Intro Financial Markets

Introduction to Financial Markets

by Ingrid Goodspeed © I Goodspeed: 2008

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The Registered Person Examination (RPE) has been designed as an entry-level qualification for the South African financial markets. The objectives of this guide are to introduce the student to the financial markets in South Africa and internationally and to prepare the student for the South African Institute of Financial Market’s 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, 4, 5, 6, and 7 focus on the features, instruments, and participants of the foreign exchange, money, bond, equity and derivatives markets respectively. Chapter 8 describes collective investment schemes such as unit trusts. Portfolio management - the process of putting together and maintaining the proper set of assets (such as those discussed in chapter 3 to 8) to meet the objectives of the investor - is considered in chapter 9. Students are advised to keep up to date with local and international financial market developments. The following internet sites may prove useful:

South Africa

South African Futures Exchange www.safex.co.za

JSE Securities Exchange www.jse.co.za

South African Bond Exchange www.bondexchange.co.za

South African Reserve Bank www.resbank.co.za

National Treasury www.finance.gov.za

Statistics South Africa www.statssa.gov.za

International

Bank for International Settlements www.bis.org

International Monetary Fund www.imf.org

World Bank www.worldbank.org

The Economist www.economist.com

Transparency International www.transparency.de

World Trade Organisation www.wto.org

New York Stock Exchange www.nyse.com

London Stock Exchange www.londonstockexchange.com

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Table of contents 1 The financial system .......................................................................... 4

1.1 The financial system defined ............................................................... 4

1.2 Financial intermediation and the flow of funds ....................................... 4

1.3 Functions of the financial system ....................................................... 10

1.4 Financial market rates ...................................................................... 11

2 The Economy .................................................................................... 15

2.1 Economic systems ............................................................................ 15

2.2 The flows of economic activity ........................................................... 17

2.3 Economic objectives ......................................................................... 20

2.4 Economic policy ............................................................................... 20

2.5 Business cycle ................................................................................. 21

2.6 Economic indicators .......................................................................... 25

2.7 International economic institutions and organisations ........................... 36

3 The foreign exchange market ........................................................... 40

3.1 The market defined .......................................................................... 40

3.2 Characteristics ................................................................................. 40

3.3 Instruments .................................................................................... 41

3.4 Participants ..................................................................................... 43

4 The money market ........................................................................... 47



4.3 Instruments .................................................................................... 47

5 The bond and long-term debt market ............................................... 55



5.3 Instruments .................................................................................... 55

6 The equity market ............................................................................ 62



6.3 Instruments .................................................................................... 63

6.4 Participants ..................................................................................... 66

6.5 Issuers: Limited public companies ...................................................... 66

7 The derivatives market .................................................................... 71



7.3 Instruments .................................................................................... 72

7.4 Other derivatives ............................................................................. 83

7.5 Participants ..................................................................................... 84

8 Collective investment schemes ........................................................ 89

8.1 Definition of collective investment schemes ......................................... 89

8.2 Structure of collective investment schemes ......................................... 89

8.3 Participants in the collective investment process .................................. 89

8.4 Categories of collective investment schemes ....................................... 90

8.5 Types of collective investment schemes .............................................. 91

8.6 Advantages and disadvantages of investing in CISs .............................. 92

9 Portfolio management ...................................................................... 96

9.1 The portfolio management process defined ......................................... 96

9.2 The portfolio management process ..................................................... 96

10 Appendix A: Exotic derivatives .................................................... 105

11 Glossary ...................................................................................... 110

12 Bibliography ................................................................................ 114

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1 The financial system

Chapter learning objectives: o To define the financial system; o To describe the four elements of the financial system namely lenders

and borrowers, financial institutions, financial instruments and financial markets;

o To explain the functions of the financial system; o To outline how financial market rates – interest rates, exchange rates

and rates of return – are determined.

This chapter provides a conceptual framework for understanding how the financial system works. Firstly the financial system will be defined. Then the elements of the financial systems within the flow of funds context will be discussed. Thereafter the central role that financial markets and intermediaries play in the financial system will be considered. Finally the chapter outlines how financial market rates are determined.

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 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 corporation in Australia 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 euros, yen, US dollars or Australian dollars.

1.2 Financial intermediation and the flow of funds

The financial system has four elements: o Lenders and borrowers; o Financial institutions; o Financial instruments; and o Financial markets. The interaction between the various components of the financial system is shown in figure 1.1 on the next page.

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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 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 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.

Indirect financing

Financialintermediaries

Financialmarkets

Borrowers(deficit units)

Household sectorBusiness sector

Government sectorForeign sector

Lenders(surplus units)

Household sectorBusiness sector

Government sectorForeign sector

Direct financing

Funds Funds

Funds

Funds

Indirec

t secur

ities

Prima

ry sec

urities

Primary securities

Primary securities

Figure 1.1: Financial intermediation and the flow of funds

Funds

Primary securities

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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 – termed indirect securities - tailored to the risk, return and liquidity requirements of the 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, unit trusts, 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. A unit trust invests funds subscribed by the public in securities such as shares and bonds and in return issues units that it may repurchase.. A mutual fund pools the funds of many small investors and re-invests the funds in shares, bonds and other financial claims with each investor having a proportional claim on the assets of the fund. Both unit trusts and mutual funds play a risk diversification role in that they are large enough to spread their investments widely i.e., they can 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 (see 1.2.1). Within these two categories, financial instruments can be characterised as marketable or non-marketable. Marketable instruments

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can be traded in secondary markets (see 1.2.4) while non-marketable instruments cannot. To recover their investment, holders of non-marketable financial instruments have recourse only to the issuers of the claims. Non-marketable claims generally involve the household sector while marketable claims are usually issued by the corporate and government sectors. Examples of financial instruments are shown in the table below.

Table 1.1: Financial instruments

Primary securities (issued by ultimate borrowers)

Indirect securities (issued by financial intermediaries)

Marketable Non-marketable Marketable Non-marketable Bankers acceptances/bills; Trade bills;

Promissory notes; Commercial paper; Company debentures; Treasury bills; Government bonds; Shares of listed

companies

Hire-purchase and leasing contracts; Mortgage advances;

Overdrafts; Personal loans; Shares of non-listed companies.

Negotiable certificates of deposit (NCDs) (issued by

banks)

Bank notes (issued by the central bank); Savings accounts;

Term or fixed deposits; Insurance policies; Retirement annuities

1.2.4 Financial markets

Financial markets can be defined as the institutional arrangements, mechanisms and conventions that exist for the issuing and trading 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. Financial market participants include: o Borrowers: the issuers of securities; o Lenders: the buyers of securities; o Financial intermediaries: issuers and buyers of securities and other

debt instruments; and o Brokers: act as conduits between lenders and borrowers in return for a

commission. Financial market terminology includes terms such as cash and derivatives markets; spot and forward markets, primary and secondary markets; financial exchanges and over-the-counter markets. These are described below.

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1.2.4.1 Cash and derivatives markets

Cash and derivatives markets are discussed with reference to figure 1.2.

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 physical goods - is a cash market but not a financial one. The foreign exchange market is the international forum for the exchange of currencies (see chapter 3). The money market (see chapter 4) is the marketplace for trading short-term debt instruments while the bond market (see chapter 5) deals in longer-term debt issues. The distinction between money and bond markets is mainly on the basis of maturity. Most money market instruments have maturities of less than one year while bonds are issued with terms of more than one year. Both money and bond markets involve interest-bearing debt instruments. Equities or shares – participation in the ownership of a company – trade on equity markets (see chapter 6). Equity and bond markets are grouped together under the term 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 (see chapter 7) are financial instruments the values of which are derived from the values of other variables. These variables can be underlying instruments in the cash market. For example a currency option is linked to a particular currency pair in the foreign exchange market, a bond futures to a certain bond in the bond market and an agricultural futures to maize or wheat in the commodities market. However derivatives can be based on almost any variable – from the price of soya

Foreign exchange

market

Derivatives

Capital market Money market

Derivatives

Derivatives Derivatives

Hybrids

Figure 1.2: Cash and derivatives markets

Commodities

Derivatives

Financial markets

Equity market Bond and long-term

debt marketInterest-bearing markets

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to the weather in Rome. There is active 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. 1.2.4.2 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. 1.2.4.3 Primary and secondary markets

The primary market is the market for the original sale or new issue of financial instruments. 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. The secondary market is a market in which previously-issued financial instruments are resold. For example 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. 1.2.4.4 Exchanges and over-the-counter markets

Exchanges are formal marketplaces where financial instruments are bought and sold. They are usually 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. Internationally, apart from corporate bond trading on the New York Stock Exchange, bond markets are usually OTC markets. In South Africa the Bond Exchange of South Africa controls trading in bonds.

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Generally equities are exchange traded. The JSE Securities Exchange controls trading in South African equities. Globally the largest stock exchange in terms of market capitalisation is the New York Stock Exchange followed by the London Stock Exchange. Derivatives are traded on-exchange and over-the-counter.

1.3 Functions of the financial system

The core functions of the financial system include: o Channeling savings into real investment; o Pooling of savings; o Clearing and settling payments; o Managing risks; and o 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., it channels funds from those who wish to save (surplus economic units) to those who need to borrow (deficit economic units). This can take place o Through 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;

o 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. Examples are mutual funds and unit trusts.

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, demand deposits, cheques, credit cards and electronic funds transfers.

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1.3.4 Management of risk

By reducing credit risk and providing liquidity through maturity transformation financial intermediaries change unacceptable claims on borrowers to acceptable claims on themselves i.e., the risky long-term liabilities of deficit units are transformed into less-risky liquid assets for surplus units.

1.3.5 Information provision

The financial system communicates information on: o Borrowers’ creditworthiness: it is costly for individual households to

obtain information on a borrower’s creditworthiness. However if financial intermediaries do this on behalf of many small savers, search costs are reduced.

o The prices of securities and market rates: this assists firms in their selection of investment projects and financing alternatives. In addition it enables asset managers to make investment decisions and households savings decisions.

1.4 Financial market rates

There are essentially three financial market rates: o Interest rates; o Exchange rates; and o Rates of 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 include: o Production opportunities: potential returns within an economy from

investing in productive, cash-generating assets; o 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;

o Time preference: lenders require compensation for saving money for use in the future rather than spending it in the present;

o 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 debt generally has no risk premium within a country. A country risk premium may apply outside a country’s borders;

o Inflation: lenders require a premium equal to the expected inflation rate over the life of the security.

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1.4.2 Exchange rate

The exchange rate is the price at which one currency is exchanged for another currency (see chapter 3). The actual exchange rate at any one time is determined by supply and demand conditions for the relevant currencies with the foreign exchange market.

1.4.3 Rates of 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 two sources: o Price appreciation (depreciation) i.e., any gain (loss) in the market

price of the asset; o Cash flow (if any) produced by the asset e.g., cash dividends paid to

shareholders, rental income from property. 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 its price is R55. The one-year rate of return (r) for the share is 15.0% calculated as follows:

%.

.

.

.

..

shareofpricebeginning

dividendcash


shareofpricebeginningshareofpriceend

cashflow)loss(gaincapitalr

015

0050

502

0050

00500055

=

+−=

+−=

+=

If the share price is R45 at year end the rate of return is –5% i.e.,

%.

.

.

.

..r

05

0050

502

0050

00500045

−=

+−=

Assume a painting is purchased at the beginning of 2001 for R2 000. At an auction on 31 December 2001 the painting is sold for R3 000. The art

investor’s annual rate of return is 50.0% calculated as follows:

%.

cashflow)loss(gaincapitalr

050

00002

00020003

=

+−=

+=

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Questions for chapter 1

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?

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Answers for chapter 1

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. The four elements of the financial system are lenders and borrowers;

financial institutions; financial instruments; and financial markets. 3. 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:

%2100

0

100

100102

=

+−=

+−=shareofpricebeginning

dividendcash


shareofpricebeginningshareofpriceendr

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2 The Economy

Chapter learning objectives:

o To describe alternative economic systems;

o To outline the flows of economic activity in a market economy; o To sketch how the performance of an economy is generally judged i.e.,

economic objectives;

o To explain the role of government in the economy; o To describe the business cycle i.e., cycles in economic activity;

o To explain how economic indicators provide insights into how economies and markets perform;

o To outline major international economic institutions and organisations.

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 those international institutions and organisations that exist for the purpose of coordinating the financial

policies of national governments will be outlined.

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 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.

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: o Owns and/or controls resources; o Sets priorities in the use of the resources;

o Determines production targets for firms, which are largely owned and/or controlled by the state;

o Directs resources to achieve the targets; and o Attempts to co-ordinate production to ensure consistency between

output and input.

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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: o Resources are privately owned and the owners are free to use the

resources as they wish;

o Firms, which are also in private ownership, make production decisions; o 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 firms provide 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 utilisation of a society’s resources, the economic problem of resource allocation has a political dimension. The link between a society’s economic system and political

regime is illustrated in figure 2.1 on the next page. 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 times of war. Typically

demands for political change have accompanied pressures for economic reform e.g., in Eastern Europe.

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2.2 The flows of economic activity

The structure of an economy is often described by a circular flow of income diagram. In its simplest form - see figure 2.2 - the economy

consists of two groups: firms and households. On the resource side i.e., real flows: households provide labour to firms and firms produce goods

and services and supply them to households for consumption. Corresponding to these 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.

cent rally planned

Political system

authoritarian

democratic

e.g., China e.g., Cuba

e.g., Eastern Europeanstates - Hungary - Bulgaria - Romania

e.g., United States,United Kingdom,Europe

Economic system

free market

Figure 2.1: Politico-economic systems

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In reality the economy is more complicated. There are leakages from the

circular flow: o Savings: money is received by households but not spent on

consumption; o Imports: money flows to foreign firms as households consume

imported goods;

o Taxes: money flows to the government.

At the same time as the leakages are taking place, additional forms of spending are occurring that represent injections into the circular flow: o 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 (see 1.2.1) to invest in capital to be used in the production of more goods and services. This generates income for firms producing

capital goods; o Exports: firms sell their production to another country in exchange for

foreign exchange. The difference between a country’s exports and imports of goods is known as the trade balance and reflects the country’s basic trading position;

o Government spending: governments use taxation to spend on the provision of public goods and services such as defense and education.

FirmsHouseholds

Labour

Income for households (expenditure for firms)

Income for firms (expenditure for households)

Goods and services

Figure 2.2: Simplified circular flow of income diagram

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A more complete picture of the economy is shown in figure 2.3.

While the revised model of the economy is still simplified e.g., firms also save and buy imports, it does show:

o The interactions between the various components of the economy; and o How variations in the level of economic activity i.e., the flow of goods

and services produced in an economy can be the result of changes in a

number of variables. For example 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 consumer or household spending, government spending or public expenditure,

investment spending on capital goods and exports of goods and services less expenditure on imports of goods and services. 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.

Government

Foreign sector

Owners of capital

FirmsHouseholds

Capital goods

Investment

Labour

Income for households (expenditure for firms)

Income for firms (expenditure for households)

Goods and services

Foreign income

Exports

Foreign expenditure

Imports

ServicesServices

TaxesTaxes

Figure 2.3: Circular flow of income diagram

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2.3 Economic objectives

The performance of an economy is generally judged in terms of the following economic objectives:

o An acceptably high rate of non-inflationary economic growth; o A high and steady level of employment of the labour force; o A stable general price level i.e., avoidance of undue inflation and

deflation; o A favourable and stable balance of payments; and

o 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 i.e., 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.

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.

Taxation and government spending are linked in the government’s 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

exceeds public-sector receipts. A budget deficit is financed by borrowing. The public or national debt is the total sum of all deficits less all 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 monetary variables such as:

o The rate of interest: lowering interest rates encourages companies to invest (i.e. invest in capital expenditure) as the cost of borrowing falls

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and 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; and o The money supply (notes, coins, bank deposits): if the money supply is

increased, interest rates tend to fall. The tools of monetary policy are:

o Reserve requirements; o Open-market operations; and

o Bank or discount rate policy. (i) Reserve requirements

The central bank requires banks to hold a specified proportion of their assets as reserves - typically against their depositors’ funds. By changing

the reserve requirement the central bank can influence the money supply and credit extension. For example if the central bank lowers the reserve requirement the money supply will increase as banks extend additional

credit on the back of their increased lending capacity.

(ii) 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. (iii) 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. 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.

2.4.3 Direct controls

Examples of direct controls are:

o Prices and incomes policies attempt to control inflationary pressures by restraining price and wages increases;

o 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., recurring 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

22

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 2.5.

The simplified sequence of events that usually delineates 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.

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.

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 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 the lift the economy again.

23

The typical behaviour of economic variables in the different phases of the

business cycle is outlined in the table 2.1.

Table 2.1: Phases of the business cycle Lower turning

point Expansion Upper turning

point Contraction

Businesses Tend to be more

liquid and less geared;

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

Weakens Weakens Stabilizes 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

Upper turning point

Lower turning point Lower turning point

Expansion

Contra

ction

Figure 2.4: Phases of the business cycle

24

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 at a high level

Increase rapidly;

idle production capacity is absorbed

Limited by capacity

constraints

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 series display cyclical patterns. These can lead (i.e., turn

in advance of), coincide with or lag (i.e., turn after) the business cycle. Leading indicators can be used to predict economic developments.

The South African Reserve Bank (SARB) uses over 200 economic time series to determine the turning points of the South African business cycle.

Using these indicators, leading, coincident and lagging composite-business-cycle indices are produced - see figure 2.5. The indices indicate

the direction of change in economic activity – not the level.

Figure 2.5: South African composite business cycles

0

20

40

60

80

100

120

140

160

180

200

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Inde

x (

1990

= 1

00)

Upward phases

Leading

Lagging

Coincident

25

2.6 Economic indicators

Economic indicators provide insights into how economies and markets are performing. Their interpretation is important for a number of reasons.

These are:

Who Why

Economists and other market analysts

o assess the performance of the economy o judge the effectiveness of a government’s

economic policy o ascertain the performance of an unfamiliar

economy;

o compare the economic performance of different countries;

o form economic and market forecasts and views.

Investors o obtain best investment return

Businesses determine if time is right to undertake: o new capital investment projects; o takeover or merger;

o entry into new markets

The following economic indicators will be discussed:

o Gross Domestic Product; o Private consumption spending; o Government spending;

o Investment spending; o Consumer price index;

o Producer price index; and o Current account balance.

26

2.6.1 GDP (Gross Domestic Product)

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 e.g., food and clothing; • government consumption e.g., remuneration of

public sector employees; • investment e.g., factories, manufacturing plants;

and

• exports (foreigners’ spending) less imports (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 2.2). 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(see figure 2.5)

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

27

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.

Figure 2.6: Gross Domestic Product (GDP)

-10

-5

0

5

10

15

73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

% c

hang

e qu

arte

r-on

-qua

rter

Upward phases

28

2.6.2 Private consumption spending

Definition: Consumption spending by households represents the largest proportion of GDP. In industrialised countries it’s

around 60% of GDP (63.5% in South Africa (2nd quarter of 2005)).

It is divided into a number of categories including durable goods (goods expected to last more than 3

years), non-durable goods (food and clothing) and services.


Focus on: Real growth rates

Timing: Coincident indicator of the business cycle

Interpretation: A change in private consumption spending has a large

effect on total production as it is the largest component of aggregate demand.

After a recession growth in private consumption expenditure is a precursor to a general recovery.

However if consumption grows faster than an economy’s productive capacity demand for imports will increase and inflation will rise.

For the likely impact on interest rates, bond prices, share prices and

exchange rates see GDP.

29

2.6.3 Government spending

Definition: 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 (19.6% in South Africa (2nd quarter

2005)). It includes spending on goods and services (defense,

judicial system and education) but excludes transfers 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 (see 2.6.4).




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 (see 2.4.1). A short-term increase in government spending can provide a stabilising boost to the economy.

Likely impact on:

Interest rates moderate with same trend as GDP (see 2.6.1)

Bond prices moderate with same trend as GDP (see 2.6.1)

Share prices moderate with same trend as GDP (see 2.6.1)

Exchange rate moderate with same trend as GDP (see 2.6.1)

30

2.6.4 Investment spending

Definition: Investment spending is a key component of GDP. and represents around 20% of GDP in industrialised countries

– 16.8% in South Africa (2nd quarter 2005).

Investment spending (or gross capital formation) is made up of: o gross domestic fixed capital investment that includes

spending on residential and non-residential buildings, construction works and machinery and other

equipment; o and change in inventories. 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.



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.

31

2.6.5 Consumer price index (CPI)

Definition: Price indices measure levels of and changes in particular baskets of prices. The consumer price index 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.


Interpretation: The CPI is used to calculate and monitor inflation.

Inflation has three main negative effects:

o it distorts 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;

o it creates uncertainty and consequently discourages investment because is it not precisely predictable;

o it redistributes income from creditors to debtors and

fixed-income earners to variable-income or wage earners.

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 effect 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.

32

Figure 2.7: Consumer Price Index (CPIX)

0

5

10

15

98 99 00 01 02 03 04 05 06 07

% c

hang

e ye

ar-o

n-ye

ar

Upward phases

33

2.6.6 Producer price index (PPI)

Definition: The producer price index 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 (see 2.6.5 and 2.6.6) 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 (2.6.5).

Figure 2.8: Producer Price Index (PPI)

-5

0

5

10

15

20

25

74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

% c

hang

e ye

ar-o

n-ye

ar

34

2.6.7 Current account balance (balance on the current account of the balance of payments

Definition: The balance of payments is a tabulation of a country’s transactions with foreign countries and international

institutions over a period – a quarter or year. It consists of the current account, capital account and official

reserves (i.e., gold and foreign currencies held by the country).

The capital account reflects international capital flows i.e., it records international transactions in assets and

liabilities e.g., a country’s capital outflows represent the acquisition of foreign assets or the repayment of foreign liabilities.

The current account balance reflects the sum of the

trade account (or trade balance), services account and transfers of a country’s balance of payments.

The trade balance is the difference between a country’s imports and exports of goods.

The services account reflects the difference between

imports and exports of services such as shipping, travel

and tourism, financial services including insurance, banking and brokerage. The services account includes

investment income (the result of previous capital flows) such as rents, interest, profit and dividends.

Presented as: Monthly money values

Focus on: Trends and size in relation to GDP.

Timing: Coincident indicator of the business cycle.

Interpretation: The current account balance reflects international payments that must be matched by capital 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 capital 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.

35

A current account surplus may indicate a competitive economy or that policy measures are in place e.g.,

import tariffs to keep imports low.

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 2.9: Current account balance

-50000

-40000

-30000

-20000

-10000

0

10000

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Rm

Upward phases

36

2.7 International economic institutions and organisations

Several international institutions currently exist for the purpose of coordinating the financial policies of national governments.

2.7.1 The World Bank Group

The World Bank Group consists of the International Bank for Reconstruction and Development (see 2.7.2), the International Development Association (see 2.7.3); International Finance Corporation

(see 2.7.4) and Multilateral Investment Guarantee Agency (see 2.7.5).

2.7.2 The International Bank for Reconstruction and

Development (IBRD)

The IBRD – less formally known as the World Bank - is part of the World Bank Group. Its purpose is to advocate capital investment for the

reconstruction and development of its approximately 180 member countries. It raises funds primarily by selling bonds in developed countries and makes loans for projects designed to encourage economic

development – mainly in developing countries.

2.7.3 International Development Association (IDA)

The IDA is part of the World Bank Group. It gives long-term loans at little

or no interest for mainly infrastructure projects in the poorer of the developing countries.

2.7.4 International Finance Corporation (IFC)

The IFC is part of the World Bank group. It encourages private investment in capital projects in developing countries.

2.7.5 Multilateral Investment Guarantee Agency

The Multilateral Investment Guarantee Agency is an agency of World Bank Group. It gives guarantees and insurance cover against non-commercial

risks such as war and appropriation of assets to private direct investors in developing countries.

2.7.6 International Monetary Fund (IMF)

“The IMF is an international organization of 183 member countries,

established to: o Promote international monetary cooperation, exchange stability, and

orderly exchange arrangements; o Foster economic growth and high levels of employment; and o Provide temporary financial assistance to countries to help ease

balance of payments adjustment” (www.imf.org/external/about.htm )

37

2.7.7 Bank for International Settlements (BIS)

The primary objective of the BIS is global monetary and financial stability, which it seeks to achieve by encouraging cooperation between central

banks. In addition the BIS offers a range of banking services to assist central banks in the management of their foreign exchange and gold reserves.

38


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 GDP growth on interest rates. 10 What is the purpose of the World Bank?

39


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, 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, utilization 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 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 The purpose of the World Bank – more formally known as the International Bank for Reconstruction and Development – is to support capital investment for the reconstruction and development of its approximately 180 member

countries. It does this by raising funds through selling bonds in developed countries and making loans for projects designed to encourage economic development – mainly in developing countries.

40

3 The foreign exchange market


o To define the foreign exchange market;

o To outline the characteristics of the foreign exchange market; o To explain foreign exchange market instruments; o To describe the participants in the foreign exchange market.

3.1 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 the foreign currency in terms of domestic currency e.g., 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. In indirect terms it is the price of the domestic currency in terms of the foreign currency e.g., if one South

African rand is equal to $0.14 the indirect exchange rate is USD0.14.

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 international trade. More recently it has

become an important adjunct to the international capital market allowing borrowers to meet their financing requirements in the currency most conducive to their needs.

3.2 Characteristics

According to the Bank for International Settlements the average daily turnover in global foreign exchange markets in April 2004 was $1.9

trillion. This is a tenfold increase over the last 15 years – the average daily turnover in 1986 was US$205bn.

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, Frankfurt and Singapore. 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.

Currencies are traded over-the-counter (OTC) with trading taking place telephonically or electronically.

Most foreign exchange transactions take place in US dollars – the primary

vehicle currency. Even if a trade between Italian lira and French francs is required, it is easier to change the lira to US dollars and the US dollars to

41

francs than to do a direct lira / franc trade. The Deutsche (German) mark (DM) and Japanese yen are also vehicle currencies but less so.

3.3 Instruments

3.3.1 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.

(i) The spot rate

The spot rate is quoted for ‘immediate’ (in practice, two working days) delivery. 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 US dollar. The bid rate is the rate the bank is willing to pay to buy dollars (and sell the non-dollar currency) and

the offer rate is the rate at which the bank will offer to sell dollars (and buy the non-dollar currency). The difference, or spread, between the two

rates provides the bank’s profit margin on transactions.

For example, a South African importer wants to buy US$1 000 000 from a bank. The bank quotes the following rates: R6.5230-6.5280. Since the importer is buying dollars and selling rand – the bank is selling dollars and

buying rand – the offer rate of R6.5280 applies and the cost to the importer will be R6 528 000 (i.e., $1 000 000 x R6.5280).

A South African exporter wishes to sell US$1 000 000 to the bank, which quotes the same rates. Since the customer is selling dollars and buying

rand – the bank is buying dollars and selling rand – the bid rate of R6.5230 applies and the exporter receives R6 523 000 (i.e., $1000 000 x

R6.5230). Of course clients may wish to transact in currencies other than the US

dollar e.g., Deutsche marks (DM) against the rand, pound sterling (£)

Time

Dealing date

(transaction made)Spot value date

(settlement)

2 working days

Spot transactions : dealing and value dates

42

against the yen (¥). In such cases cross rates – rates between two currencies where neither one is the US dollar - are calculated. For

example, a cross rate for sterling and yen, where the customer wanted to sell sterling and buy yen, would be calculated by firstly converting the

sterling into US dollars and then converting the US dollars into yen. (ii) 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. With a forward transaction, the sale or purchase is agreed to now but will take

place on some future date, thereby fixing the exchange rate now for a future exchange of currencies. Forward transactions are known as forward exchange contracts or forward contracts.

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 - points (i.e., the premium or discount 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 true).

For example, if the dollar/rand is R6.4340-6.4350 spot and the 3-month forward premium is 580-590, the forward rate is R6.4920-6.4940 (i.e., 6.4340+(580/10000) and 6.4350+(590/10000)).

3.3.2 Swaps

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

Time

Dealing date(transaction made)

Value date(settlement)

2 working days

Forward transactions : dealing and value dates

Term of forward contracte.g., 3 months

Maturity dateof contract

43

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 DM to USD, it will purchase say DM 1million against US dollars and simultaneously sell the DM forward. The account of the US bank in Germany will show a credit

balance of DM1 million as a result of the spot purchase. However the bank's exchange position in DM will be zero because it has sold the same

amount forward.

3.3.3 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 exchange’s clearing house (see chapter 8).

3.3.4 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 8)

3.4 Participants

3.4.1 Commercial banks

Commercial banks participate in the foreign exchange market by: o Offering to buy and sell foreign exchange on behalf of their customers

(retail or wholesale) as a standard financial service; o Trading in foreign exchange as intermediaries and market makers; o Managing their own foreign exchange positions via the interbank

foreign exchange market. The interbank 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 the foreign exchange markets.

3.4.2 Non-bank financial institutions

Institutional investors, insurance companies and managers of pension,

money, mutual and hedge funds directly participate in the foreign exchange market generally in pursuit of a more global approach to portfolio management.

44

3.4.3 Firms and corporations

Firms and corporations buy and sell foreign exchange because they are in

the process of buying or selling an asset, product or service. They are increasingly entering the foreign exchange market directly and not via

intermediaries especially if they own factories and plants or regularly buy components abroad.

3.4.4 Central banks

Central banks sometimes intervene in the foreign exchange market to

increase or decrease the supply of their currency or to purposely affect the exchange rate. In addition central banks act as their government’s international banker and handle the foreign exchange transactions for the

government and public sector enterprises such as the post office, railways and airlines.

45


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?

46


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 R6.4941-6.4961 (i.e., 6.4340+(601/10000) and

6.4350+(611/10000))

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.

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4 The money market


o To define the money market; o To sketch the characteristics of the money market; o To outline the definition, denomination, maturity, quality and market

participants - issuers (or borrowers) and investors - of money market instruments.


The money market is defined as that part of the financial market that deals

in instruments with maturities ranging from one day to one year – the most common maturity being 3 months.

4.2 Characteristics

Money market instruments are not traded on a formal exchange but over-the-counter (OTC). The market has no specific location - it is centred in the large financial centres of the world – with most transactions being

made by telephone or electronically.

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.

Central banks are key participants in the money market. The money market is essential for the transmission of monetary policy (see 2.4.2). Central banks control the supply of reserves available to banks primarily

through repurchase agreements (see 4.4) or the outright purchase and sale of money market instruments such as treasury bills.

4.3 Instruments

The following money market instruments will be addressed: bankers acceptances, commercial paper, negotiable certificates of deposits (NCDs) treasury bills and repurchase agreements. In each case the following will

be considered: definition, denomination, maturity, quality and market participants - issuers (or borrowers) and investors.

48

4.3.1 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 financing to from the bank to.

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.

Denomination A wide range of denominations are available but acceptances are usually issued in multiples of

R100 000 and R1million

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 o Simplicity

o It is a cheaper form of financing for the company than a bank overdraft

Disadvantages o A bank line of credit is required and the bank may require security or collateral

o Borrowing via BAs is more expensive than by

means of commercial paper (see 4.3.2). 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 o 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.

o A liquid secondary market generally exists

49

Disadvantages o 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 (see

4.3.3) of the same maturity o Large denominations are unattractive to investors

4.3.2 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 includes: o short-term secured or unsecured promissory notes with a fixed or

floating maturity;

o call bonds; o any other secured or unsecured written acknowledgement of debt

issued to acquire working capital; and o debentures or any interest-bearing written acknowledgement of debt

issued for a fixed term in accordance with the provisions of the

Companies Act, 1973 such as bonds; and excludes bankers’ acceptances.

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.

4.3.2.1 Promissory notes

Definition 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.

Denomination PNs are issued in multiples of R100 000 and R1m

Maturity PNs are usually available for 3, 6, 9 and 12 months and every 6 months thereafter up to 60 months

depending on the programme

Quality Obligation of the issuer (borrower)

Issuers Issuers are usually companies.

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Advantages o It is a cheaper form of financing for the company

than a bank overdraft o The maturity of a PN can be tailored to meet the

company’s funding requirements and / or to take

advantage of investor demand

Disadvantages o 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

o For a viable commercial paper market, access to or establishment of rating agencies is essential.

Investors Banks, pension funds, insurance companies and individuals

Advantages o PNs have a wide range of maturities to enable investors to find an instrument that best suits their requirements

o A liquid secondary market generally exists

Disadvantages o Investors are exposed to credit risk i.e., that the

issuer will fail to perform as promised

4.3.2.2 Call bonds

Definition A call bond is a loan made to the issuer (borrower) by

the investor (lender), which may be terminated or "called" at any time

Denomination Call bonds are usually issued in multiples of R1million, R5million and R10million

Maturity Call bonds are repayable on demand

Quality Obligation of the issuer (borrower)

Issuers The borrower is usually a company. Banks are also issuers of call bonds

Advantages o A call bond is a flexible form of financing in terms of arranging, drawing down and repaying the loan

Disadvantages o A call bond can be expensive when compared to other loans;

o Call bonds are exposed to sharp movements in interest rates, which is unfavourable when rates are rising.

Investors Banks, money market funds, pension funds, insurance companies and individuals

Advantages o Call bonds are immediately redeemable o A liquid secondary market generally exists

Disadvantages o Investors are exposed to credit risk i.e., that the obligor will fail to perform as promised

o Large denominations are unattractive to investors

4.3.3 Negotiable certificates of deposit (NCD)

Definition An NCD is a negotiable fixed deposit receipt issued by

a bank for a specified period at a stated rate

Denomination NCDs are issued in multiples of R1million

Maturity From less than one year to up to five years

Quality Obligation of the issuing bank

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Issuers Banks

Advantages o Generally cheaper than instruments in the inter-bank market

Disadvantages o More expensive than retail deposits

Investors Wide range of institutions: banks, private and public

corporations, pension funds, insurance companies, money market funds, hedge funds, mutual funds,

pension funds and individuals

Advantages o Active secondary market so the instruments are liquid and relatively risk free

o Banks are willing to tailor maturities to meet the needs of investors

Disadvantages o Large denominations are unattractive to investors o 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

4.3.4 Treasury bills

Definition A treasury bill (TB) is short-term debt obligation of

the government payable on a certain future date

Denomination TBs are issued in multiples of R10 000,00 and for an

amount not less than R100 000

Maturity A tenor of between 90 days and 6 months; Special

tender bills have tenors of up to one year

Quality TBs are obligations of the government and are thus

considered to be free of credit risk

Issuer The government

Advantages o Main vehicle for central bank accommodation policy

Investors Mainly held by banks - also held by insurance companies and money market funds, hedge funds,

mutual funds and pension funds

Advantages o TBs are considered to be free of credit risk

o 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

o A liquid secondary market exists

Disadvantages o Because Treasury bills are considered to be free of credit risk, they have a lower yield than other

money market instruments o Large denominations are unattractive to investors

4.3.5 Repurchase agreements (repo)

Definition A 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

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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.

Denomination Depends on the security

Maturity Overnight to 30 days and sometimes longer

Quality Obligation of the issuer with collateral usually in the

form of high-quality securities such as treasury bills

Issuers 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.

Advantages o Repos can be used to borrow short-terms funds, to finance positions and to cover short positions at

an acceptable cost

Disadvantages o 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

Investors A variety of investors including mutual and hedge funds

Advantages o If the collateral is treasury bills, investors earn a risk-free rate higher than the treasury bill rate

without sacrificing liquidity

Disadvantages o 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.

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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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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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5 The bond and long-term debt market


o To define the capital market; o To sketch the characteristics of the bond and long-term debt market; o To outline the definition, denomination, maturity, quality and market

participants - issuers (or borrowers) and investors - of bond and long-term debt market instruments.


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 fall under the capital market definition.

5.2 Characteristics

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. The Bond Exchange of South

Africa regulates the South African government and corporate bond market.

5.3 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.

5.3.1 Bonds

Definition 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

56

or public enterprises e.g., Eskom they are called

semi-gilt stock

Denomination Bonds are usually issued in multiples of R1million.

Maturity Usually the maturity of a bond is between 1 and 30 years

Quality 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

Issuers The government, public corporations, local authorities, companies and banks

Advantages o The interest cost of fixed-rate bonds is fixed over the life of the bond

Disadvantages o If market rates fall after the bond has been issued, the issuer may be locked into paying

interest rates above market rates

Investors Banks, insurance companies, hedge, mutual and

pension funds, trust companies

Advantages o A large selection of bonds e.g., in terms of quality

and maturity, is available to investors o Bonds are a good addition to an investor’s portfolio

because they are less volatile than equities in the

short- to medium-term o There is a liquid secondary market

o 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 visa versa. This gives investors an opportunity for capital

gains.

Disadvantages o Investors can incur capital losses if interest rates

increase o 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 o Large denominations are unattractive to small

investors

5.3.2 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

57

representatives of the debenture-holders setting out

the rights of individual debenture holders. Debentures can be secured, redeemable, convertible,

callable, variable-rate and profit sharing.

Denomination Debentures are usually issued in multiples of

R1million

Maturity May range from in excess of 5 years up to 30 years

Quality Obligation of the issuer

Issuers Companies

Advantages o The interest cost of a debenture is fixed over the life of the debenture. This assists in planning and

budgeting for capital projects o 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.

Disadvantages o 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

Investors Mainly insurance companies and hedge, mutual and pension funds

Advantages o 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.

Disadvantages o 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

o Investors are exposed to credit risk i.e., that the


investors

5.3.3 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 pre-determined

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.

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FRNs are also known as variable-rate bonds

Denomination FRNs are usually issued in multiples of R1million



Issuers The government, public corporations, local

authorities, companies and banks

Advantages o 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

Disadvantages o 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

Investors Mainly insurance companies and hedge, mutual and

pension funds

Advantages o Coupons are adjusted to reflect general

movements in interest rates which gives investors protection against significant capital losses in periods of interest rate uncertainty

o 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)

Disadvantages o Less opportunity for capital gains than with fixed-rate investments

o 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. o Unless the FRN is issued by the government

investors are exposed to credit risk i.e., that the


investors

5.3.4 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 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).

Denomination Zero-coupon bonds are usually issued in multiples of

R1million. Zero-coupon bonds derived from a strip may be less than R1million


59


Issuers The government, public corporations, local authorities, companies and banks

Advantages o 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

Disadvantages o 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

Investors Mainly insurance companies and hedge, mutual and

pension funds

Advantages o Because there is no coupon to reinvest, a zero-

coupon bond does not have reinvestment risk. This is beneficial when interest rates are falling

o 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

Disadvantages o Tax legislation may negatively impact the

attractiveness of zero-coupon 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).

o Because there is no coupon to reinvest, a zero-coupon bond does not have reinvestment risk. This

is unfavourable when interest rates are rising o 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

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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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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 profit-sharing.

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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6 The equity market


o To define the equity market; o To sketch the characteristics of the equity market; o To outline the feature of equity market instruments;

o To describe the participants in the equity market.


The equity market is part of 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.

Equities, also known as shares or stock, represent a residual claim against the assets of a company after obligations to creditors and bondholders

have been met. Shares in the equity capital of a company that entitle shareholders to all profits after commitments to preference shareholders

(see 6.3.2) as well as creditors and bondholders have been met are known as ordinary shares or common stock. Ordinary shareholders are entitled to choose the company’s board of directors that appoints the

managers of the company.

A private (proprietary) limited company is a company with no more than 50 owners or shareholders. The shares in the company may not be transferred without the consent of all shareholders. A public limited

company can have an unlimited number of shareholders. The shareholders of both private and public limited companies have limited

liability and will lose only the amount of money they invested in the company if it goes into liquidation. In the US a public limited company is identified by the abbreviation Inc. after its name, in the UK by Plc. and in

South Africa by Ltd.

Only the shares of public limited companies may be sold to the general public via a listing on a stock exchange.

6.2 Characteristics

Stock exchanges are organised markets for buying and selling shares. Not

all shares are traded on exchanges – some trade over-the-counter.

A distinction should be drawn between primary and secondary equity markets. The primary market is where new share issues are sold while secondary markets are where previously issued shares are bought and

sold.

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There are two types of new share issues: o Seasoned issues: for companies that already have publicly traded

shares and o Initial public offerings (IPOs) 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 and Boston in the US, Osaka and Nagoya in Japan and Dublin in Ireland. Only

qualified shares can be traded on stock exchanges and only by members of the exchange.

Stock exchanges can have one or a combination of the following trading systems:

o Order-driven or auction markets where 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

Securities Exchange and most US securities exchanges are order-driven; and

o Quote-driven or dealer markets where 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-driven and quote –driven system – its more liquid shares are traded on its order-

driven system.

6.3 Instruments

The following equity market instruments are discussed: ordinary shares,

preference shares, depository receipts and exchange traded funds.

6.3.1 Ordinary shares

The most important characteristics of ordinary shares are: o 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;

o 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;

o 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

64

additional 100 shares Rex has the right to purchase 10% or 10 of the new shares issued to maintain its 10% interest in Blob;

o Limited liability: the most ordinary shareholders can lose if a company is wound up is the amount of their investment in the company.

Returns to ordinary shareholders consist of: o Dividends: dividends are a portion of the company’s profits. They are

not guaranteed until declared by the board of directors; o Capital gains (losses): capital gains (losses) arise through changes in

the price of a company’s shares. A company’s 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 risks ordinary shares have for investors are: o 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; and

o Ordinary shareholders are the last to recover any value on their shares should the company be wound up.

6.3.2 Preference shares

Preference shares carry preferential rights over ordinary shares in terms

of entitlement to receipt of dividend as well as repayment of capital in the event of the company being wound up.

Preference shares offer holders a fixed dividend each year (unlike ordinary shares). For example if company has issued 40 000 preference shares at a

par value of R20 and dividend of 7% p.a. the preference share dividend paid by the company will be R56 000 i.e., 40 000 x R20 x 7%. This is not

necessarily guaranteed (see non-cumulative preference shares below). Preference shareholders receive their payment before ordinary shareholders. They do not carry voting rights.

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 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 they are perpetual claims and

subordinate to bonds in terms of seniority i.e., in the event of liquidation of the company preference shareholders are treated as creditors of the company with their claim on assets being ahead of ordinary share

shareholders but behind debt holders.

65

There are a number of types of preference shares: o Cumulative: dividend is cumulated if the company does not earn

sufficient profit to pay the dividend i.e., if the dividend is not paid in one year it will be carried forward to successive years;

o 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; o Participating: participating preference shares, in addition to their fixed

dividend, share in the profits of a company at a certain rate; o Convertible: apart from earning a fixed dividend, convertible

preference shares can be converted into ordinary shares on specified

terms; o Redeemable: redeemable preference shares 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.

6.3.3 Depository receipts

To reach a wider international investor base, ordinary share issues have

been packaged into depository receipt form. The most common is the American depository receipt (ADR) that is traded in New York either on one

of the exchanges or on the National Association of Securities Dealers Quotations system (NASDAQ). The shares are purchased by a US investment bank or broker and then held in trust with a US trustee bank

which issues the ADRs to acknowledge that it holds the underlying shares. The investment bank or broker then sells the ADRs to US investors. The

trustee bank collects the dividends and makes payments to the holders of the ADRs. Prices and dividends are in US dollars.

European depository receipts (EDRs) make share issues available to investors in the Euromarkets. Global depository receipts (GDRs) access

Euromarkets in the same way as EDRs but in addition have a US or ADR element.

6.3.4 Exchange traded funds

An exchange-traded fund (ETF) is a traded financial instrument

representing ownership in an underlying portfolio of securities. Investors are able to buy and sell shares of ETFs on an exchange in the same way they would any other listed share. The prices of ETFs fluctuate at once in

response to changes in their underlying portfolios. The continuous pricing of ETFs is important in that ETFs offer the same intra-day liquidity as

other securities that trade on major exchanges. ETFs were first introduced in Canada in 1990 where they are known as

Tips tracking the Toronto Stock Exchange top 60 index. The history of ETFs in the United States dates back to 1993 when the American Stock

Exchange (AMEX) listed an ETF nicknamed Spiders that tracked the S&P500. By June 2005 there were 180 EFTs listed in the United States with assets of USD244 billion under management.

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Currently (June 2005) there are 369 ETFs on the global exchanges with about USD336 billion in assets, comprising not only stocks and bonds but

also currencies and commodities.

In November 2000 the JSE launched its first ETF - Satrix 40 that tracks the top 40 companies listed on the JSE. In 2002 two other ETFs were introduced: Satrix Fini, which tracks the top 15 financial shares, and

Satrix Indi, which lists the top 25 industrial shares. In 2003 Absa Bank introduced an ETF based on the NewRand Index. The NewRand Index

comprises 10 Rand hedge shares selected from the FTSE / JSE top 40 index. In 2004 ABSA Bank launched NewGold –a gold ETF. NewGold Gold Bullion Debentures are securities backed by gold-bullion listed on and

traded through the JSE. Each NewGold Debenture is initially valued at 1/100 of one fine troy ounce of gold.

In South Africa five ETFs are currently (September 2005) listed on the JSE - the three Satrix products (Satrix40, Satrix Fini and Satrix Indi) and the

two Absa products (NewRand and NewGold).

The advantages of ETFs for investors include: o Access to a wide variety of sectors and indexes;

o Ability to track an entire market segment; o Diversification in that investors are not be impacted by market

downturns to the same extent as they would be if they held only a few

individual shares; o Lower annual management fees. ETF transactions still attract

brokerage commissions.

6.4 Participants

The major participants in the equity market are:

6.5 Issuers: Limited public companies

Equity represents ownership in a company.

Generally sole traders and partnerships constitute the majority of businesses in the private sector of an economy. However limited

companies account for the largest part of economic activity.

Limited companies differ from sole traders and partnerships in that ownership and management of the business are separated. Ownership is in the hands of shareholders that have the right to appoint the board of

directors. Directors select the managers of the firm to run the business. The directors have to report to shareholders at least annually on the

performance of the managers.

In theory ownership and control of the company ultimately rest with the shareholders. In practice because shareholders as owners are so widely dispersed, managers may effectively control the firm.

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Important features of limited companies are: o Shareholders 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;

o The liability of owners for the debts of the company is limited to their investment in the firm i.e., if the company is wound up the maximum shareholders can lose is the amount paid for the shares;

o Companies have a legal existence separate from their owners i.e., they can sue and be sued;

o Long-term business continuity i.e., life of the company is independent of the owners’ lives.

The most important types of limited companies are: o Public limited companies: the shares of public limited companies are

listed (quoted) on and sold to the general public via stock exchanges. o Private limited companies: the shares of private limited companies

cannot be sold on the stock exchange and without the approval of

other shareholders and without first offering them to existing shareholders.

6.5.1 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.

6.5.2 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.

6.5.3 Investors

There are several types of investor:

o 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; o Companies could own more than 50% of a company’s 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; o Asset or investment management firms advise and administer pension

and mutual funds on behalf of the funds stakeholders – individuals, firms and governments;

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o 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, fire; o Pension and retirement funds invest the contributions of employees

and employers in assets such as shares; o Mutual funds are portfolios of assets such as shares, bonds, money

market instruments bought in the name of a group of investors. Mutual

funds 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.

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1. What does equity (or shares or stock) represent?

2. Discuss the two types of new share issues.

3. Describe secondary equity markets. 4 Differentiate between order-driven and quote-driven markets.

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 Describe the features of American Depository Receipts.

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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: � Seasoned issues: for companies that already have publicly traded shares

and � 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 Order-driven markets are markets where 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. Quote-driven markets are market where

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.

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 American Depository Receipts (ADRs) are traded in New York either on one of the exchanges or on the National Association of Securities Dealers Quotations system (NASDAQ). The shares underlying an ADR are purchased by a US

investment bank or broker and then held in trust with a US trustee bank which issues the ADR to acknowledge that it holds the underlying shares. The investment bank or broker then sells the ADR to US investors. The trustee bank collects the dividends and makes payments to the holders of the ADR. Prices

and dividends are in US dollars.

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7 The derivatives market


o To define the derivatives market; o To sketch the characteristics of the derivatives market; o To outline the features of derivative instruments;

o To describe the participants in the derivatives market.


Derivatives are financial instruments that derive their value from the values of other underlying variables.

These variables can be underlying instruments in the cash market

(equity, money, bond, foreign exchange and commodities markets) as well as the derivatives market. For example: o A currency option is linked to a particular currency pair in the foreign

exchange market, o A bond futures is linked to a certain bond in the bond market,

o An agricultural futures is linked to maize or wheat in the commodities market and

o An option on a bond futures is linked to a bond futures trading in the

derivatives market.

Derivatives can be based on almost any variable – from the price of electricity (electricity derivatives), the weather in London (weather derivatives), the credit-worthiness of Anglo American Plc (credit

derivatives) to the amount of hurricane insurance claims paid in 2003 (insurance derivatives).

Derivatives are also referred to as contingent claims – the value of the claim being contingent or dependent on the value of the underlying

variable.

7.2 Characteristics

Derivatives can be privately negotiated over-the-counter or traded on

organised exchanges such as SAFEX (South African Futures Exchange -a division of the JSE Securities Exchange), LIFFE (London International Financial Futures and Options Exchange) and the Chicago Board of Trade.

The two organisations that make up an organised derivatives market are

the exchange and its clearinghouse. In South Africa most derivatives contracts trade on the South African Futures Exchange. It has its own clearinghouse – 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

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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.

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 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.

7.3 Instruments

Derivatives can be grouped under three general headings: o Forwards and futures; o Options; and

o Swaps.

7.3.1 Forwards and futures

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.

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.

Forwards and futures are similar instruments. However there are four

main characteristics specific to futures contracts that distinguish them from forward contracts:

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o Futures contracts are traded on organised exchanges while forwards trade over-the-counter;

o 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; o With futures contracts performance is guaranteed by the futures

exchange’s 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; and

o Futures contracts are marked-to-market i.e., valued at current market prices on a daily basis.

A payoff diagram indicates the possible value of a derivatives position given changes in the underlying. Figure 7.1 shows the payoff diagram for

a long and short forward position in US dollars. The contracts are purchased for R9.70. For the long (short) position, the upward (downward) sloping line indicates the profit or loss of the buyer (seller) of

the forward at expiration of the contract. If the price of $1 at expiration is R9.40 i.e., the rand strengthens, the seller will make R0.30 profit and the

buyer R0.30 loss. If the price is R9.90 at expiration, the buyer will make R0.20 profit and the seller R0.20 loss.

7.3.2 Options

An option contract conveys the right to buy or sell a specific quantity of an underlying asset (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:

o 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;

Figure 7.1: Payoff diagram for a long and short forward

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

8.7

8.8

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9.0

9.1

9.2

9.3

9.4

9.5

9.6

9.7

9.8

9.9

10.0

10.1

10.2

10.3

10.4

10.5

10.6

10.7

Price of underlying asset (USD)

Profit / loss

Long positionShort position

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o 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.

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 option’s 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.

The payoff diagrams in figures 7.2 to 7.5 show the profits/losses of four basic option positions held to expiration and plotted in relation to the price

of the underlying asset or derivative. The underlying asset is a share. The strike price of the option is R100 and the option price or premium is R5.

Diagram 7.2 shows the position of the buyer of a call – a long call. 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 (R5).

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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 7.3 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. 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 7.2: Payoff diagram for a long call option

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0

5

10

15

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25

30

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Price of underlying

Profit/loss

Strike price R100

Breakeven R105

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The position of the buyer of a put - a long put position - is shown in figure 8.4. 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.

The position of the put seller - a short put position - is illustrated in figure 7.5. It is the mirror image of the put buyer's position. The maximum gain to

Figure 7.3: Payoff diagram for a short call option

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0

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15

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Price of underlying

Profit/loss

Strike price R100

Figure 7.4: Payoff diagram for a long put option

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-5

0

5

10

15

20

25

30

70 75 80 85 90 95 100 105 110 115 120 125 130 135 140 145 150 155 160

Price of underlying

Profit/loss

Strike price R100

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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.

Many different forces in the market affect option prices. In general the

effects of changing market conditions on the values of options are:

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

* Volatility of the price of the underlying as well as the volatility of that volatility

7.3.3 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

Figure 7.5: Payoff diagram for a short put option

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-5

0

5

10

70 75 80 85 90 95 100 105 110 115 120 125 130 135 140 145 150 155 160

Price of underlying

Profit/loss

Strike price R100

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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.

7.3.3.1 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, since the periodic

payments - interest - are also in the same currency, only the interest differential, assuming matching payment dates, needs to be exchanged.

The original interest-rate swap structure, now called the plain-vanilla or coupon swap, is a fixed-for-floating 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 uses for interest rate swaps are to reduce the cost of financing and to hedge interest-rate risk.

(i) Reducing the cost of financing

For an interest rate swap to be viable as a tool for reducing financing costs relative advantages must exist i.e., one party must have access to

comparatively cheap fixed-rate funding but desire floating-rate funding and the other party must have access to relatively cheap floating-rate funding but requires fixed-rate funding.

For example, assume companies AAA and BBB make use of both short- and

long-term debt financing. Company AAA can borrow from banks at 6-month JIBAR plus 0.25% while company BBB pays 6-month JIBAR plus 0.50%. In the debt market, the differential between the two companies is 1% for a 5-

year bond - company AAA pays 13.50% p.a. while company BBB pays 14.50%. Company AAA wishes to lower the cost of its short-term financing

and company BBB the cost of its 5-year financing. A bank arranges: a loan for Company BBB at 6-month JIBAR + 0.50%; the issue of a 5-year bond paying coupons semi-annually by company AAA at 13.50% p.a. and a swap

transaction maturing in 5 years. In terms of the swap transaction - every 6-months - company AAA receives fixed 13.50% and pays floating 6-month

JIBAR while company BBB receives floating 6-month JIBAR and pays fixed 13.75%. The result of these transactions is shown in figure 7.6.

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The effect of the transactions is that:

o Company AAA borrows at 6-month JIBAR instead of 6-month JIBAR plus 0.25%;

o Company BBB borrows 5-year money at 14.25% (i.e., 13.75% + 0.50%) instead of 14.50%; and

o The bank has locked in a profit of 0.25% p.a.

For simplicity, the example has assumed a coincidence of requirements.

However, in reality, the bank will need to accept the risk of mismatched notionals until appropriate counterparties can be found.

(ii) Hedging interest-rate risk

Interest-rate swaps are useful tools for hedging interest-rate risk. For example, suppose company XYZ has a R10million 7-year fixed-rate asset yielding 14.00% p.a. payable half-yearly funded with R10million floating-

rate debt with semi-annual interest payments based on 6-month JIBAR. As the asset has a fixed yield while the cost of the liability re-prices every 6

months, company XYZ 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 XYZ enters into a 7-year swap agreement with a bank. In terms of the swap – every six months – company XYZ pays fixed 13.25% p.a. and receives floating 6-month JIBAR. This is shown in figure 7.7 on the next

page.

Company XYZ has effectively obtained a 13.25% 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 0.75% for the 7-

year period regardless of interest-rate fluctuations.

Debt market13.50%

13.50%

Figure 7.6: Reducing the cost of financing

Company AAA Bank Company BBB

13.75%

6-month JIBAR + 0.50%

6-month JIBAR 6-month JIBAR

Debt market13.50%

13.50%



13.75%

6-month JIBAR + 0.50%

6-month JIBAR 6-month JIBAR

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7.3.3.2 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 plain-vanilla fixed-for-floating currency swap involves three distinct sets of

cash flows: o The initial exchange of principals on commencement of the swap; o The interest payments made by each counterparty to the other during

the tenor of the swap; and o 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.

The most important uses for currency swaps are to reduce the cost of financing and hedge exchange rate risk.

(i) Reducing the cost of financing

The use of currency swaps to reduce financing costs requires one counterparty to have comparatively cheaper access to one currency than it

does to another currency.

Asset

14.00%

13.25%

Figure 7.7: Hedging interest-rate risk

Company XYZ Bank

6-month JIBAR

6-month JIBAR

Liability

Asset

14.00%

13.25%

Figure 7.7: Hedging interest-rate risk

Company XYZ Bank

6-month JIBAR

6-month JIBAR

Liability

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Debt market


Borrows R90m at 10.40% Borows $10m at 7.40%

$10m

R90m

$10m

R90m

Exchange of principals

Debt market


10.40% p.a. rand 7.40% p.a. dollars

7.40% p.a. dollars

10.40% p.a. rand 10.70% p.a. dollars

Exchange of interest


7.20% p.a. dollars

For example, assume two multinational companies AAA and BBB are seeking funding with 5-year new debt issues. Company AAA has a higher credit rating than company BBB. Their respective per annum cost of issuing

debt is 10.40% and 10.80% in South Africa and 7.30% and 7.40% in the United States. Company AAA wishes to borrow in dollars and company BBB

in rand. Both want fixed-rate financing. Company BBB would have to pay 0.40% p.a. more than company AAA in rand whereas in dollars it would have to pay 0.10% p.a. more. Therefore Company BBB has a comparative

advantage over company AAA in borrowing dollars. By negotiating a currency swap via Bank XYZ with a principal of R90million or $R10million

(an exchange rate of $1=R9 being assumed) an opportunity for lower-cost funding for both companies is created. The following rates are agreed:

company AAA will receive 10.40% p.a. fixed on R90million and pay 7.20% p.a. fixed on $10million; and company BBB will receive 7.40% p.a. fixed on $10million and pay 10.70% p.a. fixed on R90million. The result is illustrated

in figure 7.8 below – the first shows the exchange of principals and the second the exchange of interest.

Company AAA will pay 7.20% p.a. on its dollars – 0.10% p.a. less than it could obtain directly in the debt market. Company BBB will pay 10.70% p.a.

on its rand, also 0.10% less than in the debt market. Bank XYZ will make a loss of 0.20% p.a. on dollars but a profit of 0.30% p.a. on rand.

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(ii) Hedging exchange-rate risk

Currency swaps can be used to hedge the risk of losses from adverse exchange-rate movements. Exchange-rate risk can arise for example when:

o 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;

o 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.

7.3.3.3 Equity swaps

The plain-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 is 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. (i) 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 R400million with quarterly

payments. The bank prices the swap at 10,95% p.a. payable quarterly. The resultant cash flows are shown in figure 7.9.

Equityportfolio

Unit Trust BankALSI return

ALSI return

10.95%

Figure 7.9: Hedging equity positions

Equityportfolio

Unit Trust BankALSI return

ALSI return

10.95%

Figure 7.9: Hedging equity positions

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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.

(ii) 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. (iii) Benefiting from market imperfections

By circumventing market imperfections it is possible for a synthetic equity

portfolio created via a swap to outperform a ‘real’ equity portfolio. A dominant 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 a real 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.

7.4 Other derivatives

7.4.1 Exotic derivatives

The derivatives described thus far are sometimes called plain-vanilla or

standard derivatives. Non-standard derivatives – also known as exotic derivatives – can range from a simple combination of two or more plain-

vanilla derivatives to more complex financially-engineered instruments. A number of exotic derivatives (not required for examination purposes) are shown in annexure A.

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7.4.2 Credit derivatives

The value of credit derivatives depends on the creditworthiness of one or

more corporations, governments or public sector entities.

Credit derivatives permit the transfer of credit risk between parties in isolation from other forms of risk. Therefore they allow financial institutions such as banks to manage their credit exposures.

7.4.3 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.

7.4.4 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.

7.5 Participants

Participants in the derivatives market are hedgers, speculators or

arbitrageurs. Investors also use derivatives markets for income enhancement.

7.5.1 Hedgers

Hedgers are entities (investors, lenders, borrowers, producers,

manufacturers) that are exposed to the risk of adverse cash-market price movements and either:

o Eliminate 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; or o Pay 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.

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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.

7.5.2 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 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.

7.5.3 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 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.

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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 are the uses of currency swaps? 8 Explain how equity swaps can be used to hedge equity positions.

9. What does the value of insurance derivatives depend on?

10 Name the participants in the derivatives market.

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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

in South Africa are South African Futures Exchange (the exchange) and Safcom Safex Clearing Company (Pty) Ltd (the clearing house).

In South Africa most derivatives contracts trade on the South African Futures Exchange. It has its own clearinghouse – 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:

o Futures contracts are traded on organised exchanges while forwards trade over-the-counter;

o 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;

o With futures contracts performance is guaranteed by the futures exchange’s 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; and

o 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 is: o 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; o 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

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obligation to deliver 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 reduce the cost of financing and hedge

exchange rate risk.

8 Equity swaps can be used to hedge equity positions by converting volatile equity returns into stable fixed-income returns.

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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8 Collective investment schemes


o To define collective investment schemes;

o To describe the legal structure of collective investment schemes; o To explain the participants in the process of collective investment; o To categorise collective investment schemes according to fund type,

asset orientation, investment objective and locality; and o To debate the pros and cons of investing in collective investment

schemes.

8.1 Definition of 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. Whatever its legal form a CIS consists of:

o a pooling of resources to gain sufficient size for portfolio diversification and cost-efficient operation and

o professional portfolio management to execute an investment strategy.

8.2 Structure of collective investment schemes

Although the legal structures of CISs vary across the world, they generally take one of the following three basic forms:

o Corporate structure: In the corporate form, the CIS is a company, the principal objective of which is to invest in a portfolio of securities.

Investors become shareholders of the CIS by acquiring shares of the company. The company’s board of directors plays the central role in the governance of the fund.

o Trust structure: Under the trust form, the CIS is organised as a trust in which an identified group of assets is constituted and managed by

trustees for the benefit of the beneficiaries i.e., the investors. The investors own units of the trust. The trustees play the central role in the governance of the fund.

o Contractual structure: In the contractual form, investors enter into a contract with an investment management company, which agrees to

purchase a portfolio of securities and manage those securities on behalf of the investors. The investors own a proportional share of the portfolio. The depositary plays the central role in the governance of the

fund. In this model the operations of the CIS are outsourced to the investment management company.

8.3 Participants in the collective investment process

There are a number of participants in the process of collective investment. The main ones are outlined below.

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The investors entrust their savings to the CIS. CISs are not exclusively used by small investors. Sophisticated individual investors and

institutional investors also use CISs.

The CIS operator or manager (or investment management company in the contractual structure) handles administration, operations, marketing and sales of the CIS. The CIS operator has responsibility for operating the

fund in accord with: o the laws and regulations of the jurisdiction;

o the rules of the fund and o fiduciary duty to investors.

The portfolio manager is responsible for investing the pool of funds in accordance with the investment objectives and policy of the CIS.

The board of directors, trustee or depositary oversee the operations of the CIS and ensure good governance and fiduciary and regulatory compliance.

They ensure the protection of interests of CIS investors including the safekeeping of CIS assets.

The investment advisor may be delegated responsibility for investment

advice by the CIS operator.

8.4 Categories of collective investment schemes

For convenience, CISs have been categorised as either open-end funds, closed-end funds or other 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 brought 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.

Other funds can be open-end or closed-end funds.

The table below indicates the variety of names within these categories in South Africa (SA), United Kingdom (UK) and United States of America

(US).

Open-end funds Closed-end funds Other

SA o Unit trusts

o Open-ended investment

companies

SA o Investment

trusts

SA o Hedge funds

UK o Unit trusts o Open-ended

investment

UK o Investment trusts

UK o Life assurance investments

o Hedge funds

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companies

(OEICs) also called investment

companies with variable capital

(ICVCs)

US o Mutual funds US o Closed-end

funds

US o Unit

investment trusts

o Hedge funds Source: Financial Services Authority (www.fsa.gov.uk), US Securities and Exchange Commission (www.sec.gov)

Unit trusts are open-end funds with a trust structure.

OEICs or ICVCs are open-end funds with a corporate or contractual structure.

Mutual funds are open-end funds with a corporate or trust structure.

Investment trusts and closed-end funds are closed-end funds with a corporate structure.

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 pursuing leveraging and other speculative investment practices that may increase the risk of

investment loss. Life assurance investments are open-end funds made available by life

insurance companies through life assurance policies.

Unit investment trusts are open-end funds with a trust structure and limited duration.

8.5 Types of collective investment schemes

CISs may be further classified according to their asset orientation,

investment objective or locality.

8.5.1 Asset orientation

The following are examples of CISs classified according to their asset orientation:

Stock or equity funds invest primarily in shares and are geared towards

generating growth rather than income. Bond funds invest exclusively in bonds. Within bond funds there is further

specialisation according to currency, country and issuer.

Money market funds invest exclusively in money market securities.

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Participation bond funds invest in first mortgage bonds over commercial or

industrial property.

Property funds invest mostly in property shares, Real Estate Investment Trusts (REITs) invest exclusively in real estate and

related securities such as mortgage-backed securities.

Fund-of-Funds invest in other funds to increase diversification and reduce the fund’s overall risk profile.

8.5.2 Investment objective

The following are examples of CISs classified according to their

investment objectives: Balanced funds aim to balance income, growth and risk. This is generally

done by balancing the mix of asset classes and risk profiles in which the fund is invested.

Growth funds have as their primary investment objective the

maximisation of the value of invested capital. Consequently they invest in securities that have the potential for large capital gains i.e., they invest in growth stocks.

Income funds aim to increase the value of investments, via dividends,

current interest income or short-term capital gains. Index funds aim to mirror or track the performance of a particular market

index. Index funds are also known as tracker funds.

8.5.3 Locality

The following are examples of CISs classified according to their locality:

Domestic funds invest in securities originating from a single country, which is generally the country in which the fund is domiciled.

Global funds have their assets invested in all major financial markets.

International funds invest in securities outside the country in which the investor is domiciled.

Offshore funds are legally established outside the country which the investor is domiciled. Popular offshore fund locations are Bermuda,

Luxembourg, Ireland and the Channel Islands.

8.6 Advantages and disadvantages of investing in CISs

Collective investments 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

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investment strategies. In other words, the main benefits of pooled investments are:

o Diversification i.e., spreading the risk of investing over a range of investments;

o Professional expertise to manage investors’ portfolios; o Reasonable cost due to reduced dealing costs due to bulk transacting

and cost-effective administration; and

o 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:

o 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;

o Although investors have a large variety of funds to choose from, they have no control over the choice of individual holdings within their

portfolios; and o 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

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Questions for chapter 8 1 What is a collective investment scheme?

2 Although the legal structures of CISs vary across the world, they generally take one of three basic forms. Name these.

3 Who plays the central role in the governance of a fund with a

corporate structure?

4 Complete the table below by ticking the appropriate cell:

Open-end

fund

Closed-

end fund

Corporate

structure

Trust

structure

Unit trust


Open-end

fund

Closed-

end fund

Corporate

structure

Trust

structure

OEIC


Open-end

fund

Closed-

end fund

Corporate

structure

Trust

structure

Mutual fund

7 Name three CISs classified according to their asset orientation.

8 What investment objective does a growth fund have?

9 List the advantages of investing in CISs. 10 What are the disadvantages of investing in CISs?

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Answers for chapter 8 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. Whatever its legal form a CIS consists of:

o a pooling of resources to gain sufficient size for portfolio diversification and cost-efficient operation and

o professional portfolio management to execute an investment strategy.

2 The three basic forms are corporate structure, trustee structure and contractual structure.

3 The company’s board of directors plays the central role in the governance of the fund.

4 Open-end

fund

Closed-

end fund

Corporate

structure

Trust

structure

Unit trust √ √

5 Open-end

fund

Closed-

end fund

Corporate

structure

Trust

structure

OEIC √ √

6 Open-end

fund

Closed-

end fund

Corporate

structure

Trust

structure

Mutual fund √ √ √

7 Three CISs classified according to their asset orientation are equity funds, bond funds and money market funds.

8 Growth funds have as their primary investment objective the maximisation of the value of invested capital. Consequently they invest in securities that have the potential for large capital gains i.e., they invest in

growth stocks.

9 The advantages are diversification, access to professional expertise,

reasonable cost, large and increasing choice of funds and a set of legal, institutional and market-based safeguards to protect the interests of investors.

10 The disadvantages of investing in CISs are: o Costs in respect of funds management and advice could be avoided if

investors managed their own investments.

o no control over the choice of individual holdings within their portfolios; and

o 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

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9 Portfolio management

Chapter learning objectives: o To define the portfolio management process; o To 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.

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. The objective of this chapter is to describe this process.

9.1 The portfolio management process defined

A portfolio is the combination of all an investor’s 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 investor’s holdings is important because:

o When added to a portfolio of assets, the risk of an individual asset may be diversified away;

o Economic fundamentals such as inflation, interest rates and the level of economic activity affect the returns of many assets. To appreciate the risk and return prospects of an investor’s total position, it is necessary

to understand the interrelationships between individual assets .

The portfolio management process (see figure 8.1) is an integrated, consistently-applied, three-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.

9.2 The portfolio management process

The steps in the portfolio management process are:

• Plan the portfolio,

• Develop and implement portfolio strategy,

• Monitor the portfolio; and

• Adjust the portfolio.

The process is shown in figure 8.1 on the next page.

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9.2.1 Plan the portfolio

(i) 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 investor’s 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 visa 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.

An investor’s risk objective is a function of both the investor’s ability and willingness to assume risk. When the investor’s ability and willingness to

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assume risk should be consistent – if not, the investor’s willingness to take risk will need to be re-assessed (see table 8.1).

Table 8.1: Interaction between willingness and ability to take risk

Willingness to take risk Ability to take risk

Low High

Low Low risk tolerance Re-assess willingness

to take risk

High Re-assess willingness

to take risk High risk tolerance

Source: Maginn and Tuttle, 1990

Constraints are limitations such as liquidity, time horizon, taxes and

regulatory issues that restrict the investor’s 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.

(ii) Develop the investment policy statement

Once the objectives, constraints and preferences of the investor have been established, the investment policy statement is created. 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 clearly states 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 and requirements and any circumstances or preferences unique to the investor.

An investment policy statement is important because:

o The investor is better able to recognize the appropriateness of any investment strategy implemented by the investment manager;

o It ensures investment continuity because it is portable and can easily

be understood by other investment managers; o It is a document of understanding that protects both the investor and

investment manager. If manager execution or investor directions are questioned, the policy statement can be referred to for clarification.

Depending on the complexity of the investor’s 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.

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(iii) 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 investors’ objectives and constraints to formulate an appropriate strategic asset allocation. If capital market expectations are recogniz, the selected

strategic asset allocation should achieve the investor’s return objectives with an acceptable level of risk.

(iv) 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 investor’s objectives and constraints.

Typically each set is expressed in terms of the percentage of total value

invested in each asset class. Table 8.2 shows examples of possible asset allocations.

Table 8.2: Example of asset allocation alternatives

Asset class Projected total return

Expected risk (standard Deviation)

Asset allocation

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 0 30 Large-cap shares 15.0% 13.5% 30 35 30

Small-cap shares 18.5% 15.3% 20 0 10

Total 100 100 100

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.

9.2.2 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.

(i) Select the investment strategy

Portfolio strategies can be either active or passive strategies:

o 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.

o An active investment strategy seeks returns in excess of a specified benchmark. Investors who believe in active management do not follow

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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.

(ii) Formulate the inputs for portfolio construction

Passive strategies involve minimal expectational input.

Active strategies require specification of expectations about the factors that influence the performance of an asset class. This involves three

tasks: • Forecasting the factors such as interest rates, exchange rates, credit

spreads, market volatility, which are expected to impact the

performance of the portfolio; • Extrapolating market expectations from market data i.e., determining

the market’s consensus of future rates. Examples would be determining forward interest rates given the yield curve and

establishing an issue’s expected credit rating from the credit spread trading in the market; and

• Using forecasted and market-derived values to establish the relative

value of securities. Relative value refers to the ranking of securities in terms of their expected future risk / return performance.

(iii) 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.

9.2.3 Monitor the portfolio

Once constructed, the portfolio should be monitored to assess progress

towards the achievement of the investor’s objective. Monitoring a portfolio has two components: performance measurement and performance evaluation.

• Performance measurement indicates how well the investment manager is performing relative to the investor’s objectives and entails

calculating the rates of return for the portfolio achieved by the investment manager over a specific time interval; and

• Performance evaluation establishes:

� If the investment manager added value by outperforming the established benchmark and

� How the investment manager achieved the calculated return. This is done through portfolio attribution, which determines the sources of the portfolio’s 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).

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9.2.4 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

investor’s objectives and constraints. Once the desired portfolio is constructed, the following could motivate revising it: • Changes in the investor’s objectives as a result of changes in the

investor’s circumstances; and • Changes in capital market expectations.

Portfolio adjustments may be required without any changes to expectations or the investor’s situation. For example due to asset price

changes, the portfolio’s 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.

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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 investor’s asset holdings?

4 What is an investor’s 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?

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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 investor’s asset

holdings because: o When added to a portfolio of assets, the risk of an individual asset

may be diversified away; o To appreciate the risk and return prospects of an investor’s total

position, it is necessary to understand the interrelationships

between individual assets

4 An investor’s risk objective is a function of both the investor’s ability and willingness to assume risk.

5. It is important to draw up an investment portfolio statement for an investor because:

o The investor is better able to recognize the appropriateness of any investment strategy implemented by the investment manager;

o It ensures investment continuity because it is portable and can easily be understood by other investment managers;

o 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 investor’s 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

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measurement and performance evaluation

10 Once the desired portfolio is constructed, the following could motivate revising it: changes in the investor’s objectives as a result of changes

in the investor’s circumstances; and changes in capital market expectations.

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10 Appendix A: Exotic derivatives

No attempt will be made to discuss all the available exotics derivatives, merely to outline a few innovations grouped under the headings forwards, options and swaps.

1. Forwards 1.1 Range forward contract

The range forward contract is a forward foreign exchange contract that specifies a range of exchange rates within which currencies will be

exchanged at maturity. Users can take advantages of favourable range movements to the upper end of the range and the risk is limited to the

lower end of the range if the movement in exchange rates is unfavourable. If at maturity the exchange rate is within the range, the contract will be settled at the exchange rate ruling at maturity.

1.2 Break forward contract

A break forward contract is a traditional forward foreign exchange 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.

2. Options 3.3 Asian or average-rate options

The payoff of an Asian option depends on the average price of the underlying asset over a specified period of time.

There are two types of Asian options – floating-strike and fixed-strike. The floating-strike option pays the difference – if positive – between the average

value of the underlying asset and the spot value of the underlying when the option is exercised. The fixed-strike option pays the difference between the

average value and a previously agreed strike price. The floating-strike option is less widely used than the fixed-strike one. Since average rate pricing reduces price volatility, these options are generally less expensive

than plain-vanilla options.

3.3 Look back options Look-back options give the right to buy (call) at the lowest price or sell (put)

at the highest price recorded over a specific period of time. Because the payoff results in nil opportunity cost to the purchaser, these options are

more expensive than plain-vanilla options.

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3.3 Barrier options

Barrier options have a mechanism to activate or de-activate the option as a function of the price of the underlying asset. Their payoff depends not only

on the pre-agreed strike price but also on a second strike – the barrier or trigger.

Barrier options fall into two groups – knock-out and knock-in options. Knock-out options expire worthless if at any time before maturity the

underlying asset trades at the trigger price. Knock-in options expire worthless unless at some time before maturity the underlying asset trades at the trigger price. A number of different names apply to barrier options:

an up-and-in option is activated if the underlying asset trades up to the trigger; a down-and-out option is one that is activated if the underlying

asset trades down to the trigger. 2.4 Rainbow options

Rainbow options provide the highest performance of two or more chosen

markets. For example, an equity index fund could buy the right to receive the better of the German DAX or the French CAC-40 (a two-colour rainbow

option) or the best of the DAX, CAC-40 and UK’s FTSE-100 (a three-colour rainbow option).

3.3 Compound options

Compound options are options on options. The four main types of compound options are: o A call on a call;

o A put on a call; o A call on a put; and

o A put on a put. 2.6 Chooser options

A chooser or as-you-like-it option allows the holder to choose, after a

specified period of time, whether the option is a put or a call

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3. Swaps 3.3 Interest rate swap variants

The most widely used interest rate swap variants are described in the table on the next page.

Variant Description

Amortising swaps

Swaps that involve the reduction of the notional principal at one or more points in time prior to the termination of the swap.

Accreting swaps

A swap, the notional principal of which, is increased at one or more points in time before the termination of the swap.

Roller-coaster swaps

Swaps that provide for a period of accretion followed by a period of amortisation of the principal.

Basis swaps Also called floating-for-floating swaps, these are swaps on which both legs are floating but tied to different indices e.g., one leg may be tied to 3-month JIBAR and the other to 6-month JIBAR.

Yield-curve swaps

Similar to the basis swap except that the legs are tied to medium- to long-term rates

Zero-coupon swaps

These are fixed-for-floating swaps with the fixed-rate leg being a

zero-coupon. No payments are made on the fixed-rate leg of the swap until maturity when the fixed-rate side will settle for a single large payment.

Forward swaps

Also called delayed-start or deferred swaps, these are swaps

where the swap coupons are determined on transaction date but

the swap does not commence until a later date e.g., 30-days, 60-days, 1-year forward.

Delayed-rate-setting swaps

Swaps that commence immediately but on which the swap coupon

is not set until a later date. When the rate is set, at the contractually-bounded discretion of one or both of the

counterparties, it is set according to a previously agreed upon formula.

Callable,

putable and

extendable swaps

Swaps conferring the right, but not the obligation, to either extend

or shorten the tenor of the swap. Callable and putable swaps give,

respectively, the fixed-rate payer and the floating-rate payer the right to terminate the swap early. With extendable swaps, one counterparty has the right to extend the tenor of the swap beyond its termination date.

Rate-capped swaps

Swaps, the floating-rate of which, are capped.

Reversible swaps

Swaps that allow the fixed-rate payer and the floating-rate payer to reverse roles one or more times during the life of the swap.

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3.3 Currency swap variants

The most commonly-used currency swap variants are outlined in the table below.

Variant Description

Fixed-for-fixed

rate currency swaps

Currency swaps that require both parties to pay a fixed rate

of interest. This swap can be created with a single swap agreement or via two separate swap agreements. In the

latter case, a fixed-for-floating currency swap can be used for the initial exchange of currencies with a fixed-for-floating rate interest swap being used to convert the floating-rate side to a

fixed rate. If the floating-rate side of both swaps is LIBOR (London Interbank Offered Rate), the combination is called a circus swap.

Floating-for-

floating rate currency swaps

Currency swaps that require both counterparties to pay a

floating rate of interest. As with a fixed-for-fixed rate currency swap the swap can be created with a single swap agreement or via two separate swap agreements. In the

latter case, a fixed-for-floating currency swap can be used for the initial exchange of currencies with a fixed-for-floating rate

interest swap being used to convert the fixed-rate side to a floating rate.

Amortising currency swaps

Currency swaps, the principals of which are re-exchanged in

stages i.e., the principals amortise over the tenor of the swap. These currency swaps can be fixed-for-floating rate, fixed-for-fixed or floating-for-floating rate.

Accreting currency swaps

Currency swaps, the principals of which increase over the

tenor of the swap. These swap structures are useful for hedging exchange-rate risk when the size of the cash position giving rise to the exchange-rate risk is expected to increase over time.

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3.3 Equity swap variants

Equity swap variants are outlined in the table below.

Variant Description

Floating-for-

equity equity swaps

Equity swaps with one side pegged to a floating rate of interest and the other to an equity index.

Asset-allocation equity swaps

Equity swaps where the equity return is pegged to the greater of two stock indexes.

Quantro equity swaps

Swaps with two equity legs rather than one i.e., one

counterparty pays the total return on one stock index and receives the total return on another stock index.

Blended-index equity swaps

Equity swaps using a blended index i.e., a weighted average of two or more indices, on the equity-pay leg. A blended-

index consisting of many indexes from different countries is also called a rainbow.

Variable- or

fixed-notional equity swaps

Equity swaps, the notional principal of which is reset at each

payment date, implying a constant number of stocks; or

fixed, representing a constant cash value invested in equity regardless of price movements.

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11 Glossary

Agent One who acts on behalf of another (i.e., 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 option’s exercise price is approximately equal to

the current market price of the underlying.

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.

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 government’s, company’s or

individual’s 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 The settlement of a transaction often involving the

exchange of payments and / or documentation.

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 issuer’s financial soundness – specifically its ability to service debt obligations.

Cross rate Foreign exchange rate between two currencies other than the US dollar

Dealer A firm (or individual) that buys and sells securities as a principal rather than as an agent. The dealer’s profit

or loss is the difference between the price paid and the price received for the same security. The dealer

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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.

Debentures-

participation or profit-sharing

Debentures that pay their holders interest as well as a

stipulated share of the profits of the company.

Debentures- redeemable

Debentures that can be redeemed prior to maturity or at specific intervals.

Debentures – secured Debentures secured by the immovable property of a company.

Debentures – variable-rate

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.

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.

Indenture A contract specifying the legal obligations of the

issuer and the rights of the bond holder.

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Initial margin The amount of funds put on deposit by market

participants as a ‘good faith’ guarantee against a loss from adverse market movements.

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.

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 See tenor.

Maturity date The principal repayment date of a bond or the date on

which a swap terminates

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 exists primarily for purposes of calculating service payments.

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.

Payment dates The dates on which the counterparties to a swap exchange service payments.

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 their dividend rate, share in the profits of the company according to a predetermined formula.

Preference shares - Preference shares redeemable at the option of the

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redeemable 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.

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.

Secondary market The market in which previously issued securities are

traded.

Settlement The delivery of payment for a security

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).

Swap coupon The interest payment on the fixed-rate side of a swap

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.

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.

Variable rate A rate that changes periodically over the life of an instrument or contract. Also termed floating rate.

Value date See effective date.

Volatility The degree to which the price of a financial instrument tends to fluctuate over time.

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