Investment Management Certificate (IMC) Asset Classes and Financial Instruments Flashcards

24 sample cards from the Asset Classes and Financial Instruments deck

Sampled from the end of the deck, so these are different cards from the ones shown on the syllabus page.

1. State the dividend discount model (Gordon growth model) for valuing a share.

   Assuming constant dividend growth, the share value is: $$P_{0} = \frac{D_{1}}{r - g}$$ where $D_{1}$ is next year's dividend, $r$ is the required return, and $g$ is the constant dividend growth rate (with $r > g$).

2. Define the price-earnings (P/E) ratio and what it indicates.

   $$\text{P/E} = \frac{\text{Share price}}{\text{Earnings per share}}$$ It shows how much investors pay per unit of earnings. A high P/E often signals growth expectations; a low P/E may indicate a value stock or low growth/higher risk.

3. What is the dividend yield and how is it calculated?

   $$\text{Dividend yield} = \frac{\text{Annual dividend per share}}{\text{Share price}} \times 100\%$$ It measures the income return on a share, useful for comparing income-generating equities.

4. What is the difference between an order-driven and a quote-driven equity market?

   In an order-driven market (e.g. LSE SETS), buy and sell orders are matched on a central electronic order book by price/time priority. In a quote-driven (dealer) market, market makers continuously post bid and offer prices at which they will trade, providing liquidity from their own books.

5. What does T+2 settlement mean for equity trades?

   T+2 means a trade settles two business days after the trade date — the date on which securities and cash are actually exchanged. UK and most major equity markets use T+2 standard settlement (operated in the UK via CREST).

6. What is the difference between a forward contract and a futures contract?

   Both lock in a price today for future delivery. A forward is an over-the-counter, customised, bilateral contract with counterparty (credit) risk, settled at maturity. A future is exchange-traded, standardised, centrally cleared with daily margining (mark-to-market), greatly reducing counterparty risk.

7. What is meant by marking-to-market and margin in futures trading?

   Futures positions are revalued daily (marked-to-market); gains and losses are credited/debited to a margin account each day via variation margin. An initial margin is posted up front as a performance bond, ensuring counterparties can meet daily losses and reducing default risk.

8. Distinguish a call option from a put option.

   A call option gives the holder the right, not the obligation, to buy the underlying at the strike price by/on expiry. A put option gives the right to sell the underlying at the strike. Buyers pay a premium for these rights; sellers (writers) receive the premium and take on the obligation.

9. What determines whether an option has intrinsic value, and what is time value?

   Intrinsic value is the immediate exercise value: for a call, $\max(S-K,0)$; for a put, $\max(K-S,0)$, where $S$ is the spot and $K$ the strike. An option is in-the-money when intrinsic value is positive. Time value is the premium above intrinsic value, reflecting the chance of becoming more profitable before expiry.

10. List the main factors affecting an option's premium.

    Underlying price relative to strike (moneyness), time to expiry, volatility of the underlying, the risk-free interest rate, and dividends/income on the underlying. Higher volatility and longer time to expiry increase the premium of both calls and puts.

11. What is a plain vanilla interest-rate swap?

    An interest-rate swap is an OTC agreement to exchange interest payments on a notional principal: one party pays a fixed rate and receives a floating rate (e.g. SONIA), and the other does the reverse. Only net interest is exchanged; the notional principal is not exchanged.

12. Explain the difference between hedging and speculating with derivatives.

    Hedging uses derivatives to reduce or offset an existing risk exposure (e.g. a producer locking in a sale price). Speculating uses derivatives to take on risk in pursuit of profit from anticipated price moves, typically with leverage, without an underlying exposure to protect.

13. What are the two main ways to invest in real estate, and how do they differ?

    Direct investment means buying physical property — offering income (rent) and capital growth but with high cost, low liquidity, and management burden. Indirect investment uses vehicles such as REITs or property funds, giving exposure with greater liquidity, diversification and lower transaction costs.

14. What is a REIT and what is its key tax feature?

    A Real Estate Investment Trust is a listed, closed-ended company that invests in income-producing property. To qualify it must distribute most of its rental income (in the UK at least 90%) to shareholders; in return it is largely exempt from corporation tax on its property rental business, avoiding double taxation.

15. Distinguish a contango market from a backwardation market in commodities.

    Contango is when the futures price is above the expected spot/near price (upward-sloping forward curve), typically reflecting storage and carrying costs. Backwardation is when the futures price is below the spot price (downward-sloping curve), often signalling near-term scarcity or a convenience yield.

16. What are the main characteristics of an investment in hedge funds?

    Hedge funds are lightly regulated, actively managed pooled vehicles aimed at sophisticated/institutional investors. They use wide strategies including leverage, short selling and derivatives to seek absolute returns. Typical features: high minimum investment, limited liquidity (lock-ups), and 'two and twenty' fees (roughly 2% management plus 20% performance).

17. What is private equity and how do investors typically realise returns?

    Private equity invests in companies not listed on a public exchange — including venture capital (early stage) and buyouts (mature companies, often using leverage). Capital is locked up for years; returns are realised on 'exit' via a trade sale, secondary sale, or an IPO (flotation).

18. What is an open-ended fund (e.g. an OEIC or unit trust) and how is its price determined?

    An open-ended fund creates and cancels units/shares according to investor demand, so the fund size varies. Units are bought and sold at a price based on the net asset value (NAV) of the underlying assets, so the price always reflects the value of the portfolio — there is no premium or discount to NAV.

19. What is the difference between a unit trust and an OEIC in pricing structure?

    A unit trust is traditionally dual-priced, with a separate bid (sell) and offer (buy) price and a spread. An OEIC (open-ended investment company) is usually single-priced — one price for buying and selling — with charges shown separately. Both are open-ended and trade at NAV.

20. What is a closed-ended fund (investment trust) and why can it trade at a premium or discount to NAV?

    A closed-ended fund (UK: investment trust) is a listed company with a fixed number of shares. Its share price is set by supply and demand in the market, so it can trade above (premium) or below (discount) its net asset value, unlike open-ended funds which always price at NAV.

21. How can a closed-ended fund (investment trust) use gearing, and why can't an open-ended fund do so as readily?

    An investment trust has a fixed, permanent capital base, so it can borrow (gear) to invest, amplifying gains and losses. Open-ended funds face daily redemptions, so they must keep assets liquid and generally cannot gear to the same extent, since borrowing against a variable asset base is far riskier.

22. What is an exchange-traded fund (ETF) and what are its key features?

    An ETF is an open-ended fund that trades on a stock exchange like a share throughout the day. Most ETFs track an index passively, offer low costs, intraday liquidity and transparency. An authorised-participant creation/redemption mechanism keeps the market price close to NAV via arbitrage.

23. Distinguish physical (full) replication from synthetic replication in an ETF.

    Physical replication means the ETF actually holds the index securities (fully, or a representative sample). Synthetic replication uses a total-return swap with a counterparty to deliver the index return without holding the assets, introducing counterparty (credit) risk in exchange for potentially lower tracking error.

24. What is the difference between an ETF, an ETC, and an ETN?

    An ETF is a fund holding a diversified basket (usually equities/bonds). An ETC (exchange-traded commodity) gives exposure to a single commodity or basket, often via collateralised debt or physical holdings. An ETN (exchange-traded note) is an unsecured debt obligation of an issuer promising the index return, carrying the issuer's credit risk.

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