IMC Unit 2 Mannual PDF

Investment Management Certificate Unit 2: Investment Practice IMC Unit 2: Investment Practice Manual Edition 29 Copyright Notice: The copyright and all other intellectual property rights in these materials are, and shall continue to be, owned by Fitch Learning or its affiliates or licensors, as applicable, whether adapted, written for or customised for the recipient. These materials may not be reproduced or used, in whole or in part, for any purpose other than the training provided and may not be furnished to any persons or companies other than those to whom copies have been made available by Fitch Learning. This notice shall apply in respect of all materials provided by Fitch Learning in relation to any training provided by Fitch Learning. This notice may not be removed from these materials or any other such materials. Disclaimer: Please note that all of the information contained in the case materials and/or exercises has been developed by Fitch Learning and uses information from publicly available sources. Fitch Learning does not audit or verify the truth or accuracy of any such information. As a result, such information is provided “as is” without any representation or warranty of any kind. These case materials and/or exercises are included in the training materials purely as an illustrative example for participants to use during the training course. The presentations made by the trainer, the information contained in the case materials and/or exercise and any other materials provided (together, the “Training Materials”), and any comments made or issues discussed during the training course (together with the Training Materials, the “Information”) should not be regarded or construed as legal, investment or ratings advice. The Training Materials should be used by the participants solely for practising and reinforcing the analytic approach discussed in the training course and not in any other capacity. Reproduction or retransmission of the Training Materials is prohibited unless the prior written consent of Fitch Learning is obtained. In no way does any of the Information reflect the opinion of Fitch Learning, Fitch Ratings or any other Fitch group entity. Contents Chapter 1: Statistics................................................................................................................13 1. Introduction................................................................................................................................................. 13 1.1 Chapter overview.............................................................................................................................. 13 1.2 Learning outcomes........................................................................................................................... 13 2. Types and sources of data....................................................................................................................... 14 2.1 Types and sources of data............................................................................................................... 14 3. Populations and samples...............................................................................................................15 3.1 Populations........................................................................................................................................ 15 3.2 Samples............................................................................................................................................. 15 4. Presentation of data.................................................................................................................................. 16 4.1 Frequency distribution tables........................................................................................................... 16 4.2 Relative frequency distribution........................................................................................................ 17 4.3 Cumulative frequency distribution................................................................................................... 17 4.4 Visual presentation of discrete data................................................................................................ 18 4.5 Visual presentation of continuous data........................................................................................... 20 5. Summary statistics.................................................................................................................................... 22 5.1 Introduction........................................................................................................................................ 22 5.2 Mean and standard deviation.......................................................................................................... 23 5.3 Mode and range................................................................................................................................ 26 5.4 Median and inter-quartile range....................................................................................................... 26 5.5 Distributions....................................................................................................................................... 28 5.6 Geometric mean................................................................................................................................ 30 6. Covariance, correlation and bivariate linear regression................................................................... 32 6.1 Covariance........................................................................................................................................ 32 6.2 Correlation......................................................................................................................................... 32 6.3 Correlation and diversification......................................................................................................... 32 6.4 Calculating correlation coefficient.................................................................................................... 33 6.5 Scattergrams (scatter diagrams)..................................................................................................... 33 6.6 Bivariate linear regression................................................................................................................ 34 7. Statistics: Summary.................................................................................................................................. 36 7.1 Key concepts..................................................................................................................................... 36 Chapter 2: Financial Maths....................................................................................................37 1. Introduction................................................................................................................................................. 37 1.1 Chapter overview.............................................................................................................................. 37 1.2 Learning outcomes........................................................................................................................... 37 2. Simple vs. compound interest................................................................................................................ 38 2.1 Introduction........................................................................................................................................ 38 2.2 Simple interest................................................................................................................................... 38 2.3 Compound interest........................................................................................................................... 39 3. Discounting................................................................................................................................................. 41 3.1 Introduction........................................................................................................................................ 41 3.2 Calculating present values of a single cash flow........................................................................... 41 3.3 Calculating present values of multiple cash flows......................................................................... 42 3.4 Mortgages.......................................................................................................................................... 44 3.5 Perpetuities........................................................................................................................................ 45 4. Annualised rates.............................................................................................................................46 1 4.1 Annual percentage rates.................................................................................................................. 46 5. Investment appraisal techniques........................................................................................................... 47 5.1 Introduction........................................................................................................................................ 47 5.2 Net present value.............................................................................................................................. 47 5.3 Internal rate of return........................................................................................................................ 47 6. Financial maths: Summary...................................................................................................................... 49 6.1 Key concepts..................................................................................................................................... 49 Chapter 3: Information and Indices.....................................................................................51 1. Introduction................................................................................................................................................. 51 1.1 Chapter overview.............................................................................................................................. 51 1.2 Learning outcomes........................................................................................................................... 51 2. Indices: Uses.............................................................................................................................................. 52 2.1 Background....................................................................................................................................... 52 2.2 Uses of indices in fund management............................................................................................. 52 2.3 Treatment of constituent companies............................................................................................... 52 2.4 Benchmark indices........................................................................................................................... 53 3. Construction of indices............................................................................................................................ 54 3.1 Index numbers: Background............................................................................................................ 54 3.2 Creating an index.............................................................................................................................. 54 3.3 Re-basing indices............................................................................................................................. 54 3.4 Indices for financial markets............................................................................................................ 55 4. Global market indices............................................................................................................................... 57 4.1 Indices: UK........................................................................................................................................ 57 4.2 Indices: US........................................................................................................................................ 58 4.3 Indices: Europe................................................................................................................................. 58 4.4 Indices: Asian.................................................................................................................................... 59 4.5 Indices: Global................................................................................................................................... 59 4.6 Bond indices...................................................................................................................................... 59 5. Information and indices: Summary....................................................................................................... 60 5.1 Key concepts..................................................................................................................................... 60 Chapter 4: Equities: Types and Features...........................................................................61 1. Introduction................................................................................................................................................. 61 1.1 Chapter overview.............................................................................................................................. 61 1.2 Learning outcomes........................................................................................................................... 61 2. Ordinary and preference shares............................................................................................................. 62 2.1 Incorporation...................................................................................................................................... 62 2.2 Shareholders..................................................................................................................................... 62 2.3 Ordinary shares................................................................................................................................. 63 2.4 Preference shares............................................................................................................................. 64 3. American and global depositary receipts............................................................................................. 65 3.1 Introduction........................................................................................................................................ 65 3.2 Features............................................................................................................................................. 65 3.3 Summary........................................................................................................................................... 65 4. Quotation of share prices and dividends............................................................................................. 66 4.1 Share prices...................................................................................................................................... 66 4.2 Dividends........................................................................................................................................... 66 2 4.3 Dividend policy.................................................................................................................................. 66 5. Absolute valuation models...................................................................................................................... 67 5.1 Absolute vs. relative valuation techniques..................................................................................... 67 5.2 Total holding period return................................................................................................................ 67 5.3 Dividend valuation models............................................................................................................... 68 5.4 Calculating the growth rate of dividends......................................................................................... 69 6. Warrants..........................................................................................................................................70 6.1 Definition of a warrant....................................................................................................................... 70 6.2 Warrant value.................................................................................................................................... 71 6.3 Differences between call options and warrants............................................................................. 73 6.4 Covered warrants.............................................................................................................................. 73 7. Equities types and features: Summary................................................................................................. 74 7.1 Key concepts..................................................................................................................................... 74 Chapter 5: Issuing Equities...................................................................................................75 1. Introduction................................................................................................................................................. 75 1.1 Chapter overview.............................................................................................................................. 75 1.2 Learning outcomes........................................................................................................................... 75 2. Methods of issuing equity........................................................................................................................ 76 2.1 The primary market........................................................................................................................... 76 2.2 Offer for subscription........................................................................................................................ 76 2.3 Offer for sale...................................................................................................................................... 77 2.4 Placing............................................................................................................................................... 77 2.5 Intermediaries offer........................................................................................................................... 78 2.6 Equity crowdfunding......................................................................................................................... 78 2.7 Introduction (method of listing)........................................................................................................ 78 2.8 Rights issue....................................................................................................................................... 78 2.9 Scrip issue......................................................................................................................................... 80 2.10 Stock/Share splits and consolidations............................................................................................ 80 2.11 The impact of scrip issues, splits and consolidations on financial ratios.................................... 80 2.12 Underwriting...................................................................................................................................... 81 3. Share buy-backs........................................................................................................................................ 81 3.1 Introduction........................................................................................................................................ 81 3.2 Reasons for share buy-backs.......................................................................................................... 81 4. Issuing equities: Summary...................................................................................................................... 82 4.1 Key concepts..................................................................................................................................... 82 Chapter 6: Debt: Types and Features..................................................................................83 1. Introduction................................................................................................................................................. 83 1.1 Chapter overview.............................................................................................................................. 83 1.2 Learning outcomes........................................................................................................................... 83 2. Debt: Types and features......................................................................................................................... 84 2.1 Introduction........................................................................................................................................ 84 2.2 Gilts: UK Government bonds........................................................................................................... 84 2.3 Gilt Repo............................................................................................................................................ 87 2.4 Overseas government bonds.......................................................................................................... 88 2.5 Corporate bonds............................................................................................................................... 88 3. Other bonds................................................................................................................................................ 91 3.1 Convertible loan stock...................................................................................................................... 91 3 3.2 3.3 Contingent convertible bonds.......................................................................................................... 92 Callable/Puttable bonds................................................................................................................... 92 4. Debt seniority............................................................................................................................................. 93 4.1 Key risks faced by bond holders..................................................................................................... 93 4.2 Order of repayment.......................................................................................................................... 93 5. Debt types and features: Summary....................................................................................................... 94 5.1 Key concepts..................................................................................................................................... 94 Chapter 7: Debt Valuation......................................................................................................95 1. Introduction................................................................................................................................................. 95 1.1 Chapter overview.............................................................................................................................. 95 1.2 Learning outcomes........................................................................................................................... 95 2. Debt valuation: The basics...................................................................................................................... 96 2.1 Basic calculations............................................................................................................................. 96 2.2 Credit ratings..................................................................................................................................... 98 3. Prices and yields........................................................................................................................................ 99 3.1 Introduction.........................................................................................................................................100 3.2 Flat yield..............................................................................................................................................100 3.3 Redemption yields.............................................................................................................................100 3.4 Clean vs. dirty prices.........................................................................................................................103 4. Factors affecting bond prices..................................................................................................................104 4.1 Introduction.........................................................................................................................................104 4.2 Coupons..............................................................................................................................................104 4.3 Remaining life.....................................................................................................................................105 4.4 Required yield.....................................................................................................................................105 4.5 Macaulay duration.............................................................................................................................105 4.6 Modified duration................................................................................................................................106 5. Yield curves..................................................................................................................................................108 5.1 Types of yield curve...........................................................................................................................108 5.2 Yield curve theories...........................................................................................................................108 5.3 Decomposing yields...........................................................................................................................109 5.4 Forward rate, spot rates and the GRY.............................................................................................109 6. Debt valuation: Summary......................................................................................................................... 110 6.1 Key concepts..................................................................................................................................... 110 Chapter 8: Money Markets.................................................................................................... 113 1. Introduction................................................................................................................................................. 113 1.1 Chapter overview.............................................................................................................................. 113 1.2 Learning outcomes........................................................................................................................... 113 2. Cash and cash equivalents..................................................................................................................... 113 2.1 Cash................................................................................................................................................... 113 2.2 Government bills............................................................................................................................... 115 2.3 Commercial paper............................................................................................................................. 116 2.4 Certificates of deposit (CDs)............................................................................................................ 117 3. Money markets: Summary....................................................................................................................... 117 3.1 Key concepts..................................................................................................................................... 117 Chapter 9: Foreign Exchange.............................................................................................. 119 4 1. Introduction................................................................................................................................................. 119 1.1 Chapter overview.............................................................................................................................. 119 1.2 Learning outcomes........................................................................................................................... 119 2. FX rates: Standards of quotation............................................................................................................120 2.1 Background........................................................................................................................................120 2.2 Spot Markets......................................................................................................................................120 2.3 FX: Forward markets.........................................................................................................................121 3. Exchange rate determination...................................................................................................................122 3.1 Introduction.........................................................................................................................................122 3.2 Interest rate parity (IRP)....................................................................................................................122 3.3 Purchasing power parity (PPP)........................................................................................................123 3.4 International Fisher effect..................................................................................................................124 4. Portfolio measurement: foreign exchange...........................................................................................125 4.1 FX risk.................................................................................................................................................125 5. Exchange rate regimes and optimal currency areas...........................................................................125 5.1 Exchange rate regimes.....................................................................................................................125 5.2 Arguments for and against fixed exchange rate mechanisms......................................................126 5.3 Optimal currency areas.....................................................................................................................126 6. Foreign exchange: Summary...................................................................................................................126 6.1 Key concepts......................................................................................................................................126 Chapter 10: Derivatives and Other Instruments........................................................ 129 1. Introduction..................................................................................................................................................129 1.1 Chapter overview...............................................................................................................................129 1.2 Learning outcomes............................................................................................................................129 2. Futures.............................................................................................................................................130 2.1 Features..............................................................................................................................................130 2.2 Jargon.................................................................................................................................................131 3. Futures: Hedging............................................................................................................................136 3.1 Basic hedging.....................................................................................................................................136 3.2 Beta hedging......................................................................................................................................136 4. Options............................................................................................................................................137 4.1 Features..............................................................................................................................................137 4.2 Jargon.................................................................................................................................................138 4.3 Basic positions...................................................................................................................................138 4.4 Options positions: Summary.............................................................................................................141 4.5 Option premiums................................................................................................................................141 5. Options: Hedging............................................................................................................................145 5.1 Hedging using options.......................................................................................................................145 6. Strategies........................................................................................................................................146 6.1 Covered call........................................................................................................................................146 6.2 Protective put......................................................................................................................................147 6.3 Combinations: straddles and strangles...........................................................................................147 7. Derivatives: Products................................................................................................................................148 7.1 Equity derivatives...............................................................................................................................148 7.2 Bond derivatives.................................................................................................................................149 7.3 Interest rate derivatives.....................................................................................................................149 7.4 Swaps.................................................................................................................................................149 5 7.5 Credit derivatives...............................................................................................................................152 8. Commodities and Cryptocurrencies.......................................................................................................154 8.1 Introduction.........................................................................................................................................154 8.2 Types of commodity...........................................................................................................................154 8.3 Cryptocurrencies................................................................................................................................155 9. Short selling....................................................................................................................................157 9.1 Introduction.........................................................................................................................................157 9.2 Process...............................................................................................................................................157 9.3 Motivations and risks.........................................................................................................................157 9.4 Stock borrowing and lending............................................................................................................158 10. Derivatives: Clearing......................................................................................................................159 10.1 LCH.Clearnet......................................................................................................................................159 10.2 Margin.................................................................................................................................................159 11. Derivatives and other instruments: Summary..............................................................................160 11.1 Key concepts......................................................................................................................................160 Chapter 11: Property Investments.............................................................................. 163 1. Introduction..................................................................................................................................................163 1.1 Chapter overview...............................................................................................................................163 1.2 Learning outcomes............................................................................................................................163 2. Residential and Commercial Property...................................................................................................164 2.1 The UK Residential Property Market...............................................................................................164 2.2 Commercial property.........................................................................................................................164 2.3 Features of the property market.......................................................................................................164 2.4 Advantages of property as an investment.......................................................................................165 3. Property investment.......................................................................................................................165 3.1 Direct vs. indirect property investment............................................................................................165 3.2 Direct property investment................................................................................................................165 3.3 Indirect property investment.............................................................................................................167 3.4 Property derivatives...........................................................................................................................168 4. Property valuation techniques.................................................................................................................169 5. Environmental, social and governance factors...................................................................................170 6. Property investments: Summary...................................................................................................171 6.1 Key concepts......................................................................................................................................171 Chapter 12: Investment Products.........................................................................................173 1. Introduction..................................................................................................................................................173 1.1 Chapter overview...............................................................................................................................173 1.2 Learning outcomes............................................................................................................................173 2. Collective investment vehicles................................................................................................................174 2.1 Benefits and disadvantages of investing in collective investment vehicles.................................174 2.2 Unit trusts............................................................................................................................................175 2.3 Open-ended investment companies (OEICs).................................................................................177 2.4 Unit trusts vs. ICVCs.........................................................................................................................177 2.5 Investment powers of UCITS schemes...........................................................................................178 2.6 Investment trusts................................................................................................................................179 2.7 Exchange-traded products (ETPs)...................................................................................................180 2.8 Other methods of investment...........................................................................................................182 6 3. Hedge funds and private equity...............................................................................................................184 3.1 Hedge funds.......................................................................................................................................184 3.2 Private equity......................................................................................................................................185 4. Pension funds and life assurance companies.....................................................................................186 4.1 Pension funds.....................................................................................................................................186 4.2 Insurance companies........................................................................................................................186 5. Investment products: Summary..............................................................................................................187 5.1 Key concepts......................................................................................................................................187 Chapter 13: Portfolio Theory.................................................................................................189 1. Introduction..................................................................................................................................................189 1.1 Chapter overview...............................................................................................................................189 1.2 Learning outcomes............................................................................................................................189 2. Portfolio considerations............................................................................................................................192 2.1 Background........................................................................................................................................192 2.2 Choice of asset classes.....................................................................................................................193 2.3 Pricing and transaction costs............................................................................................................193 3. Passive vs. active styles............................................................................................................................195 3.1 Passive fund management...............................................................................................................195 3.2 Active fund management..................................................................................................................197 3.3 Tilting: An active/passive hybrid........................................................................................................198 3.4 Relative weightings............................................................................................................................198 3.5 Stock selection considerations.........................................................................................................198 3.6 Decomposing excess returns...........................................................................................................199 4. The Efficient Market Hypothesis..............................................................................................................200 4.1 What do we mean by ‘efficient markets’?........................................................................................200 4.2 The Three Forms of the Efficient Market Hypothesis (EMH)........................................................200 5. Behavioural Finance..................................................................................................................................201 5.1 Behavioural finance...........................................................................................................................201 5.2 Characteristics of financial crises.....................................................................................................202 6. Socially Responsible Investing and Environmental, Social and Governance Investing............203 6.1 Introduction.........................................................................................................................................203 6.2 Socially Responsible Investing.........................................................................................................203 6.3 History of Environmental, Social and Governance (ESG) Investing............................................203 6.4 Supply and demand for ESG Investing...........................................................................................204 6.5 Advantages of ESG investing on portfolio returns..........................................................................204 6.6 ESG factors in investment decisions...............................................................................................204 6.7 ESG and Impact Investing................................................................................................................205 7. Performance measurement......................................................................................................................205 7.1 Background........................................................................................................................................205 7.2 Holding period return.........................................................................................................................205 7.3 Money-weighted rate of return (MWRR)..........................................................................................206 7.4 Time-weighted rate of return (TWRR)..............................................................................................207 8. Risk and reward..........................................................................................................................................208 8.1 The risk and reward connection.......................................................................................................208 8.2 Risk premium.....................................................................................................................................208 8.3 Systematic risks.................................................................................................................................208 8.4 Unsystematic risks.............................................................................................................................209 8.5 Systemic risks.....................................................................................................................................210 8.6 Other risks..........................................................................................................................................210 7 9. Measuring risk............................................................................................................................................ 211 9.1 Standard deviation............................................................................................................................ 211 9.2 Specific vs. systematic risk...............................................................................................................212 9.3 Risk and diversification......................................................................................................................212 9.4 Drawdown as a measure of risk.......................................................................................................215 9.5 Value at risk (VaR).............................................................................................................................216 10. Pricing models............................................................................................................................................216 10.1 Capital Asset Pricing Model CAPM..................................................................................................216 10.2 Security market line...........................................................................................................................217 10.3 Alphas.................................................................................................................................................218 10.4 Using CAPM.......................................................................................................................................218 10.5 Arbitrage pricing model......................................................................................................................219 11. Risk-adjusted performance measures...................................................................................................219 11.1 Background........................................................................................................................................219 11.2 Information ratio..................................................................................................................................219 11.3 Sharpe measure.................................................................................................................................220 11.4 Treynor measure................................................................................................................................221 11.5 Jensen measure.................................................................................................................................221 11.6 Ex-ante and ex-post measures of risk.............................................................................................222 11.7 Risk adjusted performance measures: Summary..........................................................................223 12. Bond portfolios...........................................................................................................................................223 12.1 Introduction.........................................................................................................................................223 12.2 Portfolio duration................................................................................................................................223 12.3 CAPM in bond portfolios...................................................................................................................225 13. Management of bond portfolios..............................................................................................................225 13.1 Active bond portfolio management...................................................................................................225 13.2 Passive bond portfolio management................................................................................................227 13.3 Liability driven investments...............................................................................................................228 14. Portfolio theory: Summary.......................................................................................................................228 14.1 Key concepts......................................................................................................................................228 Chapter 14: Company Accounts...........................................................................................233 1. Introduction..................................................................................................................................................233 1.1 Chapter overview...............................................................................................................................233 1.2 Learning outcomes............................................................................................................................233 2. Financial statements: Framework...........................................................................................................235 2.1 Background........................................................................................................................................235 2.2 Companies Act 2006 (CA ‘06)..........................................................................................................235 2.3 International Financial Reporting Standards...................................................................................237 2.4 Accounts: UKLA Listing Rules..........................................................................................................237 2.5 Accounts: Summary..........................................................................................................................238 3. Balance sheet...............................................................................................................................................238 3.1 Introduction.........................................................................................................................................238 3.2 Balance sheet: Example...................................................................................................................239 3.3 Non-current assets (NCAs)...............................................................................................................240 3.4 Current assets....................................................................................................................................241 3.5 Share capital and share premium....................................................................................................242 3.6 Reserves.............................................................................................................................................243 3.7 Current liabilities.................................................................................................................................244 3.8 Non-current liabilities.........................................................................................................................244 3.9 Provisions for liabilities and charges................................................................................................244 8 3.10 3.11 3.12 3.13 Contingent liabilities...........................................................................................................................244 Accounting for occupational pension schemes (OPSs).................................................................245 Alterations in share capital................................................................................................................245 Classification of financial instruments..............................................................................................247 4. Balance sheet: Further issues.................................................................................................................249 4.1 Depreciation of tangible non-current assets....................................................................................249 4.2 Disposals of non-current assets.......................................................................................................251 4.3 Valuation of inventory.........................................................................................................................251 4.4 Post-balance sheet events................................................................................................................253 5. Income statement.......................................................................................................................................254 5.1 Background........................................................................................................................................254 5.2 Example..............................................................................................................................................254 5.3 Capital and revenue expenditure.....................................................................................................254 5.4 Turnover/Revenue.............................................................................................................................254 5.5 Cost of sales and operating costs....................................................................................................255 5.6 Operating/trading profit......................................................................................................................255 5.7 Interest and tax...................................................................................................................................255 5.8 Dividends............................................................................................................................................255 5.9 Retained profit....................................................................................................................................255 5.10 Alternative Performance Measures (APM)......................................................................................255 6. Statement of comprehensive income.....................................................................................................256 7. Statement of changes in equity...............................................................................................................256 8. Cash flow statement...................................................................................................................................256 8.1 Introduction.........................................................................................................................................256 8.2 Categories of cash flow.....................................................................................................................257 8.3 Cash flow statement example..........................................................................................................258 8.4 Definitions of cash flow......................................................................................................................258 9. Cash flow statement: Further issues......................................................................................................259 9.1 Reconciling net cash flow from operating activities with operating profits...................................259 10. Group accounts...........................................................................................................................................260 10.1 Introduction.........................................................................................................................................260 10.2 Parent company.................................................................................................................................260 10.3 Group..................................................................................................................................................260 10.4 Group: Example.................................................................................................................................261 10.5 Minority interest..................................................................................................................................261 11. Company accounts: Summary................................................................................................................262 11.1 Key concepts......................................................................................................................................262 Chapter 15: Ratio Analysis......................................................................................... 265 1. Introduction..................................................................................................................................................265 1.1 Chapter overview...............................................................................................................................265 1.2 Learning outcomes............................................................................................................................265 2. Investors’ ratios..............................................................................................................................266 2.1 Dividend yield.....................................................................................................................................266 2.2 Dividend cover....................................................................................................................................267 2.3 Payout ratio........................................................................................................................................267 2.4 Absolute vs. relative valuation techniques......................................................................................268 2.5 Earnings per share (EPS).................................................................................................................268 2.6 Price-earnings ratio (P/E ratio).........................................................................................................269 2.7 The EBITDA multiple (EV/EBITDA).................................................................................................270 9 2.8 2.9 Price to book, price to sales and price to cash flow........................................................................271 Other measures of shareholder value.............................................................................................271 3. Gearing and liquidity ratios......................................................................................................................272 3.1 Gearing (or Debt/Equity)...................................................................................................................272 3.2 Liquidity ratios....................................................................................................................................272 3.3 Operational gearing...........................................................................................................................273 4. Operating ratios..............................................................................................................................275 4.1 Return on capital employed (ROCE)...............................................................................................275 4.2 Operating profit margin and asset turnover.....................................................................................275 4.3 The effect of corporate actions on the major accounting ratios....................................................276 5. Ratio analysis: Summary...............................................................................................................276 5.1 Key concepts......................................................................................................................................276 Chapter 16: Microeconomics................................................................................................279 1. Introduction..................................................................................................................................................279 1.1 Chapter overview...............................................................................................................................279 1.2 Learning outcomes............................................................................................................................279 2. Microeconomics: The basics...................................................................................................................281 2.1 Introduction.........................................................................................................................................281 2.2 Production possibility frontier (PPF).................................................................................................282 2.3 Opportunity cost.................................................................................................................................282 3. Supply and demand........................................................................................................................284 3.1 Introduction.........................................................................................................................................284 3.2 Demand curve/schedule...................................................................................................................284 3.3 Supply curve/schedule......................................................................................................................285 3.4 Supply and demand in equilibrium...................................................................................................286 4. Elasticities of demand................................................................................................................................287 4.1 Introduction.........................................................................................................................................287 4.2 Price elasticity of demand (PED).....................................................................................................287 4.3 Income elasticity of demand.............................................................................................................288 4.4 Cross elasticity of demand................................................................................................................289 4.5 Elasticity of supply.............................................................................................................................289 5. The production process............................................................................................................................290 5.1 Introduction.........................................................................................................................................290 5.2 Short run (SR)....................................................................................................................................290 5.3 Long run (LR).....................................................................................................................................294 6. Market structures........................................................................................................................................295 6.1 Introduction.........................................................................................................................................295 6.2 Perfect competition............................................................................................................................295 6.3 Monopoly............................................................................................................................................297 6.4 Monopolistic competition...................................................................................................................299 6.5 Oligopoly.............................................................................................................................................299 7. Assessing industries and companies....................................................................................................300 7.1 Introduction.........................................................................................................................................300 7.2 The economic (business) cycle........................................................................................................300 7.3 Product life cycles..............................................................................................................................301 7.4 SWOT analysis..................................................................................................................................301 7.5 Product, place, promotions and price..............................................................................................302 8. Microeconomics: Summary......................................................................................................................302 10 8.1 Key concepts......................................................................................................................................302 Chapter 17: Macroeconomics...............................................................................................305 1. Introduction..................................................................................................................................................305 1.1 Chapter overviews.............................................................................................................................305 1.2 Learning outcomes............................................................................................................................305 2. UK socioeconomic trends.........................................................................................................................306 2.1 What is socio-economics?................................................................................................................306 2.2 Demography.......................................................................................................................................307 2.3 Environmental change.......................................................................................................................307 2.4 Global economy.................................................................................................................................307 3. Economic indicators..................................................................................................................................310 3.1 Introduction.........................................................................................................................................310 3.2 Government borrowing: The Public Sector Net Cash Requirement........................................... 311 3.3 Inflation indices.................................................................................................................................. 311 3.4 The Base Rate.................................................................................................................................. 311 3.5 Consumer confidence and the volume of consumer spending.................................................... 311 3.6 Level of unemployment.................................................................................................................... 311 3.7 Stock market indices.........................................................................................................................312 3.8 Stock market movements.................................................................................................................312 3.9 Trade figures.......................................................................................................................................313 3.10 The balance of payments and exchange rates...............................................................................313 3.11 Sterilisation.........................................................................................................................................314 4. The economy: A simple model.................................................................................................................314 4.1 Circular flow of money.......................................................................................................................314 4.2 Leakages and injections....................................................................................................................315 5. National income accounting.....................................................................................................................317 5.1 Definition.............................................................................................................................................317 5.2 Gross Domestic Product (GDP).......................................................................................................317 5.3 Gross National Product (GNP).........................................................................................................319 5.4 National Income.................................................................................................................................319 5.5 GDP, GNP and National Income summary.....................................................................................319 6. Aggregate demand (AD).................................................................................................................320 6.1 Definition.............................................................................................................................................320 6.2 Consumption (C)................................................................................................................................320 6.3 Investment (I)......................................................................................................................................322 6.4 Government spending (G).................................................................................................................322 6.5 Economic schools of thought...........................................................................................................323 6.6 Net exports (Exports - Imports, X - M).............................................................................................325 6.7 Multipliers............................................................................................................................................325 6.8 Stages of the Economic Cycle.........................................................................................................326 7. Central banks...............................................................................................................................................327 7.1 Role of central banks.........................................................................................................................327 7.2 Unconventional tools.........................................................................................................................327 8. Money supply, inflation and unemployment.........................................................................................328 8.1 Money supply figures........................................................................................................................328 8.2 Fractional reserve banking................................................................................................................329 8.3 Rules on capital requirements..........................................................................................................330 8.4 The quantity theory of money...........................................................................................................331 8.5 Inflation................................................................................................................................................331 8.6 Unemployment...................................................................................................................................332 11 8.7 9. The Phillips Curve..............................................................................................................................332 Macroeconomics: Summary....................................................................................................................333 9.1 Key concepts......................................................................................................................................333 Index............................................................................................................................ 336 12 Chapter 1: Statistics 1. Introduction 1.1 Chapter overview This chapter introduces the idea of ‘statistics’, looking at the different ways in which you can gather information (or data) and analyse it. You may wish to gather information concerning the salaries of people who work at your firm or on the performance of a fund manager. Either way the method of presentation of the data is critical to how easy it is for other people to interpret. This chapter introduces different ways in which data can be presented. If you gather data, it can be important to identify the central point around which the data seems to be clustered. This is known as a measure of central tendency. The most important measure of central tendency is the arithmetic average, which is a simple average of all the data you have collected. Once you have a central tendency figure you will want to know how closely clustered to that central tendency your actual data points are, i.e. you will want a measure of dispersion. The most important measure of dispersion you will learn is standard deviation. This chapter will show you the formula for standard deviation and how to calculate it on a scientific calculator. You will see that the bigger the standard deviation figure the bigger the level of dispersion around the arithmetic mean. In other words, the bigger the standard deviation, the more spread out the data will be. Standard deviation is probably the single most important calculation for statisticians as it is very useful in analysing the variability of returns to an investment. 1.2 Learning outcomes On completion of this module you will: Types and sources of data 7.1.1 Identify and distinguish between different sources and types of data 7.1.4 Distinguish between continuous and discrete data 7.1.5 Define categorical data and explain how it can be converted to ordinal data Populations and samples 7.1.2 Distinguish between a population and a sample 7.1.3 Explain the key sampling methods Presentation of data 7.1.6 Interpret a frequency and relative frequency distribution 7.1.7 Explain the use of the following in the presentation of data: pie chart, bar chart, histogram, scatter plots, line graphs Summary statistics 7.2.1 Define, explain and calculate the arithmetic mean, geometric mean, median and mode using raw and interval data, and calculate the geometric mean return using a series of returns 7.2.2 Explain the relationship between the mean, median and mode for symmetric and skewed data 13 7.2.3 Define, explain and calculate the following measures of dispersion for both raw data and interval data: standard deviation (population and sample), variance, range, quartiles and percentiles, interquartile range 7.2.4 Explain the notion of probability distributions and identify the properties of the normal distribution 7.2.5 Explain and apply the concepts of null hypothesis, alternative hypothesis and the role of statistical significance in rejecting/accepting the null/alternative hypothesis in the context of investment decision making 15.1.5 Explain the implications of assuming returns are normally distributed Correlation and bivariate linear regression 7.3.1 Define correlation and identify alternative measures of correlation 7.3.2 Explain the least-squares regression technique in deriving a line of best fit and interpret the correlation coefficient R, R squared, adjusted R squared and measures of unexplained variation (for example the mean squared error) 7.3.3 Calculate and interpret a forecast value for the dependent variable given the intercepts and slope coefficients of a regression equation taking into account their statistical significance 7.3.4 Explain the shortfalls in the application of linear regression to forecasting, including why correlation does not imply causation, and the pitfalls of data-mining 7.3.5 Describe the impact of extreme events on correlation 15.1.13 Calculate correlation coefficients from standard deviation/covariance of two investments 2. Types and sources of data 2.1 Types and sources of data Background Investment decisions require analysis and interpretation of a wide variety of information or ‘data’. Fund managers and investment analysts, for instance, require data on such things as company performance, industry life cycle and other macroeconomic factors influencing the investment decision, e.g. interest rates, exchange rates etc. This module begins by describing the different types of data and how they are collected. The module then moves on to examine the ways in which the collected data can be presented and summarised in a useful and informative way. Primary data Primary data is collected with a particular purpose in mind. For example, an advertising agency researching consumer attitudes to various brands of chocolate. Primary data refers to data that an investigator has collected themselves. The investigator therefore knows the conditions under which the data was collected and is aware of any limitations it may contain. Secondary data Secondary data is collected by many organisations, such as companies, government agencies and other bodies which have been formed specifically to gather economic and social data in a convenient form. The Office for National Statistics (ONS), for example, collects economic data on inflation and employment. Users of secondary data may not have a full understanding of the background and circumstances under which the data was initially collected. Consequently, users of secondary data may be unaware of any 14 limitations it may contain. Other sources of secondary data could be: Bank of England HM Treasury Credit rating agencies, such as Fitch, Moody’s and S&P Discrete data Discrete data refers to data where the units of measurement cannot be split up. For example, if the data refers to the number of people using a particular tube station each day, then the recorded figures might be 824 or 825 people, but never 824 ½. Data can be put into groups or categories, for example, the answers to a question could be coded 1 for yes, 2 for no and 3 for maybe. This process would separate the responses to form categorical data. Descriptive statistics are used to describe the basic features of the data. They provide simple summaries about the sample and the measures. It is not generally possible to directly apply descriptive statistics to categorical data as the actual number itself is arbitrary. Sometimes categorical data may be ranked or ordered according to set criteria, e.g. a first or second class degree. It is the order of these numbers that matters. This is known as an ordinal data. Ordinal data allows for the use of descriptive statics to compare the data using numbers and scales. Continuous data Continuous data is where the units have a constant scale and all points between the units have meaning. For example, the distance travelled by a person to work can be expressed as 5 miles, 5.1 miles, 5.12 miles and so on, to an unlimited number of decimal places. The level of accuracy in recording continuous data depends on the precision of the measuring device itself. 3. Populations and samples 3.1 Populations A population is the entire set of items which have the desired characteristics under investigation. For example, if the TV viewing habits of males under 40 years of age was under investigation, then the population refers to all males under 40 years of age. A population will give a complete set of data but will be very difficult and time consuming to collect. 3.2 Samples Using samples Sometimes it is impractical, if not impossible, to examine every member of the population under investigation. Instead, only a part, or sample, of the population is tested. A sample is a sub-set of items taken from the population with the characteristics under investigation. Selecting a sample can be done either on a random or non-random basis. Random samples A random sample is a sample selected in such a way that every member of the population has an equal chance of being selected. 15 Non-random samples The alternative to random sampling is to employ a non-random (or non-probability) method of selection. An example of non-random selection is quota sampling, which is often used in market research. Such a quota is usually categorised into different types of individual members, e.g. professional or manual workers, with ‘sub-quotas’ for each type. For example, sampling might involve interviewing the first 100 people an investigator meets in a city centre, (i.e. the quota). Quota sampling might involve using data on the first 52 women and 48 men interviewed in order to reflect the gender split of the UK. If the 52 women and 48 men were selected randomly this would be called stratified sampling. Stratified sampling is designed to reduce sampling error, it does this by selecting a sample that represents the population. Another form of non-random sampling is systematic sampling. This is where researchers select the nth record of a population. For example, if analysing how far your employees travel to work on average, we may ask every fifth person on an alphabetical list of employees. Other sampling methods Convenience sampling – choosing the sample that is easiest to collect information from. Choosing people in your local town to represent the UK, for example. Judgement sampling – making a judgement of the sample that would best represent the population, for example, believing Swindon is a good representation of the UK. Snowball sampling – This is typically used when the subjects of the data are rare. It relies on referrals from initial subjects. 4. Presentation of data 4.1 Frequency distribution tables A frequency distribution table is one of the more straightforward methods of data presentation. Such a table involves categorising the number of times something has occurred. For example, the data of 129 peoples’ salaries is illustrated on the frequency distribution table below. The salary range is grouped into subsets in the left-hand column and the number of people is shown on the right. 16 Table 1. Frequency distribution table (salary example) Salaries £ 000’s pa (nearest £) No. of people 4,999 or less 2 5 to 9,999 3 10 to 14,999 6 15 to 19,999 14 20 to 24,999 29 25 to 29,999 38 30 to 34,999 18 35 to 39,999 9 40 to 44,999 6 45 to 49,999 3 50 and above 1 Total 129 As a result of grouping, it is possible to detect patterns in the data. For instance, it is clear from the above table that the majority of people earn between £15,000 - £35,000 pa. 4.2 Relative frequency distribution A relative frequency distribution table allows us to see the category in comparison with the total frequency. Each frequency is calculated as a percentage of the whole, for example, to calculate the relative frequency of a salary of £4,999 or less, you would divide 2 by 129, giving 1.55%. Table 2. Relative frequency distribution example 4.3 Salaries £ 000’s pa (nearest £) No. of people Relative Frequency 4,999 or less 2 1.55 5 to 9,999 3 2.33 10 to 14,999 6 4.65 15 to 19,999 14 10.85 20 to 24,999 29 22.48 25 to 29,999 38 29.46 30 to 34,999 18 13.95 35 to 39,999 9 6.98 40 to 44,999 6 4.65 45 to 49,999 3 2.32 50,000 and above 1 0.78 Total 129 Total 100 Cumulative frequency distribution A cumulative frequency distribution table identifies the number of times something has occurred up to the category under investigation, i.e. it shows the proportion of a sample (or population) taking a value 17 less than or equal to a given point. The table below adds the cumulative frequency to the above data, in percentage terms. Table 3. Cumulative frequency distribution example Salaries £ 000’s pa (nearest £) No. of people Relative Frequency (%) Cumulative Frequency 4,999 or less 2 1.55 1.55 5 to 9,999 3 2.33 3.88 10 to 14,999 6 4.65 8.53 15 to 19,999 14 10.85 19.38 20 to 24,999 29 22.48 41.86 25 to 29,999 38 29.46 71.32 30 to 34,999 18 13.95 85.27 35 to 39,999 9 6.98 92.25 40 to 44,999 6 4.65 96.90 45 to 49,999 3 2.32 99.22 50 and above 1 0.78 100.00 Total 129 Total 100 Total 100 The table shows that 71% of the population earns £29,999 or less. 4.4 Visual presentation of discrete data Introduction Visual techniques are also used to present data in a user-friendly manner. To illustrate, suppose 1,000 people were asked where they spent their annual holiday and the following results were given: UK: 375 people USA: 150 people Europe: 250 people Australia: 70 people Caribbean: 100 people Africa: 55 people There are two main methods of visually presenting this (discrete data): bar charts and pie charts. Bar charts Bar charts display information as ‘bars’ (or columns) representing each class of data (in this case, holiday location) according to their frequency of occurrence. The height of the bar represents the frequency of occurrence. 18 More information could be added by stipulating whether the holiday was a winter or summer holiday. This would create a component bar chart. Pie charts A pie chart is a circle that has been divided into different ‘slices’, each representing a different category of data. The area of each slice is proportional to the frequency of occurrence. The area of the slice is determined by its angle on the pie chart. 19 The key to understanding pie charts is to remember that there are 360 degrees in a circle! In the example above, 375 people, or 37.5%, took their holiday in the UK: 37.5% of 360 degrees equals 135 degrees (0.375 x 360). The above pie chart shows that most people in the population spent their holiday in the UK, the greater the frequency, the bigger the angle of the slice. 4.5 Visual presentation of continuous data Introduction Continuous data can take any value. The only limitation is the degree of precision of the measuring equipment. There are four main methods of visually presenting continuous data. These are: Histograms Time series graphs Semi-log graphs Scatter diagrams – these will be covered later in the chapter Histograms Histograms may look similar to bar charts, but it is the area (not the height) of the bar that represents the frequency of occurrence. As illustrated above, a histogram groups continuous data into appropriate intervals and represents the frequencies by the area of the bars. 20 Time series graphs Time series graphs are very common in the financial world. The graph displays data over time e.g. a share price: A time series graph displays the path of a variable (in this case, a share price) in chronological order. Log (semi-log) graphs A (semi-) log graph is used to illustrate the rate of change of a variable. For example, consider the launching of a new website; as time goes by, the site will (hopefully) receive more and more ‘hits’. If the number of people visiting the website over a year was monitored, the results might look something like the graph below: The graph illustrates that the number of people visiting the site is accelerating over time, i.e. there is exponential growth. A log graph is constructed in order to determine the rate of acceleration over time. 21 The constant 1 in 4 gradient of the log graph shows that not only are the number of website hits increasing, but that they are increasing at a constant rate of 25% each month. Where the rate of growth is not constant, the gradient of the line on the graph will vary: Steepening to show increased growth and flattening to show the growth slowing. 5. Summary statistics 5.1 Introduction Descriptive statistics are also known as summary statistics. Two key measures that are often used are: The ‘typical’ value contained within the data set, i.e. the measure of central tendency How widely spread-out the set of data is, i.e. the measure of dispersion These statistics are used to compare two (or more) sets of populations and/or samples. The aim of descriptive statistics is to efficiently summarise large quantities of data to simplify the process of comparing samples and/or populations. There are three pairs of measures for central tendency and dispersion. These are: Table 4. Central tendency and dispersion measurement summary table Central tendency (typical values) Measures of dispersion Mean Standard deviation Mode Range Median Inter-quartile range The most appropriate pair of measures for a given set of data depends on the features of the data itself. 22 5.2 Mean and standard deviation The mean The mean – also known as the ‘simple arithmetic mean’, is calculated as the average of a set of values. The formula for calculating the mean is: If the returns for five funds are 10%, 12%, 12%, 15% and 18% respectfully, the mean return is calculated as: (10% + 12% + 12% + 15% + 18%) / 5 = 13.4%. Standard deviation The standard deviation measures the level of distribution, i.e. dispersion, around the mean of a set of data. The formula for the standard deviation is: A far quicker method of calculation is to use a calculator or computer. 23 The IMC exam uses an onscreen version of the Texas Instrumental 30XS calculator. A 90-day trial version can be downloaded to your computer. We recommend using this when you practise your calculations. Alternatively, a handheld version can be bought – although please remember that a handheld version cannot be used in the exam. Q. Calculate the mean and standard deviation of the following data: 2 3 4 6 7 9 9 10 11 14 15 16 19 23 27 Calculator buttons A: data B: enter [this is the equivalent of =] C: 2nd [this toggles to the second function of the key] D: Arrow keys [to move around the cursor] Insert data 1. Press DATA (A) 2. Enter each value using the number keys followed by ‘enter’ (B). Your keystrokes will be: After inputting the last number which should be in the 15th row of the table it is important to press the clear key. (Don’t worry the data will not be lost!) 3. For the results, preform the following keystrokes: [2nd] [STAT] [CALC] The screen will list answers to key statistical calculations, including: x̄ = Mean σx = Standard deviation of a population sx = Standard deviation of a sample The previous example calculated the mean to be 11.67 and the standard deviation to be 7.07. This can be expressed as 11.67 +/- 7.08, giving us a range of values between 4.59 and 18.75. Where the data is normal dispersed, approximately 68.26% of the data will fall in to this range. Note: The probability figure of 68.26% is not something you will need to calculate in the exam. 24 Grouped data Often, data is grouped together. Consider the following example: Table 5. Grouped data example The level of return achieved by 18 different fund managers is represented below: Return achieved / % pa No. of fund managers 0-5% 5 5-10% 3 10-15% 4 15-20% 6 18 The procedure to calculate the mean and standard deviation is shown below: Put the calculator into standard deviation mode by pressing ‘data’ Enter the data. Enter the data in the first column (L1), 2.5, enter, 7.5, enter, 12.5, enter, 17.5, enter. Note that when facing grouped data, it is common to choose the mid-point in each group of data. Enter the frequency in the second column (L2) by using the arrow keys to navigate to the top of the second column and inputting, 5, enter, 3, enter, 4, enter, 6, enter To exit the screen, press ‘clear’ Calculate by: 2nd | stat | 1: 1-Var Stats. This opens a windows asking to locate the data and the frequency. The data is in L1 (this is the default selection), the frequency is in L2 (the default is a frequency of one). Use the arrow keys to select the correct items then select CALC. As demonstrated above, the mean fund return equals 10.55% and the standard deviation equals 6.04%. Approximately 68.26% of observations in the distribution will

IMC Unit 2 Mannual PDF

Document Details

Tags

Related

Summary

Full Transcript

Upgrade to continue