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					        MAN605/705
  Investment Management

         Lecture Notes
Week 1: Introduction to Financial
   Markets & Instruments
                   Agenda
•   Class List
•   Review Course Outline
•   Review Objectives
•   Investment Introduction
    – Financial Assets
    – Financial Markets
    – Financial Securities
• Next Week
               Objectives
• Know what investment is about.
• Understand exactly what is meant by the
  term ‘financial securities’
• Basic knowledge of financial markets in
  SA.
• Know the types and characteristics of all
  the major traded financial instrument.
• Identify the major participants in financial
  markets
       Assessment

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
              Lecture Content
• 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
                      Investment
•    Definition
    –   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,
     Housing Bond.
   Taxonomy of Financial Assets
• Fixed Income Securities
  – Money Market Instrument
  – Bonds (Capital Market) and Money Market Securities
     • Predefined cash flow over a period
• Equities
  – “Ownership”/Voting rights
  – Public & Private
  – Types of shares:
     • O’s, N’s, Low voting, Prefs & Convertibles
• Derivatives
  – 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
• Process
   – 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
                   Market Players
• 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.
                    Recent Trends
• Globalisation
   – Change in the view of the world
   – ADR’s
   – Euro & ECB
• Securitisation
   – Issuance of securities, using a pool (usually of lesser quality) securities
     of other cash flow generating asset(s) as collateral.
   – ABS
       • 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
  instruments.
• MM Unit trusts are priced at R1
• Examples
   – TB’s, BA’s, ST Debentures, CD’s, NCD’s, Commercial paper or PN’s
     (Promissory Notes)
   – Repos and Reverse Repos.
• Interbank Market
   – LIBOR
• 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
       TB’s.
                  The Bond Market
• Also known as the Fixed Income Capital Market.
• Long-term (more than 12 months to maturity) Debt instruments.
• Examples
   – 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
   –                                                             rm
       Tax on Retirement Funds
                                                             r
   –   Tax free equivalent                                      1 t
                  Bond Market Players
•   Issuers
     –   Governments/Treasury (Sovereign Debt)
     –   Parastatals/government agencies (ESCOM, Transnet etc.)
     –   Municipalities
     –   Corporations
•   Market Makers & Traders & Intermediaries
     –   Investment Banks, Exchange & Stock Brokers
     –   SARB
•   Investors
     –   Retirement Funds
     –   Unit Trust/Mutual Funds
     –   Investment trusts/investment companies/Private Equity
     –   Banks
     –   Corporate treasurers
     –   Individuals/Syndicates
•   Rating Agencies
     –   Finch, Moody’s, Standard &Poor’s
     –   Investment grades: High & Medium, BB+ and above
•   Regulator
     –   FSB in SA
                     Alternative Bonds
•   TIPS / Inflation linked or Indexed bonds
     – (Treasury Inflation protected Securities)
     – Principle and coupon increases with inflation index.
•   Strips
     – 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
        fund provisions
     4. Denomination - Exchange rate (country risk)
 Term Structure of Interest Rates
• Bond rates usually higher than short-term
  rates. Why?
  – More Risky
  – Expectations of higher interest rates
    11.5%


    11.0%


    10.5%


    10.0%


    9.5%


    9.0%                         1YY


    8.5%                         YTM


    8.0%


    7.5%
            1     2      3      4      5
                          Equities
• 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
  inventory.
• Characteristics.
   Residual claim (last in the row).
   Limited liability.
   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)
                 Equities Trading
• Trading
  – 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.
  –   Security:
       • Backed by real assets legislation and regulation.
  – Liquidity:
       • Easily and cheaply traded for cash.
          Derivatives Markets
• 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.
                 Option Contracts

• 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
          Using Derivatives
• 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.
                    For Session
• Additional Reading
   –   www.investopedia.com/university/advancedbond
   –   www.jse.co.za
   –   www.bondexhange.co.za
   –   www.safex.co.za


• Markets, Funds, Indices & Trading

				
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posted:10/8/2012
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