Introduction To Financial Markets PDF

The South African Institute of Financial Markets
Introduction to Financial Markets
Ingrid Goodspeed: May 2013
Preface
The Registered Person Examination (RPE) has been designed as an entry-level qualification for the
South African financial markets. The qualification has eight modules:
The Regulation and Ethics of the South African Financial Markets (compulsory module)
Introduction to the Financial Markets (compulsory module)
The Equity Market (elective module)
The Bond Market (elective module)
The Derivatives Market (elective module)
The South African Money Market (elective module)
The South African Foreign Exchange Market (elective module)
Agricultural Products Market Dealers Examination (elective module)
The objective of this module is to provide the student with the necessary information to understand
the financial markets in South Africa and internationally and to prepare the student for the South
African Institute of Financial Markets Introduction to Financial Markets examination.
The guide is structured as follows: chapter 1 outlines the financial system of which financial markets
are an integral part. Chapter 2 discusses the macro-economic environment in which financial
markets function. Chapters 3 and 4 introduce the quantitative aspects of financial markets
respectively, the time value of money and statistics. Chapters 5, 6, 7, 8, 9 and 10 focus on the
features, instruments, and participants of the foreign exchange, money, bond, equity, derivatives
and commodities markets respectively. Chapter 11 outlines savings and investment instruments.
Portfolio management - the process of putting together and maintaining the proper set of assets
(such as those discussed in chapter 5 to 10) to meet the objectives of the investor - is considered in
chapters 12 and 13.
Students are encouraged to keep up to date with local and international financial market
developments. The following internet sites may prove useful:
South Africa
International
JSE Ltd
www.jse.co.za
Financial Services Board
www.fsb.co.za
National Treasury
www.treasury.gov.za
Strate Ltd
www.strate.co.za
South African Reserve Bank
www.reservebank.co.za
Bank for International Settlements
www.bis.org
International Monetary Fund
www.imf.org
World Bank
www.worldbank.org
New York Stock Exchange
www.nyse.com
London Stock Exchange
www.londonstockexchange.com
NYSE Euronext (including LIFFE)
www.euronext.com
World Federation of Exchanges
www.world-exchanges.org
Table of contents
1
The financial system ......................................................................................................... 8
The economy .................................................................................................................. 28
Time value of money ...................................................................................................... 54
Introduction to statistical concepts................................................................................ 68
The foreign exchange market ......................................................................................... 88
The money market ......................................................................................................... 96
The bond and long-term debt market .......................................................................... 106
The equity market ........................................................................................................ 115
The derivatives market ................................................................................................. 129
10
The commodities market ............................................................................................. 149
11
Investment instruments ............................................................................................... 159
12
Introduction to portfolio theory ................................................................................... 175
13
Portfolio Management ................................................................................................. 209
Glossary .................................................................................................................................. 220

Bibliography ........................................................................................................................... 225
Appendix A: Formula sheet Introduction to the financial markets ....................................... 227
Detailed table of contents

1
The financial system ......................................................................................................... 8
1.1
The financial system defined ........................................................................................................ 8
1.2
The flow of funds and financial intermediation ........................................................................... 9
1.3
Functions of the financial system ............................................................................................... 19
1.4
Financial market rates ................................................................................................................ 21
1.5
Determining financial market prices .......................................................................................... 23
The economy .................................................................................................................. 28
2.1
Economic systems....................................................................................................................... 28
2.2
The flows of economic activity ................................................................................................... 30
2.3
Economic objectives ................................................................................................................... 33
2.4
Economic policy .......................................................................................................................... 33
2.5
Business cycle ............................................................................................................................. 36
2.6
Economic indicators.................................................................................................................... 41
2.7
Globalisation of financial markets .............................................................................................. 50
Time value of money ...................................................................................................... 54
3.1
Introduction ................................................................................................................................ 54
3.2
The yield curve ............................................................................................................................ 55
3.3
Interest rate calculations ............................................................................................................ 58
3.4
Present and future value of an annuity ...................................................................................... 62
3.5
Present and future values of unequal cash flows....................................................................... 63
3.6
Net present value ....................................................................................................................... 64
3.7
Internal rate of return................................................................................................................. 65
Introduction to statistical concepts................................................................................ 68
4.1
Introduction ................................................................................................................................ 68
4.2
Descriptive statistics ................................................................................................................... 69
4.3
Inferential statistics .................................................................................................................... 79
The foreign exchange market ......................................................................................... 88
5.1
The market defined .................................................................................................................... 88
5.2
Characteristics of the market ..................................................................................................... 89
5.3
Foreign exchange market instruments ....................................................................................... 90
5.4
Foreign exchange market participants ....................................................................................... 92
The money market ......................................................................................................... 96
6.1
The market defined .................................................................................................................... 96
6.2
Characteristics of the market ..................................................................................................... 96
6.3
Money market instruments ........................................................................................................ 97
6.4
Money market participants ...................................................................................................... 102
The bond and long-term debt market .......................................................................... 106
7.1
The market defined .................................................................................................................. 106
7.2
Characteristics of the market ................................................................................................... 106
7.3
Bond and long-term debt instruments ..................................................................................... 107
7.4
Bond and long-term debt market participants ......................................................................... 111
The equity market ........................................................................................................ 115
8.1
8.2
8.3
Equity market instruments ....................................................................................................... 121
8.4
Equity market participants ....................................................................................................... 125
The derivatives market ................................................................................................. 129
9.1
9.2
9.3
Derivative instruments ............................................................................................................. 131
9.4
Participants in the derivatives market...................................................................................... 143
10
The commodities market ............................................................................................. 149
10.1 The market defined .................................................................................................................. 149

10.2 Characteristics of the market ................................................................................................... 150
10.3 Commodity market instruments .............................................................................................. 151
10.4 Participants in the commodity market ..................................................................................... 154
11
Investment instruments ............................................................................................... 159
11.1 Introduction .............................................................................................................................. 159

11.2 Cash .......................................................................................................................................... 159
11.3 Deposits .................................................................................................................................... 159
11.4 Equities ..................................................................................................................................... 161
11.5 Bonds and long-term debt instruments ................................................................................... 161

11.6 Retail savings bonds ................................................................................................................. 161
11.7 Money market instruments ...................................................................................................... 161
11.8 Commodities ............................................................................................................................. 161
6
11.9 Products made available by long-term insurance companies .................................................. 162

11.10 Annuities ................................................................................................................................... 162
11.11 Retirement funds ...................................................................................................................... 163
11.12 Collective investment schemes ................................................................................................ 165
11.13 Hedge funds .............................................................................................................................. 166
11.14 Property .................................................................................................................................... 168
11.15 Private equity............................................................................................................................ 171
11.16 Collectibles................................................................................................................................ 172
12
Introduction to portfolio theory ................................................................................... 175
12.1 Introduction .............................................................................................................................. 175

12.2 Markowitz portfolio theory ...................................................................................................... 176
12.3 Sharpes index models .............................................................................................................. 188
12.4 Multi-factor models .................................................................................................................. 201
12.5 Arbitrage pricing theory ........................................................................................................... 204
13
Portfolio Management ................................................................................................. 209
13.1 The portfolio management process defined ............................................................................ 209

13.2 The portfolio management process ......................................................................................... 210
13.3 Case Study: John Smith Trust.................................................................................................... 214
Glossary .................................................................................................................................. 220

Bibliography ........................................................................................................................... 225
Appendix A: Formula sheet Introduction to the financial markets ....................................... 227
1 The financial system

This chapter provides a conceptual framework for understanding how the financial system works.
Firstly the financial system is defined. Then the elements of the financial systems within the context
of the flow of funds are discussed. Thereafter the central role that financial markets and
intermediaries play in the financial system is considered. Finally the chapter describes how financial
market prices are determined.
Learning Outcome Statements
After studying this chapter, a learner should be able to:
define the financial system and understand the roles, functions and interrelationship of its
elements
understand financial intermediation, financial instruments and the flow of funds in the financial
system
know the structure and mechanics of the financial markets and its participants
name the characteristics of an efficient financial market
describe the types of financial markets: spot and forward, primary and secondary, exchanges
and over-the counter and interbank markets
name the functions of the financial system
understand the various measures of risk and return
define fundamental and technical analysis and their usefulness within the context of the
efficient market hypothesis.
1.1
The financial system defined
The financial system comprises the financial markets, financial intermediaries and other financial
institutions that execute the financial decisions of households, firms/businesses and governments.
The financial system performs the essential economic function of channeling funds from those with
a surplus of funds (i.e., net savers who spend less than their income) to those who wish to borrow
(i.e., net spenders who wish to spend more than their income). Thus the financial system acts as an
intermediary between surplus and deficit economic units. As such the financial system plays an
important role in the allocation of funds to their most efficient use amongst competing demands. In
a market system such as the South African financial system, this allocation of funds is achieved
through the price mechanism with prices being set by the forces of supply and demand within the
various financial markets.
The scope of the financial system is global. Extensive international telecommunication networks link
financial markets and intermediaries so that the trading of securities and transfer of payments can
take place 24 hours a day. If a company in South Africa wishes to finance a major investment, it can
issue shares and list them on the New York or London stock exchanges or borrow funds from a
European or Japanese pension fund. If it chooses to borrow the funds, the loan could be
denominated in Euro, Yen, US Dollars or South African Rand.
1.2
The flow of funds and financial intermediation
Flow of funds reflects the movement of funds from those sectors that are sources of funds or capital,
through intermediaries (such as banks, mutual funds, and pension funds), to sectors that use the
funds or capital to acquire physical or financial assets.
The financial system has four elements: lenders and borrowers; financial institutions; financial
instruments and financial markets. The interaction between these is shown in figure 1.1.
1.2.1 Lenders and borrowers

Lenders are the ultimate providers of savings while borrowers are the ultimate users of those
savings. Both are non-financial entities and are referred to as surplus and deficit economic units
respectively.
Lenders can be referred to as investors in that they expend cash on the acquisition of financial assets
such as bonds and shares and real or tangible assets such as land, buildings, gold, and paintings.
Lenders and borrowers can be categorised into four sectors: household, business or corporate,
government, and foreign. The household sector consists of individuals and families. In South Africa it
also includes private charitable, religious and non-profit bodies as well as unincorporated businesses
such as farmers and professional partnerships. The corporate sector comprises all non-financial firms
or companies producing and distributing goods and services. The government sector consists of
central and provincial governments as well as local authorities. The foreign sector encompasses all
individuals and institutions situated in the rest of the world.
Usually the household sector is a net saver and thus a net provider of loanable or investable funds to
the other three sectors. While the other three sectors are net users of funds, they also participate on
an individual basis as providers of funds. For example a business with a temporary excess of funds
will typically lend those funds for a brief period rather than reduce its indebtedness i.e., repay its
loans. Similarly while the household sector is a net provider of funds, individual households do
borrow funds to purchase homes and cars.
Figure 1.1: Financial intermediation and the flow of funds
The excess funds of surplus units can be transferred to deficit units either through direct financing or
indirectly via financial intermediaries.
Direct financing can only occur if lenders requirements in terms of risk, return and liquidity exactly
match borrowers needs in terms of cost and term to maturity. Direct financing usually involves the
use of a financial market broker who acts as a conduit between lenders and borrowers in return for
a commission.
Financial intermediaries perform indirect financing by making markets in two types of financial
instruments one for lenders and one for borrowers. To lenders they offer claims against
themselves known as indirect securities, tailored to the risk, return and liquidity requirements of the
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lenders. In turn they acquire claims on borrowers known as primary securities. Thus the surplus
funds of lenders are invested with financial intermediaries that then re-invest the funds with
borrowers.
1.2.2 Financial intermediaries

Financial intermediaries are financial institutions that expedite the flow of funds from lenders to
borrowers. Types of financial intermediaries include banks, insurance companies, pension and
provident funds and collective investment schemes (also referred to as unit trusts or mutual funds).
Banks accept deposits from lenders and on-lend the funds to borrowers. Insurers and pension- and
provident funds receive contractual savings from households and re-invest the funds mainly in
shares and other securities such as bonds. In addition insurers perform the function of risk
diversification i.e., they enable individuals or firms to distribute their risk amongst a large population
of insured individuals or firms.
Collective investment schemes pool the funds of many small investors and re-invest the funds in
shares, bonds and other financial assets with each investor having a proportional claim on such
assets. Collective investment schemes play a risk diversification role in that they spread the risk by
investing in number of different securities.
1.2.3 Financial instruments

Financial instruments or claims can be defined as promises to pay money in the future in exchange
for present funds i.e., money today. They are created to satisfy the needs of financial system
participants and as a result of financial innovation in the borrowing and financial intermediation
processes, a wide range of financial instruments and products exists.
Financial claims can be categorised as indirect or primary securities. Within these two categories,
financial instruments can be marketable or non-marketable. Marketable instruments can be traded
in secondary markets, while non-marketable instruments cannot. To recover their investment,
holders of marketable securities can sell their securities to other investors in the secondary market.
To recover their investment, holders of non-marketable financial instruments have recourse only to
the issuers of the securities.
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Non-marketable claims generally involve the household sector (also called the retail sector) while
marketable claims are usually issued by the corporate and government sectors (or the wholesale
sector).
Examples of the different categories of financial instruments are shown in table 1.1.
Table 1.1: Financial Instruments
Primary securities
Indirect securities
Issued by ultimate borrowers
Issued by financial intermediaries
Marketable
Bankers
acceptances/bills
Trade bills
Promissory notes
Commercial paper
Company
debentures
Treasury bills
Government bonds
Shares of listed
companies
Non-marketable
Hire-purchase and
leasing contracts
Mortgage advances
Overdrafts
Personal loans
Shares of nonlisted companies
Marketable
Negotiable
certificates of
deposit (NCD)
issued by banks
Non-marketable
Bank notes (issued

by the central
bank)
Savings accounts
Term or fixed
deposits
Insurance policies
Retirement
annuities
1.2.4 Financial markets

1.2.4.1 Definition
Financial markets can be defined as the institutional arrangements, mechanisms and conventions
that exist for the issuing and trading (i.e., buying and selling) of financial instruments.
A financial market is not a single physical place but millions of participants, spread across the world
and linked by vast telecommunications networks that brings together buyers and sellers of financial
instruments and sets prices of those instruments in the process.
1.2.4.2 Characteristics of good financial markets

In general, the characteristics of a good financial market are:
Provision of timely and accurate price and volume information on past securities transactions
and prevailing supply and demand for securities
Provision of liquidity i.e., the degree to which a security can be quickly and cheaply turned into
cash. Liquidity requires marketability, price continuity and market depth. Marketability is a
securitys ability to be sold quickly. Price continuity exists when prices do not change from one
12
transaction to another in the absence of substantial new information. Market depth is the ability
of the market to absorb large trade volumes without a significant impact on prices i.e., there are
many potential buyers and sellers willing to trade at a price above and below the current market
price
Internal efficiency i.e., transaction costs as a percentage of the value of the trade are low - even
minimal
External or informational efficiency i.e., securities prices adapt quickly to new information so
that current market prices are fair in that they reflect all available information on the security.
1.2.4.3 Financial market participants

There are a number of participants in financial markets:
Borrowers issue securities
Lenders (or investors) buy or invest in securities
Financial intermediaries expedite the flow of funds from lenders to borrowers. As such they are
issuers and buyers of securities and other debt instruments
Brokers (or agents) act as conduits between lenders and borrowers or buyers and sellers in
return for a commission
Financial advisors provide investors with recommendations, guidance or proposals for the
purchase of or investment in financial instruments. Financial advisors such as investment banks
provide advice to corporate borrowers and / or issuers of securities
Dealers (or jobbers) buy and sell securities for their own account
Market makers stand ready to buy or sell certain securities at all times. They quote both a bid
and an offer price to the market and profit from the spread between bid and offer prices as well
as from changes in market prices. Market makers adjust their bid or offer prices depending upon
positions that they hold and/or upon their outlook for changes in prices
Hedgers are exposed to the risk of adverse market price movements and mitigate the risk by
using hedging instruments such as derivatives
Speculators try to make a profit by taking a view on the market. If their view is correct, they
make profits. If their view is wrong, they make losses
Arbitrageurs attempt to make profits by exploiting inefficiencies in market prices. They

simultaneously buy securities in the market where the price is relatively cheap and sell securities
in the market where the price is relatively expensive; thereby making risk-less profits.
These categories of financial market participants are not necessarily mutually exclusive. For example
a financial intermediary such as a bank may, given the range of its business activities, be a financial
advisor, market marker, dealer, broker, speculator, arbitrageur and hedger.
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1.2.4.4 Types of financial markets

Financial markets can be described amongst others as cash and derivatives markets; spot and
forward markets; primary and secondary markets; financial exchanges and over-the-counter
markets; and interbank markets.
1.2.4.4.1 Cash and derivatives markets
Cash and derivatives markets are discussed with reference to figure 1.2.
Figure 1.2: Cash and derivatives markets
The foreign exchange, money, bond and equity markets are all considered cash markets because
transactions executed in these markets will result in physical flows of cash at some time or another.
The commodities market - a market for the buying and selling of commodities i.e., physical goods
such as oil, gold, wheat - is a cash market but not a financial one. There are markets for the sale of
other physical goods and / or physical investments such as the property, art and antiques. On the
other hand, the financial market as defined in 1.2.4.1 is a market for the buying and selling of
financial instruments.
The foreign exchange market is the international forum for the exchange of currencies. The money
market is the marketplace for trading short-term debt instruments while the bond market deals in
longer-term debt issues. The distinction between money and bond markets is mainly based on
maturity. Most money market instruments have maturities of less than one year while bonds are
14
issued with terms of more than one year. Both money and bond markets instruments are interestbearing debt instruments.
Shares or equities i.e., participation in the ownership of a company - trade on equity markets.
Together the equity and bond markets form the capital market, i.e., the market in which
corporations, financial institutions and governments raise long-term funds to finance capital
investments and expansion projects.
Derivatives are financial instruments the values of which are derived from the values of other
variables. These variables can be underlying financial instruments or commodities in the cash
market. For example a currency option is linked to a particular currency pair in the foreign exchange
market, a bond futures contract to a certain bond in the bond market and an agricultural future to
maize or wheat in the commodities market. Derivatives can be based on almost any variable from
the price of soya to the weather in Rome. There is trading internationally and in South Africa in
credit, electricity, weather and insurance derivatives.
While a distinction has been drawn between foreign exchange, money, bond, equity and derivatives
markets, several financial instruments straddle the division between these markets. These are called
hybrid financial instruments. For example a convertible bond is a hybrid of bond and equity
securities. It pays a fixed coupon with a return of the principal at maturity unless the holder chooses
to convert the bond into a certain number of shares of the issuing company before maturity.
1.2.4.4.2 Spot and forward markets
A spot market is a market in which financial instruments are traded for immediate delivery. Spot in
this context means instantly effective. The spot market is sometimes referred to as the cash market.
A forward market is a market in which contracts to buy or sell financial instruments or commodities
at some future date at a specified price are bought and sold.
1.2.4.4.3 Primary and secondary markets
The primary market is the market for the original sale or new issue of securities. Issuers or borrowers
in the primary market may be raising capital for new investment or they may be going public i.e.,
converting private capital into public capital.
15
The secondary market is a market in which previously-issued securities are resold. The proceeds
from a sale of such securities do not go to the issuer of the securities but to their seller - the previous
owner.
A stock exchange is a secondary market in which equities are traded. It is also a primary market
where shares are issued for the first time.
A secondary market can be a call market or a continuous market. A call market is a market on which
individual securities trade at specific times. Buy and sell orders are accumulated for a period. Then a
single price is set to satisfy the largest number of orders and all the orders are transacted at that
price. The method is used in smaller markets and to establish the opening price in larger markets. A
continuous market is a market in which securities trade at any time the market is open.
Securities traded on a secondary market can be priced by order (or auction) or by quote (or dealer).
Order-driven or auction markets: In an order driven market buyers and sellers submit bid and ask
prices of a particular share to a central location where the orders are matched by a broker.
Prices are determined principally by the terms of orders arriving at the central marketplace. The
JSE and most US securities exchanges are order-driven
Quote-driven or dealer markets: In a quote driven market individual dealers act as market
makers by buying and selling shares for themselves. In this type of market investors must go to a
dealer and prices are determined principally by dealers bid/offer quotations. NASDAQ is a
quote-driven market. The London Stock Exchange has both an order- and quote-driven system its more liquid shares are traded on its order-driven system.
1.2.4.4.4 Exchanges and over-the-counter markets

Exchanges are formal marketplaces where financial instruments are bought and sold. They are
governed by law and the exchanges rules and regulations.
An over-the-counter (OTC) market involves a group of dealers who provide two-way trading facilities
in financial instruments outside formal exchanges. OTC dealers stand ready to buy at the bid price
and sell at the (higher) ask or offer price hoping to profit from the difference between the two
prices.
In South Africa and internationally money and foreign exchange markets are OTC markets.
16
Internationally, apart from corporate bond trading on the New York Stock Exchange, bond markets
are usually OTC markets. In South Africa the JSEs Interest Rate Market (the former Bond Exchange
of South Africa, which became a wholly-owned subsidiary of the Johannesburg Stock Exchange (JSE)
in June 2009) regulates trading in bonds.
Generally equities are exchange traded. The JSE regulates trading in South African equities.
Commodities and derivatives are traded on-exchange and over-the-counter.
The main differences between OTC and exchange-traded markets are shown in table 1.2.
Table 1.2: Difference between over-the-counter markets and exchanges
Characteristic
Over-the-counter
Exchange-traded
Type of contract
Range from highly standardised

(exchange look-alike) to tailor made
to the specific needs of the two
contracting parties with respect to
underlying securities, contract size,
maturity and other contract terms
Fully standardised with contract

terms determined by the exchange
Credit risk - the risk

that a trading party
defaults
Each party to the contract assumes

counterparty credit risk
The exchange clearing house assumes

the counterparty credit risk of all
trading parties
Trading
Trading takes place between two

trading parties bilaterally agreeing a
contract
Trading parties generally remain

anonymous
Market participants make use of

standard master agreements
Regulation of market
developed by industry associations
such as ISDA1
Law and the rules and regulations of

the exchange
Market liquidity
Higher than OTC markets
Lower than exchange traded markets
The major advantage of over-the-counter markets is the ability to tailor-make securities to meet the
specific needs of the trading parties. The advantages of an exchange relative to an over-the-counter
market are lower credit risk, anonymity of trading parties, greater market regulation and higher
market liquidity.
ISDA the International Swaps and Derivatives Association - is a New York based trade organisation that
strives to make global OTC derivatives markets safe and efficient
17
1.2.4.4.5 Interbank markets

An interbank market is a wholesale money market for the offering of deposits between banks in a
range of currencies usually for periods not exceeding 12 months. Interbank markets are over-thecounter markets and can be national or international.
The Bank for International Settlements and the International Monetary Fund define the
international interbank market as an international money market in which banks lend either to each
other, cross-border or locally, in foreign currency large amounts of money usually for periods
between overnight and six months.
Interbank markets play at least two roles in the financial system. Firstly interbank markets can be
used by central banks to transmit the influence of monetary policy by adding or draining liquidity
from the financial system more effectively. Secondly, well-functioning interbank markets effectively
channel liquidity from banks with a surplus of funds to those with a liquidity deficit.
Various interest rates are used in the interbank market. These include the Johannesburg Interbank
Agreed Rate (JIBAR), the London Interbank Offered Rate (LIBOR), the Euro Interbank Offered Rate
(EURIBOR) and the Tokyo Interbank Offered Rate (TIBOR).
1.2.5 Financial market indices

Financial market indices attempt to reflect the overall behaviour of a group of shares or other
securities such as bonds. Examples of South African financial market indices are the FTSE/JSE All
Share Index, BESA money Market Index and South African Hedge Fund Index. International indices
include the U.K.s FTSE All-Share, the U.S.s NYSE Composite and Standard & Poors 500 Index (S&P
500)., and Japans TOPIX.
Financial market indices are used:
As a benchmark to measure portfolio performance
To create and track index funds. An index fund is a collective investment scheme with a portfolio
constructed to match the components of an index such as the FTSE/JSE Top 40 index
To estimate market rates of return
To predict future share price movements in technical analysis
As a proxy for the market portfolio when estimating systematic risk (see chapter 12).
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1.3
Functions of the financial system
The core functions of the financial system are:
Channeling savings into real investment
Pooling of savings
Clearing and settlement of payments
Managing risks
Providing information.
1.3.1 Channel savings into investment

The financial system operates as a channel through which savings can finance real investment i.e.,
tangible and productive assets such as factories, plants and machinery. It channels funds from those
who wish to save (surplus economic units) to those who need to borrow (deficit economic units) to
such purchase or build such assets.
Channeling savings can take place:
Over time. The financial system provides a link between the present and the future. It allows
savers to convert current income into future spending and borrowers current spending into
future income.
Across industries and geographical regions. Capital resources can be transferred from where
they are available and under-utilised to where they can be most effectively used. For example
emerging markets such as Poland, Russia, Brazil and South Africa require large amounts of
capital to support growth while mature economies such as Germany, the United Kingdom and
the United States tend to have surplus capital.
1.3.2 Pooling savings

The financial system provides the mechanisms to pool small amounts of funds for on-lending in
larger parcels to business firms thereby enabling them to make large capital investments.
In addition individual households can participate in investments that require large lump sums of
money by pooling their funds and then sub-dividing shares in the investment e.g. collective
investment schemes.
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1.3.3 Clearance and settlement of payments

The financial system provides an efficient way to clear and settle payments thereby facilitating the
exchange of goods, services and assets. Payment facilities include bank notes, cheques, debit and
credit card payments and electronic funds transfers.
1.3.4 Management of risk

Financial intermediaries transform unacceptable claims on borrowers to acceptable claims on
themselves i.e., the risky long-term loans of borrowers are transformed into less-risky liquid assets
for surplus units.
This transformation process is shown in table 1.3. For example banks accept short-term deposits
from lenders and transform these into long-term loans for borrowers. In this process the bank
assumes liquidity risk. Banks accept relatively small amounts from several lenders and pool these to
lend large amounts to borrowers. In this process the bank assumes liquidity risk and credit risk with
respect to the borrowers. Lenders on the other hand are exposed to the banks creditworthiness.
Table 1.3: Intermediation role of banks
Banks transform-
Lenders/investors assets
Borrowers loans
Risk assumed by
banks
Maturity
Short-term e.g. demand

deposits
Long-term e.g. 5-year loan
Liquidity risk
Denomination
Small amounts e.g. savings

accounts
Large amounts e.g. housing

Liquidity risk
loan
Interest rate
Fixed rate e.g. fixed deposit
Variable rate e.g. variablerate loan
Interest-rate risk
Currency
Local currency
Foreign currency
Exchange rate risk
Credit exposure
Investor is exposed to the

bank in respect of credit
risk i.e., to the
creditworthiness of the
bank
The bank is exposed to the

borrower in respect of
credit risk i.e., to the
creditworthiness of the
borrower
Credit risk
1.3.5 Information provision

The financial system communicates information on the following:
20
Borrowers creditworthiness: It is costly for individual households to obtain information on a

borrowers creditworthiness. However if financial intermediaries do this on behalf of many small
savers, search costs are reduced
The prices of securities and market rates: This supports firms in their selection of investment
projects and financing alternatives. In addition it assists asset managers to make investment
decisions and households to make savings decisions
1.4
Financial market rates
There are essentially three financial market rates:
Interest rates
Exchange rates
Holding period return
1.4.1 Interest rates

An interest rate is the price, levied as a percentage, paid by borrowers for the use of money they do
not own and received by lenders for deferring consumption or giving up liquidity.
Factors affecting the supply and demand for money and hence the interest rate includes the
following:
Production opportunities. Potential returns within an economy from investing in productive,

cash-generating assets
Liquidity. Lenders demand compensation for loss of liquidity. A security is considered to be liquid
if it can be converted into cash at short notice at a reasonable price
Time preference. Lenders require compensation for saving money for use in the future rather
than spending it in the present
Risk. Lenders charge a premium if investment returns are uncertain i.e., if there is a risk that the
borrower will default. The risk premium increases as the borrowers creditworthiness decreases.
Sovereign (government) debt generally has no risk premium within a country and therefore pays
a risk-free rate. A country risk premium may apply outside a countrys borders
Inflation. Lenders require a premium equal to the expected inflation rate over the life of the
security
21
1.4.2 Exchange rate

The exchange rate is the price at which one currency is exchanged for another currency. The actual
exchange rate at any one time is determined by supply and demand conditions for the relevant
currencies within the foreign exchange market.
1.4.3 Holding period return

Interest rates are promised rates i.e., they are based on contractual obligation. However other
assets such as property, shares, commodities and works of art do not carry promised rates of return.
The return from holding these assets comes from the following two sources:
Price or capital appreciation (depreciation) i.e., any gain (loss) in the market price of the asset
Cash flow (if any) produced by the asset e.g., cash dividends paid to shareholders, rental income
from property. Not all assets produce cash flows e.g. commodities.
The holding period return (HPR) is the total return on an asset or portfolio of assets over the period
it was held. Holding period return does not take into account reinvestment income between the
time cash flows occur and the end of the holding period.
For example assume at the beginning of the year a share is bought for R50. At the end of the year
the share pays a dividend of R2.50 and is sold for a price of R55. In this case the holding period of the
investment is one year. The HPR for the share is 15.0%; calculated as follows:
HPR capital gain(loss) cashflow
end price of share beginningprice of share
cash dividend
beginningprice of share
55.00 50.00 2.50
50.00
50.00
15.0%
If the share price it is sold for is R45 at year end the holding period return is 5%; calculated as
follows:
45.00 50.00 2.50
50.00
50.00
5.0%
HPR
22
Assume a painting is purchased at the beginning of 2001 for R2 000. At an auction on 31 December
2009 the painting is sold for R3 000. In this case the holding period is 9 years. The art investors
holding period return is 50.0%; calculated as follows:
HPR capitalgain(loss) cashflow

3 000 2 000
0
2 000
50.0%
The 50% return represents the return over 9 years. It may be more convenient for comparative
purposes to convert this to an effective annual rate as follows:
EAR 1 HPR1 / n 1
where
n holdingperiod in years
EAR 1 0.501 / 9 1
4.6%
1.5
Determining financial market prices
1.5.1 Fundamental and technical analysis

The two techniques frequently used to study financial market securities and their expected prices
and to make investment decisions based on such analysis are technical and fundamental analysis.
Fundamental analysis estimates the intrinsic value of a company by examining its characteristics
(such as from its financial statements) and environment including the economy and industry to
which the company belongs.
Technical analysis is not concerned about the intrinsic value of a share. Instead share price changes
are predicted from the study of graphs on which prices and sometimes trading volumes are plotted.
Technical analysts examine the price action of the stock market instead of the fundamental factors
that may impact share prices. A number of assumptions underlie technical analysis: (i) the market
value of a share is determined solely by the interaction of its demand and supply; (ii) supply and
demand are driven by both rational factors such as economic variables and irrational factors such as
23
gut-feel, moods and guesses; (iii) ignoring minor fluctuations, share prices move in trends, which
persist for long periods of time; and (iv) current trends change in reaction to variations in supply and
demand and these trend changes can eventually be identified by the action of the market.
1.5.2 Efficient markets hypothesis

In contrast to both technical and fundamental analysts, proponents of the efficient markets
hypothesis (EMH) believe that share prices adjust rapidly and fully to all information as it becomes
available. Therefore neither existing nor past prices are of any help in predicting the future. This
highlights one of the most debated and controversial questions in finance - are the price movements
of financial instruments predictable or random?
According to the EMH, at any given time, financial instrument prices fully reflect all available
information. The market is efficient if the reaction of market prices to new information is
instantaneous and unbiased. The main outcome of this theory is that price movements are random
and do not follow any patterns or trends. This means that past price movements cannot be used to
predict future price movements. Rather, prices follow a random walk - an inherently unpredictable
pattern.
There are essentially the following three forms of the EMH:
The weak form of the EMH claims all past market prices and data are fully reflected in asset
prices. The implication of this is that technical analysis will not be able to consistently produce
excess returns, though some forms of fundamental analysis may still provide excess returns.
The semi-strong form of the EMH asserts that all publicly available information is fully reflected
in asset prices. The implication of this is that neither technical nor fundamental analysis can be
used to produce excess returns.
The strong form of the EMH: All information, public and private is fully reflected in asset prices.
The implication of this is that even insider information cannot be used to beat the market.
There are a number of challenges to the EMH:
The existence of stock market anomalies, which are reliable, widely known and inexplicable
patterns in asset price returns. Examples are the shares of small firms offering higher returns
than those of large ones and the January effect, which shows that higher returns can be earned
in the first month of the year.
24
Behavioural finance, which examines the psychology underlying investors' decisions. This is used
to explain phenomena such as share price over- or under-reaction to new information. It implies
there are areas of predictability in the markets and contrarian strategies of buying losers and
selling winners can generate superior returns. In 1997 economics professor Paul Krugman stated
'The Seven Habits of Highly Defective Investors'. These behavioural traits make the markets
anything but efficient: think short-term; be greedy; believe in the greater fool; run with the herd;
over-generalise; be trendy; and play with other people's money. According to Krugman, he did
not see investors as a predatory pack of speculative wolves but an extremely dangerous flock
of financial sheep.
25
Review questions
1.
Define the financial system.
2.
What are the four elements of the financial system?
3.
Name the categories that lenders and borrowers can be grouped into.
4.
Differentiate between direct and indirect financing.
5.
Describe how pension funds expedite the flow of funds from lenders to borrowers.
6.
Describe how banks expedite the flow of funds from lenders to borrowers.
7.
List three marketable primary securities and three non-marketable indirect securities.
8.
Explain the difference between primary and secondary markets.
9.
What are the core functions of the financial system?
10. What is the one-year rate of return for a share that was bought for R100 paid no dividend
during the year and had a market price of R102 at the end of the year?
26
Answers
1.
The financial system consists of the financial markets, financial intermediaries and other
financial institutions that carry out the financial decisions of households, businesses and
governments.
2.
3.
The four elements of the financial system are:
Lenders and borrowers
Financial institutions
Financial instruments
Financial markets
Lenders and borrowers can be categorised into the household sector, the business or corporate
sector, the government sector and the foreign sector.
4.
In the direct financing process, funds are raised directly by borrowers from lenders usually
though a financial market broker who acts as a conduit between the lender and borrower in
return for a commission. In the indirect financing process, also known as financial
intermediation, funds are raised from lenders by financial intermediaries and then on lent to
borrowers.
5.
Pension funds expedite the flow of funds from lenders to borrowers by receiving contractual
savings from households and re-investing the funds in shares and other securities such as
bonds.
6.
Banks expedite the flow of funds from lenders to borrowers by accepting deposits from lenders
and on-lending the funds to borrowers.
7.
Three marketable primary securities are treasury bills, promissory notes and debentures. Three
non-marketable indirect securities are savings accounts, fixed deposits and retirement
annuities.
8.
The primary market is the market for the original sale or new issue of financial instruments
while the secondary market is a market in which previously-issued financial instruments are
resold.
9.
The core functions of the financial system are to channel savings into investment, pool savings,
clear and settle payments, manage risks and provide information.
10. The return is 2% p.a.; calculated as follows:

HPR
end price of share beginningprice of share

cash dividend
102 100 0
100
100
2%
27
2 The economy
Financial markets operate in an economic environment that shapes and is shaped by their activities.
The objective of this chapter is to outline the interactions between the various components of the
economy and to discuss mechanisms for determining the direction of current and future economic
activity and performance. Firstly alternative economic systems and their underlying principles will be
described. Then the flows of income, output and expenditure in a market economy will be sketched.
Thereafter the role of government in the economy will be considered. After that economic indicators
and their interpretation will be specified. Finally the globalisation of financial markets i.e., the
increasing integration of financial markets around the world will be discussed.
describe alternative economic systems
understand the flow of economic activity in a market economy
understand the economic objectives in a market economy and the tools used by authorities to
reach these objectives
define the business cycle and understand the relationship between the business cycle phases
and economic variables
understand the impact of the business cycle on different asset classes
understand the use, features and interpretation of economic indicators
understand globalisation of financial markets in a South African context.
2.1
Economic systems
Scarcity exists when the needs and wants of a society exceed the resources available to satisfy them.
Given scarcity, choices must be made concerning the use and apportionment of resources i.e., what
should available resources be used for - what goods and services should be produced or not be
produced?
The approach to resource allocation the assignment of scarce resources to the production of goods
and services - allows a distinction to be made between those economies that are centrally planned
and those that operate predominantly through market forces.
28
In a centrally planned or command economy most of the key decisions on production are taken by a
central planning authority, usually the state and its agencies. The state normally
owns and/or controls resources
sets priorities in the use of the resources
determines production targets for firms, which are largely owned and/or controlled by the state
directs resources to achieve the targets
attempts to co-ordinate production to ensure consistency between output and input.
In the free-market or capitalist economy firms and households interact in free markets through the
price system to determine the allocation of resources to the production of goods and services. The
key features of the free-market system are:
resources are privately owned and the owners are free to use the resources as they wish
companies, which are also in private ownership, make their own production decisions
production is co-coordinated by the price system - the mechanism that sends prices up when the
demand for goods and services is in excess of their supply and prices down when supply is in
excess of demand. In this way the price system apportions limited supplies among consumers
and signals to producers where money is to be made and consequently what they ought to be
producing.
In a mixed economy the state provides some goods and services such as postal services and
education with privately-owned companies providing the other goods and services. The exact mix of
private enterprise and public activities differs from country to country and is influenced by the
political philosophy of the government concerned.
Given its focus on the ownership, control and utilization of a societys resources, the economic
problem of resource allocation has a political dimension. The link between a societys economic
system and political regime is illustrated in Figure 2.1. Just as economic systems can extend from
free-market to centrally planned, depending on the level of state intervention in resource allocation
so political systems can range from democratic to authoritarian given the degree of state
involvement in decision making.
Market economic systems are generally associated with democratic states e.g. United Kingdom as
are centrally planned economies with authoritarian states e.g. Cuba. However some authoritarian
states have or are attempting to institute capitalistic economies e.g. China. Certain democratic states
have a substantial degree of government intervention either by choice or from necessity e.g. during
29
times of war. Typically demands for political change have accompanied pressures for economic
reform e.g. in Eastern Europe.
Figure 2.1: Political-economic systems
2.2
The flows of economic activity
The major participants in an economy are households, firms, the government and the foreign sector.
How these interact within an economy can be described by a circular flow diagram.
In its simplest form - see figure 2.2 - the economy consists of two groups: firms and households. On
the resource or real side, households provide labour to firms and firms produce goods and services
and supply them to households for consumption. Corresponding to these real or resource flows are
financial or cash flows: firms pay households for the use of their labour and households pay firms for
the goods and services firms produce.
30
Figure 2.2: Simplified circular flow of income diagram
In reality the economy is more complicated. There are leakages from the circular flow:
Savings. Money is received by households but not spent on consumption of goods and services
Imports. Money flows to foreign firms as households consume imported goods
Taxes. Money flows to the government.
At the same time as the leakages are taking place, additional forms of spending occur that represent
injections into the circular flow:
Investment spending. Firms use capital in the production process. Capital in this context refers to
assets that are capable of generating income e.g. capital equipment, plants, and premises.
Capital goods have themselves been produced. Firms borrow savings from households to invest
in capital to be used in the production of more goods and services. This generates income for
firms producing capital goods
Exports. Firms sell their production to another country in exchange for foreign exchange. The
difference between a countrys exports and imports of goods is known as the trade balance and
reflects the countrys basic trading position
Government spending. Governments use taxation to spend on the provision of public goods and
services such as defence and education.
A more complete picture of the economy is shown in figure 2.3.
31
Figure 2.3: Circular flow of income diagram
While the revised model of the economy is still simplified e.g. firms also save and buy imports, it
does show the following:
The interactions between the various components of the economy
How variations in the level of economic activity can be the result of changes in a number of
variables. If households reduce the amount of goods they purchase, firms revenues decrease.
This will impact firms need for resources such as labour and raw materials and reduce the taxes
paid to the government. A change in the amount of taxes paid to the government will impact
government spending. It will also affect the level of employment.
Inherent in the circular flow of income concept is the equality of total production, income and
expenditure for the economy as a whole. Production gives rise to income. Income is expended on
production.
The total of all expenditure within an economy is referred to as aggregate demand. The main
categories of aggregate demand are the following:
Consumer or household spending
Government spending or public expenditure
Investment spending on capital goods
Exports of goods and services less expenditure on imports of goods and services.
32
Consumer spending is regarded as the most important factor in determining the level of aggregate
demand.
Aggregate supply is the total of all goods and services produced in an economy.
2.3
Economic objectives
The performance of an economy is generally judged in terms of the following economic objectives:
An acceptably high rate of non-inflationary economic growth
A high and steady level of employment of the labour force
A stable general price level i.e., the avoidance of undue inflation and deflation
A favourable and stable balance of payments and
Equitable distribution of income.
In most market-based economies democratically elected governments prefer levels and patterns of
aggregate demand and supply to be determined by market forces without government interference.
However recognition that market forces alone cannot ensure that an economy will achieve the
economic objectives has resulted in state intervention occurring to some degree in all countries. The
intervention can take the form of fiscal policy, monetary policy and /or direct controls, collectively
economic policy.
2.4
Economic policy
2.4.1 Fiscal policy

Fiscal policy is the use of government spending and taxation policies to influence the overall level of
economic activity. Basic circular flow analysis indicates that reductions in taxation and/or increases
in government spending will inject additional income into the economy and stimulate aggregate
demand. Similarly increases in taxation and/or decreases in government spending will weaken
aggregate demand.
Fiscal policy is said to be loosening if tax rates are lowered or public expenditure is increased. Higher
tax rates or reductions in public expenditure are referred to as the tightening of fiscal policy. In
South Africa National Treasury is responsible for the execution of fiscal policy.
Taxation and government spending are linked in the governments overall fiscal or budget position.
A budget surplus exists when taxation and other receipts of the government exceed its payments for
goods and services and debt interest. A budget deficit arises when public-sector expenditure
33
exceeds public-sector receipts. A budget deficit is financed by borrowing. Expansionary fiscal policy
is usually associated with a budget deficit and contractionary fiscal policy with a budget surplus.
In South Africa the budget is presented annually to Parliament by the Minister of Finance. The
budget sets out the following:
The governments spending plans for the financial year. A financial year runs from 1 April of the
current year to 31 March of the following year
How the government intends to finance such spending e.g. through taxes and / or loans.
In his 2012 budget speech, the Minister stated that the budget was formulated to address the
challenges of creating jobs, reducing poverty, building infrastructure and expanding our economy. In
addition special emphasis was given to improving competitiveness in industry, investment in
technology, encouragement of enterprise development and support for agriculture.
The public or national debt is the total sum of all budget deficits less all budget surpluses over time.
National debt incurs interest costs and has to be paid back. It is financed by taxpayers and can be
seen as a transfer between generations. To quote Herbert Hoover: Blessed are the young, for they
shall inherit the national debt.
2.4.2 Monetary policy

Monetary policy regulates the economy by influencing the monetary variables such as:
The rate of interest. Lowering interest rates encourages (i) companies to invest in capital as the
cost of borrowing falls and (ii) households to increase consumption as disposable incomes rise
on the back of lower mortgage and overdraft rates. Rising interest rates will typically have the
opposite effect
The money supply (notes, coins, bank deposits). If the money supply is increased, interest rates
tend to fall.
The most important tools of monetary policy are:
Reserve requirements
Open-market operations
Bank or discount rate policy.
2.4.2.1 Reserve requirements

The central bank requires banks to hold a specified proportion of their assets as cash reserves typically against their depositors funds. By changing the reserve requirement the central bank can
34
influence the money supply and credit extension. For example, if the central bank lowers the cash
reserve requirement the money supply will increase as banks extend additional credit on the back of
their increased lending capacity.
2.4.2.2 Open market operations

Open market operations involve the purchase and sale of government and other securities by the
central bank to influence the supply of money in the economy and thereby interest rates and the
volume of credit. A purchase of securities expansionary monetary policy injects reserves into the
banking system and stimulates growth of money supply and credit extension. A sale of securities
contractionary monetary policy does the opposite.
2.4.2.3 Bank or discount rate policy

The bank or discount rate is the interest rate at which the central bank lends funds to the banking
system. In South Africa this rate is called the repurchase rate (repo rate). Banks borrow from the
central bank primarily to meet temporary shortfalls of reserves. By varying the interest rate on these
loans, the central bank is able to affect market interest rates e.g. increasing the bank rate raises the
cost of borrowing from the central bank and banks will tend to build up reserves. This will decrease
the money supply and reduce credit extension.
An accommodative or expansionary monetary policy reduces the bank (or repo) rate at which the
central bank provides credit to the banks. Monetary policy is restrictive or contractionary when the
central bank increases the bank (or repo) rate.
The South African Reserve Bank (SARB) is the central bank of South Africa. Operationally the SARB
influences the overall lending policies of banks and the demand for money and credit in the
economy indirectly through changes in bank liquidity and interest rates in the money market.
The SARB applies monetary policy in South Africa within an inflation targeting framework. An
inflation targeting framework has the following four elements:
A monetary policy goal of price stability
A numerical inflation target to make the price-stability objective operational
A time horizon to attain or return to the inflation target
Ongoing review as to whether the inflation target will or has been met.
35
The SARB regards its primary goal in the South African economic system to be the achievement and
maintenance of price stability. Government sets the inflation target after consultation between the
Reserve Bank and the National Treasury. The current target is for CPI inflation to be within the target
range of 3% to 6% on a continuous basis.
Fiscal policy and monetary policy must be coordinated to prevent the results of the one type of
policy from cancelling out or negating the effects of the other type of policy. To achieve this
coordination requires close cooperation between the National Treasury and the SARB.
2.4.2.4 Direct controls

Examples of direct controls are:
Prices and incomes policies attempt to control inflationary pressures by restraining price and
wages increases
Import controls endeavour to correct balance of payment deficits by placing restrictions such as
quotas and tariffs on the importation of products into the country.
2.5
Business cycle
Economic expansion and development does not occur smoothly. Rather than growing steadily year
after year, economies experience cycles in economic activity i.e., intervals of economic expansion
followed by times of recession. These cycles are termed business cycles and are defined as recurrent
but non-periodic fluctuations in the general business activity of an economy. Each cycle consisting of
four phases: a lower turning point (or trough), an expansion, an upper turning point (or peak) and a
contraction see figure 2.4.
The simplified sequence of events that usually sets the course of the business cycle is as follows:
During the expansion phase, aggregate demand increases. Firms inventories are run down.
Production increases at a faster rate than aggregate demand as inventories are rebuilt. Businesses
employ unemployed workers who spend their income on consumer goods. This generates more
demand and businesses employ more people.
The process continues until businesses encounter capacity constraints. If firms expect continued
increasing demand they will invest in capital goods - plants, factories, machinery and equipment.
Consumer demand will increase on the back of the increased demand for capital goods as firms
producing capital goods employ more labour. In addition demand for investment funds increases.
36
Production eventually reaches a ceiling due to supply constraints and bottlenecks - the upper turning
point is reached. The demand for investment funds puts upward pressure on interest rates and new
investment is no longer profitable.
Figure 2.4: Phases of the business cycle
During the contraction phase as investment demand falls, producers of capital goods lay off workers.
Increased unemployment results in decreased consumer spending businesses producing consumer
goods and services cut down on production and employment. The contraction gains momentum.
The trough or lower turning point is reached when production decreases to some minimum level. At
this level consumer demand is steady as workers employed by the government or in industries
producing essential goods and services such as food and utilities retain their jobs.
Slack demand for investment funds has resulted in a fall in interest rates making new or replacement
investment profitable at least for firms providing essentials. With steady consumer demand an
increase in investment demand will begin to lift the economy again.
The typical behaviour of economic variables in the different phases of the business cycle is outlined
in table 2.1.
37
Table 2.1: Phases of the business cycle

Lower turning point
(recovery or early
expansion)
Expansion
Upper turning point

(early contraction)
Contraction
Businesses
Tend to be more
liquid and less
geared with higher
profit expectations
Start borrowing to
finance expansion
Profits rise rapidly
Profits weaken
Profits weaken
further
Credit demand
Relatively weak
Increases strongly
Weakens
Weak
Current account of
the balance of
payments
Surplus
Surplus becomes
smaller or negative
Deficit or small
surplus
Deficit becomes
smaller or surplus
becomes larger
Employment
Relatively low
Increases
High
Falls slowly at first
Exchange rate
Relatively stable or
tending stronger
Tends to strengthen
Tends to weaken
Weakens
Stabilises or tends
stronger
Exports
Increase
Weaker (to supply

local demand)
Decrease or remain
weak
Increase
Fiscal policy
Stimulation e.g. tax

concessions
Restraint e.g. higher

taxes and/or lower
spending
Further restraint
Borrowing increases
to finance higher
expenditure
Imports
Relatively low
Rise sharply
Remain high
Decrease
Inflation
Relatively low
Increases
Increases further
Decreases
Interest rates
Relatively low
Rise
Rise or remain high
Decline
Inventory levels
Low
Rise
Rise or remain high
Decrease
Investment
Low
Starts to rise
High
Decreases
Prices
Relatively low
Rise rapidly
High
Fall slowly
Production and
sales
Start to increase
Production capacity
is at a high level
Increase rapidly
Limited by capacity
Idle production
constraints
capacity is absorbed
Decline
substantially
Production capacity
Idle capacity
Idle capacity is
rapidly absorbed;
Requirement to
expand production
capacity
Full utilisation
Utilisation falls
Salary and wage

incomes
Low
Rise slowly at first
High
Fall slowly
Many economic indicators also display cyclical patterns. These can lead (turn in advance of), coincide
with or lag (turn after) the business cycle. Leading indicators can be used to predict economic
38
developments. The SARB uses over 200 economic time series (indicators) to determine the turning
points of the South African business cycle. Using these indicators, leading, coincident and lagging
composite-business-cycle indices are produced as illustrated in figure 2.5. The indices indicate the
direction of change in economic activity; not the level.
Figure 2.5: South African composite business cycles
The longest upward phase of the business cycle since 1945 lasted 99 months from September 1999
to November 2007. In December 2007, this upward phase came to an end.
The market turbulence that began in the third quarter of 2007 with the sub-prime market meltdown
in the United States, led to worldwide financial market panic in September 2008 with the bankruptcy
of Wall Street investment bank Lehman Brothers and the near collapse and subsequent bailout of
insurer American International Group (AIG).
Credit markets seized up and liquidity evaporated. Confidence in financial institutions crumbled.
Global and domestic demand declined and South African (and world) economic growth fell steeply
throughout 2008 and into 2009.
39
In response to the financial and economic crises expansionary fiscal and monetary policies have
been adopted in most parts of the world. Since the second half of 2009 there are signs that
economic activity is bottoming out and in some instances is showing signs of recovery.
Different asset classes tend to perform differently during the phases of the business cycle.
Shares tend to perform best during both the recovery and expansion phases when economic
conditions are improving and company revenues are increasing. Share prices are volatile at the
upper turning point of the cycle as investors become less certain about the future. Share prices
decline during the contraction phase of the cycle when economic conditions are deteriorating and
corporate profits are falling.
Bonds are likely to perform best during the contraction phase and lower turning point when interest
rates generally decline. Bonds tend to perform less well during the late expansion phase and upper
turning point when interest rates are apt to rise.
Property tends to perform well during recovery and expansion when interest rates are relatively low
and employment and economic conditions are improving. Property does not perform as well during
the contraction phase when economic conditions are deteriorating and employment is declining.
Cash is generally more attractive during the contraction phase when economic conditions are
worsening and there is widespread pessimism, particularly in the business sector.
Commodities are likely to perform well during the expansion phase of the business cycle when
production is increasing rapidly; production capacity is at or near full utilisation and demand for
commodities is high. Commodities do not perform well during contraction when manufacturers are
reducing production and operating at less than full capacity.
Precious metals tend to perform best during the upper turning point when the demand for precious
metals like gold, platinum and silver rises for industrial purposes and as a hedge against inflation.
During the contraction phase, when industrial demand is low and inflation is declining, precious
metals may not perform as well.
40
2.6
Economic indicators
Economic indicators provide insights into how economies and markets are performing. Their
interpretation is important to various market participants and observers for a number of reasons.
Economists and other market analysts use economic indicators to (i) assess the performance of an
economy (ii) judge the effectiveness of a governments economic policy (iii) compare the economic
performance of different countries and (iv) form economic and market forecasts and views.
Investors use economic indicators to attempt to obtain the best investment return given risk.
Businesses use economic indicators to determine if the time is right to undertake new capital
investment projects; takeovers or mergers; or entry into new markets.
The following economic indicators will be discussed:
Gross Domestic Product (GDP)
Consumption expenditure by households
Government Spending
Investment Spending
Consumer Price Index (CPI)
Producer Price Index (PPI)
Balance of Payments.
In each case the indicator will be defined. Then how the indicator is generally presented and what
should be focused on when analysing the indicator are noted. Thereafter the timing of the indicator
with respect to the business cycle as well as the interpretation of the indicator are considered.
Finally the impact of the indicator on market variables is highlighted.
41
2.6.1 Gross Domestic Product (GDP)

Definition:
The total value of all goods and services produced in a country in a particular
period (usually one year).
Real (constant price) GDP reflects total economic activity after adjusting for
inflation.
There are three approaches to estimating GDP:
o production or output method sums the value added (value of production
less input costs) by all businesses (agriculture, mining, manufacturing,
services);.
o expenditure method adds all spending: private consumption such as food
and clothing; government consumption such as remuneration of public
sector employees; investment such as factories, manufacturing plants;
and exports (foreigners spending) less imports (domestic spending
abroad).
o income method aggregates the total incomes from production and
includes employees wages and salaries, income from self-employment,
businesses trading profits, rental income, trading surpluses of
government enterprises and corporations.
Theoretically the output, expenditure and income measures of GDP should be
identical (see 2.3). In practice discrepancies exist due to shortcomings in data
collection, timing differences and the lack of informal sector data.
Presented as:
Quarterly and annual totals
Focus on:
Percentage changes, annual or over four quarters
Timing:
Coincident indicator of the business cycle
Interpretation:
Interpretation of GDP numbers depends on business cycle timing. For

example strong economic growth after an economic recession usually
indicates the utilisation of idle capacity; during the expansion phase it may
suggest the installation of new and additional capacity to add to future
production while at the peak it may imply inflationary pressures.
Likely impact on:

Interest rates
High GDP growth could be inflationary if the economy is close to full capacity.
This will lead to rising interest rates as market participants expect the central
bank to raise interest rates to avoid higher inflation.
Bond prices
Higher interest rates mean falling bond prices.
Share prices
High growth leads to higher corporate profits this supports share prices.
However inflationary fears and higher interest rates usually impact share
prices negatively.
Exchange rate
Strong economic growth will tend to appreciate the exchange rate as higher
interest rates are expected.
42
Figure 2.6: South African Gross Domestic Product
2.6.2 Consumption expenditure by households

Definition:
Consumption expenditure or spending by households is the total amount of

money spent by households in an economy. It is divided into a number of
categories including durable goods (goods expected to last more than 3 years),
semi-durable goods (goods expected to last 3 years or less), non-durable goods
(food and clothing) and services.
Consumption spending by households represents the largest proportion of
GDP. In industrialised countries it is around 60% of GDP (58.6% in South Africa 2nd quarter of 2012).
Presented as:
Focus on:
Real growth rates
Timing:
Interpretation:
A change in consumption spending by households has a large effect on total

production as it is the largest component of aggregate demand.
After a recession growth in Private Consumption Spending is a precursor to a
general recovery. However if consumption grows faster than an economys
productive capacity demand for imports will increase and inflation will rise
Consumption spending by households has the same impact on interest rates, bond prices, share
prices and exchange rates as GDP (see 2.6.1).
43
Figure 2.7: South African consumption expenditure by households
2.6.3 Consumption expenditure by government

Definition:
Consumption expenditure by government or government spending is the total

amount of money spent by government on goods and services (defence, judicial
system and education) but excludes transfer payments such as pensions and
unemployment benefits. It does not represent total government spending as
government investment spending is included in the next item; Investment
Spending.
Consumption spending by government represents around 15% of GDP in
industrialised countries. Its share of GDP is higher in countries where the state
provides many services (21.5% in South Africa - 2nd quarter 2012).
Presented as:
Focus on:
Real growth rates
Timing:
Interpretation:
Government consumption expenditure tends to be a stable percentage of GDP.

It generally has less impact on market and asset prices than the budget deficit /
surplus. A short-term increase in government spending can provide a stabilising
boost to the economy.
For the likely impact on interest rates, bond prices, share prices and exchange rates see GDP (see
2.6.1).
44
Figure 2.7: South African consumption expenditure by government
2.6.4 Investment spending

Definition:
Investment Spending is made up of:
Gross fixed capital formation: Includes spending on residential and nonresidential buildings, construction works and machinery and other equipment
Change in inventories is erratic and can be positive or negative it falls when

demand is growing more than production and rises when demand slows. It
represents only a small proportion of Investment spending.
Investment Spending is a key component of GDP and represents around 20% of
GDP in industrialised countries 20.6 % in South Africa (2nd quarter 2012).
Presented as:
Focus on:
Real growth rates
Timing:
Leading indicator of the business cycle
Interpretation:
Investment Spending is highly cyclical. Firms investment decisions are based on

expectations of future aggregate demand, corporate profits and interest rates.
Firms are the most likely to invest if interest rates are low, they are operating at
almost full capacity and if they expect demand to remain high
For the likely impact on interest rates, bond prices, share prices and exchange rates see GDP (see
2.6.1).
45
Figure 2.8: Gross fixed capital formation (investment)
2.6.5 Consumer Price Index

Definition
Price indices measure levels of and changes in particular baskets of prices. The
Consumer Price Index (CPI) is a weighted average of the prices of a
representative group of goods and services purchased by households.
Price indices provide information on inflation. Inflation is the persistent increase
in the general level of prices and can be seen as the devaluing of the worth of
money.
Presented as:
Monthly index numbers
Focus on:
Percentage changes. Distinguish between the level of prices and rate of increase.
If the rate of increase declines but remains positive, prices are still increasing
Timing:
Interpretation:
The CPI is used to calculate and monitor inflation. Inflation has the following
three main negative effects:
Distorting the behaviour of households and firms because it obscures

relative price signals i.e., it is difficult to differentiate changes in relative
prices and changes in the general price level
Creating uncertainty and consequently discourages investment because is it

not precisely predictable
Redistributing income from creditors to debtors and fixed-income earners to

variable-income or wage earners
46
Likely impact on:

Interest rates:
Larger than expected increases or an increasing trend in CPI is considered

inflationary. Interest rates will tend to rise
Bond prices:
Higher interest rates mean falling bond prices
Share prices:
Higher than expected price inflation should negatively impact share prices as
higher inflation will lead to higher interest rates
Exchange rate:
The effect is uncertain. The exchange rate may weaken as higher prices lead to
lower competitiveness. However higher inflation typically leads to tighter
monetary policy and higher interest rates, which leads to appreciation
Figure 2.9: Consumer Price Index
47
2.6.6 Producer Price Index

Definition:
The Producer Price Index (PPI) tracks prices at the first stage of distribution or at
the point of the first commercial transaction. Prices of domestically-produced
goods / imported goods are measured when they leave the factory / arrive in the
country and not when they are sold to consumers.
The PPI measures the cost of production and as such reveals cost pressures
affecting production.
Presented as:
Monthly index numbers
Focus on:
Percentage changes. Distinguish between the level of prices and rate of increase.
If the rate of increase declines but remains positive, prices are still increasing
Timing:
Coincident indicator of the business cycle. Leading indicator of cost pressures
Interpretation:
The PPI and CPI tend to follow the same trend. The PPI reveals cost pressures
affecting production
For the likely impact on interest rates, bond prices, share prices and exchange rates see CPI (see
2.6.5).
Figure 2.10: Producer Price Index
48
2.6.7 Balance of payments

Definition:
The balance of payments (BoP) is a tabulation of a countrys transactions with

foreign countries and international institutions over a period a quarter or year.
It consists of the current (or trade) account, financial (or capital) account and
official reserves (i.e., gold and foreign currencies held by the country).
The financial (or capital) account reflects international capital or financial flows
i.e., it records international transactions in assets and liabilities e.g., a countrys
financial outflows represent the acquisition of foreign assets or the repayment
of foreign liabilities.
The current account balance records (i) the sales of goods (including gold) to the
rest of the world (i.e., exports), (ii) the purchases of goods from the rest of the
world (i.e., imports), (iii) services receipts from and payments for services to the
rest of the world, which include services such as shipping, travel and tourism,
financial services including insurance, banking and brokerage, and (iv) income
receipts from and income payments to the rest of the world such as
compensation paid to employees and investment income (the result of previous
financial flows) including interest, profit and dividends.
The gold and other foreign reserves position reflects the overall balance of
payments position of a country. A country receives foreign currency for
exporting goods and services and from inflows on the financial account (or
capital inflows). A country pays out foreign currency when importing goods and
services and for outflows on the financial account (or capital outflows). If the
receipts of foreign currency are more (less) than the payments of foreign
currency, the countrys foreign reserves i.e., the countrys holdings of various
foreign currencies, increase (decrease). As payments and receipts of foreign
currency rarely coincide, foreign reserves ensure a smooth flow of international
trade and finance.
Presented as:
Monthly money values
Focus on:
Trends and size in relation to GDP
Timing:
Interpretation:
The current account balance reflects international payments that must be

matched by financial flows or changes in official reserves. The current account
can be in deficit or surplus. A current account deficit has to be financed by
inward financial flows (i.e., foreign investment or loans) and/or the depletion of
official reserves.
A current account deficit may indicate that a country is spending more than it is
earning. However a deficit may also imply that a country has strong growth
potential that is leading to higher imports (especially in technology and capital
goods) and that other countries are willing to fund that growth either in the
form of investments or loans.
A current account surplus may indicate a competitive economy or that policy
measures are in place e.g. import tariffs to keep imports low
49
Likely impact on
Interest rates:
Limited direct impact see exchange rate below
Bond prices:
Limited direct impact see exchange rate below
Share prices:
Limited direct impact share prices may fall if an increasing current account
deficit suggests that domestic firms are not globally competitive
Exchange rate:
A worsening balance on the current account (i.e., a fall in net exports) may lead
to exchange rate depreciation. On the other hand a worsening trade balance
may also indicate high economic growth that is leading to higher imports. As
interest rates tend to rise when economic growth is strong, an exchange rate
appreciation may follow a worsening of the current account balance
Figure 2.11: Ratio of current account balance to GDP
2.7
Globalisation of financial markets
Globalisation refers to the increasing integration of economies around the world, mainly through the
movement of goods, services, and capital across international borders. The term is also often used
to refer to the movement of people, technology, information and knowledge across national
borders. Furthermore there are significant cultural, political, and environmental aspects to
globalisation.
50
One aspect of globalisation the globalisation of financial markets is complex and imperfectly
understood. There is an ongoing debate on the precise impact of financial globalisation - whether it
has given rise to or amplified shocks to global economic activity such as the 1987 stock market crash,
the crises affecting the European Union exchange rate mechanism (1992-1993), the Mexican crisis
(1994-1995), the Asian crises (1997-1998), the Russian crisis (1998) and the global financial crises
triggered by the meltdown in the U.S. sub-prime mortgages market (2007-2009).
Financial globalisation is seen by some as a catalyst for economic growth and stability. The benefits
of financial globalisation and associated more comprehensive and liquid international markets are
held to be:
Better allocation of world savings to the highest-yielding investments
Enhanced identification, pricing and trading of risk
The financing of international arbitrage in goods and services will reduce international price
differences. This should enhance welfare by shifting supply from national markets where they
are lowly valued to markets in which they are more highly valued.
On the other hand, the risk of financial globalisation is seen to be excessive and costly. Volatility in
short-term gross capital flows injects dangerousand often costlyinstability into the economies of
emerging and developing countries.
The International Monetary Fund argues that well-developed financial markets help moderate
boom-bust cycles that can be triggered by surges and sudden stops in international capital flows,
while strong domestic institutions and sound macroeconomic policies help attract stable capital
flows such as fixed direct investment. Countries such as South Africa should weigh the possible risks
involved in opening up to capital flows against the efficiency costs associated with controls.
Given South Africas sound financial institutions, sensible domestic and foreign policies, and
developed financial markets the benefits from financial globalisation are likely to outweigh the risks.
51
Review questions
1.
Explain how centrally-planned and free-market economies approach the assignment of scarce
resources to the production of goods and services.
2.
Describe a mixed economy.
3.
Name the leakages from and injections into the circular flow of income.
4.
In terms of which objectives is the performance of an economy judged?
5.
Define fiscal policy.
6.
Name the tools of monetary policy.
7.
What is a business cycle and name its four phases?
8.
Outline the behaviour of production capacity during the four phases of the business cycle.
9.
Describe the likely impact of high Gross Domestic Product (GDP) growth on interest rates.
10.
Define the globalisation of financial markets?
52
Answers
1.
In a centrally planned or command economy most of the key decisions on the assignment of
scarce resources to the production of goods and services are taken by a central planning
authority, usually the state and its agencies. In the free-market economy firms and
households interact in free markets through the price system to determine the allocation of
resources to the production of goods and services.
2.
A mixed economy is an economy in which the state provides some goods and services such as
postal services and education with privately-owned firms provide the other goods and
services.
3.
Leakages from the circular flow are savings, imports and taxes. Injections into the circular flow
are investment spending, exports and government spending.
4.
The economic objectives in terms of which the performance of an economy is generally

judged are an acceptably high rate of non-inflationary economic growth, a high and steady
level of employment, a stable general price level, a favourable and stable balance of payments
and equitable distribution of income.
5.
Fiscal policy is the use of government spending and taxation policies to influence the overall
level of economic activity.
6.
The tools of monetary policy are reserve requirements, open-market operations and bank- or
discount-rate policy.
7.
Business cycles are recurring intervals of economic expansion followed by times of recession.
The four phases of a business cycle are a lower turning point (or trough), an expansion, an
upper turning point (or peak) and a contraction.
8.
At the lower turning point of the business cycle there is idle production capacity. During the
expansion phase this idle capacity is rapidly absorbed and a need arises for additional
production capacity. At the upper turning point production capacity is fully utilized i.e., there
is no spare production capacity. As the economy moves into the contraction phase of the
business cycle, utilisation of production capacity falls until once again at the lower turning
point, there is idle production capacity.
9.
If the economy is close to full capacity, high Gross Domestic Product (GDP) growth could be
inflationary. In this case, high GDP growth will lead to rising interest rates as market
participants expect the central banks to raise interest rates to curb higher inflation.
10.
Globalisation of financial markets refers to the increasing integration of financial markets

around the world.
53
3 Time value of money

Financial decision makers in households, companies and government agencies must evaluate
whether spending money today is justified by the expected benefits in the future. To do so requires
an understanding of time value of money the subject of this chapter.
Learning outcome statements
Understand interest rates, discount rates, rates of return and opportunity cost
Define the yield curve and know the four basic yield curve shapes and the three theories
explaining the shape of the yield curve
Understand the concepts of future value and present value
Distinguish between annual, semi-annual, quarterly and monthly compounding
Distinguish between annual and effective interest rates
Understand the effects of compounding and discounting and perform the relevant calculations
Calculate future value and present value for single amounts, an ordinary annuity, an annuity due
and a perpetuity
Define and explain net present value and internal rate of return.
3.1
Introduction
Money has time value a rand today is worth more than a rand received in a year from today i.e., a
given amount of money is more valued the earlier it is received. Therefore a lesser sum of money
now (its present value) may be equivalent in value to a larger amount received in the future (its
future value).
Central to the time value of money is interest the consideration paid for the use of money. To the
borrower it represents the cost of the loan, to the lender a source of income. An interest rate can be
thought of as:
A required rate of return - the minimum rate of return an investor will accept to make the
investment
A discount rate - the rate at which a future amount is discounted (or reduced) to establish its
present value or its value today
54
An opportunity cost - the value that an investor will forego by choosing a particular course of
action. For example if an investor has R5 000 and chooses to spend it rather than invest it, the
investor will forego the interest that could have been earned on the investment
An interest rate is the annual percentage a borrower e.g. a bank pays for the use of the investors
money. A yield is the percentage rate of return that can be earned on an investment. It is an annual
rate and is either currently quoted by the market or implied by the current market price for the
investment.
For example if the interest rate is 4.5% per annum on a savings deposit of R1 000, the bank would
pay R45.00 at the end of the year. In this case the yield is equal to the interest rate. However,
interest is normally calculated and added to the savings deposit periodically (usually monthly) during
the year. Each time interest is added to the savings deposit, the funds earn interest on interest. At
the end of the year the savings account deposit will have earned R45.94 - more than R45.00. This is
the yield on the investment: 4.59%.
3.2
The yield curve
A yield curve shows how interest rates vary with term or time to maturity.
Figure 3.1: Yield curve (2 October 2012)
55
More formally the yield curve is the graphical representation of the term structure of interest rates
and plots yields against the term to maturity of similar quality bonds. The estimated South African
yield curve for 2 October 2012 is shown in figure 3.1.
There are the following four basic yield curve shapes (see figure 3.2):
Positive or normal. An upward-sloping curve with yields rising as maturity increases i.e., shortterm rates are lower than long-term rates
Inverse or negative. A downward sloping yield curve with yields declining as maturity increases
i.e., short-term rates are higher than long-term rates
Flat
Humped.
Figure 3.2: Yield curve shapes
Flat and humped yield curves are transition curves. They usually occur over an interim period when
the shape of the yield curve is changing from normal to inverse or vice versa. A humped curve shows
that a transition from higher to lower rates (or vice versa) has started to occur in the short-term part
of the yield curve. The longer-term maturity portion has as yet not reacted to the change in interest
rate expectations.
The short maturity section of the yield curve is primarily influenced by monetary policy - a restrictive
monetary policy drives short-term interest rates higher creating a flat or inverted yield curve shape.
56
An accommodative monetary policy forces short-term interest rates lower, steepening the yield
curve.
The three major theories explaining the shape of the yield curve are the expectations theory, the
liquidity preference theory and the market segmentation theory.
(i) The expectations theory
The expectations theory states that the shape of the yield curve reflects the markets current
expectations of future short-term interest rates. Thus a positively sloped yield curve indicates that
the market expects short-term rates to rise in the future. A negatively sloped yield curve implies that
future short-term rates are expected to decline. A flat curve predicts stable short-term rates and a
humped yield curve that short-term rates will rise over the short term and decline in the longer
term.
The expectations theory will only hold in a world of certainty or risk-neutral borrowers and lenders.
(ii) The liquidity preference theory
The liquidity preference theory states that risk-averse investors prefer to hold short-term bonds
because short-term bonds are more liquid i.e., the principal of the bond can be recovered in a
reasonably short period of time. Therefore to attract investors, longer-term bonds must offer a yield
premium over shorter-term bonds. The longer the maturity, the greater the liquidity premium must
be. Therefore the theory is an extension of the expectations theory in that a risk premium is added
to expected short-term rates into the future.
A major implication of the theory is that even if investors expect future short-term rates to remain
constant, the yield curve will slope upwards due to liquidity premiums. When the market expects
short-term rates to increase, the yield curves upward slope will be accentuated by liquidity
premiums. Liquidity premiums will inhibit the downward slope of the yield curve when lower shortterm rates are expected.
The main criticism of the liquidity preference theory is that it considers risk strictly in terms of price
volatility. However, to investors such as insurance companies or pension funds with obligations due
in the distant future, short-term assets are riskier than long-term assets because they leave investors
more exposed to reinvestment risk.
57
(iii)
Market segmentation theory
The market segmentation theory states that due to the nature of their liabilities, some investors
such as pension funds and insurance companies have a predetermined demand for particular
maturities investors attempt to hedge both principal and reinvestment risks by matching the
maturities or duration of their bonds to their liabilities. Thus the yield in specific maturity sectors is
determined solely by supply and demand.
In contrast to the previous two theories, the term structure of interest rates will be independent of
investors expectations about future interest rates.
3.3
Interest rate calculations
There are two basic types of interest, simple and compound.
3.3.1 Simple interest

Simple interest is also referred to as interest at the end of the term. It assumes that interest earned
on an investment is not reinvested.
The basic formula to calculate simple interest is:
I
=
where:
I
=
PV =
r
=
t
PV x r x t
interest amount
Present value the principal amount subject to interest
interest rate expressed as a percentage per unit of time e.g., 18% per annum,
9% semi-annually
time or term - the number of periods for which interest is to be calculated.
For example, R1 000 invested for 1 year at 14% p.a. will earn R140 interest (i.e., 1 000 x 0.14 x 1) at
the end of the year. R1 000 invested for 2 years at 14% p.a. will earn R280 interest (i.e., 1 000 x 0.14
x 2) at the end of the term.
The basic formula can be expanded to determine the future value of the principal at maturity i.e., to
what amount the money will grow at the end of the term.
FV
FV
FV
=
=
=
PV + I
PV + (PV x r x t)
PV (1 + r x t)
where:
58
I
FV
=
=
PV x r x t
future value
For example, R1 000 invested for 1 year at 14% p.a. will have a value of R1 140 (i.e., 1 000 x (1 + 0.14
x 1)) at the end of the year. R1 000 invested for 2 years at 14% p.a. will have a value of R1 280 (i.e.,
1 000 x (1 + 0.14 x 2)) at the end of the term.
The present value formula can be obtained from the future value formula:
FV
PV (1 + r x t)
PV
FV / (1+ r x t)
For example, a loan with a maturity value of R120 000 and interest rate of 15% p.a. has a present
value of R115 662.65 (i.e., 120 000 / (1 + 0.15 x 3/12)) 3 months prior to its maturity.
Thus far, interest has been paid at the end of the term. When interest is paid at the beginning of the
term, the lender deducts the interest at the time the loan is made. At maturity the principal or face
value is due. Loans dealt with in this way are termed discounted. The interest paid is called the
discount and the amount advanced by the lender the discounted value. Thus the discounted value is
the present value of the amount paid back at maturity.
The formula for calculating the discount amount is:

D
FV x d x t
D
FV
d
=
=
=
discount amount
principal or face value also the future value
discount rate
where
The discounted or present value formula is:

PV
PV
PV
=
=
=
FV D
FV FV x d x t
FV (1 d x t)
For example, a treasury bill with a face value of R1 million, a discount rate of 15.5% p.a. and a term
of 90 days has a discount of R38 219.18 (i.e., 1 000 000 x 0.155 x 90/365)) and discounted value of
R961 780.82 (i.e., 1 000 000 x (1 0.155 x 90/365)).
What is the difference between discount and interest? Interest is calculated on the present value
and added to the present value to determine the future value. Discount is calculated on the future
59
value and subtracted from the future value to determine the present value. The discount rate is
expressed as a percentage of the future value and the interest rate as a percentage of the present
value.
The formulas to convert discount rates to interest rates and vice versa are:
r
d
where
d
r
=
=
d / (1 d x t)
r / (1 + r x t)
=
=
discount rate
interest rate
For example a 3-month discount rate of 15% p.a. implies a 3-month interest rate of 15.58% p.a.
(i.e., 0.15 / (1 0.15 x 3 / 12)). A 3-month interest rate of 15.58% implies a 3-month discount rate of
15% p.a. (i.e., .1558 / (1 + 0.1558 x 3 / 12)).
3.3.2 Compound interest

Compound interest adds the simple interest paid on the investment in the first period to the
principal amount and, in subsequent periods, calculates interest on the principal plus the interest
earned in earlier periods. It assumes reinvestment at the same interest rate.
The future value formula for compound interest is:

FV
PV (1 + r) t
There must be consistency between r and t. t is the number of periods (years as a unit of time is
arbitrary any time period may be used) and r is the interest rate per period. For example 15% p.a.
compounded monthly for 5 years will have a t of 60 (i.e. 5 x 12) and an r of 1.25% (i.e., 15% / 12).
For example, R2 000 invested at 15% p.a. for 3 years will have one of the following future values
depending on whether interest is paid:
annually:
R3 041.75
i.e., 2 000 x (1 + 0,15) 3 x 1
semi-annually:
R3 086.60
i.e., 2 000 x (1 + 0,075) 3x2
quarterly:
R3 110.91
i.e., 2 000 x (1 + 0,0375) 3x4
monthly:
R3 127.89
i.e., 2 000 x (1 + 0,0125) 3x12
The present value formula can be obtained from the future value formula:
PV
FV / (1 + r) t
60
For example, the following amounts must be invested now to accrue to R10 000 in 5 years time at
15% p.a. compounded:
Annually:
Semi-annually:
Quarterly:
Monthly:
R4 971,77
R4 851,94
R4 788,92
R4 745,68
i.e., 10 000 / (1 + 0.15) 5

i.e., 10 000 / (1 + 0.15/2) 5x2
i.e., 10 000 / (1 + 0.15/4) 5x4
i.e., 10 000 / (1 + 0.15/12) 5x12
3.3.3 Nominal versus effective rates

The nominal rate is the quoted annual rate. Some indication is usually given of compounding
intervals e.g. rates is quoted as nacm (nominal annual compounded monthly), nacq (nominal annual
compounded quarterly), nacs (nominal annual compounded semi-annually) or naca (nominal annual
compounded annually).
The effective rate is the equivalent annual interest rate that would apply if interest were
compounded annually. The effective rate increases as the number of compounding periods
increases. By definition, there is no difference between a naca rate and the effective rate.
The formula to convert a nominal rate to an effective rate is:

re
[(1 + rn / m) m 1]
where:
re =
rn =
m =
effective rate
nominal rate
number of times interest is compounded per year
For example:
15% nacm rate implies an effective rate of:
16.08%
i.e., [(1 + 0.15/12) 12 - 1]
15% nacq rate implies an effective rate of:
15.87%
i.e., [(1 + 0.15/4) 4 - 1]
15% nacs rate implies an effective rate of:
15.56%
i.e., [(1 + 0.15/2) 2 - 1]
15% naca rate implies an effective rate of:
15.00%.
3.3.4 Continuous compounding

The number of compounding periods per year is usually 12 (monthly), 4 (quarterly) or 2 (semiannually). Continuous compounding assumes the number of compounding periods per year to be
infinite.
The future value formula for continuous compounding is:

61
FV
where:
e
r
n
PV e r x n
=
=
=
the Naperian constant (e 2.71828)

nominal annual interest rate
fraction of a year / number of years
The effective rate formula under continuous compounding is:

re
er - 1
For example, R100 invested for 5 years at 15% compounded continuously has a future value of
R211.70 (i.e., 100 x e 0.15 x 5) and an effective rate of 16.18% (i.e., e 0.15 1).
Continuous compounding, due to its simplicity, is particularly useful in complex mathematical

formulae e.g. option pricing models.
3.4
Present and future value of an annuity
An annuity is a sequence of equal payments i.e., equal cash flows, made at fixed intervals for a
specified number of periods.
If payments occur at the end of each period, the annuity is termed ordinary or deferred. An annuity
is known as an annuity due if the periodic payments are made at the start of each payment interval.
The future (or present) value of an annuity can be calculated by applying the compound interest
calculations to each individual payment i.e., the future (present) value of the annuity is simply the
sum of the future (present) values of the individual payments.
However, general formulas have been derived as shown in table 3.1.
Table 3.1: General annuity formulas

Future value:
Ordinary annuity
FV = PMT [((1 + r ) n 1) / r ]
where
PMT = the periodic payment
Annuity due
FV = (1 + r ) PMT [((1 + r ) n 1) / r ]
62
Present value:
Ordinary annuity
PV = PMT [((1 + r ) n 1) / ( r (1 + r )n ) ]
or
PV = PMT[(1 (1 / (1+ r)n)) / r]
PV = (1 + r ) PMT [((1 + r ) n 1) / ( i (1 + r )n ) ]
Annuity due
For example, assume a periodic payment of R100 per month at 15% (nacm) for 10 years.
The future value will be:

Ordinary annuity:
R27 521.71
i.e., 100 x [((1 + 0.15 / 12) (10 x 12)) 1) / (0.15 / 12)] )
Annuity due:
R27 865,73
i.e., (1 + 0.15/12) x 27 521.71)
The present value will be:

Ordinary annuity:
R6 198.28
i.e.,100x[((1+0.15/12)(10x12))- 1)/((0.15/12)x(1+0.15/12)(10x12))]
Annuity due:
R6 275.76
i.e., (1 + 0.15/12) x 6 198.28)
3.5
Present and future values of unequal cash flows
In many cases cash flow streams are unequal. This precludes use of the future value annuity
calculation. The future value of a series of unequal cash flows can be found by compounding each
individual cash flow. For example, table 3.2 shows the calculation of the future value of a series of
unequal cash flows. The cash flows are indexed to the present (year = 0). The interest rate is 8% p.a.
Table 3.2: Future value of an unequal cash flow
Year
Cash flow
Future value
in year 5
Calculation
1 000
1 360.49
1 000 x (1 + 0.08)4
2 000
2 519.42
2 000 x (1 + 0.08)3
4 000
4 665.60
4 000 x (1 + 0.08)2
5 000
5 400.00
5 000 x (1 + 0.08)1
6 000
6 000.00
6 000 x (1 + 0.08)0
Future value of cash flows
19 945.51
63
Similarly, to find the present value of a series of unequal cash flows, calculate the present value of
each cash flow and sum them (see table 3.3).
Table 3.3: Present value of an unequal cash flow
Year
Present value
in year 0
Cash flow
Calculation
1 000
925.93
1 000 / (1 + 0.08)1
2 000
1 714.68
2 000 / (1 + 0.08)2
4 000
3 175.33
4 000 / (1 + 0.08)3
5 000
3 675.15
5 000 / (1 + 0.08)4
6 000
4 083.50
6 000 / (1 + 0.08)5
Present value of cash flows
3.6
13 574.58
Net present value
The net present value (NPV) of an investment is the present value of its cash inflows minus the
present value of its cash outflows. If the NPV of an investment is positive, the investor will accept the
investment proposition. If the NPV is zero, the investor will be indifferent to the investment. If the
NPV is negative, the investor will seek another investment opportunity.
For example assume an investor has an opportunity to invest in a property development. The NPV of
the investment is shown in table 3.4. The investors required rate of return is 10%.
Table 3.4: Net present value of a property investment

Year
Cash flow
Present value
Calculation
-80 000
-80 000.00
-80 000 / (1 + 0.10)0
-500
-454.55
-500 / (1 + 0.10)1
4 500
3 719.01
4 500 / (1 + 0.10)2
5 500
4 132.23
5 500 / (1 + 0.10)3
4 500
3 073.56
4 500 / (1 + 0.10)4
115 000
71 405.95
115 000 / (1 + 0.10)5
NPV
1 876.21
64
Since the NPV is positive, the investors required rate of return is achieved. Therefore the investor
will accept the investment.
3.7
Internal rate of return
The internal rate of return (IRR) of an investment with an unequal cash flow can be calculated by
equating the net present value to zero. The IRR is the discount rate that makes the net present value
equal to zero. The calculation for an IRR is complex and involves a series of iterations. The
calculation is beyond the scope of the module.
The IRR of the property deal in 10.7 is 10.5%. Since the IRR is greater than the investors required
rate of return, the investor will accept the investment proposal.
65
Review questions
1.
What is the present value of the following stream of year-end payments discounted at 10%
p.a.?
Year 1: -R100
Year 2: -R200
Year 3: -R100
Year 4: R450
2.
An investor deposits R1 500 today and R1 500 one year from today into a deposit account. The
deposits earn 10% compounded annually. What will the total amount in the deposit account be
two years from today?
3.
An investor decides spend an inheritance of R100 000 on an overseas trip rather than invest it
at 10% p.a. What is the opportunity cost of this course of the action?
4.
What is a yield curve?
5.
If short-term rates are higher than long-term rates, the yield curve is ..
6.
What impact will a restrictive monetary policy have on the yield curve?
7.
Which theory states that the shape of the yield curve reflects the markets current expectations
of future short-term rates?
8.
An investor is setting up a charitable trust for victims of natural disasters. The trust must
provide 6 annual payments of R20 000. The first payment is to be made today. How much
money must the investor invest today at 10% p.a. compounded annually to meet the required
obligations?
9.
An investor has an opportunity to invest in a property development. The investors required

rate of return is 12%. The net present value of the investment is R26 341. Will the investor
accept the investment?
10. An investor has an opportunity to invest in a private equity investment. The investors required
rate of return for high risk investments is 18%. The estimated internal rate of return of the
private equity investment is 24%. Will the investor accept the investment?
66
Answers
1.
PV
= -R23.97
= (-100/(1 + 0.10)1 + (-200/(1 + 0.10)2) + (-100/(1 + 0.10)3) + (450/(1 + 0.10)4)
2.
FV
= R3 465
= (1 500 x (1+0.10)1 + 1 500 x (1 + 0.10)2 )
3.
10% p.a. i.e., the value the investor foregoes by choosing to spend the money on an
overseas trip.
4.
A yield curve plots yields against the term to maturity of similar quality bonds.
5.
A yield curve is inverse if short-term rates are higher than long-term rates.
6.
Restrictive monetary policy drives short-term interest rates higher creating a flat or
inverted yield curve.
7.
The expectations theory states that the shape of the yield curve reflects the markets
current expectations of future short-term interest rates.
8.
PV
= R95 815.74
= (1 + 0.10) x (20 000 x ((1 + 0.10)6 - 1)/(0.10 x (1 + 0.10)6))
9.
The investor will not accept the investment as the required rate of return is not achieved.
10. The investor will accept the investment as the internal rate of return is greater than the
required rate of return.
67
4 Introduction to statistical concepts

This chapter introduces statistics a set of tools used to organise and analyse data. Firstly
descriptive statistics used to describe the characteristics of a group of objects is discussed. Then
inferential statistics, which is used to make conclusions about an attribute of a population is
explained.
After studying this chapter, a learner should be able to
Define and differentiate between a population and a sample
Explain a parameter, a sample statistic and a frequency distribution
Define and explain the use of a histogram
Define and explain population and sample mean
Explain the main measures of dispersion range, mean absolute deviation, variance and
standard deviation
Explain symmetry and skewness
Define probability, expected value and variance and standard deviation
Distinguish between a random variable, an outcome, an event, mutually exclusive events and
exhaustive events
Distinguish between empirical, subjective, conditional, unconditional and priori probabilities
Define and calculate expected value, variance and standard deviation
Define and explain covariance and correlation.
4.1
Introduction
Statistics is the totality of methods used to collect, organise, present, analyse, interpret and make
inferences from data to assist in more effective decision making. The term statistics is also used to
refer to data e.g. a shares average return for the last 2 years is called a statistic.
Statistics is used to support decision making by firstly describing and revealing patterns in numeric
data by analysing such data (descriptive statistics) and secondly drawing conclusions and making
predictions based on the analysis of numeric data (inferential statistics).
68
4.2
Descriptive statistics
4.2.1 Basic terminology

Descriptive statistics is used to describe the characteristics of a group of objects. Objects are also
known as units, individuals or members. Examples of objects are individuals, traders, assets, shares,
banks, asset managers and households.
To obtain information about a group of objects it is necessary to obtain information about each of
the objects in the group. A variable is a measurable characteristic or attribute of an individual object.
A variable takes different values for the different objects within a group e.g. the returns (variable) of
the shares (objects) traded on the JSE (a group).
Data is collected for each variable. Descriptive statistics is then used to reveal the distribution of the
variable i.e., the way in which possible values of the variable (e.g. returns) are distributed among the
objects (e.g. shares) within the group (e.g. the shares traded on the JSE).
The entirety of the objects of a specified group is referred to as the population. Even if it were
possible to examine the entire population, it is generally too expensive in terms of time or resources
to do so. For example if the population is all banking customers in South Africa and an analyst is
interested in their propensity to save, it will be too costly to examine the whole population. Instead
the analyst will take a sample of the population.
A sample is a subset or part of the population for which data have or will be obtained. Once the
sample data are obtained the distributions of the variables among the objects in the sample will be
used to characterise the sample and make inferences or generalisations about the entire population
i.e., make inferences about the distributions of these variables among the objects in the population.
Any descriptive measure of a population characteristic is called a parameter. Examples of

parameters are the mean or average investment return, the range of investment returns and the
variance of investment returns. A descriptive measure of a sample characteristic is called a sample
statistic.
There are statistical techniques to establish the size and composition of a sample these are not in
scope for this module.
69
4.2.2 Frequency distributions

A frequency distribution is one of the simplest ways to summarise data. It is a table summarising into
a small number of intervals, the possible values and frequencies (i.e., a count of the number of times
each value occurs) of the variable. For example, table 4.1 gives the annual total returns of a stock
exchange index.
Table 4.1: Annual return of a stock exchange index
Year
Return
2000
46.21%
2001
-6.18%
2002
8.04%
2003
22.87%
2004
45.90%
2005
20.32%
2006
41.20%
2007
-9.53%
2008
-43.06%
2009
-17.75%
Assuming 5 equally-sized intervals, absolute frequency, cumulative frequency, relative frequency,

and cumulative relative frequency of the data in table 4.1 is shown in Table 4.2. There are statistical
techniques to establish the interval but these are not in scope for this module.
Table 4.2: Absolute, cumulative, relative and cumulative relative frequency
Cumulative
relative
frequency
Frequency
Cumulative
frequency
Relative
frequency
-43.06 return < -25.20
10%
10%
-25.20 return < -07.34
20%
30%
-07.34 return < 10.52
20%
50%
10.52 return < 28.38
20%
70%
28.38 return 46.24
10
30%
100%
Return interval
Calculations for the final row of the table are:
Frequency of 3 - count from table 4.1 return of 46.21%, 45.90%, 41.20%
Cumulative frequency = previous cumulative frequency + frequency i.e., 7 + 3 = 10
Relative frequency = frequency / total observations i.e., 3 /10 = 30%
Cumulative relative frequency = previous cumulative relative frequency as percentage + relative

frequency i.e., 70% + 30% = 100%
70
4.2.3 Histogram
A histogram is a graphical equivalent of a frequency distribution. It is a bar chart of data that have
been grouped into a frequency distribution. The advantage of a histogram is that it can be quickly
seen where most of the observations lie.
Figure 4.1 is the graphical equivalent of the absolute frequency distribution in table 4.2. The height
of each bar represents the absolute frequency for each return interval.
Figure 4.1: Histogram of the annual returns of a stock exchange index
The return interval 28.38% return 46.24% has a frequency of 3 and is the tallest bar in the
histogram.
4.2.4 Measures of central tendency

Frequency distributions and histograms are a convenient way to summarise data. Measures of
central tendency explain characteristics of data and specify where data is centered. The most
common measure of central tendency is the arithmetic mean (or simply the mean).
71
The mean is the most frequently used measure of the middle or centre of data. It is the sum of the
observations divided by the number of observations. The mean can be computed for both
populations and samples.
The population mean formula is:
N
i 1
where
populationmean
N the number of observations in the population
X i the i th observation
The population mean is an example of a parameter. The population mean is unique i.e., a population
has only one mean. Although knowledge of the population mean is valuable, it is often too difficult
(or impossible) to get information on the entire population. Thus inferences about the population
mean are made using the sample mean.
For example suppose a short-term insurance company wanted to know the average repair cost of
rear collisions in South Africa in 2011. To obtain the population mean the insurance company would
need to obtain the repair costs of every rear collision in South Africa in 2011. This will be a difficult
and expensive task. Instead the company could take a sample of 1 000 rear-collision accidents and
compute their average repair cost i.e., the sample mean and use this as an estimate for the
population mean. Or suppose an investment analyst wishes to estimate the mean diameter of trees
in a plantation to determine the amount of lumber and consequently the potential income the
lumber company will make. The analyst could take a sample of 500 trees and calculate their average
diameter. This sample mean would then be used as an estimate for the population mean.
The sample mean formula is:

n
i 1
where
X sample mean
n the number of observations in the sample
Xi the i th observation
72
For example, using the annual total returns in Table 4.1, the sample mean is:
X 46.21 6.18 8.04 22.87 45.90 20.32 41.20 9.53 43.06 17.75 / 10
X 10.802%
4.2.5 Measures of dispersion

Dispersion is the variability around the central tendency e.g. the mean. In investment jargon, if the
mean of the returns of an investment deals with the reward of the investment, the dispersion
around the mean addresses the risk of the investment.
The most common measures of dispersion are range, mean absolute deviation, variance and
standard deviation. If every member of a population is known, these measures can be ascertained
for the population. Since it is often too difficult (or impossible) to get information on the entire
population, inferences about the population measures of dispersion are made using sample
measures of dispersion.
4.2.5.1 The range

The range is the difference between the maximum and minimum values in a set of data.
For example, using the data in table 4.1, the range of the annual total return of the stock market
index is 89.27% i.e., 46.21 - (-43.06).
The range is easy to compute. However it uses only two pieces of information from the data set and
reflects outliers that may not be representative of the distribution i.e., it does not indicate the shape
of the distribution.
4.2.5.2 Mean absolute deviation

The mean absolute deviation (MAD) examines the absolute deviations around the mean. Absolute
deviations are used to avoid the problem of negative deviations cancelling out positive deviations
i.e., if negative and positive deviations are used, the deviations around the mean would sum to zero.
The formula to calculate the mean absolute deviation formula is:

n
X X
i
MAD
i 1
73
where
MAD mean absolutedeviation
X the sample mean
Xi the i th observation
For example, using the data in table 4.1, the mean absolute deviation is 24.50%. The calculation is
shown in Table 4.3
Table 4.3: Calculating the mean absolute deviation
Deviation from the mean of
10.80%
Xi X
Absolute value of deviation

from the mean
46.21
35.41
35.41
-6.18
-16.98
16.98
8.04
-2.76
2.76
22.87
12.07
12.07
45.90
35.10
35.10
20.32
9.52
9.52
41.20
30.40
30.40
-9.53
-20.33
20.33
-43.06
-53.86
53.86
-17.75
-28.55
Original data
(see table 4.1)
Xi X
28.55
10
244.98
X X
24.50
i 1
10
MAD
i 1
10
The mean absolute deviation uses all the observations in the data set. Thus it is better than the
range as a measure of dispersion.
4.2.5.3 Variance and standard deviation

The variance and standard deviation are the most widely used measures of dispersion.
The mean absolute deviation dealt with the problem that the sum of deviations from the mean
equals zero by taking the absolute value of the deviations. The variance and standard deviation
address this issue by squaring deviations from the mean.
The population variance formula is:

74
i 1
where
2 population variance
the population mean
N the number of observations in the population
The variance is measured in squared units. To return the squared units to original units the standard
deviation is used. The standard deviation is the square root of the variance.
The population standard deviation formula is:
2
where
the populations tandard deviation

2 the populationvariance
Both the population variance and standard deviation are examples of parameters.
In most instances, a sample of the population is all that can be observed. The sample statistics that
measure dispersion are the sample variance and sample standard deviation.
The formula for the sample variance is:
X
n
s2
i 1
n 1
where
s 2 sample var iance
X the sample mean
The sample standard deviation is the square root of the sample variance. The formula is as follows:
s s2
where
s sample standard deviation
s 2 the sample variance
75
As an example, the variance and standard deviation for the data in Table 4.1 will be calculated. This
is shown in table 4.4.
Table 4.4: Calculating the variance and standard deviation
Original data (see table 4.1)
Squared value of deviation

from the mean
Deviation from the mean of

10.802%
X X
Xi X
46.21
35.41
1 253.7265
-6.18
-16.98
288.3883
8.04
-2.76
7.6286
22.87
12.07
145.6366
45.90
35.10
1 232.8696
20.32
9.52
90.5923
41.20
30.40
924.0384
-9.53
-20.33
413.3902
-43.06
-53.86
2 901.1150
-17.75
-28.55
815.2167
8 071.6024
X X
896.8447
10
i 1
10
s2
i 1
9
s s2
29.9474
or 29.95%
4.2.5.4 Summary of the measures of dispersion

Table 4.5 shows the comparable measures of dispersion for the total annual returns data shown in
Table 4.1. The variance is not shown as it is not comparable - it indicates squared percentage.
Table 4.5: Measures of dispersion
Measure
Result
Range
89.27%
Mean absolute deviation
24.50%
Standard deviation
29.95%
The mean absolute deviation will always be equal to or less than the standard deviation. This is
because the standard deviation gives more weight to large deviations as the deviations are squared.
76
The range simply reflects the difference between maximum (46.21%) and minimum (-43.06%)
returns.
4.2.6 Symmetry and skewness in distributions

Distributions can be symmetric or skewed. A symmetric distribution is identical to the left and right
of its mean i.e., 50% of its observations is less than the mean and 50% greater. A distribution which
is not symmetric is said to be skewed.
One of the most important symmetrical distributions is the normal distribution. The normal
distribution is extensively used in finance, risk management and portfolio selection.
A normal distribution is symmetrical about its mean and is fully described by its mean (measure of
central tendency) and variance / standard deviation (measure of dispersion). 68.3% of the
observations of a normal distribution lie between plus and minus one standard deviation from the
mean, 95.5% of observations lie between plus and minus two standard deviations from the mean
and 99.7% between plus and minus three standard deviations from the mean as illustrated in Figure
4.2.
Figure 4.2: Normal distribution
When a frequency distribution is skewed, the characteristics inherent to a normal distribution no

longer apply. A skewed distribution can have a positive or negative skew (see figure 4.3). A
77
distribution with a positive skew has a long tail in a positive direction i.e., to the right. A distribution
with a negative skew has a long tail in a negative direction i.e., to the left.
Figure 4.3: Skewed distributions
Applied to an investments distribution of return, a return distribution with a positive skew has many
small losses and few substantial gains. A return distribution with a negative skew has numerous
small gains and a few large losses.
Investors may prefer positive skewness i.e., investments that offer small losses and a few substantial
gains to negative skewness i.e., numerous small gains and a few large losses.
A symmetric distribution such as a normal distribution has a skewness of zero. A positively-skewed

distribution has positive skewness and a negatively-skewed distribution has a negative skewness.
The sample skewness formula is:
X X
n
SK
n 1n 2
where
i 1
s3
SK sample skewness
s the sample s tandard deviation
For example, using the data in table 4.1, the return on the stock exchange index is slightly negatively
skewed. The calculations are shown in table 4.6.
78
Table 4.6: Calculating skewness

Original data
(see table 4.1)
Cubed value of deviation

from the mean
Deviation from the

mean of 10.802%
Xi X
X X
46.21
35.41
44 391.9466
-6.18
-16.98
-4 897.4105
8.04
-2.76
-21.0703
22.87
12.07
1 757.5428
45.90
35.10
43 236.1594
20.32
9.52
862.2577
41.20
30.40
28 088.9194
-9.53
-20.33
-8 405.0500
-43.06
-53.86
-156 259.8585
-17.75
-28.55
-23 276.0673
X
10
-74 522.6308
i 1
10
10
i 1
98 26 858.1363
4.3
-0.3854
Inferential statistics
Statistical inference is the process by which conclusions or inferences are drawn about an attribute
of a population (e.g. the mean or standard deviation) based on an analysis of sample data. To do this
inferential statistics uses the concept of probability. Probability enables the progression from
descriptive statistics to inferential statistics.
Statistics is used to support decision making. Decision-making - including financial decision-making is often based on information that is not certain. This uncertainty increases the risk attached to
decision making. Probability tools enable consistent and logical decisions to be made in an
environment of risk.
Firstly the basic tools of probability including expected value and variance will be discussed.
Thereafter the concepts of covariance and correlation, which are measures of relatedness, are
described.
79
4.3.1 Basic tools and terminology of probability

A random variable is a variable that takes on different values as a result of the outcome of an
experiment. The possible values of a random variable are uncertain. The return on a risky asset is an
example of a random variable.
An experiment is an observation of some activity or the act of taking some measurement. An

outcome is a possible value of a random variable. An event is an outcome or specified set of
outcomes of a random variable. For example an event may be a single outcome such as the
investment earns a return of 12%. An event may be a set of outcomes such as the investment
earns a return less than 12%. This event contains an infinite set of outcomes namely returns less
than 12% and greater than -100% (i.e., the worst possible return).
Probability is the chance that an event will occur. It is reflected as a number between 0 and 1. A
probability of 0 means the event will never happen. A probability of 1 means the event will always
happen. The sum of the probabilities of any set of mutually exclusive and exhaustive events equals
1.
For example assume three events:
Event A = the investment earns a return of 12%
Event B = the investment earns a return less than 12%
Event C = the investment earns a return greater than 12%
The term mutually exclusive means that only one event can occur at a time. For example an
investment portfolio cannot have a return of 12% and a return less than 12% at the same time i.e.,
thus event A and event B are mutually exclusive events.
The term exhaustive means that the set of events covers all possible outcomes. Events A and B are
not exhaustive events because they do not cover outcomes such as a return of 15%. However events
A, B and C are exhaustive i.e., they cover all possible outcomes. Events A, B and C are also mutually
exclusive.
This can be notated as follows:
P(A) is a number between 0 and 1 i.e., the probability of event A occurring is a number between
0 and 1
80
P(B) is a number between 0 and 1
P(C) is a number between 0 and 1
P(A) + P(B) + P(B) = 1 i.e., the sum of the probabilities of a set of mutually exclusive and
exhaustive events equals 1
Since making financial decisions using erroneous probabilities may have negative consequences,
how in practice are probabilities estimated? There are three methods:
Empirical probability is estimated as a relative frequency of occurrence based on historical data.
A priori or classical probability is deduced by logical reasoning and analysis rather than on
observation or personal judgment. For example probability statements about a fair coin toss can
be based on logical reasoning before any experiments take place.
Subjective probability is estimated by drawing on subjective or personal judgment. Since a priori

and empirical probabilities generally do not vary from person to person, they are considered to
be objective probabilities.
To understand probability in investment contexts, it is necessary to distinguish between conditional

and unconditional probabilities:
Unconditional or marginal probability is the single probability that an event will occur. The
probability of the event is not conditioned on another event. For example the probability that an
investment earns a return above the risk-free rate
Conditional probability is the probability that an event will occur, given that one or more other
events have occurred. For example the probability that the investment earns a return above the
risk-free rate given that the investment earns a positive return. Intuitively given a positive
return, the probability of a return above the risk-free rate is greater than the unconditional
probability, which is the probability of an event occurring without additional information.
4.3.2 Expected return

The future rate of return of an investment is not known for certain. Instead there are several
possible rates of return, each with a possibility of materialising. The expected rate of return is the
weighted average rate of return. It is calculated by weighting each possible rates of return with its
probability of occurrence.
For example, assume an investment has the possible rates of return and the probability of them
happening as shown in table 4.7.
81
Table 4.7: Rates of return and probabilities of occurrence

Rate of return %
Probability
5.0
10.0
15.0
18.0
0.20
0.30
0.30
0.20
Total
1.00
The formula for calculating the expected return is:

E(X )
P X
i
i 1
where
E X the expected return

X i rate of return X i
Pi the probability associated with rate of return X i
n the number of possible rates of return X i
The expected rate of return of the share is 7.3%. The calculation is shown in table 4.8.
Table 4.8: Calculating the expected rate of return
Rate of return %
(Xi)
Probability
(Pi)
Expected return E(X)

(PiXi)
17.0
-5.0
10.0
12.0
0.20
0.30
0.30
0.20
3.4
-1.5
3.0
2.4
Total
1.00
7.3
4.3.3 Variability of return

The variance and standard deviation (i.e., square root of the variance) are measures of the
dispersion or spread of the probability distribution around the expected rate of return. The less
spread out the distribution is i.e., the more closely concentrated round the expected value the
probability distribution is, the smaller the variance and standard deviation and the smaller the risk
that the expected rate of return will not materialise.
Thus the variance and standard deviation indicate the variability of return i.e., the risk that the
expected rate of return will not occur.
82
The formula for calculating the variance is as follows:

var(X )
P X
n
E ( X )2
i 1
where
var(X ) variance
Pi probability of the i th rate of return occuring
X i the i th rate of return
E ( X ) the expected rate of return
A disadvantage of using the variance is that it is expressed in terms of squared units of the rate of
return. Thus the square root of the variance - the standard deviation - is a more meaningful measure
of the dispersion of the probability distribution.
The formula for calculating the standard deviation is:
std(X ) var(X )
For example the variance of the share is 70.81 and the standard deviation is 8.415% i.e.,
70.81 .
Table 4.9: Calculating the variance

Rate of return
(Xi)
Probability
(Pi)
17.0
-5.0
10.0
18.0
0.20
0.30
0.30
0.20
0.20x(17.0-7.3)2 = 18.818
0.30x(-5.0-7.3)2= 45.387
0.30x(10.0-7.3)2= 2.187
0.20x(12.0-7.3)2= 4.418
Total
1.00
70.810
Pi (Xi-E(X))2
If the rate of return of the share is normally distributed and the expected rate of return is 7.3% and
the standard deviation 8.415%, the probability is roughly 68% that the actual rate of return of the
share will be between 15.715% and -1.115% (between (7.3%+ 8.415%) and (7.3% 8.415%)).
Similarly the probability is about 95% that the actual rate of return of the share will be between
24.130% and -9.530% (7.3% (2 x 8,415%)) and approximately 99.7% that the actual rate of return
of the share will be between 32.545% and 17.945% (7.3% (3 x 8.415%).
83
In general this may not hold because there is no reason to expect the distribution of a securitys
rates of return to be normal. However the function of the standard deviation is the same in every
case to measure the likely divergence of the actual rate of return from the expected rate of return.
4.3.4 Covariances and correlation coefficients

Covariances and correlation coefficients indicate the relationship between securities rates of return.
The covariance is a measure of the extent to which two variables (e.g. securities rates of return)
move together linearly. If two variables are independent their covariance is equal to zero. A positive
covariance indicates that the two variables move in the same direction and a negative covariance
that they move in opposite directions.
No significance can be attached to the magnitude of the covariance. A positive covariance means
that on average the rates of return of the two securities move in the same direction. The correlation
coefficient is a more convenient measure of linear dependence. It measures the strength of the
linear association between two variables.
Correlation coefficients range between -1 and 1 with the interpretation thereof as follows:
+1 indicating an exact positive linear relationship between the two variables X and Y i.e., an
increasing X is associated with an increasing Y
-1 indicating that although the variables move in perfect unison, they move in opposite
directions i.e., an increasing X is associated with a decreasing Y
0 indicating that there is no linear relationship between the two variables
For example, assume the correlation coefficient between the return on Telkom shares and MTN
shares is 0.904. There is a strong positive linear relationship between the returns on the two shares.
This is not surprising since both shares are in the telecommunications sector.
The correlation coefficient measures the extent of the linear association between two variables. This
association does not imply causation - both variables may be affected by a third variable. For
example, there is a strong correlation between human birth rates and stork population sizes!
84
Review questions
1.
What is the difference between a population and a sample?
2.
What is the mean annual rate of return for a share having the following annual rates of return?
2009: 12%
2008: 4%
2007: -10%
2006: 30%
3.
What is the range of the annual rates of return in question 2?
4.
What is the MAD of the annual rates of return in question 2?
5.
What is the standard deviation of the sample of annual rates of return in question 2?
6.
What is the standard deviation of the population of annual rates of return in question 2?
7.
A normal distribution is skewed. (True or False)
8.
If the distribution of an investments returns has a positive skew it has many small losses and a
few substantial gains. (True or False)
9.
Given the following expectations for a share, what is the expected return for the share?
Scenario
Probability
Return
Bear market
20%
-20%
Normal market
50%
18%
Bull market
30%
50%
10. The positive correlation coefficient between the change in the share price of an industrial
bakery and the wheat price is 0.82. So a change in the wheat price causes an 82% change in the
share price. (True or False).
85
Answers
1.
A sample is a subset or part of a population. A population is the entirety of objects of a specified

group.
2.
9% i.e., (12%+4%+-10%+30%)/4
3.
40% i.e., 30% - (-10%)
4.
12%
5.
Rates of return
Deviation from mean of 9%
Absolute value of deviation
12
-5
-10
-19
19
30
21
21
Sum
48
MAD i.e. 48/4
12
16.69%
Rates of return
Squared deviation
12
-5
25
-10
-19
361
30
21
441
Sum
6.
836
Variance i.e. 836/3
278.67
Standard deviation i.e. 278.67
16.69
14.46%
Rates of return
Squared deviation
12
-5
25
-10
-19
361
30
21
441
Sum
836
Variance i.e. 836/4
209
Standard deviation i.e. 209

7.
False. A normal distribution is symmetrical.
8.
True
9.
20% = (20% X -20% + 50% X 18% + 30% X 50%)
14.46
86
10. False. The correlation coefficient measures the extent of the linear association between two
variables. This association does not imply causation - both variables may be affected by a third
variable. In this case by the cost of fuel.
87
5 The foreign exchange market

The objective of this chapter is to describe the foreign exchange market - the market in which
currencies trade. First the foreign exchange market is defined and its characteristics described. Then
foreign exchange instruments are explained. Finally the chapter outlines the participants in the
foreign exchange market.
define the foreign exchange market
understand the characteristics of the foreign exchange market
explain foreign exchange spot, forwards, futures and options
describe the participants in the foreign exchange market.
5.1
The market defined
The foreign exchange market is the financial market where currencies are bought and sold. The price
at which they are traded is the exchange rate.
The exchange rate is the price of one currency in terms of another currency. In direct terms it is the
price of one unit of foreign currency in terms of domestic currency. For example if one US dollar
(USD) - the foreign currency - is equal to seven South African rand (ZAR) - the local currency - the
exchange rate in direct terms is ZAR7. It is usually expressed as USD/ZAR 7. In indirect terms the
exchange rate is the price of one unit of domestic currency in terms of the foreign currency. For
example if one South African rand is equal to 0.14 US dollars the indirect exchange rate is USD 0.14.
This is expressed as ZAR/USD 0.14. ZAR/USD 0.14 is the reciprocal of USD/ZAR7 i.e., 1/7 = 0.14.
The majority of currencies are quoted against the USD in direct terms. Currencies quoted in indirect
terms include the UK pound (GBP) and the Euro (EUR).
The foreign exchange market plays a crucial role in facilitating cross-border trade, investment, and
financial transactions. In a world increasingly dominated by international trade trade has grown by
a factor of three over the last 20 years - the foreign exchange market is instrumental in facilitating
such trade. The foreign exchange market is an important adjunct to the international capital market
88
allowing borrowers to meet their financing requirements in the currency that best meets their
needs.
5.2
Characteristics of the market
The foreign exchange market is the largest financial market in the world. Average daily turnover in
global foreign exchange markets in April 2012 was USD 4.9 trillion; a 308.3% increase in comparison
to April 2001 where the average daily turnover was USD 1.2 trillion (The City UK August 2012).
Most currency exchanges are made via bank deposits. Banks dealing in the foreign exchange market
tend to be concentrated in certain key financial cities - London, New York, Tokyo, and Singapore. The
UK, London in particular, is the main geographic centre for trading with 38% of global trade in April
2012. The US is the second largest with 18% followed by Singapore and Japan with about 5% each
(The City UK August 2012).
The foreign exchange market is highly integrated globally and operates 24 hours a day when one
major market is closed another is open so trading can take place 24 hours a day moving from one
centre to another. There are three major time zones. The market begins each day at 1 a.m.
Greenwich Mean Time (GMT) when Tokyo opens. The Far Eastern time zone holds sway until 9 a.m.
GMT when trading in the European time zone begins in centres such as London, Frankfurt, Paris and
Zurich. By 2 p.m. GMT trading in the American time zone begins in New York, which does not close
until 10 p.m. GMT. Dealers trade in San Francisco and Los Angeles on the West coast until Tokyo
opens the next day.
Currencies are traded over-the-counter (OTC) with trading taking place telephonically or
electronically.
Most foreign exchange transactions take place in USD; the primary vehicle currency. If a trade
between Argentina peso (ARS) and Botswana pula (BWP) is required, it is easier to change the ARS to
USD and the USD to BWP than to do a direct ARS / BWP trade. The Euro (EUR) and Japanese yen
(JPY) are also vehicle currencies but less so.
89
5.3
Foreign exchange market instruments
5.3.1 Exchange rates

It may be considered misleading to speak of the exchange rate between currencies as a range of
rates exist based on when delivery of the currency is required.
5.3.1.1 The spot rate

The spot rate is quoted for immediate (in practice, two working days) delivery as illustrated in
figure 5.1.
Figure 5.1: Spot transactions - dealing and value dates
There are two spot rates for a currency. The bid rate is the rate at which one currency can be
purchased in exchange for another while the offer rate is the rate at which one currency can be sold
in exchange for another. The terms bid and offer originate from inter-bank transactions, which are
mainly quoted against the USD. The bid rate is the rate the bank is willing to pay to buy USD (and sell
the non-USD currency) and the offer rate is the rate at which the bank will offer to sell USD (and buy
the non-USD currency). The difference, or spread, between the two rates provides the banks profit
margin on transactions.
For example assume a South African importer wants to buy USD 1 million from a bank. The bank
quotes the following rates: USD/ZAR 6.5230-6.5280. Since the importer is buying USD and selling
ZAR the bank is selling USD and buying ZAR the offer rate of R6.5280 applies and the cost to the
importer will be R6 528 000 i.e., USD1 000 000 x R6.5280. Furthermore assume a South African
exporter wishes to sell USD 1 million to the bank and is quoted the same rates. Since the customer is
selling USD and buying ZAR - the bank is buying USD and selling ZAR - the bid rate of R6.5230 applies
and the exporter will receive R6 523 000 i.e., USD1 000 000 x R6.5230. The bank earns the margin
between its bid and offer prices, in this case R5 000 i.e., R6 528 000 R6 523 000.
90
Of course clients may wish to transact in currencies other than USD e.g. Australian dollar (AUD)
against the rand (ZAR), Hong Kong dollar (HKD) against the Kenyan shilling (KES). In such cases cross
rates rates between two currencies where neither is USD - are calculated. For example, a cross rate
for HKD and KES, where the customer wanted to sell HKD and buy KES, would be calculated by firstly
converting HKD into USD and then converting the USD dollars into KES.
5.3.1.2 The forward rate

Foreign exchange can be bought and sold not only on a spot basis, but also on a forward basis for
delivery on a specified future date see figure 5.2. With a forward transaction, the sale or purchase
is agreed to now but will take place on a date in the future, thereby fixing the exchange rate now for
a future exchange of currencies. Forward transactions are known as forward exchange contracts or
forward contracts.
Figure 5.2: Forward transactions - dealing and value dates
The forward exchange rate may be higher (premium) or lower (discount) than the spot exchange
rate, rarely are they the same although this is theoretically possible. The difference between the
forward rate and the spot rate reflects the interest rate differential between the two currencies. If
this were not the case forward contracts would be used to earn risk-free profits through arbitrage.
Forward rates as such are not quoted but the premium or discount points to the spot rate are. One
point is equivalent to 0.0001 of the currency in question. Given direct quotations the forward rate is
obtained by adding the premium to or subtracting the discount from the spot rate (with indirect
quotations, the opposite is the case).
91
For example, if the spot exchange rate is USD/ZAR 6.4340 - 6.4350 and the 3-month forward
premium is 580-590. Since ZAR is trading at premium to USD, the forward USD/ZAR rate is 6.4920
6.4940 (i.e., 6.4340 + (580/10000) and 6.4350 + (590/10000)).
5.3.2 Swap transaction

A swap transaction involves the simultaneous exchange of two currencies on a specific date at a rate
agreed at the time of the contract and a reverse exchange of the same two currencies at a date
further in the future at a rate agreed at the time of the contract.
For example, if a US bank needs temporary working capital in Germany and does not want to run the
exchange risk of re-converting EUR2 to USD, it will purchase say EUR 1 million against USD and
simultaneously sell the EUR forward. The account of the US bank in Germany will show a credit
balance of EUR 1 million as a result of the spot purchase. However the company's position in EUR
will be zero because it has sold the same amount forward.
5.3.3 Futures contracts

Futures contracts are similar to forward contracts except they are traded on an exchange, have a
standard quantity of foreign currency, have standardised delivery rules and dates and their
performance is guaranteed by the exchanges clearing house (see chapter 9 for more details).
5.3.4 Options
A call option gives the buyer of the option the right to buy a certain amount of currency at a
specified exchange rate on or before a designated date. A put option gives the buyer of the option
the right to sell a certain amount of currency at a specified exchange rate on or before a designated
date. Options can be traded on-exchange or over-the-counter (see chapter 9 for more details).
5.4
Foreign exchange market participants
There are a number of participants in the foreign exchange markets.
5.4.1 Commercial banks

Commercial banks participate in the foreign exchange market by:
offering to buy and sell foreign exchange on behalf of their customers (retail or wholesale) as a
standard financial service
the Euro replaced the Deutsche Mark on 1 January 1999 when the national currencies of participating
countries (such as Germany, Italy and France) ceased to exist independently.
92
trading in foreign exchange as intermediaries and market makers
managing their proprietary foreign exchange positions via the interbank foreign exchange
market. The inter-bank market is more accurately an inter-dealer market as investment banks
and other financial institutions have become direct competitors of the commercial banks as
dealers in these markets.
5.4.2 Non-bank financial institutions

Institutional investors such as insurance companies, hedge funds, pension funds, mutual funds
directly participate in the foreign exchange market in pursuit of a more global approach to portfolio
management.
5.4.3 Firms and corporations

Firms and corporations usually participate in the foreign exchange market because of their
involvement in international trade. Firms that are importers require foreign exchange to pay
suppliers. Exporters need to convert foreign currency earnings into local currency. Both importers
and exporters may want to hedge currency exposures that arise in relation to trade.
Large international corporations are increasingly entering the foreign exchange market directly and
not via intermediaries such as banks especially if they own factories and plants or regularly buy
components abroad.
5.4.4 Central banks

Central banks sometimes intervene in the foreign exchange market to increase or decrease the
supply of their currency or to purposely impact the exchange rate. In addition central banks act as
their governments international banker and handle the foreign exchange transactions for the
government and public sector enterprises such as the post office, railways and airlines.
93
Review questions
1.
Define the foreign exchange market.
2.
What is a foreign exchange rate?
3.
What are two important roles of the foreign exchange market?
4.
Name the primary vehicle currency.
5.
Describe the two spot exchange rates for a currency.
6.
Assume a South African importer wants to buy dollars from a bank and the bank quotes the
following rates R6.5230-R6.5280. Which of the two rates applies?
7.
Assume a South African exporter wants to sell dollars to a bank and the bank quotes the
following rates R6.5230-R6.5280. Which of the two rates applies?
8.
If the US dollar / rand is R6.4340-R6.4350 and the 3-month forward premium is 601-611
points, what is the forward rate?
9.
What is a foreign exchange swap transaction?
10.
How do commercial banks participate in the foreign exchange market?
94
Answers
1.
The foreign exchange market is the financial market where currencies are bought and sold.
2.
The foreign exchange rate is the price of one currency in terms of another currency.
3.
Two important roles of the foreign exchange market are facilitating international trade and
facilitating financial transactions.
4.
US dollars are the primary vehicle currency.
5.
The two spot exchange rates for a currency are the bid rate and the offer rate. The bid rate is
the rate at which one currency can be purchased in exchange for another. The offer rate is the
rate at which one currency can be sold in exchange for another.
6.
When a South African importer buys dollars from the bank, the offer rate of R6.5280 applies.
7.
When a South African importer sells dollars to the bank, the bid rate of R6.5230 applies.
8.
The forward rate is 6.4941 - 6.4961 (i.e., 6.4340 + (601/10 000) and 6.4350 + (611/10 000))
9.
A foreign exchange swap transaction is the simultaneous exchange of two currencies on a

specific date at a rate agreed at the time of the contract and a reverse exchange of the same
two currencies at a date further in the future at a rate agreed at the time of the contract.
10.
Commercial banks participate in the foreign exchange market by offering to buy and sell
foreign exchange on behalf of their customers as a standard financial service, trading in
foreign exchange as intermediaries and market makers and managing their own foreign
exchange positions via the interbank foreign exchange market.
95
6 The money market

Chapter 6 describes the money market the market that deals in short-term debt instruments. First
the money market is defined and its characteristics described. Then money market securities are
explained and their participants outlined.
define the money market
understand the characteristics of the money market
differentiate between discount or interest-add-on money market securities
explain market instruments by discussing the definition, denomination, maturity, quality and
market participants (namely issuers and investors) of each
list money market participants.
6.1
The market defined
The money market is defined as that part of the financial market for the issuing, buying and selling of
debt instruments with maturities ranging from one day to one year the most common maturity
being 3 months.
6.2
Money market instruments are not traded on a formal exchange but over-the-counter (OTC). The
market has no specific location - it is based in the large financial centres of the world with most
transactions being made by telephone or electronically.
An electronic dematerialised money market environment has been established in South Africa. The
characteristics of the market include standardised and electronically issued money market securities,
same day settlement (T+0), electronic recording of trades in money market securities, and electronic
clearing and settlement of money market trades.
When considering money markets a distinction should be drawn between primary and secondary
money markets. The primary market is the market for the issue of new money market instruments.
The secondary market is the market in which previously issued money market instruments are
traded.
96
Central banks are key participants in the money market. The money market is essential for the
transmission of monetary policy. Central banks control the supply of reserves available to banks
primarily through repurchase agreements or the outright purchase and sale of money market
instruments such as treasury bills.
6.3
Money market instruments
The following money market instruments will be addressed: bankers acceptances, commercial
paper, negotiable certificates of deposits (NCDs) treasury bills, and repurchase agreements and
Reserve Bank debentures (RBDs). In each case the definition, denomination, maturity, quality and
market participants - issuers (or borrowers) and investors - will be considered.
Money market instruments are either discount or interest-add-on securities:
Discount instruments are securities such as treasury bills that are sold at a discount to face or
par value and redeemed at face and par value on maturity date. For example assume an investor
buys a 91-day treasury bill with a face value of R1 million for R975 000. In 91 days the investor
will receive R1 million when the National Treasury redeems the bill. Thus the investor earned
interest of R25 000 over the period of 91 days.
Interest-add-on securities are securities such as NCDs and RBDs that are sold at face or par value
and redeemed at face value plus interest on maturity date. For example assume an investor buys
a 91-day NCD with a face value of R1 million. The investor will pay R1 million for the NCD. In 91
days the investor will receive R1 million plus interest when the issuer redeems the NCD.
97
6.3.1 Bankers acceptances

Definition
A bankers acceptance (BA) is a bill of exchange drawn on and accepted by

a bank. The drawer of the bill is usually a company seeking funding from a
bank.
Before acceptance, the bill is not an obligation of the bank; it is merely an
order by the drawer to the bank to pay a specified sum of money on a
specified date to a named person or to the bearer of the bill. Upon
acceptance by the bank the bill becomes a primary and unconditional
liability of the bank. In effect the bank is substituting its credit for that of
the company, enabling the company to borrow indirectly in the money
market.
BAs are no longer an important form of financing in the South African
money market because they have lost their liquid assets status in terms of
the Banks Act and borrowers have turned to other forms of short-term
financing. BAs are also declining in importance in the US and Europe.
Denomination:
A wide range of denominations are available but acceptances are usually

issued in multiples of R100 000 and R1 million
Maturity:
Typically 90 days but could range from 30 to 270 days
Quality
Primary obligation of the accepting bank and a contingent obligation of

the drawer and endorser(s)
Issuers:
The drawer or borrower is usually a company. The acceptor is a bank
Advantages
Simplicity
It is a cheaper form of financing for the company than a bank
overdraft
Disadvantages
A bank line of credit is required and the bank may require security or
collateral
Borrowing via BAs is more expensive than by means of commercial
paper
Borrowing via BAs does allow companies who do not have direct
access to the money market to obtain indirect access. Indirect access
is more expensive than direct access as the company must pay the
accepting bank to open the door for it to obtain right of entry to the
money market
Investors:
Banks, private and public corporations, money market funds, hedge

funds, mutual funds, pension funds, insurance companies, and individuals
Advantages
BAs are considered to be relatively high-quality investments because

they are "two-name" paper i.e., two parties, the accepting bank
(primary obligator) and the drawer (contingent obligator if the bank
fails to pay) are obligated to pay the holder on maturity.
A liquid secondary market generally exists
Disadvantages
Although BAs are considered to be relatively high-quality investments,

investing therein exposes the investor to some credit risk i.e., that
neither the accepting bank nor the borrower will be able to pay the
investor at maturity date. Consequently BAs offer a higher yield than
treasury bills of the same maturity
Large denominations are unattractive to investors
98
6.3.2 Commercial paper

It is not possible to provide a precise, internationally-acceptable definition of commercial paper as
the dividing line between commercial paper and other instruments is generally country-specific and
reflects differences in countries regulatory frameworks. However in all markets, commercial paper
is a form of fixed-maturity short-term unsecured single-name negotiable debt issued primarily by
non-banks.
In South Africa, according to an exemption notice in terms of the Banks Act (Government Notice No.
2172), commercial paper excludes BAs and includes:
Short-term secured or unsecured promissory notes with a fixed or floating maturity
Call bonds
Any other secured or unsecured written acknowledgement of debt issued to acquire working
capital
Debentures or any interest-bearing written acknowledgement of debt issued for a fixed term in
accordance with the provisions of the Companies Act, 2008 such as bonds.
In line with this definition promissory notes and call bonds will be discussed in this chapter;
debentures and bonds are examined in the next chapter.
6.3.2.1 Promissory notes

Definition
Denomination
Maturity
Quality
Issuers
Advantages
A promissory note (PN) is a written promise made by the issuer

(borrower) to the investor (lender) to repay a loan or debt under specific
terms - usually at a stated time, through a specified series of payments, or
upon demand.
The issue of PNs generally takes place under a pre-announced commercial
paper programme. Once a programme is announced, the issuer is free to
raise funds from the market as and when required.
PNs are issued in multiples of R100 000 and R1 million
PNs are usually available for 3, 6, 9 and 12 months and every 6 months
thereafter up to 60 months depending on the programme
Obligation of the issuer (borrower)
Issuers are usually companies
It is a cheaper form of financing for the company than a bank
overdraft
The maturity of a PN can be tailored to meet the companys funding
requirements and / or to take advantage of investor demand
99
Disadvantages
Investors
Advantages
Disadvantages
If the PN issue is not underwritten by for example, a bank, the issuer

may not be able to place all the paper with investors and raise the
funds required
For a viable commercial paper market, access to or establishment of
rating agencies is essential
Banks, pension funds, insurance companies and individuals
PNs have a wide range of maturities to enable investors to find an
instrument that best suits their requirements
Investors are exposed to credit risk i.e., that the issuer will fail to
perform as promised
6.3.2.2 Call bonds

Definition
Denomination
Maturity
Quality
Issuers
Advantages
Disadvantages
Investors
Advantages
Disadvantages
A call bond is a loan made to the issuer (borrower) by the investor

(lender), which may be terminated or "called" at any time
Call bonds are usually issued in multiples of R1 million, R5 million and R10
million
Call bonds are repayable on demand
Obligation of the issuer (borrower)
The borrower is usually a company. Banks are also issuers of call bonds
A call bond is a flexible form of financing in terms of arranging,
drawing down and repaying the loan
A call bond can be expensive when compared to other loans
Call bonds are exposed to sharp movements in interest rates, which is
unfavourable when rates are rising
Banks, money market funds, pension funds, insurance companies and
individuals
Call bonds are immediately redeemable
Investors are exposed to credit risk i.e., that the obligor will fail to
perform as promised
6.3.3 Negotiable certificates of deposit (NCD)

Definition
Denomination
Maturity
Quality
Issuers
Advantage
Disadvantage
Investors
An NCD is a negotiable fixed deposit receipt issued by a bank for a specified

period at a stated rate. NCDs are usually issued in bearer form (i.e. payable
to whoever is in possession of it namely the bearer)
NCDs are issued in multiples of R1 million
From less than one year to up to five years
Obligation of the issuing bank
Banks
Generally cheaper than instruments in the inter-bank market
More expensive than retail deposits
Wide range of institutions: banks, private and public corporations, pension
funds, insurance companies, money market funds, hedge funds, mutual
funds, pension funds and individuals
100
Advantages
Disadvantages
Active secondary market so the instruments are liquid and relatively

risk free
Banks are willing to tailor maturities to meet the needs of investors
Although banks are generally considered to be issuers of good quality,
investors are still exposed to credit risk i.e., that the bank will fail to
perform as promised
6.3.4 Treasury bills

Definition
Denomination
Maturity
Quality
Issuer
Advantage
Investors
Advantages
Disadvantage
A treasury bill (TB) is short-term debt obligation of the government payable

on a certain future date
TBs are issued in multiples of R10 000 and for an amount not less than
R100 000
A tenor of between 90 days and 6 months; special tender bills have tenors
of up to one year
TBs are obligations of the government and are thus considered to be free
of domestic credit risk
The government
Main vehicle for central bank accommodation policy
Mainly held by banks - also held by insurance companies and money
market funds, hedge funds, mutual funds and pension funds
TBs are considered to be free of domestic credit risk
TBs usually qualify as liquid assets for banks and may be held by
insurers and pension funds to satisfy their relevant regulatory and
investment requirements
A liquid secondary market exists
Because TBs are considered to be free of domestic credit risk, they have a
lower yield than other money market instruments
6.3.5 Repurchase agreements

Definition
Denomination
Maturity
Quality
Issuers
A repurchase agreement (repo) is an agreement under which funds are

borrowed through the sale of short-term securities such as treasury bills
with a commitment by the seller (borrower) to buy the security back from
the purchaser (investor) at a specified price at a designated future date.
Essentially the borrower is borrowing money and giving the security as
collateral for the loan and the investor is lending money and accepting the
security as collateral for the loan.
Depends on the security
Overnight to 30 days and sometimes longer
Obligation of the issuer with collateral usually in the form of high-quality
securities such as treasury bills
Large companies including banks use repos to borrow short-term funds.
Repos are also used between central banks and banks as part of the
central banks open-market operations
101
Advantages
Disadvantage
Investors
Advantage
Disadvantage
Repos can be used to borrow short-terms funds, to finance positions and

to cover short positions at an acceptable cost
Investors may require credit risk mitigation such as daily margin calls i.e.,
if the value of the security falls below the amount of the loan
A variety of investors including mutual and hedge funds
If the collateral is treasury bills, investors earn a risk-free rate higher than
the treasury bill rate without sacrificing liquidity
Investors are exposed to credit risk if the value of the security falls i.e., the
amount of the collateral is less than the amount of the loan.
6.3.6 Reserve Bank Debentures

Definition
Denomination
Maturity
Quality
Issuer
Advantage
Investors
Advantages
Disadvantage
6.4
A Reserve Bank Debenture (RBD) is an unsecured fixed interest certificate

of debt issued by the SARB
RBDs are issued in multiples of R1 million and for a minimum amount of
R1 million
7, 14,28 days, 56 days or at the discretion of SARB
RBDs are obligations of the SARB. Since the creditworthiness of a central
bank is generally the same as that of the country, RBDs are considered to
be free of domestic credit risk
SARB
Used to manage liquidity conditions in the money market
Mainly held by banks - also held by insurance companies and money
market funds, hedge funds, mutual funds and pension funds
RBDs are considered to be free of domestic credit risk
RBDs qualify as liquid assets for banks and may be held by insurers and
pension funds to satisfy their relevant regulatory and investment
requirements
RBDs may be used by banks as collateral for SARB accommodation
Because RBDs are considered to be free of domestic credit risk, they have
a lower yield than other money market instruments
Money market participants
Section 6.3 shows that a large variety of institutions participate as issuers and investors in the money
market.
Banks as custodians of the general publics money and intermediators between ultimate lenders and
borrowers play a key role in that they issue and trade money markets instruments and are the main
vehicle through which the SARB intervenes in the money market.
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The SARB issues debentures and sells money market instruments in the secondary market mainly for
monetary policy purposes. It also buys money market securities in the secondary market to provide
liquidity to the banks, once again for monetary policy purposes (see 2.4.2).
The government and the corporate sector are the main ultimate borrowers in the money market.
The government borrows by issuing treasury bills. Public corporations such as Eskom and Telkom
issue commercial paper and development financial institutions like Landbank issue bills. Companies
use money market instruments like call bonds, promissory notes and commercial paper to borrow
short-term funds.
Investors in the money market include banks, insurance companies, money market funds and other
collective investment schemes, hedge funds, pension funds and the Public Investment Corporation
and the Corporation for Public Deposits. Companies with temporary surplus cash also invest in the
money market.
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Review questions
1.
What is the most common maturity of money market transactions?
2.
Differentiate between the primary and secondary money market.
3.
Define a bankers acceptance.
4.
What is the quality of a bankers acceptance?
5.
What is the disadvantage of investing in promissory notes?
6.
What are the advantages of investing in negotiable certificates of deposit?
7.
Name two money market instruments issued by banks.
8.
Why would corporations rather use promissory notes than bank overdrafts to access funding?
9.
Why would pension funds invest in Treasury bills?
10.
Describe the uses of repurchase agreements.
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Answers
1.
The most common maturity of money market transactions is 3 months.
2.
The primary money market is the market for the issue of new money market instruments. The
secondary money market is the market in which previously issued money market instruments
are traded.
3.
A bankers acceptance is a bill of exchange drawn on and accepted by a bank.
4.
A bankers acceptance is a bill of exchange drawn (by a company) on a bank and accepted by
the bank. Thus the primary obligation is that of the accepting bank. Should the accepting bank
default, the investor has recourse to the drawer and endorser(s) of the bill.
5.
Investing in promissory notes exposes the investor to credit risk i.e., that the issuer will fail to
perform as promised.
6.
The advantages of investing in negotiable certificates of deposit (NCDs) are that NCDs trade in
an active secondary market so the instruments are liquid and relatively risk free and banks are
willing to tailor the maturities of NCDs to meet the needs of investors.
7.
Banks issue negotiable certificates of deposit and call bonds.
8.
Corporations would rather use commercial paper than bank overdrafts to access funding
because it is a cheaper form of financing than an overdraft.
9.
Pension funds invest in treasury bills (TBs) because TBs are considered to be risk free, TBs can
be used to satisfy the pension funds regulatory and investment requirements and a liquid
secondary market exists in TBs.
10.
Repurchase agreements are used by large companies including banks to borrow short-term
funds. Repurchase agreements are also used between central banks and banks as part of the
central banks open-market operations.
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7 The bond and long-term debt market

This chapter describes the bond and long-term debt market the market that deals in longer-term
debt instruments. First the market is defined and its characteristics described. Then bond and longterm debt instruments are explained. Finally the chapter outlines the participants in the money
market.
define the capital market
understand the characteristics of the bond and long-term debt market
know the terminology in respect of bond and long-term debt instruments
outline the definition, denomination, maturity, quality and market participants - issuers (or
borrowers) and investors - of bond and long-term debt market instruments.
7.1
The market defined
Capital markets are markets in which institutions, corporations, companies and governments raise
long-term funds to finance capital investments and expansion projects. The bond and long-term
debt market as well as the equity market are capital markets.
Bonds and long-term debt instruments are debt instruments that require the issuer or borrower to
repay the bondholder or lender or investor the amount borrowed as well as interest thereon over a
specific fixed period of time.
7.2
Bonds and long-term debt instruments are traded on organised exchanges or over-the-counter.
A distinction should be drawn between primary and secondary bond markets. The primary market is
where new bond and long-term debt instruments issues are sold.
The secondary market is the market in which previously issued bond and long-term debt instruments
are traded. In the US trading in government bonds takes place over-the-counter while the New York
Stock Exchange is the major exchange for corporate bonds. The London Stock Exchange lists
corporate as well as government bonds.
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The South African government and corporate bond market was regulated by the Bond Exchange of
South Africa. On 22 June 2009 the Bond Exchange of South Africa became a wholly-owned subsidiary
of the JSE. The intention of the merger was to deliver increased liquidity and functionality and a
broader range of products and services to market participants, bond issuers and investors. Now
money market and bond market securities are traded on the JSEs Interest-rate market.
7.3
Bond and long-term debt instruments
The following bond and long-term debt market instruments will be addressed: bonds, debentures
and floating-rate notes. In each case the following will be considered: definition, denomination,
maturity, quality and market participants - issuers (or borrowers) and investors. Before the
instruments are considered, certain terminology in respect of bond and long-term debt instruments
will be discussed.
7.3.1 Terminology of bonds and long-term debt instruments

7.3.1.1 Principal or par value
The principal of a bond is the amount the issuer agrees to repay the bondholder on maturity date. It
is also called the nominal, face, maturity, or redemption value.
7.3.1.2 Coupon and coupon rate

The coupon rate is the rate of interest (usually fixed) that the issuer agrees to pay the bondholder
each year. The interest payment is called the coupon. It is calculated by multiplying the principal by
the coupon rate. For example a bond with a 12% coupon rate and a principal of R1 000 will pay an
annual coupon of R120 (R1 000 x 0.12).
In the United States, United Kingdom, Japan and South Africa it is usual for the issuer to pay the
coupon in two semi-annual payments. For bonds issued in the Eurobond market coupon payments
are made once a year.
All bonds make periodic coupon payments except zero-coupon bonds. The coupons paid by variablerate bonds (floating-rate notes) vary according to a specified benchmark such as the effective ruling
interest rate on South African treasury bills or JIBAR (Johannesburg Inter-bank Acceptance Rate).
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7.3.1.3 Term to maturity

The term to maturity of a bond is the number of years over which the issuer has agreed to meet the
conditions of the debt. The maturity date (also called redemption date) is the date on which the
issuer is due to redeem the bond by paying the principal.
Term to maturity indicates the life of the bond i.e., the period over which the bondholder can expect
to receive coupon payments and the number of years before the principal is repaid.
7.3.1.4 Yield to maturity

Yield to maturity is the rate of return paid on a bond or other fixed income security if the instrument
is held until its maturity date. Yield to maturity is based on the coupon rate, term to maturity, and
market price. It assumes that coupon interest paid over the life of the bond will be reinvested at the
yield to maturity. Quantitatively the yield to maturity of a bond is the single interest rate equating
the price of the bond with the cash flows to be received from the bond i.e., it is the bonds internal
rate of return.
7.3.1.5 Market price or yield

The market price or yield is the price or yield needed to persuade investors to invest in a bond. It
reflects current market prices or yields on financial instruments of comparable risk at which willing
buyers and sellers are prepared to transact.
7.3.2 Bonds
Definition
Denomination
Maturity
Quality
Issuers
Advantage
Disadvantage
A fixed-interest-bearing security sold by the issuer promising to pay the

holder interest (called coupons) at future dates (usually every six months)
and the nominal (principal or face or par) value of the security at maturity.
In South Africa and the United Kingdom bonds issued by the government
are termed gilt stock. When issued by lower-ranking public bodies such as
municipalities or public enterprises e.g., Eskom they are called semi-gilt
stock
Bonds are usually issued in multiples of R1 million.
Usually the maturity of a bond is between 1 and 30 years
Government bonds are essentially risk-free within a country as they
constitute evidence of debt of the government. Semi-gilt stock may have a
degree of credit risk. The quality of corporate bonds depends on the
issuer
The government, public corporations, local authorities, companies and
banks
The interest cost of fixed-rate bonds is fixed over the life of the bond
If market rates fall after the bond has been issued, the issuer may be
locked into paying interest rates above market rates
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Investors
Advantages
Disadvantages
Banks, insurance companies, hedge, mutual and pension funds, trust

companies
A large selection of bonds e.g., in terms of quality and maturity, is
available to investors
Bonds are a good addition to an investors portfolio because they are
less volatile than equities in the short- to medium-term
There is a liquid secondary market
The price of a fixed-rate security moves in an inverse relationship to a
movement in interest rates. When interest rates fall, the price of the
bond rises to match current yields and vice versa. This gives investors
an opportunity for capital gains.
Investors can incur capital losses if interest rates increase
Unless the bond is issued by the government investors are exposed to
credit risk i.e., that the issuer will fail to perform as promised
Large denominations are unattractive to small investors
7.3.3 Debentures
Definition
A debenture is a fixed-interest-bearing security issued by a company.

The debenture contract consists of the debenture itself and the indenture
or trust deed. The debenture is the primary contract between the issuer
and investor and represents a promise by the issuer to pay interest as
specified and repay the nominal value at maturity. The trust deed is a
supplementary contract between the issuer and the trustees, who are
representatives of the debenture-holders setting out the rights of
individual debenture holders.
Denomination
Maturity
Quality
Issuers
Advantages
Disadvantages
Investors
Advantages
Debentures can be secured, redeemable, convertible, callable, variablerate and profit sharing.
Debentures are usually issued in multiples of R1 million
May range from in excess of 5 years up to 30 years
Obligation of the issuer
Companies
The interest cost of a debenture is fixed over the life of the debenture.
This assists in planning and budgeting for capital projects
The terms and conditions of a debenture may be favourable to the

issuer. For example a redeemable feature is advantageous to the issuer
as when interest rates fall, the issuer can redeem the outstanding
debenture and re-issue a new debenture at the lower interest rate.
The terms and conditions of a debenture may be unfavourable to the
issuer. For example, a restrictive covenant may restrain the freedom of the
management of the company in its operations
Mainly insurance companies and hedge, mutual and pension funds
The terms and conditions of a debenture may be favourable to the
investor. For example, a restrictive covenant may protect investors by
limiting the risk to which the management of the company may expose the
company.
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Disadvantages
The terms and conditions of a debenture may be unfavourable to the

investor. For example, unsecured debentures have no preferential
claim over any of the assets of the company
Investors are exposed to credit risk i.e., that the issuer will fail to
perform as promised
7.3.4 Floating-rate notes

Definition
Floating-rate notes are debt securities the coupon of which is re-fixed

periodically (usually six monthly) by reference to some independent predetermined benchmark interest rate or interest rate index.
In the Euromarkets, this is usually some fixed margin over 6-month LIBOR.
In South Africa securities have been linked to the overdraft rate, 90-day
JIBAR and the rate on long-term marketable Eskom bonds.
Denomination
Maturity
Quality
Issuers
Advantages
Disadvantages
Investors
Advantages
Disadvantages
FRNs are also known as variable-rate bonds

FRNs are usually issued in multiples of R1 million
banks
If short-term rates decrease after the floating-rate note is issued, the issuer
may fund at a rate lower than that of a comparable fixed-rate loan
If interest rates rise after the floating rate note is issued, greater costs may
be incurred than if a comparable fixed-rate bond had been issued
Coupons are adjusted to reflect general movements in interest rates
which gives investors protection against significant capital losses in
periods of interest rate uncertainty
The returns on floating rate notes are usually linked to short-term
interest rates, which can be attractive when short-term rates are at
historically high levels (e.g. 1998)
Less opportunity for capital gains than with fixed-rate investments
When the coupon is determined by reference to short-term interest
rates, this may not be at the highest point on the yield curve in which
case investors will not maximise return
Unless the FRN is issued by the government investors are exposed to
credit risk i.e., that the issuer will fail to perform as promised
7.3.5 Zero-coupon bonds

Definition
Zero-coupon bonds pay no coupons. Instead they are purchased at a

discount and repay the bondholder par value on maturity date.
Strips are derived from stripping a fixed-rate coupon bond into a series of
110
Denomination
Maturity
Quality
Issuers
Advantages
Disadvantages
Investors
Advantages
zero-coupon bonds. The bond is separated into its constituent interest

and principal payments, which can then be separately held or traded. For
example a 15-year bond paying fixed semi-annual coupons can be
stripped into 31 separate zero-coupon bonds (30 coupon payments plus
the principal payment).
Zero-coupon bonds are usually issued in multiples of R1 million. Zerocoupon bonds derived from a strip may be less than R1 million
banks
The interest cost of a zero-coupon bond is fixed over the life of the
bond
The issuer does not have to make any payments until the bond
matures
If interest rates fall after issuance, the issuer is locked into paying higher
rates
Disadvantages
7.4
Because there is no coupon to reinvest, a zero-coupon bond does not

have reinvestment risk. This is beneficial when interest rates are falling
Zero-coupon bonds are more volatile than conventional bonds and
are thus an attractive investment when interest rates fall they can
be sold prior to maturity to realise capital gains
Tax legislation may negatively impact the attractiveness of zerocoupon bonds. If interest is taxed on an accrual basis the investor may
experience cash outflows in respect of tax payments before the bond
matures (i.e., there is a cash inflow).
Because there is no coupon to reinvest, a zero-coupon bond does not
have reinvestment risk. This is unfavourable when interest rates are
rising
Unless the zero-coupon bond is issued by the government investors
are exposed to credit risk i.e., that the issuer will fail to perform as
promised
Bond and long-term debt market participants
Section 7.3 shows that a large variety of institutions participate as issuers and investors in the bond
and long-term market.
The majority of bonds traded in South Africa are issued by the national government. The
government issues bonds to fund, together with taxation receipts, its spending policies for welfare,
health, education, building works, infrastructure such as roads, railways and ports, defence, police
and the legal and regulatory system.
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Corporates, both financial and non-financial, are also major issuers of bonds in South Africa.
Corporates use corporate bonds to borrow money directly from the public. Corporate bonds differ
from government bonds in one important respect credit risk. Credit risk3 is a material
consideration for investors when buying corporate bonds, although in recent years so too is
sovereign risk i.e., the risk of government default.
Investors in the bond and long-term debt market include institutional investors such as insurance
companies and pension funds. Institutional investors generally have long-term liabilities such as the
provision of members retirement income and financial protection against death. Consequently they
are long-term investors that pursue income certainty and safety of principal with less need for
liquidity. As a result bonds generally form a substantial part of such portfolios.
Credit risk is the likelihood that an obligor may fail to perform as promised i.e., the probability that a
borrower is not able to pay interest or repay the capital according to the terms specified in the loan
agreement.
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Review questions
1.
What is the capital market?
2.
Describe the secondary market in bonds and long-term debt.
3.
What is a bond?
4.
What is the marketability of floating rate notes?
5.
Describe the credit risk inherent in bonds?
6.
List six types of debentures.
7.
What is the maturity of debentures?
8.
When investing in bonds, do investors have an opportunity for capital gains in times of falling
or rising interest rates?
9.
Name the issuers of and investors in debentures.
10.
When would the issuing of a debenture be unattractive to an issuer?
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Answers
1.
The capital market is the market in which businesses and governments raise long-term funds
to finance capital investments and expansion projects. The capital market includes the bond
and long-term debt market as well as the equity market.
2.
The secondary market is the market in which previously issued bond and long-term debt
instruments are traded.
3.
A fixed-interest-bearing security sold by the issuer (the borrower) promising to pay the holder
(the investor) interest (called coupons) at future dates (usually every six months) and the
nominal (face or par) value of the security at maturity.
4.
Certain issues of floating rate notes have an active secondary market.
5.
The quality of a bond depends on its issuer. Government bonds are essentially risk-free within
a country as they constitute evidence of debt of the government. Semi-gilt stock may have a
degree of credit risk. The quality of corporate bonds depends on the issuer.
6.
Debentures can be secured, redeemable, convertible, callable, variable-rate and profitsharing.
7.
The maturity of debentures may range from in excess of 5 years up to 30 years.
8.
Investors have an opportunity for capital gains when interest rates fall due to the price of the
bond rising to match current yields (Remember there is an inverse relationship between a
movement in interest rates and the price of a bond).
9.
Corporations are issuers of debentures. Investors in debentures include insurance companies

and hedge, mutual and pension funds.
10.
The issuing of a debenture may be unattractive to an issuer if the terms and conditions of the
debenture restrained the freedom of the management of the company in their operations.
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8 The equity market

This chapter describes the equity market the financial market for the issuing, investing in and
trading of shares. First the market is defined and its characteristics described. Then equity
instruments such as ordinary shares, preference shares, depository receipts and exchange-traded
funds are discussed. Finally the chapter outlines the participants in the equity market.

define the equity market
understand the characteristics of the equity market
explain and list the features of equity market instruments
describe the participants in the equity market.
8.1
The market defined
The equity market together with the bond (and other long-term debt) market comprise the capital
market. Capital markets are markets in which institutions, corporations, companies and
governments raise long-term funds to finance capital investments and expansion projects.
The equity market consists of the mechanisms and conventions that exist for the issuing of, investing
in, and trading of equity.
But what is equity? Equity4 represents ownership in a business or company. Shareholders or
shareowners own the company through the purchase of shares in the company. A share is one of a
number of equal portions of the capital of a company and gives the owner rights in respect of the
company.
Typically a shareholder has the right to:
share in the profits of the company
share in the assets of the company if it goes into liquidation
appoint directors5 of the company
In practice the term shares or stock (in the United States) are used as synonyms for equity
Directors are individuals appointed by shareholders to manage the company on their behalf.
115
vote at shareholders meeting.
8.2
Generally the equity market is considered to be synonymous with the stock exchange. A stock
exchange is defined as a place physical or virtual where buyers and sellers (the users or members
of the exchange) can meet and trade under rules that are mandated by a regulator such as the
Financial Services Board in South Africa, the Securities and Exchange Commission in the United
States and the Financial Services Authority in the United Kingdom.
Most industrialised nations have at least one major stock exchange Johannesburg Stock Exchange
(JSE) in South Africa, London Stock Exchange (LSE) in the United Kingdom, New York Stock Exchange
(NYSE) in the United States, Euronext in Europe and Tokyo Stock Exchange (TSE) in Japan.
There are two major sub-divisions of a stock market: the primary market and the secondary market.
The primary market is where new share issues are sold while secondary markets are where
previously issued shares are bought and sold.
There are two types of new share issues:
Seasoned issues: The issuance of shares for companies that already have publicly traded shares
Initial public offerings (IPOs): The issuance of shares for companies wishing to sell shares to the
public for the first time. IPOs are usually underwritten by investment banks that acquire the
issue from the company and then on-sell it to the public.
Secondary equity markets can either be stock exchanges or over-the-counter markets. Stock
exchanges can either be national such a New York, London, Tokyo Stock Exchanges or regional such
as Chicago in the US and Osaka and Nagoya in Japan. Only qualified shares can be traded on stock
exchanges and only by members of the exchange.
8.2.1 Johannesburg Stock Exchange

The JSE is an exchange licensed in terms of the Securities Services Act, 2005 (SSA6). It regulates the
trading, clearing and settlement of inter alia equities, warrants and Krugerrand coins. The JSE is
governed externally by SSA, which is administered by the Financial Services Board (FSB). The
exchange is governed internally by its own rules and directives, which must be approved by the FSB.
6
The Securities Services Act is soon to be replaced by the Financial Markets Bill. It is expected the bill will
become law early 2013.
116
While the JSE was established in 1887 to enable new mines and their financiers to raise funds for the
development of the mining industry, the majority of the companies currently listed are non-mining
organisations.
The primary functions of the exchange are:
To generate risk capital i.e., provide a means for companies to issue new shares in order to raise
primary capital; and
To provide an orderly market for trading in shares that have already been issued.
The JSE operates four boards or markets:
The Main Board, which includes an Africa Board. The Africa Board, which is part of the JSE Main
Board allows a company domiciled in Africa, or domiciled elsewhere in the world, but with most
of its activities taking place on the African continent, to maintain its listing on its home exchange
and obtain a secondary listing on the JSE;
The Venture Capital Market (VCM);
The Development Capital Market (DCM); and
AltX is an alternative exchange running parallel to the Main Board. The primary purpose of the
exchange is to facilitate capital raising for the business expansion and development of small to
medium and growing companies.
The Venture Capital Market (VCM) and Development Capital Market (DCM) were previously
alternative markets to the Main Board. This has changed. Although VCM and DCM listings continue
to exist, the boards are not open for new listings.
The JSE operates an order-driven, central order book trading system with opening, intra-day and
closing auctions.
The JSE operates broker deal accounting system (BDA) that its members are obliged to use. The
system facilitates trade confirmation, the clearing and settlement of trades between members and
their clients, back office accounting, drawing up financial statements and compiling client portfolio
statements.
117
8.2.2 Strate
Strate Ltd is the licensed Central Securities Depository (CSD) for the electronic settlement of financial
instruments (including equity) in South Africa. As authorised CSD, Strate provides clearing,
settlement and custody or depository services for financial instruments. Strates underlying system
(comprising the South African Financial Instruments Real-time Electronic Settlement System
(SAFIRES) and its front-end system SAFE (SAFIRES Front End)) is an electronic clearing, settlement
and custody system that provides secure and efficient settlement of financial instruments.
Electronic custody of securities. Custody is the safekeeping and administration of shares on

behalf of others. Key to custody services is the depository, which is an entity with the primary
role of recording shares either physically or electronically and keeping records of the ownership
of these shares. In South Africa shares are dematerialised i.e., shares are issued and traded
without physical certificates, where ownership of shares exists only as an electronic accounting
record in a register. Shares listed on the JSE can only be bought and sold if they have been
dematerialised in the Strate system.
Clearing: Clearing is the process of transmitting, reconciling and, in some cases, confirming
payment orders or shares transfer instructions prior to settlement, and the establishment of
final positions for settlement. Sometimes the term is used (imprecisely) to include settlement.
Settlement: The completion of a share buy-and-sell transaction, where the seller transfers shares
to the buyer and the buyer transfers money to the seller. Settlement can be rolling settlement,
which is a procedure in which settlement takes place a given number of business days after the
date of the trade.
The Strate system operates through eleven Central Securities Depository Participants (CSDPs). They
are Absa Bank, Citibank South Africa Branch, Computershare, Eskom Holdings SOC Ltd, FirstRand
Bank, Link Investor Services, Nedbank, South African Reserve Bank, Standard Bank, Standard
Chartered Bank - Johannesburg Branch, and Socit Gnrale Johannesburg Branch. They are
regulated by Strate. Their functions are to hold in custody and administer securities and interest in
securities records including to collate electronically in sub-registers the shareholding records for
each listed company. CSDPs are required to balance and reconcile their registers daily with the
records in SAFIRES, where the total balance of all dematerialised shares and other securities are
recorded. Clients and brokers can only interact with Strate via a CSDP. To qualify to be a CSDP, entry
criteria such as financial soundness set out by Strate and approved by the Financial Services Board
must be complied with.
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Under the Strate system there are two types of clients:
Controlled broker clients: These clients elect to keep their shares and cash in the custody of their
broker and, therefore, indirectly in the custody of the brokers chosen CSDP. Because CSDPs are
the only market players who liaise directly with Strate, all brokers must have accounts with
CSDPs and communicate electronically with them using the international network called SWIFT
(Society for Worldwide Inter-bank Financial Telecommunications). Controlled clients deal
exclusively with their brokers and their share statements come from their brokers.
Non-controlled broker clients: These clients appoint their own CSDP to act on their behalf. The
investors open accounts with their selected CSDP and deal with their brokers only when they
want to trade when they provide their brokers with the details of their share accounts at the
CSDP. Non-controlled clients receive share statements directly from their CSDP.
Strate clears and settles both on-market and off-market trades.
Off-market trades are reported to the CSD by the CSDPs of the buyers and sellers.
There are two types of on-market transactions: broker-to-broker trades and broker-to-client
trades. Once matched in the central order book, broker-to-broker trades are passed from the
JSEs trading system to the CSD. Broker-to-client trades are passed from the BDA system to the
CSD.
The clearing and settlement process is illustrated in figure 8.1.
Key to the clearing process is the clearinghouse or central clearing counterparty (CCP). A
clearinghouse interposes itself between parties to securities transactions, becoming the buyer to the
seller and the seller to the buyer. Apart from being the CSD for both listed equity securities and
bonds and some unlisted money market securities, Strate also is a licensed clearinghouse for some
bond trading. Safcom, a wholly owned subsidiary of the JSE, is a licensed clearinghouse for
derivatives listed on the JSE. While the JSE is not licensed as a clearinghouse, it performs a
comparable function by acting as guarantor of all trading on the equity market. The JSE does not
guarantee off-market transactions.
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Figure 8.1: The clearing and settlement process

Client
(buyer)
Client
(seller)
Sell order
Exchange (JSE)
Trade
Broker
Dealer
Trade
Broker
Dealer
Broker Deal Accounting

(BDA) System
Settlement
order
Central
Securities
Depository
Participant
Claim
Commitment
Settlement
order
Central Securities
Depository
(Strate)
(System = SAFIRES)
Claim
Commitment
Settlement confirmation
Settlement confirmation
Buy order
Central
Securities
Depository
Participant
Payment
confirmation
Payment
National Payment System

(System = SAMOS)
Central Bank
(SARB)
Payment
In South Africa settlement occurs on a rolling basis in terms of which listed equities are settled in 5
business days after trade date, bonds in 3 days and money market instruments on trade date. On
settlement date Strates settlement system SAFIRES confirms the availability of securities and sends
a request for the transfer of cash to the SARB, which facilitates the movement of cash between
clearing banks through South African Multiple Option Settlement System (SAMOS). Cash
transactions are netted so a participant may be a net payer or receiver of cash from SAMOS on a
settlement day. There are separate settlements for the equity market, bond market and money
market.
Once the availability of cash is confirmed and transferred between SARB clearing bank accounts,
Strate will transfer the securities between participants. Participants are advised of a successful
settlement and the JSE reflects the corresponding client entries in its systems. The CSDPs update
their sub-registers and nominee registers and the brokers update their nominee registers.
There are two broad models of electronic settlement: immobilisation and dematerialisation. Under
immobilisation securities in physical form (called scrip) are immobilised (they do not move) and are
held by a central securities depository such as Strate in paper or electronic form to facilitate
subsequent book-entry transfers of ownership. However certificates or documents of title
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evidencing ownership of immobilised scrip can exist outside the central securities depository
because participation in the immobilisation process is usually voluntary.
Dematerialisation involves dispensing with paper-based instruments and certificates altogether by

replacing physical certificates and certified deeds indicating ownership of securities for an electronic
record of ownership of securities. At 31 December 2011 the dematerialised value of equities was
R4,8 trillion (representing 69,6% of the total market capitalisation of R6,9 trillion). By February 2012
98% of South Africas R1.15trillion in bond market assets were dematerialised.
Dematerialisation mitigates the risks associated with scrip forgery, scrip counterfeiting and loss of
scrip due to fire, theft or mutilation. It allows for quick and efficient settlement by removing the
need for paperwork and permitting the synchronisation of delivery of securities with payment of the
corresponding cash amount; called delivery versus payment (DvP). This rapid and proficient transfer
of ownership reduces cost and risk for all market participants including issuers and investors.
8.3
Equity market instruments
The following equity market instruments are discussed: ordinary shares, preference shares,
depository receipts and exchange traded funds (ETFs).
8.3.1 Ordinary shares

The most important characteristics of ordinary shares are the following:
Perpetual claim: Ordinary shares have no maturity date. Individual shareholders can liquidate
their investments in the shares of a company only by selling them to another investor
Residual claim: Ordinary shareholders have a claim on the income and net assets of the
company after obligations to creditors, bondholders and preferred shareholders have been met.
If the company is profitable this could be substantial - other providers of capital generally
receive a fixed amount. The residual income of the company may either go to retained earnings
or ordinary dividends
Preemptive right: Shareholders have the right to first option to buy new shares. Thus their voting
rights and claim to earnings cannot be diluted without their consent. For example Rex company
owns 10% or 100 of the 1 000 shares of Blob company. If Blob decides to issue an additional 100
shares Rex has the right to purchase 10% or 10 of the new shares issued to maintain its 10%
interest in Blob;
Limited liability: The most ordinary shareholders can lose if a company is wound up is the
amount of their investment in the company.
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Returns to ordinary shareholders consist of the following:
Dividends: Dividends are a portion of the companys profits. They are not guaranteed until
declared by the board of directors
Capital gains (losses). These arise through changes in the price of a companys shares. Over time,
companies hope to grow in size and profits with associated increases in the value of their shares
and capital gains to shareholders. The value of shares in companies that fail / become insolvent
will be worth less /worthless and shareholders will suffer a capital loss.
A companys authorised share capital is the number of ordinary shares that the directors of the
company are authorised to issue. When the shares are sold to investors they become issued i.e.,
issued share capital.
The risk ordinary shares have for investors are:
The value of the shareholding may fluctuate significantly over the short term as share prices are
influenced by many factors other than those relating to the company's specific performance
Ordinary shareholders are the last to recover any value on their shares should the company be
wound up.
8.3.2 Preference shares

Preference shares are hybrid securities in that they have features of both ordinary shares and debt.
Like debt, preference shares pay their holders a fixed amount (dividend) per year, have no voting
rights and in the event of non-payment of dividends, may have the cumulative dividend feature that
requires all dividends to be paid before any payment to common shareholders. Like ordinary shares
they are perpetual claims and subordinate to bonds in terms of seniority. However preference
shares carry preferential rights over ordinary shares in terms of entitlement to receipt of dividends
as well as repayment of capital in the event of the company being wound up.
Preference shares offer holders a fixed- or variable-rate dividend each year:
Fixed rate dividend. The preference share pays a fixed rate and the dividend remains the same
regardless of changes in market interest rates. For example if the company has issued 40 000
preference shares at a par value of R20 each and dividend of 7% p.a., the preference share
dividend paid by the company every year will be R56 000 i.e., 40 000 x R20 x 7%. This is not
necessarily guaranteed (see non-cumulative preference shares).
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Variable-rate dividend: The dividend paid varies with a benchmark interest rate according to a
pre-defined formula. The dividend will move in line with changes in interest rates i.e., if interest
rates increase, the dividend will also increase, if interest rates fall, the dividend will decrease.
Corporates especially banks are issuing variable rate preference shares linked to the daily prime
interest rate. For example if the pre-defined formula is 75% of prime and the prime rate is 10%,
the dividend rate will be 7.5% (i.e., 10% x 75%). Once again the dividend is not necessarily
guaranteed (see non-cumulative preference shares).
There are a number of different types of preference shares:
Cumulative: Dividend is cumulated if the company does not earn sufficient profit to pay the
dividend i.e., if dividend is not paid in one year it will be carried forward to successive years.
Non-cumulative: If the company is unable to pay the dividend on preference shares because of
insufficient profits, the dividend is not accumulated. Preference shares are cumulative unless
expressly stated otherwise.
Participating: Participating preference shares, in addition to their fixed dividend, share in the
profits of a company at a certain rate.
Convertible: Apart from earning a fixed dividend, convertible preference shares can be
converted into ordinary shares on specified terms.
Redeemable: Can be redeemed at the option of the company either at a fixed rate on a specified
date or over a certain period of time.
8.3.3 Depository receipts

Depository receipts are certicates representing ownership in the ordinary shares of a company but
that are traded and marketed outside of the companys home country (i.e., in a host country).
Depository receipts are quoted in the host countrys currency and treated in the same way as host
country shares for purposes of trading, clearance, settlement, transfer, and ownership. Depository
receipts increase the companys visibility in markets outside its home country and allow the
company access to capital in other countries. Investors in depository receipts will enjoy the same
benefits of direct ownership in the underlying shares i.e., the investor will receive dividends and will
have voting rights.
Types of depository receipts are American Depository Receipts (ADRs) and Global Depository
Receipts (GDRs). ADRs are USD-denominated depositary receipts representing ownership in non-US
shares issued by a US depository bank. The non-US shares are purchased by a broker on the companys
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home stock exchange and held by the US depository banks local custodian. The US depository bank
then issues ADRs, which are sold to US investors. The depository bank collects the dividends and makes
payments to the holders of the ADRs. Prices and dividends are in US dollars. ADRs are available to US
investors over the counter or on a stock exchange such as the New York Stock Exchange.
GDRs are depositary receipts available in one or more markets outside the companys home country.
The advantage of the GDRs, compared to the ADRs, is that they allow the issuing company to raise
capital in more than one market. GDRs are typically denominated in USD, but can be denominated in
Euro or British sterling. GDRs are commonly listed on European stock exchanges such as the London
Stock Exchange (LSE).
South African ADRs traded on the NYSE include AngloGold Ashanti, GoldFields, Harmony Gold, SAPPI
and Sasol.
8.3.4 Exchange traded funds

There are two basic structures for exchange-traded funds (ETFs): physical or synthetic.
A physical equity ETF, also called a vanilla ETF, is a traded financial instrument representing
ownership in an underlying portfolio of shares that tracks an index like the JSE/FTSE Top 40 Index.
Investors are able to buy and sell ETFs on an exchange in the same way they would any other listed
shares. The prices of ETFs fluctuate at once in response to changes in their underlying portfolios
thereby offering the same intra-day liquidity as other shares traded on exchange. ETFs give investors
exposure to a diversified basket of shares.
Synthetic ETFs attempt to obtain the return on an index by using over-the-counter derivatives such
as total return swaps. As such synthetic ETFs reproduce the index synthetically rather than by
replicating the index physically by owning the physical assets. Synthetic replication can be cost
effective, especially if the index is illiquid. There are a number of variants of synthetic ETFs. Leverage
ETFs offer multiples of for example 2 or 3 times the return of the index. Inverse ETFs return the
inverse performance of the index i.e., a positive return when the return on the index is negative.
Physical ETFs are the dominant form of ETF especially in the US and are mainly provided by large
independent asset managers. The appeal of ETFs to investors is clear-cut: access to a low-cost
diversified portfolio that can be traded intra-day. However ETFs have become increasingly complex
and opaque both in the derivatives-based structures they employ and the strategies they use to
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generate returns. This has attracted the attention of financial market and banking regulatory and
supervisory authorities and raised concerns about the risks, particularly structured ETFs, pose to
financial stability and investor protection. This is especially true when parallels are drawn between
recent developments in the ETF markets and those in the securitisation markets before the 2007/08
financial crisis. Revision of the current regulatory regime regarding ETFs may be appropriate given
the growing complexity of a market.
End 2009 there were 24 exchange-traded funds (ETFs) listed on the JSE with an annual trading value
of USD 3 657.7million. Globally there were over 4 000 ETFs listed on 36 exchanges with an annual
trading value of USD 6.6 trillion.
8.4
Equity market participants
The major participants in the equity market are:
8.4.1 Issuers: Limited public companies

Limited public companies are the issuers of shares on regulated stock exchanges.
End 2011 there were 395 companies listed on the JSE (2010: 397). Of these companies 48 were
foreign companies (2010: 45). Globally there were 46 814 companies listed on global exchanges end
2011 (2010: 46 015).
8.4.2 Investment banks

Investment banks assist companies to finance their activities by issuing securities shares or debt.
Essentially they purchase new issues of shares and place them in smaller parcels among investors.
They also facilitate mergers of companies and the acquisition of one firm by another.
8.4.3 Venture capitalists

Venture capitalists invest medium and long-term funds in new (start-up) and young firms. Venture
capital is risk capital. Venture capital firms also provide advice in running the business to the
generally inexperienced management of the firms they invest in.
8.4.4 Investors
There are several types of investors:
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Individual investors usually hold a small personal investment in equities. However they do have
several indirect investments in equity via pension and provident funds, medical aid schemes,
insurance policies, assurance policies and unit trusts
Companies could own more than 50% of a companys shares giving it controlling voting powers.
In this instance, the company holding the share is referred to as a holding company and the
company in which the holding company has the share is known as a subsidiary of the holding
company
Asset or investment management firms advise and administer pension and mutual funds on
behalf of the funds stakeholders: individuals, firms and governments
Insurance companies invest the premiums they receive in shares, bonds and property. The
premiums are received in terms of insurance policies covering specific events such as death,
accident, and fire
Pension and retirement funds invest the contributions of employees and employers in assets
such as shares
Collective investment schemes are portfolios of assets such as shares, bonds, money market
instruments bought in the name of a group of investors. The schemes are generally managed by
investment companies
In South Africa the more-liquid and better-rated shares are held almost exclusively by institutions
such as pension funds and insurance companies individuals holdings are small.
8.4.5 Brokers and broker dealers

Brokers (or agents) act as agents or conduits between lenders and borrowers or buyers and sellers in
return for a commission. They try to match the orders of buyers and sellers without taking
ownership of the securities.
Dealers stand ready and willing to buy a security for their own account (at its bid price) or sell from
their own account (at its offer price). A dealer therefore acts as a principal (buyer or seller) in a
securities transaction. As principals, dealers are market makers in securities, meaning they have to
quote both a bid and an offer price to the market at all times. This implies that they profit from the
spread between bid and offer prices as well as from changes in market prices. Market makers adjust
their bid or offer prices depending upon positions that they hold and/or upon their outlook for
changes in prices. Dealers who take positions (normally for their own account) on a very short-term
basis, such as intraday, are often referred to as jobbers. Often brokers also act as dealers and/or
jobbers.
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Review questions
1.
What does equity (or shares or stock) represent?
2.
Discuss the two types of new share issues.
3.
Describe secondary equity markets.
4.
Define dematerialisation.
5.
List the most important characteristics of ordinary shares.
6.
What do the returns to ordinary shareholders consist of?
7.
List six types of equity investors.
8.
Explain the statement preference shares are hybrid securities in that they have features of
ordinary shares and debt.
9.
Name five types of preference shares.
10.
Define a depository receipts.
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Answers
1.
Shares represent a residual claim against the assets of a company after obligations to creditors
and bondholders have been met.
2.
There are two types of new share issues:

o
Seasoned issues: for companies that already have publicly traded shares
Initial public offerings (IPOs) for companies wishing to sell shares to the public for the
first time.
3.
Secondary markets are where previously issued shares are bought and sold. Secondary equity
markets can either be stock exchanges or over-the-counter markets.
4.
Dematerialisation involves dispensing with paper-based instruments and certificates

altogether by replacing physical certificates and certified deeds indicating ownership of
securities for an electronic record of ownership of securities.
5.
The most important characteristics of ordinary shares are that they represent a perpetual
claim, a residual claim; preemptive rights and have limited liability.
6.
Returns to ordinary shareholders consist of dividends and capital gains (or losses).
7.
Six types of equity investors are individual investors, companies, asset or investment
management firms, insurance companies, pension funds and mutual funds.
8.
Like debt, preference shares pay their holders a fixed amount (dividend) per year, have no
voting rights and in event of non-payment of dividends may have a cumulative dividend
feature that requires all dividends to be paid before any payment to common shareholders.
Like ordinary shares, preference shares are perpetual claims and subordinate to bonds in
terms of seniority.
9.
Five types of preference shares are cumulative, non-cumulative, participating, convertible and
redeemable preference shares.
10.
A Depositary Receipt (DR) is a type of negotiable (transferable) financial security traded on a

local stock exchange, representing a security, usually in the form of equity that is issued by a
foreign publicly listed company. Depository Receipts allow investors to hold shares in equity of
other countries.
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9 The derivatives market

Opinions on derivatives vary. Warren Buffett7 labelled derivatives financial weapons of mass
destruction that could harm the entire financial system. The Bank for International Settlements
described them as valuable tools for financial risk management. This chapter describes derivatives.
First the market is defined and its characteristics described. Then derivative instruments forwards,
futures, options and swaps are discussed. Finally the chapter outlines the participants in the
derivatives market.
define the derivatives market
understand the characteristics of the derivatives market
examine the features of derivative instruments
describe the participants in the derivatives market.
9.1
The market defined
Derivatives are financial instruments that derive their value from the values of underlying securities
and other variables. Such variables can be an index such as FTSE/JSE All-Share Index, reference rates
such as JIBAR, an underlying instrument in the cash market (equity, money, bond, foreign exchange
or commodity) or in the derivatives market. For example:
A currency option is linked to a particular currency pair in the foreign exchange market
A bond futures contract is linked to a certain bond in the bond market
An agricultural futures contract is linked to maize or wheat in the commodities market
An option on a bond futures contract is linked to a bond futures contract trading in the
derivatives market.
Derivatives can be based on almost any variable including from the price of electricity (electricity
derivatives), the weather in London (weather derivatives), the credit-worthiness of Anglo American
7
Warren Edward Buffett, investor, industrialist, philanthropist and primary shareholder, chairman and CEO of
Berkshire Hathaway, is widely regarded as one of the most successful investors in the world. He is consistently
ranked among the world's wealthiest people (third in 2010). Students are encouraged to read his letters to
Berkshire Hathaway shareholders at www.berkshirehathaway.com.
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Plc (credit derivatives) to the amount of hurricane insurance claims paid in 2011 (insurance
derivatives).
Derivatives allow businesses to hedge risks that arise from factors outside their control such as
volatile commodity prices, equity prices, interest rates and foreign currencies. For example, a firm
can protect itself from increases in the price of a commodity that it uses in production by entering
into a derivative contract that will gain value if the price of the commodity rises. Derivatives are also
used by firms seeking profits by betting on which way prices will move. Such speculators provide
liquidity to the derivatives market and assume the risks that hedgers wish to avoid.
Derivatives are also referred to as contingent claims the value of the claim being contingent or
dependent on the value of the underlying variable.
9.2
Derivatives can be privately negotiated over-the-counter or traded on organised exchanges such as

JSE, LIFFE (London International Financial Futures and Options Exchange) and the Chicago Board of
Trade (part of the CME Group).
The two organisations that make up an organised derivatives market are the exchange and its
clearinghouse. The clearinghouse processes all trades executed on the exchange. It acts as
counterparty to all transactions entered into on the exchange and assumes the contractual
relationship between the buyer and seller i.e., it becomes the buyer to each seller and seller to each
buyer. The clearinghouse is responsible for determining the profit and loss on all open positions by
revaluing them at the end of each business day at the closing contract prices traded on the
exchange; this process is referred to as marking-to-market.
In South Africa exchange-traded derivatives contracts trade on the four JSE derivatives markets
namely the currency derivatives market, equity derivatives market, interest-rate market, and the
South African Futures Exchange (SAFEX) commodity derivatives market. The JSE derivatives markets
have their own central clearinghouse namely Safcom - the Safex Clearing Company (Pty) Ltd.
The obligation of parties to fulfill their commitments under an exchange-traded derivatives contract
is secured by margining arrangements. There are two types of margin: initial and variation. The
initial margin is a fixed sum payable in respect of each open contract. A variation margin is only
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called for if the daily marking-to-market of all open derivatives contracts results in the margin (the
initial margin plus any accumulated profits and less any accumulated losses) falling below some
maintenance level determined by the exchange. It is as a result of the margining of all open losses
that the clearinghouse is able to guarantee all contracts.
Secondary markets in exchange-traded derivatives are possible due to the existence of the
clearinghouse and standardised contracts. A buyer who does not want to hold a position to maturity
enters into another contract of identical terms but on the opposite side prior to maturity. Since the
individual is now buyer and seller of the same contract, the clearinghouse nets out the positions.
Subject to approval by regulatory authorities, exchanges are free to create virtually any derivatives
contract they please. However two opposing forces influence contract design: standardisation and
market depth and liquidity.
Standardisation implies that the asset underlying the derivatives contract is clearly and narrowly
defined. However this may fail to attract sufficient market participants to provide the depth and
liquidity necessary to allow secondary market trading in size to be carried out with relatively little
impact on price and to limit the possibility of corners or squeezes.
9.3
Derivative instruments
Derivatives based on variables in the underlying cash market (equity, money, bond, foreign exchange
or commodity) are generally grouped under the following three general headings:
Forwards and futures
Options
Swaps.
These will be discussed, as will credit and certain other derivatives.
9.3.1 Forwards and futures

9.3.1.1 Definition
A forward contract is an obligation to buy (sell) an underlying asset at a specified forward price on a
known date. The expiration date and forward price of the contract are determined when the
contract is entered into.
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A futures contract is an agreement to buy or sell, on an organised exchange, a standard quantity and
quality of an asset at a future date at a price determined at the time of trading the contract.
9.3.1.2 Forwards versus futures contracts

Forwards and futures are similar instruments. However there are four main characteristics specific
to futures contracts that distinguish them from forward contracts:
Futures contracts are traded on organised exchanges while forwards trade over-the-counter
Futures contracts are based on a standard quantity/quality of the underlying asset and have
standardised delivery rules and dates. Forward contracts are custom made
With futures contracts performance is guaranteed by the futures exchanges clearing house. This
together with margining arrangements reduces default risk. Forwards have default risk i.e., the
seller may not deliver and the buyer may not accept delivery
Futures contracts are marked-to-market i.e., valued at current market prices on a daily basis.
9.3.1.3 Example of a forward transaction

A payoff diagram indicates the possible value of a derivatives position given changes in the
underlying. Figure 9.1 shows the payoff diagram for a long and short forward position in Euro (EUR).
The buy-EUR and sell-EUR contracts are purchased for ZAR 9.70. The horizontal (or x) axis of the
payoff diagram shows the EUR/ZAR exchange rate. The vertical (or y) axis shows the profit or loss.
Figure 9.1: Payoff diagram of a long and short forward
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For the long or bought position, the upward sloping line indicates the profit or loss of the buyer of
the forward at expiration of the contract. For the short or sold position, the downward sloping line
indicates the profit or loss of the seller of the forward at expiration of the contract.
If the price of one EUR at expiration is R9.40 i.e., the rand strengthens against the EUR, the seller will
make R0.30 profit (sell price of R9.70 less buy price of R9.40) and the buyer R0.30 loss (sell price of
R9.40 less buy price of R9.70). If the price is R9.90 at expiration, the buyer will make R0.20 profit (sell
price of R9.90 less buy price of R9.70) and the seller R0.20 loss (sell price of R9.70 less buy price of
R9.90).
9.3.1.4 Example: Using futures for hedging

A farmer is concerned in January that the maize price will fall from current levels and that his
expected crop of 2 000 tons of maize will be sold in July of the same year at a low price.
White maize futures contracts for delivery in July are trading at R1 200 per ton. Therefore he sells 20
futures contracts (i.e., 2 000 tons divided by contract size of 100 tons).
In July the spot maize price is R1 100 per ton. The farmer sells his bumper crop of 2 200 tons at
R1 100 per ton.
The July futures fall to R1 100 per ton in line with the spot market. The farmer buys back his futures
at R1 100 per ton realising a gain of R100 per ton in the futures market. The R100 per ton gain
applies only to the hedged portion of the farmers crop i.e., 2 000 tons. The farmer effectively
receives R1 200 (spot of R1 100 plus R100 futures gain) for the 2 000 tons hedged.
9.3.2 Options
An option contract conveys the right to buy or sell a specific quantity of an underlying asset (e.g.,
equity, interest-bearing security, currency or commodity) or derivative (e.g., futures, swaps, options)
at a specified price at or before a known date in the future. As such an option has certain important
characteristics:
It conveys upon the buyer (or holder) a right not an obligation. Since the option can be
abandoned without further penalty, the maximum loss the buyer faces is the cost of the option
By contrast, if the buyer chooses to exercise his right to buy or sell the underlying asset or
derivative, the seller (or writer) has an obligation to deliver or take delivery of the underlying
asset or derivative. Therefore the potential loss of the seller is theoretically unlimited.
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Options are generally described by the nature of the underlying asset or derivative: an option on
equity is termed an equity option, an option on a futures contract a futures option, an option on a
swap, a swaption and so on.
The specified price at which the underlying asset or derivative may be bought (in the case of a call
option) or sold (in the case of a put option) is called the exercise or strike price of the option. To put
into effect the right to buy or sell the underlying asset or derivative pursuant to the option contract
is to exercise the option. Most options may be exercised any time up to and including the expiry
date i.e., the final date on which the option can be exercised. These are called American options.
Options that can only be exercised on expiry date are termed European options.
The buyer of an option pays the option writer an amount of money called the option premium or
option price. In return the buyer receives the right, but not the obligation, to buy (in the case of a
call option) or sell (in the case of a put option) the underlying asset or derivative for the strike price.
An option is said to be in-the-money if it has intrinsic value i.e., the strike price is below (in the case
of a call) or above (in the case of a put) the market or prevailing price of the underlying asset or
derivative. If the option strike price is above (in the case of a call) or below (in the case of a put) the
market price of the underlying asset or derivative, the option is out-of-the-money and will not be
exercised the option has no intrinsic value. When the strike price approximately equals the market
price of the underlying asset or derivative, the option is at-the-money. Technically an option that is
at-the-money is also out-of-the-money as it has no intrinsic value.
In virtually all cases, the option seller will demand a premium over and above an options intrinsic
value. The reason for this revolves around the risk that the seller takes on. Before expiration of the
option the market price of the underlying asset or derivative is almost certain to change, which will
change the intrinsic value of the option. So although the option may have a particular intrinsic value
today, the intrinsic value may be different tomorrow. The excess of the option premium over its
intrinsic value is known as time value. The amount of time value depends on the time remaining to
expiration at expiry date time value will be zero.
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The payoff diagrams in figures 9.2 to 9.5 show the profits/losses of the four basic option positions
held to expiration and plotted in relation to the price of the underlying asset. The underlying asset is
a share. The strike price of the option is R100 and the option price or premium is R5.
Figure 9.2 shows the position of the buyer of a call; a long call position.
The position is profitable if the market price of the share exceeds the strike price of R100 by more
than the price or premium of the call option namely R5. The buyer breaks even at an underlying
share price of R105 i.e., the strike price plus the option price. The gain to the call buyer is unlimited
because the intrinsic value of the option increases directly with increases in the value of the share,
which is theoretically unlimited.
The maximum loss to the call buyer is the option premium: R5.
Figure 9.2: Payoff diagram for a long call option
Figure 9.3 shows the position of the seller or writer of a call option: a short call position.
The position is the mirror image of the long call position. The profit (loss) of the short call position
for any price of the share at the expiration date is the same as the loss (profit) of the long call
position options are a zero-sum game.
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The maximum gain to the call seller is the option price.
The maximum loss to the call seller is only limited by how high the price of the share can rise by
expiration date less the option price. A call seller faces the possibility of large losses if the price of
the share increases as the call will be exercised and the call seller will be obliged to purchase the
share at the prevailing market price and deliver it to the call buyer at the strike price.
Figure 9.3: Payoff diagram for a short call option
Figure 9.4 shows the position of the buyer of a put option; a long put position. The position is
profitable if the market price of the share falls below the strike price of R100 by more than the
option price of R5. If the market price of the share exceeds the strike price, the option will not be
exercised. The maximum loss to the put buyer is the option price and the maximum profit will be
realised if the market price of the share falls to zero.
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Figure 9.4: Payoff diagram for a long put option
Figure 9.5 shows the position of the seller or writer of a put option: a short put position. It is the
mirror image of the put buyer's position. The maximum gain to the put seller is the option price of
R5. The put seller's maximum loss will be realised if the market price of the underlying falls to zero.
Figure 9.5: Payoff diagram for a short put option
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Many different forces in the market affect option prices. Table 9.1 shows the general effects of changing
market conditions on the values of options.
Table 9.1: Effects of changing market conditions on the value of options
If...
Call
premiums
will..
Put
premiums
will..
The price of the

underlying rises
Rise
Fall
The price of the

underlying falls
Fall
Rise
Volatility * increases
Rise
Rise
Volatility *
decreases
Fall
Fall
Time passes
Fall
Fall
Interest rates rise
Fall slightly
Fall slightly
Interest rates fall
Rise slightly
Rise slightly
Why
When the price of the underlying rises, the
intrinsic value of a call (put) option increases
(decreases).
When the price of the underlying falls, the
intrinsic value of a call (put) option decreases
(increases).
The greater the volatility the greater the
likelihood the price of the underlying will
change
The smaller the volatility the smaller the
likelihood the price of the underlying will
change.
As the time to expiration decreases, so does
the probability that the asset price will be
more or less than the strike price.
The purchaser of an option pays the
premium and brokerage fees up front in
order to receive a potential profit some time
in the future. If interest rates increase, the
present value of the expected future profit
declines while the implicit cost of the option
increases.
* Volatility of the price of the underlying as well as the volatility of that volatility
9.3.3 Swaps
A swap is a contractual agreement by which two parties, called counterparties, agree to exchange
(or swap) a series of cash flows at specific intervals over a certain period of time. The swap payments
are based on some underlying asset or notional, which may or may not be physically exchanged. At
least one of the series of cash flows is uncertain when the swap agreement is initiated.
Although there are four types of swaps - interest-rate, currency, commodity and equity swaps - and
many variants thereof, only plain-vanilla interest-rate, currency and equity swaps will be discussed.
9.3.3.1 Interest-rate swaps

In interest rate swaps the notional takes the form of money and is called the notional principal. As
notional principals are identical in amount and involve the same currency, they are only
hypothetically exchanged i.e., the interest rate swap is an off-balance sheet instrument. In addition,
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since the periodic payments - interest - are also in the same currency, only the interest differential,
assuming matching payment dates, is exchanged.
The original interest-rate swap structure, now called the vanilla or coupon swap, is a fixed-forfloating swap i.e., the exchange of an interest stream based on a fixed interest rate for an interest
stream based on a floating interest rate.
The most important use for interest rate swaps is to hedge interest-rate risk.
For example, suppose company Alpha has a R10 million 7-year fixed-rate asset yielding 7.00% p.a.
payable half-yearly funded with R10 million floating-rate debt with semi-annual interest payments
based on 6-month JIBAR plus a credit spread. A credit spread is the difference in yield between two
securities of similar maturity and duration. The credit spread is often used as a measure of relative
creditworthiness with a reduction in the credit spread reflecting an improvement in the borrowers
perceived creditworthiness. As the asset has a fixed yield while the cost of the liability re-prices every 6
months, company Alpha faces the risk that in a rising interest-rate scenario, the liability's cost may
exceed the asset's yield.
To eliminate this risk, company Alpha enters into a 7-year swap agreement with a bank. In terms of the
swap every six months company Alpha pays fixed 6.50% p.a. and receives floating 6-month JIBAR
plus a credit spread. This is shown in figure 9.6.
Company Alpha has effectively obtained a 6.5% half-yearly fixed cost of funds for 7 years thus
matching the tenor of the liability with that of the fixed-rate asset and locking in an interest-rate
spread of 0.50% for the 7-year period regardless of interest-rate fluctuations.
The same way that an interest rate swap can be used to hedge interest rate on a liability such as a
loan, it is often used to protect the return on an investment. Thus a company or institution with a
cash investment may wish to fix the interest rate to be earned in the future by entering to a
receivers swap; therefore receiving fix interest and paying floating.
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Figure 9.6: Hedging interest-rate risk
9.3.4 Currency swaps

In a currency swap, the currencies in which the principals are denoted are different and for this
reason usually need to be physically exchanged. The vanilla fixed-for-floating currency swap involves
the following three distinct sets of cash flows:
The initial exchange of principals on commencement of the swap
The interest payments made by each counterparty to the other during the tenor of the swap
The final re-exchange of principals on termination of the swap. Both the initial and re-exchange
of principals takes place at the spot exchange rate prevailing on contract date.
One of the most important use for currency swaps is to hedge exchange rate risk i.e., to hedge the
risk of losses from adverse exchange-rate movements. Exchange-rate risk can arise for example when:
A firm has an investment in a currency that generates a regular income stream. The firm is
exposed to a fall in the value of the currency
A firm has a liability in a foreign currency but no regular income in that currency. It is at risk to an
increase in the value of the currency that would make the loan more costly to service.
For example suppose a South African computer software company Xtreme Nerds sells the right to
produce and market its software to a company in China. The Chinese company agrees to pay Xtreme
Nerds RMB1 million each month for the next 5 years. RMB is the abbreviation for Renminbi the official
currency of the Peoples Republic of China. To hedge the risk of fluctuations in the Rand value of its
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expected stream of income, Xtreme Nerds enters into a currency swap to exchange its future stream of
Renminbi for a future stream of Rand at a set of forward foreign exchange rates specified at time of
concluding the swap contract. Therefore the swap contract is equivalent to a series of forward exchange
contracts.
9.3.5 Equity swaps

The vanilla equity swap (fixed-for-equity equity swap), like any other basic swap, involves a notional
principal, a specified tenor, pre-specified payment intervals, a fixed rate (swap coupon), and a floating
rate pegged to some well-defined index. The floating rate could be linked to the total return (i.e.,
dividend and capital appreciation) on a stock index. The stock index can be broadly based such as the
S&P500, the London Financial Times Index, the Nikkei index, the FTSE JSE All-Share index or narrowly
based such as that for a specific industry group e.g., the FTSE JSE gold index.
The most important uses for equity swaps are: to hedge equity positions, to gain entry to foreign equity
markets and to benefit from market imperfections via synthetic equity portfolios.
9.3.5.1 Hedging equity positions

Equity swaps can be used to convert volatile equity returns into stable fixed-income returns. For
example, assume a unit trust holds a diversified equity portfolio highly correlated with the return on the
FTSE JSE All-share index (ALSI). It wishes to pay the ALSI return and to receive a fixed rate thereby
hedging the pre-existing equity position against downside market risk over the tenor of the swap. It
enters into a swap agreement with its bank for a tenor of three years on a notional principal of R400
million with quarterly payments. The bank prices the swap at 8.95% p.a. payable quarterly. The
resultant cash flows are shown in figure 9.7.
Figure 9.7: Hedging equity price risk
It is important to note that because an equity return can be positive or negative, the cash flow on the
equity-linked side of the swap can go in either direction. If the equity return for the quarter is negative,
the bank pays the unit trust the negative sum as well as the swap coupon on the fixed leg.
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9.3.5.2 Gaining entry to foreign markets

Equity swaps eliminate the problems associated with different settlement, accounting and reporting
procedures among countries. They allow international investors to gain access to the high potential
growth in the equity markets of developing countries the emerging markets without the problems
associated with a lack of knowledge about local market conditions, exchange control stipulations and
foreign ownership regulations.
9.3.5.3 Benefiting from market imperfections

By circumventing market imperfections it is possible for a synthetic equity portfolio created via a swap
to outperform an actual equity portfolio. The primary source of savings is the elimination of the
transactions costs associated with acquiring the cash portfolio the transaction costs of acquiring a
synthetic equity portfolio via an equity swap are significantly less than the transaction costs of obtaining
an actual equity portfolio.
Beyond initial transaction costs, there are numerous potential savings based on regulatory or tax
arbitrage. For example many countries attach a withholding tax to dividends paid to foreign investors
e.g., United States, Germany and South Africa. In other countries the underlying equities included in an
index are often illiquid or, through monopoly control, bid-offer spreads are kept large. Some countries,
including South Africa, impose a turnover tax on transactions in equity. In most countries, foreign equity
is held through custodial banks, as is the case with ADRs in the United States. This results in the
payment of custodial fees. There are also transaction costs to rebalancing a cash equity portfolio when
there is a change in the composition of an index. Substantial benefits could accrue to the extent that
equity swaps eliminate or reduce these costs.
9.3.6 Credit derivatives

Credit derivatives are sophisticated financial instruments that derive their value from the credit
quality of an obligation such as a loan or bond of a reference entity. Put another way, the payoff of
credit derivatives depends on the creditworthiness of a company or sovereign.
Credit derivatives enable the unbundling and intermediation of credit risk. They allow banks and
other credit providers to transfer credit risk without transferring ownership of the underlying asset
i.e., to detach credit risk from an asset such as a loan or bond and place it with another party. This
lets banks actively manage their credit portfolios i.e., to retain the credit risk of certain obligators
and hedge against the credit risk of other obligators.
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9.3.7 Other derivatives

9.3.7.1 Exotic derivatives
The derivatives described thus far are sometimes called vanilla or standard derivatives. Nonstandard derivatives also known as exotic derivatives can range from a simple combination of
two or more vanilla derivatives to complex financially-engineered instruments.
There are interesting and useful exotic derivatives such as (i) the break forward contract that allows
banks customers to break the contract at a specified exchange rate (the break rate) if the spot rate
at maturity is more favourable than the forward rate specified in the contract and (ii) the look-back
option that gives the right to buy (call) at the lowest price or sell (put) at the highest price recorded
over a specific period of time and (iii) the forward swap that determines the swap coupons on
transaction date but does not commence until a later date - say 1-year forward.
9.3.7.2 Weather derivatives

The value of weather derivatives depends on the weather. Weather derivatives allow companies
whose performance can be adversely affected by the weather to hedge their weather risk in much
the same way as they would hedge their foreign exchange or interest rate risk.
9.3.7.3 Insurance derivatives

The value of insurance derivatives depends on expectations of the amount of catastrophic losses
from events such as hurricanes and earthquakes. Insurance derivatives allow insurance companies
to manage the risks of catastrophic events.
Catastrophe insurance futures, launched by the Chicago Board of Trade in 1992, are based on the
loss ratio index calculated from the dollar value of reported insurance losses due to wind, hail,
earthquake, riot or flood.
9.4
Participants in the derivatives market
Participants in the derivatives market are hedgers, speculators or arbitrageurs. Investors also use
derivatives markets for income enhancement.
9.4.1 Hedgers
Hedgers are entities (investors, lenders, borrowers, producers, manufacturers) that are exposed to
the risk of adverse cash-market price movements in one of the following ways:
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Eliminating the exposure by taking a derivatives position that is equal and opposite to an existing
or anticipated cash-market position. The risk of loss is eliminated by giving up any potential for
gain i.e., both adverse and beneficial movements in the underlying position are hedged the
end result is certainty. For example if an exporter buys a forward to hedge against the effect of
fluctuating exchange rates
Paying a premium to eliminate the risk of loss and retain the potential for gain. For example if a
maize farmer buys a maize futures put option to hedge against the effect of volatile maize
prices. The farmer will retain much of the economic benefit of an increase in the price of maize
while eliminating downside risk. However the benefit comes at the cost of paying a premium.
In practice, no hedge is perfect because the basis is rarely constant. The basis is the degree to which
the difference between two prices the cash market price and the derivatives price of the
underlying asset fluctuates. Consequently hedging can be seen as substituting price risk with basis
risk. Basis risk occurs because the derivatives and cash prices do not move together i.e., are not
perfectly correlated. The extent of basis risk is a critical factor in determining which derivatives
contract is appropriate for hedging a particular price risk.
9.4.2 Speculators
Speculators attempt to make profits by taking a view on the market if their views are right, they
make money if they are wrong they lose money. Speculators are willing to bear risk that others
hedgers wish to avoid. The advantage of speculating in derivatives contracts rather than in the
cash market is that the leverage/gearing is greater i.e., positions can be taken with minimum capital
outlay. The greater liquidity and lower transaction costs of exchange-traded derivatives trading
increase the probability of a profitable speculative position. Speculators are important participants
in the derivatives market because they add liquidity and are often the counterparties of hedgers.
9.4.3 Arbitrageurs
The global financial market place has a profusion of interrelated financial products. In many cases it
is possible to synthetically create one product from a combination of other products. Mathematical
relationships exist linking the prices of comparable instruments. The actual prices of related
products usually follow these mathematical relationships exactly.
However in turbulent markets or when there is a physical separation between markets, prices may
briefly slip out of line. When this happens arbitrageurs attempt to profit from any anomalies in the
pricing by buying in the market where the price is cheap and selling in the market where the price is
144
expensive. They hereby attempt to make risk-less profits from any differences in prices. The
activities of arbitrageurs are usually beneficial as they drive up (down) the prices of under-(over-)
priced products and restore market prices to equilibrium.
145
Review questions
1.
What is a derivative?
2.
Name and describe the two organisations in South Africa that make up the organised
derivatives market.
3.
What are the two opposing forces that influence the design of derivatives contract by
derivatives exchanges?
4.
Differentiate between forward and futures contracts.
5.
Define an option contract and describe its characteristics.
6.
What is an interest-rate swap?
7.
What is the primary use of currency swaps?
8.
Define credit derivatives.
9.
What does the value of insurance derivatives depend on?
10.
Name the participants in the derivatives market.
146
Answers
1.
A derivative is a financial instrument that derives its value from the value of another
underlying variable.
2.
The two organisations that make up an organised derivatives market are the exchange and its
clearinghouse or central counterparty (CCP). In South Africa exchange-traded derivatives
contracts trade on the four JSE derivatives markets namely the currency derivatives market,
equity derivatives market, interest-rate market, and the South African Futures Exchange
(SAFEX) commodity derivatives market. The JSE derivatives markets have their own central
clearinghouse namely Safcom - the Safex Clearing Company (Pty) Ltd.
The clearinghouse processes all trades executed on the exchange. It acts as counterparty to all
transactions entered into on the exchange and assumes the contractual relationship between
the buyer and seller i.e., it becomes the buyer to each seller and seller to each buyer. The
clearinghouse is responsible for determining the profit and loss on all open positions by
revaluing them at the end of each business day at the closing contract prices traded on the
exchange this process is referred to as marking-to-market.
3.
The two opposing forces that influence the design of derivatives contract by derivatives
exchanges are standardisation and market depth and liquidity.
4.
The four characteristics specific to futures contracts that distinguish them from forward
contracts are:
Futures contracts are traded on organised exchanges while forwards trade over-thecounter
Futures contracts are based on a standard quantity/quality of the underlying asset

and have standardised delivery rules and dates. Forward contracts are custom made
With futures contracts performance is guaranteed by the futures exchanges clearing

house. This together with margining arrangements reduces default risk. Forwards
have default risk i.e., the seller may not deliver and the buyer may not accept delivery
Futures contracts are marked-to-market i.e., valued at current market prices on a

daily basis.
5.
An option contract conveys the right to buy or sell a specific quantity of an underlying asset or
derivative at a specified price at or before a known date in the future. The important
characteristics of an option are that it conveys upon the buyer (or holder) a right not an
obligation. Since the option can be abandoned without further penalty, the maximum loss the
buyer faces is the cost of the option. By contrast, if the buyer chooses to exercise his right to
buy or sell the underlying asset or derivative, the seller (or writer) has an obligation to deliver
147
or take delivery of the underlying asset or derivative. Therefore the potential loss of the seller
is theoretically unlimited
6.
A swap is a contractual agreement by which two parties, called counterparties, agree to

exchange (or swap) a series of cash flows at specific intervals over a certain period of time.
The swap payments are based on some underlying asset or notional, which may or may not be
physically exchanged. At least one of the series of cash flows is uncertain when the swap
agreement is initiated.
7.
Currency swaps can be used to hedge exchange rate risk.
8.
Credit derivatives are financial instruments that derive their value from the credit quality of an
obligation such as a loan or bond of a reference entity. Put another way, the payoff of credit
derivatives depends on the creditworthiness of a company or sovereign.
9.
The value of insurance derivatives depends on expectations of the amount of catastrophic

losses from events such as hurricanes and earthquakes.
10.
The participants in the derivatives market are hedgers, speculators, arbitrageurs and investors.
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10 The commodities market

The commodities market consists of a physical market in which products such as maize, gold and
silver are traded and a financial market in which commodities-based financial instruments are
traded. The purpose of this chapter is to describe the commodities market. First the market is
defined and its characteristics described. Then commodity instruments spot or physical
commodities, forwards, futures and swaps - are discussed. Finally the chapter outlines the
participants in the commodities market.
define the commodities market
understand the characteristics of the commodities market
explain the features of commodities market instruments
describe the participants in the commodities market.
10.1
The market defined
Commodities are real assets - tangible assets that have intrinsic value. Real assets include land,
property, equipment, raw materials, infrastructure, intellectual property, and real options. The
counterpart to a real asset in finance is a financial asset, which is an ownership claim on a real asset.
Shares, bonds, and options are financial assets.
The commodities markets trade in physical commodities as grouped in table 10.1 and in derivative
financial instruments, such as futures and options.
Table 10.1: Physical commodities
Industrial
metals
Aluminium
Copper
Lead
Nickel
Palladium
Zinc
Precious
metals
Gold
Platinum
Silver
Energy
Food and fiber
Crude oil
Heating oil
Natural
gas
Unleaded
gas
Cocoa
Coffee
Cotton
Lumber
Orange
juice
Sugar
Rubber
Grains
Corn
Soybeans
Wheat
Oats
Rice
Maize
Sunflower
seed
Meat
Cattle
Hogs
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Commodity derivatives are used to manage commodity price risk in the underlying physical
commodities markets and for speculative trading. However increasingly commodities are used for
investment purposes.
10.2
Commodities markets are global. Trading is conducted on over-the-counter markets and exchanges.
10.2.1 Over-the-counter commodity markets

The over-the-counter (OTC) market trades on a 24-hour per day continuous basis and accounts for
most of the global commodities trading. Participants trade with each other on a principal-toprincipal basis. Counterparty credit risk exists between the parties involved in the transaction.
Transactions are tailor-made to meet the needs of the participants in terms of, amongst others,
price, quality, size and destinations for delivery.
Cash (or spot) and derivatives trading takes place in over-the-counter markets. Derivatives traded
are forwards, swaps and options.
According to the Bank for International Settlements, December 2011 the notional amount
outstanding in the global OTC commodity derivatives market was USD 3.1 trillion (December 2010:
USD 2.9 trillion).
10.2.2 Exchanges
Although there is both spot and derivatives trading of commodities on commodity exchanges, the
vast majority of trading is in derivatives. Derivatives contracts traded are futures and options.
According to the World Federation of Exchanges, the number of commodity derivative contracts
traded on exchanges in 2011 was over 2.7 trillion contracts.
Worldwide, there are around 50 major commodity exchanges that trade in more than 90
commodities. The top 5 exchanges in terms of number of futures contracts traded in 2009 are
shown in table 10.2.
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Table 10.2: Largest commodity derivatives exchanges (2009)
Exchange
Country
Commodities traded
Millions of
contracts
traded
Dalian Commodity Exchange
China
Agriculture
834
Shanghai Futures Exchange
China
Non-precious metals
435
Energy, Metals, Agriculture
431
Agriculture
227
Energy
165
CME Group
Zhengzhou Comm. Exchange
ICE Futures Europe
US
China
UK
Source: The City UK, 2011
10.3
Commodity market instruments
Commodity trading instruments include spot, forwards, swaps, futures and options. Commodity
investment instruments include commodities directly, shares of commodities producers, commodity
futures, commodity index funds, exchange traded funds and notes and exchange traded
commodities.
10.3.1 Spot
A spot contract is a contract for the immediate or on the spot delivery of the commodity by the
seller to the purchaser.
Most of the worlds commodities are sold by bilateral contracts between producers and consumers
or importers and exporters. Such contracts specify the terms of execution, delivery and payment.
10.3.2 Forwards
A forward contract will fix the price today for delivery of an asset in the future. Forward contracts
are over-the-counter instruments negotiated bilaterally between the buyer and the seller.
Forward contracts are contractual commitments e.g. if gold is bought forward at USD 800 an ounce
but the price of gold in the spot market is only USD 790 on expiry date, the buyer of the forward
cannot walk away from the forward contract and buy gold in the spot market. However it is possible
to terminate a forward contract early. This is achieved by buyer and seller agreeing a break amount,
which would reflect the current economic value of the underlying.
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10.3.3 Futures
Futures contracts are traded on organised exchanges such as SAFEX and the New York Mercantile
Exchange (part of CME Group). A futures contract achieves the same result as a forward by offering
price certainty for a period in the future. However futures contracts are standardised e.g. in terms of
quality and quantity.
10.3.4 Swaps
In a swap transaction two parties agree to exchange cash-flows, the sizes of which are based on
different price indices. Typically, this is represented as an agreed fixed rate against a floating rate.
Swaps are traded on an agreed notional amount, which is not exchanged but establishes the
magnitude of the fixed and floating cash-flows. Swap contracts are typically of longer-term maturity;
greater than one year.
The following are examples of swap contracts:
Gold swap contract: Pay fixed lease rate and receive variable lease rate
Base metals swap contract: Pay fixed aluminum price and receive average price of near dated
aluminum futures contract
10.3.5 Investment vehicles

Commodities are basically different from financial assets such as bonds and equity in the following
aspects:
Commodities are investable assets. They are not capital assets
Commodities do not generate dividends, interest payments or other income
Commodities are valued because they can be consumed or changed into something else. Their
value is determined by supply and demand
There are a number of ways of investing in commodities. These include investing in commodities
directly, shares of commodities producers, commodity futures, commodity index funds, exchange
traded funds and notes and exchange traded commodities.
10.3.5.1 Commodities
Investors can own commodities directly. Unless the investment comprises commodities such as
Krugerrand gold coins, investors would require warehouses to store the commodities, which is
generally considered impractical and uneconomic.
152
10.3.5.2 Shares of commodity producers

Investors can invest in the shares of commodity producers. However this will expose them not only
to commodities, but also to the financial structure and management of the company. In addition
management of the company may validly hedge its commodity production and as a result, investors
will not get the full benefit of changes in commodity prices.
10.3.5.3 Commodity futures

Investors can purchase commodity futures contracts to simulate ownership of commodities. By
periodically rolling over commodity futures contracts prior to their expiry date and reinvesting in
new contracts investors obtain investment returns equal to the return from a single commodity or
index of several commodities.
10.3.5.4 Commodity index funds

Commodity index funds enable investors to buy a balanced and diversified basket of commodities in
a single investment. Index funds do not have physical ownership of the underlying commodities,
instead index funds use futures contracts to buy a forward position, then sell this as it approaches
expiry, and use the proceeds from this sale to buy forward by one or two months again.
10.3.5.5 There are a number of commodity indices. The most liquid index is the Standard
& Poors Goldman Sachs Commodities Index (S&P GSCI). Other indices are the
Dow Jones-UBS Commodity Index (DJ-UBSCI), Deutsche Bank Liquid Commodity
Index (DBLCI) and Rogers International Commodity Index (Rogers). The different
index funds have different weightings of component commodities and there are
significant differences in the number of commodities tracked by each index.
Exchange traded funds and notes
Commodity based Exchange Traded Funds represent ownership in an underlying portfolio of
commodities generally achieved by tracking an index. Investors are able to buy and sell shares of
exchange traded funds (ETFs) on an exchange in the same way they would any other listed share.
Exchange Traded Notes (ETNs) are traded as debt securities that can be bought and sold like on
exchange. Exchange traded notes (ETNs) are a promise to pay the investor an amount linked to a
given benchmark i.e., commodity index. The investor takes on the credit risk of the issuer.
Commodity based exchange traded notes (ETNs) can be used to gain exposure to commodities.
153
There are currently no commodity-based ETFs or ETNs in South Africa.
10.3.5.6 Exchange traded commodities

Exchange-traded commodities are investment vehicles that track the performance of a single
underlying commodity like gold, oil or zinc or a commodity index.
Exchange-traded commodities are traded and settled exactly like normal shares. There are dedicated
exchange-traded commodities sectors on the London Stock Exchange, Euronext Amsterdam and
Deutsche Brse.
Generally both single commodity and index-tracking exchange-traded commodities benchmark a

total-return index. Thus there are three sources of return:
The change in price of the future: The price of the future is largely affected by changes in the
spot commodity price
The roll: As commodity futures contracts are rolled prior to their expiry date and reinvested in
new contracts there is usually a price difference between the two, which is reflected in the
prices of exchange-traded commodities. If the market is in backwardation (forward price lower
than spot price) index funds earn a positive roll return. If the market is in contango (forward
price higher than spot), then they will lose money through a negative roll return.
Interest: Interest is earned on the cash value of the initial investment.
The first exchange-traded commodity was a Gold ETC listed in 2003 on the Australian Securities
Exchange and on the London Stock Exchange in 2004.
10.4
Participants in the commodity market
The participants in commodity markets are diverse and vary according to the commodities being
traded.
10.4.1 Producers
Producers make, grow, or supply commodities for sale and include farmers, oil producers, refiners,
electric utilities and mining companies.
10.4.2 Consumers
Consumers buy and use commodities and include the food industry, manufacturers, wholesalers, the
airline industry and shipbuilding industry.
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10.4.3 Spot market traders

Spot market traders connect producers and consumers, sometimes accumulating commodities to
clear the market.
10.4.4 Commodity trading advisors

Commodity trading advisers (CTAs) are professional investment managers who focus in commodity
futures and options trading. CTAs generally specialise in technical buying and selling of nearby
positions based on short term trends. They look for arbitrage opportunities and other short-term
potential.
10.4.5 Hedge funds

Typically, hedge funds are interested in investing in any markets with good liquidity and high
volatility and are willing and able to undertake higher-risk trading strategies. Hedge funds buy or sell
at any price position along the forward curve based on fundamental views and will invest anywhere
they see value.
Of the hedge funds in commodities markets, an estimated 80% are looking for higher-than marketfollowing (or passive) returns. Only 20% of hedge fund money is likely to be looking for marketfollowing (or passive) returns offered by indices.
Specialist commodity hedge funds trade in a single commodity. In some instances they transact in
the physical spot market by taking delivery of physical commodities for future resale. Some
commodity hedge funds only take exposure to commodities through securities in commodity
companies e.g. mining and utility companies
10.4.6 Investors
There are three types of investors in the commodities market, they are described as follows:
Institutional investors: Institutional investors are organisations that invest professionally; this
includes insurance companies, banks, pension funds, investment companies, collective
investment schemes and endowment funds. They are large buyers and sellers of shares, bonds
and other investment instruments. Most institutional investors invest in commodities as a nonessential diversifying investment to their portfolios
Private investors: Private investors include high net worth individuals and sophisticated
investors. Commodities are classified as alternative investments and exposure to commodities
155
provides private investors with an inflation hedge, and portfolio diversification as commodities
generally have low correlation with equities and bonds
Retail investors: There is limited retail investment in commodities markets. However this may
change with the introduction of exchange traded funds
156
Review questions
1.
What is the difference between a real asset and a financial asset?
2.
Name two physical commodities.
3.
In which commodities market are commodities transactions tailor-made to meet the needs of
participants?
4.
The majority of trading on commodities exchanges is physical commodities trading? (True or

False)
5.
What are the differences between commodities and financial assets such as bonds and
equity?
6.
List six ways of investing in commodities.
7.
What is a spot commodity contract?
8.
Differentiate between producers and consumers of commodities.
9.
Spot market traders connect producers and consumers. They will sometimes buy commodities
to clear the market. (True or False)
10.
Name three types of investors in commodities.
157
Answers
1.
A real asset is a tangible asset that has intrinsic value while a financial asset is an ownership
claim on a real asset.
2.
Gold and coffee are physical commodities. See table 10.1 for a list of physical commodities.
3.
In the over-the-counter commodities market, transactions are tailor-made to meet the needs
of participants.
4.
False; the majority of trading on commodities exchanges is in derivatives.
5.
Commodities are different from financial assets in the following ways:
Commodities are investable assets. They are not capital assets
Commodities do not generate dividends, interest payments or other income
Commodities are valued because they can be consumed or changed into something else.
Their value is determined by supply and demand.
6.
Six ways to invest in commodities are: Commodities directly, Shares of commodity producers,
Commodity futures, Commodity index funds, Exchange traded funds and notes and Exchange
traded commodities.
7.
A spot commodity contract is a contract for the immediate delivery of the commodity to the
seller by the buyer.
8.
Producers make, grow and supply commodities for sale while consumers buy and use
commodities.
9.
True
10.
Three types of investors in commodities are institutional investors, private investors and retail
investors.
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11 Investment instruments
Investment is the commitment of money or capital to purchase an instrument that provides the
possibility of generating returns over a period of time within certain levels of risk. An array of
investment instruments with a variety of maturities, risk-return characteristics and cash-flow
patterns are available to the investor. In this chapter we examine some of these instruments.
The chapter starts by explaining the need for the development of different investment products. The
chapter proceeds by describing the features of the different investment instruments and the
different risks associated with them.
Learning outcome statements
understand how different needs lead to the development of different investment instruments
and products
describe the different investment products available to investors.
11.1
Introduction
The characteristics of investors and the circumstances that confront them are diverse and complex.
Each investors financial profile and attitude to return and risk are unique. Each has a different set of
constraints related to liquidity, taxes and time horizon and a set of preferences in respect of social
and environmental responsibility. To meet the varied risk/return objectives, requirements and
preferences of investors a wide array of investment products have been developed and are available
to retail and wholesale investors.
11.2
Cash
Cash can be held as notes and coins or deposited with a bank.
Holding cash has the advantage of immediate liquidity. However there are two problems with
holding cash. Firstly cash earns no interest and its real value will be eroded by inflation and secondly
large cash holdings may attract criminals.
11.3
Deposits
Cash deposited with a bank will be held in non-interest-bearing or interest-bearing accounts.

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Non-interest-bearing accounts such as cheque accounts are used to meet immediate expenditure
requirements. Cash can be withdrawn by cash or cheque at any time without notice. Since cheque
accounts generally do not pay interest they are not strictly-speaking investments. Rather they are a
convenient way to store cash and make transactions.
To choose an interest-bearing account such as a demand deposit, fixed deposit, money market
account or notice deposit account, an investor should consider the following factors:
Interest rate: Interest rates may be fixed or variable and may be paid at different times e.g.
monthly, quarterly, semi-annually or annually. Investors should ensure that when evaluating
interest rates offered, these are comparable
Term to maturity: Term to maturity indicates the set period of time for which the cash is to be
invested. The longer the term to maturity, the higher the interest rate
Period of notice: Period of notice is the amount of time that must be given by investors to
withdraw the invested funds in an account. Some accounts can be withdrawn on demand;
others require a notice period for example 30 days notice
Cost: Some accounts attract fees such as monthly maintenance fees. Since these eat into the
return and perhaps capital of the deposit, investors should ensure they are receiving value for
money.
Security: Security relates to the risk of default by the bank. Investors should consider the
financial strength of the bank before placing their funds with it. In addition they should consider
diversifying i.e., having accounts with several different banks. Some countries have deposit
insurance, which provides compensation to small retail depositors in the event of a bank failing.
Deposit insurance has been proposed in South Africa but has not yet been introduced
There are a number of deposit accounts. These include the following:
Savings accounts: Deposits that pay interest and can be withdrawn on demand. The amount of
interest will depend on the balance in the account. The higher the balance, the higher the
interest rate
Notice deposit accounts: Deposits that pay interest and are subject to a period of notice to
withdraw the funds. The longer the period of notice, the higher the rate of interest. Immediate
access to funds is generally available on the penalty of forgoing the interest
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Money market accounts: Accounts that pay interest rates closely related to money market rates
such as JIBAR. Generally such accounts have a relatively high minimum balance and upfront fees.
These accounts can be withdrawn on demand
Negotiable certificates of deposit (NCDs): Negotiable certificates of deposits are issued by banks
for a specific period at a stated interest rate. They are negotiable but have a minimum balance
of R1 million.
11.4
Equities
Equity instruments are discussed in chapter 8.
11.5
Bonds and long-term debt instruments
Bond and long-term debt instruments are addressed in chapter 7.
11.6
Retail savings bonds
In 2004 securities for the retail savings bond market were introduced. The main objectives of the
issues were to create awareness amongst the general public of the importance to save, diversify the
financial instruments on offer to the retail market and target a different source of government
funding.
The government has on issue two series of RSA retail savings bonds:
2-year, 3-year and 5-year fixed-rate retail savings bonds
3-year, 5-year and 10-year inflation-linked retail savings bonds
In terms of security, retail savings bonds are backed by the full faith of the Government.
Retail savings bonds have a minimum investment limit of R1 000 and maximum investment limit of
R5 million.
11.7
Money market instruments
Money market instruments are dealt with in chapter 6.
11.8
Commodities
Commodity instruments are dealt with in chapter 10.
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11.9
Products made available by long-term insurance companies
There are two kinds of insurance short-term and long-term insurance. Short-term insurance
insures possessions such as household goods or vehicles against events such as fire, theft, personal
liability. Long-term insurance covers major events in life such as death, retirement and disability.
Life insurance companies offer a variety of life policies and variants thereof. A life policy is a contract
between the insurance company and an individual or individuals, where payment by the insurance
company in return for premiums paid, depends in some way on the duration of the life/lives of the
individual/individuals.
There are essentially three classifications of life policies: term insurance, whole-life insurance and
endowment.
A term insurance policy is a policy for a specified number of years in terms of which, in return for
premiums paid, a fixed benefit is payable on the death of the policyholder any time before the
specified term of the contract. The policy provides no further protection if the insured person lives
beyond the specified term of the contact. It has no surrender or cash-in value.
Whole-life and endowment policies, in return for a premium paid, provide a mix of life cover and
investment. Such policies have a surrender value and can be with-profit policies i.e., the return on
the investment portion of the policy is linked to the investment performance of the insurance
company. In the case of a whole-life policy the benefit is paid out on the death of the insured
regardless of the date of such event. The endowment policy will pay out the benefit after a fixed
period or on earlier death.
11.10 Annuities
Insurance companies offer annuities to investors. An annuity is a contract to pay a set amount every
year while the person on whose life the contact depends the annuitant - is alive. Annuities may be
immediate or deferred.
An immediate annuity provides, in return for a single premium, an annual payment starting
immediately and continuing for the rest of the annuitants life. The contracts are often purchased by
retired people who want an income that is guaranteed to last the rest of their lives. The income
received depends largely on prevailing interest rates and life expectancy.
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A deferred annuity is a contract that provides for an annuity to be payable commencing at some
future date. The period between the date of the contract and the date of commencement of the
payments (also known as the vesting date) is referred to as the deferred period. Regular premiums
are payable throughout the deferred period. If the annuitant dies during the deferred period, the
insurance company will return the premiums paid. The annuity is payable from vesting date until the
annuitant dies.
There are a number of types of annuities including a compulsory purchased annuity (CPA), a
voluntary purchased annuity (VPA), a living annuity and a composite annuity.
A compulsory purchased annuity (CPA) must by law be bought with a portion of the funds received
from a matured retirement annuity or pension fund. A CPA is paid to the annuitant for life.
A VPA can be purchased by anyone wanting guaranteed income. It can be taken for life or for a fixed
term e.g. 10 years.
The biggest disadvantage of a CPA and VPA is that the income dies with the annuitant unless
insurance cover is taken out for the capital (at a cost) or a guarantee is placed on the annuity.
In terms of a living annuity, the annuitants capital is invested in equities or bonds to achieve growth,
and an income of between 5% and 20% of the investment value is withdrawn annually. The
annuitant bears the risk of a capital loss on the investment if the equity or bond markets weaken.
The advantage of a living annuity is that when the annuitant dies, the balance of the investment
goes to the heirs.
Composite annuities are a combination of CPA/VPA annuities and living annuities. Composite
annuities offer flexible income from the living annuity part and a guaranteed income from the
conventional annuity part.
11.11 Retirement funds

A retirement fund is an independent non-profit legal entity that collects, invests and administers
funds contributed to them by individuals and companies. The exclusive purpose of a retirement fund
is to finance retirement plan benefits i.e., provide an income for an individual after retirement.
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There are three basic types of retirement funds: government pension schemes, personal retirement
funds and occupational retirement funds.
11.11.1
Government pension schemes
Government pension schemes pay a state pension to elderly citizens. The pension is funded out of
taxes. In South Africa it comprises a social old age grant to elderly people (men over 65 and women
over 60) who do not have sufficient income from other sources. About 75% of South African elderly
rely on the old age grant.
11.11.2
Personal retirement fund
Personal retirement funds are funds entered into by individuals to provide for their retirement. Such
funds are funded by contributions from the individual. Retirement annuities can be used for this
purpose.
11.11.3
Occupational retirement funds
Occupational retirement funds (or simply retirement funds) are run by employers for the benefit of
their employees. They are funded by contributions from the employee or employer or both. The
main role-players in a retirement fund are the sponsor (the employer or a group of employers), the
beneficiaries (the employees who participate in the fund), the fund manager (who manages the
assets in the fund) and the trustees who govern and monitor the retirement fund on behalf of the
beneficiaries.
Retirement funds in South Africa are categorised as provident funds or pension funds. A pension
fund provides for at least two thirds of the final retirement benefit to be paid as a life-long pension
after retirement. One third of the final benefit may be taken in cash, subject to tax. A provident fund
provides for the full amount of the final retirement benefit to be taken in cash, subject to tax.
There are two broad fund structures: defined benefit funds and defined contribution funds. In a
defined benefit fund the retirement benefit is determined according to a formula linked to the
beneficiarys final salary. This means that the employer is exposed to the investment risk of the fund
i.e., if the investments of the fund are insufficient to fund retirement benefits, the employer must
contribute the shortfall. If the funds investments perform better than expected, the employer may
contribute less to the fund and may even make no contribution i.e., take a contribution holiday.
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In a defined contribution fund the retirement benefit is the sum of the total contributions made plus
the net (i.e., after costs) return on investment. This implies that the employee is exposed to the
investment risk of the fund. If fund investments perform worse/better than expected, the
beneficiarys retirement benefits are reduced/increased. Retirement benefits are dependent on the
investment return of the fund.
11.12 Collective investment schemes

Collective investment schemes (CISs) is a generic term for any scheme where funds from various
investors are pooled for investment purposes with each investor entitled to a proportional share of
the net benefits of ownership of the underlying assets. A CIS consists of the following:
Pooling of resources to gain sufficient size for portfolio diversification and cost-efficient
operation
Professional portfolio management to execute an investment strategy.
CISs can be categorised as open-end funds or closed-end funds.
Open-end funds publicly offer their shares or units to investors. Investors can buy and sell the shares
or units at their approximate net asset value. The shares can be bought from or sold to the fund
directly or via an intermediary such as a broker acting for the fund.
Closed-end funds offer their shares or units to the investing public primarily through trading on a
securities exchange. If closed-end fund investors want to sell their shares, they generally sell them to
other investors on the secondary market at a price determined by the market.
In South Africa CISs are governed by the Collective Investment Schemes Control Act 45 of 2002 (CIS
Act). The CIS Act became effective on 3 March 2003 replacing the Unit Trusts Control Act and
Participation Bonds Act.
The CIS Act makes provision for five different types of CIS:
CISs in securities: Schemes where the portfolio consists of shares, preference shares, bonds,
futures, options, warrants and / or money market instruments
CISs in properties (CISPs): Schemes where the portfolio consists of property shares, immovable
property and units in CISs in property in a foreign country. CISs in property are listed on the JSE
CISs in participation bonds (CISPBs): Schemes where the portfolio consists mainly of participation
bonds. CISPBs pool funds received from investors and lend them out by granting first mortgage
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bonds over commercial, industrial or retail properties. The interest paid on these loans is passed
on to participants in regular payments. Thus CISPBs offer security and an interest income on a
regular basis, which is why they are attractive to investors such as retired persons, charities and
pension funds
Foreign CISs: CISs established outside South Africa. A Foreign CIS invites or permits members of
the public in South Africa to invest in its portfolios. To carry on business in South Africa a Foreign
CIS must obtain approval from the Registrar of Collective Investment Schemes. Only once it is
approved, may a Foreign CIS solicit investment from members of the public in South Africa
Declared CISs: CISs deemed by the Registrar of Collective Investment Schemes to be CISs
CISs make it possible for investors, including small savers, to obtain diversified investment portfolios
with professional management at reasonable cost and to execute a widening range of investment
strategies. In other words, the main benefits of CISs are:
Diversification i.e., spreading the risk of investing over a range of investments
Professional expertise to manage investors portfolios
Reasonable cost due to reduced dealing costs due to bulk transacting and cost-effective
administration
Choice in that there are increasing numbers of alternative funds from which to choose.
In addition CISs generally exist in a set of legal, institutional and market-based safeguards to protect
the interests of investors.
The disadvantages of investing in CISs are generally held to be as follows:
Costs in respect of funds management and advice could be avoided if investors managed their
own investments. This assumes investors have the expertise to so self-manage their investments
Although investors have a large variety of funds to choose from, they have no control over the
choice of individual holdings within their portfolios
Investors have none of the rights associated with individual holdings e.g. right to attend the
annual general meeting of a company and vote on issues impacting the company.
11.13 Hedge funds

Hedge funds like other CISs, pool investors' money and invest those funds in financial instruments in
an effort to make a positive return. Many hedge funds seek to profit in all kinds of markets by
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pursuing leveraging and other speculative investment practices that may increase the risk of
investment loss.
The term hedge is generally associated with the practice of covering an investment position (longbought position) with an equal and opposite position (short sale position8), thereby neutralising the
market risk of the original investment decision. The degree to which a fund is hedged in the
traditional sense varies substantially across funds. A fund is said to have a net short position or bias
when it takes a larger bet on short positions versus long positions. A fund is said to have a net long
position or bias when it takes a larger bet on long positions versus short positions.
Hedge funds are notoriously difficult to define. The Basel Committee on Banking Supervision sees
hedge funds as financial institutions that generally have the following characteristics (none of which
individually is unique to hedge funds): (i) hedge funds are subject to very little or no direct regulatory
oversight because they are structured as limited partnerships; (ii) investors are either institutions or
sophisticated high net worth individuals and the securities issued take the form of private
placements; (iii) hedge funds are generally subject to limited disclosure requirements, and (iv) hedge
funds take on significant leverage, which increases hedge funds exposure to large movements in
market prices.
Hedge funds achieve leverage through conventional means, such as unsecured or partially secured
debt, but in reality much of the leverage of hedge funds is created through the types of trading
strategies undertaken. For example, a hedge fund uses leverage when it sells government bonds
short and uses the proceeds to establish a long position in corporate bonds.
An investor has several options for accessing hedge funds. One is to directly invest in one or several
hedge funds. Alternatively the investor can purchase an interest in a fund of hedge funds, also
known as a multi-manager fund. The investment manager of a fund of hedge funds selects and
invests in a number of hedge funds, often through an offshore corporation or similar privately placed
vehicle.
A short sale is a sale of a security that the seller does not own at the time of trade. Short sellers believe that
the price of the security will fall. If the price of the security falls, the short seller buys back the security at a
lower price and makes a profit. If the security price rises the short seller will incur a loss. Short selling allows
arbitrageurs and dealers to profit from going short of the overvalued securities.
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11.14 Property
Property comprises buildings including offices, industrial warehouses, shopping centres, factories,
residential homes, apartment buildings and land. Property is a tangible asset rather than a financial
asset such as shares or bonds. In addition it is an immovable asset comprising the land and
permanently attached improvements to the land.
Property offers an attractive way to diversify an investment portfolio. Property can be classified into
two investment categories income property and speculative property.
Income property includes residential and commercial properties that are leased out and expected to
deliver returns primarily from rental income. Income properties have a number of sources of return:
increasing rental incomes, appreciation in the value of the property and possibly tax benefits.
However such properties have risks: losses from tenant carelessness or negligence, excessive supply
of competing rental units or poor property management.
Speculative properties include land and investment properties that are expected to provide returns
primarily from appreciation in value due to location and scarcity rather than rental income.
Speculative properties give their investors the opportunity to make excessive profits from increases
in value or heavy losses due to uncertainty resulting in failure to achieve price appreciation.
Investors can either invest directly in property through individual ownership or joint
ventures/partnerships or indirectly by investing in a property entity. Property entities in South Africa
include listed property entities namely property holding and development companies (called
property loan stock companies) and collective investment schemes in property (CISPs) or property
unit trusts (PUTS) as well as unlisted property holding and development companies (or property
syndications).
11.14.1
Property loan stock companies
Property loan stock (PLS) companies (also known as property holding and development companies)
are listed on the JSE under Real Estate Holding and Development. PLS companies invest solely in
property. As with all other listed companies PLS companies are subject to the Companies Act, JSE
regulations and are governed by their memorandum of incorporation.
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The main difference between PLS companies and other companies is that PLS companies issue linked
units rather than shares. A unit in a PLS company is part share and part debenture (called a duallinked structure), with most of the value of the unit attributable to the debenture. The debenture is
not redeemable and earns interest at a variable rate. The interest comes from income that the PLS
company earns from rental incomes received from the properties in which the company invests, the
sale of properties in which the company has invested and that have appreciated in value since
purchase and fee income from property management services.
PLS companies usually distribute all their net profits, mainly through debenture interest with the
balance being paid out as dividends. Distributions are paid quarterly, semi-annually or annually.
These regular distributions provide investors with a steady cash flow.
11.14.2
Unlisted property holding and development companies
Unlisted property holding and development companies are more commonly known as property
syndications. These are unlisted investment schemes that enable a group of investors to buy
property and become part owners of it, either directly or but more usually, indirectly.
Property syndication is typically structured in one of the following ways:
A public company owns the property directly
A private company owns the property and is itself wholly owned by a public company.
The units (shares and debentures) in the public company are sold to investors. The investment can
either be solicited with a prospectus registered with the Registrar of Companies or by way of private
placement with catalogue.
In South Africa many investors have lost their investments in property syndications for various
reasons including substantial falls in property prices. In addition property syndications, because they
are unlisted and loosely regulated, have been used to fleece investors.
11.14.3
Collective investment schemes in property
A collective investment scheme in property (CISP) also known as a property units trust (PUT), is a
portfolio of investment-grade properties typically held in the form of a trust.
PUTs are approved by the FSB in terms of the Collective Investment Schemes Act. The FSB limits
PUTs to investments in listed immovable property assets, shares in property companies; and liquid
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debt-related investments. The FSB requires a PUT to be listed on the JSE and as such are subject to
all the regulatory requirements imposed by the JSE for listed securities.
The management companies of PUTs are responsible for the day-to-day operation of the portfolio of
properties and for the investment strategy of the property unit trust. The affairs of the management
companies are governed by a Trust Deed between the management company and the PUTs.
PUTs typically derive the bulk of their income from the rental of immovable property. Income (e.g.
rental) received by a PUT is taxed at standard income tax rate unless distributed to holders within a
12 month period. PUT distributions are treated as ordinary income in the hands of investors. PUTs
are free from any capital gains tax, which applies only when investors dispose of their units.
11.14.4
Real estate investment trusts
The current financial regulatory and taxation regime for PLS companies and PUTs is not the same.
Although both PLS companies and PUTs are subject to the same JSE listing requirements, only PUTs
are directly regulated by the FSB. The National Treasury, in its explanatory memorandum to the
Taxation Laws Amendment Bill, 2012, proposes a real estate investment trust (REIT) regime that will
create a unified system of regulating and taxing property investment entities such as PLS companies
and PUTs. The REIT system, which will conform to international standards, should be in place by
2014. National Treasury is in consultation with relevant stakeholders before considering the
inclusion of other forms of property entities such as property syndications into the proposed regime.
A REIT aims to provide investors with a steady rental income stream while also providing capital
growth from sales of underlying properties. To qualify as a REIT, an entity must be listed on the JSE
as a REIT. To obtain a listing the entity must:
have a minimum amount of gross property assets (direct interests in immovable property (such
as land and buildings), interests in a lease relating to immovable property, interests in a property
subsidiary or holdings in another REIT
invest in immovable property assets
distribute most of its profits on yearly basis
not have excessive borrowing (i.e. gearing) in relation to the asset value of property held by the
entity.
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The above requirements must be contained within the trust deed in the case of a PUT and in the
memorandum of incorporation in the case of a PLS company.
REITs will be exempt from capital gains. However the holders of shares or participatory interests in
REITS will be subject to tax, typically capital gains.
11.15 Private equity

Private equity is medium to long-term finance provided by investors in return for an equity stake in
potentially high-growth companies. The companies are generally not listed on a stock exchange and
need financing to fund growth, development or business improvement. In addition to providing
capital, the private equity investment encompasses hands-on application of skills, expertise and
strategic vision to the privately owned companies. The investment is often realised through flotation
on the public markets.
Private equity investments take the form of any security that has an equity participation feature.
The most common forms are ordinary shares, preference shares and subordinated debt with
conversion privileges or warrants.
In general investors invest in private equity because the risk-adjusted returns on private equity are
expected to be higher than that on other investments and there are potential diversification
benefits.
The principal ways of investing in private equity are as follows:
Indirectly through a new private equity fund
Indirectly through a private equity funds of funds, which is a private equity fund that invests in
other private equity funds
Directly through in a private equity transaction
Through a secondary purchase of an existing private equity interest.
The key characteristics of private equity are as follows:
Private equity investments are privately held as opposed to publicly traded.
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Private equity investment entails active involvement in identifying the investment, negotiating
and structuring the transaction and monitoring the company once the investment is made. This
often requires serving as a board member of the company.
Private equity investments are not intended to be held indefinitely. Generally, alternative exit
strategies are evaluated at the time the initial investment in the company is made. One such
strategy would be to take the company public and sell the shares into the public market.
Private equity investments are high risk and high reward. Private equity investors seek a high
return on their capital when the company prospers as they risk losing most, if not all, of their
investment if the company fails.
11.16 Collectibles
Collectors may collect for profit or the joy of collecting. Collectibles include stamps, coins, jewelry,
art, antiques, books and even Barbie dolls and toy soldiers.
Illiquidity adds to the costs of collectibles i.e., it is difficult to find a buyer at short notice, finding a
buyer who will pay the right price takes time. In addition the costs of buying and selling diminish
profits. These costs include commission, storage, insurance, packaging and shipping.
Real assets such as collectibles and real estate are highly regarded as hedges against inflation.
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Review questions
1.
What is a collective investment scheme?
2.
There are no disadvantages of holding cash in notes and coins.(True or False)
3.
What factors should an investor consider when choosing a bank deposit account?
4.
An investor may invest R10 million in a retail savings bond. (True or False)
5.
Name three classifications of life policies.
6.
What is an immediate annuity?
7.
Name four types of annuities.
8.
What is a retirement fund?
9.
Name three types of retirement funds.
10.
Why in general do investors invest in private equity?
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Answers
1.
A collective investment scheme (CIS) is a generic term for any scheme where funds from
various investors are pooled for investment purposes with each investor entitled to a
proportional share of the net benefits of ownership of the underlying assets.
2.
False. There are two problems with holding cash. Firstly cash earns no interest and its real
value will be eroded by inflation. Secondly large cash holdings may attract criminals.
3.
The investor should consider the interest rate, term to maturity, period of notice and risk of
bank default.
4.
False, retail bonds have a maximum limit of R5 million.
5.
Three classifications of life policies are term insurance, whole-life insurance and endowment
policies.
6.
An immediate annuity, in return for a single premium, provides an annual payment starting
immediately and continuing for the rest of the annuitants life.
7.
Four types of annuities are a compulsory purchased annuity, a voluntary purchased annuity, a
living annuity and a composite annuity.
8.
A retirement fund is an independent non-profit legal entity that collects, invests and
administers funds contributed to them by individuals and companies in order to finance
retirement plan benefits.
9.
Three types of retirement funds are government pension schemes, personal retirement funds
and occupational retirement funds.
10.
Investors invest in private equity because the risk-adjusted return on private equity is
expected to be higher than that on other investments and there are potential diversification
benefits.
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12 Introduction to portfolio theory

Given the number of available assets - bonds, shares, property, treasury bills, bank fixed deposits,
gold, art and antiques how should investors structure their portfolios of assets to best meet their
investment objectives? Answering this question is the subject of this chapter.
The chapter begins by describing Markowitzs portfolio selection process i.e., the process for
selecting an optimum portfolio for an investor. Then the development of Sharpes single index
model and the Capital Asset Pricing Model will be discussed. Thereafter multi-index models will be
described. Finally the portfolio management process will be defined and discussed. To aid the
digestion of the chapter, the calculations are, where possible, defined in the annexure to this
chapter.
explain security analysis
discuss portfolio analysis
describe portfolio selection the problem of selecting an optimum portfolio for an investor
outline the following portfolio theory models: the Markowitz model, Sharpes index models and
the capital asset pricing model (CAPM).
12.1
Introduction
Thus far the mechanics of the stock market as a whole and the valuation of individual shares have
been examined. This chapter deals with the theory of portfolios and their management. It may
appear that the selection of a portfolio would follow clearly and simply from the process of valuing
shares. That this is not true is obvious from the behaviour of investors. Almost all choose to hold a
number of shares rather that a single share that offers the greatest expected return. This would
indicate that the attractiveness of a share does not consist only of expected return.
Since 1952 when Harry Markowitz published his ground-breaking article Portfolio Selection in the
Journal of Finance, investors have come to understand why the rational and professional
management of portfolios consists of more than listing individual shares according to their
magnitude of expected return and then choosing the couple of shares that offer the highest
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expected returns. Investors while seeking high return, generally wish to avoid risk i.e., the likelihood
of loss or the variability of return.
Thus in general, the assumptions underlying portfolio theory are:
When choosing portfolios, rational investors attempt to maximise utility and are willing to base
their decision solely in terms of risk and return
Investors are risk averse
The risk of a portfolio is measured by the variability of its return
For any given level of risk an investor prefers a higher rate of return to a lower one or for any
given level of return an investor prefers less risk to more risk.
12.2
Markowitz portfolio theory
Portfolio theory also known as modern portfolio theory - was introduced by Harry Markowitz in his
paper, Portfolio Selection. Markowitz was the first to develop a specific measure of portfolio risk and
to derive the expected return and risk of a portfolio.
Markowitz analysed the implications of the fact that investors, although looking for high returns,
generally want to avoid risk. Since risk aversion characterises most investors, rational portfolio
management requires that account be taken not only of the expected return of a portfolio but also
of its risk.
While the expected return on a portfolio is directly related to the expected return on the securities
making up the portfolio, the risk of a portfolio depends on two things: the risk of its component
securities and the interrelationships between them.
Figure 12.1 shows the portfolio selection can be seen as a three-phase process:
Security analysis. Predicts the risk and return of individual securities
Portfolio analysis. Produces risk and return predictions about portfolios derived from those
determined about securities and establishes the set of efficient portfolios i.e., the efficient
frontier
Portfolio selection. Selects from those portfolios deemed efficient, the single portfolio most
suitable for the investor.
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Figure 12.1: The portfolio selection process
12.2.1 Security analysis

A portfolio consists of one or more securities. The aim of security analysis is to produce the following
estimates about securities that can be used to make estimates about portfolios:
Expected (or mean or average) return
Variance and standard deviation i.e., the variability of return. The variance of a security is a
measure of the dispersion of the returns of the security. The square root of the variance is the
standard deviation and is often used in practice because it measures dispersion in the same
units in which the underlying return is measured. The greater the variance / standard deviation
of a securitys returns, the larger the risk
The covariances and correlation coefficients between securities. It is not only the securitys own
risk that is important but also the contribution it makes to the variance of the entire portfolio,
and this is primarily a question of its correlation with all other securities in the portfolio.
12.2.1.1 Expected return of a security

The investors return is a measure of the growth in wealth resulting from that investment. This
growth measure is expressed in percentage terms and is generally expressed over a specific time
interval e.g., one year.
The future rate of return of a security is not known for certain. Instead there are several possible
rates of return, each with a possibility of materialising. The expected rate of return is the weighted
177
average rate of return. It is calculated by weighting each possible rate of return with its probability
of occurrence. For example, assume a share has the following possible rates of return. The rates as
well as the probability of them happening are shown in table 12.1 below.
Table 12.1: Rates and probabilities
Rate of return %
Probability
5.0
0.20
10.0
0.30
15.0
0.30
18.0
0.20
Total
1.00
This can be shown graphically by means of a probability distribution see figure 12.2.
Figure 12.2: Probability distribution of rates of return
The formula for calculating the expected return is:
178
E(X )
P X
i
i 1
where :
E X the expected return

Xi rate of return Xi
Pi the probability associated with rate of return Xi
n the number of possible rates of return Xi
The expected rate of return of the share is 12.1% calculated as follows:

Table 12.2: Calculating the expected rate of return
Rate of return %
Probability
Expected return E(X)
(Xi)
(Pi)
(PiXi)
5.0
0.20
1.0
10.0
0.30
3.0
15.0
0.30
4.5
18.0
0.20
3.6
Total
1.00
12.1
The expected rate of return is also referred to as the mean of the probability distribution.
12.2.1.2 Variance and standard deviation of a security

The variance and standard deviation (i.e., square root of the variance) are measures of the
dispersion or spread of the probability distribution around the expected rate of return. The less
spread out the distribution is i.e., the more closely concentrated round the expected value the
probability distribution is, the smaller the variance and standard deviation and the smaller the risk
that the expected rate of return will not materialise.
Thus the variance and standard deviation indicate the variability of return i.e., the risk that the
expected rate of return will not occur.
The formula for calculating the variance is:
var(X )
P X
n
E (X )2
i 1
where
var(X ) variance
Pi probability of the ith rate of return occuring
X i the ith rate of return
E ( X ) the expected rate of return of the security
179
A disadvantage of using the variance is that it is expressed in terms of squared units of the rate of
return. Thus the square root of the variance - the standard deviation - is a more meaningful measure
of the dispersion of the probability distribution. More formally:
std(X ) var(X )
For example the variance of the share is 20.890 and the standard deviation is 4.571 i.e.,
20.890
Table 12.3: Calculating the variance

Rate of return
Probability
Pi (Xi-E(X))2
(Xi)
(Pi)
5.0
0.20
0.20(5.0-12.1)2 = 10.082
10.0
0.30
0.30(10.0-12.1)2= 1.323
15.0
0.30
0.30(15.0-12.1)2= 2.523
18.0
0.20
0.20(18.0-12.1)2= 6.962
Total
1.00
20.890
A note on the normal probability distribution

The most widely used probability distribution is the normal probability distribution with its bellshaped curve (see figure 12.3).
The normal probability distribution has the following characteristics:
The mid-point of the normal curve is the expected value (or mean) of the distribution;
The distribution is symmetric around the expected value i.e., 50% of the values are less than the
expected value and 50% greater;
The probability of obtaining a value within one standard deviation of the expected value is
approximately 68%;
The probability of obtaining a value within two standard deviations of the expected value is
approximately 95%;
The probability of obtaining a value within three standard deviation of the expected value is
approximately 99.7%;
For example assuming the rate of return of the share is normally distributed and given that the
expected value of the share is 12.1% and the standard deviation 4.571 the probability is roughly 68%
that the actual rate of return of the share will be between 16.671% and 7.529% (i.e., between (12.1
+ 4.571) and (12.1 4.571)). Similarly the probability is about 95% that the actual rate of return of
180
the share will be between 21.85% and 2.96% (i.e., 12.1 (2 x 4.571)) and approximately 99.7% that
the actual rate of return of the share will be between 25.81% and 1.61% (i.e., 12.1 (3 x 4.571).
In general this may not hold because there is no reason to expect the distribution of a securitys
rates of return to be normal. However the function of the standard deviation is the same in every
case to measure the likely divergence of the actual rate of return from the expected rate of return.
Figure 12.3: Normal distribution
12.2.1.3 Covariances and correlation

A major attribute of portfolio theory is the requirement that interrelationships between securities
rates of return be taken into account. These relationships can be stated in terms of correlation
coefficients and covariances.
The covariance is a measure of the extent to which two variables (i.e., securities rates of return)
move together linearly. If two variables are independent their covariance is equal to zero. A positive
covariance indicates that the two variables move in the same direction and a negative covariance
that they move in opposite directions. The covariance is given by:
cov(X ,Y )
1
n 1
E(X )Yi E(Y )
i 1
For example the calculation of the covariance between the share prices of Telkom (X) and Altech (Y)
from a sample of monthly historic data is shown in table 12.4.
181
Table 12.4: Calculation of the covariance between the share prices of Telkom and Altech
Month
Telkom
Altech
Xi
Yi
(Xi-E(X))
(Yi-E(Y))
(Xi-E(X)) x
(Yi-E(Y))
167
60
6.00
4.67
28.00
170
64
9.00
8.67
78.00
160
57
-1.00
1.67
-1.66
152
46
-9.00
-9.33
84.00
157
55
-4.00
-0.33
1.33
160
50
-1.00
-5.33
5.33
Total
966
332
0.00
0.00
195.00
Expected
value (or
Note on calculation of the expected value:

161.0
55.3 Each of the 6 share price occurrences has the same
mean)
probability of occurrence. Thus the expected value is
Standard
simply the average of the data series i.e., Telkom 966
deviation
6.573
6.563 / 6 and Altech 332 / 6.
Thus
cov(X ,Y )
195.00
39.00
5
No significance can be attached to the magnitude of the covariance. A positive covariance means
that on average the rates of return of the two securities move in the same direction. The correlation
coefficient is a more convenient measure of linear dependence. It measures the strength of the
linear association between two variables. The correlation coefficient is given by:
cor( X ,Y )
cov(X ,Y )
std( X )std(Y )
where
std standard deviation
Correlation coefficients range between -1 and 1 with:
+1 indicating an exact positive linear relationship between the two variables X and Y i.e., an
increasing X is associated with an increasing Y
-1 indicating that although the variables move in perfect unison, they move in opposite
directions i.e., an increasing X is associated with a decreasing Y
0 indicating that there is no linear relationship between the two variables.
For example, the correlation coefficient between Telkom and Altech is:
182
cor(X ,Y )
39.00
0.904
(6.573)(6.563)
Since both shares are in the telecommunications sector, it is not surprising that there is a strong
positive linear relationship between the two shares.
The correlation coefficient measures the extent of the linear association between two variables. This
association does not imply causation - both variables may be affected by a third variable. For
12.2.2 Portfolio analysis

Markowitz showed that a portfolios expected return is simply the weighted average of the expected
return of component securities. However a portfolios variance depends on more than the variances
of its component securities.
While variance is a fair estimate of a securitys risk, the weighted average of the variances of a
portfolios component securities is not a good indication of the risk of the portfolio. The risk of a
portfolio depends also on the extent to which the returns of the securities move together i.e., the
extent to which their prices react in like manner to a particular event. To measure the co-movement
among security returns, Markowitz used the statistical concept of covariance.
Correlation measures only the direction and degree of the association between securities returns. It
does not account for the magnitude of variability in each securitys return. The covariance captures
this by multiplying the correlation by the standard deviations of the securities returns. For example
consider the covariance of a security with itself. The correlation is 1. Thus a securitys covariance
with itself is its standard deviation of returns squared i.e., its variance.
Ascertaining the variance of a portfolio requires the component securities standard deviations and
correlation coefficients as well as the proportion of the portfolio invested in each security. The
standard deviation of a portfolio is the square root of the variance.
Two key insights from Markowitzs formulation of portfolio risk are:
It is not possible to eliminate portfolio risk completely through diversification unless the
securities is a portfolio are perfectly negatively correlated i.e., have a correlation of -1 and
It is always possible to eliminate some portfolio risk through diversification i.e., the standard
deviation of a portfolio will be less than the weighted sum of the standard deviations of its
component securities, unless the securities in the portfolio are perfectly positively correlated
i.e., have a correlation of +1.
183
12.2.2.1 Expected return of a portfolio

The attractiveness of a portfolio depends upon both its expected return and its risk.
A portfolios expected return is the weighted average of the expected returns of its component
securities using the proportions invested as weights. Symbolically:
Ep
X E
i i
i 1
where
E p the portfolio' s expected return
X i the proportioninvested in the ith security
Ei the expected return of the ith security
n the number of securities in the portfolio
For example, the expected rate of return of the portfolio shown in table 12.5 is 17.98%.
Table 12.5: Calculation of the expected rate of return of a portfolio
Security
(i)
Bond
Proportion invested
(Xi)
50%
Rate of return
(Ei)
17.5%
8.75%
Shares
30%
20.5%
6.15%
NCD
20%
15.4%
3.08%
Total
XiEi
17.98%
12.2.2.2 Variance and standard deviation of a portfolio

The risk of a portfolio is measured by the variability of its expected return. The variance and
standard deviation of the portfolio depend on the proportion of the portfolio invested in each
security as well as the component securities standard deviations and correlation coefficients.
The variance is given by:
varp
X X
i
covij
i 1 j 1
where
varp the variance of the portfolio
X i the proportioninvested in the ith security
X j the proportioninvested in the jth security
covij the covariance(i.e., corij stdi std j ) between securities i and j
The standard deviation of the portfolio is calculated as follows:
184
stdp varp
For example (see table 12.6) the portfolio variance is 60.36 and its standard deviation is 7.77%.
Table 12.6: Calculation of the variance of a portfolio
Terms
Component securities
Total
Bond
Shares
NCD
Std *
5.0
15.0
10.0
X*
0.5
0.3
0.2
corij *
covij
(1)
XiXjcovij
(2)
1.0
Bond
Shares
NCD
Bond
Shares
NCD
Bond
Shares
NCD
1.00
0.50
0.60
0.50
1.00
0.70
0.60
0.70
1.00
25.00
37.50
30.00
37.50
225.00
105.00
30.00
105.00
100.0
6.25
5.63
3.00
5.63
20.25
6.30
3.00
6.30
4.00
60.36
Terms denoted by * are assumed to be given.

Calculations for the first three terms are shown (where cov ij = corij stdi stdj)
25.0 = 1.0 x 5.0 x 5.0
37.5 = 0.5 x 5.0 x 15.0
30.0 = 0.6 x 5.0 x 10.0
Calculations for the first three terms are shown:
6.3 = 0.5 x 0.5 x 25.0
5.6 = 0.5 x 0.3 x 37.5
3.0 = 0.5 x 0.2 x 30.0
Thus, assuming a normal distribution, given that the expected return of the portfolio is 17.98% and
the standard deviation 7.77% the probability is roughly 68% that the actual return of the portfolio
will be between 25.75% and 10.21% (i.e.. between (17.98 + 7.77) and (17.98 - 7.77)).
To illustrate how different correlation values effect the variance of a portfolio, consider the following
example. Assume that a portfolio consists of two securities. The securities have the same expected
rates of return of 16%, the same variances of 2% and equal amounts are invested in each. The
expected return of the portfolio will be 16%. The variance of the portfolio will be (where n = 2):
varp X i 2 vari X j 2 varj 2 X i X j corij stdi std j
varp ( 0.25)( 0.02) ( 0.25)( 0.02) 2( 0.5 )( 0.5 ) corij 0.02 0.02
varp 0.01 0.01 corij
If there is no correlation (corij = 0), the variance of the portfolio is 1%, or less than that of a portfolio
invested in only one of the securities. If the correlation is perfect and positive (corij = 1), the portfolio
185
variance is 2%, the same as that of a single security. If the correlation is perfect and negative (corij = 1), the variance of the portfolio is zero.
As investors generally wish to avoid risk (given return) and since the negative correlation between a
security and a portfolio reduces the variance of a portfolio, such securities would be highly valued.
However securities that are highly correlated with a portfolio do not contribute much to the kind of
risk reduction that is the purpose of diversification.
12.2.2.3 The efficient frontier

A portfolio can consist of one or more securities. For any group of securities the feasible set of
portfolios consists of all single-security portfolios and all possible combinations of them.
Figure 12.4 indicates the risk and rates of return for 10 portfolios each consisting of a single different
portfolio.
Figure 12.4: Expected return and risk of portfolios
Clearly portfolio 3 is preferred to portfolio 1 as it offers a higher return for the same risk. Portfolio 1
is preferred to portfolio 2 as it offers a lower risk for the same return. If the securities are perfectly
correlated, portfolios made up of combinations of these securities can have smaller variances for
given returns or larger returns for given variances than the single-security portfolios and would lie in
the region above and to the left of the single-security portfolios. For example portfolio P could
represent a combination of portfolios 3 and 4.
186
Therefore efficient portfolios will plot along the upper border of the feasibility set of portfolios. This
border is called the efficient frontier and is represented by curve ABC in figure 12.5.
Efficient portfolios are fully diversified in that for any given rate of return no portfolio has less risk
and for a given level of risk no other portfolio provides superior returns.
Figure 12.5: The efficient frontier
12.2.3 Portfolio selection

Portfolio theory is based on the assumption that most investors prefer high rates of return and
dislike risk and the definition of efficient portfolios follows from this. The efficient set of portfolios is
the same for all investors and rational investors will select portfolios along this efficient frontier.
However investors' preferences for return vis--vis risk differ. Investors that would like to have low
levels of risk in their portfolio, pick portfolios close to point A on the curve. Investors willing to bear
more risk will choose portfolios closer to point B on the curve. Investors willing to tolerate high
levels of risk to earn higher returns may select portfolios near to point C.
The problem of choosing an optimum portfolio for an individual investor from those that are
efficient is the subject of portfolio selection.
The underlying behaviour that guides the behaviour of investors is the maximisation of expected
utility. Utility is maximised when a given combination of expected return and risk is preferred to all
187
other combinations. Since investors wish to increase expected return and avoid risk it is possible to
establish different combinations of expected return and risk that will be equally valued by an
investor. These combinations will lie on so-called indifference curves see figure 12.6.
Figure 12.6: Indifference curves risk / return preferences
Each investor has an infinitely large family of indifference curves. Each curve represents the set of
expected return and risk that are equally valued. The investor will seek to maximise utility i.e., with
reference to figure 11.4, the investor will prefer indifference curve U3 to U2 and U2 to U1.
Conceptually the investor is now in a position to select the optimum portfolio from those making up
the efficient set. The optimum portfolio is the one at point of tangency between the efficient
frontier (curve ABC in figure 12.6) and an indifference curve, The portfolio at point B on the efficient
frontier is optimal as no other portfolio is on as high an indifference curve.
12.3
Sharpes index models
12.3.1 Introduction
To define Markowitzs efficient set of portfolios it is necessary to know the following for each
security:
Expected return
Variance and
188
Covariance with every other security.
If the efficient set were to be selected from a list of 1 000 securities, it would be necessary to have
1 000 estimates of expected return, 1 000 variances and 99 500 covariances. Because of this
practical difficulty the Markowitz portfolio model was mainly of academic interest until William
Sharpe simplified it by developing the single index model. Sharpe presented his idea in a 1964
Journal of Finance paper titled Capital asset prices: a theory of market equilibrium under conditions
of risk.
Sharpe built upon Markowitzs suggestion that each securitys price could be related to a common
broad-based market index, such as Dow-Jones Index, Standard and Poors Index, FTSE/JSE All-share
Index. By relating all securities to a common index, each would be implicitly related to all other
securities and this would eliminate the need to specify covariances of each pair of securities.
The return on a security can be written as:
ri i i I c i
where
ri return on security i
i the alpha coefficient of sec urity i - a constant indicating the return on sec urity i given I
i the beta coefficient of sec urity i - a constant measuring the change in ri given a change in I
I the rate of return on the market index
c i residual error term the return on sec urity i not explained by i or I
The equation breaks down the return on a security into two components:
The part that is independent of the market (i and ci) and
The part that is due to the market (iI). i measures the sensitivity of the securitys return to the
return on the market index. For example if i equals 2, the return on the security is expected to
increase (decrease) by 2% when the market index increases (decreases) by 1%.
12.3.2 Single index model

Sharps index models state that the only reason the return of two securities move together is
common co-movement with the market. This is equivalent to assuming that the residual error term
ci for any security i is unrelated to the residual error term cj for a second security j.
Therefore the covariance between any two securities i and j is equal to ijI2 where I2 is the
variance of the market index. If the residual risk of the return of a security (that variation in a
189
securitys return that is unrelated to the market) is defined as ci2, the expected return and variance
of a portfolio are:
Rp
x I
i
i 1
Rp
xi i
i 1
x I
i
i 1
where
Rp portfolioreturn
xi proportioninvested in security i
i alphaof security i
i beta of security i
I rate of return on the market index
n
i 1
i 1
p2 xi i i2 xi2 ci2
where
p2 portfoliovariance
i2 varianceof the market index
ci2 residual risk of return of security i
The portfolio variance now only depends on:
the weight of each share in the portfolio (xi)
The beta of each share (i)
The variance of the index (I2) and
The variance of the residual error for each share (ci2).
This represents a considerable saving in terms of data input. For example a 1 000 securities portfolio
will require 3 001 inputs approximately 0.6% of the inputs required for the Markowitz model.
If the beta of a portfolio is defined as the weighted average of the betas of each security in the
portfolio then the portfolio beta is calculated as follows:
n
P xi i
i 1
where
P portfoliobeta
xi proportioninvested in sec urity i
i beta of sec urity i
190
Similarly the alpha of a portfolio can be defined as:

n
P xi i
i 1
where
P portfolioalpha
xi proportioninvested in security i
i alpha of security i
The expected return of a portfolio can then be re-written as:

RP P P I
where
RP portfolioreturn
P portfolioalpha
P portfoliobeta
I rate of return of the market
The risk of a portfolio can also be re-written as:

n
P 2 P 2 I 2 x i 2 ci 2
i 1
If it is assumed that the portfolio consists of equal proportions of each of n securities then the risk of
the portfolio could be written as:
P2 P2 I 2
1
n2
ci 2
i 1
The last term can be expressed as n times the average residual risk of a security. As the number of
securities in the portfolio increases, the importance of the residual risk the non-beta risk
diminishes rapidly as illustrated in table 12.7.
Table 12.7: Importance of residual risk

Number of securities
Residual risk expressed as a % of the

residual risk of a one-security portfolio
100.0
50.0
33.0
25.0
20.0
191
10
10.0
20
5.0
100
1.0
1 000
0.1
The risk that is not eliminated as the number of securities in a portfolio increases, is the risk
associated with the portfolio beta. If the residual risk is assumed to be zero then the risk of a
portfolio can be re-stated as follows:
P 2 P 2 I 2
P P I
I
x
i
i 1
Due to the residual risk (ci2) of a portfolio moving to zero as the number of securities in a portfolio
increases, it is commonly referred to as diversifiable or unsystematic risk. However the effect of the
securities betas (i) on the risk of a portfolio does not decrease as the number of securities in the
portfolio (n) increases. Therefore, it is a measure of a securitys non-diversifiable or systematic risk:
P 2 xi i I 2
i 1
2
i
ci 2
i 1
systematic risk
unsystematic risk
undiversifiable risk diversifiable risk
Investors cannot avoid systematic risk as it affects all financial indexes/markets e.g. general
economic conditions, fiscal and monetary policy. Unsystematic risk is the variability not explained by
general market movements and is peculiar to the security concerned. It can be avoided through
diversification. This implies that only inefficient portfolios have unsystematic risk. This is illustrated
by Figure 12.7.
Figure 12.7 shows the concept of declining non-systematic risk in a portfolio of securities. As more
securities are added i.e., diversification increases, non-systematic risk decreases and total risk
approaches systematic risk. Since systematic risk cannot be diversified away, total risk cannot be
reduced below that of the market portfolio. This implies that only inefficient portfolios have
unsystematic risk. Investors are not rewarded for bearing risk that can be diversified away.
192
Figure 12.7: Systematic and unsystematic risk
A note on alphas and betas

If portfolio p in the equation Rp = p p I is taken to be the market portfolio i.e., all securities are
held in the same proportions as they are represented in the market then the expected return on p
(Rp) must be equal to the expected return of the market index (I). The only values that ensure Rp = I
are alpha (p) equal to zero and p equal to one. Therefore the beta of the market is one and
securities are considered to be more or less risky than the market according to whether their beta is
larger or smaller than one. If the return on a security moves exactly as the market does, it would
have a beta of one. If it were more volatile than the market its beta would be more than one and
less than one if it were less volatile. However securities seldom behave as indicated by their betas,
which is where alphas come in. They are used to account for changes in securities prices not
attributable to their betas.
There are two ways of achieving superior portfolio performance:
Forecast the market accurately and adjust the beta of the portfolio accordingly. For example if a
market upswing is expected high beta securities could be bought and low beta securities sold to
raise the portfolio beta to a level of say 2. If expectations materialise the portfolio will rise twice
as much as the market. If the expectations are incorrect the portfolio will decline twice as fast as
the market.
193
Achieve a positive alpha or excess return. If a security has a higher or lower rate of return than
another security with the same beta i.e., it does better against the market than its beta would
have suggested this could be due to its alpha or various residual non-market influences unique
to each stock. If sufficient securities with positive alphas can be selected, the portfolio will
perform better than its beta would have indicated for a given market movement. For example
assume a security has an alpha of 1% and a beta of 1.50. If the market return is 12.0% the most
likely return on the stock is 19.0% i.e., 1+ 12 x1.5.
As more securities are added to a portfolio, the chances of obtaining a positive alpha and the risk of
getting a negative alpha are diversified away. The portfolios volatility will become similar to that of
the market. Conceptually a fully diversified portfolio would have a beta of one and alpha of zero.
12.3.3 Capital asset pricing model

The concepts developed in respect of Sharpes single index model became known as the capital
asset pricing model (CAPM).
There are a number of assumptions underlying capital asset pricing theory:
Investors are risk averse in that they would prefer less risk (or smaller variance) at a given level
of return and greater return at the same level of risk (or variance. Thus investors will attempt to
hold a Markowitz-efficient portfolio
Investors are able to lend or borrow unlimited funds easily at the prevailing risk-free rate
Investors have identical time horizons
Financial market assets are divisible so investors are able to buy virtually any amount without
impacting the price
Investors have similar expectations as to the variance of future returns on different assets.
The main implication of these somewhat unrealistic assumptions is that financial market assets and
the market as a whole are priced fairly in relation to the risks of owning them. Therefore investors
should focus on the risk profiles of their portfolios and should not expect to earn high return without
increasing risk and decreasing risk should be expected to reduce return.
Capital asset pricing theory departs to a certain extent from Markowitzs theory. Where Markowitz
adjusts risk by moving up and down the efficient frontier, under the capital asset pricing theory
there is a single optimal risky portfolio and risk can be changed by borrowing or lending. This is
shown graphically in figure 12.8.
194
Figure 12.8 shows that by optimally diversifying, all investors will hold the same portfolio the
market portfolio. The market consists of risky securities only and is the best diversified portfolio that
can be held. It is the portfolio constructed by holding every security in equal proportion to its
portion of the total market value of all available securities. The market portfolio is one portfolio on
the efficient frontier (point M in figure 12.8).
Figure 12.8: The capital market line
In addition to risky investments the CAPM recognises another investment vehicle a risk-free asset
i.e., an asset that can be borrowed or lent without risk of default e.g., treasury bills. Point Rf in figure
12.8 is the rate of return on a risk-free asset such as a treasury bill. The line segment RfM shows the
various portfolios available through combinations of risk-free and risky assets. Possible portfolio
combinations range from a totally invested position in risk-free assets to one that exactly mirrors the
market. Portfolios on the line segment RfM will be preferred to portfolios on the curve AM as they
offer more return for the same risk.
It is possible to hold efficient portfolios on the line RfM beyond the point of tangency with curve
AMC since borrowing is allowed. Given the simplifying (unrealistic) assumption that investors can
borrow to purchase financial assets at the same rate that investors receive on a risk-free asset,
efficient portfolios beyond the point of tangency lie on a linear extrapolation of the line RfM line
segment MN in figure 12.8.
195
Any point on the line RfMN is achievable by combining the portfolio of risky assets at M with the riskless asset or by leveraging the portfolio at M i.e., by borrowing funds and investing them in portfolio
M. Portfolios on line RfMN are preferred to portfolios on the curves between A and M and M and C
since they offer greater return for a given level of risk or less risk for a given rate of return. The
efficient frontier is now linear and is referred to as the capital market line. Symbolically:
Ep Rf
Em R f
where
E p expected return on a portfolio
R f risk free rate
Em expected return on the market
p standard deviationof returns on the portfolio

m standard deviationof returns on the market
The formula states that the expected return on an efficient portfolio is a linear function of its risk as
measured by the standard deviation. The slope of the line can be considered the price of risk i.e., the
additional expected return for each additional unit of risk.
For example assume that the risk-free rate of return is 10.0%, the expected return on the market
portfolio is 16.0%, the standard deviation of the market portfolios return is 12% and the standard
deviation of the portfolio is 13%.
E p 0.10
16.5%
0.16 0.10
0.13
0.12
The investor will expect to earn a return of 16.5% for bearing risk equivalent to a standard deviation
of 13.0%. The slope of the line is 0.5 i.e., (0.06 / 0.12). Therefore an extra unit of risk is rewarded
with an additional half a unit of return.
The CAPM states that an investors choice of an optimum portfolio is separate from the optimal
combination of risky assets. This combination is identical for all investors. Individual investors
requirements determine only the amount of borrowing and lending. This is referred to as the
separation theorem. The theorem allows the development of valuation under uncertainty that does
not depend directly on knowledge of the degree of risk aversion of investors.
196
The capital market line holds only for efficient portfolios. It does not describe the relationship
between the return on individual securities and inefficient portfolios and their risk. To extend the
capital market line to allow for the evaluation of any individual risky asset, the CAPM redefines risk
in terms of a securitys beta (). Beta captures the systematic of the assets risk relative to the
market. This beta can be thought of as indexing the assets systemic risk to that of the market, which
has a beta of 1.0. This means that a share with a beta of 1.3 has a level of systemic risk that is 30%
more than the market and a stock with a beta of 0.7 is 30% less risky than the market.
Thus the expected return on any portfolio or security is related to the risk-free rate and return on
the market as follows:
E p R f p Em R f
where
E p return on the portfolio
R f risk free rate
Rm return on the market
p beta coefficient of the portfolio

For example assume the risk-free rate is 10.0%, the expected return on the market 16.0% and the
beta of the portfolio is 0.5, then the expected return on the portfolio is:
E p 0.10 0.5 x 0.16 0.10
13.0%
The relationship is represented graphically by the security market line - see figure 12.9.
197
Figure 12.9: The security market line
The security market line is similar but not identical to the capital market line. Like the capital market
line, the security market line shows the trade-off between risk and expected return as a straight line
intersecting the vertical axis (i.e., point of zero risk) at the risk-free rate (Rf). However the capital
market line measures risk by standard deviation (i.e., total risk) whereas the security market line
measures risk by beta (i.e., the systematic component of a securitys risk). As a result of this, the
capital market line can only be applied to efficient or fully-diversified portfolios while the security
market line can apply to any asset or collection of assets i.e., undiversified portfolio.
As previously stated the risk of any portfolio or security can be divided into systematic (as measured
by beta) and unsystematic risk. According to the security market line, systematic risk is the only
determinant of expected portfolio returns i.e., unsystematic risk plays no role. Therefore investors
are rewarded for bearing systematic risk i.e., it is not total variance that affects returns only that
part that cannot be diversified away. Since investors can eliminate all unsystematic risk through
diversification, there is no reason why they should be rewarded (in the form of returns) for bearing
it.
The CAPM has a number of applications. These include determining the cost of equity and judging
the reasonableness of investment objectives.
12.3.3.1 Cost of equity the required rate of return on equity

The required rate of return is the minimum rate of return that prospective investors will accept from
an investment to compensate them for deferring consumption. The rate of return that investors
198
require to make an equity investment in a firm is generally referred to as the cost of equity. It can be
calculated by using the security market line as follows:
ki R f i Rm R f
where
ki required rate of return on share i
R f risk free rate
Rm return on the market
p beta of share i
The term (Rm-Rf) is known as the market risk premium. It is generally based on historic data and
indicates the difference between the average return on shares and average return on risk-free
securities over a measurement period. The term i(Rm-Rf) is a shares risk premium and when added
to the risk-free rate gives the required rate of return of a share.
Example: calculating the required rate of return on a share
Given:
The shares beta is 1.4
The risk free-rate is 9.7% (the current treasury bill rate)
The return on the market (FTSE JSE All share index) is 17.5%
ki 0.097 1.4 (0.175 0.097)

20.6%

Given:
The market risk premium is 7.8%
ki 0.097 1.4 (0.078)

20.6%

Given:
The shares risk premium is 10.9%
199
ki 0.097 0.109
20.6%
12.3.3.2 Judging the reasonableness of investment objectives

The investment objective of Peoples Pension Fund is to attain maximum growth of assets and
income consistent with overall quality investments and preservation of assets in a portfolio
consisting primarily of blue-chip shares and preferred bonds and debentures. The fund requires for
the equity-related portion of the portfolio a return of 25% above the FTSE JSE all-share index. The
trustees are aware that this objective entails more volatility than the overall market. If unfavorable
market conditions are foreseen, a reduction in volatility is acceptable and desirable. At least 15%
superior performance relative to the all-share index on the downside will be expected. The
expectation for the equity-related portion of the portfolio in relation to the rate of return of the allshare index is shown in table 12.8.
Table 12.8: Peoples Pension Fund: expectations of return
FTSE JSE All-share index
Peoples Pension Fund
% above index
30.0
37.5
25.0
20.0
25.0
25.0
10.0
12.5
25.0
0.0
2.5
-10.0
-8.5
15.0
-20.0
-17.0
15.0
-30.0
-25.5
15.0
Figure 12.10 illustrates expected returns in terms of the various levels of risk as expressed by the
portfolios beta.
A portfolio with a beta of 1 would represent the market (represented by the all-share index). It is
assumed that the average rate of return on the all-share index is 10.0%, that bear markets produce
negative market returns of 10.0% and that the average risk-free rate is 5%. Using the security market
line the expected rates of return of the portfolio with a beta other than 1 can be calculated and
market lines Rf A and Rf B reflecting respectively long-term expectations and bear-market
vulnerability can be drawn. For example if the portfolio beta is 0.5, the portfolios expected rate of
return will be 7.5% i.e., 5.0 + 0.5 (10.0 - 5.0).
200
Figure 12.10: Investment objectives of Peoples Pension Fund
The funds trustees require a return of 12.5% when the market return is 10.0%. To achieve this
return the portfolios beta will have to be 1.5 see figure 12.10 a position more risky than the
market and probably in violation of the investment objective of a diversified portfolio of quality
investments with the preservation of capital.
This incompatibility is further emphasised when expected portfolio results during a bear market are
considered. When the market declines to 10.0% a loss of 8.5% is required. However a portfolio with
a beta of 1.5 is expected to return 17.5% if the market declines to 10.0%. The objective of
outperforming the market by 25.0% on the upside (12.5% when market returns are 10.0%) implies
an exposure to under-performing it on the downside by substantially larger proportions (17.5%
when market returns are 10.0%). To achieve a return of 8.5% when the market return is -10.0%
the beta will have to be reduced from 1.5 to 0.9 i.e., = ((0.05 + 0.085) / (0.10 + 0.05)).
12.4
Multi-factor models
Markowitz portfolio theory and the CAPM are the foundation for understanding the relationship
between risk and expected return. However critics claim that variance or beta as single measures of
risk do not adequately account for the volatility of a security or portfolio. The relationship between
risk and expected return is more complex expected return is explained by multiple factors such as
inflation, industrial production, growth in gross domestic product, political upheavals and changes in
interest rates. This led to the development of multi-factor models. The major difference between
201
CAPM and multi-factor models is that multi-factor models specify several risk factors to explain
expected return whereas CAPM specifies but one (beta or variance).
Multi-index models assume that relationships between the expected return of shares are due to
common associations with an appropriate series of indices such as a market index, inflation,
industrial production, interest rates. The additional sources of covariance between securities
resulting from the introduction of additional indexes can simply be added to the general return
equation as follows:
Ri i i 1I1 i 2I2 inIn ci

where
Ri return on security i
i return if all indiceswere equal to zero i.e., the uniquereturn
I1 level of index Ii
i 1 responsiveness of Ri to changes in index I1

ci residual term the return on security i not explained by the equation
Therefore to use multi-index models the following estimates will be required:
Expected return for each security
Variance of each securitys return
Beta of each securitys return in relation to each index
Expected return and variance of each index.
For example: in South Africa the gold mining and industrial sectors each comprise a significant
proportion of the total market capitalisation of the JSE Ltd. The prosperity of gold mining companies
depends on a gold price established by international, political and economic events often divorced
from developments in the South African economy. Therefore it is reasonable to assume that the
returns on mining and industrial shares will at times be influenced by different underlying factors.
Consequently a two-index model using the mining and industrial indexes (see table 12.9) has been
used to estimate the risk and return of a portfolio comprising the shares detailed in table 12.10.
Table 12.9: Index statistics
Index
Gold mining (GLDI)
Industrial (INDI)
Return
RI
12.00
11.50
Standard deviation
I
0.03063
0.02096
Table 12.10: Share statistics
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Proportion
Share
invested (%)
xi
Alpha
Beta (GLDI)
Beta (INDI)
Residual risk
GLDIi
INDIi
ci
Harmony (Har)
20.0
-0.002
1.655
-0.302
0.036
AngloGold (Ang)
30.0
0.000
0.763
0.436
0.029
Barlows (Bar)
50.0
-0.001
0.060
1.197
0.027
The alpha and beta of the portfolio are:

n
p xi i
i 1
0.20 x 0.002 0.30 x 0.000 0.50 x 0.001

0.001
GLDIp xi GLDIi
i 1
0.20 1.655 0.30 0.763 0.50 0.060

0.590
INDIp xi INDIi
i 1
0.20 0.302 0.30 0.436 0.50 1.197

0.669
The portfolio risk and return will be:
Rp p
I I
i 1
0.001 0.590 0.12 0.669 0.115

14.68%
n
p 2 GLDI 2 GLDI 2 INDI 2 INDI 2 x i ci 2

i 1
0.5902 0.030632 0.6692 0.020962 0.202 0.0362 0.302 0.0292 0.502 0.0272
0.0005232 .0003102
0.000833
p 0.000833
0.02886
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The total risk of the portfolio is 2.89%. Therefore 68% of the time the portfolio return will be
between 17.57% (i.e., 14.68% + 2.89%) and 11.80% (i.e., 14.681% - 2.886%). The systematic risk of
the portfolio is 2.29% i.e.,
0.000523 and the unsystematic risk is 1.76% i.e.,
0.000310 . The
degree of diversification is 62.80% i.e., 0.000523/0.000833, which is to be expected from a portfolio

containing only three securities.
Alternative portfolios can be calculated in different proportions and with different securities to
construct a table such as table 12.13.
Table 12.13: Alternative portfolios
Parameter
Portfolio 1
Portfolio 2
Unsystematic risk
1.76%
0.58%
Systematic risk
2.29%
0.92%
Total risk
2.89%
1.09%
Degree of diversification
62.80%
71.43%
Expected return
14.68%
13.27%
Downside potential
11.80%
12.18%
Upside potential
17.57%
14.36%
The choice facing the investor is clearly quantified. Portfolio 1 with an expected return 1.4% more
than portfolio 2 can be chosen. However in doing so downside risk is increased. The choice will
depend on the investors attitude to risk as it relates to return.
12.5
Arbitrage pricing theory
While a number of multi-factor models have been developed, arbitrage pricing theory (APT)
developed by Stephen Ross stands out as the major competitor to CAPM. The major difference
between CAPM and APT is that APT specifies several risk factors to explain expected return whereas
CAPM specifies but one (beta or variance).
The Arbitrage Pricing Theory was formulated by Ross as an alternative to the Capital Asset Pricing
Model. The Arbitrage Pricing Theory starts with a multi-factor model in that it suggests that there
are a number of systematic influences on the long-term average return on shares i.e., there are
multiple factors that represent the fundamental risks in the economy and are measures of the
systematic risk of an asset. Thus a given finite number of factors is used as a formalisation of
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systematic risks, and the expected return of an asset is related to its exposure to each of these
factors. This differs from the CAPM, which suggests the expected return of an asset is related to its
covariance with the market portfolio (or market as a whole) i.e., a single-factor model.
If the model holds and assets do not have asset-specific risk then the law of one price infers that the
expected return of any asset is simply a linear function of the other assets expected return. If this
were not the case arbitrageurs would create long-term trading position that would generate
arbitrage profits. Thus any two financial instruments or portfolios that have the same return-risk
profile should sell for the same price. If this is not the case, then assuming the portfolios have similar
risk, arbitrage profits can be made by selling short the security or portfolio with the lower return,
and buying the one with a higher return.
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Review questions
1.
Name and describe the two distinct sources of risk as classified by the single-index model?
2.
Sharpe asserted that in an efficient market, investors are only compensated for bearing
systematic risk as it cannot be diversified away (True/False).
3.
Describe the ways in which superior portfolio performance can be achieved with the singleindex model.
4.
List the assumptions underlying the capital asset pricing model (CAPM.)
5.
List the two important differences between the capital market line and the security market line.
6.
Calculate the required rate of return on a share, given the following:
7.
8.
The current treasury bill rate is 7.2%
The return on the market (FTSE JSE All share index) is 12.5%
Calculate the required rate of return on a share, given the following:

o
The current treasury bill rate is 7.7%
The shares risk premium is 10.9%
Share A with a beta of 1.5 is currently priced at R46. A year ago the share was trading at R40.
The market rate was 12% in the past year and the risk free rate at 6.0%. Is the share priced
correctly?
9.
What is the major difference between a multi-factor model and the CAPM?
10. Briefly describe the arbitrage pricing theory.
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Answers
1.
The index model divides risk into the following sources:

o
Systematic risk (or non-diversifiable risk): The portion of the price movement of a
security attributed to the movement of the market as a whole. Systematic risk cannot be
eliminated by diversification it is the risk of being in the market
Unsystematic risk (or diversifiable risk): The portion of the price movement of a security
unique to the specific security such as the price movements that result from, for
example a strike, financial leverage, competitive industry positioning, company
fundamentals. Unsystematic risk can be diversified away
2.
True
3.
There are two ways of achieving superior portfolio performance:
4.
Forecast the market accurately and adjust the beta of the portfolio accordingly.
Achieve a positive alpha or excess return.
The main assumptions underlying the CAPM are as follows:

o
Investors have homogeneous expectations
Investors have identical time horizons
Perfect competition exists i.e., there are no transaction costs or tax, costless information
is available to all investors, investors are price takers
5.
Investors are able to lend or borrow unlimited funds at the risk-free market interest rate
Assets are infinitely divisible
All investors attempt to hold Markowitz-efficient portfolios.
The two main important differences are:

o
The capital market line measures risk by standard deviation (total risk) of the investment
while the security market line considers only the systematic component of an
investment i.e., the beta of the security
The capital market line can only be applied to efficient portfolios i.e., portfolio holdings
that are already fully diversified, whereas the security market line can be applied to any
individual asset or any portfolio.
6.
The required rate of return is calculated as follows:

ki = 0.072 + 2.1(0.125 0.072) = 18.33%
7.
The required rate of return is calculated as follows:

ki = 0.077 +0.109= 18.6%
8.
Yes the share is priced correctly as according to the expected rate of return the security have to
trade at 15% higher price:
207
9.
E(R) = 0.06 + 1.5(0.12-0.06) = 15.00%
R40 + 15% = R46
Multi-factor models specify several risk factors to explain expected return whereas CAPM
specifies but one (beta or variance).
10. The Arbitrage Pricing Theory was formulated as an alternative to the Capital Asset Pricing
Model. The Arbitrage Pricing Theory starts with a multi-factor model in that it suggests that
there are a number of systematic influences on the long-term average return on shares i.e.,
there are multiple factors that represent the fundamental risks in the economy and are
measures of the systematic risk of an asset. Thus a given finite number of factors is used as a
formalisation of systematic risks, and the expected return of an asset is related to its exposure
to each of these factors.
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13 Portfolio Management
Creating wealth is the object of making investments, and risk is the energy that in the long run
drives investment returns.
Goldman Sachs Asset Management
Portfolio management is the process of putting together and maintaining the proper set of
investments to meet the objectives of the investor given any restrictions imposed. This chapter
describes this process.
Firstly the portfolio management process is defined and the steps in the process described. Finally a
case study illustrating the development of a portfolio based on specified investment preferences and
constraints is presented.
define the portfolio management process
discuss the phases of the portfolio management process namely to plan the portfolio, develop
and implement portfolio strategy, monitor the portfolio and adjust the portfolio
apply the portfolio management process to recommend a portfolio given an investors

investment preferences and constraints.
13.1
The portfolio management process defined
A portfolio is the combination of all an investors asset holdings. The assets could be bonds, shares,
property, treasury bills, bank fixed deposits, gold and collectables such as art and antiques.
A portfolio perspective of an investors holdings is important for the following reasons:
When added to a portfolio of assets, the risk of an individual asset may be diversified away
Economic fundamentals such as inflation, interest rates and the level of economic activity impact
the returns of many assets. To appreciate the risk and return prospects of an investors total
position, it is necessary to understand the interrelationships between individual assets.
209
The portfolio management process is an integrated, consistently-applied, four-step procedure to

establish and maintain an appropriate combination of assets to meet the interdependent risk and
return objectives of the investor given any constraints imposed.
13.2
The portfolio management process
The following are the four steps in the portfolio management process: plan the portfolio, develop
and implement the portfolio strategy, monitor the portfolio and adjust the portfolio. The process is
shown in figure 13.1.
Figure 13.1: The portfolio management process
13.2.1 Plan the portfolio

13.2.1.1 Determine risk/return objectives, constraints and preferences
The first activity in the portfolio management process is to ascertain and detail the objectives and
constraints of the investor. Objectives are the investors desired investment outcomes. They should
be unambiguous and measurable and specified in terms of risks and return. The return objective
should be consistent with the risk objective and vice versa. For example a high return objective may
imply an asset allocation with an expected level of risk that is too high in relation to the risk
objective of the investor.
210
An investors risk objective is a function of both the investors ability and willingness to assume risk.
The investors ability and willingness to assume risk should be consistent if not, the investors
willingness to take risk will need to be re-assessed. Table 13.1 demonstrates the interaction between
the investors willingness and ability to take risk.
Table 13.1: Interaction between willingness and ability to take risk
Willingness to take risk
Low ability to take risk
High ability to take risk
Low
Low risk tolerance
Re-assess willingness to take

risk
High
Re-assess willingness to take

risk
High risk tolerance
Source: Margin and Tuttle, 1990
Constraints are limitations such as liquidity, time horizon, taxes and regulatory issues that restrict
the investors ability to use or take advantage of a particular investment. For example the decision to
sell a low-cost share could result in a large capital gain i.e., there could be friction between
investment and tax timing.
Preferences are limitations imposed by the investor. For example investors may prefer not to invest
in tobacco shares or government bonds of countries with unacceptable human rights records.
13.2.1.2 Develop the investment policy statement

Once the objectives, constraints and preferences of the investor have been established, the
investment policy statement is crafted.
The investment policy statement is a written planning document that governs all investment
decisions made for the investor. It is essential to the portfolio management process and should
clearly state the investors return objectives and risk tolerances as well as any constraints such as
liquidity needs, the time period associated with the investment objectives, tax and regulatory
considerations such as exchange control and requirements and any circumstances or preferences
unique to the investor.
An investment policy statement is important because:
The investor is better able to assess the appropriateness of any investment strategy
implemented by the investment manager
211
It ensures investment continuity because it is portable. Should the investor wish to change
investment managers, the statement can be easily be understood by another investment
manager
As a document of understanding, it protects both the investor and investment manager. If

manager execution or investor directions are in question, the policy statement can be referred
to for clarification.
Depending on the complexity of the investors portfolio, the investment policy statement may
contain other important issues such as reporting requirements, the basis for portfolio monitoring
and review and investment manager fees.
13.2.1.3 Establish capital market expectations

Establishing capital market expectations involves forecasting the long-run risk and return
characteristics of various capital market instruments such as bonds and shares.
Capital market expectations are combined with the investors objectives and constraints to
formulate an appropriate strategic asset allocation. If capital market expectations are realised, the
selected strategic asset allocation should achieve the investors return objectives with an acceptable
level of risk.
13.2.1.4 Construct strategic asset allocation

The final activity in the planning step is the creation of a strategic asset allocation. The investment
policy statement and capital market expectations are combined to formulate a set of acceptable
asset class weights that will produce a portfolio that meets the investors objectives and constraints.
Typically each set is expressed in terms of the percentage of total value invested in each asset class.
Table 13.2 shows examples of possible asset allocations.
Table 13.2: Asset allocation alternatives

Asset allocation
Projected
total return
Expected risk
(standard
Deviation)
A
(%)
B
(%)
C
(%)
Cash
5.0%
3.9%
10
15
20
Government bonds
9.0%
10.0%
30
50
10
Corporate bonds
11.0%
11.8%
10
30
Large-cap shares
15.0%
13.5%
30
35
30
Small-cap shares
18.5%
15.3%
20
10
100
100
100
Asset class
212
It may be necessary to cater for a certain amount of flexibility that allows for temporary shifts in
asset allocation in response to changes in short-term capital market expectations.
13.2.2 Develop and implement portfolio strategies

This phase of the investment management process aims to construct a portfolio with appropriate
asset composition that is within the guidelines of the strategic asset allocation. It consists of
selecting the investment strategy, formulating the inputs for portfolio construction and constructing
the portfolio.
13.2.2.1 Select the investment strategy

Portfolio strategies can be either active or passive strategies. These two strategies are described as
follows:
A passive investment strategy attempts to construct a portfolio that has identical or very similar
characteristics to that of the benchmark index without attempting to search out mispriced
securities
An active investment strategy seeks returns in excess of a specified benchmark. Investors who
believe in active management do not follow the efficient market hypothesis i.e., they believe it is
possible to profit from financial markets through any number of strategies to identify mispriced
securities.
13.2.2.2 Construct the portfolio

Portfolio construction involves assembling the portfolio of appropriate securities. In active
management this will include identifying opportunities to enhance return relative to the benchmark
i.e., generate excess return.
13.2.3 Monitor the portfolio

Once constructed, the portfolio should be monitored to assess progress towards the achievement of
the investors objective. Monitoring a portfolio has the following two components:
Performance measurement: Performance measurement indicates how well the investment

manager is performing relative to the investors objectives and entails calculating the rates of
return for the portfolio achieved by the investment manager over a specific time interval
Performance evaluation: Performance evaluation aims to establish the following:

o
If the investment manager added value by outperforming the established benchmark
213
How the investment manager achieved the calculated return. This is done through
portfolio attribution, which determines the sources of the portfolios performance. Two
common sources of performance are market timing (returns attributable to shorter-term
tactical deviations from strategic asset allocation) and security selection (returns
attributable to skills in selecting individual securities within an asset class).
13.2.4 Adjust the portfolio

The results of portfolio monitoring will establish whether or not the portfolio needs to be adjusted
to ensure that it continues to satisfy the investors objectives and constraints. Once the desired
portfolio is constructed, the following could motivate revising it:
Changes in the investors objectives as a result of changes in the investors circumstances
Changes in capital market expectations.
Portfolio adjustments may be required without any changes to expectations or the investors
situation. For example due to asset price changes, the portfolios exposure to equities may be
different from the strategic asset allocation. Suppose the strategic asset allocation calls for an initial
portfolio mix of 70% equities and 30% bonds. If the value of equities rises by 40% and the value of
bonds by 10%, the portfolio mix will be equities / bonds of 75% / 25%. The portfolio will need to be
rebalanced to reflect the desired asset mix.
13.3
Case Study: John Smith Trust
The parents of 12-year old John Smith died in an accident. The parents accumulated assets prior to
their death were R5million in a diversified share portfolio and R5million in Smith Shop Ltd, a JSElisted company founded by John Smiths grandfather. The parents assets will be held in a trust the
John-Smith Trust - to benefit John. In addition to these assets, the trust received life insurance
proceeds of R10 million.
When John is 18 years of age he will attend university for four years. In addition to normal living
expenses, annual university costs are estimated to be R100 000 rising 8% annually.
According to the provisions of the trust deed:
The trust portfolio should earn a return sufficient to cover Johns living expenses taking taxes
into consideration and allowing for inflation of 6% per annum and growth of at least 1% per
year. Johns living expenses are currently estimated at R300 000 per year after tax. Income is
214
taxed at 40%. Taxable capital gain (to be included in taxable income) is calculated as 25% of net
capital gain
Smith Shop Ltd shares may not be sold while Johns grandmother is alive. She is 69 years of age
The trust may at the discretion of the trustee distribute a portion of the trust assets to meet
Johns heath, education or other essential needs
The trust requires shortfall risk to be limited to no less than -10% return in any one year.
Shortfall risk is defined as total expected return less two standard deviations
John is to receive a distribution from the trust until he reaches 22 years of age
The Trust will terminate and the assets distributed to John when he reaches 32 years of age.
The trustees of the John Smith trust have requested Mr. Speed at Good Asset Managers to
recommend which of the three alternative portfolios in table 13.3 is most appropriate for the trust.
Table 13.3: Alternative portfolios
Asset class
Portfolio A
Portfolio B
Portfolio C
Cash
4%
10%
5%
Bonds
58%
48%
42%
Equity
13%
17%
28%
John Smith Ltd
25%
25%
25%
Total
100%
100%
100%
Portfolio A
Portfolio B
Portfolio C
Expected return before tax
9.9%
10.9%
11.2%
Expected standard deviation
9.3%
10.7%
11.9%
Shortfall risk (expected return less 2

standard deviations)
-8.7%
-10.5%
-12.6%
Portfolio measures
After an in-depth discussion with the trustees, Mr Good completes the following analysis:
The trusts willingness to assume risk is low. The trust deed requires that the assets be invested
such that the shortfall risk is limited to -10% return in any year. This means that the trust will be
unwilling to tolerate any substantial volatility in portfolio returns.
The trusts ability to assume risk is average. This is because the total return requirement of 9.5%
(see calculation below) is relatively modest. Thus the overall risk tolerance of the trust is low.
The trusts return requirements reflect the need to cover Johns living expenses and to protect
the portfolio from the adverse effects of inflation. Johns living expenses are estimated at
R300 000 per year after tax. Since income is taxed at 40%, trust assets will need to generate
215
R500 000 (i.e., R300 000/ (1-0.40) before tax. This equals a 2.5% return on the portfolio of R20
million. With inflation of 6% and growth of 1%, trust assets will be required to yield a total return
of at least 9.5% per year (i.e., 2.5% + 6% + 1%).
The trust has no immediate liquidity requirements. Liquidity requirements will change once John
begins his university education. To provide for emergencies, the trust should maintain liquidity
equal to the first years living expenses on a pre-tax basis i.e., R500 000.
The trust has a three-stage time horizon:

o
Years 1 through 6 when Johns living expenses are expected to increase with inflation
Years 7 through 10 when Johns expenses increase with the cost of his university
education
Years 11 through 20 when John will receive distributions from the trust sufficient to
cover essential expenses in excess of his after-tax income. In year 20 John turns 32, the
trust will terminate and trust assets will be distributed to John
Tax requirements: The trust is subject to tax. Therefore after-tax returns of the portfolio are
important
Regulatory requirements: The trustees have fiduciary responsibilities
Unique circumstances: The Smith Shop Ltd shareholding comprises 25% of the portfolio. The
restriction on selling the shares is material.
Given the above analysis, Mr Speed recommends Portfolio A for John Smith Trust for the following
reasons:
Portfolio A has a before-tax expected return of 9.9%, which meets the trusts return requirement
Portfolio A has a shortfall risk of -8.7%, which falls within the trusts downside risk tolerance
criteria of no worse than -10%
Portfolio A has cash equal to 4% of total assets, which meets the trusts liquidity requirement of
2.5% of total portfolio i.e., 500 000 of R20million
Portfolios B and C do not meet the trusts downside risk requirement
Mr Speed presents his analysis and recommendation to the trustees and obtains their approval to
draw up John Smith Trusts Investment Policy Statement in line with the analysis and
recommendations.
216
Review questions
1.
What is portfolio management?
2.
Name the steps in the portfolio management process.
3.
Why is it important to have a portfolio perspective of an investors asset holdings?
4.
What is an investors risk objective a function of?
5.
Why is it important to drawn up an investment portfolio statement for an investor?
6.
Briefly describe the phase of the portfolio management process that aims to construct a
portfolio.
7.
Define investor constraints and preferences.
8.
Name two portfolio strategies.
9.
Monitoring a portfolio has two components. Name these.
10.
What could motivate revising the portfolio once the desired portfolio has been constructed?
217
Answers
1.
Portfolio management is the process of putting together and maintaining the proper set of
assets to meet the objectives of the investor given any restrictions imposed.
2.
The steps are: plan the portfolio, develop and implement the portfolio strategy, monitor the
portfolio and adjust the portfolio.
3.
It is important to have a portfolio perspective of an investors asset holdings because:

When added to a portfolio of assets, the risk of an individual asset may be diversified away
To appreciate the risk and return prospects of an investors total position, it is necessary to
understand the interrelationships between individual assets.
4.
An investors risk objective is a function of both the investors ability and willingness to
assume risk.
5.
It is important to draw up an investment portfolio statement for an investor because:

The investor is better able to recognize the appropriateness of any investment strategy
implemented by the investment manager
It ensures investment continuity because it is portable and can easily be understood by
other investment managers
It is a document of understanding that protects both the investor and investment manager.
If manager operation or investor directions are questioned, the policy statement can be
referred to for clarification.
6.
The development and implementation the portfolio strategy is the phase of the investment
management process that aims to construct a portfolio with appropriate asset composition
that is within the guidelines of the strategic asset allocation. It consists of selecting the
investment strategy, formulating the inputs for portfolio construction and constructing the
portfolio.
7.
Investor constraints are limitations such as liquidity, time horizon, taxes and regulatory issues
that restrict the investors ability to use or take advantage of a particular investment. Investor
preferences are limitations imposed by the investor. For example investors may prefer not to
invest in tobacco shares or government bonds of countries with unacceptable human rights
records.
8.
Portfolio strategies are either active or passive.
9.
Monitoring a portfolio has two components: performance measurement and performance

evaluation
218
10.
Once the desired portfolio is constructed, the following could motivate revising it: changes in
the investors objectives as a result of changes in the investors circumstances; and changes in
capital market expectations.
219
Glossary
Agent
One who acts on behalf of another - the principal
Annuity
A periodic payment arising from a contractual obligation. The amount can

be fixed or variable. The number of payments can be fixed or contingent on
an event such as death in case of an insurance annuity.
Arbitrage
Simultaneously buying and selling a security at different prices in different

markets to make risk-less profits. There are no arbitrage opportunities in
perfectly efficient markets. Transaction costs often preclude arbitrage
opportunities.
At-the-money
If an options exercise price is approximately equal to the current market

price of the underlying.
Back-testing
The validation of a model by feeding it historical data and comparing the

models results with historic reality.
Basis
The difference between two prices e.g. a cash price and its related futures
price.
Basis point
1/100 of one percent (0.01% or 0.0001). 100 basis points equals one
percent.
Bearer instrument
A financial instrument, such as a negotiable certificate of deposit, that is

payable to whoever has possession of it i.e., is the bearer or holder of the
instrument.
Broker
An agent that acts as intermediary between buyers and sellers in trading

securities, commodities or other property. Brokers charge commission for
their services.
Budget deficit
The amount by which a governments, companys or individuals

expenditure exceeds its income over a particular period of time.
Clearing house
A division or subsidiary of an exchange that verifies trades, guarantees the

trade against default risk, and transfers margin amounts. Legally a market
participant makes a futures or traded-options transaction with the clearing
house.
Clearing system
A system set up to expedite the transfer of ownership of securities.
Clearing
Clearing is the process of transmitting, reconciling and, in some cases,

confirming payment instructions or security transfer instructions prior to
settlement, possibly including the netting of instructions and the
establishment of final positions for settlement. Sometimes the term is used
(imprecisely) to include settlement.
Convertible bond
A bond that can be, at the option of the bondholder, converted into equity,
another bond or even a commodity.
Corner
Control by a market participant or group of participants of the entire

deliverable quantity of an asset underlying a derivatives contract (see
squeeze).
Credit rating
A published ranking based on detailed financial analysis by a credit bureau,

of a bond issuers financial soundness specifically its ability to service
debt obligations.
Cross rate
Foreign exchange rate between two currencies other than the US dollar.
220
Dealer
A firm (or individual) that buys and sells securities as a principal rather than
as an agent. The dealers profit or loss is the difference between the price
paid and the price received for the same security. The dealer must disclose
to the customer that it has acted as principal. The same firm may function,
at different times, either as either broker or dealer.
Debenture callable
Debentures that can be repaid on a periodic basis at the discretion of the

issuer.
Debentures
convertible
Debentures that carry the right to exchange all or part thereof for other
securities, usually shares, at previously specified terms.
Debentures
guaranteed
Debentures of a subsidiary or associated company guaranteed by the holding

or controlling company.
Debentures income
Debentures on which the payment of interest is contingent on the earnings of

the company.
Debenturesparticipation or profitsharing
Debentures that pay their holders interest as well as a stipulated share of the
profits of the company.
Debenturesredeemable
Debentures that can be redeemed prior to maturity or at specific intervals.
Debentures secured
Debentures secured by the immovable property of a company.
Debentures variablerate
Debentures on which the rates are tied to the rates on other capital or money
market instruments.
Default risk
Also called credit risk is the risk that an issuer of a bond may be unable to
make timely principal and interest payments.
Delivery versus
payment
Under this settlement rule, the delivery of and payment for bonds are
simultaneous.
Diversification
Spreading the risk of investing over a range of investments, not putting all
the eggs in one basket
Duration
Measures the price sensitivity of a bond to changes in interest rates.
Exchange
The organised market in which the purchases or sales of securities such as

shares, futures and options take place.
Exchange rate
The price of one unit of a currency stated in terms of units of another

currency.
Exercise price
The price at which the underlying will be delivered if an option is exercised.
Fixed price
A price that does not change over the life of an instrument or contract. The
term includes fixed rates of interest.
Floating price
A price that changes periodically over the life of an instrument or contract.

The term includes floating rates of interest.
Fundamental analysis
Fundamental analysis focuses on determining the intrinsic value of a share.

The emphasis is on future earnings. It requires the analysis of all variables
that affect the level and growth rate of a companys earnings such as the
quality and depth of management; competitive position of the company,
strength of the companys balance sheet; economic, technical, political and
legal environment in which the company operates; and industry
environment and characteristics.
Hedge
A position taken to offset the risk associated with some other position. Most
often, the initial position is a cash position and the hedge position involves a
risk-management instrument such as a forward, futures, option or swap.
221
Indenture
A contract specifying the legal obligations of the issuer and the rights of the
bond holder.
Initial margin
The amount of funds put on deposit by market participants as a good faith

guarantee against a loss from adverse market movements.
Interbank funds
transfer system
A funds transfer system in which most (or all) direct participants are financial
institutions, particularly banks.
Interest-rate swap
The exchange of one set of cash flows for another based on a notional
principal amount. The most common form of interest-rate swap is the
fixed-for-floating interest-rate swap. A series of cash flows is calculated by
applying a fixed interest rate to the notional principal amount. This series
of cash flows is then exchanged for a stream of cash flows calculated by
using a floating interest rate such as JIBAR.
In-the-money
A call option is in-the-money if its exercise price is lower than the current
market price of the underlying. A put option is in-the-money if its exercise
price is higher than the current market price of the underlying.
JIBAR
Johannesburg Interbank Ask Rate.
Junk bond
A bond with a speculative credit rating.
A management information indicator that provides continuous insight into

the level of risk in the firm. KRIs enable management to proactively
Key risk indicator (KRI) manage and monitor risk on an ongoing basis.
KRIs may be leading, concurrent or lagging indicators.
Legs
The two sides of a swap.
Leverage
The magnification of gains and losses by only paying for a part of the
underlying value of the instrument or asset; the smaller the amount of funds
invested, the greater the leverage.
Long
To own a financial instrument.
Margin call
When collateral falls short of the requirement e.g. the value of the collateral
is less than the amount of the loan it secures, a margin call is made on the
borrower to top up the collateral.
Maturity
The time remaining to maturity of a financial instrument.
Maturity date
The principal repayment date of a bond or the date on which a swap

terminates.
National payment
system
A national arrangement and infrastructure that manages, administers,

operates, regulates and supervises payment, clearing and settlement
systems.
Notional principal
The amount of principal on which the interest in calculated in terms of an

interest-rate swap. In the case of interest-rate swaps the principal is purely
notional in that no exchange of principal takes place.
Notional
Commodities, equities or principals that exist primarily for purposes of

calculating service payments.
Open outcry
A method of trading on a commodity exchange that uses verbal bids and

offers shouted by traders in a central meeting place -the trading pit.
Opportunity loss
Foregoing a gain (or a smaller loss) by not taking a specific action or trade.
Out-the-money
A call option is out-the-money if its exercise price is higher than the current
market price of the underlying. A put option is out-the-money if its exercise
price is lower than the current market price of the underlying.
222
Payment dates
The dates on which the counterparties to a swap exchange service payments.
Policy
A set of statements of principles, values, and intent that outline

expectations and provides a basis for consistent decision-making and
resource allocation with respect to a specific issue.
Preference shares
convertible
Preference shares that carry a right to have all or part thereof exchanged for
other securities, usually shares, on previously specified terms.
Preference shares
participating
Preference shares that, in addition to their dividend rate, share in the profits
of the company according to a predetermined formula.
Preference shares
redeemable
Preference shares redeemable at the option of the company at a specific

price on a specified date or over a stated period.
Primary market
The market in which securities are first issued.
Promissory note
An undertaking, usually issued by a company, to pay the holder the face or

par value of the note at a specific future date.
Prospectus
A formal legal document that provides details about an investment offering

for sale to the public. A prospectus should contain the facts that an
investor needs to make an informed investment decision.
Reinvestment risk
The risk that the interest rate at which interim cash flows can be reinvested
will fall. Interest rate risk (i.e., the risk that interest rates will increase, thereby
reducing the price of a fixed-interest security) and reinvestment risk offset
each other.
Repurchase
agreement (repo)
An agreement in terms of which a holder of securities sells the securities to

a lender and agrees to repurchase them at an agreed future date and price.
Risk-free rate
The interest rate for a risk-free security. Risk free securities are generally
government securities within country. Certain government securities are
considered risk-free internationally e.g. that of the United States.
Secondary market
The market in which previously issued securities are traded.
Settlement
Settlement is the completion of a transaction, wherein the seller transfers

securities or financial instruments to the buyer and the buyer transfers
money to the seller. Settlements in South Africa are final and irrevocable
(irreversible).
Short
Selling a financial instrument without owning it.
Speculating
Buying or selling financial instruments in the hope of profiting from

subsequent price movements.
Squeeze
Control by a market participant or group of participants of a sufficient

deliverable quantity of an asset underlying a derivatives contract to exert
significant pressure on prices (see corner).
Statistics
A set of tools used to collect, organise, present, analyse and interpret

numerical data for the purpose of making decisions.
Swap coupon
The interest payment on the fixed-rate side of a swap
Technical analysis
Technical analysis involves studying past asset price series and trading
volume data in attempt to profit from periodic changes in these trends.
Tenor
The time remaining to maturity of a financial instrument.
Termination date
See maturity date.
Transaction costs
The costs associated with engaging in a financial transaction.
223
Underwriting
An arrangement by which an underwriter agrees to buy a certain agreed

amount of securities of a new issue on a given date at a stated price, thereby
assuring the issuer the full proceeds of a financing issue.
VaR is the worst-case loss expected over the holding period within the
probability set out by the confidence interval such as 95%. Larger losses are
possible but with a lower probability.
Value at risk (VaR)

For example: if a portfolio has a VaR of R10 million over a one-day holding
period with a 95% confidence interval, the portfolio would have a 5%
change of suffering a one-day loss greater than R10 million.
Value date
See effective date.
Variable rate
A rate that changes periodically over the life of an instrument or contract.

Also termed floating rate.
Volatility
The degree to which the price of a financial instrument tends to fluctuate

over time.
224
Bibliography
Absa Bank, 1997, The Business cycle, Economic spotlight number 21.
Bank for International Settlements, 2005, Launch of the Asian Bond Fund (ABF) Malaysia Bond Index
Fund, www.bis.org
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Bodie, Z., Kane A and Marcus, A. J., 2009, Finance, Investments, 8th edition, Boston:McGraw-Hill.
Brigham, Eugene F, and Houston, Joel F., 1998, Fundamentals of Financial Management, 8th edition,
New York:Dryden.
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Fabozzi, F.J. 1995, Investment Management, New Jersey: Prentice Hall Inc.
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House: Southern Books.
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challenges for commodity market participants, www.fsa.gov.uk, accessed October 2012
Goldman Sachs Asset Management, 2003, Modern Investment Management, Hoboken: John Wiley
& Sons.
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Corporate Treasurers.
Goodspeed, I., Bond and long-term debt market, 2005, Study workbook for the South African
Institute of Financial Markets Registered Persons Exam
Goodspeed, I., 1990. Theory of Portfolio Management, ABSA Bank research report no 90/06.
Goodspeed, I., December 1997, Currency options in SA Treasurer.
Goodspeed, I., March 1998, The foundations of financial risk management in SA Treasurer.
Goodspeed, I., September 1997, The basics of foreign exchange management: spot and forwards in
SA Treasurer.
Gwartney, James D and Stroup, Richard L. and Sobel, Russell S., 2000, Economics Private and Public
Choice, 9th edition, New York:Dryden.
Hull, John C., 2002, Options, Futures and Other Derivatives, Upper Saddle River: Prentice Hall
IOSCO, 2005, Examination of governance for collective investment schemes, www.iosco.org
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Investor Guide University, www.investorguide.com

Livingston, M., 1993, Money and capital markets, Miami:Kolb.
Krugman. P. 1997, Seven habits of highly defective investors in Fortune,
http://money.cnn.com/magazines/fortune/fortune_archive/1997/12/29/235886/index.htm
Lorie, J.H. and M.T. Hamilton, 1973, The Stock Exchange, London: Yale University Press.
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National Treasury, July 2012. Explanatory Memorandum on the Taxation Laws Amendment Bill,
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Niemira, Michael P. & Klein, Philip A. 1994. Forecasting financial and economic cycles. New York:
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Kok & J.H. Meijer. London: The Macmillan Press Ltd.
Van Zyl, C,. Botha, Z., Skerritt, P., and Goodspeed, I (Editors), 2009, Understanding South African
Financial Markets, van Schaik Publishers
226
Appendix A: Formula sheet Introduction to the financial

markets
NOTE: This formula sheet will be presented to you upon request, which must be made to the invigilator before the exam
begins.
Should you not request a formula sheet for the exam, there can be no recourse taken with SAIFM should the outcome of
the exam not be a pass mark
You may not take your own formula sheet to the exam.
Formula 1
Formula 2
Formula 3
I = PV x r x t
Formula 4
FV = PV (1 + r x t)
Formula 5
PV = FV / (1+ r x t)
Formula 6
D = FV x d x t
Formula 7
PV = FV (1 d x t)
Formula 8
r = d / (1 d x t)
Formula 9
d = r / (1 + r x t)
Formula 10
FV = PV(1 + r)t
Formula 11
PV = FV/(1 + r)t
227
Formula 12
re = [(1 + rn / m) m 1]
Formula 13
FV = PV x e r x n
Formula 14
re = e r - 1
Formula 15
FV = PMT [((1 + r ) n 1) / r ]
Formula 16
FV = (1 + r ) PMT [((1 + r ) n 1) / r ]
PV = PMT [((1 + r ) n 1) / ( r (1 + r )n ) ]
Formula 17
or
PV = PMT[(1 (1 / (1+ r)n)) / r]

Formula 18
PV = (1 + r ) PMT [((1 + r ) n 1) / ( i (1 + r )n ) ]
Formula 19
i 1
Formula 20
i 1
Formula 21
X X
i
MAD
i 1
Formula 22
i 1
228
Formula 23
Formula 24
Formula 25
Formula 26
Formula 27
Formula 28
var(X )
P X
n
E ( X )2
i 1
Formula 29
std(X ) var(X )
Formula 30
Formula 31
Formula 32
229
Formula 33
Formula 34
Formula 35
Formula 36
Formula 37
Formula 38
230

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The South African Institute of Financial Markets

Introduction to Financial Markets

Ingrid Goodspeed: May 2013

Introduction to the Financial Markets (compulsory module)

The Equity Market (elective module)

The Bond Market (elective module)

The Derivatives Market (elective module)

The South African Money Market (elective module)

The South African Foreign Exchange Market (elective module)

Agricultural Products Market Dealers Examination (elective module)

Financial Services Board

South African Reserve Bank

Bank for International Settlements

International Monetary Fund

New York Stock Exchange

London Stock Exchange

NYSE Euronext (including LIFFE)

World Federation of Exchanges

The financial system ......................................................................................................... 8

The economy .................................................................................................................. 28

Time value of money ...................................................................................................... 54

Introduction to statistical concepts................................................................................ 68

The foreign exchange market ......................................................................................... 88

The money market ......................................................................................................... 96

The bond and long-term debt market .......................................................................... 106

The equity market ........................................................................................................ 115

The derivatives market ................................................................................................. 129

The commodities market ............................................................................................. 149

Investment instruments ............................................................................................... 159

Introduction to portfolio theory ................................................................................... 175

Portfolio Management ................................................................................................. 209

Glossary .................................................................................................................................. 220

Detailed table of contents

The financial system ......................................................................................................... 8

The financial system defined ........................................................................................................ 8

The flow of funds and financial intermediation ........................................................................... 9

Functions of the financial system ............................................................................................... 19

Financial market rates ................................................................................................................ 21

Determining financial market prices .......................................................................................... 23

The economy .................................................................................................................. 28

The flows of economic activity ................................................................................................... 30

Economic objectives ................................................................................................................... 33

Economic policy .......................................................................................................................... 33

Business cycle ............................................................................................................................. 36

Globalisation of financial markets .............................................................................................. 50

Time value of money ...................................................................................................... 54

The yield curve ............................................................................................................................ 55

Interest rate calculations ............................................................................................................ 58

Present and future value of an annuity ...................................................................................... 62

Present and future values of unequal cash flows....................................................................... 63

Net present value ....................................................................................................................... 64

Internal rate of return................................................................................................................. 65

Introduction to statistical concepts................................................................................ 68

Descriptive statistics ................................................................................................................... 69

Inferential statistics .................................................................................................................... 79

The foreign exchange market ......................................................................................... 88

The market defined .................................................................................................................... 88

Characteristics of the market ..................................................................................................... 89

Foreign exchange market instruments ....................................................................................... 90

Foreign exchange market participants ....................................................................................... 92

The money market ......................................................................................................... 96

The market defined .................................................................................................................... 96