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Financial Regulations Made Easy

Certificate in Mortgage Advice & Practice (CeMAP): Module 1

Certificate for Financial Advisers (CeFA): Module 1

Customer Service Professional (CSP)

Certificate in Regulated Complaints Handling (CeRCH)

Financial Year 2008/09

Written by Adetomi Omidiora

BA Hons, MBA, CeMAP

Published by Futuretrend Technologies Ltd

www.cemap123.co.uk | www.futuretrend.co.uk

Published by Futuretrend Technologies Ltd

Financial Regulations Made Easy

Adetomi Omidiora

Published in Great Britain 2008

Copyright © Futuretrend Technologies Ltd 2008

81 Southbury Road Enfield, EN1 1PJ Tel: 020 8443 2888 [email protected] The UK Financial Regulation Made Easy guide, as with all our supporting material, is complementary to the main accredited Textbook and will never replace the detail contained there.

It was written to highlight the main points and support the understanding of the reader, and therefore could serve as a revision guide.

Our text contains extensive summary of the syllabus. As such this guide can be useful to a person who needs a basic idea of the UK Financial Regulations and the Financial Services Industry. The Financial Regulations Made Easy Book published in November 2008 provides comprehensive and detailed study notes for the 2008/09 financial year. While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book with updated changes from relevant financial bodies. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronically, or mechanically, including photocopying, recording or any information storage or retrieval system worldwide, without prior permission in writing from publisher. Designed by Martin Pye Futuretrend Technologies Ltd Version 1.01


iContents

Contents UNIT 1: INTRODUCTION TO FINANCIAL SERVICES ENVIROMENT AND PRODUCTS Money 3 Equity Release Table 37 Inflation 3 Shared Ownership Plans 37 Background 4 Property Insurance 38 2 Types of Policies to achieve Long Term Objectives 4 Other Secured Lending 38 Influences on Interest Rates 6 Commercial loans 39 The Bank of England 6 Pension Products 39 Financial Intermediaries 6 Derivatives 41 Building Societies and Banks 7 Pooled or Collective Investments 42 Offshore Deposits (Tax Havens) 8 Collective Investment Table 45 National Saving and Investments (NS&I) 8 Financial Regulation 46 Individual Saving Accounts (ISAs) 10 Income Tax 47 Fixed Interest Securities 11 Taxable/Non taxable Income table 48 Money Market Instruments 13 Investment Income Tax 50 Limited Liability Company 14 Capital Gains Tax (2008/09) 52 Shares 14 Inheritance Tax (IHT) 2008/09 54 Company Equity Table 16 Value Added Tax 2008/09 56 Financial Ratios 16 Stamp Duty Reserve Tax 57 Partnership 17 Corporation Tax 57 Child Trust Fund (CTF) 17 Withholding Tax 58 Investment Bonds 18 National Insurance 2008/9 58 Structured Products 18 Tax Planning 58 Real Estate 19 Tax Table 59 Commodities 19 Financial Planning and Advice 61 Foreign Exchange Market 20 The Fact find 62 Insurance 20 Advisor’s Duty of Care 63 Life Assurance 20 Financial Needs and Objectives 63 ILL Health Insurance 23 Agreeing Order of Priority 63 General Insurance 25 Recommending Solutions 63 Ownership of Property 25 Implementing Recommendations 63 Social Security Benefits 26 Documentation 64 Two Types of Joint Ownership 28 Financial Advice 64 Mortgages 28 Loan Consolidation 66 Repayment Vehicles 29 Individual Voluntary Arrangements (IVA) 66 Endowment Policy 29 Wills 66 Endowment Table 31 Trustees 67 ISA Mortgage 32 Law of Contract 68 Pension Mortgage 33 Law of Agency 68 Mortgage Products 33 Power of Attorney 68 CAT Standard Mortgage 35 Insolvency 69 Home Income plans – Life time Mortgage 36 Bankruptcy (Insolvency Act 1986) 69 Home Reversion Schemes 37 Question Time Review for Unit 1 70


ii UK Financial Regulation Made Easy

UNIT 2: UK FINANCIAL SERVICES AND REGULATIONS Regulations 75 MCOB Rulebook 92

Principles for firms and approved Persons 77 Regulation of General Insurance 93

Treating Customers Fairly 78 Documentation 94

Senior Management – Arrangements, Systems and

Control

78 Client Agreement 94

Status of Advisors and disclosure of Status 95

The ‘fit and proper’ test for approved persons 79 The Menu Approach 95

The Prevention of Crime 79 Suitability Requirements 96

Regulated Activities and Investments 80 Suitability of Advice 96

Two categories of Regulated investments 80 Suitability Letters 96

Risks faced by Financial Services Firms 80 Cooling off and Cancellation 97

Risk Assessment Profile – Overall Level of Risk of Firms 81 Commission 97

Discipline and Enforcement Powers available to the FSA 81 Stakeholder –type products 98

Enforcement Powers 82 CAT Standard Mortgage 98

Approved Persons in Controlled Function 82 Money Laundering 99

Advertising and Financial Promotions 83 Complaints and Procedures 101

Record Keeping 84 Financial Ombudsman Service 102

Training and Competence 85 The Financial Services compensation Scheme 102

Three Types of Client 85 Pensions Ombudsman 102

Capital Adequacy for Deposit takers 86 Pensions Regulator 103

The Banking Code 87 The Pension Protection Fund 103

Competition Commission 88 Data Protection 104

European Union Directives 88 Other Legislation Relevant to Client Advice 105

Solvency Margins for Life Assurance Companies 91 Question Time Review for Unit 2 108

Regulation of Mortgage Advice 92

Additional Material Acts Table 112 Review Answers for Unit 1 114

European Directives Table 113 Review Answers for Unit 2 117


iiiAbbreviation Table

Abbreviation Table ADL Activities for Daily Living

APACS Association for Payment and Clearing services

APR Annual percentage Rate

ARLA Association of Rental Letting Agents

ASU Accident, Sickness, Unemployment

AVC Additional Voluntary Contributions

BACS Banking Automated Clearing Services

BOE Bank of England

BRT Basic Rate Tax Payer

CAD Capital Adequacy Directive

CAT Charges Access and Terms

CCJ County Court Judgement

CD Certificate of Deposit

CeRCC Certificate in Regulated Customer Care

CGT Capital Gains Tax

CHAPS Clearing House Automated Payment System

CIDD Combined Initial Disclosure Document

CPD Continuous Professional Development

CPI Consumer Price Index

CRD Capital Requirement Directive

CTF Child Trust Fund

EEA European Economic Area

EFTPOS Electronic Fund Transfer at the Point of Sale

EPA Enduring Power of Attorney

EPS Earnings Per Share

EU European Union

FATR Financial Services Task Force

FIS Fixed Interest Securities

FSA Financial Services Authority

FSAVC Free Standing Additional Voluntary Contributions

GDP Gross Domestic Product

GEB Guaranteed Equity Bond

Gilts Gilt Edged Securities

GSA Guaranteed Sum Assured

HRT Higher Rate Tax Payer

IDD Initial Disclosure Document


iv UK Financial Regulation Made Easy

IFA Independent Financial Advisor

IHT Inheritance Tax

ISA Individual Savings Account

ISD Investment Services Directive

IVA Individual Voluntary Arrangement

LIBOR London Interbank Offered Rate

LPA Lasting Power of Attorney

LTC Long Term Care

LTR Lower Rate Tax Payer

LTV Loan to value Ratio

MCCB Mortgage Code Compliance Board

MCOB Mortgage Conduct of Business Rules

MiFID Markets in Financial Instruments Directive

MIG Mortgage Indemnity Guarantee

MLRO Money Laundering Reporting Officer

MPP Mortgage Protection Policy

MPPI Mortgage Payment Protection Insurance

MPA Mortgage Protection Assurance (same as MPP )

MVA Market Value Adjuster

NAV Net Asset Value

NIC National Insurance Contribution

NS & I National Savings and Investment

NTP Non Tax Payer

OEIC Open Ended Investment Company

OPAS Office of Pensions Advisory Scheme

PA Personal Allowance

PAYE Pay As You Earn

PE Ratio Price Earnings Ratio

PEP Personal Equity Plans

PETS Potentially Exempt Transfers

PHI Permanent Health Insurance

PIBS Permanent Interest Bearing Shares

PMI Private Medical Insurance

PPP Personal Pension Plan

PSNB Public Sector Net Borrowing

PSNCR Public Sector Net Cash Requirement

REIT Real Estate Investment Trust

RPI Retail Price Index


vAbbreviation Table

S2P Additional State Benefit

SDLT Stamp Duty land Tax

SHEP Second Hand Endowment policies

SHIP Safe Home Income Plans

SHP Stake holder Pension Plans

SOCA Serious Organised Crime Agency

SVR Standard Variable Rate

TCF Treating Customers fairly

TEP Traded Endowment Policies

VAT Value Added Tax


3Unit 1: Introduction to financial services environment and products

UNIT 1: INTRODUCTION TO FINANCIAL SERVICES ENVIROMENT AND PRODUCTS Money In earlier civilisation exchange was by Barter. However, as transactions became bigger and complex, it became difficult for people to trade goods they had to offer against what other people had to supply them; hence a need arose for Money, which is a Common Denominator against which the value of all products could be measured.

• Money is a medium of exchange – It must be sufficient in quantity, generally acceptable to all parties in the transaction, divisible into small parts and must be portable.

• Unit of Account – All goods and services are valued at a particular price, this is only possible because of money. Moreover, money can also be used as a measure of payments of debts made in the future.

• Store of value – Money serves as a store of value. For example, a thousand pounds stored in the house today remains a thousand pounds next year. The purchasing power of the money could have decreased because of inflation, but that is another matter, the money is still £1,000.

Inflation Definitions

• Steady increase in prices.

• Decrease in the Purchasing Power of Money.

• Too much money in circulation.

• Too much money chasing few goods.

The rate of inflation is the rate at which the level of prices increase, this is measured by the Consumer Price Index.

Example If inflation were to run at 10% over an item of clothing that cost £100 at the start of 2007, at the start of 2008 the same item of clothing would cost £110. If the £100 were kept in a bank instead at the rate of 3% interest, the interest over the year would be £3 (total £103).

This means that in 2008 the funds would be insufficient to purchase that item of clothing, indicating a decrease in the purchasing power of the money.

• The Government’s target is to keep Inflation at an annual rate of 2% with maximum divergence either side of 1%.


4 UK Financial Regulation Made Easy

Money Illusion • Savers and borrowers think of the interest rate as a standalone entity without

considering inflation.

• An investor must aim to achieve a rate of growth that exceeds the rate of inflation.

• Low inflation and low interest rates are directly related.

• Savers can react to low interest rates by putting their funds into riskier instruments such as shares and bonds because of low inflation.

• Borrowers repaying loans react to lower monthly repayments (lower interest rates by borrowing more money). Unfortunately, increased demand on borrowing may even push up interest rates.

Real Rate of Return

Rate of interest minus rate of inflation

If the rate of inflation is 5% and the interest received on the investment is 3.75%

The rate of return is 3.75% - 5% = -1.25%

The rate of return here is negative 1.25% as the rate of interest is lower than the rate of inflation, so in real terms the purchasing power of the funds have fallen.

Where the rate of interest is higher than the rate of inflation there is a positive rate of return which means the purchasing power of the funds has risen in real terms. Background Policy Challenges for Macroeconomic Theory

These are the long term objectives that the Economic policies of Governments try to achieve.

• Long term Economic Growth

• Lower Unemployment

• Higher Employment

• Price Stability These are the present challenges in policy as the government strives to attain them simultaneously. Unfortunately, these objectives sometimes conflict with each other and the government will employ tools to try to control them through regulation, taxation and spending. Moreover these targets are continuously being affected by the world economy, which is not under the control of a particular government. 2 Types of Policies to achieve Long Term Objectives 1) Monetary Policy

2) Fiscal Policy Monetary Policy

Government controls the money supply through the manipulation of the interest rates, which is set by the Monetary Policy Committee Monthly. This in turn influences the demand of



credit by consumers. Monetary policy is used as a macroeconomic control (to control the economy as a whole).

Fiscal Policy (Budgetary Policy)

Government manipulates the finances of the public sector spending, revenue, borrowing and saving to influence the overall level of money supply and economic activity. Fiscal policy is used as a macro or micro economic control (could be targeted to parts of the economy or the whole economy).

The Chancellor of Exchequer outlines the Fiscal Policy in the annual budget statement in March.

• The public sector is responsible for providing education, healthcare, transport, social security amongst other things in the economy. This has to be funded by the government raising funds from the private sector in form of direct/indirect taxes.

Three Outcomes 1) Balanced Budget

Taxation = Public Spending 2) Budget Surplus

Taxation exceeds Government Spending

Amount of money taken out (taxes) is more than the amount put in (public spending).

This is contractionary in terms of employment, and deflationary in terms of the money supply. 3) Budget Deficit

Government spending exceeds taxation

Amount of money put back (public spending) exceeds amount of money taken out (taxation).

Difference is Amount Borrowed.

This is expansionary in terms of Employment and Inflationary in terms of money supply.

A Government in Deficit must borrow. Deficit is Expressed in 2 Identities

Public Sector Net Borrowing (PSNB) Current Public Spending plus Net Public Investment less Total Public Revenues

Public Sector Net Cash Requirement (PSNCR) PSNB plus financing requirements arising from financial transactions.

Golden Rule The Government’s golden rule is to borrow only to invest and not to fund current government spending. This implies that funding of public spending is nil.

Sustainable Rule Public Sector Net Debt as a proportion of Gross Domestic Product (GDP) will be stable and prudent over the economic cycle.

Gross Domestic Product – Total value of goods and services produced in a country in a fiscal year.



Influences on Interest Rates Level of Government Borrowing

Level of Individual Borrowing

Monetary Policy

Foreign Exchange rates The Bank of England The Bank of England is the Central Bank owned and backed by the UK government, which has the sole authority for issuing money (notes and coins). Other Functions

• Banker to the Government (also advises the Government)

• Banker to all the Banks.

• Sets Interest rates monthly, through the monetary Policy Committee.

• Lender of last resort (if banks are short of liquid funds)

• Issuer of Bank notes.

• Manager of UK’s Official Reserves (Gold and Foreign currencies). Financial Intermediaries These institutions receive deposits from individuals, firms or other financial institutions and give out these deposits as loans or use for purchase of financial assets. Examples of intermediaries are banks, building societies, insurance firms and brokers.

They are called intermediaries because they act as middlemen by borrowing from the surplus sector of the economy and lending it to the deficit sector of the economy. They make a profit margin between the two rates.

• Financial Intermediaries create liquidity, minimize costs of borrowing funds, minimize costs of monitoring borrower’s pool risks

Four Outcomes of Intermediation

Geographical Location – The physical location of individual borrowers differ, an access to a high street bank solves the problem. Aggregation – Retail deposits are relatively small while loans are typically larger (mortgages); intermediaries overcome this size mismatch by aggregating small deposits. Maturity Transformation – A borrower may need funds for longer than a lender is willing to lend, intermediaries are able to bridge this gap because they borrow from a large number of people who deposit funds and draw them at different times. (Different maturity dates). Risk Transformation – A lender does not lend all his funds to one borrower, he spreads the risk, so if one borrower defaults, it is not the end of his business. Disinter Mediation Opposite of intermediation. Lenders and Borrowers come together without a middleman (e.g. a company floating shares directly to the public).



Building Societies and Banks • The difference between a building society and a bank is in the legal structure.

• Building Societies are Mutual Organisations owned by the Members.

• Building Societies are permitted to borrow from the wholesale market up to 50% of their liabilities.

• Banks are Limited Liability companies owned by Shareholders (proprietary organisations).

• A building society is able to convert to a bank status. This process is known as demutualization.

• If a building society converts to a bank status it will allocate free shares to its members (depositors and borrowers).

• To this end, an individual may open an account in a building society, hoping that it will convert to a bank status for the free shares, this is known as “Carpet Bagging”.

Deposit Based Investments

• They are emergency funds put away for a rainy day (new car, next year holiday).

• It is essential to have some of your investment portfolio in readily accessible funds.

• The capital element is fixed but the income from the investment may vary.

• They are secure investments but inflation reduces the value of capital in real terms.

• Unattractive when compared to asset backed investments in the medium to long term.

• Interest paid on the accounts has tax deducted at 20% at source.

• Lower rate Tax payers (LRT) can reclaim 10%, and Basic Tax payers (BRT) have no further liability. Higher rate Taxpayers (HRT) have to pay an extra 20%.

• Non-Taxpayers can have interest paid gross if they fill out a form R85. Money Market Deposits Accounts

• Fixed Accounts – Term deposits accounts. Overnight – five years

• Notice Accounts – May allow immediate access to accounts but will charge a penalty. Tiered Interest Rates

• Available on building society accounts

• The larger the investment, the higher the rate paid. If the investment falls into a lower tier, the rate will be reduced.

Current Accounts

• A convenient system that enables the client to pay in amounts and take it out through cash, cheques or electronically. Intense competition has shifted the service from a fee based service to an interest paid service if minimum balances are maintained.

• Traditionally current accounts were the field of middle to high class persons, while the low class had pass book accounts or no accounts at all.

Recently, these accounts have been decentralised to accommodate the less sophisticated in the form of a “basic bank account”, which is a current account with an ATM card. The Basic Bank account also permits withdrawals from post office counters, but there are no cheque books, debit cards or overdraft facilities allowed. The basic bank account is available to those who do not have a current account, and those who are on state benefits or pensions.



Clearing

• The clearing process results from the use of cheque books, direct debits debit cards and all other types of banking transactions which involve transfer.

• At the end of each day banks will need to pay each other the net debt owed or the net amount due, between the cheques/monies drawn on them and those drawn in favour of them. This is usually settled through their accounts with the BOE.

• The process is coordinated in the UK by the Association for Payment And Clearing Services (APACS) that manages the system through three clearing firms:

1) Cheque and Credit Clearing company – Oversees the clearing of cheques which takes three days. As we move on in time, technology will systematically aid the disappearance of a cheque system. Most transactions are presently carried out electronically as people are slowly but surely abandoning the cheque writing process.

2) Voca Limited – Formerly the Banking Automated Clearing Services (BACS) which deals with the electronic clearing (e.g direct debits).

3) Clearing House Automated Payment System (CHAPS) – The daily inter bank transfer system.

• It is important to note that not all banks are clearing banks. All building societies are not. However all banks and building societies must be represented at the clearing house, by a clearing bank of their choice.

Offshore Deposits (Tax Havens) They are deposits in Bank or Building Society accounts based outside the UK, in countries with a more advantaged tax system.

The Investments are available in countries such as Gibraltar, Channel Islands, Cayman Islands and Luxembourg.

Offshore deposits are usually domiciled in a foreign currency e.g. US Dollars, as such, they are at risk to currency movements because when they are converted back to sterling at a later date the rate could have changed.

Moreover, they are not all covered by financial compensation schemes.

Deposits are particularly attractive to people who want money available outside the UK, or those who want to retire abroad.

• The interest is paid gross but must be declared on the tax returns of a UK resident.

• Under the double taxation agreement a UK resident might be able to get tax relief. National Saving and Investments (NS&I) These savings and investments products are offered at the post office on behalf of the government .

They are Low Risk products which are certain to return the capital sum invested, even on Premium Bonds.

Easy Access Savings

• New card and pin.

• Tiered interest rates

• Must be over 11 to open the account.



• Minimum balance is £100.

• Interest is paid gross but tax liable.

Investment Account

• Must be 7 years and over to open account.

• Tiered interest rates at 7 levels (50-50,000 and beyond)

• Minimum deposit is £20.

• Interest is paid gross but liable to income tax.

Income Bonds

• The bonds have no term.

• Capital can be withdrawn at any time, without penalty.

• Interest is paid up to, but not including the day capital it is withdrawn.

• Tiered.

• Minimum investment is £500.

• Interest is paid gross but is liable to income tax.

Guaranteed Income Bonds

• Must be 16 to take out the bond

• Lump sum investment for a fixed term.

• Guaranteed interest rate for 1, 3, and 5 year term.

• Bonds pay a monthly income.

• Interest is paid net (20% tax at source)

Guaranteed Growth Bonds

• Must be 16 to take out the bond.


• Interest added to bond at end of term (calculated yearly).

• Interest is paid net (20% tax at source).

Guaranteed Equity Bonds

• Must be 18 to take out the Bond.


• Growth of bond depends on FTSE 100 index.

• Investment is secure, as the capital invested will certainly be returned.

• Interest payable depends on growth of underlying asset.

• Interest is paid gross but is liable to income tax.

Savings Certificates

• They can be fixed or Index linked (value increases with inflation).

• Certificates are available from £100 -£15,000.

• Fixed Rate certificates have a 2 or 5 year term.

• Index linked certificates have a 3 or 5 year term.

• Interest is paid gross and there is no liability to capital gains tax or income tax.



• Most attractive to higher rate taxpayers.

Premium Bonds

• Regular tax-free prizes can be won, of up to £1m.

• Minimum amount is £100 to £30,000 maximum.

• Capital is safe but investor must give 8 days notice to cash a bond.

Children Bonus Bond

• Must be 16 to buy a bond.

• Bond can be purchased for under 16s.

• It is a single Premium Investment, which must be retained over a minimum of 5 years.

• Bonus is added to bond after 5years.

• Interest paid on bond ceases on 21st birthday.

• Latest age bond can be purchased is 16 (16 + 5 = 21).

• Bonus is added to Bond on the 21st birthday.

• Interest earned is tax free. Individual Saving Accounts (ISAs) • Tax efficient personal savings certificates with an aim to encourage savings for UK

residents.

• An ISA is not transferable and can only be held in one name.

• ISAs will now be available indefinitely.

• Although it is still possible to have the ISA with 2 different providers the former Maxi and Mini ISAs have now been scrapped.

The following rules apply:

• Going forward it will be permitted for Cash ISAs (within ISA limits) to be moved to Equity ISAs.

• It will not be permitted for Equity ISAs to be moved to cash ISAs.

• Cash mini ISAs and cash elements of maxi ISAs can be moved to cash ISAs .The same applies for TESSA –only ISAs.

• Personal Equity Plans (PEPs) have now become Equity ISAs.

Cash ISAs

• They can be opened by anyone who is 16 and above.

• They are classified as deposit type accounts.

• Can be held with a Bank, Building Society or Post-office (NS&I).

• A maximum of £3,600 can be held in a Cash ISA.

• Cash ISAs are tax – free. Equity ISAs

• Can be opened by anyone who is 18 or over

• They can be held in Shares and/or Stocks.



• The shares in the ISA fund can be held in unit trusts, open-ended investment companies or investment trusts in the UK (pooled/collective investments).

• Alternatively they can be shares listed anywhere in the world.

• The stocks (fixed interest securities) held could be corporate bonds issued by firms listed on the stock exchange world wide, Gilts and other fixed interest securities issued within the European Economic Zone.

• A maximum of £7,200 can be held in shares/stocks

• Alternatively the balance of £3,600 over the cash amount can be held in shares/stocks (£7,200 - £3,600).

• It is possible to have the Cash and Equity Components with 2 different providers (Banks).

• Equity ISAs are taxed 10% tax on the share component that is not reclaimable by anyone.

• Higher rate taxpayers are not liable to pay additional tax.

• Equity ISAs are free from CGT.

Life Assurance

• They are no longer available but existing ones can be incorporated into the Equity ISA. Fixed Interest Securities Generally, they are securities, which pay a fixed rate of interest usually half yearly and a redeemable amount on maturity or sale of the Bond.

1) Gilt Edged Securities (Gilts)

2) Local Authority Stocks

3) Permanent Interest Bearing Shares (PIBS)

4) Corporate Bonds

Gilt Edged Securities

• Government Issued securities that represents Government borrowing.

• Management of new issues of Gilts stocks is carried out by the Debt Management office of the Treasury.

• The Redemption date represents the date the Government will buy back the Gilt (return the capital invested).

• The Coupon represents the interest payable over the term at par value.

• Prices are usually quoted par value at a nominal £100.

• Gilts cannot be redeemed before Maturity but can be sold to other investors.

• This indicates that Gilts are actively traded on the secondary market. Three categories as defined by the Government

• Short dated Gilts – less than 5 years to run before redemption.

• Medium dated Gilts – 5 to 15 years to run before redemption.

• Long dated Gilts – over 15 years to run before redemption.



Undated Gilts are Gilts redeemable at the discretion of the Government who is under no obligation to redeem them. However, they can be sold to other investors in the open market. Three Categories as defined by the UK Debt Management Office

• Short Dated Gilts – 0-7 years

• Medium Dated Gilts – 7-15 years

• Long Dated Gilts – Over 15 years

Index linked Gilts are Gilts where the Interest payments (coupon) and capital value (represents redemption value, buy back date) move in line with inflation, therefore the purchasing power of the capital and interest stay constant.

• Interest on Gilts is paid half yearly.

• Interest is paid Gross but is taxable in the hands of the investor (10%, 20% or 40%)

• Gilts are not subject to Capital Gains tax.

• Factors likely to affect the sale price of Gilts are the level of market rates, nearness to redemption date and supply and demand forces.

• Gilts are sold Cum Dividend when the buyer will acquire the stock and the entitlement to the next interest payment.

• Ex- Dividend indicates that the buyer acquires the stock but the next interest payment goes to the previous owner of the stock. The Buyer will then acquire the interests paid subsequently.

Local Authority Stocks

Represent borrowing by local authorities.

Bonds are secured on local authority assets.

They are less secure than Gilts but more secure than corporate bonds and PIBS.

These Bonds are termed Non – Negotiable, as they have to be held until redemption, when the capital amount will be returned.

The term of bond is relatively short (1 to 2 years)

Interest is paid half yearly.

Capital amount is paid back at redemption.

Interest is paid net (20%), HRT pay an extra 20%, NTP can reclaim.

Permanent Interest Bearing Shares

• Represent Building society borrowing.

• Stocks are issued by Building Societies to raise capital

• These shares are termed Irredeemable as the society is under no obligation to redeem them.

• Interest on them is paid at the set rate half yearly.

• PIBS can be bought and sold on the Stock Market.

• They rank below ordinary shares if the building society becomes insolvent.

• Investors can make capital gains and losses and there is no guarantee of getting back the funds invested.

• No CGT is payable on gains made.

• Interest is paid gross, but taxable as saving income.



Corporate Bonds

• Represent Company borrowing

• They are more risky than gilts and local authority stocks, but yield more interest.

• They are issued for a fixed period and have a fixed rate of interest payable.

• They can be traded on the Stock Market

• Examples are Debentures and Loan-stocks, which will be discussed under Company Equities.

Money Market Instruments Money market instruments can be described as short term debt instruments issued by the Government, Banks, Building societies and several organisations with no interest paid to the investor during the term.

3 Types

1) Treasury Bills

2) Certificates of Deposits

3) Commercial Paper Treasury Bills

• They are low risk short-term securities issued by the Debt Management Office.

• They are backed by the UK Government.

• They are highly liquid assets, easily convertible to cash at little cost.

• Bills are usually purchased in large amounts and held by large or main corporations and financial institutions for liquidity purposes (surplus to requirements).

• They are bought and sold on the secondary market by the financial intermediaries (no centralised market place).

• They are issued for a 91 day period.

• Bills are issued at a discount to their par value.

• The par value (face value) is the amount payable at redemption.

• Treasury Bills have Zero Coupon, they do not pay any interest during the term.

• The price of the bill is affected by the issue price, redemption value, changes in interest rates and supply and demand.

• Changes in market rate must be significant enough to affect the price of the bill, as they are usually steady, being short term securities.

• They are similar to Gilts being that they are both issued by the UK Government, to raise capital, but defer because of their coupon and term.

Certificates of Deposit (CD)

• A bearer security (no name), with a fixed rate of interest, issued by building societies and banks.

• The bearer who holds the CD at the end of the term is the owner.

• A CD can be sold on and on.



• It usually has a 3 to 6 month term with a roll over option of 3-6 months (specific terms apply).

• A Typical CD will be for £50,000 or more.

• The bank will issue a receipt to acknowledge deposit and capital and interest at the end of the term will be paid to the bearer.

• Banks also trade in CDs to manage their liquidity position.

• When a bank expects to have surplus funds (liquid) it will issue CDs to coincide with that time.

• When a bank projects that it might have a shortage of funds (illiquid), it will hold on to the CDs redeemable at the projected time.

Commercial Paper

• Represents borrowing by firms for short-term purposes (working capital), with a term of between 5-45 days (average of 30-35 days)

• It is possible to roll over this transaction, if the firm still needs the funds.

• This roll over facility offers flexibility and the ability to re-arrange the interest rate.

• The commercial paper is particularly favourable to the firm who has a good credit history as borrowing is cheap.

• A firm who has poor credit ratings can have it backed by a Letter of Credit.

• The Letter of Credit, which is issued by the bank guarantees to make the payment if the firm defaults.

• The bank backs this transaction in exchange for a fee.

• Commercial Papers are usually purchased by large institutions, such as Pension Funds, because of the huge sums involved.

• They are also referred to as unsecured promissory notes.

• Transactions can be made directly or through intermediaries. Limited Liability Company A Company is a separate legal entity, owned by shareholders whose liabilities are limited to the amounts they have invested.

The most common way in which a company can raise money, to expand its operations, is to float ordinary shares. These are usually bought by private investors but more so by institutions and life pension funds.

The nature of the company, powers to borrow and rights attaching to shares are set out in the Memorandum and Articles of Association. Shares are also known as asset backed investments, in the long run, growth in these investments should generally outpace inflation. However, the investor must proceed with care as shares are generally considered to be high risk investments. Shares Investment in shares can prove risky but long-term investment will usually outpace inflation and provide higher return than deposit type investments.



Share Indices

Measure the overall performance of shares.

Financial Times Ordinary Share Index (FT index) – 30 major industrial companies – 1 Quarter (¼) of market value of UK equities.

FTSE100 (footsie) – 100 top companies in capitalisation terms. Weighted according to market value

FTSE Actuaries – About 900 shares split into sectors; yields, ratios, return of shares.

Rights Issue

New Shares must first be offered to existing shareholders to avoid dilution of their holdings in proportion to the total shareholding. The rule is set by the Stock Exchange.

Scrip Issue

• It involves increasing the number of shares to reduce the share price, at no cost to existing shareholders. Existing share holders are offered the free shares in the proportion of their shareholding and the price of the share is split accordingly (stock split).

• It is achieved by transferring reserves (profits retained from previous years) into a company’s share account. This is just a book entry.

• It is also called the Bonus / Capitalisation issue.

Buying and Selling Shares

There are two markets:

1) The Main Market

2) The Alternative market

Main Market – Shares can be bought and sold on the London Stock Exchange, on the main market subject to full listing. The requirements include a 3 year trading period, one fourth of the firm’s shares must be owned by the public and the firm must act in accordance with the rules set by the FSA ,which is the UK listing authority.

Alternative Market – The smaller and newer firms can also be registered with the stock exchange in an alternative market. The rules set here are less stringent, than those set for full listing. Benefits are that the firm can enjoy public finance, are easily exposed to investors and investors will tend to have a sense of confidence dealing with them. This will enhance their potential for expansion.

Types of Equity

Ordinary Shares – Share holders receive distributed profits (dividends) and have voting rights (participation)

Preference Shares – Dividends are payable from the company’s profits. They rank before ordinary shares in priority of distribution but after loan stocks if a firm were to wind up.

Preference shares are termed cumulative if dividends are not paid but accumulated until such a time as they can be paid. Preference shares do not carry voting rights but may acquire it if dividends have been delayed. Convertible Preference shares are shares that carry rights but not obligation to be converted into ordinary shares.

Loan Stocks – A fixed rate of interest and not dividends is payable. The interest would be paid whether or not profits are made. The loan is not secured on company property. Loan stocks have no voting rights. Loan Stocks can also be issued with convertible rights, that is, a right but not an obligation to be converted to an ordinary share.

Debentures – The same as loan stocks but are secured on the company’s property/assets.



Order of Ranking if Firm becomes Insolvent Debentures – Loan Stocks – Preference Shares – Ordinary Shares Company Equity Table

Debentures Loan Stocks Preference Shares Ordinary Shares

Fixed rate of interest paid

Fixed rate of interest paid

Dividends may be fixed, paid out of firm’s profits

Dividends are paid, if profits are made.

Interest is paid whether or not the firm makes a profit.

Interest is paid whether or not firm makes a profit.

Can be Cumulative, which means dividends have to be accumulated till they can be paid.

Dividends are only paid when the firm makes a profit.

No voting rights. No voting rights. No Voting Rights, except dividends have not been paid in a while.

Voting Rights Participation.

Loan is secured on firm’s assets or property.

Loan is not secured on firm’s assets or property.

Shares Shares

Taxed at 20% at source. NTP can reclaim 20% HRT pay extra 20%.

Taxed at 20% at source. NTP can reclaim 20% HRT pay extra 20%.

10% at source, not reclaimable by anyone, only HRT have an additional liability of 22.5%.

10% at source, not reclaimable by anyone, only HRT have an additional liability of 22.5%.

If the firm goes insolvent they are paid first.

If the firm goes insolvent they get paid next.

If firm goes insolvent they get paid after loan stocks.

If firm goes insolvent they get paid last.

Financial Ratios 1) Dividend Cover

2) Earnings per Share

3) Price Earnings Ratio (PE ratio) Dividend Cover

• It is an Indication of whether the company can continue to pay dividends in the future.

• It calculates how much of a company’s profit is paid out in dividend, as some profit will be retained for business expansion.



• If 50% of the firm’s profit is paid out in dividend, then dividend is covered twice 100/50 = 2.

• If 25% of the profit is paid out dividend, then dividend is covered four times 100/25 =4.

• A dividend cover of 2 and above is okay. It indicates that since the dividend is covered twice or more the firm should continue to pay profits in the future.

Anything below 2 is unacceptable. It indicates that the company is paying its dividend from retained surpluses from previous years (reserves).

Earnings Per Share (EPS)

• Indicates the actual earning on the shares, as profits could be retained for expansion

• EPS = Net Profits Number of shares

Price/ Earnings Ratio

This indicates the Share’s Growth Prospect,

A Ratio of 20 or more is good, 4 or less is poor

The P/E Ratio = Share Price Earnings per share Partnership • In a partnership, the partners jointly own the assets and liabilities of the company, and

are jointly responsible for the profits and losses.

• Partnerships are subject to income tax and not corporation tax.

• The Partnership Agreement (Deed) provides the detailed information regarding the practice.

• Recently (2001) Limited Liability Partnerships have emerged. They are set-up and run as limited companies (and have to be registered at the company house), but are still taxed as regular partnerships.

Child Trust Fund (CTF) • Tax free account for children born on or after 1 September 2002.

• Qualification for entitlement depends on entitlement to child benefit.

• It is a savings incentive initiated by government, and the account grows tax free.

• The initial payment is £250. It is then increased to £500 when it is established that the family is eligible for payment.

• Parents can add a maximum of £1,200 per year.

• CTF will remain in force until the child’s 18th birthday, however, after the age of 16 however, the child is allowed to manage the account.

3 Types

• Deposit type savings

• Accounts that invest directly/indirectly in shares,



• Stakeholder CTF accounts (invest in a range of company shares from age 13, maximum charge is 1.5% per year). If the CTF account is not opened by the parent after 12 months H&M will open a stakeholder account for the child.

Investment Bonds • A non-qualifying life assurance policy with collective investment instruments based on

unitised funds.

• It is a single premium, unit linked, whole of life assurance available from life assurance companies.

• Surrender value is based on the value of the units allocated to the policy which is based on the bid price on that day.

• Simplicity of documentation and switching between funds makes the investment an attractive one. Companies usually permit the switch without the charge of a bid – offer spread.

• Where the policy holder dies, the investment stops and a slightly enhanced amount is paid (usually 101% of bid price on the day of death).

• Funds are invested in an internal life company fund and attract 20% on capital gains tax which is not recoverable by anyone.

• Only HRT pay an additional 20 % in tax.

• This means the CGT allowance (£9,600) cannot be used within the fund and on the additional tax payable at 20% by HRT, which is charged as income tax and not CGT.

• It is possible to draw income from the investment, by making small withdrawals of 5% of the capital yearly.

• This is done by cashing in some of the units allocated to the policy.

• These withdrawals are tax free for everybody.

• The 5% allowance can be carried forward yearly and accumulated up to 100% of the original investment, with out incurring an immediate tax liability.

• Unfortunately, since the present introduction of a flat rate of 18% on CGT, bonds have now become unattractive to HRT because of the tax position. (On an “unwrapped investment” a HRT will be able to apply the CGT exemption and pay income tax on the income).

Structured Products • They are designed to protect the capital invested as well as allowing involvement in

underlying assets that are high performing, but risky such as ordinary shares.

• As such they are attractive to people who don’t want direct exposure to the stock market but like share growth prospects.

• The Guaranteed Equity Bond (GEB) from NS&I is an example of a structured product. Issue 14 is a five-year bond (2008) that will pay a return in line with the growth in FTSE-100 index, but will return all the capital invested if FTSE falls.

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