Securities & Investment Institute Level 3 Certificate in Investments Unit 2 – Securities Unit 4 – SFD Update Supplement This supplement should be used if your examination is on or after 19/11/07
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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. Kind regards and good luck with your study. Andy Bennett Head of Securities and Investment Institute Certificates 7city Learning 4 Chiswell Street London EC1Y 4UP Tel: 0845 072 7620 Fax: 020 7496 8607
SUMMARY OF CHANGES CHAPTER 1 – EQUITIES: TYPES AND FEATURES Subject 1 - Equites types and features: introduction • Question weighting – content updated. • Learning outcomes – content updated. Subject 3 – Ordinary and preference shares • Partly paid shares and calls – new subject added. • Preference shares – content updated. Subject 5 – Dividend payments • New subject added Subject 6 – Ownership and title documents • SDRT – new topic added Subject 8 – American and Global Depository Receipts • ADRs: features – content updated Subject 9 – Equities types and features: summary • Key concepts – new content added CHAPTER 2 – ISSUING EQUITIES Subject 1 – Issuing Equities: introduction • Learning outcomes – content updated. Subject 2 – Equities: methods of issue • The origination team – content updated. • Pricing offers for subscription and offers for sale – content updated. Subject 3 –London Stock Exchange: Official List and AIM • Introduction – content updated. • The Official List and the UK Listing Authority (UKLA) – content updated • Listing application – content updated • Sponsors and advisors – content updated • Official List: Continuing obligations – new topic added • AIM: continuing obligations – topic updated Subject 4 –Underwriting and stabilisation • Underwriting – content updated • Stabilisation – content updated Subject 5 –Issuing equites: summary • Key concepts – content updated
CHAPTER 3 – EQUITY MARKETS Subject 1 – Equity Markets: introduction • Question weighting – content updated. • Learning outcomes – content updated. Subject 3 – London Stock Exchange: an overview • LSE: the different securities traded – content updated and new content added Subject 4 –SETS • SETS: introduction – content updated • SETS: trading day – content updated and new content added • SETSqx – new topic added Subject 5 – LSE’s central counterparty service (CCP) • New subject added Subject 12 – Virt-x • Content updated and new content added Subject 13 – PLUS • Content updated Subject 15 –Settlement • New subject added Subject 17 –Equity markets: summary • Content updated and new content added CHAPTER 4 – WARRANTS Subject 1 – Warrants: introduction • Question weighting – content updated. • Leaning outcomes – new content added Subject 4 – Warrant value: introduction • New subject added CHAPTER 6 – DEBT TYPES AND FEATURES Subject 1 – Debt types and features: introduction • Question weighting – content updated. Subject 3 – Government bonds: features • Index linked gilts – content updated Subject 4 – Corporate bonds: features • Corporate bonds: security – content updated and new content added • Impact of security – content updated • Local authority loans – content updated Subject 5 – Domestic and overseas bonds: features • International bonds – content updated
CHAPTER 7 – ISSUING DEBT Subject 1 – Issuing debt: introduction • Question weighting – content updated. Subject 3 – Corporate and overseas bonds: issue • Corporate bonds: issue – content updated Subject 4 – Other bond issuers • Content updated CHAPTER 8 – DEBT VALUATION Subject 1 –Debt valuation: introduction • Learning outcomes – content updated. Subject 2 –Debt valuation: prices and yields • Bond yield calculations – content updated. • Spread analysis – new content added. • Clean vs. dirty prices – new content added. Subject 3 –Debt valuation: factors affecting prices • Bond prices: bond futures – new topic added • Convexity – content updated • Credit enhancements – new topic added. Subject 5 –Debt valuation: factors affecting prices • Key concepts – content updated. CHAPTER 9 – DEBT MARKETS Subject 1 –Debt markets: introduction • Question weighting – content updated. Subject 2 –Government bonds: trading • UK government gilts: trading – content updated Subject 3 –Corporate bonds: trading • Corporate bonds: introduction – content updated and new content added • Corporate bonds: dealing and reporting on LSE – content updated • Corporate bonds: dealing off exchange – content updated Subject 4 –International debt markets • Diagram updated Subject 5 –Eurobonds: trading • Eurobonds: trading – content updated and new content added
CHAPTER 10 – FOREIGN EXCHANGE Subject 1 –Foreign Exchange: Introduction • Learning outcomes – content updated and new content added Subject 4 –FX: forward markets • Forward FX rates - new content added Subject 5 –Foreign exchange: summary • Key concepts – content updated CHAPTER 12 – REGULATION Subject 2 –Markets in Financial Instruments Directive (MiFID) • Client categorisation – content updated • Order execution policy – content updated and new content added CHAPTER 13 – Company accounts Subject 1 –Financial statements • Chapter overview – content updated • Learning outcomes – content updated Subject 3 –Financial statements: regulatory framework • Companies Act 2006 (CA06) – content updated • Accounting standards – content updated • Accounts: summary – diagram updated Subject 5 –Income statements • Cost of sales and operating costs – content updated • Exceptionals – content updated • Extraordinary items – content updated • Interest and tax – content updated • Dividends – content updated • FRS 3: reporting financial performance – content updated Subject 6 –Cashflow: FRS1 • Subject deleted CHAPTER 14 – Ratio analysis Subject 1 –Ratio analysis: introduction • Chapter overview – content updated CHAPTER 15 – Investment planning Subject 1 –Investment planning: introduction • Question weighting – content updated • Chapter overview – content updated Subject 3 –Private client investment advice • Summary – diagram updated
CHAPTER 16 – Companies Act 2006 Subject 1 –Companies Act: introduction • Chapter overview – content updated Subject 2 –Notifiable interests • Notifiable interests: background – content updated • Disclosure of material interests – content updated • Company investigations: enquiry notices (S793 CA ’06) – content updated • Statutory rights of shareholders – topic moved from chapter one and content updated Subject 4 –Memorandum and Articles of Association • Articles – content updated Subject 5 –Share buy-backs • Share buy-backs: background – content updated and new content added Subject 6 –Companies Act: Summary • Key concepts – content updated and new content added CHAPTER 17 – Regulation on takeovers and mergers Subject 1 –Regulation on takeovers and mergers: introduction • Question weighting – content updated Subject 2 –Stake Building • Subject moved • Stake building: Background – new content added • Summary – new content added Subject 5 –City Code • City Code: background – content updated Subject 6 –Regulation on takeovers and mergers: summary • Content updated and new content added
Equities: types and features
1
CHAPTER
Chapter 1
Equities: types and features Time Allocation: Approx Question Weight:
1hr 7-9
1 Equities types and features: introduction Chapter overview Shares are issued by companies in order to raise long-term capital. Investors who buy shares are called shareholders. This chapter starts by explaining the concept of incorporation and the distinction between the ownership of a company (shareholders) and its management (directors). There are two main types of share a company can issue; ORDINARY and PREFERENCE shares. Ordinary shareholders are otherwise called EQUITY shareholders as they have an ownership stake in the company. Ordinary shareholders have the right to receive a share in the company's profits, known as a DIVIDEND, the size of which will depend on the company's profitability. Ordinary shareholders also have the right to attend and vote in company meetings on matters such as the appointment (and removal) of directors, approving the financial statements or agreeing to a takeover or merger. On the other hand, preference shares do not attract voting rights, but, to compensate for this, they pay a fixed rate dividend which is not dependant on the company's profitability.
Equities: types and features
CHAPTER
Ordinary and preference shares are examples of REGISTERED securities, which means that owners’ names are recorded on central registers. This is unlike some other forms of investments which are held in BEARER form. This means that physical possession is proof of legal title, and no central register of owners exists. This chapter provides further details of the differences between registered and bearer securities. You will learn about AMERICAN DEPOSITORY RECEIPTS (ADRs). ADRs are attractive to US investors who may otherwise be reluctant to buy shares in a nonUS company as it means having to pay for the shares (and receive dividends) in foreign currencies. As you will see, ADRs are a way of overcoming these problems. Finally we introduce the different rates of stamp duty and stamp duty reserve tax (SDRT) which are charged on share transfers, creation of bearer shares and the transfer of shares into depositary receipts (ADRs, GDRs). You will also learn which transfers are exempt.
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.
Ordinary and preference shares Know the basic rights of ordinary shareholders. Know how the rights of preference shareholders differ from ordinary shareholders.
Quotation of share prices and dividends Be able to distinguish between nominal value and share price. Know the rate of tax suffered by holders of UK shares on dividend distributions.
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.
American and Global Depository Receipts (ADRs) Know the key features of an ADR.
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Equities: types and features
CHAPTER
Right to a surplus on winding up In the event of the winding up of a company, ordinary shareholders are entitled to a share of the remaining (i.e. surplus) assets of the company, but only after ALL other liabilities have been paid. This may result in ordinary shareholders receiving more than their nominal, or face, value.
Special types of ordinary shares 'A' shares 'A' shares provide the holder with NO voting rights. Holders of 'A' shares, however, participate in profits and dividends in the normal way.
Founder shares Founder shares are shares issued to the SUBSCRIBERS of the company.
Deferred shares Deferred shares are often issued to the founders of a company, and only pay a dividend once all other ordinary dividends have been paid. Alternatively, deferred shares may pay a reduced dividend for a number of years before ranking equally with other classes of share.
Partly paid shares and calls On occasion a company will issue shares to shareholders but only request for them to paid in part. In this way shareholders are permitted to pay the full value of the share at a later date. This is an obvious advantage to the shareholder, but the company also benefits in that more investors would wish to take the opportunity to buy the shares leading to a full subscription. Later the company will make a call on the issued shares, and the current shareholders will need to pay the balance of what is owed to the company.
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.
Cumulative preference shares A cumulative dividend means that, should the company not pay a dividend, (because, for example, of a lack of profitability) the right to receive that dividend is ROLLED OVER into the next period. This is in contrast to ordinary shareholders who will lose the right to receive an annual dividend if the directors do not declare one. Ordinary dividends cannot be paid until all ARREARS of cumulative preference dividends have been satisfied.
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Equities: types and features
CHAPTER
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.
Participating preference shares Most preference shares are only entitled to a fixed rate dividend. For example, a 5% £1 preference share will entitle the shareholder to 5p dividend each year for every share held. However, the Articles may confer PARTICIPATING RIGHTS. This means that additional dividends may be paid, over and above the fixed rate, should the company be particularly profitable. Participating preference dividends will often be calculated according to a profit related formula.
Convertible preference shares A preference share with conversion rights allow the preference share to be converted into ordinary shares in the future,
Redeemable preference shares Most shares have an indefinite life, however, when issued in a redeemable format they carry a specified redemption date when the company will refund the nominal value.
4 Quotation of share prices and dividends Share prices Shares are described with a NOMINAL (or FACE or PAR) value. For example, a 50p ordinary share, or a £1 ordinary share, or a 25p preference share. 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. The total MARKET CAPITALISATION of a company is calculated by multiplying the number of shares in issue by the market value/price of each share.
Dividends Dividends, both ordinary and preference, are quoted (and paid) NET of a 10% tax credit. Consequently, when a shareholder receives a dividend, he or she is deemed to have already paid 10% income tax at source. This tax credit is taken into account when an individual's income tax bill is calculated for the year.
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Equities: types and features
CHAPTER
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
CUM-DIV PERIOD The buyer of the security will be entitled to receive the next dividend payment
E X D I V D A T E
EX-DIV PERIOD The buyer of the security will NOT be entitled to the next dividend payment. Entitlement to the next 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.
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Equities: types and features
CHAPTER
Record date
CUM-DIV PERIOD
Company proposes a dividend
E X D I V
EX-DIV PERIOD
D A T E
Record date (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 cumdiv 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. A special ex-bargain is a transaction carried out in the cum-div period, but contracted ex-div. The buyer will not receive the next dividend. The special ex-div date is 10 business days before the ex-div date itself.
1
Equities: types and features
CUM-DIV PERIOD
E X D I V D A T E
Company proposes a dividend
Special ex date (XD – 10 business days)
(Wednesday)
CHAPTER
EX-DIV PERIOD
SPECIAL-CUM PERIOD
Record date (Friday)
Dividend payment 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.
Special cum bargains It is permissible for the buyer to buy shares cum div even within the ex-div period. Such transactions are called SPECIAL CUM DIV bargains. Such special cum-div bargains can be entered into right up to the day before the dividend payment date.
1
Equities: types and features
CUM-DIV PERIOD
E X D I V D A T E
Company proposes a dividend
Special ex date (XD – 10 business days)
(Wednesday)
CHAPTER
EX-DIV PERIOD
SPECIAL-CUM PERIOD
Record date (Friday)
Dividend payment 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.
How a dividend claim may arise Consider an investor who buys a share one day before the ex-div date, but who has agreed to settle the deal in 25 business days time, the latest the LSE will allow. 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.
1
Equities: types and features
E X D I V
CUM-DIV PERIOD
Trade date Company proposes a dividend
Special ex date (XD – 10 business days)
CHAPTER
EX-DIV PERIOD
T +25
D A T E
(Wednesday)
Record date (Friday)
Dividend payment 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.
6 Ownership and title documents Title documents: background A DOCUMENT OF TITLE is evidence that an investor has legal ownership of an asset, e.g. land, real estate or financial securities. The title document may be held in different forms as described below.
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. A company maintains a register of shareholders which is updated whenever there is a change of ownership. A quoted company usually appoints an independent registrar to manage these shareholder records.
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Equities: types and features
CHAPTER
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.
8 American and Global Depository Receipts ADRs: background American Depository Receipts (ADRs) are used by non-US companies in order to encourage US investors to buy an equity stake. An ADR represents a shareholding in a non-US company, although the instrument itself is DENOMINATED IN DOLLARS. 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. An ADR issue is a way around this problem.
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. Step 3: The bank then issues ADRs, denominated in dollars, to US investors. 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.
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Equities: types and features
CHAPTER
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 freely transferable securities and standard settlement is T+3. 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 UK
American Investor
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.
9 Equities types and features: summary Key concepts Limited companies The process of incorporation. The distinction between ownership and management. The distinction between issued and authorised share capital.
Ordinary and preference shares The basic rights of ordinary shareholders. How the rights of preference shareholders differ from ordinary shareholders.
Quotation of share prices and dividends The distinction between share price and nominal value. The rate of tax suffered by holders of UK sharers on dividend distributions.
1
Equities: types and features
CHAPTER
1
Dividend Payments The purpose of the ex-dividend date and the record date When special bargains can be struck How clains can be generated
Title documents The difference between registered and bearer form securities. Examples of registered and bearer form securities. The difference between temporary and permanent documents of title.
Stamp Duty The situations in which stamp duty is payable. Exempt transfers for stamp duty purposes. The rate of stamp duty and the distinction between stamp duty and stamp duty reserve tax (SDRT).
American and Global Depository Receipts The key features of an ADR. Why a US investor might use an ADR rather than invest directly in an overseas company. The key features of a pre-release ADR.
Now you have finished this chapter you should attempt the chapter questions.
Issuing equities
2
CHAPTER
Chapter 2
Issuing equities Time Allocation: Approx Question Weight:
2hrs 8-10
1 Issuing equities: introduction Chapter overview Companies issue shares to raise cash or CAPITAL. 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. Finally, the chapter moves on to describe the procedures a company is required to follow in order to have its shares traded on the London Stock Exchange. The LSE manages two separate markets: the larger is known as the Official List and contains well-known companies such as BP Amoco and British Airways, the smaller is known as the Alternative Investment Market (AIM) and is a market for shares in smaller, younger companies.
Learning outcomes On completion of this module, you will:
Issuing equities
CHAPTER
Equities: methods of issue Know the principal characteristics and differences between primary and secondary markets. Know the role of the origination team. Know the members of an origination team. 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.
London Stock Exchange: Official List and AIM Know the criteria for entry to the Official List. Know the participants involved in gaining entry to the official list. Know the continuing obligations of listed companies. Know the methods of disclosure for official list companies. Know the criteria for entry to AIM. Know the participants involved in gaining entry to AIM. Know the continuing obligations for AIM companies.
Underwriting and stabilisation Understand the methods and purposes of underwriting. Know the purpose of stabilisation.
2 Equities: methods of issue The primary market The PRIMARY MARKET is the market on which securities are sold for the first time. Companies use the primary market as a means of RAISING new long-term CAPITAL (for both equity and debt). 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.
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Issuing equities
CHAPTER
The origination team The origination team consists of a number of specialised advisers including the sponsor, legal advisors, public relations consultants, accountants and a corporate broker. They all work with the underwriting firm which holds ultimate responsibility. 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.
Offer for subscription
£
Investor
SHARES
Company A
An offer for subscription involves a company issuing shares directly to the general public.
Offer for sale
SHARES
SHARES
£££ COMPANY
£££ ISSUING HOUSE
INVESTOR
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.
2
Issuing equities
CHAPTER
Pricing offers for subscription and offers for sale It can be difficult to ascertain a price for offers and this can be addressed in three ways:
Fixed price offer A fair price is established based on the price of a similar company's security that is already trading in the market. An offer is then made to the public, with purchasers stating the number of shares they wish to buy at the fixed price. In the event of oversubscription, allocations are dealt with on a pro rata basis. Fixed price offers are often at an offer price which is artificially low, to generate goodwill amongst purchasers. Investors who purchase shares to profit from an immediate increase in price due to underpricing, and who plan to sell as soon as this happens are known as STAGS.
Tender offer Where interested investors make bids and the issuing house then selects the applications with the highest bids. Note that once an acceptable price has been determined from the bids, successful applicants actually pay a COMMON STRIKE PRICE.
Bookbuilding The issuing house assesses interest from investor relations presentations and constructs a demand curve to ascertain possible offer prices. The level of interest from institutional investors (the number who wish to be on the issuing house's 'book') then determines whether the final price is set at the higher or lower end of the demand curve. A bookrunner or lead manager is the main underwriter in equity and debt issues and, in a particularly large issue, 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, known as co-lead managers. Each of the co-lead managers would be responsible for issuing the shares in a certain geographical region. The bookrunner is listed first among all the underwriters participating in the new issue.
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
Small investors would NOT be offered shares in a placing
3
£
Wealthy individuals
Institutions and wealthy individuals would be offered shares in a placing
2
Issuing equities
CHAPTER
3 London Stock Exchange: Official List and AIM Introduction Block 7 of the FSA Handbook, “Listing, Prospectus and Disclosure” consists of three rule books: Listing Rules. 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 LSE's own rules for members
Official List and AIM: background The London Stock Exchange provides a market place for the trading of company stocks. Companies enable trading of their shares by a process called FLOTATION. 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.
Flotation: pros and cons Pros Acquisitions and mergers The ability to issue paper securities with a market price as an acquisition currency can increase the potential of corporate growth by way of acquisition.
Public profile and prestige Exposure on a public market will usually bring about an increase in press coverage, resulting in a heightening of public awareness about the company and its products and services.
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Issuing equities
CHAPTER
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.
The Official List and the UK Listing Authority (UKLA) The main market of the Stock Exchange is known as The Official List. There are currently more than 2,000 companies, foreign and domestic, traded on the Official List. 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 Listing Principles Listing principles are designed to ensure adherence to the spirit as well as the letter of the rules and thus promote a fair and orderly market. In line with the FSA’s own approach to regulation, these principles place an emphasis on having adequate controls and systems in place.
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.
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Pre-emption rights Any subsequent issue of shares for cash (e.g. a rights issue) must contain a preemption 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.
Sponsors and advisors Appointment of a sponsor A company seeking a listing must appoint a sponsor. A sponsor will normally be a corporate broker or investment bank but may also be another type of professional advisor, e.g. accountant or lawyer. The sponsor is also responsible for seeking the FSA's approval of the listing particulars and prospectus. The 48-HOUR RULE requires that the documentation be submitted at least 48 hours prior to the hearing of the application to obtain a listing. The role of the sponsor is to: Ensure the issuer meets the requirements for a listing. Ensure the issuer is guided and advised as to the application or interpretation of the listing rules. Provide the UKLA with all information requested by them or required under the rules. Guide the issuer through the listing process and liaise with the UKLA.
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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.
Official list: Continuing obligations If a company wishes to list on an exchange, there are certain obligations that they must fufil. These include: Corporate governance - ensuring that the directors are responsible and accountable for the running of the firm. It also ensures that the responsibilities are shared and that too much influence is not placed with one person. Reporting - ensuring that all shareholders are given an equal opportunity to access price sensitive information. More on this is discussed below.
Regulatory Information Service (RIS) and Primary Information Provider (PIPs) One of the main principles of the Listing Rules is that unpublished price sensitive information must be disclosed to the market as a whole without delay. A listed company must notify the market of all relevant information which is not public knowledge concerning a change in the company's financial condition, the performance of its business or in its expectations as to its performance. Price sensitive information may not normally be disclosed to anyone else before it has been notified to an RIS (Regulatory Information Service) or PIPS (Primary Information Provider Service). A key principle of the Listing Rules is to maintain a balance between ensuring the existence of a level playing field amongst investors on the one hand and ensuring efficient and orderly markets on the other. The longest standing PIP is the LSEs Regulatory News Service (RNS).
Regulatory News Service (RNS) RNS is both a regulatory and financial communications channel for companies to communicate with the professional investor. RNS provides certainty in delivering communications consistent with local regulatory regime. Using their secure website or easy to use PC tool RNS Submit (TM), investors choose the regulators whose requirements need to be met and attach their announcement.
Secondary Information Providers (SIPs) The Primary Information Providers are responsible for distributing listed company announcements to the newswire services or Secondary Information Providers. These include Bloomberg and Reuters. These SIPS disseminate the information provided by the PIPS to the general public.
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AIM: continuing obligations Disclosure requirements The same rules apply as for companies on the Official List, including the rules on corporate governance.
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.
AIM vs. Official List: main differences in entry requirements Note that for AIM applicants there is NO: Minimum shares in the hands of the public. Trading record requirement. Shareholder approval needed. Minimum market capitalisation.
4 Underwriting and stabilisation Underwriting In its most basic sense, underwriting is a means of guaranteeing a minimum level of proceeds from a share issue. The cost of the guarantee is a fee, payable to the underwriter (normally an investment bank). 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.
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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. FSA may permit investment banks to stabilise an issue, provided that: The offer is for cash; The offer is public on a qualifying exchange; The offer is for a limited period; Adequate prior disclosure was given; Information on stabilisation activities will be provided to the issuer. 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. Where it is permitted by any existing customer agreement. 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.
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2
5 Issuing equities: summary Key concepts Equities: methods of issue The role of the origination team The members of an origination team The principal characteristics and differences between primary and secondary markets. Issue methods used in the primary market, including: Offer for subscription. Offer for sale Placing Intermediaries offer. Calculation of the dilutive effect on share price of share issues. Calculation of the dilutive effect on share price of follow on share issues.
London Stock Exchange: Official List and AIM Know the criteria for entry to the Official List. Know the participants involved in gaining entry to the official list. Know the continuing obligations of listed companies. Know the methods of disclosure for official list companies. Know the criteria for entry to AIM. Know the participants involved in gaining entry to AIM. Know the continuing obligations for AIM companies.
Underwriting and stabilisation Understand the methods of underwriting. Know the purpose of stabilisation.
Now you have finished this chapter you should attempt the chapter questions.
Equity markets
CHAPTER
3
Chapter 3
Equity markets Time Allocation: Approx Question Weight:
5hrs 13-15
1 Equity markets: introduction Chapter overview This chapter explains the purpose and role of stock exchanges in general as well as the role of the London Stock Exchange in providing a trading platform for the securities market. As you will see, it is not only shares that are traded on the Exchange, but also corporate bonds, UK Government bonds (gilts), American Depositary Receipts, warrants and a selection of other 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
Learning outcomes On completion of this module, you will:
Stock Exchanges Know the purpose and role of a stock exchange.
London Stock Exchange: an overview Know the securities covered by Rule 3000. 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. Know the features of a standard trading day on SETS. Understand the operation of a SETS screen. Be able to distinguish between different types of SETS orders. Know the definition and uses of a Worked Principal Agreement.
SETSqx Know the securities traded on SETSqx Know the key features of the operation of SETSqx
Inter-dealer brokers (IDBs) Know details of the service offered to other market participants by IDBs. Know the motivation for trading via an IDB.
Stock borrowing and lending Understand the role of SBLIs in the equity markets.
Virt-x Know the role of virt-x as a direct competitor of the London Stock Exchange in the equity markets. Know basic details of trading on virt-x. Know the reporting and publication requirements for virt-x trades. Be able to identify the role LCH.Clearnet for virt-x trades.
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PLUS Know the status of PLUS as defined by the FSA. Be able to outline features of trading on PLUS.
Overseas equity markets Be able to identify basic features of trading and settlement in the main overseas equity markets.
Prime brokerage and equity finance Know the main services provided by an equity and fixed income prime broker Know the use of the main sources of equity financing
2 Stock Exchanges: an overview Purpose and role A stock exchange is a corporation or mutual organization which provides facilities for its members to trade company stocks and other securities. Members of the exchange can be acting as brokers or dealers. Brokers are qualified and regulated professional who buy and sell securities on behalf of investors. Brokers may also offer investment advice to their clients. Dealers execute trades for their own account. They may also buy or sell securities directly from/to clients.
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).
3 London Stock Exchange: an overview LSE: introduction The LSE's origins go back to the 17th century, when people wishing to invest in joint-stock companies met in coffee houses to strike deals.
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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.
LSE: the different securities traded LSE rules 3000 and 3040 combine to govern the securities traded on the exchange. 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. The list of securities is as follows:
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 - GiltEdged 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.
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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.
Tradable instrument structure The London Stock Exchange provides a wide range of platforms, which are summarised below. The platforms that will be tested in detail in this exam are SETS, SETSqx, SEAQ, IOB, ITBB and IRS. However, we have included the other systems for completeness.
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Table 3: TradElect trading services
Trading Service
Description
Securities
Type
TradElect execution
for TradElect executions
Market makers
Equities
Order book
Continuous
Yes
Optional
Structured Products
Order book & Reporting only
Continuous
No
Mandatory
Equities
Order book & Quote book
Periodic
varies
Optional
Debt
Quote book
None
No
Mandatory
EUROSETS
Equities
Order book
Continuous
Yes
Optional
European Quoting Service
Equities
Quote book
None
No
Optional
European Trade Reporting
Equities
Reporting only
None
No
No
Depositary receipts
Order book
Continuous / Periodic
No
No
International Bulletin Board
Equities
Order book
Continuous
No
Optional
International Retail Service
Equities in DI form
Quote book
None
No
Mandatory
UK gov’t debt
Reporting only
None
No
Mandatory
Debt
Reporting only
None
No
Optional
Name
SETS Modified SETS
SETSqx
SEAQ
International Order Book
Gilt-edged market Fixed interest market
CCP
LSE: the different parties trading Member firms (also known as BROKER DEALERS) trade on the LSE.
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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). The ability to act as agent and/or principal is described as DUAL CAPACITY. Broker/dealers can gain other labels in the marketplace, depending on the activities in which they engage. Examples include: Market makers. Stock borrowing and lending intermediaries. Inter-dealer brokers. GEMMs: Gilt-edged market makers. IGEMMs: Index linked gilt-edged market makers. 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.
SETS: trading day SETS has a trading day running from 7.15am until 5.15pm. The automatic trading in SETS securities runs from 8.00am to 4.30pm each business day ('normal market hours'). The system is open before and after the automatic trading period for reporting and auction periods. 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.
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Example Example Tesco
TSCO
Currency GBX
11,000
208 - 215
1,000
11,000
208
215
1,000
3,000
207
216
7,000
2,000
206
217
6,000
218
1,000
Tesco
FILL OR KILL: Buy 2,000 at 215 limit fill or kill Order cannot be executed, order book remains unaltered.
11,000
TSCO
Currency GBX
208 - 215
1,000
11,000
208
215
1,000
3,000
207
216
7,000
2,000
206
217
6,000
218
1,000
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.
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Price range
CHAPTER
Price format code
Tick value
Less than 10p
J
0.01p
10p – 499p
Q
0.25p
500p – 999p
H
0.5p
1000p or more
W
1.0p
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.
Halt and Close This freezes and disseminates a closing price, so is designed to be used where there is little likelihood of returning to trading that day. No orders or quotes can be entered or deleted during this period.
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order / quote deletion
Dissemination of closing price
Summary order book execution
order / quote entry PAUSE
order driven
Suspended
YES
YES
NO
quote driven
N/A
NO
N/A
NO
MARKET SUSPENSION order driven
Suspended
NO
NO
NO
quote driven
N/A
NO
N/A
NO
HALT order driven
Suspended
NO
YES
NO
quote driven
N/A
NO
N/A
NO
HALT AND CLOSE order driven
Suspended
NO
NO
YES
quote driven
N/A
NO
N/A
YES
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.
Closing auction call period The closing auction call period begins at 4.30pm and runs for 5 minutes until 4.35pm (subject to a 30 second random end period). 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.
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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). There is no continuous order book trading on SETSqx. Execution on the central order book happens during four uncrossing periods (periodic auctions) throughout the day which are designed to concentrate liquidity. These occur at 8.00am, 11.00am, 3.00pm and 4.35pm.
SETSqx: order types To provide maximum flexibility, the order book supports both named and anonymous limit orders. Any member firm has the option to phone the counterparty behind a named order and fill this before the next uncrossing if terms are agreed. Market orders and Iceberg orders cannot be used on this system.
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5 LSE’s central counterparty service (CCP) All securities traded on the SETS order book and some of those traded on SETSqx must be routed through a central counterparty (CCP) to clear the trades.
Clearing involves an organisation becoming counterparty to both buyer and seller of the trade. This effectively breaks the initial trade into two separate trades.
In doing so the CCP is guaranteeing settlement of the trade and eliminating default risk for the buyer and seller.
This process is known as NOVATION.
Summary: novation 1. INITIAL TRADE
DEAL BUYER (Clearing member of CCP)
SELLER (Clearing member of CCP)
2. NOVATION
BUY
SELL
CCP
SELL
BUY
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 virtx. 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.
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Euroclear UK and Ireland Euroclear UK and Ireland offers settlement services to exchange members on equity, warrants and debt via the CREST system, and also provides the routing service from LSE to the CCPs.
6 International Order Book (IOB) International Order Book: introduction The International Order Book (IOB) is an order-driven trading service for the depositary receipts of international securities.
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.
Other key features include: The service is available to all LSE member firms. 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.
International Order Book: trading The IOB trading day is split into two models, “continuous trading day” and ''auction only trading day''. Both are available to all member firms of the LSE who are registered for order entry.
Continuous trading day
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Stock borrowing: other issues Lenders of securities tend to be institutional investors with large portfolios that are passively held. These include: Pension funds. Insurance and life companies. Mutual funds and unit trusts. 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). Key features of virt-x include: Direct trading in the constituents of all major European indices on one exchange, with one rulebook and a single regulatory environment (supervised by the FSA). An anonymous electronic order book using the SWX Trading Platform for panEuropean 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.
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Matched orders trigger an automatic settlement instruction, which is routed through SIS SEGAINTERSETTLE AG (the Swiss central securities depositary), CREST or Euroclear. virt-x provides trading in the shares of blue chips in a range of European indices, including: FTSE 100 FTSE Eurotop 100 CAC 40 DAX 30 Dow Jones EuroSTOXX 50 Dow Jones STOXX 50 AEX SMI MIB30 virt-x also offers trading in the following ETFs: FRESCO Index Shares 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.
3
Equity markets
CHAPTER
virt-x: reporting and publication All transactions resulting from order book executions are reported automatically and published to the market immediately. 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).
virt-x: clearing and settlement virt-x links with CREST, Euroclear and SIS to provide a virtual single settlement system. Members can choose a single clearing house, or a combination, to meet their settlement requirements. virt-x delivers real-time settlement instructions to the relevant clearing house(s). This straight through approach is designed to minimise uncertainty and delay, and ensure quick and accurate settlement. All order book trades are for a uniform T+3 settlement period. LCH.Clearnet is the central counterparty to trades on virt-x.
TRADING • Exchange matched trades
SELL
CLEARING:
SWX Trading Platform
BUY
LCH
• Risk management
(CENTRAL COUNTERPARTY)
• Anonymity
Shares transferred within clearing house to buyer’s account SETTLEMENT: • At virt-x member’s choice of settlement venue
CREST
EUROCLEAR
SIS
3
Equity markets
CHAPTER
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.
14 Overseas equity markets Overseas equity markets: summary diagram Key features of overseas markets are contained in the following diagram:
3
Equity markets
CHAPTER
Overseas equity markets Settlement period
Trading system
Clearing and settlement
Depositary
US
T+3
NASDAQ NYSE – Euronext SuperDot
NSCC
DTC
France
T+3
Euronext NSC
LCH.Clearnet
SICOVAM (Euroclear France)
Germany
T+2
Deutsche Borse
Clearstream
Clearstream
Japan
T+3
Tokyo stock exchange
JSCC
JASDEC
Country
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. Settlement usually occurs through an electronic settlement and registration systems, such as Euroclear UK and Ireland’s CREST. Other settlement systems in various countries throughout Europe are Euroclear, LCH.Clearnet and Clearstream. There is also the DTCC in the US and Jasdec in Japan. The use of an electronic settlement agency is not mandatory. Settlement can be achieved outside these by a paper based method. The seller would complete a STOCK TRANSFER FORM and send it with the share certificate to the buyer. The buyer would then send these forms to the company registrar who will cancel the old share certificate and issue a new one. This process is lengthy.
Euroclear UK and Ireland Euroclear UK & Ireland is the Central Securities Depository for the UK market and Irish equities, and operates the CREST settlement system. Settlement for the UK market covers a wide range of corporate and government securities, including those traded on the London and Irish Stock Exchanges and virt-x. The CREST system also settles money market instruments and funds, plus a variety of international securities. In the CREST environment, investors are able to hold their securities in dematerialised and certificated (paper) form.
3
Equity markets
CHAPTER
Euroclear UK & Ireland operates a DELIVERY VERSUS PAYMENT (DVP) settlement system. This means that it records changes in legal title and organises payment simultaneously. This is also referred to as CASH AGAINST DOCUMENT (CAD). DVP lowers settlement risks. 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. Euroclear UK & Ireland usually uses BOOK ENTRY TRANSFER (electronic transfer) to pass ownership on from the seller to the buyer, operating on a continuous basis from 5.30 am onwards throughout the day. However, investors wishing to hold paper certificates settle through the CREST Courier and Sorting Service (CCSS). 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. The following are typical services provided by the prime broker: Core settlement. Prime brokers ensure that securities and cash are exchanged in a timely manner. Custody. Safekeeping of securities and processing of corporate actions. Securities lending and borrowing (i.e. to cover short positions) Leveraged trade execution. Prime brokers offer a range of financing alternatives to facilitate leverage of client assets, Cash management. Active management of the funds’ cash positions for in order to maximise the return.
Prime Brokerage: Sources of equity finance Prime brokers offer a number of financing alternatives allowing their hedge fund clients to establish equity positions: Stock borrowing and lending. Prime brokers can arrange the temporary transfer of securities with agreement by the borrower to return equivalent securities to the lender at pre-agreed time. Borrowing hedge funds seek specific securities to cover short positions. In the cash-driven trades, the hedge fund is able to increase the returns on an underlying portfolio by receiving a fee for lending its investments, thereby boosting overall income returns on the fund.
3
Equity markets
CHAPTER
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. Rehypothecation. A prime broker pledges hypothecated client owned securities in a margin account as collateral for a brokerage's bank 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).
17 Equity markets: summary Key concepts Stock exchanges The purpose and role of stock exchanges.
London Stock Exchange: an overview The securities covered by Rule 3000. The right of the London Stock Exchange under Rule 3040. The different parties trading on the London Stock Exchange.
SETS The securities traded on SETS. The features of a standard trading day on SETS. The operation of a SETS screen. The distinctions between different types of SETS orders. The definition and uses of a Worked Principal Agreement.
SETSqx The securities traded on SETSqx. Key features of the operation of SETSqx
LSE's central counterparty service Know the role and purpose of the central counterparties used by LSE
3
Equity markets
CHAPTER
International Order Book (IOB) Know what trades on the IOB Know how trades are performed. Know who can trade on IOB
International Bulletin Board (ITBB) Know what trades on the ITBB Know how trades are performed. Know who can trade on ITBB
International Retail Service (IRS) Know what trades on the IRS Know how trades are performed. Know who can trade on IRS
Inter-dealer brokers Details of the service offered to other market participants by IDBs. The motivation for trading via an IDB.
Stock borrowing and lending The role of SBLIs in the equity markets.
Virt-x The role of virt-x as a direct competitor to the London Stock Exchange in the equity markets. Basic details of trading on virt-x. The reporting and publication requirements for virt-x trades. The role of LCH.Clearnet for virt-x trades.
PLUS The status of PLUS as defined by the FSA. Features and rues of trading on PLUS. Securities covered.
Overseas equity markets Basic features of trading and settlement in the main overseas equity markets.
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Equity markets
CHAPTER
3
Settlement Understand what settlement is. Know the ways settlement can occur
Prime brokerage The main services provided by a prime broker The use of the main sources of equity finance
Now you have finished this chapter you should attempt the chapter questions.
Warrants
4
CHAPTER
Chapter 4
Warrants Time Allocation: Approx Question Weight:
0.5hr 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
Warrants: the basics Know what is meant by the term warrant. 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
2 Warrants: the basics Warrants: background Warrants are securities issued by a company. 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).
3 Warrant value: introduction Formula value Formula value is the profit 'built-in' to a warrant (if any). 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).
4
Warrants
CHAPTER
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
Formula value
= Current share price - Exercise price = £2.50 - £2.00 = 50p per share or 500p in total
Premium value
= Warrant price – formula value = 70p – 50p = 20p per share or 200p in total
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:
Percent premium =
Warrant price - Formula value No. of shares created × Current share price
=
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.
4
Debt: types and features
6
CHAPTER
Chapter 6
Debt: types and features Time Allocation: Approx Question Weight:
2hrs 7-9
1 Debt types and features: introduction Chapter overview One way in which companies raise capital is by issuing shares. Only companies, however, can issue shares whereas both companies and governments can borrow money via the debt (or BOND) markets. A bond is an agreement to pay back an agreed amount at some point in the future, paying interest whilst the debt remains outstanding. Bonds represent a transferable loan by a company or a government, where the loan repayments and associated interest can be sold on to other investors in the secondary market. This chapter begins by considering bonds issued by the UK government, known as gilt-edged securities (or GILTS). Because the UK government often spends more money than it raises in tax revenues, it has to borrow money in the gilt market to make up the shortfall. 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
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
T0 Issue date
T1 Coupon payment
The other is index-linked; it will pay an inflation adjusted coupon every 6 months: RPI has increased by 5% 6 months
T0 Issue date 8 months prior to T0 RPI = 100
T1 Coupon payment
8 months prior to T1 RPI = 105 An index-linked gilt pays the coupon INFLATED by 5% (i.e. the increase in the RPI): £6 x 1.05 = £6.30
During a period of non-inflation, the gilt will payout the unadjusted semi-annual coupon.
Other non-conventional gilts Double dated gilts Double dated gilts are described with two dates, e.g. Treasury 11 3/4% 2007-2011. The Government has the option of redeeming AFTER the first date, but no later than the last date. Double dated gilts are categorised by using the latter date, e.g. Exchequer 12% 2017-2025 is categorised as a long-dated gilt.
Convertible gilts Convertibles grant the owner the right to convert the gilt into predefined amounts of a DIFFERENT gilt at some time in the future. Convertibles are usually short- to medium-term bonds which may be converted into a longer issue at the discretion of the INVESTOR.
6
Debt: types and features
CHAPTER
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.
Corporate bonds: security Debentures A debenture is a document which acknowledges a company's indebtedness to a third party. 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. Exchangeable - a bond that can be exchanged on redemption for third party company shares held by the bond issuer.
6
Debt: types and features
CHAPTER
Corporate bonds: summary
CORPORATE BONDS
DEBENTURES
LOAN STOCK
Secured debt securities
Unsecured debt securities
FIXED CHARGE
FLOATING CHARGE
OVER ASSETS
OVER ASSETS
• • • • •
Subordinated Guaranteed FRN Convertible Exchangeable
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.
Payment in kind (PIK) Most bonds pay cash at redemption to the bond holder, however a very small number of bonds pay in the form of payment in kind (PIK). The most common form of PIK is for the principal owed at redemption to be increased by the amount of current interest. There are also some instances where an amount of stock is transferred to the bondholder with an equal value to the current interest due. The full order of repayment is illustrated below:
6
Debt: types and features
CHAPTER
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 semiannually. 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.
Local authority loans A local authority refers to the councils that look after the needs of a region within the UK, for example the City of London local authority. They take responsibility for such things as refuse collection, education, health services and development and planning. 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:
All pay fixed income Fixed Loans
Yearlings
(Local Authority Mortgages)
(Maturity of 1 or 2 years, min denomination £1,000 nominal)
Local Authority Stocks
Tradable (on LSE)
6
Debt: types and features
CHAPTER
Protected convertible bonds A protected convertible bond means that holders receive a proportionate increase in the conversion ratio should the company make a scrip issue. 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. Exchangeable bonds can be exchanged into ordinary shares of a company, other than the issuer (or, commonly, for cash in lieu).
5 Domestic and overseas bonds: features Domestic bonds A domestic bond refers to one in which the nationality of the issuer, the denomination of the bond and the country of issue are the same. For example, a sterling denominated bond issued in London by a UK company.
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.
International bonds (also called Eurobonds) An international bond (EUROBOND) is a security where the denomination of the bond and the country of issue are all different. For example, a company issuing dollar bonds in Paris and Tokyo, or a company issuing Yen bonds in Frankfurt and Dublin. 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. Most Eurobond issues are in BULLET form, redeemable on a specified date. However, alternative redemption patterns do exist, for example: Some issues are redeemed in portions over a number of years.
6
Issuing debt
7
CHAPTER
Chapter 7
Issuing debt Time Allocation: Approx Question Weight:
0.5hr 4-6
1 Issuing debt: introduction Chapter overview This chapter describes the process of bond issuance. 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:
Government bonds: issue Understand the role of the Debt Management Office in relation to gilt issues. Be able to identify participants in and features of the competitive and noncompetitive auction processes.
Corporate and overseas bonds: issue Understand the methods of issuing corporate bonds and Eurobonds.
Issuing debt
CHAPTER
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. Where the tranche issue is small, this is referred to as a TRANCHETTE.
When issued market Trading in gilts is possible in the period between the announcement of the auction and the auction date on what is known as the WHEN ISSUED MARKET. The trades will need to be settled by the eventual purchase of gilts through the auction process or secondary markets.
Overseas government bonds The majority of overseas governments issue bonds using an auction process. However, differences exist both in the way auctions are conducted and in the bodies responsible for conducting them. For example, in the US T-bonds are issued by way of a DUTCH AUCTION. Investors wishing to buy T-bonds are required to bid, not a price, but a yield, e.g. I bid 6% yield on $10m worth of T-bonds. The yield implies a price the investor is willing to pay. 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.
3 Corporate and overseas bonds: issue Corporate bonds: issue The method commonly used for issuing corporate bonds is a PLACING. Traditionally, a lead manager is appointed who takes responsibility for negotiating the terms and conditions (e.g. coupon, maturity, what happens in the event of default, etc.), and the price of the new issue. Underwriting of corporate bond issues is common. The lead manager generally chooses an underwriter to guarantee the whole issue. 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. Spread analysis is explained further in the debt valuation chapter.
7
Issuing debt
CHAPTER
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.
Medium term notes A company can also issue medium term notes (MTNs). These are debt notes that mature in 2-10 years and pay a fixed coupon or a floating rate of interest depending on market demand. 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. Roadshow. A series of meetings with potential investors and brokers, conducted by a company and its underwriter, prior to a securities offering in order to market the issue.
7
Issuing debt
CHAPTER
Listing. In case of a listing of the bond issue, relevant documents – including a prospectus – have to be prepared and submitted to the listing authority. 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 leadmanager 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.
4 Other bond issuers Supranational bonds Supranationals such as the World bank, European Investment Bank and Asian Development Bank issue bonds. These are called supranational bonds.
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.
7
Debt valuation
CHAPTER
Debt valuation: prices and yields Be able to calculate flat yields. Understand gross redemption yields. Understand net redemption yield. Understand the relationship between flat yield, gross redemption yield and coupon. Be able to determine the relative value of debt using spread analysis. Know the relationship between clean and dirty prices.
Debt valuation: factors affecting prices Understand the effect of interest rate movements on bond prices. Be able to assess a bond's price volatility by reference to time to redemption and coupon rate. Understand the concept of modified duration. Understand the concept of convexity;
Yield curves Be able to give reasons for different shaped yield curves.
2 Debt valuation: prices and yields Bond prices Bond prices are generally quoted in quantities of £100 nominal value, e.g. £95 (per £100 nominal value). However, this does not mean that trades in bonds can only be in denominations of £100 nominal value. It is possible to buy or sell any quantity.
Bond yield calculations Introduction Yields are used to establish the return a bond is achieving. 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.
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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 × 100% = 4.4% £95 100
FLAT YIELD (coupon income) +
+
PROFIT (OR LOSS) AT REDEMPTION
(£5 Profit
8 years ) × 100 % = 0.7 % £95
NET REDEMPTION YIELD
5.1%
Comments The only difference between the GRY and NRY is the tax adjustment made to the flat yield.
Debt valuation: discounting So far, the price of a bond and the associated cash flows (interest and redemption value) have been known, and have been used to calculate the total return, or GRY. 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: Value of bond =
=
£coupon £coupon + £red val + (1 + r ) (1 + r ) n
£6.50 £106.50 + (1 + 0.045) (1 + 0.045)
= £103.74
2
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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 5.8%
-30bp
Jazzy plc bond 5.5% 10yr swap 5.45%
+5
10yr Gilt 5.3%
+20bp
Clean vs. dirty prices The concept of accrued interest Quoted bond / gilt prices, such as the prices in the Financial Times, are CLEAN prices. 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.
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The dirty price will EQUAL the clean price on the coupon payment date. Unlike equities, gilts cannot trade special ex coupon.
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.
Clean and dirty price: example An investor sells a 6% semi-annual bond on the 24th March at a clean price of £107. If the coupon dates are 1st January and 1st July what would be the dirty price received by the seller? 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: 1st January to 24th March 31 + 28 + 24 = 83 days NOTE: we assume it is not a leap year and we include the trade date. Number of days in the coupon period: 1st January to 30th June 31 + 28 + 31 + 30 + 31 + 30 = 181 days The proportion the investor is entitled to is 83 / 181 of the semi-annual coupon, or £3. This gives us: 83 181
x £3 = £1.38
The dirty price is, therefore, the clean price, £107, plus the accrued interest, £1.38. £107 + £1.38 = £108.38
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Consequently, if interest rates increase, investors could earn a higher rate of interest (a higher yield) from a bank deposit. They will therefore demand a higher return from a bond. 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). The reverse is true should interest rates (and yields) fall.
Bond prices: time to redemption PULL TO REDEMPTION 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). Therefore, volatility of bond prices decreases as the time to redemption decreases. This is described as the PULL TO REDEMPTION.
Bond prices: coupon The lower the coupon the bond offers, the more volatile / sensitive the price is to changes in interest rates. 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.
Bond prices: bond futures Although, in general terms, the price of the bond drives the value of a bond future, there are occasions when the future drives the price of the bond itself. This is mainly due to the liquidity of the respective markets.
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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.
Overall risk of bonds It follows that a LOW COUPON, LONG DATED BOND is relatively HIGH RISK. A high coupon, short dated bond is relatively low risk. 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
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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. The convexity of a bond is used to calculate a CONVEXITY ADJUSTMENT. This is added to the modified duration calculated price to give a more accurate answer.
Price vs yield 140
120
A move in yields from 1% to 2% would result in a price drop from 86 to 60 or 30.2% (approx)
100
Price
80
A move in yields from 6% to 7%, however, would result in a price drop from 20 to 16 or 20% (approx)
60
40
20
yield
0 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.
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Investment grade
Speculative grade
CHAPTER
Standard & Poor’s
Moody’s
AAA
Aaa
AA
Aa
A
A
BBB
Baa
BB
Ba
B
B
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. These can take a variety of forms Guarantees by parent companies Credit insurance Letters of credit from a bank
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.
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Maturity
Downward sloping Yield
Humped Yield
Yield
Normal / upward
CHAPTER
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.
5 Debt valuation: summary Key concepts Debt valuation: prices and yields The calculation of flat yields. The calculation of Gross redemption yields. Net redemption yield. The relationship between flat yield, gross redemption yield and coupon. The relative value of debt using spread analysis. The relationship between clean and dirty prices.
Debt valuation: factors affecting bond prices The effect of interest rate movements on bond prices.
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8
The assessment of a bond's price volatility by reference to time to redemption and coupon rate. The concept of duration and modified duration. The concept of convexity
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: Approx Question Weight:
1 Debt markets: introduction Chapter overview Now that you have seen some of the features and characteristics of bonds, you need to gain an understanding of the markets in which they trade. This chapter starts with the gilt market and, in particular, the role played by GEMMs - GILTEDGED MARKET MAKERS. Essentially, GEMMs ensure that a stable and liquid market exists for gilt-edged securities during normal market hours. 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:
Government bonds: trading Know the principal participants in the secondary market for gilts. Know the role of market makers and their obligations. Understand the method of trading for gilts.
1 hr 7-8
Debt markets
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Corporate bonds: trading Understand the method of trading for corporate debt.
International debt markets Know the methods of trading and standard settlement periods for the main overseas government debt markets.
Eurobonds: trading Understand the method of trading for Eurobonds.
Government bonds: settlement Know the clearing house and possible settlement times for gilts.
Corporate and overseas bonds: settlement Know the clearing houses and standard settlement times for corporate debt and Eurobonds.
2 Government bonds: trading UK government gilts: trading Participants Gilt-edged market makers (GEMMs) GEMMs are specialist gilt trading firms, also referred to as primary dealers, who undertake to the Debt Management Office (DMO) to make a market in gilt edged securities. GEMMs register with the DMO but are supervised by the FSA. GEMMS provide liquidity to the market by being obliged to quote two-way prices at which they are committed to deal, in appropriate sizes discussed in advance with the DMO. GEMMs are obliged to quote prices to broker dealers and other clients known to them. They are not obliged to quote to other GEMMs. GEMMs may make a market in index-linked gilts only, non-index linked gilts only or all gilts (both index linked and non-index linked).
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.
Inter dealer brokers (IDBs) A gilt IDB, like an equity IDB, is a London Stock Exchange member firm which has registered with the Exchange to provide intermediating services between other LSE member firms. IDBs are used primarily by GEMMs and equity market makers to facilitate anonymous offset of positions in securities.
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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.
Stock borrowing and lending intermediaries (SBLIs)
GILTS
Investor
GEMM - sells ‘short’ 10m Nominal 8% Treasury 2032
GILTS
S.B.L.I
Pension Fund
(Commission)
(Fee)
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.
Dealing and reporting Investors can buy gilt-edged securities either from the DMO auction (in the primary market), or by trading in gilts on the LSE (the secondary market). 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. However, trading in gilts is predominantly carried out by using e-trading systems between member firms. GEMMs do not deal directly with private customers. If a private customer wishes to trade with a GEMM they must do so through a broker.
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; Inter-dealer (business to business or B2B) electronic market systems (e.g. Electronic Trading Platforms (ETPs), such as MTS and Brokertec); Over the counter customer to dealer voice trading; Dealer to customer (business to customer or B2C) electronic market systems e.g. ETPs such as TradeWeb, BondVision, proprietary Single Dealer Platform (SDP); and On exchange trading directly.
The gilt repo market A gilt repo is a transaction where one party sells gilts to the other, agreeing at the same time to repurchase the equivalent securities at an agreed price and on an agreed date in the future. It is the sale and repurchase (REPO) of gilts.
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There are two components to a repo: 1. The sale: GILT
£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. A REVERSE REPO is a purchase and subsequent resale of a gilt at a pre-agreed price. It is simply a gilt repo viewed from the point of view of the other party to the transaction. 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. Repos can be undertaken in equities as well as gilts. 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.
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3 Corporate bonds: trading Corporate bonds: introduction The corporate bond market is similar in many respects to the gilt market, except that the DMO is not involved. Market makers register with the London Stock Exchange and are obliged to quote prices to other member firms, EXCLUDING other market makers, inter-dealer brokers and stock borrowing and lending intermediaries. 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.
Corporate bonds: dealing and reporting on LSE Display of prices Prices of corporate debt securities MAY be quoted on SEAQ, but there is no obligation for market makers to use the system in the same way as there is for the trading of equities. 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.
Corporate bonds: dealing off exchange Only a relatively small number of corporate bond dealing takes place via an exchange the majority are inter-dealer trades away from the exchange by phone or using the e-trading systems detailed in section 2 of this chapter. 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 Emerging markets securities
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4 International debt markets Key features, characteristics and names of US, French, German and Japanese government bonds are listed in the following table:
France (OATs & BTANs)
Germany
Italy (BTPs)
USA (Tbonds)
Japan (JGBs)
Legal form
Bearer
Bearer
Bearer
Registered
Registered or bearer
Life when issued (years)
BTF < 1 yr BTAN 2 - 5 yrs OAT 7 – 50yrs
Schatz: 2 Bobl: 5 Bund: 10-20
Variable
Tnotes: 2 10 Tbonds: >10
Normal :
Coupons
Annual
Annual
Semiannual
Semiannual
Semi-annual
Settlement agency
Euroclear Clearstream Relit
Euroclear Clearstream/ DBC Frankfurt Kassenvvere ine
Stanza di Compen sazio ne de Titoli
Federal Reserve
Tokyo Stock Exchange
Settlement time
T+3 (BTAN T+1)
T+3
T+3
T+1
T+3
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. Once a deal is struck, it is reported to TRAX before it is processed for settlement. TRAX is a highly sophisticated trade confirmation system operated by ICMA (the International Capital Market Association) and is able to offer trade reporting, confirmations and operational risk management. It is not a settlement system and is not a method of communicating with Euroclear or Clearstream. Trade reports need to be made within 30 minutes. Euroclear and Clearstream settle Eurobond transactions. Cross settlement can occur between the two systems via a system called the Bridge. ICMA also regulates the international bond market.
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Foreign exchange
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10
FX: spot markets Be able to use a spot rate quoted as a bid-offer spread to calculate conversion amounts.
FX: forward markets Know the terminology for quotation in the forward market. Know how the CLS works.
2 FX rates: standards of quotation FX: background The foreign exchange (FX) market is a global over the counter (OTC, or OFF EXCHANGE) market in the world’s different currencies. 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. Settlement of currency transactions is processed directly between the counterparties to the trade. There is no central counterparty operating in the markets. 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. London is the largest centre for FX trading.
FX: the role of the US Dollar The US Dollar (USD) plays a key role in the FX market. 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.
FX: exchange rate quotation Introduction Each currency is represented by a three letter code (called an ISO code); generally speaking the first two letters denote the country and the last one the currency. For example Sterling’s ISO code is GBP: Great Britain Pound.
Foreign exchange
CHAPTER
10
Spot cable please
Cable is 10 / 15
4 FX: forward markets FX forward markets: introduction FX deals for settlement other than spot (up to 12 months) are known as FORWARD DEALS. Forward deals are possible provided that both parties agree and that the date in question is a GOOD day for both currencies. 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. Sometimes deals are executed consisting of a purchase or a sale on a near date and an opposite deal on another, later date. These are known as FX SWAPS. If the first (near) leg of the FX swap is itself in the future it is called a FORWARD FORWARD SWAP. 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
This is a discount because dollars are cheaper forward than spot.
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: SPOT RATE
GBP 1 = USD 1.5020
Forward Adjustment FORWARD RATE
+ 15 pips GBP 1 = USD 1.5035
It is referred to as a discount because dollars are cheaper for forward delivery (there are more dollars to one pound).
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: SPOT RATE
GBP 1 = USD 1.5020
Forward Adjustment FORWARD RATE
- 10 pips GBP 1 = USD 1.5010
It is referred to as a premium because dollars are more expensive for forward delivery (there are less dollars to one pound).
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.
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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.
Net FX settlement using Continuous Linked Settlement (CLS) Overview Continuous Linked Settlement (CLS) is a cross currency settlement system operated by CLS Bank and owned by a syndicate of banks. Before CLS, each side of an FX trade was paid separately. Taking time-zone differences into account, this heightened the risk of one party defaulting. CLS is a real-time system that enables simultaneous settlement globally, irrespective of time zones. It operates on a net basis (netting offsetting payments/receipts owed by/to individual banks) and so reduces cash flows and Herstatt risk. Settlement occurs within a five-hour window, which represents the overlapping business hours of the participating settlement systems. This system of settlement enables users to achieve simultaneous settlement of both sides of the transaction otherwise described as PAYMENT VERSUS PAYMENT (PVP).
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.
Summary of the CLS process From 06.30 CET to 07.00 CET members submit their net payment totals to the relevant central bank
06:30
07:00
Members input settlement instructions to CLS bank before 06.30 CET. At 06.30 CET CLS provides the member with its NET payment schedule for that day
Between 09:00 and 12:00 CET The pay-ins and payouts are finalised
09:00
12:00
Between 07:00 and 09:00 CET CLS continuously receives funds from settlement members, settles instructions across its books and pays out funds to settlement members
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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 cashclearing costs Errors are minimised and any problems can be resolved fast.
The role of central banks CLS Bank is a multi-currency bank that holds accounts with the relevant Central Banks. 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. As a result the UK RTGS system was developed to accommodate Euro accounts (CHAPS Euro) so that members could make domestic and cross-border Euro payments to the CLS.
5 Foreign exchange: summary Key concepts FX rates: standards of quotation The participants in the foreign exchange market. The methods of quotation against the US Dollar. The difference between spot and forward settlement.
FX: spot markets The terminology for quotation in the sport market.
FX: forward markets The terminology for quotation in the forward market. How the CLS works How the CLS works
Now you have finished this chapter you should attempt the chapter questions.
Regulation
CHAPTER
12
Know that client consent is required for execution
CRD Know the impact of CRD on securities firms’ trading books
US: SEC disclosure of interest rules Know the US disclosure of interest rules
US, Canada and Japan: Foreign Equity and foreign Broker-Dealers Know that these markets restrict the promotion and sale of foreign equity Know that foreign broker-dealers must be registered with the local regulator
2 Markets in Financial Instruments Directive (MiFID) MiFID: introduction The UK regulatory framework is influenced by both UK and European law. European law seeks to promote a single European marketplace. It achieves this via Directives, which are agreed amongst member states and incorporated into the local statutory frameworks. The main objectives are: Increase post-trade transparency across EEA Ensure best execution of trades across the EEA Ensure cost effective execution venues are available across the EEA MiFID allows investment services firms to be passported into the UK and throughout the European Economic Area (EEA).
MiFID: the EEA Under the scope of MiFID investment businesses can set up branches in other countries in the European Economic Area (EEA) without having to seek local authorisation. The EEA comprises: European Union (EU) countries (see below), plus; Norway Iceland Liechtenstein
Client Categorisation Retail clients A retail client is a client who is not a professional client or an eligible counterparty.
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CHAPTER
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; Net turnover of €40m; Own funds of €2m. These clients receive some protection from the regulatory environment
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.
Eligible counterparty business Eligible counterparty business comprises services and activities carried on with or for an eligible counterparty in the areas of dealing on the accounts, execution of orders on behalf of clients or reception and transmission of orders (or any ancillary services directly related to these).
Instruments covered by MiFID MiFID instruments include: Transferable securities e.g. shares, bonds and CFDs Money market instruments Units in collective investment schemes Derivatives relating to securities, currencies, interest rates or yields Commodity derivatives Credit derivatives Financial contrasts for differences Other derivatives (relating, e.g. to climate variables or other statistics
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Regulation
CHAPTER
12
Order execution policy In order to satisfy its obligation to obtain the best possible result for its clients, a firm is required to establish and operate an order execution policy. This policy must include, for each class of financial instrument, information about the different execution venues that the firm will use to execute client orders and the factors affecting the choice of execution venue. Clients must consent to this policy before execution commences.
Information about the order execution policy A firm must provide appropriate information to its clients about its order execution policy and obtain their consent. In the case of retail client, the firm must provide the following details about its execution policy before executing any transaction: An account of the relative importance the firm assigns to the execution factors; A list of the main execution venues used by the firm;
Best execution obligation and execution factors When executing an order for a client, the contractual best execution duty requires a firm take all reasonable steps to obtain the best possible result for its client taking into account the execution factors. The execution factors are defined as the “price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of an order”.
Best execution criteria A firm must take into account the following criteria for determining the relative importance of the execution factors: The characteristics of the client, including the categorization of the client as retail or professional; The characteristics of the client order; 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 and post-trade disclosure requirements Markets in Financial Instruments Directive (MiFID) has laid down a framework of disclosure requirements for trading activities. The pre-trade requirements apply to regulated markets and multi-lateral trading facilities (MTFs) and the post trade requirements apply to all firms.
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12
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
Capital Requirements Directive - CRD Financial regulations provide investor protection by ensuring that a firm always has enough capital to operate. The rules ensure that what a firm has (its financial resources) exceeds what it needs (the financial resources requirement imposed by its regulator). As a result of these financial regulations, should a firm become insolvent and go into liquidation there should be enough money to close down the business and transfer positions in an orderly manner. 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
13
CHAPTER
Chapter 13
Company accounts Time Allocation: Approx Question Weight:
2.5hr 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’.
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CHAPTER
Learning outcomes On completion of this module, you will:
Financial statements: components Know the three main primary statements in a set of accounts.
Financial statements: regulatory framework Know the requirement to produce accounts. Know the fundamental principles on which the preparation of accounts is based. Know the impact of FRS 3 on accounts. Know when and how the UK Listing Rules affect the preparation of accounts.
Balance sheet Know the format of a UK balance sheet. Know the meaning of fixed and current assets. Know the function and elements of balance sheet reserves. Know the difference between a liability and share capital.
Income statement Know the format of a UK income statement. Know how FRS 3 impacts on the presentation of financial performance.
Cash flow statement: IAS 7 Know the format of the cash flow statement
Group accounts Understand the concept of a group of companies. Know the meaning of the terms parent company, subsidiary company and minority interest.
2 Financial statements: components Financial statements: background Financial statements (or ACCOUNTS) summarise all transactions entered into by a company during its ACCOUNTING PERIOD. There are three main financial statements; the profit and loss account, balance sheet and cash flow statement.
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Company accounts
CHAPTER
13
Producing a set of accounts is the responsibility of the company directors. The accounts must then be audited by an independent firm of accountants (appointed by the shareholders) before they are approved by the shareholders at the company's annual general meeting.
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.
Cash flow statement The cash flow statement shows the cash received and paid by a company during the accounting period. It is similar to a bank statement and shows the reasons for the movements in cash in the period.
3 Financial statements: regulatory framework Companies Act 2006 (CA06) Introduction The Companies Act requires the directors of a company to produce accounts annually. Those accounts must show a TRUE AND FAIR VIEW of the company. The directors have a vested interest in presenting the company in as positive a light as possible. Auditors are appointed to check the accounts really are true and fair. 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:
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CHAPTER
Develop Accounting standards through their subsidiary, the Accounting Standards Board. Enforce the application of these standards through another subsidiary - the Financial Reporting Review Panel (FRRP). 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.
Reporting financial performance (FRS 3) FRS 3 primarily impacts on the income statement. Because it is already a Companies Act requirement to produce an income statement, the impact of FRS 3 is purely presentational. FRS 3 also requires exceptional items (that is, particularly large or unusual items of income or expenditure) to be highlighted and disclosed separately.
Accounting policies (FRS 18) FRS 18 deals primarily with the selection, application and disclosure of accounting policies. It requires an entity to select whichever accounting policies are judged to be most appropriate to its particular circumstances for the purpose of giving a true and fair view. An entity should judge the appropriateness of accounting policies to its particular circumstances against the objectives of: 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.
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Company accounts
CHAPTER
Accounts: summary CA 2006
ASB (FRS 3)
IASB (IAS7)
(Requirement and format)
(Format)
(Requirement and format)
INCOME STATEMENT
CASH FLOW STATEMENT
BALANCE SHEET
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. Therefore, NET ASSETS = SHAREHOLDERS FUNDS. This is the ACCOUNTING EQUATION. Note that net asset value per share (NAV/share) can be calculated from the balance sheet as follows:
Net asset value =
Total net assets (£) The number of ordinary shares in issue
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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. Turnover is usually recognised when the production process is complete and recoverability of the associated revenue is certain. This normally equates to recognition at a 'critical point' in the sales process, like despatch of goods for a manufacturing company or point of sale for a retail outlet. 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 and operating costs Cost of sales includes all the costs directly associated with producing a product or providing a service. For example, a car manufacturer would include all the raw material, labour and other costs directly associated with car production. 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
Selling and distribution costs
Administrative expenses
Operating costs may also be subdivided further between SELLING AND DISTRIBUTION, and ADMINISTRATIVE expenses.
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. Exceptional items are defined as: Material items,
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Deriving from events or transactions falling within the ordinary activities of the company, And requiring separate disclosure because of their unusual size or incidence. 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.
Interest and tax If a company has debt finance it will be required to service that finance by paying interest. Interest is paid out of operating profit. 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. Dividends paid and proposed in relation to an accounting period will be included in the income statement for that period. 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.
FRS 3: reporting financial performance With reference to the income statement example, the headings from turnover down to operating profit have been sub-analysed into two separate columns. Discontinued Operations and Continuing Operations. Discontinued operations are parts of the business which have closed during the year.
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Ratio analysis
CHAPTER
14
Chapter 14
Ratio analysis Time Allocation: Approx Question Weight:
1 Ratio analysis: introduction Chapter overview Ratios can be used to assess many aspects of a potential investment, from the reliability of dividend payments to the ability of a company to pay its short-term debts. 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 PE and be able to interpret and compare different companies' PE ratios. Know how to calculate EV/EBITDA and understand the concept of shareholder value added (SVA). Know how to calculate dividend yield and understand what is meant by a net dividend. Know how to calculate dividend cover.
2.5hr 4-6
Investment planning
CHAPTER
15
Chapter 15
Investment planning Time Allocation: Approx Question Weight:
1 Investment planning: introduction Chapter overview This chapter will introduce you to some general principles in relation to investment planning. 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:
Investment planning: general principles Understand the relationship between risk and return. Know the meaning of diversification and hedging and the associated benefits of their use.
Private client investment advice Understand the matters a private client would consider in selecting a portfolio. Understand how different clients are likely to have different preferences for risk, liquidity and income or capital returns. Know the general risk characteristics of investments.
1hr 4-5
Investment planning
CHAPTER
15
Investment advice: tax considerations Almost all investors pay income tax, but only those with capital gains in excess of their annual exemption pay capital gains tax. 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).
Investment risk profiles Very low risk Bank and building society deposits. Gilts (long-dated gilts are riskier; index-linked gilts reduce risk). National Savings Certificates. 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. Indirect investment via authorised unit trusts and ICVCs. Local authority stocks. 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. Real estate (mostly due to high entry and exit costs).
Investment planning
CHAPTER
High
RETURN
Summary
Warrants Equities Corporate bonds Government bonds
Low
Bank Accounts
Low
RISK High
4 Institutional investment advice Investment institutions The principal institutions include pension funds, and life assurance and general insurance funds.
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. Uncertainty can be reduced by a process called IMMUNISATION, whereby, for example, a £1,000,000 liability in 10 years time can be matched by buying £1,000,000 nominal of gilts with a duration of 10 years to eliminate re-investment risk. Over recent years government legislation has imposed a minimum funding requirement on certain pension funds in order to protect investors. This has caused managers to switch from equities to gilts in order to reduce risk.
Life assurance companies Life assurance companies do pay tax, therefore tax considerations are relevant in their investment policy. 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.
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Companies Act 2006
CHAPTER
16
Chapter 16
Companies Act 2006 Time Allocation: Approx Question Weight:
1hr 5-7
1 Companies Act: introduction Chapter overview The Companies Act 2006 is a piece of legislation primarily designed to protect shareholders from unscrupulous directors. 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.
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16
Understand the purpose of and types of company meetings. 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.
Memorandum and Articles of Association Know the purpose of the Memorandum of Association. Know the purpose of the Articles of Association.
Share buy-back Understand the reason for a company to perform a share buy-back Understand the methods used in share buy-backs Know the regulations governing share buy-backs
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. In view of concerns that a group of persons may covertly buy up a substantial proportion of the company's shares, possibly in preparation for a surprise takeover bid, the UK Listing Authority's Listing Rules require prompt disclosure of substantial shareholdings, including beneficial holdings.
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. The aim of this directive is to enhance transparency on EU capital markets by establishing rules for the disclosure of periodic financial reports and of major shareholdings for companies whose securities are admitted to trading on a regulated market in the EU. The key objectives of the directive are: To improve annual financial reporting by issuers of securities through the disclosure of an annual report; Increased disclosure of periodic financial information by issuers of shares through a mix of quarterly financial reporting for the first and third quarters of the financial year, and a more detailed half-yearly financial report; To introduce half-yearly financial reporting for issuers of only debt securities; and
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16
More frequent disclosure of changes to major shareholdings within stricter disclosure deadlines. The disclosure rules only apply to public limited companies (PLCs).
Disclosure of material interests The Transparency Directive outlines disclosure thresholds as follows: 5%, 10%, 15%, 20%, 25%, 30% 50% and 75%. Investors have to inform the issuer within 4 business days when reaching, exceeding or moving below the thresholds and the issuer in turn informs the market.
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. Falls below 3%. Note: Market makers are exempt from the disclosure requirements. 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): The person’s spouse. The person’s minor children ( £70m turnover taken over
COMPETITION COMMISSION (CC)
FINAL DECISION
The Enterprise Act 2002, Part 4 (Market investigations) The OFT also has the power under the Enterprise Act to make a market investigation reference to the CC if it suspects that ANY FEATURE of a market in the UK prevents, restricts or distorts competition. This can relate to the structure of the market or the conduct of suppliers or purchasers. Although it is primarily the responsibility of the OFT to make market references to the CC, sector regulators and 'the Appropriate Minister' (the Secretary of State) may also make them. 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
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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 funded by the receipt of levies on large transactions in UK equities. There is currently a flat levy of £1 on all transactions in UK equities with consideration in excess of £10,000. The levy is paid by the purchaser and the seller. The Panel is an independent, statutory, body. The Panel is also responsible for making other rules forming the BLUE BOOK.
City Code: staffing of the Panel The Chairman of the Panel is appointed by the Governor of the Bank of England. Many of the Panel members are seconded from industry, e.g. insurers, bankers, accountants, corporate finance professionals, etc.
City Code: application The Code applies in respect of the takeover of listed and unlisted public companies which are resident in the UK, Isle of Man or Channel Islands (Jersey, Guernsey, Alderney and Sark). The Code does NOT apply to open-ended investment companies (OEICs).
City Code: responsibilities The responsibilities imposed by the Code apply equally to company directors (of both the bidding and target companies) and to all the professional advisers involved (e.g. accountants, corporate finance houses etc.).
City Code: enforcement The Code is not based on statute, and so does not have the force of law. It requires that both the spirit as well as the letter of the Code are followed. The powers of the Panel are limited to the following: To issue a private reprimand. To issue a public censure. 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
Takeovers: practical considerations Defences available to the target company The directors of the target have various defences they could employ if the takeover is unwanted (or HOSTILE): The defence document will provide projections and arguments as to why a sale to the predator is not in the shareholders' best interests. Push for a referral to the Competition Commission. The management could purchase the company themselves, a management buy out (MBO). The management could seek an alternative purchaser (or WHITE KNIGHT). 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.
Target company shareholder issues The target company's shareholders will be concerned about: Maximising the value of their shares. It may be difficult for them to assess which option will generate most value in a takeover. 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.
Predator company shareholder issues The shareholders of the predator will be concerned whether they will lose value as a result of the takeover. They will consider: The price offered for the target company shares. 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.
6 Regulation on takeovers and mergers: summary Key concepts Stake building The reasons for and problems associated with stake building. The difference between a takeover and a merger.
Statutory control of takeovers and mergers The roles of the Office of Fair Trading, Competition Commission and Department of Trade and Industry under the Enterprise Act 2002.
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Regulation on takeovers and mergers
CHAPTER
17
The EU Takeover Directive The status of the EU Takeover Directive
Panel on Takeovers and Mergers: City Code The construction of the Code. The meaning of acting in concert. The key rules relating to compulsory bids, cash offers and disclosure.
Now you have finished this chapter you should attempt the chapter questions.
