IMC Asset Classes and Valuation ā Questions and Answers
Question 1: A UK government gilt with a coupon of 4% and a face value of Ā£100 is currently trading at Ā£95. What is its current yield?
- 4.00%
- 4.21% (Correct answer)
- 5.00%
- 3.80%
Correct answer: 4.21%
Current yield = Annual Coupon / Current Market Price = Ā£4 / Ā£95 = 4.21%. The current yield is higher than the coupon rate because the bond is trading at a discount to its par value.
Question 2: Which of the following is a key characteristic of preference shares?
- They always carry voting rights
- They receive dividends before ordinary shareholders and have priority in liquidation (Correct answer)
- They have no fixed dividend rate
- Their dividends are guaranteed by the FCA
Correct answer: They receive dividends before ordinary shareholders and have priority in liquidation
Preference shares rank above ordinary shares for dividend payments and in the event of liquidation. They typically pay a fixed dividend and must receive their dividend before any payment is made to ordinary shareholders. However, dividends are not guaranteed ā the board must still declare them.
Question 3: What is the intrinsic value of an in-the-money call option?
- The option premium minus the time value
- The amount by which the underlying asset's price exceeds the strike price (Correct answer)
- The strike price minus the underlying asset's price
- The total premium paid for the option
Correct answer: The amount by which the underlying asset's price exceeds the strike price
For a call option, intrinsic value equals the current price of the underlying asset minus the strike price (when positive). If the share trades at Ā£120 and the strike is Ā£100, the intrinsic value is Ā£20. The option is in-the-money because exercising it would yield an immediate gain.
Question 4: Which valuation model estimates the value of a share by discounting expected future dividends?
- The Capital Asset Pricing Model (CAPM)
- The Dividend Discount Model (DDM) (Correct answer)
- The Arbitrage Pricing Theory (APT)
- The Efficient Market Hypothesis (EMH)
Correct answer: The Dividend Discount Model (DDM)
The Dividend Discount Model values a share as the present value of all expected future dividend payments. The simplest form, the Gordon Growth Model, assumes dividends grow at a constant rate: P = Dā / (r - g), where Dā is next year's dividend, r is the required return, and g is the growth rate.
Question 5: A corporate bond is described as 'investment grade'. According to major credit rating agencies, which of the following ratings qualifies?
- BB+
- BBB- (Correct answer)
- CCC
- D
Correct answer: BBB-
Investment grade ratings range from AAA down to BBB- (S&P/Fitch) or Baa3 (Moody's). Anything below BBB-/Baa3 is classified as sub-investment grade or 'high yield'. BB+ is the highest sub-investment grade rating, while CCC and D indicate very high risk or default.
Question 6: What is the primary risk associated with investing in commercial property as an asset class?
- Currency risk
- Illiquidity risk (Correct answer)
- Reinvestment risk
- Inflation risk
Correct answer: Illiquidity risk
Commercial property is inherently illiquid compared to financial assets like equities and bonds. Selling a property can take months and involves significant transaction costs. This illiquidity risk means investors may not be able to exit their position quickly without accepting a significant discount.
IMC Asset Classes and Valuation
A UK government gilt with a coupon of 4% and a face value of Ā£100 is currently trading at Ā£95.
What is its current yield?