CISI IAD Securities and Markets 2 — Questions and Answers
Question 1: What is the difference between 'clean' and 'dirty' prices when trading bonds?
- Clean prices include accrued interest while dirty prices exclude it
- The clean price excludes accrued interest while the dirty price (settlement price) includes accrued interest (Correct answer)
- Clean prices apply to government bonds only and dirty prices to corporate bonds only
- There is no practical difference
Correct answer: The clean price excludes accrued interest while the dirty price (settlement price) includes accrued interest
The clean price is the quoted price of a bond excluding any accrued interest since the last coupon payment. The dirty price (or full/settlement price) adds the accrued interest to the clean price and is the actual amount paid on settlement. Bonds are quoted at clean prices to allow fair comparison between bonds with different coupon dates, but settlement always occurs at the dirty price. Accrued interest = coupon × (days since last coupon / days in coupon period).
Question 2: What is 'duration' in the context of bond investment?
- The number of years until the bond matures
- A measure of a bond's price sensitivity to changes in interest rates, expressed in years (Correct answer)
- The length of time the bond has been trading
- The period between coupon payments
Correct answer: A measure of a bond's price sensitivity to changes in interest rates, expressed in years
Duration (specifically modified duration) measures a bond's price sensitivity to changes in interest rates. A duration of 5 years means that for a 1% rise in yields, the bond price will fall by approximately 5% (and vice versa). Longer duration bonds are more sensitive to interest rate changes. Duration considers all cash flows (coupons and principal) weighted by time. Zero-coupon bonds have a duration equal to their maturity; coupon-paying bonds have duration less than maturity.
Question 3: What is the purpose of a 'collective investment scheme' such as a unit trust or OEIC?
- To allow a single investor to control a company
- To pool money from multiple investors to achieve diversification, professional management, and economies of scale (Correct answer)
- To guarantee returns for investors
- To provide leverage for speculative trading
Correct answer: To pool money from multiple investors to achieve diversification, professional management, and economies of scale
Collective investment schemes pool funds from many investors into a professionally managed portfolio, providing benefits that would be difficult to achieve individually: diversification across many securities reduces unsystematic risk; professional fund management provides expertise; economies of scale reduce dealing costs per investor. In the UK, unit trusts and OEICs are the most common structures, regulated by the FCA and governed by the FCA's Collective Investment Schemes sourcebook (COLL).
Question 4: What is an 'investment trust' and how does it differ from an OEIC?
- An investment trust is an open-ended fund while an OEIC is closed-ended
- An investment trust is a closed-ended company listed on the stock exchange whose shares can trade at a premium or discount to NAV, unlike an OEIC which deals at NAV (Correct answer)
- They are the same structure with different names
- Investment trusts cannot invest in equities
Correct answer: An investment trust is a closed-ended company listed on the stock exchange whose shares can trade at a premium or discount to NAV, unlike an OEIC which deals at NAV
An investment trust is a closed-ended listed company that invests in other securities. Unlike OEICs, it has a fixed number of shares which trade on the stock exchange at prices determined by supply and demand. This means shares can trade at a premium (above NAV) or discount (below NAV). Investment trusts can also use gearing (borrowing to invest), which amplifies both gains and losses. They are governed by company law and the Listing Rules, not COLL.
Question 5: What is 'best execution' under MiFID II?
- Always achieving the lowest possible purchase price
- The obligation on firms to take all sufficient steps to obtain the best possible result for clients when executing orders, considering price, costs, speed, likelihood of execution, and other factors (Correct answer)
- Executing orders as fast as possible regardless of price
- Routing all orders through the largest exchange
Correct answer: The obligation on firms to take all sufficient steps to obtain the best possible result for clients when executing orders, considering price, costs, speed, likelihood of execution, and other factors
MiFID II best execution (Article 27) requires firms to take all sufficient steps to obtain the best possible result for clients, considering multiple factors: price, costs (explicit and implicit), speed, likelihood of execution and settlement, size, nature, and any other relevant consideration. For retail clients, the best possible result is generally determined by total consideration (price plus all costs). Firms must have an execution policy, monitor effectiveness, and disclose their top five execution venues annually.
Question 6: What is a 'structured product' in the context of UK retail investment?
- A simple savings account with a fixed interest rate
- A pre-packaged investment strategy combining derivatives with other assets to provide a defined risk-return profile, often linked to an index with capital protection features (Correct answer)
- A government-backed savings bond
- A portfolio of directly held equities
Correct answer: A pre-packaged investment strategy combining derivatives with other assets to provide a defined risk-return profile, often linked to an index with capital protection features
Structured products are pre-defined investment strategies that typically combine a deposit or zero-coupon bond with derivatives (usually options) to create a specific risk-return profile. Common features include capital protection (full or partial), returns linked to an index (e.g., FTSE 100), defined investment terms (typically 3-6 years), and kick-out/autocall features. They carry counterparty risk (the issuer's ability to pay), which became apparent during the 2008 financial crisis.
CISI IAD Securities and Markets 2
What is the difference between 'clean' and 'dirty' prices when trading bonds?