IMC Asset Classes and Valuation 2 — Questions and Answers
Question 1: What does 'duration' measure in the context of bond investment?
- The time until a bond matures
- The sensitivity of a bond's price to changes in interest rates (Correct answer)
- The credit quality of the bond issuer
- The annual coupon rate of the bond
Correct answer: The sensitivity of a bond's price to changes in interest rates
Duration (specifically modified duration) measures a bond's price sensitivity to changes in interest rates. A bond with a duration of 5 years would see approximately a 5% price change for a 1% change in yield. Higher duration means greater interest rate risk.
Question 2: A futures contract differs from a forward contract primarily because:
- Futures are privately negotiated between two parties
- Futures are standardised and traded on an exchange with daily margin settlement (Correct answer)
- Futures do not require any initial margin
- Futures can only be used for commodities, not financial instruments
Correct answer: Futures are standardised and traded on an exchange with daily margin settlement
Futures contracts are standardised instruments traded on regulated exchanges (e.g., ICE Futures Europe) with daily mark-to-market and margin requirements. Forward contracts are bespoke, over-the-counter agreements between two parties, which carry higher counterparty risk.
Question 3: In equity valuation, what does the price-to-book (P/B) ratio compare?
- Market price per share to annual revenue per share
- Market price per share to net asset value per share (Correct answer)
- Earnings per share to dividends per share
- Total debt to total equity
Correct answer: Market price per share to net asset value per share
The price-to-book ratio divides the market price per share by the book value (net asset value) per share. A P/B above 1 suggests the market values the company at more than its accounting net worth, potentially reflecting intangible assets, growth prospects, or brand value.
Question 4: Which of the following is a feature of an index-linked gilt?
- Its coupon and principal are adjusted in line with the UK Retail Prices Index (RPI) (Correct answer)
- It pays no coupon but is issued at a discount
- It can be converted into ordinary shares of a company
- Its coupon rate increases each year by a fixed amount
Correct answer: Its coupon and principal are adjusted in line with the UK Retail Prices Index (RPI)
Index-linked gilts have both their coupon payments and principal value adjusted in line with the UK Retail Prices Index (RPI), providing protection against inflation. The real return is fixed, but the nominal payments increase with the price level.
Question 5: What is a Real Estate Investment Trust (REIT) in the UK?
- A private equity fund that invests in start-up companies
- A listed company that owns and manages income-producing property and must distribute at least 90% of rental profits (Correct answer)
- A government bond secured by commercial property
- A derivatives contract based on property price indices
Correct answer: A listed company that owns and manages income-producing property and must distribute at least 90% of rental profits
A UK REIT is a listed company that holds income-generating property and is required to distribute at least 90% of its rental income to shareholders. REITs benefit from tax transparency on qualifying property income, making them a tax-efficient way for investors to gain property exposure.
Question 6: A put option gives the holder the right to:
- Buy the underlying asset at the strike price
- Sell the underlying asset at the strike price (Correct answer)
- Receive dividends from the underlying asset
- Convert the option into shares of the company
Correct answer: Sell the underlying asset at the strike price
A put option gives the holder (buyer) the right, but not the obligation, to sell the underlying asset at the predetermined strike price before or at expiry. Put options are commonly used to hedge against falling prices in a portfolio.
IMC Asset Classes and Valuation 2
What does 'duration' measure in the context of bond investment?