Part 4

Question 1

Define Beta

Answer 1

The Beta BP of a portfolio P measures the systemic risk of portfolio’s volatility relative to the market Cov(RM,RP)/Var(RM)

Question 2

List the 4 risk adjusted performance

Answer 2

Treynor measures

T = (R_P - r)/ß_P

Sharpe measure

S = (RP - r)/σ_p

Jensen measure

J = R_p - [r+ß_P(R_m - r)]

pre-specified standard deviation

J = R_p - [r+(R_m - r)σ_p/σ_M]

Question 3

List six reasons why performance of portfolio Ís different from index

Answer 3

1. active management - holding different shares from the market index
2. the portfolio beta may not be the same at all time (but the benchmark index would)
3. lack of diversification in the portfolio leading to specific risks and returns
4. dealing commissions affecting the portfolio performance
5. taxes affecting the portfolio performance
6. cashflows in and out of the portfolio affecting performance
7. constraints such as marketability preventing the portfolio from investing in some shares.

Question 4

What is the limitations of performance measurement?

Answer 4

1. Costs of performonce meosurement
2. Short-termism Past performance is no guide to the future
3. Objectives moy differ or constra¡nts
4. Risk levels may hove been different Timescoles - different timescøles leod to different conclusions
5. The formulae used rely on the Capital Asset Pricing Model. lf the assumptions on which this is based are not accepted then the results are not reliable

Question 5

What are the limitations of performance measurements

(CSPORT)

Answer 5

1. Past performance is not necessarily a good guide to future performance, but it is typically (erroneously) used as such a guide in an over-simplified manner.
2. Past performance is likely to be impacted by the amount of risk taken which may not be comparable to the risk to be taken in the future
3. The timescales considered need to balance assessing performance frequently enough to stop problems but not too frequently that it encourages short-termism. Also, the results of any analysis will depend on the timescale selected.
4. Funds with differing objectives may not be directly comparable.
   
   1. The frequency and method of performance measurement may negatively impact the behaviour of the ínvestment manager eg by encouraging short-termism.
5. There is always a cost / benefit trade off with performance measurement.
6. The returns may have been calculated on a money-weighted basis, and therefore be influenced by the timing of the cashflows.

Costs of performonce meosurement
Short-termism Past performance is no guide to the future Objectives may differ or constraints
Risk levels may have been different

Timescales - different timescales lead to different conclusions

Question 6

Actions that could be taken to address the issues of performance review

Answer 6

1. Past performance - There is no solutions to this, as it is a fact, but by drawing investors’attention to caveats and warning, it may help to influence them to pay less attention to past performance,
2. Risk - Use risk-adjusted performance measures such as Jensen and Treynor,
3. Timescale - Use a number of performance measures, and use a variety of different timescales.
4. Objectives and constraints - Only measure fund against others funds and indices that have similar constraints and objectives. This might produce smaller universes for comparisons though.
5. Short termism - Possibly restrict the use of performance reports internally, to prevent them influencing the manager.
   Give managers a performance bonus that focuses on the longer-term performance.
6. Costs - Reduce the frequency of reporting and the complexity of the information and data required.
7. Calculation - Calculate on the basis of time-weighted returns.

Question 7

What analysis needs to be done to prior to investing in this bond

Answer 7

General issues:

1. Does the loan cover the full cost ofthe restaurants, or is there another source such as internal cash holdings or another bond?
2. How much will fund the purchase of the new restaurants and how much for other setup costs, salaries efc?

Ability to repay the loan

1. Does the company have good cashflow?
2. Will the business be cashflow negative for a while following the expansion?
3. Does the company have any other marketable assets that can cover the loan, for example the freehold on any other restaurants?
4. Does the owner have ready access to other forms of finance that could be used to repay the loan at maturity?

Assess the risk to the company

1. What are the economic prospects, and how will they affect the restaurant sector?
2. Will the economic recovery succeed as the owner has suggested, and as strongly as the owner has suggested?
3. Are the restaurants spread across several economic areas, or concentrated in one?
4. What has happened to other restaurants that have opened in these areas, and what is the competitive environment like? o What is the company’s gearing, interest cover and asset cover likely to be?
5. Does the company have sufficient liquidity (current ratio) and cashflow to survive without further issues?

Structure of the bond, the term, the payment profile and the interest rate

1. How does the bond security compare to other similar issues?
2. ls the term and frequency of income suitable for the investor’s requirements or liabilities?
3. ls the return high enough to justify the risk?
4. What is the likely recovery in the event of default given the bond’s status in the company structure?
5. Asset cover and interest cover of the bond
6. ls the company able to issue more debt that ranks the same as the new debt?

Other aspects of investigation, that relate to the fundamental analysis of the health of the company

1. What is management quality
2. What is the company’s return on equity, profit margin, and efficiency ratios

Question 8

Describe the japanes equity market

Answer 8

Nikkei stock average 225

1. Unweighted arithmetic index
2. consitutient reviewed annually, but unrepresentative of Japanese equity market
3. Not suitable for performance measurement

Tokyo stock exchange first section index (Topix)

1. Comprises about 1700 shares
2. market capitalisation weighted arithmetic index
3. constitutes represent leading companies in the market
4. much more comprehensive than Nikkei
5. Suitable for performance measurement

Question 9

Main uses of investment indices that track equity markets

Answer 9

1. As a measure of short-term market movements
2. To provide a history of market movements and levels
3. As a tool for estimating future movements in the market, based on past trends .
4. as a benchmark against which to assess the investment performance of portfolios
5. to value a notional portfolio
6. to analyse sub-sectors of the market .
7. as a basis for index funds that track the particular market .
8. as a basis for the creation of derivative instruments relating to the market or a sub-section of the market.

Question 10

Main compenents of FTSE 100

Answer 10

FTSE 100 lndex

1. consists of the 100 largest quoted companies by market capitalisation .
2. accounting for about 80 per cent of the total UK equity market capitalisation o
3. the main indicator of short-term movements in the UK equity market o
4. used extensively as a basis for investment products, such as derivatives and exchangetraded funds.

FTSE 250 lndex

1. covers the 250 companies ranking below the top 100 companies by market capitalisation.

FTSE 350 Supersectors lndex .

1. combines the 100 and 250 indices.

FTSE SmollCap lndex .

1. covers all companies below the top 350 companies with a market capitalisation greater than a certain limit and whose shares are actively traded. o
2. rêpresents around 2% of the UK market capitalisation.

FTSE All-Share lndex .

1. comprises the 350 and the SmallCap indices. .
2. accounts for around 93 - 99 per cent of the total overall market capitalisation.

FTSE Fledgling lndex

1. . consists of the remaining, sufficiently marketable, quoted companies which are too smallto be included in the SmallCap index.

FTSE Aim lndex Series .

1. covers companies traded in the UK Alternative lnvestment Market.
2. ie companies which are too small or too new to apply for a listing.

Question 11

Describe a suitable method of constructing a bond index

Answer 11

A suitable methodology for a corporate bond index is a weighted average index. This can be created using the formula:
i(t) = (Summation N_i,tP_i,t)/B(t)

N_i,t - Nominal issued for the ith consituent at time t

P_i,t - price of the ith consituent at time t

B(t) - base value or divisor at time

Bt) - is obtained from B(t-1) through the chain-linking process, incorporating new issues and redemptions of bonds, and movements between categories

1. This uses the market capitalisations of the bonds as the weights.
2. ln order to use this formula, the investment bank would have to
   
   1. decide on the universe of bonds that should be included in their index, and a clear system for deciding in future which bonds should be included and excluded
   2. decide on the use of the index; this will help determine whether the bonds included should all be ‘investible’ for example, and how frequently the index needs to be calculated and published
   3. determine how many sub-divisions of the index should be published, eg country and currency, term, credit rating, …
   4. establish how to measure the income from the index, eg publish an XD index, or publish a ‘total return’ index as well.

Question 12

Specfic issues to consider when constructing bond index

Answer 12

1. Bonds are less liquid than equities, and many bonds trade infrequently.
2. Establishing regular and reliably prices will be difficult if no trading is taking place, and models may have to be used to estimate the price from the movements in other bond prices. The model used can affect the index values.
3. Due to the lack of trading, it may be that a minimum size of issue should be considered to ensure that the bonds are ‘investible’.
4. Bond indices are often sub-dívided by credit rating, but these are hard to determine and can be subjective. For example, the rating given by one credit rating agency will differ from that of another agency, and internal models may give a different rating again.
5. Ratings often change retrospectively, after an event, whereas the price of the bond will change as soon as an event becomes public knowledge. This can mean that a bond remains in a particular rating category long after it should really have been changed.
6. Many bonds have peculiar features such as embedded options. How to deal with these needs to be considered; many providers simply ignore options. Whether floating rate bonds should also be included is another issue to consider.
7. The number of bonds to be included and their weightings can be an issue. lt is important to have enough bonds to give a reasonable spread, and to make sure that the index is not overexposed to the bonds of one or two major issuers.
8. But the restricted number of bonds in a market can make this very difficult. ln particular, there are many bonds issued by financial institutions, which can lead to a concentration of risk to that sector of the market.
9. How to deal with defaulting bonds and the recovery that investors may receive after the administration process is complete.