Hi there, I came across 2 questions asking for risk characteristics, but the examiner's report for the questions seem to use different approaches in answering the questions: 1. April 2019 Paper 1, Question 7(iv) - The examiner report seems to list the risks involved in retail sector corporate bonds. 2. April 2018 Paper 1, Question 3(ii) - The examiner report seems to include a mix of elements (not just listing the risks), perhaps lightly relating to the SYSTEM T acronym for investment characteristics in the Acted course notes. Is there a general approach that I could use to generate ideas for this type of question? Thank you!
My apologies for the trouble, but another question related to the above; in April 2018 Paper 1, Question 3(iii), which I assume relates to Chapter 11: Behavior of the markets; I am quite confused about the relationship between asset prices and investment returns. For bonds, is it safe to assume that the relationship between bond prices and yields is always inverse; since coupons and redemption amounts are fixed? Is it however incorrect to assume the same relationship for share prices and returns? For example, even if the expected returns increases, this could be due to expected increases in dividends, hence the share price should remain relatively stable in this case (and not necessarily decrease with the increase in expected returns)? What about the relationship with interest rates/discount rates? Is it always right to assume that prices have an inverse relationship with interest rates, or does this depend instead on how the expected investment returns react to the change in interest rates? Thank you so much in advance!
Hi there, Both of these questions are asking about the risk characteristics of the investments. SYSTEM T is about the more general characteristics of an asset. So although SYSTEM T might be useful in both cases, it is important to focus on areas of risk. For example default risk, which we might think about based on S=security from SYSTEM T, and marketability risk, which we might think about based on M=marketability from SYSTEM T, etc. So SYSTEM T is a good starting point for idea generation on this type of question, but as with many questions in CP1, using multiple idea generation techniques is best to ensure a good answer. Another we might adopt here is to recall the broad risk classification headings provided in Chapter 25 and then consider whether any are applicable to the situation or asset described. The headings are market, credit, liquidity, business, operation and external. I'll respond to your other query in another post. Thanks, Richie
It is important to distinguish between those investors considering purchasing a bond and those investors who already hold bonds, because a change in price & yield mean very different things for each. If an investor is considering purchasing a bond, then yes, the relationship is inverse... the lower the price, the bigger the percentage return they will earn from fixed coupons and redemption. In other words, an increase in yields (ie a decrease in price) is a good thing for an investor thinking about purchasing a bond, because they can then buy the bond at a cheaper price. If an investor already holds a bond and plans to hold it until redemption, there is no relationship. If an investor already holds a bond and plans to sell it before redemption, the relationship is positive, ie a decrease in price will reduce their overall return, where overall return is made up of both income (coupons) and capital gain (sale price minus purchase price). Similar arguments can be made for equity... an increase in expected dividends is a good thing for investors already holding that equity, as the value of their equity is likely to rise. But those thinking about buying the equity might end up paying a higher purchase price for it following the increase in expected dividends. I hope this helps! Richie
Thank you so much for your reply, Richie! Just a follow-up question on the second question, is it right to say that an increase in interest rates always decreases the price of assets, since coupons and dividends are discounted at a higher rate? The reason I am confused about this is because in April 2018 Paper 1 Q3(iii), there's a statement that says: 'The certainty from guaranteed income streams will lead to lower discount rates applied to the income streams and higher values.'. Does this imply that the infrastructure asset has a direct inverse relationship with interest rates, and can we assume the same for bonds/equities/other assets? Or is it more 'correct' to consider it this way: For bonds, an increase in interest rates pushes up bond yields as investors would require a higher yield to invest in bonds, hence decreasing bond prices. For equities, an increase in interest rates may depress economic activity, reducing the profits of companies and hence dividends paid; reducing the price of equities.
Hi - your second version sounds fine. The value of an asset will typically represent the present value of the cashflows that the asset will generate. The higher the discount rate used for this, the lower the value, and vice versa. But saying that 'an increase in interest rates always decreases the price of assets' (per the first version) is too strong.
