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Introduction to Financial Markets

by Ingrid Goodspeed

© I Goodspeed: 2008
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
4.1 The market defined .......................................................................... 47
4.2 Characteristics ................................................................................. 47
4.3 Instruments .................................................................................... 47
5 The bond and long-term debt market ............................................... 55
5.1 The market defined .......................................................................... 55
5.2 Characteristics ................................................................................. 55
5.3 Instruments .................................................................................... 55
6 The equity market ............................................................................ 62
6.1 The market defined .......................................................................... 62
6.2 Characteristics ................................................................................. 62
6.3 Instruments .................................................................................... 63
6.4 Participants ..................................................................................... 66
6.5 Issuers: Limited public companies ...................................................... 66
7 The derivatives market .................................................................... 71
7.1 The market defined .......................................................................... 71
7.2 Characteristics ................................................................................. 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.

Figure 1.1: Financial intermediation and the flow of funds

Indirect financing

Financial
intermediaries Fun
ds
Fun ds

ti es Prim
c uri ary
t se
Primary securities

sec
Lenders irec urit Borrowers
Ind i es
(surplus units) (deficit units)
Funds

Household sector Household sector


Business sector Business sector
Government sector Government sector
Foreign sector F un Foreign sector
ds d s
Fun
Prim
ties
ary uri
sec sec
uri ry
ties ma
Financial Pri
markets

Direct financing

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.

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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 Indirect securities
(issued by ultimate borrowers) (issued by financial intermediaries)
Marketable Non-marketable Marketable Non-marketable
Bankers Hire-purchase and Negotiable Bank notes (issued
acceptances/bills; leasing contracts; certificates of deposit by the central bank);
Trade bills; Mortgage advances; (NCDs) (issued by Savings accounts;
Promissory notes; Overdrafts; banks) Term or fixed
Commercial paper; Personal loans; deposits;
Company Shares of non-listed Insurance policies;
debentures; companies. Retirement annuities
Treasury bills;
Government bonds;
Shares of listed
companies

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.

Figure 1.2: Cash and derivatives markets

Financial markets

Foreign exchange
Capital market Money market Commodities
market

Derivatives Derivatives Derivatives

Bond and long-term Interest-bearing markets


Equity market
debt market

Derivatives Derivatives

Hybrids

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

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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:

r = capital gain( loss ) + cashflow


end price of share − beginning price of share cash dividend
= +
beginning price of share beginning price of share
55.00 − 50.00 2.50
= +
50.00 50.00
= 15.0%

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

45.00 − 50.00 2.50


r = +
50.00 50.00
= −5.0%

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:

r = capital gain( loss ) + cashflow


3 000 − 2 000
= +0
2 000
= 50.0%

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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:

end price of share − beginning price of share cash dividend


r= +
beginning price of share beginning price of share
102 − 100 0
= +
100 100
= 2%

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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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Figure 2.1: Politico-economic systems

Political system

authoritarian

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


Economic system

centrally planned
free market

e.g., United States, e.g., Eastern European


United Kingdom, states
Europe - Hungary
- Bulgaria
- Romania

democratic

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.

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Figure 2.2: Simplified circular flow of income diagram

Labour

Income for households (expenditure for firms)

Households Firms

Income for firms (expenditure for households)

Goods and services

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.

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

Figure 2.3: Circular flow of income diagram

Labour

Income for households (expenditure for firms) Owners of capital

Services Services Capital goods

Households Taxes Government Taxes Firms


Investment

Income for firms (expenditure for households)

Goods and services

Foreign expenditure Foreign income


Foreign sector
Imports Exports

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.

19
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

20
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

21
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.

22
Figure 2.4: Phases of the business cycle

Upper turning point

Con
sion

trac
an

tion
Exp

Lower turning point Lower turning point

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 Expansion Upper turning Contraction
point point
Businesses Tend to be more Start borrowing Profits weaken Profits weaken
liquid and less to finance further
geared; expansion;
Higher profit Profits rise
expectations rapidly
Credit demand Relatively weak Increases Weakens Weak
strongly
Current account Surplus Surplus Deficit or small Deficit becomes
of the balance becomes surplus smaller or
of payments smaller or surplus becomes
negative larger
Employment Relatively low Increases High Falls slowly at
first
Exchange rate Relatively stable Weakens Weakens Stabilizes or
or tending tends stronger
stronger
Exports Increase Weaker (to Decrease or Increase
supply local remain weak
demand)
Fiscal policy Stimulation ( Restraint (e.g., Further restraint Borrowing
e.g., tax higher taxes increases to
concessions) and/or lower finance higher
spending) expenditure
Imports Relatively low Rise sharply Remain high Decrease

23
Inflation Relatively low Increases Increases Decreases
further
Interest rates Relatively low Rise Rise or remain Decline
high
Inventory levels Low Rise Rise or remain Decrease
high
Investment Low Starts to rise High Decreases
Prices Relatively low Rise rapidly High Fall slowly
Production and Start to Increase Limited by Decline
sales increase; rapidly; capacity substantially
production idle production constraints
capacity at a capacity is
high level absorbed
Production Idle capacity Idle capacity is Full utilisation Utilisation falls
capacity rapidly
absorbed;
requirement to
expand
production
capacity
Salary and wage Low Rise slowly at High Fall slowly
incomes first

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


200

180
Coincident
160
Lagging
140
Index (1990 = 100)

120

100

80

60 Leading

40

20

0
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
Upward phases

24
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 o assess the performance of the economy
market analysts 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.

25
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

26
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)


15

10
% change quarter-on-quarter

-5

-10
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
Upward phases

27
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.

Presented as: Quarterly and annual totals

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.

28
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).

Presented as: Quarterly and annual totals

Focus on: Real growth rates

Timing: Coincident indicator of the business cycle

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)

29
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.

Presented as: Quarterly and annual totals

Focus on: Real growth rates

Timing: Leading indicator of the business cycle

Interpretation: Investment spending is highly cyclical. Firms’ investment


decisions are based on expectations of future aggregate
demand, corporate profits and interest rates. Firms are
the most likely to invest if interest rates are low, they
are operating at almost full capacity and if they expect
demand to remain high.

For the likely impact on interest rates, bond prices, share prices and
exchange rates see GDP.

30
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.

Timing: Coincident indicator of the business cycle

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.

31
Figure 2.7: Consumer Price Index (CPIX)
15
% change year-on-year

10

0
98 99 00 01 02 03 04 05 06 07
Upward phases

32
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)


25

20

15
% change year-on-year

10

-5
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

33
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.

34
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


10000

-10000
Rm

-20000

-30000

-40000

-50000
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
Upward phases

35
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 )

36
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.

37
Questions for chapter 2

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?

38
Answers for chapter 2

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.

39
3 The foreign exchange market

Chapter learning objectives:


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

40
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

Spot transactions : dealing and value dates

Dealing date Spot value date


(transaction made) (settlement)

2 working days Time

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 (£)

41
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

Forward transactions : dealing and value dates

Dealing date Maturity date Value date


(transaction made) of contract (settlement)

Term of forward contract 2 working days Time


e.g., 3 months

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

42
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.

43
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.

44
Questions for chapter 3

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?

45
Answers for chapter 3

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.

46
4 The money market

Chapter learning objectives:


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.

4.1 The market defined


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.

47
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

48
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.

49
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

50
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

51
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.

52
Questions for chapter 4

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.

53
Answers for chapter 4

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.

54
5 The bond and long-term debt market

Chapter learning objectives:


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.

5.1 The market defined


Capital markets are markets in which institutions, corporations,
companies and governments raise long-term funds to finance capital
investments and expansion projects. The bond and long-term debt market
as well as the equity market 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

55
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

56
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
issuer will fail to perform as promised
o Large denominations are unattractive to small
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.

57
FRNs are also known as variable-rate bonds
Denomination FRNs 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 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
issuer will fail to perform as promised
o Large denominations are unattractive to small
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
Maturity May range from in excess of 5 years up to 30 years

58
Quality Obligation of the issuer
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

59
Questions for chapter 5

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?

60
Answers for chapter 5

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.

61
6 The equity market

Chapter learning objectives:


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.

6.1 The market defined


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

63
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.

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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.

65
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.

66
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;

67
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.

68
Questions for chapter 6

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.

69
Answers for chapter 6

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.

70
7 The derivatives market

Chapter learning objectives:


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.

7.1 The market defined


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

71
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:

72
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.

Figure 7.1: Payoff diagram for a long and short forward

1.5
Short position Long position
1.0

0.5
Profit / loss

0.0

-0.5

-1.0

-1.5
8.7

8.8

8.9

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)

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;

73
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).

74
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 7.2: Payoff diagram for a long call option

60
55
50
45
40
35
Profit/loss

30
25
20 Strike price R100
15
10
5
0
-5
-10 Breakeven R105
-15
70

75

80

85

90

95

100

105

110

115

120

125

130

135

140

145

150

155

160
Price of underlying

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.

75
Figure 7.3: Payoff diagram for a short call option

15
10
5
0
-5
-10
Profit/loss

-15
-20 Strike price R100
-25
-30
-35
-40
-45
-50
-55
-60
70 75 80 85 90 95 100 105 110 115 120 125 130 135 140 145 150 155 160
Price of underlying

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.

Figure 7.4: Payoff diagram for a long put option

30

25

20

15
Profit/loss

10 Strike price R100

-5

-10
70 75 80 85 90 95 100 105 110 115 120 125 130 135 140 145 150 155 160
Price of underlying

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

76
the put seller is the option price of R5. The put seller's maximum loss will be
realised if the market price of the underlying falls to zero.

Figure 7.5: Payoff diagram for a short put option

10

-5
Profit/loss

-10 Strike price R100

-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

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 Put premiums


will.. 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

77
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.

78
Figure 7.6: Reducing the cost of financing

13.50% 6-month JIBAR + 0.50%


Debt market

13.50% 13.75%

Company AAA Bank Company BBB


6-month JIBAR 6-month JIBAR

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.

79
Figure 7.7: Hedging interest-rate risk

Asset

14.00%

13.25%

Company XYZ Bank


6-month JIBAR

6-month
JIBAR

Liability

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.

80
Figure 7.8: Reducing the cost of financing
Exchange of principals

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


Debt market

$10m $10m

Company AAA Bank Company BBB

R90m R90m

Exchange of interest

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


Debt market

7.20% p.a. dollars 7.40% p.a. dollars

Company AAA Bank Company BBB

10.40% p.a. rand 10.70% 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.

81
(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.

Figure 7.9: Hedging equity positions

10.95%
Equity
Unit Trust Bank
portfolio ALSI return
ALSI return

82
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.

84
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.

85
Questions for chapter 7

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.

86
Answers for chapter 7

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

87
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.

88
8 Collective investment schemes

Chapter learning objectives:


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.

89
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 SA o Investment SA o Hedge funds
o Open-ended trusts
investment
companies
UK o Unit trusts UK o Investment UK o Life assurance
o Open-ended trusts investments
investment o Hedge funds

90
companies
(OEICs) also
called
investment
companies with
variable capital
(ICVCs)
US o Mutual funds US o Closed-end US o Unit
funds 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.

91
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

92
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

93
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 Closed- Corporate Trust


fund end fund structure structure
Unit trust

5 Complete the table below by ticking the appropriate cell:

Open-end Closed- Corporate Trust


fund end fund structure structure
OEIC

6 Complete the table below by ticking the appropriate cell:

Open-end Closed- Corporate Trust


fund end fund structure 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?

94
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 Closed- Corporate Trust


fund end fund structure structure
Unit trust √ √

5 Open-end Closed- Corporate Trust


fund end fund structure structure
OEIC √ √

6 Open-end Closed- Corporate Trust


fund end fund structure 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

97
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


Ability to take risk
Willingness to take risk
Low High
Re-assess willingness
Low Low risk tolerance
to take risk
Re-assess willingness
High High risk tolerance
to take risk
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.

98
(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 Expected risk Asset allocation
total (standard A B C
return Deviation) (%) (%) (%)
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

99
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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Questions for chapter 9

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?

102
Answers for chapter 9

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

103
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.

104
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.

105
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 that involve the reduction of the notional principal at one or
swaps more points in time prior to the termination of the swap.
Accreting A swap, the notional principal of which, is increased at one or more
swaps points in time before the termination of the swap.
Roller-coaster Swaps that provide for a period of accretion followed by a period of
swaps 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 Similar to the basis swap except that the legs are tied to medium-
swaps to long-term rates
Zero-coupon These are fixed-for-floating swaps with the fixed-rate leg being a
swaps 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 Also called delayed-start or deferred swaps, these are swaps
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- Swaps that commence immediately but on which the swap coupon
setting swaps 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, Swaps conferring the right, but not the obligation, to either extend
putable and or shorten the tenor of the swap. Callable and putable swaps give,
extendable respectively, the fixed-rate payer and the floating-rate payer the
swaps 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, the floating-rate of which, are capped.
swaps
Reversible Swaps that allow the fixed-rate payer and the floating-rate payer
swaps 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 Currency swaps that require both parties to pay a fixed rate
rate currency of interest. This swap can be created with a single swap
swaps 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- Currency swaps that require both counterparties to pay a
floating rate floating rate of interest. As with a fixed-for-fixed rate
currency swaps 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, the principals of which are re-exchanged in
currency swaps 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, the principals of which increase over the
currency swaps 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 swaps with one side pegged to a floating rate of


equity equity interest and the other to an equity index.
swaps

Asset-allocation Equity swaps where the equity return is pegged to the


equity swaps greater of two stock indexes.
Quantro equity Swaps with two equity legs rather than one i.e., one
swaps counterparty pays the total return on one stock index and
receives the total return on another stock index.
Blended-index Equity swaps using a blended index i.e., a weighted average
equity swaps 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 Equity swaps, the notional principal of which is reset at each
fixed-notional payment date, implying a constant number of stocks; or
equity swaps 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

110
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 – Debentures that carry the right to exchange all or part
convertible 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- Debentures that pay their holders interest as well as a
participation or profit- stipulated share of the profits of the company.
sharing
Debentures- Debentures that can be redeemed prior to maturity or
redeemable at specific intervals.
Debentures – secured Debentures secured by the immovable property of a
company.
Debentures – variable- Debentures on which the rates are tied to the rates on
rate 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 Under this settlement rule, the delivery of and
payment 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.

111
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 - Preference shares that carry a right to have all or part
convertible thereof exchanged for other securities, usually shares,
on previously specified terms.
Preference shares - Preference shares that, in addition their dividend rate,
participating share in the profits of the company according to a
predetermined formula.
Preference shares - Preference shares redeemable at the option of the

112
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 An agreement in terms of which a holder of securities
(repo) 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.

113
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