Kaplan Education Investment Planning 1 Notes SN3002

Investment Planning 1

 

Contents

Investment Planning 1. 1

Module 1: Introduction to Investment Markets, Products and Regulation. 14

1.1 The Corporations Act – SG 1.2. 14

1.1.1 The concept of a financial product – SG 1.2. 14

1.1.2 licensing of financial services industry participants – SG 1.4. 15

1.1.3 Disclosure documents – SG 1.5. 15

1.2 Securities – SG 1.7. 16

1.2.1 Equity securities – SG 1.7. 16

1.2.2 debt securities – SG 1.8. 16

1.2.3 Securities market terminology – SG 1.8. 16

1.3 Primary and Secondary Markets – SG 1.8. 16

1.3.1 the Primary Market – SG 1.8. 16

1.3.2 The Secondary Market – SG 1.9. 17

1.3.3 Links between primary & Secondary markets. 17

1.4 The Role of stockbrokers – SG 1.11. 17

1.4.1 What does a stockbroker do – SG 1.11. 17

1.4.2 Stockbroker and client relationship – SG 1.11. 17

1.4.3 Costs of trading – SG 1.13. 18

1.4.4 Equities Trading and the internet – SG 1.14. 18

1.5 the Australian Securities Exchange – SG 1.14. 18

1.5.1 Role and operation of the ASX – SG 1.15. 19

1.5.2 ASX Structure – SG 1.16. 20

1.6 Overview of derivatives – SG 1.17. 20

1.6.1 What is a derivative? – SG 1.17. 20

1.6.2 Exchange traded vs. over-the-counter derivatives – SG 1.18. 20

1.6.3 Australian derivatives markets – SG 1.19. 20

1.6.4 Growth of the global derivatives markets – SG 1.20. 20

1.6.5 Uses of derivatives – SG 1.21. 20

1.7 The Managed Investment Act 1998 – SG 1.22. 20

1.7.1 Definition of a managed investment scheme – SG 1.22. 21

Module 2: the Mathematics of investment. 22

2.1 Definition of Interest – SG 2.2. 22

2.2 simple Interest – SG 2.2. 22

2.2.1 Calculating Simple Interest – SG 2.2. 22

2.3 Multiplication by Powers – SG 2.3. 22

2.4 Compound Interest – SG 2.4. 22

2.4.1 Calculating Compound Interest – SG 2.4. 22

2.4.2 The rule of 72 – SG 2.6. 23

2.5 Future value – SG 2.6. 23

2.5.1 Effective rate. 23

2.6 Present Value – SG 2.8. 23

2.7 Interest rate and investment period – SG 2.9. 24

2.7.1 Calculating the interest rate – SG 2.9. 24

2.7.2 Calculating the investment period – SG 2.9. 24

2.8 Calculating the value of a series of future payments – SG 2.10. 24

2.8.1 Calculating the value of an annuity – SG 2.10. 24

2.8.2 Calculating the value of a deferred annuity – SG 2.12. 24

2.8.3 Calculating the value of a sinking fund – SG 2.12. 24

2.8.4 Calculating the value of a perpetuity. 25

2.9 Discount rate and Discounted cash flows SG 2.13. 25

2.10 Net present value and comparison of investment options – SG 2.16. 25

2.11 Investment yield (internal rate of return) – SG 2.17. 25

2.12 Discounted cash flow valuations applied to tax and inflation – SG 2.18. 25

Module 3. 26

3.1 The equity market. 26

3.1.1 Features of the Australian Equity Market – SG 3.2. 26

3.1.2 The role and history of share ownership in Australia – SG 3.2. 26

3.1.3 Share Market liquidity – SG 3.4. 26

3.1.4 Securities market participants – SG 3.5. 26

3.2 Definition of equity securities. 27

3.3 Types of equity security – SG 3.13. 27

3.3.1 Ordinary shares – SG 3.13. 27

3.3.2 Partly-paid shares – SG 3.13. 28

3.3.3 Installment receipts – SG 3.14. 28

3.3.4 deferred dividend shares – SG 3.14. 28

3.3.5 bonus issues – SG 3.15. 28

3.3.6 rights issue – SG 3.15. 28

3.3.7 Company options – SG 3.16. 28

3.3.8 Stapled securities – SG 3.17. 28

3.3.9 Hybrid securities – SG 3.18. 28

3.4 Listed Managed Investments – SG 3.19. 29

3.4.1 Australian Real Estate Investment Trusts – SG 3.20. 29

3.4.2 Listed investment companies – SG 3.21. 29

3.4.3 Infrastructure funds – SG 3.21. 29

3.4.4 Pooled development funds – SG 3.22. 29

3.4.5 Exchange traded funds – SG 3.22. 29

3.4.6 Hedge funds (absolute return funds). 29

3.5 comparing the features of equity securities and LMIs – SG 3.24. 29

3.6 Share market Sectors – SG 3.25. 29

3.6.1 Industrial shares – SG 3.25. 29

3.6.2 Resource shares – SG 3.25. 29

3.6.3 The Global Industry Classification standard – SG 3.26. 29

3.7 Factors influencing share market performance – SG 3.27. 30

3.7.1 Interest rates – SG 3.28. 30

3.7.2 Exchange rates – SG 3.28. 30

3.7.3 Economic Factors – SG 3.28. 30

3.7.4 Federal Government Economic and Fiscal policies – SG 3.29. 30

3.7.5 Monetary policy – SG 3.29. 30

3.7.6 Other Markets – SG 3.30. 30

3.7.7 Market Sentiment – SG 3.30. 30

3.7.8 Supply and demand – SG 3.30. 30

3.8 Global equities markets – SG 3.31. 30

3.8.1 Accessing better returns – SG 3.31. 30

3.8.2 Diversification – SG 3.31. 30

3.8.3 Why international diversification permits greater returns – SG 3.32. 30

3.9 Risk and return – SG 3.32. 30

3.9.1 Risk-adjusted return SG 3.34. 30

Module 4 Debt Securities. 30

4.1.1 structure of the debt market – SG 4.2. 30

4.1.2 features of the debt market – SG 4.3. 30

4.1.3 Participants in the debt market – SG 4.4. 31

4.1.4 settlement and registration procedures – SG 4.7. 32

4.1.5 The size of the interest rate market – SG 4.8. 32

4.1.6 Primary and secondary debt markets – SG 4.9. 32

4.2 definition and debt securities – SG 4.10. 32

4.3 Interest Rates. 33

4.3.1 What are interest rates? – SG 4.11. 33

4.3.2 Indicator interest rate – SG 4.11. 33

4.3.3 Bank bill swap preference rate – SG 4.12. 33

4.3.4 Wholesale and retail interest rates – SG 4.12. 33

4.3.5 Short-term and long-term interest rates. 33

4.3.6 Creditworthiness of issuers – SG 4.13. 34

4.3.7 The yield curve – SG 4.13. 34

4.3.8 The components of an interest rate – SG 4.14. 34

4.4 short-term interest rate securities – SG 4.16. 34

4.4.1 Cash – SG 4.16. 34

4.4.2 Treasury notes – SG 4.16. 34

4.4.3 Bills of exchange – SG 4.17. 35

4.4.4 Promissory notes – SG 4.20. 35

4.4.5 Negotiable certificates of deposit and certificated of deposit. 36

4.4.6 Repurchase agreements – SG 4.23. 36

4.4.7 Pricing of short-term securities. 36

4.4.8 Key Relationships for price short-term securities – SG 4.24. 37

4.5 Long-term interest rate securities – SG 4.25. 37

4.5.1 Commonwealth Government Securities – SG 4.26. 37

4.5.2 Participants – SG 4.27. 37

4.5.3 The Secondary market in Treasury bonds – SG 4.28. 37

4.5.4 Semi-Government securities – SG 4.28. 37

4.5.5 Features of long-term interest rate securities – SG 4.29. 37

4.5.6 Books close date – SG 4.30. 38

4.5.7 Pricing of long-term interest rate securities – SG 4.30. 38

4.6 The corporate debt market – SG 4.34. 39

4.6.1 Floating rate notes – SG 4.34. 39

4.6.2 Securitised bonds – SG4.35. 39

4.6.3 Subordinated debt – SG 4.36. 39

4.6.4 Corporate Bonds  – SG 4.36. 39

4.6.5 Debentures – SG 4.37. 39

4.6.6 fixed interest managed investments – SG 4.37. 40

4.7 Holding period return – SG 4.37. 40

4.7.1 How to calculate the holding period return – SG 4.37. 40

4.8 Volatility – SG 4.39. 40

4.8.1 How to calculate price volatility – SG 4.40. 40

4.8.2 The affects of yield and term on volatility – SG 4.41. 40

4.9 Other factors affecting the yield of debt securuites – SG 4.42. 40

4.9.1 Credit Risk – SG 4.42. 40

4.9.2 Liquidity and Marketability – SG 4.43. 40

Module 5. 41

5.1 Types of derivatives – SG 5.2. 41

5.1.1 Options – SG 5.2. 41

5.1.2 Futures – SG 5.3. 41

5.1.3 Warrants – SG 5.3. 41

5.1.4 Contracts for Difference – SG 5.3. 41

5.1.5 Forward Rate agreement – SG 5.4. 41

5.1.6 Swaps – SG 5.4. 41

5.2 What participants use derivatives? – SG 5.5. 42

5.2.1 Banks and Large Financial Institutions – SG 5.5. 42

5.2.2 Commodity producers and Merchants – SG 5.5. 42

5.2.3 Debt Issuers – SG 5.6. 42

5.2.4 Corporates – SG 5.6. 42

5.2.5 Managed futures and hedge funds – SG 5.6. 42

5.2.6 Local participants – SG 5.6. 42

5.2.7 Market Makers – SG 5.7. 42

5.2.8 Spread Traders – SG 5.7. 42

5.2.9 Arbitrageurs – SG 5.7. 42

5.3 The concept of short selling – SG 5.8. 42

5.4 what are the risks in the market for derivatives? – SG 5.8. 43

5.5 Options – SG 5.9. 43

5.5.1 The basics of options – SG 5.9. 43

5.5.2 How are options traded ? – SG 5.10. 43

5.5.3 Differences between exchange traded and OTC options. 43

5.5.4 Exercising options – SG 5.11. 43

5.5.5 Key elements of an option – SG 5.11. 43

5.5.6 Why use options? – SG 5.14. 44

5.5.7 Advantages of options – SG 5.14. 44

5.5.8 Risks of using options. 44

5.5.9 Overview of options Pricing – SG 5.16. 44

5.5.10 Expiry profit (pay off) diagrams – SG 5.18. 45

5.6 Warrants – SG 5.21. 45

5.6.1 Overview – SG 5.21. 45

5.6.2 Key features of warrants – SG 5.21. 45

5.6.3 Why investors deal in warrants – SG 5.23. 45

5.6.4 Differences between warrants and ETOs – SG 5.23. 45

5.6.5 Comparing warrants and ETOs with ordinary shares – SG 5.24. 46

5.6.6 Trading warrants – SG 5.24. 46

5.6.7 Investment Warrants. 46

Module 6. 47

6.1 Futures – SG 6.3. 47

6.1.1 What is a futures contract? – SG 6.3. 47

6.1.2 SPI 200 Futures – SG 6.4. 47

6.1.3 Using Equity futures to hedge against market risk and specific risk – SG 6.5. 47

6.2 Short-term interest rate futures – SG 6.6. 47

6.2.1 Characteristics of the interest rate futures market – SG 6.7. 47

6.2.2 90-day bank-accepted bill futures contracts – SG 6.8. 48

6.2.3 Who uses bill futures? – SG 6.8. 48

6.2.4 Hedging using bill futures – SG 6.9. 48

6.3 Long-term interest rate futures (bond futures) – SG 6.10. 48

6.3.1 The underlying instrument – SG 6.10. 48

6.3.2 6.3.2 3-year and 10-year Treasury bonds futures – SG 6.13. 49

6.4 Contracts for difference – SG 6.15. 50

6.4.1 The mechanics of CFDs – SG 6.15. 50

6.4.2 Risks involved in trading CFDs – SG 6.16. 50

6.5 Forward rate agreement – SG 6.17. 50

6.5.1 Risk Exposure – SG 6.17. 50

6.5.2 Advantages – SG 6.18. 50

6.5.3 Disadvantages – SG 6.18. 51

6.5.4 Parties to an FRA – SG 6.18. 51

6.5.5 Calculating the settlement for an FRA – SG 6.18. 51

6.5.6 FRAs and futures – SG 6.19. 51

6.6 Swaps – SG 6.20. 51

6.6.1 Equity Swaps – SG 6.20. 51

6.6.2 Advantages – SG 6.21. 51

6.6.3 Disadvantages – SG 6.21. 51

6.6.4 Uses of equity swaps – SG 6.21. 51

Module 7: Managed Investment Portfolios and structures. 51

7.1 Types of Managed investments – SG 7.2. 51

7.1.1 Managed funds – SG 7.2. 51

7.1.2 Listed managed investments – SG 7.2. 52

7.1.3 Insurance Investment Products – SG 7.2. 52

7.2 Investment platforms – SG 7.3. 52

7.3 Regulated Superannuation Funds – SG 7.3. 52

7.4 Managed Investments in perspective – SG 7.4. 53

7.4.1 Investor Markets: Retail, mezzanine and wholesale managed investments – SG 7.4. 53

7.4.2 History of Managed Investments in Australia – SG 7.5. 53

7.4.3 The managed investment industry today – SG 7.6. 53

7.4.4 Trends in the managed investments industry – SG 7.7. 53

7.5 Participants in the managed investments market – SG 7.9. 54

7.6 Advantages, disadvantages and Risks – SG 7.10. 54

7.6.1 Advantages – SG 7.10. 54

7.6.2 Disadvantages and risks – SG 7.11. 54

7.7 Managed investments vs direct investments – SG 7.12. 54

7.8 Australia: an international perspective – SG 7.12. 54

7.9 Investment options in managed investments – SG 7.13. 54

7.9.1 Single Sector Funds – SG 7.13. 55

7.9.2 Multisector funds – SG 7.21. 56

7.9.3 Hedge funds (absolute return funds) – SG 7.25. 57

7.9.4 Infrastructure funds – SG 7.27. 57

7.9.5 Other asset classes for managed funds Investment – SG 7.28. 58

7.10 Other investment schemes – SG 7.29. 58

7.10.1 Exchange-Traded funds – SG 7.29. 58

7.10.2 Listed investment companies – SG 7.29. 58

7.10.3 Insurance bonds – SG 7.30. 58

7.10.4 Friendly Society bonds – SG 7.31. 58

Module 8: managed Investment Administration Platforms and costs. 58

8.1 Administration Platforms – SG 8.2. 58

8.1.1 Master Trusts – SG 8.2. 58

8.1.2 Wrap and custodial services – SG 8.3. 59

8.1.3 Investor-directed portfolio services – SG 8.3. 59

8.1.4 Individually-managed accounts and separately-managed accounts – SG 8.4. 59

8.1.5 Fund of funds – SG 8.6. 60

8.1.6 Feeder funds – SG 8.6. 60

8.2 Costs of Managed Investments – SG 8.7. 60

8.2.1 Categories of fees – SG 8.7. 60

8.2.2 Indirect Cost Ratio – SG 8.8. 60

8.2.3 Management expense ratio – SG 8.8. 60

8.2.4 Buy/Sell spread – SG 8.8. 60

8.2.5 Performance fees – SG 8.10?. 60

Module 9: Analyzing and Evaluating Investment Products. 61

9.1 Evaluating equity securities – SG 9.3. 61

9.1.1 Pricing a share offer – SG 9.3. 61

9.1.2 Intrinsic value vs Market Price – SG 9.5. 61

9.1.3 Arriving at an appropriate discount rate – SG 9.5. 61

9.1.4 Price/Earnings ratio and earnings per share – SG 9.6. 62

9.1.5 Gearing and the share price – SG 9.8. 62

9.1.6 Value drivers and company specific factors – SG 9.10. 62

9.1.7 The Media and its impact in share offer evaluation – SG 9.12. 62

9.1.8 Advisor Role – SG 9.12. 62

9.2 Case study – SG 9.14. 63

9.3 General Investment Trading rules – SG 9.16. 63

9.3.1 Don’t buy on rumour – SG 9.16. 63

9.3.2 The successful investor – SG 9.16. 63

9.3.3 Diversification – SG 9.17. 63

9.3.4 When to Buy – SG 9.18. 63

9.3.5 timing the transaction – SG 9.19. 63

9.3.6 Stop-losses – SG 9.19. 63

9.3.7 when to sell – SG 9.20. 63

9.3.8 Don’t follow the crowd – SG 9.21. 64

9.3.9 High return probability equals high risk – SG 9.21. 64

9.3.10 Monitoring is a continuous process – SG 9.21. 64

9.4 Market indicies – SG 9.22. 64

9.4.1 S7P/ASX benchmark indicies – SG 9.22. 64

9.4.2 International Indicies – SG 9.23. 64

9.4.3 The role of share market indicies in investment – SG 9.23. 64

9.5 Debt securities: Making the investment decision – SG 9.24. 64

9.5.1 Credit ratings – SG 9.24. 64

9.6 allocating securities in an investment portfolio – SG 9.27. 64

9.6.1 Allocation of securities – SG 9.27. 64

9.7 Analysis of derivatives markets – SG 9.28. 64

9.7.1 why analyse? – SG 9.28. 64

9.7.2 Fundamental or technical analysis? – SG 9.28. 65

9.8 Users of derivatives – SG 9.29. 65

9.9 Speculative Trading – SG 9.30. 65

9.10 Hedging fundamentals – SG 9.31. 65

9.10.1 Purpose of hedging – SG 9.31. 65

9.10.2 Hedging strategies – SG 9.31. 65

9.10.3 How much of the exposure should be hedged? – SG 9.32. 66

9.10.4 Choice of delivery months – SG 9.32. 66

9.10.5 The concept of basis risk – SG 9.32. 66

9.10.6 The amount hedged – SG 9.33. 66

9.10.7 Differences in timing – SG 9.33. 66

9.11 Hedging with equity futures – SG 9.34. 66

9.11.1 Anticipatory hedging with equity futures – SG 9.34. 66

9.11.2 Hedging a current market position – SG 9.35. 66

9.11.3 Using beta factors for a more precise hedge – SG 9.37. 66

9.12 Using bank bill futures to hedge short-term interest rate exposures – SG 9.39. 67

9.12.1 A buying hedge using 90-day bank bill futures – SG 9.39. 67

9.12.2 A selling hedge using 90-day bank bill futures – SG 9.40. 67

9.12.3 Hedging long-term obligations – SG 9.41. 67

9.13 Using derivatives to hedge long-term interest rate exposures – SG 9.43. 67

9.13.1 Types of hedging – SG 9.43. 67

9.13.2 Anticipatory hedging –SG 9.43. 67

9.13.3 Hedging a current market position – SG 9.45. 67

9.14 Key Points to remember when hedging with futures – SG 9.46. 67

9.15 Overview of the managed investment process – SG 9.48. 67

9.16 Defining a managed investment’s objectives – SG 9.49. 67

9.16.1 Risk and Return – SG 9.49. 68

9.16.2 Time horizon – SG 9.50. 68

9.16.3 Example of different investment strategies – SG 9.50. 68

9.17 Formulating the investment strategy – SG 9.51. 68

9.17.1 Investment style – SG 9.52. 68

9.17.2 Active vs Passive investment management – SG 9.53. 68

9.18 Investment Management asset allocation – SG 9.55. 69

9.18.1 Neutral asset allocation – SG 9.55. 69

9.18.2 Strategic Approach – SG 9.56. 69

9.18.3 Rebalancing – SG 9.56. 69

9.18.4 Tactical asset allocation – SG 9.56. 69

9.18.5 Market Timing – SG 9.57. 69

9.18.6 diversified or sector funds? – SG 9.57. 69

9.19 Investment manager selection- SG 9.58. 69

9.19.1 People – SG 9.58. 70

9.19.2 Philosophy and Process – SG 9.58. 70

9.19.3 Performance – SG 9.59. 70

9.20 Asset Allocation and stock selection – SG 9.59. 70

9.20.1 Stock selection considerations – SG 9.59. 70

9.21 Monitoring and Reviewing – SG 9.60. 70

9.22 Selecting managed funds – SG 9.63. 70

9.22.1 Investment Process – SG 9.63. 70

9.22.2 Analysis of managed funds – SG 9.64. 70

9.22.3 Identifying manager skill – SG 9.66. 70

Module 10: Regulation, Documentation and Tax. 71

10.1 Regulation of the securities industry – SG 10.3. 71

10.1.1 ASIC – SG 10.1. 71

10.1.2 ASX group – SG 10.5. 71

10.2 Inside a stockbroker’s office – SG 10.10. 72

10.3 Compliance with stockbroking regulations and standards – SG 10.13. 72

10.3.1 Client profiles and record keeping – SG 10.13. 72

10.3.2 Order taking – SG 10.14. 73

10.3.3 Advice versus no advice – SG 10.15. 73

10.3.4 Corporate actions – SG 10.15. 73

10.3.5 Cash handling and trust account rules – SG 10.15. 73

10.4 Debt securities operations – SG 10.16. 73

10.4.1 short-term debt securities – SG 10.16. 73

10.4.2 long-term securities – SG 10.17. 73

10.5 Securities Documentation. 73

10.5.1 Definition of a prospectus – SG 10.18. 73

10.5.2 When is a prospectus required? – SG 10.18. 74

10.5.3 Lodgment and registration of a prospectus – SG 10.19. 74

10.5.4 Materiality – SG 10.20. 74

10.5.5 Types and contents of prospectuses – SG 10.20. 74

10.5.6 Structure of a share prospectus – SG 10.21. 74

10.5.7 Improving disclosure documents – SG 10.24. 74

10.6 Taxation matter for equity securities – SG 10.25. 75

10.6.1 Dividend imputation – SG 10.25. 75

10.6.2 Capital Gains Tax – SG 10.27. 75

10.6.3 Earnings from fixed interest investments – SG 10.31. 75

10.7 Supervision of derivatives trading – SG 10.31. 76

10.7.1 ASX24 Operating Rules – SG 10.32. 76

10.7.2 contract Specifications and associated rules – SG 10.32. 76

10.7.3 Trading principles – SG 10.32. 76

10.7.4 ASX24 Trading Participants – SG 10.32. 76

10.7.5 Client agreement and trading behavior of participants – SG 10.33. 76

10.7.6 Discipline of participants, penalties and code of behavior – SG 10.34. 76

10.7.7 Trading on ASX24 – SG 10.35. 76

10.7.8 The Role of the clearing house – SG 10.36. 77

10.7.9 ASX Clear (futures) – SG 10.36. 77

10.7.10 Initial Margin – SG 10.37. 77

10.7.11 Variation Margins – SG 10.37. 77

10.7.12 Margin Calls – SG 10.38. 77

10.7.13 Current developments in operating rules and market supervisions – SG 10.38. 77

10.8 Conduct of derivatives business – SG 10.39. 77

10.8.1 Confirmation of trades – SG 10.39. 77

10.8.2 Introducing a client to the market – SG 10.40. 77

10.8.3 Accounts and Audit – SG 10.40. 77

10.8.4 Compensation Arrangements – SG 10.41. 77

10.8.5 Offence Provisions – SG 10.41. 77

10.8.6 Trading Requirements – SG 10.41. 78

10.9 The OTC Market – SG 10.42. 78

10.9.1 OTC documentation – SG 10.42. 78

10.9.2 Processing derivative transactions – SG 10.44. 78

10.9.3 Back Office (operations) – SG 10.45. 78

10.9.4 Middle office – SG 10.46. 79

10.9.5 Self Regulation – SG 10.47. 79

10.10 Taxation issues to consider for derivatives – SG 10.47. 79

10.11 regulation of managed investment schemes – SG 10.48. 79

10.11.1 Duties of an RE. 79

10.11.2 constitution – SG 10.48. 79

10.11.3 Compliance committee – SG 10.48. 79

10.11.4 Compliance Plan – SG 10.49. 79

10.11.5 Custody of Assets – SG 10.49. 79

10.11.6 withdrawing from a fund – SG 10.49. 79

10.11.7 complaints procedures – SG 10.49. 79

10.12 Product Disclosure Statements – SG 10.50. 79

10.12.1 what is a Product Disclosure statement? – SG 10.50. 79

10.2.2 contents of a product disclosure statement – SG 10.51. 79

10.12.3 Master Trusts and Investor directed Portfolio services – SG 10.54. 80

10.12.4 How a product disclosure statement helps clients – SG 10.54. 80

10.13 Taxation treatment of managed funds – SG 10.55. 80

10.13.1 Income and Taxation – SG 10.56. 80

10.13.2 Tax components of income distributions – SG 10.56. 80

10.13.3 Tax-paid managed investments – SG 10.57. 80

10.13.4 taxation issues surrounding property funds – SG 10.60. 80

10.13.5 Other managed Investments – SG 10.60. 80

10.13.6 Individually and separately managed accounts – SG 10.60. 80

 

 

Module 1: Introduction to Investment Markets, Products and Regulation.

 

1.1 The Corporations Act – SG 1.2

Corporations Act 2001 including provisions introduced under the Financial services Reform act 2001 (FSRA) provides a comprehensive regulatory and licensing regime for financial products, investment product providers and investment advisers and their services.

 

1.1.1 The concept of a financial product – SG 1.2

Corp act act identifies certain products specifically included and excluded

Definition is very borad

Key definitions

Financial product allows:

                A Financial investment

                Manages a financial risk

                Makes a non-cash payment

 

A facility is defined as including:

                An intangible property

                An arrangement or a term of an arrangement including:

                                One implied by law

                                A combination of the first two points.

 

A financial investment is where:

                An investor gives money or monies worth to another person

                The other person uses it to generate a financial return or benefit

                The investor has no day-to-day control over use of the contribution

 

Manages financial risk includes:

                Managing the financial consequences of an event

                Limiting the consequences of fluctuation in receipts or costs

 

Specific inclusions that are a financial product:

                Deposit-taking facilities by authorized deposit-taking institutions

                Insurance products (unless excluded)

                Securities

                Interest in managed investment schemes

                Derivatives

                Superannuation interests

                Retirement savings accounts

                Government debentures, stocks or bonds

                Foreign exchange transactions (not spot currency exchange) that are not immediately settled

 

Specific exclusions:

                Health insurance

                State or commonwealth insurance

                Reinsurance

                A credit facility as defined in the regulations

                A physical spot foreign currency exchange subject to immediate settlement

                A payment facility for making non-cash payments to a credit facility

                Insurance provided by an employer to an employee

                Most unregistered managed investment schemes

                State banking

                Funeral benefits

 

1.1.2 licensing of financial services industry participants – SG 1.4

financial advisers need an AFSL.  Financial advisers much satisfy competency requirements set by ASIC.

 

Obligations of a financial services licensee under the Corporations act are to:

Do all things necessary to ensure financial services covered by the license are provided efficiently, honestly and fairly.

Comply with license conditions

Take reasonable steps to ensure representative comply with financial services laws.

Have adequate financial resources

Maintain the competence of those providing financial services

Ensure representatives are adequately trained and competent to provide financial services

Have adequate dispute resolution system for retail clients

Have adequate risk management systems

Have arrangements to compensate retail clients for loss arising from breaches of the FSRA

 

Representative

Individual who is a representative of a licensee does not need to obtain a license

Has responsibility to meet RG146

All representatives (other than directors and employees) must be authorized in writing known as “authorized representatives”

 

Conditions of license

See SG 1.4

 

1.1.3 Disclosure documents – SG 1.5

Chapter 7 of Corporations act – Retail clients are required to be given 3 main forms of disclosure documents

1. Financial services guide (FSG)
2. Product Disclosure documents (PDS)
3. Statement of advice (SOA)

Criminal and civil liabilities exist for licensees and representatives that:

                Fail to disclose where required

                Provide defective disclosure documentation

**For retail clients only

 

FSG

See SG 1.5

 

Product disclosure statement

See sg 1.6

Statement of Advices

See SG 1.6

 

1.2 Securities – SG 1.7

Security is documentary evidence of the ownership of a financial asset – normally purchased for the purposes of investment

Security – short for marketable security

Can be either:

                Equity securities

                Debt securities

1.2.1 Equity securities – SG 1.7

Equity refers to proportion of any asset owned by an investor

Equity security aka share

 

1.2.2 debt securities – SG 1.8

Debt security – underlying loan from one party to another

 

1.2.3 Securities market terminology – SG 1.8

Debt security – underlying loan from one party to another

 

Terms “stock market” = “Share Market” = “equities market”

Debt Market:

                Money Market – short-term fixed interest security market

                Fixed Interest or bond market – long term interest rate market

                Debt market or money market and bond market – interest rate market, collective term used for both short-term and long-term market.

 

Instrument – general term refers to a security or derivative product in either short-term or long-term debt market

 

1.3 Primary and Secondary Markets – SG 1.8

Both equity and debt can be divided into two sub-markets:

1. Primary Market
2. Secondary Market

 

1.3.1 the Primary Market – SG 1.8

Capital ($)

Investor – equity holder

allows a company or government to raise initial capital by selling part-ownership of new investment assets to investors.

 

 

 

 

Debt Primary Markets

Primary market activity in the debt market is the issuance of treasury bonds by the Australian Government, Australian Office of financial Management (AOFM) – Governments nominated agency.

 

 

 

 

1.3.2 The Secondary Market – SG 1.9

Facilitates buying and selling of the securities issued in the primary market

Trading via auction style system, where price of a share or debt security determined by supply and demand.

 

 

 

 

 

 

 

 

 

1.3.3 Links between primary & Secondary markets

Investor will generally only participate in the primary market if they can sell on the secondary market

 

1.4 The Role of stockbrokers – SG 1.11

1.4.1 What does a stockbroker do – SG 1.11

ASX market participants – stockbrokers authorized to trade shares directly on the ASX (own account or clients behalf)

Stockbrokers may:

                Advise clients on possible investments (equities/fixed interest securities)

                Take orders from clients to buy or sell securities

                Execute transactions

                Ensure selling clients or selling brokers deliver valid transfer documents

                Ensure payment is received from buying clients and register the purchases in accordance with the buyer’s instructions or alternatively deliver documents to the buying broker for payment.

                Ensure that when a client buys or sells shares, all appropriate benefits flow (dividends and new issues)

                Research and report on the performance of listed companies and their securities

                Underwrite new issues of securities

                Advise on company takeovers and mergers

                Transact business as a principle and arbitrage between markets

 

1.4.2 Stockbroker and client relationship – SG 1.11

3 licensed facilities provide access to, and support, trading on the ASX:

1. The licensed market of the ASX operated by ASX Limited
2. The clearing facility operated by ASX clear
3. The settlement facility operated by ASX settlement

 

To obtain access to these facilities, a broker must be a market participant of the ASX and either contract with or be a clearing participant of ASX clear and a settlement participant of ASX settlement.

 

Access to these facilities is regulated by the following rules:

-          ASX market operating rules – deal with access to trading facilities on the ASX

-          ASX Clear Operation Rules – Deal with the responsibility for counterparty risk for market transactions, access to clearing facilities and conduct of clearing participants

-          ASX Settlement Operating Rule – deal with access to settlement infrastructure for the purpose of payment, delivery and asset registration

Collectively these rules are referred to as the ASX rules.

 

Prior to 11^th March 2004 ASX rules were structured around the existence of a ‘broker’, current rules no underpinning presumption that a broker will be the provider of all functions in a transaction

 

General Law of principle and agent

Client is principle and broker is the agent

Based on Trust, agent always required to deal with a principle in the utmost good faith

 

Stockbrokers rights

Right to:

Receive commission

Be indemnified

Exercise a lien (i.e. hold assets as security against a debt)

 

1.4.3 Costs of trading – SG 1.13

Discount Brokerages

                Execution only brokers

Don’t need to comply with the financial advice requirements under the Corporations Act – i.e. advice has a reasonable basis.

 

1.4.4 Equities Trading and the internet – SG 1.14

 

Advantages of internet brokerage include:

                Convenience and easy access

                Transactions in all instruments

                Access to information eg market data, company information and research

                Investment tools

                Empowerment of individual investors, due to greater ability to control and track investment

                Lower costs

 

To date, providers have been fairly evenly distributed between:

                Execution-only traders

                Subscription-based services

 

1.5 the Australian Securities Exchange – SG 1.14

formed in 2006 by merger of the Australian stock Exchange and Sydney Futures exchange

ASX fulfils 2 basic and complementary needs:

1. the needs of businesses for capital
2. The need for private and institutional investors to invest excess capital efficiently

 

ASX diverse product base:

                Equities

                Debt

                Hybrid securities

                Listed Managed Investments

                Derivatives

See figure 1.4 – SG 1.15

 

Other licensed exchanges operation in Australia:

ASX 24 – SFE

Bendigo Stock Exchange

National stock Exchange of Australia

Asia Pacific Exchange

 

1.5.1 Role and operation of the ASX – SG 1.15

The corporations act requires the ASX to provide markets that are fair, orderly and transparent

In order to achieve this, the ASX has the following objectives:

Promote confidence in its markets and in its clearing and settlement facilities

Achieve appropriate levels of transparency in relation to the activities of its listed entities, and to set standard for their behavior

Promote confidence in the way market participants conduct business on it’s markets and clearing and settlement facilities

Ensure that there is fair and effective interaction with it’s clearing and settlement facilities

Reduce external systemic risk to it’s clearing and settlement facilities

 

ASX therefore provides facilities to market participants for:

                Trading

                Clearing

                Settlement

 

ASX’s role is to promote fair trading by:

                Providing efficient trading platforms

                Collecting and supplying statistics and other information concerning the specific matters with which it deals

                Publishing price quotations

 

A fair market is a market that:

                Is fully and promptly informed of all information necessary to assess the value of a security

                Has adequate liquidity

                Has brokers of the highest standards of ethics and integrity

 

ASX co-regulates its market with ASIX

 

Organizations that use the ASX:

                Listed entities

                Stockbrokers

                Institutional and private investors (domestic and international)

                External regulators

                Share Registries

                Custodians

                Other exchanges and their affiliates

 

 

1.5.2 ASX Structure – SG 1.16

see fig 1.5

 

1.6 Overview of derivatives – SG 1.17

1.6.1 What is a derivative? – SG 1.17

Derivative is a date-specific contract to buy or sell an underlying physical asset (wheat or wool) or a financial instrument (bond, bank bill or stock index)

Contract (forward, futures or options) is derived from an underlying asset and cannot exist without it

Delivery obligations are usually ‘closed out’ prior to time of contract expliration

Derivatives can be highly geared (leveraged)

Derivatives can be used to manage risk

 

1.6.2 Exchange traded vs. over-the-counter derivatives – SG 1.18

Exchange traded – highly standardized, traded on exchange

Over-the-counter (OTC) – market – highly flexible, traded between participants (banks and financial institutions) by phone.

 

1.6.3 Australian derivatives markets – SG 1.19

2008/9 – derivatives $70,000 billion vs. equity, options and futures $26,500 billion.

 

1.6.4 Growth of the global derivatives markets – SG 1.20

Used for risk management / currency exposure

 

1.6.5 Uses of derivatives – SG 1.21

Protect against future adverse interest rate movements

Reduce borrowing costs / increase investment returns

Increase flexibility

Match borrowing structure to company needs

 

1.7 The Managed Investment Act 1998 – SG 1.22

changed structure of unit trusts

replaced the fund manager and trustee of a unit trust with a single responsible entity (SRE or RE). RE – ultimately accountable for all aspects of the trusts operations (inc performance of the trust and administration).

 

1.7.1 Definition of a managed investment scheme – SG 1.22

See SG 1.22 for definition

 

Investors – provide capital and receive a return from the scheme.

Responsible entity – acts as trustee and manager of the scheme

Trust Account – collects and distributes the cashflows for the scheme

 

Structure of a managed investment

 

 

 

 

 

 

 

 

 

 

 

Investments that are not classed as managed investments include:

Regulated superannuation funds

Approved deposit funds (ADFs)

Franchises

 

 

Module 2: the Mathematics of investment

2.1 Definition of Interest – SG 2.2

Interest is the cost of borrowed money or the rate of return on money loaned or invested.

 

2.2 simple Interest – SG 2.2

Calculated on the original principal investment

Amount of interest doesn’t change, no matter how long the funds are invested

 

2.2.1 Calculating Simple Interest – SG 2.2

SI = P x I x T

Where:

SI = Simple Interest

P = Loan Principle

I = Interest rate (per annum)

T – Period of time (in years)

See example sg 2.2

 

Part-year simple interest calculation

SI = P x I x D/Y

Where:

D = number of days in the period of investment

Y = number of days in the year

See example SG 2.3

 

2.3 Multiplication by Powers – SG 2.3

See SG 2.3 + 2.4

 

2.4 Compound Interest – SG 2.4

Calculated on original principal invested plus any interest.

 

2.4.1 Calculating Compound Interest – SG 2.4

V = P(1+I)^N

Where:

V = total amount of principal and compound interest at the end of the period

P = the loan principle

I = the interest rate per period

N = the number of periods (e.g. years)

 

See example – SG 2.5

 

Compounding periods other than one year – SG 2.5

Usually interest quoted per annum rate, called the nominal interest rate, but this can be converted into the interest rate for the compounding period.

See example – SG 2.5

 

2.4.2 The rule of 72 – SG 2.6

A return of 7.2% per annum will roughly double in value in 10 years.

Years to double = 72 / annual rate of return

Rate of return required to double in x years = 72/number of years

 

2.5 Future value – SG 2.6

Future value of investment

FV = PV (1+ I/C)^N

Where:

FV = Future Value of the investment

PV = Present Value of the investment

I = Nominal interest rate (per annum)

C = Number of compounding periods per year

N = Total number of compounding periods

In this formula

I/C = interest rate for each compounding period

 

See examples – SG 2.6 + 2.7

 

2.5.1 Effective rate

Effective rate is the annualized interest rate that takes into account the effect of all compounding over a year.

The effective rate reflects the true annual interest rate paid

E = [(1 + I/C)ⁿ]-1

Where:

E = Effective annual rate

I = nominal interest rate (i.e. per annum)

C = number of compounding period per year

N = total number of compounding periods (for a year)

i/c = interest rate for each compounding period

 

see example – SG 2.7

 

used to compare mortgages

 

2.6 Present Value – SG 2.8

How much to invest to get a certain amount after a period of investment

PV = FV / (1+I/C)ⁿ

Where

PV = Present Value

FV = Future Value (the goal)

I = Interest rate

C = compounding period per year

N = total number of compounding periods

 

See example SG 2.8

 

2.7 Interest rate and investment period – SG 2.9

2.7.1 Calculating the interest rate – SG 2.9

I = [(FV/PV)^I/N-1] x C

Where:

PV = Present Value

FV = Future Value

I = Interest Rate

C = Compounding period per years

N = Total number of compounding periods

 

2.7.2 Calculating the investment period – SG 2.9

N = IN(FV/PC) / IN(1+I/C)

Where:

PV = Present Value

FV = Future Value

I = Interest Rate

C = Compounding rate per years

N = Total number of compounding periods

IN = Logarithm function

 

2.8 Calculating the value of a series of future payments – SG 2.10

2.8.1 Calculating the value of an annuity – SG 2.10

Types of annuity include:

Ordinary annuities – where an initial investment is made and payments are made at the end of each period

Deferred annuities – where an initial investment is made and payments do not start until a set number of compounding periods have elapsed

Perpetuities – payments continue indefinitely

 

Formula:

 

Where:

I = the rate of interest for each compounding period

N = the number of periods

PMT = the payment for each period

 

See examples – SG 2.10 + SG 2.11

 

2.8.2 Calculating the value of a deferred annuity – SG 2.12

PV = PMT / (1+I)^N

2.8.3 Calculating the value of a sinking fund – SG 2.12

Funds used whenever the investor must “provide” for large future expenses

FV = PMT x (((1+I)^N -1) / I)

Where:

I = the rate of interest for each compounding period

N = the number of periods

PMT – the payment for each periods

See sg 2.12

 

2.8.4 Calculating the value of a perpetuity

Perpetuity is an annuity where the payments continue indefinitely

Formula

PV = PMT / I

2.9 Discount rate and Discounted cash flows SG 2.13

Discount rate is effectively the minimum return threshold that the investor requires from the investment, should be a rate that effectively compensates the investor for the likely risk associated with the investment

Rate by which future value payments are discounted by

AKA time value of money

Formula

PV = PMT + PMT / (1+I) + PMT / (1+I)²

where

I = the discount rate

PMT = the cash flow payments for each period

See example SG 2.14

 

The impact of different discount rates

Borrowing costs and DCF valuations

Loan repayment amount should not be included in the DCF cash flow table, unless they form part of the scenario.  i.e. cost of investment 1 (borrowing) versus cost of investment 2 (no borrowing)

 

2.10 Net present value and comparison of investment options – SG 2.16

This comparison identifies the future cash flows of the investment and uses discount rates to compare the present value of the cash flows achieved from the various investment options, net of the initial investment.

See example SG 2.16

Note: does not consider how to finance the investment

 

2.11 Investment yield (internal rate of return) – SG 2.17

IRR is the investment return made from an investment

See SG 2.17

 

2.12 Discounted cash flow valuations applied to tax and inflation – SG 2.18

See example SG 2.18

 

Module 3

3.1 The equity market

Crucial part of the financial system.  It enables companies to raise funds through the issue of shares and enables investors to receive a capital gain

Also a major investment medium

 

3.1.1 Features of the Australian Equity Market – SG 3.2

One of the worlds top ten equity markets.

Subject to commodity cycles (approx 39% of market weighting is in resources)

Dominated by institutional investors both local and international (78%) and retail investors (22%)

Highly sensitive to international capital flow, subject to trade and currency cycles

Driven by current situations

3.1.2 The role and history of share ownership in Australia – SG 3.2

Historically predominant investor classes in Australia

        Decline in private investors

        Overseas investors significant purchasers

 

The post 1987 decline of direct private share investment

        Growth of managed investment funds

        Growth in capital-guaranteed assets of bonds and cash

 

The return of direct private share investment in the 1990s

        Increased direct share ownership

        Improved investor education

        Major floats

 

Australian equity market capitialisation today

Market value = 1.4 trillion

Using

Market value capitalization = total shares on issue x share price

 

The equity market and the free enterprise system

Equity market provides continuous measure of corporate efficiency and profitability

 

3.1.3 Share Market liquidity – SG 3.4

Liquidity = measure of how much buying and selling can change market price

Market liquidity (%) = turnover /total market capitalization

Turnover = dollar value of shares purchased or sold in a specific market in a given period

 

3.1.4 Securities market participants – SG 3.5

Market participants can be:

Investors (lenders)

Borrowers (capital raisers)

Intermediaries

See diagram 3.1 – flow of funds – SG 3.5

 

Investors

Can be either:

Retail (below $500,000)

Wholesale

Retail requires more disclosure

Private investors – see SG 3.6

Retirees – low risk

Speculators – short term price differences

Mums and Dads – conservative retail investors

Discretionary private client management – managed by professionals

Private client investors – has portfolio of investments

 

Institutional Investors (SG 3.7)

Superannuation and pension funds

Life offices

General insurance officers

Unit trusts and mutual funds

Corporate investors – entrepreneurs, corporations seeking to expand, investment companies

International investors

 

Business and companies

Capital raising – source money from investor for operations or expansion

Floatation – listing on the ASX

 

Financial intermediaries

Intermediaries aggregate and package funds

 

Intemediaries and securities markets – SG 3.11

Share/equity market – stockbrokers & fund managers

Long-term debt market – banks, life companies, superannuation funds

Short-term debt market – futures brokers, fund managers, market makers, option traders

Foreign exchange market – banks, foreign exchange dealers, fund managers

 

3.2 Definition of equity securities

Ownership of a business

Equity capital called risk capital

See fig 3.2 – list of equity securities – SG 3.12

 

3.3 Types of equity security – SG 3.13

3.3.1 Ordinary shares – SG 3.13

One share one vote

Exercise control over management

Entitled to dividends

Ranks after debentures and preference shares

 

3.3.2 Partly-paid shares – SG 3.13

Like ordinary shares

Dividend pro-rataed to fully paid shares

Can be asked to pay balance owing

 

3.3.3 Installment receipts – SG 3.14

Similar to partly paid

Full dividend

 

3.3.4 deferred dividend shares – SG 3.14

Dividend paid only after a specified period

 

3.3.5 bonus issues – SG 3.15

Free shares to existing holders

 

3.3.6 rights issue – SG 3.15

Entitles investor to take up additional shares at a discount to market price without paying additional brokerage

If renounceable investor can sell otherwise non-renounceable and they cant sell (they expire)

 

3.3.7 Company options – SG 3.16

See SG 3.16 benefits of company options

 

3.3.8 Stapled securities – SG 3.17

Ordinary shares in a company that are ‘stapled’ to units in a trust

 

3.3.9 Hybrid securities – SG 3.18

Characteristics of both debt and equity

 

Preference shares – SG 3.18

Preferred dividend payments on ordinary shares and on wing-up

Rank behind creditors and debenture holders

Types of issue:

        Convertible preference shares

        Converting preference shares

        Cumulative preference shares

        Participating preference shares

        Redeemable preference shares

        Reset preference shares

 

Convertible notes – SG 3.19

Fixed interest securities that carry an option to convert to ordinary shares at specific time or redeem for cash.

 

3.4 Listed Managed Investments – SG 3.19

Managed fund products that give investors access to a bread range of asset classes and investment styles.

 

3.4.1 Australian Real Estate Investment Trusts – SG 3.20

See SG 3.20

 

3.4.2 Listed investment companies – SG 3.21

See SG 3.21

 

3.4.3 Infrastructure funds – SG 3.21

Investment in the substantial capital assets that are required to fulfil major economic and social needs

 

3.4.4 Pooled development funds – SG 3.22

High risk

 

3.4.5 Exchange traded funds – SG 3.22

Open-ended funds – market price correlated closely to underlying portfolio

Can be indexed or actively managed

 

3.4.6 Hedge funds (absolute return funds)

Can invest in many things target a specific return

 

3.5 comparing the features of equity securities and LMIs – SG 3.24

 

3.6 Share market Sectors – SG 3.25

1. Industrials
2. Resources

GICS – Global Industry Classification Standard

 

3.6.1 Industrial shares – SG 3.25

See SG 3.25

 

3.6.2 Resource shares – SG 3.25

See SG 3.25

 

3.6.3 The Global Industry Classification standard – SG 3.26

See diagram SG 3.26

 

3.7 Factors influencing share market performance – SG 3.27

3.7.1 Interest rates – SG 3.28

3.7.2 Exchange rates – SG 3.28

3.7.3 Economic Factors – SG 3.28

3.7.4 Federal Government Economic and Fiscal policies – SG 3.29

3.7.5 Monetary policy – SG 3.29

3.7.6 Other Markets – SG 3.30

3.7.7 Market Sentiment – SG 3.30

3.7.8 Supply and demand – SG 3.30

 

3.8 Global equities markets – SG 3.31

3.8.1 Accessing better returns – SG 3.31

Investing in faster growing economies outside Australia

 

3.8.2 Diversification – SG 3.31

Hold international shares

 

3.8.3 Why international diversification permits greater returns – SG 3.32

Share markets do not move in tandem because:

                Differing composition of stock markets

                Lack of synchronization of national political and economic cycles

                Differing institutional structures

                Different levels of development

3.9 Risk and return – SG 3.32

Greater risk = greater return

 

3.9.1 Risk-adjusted return SG 3.34

See SG 3.34 for Risk-Adjusted return (RAR)

 

Module 4 Debt Securities

 

4.1.1 structure of the debt market – SG 4.2

2 segments:

                Short-term debt market or money market

                                Maturity dates less than 12 months + short term securities

                Long-term debt market (aka fixed interest, fixed income or bond market)

                                Longer than one year – pay coupon

See fig 4.1 – SG 4.3

 

4.1.2 features of the debt market – SG 4.3

Include:

Wholesale market for large institutions, government or corporate

Deposits accepted for short term and long term

Related to and integrated with other sectors of the financial system

Interest rates in this market are extremely sensitive

Value of the turnover in deposits and financial instruments is high

Market issuers include Commonwealth Government, State governments and corporations

Commonwealth currently uses 3 debt instruments: treasury fixed coupon bonds, treasury indexed bonds and treasury notes

 

4.1.3 Participants in the debt market – SG 4.4

Borowers – SG 4.4

The Australian government – SG 4.4

State and semi-government authorities – SG 4.5

Major authorities are:

                New South Wales Treasury Corporation

                Treasury Corporation of Victoria

                Western Australia Treasury Corporation

                Queensland Treasury Corporation

                South Australian Government financing authority

                Tasmanian Public finance Corporation

                Northern Territory Treasury Corporation

Local government

Private Sector:

                Banks

                Building societies

                Credit Unions

                Finance companies

                Corporations

 

Investors:

Major investors in the short term money market include:

                Banks, building societies and credit unions

                Investment banks

                CMTs

                Superannuation Funds

 

Major investors in the long-term debt market includes:

                Friendly societies

                Fund managers

                Insurance officers

                Superannuation funds

 

Banks, building societies and credit unions – SG 4.6

Investment banks – SG 4.6

Cash Management Trusts – SG 4.6

Friendly societies – SG 4.6

Fund Managers – SG 4.6

Insurance Offices – SG 4.7

Superannuation Funds – SG 4.7

                3 main types of fund:

1. Market linked (non-fixed interest)
2. Capital guaranteed (combination of fixed interest + non-fixed interest_
3. Capital Stable (fixed interest)

 

4.1.4 settlement and registration procedures – SG 4.7

Mostly settled electronically

 

Austraclear – SG 4.7

Computerized settlement systems for all Commonwealth Government and non-Commonwealth Government securities

See SG 4.7 for more details

 

Reserve Bank Information and Transfer System – SG 4.8

Used for Tender bids for primary issues of new CGSs – see SG 4.8 for more details.

 

4.1.5 The size of the interest rate market – SG 4.8

Depth and liquidity of the market:

Significant number of buyers + sellers = deep market

Liquidity – turnover

Australia market not as deep or liquid as US and Europe.

 

Turnover of debt securities – SG 4.8

See SG 4.8

 

4.1.6 Primary and secondary debt markets – SG 4.9

The primary market

Interest rate securities are issued via the following means:

                Tender/auction

                Private Placement

                Dealer Panels

                Public Loan

 

The secondary market

Where existing short-term and long-term securities are traded.

 

4.2 definition and debt securities – SG 4.10

The buyer (borrower) negotiates with a seller of money (the investor) about the price (interest rate)

2 distinct markets

1. Short term debt market
   1. Non-coupon securities: Promissory notes, Bank Bills, Certificates of deposit

 

1. Long-term debt market
   1. Coupon securities: treasury bonds, Semi-government bonds, Corporate bonds, Asset backed securities

 

See fig 4.3 – SG 4.10

 

4.3 Interest Rates

4.3.1 What are interest rates? – SG 4.11

An interest rate is the price of money

Interest rates are affected by many factors including:

Borrower(credit worthiness), economic, market, international and political factors.

 

Yield

Yield refers to the annual rate of return calculated as a percentage of the market price of the security

 

4.3.2 Indicator interest rate – SG 4.11

Major indicators all participants consider:

The cash rate

90-day bank bill rate

3 year bond rate

10 year bond rate

 

Cash

RBA at 9.30am each day sets targeted cash rate

RBA manages liquidity in the market (buys or sells) to achieve cash rate.

 

90-day bank bill rate

Represents the yield p.a. on bank bills traded in the wholesale market

Major indicator of the ease or tightness of official monetary policy and short-term market sentiment

 

Three-year bond rate

Dividing line between monetary policy influence and wider macroeconomic influences.

 

10-year bond rate

Market indicator of the rates at which Governemnt bonds are trading in the market and market’s views of inflation

Relates to longer-term trends in the economy

 

4.3.3 Bank bill swap preference rate – SG 4.12

Used as an indicator of likely pricing levels of many other short-term instruments

 

4.3.4 Wholesale and retail interest rates – SG 4.12

Wholesale – large amounts of money

Retail small amounts

 

4.3.5 Short-term and long-term interest rates

Two most watched interest rates in short-term are:

                Cash rate – determined by official monetary policy

                90-Day bank bill rate

Long term:

                Three-year bonds

                10-year bonds – long bond rate

 

4.3.6 Creditworthiness of issuers – SG 4.13

Lowest for government, higher for corporate

 

4.3.7 The yield curve – SG 4.13

Graph that shows the relationship between the yield to maturity and term to maturity

See SG 4.13 – for yield curve types

                Positive (normal)

                Inverse (negative)

                Flat

                Hump-backed

4.3.8 The components of an interest rate – SG 4.14

Interest rates three major components:

1. A real component
2. An inflation compensation component
3. Risk premium component

 

Real Component

Compensation to the lender for deferring current consumption

 

Inflation compensation component

Rate of inflation expected in the future

 

Risk premium component

Several factors:

                Credit Risk

                Liquidity Risk

                Currency Risk

                Political risk factors

 

Difference between nominal and real interest rates

Observed (actual) interest rates are often called nominal rates, real rate of interest = nominal interest rate – expected inflation.

 

4.4 short-term interest rate securities – SG 4.16

Less than 365 days

Security issued at discount to face value

 

4.4.1 Cash – SG 4.16

See SG 4.16

 

4.4.2 Treasury notes – SG 4.16

Short-term securities issued by RBA

Maturity of 5, 13 or 26 weeks

 

Pricing of treasury notes

Sold at discount to face value, priced on a yield to maturity basis using bank bill formula (section 4.4.7)

 

Issuing treasury notes into the market

Rediscounting

RBA can reprice treasury notes up to 90 day in maturity from 8.30am each day

Fixed penalty must be paid if notes become rediscounted

 

4.4.3 Bills of exchange – SG 4.17

Negotiable instrument sold at a discount to its face value, term can vary from one day to six months

Defined by Bill of Exchange Act 1909 as:

An unconditional order in writing addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable future time, a sum certain in money to the order of a specified person, or to bearer.

 

Types of Bills

Bank-accepted bills – bill of exchange, accepted by banks

Bank-endorsed bills of exchange – commercial bill, traded by banks but not accepted

Commercial bills – Bills accepted by non-banks, normally trade at yields higher than bank-accepted bills.

 

3 parties involved in a bank accepted bill of exchange:

1. The drawer
2. The drawee/acceptor
3. The payee/endorser

 

Subsequent holders “in due course” owners endorse the reverse (see Sg 4.19)

 

Contingent Liability

 

Pricing of Bills of exchange

Discount to face value

 

The Secondary Market

 

Users of Bills of Exchange

Trade Bills – Finance specific trade transactions

Accommodation Bills – means providing working capital

 

4.4.4 Promissory notes – SG 4.20

Promissory note is defined under section 89 of the Bills of Exchange Act as:

…an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay on demand, or at a fixed or determinable future time, a sum certain in money to the order of a specified person or to bearer.

 

3 Important elements:

1. A promissory note is an unconditional promise in writing
2. Amount will be paid either on demand or on a fixed or determinable future date
3. The note does not require a third party to pay the bearer of the note on behalf of the drawer

 

Who are the parties to a promissory note?

2 parties:

1. The issuer of the note
2. The bearer or specified person

 

Advantages of promissory notes

 

Pricing of promissory notes

Similar to Treasury notes and Bills of exchange

 

Users of promissory notes

Large corporations and semi-government authorities

 

Issuing promissory notes into the market

1. ‘tap’ issues
2. Formal tender panel procedure

 

The Secondary Market

Very active market

 

4.4.5 Negotiable certificates of deposit and certificated of deposit

No secondary market (can’t be traded)

 

Pricing of negotiable certificated of deposit- SG 4.22

Like Treasury bills, see 4.4.7 SG 4.23

 

4.4.6 Repurchase agreements – SG 4.23

Security is sold and concurrently an agreement is made to buy back or ‘repurchase’ the security at a later date at an agreed price

Repos

Buying called “reversing into”, selling “reversing out of”

Seller bears market risk.

 

Advantages of using the repo market

For the seller, obtaining short-term liquidity at an advantageous rate

For the buyer, covering short (sold) positions

For the buyer, investment of excess funds

 

4.4.7 Pricing of short-term securities

Purchase price = maturity proceeds (face value) – interest on purchase price

Formula:

Purchase Price  =             Face Value / (1+[yield x (days to maturity/365)])

Or yield to maturity

Or Bank Bill

4.4.8 Key Relationships for price short-term securities – SG 4.24

Relationship between yield and purchase price

-higher yield lower the purchase price

 

Relationship between term to maturity and purchase price

-greater term to maturity lower purchase price

 

4.5 Long-term interest rate securities – SG 4.25

Price more influenced by yield than maturity

If interest rates increase capital price for bond will fall

 

4.5.1 Commonwealth Government Securities – SG 4.26

Treasury fixed coupon bonds

Pay interest semi-annually in accordance with fixed coupon rate

Sold by tender

 

Treasury indexed bonds

Issued as capital-indexed bonds where the capital value of the investment on maturity is not fixed when issued but is linked (indexed) to Consumer Price Index (CPI)

Real yield is a better comparison

 

Coupon-indexed bonds

Principle doesn’t vary, interest payments in dual format, part fixed, part floating (linked to index).

 

Periodic tenders

Total size of tender announced in Budget Papers reflecting Governments Financial needs

Treasurer determines the maturity, coupon and quantity of each stock to be offered in the tender

 

4.5.2 Participants – SG 4.27

Most bidders are financial institutions, see SG 4.17 for list

Real investors can deal in smaller amounts

 

4.5.3 The Secondary market in Treasury bonds – SG 4.28

-has grown rapidly

 

4.5.4 Semi-Government securities – SG 4.28

See SG 4.28

Turnover and volume

See SG 4.28

 

4.5.5 Features of long-term interest rate securities – SG 4.29

 

Par

Purchasing a security at par means that the capital price and purchase price is equal to the face value

 

Discount

Capital price less than par

 

Premium

Capital price greater than par

 

A bond issue

See SG 4.30

 

4.5.6 Books close date – SG 4.30

Date when issuer (payer of coupon) closes the books and prepares payment

 

Cum interest

If a security is sold cum interest:

                The previous coupon payment has been made

                The books have not closed for the next coupon payment

                The purchasers will compensate the seller for the interest accrual to date

 

Ex-Interest

                Books close date has passed

                Coupon payment hasn’t been made

                Purchaser must be compensated for the interest accrual (seller will receive coupon payment)

 

4.5.7 Pricing of long-term interest rate securities – SG 4.30

-valued based on discounted cash flow method.

 

PV = F+C / 1+I

Where

PV = Present value price

FV = The future payment on maturity
I = The market interest rate

C = the Coupon payment amount

 

Half-yearly coupon payments

Effect of changes in interest rates on bonds with one year or more to maturity

-          A fall in interest rates increases the price of a fixed interest security, rising interest rates decrease the price of a fixed interest security

 

Parcel pricing of coupon securities

-Prices always converted to 3 decimal places

 

P = C/(1+I)ⁿ

Where:

P = Present Value

C = Future Value (i.e. coupon value)

N = number of coupon periods

I = market yield divided by 200 (eg 6% becomes .3)

 

RBA bond pricing formula

 

4.6 The corporate debt market – SG 4.34

 

4.6.1 Floating rate notes – SG 4.34

Or FRN’s

– long-term interest rate securities which are issued at a margin above the bank bill rate

-Normally reset every 3 months

-coupon is BBSW plus agreed margin

 

4.6.2 Securitised bonds – SG4.35

-are secured by a pool of assets that are held by a trust and managed by a professional manager

 

4.6.3 Subordinated debt – SG 4.36

Ranks below holders of secured and unsecured loans but ahead of equity investors (inc preference shareholders)

Also called unsecured bonds

 

4.6.4 Corporate Bonds  – SG 4.36

Direct debt obligations of corporations in a market tradeable form

Divided into:

1. Financial
2. Non-financial companies

 

Usually have the following characteristics:

                Fixed or variable interest paid semi-annual in-arrears basis

                Typical term between 2 and 10 years

                Trade at a margin above Commonwealth and semi-government securities

                Brought and sold via stockbrokers

 

Growth in Corporate bond market due to:

                Cutback in Government Borrowing

                Reduction in number of Commonwealth Government Bonds

                Attractiveness of raising funds domestically relative to offshore markets

 

4.6.5 Debentures – SG 4.37

Similar to corporate bonds

Fixed interest coupon, secured by fixed or floating charge

Medium (2 years) to long term (10 years)

May be ‘rolled over’

Relatively low risk – secured by assets

Influenced by interest rate movements

 

4.6.6 fixed interest managed investments – SG 4.37

i.e. Cash management Trusts

 

4.7 Holding period return – SG 4.37

When a security is sold prior to maturity

 

4.7.1 How to calculate the holding period return – SG 4.37

Holding Period Return

= (Sale price + Accumulated coupons) – Purchase price)/Purchase Price x 365/no of days held

 

4.8 Volatility – SG 4.39

Degree to which the purchase price of a security moves with a change in yield

 

4.8.1 How to calculate price volatility – SG 4.40

See SG 4.40

 

4.8.2 The affects of yield and term on volatility – SG 4.41

2 rules

1. The longer the term to maturity, the higher the price volatility
2. The higher the yield, the lower the price volatility

Voilatility ‘rules’ for long-term interest rate securities:

                The longer the term to maturity, the higher the price volatility for fixed interest securities with the same coupon rate

                The higher the coupon rate, the lower the price volatility for fixed interest securities with the same maturity date.

 

4.9 Other factors affecting the yield of debt securuites – SG 4.42

 

4.9.1 Credit Risk – SG 4.42

Ability to pay and ability to survive

See figure 4.13 SG 4.42

 

4.9.2 Liquidity and Marketability – SG 4.43

First line liquidity – assets saleable on a day without severe price penalty

Second line liquidity – assets saleable over several days but with potentially high price liquidation penalties

See fig 4.14 – SG 4.43

 

Marketability

Ability to on-sell a security into the market after it has been purchased.

 

Module 5

  

5.1 Types of derivatives – SG 5.2

                Options

                Futures

                Warrants

                Contracts for Difference (CFDs)

                Forward rate agreements (FRAs)

                Swaps

 

5.1.1 Options – SG 5.2

Standardized contracts that give the buyer the right, but not the obligation to either buy or sell an asset at a specific time at a predetermined price.  Buyer pays money (AKA premium) to seller.

 

Call options – right to buy

Put options – right to sell

 

5.1.2 Futures – SG 5.3

Standardised exchange traded contracts to buy or sell securities, commodities or other assets on a specified date in the future at a price agreed upon today.

Futures contract is a legally binding agreement between a buyer and seller (deliver specified quantity and quality of item).

Buyer knows price in advance, seller locks in a fixed price at a given time in the future.

Futures are centrally cleared, settled by exchange clearing house (buyers and sellers must post initial margin around 5%, in addition the post daily settlement or variation margins to cover any losses).

 

5.1.3 Warrants – SG 5.3

Give the holder the right to buy or sell an underlying security at a given price on or before a predetermined date.

 

5.1.4 Contracts for Difference – SG 5.3

Equity derivatives that involve trading the difference between the opening and closing price of an underlying asset.

Highly leveraged and very risky

 

5.1.5 Forward Rate agreement – SG 5.4

Agreement between two parties which sets a fixed interest rate for a period beginning on a future date (start date) and ending on an agreed date (maturity date)

Usually an interest rate hedge.

 

5.1.6 Swaps – SG 5.4

Interest swap, agreement, two companies borrow equivalent amounts, and then in effect ‘swap’ their borrowing obligations (interest payments) so each will service the other’s loan on term that are mutually beneficial.

 

5.2 What participants use derivatives? – SG 5.5

Broad Classification:

Trade to manage risk

                Speculators and arbitragers

 

5.2.1 Banks and Large Financial Institutions – SG 5.5

Common ways:

                Portfolio hedging

                Locking in a future purchase price

                Asset Allocation

 

5.2.2 Commodity producers and Merchants – SG 5.5

Commodity producers and merchants issue derivatives to manager price risk

 

5.2.3 Debt Issuers – SG 5.6

Issuers of debt securities (e.g. state government authorities and large corporations actively users of derivatives )

 

5.2.4 Corporates – SG 5.6

Generally risk management purposes

 

5.2.5 Managed futures and hedge funds – SG 5.6

Managed futures funds invest soley in derivative markets

Managed futures funds exhibit negative correlation to traditional asset classes (they short the market)

 

5.2.6 Local participants – SG 5.6

Speculative traders can be:

                Scalpers – frequent and short-term market positions

                Day Traders – execute far fewer trades than scalpers and hold positions for a much longer period

Day traders take position based on their analysis of the market on the day, scalpers have no directional basis.

 

5.2.7 Market Makers – SG 5.7

Hedge risk make small profit buy and sell (“spread”)

 

5.2.8 Spread Traders – SG 5.7

movements on the price differential between one security and another

 

5.2.9 Arbitrageurs – SG 5.7

Attempt to make profit between mispricing of underlying market and derivative contract

5.3 The concept of short selling – SG 5.8

Generally involves the sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value

 

5.4 what are the risks in the market for derivatives? – SG 5.8

Market Risk – Changes in market

Liquidity Risk – risk may not be able to sell the contract at a fair market price within a reasonable timeframe

Credit Risk – Issuing party my default

Operational Risk – inadequate internal controls or failures of risk management system may lead to unexpected losses

Legal Risk – counterparties performance obligations may not be legally enforceable

5.5 Options – SG 5.9

5.5.1 The basics of options – SG 5.9

Contract between two parties in which one party (the buyer) has the right but not the obligation to buy or sell a specified asset at a fixed price, on or before a set date in the future from the other party (the seller).  Seller gets a premium

 

5.5.2 How are options traded ? – SG 5.10

Over-the-counter (OTC) options are not traded on a centralized exchange

Exchange traded options (ETOs) are traded on a formal exchange

 

5.5.3 Differences between exchange traded and OTC options

1. fit with exact client requirements – ETO’s are standardized, OTC can match user requirements

2. Credit dimensions – ETO credit risk clearing house, OTC individual counterparty

3. Pricing factors – ETO’s option price is market-determined, irrespective of the financial strength of buyer and seller.  In OTC market, option premiums not only reflect underlying supply and demand conditions, but also institutions own trading position and creditworthiness of the counterparty (among other things).

4. Valuation – ETO prices are publically available. OTC hard to value.

 

5.5.4 Exercising options – SG 5.11

ETO – notify broker who notifies clearing house

OTC – buyer notifies option seller

 

5.5.5 Key elements of an option – SG 5.11

Type of option (put or call)

Underlying asset

Strike price

Expiry date

Premium

 

Types of options

                Call – buy

                Put – Sell

 

Underlying asset

Asset option is based on

 

Strike (or exercise) price

Agreed price at which underlying asset will change.

Call option “out of the money” is price is lower than strike price.

Put option is “out of the money” if price is higher than strike price.

“at the money” is underlying price is same “or close to” strike price.

 

Expiry date

American style – options can be exercised at any time from date of purchase until (including expiry date)

European style – exercised only on specified expiry Date.

 

Premium

Cost of option

 

Break-even point

Price at which the premium is equal to the proceeds after offsetting gains or losses

 

5.5.6 Why use options? – SG 5.14

Major uses:

To tailor a market participant’s risk-return profile

Liquidity

As insurance over the underlying asset

As a leveraged investment

 

5.5.7 Advantages of options – SG 5.14

Limited risk characteristics

Flexibility

Premium income for sellers of options

 

5.5.8 Risks of using options

Risks to buyers of options – option expires (worthless)

Risks to sellers of options:

                “covered” – have underlying asset

                “naked” – don’t have addet

 

5.5.9 Overview of options Pricing – SG 5.16

Price of option has 2 components:

Intrinsic value – difference in exercise price & current underlying asset price

Extrinsic Value – residual value of the option’s premium above any

 

Factors influencing the price of an option:

                Price of underlying asset

                Proximity of strike price to the current market price

                Time to expiry

                Market volatility

                Interest rates

                Market expectations

Other factors influencing the price of an option – SG 5.18

 

5.5.10 Expiry profit (pay off) diagrams – SG 5.18

See SG 5.18 to 5.20

 

5.6 Warrants – SG 5.21

5.6.1 Overview – SG 5.21

Warrant – structured financial instrument issued by a bank or other financial institution

 

5.6.2 Key features of warrants – SG 5.21

Underlying instrument

Call or put warrants

Deliverable or cash settled

Expiary date

Exercise style

Exercise (or strike) price

Issue size

Different types of warrants:

                Trading Warrants

                Investment Warrants

 

5.6.3 Why investors deal in warrants – SG 5.23

Trading for profits

Leverage

Income

Exposure

Limited risk

Hedging

 

5.6.4 Differences between warrants and ETOs – SG 5.23

Warrants can have non-standard features, options are standardized

ASX guarantees performance in options, warrant issuers secures the warrant

Warrants are generally longer-dated compared to options

Warrants usually issued by a third party

Warrants can be short sold.

 

Advantages of Warrants over ETOs are:

Warrants tend to be longer-dated to facilitate longer term views

Some warrants pass the entitlement of the income stream to holder

Warrants are issued over broader range of underlying securities

Warrant issuers are obligated by the ASX to maintain a market, while options are priced on a quote request basis

 

Disadvantages of warrants compared to ETOs are:

Higher risk

Restricted to exercise period

The cannot be short sold

 

5.6.5 Comparing warrants and ETOs with ordinary shares – SG 5.24

Advantages of Warrants and ETOs over ordinary shares:

Downside risk is limited to value of warrant or ETO rather than full value of the share

Warrants and ETOs allow holders to gain exposure to underlying security at a fraction of the cost of the underlying security

Trading warrants and ETOs have lower brokerage costs

Warrants and ETOs receive a leveraged rate of return

Installment warrants generate a higher dividend yield compared to shares

 

Disadvantages

A premium is paid above the intrinsic value

No dividends (or franking credits) are received for the holders of trading warrants and ETOs

 

5.6.6 Trading warrants – SG 5.24

Equity warrants -Warrants over ASX listed securities

Index Warrants – linked to the performance of a share price index

Currency Warrants – exchange an amount of foreign currency for Australian dollars on or before the expiary date

Commodity warrants – linked to the performance of commodity prices or commodity based securities

Knock-out warrants – same as equity warrant, except the exercise price is struck deep in-the-money, contain a “stop-loss” price if underlying asset touches this price warrants automatically expire

 

5.6.7 Investment Warrants

Investors gain direct exposure to shares, listed property trusts and ETFs by making a part payment upfront and delaying final payment until a later date.

 

 

 

 

 

 

 

 

 

Endowment warrants

Investor pay deposit, interest accrues and dividends decrease final payment (when zero holder gets shares)

 

Capital-protected warrants

Original Investment is guaranteed.

See Capital Plus – SG 5.29

And caPELs – SG 5.29

 

Module 6

6.1 Futures – SG 6.3

Launched 1960s for Sydney Greasy Wool Futures

Expanded from then

Sydney Futures Exchange (SFE) become the SFE corporation and merged with the ASX renamed in 2010 as ASX24

 

6.1.1 What is a futures contract? – SG 6.3

Standardized agreement to buy or sell a financial asset or commodity on a specified date in the future at a price agreed upon today

Centrally cleared

Settlement can be physical or cash

 

See Table 6.1 – Exchange traded futures contracts by asset class

Equity indicies

Interest rate markets

Environment and energy

Agricultural markets

 

6.1.2 SPI 200 Futures – SG 6.4

See SG 6.4

 

Settlement of SPI 200 Futures

Settled in cash

The dollar value of one contract is index value x $25 contracts not closed out are cash settled with reference to the closing price on the last trading day

 

S&P/ASX 200 Index futures

Mini 200 futures

 

6.1.3 Using Equity futures to hedge against market risk and specific risk – SG 6.5

Every investor faces “price risk” being either:

Market Risk – risk in adverse price movement across the board market

Specific risk – risk of an adverse price movement in a specific share.

 

See SG 6.5

 

6.2 Short-term interest rate futures – SG 6.6

90-day bank-accepted bill futures contracts

 

6.2.1 Characteristics of the interest rate futures market – SG 6.7

The index system

Are quoted in percentage terms, however ASX 24 uses an index system under which the yield percent per annum is deducted from 100.

This ensures the quoted price on the market moves in the same direction as the value of the security

 

Basis risk and specification risk of interest rates

Basis risk – the margin between the physical instrument and the futures contract

Specification Risk - The interest rate asset/liability being hedged may differ to some extent from the futures contract e.g. hedging a 9 year bond using 10 year bond futures

 

6.2.2 90-day bank-accepted bill futures contracts – SG 6.8

90-day bank-accepted bill or bill of exchange futures contract may be used as a hedge for future borrowings using short-term instruments such as bank bills etc.

 

Settlement

90-day bank bill futures contract unit is $1 Million face value of bank-accepted bills

Contract delivery months are each of the calendar quarters (march, June etc) with settlement taking place on the second Friday of the delivery month

Settlement is in the form of cash or physical bank-accepted bills that have a term of between 85 and 95 days from the date of settlement

 

Purchase Price = Face Value /1+[yield x (days to maturity/365)]

 

See SG 6.8 for example

 

6.2.3 Who uses bill futures? – SG 6.8

Primary purpose of futures is to gain protection (hedge) against unfavourable market movements and so manage risk exposure

 

3 major categories of potential users of interest rate futures for hedging purposes:

1. Borrowers
2. Lenders
3. Intermediaries

 

Borrowers use interest rate futures as a hedging tool against adverse interest rate movements

See SG 6.8 for more

Lenders supplier of the funds

Market intermediaries – dealer- type activities

Speculators

 

6.2.4 Hedging using bill futures – SG 6.9

Bank Bill futures can be used to hedge either a future (anticipatory) or current position i.e. borrow or lend funds at some time in the future and wish to hedge against the risk of fluctuating interest rates.

 

6.3 Long-term interest rate futures (bond futures) – SG 6.10

Used as a tool for hedging against adverse interest rate risk

 

6.3.1 The underlying instrument – SG 6.10

Fixed Interest securities

The fundamental characteristics of long-term interest rate (‘fixed interest’) securities are:

They pay a fixed rate of interest (aka coupon)

They mature at a fixed point in time (the maturity date)

Interest (Coupon) is paid at regular intervals (usually six monthly)

The purchaser receives the face value of the investment after a specified period of time call the “term” of the investment

 

Commonwealth Treasury Bonds – SG 6.10

 

Bond Pricing Principles

Bonds have two components:

1. Interest (coupon) payments
2. Face value of the bond at expiration of its term

 

Steps in calculating the present value of a bond

1. Calculate the present value of the interest payments
2. Calculate the present value of the face value
3. Add the two present values calculated above

 

Application of the RBA bond pricing Formula

See SG 6.11

 

6.3.2 6.3.2 3-year and 10-year Treasury bonds futures – SG 6.13

Used to hedge against changes in medium and longer term interest rates (traded by ASX24)

 

Cash Settlement – see SG 6.13

 

Calculating bond Futures – SG 6.13

 

Uses of Treasury bond futures

• If anticipating future sales from their portfolios, sell bond futures now to lock in a firm selling price
• Protection from a rise in interest rates, sell bond futures against their portfolios
• If intending to participate in a scheduled future bond tender could buy bond futures to protect themselves against a fall in interest rates between now and when the tender is held
• If fin insto fails at bond tender but expects interest rates to fall, take a position in bonds by buying bond futures now.  Futures then liquidated when interest rates fall or bonds are purchased
• Super fund expecting maturing bonds to yield new investment funds in six months time, could buy bond futures to protect itself against the possibility of interest rates falling
• Corp borrower intending to issue 5-year fixed rate coupon bonds in 2 months time, could sell 3-year bond futures to offset any increases in borrowing costs caused by interest rates rising in the meantime
• Investment banks and short-term money market dealers can use the contracts to facilitate bond switching or trading the yield curve
• Trading opportunities

 

 

6.4 Contracts for difference – SG 6.15

A derivative that involves trading the difference between the opening and closing price of the underlying asset

High leverage and high risk

No fixed expiry date, contract size, but have daily financing charge

Contracts settled for the cash differential between the price of opening and closing trades

 

6.4.1 The mechanics of CFDs – SG 6.15

Investor pays an initial margin

CFD provider is the counter party

Investor holding long position pays interest to the provider, investor holding short position may receive interest from the provider

 

Benefits of CFDs:

Investors can trade on margin

Easy to use and understand than most derivatives

Offer potentially high returns (at a high risk)

Enable investors to receive dividends paid on the underlying share on long positions and participate on stock splits, no voting and no franking credits

Enable investors to receive interest on short positions

Useful tool for short selling

Enable investors to take long or short positions, thereby benefit from both rising and falling markets

 

6.4.2 Risks involved in trading CFDs – SG 6.16

High levels of gearing

Margin calls

Counterparty risk

Provider not a market maker

Response timing

Accuracy of pricing

 

6.5 Forward rate agreement – SG 6.17

Agreement between 2 parties wishing to hedge against future movement in interest rates.  Interest rate cover is for a period beginning on a forward start date and ending on the agreed maturity date

Seller of the FRA is obliged to compensate the buyer of the FRA for a rise in interest rates, buy compensates the seller for a fall in interest rates.

 

6.5.1 Risk Exposure – SG 6.17

No commitment to principle, only interest rate differtial

 

6.5.2 Advantages – SG 6.18

No margin calls

Flexibility

Limited credit risks

Off balance sheet

 

6.5.3 Disadvantages – SG 6.18

Liquidity

Credit risk

 

6.5.4 Parties to an FRA – SG 6.18

See SG 6.18

6.5.5 Calculating the settlement for an FRA – SG 6.18

See SG 6.18

 

6.5.6 FRAs and futures – SG 6.19

See SG 6.19

 

 6.6 Swaps – SG 6.20

Highly traded derivative between large instos

Swaps can be interest rates and currencies

 

6.6.1 Equity Swaps – SG 6.20

Over the counter exchanges of cash flows in which at least one of the indicies is an equity index

See SG 6.20

 

6.6.2 Advantages – SG 6.21

6.6.3 Disadvantages – SG 6.21

 

6.6.4 Uses of equity swaps – SG 6.21

Diversify exposure

Asset allocation

Outperformance tool

 

Module 7: Managed Investment Portfolios and structures

 

7.1 Types of Managed investments – SG 7.2

Most common types of Managed Investments are:

Managed funds (unit trusts)

Listed managed investments (A-REITS)

Insurance investment products

 

7.1.1 Managed funds – SG 7.2

Pooled investments where ownership of the fund is divided into equal units (unitized).  Unit holders have the right to capital and income distributions is proportion to unit holdings.

Unit prices fluctuate based on underlying assets

Managed by the responsible entity (RE)

 

Advantages of managed funds:

Units can be easily transferred

There is less regulation than a company structure

Units can be re-purchased by the fund

There may be taxation advantages generated from the underlying assets of the fund

 

7.1.2 Listed managed investments – SG 7.2

Listed managed investments or listed trusts are pooled investments that are listed on the ASX.  Most common type of listed trusts are:

                Australian Real Estate Investment trusts (A-REITS)

                Exchange Traded Funds (ETFs)

                Listed Investment Companies (LICs)

*These investments are closed-ended

 

7.1.3 Insurance Investment Products – SG 7.2

Insurance bonds (or investment bonds) are basically life insurance policies that operate for a traditional term of 10 years

Investors get associated tax benefits

Friendly society bonds are similar

 

7.2 Investment platforms – SG 7.3

Types of investment platform includes:

                Investor-directed portfolio services

                Master Trusts

                Wrap Accounts

 

ASIC considers investor-directed portfolio services (IDPSs) to be managed investment schemes due to the fact that:

“…they involve the expectation of cost savings or access to investments that are not otherwise available:.

IDPSs do not satisfy several of the requirements of a managed investment scheme as defined by the Corporations Act 2001

 

A client who uses an IDPs has the facility to make all the investment decisions, either directly or by authoring another to act on their behalf

 

A master trust invests in a range of other managed funds with individual investor selecting either the underlying investment products and fund manager or a select portfolio of managed funds determined by a nominated risk profile

 

A wrap account is similar to a master trust, but acts as a custodial service, with investments made in an individual investors name

 

7.3 Regulated Superannuation Funds – SG 7.3

Many Superannuation investors find their funds invested in managed investment schemes

See fig 7.1 – SG 7.4 – types of managed funds in Australia

 

7.4 Managed Investments in perspective – SG 7.4

Types of Managed Investments:

Unitized managed investment – unit price is value of the total net assets of the managed investment asset pool divided by the number of units on issue.

                Can be either:

                Open ended – new units offered to new shareholders

                Closed Ended – finite number of units over a fixed period, sometimes listed on ASX

 

Accounts or portfolio (mandate) managed investments are pooled investments where the investor receives either an earning rate or entire reported return

 

7.4.1 Investor Markets: Retail, mezzanine and wholesale managed investments – SG 7.4

See table 7.1 SG 7.5 (should put in notes)

 

7.4.2 History of Managed Investments in Australia – SG 7.5

1936 First Fund (Australian Fixed Trusts pty ltd)

1950s First property trust (LJ Hooker)

1974 first mortgage trust

1980 First CMT (Macquarie Bank)

 

7.4.3 The managed investment industry today – SG 7.6

Australia ranks 4^th in total funds and fastest growing managed fund market in the world

See SG 7.6 for key influences

 

7.4.4 Trends in the managed investments industry – SG 7.7

Industry becoming more sophisticated from an international perspective

Diversity of managed investment continues to grow

Managed funds becoming more specialized

Public interest in managed funds growth

Growth in index funds

Regulatory changes continue, confusion still abounds

Better training for those distributing investment products

Trend towards fee-based remuneration

Investor interest in alternative investments has grown

Use of technology has increased

Need to educate investors and promote benefits of investing in managed funds has developed

Increased disclosure

Value-Added services provided by Financial Advisers has grown

Increasing media coverage of the industry

 

New Products

Distribution channels and the availability of investors

The role of fund managers

 

7.5 Participants in the managed investments market – SG 7.9

Investors – retail or wholesale

Distributors

Promoters

Regulators

Custodians

Research houses

 

See fig 7.4 Participants and structure of the managed investment market – SG 7.10

 

7.6 Advantages, disadvantages and Risks – SG 7.10

7.6.1 Advantages – SG 7.10

                See SG 7.10

7.6.2 Disadvantages and risks – SG 7.11

See SG 7.11

 

7.7 Managed investments vs direct investments – SG 7.12

Managed investments have a limited life

Managed investments have specific buy-back arrangements to accommodate redemptions

Managed Investments not requires to hold AGMs unless change in constitution materially affects the majority of unit holders

RE determines how income is paid to unit holders (must distribute all income received)

Managed investments may issue and redeem units as demand requires

 

7.8 Australia: an international perspective – SG 7.12

Offers:

                Best practice regulator environment

                A skilled and multilingual workforce

                Robust business infrastructure

 

7.9 Investment options in managed investments – SG 7.13

Main investment options can be divided into:

                Sector funds or asset class funds -> invest in specific market sectors or asset classes

                Multi-Sector funds that invest in multiple asset classes or market sectors

 

Australian managed funds use the following markets:

                The Australian Securties exchange

                The international securities markets

                The money Market

                The debt market

                The property market

                Foreign exchange markets

                Derivatives market

 

Alternative investment vehicle characteristics:

                Relatively limited investment history

                More commonly held by institutional investors than retail investors

                Distinctly different features from more traditional asset classes

                Requires specialist skills to manage

 

7.9.1 Single Sector Funds – SG 7.13

Single sector funds invest majority of funds in one asset class:

                Cash

                Bonds (fixed interest securities)

                Property

                Equities

 

Cash funds – AKA CMTs, earn higher interest rates

 

Bond and Fixed Interest funds

Invest in longer-term fixed interest securities (maturity exceeding 12 months)

 

Australia fixed interest funds

Returns generated by:

1. Coupon or interest payments
2. Earnings from Trading Securities
3. Credit order of Risk (Commonwealth Government Securities, semi-government securities, corporate securities)

 

International fixed interest funds – have currency movements as well

 

Mortgage funds

Invest in debt of mortgage, in default manager sell property

See SG 7.15 for more details

Liquidity issues may occur similar to the GFC

 

Property funds

Invest in diversified commercial properties

Benefits:

                Liquidity

                Quality of property

                Diversification

                Valuation

                Transaction costs

 

Property syndicates – long-term property investment strategy

Most are unit trusts (5 to 10 years investment term)

At end of term property is sold, net proceeds to investors

Differ from A-REITs in:

                Sell properties once investment team is complete

                Fewer but larger investors

                Fewer but larger investors

                Have pre-specified investment assets

                Do not offer ready liquidity

 

Unlisted property trusts

See SG 7.18

 

Australian Share funds

Large cap – invest in large capitalization stocks

Small cap – invest in small capitalization stocks

Value – invest in low price relative to fundamental value

Growth – invest in fast growing, tend to have high price relative to some fundamental economic variable

Market Neutral – fund has characteristics similar to broad market

 

Australian funds also have a specialization bias:

                Blue Chip (or large cap) share funds

                Ethical investment funds

                Industrial share funds

                Resource share funds

                Imputation funds – regular dividends

                Index Funds – attempt to match index

 

International Share funds

                Invest in companies listed outside Australia

                Often called Global funds

                Bring diversification benefits

 

Specialised international share funds include:

American, European and Asian share funds

Emerging market share funds

Global technology share funds

Global health and biotechnology share funds

Global resources share funds

Global renewable energy share funds

Global small companies funds

 

Emerging markets (country funds)

South America (brazil, argentina, chile and Colombia)

Eastern Europe (Russia, Poland, Czech republic)

Asia (China, india, Malaysia, Philippines and Taiwan)

Africa (south Africa)

Mediterranean (Greece, Israel, Turkey)

 

7.9.2 Multisector funds – SG 7.21

Mix of:

                Cash

                Fixed interest

                Property

                Shares

                Alternative investment vehicles

See table 7.3 – Sample diversified funds – SG 7.21

 

Capital stable funds – SG 7.21

Capital protected funds – SG 7.22

Balanced Funds – SG 7.22

Growth funds – SG 7.23

 

7.9.3 Hedge funds (absolute return funds) – SG 7.25

Can go long or short

Common features:

                Investments across any asset class or market

                Free choice of trading style

                Free choice of derivative instruments

                Restricted fund transparency

                Ability to leverage the original principal amount

 

Hedge fund strategies:

                Macro or Global

                Market neutral

                Market timing

                Opportunistic

                Directional

                Short Selling

                Special Situation

 

Characteristics of hedge funds

See Table 7.6 Traditional funds and hedge funds – SG 7.27

 

7.9.4 Infrastructure funds – SG 7.27

2 types economic infra structure and social infrastructure

Economic infrastructure:

                Transportation links

                Transportation nodes

                Power

                Water

                Telecommunications infrastructure

 

Social infrastructure includes:

                Schools and educational facilities

                Hospitals and other health facilities

                Housing

                Correctional facilities

 

Characteristics of infrastructure funds

                Typically monopoly/oligopoly elements

                High initial capital cost

                Time consuming to build

                Long lifespan

                Exist to support other economic/social activities

                Illiquidity

 

7.9.5 Other asset classes for managed funds Investment – SG 7.28

Private equity

Commodities

Managed derivatives funds

Endowment funds

Catastrophe bonds

Life settlements

Art/thoroughbreds/ostriches/films

Timber plantations

Distressed debt

Emerging market debt

 

7.10 Other investment schemes – SG 7.29

7.10.1 Exchange-Traded funds – SG 7.29

7.10.2 Listed investment companies – SG 7.29

See SG 7.29

 

7.10.3 Insurance bonds – SG 7.30

See SG 7.30

 

7.10.4 Friendly Society bonds – SG 7.31

Similar to insurance bonds

 

Module 8: managed Investment Administration Platforms and costs

 

8.1 Administration Platforms – SG 8.2

8.1.1 Master Trusts – SG 8.2

A managed investment structure that enables an investor to access one or more underlying investments, providing a central administrative hub and single reporting structure

Master trusts can include feeder funds and fund of funds structures within their choice of funds

Master trusts can include feeder funds and fund of funds structures within their choice of funds.

Master Trusts are offered in two investment formats:

1. Discretionary – Investor picks fund and fund manager
2. Non-Discretionary – sponsoring manager selects underlying fund managers and packages them into a single investment

Master trust advantages are: Consolidated reporting and cost-effective fee structures

 

See fig 8.1 – Structure of a master trust – SG 8.2

 

8.1.2 Wrap and custodial services – SG 8.3

Virtually identical to discretionary master trusts

Legal structure differs in they don’t have an overlapping trust

Wraps use a custodian to hold and acquire managed funds and other assets

Wraps are just custodial and reporting services, no single responsible entity and no PDS

Lower cost than retail investor, consolidated performance and tax reporting

 

8.1.3 Investor-directed portfolio services – SG 8.3

Collectively master trusts and wrap services are known as investor-directed portfolio services (IDPSs)

 

Main features of IDPSs are:

Operators must hold AFSL (specially authorizes them to run an IDPS)

Investors in IDPS receive a FSG

Investors will receive same disclosure documents as individually investing

Investors using IDPS receive quarterly statements

IDPS operates and investors may elect to receive information electronically

 

Advantages of IDPSs:

Access to wholesale-priced funds

Convenience of delivering consolidated tax and investment reporting

Individual privacy

Ability to create a mixed portfolio of investment assets (all professionally held)

 

Disadvantages:

Limited extra services or rights that accompany direct share ownership

Ongoing management fees

 

8.1.4 Individually-managed accounts and separately-managed accounts – SG 8.4

IMAs (individually managed accounts) and SMAs (separately managed accounts) are managed accounts

PDF, FSG both required

 

(MDAs) – Managed discretionary accounts allow investment decisions to be made at adviser’s discretion, separate legal agreement needs to be signed by client and account manager

 

Benefits using IMAs / SMAs:

Access to professional investment management

Tax-effective portfolio management

Direct ownership of the underlying securities, which limits the effects of other investor actions on an investors own portfolio

Cost – SMA style similar to wholesale managed funds

Ability to screen individual assets in a portfolio (IMAs only)

Lower turnover portfolios for lower costs and fewer capital gains tax events

Portfolio weighting can follow a broad range of asset allocation

Greater transparency, information and reporting

 

IMAs and SMAs limitations:

Investment minimums are higher than managed funds

Practical considerations of individual service and increased client contact

May not generate significant after-tax performance above managed fund

Low number of portfolio managers currently offer portfolio management services

Cost especially IMA-style managed accounts

See table 8.1 – SG 8.5

 

8.1.5 Fund of funds – SG 8.6

Managed fund that invests in other funds

See fig 8.2 – SG 8.6

 

8.1.6 Feeder funds – SG 8.6

RE sets up a group of funds that feed their investments contributions into other funds operated by that RE.

 

8.2 Costs of Managed Investments – SG 8.7

 

8.2.1 Categories of fees – SG 8.7

                1. Entry fees

                2. Exit fees

                3. Ongoing fees

 

Retail fund fees made up of:

                Management fee for the fund manager

                Custody fees for the custodian

                Other operating expenses

 

Wholesale fund fees – lower then retail doesn’t pay financial adviser commissions

Mezzanine fund fees – no upfront fees, lower ongoing fees than retail but higher than wholesale funds.  Mezzanine funds need to provide a PDS

 

8.2.2 Indirect Cost Ratio – SG 8.8

Indirect Cost ratio (ICR) is a measure of the costs incurred by an investor for investing in a managed fund covers all costs

 

8.2.3 Management expense ratio – SG 8.8

Measurement of fees prior to ICR (in 2006), doesn’t cover all costs

 

8.2.4 Buy/Sell spread – SG 8.8

See SG 8.8

 

8.2.5 Performance fees – SG 8.10?

Additional fee over and above basic management fee paid if fund exceeds benchmark

 

Advantages:

Fees rise and fall with performance

Fees better align investors and fund managers interests

Investors perceive fee as result of fund managers skills

 

2 Key Disadvantages

1. Performance fee based on index return (not absolute amount)
2. Performance fee may act as call option for the fund manager with all upside but limited downside

 

Module 9: Analyzing and Evaluating Investment Products

 

9.1 Evaluating equity securities – SG 9.3

 

9.1.1 Pricing a share offer – SG 9.3

Analyst needs to assess the future earnings of a company and determine what it is worth in todays dollars

Known as discounting and is key to determining the NPV of a company

Must apply a reasonable discount rate (based on prevailing interest rate and additional risk premium)

Calculation is done many years into the future, divided by number of shares to be issued gives offer price and DCF (an indication of the future performance of the investment)

 

See example 9.4

 

Estimated Value of a Company = Future maintainable earnings / discount rate

 

Issue Price = Estimated Present Value of the Company / Number of shares issued

 

9.1.2 Intrinsic value vs Market Price – SG 9.5

Intrinsic value = share price valuation based on DCF or relative value i.e. P/E relative to market benchmark

 

If the intrinsic value is close to, or equal to the current market price of the share, the share is fairly priced.

If intrinsic value is less than the current market price, share may be overpriced by market and investors should consider selling

If intrinsic value is greater than the current market price, share may be underpriced and investor should consider buying

 

9.1.3 Arriving at an appropriate discount rate – SG 9.5

Normally a risk premium (2% to 4%) is added to the risk-free rate.

Alternatively the average capital yield base (capital gains + dividends) of a particular industry which company trades can be used

 

9.1.4 Price/Earnings ratio and earnings per share – SG 9.6

Comparison to peers

EPS or P/E ration can be used to compare.

Company management also impacts prices

Earnings Per Share = Net Profit available to ordinary shareholders / Number of Ordinary shares issued

 

P/E Ratio = Current market Price / Earnings per share

 

See example SG 9.7

 

Application of the P/E ratio

P/E Ratio is an effective and easy way of comparing share offerings between companies in a comparable industry or group

 

P/E ratio disadvantages:

Determining future maintainable earnings is not easy

Industry average earnings multiple (or any other comparison multiple) is appropriate, however it should be blindly accepts

Earnings figure can be influenced by management and accounting methods

 

9.1.5 Gearing and the share price – SG 9.8

Companies debt figure is another key piece of information in determining correct share price for the issue

WACC

Typical debt level is 30% of the total equity of an industrial company

 

9.1.6 Value drivers and company specific factors – SG 9.10

Management ability

Core competencies (good financial management, trading operations, successful investment)

Real option values

Ability to take advantage of market opportunities

Quality and stability of earnings

Industry sector prospects

 

9.1.7 The Media and its impact in share offer evaluation – SG 9.12

Management and Personalities

Growth

Other recent successful listings

Innovations

 

9.1.8 Advisor Role – SG 9.12

Primary way a financial adviser and investor is made aware of a particular investments risk/return profile, benefits and characteristics is by reviewing the prospectus.

 

*Important that a financial adviser ensures investors receive and review relevant investment prospectus before investing

 

9.2 Case study – SG 9.14

 

9.3 General Investment Trading rules – SG 9.16

9.3.1 Don’t buy on rumour – SG 9.16

9.3.2 The successful investor – SG 9.16

                Is:

                Must do homework

                Open minded listener

                Patient

                Not:

                Guided by emotion

                Impulsive

                Fashion conscious

 

9.3.3 Diversification – SG 9.17

Key element in successful investing

 

9.3.4 When to Buy – SG 9.18

Safest to buy on market strength, client may wish to buy in falling market if stock is oversold

 

9.3.5 timing the transaction – SG 9.19

Timing is key element of strategy design

Critical for short term investor not as relevant for long term investor

May be gradually adding to stock position

 

Events significantly impacting markets:

Financial crisis

War or acts of terror

Political upheaval

Unexpected company risk

 

9.3.6 Stop-losses – SG 9.19

Limits losses in a falling market

 

9.3.7 when to sell – SG 9.20

Exit strategy designed with client’s objectives, characteristics and risk profile in mind

Should consider selling when:

A share is deemed to be overpriced

Outlook for earnings or sector performance deteriorates

When better value in another stock or sector

 

9.3.8 Don’t follow the crowd – SG 9.21

 

9.3.9 High return probability equals high risk – SG 9.21

If a return looks to good it usually is

 

9.3.10 Monitoring is a continuous process – SG 9.21

 

9.4 Market indicies – SG 9.22

Index is weighted average representation of the price movements of a sample selection of shares

 

9.4.1 S7P/ASX benchmark indicies – SG 9.22

See SG 9.22

 

9.4.2 International Indicies – SG 9.23

See SG 9.23

 

9.4.3 The role of share market indicies in investment – SG 9.23

Barometer for share market performance

Used in passive share market technique

 

9.5 Debt securities: Making the investment decision – SG 9.24

Fixed interest investments, cheaper brokerage and other fees and charges, purchases of securities below par in order to make gain on maturity or sale and the anticipation of favourable interest rate movements

Steady stream of income

 

9.5.1 Credit ratings – SG 9.24

Credit rating agencies – see Table 9.7 SG 9.25

Credit analysis – see SG 9.26

 

9.6 allocating securities in an investment portfolio – SG 9.27

See table 9.8 – model portfolio – SG 9.27

 

9.6.1 Allocation of securities – SG 9.27

See SG 9.27

 

9.7 Analysis of derivatives markets – SG 9.28

9.7.1 why analyse? – SG 9.28

Analyse factors affecting prices so informed decisions enable them to profit (or limit loss) in the market concerned

Need to understand factors influencing price

 

9.7.2 Fundamental or technical analysis? – SG 9.28

Fundamental analysis

Involves examination of all relevant factors affecting the price

Ask questions such as:

What is happening to inflation in major world economies?

Are trends in overseas markets likely to have an impact on Australian interest rates, equities, commodity prices or the value of the Australian dollar?

What effect are these factors likely to have on Australian interest rate, equity, currency and commodity derivative markets?

What is the future international demand likely to be for a commodity and what supply will be available to meet that demand?

 

Technical analysis

Study of movements in price of the underlying commodity or instrument

Dependant on accurate data

Advocates believe that all market information is expressed in the market price of a commodity

Past patters reliable at predicting future

 

Combining analysis techniques

Both can be used – see SG 9.29

 

9.8 Users of derivatives – SG 9.29

Hedger – manage risk

Speculator – purely for profit

 

9.9 Speculative Trading – SG 9.30

Plays a vital role, provides depth and volume of trading which allows hedgers to enter and exit market easily at fair market prices

 

9.10 Hedging fundamentals – SG 9.31

 

9.10.1 Purpose of hedging – SG 9.31

Reducing exposure to financial and commodity price movements, catastrophes, variable operating costs and income

 

9.10.2 Hedging strategies – SG 9.31

Losses in the physical transaction are offset by profits on futures

 

Anticipatory hedging – buying derivatives position ahead of or in anticipation of later cash market transaction

 

Hedging a current market position – take derivative position opposite to position currently held

 

9.10.3 How much of the exposure should be hedged? – SG 9.32

Suggested coverage of 60-75% of projected sales or purchases (but is dependent on many factors)

9.10.4 Choice of delivery months – SG 9.32

Ideally contract expires at the same time as the cash transaction takes place

 

9.10.5 The concept of basis risk – SG 9.32

Basis Risk – cash and futures price differ

Other forms of business risk are:

                Delivery basis

                Grade basis

                Location basis

 

9.10.6 The amount hedged – SG 9.33

Amount hedged may not correspond with physical transaction.

See SG 9.33

 

9.10.7 Differences in timing – SG 9.33

Differences in time make a difference in price

 

9.11 Hedging with equity futures – SG 9.34

 

9.11.1 Anticipatory hedging with equity futures – SG 9.34

 

Contracts required = $ amount to be hedged / $value of contract

See example SG 9.34

 

9.11.2 Hedging a current market position – SG 9.35

Sell futures against the portfolio

See example SG 9.36

 

9.11.3 Using beta factors for a more precise hedge – SG 9.37

Basis risk – impacts the effectiveness of any hedging strategy

Measuring relative volatility

                Beta factor – historical volatility stock movement relative to market

Beta of whole market is 1.0 (greater than 1.0 stock is more volatile, less than 1.0 less volatile)

 

Weighted beta of a portfolio of shares

See example SG 9.38

 

9.12 Using bank bill futures to hedge short-term interest rate exposures – SG 9.39

 

9.12.1 A buying hedge using 90-day bank bill futures – SG 9.39

See SG 9.39 for example

 

9.12.2 A selling hedge using 90-day bank bill futures – SG 9.40

See example SG 9.40

The relevance of the compound factor – SG 9.41

 

9.12.3 Hedging long-term obligations – SG 9.41

See example SG 9.42

9.13 Using derivatives to hedge long-term interest rate exposures – SG 9.43

 

9.13.1 Types of hedging – SG 9.43

1. anticipatory hedging

2. hedging a current market position

 

9.13.2 Anticipatory hedging –SG 9.43

See example SG 9.43

 

9.13.3 Hedging a current market position – SG 9.45

See example SG 9.45

 

9.14 Key Points to remember when hedging with futures – SG 9.46

Money available at maturity

Convergence of futures and physical markets

Amount hedged

Amount hedged vs contract unit

Transaction fees, commission and margins

Changes in futures vs. Changes in cash instrument (basis risk)

Maturity of the instrument being hedged

 

9.15 Overview of the managed investment process – SG 9.48

Main steps:

Defining the investment objectives

Formulating an investment strategy (inc asset allocation)

Implementing a strategy (inc decisions on asset selection)

Monitoring outcomes against stated objectives

 

9.16 Defining a managed investment’s objectives – SG 9.49

Considerations for fund managers

                Target market

                Recommended or preferred investment time horizon

                Likely role of the portfolio in the investors total portfolio

                Level of risk acceptable to target investors

 

9.16.1 Risk and Return – SG 9.49

Returns should be commensurate with the amount of risk taken

 

9.16.2 Time horizon – SG 9.50

See SG 9.50 table 9.10

 

9.16.3 Example of different investment strategies – SG 9.50

See SG 9.50

Capital guaranteed

Capital stable or secure

Balanced

Growth

Other terminology

Defensive

Conservative

Moderate

Growth

High growth

 

9.17 Formulating the investment strategy – SG 9.51

Several decisions must be made:

Which asset classes are appropriate to meet funds strategy

What is expected long-term performance relative to asset classes

Should I be passive or active

Should portfolio be managed internally or outsourced

 

9.17.1 Investment style – SG 9.52

1. active management

2. passive management

 

9.17.2 Active vs Passive investment management – SG 9.53

See SG 9.53

Passive:

                Low-cost + low-risk

                Certainty of sector returns

                Not subject to performance volatility

                Not dependent on successful forecasting of future asset price changes

 

Active:

                Try to outperform market

 

Terms applied to active equity investment managers:

                Value

                Growth

                Neutral

                GARP (Growth at Reasonable prices)

                Contrarian

                Quantitative

                Technical

                Enhanced index

 

9.18 Investment Management asset allocation – SG 9.55

1. asset allocation – what to invest in

2. stock selection – how much and when to buy and sell

 

9.18.1 Neutral asset allocation – SG 9.55

AKA strategic asset allocation (SAA) risk control measure based on expectations about long-term relative performance of each asset call.

See table SG 9.55

 

9.18.2 Strategic Approach – SG 9.56

See SG 9.56

 

9.18.3 Rebalancing – SG 9.56

See SG 9.56

 

9.18.4 Tactical asset allocation – SG 9.56

See SG 9.56

 

9.18.5 Market Timing – SG 9.57

See SG 9.57

 

9.18.6 diversified or sector funds? – SG 9.57

The multi-sector approach

The single-sector approach

Asset allocation considerations

 

9.19 Investment manager selection- SG 9.58

4 P’s:

People

Philosophy

Process

Performance

 

9.19.1 People – SG 9.58

9.19.2 Philosophy and Process – SG 9.58

9.19.3 Performance – SG 9.59

 

9.20 Asset Allocation and stock selection – SG 9.59

Separate asset allocation and stock selection functions

 

9.20.1 Stock selection considerations – SG 9.59

Two principle approaches to security selection:

1. Top down and Bottom up – see SG 9.59
2. Thematic approach

 

9.21 Monitoring and Reviewing – SG 9.60

Final and crucial step

Benchmarks – SG 9.61

 

9.22 Selecting managed funds – SG 9.63

9.22.1 Investment Process – SG 9.63

Can be summarized as:

1. Define investment objectives
2. Select the optimal asset class mix to achieve objectives
3. Select Managed funds that will provide desired asset allocation exposure
4. Select managers that will add value above strategic asset allocation

 

Step 1 – define investment objectives

                Time horizon

                Risk tolerance

                Constraints

                Return expectations

 

Step 2 – Select optimal asset class mix

Step 3 – Select managed funds

Step 4 – Select managers that add value

 

9.22.2 Analysis of managed funds – SG 9.64

See SG 9.64 for criteria

 

9.22.3 Identifying manager skill – SG 9.66

People

Philosophy

Process

Performance

 

Sources of information: PDS, Half year and fell-year reports to investors, websites

 

Monitoring investment managers

Performance

Strategy

Purpose of information

Reviewing investment managers

 

Module 10: Regulation, Documentation and Tax

10.1 Regulation of the securities industry – SG 10.3

10.1.1 ASIC – SG 10.1

ASIC is an independent Commonwealth government authority established by the Australian Securities and Investment Commission Act 1989

ASIC administers the corporations act 2001 and the Australian Securities and Investment Commission Act 2011

 

ASIC’s key responsibilities include:

Consumer protection in financial products and services

Licensing financial services providers

Regulation of companies and their conduct

The issue and trading of listed and unlisted financial products

Supervision of securities and futures industries and markets (ASX and ASX24)

Registration of auditors and liquidators

Approval for external dispute resolution schemes

 

Securities market supervisions

Market integrity rules – SG 10.3

Penalty up to $1,000,000

 

Consumer protection – SG 10.4

 

Enforcement – SG 10.4

Insider trading

Illegal fund raising

Fraud or theft

Misleading the market

Consumer protection issues

 

Remedies

Information

 

10.1.2 ASX group – SG 10.5

No longer co-regulator of it’s securities market

 

Monitoring of brokers, other market participants and listed entities

ASX has own listing rules

Rules replaced in 1.8.2010 by:

ASX market operating rules

ASX24 Market Operating Rules

Existing rules remain:

ASX clear

ASX clear (futures)

ASX Settlement

Austraclear

 

ASX objectives – SG 10.6

ASX listing rules – SG 10.7

Supervision and enforcement of the operating rules – SG 10.8

 

10.2 Inside a stockbroker’s office – SG 10.10

Institutional dealing desk – portfolio management, investment advice and dealing shares on behalf of institutional investors

 

Private client desk – individual clients, manage share portfolios and may provide financial planning advice

 

Research department – research reports and analysis of companies

 

Corporate finance department:

Underwriting new company listings

Arranging share placement

Providing advice on acquisitions

Identifying new companies for stock market listing

See SG 10.12 for more

 

Money market department – placing clients money into fixed interest investments, CMT’s or on overnight call and operating futures and options markets

 

Operating and booking department – execute buy and sell orders and book to clients

 

Administrative department – accounting services, debtor control, reception/typing, legal and compliance, marketing

 

Settlement department-  processing share transfers and account reconciliations

 

10.3 Compliance with stockbroking regulations and standards – SG 10.13

 

10.3.1 Client profiles and record keeping – SG 10.13

‘know your client’ information and client profiling data must be available for inspection by the ASX

Adviser can provide any of the main types of service:

                Order execution only

                General advice and information

                Personal advice

 

10.3.2 Order taking – SG 10.14

Brokers must ensure that:

                Correct details are received from the client

                Order placed correctly in the market

                Details of orders are maintained by the firm

                Compliance requirements followed and can be substantiated by regulators

                Proof of order instructions have been received from clients

 

See SG 10.4 for more

 

10.3.3 Advice versus no advice – SG 10.15

See SG 10.15

 

10.3.4 Corporate actions – SG 10.15

Important advisers are aware of impending corporate actions 

 

10.3.5 Cash handling and trust account rules – SG 10.15

See SG 10.15

 

10.4 Debt securities operations – SG 10.16

 

10.4.1 short-term debt securities – SG 10.16

Cash – SG 10.16

Treasury notes – SG 10.16

Bills of exchange – SG 10.16

Promissory notes – SG 10.16

Negotiable certificates of deposit – SG 10.17

Repurchase agreements – SG 10.17

 

10.4.2 long-term securities – SG 10.17

Commonwealth Government securities – SG 10.17

Semi-government securities-  SG 10.17

Corporate debt – SG 10.18

 

10.5 Securities Documentation

10.5.1 Definition of a prospectus – SG 10.18

Sec 9 of the Corporation Act ‘written notice or other instrument inviting applications or offers to subscribe for securities or offering securities for subscription’

Describe:

Risk and returns of the offering

Financial position of the offering and/or issuer

Rights attached to the offering

Other relevant matters

 

10.5.2 When is a prospectus required? – SG 10.18

When an issuer who is proposing to issue new securities either equity or debt

Prospectus must be lodged and if possible registered with ASIC prior to accepting applications from potential investors

ASIC has 7 days to review a prospectus for any misleading or deceptive conduct

Exempt offerings – SG 10.19

 

10.5.3 Lodgment and registration of a prospectus – SG 10.19

Prospectuses must be lodged and registered with ASIC prior to release for subscripts to the market.  Prospectus may not be issued for shares in a company that has not yet been incorporated

See SG 10.19 for more

 

10.5.4 Materiality – SG 10.20

Section 710 of the corporations act – a prospectus must contain all the information that investors and their financial advisers would reasonably require, and reasonably expect to find in the prospectus.

See SG 10.20

 

10.5.5 Types and contents of prospectuses – SG 10.20

1. full prospectuses – SG 10.20

2. short-form prospectuses – SG 10.21

3. Supplementary prospectuses – SG 10.21

 

10.5.6 Structure of a share prospectus – SG 10.21

The summary section – SG 10.21

The company – SG 10.22

Financial information – SG 10.23

Auditor/accountant report – SG 10.23

Company forecast, analysis and risk – SG 10.23

Other information – SG 10.24

Authorisation – SG 10.24

Application form – SG 10.24

Fixed interest prospectus – SG 10.24

 

10.5.7 Improving disclosure documents – SG 10.24

Prospectuses ASIC in 2006 released guidelines:

Make prospectus as short as possible to assist readability

Leave out extraneous material

Highlight critical information

Organize information in a logical way

Provide clear navigation around the document

Consider incorporating technical and detailed financial information by reference

Use plain direct language

Use a range of communication tools (inc graphics)

Product disclosure documents

ASIC Regulatory Guide 168 Disclosure: Product Disclosure Statements contains PDS policy guidelines

 

10.6 Taxation matter for equity securities – SG 10.25

 

10.6.1 Dividend imputation – SG 10.25

prior to dividend imputation profits were taxed twice

Now shareholder is allowed a credit known as imputation or franking credit

 

Imputation credit = Dividend x (Company Tax Rate / 100 – Company tax rate)

 

10.6.2 Capital Gains Tax – SG 10.27

Assets acquired before 20 September 1985 – generally exempt

 

Assets exempt from capital gains tax

1.Assets within a complying pension

2. Taxpayers primary residence

 

Calculation of Capital Gains tax

Taxable capital gain = net proceeds of sale of asset – cost base of asset

Where:

The proceeds from the sale are net of sale costs

The cost base of the asset includes the purchase price, any capital improvements and purchase costs

 

If held form more than 12 months discounted by 50%

 

Capital loss can be used to offset other gains or carried forward can’t be used against other income

 

Calculating CGT (post 21 sept 1999 asset) – discount method – SG 10.28

1. Calculate the cost base for each part of the asset
2. Calculate the gross capital gain
3. Gross capital gain = net proceeds of sale of asset – cost base
4. For assets held longer than 12 months, multiply result in step 2 by 50%
5. Calculate the assessable capital gain = gross capital gain – CGT discount amount
6. Offset any available capital losses
7. Add the assessable capital gain to other assessable income to determine the overall tax liability

 

See SG 10.28 for example

 

Calculating CGT (pre 21 sept 1999 assets) indexation method – SG 10.29

See SG 10.29

 

10.6.3 Earnings from fixed interest investments – SG 10.31

Dixed interest income is fully assessable in the year it is paid and taxable at the investor’s marginal rate

True return needs to take into account individuals relevant tax rate i.e. interest income x marginal tax rate

See example 10.31

 

10.7 Supervision of derivatives trading – SG 10.31

ASX supervises market behavior of it’s participants

ASIC regulates Australia’s futures markets

 

ASX24 has additional rules being:

Conduct markets in fair, orderly and transparent manner to protect interests of participants and general public

Formulate rules and supervision governing the operations of futures markets

Lay code of behavior

Provide necessary organization and support facilities to achieve the above three aims

 

10.7.1 ASX24 Operating Rules – SG 10.32

See SG 10.32

 

10.7.2 contract Specifications and associated rules – SG 10.32

See SG 10.32

 

10.7.3 Trading principles – SG 10.32

See SG 10.32

 

10.7.4 ASX24 Trading Participants – SG 10.32

2 categories:

                Full participants – Trade themselves and clients

                Full proprietary participants – Trade themselves

 

Clearing participants – SG 10.32

Admission criteria – SG 10.33

 

10.7.5 Client agreement and trading behavior of participants – SG 10.33

See SG 10.33

 

10.7.6 Discipline of participants, penalties and code of behavior – SG 10.34

See SG 10.34

 

10.7.7 Trading on ASX24 – SG 10.35

See SG 10.35

 

Execution brokers and clearing brokers – SG 10.35

ASX and ASX24 trading system upgrade – SG 10.35

 

10.7.8 The Role of the clearing house – SG 10.36

See SG 10.36

 

10.7.9 ASX Clear (futures) – SG 10.36

ASX clear (futures) has full responsibility for the registration, clearing and processing of all trades executed on ASX24

Functions of ASX clear (futures) – SG 10.36

 

10.7.10 Initial Margin – SG 10.37

Every trader must pay an initial margin for each contract they trade

 

10.7.11 Variation Margins – SG 10.37

Any adverse price movements in market must be covered daily with further deposits known as variation margins

Marked to market – SG 10.37

 

10.7.12 Margin Calls – SG 10.38

Instruction seeking payment of a variation margin is called a Margin Call

 

10.7.13 Current developments in operating rules and market supervisions – SG 10.38

See SG 10.38

 

10.8 Conduct of derivatives business – SG 10.39

10.8.1 Confirmation of trades – SG 10.39

Issue of contract notes (containing: date of transaction, description of transaction, amounts paid or payable, taxed) – retail only

 

Protection of client money – maintains separate accounts for each customer (retail and wholesale)

 

Other conduct provisions – see SG 10.39

 

10.8.2 Introducing a client to the market – SG 10.40

See SG 10.40

 

10.8.3 Accounts and Audit – SG 10.40

Accounts to be kept by a licensee

Appointment of auditor by licensee

Licensee’s Account

Reporting Requirements

 

10.8.4 Compensation Arrangements – SG 10.41

 

10.8.5 Offence Provisions – SG 10.41

Offences:

Insider trading

Dishonest conduct

Trading intended to create an artificial price

False and misleading statements likely to induce persons to deal or to affect the price

Fraudulently inducing a person to deal in financial products

Misleading or deceptive conduct

 

10.8.6 Trading Requirements – SG 10.41

Licensees are required by the Corporations Act to give priority to client orders

See SG 10.41 for more

 

10.9 The OTC Market – SG 10.42

Derivatives traded OTC include:

Interest rate and currency swaps

Interest rate caps, collars and floors

Forward rate agreements (FRAs)

Swaptions

Currency options

Bond Options

Synthetic agreements for forward exchange

Equity derivatives

Commodity Transactions

Electricity derivatives

 

10.9.1 OTC documentation – SG 10.42

Use master agreement

 

International Swaps and Derivatives Association – SG 10.43

Structure of the ISDA Master Agreement – SG 10.43

Other Master Agreements – SG 10.43

*where there are inconsistencies between the master agreement and the schedule, the schedule prevails, where inconsistency between schedule and the confirmation the confirmation prevails

 

10.9.2 Processing derivative transactions – SG 10.44

See SG 10.44

 

10.9.3 Back Office (operations) – SG 10.45

Recording

Dealing ticket

Deal-time

Direct feed

Confirmation of transactions

Settlement of transactions

Reconciliation

 

10.9.4 Middle office – SG 10.46

 

10.9.5 Self Regulation – SG 10.47

 

10.10 Taxation issues to consider for derivatives – SG 10.47

See SG 10.47

 

10.11 regulation of managed investment schemes – SG 10.48

10.11.1 Duties of an RE

Act in best interests of investors

Act honestly

Exercise appropriate skill, care and diligence

Treat all investors fairly

Treat investors of same class equally

 

10.11.2 constitution – SG 10.48

10.11.3 Compliance committee – SG 10.48

10.11.4 Compliance Plan – SG 10.49

10.11.5 Custody of Assets – SG 10.49

10.11.6 withdrawing from a fund – SG 10.49

10.11.7 complaints procedures – SG 10.49

 

10.12 Product Disclosure Statements – SG 10.50

10.12.1 what is a Product Disclosure statement? – SG 10.50

A compulsory document that describes how a managed investment is structured and how its investment decisions are made

Mandatory since march 2004

 

Supplementary product disclosure statements – SG 10.50

Electronic product disclosure statements – SG 10.50

Short form product disclosure statements – SG 10.50

 

10.2.2 contents of a product disclosure statement – SG 10.51

See SG 10.51

Introduction to the responsible entity – SG 10.51

The investment style, strategy and general notes – SG 10.52

Summary – SG 10.52

Managed Investment details – SG 10.52

Investing in the Managed Investment –SG 10.53

Additional Information – SG 10.53

Application form – SG 10.53

 

10.12.3 Master Trusts and Investor directed Portfolio services – SG 10.54

See SG 10.54

 

10.12.4 How a product disclosure statement helps clients – SG 10.54

If investment is appropriate for them

 

Problems with PDS accessibility – SG 10.55

The importance of adviser compliance – SG 10.55

 

10.13 Taxation treatment of managed funds – SG 10.55

See SG 10.55

 

10.13.1 Income and Taxation – SG 10.56

Entitlement calculated either by:

Cents per unit

Cents per unit days

 

10.13.2 Tax components of income distributions – SG 10.56

Australian income

Imputation credits

Capital Gains

Foreign Income

Foreign Tax credits

 

10.13.3 Tax-paid managed investments – SG 10.57

Insurance and friendly society bonds

Tax free after 10 years

Withdrawal prior to 10 years – SG 10.58

Additional Contributions (the 125% rule) – SG 10.58

 

10.13.4 taxation issues surrounding property funds – SG 10.60

 

Depreciation benefits – SG 10.60

Tax-deferred income – SG 10.60

 

10.13.5 Other managed Investments – SG 10.60

10.13.6 Individually and separately managed accounts – SG 10.60