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.
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
2
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
3
1 The financial system
4
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.
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
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.
5
The excess funds of surplus units can be transferred to deficit units either
through direct financing or indirectly via financial intermediaries.
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.
6
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.
7
1.2.4.1 Cash and derivatives markets
Cash and derivatives markets are discussed with reference to figure 1.2.
Financial markets
Foreign exchange
Capital market Money market Commodities
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.
8
to the weather in Rome. There is active trading internationally and in
South Africa in credit, electricity, weather and insurance derivatives.
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.
9
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.
10
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.
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.
11
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.
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:
If the share price is R45 at year end the rate of return is –5% i.e.,
12
Questions for chapter 1
3. Name the categories that lenders and borrowers can be grouped into.
5. Describe how pension funds expedite the flow of funds from lenders to
borrowers.
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?
13
Answers for chapter 1
2. The four elements of the financial system are lenders and borrowers;
financial institutions; financial instruments; and financial markets.
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.
14
2 The Economy
15
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.
16
Figure 2.1: Politico-economic systems
Political system
authoritarian
centrally planned
free market
democratic
17
Figure 2.2: Simplified circular flow of income diagram
Labour
Households Firms
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.
18
A more complete picture of the economy is shown in figure 2.3.
Labour
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.
19
2.3 Economic objectives
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.
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:
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
Con
sion
trac
an
tion
Exp
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.
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.
25
2.6.1 GDP (Gross Domestic Product)
26
rates as market participants expect the central bank to
raise interest rates to avoid higher inflation.
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
For the likely impact on interest rates, bond prices, share prices and
exchange rates see GDP.
28
2.6.3 Government spending
29
2.6.4 Investment spending
For the likely impact on interest rates, bond prices, share prices and
exchange rates see GDP.
30
2.6.5 Consumer price index (CPI)
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.
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).
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).
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.
-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.
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
3. Name the leakages from and injections into the circular flow of
income.
38
Answers for chapter 2
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.
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.
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
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.
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.
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).
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.
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.
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).
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.
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.
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.
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.
44
Questions for chapter 3
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?
45
Answers for chapter 3
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.
46
4 The money market
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.
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.
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
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.
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
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
51
purchaser (investor) at a specified price at a
designated future date.
52
Questions for chapter 4
53
Answers for chapter 4
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.
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.
54
5 The bond and long-term debt market
5.2 Characteristics
Bonds and long-term debt instruments are traded on organised exchanges
or over-the-counter.
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.
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.
56
representatives of the debenture-holders setting out
the rights of individual debenture holders.
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
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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
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Questions for chapter 5
3. What is a bond?
60
Answers for chapter 5
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).
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6 The equity market
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.
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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.
6.3 Instruments
The following equity market instruments are discussed: ordinary shares,
preference shares, depository receipts and exchange traded funds.
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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.
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.
ETFs were first introduced in Canada in 1990 where they are known as
Tips tracking the Toronto Stock Exchange top 60 index. The history of
ETFs in the United States dates back to 1993 when the American Stock
Exchange (AMEX) listed an ETF nicknamed Spiders that tracked the
S&P500. By June 2005 there were 180 EFTs listed in the United States
with assets of USD244 billion under management.
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Currently (June 2005) there are 369 ETFs on the global exchanges with
about USD336 billion in assets, comprising not only stocks and bonds but
also currencies and commodities.
In November 2000 the JSE launched its first ETF - Satrix 40 that tracks
the top 40 companies listed on the JSE. In 2002 two other ETFs were
introduced: Satrix Fini, which tracks the top 15 financial shares, and
Satrix Indi, which lists the top 25 industrial shares. In 2003 Absa Bank
introduced an ETF based on the NewRand Index. The NewRand Index
comprises 10 Rand hedge shares selected from the FTSE / JSE top 40
index. In 2004 ABSA Bank launched NewGold –a gold ETF. NewGold Gold
Bullion Debentures are securities backed by gold-bullion listed on and
traded through the JSE. Each NewGold Debenture is initially valued at
1/100 of one fine troy ounce of gold.
In South Africa five ETFs are currently (September 2005) listed on the JSE
- the three Satrix products (Satrix40, Satrix Fini and Satrix Indi) and the
two Absa products (NewRand and NewGold).
6.4 Participants
The major participants in the equity market are:
In theory ownership and control of the company ultimately rest with the
shareholders. In practice because shareholders as owners are so widely
dispersed, managers may effectively control the firm.
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Important features of limited companies are:
o Shareholders own the company through the purchase of shares in the
company. A share is one of a number of equal portions of the capital of
a company;
o The liability of owners for the debts of the company is limited to their
investment in the firm i.e., if the company is wound up the maximum
shareholders can lose is the amount paid for the shares;
o Companies have a legal existence separate from their owners i.e., they
can sue and be sued;
o Long-term business continuity i.e., life of the company is independent
of the owners’ lives.
They also facilitate mergers of companies and the acquisition of one firm
by another.
6.5.3 Investors
There are several types of investor:
o Individual investors usually hold a small personal investment in
equities. However they do have several indirect investments in equity
via pension and provident funds, medical aid schemes, insurance
policies, assurance policies and unit trusts;
o Companies could own more than 50% of a company’s shares giving it
controlling voting powers. In this instance, the company holding the
share is referred to as a holding company and the company in which
the holding company has the share is known as a subsidiary of the
holding company;
o Asset or investment management firms advise and administer pension
and mutual funds on behalf of the funds stakeholders – individuals,
firms and governments;
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o Insurance companies invest the premiums they receive in shares,
bonds and property. The premiums are received in terms of insurance
policies covering specific events such as death, accident, fire;
o Pension and retirement funds invest the contributions of employees
and employers in assets such as shares;
o Mutual funds are portfolios of assets such as shares, bonds, money
market instruments bought in the name of a group of investors. Mutual
funds are generally managed by investment companies.
In South Africa the more-liquid and better-rated shares are held almost
exclusively by institutions such as pension funds and insurance companies
– individuals’ holdings are small.
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Questions for chapter 6
69
Answers for chapter 6
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.
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.
10 American Depository Receipts (ADRs) are traded in New York either on one of
the exchanges or on the National Association of Securities Dealers Quotations
system (NASDAQ). The shares underlying an ADR are purchased by a US
investment bank or broker and then held in trust with a US trustee bank which
issues the ADR to acknowledge that it holds the underlying shares. The
investment bank or broker then sells the ADR to US investors. The trustee bank
collects the dividends and makes payments to the holders of the ADR. Prices
and dividends are in US dollars.
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7 The derivatives market
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.
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positions by revaluing them at the end of each business day at the closing
contract prices traded on the exchange – this process is referred to as
marking-to-market.
7.3 Instruments
Derivatives can be grouped under three general headings:
o Forwards and futures;
o Options; and
o Swaps.
Forwards and futures are similar instruments. However there are four
main characteristics specific to futures contracts that distinguish them
from forward contracts:
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o Futures contracts are traded on organised exchanges while forwards
trade over-the-counter;
o Futures contracts are based on a standard quantity/quality of the
underlying asset and have standardised delivery rules and dates.
Forward contracts are custom made;
o With futures contracts performance is guaranteed by the futures
exchange’s clearing house. This together with margining arrangements
reduces default risk. Forwards have default risk i.e., the seller may not
deliver and the buyer may not accept delivery; and
o Futures contracts are marked-to-market i.e., valued at current market
prices on a daily basis.
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
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.
The buyer of an option pays the option writer an amount of money called
the option premium or option price. In return the buyer receives the right,
but not the obligation, to buy (in the case of a call option) or sell (in the
case of a put option) the underlying asset or derivative for the strike
price. An option is said to be in-the-money if it has intrinsic value i.e., the
strike price is below (in the case of a call) or above (in the case of a put)
the market or prevailing price of the underlying asset or derivative. If the
option strike price is above (in the case of a call) or below (in the case of
a put) the market price of the underlying asset or derivative, the option is
out-of-the-money and will not be exercised – the option has no intrinsic
value. When the strike price approximately equals the market price of the
underlying asset or derivative, the option is at-the-money. Technically an
option that is at-the-money is also out-of-the-money as it has no intrinsic
value.
In virtually all cases, the option seller will demand a premium over and
above an option’s intrinsic value. The reason for this revolves around the
risk that the seller takes on. Before expiration of the option the market
price of the underlying asset or derivative is almost certain to change,
which will change the intrinsic value of the option. So although the option
may have a particular intrinsic value today, the intrinsic value may be
different tomorrow. The excess of the option premium over its intrinsic
value is known as time value. The amount of time value depends on the
time remaining to expiration – at expiry date time value will be zero.
The payoff diagrams in figures 7.2 to 7.5 show the profits/losses of four
basic option positions held to expiration and plotted in relation to the price
of the underlying asset or derivative. The underlying asset is a share. The
strike price of the option is R100 and the option price or premium is R5.
Diagram 7.2 shows the position of the buyer of a call – a long call. The
position is profitable if the market price of the share exceeds the strike
price of R100 by more than the price or premium of the call option (R5).
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The buyer breaks even at an underlying share price of R105 i.e., the
strike price plus the option price. The gain to the call buyer is unlimited
because the intrinsic value of the option increases directly with increases
in the value of the share, which is theoretically unlimited. The maximum
loss to the call buyer is the option premium – R5.
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.
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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.
30
25
20
15
Profit/loss
-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
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the put seller is the option price of R5. The put seller's maximum loss will be
realised if the market price of the underlying falls to zero.
10
-5
Profit/loss
-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:
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
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based on some underlying asset or notional, which may or may not be
physically exchanged. At least one of the series of cash flows is uncertain
when the swap agreement is initiated. Although there are four types of
swaps - interest-rate, currency, commodity and equity swaps - and many
variants thereof, only plain-vanilla interest-rate, currency and equity swaps
will be discussed.
The most important uses for interest rate swaps are to reduce the cost of
financing and to hedge interest-rate risk.
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% 13.75%
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.
79
Figure 7.7: Hedging interest-rate risk
Asset
14.00%
13.25%
6-month
JIBAR
Liability
The most important uses for currency swaps are to reduce the cost of
financing and hedge exchange rate risk.
80
Figure 7.8: Reducing the cost of financing
Exchange of principals
$10m $10m
R90m R90m
Exchange of interest
For example, assume two multinational companies AAA and BBB are
seeking funding with 5-year new debt issues. Company AAA has a higher
credit rating than company BBB. Their respective per annum cost of issuing
debt is 10.40% and 10.80% in South Africa and 7.30% and 7.40% in the
United States. Company AAA wishes to borrow in dollars and company BBB
in rand. Both want fixed-rate financing. Company BBB would have to pay
0.40% p.a. more than company AAA in rand whereas in dollars it would
have to pay 0.10% p.a. more. Therefore Company BBB has a comparative
advantage over company AAA in borrowing dollars. By negotiating a
currency swap via Bank XYZ with a principal of R90million or $R10million
(an exchange rate of $1=R9 being assumed) an opportunity for lower-cost
funding for both companies is created. The following rates are agreed:
company AAA will receive 10.40% p.a. fixed on R90million and pay 7.20%
p.a. fixed on $10million; and company BBB will receive 7.40% p.a. fixed on
$10million and pay 10.70% p.a. fixed on R90million. The result is illustrated
in figure 7.8 below – the first shows the exchange of principals and the
second the exchange of interest.
Company AAA will pay 7.20% p.a. on its dollars – 0.10% p.a. less than it
could obtain directly in the debt market. Company BBB will pay 10.70% p.a.
on its rand, also 0.10% less than in the debt market. Bank XYZ will make a
loss of 0.20% p.a. on dollars but a profit of 0.30% p.a. on rand.
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(ii) Hedging exchange-rate risk
Currency swaps can be used to hedge the risk of losses from adverse
exchange-rate movements. Exchange-rate risk can arise for example when:
o A firm has an investment in a currency that generates a regular income
stream. The firm is exposed to a fall in the value of the currency;
o A firm has a liability in a foreign currency but no regular income in that
currency. It is at risk to an increase in the value of the currency that
would make the loan more costly to service.
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.
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.
10.95%
Equity
Unit Trust Bank
portfolio ALSI return
ALSI return
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It is important to note that because an equity return can be positive or
negative, the cash flow on the equity-linked side of the swap can go in
either direction. If the equity return for the quarter is negative, the bank
pays the unit trust the negative sum as well as the swap coupon on the
fixed leg.
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.
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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.
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.
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Consequently hedging can be seen as substituting price risk with basis risk.
Basis risk occurs because the derivatives and cash prices do not move
together i.e., are not perfectly correlated. The extent of basis risk is a
critical factor in determining which derivatives contract is appropriate for
hedging a particular price risk.
7.5.2 Speculators
Speculators attempt to make profits by taking a view on the market – if
their views are right, they make money – if they are wrong they lose
money. Speculators are willing to bear risk that others – hedgers – wish to
avoid. The advantage of speculating in derivatives contracts rather than in
the cash market is that the gearing is greater i.e., positions can be taken
with minimum capital outlay. The greater liquidity and lower transaction
costs of exchange-traded derivatives trading increase the probability of a
profitable speculative position. Speculators are important participants in the
derivatives market because they add liquidity and are often the
counterparties of hedgers.
7.5.3 Arbitrageurs
The global financial market place has a profusion of interrelated financial
products. In many cases it is possible to synthetically create one product
from a combination of other products. Mathematical relationships exist
linking the prices of comparable instruments. The actual prices of related
products usually follow these mathematical relationships exactly. However
in turbulent markets or when there is a physical separation between
markets, prices may briefly slip out of line. When this happens
arbitrageurs attempt to profit from any anomalies in the pricing by buying
in the market where the price is cheap and selling in the market where
the price is expensive. They hereby attempt to make risk-less profits from
any differences in prices. The activities of arbitrageurs are usually
beneficial as they drive up (down) the prices of under-(over-) priced
products and restore market prices to equilibrium.
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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?
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Answers for chapter 7
87
obligation to deliver or take delivery of the underlying asset or
derivative. Therefore the potential loss of the seller is theoretically
unlimited.
7. Currency swaps can be used to reduce the cost of financing and hedge
exchange rate risk.
88
8 Collective investment schemes
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 table below indicates the variety of names within these categories in
South Africa (SA), United Kingdom (UK) and United States of America
(US).
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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)
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.
Unit investment trusts are open-end funds with a trust structure and
limited duration.
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.
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Participation bond funds invest in first mortgage bonds over commercial or
industrial property.
Real Estate Investment Trusts (REITs) invest exclusively in real estate and
related securities such as mortgage-backed securities.
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.
8.5.3 Locality
The following are examples of CISs classified according to their locality:
Global funds have their assets invested in all major financial markets.
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.
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investment strategies. In other words, the main benefits of pooled
investments are:
o Diversification i.e., spreading the risk of investing over a range of
investments;
o Professional expertise to manage investors’ portfolios;
o Reasonable cost due to reduced dealing costs due to bulk transacting
and cost-effective administration; and
o Choice in that there are increasing numbers of alternative funds from
which to choose.
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Questions for chapter 8
2 Although the legal structures of CISs vary across the world, they
generally take one of three basic forms. Name these.
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Answers for chapter 8
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.
7 Three CISs classified according to their asset orientation are equity funds,
bond funds and money market funds.
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9 Portfolio management
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9.2.1 Plan the portfolio
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assume risk should be consistent – if not, the investor’s willingness to
take risk will need to be re-assessed (see table 8.1).
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(iii) Establish capital market expectations
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.
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the efficient market hypothesis i.e., they believe it is possible to profit
from financial markets through any number of strategies to identify
mispriced securities.
(ii) Formulate the inputs for portfolio construction
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9.2.4 Adjust the portfolio
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Questions for chapter 9
10 What could motivate revising the portfolio once the desired portfolio
has been constructed?
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Answers for chapter 9
2. The steps are: plan the portfolio, develop and implement the portfolio
strategy, monitor the portfolio and adjust the portfolio.
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measurement and performance evaluation
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10 Appendix A: Exotic derivatives
1. Forwards
2. Options
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.
Look-back options give the right to buy (call) at the lowest price or sell (put)
at the highest price recorded over a specific period of time. Because the
payoff results in nil opportunity cost to the purchaser, these options are
more expensive than plain-vanilla options.
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3.3 Barrier options
Barrier options 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.
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.
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3. Swaps
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
Variant Description
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11 Glossary
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.
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Initial margin The amount of funds put on deposit by market
participants as a ‘good faith’ guarantee against a loss
from adverse market movements.
Interest-rate swap The exchange of one set of cash flows for another
based on a notional principal amount. The most
common form of interest-rate swap is the fixed-for-
floating interest-rate swap. A series of cash flows is
calculated by applying a fixed interest rate to the
notional principal amount. This series of cash flows is
then exchanged for a stream of cash flows calculated
by using a floating interest rate such as JIBAR.
In-the-money A call option is in-the-money if its exercise price is
lower than the current market price of the underlying.
A put option is in-the-money if its exercise price is
higher than the current market price of the underlying.
JIBAR Johannesburg Interbank Ask Rate.
Junk bond A bond with a speculative credit rating.
Legs The two sides of a swap.
Leverage The magnification of gains and losses by only paying
for a part of the underlying value of the instrument or
asset; the smaller the amount of funds invested, the
greater the leverage.
Long To own a financial instrument.
Margin call When collateral falls short of the requirement e.g., the
value of the collateral is less than the amount of the
loan it secures, a margin call is made on the borrower
to top up the collateral.
Maturity See tenor.
Maturity date The principal repayment date of a bond or the date on
which a swap terminates
Notional principal The amount of principal on which the interest in
calculated in terms of an interest-rate swap. In the
case of interest-rate swaps the principal is purely
notional in that no exchange of principal takes place.
Notional Commodities, equities or principals that exists primarily
for purposes of calculating service payments.
Opportunity loss Foregoing a gain (or a smaller loss) by not taking a
specific action or trade.
Out-the-money A call option is out-the-money if its exercise price is
higher than the current market price of the underlying.
A put option is out-the-money if its exercise price is
lower than the current market price of the underlying.
Payment dates The dates on which the counterparties to a swap
exchange service payments.
Preference shares - 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
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redeemable company at a specific price on a specified date or over
a stated period.
Primary market The market in which securities are first issued.
Promissory note An undertaking, usually issued by a company, to pay
the holder the face or par value of the note at a specific
future date.
Reinvestment risk The risk that the interest rate at which interim cash
flows can be reinvested will fall. Interest rate risk (i.e.,
the risk that interest rates will increase, thereby
reducing the price of a fixed-interest security) and
reinvestment risk offset each other.
Repurchase agreement 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.
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