Learning Material Sample

Investment principles, markets and environment

5. Alternative investments and derivatives

In this section, we aim to understand the main ways in which private investment into unlisted securities takes place and their relative suitability to investors.

Unlisted securities

Unlisted securities in the UK comprise shares in companies that are unquoted on the main market of the London Stock Exchange (LSE) – the Official List.

The largest market for unlisted securities is the Alternative Investment Market (AIM) which comprises over 1600 companies. The AIM is the most liquid market for unlisted securities, although there are other ways to invest in unlisted securities. It is designed for companies that are “smaller, young and growing” as defined by the LSE. Companies join AIM to raise capital, broaden their shareholder numbers by offering a trading facility for investors and increase market profile.

For a company to be admitted to the AIM:

There are no size or trading requirements as with companies admitted on to the Official List

There is no minimum trading period required

There is no requirement for any given percentage of the shares to be held in the hands of the public

Each company must appoint and retain both a nominated adviser and a nominated broker

Under AIM rules, company prospectuses must carry a warning that the AIM is designed for emerging or smaller companies and that its rules are less demanding than the Official List.

There are other ways to acquire unlisted shares such as through the PLUS market (formerly known as OFEX), a trading facility run by PLUS Markets Group plc. PLUS Markets Group is a Recognised Investment Exchange (RIE). Plus trades a wide variety of securities including listed and unlisted shares quoted on the AIM and Plus markets.

Business angels are “informal” investors into unlisted companies. They generally invest relatively small sums (£20,000 to £500,000) in exchange for a shareholding in the business. They usually operate in an areas that venture capital companies would consider to...

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The balance of the investments in qualifying companies can be held in other shares or debt which must be of at least a three year term.

A VCT cannot invest more than £1 million in total each year in any single qualifying unlisted trading company, the gross assets of which must be not more than £7 million immediately before investment.

The company must satisfy a number of other conditions similar to EIS companies.

As VCTs have a five year qualifying period in order to retain the full tax relief, the market for these investments is illiquid. It does not necessarily improve after five years either.

As stated above the qualifying conditions are due to be relaxed in the Finance Bill 2012, as follows:

The employee limit will increase to not more than 250 employees (currently less than 50)

The size threshold before investment will increase to no more than £15 million (currently £7 million)

The maximum amount that can be invested in any one company will be £10 million (currently £1 million)

Venture capital companies

These are specialist companies that use funds raised from third parties to invest in growing, unquoted companies, via MBOs, MBIs and investment directly. Most VCCs are subsidiaries of banks, pension funds etc. Some are independent. The biggest company 3i group is a member of the FTSE100.

They provide loans or new share capital or both

The majority of their returns come from sale of the VCC’s share stake three or five years later, either from going public on the stock market or private sale

They don’t usually take a controlling stake subject to the company achieving certain targets (otherwise they could under the terms of their finance, take control)

They only usually invest in established well run companies who cannot expand due to a lack of funds

They often find MBOs and MBIs attractive in well established businesses where there is a reasonable probability of future success and returns.



In this section, we aim to understand the main ways in which investment into commodities takes place and their relative suitability to investors.


Investors receive a return on commodities if their prices rise after purchase (and likewise a loss if prices fall). Trading directly into commodities is costly in terms of both transaction costs and potentially taxation. As a result most financial trading in commodities is carried out via the commodity futures and options market.

This is a highly specialist market more suitable to the professional investor although commodity funds and index trackers could be viewed as a suitable addition to a private investor to add diversification to their portfolio.

Commodity futures and options

Futures and options contracts as we shall see in more detail later, give the investor the opportunity to speculate about price movements either up or down without necessarily having to own the underlying asset that is being speculated upon.

Commodity futures

Commodity futures are traded between producers and the industries that use the primary products to protect themselves against the risk of sudden price movements.

They allow the p...

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... index such as the FTSE 100 provides access to a range of shares. There are currently a variety of commodity indices that cover energy, metal and agricultural commodities.

Commodity funds

There are a range of commodity funds covering a number of themes such as agricultural or precious metals, energy and even a blend of commodities. Investors need to assess the impact of the currency of the underlying commodities being included within the fund and whether the fund is buying or selling commodity related companies or the actual commodities themselves.

Exchange traded commodities

Exchange traded commodities (ETCs) are investment vehicles (asset-backed bonds) listed on the London Stock Exchange that follow the performance of an underlying commodity or commodity index including total return indices based on a single commodity. ETCs are traded and settled in the same way as normal shares. ETCs are supported by market makers with guaranteed liquidity, enabling investors to gain exposure to commodities on exchange during London hours.

Shares in each ETC are created or redeemed on demand by the issuer. ETCs can be linked to a single commodity or reflect the performance of indices.


In this section, we aim to understand the basics of investment into collectibles and their relative suita...

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...ecialist area of investment requiring expert advice. The risks of making losses are considerable.


In this section, we aim to understand the main ways in which investment into hedge funds takes place and their relative suitability to investors.


Since their introduction to the general market place, there are now a wide variety of hedge funds offering different investment styles ranging from risk averse to very high risk.

Traditional “absolute return” hedge funds attempt to profit regardless of the general movements in the market. They do this by carefully selecting a range of asset classes including derivatives and by holding buy, hold and sell positions.

Recent innovation has resulted in a much wider range of hedge fund strategies some of which, place a greater emphasis on producing highly geared returns than they do controlling market risk.

The common aspects of hedge funds are shown here for you.

Structure – Most hedge funds are unauthorised and therefore unregulated collective investment schemes. They canno...

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...ialist and complex nature, it is often difficult to monitor or assess hedge funds

Volatility – hedge funds can provide excellent returns and spectacular failures. They are therefore often considered high risk investments.

Fund of funds and indices

Due to the complex nature of many individual hedge funds and high minimum investments, companies have introduced fund of hedge funds allowing investors to participate in a range of hedge fund investments whilst relying upon these companies to employ specialist research teams to carry out due diligence. Fund of hedge funds is often the method used by private individual investors to access hedge funds.

Alternatively, investors can use a hedge fund index. Indices are created by companies such as Tremont, HFR and FTSE from hedge funds that can be bought and sold. However, these indices do not properly represent the full hedge fund range are often considered to be little more than fund of hedge funds.


In this section, we aim to understand the main ways in which investment into structured products takes place and their relative suitability to investors.

Key characteristics of structured products

The main characteristics of structured products are as follows:

They are fixed term investments usually 5 to 6 years. Early encashment is rarely permitted

They either provide an amount of guaranteed income or capital or both. In the case of capital returns there is often but not always a guaranteed return of 100% of the original investment provided it is held to maturity

Specified minimum/maximum returns given at outset

Returns are often ...

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... product?

What is the credit risk on the zero coupon bond?

What is the value of the dividends that have been foregone?


In the earlier years of these sorts of investments, the majority were established as life assurance based products. They are often in one of the following forms:

Deposit based accounts including NS&I and building society accounts

Closed ended company structures which can also be held in an ISA wrapper

Listed bonds and medium-term notes

Listed structured products (listed on the LSE)

Listed warrants.

When selecting an appropriate structure bear in mind the client’s tax position.


In this section, we aim to understand the main ways in which investment into derivatives takes place and their relative suitability to investors. Our audiovisual presentation provides an introduction to this topic.

What are derivatives?

Derivatives are financial contracts whose value is derived from the price of an underlying asset (“the spot price”). There are several types of derivative contract available, but we shall concentrate on two that are used heavily in the management of investment portfolios.

Main types of traded derivatives

Forwards and Futures




A forward is an over-the-counter (OTC) contract, i.e. derivatives are traded directly between the two counterparties rather than on an exchange. The contract is to buy or sell the underlying asset at a specified date in the future at a pre-arranged (settlement) price. A future is an exchange traded forward contract. The exchange sets the contract specifications and the clearing house standardises margin payments.


An option gives the buyer the right (but not the obligation) to buy or sell an asset at a specified price on or by a future date.

The buyer can:

Exercise the option

Let it expire (worthless)

Or with some options, sell it onto a third party before expiry.


Warrants are a type of option that offer the owner the right to buy the ordinary shares of a company at a fixed price at a fixed date in the future. Warrants can be bought and sold separately on the markets in the same way as options.


A swap is an agreement between two parties to exchange a series of cash flows over a given time period.

Derivatives allow investors to make profits on upward or downward movements in the value of the underlying asset.

The underlying asset may be:

Securities e.g. equities, government bonds, interest rates or foreign exchange

Indices e.g. FTSE 100, S&P 500, Nikei 225

Commodities e.g. oil, gold, pork bellies.

Trading derivatives

Derivatives are generally traded on a specialised exchange such as:

Euronext London International Financial Futures and Options Exchange (LIFFE)

The European Derivatives Exchange (EUREX)

The Tokyo Derivatives Exchange (TIFFE)

The Singapore Derivatives Exchange (SIMEX)

The Chicago Board of Trade (CBOT)

The Chicago Mercantile Exchange (CME).

Contact specifications

The exchange standardises the contract specifications in terms of:

The underlying asset

Quantity of the underlying asset

Quality of the underlying asset

Delivery date

Forward delivery settlement price.

Opening and closing futures

The buyer of a future is said to have a “long” position

The seller of a future is said to have as “short” position.

Both parties have to contract to honour their obligations. An initial trade opens a client’s position in the market. Therefore both a purchase and a sale are required to open a position.

The Clearing House and Margining System

The role of the clearing house is to clear financial transactions for daily trades, to reconcile sales and purchases and keep accounts of margin payments.

Euronext LIFFE uses the services of the London Clearing House which stands betw...

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...350p. Cost is 25p per share. These are “at the money” calls. Strike price is same as current share price.

He could reduce costs in his strategy by buying “out of the money” calls, such as the July 370 option. The premium is lower at 14p but the manager accepts the risk that he will not benefit if the share price rises between 350p and 370p.

The diagram below shows the profit or loss at expiry of the option:

If the share price rises above 384p (break even), the option holder can either exercise it or sell it. Either way he makes the same profit. The maximum loss suffered will be the option premium. The maximum gain is unlimited.

2) Portfolio insurance using puts


Instead of selling the underlying assets in a portfolio, if a manager believes that the market will fall, he could buy put options because it produces a profit if the underlying asset falls in value.

Using HWF plc again whose share price is at 350p, if the fund manager thinks that the price will fall below 330p, he could buy a July 330 put. This gives him the right to sell the shares to the writer of the option for 330 per share. Using the table below to illustrate:

Excercise price (p)
















The effective out price for the holder of a 330p put is 325p (i.e. exercise price less 5p premium)

If the share price does not fall, the holder will lose his premium. If it falls below 325p, the intrinsic value of the option will increase.

The diagram below shows the profit or loss at expiry of the option:

3) Writing calls

A fund manager may increase income coming into the fund by writing call options. He will receive the option premium, although he must accept that he will be exercised against if the share price increases.

The break even point of the writer of the call is the premium plus the exercise price (p + x).

Provided the fund owns the underlying stock, the risks are minimal. It may be that the fund manager has identified the exercise price (x) as the level at which he would have sold the shares in any case.

Big risks using this strategy derive from the writing of uncovered calls, i.e. writing the option without owning the underlying asset. Here, if the call option is exercised, the fund manager will have to buy the shares at market price for delivery at the exercise price. If the market price is well above the exercise price, he could incur real losses which are potentially unlimited.

4) Writing puts

The fund manager who writes a put option receives premium income. He does not expect the underlying asset to fall significantly.

If it does, he will be exercised against, i.e. have to buy the asset at a price above the current market place.

 Uses of Futures and Options

Fund managers can move quickly between markets using futures

A manager can capture the gains in volatile markets using derivatives that may not otherwise be possible using the underlying assets.

Currency and interest rate futures can allow managers to capture gains in indices abroad without exposing themselves unnecessarily to currency and interest rate fluctuations.

To provide extra speculative risk to a portfolio.


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