M8 Ebook

Collective Investment
Schemes
6TH Edition
Nurturing Asia’s Best

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COLLECTIVE INVESTMENT SCHEMES
6th Edition - February 2020
© 2020 by Singapore College of Insurance Limited. All rights reserved.
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1st Edition published in 2002.

2nd Edition published in 2007.
3rd Edition published in April 2010.
4th Edition published in September 2011.
5th Edition published in December 2015.
PREFACE
Capital Markets and Financial Advisory Services Examination –

Module 8 Collective Investment Schemes
In line with the licensing framework under the Securities and Futures Act (SFA) and
Financial Advisers Act (FAA), the Monetary Authority of Singapore (MAS) has launched
a modular examination structure, known as the Capital Markets and Financial Advisory
Services Examination (CMFAS Examination).
This study guide is designed for candidates preparing for Module 8 Collective
Investment Schemes examination. This examination is for new and existing
representatives of financial advisers who need to comply with MAS requirement to
possess the requisite knowledge to advise or sell Collective Investment Schemes.
The objectives of the CMFAS Module 8 Collective Investment Schemes examination are
to test candidates on their knowledge and understanding of the features, advantages,
disadvantages and risks associated with the investment of Collective Investment
Schemes, alternative investment assets and other financial assets, as well as the
techniques, strategies to evaluate and invest in the different types of unit trust funds. It
also discusses the different types of financial markets, characteristics and forms of
market efficiency, modern portfolio theory, time value of money concept, considerations
for investment relating to risks, classification and measuring risks, returns, time horizon,
diversification, the various legislation and regulation pertaining to Collective Investment
Schemes.
Organisation of the Study Guide
This study guide is divided into 8 chapters, each devoted to a specific topic that the
candidates will need to know, in order to pass the CMFAS Module 8 examination, as
outlined below.
Chapter 1: Provides an overview of the nature of a broad range of financial assets,

such as cash and equivalents, money market instruments, fixed income
securities / long-term debt instruments, equity investments, unit trusts,
life insurance, annuities and the advantages and risks associated with
investing them.
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Chapter 2: Provides an overview on some of the alternative investment assets, such
as financial derivatives, real estate investment, structured products, and
its benefits and risks associated with investing them.
Chapter 3: Discusses the mechanics of bond markets, equity markets, derivative

markets, over-the-counter market, characteristics of an efficient financial
market, forms of market efficiency and the modern portfolio theory.
Chapter 4: Explains in detail how risk and return of an investment can be quantified,
the various sources of investment risks, the relationship between risk and
return, classification of risks, risk-adjusted investment returns, required
rate of return and Jensen’s alpha (measure) under the capital asset pricing
model.
Chapter 5: Discusses the basics of time value of money and the various calculation
methods involved in determining present and future value of a single sum.
Chapter 6: Discusses the important factors to consider when planning for an

investment, the trade-off between liquidity and return, investment
objectives, risk tolerance, time horizon, tax considerations, the Risk
Classification System under the CPFIS, diversification and investment
style of fund manager, and the regulations and legal constraints.
Chapter 7: Explains in detail the nature, fees, advantages and risks associated with
unit trust investments, and the factors that need to be taken into account
when evaluating the suitability of a unit trust. The advantages and pitfalls
of unit trust investment are also discussed.
Chapter 8: Discusses the various types of unit trusts and the common investment
strategies for unit trusts. It also discusses the innovative unit trust
schemes, such as the “capital guaranteed” fund and the “capital
protected” fund, as well as investment trusts, REITs and business trusts.
This 6th edition contains changes to the existing text that will simplify and clarify key
terms and concepts. Additionally, there are new contents on developments in the
industry, as well as new products and services available in the market place.
While every effort has been made to ensure that the Study Guide materials are accurate
and up-to-date at the time of publishing, some information may become outdated before
the latest version is released. Hence candidates are advised to check the “Version
Control Record” found at the end of this Study Guide to ensure that they have the
correct version of the Study Guide. For examination purposes, the Singapore College of
Insurance adopts the policy of testing only those concepts and topics that are found in
the latest version of the Study Guide.
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ACKNOWLEDGEMENT
For this 6th Edition, we wish to thank Mr Charles Tiong for reviewing and updating this
Study Guide.
For our 5th edition of the study guide, it was developed and written by the in-house
Curriculum Development team at the SCI.
Karine Kam
Chief Executive
Singapore College of Insurance
February 2020
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STUDY GUIDE FEATURES
Several study aids have been included in each chapter to help readers to master and
apply the information in the Study Guide.
Chapter Outline and Key Learning Points

An outline of the chapter is provided on the first page of each chapter, after which the
key learning points are listed to help readers gain an overview of the chapter’s contents
and the expected learning outcomes to be achieved.
Revisions And Updates

To enable candidates to check that they have the latest version of the Study Guide, the
“Version Control Record” at the end of this Study Guide will list the relevant revisions
and updates that have been made, as well as the date when the changes will apply to
the examinations.
NB: Throughout this study guide, where applicable, we have used the masculine
gender to represent both genders, in order to avoid the tedium of the continual use
of “he or she”, “his or her” or “himself or herself”.
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Table Of Contents
Preface i
Acknowledgement iii
Study Guide Features iv
Table Of Content v
Chapter 1 Types Of Investment Assets – I 1
1. Introduction
2. Financial Assets
A. Cash And Its Equivalents, And Money Market Instruments
B. Fixed Income Securities / Long-Term Debt Instruments
C. Equity Investments
D. Unit Trusts
E. Life Insurance
F. Annuities
3. Summary
Chapter 2 Types Of Investment Assets – II 29
1. Introduction
2. An Introduction To Financial Derivatives
A. Options
B. Contracts For Difference (CFD) And Extended Settlement (ES)
C. Warrants
D. Futures
E. Swaps
F. Forward Contract
G. Summary Of Financial Derivatives
H. The Use And Misuse Of Derivatives
Contents
3. Real Estate Investment
A. Reasons For Investment In Property / Real Estate
B. Disadvantages Of Investing In Property / Real Estate
C. Risks Of Borrowing To Invest In Property / Real Estate
4. Structured Products
A. Features
B. How Structured Products Are Manufactured
C. Benefits Of Structured Products
D. Types / Categories Of Structured Products
E. Risks With The Structured Products
5. Summary
Chapter 3 Financial Markets 49
1. Introduction
A. Primary Market For Newly Issued Financial Assets And Secondary
Market For Others
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Module 8: Collective Investment Schemes
B. Types Of Financial Claims

C. Types Of Maturities
D. Features Of Contract Terms
2. Bond Market
A. Quantitative Easing (QE) And Its Impact On The Market
3. Equity Market
A. Singapore Exchange Limited (SGX)
4. Derivatives Market
A. Singapore Mercantile Exchange (SMX)
5. Over-The-Counter (OTC) Market
6. Characteristics Of An Efficient Financial Market
A. Availability Of Information
B. Liquidity
C. Transaction Cost
D. Information Efficiency
7. Forms Of Market Efficiency
A. Implications Of EMH
8. Modern Portfolio Theory (MPT)
9. Summary
Chapter 4 Risk And Return 67
1. Measures Of Return
A. Calculating Single-Period Investment Return
B. Calculating Multi-Year Investment Return
C. Calculating Real After-Tax Rate Of Return
2. Measures Of Risk
3. Risk Aversion
4. Risk And Return Trade-Off
A. Investor Risk Tolerance Questionnaire
Contents
5. Sources Of Investment Risk

A. Business Risk
B. Financial Risk
C. Marketability Risk
D. Country Risk
6. Classification Of Risks
7. Diversification Reduces Risks
A. Diversification Options
8. Risk-Adjusted Investment Returns
A. Information Ratio
B. Sharpe Ratio
C. Treynor Ratio/Index
D. Value-At-Risk (VAR)
9. Required Rate Of Return And Jensen’s Alpha (Measure) Under The Capital
Asset Pricing Model (CAPM)
A. Risk-Free Rate
B. Market Rate Of Return
C. Market Risk Premium
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Table Of Contents
D. Beta
E. Summary Of CAPM
10. Summary
Chapter 5 Time Value Of Money 91
1. The Basics Of Time Value Of Money

A. The Role Of Interest
B. The Power Of Compound Interest
C. Frequency Of Compounding Or Discounting
D. Measuring The Number Of Periods
2. Future Value Of A Single Sum
A. Basic Time-Value Formula
B. Using A Future Value Interest Factor (FVIF) Table
3. Present Value Of A Single Sum
A. Using The Time-Value Formula
4. Summary
Chapter 6 Considerations For Investments 105
1. Introduction
2. Investment Objectives And Risk Tolerance
A. Goals And Needs
B. Age
C. Wealth And Income
D. Life Cycle
3. Liquidity
4. Investment Time Horizon
A. Caveats In Investing Over A Long Time Horizon
Contents
5. Tax Considerations
6. Regulations And Legal Constraints
A. Investment Guidelines – Code On Collective Investment Schemes
(CIS)
B. CPF Investment Scheme (CPFIS)
C. CPF Investment Scheme – Risk Classification System
7. Diversification
A. Dollar Cost Averaging
B. Market Timing
8. Investment Styles Of Fund Manager
9. Summary
Chapter 7 Unit Trusts 123
1. Introduction
A. Investment Fund
B. Unit Trust – An Introduction
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C. Brief Overview Of The Administration And Control Over Unit Trusts

2. Parties Involved In A Unit Trust
A. The Trustee And Trust Deed
B. The Fund Manager
C. The Distributor
3. Charges And Fees
A. Other Types Of Costs
4. Expense Ratio
5. Bid And Offer Prices
6. Pricing Of Unit Trusts
7. Evaluation Of Unit Trusts
A. Risk Appetite
B. Investment Time Horizon
C. Diversification
D. Regular Investment Plans
E. Transaction Costs
F. Availability Of Switching Options
G. Style Of Fund Manager
H. Consistency Of Performance
8. Advantages Of Investing In Unit Trusts
A. Diversification With Small Capital Outlay
B. Professional Management
C. Switching Flexibility To Capitalise On Changing Market Conditions
D. Liquidity
E. Security
F. Reinvestment Of Income
G. More Investment Opportunities
9. Pitfalls Of Unit Trust Investment
A. Performance Of Unit Trust Is Closely Linked To Fund Manager
B. Investors Cannot Influence The Way A Unit Trust Is Managed
C. No Guarantee Of Profits
Contents
D. Past Performance Is Not A Reliable Indicator Of Future Performance

E. Fees And Charges
10. Summary Of Mas Revised Code On Collective Investment Schemes
11. Summary
Chapter 8 Fund Products 139
1. Introduction
A. Importance Of Reading The Documentation
B. Open-End And Closed-End Funds
2. Major Types Of Unit Trusts
A. Equity Fund
B. Fixed Income Fund
C. Balanced Fund
D. Money Market Fund
E. Umbrella Fund
F. Feeder Fund And UCITS Funds
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Table Of Contents
G. Index Fund And Exchange Traded Funds (ETF)

H. Hedge Fund
3. Innovative Unit Trust Investment Schemes
A. “Capital Guaranteed” Fund
B. “Capital Protected” Fund
4. Investment Trust, Real Estate Investment Trust (REIT) And Business Trusts
A. Investment Trust
B. Real Estate Investment Trust (REIT)
C. Business Trusts
5. Summary
VERSION CONTROL RECORD
Contents
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Contents
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1. Types of Investment Assets - I
CHAPTER 1
TYPES OF INVESTMENT ASSETS – I
CHAPTER OUTLINE
1. Introduction
2. Financial Assets
3. Summary
KEY LEARNING POINTS
After reading this chapter, you should be able to:

▪ understand the following main categories of financial assets:
- cash and its equivalents – bank deposits and time deposits
- money market instruments – Treasury bills, banker’s acceptance and certificate of
deposit, commercial paper and repurchase agreement
- fixed income securities / long-term debt instruments
- equity investments
- unit trusts
- life insurance
- annuities
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1. INTRODUCTION
1.1 Real assets consist of land, buildings, machines, workers and commodities that
are used to produce goods and services for the economy. The investment and
creation of real assets lead to improvement in the standard of living, as there
will be more goods and services available for everyone.
1.2 Apart from real assets, investments can be made up of a whole spectrum of
financial assets (also known as paper assets or capital market securities)
consisting of stocks, bonds, etc. They channel funds from the savings segment
of society to the investing segment of society. We can view financial assets as
the means by which investors hold their claim on real assets. For example,
when we hold shares of DBS, we hold a share of all its net assets.
1.3 The value of financial assets should reflect the fundamental value of the real
assets that it would represent over the longer term. However, in the short term,
this may not necessarily be the case. For example, during periods of extreme
optimism, the value of financial assets tends to appreciate much faster than the
fundamental value of the real assets that they represent. This is what we call a
financial market bubble. On the other hand, in times of uncertainty when the
level of risk aversion rises, the value of financial assets may collapse. Through
this alternating process of boom and bust, the excesses of the financial market
are corrected, and the value of financial assets is brought into alignment with
the long-term fundamental value of the real assets.
1.4 In general, inflationary pressure will rise if the value of financial assets rises
faster than the true and underlying value of real assets. Hence, in order to enjoy
low inflation and strong growth in real assets, rises in financial assets must be
matched by real growth, rather than excessive expectation about the growth.
2. FINANCIAL ASSETS
2.1 In this section, we will discuss the main categories of financial assets, namely
cash and its equivalents, money market instruments, fixed income securities
and long-term debt instruments. We will also discuss equity investments, unit
trusts, life insurance and annuity products in the next few sections.
2.2 In the next chapter, we will introduce alternative classes of financial assets,
starting with financial derivatives. We will then round it off with discussions on
real estate investment and structured products.
Cash And Its Equivalents, And Money Market Instruments
2.3 To satisfy the need to make transactions and to have readily accessible money
in case of an emergency, many individuals use instruments that are known as
cash equivalents. Typically, a cash equivalent has either no specified maturity
date, or a maturity of one year or less. The first major purpose for using a cash
equivalent is to have ready access to the investment principal - due to the liquid
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nature of the investment, cash can be readily available should the need arise.
This may also be due to the investor’s overriding concern for the safety of the
investment principal. Another purpose for using a cash equivalent is that it
serves as a receptacle for accumulating funds to purchase other investment
assets in an amount that meets the minimum purchase requirement, or
minimises the per unit transaction acquisition cost (such as buying a round lot
of 1,000 shares of a publicly traded stock, to avoid a higher per-share price).
Finally, a cash equivalent is used when investors are uncertain about the
direction of the economy or prices of investment alternatives; they may place
their money in these instruments until they can determine the direction of the
economy or prices of potential investments. This becomes a temporary
instrument and parking place for investors to switch out from some other
investments. However, investments in this category often provide only a
modest current income and typically have little or no potential for capital
appreciation.
2.4 Money market securities or instruments are similar in nature to cash

equivalents. These are debt instruments issued by governments, financial
institutions and corporations with maturities of less than one year. They include
Treasury bills, banker’s acceptances and certificates of deposit, commercial
paper, repurchase agreements, and bills of exchange.
A1. Cash Equivalents Include Bank Deposits And Time Deposits
A1A. Bank Deposits

2.5 The most widely known and used type of cash-equivalent investments are
savings accounts and time deposits (or fixed deposits) at banks and finance
companies. As all financial institutions in Singapore are licensed and regulated
by the Monetary Authority of Singapore (MAS), they are generally well
managed in that there is a very low risk of loss of principal and interest
involved. However, because of their low-risk nature, the disadvantage of such
deposits is that they provide a low yield in return. Also, time deposits do not
provide a good inflation hedge, as the specified interest offered at inception
generally does not change over the deposit period, and does not respond to
changes in market interest rates.
2.6 MAS does not guarantee the soundness of individual financial institutions.
Therefore, a Deposit Insurance (DI) Scheme has been set up to protect the core
savings of small depositors in Singapore in the event a full bank or finance
company fails. Since 1 May 2011, the MAS has reviewed the DI Scheme with
the Singapore Deposit Insurance Corporation (SDIC) to enhance this Scheme.
All full banks and finance companies in Singapore are members of the DI
Scheme, except those exempted by the MAS. The coverage limit has been
increased from S$20,000 to S$50,000 to S$75,000.
2.7 The insured deposits are protected up to an aggregate limit of S$75,000 per
depositor, per DI Scheme member - regardless of how many accounts the
depositor has with the same member.

2.8 Singapore Deposit Insurance Corporation Limited (SDIC) covers individuals and
other non-bank depositors with insured deposits placed with a DI Scheme
member. Other non-bank depositors include sole proprietorships, companies,
associations and societies. All these persons would be insured depositors.
2.9 SDIC insures Singapore dollar denominated deposits placed with a DI Scheme
member in any of its branches in Singapore. These include deposits or monies
in:
▪ Savings, current and fixed deposit accounts;
▪ Wadiah accounts;
▪ Murabaha accounts;
▪ Trust and client accounts;
▪ CPF Investment Scheme (CPFIS) accounts;
▪ CPF Retirement Sum Scheme (CPFRS) accounts;
▪ Supplementary Retirement Scheme (SRS) accounts; and
▪ Other products, as prescribed by the Authority.
2.10 Monies placed under the CPFIS and CPFRS are aggregated and separately
insured up to S$75,000.
2.11 Each DI Scheme member maintains a register of insured deposits it offers. To

find out if the deposit in an account opened at a DI Scheme member bank or
finance company is insured, please refer to the bank or finance company’s
register of insured deposits.
2.12 The following financial products are not insured by SDIC:

▪ Foreign currency deposits;
▪ Structured deposits; and
▪ Investment products such as unit trusts, shares and other securities.
2.13 The next two examples illustrate different scenarios to determine the insurable
amount.

Example 1.1: Calculation of deposit insurance coverage if there is more than

one type of insured deposit
2.14 A depositor has S$25,000 in his savings account, S$2,500 in his current
account and a US dollar fixed deposit of US$50,000 with Bank X. He has also
placed S$100,000 of his CPF monies under the CPFIS with Bank X. The
calculation of insured deposits is as follows:
Account Amount Amount Not

Balance Insured Insured
Savings Account S$25,000 - -
Current Account S$2,500 - -
Total S$27,500 S$27,500 S$0
Monies under CPFIS S$100,000 S$75,000 S$25,000
US Dollar Fixed US$50,000 US$0 US$50,000
Deposit
2.15 The explanation is as follows:

▪ Insured deposits are aggregated and insured up to S$75,000.
▪ Monies placed under the CPFIS and CPFRS are aggregated and insured up to
S$75,000.
▪ Foreign currency deposits are not covered under the DI Scheme
Example 1.2: Calculation of deposit insurance coverage if there are deposits and
an outstanding loan, such as credit card facility, with the same bank
2.16 Should the depositor owe the failed DI Scheme member any monies (e.g. under
a credit card or loan account), it will not affect the insured amount paid to him
by SDIC under the DI Scheme. However, he will still have to repay the
outstanding amounts to the failed Scheme member.
2.17 For example, a depositor has S$100,000 in his savings account, S$25,000 in
his fixed deposit account and a credit card account with an outstanding balance
payable of S$10,000 with Bank X. SDIC does not deduct the liabilities from the
deposits as shown below:
Account Amount Amount Not

Balance Insured Insured
Savings Account S$100,000 - -
Fixed Deposit Account S$25,000 - -
Total S$125,000 S$75,000 S$50,000
Credit Card Outstanding S$10,000 N.A N.A
Balance Payable in Full
2.18 The explanation is as follows:

▪ Foreign currency deposits are not covered under the DI Scheme
▪ Insured deposits are aggregated and insured up to S$75,000.

▪ Depositor will have to repay the credit card outstanding balance to the
liquidator of Bank X.
2.19 For further details of the DI Scheme, refer to the SDIC website at:
www.sdic.org.sg
A1B. Time Deposits

2.20 Time deposits are deposits held for a specified period of time, such as 3, 6, 12
months or even longer (such as 36 months). They tend to provide a higher
return than the savings accounts because of the time commitment made by the
investor. Generally, the longer the deposit period, the higher the interest rate
will be. However, a portion of the interest earnings may be forfeited as a
penalty for withdrawal before maturity. Otherwise, there are usually few
restrictions placed on withdrawals of deposits in time deposit accounts. The
difference in the return is referred to as liquidity or duration premium, since
tying up cash in an investment for a longer period of time exposes the investor
to more risk. Therefore, the investor will demand a better (higher) return to
compensate for this risk.
2.21 Multi Currency deposits are another type of time deposit. They are foreign
currency time deposits placed with a bank in Singapore. Except for being
denominated in foreign currencies, Multi Currency deposits are similar to
Singapore dollar fixed deposits. Popular currencies of Multi Currency deposits
include the US dollar (USD), Australian dollar (AUD), New Zealand dollar (NZD),
British pound (GBP), Canadian dollar (CAD) and Euro (EUR). Due to fluctuations
in exchange rates, investors in Multi Currency deposits can incur exchange
losses or achieve exchange gains depending on the appreciation or depreciation
of the currencies involved. An investor not only earns interest but can also
achieve gains from exchange rate appreciation.
A2. Money Market Instruments
2.22 These debt instruments are issued by governments, financial institutions and
corporations and have maturities of less than one year. Owing to their relatively
short maturity, money market instruments have relatively low risks. However,
the minimum denomination of money market instruments is usually relatively
large, at S$250,000 and above. They include Treasury bills (T-bills), negotiable
certificates of deposit (CD) or banker’s acceptances, commercial paper,
repurchase agreement and bills of exchange.
A2A. Treasury Bills

2.23 Treasury bills (T-bills) are short-term government securities (with maturity of
one year or less) issued by governments to borrow money from the investing
public to fund government expenditure. They are the safest type of investments
and are generally considered to be risk-free. Investing in a T-bill is equivalent to
lending money to a sovereign government. When the term risk-free investment
is used, it usually refers to T-bills. In this context, “risk-free” means there is no
possible risk of default on paying interest or principal when due. These
instruments are sold on a discount basis – that is, investors pay an amount less

than the face value, but will receive the face value at maturity. The difference
between the purchase price and the face value represents the interest earned
on T-bills, and is used to calculate the yield on such securities. The yield on T-
bills is usually used as a benchmark for risk-free rates. They can be readily sold
and converted to cash before maturity at a modest cost to meet client needs.
TREASURY
BILLS
GOVERNMENT INVESTORS
S$ LESS THAN
FACE VALUE
FACE VALUE
AT MATURITY
A2B. Banker’s Acceptance And Certificate Of Deposit (CD)

2.24 Money market instruments issued by financial institutions include banker’s
acceptances and certificates of deposit (CDs). A banker’s acceptance is issued
to facilitate international commercial trade transactions, as it represents a claim
on the issuing bank for a specific amount on a specific date. A banker’s
acceptance is a negotiable security that is also issued on a discounted basis. A
certificate of deposit is a certificate issued by a bank that indicates that a
specific sum of money has been deposited with the bank. It bears a maturity
date and a specific interest rate generally on a compounding basis. The interest
amount is payable upon maturity.
A2C. Commercial Paper

2.25 Commercial paper refers to a short-dated unsecured promissory note issued by
a corporation. Similar to Treasury bills and banker’s acceptances, commercial
paper is issued at a discount to face value. Owing to the unsecured nature of
this security, only corporations with a strong credit rating are able to issue
commercial papers.
A2D. Repurchase Agreement

2.26 One of the ways in which secondary trading in money market instruments takes
place is through a repurchase agreement (commonly known as a repo). A repo
is the sale of a money market instrument, with a commitment by the seller to
buy the security back from the purchaser at a specified price on a future date.
In short, it is a collateralised short-term loan, where the collateral is the money
market instrument. The yield on repo can be calculated using the difference
between the sale and purchase prices.
A2E. Bills of Exchange

2.27 Bills of exchange are widely used to finance international trade. They play an
important role because of the time lag of trade transactions and the distance
between the buyer and seller. A bill may be drawn payable on sight or on
demand. A bill may be drawn for any period of time, more commonly for 91
days, and is known as a term bill. The bill is useful because it is negotiable.
Transfer is done by endorsement and delivery.

A3. Why Invest In Money Market Instruments?
2.28 In all investment portfolios, there is generally a portion of the funds placed in
money market instruments for liquidity purposes. Liquidity usually refers to the
ability to convert an investment into cash quickly with little or no loss in value.
Money market instruments are generally low in risk and their primary function is
to provide a pool of reserves that can be used for emergencies, or to
accumulate funds for some specific purposes. Money market instruments are
basically viewed as a means of accumulating funds that will be readily available
when the need arises.
2.29 Investment in money market instruments generally increases when investors are
uncertain about prospects in other classes of investments. Investors will
increase their holding of money market instruments in an investment portfolio
when stocks and bonds are expected to perform poorly, such as when interest
rates are expected to be on an upward trend. Conversely, they will hold less
cash when they perceive a bull (rising) market in the stock and/or bond
markets.
A4. Disadvantages Of Investing In Money Market Instruments
2.30 In general, professional fund managers try not to hold too much of their funds
in money market instruments in excess of their liquidity requirements because
of the low yield. Although money market instruments carry almost no risk of
principal loss, they are subject to reinvestment risks. Reinvestment risk refers to
the risk that it may not be possible for an investor to reinvest the proceeds of
his investments at rates equivalent to those of the maturing investments,
because of possible declines in interest rates.
Fixed Income Securities / Long-Term Debt Instruments
2.31 Fixed income securities are debt instruments in which the issuer (borrower)
promises to repay to the lender the amount borrowed plus interest over some
specified period of time of more than one year. As the investment term of fixed
income securities tends to be quite long (up to 30 years), they are also referred
to as long-term debts. These debts are also referred to as bonds. They can be
issued by governments and/or corporations. Fixed income securities can be
regarded as IOUs (I owe you) issued by companies or governments to raise
funds. The face value of the fixed income security is known as the principal,
while the periodic interest payments are known as the coupon payments.
2.32 Owners of long-term debt instruments are creditors of the issuing institution,
whether it is a government or business organisation. This status grants the
investors the legal right to enforce their claims to interest income and principal
repayment as stated in the indenture (agreement) that specifies the terms and
conditions of the debt issue. In the case of business debt instruments, debt
claims have priority over any claims of its owners and/or other creditors.

2.33 Government bonds are used by the government to borrow money from the
public. They are the safest type of investments, carrying almost no default or
credit risk, since interest payments and repayment of principal are guaranteed
by the government because of its flexibility in fiscal policy. Because of its credit
quality, government bond yields are usually the lowest among fixed income
securities of similar maturity period.
2.34 For Singapore Government Securities (SGS), they are marketable debt
instruments issued by the Singapore Government through the Monetary
Authority of Singapore (MAS), the central bank. They are either bills or bonds
depending on the tenure of the instruments. The government will pay holders of
bills and bonds a fixed sum of money on the maturity date of the instrument.
Investors who need cash before the maturity date may sell them in the SGS
secondary market where primary dealers buy and sell these instruments.
B1. Corporate Debt Securities
2.35 Businesses are major contributors to the supply of debt securities or corporate
bonds available in the marketplace. These securities have various characteristics
which are detailed in the indenture. Some of the more frequently encountered
characteristics include the following:
▪ Secured – a promise backed by specific assets as further protection to the
bondholder should the corporation default on payment of coupon and/or
principal. The interest is normally quoted as a percentage (coupon rate) of the
principal which is also referred to as face value or face amount. The coupon
payments are normally payable twice a year, on a semi-annual basis, and the
coupon rates are quoted as such.
▪ Debenture – an unsecured promise based only on the issuer’s general credit
status, to pay coupon and principal.
▪ Callable – an option exercisable at the discretion of the issuer to redeem the
bond prior to its maturity date at a specified price. The price will include
compensation to the investor for the loss associated with the early redemption.
The corporation may find it beneficial to call the bond when the market interest
rate associated with the bond of similar risk, duration and characteristics is
lower than the coupon rate for the bond. Hence the call provision is detrimental
to investors, who run the risk of losing a high-coupon bond when rates begin to
decline. Because the call feature benefits the issuer and places the investor at a
disadvantage, callable bonds carry higher yields than bonds that cannot be
retired before maturity.
▪ Putable – an option which grants the investor the right to sell the bond issue
back to the issuer at par value on designated dates. The advantage to the
investor is that if interest rates rise after the issue date, thereby reducing the
value of the bond, the investor can get the issuer to redeem the bond at par.
▪ Convertible – an option exercisable by the bondholder to exchange the bond for
a predetermined number of common or preferred shares.
▪ Zero-coupon – Some bonds pay no coupon at all, but are offered at a
substantial discount below their par values (with the par or face value repaid at

the time of maturity) and hence provide returns via capital appreciation rather
than interest income.
▪ Floating rate - The bond’s coupon payment varies over time. The coupon rate is
set, for example, for the initial six-month period, after which it is adjusted every
six months based on some market indices, e.g. Singapore Interbank Offer Rate
(“SIBOR”). Floating rate bonds are popular with investors who are concerned
with the risk of rising interest rates, since the coupon received increases
whenever market interest rates rise.
2.36 It should be noted that, apart from the features mentioned above, the investment
return to the investors of bonds ultimately depends on three factors associated
with the bond, namely (1) the face value which is the payment made by the bond
issuer to the investors at maturity; (2) the purchase price paid by the investors;
and (3) the coupon rate, which determines the size of the coupon payments made
by the bond issuers to the investors.
2.37 Should the market interest yield be higher than the coupon rate, the investor
would need to pay a price that is lower than the face amount to achieve the
market interest rate. In this case, the difference between the face value and the
purchase price will cover the shortfall (difference between the market interest rate
and coupon rate) over the term of the bond, on a compounded basis.
2.38 Fixed income securities generally stress on current income and they have lower
volatility than equities. If there is an active secondary market, they can be
bought or sold at any time before maturity. This marketability gives the
investors the opportunity to realise capital gains, since bond prices may rise if
interest rates fall. However, if the secondary market is inactive, the investors’
money may be locked up for the full life span of the security.
2.39 Fixed income securities may be classified by the currency in which it is issued,
or by the issuers. Domestic fixed income security is denominated in the local
currency, while foreign-currency denominated fixed income security is
denominated in a foreign currency.
2.40 A Eurobond is a bond issued and traded outside the country in which its
currency is denominated, and outside the regulations of a single country. It is
usually a bond issued by a non-European company for sale in Europe. It is also
called global bond.
2.41 A Eurobond can be categorised according to the currency in which it is issued.

A Eurodollar bond is a Eurobond denominated in US dollars and sold outside the
United States to non-U.S. investors. Euroyen is denominated in Japanese Yen
and sold outside Japan to non-Japanese investors. Yankee bonds are US dollar
fixed income securities sold in the United States, but issued by a non-U.S.
corporation or foreign government.

2.42 Apart from governments, statutory boards and corporations, issuers of fixed
income security may be supra-nationals1. The yield on fixed income security is
dependent on the maturity of the issue and the credit rating of the issuer.
Generally, the yield on fixed income security tends to be higher for issues with
longer maturity and/or lower credit rating.
2.43 Fixed income securities are exposed to the following types of risks:
(a) Interest Rate Risk

As bonds are fixed income instruments, changes in the bond prices are
inversely related to changes in interest rates. When interest rates fall (rise),
bond prices will rise (fall). The sensitivity of the bond prices to changes in
market interest rates depends on the characteristics of the bond, such as
S coupon rate and term to maturity. Generally, bonds with lower coupon rate
and longer maturity are more sensitive to changes in interest rates.
(b) Default Risk

This is the risk that the issuer will fail to make timely principal and coupon
payments as contracted. Default risk may be reduced if the bonds are
secured, or collateralised – that is, if there is a guarantee from a bank or an
insurance company.
(c) Reinvestment Risk

Reinvestment risk is the risk that the amount of coupon payment on a bond
may have to be reinvested at a lower interest rate than the market
return/yield of the bond at the time that the coupon payments are received
by the investor. Reinvestment risk is higher for bonds with long maturity
and high coupons.
(d) Currency Risk

This is applicable to bonds denominated in foreign currency. The investor's
total return may be affected by the prevailing foreign exchange rate when
the coupon and principal payment are received. When an investor expects
the foreign currency to depreciate relative to his home currency, he can
hedge his foreign currency exchange risk by using currency forwards or
other currency derivatives (such as currency swaps) to exchange the
foreign currency cash flow back to local currency.
(e) Sovereign Risk

Sometimes a government may impose restrictions that may affect bond
investment. For example, the bond issuer’s country may impose exchange
controls, set a discriminatory rate or cause delays in payments.
(f) Liquidity Risk

This is the risk that the bond investor may not be able to sell the bond
before expiry at the purchase price. In a financial crisis, the investor
potentially might not be able to sell the bond at all because the markets are
1
Supra-nationals are entities that are formed by two or more governments through international treaties
for the purpose of promoting economic or social developments for the member countries.

in chaos. However, this risk does not matter if the investor intends to hold
the bond to maturity.
B2. Features Of Fixed Income Securities
2.44 The important features common to fixed income securities are:
(a) Par, Face Or Maturity Value

This is the amount of money for which each fixed income security can be
redeemed at maturity. This is usually S$1,000 per security. If an investor
buys five securities, the total face or par value is S$5,000, which means
that the borrower will repay S$5,000 to the investor when the securities
mature.
(b) Coupon Rate

It is the fixed rate that the issuer undertakes to pay the holder at a periodic
interval (annually, semi-annually or quarterly) on the face (par) value of the
bond. When multiplied by the principal or face value of the fixed income
security, the coupon rate provides the basis for calculating the dollar value
of the coupon payment. Payments are usually made semi-annually, although
the coupon rate is generally expressed as an annual rate. The coupon rate is
usually higher for securities with a longer period to maturity.
(c) Maturity Date

This refers to the final date on which repayment of the face (par) value of
the bond is due.
(d) Price
The market price is often quoted as a percentage of the face value. For
example, a closing price of 95½ means that the actual price of the bond is
95½ x S$1,000 par value = S$955.00 for each bond.
B3. Return On Fixed Income Securities
2.45 Yield refers to the effective interest rate that an investor earns on the fixed
income investment. It is different from the coupon rate, unless the price is
identical to the principal or face value of the security.
2.46 Two main yield calculations are used to describe the potential return from
investing in a fixed income security:
(a) Current Yield

This is simply the ratio of the payment to the current price of the security.
For example:
A bond with a price of 91 (91% of par, or S$910 for a corporate bond with
a face value of S$1,000) and a coupon of 9% has a current yield of 9.89%
(90 / 910 = 9.89%).

The main drawback of this yield measure is that it ignores the principal sum
to be paid at maturity.
(b) Yield To Maturity

This is the most important concept of yield because it is the yield in which
most fixed income prices are based. The current yield measures only
today’s return, but the yield to maturity measures the real return that an
investor will get based on the purchase price of the bond, assuming that
the security is held to maturity. It also takes into account the maturity date,
the coupon payment, the frequency of coupon payment, and the face
value. The exact way of calculating this measure is quite complicated and is
not covered within the scope of this study guide.
B4. Considerations When Selecting Fixed Income Securities
2.47 The price of a fixed income security is determined by factors such as the
coupon rate stated on the security, the length of its term to maturity, the
features associated with the bonds (e.g. convertibility and callability), credit
quality of the issuer and the general level of interest rates. Fixed income
securities fluctuate in price, and their market value is largely determined by
changes in the general level of interest rates. As mentioned earlier, when the
general level of interest rates rises, bond prices fall to keep yields in line with
market levels; when the general level of interest rates declines, bond prices
increase.
2.48 After taking into account the general level of interest rates, an investor will
consider two other factors (as described below) when selecting a fixed income
security.
B4A. Investment Quality

2.49 This is reflected by the probability that a fixed income issue will go into default.
The investor's perception of default risk will determine the interest rate that he
is willing to accept, the price to pay, and the maturity to take.
B4B. Maturity
2.50 In addition to quality, investors can control the risk of fixed income investments
through maturity selection. Yields will usually differ for different maturities
giving rise to the “yield curve”, which defines the current yield for each possible
maturity. It is usually the case that yields increase for longer maturities. The
longer the maturity, the more volatile the bond price will be. Conservative
investors tend to choose securities with shorter maturities in order to reduce
risks, such as interest rate risk, default risk and reinvestment risk. It should be
noted that price volatility would not be a concern if the investors intend to hold
the bonds till maturity without trading them for capital gains; it would,
however, be a concern if emergency needs arise, and investors are forced to
sell the bonds before maturity.

B5. Why Invest In Fixed Income Securities?
2.51 Bonds and other forms of fixed income securities can be good investments for
investors interested in having the amount of monies at maturity made known to
them and in receiving a steady stream of periodic income. Fixed income
securities have long been regarded as good vehicles for those seeking current
income. With fixed income securities, under normal circumstances, an investor
will receive cash flows with reasonable certainty. It should be noted that there
is still the possibility of default risks when investing in fixed income securities,
no matter how excellent the credit rating may be.
2.52 In addition, fixed income securities are a versatile investment vehicle. They can
be used conservatively by those who primarily (or exclusively) seek high current
income to supplement other income sources. Alternatively, they can be used
aggressively for trading purposes by those who actively seek capital gains.
Since the late 1980s and early 1990s, bonds have also become recognised as
providing investors with the opportunity to realise capital gains.
B6. Disadvantages Of Investing In Fixed Income Securities
2.53 A major disadvantage of investing in fixed income securities is that the coupon
rate is fixed for the life of the issue and, therefore, cannot move up over time in
response to inflation. Inflation is, therefore, a main worry for fixed income
investors, particularly if they are to creep up to the level of the coupon rate,
and if the term to maturity of the bond is relatively long. Not only can inflation
erode the purchasing power of the principal portion of the investment, it also
can lead to violent swings and changes in interest rates, thereby producing
dramatic fluctuations in the prices of fixed income securities, which can cause
substantial capital losses if they are not held to maturity, or if such unrealised
losses need to be reflected in the financial accounts.
2.54 Unlike ordinary shareholders, buyers of fixed income securities issued by a

company do not participate in the profits of the company. They also do not
have other shareholder rights, such as those of shareholders voting in company
meetings.
2.55 Another disadvantage of fixed income securities (particularly in Singapore) is

the inactive and small secondary market. This is not so much of a concern for
ordinary retail investors who tend not to invest in bonds directly, owing to the
large face amounts required for investment in such instruments. These retail
investors invest in fixed income unit trusts instead, where the initial capital
outlay is much smaller.
B7. Housing Loans / Mortgages And Other Types Of Fixed Income Securities
2.56 Apart from the fixed income securities issued by governments and corporations
discussed above, there are other types of fixed income securities which are
created through a technique known as securitisation. A popular instrument that
has been securitised frequently is mortgage loans. In the United States of

America (U.S.), the securitisation of sub-prime mortgage loans during the boom
years, spanning the closing years of the twentieth century and peaking around
2005/2006, was the direct cause of the 2008/2009 economic crisis. These
fixed income securities are outside of the scope of this study guide and will not
be discussed.
B8. Trading Bonds in Singapore
2.57 In Singapore, bonds may be bought or sold on the stock exchange. However,
many institutional investors and professional fund managers trade bonds in the
over-the-counter market. There are three major types of bonds: those issued by
corporations, statutory boards and the government.
B8A. Corporate Bonds

2.58 Local corporate bonds are issued by well-known companies such as CapitaLand.
Government-linked companies such as SingTel have also raised funds in the
bond market. Bonds issued by foreign corporations and international institutions
are also available in the market. An example is the bond issued by Asian
Development Bank.
B8B. Statutory Board Bonds

2.59 In 1998, the Jurong Town Corporation (JTC) was the first statutory board to
issue bonds to the public. Since then, other statutory boards such as Housing
and Development Board (HDB) and Land Transport Authority (LTA) have also
floated bond issues for public subscription.
B8C. Singapore Government Securities (SGS) Bonds, Treasury-Bills (T-Bills) And

Singapore Savings Bonds (SSB)2
2.60 SGS bonds, T-bills and Savings Bonds are all backed by the Singapore
Government.
2.61 However, each instrument has different features. The product that's right for
you will depend on your investment amount, time horizon and needs.
B8C1. SGS Bonds and T-bills

2.62 These are Government securities with varying maturities.
2.63 They are suitable for those who want:

▪ a fixed interest rate, with maturities from 6 months to 30 years.
▪ to trade in the secondary market. However, if the investor sells before
maturity, prices may be above or below what the investor paid.
▪ to invest in larger amounts, with no overall limit. The minimum amount is
S$1,000 (capped at the limits for each auction).
▪ to buy using cash, Supplementary Retirement Scheme (SRS) funds or CPF
funds.
2
Source: https://www.mas.gov.sg/bonds-and-bills/products-for-individuals

B8C2. Singapore Savings Bonds (SSB)

2.64 These are Government securities that offer individuals a flexible investment
period.
2.65 They are suitable for those who want to be able to:
▪ enjoy interest income that increases the longer the investor holds, subject to
a 10-year maturity.
▪ redeem the bonds in any month. The investor will get the principal back with
accrued interest by the second business day of the next month.
▪ enjoy a low minimum investment of S$500 (capped at S$200,000 overall
per individual).
▪ buy using cash or SRS.
B9. Bond Rating
2.66 The credit risk of a bond depends on the issuer. Rating agencies thus play an
important role in the rating of bonds. Bond rating is the agency’s opinion on the
ability of the bond issuer to pay interest and the principal amount.
2.67 Bond ratings are based on both qualitative and quantitative factors, which
include the following: issuer’s financial and profitability ratios, subordinated and
guarantee provisions (if any), outlook on the issuers, etc.
2.68 Bond issues of governments and businesses typically are rated by rating
agencies, such as Standard and Poor’s Corporation (S&P), Moody’s Investors
Service and Fitch Ratings, to assess the likelihood that the issuer will default on
the timely payment of coupon and/or principal. Based on some financial analysis
of the issuer, a letter grade is assigned to each bond issue. Bonds rated at the
top of the B grade (BBB for S&P, Baa for Moody’s) or higher are considered to
be of “investment quality.”
2.69 Lower ratings are assigned for bonds assessed as “speculative.” These bonds
are also referred to as high-yield bonds or junk bonds. These rating
organisations evaluate the bond when it is issued, and continue to monitor the
issuer during the bond’s life. The lower the quality rating, the greater the risk of
default, and the higher the coupon rate (return) that the investor will expect to
earn. The higher return reflects the risk premium which represents the reward
for the higher risk undertaken by the investor.
2.70 Bond ratings are important to both issuers and investors. First, because a
bond’s rating is an indication of its default risk, the rating has a direct,
measurable influence on the bond’s interest rate and the issuer’s cost of capital.
Second, most bonds are purchased by institutional investors rather than
individuals due to their high investment amount, and many institutions are
restricted to investment-grade bonds only. Thus, if an issuer’s bond rating falls
below investment grade, the issuer will have a difficult time selling new bonds
because many potential investors will not be allowed to buy them.

2.71 Changes in a firm’s bond rating will affect both its ability to borrow long-term
capital and its cost of capital. Rating agencies review bonds on a periodic basis,
occasionally upgrading or downgrading a bond as a result of the issuer’s
changed circumstances.
Equity Investments
2.72 Equity investments represent an ownership position in a business. As such,

they represent a higher risk for the investor than debt investments do. Although
an equity interest can be the sole owner of a proprietorship or one of several
partners in a partnership, this discussion will focus on equity as evidenced by
shares of stock issued by a corporation. Corporations acquire equity funds by
selling ownership shares to either very few individuals or to the public. An Initial
Public Offering (IPO) happens when a privately owned company issues shares
of stock to be sold to the general public. This means the company is no longer
privately owned, but is owned by a variety of investors, some of whom are not
involved with the day-to-day operations of the company -- these investors
simply own some of the company's stock, which they purchased on the open
market through stock exchanges. In an IPO, the share price is decided by the
company that offers the shares for public subscription.
2.73 Thereafter, when shares are traded on the stock exchange, the price is
determined by supply and demand for those shares. Corporations can and often
do offer different types of ownership interests of which the two most popular
are common (ordinary) and preferred stock.
2.74 Why does a company go public?3

To raise capital and have more liquidity or cash on hand by selling shares
publicly. The money received can be used in various ways, such as re-investing
in the company's infrastructure, finance debt payments or expanding the
business.
2.75 Another benefit from issuing shares is that they can be used to attract top
management candidates through the offer of stock option plans.
2.76 Stocks can also be used as part of the payment in merger and acquisition deals.
2.77 Equities have the same salient features as described below.

(a) Equity Investors Are Entitled To All Residual Claims On The Income And
Assets Of The Corporation, After All Other Creditors Have Been Repaid In
Full.
Unlike bond investors whose returns are contractual in nature, equity
investors are entitled to all residual claims. Hence, while equity investors
can enjoy the success of the corporation, they can also stand to lose their
investments if the corporation does badly.
3
Source: http://www.cnbc.com/

(b) Indefinite Tenure

Unlike money market or fixed income securities, equity is assumed to have
a perpetual lifespan. Equity need not be repaid because it represents the
capital that owners invest in a corporation.
(c) Limited Liability

The maximum amount that an equity holder can lose in the event of a
corporate failure is its paid-up capital. If you have bought the share in the
secondary market, your maximum loss is the amount that you have paid for
the shares.
(d) Entitlement To Voting Rights

Equity investors are entitled to vote at annual general meetings or
extraordinary meetings.
2.78 Equity investments have higher price volatility than money market or fixed
income securities do. This is because the cash flow associated with the former
is more volatile than the latter. The cash flow accruing to investors in money
market or fixed income securities is contractual. In the absence of default,
investors in money market or fixed income securities will receive the contractual
cash flow – nothing more, nothing less. However, the cash flow pattern
associated with equity investment is volatile, and depends on the financial
performance of the corporations and, ultimately, the decision of the Board. It
should be noted that investors are entitled to residual claims only.
2.79 There are two main kinds of shares (preferred shares and ordinary/common
shares) and investors should be familiar with both of them.
C1. The Concept Of Sector
2.80 Stocks are often grouped into different sectors depending upon the company's
business. A sector is a distinct subset of a market, society, industry or
economy, in which the components share similar characteristics. Standard &
Poor's breaks the market into 10 sectors. Two of these sectors, namely utilities
and consumer staples, are said to be defensive sectors, while the rest tend to
be more cyclical in nature. The other eight sectors are industrials, information
technology, health care, financials, energy, consumer discretionary, materials
and telecommunications services. Other groups break up the market into
different sector categorisation, and sometimes break them down further into
sub-sectors.
C2. Preferred Shares
2.81 Preferred shares are a hybrid security. This is because a preferred share has
features of fixed income security and equity. Preferred shares are shares which
give the holder a right to a fixed dividend, provided that enough profit has been
made to cover it. Investors of preferred shares rank after the investors of fixed
income security and other creditors, but ahead of equity investors in terms of
priority of payment of income, or assets in the event of a corporate failure.

2.82 Preferred shareholders usually have two privileges that provide them a
preferential position relative to ordinary shareholders. The first privilege is the
right to receive dividends before any dividends are paid to the ordinary
shareholders. This preference is usually limited to a specified amount per share
each year (which is generally expressed as some dividend rate of the face
amount of the preferred share). As previously stated, dividends are payable only
if declared by the board. If the preferred shares are non-cumulative and no
dividend is paid to the preferred shares in any year, the dividend is skipped and
does not ever have to be paid. In the following year, the corporation can pay
the specified annual preferred dividend and then pay a sizeable dividend to the
ordinary shareholders. To prevent this from happening, many preferred stocks
have a cumulative provision associated with the issue. This provision requires
the corporation to pay all the unpaid preferred dividends accumulated to the
current date, as well as the current year’s preferred dividend before any
dividend can be paid to the ordinary shareholders.
2.83 The second privilege of preferred shareholders is the right to receive up to a

specified amount for each share (plus current or cumulative dividends) at the
time of liquidation. This liquidation value must be paid to the preferred
shareholders in full, before anything can be paid to the ordinary shareholders. In
exchange for these two preferences, preferred shareholders surrender the basic
rights of ordinary shareholders.
C2A. Why Invest In Preferred Shares?

2.84 The benefits of investing in preferred shares are similar to those of bonds.
Preferred share dividends are usually paid at a fixed rate. However, they differ
from bonds in that, although the income is fixed, it is not coupon and may not
be paid if the company does not make any profit. They differ from ordinary
shares in that the dividend will never be more than the fixed rate as specified
for the preferred shares, even if profits are more than enough to cover it. As
preferred shares carry reduced risk when compared to ordinary shares (owing to
the provision of dividends particularly on a cumulative basis), they typically
offer only modest potential for capital gains when compared to ordinary shares.
2.85 In general, preferred shares appeal to investors who do not want to take on as
much risk as ordinary shareholders. Unlike ordinary shareholders, preferred
shareholders are more likely to be interested in receiving current income than
enjoying future capital gains.
C2B. Disadvantages Of Preferred Shares

2.86 Unlike ordinary shareholders, preferred shareholders do not enjoy the benefits of
rising dividends and capital appreciation as the company prospers.
C3. Common / Ordinary Shares
2.87 Companies that go public (meaning they go to the public financial markets to
raise funds for the business) issue ordinary shares to the investing public. When
an investor holds an ordinary share of a company, he is a shareholder. As a
shareholder, an investor owns part of the company and he is entitled to a

portion of the profits (after payment of debts, corporate taxes and other
business expenses) in the form of a dividend.
2.88 Investors in common/ordinary shares have the ultimate ownership rights in the
corporation. They elect the board of directors overseeing the management of
the firm. Each common share receives an equal portion of the dividends
distributed, as well as any liquidation proceeds if the company becomes
insolvent.
2.89 The current income distributed as dividends to the shareholder is at the sole
discretion of the board of directors. The board is under no legal obligation to
make dividend payments and may instead retain the profits within the business.
The owners of ordinary shares also vote on major issues, such as mergers,
name change, election of members of the board, sale of a major part of the
business, or liquidation.
C3A. Class A Shares Versus Class B Shares

2.90 Class A shares are typically the most preferred tier of classified stock, offering
more voting rights than Class B shares. Class A shares are designed to insulate
management from the short-term swings of the stock and financial markets, by
allowing those in management to control a small amount of the equity of the
company, but still maintain voting power. These types of shares are not sold to
the public and cannot be traded. Supporters say that such a dual-share system
will allow the management of the company to focus on long-term goals. In
some cases, a company will designate shares to be Class A shares, even
though they have less voting rights, and designate the shares with more voting
rights as Class B shares. Such a decision is left up to the individual company.
C3B. Why Invest In Ordinary Shares?

2.91 Ordinary shares have certain characteristics that make them attractive as
investment instruments as described below.
C3B1. Dividends
2.92 Shareholders earn income from the investment in the form of dividends.
Dividends are decided by the board of directors and paid to shareholders out of
the company’s profits. There is no certainty that the company will make profits
and, thus, no certainty that there will be a dividend. The amount to be paid will
vary with the profits made by the company and the need of the company for
additional funds. Unlike fixed income securities whose major drawback is that
inflation reduces the purchasing power of a fixed stream of funds, dividends
from owning shares, on the other hand, have the potential to increase as the
company’s sales and profits grow.
C3B2. Capital Appreciation

2.93 Ordinary shares can provide attractive returns on investment in the form of
share price appreciation or capital gains. Theoretically, there is no limit to the
extent of price appreciation that the shareholder may enjoy. The price of a listed
share will fluctuate daily according to the investors’ assessment of general

economic conditions, as well as the company’s progress and prospects of

future earnings power.
C3B3. Part Ownership

2.94 Ordinary shares offer the public a chance to own part of the company through
ownership of the shares. As the company grows and profits increase, the share
value rises; conversely, if the company fares poorly, the price of the share will
follow suit.
C3B4. Subscription Right

2.95 This is a privilege allowing existing shareholders to buy shares of an issue of
common stock shortly before it is offered to the public, at a specified and
usually discounted price, and usually in proportion to the number of shares
already owned. This is used by corporations to raise additional capital.
C3B5. Liquidity
2.96 Most shares traded on stock exchanges can be quickly bought and sold. Closing
share prices are available from the financial press/stock exchanges or via the
Internet. Investors can usually realise their investments by selling the shares
with relative ease, as compared to alternative investments, such as physical
real estate or even corporate bonds.
C3B6. Inflation Hedge

2.97 Ordinary shares, together with real estate investments, have proven to be an
excellent inflation hedge in the past, especially when compared to other
investments. The average rate on a one-year bank deposit rate varies from time
to time. However, the rate tends to be quite low. Taking into account taxes and
inflation, the real return is near zero or even negative. Interest rates on longer-
term debt instruments range from 3% to 4%. Again, after adjusting for inflation
and taxes, the real return is low. The total return of MSCI US Stocks Index (a
loose representative of World Markets), on the other hand, appreciated by an
average annual compounded rate of 11.13% over the 40-year period from 1969
to 2009. While future returns may or may not match the historical performance,
a well-diversified equity portfolio (to minimise company-specific risk) of carefully
selected blue chips and other shares promises to yield a long-term rate of return
for investors that is well in excess of the inflation rate.
2.98 Over the same 40-year period of 1969 to 2009, the U.S. average inflation rate
was approximately 4.7%. Hence, U.S. stocks would have produced an annual
return of 6.4% after adjusting for inflation. This compares better than the U.S.
long-term government bond yield after adjusting for inflation.
C3B7. Bonus Issue

2.99 When a company makes a profit, it may issue bonus issues free of charge to
existing shareholders. The number of shares given is proportionate to their
original holdings (e.g. 1 bonus share for every existing 5 shares).

C3C. Risks Associated With Investing In Ordinary Shares

2.100 Despite the obvious attraction of ordinary shares as an investment vehicle,
investors ought to be fully aware of the risks as well. Since ordinary shares are
subject to fluctuations in terms of income and price, there is a higher degree of
risk associated with them than with other forms of investments.
2.101 Share investors are exposed to both market risks (refers to factors external to
the investments that cannot be influenced to any extent by the company, such
as the general level of interest rates) and specific risks (refers to company-
specific uncertainties, such as losses, changes in top management, etc).
2.102 The value of a share fluctuates according to investors’ perception of the above
risks. A share price can rise very fast, giving huge capital gains to shareholders
of, say, a company that has discovered a miracle drug for cancer. The share
price can also fall rapidly. In the extreme, a share can become worthless if the
company becomes insolvent and all its assets are used to pay off its creditors.
A shareholder must therefore realise that he can lose all his money through poor
or careless stock selection, particularly if he invests only in shares of a limited
number of companies. A well-diversified portfolio of shares from different
sectors will help to cut down such specific risks.
(i) Risk And Return

As previously mentioned, ordinary shares have, on average, proven to be
good long-term investments. The average annual compound rate of return
of the U.S. stock market was 11.13% over the 40-year period of 1969 to
2009. Ordinary shares have therefore substantially outperformed corporate
bonds, government securities and money market instruments. However,
investors have to remember the risks associated with stock investments
that are linked to such high returns. The volatility, measured by standard
deviation, was 18.3% over the same period. Given the fluctuations of the
market, the investor may suffer losses in his investments on a short-term
basis.
Any investment involves a trade-off between risk and return. The stock
market is no different. An investor’s share portfolio will fluctuate in price
over a substantial range if held for several years. Historical data have
shown that the share market is an excellent long-term investment vehicle,
providing a rate of long-term capital appreciation that is well in excess of
the rate of inflation, as well as other asset classes, with the possible
exception of investment in property. However, it should be noted that past
performance is not a guarantee for future potential performance.
(ii) Diversification
In view of the many risks faced by share investors, it cannot be stressed
enough that diversification of shareholdings is a better strategy than just
investing in a limited number of stocks. Diversification reduces the risk of
loss and the volatility of an investor’s shareholdings.
Diversification may mean that a share portfolio includes growth stocks,

income-oriented stocks, blue chip stocks and some speculative stocks. It is

also possible to attain some diversification by buying shares of a company

that is itself widely diversified in its manufacturing and holding activities.
The investor may also wish to diversify across countries to reduce the
vulnerability of the share portfolio to the economic fortunes of any single
country. A prudent investor may also diversify his investments over time,
so as to offset the ups and downs of the market. One good avenue for
diversifying the investments in equity markets is through the purchase of
unit trusts.
Unit Trusts
2.103 A unit trust is a professionally managed investment fund that pools together
money from investors (called unitholders), with similar investment objectives to
invest in a portfolio of stocks, fixed income securities or other financial assets,
or some combination of them. It is also known as Collective Investment Scheme
(CIS) locally.
2.104 The way a unit trust investor owns units in the fund is somewhat similar to the
way an investor owns shares in a company. Each unit represents a
proportionate ownership in the underlying securities owned by the unit trust.
For example, if there are 1,000,000 units in a unit trust that owns 200,000
shares of Singapore Airlines and 1,000,000 shares of Venture Corporation,
among others, then each unit will represent 0.2 shares in Singapore Airlines and
one share in Venture Corporation. Unit holders redeem their investment by
selling units back to the fund manager.
2.105 The Securities and Futures Act (Cap. 289) provides for the MAS to authorise all
collective investment schemes to be offered to the public in Singapore, for
example, the approval of trust deeds and schemes. This deed enables a trustee
(usually a bank) to hold the pool of money and assets in trust on behalf of the
investors. The pool is managed by a third party, namely the fund manager. The
fund manager solely manages the portfolio of investments and operates the
market for the units (i.e. administers the buying and selling of shares in the unit
trust) itself. The unit trust is essentially a three-way arrangement among
investors, the fund manager and the trustee.
2.106 Investors who are interested in receiving the benefit of professional portfolio
management, but who do not have sufficient funds and/or time to purchase a
diversified mix of securities will find investing in unit trusts attractive. They can
invest in unit trusts to generate income in the form of dividends and capital
gains.
2.107 Investors in Singapore can choose from a wide variety of unit trusts with
different investment objectives. A unit trust may aim for high income or high
capital growth, or a combination of both. Some unit trusts invest in specific
countries and regions.
2.108 It is important that the investment objectives of the unit trust chosen match
those of the investor. Unit trusts are required to state their investment
objectives clearly on the prospectus which every investor should acquire before

buying. The types of assets that may be bought by the fund manager are also
specified in the objectives of the unit trust as contained in the trust deed.
2.109 The advantages of investing in unit trusts, the characteristics of unit trusts, and
different types of unit trusts are discussed in detail and in-depth in Chapters 7
and 8 of this study guide.
Life Insurance
2.110 Some life insurance products can also serve as savings/investment instruments.
These include the following two main types of life insurance policies:
▪ Whole Life Insurance; and
▪ Endowment Insurance.
E1. Whole Life Insurance Policy
2.111 The premiums payable for a whole life insurance policy provide a mixture of life
cover and investment and, therefore, have cash or surrender values. In the case
of a whole life insurance policy, the sum assured will be payable on the death
of the life insured, whenever this takes place. Policy owners pay fixed monthly
or annual premiums and beneficiaries receive fixed death benefits. Meanwhile,
reserves/assets backing up the future liabilities of the policies earn interest and
grow, building up cash values that can be withdrawn or borrowed. The cash
values of a whole life insurance policy can be withdrawn at any time by the
policy owner’s surrendering (cancelling) of the policy, subject to the terms of
the policy.
2.112 Alternatively, if policy owners do not want to surrender their policies, they have
access to accumulated policy savings. Policy owners normally can obtain loans
from the life insurance company under their policies for any amount up to a
certain percentage of the cash value, the limit being dependent upon the policy
of the insurer concerned.
E2. Endowment Insurance Policy
2.113 The premiums payable for an endowment insurance policy also provide a
mixture of life cover and investment. However, in the case of an endowment
insurance policy, the sum assured is payable on a fixed date (the maturity date)
or on the life insured’s death, whichever is earlier. As in a whole life insurance
policy, the payout by the insurer of an endowment insurance policy is certain at
a particular stage.
2.114 Endowment policies carry premiums higher than conventional whole life policies
and term insurance, but are useful in meeting special lump sum needs such as
college expenses or for buying a retirement home. The guaranteed cash values
received may be less than the sum of the premiums paid. This is because part
of the premiums will pay for insurance protection while the rest is invested and

subject to investment risk. Endowment policies usually mature after a fixed

period of time, e.g. 10, 15 or 20 years.4
E3. Whole Life And Endowment Insurance Policies As Investment Media
2.115 Both whole life and endowment insurance policies are thus effectively
investments that become payable at a future date, either on death or earlier.
Such policies may be deemed to be structured to provide a fixed amount of
death benefit (sum assured) only. In this case, the policies will provide for a
guaranteed return. As such, they are known as non-profit (non-participating)
policies, in contrast to the with-profits policy as explained in the sections that
follow below.
2.116 The return of the policies can be linked to the insurer’s investment performance
- either by having a with-profits policy where benefits are indirectly affected by
investment performance, or by having an Investment-linked Life Insurance
policy, where the link with investment performance is direct. Both whole life
and endowment insurance policies can be either with-profits or investment-
linked.
E3A. With-Profits Policies

2.117 Every year, the insurer will carry out a valuation of the assets and liabilities of
its life fund. This will normally reveal a surplus, part of which can be allocated
to the with-profits policy owner in the form of an addition to the sum assured.
This addition, called a bonus or profit, is usually reversionary. This means that it
is payable only at the same time, as when the sum assured is paid on death or
maturity.
2.118 With such a with-profits policy, the link between the policy benefits and the
investment and operating (such as mortality experience and level of operating
expenses) performance of the insurer is not direct and depends on the annual
valuation of the fund assets and liabilities, where many factors are taken into
consideration. The allocation of the surplus in the form of reversionary bonus
will ultimately depend on the decision of the board of directors, in consideration
of the recommendations made by the appointed actuary of the life insurance
company. Therefore, the bonuses added to the policy tend to follow the
investment and operating performance only in a distant fashion. Allowance
must be made for the guarantees underlying the basic sum assured, and so the
bonus system does not directly reflect the value of the underlying assets of the
life fund. In addition, bonuses are generally declared on a yearly basis.
Therefore, they cannot possibly match and reflect the daily fluctuations in the
value of assets.
E3B. Investment-linked Life Insurance Policies

2.119 Investment-linked life insurance policies offer investors policies with values
directly linked to the investment performance of the underlying instruments.
This is usually done by formally linking the values of the policies to units in a
4
Source: http://www.moneysense.gov.sg/

fund run by the insurer or by external fund managers. Such a fund usually
consists of a mixture of equity funds, fixed income funds, managed funds and
other types of funds. The investment element of investment-linked life
insurance policies varies according to the underlying assets of the portfolio, and
fluctuates daily according to the performance of those investments.
Annuities
F1. What Is An Annuity?
2.120 An annuity is a series of payments guaranteed for a number of years or over the
lifetime of the annuitant receiving the payments.
F2. Types Of Annuities
2.121 There are two main types of annuities:

▪ An immediate annuity is a contract under which payments to the annuitant
begin as soon as it is purchased. An immediate annuity is always purchased
with a lump sum (single premium).
▪ A deferred annuity, in contrast, is one in which the payments to the
annuitant begin at some future date. The date is specified in the contract or
at the annuitant's option. The amount that the annuitant will periodically
receive depends on his contributions, the interest earned on them, the
annuitant's gender, and the annuitant's age when payments begin. Deferred
annuities may be purchased with either a single premium or periodic
premiums.
F3. Uses Of Annuities
F3A. Annuities As Insurance Against The Possibility Of Outliving One's Income

2.122 In its pure form, a life annuity may be defined as a contract whereby, for a cash
consideration, one party (the insurer) agrees to pay the other (the annuitant) a
stipulated sum (the annuity) periodically throughout life (lifetime). However, the
consideration paid for the annuity will be fully earned by the insurer immediately
upon the death of the annuitant. Therefore, the purpose of the annuity is to
protect against loss of income arising from excessive longevity. Hence, this is
exactly the opposite of the purpose of a life insurance policy that furnishes
protection against loss of income arising out of premature death.
F3B. Annuities As An Investment Vehicle Or A Savings Instrument

2.123 Most annuities are savings instruments designed to first accumulate funds and
then systematically liquidate the funds, usually during the retirement years of an
annuitant. The annuitant can put in a lump sum (single premium) or set aside a
series of regular premiums over a period of years. At the annuity starting date,
the annuitant receives a guaranteed income for the rest of his life. The amount
of the income depends on the cash value in the annuity and the payment option
selected.

2.124 As such, annuities are an attractive option for any individual person who has
not yet accumulated an estate, but wants to achieve financial independence in
his old age. Professionals, entertainers and athletes who enjoy a very large
income for a limited period of time will find annuities particularly attractive as a
savings medium. Under such circumstances, annuities are an appropriate
investment, because they can be purchased through flexible periodic premiums
or through a single premium, when the annuitant comes into possession of large
amounts of money.
2.125 Therefore, in short, annuities can be used as a savings instrument which

provides protection against loss of income arising out of excessive longevity
through liquidating a principal sum.
F3C. Annuities As A Hedge Against Adverse Financial Developments

2.126 Wealthy individuals who have already accumulated an estate, either through
inheritance or by their own personal efforts, purchase annuities as a hedge
against adverse financial developments, that is, as a form of security. Large
estates can be wrecked through business reverses and unwise investments. As
a result, individuals who were once wealthy would have to depend on the
payments from annuities purchased in their more affluent days as their sole
source of income.
F4. Comparing Life Insurance And Annuities
2.127 While life insurance products are intended to guard against living too short a
life, life annuity products are intended to provide a vehicle to support the living
expenses required after retirement, for as long as the annuitants live. Hence, life
annuity products provide protection for annuitants who live longer than
expected. Again, as in the case of life insurance products, there are many
different variations of life annuity products. In achieving the aim of providing
sufficient retirement income, life annuity products are often structured as
savings and investment products before the annuity payments begin. The
savings/asset building phase is an extremely crucial part of retirement planning
and an integral part of many life annuity products, where regular premiums are
paid into the retirement savings fund for investment and growth.
3. SUMMARY
3.1 This chapter covers the main categories of financial assets which include the
following:
▪ Cash and their equivalents which include the different types of bank
deposits;
▪ Money market instruments which are debt instruments with maturities of
less than one year;
▪ Various types of fixed income securities, their characteristics and features,
and the risks and returns associated with bond investing;
▪ Features of equity investing, and pros and cons of investing in equity;

▪ Overview of unit trust investing;

▪ Introduction to the two main types of life insurance (whole life insurance and
endowment insurance);
▪ Types and uses of annuities.

2. Types of Investment Assets - II
CHAPTER 2
TYPES OF INVESTMENT ASSETS – II
CHAPTER OUTLINE
1. Introduction
2. An Introduction To Financial Derivatives
3. Real Estate Investment
4. Structured Products
5. Summary
KEY LEARNING POINTS

▪ understand the following alternative classes of investment assets:
- financial derivatives – Options, Contracts For Difference, Extended Settlement,
Warrants, Futures and Swaps
- real estate investment
- structured products

1. INTRODUCTION
1.1 Besides the traditional investment assets mentioned in the previous chapter,
investors have the option of investing in alternative classes of assets. They are
financial derivatives, real estate investment and structured products.
2. AN INTRODUCTION TO FINANCIAL DERIVATIVES
2.1 In this section, we provide a basic introduction to and discussion of financial

derivatives, the roles that they play, and the contributions that they make.
These financial derivatives include the following:
▪ Options;
▪ Contracts for difference (CFD) and Extended Settlement (ES);
▪ Warrants;
▪ Futures;
▪ Swaps; and
▪ Forwards
2.2 Simply put, financial derivatives are financial assets in which the values are
derived from, or depend on, some other assets (such as equity, foreign
exchange, commodities, bonds and others). These financial derivatives have
attained overwhelming popularity and rapid growth in recent years for a number
of reasons, including (a) helping to make the financial market more complete;
(b) allowing speculators and risk managers to use these assets to pursue their
goals; and (c) attracting traders to these markets because of their trading
efficiency, and the low transaction costs and liquid markets.
(a) Market Completeness

In a complete market, any and all identifiable payoffs can be obtained by
trading the securities in the market. The availability of financial derivatives
helps to move the market to completeness. A more complete market will
increase the welfare of the agents in the economy.
(b) Speculation
Financial derivatives have a reputation of being risky. They can be
tremendously risky in the hands of un-informed traders. However, their
risks are not necessarily evil, because they provide very powerful
instruments for knowledgeable traders to expose themselves to calculated
and well understood risks in the pursuit of profitable payoffs.
In the hands of a knowledgeable trader, a position in one or more financial

derivatives can present a careful and artful speculation on a rise or fall in
interest rates, on a change in riskiness of the entire stock market, on the
changing values of Euro versus the Japanese Yen, or on a host of other
investment propositions.

The precision and speculative power of financial derivatives stem largely

from the fact that financial derivatives help to make the financial market
more complete and robust. Although serving as a speculative tool is not the
only use (and probably not the most important use) of financial derivatives,
they are ideally suited for this purpose.
(c) Risk Management

Financial derivatives provide a powerful tool for limiting risks that
individuals and firms face in the ordinary conduct of their businesses.
For example, a corporation that is planning to issue bonds faces

considerable interest rate risk. If the interest rate rises before the bond is
issued, the firm will have to pay considerably more over the life of the
bond. Such a firm can use interest rate futures to control its exposure to
this potential risk.
Similarly, a pension fund with a diversified holding in the stock market

faces considerable risk from general fluctuation of the stock prices. The
fund manager can use options on a stock index to reduce this risk
exposure.
Even though financial derivatives are risky in the sense that their prices are
subjected to substantial fluctuations, they can be powerful tools in limiting
the downside risks as well. However, successful risk management with
derivatives requires a thorough understanding of the underlying principles
governing the pricing of these often complicated financial derivatives.
A. Options
2.3 In general, an option is a formal contract between a seller (the optioner) and a
buyer (the optionee) on the right (but not the obligation) to buy-and-sell (or to
buy-or-sell) a specific property or a fixed quantity of a commodity, currency, or
security, at a fixed price (the exercise price) on or up to a fixed date (the
expiration date). The optionee generally pays a small sum of money (premium or
option money) for the contract, thus obtaining investment leverage.
2.4 In other words, instead of buying a security outright, an investor can buy a right
to purchase or sell a security at a future date. This is called an option. Note that
an option is not issued by the company, but by investors seeking to trade in
claims (buy or sell) on the asset/security.
2.5 An option to buy (a call option) is purchased when prices are expected to rise,
an option to sell (a put option) when prices are expected to fall, and an option
to buy-or-sell (a double option) when prices may go either way.
2.6 Option prices are directly tied to the prices of the underlying security to which
they apply. The life of an option may vary, but the common durations adopted
are three, six and nine months. Over-the-counter options can also be bought by
institutions for longer periods, from one to five years.

2.7 The most popular types of options are American option (exercisable any day up
to the expiration date) and European option (exercisable only on the expiration
date). Any option that is not exercised before the expiry date is automatically
cancelled, and the optionee loses the premium paid. In practice, only a few
options are exercised and most are bought from or sold to other optioners or
optionees before the expiration date. Since options are legally binding contracts,
they have intrinsic values (which is the difference between market price and
strike price of the option) and are freely traded on the futures exchanges. A
futures exchange refers to a central marketplace where futures contracts and
options on futures contracts are traded.
A1. Why Buy Options?
2.8 The most significant advantage of options is the effective management of risk.
Options limit the investor’s exposure to risk, since the only amount of money to
be lost is the purchase price of the option. For instance, if an investor
anticipates the price of the underlying security to rise, he will buy a call option.
If the price of the underlying security increases, then he can exercise his option
to reap a profit. However, if the price of the underlying security declines, he
does not need to exercise his option, in which case, he will lose only the price
that he has paid for the option. Another major advantage of buying options is
the leverage that options offer. As options are leveraged on securities, their
values respond more than proportionately to changes in the underlying security
value.
2.9 With a good knowledge of the principles involved, sophisticated investors can
use stock options to protect profits, to create liquidity, and as an additional
avenue for investing their funds.
A2. Disadvantages Of Investing In Options
2.10 Investing in options is inherently risky. Hence, an investor must be prepared to

lose all his money in the option premiums, as options that are not exercised
before the expiry date become worthless after that date. Share options do not
provide voting privileges, ownership interest or dividend income. However, it is
noted that option contracts are adjusted for stock splits and stock dividends.
B. Contracts For Difference (CFD) And Extended Settlement (ES)
2.11 This section gives a brief description of two derivative products that are traded
and are fairly popular in Singapore via the Singapore Exchange (SGX), as well
as Over The Counter (OTC) Markets. These are (1) the Contracts For Difference
(CFD) and (2) Extended Settlement (ES).
B1. Contracts For Difference (CFD)
2.12 CFD is a derivative on some asset price (normally on stock/equity asset). It is a

contract between two parties, typically described as “buyer” and “seller”,
stipulating that the seller will pay to the buyer the difference between the

current value of an asset and its value at contract time (or if the difference is
negative, then the buyer pays to the seller instead). For example, when applied
to equities, such a contract is an equity derivative that allows investors to
speculate on share price movements, without the need for ownership of the
underlying shares. Contracts for difference allow investors to take long
(ownership) or short (sale) positions, and unlike futures contracts, they have no
fixed expiry date, standardised contract or contract size. Trades are conducted
on a leveraged basis, with margins typically ranging from 1% to 30% of the
notional value for CFDs on leading equities.
B1A. Risks with CFD

2.13 Being a derivative, CFD can result in big losses to the investors if its risks are
not properly understood and managed. Investments in CFD can be highly
leveraged, meaning that the initial amount invested may be much less than the
underlying value of the assets (stocks) involved, as a start. The gains and
losses are thus magnified with the leveraging effect, and can have severe
demand or strain on the cash balance of investors, when margin accounts are
required to be topped up and brought up-to-date, and marked to market with
the changes in the market value of the stocks. This is especially so when there
is or has been high volatility in the stock market, or when the market is moving
southward, with poor economic news and development/prospects.
2.14 Another dimension of CFD risk is the counterparty risk, an important factor in
most over-the-counter (OTC) traded derivatives. Counterparty risk is associated
with the financial stability or solvency of the counterparty to a contract. In the
context of CFD contracts, if the counterparty to a contract fails to meet their
financial obligations, the CFD may have little or no value, regardless of the
underlying instrument. This means that a CFD investor can potentially incur
severe losses, even if the underlying instrument moves in the desired direction.
2.15 OTC CFD providers are required to segregate clients’ funds to protect clients’
balances in the event of a company’s default. Exchange-traded contracts traded
through a clearing house are generally believed to have less counterparty risk.
Ultimately, the degree of counterparty risk is defined by the credit risk of the
counterparty, including the clearing house, where applicable.
B2. Extended Settlement (ES)
2.16 ES was another derivative product launched by SGX in early 2009. With effect
from 1 April 2015, SGX had designated ES as dormant. In short, it is a contract
between two parties to buy or sell a specific quantity (e.g. 1,000 shares) in a
specific underlying share (e.g. DBS) at a specific price (e.g. S$14.20) for
settlement at a specific future date (e.g. last business day of the month) when
the contract matures or expires.
2.17 ES contracts have fixed expiry dates (about 35 days from the listing date) and
there is no need for daily settlement, as the contract is settled on maturity. ES
contracts are listed and traded on the SGX. The investor can buy and sell ES
contracts in the same way that he buys and sells shares through a stockbroker.

2.18 However, note that ES contracts are classified as contracts under the Securities
and Futures Act (Cap. 289). Before an investor can trade ES contracts for the
first time with his broker, the investor must sign a Risk Disclosure Statement. In
addition, when an investor buys or sells an ES contract, he must use a margin
account.
2.19 ES contracts are flexible instruments that offer the investor numerous
advantages, such as capital efficiency, ease of taking short positions and longer
view of the market. In addition, it can be used as a hedging tool, taking
advantage of stock spreads, as well as arbitraging.
B2A. Risks Of Trading In Extended Settlement (ES) Contracts

2.20 The risks associated with ES include (i) the leveraged nature of ES contracts; (ii)
margin calls; (iii) liquidity; (iv) volatility; and (v) buy-in by clearing house.
(i) Leveraged Nature Of ES Contracts

As in most investments, trading in ES contracts can lead to losses for
investors if the price in the underlying security moves against the investors.
Since ES is a leveraged product, the losses suffered from trading ES
contracts will be greater in percentage terms of the initial cost or capital
outlay needed to enter into an ES position, (i.e. the margin deposit put up
by the investors) against the price movement in the underlying asset.
Trading a contract value several times larger than the margins deposited
means that the risks and returns are similarly magnified, as opposed to
placing the same amount of capital for a position directly in the underlying
asset. For example, if the initial margin required for a particular ES contract
is 10% of that ES contract value, then the leverage is 10 times, and the
risk and return are magnified 10 times.
The small initial outlay required may work against the investor. He may be
tempted to over-extend himself by buying too many ES contracts with the
sum that he has to invest. For example, while an investor may be able to
buy only one lot of a company’s shares for S$5,000, he may be able to buy
10 lots of ES contracts for the same amount of S$5,000 if the margin of
those contracts is 10%. He should bear in mind that when the ES contracts
are due for settlement, he would have to pay the balance of S$45,000.
(ii) Margin Calls

An investor may sustain a total loss of the funds placed for initial margin
and any additional funds deposited to maintain a position in the ES
contract. If the market moves against the investor or margin levels are
increased, the investor may be required by his broker to pay additional
funds on short notice to maintain the position. If the investor fails to
comply with a request for additional funds within the specified time, the
broker may liquidate the position, and the investor will be liable for any
resulting deficit in his account. Therefore, the potential loss from trading ES
contracts is not limited and can be several times the initial margin paid
originally to support the position.

(iii) Liquidity
Similar to ordinary shares in the ready market, there is no assurance that a
liquid market will always exist for an ES contract. An illiquid market can
occur if there are few willing buyers and/or sellers for the ES contract. This
may increase the risk of loss, by making it difficult or impossible for an
investor to liquidate a position in the ES contract.
Two useful indicators of liquidity are the volume of trading and the open
interest of the contract (the number of ES positions still remaining to be
liquidated by an offsetting trade or to be satisfied by delivery).
In addition to an illiquid market, the ability of an investor to liquidate his ES

position may be affected by the operation of certain rules, e.g. the
suspension of trading in any ES contract or the underlying security owing to
unusual trading activity or news events involving the issuer of the
underlying security.
(iv) Volatility
Since the stock market can be volatile at times, the prices of ES contracts
are similarly affected. The investor must be aware of the impact of volatility
on risk and return.
(v) Buy-In By Clearing House

If you hold a short ES position until expiration, you have an obligation to
physically deliver the underlying security for settlement. If you do not have
the required securities in your account on the settlement day, the Central
Clearing House will buy-in shares on your behalf to satisfy your delivery
obligation. You are required to pay for the bought-in securities and any
associated costs.
B3. Comparison of CFD and ES
2.21 It is noted that both CFD and ES are financial derivatives and therefore can be
quite risky if the exposure is not properly managed, and if the risks are not
properly understood and contained. Both instruments can be highly leveraged.
They can both be used for shorting and speculating on the price trend of the
underlying assets. One key difference is that ES has a relatively short expiry
date (like 35 days), while CFD technically can be held for a much longer period
of time.
C. Warrants
2.22 Warrants, also known as Transferable Subscription Rights (TSR), are a special
type of call option issued by a corporation that gives the holder the right to
acquire equity at a specified price and within a designated time period, typically
several years.
2.23 Warrants are seldom issued on their own, but are often provided free as an
added attraction to rights or loan stocks (which are unsecured stock delivered

to an entity that has furnished a loan for a company, and earns interest at a
fixed rate) issued by a company to raise extra capital. Warrants, in the form of
a certificate, are usually issued along with a bond or preferred stock, entitling
the holder to buy a specific amount of securities at a specific price, usually
above the current market price at the time of issuance, for an extended period,
anywhere from a few years to forever.
C1. Why Buy Warrants?
2.24 Warrants offer some attractive features:

▪ An investor can buy a warrant as a way to establish an exposure to a share,
without a large initial capital outlay. The investor will buy the warrant, pay the
exercise price at a later date, and convert the warrant to the underlying share.
▪ An investor may benefit from capital gains by selling the warrants given to him
in the first instance. When the price of the underlying share goes up, the
investor may profit by selling the warrant, or exercise it to buy and then sell the
stock to reap the capital gain. Note that capital gain is not taxable in Singapore.
C2. Disadvantages Of Investing In Warrants
2.25 The main drawback is that on expiry, warrants that are not exercised will lose
their value completely. Unlike ordinary shares, there is no chance for price
recovery. Once the warrant has expired, it is worthless. Another disadvantage
is that warrant holders do not receive any income in the form of interest or
dividends. They also carry no voting privileges.
D. Futures
2.26 In general, futures are a standardised, transferable, exchange-traded contract

between two parties that requires delivery of a commodity, bond, currency, or
stock index1, at a specified price on a specified future date. Unlike options,
futures convey an obligation to buy. The risk to the holder is unlimited, and
because the payoff pattern is symmetrical, the risk to the seller is unlimited as
well. Dollars lost and gained by each party on a futures contract are equal and
opposite. In other words, futures trading is a zero-sum game. Futures contracts
are forward contracts, meaning they represent a pledge to make a certain
transaction at a future date. The exchange of assets occurs on the date
specified in the contract. Futures are distinguished from generic forward
contracts in that they contain standardised terms, trade on a formal exchange,
are regulated by overseeing agencies, and are guaranteed by clearing houses.
Also, in order to ensure that payment will occur, futures have a margin
requirement that must be settled daily.
2.27 The Initial Margin is the sum of money (or collateral) to be deposited by a firm
to the clearing corporation to cover possible future loss in the positions (the set
of positions held is also called the portfolio) held by a firm. The Mark-to-Market
Margin (MTM margin), on the other hand, is the margin collected to offset
1
Futures contracts are cash-settled when the underlying assets are intangible, such as stock index.

losses (if any) that have already been incurred on the positions held by a firm.
This is computed as the difference between the cost of the position held and
the current market value of that position.
2.28 In summary, a futures contract is one where a buyer and seller are obligated to
buy or sell an asset within a specified time period at a specified price. They
differ from options in that there is an obligation to transact, regardless of future
price movement. Another difference is that futures contracts cannot lapse, and
their holders have to sell them before their expiration date, or take delivery of
the underlying item.
D1. Why Buy Futures?
2.29 Investors can protect their investments by taking positions in the futures market
to protect the gains that they have made in the cash market. An investor may
also wish to engage in speculative trading. The investor takes on price
fluctuation risks in order to have a chance at making large gains. However,
before an investor ventures into investing in future contracts, he must have a
clear understanding of the concept of hedging, and of the amount of gain or
loss that can result from any change in the price of the futures contract.
2.30 Finally, by making an offsetting trade, taking delivery of goods, or arranging for
an exchange of goods, futures contracts can be closed. Hedgers often trade
futures for the purpose of keeping price risk in check. Speculators on futures
price fluctuations not intending to make or take ultimate delivery must take care
to “zero their positions” before the expiry of the contracts. After expiry, each
contract will be settled, either by physical delivery (typically for commodity
underlyings), or by a cash settlement (typically for financial underlyings).
2.31 The contracts are ultimately not between the original buyer and the original
seller, but between the holders at expiry and the stock exchange. As a contract
may pass through many hands after it is created by its initial purchase and sale,
settling parties generally do not know with whom they have ultimately traded.
E. Swaps
2.32 A swap is a derivative in which two counterparties exchange certain benefits of

one party’s financial instrument with those of the other party’s financial
instrument. The benefits in question depend on the type of financial instruments
involved. Specifically, the two counterparties agree to exchange one stream of
cash flows against another stream. These streams are called the legs of the
swap. The swap agreement defines the dates when the cash flows are to be
paid and the way they are calculated. Usually at the time when the contract is
initiated, at least one of these series of cash flows is determined by a random
or uncertain variable, such as an interest rate, foreign exchange rate, equity
price or commodity price.
2.33 The cash flows are calculated over a notional principal amount, which is usually
not exchanged between the counterparties. Consequently, swaps can be used

to create unfunded exposures to an underlying asset, since counterparties can

earn a profit or suffer a loss from movements in price without having to post
the notional amount in cash or collateral.
2.34 Swaps can be used to hedge certain risks, such as interest rate risk, or to
speculate on changes in the expected direction of prices of underlying
securities. The first swaps were produced in the early 1980s. Today, swaps are
among the most heavily traded financial contracts in the world.
2.35 It is noted that with swaps, exchange of cash flows can happen between a
number of different asset classes. Also, the cash flows can arise from an asset,
a liability, or some payment streams.
2.36 Common types of swaps include:

▪ Currency swap: simultaneous buying and selling of a currency to convert
debt principal from the lender’s currency to the debtor’s currency;
▪ Debt swap: exchange of a loan (usually to a third-world country) between
banks;
▪ Debt to equity swap: exchange of a foreign debt (usually to a third-world
country) for a stake in the debtor country’s national enterprises (such as power
or water utilities);
▪ Debt to debt swap: exchange of an existing liability into a new loan, usually
with an extended payback period; and
▪ Interest rate swap: exchange of periodic interest payments between two
parties (called counterparties) as a means of exchanging future cash flows.
F. Forward Contract
2.37 A forward contract is a transaction in which the buyer and the seller agree upon
the delivery of a specified quality and quantity of asset (e.g. a commodity or
currency) at a specified future date. Forward contracts are very similar to
futures contracts, except they are not exchange-traded, or defined on
standardised assets.
2.38 A currency forward contract enables a person with a future commitment in a

particular foreign currency to cover the risk of any fluctuations in the exchange
rate before the maturity of the commitment. Banks that offer foreign exchange
on a spot basis also deal in forward transactions.
G. Summary of Financial Derivatives
2.39 Futures and forward contracts are similar, but they have some differences as
below:
▪ A forward contract is a non-standardised contract traded over-the-counter
(OTC) between two parties. On the other hand, a futures contract is a
standardised contract traded on organized future exchanges.

▪ Futures contracts are subjected to margin requirements and a daily mark-to-

market process. Terms on forward contracts are negotiated in specific
contracts.
2.40 The following tables provide a summarised comparison of the different types of
financial derivatives discussed above. The tables bring out the differences
among them, in terms of definition, right/obligation, management of risk,
leverage and expiry, voting privileges, ownership interest or dividend income,
use, margin account, trading and settlement of contracts.
Table 2.1 Definition

Options Warrants Futures Swaps
A formal contract A special type of A standardised, A derivative in
between a seller call option issued transferable, which two
and a buyer to buy by a corporation exchange-traded counterparties
or sell some stock that gives the contract between exchange certain
in the future at holder the right to two parties, giving benefits (cash
some pre-set price acquire equity at a the holder the flows) of one
(strike price). specified price and obligation to make party’s financial
within a or take delivery instrument for
designated time under the terms of those (the cash
period. the contract. flows) of the other
party’s financial
instrument.
Table 2.2 Buy / Sell: Right Versus Obligation

Equity call option Give the right but Obligation to buy Obligation to
gives the right there is no or sell within a carry out the
(not obligation) to obligation to specific time terms of the
buy at strike acquire the period at a contract till
price; put option equity. specific price. completion.
gives the right
(not obligation) to
sell at strike
price.

Table 2.3 Management Of Risk

Limited exposure Exposure to a Necessary to Failure of
for the option share without a have a clear counterparty to
buyer – the huge capital understanding of carry out the
maximum capital outlay (warrant hedging, and exchange of cash
loss for the premium or free). amount of gain or flows owing to
option buyer is For the warrant loss owing to failure or
the purchase issuer, the change in price of insolvency; can
price of the maximum loss is futures; cash be hedged by the
option (option the difference flows needed to use of credit
premium). For the between the maintain margin default swaps.
option issuer, the market value and account under
maximum loss is the strike price of volatile market
the difference the stock less the conditions.
between the warrant premium.
market value and This magnitude
the strike price of turns out to be
the stock less the the maximum
option premium. gain for the
This magnitude warrant buyer.
turns out to be
the maximum
gain/profit for the
option buyer.
Table 2.4 Leverage And Expiry

Leverage: Yes Leverage: Yes Leverage: Yes Leverage: Yes
Expiry: Yes, if the Expiry: Yes, if not Expiry: Yes. The Expiry: Yes,
right is not exercised before expiry date is when the term
exercised by the the expiry date. known as the for the exchange
expiry date. delivery date or of cash flows is
final settlement completed.
date.
Table 2.5 Voting Privileges, Ownership Interest Or Dividend Income

No No No No

Table 2.6 Use

Leverage/hedge By corporations/ Financial futures Used to hedge
against the price issuers to are extensively interest rate risk
fluctuation promote the sale used in the (interest rate
of preferred hedging of swaps), credit
shares or interest rate default risk
issuance of swaps; also by (credit swaps),
bonds speculators who speculate on
seek to make a changes in
profit by expected
predicting market direction of
movements. prices of
underlying
securities
(commodity
swaps and equity
swaps)
Table 2.7 Margin Account

Not Applicable Not Applicable Yes, to minimise Not Applicable
credit risk,
traders must post
an initial margin
or a performance
bond, typically
5% to 15% of
the contract
value; and
marked to market
daily by
maintenance
margin.
Table 2.8 Trading

Via stock Via stock Mercantile OTC or
exchange or OTC exchange or OTC exchange/futures mercantile
exchange exchange/futures
exchange.

Table 2.9 Settlement

Normally by cash By cash for By physical By proper
(representing the acquisition of delivery (common exchange of cash
difference stocks with commodities flows until the
between the and bonds) or completion of the
market value and cash settlement term
strike price of the
stock) or transfer
of security (rare);
same for
warrants.
H. The Use and Misuse of Derivatives
2.41 Most of the news stories about derivatives are related to financial disasters.
Much less is heard about the benefits of derivatives. However, because of these
benefits, more than 90%of large companies use derivatives on a regular basis.
2.42 There are many advantages to these financial strategies. Financial derivatives
can help reduce risks by insuring against potential risks. A wise business owner
or investor can enter into a transaction with another party by using this feature
of financial derivatives in order to decrease the impact of potential risks, and
hence, increase profits.
2.43 Another advantage of financial derivatives is the chance to let investors earn
more profits. Through a contract, the investor can choose to buy or sell
products in a manner that earns him more profit. The concept of financial
derivatives also gives the investor the freedom to buy assets at a low cost or
sell them at a higher price.
2.44 However, there is also a downside to the use of derivatives. Hedging is

invariably cited as a “good” use of derivatives, whereas speculating with
derivatives is often cited as a “bad” use. Some organisations can afford to bear
the risks involved in speculating with derivatives, but others are either not
sufficiently knowledgeable about the risks they are taking or should not be
taking those risks in the first place. Most would agree that the typical
corporation should use derivatives only to hedge risks, not to speculate in an
effort to increase profits. Hedging allows managers to concentrate on running
their core businesses without having to worry about interest rate, currency and
commodity price volatility. However, problems can arise quickly when hedges
are improperly executed or when a corporate treasurer, eager to report relatively
high returns, uses derivatives for speculative purposes instead.
2.45 One interesting example of a derivatives debacle involved Kashima Oil, a

Japanese firm that imports oil. It buys oil in U.S. dollar but sells oil in the
Japanese market in Japanese yen. Kashima began by using currency futures to
hedge, but it then started to speculate on dollar-yen price movements, hoping
to increase profits. When the currency markets moved against Kashima’s

speculative position, lax accounting rules allowed it to avoid reporting the

losses by simply rolling over the contract. By the time Kashima bit the bullet
and closed its position, it had lost US$1.5 billion.
2.46 Evidently, derivatives can and should be used to hedge against certain risks, but
the leverage inherent in derivatives contracts makes them potentially dangerous
instruments. Policies should be established regarding when derivatives can be
used and how they should be used, and there should be proper audit procedures
to ensure that the policies are carried out and complied with.
3. REAL ESTATE INVESTMENT
3.1 Investment in real estate has been a part of the investment portfolio and
activity for many investors, mainly because ownership of real estate and
properties is very much tied to the housing and sheltering needs of the
investors and their families. Housing and sheltering needs may be fulfilled by
renting or purchasing properties. In many other parts of the world, renting has
been and is a key way of addressing the need for sheltering. Besides housing
and sheltering needs, ownership of real estate is a popular investment activity
and strategy.
3.2 There are many forms of real estate ownership available to investors. One such
form is the purchase of property directly, either as an individual, or as a
managing partner in a partnership. Another way that requires less active
management by the investor is to own shares in a real estate investment trust
(REIT). A third way is by owning a limited-partnership interest in a general
partnership. This limited-partnership interest has no active role in the firm’s
management.
3.3 Real estate investments usually involve more complexities than the other
investment categories because of:
▪ the uniqueness of each property;
▪ the differing rights associated with ownership of each property; and
▪ the absence of organised markets for the ready sale and purchase of the
property or ownership interest.
3.4 Most individuals purchase homes to provide shelter for themselves and their
families. At the same time, they hope to enjoy a current return or capital
appreciation in the property’s value.
3.5 In recent years, investments in real estate and housing have produced fairly
high and good returns for many investors. As with all investments, market
conditions can change. If expenditures for the primary residence are being made
because the main objective is to achieve the benefits from an investment, then
the property must be examined from that perspective.

A. Reasons For Investment In Property / Real Estate
3.6 Property is a good investment for the following reasons:
A1. Inflation Hedge
3.7 Over time, it has been observed that on average, real estate has been a very
good hedge against inflation in most countries, because property values and the
income from properties tend to rise to keep pace with inflation.
A2. Capital Appreciation
3.8 Real estate values tend to appreciate over time, although this is not guaranteed.
When an investor buys a property, a downpayment of at least 20% is normally
paid, while the balance is borrowed through a loan (set up as a mortgage)
arranged with a commercial bank. The investor gets the benefit of 100% of the
investment. This means that the investor maximises his return with other
people’s money. The use of mortgages and leverage enables the investor to use
a small amount of cash to gain control of large investments and earn large
returns on the money invested.
A3. Pride Of Ownership
3.9 An investor may find great personal satisfaction in owning a property rather
than other forms of investments.
B. Disadvantages Of Investing In Property / Real Estate
3.10 Of course, investing in real estate is not free from problems. Some of the
problems are highlighted below.
▪ High transaction costs, such as brokerage commissions, legal fees and stamp
duties. These costs eat up short-term profits. For an investor who may need
liquidity, investing in real estate is not advisable.
▪ Real estate is usually not as liquid as other types of investments, such as
stocks, bonds, etc. The lack of a central market or exchange makes it difficult
to develop liquidity in real estate transactions. Property investments must be
seen as long-term investments.
▪ Management woes when the investor encounters unreliable tenants.
▪ Negative cash flow for highly leveraged investors. This is due to the fact that
rentals can be lower than mortgage servicing costs.
C. Risks Of Borrowing To Invest In Property / Real Estate
3.11 Highly leveraged property investing, which makes it possible for investors to
earn huge gains on a small amount of invested capital, also has many pitfalls.
Property values can go down, as well as up, very quickly over a relatively short
period of time. It is important for the investor to select the property carefully.

He must be able to anticipate a rising market owing to lower interest rates, or

high inflation rates, before engaging in highly leveraged property investing.
4. STRUCTURED PRODUCTS
4.1 A structured product is generally a pre-packaged investment strategy involving

financial derivatives, a single security or a basket of securities, options, indices,
commodities, debt issuances and/or foreign currencies, and to a lesser extent,
swaps. The variety of products just described is demonstrative of the fact that
there is no single, uniform definition of a structured product.
4.2 These products have a fixed maturity and two components, namely a note and
a derivative. The derivative component is often an option. The note provides for
periodic interest payments to the investor at a predetermined rate, and the
derivative component provides for the payment at maturity. Some products use
the derivative component as a put option written by the investor that gives the
buyer of the put option the right to sell to the investor the security or securities
at a predetermined price. Other products use the derivative component to
provide for a call option written by the investor that gives the buyer of the call
option the right to buy the security or securities from the investor at a
predetermined price.
A. Features
4.3 A feature of some structured products is a “capital guaranteed” function, which

offers return of principal if held to maturity. For example, an investor invests
S$100; the issuer simply invests in a risk-free bond that has sufficient interest
to grow to S$100 (at the end of the maturity period). This bond may cost S$80
today, and over the product term, it will grow to S$100. With the leftover
funds, the issuer purchases the options and swaps needed to pursue the
necessary investment strategy. Theoretically, an investor can just perform these
steps himself, but the costs and transaction volume requirements of many
options and swaps are beyond many individual investors.
4.4 U.S. Securities and Exchange Commission (SEC) Rule 434 (regarding certain
prospectus deliveries) defines structured securities as “securities whose cash
flow characteristics depend upon one or more indices or that have embedded
forwards or options or securities where an investor’s investment return and the
issuer’s payment obligations are contingent on, or highly sensitive to, changes
in the value of underlying assets, indices, interest rates or cash flows.” What
this is saying is that such structured products are quite complex, and are
generally not for the ordinary investor, nor the faint-hearted.
B. How Structured Products Are Manufactured
4.5 Combinations of derivatives and financial instruments create structures that

have significant risk/return and/or cost savings profiles that may not otherwise
be achievable in the marketplace. Structured products are designed to provide

investors with highly targeted investments tied to their specific risk profiles,
return requirements and market expectations.
4.6 These products are created through the process of financial engineering, i.e., by
combining underlying like shares, bonds, indices or commodities with
derivatives. The value of derivative securities, such as options, forwards and
swaps, is determined by (respectively, derives from) the prices of the underlying
securities.
4.7 The market for derivative securities has grown quickly in recent years. The main
reason for this lies in the economic function of derivatives. It enables the
transfer of risk, for a fee, from those who do not want to bear it, to those who
are willing to bear it.
B1. An Example Of The Working Of A Structured Product
4.8 The investor provides the capital. The capital is used by the issuer to purchase
a basket of AA-rated credit-linked notes [often termed as synthetic
Collateralised Debt Obligations (CDOs)]. This is called the underlying securities.
Therefore, the investor has exposure against credit default of the underlying
securities. (A note is a short-term debt security, usually with a maturity of five
years or less.)
4.9 A CDO is an investment-grade security backed by a pool of various other

securities. A CDO is a type of asset-backed security (ABS). CDOs can be made
up of any type of debt, in the form of bonds or loans, and usually do not deal
with mortgages. CDOs are generally divided into slices, and each slice is made
up of debt which has a unique amount of risk associated with it. CDOs are
often sold to investors who want exposure to the income generated by the
debt, but do not want to purchase the debt itself.
4.10 To produce the series of payments to the investors, the issuer will normally
engage some investment banks to swap the coupons on the notes into local
currency. Hence, coupons on the notes are paid to the swap counterparty. In
return, the swap counterparty pays the investor the promised periodic payouts
under the product.
4.11 In general, the swap counterparty will insure itself against the credit default risk
of the reference entities which may comprise of several companies (names).
This is generally executed with the set-up of credit default swap, with
premiums paid by the swap counterparty. In the event of a default by any of
these companies, the swap counterparty will take over the underlying securities
and pay the investor what is left of the defaulted notes of the reference entities
minus costs and other deductions.
4.12 If nothing happens up to maturity, the proceeds from the underlying securities
will enable the product to pay back the original capital to the investor. More
details of CDOs can be found in Chapter 8 of this study guide.

C. Benefits Of Structured Products
(a) Return of initial capital on maturity;

(b) Enhanced returns within an investment;
(c) They can be used as an alternative to a direct investment;
(d) They can be used as part of the asset allocation process to reduce risk
exposure of a portfolio;
(e) They can be created to take advantage of the current market trend; and
(f) They can be created to meet specific needs that cannot be met from the
standardised financial instruments available in the markets.
D. Types / Categories Of Structured Products
4.13 Structured products are by nature not homogeneous – a large number of

derivatives and underlying can be used. However, the more popular ones can be
classified under the categories described below.
(a) Interest rate-linked Notes and Deposits: These are structured products
designed to be linked to interest rates such as Libor or Euribor.
(b) Equity-linked Notes and Deposits: These refer to investment securities that
combine the characteristics of zero or low-coupon bonds or notes with a
return component, based on the performance of a single equity security, a
basket of equity securities, or an equity index.
(c) FX and Commodity-linked Notes and Deposits: These involve investment

instruments linked to the performance of a specific commodity, a basket of
commodities, a specific foreign exchange rate, or a basket of foreign
exchange rates.
(d) Hybrid-linked Notes and Deposits: These are structured notes, sometimes
called “hybrid debts”. They are intermediate-term debt securities, in which the
interest payments are determined by some type of formula tied to the
movement of interest rate, stock, stock index, commodity, or currency.
Although structured notes are derivatives, they often do not include an
option, forward or futures contract.
(e) Credit-linked Notes and Deposits: They are a form of funded credit derivative.
They are structured as a security with an embedded credit default swap,
allowing the issuer to transfer a specific credit risk to credit investors. The
issuer is not obligated to repay the debt if a specified event occurs. This
eliminates a third-party insurance provider.
(f) Market-linked Notes and Deposits: These are structured products linked to a
certain market index or a basket of market indices.

E. Risks With The Structured Products
4.14 Structured products tend to be quite complex owing to the fact that financial
derivatives and swap arrangements/counterparties are involved.
4.15 The risks associated with many structured products, especially those products
that present risks of loss of principal owing to market movements, are similar to
the risks involved with options and financial derivatives. The potential for
serious risks involved with options trading is well-established, and as a result of
those risks, customers must be explicitly approved for options trading. In the
same vein, FINRA (the Financial Industry Regulatory Authority, Inc, which is a
private corporation that acts as a self-regulatory organisation in the U.S.)
suggests that firms “consider” whether purchasers of some or all structured
products be required to go through a similar approval process, so that only
accounts approved for options trading will also be approved for some or all
structured products.
4.16 In the case of so-called “principal protected” products, they are not insured by
the government authority. They may only be insured by the issuer, and thus
have the potential for loss of the principal in the case of a liquidity crisis, or
other solvency problems with the issuing company. (The problems with the Mini
Bond series and the like in the 2008/2009 global recession could not be a
better example of how risky such structured products can be.) The terms
“capital protected” and “principal protected” have been prohibited by the
Monetary Authority of Singapore (MAS) under the Revised Code on Collective
Investment Schemes.
5. SUMMARY
5.1 This chapter covers the alternative classes of financial assets and their related
topics:
▪ Introduction to the main types of financial derivatives, which include
Options, Contracts for Difference and Extended Settlement, Warrants,
Futures, Swaps and Forwards, and an explanation of their intrinsic
characteristics;
▪ The important roles these financial derivatives play in enhancing trading
efficiency and risk management purpose;
▪ Case study on the use and misuse of financial derivatives;
▪ Characteristics of the various types of real estate investments and the
advantages and disadvantages of their different exposures;
▪ Types of Structured Products, their features and how they are manufactured;
▪ Main categories of Structured Products with different underlying assets such
as interest rate, equity, FX, commodity, credit, and hybrid-linked notes;
▪ Investment risks associated with Structured Products.

3. Financial Markets
CHAPTER 3
FINANCIAL MARKETS
CHAPTER OUTLINE
1. Introduction
2. Bond Market
3. Equity Market
4. Derivatives Market
5. Over-The-Counter (OTC) Market
6. Characteristics Of An Efficient Financial Market
7. Forms Of Market Efficiency
8. Modern Portfolio Theory (MPT)
9. Summary
KEY LEARNING POINTS
After reading this chapter, you should be able to understand:

▪ bond market
▪ equity market
▪ derivatives market
▪ over-the-counter (OTC) market
▪ characteristics of an efficient financial market
▪ forms of market efficiency
▪ modern portfolio theory (MPT)

1. INTRODUCTION
1.1 A financial market provides a mechanism for the trading of financial assets. It
provides the means for the segments of the economy with surpluses to invest
these surpluses in corporations or governments requiring funds. It is the heart of
the global financial system, attracting and allocating savings, and setting or
influencing interest rates and prices of financial assets (stocks, bonds, etc.).
1.2 In terms of what it does or achieves, a financial market is a market that

facilitates the exchange of capital and credit. It includes the money market and
the capital markets.
1.3 A money market is a market for short-term debt securities, such as bankers
acceptances, commercial paper, repos, negotiable certificates of deposit, and
Treasury Bills with a maturity of one year or less (often 30 days or less). Money
market securities/ instruments are generally very safe investments which return
a relatively low interest rate. Hence, these are most appropriate for temporary
cash storage or for short-term time horizons. The spreads between bid and ask
yields on the securities are relatively small owing to the large size and high
liquidity of the market.
1.4 The capital market is a market where debt or equity securities are traded.
1.5 Financial markets may be classified in the following three ways depending on
how the securities are traded. They are the Primary Market, the Secondary
Market and the Over-The-Counter (OTC) Market.
A. Primary Market For Newly Issued Financial Assets And Secondary Market For
Others
1.6 The primary market is one where new issues of financial assets are sold.
Examples of new issues include initial public offering for equities, tender of
government bonds and offers of new fixed income securities. The issuers of
these securities receive funds from investors who then become owners of the
newly issued financial assets. In the primary market, the security is purchased
directly from the issuer.
1.7 The secondary market is one where trading takes place for financial assets. It is
a market where an investor purchases a security from another investor rather
than from the issuer, subsequent to the original issuance in the primary market.
It is also called the aftermarket. The secondary market provides the liquidity
necessary for the proper functioning of the primary market. Investors will be
more hesitant to purchase financial assets in the primary market if they cannot
divest them readily in the secondary market. If the financial assets can be easily
traded in the secondary market, it encourages a vibrant primary market. When
trading takes place, the ownership of these assets changes hands. However, no
new funds are raised for the original issuers of these assets. Hence, the
secondary market serves a very important function in that it allows and
facilitates the orderly and timely transfer of assets and wealth between

different segments of the investment community. Examples of secondary

markets include formal centralised exchanges and Over-The-Counter (OTC)
markets. OTC can be used to refer to securities that are traded via a dealer
network as opposed to a centralised exchange. It also refers to debt securities
and other financial instruments such as derivatives, which are traded through a
dealer network.
B. Types Of Financial Claims
1.8 Claims in financial assets may be a fixed amount, a residual amount or may be
dependent on an underlying asset. If the claim is for a fixed amount, the
financial market in which such assets are traded is known as a debt or fixed
income/bond market. Financial assets with fixed amounts of claims on the
issuers, such as money market instruments and fixed income securities, are
traded here. Equities are assets with a residual claim on the issuers. The
financial market in which equities are traded is known as an equity market.
Finally, the derivatives market is where trading of derivatives takes place. The
claim of derivatives is dependent on the value of an underlying asset. Examples
are currency futures and forwards, and interest rate futures.
C. Types Of Maturities
1.9 The financial market for short-dated financial assets is called the money market.
They have maturities of less than one year. Examples are treasury bills,
certificates of deposit, short-dated government securities, bills of exchange and
commercial papers.
1.10 The financial market for longer-dated financial assets is called the capital
market. Assets traded on the capital market have maturities of more than one
year. Thus, the debt market can be considered a money market or capital
market depending on the maturities of the assets. Equities are perpetual assets
and are thus traded in the capital market.
1.11 Some institutions deal mainly in short-term funds (e.g. discount houses and
inter-bank transactions). Others may focus on long-term funds (pension funds
and insurance companies). Many institutions (e.g. commercial banks) are
involved in both money and capital markets. They may deal in both short- and
long-term funds.
D. Features Of Contract Terms
1.12 Bank loans and private placements of debt are examples of private market
transactions. Since these transactions are private, they may be structured in a
manner that appeals to the involved parties and can be highly customised to the
requirements of involved parties.
1.13 By contrast, securities that are issued in public markets (for example, ordinary
shares) have fairly standardised features, both to appeal to a broad range of

investors and also because public investors may not have the time to study
unique and non-standardised contracts.
1.14 Public securities are therefore relatively more liquid than private market
securities which are more tailor-made to fit the specific requirements of
involved parties.
2. BOND MARKET
2.1 The bond market (also known as the debt, credit, or fixed income market) is a
financial market where participants buy and sell debt securities, usually in the
form of bonds. Nearly all of the US$800 billion average daily trading volume (as
at early 2015) in the U.S. bond market takes place between broker-dealers and
large institutions in a decentralised, over-the-counter (OTC) market. However,
there is a small number of bonds, primarily corporate listed on the stock
exchanges. The New York Stock Exchange (NYSE) is the largest centralised
bond market, representing mostly corporate bonds.
2.2 References to the “bond market” usually refer to the government bond market
because of its size, liquidity, lack of credit risk and, therefore, sensitivity to
interest rates. Because of the typically inverse relationship between bond
valuation and interest rates, the bond market is often used to indicate changes
in interest rates or the shape of the yield curve.
2.3 Owing to its status as the world’s reserve currency, the US$ bond market is the
largest in the world. The U.S. government, and its corporate and non-U.S.
entities regularly issue bonds to refinance maturing bonds or to raise new funds.
As at 2017, the amount outstanding on the global bond market was estimated
at US$100 trillion, and the U.S. was one of the largest markets in terms of the
value of bonds outstanding.
2.4 The U.S. government is the world’s largest issuer of bonds. They are usually
issued through an auction where dealers submit competitive bids. Trading of
bonds is typically done over the counter through bond dealers, comprising
mainly commercial banks and investment banks. U.S. government securities are
the most liquid fixed income securities in the secondary market.
2.5 The Eurobond market is a very important source of funding for issuers raising
foreign currency debts. Eurobonds refer to bonds denominated in any foreign
currency issued to the investors. Owing to the global distribution of investors
and dealers, the dealing and settlement procedures for Eurobonds are governed
by an international association, which is known as the International Capital
Market Association (ICMA). [Note: ICMA was formed in July 2005 following
the merger of the International Securities Market Association (ISMA) and the
International Primary Market Association (IPMA)]. ICMA is a self-regulated trade
association that plays an active role in the capital markets by influencing the
financial regulations in Europe. Based out of Zurich, Switzerland, ICMA has
grown to include more than 400 members across 50 countries.

2.6 The Singapore dollar bond market is relatively less developed compared to other
more developed countries. This is due to the restrictions imposed on trading of
Singapore dollars, the relative lack of issuers, and the small financial market.
However, the authorities have been working to change this. They have relaxed
certain rules to vitalise the Singapore dollar bond market. The public sector,
including the statutory boards (such as the Housing & Development Board,
Jurong Town Corporation and Land and Transport Authority), is now a regular
issuer of bonds. The restrictions on internationalisation of the Singapore dollar
have also been relaxed to allow some foreign entities to issue bonds under
certain conditions. For example, in 1998, MAS revised its guidelines to allow
foreign entities of good credit standing to issue S$ denominated bonds,
provided that they swapped the S$ proceeds into foreign currency. This has
boosted the development of the Singapore bond market.
A. Quantitative Easing (QE) and its impact on the market
2.7 The U.S. Federal Reserve (the Fed) plays an increasingly active role in the
performance of the economy and financial markets through the use of its many
tools.
2.8 The most well-known of these tools is its ability to set short-term interest rates,
which in turn influences economic trends and the yield levels for bonds across
all maturities. The central bank enacts a low-rate policy when it wants to
stimulate growth, and it maintains higher rates when it wants to contain
inflation. In recent years, however, this approach ran into a problem: the Fed
effectively cut rates to zero, meaning that it no longer had the ability to
stimulate growth through its interest rate policy. This problem prompted the Fed
to turn to the next weapon in its arsenal: quantitative easing.
2.9 The Fed, or any Central Bank, enacts quantitative easing by creating money and
then buying bonds or other financial assets from banks. The banks then will
have more cash available to loan. Higher loan growth, in turn, should make it
easier to finance projects, for example, the construction of a new office
building. These projects put people to work, thereby helping the economy to
grow. In addition, the Fed’s purchases help drive up the prices of bonds by
reducing their supply, which causes their yields to fall. Lower yields, in turn,
provide the fuel for economic expansion by lowering borrowers’ costs.
2.10 In the midst of the 2008 financial crisis, slow growth and high unemployment
forced the Fed to stimulate the economy through its policy of quantitative
easing (QE) from November 25, 2008 through March 2010. The program had
little impact initially, so the Fed announced an expansion of the program from
$600 billion to $1.25 trillion on March 18, 2009. This was commonly known as
“QE1”.
2.11 Immediately after the program wrapped up, trouble emerged in the form of
slower growth, the rise of the European debt crisis, and renewed instability in
the financial markets. The Fed moved in with a second round of quantitative
easing, which became known as “QE2” and involved the purchase of $600

billion worth of short-term bonds. This program - which Chairman Ben Bernanke
first hinted at on August 27, 2010 - ran from November 2010 through June
2011. QE2 sparked a rally in the financial markets but did little to spur
sustainable economic growth.
2.12 On September 13, 2012, the U.S. Federal Reserve launched its third round of
quantitative easing. In addition, the Fed officially stated – for the first time –
that it would keep short-term rates low through 2015. These moves reflect the
Fed’s view that the economy still hasn’t reached the point of self-sustaining
growth (in other words, the ability to keep growing without stimulus).
Accordingly, the Fed has adopted what has been called “QE Infinity”, a plan to
purchase $85 billion of fixed income securities per month, $40 billion of
mortgage-backed securities and $45 billion of U.S. Treasuries.
2.13 Unlike QE1 and QE2, the current program has no set end date. However, the
consensus was that the Fed would begin to wind down the size of its
purchases before 2013 was over, with the goal of ending the program by 2015.
A QE is fluid and subject to change based on economic conditions. This is
illustrated by Fed Chairman Ben Bernanke's May 22, 2013 hint that the Fed
could “taper” QE before year-end. While the vast majority of economists and
investors expected the first tapering to occur on September 18, 2013, the Fed
surprised the markets by announcing that the program would stay at $85 billion
per month indefinitely based on economic conditions.
2.14 On December 18, 2013, the Fed announced the first tapering. Beginning in
January, it reduced its purchases to $75 billion per month - $35 billion of
mortgage-backed securities and $40 billion of Treasuries. The Fed subsequently
announced several additional reductions, gradually reducing its purchases and
finally concluding the program in October 2014.
2.15 In Europe, there was a dramatic change of policy on 22 January 2015 when
Mario Draghi, President of the European Central Bank, announced an “expanded
asset purchase programme”, where €60 billion per month of euro-area bonds
from central governments, agencies and European institutions would be bought.
The stimulus was planned to last until September 2016 at the earliest with a
total QE of at least €1.1 trillion. Mario Draghi announced that the programme
would continue “until we see a continued adjustment in the path of inflation”,
referring to the ECB’s need to combat the growing threat of deflation across the
Eurozone in early 2015.
2.16 In summary, quantitative easing is the mechanism by which the Central Bank
buys assets, usually government bonds, with money it has “printed”, or, in
today’s context, created electronically.
2.17 The Central Bank then buys bonds from investors such as banks or pension
funds using this “new” money, which increases the amount of cash in the
financial system, encouraging financial institutions to lend more to businesses
and individuals. This in turn should allow them to invest and spend more, and
hopefully, increase growth.

2.18 The flowchart below illustrates the manner in which QE is implemented through
the buying of bonds from financial institutions and its intended impact on the
markets and economy.
3. EQUITY MARKET
3.1 An equity market or stock market is a public market for the trading of
securities, including company stock and derivatives listed on a stock exchange,
as well as those traded only privately. A stock exchange refers to any
organisation, association or group that provides or maintains a marketplace
where securities, options, futures, or commodities can be traded. It specialises
in the business of bringing buyers and sellers of securities together. The major
stock market in the United States is the New York Stock Exchange, while in
Canada, it is the Toronto Stock Exchange. Major European examples of stock
exchanges include the London Stock Exchange (the largest in Europe), Paris

Bourse, and Deutsche Börse. Asian examples include the Shanghai Stock
Exchange, Tokyo Stock Exchange, Hong Kong Stock Exchange, and Bombay
Stock Exchange. Shanghai overtook Tokyo in 2009 to become Asia’s biggest
and busiest stock market by value of shares traded, after activity there doubled
year on year.
3.2 Equities and other equity-linked derivatives, such as warrants and preferred
stocks, are traded on the equity markets. Equity markets can be differentiated
by their size, liquidity, trading and settlement system, and their restrictions on
foreign participation.
3.3 The world’s largest equity market is the U.S. stock market, accounting for
about half the total market capitalisation of the total world equities. The size of
the world stock market was estimated at about US$55 trillion at the end of
2012. The total world derivatives market has been estimated at about US$791
trillion, with its face or notional value at 11 times the size of the entire world
economy. The value of the derivatives market, because it is stated in terms of
notional values, cannot be directly compared to a stock or a fixed income
security, which traditionally refers to an actual value. Moreover, the vast
majority of derivatives “cancel” each other out (i.e., a derivative “bet” on an
event occurring is generally offset by a comparable derivative “bet” on the
event not occurring). Many such relatively illiquid securities are valued as
“mark-to-model”, rather than at actual market price. Note that the notional
value is the value of a derivative’s underlying assets at the spot price. In the
case of an options or futures contract, this is the number of units of an asset
underlying the contract, multiplied by the spot price of the asset.
3.4 Liquidity is the trading volume of equities in the market. It is related to the size
of the market, as well as the percentage of free-float shares. A free-float share
is the portion of the total corporate issued shares that are not locked up by
strategic and long-term investors. Liquidity is an important criterion for large
funds when deciding if the particular equity market is investable.
3.5 The trading and settlement system differs from one market to another. Most
equity markets today have an electronic settlement system. This is a more
efficient system when compared to the previous scrip-based settlement system.
In some markets, such as Taiwan, the use of electronic settlement also allows
trades to be settled by the following day.
3.6 Some equity markets, such as Thailand, still maintain a system of restricting
foreign participation in the market by imposing a shareholding limit on
foreigners. In Thailand, the Foreign Board, set up in 1987, serves as an
alternative board for foreign investors to trade shares and to register such
shares under their own names. There are foreign ownership limits set forth in
the Articles of Association of each listed company.
3.7 In other markets, such as Taiwan, Korea and India, foreign investors wanting to
trade in the equity market have to obtain prior approval before trading can
begin. For example, investors belonging to foreign countries other than those

from a few neighbouring countries are barred from investing through the Indian
Stock Exchanges in India. However, there are ways to get around it, through
the use of, say, ADRs (American Depository Receipts) and GDRs (Global
Depository Receipts) issued in foreign markets by companies operating in India,
and through investment in mutual funds.
3.8 Like several emerging stock markets, the Taiwan stock market historically set
several limitations on foreign investment. However, with the growth of the
Taiwan stock market and the development of sounder systems, the government
has gradually relaxed these limitations on foreign investors. Since 1 October
2003, the review process for investment by foreign investors in the stock
market has been changed from the “permit” system to the “registration”
system. This has consequently simplified the application procedures for foreign
investment in the Taiwan stock market.
3.9 Under the registration system in Taiwan, foreign investors are required to
register with the Taiwan Stock Exchange so as to obtain an “Investor ID” and
“Tax ID”, before opening a trading account with a local securities firm.
3.10 For South Korea, foreign portfolio investors now enjoy good access to Korea’s
stock markets. Aggregate foreign investment ceilings in the Korean Stock
Exchange (KSE) were abolished in 1998, and foreign investors owned 32.9% of
KSE stocks and 10.3% of the KOSDAQ in 2010.
A. Singapore Exchange Limited (SGX)
3.11 SGX owns and operates the only integrated securities exchange (SGX Securities
Trading Limited or SGX-ST) and derivatives exchange (SGX Derivatives Trading
Limited or SGX-DT) in Singapore and their related clearing houses.
3.12 SGX-ST operates Asia’s first-ever fully electronic and floorless exchange.
Besides facilitating the listing of leading companies in Singapore, it has also
attracted listings of companies from other countries.
3.13 Major products traded at SGX-ST include stocks, bonds, exchange traded funds
(ETFs), real estate investment trusts (REITs), American Global Depository
Receipts (ADRs), Global Depository Receipts (GDRs, which are certificates
representing an issuer’s underlying shares), business trusts and warrants.
3.14 SGX-DT has, over the years, expanded its range of international products and
trading activities, making it one of the leading derivatives exchanges in Asia. It
has also developed a reputation for being committed to an innovative and pro-
market approach.
3.15 SGX-DT offers the widest range of Asian derivatives in the world and also the
widest range of international derivatives in the Asia-Pacific. These instruments
include futures and options on interest rates, stock indices, energy and
commodities. It was also the first Asian exchange to offer Eurodollar futures

and the first exchange in the world to offer Japanese and Taiwanese stock
index futures.
3.16 Together, the securities and derivatives exchanges serve a wide array of
international and domestic investors and end users, including many of the
world’s largest financial institutions. They are also among the most innovative
exchanges in the world in terms of technological and new product development.
3.17 On 23 November 2000, SGX became the first exchange in Asia-Pacific to be
listed via a public offer and a private placement. Listed on the SGX itself, the
SGX stock is a component of benchmark indices, such as the MSCI Singapore
Free Index and the Straits Times Index.
A1. Regulatory Conflicts
3.18 SGX has a dual role as a market regulator and a listed company. There is
potential for conflict when SGX’s commercial interests come up against its goal
to maintain high standards as the market operator and regulator. However,
there is an alignment of SGX’s dual roles because maintaining the trust of
market participants is the foundation of SGX’s business. The robust framework
for regulatory conflicts management serves to uphold high regulatory standards
and strengthen trust in the market.
A2. Regulatory Conflicts Governance Framework
3.19 SGX has a comprehensive framework in place guiding the whole organisation in
managing regulatory conflicts.
3.20 SGX’s subsidiary, Singapore Exchange Regulation Pte. Ltd. (SGX RegCo), was
set up in August 2017 to undertake all regulatory functions on behalf of SGX
and its regulated subsidiaries. SGX RegCo also has the authority to require
action to be taken by the regulated subsidiaries in respect of all regulatory
matters. SGX RegCo does not have any profit objectives that are linked to the
business activities of SGX and its group of companies.
3.21 SGX’s Risk Management units bear frontline and operational responsibilities for
risk matters. Each unit in SGX is subject to SGX’s Regulatory Conflicts Code.
They have to abide by Regulatory Conflict Guidelines relevant to the units’ area
of responsibility. The Code and the Guidelines set out the processes for
escalation and resolution of all actual and perceived Regulatory Conflicts,
applicable to collaborators and competitors.
A3. Oversight by Independent Board
3.22 As licensed entities, SGX and its regulated subsidiaries are subject to the
legislative obligations under the SFA. However, SGX has given SGX RegCo the
authority to discharge its regulatory obligations impartially. SGX ensures that
SGX RegCo is provided with adequate resources and assistance as may be
required to discharge its functions. It carries out regular reviews for this
purpose.

3.23 SGX RegCo is accountable to SGX for, inter alia, formulating and maintaining
arrangements and processes within SGX Group for managing conflicts between
its regulatory and commercial functions.
3.24 The SGX RegCo Board is responsible for ensuring that SGX RegCo exercises its
judgement independently of the business functions of SGX and its regulated
subsidiaries in the performance of its regulatory duties. It has responsibility for
dealing with any potential, perceived or actual conflict between the SGX
Group’s regulatory responsibilities and commercial interests.
3.25 To maintain its independence, the majority of the SGX RegCo Board, including
the chairman, comprise directors independent from the SGX Group. All SGX
RegCo directors are also independent of any other corporation listed on SGX-ST
and the member firms of the SGX Group. SGX RegCo’s chairman and directors
are also approved by the MAS. The SGX RegCo Board reports to the MAS and
the SGX Board of Directors on the discharge of its duties.
A4. Oversight by Monetary Authority of Singapore (MAS)
3.26 MAS holds SGX accountable for the appropriate management of Regulatory
Conflicts. MAS approves the chairman, CEO and directors of the SGX board, as
well as those of SGX RegCo. The Securities and Future Acts (SFA) empowers
MAS to remove officers who have wilfully contravened or failed to ensure that
SGX complies with the SFA or SGX rules.
A5. Transparent to the Public
3.27 Transparency regarding regulatory actions (such as Disciplinary Committee

actions, rule waivers and extensive public consultations on rule changes)
increases accountability and acts as a check on regulatory conflicts in
regulatory decision making. Information and outcomes pertaining to listings and
regulatory decisions are made public not to mention open to public scrutiny.
A6. Regulatory Functions of SGX
3.28 SGX also carries out regulatory functions, which include the following:
▪ Issuer regulation: To review listing applications and monitor compliance with
listing requirements;
▪ Member supervision: To process membership applications, monitor members’
compliance with SGX rules, provide support to members on regulatory issues
and investigate complaints concerning members;
▪ Market surveillance: To maintain surveillance of all trading activities;
▪ Enforcement: To investigate suspected complaints and perform disciplinary
action;
▪ Risk management: To monitor and manage SFX’s counterparty risk exposure to
clearing members for SGX trades;
▪ Catalist regulation – To promote a high standard of disclosure and corporate
governance by listed companies; and

▪ Clearing risk – to develop and enhance the risk frameworks for product and
service offerings in the SGX.
A7. Recent Developments At SGX
3.29 In 2011, SGX launched a data centre to raise trading speed and international
connectivity. The centre would provide a co-location service for brokers to store
their data physically in the same place and connect to SGX’s trading engines.
3.30 In 2014, SGX rolled out circuit breakers. These circuit breakers would be
triggered when a potential trade is matched at a price that is over 10% away
from the reference price. The reference price is the last traded price of at least
five minutes earlier.
3.31 Once a circuit breaker is triggered, a five-minute cooling-off period would follow
where trading can only take place within a price band that is 10% above or
below the reference price. After that, trading would resume with a new
reference price that was established during the cooling-off period.
3.32 In Jan 2015, SGX reduced the minimum purchase “lot” of SGX-listed securities
from 1,000 to 100 units. This would make blue chips and index component
stocks more affordable and help investors build portfolios with a smaller capital
outlay. Young investors with typically smaller cash reserves would have a wider
range of equities to choose from, while longstanding investors would be able to
diversify further into blue chips.
3.33 From March 2015 onwards, mainboard-listed firms will need to have a minimum
trading price of 20 cents. This rule is aimed at curbing speculation as low-priced
securities may be more susceptible to market manipulation.
3.34 From mid-2016, when SGX launches its new Post-Trade System, investors will
have to post at least 5% collateral on unsettled positions by the end of a
trading session. That means that if you want to buy 1,000 DBS shares costing
$18,310, you will have to put up $915.50 as collateral in cash, stock or bank
guarantee. This replaces the current rules which allow contra trading, where
investors are permitted to buy shares without cash upfront and resell them
within two days, pocketing the profit or paying up the loss rather than the full
sum.
4. DERIVATIVES MARKET
4.1 The derivatives market relates to the trading of options, futures and other
derivatives. It is experiencing tremendous growth as more derivatives are being
introduced.
4.2 Futures exchanges, such as Euronext.liffe and the Chicago Mercantile Exchange
(CME) in the U.S., trade in standardised derivative contracts. These are options
contracts and futures contracts on a whole range of underlying products. The

members of the exchange hold positions in these contracts with the exchange,
which acts as a central counterparty. When one party goes long on (buys) a
futures contract, another goes short (sells). When a new contract is introduced,
the total position in the contract is zero. Therefore, the sum of all the long
positions must be equal to the sum of all the short positions. In other words,
risk is transferred from one party to another. The total notional amount of all
the outstanding positions at the end of June 2004 stood at US$53 trillion. That
figure grew to US$81 trillion by the end of March 2008.
4.3 Tailor-made derivatives not traded on a futures exchange are traded on over-
the-counter markets (the OTC market). These consist of investment banks
which have traders who make markets in these derivatives, and clients, such as
hedge funds, commercial banks, government-sponsored enterprises, etc.
Products that are always traded over-the-counter are swaps, forward rate
agreements, forward contracts, credit derivatives, etc. The total notional
amount of all the outstanding positions at the end of June 2004 stood at
US$220 trillion. By the end of 2007, that figure had risen to US$596 trillion. In
2009, it had grown to US$615 trillion.
4.4 Established in 1973, the Chicago Board Options Exchange (CBOE) is the largest
U.S. options exchange. With annual trading volume that hovered around 1.27
billion contracts at the end of 2014, CBOE offers options on over 2,200
companies, 22 stock indexes, and 140 exchange traded funds (ETFs).
4.5 In the U.S., apart from CBOE, another established exchange for the trading of
futures and options is the Chicago Board of Trade (CBOT). In July 2007, the
CBOT merged with the CME to form the CME Group. Futures and options are
traded on the floor of exchanges, such as by using a system of open outcry.
Under this system, a pit trader offers to buy or sell futures contracts at a
certain price, while other pit traders are free to transact with him if they wish.
The clearing house acts as an intermediary between the buyers and the sellers.
It guarantees that all contract obligations will be honoured. In Singapore, the
derivative exchange is the SGX Derivatives Trading (SGX-DT).
A. Singapore Mercantile Exchange (SMX)
4.6 Singapore is looking to further develop its commodity markets, with the entry of
SGX and the Singapore Mercantile Exchange (SMX) into the commodity
markets in the first quarter of 2010 and mid-2010 respectively. The SMX was
launched on 31 August 2010.
4.7 In view of the fact that commodities have become important investment
vehicles worldwide, and given Singapore’s unique geographical location, SGX is
looking to tap on commodities trading to drive growth, and is also planning to
expand its product base under the Singapore Commodity Exchange Limited
(Sicom). SMX products currently include selected precious metals, base metals,
energy and currency pairs. As at 2010, Singapore was the world’s third largest
oil trading centre after New York and London. For the currency markets, it is
the fifth largest foreign exchange trading centre in the world, and the second

largest in Asia, closely behind Tokyo. For the OTC markets, Singapore is the
eight largest OTC derivatives centre in the world.
4.8 There are two basic types of membership: clearing and non-clearing. For
General Clearing Members, they can clear and settle their own trades, as well
as those of its customers. For Non-clearing Broking Members, they can be
corporations as defined under the Singapore Companies Act, can trade for
themselves or on behalf of their customers, can be a Singapore-licenced bank or
a non-bank.
4.9 With the objective of implementing the best clearing and settlement practices,
SMX has incorporated its clearing corporation, Singapore Mercantile Exchange
Clearing Corporation (SMXCC) which will perform the role of being the clearing
house of SMX and will handle clearing, settlement and risk management
functions. SMXCC will be a Central Counterparty for trades executed on the
SMX trading platform between the buyer and the seller. In order to protect
market participants from counterparty credit risk, SMXCC will have in place a
Settlement Guarantee Fund. Non-performance by any one party will not affect
the other party, as SMXCC will step in and fulfil the obligations of the
defaulting party through the Settlement Guarantee Fund. Guaranteed
performance on SMX products will provide immense confidence to market
participants as counterparty risk will be eliminated. This process ensures market
integrity.
4.10 As a significant milestone, SMX announced on 2 December 2009 that it had

received in-principle regulatory clearance from MAS to operate the first Pan-
Asian, multi-product commodity derivatives exchange.
5. OVER-THE-COUNTER (OTC) MARKET
5.1 Most financial assets are traded in an organised market where there is a
centralised order flow. In a centralised order flow, there is only one price in the
entire market, and every participant in the market is a price-taker. This makes it
very efficient because market participants do not have to “hunt” for the best
price. The prevailing market price is the best price. In an organised exchange,
there is only one monopolistic market maker in each security, and that is the
exchange itself.
5.2 An over-the-counter market is a way of trading financial assets other than in the
organised exchanges. The brokers and dealers who make up the participants of
over-the-counter markets are connected by a network of telephones and
computer systems through which they deal directly with one another and with
customers. Unlike an organised exchange, an over-the-counter market does not
have a centralised order flow. Thus, prices are arrived at through a process that
takes place between two parties. If any one of the parties is not satisfied with
that price, he can approach another counterparty.

5.3 Fixed income securities are commonly traded over the counter, which is the
case in Singapore. Stocks with small market capitalisation, which are tightly
held, or which are unlisted, are also commonly traded over the counter.
5.4 Instruments such as bonds do not trade on a formal exchange. Therefore, they
are also considered as OTC securities. Most debt instruments are traded by
investment banks making markets for specific issues. If an investor wants to
buy or sell a bond, he must call the bank that makes the market in that bond,
and ask for price quotes.
6. CHARACTERISTICS OF AN EFFICIENT FINANCIAL MARKET
6.1 In finance, the Efficient Market Hypothesis (EMH) asserts that financial markets
are “informationally efficient”, and that prices on traded assets (e.g. stocks,
bonds or property) already reflect all known information, and instantly change
to reflect new information. Therefore, according to this theory, it is impossible
to consistently outperform the market by using any information that the market
already knows, except through luck. Information or news in the EMH is defined
as anything that may affect prices unknown in the present, and thus, appears
randomly in the future. The hypothesis has been attacked by critics that blame
this belief in rational markets for much of the 2008/2009 financial crisis, with
noted financial journalist, Roger Lowenstein, declaring, “The upside of the
current Great Recession is that it could drive a stake through the heart of the
academic nostrum known as the efficient-market hypothesis.”
6.2 However, when not in a recession, an efficient financial market is one that
provides an ideal setting for the trading of financial assets. The following are
some of the characteristics that create an efficient financial market.
A. Availability Of Information
6.3 It is important to make available all information, such as corporate

announcements, price history and all outstanding bids and offers to all
investors. Such information will enable investors to make informed investment
decisions. The use of the Internet has greatly enhanced the availability and
timely dissemination of information.
B. Liquidity
6.4 Liquidity is the ability of investors to buy and sell a security quickly and at a
price that is not substantially different from the prevailing prices. The
prerequisites of liquidity are marketability, price continuity and depth.
Marketability is a security’s likelihood of being sold quickly. Price continuity
indicates that prices do not change much from one transaction to the next,
unless there is new price-sensitive information. Implicit in price continuity is the
existence of market depth, which means that there are numerous buyers and
sellers willing to trade at prices above and below current prices, thus preventing
drastic price movements.

C. Transaction Cost
6.5 The transaction cost relating to a trade includes brokerage fees, clearing fees
and associated stamp duties. The current trend has been towards a lower
transaction cost. In some markets, stamp duties have been abolished to foster a
more vibrant financial market. A low transaction cost indicates that the financial
market is internally efficient.
D. Information Efficiency
6.6 This is also known as external efficiency. It means that prices adjust rapidly to
new information. The institutionalisation of the financial market contributes to
this efficiency. Institutionalisation of a financial market refers to the increased
participation in the financial market by institutional investors. Their participation
has greatly enhanced the information efficiency of the markets.
7. FORMS OF MARKET EFFICIENCY
7.1 EMH consists of the three major forms described below.
▪ Weak Form: In its weak form, the historical price and volume data of a
security should already be reflected at the current time, and is of no value in
assessing future changes in prices. No excess return can be generated by
using strategies which trade on historical price data or other historical
information. The EMH will in no way imply that the expected return of a
security is zero.
▪ Semi-strong Form: The semi-strong form encompasses the weak form of the
EMH. In this form, the price quickly reflects all publicly known information
and data. These data may include earning reports, dividends, new product
development, financing difficulties, etc. No excess return can be generated
by using strategies which trade on such public information and data.
▪ Strong Form: The strong form encompasses both the weak and semi-strong
form of the EMH. In this form, the price fully reflects all public and non-public
information and data. In this form, nobody should be able to earn superior
returns over a reasonable period of time by using publicly available
information in a superior manner. This also applies to all non-public
information, including information that may be restricted to certain groups,
such as specialists on the exchanges.
A. Implications of EMH
7.2 What bearing does EMH have on financial decisions?
7.3 Since stock prices seem to reflect public information, most stocks appear to be
fairly valued. This does not mean that new developments could not cause a
stock’s price to soar or to plummet, but it does mean that stocks in general are

neither overvalued nor undervalued – they are fairly priced in an equilibrium.

However, there are certainly cases in which corporate insiders have information
not known to outsiders.
7.4 Empirical tests have shown that the EMH is, in its weak and semi-strong forms,
valid. However, people such as corporate officers who have inside information
can do better than average, and individuals and organisations that possess
insider information on small, new companies also seem to do consistently well.
Also, some investors may be able to analyse and react more quickly than others
to new information, and these investors may have an advantage over others.
However, the buy-sell actions of these investors quickly bring market prices into
equilibrium.
8. MODERN PORTFOLIO THEORY (MPT)
8.1 The Modern Portfolio Theory was developed in the 1950s and was considered
an important step in the mathematical modeling of finance. The theory is about
coming up with an overall investment strategy that seeks to construct an
optimal portfolio, by considering the relationship between risk and return.
8.2 Technically, MPT is a mathematical formulation of the concept of diversification

in investing, with the aim of selecting a collection of investment assets that
collectively have lower risk than any individual asset. In theory, this is possible,
because different types of assets often change in value in opposite ways. For
example, when the prices in the stock market fall, the prices in the bond market
often increase, and vice versa. Hence, a collection of both types of assets can
have lower overall risk than either one individually. By combining different
assets whose returns are not correlated, MPT seeks to reduce the total variance
(which is the square of the standard deviation) of the return of the portfolio.
Therefore, an investment portfolio should not be based on the merits of each of
its assets. Rather, it is important to take into account how each asset’s price
would change relative to that of every other asset in the portfolio.
8.3 The theory goes on to state that, given an investor’s preferred level of risk, a
particular portfolio can be constructed to maximise an expected return for that
level of risk. MPT assumes that investors are risk-averse, meaning investors will
always select a less risky portfolio when comparing two portfolios that offer the
same expected return.
9. SUMMARY
9.1 This chapter covers the main types of financial markets and includes the
following:
▪ Depending on how securities are traded, financial markets may be grouped

into primary versus secondary markets, debt/equity/derivative markets,
money markets versus capital markets, private versus public markets;

▪ Overview of bond markets and a quick discussion on Quantitative Easing and

its impact on the financial markets;
▪ Equity markets, with special reference to Singapore Exchange Ltd, which
owns and operates the integrated securities exchange (SGX-ST) and
derivatives exchange (SGX-DT);
▪ Regulatory functions and recent developments at SGX were also discussed;
▪ Derivatives market which refers to the trading of options, futures and other
derivatives;
▪ Over-the-counter (OTC) market which is a way of trading financial assets
other than in the organised exchanges. Fixed income securities are commonly
traded over-the-counter;
▪ Efficient Market Hypothesis (EMH) which asserts that financial markets are
“informationally efficient”, and that prices on traded assets already reflect all
known information, and instantly change to reflect any new information.
Those with insider information will still have an advantage over others, but
the buy-sell actions of these investors quickly bring market prices into
equilibrium.
▪ Modern Portfolio Theory (MPT) states that given an investor’s preferred level
of risk, a particular portfolio can be constructed to maximise an expected
return for that level of risk. MPT assumes that investors are risk-averse,
meaning investors will always select a less risky portfolio when comparing
portfolios that offer the same expected return.

4. Risk and Return
CHAPTER 4
RISK AND RETURN
CHAPTER OUTLINE
1. Measures Of Return
2. Measures Of Risk
3. Risk Aversion
4. Risk And Return Trade-Off
5. Sources Of Investment Risk
6. Classification Of Risks
7. Diversification Reduces Risks
8. Risk-Adjusted Investment Returns
9. Required Rate Of Return And Jensen’s Alpha (Measure) Under The Capital Asset
Pricing Model (CAPM)
10. Summary
KEY LEARNING POINTS

▪ understand and calculate the different ways of measuring returns
▪ explain how investment risk can be quantified
▪ calculate standard deviation
▪ know the risk and return trade-off
▪ explain the sources of investment risk and how risks are classified
▪ explain why diversification reduces risks and learn how to diversify
▪ understand and calculate the various measures of risk-adjusted returns
▪ know and calculate the required rate of return and Jensen’s alpha

1. MEASURES OF RETURN
1.1 Investment is the act of postponing present consumption in order to grow your
savings. The higher the growth rate of the investment, the more successful you
are as an investor. In order to know the growth rate of an investment, we need
to know how investment returns are calculated. The calculation of investment
returns depends on whether it is a single-period investment or a multi-period
investment.
1.2 A single-period investment is an investment that is held for only one period,
which is usually less than a year. A multi-period investment is an investment
that is held for more than one period, which is usually defined as a year or more
than a year.
A. Calculating Single-Period Investment Return
1.3 You invest S$1,000 in a unit trust at the beginning of a period and that
investment paid a dividend of S$50 during your holding period. At the end of
your holding period, the market value of that unit trust is S$1,100. What is
your return for the period in percentage terms?
(Capital gain+Dividend)
Single-period investment return (%) = X 100
Initial investment
1.4 Capital gain refers to the appreciation in the price of the unit trust or any
investment asset. Dividend refers to the distribution made to unitholders during
the holding period.
1.5 When the asset is sold to cash in on the capital gain, the profit achieved (equal
to the excess of the selling value over the cost price) is referred to as realised
capital gain. In the example above, realised capital gain amounts to S$100 if
the asset is sold for S$1,100. It should be clear that when the investment is
not sold, the profit is not yet realised, and the return calculated using the above
formula is not meaningful.
1.6 Capital loss refers to the depreciation in the price of the unit trust. When the
asset is sold for a loss, equal to the depreciation in the price, the capital loss
becomes realised. Using the above example, if the price falls to S$900, the
unrealised capital loss amounts to S$100. Now if the asset is sold for S$900,
the capital loss of S$100 is realised.
1.7 It should be clear that if the investor has holding power and does not have to
sell the investment when there are unrealised capital losses, the unrealised
capital losses are just paper loss. If the market were to improve in the future, to
the extent that the unrealised capital losses were fully reversed, the investor
would not experience realised capital loss if the investment were subsequently
sold.

4. Risk and Return
In the above example, the realised capital gain = S$1,100 - S$1,000

= S$100
(S$100 + S$50)
Investment return = [ S$1,000
X 100 ]
S$150
= ( S$1,000 ) X 100
= 15%
Another way of calculating single-period investment return (%) is given in the

formula below:
End Value of Investment + Dividend

[ ( Initial Investment ) -1 ] X 100
In the same example, the investment return =

S$1,100 + S$50
[ ( S$1,000
-1 )
X 100 ] = 15%
1.8 The investment return calculated above is also known as the simple rate of
return over the single investment period. This is different from the compound
rate of return that is explained in the following section.
A1. Annualising Single-Period Investment Return
1.9 In order to compare the returns from two investments of different holding
periods, we need to annualise their investment returns. Annualising investment
returns of the two investments is equivalent to re-stating their investment
returns, as if the two investments were held for exactly one year, and that the
rates of return throughout the entire one-year period were exactly the same as
the returns over the original investment periods of the two investments.
1.10 Noted that in annualising the investment, we are really calculating the effective
rates of returns for the two investments on a compounded basis. Therefore,
these returns are known as compound rate of return, as they represent the
investment return earned on the original investment, as well as the intermediate
gains/returns over the course of the investment period.
Annualised return (%) = [(1 + r)1/n – 1] X 100
where r = is the investment return in percentage terms during the holding

period; and
n = is the holding period in number of years.
Note that n may be fractional or integral. For example, if the holding period is one
year, n=1. If the holding period is 5 months, n=5/12; and if the holding period is
one month, n=1/12.

1.11 Assume that the following two funds (see Table 4.1) can achieve the respective
returns during the holding periods:
Table 4.1 Returns Of Fund A And Fund B During Their Holding Period
Return (%) Holding Period
Fund A 15 1 year
Fund B 8 6 months
With reference to Table 4.1, the annualised return for both funds can be
calculated as follows:
Fund A = [(1 + 0.15)1/1 - 1] X 100 = (1.15 – 1) X 100

= 15.00%
Fund B = [(1 + 0.08)1/0.5 – 1] X 100 = (1.1664 –1) X 100

= 16.64%
Hence, Fund B has achieved a higher annualised rate of return, although its
return over the 6-month holding period (8%) is less than that of Fund A (15%).
B. Calculating Multi-Year Investment Return
1.12 The calculation of a rate of return for an investment that has been held over a
multi-year period (for example, more than one year) is more complicated,
because of the need to account for the variation/changes in the market values
of the investment during the multi-year period. In effect, we are computing the
annual effective rates of return on a compounded basis.
1.13 Assume that you buy 1,000 units in a unit trust at S$1.00 per unit at the
beginning of Year 1, and that you hold this investment for the next five years.
During this period, the unit trust does not pay any dividend.
1.14 The price of the unit trust at the end of each of the five years is shown below
Table 4.2:
Table 4.2 Price Of The Unit Trust At The End Of Each Year
Year Unit Trust Price (S$) Gain / Loss (%)
1 0.95 (5.0)
2 1.02 7.4
3 1.12 9.8
4 1.10 (1.8)
5 1.25 13.6

4. Risk and Return
1.15 The investment would have appreciated to S$1.25 X 1,000 units = S$1,250
by the end of the fifth year. The cumulative return from this investment over
the five years is:
S$1,250
[( S$1,000 ) -1 ] X 100 = 25%
1.16 The mean rate of return during the 5-year period is defined as the effective
annual rate of return, which when compounded over the 5-year period, gives us
a cumulative return of 25% in Year 5 (in the above example).
1.17 One simple way of estimating the mean rate of return would be to add the
yearly returns in the rightmost column of Table 4.2 and divide that by 5, as
follows:
[(-5%) + 7.4% + 9.8% + (-1.8%) + 13.6%] 24%

X 100 = = 4.8%
5 5
1.18 This approach of estimating the mean rate of return is also known as the
arithmetic mean rate of return (AM). However, the AM does not present an
accurate annual compounded rate of return of the investment over the 5-year
period. If we use 4.8% as the compounded rate of return for our investment,
the value will be:
S$1,000 (1 + 0.048)5 = S$1,264
1.19 The value of the investment in Year 5 using 4.8% as the compounded rate of
return is S$1,264. This is slightly more than the actual value of the investment
at S$1,250. This shows that 4.8% is not the exact and true effective
compounded rate of return over the 5-year investment holding period.
1.20 An accurate and exact calculation of the historical return will be to annualise
the cumulative return of 25% as follows:
[(1 + 0.25) 1/5 - 1] X 100 = (1.0456 – 1) X 100 = 4.56%
1.21 Using 4.56% as the compounded rate of return, the initial investment of
S$1,000 will grow to S$1,250 as follows:
S$1,000 (1 + 0.0456)5 = S$1,250
1.22 The above example assumes that we are given information on the prices of the
fund at the beginning and at the end of the multi-period. It further assumes that
these prices have not been adjusted for bonus issues or dividends. Hence, it is
more common for us to calculate the (estimated) mean rate of return, using the
yearly change in the fund values in percentage terms (right most column of
Table 4.2). Under such circumstances, we have to geometrically link each
return to obtain the annual effective rate of return. This is known as the
geometric mean rate of return (GM), or the time-weighted mean rate of return.

GM (%) = {[(1 + r1) X (1 + r2) X (1 + r3) X … X (1 + rn) ]1/n – 1} X 100
where r1, r2, r3, …, rn = return in % term for each period (year)
n = number of periods (years)
1.23 In the above example, the geometric mean return on this investment is:
{[(1–0.05) X (1+0.074) X (1+0.098) X (1–0.018) X

(1+0.136)]1/5–1} X 100
= {[(0.95) X (1.074) X (1.098) X (0.982) X (1.136)] 1/5 – 1} X 100
= {(1.2497)1/5 – 1} X 100
= (1.0456 – 1) X 100
= 4.56%
1.24 Geometric mean is a better and more accurate measurement of historical

investment return. In fact, it is the compounded rate of return of an investment,
assuming that it is held for more than a year, and that compounded rate of
return is earned throughout that period. Arithmetic mean, on the other hand, is
a measurement of the expected return over the long term.
1.25 Some illustrations will make these points clearer. Consider the following
investment, as shown in Table 4.3:
Table 4.3
Year Beginning Value (S$) Ending Value (S$) Return (%)
1 50 100 100
2 100 50 -50
where 100% = 1
- 50% = - 0.5
(1.0) + (-0.5) 0.5

AM = = =0.25 = 25%
2 2
GM = {[1 + 1] X [1 + (-0.5)]}1/2 – 1 = 11/2 – 1 = 0
1.26 The investment has brought no change in wealth. Therefore, there is no return.
Yet, the AM computes a mean return of 25%. GM accurately measures that the
investment has not yielded any return.
1.27 However, if one had to give an estimate of the expected long-term return from
this investment, AM would have been a better answer.

4. Risk and Return
1.28 Note that the geometric mean rate of return which we have calculated from
Table 4.2 (4.56%) is smaller than the arithmetic mean rate of return. Generally,
GM is smaller than AM for the same set of data. However, when rates of return
for each year are identical, GM = AM (see Example 4.1).
Example 4.1
Year Beginning Value (S$) Ending Value (S$) Return (%)

1 100.0 110.0 10
2 110.0 121.0 10
3 121.0 133.1 10
(0.1) + (0.1) + (0.1) 0.3

AM = = =0.1 = 10%
3 3
GM = {[(1 + 0.1) X (1 + 0.1) X (1 + 0.1)]1/3 – 1} X 100

= {(1.331)1/3 – 1} X 100
= {1.10 – 1} X 100
= 10%
C. Calculating Real After-Tax Rate Of Return
1.29 The investment return used in this section relates to the total amount of current
income plus the total amount of capital appreciation to the beginning dollar
value of the investment. The following formula will determine the before-tax
investment return for a one-year period:
Before-tax Total current income + Total capital appreciation

Investment = Total initial investment
Return
1.30 For example, assume that Michael Mok purchased an investment of S$800 on 1
September 2010. It is now 1 September 2011, and he wants to know what the
return on his investment has been. During his one-year holding period, he has
received S$50 of current income. In addition, the market price of the
investment has increased to S$840. Based on this information, the before-tax
investment return for this investment will be as follows:
Before-tax S$50 + (S$840–S$800)

= S$800
Investment Return
S$90
= S$800
= 11.25%

1.31 If an after-tax basis is desired, the marginal income tax rate (MRT) has to be
taken into account, then the investment return formula becomes:
total current income total capital appreciation

After-tax
= [ x (1 – MRT) + ] [ x (1 – MRT) ]
Investment Return
Total initial investment
1.32 If Michael is in the income tax bracket of 20%, then his after-tax return will be:
After-tax S$50 (1–0.2) + [(S$840 – S$800) (1–0.0)]

Investment Return = S$800
= 10%
1.33 (Note that in Singapore, capital gains are not taxable for individuals. Hence,
there is no tax rate for this investment. For illustration purposes, the current
income refers to a taxable form of dividend and has been reported for individual
income tax.)
1.34 For holding periods shorter than one year, investors might need to estimate the
after-tax investment return on an annualised basis. Thus, the investment return
calculated above requires modification. If, for example, Michael held the
investment for only half a year and achieved the same results, his after-tax
investment return should be multiplied by 2. This would result in an annualised
after-tax investment return of 20% (10% x 2). Or, if Michael had achieved his
gains in 3 months or in 2 weeks, his annualised investment return would be
found by multiplying the after-tax investment return by 4 or 26 respectively.
However, the above are just estimates of annualised after-tax investment
returns. The formula on page 75 provides the exact mathematical calculation
for annualized return.
1.35 Inflation has almost been continual over the last 50 years. Therefore, any
analysis or recommendation to a client concerning a particular investment
should include inflation as a factor. One useful method adjusts the annual after-
tax rate of return for inflation, and the result is known as the Real Rate of
Return. If the investment return is used, for example, the real after-tax rate of
return can be calculated using the following formula:
Real After-tax (1 + after-tax investment return)

= –1
Rate of Return (1 + current rate of inflation)
1.36 For example, if an investor can earn an after-tax investment return of 8% during
a year when the inflation rate is 4%, the investor's real after-tax rate of return
will be:
Real After-tax (1 +0.08)

= –1
Rate of Return (1 + 0.04)
= 1.038 – 1
= 3.8%

4. Risk and Return
1.37 Whenever the rate of inflation exceeds the after-tax rate of return obtained over
a holding period, the investor will realise a negative real after-tax rate of return.
This was the result for many investments during the late 1970s and early
1980s in the United States, when inflation rates were close to and even
exceeded 10%, and the before-tax return on some investments was 5%.
Today, good-grade corporate bonds in Singapore often pay a before-tax rate of
return of less than 4%, while the rate of inflation has been an average of
around 3%. The resulting real after-tax investment return would be
approximately 1%.
2. MEASURES OF RISK
2.1 Generally, individual investors perceive investment risk as one or both of the
following:
▪ uncertainty of the outcome of investment return; and/or
▪ probability of losing money, i.e., earning a negative return.
2.2 From past experience, we know that the returns from stock market investments
are volatile. While stock market returns tend to be quite attractive in the long
term, there is a possibility that an investor in the stock market may suffer
financial losses in the short term. In other words, the outcome of a stock
market investment is subject to great uncertainty, as the volatility in stock
market investments is high. This is an investment risk because an investor who
purchases the investment at a high price may suffer financial losses if the
investment declines in value, and particularly, if the investor has to sell it when
its market value is less than the purchase price.
2.3 The poor performance and high volatility of the stock market as an asset class,
since the late 1980s, has led to increased concern among many investors about
the negative returns on their investments. The financial market has risen to this
challenge by offering innovative products, such as capital-guaranteed funds and
hedge funds. For more information on these funds, please refer to Chapter 8.
2.4 Investment risk has been generally quantified and measured by a statistical
concept known as standard deviation. This is the dispersion of all probable
investment returns around its long-term expected/realised return. The more
dispersed the probable investment returns around its long-term
expected/realised returns are, the higher the standard deviation will be. A higher
standard deviation thus implies greater risk or higher volatility. Owing mainly to
the ease with which standard deviation can be calculated, the apparent
reasonableness of the concept, and the lack of other measures, the use of
standard deviation to measure risk has gained popularity and been widely
accepted by the key communities involved in investments — from investment
professionals, economists and academia, to the investors.
2.5 Let us now learn how to compute the standard deviation of the U.S. stock
market between the years 1969 to 2008.

Table 4.4 Returns Of U.S. Stock Market Between The Years 1969 To 2008
Year Returns (%) Year Returns (%) Year Returns (%)
1969 4.83 1983 5.98 1997 30.72
1970 13.50 1984 32.75 1998 22.38
1971 16.56 1985 17.53 1999 -12.54
1972 -16.24 1986 3.91 2000 -12.03
1973 -27.68 1987 15.91 2001 -22.71
1974 35.82 1988 31.36 2002 29.11
1975 23.25 1989 -2.08 2003 10.71
1976 -8.02 1990 31.33 2004 5.72
1977 5.97 1991 7.36 2005 15.32
1978 14.45 1992 10.07 2006 6.03
1979 30.04 1993 2.00 2007 -37.14
1980 -4.13 1994 38.19 2008 24.58
1981 22.14 1995 24.06
1982 22.02 1996 34.09
Source: MSCI U.S. Stocks
2.6 Standard deviation can be calculated by using the following steps:
(i) Calculate the most likely outcome. This is the arithmetic mean (AM) or the
simple average of the data in Table 4.4.
(ii) Take the return from each year and subtract from the AM that you have
calculated in Step 1.
(iii) Square each of the numbers obtained in Step 2.
(iv) Add all the numbers obtained in Step 3, divide the answer by the number of
data less one (40 – 1 = 39 in this case).
(v) Calculate the square root of this number. This is the standard deviation.

4. Risk and Return
2.7 A simple table will make this computation very easy.
Table 4.5 Calculation Of Standard Deviation Of U.S. Stock Market Yearly Return
Year Returns (%) Return – AM = A (%) A2 (%)
1969 4.83 -6.30 0.40
1970 13.50 2.37 0.06
1971 16.56 5.43 0.29
1972 -16.24 -27.37 7.49
1973 -27.68 -38.81 15.06
1974 35.82 24.69 6.10
1975 23.25 12.12 1.47
1976 -8.02 -19.15 3.67
1977 5.97 -5.16 0.27
1978 14.45 3.32 0.11
1979 30.04 18.92 3.58
1980 -4.13 -15.26 2.33
1981 22.14 11.02 1.21
1982 22.02 10.89 1.19
1983 5.98 -5.15 0.27
1984 32.75 21.62 4.68
1985 17.53 6.40 0.41
1986 3.91 -7.22 0.52
1987 15.91 4.79 0.23
1988 31.36 20.23 4.09
1989 -2.08 -13.21 1.74
1990 31.33 20.20 4.08
1991 7.36 -3.77 0.14
1992 10.07 -1.06 0.01
1993 2.00 -9.13 0.83
1994 38.19 27.06 7.32
1995 24.06 12.93 1.67
1996 34.09 22.96 5.27
1997 30.72 19.60 3.84
1998 22.38 11.25 1.27
1999 -12.54 -23.66 5.60
2000 -12.03 -23.16 5.36
2001 -22.71 -33.84 11.45
2002 29.11 17.98 3.23
2003 10.71 -0.41 0.00
2004 5.72 -5.41 0.29
2005 15.32 4.19 0.18
2006 6.03 -5.10 0.26
2007 -37.14 -48.26 23.29
2008 24.58 13.45 1.81
Average Return 11.13
Total 131.06
Standard Deviation 18.33
2.8 Table 4.5 summarises the standard deviation and expected return from
investing in the U.S. stock market between the years 1969 to 2008.

2.9 The mean and standard deviation of this series of stock market return figures
can be shown in a graph as follows:
Probability
1 SD* 1 SD*
-7.2% 11.13% 29.46%

* = Standard deviation
2.10 The wider the curve, the higher the standard deviation will be, i.e., the more
uncertain the returns will be. Hence, the more risky the investment will be.
2.11 In the above example on the U.S. stock market, one standard deviation =
18.33%. One standard deviation to the left of the mean gives us a negative
return of 7.2% (11.13% – 18.33%), while one standard deviation to the right
of the mean gives us 29.46% (11.13% + 18.33%).
2.12 In statistical terms, there is a 68%, 95% and 99.7% probability that the returns
of any year will fall within one, two and three standard deviations of the mean
respectively. Note that this assumes that the stock returns will follow an
important statistical distribution known as the normal distribution.
3. RISK AVERSION
3.1 Other things being equal, it is assumed that investors generally prefer a higher
expected return than a lower expected return, and a lower risk than a higher
risk.
3.2 This means that investors prefer to have:

▪ a higher return for a given level of risk; and
▪ a lower risk for a given level of return.

4. Risk and Return
3.3 In general, investors will undertake additional units of risk only if accompanied
by additional reward in the form of higher expected return. In order for an
investor to take on higher risk, i.e., to invest in a fund with higher volatility, he
has to be compensated with higher return. Hence, the maxim “higher risk,
higher return”. The additional return is also referred to as the risk premium.
4. RISK AND RETURN TRADE-OFF
4.1 Suppose an investor is indifferent to the investments shown in Table 4.6 below:
Table 4.6
Investment Expected Return (%) Standard Deviation
A 9 15
B 10 20
C 12 25
D 15 30
4.2 This means that he has no preference as to which of the four investments to
choose. That is, he is risk-neutral to the four investments. Investment A offers
him lower return, but at a lower risk as well. On the other hand, Investment D
offers him the highest return, but with the highest level of risk. This is the risk
and return trade off. Investors need to be offered higher returns in order to take
on higher risk.
4.3 Another important implication of risk aversion is that, at a higher level of risk,
the extra return that is needed to induce them to take on that risk will be higher
than the previous level of risk. Hence, to take on the first 5% higher standard
deviation (Investment B), the investor requires an extra 1% in return. However,
to induce him to take on the next 5% standard deviation (Investment C), he
now requires 2% higher return. This increases to 3% higher return in the next
level of risk for Investment D.
4.4 In economics, this means that this investor has an increasing utility function
which is not linear. For this investor to take on increasing risk, he expects to
receive increasing rewards, in that the risk premium is to increase faster than a
linear function.
A. Investor Risk Tolerance Questionnaire
4.5 The Investor Risk Tolerance Questionnaire (IRTQ) is used widely by financial
institutions to help investors to better understand their own risk tolerance
profiles, so that the institutions can go on to make recommendations on the
purchase of investment products. Although much research and tests have been
carried out over the years, it is generally recognised and agreed that there is no
perfect or flawless IRTQ. This is also one of the reasons why the IRTQs that are

used in the market are mostly different from each other and customised to meet
the needs of the different financial institutions. Though different, most IRTQs
seek to address five areas:
▪ risk propensity (tendencies in financial situations) — e.g. if market drops 20% ,
the action that a person is likely to take;
▪ risk attitude (willingness to incur monetary risk) — e.g. risk tolerance of change
in market value or paper loss in investment;
▪ capacity (financial ability to incur risk) — e.g. age, net worth, income, time
horizon, need for cash and timing;
▪ knowledge (understanding of risk and risk-return trade-off) — e.g. experience in
trading of certain assets, view and choice for hypothetical investment portfolio;
and
▪ objectives (investment goals) — e.g. philosophy, return requirement, view/
inclination on preservation of capital, preference for steady asset growth, etc.
5. SOURCES OF INVESTMENT RISK
5.1 One way to model or estimate the market value of any risky investment is to
evaluate the present value of its future stream of cash flow accruing to the
investors. This implies that the market value of risky investments is affected by:
▪ changes in the future stream of cash flows; and/or
▪ changes in the discount rate used to convert this stream of cash flow to its
present value.
5.2 The more volatile the above factors, the greater the fluctuation of the market
value of the investment will be. In other words, the investment will have greater
risks.
5.3 In the case of fixed income investments, the stream of cash flows accruing to
investors is more predictable than stock investments. This is because the cash
flows accruing to fixed income investors are contractual. When the company is
doing badly, the fixed income investors are still entitled to coupon payments,
unless the company is insolvent. On the contrary, when the company is doing
very well, investors in fixed income instruments do not participate in the upside
performance of the company, which is manifested in the increase in the price of
the company stocks and potential dividend payouts. However, it should be
noted that the fixed income instruments do contractually provide the return of
face (par) value of the investment to the investors at the time of maturity.
Furthermore, given that there is a greater degree of certainty with the stream of
cash flows for the fixed income instruments, the discount rate used to convert
them to their present value will be correspondingly lower. This reflects the
lower risk premium required and the lower investment return received by the
investors.
5.4 Stock investors are subjected to higher risks because the stream of cash flows
accruing to them is not contractual and uncertain. This stream of cash flows

4. Risk and Return
from stock investments comes in the form of dividend payments and the
eventual price at which the stock is sold. Both are not contractual. Hence, the
cash flows are more unpredictable, and the discount rate used to convert this
stream of cash flows tends to be larger, reflecting the higher risk associated
with stock investments.
5.5 Generally, uncertainty in the stream of cash flows arises from one or more of
the factors described below.
A. Business Risk
5.6 Business risk is the risk that the profits of a company will fall unexpectedly.
This may arise because of cyclical slowdown, intense competition or simply
incompetent management. The level of profitability affects the ability of a
company to pay dividends and to service its debts, which will ultimately affect
the share price performance.
5.7 The level of business risk inherent in any risky investment depends on the
nature of the industry it is being exposed to. A cyclical industry has an earnings
profile that is more sensitive to economic growth. During boom years, the
earnings of cyclical industry tend to rise faster than the broad economy. On the
other hand, their earnings tend to fall more than the broad economy during a
recession too. A defensive industry has an earnings profile that is not as volatile
as the broad economy. For example, during boom years, the earnings of a
defensive industry tend to rise more slowly than the broad economy. However,
its earnings also tend to be more resilient than the broad economy during a
recession.
B. Financial Risk
5.8 This is the risk that interest rate changes may negatively affect the value of
your investment. Rising interest rates tend to negatively affect the share prices
of corporations with high debt levels and poor operating cash flows. This is due
to the fact that higher interest rates lead to higher interest charges, and hence,
higher debt servicing expenses. This may in turn negatively affect the revenue,
and hence, the income performance of the corporations. Also, higher interest
rates will result in a reduction in the market values of the fixed income
securities held by the corporations, weakening the balance sheet and financial
position of the corporations.
C. Marketability Risk
5.9 This is also known as liquidity risk. Marketability or liquidity risk is the risk that
a given security or asset cannot be traded quickly enough in the market to
prevent a loss (or make the required profit). It is the risk that an investor will
have to sell his investment at a price below the prevailing price, owing to low
trading activity which is commonly termed as poor liquidity. Investments with
higher trading liquidity tend to have lower marketability risk, compared to those
with lower/poorer trading liquidity.

D. Country Risk
5.10 This is the risk that an investment denominated in a foreign currency may be
exposed to volatility in the exchange rate. The volatility may be caused by
financial mismanagement, poor economic development and growth, or political
problems and social instability of that country. Aside from the foreign exchange
risk, country risk is also related to the risk that the country concerned may run
into financial difficulty (for the reasons mentioned above), and hence, may not
be able to honour the contractual terms associated with the investments. An
example of this is the failure to make the regular coupon payments under the
long-term bonds issued by the government of a country. This is also known as
default risk.
6. CLASSIFICATION OF RISKS
6.1 It is convenient to classify risks into systematic or unsystematic risks,

depending on whether the risk is pervasive to all securities in the market or only
affects specific securities.
6.2 Systematic or nondiversifiable risks are caused by macroeconomic, political and

social factors that affect the value of all risky assets in the financial market.
There is little the investor can do to protect himself against such risks, other
than to stay out of the market altogether or hedge through futures and options.
6.3 Unsystematic or diversifiable risks are caused by factors that are unique to a
company, an industry or a country that an investor invests in. Hence, it only
affects the value of certain securities in the financial market. They can be
controlled and reduced through diversification by investing in other companies,
industries or countries.
7. DIVERSIFICATION REDUCES RISKS
7.1 In a well diversified portfolio, most of the unsystematic risks have been
eliminated, resulting in lower risk. Unit trust investment is a diversified portfolio,
and hence, it is subjected to a lower level of risk compared to investing in the
underlying assets individually.
7.2 Combining assets whose returns are out of step with one another is the whole
idea behind diversification. If the returns on investments move together, we say
that they are correlated with one another. The correlation of returns is the
tendency for the returns of two assets to move in the same direction.
7.3 The returns on the two investments are:

▪ perfectly positively correlated (correlation = 1) if their returns move in the
same direction;

4. Risk and Return
▪ perfectly negatively correlated (correlation = -1) if their returns move in

opposite directions; or
▪ uncorrelated (correlation = 0) if their returns have no relationship with each
other.
7.4 The correlation of returns ranges between +1 to –1. Investors can eliminate
unsystematic risk (and hence, portfolio risk) by combining assets whose
correlation of returns is less than +1. The smaller the correlation (the closer it
is to –1), the greater the reduction in the portfolio risk, and hence the
diversification benefits.
A. Diversification Options
7.5 Diversification can be achieved by spreading the funds in a variety of ways,

such as (a) diversifying into different asset classes; (b) buying securities from
different industries; (c) buying securities from different countries; and (d) buying
securities from different regions:
(a) Diversifying Into Different Asset Classes

Stock securities offer higher returns in the long term, but are more risky;
fixed income securities offer modest returns, but the risks tend to be more
stable due to the certainty in contractual repayment of principal.
(b) Buying Securities From Different Industries

A sector fund is a unit trust that invests entirely or predominantly in a
single sector/industry.
The following points about the sector fund should also be noted:
(i) Sector funds tend to be riskier and more volatile than the broad market
because they are less diversified, although the risk level depends on the
specific sector;
(ii) Some investors choose sector funds when they believe that a specific
sector will outperform the overall market, while others choose sector
funds to hedge against other holdings in a portfolio; and
(iii) Some common sector funds include financial services funds, gold and
precious metals funds, health care funds, and real estate funds.
However, sector funds exist for just about every sector.
(c) Buying Securities From Different Countries

Country funds represent an interesting asset class when stock market
themes such as corporate restructuring or rising consumerism are expected
to drive the stock market return in that country. A single-country unit trust
is a type of unit trust that invests funds in a particular country’s securities.
For example, a single-country unit trust may be offered in Switzerland.
Funds received for this unit trust will then be invested in securities that are
specific to Switzerland only.

(d) Buying Securities From Different Regions

There are a number of similarities among different political groups or
economic blocks, such as Europe, emerging Asia and other emerging
countries. This is the result of common economic policies or preferential
tariff treatment within the political groups or economic blocks (e.g.
European Union and ASEAN). Hence, their stock markets tend to perform in
line as a grouping. Regional funds refer to unit trusts in which the funds are
invested in the securities of a specific region.
It is noted that, when an investor diversifies, his investment may take on
currency risks. These currency risks can be hedged if an investor is averse
to the risk of exposure to a certain currency.
8. RISK-ADJUSTED INVESTMENT RETURNS
8.1 The concept of risk-return trade-off suggests that the measurement of portfolio
returns needs to be adjusted for risk. Returns must be higher in order to
compensate for higher risk. Risk-adjusted returns provide a meaningful
comparison of the performance of your investment against that of the market
and within peer groups. A portfolio manager who has achieved a very high
return is not necessarily the better manager if he has taken too much risk in
achieving that return. Such a high-risk profile can potentially lead to substantial
under-performance in future.
8.2 There are three commonly used measures of risk-adjusted returns. These are:
(a) Information ratio; (b) Sharpe ratio; and (c) Treynor ratio / index. Another
measure of risk-adjusted return is known as the Jensen’s measure. It is related
to the Capital Asset Pricing Model (CAPM), and is covered in Section 9 of this
chapter.
A. Information Ratio
8.3 In general, this is a ratio of expected return to risk, as measured by standard

deviation. Usually, this statistical metric is used to measure a manager’s
performance against a benchmark.
8.4 Specifically, this is a ratio to measure the consistency of the “value add”
achieved by a fund manager. It is the value that has been added by the
manager per unit of risk taken relative to some benchmark. Information ratio is
calculated as:
Fund Return – Benchmark Return

Tracking Error
8.5 In short, tracking error is the standard deviation of the monthly differences in
return between the fund and the benchmark.
8.6 When using a benchmarking strategy, tracking error represents the amount by
which the performance of the portfolio differs from that of the benchmark. In

4. Risk and Return
reality, no strategy can perfectly match the performance of the benchmark, and
the tracking error quantifies the degree to which the strategy differs from the
benchmark, by measuring the standard deviation between the two values. All
else being equal, the higher the information ratio, the better the performance
will be.
B. Sharpe Ratio
8.7 The Sharpe ratio relates the fund’s excess return to its total risk. The excess
return is the return above the risk-free rate. The total risk of the unit trust is the
standard deviation of return for that fund during a similar period. This ratio is a
measure of the excess returns per unit of total risk taken. The higher the ratio,
the better the risk-adjusted performance of the fund is. The investment
community tends to compare the Sharpe ratio of one portfolio manager against
those of his peers, as well as that of the market.
(Rp – Rf)
Sharpe ratio =
p
where Rp is the return for the fund;
Rf is the risk-free rate; and
p is the standard deviation of the return for the fund.
C. Treynor Ratio/Index
8.8 The Treynor ratio/index is a measure of a portfolio’s excess return per unit of
risk, equal to the portfolio’s rate of return minus the risk-free rate of return,
divided by the portfolio’s beta. It assumes that the unsystematic risk can be
eliminated through a portfolio diversification, and hence, the only risk that
matters is the systematic risk. As in the Sharpe ratio, a higher ratio tends to
indicate a better performance in the risk-adjusted return.
(Rp – Rf)
Treynor ratio =
p
where Rp is the return for the fund;
Rf is the risk-free rate; and
p is the beta for the fund.

Difference Between Sharpe Ratio And Treynor Ratio
The main difference between the Sharpe and Treynor performance measures
lies in the definition of risk. The Sharpe ratio uses a total risk concept
(standard deviation of returns of the portfolio), while the Treynor ratio uses a
relative risk concept (beta) of the portfolio. Since the Sharpe ratio adjusts for
total risk, it can be useful for assessing the performance of a portfolio that is
a substantial portion of an investor’s total invested funds. In fact, both the
Sharpe and Treynor ratios are often used to rank the performance of the
overall portfolio, as well as that of the unit trust managers (sub-portfolios of a
broader, fully diversified portfolio). With the help of investment consultants,
investors can make use of the Treynor ratio to evaluate and rank the
performance of sub-portfolios that make up the overall investment funds, and
see how the total invested funds should be constructed and constituted.
D. Value-at-Risk (VAR)
8.9 A statistical technique used to measure and quantify the level of financial risk
within a firm or investment portfolio over a specific time frame is known as
Value-at-Risk (VAR). VAR is used by risk managers to measure and control the
level of risk which the firm undertakes. The risk manager’s job is to ensure that
risks are not taken beyond the level at which the firm can absorb in the worst
case scenario.
8.10 VAR is measured in three variables:

(i) the amount of potential loss;
(ii) the probability of that amount of loss; and
(iii) the time frame.
8.11 For example, a financial firm may determine that it has a 5% one-month value
at risk of $100 million. This means that there is a 5% chance that the firm
could lose more than $100 million in any given month. Therefore, a $100
million loss should be expected to occur once every 20 months.
8.12 The most popular and traditional measure of risk is volatility. The main problem
with volatility, however, is that it does not reflect the direction of change in an
investment. For investors, risk is about the odds of losing money, and VAR is
based on that common-sense fact. By assuming investors care about the odds
of a really big loss, VAR answers the question, “What is my worst-case
scenario?” or “How much could I lose in a really bad month?”
8.13 There are three main methods of calculating VAR:
D1. Historical Method
8.14 The historical method simply reorganises actual historical returns, putting them
in order from worst to best. It then assumes that history will repeat itself, from
a risk perspective.

4. Risk and Return
D2. The Parametric Model
8.15 This approach requires only two inputs, the mean and the variance (standard
deviation of the periodic returns). The advantage of using the parametric
method is that it is very easy to determine the confidence levels. The
disadvantage of the parametric model is that it assumes a normal
distribution. Normal distributions are terrible at predicting black swan events.
PARAMETRIC APPROACH TO VALUE

AT RISK
VAR EQUATION FOR MEAN+(-1.65 x STANDARD

95% CONFIDENCE DEVIATION)
VAR EQUATION FOR MEAN+(-2.33 x STANDARD

95% CONFIDENCE DEVIATION)
D3. Monte Carlo Simulation
8.16 Monte Carlo Simulation uses random numbers and probabilities to make real-life
predictions. It involves entering known pertinent variables, selecting the type of
simulation, and then letting the computer run the simulation hundreds or
thousands of times. The data is then analysed to determine the worst 5% or
1% of the results, our 95% VAR and 99% VAR. Most enterprise resource
planning software, such as SAP, contain Monte Carlo applications.
8.17 Advantages of VAR as a risk indicator are that it:

▪ quantifies potential losses in simple terms (a 5% chance of a loss exceeding
$1 million);
▪ has met with approval from various regulatory bodies concerned with the
risks faced by financial institutions;
▪ is versatile.
8.18 Limitations of VAR as a risk indicator include:

▪ estimation difficulties, and sensitivity to estimation methods used;
▪ the potential to create a false sense of security;
▪ its tendency to underestimate worst-case outcomes;
▪ the inability of the VAR of a specific position to always translate well into
the VAR of the overall portfolio.

9. REQUIRED RATE OF RETURN AND JENSEN’S ALPHA (MEASURE) UNDER THE

CAPITAL ASSET PRICING MODEL (CAPM)
9.1 Under the Capital Asset Pricing Model (CAPM), the required rate of return for
any risky investment, including unit trusts, should commensurate with the risk
of that investment. It is the sum of two factors:
▪ risk-free rate - to compensate for the time value of money; and
▪ risk premium - to compensate for the risk inherent in the risky investment, e.g.
for the risks discussed in an earlier section.
RR = Rf +  (Rm – Rf)
9.2 This required rate of return is also referred to as the expected rate of return. An
explanation is provided below for the definition of the terms in the formula.
where RR is the required rate of return of any risky investment;

Rf is the risk-free rate;
Rm is the market rate of return; and
 is the beta of the risky investment.
9.3 The actual performance or the actual return of the fund (portfolio) is likely to be
different from the required (expected) rate of return. The deviation (difference)
between the actual and required (expected) rates of return, is known as the
Jensen’s Alpha, or Jensen’s measure. The Jensen’s measure is also referred to
as the portfolio’s alpha (α). In fact, it is a risk-adjusted performance
representing the required return on a portfolio over and above that predicted by
the CAPM, given the portfolio’s beta and the average market return. In fact,
Jensen’s measure can be calculated as:
α = actual return – RR
where RR = Rf +  (Rm – Rf)
9.4 The basic idea of calculating the Jensen’s measure is to analyse the
performance of an investment manager. One must look at not only the overall
return of a portfolio, but also the risk of that portfolio. For example, if there are
two unit trusts that both have a 12% return, a rational investor will want the
fund that is less risky. Jensen's measure is one of the ways to help determine if
a portfolio is earning the excess return for its level of risk. If the value is
positive, then the portfolio is earning excess returns. In other words, a positive
value for Jensen’s alpha means a fund manager has “outperformed the market”
with his stock picking skills.
A. Risk-Free Rate
9.5 A risk-free rate is the return that you expect from an investment that has an
assured and certain outcome. An investment in 3-month Treasury Bills can be
considered risk-free. This is because the return that you will receive at the end

4. Risk and Return
of the three months from holding this investment is regarded as default-free,

and known with certainty. That is, the sovereign government is deemed to be
default-free, and hence, risk-free.
B. Market Rate Of Return
9.6 This is the required return for investing in a basket of securities whose
performance replicates the investment universe of the fund. For example, if the
investment universe of a unit trust is Singapore equities, the market rate of
return is the required return for Singapore equities. The difference between the
market rate of return and the risk-free rate is the market risk premium (Rm - Rf).
C. Market Risk Premium
9.7 The market risk premium is the return over and above the risk-free rate, in order
to compensate investors for the uncertainty in the market rate of return. The
market risk premium is directly affected by the level of risk aversion. If the level
of risk aversion rises, investors will require a higher return in order for them to
undertake a risky investment. For example, when investors are increasingly
cautious about the level of corporate governance, they become more risk-
averse, and will require a higher return. When the level of risk aversion falls,
investors will tend to lower their return requirement when assessing risks. For
example, when they believe that the economy is poised for a strong recovery,
their risk aversion will fall, and they may thus require a lower return.
9.8 When the required rate of return rises, investors must buy risky assets at a
lower price in order to achieve that higher return. This implies that the market
price for risky assets must fall. Conversely, when the required rate of return
falls, the market price for risky assets will rise such that prices paid by investors
will earn them a lower return.
D. Beta
9.9 The beta of a fund is the volatility in the return of that asset relative to the
market. A fund with a beta of 1 indicates that its price moves with the market.
Hence, a fund with a beta of more than one means that the fund is more
volatile than the market. The return of this fund is also expected to be higher
than that of the market. A fund with a beta of less than 1 means that the fund
is less risky than the market. The return of this fund is expected to be less than
that of the market.
E. Summary of CAPM
9.10 A risky investment has two components of risk: market risk and diversifiable
risk. Diversifiable risk can be eliminated by diversification, and most investors
do diversify, either by holding large portfolios across different sectors and
geographies or by purchasing unit trusts. What is left then is only market risk
which is caused by general market movements and is nondiversifiable. Investors
must be compensated for bearing risks – the greater the risk of an investment,

the higher the required rate of return will be. The market risk of an investment
is measured by its beta, which is an index of the investment’s relative volatility
to the market. Since beta determines the risk level of an investment, it is
extremely important to take note of the beta of any investment.
10. SUMMARY
10.1 This chapter covers the main measures of risk and return trade-off which
include the following:
▪ How single-period investment return is calculated, and the importance of
annualising investment returns of different investments over different
investment periods to objectively compare their returns;
▪ Using Arithmetic Return and Geometric Return to calculate multi-year
investment returns and why Geometric Return is a superior measure;
▪ The importance of calculating real after-tax rate of return which takes into
account the impact of inflation;
▪ Explain how investment risk can be quantified and measured by a statistical
concept known as Standard Deviation;
▪ Understand that there is a risk and return trade-off, i.e., investors will
undertake additional units of risk only when accompanied by additional
reward in the form of higher expected return;
▪ Explain the sources of investment risk and how risks are classified into
systematic (nondiversifiable risks) and unsystematic (diversifiable) risks;
▪ Explain how diversification helps to reduce risks by combining assets with
smaller degrees of correlation, or even negative correlation in a portfolio;
▪ Discuss the various diversification options via investment in different asset
classes, buying securities from different industries, countries and regions;
▪ Understand and calculate the various measures of risk-adjusted indicators
such as Information ratio, Sharpe ratio, Treynor ratio and Value-at-Risk;
▪ Present the Capital Asset Pricing Model which states that the required rate of
return for any risky investment should commensurate with the risk level of
that investment. It is the sum of two factors: risk-free rate (to compensate
for the time value of money) and risk premium (to compensate for the risk
inherent in the risky investment).

5. Time Value Of Money
CHAPTER 5
TIME VALUE OF MONEY
CHAPTER OUTLINE
1. The Basics Of Time Value Of Money

2. Future Value Of A Single Sum
3. Present Value Of A Single Sum
4. Summary
KEY LEARNING POINTS

▪ Understand the concept of time value of money
▪ Calculate the future value of a single sum
▪ Calculate the present value of a single sum

1. THE BASICS OF TIME VALUE OF MONEY
1.1 Some people erroneously believe that a dollar is a dollar regardless of the passage
of time. The fact is that dollars to be paid or received in different time periods
have different values. A person would prefer to collect rent from the tenant at the
beginning of the month than at the end of the month. A company would choose
to maximise the credit period given by paying the supplier later. This is because
people and companies have an opportunity to earn a return on any money that
they have in hand, and generally, the longer they hold the money, the more they
expect to earn on it. Therefore, receiving money earlier or keeping it longer gives
an additional opportunity to earn more.
1.2 Earning a return on money can be done in many ways, including depositing it with
a bank or investing in a new business or buying shares, although of course, some
methods are riskier than others.
1.3 The above examples illustrate the time value of money (TVM). TVM is the
concept that a sum of money will increase in value over time as a result of earning
a return on the money while it is being held. This also implies that in order to pay
a sum of money in the future, an amount that is less than that sum needs to be
held now, because of the return that can be earned on the money being held now.
1.4 The TVM concept is used by financial institutions such as insurance companies to
make decisions daily. Insurers use it to calculate the cost of claim benefits, and to
determine and invest the premiums. Insurance involves a legal promise of a
financial benefit in the future in exchange for a policy owner’s payment of a
premium now or at regular intervals in the future. It is important for insurers to
price the premiums correctly as the premium cannot be changed once a policy is
issued, and the contract cannot be cancelled by the insurer if the policy owner
fulfils his obligations.
1.5 Representatives of financial advisers need to understand the TVM concept as it is

used in many financial products, such as traditional life insurance policies,
investment-linked life insurance policies and so on, so that they can better explain
these products to their clients.
1.6 Normally, for more complex time value of money problems, a financial calculator
or a spreadsheet would be used to obtain the various values. For simple problems,
a mathematical formula can be directly applied to the data. For the purpose of this
study guide, only the application of the formula would be discussed. A calculator
would still be useful for this purpose.
1.7 The TVM concept can be used to calculate present and future income streams of
a plan, e.g., the value of a series of monthly premium payments. Complex
problems that involve uneven cash flows or payment frequency can also be
analysed using the TVM concept. You should be able to apply this concept to
various investment decisions or while planning for your clients.

A. The Role Of Interest
1.8 Interest can be viewed as the cost of “renting” money, and is paid by the
borrower to the lender. We are all familiar with the idea that if you borrow money
from a bank, you will have to pay interest on the loan. When we deposit money
with a bank, we are actually lending our money to the bank, although we do not
usually think of it in this way. In this case, since we are the lender and the bank is
the borrower, the bank pays us interest.
1.9 Suppose an investor puts S$5,200 in an account that pays 6% interest per year.
The interest earned will be derived by multiplying the principal by the interest rate
as shown below:
Interest earned = S$5,200 x 6%

= S$5,200 x 0.06
= S$312
A1. Simple Interest Versus Compound Interest
1.10 There are two ways of computing interest. Simple interest is computed by
applying an interest rate to the original principal sum only. Compound interest is
computed by applying an interest rate to the total of an original principal sum and
the interest credited to it in earlier time periods.
1.11 To illustrate the difference, assume S$100 is deposited in an account that earns
6% simple interest per year. At the end of each year the account will be credited
with S$6.00 of interest. At the end of five years, there will be S$130 in the
account (if no withdrawals have been made), as shown in Table 5.1.
Table 5.1 Accumulation Of S$100 In Five Years At 6% Simple Interest Per Year
Simple Interest (S$)
Year Principal Sum Interest Ending Balance
1 100.00 6.00 106.00
2 100.00 6.00 112.00
3 100.00 6.00 118.00
4 100.00 6.00 124.00
5 100.00 6.00 130.00
1.12 If, instead, the account earns 6% compound interest per year, it will grow to a
larger amount, as shown in Table 5.2. The extra S$3.83 in the account when it
is credited with the compound interest is the interest earned on previous
interest earnings.

Table 5.2 Accumulation Of S$100 In Five Years At 6% Compound Interest Per

Year
Compound Interest (S$)
Year Principal Sum Interest Ending Balance
1 100.00 6.00 106.00
2 106.00 6.36 112.36
3 112.36 6.74 119.10
4 119.10 7.15 126.25
5 126.25 7.58 133.83
1.13 For the account which was credited using simple interest, the balance grows by
a constant amount of S$6.00 per year.
1.14 For the account which was credited using compound interest, the balance
grows by an increasing amount each year, because interest is being earned on
the interest being accumulated. Assuming there is no withdrawal and the same
interest rate, it is clear that compound interest will result in a higher balance
over the end of a period of time than simple interest will.
1.15 Note that in this compound interest example, the interest is compounded yearly.
Interest can also be compounded at shorter intervals, such as quarterly, or
monthly.
1.16 For the purpose of this study guide, we will only look into compound interest,
as this is used far more commonly than simple interest.
A2. Compounding Versus Discounting
1.17 The process by which money today (a present value) grows over time to a larger
amount (a future value) is called compounding. The process by which money due
in the future (a future value) is reduced over time to a smaller amount today (a
present value) is called discounting.
Figure 5.1 Compound Interest As The Link Between Present Value And
Future Value
Dollar
Amounts
(S$) Future Value
Present
Value
Number Of Periods (n)
1.18 Figure 5.1 shows how compound interest acts as a link between the present and
future values. Compounding may be viewed as a movement up the curve, while

discounting may be viewed as a movement down the curve. The relationship is a

curve rather than a straight line, reflecting the application of compound interest,
rather than simple interest. When compound interest is used, the future value
rises each year by an increasing amount of money, as one moves up the curve (or
the present value declines by a decreasing amount of money, as one moves down
the curve).
1.19 As the number of periods increases, the difference between the present value and
the future value also increases. This is reflected in the curve constantly moving
higher, as it moves to the right. Also, although not illustrated, the greater the
interest rate, the steeper the slope of the curve will be. Thus, if the interest rate
increases, the difference between the present value and the future value also
increases for the same time period.
1.20 These relationships among the number of periods (n), the interest rate (i), the
future value of money (FV), and the present value of money (PV) are the main
variables when considering problems involving the time value of money and may
be summarised as follows: In compounding, FV moves in the same direction as n
and i (it increases as they increase); in discounting, PV moves in the opposite
direction from n and i (it decreases as they increase).
B. The Power Of Compound Interest
1.21 The effect of compound interest is extremely powerful, especially in cases

involving high interest rates, or over a long period of time.
1.22 Imagine one had deposited S$10 in a bank account 500 years ago, as shown in
Table 5.3. Assuming the bank pays a 3% compound interest per year, the
account would have grown to about S$26 million at the end of 500 years!
Table 5.3 Accumulation Of S$10 In 500 Years At 3% Compound

Interest Per Year
Year Approximate Ending Balance (S$)
1511 10
1611 192
1711 3,693
1811 70,985
1911 1,364,237
2011 26,218,772
B1. Rule of 72
1.23 Relating to the concept of compound interest, a useful way to estimate how
long it will take an investment to double at a given rate of interest is “the rule
of 72”. Simply divide 72 by the annual interest rate, and we will get the
approximate length of time it will take to double an initial investment.

Example: How long will it take for $10,000 to double at 5% a year?

72/5 = 14.4
1.24 It will take about 14.4 years. If the investor holds the investment for
approximately 28.8 years (2 * 14.4), the investment will double again, so the
original $10,000 will have grown to $40,000.
C. Frequency Of Compounding Or Discounting
1.25 So far, it has been assumed that the interest rate is applied once per year or, in
other words, interest is compounded annually. However, interest can be
compounded at shorter intervals, and this must also be taken into consideration,
in addition to the interest rate and the length of time.
1.26 In many cases, interest rates can be applied semi-annually (twice a year),
quarterly (4 times a year), monthly (12 times a year), or even daily (365 times a
year).
C1. Effective Interest Rates
1.27 Nominal interest rates are quoted when the effects of compounding are not
taken into consideration. “Nominal” actually means “in name only”. For
example, when a bank quotes you an interest rate, it is quoting a nominal
interest rate of, say, 6% per annum.
1.28 The interest rate that includes the effects of compounding is known as the
effective interest rate. The effective rate of interest is greater than the nominal
rate of interest because of the effects of compounding.
1.29 To illustrate, assume you have borrowed S$500 at a 10% nominal annual
interest. You may expect to pay S$50 in interest. However, the bank may say
that the interest is payable twice a year. This means that after six months, you
are charged 5%, and then, after another six months, you are charged the
remaining 5%. However, since the interest is compounded, the calculation is as
follows:
Loan repayable after the first six months:

S$500 x 1.05 = S$525
Loan repayable after the second six months:

S$525 x 1.05 = S$551.25
The loan is repayable in a lump sum of S$551.25 at the end of one year.
Interest = S$551.25 – $S500 = S$51.25
Effective interest rate = S$51.25 / S$500= 0.1025 or 10.25%

1.30 Notice that the effect of compounding is to make the effective interest rate a
quarter of a percentage point greater than the nominal interest rate.
1.31 The greater the frequency with which compounding or discounting occurs, the
greater the effect on the growth of a future value or the decline of a present
value. For example, a S$1,000 principal sum that is credited with 8%
compound interest will grow to a future value of S$1,166.40 in two years if
compounding occurs annually. If compounding occurs semi-annually, on the
other hand, it will grow to S$1,169.86; and if compounding occurs monthly, it
will grow to S$1,172.89. Conversely, the present value of S$1,000 due two
years from now is S$857.34 if an 8% annual interest rate is applied once per
year. However, if the discounting is applied semi-annually, the present value is
only S$854.80.
D. Measuring The Number Of Periods
1.32 The number of periods has to be accurately reflected for the compounding or
discounting process. It greatly depends on the period when the process started;
whether it is at the beginning or the end of the period.
1.33 In the illustration provided in Table 5.3, the account balance for year 1511 was
S$10. It was assumed that S$10 was deposited at the beginning of year 1511
and the account balance was computed at the end of year 1511. Therefore, the
first year would have produced S$0.30 of interest.
1.34 On the other hand, if the initial S$10 was deposited at the end of year 1511,
the ending account balance would have been S$10. No interest would have
been earned in that year.
1.35 Referring back to Table 5.3, if the compounding were to start one year later,
the amount available in 2011 would be only S$25,455,118 as compared to
S$26,218,772. That is a difference of about S$763,654!
1.36 To assist in counting the number of periods (n), it is useful to draw time lines
such as those in Figure 5.2. The timing should be marked with vertical arrows
along the time line and the timing of unknown dollar values should be marked
with question marks.
1.37 For example, the upper time line depicts a case where you need to calculate the
future value (FV) as of the beginning of the sixth period (which is the same as
the end of the fifth period) of a deposit made at the beginning of the first
period. The lower time line depicts a situation in which you need to compute
the present value (PV) as at today (the start of period one) of a series of
payments that will occur at the end of each of the next four periods. Time lines
are useful for all types of time value of money calculations.

Figure 5.2 The Use Of Time Lines In Counting The Number Of

Periods Of Compounding Or Discounting
1 2 3
3 4
4 55 66 77 88 99 10
10
S$
S$ S$ S$ S$
1 2 3 4 5 6 7 8 9 10
?
2. FUTURE VALUE OF A SINGLE SUM
2.1 The simplest form of time value of money problems involves obtaining the future
value (FV) from a present value (PV) of a single sum. Determination of this future
value entails a process of compounding a present value with an interest rate (i) for
a certain number of periods (n).
2.2 We refer back to Table 5.2, where a S$100 deposit made today (present value)
will grow to S$133.83 (future value) at the end of five years at 6% compound
interest. This can be related to a common interest-bearing account with a financial
institution.
A. Basic Time-Value Formula
2.3 The basic formula for computing the future value of a single sum of money is as
follows:
FV = PV x (1 + i)n
where: FV = the future value of a single sum

PV = the present value of a single sum
i = the compound annual interest rate, expressed as a decimal
n = the number of periods during which compounding occurs
2.4 We will next discuss a simple problem to recognise the need to understand both
conceptually and mathematically, in order to come up with a solution.

2.5 For example, assume that S$5,000 is placed on deposit today in an account that
will earn 9% compound annual interest. What will be the future value of this sum
of money at the end of year 7? The problem is depicted on a time line in Figure
5.3.
2.6 For the sake of consistency among the time lines used to depict various types of
problems, present values will be depicted below the line, as will periodic cash
outflows. Future values and periodic cash inflows will be shown as above-the-line
factors.
2.7 First, we would come up with the time line, indicating a present value of
S$5,000, a period of seven years, and a question mark (future value) at the end
of year 7.
FV = S$5,000 x (1.09x1.09x1.09x1.09x1.09x1.09x1.09)
= S$9,140.20
2.8 Typically, shorthand notation is used to express the multiplied interest rates. For
example,
1.09x1.09 = (1.09)2
1.09x1.09x1.09 = (1.09)3
1.09x1.09x1.09x1.09 = (1.09)4
1.09x1.09x1.09x1.09x1.09 = (1.09)5
and so on. The superscript – the small, raised number at the end – means “the
power of.” In the example above, 1.09 is multiplied by itself the number of times
indicated by the superscript, so that 1.09 to the seventh power is written as
(1.09)7 and means 1.09x1.09x1.09x1.09x1.09x1.09x1.09.
2.9 The basic time-value formula can also be used to compute the solution as follows:
FV = PV x (1 + i)n
= S$5,000 x (1.09)7
= S$5,000 x 1.828039
= S$9,140.20
Figure 5.3 Time Line Depiction Of FV Problem
1 2 3 4 5 6 7 8 9 10
S$5,000

2.10 The time line also illustrates the basic trade-off present in all time value of money
problems. Here, the trade-off is a cash outflow today (the deposit shown below
the time line) for a larger cash inflow later (the account balance at the end of the
seventh year, shown above the time line).
2.11 Using the formula, what would happen to the FV if the value of i or n were to be
increased? In either case, (1 + i)n would be larger than 1.828039 and when
multiplied by S$5,000, the FV would be larger than S$9,140.20. That is, future
value increases as the interest rate or the number of years increases, and it falls
as either of them is lowered. This was illustrated earlier in Figure 5.1.
2.12 For instance, if the interest rate in the above example is increased to 10%:
FV = PV x (1 + i)n
= S$5,000 x 1.107
= S$5,000 x 1.948717
= S$9,743.59
However, if the interest rate in the above example is decreased to 5%:
FV = PV x (1 + i)n
= S$5,000 x 1.057
= S$5,000 x 1.4071
= S$7,035.50
B. Using A Future Value Interest Factor (FVIF) Table
2.13 A future value interest factor (FVIF) is a factor equal to the future value of S$1
after a given number of compounding periods at a given interest rate. You can
multiply the present value of a sum by these factors to determine the future value.
The method of finding the right factor to use in a FVIF table is fairly simple. For
example, the future value interest factor for a 2% interest rate compounded for
two periods is 1.0404. This is derived as follows:
2.14 Refer to Table 5.4 below which shows a section of the FVIF table. Notice the
shaded number in Table 5.4. It is at the point where the two periods (n=2) row
intersects the 2% column. It can be seen that the FVIF is 1.0404. The FVIF table
is available at the end of this study guide as Table 1 Future Value Interest Factors
For One Dollar.
Table 5.4 Future Value Interest Factors For One Dollar
FVSS Factor = (1 + i)n where i = rate and n = periods

i= 0.5% 1% 1.5% 2% 3%
n=1 1.0050 1.0100 1.0150 1.0200 1.0300
2 1.0100 1.0201 1.0302 1.0404 1.0609
3 1.0151 1.0303 1.0457 1.0612 1.0927
2.15 We will look at another example. Assume that you have placed S$100,000 in a
single premium policy with a maturity value of S$103,000 at the end of Year 3.
Calculate the annual compound interest rate.
Using the Time Value formula:
Initial Single Premium (1 + i)n = Maturity value at end of Year 3

S$100,000 (1+i)3 = S$103,000
(1+i)3 = 1.03
Using Table 5.4, the closest factor is 1.0303. Hence, the interest rate is close to
1% per annum.
3. PRESENT VALUE OF A SINGLE SUM
3.1 We now reverse the question to find out the sum of money needed today if we
were able to assume the future amount needed.
3.2 For example, assume that in four years’ time, you will need S$100,000 as
downpayment for your new house. How much money should you have today in
an account which earns 4% compound interest in order to reach S$100,000 in
four years?
A. Using The Time-Value Formula
3.3 You learned earlier that FV can be calculated using the formula:
FV = PV x (1 + i)n
3.4 By rearranging the formula above, the formula for present value (PV) is as follows:
1 FV
PV = FV x =
(1 + i)n (1 + i)n
Figure 5.4 Time Line Representation Of PV Problems
S$100,000
1 2 3 4 5 6 7 8 9 10
3.5 Figure 5.4 shows a problem in which you are asked to determine the present
value of a single sum of S$100,000 that is due in four years.
3.6 If you can earn 4% compound interest, you should set aside today an amount of
S$85,477.39 as calculated below:
 1  S$100,000 S$100,000
PV = S$100,000   =
 =
 (1.04) (1.04)4
4
 1.1699
= S$85,477.39
3.7 This amount, accumulating at 4% compound annual interest, will grow to the
S$100,000 needed in four years.
3.8 Note the effect of a change in i or n on PV. If either of these is increased, the
denominator of the formula increases and the resulting PV declines. In the
example above, if the interest rate is increased to 5%, the present value
decreases to S$82,270.67 as calculated below:
 1  S$100,000 S$100,000
PV = S$100,000   =
 =
 (1.05) (1.05)4
4
 1.2155
= S$82,270.67
3.9 On the other hand, a decrease in either i or n, will cause PV to rise. For instance,
if the S$100,000 is needed in three years’ time instead of four years’ time, and
the interest rate remains at 4%, the present value increases to S$88,896.79 as
calculated below:
 1  S$100,000 S$100,000
PV = S$100,000   =
3 
=
 (1.04)  (1.04)3
1.1249
= S$88,896.79
3.10 We can see that this is logical: if we can earn a higher rate of interest, then we do
not need as much money now. Similarly, if we have a shorter period over which
we can earn interest, we need to start with more money.
4. SUMMARY
4.1 This chapter covers essential concepts associated with time value of money and
includes the following:
▪ Basics of time value of money (TVM), which is the concept that a sum of
money will increase over time as a result of earning a return on the money
while it is being held. This also implies that to pay a sum of money in the
future, less than that future sum needs to be held now, because of the return
that can be earned on the current sum of money;
▪ TVM concept is important as this concept is used in many financial products,
such as life insurance, investment-linked insurance products and annuities etc;
▪ Simple interest versus compound interest and the power of compounding

interest, and the rule of 72 which states the number of years required for initial
investment to double in value;
▪ Explain the concept of future value from a present value of a single sum, and
the calculation formula for computation of future value;
▪ Explain the concept of present value for a single sum today in terms of the sum
of money needed today if we were to be able to assume the required future
amount.
6. Considerations For Investments
CHAPTER 6
CONSIDERATIONS FOR INVESTMENTS
CHAPTER OUTLINE
1. Introduction
2. Investment Objectives And Risk Tolerance
3. Liquidity
4. Investment Time Horizon
5. Tax Considerations
6. Regulations And Legal Constraints
7. Diversification
8. Investment Styles Of Fund Manager
9. Summary
KEY LEARNING POINTS

▪ know and understand the issues and factors that an investor should consider when
establishing and planning for his investment
▪ explain liquidity and returns
▪ explain investment time horizon
▪ understand the tax effects of investment
▪ know the regulations and legal constraints
▪ explain diversification
▪ understand the investment style of a fund manager and how it affects selection of a
unit trust
1. INTRODUCTION
1.1 The most important step that an individual investor should take before
contemplating any unit trust investment scheme is to establish an investment
policy. The purpose of an investment policy is to provide useful guidelines for
investing that are appropriate to the investor’s investment objectives and
personal profile.
1.2 A good investment policy should consider both the external and internal aspects
of investment. This means that the investment policy should ultimately reflect
and be in line with the investment style of the investor. The investment style of
an investor is about the approach, mindset, and/or philosophy that influence
how investors frame their expectations and choose the means to achieve their
investment objectives. The investment style of an investor is largely determined
by the amount and type of available resources, time constraints, level of risk
tolerance, and the extent of his freedom in choosing from the alternative
means. The external aspect of investment refers to the risks involved and
returns achievable under various market conditions. It is important to set
realistic expectations about market performance in order to meet the investment
objectives of investors. The internal aspect of investment considers the
investment objectives of investors and their attitudes towards risks. Having a
clear understanding of the internal aspect of investment keeps investors
focused on their investment objectives, and avoids ad hoc revisions in asset
allocation caused by short-term distress in the marketplace. Such ad hoc
revisions may lead to buying at the top of a speculative bull market, or selling at
a time of extreme market pessimism. Both actions often lead to poor
investment returns in the long term.
1.3 By considering both the external and internal aspects of investment, the
individual investor will be able to design an investment plan appropriate to his
investment objectives and within his risk tolerance. The external aspect of
investment has been discussed in the earlier chapter on risk and return. This
chapter will discuss the internal aspect of investment.
1.4 Investors should consider the following issues when planning for investment:
▪ investment objectives and risk tolerance;
▪ liquidity;
▪ investment time horizon;
▪ tax considerations;
▪ regulations and legal constraints;
▪ diversification; and
▪ investment styles of fund managers.
2. INVESTMENT OBJECTIVES AND RISK TOLERANCE
2.1 Every investor has different objectives to meet, depending on his age, income,
planned activities and attitudes towards risk.
2.2 When defining investment objectives, some important factors should be

considered by investors. They are discussed below.
A. Goals And Needs
2.3 The most common goals are retirement, education and emergency reserves. In
considering retirement, investors should consider the proportion of their final
income that they need when they retire in order to maintain a comfortable
lifestyle, and the length of time before they retire. Investing for the education
needs of children should start at very young age, so that the investment time
horizon will be lengthened considerably. Emergency reserves are assets that
investors may need at short notice to meet unexpected needs. Money market
funds or other short-dated bond funds are appropriate for meeting this
objective.
B. Age
2.4 When investment starts early, the investment time horizon is longer. An
investor will be able to take on higher-risk investments to earn a higher return.
With a longer investment time horizon, he can ride out the short-term volatility
of risky assets. On the contrary, an investor who is close to retirement should
invest a greater proportion of his funds in money market funds and fixed
income funds. This will help to reduce the potential negative and devastating
impact of volatile market movements that can cause a loss in asset value and/or
assets, making them unavailable for meeting the objectives of retirement.
C. Wealth And Income
2.5 The better the financial position of the investor, the higher the risk that he can
afford to take. Even if the investment suffers temporary losses, he will still be
able to maintain his lifestyle, or even contribute additional capital to his
investments. On the other hand, if he needs the income from his investment to
supplement his lifestyle, then he may need to allocate a greater proportion of
his funds to income-generating funds.
D. Life Cycle
2.6 Investors at different stages of their life cycles will have different risk tolerance
and objectives. There are essentially four stages of financial life: Young
adulthood, building a family, middle age and retirement. Investment needs will
be different at these different life stages.
2.7 Risk appetite usually increases at the wealth building stage and gradually
decreases at the later stages in the life cycle. For many young investors, their
time horizon is long but their wealth level is still low. Thus they can assume
larger risks at this early stage of the life cycle. Middle age is the time when they
are at the peak of their career and earning power. Furthermore, it is also the age
at which they have the experience as well as the money to take on a more
active approach to investment.
2.8 With retirement age approaching and an abundance of funds compared to early
adulthood, middle age is also the time to transform these optimal earnings into
investment capital. Many people in middle age often find that they have the
knowledge and available funds to take a more active approach to investment in
order to make their money grow faster. Hence it is often at this stage that they
undertake higher-risk investments to commensurate with their return profile.
2.9 Risk tolerance is a very personal decision, and hence a very difficult one to
assess. It is important for an investor to be honest with himself in assessing
whether he is comfortable with market volatility, as well as whether he can
tolerate financial losses in the short term. Many investors make the mistake of
looking at recent market performance to define their own risk tolerance.
Instead, they should take a more realistic view of anticipating the risk that could
occur in the future.
2.10 The degree of risk aversion varies among investors. For those with a lower level
of risk aversion, the emotional distress associated with investment loss is
lower. These investors have a higher level of risk tolerance. For other investors
with a higher level of risk aversion, it is recommended that they seek
investment with a lower risk profile. This is because the effects of investment
loss can be devastating to their personal life.
2.11 The questions to ask the investor include:

(i) Can he stand to see the fluctuation/volatility in the market value of his
investment, or afford the loss in some invested asset if the whole economy
and markets head south?
(ii) Does he have a position/plan to fall back on if things turn very wrong with
the investments that he has made?
(iii) Realistically, how far can he extend himself? All these will say something
about the level of leverage and the extent/depth of speculation that he can
go to.
3. LIQUIDITY
3.1 Liquidity is the ease with which an investor can convert his investments into
cash at prevailing market prices. In general, greater liquidity will tend to lower
and reduce the returns of investment assets. Hence, it is necessary to bear in
mind the trade-offs between liquidity and returns. Once the investment is
chosen, it should be maintained until the investment objective is met, or until
any change in the market condition necessitates a change in the investment
strategy. Selling an investment based purely on liquidity needs can compromise
the long-term return from the investment plan. Investors should commit to an
investment scheme using only funds that they could reasonably live without.
4. INVESTMENT TIME HORIZON
4.1 Investment time horizon refers to the length of time during which an investor
expects to stay invested. Investment time horizon has major implications on the
risks and returns.
4.2 As the investment horizon lengthens, the risks associated with investing in risky
assets tend to fall. However, the expected returns remain quite constant. This
suggests that investors with a very long investment horizon should focus on
equities for higher potential returns. The risk associated with investing for
longer time horizons is lower than that for shorter time horizons.
4.3 The yearly data for the U.S. stock market returns between the years 1969 to
2009 illustrate these conclusions. In Table 6.1 below, the 1-year, 5-year, 10-
year, 15-year and 20-year returns are computed. For example, for the 5-year
period ending December 1969, the return was a negative 3.42%, while for the
next 5-year period ending December 1970, the return was a positive 1.7%.
Table 6.1
USA MSCI Index 1-year 5-years 10- years 15 -years 20- years
Dec 1969 100.000 4.83% -3.42% 3.20% 7.39% 9.19%
Dec 1970 104.830 13.50% 1.71% 4.11% 7.47% 10.43%
Dec 1971 118.980 16.56% 3.40% 5.54% 8.60% 9.62%
Dec 1972 138.680 -16.24% -1.38% 3.50% 8.66% 10.27%
Dec 1973 116.160 -27.68% 3.37% 7.48% 10.23% 11.65%
Dec 1974 84.010 35.82% 13.30% 13.25% 13.75% 14.02%
Dec 1975 114.100 23.25% 12.32% 10.47% 13.50% 12.40%
Dec 1976 140.630 -8.02% 6.82% 11.30% 11.77% 13.04%
Dec 1977 129.350 5.97% 13.05% 14.06% 14.46% 14.75%
Dec 1978 137.070 14.45% 16.29% 13.83% 14.56% 16.11%
Dec 1979 156.870 30.04% 14.51% 13.98% 14.26% 16.88%
Dec 1980 204.000 -4.13% 14.99% 14.09% 12.43% 16.53%
Dec 1981 195.580 22.14% 19.77% 14.34% 15.20% 15.99%
Dec 1982 238.890 22.02% 15.96% 15.17% 15.32% 14.11%
Dec 1983 291.500 5.98% 14.77% 13.70% 16.05% 11.53%
Dec 1984 308.920 32.75% 19.81% 14.13% 17.68% 12.64%
Dec 1985 410.100 17.53% 12.73% 11.17% 17.04% 11.62%
Dec 1986 481.980 3.91% 15.26% 12.98% 14.76% 11.03%
Dec 1987 500.820 15.91% 16.02% 15.00% 13.49% 11.61%
Dec 1988 580.520 31.36% 14.83% 16.69% 10.47% 11.11%
Dec 1989 762.580 -2.08% 9.16% 16.63% 10.34% 7.09%
Dec 1990 746.710 31.33% 16.95% 19.26% 11.25% 8.39%
Dec 1991 980.630 7.36% 15.62% 14.51% 9.65%
Dec 1992 1,052.830 10.07% 20.88% 12.25% 10.18%
Dec 1993 1,158.850 2.00% 25.11% 8.35% 9.90%
Dec 1994 1,182.010 38.19% 29.75% 10.94% 6.41%
Dec 1995 1,633.380 24.06% 18.41% 8.51% 5.68%
Dec 1996 2,026.290 34.09% 10.54% 6.78%
Dec 1997 2,716.980 30.72% -0.99% 5.19%
Dec 1998 3,551.720 22.38% -1.24% 3.01%
Dec 1999 4,346.660 -12.54% -3.20% -3.63%
Dec 2000 3,801.780 -12.03% 0.54% -0.16%
Dec 2001 3,344.370 -22.71% 6.14%
Dec 2002 2,584.930 29.11% 13.07%
Dec 2003 3,337.410 10.71% -2.09%
Dec 2004 3,694.970 5.72% 0.25%

Dec 2005 3,906.350 15.32%
Dec 2006 4,504.770 6.03%
Dec 2007 4,776.320 -37.14%
Dec 2008 3,002.600 24.58%
Dec 2009 3,740.560
Highest Return 38.19% 29.75% 19.26% 17.68% 16.88%
Lowest Return -37.14% -3.42% -3.63% 5.68% 7.09%
Arithmetic Return 11.13% 11.27% 10.30% 11.87% 12.27%
Standard Deviation Of Return 18.33% 8.46% 5.42% 3.31%
Source: MSCI U.S. Stocks
4.4 We can see from Table 6.1 above that the range between the highest and
lowest return narrows progressively as the investment horizon lengthens—from
the difference of 75.33% for 1-year to 9.79% for 20-year time horizon. In fact,
for the longer time horizon, such as 15-years and above, the lowest annualised
returns are positive. It follows that the standard deviation of return also reduces
progressively as the investment time horizon lengthens. This suggests that the
risk associated with a longer investment time horizon is lower. However, the
expected return as represented by the arithmetic mean ranges from 10.3% to
12.3% for all investment time horizons. This suggests that the expected return
is relatively unaffected by different investment time horizons.
A. Caveats In Investing Over A Long Time Horizon
4.5 While the above analysis and statistics do illustrate that investing over a longer
time horizon offers certain benefits (e.g. smaller standard deviation and the
resulting lower volatility in returns, and the diminishing gap between highest
and lowest returns as the investment time horizon lengthens), it should be
emphasised that the above analysis on the investment time horizon has been
made with reference to the changes specific to the U.S. MSCI market index.
The progression or changes of returns over the different investment time
horizons (from 1-year, to 5-year, 10- year, and so on) has therefore implicitly
incorporated in them the benefit of diversification in the different market
segments and sectors of the stock market. In this sense, the reduction in
standard deviation, and the narrowing spread between highest and lowest
returns over the different investment time horizons might be due in some way
(and perhaps in a large part) to the diversification of the market, as the data of
the entire market had been used. Additional analyses involving, for example,
segmentation of data into different sectors, will be needed if we want to make
the statement and conclusion that lengthening the investment time horizon will,
for sure, lead to lower volatility and higher return overall. This will entail a
separate and different study, and further research, which are outside the scope
of this study guide.
4.6 Having pointed out the limitation of the analysis above, it may be worthwhile
just highlighting the benefit of diversification. The statistics suggest that, when
the entire market is involved, the volatility and risks can be much reduced, and
it appears that lengthening the investment time horizon is a good thing to do.
The eggs are spread out over the market!
4.7 In short, the arguments and points raised above suggest the pitfalls of putting
all your bets in a particular sector like technology, especially when the intention
is to hold the investment over a long time horizon. The financial crisis of
2008/2009 and some other earlier ones gave numerous examples of stocks
losing much of their value over a short duration of time—who would have
thought that Lehman Brothers could go down so quickly! In fact, one argument
against investing over a long time horizon is that, given all the changes and
developments, new risks may pop up along the way; and these may not have
been foreseen or known when the investments were first made. Case in point:
excessive over-leveraging and financial engineering in the financial markets
leading to cheap liquidity and the sub-prime mortgage and housing asset bubble.
In fact, one possible strategy may well involve taking the middle road—locking
in the profits and gains at or close to the top of the economic cycle, and
switching to a safer investment with lower risks/volatility or to assets which the
investor is more familiar and comfortable with. In other words, divide the
investment time horizon up in segments, in line with the economic cycles.
Obviously, it is easier said than done. It involves good understanding of the
market, sensing and seeing the trends, and having strong discipline – knowing
when to stop and let go, and when to restart!
5. TAX CONSIDERATIONS
5.1 Investors should consider the tax effect of investing.
5.2 In Singapore, capital gains from stock market and unit trust investments are
non-taxable. Income from bonds and savings accounts have become exempt
from tax since 11 January 2005.
5.3 For longer-term investors in the higher tax brackets, they can consider the
Supplementary Retirement Scheme (SRS) which offers attractive tax benefits.
Contributions are eligible for tax relief, while investment returns are
accumulated tax-free (with the exception of Singapore dividends) and only 50%
of the withdrawals from SRS are taxable at retirement. In general, the personal
income tax laws and regulations in Singapore are fairly straightforward and
uncomplicated. There are really not many tax angles and tax-saving schemes
that the individuals can look to to reduce their income taxes. Therefore, the key
idea is to come up with an investment strategy/plan, coupled with proper
execution, so as to achieve a good return over time.
5.4 With the rising popularity of online trading and the globalisation of the finance
industry, more investors are making offshore investments. Investors typically
have to take note of the tax issues in the respective jurisdiction as they may be
taxed on capital gains. Investors should consult their tax advisers to get a clear
picture of tax issues before making any offshore investments.
6. REGULATIONS AND LEGAL CONSTRAINTS
6.1 The Monetary Authority of Singapore (MAS) is responsible for regulating the
unit trust industry, formulating guidelines on unit trust operations and
supervising fund management companies in Singapore. These are achieved
through legislative frameworks and non-statutory guidelines on best practices in
collective investment schemes. The Central Provident Fund (CPF) Board is
involved in ensuring that the funds included under the CPF Investment Scheme
(CPFIS) comply with the various CPFIS investment guidelines.
A. Investment Guidelines – Code On Collective Investment Schemes (CIS)
6.2 This Code on Collective Investment Schemes was issued by MAS pursuant to
Section 321 of the Securities and Futures Act (Cap. 289) (SFA). The Code sets
out best practices on the management, operation and marketing of such
schemes that managers and trustees are expected to observe.
6.3 The Code was first issued on 23 May 2002 and last revised in August 2014. In
revising the Code, MAS considered public feedback received from its public
consultation on proposed amendments to the Code released in May 2010.
6.4 The revised Code took effect from 1 October 2011 and apply to all authorised
schemes, except structured product funds. In view of the industry’s feedback
that structured product funds had customised structures which required time
and potentially higher costs to unwind, MAS allowed such funds to comply with
the revised Code by 1 April 2012 or be grandfathered (exempted) on condition
that they did not take in new retail investors after that date. Investment-linked
life insurance policies had to comply with similar guidelines on 1 October 2011.
6.5 Details of the revised Code are specified in the MAS website which should be
visited for guidance from time to time at:
https://www.mas.gov.sg/regulation/codes/code-on-collective-investment-
schemes. The revised Code is also covered in CMFAS Module 5 – Rules and
Regulations for Financial Advisory Services published by the Singapore College
of Insurance.
B. CPF Investment Scheme (CPFIS)
6.6 Profits made from investments under the CPFIS-OA and/or CPFIS-SA are not
withdrawable, as the purpose of investing is to grow the savings for retirement.
However, the profits can be used for other CPF schemes, subject to the terms
and conditions of these schemes.
6.7 All CPF members who satisfy the following requirements can invest and
participate in the CPFIS:
▪ are at least 18 years old;
▪ are not undischarged bankrupts; and
▪ have more than S$20,000 in their Ordinary Account (for investment under
CPFIS-OA) and/or more than S$40,000 in their Special Account (for
investment under CPFIS-SA).
6.8 From 1 October 2018, as a new CPFIS investor, the CPF member will need to
complete the Self-Awareness Questionnaire (SAQ) before the CPF member can
start investing under CPFIS.
B1. Instrument Products Included Under CPF Investment Scheme (CPFIS)
6.9 Table 6.2 below shows the instruments available for investment under the
CPFIS-OA and CPFIS-SA:
Table 6.2: Investment Products Included Under CPF Investment Scheme (CPFIS)
Investment products included under You can invest using your CPF
CPFIS savings from
OA SA
Unit Trusts (UTs) ✔ ✔
Higher risk UTs are
not included
Investment-linked insurance products ✔ ✔
(ILPs) Higher risk UTs are
not included
Annuities ✔ ✔
Endowment policies ✔ ✔
Singapore Government Bonds (SGBs) ✔ ✔
Treasury Bills (T-bills) ✔ ✔
Exchange Traded Funds (ETFs) ✔ No products
currently available.
Higher risk ETFs

are not included
Fund Management Accounts ✔ ✘
Fixed Deposits (FDs) No products No products
currently available currently available
Statutory Board Bonds No products No products
currently available currently available
Bonds Guaranteed by Singapore No products No products
Government currently available currently available
Up to 35% of investible savings can be invested in:
Shares ✔ ✘
Property Funds ✔ ✘
Corporate Bonds ✔ ✘
Up to 10% of investible savings can be invested in:
Gold ETFs ✔ ✘
Other Gold products (such as Gold ✔ ✘
certificates, Gold savings accounts,
Physical Gold)
Important Note: (extracted from CPF website)

“The CPF Board does not specifically endorse any product providers or
investment products included under the CPF Investment Scheme (CPFIS). All
investments come with risk and you may lose all or a portion of the amount
invested. If you are not confident of investing on your own, you may consider
leaving your money in your CPF accounts, which earns risk-free interest.”
Source: https://www.cpf.gov.sg/Members/Schemes/schemes/optimising-my-
cpf/cpf-investment-schemes (extracted 20 Jan 2020)
6.10 The first S$60,000 in a member’s combined CPF accounts earns an extra 1%
interest. To enable members to earn extra interest, only moneys in excess of
S$20,000 in the Ordinary Account and S$40,000 in the Special Account can
be invested.
6.11 However, CPF members can continue to service their regular premium insurance
policies (but NOT recurring single premium insurance policies or regular savings
plans for unit trusts) and agent bank fees even if the Ordinary Account balance
falls below S$20,000.
6.12 All investments made under CPFIS must be in Singapore dollars except where
otherwise stated. Investments under CPFIS cannot be assigned, pledged or used
as collateral.
(a) Fixed Deposits

▪ Must be placed with a CPF Fixed Deposit Bank.
(b) Singapore Government Bonds

Singapore Government Treasury Bills
▪ Can be bought from the primary and secondary markets.
▪ Can be traded through bond dealers.
(c) Statutory Board Bonds

▪ Can be traded through bond dealers or brokers.
(d) Bonds Guaranteed by the Singapore Government

▪ Can be traded through brokers.
(e) Annuities
Endowment Policies
Investment-linked Insurance Products
▪ Must be offered by insurance companies included under CPFIS.
▪ Life insured must be the member himself.
▪ Only single premium or recurring single premium policies are allowed (new
regular premium policies are not allowed from 1 January 2001).
▪ For endowment policies, maturity date must not be later than the
member’s 62nd birthday.
(f) Unit Trusts

▪ Must be managed by Fund Management Companies included under CPFIS.
▪ Fund managers are required to invest according to the Investment
Guidelines set by the CPF Board.
(g) Exchange Traded Funds

▪ Must meet guidelines set by the CPF Board and be listed on the Singapore
Exchange-Securities Trading (SGX-ST).
(h) Fund Management Accounts (CPFIS-OA only)

▪ Fund managers are required to invest according to the Investment
Guidelines set by the CPF Board.
(i) Shares of Companies, Units of Property Funds or Property Trusts and

Corporate Bonds (CPFIS-OA only)
▪ Must be offered by companies incorporated in Singapore.
▪ Must be fully paid ordinary or preference shares or corporate bonds listed
on the Singapore Exchange-Securities Trading (SGX-ST).
(j) Gold (CPFIS-OA only)

▪ Gold ETFs
Must meet guidelines set by the CPF Board and be listed on the Singapore
Exchange Securities Trading (SGX-ST).
▪ Other Gold products

Only UOB offers these gold products. If you wish to invest in gold, you
need an investment account with UOB.
C. CPF Investment Scheme – Risk Classification System
6.13 In 1999, the Central Provident Fund (CPF) Board engaged an international
investment consultant, William M Mercer, to approve, review and classify funds
approved under the CPF Investment Scheme. The aim was to provide sufficient
information to CPF members so that they could make informed investment
decisions when investing in such funds. CPF members are still responsible for
making their own investment decisions, and for understanding the risks that
they are taking.
6.14 Mercer has developed a risk classification system to help CPF members
understand the nature and types of risks associated with each unit trust, so
that they can make an informed judgment on a suitable investment.
6.15 Mercer classifies investment risks into two major types – equity risk and focus
risk.
6.16 Equity risk is related to the exposure of the “riskier” types of investments in the
unit trust. Risky investment refers to equities. Generally, where the unit trust
has a higher proportion of equities, the equity risk will be higher. The longer an
investor’s investment time horizon, the more likely he can comfortably take on
more equity risk and vice versa. Over the long term, a unit trust with high
equity risk may reasonably be expected to outperform a unit trust with lower
equity risk. However, in the shorter term, a unit trust with high equity risk may
substantially underperform, compared to a unit trust with low equity risk. This
is due to the volatility in stock prices connected to changes in economic forces
(e.g., changes in interest rates, monetary and fiscal policies, etc.). Occasionally,
it will not hold true even for some fairly long periods (as long as a decade or
more).
6.17 Focus risk reflects the focus of unit trusts in one particular geographical region,
country, or industry sector. The purpose of providing information on focus risk
is to make CPF members aware of certain types of risks associated with a given
investment which may not be readily apparent at first glance. Investments
within each equity risk category are further classified into either broadly
diversified or narrowly focused.
6.18 Broadly diversified unit trusts tend to have investments that are spread across
relatively more geographical regions, countries, industry sectors and individual
securities. This portfolio tends to contain more securities and is less
concentrated.
6.19 Narrowly focused unit trusts tend to have investments that may be focused in
particular geographical regions, countries, industries or individual companies.
This portfolio tends to contain fewer securities and is more concentrated. In
general, not only will a narrowly focused unit trust have the potential to
produce higher returns in a short-term period, but also more downside risk than
a broadly diversified unit trust. In other words, a narrowly focused unit trust
within a given equity risk category tends to have greater volatility. However,
they will not necessarily be associated with a higher level of long-term expected
results.
6.20 Since July 2002, Standard & Poor’s (S&P) has replaced William M Mercer to
provide quarterly evaluations of the performance of insurance-linked
investments and unit trusts under the CPFIS.
6.21 Starting from 2005, with the aim of improving the value and return to CPF
members investing in unit trusts and investment-linked life insurance policies,
the CPF Board stipulated certain guidelines for unit trusts, in order for them to
be continually included under the CPFIS. These include the investment
performance of the unit trusts, as well as meeting certain expense ratio criteria.
The expense ratio refers to the operating cost of unit trusts and investment-
linked life insurance products, including investment management fees and other
administration costs, expressed as a percentage of the fund’s average net
assets for a given time period. The expense ratio does not include brokerage
costs and various other transaction costs that may also contribute to the total
expenses of a fund.
6.22 In February 2008, the CPF Board appointed Morningstar Research Pte Limited
(Morningstar) as its investment consultant under the CPFIS with effect from 7
March 2008. Morningstar assumed the role of evaluating suitable product

providers such as fund management companies and insurers, as well as their
products such as unit trusts, investment-linked life insurance products, and
exchange traded funds, etc., seeking to be included under the CPFIS. The
contract with the CPF Board would be for a period of three years from the
commencement of the consultancy services, with the option by the CPF Board
to extend it for two additional one-year terms. CPF Board reappointed
Morningstar as its investment consultant under the CPFIS, starting from 7th
March 2012.
6.23 In August 2008, the Investment Management Association of Singapore (IMAS)

and the Life Insurance Association, Singapore (LIA) entered into an agreement
with Lipper, a Thomson Reuters specialist fund subsidiary, to be the provider of
fund performance data for the Central Provident Fund Investment Scheme
(CPFIS) of Singapore.
6.24 With the appointment, Lipper worked with IMAS and LIA to enhance the CPFIS
Performance & Risk Monitoring Report, and the fundsingapore.com web portal,
to better meet the needs of the investing community.
7. DIVERSIFICATION
7.1 The purpose of diversification is to reduce investment risk. Simply put, it is

about not putting all your eggs in one basket. By doing so, the volatility of your
investment returns is reduced. Diversification can be achieved by combining
assets in your portfolio which have a correlation of return that is less than one
or better still, negative.
7.2 In assessing the appropriate level of diversification, the factors described below
should be considered by the investors. These include: (a) the asset class the
portfolio is invested in; (b) concentration of investments; (c) concentration of
sector exposure; and (d) concentration of geographical exposure. In addition,
dollar cost averaging reduces the timing risk in investment, and is a very
important and effective tool in diversifying the investment over time.
(a) The Asset Class The Portfolio Is Invested In

Generally, the higher the proportion of equities is, the higher the risk of that
fund will be. After taking into account other considerations such as risk
tolerance and investment time horizon, investors may want to diversify
their funds to include some money market or fixed income securities.
(b) Concentration Of Investments

A concentrated portfolio is one that owns a smaller number of investments,
but each investment has a sizeable weightage in the unit trust. Hence, a
portfolio with 20 investments is more concentrated than one with 50
investments. Hedge funds usually have a higher concentration of bets than
traditional funds do.
(c) Concentration Of Sector Exposure

A portfolio that concentrates its investments in one particular sector is
generally more risky than one that is diversified in its sector exposure.
(d) Concentration Of Geographical Exposure

A portfolio that concentrates its investments in one geographical region is
generally more risky than one that is diversified geographically. Hence, a
country-focused portfolio is generally more risky than a regional-focused
portfolio; a globally diversified portfolio is, in general, the least risky among
them, as the exposure is spread over a larger number of countries and/or
regions.
Another way to achieve diversification is to have a regular savings plan,

where you invest a certain amount into a unit trust, for example, regardless
of market conditions. This is also known as dollar cost averaging.
A. Dollar Cost Averaging
7.3 This is a practice adopted by investors who do not want to undertake market-
timing risks. The risks of market timing are discussed in the next section.
Investors invest in steady, equal amounts over a period of time. It has the
effect of making their average cost of purchases lower than the average price
during that period (see Example 6.1).
Example 6.1: How Dollar Cost Averaging Works
You decide to invest S$1,000 in a stock fund at the end of every month.
Month Price Quantity Purchased

(S$) (Units)
January 1.02 980.39
February 1.00 1,000.00
March 1.15 869.57
April 0.98 1,020.41
May 1.10 909.09
June 0.95 1,052.63
July 0.90 1,111.11
August 0.88 1,136.36
September 0.75 1,333.33
October 0.95 1,052.63
November 1.10 909.09
December 1.00 1,000.00
Total units purchased 12,374.61 units

Total investment (12 X S$1,000) S$12,000.00
Average price S$0.9697 per unit
The average purchase price of S$0.9697 per unit is lower than the average of
the monthly closing price over the one-year period of S$0.9817 (add up the
monthly closing price during that one-year period and divide by 12). Dollar
cost averaging has the advantage of buying more units when the market is
low, and buying less when the market is high (expensive). This is consistent
with the concept of buying low and selling high.
B. Market Timing
7.4 Market timing is a technique of shifting your investments in and out of risky
asset classes, to capture the upside for risky asset classes during bull markets,
and to exit the market before the onslaught of bear markets.
7.5 Empirical evidence suggests that most investors fail to use market timing to
make a positive impact on their investments on a sustainable basis. Not only are
the odds against them, but also the “punishments” inflicted on investment
returns can be devastating if the best trading days are missed.
7.6 To illustrate the impact of missing the best trading days on portfolio returns, we
shall use the daily MSCI index return for the Singapore stock market over the
three-year period between 5 April 2007 and 5 April 2010. The cumulative
return for the MSCI Index during the 3-year period was a negative 3.68%.
However, missing the best 5 and best 10 trading days reduced the MSCI Index
return to a larger negative return of 30.03% and 47.8% respectively.
7.7 There are two further risks in trying to time the market. The best trading days
usually occur immediately after some of the worst trading days. Hence, the
chances of missing out on the best trading days are high as investors sell on
panic. Furthermore, best trading days tend to occur within close proximity of
each other. This further heightens the risk of missing out on most, if not all, of
the best trading days. It should be noted that it is almost impossible to spot the
best and worst trading days in the market. This is because the daily movements
in any market are affected by many events that are beyond the predictions of
even the best investment managers in the world. Thus, the best and worst days
are usually only identified on hindsight. In this sense, instead of trying to
pinpoint the good and bad days, the best strategy may well be to use dollar
cost averaging—that is, follow and attain the average performance of the
markets.
8. INVESTMENT STYLES OF FUND MANAGER
8.1 It is important that an investor in unit trust investments selects a fund manager
whose investment style he (the investor) appreciates and fully understands. In
this way, the investor will not be disappointed, as long as the fund performs in
line with the selected style.
8.2 The two most common investment styles are growth and value. In growth
investing, the fund manager typically holds stocks with high earnings growth
rates (either shown by historical track record and performance, or projected and
judged to be potentially so in the future, given the nature of the industry,

economy, expectation and outlook on the company performance). Even though
the valuation of these stocks may be high, a growth fund manager believes that
strong earnings and growth rates will result in the increased market/real value
of the asset, proving that the valuation is justified and in line with the original
assessment. Consequently, the valuation metric, such as price (valuation) to
earnings (P/E) ratio, will be brought down to a level that is in line with the
market. The risk in the growth style lies in the possibility that the company will
not be able to deliver the projected strong earnings growth rate that is expected
of it.
8.3 In value investing, the fund manager typically holds stocks with cheap
valuation. The value fund manager believes that, over time, the market will re-
rate these stocks at a higher valuation. The risk in value investing lies in the
fact that the market may not give the expected higher valuation to the
asset/investment over a longer period of time.
8.4 There are other investment styles commonly adopted by professional fund
managers too. Another school of thought involves top-down and bottom-up
investing.
8.5 Top-down investing involves analyzing the "big picture". Investors using this
approach look at the economy and try to forecast which industry will generate
the best returns. These investors then look for individual companies within the
chosen industry and add the stock to their portfolios.
Conversely, a bottom-up investor overlooks broad sector and economic

conditions and instead focuses on selecting a stock based on the individual
attributes of a company. Advocates of the bottom-up approach simply seek
strong companies with good prospects, regardless of industry or
macroeconomic factors. What constitutes "good prospects", however, is a
matter of opinion. Some investors look for earnings growth while others find
companies with low P/E ratios attractive. A bottom-up investor will compare
companies based on these fundamentals; as long as the companies are strong,
the business cycle or broader industry conditions are of lesser concern.
8.6 Fund managers can also invest according to the styles of “large cap” versus
“small cap” investing. Fund managers choose companies by the size of their
market capitalisation, which is the current price of the stock multiplied by the
number of shares in issue. Large cap funds choose companies with very large
market capitalisation (typically US$8 billion or more). Small cap funds choose
companies that have low market capitalisation (typically below US$1 billion)
and that are expected to grow in the future. Keep in mind that the dollar
amounts used for the classifications “large cap” and “small cap” are only
approximations that change over time. Even among market participants, their
exact definitions can vary.
8.7 There are also active versus passive styles of investment management.
Investors who want to have professional investment managers who carefully
select their holdings will be interested in active management. Actively managed

funds typically have a team of financial researchers and portfolio managers
who are constantly seeking to gain higher returns for investors. Since investors
must pay for the expertise of investment staff, actively managed funds typically
charge higher expenses than passively managed funds do.
8.8 Some investors doubt the ability of active managers in their quest for outsized
returns. This position rests primarily on empirical research which shows that,
over the long run, many passive funds earn better returns for their investors
than similar actively managed funds do. Passively managed funds have a built-in
fee advantage – since they do not require researchers, fund expenses are often
very low.
8.9 Funds with different styles may perform rather differently at any one point of
time, depending on the prevailing market environment. Thus, for the purpose of
diversification, it may be worthwhile to invest in funds with different
investment styles.
9. SUMMARY
9.1 This chapter covers the essential considerations prior to undertaking investment
and includes the following:
▪ Understand the importance of setting up an investment policy to articulate
investment objectives and risk tolerance prior to undertaking an investment;
▪ Factors influencing investment objectives may include goals such as
retirement and education, investor’s age, wealth position, investment time
horizon, liquidity needs and tax considerations;
▪ Know the rules and regulations governing the unit trust industry in Singapore,
including Code of Collective Investment Scheme administered by Monetary
Authority of Singapore, and CPF Investment Scheme which allows investors
to use CPF funds for investment purposes with prescribed guidelines and
restrictions;
▪ Understand the concept of diversification, the importance of having
diversification in the investment portfolio and ways to attain diversification;
▪ Concepts of dollar cost averaging and market timing are also discussed;
▪ The major styles of investment managers which include: value versus growth,
large cap versus small cap, active versus passive etc.
7. Unit Trusts
CHAPTER 7
UNIT TRUSTS
CHAPTER OUTLINE
1. Introduction
2. Parties Involved In A Unit Trust
3. Charges And Fees
4. Expense Ratio
5. Bid And Offer Prices
6. Pricing Of Unit Trusts
7. Evaluation Of Unit Trusts
8. Advantages Of Investing In Unit Trusts
9. Pitfalls Of Unit Trust Investment
10. Summary Of MAS Revised Code On Collective Investment Schemes
11. Summary
KEY LEARNING POINTS

▪ describe the benefits of a unit trust and the parties involved in it
▪ list the charges and fees related to Collective Investment Schemes
▪ understand and calculate expense ratio and the types of unit trusts with high expense
ratio
▪ know the bid and offer prices and how unit trusts are priced
▪ evaluate the suitability of unit trusts
▪ know the advantages and pitfalls of investing in unit trusts
1. INTRODUCTION
A. Investment Fund
1.1 An investment fund is a fund managed by a firm or investment manager who

pools together the investments by retail investors for a fee. By aggregating the
funds of a large number of small investors into specific investments (in line with
the objectives of the investors and detailed in the prospectus), an investment
company gives individual investors access to a wider range of securities (such
as corporate securities, commodities, options, etc.) than the investors
themselves are able to access. Also, individual investors are not hampered by
high trading costs, since the investment company is able to gain economies of
scale in operations. They can be classified as open-end or closed-end funds.
B. Unit Trust – An Introduction
1.2 A unit trust is a professionally managed investment fund that pools together
money from investors (called unitholders) with similar investment objectives to
invest in a portfolio of stocks, fixed income securities or other financial assets
or some related combinations. A unit trust, also known as collective investment
scheme (CIS) locally, is typically set up as a trust where there is a trustee. In
other countries, similar structures called mutual funds may be set up as
investment companies with no involvement of a trustee.
1.3 A unit trust investor owns units in the funds, which are somewhat similar to
shares in a company. Each unit represents a proportionate ownership in the
underlying securities owned by the unit trust. For example, if there are
1,000,000 units in a unit trust that owns 200,000 shares of Singapore Airlines
and 1,000,000 shares of Venture Corporation, among others, then each unit
will represent 0.2 shares in Singapore Airlines and 1 share in Venture
Corporation. Unitholders redeem their investments by selling units back to the
fund manager.
C. Brief Overview Of The Administration And Control Over Unit Trusts
1.4 The level of a unit trust’s income from its portfolio, and the market values of
the underlying investments determine the daily market value (called net asset
value) at which its units are redeemable on any business day, and the dividends
paid to its unitholders. There are two main types of unit trusts, namely (1)
open-end fund, where the capitalisation of the fund is not fixed, and more units
may be sold at any time to increase its capital base; and (2) closed-end fund,
where capitalisation is fixed and limited to the number of units authorised at the
fund’s inception (or as formally altered after that).
1.5 Unit trusts usually charge a management fee (typically between 1% and 2% of
the fund’s annual earnings depending on the type of unit trust) and may also
levy other fees and sales commission (called load) if units are bought from a
financial adviser or distributor.
7. Unit Trusts
1.6 Hence, a unit trust is a pool of co-mingled funds contributed by many investors,
kept in trust by a trustee, and managed by a professional fund manager.
1.7 The Securities and Futures Act (Cap.289) provides for MAS to authorise all
collective investment schemes to be offered to the public in Singapore, for
example, the approval of trust deeds and schemes. This deed enables a trustee
(usually a financial institution) to hold the pool of money and assets in trust on
behalf of all the investors. The pool is managed by a third party, namely, the
investment fund manager. The fund manager manages the portfolio of
investments and operates the market for the units (i.e., administers the buying
and selling of shares and securities in the unit trust) itself for the benefit of
unitholders. The unit trust is essentially a three-way arrangement made up of
the investors, the fund manager and the trustee.
1.8 Investors who are interested in receiving the benefit of professional portfolio
management, but who do not have sufficient funds and/or time to purchase a
diversified mix of securities will find investing in unit trusts attractive. They can
invest in unit trusts to generate income in the form of dividends, interest and
capital gains.
1.9 Investors in Singapore can choose from a wide variety of unit trusts with
different investment objectives. A unit trust may aim for high income or high
capital growth, or a combination of both. Some unit trusts invest in specific
industry themes, sectors, countries or regions.
1.10 It is important that the investment objectives of the unit trust chosen match the
investor’s risk profile and investment objectives. Unit trusts are required to
state their investment objectives clearly on the prospectus which every investor
should acquire before buying. The types of assets that may be bought by the
fund manager are also specified in the objectives of the unit trust and contained
in the trust deed.
1.11 The coverage of unit trust investments is divided into two chapters. This
chapter covers the: (a) parties involved in a unit trust; (b) charges and fees; (c)
expense ratio; (d) bid and offer prices; (e) pricing of unit trusts; (f) evaluation of
unit trusts; (g) advantages of investing in unit trusts; and (h) pitfalls of unit trust
investments. Chapter 8 covers: (a) major types of unit trusts; (b) innovative unit
trust investment schemes; and (c) investment trust, real estate investment trust
and business trust.
2. PARTIES INVOLVED IN A UNIT TRUST
2.1 The operation of a collective investment scheme involves three main parties,
namely: (1) the trustee; (2) the fund manager; and (3) the distributor.
A. The Trustee and Trust Deed
2.2 In Singapore, a collective investment scheme such as a unit trust is set up by

virtue of a Trust Deed. The deed spells out the duties and responsibilities of the
fund manager, the trustee and the unitholders.
2.3 The Trust Deed must be approved by the authorities before the units in a fund
can be advertised for sale to the public. Before a fund can be set up, the fund
manager must issue a prospectus that is to be approved by the authorities.
2.4 By virtue of the Trust Deed, the trustee acts as the “watchdog” to safeguard
the rights and interests of the investors. To fulfil this objective, the trustee must
perform the following key roles to:
▪ ensure that investments in the unit trusts comply with the trust deed which
is a legal document drawn up to govern the aims and objectives of the fund,
as well as its investment guidelines. This is to minimise the risk of
mismanagement by the fund manager;
▪ assume legal ownership of all assets (securities and residual

cash) belonging to the unit trust and holds them in trust for unitholders ‒ this
is to ensure that all assets belonging to the unit trust are protected from the
other operational and financial risks of the fund management company;
▪ maintain proper accounting records for the unit trust and have them audited
yearly; and
▪ keep in custody all investments and other assets that form the capital of the
fund.
2.5 To perform these roles effectively, the trustee must be independent from the
fund management company. For these services, the trustee earns a fee, known
as trustee’s fee. This is usually 0.1% to 0.15% of the asset value in the unit
trust.
B. The Fund Manager
2.6 The fund manager is responsible for the performance of the fund and manages
it in accordance with the objectives set out in the trust deed.
2.7 To fulfil these objectives, the manager must perform the following key roles to:
▪ invest all assets in the unit trust to meet its objective as set out in the trust
deed;
▪ create or redeem units in accordance with the stipulated methods of calculating
the unit price; and
▪ prepare semi-annual and annual performance reports of the unit trust and send
them to unitholders.
7. Unit Trusts
2.8 For its services in managing the assets in the unit trust, the fund manager is
paid a management fee. This is usually between 0.5% and 1.5% of the asset
value in the unit trust, depending on the types of unit trusts (and hence the
types of investment assets) involved.
C. The Distributor
2.9 The distributor has assumed greater importance in recent years owing to the
proliferation of unit trusts available locally, as well as the strategic marketing
reach of the distributor. The distributor has been largely responsible for
marketing unit trusts through the media, investment seminars and mail.
2.10 For these services, the distributor earns a one-off sales charge (also known as
front-end load). This is typically in the range of 3% to 5% of the initial
investment. The distributor may also earn a portion of the recurring annual
management fee, known as trailer fee. This is usually pegged at a quarter of the
annual fee. However, in recent times, increased competition from local banks
with strong branch network and online investing websites has exerted
downward pressure on the sales charge, which will benefit investors.
3. CHARGES AND FEES
3.1 The charges and fees related to a collective investment scheme are broadly
divided into initial charge and recurring charges. Initial charge refers to the sales
charge that is payable when the fund is first purchased, commonly known as
front-end load. It is the single most substantial portion of the total fees paid by
investors in a collective investment scheme. Funds with an initial sales charge
would usually not charge a redemption fee.
Type Of Charges Quantum Payable To

Sales charge Typically 3% to 5% Distributor
Management fee Typically 0.5% to 1.5% per Fund management

annum company
Trailer fee 25% of annual management Distributor

fee. (May vary across the
various funds or
distributors.)
Trustee fee Typically 0.1% to 0.15% Trustee

per annum
A. Other Types Of Costs
3.2 These are described below.
(a) Switching Fee

This may be imposed when the unitholder switches from one fund to
another fund under the same umbrella. Thus, constant switching of funds
can be an expensive affair for unitholders because most fund management
companies allow free switching only once a year. Some fund houses may
charge a switching fee amounting to 1% of the investment amount.
(b) Custodian Fee

This is levied by a custodian for the safe custody of securities in a unit
trust. The fee structure is typically transaction-based. This means that there
can be a fixed transaction charge for each trade, regardless of fund size.
(c) Audit Fee

An annual audit is mandatory for unit trusts.
(d) Marketing Costs

These costs are incurred when promoting the unit trust at a new launch or
at a re-launch. However, marketing costs are not allowed to be charged to
the fund or passed on to investors.
(e) Redemption Fee (also known as back-end load)

This is usually levied by the fund house on investors who liquidate their
investments within a specified time. Some unit trusts progressively reduce
the redemption fee if investors hold their investment over a longer period of
time. However, this fee is applicable only in the case of a no-load fund (a
unit trust without an upfront sales charge).
3.3 From the above descriptions, it should be apparent that a unit trust should be
held at least as a medium-term investment, or at best as a long-term
investment, since the charges and fees involved are quite prohibitive for short-
term trading.
4. EXPENSE RATIO
4.1 This is the ratio of expenses incurred by the unit trust to its average net asset
value. Expenses to be included in the calculation of the expense ratio include:
▪ fund management fee;
▪ trustee fee;
▪ administrative fee;
▪ accounting and valuation fees;
▪ custodian fee;
▪ registrar fee;
▪ legal and other professional fees;
▪ audit fee;
7. Unit Trusts
▪ printing and distribution fees; and

▪ amortised expenses.
4.2 Note that expenses NOT included in expense ratio computation are:
▪ interest charges;
▪ performance fee;
▪ brokerage; and
▪ sales charge.
4.3 High expense ratios can affect fund performance negatively, especially when
they are compounded over the longer term. For example, over a 5-year holding
period, the fund performance can be worse off by more than 10% if the
expense ratio is 2% higher.
4.4 In general, the expense ratio ranges from 1% to 2%. However, some types of
unit trusts have higher expense ratios (> 3%). These include:
(a) Unit Trusts With Small Fund Size, Particularly If The Fund Is Actively
Managed
A transaction fee is usually a flat fee levied on each transaction made by
the fund manager. Hence, an actively managed fund has high transaction
charges. The effect on expense ratio is compounded on funds with a small
size or net asset value.
(b) Feeder Fund

Such funds have two layers of expenses – one incurred in Singapore and
the other incurred at the level of the parent fund.
5. BID AND OFFER PRICES
5.1 The standard quotation of most unit trusts has a bid and offer price (although
there are now fund houses that practise single pricing and impose a back-end
charge at surrender). These are the prices at which the fund manager will buy
and sell units in the fund respectively. The bid and offer prices are usually
quoted in three to five decimal points. The bid price is the net asset value per
unit of the fund, while the offer price includes the sales charge.
5.2 For example, as at a certain date, the Singapore Index Fund appears as
S$1.7466 / S$1.7815. The bid price of S$1.7466 is the net asset value per
unit of the fund. It is the price that an investor in the fund will receive if he
decides to redeem his investment. The fund manager will buy back units at this
price.
5.3 The price of S$1.7815 is the offer price of the fund. It incorporates a 2%
spread over the bid price as its sales charge payable to the distributors. New
investors wishing to come into the fund will have to pay S$1.7815 for every
unit purchased. In other words, they are paying the net asset value per share
plus a sales charge. In short, an investor pays the offer price when buying, and
receives the bid price when selling.
5.4 Net Asset Value (NAV) is commonly used to quote unit trusts these days. The
NAV of a unit trust is calculated by dividing the sum of the values of all the
underlying securities, less liabilities, by the total number of outstanding units.
For example, for a fund size of S$100 million with 100,000 outstanding units,
the NAV will be at S$10 per unit.
6. PRICING OF UNIT TRUSTS
6.1 The pricing of a unit trust is based on the principle of dividing the net asset
value of a fund into equal portions referred to as units. For example, if the net
asset value of a unit trust is S$10 million, and if there are 5 million units in
issue, each unit will be worth S$2. This is the net asset value of each unit. It is
also the bid price that was described in the earlier section.
6.2 Most unit trusts are open-end funds. This means that there is no limit to the
number of units that can be created. New units can be created as and when
there is demand from the investors. Similarly, units may be cancelled when
investors redeem their investments and the small fund size makes it
economically unfeasible to continue operating the fund due to high expense
ratio. Whenever there are changes in the total number of units, the fund
manager must be given sufficient time to rebalance his fund. For example, if
S$100,000 worth of new units is to be created, this sum of money will be
represented by an increase in the cash holding of the fund. A fund manager has
to decide on the deployment of this amount—the security to purchase (if the
increase in the units is not linked to any specific security). On the other hand, if
S$100,000 worth of units is redeemed, this will be represented by a cash
outflow in the fund. The fund manager has to decide on which securities to sell
(if the redemption is not linked to any specific security) in order to raise the
cash to meet the redemption request.
6.3 Hence, a unit trust is priced on a forward basis. This means that at the point of
application or redemption of his unit trust investment, an investor will be given
an “indicative” price based on the closing price of the previous dealing day. The
actual dealing price will be determined at the close of the current dealing day.
Therefore, the fund management company can calculate the bid/offer price for
the unit trust only after the financial market is closed. All the underlying
investments in the unit trust can then be priced, in order to arrive at the current
market valuation for the unit trust.
6.4 Investors will not be able to find out the transacted prices of the units until the
next dealing day, and this is known as forward pricing.
6.5 Despite being priced on a forward basis, a unit trust is a highly liquid
investment, because the underlying securities of the fund are relatively liquid in
nature. Most trust deeds also allow unit trusts to borrow up to 10% of the net
7. Unit Trusts
asset value to meet redemption needs, whenever there is any cash flow
mismatch. The latter may happen because timing between trade settlement on
the sale of securities and redemption payments may be mismatched.
7. EVALUATION OF UNIT TRUSTS
7.1 When evaluating the suitability of a unit trust as part of their long-term
investment plan, investors should take into account the factors described
below.
A. Risk Appetite
7.2 Investors should understand their risk appetite or risk tolerance level, and
choose the right unit trust that fits into their risk profile. Risk appetite is
affected by their investment time horizon, personality and financial background.
If their risk appetite is high, they can consider higher-risk investments or unit
trusts with higher risks. These also offer prospects of higher investment return
over the longer term. On the other hand, if they cannot afford to suffer price
declines in the short term, then a money market or fixed income fund is
probably more suitable for them.
B. Investment Time Horizon
7.3 The investment time horizon is the expected length of time during which
investors will stay invested in the fund. If the investment time horizon is long,
investors may have a higher tolerance for risk and may consider riskier assets,
because they offer potentially higher expected returns.
C. Diversification
7.4 While unit trusts are already a diversified portfolio, investors should also
diversify their holdings in the various types of unit trusts. At the outset, they
should divide their funds between various asset classes, such as fixed income
and equity funds. Within each of the equity and fixed income funds, further
diversification should be made in industry sectors, geographical regions and
countries. For some investors, diversification into hedge funds may also be
appropriate, provided the risks associated with them are well understood.
D. Regular Investment Plans
7.5 While the initial outlay for a unit trust may be affordable, investors should also
consider regular investment plans in order to take advantage of dollar cost
averaging. Some fund management companies have regular investment plans
that allow investors to invest minimal amounts of a hundred dollars each
month, subsequent to the initial investment.
E. Transaction Costs
7.6 Other than the one-off sales charge and annual management fee, investors
should also look at the expense ratio. This is calculated by taking all the
operating expenses of the unit trust, such as custodian fees, management fees
and other fees for shareholders’ services, and dividing them by the average net
asset value of the fund. As mentioned above, other things being equal, funds
with small net asset values and feeder funds tend to have higher expense
ratios. Generally, funds with low transaction costs and low expense ratios are
preferred.
F. Availability Of Switching Options
7.7 While most fund managers offer a variety of funds, it may be desirable to
switch from one fund to another in order to take advantage of the changing
investment environments and to adjust one’s investment plans over time.
Investors should find out from the distributor or the fund management company
the costs associated with switching of funds.
G. Style Of Fund Manager
7.8 All the major investment styles, such as growth and value, active and passive,
big cap and small cap, have different fortunes at different phases of the
economic cycle. Investors should understand and be comfortable with the
professed style of the fund manager before investing in any unit trust. Only by
doing so will they have a better appreciation of the performance of the unit
trust they have chosen. For example, if an investor believes in value style, he
will have a better appreciation of a unit trust managed using the value style. In
times when the fund is not performing as well as the other styles, he will have
the conviction to ride out the cycle.
H. Consistency Of Performance
7.9 Other things being equal, a fund management company that demonstrates
consistently superior performance on a risk-adjusted basis is preferred. When
measuring fund performance, investors should also consider its investment
objectives, selected style, and the risks taken to achieve those returns.
However, investors should always remember that past performance is no
guarantee of future performance.
8. ADVANTAGES OF INVESTING IN UNIT TRUSTS
A. Diversification With Small Capital Outlay
8.1 With a small sum of money invested in unit trusts, investors are able to invest
in a sufficient number of companies to achieve effective diversification. By
pooling investors’ money, investment companies enable unitholders to hold
fractional shares of many different securities. A diversified portfolio of
7. Unit Trusts
securities, as we have seen, can reduce investment risks. Most unit trusts
require relatively small capital outlay ranging from S$1,000 to S$5,000.
Investors can continue to invest more of their funds into the same unit trust at
a smaller outlay, as low as a few hundred dollars, using the regular savings
plan. This is generally quite affordable to most investors. Unit trusts also allow
investors to invest in certain markets and sectors which they may find difficult
to access on their own. For example, investments in the stock markets of India,
Taiwan and Korea require an investment licence, which is typically available
only to institutional investors, such as fund management companies.
B. Professional Management
8.2 All else being equal, investment professionals devote their full time to analysing
market trends in order to make sound investment decisions. With their training
and qualifications, they are more aware of changes in the investment
environment and are thus able to react to them promptly. Furthermore, they
have access to the vast research capabilities of major international brokers, by
virtue of the commissions they pay on the larger pool of funds that they
manage. With such advantages, they are in a better position to make better
investment decisions by controlling risks and exploiting market and information
inefficiencies.
C. Switching Flexibility To Capitalise On Changing Market Conditions
8.3 The choice of unit trusts need not be restricted to the initial purchase.
Investment companies typically allow investors to switch within a “family of
funds”. Investors can switch from one fund to another conveniently and with
minimal costs. Switching between funds provides investors the benefits of
flexibility, as they can respond easily to changes in their investment plans and
market movements. For example, if the investment plan of an investor
necessitates a change from one of moderate risk to higher risk, he may consider
switching from a balanced fund to an equity fund.
D. Liquidity
8.4 The manager’s price for each type of fund is published in the local newspapers.
Investors can sell their investments to the investment managers who are
required to buy back the units, based on the net asset value of the unit trusts.
They can do so at relatively short notice with no prior notice required.
E. Security
8.5 Unit trusts in Singapore are subject to certain rules, regulations and guidelines
imposed by the Monetary Authority of Singapore, and the Central Provident
Fund Board in the case of CPF-approved investments. The assets of a unit trust
are always legally held on the investors’ behalf by an independent trustee, and
not by the fund manager, in order to safeguard the interests of unitholders, a
practice commonly termed as “ring-fencing’. The trust deed regulates the
actions of fund managers to ensure that they act within legislated boundaries.
Fund management companies hold investment advisory licences approved under

the Securities And Futures Act (Cap. 289). Trustees will also have to abide by
the Trust Companies Act (Cap. 336).
F. Reinvestment Of Income
8.6 Usually, the manager will automatically reinvest the dividends or interests
received by the unit trust. This is an advantage over personal investing,
because the dividends or interests collected by an individual are usually too
small for any meaningful capital investment.
G. More Investment Opportunities
8.7 By investing in a unit trust, there is pooling of money with that of other
investors. Hence, the fund manager is able to invest in a wider range of assets.
Some assets such as bonds require a minimum investment of around
$250,000, which may be difficult for individuals to access directly. Some funds
invest in foreign stock markets that are not readily accessible to small investors.
Thus, investors of unit trusts will be able to tap overseas markets with less
hassle, and as the size of the assets under management is large, investors will
benefit from potentially lower transaction costs.
9. PITFALLS OF UNIT TRUST INVESTMENT
9.1 Unit trusts are very effective in achieving risk diversification with minimal
investment outlay. However, each unit trust should be selected after
considering the factors mentioned in the earlier chapters and Section 7 –
Evaluation Of Unit Trusts of this chapter. Nevertheless, there are some pitfalls
that all investors should try to avoid in unit trust investments:
A. Performance Of Unit Trust Is Closely Linked To Fund Manager
9.2 While all fund management companies have an internal investment process to
ensure that all its funds are managed using a similar philosophy and approach, it
is common for a fund which has performed very well in the past to
underperform its peer group, after the departure of the individual fund manager
who was previously managing the fund. This is often termed as “key man risk”.
This can be due to the unique skills and insight that the fund manager brings to
the fund, in addition to the investment process adopted by the company. During
their performance review, investment consultants regularly enquire if there has
been any change in the fund manager managing a particular fund. Investors
should also attempt to keep track of changes in the fund manager and the
investment team, since the future performance of the fund may be affected by
such investment personnel changes.
7. Unit Trusts
B. Investors Cannot Influence The Way A Unit Trust Is Managed
9.3 The management of a unit trust is at the complete discretion of the fund
manager. Investors will not be able to influence the way in which it is being
managed. For example, investors cannot insist that the unit trust raises more
cash to protect its net asset value, even if they are convinced that the stock
market is going to weaken further. (If that is the case, the investors should sell
their units.) Similarly, investors cannot influence the sector allocation or the
stock selection of the unit trust. Therefore, it is important that they choose a
unit trust that shares their investment philosophy and investment approach.
C. No Guarantee Of Profits
9.4 All unit trusts carry investment risks. Even capital guaranteed unit trusts are
subjected to investment losses if they are redeemed before the end of their
maturity. The level of risk associated with each unit trust is dependent on its
underlying assets. Hence, a technology fund is exposed to the volatility of
technology stock prices in general. A globally balanced fund is exposed to the
volatility of both global equities and global bonds.
9.5 There is no guarantee that a unit trust investment will result in profits, even if held
over the long term. Investors should regularly evaluate their unit trust investments
to assess if the risk and return profile is still relevant to their investment needs.
D. Past Performance Is Not A Reliable Indicator Of Future Performance
9.6 Investors should be careful not to consider the recent success of an investment
strategy as being sustainable indefinitely into the future. For example, following
the phenomenal success of technology funds in the late 1990s, many investors
invested heavily in such funds, as they believed that the bull market for the
technology sector would continue forever.
9.7 Investors should be wary of this pitfall as fund management companies and
distributors tend to promote new funds or re-launch existing funds that have
experienced recent investment success. Since such funds are much easier to sell,
more money can be raised.
E. Fees and charges
9.8 Investors would usually have to pay a one-time initial sales charge when they buy
unit trusts. There will also be other costs, such as trustee fees, management fees
and redemption fees that investors do not have to pay if they buy and sell shares
directly in the stock market by themselves.
10. SUMMARY OF MAS REVISED CODE ON COLLECTIVE INVESTMENT SCHEMES
10.1 The revised Code on Collective Investment Schemes aims to provide greater
clarity and to increase the flexibility for fund managers in managing their funds.
The Code also aims to enhance safeguards for retail investors. The Monetary
Authority of Singapore (MAS) will only recognise a foreign scheme if it is satisfied
that the scheme is subject to investment guidelines which are substantially similar
to those as set out in the revised Code. The key changes include the following:
(a) Strengthening core investment requirements

▪ Introducing a list of permissible investments for funds
▪ Strengthening safeguards on the use of financial derivatives and
counterparty requirements
▪ Enhancing guidelines on securities lending activities
▪ Enhancing requirements for funds investing in structural instruments
(b) Introducing new guidelines for certain fund categories

▪ Establishing new guidelines for funds that track an index
▪ Introducing the concept of weighted portfolio maturities for money market
funds
(c) Other safeguards to enhance investor protection

▪ Standardising the methods used to calculate any performance fee imposed
▪ Introducing principles on the naming of funds
▪ Prohibiting the use of simulated past performance data
10.2 The Code was first issued on 23 May 2002 and was last revised on 8 October
2018. The effective date of this revised Code is 8 October 2018, except for the
following:
(a) Revisions made to paragraph 8.8 of Appendix 1 and paragraph 11.1(c)(v) of

Appendix 6 will take effect for the first annual report relating to the Fund
Manager’s respective financial year ending on or after 31 December 2018.
(b) Revisions made to paragraph 5 of Appendix 2 took effect on 18 February

2019.
11. SUMMARY
11.1 This chapter covers the salient points relating to unit trust investment and includes
the following:
▪ Three main parties involved in a Collective Investment Scheme which are the
Trustee, the Fund Manager and the Distributor;
▪ The duties and responsibilities of these three parties;
▪ Applicable charges and fees relating to Collective Investment Scheme which
include initial sales charges (or front-end load), management fee, trailer fee,
trustee fee, switching fee, custodian fee, redemption fee etc.;
7. Unit Trusts
▪ Understand the charges that make up total expense ratio and their impact on
net asset value and return on investments;
▪ Know that quotation of most unit trusts has a bid and offer price and
understand how net asset value is derived;
▪ Understand various factors involved in evaluating suitability of unit trusts
before investment;
▪ Know that there are advantages as well as pitfalls in unit trust investment;
▪ Overview of changes to Code of Collective Investment Scheme and how these
revisions will help to enhance investor protection.
8. Fund Products
CHAPTER 8
FUND PRODUCTS
CHAPTER OUTLINE
1. Introduction
2. Major Types Of Unit Trusts
3. Innovative Unit Trust Investment Schemes
4. Investment Trust, Real Estate Investment Trust (REIT) And Business Trusts
5. Summary
KEY LEARNING POINTS

▪ understand and explain the major types of unit trusts and funds
▪ know the innovative unit trust investment schemes
▪ understand investment trusts, REITs and business trusts
1. INTRODUCTION
1.1 In the previous chapter, we covered the fundamentals, advantages and pitfalls
of unit trust investments. In this chapter, we shall discuss: (a) the major types
of unit trusts; (b) innovative unit trust investment schemes; and (c) investment
trust, real estate investment trust (REIT) and business trusts.
A. Importance Of Reading The Documentation
1.2 It is very important for an investor to read and understand a fund’s

documentation before making the decision to invest. Some of the important
documentation includes the latest prospectus and periodic report of each
shortlisted fund.
1.3 The prospectus is a legal document that describes the fund’s objectives,
policies, and investment restriction in detail. It will also give details of all
applicable charges, including operating fees and switching fees. The prospectus
will give the “fine print” of the fund offering.
1.4 Periodic fund reports such as the semi-annual report and the annual report will
include information on the fund’s past performance and give a breakdown of its
investment by size. They include a financial statement that lists any gains,
losses, sales or liquidation of the fund, as well as any liabilities, and the net
current assets of the fund. There is also an income statement that lists any
income generated by cash or bonds within the portfolio, and all expenses
incurred by the fund, such as management fees and any taxes paid.
B. Open-end And Closed-end Funds
1.5 There are 2 major ways in which a unit trust may be organised, and the
differences are important:
▪ Open-end funds: These are the type that people usually call “mutual funds”
or “unit trusts”. The investor buys “units” in the fund from the fund
management company. These units are not traded on the stock exchange.
Unit trusts are very strictly regulated to ensure that investors can sell their
units at any time at a price linked to the current net asset value (NAV).
Investor can choose to buy or sell units in an open-end fund on any business
day, either through a distributor or with the fund manager.
▪ Closed-end funds: These funds have shares that are listed on the stock
exchange. This means that their share price is not directly linked to the value
of their assets. Often, the share price of a closed-end fund trades at a
discount or a premium to its NAV.
8. Fund Products
2. MAJOR TYPES OF UNIT TRUSTS
2.1 Depending on the types of underlying assets involved, unit trusts can be
classified as any of the following types:
A. Equity Fund
2.2 An equity fund invests predominantly in equities. A unitholder in an equity fund

is a part owner of each of the securities in the fund. The total return from an
equity fund comes from the dividend paid by the underlying securities in the
fund, as well as an appreciation in their share prices. An equity fund is the most
common type of unit trust. It can be further classified into:
▪ Single-country fund, where all the investments in the fund are placed in one
specific country;
▪ Regional fund, where the investments are spread out over the countries in a
particular geographical region (Asia-Pacific, Middle East, or South America), or
a particular economic/political grouping (e.g. ASEAN, European Union);
▪ Global fund, where the investments are spread out or diversified over the
world;
▪ Sector fund, where the investments are concentrated in certain sectors or
industries (such as finance, technology, automobile, etc.);
▪ Growth fund, where the investments are in companies which the fund
managers believe will grow well over time, Often the companies are not very
large in market capitalisation, but have a good track record of growth in sales
and profits and are in promising markets or industries;
▪ Income fund, where the investments can be comprised of just bonds or a
mixture of bonds and equities. These funds are managed with the investment
objective of providing investors with a regular stream of income payout while
keeping their fund prices fairly constant;
▪ Value fund, where the investments are typically in undervalued companies
whose stock prices are too low. Some value funds will also invest in
turnaround situations or cyclical industries; and
▪ Small cap and large cap fund, where investments are chosen by the size of
their market capitalisation, which is the current price of the stock times the
number of shares in issue. Large cap funds choose companies with a very large
market capitalisation of typically US$8 billion or more. Small cap funds choose
companies with a low market capitalisation of typically under US$1 billion that
are expected to grow in the future.
2.3 In general, owing to the risks associated with investment in equities, an equity
fund tends to have a higher level of investment risk than other types of unit
trusts, such as a fixed income fund or a balanced fund. However, the risks
associated with each sub-classification of an equity fund vary depending on the
nature and concentration of the underlying securities. Unit trusts invested in a
cyclical industry and highly concentrated unit trusts have higher risks. A cyclical
industry is one whose earnings are more sensitive to changes in the economic
condition and cycles. A highly concentrated unit trust has fewer securities, but
each security has more significant weighting.
2.4 For example, the technology sector is considered more cyclical than the
consumer staples sector. Hence, a technology fund will have higher risks than a
consumer staples fund. A global equity fund tends to have more stock holdings
than a single-country equity fund. This means that the global equity fund will
own more listed companies, but the individual weighting of each company in
the fund may be smaller. Hence, it may be more diversified than the single-
country equity fund, and therefore, it may not be as risky. Note that, in
understanding or assessing the riskiness of any fund, it is important to consider:
(a) the number of companies (investments) selected, which says a lot about the
diversification; and (b) the riskiness of individual companies selected. The
interaction and correlation of these two factors will affect the overall riskiness
of the fund.
2.5 While an equity fund has a higher risk, it has historically performed better than
other types of unit trusts in the long run. In general, investors will expect to
receive a higher return for investments with higher risks. The additional return
represents the premium for the additional risk undertaken by the investors.
Since this type of unit trust tends to be more volatile in nature and may perform
negatively during certain periods, it is typically more suited to investors with a
longer time horizon and who are able to withstand short-term volatility. As
illustrated in Chapter 6 on the returns of U.S. stocks from 1969 to 2009, the
risks associated with stock investments decreased as the investment time
horizon increased. However, one should take note of the caveats in investing
over a long-term horizon, as explained in Chapter 6.
B. Fixed Income Fund
2.6 A fixed income fund invests predominantly in fixed income securities. An

investor in a fixed income fund is a part owner of the underlying fixed income
securities in the fund. The total return from a fixed income fund comes from the
periodic coupon payments, as well as appreciation in the prices of the
underlying securities. The prices of the underlying fixed income securities will
change (increase or decrease) in response to the changes (decrease or increase)
in the market interest rate. As fixed income securities tend to involve bonds,
fixed income funds are also referred to as bond funds.
2.7 As in an equity fund, the risk level associated with each fixed income fund may
vary depending on the risk and concentration of fixed income securities that it
owns. The risks of fixed income securities are dependent on the credit quality
of the issuers and the duration of the underlying securities, as well as the
economic environment, which will affect the level and movement of market
interest rates.
2.8 Issuers of fixed income securities may be classified into corporate and sovereign
issuers. International credit rating agencies such as Moody’s, Standard & Poor’s
and Fitch Ratings usually have credit ratings for major issues. The credit rating
8. Fund Products
is assigned based on the risk of possible default. Issuers with lower credit
ratings are considered more risky than those with higher credit ratings, while
corporate issues are generally considered to be more risky than sovereign issues
(owing to the default risk of corporations). Fixed income securities with longer
duration are also considered to be more risky than those with shorter duration,
because their prices are more sensitive to changes in interest rates. Also, the
longer duration will imply increased exposure to the risk of changes in interest
rates and default risk. Duration is the cash-flow-weighted average term to
maturity of the fixed income security. Other things being equal, a lower-coupon
fixed income security has a longer duration than a higher-coupon fixed income
security, because more cash flow is paid out further into the future (note that
the face amount is paid out at maturity of the fixed income security). A
diversified fixed income fund, such as a global bond fund, generally has a lower
level of investment risk, because the fund is more diversified over different
countries or areas, and different industries or sectors, when compared to a
fixed income fund invested in emerging markets.
2.9 Major risks of fixed income funds include the following:
(a) Interest Rate Risk

This is the risk that rising interest rates may lead to a fall in the market
price of the fixed income security. Duration is a measure of a fixed income
security’s market price sensitivity to interest rate movements. Prices of
fixed income securities with a longer duration are more sensitive to
changing interest rates. In general, fixed income securities with longer
maturity dates and with lower coupon rates (and hence, coupon payments)
tend to have a longer duration.
(b) Credit Risk

This is the risk that the issuer may default on coupon payments and/or
principal repayments. It is directly related to the credit-worthiness and
business risks (nature of business and quality of management, etc.) of the
issuer.
(c) Reinvestment Risk

This is the risk that the coupon income can only be reinvested at lower
yields when the coupons are received, owing to the changing interest rate
and economic environment.
2.10 In general, a fixed income fund tends to be less volatile in terms of its market
prices, when compared to an equity fund. Hence, its relevance to investors’
overall investment portfolio tends to become more important as their time
horizon becomes shorter (e.g. approaching retirement), since investors will need
to cash out some of the investments to cover the needs for cash and living, as
well as other expenses.
2.11 The following chart is the yearly return on the G7 government bonds over a 25-
year period (from 1985 to 2009). During this period, the geometric mean rate
of return is 7.54%. Note that negative return occurred in only one out of the 25
years. However, it is interesting to also note that the number of months where
there was a drop in bond index, and hence, negative return (not shown in chart)
over the 25-year period is 78, or 26% of the time (78/300 months). Although
bond returns are typically not measured on a monthly basis, the statistics serve
to illustrate the potential volatility in the bond return over the months owing to
changes in the economic environment and/or market and interest rates.
2.12 In view of this volatility in month-to-month return, the price of fixed income
funds may still be subject to fluctuations, albeit not as much as equity funds.
On the other hand, if the unitholders have holding power and do not intend to
trade the units on a fixed income fund regularly to realise gains or losses, this
will be of a lesser concern.
Source: Citigroup
B1. Risk and Portfolio Strategies
2.13 To build an investment portfolio of unit trusts that is appropriate for an investor,
it is important to take note of the investment objective and acceptable risk
level. The table below shows some investment portfolios that can be built with
different underlying types of unit trusts compatible with different investment
objectives.
Investment Recommended Portfolio Investor Suitability

objective/Risk Asset Allocation
Income 100% fixed income For investors who:
funds - want to preserve their
investment;
- look at regular income as the
main investment consideration.
Conservative 70-80% fixed income For investors who:
funds - want relatively stable returns;
20-30% equity funds - are willing to accept some
short-term fluctuations.
8. Fund Products
Investment Recommended Portfolio Investor Suitability

objective/Risk Asset Allocation
Balanced 50% fixed income funds For investors who:
50% equity funds - prefer a balanced approach and
would like to have investments
with both growth and income
characteristics
- can accept some negative
fluctuations in investment value
in the short-term.
Growth 70-80% equity funds For investors who:
20-30% fixed income - want their investments to grow
funds at a faster rate;
- understand that they may have
to ride out longer periods of
negative return.
Enhanced 80-95% equity funds For investors who:
growth 5-20% fixed income - look at asset accumulation as
funds the main objective;
- can ride out investment
fluctuation over a prolonged
period and accept possible loss
of initial investment.
B2. Collateralised Debt Obligation (CDO)
2.14 Collateralised Debt Obligation (CDO) is a form of asset-backed security (ABS)

which consists of many layers or tranches. These are typically issued by special
purpose entities (SPE). An ABS’s value and income is derived from its
underlying assets. Pooling these underlying assets into financial instruments,
and in turn selling these instruments to general investors, allows the risk of
investing in the pool to be diversified. This is because each security will now
only represent a fraction of the total value of the diverse pool of underlying
assets. These underlying assets may include payments from credit cards, car
loans, residential mortgages, commercial mortgages, cash flows from aircraft
leases, royalty payments, movie revenues, etc. Some of these assets may even
include small or illiquid assets that are unable to be sold on an individual basis.
CDO may vary in structure and underlying assets, but the basic principle is the
same.
2.15 A SPE plays the role of creating and selling these underlying assets. The SPE
will normally bundle these assets to market and suit the risk preferences or
other needs of investors who may want to buy the securities, for example, for
the purpose of managing credit risk. The sale proceeds will be paid back to the
financial institution that created or originated the respective underlying assets.
By “bundling” and selling to many investors, the credit risk of the underlying
assets is transferred to another holder. The originating financial institution
therefore “removes” these underlying assets from their balance sheet and
receives cash for it. This transaction may potentially increase the financial
institution’s credit rating, which is advantageous in various ways. In this case,

the credit rating of the ABS will be based only on the assets and liabilities of
the SPE, and this rating can be higher than if the originating financial institution
issued the securities. The risk of the ABS will no longer be associated with
other risks that the originating financial institution may bear once it goes
through a SPE. A higher credit rating will also allow the SPE to pay a lower
interest rate (or charge a higher price) on the ABS than if the originating
financial institution were to borrow funds or issue bonds. In short, the
originating financial institution removes risky assets from their balance sheets
by having another party take on this credit risk. The originating financial
institution receives cash in return and is able to channel more of their capital to
new loans or other assets and investments. It may also have a lower capital
requirement due to a good credit rating.
2.16 CDOs will pay the cash flow to investors by tranches/levels. This cash flow
depends on the amount the CDO is able to collect from its underlying assets. If
the amount collected is less than the amount to be paid to the investors, the
CDO will pay the higher (“senior”) tranches/levels first. In this manner, the
investors in the lower (“junior”) tranches/levels will not receive any cash flow
and may suffer losses.
2.17 CDOs were very popular between 2000 and 2006, and the demand volume
was growing very quickly. However, during the subprime mortgage crisis in
2007, this demand declined dramatically mainly because many of the CDOs’
underlying assets were subprime-mortgage-backed securities. With a drop in
demand, the CDOs were no longer funded and this led to the collapse of certain
structured investments held by major investment banks. Bankruptcy of several
subprime lenders also took place, and Lehman Brothers was one of them.
2.18 Valuation of a CDO is on a mark to market basis. When the subprime market
collapsed, the value plunged as the banks had to write down the value of their
CDO holdings. In some structures, the assets held by one CDO consisted
entirely of another tranche of an existing CDO in the market. This explained the
“domino” effect at that period of time and why some CDOs became entirely
worthless. This was because there was insufficient cash flow from the
underlying subprime mortgages (many of which defaulted) to fund even the first
tranches.
2.19 The risk and return for a CDO investor depends directly on how the tranches
were defined, and only indirectly on the underlying assets. The investment
depends on the assumptions and methods used to define the risk and return of
the tranches. CDOs, like all asset-backed securities, enable the originators of
the underlying assets to pass credit risk to another institution or to individual
investors. Thus, investors must understand how the risk for CDOs is calculated.
B3. CDO And Subprime Crisis
2.20 The U.S. subprime mortgage crisis was a nationwide banking emergency that
coincided with the U.S. recession of December 2007 to June 2009. It was
8. Fund Products
triggered by a large decline in home prices, leading to mortgage delinquencies

and foreclosures, and the devaluation of housing-related securities. Declines in
residential investment preceded the recession and were followed by reductions
in household spending and then business investment. Spending reductions were
more significant in areas with a combination of high household debt and larger
housing price declines.
2.21 The expansion of household debt was financed with mortgage-backed securities
(MBS) and CDOs, which initially offered attractive rates of return due to the
higher interest rates on the mortgages. However, the lower credit quality
ultimately caused massive defaults. While elements of the crisis first became
more visible in 2007, several major financial institutions collapsed in September
2008, with significant disruption in the flow of credit to businesses and
consumers and the onset of a severe global recession.
2.22 There were many causes of the crisis, with commentators assigning different
levels of blame to financial institutions, regulators, credit agencies, government
housing policies, and consumers, among others. A likely cause was the rise in
subprime lending. The percentage of lower-quality subprime mortgages that
originated during a given year rose from the historical 8% or lower range to
approximately 20% from 2004 to 2006, with much higher ratios in some parts
of the U.S. A high percentage of these subprime mortgages, over 90% in 2006,
for example, were adjustable-rate mortgages. These two changes were part of a
broader trend of lowered lending standards and higher-risk mortgage products.
Further, U.S. households had become increasingly indebted, with the ratio of
debt to disposable personal income rising from 77% in 1990 to 127% at the
end of 2007, much of this increase being mortgage-related.
2.23 When U.S. home prices declined steeply after peaking in mid-2006, it became
more difficult for borrowers to refinance their loans. As adjustable-rate
mortgages began to reset at higher interest rates (causing higher monthly
payments), mortgage delinquencies soared. Securities backed with mortgages,
including subprime mortgages, widely held by financial firms globally, lost most
of their value. Global investors also drastically reduced purchases of mortgage-
backed debt and other securities as part of a decline in the capacity and
willingness of the private financial system to support lending. Concerns about
the soundness of U.S. credit and financial markets led to tightening credit
around the world and slowing economic growth in the U.S. and Europe.
2.24 The crisis had severe, long-lasting consequences for the U.S. and European
economies. The U.S. entered a deep recession, with nearly 9 million jobs lost
during 2008 and 2009, roughly 6% of the workforce. One estimate of lost
output from the crisis comes to “at least 40% of 2007 gross domestic
product”. U.S. housing prices fell nearly 30% on average and the U.S. stock
market had fallen approximately 50% by early 2009. As of early 2013, the U.S.
stock market had recovered to its pre-crisis peak but housing prices remained
near their low point and unemployment remained elevated. Economic growth
remained below pre-crisis levels. Europe also continued to struggle with its own
economic crisis, with elevated unemployment and severe banking impairments

estimated at €940 billion between 2008 and 2012.
C. Balanced Fund
2.25 A balanced fund invests in both equity and fixed income securities. The relative
weighting between equity and fixed income securities may vary according to
the strategy employed by the fund manager. If they are bullish on the equity
market, the proportion invested in equities will be higher and vice versa. A
balanced fund attempts to strike a balance between long-term capital growth
(equity) and recurrent income generation (fixed income security). It has more
limited capital appreciation potential than an equity fund does, but provides a
higher degree of safety (in terms of lower default risks and lower volatility, and
lower chances of losses in assets/unit values) and moderate to high income
potential. The risks associated with balanced funds are proportionately related
to the weighting in equities and fixed income securities.
D. Money Market Fund
2.26 Money market fund invests in short-term fixed-income instruments that have
less than one year of maturity, such as bank certificates of deposit, commercial
paper, and Treasury bills. Some of these instruments have a minimum lot size of
at least S$250,000. Thus, some retail investors will find that investing in each
of them individually is prohibitive. A money market fund provides an avenue for
retail investors seeking higher rates through money market instruments, as
compared to the fixed savings deposit rates with the banks. Investors in money
market funds normally do not pay a sales charge or a redemption charge, but
they do pay a management fee to the fund manager. A money market fund
provides investors a low-risk investment alternative to usually low cash rates.
2.27 In general, the risk associated with a money market fund is quite minimal,
owing to the fact that its underlying securities have less than a year to
maturity, and that the credit quality associated with these underlying securities
is generally better. Also, because of the short duration and lower yield level as a
start, these securities are not as sensitive to interest rate changes which will
affect the underlying bond valuation. However, they are still subjected to credit
risk of the underlying securities.
2.28 The money market fund has grown in popularity recently owing to the
historically low interest rates, and the relatively lower returns on bank deposits.
It is appropriate for conservative investors seeking capital preservation, while
looking for a better rate of return than that of bank deposits for yield pick-up.
E. Umbrella Fund
2.29 An umbrella fund refers to a set of funds with different investment objectives
offered by a single fund management company. Umbrella funds generally permit
their investors to switch from one fund to another within the family, at little or
8. Fund Products
no cost. This feature allows the investor to change his investment strategy as
the need arises, without incurring high transaction costs.
2.30 An umbrella fund may be a combination of equity, fixed income and money
market funds that are managed by that fund management company.
F. Feeder Fund And UCITS Funds
2.31 Feeder funds are unit trusts that invest directly or “feed” into existing offshore
unit trusts (known as the parent fund) established in another jurisdiction. This
fund has two layers of fees - one for the feeder fund and another for the parent
fund. If the feeder fund charges a management fee of 0.75% per annum and
the parent fund charges 1.5%, the unitholders end up paying 2.25% in total.
Like any other unit trust, a feeder fund has a Singapore-based manager and a
trustee.
2.32 Previously, some foreign funds in Singapore were not offered directly to the
public, because they did not meet the requirements of the Companies Act (Cap.
50). This requirement was put in place so that the funds would be subject to
the jurisdiction of the Singapore courts. Investors could seek legal recourse
locally in the event of a legal dispute. Hence, feeder funds were offered as an
alternative to gain exposure to these foreign funds.
2.33 To cut down on the additional layer of fees, the authority has allowed funds
denominated in foreign currencies that are regulated and supervised in a manner
comparable to Singapore to be offered locally. These funds may be included
under the CPF Investment Scheme, as long as they meet the criteria set by the
CPF Board. These include the fund manager’s inclusion under the CPF
Investment Scheme, and the foreign fund passing a due diligence evaluation
exercise by the investment consultant appointed by the CPF Board. With the
changes, existing feeder funds may continue as they are, or they may be
wound up and the units held by investors in the feeder fund exchanged for units
in the recognised foreign fund.
2.34 The most common type of feeder fund is equity fund. Hence, this is subject to
similar risk and return characteristics as any other equity fund. However, there
are also feeder funds that “feed” into hedge and/or fixed income funds.
2.35 Another development will be the availability of UCITS funds in Singapore.

UCITS stands for Undertakings for Collective Investments in Transferable
Securities. UCITS provides a single European regulatory framework for an
investment vehicle which means it is possible to market the vehicle across the
EU without worrying which country it is domiciled in.
2.36 Designed to enhance the single European market while maintaining high levels
of investor protection, UCITS funds have also become successful in Asia and
Latin America because the UCITS “label” means investors can have some
assurance that certain regulatory and investor protection requirements have
been met.
2.37 The creation of the UCITS system also brought costs down for fund providers
because it means they no longer had to create a new investment vehicle for
each country in which they intended to market the product.
G. Index Fund And Exchange Traded Funds (ETF)
2.38 An index fund is designed to track the performance of a specific market index.
The fund is “passively managed” in a fairly static portfolio and is always fully
invested in the securities of the index that it tracks. If the overall market
advances, the index fund will match the market appreciation. If the market
declines, so will the index fund. The attractions of such a fund are its low
management fees and low transaction cost in managing the fund. The
management fees of index funds are significantly lower than those charged by
active managers for other types of funds.
2.39 An index fund is usually an equity fund. Hence, it is subject to similar risk and
return characteristics as an equity fund. Examples of the index fund include
Exchange Traded Fund (ETF) and Exchange Traded Note (ETN).
G1. Exchange Traded Fund (ETF)
2.40 An Exchange Traded Fund is an investment fund that tracks an index of

markets and sectors, or a fixed basket of stocks. It can be traded like a stock
on an exchange. Most ETFs are bundled together with the securities that are in
an index. Some ETFs known as synthetic ETFs will hold financial derivatives
instruments to replicate the index rather than holding the actual securities that
are in the index.
2.41 Investors can do just about anything with an ETF that they can do with a
normal stock, such as short selling (however, see note at the end of this
section). Since ETFs are traded on stock exchanges, they can be bought and
sold at any time during the day (unlike most unit trusts). Their prices will
fluctuate from moment to moment, as with any other stock price. An investor
will need a broker in order to purchase them, which means that he will have to
pay a commission.
2.42 On the plus side, ETFs are more cost-efficient than normal unit trusts. Since
they track indices, they have very low operating and transaction costs
associated with them. There are no sales loads or minimum investment amount
required to purchase an ETF. The first ETF created was the Standard and Poor's
Deposit Receipt (SPDR, pronounced “Spider”) in 1993. SPDRs gave investors
an easy way to track the S&P 500 without buying an index fund, and they soon
became quite popular.
2.43 ETFs offer investors the benefit of diversification as investors need only to buy
an ETF share to gain exposure to a diversified portfolio of domestic or
international stocks. ETFs have low annual management fees. Investors may
buy or sell ETFs at prevailing market prices during trading hours in the relevant
stock exchange. Besides cost efficiency, ETFs also provide the benefits of
8. Fund Products
transparency and flexibility. Investors can access and monitor information on

ETF prices, and trade ETFs throughout the trading day. Moreover, they can
employ the traditional techniques of stock trading, including stop-loss orders,
limit orders, margin purchases, etc. Investors are also able to see what stocks
they are buying, as ETFs offer transparency in its portfolio composition.
Investors can track an ETF’s performance by monitoring the particular
underlying index’s performance. In this sense, ETFs provide an efficient way for
investors to invest in the stock market.
2.44 It should be noted that in Singapore, some brokerage houses have

recommended that ETFs be bought by investors using margin accounts (that is,
without paying for the full cost upfront). ETFs can be short-sold with the use of
CFDs (contracts for difference).
2.45 In considering using CFDs and margin accounts, investors should exercise care
and be aware of the risks involved. CFDs are complex financial derivatives, and
margin accounts can be highly leveraged. Investors can be caught and may be
short of cash if markets move in a somewhat erratic fashion.
2.46 Other risks associated with ETFs are: (a) investing in ETFs with longer than the
intended tracking period; (b) market risk; (c) counterparty risk; (d) tracking error
risk (the risk that the ETF’s performance is markedly different from the index
that it is tracking); (e) market price not reflecting NAV; (f) foreign exchange
risk; and (g) liquidity risk.
G2. Structuring Of ETF
2.47 Investors should first of all note that not all ETFs have the same structure and
level of complexity.
2.48 ETFs can be structured differently to track the same underlying index, and they
may not invest directly in the assets or components of the indices that they
track. For example, some ETFs replicate the index by fully investing in the
underlying index’s component stocks. Others may invest in a representative
sample of stocks from the index that they are designed to track. In view of this,
some ETFs may not be able to replicate the returns of the underlying asset or
index as closely as others. Consequently, some ETFs may be exposed to more
risks and have a higher tracking error than others.
2.49 Some ETFs come with more complex structures. They may even use swaps and
participatory notes, in addition to holding a basket of representative stocks or
collateral. Depending on the structure of the ETF, the risk elements may differ
greatly among ETFs. Hence, the use of swaps and notes exposes the ETF to
counterparty risk from the swap counterparty or participatory note issuer.
G3. Examples Of ETF
2.50 The objective of an ETF is to track a specific benchmark, such as a stock, a

commodity index or a commodity price. Here are some examples of assets or
indices tracked by ETFs that are available on the Singapore Exchange (SGX): (a)
commodity and commodity index; (b) bond index; and (c) equity.
(a) Commodity and commodity index - These ETFs are intended to provide
exposure to only one type of commodity or a basket of closely related
commodities. As such, they may not be as diversified as ETFs linked to a
broad-based equity index.
(b) Bond index – ETFs can also track a specific bond index, and provide
exposure to the fixed income market.
(c) Equity - There are two types of equity ETFs - long stock index ETFs and
inverse (“short”) index ETFs. Long index ETFs closely track the movement
of some indices and are expected to gain by a margin that is similar to that
of the index. On the other hand, inverse (“short”) index ETFs track the
movement of a short index. The short index moves inversely to its
corresponding long index on a daily basis. Note that these ETFs are
generally not intended for long-term investments and are generally not
suitable for retail investors who plan to hold them for longer than one day,
particularly not in volatile markets.
G4. Exchange Traded Note (ETN)
2.51 Although similar to ETFs, an ETN is actually a type of structured product and is
issued as a senior unsecured debt security, combining features of an ETF and a
bond. It is linked to and tracks the total return of a market index. ETNs are not
only traded on an exchange such as SGX, but also can come with a maturity
date, like bonds. The returns for an ETN are based upon the performance of a
particular market index, and its value is affected by many things, including
changes in the credit rating of the party that issued the ETN.
2.52 An ETN is issued by a third-party financial institution over a wide range of

assets. It combines both the benefits and risks common to investments in
bonds and ETFs. Like an ETF, ETN returns are meant to track the performance
of the underlying assets, such as an equity index, commodity price, currency
exchange rate, etc., minus investor fees. Like a bond, the value of the ETN
depends on market factors, as well as the credit rating of the issuer. Hence, it
gives retail and institutional investors a chance to gain exposure to a broad
range of commodities.
2.53 ETNs are suitable for investors who seek to invest in a debt instrument where
the returns are linked to the performance of the index underlying the ETNs.
Investors should be aware that an investment in ETNs will subject them to the
issuer’s credit risks.
2.54 The benefits of ETFs include: (a) ease of access; (b) intraday exchange liquidity;
and (c) transparent performance tracking. The risks of investing in ETNs
include: (i) credit risk of issuer; (ii) liquidity risk; (iii) market risk; and (iv) foreign
exchange risk.
8. Fund Products
H. Hedge Fund
2.55 A hedge fund aims to achieve absolute returns under any market condition. It is
different from the traditional funds described earlier. The investment objective
of a traditional fund is related to the benchmark that it has adopted. Hence, the
returns tend to be highly correlated with the returns of that benchmark.
2.56 In general, a hedge fund is open to a limited range of investors or wealthy

investors (hedge funds are restricted under U.S. law to fewer than 100
investors who typically put in a minimum of US$1 million each).
2.57 It also pays a performance fee to its investment manager. Every hedge fund has
its own investment strategy that determines the type of investments and the
methods of investment it undertakes. Hedge funds, as a class, invest in a broad
range of investments, including shares, debt, real estates, and commodities
(that are unlikely to all move in the same direction). The goal of diversification is
to reduce the risk in a portfolio. Volatility is limited by the fact that not all asset
classes, industries or individual companies move up and down in value at the
same time, or at the same rate. Diversification reduces both the upside and
downside potential, and allows for more consistent performance under a wide
range of economic conditions.
2.58 This provides them with an exemption in many jurisdictions from regulations
governing short selling, derivatives, leverage, fee structures and the liquidity of
interests in the fund, in comparison to the investment and trading activities of
other investment funds. This, along with the performance fee and the fund’s
open-end structure, differentiates a hedge fund from an ordinary investment
fund.
2.59 The net asset value of a hedge fund can run into many billions of dollars, and
the gross assets of the fund will usually be higher due to leverage. Hedge funds
dominate certain specialty markets, such as trading with derivatives, with high-
yield ratings and distressed debt. As the name implies, hedge funds often seek
to hedge some of the risks inherent in their investments using a variety of
methods, most notably short selling and derivatives. However, the term “hedge
fund” also extends to certain funds that do not hedge their investments, and in
particular, to funds using short selling and other “hedging” methods to increase
rather than reduce risk, with the expectation of increasing the return on their
investment.
H1. Hedge Fund Characteristics
H1A. Investment Objective

2.60 Hedge funds employ a variety of investment strategies, asset classes and
financial instruments to achieve absolute returns under all market conditions.
This is different from a traditional fund. The investment objective of a traditional
fund is related to the benchmark that it has adopted. Hence, the returns tend to
be highly correlated with the returns of that benchmark.
H1B. Fee Structure

2.61 It is common for a hedge fund to have a performance fee of up to 20% of the
excess return of the fund over a specified absolute return to incentivise the
fund manager to seek greater alpha for the investors. This is in addition to the
usual annual management fee of 1% to 2%. On the other hand, a traditional
fund rarely has a performance fee as part of its fee structure.
H1C. Lock–In Period

2.62 There are no rules governing the adoption of a certain level of liquidity in a
hedge fund. In fact, most of its investments may be invested in securities that
are highly illiquid. Hence, a hedge fund has guidelines on redemptions, such as
requiring advance notice to be served before hedge fund investors can redeem
their investments. This is to allow the manager time to liquidate his investment
to meet redemption needs. Traditional funds are usually invested in securities
that are highly liquid and thus typically do not impose a lock-in period.
H1D. Use Of Leverage

2.63 Unlike traditional funds, a hedge fund has provisions to use leverage in order to
gear up the portfolio.
H1E. Specialisation
2.64 Most hedge funds “specialise” in some narrowly defined investment strategies.
As a result, the underlying securities tend to have concentrated bets in the
direction of the market in one way or another. A description of some of the
common strategies is given below.
H2. Some Common Investment Strategies Used By Hedge Funds
2.65 The common investment strategies used by hedge funds include the
descriptions below.
H2A. Long/Short Equity

2.66 This is a relative strategy that involves going long on a segment of the market
that is likely to perform better than another market segment. There are many
ways to define market segments, such as value versus growth, USA market
versus European market, technology sector versus healthcare sector, emerging
market banks versus developed market banks. A long/short strategy may be
implemented by using stocks (where facilities exist for shorting) or by using
index derivatives.
H2B. Event-Driven
2.67 The managers take significant position in companies undergoing “special
situations”, such as mergers and acquisitions, corporate restructuring or
companies whose share price is trading at a distressed level without
fundamental justification.
H2C. Fixed-Income Arbitrage

2.68 This is a fixed income strategy whereby the manager strives to arbitrage on
price anomalies between related fixed income securities. Such anomalies may
8. Fund Products
include large or unusual spreads in the yields between government and

corporate bonds, emerging and developed market bonds, etc.
H2D. Global Macro

2.69 The manager takes long or short positions in the financial market to reflect his
views on economic trends or events. The shorting of emerging Asia equities and
selling of Asian currencies following the devaluation of the Thai Baht in 1997 is
an example of a global macro strategy. The strategy can be executed using
equities, bonds, currencies or commodities.
H2E. Convertible Arbitrage

2.70 This strategy involves taking a position in a convertible bond security and an
offsetting position in its underlying equities. An example of a convertible
arbitrage is that of buying the convertible bond of UOB Bank and simultaneously
shorting (i.e. selling) its underlying equities. Such a strategy can generate profit
from the relative spread between the price of the convertible bond and those of
its underlying equities.
H3. The Risks Of Hedge Fund Investing
2.71 It should be emphasised that investing in a hedge fund can be exceptionally

risky. It employs aggressive leverage to multiply gains (or losses) from
fluctuations in the prices of financial instruments (bonds, notes, securities, etc).
In Singapore, hedge funds are quite well regulated. For example, the Monetary
Authority of Singapore (MAS) regularly surveys the hedge fund industry in
Singapore to evaluate the Singapore banking sector’s exposure to hedge funds.
It has also regularly reviewed and revised the guidelines for retail hedge funds.
2.72 In general, Singapore's approach to regulating hedge funds is risk-focused and

differentiated, balancing the potential benefits with the risks that hedge funds
can pose to the financial system. Also, hedge fund managers are regulated like
any other fund manager that manages third-party funds. MAS’s regulatory
oversight of the marketing of hedge funds is focused on retail investors, as
retail investors may not be familiar with the differences between a hedge fund
and a typical collective investment scheme, especially when funds of hedge
funds and other hedge fund-linked products are increasingly being marketed to
the retail market.
2.73 Although heavily regulated, hedge funds may still suffer from huge losses when
the market turns against it for the reasons mentioned below. This is all the more
obvious when the value of hedge funds has dropped by a huge percentage
since the global recession got underway in 2008/2009.
2.74 Risks of investing in hedge funds include the following:

▪ highly concentrated bets taken by the manager;
▪ holding of illiquid securities may aggravate losses, when there is no orderly
asset-clearing prices;
▪ requirement of lock-in period suggests that investors cannot redeem their

investments at short notice, even when they are convinced that the market has
further downside ahead;
▪ use of leverage subjects the hedge fund to greater risk; or
▪ skewed structure of performance fee encourages excessive risk-taking without
adequate risk management measures by the fund manager, as seen in the
2008/2009 recession that was linked to the sub-prime mortgage crisis in the
USA.
H3A. Case study: The rise and fall of Long Term Capital Management
2.75 One of the most extraordinary investment stories of recent years is the rise and
fall of a hedge fund named Long Term Capital Management (LTCM). LTCM was
established in 1994, raising US$1 billion from financial institutions and wealthy
individuals as an initial stake. Its aim was to achieve above-average returns for
investors by exploiting short-term value differences in a very wide range of
international securities.
2.76 Here is an example of this approach. Suppose the yields on the bonds of
country X and country Y are expected to converge in the future for political or
economic reasons. If Country X’s bonds have a higher yield, they will be bought
while selling short an equivalent amount of country Y’s bonds in the futures
market as a hedge. In this case, the idea is that the investor will make a profit
irrespective of interest rate movements since there is a long position on country
X’s bonds and a short position on country Y’s bonds.
2.77 To increase its profits, LTCM made a large number of complex transactions
using margin. The firm used state-of-the-art mathematical models that analysed
very large amounts of historical price data to plan its transactions. These
models were quite effective under normal market conditions, allowing LTCM to
spot short-term inconsistencies.
2.78 In 1995 and 1996, LTCM produced impressively high returns of over 40% net
profit in a year. It had a cachet in financial circles as a firm on the cutting edge,
with two Nobel prize winners as employees and some very senior financiers as
investors.
2.79 Other derivatives traders began to find ways of using their techniques, and
gradually the number of arbitrage opportunities declined. In 1997, LTCM
reported a lower net profit of 17%. With its profits under pressure, the firm
began to take more risks by engaging in derivatives.
2.80 Unfortunately, 1997 was a year of financial chaos which the assumptions of
the firm’s pricing models did not predict. LTCM’s models assumed that stock
market volatility would be within a range of 15-20%. However, market volatility
increased to 19%, and LTCM took heavily leveraged positions in the
expectation that it would remain within that range.
8. Fund Products
2.81 Market volatility spiked to 38% and LTCM lost US$1.3 billion. The firm was
unable to unwind all its contracts immediately. The following year, 1998, was
no better. LTCM suffered more losses on derivatives, and there was now a
danger that if it collapsed, it would bring other firms down with it too and cause
a financial panic. It was alleged at the time that potential losses were as high as
US$80 billion.
2.82 To prevent a worldwide crisis, a number of LTCM’s creditors took control of the
firm and invested US$3.65 billion to allow it to gradually liquidate its positions.
H4. Fund Of Hedge Funds (FOHFs)
2.83 A fund of hedge funds is where the portfolio is constructed by selecting a

number of hedge funds to invest in. How the underlying hedge funds are
chosen can vary. A fund of hedge funds may invest only in hedge funds using a
particular management strategy. Alternatively, a fund of hedge funds may
invest in hedge funds using many different strategies in an attempt to gain
exposure to all of them. A fund of hedge funds can also invest in strategies
managed by a single manager, or a combination of different managers.
2.84 The benefits of investing in a fund of hedge funds include exposure to fund
management expertise and diversification between funds. A portfolio manager
uses his experience and skill to select the best underlying funds based on past
performance and other factors. If the portfolio manager is talented, this can
increase the return potential and decrease the risk potential, since putting your
eggs in more than one basket may reduce the dangers associated with investing
in a single hedge fund.
2.85 Given that most hedge funds have prohibitively high initial minimum
investments, a fund of hedge funds can theoretically provide investors access
to a number of the country’s best hedge funds, with a relatively smaller
investment. For example, investing in five hedge funds with a minimum
subscription amount of S$100,000 per fund will require S$500,000. Investing
in a fund of hedge funds that invests in those same underlying funds may
require just S$100,000.
2.86 In fact, it may require even less. Sometimes a fund of hedge funds will invest in
only one hedge fund, but offer shares at a much lower initial minimum
investment than the underlying hedge fund does. This gives investors access to
an acclaimed fund with less cash than is normally required. The minimum
subscription amount can at times be as low as S$20,000.
2.87 One disadvantage of investing in a fund of hedge funds is the layers of fees
being charged. These funds generally charge a fee for their services in addition
to the fees charged by the underlying hedge funds. In other words, each
underlying hedge fund will charge a fee of 1% to 2% of assets under
management and a performance fee of 15% to 25% of profits generated. On
top of that, a fund of hedge funds will typically charge its own fees.
2.88 In summary, funds of hedge funds may be appealing to investors seeking the
high return potential of hedge funds, along with some diversification to help
manage risk and lower investment minimums. As with any other investments,
investors should make sure that they know the risks and fees before investing.
3. INNOVATIVE UNIT TRUST INVESTMENT SCHEMES
3.1 During the unpredictable and volatile market conditions that characterised the
late 1990s and early 2000s (low interest rates and dismal performance of asset
classes, such as equity and fixed income securities), investors increasingly
sought new approaches to investing that offered both security and potential
growth. It was under these circumstances that financial engineering and
innovation in the fields of finance and investment brought about new product
features, such as “capital guarantee” and “capital protection”.
3.2 These innovative unit trusts aim to preserve the capital of investors and, at the
same time, enhance the returns that they would have otherwise earned from
keeping their money in bank deposits. Consequently, a number of new products
have been created, packaged and pushed into the market, often with fanciful
names, like “Principal Protected Notes” and “Guaranteed Linked Notes”.
A. “Capital Guaranteed” Fund
3.3 Under the “capital guaranteed” fund, the principal amount invested in the fund
is guaranteed by a financial institution at the end of a three- to five-year period
or longer. Investors who cash out before its maturity will not be entitled to
capital guarantee. A substantial portion of the underlying assets in a guaranteed
fund comprises mainly good quality fixed income securities known as zero-
coupon bonds (which are essentially bonds that do not have coupons). The
remainder is invested in long-dated derivative instruments that provide higher
return to the fund upon its maturity, assuming the derivative instrument is in
the money (i.e. profitable) by then.
3.4 Take for instance a “capital guaranteed” fund with a fund size of S$100 million
and that matures in five years. Then assume that the yield on good quality fixed
income securities is 3% per annum over the next five years. The minimum
amount of principal that needs to be invested today to generate S$100 million
in five years’ time will be:
S$100m
= S$86.26m
(1 + 0.03)5
3.5 Assuming that the projected fees (such as custodian, trustee and management
fees) aggregated to S$5m over the 5-year period, the remaining amount that
can be used to buy into some derivative instruments to provide for potential
upside to the fund is up to S$8.74 m (S$100m – S$86.26m – S$5m =
S$8.74m). The derivative instrument may be an option on the STI Index that is
customised by an investment bank to suit the maturity profile of the fund. If, at
8. Fund Products
the end of the 5-year period, the STI Index is higher than the strike price of the
option, investors in the fund will enjoy higher return. If the STI Index is lower
than the strike price of the option, the option will expire worthless. In this case,
investors will still get back their principal from the portion invested in the fixed
income securities.
3.6 The risk of such a fund lies in credit default in any of its bond holdings.
However, such a risk can be reduced by diversifying the underlying securities,
going with underlying securities of very good quality, or investing more than the
minimum amount needed to generate the principal at the end of the guarantee
period. However, the last option is usually not advisable, as this will be costly
and will make the economics and return on the product less attractive. The final
protection to investors will be to call on the guarantee.
3.7 The guaranteed fund trades at its Net Asset Value (NAV) before its maturity.
Investors who cash out before the end of the maturity of the fund will do so at
the prevailing NAV. This can be above or below the principal amount. At
maturity, if the NAV is above the principal, investors will cash out at the NAV.
On the other hand, if the NAV at maturity is less than the principal, the
investors will receive the principal amount as guaranteed, to be topped up by
the financial institution offering the principal guaranteed fund.
B. “Capital Protected” Fund
3.8 This is similar to a “capital guaranteed” fund, except that the principal amount
is not guaranteed. Instead, the fund is “protected” by its investment in high
quality fixed income securities (e.g. sovereign bonds). In the event that the
NAV of the fund is below that of the principal at maturity, investors will still get
back their principal, unless there is a default in one or more of the fixed income
securities that the fund is invested in.
3.9 The return profile of the “capital protected” fund is similar to that of the
guaranteed fund, so long as the NAV is above the principal amount. However,
when the NAV is lower than the principal amount, the investors in a “capital
protected” fund may face some downside risk, depending on how the fund is
structured. There are also products in the market protecting only a portion of
the principal (e.g. 90%), but not the full amount.
3.10 There are many innovative features on such funds. Such features usually
revolve around the pattern of cash flow accruing to the investors during the
tenure of the fund. For example, some funds pay a predetermined rate of return
during the tenure of the fund. Others attempt to “lock-in” some capital gains, if
any, on the derivative instrument on a yearly basis.
B1. Prohibition On The Use Of The Term “Capital / Principal Protected”
3.11 Having explained the concept of “capital protected” fund above, it should,
however, be noted that with effect from 8 September 2009, the use of the
term “capital protected” or “principal protected” or any other derivative or form
of this term in all disclosure documents, and sales and marketing materials
would be prohibited.
3.12 In the process, MAS has solicited definitions for “capital protected” and
“principal protected”. Unfortunately, the suggested definitions tend to be quite
lengthy and not easily understood by investors. Furthermore, investors may not
understand that a number of conditions need to be satisfied before they may
receive in full their principal at maturity. In view of the lack of an agreement on
the definition of such terms that could be clearly and easily understood by
investors, MAS proceeded with the ban. This was also specified in the April
2011 release of the Code on Collective Investment Scheme.
3.13 Having made the above decision, MAS stressed that the prohibition does not
intend to discourage the selling of products structured with the objective of
returning full principal to investors at maturity. However, issuers and
distributors should highlight to the investors that these products would not
unconditionally guarantee the return at maturity of their principal amounts
invested.
3.14 Details of the revised Code are specified in the MAS website which should be
visited for guidance from time to time at:
https://www.mas.gov.sg/regulation/codes/code-on-collective-investment-
schemes. The revised Code is also covered in CMFAS Module 5 – Rules and
Regulations for Financial Advisory Services published by the Singapore College
of Insurance.
4. INVESTMENT TRUST, REAL ESTATE INVESTMENT TRUST (REIT) AND

BUSINESS TRUSTS
A. Investment Trust
4.1 An investment trust is a company formed for the purpose of investing in

securities. In that respect, it is similar to a unit trust in that the funds are
professionally managed. However, it differs from a unit trust in the following
ways:
A1. It Has No Independent Trustee
4.2 The legal title of all its assets is vested in the company. The board of directors
safeguards the interests of shareholders in an investment trust.
A2. The Capital Fund Of The Trust Is Fixed
4.3 In other words, an investment trust is a closed-end fund, as compared to a unit

trust which is usually open-end. In the case of a closed-end fund, the capital
fund is fixed. For every buyer in a share of the investment trust, there must be
a seller. Buying and selling of investment trust are done just like in any other
share that is listed on the stock exchange.
8. Fund Products
4.4 An investment trust usually trades at a discount to its underlying assets. This
can be due to any of the following reasons:
▪ the trading in the shares of an investment trust is illiquid;
▪ the investment trust may not be managed in a way in which the risk-return of
the fund is maximised. This can happen, for example, when the investment
trust is used to invest in companies related to the trust; or
▪ the investment trust is tightly held. Hence, minority investors cannot seek to
break up the trust in order to realise the value of the underlying assets.
B. Real Estate Investment Trust (REIT)
4.5 A REIT is a specialised form of investment trust. It is an investment vehicle

where the funds of individual investors are pooled together to invest in or
purchase and manage income property (equity REIT) and/or mortgage loans
(mortgage REIT). A REIT can thus be classified as equity, mortgage or hybrid.
4.6 REITs are traded on major stock exchanges just like stocks. They are also
granted special tax considerations. REITs offer several benefits over actually
owning properties. First, they are highly liquid, unlike traditional real estate.
Second, REITs enable sharing in non-residential properties as well, such as
hotels, malls, logistics, offices and other commercial or industrial properties.
Third, there is no minimum investment with REITs. REITs do not necessarily
increase or decrease in value along with the broader market. However, they
may pay yields in the form of dividends when the underlying property and loans
generate net income or profits. REITs can be valued based upon fundamental
measures, similar to the valuation of stocks.
4.7 In many respects, a REIT is similar to any unit trust, such as in providing the
benefits of diversification, professional management, affordability and liquidity.
Yet, a REIT can be different from a typical unit trust in the following ways:
(a) It requires a wider range of specialists to manage. A REIT manager has to
be more hands-on and knowledgeable, as he is involved in the actual
running and operation of the properties which he buys into;
(b) Its market value is determined by the demand and supply of its shares in
the stock exchange. A unit trust, on the other hand, trades at its net asset
value; and
(c) It pays a substantial portion of the surplus to investors. This surplus is
determined after deducting the income generated from its underlying
properties, and all relevant expenses necessary to maintain the property.
4.8 There are different types of REITs. They can be sector-specific, such as being
invested only in office properties. Alternatively, they can be hybrid, with
investments in different sectors of property, such as offices, retail and industrial
warehouses. REITs are long-term investments and are subjected to the ups and
downs of the property cycle. Like other corporations, REITs can be publicly or
privately held. Public REITs may be listed on stock exchanges like shares of
common stocks in other firms. Equity REITs invest in and own properties (and
are thus responsible for the equity or value of their real estate assets). Their
revenues come principally from their properties’ rents. Mortgage REITs deal in
investment and ownership of property mortgages. These REITs loan money for
mortgages to owners of real estate, or purchase existing mortgages or
mortgage-backed securities. Their revenues are generated primarily by the
interest that they earn on the mortgage loans. Hybrid REITs combine the
investment strategies of equity REITs and mortgage REITs by investing in both
properties and mortgages.
4.9 In July 2002, CapitalMall became the first REIT to be listed on the SGX. Since
1 June 2011, 20 REITs have been listed on the SGX. They represent a range of
property sectors, including retail, office, industrial, hospitality, logistics and
residential. These REITs hold a variety of properties in countries, including
Japan, China, Indonesia and Hong Kong, in addition to properties in Singapore.
REITs also enjoy a tax-advantage position in Singapore. In return, they are
required to distribute 90% of their income, which may be taxable in the hands
of the investors. From the above description, it can be seen that the REIT
structure is designed to provide a similar structure for investment in real estate,
like the way unit trusts provide for investment in stocks.
4.10 In October 2014, the Monetary Authority of Singapore (“MAS”) released a

consultation paper highlighting potential changes to the current regulatory
regime governing REITs and REIT managers. In response to industry feedback,
MAS approved the following changes to strengthen the REITS market. Key
measures include:
(a) improving corporate governance and disclosures for REIT managers for
example through the disclosure of remuneration policies and procedures in
annual reports;
(b) increasing transparency in the fee structure to minimise “conflicts of
interests” between REIT managers and investors by disclosing the
justification for each type of fees charged as well as the methodology for
computing performance fees; and
(c) increasing operational flexibility through the increase in the development
limit of a REIT from 10% to 25% of its deposited property. In addition, a
REIT will now have a higher leverage limit of 45% (versus 35% currently)
of its total assets. However, REITs with credit ratings will no longer be
allowed to leverage up to 60%.
4.11 These amendments will come into effect in various stages, beginning on 1 Jan
2016.1
1
Source: www.mas.gov.sg
8. Fund Products
B1. Factors That Affect Returns On REITs
4.12 Unitholders of REITs are subjected to similar risks as holders of other diversified
asset portfolios. Some of the factors that affect returns on REITs are discussed
below.
(a) A rise or decline in the general level of real property prices can adversely
affect the value of a REIT. The overall depth and liquidity of the real estate
market and other assets in which REITs are invested may fluctuate and can
correspondingly affect the depth and liquidity of trading in REITs;
(b) A rise or decline in rental income will affect the distribution that the REITs
are able to return to the investors, and this will affect the value of the REIT;
(c) The overall performance or expected performance of the real estate industry
and other related industries;
(d) The general economic climate and outlook;
(e) Wear and tear, and disasters which damage physical real estate assets
owned by the REITs;
(f) Substantial increase or fall in interest rates, making a listed REIT less or
more attractive as an investment instrument;
(g) Professionalism and experience affecting the performance of the property
management firm;
(h) Quality of assets owned by the REITs, essentially affecting sustainability
and stability of revenues; and
(i) Laws and taxation changes affecting real estate property prices which may
impact returns on the REITs. REITs participating in properties or
investments outside Singapore may be subjected to the risks of fluctuations
in currency values, differences in generally accepted accounting principles,
or local economic or political events in the countries in which those
properties or investments are located.
C. Business Trusts2
4.13 Business trusts offer investors a new way to invest in cash-generating assets.
Business trusts are business enterprises set up as trusts, instead of companies.
They are hybrid structures with elements of both companies and trusts.
4.14 Like a company, a business trust operates and runs a business enterprise.
However, unlike a company, a business trust is not a separate legal entity. It is
created by a trust deed under which the trustee has legal ownership of the trust
assets and manages the assets for the benefit of the beneficiaries of the trust.
4.15 Purchasers of units in the business trusts, being beneficiaries of the trust, hold
beneficial interest in assets of the business trust.
2
Source: www.sgx.com
4.16 While REITs are regulated as property funds under the Code on Collective
Investment Schemes, business trusts are governed by the Business Trusts Act
(Cap. 31A) under a different regime.
4.17 One of the key differences between business trusts and REITs is that business
trusts are premised on a single responsible entity, namely the Trustee-Manager.
Whereas in the case of REITs where the assets are legally owned by the
trustee, in a business trust, the assets are managed by a separate asset
manager, more like unit trusts and mutual funds.
4.18 The shares in the trustee-manager will likely be owned by the sponsor of the
business trust, which is likely to sponsor the trust by injecting assets into the
business trust. The trustee-manager will raise funds from public investors by
issuing business trust units in an initial public offering. The proceeds from the
initial public offering, together with any borrowings, will be used to acquire the
trust assets.
4.19 The trustee-manager of business trusts thus has dual responsibility of

safeguarding the interests of unitholders and managing the business trusts. This
stems from the difficulty in apportioning the fiduciary responsibility between
two roles given the nature of business trusts as active enterprises.
4.20 To address any potential conflict of duties of the trustee-manager to the

shareholders of the trustee-manager and to the unitholders of the business
trust, the Business Trust Act (Cap. 31A) stipulates a higher requirement on
corporate governance.
4.21 Another key difference is in taxation. While REITs with Singapore assets have a
tax-transparent investment structure focused on real estate assets, business
trusts are like companies, subject to the Income Tax Act (Cap. 134). However,
certain assets or businesses that enjoy tax benefits under the Income Tax Act
(Cap. 134) will continue to enjoy these benefits.
C1. Benefits And Risks Of Investing In Business Trusts3
4.22 Business trusts allow investors to have direct exposure to cash flow-generating
assets, such as utilities, shipping or aircraft. The structure unitises big ticket
assets into liquid and affordable units which are traded on the Singapore
Exchange, giving investors a new alternative to existing yield plays.
4.23 Business trusts typically have high payout ratios because of their ability to
distribute cash flows in excess of accounting profits. This imposes discipline on
the trustee-manager when considering acquisitions.
4.24 In addition to maintaining the payout, the trustee-manager, as the responsible

entity, is also expected to actively manage the business for growth via
acquisitions and expansion, to enhance returns to the investors. The incentives
3
Source: www.sgx.com
8. Fund Products
of the trustee-managers are typically structured to align their interests with

those of the unitholders.
4.25 The risks of investing in business trusts will largely depend on the kind of
assets and investment focus the business trust has. These include, but are not
limited to, risks that the value of the units may fluctuate and that the projected
distributions may not be achieved, as well as other risks. Investors should
carefully read the prospectus and seek advice from the relevant professionals in
evaluating any potential investments in business trusts.
5. SUMMARY
5.1 This chapter covers the various types of fund products which include the
following:
▪ Main types of unit trusts and funds, and their characteristics, which include
equity funds, fixed income funds, balanced funds, money market funds,
umbrella funds, feeder and UCITS funds, index fund and exchange traded
funds;
▪ Discussion on hedge fund overview and some common investment strategies
employed by hedge funds;
▪ Risks of hedge fund investing, with a case study on Long Term Capital
Management provided;
▪ Evolution of the innovative unit trust investment schemes which include
product features such as “capital guarantee” and “capital protection”, and
MAS’s stance on these investment schemes;
▪ Overview of investment trusts, real estate investment trusts (REITs) and
business trusts.
Table 1 Future Value Interest Factors For One Dollar

i= 0.5% 1% 1.5% 2% 2.5% 3% 3.5% 4% 4.5% 5%

n=1 1.0050 1.0100 1.0150 1.0200 1.0250 1.0300 1.0350 1.0400 1.0450 1.0500
2 1.0100 1.0201 1.0302 1.0404 1.0506 1.0609 1.0712 1.0816 1.0920 1.1025
3 1.0151 1.0303 1.0457 1.0612 1.0769 1.0927 1.1087 1.1249 1.1412 1.1576
4 1.0202 1.0406 1.0614 1.0824 1.1038 1.1255 1.1475 1.1699 1.1925 1.2155
5 1.0253 1.0510 1.0773 1.1041 1.1314 1.1593 1.1877 1.2167 1.2462 1.2763
6 1.0304 1.0615 1.0934 1.1262 1.1597 1.1941 1.2293 1.2653 1.3023 1.3401
7 1.0355 1.0721 1.1098 1.1487 1.1887 1.2299 1.2723 1.3159 1.3609 1.4071
8 1.0407 1.0829 1.1265 1.1717 1.2184 1.2668 1.3168 1.3686 1.4221 1.4775
9 1.0459 1.0937 1.1434 1.1951 1.2489 1.3048 1.3629 1.4233 1.4861 1.5513
10 1.0511 1.1046 1.1605 1.2190 1.2801 1.3439 1.4106 1.4802 1.5530 1.6289
11 1.0564 1.1157 1.1779 1.2434 1.3121 1.3842 1.4600 1.5395 1.6229 1.7103
12 1.0617 1.1268 1.1956 1.2682 1.3449 1.4258 1.5111 1.6010 1.6959 1.7959
13 1.0670 1.1381 1.2136 1.2936 1.3785 1.4685 1.5640 1.6651 1.7722 1.8856
14 1.0723 1.1495 1.2318 1.3195 1.4130 1.5126 1.6187 1.7317 1.8519 1.9799
15 1.0777 1.1610 1.2502 1.3459 1.4483 1.5580 1.6753 1.8009 1.9353 2.0789
16 1.0831 1.1726 1.2690 1.3728 1.4845 1.6047 1.7340 1.8730 2.0224 2.1829
17 1.0885 1.1843 1.2880 1.4002 1.5216 1.6528 1.7947 1.9479 2.1134 2.2920
18 1.0939 1.1961 1.3073 1.4282 1.5597 1.7024 1.8575 2.0258 2.2085 2.4066
19 1.0994 1.2081 1.3270 1.4568 1.5987 1.7535 1.9225 2.1068 2.3079 2.5270
20 1.1049 1.2202 1.3469 1.4859 1.6386 1.8061 1.9898 2.1911 2.4117 2.6533
21 1.1104 1.2324 1.3671 1.5157 1.6796 1.8603 2.0594 2.2788 2.5202 2.7860
22 1.1160 1.2447 1.3876 1.5460 1.7216 1.9161 2.1315 2.3699 2.6337 2.9253
23 1.1216 1.2572 1.4084 1.5769 1.7646 1.9736 2.2061 2.4647 2.7522 3.0715
24 1.1272 1.2697 1.4295 1.6084 1.8087 2.0328 2.2833 2.5633 2.8760 3.2251
25 1.1328 1.2824 1.4509 1.6406 1.8539 2.0938 2.3632 2.6658 3.0054 3.3864
26 1.1385 1.2953 1.4727 1.6734 1.9003 2.1566 2.4460 2.7725 3.1407 3.5557
27 1.1442 1.3082 1.4948 1.7069 1.9478 2.2213 2.5316 2.8834 3.2820 3.7335
28 1.1499 1.3213 1.5172 1.7410 1.9965 2.2879 2.6202 2.9987 3.4297 3.9201
29 1.1556 1.3345 1.5400 1.7758 2.0464 2.3566 2.7119 3.1187 3.5840 4.1161
30 1.1614 1.3478 1.5631 1.8114 2.0976 2.4273 2.8068 3.2434 3.7453 4.3219
35 1.1907 1.4166 1.6839 1.9999 2.3732 2.8139 3.3336 3.9461 4.6673 5.5160
40 1.2208 1.4889 1.8140 2.2080 2.6851 3.2620 3.9593 4.8010 5.8164 7.0400
45 1.2516 1.5648 1.9542 2.4379 3.0379 3.7816 4.7024 5.8412 7.2482 8.9850
50 1.2832 1.6446 2.1052 2.6916 3.4371 4.3839 5.5849 7.1067 9.0326 11.4674
Table 1: Future Value Interest Factors For One Dollar
i= 5.5% 6% 6.5% 7% 7.5% 8% 8.5% 9% 9.5% 10%

n=1 1.0550 1.0600 1.0650 1.0700 1.0750 1.0800 1.0850 1.0900 1.0950 1.1000
2 1.1130 1.1236 1.1342 1.1449 1.1556 1.1664 1.1772 1.1881 1.1990 1.2100
3 1.1742 1.1910 1.2079 1.2250 1.2423 1.2597 1.2773 1.2950 1.3129 1.3310
4 1.2388 1.2625 1.2865 1.3108 1.3355 1.3605 1.3859 1.4116 1.4377 1.4641
5 1.3070 1.3382 1.3701 1.4026 1.4356 1.4693 1.5037 1.5386 1.5742 1.6105
6 1.3788 1.4185 1.4591 1.5007 1.5433 1.5869 1.6315 1.6771 1.7238 1.7716
7 1.4547 1.5036 1.5540 1.6058 1.6590 1.7138 1.7701 1.8280 1.8876 1.9487
8 1.5347 1.5938 1.6550 1.7182 1.7835 1.8509 1.9206 1.9926 2.0669 2.1436
9 1.6191 1.6895 1.7626 1.8385 1.9172 1.9990 2.0839 2.1719 2.2632 2.3579
10 1.7081 1.7908 1.8771 1.9672 2.0610 2.1589 2.2610 2.3674 2.4782 2.5937
11 1.8021 1.8983 1.9992 2.1049 2.2156 2.3316 2.4532 2.5804 2.7137 2.8531
12 1.9012 2.0122 2.1291 2.2522 2.3818 2.5182 2.6617 2.8127 2.9715 3.1384
13 2.0058 2.1329 2.2675 2.4098 2.5604 2.7196 2.8879 3.0658 3.2537 3.4523
14 2.1161 2.2609 2.4149 2.5785 2.7524 2.9372 3.1334 3.3417 3.5629 3.7975
15 2.2325 2.3966 2.5718 2.7590 2.9589 3.1722 3.3997 3.6425 3.9013 4.1772
16 2.3553 2.5404 2.7390 2.9522 3.1808 3.4259 3.6887 3.9703 4.2719 4.5950
17 2.4848 2.6928 2.9170 3.1588 3.4194 3.7000 4.0023 4.3276 4.6778 5.0545
18 2.6215 2.8543 3.1067 3.3799 3.6758 3.9960 4.3425 4.7171 5.1222 5.5599
19 2.7656 3.0256 3.3086 3.6165 3.9515 4.3157 4.7116 5.1417 5.6088 6.1159
20 2.9178 3.2071 3.5236 3.8697 4.2479 4.6610 5.1120 5.6044 6.1416 6.7275
21 3.0782 3.3996 3.7527 4.1406 4.5664 5.0338 5.5466 6.1088 6.7251 7.4002
22 3.2475 3.6035 3.9966 4.4304 4.9089 5.4365 6.0180 6.6586 7.3639 8.1403
23 3.4262 3.8197 4.2564 4.7405 5.2771 5.8715 6.5296 7.2579 8.0635 8.9543
24 3.6146 4.0489 4.5331 5.0724 5.6729 6.3412 7.0846 7.9111 8.8296 9.8497
25 3.8134 4.2919 4.8277 5.4274 6.0983 6.8485 7.6868 8.6231 9.6684 10.8347
26 4.0231 4.5494 5.1415 5.8074 6.5557 7.3964 8.3401 9.3992 10.5869 11.9182
27 4.2444 4.8223 5.4757 6.2139 7.0474 7.9881 9.0490 10.2451 11.5926 13.1100
28 4.4778 5.1117 5.8316 6.6488 7.5759 8.6271 9.8182 11.1671 12.6939 14.4210
29 4.7241 5.4184 6.2107 7.1143 8.1441 9.3173 10.6528 12.1722 13.8998 15.8631
30 4.9840 5.7435 6.6144 7.6123 8.7550 10.0627 11.5583 13.2677 15.2203 17.4494
35 6.5138 7.6861 9.0623 10.6766 12.5689 14.7853 17.3796 20.4140 23.9604 28.1024
40 8.5133 10.2857 12.4161 14.9745 18.0442 21.7245 26.1330 31.4094 37.7194 45.2593
45 11.1266 13.7646 17.0111 21.0025 25.9048 31.9204 39.2951 48.3273 59.3793 72.8905
50 14.5420 18.4202 23.3067 29.4570 37.1897 46.9016 59.0863 74.3575 93.4773 117.391
i= 10.5% 11% 11.5% 12% 12.5% 13% 13.5% 14% 14.5% 15%
n=1 1.1050 1.1100 1.1150 1.1200 1.1250 1.1300 1.1350 1.1400 1.1450 1.1500
2 1.2210 1.2321 1.2432 1.2544 1.2656 1.2769 1.2882 1.2996 1.3110 1.3225
3 1.3492 1.3676 1.3862 1.4049 1.4238 1.4429 1.4621 1.4815 1.5011 1.5209
4 1.4909 1.5181 1.5456 1.5735 1.6018 1.6305 1.6595 1.6890 1.7188 1.7490
5 1.6474 1.6851 1.7234 1.7623 1.8020 1.8424 1.8836 1.9254 1.9680 2.0114
6 1.8204 1.8704 1.9215 1.9738 2.0273 2.0820 2.1378 2.1950 2.2534 2.3131
7 2.0116 2.0762 2.1425 2.2107 2.2807 2.3526 2.4264 2.5023 2.5801 2.6600
8 2.2228 2.3045 2.3889 2.4760 2.5658 2.6584 2.7540 2.8526 2.9542 3.0590
9 2.4562 2.5580 2.6636 2.7731 2.8865 3.0040 3.1258 3.2519 3.3826 3.5179
10 2.7141 2.8394 2.9699 3.1058 3.2473 3.3946 3.5478 3.7072 3.8731 4.0456
11 2.9991 3.1518 3.3115 3.4785 3.6532 3.8359 4.0267 4.2262 4.4347 4.6524
12 3.3140 3.4985 3.6923 3.8960 4.1099 4.3345 4.5704 4.8179 5.0777 5.3503
13 3.6619 3.8833 4.1169 4.3635 4.6236 4.8980 5.1874 5.4924 5.8140 6.1528
14 4.0464 4.3104 4.5904 4.8871 5.2016 5.5348 5.8877 6.2613 6.6570 7.0757
15 4.4713 4.7846 5.1183 5.4736 5.8518 6.2543 6.6825 7.1379 7.6222 8.1371
16 4.9408 5.3109 5.7069 6.1304 6.5833 7.0673 7.5846 8.1372 8.7275 9.3576
17 5.4596 5.8951 6.3632 6.8660 7.4062 7.9861 8.6085 9.2765 9.9929 10.7613
18 6.0328 6.5436 7.0949 7.6900 8.3319 9.0243 9.7707 10.5752 11.4419 12.3755
19 6.6663 7.2633 7.9108 8.6128 9.3734 10.1974 11.0897 12.0557 13.1010 14.2318
20 7.3662 8.0623 8.8206 9.6463 10.5451 11.5231 12.5869 13.7435 15.0006 16.3665
21 8.1397 8.9492 9.8350 10.8038 11.8632 13.0211 14.2861 15.6676 17.1757 18.8215
22 8.9944 9.9336 10.9660 12.1003 13.3461 14.7138 16.2147 17.8610 19.6662 21.6447
23 9.9388 11.0263 12.2271 13.5523 15.0144 16.6266 18.4037 20.3616 22.5178 24.8915
24 10.9823 12.2392 13.6332 15.1786 16.8912 18.7881 20.8882 23.2122 25.7829 28.6252
25 12.1355 13.5855 15.2010 17.0001 19.0026 21.2305 23.7081 26.4619 29.5214 32.9190
26 13.4097 15.0799 16.9491 19.0401 21.3779 23.9905 26.9087 30.1666 33.8020 37.8568
27 14.8177 16.7386 18.8982 21.3249 24.0502 27.1093 30.5414 34.3899 38.7033 43.5353
28 16.3736 18.5799 21.0715 23.8839 27.0564 30.6335 34.6644 39.2045 44.3153 50.0656
29 18.0928 20.6237 23.4948 26.7499 30.4385 34.6158 39.3441 44.6931 50.7410 57.5755
30 19.9926 22.8923 26.1967 29.9599 34.2433 39.1159 44.6556 50.9502 58.0985 66.2118
35 32.9367 38.5749 45.1461 52.7996 61.7075 72.0685 84.1115 98.1002 114.338 133.176
40 54.2614 65.0009 77.8027 93.0510 111.199 132.782 158.429 188.884 225.019 267.864
45 89.3928 109.530 134.082 163.988 200.384 244.641 298.410 363.679 442.840 538.769
50 147.270 184.565 231.070 289.002 361.099 450.736 562.073 700.233 871.514 1083.66
Table 1: Future Value Interest Factors For One Dollar
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Collective Investment

Nurturing Asia’s Best

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1st Edition published in 2002.

Capital Markets and Financial Advisory Services Examination –

Organisation of the Study Guide

Chapter 1: Provides an overview of the nature of a broad range of financial assets,

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Chapter 3: Discusses the mechanics of bond markets, equity markets, derivative

Chapter 6: Discusses the important factors to consider when planning for an

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Chapter Outline and Key Learning Points

Revisions And Updates

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Chapter 1 Types Of Investment Assets – I 1

Chapter 2 Types Of Investment Assets – II 29

Chapter 3 Financial Markets 49

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B. Types Of Financial Claims

Chapter 4 Risk And Return 67

5. Sources Of Investment Risk

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Chapter 5 Time Value Of Money 91

1. The Basics Of Time Value Of Money

Chapter 6 Considerations For Investments 105

Chapter 7 Unit Trusts 123

C. Brief Overview Of The Administration And Control Over Unit Trusts

D. Past Performance Is Not A Reliable Indicator Of Future Performance

Chapter 8 Fund Products 139

G. Index Fund And Exchange Traded Funds (ETF)

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KEY LEARNING POINTS

After reading this chapter, you should be able to:

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Cash And Its Equivalents, And Money Market Instruments

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2.4 Money market securities or instruments are similar in nature to cash

A1. Cash Equivalents Include Bank Deposits And Time Deposits

A1A. Bank Deposits

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2.11 Each DI Scheme member maintains a register of insured deposits it offers. To

2.12 The following financial products are not insured by SDIC:

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Example 1.1: Calculation of deposit insurance coverage if there is more than

Account Amount Amount Not

2.15 The explanation is as follows:

Account Amount Amount Not

2.18 The explanation is as follows:

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A1B. Time Deposits