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Suggested answers and examiner’s comments

Portfolio Management February 2015 Important notice When reading these suggested answers, please note that the answers are intended as an indication of what is required rather than a definitive “right” answer. In many cases, there are several possible answers/approaches to a question. Please be aware also that the length of the suggested answers given here may be somewhat exaggerated compared with what might be achieved in the reality of an unseen, time-constrained examination. Examiner’s general comments The pass rate for this paper was 55%. There was one really outstanding answer script achieving a Distinction – 14 percentage points above the next best scripts attaining Merit grades. The main area of weakness was in Section C, with the average mark for all questions falling below the pass rate – though this was only marginally the case for Questions 12 and 14. Question 13 was generally poorly answered. Students are urged to write and present their efforts clearly. In too many instances, the writing was not legible and made marking extremely difficult.

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Section A Answer all parts of Question 1. Select only one of the options A, B, C or D for each part. 1 (i) In portfolio analysis, the measure of a fund manager’s ability to generate excess returns is:

A Alpha

B Variance

C Beta D Standard deviation

(ii) An index-linked bond:

A Has its value linked to the performance of an equity market index such as the FTSE-100.

B Is purchased by managers of index-tracking funds. C Is used as the basis for valuing index options. D Has its value linked to movements in a specified index of price inflation.

(iii) As a result of the Financial Services Act 2012, some of the responsibilities of the UK

Financial Services Authority were taken over by the: A Securities and Exchange Commission B Financial Conduct Authority C International Capital Markets Association

D British Bankers Association (iv) If the returns on two assets are perfectly positively correlated, it suggests that:

A Investors can reduce risk through asset diversification. B It would be theoretically possible to create a risk-free portfolio of the two assets.

C There is no risk reduction effect linked to asset diversification. D Investors should avoid both assets.

(v) In finance, the term ‘arbitrage’ describes situations where:

A Two parties negotiate the price of an asset. B A third party settles a disagreement over the price of an asset. C A certain profit is available due to price differences on similar assets. D A trader buys at one price and later sells at a higher price.

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(vi) In futures markets, the term ‘settlement price’ refers to the:

A Price at which two parties agree to trade a futures contract. B Price used as the basis for crediting and debiting daily gains and losses to and from

contract dealers. C Standard amount of the reference asset delivered under the terms of a futures contract. D Difference between the prevailing price of the underlying asset and the futures price.

(vii) In the standard Capital Asset Pricing Model, the expected return on an asset is a function of

its beta, the expected return on the market portfolio, and the:

A Standard deviation of returns. B Return on risk-free assets. C Degree of leverage employed in acquiring the asset. D Specific risk of the asset.

(viii) In fund management, tracking error is the difference between the:

A Return on a fund and the return on a benchmark portfolio. B Expected value of a fund and its actual value. C Market value of a fund’s assets and the market value of the fund itself. D Gross value of a fund and its value after the subtraction of management charges.

(ix) The Sharpe ratio measures the:

A Total portfolio return as a ratio of the portfolio’s total risk. B Portfolio risk premium as a ratio of the portfolio’s total risk. C Portfolio risk premium as a ratio of the portfolio beta. D Portfolio risk premium as a ratio of the risk-free return.

(x) Which of the following statements concerning private placings is not true?

A Placings involve the sale of new shares to selected shareholders. B Placings can enable the issuing company to raise funds without producing a

prospectus. C Placings cause ownership dilution for many shareholders. D Placings normally involve new shares being sold at discounts in excess of 20%.

(Total: 10 marks)

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Suggested answers

(i) A Alpha

(ii) D Has its value linked to movements in a specified index of price inflation.

(iii) B Financial Conduct Authority

(iv) C There is no risk reduction effect linked to asset diversification.

(v) C A certain profit is available due to price differences on similar assets.

(vi) B Price used as the basis for crediting and debiting daily gains and losses to and from

contract dealers.

(vii) B Return on risk-free assets.

(viii) A Return on a fund and the return on a benchmark portfolio. (ix) B Portfolio risk premium as a ratio of the portfolio’s total risk.

(x) D Placings normally involve new shares being sold at discounts in excess of 20%.

Examiner’s comments

There was an improvement in this section relative to previous cohorts with more than a quarter of candidates achieving almost full marks for Section A. No candidate achieved full marks in Section A at the last exam. Three candidates did so this time around.

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Section B Answer all ten questions. 2 Explain what a ‘repo’ is and outline the key characteristics of a repo arrangement.

(4 marks) Suggested answer Repo = sale and repurchase agreement. In formal terms a repo involves the sale of securities to a counterparty (normally a broker) and simultaneously agreeing to repurchase them at an agreed price some point in the future. Repos are short-term arrangements of less than one year maturity with the majority exhibiting considerably shorter maturities, often as little as one day. In substance, a repo is a mechanism for borrowing money short term to finance the acquisition of assets. The repo buyer ‘sells’ the assets to the broker in return for funds needed to finance the purchase of the same assets. The agreement to buy the assets back at a later date means that the funds forwarded by the broker are really a short-term loan to finance the purchase. This is demonstrated by the fact that the broker charges a repo rate, which is effectively an interest rate on the short-term loan.

Examiner’s comments

Question 2 produced a significantly higher average score than the other questions in Section B.

3 Explain two reasons for including bonds as part of an investment portfolio.

(4 marks) Suggested answer Plain vanilla bonds are considered to be a less risky investment than equities. In the case of government bonds, those of many countries are considered virtually free of default risk. Hence capital can be shifted in and out of bonds as a facet of risk-management practice. For instance, a shift towards investment in bonds may reflect fears about the prospects for equities and a desire to seek a safer haven. Some investors may have strategic objectives that make bond investments the most suitable. Liability funding-style obligations, associated for instance with pension funds, tend to favour the wealth and cash-flow certainties of bonds relative to equity. Bonds may form part of a high-risk investment initiative if their acquisition is highly leveraged. The appeal is that the cost of borrowing funds to purchase bonds is liable to be significantly lower than the cost of borrowing to leverage equity acquisitions. Examiner’s comments

This question was among the less well answered. Answers were generally not precise enough to warrant high marks.

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4 An investor holds shares with a broker worth £30,000, half of which were bought using a loan from

the broker.

(a) Calculate the investor’s margin in value and percentage terms. (b) If the value of the shares falls to £25,000, what is the new margin?

100Value Total

MarginMargin Percentage

(4 marks) Suggested answer

(a) Investor margin is £30000 – £15000 = £15000

In percentage terms: %5010030000

15000

(b) Investor still owes £15000. Hence the margin has fallen to £10000. In percentage terms the

margin is:

%4010025000

10000

Examiner’s comments

Many candidates achieved full marks for this question. The average score, though quite good, was however dragged down by a smaller number of candidates who scored zero or one mark.

5 Explain the term ‘actively-managed fund’. (4 marks)

Suggested answer Investment funds that involve managers adopting trading and investment strategies that aim to exceed the performance of predetermined benchmarks as opposed to achieving merely the benchmark outcome. Active fund management is about managers beating the benchmark on a risk-adjusted basis. Furthermore, they need to beat the benchmark by more than the additional management costs. It encompasses a variety of investment styles.

Examiner’s comments

Students were awarded marks for outlining issues such as bottom-up/top-down investment strategies. The good average mark for this question suggested that a large number of candidates succeeded in answering the question competently.

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6 An investment fund has a three-year loan on which it pays an annual rate of interest equal to the

one-year London Interbank Offered Rate (LIBOR) plus 2%. One-year LIBOR currently stands at 1.4%. The fund manager believes that LIBOR is liable to rise over the next few years and intends to enter into a swap agreement to fix the interest rate on the loan. A bank quotes a three-year swap rate on LIBOR of 2.7% - 2.8%pa.

Calculate the current variable rate paid by the fund, and the three-year fixed rate that it can achieve via a swap. Compare the two rates. (4 marks) Suggested answer Current rate = 1.4%pa + 2%pa = 3.4%pa. Company needs to receive LIBOR under the swap to neutralise payment of LIBOR on the loan. It therefore pays swap rate of 2.8%pa (the higher side of the spread). Therefore: Fixed rate = 2%pa + 2.8%pa = 4.8%pa The fixed rate is higher than the current variable rate. But, if LIBOR exceeds 2.8%pa, the swap offers a cheaper loan rate. Examiner’s comments

The average mark for this question was two out of four. However, the question was answered very well by some candidates, and rather badly by other candidates.

7. Explain two differences between the full and synthetic replication methods employed by index-tracking funds.

(4 marks) Suggested answer Full involves holding all the assets in the index in proportion to the weighting in the index. Synthetic involves derivative agreements (such as an OTC equity swap) designed to imitate the performance of the index. Adjustments to full replication trackers involve trading the constituent assets to maintain appropriate weightings. Adjustments to synthetic replication trackers consist of cash and asset exchanges between two counterparties on agreed settlement dates. Full replication funds tend to incur higher trading costs as a result of the desire to sustain tracking accuracy. Synthetic funds incur costs in the form of swap arrangement fees charged by counterparties and third-party custodial fees related to the management of collateral. Examiner’s comments

It was notable that no candidate scored full marks for this question. The answers were generally too imprecise with evidence of pure guesswork in many instances.

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8. Identify two ways in which ordinary shares differ from corporate debt securities, explaining the

significance of the differences. (4 marks) Suggested answer Ordinary shares do not offer contractually-predetermined cash flows. They offer the prospect of dividend payments, but there is no legal obligation for companies to pay dividends; and, where they do, the size of the payment is at the discretion of the board of directors. Normally ordinary shares do not have specified redemption dates or amounts. Shareholders get back their investments through the sale of shares rather than the repayment of principal on a given maturity date. The secondary market in trading ordinary shares is therefore more active than the secondary trading of corporate debt securities. It also means that the size of the payback is less certain, being dependent upon a market valuations rather than a legally-promised payment. Ordinary shares entail greater exposure to default risk. Shareholders are the first to experience erosions of wealth if firms experience operating losses, and, in more extreme cases, it is the investors who stand to lose most in the case of bankruptcy. But the risks work both ways. Shareholders are liable to benefit more than bondholders from corporate success. Examiner’s comments

As with some other questions requiring precise definition, many answers were vaguely relevant rather than outright wrong.

9. Explain the similarities and differences between bonus issues and stock splits. (4 marks)

Suggested answer Similarities Both refer to adjustments in the structure of a company’s equity capital. Neither involves a company receiving cash in exchange for shares. Differences A bonus issue involves issuing new shares with the same characteristics as existing shares, most importantly with the same par value. It produces a readjustment of the shareholders’ interest towards the share account and away from accounts such as retained profits or share premiums. A stock split involves a company issuing additional shares to existing shareholders with a reduction in the nominal value of each share in direct proportion to the increase in the number of additional shares issued. Examiner’s comments The second highest average mark for Section B was attained with this question. From the answers provided, this question appeared more familiar to candidates than some other financial securities/arrangements.

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10 Define the term ‘duration’ and explain how it can be useful in assessing the risk associated with

bonds. (4 marks)

Suggested answer Duration is a measure of the maturity of a bond which emphasises not just the loan redemption

date but the terms to maturity of each cash-flow accruing on a bond. It is therefore a weighted

average term to maturity.

It is a useful concept for assessing the market risk of bonds, i.e., the sensitivity of a bond’s price to

alterations in yields. Higher duration bonds may be considered more risky than lower duration

bonds.

Examiner’s comments The definition of ‘duration’ is quite technical and a lack of knowledge was apparent in many of the answers. Only two students scored full marks.

11 Explain the meaning of a ‘stop’ and a ‘limit’ order in the context of security trading.

(4 marks) Suggested answer A stop order is an instruction to a broker to trade a security in the event of the stop order price being reached. For instance, a buy-stop order is set above the prevailing market price and is executed if the price is reached in the market. A limit order is a ‘no worse than’ instruction to a broker. For instance, a sell limit order is an order to sell at a price not lower than X, whereas a buy limit order is an instruction to purchase at a price no higher than X. The execution of limit orders depends on how security prices evolve over the lifetime of the limit order.

Examiner’s comments This question was poorly answered overall. The answers generally lacked precision.

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Section C Answer two questions only.

12 A UK-based investment fund is due to receive a dividend payment of €300,000 three months from today. It intends to convert the euros to sterling. The spot exchange rate and annualised interest rates on three-month money-market transactions are:

Euros per pound: €1.2581 Three-month sterling money market rate: 1.5%pa Three-month euro money market rate: 0.5%pa

(a) Explain the nature of the exchange rate-risk that the UK fund faces in relation to the

forthcoming receipt of €300,000 and discuss the fund managers’ options with regard to managing the risk.

(12 marks)

(b) Calculate and comment on the fixed forward exchange rate that the fund can achieve through undertaking money-market transactions. Use the following formulas:

t

r1

FlowCash Borrow

t

r1FlowCash Value Future

(13 marks)

(Total: 25 marks) (Total: 25 marks)

Suggested answer (a) The exchange-rate risk is that the euro might depreciate against sterling over the next three

months. If this were to be the case, then the €300,000 would translate into fewer pounds sterling, thereby having an adverse effect on the potential sterling-denominated worth of the fund and the wealth of the fund’s investors.

One option is to do nothing. The fund managers may judge that the euro is likely to strengthen against sterling over the next three months. If this is the case, the €300,000 will buy more in sterling in three months which will benefit the fund’s investors. But the “do nothing” option leaves the fund exposed to euro depreciation, and the management may consider it prudent to hedge against the uncertainty by fixing the exchange rate at the outset, effectively three months in advance.

The options open to the fund’s management are:

A money-market hedge whereby a specific set of money-market transactions produce a fixed three-month forward exchange rate.

An OTC forward arrangement with a bank.

£/€ futures contracts.

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(b) Given that the fund is set to receive €300,000 in three months, it could borrow euros

immediately and use the forthcoming income to pay off the loan. The euros can then be used to buy sterling today with the net effect that the exchange rate applicable to the future euro income is fixed.

The UK fund could establish a fixed sterling value for the euros, equivalent to a forward rate of €1.2550.

Examiner’s comments

Question 12 was the least popular in Section C.

In part (a), few candidates pointed out that one option is to do nothing. Other valid observations were awarded marks. For instance, currency options could be used to hedge; or the fund may be planning to reinvest euros in euro-area investments. In part (b), only a limited number of students were able to complete the numerical work successfully. The main issue was not the mathematical procedure itself but knowing the correct number to place in the equation.

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13 (a) Explain the concept of financial disintermediation in the context of corporate debt and outline

the distinctive features of securitised borrowing. (12 marks)

(b) Outline the main functions of banks in the markets for securitised borrowing. (13 marks)

(Total: 25 marks) Suggested answer (a) Traditionally companies borrowed money from financial institutions, primarily banks in the

form of term loans of various types. The banks functioned as intermediaries, converting the deposits from savers into loans forwarded to borrowers. But nowadays it is commonplace for large corporate borrowers to bypass banks and borrow money directly from investors. This development is known as financial disintermediation. It constitutes an erosion of the traditional intermediary position of banks between savers and borrowers. Disintermediation is largely restricted to the borrowing arrangements of large, well-established companies. For smaller companies, banks continue to be the primary source of credit.

Borrowing occurs in the securitised form of bonds, the basic type being a plain-vanilla bond. The characteristics of a plain vanilla bond are as follows.

The issuer borrows capital for a fixed period, starting from the issue date, and ending on a specified redemption or maturity date.

The bond specifies a repayment value, an amount paid to the owner of the bond on the maturity date. This is known by various names: par value; face value; nominal value; principal value; and redemption value.

The bond offers a fixed rate of interest expressed as a percentage of the face value. The rate is also known as a coupon rate, with the payments being called coupon payments.

There are many variations on the plain vanilla form: variable rate bonds; index-linked bonds; and callable bonds.

(b) Instead of lending funds from their own accounts, banks act as agents helping corporate

clients to arrange bond issues. It is one of many corporate client services that banks offer. The process of administering a bond issue embraces:

Advice on how to structure the issue in terms of maturity, interest payments, currency denomination, etc;

Obtaining credit ratings;

Negotiating with relevant regulatory and listing bodies;

Promoting the issue to potential investors; and

Underwriting the bond issue.

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In schematic terms, a typical bond issue involves a lead bank being mandated to act as the ‘arranger’ whose first task is to organise a syndicate of other banks willing to participate in the issue. Each bank in the syndicate agrees to subscribe to a portion of the issue, and, in the meantime, seeks to register customers prepared to buy the bonds. By the time the banks are required to pay for the bonds, they aim to have persuaded sufficient numbers of investors to take up the allotted amount. In general, banks do not wish to hold bonds themselves beyond what might be required for trading purposes.

The lead bank is paid a management fee by the borrower, and shares it out among the syndicate members. The fee covers the expenses incurred by the banks administering the bond issue as well as incorporating a premium paid for underwriting the bonds. Furthermore, the bonds are priced so that the banks can expect to sell them to clients at a modest premium. According to one survey covering of 255 corporate bond issues, when all factors are considered the average issue cost averaged just 0.37% of the funds raised. This compares very favourably with the costs of equity capital issues of a similar size. It is also possible for companies to raise funds quickly – in as little as six weeks after mandating the lead bank, according to issuing guidelines available from the London Stock Exchange. Given that the amounts of money being raised often run to many hundreds of millions (of dollars, euros, pounds, etc), this is very quick.

Examiner’s comments

Other themes in part (a) were also awarded marks, such as a discussion of the meaning and significance of Eurobond markets.

More than half of candidates answered Question 13. Too many answers suggested that little more than guesswork was going on. There were only a few strong answers.

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14 Evaluate the rival claims of the efficient market hypothesis (EMH) and behavioural finance with regard to the operation of modern financial markets.

(25 marks) Suggested answer EMH argues that prevailing prices of risky assets are the outcome of future-oriented assessments of the available information undertaken by rational investors equipped with the analytical tools furnished by portfolio theory. In effect, the EMH presumes risk-averse investors who view capital markets through the mean-variance model of portfolio theory. As a result, prices are normally ‘fair’ in the sense that there is generally no systematic tendency for assets to be under or over-valued. The claim has been extensively tested, with tests oriented towards testing efficiency in the face of particular categories of information. The classic framework poses the question in terms of whether a market can be considered weak, semi-strong, and strong-form efficient. Weak-form market efficiency

Current prices already fully incorporate the value of all insights discernible from any examination of past trading data.

Information considered is confined to the past price and trading data associated with securities and markets.

It asks: is it possible to gain valuable insights about the course of future asset prices by analysing historical price data? If so, investors can earn superior returns. More precise formulation is that they will systematically earn a rate of return in excess of that which is explained by the level of systematic risk.

If a market is weak-form efficient, analysis of price data produces only what is already known, and, therefore, already reflected in current prices. The EMH argues, in effect, that security trading based on such information does not enable traders to ‘beat the market’.

Semi-strong market efficiency

Broadens the information set to include all publicly-available information.

Poses the question: does the prevailing asset price fully reflect the implications of all the information in the public domain? Includes price data but extends to other company information (published accounts, strategic plans, media commentary, etc). It also includes consideration of issues such as competition, regulation and the overall macroeconomic climate.

If security prices are semi-strong efficient, then no amount of careful appraisal of the information can reliably produce above-average returns.

Strong-form efficiency

Asset prices reflect the impact of all information so that even investors with privileged access to information would not earn an excess return.

Few observers maintain that capital markets are efficient in the strongest sense. Behavioural finance contests the notion that investor behaviour is always in accordance with the rational-actor assumption. Studies that fall under the concept of prospect theory suggest that investors are not systematically risk-averse: behaviour is contingent on context. So, for instance, behaviour directed at avoiding losses often appears to be risk-embracing rather than risk-averse irrational behaviour according to the EMH.

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Behavioural finance points to evidence of other behavioural characteristics at odds with the risk-averse model. Among the most prominent are:

Confirmation bias: an irrational adherence to first impressions even in the face of contradictory evidence. Encourages data mining in contrast to a dispassionate examination of information.

Herd behaviour: propensity to follow prevailing investment trends which, as a consequence, often evolve into asset price bubbles.

Hindsight bias: a tendency to exaggerate one’s foresight in relation to past developments, which is reflected in a tendency to overestimate powers of predictability in relation to future events. This is liable to cause systematic over or under-pricing of assets depending on whether predictions are overly optimistic or overly pessimistic.

Examiner’s comments

The majority of candidates attempted this question, making it the most popular in Section C. There were a good number of strong marks, but this was offset by an equally significant number of exceptionally weak performances.

The scenarios included here are entirely fictional. Any resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental.