Investment principles and risk

Course content

The course material consists of:

10 chapters of study text

Several test your knowledge questions in each chapter

7 short audiovisual presentations to help introduce chapters 2 - 6, chapter 7.2 and chapter 8; you will find the links to these in the introduct...

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...CPD credit

You will be credited with the CPD times listed within the revision test sections. This will be added to your CPD certificate when you complete each assessment. Your CPD certificate can be viewed and printed from the CPD certificate link on the left hand menu at any time.

As well as acting as training module to help you pass the exam this online course can also be used for CPD.

By studying each chapter and then taking the end of chapter assessment this will create an entry on your CPD certificate containing:

Your personal details

Course name

Chapter name

Assessment results for each chapter

Estimated CPD time for each chapter

After taking a chapter assessment if you go to the CPD certificate link you can produce a CPD certificate. By selecting the date filter you can choose which items to include on your certificate. You can also download this to excel which will allow you to edit the certificate as required.

The estimated CPD times allocated the first time you take the end of chapter assessments are:

R02

Hours

Chapter 1

7

Chapter 2

7.6

Chapter 3

4.1

Chapter 4

3.8

Chapter 5

2.1

Chapter 6

2.3

Chapter 7.1

8.1

Chapter 7.2

11.4

Chapter 8

4.8

Chapter 9

4.1

Chapter 10

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...t;

Statement of Professional Standing (SPS)

All advisers giving independent or restricted advice must hold a Statement of Professional Standing (SPS). This details evidence they subscribe to a code of ethics, are qualified and have kept their knowledge up to date.

Bodies accredited by the FCA will be responsible for issuing individuals with an SPS and for ensuring that advisers hold an appropriate QCF Level 4 qualification.

If an SPS is removed from an adviser, the FCA could levy a fine on them, suspend them or even decide to remove their approved person status, although it could also agree to an action plan to be undertaken before reinstatement.

FCA monitoring

Firms are obliged to inform the FCA if any of their advisers fall below its competence or ethical standards.

The FCA collects information about individual advisers, such as the qualifications they hold and which accredited body they use. The FCA uses this database to help identify the highest risk individuals.

Advisers have a wide range of investments to choose from when making recommendations. It is important to understand the natur...

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...financial education areas. This presentation will be of most benefit to those learning about this area for the first time:

Providing the investment are recognised financial institutions such as a UK bank or building society or via National Savings and Investments. Any capital invested via deposit accounts is exposed to low risk but equally there is little potential for capital growth. The main characteristics of cash deposits are:

Investors will receive regular interest on their cash deposit. The interest rate will be set by the deposit taker and can be fixed or variable. Income will rise and fall at the specific rate offered by the deposit taker and in line with interest rates generally. The term can be fixed or open ended

Investor’s capital is not exposed to investment r...

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... B

Deposit day 1

£10,000

£10,000

Interest credited at 183 days

     -

    £255

Balance carried forward

£10,000

£10,255

Interest credited at 365 days

   £510

    £261.50

Final Balance

£10,510

£10,516.50

Effective rate

£10,000 to £10,510

£10,000 to £10,516.50

5.1%

5.16%

This is a simple example but illustrates the effect had by compounding using different frequencies.

What type of return on their capital should a cash investor expect?

Answer : Purchase course for answer

In the case of cash deposits the amount invested defines the amount of interest payments.

Where an individual makes regular savings into a deposit it is worth checking what level they will need to reach b...

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...o release funds should interest rates rise (so long as they are not penalised as a result).

What defines the amount of interest a depositor receives from a cash account?

Answer : Purchase course for answer

Although relatively straightforward and simple products, cash deposits do carry some inherent risks that need to be fully considered and understood.

Credit or default risk

Capital volatility is only likely to occur where the deposit taking institution has solvency problems. This is a rare event in the UK but can on occasion happen. In recent years we have witnessed the effects of the economic crisis on UK banks, although the Government was quick to back institutions that faltered. In the future it may be more common to witness ‘bail in’ as opposed to Government bail-out. We saw this in Cyprus in 2013 where bondholders and depositors were forced to write off some of their holdings in banks where they held more than 100,000 euros.

National Savings and Investments accounts are considered the most secure due to their permanent Government backing.

If default by the deposit taking institution does happen then the Financial Services Compensation Scheme provides some protection against insolvency. The protection for deposits is 100% of the first £85,000 per authorised institution.

In addition to the limitations in terms o...

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...w rates of interest once converted back to sterling.

Some foreign countries do not have the same amount of supervisory control as in the UK, so the collapse of a deposit taking institution may result in complete loss of the capital investment.

When investing in foreign currency cash investments the following should be taken into account:

Consider how the currency is expected to move against sterling in the future

The volatility of the currency in the past in relation to other major currencies

For variable rates, the possible future trends for interest rates and previous volatility

The ability of the financial institution to repay the capital (financial strength)

Whether there are statutory or industry compensation schemes and the extent to which the investor would be covered

Foreign current accounts may be suitable for people who require income in a particular currency to meet liabilities in that currency, as well as for those who wish to speculate on currency movements and earn interest at the same time.

What are the four main types of risk associated with cash deposits?

Answer : Purchase course for answer

The accounts generally come in two forms; instant access or restricted access.

Instant access accounts

An instant access account can only be so named where the individual account holder is able to withdraw funds immediately. Rates for these accounts will tend to be somewhat lower than deposits with restricted access.

Restricted access accounts

Where restricted access accounts are used investors will have to understand that whilst they may receive higher rates of interest, they will also have to assess the impact of the notice period they may have to give. This is because economic conditions could alter and better terms may be offered elsewhere.

Interest rates on restricted access accounts can be either fixed or variable. Investors may operate accounts that either work on the basis of a required notice period or as term deposits.

Notice accounts

Where accounts have a notice period the rate of interest will tend to be higher, the longer the period of notice. If ear...

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... is also possible to transfer from a stocks and shares ISA to a Cash ISA

Cash ISAs are available to those aged 16 and older, however where the money invested is given to someone under the age of 18 by a parent and the income is more than £100 per year the income will be taxed as the parents and will not be tax-free until the child reaches 18

Cash ISA eligible investments are:

Bank or building society accounts

Units or shares in UK authorised unit trusts and OEICs which are money market schemes (including fund of funds)

Units or shares in a unit trust, OEIC,  UK UCITS (undertakings for collective investments in transferable securities) or a life assurance policy that would be likely to return at least 95% of the investor’s original capital within five years from the date of investment

NS&I Direct ISA

Stakeholder cash deposit products

Which type of cash account offers income in a currency other than sterling?

Answer : Purchase course for answer

National Savings & Investment (NS&I) products are Government investments which are secure and are guaranteed by the Government. They can be purchased online, by telephone or by post directly from NS&I. The products offered are all cash based and come in a variety of different structures to meet the needs of different investors.

At the time of writing the following are available for new customers:

Premium Bonds

Green Savings Bonds

Direct Saver accounts

Investment accounts

Income Bonds

Direct ISAs and Junior ISAs

These products are available to those with maturing investments:

Index linked and fixed interest savings c...

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...tment is £500.

Guaranteed Growth bonds

The Guaranteed Growth Bond has a fixed term of one year. Interest is paid gross, is taxable but can be set against the PSA.

Green Savings Bond

The Green Savings Bond is available online only for customers aged 16 or over. It has a 3 year fixed term and Issue 4 pays fixed interest of 4.2% on each anniversary. Can invest up to £100,000. Interest is paid gross but is taxable so can be set against the PSA.

To keep up to date with the latest product offerings visit: www.nsandi.com/our-products

How is the interest from an Income Bond paid and taxed?

Answer : Purchase course for answer

Large institutions with spare cash may wish to earn returns on these funds whilst retaining the ability to access them at short notice. The wholesale “money markets” provide these institutions with the ability to trade short-term “debt”.

Equally, some institutions may wish to borrow funds over short terms therefore providing the market for such securities.

There are three main types of security traded:

Treasury Bills (TBs)

These are short-term loan notes issued by the Government. The issue of TBs is managed by the Debt Management Office (DMO) of HM Treasury and these are used to manage the short-term cash flow needs of the Government.

TBs are issued at weekly auctions and usually have terms of one, three or six months. They pay no interest but instead are sold at a discount so that at redemption date, their face val...

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...ure cash will generate lower returns than those that invest in commercial bills. Risks are the same as those relating to any other type of cash investment. The main difference will be the extent to which different funds are liable to credit risk which will depend on the quality of their underlying investment.

So that investors are clear about the type of money market fund they are investing in, funds have to meet a set of rules that clearly defines the types of assets, duration and controls expected from them. ‘Short term money market funds’ have a weighted average maturity of no more than 60 days and a weighted average life of no more than 120 days. ‘Standard money market funds’ have these periods extended to 6 and 12 months.

What are the three main types of security traded on money markets in the UK?

Answer : Purchase course for answer

Fixed-Interest Securities or bonds are loans that are issued by companies, Governments and other bodies such as local authorities to raise long term finance perhaps because the banks may not be able or willing to lend the amount required.

Many types of these securities are now available on the open market to suit different types of needs and risk profiles.

They have several common features. They cannot be cashed before their official maturity date; however these securities are tradable in that once an investor buys a bond (by doing so they lend money to the borrowing institution), they can sell it to a third party prior to redemption. This can be done several times before the term of the security ends.

In general, fixed interest securities will carry a fixed coupon or rate of interest. Some stocks e.g. index linked gilts, offer a coupon and capital value at redemption that currently increases with the RPI.

Bonds can be described as:

Negotiable - after making the original loan by buying a security, a lender can freely trade the entitlement to capital and interest repayments

Fixed-interest ...

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... to the investor who owns it at that time. It is decided at inception by the issuer and usually coincides with one of the interest payment dates. In the past some bonds were issued with two dates that allowed the bond to be repaid at any time between the two dates specified subject to at least three months’ notice. The last gilt of this type was redeemed in 2013

Example

Aviva Plc 6.125% 2026 – issued by Aviva, will pay interest of 6.125% per £100 on nominal stock and the capital will be repaid in 2026 (actually on 16 November 2026).

Taxation

Interest received is subject to income tax in the year received at the rates for interest applicable at that time, so currently 20%, 40% or 45% depending upon the individual’s tax status.

Capital gains on direct investment into gilts and qualifying corporate bonds are free of capital gains tax.

Holdings of gilts and corporate bonds can be made within an ISA in which case, interest received is also tax free.

What three key pieces of information are contained in a bond’s title?

Answer : Purchase course for answer

The bond market offers a wide range of lenders to tap into. There are 2 different types of bond market, the primary market for the issue of new bonds and the secondary market for the trading of existing bonds

The Primary Market

The method used for issuing new bonds will depend on the issuer.

Governments are the largest issuers in the bond markets and in the UK this is managed by the Debt Management Office (DMO) of HM Treasury. The DMO issues new gilts weekly to meet the Government's long term financial needs and uses the auction process:

Large investors place bids for the amount of stock they wish to bu...

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...f domestic and foreign companies and Governments.

These are international bonds issued in a currency other than that of the country in which it is issued. It is named according to the currency in which it is issued, e.g. a bond issued in American dollars would be a Eurodollar bond.

Multinational companies, national Governments and international organisations such as the World Bank use Eurobonds to raise capital in international markets. Turnover and demand is high making this a very liquid market.

What is the difference between the primary and secondary bond markets?

Answer : Purchase course for answer

Bond Yields

As stated earlier, all bonds bear a nominal rate of interest based on the simple interest of the coupon on £100 of nominal stock. The yields on bonds measure the returns they provide in relation to their market price.

Interest yield

Also known as the running or income yield, it expresses the annual income from the bond as a percentage of the market price.

The formula for interest yield is:

(Coupon or nominal yield/Clean price) x 100

Example

An investor pays £115.75 (clean price) for £100 nominal stock with a coupon of 5%. The interest yield would be (5/115.75) x 100 = 4.32. The investor’s return on his investment is therefore 4.32%

Interest yields do not tell the whole story, however, as the bond could produce a capi...

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...ng bond prices

As the income from a bond remains constant throughout its life (with the exception of index linked stocks), the only way in which the desired yield from the investment can be obtained is by adjustment of price.

Price will therefore be determined by the yield required when the investor considers rates on offer from other securities and the timescale involved.

When interest rates rise, bond prices fall (because of reduced demand) and the yield adjusts up. When interest rates fall, the price of bonds rise (because of an increase in demand) and the yield adjusts down.

Investors will therefore make capital gains (or losses) which will generally be tax free.

Which bond yield takes into account a capital loss or gain?

Answer : Purchase course for answer

In the case of fixed-interest securities we need to consider factors that could affect an institution’s ability to repay capital and/or income. The risks of this happening can be categorised once again under the headings of non-systematic risk and systematic risk.

Non-systematic risk (specific or commercial risk)

The ability of the issuer of a bond to meet their interest payments and repay capital will vary depending on the creditworthiness of the institution.

The Government is the most secure bond provider having never previously defaulted on a loan and therefore yields will be less as a result of this security. This in turn means that interest rates are usually lower on Government bonds as investors need less compensation for the potential risk that the Government will default.

Not all Governme...

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...vestment and increasing economic growth causing inflation and hence rising interest rates. One could consider the opposites of these scenarios and obtain the opposite results.

Volatility

A bondholder with a high coupon will receive a return quicker than a similarly dated low coupon where the majority of return is tied up until the final payment at the bond’s maturity.

The holder of a shorter dated bond will get a return on the bond earlier than a holder of a longer dated stock and will be exposed to interest rate movements over a shorter period of time.

Therefore, the stocks that tend to be most volatile in price movements are longer dated stocks with lower coupons.

What usually happens to bond prices when the expectation is that inflation will increase?

Answer : Purchase course for answer

Analysts track the yield to redemption on bonds to spot trends in the market in order to increase overall returns. One method of this analysis is through assessment of yield curves.

Normal Yield Curve

Investors will, in normal conditions, expect to receive higher yields for longer-term bonds to cover the increased uncertainty of interest rate changes over time....

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...lty for moving from one part of the curve to the next.

Inverted or reverse curve

When pessimism about the long-term future over aspects such as inflation changes to optimism, investors will shift over to short dated stocks bringing long term yields below shorter dated stocks.

 

Name three types of yield curves.

Answer : Purchase course for answer

The term 'gilts' is the shortened form of 'gilt-edged stock' and refers to the bonds issued by the UK Government because of their reputation for safety and security.

Gilts are categorised in relation to their redemption periods by the Debt Management Office (DMO).

Shorts have less than seven years to redemption. Favoured as surplus deposits by larger financial institutions. Classified by the Financial Times as having less than five years to redemption

Mediums are from seven to 15 years. The term is too long to be of interest to banks as a means of holding excess liquidity and too short to be of interest to pension funds. They are often the least popular gilts. The Financial Times classifies mediums as having a term of five to 15 years...

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...y of gilt markets. It is effectively a loan taken out by the original seller using the gilt as security. The price difference between the sale and repurchase price represents the cost of the borrowing and usually the longer the term the higher the repurchase cost to reflect the interest cost of the borrowing.

If the original owner does not buy back their stock on the set date at the agreed price then the gilt will become the property of the new owner and they will be within their rights to sell it on the open market. The buy-back period is usually 2 weeks but can range from overnight to several months.

In practice the Bank of England uses the repo market to influence interest rates.

What is the definition of “longs” in relation to gilts?

Answer : Purchase course for answer

These serve the same purpose as gilts. However, there are some important differences:

Yields are generally higher than gilts to compensate for the extra risks

The buying and selling prices (bid/offer spreads) are wider than gilts to account for the higher risk

The price of corporate bonds is generally more volatile than for gilts

The markets are less liquid i.e. fewer buyers and sellers

It may be difficult or impossible to sell lower rated bonds especially in times of crisis

Creditworthiness of institutions is forever being updated

Corporate bonds may be secured or unsecured, and...

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...oan and cannot be sold or otherwise disposed of without the permission of the debenture holder. Or;

A floating charge over any assets of the company that are not otherwise secured in favour of other lenders. Assets can be freely disposed of during the normal course of business without the debenture holder’s permission; however, assets can be seized and used to repay the loan if the borrower defaults.

Debentures with a fixed charge will rank above debentures with a floating charge in the event of wind up.

What is the definition of a debenture?

Answer : Purchase course for answer

Convertible loan stock

Loan stock or debentures can be issued as “convertibles” which offer the option to convert into shares of the company at pre-stated prices and dates.

Interest is paid in the normal way until the conversion is exercised

If the option is not exercised then the bondholder receives the normal redemption value of the bond, though the company usually reserves the right to redeem any outstanding stock once a certain percentage has been converted

They normally carry ...

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...nated bonds (PSBs)

PIBs were a type of fixed-interest investment issued by building societies listed and traded on the Stock Exchange. PSBs were originally issued as PIBs by building societies that went on to convert to banks.

Neither bond can now be issued as they do not meet regulatory requirements.  Existing investments can however still be traded on the stock exchange.

What does the conversion option of convertible loan stock allow the bondholder to do?

Answer : Purchase course for answer

NOTE - These questions are designed for revision purposes only and are therefore not written in an exam style. If ...

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...e test then additional CPD time for the test only will be added to your CPD certificate.

Estimated study time 7 hours