Académique Documents
Professionnel Documents
Culture Documents
Update Supplement
4 Chiswell Street
London
EC1Y 4UP
Email: info@7city.com
www.7city.com
Copyright 7city Learning Limited 2007
All rights reserved. No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any
means (electronic, mechanical, photocopying, recording or otherwise) without the prior permission of the copyright owner. Any person who does any
unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages.
While every effort has been made to ensure its accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result
of any material in this publication can be accepted by 7city Learning Limited.
Edition 5 (01/04/2004)
Edition 8 (19/11/07)
Edition 5 (1/4/04)
Dear Delegate
In order to give you a more rounded view of the syllabus, we have made some updates to the study material.
A summary of the changes follows this page. Where new content has been added, updated subject(s) appear towards
end of the supplement. These changes are also reflected in 7C-online where content and questions are constantly
updated from the database.
The majority of the amendments made to the material are aimed at tightening up the existing content and better defining
examinable areas. If you have any concerns about this update, feel free to call the number below and speak to myself or
another 7city Certificates tutor.
Andy Bennett
Head of Securities and Investment Institute Certificates
7city Learning
4 Chiswell Street
London
EC1Y 4UP
Subject 4 –SETS
• SETS: introduction – content updated
• SETS: trading day – content updated and new content added
• SETSqx – new topic added
Subject 12 – Virt-x
• Content updated and new content added
Subject 13 – PLUS
• Content updated
Subject 15 –Settlement
• New subject added
CHAPTER 4 – WARRANTS
CHAPTER 12 – REGULATION
Chapter 1
Learning outcomes
On completion of this chapter you will:
Limited companies
Know the process of incorporation.
Know the distinction between ownership and management.
Know the distinction between authorised and issued share capital.
Dividend Payments
Know the purpose of the ex-dividend date and the record date
Know when special bargains can be struck
Understand how clains can be generated
Title documents
Know the difference between registered and bearer form securities.
Be able to identify examples of registered and bearer form securities.
Know the difference between temporary and permanent documents of title.
Stamp Duty
Know the situations in which stamp duty is payable.
Identify exempt transfers for stamp duty purposes.
Preference shares
Background
Preference shares do not normally carry the right to vote in general meetings.
However, unlike ordinary shares, preference shares carry an expectation of a
FIXED RATE dividend. This dividend is payable AFTER interest but BEFORE
ordinary dividends. Like all dividends, this dividend is payable at the discretion of
the directors.
A company cannot pay ordinary dividends without paying off any preference
dividends due.
Some companies issue preference shares that are redeemable by the company at
a future date. Other types may give the investor the right to convert into ordinary
shares. These, and other rights, will be stated in the company's Articles of
Association.
The Articles of Association will usually specify that, should a cumulative preference
dividend not be paid then the preference shareholders will be entitled to vote at the
next Annual General Meeting. The most common period for non-payment which
invokes the right to vote is 3 years, but this may vary from company to company.
This is referred to as enfranchisement.
The holders of ZERO DIVIDEND preference shares are also normally afforded
voting rights.
The nominal value is shown on the face of the share certificate. The nominal value
does NOT represent the market value of the share.
The market value is the PRICE of the share (i.e. its worth). Should a company issue
shares at a value above nominal, the excess is called the SHARE PREMIUM.
Dividends
Dividends, both ordinary and preference, are quoted (and paid) NET of a 10% tax
credit.
This tax credit is taken into account when an individual's income tax bill is
calculated for the year.
Equities: types and features CHAPTER 1
Example:
An investor receives a dividend of 10p:
Gross dividend = 10 x 100/90 = 11.1p
Tax credit =1.1p
5 Dividend payments
Background
As we have seen, ordinary shares tend to pay a dividend to shareholders based on
the profits of a company. These dividends are price sensitive information, and as
we will see in the next chapter, all price sensitive information needs to be disclosed
to the market via a primary information provider. Once announced, the share will be
trading cum-dividend, or WITH dividend, which will give it extra value on the market.
Once the dividend has been paid, the share will trade ex-dividend, or WITHOUT
dividend, causing it to drop in value.
The ideas around the share moving from cum- to ex-dividend are discussed below.
Ex-dividend date
E
X
-
D
CUM-DIV PERIOD EX-DIV PERIOD
I
V
The buyer of the security will The buyer of the security will
be entitled to receive the next D NOT be entitled to the next
dividend payment A dividend payment.
T Entitlement to the next
E dividend payment remains
with the seller
The EX-DIVIDEND (or EX-DIV) date is the date from which all transfers of the
security are contracted WITHOUT the right to receive the dividend. The period from
the ex-div date is called the ex-div period. The period before the ex-div date is
called the cum-div period.
Any transfers of the security during the cum-div period are contracted WITH the
right to receive the next dividend payment.
The LSE usually declares the ex-div date as the WEDNESDAY FOLLOWING the
day on which the dividend is announced.
The LSE usually requires 3 clear business days between the dividend declared
date and the ex-div date. Therefore, when a dividend announcement falls on a
Friday, the ex-div date is TWO Wednesdays later.
Equities: types and features CHAPTER 1
Record date
E
X
-
D
CUM-DIV PERIOD EX-DIV PERIOD
I
V
D
A
Company proposes a T Record date
dividend E (Friday)
(Usually a Wednesday)
The RECORD DATE is the date on which a company inspects the register of
members in order to establish which shareholders will be sent the dividend.
The record date (or REGISTER DATE or BOOKS CLOSED DATE) is usually the
Friday after the ex-div date.
The company chooses this date as the record date because a purchaser in the cum-
div period would normally be expected to settle on or before this date (T+3).
Therefore, the purchaser's name would be expected to appear on the shareholders'
register by this date.
Special ex date
The SPECIAL EX DATE is the first date in the cum-div period from which SPECIAL
EX transactions can be agreed.
The special ex-div date is 10 business days before the ex-div date itself.
Equities: types and features CHAPTER 1
E
CUM-DIV PERIOD X EX-DIV PERIOD
-
D
I
V
D SPECIAL-CUM PERIOD
A
T
E
Company Special Record
proposes ex date (Wednesday) date
a dividend (XD – 10 (Friday) Dividend
business payment
days) date
Ex-div deals may be struck in the cum-div period 10 business days before the ex-div date.
Such deals are known as ‘special ex-div’ bargains.
Such special cum-div bargains can be entered into right up to the day before the
dividend payment date.
Equities: types and features CHAPTER 1
E
CUM-DIV PERIOD X EX-DIV PERIOD
-
D
I
V
D SPECIAL-CUM PERIOD
A
T
E
Company Special Record
proposes ex date (Wednesday) date
a dividend (XD – 10 (Friday) Dividend
business payment
days) date
Cum-div deals may be struck in the ex-div period right up to the day before the dividend
payment date. Such deals are called ‘special cum’ bargains.
The deal is therefore in the cum-div period. It follows that the buyer is entitled to
receive the dividend payment from the company.
However, because the trade is to be settled T+25, the buyers name will NOT be on
the register by the books closed date.
Equities: types and features CHAPTER 1
E
CUM-DIV PERIOD X EX-DIV PERIOD
-
D
I
V T +25
D
A
Trade date T
E
Company Special Record
proposes ex date (Wednesday) date
a dividend (XD – 10 (Friday) Dividend
business payment
days) date
The buyer’s name will not be on the register of members by the record
date. The company will therefore pay the dividend to the seller, even
though it was sold cum-div. A claim between the brokers is therefore
necessary.
On the dividend payment date, the company will pay the dividend to the selling
investor instead of the buyer, as it will use the name of the registered holder on the
record date to determine the recipient of the dividend.
The buyer's broker will have to claim the dividend amount from the seller's broker.
The buyer's broker will have to claim the dividend amount from the seller's broker.
Registered securities
A registered security is one whose ownership is recorded on a central register.
This is the same as for cars and real estate, where the asset is registered in the
owner's name. Registration denotes LEGAL ownership.
Stamp duty
Stamp duty is charged at 0.5% of the amount paid for the securities (i.e. ad
valorem). If nothing is charged (i.e. the shares are gifted) no stamp duty is due.
The tax legislation refers to the rate as '£5 per £1,000 of consideration or any part
thereof'. This means that stamp duty is always ROUNDED UP to the next £5.
SDRT
SDRT is also charged at 0.5% of the amount paid for the securities. The major
difference is that it is rounded to the NEAREST PENNY.
The problem non-US companies face, is that US investors like to buy dollar
denominated shares and to receive dollar dividends. Therefore, unless a non-US
company issues dollar denominated shares, it may lose out on the potential US
investor base.
ADRs: features
The following description explains how a fictional UK company, Brit plc, issues
ADRs on the back of sterling denominated shares.
Step 1: Brit plc issues sterling shares to a UK branch of an American bank. The
bank will pay Brit plc for these shares in sterling.
Step 2: The bank will keep the sterling shares in a safe place by acting as a
depository.
Usually, one ADR represents several underlying securities. For example, one ADR
may represent 100 shares in Brit plc.
ADR holders receive most privileges of the underlying shares, including voting
rights and dividends. Dividends will, however, be paid in dollars. Holders of ADRs
are generally NOT granted pre-emptive rights in a rights issue. Instead, they receive
the NIL PAID price (i.e. the value of the right) instead.
Although the underlying shares in Brit plc are registered in the name of the bank
acting as depository, the ADRs themselves trade as bearer documents.
Nevertheless, as the depository receipt must be registered in the name of the
depository, they are not considered pure bearer documents.
US investors do not pay stamp duty when purchasing ADRs. However, the
depository pays a one-off stamp duty charge of 1.5% on the creation of the ADRs
themselves.
Equities: types and features CHAPTER 1
ADRs can be issued and traded BEFORE the underlying shares have been issued;
these are known as PRE-RELEASE ADRs.
ADRs can only trade in pre-release form for 3 months, and, during that period, cash
from the sale of the ADRs (COLLATERAL) must be deposited with the depository.
Cash is the only acceptable form of collateral.
ADRs are not restricted to trading in the US, they can also be traded in the UK and
elsewhere.
Should the investor wish to, these instruments can be converted back into the
underlying shares by returning the ADR to the depository.
Global Depositary Receipts (GDRs) work in the same way and are likely to be
created for distribution across several countries.
ADRs: a summary
SHARES ADRs
££££s $$$$s
BRIT PLC BANK A American
Investor
UK USA
Brit Plc will pay dividends in sterling to Bank A. Bank A will convert them
into US dollars and pass them on to the ADR holder.
Dividend Payments
The purpose of the ex-dividend date and the record date
Title documents
The difference between registered and bearer form securities.
Stamp Duty
The situations in which stamp duty is payable.
The rate of stamp duty and the distinction between stamp duty and stamp duty
reserve tax (SDRT).
Why a US investor might use an ADR rather than invest directly in an overseas
company.
Now you have finished this chapter you should attempt the chapter
questions.
Issuing equities CHAPTER 2
Chapter 2
Issuing equities
Time Allocation: 2hrs
Approx Question Weight: 8-10
This chapter starts by explaining the two markets in which shares are traded; the
PRIMARY and SECONDARY markets. Issues into the primary market occur when a
company is seeking to raise long-term capital from investors - new shares are
therefore issued by the company in return for finance from investors. Secondary
market trading, however, is the market in 'second-hand' shares. In the secondary
market, no new finance is raised by the company as the trading is done directly
between investors.
Despite the general idea that shares are issued to raise capital, this chapter also
identifies limited situations where shares are issued FREE. This does not raise any
new money for the company but can have the effect of making shares more
attractive to investors by reducing the share price and encouraging trading.
Learning outcomes
On completion of this module, you will:
Issuing equities CHAPTER 2
Know and explain the different issue methods used in the primary market, including:
Offer for subscription.
Offer for sale
Placing
Intermediaries offer.
Be able to calculate the dilutive effect on share price of share issues.
The SECONDARY MARKET, on the other hand, is the market on which existing
securities are traded. The secondary market exists to support the primary market. It
provides subscribers to shares in the primary market with a place to sell them on
again and also acts as a benchmark for primary market pricing decisions.
Secondary market activity does NOT raise new capital for the company.
Many international stock exchanges, including the London Stock Exchange, fulfil
the role of both primary and secondary markets.
An initial public offer (IPO) is the first sale of stock by a private company to the
public. In an IPO, the issuer obtains the assistance of an underwriting firm (typically
an investment bank), which helps it determine what type of security to issue, best
offering price and time to bring it to the market and acts as sponsor.
Issuing equities CHAPTER 2
Once a company has made the decision to raise capital via an IPO and has
produced a prospectus, it is ready to issue shares on the primary market.
The following illustrations describe the various means by which a company can
issue shares in the primary market.
SHARES Investor
Company A
An offer for subscription involves a company issuing shares directly to the general
public.
SHARES SHARES
£££ £££
COMPANY ISSUING INVESTOR
HOUSE
An offer for sale is similar to an offer for subscription. However, in this case, the
issuing house (or LEAD MANAGER) initially buys up new shares from the issuing
company before re-selling them to the investing community.
An offer for sale is not restricted to the issue of new securities. It can also be used
for a large shareholding being sold into the market place, e.g. government
privatisations.
Issuing equities CHAPTER 2
Placing
A placing is similar to an offer for sale, however the lead manager does NOT offer
to resell the shares to the investing community at large. Instead, the shares are only
offered to selected investors such as pension funds and wealthy individuals. For
this reason, a placing is sometimes referred to as SELECTIVE MARKETING.
2 3
£
Wealthy individuals
Prospectus Rules.
Disclosure Rules.
The Prospectus Rules affect all publicly traded companies whether they trade on
the main market or AIM, whereas the Listing Rules do not apply to AIM or other
similar securities. Both sets of rules are discussed in detail below.
The Disclosure Rules apply to shares traded on a regulated market in the UK and
help prevent insider dealing and market abuse.
Once a company's shares are on the LSE, the company will find themselves bound
by three sets of regulation:
The Companies Act
FSA rules
The London Stock Exchange manages and administers two markets, a main
market, called the Official List, and a junior market called the Alternative
Investments Market (AIM).
A flotation can go hand in hand with an issue of new shares (i.e. as part of a
marketing operation) or by way of an introduction.
Cons
Regulation and cost
A publicly quoted company is more accountable to regulators. It therefore entails a
much higher level of disclosure and reporting than is required by non-quoted
companies. This, in turn, will lead to additional costs.
Market conditions
A company's share price is susceptible to volatile market conditions. This may
result in a lack of liquidity in the company's shares that is beyond the control of the
company's directors.
Investor power
Where shares are held by large institutional investors there is a risk that the
founders could lose control of what they perceive to be their business.
In order to obtain a listing on the main market, a company must apply to the UK
Listing Authority (UKLA). Successful companies are referred to as LISTED
companies.
The Principles
Principle 1
A listed company must take reasonable steps to enable its directors to understand
their responsibilities and obligations as directors.
Principle 2
A listed company must take reasonable steps to establish and maintain adequate
procedures, systems and controls to enable it to comply with its obligations.
Principle 3
A listed company must act with integrity towards holders and potential holders of its
listed equity securities.
Principle 4
A listed company must communicate information to holders and potential holders of
its listed equity securities in such a way as to avoid the creation or continuation of a
false market in such listed equity securities.
Principle 5
A listed company must ensure that it treats all holders of the same class of its listed
equity securities that are in the same position equally in respect of the rights
attaching to such listed equity securities.
Principle 6
A listed company must deal with the FSA in an open and co-operative manner.
Issuing equities CHAPTER 2
Pre-emption rights
Any subsequent issue of shares for cash (e.g. a rights issue) must contain a pre-
emption right. Although shareholders may vote to waive their pre-emption rights,
the maximum waiver is 5 years.
Controlling shareholdings
The existence of controlling shareholders could lead to the application for listing
being rejected unless the company can demonstrate to the UKLA that conflicts of
interest will be controlled.
A controlling shareholder is any person (or persons acting jointly) who is entitled to
exercise, or to control the exercise of, 30% or more of the rights to vote at the AGM.
Warrants
The issue of warrants or options to subscribe for equity shares must not be greater
than 20% of the company's issued share capital at the time of the issue of the
warrants or the options.
Settlement
The shares must be eligible for electronic settlement.
Listing application
A company must submit listing documents accompanied by the fee to the FSA for
approval before a listing on the Exchange is granted.
These documents consist of the prospectus (where new securities are issued along
with listing) or the listing particulars (if this is an introduction), and the completed
admission form.
Full documentation must be made available 48 hours prior to the hearing of the
application to obtain a listing.
Advertising
Once the UKLA has approved the listing particulars, a formal notice must be
published in at least one national newspaper.
Appointment of advisors
The sponsor will also appoint and co-ordinate the activities of other advisors in
relation to a listing. The other advisors and their roles are as follows:
Reporting accountants: reporting accountants give an independent view of the past,
present and future performance of the issuer. They summarise their findings in a
LONG FORM REPORT, which is delivered to the sponsor, accompanied by a
WORKING CAPITAL STATEMENT to support the sponsor's report to the UKLA on
the issuer's working capital position.
Lawyers: ensure the listing process is carried out in accordance with the
appropriate regulations.
Underwriters: underwriting syndicates guarantee to buy any unsold shares under
the issue.
Bookrunners/global coordinators: help determine the price of issue, where shares
are being placed with financial institutions.
PR consultants: enhance the attractiveness of the issue by ensuring it is marketed
effectively.
Reporting - ensuring that all shareholders are given an equal opportunity to access
price sensitive information. More on this is discussed below.
Financial information
The company is required to publish audited annual accounts within 6 months of the
financial year end and half yearly reports within 3 months of the period to which
they relate.
In the event that demand is insufficient to generate the minimum level of proceeds,
the underwriter agrees to take up any shortfall, paying cash for the unwanted stock.
The underwriter will usually agree to a ‘firm’ underwriting, whereby the proceeds of
the issue are guaranteed (for a fee). Alternatively, they market the issue on a best
efforts basis, meaning that they will do their best to sell the securities at a certain
price, but that there is no guarantee and the issuer bears the risk. The process
whereby a firm of underwriters attempts to generate a book of investor demand for
an IPO is known as book-building.
In these bought deals, the issuing company usually allows the underwriters an
option to increase the size of the offering by up to 15% in certain circumstances,
known as 'greenshoe' or 'overallotment' option. This option may be used if the
demand for the new shares is in excess of the base number of shares that the
company planned to issue. Where there is no greenshoe option, it would be
referred to as a base deal.
Alternatively, an issue can be marketed on a best efforts basis, meaning that the
underwriter will do their best to sell the securities at a certain price but that there is
no guarantee and the issuer bears the risk.
Issuing equities CHAPTER 2
A bookrunner or lead manager is the main underwriter in equity and debt issues
and will usually syndicate the new issue with other firms of underwriters in order to
lower its risk. If the size of the issue is large enough, there can be several lead
managers with each of the co-lead managers being responsible for a certain
geographic region. The bookrunner is listed first among all the underwriters
participating in the new issue.
Underwriting is used in all situations where share issues are generating proceeds,
e.g. offers, placings and rights issues. It is not necessary for bonus issues and
introductions, which are not marketing operations (i.e. no new capital is being
raised).
There is no limit to the number of underwriters who can participate in the purchase
of shares in an underwriting syndicate.
Stabilisation
Stabilisation is the process where a lead manager in an issue purchases stock in
the secondary market in order to support the price of the issue.
The market is made aware that stabilisation is taking place by the letter 'S' being
displayed on trading screens.
The Financial Services and Markets Act 2000 (FSMA 2000) has permitted the FSA
to create rules governing standardisation.
The FSA's stabilisation rules provide a 'safe harbour' to the offence of Market
Abuse.
The FSA's Conduct of Business rules state that a firm may only recommend a
security whose price has been affected by stabilisation to a private customer where
ALL of the following conditions are satisfied:
The customer has been given a verbal or written explanation of stabilisation.
The firm drew the customer's attention to the fact that the market price of the
security might be temporarily higher than usual at the time of the transaction.
Issuing equities CHAPTER 2
Placing
Intermediaries offer.
Now you have finished this chapter you should attempt the chapter
questions.
Equity markets CHAPTER 3
Chapter 3
Equity markets
Time Allocation: 5hrs
Approx Question Weight: 13-15
Importantly, you will learn each of the different trading systems the LSE operates. For
example, the system used to trade shares in large UK companies is the Stock
Exchange Electronic Trading Service (or SETS). You will be taken through the
details of each different trading system including the types of trades and how they
are executed.
You will understand different roles played by London Stock Exchange member firms
and identify alternative markets for the trading of shares, e.g. virt-x, a market for
Pan-European stocks and a direct competitor of the London Stock Exchange.
The chapter finishes introducing you to the main services provided by prime brokers
including securities lending and borrowing, leverage trade execution, cash
management, core settlement and custody. You will also learn about the main
sources of equity financing.
This is a detailed chapter with lots of information to absorb and is very important for
your exam.
Equity markets CHAPTER 3
Learning outcomes
On completion of this module, you will:
Stock Exchanges
Know the purpose and role of a stock exchange.
Know the right of the London Stock Exchange under Rule 3040.
Be able to identify the different parties trading on the London Stock Exchange.
SETS
Know the securities traded on SETS.
SETSqx
Know the securities traded on SETSqx
Virt-x
Know the role of virt-x as a direct competitor of the London Stock Exchange in the
equity markets.
PLUS
Know the status of PLUS as defined by the FSA.
Stock exchanges also provide facilities for the issue and redemption of securities as
well as other financial instruments. The securities traded on a stock exchange
include: shares issued by companies, unit trusts and other pooled investment
products and bonds. The initial offering of stocks and bonds to investors is done in
the primary market and subsequent trading is done in the secondary market.
Stock exchanges provide liquidity to existing and potential investors allowing them
to sell and buy securities more easily. The concentration of buy and sell orders
(supply and demand) in an organized market enables a price formation process
which leads to a market price at all times.
Today, stock exchanges usually have a central location at least for recordkeeping,
but trade is less and less linked to such a physical place, as modern markets are
electronic networks, which gives them advantages of speed and cost of
transactions. Historically, stock exchanges were physical locations where brokers
and dealers (members) met to trade face to face. They would shout and/or hand
signal to transfer information about buy and sell orders (open outcry).
The headquarters are now at Paternoster Square, next to St Paul's Cathedral, and
the LSE has grown into one of the major stock exchanges of the world. The LSE
provides a marketplace where over 3,000 company securities, domestic and
international, are traded.
However, equities are not the only products that can be bought and sold on the LSE.
Rule 3000 defines a transaction as a deal that involves AT LEAST ONE member
firm in any of the securities listed below.
Rule 3040 gives the LSE the right to prohibit dealings in any of these securities, at
any time, for any reason.
UK equities
Ordinary shares issued by UK companies. These are traded on the SETS order
book or SETSqx.
International equities
Ordinary shares issued by non-UK companies traded on the International Order
Book, the International Bulletin Board and the International Retail Service.
AIM securities
Shares and corporate debt of smaller young and growing companies. Most AIM
stockshave recently been moved onto SETS, and the remainder trade on SETSqx.
UK gilts
UK Government bonds, traded principally over the telephone by GEMMs - Gilt-
Edged Market Makers.
Sterling bonds
Issued by companies and local authorities. These are quoted on the SEAQ system.
Warrants
Issued by companies giving the right to buy new shares. These are traded on the
covered warrant order book.
Covered warrants
Covered warrants are issued by a person other than the issuer of the underlying
asset. These are traded on the covered warrant order book or the covered warrant
request for quote system.
Depositary receipts
Instruments such as ADRs can be traded on the LSE's International Order Book.
Equity markets CHAPTER 3
Other instruments
Corporate Eurobonds and traditional options are traded on SEAQ.
LSE: TradElect ©
The LSE has created a new system to support its range of trading platforms called
TradElect.
Trading
Service Description
Modified SETS
Order book
Structured &
Continuous No Mandatory
Products Reporting
only
Order book
SETSqx Equities & Quote Periodic varies Optional
book
European
Quoting Equities Quote book None No Optional
Service
European
Reporting
Trade Equities
only
None No No
Reporting
International
Equities Order book Continuous No Optional
Bulletin Board
International Equities in
Quote book None No Mandatory
Retail Service DI form
A broker/dealer can trade in one (or both) of two ways: buy and sell securities on
behalf of clients (act as AGENT), and/or buy and sell securities for their own
account (act as PRINCIPAL).
Broker/dealers can gain other labels in the marketplace, depending on the activities
in which they engage. Examples include:
Market makers.
Inter-dealer brokers.
However, despite differing terminology, they are essentially all broker/dealers acting
in one (or both) of their permitted capacities: agent and/or principal.
4 SETS
SETS: introduction
The Stock Exchange Electronic Trading Service - SETS is the central trading
mechanism for the constituents of the FTSE All share index and some Euro
denominated Irish securities. It is also the platform used for the trading of ETFs -
Exchange Traded Funds, and ETCs - Exchange Traded Commodities.
Only member firms authorised to use SETS can place orders on the SETS order
book, either for their own account or on behalf of clients. However, anybody is able
to view the order book to see the orders being placed.
Once an order has been placed on the order book, it will automatically be matched
against a corresponding order. If there is no such corresponding order to match
against, the order will either stay on the order book for future execution or will be
returned (in full or in part) to the member who originally entered the order.
The opening of the market is preceded each day by a 10 minute AUCTION CALL
PERIOD, running from 7.50am to 8.00am. This allows member firms to enter orders
onto the order book without automatic execution taking place.
At 8.00am a matching algorithm is run by the system which calculates the opening
price of the security. Normal trading activity then continues until 4.30pm.
When trading stops at 4.30pm, there is a 5 minute closing auction call period,
similar to the opening one, which establishes the closing price of the security.
Equity markets CHAPTER 3
Example
Example
Iceberg order
ICEBERG orders were introduced in September 2003 and are available on SETS,
the International Order Book and SETSmm.
Previously, market participants with large orders to execute would have been
reluctant to route these through the order book because of the potentially adverse
market impact.
An iceberg order manages this problem by allowing the order to be partially hidden
from the market view.
Upon entry of the order, the participant specifies the total order size and the visible
''peak'' size. The peak size is the maximum volume that will be shown to the market
at any time. Matching orders will exhaust the total iceberg volume before executing
orders further down the price queue.
Named Orders
SETS has recently combined with SETSmm to provide market maker support to all
securities traded on the order book. These are done through named orders.
Named orders are buy and sell orders placed on the order book by market making
firms and allow traders to call these firms to buy or sell shares, rather than place an
order on the order book. Named orders are also referred to as commited principal
(CP) orders.
Market makers are member firms who have volunteered to provide buy and sell
prices during a fixed period of time called a mandatory quote period (MPQ). The
mandatory quote period runs from 08:00 to 16:35.
Equity markets CHAPTER 3
Interruptions to trading
The following are interruptions to SETS trading that may be declared by the
Exchange:
Pause
In order book securities, this acts like an auction call, although no indicative
uncrossing price is disseminated. Orders can continue to be entered and deleted.
Trading halts
Trading halts are triggered due to rapid movements in the trading price. Halts
protect against erroneous trades and provide the market with time to respond to
price movements in an orderly manner.
This will happen if the price of one automatic trade is +/- 5% from the price of the
last automatic trade.
When a trading halt is declared, automatic execution in that security is halted,
however, members are permitted to trade away from the order book. Members may
also continue to submit/delete orders to/from the order book during a trading halt.
Trading halts last 5 minutes and, once the halt has been lifted, the auction process
is run and trading may commence.
Suspension of trading
If a security's listing is suspended, member firms CANNOT TRADE in that security
(without the permission of the Market Supervision Division of the Exchange). All
orders in that security are REMOVED from the order book.
Summary
order book order / quote order / quote Dissemination of
execution entry deletion closing price
PAUSE
MARKET SUSPENSION
HALT
Resumption of Trading
Trading will be restored when the market situation has been resolved. Order driven
securities trading will recommence with an auction call. Quote driven will
recommence with a pre-mandatory quote period. The duration of these periods will
be determined according to the specific circumstances at the time.
The closing auction is similar to the opening auction in that only limit and market
orders may be entered.
Just like the opening auction, the price calculated is the one that will execute the
maximum VOLUME of shares.
Closing prices
The official closing price on SETS will be the auction price of the closing auction
provided:
The price falls within pre-determined price tolerance levels; and
The executable volume is sufficiently large (normally half NMS or more) for the
price to be deemed representative.
If these criteria are not met then no auction matching will occur. Instead the volume
weighted average price (VWAP) of the last 10 MINUTES of order book trading
(4.20pm - 4.30pm) is used.
Equity markets CHAPTER 3
If the WPA was entered into after 3.00pm on any business day, the basic working
period is until 80% of the risk position has been offset or until 4.35pm on the NEXT
business day, whichever is sooner.
Portfolio trades
The basic working period for portfolio transactions is until either 100% of the risk
position created by the WPA is offset or 4.35pm, whichever is SOONER.
For extremely large WPAs, the Exchange may allow a longer period of time to work
the agreement.
Volatility
Share prices are by their nature uncertain, but particular events can lead to extreme
price movements:
Witching hours: occur when stock options, futures on stock indexes, and options on
these futures expire concurrently. Massive trades in index futures, options, and
underlying stock by hedge strategists and arbitrageurs cause abnormal activity
(noise) and volatility.
Early and late trades: large, automatic trades (programme trades) that become
active during auction calls can cause large swings in price.
SETSqx
SETSqx: introduction
SETSqx stands for the Stock Exchange Electronic Trading Service – quotes and
crosses. The LSE introduced SETSqx in mid 2007, as a new trading platform for the
less liquid stocks replacing SEATS Plus. SETSqx enables market participants to
comply with the limit order display requirements implemented as part of MiFID
(Markets in Financial Instruments Directive) on 1st November 2007.
SETSqx is used for the trading of domestic listed securities that are not traded on
SETS.
SETSqx: operation
SETSqx is a hybrid system combining a central order book displaying buy and sell
orders with two-way prices quoted by market makers.
There is no required minimum number of market makers (there could be zero for a
certain stock). If there are market makers, they provide continuous liquidity
throughout the day with a mandatory quote period running from 8.00am – 4.35pm.
The minimum quote size (MQS) is 1 x Normal Market Size (NMS).
In doing so the CCP is guaranteeing settlement of the trade and eliminating default
risk for the buyer and seller.
Summary: novation
1. INITIAL TRADE
DEAL
BUYER SELLER
(Clearing member of CCP) (Clearing member of CCP)
2. NOVATION
This element of risk management, obviously, does not come free of charge, and
CCPs charge for their services.
The LSE offers members the choice of two CCPs: LCH.Clearnet or X-Clear.
LCH.Clearnet
LCH.Clearnet is part of the LCH.Clearnet Group. LCH.Clearnet Ltd provides central
counterparty services for cash equity trades to the London Stock Exchange and virt-
x. It also provides central counterparty services in other products, particularly in
derivatives for Euronext.liffe. LCH.Clearnet Ltd is regulated as a Recognised
Clearing House by the Financial Services Authority.
X-clear
X-clear is part of the SIS group, based in Switzerland. X-clear also provides central
counterparty services to virt-x. X-clear is regulated as a bank in Switzerland by the
Swiss Banking Commission and the Swiss National Bank. It is also regulated as a
Recognised Overseas Clearing House by the Financial Services Authority.
Equity markets CHAPTER 3
The IOB is based on the existing SETS order book. It uses non-anonymous orders
(‘named orders') where the identity of the member firm is displayed alongside the
order.
All SETS order types can be used as well as the non-anonymous ‘named’ orders.
Execution can take place via electronic order matching or telephone dealing.
All trades executed are published with price, size and time.
There are currently both global depositary receipts (GDRs) and American
depositary receipts (ADRs) trading on the IOB, mostly from developing countries in
Central and Eastern Europe and Asia.
It is possible that active funds might also lend but there is more chance that the
securities will be recalled making it less attractive to borrowers.
Fees vary but for FTSE 100 equities they are typically 40 basis points but can be as
high as 200 basis points per annum. For gilts it tends to be around 5 basis points
per annum.
12 Virt-x
Virt-x: introduction
virt-x is a market for pan-European blue chip stocks, developed jointly by SWX
Swiss Exchange and Tradepoint Financial Networks plc.
virt-x was created in 2001 as a real response to growing demand from both the
investment and corporate communities for a pan-European blue chip exchange.
Today it competes with the markets for international equities offered by the London
Stock Exchange (primarily the International Order Book and International Bulletin
Board).
An anonymous electronic order book using the SWX Trading Platform for pan-
European equities.
Fully integrated trading, clearing and settlement with a central counterparty for
cross border trading provided by LCH.Clearnet
Multi-currency capability.
virt-x: trading
Overview
virt-x provides a single trading mechanism for European equities and straight
through processing of trades.
Incoming orders from investors are registered by virt-x members and fed into the
trading system. From here they go to the central exchange system of virt-x, which
acknowledges receipt and verifies correctness.
The central exchange system automatically matches buy and sell orders, on a price
(first priority) and time (second priority) basis.
Equity markets CHAPTER 3
virt-x provides trading in the shares of blue chips in a range of European indices,
including:
FTSE 100
CAC 40
DAX 30
AEX
SMI
MIB30
iShares
SPDR
Trading hours
Introduction
Operating hours of virt-x are 6.00am to 10.00pm (all times are Central European
Time). Trading hours are 9.00am to 5.30pm.
Trading currencies are Euro (for Eurozone countries) and domestic currencies for
the UK, Switzerland, Sweden, Norway and Denmark.
Pre-opening
Pre-opening starts at 5.30pm on the previous day and lasts until 10.00pm. It
resumes again at 6.00am on the current business day and runs through to the
opening of permanent trading, commencing at 9.00am.
Orders may be entered or deleted during pre-opening times, but no automatic
execution occurs. A theoretical opening price is continuously calculated and
displayed for the guidance of traders.
Permanent trading
At 9.00am the pre-opening period finishes with an auction call and an opening
auction. The end of the auction is random to avoid price manipulation.
Once this opening rotation is completed, permanent trading begins, where orders
are stored in the order book until a counterparty is found or they expire.
Closing auction
At 5.20pm orders change into closing auction status. The closing auction stops at
5.30pm, when closing prices are calculated.
Equity markets CHAPTER 3
virt-x will sometimes delay publication of block trades (large trades) and portfolio
trades (at least 10 securities).
Off order book transactions must be reported within 3 minutes of the trade taking
place (except where the transaction is conducted in an SWX listed security, where
the trade must be reported within 30 minutes).
All order book trades are for a uniform T+3 settlement period.
SWX Trading
TRADING
Platform
SELL BUY
• Exchange matched
trades
CLEARING: LCH
• Risk management
(CENTRAL
• Anonymity COUNTERPARTY)
SETTLEMENT:
• At virt-x member’s
choice of settlement
venue CREST EUROCLEAR SIS
Equity markets CHAPTER 3
13 PLUS
PLUS: introduction
Plus is a relatively new stock exchange in the UK. PLUS,is part of the PLUS
Markets Group plc and provides a trading platform for over 7,000 unquoted and
unlisted securities from the UK and Europe.
Approximately 1000 company shares from the FTSE Small-Cap, FTSE Fledgling, a
number from the FTSE 250 and AIM, are presently traded on PLUS.
PLUS has been given Recognised Investment Exchange (RIE) status by the FSA. It
operates both primary and secondary markets.
PLUS: trading
PLUS is a quote driven (market maker) electronic trading platform. The PLUS
trading platform (known as the ‘secondary market’) offers an execution facility for
the trading of securities.
PLUS traded securities are companies which are listed or quoted on other markets
but also traded on PLUS. Around 200 companies are currently traded on the ‘PLUS
quoted’ market segment, an exchange regulated market for smaller companies.. It
offers an alternative to AIM for high quality applicants offering the potential for
investment returns.
The ‘PLUS-listed’ market offers a choice of admission options (i.e. the LSE’s Main
Market or the PLUS-listed market) for companies admitted to the Official List by the
FSA’s UK Listing Authority.
The PLUS ‘primary market’ is a quotation and listing destination, effectively offering
a ‘meeting place’ for companies and capital in the UK.
Euronext - SICOVAM
France T+3 LCH.Clearnet (Euroclear
NSC France)
Deutsche
Germany T+2 Clearstream Clearstream
Borse
Tokyo stock
Japan T+3 JSCC JASDEC
exchange
Note that:
Trading in France takes place on the Euronext exchange (originally created by the
merging of the Paris, Brussels and Amsterdam exchanges). The Euronext group
expanded at the beginning of 2002 with the acquisition of LIFFE (London
International Financial Futures and Options Exchange) and the merger with the
Portuguese exchange BVLP (Bolsa de Valores de Lisboa e Porto).
15 Settlement
Settlement: background
Once a deal has been struck and the terms agreed, the transaction must then be
settled.
Settlement is the process of organising payment and delivery of the security, and is
the point at which legal title changes hands.
Euroclear UK & Ireland can also accommodate FREE DELIVERY and/or FREE
PAYMENT, where only one side of a deal (share movement or cash movement)
takes place through the CREST system.
The standard settlement time for UK equities and corporate bonds held within
CREST is three business days (T+3).
16 Prime Brokerage
Prime Brokerage: Overview
Prime brokerage is the generic name for a bundled package of services offered by
investment banks to hedge funs. The business advantage to a hedge fund of using
a prime broker is that the prime broker provides a centralised securities clearing
facility for the hedge fund. Also the hedge fund’s collateral requirements are netted
across all deals handled by the prime broker. The prime broker benefits by earning
fees on financing the client’s long and short term cash and security positions and by
charging additional fees for clearing and any other services the client may require.
Cash management. Active management of the funds’ cash positions for in order to
maximise the return.
Repurchase agreements. Prime brokers arrange the sale of securities owned by the
hedge fund in return for cash, which at the same time agrees to repurchase those
securities from the buyer for a greater sum of cash at some later date. That greater
sum being all of the cash lent and some extra cash constituting interest (the repo
rate).
Collateralised borrowing. Allowing a prime broker a first charge over its portfolio, a
Hedge funds can achieve more competitive rates when borrowing funds compared
to an unsecured loan.
Synthetic financing. In order to reduce trading costs, securities are not purchased
outright. Instead exposure to these securities is created by using derivatives (i.e.
options, futures, swaps).
SETS
The securities traded on SETS.
SETSqx
The securities traded on SETSqx.
Inter-dealer brokers
Details of the service offered to other market participants by IDBs.
Virt-x
The role of virt-x as a direct competitor to the London Stock Exchange in the equity
markets.
PLUS
The status of PLUS as defined by the FSA.
Securities covered.
Settlement
Understand what settlement is.
Prime brokerage
The main services provided by a prime broker
Now you have finished this chapter you should attempt the chapter
questions.
Warrants CHAPTER 4
Chapter 4
Warrants
Time Allocation: 0.5hr
Approx Question Weight: 2-3
1 Warrants: introduction
Chapter overview
Warrants give the holder the right to buy new shares in a company at a future date
for a pre-agreed price.
This short chapter familiarises you with the different types of warrants that exist,
and distinguishes between warrants and another similar type of instrument, a CALL
OPTION.
Learning outcomes
On completion of this module, you will
Understand the rights of warrant holders and the implications for issuers.
Warrant value
Know how to calculate the conversion premium (discount) on a warrant
Covered warrants
Identify the key differences between traditional warrants and covered warrants.
Warrants CHAPTER 4
They give their owner the right to subscribe for NEW shares in the company at a
fixed price (the EXERCISE price) on a future date (the EXPIRY date).
Warrants are some of the riskiest investments available on the London Stock
Exchange.
They are very similar to call options, both in terms of the amount of risk to which an
investor may be exposed and in the way they work.
Warrants: issuance
Warrants are usually given away as a sweetener with another issue, such as bonds.
If the warrants may be separated and traded in their own right, they are said to be in
DETACHABLE form. They may also be issued in NON-DETACHABLE FORM.
Different warrants may have differing characteristics. Usually the exercise price is
above the share price at issue and the expiry date is a number of years away (often
four or five).
For example, if a warrant has an exercise price is £2 and the current share price is
£2.50, the formula value will be 50p.
This equates to the amount saved by exercising the warrant relative to buying the
share in the open market.
Formula value can only be positive (if a warrant is 'in-the-money') or nil. It can
NEVER be negative, as a warrant is a RIGHT to buy at a set price, not an obligation.
Premium value
Premium value is the remainder of the warrant value (i.e. warrant value less formula
value).
Warrants CHAPTER 4
The example below illustrates the calculation of formula and premium value:
Example:
Warrant price = 700p
Warrant exercise price = £2.00 per share
Current share price = £2.50
No. of new shares issued on exercise of warrant = 10
The warrant's price of 700p is therefore made up of 500p formula value and 200p
premium value.
Percent premium
Often the premium value is expressed as a percentage of the current share price.
The PERCENT PREMIUM may be calculated as follows:
700p - 500p
=
10 × 250p
200p
=
2500p
= 0.08 or 8%
4 Covered warrants
Covered warrants: background
Covered warrants are warrants in a company's shares issued by an organisation
other than the company itself. They are referred to by the FSA as 'securitised
derivatives'.
Investment banks usually issue covered warrants. Issuers 'cover' their issues by
either shares in the company or warrants issued by the company.
Debt: types and features CHAPTER 6
Chapter 6
You will also learn about bonds issued by overseas governments. The chapter
provides details of the names of these bonds, how often they are issued and when
they pay interest to the bondholder.
Once government bonds have been considered, the chapter turns its attention to
the range of corporate bonds in the marketplace and the various features that are
often attached to these instruments.
Debt: types and features CHAPTER 6
Index-linked gilts
Index-linked bonds have coupons AND redemption values which are linked to the
UK General Index of Retail Prices (RPI).
Each index-linked payment, either of interest or capital, is related to the RPI eight
months PRIOR to the month of payment. Values are adjusted by the ratio of this
RPI to the BASE RPI, which is the RPI eight months prior to issue.
The eight month RPI lag allows an investor to know in advance what the next
coupon payment will be rather than have to wait until the RPI figure is published for
the payment month.
Note that for index-linked gilts issued after 23rd September 2005 the RPI lag will be
3 MONTHS. For those in existence that were issued before this date the time lag
remains at 8 months.
Example
Consider 2 gilts, each with a 12 % coupon (issued prior to 23/09/05). One is
non-index-linked; it will pay £6 interest per £100 nominal every 6 months with
no adjustment for inflation:
6 months
During a period of non-inflation, the gilt will payout the unadjusted semi-annual
coupon.
Sinking funds - enable the issuer to repay a part of the nominal value each year
prior to redemption.
Convertibility - where the bond can be converted into a certain number of equities,
often seen as a low risk way of gaining exposure to an equity price increase.
The London Stock Exchange limit the use of the term debenture to refer to
SECURED debt instruments.
Debt can be secured in one of two ways; by a floating charge or fixed charge.
A fixed charge is security over a certain specific company asset, e.g. a building or
land. A mortgage charge is a type of fixed charge.
A floating charge is security over a class of assets, e.g. plant and machinery,
fixtures and fittings, trade debtors.
Should the company default on its interest and/or capital repayments, the secured
assets are sold off in order to repay the debts of the company.
Both fixed and floating charges should be registered with the company in order to
be valid.
Loan stock
The term LOAN STOCK refers to UNSECURED corporate debt securities. Lenders
have no legal charge over any of the company's assets.
However, in order to make these debt instruments more attractive to the investor,
they can take the following forms:
Subordinated - investors receive a higher return on the stock, but also take on the
added risk of being paid back after all other creditors.
Guaranteed - the loan stock, although not secured by the assets of the company, is
guaranteed, usually by a parent company. In the case of default, the parent
guarantees payment of interest and capital.
Floating rate - where the coupon floats in line with an interest rate benchmark.
Convertible - a bond that can be converted into an ordinary bond. These are
discussed in more detail later.
CORPORATE BONDS
Impact of security
Background
The impact of security is significant when a company becomes insolvent or is
wound up. The Insolvency Act 1986 defines a strict order of repayment of company
debts in liquidation.
All classes of debt rank more highly than equity, i.e. debt is paid back before equity.
However, not all types of debt are equal. Some are SENIOR (take priority), while
others are SUBORDINATE.
Mezzanine finance
Mezzanine capital (or mezzanine debt) is a broad financial term that refers to
unsecured, high-yield, subordinated debt or preferred stock that represents a claim
on a company’s assets, that is senior only to that of a company’s shareholders.
In the Financial Times, they are identifiable by the abbreviation 'Conv' in the title,
e.g. Conv 9% 2009.
Floating rate gilts
Floating rate gilts are unusual in that they pay variable coupons. The coupon is set
by reference to the London Inter-bank Bid Rate (LIBID) at the beginning of each
interest payment period. (LIBOR - x% may also be used as a reference rate).
They are also unusual in that they pay interest four times a year instead of semi-
annually.
They tend to trade at around their par (nominal) value.
The strips market
STRIPS stands for Separate Trading of Registered Interest and Principal of
Securities.
These gilts can be stripped into their constituent cash flows, i.e. coupons and a
redemption amount, and traded separately. These individual strips are registered
securities.
For example, a five year gilt is strippable into ten semi-annual coupons and a final
capital payment (11 separate cash flows). If the cash flows are separated out, this
equates to eleven individual zero coupon securities, with maturities of 6, 12, 18
months and so on to maturity.
The coupons are redeemed semi-annually on 7 June and 7 December.
The process of stripping is carried out by special firms called GEMMs, although HM
Treasury and the Bank of England are also permitted to strip gilts.
In the UK, local authorities borrow money in the same way as the central
government: by issuing debt securities.
There are three types of local authority loans, and their key features are as follows:
For example, if a company was to make a 1:1 scrip issue and protected convertible
bonds had a conversion ratio of 50 shares, the conversion ratio would double to
100 shares.
Exchangeable bonds
Exchangeable bonds are typically available in three to six year maturities.
Foreign bonds
A foreign bond is one in which the nationality of the issuer is different to that of the
denomination of the bond and the country of issue. For example, a sterling bond
issued in London by a US company.
Foreign bonds are known as BULLDOGS in the UK, YANKEES in the US,
MATADORS in Spain and SAMURAI in Japan.
Commonly, Eurobonds are issued in the currency and country where the issuer
finds it cheapest to raise the finance, and then swapped into the currency the issuer
wants.
Eurobonds are BEARER bonds, i.e. anonymous, freely transferable securities. Due
to the risks of holding bearer documents many Eurobonds are kept in safe
depositaries such as Euroclear or Clearstream.
Interest is usually paid on Eurobond issues (fixed or floating) ONCE per year, and
all coupons are paid gross of tax.
Chapter 7
Issuing debt
Time Allocation: 0.5hr
Approx Question Weight: 4-6
We begin by describing the process used by the UK government to issue gilts into
the primary market. The most common form of issuance method is via an auction
process. As you will see, institutional investors tend to buy gilts through a
competitive auction which is managed by the DEBT MANAGEMENT OFFICE
(DMO). Private investors may also buy gilts through a non-competitive process, or
via the post office.
The chapter takes you through the process by which corporate bonds and
Eurobonds are issued.
Learning outcomes
On completion of this module, you will:
Tranches
When demand is particularly strong for an existing gilt, the DMO will commonly
issue a further block. This additional block is known as a TRANCHE and is denoted
in the Financial Times by an A marking.
If the tranche is offered between coupon dates then the gilt will usually be issued at
the dirty price to compensate for the accrued interest. This is referred to as FULLY
FUNGIBLE STOCK.
Ireland, Sweden, Portugal and New Zealand follow the UK system and have a Debt
Management Office issuing bonds on behalf of the government.
In the US, Germany and France, bonds are issued directly by the Central Bank. The
Ministry of Finance is responsible for the issue of government bonds in the
Netherlands and Japan.
Standard practice when pricing new issues is by reference to a yield margin over
that of a specified gilt. This allows investors to examine the terms of an issue on a
comparative basis against gilts as soon as the issue is announced.
A potential issuer of a bond can send a Request for Quote (RFQ) to the potential
underwriter of the issuer. This will be in the form of a series of questions to evaluate
how suitable the underwriting firm is .The questions may relate to how the bond
issue will specifically be marketed, the plan of finance and the estimated costs
associated with the issue.
For smaller issues (under £50 million), bonds may be placed on a fixed price basis,
without going through the yield process.
Payment for new issues is usually required within a few days of the placing.
The notes are usually issued with a medium term note programme (or scheduled
funding programme), which is a funding programme used by issuers to receive
bond debt funding on a regular basis. Most large companies have established
these to finance their medium term financing needs and to be able to take
advantage of advantages market conditions (opportunistic issuance).
Reverse inquiry
An investor may wish to buy a bond that pays a particular coupon rate and has a
particular redemption date, from a particular issuer. Such a bond may not exist in
the markets. However the investor may be able to obtain it in the medium term note
market through a reverse inquiry.
In this process, the investor relays the inquiry to the issuer of medium term notes
via the issuer’s agent. If the issuer finds the terms of the reverse inquiry attractive, it
may agree to the issue of a new medium term note.
Origination team
For larger bond issues or when the bond is going to be listed, investment banks will
form an origination team including legal advisors, accountants and public relations
advisors. The team will advise their clients on debt financing strategies, including
structuring, marketing and pricing.
The stages of a typical bond issue include some or all of the following:
Pitching. The bond issuer selects an investment bank(s) based on a number of
criteria including a pitch – a presentation made by the bank(s) to the issuer.
Indicative bid. An indication given by the investment bank to the issuer regarding
amount of financing available given the terms of the bond issue.
Mandate announcement. The announcement of the bank(s) that have been given
the mandate to manage the bond issue on behalf of the issuer.
Credit rating. The investment bank will try to obtain a favourable credit rating for the
planned bond issue from a credit rating agency. The ability to raise finance as well
as the interest rate which investors require depends on the credit rating of the bond.
Syndication. Depending on the size of the issue, there might be a number of banks
involved in the sale of the bonds. This group of banks is call a syndicate. The lead-
manager together with the co-managers will sell the issue to their respective clients.
Eurobonds: issue
Eurobonds are usually issued simultaneously in more than one country at a time.
Once the issuer has appointed an investment bank to be the lead manager of the
issue (awarded the mandate) the lead manager will arrange roadshows, prepare
the prospectus and may assemble a syndicate of other banks and issuing houses
to share in the underwriting and distribution of the issue.
If issues are then made under the FIXED PRICE RE-OFFER system, all firms in the
syndicate undertake to offer the new bonds to potential investors at the same price
for a given period of time. Once the lead manager notifies the syndicate members
that the syndicate is broken, they can price the bonds as they wish as dictated by
demand and supply.
The fixed price re-offer system gives all investors an equal opportunity to buy bonds
at a common price.
If the issue is a BOUGHT DEAL, the lead manager (Broker) agrees detailed terms
(e.g. the coupon and maturity) with the issuer and then places the entire deal
themselves without forming a syndicate.
Municipal bonds
Sub-sovereign, provincial, state or local authorities (municipalities) issue bonds. In
the US, state and local government bonds are known as municipal bonds.
Agency bonds
Some government sponsored entities also issue bonds. In the US, examples
include the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal
National Mortgage Association (Fannie Mae) and the Federal Home Loan Banks.
These bonds are known as agency bonds.
Debt valuation CHAPTER 8
Understand the relationship between flat yield, gross redemption yield and coupon.
Yield curves
Be able to give reasons for different shaped yield curves.
Investors can then make comparisons with other investments and decide which
best suits their investment objectives.
Flat yield
Rationale
The flat yield (also known as SIMPLE yield, INCOME yield, INTEREST yield or
RUNNING yield) quantifies the return based on the gross coupon income.
It quantifies the gross return the coupon represents as a proportion of market price.
The flat yield is expressed as a percentage return and ignores the impact of
taxation.
Debt valuation CHAPTER 8
Example
Example
An investor (who is a higher rate taxpayer) purchases an 8-year 7% coupon
bond at a market price of £95.00 (per £100 nominal). The net redemption
yield is calculated as follows:
£7 60
FLAT YIELD (coupon income) × 100% = 4.4%
£95 100
+ +
(£5 Profit
8 years )
PROFIT (OR LOSS) AT REDEMPTION × 100 % = 0.7 %
£95
Comments
The only difference between the GRY and NRY is the tax adjustment made to the
flat yield.
It therefore follows that if the cash flows and GRY are known, then they can be used
to calculate the price.
The process by which this is possible is known as 'discounting'. Future cash flows
are discounted back to their present value, which is the price that an investor would
be prepared to pay for the bond today.
Example
A bond with a nominal value of £100 has an annual coupon of 6.5% and two years
to redemption. If prevailing interest rates are 4.5% per annum, the present value of
the income from the bond (interest and capital) would be calculated as follows:
Example
The value of a 2-year 6.5% coupon bond using 4.5% interest rates:
£6.50 £106.50
= +
(1 + 0.045) (1 + 0.045) 2
= £103.74
Debt valuation CHAPTER 8
Spread analysis
Spread analysis is often used to determine the RELATIVE value of a debt
instrument.
The spread is the difference between the yield achieved by, say, a corporate bond,
compared to the yield achieve by a benchmark instrument, for instance, gilt-edged
securities. Spreads can be above or below the benchmark.
Spreads are also often calculated against LIBOR - the London Inter-bank Offered
Rate and against swap rates. Spreads are typically expressed in basis points (one
basis point = 0.01%)
Example
Jazzy plc has recently issued 10 year AAA rated bonds with a current spread over
10 year government securities of 20 basis points. 10 year government securities
are currently yielding 5.30%, LIBOR is currently 5.80% and the10 year swap rate is
5.45%.
Given the above, Jazzy's bonds are currently yielding 5.3% (the yield on
government securities) + 0.20% (the spread over government securities) = 5.5%%.
Therefore the current spread against LIBOR is equal to the difference between
5.5% and 5.80% (i.e. 30 basis points below LIBOR) and the swap spread is 5 basis
points over swap rates.
LIBOR
-30bp
5.8%
10yr swap
+5
5.45%
10yr Gilt
+20bp
5.3%
However, when buying a bond, an investor not only pays the 'true' (CLEAN) price of
the bond, but also the interest that has accrued to date. This price paid for the bond
is called the DIRTY price.
The difference between the clean and dirty price is accrued interest.
Like equities, bonds have ex-coupon dates which determine who will receive the
next coupon. Ex-div and cum-div trading periods are also based on the same
principles.
Debt valuation CHAPTER 8
The dirty price will EQUAL the clean price on the coupon payment date.
Summary
During the cum coupon period, the dirty price exceeds the clean price.
On the ex coupon date, the dirty price drops below the clean price.
During the ex coupon period, the dirty price is less than the clean price.
On the coupon payment date, the dirty and clean prices are equal.
We saw above that the dirty price is the clean price plus accrued interest. We have
been given the clean price, £107, we now need to calculated the accrued interest.
In the UK, accrued interest is calculated on an actual over actual basis. That is, we
create the proportion of the coupon that the seller is entitled to by dividing the
actual number of days the bond was held by the actual number of days in the
coupon period.
Calculation
Number of days held:
31 + 28 + 24 = 83 days
NOTE: we assume it is not a leap year and we include the trade date.
31 + 28 + 31 + 30 + 31 + 30 = 181 days
83 x £3 = £1.38
181
The dirty price is, therefore, the clean price, £107, plus the accrued interest,
£1.38.
Because the coupon is generally fixed, the price investors are willing to pay for the
bond will fall (and therefore the yield on the bond will rise).
PRICE
£100
(nominal value)
TIME
0
Redemption date
As the remaining life of a bond decreases, the price tends towards nominal value.
This is because on maturity, when the bond is redeemed at £100 (per £100 nominal
value), the value of the bond would also be £100 (per £100 nominal value).
Bonds with low coupons are more risky for an investor compared to high coupon
bonds because the annual return, the coupon payment, is smaller. The return is
therefore achieved over a longer period of time than with a high coupon bond,
exposing the holder to interest rate movements for a longer period.
The bigger the risk investors take, the more they will want to be compensated by
higher returns. Consequently, the volatility of the bond's price increases.
The bond future market is much more liquid than the bond market. This means it
tends to react to market conditions more quickly. As the future represents an
agreement to buy to physical bond, the bonds will follow suit. If it did not, arbitrage
opportunities would soon correct the difference in prices.
To determine the risk of a low coupon, short dated bond compared to a high
coupon, long dated bond, a measure called MODIFIED DURATION is useful.
Modified duration
Modified duration measures how much a gilt price changes given a 1% movement
in interest rates (or GRY). It is therefore a measure of VOLATILITY.
There is an inverse relationship between interest rates and gilts prices. If interest
rates increase, gilt prices will decrease and vice versa. Modified duration measures
the % change in a bond's price for a % change in interest rates.
Bonds with HIGHER modified durations will be MORE volatile than bonds with lower
modified durations.
Example
Take a bond with a current price of £96, GRY of 8% and a modified duration of 4.05.
If the bond's GRY increased by 0.1% (to 8.1%), the resultant price change can be
calculated as follows:
Example
The formula for calculating the price change of a bond given its modifeid
duration is:
Δ P = - MD × Δ r × P
Where
Δ P is the change in the bond' s price
- MD is the bond' s modified duration
Δ r is the change in interest rates (or the bond' s yield)
P is the bond' s current price
Inserting the numbers from the example above using a bond with a value
of £96.00:
= ( - 4.05 ) x 0.001 x 96.00
(Notice that a negative value of the bond’s modified duration is
used this is to account for the negative price/yield relationship)
= - 0.3888 or - 0.39
The bond’s price would FALL by £0.39, giving a new price of £95.61
Debt valuation CHAPTER 8
Convexity
Modified duration does not do a perfect job of predicting the change in price
resulting from a change in yield. It over estimates price falls and under estimates
price rises WHEN THE CHANGE IN YIELD IS LARGE.
This margin of error is due to the curved, or non-linear, nature of the price yield
relationship. The degree of curvature is referred to as the bond's CONVEXITY.
Price vs yield
140
120
20
0 yield
0 1 2 3 4 5 6 7
Credit ratings
Credit rating agencies, such as Standard and Poor's and Moody's, place a rating on
each bond; in assessing the bond, they are determining how likely it is that the
issuer will be pay able to pay the interest and to repay the principal.
A Standard and Poor's rating of AAA, AA, A or BBB indicates an investment grade
bond; other bonds are regarded as 'speculative' (or non-investment grade).
A Moody's rating of Aaa, Aa, A or Baa indicates an investment grade bond; other
bonds are regarded as 'speculative' (or non-investment grade). A rating of D
indicates a bond IN DEFAULT.
Debt valuation CHAPTER 8
AAA Aaa
AA Aa
Investment grade
A A
BBB Baa
BB Ba
B B
Speculative grade
CCC Caa
CC Ca
C C
D D
If a bond is downgraded, this will have a negative impact on price (and a positive
impact on yield). The most marked impact on price will be if a bond is downgraded
from investment grade to non-investment grade. The opposite is true if a bond is
upgraded.
Credit enhancements
To protect an investor from downgrades on bonds falling into default, some issuers
can offer credit enhancements.
Credit insurance
4 Yield curves
Yield curves: background
The yield offered by bonds varies according to their maturity dates.
The yield curve (or ‘term structure of interest rates’) illustrates the relationship
between maturity dates and yields.
The yield curve for a particular bond market is the result of plotting the yields
offered on varying bonds against the maturities of those bonds.
Debt valuation CHAPTER 8
Yield
Yield
Yield
Maturity Maturity Maturity
There are three theories that attempt to justify the shape of the yield curve. Each of
these is outlined below:
Liquidity preference theory - This only explains upward or normal yield curves. It is
based on the assumption that longer dated bonds are more risky than near dated
bonds. For this reason investors will require a higher rate of interest for a longer
loan.
Market segmentation theory - The premise here is that the market is made up of
many different components. Each component is a market in its own right with its
own supply and demand forces. The yield curve's overall shape is the sum of the
different conditions in each segment.
Pure expectations theory - This states that 'the long term rate is a geometric
average of expected future short term rates'. In other words if the market thinks
short term rates are going to increase long term rates will be high. Alternatively, if
the view is that short term rates will fall, longer dated yields will come down.
The relationship between flat yield, gross redemption yield and coupon.
Yield curves
The reasons for different shaped yield curves.
Now you have finished this chapter you should attempt the chapter
questions.
Debt markets CHAPTER 9
Chapter 9
Debt markets
Time Allocation: 1 hr
Approx Question Weight: 7-8
The chapter then highlights the operation of the UK corporate bond market, as well
as the world’s main international debt markets including Japan, the US, Germany,
France and Italy.
Finally, the chapter finishes by taking you through the settlement procedures and
deadlines for the various bond markets discussed in the chapter.
Note: the market in corporate bonds is often referred to as the CREDIT market.
Learning outcomes
On completion of this module, you will:
Eurobonds: trading
Understand the method of trading for Eurobonds.
Broker dealers
Broker dealers are LSE member firms who can trade gilts on behalf of clients (as
agents) and/or on their own account (as principal). They have dual capacity.
Broker dealers acting in the gilt market act in the same way as broker dealers in the
equity market.
IDBs settle as principal, i.e. the parties dealing via the IDB are unaware of each
other's identity. They cannot take positions in anticipation of finding other parties
requiring their services.
GILTS GILTS
Pension
S.B.L.I
Fund
After the market maker has sold the gilts ‘short’, it will borrow stock via an
SBLI so that it can settle its position with the investor.
SBLIs perform the same function in debt markets as they do in equity markets,
namely facilitating stock lending.
The LSE provides an orderly market place for the trading of gilt-edged and fixed
interest securities. It ensures order through rules and guidance, and the monitoring
of trading and market activity. The Mandatory quote period on LSE is 8:30am to
4:30pm, and reports should be made within 3 minutes.
E-trading systems
Over the counter (OTC) inter-dealer voice trading e.g. direct dealer to dealer or
indirect dealer to dealer via voice broker;
£900
2. The repurchase:
GILT
£1,000
The difference between the sale and repurchase price
(£1,000 - £900 = £100) is the ‘repo rate’. It is, in effect, the interest
paid for borrowing money.
Gilt repo transactions are subject to a formal legal agreement. The market standard
for this agreement is contained in the Code of Best Practice for repo agreements,
which is maintained and reviewed by the Stock Lending and Repo Committee. The
Code represents best market practice in the repo market. The documentation
required as part of a repo is a TBMA/ICMA Global Master Repurchase Agreement
(GMRA).
An OPEN REPO is where there is no fixed time for repurchase. Maturity dates in
excess of overnight are known as TERM REPOs.
Gilt repos are used for a variety of reasons. Repos may be used as a method of
borrowing funds and using gilts as collateral, or a GEMM may need to cover a short
position taken on in the course of its market making activities.
All market participants can enter into gilt repos, e.g. GEMMs, Broker Dealers, IDBs
and SBLIs.
TRIPARTITE repos are transactions involving cash and bonds being deposited with
an independent custodian who will be responsible for the maintenance of adequate
collateral value. This process is also known as rehypothecation.
Debt markets CHAPTER 9
Market makers in the corporate debt market are essentially the same as GEMMs;
however, unlike GEMMS, they DO make use of SEAQ. Both firm and indicative
prices may be available on the SEAQ screen during the mandatory quote period.
However, there is also a decentralised dealer market where dealers make a market
amongst themselves, creating pools of liquidity rather than having a centralised
exchange. This creates an extra liquidity risk to the price of these bonds.
Corporate bonds can also have a maturity date much longer than is found in gilts.
Bonds with maturities of up to 100 years are not uncommon.
Prices quoted on SEAQ are either FIRM or INDICATIVE. Prices for trade sizes
greater than £1,000 nominal are firm. Market makers may only enter indicative
prices for trades of £1,000 nominal or less. Where a firm price is displayed, the
market maker must be prepared to deal at that price up to the quoted size with any
enquiring member firm.
Market makers may display different prices for different sizes of trade. Trades on
LSE are reported as usual within 3 minutes.
Often a party wanting to execute OTC deals in debt securities with either high yield,
high volatility or of large size calls a dealer with a ‘request for quote’ (RFQ). This
method is common for:
High yield securities
Asset-backed securities
Registered
Legal form Bearer Bearer Bearer Registered
or bearer
Euroclear
Stanza
Euroclear Clearstream/
di
Settlement DBC Federal Tokyo Stock
Clearstream Compen
agency Frankfurt Reserve Exchange
Relit sazio ne
Kassenvvere de Titoli
ine
5 Eurobonds: trading
Eurobonds: trading
Most trading in the Eurobond market is conducted over the counter (OTC) via the
telephone rather than on domestic exchanges.
It is a quote driven market in which major international banks (about 10) are the
only participants. It is not a market in which private investors or corporates act
directly. Even large companies and investment funds use banks to access the FX
markets.
Each of the major banks acts as a market maker by making two-way prices on
demand to any of the others.
There are two components to the FX market, the SPOT market, which is the largest,
and the FORWARD market. Most deals are carried out for speculative purposes.
The FX market is the market for the USD against the rest of the world’s currencies.
The USD is the central focus of the FX markets.
All currencies have their value expressed against the USD and, to determine the
value of one currency against another, we use two dollar rates to calculate a
CROSS RATE.
Cable is 10 / 15
Different countries have different public holidays; therefore a good day in one
currency is not guaranteed to be a good day for another.
It is also possible to deal pre-spot (e.g. T0 or T+1); however the time difference
must be considered. For instance you cannot do a deal for T0 settlement in
sterling/yen if it is noon in London, because Tokyo’s business day would have
already finished.
A forward forward with a purchase in 2 months time and a sale in 5 months time
would be referred to as a 2s versus 5s or 2 x 5 forward forward. Here the dealer is,
in effect, borrowing the currency for a 3 month period starting in 2 months time.
Forward FX rates
Adjustments to the spot rate
In order to agree a forward FX deal, the spot rate needs to be adjusted. This
adjustment can either be positive or negative.
Discounts
If the adjustment is positive, pips are added on, and the forward rate is known as a
DISCOUNT.
Foreign exchange CHAPTER 10
Example
A bank quotes a spot rate of 1.5020 and a forward adjustment of +15 pips
(i.e. a 15 pip DISCOUNT). The forward rate is calculated as follows:
Premiums
Alternatively the adjustment could be negative; pips are subtracted from the spot
rate. This is known as a PREMIUM.
The premium arises because the dollars are more expensive forward than the spot.
Example
A bank quotes a spot rate of 1.5020 and a forward adjustment of -10 pips
(i.e. a 10 pip PREMIUM). The forward rate is calculated as follows:
Par
It is also possible to have a situation where no adjustment is necessary. In this
instance the forward rate is said to be at PAR.
FX settlement
Gross FX settlement and Herstatt risk
For many years foreign exchange deals have been settled on a gross basis rather
than a net basis.
Under gross settlement the entire value of each deal is paid to the other party. This
means that for any given settlement day a bank may be paying currency to a
counterparty in respect of one deal and receiving the same currency from the same
counterparty in respect of another deal.
Gross settlement means that an enormous amount of money is at risk during the
settlement process. It also means that banks are exposed to Herstatt risk.
Foreign exchange CHAPTER 10
HERSTATT RISK (so called after the bank that was involved in the first recorded
incident in 1974) is the risk that a foreign exchange bank pays all of its FX
obligations to a counterparty and fails to receive a payment in return. It is also
known as SETTLEMENT RISK.
Users
The CLS process involves the following different parties:
Settlement members
CLS Bank is owned by nearly 70 of the world's largest financial groups throughout
the US, Europe and Asia Pacific. Between them, CLS shareholders are responsible
for more than half the value transferred in the world's FX market. Five CLS
shareholders alone represent over 44% of the market.
User members
User members can submit settlement instructions for themselves and their
customers. However, they DO NOT have an account with CLS Bank and have to be
sponsored by a settlement member who acts on their behalf.
Third parties
Third parties are customers of settlement and user members and have no direct
access to CLS. Settlement or user members must handle all their instructions and
financial flows.
Benefits to treasurers
The benefits of CLS to treasury and cash managers are as follows:
More certainty about end-of-day cash positions.
The volume and overall value of payments is reduced, which in turn reduces cash-
clearing costs
Payments to and from CLS Bank are made through the Bank of England in the UK.
Payments are processed individually during the day in the RTGS (real time gross
settlement system). Payments involving UK clearing banks are made through the
Clearing House Automated Payment System (CHAPS).
With the advent of the Euro in 1999 a real time cross border system was
implemented to promote efficient payment mechanisms across the EU. This linked
Euro RTGS systems in all the EU central banks with each other and the European
Central Bank to create the TARGET system.
Now you have finished this chapter you should attempt the chapter
questions.
Regulation CHAPTER 12
CRD
Know the impact of CRD on securities firms’ trading books
Know that foreign broker-dealers must be registered with the local regulator
Ensure cost effective execution venues are available across the EEA
Norway
Iceland
Liechtenstein
Client Categorisation
Retail clients
A retail client is a client who is not a professional client or an eligible counterparty.
Regulation CHAPTER 12
These clients receive the most protection from the regulatory environment.
Professional clients
Professional clients are entities required to be authorised or regulated to operate in
the financial markets. They have the knowledge, experience and expertise to
assess the risks when making investment decisions and include financial services
firms as well as governments.
In addition, companies meeting two of the following size requirements are classified
as professional clients:
Balance sheet total of €20m;
Eligible counterparties
Eligible counterparties are the most sophisticated investors or market participants
including financial services firms and governments. A client can only be an eligible
counterparty in relation to eligible counterparty business.
Eligible counterparties receive the least protection from the regulatory environment.
Commodity derivatives
Credit derivatives
The characteristics of financial instruments that are the subject of that order;
The characteristics of the execution venues to which the order can be dissected.
For the purposes of this rule, execution venue means a regulated market, an MTF,
or a market maker or other liquidity provider.
Role of price
In the case of a retail client, the best possible result must be determined in terms of
the total consideration, representing the price of the financial instrument and the
costs related to execution.
The costs related to execution must include all expenses incurred by the client
which are directly related to the execution of the order, including execution venue
fees, clearing and settlement fees and any other fees paid to third parties involved
in the execution of the order.
Pre-trade disclosure
This refers to information displayed by execution venues to investors.
If the execution venue is an order book, the best five prices for both buying and
selling orders with trading volumes must be displayed.
Post-trade disclosure
For the first time, all firms will be required to publish their completed transactions as
soon as possible after completion, whether they are conducted on a regulated
market, MTF or other market. The publication may be subject to a delay,
dependent on the size of the trade.
Disclosure venues
Historically, the disclosure venues have been the exchanges on which the
transactions have occurred. However, with the advent of MiFID, transactions off
exchange also need to be reported, creating opportunities for the creation of new
disclosure venues.
Exchanges continue to be the obvious choice for disclosure, due to the systems
being already in place.
Secondary information providers have created services in this field, such as
Reuters' X-system.
The FSA has granted various organisations with Approved Reporting Mechanism
(ARM) status, including:
CREST
TRS
TRAX 2
Euroclear UK and Ireland
Financial Services Authority
International Capital Association
On 1 January 2007, the Capital Requirements Directive (CRD) came into force. The
CRD rules require that investment firms and credit institutions (banks) maintain
financial recourses in excess of their financial resources requirement. It is a major
piece of legislation that introduces a modern prudential framework relating capital
levels more closely to risks. The CRD offers some flexibility when it comes to the
methods used by firms to measure the risks resulting from their trading books. As
long as the FSA approves it, firms can calculate risks using their own
methodologies. Nevertheless, they have to quantify risks on an ongoing basis and
include all exchange-traded and over-the-counter positions.
Company accounts CHAPTER 13
Chapter 13
Company accounts
Time Allocation: 2.5hr
Approx Question Weight: 6-8
1 Financial statements
Chapter overview
There is a legal requirement for companies to prepare financial statements or
‘accounts’. Accounts summarise the results of transactions entered into by a
company during a defined period of time (the ‘period of account’). Accounts have
many users, including investors, who use them to assess the company’s financial
position.
This chapter takes you through the three major financial statements that a company
is required to prepare:
The BALANCE SHEET: a snapshot of the company’s assets and liabilities at the
end of the accounting period.
The INCOME STATEMENT: shows all the income and expenditure relating to a
companies accounting period.
The CASH FLOW STATEMENT: shows the cash received and cash paid by the
company during the accounting period.
This chapter summarises the main elements of these statements, including the
legislation and the rules governing their preparation. Although you will be expected
to know the laws and rules, you will not be tested on the section numbers
themselves.
The chapter finishes with a short section on group account, which explains terms
such as ‘parent’, ‘subsidiary’ and ‘minority interests’.
Company accounts CHAPTER 13
Learning outcomes
On completion of this module, you will:
Know when and how the UK Listing Rules affect the preparation of accounts.
Balance sheet
Know the format of a UK balance sheet.
Income statement
Know the format of a UK income statement.
Group accounts
Understand the concept of a group of companies.
Know the meaning of the terms parent company, subsidiary company and
minority interest.
There are three main financial statements; the profit and loss account, balance
sheet and cash flow statement.
Company accounts CHAPTER 13
Balance sheet
The balance sheet is a 'snap-shot' of a company taken on the last day of the
accounting period (also known as the YEAR END or BALANCE SHEET DATE). The
balance sheet lists the assets and liabilities of a company, and provides a picture of
the company's financial health at the year end.
If, at the year end, assets exceed liabilities, then the company has net assets. If the
reverse is true, the company has net liabilities.
Income statement
The income statement shows all the income and expenditure relating to a
company's period of account, usually lasting one year. It summarises income and
expenditure for the whole 12 month period.
If income for a given period of account exceeds expenditure, a profit is made. If the
reverse is true, a company will be loss-making.
The auditors will review the accounts. If they are satisfied they state that, in their
opinion, the accounts show a true and fair view, and that they have been prepared
in accordance with relevant accounting standards.
The Companies Act also prescribes the basic formats and disclosures for the
income statement and balance sheet.
Accounting standards
Background
The UK accounting profession, the Government and the London Stock Exchange
have together formed the Financial Reporting Council (FRC) to:
Company accounts CHAPTER 13
Accounting standards are the detailed rules which govern the preparation of
accounts. They provide detail to the basic principles given by the Companies Act.
Further guidance is produced in the form of Abstracts by the Urgent Issues Task
Force (UITF), a subsidiary of the ASB. They are not proper standards but provide
guidance in areas where no current guidance exists.
Accounting standards and UITFs are not legally binding in themselves, and so do
not have the same statutory status as the Companies Act. However, they are
effectively mandatory, in that compliance with them is required to give a true and
fair view (a statutory requirement).
There are two types of accounting standard in the UK: Statements of Standard
Accounting Practice (SSAPs) and Financial Reporting Standards (FRSs). Each
FRS or SSAP is accompanied by a distinguishing number. Some important ones
are discussed below.
FRS 3 also requires exceptional items (that is, particularly large or unusual items of
income or expenditure) to be highlighted and disclosed separately.
Relevance.
Reliability.
Comparability.
Understandability.
FRS 18 also sets out two of the five accounting principles (accruals and prudence)
as the most important principles of accounting.
Company accounts CHAPTER 13
Accounts: summary
CA 2006 ASB (FRS 3) IASB (IAS7)
(Requirement and format) (Format) (Requirement and format)
4 Balance sheet
Balance sheet: introduction
The balance sheet is a list of the assets and liabilities of a company at its year-end.
This is important and a new fact.
It breaks down into two distinct halves; the top half reflects the total net assets
owned by the company. The bottom half reflects SHAREHOLDERS FUNDS, i.e.
amounts paid in (or left in) by shareholders.
The total net assets of a company (the top half) always equal shareholders' funds
(the bottom half), i.e. the balance sheet balances.
Note that net asset value per share (NAV/share) can be calculated from the
balance sheet as follows:
Turnover
Turnover consists of sales the company has made. It represents the income
generated by a company from selling its products or services. Both cash and credit
sales are included.
Where companies undertake long-term contracts which span more than one
accounting period, e.g. construction of major assets like roads or bridges, it may be
appropriate to apportion revenues, costs and profits over the life of the projects and
recognise a proportion in each of the accounting periods affected.
Cost of sales does not include the general costs of running a business. These costs
are known as INDIRECT OVERHEADS. Examples of these indirect overheads
might include rent of buildings, heat, light, power and telephone costs, which are
categorised as OPERATING COSTS in the income statement.
OPERATING COSTS
Operating profit
Turnover less the costs of producing the product and running the business gives
operating profit. This is the profit from trading.
Other ways of referring to operating profit are PROFIT BEFORE INTEREST AND
TAX (PBIT) or EARNINGS BEFORE INTEREST AND TAX (EBIT).
Exceptionals
Unusually large items of income or expense may need to be highlighted in the
income statement to assist the reader in determining profit from normal operations.
Material items,
Company accounts CHAPTER 13
Deriving from events or transactions falling within the ordinary activities of the
company,
Examples might include the costs of a redundancy programme, unusually large bad
debts, settlement of a law suit or sizeable profit on the disposal of a fixed asset.
Extraordinary items
Like exceptional items, these are material items but they fall OUTSIDE the ordinary
activities of the company and are not expected to recur.
As a result, the occurrence of such items is extremely rare, but where found they
require separate disclosure in the income statement.
Corporation tax is paid out of operating profit less interest. The amount charged in
the income statement is not necessarily the same as the amount paid in the year as
the income statement amount is calculated on an accruals basis.
Dividends
If a company has profit remaining after the payment of interest and tax, it can
reward shareholders by paying out dividends.
If a company has preference and ordinary shares, both types of dividend will be
included in this line.
Retained profit
Any profit remaining after ALL payments have been made is retained by the
business.
The retained profit is added to the profit and loss reserve in the balance sheet.
Discontinued operations are parts of the business which have closed during the
year.
Ratio analysis CHAPTER 14
Chapter 14
Ratio analysis
Time Allocation: 2.5hr
Approx Question Weight: 4-6
This chapter takes you through some of the most commonly used ratios.
You will cover both calculation and interpretation, giving you the basic tools for
investment analysis and corporate comparisons.
Learning outcomes
On completion of this module, you will:
Investors' ratios
Know how to calculate EPS and understand the concept of diluted EPS.
Know how to calculate dividend yield and understand what is meant by a net
dividend.
Chapter 15
Investment planning
Time Allocation: 1hr
Approx Question Weight: 4-5
You will see the different factors an investor may take into account when selecting
investments, such as attitude to RISK (generally the greater the risk taken, the
greater the potential return), DIVERSIFICATION (reducing risk by investing in
different asset classes, different securities and different sectors), and HEDGING
(using futures and options to manage risk).
Learning outcomes
On completion of this module, you will:
Know the meaning of diversification and hedging and the associated benefits of
their use.
Understand how different clients are likely to have different preferences for risk,
liquidity and income or capital returns.
Gilts and sterling corporate bonds are exempt from capital gains tax.
Investors can make use of the tax exemptions given by the ISA wrapper (£7,000 in
the current tax year).
Money market funds (invest at least 95% of the fund in money market instruments,
e.g. CDs, bank deposits, FRNs, T-bills).
Low risk
Life assurance products.
Company loan stocks / debentures (less risky if secured on the assets of the
company).
Moderate risk
Investment trusts.
Permanent interest bearing shares (PIBS). PIBS are irredeemable debt issued by
building societies. They are not protected under the depositor's protection scheme if
the issuer goes bust.
Listed equities (Ordinary Shares are riskier than Preference Shares; the very cheap
PENNY SHARES have the greatest degree of risk).
High risk
Buying warrants.
Summary
RETURN
High
Warrants
Equities
Corporate bonds
Government bonds
Bank Accounts
Low RISK
Low High
Pension funds
Pension funds are exempt from taxation, therefore tax considerations play little part
in their investment policy.
The liabilities of pension funds are generally long term and, as a result, are
prepared to be exposed to a higher degree of risk. Managers will seek to invest the
funds in long term, more speculative assets such as equities and property. Such
investments are referred to as REAL ASSETS since they offer a degree of
protection against inflation.
The liabilities of life assurance companies are generally long term and uncertain.
Managers will seek to invest the funds in long term assets (HIGHER DURATION
stocks), such as equities and gilts. Uncertainty can be reduced by immunisation.
Companies Act 2006 CHAPTER 16
Chapter 16
This chapter starts by showing you how companies ensure that their record of
shareholders is up-to-date and accurate, and how they identify groups of
shareholders who may exercise their voting rights in a similar way.
You will then see formal documentation underlying the constitution of companies:
the Memorandum and Articles of Association.
The chapter finishes with details of company meetings and how decisions are
reached by shareholders.
Learning outcomes
On completion of this module, you will:
Notifiable interests
Know and be able to apply the disclosure requirement for shareholders in respect of
substantial acquisitions and disposals.
Know a company's right to send out enquiry notices to identify the existence of
undisclosed substantial shareholdings.
Company meetings
Understand the legal framework within which companies operate.
Companies Act 2006 CHAPTER 16
Know key procedural requirements with respect to statutory notice periods and
resolutions.
Know the different types of resolutions and the percentage of votes required to pass
them.
Share buy-back
Understand the reason for a company to perform a share buy-back
2 Notifiable interests
Notifiable interests: background
Every company has a register of shareholders maintained by its Company
Secretary. However the register contains no information about the beneficiaries of
shares held on trust, or about the collective holdings of closely connected persons.
EU Transparency Directive
There has been a European Union Transparency Directive relating to the disclosure
of interests has been implemented across the EU and this was introduced in the UK
early 2007.
To introduce half-yearly financial reporting for issuers of only debt securities; and
Companies Act 2006 CHAPTER 16
UK Requirements
When implementing the Directive, EU member states are free to exceed the
disclosure requirements in their regulations (‘super-equivalence’). The regulations
in the UK, now the responsibility of the FSA in its guise as the listing authority and
outlined in their listing rules, are more stringent. Disclosure of purchases in a UK
issuer must be made to the company WITHIN TWO BUSINESS DAYS if a person's
notifiable interest in the company's voting shares:
Reaches 3%.
Having reached 3%, changes (up or down) to the NEXT whole percentage point or
more. For example, an increase from 3.9% to 4.1% is notifiable, whereas an
increase from 3.1% to 3.9% is not.
Note:
Fund managers of authorised, recognised and UCITS schemes are not exempt but
their notifiable threshold is 5% and then 10%instead of 3%.
Market makers have imposed upon them a restriction of not greater than or equal to
10%.
NOTE: If the issuer of the shares is non-UK, then the FSA disclosure rules do not
apply. Instead an investor would use the rules under the Transparency Directive.
Connected Parties
To determine whether a notifiable 3% shareholding is held, a person must include
shares held by the following parties (referred to as connected parties):
Companies where the person controls more than a third of the votes.
Fellow members of any CONCERT PARTY. A concert party will exist where there is
an agreement between persons to acquire and act collectively in the use of a plc's
shares (e.g. on voting).
Companies Act 2006 CHAPTER 16
If two parties acting in concert each hold 2%, a joint holding of 4% is required to be
reported BY BOTH.
Enquiry notices are always sent out by the company. If the recipient is also a
company, it will disclose the information at the direction of the COMPANY
SECRETARY (who deals with the majority of the legal administration for the
company).
Only PLCs have the power to send enquiry notices. This rule serves to reinforce the
disclosure requirement for notifiable interests.
Also under S303, the right is given to shareholders who between them hold 10% or
more of the voting shares to convene an Extraordinary General Meeting (EGM).
Under S306, the court has the power to call a general meeting if it is impractical to
call one in the usual way.
3 Company meetings
Company meetings: types
General meetings give an opportunity to the shareholders of the company to vote
on important matters, thereby exercising their ultimate powers of control over the
company.
Companies normally hold an Annual General Meeting (AGM) every year. Matters
discussed will typically include normal recurring business such as directors' and
auditor's appointments. Listed companies also have to present a remuneration
report explaining the various aspects of director's remuneration.
Resolutions
At company meetings decisions are made by the passing of resolutions.
Ordinary resolutions
Ordinary resolutions require a simple majority of the votes to be passed i.e. MORE
THAN 50%.
Approval of a dividend.
Special resolutions
Special resolutions require a majority of AT LEAST 75% of the votes in order to be
passed.
Memorandum
Purpose and content
The Memorandum sets out information about the company in relation to the outside
world. It must give the following information about the company:
Name.
Country of domicile.
Objects.
Plc status.
Association clause (agreement that the shareholders are bound by the company
constitution).
Memorandum: example
Articles
The Articles detail the company's internal regulations. They set out, for example,
proceedings at General and Board Meetings, voting rights, borrowing powers and
powers of directors.
The Companies Act 2006 contains a model set of Articles (Table A) which the
company can adopt in its entirety or adapt to its requirements.
Companies Act 2006 CHAPTER 16
Company investigations.
5 Share buy-backs
Share buy-backs: background
The purchase by a company of its own shares is called share buyback. Regulatory
as well as shareholder approval is required before a company is allowed to buy
back its shares.
To substitute dividend payouts with share repurchases. Capital gains may be taxed
at lower rate than dividend income.
To deploy excess cash flow and return it to shareholders. This could be the case
after the company has sold a major part of its business.
Accelerated bookbuild. The company and its investment banker agree on either a
guaranteed maximum price the company will pay to buyback its shares (‘back stop
price’) or to do the deal on a ‘best efforts’ basis. Subsequently, the investment
banker contacts large institutional investors in the company to determine if they are
willing to sell their positions and at what price.
Bought deal. In a bought deal the price the company will pay to buyback its shares
is agreed and the investment bank takes the risk of not being able to purchase the
share at or below the agreed price.
Governing regulation
Rules relating to he purchase by a company of its own shares is contained in the
Companies Act 2006. The purpose of the rules is to protect the interest of creditors,
who may become exposed to greater risk if cash is returned to shareholders.
According to the Market Abuse Directive (MAD), the issuer must not, when
executing trades under a “buy-back” programme:
purchase shares at a price higher than the higher of the price of the last
independent trade and the highest current independent bid on the trading venues
where the purchase is carried out;
purchase more than 25% of the average daily volume of the shares in any one day
on the regulated market on which the purchase is carried out.
Company meetings
The legal framework within which companies operate.
The key procedural requirement with respect to statutory notice periods and
resolutions.
The different types of resolutions and the percentage of votes required to pass
them.
Share buy-back
The reason for a company to perform a share buy-back
Now you have finished this chapter you should attempt the chapter
questions.
Regulation on takeovers and mergers CHAPTER 17
Chapter 17
Regulation on
takeovers and
mergers
Time Allocation: 1.5hr
Approx Question Weight: 5-7
This chapter takes you through the process used to decide whether or not a
combining of companies should be allowed to go ahead. If the combined enterprise
may be too dominant in the market place, certain government-backed organisations
may decide to intervene.
Learning outcomes
On completion of this module, you will:
Stake building
Know the reasons for and problems with stake building
Understand the key rules relating to compulsory bids, cash offers and disclosure.
Know the limited actions available to the Panel on Takeovers and Mergers.
2 Stake Building
Stake building: Background
An investor may wish to buy a stake in a company with the intention of:
Merely owning shares in that company for investment purposes.
Building a strategic link . In the case that a company depends heavily on one
supplier, it might want to build up a strategic position preventing competitors from
taking over its main supplier.
Acquiring the target company. In order to gain control of the target company (the
company to be acquired) the predator (the acquiring company) has to purchase
more than 50% of its voting shares. The predator has to comply with regulatory
restrictions during the stake building process.
The stake building process may take place directly, i.e. with the investor buying
shares directly in the company or indirectly by buying derivatives like options,
futures or contracts for difference (CDFs) instead.
If the CC finds that the merger or takeover will substantially reduce competition,
then it has the power to prohibit the deal or impose conditions which need to be
satisfied before the deal can go ahead. It also has the power to impose fines for
failure to comply with any request for information.
Decisions of the CC may be reviewed by the Competition Appeal Tribunal, which is
independent of the Competition Commission. Appeals of decisions by CAT can be
made to Appeal Court.
Summary
Referral if:
• 25% legal monopoly
• > £70m turnover taken over
FINAL DECISION
Where market references are made, the CC must decide whether there is an
adverse effect on competition and what action is necessary to remedy any
detrimental effects on customers.
The CC has the power to make orders to remedy any identified concerns or may
recommend that remedial action is taken by the government.
Regulation on takeovers and mergers CHAPTER 17
5 City Code
City Code: background
The City Code is administered by the Panel on Takeovers and Mergers (PTM or
THE PANEL).
The Panel is concerned to ensure that all shareholders in a takeover are treated
fairly and equally. It is not concerned with issues such as competition policy, which
is the responsibility of the Competition Commission.
The Panel is also responsible for making other rules forming the BLUE BOOK.
To report the offender to another regulatory authority such as the DTI, the LSE or
the FSA. This is the most effective power since offenders may find themselves
being denied market facilities (e.g. suspension of a company's shares) or
authorisation.
Regulation on takeovers and mergers CHAPTER 17
The management could purchase the company themselves, a management buy out
(MBO).
Prior to the takeover the management may have arranged for all the debt to be
repaid in the event of a takeover. This may make the company less attractive and is
known as a POISON PILL.
Whether cash or equity is being offered. Cash is more certain but may give rise to a
capital gain on receipt (as it is effectively a normal share sale). If equity is received
then this does not count as a disposal for tax purposes.
Whether the offer is in cash or equity. An equity offer will dilute their holding but
may be favourable to taking on debt to finance a cash offer.
The nature of the new group and how it will be perceived by the markets, in
particular whether the acquired company will bring a new strategy and direction.
The key rules relating to compulsory bids, cash offers and disclosure.
Now you have finished this chapter you should attempt the chapter
questions.