometric index
= n√ [product of current share prices/product of base shares prices] x base index value,
where n = number of index constituents
= [(90 x 105 x 120)/(100 x 100 x 100)]1/3 x 100 = 104.28
3. Market value weighted arithmetic index = (Σpt1qt1)/(Σpt0qt0) x base index value, where q =
number of shares each constituent has in issue
= [[(90 x 800) + (105 x 100) + (120 x 100]/[(100 x 800) + (100 x 100) + (100 x 100)]] x 100 = 94.5
In period t2, the indices become:
1. Price weighted arithmetic index = [(100 + 0 + 100)/(100 + 100 + 100)] x 100 = 66.67
2. Unweighted geometric index = [(100 x 0 x 100)/(100 x 100 x 100)]1/3 x 100 = 0
3. Market value weighted arithmetic index
= [[(100 x 800) + (0 x 100) + (100 x 100)]/[(100 x 800) + (100 x 100) + (100 x 100)]] x 100 = 90
Comparison of Index Averaging Methods
1. Price weighted arithmetic indices. Despite their ease of calculation, these indices are influenced
solely by the relative share prices of their underlying constituents; favouring highly priced shares
over lowly priced. By ignoring the number of shares each constituent has in issue, unlike market
value weighted arithmetic indices, changes in the value of price weighted arithmetic indices are
unrepresentative of how the value of their constituent shares would change within a real world
portfolio.
This is particularly prominent in period t1 when a fall in the share price of X and a rise in the
share prices of Y and Z result in the price weighted arithmetic index rising and the market value
weighted index falling and in period t2 when the share price of Y falling to zero causes the former
index to exaggerate the event. Therefore, these indices are of limited use as market barometers
and as performance measurement benchmarks.
2. Unweighted geometric indices. This type of index has two main drawbacks:
a. It always understates the price rises and overstates the price falls of constituents relative to
that of a price weighted arithmetic index.
b. It collapses if the price of an index constituent falls to zero.

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Given these shortcomings, unweighted geometric indices should not be used for performance
measurement purposes or as a guide to broad market movements.
3. Market value weighted arithmetic indices. These indices, although subject to significant data
requirements and more complex calculations than their peers, replicate the precise effect
changing share values would have on a portfolio comprising the same underlying index
constituents weighted in accordance with their relative market capitalisations. Moreover, most,
unlike many price weighted arithmetic and unweighted geometric indices, have a broad coverage
of the market being represented.
They are, therefore, the most suitable type of index to assess market trends, act as performance
benchmarks, provide a basis for pricing index relate products and support research and asset
allocation decisions.
Index Changes
Changes to equity indices encompass:
1. Index rebasing, and
2. Constituent changes.
Index Rebasing
When an index is rebased the following formula is applied:
Rebased index value =

original index value x new base index value/index value when index rebased
So, if the period t0 base value of 100 for each of the above indices is rebased to 120, then the above
index values will become:
Period Price weighted Unweighted Market value weighted

arithmetic index geometric index arithmetic index
to 120 120 120
t1 126 125.1 113.4
t2 80 0 108
Constituent Changes
Most indices have set criteria as to when incumbent constituents should be replaced. However, if
the index is to continue to convey the same information as before the constituent change, then its
value must remain unaltered at the time of the adjustment.
Period Stock X Stock Y Stock Z Price Unweighted Market

(800 shares (100 shares (100 shares weighted geometric value
in issue) in issue) in issue)
arithmetic index weighted
index arithmetic
index
to 100p 100p 100p 100 100 100
t1 90p 105p 120p 105 104.28 94.5
t2 100p 0p 100p 66.67 0 90

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Take the price weighted arithmetic index value in period t1 of 105. If share X was to be replaced by
share A with 200 shares in issue and a share price of 120p, then for the price weighted arithmetic
index to maintain its value of 105, that is to prevent the index value rising to:
[(120 + 105 + 120)/(100 + 100 + 100)] x 100 = 115, a new divisor, or denominator,
must replace the Σpt0 denominator, as follows:
Old divisor = former Σpt1/t1 index value = [(90 + 105 + 120)/105] = 3
New divisor = old divisor x (new Σpt1/former Σpt1)
New divisor = 3 x [(120 + 105 + 120)/(90 + 105 + 120)] = 3.286
By dividing the total of the new share prices, by the new divisor of 3.286, the price weighted
arithmetic index remains at 105:
[(120 + 105 + 120)/3.286] = 105
Index values calculated from period t1 onwards, will, therefore, draw on the following formula:
[Σptn/3.286] where Σptn is the sum of the constituent share prices in period n.
A similar adjustment would be made to the unweighted geometric and market value weighted
indices though that made to the unweighted geometric index is not as complex as the process
described above.
1.3 The Main Equity Indices

LEARNING OBJECTIVES
10.1.1 Know the main features of the named indices
(see the syllabus learning map at the back of this book
for the full version of this learning objective)
10.1.2 Know why free float indices were introduced
FTSE International Equity Indices

FTSE International Limited produce a range of free float capitalisation weighted indices, each of
which have stringent entry criteria for the inclusion of constituents. The free float restrictions are
graduated and apply to all constituents whose free floats are less than 75% of their market
capitalisation.
FTSE index Constituents Approximate

percentage of FTSE All
Share index
FTSE 100 The 100 largest companies 80%
FTSE 250 The next 250 largest companies 15%
FTSE 350 FTSE 100 + FTSE 250 95%
FTSE SmallCap FTSE All Share - FTSE 350 5%
FTSE All Share FTSE 100 + FTSE 250 + FTSE SmallCap 100%
FTSE Fledgling Those that do not meet the size criteria 1.5%
for the FTSE All Share

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1. FTSE All Share index. The All Share index provides the broadest measure of UK equity market
performance. Introduced in 1962 with a base, or starting, value of 100, the All Share index
contains around 700 companies and represents about 98% of the capitalisation of the UK equity
market. It is an amalgamation of the FTSE 100 and FTSE 250 indices, which together comprise
the FTSE 350, and the FTSE SmallCap index of around 400 stocks. The FTSE 350 is further sub
divided into a 175 high yield stocks index and a 175 low yield stocks index. The former acts as a
proxy for the performance of value stocks and the latter for growth stocks. The All Share index is
also segmented into 10 industry sub-sectors which themselves are divided into a further 34 key
industry sectors by the FTSE Actuaries Industry Classification Committee. You can locate these
sectors on the back page of the Companies and Markets section of the Financial Times.
Outside of the All Share index is the FTSE Fledgling index, introduced in 1995, that contains
those companies whose market capitalisation is insufficient to gain entry to the FTSE SmallCap
index. These companies account for about 1.5% of UK stock market capitalisation. There are
also specialist indices such as the FTSE All-Small index which is an amalgamation of the SmallCap
and Fledgling indices, the FTSE AIM which covers those companies admitted the Alternative
Investment Market (AIM) and the FTSE techMARK 100 and FTSE techMARK All Share indices
which represent those companies from Fledgling to FTSE 100 committed to technological
innovation.
The All Share index, in common with the other FTSE indices, is only published as a capital return
index. However, total return data on all FTSE indices is made available. The value of the All Share
index is calculated at the end of each trading day as well as intraday on a minute-by-minute basis.
2. FTSE 100 index. The Footsie, as it is colloquially known, was introduced on 3 January 1984 with
a base value of 1000 and is the most widely monitored barometer of UK equity market
sentiment. Computed on a real time basis (every 15 seconds), the FTSE 100 index comprises the
100 largest publicly quoted companies in the UK, many of which are multinationals, and
represents about 80% of the All Share index by market capitalisation. The composition of the
index is reviewed at the end of each quarter. Any FTSE 100 company that has fallen in value to
110th place or below in the All Share index is automatically replaced by a FTSE 250 constituent.
3. FTSE 250 index. Introduced in 1992 but with a 1985 base value of 1412.60, the FTSE 250
comprises those 250 companies that by market capitalisation are positioned directly beneath the
FTSE 100. Like the FTSE 100, the FTSE 250 is also calculated on a real time basis (every 15
seconds). FTSE 250 companies account for about 15% of the All Share index.
4. FTSE SmallCap index. The SmallCap index was introduced in 1992 with a base value of 1363.79
and comprises approximately 350 stocks. SmallCap index constituents are reviewed annually by
the FTSE Equity Indices Committee in conjunction with the FTSE Fledgling index, in a similar
fashion to that of the FTSE 100 and FTSE 250 quarterly reshuffle, though the criteria is a little
more complicated. As a result there could be more or less than 400 companies in the SmallCap
index in successive years. The index is calculated at the end of each trading day as well as intraday
on a minute-by-minute basis.
5. FTSE4Good indices. As noted in Chapter 9, the FTSE4Good indices were introduced in July 2001
to provide a benchmark against which to judge the performance of ethical and SRI portfolios.
There are four indices representing the UK, US, European and global equity markets each of
which is based upon selected constituents of existing FTSE International indices. As the index
constituents are screened by EIRIS, the indices veer towards the ethical end of the green
investment spectrum. FTSE International, in conjunction with EIRIS, judges companies for
inclusion in each of these indices against best practice in three areas:
i. upholding and supporting universal human rights;
ii. working towards environmental sustainability;
iii. developing positive relations with shareholders and customers.

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6. FTSE All World index. The FTSE All World index was launched on 30 June 2000. It is a US$
denominated index that monitors the performance of over 2,200 stocks in the equity markets of
48 countries and attempts to cover up to 90% of the free float capitalisation of each equity
market it monitors. The index also compiles regional indices, indices for economic groups and
industry sectors. Like the domestic FTSE International indices, it has stringent entry criteria.
Other Prominent Equity Indices

1. MSCI World index. The Morgan Stanley Capital International (MSCI) World index is a global
index covering 1,700 stocks from 23 developed countries representing about 85% of the free
float capitalisation of each market. Like the FTSE World index, it also comprises a series of
country, industry and economic group indices. It is denominated in US$ but is also calculated in
the local currencies of the 23 equity markets covered.
2. Dow Jones Industrial Average (DJIA) index. Introduced in 1897 with 12 constituents at a
base value of 40, this price weighted arithmetic index has, since the late 1920s, had 30
constituents. Although not suitable for benchmarking purposes because of the significant
drawbacks in its calculation and its narrow representation of the US equity market, it nonetheless
remains the most popular measure of US equity market performance.
3. Standard & Poors (S&P) 500 index. The S&P 500 index comprises 500 of the most widely
held NYSE listed companies and represents about 80% of NYSE market capitalisation. This
market capitalisation weighted index was rebased in 1941 at an index value of 10.
4. DAX 30 index. The DAX 30 index contains the largest 30 German stocks by market
capitalisation. It is a real time index and is uniquely calculated inclusive of reinvested income.
5. CAC 40 index. The CAC 40 index comprises the 40 largest French companies by market
capitalisation and is calculated on a real time basis.
6. Nikkei Dow indices. The Nikkei 225 index is a price weighted arithmetic index of 225 Japanese
companies that are considered representative of the Japanese equity market. The index was
introduced in 1949 with a base value of 176.21. The Nikkei 300, introduced in 1993, however,
being a market capitalisation weighted index is more suitable than the Nikkei 225 to act as a
benchmark for performance measurement purposes.
7. Hang Seng index. The Hang Seng index contains approximately 38 companies listed on the
Hong Kong Stock Exchange. It is a capitalisation-weighted index.
8. All Ordinaries (‘All Ords’). This index contains more than 300 Australian companies and
measures the share price movements on a daily basis. The companies in the index have a market
capitalisation of around 95% of all shares listed on the Australian Stock Exchange.
Limitations of Equity Indices for Performance Measurement Purposes

All equity indices suffer from the following limitations as a performance measurement benchmarks:
1. Most only measure the change in constituent capital values, or price movements, rather than
including the reinvestment of dividend income to measure the change in total return. Although
FTSE International take dividend income into account in their total return indices, it is assumed
that dividend payments are reinvested on the xd date rather than on the date when the dividend
is actually paid.
2. All assume that the investor is fully invested in the constituent equities at all times.
3. All fail to reflect the cost of setting up and administering a portfolio and the impact of taxation on
subsequent returns.

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4. All suffer from survivorship bias. At any point in time an index only contains and reflects the
performance of those constituents that continue to meet its criteria rather than those that have
left the index perhaps as a result of a decline in fortunes, merger or acquisition, even though
those shares that have left the index may remain in a real world portfolio.
5. The combination and weighting of constituents in most indices rarely result in a low covariance
portfolio. This point was explored in Chapter 9.
1.4 Bond Indices
FTSE Actuaries Government Securities indices

The FTSE Actuaries Government Securities indices were introduced in 1977 and comprise price
and yield indices for conventional and index-linked gilts across different maturities. Each index is
weighted according to the market value of each constituent stock and is calculated daily. Although
each price index can be individually used for performance measurement, taken together these price
indices form a broad measure of gilt market performance in the All Stocks index.
Citi World Government Bond index

The Citi World Government Bond index can be used as a benchmark against which to monitor and
evaluate portfolios of government bonds held in the major government bond markets.
Other Bond Indices

Corporate bond indices are compiled by investment banks such as Merrill Lynch and Goldman
Sachs.
1.5 Peer Group Average Benchmarks

LEARNING OBJECTIVES
10.1.4 Know the alternative ways of benchmarking:
• Peer group average (WM and CAPS)
Rather than use an established index to benchmark portfolio performance, a peer group average is
often employed. Owing to the asset allocation by consensus methodology adopted by most top
down institutional portfolio managers in the running of pension fund portfolios, extensive use is
made of the standardised benchmarks provided by:
i. The WM company (WM), and
ii. The Combined Actuarial Performance Service (CAPS).
WM and CAPS provide, what are known as, universe returns for the pension fund industry: a
universe being defined by pension funds of a particular size. These universe returns are calculated
quarterly, from survey evidence received from pension fund managers, on both a median and
weighted average basis, usually within six to eight weeks after the quarter end. This time delay is
due to the amount of performance data that must be collected in order to calculate these peer
group performance averages.

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Portfolios run for retail clients, however, in addition to the indices detailed above and those
provided by the Association of Private Client Investment Managers and Stockbrokers (APCIMS),
often use peer group performance figures provided by Micropal and Hindsight. The APCIMS private
investor indices are constructed in conjunction with FTSE International. They comprise a growth,
balanced and income index, each of which is designed to provide investors with a benchmark
against which to measure the performance of their portfolios. Each index has its own unique
percentage weighting in the FTSE All Share index, FTSE All-World ex-UK index (priced in sterling),
FTSE Gilts (All Stocks) index and in cash, represented by seven-day LIBOR minus 1%. These
percentage weightings are reviewed by APCIMS survey evidence every six months.
Where peer group average benchmarks are used, whether for institutional or retail portfolios,
clients will usually wish to see evidence of consistent above average performance and in many cases
first quartile performance. Average in this context is typically taken to be the median. Performance
measurement statistics within a defined universe are also usually categorised into deciles and
percentiles. These were considered in Chapter 2.
Peer Group Averages Versus Indices

i. Continuous data. Indices calculated on a real time basis provide continuous data for performance
measurement purposes whereas peer group average benchmarks are only published periodically
and not always in a timely fashion.
ii. Transparency. For WM and CAPS universe performance data, only at the time of publishing the
performance figures for each universe are the benchmark weights applied to the average pension
fund in each universe known for the previous quarter. Moreover, these benchmark asset
allocation weights are only provided in respect of broad investment regions. No individual
country weights or sector weightings are given. The composition of an index, by contrast, is
totally transparent and known at any point in time.
iii. Chain linking. The performance of indices can be chain linked, or reconciled, over time whereas
WM and CAPS median performance data cannot.
iv. Survivorship bias. Both indices and peer group average benchmarks in general suffer from
survivorship bias.
1.6 Global Investment Performance Standards (GIPS)

LEARNING OBJECTIVES
10.1.4 Know the alternative ways of benchmarking:
• GIPS (Global Investment Performance Standards)
GIPS are not a way of benchmarking performance but are performance standards, developed by
the Society of Investment Professionals, that set out global guidelines for the standardisation of the
calculation and presentation of performance figures. As such, they represent a great leap forward
for the performance measurement industry.

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2. PERFORMANCE ATTRIBUTION
2.1 Total Return

LEARNING OBJECTIVES
10.2.1 Understand total return and its components
Total return is a measure of investment performance that includes the change in price of the asset
plus any other income (including dividends, interest and capital gains distributions). It is assumed
that all income is reinvested over the period. The calculation of total return is expressed as a
percentage of the initial asset value.
2.2 Performance Attribution

LEARNING OBJECTIVES
10.2.2 Be able to calculate the deviations from a performance
benchmark attributable to: actual vs relative
performance; asset allocation; stock selection
Performance attribution is used to decompose the results of top down active portfolio
management. It involves:
i. Comparing a portfolio manager’s performance against an agreed benchmark, and
ii. Attributing the resulting outperformance or underperformance to:
a. the degree of asset allocation skill, that is whether the portfolio manager has invested in the
right asset classes and in the right geographical regions; and/or
b. the degree of stock selection skill, that is having decided upon the asset allocation, has the
portfolio manager invested in the right sectors and stocks?
To determine a fund manager’s asset allocation skill, you need to apply the following formula for
each asset class:
(fund value at start of period x portfolio manager asset class weightings x benchmark asset class
returns)
minus
(fund value at start of period x benchmark asset class weightings x benchmark asset class returns)
This isolates that part of the return attributable to diligent asset allocation by comparing the
portfolio manager’s exposure to asset classes and geographical areas to that of the benchmark and
then multiplying this difference by the benchmark returns.
To determine a portfolio manager’s stock selection skill, you need to subtract the fund value
resulting from asset allocation from the actual fund value at the end of the period.

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Example (1)
Fund value at start of period = £20m
Fund value at end of period = £18.75m
Asset allocation and Equities % Gilts %

returns during period
Fund asset allocation 75 25
Benchmark asset allocation 50 50
Benchmark returns - 10 -5
Given the fund and benchmark statistics above, what is the absolute outperformance or
underperformance of the fund relative to the benchmark?
Solution (1)
Absolute outperformance or underperformance:
Benchmark at end of period = [0.5 x £20m x (1 - 0.1)] + [0.5 x £20m x (1 - 0.05)] = £18.5m
Fund value at end of period = £18.75m
Fund outperformance = £18.75m - £18.5m = £0.25m
Example (2)
Given the fund and benchmark statistics above, calculate the absolute outperformance or
underperformance of the fund relative to the benchmark attributable to asset allocation.
Solution (2)
The contribution of asset allocation to fund returns is established by applying the following formula
to both the fund’s equity and gilt weightings and to the benchmark returns:
(fund value at start of period x portfolio manager asset class weightings x benchmark asset class
returns)
minus
(fund value at start of period x benchmark asset class weightings x benchmark asset class returns)
However, as the value of the benchmark at the end of the period is already known, then a quicker
way of establishing the out or under performance due to asset allocation is to apply the following
formula:
[fund value at start of period x fund equity weighting x benchmark equity return] + [fund value at
start of period x fund gilt weighting x benchmark gilt return] - benchmark at end of period
Performance attributable to asset allocation =
[£20m x 0.75 x (1 - 0.1)] + [£20m x 0.25 x (1 - 0.05)] - £18.5m = £(0.25m)
Poor asset allocation has caused the fund to under perform the benchmark by £0.25m.
Example (3)
Given the fund and benchmark statistics above, calculate the absolute contribution to performance
attributable to stock selection.
Solution (3)
The fund value at the end of the period is £18.75m whilst the fund value attributable to asset
allocation is £18.25m. Therefore, good stock selection has added £0.5m to performance.

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}
The outcome of this performance attribution is summarised in the diagram below.
FUND VALUE £20m

AT START OF
YEAR
ABSOLUTE LOSS IN
VALUE OF FUND
} }
FUND VALUE AT £18.75m
END OF YEAR NET OUTPERFORMANCE OF
OUTPERFORMANCE
DUE TO STOCK FUND
}
BENCHMARK £18.50m
SELECTION
UNDERPERFORMANCE DUE
TO ASSET ALLOCATION
£18.25m
Figure 1: Outcome of Performance Attribution Summary
3. PERFORMANCE MEASUREMENT
3.1 Introduction
Fund performance can be measured in a number of ways. The two most common are:
1. Money weighted rate of return (MWRR), and
2. Time weighted rate of return (TWRR).
3.2 Money Weighted Rate of Return (MWRR)

LEARNING OBJECTIVES
10.3.1 Be able to calculate the money weighted rates of
return (MWRR)
The MWRR is the internal rate of return (IRR) that equates the value of a portfolio at the start of an
investment period plus the net new capital invested during the investment period with the value of
the portfolio at the end of the period.
The MWRR, therefore, measures the fund growth resulting from both the underlying performance
of the portfolio and the size and timing of cashflows to and from the fund over the period.

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To establish the IRR, you must solve the following equation for r, the simple rate of interest:
[(V0 + C0) (1 + 2r)] + C1(1 + r) + C2 = V2 where:
V0 = value of the portfolio in period t0 including any cashflow (C0) received in

period t0
C1 = value of the cashflow received in period t1
V2 = value of the portfolio in period t2 including any cash flow (C2) received in period t2.
V0 + C0 is invested for two periods, hence (1 + 2r), whilst C1 is only invested for one period,
hence (1+ r).
3.3 Time Weighted Rate of Return (TWRR)

LEARNING OBJECTIVES
10.3.2 Be able to calculate the time weighted rates of
return (TWRR)
As the distorting effects that cashflows have on portfolio performance are beyond the control of the
portfolio manager, it makes sense to adopt a performance measure that eliminates them. This is
exactly what the TWRR does.
The TWRR is established by breaking the investment period into a series of sub periods. A sub
period is created whenever there is a movement of capital into or out of the fund. Immediately
prior to this point, a portfolio valuation must be obtained to ensure that the rate of return is not
distorted by the size and timing of the cashflow. The TWRR is calculated by compounding the rate
of return for each of these individual sub periods, applying an equal weight to each sub period in the
process. This is known as unitised fund performance.
The TWRR is given by the following formula:
R = [(V1/(V0 + C0)) x (V2/(V1 + C1))]1/n - 1, where:
V0 = value of the portfolio in period t0 before the receipt of cashflow C0
C0 = value of the cash flow, if any, received at the start of the period
V1 = value of the portfolio immediately before the receipt of cashflow C1 in

period t1
V2 = value of the portfolio immediately before the receipt of any cashflow C2 in
period t2
n = number of sub periods
You may recognise the TWRR formula as being similar to that used in Chapter 2 to calculate an
annual compound rate of growth or geometric mean.

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Example
Time period Portfolio value Cash inflow

t0 10 6
t1 20 4
t2 30 1
Calculate the money weighted rate of return (MWRR) and the time weighted rate of return
(TWRR) for the above portfolio.
Solution
To obtain MWRR, solve for r. So, if 16 (1+2r) + 4 (1+r) + 1 = 31, then r = 27.8%
TWRR = (20/16 x 30/24)1/2 -1 = 25%
You will notice that the cash inflow C0 of six received in period t0 increases the initial portfolio
value for both equations from 10 to 16. By contrast, cashflow C2 received by the portfolio in period
t2, is treated differently by each of the two performance measures. Whereas both sides of the
MWRR equation are increased by C2, the TWRR equation ignores the cashflow. Instead C2 will
simply increase the TWRR portfolio starting value from 30 to 31 for the next investment period.
MWRR versus TWRR

The data requirements, calculation differences and the interpretation of the MWRR and TWRR are
summarised below.
Money weighted rate Time weighted rate of

of return return
Data requirements Portfolio values at start Portfolio value immediately
and end of period before each new cashflow
Date and size of each Date and size of each capital
capital cashflow cashflow
Calculation differences Fund growth resulting Unitised fund performance
from fund performance unaffected by the size and
and size and timing of timing of cashflows as equal
cashflows weight placed upon each
sub period rate of return
Interpreting the data Not suitable for Suitable for collective
inter-fund performance investment fund
comparisons performance measurement
Example
Why is the use of a time weighted rate of return (TWRR) preferable to using a money weighted
rate of return (MWRR) when comparing the performance of two open ended investment
companies (OEICs) over a period of time?
Solution
TWRRs calculate unitised fund performance rather than measure fund growth by eliminating the
distorting timing effect of cashflows on portfolio performance and by placing equal weight on the
size of cashflows to and from the portfolio and on the rates of return achieved in each sub period.
Therefore, fund performance can be compared on a like-for-like basis.

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3.4 Calculating Risk Adjusted Returns for Equity Portfolios

LEARNING OBJECTIVES
10.3.3 Be able to calculate the risk-adjusted returns for
equities: Sharpe; Treyno; Jensen
Having calculated a portfolio’s rate of return it makes intuitive sense to evaluate this performance
on a risk-adjusted basis, given the various links between risk and return that have been established
in Chapters 2 and 9. The risk-adjusted performance of actively managed equity portfolios can be
evaluated using:
1. The Sharpe ratio.
2. The Treynor ratio.
3. The Jensen measure.
The Sharpe Ratio

The Sharpe ratio = (Rp - Rf)/σp
The Sharpe ratio measures the return over and above the risk free interest rate from an
undiversified equity portfolio for each unit of risk assumed by the portfolio: risk being measured by
the standard deviation of the portfolio’s returns. The higher the Sharpe ratio, the better the risk
adjusted performance of the portfolio and the greater the implied level of active management skill.
The Sharpe ratio provides an objective measure of the relative performance of two similarly
undiversified portfolios.
The Treynor Ratio

The Treynor ratio = (Rp - Rf)/βp
The Treynor ratio takes a similar approach to the Sharpe ratio but is calculated for a well diversified
equity portfolio. As the portfolio’s return would have been generated only by the systemic risk it
had assumed, the Treynor ratio, therefore, divides the portfolio’s return over and above the risk
free interest rate by its CAPM beta.
Once again, the higher the ratio, the greater the implied level of active management skill.
Example (1)
If an equity portfolio returns 15% given a beta of 1.2 and a standard deviation of 18% whilst the
risk free rate of interest is 5%, calculate the:
i. Sharpe ratio.
ii. Treynor ratio.
Solution (1)
The Sharpe ratio = (Rp - Rf)/σp = 15 - 5/18 = 0.56

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The Treynor ratio = (Rp - Rf)/βp = 15 - 5/1.2 = 8.33
Example (2)
Assuming the above portfolio is well diversified and a competing portfolio has a Sharpe ratio of 0.64
and a Treynor ratio of 7.33, which of the two portfolios has been better managed?
Solution (2)
As the appropriate measure of risk-adjusted returns for a well diversified portfolio is the Treynor
ratio, the higher Treynor ratio of the original portfolio implies a superior risk-adjusted return.
The Jensen measure
The Jensen measure of risk-adjusted equity portfolio returns is employed to evaluate the
performance of a well diversified portfolio against a CAPM benchmark with the same level
systematic risk as that assumed by the portfolio. That is, the CAPM benchmark beta is the same as
that of the portfolio (bp).
The Jensen measure = Rp - [Rf + βp(Rm - Rf)]
The Jensen measure establishes whether the portfolio has performed in line with its CAPM
benchmark and, therefore, lies on the SML, or whether it has out or under performed the
benchmark and is, therefore, positioned above or below the SML, respectively. The extent of any
out or under performance is known as the portfolio’s alpha.
3.5 Calculating risk adjusted returns for bond portfolios
Having considered the evaluation of risk-adjusted equity portfolio returns, we now turn briefly to
the evaluation of risk-adjusted returns from bond portfolios.
The simplest way of measuring the risk-adjusted performance of a bond portfolio is by dividing its
return over and above the risk free interest rate by its duration relative to that of the broader bond
market. This is summarised by the following formula:
(Rp - Rf)/(durationp/durationm), where
Rp is the return on the portfolio
Rf is the risk free rate of return
durationp is the Macaulay duration of the portfolio
durationm is the Macaulay duration of the bond market.

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APPENDIX
1.
2.
REGRESSION, CORRELATION AND COVARIANCE
DATA FOR REGRESSION, CORRELATION AND
COVARIANCE CALCULATIONS
A 335
335
2. STANDARD DEVIATION CALCULATION FOR X AND Y 336

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1. REGRESSION, CORRELATION AND COVARIANCE
The following observations were made on X (independent variable) and Y (dependent variable):
X 0 1 2 3 4 5
Y 2 3 6 8 9 11
1. Establish the equation that underlies the regression line (line of best fit)
2. Calculate the correlation coefficient between X and Y (ρXY)
3. Calculate the covariance of X and Y (covXY)
2. DATA FOR REGRESSION, CORRELATION AND

COVARIANCE CALCULATIONS
X Y (X-X) (Y-Y) (X-X)(Y-Y) X2 Y2 XY
0 2 -2.5 -4.5 11.25 0 4 0
1 3 -1.5 -3.5 5.25 1 9 3
2 6 -0.5 -0.5 0.25 4 36 12
3 8 0.5 1.5 0.75 9 64 24
4 9 1.5 2.5 3.75 16 81 36
5 11 2.5 4.5 11.25 25 121 55
ΣX=15 ΣY=39 Σ(X-X)=0 Σ(Y-Y)=0 Σ(X-X)(Y-Y) ΣX2=55 ΣY2=315 ΣXY=130
n=6 n=6 =32.5
X=15/6 Y=39/6
=2.5 =6.5
1. The line of best fit is given by the equation: Y = a+bX

where b = (nΣXY)-(ΣY)(ΣY) = (6 x 130)-(15 x 39) = 195 = 1.86
(nΣX2) - (ΣX)2 (6 x 55) - 152 105
and a = Y - bX = 6.5 - (1.86 x 2.5) = 1.85
So, Y = 1.85 + 1.86X
This can be shown graphically:
Y (dependent variable)
12 Y = 11.15
11
10
9
8
7
6
5
4
3
2 Y = 1.85
1
0
0 1 2 3 4 5 6 7 8 9 10 X(independent
variable)

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You will notice that the regression line intersects the y-axis at Y=1.85 even though it has been
observed that when X=0, Y=2. This is because the line of best fit takes into account each
observation, not just the extreme observations, when determining the minimum square of each of
the vertical distances of these observations from the unique straight line.
2. The correlation coefficient between X and Y (PXY)
PXY = (nΣXY) - (ΣX)(ΣY)

√[(nΣX2)-(ΣX)2][(nΣY2)-(ΣY)2]
= (6 x 130) - (15 x 39) = 195 = 0.99

√[(6 x 55) - 152] x [(6x315) - 392 196.8
There is almost a perfectly positive correlation between X and Y.
3. The covariance of X and Y(covXY):
covXY = Σ(X-X)(Y-Y) = 32.5 = 5.42

n 6
This small positive covariance indicates that X and Y have moved in the same direction, as
confirmed by their positive correlation, but due to both X and Y having low standard deviations
relative to their respective means, their historic joint movements are small. This is demonstrated by
the following equation:
covXY = ρXYXσXXσY
5.42 = 0.99 x 1.71 x 3.2
3. STANDARD DEVIATION CALCULATION FOR X AND Y

(X-X) (X-X) 2 (Y-Y) (Y-Y) 2
-2.5 6.25 -4.5 20.25
-1.5 2.25 -3.5 12.25
-0.5 0.25 -0.5 0.25
0.5 0.25 1.5 2.25
1.5 2.25 2.5 6.25
2.5 6.25 4.5 20.25
Σ(X-X)=0 Σ(X-X) 2=17.5 Σ(Y-Y)=0 Σ(Y-Y) 2=61.5
σX2=17.5 /6=2.92 σY2=61.5 /6=10.25
σX=√2.92=1.71 σY=√10.25=3.2

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GLOSSARY
Active management
An investment approach employed to exploit pricing anomalies in those securities markets that are
believed to be subject to mispricing by utilising fundamental and/or technical analysis to assist in the
forecasting of future events and the timing of purchases and sales of securities. Also known as
Market Timing.
Active Risk
The risk that arises from holding securities in an actively managed portfolio in different proportions
to their weighting in a benchmark index. Also known as Tracking Error.
Aggregate demand
The total demand for goods and services within an economy.
Aggregate supply
The amount of output firms are prepared to supply in aggregate at each general price level in an
economy, assuming the price of inputs to the production process are fixed, in order to meet
aggregate demand.
Alpha
The return from a security or a portfolio in excess of a risk adjusted benchmark return. Also known
as Jensen’s Alpha.
Alternative Investment
Alternative investments are those which fall outside the traditional asset classes of equities,
property, fixed interest, cash and money market instruments. Alternative investments are often
physical assets which tend to be popular with collectors.
Alternative Investment Market (AIM)

The London Stock Exchange’s (LSE) market for smaller UK public limited companies (plcs). AIM has
less demanding admission requirements and places less onerous continuing obligation requirements
upon those companies admitted to the market than those applying for a full list on the LSE.
Amortisation
The depreciation charge applied in company accounts against capitalised intangible assets.
Annual equivalent rate (AER)

See Effective Rate.
Annual general meeting (AGM)

The annual meeting of directors and ordinary shareholders of a company. All companies are obliged
to hold an AGM at which the shareholders receive the company’s report and accounts and have the
opportunity to vote on the appointment of the company’s directors and auditors and the payment
of a final dividend recommended by the directors.
Annuity
An investment that provides a series of prespecified periodic payments over a specific term or until
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Arbitrage
The process of deriving a risk-free profit by simultaneously buying and selling the same asset in two
related markets where a pricing anomaly exists.
Arithmetic mean
A measure of central tendency established by summing the observed values in a data distribution
and dividing this sum by the number of observations. The arithmetic mean takes account of every
value in the distribution.
Articles of association
The legal document which sets out the internal constitution of a company. Included within the
articles will be details of shareholder voting rights and company borrowing powers.
Asset allocation
The process of investing an international portfolio’s assets geographically and between asset classes
before deciding upon sector and stock selection.
Association of British Insurers (ABI)

The trade body that represents the interests of the UK insurance industry.
Association of Investment Trust Companies (AITC)

The trade body that exists to further the interests of the UK investment trust industry.
Association of Private Client Investment Managers and Stockbrokers (APCIMS)

The trade association that represents stockbrokers’ interests.
Backwardation
When the futures price stands at a discount to the price of the underlying asset.
Balance of payments
A summary of all economic transactions between one country and the rest of the world typically
conducted over a calendar year.
Base currency
The currency against which the value of the quoted currency is expressed. The base currency
would be currency X for the X/Y exchange rate.
Basis
The difference between the futures price and the price of the underlying asset.
Bear market
Conventionally defined as a 20%+ decline in a securities market. The duration of the market move
is immaterial.

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Bearer securities
Those whose ownership is evidenced by the mere possession of a certificate. Ownership can,
therefore, pass from hand to hand without any formalities.
Beneficiaries
The beneficial owners of trust property.
Beta
The covariance between the returns from a security and those of the market relative to the
variance of returns from the market.
Bond
See Fixed Interest Security.
Bonus issue
The free issue of new ordinary shares to a company’s ordinary shareholders in proportion to their
existing shareholdings through the conversion, or capitalisation, of the company’s reserves. By pro-
portionately reducing the market value of each existing share, a bonus issue makes the shares more
marketable. Also known as a
Capitalisation Issue or Scrip Issue.
British Venture Capital Association (BVCA)

The trade association that represents all principal sources of private and venture capital in the UK.
Broker dealer
A London Stock Exchange (LSE) member firm that can act in a dual capacity both as a broker acting
on behalf of clients and as a dealer dealing in securities on their own account.
Bull market
A rising securities market. The duration of the market move is immaterial.
Business cycle
See Economic Cycle.
Call option
An option that confers a right on the holder to buy a specified amount of an asset at a prespecified
price on or sometimes before a prespecified date.
CapitALisation Issue
See Bonus Issue.
Central bank
Those public institutions that operate at the heart of a nation’s financial system. Central banks
typically have responsibility for setting a nation’s or a region’s short term interest rate, controlling
the money supply, acting as banker and lender of last resort to the banking system and managing the
national debt. They increasingly implement their policies independently of government control. The
Bank of England is the UK’s central bank.
Certificate of Deposit (CD)

Negotiable bearer securities issued by commercial banks in exchange for fixed term deposits.

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Ceteris paribus
Other things being equal. In economics, the ceteris paribus caveat is used when considering the
impact of a change in one factor or variable on another variable, market or the economy as a
whole, holding all other factors constant.
Clean price
The quoted price of a Gilt. The clean price excludes accrued interest or interest to be deducted, as
appropriate.
Closing out
The process of terminating an open position in a derivatives contract by entering into an equal and
opposite transaction to that originally undertaken.
Code of best practice

See Combined Code.
Combinations
A strategy requiring the simultaneous purchase or sale of both a call and a put option on the same
underlying asset, sometimes with different exercise prices but always with the same expiry dates.
Combinations include straddles and strangles.
Combined Code
The code that embodies best corporate governance practice for all public limited companies (plcs)
quoted on the London Stock Exchange (LSE). Also known as the
Code of Best Practice.
Commercial Paper (CP)

Unsecured bearer securities issued at a discount to par by public limited companies (plcs) with a full
listing on the London Stock Exchange (LSE). Commercial Paper does not pay coupons but is
redeemed at par.
Competition Commission
The body to which a merger or takeover is referred for investigation by the Secretary of State for
Trade and Industry in order to establish whether the combined entity would work against the public
interest or would prove to be anti-competitive.
Complement
A good is a complement for another if a rise in the price of one results in a decrease in demand for
the other. Complementary goods are typically purchased in conjunction with one another.
Consumer Prices Index (CPI)

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Contango
When the futures price stands at a premium to the price of the underlying asset.
Continuous data
Where numbers in a data series can assume any value.
Convertible bonds
Bonds issued with a right to convert into either another of the issuer’s bonds or, if issued by a com-
pany, the company’s equity, both on prespecified terms.
Convertible loan stock

Bonds issued with a right to convert into the issuing company’s equity on prespecified terms.
Convertible preference shares

Preference shares issued with a right to convert into the issuing company’s equity on prespecified
terms.
Convexity
The non-symmetrical relationship that exists between a bond’s price and its yield. The more convex
the bond, the greater the price rise for a fall in its yield and the smaller the price fall for a rise in its
yield. Also see Modified Duration.
Corporate governance
The mechanism that seeks to ensure that companies are run in the best long term interests of their
shareholders. Also see Combined Code.
Correlation
The degree of co-movement between two variables determined through regression analysis and
quantified by the correlation coefficient. Correlation does not prove that a cause-and-effect or,
indeed, a steady relationship exists between two variables as correlations can arise from pure
chance.
Coupon
The predetermined rate of interest applying to a bond over its term expressed as a percentage of
the bond’s nominal, or par, value. The coupon is usually a fixed rate of interest.
Covariance
The correlation coefficient between two variables multiplied by their individual standard deviations.
Cross elasticity of demand (XED)

The effect of a small percentage change in the price of a complement or substitute good on a
complement or substitute.
Discounted cash flow (DCF) yield

See Internal Rate of Return (IRR).
Deadweight loss
A measure of the inefficient allocation of resources that results from a monopoly restricting output
and raising price to maximise profit.

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Debenture
A corporate bond issued in the domestic bond market and secured on the issuing company’s assets
by way of a fixed or a floating charge.
Demand curve
The depiction of the quantity of a particular good or service consumers will buy at a given price.
Plotted against price on the vertical axis and quantity on the horizontal axis, a demand curve slopes
downward from left to right.
Depreciation
The charge applied in a company’s accounts against its tangible fixed assets to reflect the usage of
these assets over the accounting period.
Derivative
An instrument whose value is based on the price of an underlying asset. Derivatives can be based on
both financial and commodity assets.
Dirty price
The price of a Gilt inclusive of accrued interest or exclusive of interest to be deducted, as appropri-
ate.
Discount
The difference in the Spot and Forward Exchange Rate that arises when interest rates in the quoted
currency are higher than those in the base currency.
Discount rate
The rate of interest used to establish the present value of a sum of money receivable in the future.
Discrete data
Where numbers in a data series are restricted to specific values.
Dividend
The distribution of a proportion of a company’s distributable profit to its shareholders. Dividends
are usually paid twice a year and are expressed in pence per share.
Dow Jones Industrial Average (DJIA)

A price weighted arithmetic index of 30 actively traded, and mainly industrial, US stocks.
Duration
The weighted average time, expressed in years, for the present value of a bond’s cash flows to be
received. Also known as Macaulay Duration.
Economic cycle
The course an economy conventionally takes as economic growth fluctuates over time. Also known
as the Business Cycle.
Economic growth
The growth of GDP or GNP expressed in real terms usually over the course of a calendar year.
Often used as a barometer of an economy’s health.

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Economies of scale
The resulting reduction in a firm’s unit costs as the firm’s productive capacity and output increases.
Economies of scale are maximised and unit costs minimised at the Minimum Efficient Scale (MES)
on a firm’s long term average total cost (LTATC) curve. Beyond this point diseconomies of scale set
in.
Effective rate
The annualised compound rate of interest applied to a cash deposit. Also known as the Annual
Equivalent Rate (AER).
Efficient frontier
A convex curve used in Modern Portfolio Theory that represents those efficient portfolios that offer
the maximum expected return for any given level of risk.
Efficient Markets Hypothesis (EMH)

The proposition that everything that is publicly known about a particular stock or market should be
instantaneously reflect in its price. As a result of active portfolio managers and other investment
professionals exhaustively researching those securities traded in developed markets, the EMH
argues that share prices move randomly and independently of past trends, in response to fresh
information, which itself is released at random.
Equilibrium
A condition that describes a market in perfect balance, where demand is equal to supply.
Equity
That which confers a direct stake in a company’s fortunes. Also known as a company’s ordinary
share capital.
Eurobond
International bond issues denominated in a currency different from that of the financial centre(s) in
which they are issued. Most Eurobonds are issued in bearer form through bank syndicates.
Euronext
The Paris, Amsterdam and Brussels stock and derivatives exchange.
European Monetary Union (EMU)

The creation of a single European currency, the euro, and the European Central Bank (ECB), which
sets monetary policy across the eurozone. Currently, 12 of the
European Union’s (EU) 25 members participate in EMU.
Exchange rate
The price of one currency in terms of another.
Ex-dividend (xd)
The period during which the purchase of shares or bonds (on which a Dividend or Coupon
payment has been declared) does not entitle the new holder to this next dividend or interest
payment.

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Exercise price
The price at which the right conferred by an Option can be exercised by the holder against the
writer.
Expectations theory
The proposition that the difference between short and long term interest rates can be explained by
the course short term interest rates are expected to take over time.
Ex-rights (xr)
The period during which the purchase of a company’s shares does not entitle the new shareholder
to participate in a rights issue announced by the issuing company. Shares are usually traded ex-rights
(xr) on or within a few days of the company making the rights issue announcement.
Extraordinary General Meeting (EGM)

A company meeting, other than an AGM, at which matters that urgently require a special resolution
are put to the company’s shareholders.
Fair value
The theoretical price of a futures contract.
Financial gearing
The ratio of debt to equity employed by a company within its capital structure.
Financial Services Authority (FSA)

The UK regulator for financial services created by FSMA 2000.
Fiscal policy
The use of government spending, taxation and borrowing policies to either boost or restrain
domestic demand in the economy so as to maintain full employment and price stability. Also known
as Stabilisation Policy.
Fixed interest security

A tradeable negotiable instrument, issued by a borrower for a fixed term, during which a regular
and predetermined fixed rate of interest based upon a nominal value is paid to the holder until it is
redeemed and the principal is repaid.
Flat rate
The annual simple rate of interest applied to a cash deposit.
Flat yield
See Running Yield.
Flight to quality
The movement of capital to a safe haven during periods of market turmoil to avoid capital loss.
Floating Rate Notes (FRNs)

Debt securities issued with a coupon periodically referenced to a benchmark interest rate.

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Forward
A derivatives contract that creates a legally binding obligation between two parties for one to buy
and the other to sell a pre-specified amount of an asset at a pre-specified price on a pre-specified
future date. As individually negotiated contracts, forwards are not traded on a derivatives exchange.
Forward exchange rate

An exchange rate set today, embodied in a forward contract, that will apply to a foreign exchange
transaction at some pre-specified point in the future.
Forward rate
The implied annual compound rate of interest that links one spot rate to another assuming no inter-
est payments are made over the investment period.
Fractional reserve banking

See Reserve Ratio.
Frequency distribution
Data either presented in tabulated form or diagrammatically, whether in ascending or descending
order, where the observed frequency of occurrence is assigned to either individual values or groups
of values within the distribution.
Full employment level of output

See Potential Output Level.
Full listing
Those public limited companies (plcs) admitted to the London Stock Exchange’s (LSE) official list.
Companies seeking a full listing on the LSE must satisfy the UK Listing Authority’s (UKLA) stringent
listing requirements and continuing obligations once listed.
Fund of Funds
A fund of funds is a multi-manager fund. It has one overall manager that invests in a portfolio of
other existing investment funds and seeks to harness the best investment manager talent available
within a diversified portfolio.
Fund Managers Association (FMA)

See Investment Managers Association (IMA).
Fundamental analysis
The calculation and interpretation of yields, ratios and discounted cash flows (DCFs) that seek to
establish the intrinsic value of a security or the correct valuation of the broader market. The use of
fundamental analysis is nullified by the semi-strong form of the Efficient Markets Hypothesis (EMH).
Future
A derivatives contract that creates a legally binding obligation between two parties for one to buy
and the other to sell a pre-specified amount of an asset at a pre-specified price on a pre-specified
future date. Futures contracts differ from forward contracts in that their contract specification is
standardised so that they may be traded on a derivatives exchange.
Future value
The accumulated value of a sum of money invested today at a known rate of interest over a specific
term.

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Geometric mean
A measure of central tendency established by taking the nth root of the product (multiplication) of n
values.
Geometric progression
The product (multiplication) of n values.
Gilts
UK government securities issued primarily to finance government borrowing. See also Public Sector
Net Cash Requirement (PSNCR).
Gross domestic product (GDP)

A measure of the level of activity within an economy. More precisely, GDP is the total market value
of all final goods and services produced domestically in an economy typically during a calendar year.
Gross national product (GNP)

GDP at market prices plus net property income generated from overseas economies by UK factors
of production.
Gross redemption yield (GRY)

The annual compound return from holding a bond to maturity taking into account both interest
payments and any capital gain or loss at maturity. Also known as the Yield to Maturity (YTM).
Hedging
A technique employed to reduce the impact of adverse price movements in financial assets held.
Immunisation
Passive bond management techniques that comprise cash matching and duration based
immunisation.
Income elasticity of demand (YED)

The effect of a small percentage change in income on the quantity of a good demanded.
Index
A single number that summarises the collective movement of certain variables at a point in time in
relation to their average value on a base date or a single variable in relation to its base date value.
Index linked gilts (ILGs)

Gilts whose principal and interest payments are linked to the Retail Price Index (RPI) with an eight
month time lag.
Inflation
The rate of change in the general price level or the erosion in the purchasing power of money.
Inflation risk premium (IRP)

The additional return demanded by bond investors based on the volatility of inflation in the recent
past.

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Initial margin
The collateral deposited by exchange clearing members with the clearing house when opening
certain derivative transactions.
Initial public offering (IPO)

See New Issue.
Interest rate parity

The mathematical relationship that exists between the Spot and Forward Exchange Rate for two
currencies. This is given by the differential between their respective nominal interest rates over the
term being considered.
Internal rate of return (IRR)

The discount rate that when applied to a series of cash flows produces a net present value (NPV) of
zero. Also known as the DCF Yield.
International Fisher Effect

The proposition that in a world of perfect capital mobility nominal interest rates should take full
account of expected inflation rates so that real interest rates are equal worldwide.
International Organisation of Securities Commissions (IOSCO)

IOSCO aims to establish high regulatory standards across the world for the securities industry. The
membership of this organisaction collectively regulates 90% of the worlds’s securities markets.
Interpolation
A method by which to establish an approximate Internal Rate of Return (IRR).
Irredeemable security
A security issued without a pre-specified redemption, or maturity, date.
Issuing house
An institution that facilitates the issue of securities.
Japan Financial Services Agency (JFSA)

The Financial Services Agency is a government regulator that is responsible for ensuring the stability
of the Japanese financial services market.
Jensen’s alpha
See Alpha.
Keynesians
Those economists who believe that markets are slow to self correct and, therefore, advocate the
use of fiscal policy to return the economy back to a full employment level of output.
Kondratieff cycles
Long term economic cycles of 50 years+ duration that result from innovation and investment in
new technology.

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Liquidity
The ease with which a security can be converted into cash. Liquidity is determined by the amount
of two-way trade conducted in a security. Liquidity also describes that amount of an investor’s
financial resources held in cash.
Liquidity preference theory

The proposition that investors have a natural preference for short term investments and, therefore,
demand a liquidity premium in the form of a higher return the longer the term of the investment.
Loan stock
A corporate bond issued in the domestic bond market without any underlying collateral, or security.
London Clearing House (LCH)

The institution that clears and acts as central counterparty to all trades executed on member
exchanges.
London Interbank Offered Rate (LIBOR)

A benchmark money market interest rate.
London International Financial Futures and Options Exchange (euronext.liffe)

The UK’s principal derivatives exchange for trading financial and soft commodity derivatives
products. Since it was purchased by Euronext, LIFFE is commonly referred to as euronext.liffe.
London Stock Exchange (LSE)

The UK market for listing and trading domestic and international securities.
Long position
The position following the purchase of a security or buying a derivative.
Macaulay duration
See Duration.
Macroeconomics
The study of how the aggregation of decisions taken in individual markets determine variables such
as national income, employment and inflation. Macroeconomics is also concerned with explaining
the relationship between these variables, their rates of change over time and the impact of
monetary and fiscal policy on the general level of economic activity.
Manager of Managers Fund

A manager of managers fund is a multi-manager fund. It does not invest in other existing retail
collective investment schemes. Instead it entails the MoM fund arranging segregated mandates with
individually chosen fund managers.
Margin
See Initial Margin and Variation Margin.
Marginal cost (MC)

The change in a firm’s total cost resulting from producing one additional unit of output.

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Marginal revenue (MR)
The change in the total revenue generated by a firm from the sale of one additional unit of output.
Market capitalisation
The total market value of a company’s shares or 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.
Market segmentation
The proposition that each bond market can be divided up into distinct segments based upon term
to maturity with each segment operating as if it is a separate bond market operating independently
of interest rate expectations.
Market timing
See Active Management.
Marking to market
The process of valuing a position taken in a securities or a derivatives market.
Mean-variance analysis
The use of past investment returns to predict the investment’s most likely future return and to
quantify the risk attached to this expected return. Mean variance analysis underpins Modern
Portfolio Theory (MPT).
Median
A measure of central tendency established by the middle value within an ordered distribution
containing an odd number of observed values or the arithmetic mean of the middle two values in an
ordered distribution containing an even number of values.
Member firm
A firm that is a member of a Stock Exchange or clearing house.
Microeconomics
Microeconomics is principally concerned with analysing the allocation of scarce resources within an
economic system. That is, microeconomics is the study of the decisions made by individuals and
firms in particular markets and how these interactions determine the relative prices and quantities
of factors of production, goods and services demanded and supplied.
Minimum Efficient Scale (MES)
The level of production at which a firm’s long run average production costs are minimised and its
economies of scale are maximised.
Mode
A measure of central tendency established by the value or values that occur most frequently within
a data distribution.
Modern Portfolio Theory (MPT)

The proposition that investors will only choose to hold those diversified, or efficient, portfolios that
lie on the efficient frontier.

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Modified duration (MD)

A measure of the sensitivity of a bond’s price to changes in its yield. Modified duration approximates
a bond’s convexity.
Monetarists
Those economists who believe that markets are self correcting, that the level of economic activity
can be regulated by controlling the money supply and that fiscal policy is ineffective and possibly
harmful as a macroeconomic policy tool. Also known as New Classical Economists.
Monetary policy
The setting of short term interest rates by a central bank in order to manage domestic demand and
achieve price stability in the economy. Monetary policy is also known as Stabilisation Policy.
Money
Anything that is generally acceptable as a means of settling a debt.
Money weighted rate of return (MWRR)

The internal rate of return (IRR) that equates the value of a portfolio at the start of an investment
period plus the net new capital invested during the investment period with the value of the portfolio
at the end of this period. The MWRR, therefore, measures the fund growth resulting from both the
underlying performance of the portfolio and the size and timing of cash flows to and from the fund
over this period.
Multi-Manager Funds
A fund that offers a portfolio of separately managed funds. There are two main types: fund-of-funds
and manager of managers.
Multiplier
The factor by which national income changes as a result of a unit change in aggregate demand.
Myners Report
The report commissioned by the UK government in November 2000 which comprehensively
reviewed institutional investment in the UK. The report was formally entitled Institutional
Investment in the UK: A Review.
NASDAQ
The second largest Stock Exchange in the US. NASDAQ lists certain US and international stocks
and provides a screen based quote driven secondary market that links buyers and sellers
worldwide. NASDAQ also operates a stock exchange in Europe (Nasdaq Europe).
National Association of Pension Funds (NAPF)

The trade body that represents the interests of the occupational pension scheme industry.
National debt
A government’s total outstanding borrowing resulting from financing successive budget deficits,
mainly through the issue of government backed securities.
Negotiable security
A security whose ownership can pass freely from one party to another. Negotiable securities are,
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Net present value (NPV)
The result of subtracting the discounted, or present, value of a project’s expected cash outflows
from the present value of its expected cash inflows.
Net redemption yield (NRY)

The annual compound return from holding a bond to maturity taking account of both the coupon
payments net of income tax and the capital gain or loss to maturity.
New Classical Economists
See Monetarists.
New issue
A new issue of ordinary shares whether made by an offer for sale, an offer for subscription or a
placing. Also known as an Initial Public Offering (IPO).
New paradigm
The term applied to an economy that can produce robust economic growth without accompanying
inflation through the employment of productivity enhancing new technology.
Nominal value
The face or par value of a security. The nominal value is the price at which a bond is issued and usu-
ally redeemed and the price below which a company’s ordinary shares cannot be issued.
Non-accelerating inflation rate of unemployment (NAIRU)

That level of unemployment that is consistent with a stable inflation rate. Also known as the natural
rate of unemployment or the vertical long run Phillip’s curve.
Normal distribution
A distribution whose values are evenly, or symmetrically, distributed about the arithmetic mean.
Depicted graphically, a normal distribution is plotted as a symmetrical, continuous, bell shaped
curve.
Normal profit
The required rate of return for a firm to remain in business taking account of all opportunity costs.
OFEX
A market for unquoted companies in the early stages of development. OFEX is short for off
exchange.
Opportunity cost
The cost of foregoing the next best alternative course of action. In economics, costs are defined not
as financial but as opportunity costs.
Option
A derivatives contract that confers the right from one party (the writer) to another (the holder) to
either buy (call option) or sell (put option) an asset at a pre-specified price on, and sometimes
before, a pre-specified future date, in exchange for the payment of a premium.
Ordinary shares
See Equity.

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Over-the-counter (OTC) derivatives

Derivatives that are not traded on a derivatives exchange owing to their non-standardised contract
specifications.
Par value
See Nominal Value.
Pari passu
Of equal ranking. New Ordinary Shares issued under a rights issue, for instance, rank pari passu
with the company’s existing Ordinary Shares.
Passive management
An investment approach employed in those securities markets that are believed to be price
efficient. The term also extends to passive bond management techniques collectively known as
Immunisation.
Permanent Interest Bearing Securities (PIBS)

Irredeemable Fixed Interest Securities issued by mutual building societies. Known as Perpetual
Subordinated Bonds (PSBs) if the building society demutualises.
Perpetual Subordinated Bonds (PSBs)

See Permanent Interest Bearing Securities (PIBS).
Perpetuities
An investment that provides an indefinite stream of equal prespecified periodic payments.
Population
A statistical term applied to a particular group where every member or constituent of the group is
included.
Portfolio Theory
See Modern Portfolio Theory (MPT).
Potential output level

The sustainable level of output produced by an economy when all of its resources are productively
employed. Also known as the Full Employment Level of Output.
Pre-emption rights
The rights accorded to ordinary shareholders under company law to subscribe for new ordinary
shares issued by the company, in which they have the shareholding, for cash before the shares are
offered to outside investors.
Preference shares
Those shares issued by a company that rank ahead of ordinary shares for the payment of dividends
and for capital repayment in the event of the company going into liquidation.
Premium
The amount of cash paid by the holder of an option to the writer in exchange for conferring a right.
Also the difference in the spot and forward exchange rate that arises when interest rates in the base
currency are higher than those in the quoted currency.

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Present value
The value of a sum of money receivable at a known future date expressed in terms of its value
today. A present value is obtained by discounting the future sum by a known rate of interest.
Price elasticity of demand (PED)

The effect of a small percentage change in the price of a good on the quantity of the good
demanded. PED is expressed as a figure between zero and infinity.
Prima facie
At first sight. For instance, a portfolio’s past performance provides prima facie evidence of a portfo-
lio manager’s skill and investment style.
Primary data
Data commissioned for a specific purpose.
Primary market
The market for New Issues or Initial Public Offerings (IPOs).
Production Possibility Frontier (PPF)

The PPF depicts all feasible combinations of output that can be produced within an economy given
the limit of its resources and production techniques.
Provisional allotment letter

That which is sent to those shareholders who are entitled to participate in a rights issue. The letter
details the shareholder’s existing shareholding, their rights over the new shares allotted and the
date(s) by which they must act.
Public Sector Net Cash Requirement (PSNCR)

The extent to which the UK government needs to borrow, mainly through the issue of government
backed securities, to finance a budget deficit as a result of its spending exceeding tax revenue for
the fiscal year.
Pull to maturity
A term used to explain why the price of short dated bonds are less affected by interest rate changes
than that of long dated bonds.
Purchasing power parity (PPP)

The nominal exchange rate between two countries that reflects the difference in their respective
rates of inflation.
Put option
An option that confers a right on the holder to sell a specified amount of an asset at a prespecified
price on or sometimes before a prespecified date.
Qualifying corporate bonds (QCBs)

UK corporate bonds issued in sterling without conversion rights. QCBs are free of capital gains tax
(CGT).

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Quantity Theory of Money

A truism that formalises the relationship between the domestic money supply and the general price
level.
Quoted currency
The currency whose value is expressed in terms of one unit of the base currency. The quoted
currency would be currency Y for the X/Y exchange rate.
Redeemable security
A security issued with a known maturity, or redemption, date.
Redemption
The repayment of principal to the holder of a redeemable security.
Regression analysis
A statistical technique used to establish the degree of correlation that exists between two variables.
Reinvestment risk
The inability to reinvest coupons at the same rate of interest as the Gross Redemption Yield (GRY).
This in turn makes the GRY conceptually flawed.
Repo
The sale and repurchase of bonds between two parties: the repurchase being made at a price and
date fixed in advance. Repos are categorised into general repos and specific repos.
Reserve ratio
The proportion of deposits held by banks as reserves to meet depositor withdrawals and Bank of
England credit control requirements.
Resistance level
A term used in Technical Analysis to describe the ceiling put on the price of a security resulting from
persistent investor selling at that price level.
Retail Price Index (RPI)

An expenditure weighted measure of UK inflation based on a representative basket of goods and
services purchased by an average UK household.
Rights issue
The issue of new ordinary shares to a company’s shareholders in proportion to each shareholder’s
existing shareholding, usually at a price deeply discounted to that prevailing in the market. Also see
Pre-emption Rights.
Running yield
The return from a bond calculated by expressing the coupon as a percentage of the clean price.
Also known as the Flat Yield or interest yield.
Sample
A statistical term applied to a representative subset of a particular population. Samples enable infer-
ences to be made about the population.

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Scrip issue
See Bonus Issue.
Secondary data
Pre-existing data.
Secondary market
The market for trading securities already in issue.
Securities and Exchange Commission (SEC)

The SEC is the USA’s financial services market regulator.
Securitisation
The packaging of rights to the future revenue stream from a collection of assets into a bond issue.
Settlor
The creator of a trust.
Share buyback
The redemption and cancellation by a company of a proportion of its irredeemable ordinary shares
subject to the permission of the High Court and agreement from HM Revenue & Customs.
Share capital
The Nominal Value of a company’s Equity or Ordinary Shares. A company’s authorised share capital
is the Nominal Value of Equity the company may issue whilst issued share capital is that which the
company has issued. The term share capital is often extended to include a company’s preference
shares.
Share split
A method by which a company can reduce the market price of its shares to make them more
marketable without capitalising its reserves. A share split simply entails the company reducing the
nominal value of each of its shares in issue whilst maintaining the overall nominal value of its share
capital. A share split should have the same impact on a company’s share price as a Bonus Issue.
Short position
The position following the sale of a security not owned or selling a derivative.
Spot rate
A compound annual fixed rate of interest that applies to an investment over a specific time period.
Also see Forward Rate.
Spreads
A strategy requiring the simultaneous purchase of one or more options and the sale of another or
several others on the same underlying asset with either different exercise prices and the same
expiry date or the same exercise prices and different expiry dates. Spreads include bull spreads,
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Stabilisation Policy
See Fiscal Policy and Monetary Policy.
Standard deviation
A measure of dispersion. In relation to the values within a distribution, the standard deviation is the
square root of the distribution’s variance.
Stock exchange
An organised market place for issuing and trading securities by members of that exchange.
Stock Exchange Alternative Trading SERVICE (SEATS Plus)

The London Stock Exchange’s (LSE) electronic order driven bulletin board for trading less liquid
securities, notably those fully listed or AIM shares with less than two registered market makers.
Stock Exchange Automated Quotation (SEAQ)

The London Stock Exchange’s (LSE) quote driven screen based trading system that displays firm bid
and offer prices quoted by competing market makers during the mandatory quote period.
Stock Exchange Electronic Trading SERVICE (SETS)

The London Stock Exchange’s (LSE) screen based order driven trading system that electronically
matches buy and sell orders input to the system. Only the most liquid securities in the UK equity
market can be traded through SETS and all orders must be firm and not indicative, as once
displayed an order must be capable of immediate execution.
Strike price
See Exercise Price.
STRIPS
The principal and interest payments of those designated Gilts that can be separately traded as Zero
Coupon Bonds (ZCBs). STRIPS is the mnemonic for Separate Trading of Registered Interest and
Principal.
Subordinated loan stock

Loan Stock issued by a company that ranks above its Preference Shares but below its unsecured
creditors in the event of the company’s liquidation.
Substitute
A good is a substitute for another if a rise in the price of one results in an increase in demand for the
other. As substitute goods perform a similar function to each other, they typically have a high price
elasticity of demand.
Supply curve
The depiction of the quantity of a particular good or service firms are willing to supply at a given
price. Plotted against price on the vertical axis and quantity on the horizontal axis, a supply curve
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Swap
An Over the Counter (OTC) Derivative whereby two parties exchange a series of periodic
payments based on a notional principal amount over an agreed term. Swaps can take the form of
interest rate swaps, currency swaps and equity swaps.
T+3
The three day rolling settlement period over which all deals executed on the London Stock
Exchange’s (LSE) SETS are settled.
TechMARK
The London Stock Exchange (LSE) sub-market for those public limited companies (plcs) committed
to technological innovation.
Technical analysis
The analysis of charts depicting past price and volume movements to determine the future course
of a particular market or the price of an individual security. Technical analysis is nullified by the weak
form of the Efficient Markets Hypothesis (EMH).
Tick
The minimum price movement of a derivatives contract as specified by the exchange on which the
product is traded.
Tick value
The monetary value of one tick.
Time value
That element of an option premium that is not intrinsic value. The term time value also relates to a
sum of money which, by taking account of a prevailing rate of interest and the term over which the
sum is to be invested or received, can be expressed as either a future value or as a present value,
respectively.
Time weighted rate of return (TWRR)

The unitised performance of a portfolio over an investment period that eliminates the distorting
effect of cash flows. The TWRR is calculated by compounding the rates of return from each
investment sub period, a sub-period being created whenever there is a movement of capital into or
out of the portfolio.
Tracking error
See Active Risk.
Treasury bills
Short term government-backed securities issued at a discount to par via a weekly Bank of England
auction. Treasury bills do not pay coupons but are redeemed at par.
Trustees
The legal owners of trust property who owe a duty of skill and care to the trust’s beneficiaries.

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UK Listing Authority (UKLA)

The body responsible for setting and administering the listing requirements and continuing
obligations for public limited companies (plcs) seeking and obtaining a full list on the London Stock
Exchange (LSE). The Financial Services Authority (FSA) as appointed as the UKLA in May 2000.
UndertakingS for Collective InvestmentS in Transferable Securities (UCITS) Directive

An EU Directive originally introduced in 1985 but since revised to enable collective investment
schemes (CISs) authorised in one EU member state to be freely marketed throughout the EU, sub-
ject to the marketing rules of the host state(s) and certain fund structure rules being complied with.
Unemployment
The percentage of the labour force registered as available to work at the current wage rate.
Variance
A measure of dispersion. In relation to the values within a distribution, the variance is the mean of
the sum of the squared deviations from the distribution’s arithmetic mean.
Variation margin
The cash that passes between the exchange clearing members daily via the clearing house in
settlement of the previous day’s price movement in an open derivatives contract.
virt-x
A pan-European stock exchange for the trading of blue chip shares. virt-x was formed by the
amalgamation of the Tradepoint exchange and the Swiss stock exchange.
Volatility
A measure of the extent to which investment returns, asset prices and economic variables fluctuate.
Volatility is measured by the standard deviation of these returns, prices and values.
Warrants
Negotiable securities issued by public limited companies (plcs) that confer a right on the holder to
buy a certain number of the company’s ordinary shares on prespecified terms. Warrants are
essentially long dated Call Options but are traded on a Stock Exchange rather than on a derivatives
exchange.
Weighted Average Cost of Capital (WACC)

The average post-tax cost of servicing a company’s long term sources of finance. The WACC acts
as the discount rate for establishing the Net Present Value (NPV) of investment projects of
equivalent risk to those currently undertaken by the company.
Yield curve
The depiction of the relationship between the Gross Redemption Yields (GRYs) and the maturity of
bonds of the same type.
Yield to maturity (YTM)

See Gross Redemption Yield (GRY).

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Zakat
Depending on various conditions, some Muslims are required to pay 2.5% of their wealth to the
Department of Zakat and Income Tax (DZIT).
Zero coupon bonds (ZCBs)

Bonds issued at a discount to their Nominal Value that do not pay a Coupon but which are
redeemed at par on a prespecified future date.

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SYLLABUS LEARNING MAP
SYLLABUS 1.0 / WORKBOOK EDITION 1 COMPARISON
ELEMENT 1 ECONOMICS CHAPTER/SECTION

1.1 Microeconomic Theory
On completion, the candidate should:
1.1.1 understand how price is determined and the interaction of supply and demand Chapter 1, Section 1.2
1.1.2 be able to calculate elasticities of demand Chapter 1, Section 1.3
1.1.3 understand the theory of the firm: Chapter 1, Section 1.4
• profit maximisation
• short and long run costs
• increasing and diminishing returns to factors
• economies and diseconomies of scale
1.1.4 understand firm and industry behaviour under perfect competition Chapter 1, Section 1.6
1.1.5 understand firm and industry behaviour under monopoly and oligopoly Chapter 1, Section 1.7
1.2 Macroeconomic Analysis
1.2.1 know how national income is determined, composed and measured in both an Chapter 1, Section 2.2
open and closed economy
1.2.2 know the stages of the economic cycle Chapter 1, Section 2.3
1.2.3 understand the composition of the balance of payments and the factors behind Chapter 1, Section 2.8
and benefits of international trade and capital flows
1.2.4 know the nature, determination and measurement of the money supply Chapter 1, Section 2.5
1.2.5 understand the role, basis and framework within which monetary and fiscal Chapter 1, Section 2.5
policy operate
1.2.6 know the role of central banks and of the major G8 central banks Chapter 1, Section 2.10
1.2.7 know how inflation/deflation and unemployment are determined, measured and Chapter 1, Sections 2.6, 2.7
their inter-relationship
ELEMENT 2 FINANCIAL MATHEMATICS AND STATISTICS
2.1 Statistics
2.1.1 understand where financial data may be sourced from and how it can be Chapter 2, Section 1.2
presented
2.1.2 be able to calculate the measures of central tendency: Chapter 2, Section 1.3
• arithmetic mean
• geometric mean
• median
• mode
2.1.3 be able to calculate the measures of dispersion: Chapter 2, Section 1.3
• variance (sample/population)
• standard deviation (sample/population)
• range
2.1.4 understand the correlation between two variables and the interpretation of the Chapter 2, Section 1.4
data
2.1.5 understand the covariance between two variables and the interpretation of the Chapter 2, Section 1.4
data
2.1.6 understand the use of regression analysis to quantify the relationship between Chapter 2, Section 1.4
two variables and the interpretation of the data
2.2 Financial Mathematics
2.2.1 be able to calculate the present value of lump sums and regular payments, Chapter 2, Sections 2.3, 2.4
annuities and perpetuities
2.2.2 be able to calculate the future value of lump sums and regular payments Chapter 2, Sections 2.2, 2.3
2.2.3 be able to calculate simple and compound interest, discounted cash flows Chapter 2, Section 2.6
(DCFs), net present values (NPV) and internal rates of return (IRR) and
interpret the data

2.2.4 understand the importance of selecting an appropriate discount rate for Chapter 2, Sections 2.4, 2.6
discounting cash flows
ELEMENT 3 INDUSTRY REGULATION
3.1 Corporate Governance
3.1.1 know the origins and nature of Corporate Governance Chapter 3, Section 1
3.1.2 know the Corporate Governance mechanisms available to stakeholders to Chapter 3, Section 1
exercise their rights
3.1.3 understand the role of auditors and non-executive directors Chapter 3, Section 1
3.1.4 know the implications of the Sarbanes-Oxley Act and its main provisions Chapter 3, Section 1
3.2 Overseas Regulators
3.2.1 know the primary function of the following bodies in the regulation of the Chapter 3, Section 2
financial services industry:
• Securities and Exchange Commission (SEC)
• Financial Services Authority (FSA)
• Japan Financial Services Agency (JFSA)
• European Union (EU)
• International Organisation of Securities Commissions
(IOSCO)
3.2.2 know the impact of high profile failures on the various markets, participants and Chapter 3, Section 1
regulation of them:
• Barings Bank
• Enron
• Equitable Life
• National Australia Bank
ELEMENT 4 ASSET CLASSES
4.1 Equities
4.1.1 know the characteristics and risks of different classes of share capital (preference Chapter 4, Sections 1.2, 1.3
shares, ordinary shares), shareholder rights and priority for dividends and capital
repayment for both private and public companies
4.1.2 know the main characteristics and reasons for issuing convertible preference Chapter 4, Section 1.3
shares
4.1.3 be able to calculate a conversion premium or discount on a convertible Chapter 4, Section 1.3
preference share
4.1.4 understand the main characteristics of GDRs and ADRs Chapter 4, Section 1.5
4.1.5 know the principal purpose and requirements of the listing rules Chapter 4, Section 1.4
4.1.6 understand the different new issue methods: Chapter 4, Section 1.5
• offer for sale by subscription
• offer for sale
• placing
4.1.7 know the main mandatory corporate actions Chapter 4, Section 1.5
• bonus/scrip
• consolidation
• final redemption
• subdivision/stock splits
4.1.8 know the main optional corporate actions Chapter 4, Section 1.5
• warrant exercise
• placing with clawback
• rights issue call
4.1.9 know the difference between optional and mandatory corporate actions Chapter 4, Section 1.5
4.1.10 understand the reasons for capitalisation and rights issues and the options Chapter 4, Section 1.5
available to the shareholder when a rights issue is made
4.1.11 be able to calculate the effect of capitalisation and rights issues on the issuer’s Chapter 4, Section 1.5
share price
4.1.12 know the reasons for companies paying dividends, how dividend policy is Chapter 4, Section 1.6
determined and the practical constraints on paying dividends
4.1.13 know the reasons for companies buying back their own shares Chapter 4, Section 1.7
4.1.14 know the means by which companies communicate price sensitive information, Chapter 4, Section 1.4
the nature of such information and the primary information providers
4.2 Fixed Interest
4.2.1 know the structure, characteristics and risks of the different types of fixed Chapter 4, Sections 2.1, 2.2
interest securities
4.2.2 know the characteristics and reasons for issuing convertible bonds Chapter 4, Section 2.2
4.2.3 be able to calculate a conversion premium on a convertible bond Chapter 4, Section 2.2
4.2.4 know the main risks faced by bondholders Chapter 4, Section 2.5
4.2.5 understand what is meant by running yield, net redemption yield (NRY), gross Chapter 4, Section 2.3
redemption yield (GRY), duration
4.2.6 be able to calculate running yields, net redemption yields (NRYs), gross Chapter 4, Section 2.3
redemption yields (GRYs), duration
4.2.7 know the characteristics of the yield curve: Chapter 4, Section 2.3
• normal
• inverted
4.2.8 be able to calculate forward rates given two spot rates of different maturities Chapter 4, Section 2.4
4.2.9 know the characteristics and uses of strips and repos Chapter 4, Sections 2.2, 2.6
4.2.10 know the concept of securitisation Chapter 4, Section 2.7
4.2.11 know the main bond strategies: Chapter 4, Section 2.8
• bond switching
• riding the yield curve
• immunisation
• Barbell/Bullet/Ladder portfolios
4.2.12 know the role of ratings agencies: Fitch, Moody’s, Standard & Poor’s and the Chapter 4, Section 2.9
structure of their credit ratings
4.3 Cash and Money Market Instruments
4.3.1 know the main characteristics and risks of cash deposits and money market Chapter 4, Sections 3.2, 3.3
instruments:
• Money Market Deposits
• Certificates of Deposit (CDs)
• Commercial Paper (CP)
• Treasury Bills
4.4 Derivatives
4.4.1 know the characteristics of futures Chapter 4, Section 4.2
4.4.2 understand the risk reward profile of buying and selling futures Chapter 4, Section 4.2
4.4.3 know the characteristics of options Chapter 4, Section 4.6
4.4.4 be able to calculate the outcome of basic option strategies and the potential risks Chapter 4, Section 4.6
and rewards of each
• buying calls
• buying puts
• selling calls
• selling puts
4.4.5 understand American and European exercise styles Chapter 4, Section 4.6
4.4.6 understand the geared nature of futures and options Chapter 4, Sections 4.2, 4.6
4.4.7 understand the principles of margin Chapter 4, Sections 4.3, 4.5
4.4.8 know the differences between forwards, futures and options Chapter 4, Sections 4.2, 4.6
4.4.9 know the differences between physically settled and cash settled derivatives and Chapter 4, Sections 4.2, 4.3
the role of the clearing house
4.4.10 know the main characteristics, contract specifications and uses within investment Chapter 4, Sections 4.5, 4.6
management of Euronext.liffe (formerly LIFFE)
• FTSE 100 index futures and options
• Long Gilt futures
• Short Term Interest Rate (STIR) futures
• Universal Stock Futures
• Individual equity options
4.4.11 know the characteristics of a contract for difference Chapter 4, Sections 4.2, 4.5
4.4.12 know the meaning of contango and backwardation Chapter 4, Section 4.5
4.4.13 know the meaning of in-the-money, at-the-money and out-of-the money in Chapter 4, Section 4.6
relation to options
4.4.14 be able to calculate the time and intrinsic value of an option premium given the Chapter 4, Section 4.6
premium and the underlying price
4.4.15 know the factors that determine an option premium Chapter 4, Section 4.6
4.4.16 know the main characteristics of a warrant Chapter 4, Section 4.7
4.4.17 be able to calculate a warrant conversion premium Chapter 4, Section 4.7
4.4.18 know the difference between warrants and covered warrants Chapter 4, Section 4.7
4.4.19 know the basic structure of an Interest Rate Swap Chapter 4, Section 4.8
4.4.20 know the basic structure of a Currency Swap Chapter 4, Section 4.8
4.4.21 know the basic structure of an Equity Swap Chapter 4, Section 4.8
4.5 Property
4.5.1 know the direct and indirect means of investing in property, property investment Chapter 4, Sections 5.2, 5.3
trusts, property bonds, shares in property companies, pension holdings
4.5.2 understand the characteristics of a property market and the differences between Chapter 4, Section 5.1
the property market, securities market and money market
4.6 Alternative Investments
4.6.1 know the main types and characteristics of alternative investments: Chapter 4, Section 6.1
• commodities
• private equity
• structured products
ELEMENT 5 FINANCIAL MARKETS
5.1 Exchanges
5.1.1 understand the role of the exchanges for trading: Chapter 5, Section 1.2
• shares
• bonds
• derivatives
5.1.2 know why companies obtain listings on overseas stock exchanges Chapter 5, Section 1.2
5.1.3 know the role and responsibilities of the London Stock Exchange (LSE) Chapter 5, Section 1.2
5.1.4 understand the reasons for the emergence of alternative trading systems: Chapter 5, Section 1.3
• Crossing networks and Electronic Communication Networks
(ECNs)
5.2 Dealing and Settlement

5.2.1 know the differences between a primary market and a secondary market Chapter 5, Section 2.1
5.2.2 know the structure and operation of the primary and secondary markets for: Chapter 5, Section 2.1
• Government/local authority/supranational agencies
• Corporate bonds
• Eurobonds
5.2.3 know the features and differences of quote and order driven markets Chapter 5, Section 2.1
5.2.4 know the types of transaction costs incurred in dealing in different asset classes Chapter 5, Section 2.2
5.3 International Markets
5.3.1 know the main characteristics of the major stock exchanges for the following Chapter 5, Sections 1.2, 3.2,
3.3, 3.4
markets: USA, UK, Japan, France, Germany
5.3.2 know the settlement cycles for the following markets: USA, UK, Japan, France, Chapter 5, Sections 3.2, 3.3,
3.4
Germany
5.3.3 know the main characteristics of the following Asian and Middle East stock Chapter 5, Section 3.4
exchanges: China, India, Dubai, Egypt, Saudi Arabia
5.3.4 know the settlement cycles for the following Asian and Middle East markets: Chapter 5, Section 3.4
China, India, Dubai, Egypt, Saudi Arabia
5.3.5 know the characteristics of an emerging market Chapter 5, Sections 3.4, 3.5
5.4 Foreign Exchange
5.4.1 know the basic structure and operation of the foreign exchange market Chapter 5, Section 4.2
5.4.2 understand the difference between spot and forward exchange rates Chapter 5, Section 4.2
5.4.3 be able to calculate forward exchange rates and parity relationships Chapter 5, Section 4.3
5.4.4 know the mechanisms through which currency exposure can be hedged Chapter 5, Section 4.4
5.4.5 understand the reasons for changes in exchange rates Chapter 5, Section 4
ELEMENT 6 ACCOUNTING
6.1 Basic principles
6.1.1 know the legal requirements to prepare accounts and the differences between Chapter 6, Section 1.1
private and public company requirements
6.1.2 know the fundamental accounting bases upon which company accounts are Chapter 6, Section 1.1
prepared (concepts of entity, going concern, prudence, matching, consistency
and historic cost)
6.1.3 know the function of the Accounting Standards Board (ASB) and International Chapter 6, Section 1.1
Accounting Standards Board (IASB)
6.1.4 know the purpose of the International Financial Reporting Standards (IFRSs) Chapter 6, Section 1.1
6.1.5 understand the purpose of the auditors’ report and the reasons why reports are Chapter 6, Section 1.1
modified
6.2 Balance Sheet
6.2.1 know the purpose and main contents of the balance sheet Chapter 6, Sections 2.1, 2.2
6.2.2 understand how assets are classified and valued Chapter 6, Section 2.3
6.2.3 know the difference between capitalising costs and expensing costs Chapter 6, Section 2.3
6.2.4 know how goodwill and other intangible assets arise and are treated Chapter 6, Section 2.3
6.2.5 be able to calculate the different methods of depreciation and amortisation Chapter 6, Section 2.3
6.2.6 know how liabilities are categorised Chapter 6, Section 2.4
6.2.7 understand the difference between authorised and issued share capital and Chapter 6, Section 2.5
capital reserves and revenue reserves
6.2.8 know what contingent liabilities and post balance sheet events are Chapter 6, Section 2.6
6.3 Income Statement

6.3.1 know the purpose and main contents of the income statement Chapter 6, Sections 3.1, 3.2
6.3.2 know the basic concepts underlying revenue recognition Chapter 6, Section 3.3
6.3.3 know how expenses, provisions and dividends are accounted for Chapter 6, Section 3.3
6.3.4 be able to calculate the different levels of profit given revenue and different Chapter 6, Section 3.3
categories of cost
6.3.5 know the difference between revenue and reserve accounting Chapter 6, Section 3.3
6.4 Cash Flow Statement
6.4.1 know the purpose and main contents of the cash flow statement Chapter 6, Section 4.2
6.4.2 be able to calculate net cash flow from operations from operating profit Chapter 6, Section 4.3
6.5 Consolidated Company Report and Accounts
6.5.1 know the basic principles of accounting for: Chapter 6, Section 5.2
• Associated Companies
• Subsidiaries
ELEMENT 7 INVESTMENT ANALYSIS
7.1 Fundamental and Technical Analysis
7.1.1 know the difference between fundamental and technical analysis Chapter 7, Sections 1.2, 1.3
7.2 Yields and Ratios
7.2.1 be able to calculate Return on Equity (ROE) Chapter 7, Section 2.2
7.2.2 be able to calculate Return on Capital Employed (ROCE) Chapter 7, Section 2.2
7.2.3 be able to calculate asset turnover Chapter 7, Section 2.2
7.2.4 be able to calculate profit margin Chapter 7, Section 2.2
7.2.5 be able to calculate financial gearing Chapter 7, Section 2.3
7.2.6 be able to calculate interest cover Chapter 7, Section 2.3
7.2.7 be able to calculate the working capital (current) ratio Chapter 7, Section 2.4
7.2.8 be able to calculate the liquidity (acid test) ratio Chapter 7, Section 2.4
7.2.9 be able to calculate debtor turnover Chapter 7, Section 2.4
7.2.10 be able to calculate creditor turnover Chapter 7, Section 2.4
7.2.11 be able to calculate stock turnover Chapter 7, Section 2.4
7.2.12 know the purpose of z score analysis Chapter 7, Section 2.4
7.2.13 understand the difficulties in interpreting the key accounting ratios for: Chapter 7, in general
• companies in different industries
• different companies within the same industry
• the same company over successive accounting periods
7.2.14 be able to calculate earnings per share (EPS) Chapter 7, Section 2.6
7.2.15 be able to calculate earnings before interest, tax, depreciation, and amortisation Chapter 7, Section 2.6
(EBITDA)
7.2.16 be able to calculate historic and prospective price earnings ratios (PERs) Chapter 7, Sections 2.7, 3.3
7.2.17 be able to calculate dividend yields Chapter 7, Section 2.8
7.2.18 be able to calculate dividend cover Chapter 7, Section 2.8
7.2.19 be able to calculate price to book ratios Chapter 7, Section 2.9
7.3 Valuation
7.3.1 be able to calculate equity valuations based on Dividends: Chapter 7, Section 3.2
- Gordon’s Growth Model
7.3.2 be able to calculate equity valuations based on Earnings: Chapter 7, Section 3.3
- Price earnings ratios (PERs)
7.3.3 be able to calculate equity valuations based on Assets: Chapter 7, Section 3.4
- Net Asset Value
7.3.4 know the basic concept behind shareholder value models: Chapter 7, Section 3.5
• Economic Value Added (EVA)
• Market Value Added (MVA)
ELEMENT 8 TAXATION
8.1 Business Tax
8.1.1 understand the application of the main business taxes: Chapter 8, Section 1
• Business tax
• Transaction tax (ie, Stamp Duty/Stamp Duty Reserve Tax)
• Tax on sales
8.1.2 know the purpose of tax-efficient incentive schemes sponsored by governments Chapter 8, Section 1
and supranational agencies (eg, International Monetary Fund)
8.2 Personal Taxes
8.2.1 understand the direct and indirect taxes as they apply to individuals: Chapter 8, Section 2
• Tax on income
• Tax on capital gains
• Estate tax
• Transaction tax (Stamp Duty)
• Tax on Sales
8.3 Overseas Taxation
8.3.1 know the principles of withholding tax Chapter 8, Section 3
8.3.2 know the principles of double taxation relief (DTR) Chapter 8, Section 3
ELEMENT 9 PORTFOLIO MANAGEMENT
9.1 Risk and Return
9.1.1 know the main principles of Modern Portfolio Theory (MPT) and the need for Chapter 9, Section 1.2
diversification
9.1.2 know the main propositions and limitations of the Efficient Markets Hypothesis Chapter 9, Section 1.3
(EMH)
9.1.3 understand the assumptions underlying the construction of the Capital Asset Chapter 9, Section 1.4
Pricing Model (CAPM) and its limitations
9.1.4 be able to apply the CAPM formula to equity portfolio selection decisions Chapter 9, Section 1.4
9.1.5 know the main: Chapter 9, Section 1.5
• principles behind Arbitrage Pricing Theory (APT)
• differences between CAPM and APT
9.2 The Role of the Portfolio Manager
9.2.1 understand the establishment of: Chapter 9, Section 2.2
• relationships with clients
• client objectives and risk profile including income and/or
growth, time horizons, restrictions and liquidity
• discretionary and non-discretionary portfolio management
9.2.2 understand the establishment of the investment strategy Chapter 9, Section 2.2
• the difference between active and passive management
• top down versus bottom up active management
• investment styles
• ethical, environmental and socially responsible investment
• alternative investment strategies
9.2.3 understand deciding on the benchmark and the basis for review Chapter 9, Section 2.2
9.2.4 understand the measurement and evaluation of performance and the purpose Chapter 9, Section 2.2
and requirements of annual and periodic reviews including client reporting
9.2.5 understand the benefits of employing derivatives within the investment Chapter 9, Section 2.2
management process
9.2.6 understand the issues associated with conflicts of interest and the duty to clients Chapter 9, Section 2.3
9.3 Fund Characteristics
9.3.1 know the main features and risk characteristics of the following: Chapter 9, Sections 3.2, 3.3,
3.4, 3.5, 3.6, 3.7, 3.8, 3.9,
3.10, 3.11, 3.12
• Private Client Funds
• Investment Trusts
• Unit Trusts
• OEICs (ICVCs)
• Insurance Companies (life and general)
• Exchange-Traded Funds (ETFs)
• Venture Capital Trusts (VCTs)
• Venture Capital Funds (limited partnerships)
• Offshore Funds
• Common Investment Funds
• Hedge Funds
• Private Equity Funds
• Fund of Funds
• Manager of Managers
9.3.2 understand the main features and risk characteristics of retirement funds Chapter 9, Section 3.13
ELEMENT 10 PERFORMANCE MEASUREMENT
10.1 Performance Benchmarks
10.1.1 know the main features of: Chapter 10, Section 1.3
- FTSE UK equity indices
• FTSE All World index
• FTSE Actuaries Government Securities indices
• MSCI World index
• Dow Jones Industrial Average index
• S&P 500 index
• DAX index
• CAC 40 index
• Nikkei Dow indices
• Hang Seng
• ASX
10.1.2 know why free float indices were introduced Chapter 10, Section 1.3
10.1.3 be able to calculate the main types of equity indices (arithmetic price and market Chapter 10, Section 1.2
value weighted and geometric unweighted)
10.1.4 know the alternative ways of benchmarking: Chapter 10, Sections 1.5, 1.6
• GIPS (Global Investment Performance Standards)
• Peer group average (WM and CAPS)
10.2 Performance Attribution
10.2.1 understand total return and its components Chapter 10, Section 2.1
10.2.2 be able to calculate the deviations from a performance benchmark attributable Chapter 10, Section 2.2
to:
• actual vs relative performance

• asset allocation
• stock selection
10.3 Performance Measures
10.3.1 be able to calculate the money weighted rates of return (MWRR) Chapter 10, Section 3.2
10.3.2 be able to calculate the time weighted rates of return (TWRR) Chapter 10, Section 3.3
10.3.3 be able to calculate the risk-adjusted returns for equities: Chapter 10, Section 3.4
• Sharpe
• Treynor
• Jensen
ASSESSMENT STRUCTURE
A 2 hour examination consisting of 100 multiple choice questions.
Candidates may have, in addition to the assessed questions, a small number of trial questions that will not
be separately identified and do not contribute to the result. Candidates will be given proportionately more
time to complete the test. For example a 100 question exam may actually have up to 110 questions in total,
the test will last a few minutes longer, but 10 of these will be trial unscored questions.
SYLLABUS STRUCTURE
The syllabus is divided into sections. These are divided into elements and the elements are made up
of learning objectives.
Each learning objective begins with one of the following prefixes: know, understand, be able to
calculate or be able to apply. These words indicate the different levels of skill to be tested.
Learning objectives prefixed:
‘Know’ - require candidates to recall information such as facts, rules and principles.
‘Understand’ - require candidates to demonstrate comprehension of an issue, fact, rule or principle.
‘Be able to calculate’ - require candidates to be able to use formulae to perform calculations
‘Be able to apply’ - require candidates to be able to apply their knowledge to a given set of
circumstances in order to present a clear and detailed explanation of a situation, rule or principle.
Where a learning objective refers to main or basic, this signifies that the candidate needs to be aware
of the topic’s key principles rather than possessing an in-depth grasp of the topic.
As this examination has a practical bias, candidates will be tested on topical investment issues detailed
in the syllabus. Some topics may also be examined through the use of diagrams, charts and other
pictorial representations and in the case of the accounting and investment analysis sections via a basic
set of company accounts.
CANDIDATE UPDATE
Candidates are reminded to check the 'Candidate Update' area of the Institute's website on a regular
basis for updates resulting from industry changes that may affect their examination. (www.sii.org.uk)
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 Total LOs Questions
1 12 8
2 10 7
3 6 4
4 51 31
5 18 12
6 21 13
7 24 8
8 5 3
9 13 9
10 9 5
TOTAL 169 100
Candidates should adopt professional updating practices early in their training and learn to draw on
many sources of technical advice. In particular, candidates should supplement their studies by reading
the journals, reference sources and texts listed below. In the case of textbooks these can be expected
to go beyond the requirements of the syllabus, but candidates may find this helpful as it will bring a
different perspective to their studies.
Periodicals
The Economist
Financial News
Financial Times (particularly the weekend editions, and the financial sections of other
newspapers)
Investors Chronicle
Investment Adviser
Investment Week
Money Management
Professional Pensions
The Wall Street Journal Europe
Texts
Economics: Begg, Fischer and Dornbusch; McGraw Hill
Essential Quantitative Methods for Business Management and Finance: Oakeshott; Palgrave
or
Quantitative Methods for Business and Economics: Burton, Carol and Wall; FT Prentice Hall
A Practitioner’s Guide to the City Code on Takeovers & Mergers; 2002-03 Button; City & Financial
Publishing
Investment Management: Lofthouse; Wiley
Finance & Financial Markets; Pilbeam; Palgrave
Interpreting Company Reports and Accounts: Holmes, Sugden & Gee; FT/ Prentice Hall
Modern Portfolio Theory and Analysis: Elton and Gruber; John Wiley & Sons
or
Investments: Bodie, Kane, Marcus; McGraw Hill International
The City: Inside the Great Expectation Machine (myth and reality in institutional investment and the
stock market) by Tony Golding, published by FT Prentice Hall
Useful websites
www.fsa.gov.uk
www.hm-treasury.gov.uk
www.hmrc.gov.uk
www.dmo.gov.uk
www.gad.gov.uk
www.bankofengland.co.uk
www.competition-commission.org.uk
www.thetakeoverpanel.org.uk/
www.londonstockex.co.uk
www.liffe.com
www.aca.org.uk
www.abi.org.uk
www.aitc.co.uk
www.bvca.co.uk
www.investmentuk.org
www.apcims.co.uk
Global business news websites:

• CNN.com
• S&P.com
• FT.com
• BusinessWeek.com
• Efinancialnews.com
NEXT STEPS
IAQTM Programme:
Candidates who have passed three IAQ examinations achieve the IAQ Award and are eligible for Associate
membership of the SII.
Certificate Programme:
Candidates who have passed two Certificate examinations achieve the SII Certificate Award and are eligible for
Associate membership of the SII.
Visit our website to learn about the numerous career benefits SII membership will bring: www.sii.org.uk
After completing the IAQ or Certificate programmes, you are encouraged to progress your career by preparing
for one or more of the SII Advanced examinations:
• Advanced Operational Risk
• Advanced Global Securities Operations
• Advanced Investment Schemes Administration.
You may also consider preparing for the SII Diploma qualification – the highest award for professionals in the
securities and investment industry.
To sit the Institute’s examinations or to purchase any of our publications please visit the our website at
www.sii.org.uk or contact Client Services on 020 7645 0680. Details on all of these awards and further
information can also be found on the Institute’s website. Candidates are reminded to check the ‘Content Update’
area of the Institute's website on a regular basis for updates that could affect their examination as a result of
industry change.
SII Membership Progression

L E V E L 3 I A Q TM P R O G R A M M E
The Investment Administration Qualification (IAQTM) is a practitioner led programme for administration and operations
staff. It equips individuals with an overview of the nature of the financial services industry and its regulation as well as
providing a detailed picture of their particular industry sector. The IAQ is awarded on the basis of passes in any three
modules (or two modules plus one exemption). Module selection depends on each candidate’s individual
circumstances, generally candidates fall into four groups:
1. Individuals presently in an overseeing role, working for a firm which is authorised and regulated by the FSA, are
required to take the following modules recommended by the FSA:
• Introduction to Securities & Investment
• FSA Financial Regulation or Principles of Financial Regulation
• A technical module relevant to the role.
2. Individuals working for a firm which is authorised and regulated by the FSA, who are not expected to take on an
overseeing role, may, if their firm agrees, select any three modules.
3. Individuals working for a firm which is not authorised and regulated by the FSA, particularly in firms based offshore,
may, if the firm agrees, select any three modules but are recommended to consider first passing Introduction to
Securities & Investment and then selecting any two modules.
4. Individuals entering the IAQ examination privately are advised to take Introduction to Securities & Investment and
FSA Financial Regulation (or Principles of Financial Regulation) as two of the three modules, but may select any
three modules.
All IAQ modules have been recognised by the Financial Services Skills Council for “overseeing” functions as
defined by the FSA. For details of the “overseeing” categories for which the IAQ is recognised, please refer to the
Financial Services Skills Council’s Appropriate Examinations list which can be found on their website
(www.fssc.org.uk).
L E V E L 3 C E R T I F I C AT E I N I N V E S T M E N T S
The Securities & Investment Institute Certificate in Investments (previously the Securities Institute Certificate) is a
series of examinations designed to satisfy the Financial Services Skills Council’s examination requirements for
advising on, and dealing in, securities and/or derivatives, and for managing investments.
In order to be awarded the Securities qualification, candidates must pass two modules:
• FSA Financial Regulation or Principles of Financial Regulation, and then one of:
• Securities - a two-hour, 100 multiple-choice question examination.
• Derivatives - a two-hour, 100 multiple-choice question examination.
• Securities and Financial Derivatives - this examination consists of two sections:
• Section 1 (Securities & Markets) is a 2 hour, 100 multiple choice question paper.
• Section 2 (Financial Derivatives) is a 1 hour 24 minute, 70 multiple choice question paper.
• Investment Management - a two-hour, 100 multiple-choice question examination.
• Financial Derivatives Module* - a 1 hour 24 minute, 70 multiple choice question paper.
(*If you have passed the Certificate in Securities and want to gain the Certificate in Securities and Financial
Derivatives, you can do this through the Financial Derivatives Module. Please note that taking the Financial
Derivatives Module after taking Unit 1 - Financial Regulation or Unit 6 - Principles of Financial Regulation does not
lead to a Ceritificate).
Candidates can sit the modules independently of each other and in either order.
SECURITIES & INVESTMENT INSTITUTE
The Securities & Investment Institute is the professional body for qualified and experienced practitioners of good
repute engaged in a wide range of securities and other financial services businesses. The Institute’s purpose is to
promote high standards of personal integrity, business ethics and professional competence and to create opportunities
for practitioners to meet for professional and social purposes. Please call 020 7645 0600 or visit www.sii.org.uk for
more information.
ASSOCIATE STATUS
Associate status is a professional designation offered by the Securities & Investment Institute in recognition of the
achievement of a benchmark qualification. Through Associate status, the Institute offers practitioners the
opportunity to meet regulatory requirements to maintain competence.
Upon achieving the Investment Administration Qualification (IAQ) individuals become eligible for Associate status. The
use of the designatory letters ‘ASI’ demonstrates a high level of competency within the financial services industry and a
commitment to high standards and professional integrity. For further information please telephone the Membership
Department on 020 7645 0650.
CONTINUING COMPETENCE
On successful completion of the IAQ, and to meet regulatory requirements, individuals will be required to keep
their industry knowledge up–to–date by undertaking Continuing Competence. The Institute offers an extensive
range of courses, conferences and workshops which provide excellent opportunities to keep in touch with
industry developments. Telephone our Client Services team on 020 7645 0680 for more information.
Membership of the Institute provides access to a programme of free Continuing Professional Development (CPD)
Events and information on a range of topics on the website. See the Membership section of our website
(www.sii.org.uk) or telephone the Membership Department on 020 7645 0650.
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International

1st Edition, July 2007

PROFESSIONALISM INTEGRITY EXCELLENCE

Workbook version: 1.3 (August 2008)

Chapter 2: Financial Mathematics and Statistics 49

Chapter 3: Industry Regulation 87

Chapter 4: Asset Classes 95

Chapter 5: Financial Markets 181

Chapter 6: Accounting 205

Chapter 7: Investment Analysis 237

Chapter 8: Taxation 263

Chapter 9: Portfolio Management 269

Chapter 10: Performance Measurement 313

International Certificate in Investment Management

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1.2 The Determination of Price and Output

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Figure 1: The Demand Curve

Figure 2: Shifts in the Demand Curve

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Figure 3: The Supply Curve

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Figure 4: Shifts in the Supply Curve

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1.3 Elasticities of Demand

Price Elasticity of Demand (PED)

Formally put, the PED = percentage change in quantity

The PED of a gadget, therefore = + 20% = -4

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elastic demand > -1

inelastic demand < -1

Figure 6: Price Elasticity of Demand (PED)

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Unit elasticity Inelastic

Figure 7: Price Elasticity of Demand and Total Revenue

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Cross Elasticities of Demand (XED)

The XED = percentage change in quantity

Income Elasticity of Demand (YED)

The YED = percentage change in quantity

1.4 The Theory of the Firm

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Figure 8: Total Average and Marginal Revenue

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Cost Short run marginal cost (SRMC)

Figure 9: Short Run Average and Marginal Costs

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Figure 10: The Optimal Level of Output

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Figure 11: Long Run Average Total Cost (LRATC)

1.5 Industrial Structure

Number of firms in industry

Figure 12: Industrial structure

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Figure 13: Minimum Efficient Scale (MES)

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1.6 Perfect Competition

£ Marginal cost (MC)

Ps Average total cost (ATC)

Average variable cost (AVC)

Figure 14: A Perfectly Competitive Firm

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1.7 Monopoly and Oligopoly