RO2 Chapter 1 - Asset Class Risks

Questions and Answers

What are sterling bonds to foreign borrowers?

This is a bond market with the UK market selling sterling loans to foreign governments and companies.

What is a Eurobond and give an example of a Euroyen bond.

A Eurobond is an international bond denominated in a currency other than that of the country where it is issued, such as a UK company issuing a Eurobond in America in Japanese Yen.

Name 2 bond indices.

FTSE Actuaries UK Gilt Index for domestic bonds and Barclays Capital Aggregate Bond Index for global bonds.

The yields on bonds measure what?

The returns bonds provide in relation to their marketplace. Signup and view all the answers

Which two bond yields are regularly published in the financial press?

The interest yield and the redemption yield. Signup and view all the answers

What are some other names for interest yield?

Running yield, flat yield, and income yield. Signup and view all the answers

The coupon is based on £100 of stock, however the interest yield formula is what?

coupon on nominal yield / clean price x 100 = interest yield. Signup and view all the answers

Why can the interest yield formula be misleading?

A bond can produce a capital gain or loss if held until redemption depending on the price they were purchased. Signup and view all the answers

Which is the most accurate calculation for the yield of a bond and what does it take into account?

The redemption yield is the most accurate calculation because it takes into account the income payments and the capital gain or loss. Signup and view all the answers

When does the capital gain or loss on a bond take place?

The gain or loss on a bond occurs in the last year, while the income payments are received half-yearly over the lifetime of the bond. Signup and view all the answers

Why is the redemption yield tough to calculate?

To calculate the redemption yield, you need a financial calculator for compound interest. Signup and view all the answers

Where the redemption yield is less than the interest yield there will be capital loss if the bond is held until ____.

redemption date. Signup and view all the answers

While the redemption yield helps to compare bonds on a common basis, this is not useful for the common investor because it does not take into account what?

Tax is ignored in the calculation for the average investor. Signup and view all the answers

Which bonds tend to be tax free?

Gilts and Corporate bonds tend to be tax free. Signup and view all the answers

How do yields on collective funds work?

Fund managers quote both yield measurements as an average of the stocks they hold. Signup and view all the answers

What are the key risks to bonds?

Interest rate risk, liquidity risk, inflation risk, currency risk, default risk. Signup and view all the answers

Describe the interest rate risk with bonds.

This bond risk is that capital value falls when interest rates rise. Signup and view all the answers

Describe the liquidity risk with bonds.

This bond risk is because many bonds trade infrequently and are hard to sell at a good price. Signup and view all the answers

Describe the inflation risk with bonds and what is a good method to protect.

Returns are eroded with inflation, although index-linked bonds provide some protection. Signup and view all the answers

Describe currency risk with bonds.

Most bond portfolios include global bonds for diversification, but this carries currency risk because of exchange rates. Signup and view all the answers

Describe the default risk with bonds.

All bonds carry the risk that the issuer will not meet the commitment to pay interest or principal at bond maturity. Signup and view all the answers

What determines the market price of a bond?

The yield required by the investor. Signup and view all the answers

What are the two broad factors that affect bond prices?

Specific/commercial risks of a particular issuer and market/systemic risks. Signup and view all the answers

Why are government bonds considered the most secure?

Because they can raise taxation for additional money. Signup and view all the answers

What is the lowest investment grade rating in both Standard & Poor's and Moody's?

BBB- from S&P and Baa3 are the lowest investment grade bonds. Signup and view all the answers

What are the ratings for non-investment grade bonds and other names for the same?

High yield or junk bonds are below BBB- & Baa3. Signup and view all the answers

What is the very worst bond rating in S&P vs. Moody's?

D versus C are the very worst ratings. Signup and view all the answers

Name examples of market or systemic risk of bonds.

Inflation, interest, and currency risks. Signup and view all the answers

If there is an increasing balance of payments problem, what happens to interest rates and bond values?

If there is an increasing balance of payments problem, interest rates rise and bond values decline. Signup and view all the answers

Why would economic growth show a decline in bond values?

Inflation rises with economic growth, and interest rates rise, which makes bond pricing decline. Signup and view all the answers

What are the 9 types of risk?

Systemic & Non Systemic Signup and view all the answers

What are the negative aspects of holding cash?

Capital value erodes Signup and view all the answers

Why should investors hold some money in cash even if there are low returns?

Emergency situations Signup and view all the answers

List the types of interest rates applied to a deposit.

Fixed or variable Signup and view all the answers

What do money market accounts offer?

Higher interest rates for cash Signup and view all the answers

What are the types of penalties imposed on early withdrawal from money markets?

Loss of interest for the notice period Signup and view all the answers

What is the most important thing to remember about money market accounts?

Notice period and minimum balances Signup and view all the answers

Are cash deposits risk free?

False Signup and view all the answers

To judge the level of ______ of your cash consider the credit worthiness of the bank and the extent that the compensation scheme will protect the deposits made.

default risk Signup and view all the answers

What judges the default risk associated with government bonds?

Credit rating by agencies Signup and view all the answers

What is the protection offered by the FSCS?

Fund of last resort Signup and view all the answers

How much will the FSCS cover in the event of bank failure of your deposit?

75k Signup and view all the answers

What are some key points to remember regarding the FSCS and your cash deposits?

Limits apply for each investor Signup and view all the answers

How are current rates of inflation measured?

RPI, CPI, CPIH, RPIX Signup and view all the answers

What risk does fixed term deposits at fixed interest rates carry?

Reinvestment risk Signup and view all the answers

What risks do offshore accounts carry?

Higher inflation Signup and view all the answers

What factors should you consider when investing in foreign currency accounts?

Reputation of the institution Signup and view all the answers

What are the two types of accounts available in banks and building societies?

Restricted access accounts Signup and view all the answers

What are teaser rate accounts?

Accounts with higher headline rates Signup and view all the answers

What are the two types of restricted access accounts?

Notice accounts Signup and view all the answers

What are notice accounts?

High initial rate Signup and view all the answers

What are term or time deposit accounts?

Requires minimum amounts Signup and view all the answers

What is the difference between a restricted access bank account and a structured deposit?

Returns based on performance Signup and view all the answers

What are some alternative names for a structured deposit?

Guaranteed Investment Account Signup and view all the answers

What are the usual minimum balances for a foreign currency deposit account?

$10,000 to $15,000 Signup and view all the answers

What is an advantage of an offshore sterling deposit account?

Higher interest rates Signup and view all the answers

Are ISAs/NISAs tax wrappers?

True Signup and view all the answers

What is the subscription limit amount on an ISA for an individual?

£15,240 Signup and view all the answers

What changes to ISAs are planned for April 2016?

Withdrawal and replacement without counting towards annual limit Signup and view all the answers

What are the ISA transfer rules?

Can change managers anytime Signup and view all the answers

What are ISA relevant investments?

Bank accounts Signup and view all the answers

What are the rules for 16 & 17 year olds with ISAs?

Parental income treatment Signup and view all the answers

What is a Help to Buy ISA starting December 2015?

Government bonus for first home purchase Signup and view all the answers

What are NS&I National Savings and Investments products?

Guaranteed by government Signup and view all the answers

Name 4 NS&I products that are no longer available.

Children's Bonds Signup and view all the answers

Describe the NS&I Income Bond.

No risk to capital Signup and view all the answers

What are Money Market Investments?

Wholesale markets for lending and borrowing Signup and view all the answers

Why are Money Markets important?

Provide capital for governments and companies Signup and view all the answers

What are 4 Money Market instruments?

Treasury Bills Signup and view all the answers

Describe a treasury bill.

Short-term cash instrument Signup and view all the answers

What are certificates of deposit?

Receipts from banks for deposits Signup and view all the answers

What are commercial bills?

Money market instrument Signup and view all the answers

What is the most important to understand about investment vehicles?

Underlying composition of the portfolio Signup and view all the answers

What are the two periods/types for money market funds?

6-12 months Signup and view all the answers

What criteria is used to assess whether a money market fund is suitable for a client?

Duration for fund access Signup and view all the answers

What is a typical annual charge for a money market?

0.15% Signup and view all the answers

What are the risks that cash investments and money markets have in common?

Inflation risk Signup and view all the answers

Why might a money market be less risky than a cash investment?

Diversification among providers Signup and view all the answers

What kind of instruments are bonds?

Negotiable fixed interest instruments Signup and view all the answers

Give some alternative names for bonds.

Debentures, securities, gilts Signup and view all the answers

More and more companies are borrowing from ____ versus their bank.

Capital markets Signup and view all the answers

What are the general characteristics of bonds?

Redeemed after fixed period Signup and view all the answers

What are the 3 features of a bond title?

Issuer name Signup and view all the answers

What is the nominal value of a bond?

£100 Signup and view all the answers

How often do bonds pay interest?

Twice a year Signup and view all the answers

What is a double dated gilt and an undated gilt?

No redemption date stated Signup and view all the answers

A bond holding £10,000 refers to the ____ of the stock.

Nominal value Signup and view all the answers

The ____ value determines the price the stock will be redeemed by the issuer.

Par value Signup and view all the answers

Is the price quoted in the paper the price for a bond an investor would pay?

No, it's different Signup and view all the answers

What is the mid-market price of a bond?

Price investor pays Signup and view all the answers

What are clean prices of a bond?

Price excluding accrued interest Signup and view all the answers

What are the 3 bond markets?

Secondary market Signup and view all the answers

How often does DMO issue new gilts?

Every week Signup and view all the answers

The issue and prospective coupon are marketed to ____.

Potential investors Signup and view all the answers

After bond issue, subsequent trading takes place on the ____ market.

Secondary Signup and view all the answers

Why is bond trading so brisk?

Income needs and market strategy Signup and view all the answers

What are the four major markets that make up bond trading activity?

Government sector Signup and view all the answers

Study Notes

Types of Risk

Systemic and Non-Systemic Risks: Systemic affects the entire market; Non-Systemic impacts specific sectors.
Currency Risk: Potential loss from fluctuations in currency exchange rates.
Interest Rate Risk: Exposure to changes in interest rates affecting asset values.
Liquidity Risk: Difficulty in converting an asset into cash without loss.
Counterparty Risk: Risk of the other party failing to fulfill contractual obligations.
Regulatory Risk: Changes in laws or regulations affecting investments.
Income Risk: Variability in income from investments or assets.
Inflation Risk: Erosion of purchasing power due to rising prices.
Shortfall Risk: Inability to meet financial obligations or expenses.

Negative Aspects of Holding Cash

Cash holdings lose capital value over time due to inflation, offering little protection.

Importance of Holding Cash

Maintaining an emergency cash reserve is crucial for financial security, even with low returns.

Types of Interest Rates on Deposits

Includes flat, fixed or variable rates, and the implications of tax, tenure, and penalties for early withdrawal.

Money Market Accounts

These accounts can provide higher interest rates for cash savings.

Early Withdrawal Penalties in Money Markets

Loss of interest based on deposit size and notice periods is common for early withdrawals.

Key Consideration for Money Market Accounts

Be mindful of notice periods and minimum balances to avoid penalties.

Cash Deposits and Associated Risks

Cash deposits are not risk-free due to institutional creditworthiness, inflation, fluctuating interest rates, and currency exchange impacts.

Assessing Default Risk

Evaluate the creditworthiness of financial institutions and the effectiveness of compensation schemes.

Government Bonds Default Risk Assessment

Credit ratings from agencies like Standard & Poor's, Fitch, and Moody's signify default risk regarding government bonds and bank performance.

FSCS Protection

The Financial Services Compensation Scheme acts as a safety net during bank failures, covering deposits.

FSCS Coverage Limit

As of January 1, 2016, FSCS covers deposits up to £75,000, down from £85,000.

Key Points on FSCS and Deposits

Individual limits per investor, joint account rules, recovery conditions with subsidiaries, and the time frame for cash recovery after failure.

Measuring Inflation Rates

Different indices:
- RPI includes housing costs,
- CPI is standardized in Europe without housing costs,
- CPIH includes owner-occupied housing,
- RPIX excludes mortgage interest.

Fixed Term Deposits Risks

Reinvestment risk arises when interest rates fall, leading to reduced returns upon maturity.

Risks Associated with Offshore Accounts

Offshore accounts may lack protections like the FSCS, and adverse currency movements can negate higher interest benefits.

Considerations for Foreign Currency Accounts

Key factors include market opinions on the currency, historical volatility, interest rate changes, and institutional reliability.

Types of Banking Accounts

Instant access accounts versus restricted access accounts.

Teaser Rate Accounts

These accounts offer higher headline interest rates with limits and may require other investments.

Restricted Access Account Types

Includes notice accounts and term (time deposit) accounts.

Notice Accounts and Associated Risks

Penalties for early withdrawal and potential reduced returns after an initial high rate.

Term or Time Deposit Accounts

Fixed interest rates for 1 to 5 years with limited access to capital.

Structured Deposits vs. Restricted Access Accounts

Structured deposits are linked to equity performance and carry inflation risk, differing from traditional restricted accounts.

Alternative Names for Structured Deposits

Includes Guaranteed Investment Account and Deposit Plan.

Capital Protection in Structured Deposits vs. Products

Structured deposits provide guaranteed capital from the deposit-taking firm, while structured products rely on third-party securities.

Minimum Balances for Foreign Currency Deposits

Typically range from $10,000 to $15,000, with interests reflecting market rates.

Offshore Sterling Deposit Advantages

Higher interest rates in tax havens with gross interest receipts.

ISA/NISA Structure

ISAs serve as tax wrappers providing interest income tax exemptions.

ISA Subscription Limit

£15,240 is the annual subscription limit for individual ISAs.

Upcoming ISA Changes (April 2016)

Allowance for withdrawing and replacing funds without counting against annual limits.

ISA Transfer Rules

No limits on transferring to cash or stocks, with allowances to change managers or transfer entire yearly amounts.

Relevant ISA Investments

Includes bank accounts, investment funds, and certain policies meeting capital guarantees.

ISA Rules for 16 & 17 Year Olds

Money over £100 classified as parental income until the age of 18.

Help to Buy ISA Overview

Government bonuses for first-time homebuyers based on saved amounts, with specific conditions and limits.

NS&I Products

Government-backed savings products purchased directly from NS&I, with variability in availability.

NS&I Product Types

Includes Direct ISAs, Income Bonds, with others like Growth Bonds no longer available.

NS&I Income Bond Characteristics

No capital risk, consistent interest rate, and flexible cash-out options.

Money Market Investments

Wholesale markets for lending and borrowing among banks and governments.

Importance of Money Markets

Provide essential capital for governments and companies, maintaining liquidity at low rates.

Money Market Instruments

Include Certificates of Deposit, Treasury Bills, and Commercial Bills.

Treasury Bills Description

Short-term government-issued instruments, with returns based on maturity value.

Certificates of Deposit Overview

Issued by banks with short maturities, reflecting market-related interest rates.

Commercial Bills Definition

Unsecured short-term instruments issued by companies to manage cash flow.

Understanding Investment Vehicles

The composition of a portfolio is crucial to understanding investment vehicles.

Money Market Fund Types

Short-term and longer-term funds with varied maturities.

Criteria for Money Market Fund Suitability

Evaluation includes comparative returns, accessibility, underlying asset risks, and fund manager experience.

Typical Money Market Annual Charge

Average charge is approximately 0.15% with no initial fees.

Common Risks in Cash Investments and Money Markets

Shared risks: credit, inflation, and interest rate risks, varying in credit risk evaluations.

Money Markets vs. Cash Investments Risk Comparison

Money markets typically feature lower risk due to diversified provider investments.

Bonds as Negotiable Instruments

Bonds represent long-term debt with fixed interest, and they can be sold in the market.

Alternative Names for Bonds

Common terminologies include stocks, debentures, and securities.

Trend of Companies Borrowing from Capital Markets

Increasing preference among companies to borrow from capital markets over traditional banks.

General Characteristics of Bonds

Bonds feature fixed interest rates, redemption values, and set repayment periods.

Features of a Bond Title

Includes issuer name, interest rate (coupon), and maturity date.

Nominal Value of a Bond

The nominal value is typically £100, distinct from market price.

Bond Interest Payment Frequency

Bonds generally pay interest bi-annually, with variations across types.

Types of Gilts

Double-dated gilts allow redemption between two dates; undated gilts lack a redemption date.

Nominal Value vs. Market Price

Refers to the face value of a bond separate from its market acquisition cost.

Par Value Significance

Determines redemption price and interest earnings at maturity.

Quoted Bond Prices vs. Market Prices

Market prices differ from reported prices due to clean price evaluations factoring accrued interest.

Understanding Mid-Market Price

Reflects the actual cost an investor incurs to buy a bond and the price received upon selling.

Clean Prices Explained

Clean prices exclude accrued interest, impacting total costs for investors.

Types of Bond Markets

Primary, secondary, and indexed bond markets signify various trading environments.

Frequency of Gilt Issues

The DMO issues new gilts weekly, with differentiated bidding processes for large investors and individuals.

Bond Trading Bid Process

Potential investors provide indicative bids with firm commitments due within a specified timeframe.

Leading City for Bond Trading

London stands as the primary location for secondary bond market activities.

Factors Influencing Bond Trading Dynamics

Investors adjust holdings based on income needs, issuer ratings, interest rate projections, and economic conditions.

Major Components of Bond Trading Activity

Distinguished sectors: government, corporate, foreign sterling loans, and Eurobond markets.

Sterling Bonds Overview

Refers to UK bonds sold to overseas borrowers, facilitating cross-border lending.

Eurobonds Definition

International bonds issued in a currency that differs from the country of issuance, exemplified by UK companies issuing Euroyen bonds.

Examples of Bond Indices

FTSE Actuaries UK Gilt Index and Barclays Capital Aggregate Bond Index represent different bond asset classes.

Understanding Bond Yields

Yields signify the returns that bonds yield in relation to market conditions.

Commonly Reported Bond Yields

Interest yield and redemption yield are frequently highlighted in financial outlets.

Alternative Terms for Interest Yield

Also known as running yield, flat yield, and income yield within financial discussions.

Interest Yield Calculation Formula

Calculated as (Coupon/Clean Price) x 100.

Misleading Nature of Interest Yield

Can give false impressions due to potential capital gains or losses depending on purchase pricing and current market conditions.### Redemption Yield
Redemption yield factors in income payments and capital gain or loss when holding a bond to maturity.
Each payment's value is adjusted based on the timing of receipt, making redemption yield a thorough yield calculation.

Capital Gain or Loss

Capital gain or loss on a bond occurs in the last year of its term.
Income payments are received semiannually over the bond's lifetime.

Calculation Difficulty

Calculating redemption yield typically requires a financial calculator for compound interest, which is often found in financial press.

Redemption Yield vs. Interest Yield

A capital loss occurs if the redemption yield is lower than the interest yield when held until the redemption date.

Tax Considerations

Redemption yield calculations ignore taxes, limiting its usefulness for average investors.

Tax-Free Bonds

Gilt-edged and corporate bonds tend to be tax-free.
However, income from all bonds is taxable.

Collective Fund Yields

Fund managers provide average yield measurements based on the stocks held due to the variability of interest and lack of maturity date.

Key Risks to Bonds

Interest rate risk
Liquidity risk
Inflation risk
Currency risk
Default risk

Interest Rate Risk

Bond values fall when interest rates rise, particularly affecting long-term bonds which are more volatile.

Liquidity Risk

Bonds often trade infrequently, making them difficult to sell at favorable prices.

Inflation Risk

Inflation erodes returns; index-linked bonds can hedge against this risk.

Currency Risk

Global bonds in portfolios introduce currency risk from fluctuating exchange rates.

Default Risk

All bonds carry a risk that the issuer may fail to pay interest and principal at maturity.

Market Price Determination

The yield required by investors is a key determinant of a bond's market price.

Factors Affecting Bond Prices

Specific risks associated with the issuer and broader systemic risks affecting fixed-interest securities are major influences on bond prices.

Government Bonds Security

Government bonds are regarded as the most secure due to the ability to raise taxes for additional funding.

Investment Grade Ratings

The lowest investment grade ratings are BBB- (Standard & Poor's) and Baa3 (Moody's).

Non-Investment Grade Classification

Bonds rated below BBB- & Baa3 are referred to as high yield or junk bonds.

Worst Bond Ratings

The lowest ratings are D (S&P) and C (Moody's).

Market/Systemic Risks Examples

Inflation, interest rates, and currency fluctuations exemplify market or systemic risks affecting bonds.

Balance of Payments Impact

An increasing balance of payments problem leads to rising interest rates and declining bond values.

Economic Growth and Bond Values

During economic growth, inflation and interest rates typically rise, causing a decline in bond prices.

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Description

Explore the various risks associated with different asset classes in this quiz based on RO2 Chapter 1. Understand the characteristics, systemic and non-systemic risks, as well as the implications of holding cash. Test your knowledge on how these factors impact investment strategies.