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• Financial Development facilitates economic grow.

• What do you think are the causes of the global financial
  crisis? What lessons can be learnt from the crisis?

• Financial system in general and the banks, in particular
  must be heavily regulated. Discuss taking into account
  the current global financial crisis.

• The JSE is the largest stock exchange in Africa and one
  of the biggest in the world. Describe the evolution of this
  institution from when it was established up until now.
  Include the following in your description its size in terms
  of market capitalization, number of listed firms, etc. Also
  explain the ownership structure of JSE.
• BESA is South Africa’s bond exchange.
  Describe the evolution of this institution from
  when it was established up until now. Include the
  following in your description its size, ownership
  structure, etc.
• As discussed in class there are four main term
  structure theories of interest rates. Explain in
  detail the main postulations of each. Which one
  do you think is appropriate for an economy like
  South Africa?
• Enumerate the different financial instruments
  trade in South Africa. Give a detailed
  explanation of the risks associated with each.
  Given your risk tolerance level which one would
  you go for?

• Explain the principal-agent problem between
  shareholders and the management of a firm. Get
  10 financial statements from 10 listed firms and
  do a critical assessment on whether the firms
  have managed to put in place mechanisms to
  correct or reduce the principal agent problem.

• The banking sector in South Africa is not
  competitive. Discuss. How do customers benefit
  from a competitive sector.

• The South African monetary policy must be
  revamped? Discuss.
• Def: A bond is an instrument in which the issuer
  (borrower) promises to repay the lender/investor
  the amount borrowed plus interest over some
  specified period of time.

• Bond Features
• The borrower issues a bond to the lender for some
  amount of cash. The arrangement obligates the
  issuer to make specific payments to the bondholder
  on specific dates.

• A typical bond obligates the issuer to make semi-
  annual payments of interest to the bondholder for
  the life of the bond. When the bond matures, the
  issuer repays the debt by paying the bondholder
  the bond’s par value.                          4
                       Bond Features
• The term to maturity of a bond is the number of years during
  which the issuer has promised to meet the conditions of the

• The maturity of a bond refers to the day the debt will cease
  to exist and the day the issuer will redeem the bond by
  paying back the principal.

• The principal value of a bond is the amount the issuer
  agrees to repay the bondholder at the maturity date.

•    Example: A 30 year bond with interest of 8% and a par
    value of R1000 entitles the bondholder an annual cash flow
    of R80 (8% of 1000) for 30 years. At the end of 30 years the
    issuer also pays the R1000 par value to the bond holder.
• Examples of bonds:- Treasury bonds and notes, corporate
  bonds, etc.                                          5
                    Bond Categories
• Depending on their duration and interest payments bonds
  can be categorized into four basic types: -

• Zero-coupon bonds- these promise a single future
  payment. They make no coupon (interest) payment. In this
  case investors receive par value at maturity date but receive
  no interest payments.

• Fixed payments bonds – e.g. Mortgages.

• Coupon bonds – these make periodic interest payments
  and repay the principal at maturity.

• Consols – these make periodic interest payments forever
  never repaying the principal that was borrowed.
                        Bond Pricing
• To value a security, we discount its expected cash flow
  by an appropriate discount rate. The cash flows from a
  bond consist of coupon payments until the maturity date
  plus the final payments of the par value.
• Bond value = Present Value (PV) of coupons + PV of par
• The value of a bond can be written as:
                        Coupon ParValue
• Bond Value =
                    (1  r ) t  (1  r )T
                   t 1

• Where T is the term to maturity and r is the interest rate.

            Pricing Different Types of Bonds
• Zero-coupon bonds -
• Example: Consider a zero coupon bond with a face
  value of R100 sold at $96. The difference of R4 is a
  discount and is the interest payment to the lender. So
  the value of a zero-coupon bond is just the value of the
  payment discounted with an appropriate discount rate:
   Price of R100 face value zero coupon bond 
                                                 (1  i) T

• Where i is the interest rate in decimal form and T is term
  to maturity.

• Fixed Payment (FP) bonds - These are loans that
  promise to pay a fixed number of equal payments
  regularly. The borrower pays off the principal along with
  the interest over the life of the loan.
• The value of such a bond today is the present value of
  all payments.
• Value of a FP loan =

                                                        1  i 
               FP      FP                   FP                FP
                               .....            
              1  i 1  i  2
                                         1  i T
                                                       i 1

• Coupon bonds - The issuer of a coupon
  bond promises to make a series of periodic
  interest payments plus a principal payment
  at maturity.

• Price of Coupon bond =
• Coupon Coupon                    Coupon FaceValue
                      ........            
•  1  i  1  i 2
                                   1  i T
                                               1  i T   =

    (1  r )
           Coupon        ParValue
    t 1
                         (1  r ) T

• Consols or Perpetuities - This type of a
  bond offers periodic payments ad
  infinitum. The borrower only pays the
  interest and never repays the principal.

• Price of a consol =   Yearly coupon payments

                        Bond Yields
• The yield on a bond should reflect the coupon interest that
  will be earned plus any capital gain/loss that will be realized
  from holding the bond to maturity.

• For example, if a 4-year bond with a coupon rate of 5% and
  a par value of R1000 is selling for R900.64, the yield should
  reflect the coupon interest of R50 (5% of R1000) every year
  plus the capital gain of R99.36 (1000-900.64) when the
  bond is redeemed at maturity.

• There are two important types of yields – the current yield
  and the yield to maturity.

• Current yield of a bond -            measures the cash
  income provided by the bond as a percentage of bond
  price. It measures the proceeds the bondholder receives
  for making the loan. It is the yearly interest payments
  divided by the price.

                    Yearly coupon payment
• Current Yield =    Price of the bond paid

• From the formula it can be seen that the current yield
  measures that part of the return from buying the bond
  that arises solely from the coupon payments.

                Yield to Maturity (YTM)
• Yield to maturity (YTM) – this is the yield bondholders
  receive if they hold the bond to maturity when the final
  payment is made.

• More formally the YTM is the interest rate that makes the
  present value of the cash flow of a bond equal to the
  market price. The YTM, y, is found by solving the
  following equation for y:

          C          C                        C       M
    P                      .........            
       1  y 1 1  y  2
                                          1  y  1  y 
                                                  T        T

               Holding period returns
• YTM can be different to holding period return because
  holders can sell bonds before maturity. The price of the
  bond can also change between the time of purchase and
  the time of sale.
• Holding period return =

              Yearly coupon payment Change in price of bond
                    Price paid          Price of bond

                   The Bond Market
• Bond prices are determined in the market for bonds by
  supply and demand for bonds. To simplify things we
  shall look at a stock of bonds existing at a given time

• Bond Supply Curve
• It shows the relationship between the price and quantity
  of bonds people are willing to sell, ceteris paribus.

• The curve is upward slopping. If the price of a bond
  increases, a holder of the bond would sell it as the
  investor tries to take advantage of the capital gains. For
  firms seeking to raise funds the higher the price of bonds
  the more the funds they can generate if they issue the
    Factors that shift the bond supply curve
• Change in government borrowing – an increase in
  government borrowing needs can increase the quantity
  of outstanding bonds if it finances its deficit for example
  using bonds.

• Changes in general business conditions – As the
  economy goes through different phases of the business
  cycle the different economic’ needs for funds also
  change. For example, during expansion business
  conditions are good and investment opportunities
  abound, thus prompting firms to increase borrowing. One
  option is to borrow by issuing bonds, shifting the bond
  supply to the right.
              Bond Demand Curve

• The bond demand curve shows the relation
  between price and quantity of bonds investors
  demand, ceteris paribus. It is downward sloping
  i.e, as price falls the reward for holding bonds
  rises, so demand goes up.

• Suppose you are holding a bond with a face
  value of R1000 with an interest rate of 10%.
  Now suppose in the bond market the bond is
  selling at R900. Would you buy more of this
  bond? Yes because you get interest equal to
  R100 and an additional capital gain equal to 100
    Factors that shift the bond demand curve
• Wealth – as wealth increases individuals increase their
  investments in stocks, real estates and bonds etc.

• Expected inflation – a fall in expected inflation shifts the
  demand curve to the right.
• Expected returns and expected interest rates – if the
  return on bonds rises relative to other alternatives the
  demand for bonds will rise. For example if there is a
  shock that adversely affect the stock market then
  investors can start demanding more bonds as alternative
• Risk to alternatives - if a bond becomes less risky
  relative to alternative investments the demand for the
  bond shifts to the right.
• Liquidity relative to alternatives – other things being
  equal the more liquid the bond the higher the demand for

          Risks Faced by Bondholders
• Default risk – this is the chance that the issuer
  of the bond may fail to make promised
  payments. There is no guarantee that the bond
  issuer will make the promised payments.
• Inflation risk – since inflation is a fact of life an
  investor cannot be sure of what the real value of
  his/her payments will be.
• Interest rate risk – If the interest rate changes
  between the times the bond is purchased and
  the time it is sold the investor can suffer a capital
          Default Risk and Bond Pricing
• We stated that the income stream from bonds is
  not riskless because the issuer of the bond can
  default on his or her obligation. The actual
  payments on bonds are uncertain; they depend
  to some degree on the ultimate financial status
  of the issuer or firm.

• Bond default risk/credit risk is measured by a
  number of rating agencies such as Moody’s
  Investors Services and Standard and Poor’s
  Corporation. These firms provide quality ratings
  of firms. The firm’s bonds are assigned some
  grades that reflect the safety of the bonds.
Quality             Standard and Poor's   Moody's

Very High quality   AAA or AA             Aaa

High quality        A and BBB             A and Baa

Speculative         BB and B              Ba and B

Very Poor           CCC and D             Caa and C
           Determinants of bond safety
• Coverage ratio – ratios of company earnings to fixed
  assets, e.g. EBIT over interest. Low or falling coverage
  ratios signal possible cash flow difficulties.
• Leverage ratio – debt to equity ratio. A too high
  leverage ratio indicates excessive indebtedness,
  signaling the possibility that the firm will be unable to
  satisfy the obligations on its bonds.
• Liquidity ratio – two common liquidity ratios are –
  current ratio (current asset over current liabilities) and
  quick ratio (current assets less ST over CL). These ratios
  measure the firm’s ability to pay bills coming due with
  cash currently being generated.
• Profitability ratio – this is an indicator of a firm’s
  financial strength. An example of profitability ratio is
  return on assets (EBIT over TA).
• Cash flow to debt ratio - ratio of cash flow to
  outstanding debt.
   Bond Indentures or Protective Covenants
• Subordination of further debt - One of the factors
  affecting bond safety is total outstanding debt of the
  issuer. More debt issued after you have already lent to
  the firm can reduce the quality of your debt. To prevent
  firms from harming bondholders in this manner,
  subordination clauses that restrict the amount of
  additional borrowing can be included in the debt
• Dividend restrictions - Dividend restrictions can limit
  the amount of dividends the firm can pay. These
  limitations protect the bondholders because they force
  the firm to retain assets of the firm rather than paying
  them to shareholders.
• Collateral - Some bonds are issued with specific
  collateral behind. In this case they are called secured

Bond Indentures or Protective Covenants
• Sinking Funds - Bonds call for the payment of par value
  at the end of the bond’s life. This payment constitutes a
  large cash commitment on the part of the issuer. In order
  to ensure that this commitment does not result in a cash
  crisis the firm can be required to establish a sinking fund
  to spread the burden over several years.

         The Term Structure of Interest Rates
• The "term structure" of interest rates refers to the
  relationship between the fixed amount of interest paid on a
  financial security (e.g. government or corporate bond) and
  the amount of time before the bond reaches its maturity

•    The theory is based on the observation that in general the
    interest rate on a loans depends on the length of time that
    the bond is held.

• When interest rates of bonds are plotted against their terms,
  this is called the "yield curve".

• Usually, longer term interest rates are higher than shorter
  term interest rates. This is called a "normal yield curve" and
  is thought to reflect the higher risk premium that investors
  demand for longer term bonds.
        Yield Curve Shapes


   0                        0
             Maturity           Maturity

        Yield Curve Shapes


   0                        0
             Maturity           Maturity

• Economists and financial academics have
  developed theories to explain the shape of the
  yield curve. The four main theories are:
   – The Expectations Hypothesis Theory

  – The Liquidity Premium Theory

  – The Preferred Habitat Theory

  – The Market Segmentation Theory

       The Expectations Hypothesis Theory
• The expectations hypothesis assumes no uncertainty about
  the future.

• It assumes that a risk-free interest rate can be computed
  assuming no uncertainty about the future.

• According to the expectations hypothesis we know the yield
  on bonds available today as well as the yields on bonds
  available in the future.

• So for a surplus unit in the market who has excess cash
  which he wants to use in two years’ time there are two
  options of purchasing bonds.

•   He can purchase a 2-year bond or he can purchase a 1-year bond today
    and a second 1-year bond when the first 1-year bond matures. The investor
    will be indifferent between holding the 2-year bond and holding a series of
    two 1-year bonds.

•   Consider an investor with a 2-year horizon. He has two strategies:

•   Strategy A
•   Invest in a 2-year bond and hold the bond to maturity. Let us call the interest
    rate associated with this investment i2t.

•   Investing a dollar in this bond will yield the following two years later:

     1  i 2t 1  i 2t 
•   Strategy B
•   Invest in two 1-year bonds; one today and a second one when the first one
    matures. Let i1t be the interest rate on the 1-year bond purchased today.
•   Let i te1 be the interest on the1-year bond purchased one year from now.

• So $1 invested using this strategy will in
  two years’ time yield:

   1  i 1  i 
                          it 1

• According to the expectations hypothesis investors will
  be indifferent between these two strategies: i.e.;

1  i2t 1  i2t   (1  i1t )(1  i             e
                                                    1t 1   )
               i1t                 e
                                  i t 1
  i 2t       
• Thus the two year interest rate is the average of
  the current and the future expected 1-year
  interest rates.
• For a comparison between a 3-year bond
  and three 1-year bonds we get:

           i1t  i1t 1
                            i1t  2
  i3t 

• Generalizing the above we get:

         i1t  i  i
               e        e
                                  .........  i
 int          1t 1    1t  2                 1t  n 1
• According to the expectations hypothesis when
  interest rates are expected to rise in the future,
  long term interest rates will be higher than short
  term interest rates, i.e. the yield curve slopes up.

      The Liquidity Premium Theory
• The liquidity premium theory asserts that investors
  usually prefer short-term fixed securities over long-
  term securities.

• Because investors do not like to tie up capital in
  long-term securities, since those funds may be
  needed before the maturity date. Investors prefer
  their funds to be liquid rather than tied up.

• It assumes investors must be offered a higher
  expected return to hold a bond with a horizon
  different from their preferred horizon.

• Generally there is a shortage of long-term
  investors as compared to short-term investors so
  that an incentive is required to attract more
  investors into the long-term debt markets.

• One weakness of the expectations hypothesis is
  that it ignores risk.

• Bondholders face inflation and interest-rate risk.
  The longer the term of the bond the higher the
  inflation and interest rate risk.

• Inflation risk
• Bondholders care about the real return of their
  investment not just the nominal dollar value of
  the interest payments.
• Computing the real return from the nominal
  requires a forecast of future inflation (expected
• Forecasting a longer period is more difficult and
  less accurate than forecasting a shorter period.
• Hence real returns ten years into the future are
  more risky than real returns two months into the
• Therefore the further we look into the future the
  greater the uncertainty about inflation. Thus a
  bond’s inflation risk increases with its time to
• Interest rate risk
• This arises from a mis-match between the investor’s
  investment horizon and a bond’s time to maturity.

• If a bondholder plans to sell a bond prior to maturity
  changes in interest rate, which causes the bond price to
  change, generate gains or losses.

• The longer the term of the bond the greater the price
  changes for a given change in interest rates and the larger
  the potential capital losses. The interest rate risk also
  increases with the term to maturity.

• So both inflation and interest rate risks are positively related
  to the term to maturity of a bond. For any investor to be
  willing to tolerate more risk the return must increase to
  compensate him/her.

• The liquidity premium theory adds risk
  premium to the expectation hypothesis
  general equation, yielding:

        i1t  i1t 1  i1t 2
               e        e
                                 .........i1t n1
int                                                   rp n
• Since risk increases with maturity and rpn
  increases with n; the yield on a long-term
  bond includes a larger risk than the yield
  on a short-term bond.
• Another explanation of the liquidity premium theory
  which argues that long-term rates should always be
  higher than short-term rates is that investors prefer to
  preserve their liquidity and invest for short-term periods.

• Borrowers, on the other hand, usually prefer to borrow
  for long periods of time. This results in a mis-match
  between the requirements of borrowers and depositors.

• In order to solve this problem the banks then offer higher
  interest to depositors if they make deposits for longer
  periods (while charging higher rates to investors who
  borrow for long terms).

• This means short term interest rates would be lower than
  long term interest rates.

           The Market Segmentation Theory
• The market segmentation theory argues that the market for
  bonds is segmented by maturity dates.

• It holds that long-term and short-term bonds are traded in
  segmented markets, each of which finds its own equilibrium

• The group of investors competing for long-term bonds is
  different from the group competing for short-term bonds.

• Hence there need not be any relation between prices
  (defined by the interest rates) of short and long term bonds.
• So all points on the yield curve are independent, each is
  determined by the forces of supply and demand in its own

• The short-term interest rate is determined by demand and
  supply in the short-term bond market; the long-term interest
  is determined by demand and supply in the long-term market.

• The activities of long-term borrowers and lenders determine
  rates on long-term while short-term traders similarly set
  short-term rates independently of long-term expectations.

• The market segmentation theory assumes that neither
  investors nor borrowers are willing to shift from one maturity
  sector to another to take advantage of the opportunities
  arising between expectations and forwards rates.

• For the segmentation theory the shape of the yield curve is
  determined by the supply and demand for securities within
  each maturity sector.
             The Preferred Habitat Theory
• The preferred habitat theory states that investors have
  distinct investment horizons and require a meaningful
  premium to buy bonds with maturities outside their
  "preferred" maturity, or preferred habitat.

• Risk-averse investors prefer to match the life of their assets
  and the life of their liabilities. This is referred to as their
  preferred habitat.

• They can only adjust to other habitats if they are offered an
  extra return (incentive) to leave their habitats.

• If this theory is correct, premiums will exist for maturities
  where there is insufficient demand.

• These premiums are necessary to induce investors to leave
  their preferred habitat.
• For example, if there is a large number of firms issuing long-
  term debt relative to the number of investors interested in the
  long-term debt, supply exceeds the demand for the loans. In
  order to attract more investors to buy the bonds the firms
  must increase the interest rates on the long-term bonds. i.e.,
  the firms must offer a premium on the long-term debt.

• If many firms and institutions wish to issue short-term debt
  and there are few investors who wish to invest short-term, a
  premium will have to be offered on short-term debt.

• Proponents of this theory believe that short-term investors
  are more prevalent in the fixed-income market and therefore,
  longer-term rates tend to be higher than short-term rates.

• But short-term rates can be higher than long-term rates
• Each of the above explanations or theories
  embodies an element of truth.

• The whole truth is         probably   some
  combination of them all.


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