Part 2

Question 1

List the behavour science of investing

Answer 1

1. Anchoring
   
   1. Refers to the fact that investors sometiimes base their perceptions on past experience or expert opinon, which they then tend amend to allow for evident differences to the current conditions
   2. Investors expectation on future levels of inflation will be heavily based on past actual inflations in the past
   3. It make take time for investors to be convinced that a long term reduction in inflation will occur
2. Prospect theory
   
   1. This is the theory of how people make decisions when faced with risk and undercertaintity
   2. It explains why people make asymetric decisions when faced with similar possible gains and losses
   3. Individuals are assumed risk adverse when facing gains and risk seekers when facing losses defined in terms of a reference point
   4. This generates utility curves that are concave above the reference point, convex below the reference point and with a point of inflexion at the chosen reference point
   5. Propect theory suggests that the way in which alternatives are presented or framed can be very important
3. people are more risk adverse for gains and risk taking for losses
4. Myopic losses
   
   1. Less risk adverse if the gamble is muti-period
5. Estimate probabilities
   
   1. Dislike of negative events
   2. Representative heuristic - people find more probable for events they can imagine
   3. Availability
6. Overconfidence
7. Mental accounting
   
   1. People find it hard to aggregate events
   2. They think individually
8. Effects of options
   
   1. Primary effect
   2. recency
   3. Middle
   4. Dislike complexity and are more likely to deffer
   5. Status quo
   6. Regret aversion
   7. ambiguity
      
      1. Dislike uncertainity
9. Herding
   
   1. Spurious - Where many investors make the same investment decisions based on some real piece of economic or political news.
   2. This occurs when investors do something without reference to the actions of another investor
10. Cross sectional momentum
    
    1. Stocks performs inline with their groups
11. Influenced by past performance or sentiment
12. Belief perseverance
13. Mood - Based anomaly
    
    1. When an investment decision is being made on some unrelated event that has no bearing on the value of the investment being purchased

Question 2

Aims of regulation

Answer 2

Correct market inefficiencies

Protect consumers of financial products

To maintain confidence in the financial services

To reduce financial crimes

Question 3

Forms of regulatory regime

Answer 3

Prescriptive

Freedom with publicity

Outcome based regimes

Question 4

Types of regulatory regime

Answer 4

Unregulated

Voluntary code of conduct

Statutory

Self regulated

Question 5

Factors to consider when analysing the prospects for a company

Answer 5

Management

Retained profits

Competition within industry

History (recent) of company

Input costs

Market growth prospects

Products

Question 6

The risk of oversea investments

Answer 6

Custodian needed

Additional admin required

Time delays

Expenses incurred / expertise needed

Regulation poor

Political instability

Information harder to obtain (and less of it)

Language difficulties

Liquidity problems

Accounting differences

Restrictions on foreign ownership / repatriation problems

Question 7

What is Basis risk

Answer 7

1. Basis risk arise happens when the asset whose price is being hedged is not exactly the same as the assets underlying the futures contract. The price of the underlying asset does not move in the same way as the price of the asset to be hedged.
   
   1. This is Cross hedging risk
2. The hedger is uncertain as to the exact date when the assets were brought or sold
   
   1. If investor needs to close the futures early or roll over, movements in the interest could mean gains or losses are made on the variaitons of interest rate
3. The hedge requires the futures contract to be closed well before its expiration date

Question 8

What is the optimum hedge ratio

Answer 8

h = P*σs/σ_f

Question 9

What are the operational aspect of financial services that regulation seek to address

Answer 9

1. Sales process - only sold to suitable investors i.e. those that are well informed, reasonably wealthy
2. Operations and the extent of any lock in periods and notice periods
   
   1. Levels of surrender penulties are included
3. Reporting to investors - both frequency of reporting and the information that must be provided with regard to fund performance, investment strategy
4. Pricing - methodology must be stated
5. The fees charged
6. Suitability of the employees - need to have qualificiations
7. The allowable legal structure

Question 10

Pros of regulating the shares issues

Answer 10

1. Ensure that the issue of shares are conducted in an orderly and fair way
2. The regulation can be extended to post - issue to ensure that company acts in accordance to pre-issue promises
3. Regulations can help protect investors against unscruplous dealings or claims
4. Increases confidence in the market helping thfe to make share issues a success
5. Regulations could lead to investors having additional knowledge
6. Most countries regulate listing of shares, so this is important in the global economy
   7.

Question 11

Cons of regulating shares

Answer 11

1. Will be costly to maintain and may not be appropriate for all companies all the time
2. Companies may act in line with the letter of the law but not in spirit of the law
3. They need to disclose sensitive information

Question 12

Regulation of the issue process

Answer 12

Prior to issue

1. Published audited accounts - governments may require companies to produce audited on a regular basis so that potential investors can assess the financial strengths and the level of risk

Share prospectus at issue

1. Companies maybe required to publish share prospectus before share issuance. The following information is required
   
   1. details of the number shares and offer price - this provides investors the information on the market capitialisation of the company
   2. the underwriters of the issues - the investor can assess the quality of the underwriter and infer the quality of the shares on offer
   3. Details of share allocation
   4. how the money will be used by the company - will allow investors to assess the risk reward. This could be a reguatory requirement that ensures that company use the money on the stated purpose
   5. intended dividend policy - so that potential investors can assess the likely dividend stream. Such requirement could focus the management on achieving this return
   6. details of salaries of directors and senior managers and their salaries.
      
      1. This will allow investors to assess the quality of management

Post issue regulation

The following regulation could improve the market confidence of investors in the market and help with the overall issuance process

1. production of audited accounts
2. mangement details to be published
3. requirement for share prices to be made regularly available
4. Requirement for interim reports, forecasts and profit warnings
5. any interest by potential takeover partners to be made available

Question 13

The key principles underlying the legislation of financial services

Answer 13

Integrity

Company needs to act in the best interest of the customers and be transparent with the customers

Skill and care

Market practice

The design, sales and disclosure of the product should be in line with modern market practice. ln particular it should comply with any local and international standards and regulations.

Information about the customers

The bank should keep customers fully informed of events that affect their policies and deposits.

They should also obtain sufficient information about customers in order to offer a service to them.

Perhaps Bank A did not get enough information about the customers of B to determine that the debts were in fact non-performing.

Information for or to the customers

lf the product is marketed on the internet, it may be important that the company has some process to ensure that the product is suitable for them. ln particular the company needs to assess customers’ risk appetite and financial resources prior to allowing them to invest. Such information should be collected regularly to ensure that the circumwstances have not changed.

While marketed as a savings product, this product is clearly quite a volatile and risky investment. lt is important that customers are made aware of this, both through information and disclosures in the marketing literature. The fact that this product is marketed via the internet makes this even more important, as investors will not speak with any advisers prior to buying the product. lnformation on the product’s performance and ongoing risk needs to be communicated regularly, and not just at the point of sale

Conflicts of interests

Customer assets

lt is important that customer assets are protected and separated from the assets of the company itself, so they are safeguarded in the event of the company becoming bankrupt.

As the customer assets are to be ‘pooled’, it is vital that such an individual’s share of the assets can be identified and properly accounted for.

Financial resources

Companies should operate with an appropriate and adequate amount of capital resources for the risks of the business. lt seems that A did not monitor the risk appropriately, and failed to keep sufficient financial resources, because it required fresh capital following the takeover.
lf this product uses derivatives extensively, then margin requirements will be important. The company needs to be sure that it has adequate liquidity, and that it has assets that qualify as collateral with its derivative trading partners, The level of counterparty risk should be assessed relative to the capital that the company has.

internal organisation

Companies should arrange their affairs in an organised and efficient manner. Perhaps in this case A did not keep proper records of the due diligence and relied on second hand reporting from the team. Proper record keeping, audit trails and disclosure should be carried out on such internal projects.

Perhaps the compliance function of the bank should be revisited. Proper compliance should be embedded in every part of the day to day business, including due diligence reporting.

Relations with regulators

Bank A should maintain an open and cooperative relationship with the regulator at all times. By doing this, the regulator is able to determine whether mistakes were caused by fraud, mismanagement or mistakes, and penalties can be determined accordingly. Bank A should have kept the regulator up to date at all times as it carried out the due diligence and as it discovered the bad debt.

Question 14

The key principles underlying the legislation of institutional investment practices

Answer 14

1. Effective decision making
2. Clear objectives
3. Focus on asset allocation
4. Explicit mandates
5. Explicit reporting
6. Activism
7. Appropriate benchmarks
8. Performance measurements
9. Transparency
10. Effective operations

Question 15

The role of the credit rating agencies

Answer 15

1. Ratings agencies apply a mix of qualitative and quantitative analysis in carrying out their assessments, and also have direct access to senior officers of the issuer.
2. Having carried out their analysis, they form a view and provide an issuer rating and a bond rating (which can be higher or lower than the issuer rating, and differ from other bonds from the same issuer).
3. Ratings agencies provide significant amounts of detail on their methodologies, however they do not provide detailed supporting information relating to their specific assessments.
4. Historically, many bond investors have tended to place significant reliance on issuer and bond credit ratings, rather than carry out their own credit analysis independently.
5. For smaller investors, this may be appropriate on the grounds of lower costs relative to buying independent research or building an internal team of credit experts. However, for larger investors these factors are less compelling and it is generally considered desirable to obtain or carry out independent research in addition to monitoring ratings.
6. Provided an investor has confidence in the process applied by a ratings agency, an investor can place a certain degree of reliance on bond and issuer ratings.

Question 16

State why pension funds have investment restrictions

Answer 16

1. To restrict the investment manager from taking too much active risk
   
   • lnvestment managers are responsible for stock selection, and can take large ‘active money’ positions in certain shares. lf these are unrestricted, the manager could expose the fund to too much active risk. This would not be the case if the fund was passively managed.
   • Managers that operate on a ‘specialist’ basis, will aim to take risk in order to outperform the benchmark, and this risk must be restricted in some way.
2. To specify the split between the major asset categories in order to keep the fund in line with the strategic benchmark. This would apply particularly to a balanced manager.
3. To comply with regulation.
   
   • For example, to avoid self-investment, or to avoid levies (such as the PPF levy) that are based on the riskiness of the portfolio.

Question 17

Types of corporate tax

Answer 17

1. Classicall system
   
   • Company profits are taxed twice: .
     
     • once in the hands of the company .
     • once in the hands of the investor.
2. Split-rate system
   
   • Similar to the classical system…
   • ,,.but different rates are levied on distributed profits and retained profits.
   • This system is often used when income and capital gains are taxed at different rates.
3. lmputation system
   
   • The company deducts some of the tax payable by investors on distributions…
   • …and pays it directly to the government.
   • This amount can then be set off against the company’s total corporation tax bill.

Question 18

Benefits and risks of Quantitative easing

Answer 18

1. QE increases the money supply. This has a knock-on effect through the fractional reserve banking system to increase the money supply even further.
2. This is intended to:
   
   • reduce interest rates
   • increase consumer spending
   • thereby stimulating economic growth .
   • ensure that inflation does not fall below target.
3. Overall, the actions of the central bank aim to improve market confidence, which may lead to increased business lending, employment etc,
4. Equity markets are likely to increase in value as a result both of improved market confidence and future earnings being discounted at a lower discount rate.
5. Lower interest rates and the threat of inflation can cause the domestic currency to weaken relatíve to other currencies. This may help exporters to sell their products abroad.

However, possible risks from QE are:

1. the price of government bonds increases, thereby reducing the yield available to investors.
   
   • This can increase pension scheme deficits which are often calculated with reference to government bond yields and reduce the income that can be obtained by buying an annuity. .
   • equity market are being kept artificially high creating a ‘bubble’ of inflated prices, which will burst as QE is eventually unwound.
   • the increased money supply can lead to higher inflation in the longer term.
   • Lower interest rates encourages people to buy property financed through mortgage lending. This can cause property prices to rise and create another credit bubble.
   • The weaker currency can cause the cost of raw materials to rise and cause imported (cost push) inflation.

Question 19

What can the government do to encourage the econommy

Answer 19

1. Fiscal policy .
   
   1. decisions on the level and structure of taxation and government expenditure
   2. hence, by implication, the public sector borrowing requirement (or debt repayment)
   3. aim to stimulate the economy through increased government expenditure
2. Notional debt management policy
   
   1. the manipulation of the outstanding stock of government debt instruments held by the domestic private sector,
   2. similar to QE, the aim is to influence the level and structure of interest rates.
3. Exchange rate policy
   
   1. achieving some target for the exchange rate of the domestic currency in terms of foreig currencies
   2. aims to influence the country’s international trading and investment patterns, ie stimulate exports or inward investment
   3. to help the country emerge from recession, it would be appropriate to weaken the currency relative to its trading partners.

Question 20

Why study behavour finance

Answer 20

1. Humans are rarely as rational in their decision-making as financial theory would suggest.
2. By studying behavioural finance, an investor can: .
   
   1. avoid human biases affecting any investment decisions made, which might perhaps make them less efficient o
   2. profit from the biased investment decisions of other investors.
3. This is possible because human behavioural biases can affect investment markets and influence prices. Many investment actions are taken by humans.