IMC UNIT 1 CH 1

What are the four functions of the financial services industry on the economy?

Financial intermediation, pooling and managing risk, payments and settlement services, portfolio management

How do intermediaries reduce information and transaction costs?

Providing services and products that allow savers to become investors, ensuring provision of information, allowing borrowers to access a range of savers

What are the two ways that Savers can supply funds?

By holding the debt and equity securities issued by borrowers (directly) or via an intermediary, such as a bank or investement institution.

What is an OEIC and what does it do?

An open-ended investment company, a pooled investment vehicle that creates new shares when an investor buys in

What is the difference between a unit trust and an OEIC?

Their legal structure and pricing: an OEIC is set up as a corporate company using single pricing, while a unit trust is a legal trust often using dual pricing

What are the key ways the financial system manages risk?

Pooling investments, insurance and derivatives.

How do pooled investments and insurance reduce risk?

Pooling spreads risk across investments; insurance transfers specified risks to an insurer for a premium.

What are derivatives used for?

Managing exposure to financial risks, e.g. options and futures

What is the difference between payments and settlement?

Payments transfer money; settlement completes a transaction between buyers and sellers of securities.

What are the two main investment services?

Investment Advice and Investment Management (portfolio management)

What does ESG stand for, and why does it matter?

Environmental, Social and Governance; ESG risks can affect long-term investment value.

What is a central bank?

A financial institution that sets the monetary framework within which financial organisations operate. They often set short-term interest rates, or supply liquidity during times of crisis (eg. Bank of England)

What are surplus and deficit agents?

Surplus agents are typically households, and deficit agents are those who need to borrow - firms and governments

What are financial intermediaries do?

Trasnfer funds from surplus agents (savers) to deficit agents (borrowers)

What are deposit institutions?

Accept deposits from economic agents which become liabilities that they then lend as direct funds or investments. E.g., commercial banks and building societies (your money is deposited with the institution).

What are investment institutions?

Invest in the funds they raise in tradable securities such as bonds and equities (your money is invested in assets to pursue a return)

Which assets do life insurance policies tend to hold?

Long-term

Which assets do general insurance companies tend to hold?

Short-term

What are the four functions of the government?

• Providing services that private firms are unwilling to provide, aka ‘market failure’ (eg. defence, law and order, maintainance of certain infrastructures)

• Regulating to protect the consumer: including to promote competition, prevent fraud. Can also regulate markets by restricting entry to them and enforcing regulation to govern behaviour (FCA, PRA, FPC)

• intervening in the distribution of income generated by private market transactions (using taxes, benefits and other government transfers to redistribute wealth and income across society.)

• stabilising the economy: using monetary policy, particularly interest rates, to control inflation and support economic stability.

What stabilises the economy in the UK?

The Bank of England's Monetary Policy Committee (MPC)

What is market failure?

Services that private firms cannot provide e.g., defence, law and order

Which are the main UK regulatory bodies?

FCA, PRA, FPC

What are debt claims?

Loans made by lenders to borrowers, expecting repayment and interest payments. Most debt claims are tradable.

What is a simple example of a debt claim?

A bank deposit (depositing money into your bank, and the bank owes you that money)

What is a bond?

An example of a debt claim. It is a formal documented loan.

What are equity securities?

Shares of companies. They are tradable. The company doesn’t have obligation to repay the money to shareholders, but investors expect to make a return by selling shares at a higher price than they bought them, and possibly, but receving dividends.

What are advantages of indirect investments through intermediaries?

• Reduction in risk due to greater diversification

• Reduced transaction costs

• Access to expertise

• The ability to invest in less accessible assets

What are the three parties to a unit trust?

The manager, the trustee and the unit holders

What is the role of the The Manager (Fund Manager) of a unit trust?

Operate the trust funds, invests the cash contributions received by investors

What is the role of the Trustee of a unit trust?

Unconnected with the manager, entrusted with the custody of investments held on behalf of unit holders. Main role is to enusre that the fund manager runs the trust following the investment rules and objectives.

Who is the unit holder of a unit trust?

The trust beneficiary.

What is a derivative?

A financial contract that derives its value from the value of underlying assets such as stocks, bonds, or mortgages

How can derivative contracts be used?

• To speculate

• Buy hard to access underlying assets

Which four important functions do securities markets perform?

(RICH TRADERS PICK LIQUIDITY)!

• Raising capital

• Transferring risk

• Price discovery

• Creating liquidity

How can firms raise capital (in the capital markets)

By issuing equities (ordinary shares) or bonds (corporate bonds).

What are the advantages/impacts of raising capital

• The funds raised can go towards the firm’s growth

• People’s savings are mobilised. The liquidity provided by markets encourages the buying of shares

What are primary markets?

Those where securities are initially sold to investors, first issue is an IPO (Initial Public Offering)

What are secondary markets?

Where subsequent share trading takes place between investors

What is a sell-side firm?

Providing transactions services and investment products e.g., investment banks

What is a buy-side firm?

Firms that purchase off of sell-side firms e.g., investment managers and asset management

What are the two types of price dissemination?

Pre- and post-trade transparent

What does pre-trade transparency mean?

Real time price data is published

What does post-trade transparency mean?

Price data is published shortly after trades occur

What types of price dissemination do buy and sell-side traders prefer?

Buy-side prefers transparency, sell-side prefers opaque pricing so that they have an informational advantage

What requires pre- and post-trade transparency?

MiFID II

Which markets tend to be more and less transparent?

LSE tends to be more transparent than OTC markets such as the credit default swap market

What is a bid-ask spread?

The difference between the price quoted for immediate sell and immediate purchase

Which type of price dissemination causes higher bid-ask spreads?

Opaque markets

How can liquidity be judged?

The difference between the best buy and sell prices in the order book (in order-driven markets) and if there are lots of ready-and-willing buyers and sellers (market depth)

What is market depth?

A measure of the size of an order needed to move the market and price by a certain amount

What would a deep stock market have?

A sufficient volume of pending orders on both bid and ask sides

What does the US Treasuries market have?

A large volume of transactions, low bid-ask spreads, high depth and low transaction costs

Why may illiquid assets be harder to sell?

Uncertainty about future market value or lack of market depth

What is liquidity risk?

The risk of not being able to sell quickly

Where is liquidity risk higher?

Low volume and emerging markets

Which trading environments tend to increase the flow of capital?

Transparent, liquid markets which have low transaction costs and small bid-ask spreads

What is informational efficiency and what makes it better?

Trading with asset prices which reflect all relevant information about the value, which is enhanced by price transparency

What is the bid-ask spread cost?

Price set by the dealer in order to cover their own costs and make a profit, tends to be higher in smaller, riskier and less liquid stocks

What is the price impact of a trade?

When a large volume of stock is bought, it can create an imbalance in supply and demand which may be resolved by a price increase to bring in more supply. Same argument for selling and price falls

What is opportunity cost?

The cost of waiting

What are the explicit costs of trading?

Commissions What is the commission charged by brokers?

Do brokers' commissions get charged tax/VAT?

No

What SDRT is payed on purchases?

Payable on all transactions by the purchaser and is levied at a rate of 0.5%, rounded to the nearest 1p for CREST settled payments, or nearest 500p if not

What is CREST?

A computerised system which allows investors to hold shares in electronic form rather than paper

What levy is charged to finance the Takeover panel?

1.50 on all purchases and sales in excess of 10,000 (PTM levy)

Who is exempt from paying the SDRT and PTM levy?

Money makers

What are the transaction charges on gilts?

Commission rates of 0.5%-1% for purchases below 5,000, or none for purchases over 1 million

When are gilts usually settled?

The next day

Which securities are exempt from SDRT?

Gilts, loan stocks, foreign securities registered out of the UK, bearer securities and deals in traded options through ICE Futures Europe

What are the two transaction costs for pooled investments?

An entry cost and an OCF

What are the transaction costs for direct property investments?

Stamp duty, legal costs and ongoing maintenance costs

How much do retail customers vs institutional investors usually spend on brokers commission?

Retail customers usually spend 5-12.50 per trade, whilst institutional investors usually spend 10-20bps

How to calculate the bid-ask spread?

(Difference between the bid and offer/offer price) x 100

Which three types of order execution venues are permitted under MiFID?

Regulated markets, multilateral trading facilities and systematic internalisers

Which further trading venue was introduced with MiFID II?

An organised trading facility (OTF)

Which market models are offered by the London Stock Exchange for trading UK shares?

SETS and SETSqx

What is traded in SETS vs SETSqx?

SETS is used to trade stocks like FTSE 100, as well as many of the most traded AIM and Irish securities and ETFs and ETPs

What is SETS?

An electronic limit order book used to trade liquid stocks

What is the EMS?

The normal market size for orders set by the LSE. A money maker is obliged to quote bid/offer prices that are firm for order sizes up the EMS

When do auctions happen on SETS?

Opening and closing (7:50am and 4:30am)

When are matching bids and offers executed on SETS?

10 minutes at opening and 5 minutes at closing

What is the goal of the matching algorithm on SETS?

To find the most popular price

What is an uncrossing?

When matched price orders are executed

When may unscheduled auctions happen on SETS?

Triggered when the price crosses the percentage threshold since the previous uncrossing trade, may happen when intraday news is announced if prices move significantly

What is traded on SETSqx?

Less liquid stocks than SETS

What is SETSqx?

A combination of an electronic auction book with non-electronic quote-driven market making

When do uncrossings happen on SETSqx?

Through auctions at 8am, 9am, 11am, 2pm and at closing

What is SEAQ?

A quote-display system used as the price reference point for telephone execution between market participants and registered market makers

What is SEAQ used for?

Fixed-interest securities not and AIM securities not traded on SETS or SETSqx

What is LCH and what does it do?

The central counterparty to all SETS and SETSqx trades at the point of execution which assumes the risk from a trade incase a clearing member defaults

How are international securities traded on the LSE?

Through the International Order Book and the European Quoting Service

What is the International Order Book?

An electronic order book for trading international securities in the form of a depository receipt on the LSE

What is the European Quoting Service?

A quote-driven market making and trade-reporting platform that supports all EU liquid securities. It allows clients to meet their MiFID post-trade reporting obligations

How does the EQS allow clients to meet their MiFID post-trade reporting obligations?

Through on-exchange, off-book trade publication for regulated trades or OTC trade publication for unregulated trades

What is the current standard LSE equity settlement period and what is it settled through?

T + 2 and through CREST

What is the current standard US equity settlement period?

T + 1

What are gilts settled through and what is the period?

T + 1 and through CREST

When was MiFID?

2007

When do gilts pay interest?

gross coupons semi-annually

What are gilts used to finance?

The shortfall between government expenditure and government revenue