Investment Analysis

Table of Contents

Covered Interest Arbitrage

Laws and Regulations Controlling the Financial Industry

Principles of Direct and Indirect Taxation, and Impact to Stakeholders

Key Characteristics of Various Types of Securities

Equity Securities

Debt Securities

Derivative Instruments

Securities Trading Regulations, Policies, and Procedures

Issues in Global Markets Including LSE

Portfolio Management

Appropriate Types of Savings and Investment for Expansion of Air UK & Co

Principles of Investment Theory

Underlying Concepts of Market Analysis and Efficiency

References

INVESTMENT ANALYSIS.

Part A.

Covered Interest Arbitrage

Interest rate arbitrage refers to the mechanism in which an investor strategises to profit from differences in interest rates between two countries or financial markets. However, the investor may be taking a risk due to the uncertainties of future currency exchange rates. When the investor incorporates an aspect of hedging while practicing interest rate arbitrage, he is assured to pocket a riskless profit. The term covered interest arbitrage is used to describe the form of interest arbitrage where currency exchange has been hedged using derivative instruments. The investor, therefore, makes simultaneous spot and forward transactions (Fong, Valente & Fung, 2010).

For Tim & Co to take advantage of the arbitrage opportunity, it has to borrow the currency with the lower interest rate, convert it at the spot rate and invest in the currency with the higher interest rate. Tim & Co should, therefore, borrow £9,000,000 at an annual interest rate of 3.55% for the six months. The cost of borrowing will be £9,000,000 x 3.55 % (6/12) = £159,750. The borrowed amount of sterling pounds should be converted at the spot rate into euros. The amount after conversion will be £9,000,000 x €1.4876/£ = €13,388,400. The amount should be invested at an annual rate of 4.10% for six months. The interest income will be €13,388,400 x 4.10 % (6/12) = €274,462.

The following part of the process is to change the euros to pounds at the forward rate provided. After six months, Tim & Co will have a total amount of euros of €13,388,400 + €274,462 = €13,662,862. When this amount is converted into sterling pounds at the forward rate, Tim & Co will receive a total amount of €13,662,862 ÷ €1.4906/£ = £9,166,015. The principal amount and the cost are deducted to arrive at the total profit. That is, £9,166,015 - 9,000,000 - 159,750 = £6,265. Tim & Co will be assured to gain a diskless profit of £6,265 after the period of six months.

The calculations show that a viable opportunity exists to take advantage of interest rate arbitrage. Key to note is that the cost of hedging, in this case, does not exceed the interest differential between the borrowing rate and deposit rate. The value of the euro is slightly lower in the forward rate as compared with the spot rate. The difference in the exchange rate is what caters for the cost of hedging. The hedging cost makes the euro sell at a discount in the forward rate. The discount goes to the counterparty as compensation for the risk assumed when entering into a forward contract (Fong, Valente & Fung, 2010).

Through hedging, Tim & Co benefits in multiple ways. First, it is able to cover itself from a loss arising from the adverse movement in the exchange rate by entering into the forward contract. This is necessary because the company is anticipating a requirement of sterling pounds after six months to make the final construction payment. Since there is no way of knowing the future movements of the currency exchange rate, getting into a forward contract is the only way to manage currency risk (Fong, Valente & Fung, 2010). Secondly, the company benefits by making a riskless profit by entering into the forward contract.

Laws and Regulations Controlling the Financial Industry

The financial sector is usually sensitive and thus there are a lot of regulations for financial institutions especially to prevent malpractices from occurring. The financial sector plays a central role in world economies. Governments across the world are thus interested in increasing financial inclusion by ensuring the financial sector exudes the confidence required to attract people. However, financial scandals have in the past necessitated regulators to implement broader measures to prevent malpractices. The global financial crisis of the year 2007 and 2008 was the unravelling of the greatest financial scandal in history. The crisis had global ripple effects that shook even the greatest economies of the world. Thousands of people lost their jobs, their homes and were left in poverty. Major financial institutions also collapsed taking trillions of dollars down the drain (Bungenberg, Griebel & Hindelang, 2011). The taxpayers also had to bear the brunt as public funds were used to bail out financial institutions that previously misappropriated their finances (Borio, 2011).

The regulations of the financial sector arise from legislation, statutes as well as other government agencies that serve as financial regulators. The scope of the regulations entails both national and international regulations. UK is among the G20 which began spearheading the global financial report program. The BASEL III framework is a revision of previous BASEL accords in tightening the regulation on banks (Mott, 2012). The framework is used to ensure that banks maintain appropriate risk management practices. The framework has also placed more stringent measures aimed at strengthening the liquidity ratios, leverage ratios risk management, and improving the corporate governance of financial institutions as well. The incorporation of the BASEL framework has widely been considered to eliminate systemic risk (Mott, 2012).

At the national level, the Bank of England regulates banks and other deposit-taking institutions. As the central bank of the UK, it is mandated to issue bank notes and set the monetary policy. Previously, the Financial Services Authority (FSA) was the government agency in the UK mandated to oversee financial institutions up to the year 2013. The body was abolished after the lapses in regulation that culminated in the global financial crisis. Since 2013, the role of FSA was taken over by two bodies which are Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA). PRA is in charge of supervising banks and enforcing prudential regulations. The FCA, on the other hand, is structured as an independent body that oversees financial institutions and financial markets in the UK (Borio, 2011).

Principles of Direct and Indirect Taxation, and Impact to Stakeholders

Direct taxation refers to taxes levied on the income or profits gained by an individual or a business. Such taxes include Pay As You Earn (PAYE), corporation tax, income tax, among others. On the other hand, indirect taxation is a different mode of taxation that entails taxing of products or services rather than incomes. Such taxes include VAT, sales tax, among others (Lang, Pistone, Schuch, & Staringer, 2015).

The principle of equality is an essential factor, mostly applicable to direct taxes. Equality principle means that everyone is taxed in accordance with their ability to pay. The principle does not mean that everyone should be taxed equally, but rather it means that the sacrifice to pay the tax for each individual should be equal (Lang, Pistone, Schuch, & Staringer, 2015). The principle is in line with a progressive tax system whereby those with higher incomes are taxed more, whereas those with lower incomes are taxed relatively less. The stakeholders affected by these principles are the citizens of a nation who are obliged to pay income taxes by the laws of the land. A progressive tax system is used as a measure of income distribution to some extent. It ensures that the tax burden is fair to everybody in the economic system. A progressive tax system encourages people to have a positive perception of the tax system and thus support it.

The second principle of taxation is certainty. The principle means that a taxpayer should be in a position to determine the taxes he or she is supposed to pay either on his/her income or even for a product or service. The principle is applicable to both direct and indirect taxes. The principle essentially eliminates any aspect of arbitrariness within the taxation system that may increase corruption (Lang, Pistone, Schuch, & Staringer, 2015). When an individual or an entity knows with certainty the amount of tax supposed to be paid for various transactions, it becomes easier for them to pay in a timely manner. The principle of certainty benefits several stakeholders including individuals, business entities, and even the body charged with tax administration. Individuals or business entities are able to assess their tax liability by themselves and meet the obligations in a timely manner. Furthermore, the tax administration body is able to project its expected revenue collection in the form of taxes.

The principle of convenience implies that the tax should be levied in a method that makes it easy for the taxpayer to pay. For instance, an income should be taxed when it is received. For instance, the PAYE is deducted from an individual's salary in a convenient manner that maximises the output. Also, VAT is charged together with the sale price at the time of purchasing an item or a service. Convenience ensures that taxpayers are granted the most conducive opportunity to pay their tax obligations. The taxpayers benefit from a convenient tax system since the hassles to pay taxes are minimised (Lang, Pistone, Schuch, & Staringer, 2015).

The principle of economy emphasises the need to have a taxation mechanism that is efficient such that the expenses to collect the taxes are minimised. Both direct and indirect taxes should be collected in a manner that is highly efficient to preserve the value. Also, the burden of taxation should not be too heavy such that it leads to capital flight whereby capital exported to other countries (Lang, Pistone, Schuch, & Staringer, 2015). The principle of economy favours the tax administration by making it preserve the value of taxes collected.

Key Characteristics of Various Types of Securities

There are several types of securities that trade in the financial market today. The major classes of these securities include debt securities, equity securities, and derivatives. Each type of securities has their own unique characteristics, strengths, and weaknesses. The financial securities are used to mobilise capital by companies that are seeking to expand. Other securities referred to as debentures are used as instruments of risk management.

Equity Securities

Equity securities are comprised of the common stock or shares of a publicly traded company. Apart from the common stock, there may be another class of shares referred to as preferential shares. Shares are tradable financial instruments that represent units of ownership in a public company. Floating shares in the stocks exchange is a common method of mobilising capital that is used by many companies across the world. Common stock does not entitle the holder to any periodic payments. However, they are entitled to participate in the sharing of the company’s profits in accordance with their proportion of ownership. The holders of common stock also gain the right to participate in voting for various issues affecting a company. In case a company is wound up, common stockholders are the residue recipients of any proceeds that remain after other classes of securities such as debt and preferential shares have been paid off (Ehrmann, Fratzscher, & Rigobon, 2011).

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