CISI IoI Equities and Bonds Basics — Questions and Answers
Question 1: What is a 'dividend' in the context of equity investment?
- The interest payment made by a company on its bonds
- A share of the company's profits distributed to shareholders (Correct answer)
- The capital gain made on selling shares
- A fee charged by a stockbroker for executing a share trade
Correct answer: A share of the company's profits distributed to shareholders
A dividend is a distribution of a company's profits to its shareholders. Companies may pay dividends quarterly, semi-annually, or annually. Dividends are not guaranteed and can be reduced or cancelled if profits fall.
Question 2: What does it mean when a share goes 'ex-dividend'?
- The company has cancelled its dividend payment
- After the ex-dividend date, a buyer of the shares will not receive the forthcoming dividend payment (Correct answer)
- The share has been removed from the FTSE 100
- The company has bought back all outstanding shares
Correct answer: After the ex-dividend date, a buyer of the shares will not receive the forthcoming dividend payment
The ex-dividend date is the cutoff — investors who buy shares on or after this date will not receive the next dividend; that payment goes to the seller. Buyers before the ex-dividend date are entitled to the upcoming dividend.
Question 3: What is the 'coupon' on a bond?
- The discount to face value at which a bond is issued
- The fixed interest payment made by the bond issuer to the bondholder, expressed as a percentage of the face value (Correct answer)
- The capital gain earned when a bond is redeemed
- The rating assigned to a bond by a credit rating agency
Correct answer: The fixed interest payment made by the bond issuer to the bondholder, expressed as a percentage of the face value
The coupon is the annual interest payment on a bond, fixed at issuance. For example, a £1,000 bond with a 5% coupon pays £50 interest per year. Coupons are typically paid semi-annually for UK gilts and corporate bonds.
Question 4: What happens to the price of an existing bond when interest rates rise?
- Bond prices rise proportionally
- Bond prices fall, because the fixed coupon is less attractive relative to new bonds issued at higher rates (Correct answer)
- Bond prices are unaffected by interest rate changes
- Bond prices double to compensate bondholders for the rate rise
Correct answer: Bond prices fall, because the fixed coupon is less attractive relative to new bonds issued at higher rates
When interest rates rise, newly issued bonds offer higher coupons, making existing lower-coupon bonds less attractive. To compensate, the price of existing bonds falls until their effective yield matches the new market rate.
Question 5: What is the difference between 'ordinary shares' and 'preference shares'?
- Ordinary shares carry voting rights and variable dividends; preference shares carry a fixed dividend and rank ahead of ordinary shareholders in a winding up (Correct answer)
- Preference shares carry voting rights; ordinary shares do not
- Ordinary shares are only available to institutional investors
- Preference shares can only be issued by government-backed entities
Correct answer: Ordinary shares carry voting rights and variable dividends; preference shares carry a fixed dividend and rank ahead of ordinary shareholders in a winding up
Ordinary shareholders are the residual owners of a company with voting rights but variable (or no) dividends. Preference shareholders receive a fixed dividend paid before ordinary dividends and rank ahead in a winding up, but usually have no voting rights.
Question 6: What is 'yield to maturity' (YTM) on a bond?
- The annual coupon payment divided by the current market price
- The total return an investor earns if they buy the bond today at the current market price and hold it until maturity, receiving all coupon payments (Correct answer)
- The premium above face value at which a bond is trading
- The credit risk associated with holding a bond to maturity
Correct answer: The total return an investor earns if they buy the bond today at the current market price and hold it until maturity, receiving all coupon payments
Yield to maturity calculates the total annualised return from a bond including all coupon payments and any capital gain or loss from buying below or above face value and holding to redemption. It allows comparison between bonds of different prices and coupons.
CISI IoI Equities and Bonds Basics
What is a 'dividend' in the context of equity investment?