Learning objectives 1.2.1 Differentiate between a financial security and a real asset
1.2.2 Identify the key features of: a common equity share, a bond, a derivative contract, a unit in a pooled fund, and a foreign exchange transaction
4.1 Types of asset
An asset is an item that has value.
Tangible assets such as land and buildings (property, or real estate), machinery, oil, sugar and gold, are all real assets.
In a monetary economy, there are claims that may represent the right to a return, such as interest and the eventual repayment of principal (on a loan), or dividends payable out of a company’s profits (for shares in a company). Such claims are financial assets.
Loans (debt) and shares (equity) represent the two main types of financial security. Many companies have both debt and equity in their financing structure.
4.2 Ordinary shares
Ordinary shares are often referred to as equity shares, or simply equities. The term 'equity' means that each share has an equal right to share in profits. For example, if a company has 10,000 ordinary shares, each share is entitled to 1/10,000 of the profits made during any period.
The ordinary shareholders of a company are the owners of the company. However, it is normal for ordinary shares to possess a vote. This means that the holder of any ordinary shares may attend and vote at any meetings held by the company. Whilst the day-to-day control of the company is passed into the hands of the directors and managers, the shareholders must have the right to decide upon the most important issues that affect the business.
Although voting rights may vary for different classes of share, each equity share most typically carries one vote.
Companies legally do not have to declare a dividend on ordinary shares, many of them do in order to maintain shareholder loyalty. Companies may pay an interim dividend based on the six-month results, and declare a final dividend based on the year-end results. For public companies, this will not be paid until the shareholders have agreed it at the AGM. Some companies give their shareholders the choice to take their dividend in new shares, rather than cash. New shares are created, but in a way that there will be no significant impact on the share price. The investors are taxed as if they had taken the cash dividend.
Companies may only pay dividends out of post-tax profits – that is, from their distributable reserves. In any single year, the dividend paid could exceed the profit for that year, because there may be distributable reserves brought forward from earlier years.
Not only do shares offer income in the form of dividends, they also offer the possibility of capital growth when the share price rises.
4.3 Bonds
The term 'bonds' is used to encompass the asset class of fixed income securities.
A bond may be defined as a negotiable debt instrument for a fixed principal amount issued by a borrower for a specific period of time, making a regular payment of interest/coupon to the holder until it is
redeemed at maturity, when the principal amount is repaid.
Historically, bonds began as very simple negotiable debt instruments, paying a fixed coupon for a specified period, then being redeemed at face value – a 'straight bond'. In the past, bond markets were seen as being investment vehicles that was safe enough for 'widows and orphans'. They were thought to be dull markets with predictable returns and very little in the way of gains to be made from trading.
The bond markets emerged from this shadow during the mid-1970s when both interest rates and
currencies became substantially more volatile. Bonds have emerged over the past few decades to be much more complex investments, and there are now a significant number of variations on the basic theme.
Whilst it is perhaps easy to be confused by the variety of 'bells and whistles' that have been introduced into the market in recent years, one should always bear in mind that the vast majority of issues are still straight bonds. The reason for this is that investors are wary of buying investments that they do not fully understand. If an issue is too complex, it will be difficult to market.
Bonds are used by a number of issuers as a means of raising finance. Major bond issuers include the following.
Sovereign governments – who need to raise finance to help them cover any national debt or budget shortfall
Local authorities – who need to raise finance to help them cover any local budget shortfall
Companies – who need to raise cash to help them finance business requirements
Regardless of who the issuer is, there are a number of general characteristics that any bond is likely to have which we will examine next.
Negotiability means that it is a piece of paper that can be bought and sold. For certain types of bonds, this is easier than for others. Government bonds tend to be highly liquid, ie very easy to buy or sell, whereas certain corporate bonds are almost illiquid and are usually held to maturity by the initial buyer.
4.4 Pooled funds
In order to minimise the risk involved in investment, it is often a good idea for the investor to spread invested money over a range of instruments, thereby diversifying risk. However, if the individual has a limited amount of money to invest, it will be very difficult to buy a range of individual equities or bonds without incurring relatively high transaction costs.
A way around this problem is for individual investors’ investments to be grouped together and form a collective investment vehicle. Here they pool their money in a large fund, which is managed and invested for them by a fund manager.
There are different types of ‘pooled’ or collective investment vehicle available, the main types being unit trusts, open-ended investment companies (OEICs) and investment trusts. There are also exchange traded funds (ETFs), which are typically designed to track an index.
Authorised unit trusts and OEICs are Authorised Investment Funds (AIFs) and are often referred to simply as funds.
A unit trust differs from investment trusts and OEICs in the way it is set up, as a unit trust is not a company with shares. A key difference between different pooled investments is the way in which the fund is priced. For unit trusts and OEICs (for example), there is a direct relationship between the value of the underlying investments and the value of units. Units are priced according to Net Asset Value (NAV).
Investment trust shares and also ETFs, however, are priced according to supply and demand in the stock market.
Unit trusts are, like OEICs, called open-ended funds as there is no limit to the amount of money which can be invested. If no ‘second-hand’ units are available, the fund is permitted to create more units and expand the fund. Investment trusts, on the other hand, are closed-ended: except when new shares are issued – eg, on launch of the trust – the buyer of investment trust shares is buying them from existing holders of the shares.
The advantages and disadvantages of collective (or ‘pooled’) investment, as compared with direct investment can be summarised as follows.
Advantages of collective investments
An individual can invest relatively small amounts, perhaps on a regular basis.
The pooling of investments enables the fund to make purchases of securities at lower cost than would be possible for an individual.
The time involved in directly managing one's own portfolio is saved.
The funds are managed by professional fund managers. A fund manager with a good past performance record may be able to repeat the performance in the future.
A wide diversification between different shares and sectors can be achieved: this can be impractical and costly in dealing charges for a small portfolio held by an individual.
Risk is reduced by exposure to a widely diversified spread of investments in the underlying portfolio.
Specialisation in particular sectors is possible.
The investor can gain exposure to foreign stocks, which can be costly and inconvenient for an individual who holds shares directly.
Different funds provide for different investment objectives, such as income or growth, or a combination of both.
Disadvantages of collective investments
The individual can only choose baskets of investments selected by fund managers, not by himself, and this will not suit all investors.
Although the individual does not have to pick individual securities, he still has to choose the fund manager, and different managers' performance can vary widely.
Although 'star' fund managers can have a successful track record with a fund, such 'star' managers may switch jobs, making future management of the fund less certain.
Larger collective funds find it more difficult to invest in shares of companies with a relatively small capitalisation, because of the small quantities of stock available.
Successful collective funds investing in smaller companies can become a victim of their own success if more funds are brought in, as a greater fund size can make it more difficult for such a fund to follow their successful strategy.
4.5 Derivative contracts
Derivative contracts is a term encompassing contracts such as futures, options and swaps which derive their value from the movement, up or down, in the price of an underlying asset. Derivatives can be used to speculate on future price changes, and risks can be high when derivatives are geared to be very sensitive to price changes. Derivatives allow both ‘long’ and ‘short’ positions to be taken. They may be used to hedge or reduce someone’s exposure to risks, which can be achieved by taking an opposite position in a derivative relative to an existing risk exposure.
For example, a wheat farmer may sell wheat futures (called a short hedge) to guarantee him a known fixed price for his wheat. If the price of wheat falls between when the farmer buys the contract and its maturity date. The farmer will gain on the futures contract if the wheat price falls, and will lose on the futures contract if the wheat price rises. These gains and losses can respectively be set against the losses and gains that the farmer makes from actually selling his wheat, so that the net effect will be to give him a price that was known in advance.
The FTSE 100 index futures contract could be used to hedge against falls in the share price index over future periods. An investment intermediary, such as a collective (pooled) fund or a pension fund, may use derivative contracts to achieve their objectives. The fund may hold a portfolio of UK shares, and may hedge against a possible fall in the value of its portfolio by selling FTSE 100 index futures. If the market falls while the contract is held, the value of the share portfolio will most probably fall, but this will be compensated for by gains on the futures contract. Having opened the futures contact by selling it, the fund manager will later buy the futures contract in order to crystallise the gain on the contract.
Derivatives contract enable investors to take a position in the price of an asset without actually taking delivery of the underlying asset. For example, a position can be taken on the price of oil, without participants in the related derivative contract taking physical delivery of oil at any point.
Derivatives, including options, can be divided into exchange-traded and over-the-counter (OTC) types.
Exchange-traded derivatives are more standardised and offer greater liquidity than OTC contracts, which are tailor-made to meet the needs of buyers and sellers. Traded options are available on the shares of over 90 major listed UK companies. As they are traded products, they are standardised in terms of expiry dates, quantity of shares per option contract and so on.
4.6 Currency transactions
Currency or foreign exchange trading (or FOREX as it is commonly known) is the dealing of the currencies of various countries. London is the biggest centre in the world for FOREX trading, with hundreds of billions in US$ equivalents traded per day. Although some FOREX is required for overseas trade, much of it is traded for speculative purposes, where FOREX traders seek to exploit a particular view on interest rate differentials or exchange rate movements. An investment manager might convert sterling into US dollars, for example, in order to make a purchase of US securities.
There is no formal market place for FOREX trades: in London, trading is over-the-counter (OTC). Prices are advertised on screens and deals are conducted over telephones. The major players are investment banks and specialist currency brokers. This is not a market place where the private investor usually gets directly involved – his currency needs are more often met through specialist money organisations, who themselves have accessed the currency markets through their own specialist broker.
FOREX transactions are described either as spot or forward. Spot means the trade is to meet immediate currency needs and will settle in two business days after the trade day (known as T + 2). Forward is when an exchange rate is agreed today for settlement at some future date, as agreed by the parties. This is a particularly useful way of eliminating risk from transactions requiring currency (import and export dealings) at some time in the future. Most currencies are quoted against the US dollar.
4.7 Functions of securities markets
Learning objective 1.2.3 Identify the functions of securities market in providing price transparency and liquidity Financial markets mobilise people’s savings and put them to use in enabling firms to grow, thus contributing to the wealth of the economy.
An effective securities market will have the following characteristics.
Cost efficiency – in order to maximise volumes and to compete with alternative market venues, the market needs to be cost-effective. Electronic order systems should be the most cost-effective.
Liquidity – liquidity is the ability to enter or exit the market at an acceptable price spread, creating only modest price distortion on a transaction of a reasonable size. Factors contributing to liquidity are effective and efficient IT and settlement systems, stock availability and stock lending facilities and a diverse membership.
Price discovery (the process through which an equilibrium price for a financial instrument is revealed continuously through bid and offer prices, and trading) and transparency – it is important that the investor knows the price before, during and after a deal in order to be satisfied that he has a good deal. We discuss this later in this section.
Sophisticated financial markets also fulfil an important role in the transfer of risk. We have described, for example, how derivatives markets enable investors, entrepreneurs and market participants to hedge risks as well as to speculate on the prices for assets.
Quote-driven markets depend on the existence of market makers who are prepared to offer two-way quotes in shares. Dealers or ‘market makers’ are prepared to take risks in meeting orders, and their participation enhances liquidity in the market. In an order-driven market, it is buyers’ and sellers’
respective bids and offers that are matched with one another.
Most shares, futures contracts, and standard options contracts are now traded mainly through an order-driven system. Automated trading, such as the LSE's SETS system, can bypass the need for a human intermediary. Large orders can present a problem, as the broker (or the system) may struggle to find a
counterparty at a suitable price. Various order types exist whereby orders may be presented to execute immediately at the prevailing market price, or may be conditional orders depending on price and quantities to match before a trade is achieved.
The bid price is the price at which dealers or investors are willing to pay for a stock and the offer price is the selling price at which dealers or other investors are willing to sell. In a quote-driven market, the spread or turn – the difference between the bid and the offer – enables dealers to make a profit on transactions.
Depending on which securities are being traded, dealers may be working for proprietary trading houses, investment banks, commercial banks, or broker-dealers.
Traders in financial markets are sometimes categorised broadly into sell-side and buy-side.
Sell-side firms comprise investment banks, brokers, and dealers who provide investment products and transaction services
Buy-side firms are mainly investment managers (including pension funds, mutual funds, hedge funds and insurance companies) who purchase investment products and transaction services The sell-side / buy-side distinction is not clear-cut, given that a particular firm may encompass market participants on the buy-side as well as the sell-side – for example, many investment banks have subsidiaries or divisions that provide asset management services.
4.8 Transaction costs
Learning objective 1.2.5 Calculate round trip transaction costs incorporating bid-ask spreads, dealing commission and transaction taxes, both in percentages and in absolute amounts
The typical costs of a share transaction for a UK investor can be broken down as follows.
Purchase cost. The purchase cost includes a spread which is the difference between the bid and offer price of the share. The spread, from which market makers makes their profits, could be 0.5%
for a liquid share or 5% or more for a less easily traded share.
Broker's commission. A typical charge could be, say, 1.5% on a deal up to £7,000 and 1.0% above that, with a minimum charge of £25. Execution only services, including online brokers, are
generally cheaper than this for individuals, ranging from around £10 per deal upwards. Brokers incur various costs for the resources they employ to fill orders, including costs for market data and order routing systems, exchange memberships and fees, regulatory fees, clearing fees, accounting systems, office space, and staff to manage the trading process.
Stamp Duty and SDRT. Stamp Duty Reserve Tax (SDRT) is payable at 0.5% on the value of purchases of UK equities settled through CREST (ie most transactions), rounded up to the nearest 1p. Stamp Duty is payable on the much less common situation of purchases of UK equities not settled through CREST, at 0.5%, rounded up to the nearest £5. (There is no Stamp Duty if the charge so calculated would be £5 or less.) Stamp Duty on stock registered in Ireland is charged at 0.1%.
Panel on Takeovers and Mergers Levy. The PTM levy is a flat £1 on transactions (sales and purchases) that are in excess of £10,000.
Below is an example of the possible cost of the purchase and sale of shares to the value of £10,001.
Cost of purchase
£
Shares 10,001.00
Brokerage commission 1.0% 100.00
SDRT at 0.5% 50.01
PTM levy 1.00
Total cost 10,152.01
Cost of sale
£
Shares 10,001.00
Brokerage commission 1.0% 100.00
PTM levy 1.00
Total cost 10,102.00
Market participants will typically want to make timely trades, often responding quickly to new information about a security or about the wider market, and will typically buy at higher prices than the prices at which they are able to sell, overall. Buyers putting through relatively large buy orders may need to push the price of the security up in order to make the trade. Sellers who want to put through a large sell order quickly
Market participants will typically want to make timely trades, often responding quickly to new information about a security or about the wider market, and will typically buy at higher prices than the prices at which they are able to sell, overall. Buyers putting through relatively large buy orders may need to push the price of the security up in order to make the trade. Sellers who want to put through a large sell order quickly