What is the purpose of using cash equivalents?

The first major purpose for using a cash equivalent is to have ready access to the investment principal – due to the liquid nature of the investment, cash can be readily available should the need arise. Another purpose for using a cash equivalent is that it serves as a receptacle for accumulating funds to purchase other investment assets in an amount that meets the minimum purchase requirement, or minimises the per unit transaction acquisition cost (such as buying a round lot of 1,000 shares of a publicly traded stock, to avoid a higher per-share price). Finally, a cash equivalent is used when investors are uncertain about the direction of the economy or prices of investment alternatives; they may place their money in these instruments until they can determine the direction of the economy or prices of potential investments.

Why investors should invest in money market instruments?

Money market instruments are generally low in risk and their primary function is to provide a pool of reserves that can be used for emergencies, or to accumulate funds for some specific purposes. Money market instruments are basically viewed as a means of accumulating funds that will be readily available when the need arises.

Explain the reinvestment risk faced in money market instruments?

Reinvestment risk refers to the risk that it may not be possible for an investor to reinvest the proceeds of his investments at rates equivalent to those of the maturing investments, because of possible declines in interest rates.
Money market instruments are subject to reinvestment risk because they are short-term instruments. The investor has to reinvest his proceeds from the investment each time his shortterm investment matures.

Which two factors need to be considered when selecting a fixed income security?

Investment Quality
This is reflected by the probability that a fixed income issue will go into default. The investor’s perception of default risk will determine the interest rate that he is willing to accept, the price to pay, and the maturity to take.

Maturity
In addition to quality, investors can control the risk of fixed income investments through maturity selection. Yields will usually differ for different maturities giving rise to the “yield curve”, which defines the current yield for each possible maturity. It is usually the case that yields increase for longer
maturities. The longer the maturity, the more volatile the bond price will be.

What are the disadvantages of investing in fixed income securities?

A major disadvantage of investing in fixed income securities is that the coupon rate is fixed for the life of the issue and, therefore, cannot move up over time in response to inflation.

Unlike ordinary shareholders, buyers of fixed income securities issued by a company do not participate in the profits of the company. They also do not have other shareholder rights, such as those of shareholders voting in company meetings.

Why bond ratings are important to issuers and investors?

Bond ratings are important to both issuers and investors. First, because a bond’s rating is an indication of its default risk, the rating has a direct, measurable influence on the bond’s interest rate and the issuer’s cost of capital. Second, most bonds are purchased by institutional investors rather than individuals due to their high investment amount, and many institutions are restricted to investment-grade bonds only. Thus, if an issuer’s bond rating falls below investment grade, the issuer will have a difficult time selling new bonds because many potential investors will not be allowed to buy them.

What are the benefits of buying options?

The most significant advantage of options is the effective management of risk. Options limit the investor’s exposure to risk, since the only amount of money to be lost is the purchase price of the option.

Another major advantage of buying options is the leverage that options offer. As options are leveraged on securities, their values respond more than proportionately to changes in the underlying security value.

What are the advantages of ES contracts?

ES contracts are flexible instruments that offer the investor numerous advantages, such as capital efficiency, ease of taking short positions and longer view of the market. In addition, it can be used as a hedging tool, taking advantage of stock spreads, as  well as arbitraging.

What are the disadvantages of investing in warrants?

The main drawback is that on expiry, warrants that are not exercised will lose their value completely. Unlike ordinary shares, there is no chance for price recovery. Once the warrant has expired, it is worthless. Another disadvantage is that warrant holders do not receive any income in the form of interest or dividends. They also carry no voting privileges.

What are the common types of swaps?

Common types of swaps include:

•  Currency swap: simultaneous buying and selling of a currency to convert debt principal from the lender’s currency to the debtor’s currency;
• Debt swap: exchange of a loan (usually to a third-world country) between banks;
• Debt to equity swap: exchange of a foreign debt (usually to a third-world country) for a stake in the debtor country’s national enterprises (such as power or water utilities);
• Debt to debt swap: exchange of an existing liability into a new loan, usually with an extended payback period; and
• Interest rate swap: exchange of periodic interest payments between two parties (called counter parties) as a means of exchanging future cash flows.

Why real estate investments are more complex than any other types of investments?

Real estate investments usually involve more complexities than the other investment categories because of:

•  the uniqueness of each property;
• the differing rights associated with ownership of each property; and
• the absence of organised markets for the ready sale and purchase of the property or ownership interest.

What are the benefits of structured products?

(a) Return of initial capital on maturity;
(b) Enhanced returns within an investment;
(c) They can be used as an alternative to a direct investment;
(d) They can be used as part of the asset allocation process to reduce risk exposure of a portfolio;
(e) They can be created to take advantage of the current market trend; and
(f) They can be created to meet specific needs that cannot be met from the standardised financial instruments available in the markets.

What are the different regulatory functions of SGX?

SGX also carries out regulatory functions, which include the following:

• Issuer regulation: To review listing applications and monitor compliance with listing requirements;
• Member supervision: To process membership applications, monitor members’ compliance with SGX rules, provide support to members on  regulatory issues and investigate complaints concerning members;
• Market surveillance: To maintain surveillance of all trading activities;
•  Enforcement: To investigate suspected complaints and perform disciplinary action;
• Risk management: To monitor and manage SFX’s counterparty risk exposure to clearing members for SGX trades.

How transaction costs help in showing the efficient financial market?

The transaction cost relating to a trade includes brokerage fees, clearing fees and associated stamp duties. The current trend has been towards a lower transaction cost. In some markets, stamp duties have been abolished to foster a more vibrant financial market. A low transaction cost indicates that the financial market is internally efficient.

Explain the maxim “higher risk, higher return“?

Other things being equal, it is assumed that investors generally prefer a higher expected return than a lower expected return, and a lower risk than a higher risk.
This means that investors prefer to have:

• a higher return for a given level of risk; and
• a lower risk for a given level of return

In general, investors will undertake additional units of risk only if accompanied by additional reward in the form of higher expected return. In order for an  investor to take on higher risk, i.e., to invest in a fund with higher volatility, he has to be compensated with higher return. Hence, the maxim “higher risk, higher return”. The additional return is also referred to as the risk premium.

How the diversification helps in reducing risks?

The returns on the two investments are:

• perfectly positively correlated (correlation = 1) if their returns move in the same direction;
•  perfectly negatively correlated (correlation = -1) if their returns move in opposite directions; or
• uncorrelated (correlation = 0) if their returns have no relationship with each other.
  The correlation of returns ranges between +1 to –1. Investors can eliminate unsystematic risk (and hence, portfolio risk) by combining assets whose correlation of returns is less than +1. The smaller the correlation (the closer it is to –1), the greater the reduction in the portfolio risk, and hence the diversification benefits.

What is represented by the tracking error when using a benchmarking strategy?

When using a benchmarking strategy, tracking error represents the amount by which the performance of the portfolio differs from that of the benchmark. In reality, no strategy can perfectly match the performance of the benchmark, and the tracking error quantifies the degree to which the strategy differs from the benchmark, by measuring the standard deviation between the two values. All else being equal, the higher the information ratio, the better the performance will be.

What are the three variables involved in Value at Risk variables measurement?

VAR is measured in three variables:
i) the amount of potential loss;
ii) the probability of that amount of loss; and
iii) the time frame.

Explain the parametric model used for calculating VAR?

This approach requires only two inputs, the mean and the variance (standard deviation of the periodic returns). The advantage of using the parametric method is that it is very easy to determine the confidence levels. The disadvantage of the parametric model is that it assumes a normal distribution. Normal distributions are terrible at predicting black swan events.

What are the limitations of VAR as the risk indicator?

Limitations of VAR as a risk indicator include:

• estimation difficulties, and sensitivity to estimation methods used;
•  the potential to create a false sense of security;
•  its tendency to underestimate worst-case outcomes;
• the inability of the VAR of a specific position to always translate well into the VAR of the overall portfolio.

What issues should be considered by investors when planning for an investment?

Investors should consider the following issues when planning for investment:

• investment objectives and risk tolerance;
• liquidity;
•  investment time horizon;
•  tax considerations;
• regulations and legal constraints;
• diversification; and
• investment styles of fund managers.

What should be considered by the good investment policy?

A good investment policy should consider both the external and internal aspects of investment. This means that the investment policy should ultimately reflect and be in line with the investment style of the investor. The investment style of an investor is about the approach, mindset, and/or philosophy that influence how investors frame their expectations and choose the means to achieve their investment objectives.

Why wealth and income should be considered when defining investment objectives?

The better the financial position of the investor, the higher the risk that he can afford to take. Even if the investment suffers temporary losses, he will still be able to maintain his lifestyle, or even contribute additional capital to his investments. On the other hand, if he needs the income from his investment to supplement his lifestyle, then he may need to allocate a greater proportion of his funds to income-generating funds.

What is the purpose of diversification?

The purpose of diversification is to reduce investment risk. Simply put, it is about not putting all your eggs in one basket. By doing so, the volatility of your investment returns is reduced. Diversification can be achieved by combining assets in your portfolio which have a correlation of return that is less than one or better still, negative.

Differentiate between top down and bottom up styles of investment?

Top-down investing involves analyzing the “big picture”. Investors using this approach look at the economy and try to forecast which industry will generate the best returns. These investors then look for individual companies within the chosen industry and add the stock to their portfolios.
Conversely, a bottom-up investor overlooks broad sector and economic conditions and instead focuses on selecting a stock based on the individual attributes of a company. Advocates of the bottom-up approach simply seek strong companies with good prospects, regardless of industry or macroeconomic factors.

What are the different parties included in the collective investment scheme?

The operation of a collective investment scheme involves three main parties, namely: (1) the trustee; (2) the fund manager; and (3) the distributor.

Which objectives need to be fulfilled by the trustee when acting as a “watchdog“?

By virtue of the Trust Deed, the trustee acts as the “watchdog” to safeguard the rights and interests of the investors. To fulfil this objective, the trustee must perform the following key roles to:

• ensure that investments in the unit trusts comply with the trust deed which is a legal document drawn up to govern the aims and objectives of the fund, as well as its investment guidelines. This is to minimise the risk of is management by the fund manager;
•  assume legal ownership of all assets (securities and residual cash) belonging to the unit trust and holds them in trust for unit holders ‒ this is to ensure that all assets belonging to the unit trust are protected from the other operational and financial risks of the fund management company;
•  maintain proper accounting records for the unit trust and have them audited yearly; and
• keep in custody all investments and other assets that form the capital of the fund.

What are the key roles of the fund manager under the objectives in the trust deed?

To fulfill these objectives, the manager must perform the following key roles to:

• invest all assets in the unit trust to meet its objective as set out in the trust deed;
• create or redeem units in accordance with the stipulated methods of calculating the unit price; and
• prepare semi-annual and annual performance reports of the unit trust and send them to unit holders.

How fees and charges are pitfall of the unit investment trust compared to other investment options?

Investors would usually have to pay a one-time initial sales charge when they buy unit trusts. There will also be other costs, such as trustee fees, management fees and redemption fees that investors do not have to pay if they buy and sell shares directly in the stock market by themselves.

What are the risks involved in investing in ETNs?

The risks of investing in ETNs include: (i) credit risk of issuer; (ii) liquidity risk; (iii) market risk; and (iv) foreign exchange risk.