Week 1: Introduction to Financial
Markets & Instruments
• Class List
• Review Course Outline
• Review Objectives
• Investment Introduction
– Financial Assets
– Financial Markets
– Financial Securities
• Next Week
• Know what investment is about.
• Understand exactly what is meant by the
term ‘financial securities’
• Basic knowledge of financial markets in
• Know the types and characteristics of all
the major traded financial instrument.
• Identify the major participants in financial
50% Weight 6 x 3% 2 x 12% 1 x8%
Week Date Short Test Mid-Term Assignment
3 22-Feb ST1
5 08-Mar ST2
6 16-Mar CT1 *
7 22-Mar ST3
9 12-Apr ST4
11 26-Apr ST5
12 3-May ST6 Hand in
12 4-May CT2 *
13 10-May ST7
• Investments: Background & Issues
– Financial vs. Real Assets
– Taxonomy of Financial Assets
– Financial Markets & the Economy
– Investment Process & Markets
– Market Players
– Recent Trends
• Major Financial Market Instruments
– Money Market
– Capital Market
– Equity Market
– Derivative Markets
– The current commitment of funds for a period of
time in order to derive future payments that will
compensate the investor for:
1. The time the funds are committed. -RRFR
2. The expected Inflation rate of that time. - E(Inf)
3. The uncertainty of the future payments. - Rp
This rate of return that the investor demands for
compensation as described above is known as the
‘Required Rate Return’ - R(Ret)
You will invest when the expected rate of return E(Ret)>
required rate of return.
Financial vs. Real Assets
• Real Assets
– Real assets create or store wealth.
– Real assets are usually physical assets.
– Can be intangible, such as copyright, patent, brand name.
– Examples: Property, Vehicles, Business, Patent.
– No-one else’s liability.
• Financial assets
– Financial Assets are also known as paper assets.
– Financial assets contains a distinct promise.
– Some right is implied. Can be a right to certain or uncertain cash
flow, voting rights etc.
– Examples: Currency Notes, Equity, Bonds, Promissory notes.
– Someone else's liability.
• Quiz: What type of asset are the following.
– R10 note, R5 Coin, Kruger Rand, Patent, Goodwill, Education,
Taxonomy of Financial Assets
• Fixed Income Securities
– Money Market Instrument
– Bonds (Capital Market) and Money Market Securities
• Predefined cash flow over a period
– “Ownership”/Voting rights
– Public & Private
– Types of shares:
• O’s, N’s, Low voting, Prefs & Convertibles
– Is based on the value an ‘underlying’ asset
– Options (OTC vs. Exchange Traded)
– Future Contracts
Financial Markets & the Economy
• Time Shifting of Expenditure
– Time Value of Money
• Allocation of Risk
• Separation of Ownership & Management
– The Agency Problem
• Corporate Governance
– Accounting Standards
– Analyst Impartiality
– Board Responsibility
• Read Case Studies
– Scandal Scorecard (Bodie Table1.4)
Investment Process & Markets
– Top Down vs. Bottom up
– Asset Class, sector, security
• Risk-Return trade-off
– Risk: Probability of a loss (below threshold/expected return) over
a certain period.
– How do we measure risk?
– Higher expected return is a compensation for Risk
– Diversification and MPT
• Market Efficiency
– Is all information already discounted?
• Dividend test
– Active vs. Passive management
• Primary & Secondary Market
• The Issuers
– Those that borrow and raise capital
– Usually Government & Corporates
• The Investors
– Those with surplus savings
– Retirement funds, Investor funds, individuals
– Can also be Government and Corporates
• The Intermediaries
– Investment Banks, Stock Brokers, Securities Exchanges.
• Market Makers, IPO’s
– Investment Vehicles, E.g.. Unit Trusts/Mutual funds
• Wholesale and retail financial markets
– On/Off balance sheet financing.
• Intermediation vs. Disintermediation
• The Regulators
– SARB and FSB in SA, FSA in UK, SEC in the US.
– Change in the view of the world
– Euro & ECB
– Issuance of securities, using a pool (usually of lesser quality) securities
of other cash flow generating asset(s) as collateral.
• Brady Bond, Mortgage Backed Securities (SA Home loans)
• Ziggy Stardust (David Bowie)
• Financial Engineering
– Bundling & unbundling E.g.. Strips
– Tax implications
• Computer networks
– Instant access
– Day Traders
The Money Market
• Short-term debt market.
• Any FI security with maturity of less than 12 months.
• FRN’s can be longer dated, but act and are priced as MM
• MM Unit trusts are priced at R1
– TB’s, BA’s, ST Debentures, CD’s, NCD’s, Commercial paper or PN’s
– Repos and Reverse Repos.
• Interbank Market
• MM Yields
– Instruments usually trade at discount not a yield.
– Low risk but not risk-free.
– TB’s has almost no default risk, but has interest rate risk.
– Risk premium – What banks/Corporates have to pay (in yield) above
The Bond Market
• Also known as the Fixed Income Capital Market.
• Long-term (more than 12 months to maturity) Debt instruments.
– Government bonds, corporate bonds, notes & debentures.
– Exceptions: FRN’s act and is priced as a MM instrument but traded on
the Bond Market.
– Credit Risk
• Gilts, Para-statals, Munis, Corporate, High Yield, Junk
• Guarantees, Collateral, Convergence, Consolidation, Options
– Foreign Bonds
• Sovereign vs. Credit bonds
• Issue Currency (Eurobonds, Yankee banks, Samurai/Nippon Bonds)
• Traded on Price or Yield
• Tax issues
– Interest eared vs. interest bought/sold r (1 t ) rm
– Capital Gains Tax
Tax on Retirement Funds
– Tax free equivalent 1 t
Bond Market Players
– Governments/Treasury (Sovereign Debt)
– Parastatals/government agencies (ESCOM, Transnet etc.)
• Market Makers & Traders & Intermediaries
– Investment Banks, Exchange & Stock Brokers
– Retirement Funds
– Unit Trust/Mutual Funds
– Investment trusts/investment companies/Private Equity
– Corporate treasurers
• Rating Agencies
– Finch, Moody’s, Standard &Poor’s
– Investment grades: High & Medium, BB+ and above
– FSB in SA
• TIPS / Inflation linked or Indexed bonds
– (Treasury Inflation protected Securities)
– Principle and coupon increases with inflation index.
– Splitting the coupons and principle
• Corporate Bonds
– Mortgage backed bonds
– Asset Backed Securities (ABS)
– Variable/Floating Rate Notes
• Coupon is linked to a market interest rate, usually a money market rate.
– Zero Coupon Bonds
– High Yield Bonds
• Speculative grade and junk bonds
– Callable & puttable Bonds
– Convertible Bonds
– Subordinated of Junior Debt
• Price Quotes
– Quoted as YTM or R%
What determines Interest Rates?
• Risk Premia
– Sovereign Risk i RFR Inf RP
– Currency Risk
– Credit risk (Corporate)
• Expected Inflation
• In SA the expected inflation and Government deficit
funding (crowding out effect) is the major
determinants of bond rates.
• Factors determining bond rate are:
1. Quality of issue
2. Term to maturity
3. Indenture provisions: Collateral, call features and sinking
4. Denomination - Exchange rate (country risk)
Term Structure of Interest Rates
• Bond rates usually higher than short-term
– More Risky
– Expectations of higher interest rates
1 2 3 4 5
• Common Shares/equity securities as ownership.
• We do not use the term ‘stock’. It is an Americanism and
confusing since ‘stock’ can also refer to a bond or
Residual claim (last in the row).
Dividends are tax free in SA except for STC.
• Classes of shares.
– Ordinary shares.
– Preferred shares (popular for individuals because it is tax-free.)
– Redeemable/Convertible prefs.
– N-shares. (No or low voting shares)
– Listed share trades on an exchange.
– Priced in cents.
– Trading floor replaced by computer trading.
• Why hold equities?
– Dividends (cash flow stream).
– Capital Appreciation (Growth).
– Control: Through voting and board appointments.
• Backed by real assets legislation and regulation.
• Easily and cheaply traded for cash.
• Derivative instrument.
– Security with a payoff that depends on the price of
another security. (the underlying instrument)
• Futures Contracts
– Obliges party to purchase or sell an asset at a agreed
price at a specific future date.
– Enables Forward selling/buying.
– Short & Long positions.
– Neutralising vs. gearing.
– Exchange traded and only settled on expiry.
• Call option is a right, but not the obligation, to buy a specific asset at
a specific (exercise) price on or before a specified date.
• Put option is a right but not the obligation, to buy a specific asset at
a specific price on or before a specified date.
• Choice to execute or not.
• Not to be confused with a right of first refusal.
• Price of options is known as a premium.
• OTC or exchange traded.
• Options are available on share, bonds, interest rates, currencies,
futures and even options.
• American vs. European
• Vanilla vs. Exotics
• Why use derivatives?
– Hedge Risk of price changes.
• Offset future exposures.
• Guarantee profits.
– Leverage opportunities of price changes.
• Less capital needed to get similar exposures.
– Underlying security my not be available.
• Additional Reading
• Markets, Funds, Indices & Trading