Asset Classes & Investment Products

• Topic 01

  Asset Classes & Investment Products

  99 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. Why do money market instruments such as treasury bills and certificates of deposit tend to offer lower long-term real returns than equities?

   • A
     They have shorter maturities, which automatically restricts their return potential
   • B
     They are issued only by governments, which limits supply and suppresses yields
   • C
     They are not eligible for ISA wrappers, which reduces their after-tax return
   • D
     They carry lower risk, so investors require a lower return; over the long run, equities deliver an equity risk premium that compensates for their higher volatility
     Correct answer
   Explanation

   The risk-return trade-off is fundamental: money market instruments are near risk-free, so investors accept a low return. Equities carry market risk, business risk, and volatility, so investors demand an equity risk premium as compensation. Historically, this premium means equities have outperformed cash and money market instruments in real terms over long periods, though with much greater short-term volatility.

2. An investment adviser is comparing a bond portfolio's running yield against its redemption yield for a client approaching retirement who plans to hold to maturity. The portfolio's average price is significantly above par due to a period of falling interest rates. The adviser notes the redemption yield is substantially below the running yield. What should the adviser highlight to the client?

   • A
     The premium portfolio is advantageous for the client because higher-priced bonds tend to indicate superior credit quality
   • B
     The redemption yield being below the running yield indicates the bonds have been incorrectly priced by the market
   • C
     The client should sell the portfolio immediately to lock in the capital gains before maturity erodes them
   • D
     The income stream will be higher than the total return suggests, because the capital losses embedded in premium-priced bonds will reduce the real wealth returned at maturity; the client should plan for a lower total return than the running yield implies
     Correct answer
   Explanation

   When a bond portfolio has an average price above par, the running yield overstates the total return the investor will actually receive. The redemption yield is the correct measure of what the hold-to-maturity investor will earn in total — it accounts for the fact that bonds bought above par will 'pull' back to £100 at maturity, resulting in a capital loss. For retirement planning, the adviser must use redemption yield (not running yield) to project future wealth accurately. Using running yield would lead the client to overestimate their total return and potentially underfund their retirement.

3. A gilt with a par value of £100 and a 4% coupon is trading in the secondary market at £96. What annual coupon payment does the holder receive, and at what price will the gilt be redeemed at maturity?

   • A
     Annual coupon payment of £4, but the redemption price adjusts to match the market price at maturity
   • B
     Annual coupon payment of £4.16 (adjusted for the discount), redeemed at £100
   • C
     Annual coupon payment of £4, redeemed at £96 at maturity
   • D
     Annual coupon payment of £4, redeemed at £100 at maturity
     Correct answer
   Explanation

   Coupon payments are always calculated as a percentage of the par value (£100), not the market price. A 4% coupon on a £100 par value bond pays £4 per year regardless of what price the bond is trading at in the market. At maturity, the bond is always redeemed at par (£100), again regardless of the market price. This is why an investor buying at £96 will receive both the £4 annual coupon and a capital gain of £4 at maturity (since they paid £96 but receive £100 back), making the redemption yield higher than the running yield.