1

Introduction to Introduction to InvestmentInvestment

Bruce VineyDirector of Training and Client Services

2

Why we are here….

• Exam (syllabus valid from 1 October 2006)

– 60 minutes

– 50 Questions

– Multiple choice

– Pass mark is 70%

3

Programme/SyllabusWorkbook

Chapter

Content Questions in exam*

1 Financial Services in the UK 8

2 Asset Classes 13

3 Derivatives 2

4 Financial Products 6

5 Pooled Funds 9

6 Investment Wrappers 2

7 Financial Services Regulation 8

8 Taxation 2

Total 50

* plus/minus 2

4

IntroductionIntroduction

CHAPTER 1CHAPTER 1

•The Role of the Financial Markets•Financial Institutions•London’s Markets•The Bank of England•The UK Economy

The Role of Financial Markets

SaversBorrowers

Companies

Governments

Surplus capital, looking for a return

Need capital

The C

ity

The Role of Financial Markets

SaversBorrowers

Companies

Governments

Capital MarketsMoney Markets

BANKS

Financial MarketsSHARE

MARKETS

BOND MARKETS

Deposits

Buys shares

Loans and

overdrafts

Issues shares

Issues bondsBuys bonds

7

Financial Market stagesonward trading of shares at market

price

Company

issueshares

at£2.20 each

PRIMARYPRIMARYMARKETMARKET

SECONDARYSECONDARYMARKETMARKET

8

Financial Institutions

• Retail banks and building societies

• Investment banks

• Pension funds

• Insurance companies

• Fund managers

• Stockbrokers

• Custodians

• Credit card companies

London’s Markets

Soft commoditiesFinancial futuresTraded Options

Non-ferrousNon-precious

Brent crudeGas oilNatural gas

UK equities and corporate bondsGiltsOverseas equities and bonds

Insurance market

10

Date Event

1773 Brokers create The Stock Exchange

1986 Big Bang - major reforms

1995 Tradepoint starts in competition with LSE

1997 SETS - electronic order book

2001 Listed as a quoted company

London Stock ExchangeLondon Stock Exchange

Policy £60mSynd A £20m

The Lloyds Market

Syndicate

Clients

Broker

Members

£15m£15m

£10m

SyndicateSyndicate

Syndicate

12

World Securities Markets

• NYSE

• Nasdaq

• Euronext

• Japan

• Deutsche Borse

13

Economics

• Categorising Economies

• Gross Domestic Product

• Gross National Product

• Balance of Payments

• Inflation

• PSNCR

Market

Mixed

Open

State controlled

14

Gross Domestic Product

• Market value of goods and services produced in a country

• Measure of the level of economic activity

• Three ways of representing:

–Total GDP

–GDP per head (per capita)

–GDP growth

15

Gross National Product

• GNP for the UK is the GDP:

–Plus interest, profits, and dividends received from abroad by UK residents

–Less income earned in the UK by overseas residents

Balance of Payments• Measures the difference between money flowing into

and out of the country

Imports Exports

visible

invisibleinvisible

visible

Cur

rent

acco

unt

17

Inflation

• What is it?

• Problems caused by inflation

• Measurement

–headline RPI

–underlying RPIX

–harmonised HICP

• Caused by an increase in the money supply?

What is money?

Bank of England• Three core purposes:

– maintain integrity and value of the currency

– maintain stability of financial system

– seek to ensure the effectiveness of the UK’s financial sector

• Intervenes in the forex market (in accordance with govt policy)

• Bank for

– Commercial banks

– Government

• Sets interest rates through the Monetary Policy Committee (MPC)

Interest Rates• Short term interest rates are set by the MPC

• MPC are to use interest rates to meet a set inflation target (currently 2.5%)

• Interest rates are changed as a result of Bank of England’s dealings with banks

customer

bank

Bank of England

bankbank%

%%%

%%

MPC control this rate

LIBOR

Government Borrowing

• Government income from taxation

• Government expenditure

• Difference is called:

Public sector net cash requirement (PSNCR)

21

Foreign Exchange

• Market in currencies

• No central market

• London is the largest centre

• Dominated by banks

• Types of contract

–spot

–forward

22

Companies, Capital and Asset Companies, Capital and Asset ClassesClasses

CHAPTER 2CHAPTER 2

• Equities• Corporate actions• LSE trading and settlement• Bonds• Money market instruments• Company administration

23

Security

General term for any type of financial instrument (usually) traded on an investment exchange.

BondsEquities

Part ownership = shares Debt in the form of IOUs

In the UK, capital market securities are generally held in registered form whilst money market instruments are issued in bearer form

Equity types

Equity

type

Voting rights Dividend

Ordinary

Preference

• The two main equity types in the UK are ordinary and preference shares

• Preference shares have preference over ordinary shares in terms of:

• Dividend payment• Repayment on winding up

Variable, not guaranteed

Fixed, not guaranteed(can be cumulative)

Yes

No

25

Why own shares?• Voting

• Income – dividends

• Capital growth

• Trade perks

Risks

• Price

• Liquidity

• Issuer

26

Corporate Actions

• Types of action– mandatory

– voluntary

– mandatory with options

• Examples– bonus issue (to increase the liquidity of shares)

– dividend (to distribute profits)

– takeover offer (to acquire the shares)

– rights issue (to raise funds)

27

Rights Issues

• Company raising additional finance

–new shares are issued

–existing shareholders can buy them first (pre-emptive rights)

• Upon receipt of a rights letter a shareholder has to decide upon their course of action

Calculating the ex price

A company announces a 1:5 rights issue at £3.50. If the cum market price of the underlying shares is £4.00, what is the theoretical ex price of the shares?

Before

Rights

After

Numberof shares

Price per share

Total value

5

1

6

£4.00

£3.92

£3.50

£20.00

£3.50

£23.50

23.506

How much is the right to buy a share worth?

29

Bonus Issues

• Free shares

• The effect on share price?

• Why would a company do it?

Calculating the ex priceThere is a 1:1 bonus issue.The market price of the shares before the capitalisation is £12.00.What is the theoretical ex price of the shares?

Before

Scrip

After

Numberof shares

Price per share

Total value

1

1

2

£12.00

£6.00

£0.00

£12.00

£0.00

£12.00

£122

31

Cash dividends• What is a dividend

–Payment/distribution to shareholders from realised profits

• Interim and final dividend

• Timetable

Feb

Dividendannounced

Wed 8March

Ex-dividendday

Fri 10March

RecordDay

(Books closed day)

DividendPayment date

Fri 10May

ex divcum div

AGM

Tues 7May

Listing on the Stock ExchangeThe main advantages are:

Takeovers – using shares to fund the acquisition of other co’s

Employees – stock options can be used to retain key staff

Capital - access to a large pool of capital

The main disadvantages are:

Short termism – impatience and emphasis on short term goals

Regulations – disclosure requirements are more stringent

Status/prestige – assist company’s trading prospects

Threat of takeover – anyone can become a part owner

Listing

Full list Alternative Investment

Market

Trading history Minimum 3 years

No minimum

Market capitalisation

Minimum £700,000

No minimum

‘Public’ holding At least 25% No minimum

34

Indices

• Indices enable investors to:–measure performance of a market

–use as a benchmark to judge actively managed portfolios

– trade futures and options based on them

• The main indices on LSE equities are:–FTSE 100

–FTSE 250

–FTSE Actuaries 350

–FTSE All Share Index

FTSE Indices

1

100

350

c900

FTSE 100

FTSE 250

FTSE Small Cap

FTSE All Share

36

World Markets

Securities

• New York

• NASDAQ

• London

• Euronext (Paris)

• Tokyo

• Deutsche Borse

• Hong Kong

Indices

Dow JonesS&P 500NASDAQ Composite

Nikkei 225

CAC 40

Xetra DAX

Hang Seng

37

Broker

Broker

Buyer

Seller

Order driven

Buyer

Seller

Broker

Broker

Market Maker

Quote driven

Domestic Equity Market

38

Domestic Equity Market

• SETS– FTSE 100; FTSE 100 reserve stocks; stocks removed from

FTSE 100.

• SETSmm– FTSE 250 shares not on SETS, order book plus one or more

market makers

• SEAQ– fully listed shares, not on SETS or SETSmm, with two or more

market makers

– AIM shares with two or more market makers

39

SETS

Buy & sell orders displayed (price/time priority)

• Standard settlement

• Visible to all but only member firms can input and delete orders

40

41

SEAQ

• Market makers show prices and sizes

• Two way prices (bid, offer, spread)

• Touch strip

42

43

Equity Settlement

BrokerMarket Maker

£

shares

Settlement

TradeBuy me 1000

PJC plc shares

Contract Note

44

• CREST is an electronic settlement system

• Mainly settles UK equities, corporate loan stock and gilts

• Dematerialised/uncertificated settlement

45

Member

Crest Structure

Investors

Companies

Bank

Registrar

Regulators

Revenue(s)

46

Bonds

• A bond is a tradeable loan

• Issuer promises to:–repay the loan at a future date (on

maturity)

–pay interest at a defined rate (usually fixed)

• Issuer might be the British government

–bonds are called gilt edged securities

• Issuer might be a company

47

Corporate Bonds

Domestic Foreign Eurobond

Issued by homecompany to homeinvestors in homecurrency

Issued by overseascompany to homeinvestors in homecurrency

Issued to manyinvestors in anycurrency – international issues

48

Other bonds - features

• Zero Coupon Bonds

• Convertibles

Gilts• Interest (coupon)

– gross annual interest on the nominal value (£100)

– paid semi annually

• Repayment (redemption)

• Classification by DMO– Short Less than 7 years

– Medium 7-15 years

– Long More than 15 years

• Issue by DMO

– bid basis (auction to those on an Approved List)

– individuals may submit non-competitive bids (up to £500,000)

• Secondary Market– GEMMS or DMO/Computershare service

50

Yields

• Flat Yield

Example: Treasury 2006 6% is currently trading at £102, calculate the flat yield

A 3.6%

B 4.9%

C 5.9%

D 6.0%

annual coupon x 100%---------------------- market price

51

Money market instruments

• Money market instruments are forms of short term tradeable debt. The products you need to be aware of are:

–Treasury bills

–Commercial paper

–Certificates of Deposit

52

Treasury bills

• Short term zero coupon bonds

• Maturities generally after 3 months

• Issued weekly by the DMO on behalf of the Treasury

• Sold at a discount to their face value

53

Commercial paper

• Short term unsecured debt

• Usually zero coupon therefore issued at a discount

• Usually high nominal value

• A CP programme specifies a total amount that can be issued and may have an end date

CP programmeissue limit £150m

end date 2008

Date Issue TermMar 2006 £100m 6mthApr 2006 £50m 3mthOct 2006 £75m 6mthJan 2007 £75m 3mth

54

Certificates of Deposit (CD)

Investor A

Investor B

Bank

Company types

All companies

public

(plc)

private

(ltd)

fully

listed

AIM

listed unquoted

56

Company Administration

Company

Shareholders

Memorandum

Articles

Company Directors

ExecutiveNon-executive

Meeting types:AGMEGM

ARTICLES:Shareholders rightsBorrowing powersDividendsMeetingsDirectorsWinding up

MEMORANDUM:Name of CoDomicileAuthorised Share CapitalStatement of liabilityObjectsPLC or not.

57

DerivativesDerivatives

CHAPTER 3CHAPTER 3

•Futures•Options

58

Futures

• An agreement to buy or sell a specified quantity of a specified asset at an agreed price on an agreed date

• Exchange traded and on standardised terms

• For example: Futures on metals, oil, agricultural products

• Motives: Hedge or Speculate

59

Futures Terminology

• Long = buy a future

• Short = sell a future

• Open = enter into a futures position

• Close = trade out of a futures position

60

Options

• A contract that gives the right but not the obligation to buy or sell a specified quantity of an underlying asset at a specified price within a specified period

• Call option = the right to buy

• Put option = the right to sell

An example of an Equity Call Option

PJC plc 1000 shares

Market price 105p

I grant youThe right to buy1,000 PJC plc sharesFrom meAt a price of 100pWithin 3 months

WriterWriter

HolderHolder

Option PremiumOption Premium

Call Option Call Option (10p per share)

(£100)

Options terminologyConsider an equity call option with a strike price of 100p and premium of 10p. The underlying share is currently valued at 105p

strike100p

Price

Time

105p

breakeven110p“in the money”

“out of the money”

“at the money”

63

Options Terminology

• Call Option

• Put Option

• In the money

• At the money

• Out of the money

• Breakeven

64

Financial ProductsFinancial Products

CHAPTER 4CHAPTER 4

•Deposits and loans• Interest rates•Mortgages• Insurance and Pensions•National Savings and Investments

65

Deposits and loans

• Deposits– Fixed term v Instant access

– Interest• Gross v Net

– R85 enables payment gross

• Loans– Bank loans

• Secured v Unsecured

– Overdrafts• Authorised v Unauthorised

– Credit cards

66

Interest Rates

• Quoted rate v Effective rate

• Steps to turn quoted into effective1. Quoted expressed as a decimal

2. Divided by number of periods per year

3. Added to one

4. To the power of the number of periods per year

5. Subtract one and times by 100

67

Mortgages

• Secured loan on property• Mortgage types

– Repayment– Interest only

• Mortgage interest– Fixed– Capped– Discounted– Variable

• Redemption penalties• Other types

– Endowment– Pension linked– ISA– Unit linked– Flexible

68

Insurance and Pensions

• Life policies– Term v Whole of life

– With profit (incl unit linked) v non profit

• Pensions– State

• Basic v Second

– Occupational• Defined benefit v defined contribution

– Private/Personal

– Stakeholder

69

National savings products

• National Savings accounts:

– Easy Access a/c (instant access)

– Investment a/c (one month notice)

• Premium bonds

– Random prize

• Other products

– Fixed Interest Savings Certs

– Fixed Rate Savings Bonds

Paid Grossbut taxable.

Paid GrossBut taxable

Tax free.

Paid on maturityTax free up to

£15,000 per issue.

Taxable,Paid net of 20%

70

Pooled FundsPooled Funds

CHAPTER 5CHAPTER 5

•Unit Trusts•OEICs• Investment Trusts

71

Rationale of Collective Investment

Fund Manager

Advertise £5,000£5,000

I’ve got a spare five thousand, I think I’ll invest in a UK equity fund.

Shares/units in Shares/units in collective inv’tcollective inv’t

72

Role of the FSA

• Authorised v unauthorised

• Onshore v offshore

73

Unit Trusts - Basics

Investors(1,000)

Fund Manager

£5,000 x 1,000£5,000 x 1,0001 million units1 million unitsx 500p per unitx 500p per unit

InvestmentsInvestments

Trustee

InvestmentsInvestments

Markets

Makes investment decisions

Prices the units

Deals with investors

Legal owner of the trust propertySafeguards assetsMonitors the manager

• Securities Funds - most common• Money Market funds• Futures and Options funds• Geared F&O• Warrant funds• Property funds• Fund of funds• Feeder Funds• Umbrella Funds• Limited issue funds• Principal protected funds• Mixed funds

Types of Unit Trust

Authorised/regulated funds

Buying more Units

Fund Manager

Trustee

InvestmentsInvestments

FM prices Bid Offer

UK Equity 485 515

£5,150£5,1501 000 units1 000 unitsx 515p per unitx 515p per unit

Another 1,000 units created (open

ended)

Creation of more units?

Fund Manager

Trustee

InvestmentsInvestments

10,000 units10,000 units9,000 units9,000 units

BuyersBuyersSellersSellers

“Create 1,000 units”

InvestmentsInvestments

Markets

77

How to price a unit

• Prices calculated by the managers

• FSA rules

– prices based on net asset value at the most recent valuation

– calculate separate bid and offer prices although single pricing is possible

– maximum offer price = creation price plus initial charge

• Offer price tend to include an initial charge - around 5-6% on top of allowances for stamp duty and brokerage

78

What is an OEIC ?

• Open Ended Investment Company

• Also known as an ICVC (Investment Company with Variable Capital)

• Invests money on behalf of it’s shareholders in shares and bonds

79

Key elements of an OEIC

• Variable capital base

• Shareholders are direct owners of the company

• Shares are traded at a single price (at NAV)

• Authorised Corporate Director instead of Manager

• Depository instead of Trustee

• An OEIC is a UK company that can repurchase its own shares on demand

Investment Trusts

Investors

Investment Trust

£5,000 x 1,000£5,000 x 1,0005 million £1 ord shares5 million £1 ord shares

InvestmentsInvestments

Depository

InvestmentsInvestments

Markets

Trade

Price tends to be at a discount to the net asset value of the company. This discount narrows in a bull market and widens in a bear market

81

Exchange Traded Funds (ETF’s)

• Index tracking funds

• Open ended

• Structured as a company

• Listed on exchanges (such as the LSE’s extraMARK)

• Trade at net asset value

82

Collective investments comparison

Feature Unit Trust Invt Trust OEIC/

ICVC

ETF

Open/

closed ended

open closed open open

Legal structure/

Investment unit

Trust/

unit

Company/

share

Company/

share

Company/

share

Price based on Net asset value

Demand and supply

Net asset value

Net asset value

Bid/offer or single price

Bid/offer Bid/offer Single price Bid/offer

Investments purchased from

Fund manager Stock market Authorised corporate director

Stock market

Investments held by Trustee Authorised depositary

Authorised depositary

Custodian

83

Hedge Funds

• Unregulated schemes

• High investment entry levels

• Flexible investment style, including gearing

• Fees are performance related

84

Investment WrappersInvestment Wrappers

CHAPTER 6CHAPTER 6

• ISAs/PEPs•Child Trust Funds

85

ISAs• Designed to replace PEPs

– no tax on income or capital gains

• An ISA is a tax free wrapper that can be applied to a wide range of products

• Up to 2 components as follows

–Cash

–Stocks & Shares

ISA limits

Mini ISA

Stocks &shares

£4,000 p.a.

Cash£3,000 p.a.

Maxi ISAStocks

&shares

no limit

Cash £3,000 p.a

£7,000 p.a

87

Child Trust Funds

• For children born on or after 1 Sept 2002

• Money cannot be withdrawn until child turns 18 (child can manage from 16)

• Government starts CTF with £250 (£500 for lower income families)

• Can add up to £1200 per annum

• Savings, shares or stakeholder accounts

• No tax on income or gains

88

RegulationRegulation

CHAPTER 7CHAPTER 7

•FSMA 2000•Money Laundering• Insider Dealing and Market Abuse•Takeovers and Mergers

89

UK Financial Regulation

• The UK’s main financial regulator is the Financial Services Authority (FSA)

• The FSA operates under the Financial Services and Markets Act 2000 (FSMA 2000)

• The Act states that any person (firm) conducting regulated activities in the UK must be authorised by the FSA or exempt

• Certain individuals within the firm must also be approved by the FSA for their roles

• The FSA have written a handbook which must be complied with to avoid prosecution

90

The FSA’s four objectives

• Maintaining confidence

• Promoting public awareness

• Appropriate protection for consumers

• Reduce scope for financial crime

91

Approved persons regime

• Certain people working for an authorised person (firm) must be approved by the FSA for their role. The 27 separate controlled functions (jobs) that require approval are grouped under five categories:

–Governing functions (e.g. Directors)

–Required control functions (e.g. MLRO)

–Systems and controls functions

–Significant management functions

–Customer functions

92

Key statutes governing financial services

• Financial Services and Markets Act 2000

• Proceeds of Crime Act 2002 and ML Regs 2003

– Anti-money laundering

• Criminal Justice Act 1993

Money Laundering• Definition• 3 stages• ML Regs 2003: Financial institution procedures :

– identify new clients– record keeping– internal reporting– internal controls to prevent the firm being used for money

laundering• POCA ’02 Offences:

– concealing; arrangements that you know or suspect is to acquire, retain, use/control criminal property; acquire, use or possess criminal property; failure to report; tipping off

• Suspicion reporting process– Employee => MLRO => SOCA

Insider Dealing

If an individual who possesses inside information from a

primary or secondary insider

Deals

Encourages others to deal

Tell others the information

95

Market abuse

Offence under FSMA 2000

Includes : Using

information not

generally available to

others

Regular user test employed to establish guilt or innocence

96

• There are two main concerns regarding a takeover and different regulatory bodies are in place to address each concern:

• Is the takeover anti competitive?

• Are shareholders treated fairly?

Takeovers and Mergers

Competition Commission

Panel on Takeovers and Mergers

97

Takeovers and Competition

CCCC

The Office of Fair Trading considers whether a proposed takeover might be anti-competitive.The OFT could result in the bid being referred to the Competition Commission

The Competition Commission decides on whether the takeover should be allowed to proceed, any restrictions required and the like

OFTOFT

98

Takeovers and shareholders

• The Panel on Takeovers and Mergers (POTAM or PTM) ensures that all shareholders are treated fairly

• Their rulebook is known as the Takeover Code or Blue Book

• The rulebook principles state:–Shareholders of a target company must be treated

equally in all respects during an offer–Don’t bid for a company unless you intend to, and

can afford to, go through with the bid–Directors should make decisions by considering

what is best for shareholders, not themselves

99

Takeovers – key %’s

30%Effectivecontrol

50%Actualcontrol

Must make a bid for the remainingshares in the company

0%

100%

SARs – prevent the following:(1) 10% or more(2) Within 7 calendar days(3) From more than one source(4) Resultant shareholding is 15% or more

Takeover of a Listed Company

Offerdocumentdispatched

28days

Bid announced

through Stock Exchange

21

Firstclosing

39

Finaltarget

companyannouncements

46

Finalrevision

0

Finalclosing

60

101

Other Regulations

• Data Protection Act– 8 principles especially ‘adequate, relevant and not

excessive’

• Complaints– System required and Financial Ombudsman

Service can compel firms to pay up to £100,000

• Compensation– Financial Services Compensation Scheme payout

maximum of £48,000

102

TaxationTaxation

CHAPTER 8CHAPTER 8

• Income tax• Capital Gains Tax• Inheritance Tax• Stamp Duty

103

Taxation

• Income tax

• Capital gains tax

• Inheritance tax

Paid on income, potentially including investment income

Potentially payable on the sale of an investment

Potentially payable on investments held at death

104

Income Tax

• Salary

• Profits from running a business

• Dividends

• Interest

From an employer

Individuals orpartnerships

From companies

From banks/building societies/bonds

105

Income Tax

Income

£5,035

10%

22%

40%

Personal allowance

Lower rate

Basic rate

Higher rate

£2,150

£33,300

£33,301

106

Taxation (Income)

• Tax is usually deducted at source.

– salaries PAYE

– savings income (interest)• basic rate of 20% is automatically deducted

– dividend income • basic rate of 10% is automatically deducted

107

Taxation (CGT)

• Capital GainsCapital Gains– Shares

– Bonds (some)

– Property

– Antiques

• ExemptionsExemptions– Main home

– Gilts

– Cars

108

Taxation (CGT)

• Allowance of £8,800 for the year

• CGT only paid on gains above the allowance

• Any losses can be carried forward

• Paid at the investor’s marginal rate of 10%, 20% or 40%

109

Inheritance Tax

• A certain amount is exempt

– threshold of £285,000

–anything left to a spouse

–anything left to a charity

–items given away more than seven years before death

–IHT charged at 40%

110

Stamp Duty/SDRT/SDLT

• 0.5% on the purchase of shares

• 1% on homes >£120,000

• 3% on homes >£250,000

• 4% on homes >£500,000

111

End of Course