Fundamentals of

Investment
Only Study Guide for

INV2601

university
of south africa
© 2022 University of South Africa

All rights reserved

Printed and published by the

University of South Africa
Muckleneuk, Pretoria

INV2601/1/2022

10031731

InDesign

Framework for Team Approach Participants in the design and development of the INV2601
1

study guide:

2Authors (Revision) : Mr Ntomolane Matsoma; Mr Lenny Mamaro

3Academic Team
4Section Leader : Ms Lindiwe Ngcobo
5Critical Reader/Reviewer : Internally reviewed
6Education Consultant : Ms Gugu Ngokha (DCDT)
7Librarian : Ms Leanne Brown
8Language Services Editor : Mr Conrad Baudin
9Production (Graphic Designer) : Mr Dawid Kahts
Production (Electronic Originator)
10 : Ms Kim Barnard
Overall Copyright Consultant
11 : Mr Lourens Claassens
CONTENTS

12 MODULE AIM
13 The learning outcomes of this module
14 Overview of the module
15 Effective learning
16 The prescribed textbook
17 Tutorial letters
18 Icons used in this study guide
19 Module framework

20 TOPIC 1: THE INVESTMENT BACKGROUND 1

21 Learning unit 1: The investment setting 3
22 Learning unit 2: Organisation and functioning of securities markets 15
23 Learning unit 3: Developments in investment theory 23
24 Learning unit 4: Valuation principles and practices 41
25 Learning unit 5: Fundamental analysis 51

26 TOPIC 2: EQUITY ANALYSIS 63

27 Learning unit 6: Industry analysis 64
28 Learning unit 7: Company analysis 71
29 Learning unit 8: Company valuatio 87
30 Learning unit 9: Technical analysis 96

31 TOPIC 3: THE ANALYSIS OF FIXED-INTEREST SECURITIES 111

32 Learning unit 10: Fundamental of the analysis of fixed-interest securities 112
33 Learning unit 11: Valuation of fixed-interest securities 117

34 TOPIC 4: PORTFOLIO MANAGEMENT 146

35 Learning unit 12: An introduction to derivative instruments 147
36 Learning unit 13: Portfolio management 178
37 Learning unit 14: Evaluation of portfolio management 191

38 TOPIC 5: FOREIGN EXCHANGE 201

39 Learning unit 15: Foreign exchange management 202

40 REFERENCES 212
41 WEBSITES 212

iii
MODULE AIM
The aim of this module is to equip you with the necessary knowledge and skills to perform
investment analysis and portfolio management.

THE LEARNING OUTCOMES OF THIS MODULE

On completion of this module, you should:

• have an overall view of the investment setting and the portfolio management process
• understand the organisation and functioning of the securities market in South Africa
• know about developments in investment theory
• know the basic security valuation principles and practices
• understand that fundamental analysis is a three-step process consisting of the evaluation of
the economy, an industry and an individual company
• be able to apply basic valuation principles to value a company
• know the basic principles related to technical analysis
• understand the fundamentals of fixed-interest securities
• be able to apply basic valuation principles to value fixed-interest securities
• understand the basics of derivative instruments and their application
• know the important aspects related to the construction and management of a portfolio
• be able to evaluate portfolio management
• understand the functioning of the foreign exchange market

OVERVIEW OF THE MODULE

Investment is the commitment of funds to one or more assets that will be held over a period of
time in order to derive future payments that will compensate the investor for the time the funds
are committed. The investment strategy must take account of the expected rate of inflation and
the uncertainty of future payments. Investment management is concerned with the
management of an investor's wealth, which is the sum of current income and the present value
of all future income.
There are a variety of investment opportunities, ranging from real assets (such as real estate,
diamonds, precious metals and coins made of precious metals, art and collectibles) to financial
assets and marketable securities. Financial assets are paper (or electronic) claims on some issuer,
such as the government or a company. Marketable securities are financial assets that are easily and
cheaply tradeable in organised markets, such as the Johannesburg Securities Exchange (JSE Ltd) or
the SA Futures Exchange (Safex).

EFFECTIVE LEARNING

Investment management may be a totally new area of study for students who have not had any
previous exposure to this field of study. Such students, especially, might have to spend a fair amount
of time working through the study material before fully understanding all the topics covered. It is
important to test whether you understand the ideas presented in each learning unit, since each
learning unit contains crucial knowledge that forms the basis for those that follow. You can test
your understanding in the following simple ways:

• Identify the important ideas in the section and then try to explain them to someone else.
• Try to predict what questions you could be asked about the section concerned.
• Work thoroughly through the textbook examples and construct your own examples to illustrate
the ideas and calculations presented in the section.
• Answer both the self-assessment questions in the textbook and the assessment questions at the
end of each learning unit in this study guide.

If you compose written responses to each of these activities, you will be able to check your answers
and your reasoning by referring to the textbook and/or the study guide. Self-assessment is one of
the most effective ways of learning.
THE PRESCRIBED TEXTBOOK

The prescribed textbook for Investment Management is:

Marx, J., Mpofu, R.T., De Beer, J.S., Mynhardt, R.H., & Nortje, A.2021. INVESTMENT
MANAGEMENT. 6th edition

Each learning unit in the study guide represents a chapter of the prescribed book. Detailed learning
outcomes are given at the start of each learning unit to help you to prepare for the examination.
The assessment questions are aimed at improving your practical application of knowledge and
should be mastered before the examination. The prescribed textbook also contains self-assessment
questions and solutions at the end of each chapter.

TUTORIAL LETTERS

Tutorial Letter 101 contains important general information about academic and administrative
matters, and about assignments and their due dates. The purpose of tutorial letters is to give you
feedback on the assignments and to provide information about the examination and any other
aspects that may arise during the study period. Tutorial Letter 201 contains the suggested solutions
to the online assignments (SAmigo).
ICONS USED IN THIS STUDY GUIDE

Self-Reflective Activity Icon

The self-reflective activity indicates what aspects of the particular learning unit
you have to master and demonstrate that you have mastered them.

Key concepts. The key concepts icon draws your attention to certain
keywords or concepts that you will come across in the topic or learning unit.

Activity. The activity icon refers to activities that you must do in order to
develop a deeper understanding of the learning material.

Assessment. When you see the assessment icon you will be required to test
your knowledge, understanding and application of the material you have
just studied.

Feedback. The feedback icon indicates that you will receive

feedback on your answers to the self-assessment activities.

Study this. The learning unit icon indicates which sections of the
prescribed book or the learning guide you need to study and internalise.

Discussion Icon

This icon shows that the activity will take place as part of a myUnisa
discussion post on the Forum.
E-Tutor Icon
This icon indicates E-tutor engagements.
MODULE FRAMEWORK

Topic Lessons Chapter

1. THE INVESTMENT 1 The investment setting 1
BACKGROUND 2 Organisation and functioning of securities 2
markets
3 Developments in investment theory 3
4 Valuation principles and practices 5
5 Fundamental analysis 6

2. EQUITY ANALYSIS 6 Industry analysis 7

7 Company analysis 8
8 Company valuation 9
9 Technical analysis 10

3. THE ANALYSIS OF 10 Fundamentals of the analysis of 11

FIXED-INTEREST fixed-interest securities
SECURITIES 11 Valuation of fixed-interest securities 12

4. PORTFOLIO 12 An introduction to derivative instruments 13

MANAGEMENT 13 Portfolio management 14
14 Evaluation of portfolio management 15

5. FOREIGN EXCHANGE 15 Foreign exchange management 16

Topic 1
THE INVESTMENT BACKGROUND

AIM
Topic 1 serves as an introduction to your study of investment management.

The topic starts off by explaining the investment setting. The investment setting defines concepts
such as wealth, investment, speculation and gambling, and discusses the following fundamental
principles of investment:

• risk versus return

• diversification

It also explains the significance of asset allocation and highlights the organisation and functioning
of securities markets, as well as the use of security market indicator series for the evaluation of
market performance.

In addition, in this topic, we look at the developments in investment theory, particularly those
pertaining to the measurement of risk and return, and the way in which the required rate of return
can be linked to risk. The capital asset pricing model (CAPM) and the arbitrage pricing theory (APT)
are explained.

Valuation is based on the above-mentioned estimates of risk and required rate of return. The
various models that can be used for the valuation of different kinds of financial assets (such as
bonds, preference shares and ordinary shares) are explained.

This topic also lays the foundation for the rest of the module by explaining the first step in the
three-step, top-down valuation process of fundamental analysis. Fundamental analysis is the
process of analysing the macroeconomic, industry-specific and company-specific factors that will

1
influence the value of all financial assets.

Scientific investment decisions require diligent, independent and objective fundamental analysis.

TOPIC LEARNING OUTCOMES

Once you have worked through this topic, you should be able to:

• explain the investment setting

• explain the organisation and functioning of securities markets
• explain the developments in investment theory
• explain the valuation principles and practices regarding shares, preference
shares and bonds
• discuss fundamental analysis and understand its importance

TOPIC CONTENT

Learning unit 1: The investment setting

Learning unit 2: Organisation and functioning of securities markets
Learning unit 3: Developments in investment theory
Learning unit 4: Valuation principles and practices
Learning unit 5: Fundamental analysis

2
Learning unit 1

The investment setting

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• explain the concept of required rate of return and discuss the components of an investor's
required rate of return
• differentiate between the real risk-free rate of return and the nominal risk-free rate of return
and calculate both return measures
• explain the risk premium, the associated fundamental sources of risk, and why these sources
are complementary to systematic risk
• comprehend the trade-off between risk and return (risk/return principle)
• calculate historical returns by means of the holding period return and holding period yield
• calculate the expected return for an individual investment
• calculate the variance and standard deviation for an individual investment
• calculate the coefficient of variation as a measure of risk per unit of return
• explain diversification and its effect on the systematic risk of a portfolio
• define asset classes and distinguish between various kinds of asset classes

3
• distinguish between unit trusts, investment trusts and hedge funds as investment
alternatives
• explain the benefits, constraints and costs of international diversification
• explain the investment management process

KEY CONCEPTS

Asset classes Holding period return Portfolio strategy

Callability risk Holding period yield Real assets
Coefficient of variation Inflation Real rate of return
Convertibility risk International diversification Required rate of return
Currency risk Investment management Return
Diversification Investment policy Risk premium
Equity Liquidity risk Standard deviation
Expected return Nominal rate of return Systematic risk
Financial assets Non-systematic risk Total risk
Financial risk Performance Variance
Fixed income securities Political risk

OVERVIEW

This learning unit introduces some of the basic terminology used in investment management. It also
introduces the risk-return principle, that is, the higher the risk, the higher the required return will be. One
of the distinguishing features of risk, as opposed to uncertainty, is that it is measurable. It can be
measured using statistical measures such as variance, standard deviation and the coefficient of
variation.

4
Study chapter 1 of the prescribed book.

ACTIVITY

Your rate of return expectations for the shares of Gray Disc Company during the next year are:

GRAY DISC COMPANY

Possible rate of return Probability

% %
-10 25
00 15
10 35
25 25

(a) Calculate the expected return [E(Ri)] on this investment, the variance of this return (σ2), and

its standard deviation (σ).

(b) Under what conditions can the standard deviation be used to measure the relative risk of
two investments?
(c) Under what conditions must the coefficient of variation be used to measure the relative
risk of two investments?

Your rate of return expectations for Kayleigh Computer Company during the next year are:

KAYLEIGH COMPUTER COMPANY

Possible rate of return Probability

% %
-60 15
-30 10
-10 5
20 40
40 20
80 10

5
(d) Calculate the expected return [E(Ri)] on this investment, the variance of this return (σ2), and

its standard deviation (σ).

(e) On the basis of expected return [E(Ri)] alone, discuss whether Gray Disc or Kayleigh
Computer is preferable.
(f) On the basis of expected return [E(Ri)] alone, discuss whether Gray Disc or Kayleigh
Computer is preferable.
(g) Calculate the coefficients of variation (CVs) for Gray Disc and Kayleigh Computer and
discuss which share return series has the greater relative dispersion.

FEEDBACK

a) 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = ∑[(𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅) × (𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅)]

𝑛𝑛

𝐸𝐸(𝑅𝑅𝐺𝐺𝐺𝐺𝐺𝐺 ) = � 𝑃𝑃𝑖𝑖 (𝑅𝑅𝑖𝑖 )

𝑖𝑖−1

= [(0,25 × −0,10) + (0,15 × 0,00) + (0,35 × 0,10) + (0,25 × 0,25)]

= (−0,025 + 0,00 + 0,035 + 0,0625)
= 0,0725 = 7,25%

𝑛𝑛

𝛿𝛿 = � 𝑃𝑃𝑖𝑖 [𝑅𝑅𝑖𝑖 − 𝐸𝐸(𝑅𝑅𝑖𝑖 ]2

2

𝑖𝑖−1

σ2 = [(0,25)(−0,10 − 0,0725)2 + (0,15)(0,00 − 0,0725)2 + (0,35)(0,10 − 0,0725)2

+ (0,25)(0,25 − 0,0725)2 ]
= (0,0074 + 0,0008 + 0,0003 + 0,0079)
= 0,0164
σ = �0,0164 = 0,128

(b) Standard deviation can be used as a good measure of relative risk between two
investments that have the same expected rate of return.

(c) The coefficient of variation must be used to measure the relative variability of two
investments if there are major differences in the expected rates of returns.

6
b) 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = ∑[(𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅) × (𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅)]
𝑛𝑛

𝐸𝐸(𝑅𝑅𝐾𝐾𝐾𝐾𝐾𝐾 ) = � 𝑃𝑃𝑖𝑖 (𝑅𝑅𝑖𝑖 )

𝑖𝑖−1

= [(0,15 × −0,60) + (0,10 × 0,30) + (0,05 × −0,10) + (0,40 × 0,20)

+ (0,20 × 0,40)(0,10 × 0,80)]
= (−0,09 − 0,03 − 0,005 + 0,08 + 0,08)
= 0,115 = 11,50%

𝑛𝑛

𝛿𝛿 = � 𝑃𝑃𝑖𝑖 [𝑅𝑅𝑖𝑖 − 𝐸𝐸(𝑅𝑅𝑖𝑖 ]2

2

𝑖𝑖−1

𝛿𝛿 2 = [(0,15)(−0,60 − 0,115)2 + (0,20)(−0,30 − 0,115)2 + (0,05)(0,10 − 0,115)2

+ (0,40)(0,20 − 0,115)2 + (0,20)(0,40 − 0,115)2 + (0,10)(0,80 − 0,115)2 ]
= (0,007668 + 0,01722 + 0,00231 + 0,00288 + 0,01624 + 0,04692)
= 0,16225

𝛿𝛿 = �0,16225 = 0,403

(e) Based on [E(Ri)] alone, Kayleigh Computer Company's shares are preferable because of the

higher return available.

(f) Based on standard deviation alone, Gray Disc Company's shares are preferable because of
the likelihood of obtaining the expected returns.

𝛿𝛿
𝐶𝐶𝐶𝐶 =
𝐸𝐸(𝑅𝑅)
0128
𝐶𝐶𝐶𝐶𝐺𝐺𝐺𝐺𝐺𝐺 = = 1,77
0,0725
0,403
𝐶𝐶𝐶𝐶𝐾𝐾𝐾𝐾𝐾𝐾 = = 3.50
0,115

Based on CV, Kayleigh Computer Company's return has approximately twice the relative
dispersion of Gray Disc Company's return. Gray Disc has less risk per unit of expected return
than Kayleigh Computer.

7
ASSESSMENT

(1) Answer the self-assessment questions at the end of chapter 1 in the prescribed book.

(2) Additional assessment questions:

(a) Assume the expected rate of inflation is 6% and the real risk-free rate is 7%.
Calculate the nominal risk-free rate of return (NRFR).
(b) What is a warrant?
(c) Name the fundamental principles of investing.
(d) Given the following information, calculate the:

(i) expected return

(ii) standard deviation of the returns
(iii) coefficient of variation (CV)

Possible Probability Return

outcomes (%) (%)

Pessimistic 25 13

Most likely 50 15

Optimistic 25 17

(e) On February 1, you bought 100 shares at R34 a share and a year later you sold them
for R39 a share. During the year, you received dividends of R1,50 per share. Calculate
your HPR and HPY on this investment.

(f) On August 15, you bought 100 shares at R65 a share and, a year later, you sold them
for R61 a share. During the year, you received dividends of R3 per share. Calculate your
HPR and HPY on this investment.

(g) The rates of return calculated in (e) and (f) are nominal rates of return. Assuming that
the rate of inflation during the year was 4 %, calculate the real rates of return on these
investments.

8
(h) The annual holding period of an investment that was held for six years is minus (–)
14 %. The ending value of this investment was R11 200. The beginning value is closest
to:

(1) R12 768

(2) R13 023
(3) R24 584
(4) R27 682

(i) Which of the following statements is FALSE?

(1) Hedge funds are not allowed to advertise.

(2) Unit trusts are managed by fund managers whose payment is dependent on
whether investors have a gain or loss in their portfolio.
(3) Hedge funds have a private pool of investment capital limited to the partners.
(4) Investment trusts have the freedom to invest in accordance with the investment
strategy of the trust.

(j) The expected return [EX ] for Share X and the standard deviation [𝜎𝜎𝑦𝑦 ] of returns for
Share Y are:

Bear market Normal market Bull market

Probability 0.2 0.5 0.3
Share X –20% 18% 50%
Share Y –15% 20% 10%

𝑬𝑬𝑿𝑿 𝝈𝝈𝒀𝒀
(1) 16% 22%
(2) 16% 13%
(3) 20% 24%
(4) 20% 13%

9
(k) Calculate the standard deviation of Investment Z.

Investment Z Probability Return

Boom 0.2 15%

Normal 0.3 10%

Recession 0.5 7%

(1) 1.74%
(2) 3.04%
(3) 9.26%
(4) 9.50%

(l) A share has a beta of 1.1 and a standard deviation of 15.67%. It also has an
expected return of 14.02%. Calculate the coefficient of variation [CV].

(1) 0.01
(2) 0.08
(3) 0.89
(4) 1.12

(m) What type of risk(s) does a portfolio that is not well diversified have?

(1) systematic risk

(2) non-systematic risk
(3) liquidity risk
(4) systematic and non-systematic risk

Answers to additional assessment questions

(a) 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 = [(1 + 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅)(1 + 𝐸𝐸𝐸𝐸) − 1] × 100

= [(1,07 × 1,06) − 1] × 100 = 13,47%

(b) Warrants are derivative securities that give the holder the right to buy a stated number
of the ordinary shares of the issuing company at a specific price, called the exercise price,
during the life of the warrant. Warrants (call warrants only) are issued by a company
whose own ordinary shares are the underlying asset. Upon exercise, new shares are
issued by the company, diluting the value of existing shares. This is in contrast to covered
warrants (call, put and exotic warrant structures), which are issued by large financial

10
institutions over the shares of other companies. No new shares are issued.

(c) The fundamental principles in investing are the time value of money, risk and return, and
diversification.

(d) (i)

Possible Probability Return Weighted value

outcomes (%) P (%) k (Pxk)

Pessimistic 25 13 (0.25x13) = 3.25%

Most likely 50 15 (0.50x15) = 7.50%

Optimistic 25 17 (0.25x17) = 4.25%

Expected return E(k) (3,25 + 7,50 + 4,25) 15%

(ii)

k% E(k) % k–E(k) % [k–E(k)]2 P% Px[k–E(k)]2

13 15 –2 4 25 1

15 15 0 0 50 0

17 15 2 4 25 1

Variance 2

Standard deviation (σ) √2 1,4142

11
(iii)

𝛿𝛿 1,4142
𝐶𝐶𝐶𝐶 = = = 0,094
𝐸𝐸(𝐾𝐾) 15

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 (𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑐𝑐𝑐𝑐𝑐𝑐ℎ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓)

𝐻𝐻𝐻𝐻𝐻𝐻 =
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
39 + 1,50
= = 1,1912
34
𝐻𝐻𝐻𝐻𝐻𝐻 = (𝐻𝐻𝐻𝐻𝐻𝐻 − 1) × 100 = (1,1912 − 1) × 100 = 19,12%

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 (𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑐𝑐𝑐𝑐𝑐𝑐ℎ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓)

𝐻𝐻𝐻𝐻𝐻𝐻 =
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
61 + 3
= = 0,9845
65
𝐻𝐻𝐻𝐻𝐻𝐻 = (𝐻𝐻𝐻𝐻𝐻𝐻 − 1) × 100 = (0,9846 − 1) × 100 = 1,54%

𝐻𝐻𝐻𝐻𝐻𝐻
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 (𝑒𝑒) = �� � − 1� × 100
1 + 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
1,1912
=� − 1� × 100 = 14,54%
1,04

𝐻𝐻𝐻𝐻𝐻𝐻
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 (𝑒𝑒) = �� � − 1� × 100
1 + 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
0,9845
=� − 1� × 100 = 5,33%
1,04

(h) Annual HPY = HPR1/N

–0.14 = HPR1/6

(1 − 0.14) = 𝐻𝐻𝐻𝐻𝐻𝐻1/6

0.86 = 𝐻𝐻𝐻𝐻𝐻𝐻1/6

12
HPR = 0.866

HPR = 0.4046

Ending value
HPR =
Beginning Value

11 200
0.4046 =
Beginning value

11 200
Beginning value =
0.4046
(4) = R27 682

(i) (2) Unit trusts are managed by fund managers who are paid regardless of
whether investors gain or lose.

(j) 𝐸𝐸𝑋𝑋 = 0.20(−20) + 0.5(18) + 0.3(50)

= −4 + 9 + 15
= 20%
𝐸𝐸𝑌𝑌 = 0.2(−15) + 0.5(20) + 0.3(10)
= −3 + 10 + 3
= 10%

𝜎𝜎𝑌𝑌 = �0. 2(−15 − 10)2 + 0.5(20 − 10)2 + 0.3(10 − 10)2

= √125 + 50 + 0
= 13%

(4) 𝐸𝐸𝑋𝑋 = 20% 𝜎𝜎𝑌𝑌 = 13%

(k) Ez = 0.2(15) + 0.3(10) +0.5(7)

= 3 + 3 + 3.5

= 9.50%

13
𝜎𝜎𝑍𝑍 = �0.2(15 – 9.5)2 + 0.3(10 – 9.5)2 + 0.5(7 – 9.5)2

= �0.2(30.25) + 0.3(0.25) + 0.5(6.25)

= √6.05 + 0.08 + 3.13
= √9.26%
(2) 𝜎𝜎𝑍𝑍 = 3.04%

Standard deviation (σ)

(l) Coefficient of variation (CV) =
Expected return (Er)

15.67%
=
14.02%

(4) CV = 1.12

(m) (4) Systematic and non-systematic risk

• Systematic risk includes general economic conditions, that is, the impact of
monetary and fiscal policies, inflation and political and other events that affect all
firms.
• Non-systematic risk relates to events that affect individual companies, for example,
implementation of strategies on innovation, market development and other
activities unique to an individual firm.
• Systematic risk remains whether a portfolio is formed or not. The only risk a well-
diversified portfolio has is systematic risk. Hence, contribution of any security to the
risk of a portfolio constitutes its systematic risk.

SUMMARY

Chapter 1 of the prescribed book has introduced you to some of the basic terminology used
in investment management. The required rate of return, diversification and the overall
investment process have been explained in brief. We will elaborate on these concepts as we
work through the prescribed book. In the next learning unit, we look at the characteristics of
a well-functioning securities market and the exchanges responsible for trading equity, fixed-
interest securities and derivatives in South Africa.

14
Learning unit 2

Organisation and functioning of securities markets

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• describe the characteristics of a well-functioning securities market

• distinguish between exchange markets, over-the-counter markets and other related markets
• distinguish between primary and secondary capital markets, and explain how secondary
markets support primary markets
• compare and contrast the characteristics of South African securities markets, including
membership and types of orders
• contrast equity market indices and bond market indices
• distinguish between the composition and characteristics of the three predominant weighting
schemes used in constructing market indices
• explain the major changes that have occurred in global securities markets

15
KEY CONCEPTS

AltX Liquidity Short sale

Bond Exchange of South Africa Listing criteria South African Futures
Bond market indices Margin transactions Exchange
Equally weighted Market Special orders
Equity market indices Market indices Stop-loss order
External efficiency Market order TALX
Fourth market Market structures Third market
FTSE/JSE Over-the-counter market (OTC) Trading system
Global securities market Price continuity Transaction costs
Information Price weighted Value weighted
Initial public offerings (IPOs) Primary markets Weighting schemes
JSE Limited Satrix Yield-X
Limit order Secondary markets

OVERVIEW

In this learning unit, we look at the characteristics of a well-functioning securities market. A distinction is
made between primary and secondary markets and we are introduced to the market structures relating
to the different types of transactions and the trading system. The South African exchanges are introduced,
and market indices are explained.

Study chapter 2 of the prescribed book.

ACTIVITY

Go onto the JSE Limited website and find the other exchanges listed. Record their URLs (web
addresses) and provide a brief description of the function and purpose of each exchange.

16
URL: http://www.jse.co.za

Click on: “Links” (in the left-hand side menu)

Select: AltX, Safex and Yield-X alternately

FEEDBACK

AltX

URL: http://www.altx.co.za

AltX plays a vital role within the JSE by providing smaller companies not yet able to list on the JSE
Main Board with a clear growth path and access to capital. Expected benefits from listing and
trading on this exchange include the following:

For companies:

• access to long-term investment capital for development of the business

• access to a central trading facility, thereby providing liquidity
• the ability to realise value through an effective price discovery mechanism
• improved image amongst suppliers, customers, staff and other stakeholders due to the
prestige associated with being a listed entity
• the opportunity to use the issue of shares as consideration for an acquisition

For investors:

• the opportunity to diversify share portfolios by investing in a wide range of

high-growth small and medium-sized companies
• increased confidence due to the knowledge that AltX is regulated by the JSE, which
provides substantial investor protection

For the South African economy:

• growth of the economy by providing growth opportunities to small and medium-sized
companies
• promotion of black economic empowerment in South Africa

17
SAFEX

URL: https://www.jse.co.za/trade/derivative-market/equity-derivatives

In South Africa, the development of formal, exchange-traded derivative instruments started in

1987 when Rand Merchant Bank (RMB) initiated trades in five equity index and bond futures
contracts. The South African Futures Exchange (Safex) was founded in September 1988 as a result of
this RMB initiative. In 1989, Safex was officially licensed as a derivative market through the Financial
Markets Control Act and was officially opened on 10 August 1990.

Since then, Safex has developed in size and stature. In January 1995, it launched an agricultural
market division (AMD) where futures contracts in beef, wheat, sunflower and maize are traded. On
1 July 2001, Safex was taken over by the JSE Securities Exchange, thereby creating a more effective,
single securities exchange where underlying financial assets such as equity shares can be traded,
as well as derivatives based on such assets.

Yield-X

URL: http://www.saderivatives.co.za/Page2010.aspx?ID=YXInfo

In most major markets in the world, exchange-traded interest rate derivatives form a
significant portion of a healthy and vibrant market. This is not the case in South Africa,
where SAFEX interest rate products have enjoyed limited success.

To identify issues, the JSE consulted with market participants, during which time it
became evident that the underlying causes were numerous and diverse and that
tinkering on the periphery would not solve the problems.

During the consultative process, many market participants suggested that the JSE
should initiate a totally separate environment for the trading, clearing and settling of all
interest rate products. In so doing the JSE would create a "one-stop yield shop" for a wide
range of interest rate products.

After careful investigation, the JSE decided to effect such a new system and the concept
of Yield-X was born.

18
ASSESSMENT

(1) Answer the self-assessment questions found at the end of chapter 2 in the prescribed
book.

(2) Additional assessment questions:

(a) Define market and briefly discuss the characteristics of a good market.

(b) Define liquidity and discuss the factors that contribute to it. Give examples of a
liquid and an illiquid asset and discuss why they are considered liquid and
illiquid.

(c) Define a primary and secondary market for securities and discuss how they differ.
Discuss why the primary market is dependent on the secondary market.

(d) Briefly define each of the following terms and give an example:

(i) Market order

(ii) Limit order

(iii) Short sale

(iv) Stop-loss order

(e) If you place a stop-loss order to sell 100 shares of ABSA at R55 when the current
price is R62, how much will you receive for each share if the price drops to R50?

(1) Close to R50

(2) Close to R55

(3) Close to R62

(4) Won’t sell because the price is too low

19
(f) Which one of the following orders is most useful to short sellers who want to limit
their potential losses?

(1) Limit order

(2) Restricted order
(3) Limit-loss order
(4) Stop-buy order

Answers to additional assessment questions

(a) A market is a means whereby buyers and sellers are brought together to aid in the transfer of
goods and/or services. While it generally has a physical location, it need not necessarily have
one. Secondly, there is no requirement of ownership by those who establish and administer
the market – they need only provide a cheap, smooth transfer of goods and/or services for a
diverse clientele.

A good market should provide accurate information on the price and volume of past
transactions, and current supply and demand. Clearly, there should be rapid dissemination of
this information. Adequate liquidity is desirable so that participants may buy and sell their
goods and/or services rapidly, at a price reflecting the
supply and demand. The costs of transferring ownership and middleman commissions should
be low. Finally, the prevailing price should reflect all available information.

(b) Liquidity is the ability to sell an asset quickly at a price not substantially different from the
current market price, assuming no new information is available. A share of Anglo-American
PLC (ANG) is very liquid, while an antique would be a fairly illiquid asset. A share of ANG is
highly liquid since an investor could convert it into cash within a fraction of a percentage point
of the current market price. An antique is illiquid since it is relatively difficult to find a buyer, and
then you are uncertain as to what price the prospective buyer would offer.

(c) The primary market in securities is where new issues are sold by companies to
acquire new capital via the sale of bonds, preferred shares or common shares. The sale typically
takes place through an investment banker.

The secondary market is simply trading in outstanding securities. It involves transactions

between owners after the issue has been sold to the public by the company. Consequently, the

20
proceeds from the sale do not go to the company, as is the case with a primary offering. Thus,
the price of the security is important to the buyer and seller.

The functioning of the primary market would be seriously hampered in the absence of a good
secondary market. A good secondary market provides liquidity to an investor if he or she wants
to alter the composition of his or her portfolio from securities to other assets (for example a
house). Thus, investors would be reluctant to acquire securities in the primary market if they
felt they would not subsequently be able to sell the securities quickly at a known price.

(d) (i) Market order

A market order is an order to buy/sell a share at the most profitable ask/bid

prices prevailing at the time the order is matched/executed on an electronic exchange or
reaches the exchange floor (open outcry system). A market order implies that the investor
wants the transaction completed quickly at the prevailing price. Example: I read good
reports about Harmony and I’m certain the share will go up in value. When I call my
broker and submit a market buy order for 100 shares of Harmony, the prevailing asking
price is R100,30. Total cost for my shares will be R10 030 + commission.

(ii) Limit order

A limit order specifies a maximum price that the individual will pay to purchase a share
or the minimum he/she will accept to sell it. Example: ABSA is selling at R98,50 – I would
put in a limit buy order for one week to buy 100 shares at R97.

(iii) Short sale

A short sale is the sale of shares that are not currently owned by the seller, with the intent
of purchasing them later at lower prices. This is done by borrowing the shares from
another investor through a broker. Example: I expect SABMiller to go to R125 – I would
sell the shares short at R135,53 and expect to replace them when the price gets to R130.
This option/strategy is not freely available in all countries (e.g. South Africa) and, even
then, restrictions are imposed related to the timing, percentage of the proceeds available
to the investor and margin requirements.

21
(iv) Stop-loss order
A stop-loss order is a conditional order whereby the investor indicates that he or she
wants to sell a share when the price drops to a specified price, thus protecting himself or
herself from a large and rapid decline in price. Example: I buy Murray and Roberts
Holdings (M&R HLD) at R30 and put in a stop-loss at R27 that protects me from a major
loss if it starts to decline.

(e) (2) The stop-loss ensures a selling price close to R55.

(f) (4) The stop-buy sets a certain buy-back price to limit the potential loss from a short sale.

SUMMARY

This learning unit has provided you with a clearer understanding of the functioning and structure of the
securities markets in South Africa. In the next learning unit, we will have a look at the developments in
investment theory.

22
Learning unit 3
Developments in investment theory

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• define and discuss an efficient capital market

• describe and contrast the forms of the efficient market hypothesis (EMH)
• explain the implications of share market efficiency for fundamental analysis and technical
analysis
• discuss the implications of efficient markets for the portfolio management process and the
role of the portfolio manager
• explain the rationale for investing in index funds
• define risk aversion
• list the Markowitz Portfolio Theory's assumptions about individuals' investment behaviour
• describe the efficient frontier and explain the implications for incremental return as an
investor assumes more risk
• define the security market line (SML) and discuss the factors that cause movements along,
changes in the slope of, and shifts of the security market line
• list the assumptions of the capital market theory

23
• explain what happens to the expected return, standard deviation of returns, and possible
risk-return combinations when a risk-free asset is combined with a portfolio of risky assets
• identify the market portfolio and describe the role of the market portfolio in the formation of
the capital market line (CML)
• define systematic risk and unsystematic risk, and explain why an investor should not expect
to receive additional return for assuming unsystematic risk
• describe the capital asset pricing model (CAPM), draw a diagram of the security market line
(SML) and define beta (β)
• calculate and interpret, using the SML, the expected return on a security, and evaluate
whether the security is undervalued, overvalued or properly valued
• describe the arbitrage pricing theory (APT)

KEY CONCEPTS

Arbitrage pricing theory (APT) Fundamental analysis Semi-strong EMH

Asset pricing models Investment theory Standard deviation
Beta (β) Markowitz Portfolio Theory Strong-form EMH
Capital asset pricing model Overvalued Systematic risk
Capital market line Properly/fairly valued Technical analysis
Capital market theory Risk aversion Undervalued
Efficient market Risk and return Unsystematic risk
Efficient frontier Risk-free asset Weak-form EMH
Efficient market hypothesis Security market line (SML)

OVERVIEW

Valuation requires an estimate of expected returns and a determination of the risk involved.

We start this learning unit by explaining the concept of efficient capital markets, which hypothesises that
security prices reflect the effect of all information. We also consider why markets should be efficient, how the
hypothesis may be tested, the results of tests and the implications of the results for those engaged in
fundamental and technical analysis, as well as portfolio management.

24
The Markowitz theory provides the first rigorous measure of risk for investors and shows one how to select
alternative assets to diversify and reduce the risk of a portfolio. Markowitz also derives a risk measure for
individual securities in the context of an efficient portfolio.

This learning unit also outlines several major developments in investment theory that have influenced the way
in which risk is specified and measured in the valuation process. The emphasis falls on the capital asset pricing
model (CAPM) and the arbitrage pricing theory (APT), and some background on risk and asset valuation is
provided.

Study chapter 3 of the prescribed book.

ACTIVITY

Explain the security market line (SML) and capital market line (CML) in detail.

FEEDBACK

The Markowitz efficient frontier and capital market line (CML)

Efficient portfolios are the set of portfolios with the maximum expected return at a given risk or,
conversely, the set of portfolios with the minimum risk at a given level of expected rate of return. The
set of all the efficient portfolios that can be created from a group of diversified investment possibilities
is called the efficient frontier.

Because diversification can reduce the risk of a portfolio that contains different assets, the
efficient frontier will usually contain only portfolios. Individual assets cannot have their risk
reduced by diversification.

25
An example of an efficient frontier is shown in figure 3.1. Every portfolio that lies on the efficient
frontier has either a higher rate of return for equal risk, or a lower risk for an equal rate of return
than some portfolio beneath the frontier. Thus, we would say that portfolio A dominates
portfolio C because it has an equal rate of return but substantially less risk. Similarly, portfolio B
dominates portfolio C because it has equal risk but a higher expected rate of return. No portfolio
on the efficient frontier can dominate any other portfolio on the efficient frontier. All of these
portfolios have different return and risk measures, with expected rates of return that increase
with higher risk.

FIGURE 3.1

Efficient frontier for alternative portfolios

Let us see what happens to the average rate of return when you combine a risk-free asset with
a portfolio of risky assets, such as those that exist on the efficient frontier. The expected rate of
return for a portfolio of risky assets is the weighted average rate of return of those assets. The
expected rate of return for a portfolio that includes a risk-free asset is also the weighted average
of these assets.

Adding a risk-free asset to the risky assets on the efficient frontier leads to a more desirable set
of investment opportunities, which in turn leads to a straight line called the capital market line
(CML). Investing all your money in a risk-free asset will give a standard deviation of 0. In figure
3.2, such an investment would lie at point R on the CML. Adding risky assets to the investment

26
would result in a movement along the CML. At the point of tangency, (m), lies the market
portfolio, which includes all risky assets. Because the market portfolio includes all risky assets,
it is a completely diversified portfolio, which means that all risk unique to individual assets in
the portfolio is diversified away.

Definition: The capital market line (CML)

The CML is a risk-return for efficient portfolios. The CML states that the required rates of
return for portfolios are a positive linear function of the portfolios’ standard deviation (or
total risk).

In the case of the SML, risk is measured by means of beta (systematic or non-diversifiable risk),
whereas, in the case of the CML, risk is measured by means of standard deviation (total risk).

FIGURE 3.2

Lending and borrowing (or leveraged) portfolios on the CML

27
Lending and borrowing (or leverage) portfolios on the CML

The portfolios along the CML between points R and m are lending portfolios. The set of portfolio
possibilities along line R–m dominates all portfolios on the original efficient frontier (EmF) below
point m. For example, you could attain a risk and return combination between R and point m by
investing a portion of your investment funds in the risk-free asset (that is, lending money at the
risk-free rate) and the remains of your investment funds in the risky portfolio at point m.

The portfolios above point m along the CML are leveraged, that is, they are borrowing portfolios.
These portfolios were constructed by borrowing at a fixed-interest rate and investing the borrowed
funds in the risky portfolio m. Borrowing more money leverages the portfolio farther out on the CML
and increases the investor's risk exposure.

The capital asset pricing model and security market line (SML)

Total risk of a security consists of two parts: non-diversifiable risk (systematic risk) and diversifiable
risk (unsystematic risk). The beta coefficient is used to measure
non-diversifiable (systematic risk) and standard deviation is the measure for total risk. Unsystematic
risk is the type of risk that is unique to individual assets in a portfolio and can be diversified away.
Systematic risk is defined as the variability in all risky assets caused by macroeconomic variables
that cannot be diversified away.

The basic theory that links together risk and return for all assets is called the capital
asset pricing model (CAPM). The CAPM links together non-diversifiable risk and return for all
assets.

Definition: The capital asset pricing model (CAPM)

The CAPM is a linear relationship in which required rate of return k from an asset is determined
by that asset’s non-diversifiable (or systematic, or beta) risk.

When the CAPM (k j = R F + [bj x (k m – R F)]) is depicted graphically, it is called the security market

line (SML). The SML will, in fact, be a straight line. It reflects, for each level of non-diversifiable risk
(beta), the required return in the marketplace. In the graphs of the SML, risk as measured by beta, b,
is plotted on the x-axis, and required returns, k, are plotted on the y-axis.

28
The following three changes with respect to the SML will be discussed briefly:

• a movement along the SML

• changes in the slope of the SML
• the parallel shift of the SML

FIGURE 3.3

Movement along the SML

A movement along the SML is caused by a change in the beta. Assume that the
risk-free rate, RF, was 7% and the market return, km, was 11%. Since the beta associated with km is 1

and with RF is 0, the SML can be plotted by using these two coordinates. Looking at figure 3.3 and

using the beta for asset Z, bz, of 1.5, the required return for bz is 13%.

It should be clear that, for assets with a beta greater than 1, the risk premium is greater than that for
the market, and so is the return. For assets with betas less than 1, the risk premium is less than that
for the market and so is the return.

Changes in the slope of the SML are caused by changes in the market risk premium. The slope of the
SML reflects the general risk preferences of investors in the marketplace. The slope of the SML reflects

29
the degree of risk aversion: the steeper the slope, the greater the degree of risk aversion, since a higher
level of return would be required for each level of risk as measured by beta.

The result can be seen in figure 3.4. Note that, although asset Z’s risk as measured by beta does not
change, its required return has increased due to the increased risk aversion reflected in the market risk
premium, which rose from 4% to 7%. It should now be clear that greater risk aversion results in higher
required returns for each level of risk, whereas a reduction in risk aversion would cause the required
return for each level of risk to decline.

FIGURE 3.4

Changes in the slope of the SML

The parallel shift of the SML is caused by an increase (upward shift of SML) or decrease (downward
shift of SML) in inflation, which will result in changes in the nominal risk-free rate.

30
Figure 3.5 graphically depicts the situation. It shows that a 3% increase in inflation results in a parallel
shift upwards by a vertical distance of 3% in the SML. The required return on all assets rises by 3%. Note
that a rise in the inflation from, say, 5% to 8% causes the risk-free rate to rise from 7% to 10% and the
market return to increase from 11% to 14%. The SML therefore shifts upwards by 3%, causing the
required return on all risky assets such as asset Z to rise by 3%, from 13% to 16%. Thus, a given change
in inflation will be fully reflected in a corresponding change in the returns of all assets as reflected
graphically in a parallel shift of the SML.

FIGURE 3.5

Parallel shift of the SML

ACTIVITY

Assume the long-run growth rate of the economy increased by 1% and the expected rate of
inflation increased by 4%. What would happen to the required rates of return on government
bonds and common shares? Show graphically how the effects of these changes would differ
between these alternative investments.

31
FEEDBACK

Both changes cause an increase in the required return on all investments. Specifically, an increase
in the real growth rate will cause an increase in the economy’s risk-free rate because of a higher
level of investment opportunities. In addition, the increase in the rate of inflation will result in an
increase in the nominal risk-free rate. Because both changes affect the nominal risk-free rate, they
will cause an equal increase in the required return on all investments of 5%.

The graph should show a parallel shift upward in the capital market line of 5%.

ACTIVITY

You see in the Finance Week that the yield spread between BAA corporate bonds and AAA corporate
bonds has gone from 350 basis points (3.5%) to 200 basis points (2%). Show graphically the effect
of this change in yield spread on the SML and discuss its effect on the required rate of return for
common shares.

FEEDBACK

Such a change in the yield spread would imply a change in the market risk premium because,
although the risk levels of bonds remain relatively constant, investors have changed the spreads
they demand to accept this risk. In this case, because the yield spread (risk premium) has declined,
this implies a decline in the slope of the SML, as shown in the following graph.

32
ASSESSMENT

(1) Answer the self-assessment questions found at the end of chapter 3 in the prescribed
book.

(2) Additional assessment questions:

(a) Define Markowitz diversification.

(b) What is meant by the term abnormal rate of return?

(c) List and briefly discuss the three forms of the efficient market hypothesis.

(d) List and discuss the role of a portfolio manager in a perfectly efficient market.

(e) Two portfolios (V and W) consist of the following assets:

PORTFOLIO V PORTFOLIO W

ASSET Proportion (%) BETA Proportion (%) BETA

1 10 1,65 10 0,80

2 30 1,00 10 1,00

3 20 1,30 20 0,65

4 20 1,10 10 0,75

5 20 1,25 50 1,05

33
Calculate the betas of these two portfolios and state which portfolio’s return is the
more responsive to changes in the market.

(f) Calculate the required rate of return of asset A, which has a beta of 1,5.
The risk-free rate of return is found to be 7% and the return on the market portfolio
of assets is 11%.

(g) What would the required rate of return for asset G be if an investor estimated the risk-
free rate of return to be 4% and the market price of risk to be 1,1 for interest rate risk
and 0,9 for purchasing-power risk? Furthermore, suppose that asset G has 40% more
than the average amount of the interest rate risk factor combined with an average
amount of purchasing-power risk of 1,0.

(h) The required annual rate of return for a company is 14.6%. The risk-free rate of return
is 11% per annum, and the estimated return of the market is 15%. The beta of this
company is:

(1) 0.40
(2) 0.90
(3) 1.00
(4) 1.30

(i) Your broker has advised you that he believes that the shares of a company are going
to rise from R20 to R23 per share over the next year. You know that the annual return
on the ALSI has been 11.25% and the 90-day treasury rate is 4.75% per annum. If the
beta for this company is 0.95, will you purchase the share?

(1) Yes, because it is overvalued

(2) No, because it is overvalued
(3) No, because it is undervalued
(4) Yes, because it is undervalued

34
(j) The estimated rate of return of Company C is 22.60%. The beta is 1.6 and the
standard deviation is 13%. The expected rate of return of the market is 19%. The risk-
free rate of return is 11%, Company C is …

(1) overvalued by 1.20%

(2) undervalued by 1.20%
(3) overvalued by 8.40%
(4) properly valued

(k) The variance of the market is 0.9. The Covariance of the Glen Co and the market is
0.49. Calculate the beta of the share.

(1) 0.54
(2) 0.56
(3) 1.04
(4) 1.84

(l) The Markowitz efficient frontier represents that set of portfolios (of risky
investments) that have the ....... (a) ....... returns for every given level of risk, or the .......
(b) ....... risk for every level of return.

A B

(1) maximum maximum

(2) maximum minimum
(3) minimum maximum
(4) minimum minimum

(m) The efficient frontier represents

(a) only portfolios

(b) a portfolio of risky assets
(c) a set of portfolios with a maximum expected rate of return to a given risk
(d) single assets

(1) a, b, d
(2) a, b, c
(3) d, b, c
(4) a, b, c and d

35
(n) Which one of the following is not a systematic risk factor?

(1) interest rate risk

(2) market risk
(3) business risk
(4) inflation risk

Answers to additional assessment questions

(a) Markowitz diversification is an analytical procedure that involves combining assets

that are less than perfectly positively correlated in order to form an efficient portfolio.

(b) Abnormal rate of return is the amount by which a security's return differs from the
expected rate of return based upon the market's rate of return and the security's
relationship with the market.

(c) The notion that share prices already reflect all available information is referred to as the
efficient market hypothesis (EMH). It is common to distinguish between three versions
of the EMH: the weak, semi-strong and strong forms. These versions differ by their
treatment of what is meant by "available information".

The weak-form hypothesis asserts that share prices already reflect all information that
can be derived from studying past market trading data. Therefore, technical analysis,
trend analysis and so on are fruitless pursuits. Past share prices are publicly available
and virtually costless to obtain. If such data ever conveyed reliable signals about future
share performance, all investors would have learned to exploit such signals.

The semi-strong form hypothesis states that all publicly available information about the
prospects of a firm must be reflected already in the share's price. Such information
includes, in addition to past prices, all fundamental data on the firm, its product, its
management, its finances, its earnings, and so on that can be found in public information
sources.

The strong-form hypothesis states that share prices reflect all information relevant to
the firm, even including information available to company "insiders". This version is an

36
extreme one. Obviously, some "insiders" do have access to pertinent information long
enough for them to profit from trading on that information before the public obtains
it. Indeed, such trading – not only by the “insiders” themselves, but also relatives and
associates – is illegal.

For weak-form or semi-strong forms of the hypothesis to be valid, the

strong-form version is not required to hold. If the strong-form version was valid,
however, both the semi-strong and the weak-form versions of efficiency would also be
valid.

(d) Even in an efficient market, a portfolio manager would have the important role of
constructing and implementing an integrated set of steps to create and maintain
appropriate combinations of investment assets. Listed below are the necessary steps
in the portfolio management process.

(i) The client is counselled to help him or her determine appropriate objectives
and identify and evaluate constraints. The portfolio manager, together with
the client, should specify and quantify risk tolerance, required rate of return,
time horizon, tax considerations, income needs, liquidity, legal and regulatory
constraints, and any unique circumstances that will influence or modify
normal management procedures or goals.

(ii) Capital market expectations are monitored and evaluated. Relevant

considerations such as economic, social and political conditions or
expectations are factored into the decision-making process in terms of the
expected risk/reward relationship for the various asset categories. Different
expectations may lead the portfolio manager to adjust a client's systematic
risk level even if markets are efficient.

(iii) The above steps are decisions derived from or implemented through portfolio
policy and strategy setting. Investment policies are set and implemented
through the choice of optimal combinations of financial and real assets in the
marketplace – that is, asset allocation. Under the assumption of a perfectly
efficient market, shares would be priced fairly, eliminating any added value by
specific security selection. It might be argued that an investment policy that

37
stresses diversification is even more important in an efficient market context
because the elimination of specific risk becomes extremely important.

(iv) Market conditions, relative asset category percentages and the investor's
circumstances are monitored.

(v) Portfolio adjustments are made as a result of significant changes in any or all
relevant variables.

(e) 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝑣𝑣 = [(0,10 × 1,65) + (0,30 × 1,00) + (0,20 × 1,30) + (0,20 × 1,10) + (0,20 × 1,25)]
= 1,20
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝑤𝑤 = [(0,10 × 0,80) + (0,10 × 1,00) + (0,20 × 0,65) + (0,10 × 0,75) + (0,50 × 1,05)]
= 0,91

Portfolio V's beta is 1,20 and portfolio W's beta is 0,91. These values make sense since
portfolio V contains relatively high-beta assets and portfolio W contains relatively low-
beta assets. Clearly, portfolio V returns are more responsive to changes in market returns
and therefore riskier than those of portfolio W.

(f) Capital asset pricing model (CAPM)

𝐾𝐾𝐴𝐴 = 7 + 1.5(11 − 7) = 13%

(g) Arbitrage pricing theory (APT)

𝐾𝐾𝑐𝑐 = 4 + (1,1 × 1,4) + (0,9 × 1,0) = 6,44%

(h) Required return = rf+ β (km–r f )

14.6 = 11+ β(15 -11)
14.6 – 11
β =
4
(2) β = 0.90

38
(i) Required rate of return = 4.75 + 0.95(11.25 – 4.75)

= 4.75 + 6.175

= 10.925%
23
HPR = – 1 × 100
20
= (1.15 – 1) – 100

Estimated rate of return (HPR) = 15%

Required rate of return < Estimated rate of return

10.925% < 15%

Therefore, the share is undervalued.

(4) Yes, you will purchase the share because it is undervalued.

(j) Required return (k) = rf+ β (km– rf)

= 11 + 1.6 (19 – 11)

= 11 + 12.80

= 23.80%

Estimated rate of return = 22.60%

Required rate of return > Estimated rate of return

23.80% > 22.60%

23.80% – 22.60% = 1.20%

Therefore, the share is overvalued.

(1) The share is overvalued by 1.20%.

Covariance (glen co. and market)

(k) beta (β) =

39
Variance of market

0.49
β=
0.90

(1) β = 0.54

(l) (2) maximum returns and minimum risk

(m) (2) a, b, c. Only portfolios; a portfolio of risky assets and a set of portfolios with a
maximum expected rate of return to a given risk

(n) (3) business risk

SUMMARY
In this learning unit, we discussed the investment theories underlying investment analysis and portfolio
management. The efficient market hypothesis, the Markowitz efficient frontier and Modern Portfolio
Theory are fundamental to the study of investments. The capital asset pricing model and arbitrage pricing
theory, used to determine the return required on investments dependent on the risk involved and overall
market return, were introduced. In the following learning unit, we look at the very important concept of
valuation principles and practices. You should fully understand these principles and master all the
calculations before continuing with the other learning units.

40
Learning unit 4
Valuation principles and practices

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• differentiate between par value, market value, book value and fair (intrinsic) value
• identify the required input variables for valuation purposes
• explain the components of an investor's required rate of return (i.e. the real
risk-free rate, the expected rate of inflation and a risk premium)
• calculate the growth rate (g), incorporating the return on equity (ROE) and the earnings retention rate
(RR)
• determine the value of a bond
• approximate and calculate the yield to maturity (YTM) of a bond
• calculate the value of preference shares and common shares using the various dividend discount
models (i.e. no-growth, constant-growth, two-stage and three-stage models)
• use relative valuation models (i.e. P/E ratio, P/BV ratio, P/S ratio and P/CF ratio) for ranking shares of
similar firms or firms from the same sector
• determine the value of investment trusts using the net asset value (NAV) method
• explain the determinants of the value of warrants

41
KEY CONCEPTS

Approximate yield Market price Required return

Bond Market value Retention rate (RR)
Book value Net asset value Return on equity (ROE)
Cash flows No growth model Three-stage DDM
Constant growth model Ordinary shares Time to maturity
Discount rate Par value Timing
Dividend discount models (DDM) Preference shares Two-stage DDM
Exercise price Price/book value Valuation
Fair (intrinsic) value Price/cash flow Warrants
Growth rate Price/earnings Yield to maturity
Intrinsic value Price/sales
Investment trusts Relative valuation models

OVERVIEW

Valuation refers to the process of finding the fair (intrinsic) value of an asset. In this learning unit, we focus on
the valuation of financial assets, such as preference shares, ordinary shares, investment trusts and warrants.
We also explain various models that can be used to determine the fair (intrinsic) value of the above-
mentioned financial assets.

Some investors follow a "stock-picking" approach to investments. This involves using the valuation models
and comparing the intrinsic value with the market value. The investment is regarded as undervalued if the
intrinsic value exceeds the market value, and as overvalued if the market value exceeds the intrinsic value.
The stock-picking approach therefore does not involve fundamental analysis.

Study chapter 5 of the prescribed book.

42
Net asset value

The net asset value (NAV) per share is the available shareholders' funds divided by the number of shares
in issue. The shareholders' funds are the net value of all the company's assets having deducted liabilities.

If the share price of an investment trust is lower than the NAV per share, the trust is trading at a discount. The
discount is shown as a percentage of NAV. This may represent a good buying opportunity. If the share
price of an investment trust is higher than the NAV per share, the trust is trading at a premium. The
premium is shown as a percentage of the NAV. This may represent a good selling opportunity.

ACTIVITY

Assume Nani Ltd has issued 143 380 ordinary shares and that the firm's shares are trading at R10
each. The firm's total assets amount to R2 800 000 and its total liabilities to R850 000. Further
assume that investment trust companies similar to Nani normally trade at a discount of 20% to
NAV.

FEEDBACK

The NAV of Nani shares is calculated as follows:

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 − 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙

𝑁𝑁𝑁𝑁𝑁𝑁 =
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
2 800 000 − 850 000
= = 𝑅𝑅13,60
143 380

The shares are trading at R10 per share, representing a discount of R(13.60–10)
= R3.60 p/s. Therefore, the shares are trading at a discount of 26,47% (3,60/13.60) to NAV, compared
to similar companies trading at a discount of only 20% to NAV.

At a NAV of 13,60 and a discount of 20% regarded as the norm, the share should trade at
R(13.60x0,80) = R10.88 and not R10 per share.

The NAV indicates that the share is undervalued and offers an opportunity to buy.

43
ACTIVITY

Philadi Ltd has issued 10 million ordinary shares, and the firm's shares are trading at R5.50 each. The
firm's total assets amount to R100 million and its total liabilities to R60 million. Further assume that
investment trust companies similar to Philadi normally trade at a premium of 20% to NAV.

FEEDBACK

The NAV of Philadi shares is calculated as follows:

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎−𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 100−60

𝑁𝑁𝑁𝑁𝑁𝑁 = = = 𝑅𝑅4
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 10

The shares are trading at R5.50 p/s, representing a discount of R(5,50–4) = R1.50 p/s. Therefore, the
shares are trading at a premium of 37.5% (1,5/4) to NAV, compared to similar
companies trading at a premium of only 20% to NAV.

At a NAV of 4 and a premium of 20% being regarded as the norm, the share should trade at R(4x1.2)
= R4.80 and not at R5.50 per share.

The NAV indicates that the share is overvalued and offers an opportunity to sell.

ASSESSMENT

(1) Answer the self-assessment questions at the end of chapter 5 in the prescribed book.

(2) Additional assessment questions:

(a) What are three key inputs when calculating the present value of any asset?

(b) A firm has a return on equity of 16%. The dividend payout ratio (DPR) of this firm is 25%.
What is the growth rate of this firm?

44
(c) Approximate the yield to maturity for a bond that pays an 8% coupon rate annually on its
R1 000 face value, matures in four years and is selling for R967.59.

(d) Consider a share that has an annual cash dividend of R5 per share for the next year and
an average growth rate of 2% per year in its cash dividends. Assume that this share is in a
risk class requiring a 10% per year rate of return to attract investors. Calculate this share's
present value by using the constant growth dividend discount model (DDM).

(e) A share is expected to pay a dividend of R1 one year from now, with growth at 5%
thereafter. In the context of a dividend discount model, the share is correctly priced today
at R10. Determine the value of the share two years from now according to the single
stage, constant growth dividend model, if the required return is 15%.

(f) Calculate the fair (intrinsic) value of a share with a constant earning of R1 per share
and a required rate of return of 10%.

(g) A firm has issued 20 million ordinary shares. The firm's total liabilities amount to R120
million and the total assets amount to R200 million. The firm's shares are trading at R6
each. Investment trust companies similar to this firm normally trade at a premium of
20% to net asset value (NAV). Calculate the NAV of this firm and relate it to its market
price.

(h) A company issues 8.5% preference shares at R80 each. Determine the intrinsic value of
a preference share, assuming a 6.5% required rate of return.

(1) R 94.12
(2) R104.20
(3) R123.80
(4) R130.70

(i) An investor in Fun Ltd's ordinary share expects it to pay annual cash dividends of R2.00
and R2.30 per share during the next two years. This investor plans to sell the share for R33
at the end of the second year, after collecting the two dividends. Fun Ltd's required rate of
return is 10%. Calculate the present value of this share.

(1) R25.00

45
(2) R30.99
(3) R33.60
(4) R37.30

(j) A company has a beta of 1.3, while the market return equals 18% and the risk-free rate
of return equals 12%. The company is expected to pay a dividend of R10.89 next year,
with no further growth anticipated. Determine the value of the firm's ordinary shares.

(1) R36.25
(2) R55.00
(3) R60.50
(4) R90.75

(k) A firm has a current price of R40 a share, an expected growth rate of 11% and an expected
dividend per share (D1) of R2. Given its risk, you have a required rate of return for the

share of 12%. Your expected rate of return and investment decision is as follows:

(1) 14% – do not buy

(2) 16% – do not buy
(3) 14% – buy
(4) 16% – buy

(l) The following information on a company is available:

Return on equity (ROE) 18%

Required rate of return 12%
Expected earnings (E1) R7 per share

Expected dividends (D1) R3.85

Market price R95

The current value per share of this company is closest to:

(1) R96.70
(2) R97.70
(3) R98.70
(4) R99.70

46
(m) Themba Modise is an analyst for Investment Holdings. He has collected information
about Fin Ltd.

A retention ratio of 40% is projected to continue into the future. ROE is 12% and it has a
beta of 1.2. The risk-free rate is 6% and the expected market return is 11%.

If Themba believes next year's earnings (E1) will be R4.00 per share, what value should

be placed on this share?

(1) R22.64
(2) R26.67
(3) R33.33
(4) R45.45

Answers to additional assessment questions

(a) cash flows, timing and the discount rate

b) 𝑔𝑔 = 𝑅𝑅𝑅𝑅𝑅𝑅 × 𝑅𝑅𝑅𝑅 = 𝑅𝑅𝑅𝑅𝑅𝑅 × (1 − 𝐷𝐷𝐷𝐷𝐷𝐷)

= 16 × (1 − 0,25) = 12%

1+(𝑀𝑀−𝐷𝐷𝐷𝐷0 )/𝑛𝑛 80+(1000−967,59)/4

c) 𝐴𝐴𝐴𝐴 = = = 8.96%
(𝑀𝑀+𝐷𝐷𝐷𝐷0 )/2 (1000+967,59)/2

1 𝐷𝐷 5
d) 𝑃𝑃0 = 𝑘𝑘−𝑔𝑔 = (0,10−0,02) = 𝑅𝑅62,52

𝐷𝐷1 (1+𝑔𝑔)2 1(1,05)2

e) 𝑃𝑃0 = 𝑘𝑘−𝑔𝑔
= (0,15−0,05) = 𝑅𝑅11,03

𝐸𝐸 1
f) 𝑉𝑉 = = = 𝑅𝑅10
𝐾𝐾 0,10

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎−𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 200−120

g) 𝑁𝑁𝑁𝑁𝑁𝑁 = = = 𝑅𝑅4
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 20

The shares are trading at R6 per share, representing a premium of R(6–4) = R2 per share.

47
Therefore, they are trading at a premium of 50% (2/4) to NAV, compared to similar companies
trading at a premium of only 20% to NAV.

At a NAV of 4 and a premium of 20% regarded as the norm, the share should trade at R(4x1,2)
= R4.80 and not R6 per share.

The NAV indicates that the share is overvalued and offers an opportunity to sell.

(h) Vp = Dp

kp

Dp = 0.085 × R80

= R6.80

6.80
=
0.065
(2) = R104.62

(i) Two-stage dividend discount model:

D1 = R2.00

D2 = R2.30

P2 = R33

Required rate of return (k) = 10%

D1 + D2 + P2
Value of the share = (1+k)¹ (1+k)² (1+k)²

= 2.00 + 2.30 + 33
(1.10)¹ (1.10)² (1.10)²
= 1.8182 + 1.9008 + 27.2727
(3) V = R30.99

E
(j) No-growth model: V =
k
Required return (k) = rf+ β (km – rf )
= 12 + 1.3 (18 – 12)

= 12 + 7.80

= 19.80%

48
V = 10.89
0.198
(2) = R55

(k) E(r) = D1 +g

P0

2
= + 0.11
40
= 0.05 + 0.11
= 16%

(4) The expected rate of return is 16%, which is greater than the required rate of
return of 12%. Therefore, you should buy the share.

(l) Payout ratio = D1

E1

3.85
= = 55%
7

Retention ratio = 1 – payout ratio

= 1 – 0.55
= 45%

Growth (g) = Retention ratio × ROE

= 0.45 × 8%
= 10%

Required rate of return (k) = 12%

P0 = D1
k–g

= 3.85
0.12 – 0.081

3.85
=
0.039

(3) P0 = R98.70

49
(m) Retention ratio (RR) = 40%
ROE = 12%

Growth (g) = RR × ROE

= 0.4 × 12%
= 4.80%

Required return = rf+ β (km – rf)

= 6 + 1.2 (11 – 6)

=6+6

= 12%

E1 = R4.00

D1 = payout ratio × E1 Where: payout ratio = 1 – retention ratio

= 1 – 0.40

= 0.60

D1 = 0.60 × R4.00

= R2.40

D1
P0 =
k–g
2.40
=
0.12 – 0.048
2.40
=
0.072
(3) P0 = R33.33

SUMMARY

In this learning unit, you were introduced to the basic valuation principles and practices applied in other
chapters of the prescribed book. Next, we look at the process employed to discover undervalued securities,
namely fundamental analysis, featuring the three-step valuation approach.

50
Learning unit 5

Fundamental analysis

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• define fundamental analysis

• explain the three-step valuation process (top-down approach to the security valuation
process) and its underlying logic
• explain the three methods that may be used for economic forecasting
• explain the key macroeconomic variables that need to be analysed for the purpose of
fundamental analysis
• briefly explain the concept of industry analysis
• briefly explain the concept of company analysis

KEY CONCEPTS

Balance of payments Gross domestic product (GDP) Production price index (PPI) Budget

51
deficit Gross national product (GNP) Repo rate
Company analysis Industry analysis Reserve requirements Consumer
price index (CPI) Inflation Three-step valuation
process
Economic forecasting Interest rates Top-down approach
Exchange rates Leading economic indicators Unemployment rates Forecasting
models Macroeconomic analysis
Fundamental analysis Market signals

OVERVIEW

Fundamental analysis refers to the three-step, top-down approach to investment decisions. In this learning
unit, we explain these steps by means of macroeconomic analysis and its relationship to industry and
company analysis.

FIGURE 6.1
Three-step valuation process of fundamental analysis

52
In this learning unit, the top part of figure 6.1, namely the analysis of macroeconomic factors, is discussed.
As mentioned earlier, this is the first step in fundamental analysis. The second step (industry analysis) in
chapter 7 of the prescribed book, and the third step (company analysis) in chapters 8 and 9 of the prescribed
book, will be discussed in topic 2, learning units 7, 8 and 9.

Study chapter 6 of the prescribed book.

ACTIVITY

Discuss the difference between the top-down and bottom-up approaches. What is the major
assumption that causes the difference in these two approaches?

FEEDBACK

The top-down valuation process begins by examining the influence of the general economy on all
firms and the security markets. The next step is to analyse the various industries in light of the
economic environment. The final step is to select and analyse the individual firms within the
superior industries and the common shares of these firms. The top-down approach thus assumes
that the first two steps (economy-market and industry) have a significant influence on the
individual firm and its shares (the third step). In contrast, the bottom-up approach assumes that it
is possible to select investments (i.e. firms) without considering the aggregate market and industry
influences.

53
ACTIVITY

Go onto the websites of the South African Reserve Bank (http://reservebank.co.za), Statistics South
Africa (http://www.statssa.gov.za) and other relevant bodies to find the latest macroeconomic
data.

Browse through these websites and try to find information on the gross domestic product (GDP),
interest rates, inflation rate, budget deficit, balance of payments, exchange rates and
unemployment rate.

FEEDBACK

Indicator Value Latest period

Real GDP growth rate 4.6% Mar, 2021
Gross saving as % of GDP 18.00 % Mar, 2021
Foreign debt as % of GDP 56.4% 2020
National government balance as % of GDP (fiscal year) -10.6% Dec, 2020
Current account balance (R millions, seasonally -267348 Mar, 2021
adjusted at annual rate)
M3 1.93 Jul, 2021
Claims on the domestic private sector 0.61 Jul, 2021
Import cover (weeks) 5.9 Mar, 2021

Source: SARB

Full Quarterly Bulletin – No 300 – June 2021

Growth in the real output of the secondary sector slowed sharply in the first quarter of 2021, as
growth in the real GVA by both the manufacturing and the construction sectors moderated
markedly and that in the electricity, gas and water sector contracted. Activity in the manufacturing
sector was suppressed by electricity-supply disruptions and the shortage of certain input materials,
coupled with the concomitant rising cost thereof. The volume of electricity produced and consumed
both decreased in the first quarter of 2021, reflecting the moderation in overall economic activity as
well as bouts of load-shedding due to plant breakdowns at Eskom’s ageing power stations and the
delayed return to service of some power units. The slower growth in real construction activity in the
first quarter of 2021 was evident in civil construction as well as in non-residential building activity,
while residential building activity declined. Despite three consecutive quarterly increases, the real

54
output of the construction sector remained well below pre-lockdown levels and was still 25.3%
below its most recent peak in the fourth quarter of 2016.

The real GVA by the tertiary sector expanded at a faster pace in the first quarter of 2021, as the real
output of the finance, insurance, real estate and business services sector reverted to an expansion
from a contraction in the previous quarter. Growth in the real GVA by the commerce as well as
transport, storage and communication services sectors moderated over the period.

Real retail and motor trade activity increased at a slower pace, while real wholesale trade activity
switched from a contraction in the fourth quarter of 2020 to an expansion in the first quarter of
2021. The reduced rail freight transportation in part reflected the poor state of South Africa’s rail
infrastructure. The number of passenger journeys undertaken decreased in the first quarter of 2021,
while the volume of goods transported by road increased.

Contrary to real GDP, growth in real gross domestic expenditure (GDE) accelerated slightly from
10.8% in the fourth quarter of 2020 to 12.2% in the first quarter of 2021. Real inventory holdings
decreased for a seventh successive quarter, albeit at a much slower pace, and as such contributed
the most to growth in real GDP in the first quarter of 2021. The real final consumption expenditure
by both households and general government increased further, but at a slower pace. By contrast,
real gross fixed capital formation contracted anew following two quarters of expansion. Real net
exports subtracted significantly from overall economic growth in the first quarter of 2021, as real
imports increased further while real exports contracted marginally.

The slower growth in real household consumption expenditure in the first quarter of 2021 resulted
from slowdowns in real spending on services, semi-durable goods and, in particular, non-durable
goods. Real outlays on petroleum products declined significantly while spending on most other
non-durable goods increased at a slower pace, likely affected by cautiousness during the second
wave of COVID-19 infections. By contrast, real outlays on durable goods surged in the first quarter
of 2021 after a marginal increase in the previous quarter. Spending on personal transport
equipment rebounded sharply amid record-low interest rates, bringing spending on this subsector
close to pre-lockdown levels, with real spending on furniture and household appliances also
advancing in the first quarter of 2021.

The ratio of household debt to disposable income decreased slightly from 75.4% in the fourth
quarter of 2020 to 75.3% in the first quarter of 2021, as the quarter-to-quarter increase in nominal
disposable income exceeded that in household debt. Households’ cost of servicing debt relative to
nominal disposable income remained unchanged at 7.7% over this period, amid the stable interest
rates.

Households’ net wealth increased further in the first quarter of 2021 as the increase in total assets
outweighed that in total liabilities. The value of assets was boosted by an increase in equity holdings
in particular, as share prices increased substantially further. The FTSE/JSE All-Share Index (Alsi)
reached new highs in the opening months of 2021 and surged by 14.4% in the five months to May
2021, in line with international share prices. In addition, growth in domestic residential property
prices accelerated slightly further over the period, supported by increased demand amid the
prevailing low interest rates.

The contraction in real gross fixed capital formation in the first quarter of 2021 resulted from the
decrease in fixed investment by private business enterprises, as they invested significantly less in
transport equipment as well as in machinery and other equipment. Consequently, real gross fixed

55
capital formation by the private sector was still well below pre-lockdown levels. Real capital outlays
by the public sector increased at a slower pace in the first quarter of 2021, reflecting the marked
slowdown in fixed investment growth by public corporations while that by general government
increased at a slightly faster pace.

South Africa’s national saving rate increased significantly from 14.2% in the fourth quarter of 2020
to 18.0% in the first quarter of 2021. The higher saving rates of both corporate business enterprises
and households more than offset the increased dissaving by general government. The national
saving rate remains much higher than before the COVID-19 pandemic, in part reflecting caution
among corporates in distributing dividends to shareholders and in the spending behaviour of
households.

The recovery in employment has been much weaker than that in economic activity up to the first
quarter of 2021, following the sharp contraction in both employment and output in the second
quarter of 2020. Total household-surveyed employment decreased slightly in the first quarter of
2021 and was still 1.4 million below that of a year earlier. The number of unemployed persons
remained almost unchanged at just over 7.2 million in the first quarter of 2021, while the number of
discouraged work seekers increased significantly. In addition, the ‘other not economically active’
population increased notably as lockdown restrictions still impeded job-searching activity. As a
result, the official unemployment rate increased marginally from 32.5% in the fourth quarter of
2020 to a new record high of 32.6% in the first quarter of 2021. The expanded unemployment rate,
which includes the discouraged work seekers and those who did not search for work due to other
reasons, increased from 42.6% to 43.2% over the same period.

Growth in nominal remuneration per worker in the formal non-agricultural sector accelerated from
0.4% in the third quarter of 2020 to 1.1% in the fourth quarter, as private sector remuneration
increased at a slightly faster pace while public sector remuneration contracted notably. The
decrease in public sector wages per worker reflected the non-implementation of the annual public
sector wage increase in 2020 to curb government expenditure. On an annual average basis, the
pace of increase in nominal remuneration per worker slowed gradually from a peak of 13.8% in
2010 to 4.1% in 2019, and then sharply to an all-time low of only 0.8% in 2020. Real wages per
worker contracted at a much faster pace of 5.2% in the fourth quarter of 2020, contributing to an
annual average decrease of 3.8%.

Labour productivity in the formal non-agricultural sector of the economy increased slightly in the
fourth quarter of 2020 but decreased by a notable 2.6% on an annual average basis, reflecting the
significant contraction in output in 2020. Growth in the nominal unit labour cost in the formal non-
agricultural sector decelerated further to an all-time low of only 0.2% in the fourth quarter of 2020,
suggesting the absence of inflationary pressures emanating from wage increases in the current
economic environment.

Headline consumer price inflation moved broadly sideways near the 3% lower bound of the
inflation target range between July 2020 and March 2021, as the acceleration in consumer goods
price inflation was countered by the slowdown in services price inflation. Subsequently, consumer
price inflation accelerated to 4.4% in April following a notable quickening in goods price inflation,
largely due to the marked acceleration in fuel price inflation and, to a lesser extent, in certain
durable and semi-durable goods. This reflected the low base established in April 2020 following the
collapse in international crude oil prices as well as the lockdown-induced price imputations by
Statistics South Africa (Stats SA) at the onset of the COVID-19 pandemic. However, final and
intermediate manufactured producer price inflation has accelerated notably thus far in 2021, with
price inflation for intermediate goods surging to 11.4% in April as global supply-chain disruptions

56
have resulted in shortages of some raw materials. Underlying inflationary pressures remained well-
contained, despite core inflation accelerating in April 2021 largely due to base effects.

South Africa’s trade surplus with the rest of the world widened slightly in the first quarter of 2021 as
the increase in the value of net gold and merchandise exports, which reached a new all-time high,
marginally outpaced the increase in the value of imports. The higher value of exported goods
reflected an increase in prices, while the value of imports was driven by higher volumes. South
Africa’s terms of trade improved for the seventh consecutive quarter in the first quarter of 2021,
representing the longest period of consecutive quarterly increases on record.

Exports continued to benefit from the improvement in global economic activity and higher
commodity prices, as the value of mining, agricultural and manufacturing exports all increased in
the first quarter of 2021. The higher value of imports resulted from an increase in imported mining
and manufactured products. Imported refined petroleum products rose significantly as operations
came to a halt at key domestic refineries, while the value of imported base metals and articles
thereof also increased notably further in order to make up for domestic supply shortages amid
significant increases in the prices of these products.

The larger trade surplus, together with a significant narrowing of the shortfall on the services,
income and current transfer account, led to a widening of the surplus on the current account of the
balance of payments from 3.7% of GDP in the fourth quarter of 2020 to 5.0% of GDP in the first
quarter of 2021. The deficit on the income account narrowed significantly along with a slightly
smaller services deficit. The marked improvement in the income deficit resulted from another
dividend surplus in the first quarter of 2021 – only the second surplus in 25 years – as gross dividend
receipts increased notably while gross dividend payments decreased.

The net outflow of capital on South Africa’s financial account of the balance of payments increased
to R64.7 billion in the first quarter of 2021 following an outflow of R58.9 billion in the fourth quarter
of 2020. On a net basis, portfolio investment, financial derivatives and other investment recorded
outflows, while direct investment and reserve assets registered inflows. Portfolio investment flows
largely reflected the further acquisition of foreign portfolio assets by the South African domestic
private banking and non-banking sectors, in particular foreign debt securities.

South Africa’s total external debt increased substantially from US$156.9 billion at the end of
September 2020 to US$170.4 billion at the end of December. The rand-denominated external debt
increased significantly due to the net purchases of domestic rand-denominated bonds by non-
residents, an increase in the market value of non-resident bond holdings, and an increase in the
United States (US) dollar value of rand-denominated external debt as the exchange value of the
rand appreciated over the period. However, South Africa’s total external debt decreased in rand
terms over this period, due to the appreciation in the exchange value of the rand against the US
dollar.

South Africa’s positive net international investment position (IIP) decreased in the three months to
the end of December 2020, as the value of foreign assets declined while that of foreign liabilities
increased further. Movements in the exchange value of the rand had a significant effect on foreign
assets and, to a lesser extent, on foreign liabilities, as the nominal effective exchange rate (NEER) of
the rand increased, on balance, by 11.6% in the fourth quarter of 2020.

The NEER increased by a further 1.0% in the first quarter of 2021. The exchange value of the rand
initially depreciated in January 2021 as sentiment towards the rand deteriorated amid further
lockdown restrictions brought about by the second wave of COVID-19 infections. However, the
external value of the rand then appreciated up to mid-June 2021, reflecting improved investor

57
sentiment towards some emerging market currencies amid continued accommodative monetary
policy in the US as well as better-than-expected domestic economic outcomes.

South African government bond yields increased notably between early February 2021 and the end
of March, reflecting net sales of bonds by non-residents in tandem with the increase in US
government bond yields amid concerns over global inflation. Subsequently, domestic bond yields
receded up to mid-June along with the continued further appreciation in the exchange value of the
rand and demand for higher-yielding emerging market assets as COVID-19 vaccination gained
traction globally and as the US Federal Reserve allayed concerns about higher interest rates in the
short term despite rising inflation.

Growth in the broadly defined money supply (M3) moderated significantly in the first four months
of 2021, partly reflecting base effects a year after the initial implementation of the COVID-19
lockdown restrictions. The deposit holdings of the corporate sector contracted in April 2021, led by
a notable contraction in those of financial companies, which reflected the movement of deposits to
higher-yielding investments in the low interest rate environment. Household deposits continued to
grow at double-digit rates up to March 2021 before decelerating in April. The deposit balances of
households reflected cautiousness in the uncertain environment and banks’ efforts to attract and
maintain relatively stable deposit balances.

Continued muted growth in the total loans and advances extended by monetary institutions to the
domestic private sector reflects the effect of the lockdown on economic activity, and hence on the
demand for credit. Credit extension to companies contracted on a year-on-year basis in the first four
months of 2021 as they avoided undue exposure to debt in the current uncertain economic
environment. By contrast, the moderation of credit extension to the household sector throughout
2020 seems to have bottomed out in early 2021 as fewer COVID-19 restrictions and low interest rates
probably boosted demand for credit somewhat, in particular for mortgage advances and
instalment sale credit.

The preliminary non-financial public sector net borrowing requirement increased sharply to R547
billion in fiscal 2020/21. The increase resulted from a significant widening in the cash deficit of
national government and as social security funds reverted from a cash surplus to a deficit. By
contrast, the borrowing requirement of the non-financial public enterprises and corporations
decreased significantly.

National government’s cash book deficit increased significantly in fiscal 2020/21 and far exceeded
the February 2020 Budget projection, but was less than expected in the 2020 Medium Term Budget
Policy Statement (2020 MTBPS). The larger cash book deficit resulted from significantly lower
revenue and higher expenditure than in the previous fiscal year. Although national government
revenue contracted by an unprecedented 8.0% in fiscal 2020/21, this was much less than the
contraction of 18.3% expected in the 2020 MTBPS. The higher net borrowing requirement of
national government was financed primarily in the domestic financial markets through the net
issuance of domestic long-term government bonds and Treasury bills. The net issuance of foreign
bonds and loans was also much higher than in the previous fiscal year. Accordingly, the gross loan
debt increased sharply by 20.7% year on year to R3 936 billion as at 31 March 2021, or 78.8% of GDP

Source: SARB

58
Main key indicators:

• CPI August 2021 = +4,9% q/q

• PPI July 2021 = –7,1% q/q

• GDP 2nd quarter 2021 +1,2% q/q

• Unemployment 2nd Quarter 2021 +34.4% q/q

• Population (Mid-year estimate) 60.14 million Mid-2021

Source: StatsSA

ASSESSMENT

(1) Answer the self-assessment questions found at the end of chapter 6 in the prescribed
book.

(2) Additional assessment questions:

(a) Provide a summary of what fundamental analysis involves.

(b) Describe the differences between fundamental and technical analysis.

(c) A restrictive monetary policy leads to:

(1) higher taxes, decreased consumption and higher imports

(2) lower interest rates, increased consumption and higher net exports
(3) higher interest rates, decreased consumption and higher net exports
(4) lower interest rates, increased consumption and an appreciation of the domestic
currency

Answers to additional assessment questions

(a) Fundamental analysis involves a process consisting of:

• an analysis of the macroeconomic environment (aggregate market analysis)

• industry analysis
• company analysis and valuation

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The aim of fundamental analysis is to identify companies that are offering value.
A share offers value when its intrinsic value is higher than the market value.

An investment analyst would have to decide on a forecast period and focus on factors
that will influence the profitability of companies. The first step in a
top-down approach would be the analysis of the macroeconomic environment.

• The analysis of the macroeconomic environment

Most of the systematic risk factors have their origin in the macroeconomic
environment. The systematic risk factors influence the various industries and firms to a
greater or lesser extent. Examples of macroeconomic factors are the fiscal policy (such as
changes in tax legislation) and monetary policy (such as changes in interest rates).

An important aspect of the macroeconomic environment for the purpose of

fundamental analysis is to estimate the gross domestic product (GDP). GDP measures
national economic activity generated domestically.

GDP could be analysed in terms of the business cycle. The business cycle refers to the
fluctuations in the general level of economic activity. The business cycle may be
approaching an expansion, peak, contraction, recession or depression during the forecast
period. During an expansion, GDP grows rapidly, business sales increase and
unemployment declines. During a peak, most businesses are functioning close to full
capacity and real GDP is growing rapidly. During contraction, the sales of most businesses
are declining, real GDP grows at a slow rate, or declines, and unemployment increases. A
recession may be regarded as a period during which real GDP has declined for at least two
successive quarters. A depression may be regarded as a prolonged and severe recession.

From the GDP estimate, it should be possible to determine the contribution or share of
each industry. GDP is generally indicative of industry sales, although the exact relationship
will vary between industries.

• Industry analysis

Future years' sales can be predicted by projecting:

– industry sales as a whole by taking the projections of macroeconomic conditions

and industry characteristics into account, and
– the firm's market share based on an evaluation of the strengths and

60
weaknesses of competitors within an industry.

Various techniques may be used for industry analysis, such as:

■ industry competitiveness (using Porter's model)

■ industry life cycles
■ input-output analysis
■ statistical techniques (for example, regression analysis), which may be
used for the above-mentioned projections.

• Company analysis and valuation

• Company analysis should enable the investment analyst to distinguish between good
companies and good shares. A company may have good growth prospects, but if this
is already recognised in its share price, then one has not found a good share to invest
in.

The final step in fundamental analysis would be to select and apply appropriate valuation
models to determine the range within which the share should be trading.

(b) Difference between fundamental and technical analysis:

Fundamental analysis Technical analysis

Macro-approach (top-down) studying Micro-approach, looking at the

the macroeconomic situation, the company first, then industry and,
industry and the individual company finally, the economic prospects

Future orientated, but includes Uses past performance to predict

financial statement analysis in order future movements
to determine certain relationships for
prediction purposes

Uses mainly economic data Uses market data

Price adjustments (in reaction to new Gradual adjustments (based on the

61
information) are abrupt due to the assumption that information filters
random nature of information gradually into the market).
received

Assumes a weak form of market

Assumes a strong form of market
efficiency
efficiency

Believes share prices move in a Believes that share prices move in

random manner as new information trends
becomes available

(c) (3) Higher interest rates, decreased consumption and higher net exports

SUMMARY

This learning unit explained the first step of fundamental analysis. The second step, industry analysis, in
chapter 7 of the prescribed book and the third step, company analysis and valuation, in chapters 8 and 9
of the prescribed book, will be discussed in topic 2, learning units 6, 7 and 8.

62
Topic 2

EQUITY ANALYSIS

AIM

The aim of this topic is to explain the second (industry analysis) and third (company analysis) steps of
fundamental analysis and to discuss technical analysis.

The value of any security lies at the heart of investing and constructing a portfolio consistent with risk-
return objectives. Only once the intrinsic value has been determined can it be compared with the market
value to determine if the asset is undervalued or overvalued.

The theory and practice of estimating the value of equity investments are explained.

TOPIC LEARNING OUTCOMES

Once you have worked through this topic, you should be able to:

• explain industry analysis as the second step in fundamental analysis

• explain company analysis and company valuation as the third step in fundamental analysis
• explain technical analysis

TOPIC CONTENT
Learning unit 6: Industry analysis
Learning unit 7: Company analysis
Learning unit 8: Company valuation
Learning unit 9: Technical analysis

63
Learning unit 6

Industry analysis

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• explain the effect of the global economy on local industries

• explain the effect of exchange rates on imported and domestically produced goods
• relate the importance of the domestic economy and macroeconomic environment to
industry analysis
• explain how the business cycle may influence industry sectors
• define cyclical indicators and explain the significance and use of each
• explain the methods used in determining the reference turning point of the business cycle
in South Africa
• define an industry and industry analysis
• elaborate on the sensitivity of a company's earnings to the business cycle with reference
to sales, operating leverage and financial leverage
• describe the industry life cycle and identify an industry's stage in its life cycle
• describe the five determinants of competition (Michael Porter's industry forces model)
• define and elaborate on the three competitive strategies (i.e. strategic groups, Porter's
generic competitive strategies and SWOT analysis)

64
KEY CONCEPTS

Bargaining power Domestic economy Leading indicators

Business cycles Exchange rates Maturity stage
Coincident indicators Focus strategy New entrants
Competitive forces Generic strategies Reference turning point
Competitive strategies Global economy Relative decline
Composite business cycle Industry Rivalry
Consolidation stage Industry analysis Start-up stage
Cost leadership Industry forces model Statistical results
Differentiation Industry life cycle Strategic groups
Diffusion index Lagging indicators SWOT analysis

OVERVIEW

Industry analysis forms part of fundamental analysis and extends investment analysis by studying the
influence of macroeconomic forces on industries. It also provides the investment analyst with information
about the competitive forces that will have an impact on the risk and return of companies in these
industries.

In this learning unit, we look at the role of competitive forces in an industry, such as rivalry in the industry,
the threat of new entrants, the bargaining power of suppliers and customers, as well as the threat of
substitute products. Competitive strategies, such as cost leadership and differentiation, are also explained.

65
Study chapter 7 of the prescribed book.

ACTIVITY

Discuss an alternative industry life cycle model to the one presented in chapter 7 of the
prescribed book.

FEEDBACK

(1) Pioneering development. During this start-up stage, an industry experiences modest
sales growth and very small or negative profit margins and profits. The market for the
industry's product or service during this time is small and the firms involved incur major
development costs.

(2) Rapid accelerating growth. During this rapid growth stage, a market develops for the product
or service and demand becomes substantial. The limited number of firms in the industry face
little competition and individual firms experience substantial backlogs. The profit margins
are very high. The industry builds its productive capacity as sales grow at an increasing rate
as the industry attempts to meet excess demand. High sales growth, as well as high profit
margins that increase as firms become more efficient, cause industry and firm profits to
explode. During this phase, profits can grow at over 100% a year as a result of the low
earnings base and the rapid growth of sales and net profit margins.

66
(3) Mature growth. The success in stage 2 has satisfied most of the demand for the industry’s
goods or services. Thus, future sales growth may be above normal, but it no longer
accelerates. For example, if the overall economy is growing at 8%, sales for this industry
might grow at an above normal rate of 15% to 20% a year. Also, the rapid growth of sales and
the high profit margins attract competitors to the industry, causing an increase in supply and
lower prices, which means that the profit margins begin to decline to normal levels.

(4) Stabilisation and market maturity. During this stage, which is probably the longest
phase, the industry growth rate declines to the growth rate of the aggregate economy or
its industry segment. Also during this stage, investors can estimate growth easily because
sales correlate highly with an economic series. Although sales grow in line with the
economy, profit growth varies by industry because the competitive structure also varies
by industry and by individual firms within the industry because the ability to control costs
differs among companies. Competition produces tight profit margins and the rates of
return on capital (e.g. return on assets, return on equity) eventually become equal to or
slightly below the competitive level.

(5) Deceleration of growth and decline. At this stage of maturity, the industry's sales growth
declines because of shifts in demand or growth of substitutes. Profit margins continue to
be squeezed and some firms experience low profits or even losses. Firms that remain
profitable may show very slow rates of return on capital. Finally, investors begin thinking
about alternative uses for the capital tied up in this industry.

Although these are general descriptions of the alternative life cycle stages, they should help
you identify the stage your industry is in, which should in turn help you estimate its potential
sales growth. Obviously, everyone is looking for an industry in the early phases of stage 2 and
hopes to avoid stage 4 or stage 5. Comparing the sales and earnings growth of an industry to
similar growth in the economy as a whole should help you identify the industry's stage within
the industrial life cycle.

67
ASSESSMENT

(1) Answer the self-assessment questions found at the end of chapter 7 in the prescribed
book.

(2) Additional assessment questions:

(a) Assume all the firms in a particular industry have consistently experienced similar
rates of return. Discuss what this implies regarding the importance of industry
analysis and company analysis for this industry.

(b) Discuss the contention that differences in the performance of various firms within
an industry limit the usefulness of industry analysis.

(c) Discuss the impact of the threat of substitute products on the steel industry's
profitability.

(d) Discuss at what stage in the industry life cycle you would like to discover an
industry. Justify your decision.

(e) Assume the industry you are analysing is in the fourth stage of the industrial life
cycle. How would you react if your industry-economic analysis predicted that sales
per share for this industry would increase by 20%? Discuss your reasoning.

(f) Give an example of an industry in stage 2 of the industrial life cycle.

(g) An industry is currently growing at twice the rate of the overall economy. New
competitors are entering the industry and the formerly high profit margins have
begun to decline. The life cycle that best characterises this industry is:

(1) mature growth

(2) pioneering development
(3) rapid accelerating growth
(4) stabilisation and market maturity

(h) Which of the following is TRUE about the focus competitive strategy?

68
(1) Price reduction can protect new entrants.
(2) Perceived quality insulates the company from threats.
(3) Customer loyalty protects new entrants and substitute products.
(4) New product features are added only after the market demands them.

Answers to additional assessment questions

(a) A greater emphasis must be placed upon industry analysis when the performances of
the individual firms cluster around the industry performance. In contrast, once the
industry performance is estimated, the need for individual firm analysis is reduced since
all firms will behave similarly to the industry.

(b) Disagree. Although studies have shown a significant dispersion of individual firm
performance within a given industry, they have also found that the industry component
could partially explain individual firm performance. Although the strength of the
industry component varies among industries, industry analysis is an important step
before proceeding to the company analysis. The important implication is that individual
company analysis would be relatively more important for industries where individual
company returns were widely dispersed. The point is that the dispersion among
companies within industries indicates a need for company analysis after industry
analysis.

(c) A substitute product for steel would limit the prices that firms in that industry could
charge. The degree of limitation would depend on how close the substitute product was
in price and function to steel.

(d) As an investor, you would like to discover a firm that is just entering the rapid
accelerating growth stage. During this stage, a firm will experience high sales growth,
high profit margins and little competition.

(e) The fourth stage of the industrial life cycle is stabilisation and market maturity. During
this stage, sales grow in line with the economy. If sales per share for an industry in this
stage of the life cycle were predicted to increase by 20%, this would imply a growth rate
of 20% for the aggregate economy. A sales growth rate of 20% is high for an industry in

69
the fourth stage of the industrial life cycle.

(f) An industry that experienced the kind of explosive growth characteristics of stage two
(rapid accelerating growth) was the internet-related industry in the late 1990s.

(g) (1) mature growth

(h) (3) Customer loyalty protects new entrants and substitute products.

SUMMARY

This learning unit focused on the second step in the fundamental analysis process, namely industry
analysis. Having determined the most promising industry, we now have to identify the company
expected to outperform within that industry. Learning unit 8 will introduce you to the financial
statements of a company and the financial ratios and information derived from those statements.

70
Learning unit 7

Company analysis

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• distinguish between capital costs and operational/revenue costs

• describe the format of the income statement and describe the components of net
income
• describe the format and the components of the balance sheet and the format,
classification and use of each component of the statement of shareholders' equity
• identify the types of important information for investment decision making presented
in the statement of cash flows
• classify a particular transaction or item as cash flow from (1) operations, (2) investing or
(3) financing
• distinguish between statistical analysis, subjective analysis and ratio analysis
• calculate, interpret and discuss the uses of measures of a company's liquidity, debt
management (solvency), asset management (operating performance/ activity),
profitability and market value
• calculate and interpret the various components of the company's return on equity using

71
the DuPont model
• define leasing, state the advantages of leasing, and distinguish between operating
leases and capital leases

KEY CONCEPTS

Asset management ratios Financing cash flows Profit

Balance sheet Income statement Profitability ratios
Capital lease Investment cash flows Ratio analysis
Cash flow Liquidity ratios Return on equity
Cash flow statement Market value ratios Solvency ratios
Debt management ratios Operating cash flows Statistical analysis
DuPont model Operating lease Subjective analysis

OVERVIEW

Financial statements are a major source of information about a company's shares and/or debentures. In
this learning unit, we look at the income statement, the balance sheet, the statement of changes in equity,
and the cash flow statement as financial statements. This is followed by a discussion of the financial ratios
used to answer important questions about a firm's profitability, liquidity, risk profile and growth potential.
The financial statements of a firm are intended to reflect the financial position of that firm. The financial
statements consist of four basic statements:

• income statement
• balance sheet
• statement of changes in equity
• statement of cash flows

72
Study chapter 8 of the prescribed book.

ACTIVITY

Construct a basic framework for each of the financial statements of a firm.

FEEDBACK

Income statement

The income statement provides a financial summary of the firm's operating results during a
certain period, usually the financial year. The income statement measures the flows of revenues
and expenses during an interval of time.

Framework of the INCOME STATEMENT

revenue (sales)
Cost of sales

Gross profit
Other operating income
Selling, general and administrative expenses
Other operating expenses

EBITDA (earnings before interest, tax, depreciation and amortisation)

Depreciation and amortisation

Profit from operations (operating income) – non-operating income and expenses

EBIT (earnings before interest and taxes)

Finance cost (interest paid)

Profit before tax (PBT/EBT) – income tax expense

Profit after tax (PAT/EAT) – minority interest

Net profit from ordinary activities

Extraordinary items

Net profit for the year (net income – NI)

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Balance sheet

The balance sheet is a summary of the firm's financial position on a given day, usually the last day
of the financial year. The date of the balance sheet is the last day of the period covered by or
relating to the income statement.

Framework of the BALANCE SHEET

ASSETS

Non-current assets

Property, plant and equipment

Goodwill
Investments

Current assets

Inventories
Trade and other receivables
Cash and cash equivalents

TOTAL ASSETS

EQUITY AND LIABILITIES

Capital and reserves

Issued capital

– Ordinary shares
– Preference shares

Non-distributable reserves
Distributable reserves
Accumulated profits / retained earnings
Minority interest

Non-current liabilities
Debentures
Long-term loans

Current liabilities

Trade and other payables

Bank overdraft
Tax payable
Shareholders for dividend

74
TOTAL EQUITY AND LIABILITIES
Statement of changes in equity (retained earnings)

The statement of changes in equity reconciles the net income earned during a certain year, less
any dividends paid, with the change in accumulated profits between the total of a particular year
and that of the previous year.

FRAMEWORK OF THE STATEMENT OF CHANGES IN EQUITY

Balance (beginning)
Net profit for the year

Non-distributable reserves
Ordinary dividend

Distributable reserves
Accumulated profits
Preference shares
Preference dividend
Ordinary shares
Transfer to/from reserves
Issue/redemption of shares

TOTAL
Balance (ending)

The cash flow statement

The cash flow statement is required to show the flow of cash through the firm's business affairs. The
form and extent of a cash flow statement will depend largely on the
circumstances of the individual firm, that is, the kind of industry in which the firm is operating and
the risk involved. In general, the cash flow statement would include the following items:

• cash generated by operating activities, namely:

─ cash generated from operations
─ investment income
─ changes in the non-cash components of working capital, for example, changes in
inventory or accounts receivable

• cash expended on interest and tax

• cash expended on rewards to shareholders
• changes in cash arising from financing activities and that relate to cash in long-term debt in
the capital structure and to the issuing of shares to raise long-term funds

75
Framework of the CASH FLOW STATEMENT

Cash flow from operations (CFO) Cash +/- xx

flow from investing (CFI) yy
+/-
Cash flow from financing (CFF) zz

+/-

Equals change in the cash account = Cash

Plus beginning of period cash + Beginning cash

Equals ending cash balance = Ending cash

Cash flow from operations – Direct method

Step 1: Net sales

+/– Changes in accounts receivable

+ Other cash collections (interest and dividends)

= Cash collections and other receipts

Step 2: Cost of goods sold

+/– Changes in inventory

+/– Changes in accounts payable

= Direct cash inputs and costs

Step 3: Cash expenses (other cash flows)

+ Cash taxes paid

+ Cash interest paid

= Other cash outflows and costs

76
Cash flow from operations using the direct method is a summary of steps 1 to 3.

CFO = + Step 1: Cash collections

– Step 2: Direct cash inputs

– Step 3: Other cash outflows

= Cash flow from operations

Cash flow from operations – Indirect method

Net income

Adjusted for:

+ Non-cash expenses or losses

– Non-cash revenues or gains (e.g. depreciation)

Adjust for changes in working capital:

+ Decreases in operating asset accounts (source)

– Increases in operating asset accounts (use)

+ Increases in operating liability accounts (source)

– Decreases in operating liability accounts (use)

= Cash flow from operations

Cash flow from investing

Capital expenditures for long-term assets

Proceeds from the sale of assets

Investments in joint ventures/affiliates/securities (long term)

Cash flow from financing

Additional debt (short/long term) and equity financing
Dividends paid (flows through changes in equity statement) Additional
debt (short/long term) and equity financing
Dividends paid (flows through changes in equity statement)

77
The purpose of the cash flow statement is to provide interested parties with information on the
sources and uses of all financial resources during a financial period or year. The most important
reason for drawing up the cash flow statement is to provide a clearer picture of a firm's liquidity
position. The following table provides a simple guide to determining what a source of cash and
what a use of cash are:

Source of cash Use of cash

Decrease in any asset Increase in any asset

Increase in any liability Decrease in any liability

Operating loss (-EBIT) Cash
Earnings before interest and tax (EBIT)
dividends paid Taxation paid
Depreciation
Issuing of shares

ASSESSMENT

(1) Answer the self-assessment questions found at the end of chapter 8 in the prescribed
book.

(2) Additional assessment questions:

(a) Use the following information for questions (i) to (iv):

Roberts Manufacturing balance sheet

December 31, 2020
(R'000)
Cash 200 Accounts payable 205
Receivables 245 Notes payable 425
Inventory 625 Other current liabilities 115
Total current assets 1 070 Total current liabilities 745
Net non-current assets 1 200 Long-term debt Common 420
equity 1 105

TOTAL ASSETS 2 270 TOTAL LIABILITIES AND EQUITY 2 270

78
Roberts Manufacturing income statement for the
year ended December 31, 2020 (R'000)

Sales 2 400
Cost of goods sold 1 834

566
Gross profit
175
Selling expenses
216
General and administrative expenses
175
Earnings before interest and taxes (EBIT)
35
Less: Interest expense
140
Earnings before taxes (EBT) Less: Taxes
42
(30%)
98
NET INCOME (NI)

(i) Calculate the liquidity ratios, that is, the current ratio and the quick ratio.
(ii) Calculate the asset management ratios, that is, the inventory turnover, fixed
asset turnover, total asset turnover and average collection period.
(iii) Calculate the debt management ratios, that is, the debt and
time-interest earned ratios.
(iv) Calculate the profitability ratios, that is, the gross profit margin, net profit
margin, return on total assets and return on equity.

(b) Use the following information for questions (i) to (iii):

Income statement items 2020 2018

Sales 16 000 8 000

Depreciation and amortisation 300 200

Interest expense 480 200

Operating expense Gross 2 000 1 200
profit margin Tax rate
40% 50%

30% 35%

79
Balance sheet items 2020 2018

Accounts payable 1 000 500

Accounts receivable 1 500 1 000
Accumulated profits
4 000 2 000
Cash
Inventory 500 1 000

Long-term loans 2 000 1 000

Ordinary shares 2 000 1 000

Property, plant and equipment 3 000 3 000

Short-term loans 8 000 4 000

2 000 500

(i) The DuPont formula defines the net return on shareholder's equity
(ROE) as a function of the following components:

• net profit margin (NPM)

• total asset turnover (TAT)
• financial leverage multiplier (FLM)

Calculate each of the three components listed above for 2018 and 2020, then
calculate the return on equity (ROE) for 2004 and 2006, using all three
components. Briefly discuss the impact of the changes in total asset turnover
and financial leverage on the change in ROE from 2018 to 2020.

(ii) Calculate the firm's cash conversion cycle (ccc) for 2018 and 2020 and comment
on the effect of the change from 2018 to 2020 2004 to 2006.
(iii) Calculate two debt management ratios for 2018 and 2020 and state the
impact on the firm's exposure to financial risk due to the change from 2018 to
2020.

80
(c) An analyst gathered the following information about a company:

• 2018 net sales R10 000 000

• 2018 net profit margin 5.0%
2020 expected sales growth –15.0%
2020 expected profit margin 5.4%
• 2020 expected ordinary shares outstanding 120 000

The analyst's estimate of the company's 2020 earnings per share should be closest to:

(1) R3.26

(2) R3.72

(3) R3.83

(4) R4.17

(d) Use the information below to calculate the return on equity (ROE).

Total asset turnover 1.20

Interest burden 1.90
Equity multiplier 2.02
Net profit margin 15%
Tax burden 0.50
(1) 14.25%
(2) 18.18%
(3) 34.20%
(4) 36.36%

Answers to additional assessment questions

(a) (i) Liquidity ratios

𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 1070

𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = = = 1,44𝑥𝑥
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 745

1070 − 625
𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = = 0,60𝑥𝑥
745
(ii) Asset management ratios

𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 1834

𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 = = = 2,93𝑥𝑥
𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 625

81
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 2400
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 = = = 2,00𝑥𝑥
𝑁𝑁𝑁𝑁𝑁𝑁 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 1200

𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 2400
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 = = = 1,06𝑥𝑥
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 2270

𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 245

𝑅𝑅𝑅𝑅𝑅𝑅 = = = 37,26 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠/365 2400/365

(iii) Debt management ratios

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 1165

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = = = 0,51𝑥𝑥
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 2270
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 175
𝑇𝑇𝑇𝑇𝑇𝑇 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = = = 5,00𝑥𝑥
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 35

(iv) Profitability ratios

𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 566

𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 = = = 23.58%
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 2400
𝑁𝑁𝑁𝑁𝑁𝑁 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 98
𝑁𝑁𝑁𝑁𝑁𝑁 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 = = = 4.08%
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 2400
𝑁𝑁𝑁𝑁𝑁𝑁 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 98
𝑅𝑅𝑅𝑅𝑅𝑅 = = = 4.32%
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 2270
𝑁𝑁𝑁𝑁𝑁𝑁 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 98
𝑅𝑅𝑅𝑅𝑅𝑅 = = = 8,87%
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 1105

(b) Income statement and balance sheet

Income statement items 2020 2018

Sales 16 000 8 000

Cost of goods sold 9 600 4 000

Gross profit Operating 6 400 4 000

82
expense EBITDA 2 000 1 200
Depreciation and amortisation 4 400 2 800
EBIT 300 200
Interest expense 4 100 2 600
EBT 480 200
Tax EAT/NI 3 620 2 400

1 086 840
2 534 1 560

Balance sheet items 2020 2018

Non-current assets 8 000 4 000
Current assets Inventory 4 000 3 000
Receivables 2 000 1 000
Cash
1 500 1 000
TOTAL ASSETS
500 1 000
Capital and reserves (equity)
12 000 7 000
Shares 7 000 5 000
Accumulated profits 3 000 3 000
Non-current liabilities
4 000 2 000
Current liabilities
2 000 1 000
Payables
3 000 1 000
Short-term loans
1 000 500
Total liabilities
2 000 500
TOTAL EQUITY AND LIABILITIES
5 000 2 000
12 000 7 000

(i) DuPont components and ROE

(i) DuPont components and ROE

𝑁𝑁𝑁𝑁𝑁𝑁 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 1 560

𝑁𝑁𝑁𝑁𝑁𝑁2018 = = = 19.50%
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 8 000

83
2 534
𝑁𝑁𝑁𝑁𝑁𝑁2020 = = 15.84%
16 000

𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 8 000
𝑇𝑇𝑇𝑇𝑇𝑇2018 = = = 1.14𝑥𝑥
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 7 000
16 000
𝑇𝑇𝑇𝑇𝑇𝑇2020 = = 1,33𝑥𝑥
12 000
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 7 000
𝐹𝐹𝐹𝐹𝐹𝐹2018 = = = 1.14𝑥𝑥
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 5 000
12 000
𝐹𝐹𝐹𝐹𝐹𝐹2020 = = 1,71𝑥𝑥
7 000

𝑅𝑅𝑅𝑅𝑅𝑅2018 = 𝑁𝑁𝑁𝑁𝑁𝑁 × 𝑇𝑇𝑇𝑇𝑇𝑇 × 𝐹𝐹𝐹𝐹𝐹𝐹

𝑁𝑁𝑁𝑁𝑁𝑁 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
= × ×
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
= 19,50% × 1,14 × 1,40
= 31,20%

𝑅𝑅𝑅𝑅𝑅𝑅2020 = 15,84 × 1,33 × 1,71

= 36,20%

Higher financial leverage and more efficient asset turnover resulted in an improved
return on equity, in spite of a lower net profit margin (2020). Increased leverage
translates into increased financial risk [see question (iii) – debt management ratios].

(ii) Cash conversion cycle

𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 1 000

𝑅𝑅𝑅𝑅𝑅𝑅2018 = = = 45,63 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆/365 8 000/365
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 5 000
𝑃𝑃𝑃𝑃𝑃𝑃2018 = = = 45,63 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶/365 4 000/365
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 1 000
𝐼𝐼𝐼𝐼𝐼𝐼2018 = = = 91,25 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶/365 4 000/365
𝐶𝐶𝐶𝐶𝐶𝐶2018 = 𝑅𝑅𝑅𝑅𝑅𝑅 + 𝐼𝐼𝐼𝐼𝐼𝐼 − 𝑃𝑃𝑃𝑃𝑃𝑃
= (46 + 91 − 46)
= 91 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑

84
All three ratios decreased, resulting in a decrease in the length of time it takes to turn the
firm's investment into cash. Although high cash conversion cycles are considered to be
undesirable, one should also review each component individually (relative to industry
standards) to determine, for instance, if the firm's credit policy is too rigorous
(hampering sales), and so on.

(iii) Debt management ratios

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 2 000
= = = 0,40𝑥𝑥
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸2018 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 5 000

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 5 000
= = 0,71𝑥𝑥
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸2020 7 000

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 2 600
𝑇𝑇𝑇𝑇𝑇𝑇2018 = = = 13𝑥𝑥
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 200
4 100
𝑇𝑇𝑇𝑇𝑇𝑇2020 = = 8,54𝑥𝑥
480
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 2 000
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷2018 = = = 0,29𝑥𝑥
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 7 000
5 000
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷2020 = = 0,42𝑥𝑥
12 000

The firm's financial risk has increased [confirmed by the increase in financial leverage –
see question (i)], as indicated by a higher debt ratio and debt/equity ratio, as well as
declining interest coverage.

𝑁𝑁𝑁𝑁𝑁𝑁 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
(c) EPS=
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎

2019 𝑛𝑛𝑛𝑛𝑛𝑛 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 𝑅𝑅 10 000 000 × (1 − 0,15)

= 𝑅𝑅 8 500 000

𝑁𝑁𝑁𝑁𝑁𝑁 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 2019 𝑁𝑁𝑁𝑁𝑁𝑁 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 × 2019 𝑛𝑛𝑛𝑛𝑛𝑛 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠

= 0.054 × 𝑅𝑅 8 500 000
= 𝑅𝑅 459 000
459 000
=
120 000
= 𝑅𝑅3.83

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(d) 𝑅𝑅𝑅𝑅𝑅𝑅 = 𝑁𝑁𝑁𝑁𝑁𝑁 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 × 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 × 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
= 15 × 1.2 × 2.02
= 36,36%

(d) ROE = Net profit margin × Total asset turnover × Equity multiplier
= 15×1.2×2.02

(4) ROE = 36.36%

SUMMARY

In this learning unit, we looked at the financial statements of a company. Various ratios were calculated
and, from those, we concluded the financial status and prospects of the company. In the next learning
unit, we show how to put a value on the shares of a company using various growth models as well as
relative valuation techniques.

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Learning unit 8

Company valuation

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• explain and distinguish between investment styles (e.g. growth share or earnings momentum,
value investing)
• explain the use of measures of value added in company valuation
• define economic profit
• discuss economic value added (EVA)
• discuss cash value added (CVA) and the concept of strategic investments
• contrast the CVA and EVA models
• discuss market value added (MVA)
• explain the earnings multiplier model
• calculate the future earnings per share for a company using the earnings multiplier model
• estimate earnings per share for an industry
• discuss the use of dividend discount models (DDM) to value growth shares
• determine the value of a company using the constant growth dividend discount model
• explain and apply four alternative growth models (e.g. two-stage, H-model, three-stage and

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growth duration) in the valuation of companies
• discuss the advantages and limitations of dividend discount models
• explain the various relative valuation ratios which analysts use to evaluate equity
investments (i.e. price/earnings, dividend yields, price/sales, price/asset value, price/cash
flow)

KEY CONCEPTS

Dividend discount models Growth share Price/sales ratio

Dividend yield H-model Relative valuation ratios
Earnings momentum Investment styles Strategic investments
Earnings multiplier model Market value added (MVA) Three-stage DDM
Earnings per share Measures of value added Two-stage DDM
Economic profit Price/asset value ratio Value investing
Economic value added (EVA) Price/cash flow ratio

OVERVIEW

This learning unit starts with a discussion of the difference between a company and its shares. Fundamental
analysis may lead one to conclude that a company has sound prospects. However, if these prospects are
already fully reflected in the share price, then the share in question is not that promising.

Company analysis and valuation are two separate but interdependent activities. In this learning unit, we
consider various techniques that provide insight into the economic success of a firm and its management,
such as economic value added (EVA).

The goal of company analysis and valuation is to select one of the best companies in a superior industry
during particular market conditions.

This learning unit applies the basic principles of valuation to the valuation of ordinary shares. Two general
approaches to the valuation of ordinary shares are provided, namely discounted cash flow models and
relative valuation ratios.

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Study chapter 9 of the prescribed book.

ACTIVITY

Discuss the contention that, in a completely competitive economy, there would never be a true
growth company.

FEEDBACK

If companies in a perfectly competitive economy see a particular firm achieving returns that are
consistently above risk-based expectations, these companies are expected to enter that
particular industry or market and eventually drive prices down until the returns are consistent
with the inherent risk. In other words, the competition would not allow the continuing existence
of excess return investments and competition would therefore negate such growth. The
computer/information technology industry is a good example of increased competition
resulting in lower profit margins. The theory implies that, in truly competitive environments, a
true growth company is a temporary classification.

ACTIVITY

The value of an asset is the present value of the expected returns from the asset during the holding
period. An investment will provide a stream of returns during this period, and it is necessary to
discount this stream of returns at an appropriate rate to determine the asset's present value. The
constant growth dividend discount model (Gordon model) is a valuation model which is frequently
used. Identify the three factors that must be estimated for any valuation model and explain why
these estimates are more difficult to derive for common equity shares than for bonds. In addition,
explain the principal problem involved in using a dividend valuation model to value (1)
companies whose operations are closely correlated with economic cycles, (2) companies that
are of very large (giant) size and are maturing, (3) companies that are of small size and are
growing rapidly, assuming all companies pay dividends.

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FEEDBACK

The three factors that must be estimated for any valuation model are as follows:

• The expected stream of earnings, which is specified for bonds in terms of interest (coupon)
and principal payments, but is uncertain for common equity shares as dividends are not
contractual or precisely predictable.
• The time pattern of expected returns, which is specified for bonds, in terms of semi-annual
interest payments and principal payments at maturity, but is uncertain for common equity
shares because, although dividends may be paid annually, a share is in effect "perpetual".
The maturity value of a bond is known, while the sale price for shares involves an estimate of
earnings in that year and the price earnings ratio (P/E) that will then prevail, employing the
concept of a terminal P/E.
• The required rate of return on the investment adjusted for risk, which is uncertain for both
equity and bonds. For bonds, this generally depends upon the prevailing risk-free rate. For
equity shares, given the security market line prevailing at a point in time and an estimate of
the share's beta with the market portfolio of risky assets, it is possible to derive the return
that should be required for the investment.

The problem with using a dividend valuation model is that growth is a changing phenomenon
and cannot be projected to infinity. Constant growth in dividends is unrealistic for a company
that is subject to cyclical swings in its business. Maturing companies might be experiencing a
slowing in the rate of growth of dividends. Although some such companies maintain dividend
growth by increasing the payout ratio, this is a short-term occurrence. Small, rapidly growing
companies are not able to sustain above-average rates of growth indefinitely.

ASSESSMENT

(1) Answer the self-assessment questions found at the end of chapter 9 in the prescribed
book.

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(2) Additional assessment questions:

(a) Under what conditions would you use a two-stage or three-stage dividend
discount model rather than the constant growth model?

(b) You are told that a company retains 80% of its earnings and its earnings are growing
at a rate of about 8% a year versus an average growth rate of 6% for all firms. Discuss
whether you would consider this a growth company.

(c) Specify the major components for the calculation of economic value added and
describe what a positive EVA signifies.

(d) You have been reading about the Maddy Computer Company (MCC), which currently
retains 90% of its earnings (R5 a share this year). It earns an ROE of almost 30%.
Assuming a required rate of return of 14%, how much would you pay for MCC on the
basis of the earnings multiplier model? Discuss your answer. What would you pay for
Maddy Computer if its retention rate was 60% and its ROE was 19%?

(e) Gentry Can Company's (GCC) latest annual dividend of R1.25 was paid yesterday and
maintained its historic 7% rate of growth. You plan to purchase the share today,
because you believe that the dividend growth rate will increase to 8% for the next three
years and the selling price for the share will be R40 per share at the end of that time.

(i) How much should you be willing to pay for the GCC share if you require a 12%
return?
(ii) What is the maximum price you should be willing to pay for the GCC share if you
believe that the 8% growth rate can be maintained indefinitely and you require
a 12% return?
(iii) If the 8% rate of growth is achieved, what will the price be at the end of the third
year, assuming the conditions in (ii)?

(f) Micro Corporation just paid dividends of R2 per share. Assume that, over the next three
years, dividends will grow as follows: 5% next year, 15% in year two and 25% in year
three. After that, growth is expected to level off to a constant growth rate of 10% per year.
The required rate of return is 15%. Calculate the intrinsic value using the multistage

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model.

(1) R43.66
(2) R49.30
(3) R59.56
(4) R66.40

Answers to additional assessment questions

(a) The constant growth DDM assumes that (1) dividends grow at a constant rate, (2) the
constant growth rate will continue for an infinite period and (3) the required rate of return
(k or r) is greater than the infinite growth rate (g). Therefore, the constant growth DDM
cannot be applied to the valuation of shares for growth companies because the high
growth of earnings for the growth company is inconsistent with the assumptions of the
infinite period constant growth DDM model. A company cannot permanently maintain a
growth rate higher than its required rate of return because competition will eventually
enter this apparently lucrative business, which will reduce the firm's profit margins and
therefore its ROE and growth rate. Therefore, after a few years of exceptional growth (a
period of temporary supernormal growth) a firm's growth rate should decline. Eventually
its growth rate is expected to stabilise at a level consistent with the assumptions of the
infinite period.

(b) Above average earnings growth is a characteristic of a growth company. Additionally,

a rather high retention rate of 80% implies that the firm will have the resources to take
advantage of high-return investment opportunities. These factors lend support to
classifying the firm as a growth company. However, as a result of the high retention rate,
investors will continue to require a high return on investment. Only if the firm can
continue to achieve returns above its cost of capital will the firm continue to be classified
as a growth company.

(c) The major components of EVA include the firm's net operating profit less adjusted taxes
(NOPLAT) and its total cost of capital (in rand) including the cost of equity. A positive
EVA implies that NOPLAT exceeds the cost of capital and that value has been added for
shareholders.

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(d) Required rate of return (k) 14% Return on equity (ROE) 30% Retention rate (RR)
90%
Earnings per share (EPS) R5,00

𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺ℎ 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 (𝑔𝑔) = 𝑅𝑅𝑅𝑅𝑅𝑅 𝑥𝑥 𝑅𝑅𝑅𝑅 = 30 𝑥𝑥 0,90 = 27%

𝐷𝐷⁄𝐸𝐸 (1 − 0,90)
𝑃𝑃⁄𝐸𝐸 = =
𝑘𝑘 − 𝑔𝑔 0,14 − 0,27

Since the required rate of return (k) is less than the growth rate (g), the earnings multiplier
cannot be used (the answer is meaningless).

However, if the ROE = 19% and the RR is 60%, then

𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺ℎ 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 (𝑔𝑔) = 𝑅𝑅𝑅𝑅𝑅𝑅 × 𝑅𝑅𝑅𝑅 = 19 × 0,60 = 11,4%

𝐷𝐷⁄𝐸𝐸 (1 − 0,60)
𝑃𝑃⁄𝐸𝐸 = = = 15.58 ×
𝑘𝑘 − 𝑔𝑔 0,14 − 0,114

Next year's earnings are expected to be:

Therefore:

𝐸𝐸0 (1 + 𝑔𝑔) = (5,00 × 1,114) = 𝑅𝑅5,57.

𝑃𝑃0 = 𝑃𝑃/𝐸𝐸 × 𝐸𝐸1 = (15,38 × 5,57) = 𝑅𝑅85,69.

Thus, you will be willing to pay up to R85,69 per share for Maddy Computer Company
shares.

(e) (i) Required rate of return (k) 12%

Growth rate of dividends (g) 8%

1,25(1,08) 1,25(1,08)2 1,25(1,08)3 40

𝑃𝑃0 = + 2
+ 3
+
1,12 (1,12) (1,12) (1,12)3
= 𝑅𝑅31,96

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𝐷𝐷0 (1+𝑔𝑔) 1,25(1,08)
(ii) 𝑃𝑃0 = = = 𝑅𝑅33,75
𝑘𝑘−𝑔𝑔 (0,12−0,08)

(iii) Assuming all the above assumptions remain the same, the price at the end of year
three will be:

𝐷𝐷0 (1 + 𝑔𝑔)4 1,25(1,08)4

𝑃𝑃3 = = = 𝑅𝑅42,52
𝑘𝑘 − 𝑔𝑔 (0,12 − 0,08)

(f) Three-stage dividend discount model: D0 = 2.00

D1 = 2.00(1.05) = 2.10

D2 = 2.00(1.05) (1.15) = 2.415

D3 = 2.00(1.05) (1.15) (1.25) = 3.0188

D4 = 2.00(1.05) (1.15) (1.25) (1.10) = 3.3206

Required rate of return = k = 15%; Growth rate = g = 10%

Value of the share:

𝐷𝐷
𝐷𝐷1 𝐷𝐷2 𝐷𝐷3 � 4 �
𝑘𝑘 − 𝑔𝑔
= + + +
(1 + 𝑘𝑘)1 (1 + 𝑘𝑘)2 (1 + 𝑘𝑘)3 (1 + 𝑘𝑘)3

SUMMARY

This learning unit wraps up the fundamental analysis process. We started off by examining the domestic
economy, finding the industry most likely to do well, and we concluded by identifying the company in

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this industry expected to outperform. Placing a value on the shares of this company, determining
whether it was undervalued or overvalued, was the last step in this process. We will now turn our
attention to technical analysis, either as an alternative to fundamental analysis or as a way to
complement and affirm its conclusions.

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Learning unit 9

Technical analysis

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• list and explain the underlying assumptions of technical analysis

• identify and discuss the basic charts used in technical analysis (i.e. line, bar and volume
bar charts)
• discuss various indicators used to anticipate future price movements (i.e. price fields,
volume, open interest, support and resistance, linear regression, trend lines, supply and
demand)
• explain the price fields defining a security's price and volume
• discuss the rules for interpreting open interest
• discuss price, volume and open interest interpretations related to both rising and
declining markets
• discuss the interpretation and merits of moving averages as an analytical tool
• contrast leading and lagging indicators
• discuss the assumptions underlying Dow Theory

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• discuss the application of the overbought/oversold oscillator in technical analysis
• discuss the application of the absolute breadth index in technical analysis
• discuss the application of the breadth thrust in technical analysis
• discuss line studies as an analytical tool (i.e. support, resistance, trend, Fibonacci arcs
and retracements)
• discuss market indicators with reference to the different categories
• explain the use of the relative strength index and positive volume index as market
indicators
• list and explain the challenges to technical analysis

KEY CONCEPTS

Absolute breadth index Linear regression Resistance lines

Bar charts Market indicators Reversal signal

Breadth thrust Minor trend Secondary trend

Charts Moving averages Supply

Demand Open interest Support lines

Dow Theory Overbought/oversold oscillator Time element
Indicators Price fields Trend lines
Lagging indicators Price volume index Volume
Leading indicators Primary trend Volume bar charts
Line charts Relative strength index

OVERVIEW

Technical analysis is the examination of past price movements to forecast future price movements and
may be viewed as an alternative or supplement to fundamental analysis. All the determinants of price,
including fundamental, economic, political and psychological factors, are supposedly reflected in the
current market price. Technical analysts (chartists) rely almost exclusively on charts for their analysis,
using a company's share price and volume history in various mathematical calculations (technical
indicators) to predict future behaviour for the market as a whole and for individual shares. Market timing
(predicting market movements) is considered a critical success factor for active trading, and technical

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analysis is consequently employed to determine the optimum time to buy and sell shares (sell high and
buy low).

Study chapter 10 of the prescribed book.

John Murphy's ten laws of technical trading

Behind the charts and graphs and mathematical formulas used to analyse market trends are some basic
concepts that apply to most of the theories employed by today's technical analysts. We will page through
chapter 10 in light of the ten basic laws of technical trading as identified by John Murphy,
StockCharts.com's chief technical analyst. These laws are designed to help explain the whole idea of
technical trading for the beginner and to streamline the trading methodology for the more experienced
practitioner. They define the key tools of technical analysis and how to use them to identify buying and
selling opportunities. The ten laws follow below, as outlined by Murphy at http://www.
stockcharts.com/education/Trading Strategies/MurphysLaws.html.

1 Map the trends

Study long-term charts. Begin a chart analysis with monthly and weekly charts spanning several years. A
larger scale map of the market provides more visibility and a better long-term perspective on a market.
Once the long-term market view has been established, then consult daily and intra-day charts. A short-
term market view alone can often be deceptive. Even if you only trade the very short term, you will do better
if you're trading in the same direction as the intermediate and longer-term trends.

2 Spot the trend and go with it

Determine the trend and follow it. Market trends come in many sizes – long-term, intermediate-term and
short-term. First, determine which one you're going to trade and use the appropriate chart. Make sure
you trade in the direction of that trend. Buy dips if the trend is up. Sell rallies if the trend is down. If you're
trading the intermediate trend, use daily and weekly charts. If you are day-trading, use daily and intra-
day charts. But in each case, let the longer-range chart determine the trend, and then use the shorter-
term chart for timing.

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3 Find the low and high of it

Find support and resistance levels. The best place to buy a market is near support levels. That support is
usually a previous reaction low. The best place to sell a market is near resistance levels. Resistance is usually
a previous peak. After a resistance peak has been broken, it will usually provide support on subsequent
pullbacks. In other words, the old "high" becomes the new "low". In the same way, when a support level has
been broken, it will usually produce selling on subsequent rallies – the old "low" can become the new "high".

4 Know how far to backtrack

Measure percentage retracements. Market corrections up or down usually retrace a significant portion
of the previous trend. You can measure the corrections in an existing trend in simple percentages. A 50%
retracement of a prior trend is most common. A minimum retracement is usually one-third of the prior
trend. The maximum retracement is usually two-thirds. Fibonacci retracements of 38% and 62% are also
worth watching. During a pullback in an up-trend, therefore, initial buy points are in the 33% to 38%
retracement area.

5 Draw the line

Draw trend lines. Trend lines are one of the simplest and most effective charting tools. All you need is a
straight edge and two points on the chart. Up-trend lines are drawn along two successive lows. Down-
trend lines are drawn along two successive peaks. Prices will often pull back to trend lines before resuming
their trend. The breaking of trend lines usually signals a change in trend. A valid trend line should be
touched at least three times. The longer a trend line has been in effect, and the more times it has been
tested, the more important it becomes.

6 Follow that average

Follow moving averages. Moving averages provide objective buy and sell signals. They tell you if an existing
trend is still in motion and help confirm a trend change. Moving averages do not tell you in advance,
however, that a trend change is imminent. A combination chart of two moving averages is the most popular
way of finding trading signals. Some popular futures combinations are 4-day and 9-day moving averages,
9-day and 18-day, as well as 5-day and 20-day. Signals are given when the shorter average line crosses the
longer. Price crossings above and below a 40-day moving average also provide good trading signals. Since
moving average chart lines are trend-following indicators, they work best in a trending market.

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7 Learn the turns

Track oscillators. Oscillators help identify overbought and oversold markets. While moving averages offer
confirmation of a market trend change, oscillators often help warn us in advance that a market has rallied
or fallen too far and will soon turn. Two of the most popular are the relative strength index (RSI) and
Stochastics. They both work on a scale of 0 to 100. With the RSI, readings over 70 are overbought while
readings below 30 are oversold. The overbought and oversold values for Stochastics are 80 and 20. Most
traders use 14 days or weeks for Stochastics and either 9 or 14 days or weeks for RSI. Oscillator divergences
often warn of market turns. These tools work best in a trading market range. Weekly signals can be used as
filters on daily signals. Daily signals can be used as filters for intra-day charts.

8 Know the warning signs (not covered in the prescribed book, refer to Sharenet chart)

Trade MACD. The Moving Average Convergence Divergence (MACD) indicator (developed by Gerald Appel)
combines a moving average crossover system with the overbought/oversold elements of an oscillator. A buy
signal occurs when the faster line crosses above the slower and both lines are below zero. A sell signal takes
place when the faster line crosses below the slower from above the zero line. Weekly signals take precedence
over daily signals. An MACD histogram plots the difference between the two lines and gives even earlier
warnings of trend changes. It's called a "histogram" because vertical bars are used to show the difference
between the two lines on the chart.

9 Trend or not a trend (not covered in the prescribed book, refer to Sharenet chart)

Use ADX. The average directional movement index (ADX) line helps determine whether a market is in a
trending or a trading phase. It measures the degree of trend or direction in the market. A rising ADX line
suggests the presence of a strong trend. A falling ADX line suggests the presence of a trading market and the
absence of a trend. A rising ADX line favours moving averages; a falling ADX favours oscillators. By plotting
the direction of the ADX line, the trader is able to determine which trading style and which set of indicators
are most suitable for the current market environment.

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10 Know the confirming signs

Include volume and open interest. Volume and open interest are important confirming indicators in futures
markets. Volume precedes price. It is important to ensure that heavier volume is taking place in the direction
of the prevailing trend. In an up-trend, heavier volume should be seen on up days. Rising open interest
confirms that new money is supporting the prevailing trend. Declining open interest is often a warning that
the trend is near completion. A solid price up-trend should be accompanied by rising volume and rising
open interest.

Technical analysis is a skill that improves with experience and study.

ACTIVITY

Read the following excerpts from More About Sharenet, to be found at http://www.
sharenet.co.za/v3/about.php.

"Sharenet was founded in 1988 as Network Information Services cc, by Anthony

Walker, as a registered vendor of JSE share prices to the public on a subscription basis.
Sharenet initially used the Beltel system introduced by Telkom as a platform for
conveying real time share prices, but in response to the potential it saw in the Internet,
was quick to modify its systems, and by 1995 had moved its access online, becoming the
first vendor of JSE prices via the Internet."

"Since then Sharenet has constantly improved its service and as a result has retained its
position as the leading provider of financial information to the consumer market. It is on
this platform, that Sharenet has developed its transactional capabilities and significant
market share."

"The site www.sharenet.co.za is by far the most accessed financial and investment site in
the country, serving in excess of 2.5 million impressions per month. The company delivers
a wide range of investment and share price information through the site and operates its
own highly sophisticated proprietary developed online trading infrastructure."

Go onto the following website to look at Sharenet's Java Technical Analysis Charts Free Version.

101
URL: http://www.sharenet.co.za/charts/

Click on: “Help” (top right-hand corner)

Find the indicators referred to in the prescribed book (chapter 10) and John Murphy's
ten laws of technical trading on the Sharenet display, and look at the descriptions
provided.

Click on: “Back” (return to previous screen)

Choose a company code (follow the instructions) and play around with the various
indicator selections to note the effects and changes on the chart.

FEEDBACK

The following screen will appear, showing and explaining the indicators available on this chart.
Many of these indicators are also referred to in the prescribed textbook. You can return (click on
"back") to the previous screen, choose a company code (follow the instructions) and play around
with the various indicator selections to note the effects and changes.

Charts

Help notes for Java technical analysis charts

Note that Sharenet Support does not offer any advice or explanation in regard to
technical analysis. We do, however, highly recommend the following book.

Technical analysis from A to Z

This revised edition provides a basic overview of technical analysis for readers
who are new to the subject, explaining what technical analysis with regard to
trading actually entails.

It presents 102 technical indicators with detailed explanations and instructions on how to go about
using them.

102
103
Details

(1) Displaying charts

To display a given chart, enter a share code or name into the symbol field and press the
[ENTER] key.

(2) Working with indicators

To display technical indicators, select them using the options available in the second toolbar.
Indicator parameters can be adjusted using text fields to the right of an indicator. Enter the
desired parameter value and press the [ENTER] key to apply the new parameter.

(3) Chart customisation

Using the options available in the first toolbar, you can set a chart type, a scale, data
compression or adjust the amount of data displayed.

(4) Working with trend lines and formations

You can draw lines on the chart using a mouse. Press the left mouse button and drag the mouse
to draw a line. To move or delete existing lines, first click on the "move lines" or "delete lines"
button, and then use the mouse.

The following indicators are available:

These descriptions are only a guide to provide some insight into their use.

• Accumulation distribution (AD) – variation of OBV, assesses the cumulative flow of money
into and out of a security by relating volumes and price movements.
• Bollinger (BOL) bands – are wide when prices are volatile
• Chaikin oscillator (ChO) – moving average oscillator based on the
accumulation/distribution indicator.
• Commodity channel index (CCI) – measures the change of a security's price from its
statistical mean.
• Moving average convergence divergence (MACD) – relationship between
26-day and 12-day exponential moving average (EMA) with a nine-day EMA plotted on top of
it as a trigger line to show potential buy/sell opportunities. Sell when MACD falls below trigger
line, buy when MACD goes above the trigger line.

104
• Momentum (MTM) – measures price change over a given time period.
• Money flow index (MFI) –momentum indicator showing strength of money flowing into and out
of a stock. If price trends are higher and MFI is lower (or vice versa), a reversal may follow. Stock
is likely to be at the top when MFI is greater than 80 and at the bottom when MFI is less than
20.
• Negative volume index (NVI) – attempts to identify bull markets on the theory that, when
volumes increase, uninformed investors are following like sheep, while when volumes are
lower, informed investors are at work. Thus, it shows what the informed investors are doing.
In Stock market logic, Norman Fosback points out that the odds of a bull market are 95 out
of 100 when the NVI rises above its one-year moving average. The odds of a bull market are
roughly 50/50 when the NVI is below its one-year average.
• On balance volume (OBV) – momentum indicator relating volume to price moves. If the stock
ends up, volume total is added to the cumulative total, if the stock ends down, day’s volume is
subtracted. Rising OBV is a sign of informed investors buying.
• Positive volume index (PVI) – opposite of the NVI. Shows what uninformed investors are
doing. When PVI is above its moving average, it indicates a bull market and a bear market
when it is below.
• Price oscillator (POS) – shows variation between moving averages.
• Price and volume trend (PVT) – momentum indicator relating volume to price moves (similar
to OBV), but adding or subtracting only a percentage of the day’s volume (using the % move
up or down). Thus, it seems to be a more accurate reflection than OBV. Look for PVT trending
higher while prices trend lower. A strong price increase could follow.
• Rate of change (ROC) – percentage difference between current price and price x days ago. The
default here is to show both the 5-day and 9-day ROC. As prices increase, the ROC rises and as
prices fall, the ROC falls. The greater the change in prices, the greater the change in the ROC.
• Relative s trength i ndex (RSI) – p rice oscillator that ranges between
0 and 100. Divergence with the price is used to hint for a reversal. Default is to show a 14-day
RSI, drawing a line at 30 and 70 as RSI usually tops above 70 and bottoms below 30.
• Simple moving average (SMA1, SMA2, SMA3) – average price over x days. Investors typically
buy when a security's price rises above its moving average and sell when the price falls below
its moving average.
• Stochastic (STS) – display as 2 lines, the orange line (called %D) is a moving average of the
main blue line (called %K). Buy when either %K or %D falls below 20 and then rises back above
that level. Similarly, sell when the either line rises above 80 and then falls back below. Another
pattern to look for when timing trades is buy when the %K line rises above the %D line or sell

105
when the %K line falls below the %D line. Be on the lookout for divergences, if prices are
making a series of new highs and the stochastic oscillator fails to surpass its previous highs, the
indicator typically will provide the clue as to where prices will soon head.
• Trend deviation (TRD) – Trend deviation (TRD) is the ratio of the close price to is number of
bars simple moving average.
• TRIX index (Trix) – Trix is a momentum indicator that displays the percentage
rate-of-change of a triple exponentially smoothed moving average of the security's closing
price. It is designed to keep you in trends equal to or shorter than the number of periods you
specify. Trix crossing above the zero line is a potential buy signal and a closing below the zero
line is a potential sell signal. Divergence between price and Trix can also indicate significant
turning points in the market.
• Ultimate oscillator (ULT) – uses weighted sums of three oscillators, each of which uses a
different time period expressed as a single line plotted between
0 and 100, with oversold territory below 30 and overbought territory above 70.
• Volatility ratio (VLT) – Volatility ratio (VLT) is the technical measure of the changes in the
prices of certain security.
• Volume o scillator (VOS) – uses the difference between two moving averages of volume
to determine if the overall volume trend is increasing or decreasing.
• Williams’ accumulation distribution (WAD1) – used to determine if the marketplace is
controlled by buyers (accumulation) or by sellers (distribution). Williams recommends trading
this indicator based on divergences: Distribution of the security is indicated when the security
is making a new high and the A/D indicator is failing to make a new high. Accumulation of the
security is indicated when the security is making a new low and the A/D indicator is failing to
make a new low.
• Williams’ %R (%R) – momentum indicator that measures overbought/oversold levels. –80 to
–100% indicate that the security is oversold, while values in the
0 to –20% range suggest that it is overbought. An interesting phenomenon of the %R indicator
is its uncanny ability to anticipate a reversal in the price of the underlying security. The
indicator almost always forms a peak and turns down a few days before the price of the security
peaks and turns down. Likewise, %R usually creates a trough and turns up a few days before
the security's price turns up.

106
ASSESSMENT

(1) Answer the self-assessment questions found at the end of chapter 10 in the prescribed
book.

(2) Additional assessment questions:

(a) Technical analysts believe that one can use past price changes to predict future
price changes. How do they justify this belief?

(b) Indicate some disadvantages of technical analysis.

(c) Describe the Dow Theory and its three components. Which component is most
important? What is the reason for the intermediate reversal?

(d) Explain the reasoning behind a support level and a resistance level.

(e) What is the purpose of computing a moving average line for a share? Describe a
bullish pattern using a moving average line and the volume of trading. Discuss why
this pattern is bullish.

(f) Discuss why most technicians follow several technical rules in an attempt to
derive consensus.

(g) When technical analysts say a share has “good relative strength”, they mean the:

(1) ratio of the price of the share to a market index has trended upward
(2) recent trading volume in the share has exceeded the normal trading volume
(3) total return on the share has exceed the total return on other shares in the
same industry
(4) share has performed well compared with other shares in the same risk
category as measured by beta

107
(h) Based on technical analysis, a share should be bought if:

(1) the moving average line declines and crosses the share price line
(2) the moving average line increases and crosses the share price line
(3) the overbought-oversold (OB-OS) line starts to increase from its maximum
negative value
(4) Alternatives 2 and 3 above.

(i) The Dow Jones industrial average has all of the following characteristics as a share
market index, except:

(1) it is price weighted

(2) it is dominated by just a few companies
(3) companies having share splits are weighted less heavily
(4) it is affected equally by changes in low- and high-priced shares

(j) Which of the following is not a component outlined by Charles Dow (Dow Theory)?

(1) Tertiary moves, which are simply the daily fluctuations. The chartist should
plot an asset's price or the market average each day in order to trace the
primary and secondary trends.
(2) Primary trends, which are long-term movements, commonly called bear or
bull markets.
(3) Bar charts have one vertical bar representing each day's price movements.
(4) Secondary movements, which last only a few months.

108
Answers to additional assessment questions

(a) The principal contention of technicians is that share prices move in trends that persist
for long periods of time. Because these trends persist, they can be predicted by analysing
past prices.

(b) The disadvantages of technical analysis are as follows:

(1) Past price patterns may not be repeated in the future.

(2) The intense competition of those using the trading rules may render a specific
technique useless.
(3 The trading rules require a great deal of subjective judgement.
(4) The values that signal action are constantly changing.

(c) The Dow Theory contends that share prices move in waves. Specifically, these waves may
be grouped into three categories based upon the period of the wave:

(1) major trends for long periods (tides)

(2) intermediate trends (waves)
(3) short-run movements for very short periods (ripples)

The major trend (the tide) is most important to investors. An intermediate reversal
occurs when some investors decide to take profits.

(d) A support level is a price range where considerable demand is expected, while a
resistance level is a price range where a large supply is expected. Support and resistance
levels exist due to the behaviour of a number of investors who are closely monitoring the
market and will trade quickly at attractive price levels. Specifically, a support level occurs
after a share has increased in price, followed by a brief period of profit-taking at which
time some investors, who did not get in on the first round, decide to take to opportunity
to get in. A resistance level occurs after a share has declined, and when it experiences a
recovery some investors who missed selling at a price peak take the opportunity to sell.

A price-break through a resistance level on strong volume would be considered very

bullish. This is because as the price rises to the target set by investors, the supply
increases, usually causing the price increase to reverse. Thus, a price-break through on
strong volume would be bullish because it would mean the excess supply had dissipated.

109
(e) A moving average line indicates the major trend of a security's price. When daily prices
break through the long-term trend from below on heavy volume, it is considered a bullish
action. The move above the trend line may indicate a new upward change in the trend.

(f) Technicians recognise that there is no single technical trading rule that is correct all the
time – even the best ones miss certain turns or give false signals. Also, various indicators
provide different information for alternative segments of the market. Therefore, you do
not want to depend on any one technique, but should rather look at several and derive
consensus.

(g) (1) ratio of the price of the share to a market index has trended upward

(h) (4) Alternative 2 and 3 above.

(i) (4) It is affected equally by changes in low and high-priced shares.

(j) (3) Bar charts have one vertical bar representing each day's price movements.

SUMMARY

The chapter in the prescribed textbook is by no means a comprehensive and exhaustive coverage of
technical analysis. It is merely an introduction to the underlying assumptions and some of the different
techniques related to this complicated and challenging topic. The actual application and interpretation
of the various indicators and charts fall outside the scope of this module. We now move on to the analysis
and valuation of fixed-interest securities.

110
Topic 3

THE ANALYSIS OF FIXED-INTEREST

SECURITIES

AIM

Topic 3 promotes a basic understanding of fixed-interest securities such as bonds. The

valuation of bonds and the measurement of risk through duration are explained.

TOPIC LEARNING OUTCOMES

Once you have worked through this topic, you should be able to:

• discuss the features and determinant factors of fixed-interest securities

• evaluate the risks and returns of fixed-interest securities such as bonds
• compare and select bonds in constructing a portfolio to suit specific outcomes and
circumstances

TOPIC CONTENT

Learning unit 10: Fundamentals of the analysis of fixed-interest securities

Learning unit 11: Valuation of fixed-interest securities

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Learning unit 10

Fundamentals of the analysis of fixed-interest

securities

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• describe the basic characteristics/features of a bond (e.g. maturity, par value, coupon rate)
• calculate the holding period return (HPR) of a bond
• explain the risks associated with investing in bonds (e.g. interest rate risk, yield curve risk,
call and prepayment risk, reinvestment risk, credit risk, liquidity risk, exchange-rate risk,
inflation risk, volatility risk and event risk)
• identify the bond indices available in South Africa and explain their uses
• describe the different types of international bonds (e.g. foreign bonds and Eurobonds)
• describe bonds with embedded options (e.g. callable bonds and putable bonds) describe
zero-coupon bonds
• describe variable rate bonds
• define an asset-backed security
• describe a mortgage-backed security

112
KEY CONCEPTS

Asset-backed Holding period return Structured securities

Bond indices International bonds Time to maturity
Bonds Market price Variable rate bonds
Coupon interest Mortgage-backed Yield to maturity
Embedded options Rating agencies Zero-coupon bonds
Face value Risk exposures

OVERVIEW

Chapter 11 of the prescribed book focuses on the basic characteristics of bonds, bond risk exposures and
the types of bonds available in the market. In the following chapter, we look at the pricing of bonds and the
determination of zero rates and forward rates. It is important to examine and understand the basic
characteristics of the most common interest rate instrument, the bond. The following section also applies
to learning unit 11 (Valuation of fixed-interest securities).

Study chapter 11 of the prescribed book.

ACTIVITY

Go onto the Bond Exchange of South Africa (BESA) website and download the
PDF file, “Introduction to bonds”. Read this file in conjunction with chapters 11 and 12 of the
prescribed book.
URL: http://www.bondexchange.co.za
Click on: “Instruments”
Select: Bonds
Click on: “Introduction to bonds” (select from “Document Downloads”)
Save as PDF file

113
FEEDBACK

This PDF document titled "An introduction to bond pricing in layman's terms" refers to the
terminology and topics covered in chapters 11 and 12. The following is an excerpt from this
document:

A bond can simply be described as a long-term loan. Most people will have borrowed
money at some stage in their lives and will have paid interest on the amount that they
borrowed. When a person lends or invests money, he or she is giving up the opportunity
to convert those funds into goods and services immediately which must be compensated
for. The concept of interest is the basis of how the borrower compensates the lender for the
amount borrowed.

Furthermore, the lender faces uncertainty with respect to when the money is repaid. This
uncertainty is called risk, which has to be included in the compensation amount. There are
several types of risks the lender will face; some of these risks are:
• Inflation
• Default of the borrower. Default is the failure of the borrower to repay the debt for
reasons that are not technical or temporary but usually as a result of bankruptcy.
• Government policy, e.g. taxation on interest etc.
• The amount of time to repay the debt, i.e. the longer the period, the higher the
compensation one would require.

ASSESSMENT

(1) Answer the self-assessment questions found at the end of chapter 11 in the
prescribed book.

(2) Additional assessment questions:

(a) Identify the three most important determinants of the price of a bond. Describe
the effect of each.

114
(b) Given a change in the level of interest rates, discuss how two major factors will
influence the relative change in price for individual bonds.

(c) Why should investors be aware of the trading volume for bonds in their
portfolio?

(d) What is the purpose of bond ratings?

(e) Discuss the differences between a foreign bond (e.g. a Samurai) and a Eurobond
(e.g. Euroyen) issue.

Answers to additional assessment questions

(a) The three factors affecting the price of a bond are coupon, yield and term to maturity.
The relationship between price and coupon is a direct one – the higher the coupon,
the higher the price. The relationship between price and yield is an inverse one – the
higher the yield, the lower the price; all other factors held constant. The relationship
between price and maturity is not so clearly evident. Price changes resulting from
changes in yields will be more pronounced the longer the term to maturity.

(b) For a given change in the level of interest rates, two factors that will influence the
relative change in bond prices are the coupon and maturity of the issues. Bonds with
longer maturity and/or lower coupons will respond most vigorously to a given
change in interest rates. Other factors, likewise, cause differences in price volatility,
including the call features, but these factors are typically much less important.

(c) An investor should be aware of the trading volume for a particular bond because a
lack of sufficient trading volume may make it impossible to sell the bond in a timely
manner. As a result, prices may vary widely while the investor is trying to change his or
her position in the bond.

(d) Bond ratings provide a very important service in the market for fixed income securities
because they provide the fundamental analysis for hundreds of issues. The rating
agencies conduct extensive analysis of the intrinsic characteristics of the issue to
determine the default risk for the investor and inform the market of the analyses
through their ratings.

115
(e) The difference between a foreign bond and a Eurobond can be defined as a difference
in issuer and the market in which they are issued. For example, a foreign bond in Japan
(e.g. a Samurai) is denominated in the domestic currency (yen) and is sold in the
domestic market (Japan), but is sold by non-Japanese issuers. On the other hand, a
Eurobond (e.g. a Euro) is denominated in the domestic currency (Eurobond), but is sold
outside the domestic country in a number of international markets. International
syndicates typically underwrite these bonds. The relative size of these two markets
varies by country.

SUMMARY

This chapter has provided an introduction to fixed-interest securities, specifically bonds. In the next learning
unit, we look at the pricing valuation (pricing and risk assessment) of fixed interest.

116
Learning unit 11

Valuation of fixed-interest securities

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• explain the sources of return from investing in a bond (i.e. coupon interest payments, capital
gain/loss, reinvestment income)
• calculate the traditional yield measures for fixed-rate bonds (i.e. nominal yield, current yield,
yield to maturity, yield to call)
• describe the fundamental principles of bond valuation
• calculate the value of a bond given the expected annual or semi-annual cash flows and the
appropriate single (constant) discount rate
• explain how the value of a bond changes if the discount rate increases or decreases
• calculate the change in value that is attributable to the rate change
• explain how the price of a bond changes as the bond approaches its maturity date
• calculate the change in value that is attributable to the passage of time
• identify the relationship among a bond's coupon rate, the yield required by the market and the
bond's price relative to par value (i.e. discount, premium or equal to par)

117
• distinguish between the alternative definitions of duration (Macaulay, modified and
effective)
• explain why effective duration is the most appropriate measure of interest rate risk for bonds
with embedded options
• describe why duration is best interpreted as a measure of a bond's sensitivity to changes in
interest rates
• calculate and interpret the duration (Macaulay, modified and effective) of a bond, given
information about how the bond's price will increase or decrease for given changes in interest
rates
• calculate the approximate percentage price change for a bond, given the bond's duration and
a specified change in yield
• discuss the convexity measure of a bond and estimate a bond's percentage price change given
the bond's duration and convexity and a specified change in interest rates
• describe a yield curve and the different yield curve shapes observed
• explain the basic theories of the term structure of interest rates (i.e. pure expectations theory,
liquidity preference theory and market segmentation theory)
• describe the implications of each theory for the shape of the yield curve
• calculate spot/zero-coupon interest rates by means of the bootstrap method
• calculate forward rates from a series of zero rates
• calculate a bond's value using spot rates
• discuss forward rate agreements (FRAs) and calculate an FRA payoff

KEY CONCEPTS

Bond prices Forward rates Reinvestment

Bootstrapping Interest rates Segmented market
Callable bonds Liquidity preference Spot rates
Convexity Macaulay duration Valuation
Coupon Modified duration Volatility
Current yield Nominal yield Yield curve theories
Duration Price-yield Yield to call
Effective duration Pure expectations Yield to maturity
Forward rate agreements Realised return Yield-maturity

118
OVERVIEW

In this learning unit, we explain the valuation of fixed-interest securities. This includes a discussion of how
one values a bond by using a single discount rate or spot rates from the theoretical spot curve. We also
consider the factors that influence yields on bonds and the volatility of bond returns. This includes a
discussion of duration. Duration is important in active and passive bond portfolio management. A related
concept, bond convexity, and its impact on bond price volatility are also explained.

Study chapter 12 of the prescribed book.

Determining treasury zero rates

A spot rate over a period of time can be defined as the yield to maturity on a single
end-of-period cash flow value. Calculating the spot rate entails a process called "stripping" or
"bootstrapping" of bonds. The stripping of bonds allows the separation or stripping of each of the cash flow
components (coupon interest payments and face value) of a bond to be traded as separate and independent
bonds. Bonds are thus stripped of their cash flows and sold as separate and individual "zero-coupon" bonds.
The ability to recreate these separate, independent cash flow strips through bootstrapping opens up a
significant arbitrage trading opportunity.

Consider a bond that has a set of coupon and final face value cash flows that can be replicated using a
combination of individual zero-coupon bonds. If each of the independent zero-coupon bonds is similar to
each of the corresponding bond's cash flows, the reconstructing of those cash flows can offer an arbitrage
profit if differences exist between the two sets of instruments. To remove such arbitrage action, the present
value of all coupon and face value cash flows from the original bond should equal the sum of the present
values of the collective group of independent zero-coupon bonds.

Since the yield to maturity of the original, conventional bond would by definition have equated to the price
of the bond, it follows that the yield to maturity comprises a series of overriding rates of interest. The yield to
maturity itself is actually often regarded as an average rate of return, comprising this set of superseding rates
of interest. When traditional bonds are used to estimate spot rates, these rates are the outcome to this
theoretical arbitrage-free argument that generates the theoretical spot rates. The following example
illustrates the calculation of these spot rates:

119
ACTIVITY

By using the following data, determine the equivalent spot rates (zero-coupon rates) using the
bootstrapping method. All bonds have a face value of R100 and semi-annual coupon payments.

Bond Maturity Annual Coupon per Price Yield to

coupon Period maturity

A 6 10% R5,00 R99,06 12%

B 12 15% R7,50 R99,11 16%

C 18 12% R6,00 R92,41 18%

Bond value or price =

1
6-month spot rate(𝑆𝑆𝑆𝑆6 ) = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 𝐹𝐹𝐹𝐹 + 𝑦𝑦𝑦𝑦𝑦𝑦(1 + 𝑆𝑆𝑆𝑆6 )−1
2

1
12-month spot rate(𝑆𝑆𝑆𝑆12 ) = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 𝑦𝑦𝑦𝑦𝑦𝑦(1 + 𝑆𝑆𝑆𝑆6 )−1 + 𝐹𝐹𝐹𝐹 + 𝑦𝑦𝑦𝑦𝑦𝑦(1 + 𝑆𝑆𝑆𝑆6 )−2
2

18-month spot rate(𝑆𝑆𝑆𝑆18 ) = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 𝑦𝑦𝑦𝑦𝑦𝑦(1 + 𝑆𝑆𝑆𝑆6 )−1 + 𝑦𝑦𝑦𝑦𝑦𝑦(1 + 𝑆𝑆𝑆𝑆12 )−2 +
1
𝐹𝐹𝐹𝐹 + 𝑦𝑦𝑦𝑦𝑦𝑦(1 + 𝑆𝑆𝑆𝑆6 )−3
2

FEEDBACK

Bond A:

Therefore, the one-year spot rate = (0,06 x 2) = 12%

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The 6-month spot rate will always equal the yield to maturity since the bond will only
make one payment: No calculation is required.

Bond B:

Therefore, the two-year spot rate = (0,0808 x 2) = 16,15%

OR

1 −2
𝑆𝑆𝑆𝑆12 = 99.11 = 7.5(1.06)−1 + 107.5 �1 + 𝑆𝑆𝑆𝑆12 �
2
−2
1
99.11 = 7.0755 + 107.5 �1 + 𝑆𝑆𝑆𝑆12 �
2
2
1 107.5
�1 + 𝑆𝑆𝑆𝑆12 � =
2 99.11 − 7.0755
1 1
1 + 𝑆𝑆𝑆𝑆12 = (1.1680)2
2
1
𝑆𝑆𝑆𝑆 = 0.0807
2 12
𝑆𝑆𝑆𝑆12 = 0.1615

121
Bond C:

Therefore, the three-year spot rate = (0,0911 x 2) = 18,21%

OR
−3
−1 −2
1
𝑆𝑆𝑆𝑆18 = 92.41 = 6(1.06) + 6(1.0808) + 106 �1 + 𝑆𝑆𝑆𝑆18 �
2
−3
1
92.41 = 5.6604 + 5.1364 + 106 �1 + 𝑆𝑆𝑆𝑆18 �
2
3
1 106
�1 + 𝑆𝑆𝑆𝑆18 � =
2 92.41 − 5.6604 − 5.1364
1 1
1 + 𝑆𝑆𝑆𝑆18 = (1.2988)3
2
1
𝑆𝑆𝑆𝑆 = 0.0910
2 18
𝑆𝑆𝑆𝑆18 = 0.1821

Notes on calculations:

• The one-year spot rate will always be equal to the appropriate yield to maturity,
in this instance 12%.
• Semi-annual compounding was used in this example, and we therefore had to:

– divide the yield to maturity (YTM) and coupon payments (CPN) by 2

– multiply the maturity/time period (t) by 2

– multiply the calculated spot / zero-coupon rate (i) by 2

Forward rates

Using the spot rate curve calculated above, we can now deduct a further interest rate referred to as

122
the forward rate. The forward rate is simply the market's consensus of future interest rates and is
used by institutions that would want to fix a certain rate of interest sometime in the future.

To calculate a forward rate, assume, for example, that an investor wants to invest R100 for a one-year
period. The investor has the following spot (market) rate alternatives:

• Invest in a one-year zero-coupon bond yielding a spot rate of 10,50 per cent.
• Invest in a six-month zero-coupon bond yielding a spot rate of 10,30 per cent. After six months,
the investor will have to reinvest in another six-month zero-coupon bond.
The spot rate for this additional six-month period is currently unknown.

If both alternatives will provide the same return, the investor will be indifferent in his or her choice
of investment. Given that we know the spot rates of the six-month and one-year bonds, we can
deduce that the forward rate (the six-month rate six months from today) is the rate that equates
the rand interest return between the two alternatives. Investing R100 in either of the two bonds will
yield the following rand returns:

One-year bond Six-month bond

Time to maturity 2 periods 1 period
Investment amount R100 R100
Annualised spot rate 10.50% 10.30%
Ending investment value R110.78 * R105.15 **

[ ∗ 100 × (1 + 0.105⁄2)2 ; ∗∗ 100 × (1 + 0.103⁄2)1 ]

In order for the investor to be indifferent in his or her choice between the two alternatives, he or
she should be able reinvest the R105,15 and end up with exactly R110,78 at the end of the one-
year period. The rate at which he or she should be able to accomplish this is the forward rate,
which is calculated as follows:

123
Financial calculator

Sharp EL733
HP10B
Input Function
Input Function
110.78 FV
110.78 FV
–105.15 PV
–105.15 PV
1 N
1 N
COMP
I/YR
I/YR
5.3543
5.3543

The annualised six-month rate six months from today = (5.3543 x 2) = 10.71%

Manually:

Or you could simply have used this formula (annual/semi-annual/quarterly compounding):

The annualised six-month rate, six months from today = (5.3501 x 2) = 10,70%*
(* difference due to rounding errors)

ACTIVITY

Using the following data, determine the forward rates between years one and two and years two
and three:

Bond Maturity Zero-coupon

yield to maturity

A 1 year 8,300%

124
B 2 years 9,247%

C 3 years 9,787%

FEEDBACK

One-year forward rate (current spot rate)

i = 8,30%
One-year forward rate one year from now (between years one and two)

One-year forward rate, two years from now (between years two and three)

Theories of the term structure of interest rates

• Expectations theories
─ Pure (unbiased) expectations theory
Forward rates are solely a function of expected future spot prices.
─ Biased expectations theories
■ Liquidity premium

Forward rates reflect investor's expectations of future rates plus a liquidity premium
(positively related to maturity) to compensate them for exposure to interest rate risk
(price risk – bond sold before maturity; reinvestment risk – rate at which cash flows can
be reinvested over investment horizon).

■ Preferred habitat

Also proposes that forward rates represent expected future spot rates plus a

125
premium, but it does not support the view that this premium is directly related to
maturity. The existence of an imbalance between supply and demand for funds in a
given maturity range will induce lenders and borrowers to shift from their preferred
habitats (maturity range) to one that has the opposite imbalance. They, however,
require to be compensated (risk premium) for the exposure to interest rate risk.

• Market segmentation theory

This is similar to the preferred habitat theory in that it proposes that lenders and borrowers
have preferred maturity ranges. Some investors, however, have restrictions (either legal or
practical) on their maturity structure and will therefore not be enticed to shift out of their
preferred maturity ranges. That means the shape of the yield curve is completely
determined by the supply and demand for securities within each maturity segment. This
implies that rates for a given maturity band will be determined independently of those for
all other maturity bands. Theory can be used to explain any shape of the yield curve.

Bond price volatility and duration

Duration is by far the most widely used measure of bond price volatility. Basically, it shows how the
price of a bond is likely to react to different interest rate environments. A bond's duration and its
price volatility are directly related, that is, the longer the duration, the more price volatility there is
in a bond. Duration is a measure of a bond's sensitivity to a 1% change in interest rates. This
measure is often referred to as effective duration. It can be used with either non-callable, callable
bonds or bonds with any type of embedded option. Another way to measure duration is to use
what is known as modified duration. This measure is found by first computing a bond's Macaulay
duration, and then adjusting it for the bond's yield to maturity (YTM). Modified duration is the
same as (equal to) effective duration for bonds without any embedded options. Modified
duration does not work for bonds with embedded options.

ACTIVITY

Calculate the Macaulay duration of the following bond:

Face value: R1 000

Time to maturity: 2 years (thus, n = 4)
Coupon payment: 12% per annum (thus, R60 per six-month period)

126
Yield to maturity: 14% per annum (thus, 7% per six-month period)
Price: R966.13*

Financial calculator

HP10B Sharp EL733

Input Function Input Function

1 000 FV
1 000 FV
60 PMT
60 PMT
70 I/YR
7 I/YR
4 N
4 N COMP
PV PV
966.13 966.13

FEEDBACK

(1) (2) (3) (4) (5)

Time Cash Present (3) ÷ price (1) x (4)

period flows value at
7%

1 R60 R56.07 0.0580 0.0580

2 R60 R52.41 0.0543 0.1085

3 R60 R48.98 0.0507 0.1521

4 R1 060 R808.67 0.8370 3.3481

Total R966.13* 1.0000 3.6667

* Macaulay duration = 3.6667 ÷ 2 = 1.83 years

The duration measurement has the following characteristics:

• The duration of a normal coupon-paying bond is always less than its time to maturity because
duration assigns weights to the coupon payments. It would then follow that the duration of a

127
zero-coupon bond would be equal to the time to maturity of the bond since there are no
coupon payments.
• There is an inverse relationship between duration and coupon rates and between duration
and yield to maturity.
• There is a positive relationship between duration and time to maturity.

ACTIVITY

Using the previously calculated Macaulay duration, determine the modified duration of the
bond.

FEEDBACK

In the previous example, we measured the Macaulay duration at 1.83 years. From this we can
calculate the modified duration as follows:

ACTIVITY

Use the bond information as above and calculate the effective duration of this bond.

FEEDBACK

where: V– = estimated price if yield decreases by a given amount, Δy

V+ = estimated price if yield increases by a given amount, Δy

V0 = initial observed price

Δy = change in required yield in decimal form

V- V0 V+

FV 1 000 1 000 1 000

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PMT 60 60 60

I 6.5 7 7.5

N 4 4 4

PV? 982.87 966.13 949.76

Effective duration will equal modified duration provided the bond has no embedded options. One
cannot apply the modified duration calculation to a bond that is callable or putable. Effective
duration, on the other hand, may be used in all circumstances.

The duration effect

With the help of the modified duration measure, we can now deduce to what extent price and
yield will influence each other, since it was found that price movements would vary proportionally
with modified duration for small changes in yields.

Approximate percentage change in price due to duration:

where: % Δ P = percentage change in price of bond

Δy = yield change (basis points ÷ 100)

Note the negative sign in the equation – it's there because bond prices and yields move in opposite
directions (inverse relationship).

ACTIVITY

In the previous example, we measured the modified duration at 1.71 years. Suppose we want to
see what the influence of an increase of 20 basis points (0.20%) in the yield to maturity of the bond
will be on the price of the bond.

129
FEEDBACK

This would imply that the price of the bond would decrease by 0.3420% or R3.30 (966.13 x 0.00342)
to R962.83 if the yield to maturity were to increase by 20 basis points.

Alternatively:

Estimated price of bond = R966.13 x [1+ (–0.00342)] = R962.83

Actual price of bond = R962.82 (FV = 1 000; PMT = 60; N = 4; I/YR = 7.1)

Note, in the above calculations, that the estimated price change differs from the actual price
change. For large changes in yield, a very common behavioural characteristic of duration – that
is, for wide swings in yield (of 50 to 100 basis points or more), duration tends to underestimate the
increase in price that occurs with a decrease in yield, and overestimate the decrease in price that
comes with an increase in yield. That is not the case, however, with very small changes in yield (of 10
to 25 basis points or so); under those conditions, the estimated and actual price changes are equal
(or very close) to one another, as in the example. This phenomenon is referred to as the convexity
effect, and fortunately, the amount of convexity in a bond can be measured and used to
supplement duration in order to achieve a more accurate estimate of the change in price.

Convexity

While a precise calculation of convexity involves the use of calculus (convexity is the second
derivative of the price function with respect to yield), we can generate an

approximate measure of convexity as follows:

where: V- = estimated price if yield decreases by a given amount, Δy

V+ = estimated price if yield increases by a given amount, Δy

V0 = initial observed price

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Δy = change in required yield in decimal form

ACTIVITY

A bond has the following characteristics. Calculate the convexity of the bond, taking into account
a 1% change in the yield to maturity.

Face value R100

Time to maturity: 2 years

Coupon payments: 10% per annum (thus, R5 per six-month period)

Yield to maturity: 12% per annum (thus, 6% per six-month period)

Price: R96.5349

FEEDBACK

V- V0 V+
FV 100 100 100
PMT 5 5 5
I 5.5 6 6.5
N 4 4 4
PV? 98.2474 96.5349 94.8613

[The convexity is shown as 4.03 but that should be divided by two → 2.02]

The convexity effect

131
where: % Δ P = percentage change in price of bond

Δy = yield change in decimal form

Percentage change in price

By combining duration and convexity, we can obtain a far more accurate estimate of the
percentage change in the price of a bond, especially for large swings in yield. That is, you can
account for the amount of convexity embedded in a bond by adding the convexity effect to
duration, as follows:

ASSESSMENT

(1) Answer the self-assessment questions found at the end of chapter 12 in the prescribed
book.

(2) Additional assessment questions:

(a) Explain the relationship between the yield to maturity, coupon rate and price of a
bond.

(b) Calculate the realised compound yield of the following bond:

Time to maturity 12 years

Coupon rate 13% (semi-annual payments)
Face value R1 000
Yield to maturity 15.50% Market price R865.60
Reinvestment rate 9%

(c) You are estimating the interest rate risk of a 14% semi-annual coupon bond with six

132
years to maturity. The bond is currently trading at par. Use a
25 basis point change in yield to compute the effective/modified duration.

(d) Suppose that the bond in question (c) is callable at par today. Using a
25 basis point change in yield, calculate the effective duration of the bond, assuming
that its price cannot exceed 100.

(e) Referring to the bond in question (d), suppose that the bond is option free.
Calculate its convexity value (again use a 25bp change in yield).

(f) Suppose that you determine that the modified duration of a bond is 7.87.
Estimate the percentage change in price due to duration, given that yields decrease by
110 basis points.

(g) Suppose that you have found the convexity of a bond to be 57.3. Estimate the convexity
effect if yields decrease by 110 basis points.

(h) Assume you are looking at a bond that has an effective duration of 10.5 and a
convexity of 97.3. Using both of these measures, find the estimated percentage change
in price for this bond, given market yields are expected to decline by 200 basis points.

(i) You purchased an annual interest coupon bond one year ago that now has six years
remaining until maturity. The coupon rate of interest was 10% and the par value was
R1 000. At the time of purchase, the yield to maturity was 8%. The amount that you
paid for this bond one year ago was:

(1) 1. R1 057.50
(2) 2. R1 075.50
(3) 3. R1 088.50
(4) 4. R1 104.13

(j) Bond E has a par value of R1 000 000 and matures in 13 years. It is callable in 12 years by
the issuer at a call price of R1 268 000. It has coupon payments of 8% per annum (semi-
annual). Calculate the yield to call of Bond E.

(1) 4.26%
(2) 4.56%

133
(3) 8.53%
(4) 9.12%

Use the information below to answer questions k and l.

A firm's outstanding bond issue has eight years remaining until maturity. The bond
was issued with a 6.5% coupon rate (paid quarterly) and a par value of R1 000. The
required rate of return is 4.25%.

(k) What is the current value of this bond?

(1) R433.15
(2) R860.50
(3) R1 149.94
(4) R1 151.92

(l) Determine the bond's value in one year if the required return is 7%.

(1) R 970.14
(2) R1 031.15
(3) R1 035.81
(4) R 972.52

(m) A five-year, 6% coupon bond pays interest semi-annually and sells for R958.42. The
effective duration of this bond is closest to:

(1) 4.03
(2) 4.11
(3) 4.17
(4) 4.23

(n) A 12-year, 10% semi-annual coupon bond (R1 000 par value) is priced at a yield to
maturity (YTM) of 8%. The convexity adjustment with a 150 basis point decrease in
yield is closest to:

(1) R4.21
(2) R6.53

134
(3) R9.47
(4) R9.86

(o) Consider a bond portfolio manager who expects interest rates to decline and has to
choose between the following two semi-annual bonds.

• Bond A 10 years to maturity with a 5% coupon and yielding 5%

• Bond B 10 years to maturity, priced at R918.24 to yield 4%

(1) Bond B because it has a lower coupon rate

(2) Bond A because it has a higher coupon rate
(3) Bond B because it has a lower yield to maturity
(4) Bond A or Bond B because the maturities are the same

(p) The following information is for Bond D.

Yield to maturity 13%

Coupon rate 10%
Coupon payments Semi-annual
Time to maturity 3.5 years
Market price R901 375
Face value R1 000 000

Given a reinvestment rate of 15%, calculate the realised compounded yield of Bond D.

(1) 4.33%
(2) 13.83%
(3) 17.66%
(4) 18.56%

(q) Assume that you purchase a three-year R1 000 par value bond with an 8% coupon
and a yield of 10%.

After the purchase of the bond, one-year interest rates are as follows:
Year 1 = 10%
Year 2 = 8%

135
Year 3 = 6% (these are the reinvestment rates)

Calculate the realised compound or horizon yield if you hold the bond to maturity, interest
paid annually.
(1) 7.28%
(2) 8.37%
(3) 9.76%
(4) 10.67%

(r) Suppose the current six-year spot rate is 8% and the current five-year spot rate is 7%. What
is the one-year forward rate in five years?

(1) 11.58%
(2) 13.14%
(3) 14.65%
(4) 15.14%

(s) The current one-year spot rate is 6%, the current two-year spot is 9.2% and the current three-
year spot rate is 14%. Calculate the forward rate two years from now.

(1) 4.58%
(2) 19.05%
(3) 24.23%
(4) 30.00%

(t) For an option-free bond, what are the convexity adjustments on the value of the
approximate bond price change with regards to an increase in yield and a decrease in yield
respectively?

Increase in yield Decrease in yield

(1) Decrease in value Increase in value

(2) Increase in value Increase in value
(3) Decrease in value Decrease in value
(4) Increase in value Decrease in value

136
(u) Which of the following statements is least accurate about forward rates?

(1) A forward rate is the interest rate applicable to a future period.

(2) Forward rates are derived from the calculated spot rates.
(3) The lengths of the future period and the pre-period are not specified.
(4) Difference between subsequent periods is indicated by n in the forward rate formula.

Answers to additional assessment questions

(a) Coupon rate = Yield to maturity, then Market price = Face value
Coupon rate > Yield to maturity, then Market price > Face value
Coupon rate < Yield to maturity, then Market price < Face value

(b) Step 1: PMT 65

N 24
I/YR 4.5 (reinvestment rate of 9%)
FV? 2 709.80
Step 2: R(1 000 + 2 709.80) = R3 709.80

Step 3: FV 3 709.80
PV –865.60
N 24
I/YR? 12.50% (6.25 x 2)

(c) Effective/modified duration

V- V0 V+

FV 100 100 100

PMT 7 7 7

I 6.875 7 7.125

N 12 12 12

PV? 100.9995 100 99.0137

137
[Note that the interest changes by 25bp, therefore (14–0.25) = 13.75 → 6.875, etc]

(d) Effective duration (callable at par)

(e) Convexity

(f) Duration effect

%∆𝑃𝑃 = −7.87(−1,10) = 8,657%

(g) Convexity effect

(h) Combined effect

(i) HP10B

Input Function

1 000 FV

100 PMT

7 N

8 I/YR

PV

4. R1 104.13

138
(j)

HP10B
Input Function
1 268 000 FV
–1 000 000 PV
40 000 PMT
26 N
I/YR
4.5587% ×2
= 9.12%
4.

(k)

HP10B
Input Function
1 000 FV
16.25 PMT
32 N
1.0625 I/YR
PV
(4)
R1 151.92

(l)

HP10B
Input Function
1 000 FV
16.25 PMT
28 N
1.75 I/YR

(4) PV

R972.52

139
(m)

HP10B

Input Function

1 000 FV

-958.42 PV

30 PMT

10 N

I/YR

3.5% ×2
= 7%

V- V0 V+

FV 1 000 1 000 1 000

PMT 30 30 30

N 10 10 10

I 3 3.5 4

PV 1 000 958.42 918.89

Effective duration = (V-) – (V+)

2V0 (Δy/100)

= 1 000 – 918.89
2 × 958.42 × 0.01

4. = 4.23

140
(𝑉𝑉− ) + (𝑉𝑉+ ) − 2(𝑉𝑉0 )
(n) 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 =
2(𝑉𝑉0 ) (∆𝑦𝑦⁄100)2

V- V0 V+

FV 1 000 1 000 1 000

PMT 50 50 50

N 24 24 24

I 3.25 4 4.75

PV 1 288.546 1 152.47 1 035.35

= 1288.546 + 1035.35 – (2 × 1152.47)

2×1152.47 × 0.015²

= 18.956
0.51859

= 36.553

ΔP = V0 × convexity × (Δy/100)²

= 1152.47 × 36.553 × (0.015)²

3. = R9.47

(o) Bond B

HP10B

Input Function

1 000 FV

–918.24 PV

20 N

2 I/YR

141
PMT

R15 × 2

=R30

1. = 3% coupon. Choose Bond B because it has a lower coupon rate.

(p) Step 1: Calculate the future value of the coupon payments reinvested.

HP10B
Input Function
50 000 PMT
7 N
7.5 I/YR
FV
R439 366.09

Step 2: Add the face value of the bond to the future value of the
coupon payments.

= R1 000 000 + R439 366.09

= R1 439 366.09

Step 3: Calculate the actual yield received.

HP10B
Input Function
1 439 366.09 FV
– 901 375 PV
7 N

2. I/YR
6.9148 × 2
= 13.83%

142
(q)

HP10B
Input Function
1 000 FV
80 PMT
3 N
10 I/YR
PV

Market price R950.263

Step 1: Calculate the future value of the coupon payments reinvested.

= 80(1.08)(1.06) + 80(1.06) + 80

= 91.584 + 84.80 + 80

= R256.384

Step 2: Add the face value of the bond to the future value of the coupon payments.

= R1 000 + R256.384

= R1 256.384

Step 3: Calculate the actual yield received.

HP10B
Input Function
1 256.384 FV
–950.263 PV
3 N
143
I/YR
(3) 9.76%
(r) Forward rate = 1.086
1.075
1.5869
=
1.4026

= 1.1314
= (1.1314 – 1) × 100

(2) = 13.14%

(s) Forward rate =1.143

1.0922

= 1.4815
1.1925

= 1.2423

= (1.2423 – 1) × 100

(3) = 24.23

(t) 4. Increase in yield: increase in value Decrease in yield: decrease in value

This is because the price change due to an increase in yield is smaller than the price change
due to a decrease in yield for option-free bonds.

(u) Forward rates

The length of the future period and the pre-period is not specified.

SUMMARY

In this learning unit, we have determined spot rates (bootstrapping/stripping), calculated forward rates
and discussed the theories offered to explain the shape of the yield curve. We have calculated the duration
and convexity of a bond in order to compare and select between different bonds in constructing a portfolio

144
of bonds suited to the prevailing and expected interest rate environment. All the previous learning units
have been leading up to the topic to follow – portfolio management. In this topic, we are introduced to
derivative instruments (used to manage risk and alter portfolio composition), the basics for constructing a
portfolio and the measurement of the performance of these portfolios.

145
Topic 4

PORTFOLIO MANAGEMENT

AIM

The key to portfolio management is the enhancement of return whilst simultaneously reducing risk by
means of diversification and/or derivatives. This topic provides you with a general overview of the field
of derivatives, including the derivative markets and market participants, and the basic concepts of forwards,
futures, options and swaps. We introduce the criteria for security selection in constructing a portfolio and
measure the performance of a portfolio.

TOPIC LEARNING OUTCOMES

Once you have worked through this topic, you should be able to:

• use derivatives to manage risk or enhance portfolio return

• construct and manage a portfolio

TOPIC CONTENT

Learning unit 12: An introduction to derivative instruments

Learning unit 13: Portfolio management
Learning unit 14: Evaluation of portfolio management

146
Learning unit 12

An introduction to derivative instruments

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this unit, you should be able to:

• define a derivative and differentiate between exchange-traded and

over-the-counter derivatives
• define a forward commitment, identify the types of forward commitments and describe
the basic characteristics of forward contracts, futures contracts and swaps
• define a contingent claim and identify the types of contingent claims
• describe the basic characteristics of options and distinguish between an option to buy
(call) and an option to sell (put)
• discuss the purposes and criticisms of derivative markets
• explain the concept of arbitrage and the role it plays in determining prices and in
promoting market efficiency
• describe how a futures position may be closed out (i.e. offset) prior to expiration
• define initial margin, maintenance margin, variation margin and settlement price
• describe how a futures contract can be terminated by close-out at expiration, delivery,

147
an equivalent cash settlement or an exchange-for-physicals
• identify the basic elements and describe the characteristics of option contracts
• define European option, American option, moneyness, payoff, intrinsic value and time
value
• explain how payoffs are determined
• identify the minimum and maximum values of European options and American options
• calculate put-call parity for European options
• describe the characteristics of swap contracts and explain how swaps are terminated
• define currency swaps and calculate and interpret the payments on a currency swap
• define a plain-vanilla interest rate swap and calculate and interpret the payments on an
interest rate swap
• determine the value at expiration, profit, maximum profit, maximum loss, breakeven
underlying price at expiration, and general shape of the graph of the strategies of buying
and selling calls and puts, and explain each strategy's characteristics
• determine the value at expiration, profit, maximum profit, maximum loss, breakeven
underlying price at expiration, and general shape of the graph of the covered call
strategy and the protective put strategy, and explain each strategy's characteristics

KEY CONCEPTS

American options Hedge profiles Options

Arbitrage Hedge ratio Payoff
Call option Interest rate swap Protective put
Clearinghouse Long Put option
Covered call Margins Put-call parity
Currency swap Marking-to-market Risk management
Derivatives Open interest Risk profiles
European options Option bounds Short
Forward options Option delta Swaps
Futures contracts Option premium Volume
Futures price Option pricing

148
OVERVIEW

A major development in the field of investments has been the creation and development of new financial
instruments and the introduction of derivatives such as futures, options and swaps. Derivatives afford
investors an opportunity of adjusting the risk-return characteristics of their portfolios.

In this learning unit, we explain derivative instruments. We also look at the key aspects of futures contracts,
such as futures pricing, arbitrage, speculation versus hedging, volume, open interest, marking to market,
the clearinghouse, closing a futures position, the zero-sum game and how the hedge ratio is determined.

Options are then discussed and the differences between call and put options and between an American
and a European option are highlighted. We also consider the factors that determine an option premium,
and we explain put-call parity and the combining of options in order to achieve a covered call strategy or a
portfolio insurance strategy. The learning unit concludes with a discussion of interest rate swaps and
currency swaps, and the underlying principle of comparative advantage.

Study chapter 13 of the prescribed book.

Derivative market terms and concepts

Arbitrage

It is important to understand the concept of arbitrage and the no-arbitrage principle. Arbitrage refers
to the opportunity to make a riskless profit with no investment. Theoretically, markets are said to be
efficient, alluding to the fact that quoted security prices supposedly impound all relevant information. This
excludes the possibility of arbitrage in utilising disparate pricing in the same or different markets. Since any
observed pricing errors would be instantaneously corrected, any quoted prices must be free of all known
errors. The
no-arbitrage opportunity assumption is the basic requirement for rational prices in the financial markets.
Arbitrage and efficient markets enabled the evolution of the option and futures pricing models as
presented in the textbook and study guide.

149
Arbitrage is the simultaneous buying and selling of identical or related securities (commodity or
financial) in the same (spot or futures) or different (spot and futures) markets, resulting in a profit
through a discrepancy in the pricing of these securities as quoted on various formal and over-the-
counter (OTC) exchanges. The immediate nature of the transaction affords the investor a risk-less
profit without the transfer of money. This will result in the fair and/or equal pricing of
identical/related securities across and within markets. An arbitrageur is a person who engages in
arbitrage.

Markets

The spot market, also called cash market, is a market for buying or selling commodities or securities for
immediate delivery and for cash payment at the price prevailing at the time of sale.

The futures market, also called forward or derivative market, is a market in which contracts for future delivery
of a commodity or a security are bought or sold at a predetermined price (date of contract) and
settlement/payment is deferred until maturity/expiration of contract.

The over-the-counter market, sometimes referred to as the unlisted market, facilitates transactions across
the desk of interested parties, or frequently, using computer terminals (electronically) and telephones. The
OTC market permits the parties to innovate in accordance with their needs (tailor-made contracts).

Any organisation, association or group that provides or maintains a marketplace where securities or
commodities can be traded is referred to as an exchange, representing the formal market. These markets
are highly regulated and trade in standardised instruments. The formal exchanges in South Africa are
the JSE Securities Exchange, the South African Futures Exchange (Safex) and the Bond Exchange of South
Africa (Besa).

Marking to market records the price or value of a security, portfolio, or account on a daily basis in order to
calculate profits and losses or to confirm that margin requirements are being met. The clearinghouse sets
and maintains the margins as required when trading futures contracts.

The primary market is the market for new securities issues. In the primary market, the security is
purchased directly from the issuer. This differs from the secondary market.

The secondary market, also called aftermarket, is a market in which an investor purchases a security from

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another investor rather than the issuer, subsequent to the original issuance in the primary market.

A bear market (opposite of bull market) is a prolonged period in which prices fall,
accompanied by widespread pessimism. If the period of falling stock prices is short and immediately
follows a period of rising share prices, it is instead called a correction. Bear markets usually occur when the
economy is in a recession and unemployment is high, or when inflation is rising quickly. Analogous to this is
being bearish (opposite of bullish) and therefore believing that a particular security, sector, or the overall
market is about to fall.

A bull market (opposite of bear market) represents a prolonged period in which investment prices rise faster
than their historical average. Bull markets can happen as a result of an economic recovery, an economic
boom, or investor psychology/sentiment. Related to this is being bullish (opposite of bearish), thus believing
that a particular security, sector, or the overall market is about to rise.

Tradeable assets

A commodity is a physical substance, such as food, grains, or metals, which is interchangeable with another
product of the same type, and which investors buy or sell, either in the spot commodity market or through
futures contracts. The price of the commodity is subject to supply and demand. Risk is actually the reason
exchange trading of the basic agricultural products began. For example, a farmer risks the cost of producing
a product ready for market at some time in the future because he or she does not know what the selling price
will be.

A financial security/instrument is a general term for any written instrument having monetary value or
evidencing a monetary transaction. These securities provide a mechanism for investment in the financial
markets and include equity (shares), fixed-income securities (debt/bonds), share indexes, forwards, futures,
options, swaps and currencies.

Derivative contracts

A forward contract or forward is an over-the-counter market transaction in which a seller agrees to deliver a
specific security to a buyer at some point in the future. Unlike futures contracts (which occur through a
clearing firm), forward contracts are privately negotiated and are not standardised. Further, the two parties
must bear each other's credit risk, which is not the case with a futures contract. Also, since the contracts are
not exchange-traded, there is no marking to market requirement, which allows a buyer to avoid almost all

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capital outflow initially (though some counter-parties might set collateral requirements). Given the lack of
standardisation in these contracts, there is very little scope for a secondary market in forwards.

A futures contract, or futures, is a standardised, transferable, exchange-traded contract that requires delivery
of a commodity, bond, currency, or share index at a specified price, on a specified future date. Unlike options,
futures convey an obligation to buy. The risk to the holder is unlimited, and because the payoff pattern is
symmetrical, the risk to the seller is unlimited as well. Monetary values lost and gained by each party on a
futures contract are equal and opposite. In other words, futures trading is a zero-sum game. Futures contracts
are forward contracts, meaning they represent a pledge to make a certain transaction at a future date. The
exchange of assets or cash settlement occurs on the date specified in the contract. Futures are distinguished
from generic forward contracts in that they contain standardised terms, trade on a formal exchange, are
regulated by overseeing agencies, and are guaranteed by a clearinghouse (Safex Clearing Company (Pty) Ltd
– Safcom). Also, in order to ensure that payment will occur, futures have a margin requirement that must be
settled daily.

An option contract or option is the right, but not the obligation, to buy (call option) or sell (put option) a
specific amount of a given share, commodity, currency, index, or bond at a specified price (the strike price)
during a specified period of time. Each option has a buyer, called the holder, and a seller, known as the writer.
If the option contract is exercised, the writer is responsible for fulfilling the terms of the contract. While the
holder's upside potential is unlimited, the potential loss is limited to the price paid to acquire the option. When
an option is not exercised, it expires with no shares changing hands and the money spent to purchase the
option is forfeited. Options, like shares, are therefore said to have an asymmetrical payoff pattern. For the
writer, the potential loss is unlimited unless the contract is covered, meaning that the writer already owns the
security underlying the option. Options are most frequently used as either leverage or protection. As leverage,
options allow the holder to control equity in a limited capacity for a fraction of what the shares would cost.
The difference can be invested elsewhere until the option is exercised. As protection, options can guard
against price fluctuations in the near term because they provide the right to acquire the underlying share at
a fixed price for a limited time. Risk is limited to the option premium (except when writing options for a
security that is not already owned). However, the costs of trading options are higher on a percentage basis
than trading the underlying share. In addition, options are very complex and require a great deal of
observation and maintenance.

An option contract that gives the holder the right to buy a certain quantity of an underlying security from
the writer/seller of the option at a specified price (the strike or exercise price) up to a specified date (the
expiration date) is referred to as a call option or call. Alternatively, an option contract that gives the holder

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the right to sell a certain quantity of an underlying security to the writer/seller of the option at a specified
exercise price up to the specified expiration date is known as a put option or put.

A swap is defined as an exchange of cash flows based on a notional principal amount according to specified
terms. The two most common types of swaps are an interest rate swap, in which one party agrees to pay a
fixed-interest rate in return for receiving a
floating-interest rate from another party, and a currency swap, in which parties swap principal amounts and
interest on different currencies. Closely related to swaps is a forward rate agreement (FRA), which is an
agreement to pay or receive, on an agreed future date, the difference between an agreed interest rate and
the interest rate actually prevailing on that date, based on a notional principal amount. The difference is
that the FRA is applied to a single period and a swap to cash flows over several periods. A swap is therefore
considered to be a series of forward rate agreements.

Financial engineering is the process of researching and developing new financial products and services
that would meet customer needs and prove profitable. Financial institutions use financial engineering
to create complex derivative instruments, combining or carving up existing instruments to create new
financial products.

Primary trading strategies

A covered call involves the selling of a call option while simultaneously holding an equivalent position in
the underlying security. This is an attempt to take advantage of a neutral or declining share. If the option
expires unexercised, the writer keeps the premium. Should the holder exercise the option, the share must
be delivered, but, because the writer already owns the stock, risk is limited. This is the opposite of an
uncovered call, when the writer sells a call for a share that he or she does not already own, a dangerous
strategy with unlimited risk. Covered calls relate to one of the uses of derivatives, namely income
generation. Writing calls to generate income is especially popular during a flat period in the market or
when prices are trending downward.

A protective put offers protection against a decline in the share price of the underlying security. This
constitutes the purchase of a put option for an underlying security that is already owned by the holder of
the option and relates to the primary use of derivatives, namely hedging.

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Description of forward and futures contracts

A forward contract is a privately negotiated contract between two parties. The contract is negotiated in the
present and gives the contract holders both the right and the full legal obligation to conduct a transaction
at a specific future time involving a specific quantity and type of asset at a predetermined price. The
purchaser/buyer (long position) of the contract is to receive delivery of the good and pay for it, while the
seller (short position) of the contract promises to deliver the good and receive payment. This is in contrast
to a spot market contract, which is an agreement between two parties to buy or sell an asset for immediate
delivery and payment. The forward contract provides predictability to market participants since it is
known in advance what price (determined at the initial time of the contract) will be paid for an asset.

The futures contract is an extension of the forward contract, with one major difference being that futures
contracts have formalised and standardised characteristics. The standardised characteristics specified under
the contract include a specification of the asset, contract size, and where and when it can be delivered. A futures
contract is thus not just a contract between two parties; it becomes a tradeable financial instrument, regardless
of whether the underlying asset happens to be gold, maize, dollars or stocks.

A futures contract is a forward contract that has been highly standardised and closely specified.

Differences between forward and futures contracts

• Forwards are private contracts (OTC) and do not trade on an organised exchange
• Futures trade on organised exchanges (South Africa – Safex)
• Forwards are unique contracts satisfying the needs of the parties involved
• Futures are highly standardised (specification of the quantity, quality, delivery date, and delivery
mechanism)
• Forwards have default risk (the seller may not deliver, and the buyer may not accept delivery)
• Futures trade on an organised exchange and performance is guaranteed by the
exchanges' clearinghouse (South Africa – Safcom)
• Forwards require no cash transactions until the delivery date
• Futures require marking to market (traders required to post margin – good faith money that supports
the trader's promise to fulfil his/her obligation)
• Forwards are usually not regulated – self-regulated
• Futures trade on organised exchanges regulated by government
• Forwards (tailor-made) have little secondary market trading
• Futures (standardised – exchange traded) have active secondary market trading

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Regardless of the institutional differences, forwards and futures are very similar contracts and are priced
according to identical economic principles.

Different types of futures contracts

This chapter describes the fundamental characteristics (specifications) of futures contracts but does little
towards explaining the practical reasons and uses of futures contracts. The difference between hedgers and
speculators was discussed in the previous learning unit. The following table summarises, from a hedger's
perspective, how the different types of futures contracts can be used:

Type of futures contract Reason/s for taking a long Reason/s for taking a short
position position

Equity index futures Covering a short selling exposure * Hedge total portfolio against
downward prices

Individual equity share Covering a short selling exposure * Hedge individual shares against
futures downward prices

Interest rate futures Hedge a floating rate loan against Hedge a floating rate loan against
an increase in interest rates a decrease in interest rates

Bond futures Buyer of bond hedge against a An issuer (seller) of bonds hedge
decrease in interest rates (increase against an increase in interest
in the price of bond) rates

Bond index futures Buyer of a bond portfolio hedge An issuer (seller) of a bond
against a decrease in interest rates portfolio hedge against an
increase in interest rates

Commodity/agricultural Buyer of commodities hedge Producer of commodities hedge

futures against price increases against a decrease in prices

* Short selling involves selling securities or underlying assets that are not owned.

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ACTIVITY

Go onto the JSE's futures market (Safex) website and note the derivative products that are
available on individual equities (single stocks).

URL: http://www.jse.co.za/trade/derivative-market/equity-derivatives

Click on: “Single Stock Futures” (on the right-hand side of the
screen)
Scroll down and note the specifications and underlying shares/stocks.

FEEDBACK

These are futures on individual shares and differ from the index futures in that the settlement at
expiry requires physical delivery as opposed to cash settlement.

Contract specifications for individual equity futures

Underlying instrument Specified individual equities/stocks

Contract size 100 times the share price

Expiry date Third Thursday of March, June, September and December, or the
previous business day if it is a public holiday

Settlement method Physically settled. Position holders must elect a stockbroker to

facilitate the physical settlement.

Tick value (minimum R1 (1 cent per share)

movement)

Expiry valuation method Based on the arithmetic average share price as calculated by the
JSE between the hours of 14h01 and 15h40 on the expiry date

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The following table summarises, from a speculator's perspective, how the different types of futures
contracts can be used:

Type of futures contract Reason/s for taking a Reason/s for taking a short
long position position

Equity index futures The speculator believes that The speculator believes that
there will be an upward there will be a
(favourable) movement in downward (unfavourable)
the equity market and that, movement in the equity
in general, the prices of market and that, in general,
shares will increase the prices of shares will
decrease

Individual equity share The speculator believes that The speculator believes there
futures there will be an upward will be a downward
(favourable) movement in (unfavourable) movement in
the prices of individual the prices of individual shares
shares

Interest rate futures The speculator believes that The speculator believes that
market interest rates will market interest rates will
increase decrease

Bond futures The speculator believes that The speculator believes that
market interest rates will market interest rates will
decrease increase

Bond index futures The speculator believes that The speculator believes that
market interest rates will market interest rates will
decrease increase

Commodity/agricultural The speculator believes that The speculator believes that

futures the prices of commodities the prices of commodities will
will increase decrease

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Margins

The futures exchange calculates profits or losses on each open futures contract position on a daily
basis by a process known as "marking-to-market". This process involves averaging out the closing
bid and offer prices quoted on the futures exchange for every open futures contract at the end of
the day. These average bid and offer prices are then compared with the bought or sold prices
executed by each party on their contracts. The so-called mark-to-market profits are then calculated
and credited or debited to each account accordingly. To manage risk and to avoid default risk
exposure, no futures participant is permitted to build up large unrealised losses. Any loss incurred
must be paid for as it occurs, that is on a daily basis. To ensure that this takes place, a margin system
is used.

In order to arrive at an appropriate margin percentage value for a futures contract, the futures
exchange estimates the maximum amount that each participant could reasonably lose on the
individual futures contract from one day to the next. The futures participant is required to lodge
with the futures exchange, in cash, a margin equal to this maximum potential daily loss, and this is
known as the initial margin. In South Africa, this margin is between 5% and 10% of the value of the
futures contract, and is in essence a "good faith" deposit.

The initial margin is payable when the futures contract is initially entered into. This margin account
then earns interest at a money-market-related interest rate, and the balance is returned to the
investor when the contract is eventually closed out.

The operation of margins

There are three types of margin. The first deposit is
called the initial margin. The initial margin must be
posted before any trading takes place. This margin
is fairly low and equals about one day's maximum
price fluctuation. The margin requirement is low,
because at the end of every day there is a daily

settlement process called marking-the-account-to-market. In marking to market, any losses

for the day are removed from the trader's account and any gains are added to the trader's
account. If the margin balance in the trader's account falls below a certain level (called the
maintenance margin), the trader will get a margin call and have to deposit more money (called

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the variation margin) into the account to bring the account back up to the initial margin level.

The clearinghouse

Consistency on the part of both buyers and sellers is a prerequisite for an efficient and actively traded
futures market. If speculators and hedgers knew that the other participants could simply default on
their contracts and that their only resort would be legal action, futures markets would simply never
function efficiently. Every buyer and seller in the futures market must thus be confident that every
futures contract will be honoured, thereby eliminating default risk.

In order to create this certainty, a futures exchange clearinghouse becomes a party to each and
every contract and thereby guarantees performance. The South African Futures Exchange (Safex)
has its own independent clearinghouse, Safcom (South African Clearing Company). Safcom is a
non-profit organisation designed to provide efficient service to the market and to market
participants. All purchases and sales are matched in the futures market so that ownership can pass
to the buyer and payment to the seller without undue delay; this ensures default-free transactions.

Safcom undertakes this matching process and acts like an insurance company, since it saves part
of the fees it collects in an insurance fund. Should one party to a futures contract then default, the
clearinghouse will pay, from its insurance fund, any costs needed to carry out the contract. This
process ensures the liquidity and exchangeability of futures contracts.

Hedging

• Short hedge

A short hedge involves a short position in a futures contract and is appropriate when the hedger
already owns (long) an asset and expects to sell it at some time in the future. Exposure to
fluctuating prices is eliminated, or at least reduced. (Note: If you're long on the underlying, then
use a short hedge. If you're short on the underlying, then use a long hedge.)

• Long hedge

A long hedge involves a long position in a futures contract and is appropriate when a company
knows it will have to purchase a certain asset in the future and wants to lock in a price now. This

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is also referred to as an anticipatory hedge since the company anticipated a need for a certain
commodity and locked in the price for that future purchase. In both cases, the hedger has
essentially purchased insurance against unfavourable market volatility.

• Cross-hedging

A cross-hedge is a hedge in which the hedge vehicle (the futures contract) is not perfectly
correlated with the underlying exposure that is being hedged.

• Basis risk

─ Reasons

■ hedged asset not the same as underlying asset

■ uncertainty as to the exact date when the asset has to be bought or sold

■ futures contract closed out well before the expiration date

─ Basis = spot price of the asset to be hedged minus the futures price of the contract
used

■ strengthening of the basis – spot price increases more than futures price

■ weakening of the basis – futures price increases more than spot price

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ACTIVITY

Go onto the JSE Securities Exchange website and take a look at the information provided on the
FTSE/JSE Africa Index Series.

URL: http://www.jse.co.za

Click on: “Financial Data” (on the left-hand side of the screen) FTSE/JSE – FAQ (frequently
asked questions)
Choose “Index Series” from the alternatives listed
Scroll down the different topics and look at the questions and answers on this series

FEEDBACK

What is a tradeable index?

A tradeable index is one on which a derivative product exists. This derivative product is then traded
on the JSE's futures market (Safex).

Are all the indices of the FTSE/JSE Africa Index Series tradeable?

No, not all the indices are tradeable.

The FTSE/JSE Africa tradeable indices consist of:

• FTSE/JSE Africa TOP 40

The top forty companies, which are constituents of the FTSE/JSE Africa All Share Index, ranked
by full market capitalisation

• FTSE/JSE Africa RESI 20

The top twenty companies, which are constituents of the Resources economic group ranked
by full market capitalisation

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• FTSE/JSE Africa INDI 25

The top 25 companies, which are constituents of either the Basic Industrial or General Industrial
economic groups ranked by full market capitalisation

• FTSE/JSE Africa FINI 15

The top 15 companies, which are constituents of the Financial economic group, ranked by full
market capitalisation

• FTSE/JSE Africa FINDI 30

The top 30 companies, which are constituents of either the Financial, Basic Industrial or
General Industrial economic groups ranked by full market capitalisation (although this index
is calculated, there are currently no derivatives based upon this calculation)

• FTSE/JSE Africa GLDX

All companies that are constituents of the FTSE/JSE Africa All Share Index and the Gold Mining
sub-sector.

• Minimum variance hedge ratio

The hedge ratio is the ratio of the size of the position taken in futures contracts to the size of
the exposure. A one-to-one hedge may not always be optimal since the beta of the hedge
vehicle does not match the beta of the underlying portfolio to be hedged. The goal of risk-
minimisation hedging is to minimise the variance of the hedged position. The hedge ratio that
accomplishes this goal is:

Forward/futures price

The pricing of forwards/futures is important and this must be taken into consideration when

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entering into such a contract. Both parties involved in the contract must
understand their future commitment and they must realise the implications of entering into the
contract. When determining the price of a future/forward, we calculate what is called the fair
value.

Terminology

• Short selling – selling an asset that is not owned

• Cash-and-carry – the total cost of carrying a good forward in time
• Arbitrage – the possibility to generate a risk-less profit without investment

─ The relationship between the forward/futures price (F0) and the spot price (S0)

or with continuous compounding

─ Cash-and-carry arbitrage ( )

■ Sell futures

■ Borrow money

■ Buy spot

─ Reverse cash-and-carry arbitrage ( )

■ Short spot

■ Invest money

■ Purchase futures

The determination of forward and futures prices is derived from the principle of arbitrage. This
is an important concept since arbitrage ensures that the theoretical futures price will equal the
actual market price for the contract. The following is a more detailed discussion of this
important pricing principle.

Arbitrage

Arbitrageurs are market participants who take advantage of small price differentials between
similar products in different markets. When futures and spot prices move temporarily out of line
with each other over a very short term, market traders will buy in the lower-priced market and

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simultaneously sell in the higher-priced market to generate a riskless profit. This strategy
guarantees that futures prices are correctly priced in relation to current spot prices. Through this
price determination, arbitrage therefore also guarantees that futures contracts provide an
effective hedge for spot risk exposures. The following example illustrates how arbitrage profits
will correct market inefficiencies.

ACTIVITY

Given a current spot market price of R50 and a risk-free interest rate of 10% per annum, calculate
the price of a six-month futures contract. Describe the scenario with actual futures prices of R55
and R50 respectively.

FEEDBACK

Arbitrage scenario 1: Futures price = R55

In this case, the actual futures price of R55 is higher than the theoretical futures price of R52.56.
An arbitrageur would follow the following strategy:

• Cash-and-carry arbitrage ( )

Sell/short futures → Asset sold six months forward

■
■ Borrow money → R50 @ 10% interest for six months

■ Buy/long spot → Pay R50 on the spot market

• Six months later

■ Repay loan of R52,56 (R50 + 10% interest for 6 months)

■ Deliver asset under futures contract and receive R55

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By following this cash-and-carry arbitrage strategy, a risk-free profit of R2,44
(R55 – R52,56) would be made.

Arbitrage scenario 2: Futures price = R50

In this case, the actual futures price of R50 is lower than the theoretical futures price of R52.56. An
arbitrageur would follow the following strategy:

• Reverse cash-and-carry arbitrage ( )

─ Sell/short spot → Receives R50 from short sale

─ Invest proceeds → R50 @ 10% interest for six
─ Buy/long futures → Asset bought six months
─ Six months later

● Take delivery of asset (return shorted asset) and pay R50

● Collect investment of R52,56 (R50 + 10%)

By following this reverse cash-and-carry arbitrage strategy, a risk-free profit of R2,56 (R52,56 –
R50) would be made.

From the scenarios above, one can see that arbitrage will always be possible if the actual futures prices in
the market do not equal their corresponding theoretical prices. As traders use arbitrage to exploit market
inefficiencies, prices start moving to their theoretical values, thereby eliminating any arbitrage
opportunity and ensuring that futures are correctly priced.

ACTIVITY

Go onto the JSE's futures market (Safex) website and note the derivative products that are
available on tradeable indices.

URL: http://www.jse.co.za/trade/derivative-market/equity-derivatives

Click on: “Equity Index Futures”

“Contract Specifications”

Scroll down the tables and identify the relevant derivatives.

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FEEDBACK

Contract specifications for equity index futures

Underlying instrument An equity index: Top 40, Resi 20, Indi 25, Fini 15, Findi 30 or
GLDX

Contract size 10 times the index level

Expiry date Third Thursday of March, June, September and December, or the
previous business day if it is a public holiday
Settlement method Cash
Tick value (minimum One index point (R10)
movement)
Expiry valuation Based on the arithmetic average of the index as calculated by the JSE
method between the hours of 14h01 and 15h40 on the expiry date

Options

Option contracts are instruments that give the buyer the right – but without the obligation
– to buy or sell shares, bonds, currencies, commodities or any other form of security at a certain
price, usually on or before a certain date. A distinction can be made between a call option,
which is an option to buy an asset, and a put option, which is an option to sell an asset.

Option contracts were defined earlier as contracts that give the buyer or holder of the contract
the right to buy or sell underlying securities at a certain price, on or before a certain date. In
the case of option contracts, the seller or writer of the contract has an obligation to honour
his or her obligation. The choice (the right to exercise) thus lies with the holder of the contract.
This is in contrast to futures and forward contracts, where parties are obliged to buy or sell an
asset.

This distinction between the types of futures derivatives is important, since it gives the option
contract buyer/holder a distinct advantage over the futures contract holder, the forward
contract holder and even the option writer/seller. The option holder will exercise his or her
option (i.e. take up the rights obtained under the option) only if it is profitable to do so. The
maximum possible loss that can be incurred by the holder of an option is limited, but the

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potential profit is unlimited.

You need to develop an understanding of the mechanics of option contracts, just as you have
had to with the other instruments dealt with thus far. These instruments are relatively simple
in principle, but their pricing involves complex calculations. These instruments are
exchange-traded (on the Traded Options Market or TOM), or may be traded over the counter.
As with forwards, the over-the-counter contracts are a greater credit risk and are less liquid
since these contracts are tailor-made to suit the needs of the contracting parties.

Options notation and variables

The table below sets out the five main variables (excluding dividends) that influence the
value/price or premium of an option, namely the underlying asset’s spot price, the strike or
exercise price, the volatility (standard deviation) of the underlying asset, time to maturity or
expiration and the risk-free rate of return

Options notation and variables

Variable Notation State Call option Put option
value value
Spot price S Increase Increase Decrease
Strike price X Higher Lower Higher
Volatility Δ Higher Higher Higher
Time to T Longer Higher Uncertain
maturity
Interest R Higher Higher Lower
rates
Call option C or c Max(0;S – X)
Put option P or p Max(0;X – S)

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Option types, positions and payoffs

Buy or sell a call option

The intrinsic value of a call at

expiration is the greater of (S–
X) or 0. The call holder will
exercise the option only when
the stock's price exceeds the
strike price.

Buyer of call
Potential profit: unlimited

Seller of call
Potential profit: premium

Breakeven point = strike price + premium

The sum of the profits between the buyer and seller of the call is always zero; thus, options
trading is a zero-sum game.

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Buy or sell a put option

The intrinsic value of a put

option at expiration will be the
greater of (X – S) or 0. The put
holder will only exercise the
option when the strike price
exceeds the stock's price.

Buyer of put
Potential profit: Strike price less
premium

Seller of put
Potential profit: premium

Breakeven point = strike price – premium

Puts (like calls) are a zero-

sum game.

Moneyness

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Trading strategies involving options

Strategies involving a single option and a stock

• Covered call

─ Buying the underlying security and selling a call option

─ Generate additional portfolio income while underlying stock price remains
unchanged
─ Same structure as a short put

• Protective put (portfolio insurance or hedged portfolio)

─ Long position in the underlying security and buying a put option

─ Ensuring your stock position on the downside while still enjoying the upside potential
─ Same structure as a long call

Swaps

A swap is an agreement between two parties to exchange future cash flows (based on a
notional principal amount) at specified times in the future according to certain predetermined
rules. It is an extremely effective tool for hedging interest rate risk, where a floating rate liability
(risk exposure) can be converted to a fixed rate liability. This is the youngest of the major
derivative classes, with the first interest rate swap taking place between IBM and the World Bank
in 1981. The growth of the swaps since the early 1980s makes them one of the most important
derivative instruments. It is important that you be able to discuss and design both interest rate
and currency swaps.

• A swap is a contract between two counterparties to exchange cash flows at regular intervals
over a specified period of time. There are two basic types of swaps:

─ Interest rate swaps, in which the counterparties exchange cash flows in a single
currency, tied to a fixed interest rate and/or floating-market interest rates
─ Currency swaps, in which the counterparties exchange cash flows in two different
currencies, tied to fixed interest rate and/or floating-market interest rates

• The traditional motivation for swaps was to reduce borrowing costs by exploiting

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comparative advantages in segregated capital markets, but, as global capital markets have
become more integrated and more competitive, interest savings available from this type of
arbitrage have all but disappeared. However, swaps can be used to efficiently manage
interest rate and currency exposure by:

─ Converting fixed-rate assets into floating rate assets

─ Creating hybrid fixed/floating-rate debt

• In a plain-vanilla interest rate swap, one party (the pay-fixed party) pays a
fixed-interest rate and receives a floating rate based on LIBOR from the
receive-fixed party. Interest payments are made on a net basis and no principal is
exchanged.

• The simplest kind of currency swap arises when each party pays a fixed rate of interest
on the currency it receives. The fixed-for-fixed currency swap involves three different sets of
cash flows:
─ At the initiation of the swap, the two parties actually exchange cash. Typically, the
motivation for the currency swap is the actual need for funds denominated in a
different currency. This differs from the interest rate swap in which both parties deal
in a single currency and can pay the net amount.
─ The parties make periodic interest payments to each other during the life of the swap
agreement, and these payments are made in full without netting.
─ At the termination of the swap, the parties again exchange the principal.

ASSESSMENT

(1) Answer the self-assessment questions found at the end of chapter 13 in the prescribed
book.

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(2) Additional assessment questions:

(a) The fair value of a futures contract is derived from the spot price of the security and
the risk-free interest rate. List and briefly describe five additional factors that may
influence the price of a futures contract.

(b) The price of a European call option that has a strike price of R30 and expires in six
months is R2. The underlying share price is R29 and the
risk-free rate of interest is 10%. Using put-call-parity, what is the price of a European
put option that expires in six months and has a strike price of R30?

(c) Jake Gray, CFA, believes he has identified an arbitrage opportunity for a commodity
as indicated by the information given in the following table.

Commodity price and interest rate information

Spot price for commodity R120

Futures price for commodity expiring in 1 year R125

One-year interest rate 8%

The theoretical futures price is calculated as:

(1) R110.40
(2) R120.00
(3) R125.00
(4) R129.60

(d) The following actions will realise an arbitrage profit.

(1) Buy futures; short spot; borrow money

(2) Buy futures; sell spot; borrow money
(3) Buy futures; long spot, invest proceeds
(4) Buy futures; short spot; invest proceeds

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(e) A one-year call option has a strike price of R55, expires in six months, and has a price of
R5.04. If the risk-free rate is 5% and the current share price is R50, what should the
corresponding put be worth?

(1) R5.04
(2) R6.08
(3) R7.42
(4) R8.71

(f) A three-month European call option with a strike price of R70 sells at a premium of
R6.00. It has a risk-free rate of 8% and a current share price of R73. Using the put call
parity, what is the equivalent value of the European put option?

(1) R1.67
(2) R3.00
(3) R4.43
(4) R10.37

(g) You wish to obtain an exposure to a specific share. Suppose that you buy a call with
a strike price of R70 and a price of R6.75. Calculate the effective price paid to purchase
the share if the price after 35 days is R65.

(1) R58.25

(2) R71.75

(3) R76.75

(4) R81.75

(h) Assume that you have purchased a call option with a strike price of R60 for R5. At the
same time, you purchase a put option on the same share with a strike price of R60 for
R4. If the share is currently selling for R75 per share, calculate the profit or loss from this
option strategy.

(1) –R9
(2) R6
(3) R10
(4) R1

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(i) Which strategy offers protection in case of a decrease in the market by ensuring that
the downside risk of a price decrease is hedged?

(1) Buying a call

(2) Buying a put
(3) Covered call
(4) Portfolio insurance

(j) Which of the following statements are correct?

(a) American options can only be exercised at expiration.

(b) European options can be exercised on or before expiration.
(c) Most options issued are American options.
(d) American options prices will be equal to or greater than European options.

(1) All of the above.

(2) None of the above.
(3) (a) and (b) only
(4) (c) and (d) only

(k) Which one of the following statements is true?

(1) The premium of the call option is inversely related to the share
price.
(2) The premium of the call option does not depend on the volatility of the
underlying share.
(3) Option prices are not affected by market interest rates.
(4) The premium of the call option is inversely related to the strike/exercise price.

(l) Which of the following correctly describes the position of a put writer?

(1) The put holder has the obligation to sell the optioned securities to the writer of the
put option.
(2) The put buyer has the right to require the writer to purchase the optioned
securities at a pre-set price.
(3) The put writer usually wants to sell the optioned securities.
(4) The put writer is paid a premium by the option exchange.
(m) Which of the following statements is correct about option notation and variables?

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(1) An increase on a spot price will increase call option value and decrease put
option value
(2) A higher volatility will lower the call value and increase put option value
(3) An increase in interest rate will increase call and put option values
(4) An increase on a strike price will lower call and put option.

Answers to additional assessment questions

(a) Factors, apart from the spot price and risk-free rate, that may influence the futures
price are:

• Transportation costs – depending on the underlying commodity (white maize

delivered at registered silos)
• Restrictions on short selling – limited access to proceeds
• Storage limitations – some soft commodities have a limited storage life
• Interest compounding – compounding frequency (i.e. annual,
semi-annual, continuous, etc)
• Convenience yield – benefit of holding a non-income-producing asset increases
the futures price
• Differential borrowing and lending rates – borrow money at a higher rate

Interest rate swap

(b) Put-call parity

(c) F =S(1 + r)T

=120(1.08)¹
(4) =R129.60

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(d) The theoretical or fair value (R129.60) exceeds the actual market price (R125). The
futures contract is available at a cheap price, therefore:

(4) Buy futures contract, sell spot and invest proceeds (reverse cash and carry
arbitrage).

(e) Put-call parity

S+p= X +c
(1 + r)T
50 + p = 55 + 5.04
(1.05)0.5

p = 55 + 5.04 – 50
1.0247

p = 53.6742 + 5.04 – 50
(4) p = R8.71

(f) Put-call parity

S+p=X+c
(1 + r)T

73 + p = 70 + 6 (1.08)0.25

p = 70 + 6 – 73
1.0194
p = 68.6678 + 6 – 73 (1)
p = R1.67

(g) At a spot of R65 the call will not be exercised. Share bought in spot market at R65.

Effective cost = R65 + R6.75

(2) = R71.75

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(h) X = 60; S = 75; c = 5; p = 4

Profit/Loss = S – X – c – p Profit/Loss = 75
– 60 – 5 – 4

(2) Profit = R6

(i) (4) Portfolio insurance

(j) (4) (c) and (d)

(k) (4) The premium of the call option is inversely related to the strike/exercise price.

(l) (2) The put buyer has the right to require the writer to purchase the optioned
securities at a pre-set price.
(m) (1) An increase on a spot price will increase call option value and decrease put
option value

SUMMARY

In this learning unit, you have learned how to calculate the forward/futures prices and perform arbitrage.
We have discussed options and their basic payoff structures and looked at two trading strategies. The
comparative advantage argument and cash flows for both interest rate and currency swaps were
illustrated.

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Learning unit 13

Portfolio management

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• discuss the different phases in the life cycle of an investor (i.e. accumulation, consolidation and
spending)
• discuss the objectives regarding the risk and return of the portfolio (i.e. capital preservation,
capital appreciation and/or current income)
• discuss the constraints faced by investors (i.e. liquidity, time horizon, tax concerns, legal and
regulatory requirements, unique needs and personal preferences)
• distinguish between individual and institutional objectives and constraints
• explain asset allocation and its importance to portfolio performance
• explain the importance of diversification
• discuss the determination of the asset mix, referring to policy and tactical asset allocation
• explain portfolio construction, referring to the measuring of risk and return
• calculate the expected return for an individual security and a portfolio of securities
• calculate the expected standard deviation for an individual security and a portfolio of

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securities
• explain and calculate the covariance and the correlation between assets
• determine the optimal asset allocation for a two-security portfolio
• distinguish between two equity portfolio management strategies (i.e. active and passive)
• describe the various active management strategies related to equity portfolios (e.g. intrinsic
valuation, relative valuation, technical valuation)
• describe the various passive management strategies related to equity portfolios (e.g. buy-
and-hold, indexing)
• distinguish between two fixed-interest-bearing security portfolio management strategies
(i.e. active and passive)
• describe the various active management strategies related to
fixed-interest-bearing security portfolios (e.g. interest rate anticipation, credit analysis, yield
spread analysis, bond swaps)
• illustrate the merits of a proposed bond swap transaction
• describe the various passive management strategies related to fixed-interest-bearing
security portfolios (e.g. buy-and-hold, indexing)

KEY CONCEPTS

Active management Expected return Portfolio risk

Asset allocation Fixed-interest-bearing Relative valuation
Asset mix Indexing Spending phase
Bond swaps Interest rate anticipation Standard deviation
Buy-and-hold Intrinsic valuation Tactical asset allocation
Capital appreciation Legal and regulatory Tax concerns
Capital preservation Life cycle Technical valuation
Consolidation phase Liquidity Time horizon
Constraints Objectives Unique/personal preferences
Correlation Passive management Yield spread analysis
Covariance Policy asset allocation
Current income Portfolio construction

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OVERVIEW

Portfolio management refers to the combination of assets in order to achieve a certain

risk-return profile.

In this learning unit, we look at the objectives and constraints of portfolio management. The life cycle of an
investor has an influence on the types of investments that that investor should make. Asset allocation is
the key to portfolio performance. We also explain the calculation of portfolio risk, as well as return.

We then go on to discuss the management of both equity and fixed-interest-bearing portfolios, and we
look at the three major active management styles for equity portfolios, namely market-timing, theme
selection and share selection. Indexing is also covered.

The learning unit explains how a portfolio consisting of fixed-interest securities may be managed. A
distinction is made between passive and active management styles. Active management strategies
include interest rate anticipation, valuation analysis, credit analysis, yield spread analysis or bond swaps,
whereas passive portfolio management strategies include a simple buy-and-hold strategy and indexing.

Study chapter 14 of the prescribed book.

ACTIVITY

Discuss how an individual's investment strategy may change as he or she goes through the
accumulation, consolidation, spending and gifting phases of life.

FEEDBACK

Typically investment strategies change during an individual's lifetime. In the accumulating

phase, the individual is accumulating net worth to satisfy short-term needs (e.g. house and car
purchases) and long-term goals (e.g. retirement and children's education). In this phase, the
individual is willing to invest in moderately high-risk investments in order to achieve above-
average rates of return.

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In the consolidating phase, an investor has paid off many outstanding debts and typically has
earnings that exceed expenses. In this phase, the investor is becoming more concerned with the
long-term needs of retirement or estate planning. Although the investor is willing to accept
moderate portfolio risk, he or she is not willing to jeopardize the "nest egg".

In the spending phase, the typical investor is retired or semi-retired. This investor wishes to
protect the nominal value of his or her savings, but at the same time must make some
investments for inflation purposes.

The gifting phase is often concurrent with the spending phase. The individual believes that the
portfolio will provide sufficient income to meet expenses, plus a reserve for uncertainties. If an
investor believes there are excess amounts available in the portfolio, he or she may decide to
make “gifts” to family and friends, institute charitable trusts, or establish trusts to minimise
estate taxes.

ASSESSMENT

(1) Answer the self-assessment questions found at the end of chapter 14 in the
prescribed book.

(2) Additional assessment questions:

The following are the monthly rates of return for Madison Corporation and for Sophie
Electric during a six-month period:

Month Madison Corporation Sophie Electric

1 –0,04 0,07

2 0,06 –0,02

3 –0,07 –0,10

4 0,12 0,15

5 –0,02 –0,06

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6 0,05 0,02

Calculate the following:

(a) Average monthly rate of return for each share

(b) Standard deviation of returns for each share
(c) Covariance between the rates of return
(d) The correlation coefficient between the rates of return

What level of correlation did you expect? How did your expectations
compare with the calculated correlation? Would these two shares offer a good
opportunity for diversification? Why or why not?

(e) A portfolio is made up of share A and share B. Share A has a standard deviation of 24%
and has a weight of 40% in the portfolio. Share B, on the other hand, has a standard
deviation of 11% and a weight of 60% in the portfolio. The correlation of share A and
share B is 0.7. Calculate the standard deviation of the portfolio.

(1) 13.42%
(2) 14.97%
(3) 40.79%
(4) 41.33%

(f) Calculate the standard deviation of both securities.

Probability of Security A Security B

occurrence

50% 12% 10%

25% 10% 11%

25% 8% 9%

(1) A 0.71 B 1.66

(2) A 0.85 B 1.66
(3) A 1.71 B 1.66
(4) A 1.66 B 0.71

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(g) Calculate the correlation between the two securities.

(1) 0.21
(2) 0.35
(3) 0.42
(4) –0.21

(h) Calculate the portfolio risk if the investment is 50/50 in A and B.

(1) 1.030%
(2) 0.770%
(3) 0.087%
(4) 0.910

(i) An investor wishes to construct a portfolio of a 30% allocation to a share index and
a 70% allocation to a risk-free asset. The return on the risk-free asset is 4.5% and the
expected return on the share index is 12%. The standard deviation of returns on the
share index is 6%. Calculate the expected standard deviation of the portfolio.

(1) 1.80%
(2) 3.60%
(3) 4.20%
(4) 6.00%

(j) The standard deviation of return is 0.45 for share X and 0.7 for share Z. The
covariance between the returns of X and Z is 0.295. The correlation between X and
Z is:

(1) 0.42
(2) 0.66
(3) 0.94
(4) 1.08

(k) The correlation coefficient of Portfolio X's returns and the market's returns is –0.95,
and the correlation coefficient of Portfolio Y's returns and the market's returns is 0.70.
Which of the following statements best describes the levels of portfolio
diversification?

(1) Both Portfolio X and Portfolio Y are well diversified.

(2) Both Portfolio X and Portfolio Y are poorly diversified.

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(3) Portfolio X is well diversified and Portfolio Y is poorly diversified.
(4) Portfolio X is poorly diversified and Portfolio Y is well diversified.

(l) Shares A, B and C each have the same expected return and standard deviation. The
following table shows the correlation between the returns on these shares.

Correlation of share returns

Share A Share B Share C
+1.0
Share A
Share B +0.9 +1.0
Share C +0.1 –0.4 +1.0

Given these correlations, the portfolio from these shares having the lowest risk is a
portfolio … .

(1) equally invested in shares A and B

(2) equally invested in shares A and C
(3) equally invested in shares B and C
(4) totally invested in share C

(m) An analyst makes the following estimates.

Rate of return

Scenario Probability Share I Share J

1 50% 30% 20%

2 50% 10% –10%

Based on these data, the covariance between the rates of return of

Share I and Share J is:

(1) –0.050
(2) +0.050
(3) +0.015
(4) +0.200

(n) Active portfolio management is based on three principles, which are:

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(1) Market timing, theme selection and buy-and-hold
(2) Market timing, buy-and-hold and share selection
(3) Share selection, market timing and theme selection
(4) Theme selection, share selection and buy-and-hold

(o) What are four broad active management strategies that a fixed income portfolio
manager can follow?
(1) Interest rate anticipation, credit analysis, yield spread analysis and bond swaps.
(2) Interest rate anticipation, credit analysis, yield spread analysis and indexing.
(3) Interest rate anticipation, Theme selection, yield spread analysis and bond
swaps.
(4) Market timing, credit analysis, yield spread analysis and bond swaps.

(p) Asset allocation can be defined as:

(1) The process of allocating funds of a portfolio to classes of assets such as bonds
or equity.
(2) The ability to convert assets into cash.
(3) The process of allocating interest of a portfolio to classes of assets such as
bonds or equity.
(4) The process of allocating tax income of a portfolio to classes of assets such as
bonds or equity.

Answer to additional assessment questions

(a)
(−0.04 + 0.06 − 0.07 + 0.12 − 0.02 + 0.05)
𝑅𝑅𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = = 0.0167 = 1.67%
6

(0.07 − 0.02 − 0.10 + 0.15 − 0.06 + 0.02)

𝑅𝑅𝑆𝑆𝑆𝑆𝑆𝑆ℎ𝑖𝑖𝑖𝑖 = = 0.01 = 1.00%
6

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(b)

(c)

(d)

One should have expected a positive correlation between the two

shares since they tend to move in the same direction(s). Risk can be
reduced by combining assets that have low positive or negative
correlations, which is not the case for Madison Corporation and
Sophie Electric.

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(e) Portfolio standard deviation (δp)

(f)

EA = 0.5 (12) + 0.25 (10) + 0.25 (8)

=10.50%

EB = 0.5 (10) + 0.25 (11) + 0.25 (9)

=10.00%

δA = √ 0.5 (12 – 10.5)² + 0.25 (10 – 10.5)² + 0.25 (8 – 10.5)²

= √ 1.125 + 0.0625 + 1.5625

= √ 2.75
= 1.66

δB = √ 0.5 (10 – 10) ² + 0.25 (11 – 10) ² + 0.25 (9 – 10)²

= √ 0 + 0.25 + 0.25
= √0.50
= 0.71

(4) A 1.66 B 0.71

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(g) Correlation (r) = CovarianceA,B ÷ (δA × δB)

Where CovarianceA,B = ∑probability × (returnA – k A) × (returnB – kB) )

= 0.5(12–10.5)(10–10) × 0.25(10–10.5)(11–10) × 0.25(8–

10.5)(9–10)
= 0 + – 0.125 + 0.625
= 0.50

rA,B = 0.50 ÷ (1.66 × 0.71)

= 0.50 ÷1.1786

(3) rA,B = 0.42

(h) Portfolio standard deviation (δp)

= √ [WA² × δA² ] + [WB² × δB²] + [2 × WA × WB × rAB × δA ×δB] WA =

0.5 WB = 0.5 r = 0.4242 δA = 1.66 δB = 0.71

= √ [0.5² × 1.66²] + [0.5² × 0.71²] + [2 × 0.5 × 0.5 × 0.42 × 1.66 × 0.71]

= √ [0.6889 + 0.126 + 0.2475]

= √ 1.0624
(1) δp = 1.030%

(i) Portfolio standard deviation (δp)

= √ [WSI² × δSI²] + [WRFA² × δRFA ²] + [2 × WSI × WRFA × rSI,RFA × δSI × δRFA]

A risk-free asset has no risk and therefore its standard deviation [δA] is 0. The only

remaining part of the above formula will be = √ [WSI² × δSI² ] because the other two

parts of the formula will be cancelled off to 0.

Portfolio standard deviation (δp) = √ [WSI² × δSI²]

δp = √ [0.3² × 6²]

= √ [0.09 × 36]
= √ 3.24
(1) δp = 1.80%

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(j) Correlation (r) = CovarianceX,Y ÷ (δX × δ
j
= 0.295 ÷ (0.45 × 0.7)
= 0.295 ÷ 0.315
=0.94

(3) r =0.94

(k) (3) Portfolio X is well diversified and Portfolio Y is poorly diversified.

Portfolio X has a correlation coefficient of –0.95, which means it is well diversified and
hence low risk. Portfolio Y, on the other hand, has a correlation coefficient of 0.70 which
means it is poorly diversified thus a higher risk.

(l) (3) Equally invested in shares B and C

The portfolio that will be equally invested in shares that have the lowest correlation, that
is, a correlation that is close to –1, will have the lowest risk. This is because that portfolio
will be the most diversified. A portfolio that is equally invested in B and C will have the
lowest correlation of shares (–0.4) compared to the other correlations of share returns.

(m) CovarianceI,J = ∑probability × (returnI –kI) × (returnJ– kJ)

EI = 0.5(0.3) + 0.5(0.1)
= 0.15 + 0.05
= 0.20

EJ = 0.5(0.2) + 0.5(–0.1)
= 0.10 - 0.05
= 0.05

CovarianceI,J = 0.5(0.3 – 0.2)(0.2 – 0.05) + 0.5(0.1 – 0.2)(–0.1 – 0.05)

= 0.0075 + 0.0075
= +0.015
(3) CovarianceI,J = +0.015

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(n) (3) Three principles of active portfolio management are market timing, theme selection
and share selection.

(o) (1) Four broad active management strategies that a fixed income portfolio manager can
follow are interest rate anticipation, credit analysis, yield spread analysis and bond
swaps.

(p) (1) The process of allocating funds of a portfolio to classes of assets such as bonds or
equity.

SUMMARY

In this learning unit, we have looked at determining the risk and return of a portfolio. The importance of
diversification and the correlation of assets included in a portfolio were emphasised. Different portfolio
management strategies were also discussed. The following learning unit will show you how to measure
the performance of a portfolio.

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Learning unit 14

Evaluation of portfolio management

CONTENTS

Learning outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• discuss the fundamental issues in performance measurement

• explain and calculate Treynor's performance index
• explain and calculate Sharpe's performance index
• explain and calculate Jensen's performance index
• compare the traditional methods (Treynor, Sharpe and Jensen) for calculating risk-
adjusted portfolio performance
• explain performance attribution analysis with reference to:

– total return calculations

– evaluation of performance fees
– benchmark portfolios
– measurement of allocation effect
– measurement of selection effect

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KEY CONCEPTS

Allocation effect Performance fees Total return

Attribution analysis Performance measurement Treynor's performance index

Benchmark Selection effect

Jensen’s measure Sharpe’s performance index

OVERVIEW

In this learning unit, we look at the fundamental issues in performance measurement. Various risk-
adjusted portfolio performance models are reviewed, such as those of Sharpe, Treynor and Jensen.
Performance attribution analysis is also explained.

Study chapter 15 of the prescribed book.

ACTIVITY

Compare and contrast four prominent approaches to measuring investment performance on a

risk-adjusted basis. In developing your answer, comment on the conditions under which each
measure will be most useful.

FEEDBACK

Treynor (1965) divides a fund's excess return (return less risk-free rate) by its beta. For a fund not
completely diversified, Treynor's "T" value will understate risk and overstate performance.

Sharpe (1966) divides a fund's excess return by its standard deviation. Sharpe's "S" value will
produce evaluations very similar to Treynor's for funds that are well diversified.

Jensen (1968) measures performance as the difference between a fund's actual and required
returns. Since the latter return is based on CAPM and a fund's beta, Jensen makes the same implicit

192
assumption as Treynor, namely that funds are completely diversified.

The information ratio (IR) is calculated by dividing the average return on the portfolio less a
benchmark return by the standard deviation of this excess return. The IR can be viewed as a cost-
benefit ratio in that the standard deviation of return can be viewed as a cost associated in the
sense that it measures the unsystematic risk taken on by active management. Thus, the IR is a
cost-benefit ratio that assesses the quality of the investor's information deflated by unsystematic
risk generated by the investment process.

ASSESSMENT

(1) Answer the self-assessment questions found at the end of chapter 15 in the
prescribed book.

(2) Additional assessment questions:

(a) Describe two major factors that a portfolio manager should consider before
designing an investment strategy. What types of decisions can a manager
make to achieve these goals?

(b) Describe how the Jensen measure of performance is calculated. Under what
conditions should it give a similar set of portfolio rankings to the Sharpe and
Treynor measures? Is it possible to adjust the Jensen measure so that a
portfolio's alpha value is measured relative to an empirical form of the
arbitrage pricing theory rather than the capital asset pricing model? Explain.

193
(c) The following portfolios are being considered for investment. During the
period under consideration the risk-free rate is 7%.

Portfolio Return (%) Beta σ (%)

P 15 1,0 5
Q 20 1,5 10
R 10 0,6 3
S 17 1,1 6
Market 13 1,0 4

(i) Calculate the Sharpe measure for each portfolio and the market portfolio.
(ii) Calculate the Treynor measure for each portfolio and the market portfolio.
(iii) Rank the portfolios using each measure, explaining the cause of any
differences you find in the rankings.

Use the following information to calculate the answers to questions d and e.

Portfolio Average return Standard Beta

deviation

Alpha 7% 3% 0.4

Beta 10% 8% 1.0

Gamma 13% 6% 1.1

Assume a risk-free rate of return (Rf) of 3%.

(d) Calculate the risk-adjusted portfolio performances of the three portfolios using
the Sharpe measure.

(1) Alpha 0.10 Beta 0.07 Gamma 0.09

(2) Alpha 1.33 Beta 0.88 Gamma 1.67
(3) Alpha 1.20 Beta 0.00 Gamma 2.30
(4) Alpha 0.20 Beta 1.50 Gamma 2.30

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(e) Calculate the risk-adjusted portfolio performances of the three portfolios
using the Jensen measure.

(1) Alpha 0.10 Beta 0.07 Gamma 0.09

(2) Alpha 1.33 Beta 0.88 Gamma 1.67
(3) Alpha 1.20 Beta 0.00 Gamma 2.30
(4) Alpha 0.20 Beta 1.50 Gamma 2.30

Use the table below to answer the following questions f, g and h.

Unit trust Average rate of Variance Beta

return

SBIF 26 4.84 0.94

RDPF 18 1.00 0.22

RMBF 22 3.24 0.65

Total market index 24 4.00

Assume a risk-free rate of return of 15%.

(f) Evaluate the performance of unit trust SBIF according to the method of
Sharpe.

(1) –0.50
(2) 1.20 (3)
2.20 (4)
5.00

(g) Evaluate the performance of unit trust RDPF according to the method of
Jensen.

(1) –0.21
(2) 0.102
(3) 1.02 (4)
2.10

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(h) Evaluate the performance of unit trust RMBF according to the method of
Treynor.

(1) 2.16
(2) 3.88
(3) 10.77
(4) 13.85

(i) Treynor’s Performance Index (TPI) of 1965 may be calculated as.

(1) 𝑇𝑇𝑇𝑇𝑇𝑇 = (𝑟𝑟𝑝𝑝 − 𝑟𝑟𝑓𝑓 ) ÷ 𝛽𝛽𝑝𝑝

(2) 𝑇𝑇𝑇𝑇𝑇𝑇 = (𝑟𝑟𝑝𝑝 + 𝑟𝑟𝑓𝑓 ) ÷ 𝑟𝑟𝑝𝑝
(3) 𝑇𝑇𝑇𝑇𝑇𝑇 = (𝑟𝑟𝑝𝑝 × 𝑟𝑟𝑓𝑓 ) ÷ 𝛽𝛽𝑝𝑝
(4) 𝑇𝑇𝑇𝑇𝑇𝑇 = (𝑟𝑟𝑝𝑝 − 𝑟𝑟𝑓𝑓 ) × 𝛽𝛽𝑝𝑝

(j) Which one of the following statements is most accurate performance

measurement?
(1) Treynor’s performance index indicates the portfolio’s return per unit of return.
(2) Sharpe’s performance index indicates that a lower number shows a higher
return for a given risk.
(3) Jensen’s measure indicates the excess actual return that a portfolio produced
over the return required of the portfolio indicated by the capital asset pricing
model (CAPM).
(4) Sharpe’s performance index indicates that a higher number shows a lower
return for a given risk.

Answers to additional assessment questions

(a) The two major factors would be: (1) attempting to derive risk-adjusted returns that
exceed a naïve buy-and-hold policy, and (2) completely diversifying – that is,
eliminating all unsystematic risk from the portfolio. A portfolio manager can do one or
both of two things to derive superior risk-adjusted returns. The first is to have superior
timing regarding market cycles and adjusting the portfolio accordingly. Alternatively,
you can consistently select under-valued shares. As long as you do not make major
mistakes with the rest of the portfolio, these actions should result in superior risk-
adjusted returns.

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(b) Jensen's alpha (α) is found from the equation.
The αj indicates whether a manager has superior (αj > 0) or inferior (αj < 0)

ability in market timing or share selection, or both. As suggested above, Jensen defines
superior (inferior) performance as a positive (negative) difference between a manager's
actual return and his or her CAPM-based required return. For poorly diversified funds,
Jensen's rankings would follow those of both Treynor and Sharpe. By replacing the
CAPM with the APT, differences between funds' actual and required returns (or
“alphas”) could provide fresh evaluations of funds.

(c) (i) Sharpe

(ii) Treynor

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(iii) Rankings

Sharpe Treynor

P 2 3

Q 4 2
R 5 5
S 1 1
Market 3 4

It is apparent from the rankings above that Portfolio Q was poorly diversified, since
Treynor ranked it #2 and Sharpe ranked it #4. Otherwise, the rankings are similar.

(d) Sharp measure:

SPI = (rp – rf) / (δp)

(2) Alpha = (7% – 3%) / 3% = 1.33%

Beta = (10% – 3%) / 8% = 0.88%
Gamma = (13% – 3%) / 6% = 1.67%

(e) Jensen measure:

Jensen's alpha (α) = rp – [rf + β (rm – rf)]

(4) Alpha = 7% – [3% + 0.4(10% – 3%)]

= 7% – 5.8%

= 1.2%

Beta = 10% – [3 % + 1.0(10% – 3%)]

= 10% – 10%

= 0.00%

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Gamma = 13% – [3% + 1.1(10% – 3%)]

= 13% – 10.70%

= 2.30%

(f) Sharpe:

SPI = (rp – rf ) / δp

= (26 – 15) / √4.84

= 11 / 2.2
(4) SPI = 5.00

(g) Jensen's alpha (α) = rp – [rf + β (rm – rf)]

α = 18 – [15 + 0.22 (24- 15)]

α = 18 – 16.98
(3) α = 1.02%

(h) Treynor:

TPI = (rp – rf) / β

= (22 – 15) / 0.65

= 7 / 0.65
(3) TPI = 10.77

(i) Treynor’s Performance Index (TPI) of 1965 may be calculated as.

(1)
𝑇𝑇𝑇𝑇𝑇𝑇 = (𝑟𝑟𝑝𝑝 − 𝑟𝑟𝑓𝑓 ) ÷ 𝛽𝛽𝑝𝑝
(j) (3) Jensen’s measure indicates the excess actual return that a portfolio
produced over the return required of the portfolio indicated by the capital
asset pricing model (CAPM).

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SUMMARY

This learning unit has shown you how to judge and assign the performance of a portfolio. The following
learning unit presents the foreign exchange market and shows how exchange rates are determined and
influenced by domestic or foreign inflation and interest rates.

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Topic 5

FOREIGN EXCHANGE

AIM

This topic serves as an introduction to the foreign exchange market and the factors determining
exchange rates. The value of currencies is established by the interplay of domestic and foreign interest or
inflation rates. Different theories (interest rate parity, purchasing power parity, and the international Fischer
effect) are presented in an attempt to explain exchange rate behaviour.

TOPIC LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• discuss foreign investment by South African residents

• explain the foreign exchange market
• explain exchange rate determination and behaviour
• discuss foreign exchange investments as an alternative asset class

TOPIC CONTENT

Learning unit 15: Foreign exchange management

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Learning unit 15

Foreign exchange management

CONTENTS

Learning
outcomes
Key concepts
Overview
Assessment
Summary

LEARNING OUTCOMES

Once you have worked through this learning unit, you should be able to:

• discuss the restrictions faced by South African residents interested in making foreign
investments
• explain what foreign exchange is and how it trades
• explain and use the foreign exchange conventions adopted by the Financial Markets
Association (ACI)
• explain and calculate the bid-ask spread and discuss the factors influencing the spread
• define direct and indirect methods of foreign exchange quotations and convert direct
(indirect) foreign exchange quotations into indirect (direct) foreign exchange quotations
• define currency appreciation and depreciation and calculate the percentage
appreciation/depreciation
• calculate and interpret currency cross rates, given two spot exchange rate quotations
involving three currencies

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• define currency arbitrage and perform triangular arbitrage
• distinguish between the spot and forward markets for foreign exchange
• calculate and interpret a forward discount or premium and express it as an annualised rate
• explain interest rate parity and illustrate covered interest arbitrage
• discuss exchange rate determination and behaviour
• discuss the economic and political factors affecting exchange (i.e. supply and demand,
balance of payments, current/capital account balances, relative inflation rates, relative
interest rates, real interest rates and government policies)
• explain how exchange rates are determined in a flexible or floating exchange rate system
• describe a fixed exchange rate and pegged exchange rate system
• discuss absolute purchasing power parity and relative purchasing power parity
• forecast future exchange rates using relative purchasing power parity (PPP)
• discuss the Big Mac index as an example of how to use purchasing power parity in comparing
living standards across countries
• discuss the international Fischer effect (IFE)
• forecast future exchange rates using interest rate differentials (i.e. the relative purchasing
power parity and international Fischer effect combination)
• discuss foreign exchange investments as an alternative investment class

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KEY CONCEPTS

Alternative asset class Economic/political factors Interest rate parity

Balance of payments Foreign exchange conventions
Bid-ask spread Foreign exchange market International parity relationships
Big Mac index Foreign investment Purchasing power parity (PPP)
Capital account Forward discount/premium Real interest rates
Cross rates Forward exchange market Relative inflation rates
Currency arbitrage Government policies Relative interest rates
Current account Inflation rate differential Supply and demand
Direct/indirect quotation Interest rate differential Triangular arbitrage

OVERVIEW

The trading of currencies takes place in foreign exchange markets whose primary function is to facilitate
international trade and investment. Knowledge of the operation and mechanics of these markets is
important for any fundamental understanding of international financial management. The foreign
exchange market permits the transfer of purchasing power denominated in one currency for that of
another currency. This market is not a physical place, but rather an electronically linked network of banks,
foreign exchange brokers and dealers whose function it is to bring together buyers and sellers of foreign
exchange. You should know that currencies trade for immediate delivery in the spot market and for future
delivery in the forward market. Prepare for questions in the form of calculations – know how to calculate a
bid-ask spread and cross rates and how to determine if an arbitrage opportunity exists. Also, be familiar
with the theories presented in chapter 16 of the prescribed book. The interest rate parity theorem equates
the difference in the domestic and foreign interest rate to the forward discount or premium and is a useful
tool to determine if arbitrage opportunities exist.

Foreign exchange management

The globalisation of the investment management activity has emphasised the importance of
managing an investment’s foreign exchange exposure. Large flows of funds shift between countries
and are ultimately reconciled into gains and losses on valuations when converted to the home

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currency of the investor. The rate of exchange between the currencies of countries can be volatile and
can have a significant and long-lasting influence on the value of an investment. To understand the
importance of investment timing in terms of the value of one country’s currency against another, we
only have to remember the South African (SA) rand’s exchange rate antics against the US dollar,
illustrated in figure 15.1. This figure shows that the rand weakened by nearly 30% against the US
dollar from 1 January 2015 to 31 December 2015.

Figure 15.1 Daily close of the USD/ZAR exchange rate from 01 January 2015 to 31 December 2015

Source: http://www.resbank.co.za

Covered interest arbitrage

Example

One-year futures rate (USD/GBP) $1,58/£

Spot rate (USD/GBP) $1,60/£
US one-year rate (C1) 6%
UK one-year rate (C2) 10%

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Identify whether or not an arbitrage opportunity exists. If one does exist, construct the appropriate
strategy and compute the arbitrage profits.

Step 1: Identify the existence of an arbitrage opportunity.

Step 2: Identify and arrange the appropriate strategy.

The USD interest rate is less than the USD-adjusted GBP rate (hedged foreign rate). Therefore, we should
borrow USD (at the low rate); convert to GBP and invest the GBP (at the high rate); and, at the end of the
year, convert back to USD at the forward rate and pay off the loan with the proceeds.

Step 3: Construct the trades necessary to execute the arbitrage strategy:

• Borrow USD1 for one year at 6% and repay USD1,06 in one year
• Exchange your USD1 for 0.6250 GBP at the current exchange rate
• Lend GBP for one year at 10%. You will have GBP0.6250 x 1,10 = GBP0.6875 in one year
• Enter into a forward agreement to exchange GBP0.6875 for USD at the forward rate of USD1.5800
per GBP
• Wait one year. Collect 0.6875 x USD1.5800 = USD1.0863 from your British lending activities and
repay your USD-based loan of USD1.06

Step 4: Compute the arbitrage profits.

Arbitrage profits are USD1.0863 – USD1.06 = USD0.0263

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Notice that the currency we chose to borrow depended on the relationship between the
unhedged and hedged interest rates. Remember to borrow in the low-rate currency and invest in the high
interest rate currency.

ACTIVITY

(1) Assume that the current ZAR/USD spot rate is quoted at 2.1079/82 and the 6-month
forward rate at 2.1091/98. What will be the premium per ZAR and the annualised
ZAR/USD forward premium?

FEEDBACK

(1). Premium per ZAR = 2.1098 – 2.1082

= 0.0016 USD cent
This means the forward rate will trade at 0.0016 USD cent premium per ZAR.

Annualised ZARUSD forward premium = [(Forward rate – spot rate)/spot rate] × [12/maturity in
months of forward] ×100
= [(2.1098 – 2.1082)/2.1082] × (12/6) ×100
= 0.15%

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ASSESSMENT

(1) Answer the self-assessment questions found at the end of chapter 16 in the
prescribed book.

(2) Additional assessment question:

You are given the following bid-ask information on the USD/GBP exchange rate and
the interest rates in each currency.

Rate Bid Ask

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Spot (USD/GBP) 1.6000 1.6400
Forward (USD/GBP) 1.5400 1.5800
rUSD 6.0% 6.1%

rGBP 10.0% 10.2%

Determine whether arbitrage profits are available by calculating covered interest

arbitrage. Assume you start with USD1 million or GBP625 000.

Answer to additional assessment question

Here is how we can interpret each of these rates:

Rate Bid Ask

Spot (USD/GBP) 1.6000 1.6400

GBP to USD USD to GBP

Forward (USD/GBP) 1.5400 1.5800

GBP to USD USD to GBP

Rate Bid Ask

rUSD 6.0% 6.1%

Invest USD @ 6,0% Borrow USD @ 6,1%

rGBP 10.0% 10.2%

Invest GBP @ 10.0% Borrow GBP @ 10.21%

The bid interest rate (the lower rate) is the rate at which you can invest in that currency
and the ask rate (the higher rate) is the rate at which you can borrow in that currency.
Unfortunately, the only way to determine whether arbitrage is profitable is to calculate the
profits going both directions – borrowing in currency one and investing in currency two,
and then borrowing in currency two and investing in currency one. The best way to keep
this straight is to draw the IRP diagram with arrows indicating the direction of the cash

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flows. For example, the USD/GBP bid rate of 1,60 is the rate to convert GBP to USD, as
indicated by the arrow.

Let's start by borrowing USD1 million.

• Borrow USD1 million for one year at 6.1% and repay USD1 061 000 in one year.
• Exchange your USD1 million for GBP609 756 at the spot ask rate of 1,64.
• Invest GBP for one year at 10%. You will have GBP (609 756 x 1.10)
= GBP670 732 in one year.
• Enter into a forward exchange agreement to exchange GBP670 732 for USD at the
forward bid rate of USD1.54 per GBP.
• Wait one year. Collect GBP670 732 x USD1.54/GBP = USD1 032 927 from your British
investing activities and repay your USD-based loan of
USD1 061 000.
• Your arbitrage profit is USD(1 032 927 – 1 061 000) = –USD28 073
There is no arbitrage opportunity available by borrowing USD and investing GBP.

If we start with GBP625 000:

• Borrow GBP625 000 at 10.2% and repay GBP688 750 in one year.
• Exchange your GBP625 000 for USD1 million at the spot bid rate of 1,6.
• Invest USD for one year at 6%. You will have USD(1 000 000 x 1.06) = USD1 060
000 in one year.
• Enter into a forward exchange agreement to exchange USD1 060 000 for GBP at the
forward ask rate of USD1.58 per GBP.
• Wait one year. Collect USD1 060 000 ÷ USD1.58/GBP = GBP670 886 from your US

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investing activities and repay your GBP-based loan of GBP688 750.
• Your arbitrage profit is GBP(670 886 – 688 750) = –GBP17 864.

Arbitrage profits are also not available by borrowing GBP and investing USD.

This example illustrates the fact that in all instances transaction costs
(bid-ask spread) reduce possible arbitrage profits, and in many cases, this may even
prevent any arbitrage opportunity.

SUMMARY

The chapter in the prescribed textbook has introduced you to the foreign exchange market and the factors
influencing/determining exchange rates. The interest rate parity (IRP), purchasing power parity (PPP) and
international Fischer effect (IFE) theories were covered. Arbitrage opportunities due to the violation of the
principles contained in these international parity relationships were illustrated. This concludes the
module on portfolio management.

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REFERENCES
Delport, ME & Marx, J. 2005. Investment management: only study Guide for MNF3026.
Pretoria: University of South Africa.
Marx, J, De Beer, JS, Mpofu, RT & Van de Venter, G. 2009. Investment Management. 3rd edition. Pretoria:
Van Schaik Publishers.
Marx, J, Mpofu, RT, Nortjé, A & Van de Venter, TWG. 2006. Investment management. 2nd edition. Pretoria.
Van Schaik Publishers.
Reilly, FK & Brown, KC. 2003. Investment analysis and portfolio management. 7th edition. Ohio: Thomson
South-Western.
Reilly, FK & Brown, KC. 2003. Solutions manual for investment analysis and portfolio management. 7th
edition. Ohio: Thomson South-Western.

Schweser Study Program: Study notes for the 2003 CFA® Program.
South African Reserve Bank. 2019. Quarterly Bulletin, December.

WEBSITES
www.bondexchange.co.za
www.jse.co.za www.reservebank.co.za
https://www.jse.co.za/trade/derivative-market/equity-derivatives
www.sharenet.co.za
www.statssa.gov.za
www.stockcharts.com
www.x-rates.com
www.yield-x.co.za

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