Fundamentals of Financial

Services
Edition 6, May 2023
This learning manual relates to syllabus
version 6.0 and will cover examinations from
1 August 2023 to 31 July 2025
Welcome to the Chartered Institute for Securities & Investment’s Fundamentals of Financial Services study
material.

This learning workbook has been written to prepare you for the Chartered Institute for Securities
& Investment’s examination.

Published By:
Chartered Institute for Securities & Investment
© Chartered Institute for Securities & Investment 2023
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Tel: +44 20 7645 0600 Fax: +44 20 7645 0601

Email: [email protected] www.cisi.org/qualifications

Author:
Martin Mitchell FCSI
Reviewers:
Dianne Ramdeen, MSc, FCCA, CFA, MCSI
Natalie Schoon, ACSI

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Workbook version: 6.2 (May 2023)

ii
Important – Keep Informed on Changes to this Workbook and Examination Dates

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iii
iv
Ethics and Integrity in Financial Services . . . . . . . . . . . . . . . . . . . . 1

1
Saving and Borrowing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

2
Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

3
Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63

4
Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

5
Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

6
Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

7
Other Areas of Financial Services . . . . . . . . . . . . . . . . . . . . . . . 125

8
Glossary of Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

Multiple Choice Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . 163

Syllabus Learning Map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

It is estimated that this workbook will require approximately 60 hours of study time.

What next?
See the back of this book for details of CISI membership.

Need more support to pass your exam?

See our section on Accredited Training Partners.

Want to leave feedback?

Please email your comments to [email protected]

v
vi
 Before you open Chapter 1
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 1
Chapter One

Ethics and Integrity in

Financial Services

5
1. Introduction 3

2. Ethics in Practice 4

3. Ethics in Financial Services 5

4. Environmental, Social and Governance (ESG) Factors 8

5. Responsible Investment 8

6. Impact Investing 9

This syllabus area will provide approximately 1 of the 30 examination questions

2
 Ethics and Integrity in Financial Services

1. Introduction

1
Learning Objective

1.1.1 Know the key principles of ethical behaviour in

financial services

What does behaving ethically mean to you? Do you

think you know? Of course you do! Who doesn’t?
Everyone knows. It is about being honest, fair and
doing things properly.

Words frequently used alongside, or sometimes

instead of ethics include: values, integrity and morals.

Most of us face ethical choices on a regular basis, and

doing the right thing is usually obvious, particularly in
our personal lives, for example, you are not likely to
steal your friend’s smartphone, but what would you
do if you found a smartphone on the bus, particularly
a top-of-the-range model that you have been saving
towards buying for yourself?

Might you be tempted to keep it?

Perhaps, but you know that it is not yours and it is

worth at least £1,000, so the thought of keeping it
should make you feel uncomfortable.

Accordingly, you decide that you will hand it to the

driver, whom you trust to hand it to the bus company’s
lost property office. So doing the right thing – acting
ethically – would appear straightforward.

So, why are there so many reported business situations

in which seemingly rational people are said to have
behaved unethically?

• Is it because they chose to do so?

• Is it because they consider that there are some
situations where ethics apply and others where
they do not?
• Is it because they did not think that their behaviour
was unethical?
• Or, is it perhaps because they thought they could
get away with it?

3
Could it be that it involves a combination of all of these thoughts and actions, as well as some more
perhaps?

There is also the question of why ethical behaviour has become such an issue, particularly in financial
services. If ethics are as important as people are now saying, then surely they have always been
important?

The answer to that is a resounding ‘yes’. Ethical behaviour has always been important. The collective
failure of those working in the financial services sector to keep the importance of ethical behaviour in
the forefront of their minds and actions has been a major contributor to the huge loss of trust suffered
by the sector and, unfortunately, trust is much easier to lose than it is to restore. As Dr Mark Carney, the
Governor of the Bank of England (2013–20), said ‘Trust arrives on foot, but leaves in a Ferrari’.

2. Ethics in Practice
This might be simply rephrased as ‘doing the right thing’. The key point about ethical decision-making
is that you make the choice about the action that you take. Ethics and regulation, or the law, are not one
and the same thing. You may act unethically without breaking the law; your actions may be unpleasant
or antisocial, but not illegal. However, if you break the law, your actions will be both unethical and
illegal.

One of the observations sometimes made about ethics is that the benefit of ignoring ethical standards
and behaviour far outweighs the benefit of adhering to them, both from an individual and also from a
corporate perspective.

In other words, an action taken simply because it seems to be in the best interests of the doer (you)
makes obvious sense. In the earlier example of finding the smartphone on the bus, keeping the phone is
to your advantage. You have something that you want and you have not actively stolen it; you’ve simply
found it. You do not know the owner (the person who lost it), so you do not have a personal connection
which might influence your behaviour.

However, what this argument ignores is that, while a policy of acting in your own interests may seem to
make sense and be sustainable for a short period, in our society the inevitable outcome is likely to be at
least social and at worst criminal sanctions.

In addition, the fact is that either of these outcomes, whether social or legal sanction, is likely to overturn
whatever economic justi­fication there appeared to be for the unethical behaviour. In other words, any
apparent short-term advantage is likely to be a small fraction of the inevitable long-term damage.

So what might you do when faced with a situation where doing the right thing may not be immediately
obvious? There is one simple question, with four key principles embedded within it, that you should ask
yourself:

Is what I am about to do, or are the actions that I am about to take, honest, open, transparent and
fair?

4
 Ethics and Integrity in Financial Services

To test this, let’s go back to the smartphone example. Instead of handing in the phone to the driver, you

1
decide that you will keep it. How would your actions in keeping a valuable phone, which you had found,
not stolen, measure up to the test?

• Was your action honest? This should be simple. You found the phone. It does not belong to you; it
belongs to someone else and the fact that you do not know who is irrelevant. Keeping it for yourself
cannot be considered honest.
• Was your action open? Did you ask anyone on the bus if they had dropped their phone, or look
around to see if anyone was searching for it? Did you try and find out who the phone belonged to
and return it? If not, your action cannot be said to be open.
• Was your action transparent? This depends on your reaction to your friends admiring your new
phone. If you are reluctant to say how you came to have the phone, your actions are not transparent.
• Was your action fair? How can you claim that keeping something that does not belong to you is fair?
You have deprived the rightful owner of their possession. There is a mechanism for returning lost
property and you have not used it.

What seemed like a good idea at the time should now be coming back to haunt you!

3. Ethics in Financial Services

As touched on at the beginning of this chapter, the integrity of people and practices in financial services
has been undermined by a number of recent scandals, one example of which was the rigging of the
LIBOR (London Interbank Offered Rate) interest rate setting mechanism.

Banks were supposed to submit the actual interest rates they were paying, or would expect to pay, for
borrowing from other banks so that a benchmark interest rate (such as the LIBOR rate) can be set.
Having a set interest rate is necessary as it serves as a benchmark for setting the price of government
and corporate bonds, mortgages, student loans, credit cards and other financial products (which will
be covered in more detail later in this workbook).

However, it was discovered that some traders working at banks, such as Barclays, Lloyds, UBS, Deutsche
Bank, JPMorgan Chase, Bank of America and HSBC, had been falsely inflating or deflating interest rates
in order to profit from trades, or to give the impression they were more creditworthy than they actually
were. While inflating the rate may have benefited banks and individual traders involved in the scandal,
benchmark interest rates are used to calculate financial products for people trying to obtain a mortgage
or take out a student loan, and so had significant negative effects on consumers and financial markets
around the world. This eventually resulted in billions of dollars of fines for the banks involved as well as
jail sentences for some of the guilty individuals.

The LIBOR scandal saw the interests of the customer become secondary to the interest of the banks
and individual traders, which is the complete reverse of what the relationship should be. The banks
and those individuals involved in the scandal were not behaving in a way that was honest, open,
transparent and fair.

Another area of financial services which is particularly open to the risk of unethical behaviour is sales.
The examples below discuss the ethics of selling in financial services in a little more depth.

5
 Example.
A company has designed an acceptable product and is trying to establish how best to sell it in
the face of competition. The company decides that the best means of doing this is to pay a sales
commission for each product sold.

The sales force is remunerated on the basis of performance. The more they sell, the more they earn.

It can be argued that there is nothing wrong with such a structure, which simply reflects an established
method of doing business around the world and applies to almost any large or even not so large item.

But there are fundamental differences in the financial services sector which particularly may affect the
relationship between the salesperson and the customer.

For example, if you buy a car, you can see it, you can try it out and you will discover very quickly whether
it performs in the manner advertised and which you expect. You will also be provided, in the case
of a new car, with a warranty from the manufacturer. You can thus make your decision to buy with
considerable confidence, despite knowing that the reward system in the motor industry means that the
salesperson will almost certainly receive a commission as a result of your purchase.

Contrast this with an imaginary financial product:

Example
You, the customer, wish to make financial provision for the future, either by buying a product for a
lump sum, or by making a series of regular payments over a period. You see an advertisement for a
financial product which seems attractive: it promises a return of 5% per annum, compared with the
2% per annum which your savings will receive in the bank.

You contact the company, which has a well-known name, although you have had no previous
dealings with them. A salesperson comes to see you and explains the product in general terms,
focusing particularly on the return offered by the product. The salesperson explains the mechanism
by which the company improves the return to you, over and above what you would receive from
your bank. You are not financially aware and do not really understand everything the salesperson is
saying.

You are now entering the area where, particularly in the financial services sector, the greatest
opportunity arises for the salesperson either to display adherence to ethical values and behaviours, or
to ignore them. The customer who buys a financial product is buying something whose performance is
likely to be determined over a period of time. Ethical salespersons will take you through the structure
of the product offered in such a manner that you may be reasonably sure that you understand what it
is and from whom you are buying. They will explain the risk factors which determine the rate of return
that is offered, and tell you whether that is an actual rate or an anticipated rate which is dependent
upon certain other things happening, over which the product originator may have no control. They will
also tell you what they are being paid if you buy the product.

6
 Ethics and Integrity in Financial Services

In other words, the ethical salesperson will give you all the facts that you need to make an informed

1
decision as to whether you wish to invest. They will be honest, open, transparent and fair.

Conversely, unethical salespersons may seek to convince you with phrases such as ‘no-one else has
asked me about that’, or ‘don’t worry, I wouldn’t sell a product that I didn’t have confidence in’, or ‘no,
I don’t understand it either, but we have rocket scientists to design these things’. Or they may suggest
that this is a limited opportunity and you need to decide now if you wish to take advantage of it.

Unethical salespersons might reassure and convince you with bland words that actually convey nothing,
and you will be encouraged to make a decision without sufficient facts. Consider whether they are being
honest, open, transparent and fair? Fairly obviously not.

They are failing to display ethical values, qualities and behaviours.

The Chartered Institute for Securities and Investment (CISI) recommends its members use the four
ethical principles when considering what the correct course of action might be in situations where it is
not immediately obvious. However, it neatly restates and captures each of the principles to reflect the
acronym CISI as illustrated below:

• Honest becomes ‘Clear and honest’.

• Open becomes ‘Impartial and open’.
• Transparent becomes ‘Straightforward and transparent’.
• Fair becomes ‘Informed and fair’.

7
4. Environmental, Social and Governance (ESG) Factors
Learning Objective

1.1.2 Know the meaning and characteristics of environmental, social, and corporate governance
(ESG) factors and issues

ESG stands for environmental, social and governance and it has become increasingly important over
the recent years. ESG is linked to ethics in that it assesses whether a company is ‘doing the right thing’
in terms of the impact it has on the environment, the community in which it operates and the way it is
governed. When it relates to companies, because companies are corporate bodies, governance is often
referred to as corporate governance.

Examples of what might be assessed include the following:

• Environmental criteria:
• How much energy the company uses and how responsible it is in conserving energy.
• Whether the company minimises waste and pollution.
• The conservation efforts of the company and the impact it has on the natural world.
• Social criteria:
• The extent to which the company supports its local community.
• Charitable contributions made by the company.
• Whether the health and safety of the workforce is held in high regard.
• The values encouraged and required of the company’s suppliers, such as their working
conditions and the way their employees are treated.
• (Corporate) Governance criteria:
• The diversity of the company’s management and board of directors, in terms of age, experience,
ethnicity and gender.
• The balance between executive directors (making day-to-day decisions) and non-executive
directors (acting in a more consultative capacity).
• The values and ethical expectations placed on the staff, particularly the senior management.

5. Responsible Investment
Learning Objective

1.1.3 Know the role of responsible investment

Consideration of ESG criteria, such as those above, is an increasing part of the investment process. The
primary aim of investing might still be to grow the money invested over time, but this can be combined
with other ethical criteria that will distinguish which investments are acceptable or unacceptable. What
is acceptable or unacceptable is likely to vary by investor, however combining ethical and other factors
will hopefully mean that investment is made more responsibly, benefiting the environment and society.
This is referred to as ‘responsible investment’.

8
 Ethics and Integrity in Financial Services

So, before an investor is willing to buy shares in a company, that investor might first want to assess how

1
responsible that company is. However, what is deemed to be responsible is likely to vary.

Some investors might want to avoid companies that are engaged in what they feel is inappropriate
because of the environmental or social harm it might cause. Companies involved in tobacco, gambling,
the production of alcoholic drinks or weapons might be good examples.

Others might like to confine their investments to companies that make a positive impact, such as those
creating clean energy or organic produce. Using a gender lens and microfinance are specific examples
of this form of responsible investment that are considered further in the following section.

Finally and critically, it is possible that, as doing the ‘right’ thing morally and ethically becomes
increasingly important, those companies that do so become more successful and valuable. So, investing
responsibly might be helpful in generating better investment returns than might otherwise be the case.

6. Impact Investing
Learning Objective

1.1.4 Know types of impact investing: gender lens investing; microfinance

6.1 Introduction
As the term suggests, impact investing involves investing money that, in addition to generating a
financial return, is also targeted at having a positive impact on society or the environment. It enables
investors to invest with a conscience in the knowledge that the investment will make a favourable
difference. Both gender lens investing and microfinance are examples of impact investing.

6.2 Gender Lens Investing

Gender lens investing is about focusing on investments that will promote gender equality, providing
opportunities to women. These opportunities could be providing capital to enable women to launch or
expand their businesses, or to help fund products and services that will benefit women and girls.

A ‘gender lens’ can also be applied by investors pushing for an appropriate balance of male and female
membership of the board of directors and the broader workforce, as well as putting pressure on the
company towards equality of working conditions, including levels of pay between male and female
employees.

9
6.3 Microfinance
Microfinance tries to make an impact on low income or unemployed individuals, who would not
normally have access to conventional financial services. Often targeting under-developed or developing
countries, microfinance typically takes the form of low value loans (microloans) that are often combined
with some financial or business education. It usually helps sole traders, family businesses and small
cooperatives become more organised in order to buy the equipment they need, becoming more stable
and resilient as a result. Crucially, it can also remove the need for the impoverished to utilise what are
often unprincipled and expensive moneylenders.

Exercise 1
The four key principles and tests to assess whether or not behaviour is ethical revolve around
whether the action taken was open, honest, transparent, and which of the following?

a. Fair
b. Balanced
c. Legal
d. Harmless

Exercise 2
Consider what you read in section 2 and think about how you could apply the four key ethical
principles to:

• A situation at home or in your private life.

• A situation at work.
• A situation reported in the media.

You should now be able to rationalise what is the right and ethical thing to do by using the four key
ethical principles.

Exercise 3
Consider the criteria that you feel strongly about beyond simply maximising the return that you
get on your investments. For example, if you were considering investing in a company, do you care
about any of the following:

• The environmental impact of the company’s activities.

• The extent to which the company supports the local community in which it operates.
• The diversity of the company’s board of directors.
• Whether the company is involved in the manufacture of weapons, alcoholic drinks, animal
products or gambling.

This should enable you to begin to identify the elements that you feel are important for your
investments to be responsible.

10
 Ethics and Integrity in Financial Services

Answers to Chapter Exercises

1
Exercise 1 – Ethical Behaviour
A (chapter 1, section 3).

The four ethical principles are to assess whether the behaviour was honest, open, transparent and
fair.

11
12
Chapter Two

Saving and Borrowing

5
1. Introduction 15

2. Who are the Savers and Borrowers? 20

3. Risk and Reward 21

4. Equity and Bond Markets 24

5. Insurance 25

6. Foreign Exchange 27

This syllabus area will provide approximately 4 of the 30 examination questions

14
 Saving and Borrowing

1. Introduction
Learning Objective

2
2.1.1 Know how the financial services sector can be
viewed as linking those with surplus money
(savers) and those with a need for money
(borrowers) in the following ways: via banks
(deposits, loans); via equities (ownership
stake); via bonds (IOUs)

Let’s not fool ourselves. The financial services sector

looks pretty complicated to most of us. Why is this?
Well, it’s primarily because of the technical jargon
that is used to explain things: bonds, shares, funds,
interest rates and inflation rates are just some of the
many examples. This workbook will unravel most of
the complexity and you will emerge with sufficient
understanding to deal confidently with financial
matters. You will have the ability to ask relevant and
sensible questions and be able to properly comprehend
the answers.

This could help you in a variety of ways. Perhaps a

job in finance is right for you. Perhaps you simply
need to be able to manage your own, or your family’s,
financial affairs better. Hopefully, this course of study
will help you do either one, or both!

To start with, let’s try to portray the world of finance as

simply as we can. Let’s think of it as the link between
two groups – we will call one of them the ‘savers’ and
the other the ‘borrowers’. The savers are fortunate –
they have more money than they need right now, so
they want to do something with their surplus money
that will hopefully see it grow.

These savers could be individuals, companies or

governments, and some of them have a lot more
surplus money than others. The financial services
world tends to refer to individuals who have
substantial amounts of surplus money as ‘high net
worth individuals’ (HNWIs). Some companies also
have a lot of spare cash, for example Apple had
around $27.5 billion in its bank accounts at the end
of 2022.

15
Like savers, the borrowers can also be individuals, companies and governments.

An example of a borrower might be a small start-up idea, such as CareerComic, as detailed below.

Example
Two young college graduates have a great idea. They think that other college graduates and
schoolkids would love to have access to a database of available careers that is portrayed in a fun,
simple and understandable way. They want to pull together a comic strip of a day in the life of each
career – CareerComic.

They have talked to people about their plans for CareerComic and they have potentially found
someone – an investor – who will provide them with some money to produce a high-quality example
of how the comic will look. In return for their investment, the investor will be given a 50% share of the
business – they are hoping the business might grow and be worth a lot of money one day.

It is the financial markets that provide the link between savers and borrowers. The link between the two
is provided in three main ways – by the banks, by equity and by bonds – each of which is explained in
the following paragraphs.

In
nd re ter
s t a nts pa es
ym t a
re e
te ym
Banks en nd
In pa ts
re Lo
an
s

s
an
Lo

Equity

Bonds

16
 Saving and Borrowing

1.1 The Role of Banks

Traditionally, banks have provided a convenient link between savers and borrowers, making a profit on
the difference between what they pay savers and what they charge borrowers.

2
The savers deposit their surplus money at the bank, for which the bank is willing to pay interest – say,
5% pa. The bank will then lend the deposited money on to borrowers, perhaps charging them 8% pa
interest on the loans. So, if a bank attracted a combined £100 million in deposits, it would need to pay £5
million interest for the year (5% x £100 million). If the bank managed to lend the £100 million, it would
receive £8 million interest for the year (8% x £100 million). By receiving interest of £8 million and paying
interest of only £5 million, the bank is generating a £3 million surplus. This is not profit, but a surplus
from which its various costs need to be paid, such as staff wages, office rental payments and taxes. What
is left after deducting these costs is profit.

Banks
Pay £5m Receive
interest £8m
interest

£ £ £

Deposited Borrowed
£100m £100m

1.2 Equity
For businesses looking to raise money, an alternative to borrowing from banks is for the business to sell
equity. Equity is alternatively referred to as shares or stock and it represents ownership. The holders of
the equity in a company own that company. So, if a business is set up as a company, it can raise money
by selling shares. This is exactly what happened in the earlier CareerComic example – finance was raised
by selling an equity stake in the business.

What is the essential

difference between equity
and borrowing?

So, why might equity be preferred as a source of finance to borrowing? There are a number of differences
between the two that will need to be considered and which will be explored a little later in the chapter
with a further look at CareerComic. For the moment, perhaps the key differences are that interest needs
to be paid on borrowing, and the money borrowed has to be repaid. There is no interest paid on equity
and equity does not need to be repaid.

17
It is not only start-ups that raise money by selling equity – big companies occasion­ally sell large
quantities of equity in initial public offerings (IPOs). A good example is the massive IPO of the US
communication company, Zoom inc which floated in April 2019.

Example
The Zoom IPO

Zoom Video Communications inc, sold 20.1 million shares at $36 per share in April 2019, raising
just over $725m in total and valuing the company at $9 billion. On its first day of trading, the shares
doubled to $72. Then as the COVID-19 pandemic struck in March 2020 and the world went into
lockdown, Zoom’s business expanded significantly and its share price reached $250 in June 2020. This
prompted a number of investors to sell their shares at a significant gain.

However, if these investors had held onto their shares, they could have more than doubled their
money again. In October 2020, Zoom’s share price was almost sixteen times its original IPO price, at
$575. It has since fallen substantially and at the time of writing (end of 2022) Zoom shares trade for
$83 each.

Company
issues shares

Equity

Investors buy the

shares

1.3 Bonds
The third major way that savers and borrowers are linked in the financial markets is where the borrowers
issue IOUs (IOU = ‘I owe you’), typically called bonds. These IOUs are issued directly to the investors,
missing out the banks. Like a loan from a bank, borrowing money by issuing bonds is another form of
debt on which the borrower will pay interest and which needs to be repaid.

If a borrower wants to raise £100 million, it could subdivide the amount into one million IOUs, each
representing £100 – these are called bonds. The borrower might agree to pay the holders of the bonds
their £100 back in ten years, and until that point agree to pay them a rate of interest each year. In this
example, we are assuming the company pays interest to the lender of 7% each year.

18
 Saving and Borrowing

Investors Company
buy the issues
bonds bonds

2
£ £ Bonds
For example:
IOU £100
To be repaid in ten years
paying interest at 7% each
year

Exercise 1 – Financing Choices

Remember CareerComic is the idea of two young college graduates. They think that other college
graduates and schoolchildren would love to have access to a database of available careers in the
form of a comic strip of a day in the life of each career. However, they need to raise some finance to
produce a high-quality example of how the comic will look.

Businesses like CareerComic have two potential sources of finance – either borrowing the money or
raising equity by selling shares.

Try to complete the following table to highlight how the two sources compare and what may have
driven CareerComic to choose equity. Once you have completed the table, please compare your
answers with the completed table in the appendix to the chapter.

Borrowing
Consideration
or Equity?
Which one is more
expensive (in terms of ?
annual cash costs)?
Which one is likely to
?
need to be repaid earlier?
Which one is more likely
to be available for a start- ?
up company?
Which one is likely to be
the more risky for the ?
finance provider?
Which one is likely to
have the largest potential
?
‘upside’ for the finance
provider?

Based on the above, can you understand why CareerComic chose to raise finance through equity?

19
2. Who are the Savers and Borrowers?
Learning Objective

2.1.2 Know that borrowers include companies and governments and that governments issue bonds
rather than equities

We have already seen that many savers are individuals or firms with surplus money that they do not
need right now. They will invest this money instead, perhaps by depositing it in a bank, or by buying
bonds or equities.

The borrowers we have encountered so far are companies that are looking for finance either to start
up (like CareerComic) or to grow from an already established base (like Zoom). However, it is not only
companies that borrow. Many individuals do not have surplus money, and instead have a shortage
of money, particularly when it comes to financing high-cost items such as household items (washing
machines, televisions and fridges) or a house. Clearly, such individuals can be borrowers when they take
out loans to make such purchases. Loans to buy homes are known as mortgages.

As will be explored in chapter 3 of this workbook, there are different ways for individuals to borrow
money. Sometimes, the money is borrowed for a particular purpose, such as a mortgage, or a car loan.
On other occasions, money can be borrowed for a consumer item such as a widescreen TV or a washing
machine. These are often simply described as personal loans. Furthermore, some forms of borrowing
may need to be repaid earlier and some much later.

A good example is the bank overdraft, which is a form of loan on which the bank can demand
repayment immediately. By contrast, a typical mortgage may not be totally repaid for 25 or 30 years.

One important group of borrowers that we have not yet encountered is governments. Many
governments collect substantial sums of money each year by imposing taxes on their residents to spend
on a variety of items, including roads, hospitals, defence, education and the wages of government staff.

In some cases, government expenditure exceeds government revenue. The difference needs to be
financed in some way and it is generally borrowed.

20
 Saving and Borrowing

However, government borrowing tends not to come from banks but from individuals and firms in the
form of regular issues of bonds. For example, in summer 2022, the UK had outstanding bonds that
added up to more than £2.4 trillion – that is two point four thousand, billion pounds – and the US had
more than $30 trillion! These amounts are known as the country’s national debt.

2
Not all governments are borrowers. In places such as Norway, some Gulf states and Singapore, the
government generates a surplus that puts it in the position of being a saver rather than a borrower.

In Norway and the Gulf, this is often due to an abundance of natural resources, particularly oil and gas.
In Singapore, it is essentially due to a very successful economy and a government that is careful about
how it spends its revenues.

3. Risk and Reward

Learning Objective

2.1.3 Know the relationship between the level of risk and the prospect of reward

We have established that there are a variety of possible ways that savers can invest their surplus money,
particularly by depositing the money at a bank, or by buying equities or bonds. So, what would make
them choose one investment over another?

Have a look at the example below to discover a little more.

Example
Sophie has some money she wants to invest. She wants to be reasonably confident that she will be
able to get all of her money back in two or three years’ time, when she hopes to use the money as
a deposit for the purchase of her first home. She has narrowed down two possibilities: an instant
access bank deposit account that will pay 5% pa, and a two-year bond issued by a company that
will pay 7% pa. Which one should she go for?

The answer is that it depends on what Sophie is looking for in terms of flexibility and how much risk
she is willing to take with her money.

On the face of it, the two-year bond is better in that it pays interest that is 2% higher. However, the
bond may be risky – it might be issued by a small company that may not have the cash to repay it
in two years’ time. The deposit account is instant access, so that if Sophie were to need her money
earlier than planned, she could access it.

Therefore, it is Sophie’s preference – to take possibly greater risk for greater reward, or to take less
risk and accept a lower reward and/or immediate access – which will ultimately determine which
investment is right for her.

21
As the above example illustrates, making the right investment choice is not always straightforward.
In fact, there is always a direct link between the risk the investor is willing to take and the potential
reward that the investor might realise from the investment. It’s the financial equivalent of the fitness
industry saying ‘no pain, no gain’. In investment terms, the returns can be positive and generate gains,
or negative and generate losses. The less likely it is that the investor will lose money, the less spectacular
the potential level of return the investor can hope for. Risk and reward run hand in hand.

Higher Reward

Increasing Risk

More risky and less risky investments are sometimes straightforward to identify. If you were to buy shares
in an established company like Microsoft or Apple, there would generally be somewhat less risk, in the
longer term, than if you were to invest in a loss-making, early-stage company. Similarly, investing your
surplus money by putting it into an established bank’s deposit account is likely to be significantly less risky
than investing it by lending to a friend.

22
 Saving and Borrowing

Try the following exercise to see if you can identify the riskier and, potentially, more rewarding
investments:

2
Exercise 2 – Risk and Reward
Put the following investments in order, from the most risky (and potentially rewarding) to the least
risky (and safer). The suggested answer can be found at the end of the chapter.

Risk ranking
Investments (where 1 is the highest risk and
6 the lowest risk)
US government bonds ?
Equities issued by a start-up
?
company
Equities issued by a large, well-
?
established company
Bonds issued by a large, well-
?
established company
Bonds issued in US dollars by
a country with a stuttering
?
economy and unstable
government.
Roulette wheel at a casino ?

As the above exercise should illustrate, it is generally the case that equities are more risky than bonds.
This is because, unlike bonds, equities do not specify a percentage return that will be paid each year
and do not have a set date at which they are repaid. Furthermore, when something goes wrong, it is the
equities that are last in the queue when it comes to getting any money back.

It is also the case that when looking at two bonds, or two equities, the bonds or equities issued by the
smaller, less financially secure entity are going to be more risky than the bonds or equities issued by the
larger, more financially secure entity.

23
4. Equity and Bond Markets
Learning Objective

2.1.4 Know that the financial services sector also includes markets to enable investors in equities
and bonds to buy or sell investments

As has been made clear in the preceding section, equities are different from bonds in a number of
respects including the following:

• Equities give the holder an ownership stake in the issuing company. Bonds do not.
• Equities have no set date of repayment. Bonds typically have a set repayment date.
• Equities do not pay interest. Bonds typically do pay a specified percentage interest each year.

With this in mind, why are investors willing to put money into equities when they can see little or no
prospect of the issuing company buying those equities back in the future? Fundamentally, they hope
the company will perform well and generate profits. A share of these profits might be paid by the
company to the shareholders in the form of dividends (see chapter 4, section 3), but ultimately the
holders of equity know that they will be able to sell the equities they own to someone else. Selling the
equities will enable them to realise their investment, potentially for more money than they paid for the
shares.

Facilities to sell equities are provided by the equity markets and include world-famous exchanges
like the New York Stock Exchange (NYSE), the Abu Dhabi Securities Exchange (ADX), the London
Stock Exchange (LSE), Europe’s Euronext exchange, Japan’s Tokyo Stock Exchange (TSE) and China’s
Shanghai Stock Exchange (SSE). Most countries have stock exchanges and other examples include
Singapore’s SGX, Sri Lanka’s Colombo Stock Exchange, India’s Bombay Stock Exchange, South Africa’s
Johannesburg Stock Exchange (JSE) and Saudi Arabia’s Tadawul. These exchanges trade millions of
shares every day and began as meeting places where buyers (or people representing them) would meet
sellers (or people representing them) to agree purchases and sales. Now the majority of deals are made
electronically, with most exchanges essentially operating as electronic auction facilities similar to eBay.

Buyers Sellers
of shares of shares

Markets

Where deals are arranged.

Known as stock exchanges.

24
 Saving and Borrowing

Like equities, bonds can be bought or sold before they reach their repayment dates.

However, in contrast to equities, most bonds tend to be bought and sold away from the big exchanges.
This is largely due to the fact that nearly all bonds have a maturity or repayment date when the

2
bondholder’s IOU will be repaid. For equity holders this will not happen, so a facility to sell the shares
has traditionally been much more important. Those buyers of bonds that do wish to sell before the
repayment date are brought together with sellers of bonds via electronic facilities that are generally
described as over-the-counter (OTC) facilities. OTC is simply a term for trades that are arranged away
from the established exchanges either directly between buyer and seller or via an intermediary such as
a bank or a broker.

5. Insurance
Learning Objective

2.1.5 Know that the financial services sector also includes insurance providers to enable financial
risks to be managed

In addition to providing the link between savers and borrowers, the financial services sector also includes
activities that are best described as risk management. We all face risk in our lives, and the examples of
the risks faced are numerous – from the risk of a car crash to the risk of a household burglary and the risk
of suffering from a serious illness.

These and other risks can be controlled by taking out insurance from insurance companies. The
insurance company will take on specified risks in exchange for a series of premium payments. If the risk
materialises, the insurance company will pay out.

There are numerous different forms of insurance, ranging from a large shipping company covering the
risks that its ships may break down or hit rocks – known as marine insurance – to a ‘life policy’ where
an individual insures that, if they die, their dependants will receive a lump sum or annuity of money
sufficient to clear the mortgage loan on the family home. Further examples are detailed below.

Example
Motor Insurance

Charlie is 21 years old and has just bought his first car – a second hand, seven-year-old but high
specification Volkswagen Golf that is worth £7,000. It is a legal requirement that Charlie has insurance
before he takes the car out on the road. He contacts an insurance company, which quotes him £2,400
for a one-year policy that will pay out in the event of an accident that is Charlie’s fault. Charlie signs
up, agreeing to pay a monthly premium of £200, and starts to enjoy driving his new car on the road.

25
 Exercise 3 – Insurance Premiums
Charlie’s mother Sarah has a two-year-old car, a BMW worth £18,000. Sarah has been driving for 20
years and has never had an accident. Her monthly premium is £60.

Why do you think Sarah’s monthly premium is so much less than Charlie’s, despite her car being
worth more?

The answer can be found in the appendix at the end of this chapter.

Example
Oil Rig Insurance

A recently established oil exploration company – Explo inc – has just completed the construction of
its first oil rig in the ocean off West Africa. The rig is estimated to be worth around $100 million and
Explo wants to insure the rig in case of damage due to mechanical failure or adverse weather. An
insurance company offers to insure the rig for $5 million pa.

By taking up the offer with the insurance company, Explo’s worries about mechanical and weather
damage are much reduced – the risks have been transferred to the insurance company in exchange
for the premium of $5 million each year.

There are a number of substantial insurance companies in the world, including well-known names like
Axa of France and Allianz of Germany. However, despite the size of an individual insurance company, the
amount of risk it takes on when it sells insurance may be too big for it to be willing to bear alone.

To manage the risk, insurance companies can, and do, take out insurance themselves and this is generally
referred to as reinsurance. Reinsurance allows the risk taken on by insurance companies to be shared.

Exercise 4 – Oil Rig Insurance

Explo inc has essentially transferred the risk of damage to the oil rig to the insurance company. Now
the insurance company is facing a risk that could result in paying out $100 million if the oil rig is
destroyed in a typhoon.

What could the insurance company do to reduce its risk?

The answer can be found in the appendix at the end of this chapter.

26
 Saving and Borrowing

6. Foreign Exchange
Learning Objective

2
2.1.6 Know that the financial services sector also includes foreign exchange dealers to allow one
currency to be exchanged for another to facilitate international trade

Foreign exchange (Forex, or FX) is simply changing a particular quantity of one currency, such as
US$100, for an equivalent amount of another currency, such as €90.

There are a considerable number of currencies across the globe, and the most obvious example of the
need for foreign exchange arises whenever individuals travel to different parts of the world.

Example
When an American crosses the Atlantic and visits France for a holiday, they will need euros rather than
their more familiar US dollars. To get hold of euros they will probably go to their bank in advance of
the trip and purchase a couple of hundred US dollars’ worth of euros. If the appropriate rate for euros
per US dollar were 0.86, their $200 would get them €172.

So, individuals travelling gives rise to some foreign exchange activity, but this is dwarfed by the
impact of businesses buying and selling things across borders.

Example
An American company – SurfBoards of America (SBoA) – manufactures surfboards and receives a
substantial order from a European retailer that wants to pay in euros.

SBoA ships the surfboards and ends up receiving thousands of euros from the European client.
However, SBoA needs US dollars, so it calls up the foreign exchange dealer at its local bank and
agrees to sell the euros for the US dollars it wants.

27
 Exercise 5 – Where to Go Next?
Raj is a US citizen and has two great loves – seeing the world and enjoying his favourite creamy
cappuccino coffee. He is trying to decide which capital city he will visit next, and has decided to go
to the one with the cheapest cappuccino in US dollar terms. His local café in New York sells large
cappuccinos for $5. Below, are the local currency prices in the ten cities that Raj is considering.
Using either newspapers or the internet, please find the relevant exchange rates and calculate the
equivalent US dollar price. Then rank the cities from the cheapest to the most expensive cappuccino.
The answer is provided in the appendix at the end of this chapter, and the rates detailed there are as
at Winter 2022.

Ranking:
Cappuccino Exchange rate Equivalent
cheapest (1) to
City and currency price in local with the US US dollar
most expensive
currency dollar price
(10)
Rio – Brazilian reals 9.00
Hong Kong – Hong
42.50
Kong dollars
Mumbai – Indian rupees 240.00
Tokyo – Japanese yen 500.00
Paris – euros 4.00
London – UK pounds 4.00
Dubai – UAE dirham 18.00
Jeddah – Saudi Arabian
22.00
riyals
Zurich – Swiss francs 5.50
Moscow – Russian
210.00
roubles

The US dollar is regarded as the most important currency in the world, and as a result it is typical that
the way foreign exchange tends to be quoted is by the number of a particular currency that a US dollar
is worth. The attraction to the banks and their dealers in offering foreign exchange quotes is in providing
services their clients need, arising from international trade and international travel in particular. The banks
and their dealers earn fees in the form of commission and also have the potential to make money from the
exchange rate differences. As an indication of activity in the foreign exchange market, in 2022, the daily
activity in foreign exchange exceeded a massive $7.5 trillion (that’s $7,500 billion).

28
 Saving and Borrowing

Exercise 6
If a company borrows money by issuing IOUs (‘I owe you’) in return for the money loaned, how are
these IOUs typically described?

2
a. Shares
b. Bonds
c. Equity
d. Loans

Exercise 7
Certain governments, such as the US and the UK, have substantial amounts of national debt. How is
this national debt usually funded?

a. Using equity
b. Using bonds
c. Using loans
d. Using shares

Exercise 8
If the holder of a bond wants to realise their investment before the scheduled repayment date, which
of the following would they normally do?

a. Arrange an early repayment with the bond issuer

b. Exchange the bond for equities
c. Sell the bond on the stock market
d. Sell the bond OTC

29
Answers to Chapter Exercises
Exercise 1 – Financing Choices

Consideration Borrowing or Equity?

Which one is more Answer: Borrowing

expensive (in terms of Borrowing is the more expensive in terms of the requirement to pay
annual cash costs)? interest each year. Equity does not require the payment of interest.
Which one is likely Answer: Borrowing
to need to be repaid Borrowing is generally required to be repaid on, or by, an agreed future
earlier? date. There is no such requirement in relation to shares.
Answer: Equity
Since a start-up has not established a pattern of making money,
borrowing is often unavailable. However, equity finance may be
Which one is more
available from investors who are willing to take a risk in the hope of
likely to be available
making a substantial return if the start-up is successful. Furthermore,
for a start-up
governments often provide incentives for equity investors in early-
company?
stage and start-up companies that enable them to save some tax. The
logic of the incentives is to encourage job creation and increase the
attractiveness of investing in the equity of start-ups.
Answer: Equity
If the company is a start-up, then both forms of finance are risky. The
business may not succeed and has not yet proved itself. However, if the
Which one is likely to business does get off the ground, but is not particularly successful, the
be the more risky for providers of borrowed finance will at least receive some interest. It is
the finance provider? also the case that if the company does fail and there is any money left
at all, the borrowing is repaid before the equity. So, equity is more risky
because it is the last in the queue, standing behind borrowings in terms
of the order of repayment.
Answer: Equity
When a company does spectacularly well, it is the shareholders (as
Which one is likely
owners) who will benefit. There are numerous stories of technology
to have the largest
billionaires who provided equity to companies like Microsoft®, Google,
potential ‘upside’ for
Facebook and Zoom. By contrast, the upside for those banks that have
the finance provider?
provided borrowed finance to successful start-ups is simply to get the
interest and to be repaid in full.

30
 Saving and Borrowing

Based on the above, can you understand why CareerComic chose to raise finance through equity?

For CareerComic, borrowing might not have been available, and even if it were available it would
mean CareerComic would need to find the cash to pay the interest and ultimately to repay the money.

2
Equity finance will not demand the payment of interest and, from the finance provider’s perspective,
provides the upside potential that could run into thousands, millions or even billions.

Exercise 2 – Risk and Reward

Suggested order, from the most risky (and potentially rewarding) to the least risky (and safer).

Risk ranking (where 1 is the highest

Investments
risk and 6 the lowest risk)
US government bonds 6
Equities issued by a start-up company 2
Equities issued by a large, well-established company 3
Bonds issued by a large, well-established company 4
Bonds issued in US dollars by a country with a
5
stuttering economy and unstable government
Roulette wheel at a casino 1

Note that it is debatable whether money invested in US government bonds faces less risk than a bank
account. Some would argue that the US government bonds are safest, as they are denominated in US
dollars and the US prints the dollars. A bank could collapse, and the depositor might lose money as a
result. This view is taken in the above suggested answer.

However, bank balances within certain limits are typically provided with insurance in the form of
a government guarantee. If the bank account is assumed to be within the government’s insurance
limits, it could be considered to be at the same risk ranking as the government’s bonds. Furthermore,
since the US occasionally suffers from political infighting when its borrowing is approaching certain
limits (known as the ‘debt ceiling’), it could be that the bank account is considered less risky than the
government bonds. The real world is not quite as straightforward as we might like!

31
Exercise 3 – Insurance Premiums
Charlie is 21 years old and he has just bought his first car – a seven-year-old VW Golf that is worth
£7,000. His insurance costs him £2,400 for one year – £200 per month. Charlie’s mother Sarah has a
two-year-old car, a BMW worth £18,000. Sarah has been driving for 20 years and has never had an
accident. Her monthly premium is £60.

The reason Sarah’s monthly premium is less than one third of the amount of Charlie’s, despite her
car being worth much more, is all about risk. The insurance company judges the likelihood of Charlie
having an accident as much greater than the likelihood of Sarah having an accident. The reasons
include the fact that Charlie is a young, inexperienced male driver, and such drivers have a history of
driving too fast and being involved in a significant number of road accidents.

By contrast, Sarah has already proven to be accident-free for the last 20 years and is a far more
experienced driver. Middle-aged women tend to be involved in far fewer road accidents than young
males.

So, the likelihood of the insurance company being required to pay out on a claim for Sarah is deemed
to be much less than for Charlie. Despite the relative values of the cars, the insurance company deems
the risk and size of possible payout to be less for Sarah than for Charlie.

Exercise 4 – Oil Rig Insurance

Explo inc has transferred the risk of damage of an oil rig worth $100 million to the insurance company.
The insurance company is facing a risk that could result in it paying out $100 million if the oil rig is
destroyed in a typhoon or another incident.

If this is deemed to be too large a risk for the insurance company to bear, the solution is for the
insurance company to share the risk by taking out insurance with other insurers. This often happens
and is called reinsurance. The insurer of Explo’s $100 million oil rig is likely to reinsure a significant
portion of this, such as $90 million, with other insurers. This would subsequently leave Explo with just
$10 million of risk, a sum that it can handle with more ease.

32
 Saving and Borrowing

Exercise 5 – Where To Go Next?

Based on the exchange rates in winter 2022, Raj should choose Rio for his next visit, as a cappuccino
there is the cheapest in US dollar terms at just $1.67. This is significantly cheaper than Raj pays in his

2
local New York café, where the price is $5.

Ranking:
Cappuccino Exchange rate Equivalent
cheapest (1) to
City and currency price in local with the US US dollar
most expensive
currency dollar price
(10)
Rio – Brazilian reals 9.00 5.3848 1.67 1
Hong Kong – Hong
42.50 7.7522 5.48 7
Kong dollars
Mumbai – Indian rupees 240.00 72.8425 3.29 3
Tokyo – Japanese yen 500.00 104.665 4.78 4
Paris – euros 4.00 0.8244 4.85 5
London – UK pounds 4.00 0.7223 5.54 8
Dubai – UAE dirham 18.00 3.6732 4.90 6
Jeddah – Saudi Arabian
22.00 3.7500 5.87 9
riyals
Zurich – Swiss francs 5.50 0.8904 6.18 10
Moscow – Russian
210.00 73.8725 2.84 2
roubles

Exercise 6 – Bonds
6. B (chapter 2, section 1.3).

Bonds are effectively IOUs issued by organisations such as companies and governments in return for
money for a period of time.

Exercise 7 – National Debt

7. B (chapter 2, section 2).

National debt is generally funded by the issue of government bonds.

Exercise 8 – OTC Facilities

8. D (chapter 2, section 4).

The vast majority of bonds that are sold before the scheduled repayment date are traded away from
established exchanges on OTC facilities.

33
34
Chapter Three

Banking

5
1. Retail and Commercial Banking 37

2. Retail Borrowing in Focus 38

3. Interest Rates 43

4. Secured and Unsecured Borrowing 49

5. The Relative Cost of Borrowing 50

6. Investment Banks 51

7. Central Banks 53

This syllabus area will provide approximately 5 of the 30 examination questions

36
 Banking

This chapter will focus on banks – what they do and

in particular how the various types of bank differ from
one another. As already mentioned in chapter 2, part
of the complexity that appears to be present within
financial services is simply the result of the jargon
that is invariably used. We will unravel and explain the
special language that is used in banking in this chapter.

3
1. Retail and Commercial
Banking
Learning Objective

3.1.1 Know the difference between retail and

commercial banking and the types of
customer – individuals/corporates

Most of us are aware of what retail banks do, because

we see them on the high street. Individuals are often
referred to as retail customers, and banks that provide
services to individuals are referred to as retail banks.
The business model for a retail bank is similar to the
business model that was introduced in the previous
chapter – the bank will try to attract deposits from
individuals, and use these deposits to make loans to
other individuals. The bank should generate a surplus
because the interest it pays on deposits is less than
the interest it demands on loans. This surplus can then
be used by the bank to pay its other expenses, such
as paying the wages of the staff and the rental on the
premises. If a surplus still remains after paying all of
these other expenses, the bank has generated a profit.

The term commercial bank is often encountered in the

financial services sector, especially in the US. It is used
in one of two contexts. The US uses it as a term that
captures all the banks that are doing what has thus far
been referred to as the activities of a bank: attracting
deposits and making loans. In other parts of the world,
the term ‘commercial banking’ is often used to isolate
those banks that specialise in providing banking
facilities (deposits and loans) to commercial entities,
in other words to businesses, rather than individuals.

37
This latter definition is alternatively described as corporate banking, since the business clients are
predominantly corporate entities, ie, companies.

Commercial Banks
The US definition – all banks that take
deposits and grant loans

Retail Banks Corporate Banks

Banks that specialise Banks that specialise in taking
in taking deposits and deposits and providing loans to
providing loans to businesses. In parts of the world
individuals outside the US, these are often
referred to as commercial banks

It can be a little misleading to refer to banks as retail or commercial, since the reality is that most banks do
both. Just think of the likes of Bank of America in the US, Lloyds and Barclays in the UK and HSBC globally,
where both retail and corporate clients are catered for.

2. Retail Borrowing in Focus

Learning Objective

3.1.2 Know the nature and types of borrowing available to retail customers: from banks – loans,
mortgage loans, overdrafts; from banks and credit card companies – credit cards; from other
sources – pawnbrokers, payday loans

Individuals sometimes like, or even need, to spend more money than they have by borrowing. The bank
is often the first place they go to in order to borrow money, as they tend to deposit their funds in retail
bank accounts.

2.1 Loans, Mortgages and Overdrafts

The three most common forms of borrowing provided to retail customers by banks are loans, mortgages
and overdrafts. Each of these are illustrated in the examples below.

38
 Banking

Example
Three college graduates – Dot, Jade and Anna – have started working full-time.

Dot’s job is some distance from her home and public transport is not great, so she decides that she
needs to buy a car. She finds an ideal vehicle, a second-hand Volkswagen Polo that will cost around
$6,000.

3
As Dot has little in the way of savings, she applies to her bank for a $6,000 loan. The terms are that
the loan will be repaid in monthly instalments over three years, and interest will be charged at 8% pa.

The above example saw Dot borrow money for the car purchase using a bank loan. Bank loans can be
taken out for any purpose – it does not have to be for a car – but the standard features are that the loan
is normally:

• for a set period that is generally less than five years (it is three years in the above example)
• at a set rate of interest (8% in the above example)
• with a defined repayment schedule (monthly in the above example).
Dot’s loan is also called an unsecured loan. This is because the bank does not require any security, such
as the car, to be handed over to it while the loan is outstanding.

Jade is fortunate enough to have wealthy parents who have encouraged her to buy a home of her
own. Jade has found a property that is ideal, but it will cost her $250,000. Her parents have agreed to
give her $50,000 and she borrows the rest from the bank in the form of a mortgage.

The terms are that Jade will make monthly repayments over 25 years; the interest rate for the loan will
be at the bank’s standard variable rate (currently 6%, but liable to change) and, in the event of Jade
failing to make the required payments, the bank has the ability to take ownership of the property in
order to recoup the money owed.

The above example is a mortgage loan, often just described as a mortgage. Mortgage loans are always
taken out to buy property, and because they tend to involve substantial sums of money, the loans are
generally repaid over longer periods than other forms of loan. Since the bank that lends the money will
be repaid over this lengthy period, the bank tends to charge a variable rate of interest that can increase
or decrease to stay in line with general interest rates.

Furthermore, unlike most other forms of loan, the mortgage loan has the safety feature for the bank that
it is secured on the property. If the borrower fails to make the scheduled repayments, the bank can take
the property in order to repay the loan. Other loans tend not to have the same feature and are described
as unsecured.

39
In summary, mortgages are typically:

• for a set period (25 years in the above example)

• at a variable rate of interest (the bank’s ‘standard variable rate’ in the above example)
• with a defined repayment schedule (monthly in the above example)
• secured on the property the loan is used to buy.

Anna is a writer and her income varies. Some months she earns a lot, but in the summer months she
prefers to travel rather than write, so her income falls. Anna enjoys food and loves nothing more
than a good meal at a restaurant. In fact, she is so keen on eating out that in some months, the
habit is costing her more than the money she is earning. Because of her variable income, Anna has
an agreement with her bank that she is allowed to spend up to $1,000 more money than she has in
her account, mostly in the lean summer months. This is described as an overdraft facility. There is
no set date or schedule for repayment; however, the bank is able to remove this facility whenever it
wishes. There is the expectation that Anna will be able to repay the overdraft during the busier winter
months. The bank will charge Anna an overdraft rate that is currently 10% pa, but this can be changed
at any time as long as the bank gives Anna at least 14 days’ notice. Anna also has to pay an annual
arrangement fee of $50 to the bank to start and retain the overdraft facility.

The above example is a typical overdraft facility. Overdrafts are flexible, so Anna can use as much or as
little of the $1,000 as she needs. She can also repay the overdraft and then draw cash from the facility
again at a later date. However, the lending bank can technically demand repayment at any time,
although it would be unlikely to do so. Overdrafts are also relatively expensive in terms of the interest
rate they charge, and may also incur a fee for the facility being set up (known as an arrangement fee).

In summary, bank overdrafts are generally:

• flexible – able to be drawn, repaid, drawn again up to the overdraft limit ($1,000 in the above
example)
• at a variable rate of interest (the bank’s overdraft rate in the above example), an arrangement fee
may also be payable ($50 in the above example)
• unsecured and repayable on demand.

Forms of Retail Borrowing from Banks

Loans Mortgage Loans Overdrafts

– fixed term – fixed term – repayable on
demand
– set interest rate – agreed repayment
– variable interest
– agreed repayment schedule rate
schedule – secured on the – no set repayment
– unsecured property schedule
– unsecured

40
 Banking

2.2 Credit Cards

Borrowing that is even more flexible than an overdraft is often available through credit cards. Credit
cards are available from banks, as well as specialist providers like Visa and Mastercard and even through
supermarkets, football clubs and charities.

The way a credit card works is that an individual applies for a card and, if successful, is granted a card

3
with a certain borrowing limit (the credit limit). They can then use the card to purchase things and with
each purchase the amount borrowed will increase. At least part of the borrowed money needs to be
paid off monthly. Generally, the borrowed money that is not paid off incurs a hefty amount of interest,
usually around 20% pa, so it is a good idea to pay off all of the borrowed money each month to avoid
any interest being charged.

So, credit cards typically have the following characteristics:

• Flexible – able to be used up to the credit limit.

• At a variable rate of interest, which tends to be expensive.
• Repayments of at least a minimum amount are required monthly.

2.3 Other Sources

For individuals who are somewhat desperate to borrow money – often where the banks and credit
card issuers have already reached the maximum lending available – other options exist in the form of
pawnbrokers and payday loans. To obtain a loan from a pawnbroker, something of value is required
that provides the pawnbroker with some security. This might be a wedding ring or another valuable
piece of jewellery, such as a watch. The security needs to be something of value (real, sentimental
or both) that the pawnbroker can hold and store until the loan is repaid. The decision on the loan is
usually made immediately by the pawnbroker. Invariably, the interest rate charged on borrowing from a
pawnbroker is much greater than borrowing from a bank or on a credit card.

Exercise 1 – Pawnbroker Loans

Why do you think a loan from the pawnbroker is more expensive than a loan or overdraft from a bank,
or borrowing on a credit card?

The answer can be found in the appendix at the end of this chapter.

Payday loans are marketed as loans that enable the borrower to get hold of cash before the next time
they are paid by their employer. They are a very expensive form of borrowing, but the offer is a very
simple one, as shown in the example below.

41
 Example
A payday loan provider offers Mr Short the ability to ‘borrow up to £1,000 now’. It is true that the
lender will make an immediate decision, but the bad news is that the loan also comes at a cost:
‘£16.80 per £100’. The terms also require repayment at Mr Short’s next pay date, which is only three
weeks away. So the cost of borrowing is 16.8% for a period of just 21 days, which equates to around
292% pa!

However, because of a public outcry over the high rates of interest charged, in some countries, such as
the UK, the regulator has imposed a limit on the rate of interest that can be charged. Since January 2015,
UK-based payday lenders can charge no more than 0.8% per day.

In summary, loans from pawnbrokers and payday loans are:

• Easily available – the decisions tend to be made immediately.

• Very expensive in comparison to other forms of borrowing.
• For pawned items, repayment is required to regain possession of the item from the pawnbroker.
• For payday loans, loans are very short-term, with repayment required at the next payday.

Other Forms of Borrowing

Credit Cards Pawnbrokers Payday Loans

– flexible – requires valuable(s) – borrower needs
– variable interest to be employed
to be left as
rate security (pawned) – repayable on next
– minimum payment – immediate decision payday
required each – expensive – immediate decision
month – expensive
– unsecured

2.4 Student Loans

Most would agree that education is important and worthwhile. To reflect this, schooling is often funded
by governments. Once primary and secondary school is over, many continue their studies at colleges
or universities and this tertiary education is typically not free. There will be tuition fees charged by the
college/university and the students will also have to pay living costs which may include accommodation
if the individual moves away from the family home.

To encourage all of those capable of going to university or college not to be put off by the costs,
developed governments like those of the UK and the US make student loans available. The loans are
often made available at attractively low rates of interest, and the borrowers do not need to start paying
the loans back until they earn a wage above a pre-determined level.

42
 Banking

Example
Student loans in England

When a student loan is taken out, the recipient must agree to repay the loan in line with the
regulations that apply at the time. The loan contract is with the Secretary of State for Education in
England and a non-profit government organisation called The Student Loans Company Limited (SLC)

3
acts as an agent and administers the loan on the Secretary of State’s behalf.

Repayments of student loans are made once the student is employed. This is done by deduction from
the employee’s salary, and then payment by the employer on the employee’s behalf via the UK tax
authority (the HMRC).

Borrowers only start making repayments if their income is over the repayment threshold, which (at
the time of writing in Nov 2022) is £27,295 a year, £2,274 a month or £524 a week.

Borrowers repay 9% of their income over the repayment threshold, and if the level of income changes,
either rising or falling, the repayment amounts will automatically change to reflect the new level.
Interest is based on the Retail Price Index (RPI) and is added to the loan. However, any remaining
balance on the loan after 30 years is cancelled.

3. Interest Rates
Learning Objective

3.1.3 Know the difference between the quoted interest rate on borrowing and the effective annual
rate of borrowing

When borrowing money, it is normal for the lender to charge interest. The lender might be a bank,
a credit card company or even a payday loan company. The way the interest rate is disclosed could
potentially be rather misleading.

Here are some fictional examples:

Tom is looking to borrow some money to buy a new laptop; he has found four alternative sources:

1. Example Bank is offering a personal loan that will charge interest at 10% pa, with the interest being
added to the loan each quarter.
2. XYZ Bank is offering a loan that will charge interest at 10% pa, with the interest being added to the
loan each month.
3. The MISA credit card will charge interest at 1% each month.
4. The Payday Loan Company will charge interest at 0.8% each day.

Which is the cheapest source of finance for Tom?

43
On a superficial basis, the two lower quotes (the credit card and the payday loan) might seem cheaper
than the 10% quotes from the banks. However, it is pretty clear that the payday loan is the most
expensive despite only quoting 0.8%, because the percentage is a daily rate. It can immediately be
calculated as more like 292% pa (as there are 365 days most years).

Similarly, but nowhere near as excessively, the MISA credit card looks expensive compared to the two
banks. The banks are both quoting 10% and a monthly charge of 1% can immediately be thought of as
around 12% pa, as there are 12 months in each year.

So, Tom is left with the choice of Example Bank or XYZ Bank, each quoting 10%. However, there is a clear
winner here – Example Bank is cheaper because it charges interest every quarter, whereas XYZ Bank
adds interest every month. This means that the balance on the loan increases every month at XYZ Bank
but only every quarter at Example Bank. Interest is charged on the outstanding balance, so, in effect,
interest is being charged on interest more frequently at XYZ Bank. This is shown below if we assume
Tom borrows $1,000 and we look at how the balance on the loan increases in the two banks over the
first six months.

Example Bank
The quarterly interest rate that is added to the loan is the annual rate of 10% divided by the four
quarters in the year = 10%/4 = 2.5%.

Opening
Date balance Interest ($) Closing balance ($)
($)
End of month 1 1,000.00 – 1,000.00
End of month 2 1,000.00 – 1,000.00
End of month 3 1,000.00 25.00 1,025.00
End of month 4 1,025.00 – 1,025.00
End of month 5 1,025.00 – 1,025.00
End of month 6 1,025.00 25.625 1,050.625

44
 Banking

XYZ Bank
The monthly interest rate that is added to the loan is the annual rate of 10% divided by the 12 months
in the year = 10%/12 = 0.833%.

Opening balance

3
Date Interest ($) Closing balance ($)
($)

End of month 1 1,000.00 8.33 1,008.33

End of month 2 1,008.33 8.40 1,016.73
End of month 3 1,016.73 8.47 1,025.20
End of month 4 1,025.20 8.54 1,033.74
End of month 5 1,033.74 8.61 1,042.35
End of month 6 1,042.35 8.68 1,051.03

So, after six months it is clear from the above that Example Bank is cheaper, with a loan balance of
$1,050.625 compared to the larger loan balance of $1,051.03 at XYZ Bank. This is because Example
Bank is charging interest less frequently (quarterly compared to XYZ Bank monthly).

The above example shows that the way interest is disclosed could be misleading unless care is taken to
make sure everything is taken into account. In reality, the regulatory authorities help too by requiring
lenders to quote rates on a comparable basis. Generally the quoted rate has to be made available on an
annual basis, and some form of effective annual rate is also disclosed. The effective annual rate takes
the quoted rate and adjusts it to take into account the frequency of interest charges. This is also known
as compound interest (or interest on top of interest). If the frequency of charging interest is annually,
the quoted rate and the effective annual rate are the same. When interest is charged more frequently
than annually – for example quarterly, or monthly – the effective annual rate will be greater than the
quoted rate.

Below is the detail from the earlier example presented with both annual quoted rates and effective
annual rates, making the cheapest option much more straightforward to isolate.

45
 Example

Quoted rate Effective annual

Lender and detail
(pa) rate
Example Bank – interest
10% 10.38%
10% pa, each quarter
XYZ Bank – interest 10%
10% 10.47%
pa, each month
MISA credit card –
interest at 1% each 12% 12.68%
month
Payday Loan Company –
292% 1,733%
interest at 0.8% each day

As the table shows, the quoted rate on an annual basis begins to identify the more expensive options
immediately, particularly the Payday Loan Company’s 292%. However, it is the effective annual rate that
shows just how expensive the payday loan is compared to all of the others at over 1,700%! The effective
annual rate also clearly shows that the Example Bank option is the cheapest, since, despite having the
same quoted rate as XYZ Bank, the interest is charged less frequently.

In summary, when comparing the cost of borrowing, it is sensible to:

• look at the annual quoted percentages, rather than quarterly, monthly, weekly or daily percentages
• look for the effective annual rates to make a true comparison, including the impact of how often the
interest is charged.

3.1 Calculating the Effective Annual Rate

Learning Objective

3.1.4 Be able to calculate the effective annual rate given the quoted rate and frequency of interest
payment

The annual quoted percentage on borrowing can be very different from the effective annual rate of
borrowing, as illustrated in the earlier example. Calculating the effective annual rate from the annual
quoted percentage can be done in the following way:

46
 Banking

Example

Returning to the earlier example of a loan from Example Bank that charges interest each quarter
based on a quoted rate of 10% pa:

Step 1: Calculate the interest rate charged for each period specified by the loan.

3
The loan charges interest quarterly, so the interest rate charged each quarter is the annual rate of 10%
divided by 4 (because there are four quarters in each year).

Interest charged each quarter = 10% ÷ 4 = 2.5% each quarter.

Step 2: Assuming a loan of £100 at the start of the year, calculate how much will be owed at the end
of the year using the rate calculated in Step 1 and assuming no interest is paid during the year.

Starting balance on the loan at the beginning of the year = £100.

Interest charged at the end of the first quarter = 100 x 2.5% = £2.50.

Starting balance on the loan at the start of the second quarter (assuming no interest has been paid) =
£100 + £2.50 = £102.50.

Interest charged at the end of the second quarter = £102.50 x 2.5% = £2.56 (rounded to the nearest
penny).

Starting balance on the loan at the start of the third quarter (assuming no interest has been paid) =
£102.50 + £2.56 = £105.06.

Interest charged at the end of the third quarter = £105.06 x 2.5% = £2.63 (rounded to the nearest
penny).

Starting balance on the loan at the start of the fourth quarter (assuming no interest has been paid) =
£105.06 + £2.63 = £107.69.

Interest charged at the end of the fourth quarter = £107.69 x 2.5% = £2.69 (rounded to the nearest
penny).

Balance on the loan at the end of the year (assuming no interest has been paid) = £107.69 + £2.69 =
£110.38.

Step 3: Using the end balance on the loan calculated in Step 2, work out the effective interest charged
for the year.

Ending balance less starting balance = £110.38 – £100.00 = £10.38 effective interest charged over the
year.

Step 4: Express the effective interest charged as a percentage of the starting balance to give the
effective annual rate.

Effective interest divided by starting balance = £10.38 ÷ £100.00 = 0.1038.

Multiplied by 100 to give a percentage = 0.1038 x 100 = 10.38%.

NOTE: UK sterling (pounds or £) are divided into 100 pence, singular penny, also written ’p’.
US dollars ($) are divided into 100 cents, also written ‘c’ or ‘¢’.

47
 Exercise 2 – Calculating the Effective Annual Rate
Greenboot Bank is offering a loan at a quoted rate of 2% per month (that is 24% pa). What is the
effective annual rate?

The answer can be found in the appendix to this chapter.

Using the approach detailed above to answer Exercise 2 is quite a task when the interest is charged to
the account each month, needing a total of 12 calculations. Imagine if the quoted rate were charged on
a weekly or daily basis – that would mean 52 or 365 calculations!

Thankfully, there is an alternative approach that can handle more frequent charges without the need to
perform multiple calculations. This alternative approach is detailed below using the earlier example of
10% charged quarterly.

Example
Alternative approach to calculating the effective annual rate:

Step 1: Calculate the interest rate charged for each period specified by the loan.

This is 10% pa, charged quarterly. Since there are four quarters in a year the rate is 10/4 = 2.5% each
quarter.

Step 2: Express the rate from Step 1 as a decimal, by dividing it by 100.

2.5/100 is 0.025.

Step 3: Add the number 1 to the result from Step 2 and multiply it by itself by the number of times
interest will be charged over the year.

1 + 0.025 = 1.025.

1.025 multiplied by itself four times (since interest is charged quarterly) = 1.025 4 = 1.1038.

Note: 1.025 4 (1.025 ‘to the power of 4’) is another way of expressing 1.025 x 1.025 x 1.025 x 1.025.

Step 4: Deduct 1 from the result of Step 3 and express the result as a percentage by multiplying it by
100.

1.1038 – 1 = 0.1038
0.1038 x 100 = 10.38%.

Exercise 3 – Effective Annual Rate Calculation Using an Alternative Approach

Please try to calculate the effective annual rate for Greenboot Bank’s loan that charges 2% each
month using the alternative approach.

The answer can be found in the appendix at the end of this chapter.

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 Banking

4. Secured and Unsecured Borrowing

Learning Objective

3.1.5 Know the difference between secured and unsecured borrowing

3
Earlier in this chapter (in section 2), a number of sources of borrowing were encountered of which two in
particular were identified as secured borrowing. Secured borrowing is where the lender has the right to
take something that belongs to the borrower if the borrower fails to meet the terms of the loan. This is
also known as the lender ‘taking security’.

The most obvious example of secured borrowing is when an individual raises a loan to buy a home – a
mortgage. It is normal for the lender to assess the value of the property being purchased before granting
the loan, and to restrict the loan to a percentage of that value. The rationale is best illustrated by looking
at an example.

Example
Jade is buying a property that will cost her $250,000. The bank has agreed the value to be $250,000
and is willing to lend 80% of the value to Jade. In the event of Jade failing to make the required
payments, the bank has the right to take ownership of the property in order to recoup the money
owed.

The reason that lenders such as banks want the security of the property is that, in the event of financial
hardship for the borrower, the bank can take and sell the property if it needs to and, since it has only
loaned a proportion of the value (80% in the above example), the bank has a reasonable safety net
against property prices falling. Of course, since it is a safer loan for the bank because of the security, it is
also a cheaper loan for the borrower.

Exercise 4 – The Value of a Bank’s Security

How much must the value of the house Jade is buying fall, before the bank has no security?

The answer can be found in the appendix to this chapter.

It is not only mortgage loans that are secured. We encountered pawnbrokers earlier that also provide
a form of secured loan. Furthermore, companies that need to borrow money generally may be able to
borrow more cheaply by offering some of their assets as security. The company’s assets might include
land and buildings.

If a loan is not secured, it is described as unsecured. Generally, unsecured loans are more expensive than
secured loans because the risk to the lender is greater.

49
5. The Relative Cost of Borrowing
Learning Objective

3.1.6 Know what types of borrowing are likely to be relatively expensive – pawnbrokers/payday
loans, credit cards, overdrafts, unsecured loans; and cheaper – secured loans, eg, mortgages

The previous sections have highlighted the relative costs of various forms of borrowing. The following
exercise will explore and reinforce these costs further.

Exercise 5 – Which Form of Borrowing is Cheapest?

Ranking
Borrowing source (1 = least expensive; 6 = most
expensive)
Greg is in great need of cash, having exhausted most sources
and being unemployed. He manages to find a pawnbroker
?
willing to lend him $2,000, but he has to deposit his wife's
wedding ring with the pawnbroker.
Aaron is a reasonably well-paid office worker who has saved
up enough cash to enable him to pay 10% of the purchase
?
price of a $200,000 flat. The remainder will come from a bank
in the form of a mortgage loan.
Maya is a trainee solicitor and has just rented her first flat.
Unfortunately, the flat is lacking a washing machine and Maya
is borrowing $1,000 in the form of an unsecured loan from ?
a bank to enable her to buy a washing machine and have it
plumbed in.
Zeenat is 25 years old and is a very capable musician. She is
self-employed and tends to be particularly busy in the winter
season in theatre orchestras. To cover the seasonal nature of ?
her earnings, she has arranged a $1,500 overdraft facility with
her bank.
Rajiv is 30 and is trying very hard to establish a business as
a DJ. He has a regular slot at a nightspot in his local town,
and in order to widen his appeal he is planning to purchase
some new equipment that will cost around $1,200. Rajiv ?
decides that the best way to fund the purchase is to buy the
equipment on his credit card, which he hopes he will be in a
position to repay in full in six months or so.

50
 Banking

Ranking
Borrowing source (1 = least expensive; 6 = most
expensive)
Mohammed is employed but has got himself into a financial
mess with his love of expensive holidays. He is finding it very

3
difficult to get any more borrowing from his bank or his credit
?
card providers. He has decided to borrow $500 in the form
of a payday loan that will cover him until he gets paid in two
weeks.

It is generally cheaper to borrow on a secured basis than on an unsecured basis. A bank will invariably
offer mortgage loans at a lower interest rate than an unsecured loan to the same borrower. This ties
back to the idea of risk and reward – for the lender, secured borrowing provides a safety net, so there is
less risk. If there is less risk, the lender will accept less reward.

6. Investment Banks
Learning Objective

3.1.7 Know that investment banks help companies to raise money and advise them on strategy, eg,
mergers and acquisitions

Banks have been repeatedly mentioned in the first two chapters. However, two types of banks have not
yet been expanded upon – investment banks and central banks.

Investment banks are not like the deposit-taking banks encountered so far. They are specialists in what is
commonly referred to as ‘capital-raising’, and particularly in large-scale capital-raising, starting at around
£5 million and upwards to around £100 billion. Capital is long-term finance and is required by
companies and many governments. Broadly, it comes in two forms – equity and debt (bonds or loans).
So, when a company is looking to raise long-term finance, it will go to an investment bank for advice. The
investment bank may recommend equity, it may recommend debt or perhaps a combination of both.

Presuming the company elects to go ahead, the investment bank will make it happen – ‘executing the deal’ in
the jargon of the markets – by putting together the required paperwork and marketing the deal to potential
investors.

In addition to helping organisations raise capital, another major line of business for investment banks is
mergers and acquisitions (M&A). This is where investment banks advise companies on their business
strategy, in particular on how the companies can grow by buying other businesses.

The following example is fictional, but illustrates the typical activities of an investment bank:

51
 Razak inc is already a large global player in technology that supports smartphones. Razak uses the
advice of Coldman Jones, an investment bank. Coldman’s M&A team recommends that Razak should
buy a minor competitor company to gain access to the Japanese market. The Japanese company will
cost around $100 million.

The cost of purchase needs to be raised by Razak and, again on the advice of the investment bank,
Razak uses Coldman Jones to raise the required funds by selling bonds to investors.

In the above example, the investment bank recommended that Razak raise money by borrowing. This is
generally referred to as debt and could have been raised by taking a loan from an individual bank or a
group of banks, or by issuing bonds to investors. The choice of loans or bonds is often a matter of how
much the banks are keen to lend. When banks have plentiful funds, they tend to be willing and able
to lend at competitive interest rates. When the banks are less willing to lend, companies that want to
borrow have little choice other than the bond market.

The alternative is equity, which involves issuing shares. In which circumstances debt might be considered
to be a more appropriate way to raise capital, and when equity might be more appropriate. There is no hard
and fast rule – it is ultimately a matter of judgement – but there are circumstances that make debt more or
less appropriate.

• If the company is raising the finance for something that can easily be sold, then borrowing might
be more appropriate because the asset being purchased can be used as security against the loan.
Property is perhaps the most obvious example for this. It tends to retain most if not all of its value and
can be sold relatively easily to enable the borrowed money to be repaid. Furthermore, if required,
property can be rented out to generate funds that might cover the interest on the money borrowed.
• By contrast, when finance is being raised for items that are more inherently risky, such as a
pharmaceuticals company raising capital to research a potential cure for cancer, equity tends to be
the more logical choice. The outcome of the research is uncertain, and, if it does not work out, paying
interest and then repaying the money may become difficult for the borrowing company. By raising
equity, there is no obligation to repay, and dividends on equity are unlike interest, in that there is no
requirement to pay dividends at all.

Companies choose to have a particular proportion of their capital in the form of debt and, when any of
the existing debt is repaid, the company will replace it with new debt. This will mean that the company
retains the same proportion of debt capital to equity capital.

52
 Banking

Exercise 6 – The Trivandrum Tigers and Culchester United

The Trivandrum Tigers is an Indian cricket club that has grown rapidly and is hoping to finally reach
Premier League status. It feels it needs to raise more money (around $50 million) to attract the best
stars to the team and is considering where to get the finance. The Tigers want your advice as to how
to raise the money.

3
Culchester United is a well-established UK football team that has just reached the top division. The
football it plays is very fast and innovative, but it currently shares a ground with another London
team. It owns a site in West London with permission to build, and wants to construct its own football
stadium combined with a residential development. Culchester United is looking for advice on how to
raise the £1 billion that will be required.

Once you have considered the above, take a look at the suggested answer in the appendix at the end
of the chapter.

Investment banks are either stand-alone entities, of which some of the more well-known include Morgan
Stanley and Goldman Sachs, or they are divisions of larger financial services companies that often
include commercial banks, such as Deutsche Bank of Germany, or Switzerland’s UBS and Credit Suisse.

7. Central Banks
Learning Objective

3.1.8 Know the role of central banks: banker to banking system; banker for the government;
regulatory role (interest rate setting)

Central banks should be familiar in name at least – the Bank of England is the UK’s central bank, the
Federal Reserve is the central bank of the US, and Europe has its own European Central Bank. This is not
a comprehensive list; almost every country in the world has its own central bank.

What do these central banks do? Despite minor differences in their role, their main functions are
threefold:

53
 The Three Main Activities
of Central Banks

Banker to the
Banks Regulatory Role
–Banks hold –Many central banks
accounts with regulate other banks
the central Banker for the –Set interest rates in
bank Government accordance with
–The government gathers government policy
tax receipts, spends on
defence and welfare
–Many governments also
hold money in other
currencies – foreign
exchange reserves

Looking at each function in turn:

• As banker to the banks, it is the central bank that holds the cash reserves of the various banks.
When a cheque is drawn from one person’s bank account with Citigroup and paid into another
person’s bank account with HSBC, the money moves across the two banks via their accounts at the
central bank. Central banks also occasionally need to act as ‘lender of last resort’ to banks that are in
temporary financial difficulties.
• As banker for the government, the central bank will accumulate the nation’s tax receipts, and
payments to the various government departments, such as health and defence, will be drawn
from accounts in the central bank. As well as holding the country’s foreign currency reserves, the
majority of central banks also issue notes and coins on behalf of the government and manage the
government debt.
• In its regulatory role, it is the central bank that licenses banks to operate and subsequently oversees
their activities. Additionally, the central bank often has the responsibility of setting the appropriate
interest rate in order to control inflation.

Example
The Bank of England

In the UK, the central bank is the Bank of England. The role it plays includes setting the interest rate,
the so-called ‘bank base rate’ and it does this through a particular committee called the Monetary
Policy Committee (MPC).

54
 Banking

Mini Assignment
Use the internet to discover a little more detail about the activities of the central bank where you are
based. In particular:

1. What is it called?
2. Where is it located?

3
3. How long has it been established?
4. Who leads the bank and how much financial experience does this person have?
5. Does it act as any, or all, of the following?

a. Banker to the banks

b. Banker for the government
c. Regulator of the banks

Exercise 7
Which of the following is typically used by retail customers to borrow money to fund the purchase of
a home?

a. Bank loan
b. Overdraft
c. Mortgage
d. Payday loan

Exercise 8
A bank is quoting a rate of borrowing on a loan at 10% annually, charged quarterly. Which of the
following statements is true of the effective annual rate on the loan?

a. It is 10%
b. It is greater than 10%
c. It is less than 10%
d. It is impossible to calculate without more information

Exercise 9
What is the effective annual rate for a loan with interest charged at 12% pa on a monthly basis?

a. 1%
b. 12%
c. 12.68%
d. 14%

55
Exercise 10
What type of bank typically specialises in helping companies raise money and advising them on
strategy including M&A opportunities?

a. Central bank
b. Commercial bank
c. Corporate bank
d. Investment bank

Exercise 11
What type of bank is typically described as the banker to the banks?

a. Central bank
b. Commercial bank
c. Corporate bank
d. Investment bank

Answers to Chapter Exercises

Exercise 1 – Pawnbroker Loans

The reason that a loan from the pawnbroker is more expensive than a loan or overdraft from a bank
comes down to the risk being borne by the pawnbroker, combined with the desperation of the
borrower.

The pawnbroker typically knows very little about the borrower, other than that the borrower needs
cash urgently and is willing to leave something of value as security. The borrower could take the
money and never be seen again, while the security may turn out to have little value, or to be stolen.
So, from the pawnbroker’s standpoint, they are taking a substantial risk and want to be rewarded with
a reasonable return.

Similarly, the borrower’s need to go to the pawnbroker for a loan indicates that they have a pressing
need for cash, cannot find it easily elsewhere and are therefore forced to pay a higher rate of interest
than on other forms of loan.

56
 Banking

Exercise 2 – Calculating the Effective Annual Rate

Greenboot Bank loan at a quoted rate of 2% per month. The effective annual rate can be calculated
as follows:

Step 1: Calculate the interest rate charged for each period specified by the loan.

3
This is given as 2% per month. It can also be calculated by dividing the annual quoted rate of 24% by
12 (because there are 12 months in each year).

Step 2: Assuming a loan of £100 at the start of the year, calculate how much will be owed at the end
of the year using the rate calculated in Step 1 and assuming no interest is paid during the year.

Starting balance on the loan at the beginning of the year = £100.

Interest charged at the end of the first month = 100 x 2% = £2.00.

Starting balance on the loan at the start of the second month (assuming no interest has been paid) =
£100 + £2.00 = £102.00.

Interest charged at the end of the second month = £102.00 x 2% = £2.04.

Starting balance on the loan at the start of the third month (assuming no interest has been paid) =
£102.00 + £2.04 = £104.04.

Interest charged at the end of the third month = £104.04 x 2% = £2.08 (rounded to the nearest penny).

Starting balance on the loan at the start of the fourth month (assuming no interest has been paid) =
£104.04 + £2.08 = £106.12.

Interest charged at the end of the fourth month = £106.12 x 2% = £2.12 (rounded to the nearest
penny).

Starting balance on the loan at the start of the fifth month (assuming no interest has been paid) =
£106.12 + £2.12 = £108.24.

Interest charged at the end of the fifth month = £108.24 x 2% = £2.16 (rounded to the nearest penny)

Starting balance on the loan at the start of the sixth month (assuming no interest has been paid) =
£108.24 + £2.16 = £110.40.

Interest charged at the end of the sixth month = £110.40 x 2% = £2.21 (rounded to the nearest penny)

Starting balance on the loan at the start of the seventh month (assuming no interest has been paid) =
£110.40 + £2.21 = £112.61.

Interest charged at the end of the seventh month = £112.61 x 2% = £2.25 (rounded to the nearest
penny).

Starting balance on the loan at the start of the eighth month (assuming no interest has been paid) =
£112.61 + £2.25 = £114.86.

Interest charged at the end of the eighth month = £114.86 x 2% = £2.30 (rounded to the nearest
penny).

57
Starting balance on the loan at the start of the ninth month (assuming no interest has been paid) =
£114.86 + £2.30 = £117.16.

Interest charged at the end of the ninth month = £117.16 x 2% = £2.34 (rounded to the nearest penny).

Starting balance on the loan at the start of the tenth month (assuming no interest has been paid) =
£117.16 + £2.34 = £119.50.

Interest charged at the end of the tenth month = £119.50 x 2% = £2.39 (rounded to the nearest
penny).

Starting balance on the loan at the start of the eleventh month (assuming no interest has been paid)
= £119.50 + £2.39 = £121.89.

Interest charged at the end of the eleventh month = £121.89 x 2% = £2.44 (rounded to the nearest
penny).

Starting balance on the loan at the start of the twelfth month (assuming no interest has been paid) =
£121.89 + £2.44 = £124.33.

Interest charged at the end of the twelfth month = £124.33 x 2% = £2.49 (rounded to the nearest
penny).

Balance on the loan at the end of the year (assuming no interest has been paid) = £124.33 + £2.49 =
£126.82.

Step 3: Use the ending balance on the loan calculated in Step 2, work out the effective interest
charged for the year.

Ending balance less starting balance = £126.82 – £100.00 = £26.82 effective interest charged over the
year.

Step 4: Express the effective interest charged as a percentage of the starting balance to give the
effective annual rate.

Effective interest divided by starting balance = £26.82/£100.00 = 0.2682.

Multiplied by 100 to give a percentage = 0.2682 x 100 = 26.82%.

58
 Banking

Exercise 3 – Effective Annual Rate Calculation (Alternative Approach)

Step 1: Calculate the interest rate charged for each period specified by the loan.

This is given as 2% per month. It can also be calculated by dividing the annual quoted rate of 24% by
12 (because there are 12 months in each year).

3
Step 2: Express the rate from Step 1 as a decimal, by dividing it by 100.

2/100 is 0.02

Step 3: Add 1 to the result from Step 2 and multiply it by itself by the number of times interest will be
charged over the year.

1 + 0.02 = 1.02

1.02 multiplied by itself 12 times (since interest is charged monthly = 1.02 12 = 1.2682

Step 4: Deduct 1 from the result of Step 3 and express the result as a percentage by multiplying it by
100.

1.2682 – 1 = 0.2682

0.2682 x 100 = 26.82%

Exercise 4 – The Value of a Bank’s Security

The value of the house starts at $250,000 and the bank lends 80% of this value (80% x $250,000 =
$200,000).

The house could fall in value by up to $50,000 (20% of the purchase price) and the bank would still be
able to get all of its money back by selling it.

However, if the value were to fall below $200,000, the bank’s security would not be sufficient to
recoup the entire loan.

The bank’s security would become zero only if the house were to become worthless.

59
Exercise 5 – Which Form of Borrowing is Cheapest?

Ranking
(1 = least
Borrowing source Explanation
expensive; 6 =
most expensive)
Owing to the secured nature of
Greg is in great need of cash,
pawnbroking, the borrowing costs
having exhausted most sources and
tend to be cheaper than payday
being unemployed. He manages to
loans, although pawnbrokers are
find a pawnbroker willing to lend 5
more expensive than most other
him $2,000, but he has to deposit
forms of borrowing since they are
his wife’s wedding ring with the
attracting more desperate borrowers
pawnbroker.
like Greg.
Aaron is a reasonably well-paid This is likely to be the least expensive
office worker who has saved up form of borrowing. Not only is the
enough cash to enable him to pay loan secured on the flat, but Aaron
10% of the purchase price of a 1 has also managed to fund 10% of
$200,000 flat. The remainder will the purchase price, so the loan only
come from a bank in the form of a represents 90% of the value of the flat
mortgage loan. it is secured against.
This source of finance is likely to
Maya is a trainee solicitor and
be cheaper than most due to the
has just rented her first flat.
structured nature of the loan and
Unfortunately, the flat is lacking
the fact that Maya is an aspiring
a washing machine and Maya is
2 professional and, therefore, likely to
borrowing $1,000 in the form of
be able to repay and service the loan.
an unsecured loan from a bank
However, without any security the
to enable her to buy a washing
loan is likely to be more expensive
machine and have it plumbed in.
than a mortgage loan.
The flexibility required by Zeenat
Zeenat is 25 years old and is a
from her overdraft means that it is
very capable musician. She is
likely to be more expensive than
self-employed and tends to be
the unsecured loan from the bank.
particularly busy in the winter
3 However, bank finance is generally
season in theatre orchestras. To
cheaper than credit cards and other
cover the seasonal nature of her
more desperate forms of borrowing
earnings, she has arranged a $1,500
from pawnbrokers and payday loan
overdraft facility with her bank.
providers.

60
 Banking

Ranking
(1 = least
Borrowing source expensive; Explanation
6 = most
expensive)

3
Rajiv is 30 and is trying very hard to establish
a business as a DJ. He has a regular slot at a
Rajiv will pay substantial
nightspot in his local town, and in order to
interest by not paying
widen his appeal he is planning to purchase
off his credit card in full
some new equipment that will cost around 4
each month. The interest
$1,200. Rajiv decides that the best way to fund
charged is likely to be
the purchase is to buy the equipment on his
higher than overdrafts.
credit card, which he hopes he will be in a
position to repay in full in six months or so.
Mohammed’s borrowing is
Mohammed is employed but has got himself likely to be more expensive
into a financial mess with his love of expensive than all of the others.
holidays. He is finding it very difficult to get Payday loans represent
any more borrowing from his bank or his credit 6 unsecured loans for the
card providers. He has decided to borrow $500 desperate borrower and are
in the form of a payday loan that will cover him priced accordingly by the
until he gets paid in two weeks. providers – they are very
expensive.

Exercise 6 – The Trivandrum Tigers and Culchester United

In both situations, the broad consideration is whether to borrow the money or to sell shares.

The Trivandrum Tigers’ requirement is for $50 million to attract the best stars to its team. This is highly
speculative – there is no guarantee that attracting big-name stars will translate into success on the
pitch. As a result, it may be inappropriate to borrow the money as the Tigers may find it difficult to
pay the interest and then repay the borrowed funds. Additional equity finance will probably be most
appropriate. By selling shares, if the strategy does not provide the hoped-for success, the Tigers will
not be burdened with interest and repayment requirements.

Culchester United’s requirement is for £1 billion to construct a new stadium. Culchester United could
raise money by selling further shares, but, given that this finance will be used to construct a property,
there is a possibility of raising debt. As well as offering some security to the lender, the stadium
development should result in increased income from attendance that could be used to pay interest,
and renting or selling homes in the residential development should also generate additional cash.

Assuming the debt finance route is chosen, the £1 billion being raised is probably large enough to
make a Culchester United bond issue a possibility. This will potentially be cheaper than borrowing
from banks since it raises finance directly from investors.

61
Exercise 7 – Mortgages
7. C (chapter 3, section 2.1).

The substantial amounts of money required to buy property mean borrowing is generally over a long
period of time and secured on the property – a mortgage loan.

Exercise 8 – Effective Annual Rate

8. B (chapter 3, section 3.1).

The effective annual rate will be greater than 10% as long as interest is charged more frequently than
once per annum. The effective annual rate here is approximately 10.38%, based on the following
calculation:

Step 1: 10% divided by 4 quarters = 2.5% per quarter

Step 2: Expressed as a decimal = 0.025

Step 3: Adding 1 and multiplying by itself 4 times = 1.0254 = 1.1038

Deducting 1 and expressing as a percentage = 10.38%

Exercise 9 – Effective Annual Rate

9. C (chapter 3, section 3.1).

The effective annual rate is most easily calculated using the following approach:

Step 1: 12% divided by 12 months = 1% per month

Step 2: Expressed as a decimal = 0.01

Step 3: Adding 1 and multiplying by itself 12 times = 1.0112 = 1.1268

Deducting 1 and expressing as a percentage = 12.68%

Exercise 10 – Investment Banks

10. D (chapter 3, section 6).

Investment banks specialise in capital raising and advise on strategy including M&A.

Exercise 11 – Central Banks

11. A (chapter 3, section 7).

The central bank, such as the US Federal Reserve, has three main activities – acting as banker to the
government, acting as banker to the banks and regulating the banks.

62
 1
Chapter Four

Equities

5
1. The Reasons for Issuing Shares 65

2. Initial Public Offerings (IPOs) 67

3. Potential Returns from Shares 69

4. Shareholder Voting Rights 72

5. The Risks Involved in Owning Shares 74

This syllabus area will provide approximately 5 of the 30 examination questions

64
 Equities

This chapter focuses on equities, which are alternatively

referred to as shares or stock. Equities were briefly
introduced in chapter 2. This chapter will add some
further detail as well as reinforce what has already been
covered.

1. The Reasons for Issuing

Shares

4
Learning Objective

4.1.1 Know the reasons for issuing shares (stock) – to

finance a company

A fictional example was introduced in chapter 2

regarding a start-up company called CareerComic.

Example

Two young college graduates have a great idea. They

think that other college graduates and schoolchildren
would love to have access to a database of available
careers that are portrayed in a fun, simple and
understandable way. They want to pull together
a comic strip of a day in the life of each career –
CareerComic.

They have talked to people about their plans for

CareerComic and they have potentially found
someone who will provide them with some money
to get a prototype established. That person is willing
to provide money in return for a stake in the business.
They are hoping the business might grow and be
worth a lot of money one day.

Companies like CareerComic cost money to set up –

even if the founding graduates are willing to provide
their time at no cost, the company will still incur costs
such as renting office space from which to operate, the
bills for electricity and water that will come with the
offices, plus the cost of equipment (such as computers,
printers, or phones) and possibly advertising and
marketing the product.

65
The long-term finance for this capital that is required by start-up companies can come from borrowing,
selling equity or a combination of both.

In our CareerComic example, the founders decided to sell equity. Every company issues equity and it is
the owners of equity that own the company. Below is a bit more detail about the equity in CareerComic.

Example
CareerComic is incorporated as a company – strictly it is CareerComic inc – and the original owners
of the company were the two brains behind the idea: Brad Michaels and Marvin Gardner. Brad and
Marvin each put $50 into the company and were each given 50 shares. As the CareerComic idea was
developed further, Brad and Marvin got talking to Warren, a local businessman. Warren liked the idea
and wanted to invest in it. Warren agreed to pay $3,000 for another 100 shares in CareerComic inc.

CareerComic’s shares in issue have increased. Since Brad and Marvin originally held 100 shares, and
Warren has purchased a further 100, CareerComic now has 200 shares in issue. With 200 shares in
issue, Warren has the most shares. He holds 100, so he has half of the company, or 50%. Brad and
Marvin each own 50 shares, so they each own a quarter (25%) of the company.

The reason for CareerComic selling more shares to Warren was to raise more finance. The additional
$3,000 from Warren will be enough to finance CareerComic into its next stage, building up its product
and starting to market it to potential customers.

A further benefit of involving Warren may be that, as an established businessman, his contacts and
know-how will be very useful too.

In the CareerComic example, the price Brad and Marvin paid for their shares was just $1 each, and later
on Warren agreed to pay $30 for each of his shares. Brad and Marvin demanded more than $1 per share
and Warren was willing to pay more because he was buying a part of the realisation of their idea. The
concept of CareerComic came from Brad and Marvin and they spent their time coming up with it and
setting up CareerComic inc. Warren was investing in something that was already established. It was
Warren’s view that Brad and Marvin’s concept of CareerComic was a good one, and for him to become
involved he had to recognise the value of that idea by paying more than the $1 that Brad and Marvin
paid for their shares.

In summary, as illustrated by the CareerComic example, the major reason for a company issuing shares
is to raise finance.

66
 Equities

Exercise 1 – Fuelmonitor ltd

Fuelmonitor ltd is a company that has been recently set up to provide details of the cheapest car fuel
prices in the subscribers’ local area by email each week. Fuelmonitor hopes to generate revenues
both from subscription and from site sponsorship. Fuelmonitor was set up by Patrick Brightman, who
paid £300 for all 30 shares that Fuelmonitor issued.

During the first months of its existence, Patrick has set up a website for Fuelmonitor and researched
fuel prices in his local area. Fuelmonitor has attracted some subscribers and has a local newspaper

4
interested in sponsoring the site. It now needs more finance to expand and is planning to issue new
equity. Patrick has a list of contacts that he feels may be interested in buying the 20 new shares
Fuelmonitor will issue.

1. How much should Fuelmonitor issue the new shares for? £10, less than £10 or more than £10?
2. After issuing the new shares, what will Patrick’s ownership proportion of Fuelmonitor be?
3. What will be the proportion of Fuelmonitor owned by the new shareholders?
4. How might the shareholders of Fuelmonitor get a return on their investment?

The answers to the exercise can be found in the appendix at the end of the chapter.

2. Initial Public Offerings (IPOs)

Learning Objective

4.1.2 Know the definition of an initial public offering (IPO)

As the name suggests, an initial public offering (IPO) is the first time shares are offered to members of
the public.

In the CareerComic example we have just looked at, an IPO has not happened with the sale of shares to
Warren because he is just one selected person. An IPO is a general offer that is made widely available by
offering the shares to unconnected third parties. CareerComic might see an IPO as the ultimate aim for
the company, as detailed below.

67
 Example
Let’s assume that CareerComic has now been established for a number of years since Warren’s
investment. Both Warren’s business know-how and the popularity of the product have made
CareerComic very successful. It is generating a healthy profit, and has paid dividends to its
shareholders for the last two years. It now has international appeal and, as well as being very
successful in the US, it is being heavily used in Asia.

Warren, Brad and Marvin decide that CareerComic needs to raise further money that will enable it to
continue its global expansion, in particular the creation of a Mandarin version for the Chinese market.

CareerComic inc decides that it will offer new shares to the public in an IPO. Not only will the IPO
enable CareerComic to raise money, but the publicity surrounding it will increase awareness of the
product too.

As mentioned in chapter 2, an example of an IPO was Zoom, which came a couple of years after
the IPO of the social networking site, Facebook. Below you will find another example of an IPO, the
accommodation rental site Airbnb which does not own any property.

Example
Airbnb IPO

In December 2020, right in the middle of the COVID-19 pandemic, when very few people were
travelling and demand for hotel rooms was low, Airbnb launched its IPO. Many people thought this
was a bad idea, so the price was set quite low at $68 a share. However, there was far more demand
for the shares than expected and on the first day, the share price soared to $150. As the global
vaccination programme against COVID-19 started to work in 2021, investors became more confident
that travel would start again and people would want to book their accommodation through Airbnb.
Airbnb’s share price reached $216 in February 2021. Since then, the price has fallen significantly,
mainly due to concerns about economic growth and inflation that has impacted shares generally. At
the time of writing (December 2022) it was just above the IPO price at $82.49.

A key part of an IPO is that the issuing company will have its shares subsequently traded on a stock
exchange. After all, the public that buy shares in an IPO will want the ability to sell those shares at a later
date. When a company’s shares begin trading on a stock exchange, the company is often described as
becoming listed. Facebook (now under the name of Meta Platforms inc) is listed on the NASDAQ, the US
stock exchange that specialises in technology company shares.

Like Zoom, Facebook and Airbnb, Google also sold shares to the public, although this happened in 2004.

68
 Equities

Example
The Google IPO
It was 2004 when Google became a listed company. Like Facebook, Google chose to list on NASDAQ,
and Google sold around 19.5 million shares at $85 each to raise approximately $1.7 billion. Most of
the money raised went to the company. On the first day of trading, Google shares rose to $100. After
a change of name for the company that owns the Google search engine to Alphabet in October 2015,
the shares were changing hands at $2,280 each in June 2022. The investors who purchased Google
shares in the IPO have done rather well.

4
In summary, an initial public offering is:

• Commonly referred to as an IPO.

• When a company first makes its shares available to the public.
• When the company becomes listed on a stock exchange.

See also chapter 6, section 2.

3. Potential Returns from Shares

Learning Objectives

4.1.3 Know the potential sources of return from shares: dividend; capital gain
4.1.4 Be able to calculate the dividend yield given the share price and the dividends paid in the year

An investor buying shares is hoping for a combination of two things to provide a return – dividends and
a capital gain.

Dividends are the regular ongoing income that a shareholder may receive. Well-established listed
companies pay dividends every quarter or every half-year. The amount of dividend paid is not fixed;
instead it is determined by the management of the company and driven mainly by two things –
profitability and expectation. This is illustrated in the fictional example that follows:

Example
ABM inc is a well-established manufacturer of sophisticated computer equipment and a listed
company. It has shown a pattern of increasing its quarterly dividends by around 10% each year for the
last three years. In the same quarter of the previous year, ABM paid a 90 cents dividend on each share.

This quarter has been a good one. After winning some significant new business, profits are up 15%
on a year earlier. ABM’s management decides that it is right to increase the quarterly dividend by
10% to 99 cents per share. The dividend increase should meet the expectation of the shareholders,
since it continues the established pattern, and it is comfortably covered by the percentage increase
in company profits.

69
Dividends are usually expressed both in absolute terms, such as 99 cents in the previous example, and as
a percentage of the share price. When expressed as a percentage of the share price, the resultant figure
is described as the dividend yield. A bigger dividend yield means a greater proportion of the share
price is being paid to investors. So, if the investor is looking to generate income from their investment,
then a bigger dividend yield is better than a smaller dividend yield.

Example
ABM inc paid dividends of 99 cents per share in each of the last four quarters – a total of $3.96 for the
year. If the ABM share price is currently $150, then the dividend yield is (3.96/150) x 100 = 2.64%.

Exercise 2 – Dividend Yield

Below are details for three fictional companies. What is the dividend yield for each?

Total dividends paid

Company name Share price ($) Dividend yield (%)
in the last year ($)
ABC inc 4.32 172.00
FGH inc 8.64 403.00
XYZ inc 12.24 702.00

The answer to this exercise can be found in the appendix at the end of this chapter.

Equity investors hope their shares will increase in value – make a capital gain – as well as pay regular
income in the form of dividends. As we have already seen, many larger company shares are regularly
traded on stock exchanges. The stock exchanges provide information about the prices at which
shares are currently trading, so assessing the extent to which listed shares are gaining in value is
straightforward. This is illustrated by continuing with the ABM inc example below.

70
 Equities

Example
James Lester holds a significant number of shares in ABM inc. He purchased the shares at an average
price of $100 some years ago, and just prior to the announcement of the latest quarterly results, the
ABM share price was $150. Obviously, James is pleased to see that the latest quarterly results from
ABM are strong and even happier to see that, as a result, the trading price of ABM shares increases to
$165.

James decides that he will sell a significant number of his shares, realising a capital gain of $65 per
share ($165 – $100).

4
Before the announcement of the quarterly results, James’s position was pretty good – he was already
50% up, although he had not actually sold any shares at that point. However, when the share price
increased to $165, the 65% gain was enough to prompt him to sell at least some of his shares.

As shown in the examples above, shares have the potential to provide returns to the investor in two
ways, by:

• Paying regular dividends.

• Increasing in value to deliver a capital gain.

However, it is important to point out that investments in equity do not always go the way of ABM inc
in the previous example. Unprofitable companies may be unable to afford to pay dividends, so the
shareholders will not get any income. Furthermore, the price of shares can go down – so investors can
end up facing capital losses rather than capital gains. In summary:

shareholders will get either

a share of the gain...

or...

... a share of the pain!

71
 Exercise 3 – Which Share Offers the Best Investment Opportunity?

The December 2022 details in relation to the shares of five well-established US listed companies
(Apple, Exxon Mobil, JPMorgan Chase, McDonald’s and Microsoft®) are provided below.

You may already be familiar with these companies, but if not, then please do a little research on them
and try answering the following questions for each:

• What does the company do?

• What products does the company sell?
• Do you use the company’s products? If not, do you know people who do and do you anticipate
using them in the next few years?

Share price high Share price

Current share Dividend yield
Company name in the last year low in the last
price ($) (%)
($) year ($)
Apple 129.94 182.94 128.72 0.59
Exxon Mobil 109.72 114.66 60.42 2.82
JPMorgan Chase 131.93 160.24 101.28 2.56
McDonald’s 267.76 281.67 217.68 1.74
Microsoft® 237.55 344.30 213.43 0.86

Then combine your research with the details in the table about each company’s shares and determine
which share do you think offers the best value as an investment and why.

A suggested answer is provided in the appendix to this chapter.

4. Shareholder Voting Rights

Learning Objective

4.1.5 Know that shares provide their owners with the right to vote at company meetings/assemblies

We have already seen that it is the equity holders that own companies. This section looks at the key right
that owning shares provides – the right to attend and vote at company meetings.

In different parts of the world, company meetings are referred to in different ways. They are often
referred to as company assemblies, or even general assemblies. Typically, they occur once a year and,
however they are termed, the format and purpose is the same – these meetings give the owners of the
company (the shareholders) the opportunity to find out how the company is performing and to make
decisions on what should happen.

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 Equities

The reason that company meetings are necessary is simple. It is very often the case that the day-to-day
management of a company is performed by persons who are not the owners of that company, as shown
below.

The Owners of the Company

(the Shareholders)
Decisions made
by voting

Information
about performance

4
The Management of the
Company (the Executives)

As the above diagram shows, it is at company meetings that the management of the company (the
executives including the chief executive) provide an update for the owners (the shareholders) and are
also available to be questioned about the company’s performance and plans. The owners can then
make decisions on a variety of matters, such as the salary paid to the chief executive. These decisions are
voted on, and in most cases they are agreed when the majority vote in favour.

Example
Joseph is a shareholder in a large listed bank, VBS Bank inc. VBS’s annual company meeting is
scheduled to happen in a month’s time and Joseph receives an invitation to attend with some
financial information about VBS’s recent performance that includes a proposed salary increase for
VBS’s executive directors. Joseph can go along to the meeting and will have the opportunity to vote
on significant matters, including whether he feels the executive directors’ pay increases are justified
and should go ahead.

However, even if Joseph votes against the increases, it may not prevent the pay awards going ahead.
The decision will be made on a simple majority of the voting shareholders.

As shown in the example, it is the shareholders, as owners of the business, who need to be made aware
of how the company is performing and who make key decisions, such as whether the pay levels for the
company’s executive directors are excessive. In summary, company meetings or assemblies:

• Are meetings to which all of the shareholders are invited.

• Are generally required to be held at least annually.
• Provide the opportunity for the owners of the company (the shareholders) to vote on significant
matters.

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5. The Risks Involved in Owning Shares
Learning Objective

4.1.6 Know the risks involved in owning shares: lack of profit; bankruptcy/collapse

As owners of a company, the shareholders face the risk that the company does not do well. If the
company makes no profit, it will not be in a position to pay any dividends to the shareholders and those
shareholders are unlikely to be able to sell their shares and make any capital gain.

In the extreme case, if a company collapses into bankruptcy the shareholders will get nothing, as
shown in the following illustration:

Example
Tom Clarke thinks he has found a way to manufacture the ultimate yo-yo using recycled tin cans. He
is confident that the combination of the popularity of yo-yos with the environmentally friendly use of
recycled materials will make his yo-yos a big success.

He sets up a company – Yo-Yo ltd – to manufacture and sell the yo-yos, selling some shares to his
friend Max and using some of his own money to buy the remainder. Max contributes £10,000 and
Tom contributes £5,000, so Yo-Yo ltd starts with £15,000 of cash, as shown below:

Total
Max buys 1,000 shares for £10
£10,000
each
Tom buys 1,000 shares for £5
£5,000
each
Yo-Yo ltd starting cash £15,000

Unfortunately, the business does not do well. After struggling for a couple of years, the company runs
out of cash. Since it still owes a few hundred pounds in rent, the company is declared bankrupt and
unable to pay its bills.

Tom and Max have lost their £15,000 and the only bit of good news for Tom and his co-investor friend
is that they cannot lose any more than their invested money. As shareholders they are legally separate
from the company – their shares are worth nothing, but they do not have to pay the company’s bills.

So, who does pay the unpaid bills? The answer is no-one – the landlord will not get the unpaid rent.

74
 Equities

Equity is at the bottom of the food chain.

• In the event of collapse it will be the lenders that get their money first.
• Only if anything is left will the shareholders get anything at all.

In summary, the risks faced by shareholders are:

4
• That the company’s level of profits (or losses) means it is unable to pay dividends.
• That the value of shares falls – potentially to zero if the company collapses into bankruptcy.

Exercise 4
All of the following are potential sources of return from shares EXCEPT?

a. Regular dividends
b. Capital gain
c. Increasing dividends
d. Coupons

Exercise 5
An unsuccessful company collapses and falls into bankruptcy. Which of the following best describes
what will happen to the unpaid debts?

a. The company’s bankers will pay them

b. The company’s shareholders will pay them
c. They will be paid by the government
d. They will remain unpaid

75
Answers to Chapter Exercises
Exercise 1 – Fuelmonitor ltd
Fuelmonitor was set up by Patrick Brightman who paid £300 for all 30 shares that Fuelmonitor issued.
After setting up its website, Fuelmonitor has attracted some subscribers and has a local newspaper
interested in sponsoring the site. It now needs more finance to expand and is planning to issue 20
new shares.

1. How much should Fuelmonitor issue the new shares for?

Given that Fuelmonitor has already set up a website and started to attract interest and some
business, it is logical to expect its shares to have a value in excess of the original £10 Patrick paid.
Precisely how much would be judged by the existing and potential profitability of Fuelmonitor
ltd.

2. After issuing the new shares, what will Patrick’s ownership proportion of Fuelmonitor be?
Patrick originally held all 30 shares that Fuelmonitor had issued. Now the addition of 20 new
shares means that Patrick owns 30 of the 50 shares in issue – 60% of the company.

3. What will be the proportion of Fuelmonitor owned by the new shareholders?

The new shareholders will hold 20 of the 50 shares in issue, which represents 40% of the company.

4. How will the shareholders of Fuelmonitor get a return on their investment?

The shareholders of Fuelmonitor will hope that the company will make enough profits to pay
them regular dividends and they will also hope that Fuelmonitor will become more valuable so
they can sell the shares for more than they paid for them.

Exercise 2 – Dividend Yield

Below are details relating to three fictional companies. What is the dividend yield for each?

Total dividends paid in the last

Company name Share price ($) Dividend yield (%)
year ($)
ABC inc 4.32 172.00 2.51%
FGH inc 8.64 403.00 2.14%
XYZ inc 12.24 702.00 1.74%

76
 Equities

Exercise 3 – Which Share Offers the Best Investment Opportunity?

Company Current share Share price high in Share price low in Dividend yield
name price ($) the last year ($) the last year ($) (%)
Apple 129.94 182.94 128.72 0.59
Exxon Mobil 109.72 114.66 60.42 2.82
JPMorgan
131.93 160.24 101.28 2.56

4
Chase
McDonald’s 267.76 281.67 217.68 1.74
Microsoft® 237.55 344.30 213.43 0.86

Deciding which share offers the best value as an investment and why is no easy task, and there is no
one right answer. It is very much a matter of judgement.

However, looking at each column in turn and considering which company might be best is a logical
way of approaching the task. The overall picture after considering each column will hopefully reveal
which one may be the best investment opportunity.

The first column provides only the company name, and your research about what these companies do
and what products they sell may help you determine which ones are better investment opportunities
than others.

• Apple is known to be an extremely successful company with products like the iPad, and iPhone that
are increasingly sophisticated and considered as ‘must haves’ by many consumers.
• Exxon Mobil is one of the world’s biggest oil companies, and oil, plus the products extracted from it,
are vital to run motor vehicles, ships and aeroplanes; and provide energy.
• JPMorgan Chase is one of the world’s largest banks. It does everything including retail, corporate and
investment banking.
• McDonald’s is the most well-known fast-food brand in the world, selling meals to millions every day
from almost every city on the planet.
• Microsoft® provides the software that most computers around the world rely on, particularly those
used for business purposes.

77
The second column provides the share prices. Alone, these are not particularly useful. Although
Exxon Mobil shares are the least expensive to purchase and less than half the price of McDonald’s
or Microsoft, this is not helpful from an investment perspective. Each company will have different
numbers of shares in issue, so some are essentially bigger slices of the whole than others.

When the current share price in column two is combined with the highs and lows from the last year
(columns three and four), more investment insight can be gathered. Exxon Mobil and McDonald’s
are both close to their annual high points, suggesting it is perhaps not the right time to buy as there
may not be a lot of scope for the price to increase in the short term. In contrast, Apple is the closest
to its low for the year, which may indicate a bargain at the current price or concern for its future. For
example, one of the reasons for Apple’s share price being close to its low point is concern surrounding
iPhone production from factories in China where coronavirus remains an ongoing issue. If investors
think this will be solved quickly, then it might be a good time to buy, but if investors think this will be
a longer-term issue, they may decide to sell.

The final column gives the dividend yield as a percentage. Generally, a high dividend yield is more
attractive as it indicates a strong level of income will be forthcoming. Exxon Mobil, JPMorgan Chase
and McDonald’s are three well-established, profit-making businesses and are paying 2.82%, 2.56%
and 1.74% respectively, while Microsoft and Apple pay a less generous 0.86% and 0.59% respectively.

Ultimately, it is a question of judgement. For investors looking for income and possible growth in the
short term, perhaps Microsoft or Apple are better as they combine some dividends with innovative
products that consumers are more and more dependent upon, especially in a post COVID-19 world
which has relied heavily on technology to communicate.

However, please be aware that this is only superficial analysis. There are investment cases to be made for
the others too. These obviously include Exxon Mobil’s substantial oil reserves, JPMorgan Chase’s huge
presence and customer base; and McDonald’s, which has established, well-known products which are
now a part of the eating culture in many countries. Long-term strategic plans for these companies
should also be considered when making decisions to buy.

Exercise 4 – Potential Sources of Return

4. D (chapter 4, section 3).

The potential sources of return on shares are dividends and capital gains. Coupons are paid by bonds,
not shares.

Exercise 5 – Bankruptcy
5. D (chapter 4, section 5).

Shareholders are separate to the company, so if a company collapses, some of its debts may remain
unpaid but the shares will be worthless.

78
 1
Chapter Five

Bonds

5
1. Introduction to Bonds 81

2. Bond Issuers 82

3. Features of Bonds 84

4. Bond Terminology 86

5. Advantages and Disadvantages of Investing in Bonds 89

6. Credit Rating Agencies 91

7. Bonds or Equities? 93

This syllabus area will provide approximately 5 of the 30 examination questions

80
 Bonds

1. Introduction to Bonds
Learning Objective

5.1.1 Know the definition of a bond and the reasons for issue: alternative to loans or issuing shares

Having already encountered bonds earlier in this workbook, we know bonds are essentially IOUs.
However, a more formal definition of a bond would be: a debt instrument whereby an investor lends
money to an entity (such as a company or a government) that borrows the funds for a defined period of
time at a fixed interest rate.

5
Clearly, the reason for issuing bonds is for the issuer to raise finance, perhaps to fund something in
particular as shown in the following example.

Example
Crazy Jet inc is a small airline that has been successful to date and wants to expand its fleet of aircraft.
Needing to raise the necessary cash from somewhere, Crazy Jet considers borrowing the money from
a bank, and is quoted an interest rate of 6% for the five-year loan it is looking for. Instead, it decides to
issue 1,000 bonds, each for $1,000, in order to raise the finance to buy more aircraft. Crazy Jet will pay
just 5% interest on the bonds.

Will Lend has $1,000 to invest. He has travelled on Crazy Jet and particularly enjoyed the experience.
He decides to buy a bond, paying $1,000 and receiving the following:

I owe you (IOU)

$1,000 Nominal
The above sum will be value
repaid in five years’ time
(on 30 June). Maturity or
5% of the above sum will be redemption
paid each year on 30 June date
up to, and including the
Coupon
date of repayment.
Issued by Crazy Jet inc

As shown in the above example, the issuer of the bonds (Crazy Jet) chose to issue bonds in preference to
other potential forms of finance. The bonds were actually cheaper (costing 5% in interest) than the bank
loan that was available (costing 6% in interest).

81
 Exercise 1 – Crazy Jet’s Financing
Why do you think Crazy Jet might not have wanted to issue equity as an alternative to borrowing the
money?

The answer to this exercise can be found in the appendix at the end of the chapter.

It is increasingly common to see bonds issued to fund activities that are environmentally responsible.
Such bonds are often referred to as ‘green’ bonds. There is also a subset of green bonds that aim to
conserve oceans. These are referred to as ‘blue’ bonds. The fact that the bonds are a form of responsible
investing might make them more attractive to investors and, therefore, make the cost to the issuer a
little less.

So, bonds are one of three major ways for a company to raise finance. The alternatives are bank loans
and equity issues.

2. Bond Issuers
Learning Objective

5.1.2 Know the bond issuers: governments; corporates

The issuers of bonds can be subdivided into two major groups – companies and governments.

The Two Major Issuers of Bonds

Companies Governments
Issuing Issuing
corporate bonds government bonds

Since companies are alternatively referred to as corporates, bonds issued by companies are often
termed ‘corporate bonds’.

82
 Bonds

Microsoft® Bond Issue, August 2016

Microsoft®, the world’s largest software maker, sold $19.75 billion of corporate bonds in August 2016.
It chose to sell seven individual groups of bonds, repaying the money at different dates and paying
different interest rates as follows:

Quantity issued Repayment Interest payment

$2.5bn 3 years 1.1% pa
$2.75bn 5 years 1.55% pa
$1.5bn 7 years 2.0% pa
$4.0bn 10 years 2.4% pa

5
$2.25bn 20 years 3.45% pa
$4.5bn 30 years 3.7% pa
$2.25bn 40 years 3.95% pa
Total $19.75bn

Microsoft® was unspecific about how the money raised will be used although some of the proceeds
were probably used to help fund the previously announced acquisition of LinkedIn Corp for $26.2
billion in cash. The different interest rates payable on the seven bonds are driven by the returns
demanded by investors for bonds with different repayment dates.

The fact that the required interest payment increases as the time to repayment increases is a function
of risk and reward. Longer-dated bonds are more risky and hence the investors want greater returns –
Microsoft® is more likely to have problems over the next 40 years than over the next 3 years.

As the above example shows, companies can choose to issue bonds with different dates of repayment.
The repayment dates chosen will depend on a number of factors, including the financial plans of the
issuing company and the periods over which investors may wish to invest.

A significant number of developed countries’ governments issue bonds, as they often spend more in a
given year than they receive in taxes. Major countries like the US, Germany, France and the UK are all
significant issuers of government bonds.

UK Government Bond Issue, November 2022

The UK government sold £6.0 billion of bonds called Treasury Gilts in November 2022. The bonds
will repay the borrowed money in 2038 and will pay interest of 3.75% each year.

83
 Exercise 2 – Government Bonds
Why do governments such as the US and the UK issue bonds?

The answer to this exercise can be found in the appendix at the end of the chapter.

To provide some insight into the reasons governments might want to borrow, the following example
outlines the US federal budget and actual outcome for the year ending 30 September 2022. The federal
budget is the expected income and expenditure of the US for the period and showed that expenditure
was expected to exceed income and create a deficit. The deficit turned out to be even larger than the
budget expectation.

This deficit needed to be funded in some way and increased the US’s national debt.

US Federal Budget 2022

For the period from 1 October 2021 through to 30 September 2022, revenue was $4.90 trillion. This
was significantly less than the $6.27 trillion in spending, creating a $1.38 trillion deficit.

This difference was funded primarily through the issue of US Treasury bonds.

3. Features of Bonds
Learning Objective

5.1.3 Know the features of bonds: repayment date; frequency of interest payments; tradeable

All bonds tend to exhibit certain key features – particularly a date when the bond will repay the money
loaned and the frequency at which the interest payments will be made. Returning to our earlier example
of the Crazy Jet corporate bond, both of these features are clearly displayed:

I owe you (IOU)

$1,000 Nominal
The above sum will be value
repaid in five years’ time
(on 30 June). Maturity or
5% of the above sum will be redemption
paid each year on 30 June date
up to, and including the
Coupon
date of repayment.
Issued by Crazy Jet inc

84
 Bonds

The repayment date is in five years’ time and the interest payments are paid annually on 30 June. Each
interest payment will be 5% x $1,000 = $50. Some bonds pay interest more frequently, perhaps semi-
annually rather than annually. If the Crazy Jet bond paid interest semi-annually then it would split the
annual $50 into two $25 payments, one on 31 December and the other on 30 June.

Bonds are tradeable instruments. This means that they can be bought and sold. To see why this feature
might be important, let’s revisit Will Lend, who purchased a Crazy Jet bond in the earlier example.

Example
You will recall that Will Lend purchased a Crazy Jet bond that will repay $1,000 in five years’ time and
pays annual interest of 5%, or $50 every year on 30 June.

5
Three years have elapsed and Will has money problems himself. He is trying to get together enough
cash to buy a car and could really benefit from an additional $1,000. The answer may lie with the
Crazy Jet bond – the bonds can be traded, so Will can offer the bond for sale. Hopefully, he will be
able to get $1,000 for the bond two years earlier than the repayment date. However, he will obviously
miss out on any more interest payments – these will be paid to the new owner of the bond.

The factors that will impact whether Will can get $1,000 for his bond include:

1. Whether Crazy Jet is still successful in business.

2. Whether the 5% coupon that is available on the bond is still competitive with other forms of
investments, such as the interest payable on deposits with banks.

Bond Features
2019

Repayment date Tradeable

When the money Bonds can be sold before
will be returned they reach their repayment
date

Interest rate and frequency

Percentage paid as interest and
how often it is paid

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4. Bond Terminology
Learning Objective

5.1.4 Know the key terms: nominal; coupon; redemp­­­­tion/maturity; yield

Like finance generally, there are a number of terms that are used for bonds which need to be understood.

The nominal value of a bond is the amount that is owed by the bond issuer, and that will be repaid on
the repayment date. It is also referred to as the par value, or as the face value (because it is the amount
that is written on the face of the bond certificate – the IOU).

The repayment date is usually referred to as the redemption date, or the maturity date. So
commentators will talk about bonds redeeming in perhaps five years’ time, or maturing in five years’
time.

The interest rate that is applied to the nominal value is more typically termed the coupon on the bond.

So, returning to our earlier example of the Crazy Jet bond, we can see that the nominal value or face
value is $1,000, the maturity or redemption date is in five years, and the coupon is 5% paid annually on
30 June.

I owe you (IOU)

$1,000 Nominal
The above sum will value
be repaid in five
years’ time (on 30 June). Maturity or
redemption
5% of the above sum will be date
paid each year on 30 June
up to, and including the Coupon
date of repayment.

Issued by Crazy Jet inc

86
 Bonds

4.1 Bond Yields

The final piece of terminology to consider in relation to bonds is the yield. Yield is another word for
return and it is expressed as an annual percentage. For bonds, it is tempting to think that the return –
the yield – is the same as the coupon. This is only the case if the bond is being bought and sold at its
nominal value. If the traded price rises above or falls below the nominal value, the yield will be different
from the coupon, because to calculate the yield you divide the annual coupon by the price paid.

Example

Returning to the Crazy Jet bond, we saw that when it was issued it was sold at its nominal value of
$1,000. So the original buyer, Will Lend, has invested in a bond that will provide him with a yield of

5
5% – the coupon rate and the yield for the investor are the same, at 5% each year (50/1,000 = 0.05 x
100 = 5%).

Now let’s presume that one year has elapsed and the Crazy Jet bonds have four years left to run
until they mature. The general economy is going well and interest rates in general have gone up, so
alternatives to the Crazy Jet bond, like deposit accounts and other bonds, are offering higher rates
of interest of 7%. If Will Lend were to consider selling his bond at this point, no one would be willing
to pay $1,000 and only receive 5% yield – they would want a higher yield because higher rates are
on offer elsewhere. The required yield has increased, meaning the price of the Crazy Jet bond will fall
such that the yield it provides the buyer is competitive.

I owe you (IOU)

$1,000

The above sum will

be repaid in five
years’ time (on 30 June).
Price
slashed
5% of the above sum will be
$1,000
paid each year on 30 June
up to, and including the
date of repayment.
$800
Issued by Crazy Jet inc

The example above shows that, if interest rates generally increase after a bond issue, then to sell the
bond the yield will have to increase to attract any buyer. The only way this can happen is by reducing
the price. In the Crazy Jet example, the coupon payment does not change, but the price fall means that
the coupon received of $50 is a bigger percentage of the amount paid (6.25%, based on (50/800) x 100).

87
It would be the opposite situation if interest rates in general fell. Buyers of the bond would be willing to
accept a lower yield and the price of the bond would increase.

Note that, if the buyer keeps the bond until its maturity date, the yield will also be supplemented by
the fact that the buyer will make a gain when the bond matures and repays $1,000, because they only
paid $800 for it. When the yield calculation includes only the calculation of coupon divided by price, it
is called the flat yield. When the calculation includes the capital gain (or loss) if the bond is held until its
maturity date, it is called the yield to maturity.

In summary, there is an inverse relationship between yield and bond prices. If required yields increase, bond
prices decrease; if required yields decrease, bond prices increase. The relationship can be thought of as a see-
saw.

Bond Price

Bond Yields

Exercise 3 – Yields
Please try to answer the following three questions about yields:

1. $1,000 nominal value of a bond redeeming in 30 years is paying a 7% coupon and is currently
priced at face value. What is the current yield on the bond?
2. If the above bond’s price falls to $980, what happens to the yield? Does it increase or decrease?
3. If the bond’s price now increases to $1,100, what happens to the yield? Does it increase or
decrease?

The answers to this exercise can be found in the appendix at the end of the chapter.

4.2 Interest Rates and Bond Prices

As explained in section 4.1, bond prices are susceptible to movements in general interest rates because
for their yield to be attractive to an investor it needs to remain competitive with the return available on
alternative investments.

The following exercise explores this further:

88
 Bonds

Exercise 4 – What Happens to the Bond Price? Part 1

Now you know the relationship between a bond’s price and its yield, try to fill in the following table.
Are the bonds likely to go up in value, down in value, or stay the same in the following situations?

Price will go up, down, or stay

Situation
the same?
The European Central Bank
decreases interest rates
in the eurozone. What is
likely to happen to the
bond prices of German and

5
French government bonds?
The central bank in the
UK (the Bank of England)
increases interest rates.
What will happen to the
price of UK government
bonds?

Suggested answers can be found in the appendix at the end of this chapter.

5. Advantages and Disadvantages of Investing in Bonds

Learning Objective

5.1.5 Know the advantages and disadvantages of investing in bonds: regular income; fixed maturity
date; credit risk

Now the features and characteristics of bonds have been encountered, the advantages and disadvantages
of investing in bonds can be considered. Two particular features provide the key advantages of investing
in bonds – coupons and the redemption date.

For investors, a predictable income is seen as an advantage and most bonds pay a stated amount of income
every year or half-year in the form of coupons. This is in stark contrast to equities, where the amount of the
dividend can be unpredictable as companies have profitable or unprofitable years.

Similarly, it is seen as a positive feature that bonds will repay a set amount of cash at an agreed date in
the future. The investors know, when investing, how much and when the redemption will occur. Again
this contrasts with investing in equities, where the price at which the shares can be sold is unknown –
share prices can go down as well as up.

89
The potential disadvantage of investing in bonds is the possibility that the issuer will fail to pay some
or all of the coupons and the redemption amount because it does not have the available funds. In such
circumstances, the issuer is described as being in default. Less substantial issuers are more likely to
default than other, more substantial issuers. However, rather than a complete default, just an increased
possibility of default can have an adverse impact on the return for an investor. This will be the case if the
investor has to sell the bond before it reaches maturity. This is illustrated below:

Example
Carlton Barratt is a musician who has fallen on hard times. Fortunately, when he was earning
substantial money he purchased a $10,000 face value 15-year bond paying a 6% annual coupon,
issued by Worldwide Resources inc.

The bond’s maturity is still seven years away, but Carlton really needs cash now. He decides that
selling the bond is the sensible thing to do.

Interest rates remain the same as when he purchased the bond. However, Worldwide Resources
has itself not performed well and there is an increased risk that it will default on its bonds. Because
of this increase in risk, investors are now looking for an increased return and a yield nearer 14% on
Worldwide Resources bonds. This has meant that the resale value of Carlton’s bond is only $6,500,
compared to the $10,000 that Carlton paid when he purchased the bond.

This example illustrates what happens when a bond is sold before maturity and the risk that the issuer
will default has increased. This is alternatively described as an increase in the credit risk of the issuer –
the risk that the amount owing (the credit) may not be repaid.

Here is a summary of the key advantages of investing in bonds:

• Predictable income in the form of regular, fixed coupons.

• Fixed date and amount to be repaid at redemption.

Here are the key disadvantages of investing in bonds:

• Actual default – the failure of the issuer to be able to pay the coupons and/or the redemption
amount.
• An increased risk of default resulting in a fall in the bond’s value.

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 Bonds

Exercise 5 – What Happens to the Bond Price? Part 2

Try to fill in the following table. Are the bonds likely to go up in value, down in value, or stay the same?

Price will go up, down, or stay the

Situation
same?
Buddy inc is an oil exploration company
that has just announced a significant
discovery of easily accessible oil. What
happens to the price of Buddy’s 5%
coupon-paying bonds?

5
Anemone plc’s sales have suffered due to
a recession in its main market. Anemone
has a number of 7% coupon-paying
bonds in issue – what is likely to happen
to their price?
Lakeground inc announces a substantial
equity issue aimed at reducing its debt
burden. What is likely to happen to the
price of Lakeground’s bonds?

Suggested answers to this exercise can be found in the appendix at the end of this chapter.

6. Credit Rating Agencies

Learning Objective

5.1.6 Know the role of credit rating agencies: investment grade/non-investment grade

We have just seen what happens when the credit risk of the issuer of a bond increases – investors
become more nervous about whether the coupons will continue to be paid and whether the repayment
will happen at maturity. The combination of these two factors means that any new investors are not
willing to pay as much for the bond as previously. As what happened with Worldwide Resources bonds,
the result is that the bond’s price will fall.

Assessing the credit risk for particular bond issues and monitoring any changes is not just done by the
existing and potential investors – there are a small number of specialist firms known as credit rating
agencies that look at bond issuers and assess the credit risk. There are three dominant credit rating
agencies globally – Moody’s, Standard & Poor’s and Fitch Ratings.

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All three adopt similar methods for assessing credit risk and have come up with a similar output – an
alphabetic system where the safest issuers with least credit risk are termed ‘triple A’. Standard & Poor’s
and Fitch use an identical scale, while the scale adopted by Moody’s is slightly different as shown in the
next column.

Standard & Poor’s/ Moody’s

Fitch Ratings Ratings
AAA Aaa
AA Aa
A A
Increasing
BBB Baa levels of
credit risk
BB Ba
B B
CCC Caa
CC Ca
C C
D

Issuers rated triple A by Standard & Poor’s are described as having an ‘extremely high capacity to meet
their financial commitments’ and by Fitch Ratings as having an ‘exceptionally strong capacity for payment
of financial commitments’ – in other words, they are likely to be able to pay the bonds’ coupons and
repay the nominal value at maturity. Moody’s describes Aaa as reflecting issuers of the ‘highest quality
with minimal credit risk’, essentially saying the same thing as the two other agencies. As the credit risk
of the issuer increases, the assessment from the agencies moves down the scale with the lowest for
Standard & Poor’s and Fitch Ratings being D. This is generally for issuers already in default and failing to
pay the bond coupons. The lowest rating from Moody’s is C.

There is an important dividing line between bonds that are rated by the agencies as having less credit
risk, and therefore more appropriate for prudent investors, and bonds that are more risky and therefore
less appropriate for prudent investors. This is the dividing line between what are termed investment
grade bonds and non-investment grade bonds, and it is drawn just below Standard & Poor’s BBB and
Moody’s Baa levels as shown opposite.

92
 Bonds

Standard &
Moody’s
Poor’s/Fitch
Ratings
Ratings
AAA Aaa
Investment
AA Aa grade
A A
BBB Baa
BB Ba
B B
Non-investment
CCC Caa grade
CC Ca

5
C C
D

Exercise 6 – Credit Ratings

Please complete the following table in relation to credit ratings:

Standard & Poor’s/Fitch

Investment grade or
Credit rating Ratings, Moody’s Ratings or
non-investment grade?
all three?
Aaa
AA
Ba
BBB
B

The answers to this exercise can be found in the appendix at the end of the chapter.

7. Bonds or Equities?
Learning Objective

5.1.7 Understand the benefits and risk of leverage in a company’s financing structure

When a company raises finance it has two broad choices – to raise money by borrowing (in the forms of
bonds or bank loans) or to raise money by selling more equity. To illustrate the impact of choosing one
over the other, we will further develop the example of Crazy Jet.

93
Let’s assume that Crazy Jet at the start of the period is worth $100 million. The company has a good
profitable year, filling its aeroplanes with passengers on both its existing routes and a number of new
routes, and at the end of the year it is worth $120 million. That’s an increase of 20% over the year.

$120m

$100m

20% up

Starting value Ending value

Now, if we assume that at the start of the period Crazy Jet was financed only by equity and had no
borrowing at all, and no additional finance was raised during the period, then all of the 20% gain over
the year will be to the shareholders. Their shares will be worth 20% more than they were worth before.

$120m

$100m

20%
increase
in the
value
of the
equity
Equity
Equity

Starting value Ending value

However, what if, instead of being 100% financed by equity at the start of the period, Crazy Jet had
been 50% funded by equity and 50% funded by debt? Let us assume that the debt has not increased or
decreased during the year; at the end of the period $50 million is still owed by Crazy Jet. However, all of
the $20 million increase in value has been earned for the owners of the business, the shareholders.

94
 Bonds

$120m
40%
increase
$100m in the
value
of the
equity

$50m Equity Equity $70m

$50m Borrowing Borrowing $50m

5
Starting value Ending value

This means that the equity has grown from a starting value of $50 million to an ending value of $70
million. This is a 40% increase and will be preferred by the shareholders to the 20% increase they would
earn if Crazy Jet were 100% equity-financed.

This is the beneficial impact of leverage. Leverage is the proportion of debt finance compared to equity
finance in the company.

Exercise 7 – What if the Borrowing Had Been Even Bigger? Part 1

Try to assess the impact on the shareholders of Crazy Jet in the same situation, but this time with:

a. 60% debt
b. 90% debt

The answers to this exercise can be found in the appendix at the end of the chapter.

The impact of leverage is that, when a company like the fictional Crazy Jet performs well, it appears that
the larger the proportion of the financing that comes from debt, the better. The larger the leverage, the
more the gain to the shareholders is magnified.
However, two particular things have an impact on how much borrowing companies like Crazy Jet have:
• How much lenders are willing to lend, and how much they charge for that lending.
• The fact that, if the company does not perform well, a larger proportion of borrowing will have the
opposite effect on the equity value.
Expanding on the first point, providers of debt finance, like banks and bond investors, will consider
the risks they face when making their loans. Simplistically, the more a company borrows, the greater
the risks. As a result, the proportion of debt cannot go beyond the level that presents too large a risk
for the lenders to be willing to lend. Furthermore, as the proportion of debt increases, the credit rating
assessment will fall, which will make the borrowing more expensive, perhaps prohibitively so.

95
On the second point, if a company performs badly, then the impact of leverage magnifies the loss to the
shareholders rather than the gain. Let’s consider Crazy Jet again, and this time presume the value of the
business falls over a period, from a starting level of $100 million to an ending level of $90 million.

$100m $90m
10%
down

Starting value Ending value

Clearly, if the business were 100% funded by equity, the shareholders would have suffered a 10% fall in
the value of their investment. The shares were worth a combined $100 million, now they are only worth
$90 million.

What would have happened to the value of their shares if the business had been 50% funded by debt
and 50% funded by equity? Well, the leverage would have magnified the loss for the shareholders. The
business would still owe $50 million in borrowing at the end of the period, so the equity would be worth
the remaining $40 million. That is a 20% fall from the starting value of $50 million.

20%
decrease
$100m $90m
in the
value
of the
equity

$50m Equity Equity $40m

$50m Borrowing Borrowing $50m

Starting value Ending value

96
 Bonds

Exercise 8 – What if the Borrowing Had Been Even Bigger? Part 2

Try to assess the impact on the shareholders of Crazy Jet in the same loss situation, but this time with:

a. 60% debt
b. 90% debt

The answers to this exercise can be found in the appendix at the end of the chapter.

In summary, financial leverage is the proportion of a debt relative to the equity within a business.
The greater the proportion of debt, the more gains in the business are magnified to the shareholders.
However, the greater the proportion of debt, the more losses are magnified to the shareholders.

5
Exercise 9
The date at which a bond’s life ends and the nominal value is paid by the issuer to the bondholder is
known by all of the following, EXCEPT:

a. Repayment date
b. Maturity date
c. Sale date
d. Redemption date

Answers to Chapter Exercises

Exercise 1 – Crazy Jet’s Financing
Crazy Jet might not have wanted to issue equity as an alternative to borrowing the money for
two broad reasons. The first is that when more shares are issued to new shareholders, the existing
shareholders’ ownership stake in the company will become less substantial. This is typically described
as the shareholders’ influence becoming diluted. Simply put, if a company doubles its number of
shares by selling new shares to new shareholders, the original shareholders’ 100% original ownership
will be diluted to just 50% after the new issue. Dilution tends to be unpopular with the existing
shareholders.

The second is that raising finance by borrowing (debt) is potentially beneficial because of leverage.
This is explored in detail in section 7 of this chapter, but relates to the fact that the borrowed funds
have to be serviced and then repaid, while it is the shareholders who benefit from an increase in the
value of the company that the additional finance has facilitated.

97
Exercise 2 – Government Bonds
The prime reason governments like the USA and the UK issue bonds is simply to fund their debt.
Governments receive money mainly in the form of taxes and duties and spend money on things
like benefits for the unemployed, medical facilities for the population, and roads and railways. Just
like individuals and businesses, governments need to find the money somewhere when they are
spending more than they are receiving. Bond issues are typically used to finance the difference.

Exercise 3 – Yields
1. 1. $1,000 nominal value of a bond redeeming in 30 years is paying a 7% coupon and is currently
priced at face value. The current yield on the bond is the same as the coupon rate at 7%. When the
price of a bond is at nominal value, the yield is the same as the coupon rate.
2. If the above bond’s price falls to $980, the yield will increase above 7%. The fall in price results
in an increase to the percentage the investor receives each year. A purchaser will receive 7% of
$1,000, having paid $980. This means the purchaser receives around 7.14% of their investment
each year (calculated as interest rate x (nominal value/actual value), ie, 7% x 1000/980). If they
hold on to the bond for the 30 years, the purchaser will also benefit from a windfall gain of a
further $20 on redemption, having paid $980 and receiving back $1,000.
3. If the bond’s price now increases to $1,100, the yield will decrease because an increase in a bond’s
price results in a fall in the bond’s yield. For a buyer paying $1,100, the annual yield generated by
the bond will fall to 6.36% each year (calculated as interest rate x (nominal value/actual value), ie,
7% x 1,000/1,100) and the purchaser will also suffer a further loss at redemption when the bond
will only pay back $1,000 after the purchaser paid $1,100 to buy the bond.

Exercise 4 – What Happens to the Bond Price? Part 1

Situation Price will go up, down, or stay the same?

Up
The European Central Bank decreases When interest rates in general go down,
interest rates in the eurozone. What is likely bondholders are willing to accept a lower
to happen to the bond prices of German return when they buy bonds, so the price of
and French government bonds? the bonds will go up. This brings about a fall in
yield.
Down
The central bank in the UK (the Bank of An increase in interest rates means that bond
England) increases interest rates. What yields need to increase too, to keep them
will happen to the price of UK government attractive to investors. The increase in bond
bonds? yields is generated by the prices of those
bonds falling.

In summary, interest rates and bond prices are said to have an inverse relationship – when interest
rates in general rise, bond prices tend to fall, and vice versa.

98
 Bonds

Exercise 5 – What Happens to the Bond Price? Part 2

Situation Price will go up, down, or stay the same?

Up
Buddy inc is an oil exploration company and
The increased likelihood of Buddy being able
has just announced a significant discovery of
to pay the coupons and repay the bonds
easily accessible oil. What happens to the price
should result in the yield required by investors
of Buddy’s 5% coupon-paying bonds?
falling and the price of the bonds rising.
Down
Anemone plc’s sales have suffered due to a Anemone’s credit risk has increased as its

5
recession in its main market. Anemone has a main market is in recession. The result is likely
number of 7% coupon-paying bonds in issue – to be that Anemone’s bonds will fall in price,
what is likely to happen to their price? resulting in an increase in the yield to reflect
the additional credit risk.
Up
A reduced amount of debt relative to the size
Lakeground inc announces a substantial equity of the issuing company will mean there is
issue aimed at reducing its debt burden. What less risk that Lakeground may fail to pay the
is likely to happen to the price of Lakeground’s coupons and repay the debt. The lower credit
bonds? risk should mean the bonds’ prices increase,
with the investors willing to accept a lower
yield.

Exercise 6 – Credit Ratings

Credit Standard & Poor’s/Fitch Ratings,

Investment grade or non-investment grade?
rating Moody’s or all three?
Aaa Moody’s Investment grade
AA Standard & Poor’s/Fitch Investment grade
Ba Moody’s Non-investment grade
BBB Standard & Poor’s/Fitch Investment grade
B All three Non-investment grade

99
Exercise 7 – What if the Borrowing Had Been Even Bigger? Part 1
This is the impact on the shareholders of Crazy Jet if the value of the business had increased from
$100 million to $120 million and it had been financed with:

a. 60% borrowing. The starting situation was that the borrowing was $60 million (60%) and the equity
was $40 million. At the end of the period, Crazy Jet is worth $120 million. $60 million is still owed to
the lenders and the balance of $60 million is the equity value. That is an increase of 50% from the
starting point of $40 million.

b. 90% borrowing. The starting situation was that the borrowing was $90 million (90%) and the equity
was $10 million. At the end of the period, Crazy Jet is worth $120 million. $90 million is still owed to
the lenders and the balance of $30 million is the equity value. That is an increase of 200% from the
starting point of $10 million!

Exercise 8 – What if the Borrowing Had Been Even Bigger? Part 2

The impact on the shareholders of Crazy Jet if the value of the business had decreased from $100
million to $90 million and it had been financed with:

a. 60% borrowing. The starting situation was that the borrowing was $60 million (60%) and the equity
was $40 million. At the end of the period, Crazy Jet is worth $90 million. $60 million is still owed to the
lenders and the balance of $30 million is the equity value. That is a decrease of 25% from the starting
point of $40 million.

b. 90% borrowing. The starting situation was that the borrowing was $90 million (90%) and the equity
was $10 million. At the end of the period, Crazy Jet is worth $90 million. $90 million is still owed to the
lenders and the balance is an equity value of zero. So, a 10% fall in the value of the business has wiped
out the value of the equity completely!

Exercise 9 – End of a Bond’s Life

9. C (chapter 5, section 4).

The end of a bond’s life is alternatively known as the repayment, redemption or maturity date, when
the bond’s nominal value is paid to the bondholder.

100
 1
Chapter Six

Derivatives

5
1. Introduction 103

2. Futures 105

3. Options 106

This syllabus area will provide approximately 1 of the 30 examination questions

102
 Derivatives

1. Introduction
Derivatives are not a new concept – they have
been around for hundreds of years. Their origins
can be traced back to agricultural markets, where
farmers needed a mechanism to guard against
price fluctuations caused by gluts of produce, and
merchants wanted to guard against shortages that
might arise from periods of drought.

So, in order to fix the price of agricultural produce

in advance of harvest time, farmers and merchants
would enter into forward contracts. These set the
price at which a stated amount of a commodity
would be delivered between a farmer and a

6
merchant (termed the ‘counterparties’ to the trade)
at a pre-specified future date.

These early derivative contracts introduced an

element of certainty into commerce and gained
immense popularity. This popularity eventually led
to the introduction of other derivatives, particularly
futures and options contracts, and the opening of
the world’s first derivatives exchange in 1848, the
Chicago Board of Trade (CBOT).

Modern derivatives markets have their roots in

this trading of agricultural products and today’s
derivatives have widened beyond agricultural
products to include financial instruments such as
shares and bonds, metals, energy and a wide range
of other assets.

1.1 Uses of Derivatives

Learning Objective

6.1.1 Know the uses and applications of

derivatives

A derivative is a financial instrument whose

price is based on the price of something else,
typically an underlying asset. This asset could be a
financial instrument, such as a bond or a share, or a
commodity, like oil, gold, silver, corn or wheat.

103
Derivatives come in a number of forms, including forwards, futures and options. Forwards have already
been mentioned in the introduction to this chapter, and we will go on to consider futures and options
in the following sections.

The way in which derivatives are used is fundamentally for one of two purposes – hedging or speculation.

Hedging
In essence, hedging involves replacing uncertainty with certainty so that risk is reduced. The farmer
agreeing a price for their harvest in advance means they can plan with certainty and will not need to
worry about how market prices might change between sowing seeds and harvest time. Similarly, the
merchant has locked-in a future purchase price and can begin to plan and prepare their price list for
selling their agricultural produce with certainty about the mark-up they will earn. Both participants
are using the derivative (the forward contract) to ‘hedge’ (reduce) the risks they face by replacing an
uncertain price with a certain price.

Speculation
The second key use for derivatives is speculation; in other words, using derivatives to make money.
It is fairly obvious that someone might try to make money by correctly anticipating that the price of
something, such as an agricultural product like wheat or barley, will increase. Without derivatives, the
speculator could buy the wheat or barley, store it for a time while its price increases and then sell it at
the higher price to generate a profit. This would require the speculator to receive and store the wheat
or barley, which will mean that they will need a temperature-controlled, weatherproof storage facility,
such as a warehouse, and will also probably want to insure the grain in case of damage.

Speculating using derivatives could remove the need for storage and insurance completely – the
speculator could use a derivative contract to commit to buying grain at an agreed future date at a
pre-agreed price. If the price increases, the grain could then be sold onwards at a profit as soon as it is
delivered, minimising the need to store and insure it. In fact, the speculator could choose to simply sell
on the derivative contract, which will presumably reflect the increase in value, and generate a profit
without even needing to take delivery of the grain.

But what if the speculator was not correct and the price of the grain fell in the period, instead of the
hoped-for increase? Without derivatives, the speculator will have to sell their grain at a loss. With
derivatives, the outcome is similar – the speculator will either take delivery of the grain and then have to
sell it at a loss, or alternatively choose to pay someone else to take on the derivative contract.

Derivatives also make it relatively easy to speculate on the price of something falling, rather than rising.
If a speculator thought the price of wheat was going to fall in the near future, it is possible to commit to
selling wheat now at the current market price. If the price falls, then the speculator can buy the cheaper
grain and deliver it for the higher price agreed in the derivative contract. Again, the alternative would
be to realise the profit by selling the derivative that enables the sale of something at a price higher than
the market price.

104
 Derivatives

Exercise 1 – Hedging Using Derivatives

A producer wants to hedge its revenues. Should the producer buy or sell forward contracts?

A consumer wants to hedge its costs. Should the consumer buy or sell forward contracts?

The answers can be found at the end of the chapter.

2. Futures
Learning Objective

6.1.2 Know the definition and function of a future

6
As mentioned in section 1, the CBOT opened the world’s first derivatives exchange in 1848. The
exchange soon developed futures contracts that enabled standardised qualities and quantities of grain
to be traded for a fixed future price on a stated delivery date.

Unlike the forward contracts that preceded them, the futures contract could themselves be traded.
These futures contracts have subsequently been extended to a wide variety of underlying assets and are
offered by an ever increasing number of derivatives exchanges.

A future is a legally binding agreement between a buyer and a seller. The buyer agrees to pay a pre-
specified amount for the delivery of a particular pre-specified quantity of an asset at a pre-specified
future date. The seller agrees to deliver the asset at the future date, in exchange for the pre-specified
amount of money.

105
 Example
A buyer might agree with a seller to pay US$80 per barrel for 1,000 barrels of crude oil in three
months’ time. The buyer might be an electricity generating company wanting to fix the price it will
have to pay for the oil to use in its oil-fired power stations, and the seller might be an oil company
wanting to fix the sales price of some of its future oil production.

Futures contracts have two distinct features:

• They are exchange-traded – for example, on any one of a multitude of derivatives exchanges around
the world such as the Chicago Mercantile Exchange (CME) or London’s ICE Futures exchange.
• They are dealt on standardised terms – the exchange specifies the quality of the underlying asset,
the quantity underlying each contract, the future date and the delivery location. Only the price is
open to negotiation. In the above example, the oil quality will be based on the oilfield from which
it originates (eg, Brent crude – from the Brent oilfield in the North Sea), the quantity is 1,000 barrels,
the date is three months ahead and the location might be the port of Rotterdam in the Netherlands,
for example.

In the same way as forwards, futures can be used to hedge – replacing uncertainty about prices at a later
date, with certainty about those prices. Futures can also be used for speculation – trying to make money
by correctly anticipating a rise, or a fall, in price.

Exercise 2 – Futures
An oil producer wants to hedge its revenues. Should it buy or sell futures contracts?

A speculator wants to make money out of an anticipated fall in the price of oil. Should the speculator
buy or sell futures contracts?

The answers can be found at the end of the chapter.

3. Options
Learning Objective

6.1.3 Know the definition and function of an option (calls and puts)

An option is a derivative that gives a buyer the right, but not the obligation, to buy or sell a specified
quantity of an underlying asset at a pre-agreed exercise price, on or before a pre-specified future date or
between two specified dates. The seller, in exchange for the payment of a premium, grants the option
to the buyer.

106
 Derivatives

There are two classes of options:

• A call option is when the buyer has the right to buy the asset at the exercise price, if they choose to.
The seller is obliged to deliver if the buyer exercises the option.
• A put option is when the buyer has the right to sell the underlying asset at the exercise price. The
seller of the put option is obliged to take delivery and pay the exercise price, if the buyer exercises
the option.

The premium is the money paid by the buyer to the seller at the beginning of the options contract; it is
not refundable.

The following example of an options contract is intended to assist understanding of the way in which
option contracts might be used. It is an option that is based on a share – an equity option.

Example

6
Suppose shares in New Jersey inc are trading at $3.24, and an investor buys a $3.50 call for three
months. The investor, Frank, has the right to buy New Jersey shares from the seller of the option
(another investor – Steve) at $3.50 if he chooses, at any stage over the next three months. If New
Jersey shares are trading below $3.50 three months later, Frank will abandon the option and it will
expire worthless, and Steve will keep the premium Frank paid him.

If New Jersey shares rise to, say, $6.00, Frank will contact Steve and either:

• exercise the option (buy the shares at $3.50 each and keep them, or sell them at $6.00 per share),
or
• persuade Steve to give him $6.00 – $3.50 = $2.50 per share to settle the transaction.

Assuming Frank paid a premium of 42 cents to Steve, what is Frank’s maximum loss and what level
does New Jersey inc have to reach for Frank to make a profit?

The most Frank can lose is 42 cents, ie, the premium he has paid. If the New Jersey inc shares rise
above $3.50 + 42 cents, or $3.92, then Frank makes a profit. If the shares rise to $3.51, then Frank will
exercise his right to buy – better to make a cent and cut his losses to 41 cents than lose the whole
42 cents. The most Steve can gain is the premium, ie, 42 cents. Steve’s potential loss, however, is
theoretically unlimited, unless he actually holds the underlying shares.

So, as seen, when a call option is purchased for speculative purposes, it is possible for the buyer to make
a profit or incur a loss. In order to make a profit, the underlying asset on which the call option is based
has to increase to a price above the exercise price plus the premium. The buyer of the option cannot
lose more than the premium paid because they have the choice of whether to exercise the option or not
– if the exercise of the option is not worthwhile, the buyer will simply not exercise it.

It is also helpful to appreciate that in the real world, option contracts are typically for a minimum of
1,000 shares at a time. Therefore, the buyer of the call could gain 1,000 times the amounts illustrated in
the example, and the loss would be restricted to 1,000 times the premium paid.

To underline your understanding of call options in particular, please try the following exercise. The
answer can be found at the end of the chapter.

107
 Exercise 3 – Equity Call Options
ABC inc is a listed company and its shares are currently trading at $100 each.

In addition to the shares, there are also equity options available on ABC inc shares. The three-month
call option with an exercise price of $100 is currently available for a premium of $10.

Assuming you anticipate that ABC shares will increase in value over the next three months, calculate
the gain or loss the call option would produce in each of the following three outcomes:

Three months later, the ABC share price:

1. has increased by 20% to $120

2. remains at $100
3. has fallen by 5% to $95.

To complete the coverage of derivatives, below is a short exercise that tests and clarifies your
understanding of the key differences between forward contracts, futures contracts and option contracts.
The solution can be found at the end of the chapter.

Exercise 4 – Forwards, Futures and Options

1. Which one of the following derivatives gives the buyer a choice as to whether to go ahead with
the contract or not?
a. Forward contract
b. Futures contract
c. Option contract

2. Which of the following derivatives is/are traded in standardised sizes on derivatives exchanges?
a. Forward contracts
b. Futures contracts
c. Options contracts

3. Which one of the following derivatives requires the buyer to pay a non-returnable premium?
a. Forward contracts
b. Futures contracts
c. Options contracts

4. A speculator wants to have the choice as to whether to buy an underlying asset or not. Which one
of the following derivatives is most appropriate?
a. Buying futures contracts
b. Buying call options
c. Buying put options

5. A speculator wants to have the choice as to whether to sell an underlying asset or not. Which one
of the following derivatives is the most appropriate?
a. Selling futures contracts
b. Buying call options
c. Buying put options

108
 Derivatives

Answers to Chapter Exercises

Exercise 1 – Hedging Using Derivatives
A producer wants to hedge its revenues. Should the producer buy or sell forward contracts?

Producers (such as farmers growing agricultural produce or oil companies extracting oil) will hedge
their revenues by selling their product at a pre-agreed certain price for delivery at a later date – selling
forwards.

A consumer wants to hedge its costs. Should the consumer buy or sell forward contracts?

Consumers (such as cereal manufacturers needing agricultural produce or oil-fired power stations
requiring oil for their furnaces) will hedge the costs they face by buying their product at a pre-agreed
certain price for delivery at a later date – buying forwards.

6
Exercise 2 – Futures
An oil producer wants to hedge its revenues. Should it buy or sell futures contracts?

The oil producer will want to fix the price at which it can sell oil, so it will sell futures contracts. The
precise number of contracts will depend upon the quantity of oil that is to be sold, and the standard
size of each contract. For example, if the oil producer wants to fix the price for 10,000 barrels, and the
standard contract size is 1,000 barrels per contract, the oil producer will need to sell ten contracts.

A speculator wants to make money out of an anticipated fall in the price of oil. Should the speculator
buy or sell futures contracts?

If the speculator is right, they will want to sell at the higher, current price when the price of oil has
fallen to a lower level. So the speculator will want to sell futures contracts.

109
 Exercise 3 – Equity Call Options
ABC inc is a listed company and its shares are currently trading at $100 each.

In addition to the shares, there are also equity options available on ABC inc shares. The three-month
call option with an exercise price of $100 is currently available for a premium of $10.

Assuming you anticipate that ABC shares will increase in value over the next three months, calculate
the gain or loss the call option would produce in each of the following three outcomes:

Three months later, the ABC share price:

1. Has increased by 20% to $120

If the share price of ABC shares has increased to $120, the right to buy at $100 will be worth $20.
However, the buyer of the call option has paid a non-refundable premium of $10, so the net profit will
be $20 less $10 = $10. The buyer of the call has essentially doubled their invested cash over the three
months (generating $20, getting the $10 premium back and making a further $10).

2. Remains at $100
If the share price of ABC shares has remained at $100, the right to buy at $100 will be worth nothing
since the shares can be purchased in the market for the same price. However, the buyer of the call
option has paid a non-refundable premium of $10, so the net loss will be this $10 premium. The buyer
of the call has lost the premium, which represents all of their invested cash.

3. Has fallen by 5% to $95

If the share price of ABC shares has fallen to $95, the right to buy at $100 will be worth nothing
since the shares can be purchased in the market for the lower amount of $95. The buyer of the call
option has paid a non-refundable premium of $10, so the total loss will be this $10 premium. Again,
the buyer of the call has lost all of their invested cash, but thankfully cannot suffer a loss that is any
greater than this.

110
 Derivatives

Exercise 4 – Forwards, Futures and Options

1. Answer = c. It is only the option that gives the buyer a choice. If it is a call option, the choice is
whether to buy at the exercise price or not. If it is a put option, the choice is whether to sell at the
exercise price or not. Buyers of forwards and futures are both committed to buy.
2. Answer = b and c. Both futures and options are traded on exchanges on standardised terms. For
example, a minimum commitment to buy or sell 1,000 barrels of oil, or perhaps the right to buy a
minimum of 1,000 shares.
3. Answer = c. It is only options that require the buyer to pay a non-returnable premium. The
premium is a payment made to have a choice – to exercise the option or not. Futures and
forwards have no choice and, therefore, no premium.
4. Answer = b. Call options give the buyer the choice as to whether or not to buy. Put options give
the buyer the choice as to whether or not to sell. Futures contracts give no choice, with the buyer
committed to buying at the pre-specified price, on the specified future date.

6
5. Answer = c. Put options give the buyer the choice as to whether or not to sell. Call options give
the buyer the choice as to whether or not to buy. Futures contracts give no choice, with the seller
committed to sell at the pre-specified price, on the specified future date.

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112
 1
Chapter Seven

Markets

5
1. The Function of a Stock Exchange 115

2. Initial Public Offerings (IPOs) 116

3. Stock Exchange Indices 117

This syllabus area will provide approximately 4 of the 30 examination questions

114
 Markets

1. The Function of a Stock

Exchange
Learning Objective

7.1.1 Know the function of a stock exchange

A stock exchange is simply a place where financial

instruments can be purchased or sold.

It is where sellers are matched with buyers and

transactions are agreed.

A stock exchange was originally, and still can be,

a physical marketplace where interested buyers
and sellers gather and enter into deals, commonly

7
referred to as trades.

However, most exchanges have developed into

electronic markets and only members of the
exchange are able to access the electronic market.

Example
Roger holds shares in an international oil
company that he is considering selling. He
hopes to find other buyers and sellers of shares
gathered at his nearest stock exchange and that
at least one of them will be willing to pay a price
that he considers reasonable for his oil company
shares.

Roger would probably have to use the services of

a member firm, such as a bank, to put his wish to
sell the oil company shares onto the exchange’s
computer system. The exchange’s system may have
a number of interested parties that have already
expressed a wish to buy the oil company’s shares.
As long as Roger is willing to sell at the same
price a purchaser is willing to buy, the exchange’s
system will match Roger’s order to buy with the
appropriate order to sell. The exchange will then
make arrangements to transfer ownership of the
shares to the new owner and transfer the cash
proceeds to Roger.

115
So, the function of a stock exchange is essentially straightforward. It is to facilitate trading in financial
instruments, particularly shares, enabling sellers to sell their invest­ments and enabling interested
buyers to purchase investments.

Today, stock exchanges are found in most major centres such as New York, London, Frankfurt and
Tokyo. A number of these have become major businesses themselves, arranging deals in millions of
shares every day.

Financial
instruments

Cash
Buyers Sellers
Stock
Exchange Financial
Cash
instruments

2. Initial Public Offerings (IPOs)

Learning Objective

7.1.2 Know the reasons why a company makes an initial public offering (IPO)

Stock exchanges do not arrange trades in the shares of just any company. Companies have to be
accepted for trading on an exchange and become what is known as listed companies.

The requirements for companies to become listed vary around the world, but companies generally need to
be well established and large enough to attract sufficient trading in their shares.

The process of a company becoming listed and having its shares admitted to trading on a stock exchange
for the first time is referred to as an initial public offering (IPO). It is at this point that members of the public
can choose to buy shares in the company for the first time.

You will recall that IPOs were defined in section 2 of chapter 4 on equities, where an IPO of the fictional
CareerComic was considered.

116
 Markets

Example
CareerComic is a business that provides a database of available careers portrayed in a fun, simple and
understandable way – a comic strip of a day in the life of each career. It has been established for a
number of years and the popularity of the product has made CareerComic very successful. It now has
international appeal and, as well as being very successful in the US, it is being heavily used in Asia.
The current shareholders decide that CareerComic needs to raise further money that will enable it to
continue its geographical expansion, in particular the creation of a Mandarin version for the Chinese
market.

CareerComic inc decides that it will offer new shares to the public in an IPO. Not only will the IPO
enable CareerComic to raise money, but the publicity surrounding it will increase awareness of the
product too.

The example of CareerComic highlights two of the typical reasons for companies becoming listed, or
undertaking an IPO:

• raising money by selling shares, and

7
• increasing the public profile and awareness of the company.

The raising of money could be for the company itself, or it could be for some of the early investors
deciding to cash in their shares or both. For example, the IPO of social networking site Facebook raised
around $16 billion: $7 billion for the company and the other $9 billion for some earlier investors to sell
some, or all, of their shares.

A further reason companies undertake an IPO is that it is much easier to buy or sell their shares after
the IPO because the shares are then traded on a stock exchange. This is often described as the shares
becoming more liquid.

3. Stock Exchange Indices

3.1 The Purpose of a Stock Exchange Index

Learning Objective

7.1.3 Know the purpose of a stock exchange index: single market; global markets

The larger stock exchanges, such as those in New York and London, trade millions of shares in thousands
of companies every day. The prices at which those shares are traded change in response to a huge
variety of factors, such as whether the company reports strong sales, whether a competing company
launches a successful new product, and whether the unemployment rate decreases such that people
have more money to spend.

117
The exchange will report the prices at which the shares are trading. This is clearly vital to the participants
so that they can judge at what prices they may be able to buy or sell. There will also be a more formal
report of the prices at which the shares are trading at the end of the day – the closing prices. As a result,
it is easy to discover how well, or badly, a share’s price has performed from day to day.

But how can investors get a feel for how well or badly shares are doing generally?

Thankfully, rather than having to amalgamate all of the price movements, investors can just look at a
stock exchange index instead. A stock exchange index, of which the most well-known is probably the
Dow Jones Industrial Average (DJIA) drawn from New York share prices, performs the amalgamation
for investors. If the index has increased, then prices in general have increased. If the index has decreased,
then prices in general have decreased.

Such indices are sometimes drawn from the shares listed on just one stock exchange and are, therefore,
referred to as single market indices. Others are drawn from shares listed on various exchanges
internationally and are therefore referred to as global market indices.

One way in which a stock market index is used is shown in the following example:

Example
Stuart Radcliffe prides himself on selecting the best shares for his portfolio. He holds shares in ten
companies that are all listed on the same market. His portfolio has increased by 12% on average over
the last year. Stuart considers that his portfolio has done well.

However, it has been a good year on the stock market in general, and the index for the market has
increased by 15%. So, the reality is that Stuart’s portfolio has increased in value, but it has not done as
well as the market average that is represented by the index – it has underperformed by 3% relative to
the average portfolio.

Here the index is being used as a benchmark against which to compare the performance of a portfolio
of investments.

The following section will provide some examples of the key stock indices around the world.

3.2 Example Stock Market Indices

Learning Objective

7.1.4 Know the following stock market indices and which market they relate to: Dow Jones Industrial
Average; S&P 500; NASDAQ; FTSE 100; DAX; Hang Seng; Nikkei 225

A stock market index is simply a number that amalgamates a group of share prices weighted by the
size of the firm, so the price movements of larger firms have a bigger effect on the overall index. As the
shares in the group change value, the index also changes value but, in essence, if the group of shares
goes up by 2% on average, the index will similarly go up by 2%.

118
 Markets

Here is the way in which index movements are typically reported in the press:

S&P 500 Index FTSE 100 Index

3,904.9 6,663.6

Change on Change on
the day the day
+26.6 -41.6
+0.69% -0.62%

7
The S&P 500 Index The FTSE 100 Index was
was slightly up on slightly down on the
the day, boosted by day, after a negative
positive results from assessment of Vodafone
Apple from Goldman Sachs

It is clear from the above that the significance of the index is how much it has moved, and that move
could be largely attributable to particular shares that are included in the index. In the above examples it
is Apple that has particularly impacted the S&P 500 Index and Vodafone that has particularly impacted
the FTSE 100 Index.

The index value is termed points – as in ‘the DJIA increased by 50 points today’. This means that the
index went from perhaps 31,150 points to 31,200 points. The points have no specific value in themselves
– the way to look at an index number is to compare it with a previous value, such as the previous day’s
number or the previous high.

Each index has a particular number of constituent companies. For example, there are
100 companies included in the FTSE 100 and there are 500 companies included in the
S&P 500.

Many stock market indices relate to particular markets, or geographies. For example, the DJIA consists
of 30 large listed US companies that are listed either on the New York Stock Exchange (NYSE) or the
NASDAQ. These indices are dynamic and the constituents regularly change. For example, one of the
world’s most valuable companies, Apple, has only been included within the DJIA’s 30 constituent
companies since March 2015 when it replaced AT&T.

119
The examination syllabus includes the requirement that candidates know which geographies five other
indices relate to. All are commonly reported on the news, so you may already be aware of them. If so, the
exercise below should be reasonably straightforward. If not, please feel free to look at the appendix for
the answer and make sure you are clear as to which index relates to which geographical area.

Exercise 1 – Indices and Geographical Markets

There are six specific stock market indices that are listed in the table below and only the first one
includes the geographical market that it represents. Below are the remaining five geographical
markets in no particular order. Have a go at identifying which market relates to which index – the
answers can be found in the appendix to this chapter.

Geographical market
Stock market index
represented
Dow Jones Industrial
US
Average
S&P 500
FTSE 100
DAX
Hang Seng
Nikkei 225

Geographical markets
UK
US
Japan
Germany
Hong Kong/China

Now you know which geographic markets the various indices relate to, it should not be too difficult to
work out which index (or indices) the following well-known companies are included within:

120
 Markets

Exercise 2 – Indices and Companies

Which index (or indices) are the following 15 companies included within?

Which index/indices? (DJIA, S&P

Company Name 500, FTSE 100, DAX, Hang Seng,
Nikkei 225)
Adidas
Apple
Barclays
BP
Canon
Coca-Cola
Exxon Mobil
Geely Auto
Honda

7
HSBC
McDonald’s
Softbank
Sony
Toyota
Volkswagen

The answers can be found in the appendix at the end of this chapter.

Given that the stock market indices reflect the share prices of the constituent companies, it is useful to
be aware of how the indices are doing – such as whether they are near the year’s high or low. Please try
the following assignment to enable you to get a feel for the current situation:

121
 Mini Assignment
Use the internet and/or newspapers to extract the current index and the last year’s highs and lows for
the following:

High in the Low in the

Index Current level
last year last year
Dow Jones
Industrial
Average
S&P 500
FTSE 100
DAX
Hang Seng

Nikkei 225

An answer extracted in December 2022 is included in the appendix.

Exercise 3
What is normally used to ascertain whether share prices generally are moving up, down or sideways?

a. Bank interest rates

b. Stock market indices
c. Bond yields
d. Credit ratings

122
 Markets

Answers to Chapter Exercises

Exercise 1 – Indices and Geographical Markets

The correctly completed table is as follows:

Stock market index Geographical market represented

Dow Jones Industrial Average US
S&P 500 US
FTSE 100 UK
DAX Germany
Hang Seng Hong Kong/China
Nikkei 225 Japan

Exercise 2 – Indices and Companies

7
Which index (or indices) are the following 15 companies are included within?

Which index/indices? (DJIA, S&P500, FTSE100, DAX, Hang

Company Name
Seng, Nikkei 225)
Adidas DAX
Apple DJIA and S&P 500
Barclays FTSE 100
BP FTSE 100
Canon Nikkei 225
Coca-Cola DJIA and S&P 500
Exxon Mobil DJIA and S&P 500
Geely Auto Hang Seng
Honda Nikkei 225
HSBC FTSE 100 and Hang Seng
McDonald’s DJIA and the S&P 500
Softbank Nikkei 225
Sony Nikkei 225
Toyota Nikkei 225
Volkswagen DAX

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 Mini Assignment

Index levels as at December 2022:

Index Current level High in the last year Low in the last year
Dow Jones Industrial
32,875 36,952 28,660
Average
S&P 500 3,783 4,818 3,491
FTSE 100 7,483 7,687 6,707
DAX 13,951 16,285 11,862
Hang Seng 19,741 25,050 14,597
Nikkei 225 26,093 29,388 24,681

Exercise 3 – Stock Market Indices

3. B (chapter 7, section 3.1).

Stock market indices, such as the S&P 500 or the FTSE 100, give investors single figures that reflect the
value of a number of shares (500 and 100 respectively for the S&P 500 and FTSE 100), giving a feel for
how prices are generally moving.

124
Chapter Eight

Other Areas of Financial

Services

5
1. Fund Management 128

2. Foreign Exchange 132

3. Insurance 137

4. Financial Planning 140

5. Financial Technology (Fintech) 147

This syllabus area will provide approximately 5 of the 30 examination questions

126
 Other Areas of Financial Services

In this final chapter of this workbook, five areas

will be explored in a little more detail – fund
management; foreign exchange; insurance;
financial planning; and financial technology. Below
is an introduction to each of the five:

• Fund management is where a firm creates an

investment fund for its clients, which will enable
those clients to invest together, sharing in any gains
made or losses suffered. The investment decisions
will be made by the fund management firm.
• Foreign exchange is the result of international
trade or international travel – the money held by
one party needs to be exchanged into another
currency before a transaction can be completed.
• Insurance is a method of managing risk. For
example, an individual may suffer from a serious
illness that needs medical attention. An insurance
company may be required to pay for the treatment
under a health insurance policy.
• Financial planning is providing assistance

8
to individuals, their families and businesses in
organising their financial affairs to achieve their
financial and lifestyle objectives. Within this,
retirement planning is important for individuals
saving for the time of life when they will no longer
be working and will have to manage without
earning a salary.
• Estate planning is contemplating how best
to deal with any assets, such as investments and
property, on death, and making arrangements so
that these assets are distributed in accordance
with the deceased’s wishes. Estate planning can
also involve passing on assets as gifts during one’s
lifetime.
• Financial technology is often referred to as
Fintech. Technology is enabling more and more
automation, particularly in the area of investment
with so-called ‘robo advisers’. Technology
companies also continue to make inroads into
areas of finance that were traditionally the preserve
of the banks, such as the growing importance of
smartphone payments.

127
1. Fund Management
Learning Objective

8.1.1 Know the principle of collective investment schemes: comparison with direct investment;
pooling; diversification; expertise

As stated in the introduction to this chapter, fund management is when a firm gives its clients the
opportunity to invest in a fund which is an amalgamation of all of the clients’ invested money. The
fund’s investments will be chosen by the firm, and the client investors will share in any gains or losses
generated. This can be described as collective investment since the clients are investing together, and
the fund can be termed a scheme – a collective investment scheme (CIS).

The logic and features are best illustrated by looking at an example.

Collective
Investment
Scheme

Investments in the Economy

Manufacturing Services Agriculture

128
 Other Areas of Financial Services

Example

Mohamed is a recent graduate with a good job. He is smart but knows little about investment, and
he has been told it would be sensible to invest a modest amount of around $100 per month into
equities, hopefully to enable him to afford a house one day. He particularly likes shares in technology
companies as he feels technology is the future.

He could choose, and then buy, equities himself – termed direct investment. Why might that be a
good or bad idea?

Looking at some of the more popular technology companies:

Assume Apple is trading at a price of $130 per share, Alphabet (the holding co that owns Google)
is trading at $88 per share, Microsoft® is $240 per share and Meta Platforms (formerly Facebook) is
trading at $120 per share.

With $100, Mohamed could buy a single share in Alphabet, but cannot afford to buy any of the other
shares. He would have to wait for two months before he has sufficient cash to buy a single share in
Apple or Meta, and three months before he could afford a share in Microsoft® – and that is assuming
that these share prices do not go up in the intervening period.

This may be bad news on two fronts.

8
Ideally he would like to put some money in all of these companies, because common sense tells
Mohamed he is better off spreading his investment around. That way, if one of the shares does not
perform too well, this will hopefully be compensated for by another of the shares doing well.

The second is that Mohamed is not really the person best placed to decide which of these technology
companies is likely to do better. He is only considering these four companies because he has heard
of them. There may be many more promising technology company shares available that he knows
nothing about.

The difficulties highlighted in the example could be addressed if Mohamed were to invest in a fund
rather than directly. Investing in a fund is described as indirect investment, because the investor invests
in the fund, and then the fund invests in the shares.

Cash
Shares

Direct investment

Cash
Fund Shares

Indirect investment

129
The first issue for Mohamed was that he was looking at a long wait before he would have his four
chosen technology company shares. Initially, he could only directly invest in one (Alphabet) and would
then have to wait a month before buying another. This would have stopped him from benefiting from
diversification. Diversification is simply the technical term for not putting all of your eggs in one basket
– the more companies’ shares held, the more likely it is that surprising bad news in one company is
offset by surprisingly good news in another.

Diversification is a key advantage of a fund, because the fund is gathering together lots of individual
investments and therefore is able to invest larger sums of money in a variety of different company
shares. So if Mohamed were to invest his money in a technology fund, he would begin to solve his
diversification issues.

It would only begin to solve the diversification issues because his portfolio could be further diversified
by not confining his investments to just the four technology companies’ shares, instead broadening
his investments to include other tech companies, or even to shares in companies in other sectors like
pharmaceuticals, banks, industrials, oil and gas, media and food. After all, if a negative event occurs
within a particular industry – for example, the technology sector generally suffering due to concerns
about exploitation by terrorist organisations or poor defences against cyberattacks – it might be
countered by positive events in other sectors, such as an increase in the price of oil.

Investing in a fund would also deal with Mohamed’s problem that the money he has to invest each
month is not large enough to buy a single share in companies such as Apple, Meta and Microsoft. The
size of the fund and the way it is structured enables investors like Mohamed to buy a portion of the fund
for modest amounts of money, as shown overleaf.

130
 Other Areas of Financial Services

Example

The Apple and Alphabet Fund

A fund manager has set up a fund to invest in the best-value technology companies, and advertises
for investors. Each investor is only asked to invest $100. The fund manages to attract 1,000 investors
– a total of $100,000.

The fund manager feels that the current best-value shares are those of Apple and Alphabet (the listed
company that owns Google). He feels slightly more positive about Apple and uses the money to buy
500 Apple shares (costing $130 each) and 397 shares in Alphabet (costing $88 each). The remaining
money in the fund is kept on deposit for the moment, ready to spend when the right opportunity
arises.

The fund’s investments are as follows:

Share Number of
Investment Total
price shares
Apple $130 500 $65,000
Alphabet $88 397 $34,936
Cash n/a n/a $64

8
$100,000

Each investor’s $100 is now invested in Apple and Alphabet, despite the fact that one individual Apple
or Alphabet share is too expensive for $100 to purchase.

Assuming Mohamed uses his $100 to invest in this fund, he would now own 1/1,000th of the fund,
which effectively means he has spent $65 on Apple (equivalent to 50% of an Apple share), and almost
$35 on Alphabet (equivalent to 40% of an Alphabet share), plus a little bit of cash.

Number of
Share price Total M’s I*
shares
Apple $130 500 $65,000 $65.00
Alphabet $88 397 $34,936 $34.94
Cash n/a n/a $64 $0.06
$100,000 $100
* M’s I = Mohamed’s investment

The fund has essentially allowed Mohamed and the other 999 investors to purchase a portion of an
Apple and an Alphabet share.

131
The final issue that Mohamed faced was a lack of expertise. He knows little about the variety of
technology companies that are available for investment and has difficulty assessing which technology
companies are likely to do better than others.

Again this can be solved by investing in a fund. The technology funds that are made available by
fund management firms are run by professionals who are constantly monitoring all of the technology
companies and assessing which companies are the better investments. Each fund, of course, is likely to
invest in considerably more than just two companies (Apple and Alphabet).

In summary, using a fund rather than directly investing will result in the following benefits:

• Money from a variety of investors is pooled into a single fund.

• This will enable the fund to benefit from diversification benefits that might not be available to
individual direct investors.
• Fund investors are effectively able to buy portions of individual shares.
• The fund is run by a professional fund manager, who will be best placed to select the stronger
investments.

Benefits of
Funds

Pooling of Expertise of
money to the professional
invest fund manager

Fractions of
Diversification –
shares can be bought
not putting all your
by individual
investments into
investors
one firm

2. Foreign Exchange
Learning Objective

8.2.1 Know the basic characteristics of the foreign exchange market: currency trading; exchange
rate; cryptocurrencies

As introduced in chapter 2, foreign exchange (Forex, or FX) is an integral part of many business
transactions and personal transactions when international travel is involved.

The smaller part of the foreign exchange market involves individuals travelling abroad, perhaps for
holidays, as detailed in the following example:

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 Other Areas of Financial Services

Example

Usain is visiting London for a short break. He is normally based in the US, so all of his money is in US
dollars. He knows he will need some UK sterling to pay for taxis, buses, food and entertainment. He
draws a lot of US dollars out of his US bank and sells them for UK sterling at the foreign exchange
dealer’s kiosk at the airport.

Usain has entered into a currency trade.

Exercise 1 – Usain’s Transaction Part 1

The amount of UK sterling that Usain receives at the kiosk will be determined by the prevailing
exchange rate between US dollars and UK sterling. The quoted rates might be as follows:

Quoted Rates
$s per £ 1.25 – 1.35
£s per $ 0.74 – 0.80

You can see there are actually two sets of quotes – the first is for the number of US dollars per pound;
the second is for the number of UK pounds per dollar. Which of the two rates will be highlighted by

8
the kiosk assistant for Usain?

The answer can be found in the appendix at the end of the chapter.

Each quote is also made up of two figures, a lower figure on the left and a higher figure on the right.
The relevant side depends on whether the client at the kiosk is buying or selling the particular currency.

Exercise 2 – Usain’s Transaction Part 2

Given that the following quote is the one highlighted by the assistant at the kiosk, how many pounds
will Usain get, assuming he is selling $1,000?

Quoted Rates
£s per $ 0.74 – 0.80

The answer can be found in the appendix at the end of the chapter.

How the two sides of a foreign exchange quote are applied is logical. The left-hand side is the number
of UK pounds handed over for each US dollar, and the right-hand side is the number of UK pounds
required for the kiosk to hand over a US dollar. Looking at the 0.74 to 0.80 rate, knowing that the quotes
are the amounts in UK pounds per dollar, a US dollar will buy £0.74, and £0.80 is required to buy a single
US dollar. If it were the other way round, clients of the kiosk could use a dollar to buy £0.80 and it would
only require £0.74 to buy back the US dollar, leaving the client with a guaranteed profit of £0.06. That
would be fantastic for the client, but the foreign currency kiosk is trying to make money, not lose it! The
£0.06 is effectively the margin the kiosk makes.

133
 Exercise 3 – Usain’s Transaction Part 3
Usain’s holiday break in the UK is now over and he still has £100 in cash. Assuming that the quote at
the kiosk is still the same, how many US dollars can Usain expect?

Quoted Rates
£s per $ 0.74 – 0.80

The answer can be found in the appendix at the end of this chapter.

Let’s go back and investigate the relationship between the two sets of quotes that Usain encountered at
the foreign exchange dealer’s kiosk:
Quoted Rates
$s per £ 1.25 – 1.35
£s per $ 0.74 – 0.80

There is a mathematical relationship between these quotes. The left-hand side of the first quote
represents the number of US dollars per UK pound. If this is ‘flipped’ by dividing it into 1, it reveals the
following: 1/1.25 = 0.80, the same number as appears on the right-hand side of the second quote.

The same is true when the right-hand side of the first quote is ‘flipped’ by dividing it into 1 (1/1.35 =
0.74). This gives the same number as on the left-hand side of the second quote. This is all logical. The
number of US dollars a UK pound will buy ($1.25) should be based on the same rate as the number of UK
pounds that are required to buy a dollar (1/1.25 = £0.80). Similarly, the number of US dollars that will buy
a UK pound ($1.35) should be based on the same rate as the number of UK pounds that are received in
exchange for a dollar (1/1.35 = £0.74).

Exercise 4 – Flipping an Exchange Rate Quote

A foreign exchange dealer is quoting the following rate for the number of euros per UK pound:

Quoted Rates
€s per £ 1.245 – 1.255

Try to work out what the same quote would be, but expressed as the number of UK pounds per euro.
The answer can be found in the appendix at the end of this chapter.

The more significant portion of the foreign exchange market is the result of transactions by companies,
rather than individuals.

134
 Other Areas of Financial Services

The foreign exchange market is huge, with the most recent survey of activity showing an average
turnover of $7.5 trillion each day*! Within this total, the major currencies that are involved in transactions
are the US dollar (around 88%), the euro (31%), the Japanese yen (17%) and the UK pound (13%)*. The
most popularly traded pair of currencies is the US dollar and the euro with almost 23% of the total.

*Source: Bank for International Settlements (BIS) triennial survey 2022

The following example highlights how and why companies use the foreign exchange market.

Example
Pogo Gogo inc is a US company that manufactures and sells pogo sticks. With pogo sticks becoming
increasingly popular with children, Pogo Gogo has just received a large order for pogo sticks from a
large European retailer. It is the first order the company has ever received from outside the US, and
the European retailer is demanding that the price is agreed in euros and not US dollars.

When the money is received by Pogo Gogo it will be in euros, requiring Pogo Gogo to enter into a
foreign currency transaction, selling the euros in exchange for US dollars.

Exercise 5 – Pogo Gogo Part 1

8
If Pogo Gogo sells €1 million worth of pogo sticks to the European retailer and the bank’s quote for €/
US dollar is 1.1394 – 1.1399, how many US dollars will Pogo Gogo receive?

The answer can be found in the appendix at the end of the chapter.

The foreign currency transaction that Pogo Gogo requires will be a currency trade that involves selling
the euros it receives for US dollars. There is a danger that Pogo Gogo will not receive as many US dollars
as it hoped for when the sale was agreed, because the exchange rate between the euro and the US
dollar changes. However, the opposite could occur and Pogo Gogo may end up being in the position
of receiving more US dollars than it had hoped for because the exchange rate has moved in its favour.

Exercise 6 – Pogo Gogo Part 2

The exchange rate at the time that Pogo Gogo made the sale was €/US dollar 1.1382 – 1.1387. When
Pogo Gogo sold the €1 million worth, the bank’s quote for €/US dollar was 1.1394 – 1.1399. Has the
exchange rate movement worked in Pogo Gogo’s favour or against it and what is the impact in US
dollars?

The answer can be found in the appendix at the end of the chapter.

These foreign currency trades are very common as a result of all the international business that takes
place around the world. They are generally done with the banks – so in the above examples it would
be Pogo Gogo’s bank that will receive the euros and convert them into US dollars at the appropriate
exchange rate at the date of receipt.

135
Cryptocurrencies are virtual or electronic currencies which (as their name suggests) use encryption
technology, to control the amount of currency issued as well as to record ownership and payments.
You have probably heard of the first established cryptocurrency – Bitcoin – which was created in
2009, yet now today, about 3,000 cryptocurrencies are available. Those wishing to participate in the
cryptocurrencies market must first set up a digital wallet. Here they can securely store their coins or
tokens, which they may acquire in one of the following ways:

• purchasing them in exchange for more traditional currencies like dollars or pounds
• earning them; for example, by publishing blog posts on platforms that pay users in cryptocurrency
• through mining (cryptomining) by solving mathematical problems to generate new cryptographic
keys.

While cryptocurrencies may go up in value, they are high risk and speculative. It is not uncommon for
the value of cryptocurrencies to fluctuate by hundreds, or even thousands, of US dollars. This can be
driven by many factors, as shown by the following contrasting examples:

Example 1: February 2021

Bitcoin surges in price

The price of Bitcoin surged to a new record high after two finance giants announced their own
cryptocurrency projects.

The price of a single Bitcoin hit nearly $48,000 (£34,400) after the announcement, which investors
believe shows that the cryptocurrency markets are beginning to be embraced by the traditional
finance world.

Both Mastercard and BNY Mellon, America’s oldest bank, announced their plans to incorporate
Bitcoin into their multi-billion dollar businesses.

Mastercard said they would begin allowing their platform to support Bitcoin payments this year, while
BNY Mellon went a step further and said they will be transferring and issuing the cryptocurrency.

This followed an announcement from Tesla that it would soon be allowing customers to purchase
items using Bitcoin, and the revelation that the Elon Musk controlled firm had also invested 1.5 billion
US dollars in Bitcoin itself.

Example 2: November 2022

Bitcoin tumbles after FTX bankruptcy

Following the bankruptcy of one of the world’s largest cryptocurrency exchanges, FTX, the price of
bitcoin (BTC) tumbled. It is now about $16,500 – a far cry from the all-time high of $66,000 just a year
earlier.

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 Other Areas of Financial Services

3. Insurance
Learning Objective

8.3.1 Know the types of insurance available: personal; corporate; the concept of syndication

The concept of insurance is straightforward – it is to put in place a safety net just in case something
unfortunate happens. For example, most countries require individuals that are driving cars to be insured.
So, if the driver is involved in a crash and is at fault, the insurance policy will be used to cover the cost of
the crash, such as repairing the damage to the other car.

The insurance policy is provided by an insurance company in exchange for a payment, referred to as the
insurance premium.

Example

Mack Radcliffe has just purchased a new car. He knows he needs to be insured and searches the
internet for possible insurers. He finds that Draxa inc is offering insurance for a very competitive
premium of just $80 each month. Mack takes up the policy and begins to enjoy driving his new car.

8
Mack is referred to as ‘the insured’, and he has entered into an insurance policy with Draxa inc as ‘the
insurer’ or the ‘insurance company’. The $80 monthly payment from Mack to Draxa is the insurance
premium payable.

The above example relates to personal insurance because the insurance is being provided for an
individual for their personal situation. There are many possible forms of personal insurance, such as
insurance against the risk of theft from an individual’s home (contents insurance) and insurance against
the risk of sickness (medical insurance).

However, it is not only individuals that might find it helpful to use insurance as a safety net against
unfortunate events. Imagine a small company that runs a general store – a fire or a flood could destroy
most or all of the goods it holds for sale. Insurance taken out to cover the risks faced by companies rather
than individuals is known as corporate insurance.

We saw in chapter 2 how insurance companies might reduce the risk they face by insuring large risks
using reinsurance. Essentially reinsurance is an insurer taking out insurance against the possibility of a
claim against the policy they have insured. Another possibility for the larger risks is that insurers each
take a share of the risk using syndication.

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 Example
Total Shipping (TS) is a shipping company that has 100 container ships that move goods around the
world. Each ship is worth around $100 million. TS is looking for insurance against the risk that any of
these ships suffer damage through fire, adverse weather, mechanical fault or hijacking.

Due to the size of the potential claim if something were to go wrong, it is tempting to think that
the insurer for TS would need to be absolutely huge. However, the reality is that insurance will be
provided by a group of insurers rather than just a single insurance company. This group of insurers
forms a syndicate and each participant agrees to receive a set proportion of the insurance premium
and bear an agreed proportion of any claim. If there were five participants that agreed to share the
premium and the risk equally, they would each get 20% of the premium and bear 20% of any claim.

Total Shipping

100% of the risk

Syndicate of Insurers

Insurance Insurance
Co 1 Co 5
20% of the risk 20% of the risk

Insurance Insurance
Co 2 Insurance Co 4
20% of the risk Co 3 20% of the risk
20% of the risk

As the above example makes clear, syndication is the grouping of insurers to enable them to underwrite
substantial risks such as those of TS. The effect of syndication is to spread the risk around the insurance
companies, which enables the insurance industry to take on insurance for even the largest, most
expensive risks including damages caused by leaks from oil rigs or airline crashes and the like.

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 Other Areas of Financial Services

Exercise 7 – Types of Insurance

Here are four insurance policies that have been taken out. Please identify whether the insurance is
corporate or personal.

Personal or
Details of the insurance
corporate?

Shipping company Big Boats inc takes

out a policy that will cover it against the
risk of mechanical failure on its ships.

Corporate executive James Yeats is

concerned about his health and enters
into a medical insurance policy that
will enable any illness to be dealt with
quickly in a private medical facility.

Alistair McQuitty is a company director

and has just been relocated by his

8
employer to the Middle East. He buys
a new car and takes out a local motor
insurance policy.

Exporta inc is an international business

that exports mainly to countries in Africa.
It takes out an insurance policy that will
pay out if any of its overseas clients fail to
pay for goods that have been shipped to
them.

The answer can be found in the appendix at the end of the chapter.

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 Insurance

An individual –
Someone personal insurance
takes
out an
insurance
policy to
provide a A company –
safety net corporate insurance
against
certain
risks
Provided by the
insurer – the
insurance company

Where the policy is substantial, the

‘someone’ may be a syndicate of
insurers, rather than a single insurer

4. Financial Planning

4.1 Introduction
Financial planning is a professional service available to individuals, their families and businesses, who
need objective assistance in organising their financial affairs to achieve their financial and lifestyle
objectives more easily.

Financial planning is clearly about financial matters, so it deals with money and assets that have
monetary value. Invariably this will involve looking at the current value of clients’ bank balances, any
loans, investments and other assets. It is also about planning, ie, defining, quantifying and qualifying
goals and objectives and then working out how those goals and objectives can be achieved. In order to
do this, it is vital that a client’s current financial status is known in detail.

Financial planning is ultimately about meeting a client’s financial and lifestyle objectives, not the
adviser’s objectives. Any advice should be relevant to the goals and objectives agreed. Financial
planning plays a significant role in helping individuals get the most out of their money. Careful planning
can help individuals define their goals and objectives, and work out how these may be achieved in the
future using available resources. Financial planning can look at all aspects of an individual’s financial
situation and may include tax planning, both during lifetime and on death, asset management, debt
management, retirement planning and personal risk management – protecting income and capital in
the event of illness and providing for dependants on death.

The CISI offers qualifications and related products at all levels for those working in, or looking for a career
in financial planning. Further details can be found on the CISI’s website.

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 Other Areas of Financial Services

Two vital subsets of financial planning are planning for an individual’s retirement – retirement planning
– and planning for how the assets left behind when an individual dies are distributed – estate planning.
It is these two that are specifically mentioned in the syllabus for this qualification.

4.2 Retirement Planning

Learning Objective

8.4.1 Know the importance of planning for retirement

As healthcare standards improve and medical advances continue, most of us will be lucky enough to live
longer than our parents and grandparents. However, do we want and expect to continue working until
we die? The answer to this for most of us is no.

Those of us expecting to enjoy a lengthy retirement must recognise that this will need to be funded
in some way – the bills will still need to be paid and we will still need to put food on the table. Putting
money away to use in retirement is called retirement planning.

The money earmarked for retirement is often termed a pension and there are three potential sources of

8
pension, as shown below.
Pension Sources

Provided by Provided by
the individual – the state –
personal pension state pension

Provided by the
individual’s employer –
employer-sponsored
pension

As can be seen, the most obvious source of a pension fund to cover an individual’s financial needs
in retirement is to put money into a personal pension scheme. These schemes are typically made
available by banks, insurance companies and fund managers. They generally involve the individual
putting a proportion of their monthly salary into a pension scheme, which the pension scheme then
invests in various shares, bonds and other financial assets. The expectation is that the contributions into
the scheme, plus the potential growth in the value of the investments, will provide the individual with
enough money to fund a relaxed retirement. Clearly the more money that is invested and the earlier it is
invested (to maximise the potential for it to grow), the more comfortable retirement is likely to be.

It is also common for the firm that an individual works for to provide a pension scheme. This may attract
good-quality staff as well as encourage them to stay. These employer pension schemes can be paid for
completely by the firm (fully–funded scheme) or might require the employee to contribute a proportion
too (contributory scheme).

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A number of countries around the world will provide a pension to their citizens in their retirement years,
known as state schemes. However, these schemes are generally insufficient to fund what most of us
would describe as a comfortable retirement. The state scheme will need to be supplemented if anything
more than a very basic level of retirement income is expected.

Exercise 8 – Types of Pension

Here are some details relating to three individuals. Please identify whether the pension they have is
personal, employer-sponsored or state.

Is the pension
Details of the individual personal, employer-
sponsored or state?

Steven is employed by Dareds inc.

Dareds have a pension scheme
into which Steven pays some
money that is supplemented by
the company.

Conrad is approaching retirement

and has never contributed to
any pension, nor worked for an
employer providing a pension.

Abdullah is self-employed and

has a pension scheme that he has
been contributing to for many
years.

The answer can be found in the appendix at the end of the chapter.

Example

Mr Average is a 48-year-old UK resident. He is employed, but his employer does not provide him with
any pension and he has not set up a personal pension scheme. His children have grown up and left
the family home and he is beginning to think about his retirement. His earnings are currently £560
per week.

Mr Average uses the internet to discover how much state pension he can expect when he retires. He
is shocked to find that the maximum he can expect is less than one third of his earnings, at £172.50
per week. He is worried, because despite the fact that life may be cheaper in retirement as he will not
have to travel to and from work and should have paid off his mortgage, he does not think he will be
able to make ends meet. He immediately sets up a meeting with a financial adviser to discuss setting
up a personal pension scheme.

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 Other Areas of Financial Services

The above example of Mr Average actually uses the UK’s 2020 average level of earnings of £560 per week
and the UK’s maximum state pension of approximately £175 per week (2021–22).

Mr Average will probably struggle to build up a substantial personal pension as he is starting so late
in life, although the number of his dependents should fall over time as any children he is responsible
for may leave home as they become young adults. The longer pension money is invested for, the more
opportunity it has to grow. He should have started his retirement planning earlier to fund the shortfall
between the amount of money he will receive from his state pension in his retirement and the amount
of income that will enable him to enjoy life.

As mentioned earlier, people are generally living longer due to medical, nutritional and social advances,
and this increase in life expectancy has a serious impact on pension provision. This problem is typically
referred to as the longevity issue – as people live longer, how will their need for a larger amount to
provide them with a pension be financed?

In the US, life expectancy has increased significantly in the recent past. World Bank data shows
that those born in 1960 have a life expectancy of almost 70 years, and those born in 2015 have an
increased life expectancy of almost 79 years.

US life expectancy

8
Year of birth Life expectancy (years)
1960 69.8
1980 73.6
2000 76.6
2010 78.5
2020 78.9

This has ramifications for pensions. An individual born in 1960 and retiring at 65 years of age on
average will only need a five-year pension, but this requirement increases to almost 14 years for
individuals born in 2015.

As individuals live longer, the funding required for the same level of pension increases. If the pension
is a personal pension, the solution is to pay more into the pension, work for more years and retire later
or do both: combine greater contributions with a later retirement date. If it is an employer-sponsored
pension the employer may be willing to pay more into the pension, but the impact this will have on the
employer’s profitability may mean that it needs to be combined with a later retirement date. For the
state, a longer life simply means more money is required, which will mean higher taxes will need to be
collected from the working population to pay for the pensioners who are living longer.

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 Mini Assignment
Life expectancy in selected countries

Please use the internet to discover the current life expectancy in the following six countries.

Life expectancy
Country
(years)
China
India
Japan
Mozambique
Sri Lanka
UK

An answer extracting details from 2022 is shown in the appendix to this chapter.

Exercise 9 – Mr Slater
Mr Slater is a 40-year-old UK resident and a self-employed writer. He has contributed to a personal
pension for a number of years and continues to make monthly payments into his pension scheme.
He is planning to retire at 60 and move to a cottage on the coast. He has recently read the good news
that life expectancy has increased in the UK. On reflection, he starts to think about the impact this
may have on his pension. What steps would you advise?
The answer to this exercise can be found in the appendix at the end of this chapter.

In summary, the importance of retirement planning is that, if an individual wants to enjoy a comfortable
retirement, it is vital to put money into some form of pension scheme. Generally, it is sensible to start
contributing to a pension earlier rather than later, to take advantage of the potential growth in the value
of the investments made.

However, the reality for many people is that it is only after some years in work that earnings have
increased sufficiently to enable them to save for a pension.

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 Other Areas of Financial Services

4.3 Estate Planning

Learning Objective

8.4.2 Know the importance of estate planning

Estate planning is concerned with taking the appropriate steps to ensure that an individual’s
accumulated wealth passes to their intended beneficiaries, and does so in a tax-efficient way. It can be
a complex subject but essentially involves determining who is to inherit the assets of the individual and
whether there is anything that can be done to legitimately reduce any estate taxes that will arise on
death.

The steps that can be taken vary significantly from country to country. Some jurisdictions allow complete
freedom over to whom an individual can leave their estate, while in others, certain people will have a
right to a specific share of the estate.

4.3.1 Assessing a Client’s Estate

A key first step in estate planning is to assess the extent of a client’s assets and liabilities.

8
These include their property, their savings and any investments, but it is also necessary to identify
any other funds that would become payable if the client were to die, such as the proceeds of any life
assurance policies or payment of death-in-service benefits if the client is still working. The assessment of
a client’s liabilities should also take account of any protection policies that may be in place to meet that
liability, such as a mortgage protection policy.

Once identified, the assets and liabilities can be summarised to enable the consideration of three key
areas:

1. Whether a power of attorney is necessary to protect the individual’s interests when they are
incapable of managing their affairs.
2. Whom they wish to inherit their estate and whether there are any specific gifts they wish to make.
3. The extent of any liability to inheritance tax or estate duties that may arise, and whether action
should be taken to mitigate this.

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4.3.2 Power of Attorney
A power of attorney is a legal document that authorises someone to undertake a specific transaction or
for someone to manage their affairs.

An individual can execute a power of attorney during their life while they are of sound mind and appoint
someone to carry out certain activities. Once the individual is no longer of sound mind, the attorney will
make the decisions on that individual’s behalf. The attorney might be a member of the individual’s family,
or a lawyer. How they are appointed will depend upon whether the individual makes the arrangements
in advance or not, but either way, there are rules and legal procedures that have to be followed. An
individual may become incapable of managing their affairs and have made no arrangements for what is
to happen in that event. If that occurs, someone else will need to apply to the courts to have authority
to act.

4.3.3 Execution of a Will

A will is a legal document that tells the world what is to happen to an individual’s estate in the event of
death. Where possible, an individual should make a will in order to ensure that the assets of their estate
are distributed in accordance with their wishes, and should take specialist advice to ensure that relevant
laws are taken into account.

A will is generally regarded as essential for everyone, but particularly so in the case of a family with young
children. What will happen to the children if their parents were unfortunate enough to be involved in a
fatal accident? Who will look after the children, who will invest any money until they came of age and
what will happen if the children needed some essential expenditure such as the payment of school fees?
A properly drafted will should ensure that all of these points are covered.

If no will is made, the legal system will determine who inherits. When a person dies without leaving a
will, they are described as having died intestate and a set of intestacy rules will determine who is to
inherit. These may well provide for the estate to be distributed in a way that the individual would not
have intended.

4.3.4 Estate Taxes

Having prepared a schedule of an individual’s assets and liabilities, an estimate can be made of how
much estate tax might be payable. These types of taxes go by various names such as death duties, estate
taxes, gifts tax, inheritance tax or wealth tax. These may be separate taxes or combined into one.

In most countries, there are exemptions and allowances that can be taken advantage of to mitigate
the eventual estate taxes that might be due. When a will is drafted, it will specify who the client wishes
to inherit their estate, but careful consideration should also be given to drafting it in such a way as to
maximise the use of exemptions and allowances.

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 Other Areas of Financial Services

Mini Assignment
To discover more about estate taxes in your jurisdiction, please search the internet for your local tax
authority and, within their website, search for the various types of tax detailed above – death duties,
estate taxes, gifts tax, inheritance tax, wealth tax.

5. Financial Technology (Fintech)

Introduction
Technology is embedded in everything we do, changing the way we live, work, and experience the
world. Advances in technology have made the internet much more accessible and have radically altered
the way we communicate. These changes are, in turn, disrupting traditional industries.

Financial technology, known as Fintech, is impacting the traditional banking and wealth management
industry. People across all generations are now digitally proficient, and they desire constant access to
sophisticated tools and services, with clients of financial services firms being no different.

In the following sub-sections five areas of Fintech are explored and explained under five headings –

8
collective investments; crowdfunding; peer-to-peer finance; stock markets and distributed ledger
technology (DLT).

5.1 Collective Investments

Learning Objective

8.5.1 Know the application of technology in collective investment: platforms; screening tools

In the context of Fintech, an investment platform is a website or a smartphone app on which

investments can be purchased and sold. Generally aimed at individual clients, these investments could
include equities and bonds, but tend to concentrate on collective investments in the form of funds. This
is reflected in the alternative name for investment platforms – ‘fund supermarkets’. They can be sub-
divided into three types:

1. Low cost, ‘no-frills’ investment platforms – these platforms do not provide the clients with any
advice about which fund is most suitable. They simply allow the client to make their own choice at
a fee that is likely to be significantly lower than competing premium platforms and robo advisers
detailed below.
2. Premium platforms – in contrast to the ‘no-frills’ platforms, these investment platforms provide
their clients with analytical screening tools that will assist the investor in selecting the ‘best’ fund,
given the aims and objectives.
3. Robo advisers – these investment platforms provide automated advice to clients that is based on
the answers to a series of questions. The answers should clarify the investor’s aims and risk attitude
so that the most appropriate fund is recommended.

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5.2 Crowdfunding
Learning Objective

8.5.2 Know how crowdfunding works

Crowdfunding is the practice of funding a project or venture by raising small amounts of money from
a large number of people typically using the internet. Traditionally, financing a business, project or
venture involved asking a small number of participants for large sums of money. Crowdfunding switches
this idea around, using the internet to access many potential funders who only need to individually
provide more modest sums of money. Crowdfunding can take a number of forms:

• Seeking donations from people that believe in the cause or innovation. This form of crowdfunding
offers no possibility of investment return for the donors.
• Debt crowdfunding, where investors receive their money back with interest. This form of
crowdfunding is similar to investing in a bond, or lending money to the venture.
• Equity crowdfunding, where people invest in exchange for equity or shares in the venture.

5.3 Peer-to-Peer Finance

Learning Objective

8.5.3 Know the principles of peer-to-peer finance

As you have seen, in the traditional banking model, banks take in deposits on which they pay interest
and then lend out at a higher rate. The ‘spread’ between the two rates is what allows the banks to earn a
profit. Peer-to-peer lending cuts out the banks so that borrowers can often borrow at slightly lower rates
of interest, while savers get much improved interest rates, with the peer-to-peer firms also profiting by
charging a fee for arranging the transaction.

Peer-to-peer lending has become a realistic possibility due to the wide adoption of the internet. The
peer-to-peer firm can set up, access and connect investors and borrowers cheaply using the internet
infrastructure. However, this can be more risky for investors since they will be making the final
decision in terms of whether the investment opportunity and associated risks are appropriate for their
circumstances.

Mini Assignment
To discover more about peer-to-peer finance and crowdfunding, please take a look at the following
websites: LendingClub (at www.lendingclub.com) and Kickstarter (at www.kickstarter.com).

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 Other Areas of Financial Services

5.4 Stock Markets

Learning Objective

8.5.4 Know how global stock markets have benefited from the application of Fintech: technology
indices; high-frequency trading

The use of technology in finance has radically increased in the recent past for both professional and
individual, or ‘retail’ investors. This can be seen in the way that the world’s stock markets have moved
away from the traditional trading floor – where brokers get together with dealers to arrange trades for
their clients – to electronic systems where the trading floor is either used very little, or completely shut
down.

These electronic stock exchange trading systems have enabled transaction costs to be reduced, and
opened up the possibility of so-called ‘high-frequency trading’ (HFT). This is where some participants
automate the transactions that they want to execute by writing algorithms that will act on pre-set
indicators, signals and trends. Here is a very simple example of how this might work:

High-Frequency Trading Example

8
A fictional investment bank – Cauldron Stanley – trades in listed company shares, hoping to profit
from changes in price. The Cauldron Stanley technology team has written an algorithm that monitors
the internet for the number of instances that positive words and associations link with the largest
listed companies. These include the number of instances of ‘increase’ is linked with ‘profits’, ‘sales’
or ‘revenues’, and ‘buy’ is linked with ‘shares’ or ‘stock’. When the number moves above the recent
average, an automatic order to buy is generated. Cauldron Stanley hopes that the algorithm will
enable purchases to be made ahead of the crowd, and the shares can be sold at a profit once the
‘crowd’ catches up and the price increases.

As the example shows, HFT is commonly used by big investment banks and other market players who
combine large order volumes with rapid executions. HFT can be described as an approach to trading
financial instruments that involves using cutting-edge technology and sophisticated algorithms
to perform a large number of incredibly fast trades. High-frequency traders use their technological
advantages to rapidly scan news releases with algorithms and sometimes co-locate their computers
near outlet servers to receive news first. The algorithms enable them to place large orders before others
react.

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5.5 Distributed Ledger Technology
Learning Objective

8.5.5 Know the basic principles of distributed ledger technology

Distributed ledger technology (DLT) is, in simple terms, the replacement of one, centralised ledger
of transactions with a decentralised network of computers all holding copies of exactly the same
ledger. The computers are often referred to as ‘nodes’ and any changes to the ledger must be done by
consensus. Consensus is typically achieved using a consensus algorithm – a process used to achieve
agreement.

The distributed ledger could be open and described as any participant, and described as ‘public’, or it
could be restricted to a select group of participants and ‘private’.

Blockchain is an example of DLT and is commonly associated with the cryptocurrency Bitcoin. Bitcoin is
a public system that uses blockchain DLT.

Among the advantages of DLT are that it should:

• Produce a trustworthy and reliable record, since consensus is required for any changes.
• Prevent any single point of failure (in one of the nodes) from creating a wider problem, because all
the remaining nodes hold copies of the valid ledger.
• Be very difficult to hack, because of the use of multiple nodes.
• Remove the costs and delays caused by the need to maintain and update a single, central database.

The above advantages make it clear that DLT could be adopted to help settle trades in financial
instruments and there is much excitement about how this could speed up settlement and reduce
settlement costs.

Additionally, some countries are exploring the creation of digital versions of their national currency with
an associated underlying distributed ledger system, which will facilitate use in international trade.

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Answers to Chapter Exercises and Assignments

Exercise 1 – Usain’s Transaction Part 1
The amount of UK sterling that Usain receives at the kiosk will be determined by the prevailing
exchange rate between US dollars and UK sterling. The quoted rates might be as follows:

Quoted Rates
$s per £ 1.25 – 1.35
£s per $ 0.74 – 0.80

You can see there are actually two sets of quotes – the first is for the number of US dollars per pound,
the second is for the number of UK pounds per dollar.

Which of the two rates will be highlighted by the kiosk assistant for Usain?

The relevant rate for Usain is the number of UK pounds per US dollar, since he is selling dollars for UK
pounds, so the 0.74 – 0.80 is the quote that will be highlighted.

Exercise 2 – Usain’s Transaction Part 2

8
Quoted Rates
£s per $ 0.74 – 0.80

The left-hand side of the quote gives the amount of UK pounds that each dollar will buy, and is the
relevant quote for Usain. The right-hand side is the amount of UK pounds that would be required to
buy a single US dollar.

So Usain’s $1,000 will buy £740 ($1,000 x 0.74).

Exercise 3 – Usain’s Transaction Part 3

Usain’s holiday break in the UK is now over and he still has £100 in cash. Assuming that the quote at
the kiosk is as follows:

Quoted Rates
£s per $ 0.74 – 0.80

Usain will be able to sell his £100 and buy dollars for £0.80 each. This will generate $125 (based on
£100/0.80 = $125.00). You may remember the second quote from the kiosk. This quote would have
enabled this question to be answered more easily – it gave the number of US dollars per pound.

Quoted Rates

$s per £ 1.25 – 1.35

In Usain’s situation his £100 would buy $1.25 each, which gives the same result of $125.

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Exercise 4 – Flipping an Exchange Rate Quote
The foreign exchange dealer’s quote of euros per UK pound needs to be flipped to provide the
number of UK pounds per euro:

£s per €: 1/1.255 = 0.797 – 1/1.245 = 0.803

So the quote would be £s per €: 0.797 – 0.803

Exercise 5 – Pogo Gogo Part 1

Assuming that Pogo Gogo sells €1 million of pogo sticks to the European retailer and the bank’s quote
for €/US dollar is 1.1394 – 1.1399, Pogo Gogo will receive €1 million x 1.1394 = $1,139,400.

Exercise 6 – Pogo Gogo Part 2

The exchange rate at the time that Pogo Gogo made the sale was €/US dollar 1.1382 – 1.1387. When
Pogo Gogo sold the €1 million the bank’s quote for €/US dollar was 1.1394 – 1.1399.

Pogo Gogo received €1 million x 1.1394 = $1,139,400.

If the exchange rate had stayed the same, then Pogo Gogo would have received €1 million x 1.1382
= $1,138,200.

So the exchange rate has moved in Pogo Gogo’s favour, and it has generated an extra $1,200 (the
difference between the amount received of $1,139,400 and the amount based on the original rate of
exchange of $1,138,200).

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Exercise 7 – Types of Insurance

Here are the four insurance policies that have been taken out and the type of insurance – corporate or
personal – plus a brief explanation:

Details of the insurance Personal or corporate

Corporate
Shipping company Big Boats inc takes out Insurance taken out by a company is
a policy that will cover it against the risk of corporate and this policy may also have
mechanical failure on its ships. been syndicated as the risk may be too large
for a single insurer to bear.
Corporate executive James Yeats is concerned
about his health and enters into a medical Personal
insurance policy that will enable any illness Despite James being a corporate executive,
to be dealt with quickly in a private medical the policy is for James personally.
facility.
Alistair McQuitty is a company director and
Personal
has just been relocated by his employer to the
Despite the fact that Alistair is a company
Middle East. He buys a new car and takes out a
director, the policy is for Alistair personally.
local motor insurance policy.

8
Exporta inc is an international business that
Corporate
exports mainly to countries in Africa. It takes out
Insurance taken out by a company is
an insurance policy that will pay out if any of its
corporate, and this policy relates to the risk
overseas clients fail to pay for goods that have
that Exporta’s clients may fail to pay.
been shipped to them.

153
Exercise 8 – Types of Pension
Here are the details relating to the three individuals plus the type of pension they hold and a brief
explanation.

Is the pension personal, employer-sponsored

Details of the individual
or state?
Employer-sponsored
Steven is employed by Dareds inc.
Steven’s pension was set up by his employer, so it is
Dareds has a pension scheme into
employer-sponsored, and since Steven pays some
which Steven pays some money that
money into it as well as the company, it is contributory
is supplemented by the company.
in nature.
Conrad is approaching retirement
State
and has never contributed to any
With no other pension, Conrad will be relying on the
pension, nor worked for an employer
state for any pension.
providing a pension.
Abdullah is self-employed and has Personal
a pension scheme that he has been As a self-employed individual, Abdullah has sensibly
contributing to for many years. contributed to a personal scheme.

Mini Assignment
Life expectancy in selected countries (2022)

Country Life Expectancy (years)

China 77.47
India 70.42
Japan 85.03
Mozambique 62.13
Sri Lanka 77.56
UK 81.77

Source: www.worldometers.info

Exercise 9 – Mr Slater
There are two possible solutions for Mr Slater. He could choose to change his plans and retire later
while paying the same amount into his pension each month. This would mean he works for more
years, during which time he will pay more contributions into his pension.

Alternatively, he could keep his planned retirement date the same and put more of his earnings into
his pension each month.

Clearly, he could also choose to combine putting more into his pension with a later date for retirement.

154
 1
Glossary

155
156
 Glossary

Acquisition Central Bank

A term used to describe the takeover or buying Central banks typically have responsibility for
of a company by another. setting a nation’s or a region’s short-term interest
rate, controlling the money supply, acting as
banker and lender of last resort to the banking
Asset
system and managing the national debt.
Any item of economic or financial value owned
by someone or a company.
Closing Price
The price of a security, such as a share or a bond,
Bank of England
at the end of the day.
The UK’s central bank. Implements economic
policy decided by the Treasury and determines
interest rates. Collective Investment Scheme (CIS)
A fund run by a professional manager that
enables investors to pool their money. The
Bankruptcy
manager selects the investments and the
The situation where an individual, company or
investors share in any increase (or decrease) in
other organisation is unable to pay its debts.
their value.

Bonds
Commission
Interest-bearing securities which entitle holders
Charges for acting as agent or broker.
to annual interest and repayment at maturity.
Commonly issued by both companies and
governments. Coupon
Amount of interest paid on a bond.
Bitcoin
The most well-known cryptocurrency. Credit Rating
An assessment of a bond issuer’s ability to pay
the interest and repay the capital on the bonds.
Blockchain
The best rating is triple A.
An example of a distributed ledger technology.

Credit Risk
Capital
The likelihood of a borrower being unable to pay
Cash and assets used to generate income or
the interest or repay the debt.
make an investment.

Currency
Capital Gain
Any form of money that circulates in an economy
An increase in the market value of a security (ie,
as an accepted means of exchange for goods
the value of the asset is greater than the price it
and services.
was bought for).

157
Cryptocurrency Dividend
Virtual or electronic currencies which (as their Distribution of profits by a company.
name suggests) use encryption technology, to
control the amount of currency issued as well as
Dividend Yield
to record ownership and payments.
Most recent dividend expressed as a percentage
of current share price.
DAX
German shares index, comprising the largest
Dow Jones Industrial Average Index (DJIA)
companies (40 shares).
Major share index in the USA, based on the
prices of 30 major company shares.
Dealer
An individual or firm acting in order to buy or sell
Effective Annual Rate
a security for its own account and risk.
The annualised compound rate of interest
applied to a cash deposit or loan. Also known as
Default the annual equivalent rate (AER).
The situation where a borrower has failed to
meet the requirements of their borrowing, for
Equity
example by failing to pay the interest due.
Another name for shares or stock. It can also be
used to refer to the amount by which the value
Deposit of a house exceeds any mortgage or borrowings
A deposit is a sum of money held at a financial secured on it.
institution on behalf of an account holder for
safekeeping.
ESG
ESG stands for environmental, social and
Derivative (corporate) governance. It involves considering
A financial instrument whose price is based on whether a company is ‘doing the right thing’ in
the price of something else, typically another terms of the impact it has on the environment,
underlying asset. The other underlying asset the community in which it operates, and the way
could be a financial instrument, such as a bond it is governed.
or a share, or a commodity like oil, gold, silver,
corn or wheat.
Estate
An individual’s estate is comprised of the net
Diversification assets that individual leaves behind on death.
Investment strategy of spreading risk by Estate planning is concerned with taking the
investing in a range of investments. appropriate steps to ensure that an individual’s
accumulated wealth passes to their intended
beneficiaries and does so in a tax-efficient way.
Distributed Ledger Technology (DLT)
The replacement of one centralised ledger of
transactions with a decentralised network of Exchange
computers all holding copies of exactly the same Marketplace for trading investments.
ledger.

158
 Glossary

Exchange Rate Initial Public Offering (IPO)

Rate at which one currency can be exchanged A new issue of ordinary shares, whether made
for another. by an offer for sale, an offer for subscription or a
placing. Also known as a new issue.

Face Value
Also known as the par or nominal value. This is Interest
the amount that needs to be repaid on a bond. The price paid for borrowing money. Generally,
It is also the amount that is used to calculate interest is expressed as a percentage rate over a
the coupon payment (face value x coupon period of time, such as 5% per annum.
percentage = coupon payment).

Investment Bank
Foreign Exchange Market A business that specialises in raising debt and
A market for the trading of foreign currencies. equity for companies.

FTSE 100 (‘Footsie’) Leverage

Main UK share index of 100 leading shares. A measure of the extent to which a company
finances itself from debt, relative to equity.

Fund
A collective investment scheme where money is Listing
combined and invested in a portfolio of shares Companies whose securities are listed on the LSE
with a common investment purpose. and available to be traded.

Fund Manager Loan

A firm that invests money on behalf of customers. A form of debt where a borrower receives a
certain amount of money from a lender. The
borrower agrees to pay a contracted rate of
Impact investing
interest to the lender and also agrees a date on
Investing money that, in addition to generating which the loan will be repaid.
a financial return, is also targeted at having a
positive impact on society or the environment.
Both gender lens investing and microfinance are London Stock Exchange (LSE)
examples of impact investing. Main UK market for securities.

Index Market
A statistical measure of the changes in a selection All exchanges are markets – electronic or physical
of stocks representing a portion of the overall meeting places where assets are bought or sold.
market.

Market Price
Inflation Price of a share as quoted on the exchange.
An increase in the general level of prices.

159
Maturity Overdraft
Date when the capital on a bond is repaid. A form of borrowing from a bank where the
lending bank can demand repayment at any
time.
Merger
The combining of two or more companies into
one new entity. Over-the-Counter (OTC)
Transactions that are undertaken away from an
exchange.
Mortgage
A mortgage, or more precisely a mortgage loan,
is a long-term loan used to finance the purchase Pawnbroker
of real estate (eg, a house). Under the mortgage A business that provides loans to individuals.
agreement, the borrower agrees to make a series The pawnbroker takes an item of security (such
of payments back to the lender. The money as jewellery) in exchange for the loan. The loan
lent by the bank (or building society) is secured needs to be repaid for the borrower to reclaim
against the value of the property. If the payments the item.
are not made by the borrower, the lender can
take back the property.
Payday Loan
Very short-term loan that needs to be repaid on
NASDAQ the borrower’s next payday, usually the end of
Originally the National Association of Securities the month. Such loans are often very expensive.
Dealers Automated Quotations. NASDAQ is a US
stock market that started out specialising in the
Pension Fund
shares of technology companies.
A fund set up by a company or government to
invest the pension contributions of members
National Debt and employees to be paid out at retirement age.
A government’s total outstanding borrowing
resulting from financing successive budget
Personal Loan
deficits, mainly through the issue of government-
backed securities. A loan taken out by an individual where the
precise purpose for which the money will be
used is not detailed in the loan agreement.
Nikkei 225
Main Japanese share index, composed of shares
Personal Pension Scheme
in the largest 225 companies listed on the
Japanese stock exchange. A retirement saving scheme set up by an
individual, rather than set up by the individual’s
employer.
Nominal Value
The amount of a bond that will be repaid on
Portfolio
maturity. Also known as face or par value.
A selection of investments.

160
 Glossary

Power of attorney Secured

A power of attorney is a legal document where The situation where a lender (such as a bank or
an individual authorises one of more other a pawnbroker) takes something of value. If the
person (the attorney(s)) to undertake a specific borrower fails to repay the debt, the lender is
transaction or to manage their affairs. A typical able to keep and sell the item.
example is where an individual executes a power
of attorney while of sound mind that allows the
Security
attorney to make decisions on their behalf if and
when the individual is no longer of sound mind. A bank has taken security for its loan when it
holds something of value. The most obvious
example is if a bank takes security in the form of
Premium property ownership on a mortgage.
The regular payment made to an insurance
company for insurance against a range of risks.
Shareholders
Those who own the shares of the company.
Redemption Date Essentially, they are the owners of the company.
The date at which a bond issuer has to repay the
face value of the bond.
Start-Up
A business or company in its early stages.
Reinsurance Typically start-ups are businesses that are not yet
The term for insurance taken out by an insurer generating any profits.
on a policy that it has underwritten.

State Pension Scheme

Responsible Investment A retirement scheme that is provided by the
The inclusion of environmental, social and state. Such schemes are generally not particularly
governance criteria when making investment generous and need to be supple­mented by other
choices. forms of income in retirement (such as personal
pension schemes, or pension schemes provided
by the employer).
Retail Bank
Organisation that provides banking facilities to
individuals and small/medium businesses. Syndicate
Insurance companies joining together to
underwrite insurance.
Return
A measure of the financial reward on an
investment, such as dividends and capital Trade
growth on a share. Return is always linked to The purchase and sale of a security. Trades in
risk: to have the possibility of a bigger reward, a shares are often agreed on exchanges.
bigger risk will need to be taken.

Treasury
Government department ultimately responsible
for the regulation of the financial services sector.

161
Unsecured
A loan provided to a borrower where the lender
takes no security.

Will
A will is a legal document that details what is to
happen to an individual’s estate in the event of
their death. Where possible, an individual should
make a will in order to ensure that the assets of
their estate pass in accordance with their wishes.

162
 1
Multiple Choice Questions
164
 Multiple Choice Questions

The assessment for this course will be a one-hour examination consisting of 30 multiple choice questions.

The following questions have been compiled to reflect as closely as possible the standard you will
experience in your examination. Please note, however, they are not the CISI examination questions
themselves.

Tick one answer for each question. When you have completed all questions, refer to the end of this
section for the answers.

1. Which of the following investments is likely to be the most risky?

A. Bonds issued by a start-up company
B. Equities issued by a start-up company
C. Equities issued by a large oil company
D. Government bonds

2. A company paid dividends of 3.60 per share in each of the last four quarters. The share price is
currently 198.50. What is the dividend yield?
A. 0.90%
B. 1.81%
C. 3.60%
D. 7.25%

3. If interest rates increase, what will normally be the effect on a 5% government bond?
A. Price will rise
B. Price will fall
C. Maturity will increase
D. Maturity will decrease

4. Which of the following is one of the main benefits of indirect investment in an equity collective
investment scheme managed by an experienced fund manager?
A. Diversification
B. Lower fees and charges
C. Greater personal control over the investment decisions
D. A fixed, guaranteed return

165
5. An unlisted company wishes to raise money to fund its overseas expansion plans, widen its
public profile and increase the liquidity of its shares. Which of the following actions is likely to
achieve all three things?
A. Issuing international bonds
B. Investing in a global marketing campaign
C. Undertaking an IPO
D. Seeking more international trades

6. If a credit card company quotes its interest rate as 20% pa, charged half-yearly, what is the
effective annual rate?
A. 10%
B. 20%
C. 21%
D. 40%

7. In the event of a company going into liquidation, who would normally have the lowest priority
for payment?
A. Shareholders
B. Banks
C. The tax office
D. Bondholders

8. A stock market participant has written an algorithm that will automatically place orders on the
exchange system based on pre-set indicators in the hope of gaining an advantage over others.
This is best described as an example of which one of the following?
A. Peer-to-peer finance
B. Blockchain technology
C. High-frequency trading
D. Unethical practice

9. Advising companies on M&A is one of the principal activities of:

A. a corporate bank
B. a central bank
C. an investment bank
D. a retail bank

166
 Multiple Choice Questions

10. How does a government typically raise money to fund its national debt?
A. Issuing bonds to individuals and firms
B. Making an appeal for donations from wealthy citizens
C. Issuing equities on a stock exchange
D. Doubling taxes for large corporations

11. An investor holds $1,000 nominal value of a 7% UK government bond trading at $970. What is
the next half yearly gross interest payment that the investor can normally expect to receive?
A. £33.95
B. £34.70
C. £35.00
D. £36.08

12. When would the effective annual rate of a loan be higher than the quoted rate?
A. When the borrower is unemployed rather than employed
B. When the interest is charged monthly rather than annually
C. When the loan is unsecured rather than secured
D. When the loan is a bank overdraft rather than a personal loan

13. Which of the following has the right to vote at company meetings or assemblies?
A. The holder of equities in the company
B. The co-signatory of a contract of business with the company
C. The largest clients of the company
D. The holder of bonds issued by the company

14. You wish to invest money in some bonds. You wish to take as high a risk as possible in order
to maximise your return. However, you do not want to buy bonds that are classified as ‘non-
investment grade’. According to the credit ratings given by major agencies Standard & Poor’s
and Fitch Ratings, which class of bonds should you buy?
A. BB
B. C
C. B
D. BBB

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15. The DAX is an index of which country?
A. England
B. US
C. Germany
D. Japan

16. Which one of the following best describes what is meant by ethical conduct?
A. Complying with the law
B. Maximising the client’s profit potential
C. Minimising the risk to the firm
D. Doing the right thing

17. Banks provide one way of linking savers and borrowers. Which of the following best describes
the way this link works?
A. Paying less interest on deposits than earned on loans
B. Paying more interest on deposits than earned on loans
C. Paying zero interest on deposits and lending the money for an upfront fee
D. Earning interest on deposits that is greater than the interest paid on loans

18. Which of the following provides a regular opportunity for savers/investors to sell their equity
investments?
A. Stock markets
B. Equity redemption
C. Government incentives
D. IPOs

19. Outside of the US, the term ‘commercial banking’ is generally used to describe which of the
following?
A. The way a bank makes money
B. A bank that specialises in providing banking services to businesses
C. A bank that only provides advice
D. A bank that specialises in providing loans and deposit facilities to individuals

20. Which of the following is an example of a secured loan?

A. Mortgage
B. Overdraft
C. Credit card borrowing
D. Payday loan

168
 Multiple Choice Questions

21. Which of the following best describes an IPO?

A. A company raising capital by selling equity or bonds
B. A company generating its first profits
C. A company raising money by selling shares to the public for the first time
D. A company reaching levels of profit that are growing year on year

22. A shareholder typically has the right to all of the following, EXCEPT:
A. dividends from the company
B. vote at general meetings
C. sell their shares
D. regular coupons

23. When compared to equities, which of the following is considered an advantage to an investor in
bonds?
A. More scope for income growth
B. Greater potential for capital gain
C. Voting rights
D. Regular and predictable income

24. Interest rates are suddenly and surprisingly increased by the central bank. What is most likely to
happen to the price of fixed-coupon bonds?
A. It will increase
B. It will decrease
C. It will remain the same
D. The response depends on the credit rating of the issuer

25. Derivatives are used for two major purposes – hedging and which of the following?
A. Speculation
B. Risk reduction
C. Insurance
D. Reducing uncertainty

26. An investor buys an oil future. Which of the following best describes the investor’s position?
A. Obliged to deliver oil at a pre-agreed price on a future date
B. Obliged to purchase oil at a pre-agreed price on a future date
C. Obliged to deliver oil at a price to be agreed on a future date
D. Obliged to purchase oil at a price to be agreed on a future date

169
27. Which of the following best describes the function of a stock exchange?
A. To generate market indices
B. To arrange the payment of dividends on shares
C. To facilitate trading in financial instruments
D. To provide a location for listed companies’ general meetings

28. Which of the following indices is a narrow index that reflects share prices of US-listed
companies?
A. S&P 500
B. Dow Jones Industrial Average
C. DAX
D. FTSE 100

29. The US $ per £ rate is quoted at 1.220 – 1.226. Which of the following is correct?
A. $1.22 are required to buy £1
B. £1.22 are required to buy $1
C. $1.226 are required to buy £1
D. £1.226 are required to buy $1

30. Bitcoin is best described as which of the following?

A. A company that provides Fintech services
B. A cryptocurrency that uses blockchain distributed ledger technology
C. A peer-to-peer finance initiative
D. A tool to enable microfinance to flourish

170
 Multiple Choice Questions

Answers to Multiple Choice Questions

Q1. Answer: B Ref: Chapter 2, Section 3
It is generally the case that equities are more risky than bonds. It is also the case that when comparing
two bonds, or two equities, the bonds or equities issued by the smaller, less financially secure entity are
likely to be more risky than the bonds or equities issued by the larger, more financially secure entity.

Q2. Answer: D Ref: Chapter 4, Section 3

The dividend for the year is 3.60 x 4 = 14.40. The dividend yield is (14.40/198.50) x 100 = 7.25%.

Q3. Answer: B Ref: Chapter 5, Section 4.1

If interest rates generally increase after a bond issue, then to sell the bond the yield will have to increase
to attract any buyer. The only way this can happen is by reducing the price. Therefore, bonds have an
inverse relationship with interest rates: if interest rates rise, then bond prices will fall, and vice versa.

Q4. Answer: A Ref: Chapter 8, Section 1

Diversification is a key advantage of a fund, because the fund is gathering together lots of individual
investments and therefore is able to invest in a variety of different company shares.

Q5. Answer: C Ref: Chapter 7, Section 2

The process of becoming listed, and a company’s shares being admitted to trading on a stock exchange
for the first time, is referred to as an initial public offering (IPO). Two of the main reasons for companies
becoming listed, or undertaking an IPO, are raising money by selling shares, and increasing the public
profile and awareness of the company. Another reason why companies undertake an IPO is that it
is much easier to buy or sell their shares after the IPO because the shares are then traded on a stock
exchange. This is often described as the shares becoming more liquid.

Q6. Answer: C Ref: Chapter 3, Section 3.1

Interest rate is 20% per year, divided by 2 = 10% per half year, expressed as 0.10.
Interest calculation is 1 + 0.10 = 1.10 per half year.
1.102 = 1.10 x 1.10 = 1.21.
1.21 – 1 = 0.21 x 100 = 21%.

Q7. Answer: A Ref: Chapter 4, Section 5

If the company closes down, often described as the company being ‘wound up’, the equity holders are
paid after everybody else. Equity is at the bottom of the ‘food chain’.

Q8. Answer: C Ref: Chapter 8, Section 5.4

Electronic stock exchange trading systems have opened up the possibility of so-called ‘high frequency
trading’ (HFT) that often involves the use of algorithms to submit trades ahead of the ‘crowd’.

171
Q9. Answer: C Ref: Chapter 3, Section 6
In addition to helping organisations raise capital, one major line of business for investment banks is
mergers and acquisitions (M&A). This is where investment banks advise companies on their business
strategy, in particular on how the companies can grow by buying other businesses.

Q10. Answer: A Ref: Chapter 2, Section 2

When government expenditure exceeds government revenue, the difference needs to be financed in
some way and it is invariably borrowed. However, government borrowing tends not to come from banks
but from individuals and firms in the form of regular issues of bonds.

Q11. Answer: C Ref: Chapter 5, Section 3

The interest is normally payable half-yearly and is based on the nominal value, ie, $1,000 x 7% x 6/12 =
$35.00.

Q12. Answer: B Ref: Chapter 3, Section 3

If the frequency of charging interest is annually, the quoted rate and the effective annual rate are the
same. When interest is charged more frequently than annually – for example quarterly, or monthly – the
effective annual rate will be greater than the quoted rate.

Q13. Answer: A Ref: Chapter 4, Section 4

It is the equity holders that own companies. One of the key rights that owning shares provides is the
right to attend and vote at company meetings.

Q14. Answer: D Ref: Chapter 5, Section 6

There is an important dividing line between bonds that are rated by the agencies as having less credit
risk and therefore more appropriate for prudent investors and bonds that are more risky and therefore
less appropriate for prudent investors. This is the dividing line between what are termed ‘investment
grade’ bonds and ‘non-investment grade’ bonds, and it is drawn just below Standard & Poor’s BBB.

Q15. Answer: C Ref: Chapter 7, Section 3.2

The DAX index is used in the German market.

Q16. Answer: D Ref: Chapter 1, Section 1

Ethical conduct often goes beyond what is laid down in the law and is perhaps best summarised as
‘doing the right thing’.

Q17. Answer: A Ref: Chapter 2, Section 1.1

Banks pay less interest on deposited funds, than they earn on loans. The difference is used to fund the
bank’s operations and generate a profit.

Q18. Answer: A Ref: Chapter 2, Section 4

Facilities to sell equities are provided by stock markets, including world-famous exchanges like the LSE
and the NYSE.

172
 Multiple Choice Questions

Q19. Answer: B Ref: Chapter 3, Section 1

In most parts of the world excluding the US, the term commercial banking is used to describe a bank
that specialises in providing banking services to commercial entities, ie, businesses. In the US, it is used
more broadly to cover banks that provide services to individuals and businesses.

Q20. Answer: A Ref: Chapter 3, Section 4

A mortgage is a loan made to facilitate the purchase of a home, with the property providing the security
to the lender.

Q21. Answer: C Ref: Chapter 4, Section 2

An IPO is an initial public offer. It is the first time shares in a company are offered to members of the
public and coincides with the company gaining a stock market listing.

Q22. Answer: D Ref: Chapter 4, Sections 3 and 4

Shareholders can get return from their shares by receiving dividends and selling their shares to generate
a capital gain. As owners, shareholders can vote at general meetings. Coupons are paid on bonds, not
shares.

Q23. Answer: D Ref: Chapter 5, Section 5

Unlike equities, bonds typically pay a regular, fixed coupon. However, they provide little in the way of
potential for capital gain and no voting rights.

Q24. Answer: B Ref: Chapter 5, Section 4

Bonds have an inverse relationship with prevailing interest rates – when interest rates rise, bond prices
fall and vice versa.

Q25. Answer: A Ref: Chapter 6, Section 1

Derivatives tend to be used for hedging or speculation. Hedging is using derivatives as a form of
insurance, reducing risk and uncertainty.

Q26. Answer: B Ref: Chapter 6, Section 2

A future is an obligation in which the price is pre-agreed. Buying a future means the investor is
committed to purchase the underlying asset (here oil) at an agreed future date.

Q27. Answer: C Ref: Chapter 7, Section 1

Stock markets are primarily trading venues for financial instruments, especially shares.

Q28. Answer: B Ref: Chapter 7, Section 3.2

Both the S&P 500 and the Dow Jones Industrial Average reflect US share prices. The DJIA has only 30
constituents, compared to the 500 in the S&P 500. The DAX is for German companies’ share prices and
the FTSE 100 is for UK-listed companies.

173
Q29. Answer: C Ref: Chapter 8, Section 2
The quote is the number of dollars per pound and the lower rate will be the number of dollars a single
pound will buy. The higher rate will be the number of dollars needed to buy a single pound.

Q30. Answer: B Ref: Chapter 8, Section 5.5

Bitcoin is a cryptocurrency. It uses blockchain distributed ledger technology (DLT) that replaces one
centralised ledger of transactions with a decentralised network of computers all holding copies of
exactly the same ledger.

174
 1
Syllabus Learning Map
176
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section

ELEMENT 1 ETHICS AND INTEGRITY IN FINANCIAL SERVICES Chapter 1

Introduction: Ethics and Integrity in Financial Services
1.1
On completion, the candidate should:
1.1.1 Know the key principles of ethical behaviour in financial services Section 1
Know the meaning and characteristics of environmental, social, and
1.1.2 Section 4
corporate governance (ESG)
1.1.3 Know the role of responsible investment Section 5
Know types of impact investing:
1.1.4 • gender lens investing Section 6
• microfinance

ELEMENT 2 SAVING AND BORROWING Chapter 2

Savers/Borrowers
2.1
On completion, the candidate should:
Know how the financial services sector can be viewed as linking
those with surplus money (savers) and those with a need for money
(borrowers) in the following ways:
2.1.1 Section 1
• via banks (deposits, loans)
• via equities (ownership stake)
• via bonds (IOUs)
Know that borrowers include companies and governments and that
2.1.2 Section 2
governments issue bonds rather than equities
Know the relationship between the level of risk and the prospect of
2.1.3 Section 3
reward
Know that the financial services sector also includes markets to
2.1.4 Section 4
enable investors in equities and bonds to buy or sell investments
Know that the financial services sector also includes insurance
2.1.5 Section 5
providers to enable financial risks to be managed
Know that the financial services sector also includes foreign
2.1.6 exchange dealers to allow one currency to be exchanged for Section 6
another to facilitate international trade

ELEMENT 3 BANKING Chapter 3

Banking
3.1
On completion, the candidate should:
Know the difference between retail and commercial banking and
3.1.1 Section 1
the types of customer – individuals/corporates

177
 Syllabus Unit/ Chapter/
Element Section
Know the nature and types of borrowing available to retail
customers:
3.1.2 • from banks – loans, mortgage loans, overdrafts Section 2
• from banks and credit card companies – credit cards
• from other sources – pawnbrokers, payday loans
Know the difference between the quoted interest rate on borrowing
3.1.3 Section 3
and the effective annual rate of borrowing
Be able to calculate the effective annual rate given the quoted rate
3.1.4 Section 3.1
and frequency of interest payment
3.1.5 Know the difference between secured and unsecured borrowing Section 4
Know what types of borrowing are likely to be relatively expensive
3.1.6 – pawnbrokers/payday loans, credit cards, overdrafts, unsecured Section 5
loans and cheaper – secured loans, eg, mortgages
Know that investment banks help companies to raise money and
3.1.7 Section 6
advise them on strategy, eg, mergers and acquisitions
Know the role of central banks:
• banker to banking system
3.1.8 Section 7
• banker for the government
• regulatory role (interest rate setting)

ELEMENT 4 EQUITIES Chapter 4

Equities
4.1
On completion, the candidate should:
4.1.1 Know the reasons for issuing shares (stock) – to finance a company Section 1
4.1.2 Know the definition of an initial public offering (IPO) Section 2
Know the potential sources of return from shares:
4.1.3 • dividend Section 3
• capital gain
Be able to calculate the dividend yield given the share price and the
4.1.4 Section 3
dividends paid in the year
Know that shares provide their owners with the right to vote at
4.1.5 Section 4
company meetings/assemblies
Know the risks involved in owning shares:
4.1.6 • lack of profit Section 5
• bankruptcy/collapse

178
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section

ELEMENT 5 BONDS Chapter 5

Introduction to Bonds
5.1
On completion, the candidate should:
Know the definition of a bond and the reasons for issue:
5.1.1 Section 1
• alternative to loans or issuing shares
Know the bond issuers:
5.1.2 • governments Section 2
• corporates
Know the features of bonds:
• repayment date
5.1.3 Section 3
• frequency of interest payments
• tradeable
Know the key terms:
• nominal
5.1.4 • coupon Section 4
• redemption/maturity
• yield
Know the advantages and disadvantages of investing in bonds:
• regular income
5.1.5 Section 5
• fixed maturity date
• credit risk
Know the role of credit rating agencies:
5.1.6 Section 6
• investment grade/non-investment grade
Understand the benefits and risk of leverage in a company’s
5.1.7 Section 7
financing structure

ELEMENT 6 DERIVATIVES Chapter 6

Derivatives
6.1
On completion, the candidate should:
6.1.1 Know the uses and applications of derivatives Section 1.1
6.1.2 Know the definition and function of a future Section 2
6.1.3 Know the definition and function of an option (calls and puts) Section 3

ELEMENT 7 MARKETS Chapter 6

Markets
7.1
On completion, the candidate should:
7.1.1 Know the function of a stock exchange Section 1

179
 Syllabus Unit/ Chapter/
Element Section
Know the reasons why a company makes an initial public offering
7.1.2 Section 2
(IPO)
Know the purpose of a stock exchange index:
7.1.3 • single market Section 3.1
• global markets
Know the following stock market indices and which market they
relate to:
• Dow Jones Industrial Average
• S&P 500
7.1.4 • NASDAQ Section 3.2
• FTSE 100
• DAX
• Hang Seng
• Nikkei 225

ELEMENT 8 OTHER AREAS OF FINANCIAL SERVICES Chapter 7

Fund Management
8.1
On completion, the candidate should:
Know the principle of collective investment schemes:
• comparison with direct investment
8.1.1 • pooling Section 1
• diversification
• expertise
Foreign Exchange
8.2
On completion, the candidate should:
Know the basic characteristics of the foreign exchange market:
• currency trading
8.2.1 Section 2
• exchange rate
• cryptocurrencies
Insurance
8.3
On completion, the candidate should:
Know the types of insurance available:
• personal
8.3.1 Section 3
• corporate
• the concept of syndication
Estate and Retirement Planning
8.4
On completion, the candidate should:

180
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
8.4.1 Know the importance of planning for retirement Section 4.2
8.4.2 Know the importance of estate planning Section 4.3
Financial Technology (Fintech)
8.5
On completion, the candidate should:
Know the application of technology in collective investment:
8.5.1 • platforms Section 5.1
• screening tools
8.5.2 Know how crowdfunding works Section 5.2
8.5.3 Know the principles of peer-to-peer finance Section 5.3
Know how global stock markets have benefited from the application
of Fintech:
8.5.4 Section 5.4
• technology indices
• high frequency trading
8.5.5 Know the basic principles of distributed ledger technology Section 5.5

181
182
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