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MANAGEMENT
STUDY GUIDE
Copyright © 2016
MANAGEMENT COLLEGE OF SOUTHERN AFRICA
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Investment and Portfolio Management
INTRODUCTION
INTRODUCTION
Investment analysis and portfolio management is challenging for two main reasons: firstly, the
subject embraces many diversified fields including managerial finance, accounting, economics,
statistics and mathematics; secondly, it provides a unique opportunity to apply investment
theories and concepts to find a solution to real world investment problems.
A broad theoretical framework has been applied to discuss the essentials of investment analysis
and portfolio management.
The main objective of this manual is to write an effective and comprehensive guide for
understanding investments and portfolio management. However, you are reminded that the guide
does not replace your core textbook. In fact, the purpose of this manual is to guide you through
the chapters of the prescribed textbook, other supporting texts and references. The prescribed
Textbook is:
Bodie, Z., Kane, A., and Marcus, A.J (2010) Essential of Investments (8th edition) New York:
McGraw-Hill /Irwin
This module should be studied using this manual and the recommended text book(s). You should
read about the topic that you intend to study in the chapter, together with its accompanying
section(s).
In the course manual chapters, you will find the following symbol: , which means that these
are self-assessment activities, which will test your understanding of what you learnt so far.
Answers to these questions, are given at the end of each chapter. You should refer to the
textbook(s) when attempting to answer these questions.
You may come across self-assessment questions, which will test your understanding of what you
have learnt so far. Answers to these questions are given at the end of each chapter. You should
refer to the textbook(s) when attempting to answer the questions.
You will be required to complete and submit an assignment. The assignment would be a
A think point asks you to stop and think about an issue. Sometimes you are asked to apply a
mixture of calculations and research. This assignment would be assessed as part of the
concept to your own experience or to think of an example.
coursework. Therefore, it is very important that you complete it within the prescribed time.
MODULE OBJECTIVES
1. To explore the risk-return trade-off and the principles of rational portfolio choice,
associated with it.
2. The allocation of investments and the strategies of passive and active management of
funds.
LEARNING OUTCOMES
2. Analyse and interpret the financial statements of a company with the objective of
determining the fair value of its share price.
3. Improve the risk return trade-off, of a portfolio, by security selection and market
timing.
5. Use technical analysis to search for recurrent and predictable patterns in stock
prices.
SYLLABUS DETAILS
CONTENTS
Page
Part One: Elements of Investments
Chapter 1 Financial markets and instruments 8
Chapter 2 How securities are traded 16
Bibliography 164
PART ONE
ELEMENTS OF INVESTMENTS
CONTENTS
CHAPTER 1
CHAPTER ONE
OBJECTIVES
After completing this chapter you should:
Have a foundation for more analytical work to follow.
Understand the basics of the Money Market and Capital Market and the
instruments traded in these markets.
Against this backdrop the term investing can cover a wide range of activities translating into
investing money in certificates of deposits, bonds, common stocks, or mutual funds. Other
investors would include “paper assets”, such as warrants, options, futures and convertible
securities, as well as tangible assets, such as gold, real estate and collectables, even other assets
like platinum and precious stones.
In terms of the study of economics, the wealth of a country is ultimately determined by the
productive capacity of the economy. This then, is the function of real assets that produce goods
and services thereby generating net income to the economy (example of real assets: land and
buildings; plant and machinery; labour and knowledge). In direct contrast to real assets, are
financial assets, which we refer to as “paper assets”. These merely define the allocation of
income or wealth among investors.
Financial assets could be divided into three broad types; namely, fixed income, equity, and
derivatives (options, swaps and futures contracts).
Fixed income securities, pay a specified cash flow over a specific period.
Equity, also termed as common stock, represents an ownership share in a corporation. Holders of
common stock, receive only dividends that the firm may pay.
Derivative securities, such as options and future’s contracts, provide payoffs that are determined
by the prices of the underlying assets (eg: bonds and stocks)
Financial Markets
Corporate forms of organizations have the primary advantage of transferring ownership more
quickly and easily, than other forms and they can easily raise money. These advantages are
enhanced by the existence of financial institutions and markets.
Financial markets play a very important role in investment and portfolio management.
The interplay between the corporate organization and financial markets is illustrated in figure 1,
below:
Figure 1
Cash flows between the Corporate Organization and Financial Markets
B. Firm Invests
A. Firm issues securities to raise cash Financial
in Assets
Markets
D. Government
Other stakeholders
(Cash is paid to Government as taxes &
other payments to other stakeholders)
Financial Institutions
These institutions act as intermediaries between investors who are suppliers of funds and the
firms raising funds. Other individuals or institutions (other than corporate organizations) also
raise funds in financial markets. These financial institutions, justify their existence, by providing
a variety of financial services that promote efficient allocation of funds.
Financial markets may be classified as either money markets or capital markets. Short-term debt
securities are bought and sold in money markets (usually follows a one year duration period)
while long-term debt (follows more than a one year duration period). Equity securities are
bought and sold in capital markets.
The main players in the South African money markets are banks, other financial institutions as
well as large companies. The money market has no central or fixed location. Business is
conducted from the premises of various participants.
As mentioned above, capital markets (eg: JSE), are markets for the raising and trading of
securities of a long-term nature.
The debt and equity securities are traded in both the primary and secondary markets. In the
primary markets new securities (where the company is the seller) securities are made available
by organizations in both the public and private sectors and in this way monies are raised for the
organization.
In the secondary markets existing securities (those that have already been issued on the primary
market) are traded. An active secondary market, is essential to create liquidity and tradeability of
investments.
In recent years four important trends have changed the contemporary investment environment.
3. Financial engineering: the process of creating and designing securities with custom-
tailored characteristics.
The money market is a sub-sector of the fixed income market. It consists of very short-term debt
securities that usually are highly marketable. Many of these debt securities trade in large
denominations and so are out of reach of individual investors.
Treasury bills or T-Bills are the most marketable of all money market instruments. It
is the simplest form of borrowing. T-Bills are supposed to be risk-free investments.
The investors’ earnings or profit is the difference between the purchase price and the
ultimate maturity of the T-Bill.
Certificate of Deposit (CD): this instrument is a fixed deposit with a bank. Deposits
may only be demanded or drawn on debt maturity. The CD’s earn interest which is
payable together with the principal, only at the end of the fixed term.
Commercial Paper (CP) is short-term unsecured debt issued by reputable
corporates. Commercial paper is considered to be a fairly safe asset, given that the
firm issuing it is of good financial standing.
Bankers’ Acceptances (BA). A BA is an order to the bank by a customer to pay a
sum of money at a future date.
Other money market instruments are: bank discount yields; repos and reverses,
federal funds and brokers’ calls.
1. T- Bills or treasury bills are issued by the government to raise money. A good example is
the launch of new RSA bonds in May 2004 by the South African Government. Because
T-Bills are issued by the government, they are supposedly to be risk free.
2. The financial markets are, by tradition, segmented into money markets and capital
markets. Money markets trade in short-term securities, which are easily marketable,
liquid, and of a low risk nature. The short-term instruments are called cash equivalents.
Capital markets on the other hand, include longer-term and riskier securities. Securities in
the capital market are much more diverse than those found within the money market. The
capital market could be further sub-divided into four segments:
longer-term debt markets;
equity markets;
the derivative market for options and
derivative market for futures.
These characteristics are found in a well-developed financial market and assist in its
development and security.
4. Mutual funds accept funds from small investors and invest, on behalf of these investors,
in the national and international securities markets.
Pension funds accept funds and then invest, on behalf of current and future retirees,
thereby channelling funds from one sector of the economy to another.
Venture capital firms pool the funds of private investors and invest in start-up firms.
Banks accept deposits from customers and loan those funds to businesses, or use the
funds to buy securities of large corporations.
? THINK POINT
Do you think institutional investors and creditors may encounter agency problems? What is
your opinion of agency problems or corporate governance? (hint: read the “King’s Report).
Examine the relationship between securitization and the role of financial intermediaries in the
economy. What impact does securitization have on financial intermediaries?
CHAPTER 2
CHAPTER TWO
OBJECTIVE
After completing this section you should have a good overview of how markets trade and
operate.
2.1 Introduction
In the previous chapter it was considered how securities’ markets were organised. In this chapter
we study the mechanics of trading securities, which investors need to know in order to operate
successfully in the market place.
This chapter will briefly give an overview of the following aspects that are relevant to our study
of investment and portfolio management.
This is a brokerage firm that offers a full range of services including information and advice.
Investors obtain a wide range of information on the economy, particular industries, individual
companies and the bond market, from these full service brokers that include Merrill Lynch, Paine
Webber, Morgan Webber and others. These large retail brokerage firms execute their customers’
orders, provide advice and recommendations about securities, send publications about individual
stocks, industries, bonds and so forth. These full service brokers are also known as financial
consultants or investment executives.
Discount brokers
Discount brokerage firms virtually offer all of the same services as a full service broker, except
that they offer less (or no) advice. There are also fewer or no publications and would charge less
for certain services. Investors can choose the alternative that best suits them.
Cash account, whereby clients pay the brokerage the full price for any securities
purchased.
Margin account, an account that permits margin trading. This account allows the
customer to borrow from the brokerage firm to purchase securities.
Asset management accounts are brokerage accounts offering various services for
investors such as portfolio management, investment of cash balances and cheque
writing privileges.
Wrap accounts, a newer type of brokerage account in which all costs are wrapped in
one fee.
Example:
To be listed on the main board of the JSE, a company is expected to have a share capital of a
minimum of two million rands in the form of at least one million shares, the initial issue price of
which shall be at least 100 cents. Further requirements are a satisfactory three year profit history
with current audited profit level of at least one million rand before tax and 300 public
shareholders.
NB: In mid 1999 the JSE was the world’s 20th largest stock exchange ranked by market
capitalization (Firer et al, 2004:17).
Primary markets
According to Firer et al (2004:17) the term primary markets refers to the original sale of
securities by governments and companies. A transaction in the primary market typically involves
the company as the seller. This transaction raises money for the company. Two types of primary
market transactions are public offerings and private placements.
Secondary markets
Usually securities are issued to the public. Investors may trade among themselves. However,
purchase and sale of already-issued securities occur in the secondary market. The market also
provides a means of transferring ownership of corporate securities. Secondary markets could be
subdivided into dealer markets and auction markets.
Stop orders (SO) specifies a certain price at which a market order takes effect. For example, a
stop order to sell at R100 becomes a market order to sell as soon as the market price reaches (or
declines) R100. However, the order may not be filled exactly at R100 because the closest price at
which the stock trades, maybe R99,95. The exact price specified in the SO, is therefore not
guaranteed and may not be realized (Jones, 2004:123).
Short sales
Here the stock is sold (not owned but borrowed) in order to take advantage of the expected
decline in the price of the stock.
Note: In a normal transaction (long position), a security is bought and kept because the investor
believes the price is likely to rise. Eventually the stock is sold. When the stock is sold the
position is closed out. This situation is, “first you buy, then you sell”.
The reverse situation or reverse transaction (short position) – results in the question being raised
- the question “What if the investor thinks that the price of a security would decline?” arises. If it
is owned it would be wise to sell. If the security is not owned, the investor wishing to profit from
the expected decline in price, can sell the security short.
Insider trading
According to Jones (2004:324), a corporate insider, is an officer, director, or a major stockholder
of a corporation, who might be expected to have valuable inside information. The Securities
Exchange Commission (SEC) requires insiders to report their monthly purchase or sale of
transactions to the SEC by the tenth of the next month. This information is made public in the
SEC’s monthly publication.
JSE requirements compel directors to provide details of the transactions “as soon as possible and
in any event no later than 48 hours” following the trade. It says directors must do this as soon as
it comes to their attention that shares have been traded. Disclosure of directors’ dealings became
mandatory in 2001.
Insiders have access to privileged information and are able to act on it and profit before the
information is made public. Profitable insider trading is a violation of the strong form efficiency,
which requires a market in which the investor can consistently earn abnormal profits. Dealing
with the benefit of such privileged information is considered, in most countries, to be an abuse of
the position of directors and other insiders, and it is an offence.
Briefly summarize the important characteristics of the exchanges mentioned at the end of this
chapter. You may list other notable exchanges and refer to their listing requirements.
? THINK POINT
Refer to Bodie et al then Standard and Poor’s. Go to the appropriate website and attempt the
exercise.
PART TWO
PORTFOLIO THEORY
CONTENTS
CHAPTER 3
CHAPTER THREE
OBJECTIVE
After completing this chapter you should understand the concepts and measures for return
and risk as they are used in portfolio theory.
3.1 Introduction
In financial management we categorized risk into its main forms, that is, business risk and
financial risk. This chapter considers how we might analyze, particularly risk, but not exclusively
financial risk. This chapter also considers the connection or relationship between risk and return.
Investors have access to a wide array of assets that allows them to contemplate complex portfolio
strategies that may include foreign stocks and bonds, real estate and other assets. Clearly, each
individual security must be judged on its contributions to both the expected return and the risk of
the entire portfolio.
Therefore the focus of this chapter is to gain an understanding of risk and return. After
considering some of the various measures of investment return, the concept of risk would be
explained. You would be introduced to a “risk-free” asset and the construction of a portfolio of
risky and risk-free assets.
Risk, according to Gitman (2003:214), can be defined as the chance of financial loss or more
formally, the variability of returns associated with a given asset. More simply explained the
concept of risk can be termed as an uncertain future outcome that may improve or worsen our
position. The key point about this concept is that uncertainty is inextricably bound in it. The
outcome may be pleasant or unpleasant and finally it involves change. Note that we must not
think of risk as restricted to the “potential loss”. There is up-side risk and there is down-side risk
as well.
Rates of return
Rate of return on an investment can be measured as the total gain or loss, experienced by the
investor, over a given period of time.
The key measure of an investors’ return, is the rate at which their funds have grown during the
investment period that is referred to as the “holding period return” (HPR).
This HPR could be defined in its simplest form as:
Therefore the total holding period rate of return (HPR) is the sum of the dividend yield plus the
capital gain yield, that is, 4% + 10% = 14%.
Or substituting into the HPR formula:
HPR = (R110 – R100 + R4) /R100 = 14%
However, investment returns are received in multiple periods (eg: quarterly; semi-annually;
annually) and these returns are complicated by various inflows and outflows of additional
investment amounts which gives rise to a number of different ways of measuring investment
returns over various periods.
Refer to (Bodie et al, 2010:111): TABLE 5.1 (Quarterly cash flows and rates of return of a
Mutual Fund)
This table concerns a fund that starts with $1 million under management at the beginning of the
year. Study this example very carefully.
Using the information given in Table 5.1 we could characterize fund performance over the year,
given that the fund experienced both cash outflows and inflows.
We are aware that any investment involves some degree of uncertainty about future holding
period returns. In some instances the uncertainty may be considerable.
We are aware of the old adage “higher the risk, the higher the return”. To support this statement
there is a need to understand risk and at the same time quantify risk. Therefore when considering
a share or security we need some measure of how far the returns may differ from expected
returns.
We initially know that risk should be related to the dispersions or spread of possible outcomes.
Larger dispersions imply larger risk. It is in fact this dispersion that we use to measure risk. From
earlier studies of basic statistics we know that variance and standard deviations are used to
measure dispersion about a mean. We therefore use this, as a measure of risk.
deviation:
SD(r ) Var (r )
To find the variance, first we take the difference between the holding period return in each
scenario and the mean return, then we square the difference and finally multiply by the
probability of each scenario to find the average of the squared deviations. The result is : σ² =
0,25 (-16 –14)² + 0,50(14 –14)² + 0,25 (44 –14)² = 450
and so the standard deviation is : 450 21,21%
Note risk premium can be defined as the difference between the return on a risky investment and
a risk-free investment.
Assume the risk-free investments are currently offering 6%, we can calculate the projected
premium on the share index fund, using the following equation:
Thus far, we dealt with individual securities separately. However, investments consist of several
securities, which are held as a portfolio of assets. Therefore portfolio return and portfolio risk
are of relevance to investors. To obtain portfolio expected returns, the approach is to list the
proportion of the total portfolio’s value invested in each portfolio asset. These proportion
percentages are called portfolio weights.
Portfolio weights
Assume we have two assets in a portfolio, that is, Asset V and Asset W. Asset V is worth R800
and Asset W is worth R1 200. The total value of the portfolio is R2 000. In terms of percentages
Asset V is R800/R2 000 = 40% and Asset W is R1 200/2 000 = 60%.
The portfolio weights, therefore, are 0,4 and 0,6 respectively. Note the weights add up to 1,00.
Consider the following example, which demonstrates portfolio expected returns and portfolio
weights.
The following data is available for two shares V and W in a particular state of the economy:
State of the economy Probability of economy Share returns
V W
Slump 0,25 13% 7%
Normal 0,50 15% 15%
Prosperity 0,25 17% 23%
The portfolio is equally weighted in share V and W.
Calculate the expected return on the above equally weighted portfolio of Shares V and W.
Solution:
(1) (2) (3) (4)
State of the economy Probability Portfolio return E(rp)
(2)x(3)
Slump 0,25 0,50(.13) + 0.50(.07) 0.025
Normal 0,50 0,50(.15) + 0.50(.15) 0,075
Prosperity 0,25 0,50(.17) + 0,50(.23) 0,050
0,150
Therefore E(rp) = 15%
Asset allocation is a decision making process to allocate a portfolios’ funds to classes of assets
such as stocks, bonds, cash equivalents, equities and so forth.
According to Jones (2004:210), examining the asset allocation decision globally, leads us to ask
the following questions:
1. What percentage of portfolio funds is to be invested in each of the countries for which
financial markets are available to investors?
2. Within each country, what percentage of portfolio funds is to be invested in stocks,
bonds, bills and other assets?
3. With each of the major asset classes, what percentage of portfolio funds is to be
invested in various individual securities?
The rationale here is that different asset classes offer different potential returns at different or
various levels of risk. It must be noted that in many respects, asset allocation is the most
important decision an investor makes, and as such, tactical asset allocation methods are
important.
Question One
Ice Ripple is considering putting together a portfolio containing two assets, R and I. Asset R will
represent 40% of the rand value of the portfolio, and asset I will account for the other 60%. The
expected returns over the next six years, 2004 to 2009, for each of these assets, are given below:
Expected return
(1) Calculate the expected portfolio return, E (rp) for each of the six years.
(2) Calculate the expected value of portfolio returns over the 6-year period.
(3) Calculate the standard deviation of expected portfolio returns over the 6-year period.
(4) How would you characterize the correlation of returns of the two assets R and I?
(5) Discuss any benefits of diversification achieved through the creation of the portfolio.
Question Two
Required
(1) Calculate the expected return and standard deviation of a client’s portfolio who wishes to
invest 70% in the risky portfolio and 30% in T-Bill money market.
Solution
Question One
(1) Expected Portfolio Return for Each Year: kP = (wL x kL) + (wM x kM)
Expected
Asset L Asset M Portfolio Return
Year (wL x kL) + (wM x kM) kp
2004 (14% x .40 = 5.6%) + (20% x .60 = 12.0%) = 17.6%
2005 (14% x .40 = 5.6%) + (18% x .60 = 10.8%) = 16.4%
2006 (16% x .40 = 6.4%) + (16% x .60 = 9.6%) = 16.0%
2007 (17% x .40 = 6.8% + (14% x .60 = 8.4%) = 15.2%
2008 (17% x .40 = 6.8%) + (12% x .60 = 7.2%) = 14.0%
2009 (19% x .40 = 7.6%) + (10% x .60 = 6.0%) = 13.6%
w
j 1
j kj
(2) Portfolio Return: k p
n
17.6 16.4 16.0 15.2 14.0 13.6
kp 15.467 15.5%
6
(ki k ) 2
n
(3) Standard Deviation: kp
i 1 ( n 1)
kp
6 1
kp
5
11.42
kp 2.284 1.51129
5
Question Two
? THINK POINT
1. Apply your mind to consider the trade-offs investors face, when they practise the simplest form
of risk control.
2. How can the capital market line be applied to passive investment strategies?
CHAPTER 4
CHAPTER FOUR
OBJECTIVES
After completing this section you should understand both the CAPM and APT models of
Portfolio theory and be able to compare the two and discuss the merits of each.
4.1 Introduction
This chapter investigates the development of modern portfolio theory. Prior to “Dr Harry
Markowitz’s Portfolio Theory”, investment analysts and portfolio managers dealt loosely with
the concepts of risk and return. They battled to express quantitatively their views concerning risk
and its relationships to investment return. These analysts and investors knew intuitively that it
was smart to diversify according to the proverbial, “don’t put all your eggs in one basket”. Risk
was not expressed in quantitative form. As a result it was difficult to compare returns and there
was no generally accepted common denominator for risk.
Up until the fifties, analysts and investors prided themselves as superior fund managers but what
they were doing was simply adopting aggressive investment policies which gave rise to fairly
reasonable returns.
These deficiencies along with the large volumes of performance data that were available, gave
rise to scholars applying analytical techniques to the problems. This resulted in a significant
body of new thought concerning the investment decision-making process.
In the fifties the modern portfolio theory (MPT) emerged. With the emergence, basic portfolio
principles were developed. Dr Harry Markowitz, who was considered the father of modern
portfolio theory, contributed to this body of knowledge. The principles that underlie modern
portfolio theory have been widely accepted and adopted by the financial community.
Jones (2004:182) explains that Dr Harry Markowitz was the first to develop the concept of
portfolio diversification in a formal way – he quantified the concept of diversification. He
showed quantitatively, why and how portfolio diversification works to reduce the risk of a
portfolio to an investor.
The central theme of his work is that rational investors are risk averse and that for a given return
they would want a minimum standard deviation about the mean. Risk was defined by Markowitz
as the uncertainty or variability of returns, measured by the standard deviation of expected
returns about the mean.
Markowitz’s claim was that investors should try to minimize deviations (that is, standard
deviations of returns as a measure of risk) from expected returns, by diversifying the security
selections or asset class.
Note the concept of correlation is integral to developing an efficient portfolio. Efficient portfolio
refers to the reduction of overall risk. Therefore, effective diversification is only achieved if the
portfolio comprises securities that do not fluctuate in a similar fashion.
Asset B
Asset B
Return
Return
Asset A
Asset A
Time Time
Perfectly Positively Correlated Negatively Correlated
To add to the above, the following diagrams demonstrate how overall variability of returns are
reduced when two negatively correlated assets are combined.
Asset A Asset B Portfolio of Asset A & B
L M
Return
Return Return
Markowitz , using his set of quadratic equations calculated a set of optimal portfolios illustrated
below. He referred to them as efficient portfolios.
D
C
A
B
The model considers portfolio A to be sub-optimal or inefficient because portfolio B can produce
the same return at a lower risk level. Similarly, portfolio C produces a higher return at the same
level of risk. A more aggressive investor may wish to form a portfolio at point D.
The capital asset pricing model or CAPM (pronounced: Cap M) is an equilibrium model of
interest to investors. The CAPM measures the relevant risk of an individual security and as well
as assesses the relationship between risk and return expected from investing. The CAPM is an
attractive risk-return relationship model, because of its simplicity, and its implication. Owing to
some serious challenges to the model, alternatives have been developed. The one alternative to
the CAPM is the arbitrage pricing theory (APT), which allows for multiple sources of risk.
The CAPM
To understand the CAPM we need to briefly discuss the security market line (SML). The SML is
a positively sloped straight line displaying the relationship between expected return and beta
(risk) (Firer et al., 2004:411).
The CAPM explains the behaviour of security prices and provides a mechanism whereby an
investor can assess the impact of a proposed security investment on their portfolios’ overall risk
and return.
Thus the expected return on a risky asset has three components, namely, pure time value of
money, market risk premium and beta of the portfolio.
there are many small investors all having the same information and expectations
no restrictions on investments
no taxes
no transaction costs
investors, who view securities similarly and are risk averse, rationalize preferring
higher returns and lower risks.
Risk can be separated into two distinct elements. The first is called “market risk” (or systematic
or non-diversifiable risk, represented as β) that portion of a security’s price movement which can
be attributed to the movement of the market as a whole. The second element of risk is that
portion of price movement unique to the specific asset and is defined as non-systematic or
diversifiable risk and is denoted as “α”
The diagram below demonstrates the CAPM and the “sensitivity to market” relationships in two
basic elements – a market component and a security specific component.
Return
Risk
Point M represents the market performance. The best proxy for the market is the S & P 500 stock
price index or in South Africa the JSE ALSI (all share index). Capital asset pricing theory
chooses point M (the market) as the optimal risky portfolio. It is the expected return and the
variability (risk) for the market as a whole. No other combination of investments can produce a
better trade-off between risk and reward.
Point Rf is the return from a risk-free asset. Line Rf M represents the return from risk-free to risky
assets as represented by the market index. Rf is a portfolio 100%, invested in risk-free assets and
M is a portfolio 100%, invested in risky assets to replicate the market.
To achieve greater returns than the market as indicated along segment MA, the investor is
assumed to be able to borrow at the risk-free rate and so “leverage” the portfolio, by re-investing
the borrowed funds in the market. The returns are therefore “geared” in financial jargon.
3. The market portfolio of risky assets cannot be defined precisely, since it contains a wide
range of assets beyond listed company shares i.e.
Debentures
Government securities
Real estate
Hard assets, etc.
4. The market index is not appropriate for
Small cap portfolios
Foreign securities
Unlisted companies.
5. Portfolio beta’s are sensitive to holding period, that is, betas will differ if the time period
used is weeks, months, quarters or years.
Conclusion: The relationship between risk and return is not strong as portfolio theory argues, but
nonetheless, the CAPM has improved the ability to measure the performance of competing
portfolio managers.
Definition
According to Jones (2004:236), the arbitrage pricing theory is an equilibrium theory of expected
returns for securities involving few assumptions about investor preferences.
The APT
The APT has become one of the alternative theory of asset pricing to the CAPM. It seems to be
more general than the CAPM, with less restrictions.
Similar to the CAPM, the APT displays a relationship between expected return and risk, using
different assumptions and procedures.
The important difference between the CAPM and the APT, is that the APT is not critically
dependent on an underlying market portfolio as does the CAPM. (NB: The CAPM predicts that
only market risk has an influence on expected returns).
Jones (2004: 236), in his discussion explains that the APT is based on the law of one price,
which states that two otherwise identical assets cannot sell at different prices. APT assumes that
asset returns are linearly related to a set of indexes, where each index represents a factor that
influences the return on an asset.
Investors who participate in the market, develop some expectations of how sensitive the assets
are to these factors. Therefore the investors buy and sell securities, given the law of the prices.
The buying and selling, which determines the prices of securities, is the arbitrage process.
According to the APT, the equilibrium prices will adjust such that arbitrage opportunities would
be eliminated.
Jones (2004:237) succinctly summarizes the differences and similarities between the CAPM and
the APT as follows:
Factor Model: The model that is used to show these underlying risk factors that affect realised
expected returns of securities. These factors are not company-specific factors but merely broad
economic forces, which by definition represent an element of surprise in the risk factor (which
can be termed as the difference between the actual value for the factor and its expected value).
The factors must have three characteristics as follows:
A risk factor must have an all reaching influence on stock return (note, it must not be firm
specific events as they are not APT risk factors)
The risk factors must have influence over the expected return, which really means that they
must have non-zero prices. This influence must be determined empirically by statistical
analysis of stock returns to recognize which factors affect returns all the time.
The risk factors must be unpredictable to the market and the investors at the beginning of
each period.
eg, Rate of inflation (it is partially predictable) is not an APT factor. However, the
difference between, actual inflation and expected inflation could be an APT factor because
it cannot be predicted.
Eg, If the expected value of inflation is 8% the actual rate of inflation for a period is only
7%. The 1% difference (APT factor) will affect the actual return for this period. So, from
this, we can deduce that what really matters, are the deviations of the factors from their
expected values.
NB (1) the expected value of each factor, F, is zero. Therefore, the f’s are
measuring deviation of each factor from its expected value.
(2) the random error term :-
it is assumed that all co-variances between returns on securities are attributable to
the effects of the factors. Therefore, the error terms are uncorrelated.
The factor model does not accommodate equilibrium. Therefore equation *1 above needs to be
transformed into an equilibrium model (which says something about expected returns across
securities) because the APT is an equilibrium theory of expected returns therefore the equation
for expected return on a security is stated as follows:
E ( Ri ) ao bi1 F1 bi 2 F2 bin Fn Equation (2)
where :
E ( Ri ) = expected return on security I
In terms of APT, risk is defined in terms of a stock’s sensitivity to basic economic factors,
whereas expected return is directly related to sensitivity.
In the CAPM, the expected return risk relationship can be stated as follows:
E ( Ri ) R f Bi (market premium risk)
The equation shows that the CAPM assumes that the only required measure of risk is the
sensitivity to the market. (NB. the difference between the expected return on the market and the
risk free rate).
The expected return risk relationship for the APT can be described as follows:
E ( Ri ) Rf bi 1 (risk premium for factor 1) +
NB: the sensitivity measures Bi and bi have similar meanings (that is relative sensitivity of a
security’s return to particular risk premium.
Finally, take note that the discussion hinges on risk premiums in both cases.
In conclusion, note that the CAPM relationship is the same as that provided by the APT if there
was only one pervasive factor influencing returns.
? THINK POINT
(1) Stop awhile and think about the differences between the CAPM and the APT.
(2) The following beta is for a one-factor economy. Assume all portfolios are well
diversified.
Portfolio Beta E (r)
D 1.0 0,10
E 0 4%
Assume another portfolio F is well diversified with a beta of 2/3 and an expected return of 9%.
Would an arbitrage opportunity exist? If so, explain the arbitrage strategy.
Solutions
(2) Since the beta for Portfolio E is zero, the expected return for portfolio E equals the risk-
free rate. For Portfolio D, the ratio of risk premium to beta is: (10% - 4%)/1 = 6%. The
ratio for Portfolio F is higher: (9% - 4%)/(2/3) = 7.5%. This implies that an arbitrage
opportunity exists. For instance, you can create a Portfolio G with beta equal to 1 (the
same as the beta for Portfolio D) by taking a long position in Portfolio F and a short
position in Portfolio E (that is, borrowing at the risk-free rate and investing the proceeds
in Portfolio F). For the beta of G to equal 1, the proportion, w, of funds invested in F
must be 3/2 = 1.5. The expected return of G is then:
F(rG) = [(-0.50) x 4%] + (1.5 x 9%) = 11.5%
G = 1.5 x (2/3) = 1.0
Comparing Portfolio G to Portfolio D, G has the same beta and a higher expected return.
Now, consider Portfolio H, which is a short position in Portfolio D with the proceeds
invested in Portfolio G:
H = 1G + (-1) D = (1 x 1) + [(-1) x 1] = 0
F(rH) + (1 x rG) + [(-1) x rD] = (1 x 11.5%) + [(-1) x 10%] = 1.5%
The result is a zero investment portfolio (all proceeds from the short sale of Portfolio D
are invested in Portfolio G) with zero risk (because = 0 and the portfolios are well
diversified), and a positive return of 1.5%. Portfolio H is an arbitrage portfolio.
CHAPTER 5
CHAPTER FIVE
OBJECTIVES
Having completed this section you would have an understanding of the implications of the
EMH on security analysis and investment.
5.1 Introduction
If stock prices could be predicted by means of equations and formulas, imagine what the reaction
of investors would be. Investors would be able to reap unending benefits and profits simply by
purchasing stocks calculated via these formulas. There have been attempts to analyze business
cycles and trends in the hope to ascertain predictable patterns. However, attempts to find
recurring patterns in stock price movements were in vain. Prices appeared to display random
erratic behaviour.
The conclusion from these researched studies was that this random behaviour was in fact the
result of the efficient market hypothesis.
Studies accomplished in the fifties suggested that changes in the security prices followed a
random pattern. This theory then led to the efficient market notion.
To support the statement that “security price changes have no pattern”, the following explanation
would throw some light on the matter.
Assume investors who play the market are keen to make money, then we should expect them to
grab every potentially profitable opportunity to do so. When the opportunity arises to make
money, they would then act, and prices would either rise or fall in response to their purchases
and sales and the stock would then be priced so that there is no further opportunity to make
further profit. Stocks would be priced at their basic or intrinsic value.
However, all stocks would not offer the same expected returns. Investors would demand
additional returns for bearing extra risk and so on. Therefore, for this to work, the following
would be required: there must be an abundant flow of information, prices quickly responding to
changes in information, rational decision making by investors, transactions must be easy,
frequent and cheap.
Because of these assumptions, stock prices should then fully reflect all available information.
Therefore, rational, profit-maximizing behaviour by investors would have driven all prices to a
level that reflects available information. Thus, stock prices might be expected to take a random
walk.
We see, therefore, that the random walk theory and the efficient market hypothesis clearly
suggest that it is not possible to outsmart the market. In fact, at any point in time, the actual price
of a stock reflects all available information.
It must be noted that the random walk theory and efficient market hypothesis do not support
senseless price fluctuations but rather that around a price-earnings trend line, stock prices will
move fairly randomly.
According to the reviews in literature, the efficient market was divided into three increasingly
wide categories depending on the information assumed to be impounded in prices (Fama, 1970).
Fama (1970), in his reviews states that in the weak-form hypothesis, security prices reflect all
security market information including all past prices, volume, etc. In the semi-strong hypothesis,
all publicly available information is reflected in security prices. Lastly, in the strong-form
hypothesis, all public and private information (that is, information not generally available e.g.
information which company executives might possess about their companies) is subsequently
impounded in prices.
To further expand on the three categories proposed by Fama (1970), the three classifications are
illustrated in Figure 5.1 below followed by relevant discussion.
Figure 5.1
Strong form (all information)
Weak-form
Cumulative levels of market efficiency and the information associated with each.
Fama, (May, 1970) Efficient Capital Markets: A Review of Theory and Empirical Work” Journal
of Finance, 25, no. 2, p g 383-417.
1. Weak Form
The traditional type of information that is used in assessing security values is market data, the
market data refers to all past prices (and volume) information. When security prices are
determined in a market that comprises weak-form efficient, historical price and volume data
would already be reflected in current prices and should be of no value in predicting future price
changes.
We know the basis of technical analysis is price data, but technical analysis that relies on past
history of price information is of little or no value (Jones, 2004). In other words if current price
reflects all past market data it can be said that the market is weakly efficient. This could be
implied that in a weak-form efficient market, the past history of price information is of no value
in assessing future changes in price.
2. Semi-strong Form
The semi-strong form efficiency is that part of the efficient market hypothesis that states that
prices reflect all publicity available information including available data such as earnings,
dividends; stock split announcements, new product developments, financing difficulties and
accounting changes.
This implies that if the market quickly incorporates all the above mentioned (current)
information it is said to be “efficient in the semi strong sense”. A further implication is that in a
semi-strong efficient market, investors cannot act on new public information after its
announcement and expect to earn above-average risk-adjusted returns.
3. Strong Form
This form asserts that stock prices fully reflect all information, both public and non-public. The
strong form goes beyond the semi-strong form in considering the value of the information
contained in announcements, while the semi-strong form focuses on the speed with which
information is impounded into stock forces.
In a strong form efficient market no investor or groups of investors would be able to earn, over a
reasonable period of time, abnormal rates of return by using information in a superior manner.
Another aspect of the strong form has to do with private information – that is, information that is
not publicity available because it is restricted to certain groups such as corporate investors and
specialists on the exchange. It could be asserted that the story form holds that no one with
private information can make money using this information.
In conclusion, it must be noted that market efficiency is cumulative. The reference to Figure 5.1,
which if one believes in semi-strong efficiency, the weak form is also encompassed. Strong
form efficiency encompasses both the weak form and semi-strong form and represents the
highest level of market efficiency.
Having considered market efficiency, we can now appropriately consider some market
anomalies. A market anomaly could be defined as an exception to a rule or model. To expand
further on the definition, we can say market anomalies are techniques or strategies that appear on
the contrary to an efficient market. The following discussion will include the more important
anomalies that have generated much attention. However, one must be cautious in viewing any of
these anomalies as stock selection methods guaranteed to out- perform the market. There is no
such guarantee.
These types of announcements have been studied, opening up some interesting questions and
possibilities. The questions that need to be answered when viewing these announcements are:
5.4.1.1 How much of the earnings announcements is new information and how much has been
anticipated by the market? In other words, how much of the announcement is a
“surprise”? (Jones, 2004:328)
5.4.1.2 How quickly is the “surprise” portion of the announcement reflected in the form of
STOCK? Is it immediate, as would be expected in an efficient market, or is there a lag in
the adjustment process? If a lag occurs, investors have a chance to realize excess returns
by quickly acting on the publicly available earnings announcements.
To assess these announcement issues properly, one must separate a particular earnings
announcement into an expected and an unexpected part. This expected part anticipated
by the investors requires no adjustment in stock prices, whereas the unexpected part is
unanticipated and therefore requires adjustment.
The interesting fact about P/E ratios is that investors believe that low P/E stocks, on an average,
outperform high P/E stocks. This is not necessarily so. A comparative study conducted by Basu
(1977), between high P/E ratios and low P/E ratios, a twelve months following purchase
indicated that the low P/E ratio stocks outperformed high P/E ratio stocks. Furthermore, risk was
not a factor. After various adjustments for risk, the low P/E ratio stocks still outperformed high
P/E ratio stocks. These results attracted considerable attention because of their implications for
the concept of market efficiency and because P/E ratio is an easy and well-known strategy to
select stocks.
In response to the validity of P/E ratios, further studies were conducted to re-examine the
relationship between P/E ratio, the size effect, and returns. The study showed that stocks of low
P/E firms generally had higher risk-adjusted returns than firms with high P/E ratios. Regardless
of the measure of risk used, low P/E securities provided significant positive excess returns across
all risk levels.
This anomaly appears to offer investors a potential strategy for investing that could produce
superior returns to many alternatives.
The size effect anomaly also generated considerable attention. This anomaly is an observed
tendency for smaller firms to have higher stock returns than large firms.
Two separate researches by Banz (1981) and Reinganum (1981), found abnormally large risk-
adjusted returns for small firms. Both researchers attributed the results to a mis-specification of
the capital asset pricing model (CAPM) rather than a market inefficiency.
This is an observed tendency for small cap stocks to be higher in January than in other months.
Studies have suggested that seasonality exists in the stock market.
The following table as measured by the performance of the NASDAQ composite index for the
month of January that the January effect has continued to exist in recent years.
The following is an example of the January effect on returns on the Johannesburg Stock
Exchange.
These results suggest that the JSE is no different from other markets.
Visit the website: www.iassa.co.za
Other References
Philpott, W.F; Firer, C: (1994/95): Share price anomalies and the efficiency of the JSE
(Investment Analysts Journal, No 40)
How much faith investors have in the efficient market theory (EMT) should determine their
approach to managing investments. Funds may be managed passively or actively. A passive
manager simply aims to match the return on some appropriate index, whereas, an active manager
aims to purchase mis-priced securities and assets and thereby earn a positive abnormal rate of
return. Passive managers assume that:
Passive managers will adopt a strategy of determining the appropriate strategic asset class
allocation and then broadly diversifying within each asset class. This might be achieved via
index funds. Active managers assume:
Information bet: the active managers assume they have knowledge that nobody else
has e.g. they have better company profit forecasts, or that they can respond faster to
new information.
Valuation bet: the active managers assume that a security or asset class is mispriced
on the basis of generally known information.
Factor bet: active managers (and passive managers) can make a factor bet if there is a
priced factor that earns an abnormal return, and the risks associated with that factor
are not risks that affect the investor.
(1) A successful firm like Old Mutual has consistently generated large profits for years. Is
this a violation of the EMH?
(2) You are a portfolio manager meeting a client. During the conversation that followed
your formal review of her account, your client asked the following question:
My grandson, who is studying investments tells me that one of the best ways to make money in
the stock market is to buy stocks of small capitalization firms, late in December, and to sell
stocks one month later. What is he talking about?
(a) Identify the apparent market anomalies that would justify the proposed strategy.
(b) Explain why you believe such a strategy might or might not work in the future?
Solutions
(1) No, this is not a violation of the EMH. OM’s continuing large profits do not imply that
stock market investors who purchased OM’s shares after its success was already evident
would have earned a high return on their investments.
(2) The grandson is recommending taking advantage of (i) the small firm in January anomaly
and (ii) the weekend anomaly.
(i) Concentration of one’s portfolio in stocks having very similar attributes may expose
the portfolio to more risk than is desirable. The strategy limits the potential for
diversification.
(ii) Even if the study results are correct as described, each such study covers a specific
time period. There is no assurance that future time periods would yield similar
results.
(iii) After the results of the studies became publicly known, investment decisions might
nullify these relationships. If these firms in fact offered investment bargains, their
prices may possibly bid up to reflect the now-known opportunity.
? THINK POINT
PART THREE
DEBT SECURITIES
CONTENTS
CHAPTER 6
CHAPTER SIX
OBJECTIVES:
After studying this chapter you will be able to:
Understand the characteristic of bonds.
Compute a bond’s price given its yield to maturity and vice versa.
Calculate the change in price of bonds over time for a given interest rate and
projection.
6.1 Introduction
This chapter discusses particular security markets, valuation principles, determinants of risk and
return and the different types of bonds commonly used within and across the various markets.
Bodie et al, (2008:291) state that a debt security is a claim on a specified periodic stream of
income. These securities are often called, “fixed income securities” because they “promise either
a fixed stream of income or a stream of income that is determined according to a specified
formula (Bodie et al, 2008:291). The income or payment formulas are specified in advance and
the uncertainty that surrounds the cash flows is minimal because the issuer of the security is
always sufficiently credit worthy.
The issuer is obligated to make semi-annual (or annual) payments of interest. These payments
are called coupon payments which are made to the bond holder for a period of time (over the life
of the bond). At maturity the issuer repays the debt by paying the bond holder the par value (or
its equivalent, the face value) of the bond. The interest rate is determined by the coupon rate.
The coupon rate, maturity date and the par value of the bond are part of the bond indenture,
which is the contract between the issuer and the bond holder.
To make bonds attractive they may be issued with high coupon rates and at discounted prices.
However, there are also zero coupon bonds that make no coupon payments. Here the investors
receive par value at maturity, but receive no interest payments until then. To make these types of
bonds attractive they are offered at below par value (discounted prices). The income on this bond
is calculated between issue price and the payment of par value at maturity.
Treasury bonds and notes are issued by the Treasury (Government). Both make semi-annual
coupon payments. The major distinction between T-bonds and T-notes are differing maturities at
the issue date and in the past, T-bonds were callable (that is, these bonds may be repurchased by
the issuer at a specified call price during the call period) at a given period or time.
An example of treasury bonds are the RSA retail bonds which were made available to the South
African public as of May, 2004.
Bond prices that are quoted in the financial papers are not the actual prices that investors pay for
the bond because the quoted price does not include the interest that accrues between coupon
payment and the dates.
Example:
Solution
Semi-annual coupon payment = 4% of R1000 = R40
Number of days passed since last coupon payment = 40 days
Therefore, accrued interest on bond = R40 x (40/182)
= R8,79
Therefore, invoice price of this bond = R8,79 + R990 (quoted price = R998,79
Some corporate bonds are issued with call provisions. The callable bonds come with a period of
call protection, that is, an initial term when bonds are not callable. These bonds are referred to as
deferred callable bonds.
Bondholders may have an option to exchange a bond for a specified number of shares. This type
of bond is referred to as convertible bonds. The conversion ratio (that is, the number of shares for
one bond) may also be stated.
Other types of bond that fall under this category are putable bonds (the issuer is given the option
to extend or retire the bond at the call date) and floating rate bonds (where interest payments are
tied to some measure of current rates.
A bond’s coupon and principal repayments occurs months or years into the future. Therefore, the
price the investor would be willing to pay for a claim to these payments depends on the value of
rands to be received in the future compared to rands in hand today. However, this “present
value” (or time value) calculation depends on the market interest rates.
Therefore, to value a bond or debt security the following formula can be used:
If the maturity date is “T” and the discount rate is “r”, the bond value can be written as:
r
coupon par value
Bond value
t 1 (1 r) t (1 r ) t
Example 1:
In this example the coupon rate equals the market interest rate and the bond price is equal to the
par value.
Example 2:
Using the same data as in Example 1, above, we now use a new market interest rate at 10%
(market interest rate > coupon rate).
Solution:
Bond value = R40 (PVIFA 5%,40) + 1000 (PVIF 5%,40)
= (40 x 17,1591) + (1000 x 0,1420)
= R828,36
Note: The market rate > coupon rate. The result is that the value of the bond falls below par
value.
Example 3:
What if the market rate falls below the coupon rate, say to 6%?
Solution:
The result would be:
Bond value = R40 (PVIFA 3%,40) + R1000 (PVIF 3%,40)
= R1231,19
Note: The value of the bond increases beyond the par value.
Therefore, we can conclude from the above that the inverse relationship between price and yield
is a central feature of fixed income securities.
In practice this is defined as the discount rate that makes the present value of a bond’s payments
equal to its price. Put another way, it is the rate of return that investors can earn if they buy a
bond at a specific price and hold it until maturity (this is on assumption that all scheduled interest
and principal payments are accomplished as promised).
The following example would illustrate the YTM or the “r” (market interest rate) in our case.
Assume Company XYZ’s bond is currently selling for R1080, with a coupon rate of 10% and a
par value of R1000, pays an annual interest and has 10 years to maturity. According to the
formula, we could arrange the data in the following manner:
In the equation the objective is to solve for “r”. This could be solved by means of a “trial and
error” method. But take note that the interest rate would be lower than the coupon rate of 10%
because the bond value is higher than the par value (see example 3 above).
“r” in this case equals 8,77% (using the trial and error method and interpolation or via the
calculator).
(reference: Gitman, (2004:291)
Callable bonds:
Study the example from Bodie et al, (2010:301) which illustrates how callable bonds’ yield to
call, may be calculated.
Bonds usually promise a fixed flow of income. This income becomes only risky when the issuer
defaults on obligation (that is, issuer does not pay the promised income). Treasury bonds (T-
bonds) maybe treated as free of default risk, however, this could not be said of corporate bonds.
If the company goes bankrupt the bondholders may not receive the promised payments.
Therefore, the payments on these bonds are reliant on the financial status of these companies.
1. Bonds of Company ABC sell for R960 (par value R1000), mature in 5 years, and have a 7%
annual coupon rate, paid semi-annually.
1.2 Cite one major shortcoming for each of the following fixed – income yield measure:
1.2.1 Current yield
1.2.2 Yield to maturity
1.2.3 Horizon yield (also called realized compound yield)
(Source: Adapted from Bodie et al (2006:315)
Solution
(1) Zvi Bodie, Alex Kane, Alan J. Marcus: Read Chapter 10.
CHAPTER 7
CHAPTER SEVEN
OBJECTIVES:
After studying this chapter you will be able to:
Recognize those features of a bond that affect the sensitivity of a bond.
Compute the duration of bonds.
Understand the concept of immunization.
Have an overview of immunization strategies for investments; and finally
engage in an understanding of active and passive managed bond portfolio.
7.1 Introduction
This chapter deals with various strategies that bond managers can follow, making a distinction
between passive and active strategies. You would be introduced to the concept of duration and
immunization and their application.
In the previous chapter we stated that there is an inverse relationship between bond prices and
yields and how interest rates can fluctuate substantially. The rise and fall in interest rates causes
capital losses and gains to bond holders.
The sensitivity of bond prices to changes in interest rates is usually of great concern to investors.
7.3 Duration
Example 1:
A R100 bond, matures in four years’ time, and pays a 6% p a coupon rate. Yield to
maturity is 8%. Calculate the duration of the bond.
Solution:
1. To calculate the weighted average directly associated with the cash flow (CFt) made at
time “t” the following formula is used:
CFt /(1 y ) t
wt
Bond price
r
D t wt
t 1
NB : Duration is always less than the maturity of the bond, unless it is a zero coupon
bond, in which case duration equals maturity. (adapted from Bodie et al, 2003:343/4)
The bond price relation characterizes the determinants of interest rate sensitivity, and duration
allows us to quantify that sensitivity to greatly enhance our ability, to formulate investment
strategies.
Managers who follow this investment strategy take bond prices as fairly set and seek to control
only the risk of their fixed income portfolios. This (the risk), could be viewed in two ways
depending on the investor’s circumstances. Some institutions are concerned with protecting the
portfolio’s current net worth or net market value against interest rate fluctuations, while other
investors (such as pension funds) who may have investment goals that are more concerned with
protecting the future values of their portfolios. The interest rate risk is common to both banks
and pension funds.
However, if the maturity structure of the portfolios is adjusted, the interest rate risk could be
shed. A strategy to shield net worth from interest rate movements is immunization.
Immunization is accomplished simply by calculating the duration of the promised outflows and
then investing in a portfolio of bonds that has an identical duration. This technique takes
advantage of the observation that duration of a portfolio of bonds, is equal to the weighted
average of the durations of individual bonds in the portfolio.
A much simpler approach to immunize a portfolio is cash matching. Given a liability structure,
one aims to match the liability. For example, if one requires R100 in 91 days’ time, one can
simply buy a 91 T-bill today at a price of, say R99 (sold on a discount to par value basis) and
you will receive R100 on the required date.
In order to make this form of structured portfolio strategy work, one must think of interest rate
risk as being composed of two components, namely, the price risk which results from the inverse
relationship between bond prices and required rates of return and the re-investment rate risk,
resulting from the uncertainty of the future coupon income re-investment rate.
7.5 Convexity
Duration asserts that, as the yield of a bond changes, the price of the bond changes
proportionately. In other words, it approximates a straight-line relationship between interest rates
and the value of the bond. However, there is a curved relationship between price and yield which
is known as convexity of the yield curve.
Price
Yield
The diagram shows a curved relationship between price and yield. The slope is continually
changing, and as duration is a measure of the slope, it therefore also changes.
Convexity is, therefore, a measure of the rate of duration, or the rate of change of the slope.
Convexity is always to the benefit of the bondholder. When the interest rate falls, the bond price
risks are more than predicted by duration, and for increases in the interest rates, the price falls
less than predicted. Therefore, the more convex a bond, the more attractive it is.
Bodie et al (2010:348), assert that Homer and Leibowitz have developed a popular taxonomy of
active bond portfolio strategies. They characterize portfolio rebalancing activities as one of the
following four types of bond swaps:
Finally, we could also add here, a small note on interest rate swaps as part of the active bond
management. These are contracts between two parties to trade the cash flows corresponding to
different securities without actually exchanging the securities directly. The principal amount
used to calculate swap payments is called a notional principal.
1. Calculate the duration of a 6% coupon bond making annual payment if it has three years until
maturity, and a yield to maturity of 6%. What is the duration if the yield to maturity is 10%.
Solution
1. Computation of duration:
a. YTM = 6%
(1) (2) (3) (4) (5)
Time until Payment Column (1)
Payment Discounted X
(Years) Payment at 6% Weight Column (4)
__________________________________________________________________
1 60 56.60 0.0566 0.0566
2 60 53.40 0.0534 0.1068
3 1060 890.00 0.8900 2.6700
Column Sum: 1000.00 1.0000 2.8334
Duration = 2.833 years
b. YTM = 10%
(1) (2) (3) (4) (5)
Time until Payment Column (1)
Payment Discounted X
(Years) Payment at 10% Weight Column (4)
1 60 54.55 0.0606 0.0606
2 60 49.59 0.0551 0.1102
3 1060 796.39 0.8844 2.6532
Column Sum: 900.53 1.0000 2.8240
Duration = 2.824 years, which is less than the duration at the YTM of 6%.
2.1 The answer depends on the nature of the long-term assets that the corporation is holding.
If those assets produce a return that varies with short-term interest rates, then an interest-
rate swap would not be appropriate. If, however, the long-term assets are fixed-rate
financial assets, such as fixed-rate mortgages, then a swap might reduce risk. In such a
case, the corporation would swap its floating-rate bond liability for a fixed-rate long-term
liability.
2.2 The speculator who believes interest rates will fall wants to pay the floating rate and
receive the fixed rate. This investor will benefit if the short-term reference rate does in
fact fall, resulting in an increase in the net cash flow from the swap.
? THINK POINT
1. 1. Stop to think how duration is related to the key bond variables (that is, the calculation
of duration depends on these factors).
2. 2. What other conclusions can one draw concerning duration. (hint: popularity; is it
always appropriate? etc).
3. “Bond prices move inversely with interest rates.” Try to explain why this is so.
(1) Zvi Bodie, Alex Kane, Alan J. Marcus – Read Chapter 11.
PART FOUR
SECURITY ANALYSIS
CONTENTS
CHAPTER 8
CHAPTER EIGHT
OBJECTIVES:
After reading this chapter you should be able to:
Understand the key macro-economic variables and use them as leading indicators.
Understand the effects of monetary and fiscal policy.
Conduct an Industry Analysis.
Analyze the prospects of an Industry in relation to the underlying trend of the
economy.
8.1 Introduction
It is always difficult for a security analyst to determine proper prices for a firm’s stocks. The task
of the analyst is to forecast the expected dividends and earnings of a firm. This then, is the heart
of fundamental analysis where the values of these earnings are determined. However, it must be
noted that the prospects of a firm are tied to those of the broader economy and as such analysts
must consider the business environment in which the firm operates.
Technical analysis, on the other hand, is the analysis of past share prices and the making of
investment decisions on the basis of trends in these prices.
In order to conduct a fundamental analysis we need to understand the macro- and micro-
economies so that we are able to forecast the general direction of the market as a whole. We need
to have an understanding of the demographic and the social trends to identify industries with
bright prospects. This would then be followed by the company’s financial status as presented in
its annual financial statements.
What follows are the broader aspects of fundamental analysis, namely, the international
economy, the aggregate economy and we will then provide a model for the analysis of any
specific industry.
This section will analyze both the international and domestic economy. The international
economy because it affects the export prospects, price competition and foreign exchange and
profits. The domestic economy because this environment has a direct influence upon the firm’s
operating environment. In both instances we will discuss those key concepts that have a greater
impact on the firm.
All countries are linked to the global or international macro-economy. These countries are
dependent upon other economies to purchase their exports and also to supply them with their
factor imports.
The major factors in the macro-economy environment that impacts on the firm are the political,
economic, sociological and technological factors.
One of the most obvious factors affecting the international competitiveness of a country’s
industries, is the currency exchange rate, that is, the rate at which the domestic currency can be
converted into foreign currency.
This is the local economy or industry environment in which the firm operates. There are a
number of key economic statistics that describe the domestic economy and will allow us to
predict stock price movements. The following are some of them:
The GDP is the total value of all goods and services produced by the country within a year. It is
the measure of the overall economic activity within the country. A rapidly growing GDP
indicates an expanding economy with ample opportunities for a firm to increase revenues and
market share. If the GDP increases from quarter to quarter, the economy is said to be expanding,
while a decreasing GDP for two consecutive quarters is often used as the definition of a
recession.
The annual percentage increase in GDP is a commonly used measurement of economic growth.
It is always desirable for the economy to grow at a reasonable rate because if the growth is too
fast it will lead to inflation, which in turn will lead to higher interest rates which will reduce the
real value of company profits.
* Money Supply
The money supply is the amount of money in circulation. Different measures of money supply
are used which are given an “M” designation. For example, Mo generally represents notes and
coins in circulation and is called narrow money.
Again, the rapid growth in money supply will lead to inflation, which leads to the diminishing of
real company profits.
* Inflation
Results can be distorted by inflation because inflation is the rate at which the general level of
prices continues to rise. High inflation leads to uncertainty for companies and private
individuals. For companies it can cause the book values of inventory and depreciable assets to
differ greatly from their true (replacement) values.
Companies increase their prices but find their costs increasing. Individuals will find prices
increasing which may not be matched by increases in income, thus real buying power
diminishes.
A common measure of inflation is the Consumer Price Index (CPI).
* Budget deficit
This particular item concerns government borrowing. A deficit describes the shortfall arising
from government spending over government revenues from taxes. Usually a deficit is funded by
the government issuing government bonds. Controlled government borrowing is a welcome and
normal aspect of the markets. However, large increases in government borrowing will imply
increased bond yields to attract the investment. This will mop up the excess liquidity in the
economy meaning that there will be less for investors to invest in companies. The subsequent
demand for credit extension in the economy will compound the interest rate increase and
inflation and choke off business investments.
* Retail sales
Statistics from retail stores gives immediate measure of the economic activities supporting the
economy. Healthy and increased sales are important, but excessive growth may be inflationary.
* Balance of payments
This is a record of the country’s transactions with the rest of the world including trade in
manufactured goods, raw materials, services and capital investments. It is a measurement of
exports and imports. A surplus balance of payments arises if exports exceed imports. The
opposite would cause a deficit. A healthy balance of payments surplus is needed for a healthy
economy. The balance of payments status also affects the external value of the currency which
in turn will have an impact on the competitive position with respect to imports and exports.
* Government policy
The government engages in two micro-economic tools to regulate the macro-economy, viz.
Fiscal policy and Monetary policy. Fiscal policy describes government spending and tax
collections. It is the most direct way of stimulating or slowing down the economy. Monetary
policy is the manipulation of the money supply by the government to regulate the macro-
economy.
* Employment
The unemployment rate measures the extent to which the economy is operating at full capacity.
It is the percentage of the total labour force yet to find work. The unemployment rate has an
impact on consumer confidence and its corresponding influence on the level of business activity.
* Interest rates
The current and future projection of interest rate is probably the most important factor in an
investment analysis. High interest rates increase companies’ and individuals’ borrowing costs
and thereby reduce profits. Furthermore, high interest rates reduce the present value of future
cash flows, which in turn reduces the value and attractiveness of investment opportunities. There
appears to be a negative correlation between short-term interest rates and the level of share
prices.
Following the global and macro-economic analysis we will now discuss industry analysis.
Industry groups vary significantly and can respond to a number of factors, e.g. business cycles,
industry life cycles, the industry structure, etc. The following are some of the factors that can
affect or shape the industry.
Most industries are particularly sensitive to economic slowdowns and high interest rates. The
ones that are not so sensitive, would be the basic consumer goods industries. Examples of
industries in this group are food, pharmaceuticals, and medical services.
Another important factor in determining the firm’s sensitivity to an economic slowdown would
be the typical firm’s degree of operating leverage. This describes the division of fixed and
variable costs. A large level of fixed costs as in capital-intensive industries will result in large
negative impacts on profitability.
* Industry life cycles
An industry’s life cycle can broadly be explained as the distinct growth phases that the industry
experiences. Each of them has their own set of implications for firms regarding the firm’s
strategy, production variables, etc. The phases in an industry’s life cycle are: research and
development, introduction, growth, maturity and finally, decline. The diagram below depicts a
typical industry life cycle.
Maturity
R&D Introduction Growth Decline
Costs
Time
When a company or firm, in a particular industry, reaches the maturation stage, the firm needs to
re-assess its competitive environment. Therefore, in this final section we dwell briefly on
Michael Porter’s (1980/85) five-force model of competitor analysis. The model could be used
to examine the relationship between industry structure, competitive strategy and profitability.
The following are the five external forces that a firm experiences in its competitive environment:
After analyzing the subject industry in the context of the above, we would be able to draw
conclusions on the following:
Industry analysis is limited by the fact that various companies within that industry may be facing
challenges and opportunities unique to themselves. Consequently, the prospects for the
individual company may not be the same as that for the industry as a whole. It is the
identification of the unique company – specific challenges and opportunities that will reap the
greatest investment rewards for astute investors.
CHAPTER 9
EQUITY VALUATION
CHAPTER NINE
EQUITY VALUATION
OBJECTIVES:
After completing this chapter you should able to:
Understand and calculate the value of a firm using either the constant growth or
dividend discount model.
Assess the growth prospects of a firm using the price earnings ratio.
9.1 Introduction
A number of methods are available to value a company. Of these methods this chapter would
introduce the following three methods:
Balance sheet valuations
Dividend discount models
Price earnings ratio method.
* Book value
This valuation method measures the net worth of a company as shown on the balance sheet. This
is a very static method and places reliance upon the interpretation of accounting rules to provide
its input.
In contrast to the book value, the market value of the shares takes account of the firm’s value as a
going concern.
* Liquidation value
The liquidation value per share, really accounts for the net amount that can be realized by selling
the assets of the firm and paying off the debt. (Note: the assets could be sold all at once or
piecemeal). If the firm’s share price falls below the liquidation price then that firm could be an
attractive takeover target.
* Replacement cost
This valuation concept, is the cost of replacing the firm’s assets after settling its liabilities.
* Tobin’s q
This method refers to the ratio of market price to replacement cost. This view describes the ratio
of market price to replacement cost will tend towards 1, but the evidence is that this ratio can
differ significantly from 1, for very long periods of time.
In conclusion, focusing on the balance sheet gives useful insight and information about valuing a
firm’s net worth. But for a better insight and estimate one must turn to the expected future cash
flows of a firm’s value as a going concern.
These are quantitative models that analysts use to value common stock in terms of future
earnings and dividends the firm will yield. These models give a more realistic view as they rely
upon the accurate prediction of future dividend flows.
Variations in the model are due to the timing and variations in amount of the expected
dividends. The discount rate used is the cost of equity funds invested.
The discussion of the valuation models would be illustrated mainly by worked examples.
The variations in the amount of expected dividends follows two basic steps, that is, first to
estimate the cash flows and secondly to determine the present value of the cash flows.
In this case the value would be equal to the present value of all dividends.
The valuation of ordinary shares would be dealt under three different scenarios, that is,
When:
Dividends have a zero growth rate
Dividends grow at a constant rate
Dividends have supernormal and constant growth rate.
D1 D2 D3 Dn
Value of Share at end of period (Po)
(1 k ) (1 k ) 2
(1 k ) 3
(1 k ) n
D1
Po where k is the required return
k
Example 1:
Each year a dividend of R8,00 is paid by a company. Investors require a 20% return on their
investment. Calculate the value of the share.
Therefore :
D1 = Do x (1 + g) that is dividend in period 1
D2 = D1 x (1 + g) that is dividend in period 2
Or D2 = Do x (1 + g)² that is dividend in period 2
Then Dt = Do x ( 1 + g )t that is dividend in period t
Example 2:
In this situation the value of the company’s shares are made up of 2 components, namely,
Present value of the company’s dividends in the supernormal growth period (say
years 1 to 5)
Present value of dividends in the period of constant growth (say years 6 to 20).
The need here is to calculate the required rate of return of ordinary shares using the dividend
discount model as follows:
D1
Po =
kg
Make “k” the subject of the equation as follows :
D1
k = g
Po
= Dividend yield + capital gain
Example 3 :
Calculation:
Using the above formula, the required rate of return (k) is calculated as follows:
2
k 4%
40
= 5% + 4%
= 9%
The P/E ratio is the best known and most widely used valuation technique. Most analysts are
comfortable with this technique.
As a definition, the P/E ratio is simply the number times investors value earnings as expressed in
the stock price. For example, a stock priced at R100, with most recent 12-month earnings of R5,
is to be selling for a multiple of 20. In contrast to this, if another stock had earnings of R2,50 and
was selling for R100, the stock would be valued at 40 times earnings.
The above could be written as :
Value of share (Po) = EPS x P/E ratio.
The question that needs to be answered is : “What variables affect the P/E ratio ?”
To answer this question the P/E ratio can be derived from the dividend discount model, which is
the foundation of valuation of common stocks. However, this process applies only for the case of
constant growth model.
Now using the following constant growth model :
D1
Po
kg
We divide both sides of the equation by expected earnings E1 :
P D1 / E1
E1 kg
The above equation indicates those factors that affect the estimated P/E ratio:
The expected dividend pay-out ratio, D1/E1.
The required rate of return, which has to be estimated.
The expected growth rate of dividends.
“With other things being equal”, we could relate to the following relationships:
The higher the expected pay–out ratio, the higher the P/E ratio.
The higher the expected growth rate, g, the higher the P/E ratio.
The higher the required rate of return, k, the lower the P/e ratio.
The normal P/E ratio used by analysts is a ratio of today’s price to the trend value of future
earnings. The P/E ratio can vary substantially over the business cycle, as accounting earnings
and trend value of economic earnings diverge by greater and lesser amounts.
1. Company ABC has produced a new and improved widget. This widget is forecasted to
produce an ROE of 20%. The company would maintain a plowback ratio of 20%. Its earnings
this year would be R2 per share. Investors expect a rate of return of 12% on these shares.
Required
1.1 A firm is selling a product. Calculate the price and P/E ratio according to your
expectations.
1.2 What is the present value of growth opportunities.
1.3 Calcuate the P/E ratio and the present value of growth opportunities if the firm planned to
re-invest only 20% of its earnings.
Calculate
2.1 Expected dividend payout ratios for Stock X and Stock Y.
2.2 Expected dividend growth rates of each stock.
2.3 The intrinsic value of each stock.
2.4 Would you choose both, or one of them (if so, which one?).
Solution
Question 1
1.1 g = ROE x b = 0.20 x 0.30 = 0.06 = 6.0%
D1 = R2(1 – b) = R2(1 – 30) = R1.40
D1 R1.40
P0 R 23.33
k g 0.12 0.06
E0 R2.00
1.2 PVGO P0 R23.33 R6.66
k 0.12
Question 2
Stock X Stock Y
a. Dividend payout ratio = 1 – b R1/R2 = 0.50 R1/R1.65 = 0.606
b. Growth rate = g = ROE x b 0.14 x 0.5 = 0.12 x 0.394 = 4.728%
c. Intrinsic value = V0 R1/(0.10 – 0.07) R1/(0.10 – 0.04728)
= 33.33 = R18.97
d. You would choose to invest in Stock X since its intrinsic value exceeds its price. You
might choose to sell short stock Y.
Question 3
CHAPTER 10
CHAPTER 10
OBJECTIVES:
10.1 Introduction
A company’s financial statement is regarded as the output of a model of the firm. The particular
model is designed by the management or the accountant etc. Different companies use different
methods or models treating similar events in different ways. This is so, because, the generally
accepted accounting principles (GAAP) allows some degree of latitude as to how to account for
various events.
One of the key elements of Fundamental Analysis is the analysis of financial statements. It
provides us with an important input into stock valuation. An important input in the valuation of
stock prices is determining the earnings per share (EPS), since it is the view of future earnings of
a company and the sustainability thereof that provides the basis of stock valuation. Much of this
analysis is carried out by calculating various ratios. It is important to note, however, that
financial ratios do not give absolute solutions. They are just a convenient way to summarize
large quantities of financial data and to compare a firm’s performance. Ratios help to prompt us
to ask the right questions; they seldom have all the answers.
Our discussion will come from three basic sources and center around five groups of financial
ratios.
The three basic source documents are: the income statement; the balance sheet; and the cash flow
statement.
The five groups of ratios are: profitability; liquidity; leverage; activity and market value ratios.
At this stage in your studies you would have come across ratios in other pre-requisite courses in
accounting and finance, therefore, what follows is a very brief summary of some of the key
analytical ratios including the Du Pont Cascade with some comments on the limitations of
financial analysis.
Closely related to these measures of cash flows is the free cash flows of the company which
takes two forms:
Net income
+ Depreciation, amortization, and deferred taxes
- Increase in working capital
- Investment in fixed assets
- Principal payments
+ New debt issued
= Free cash flow to equity
From the above sources we can extract a number of financial ratios. The following is a summary
of key ratios and their significance.
6. Return on common Profit after taxes – preferred stock dividends A measure of the rate of return on
equity Total stockholders’ equity – par value of preferred stock the investment the owners of the
common stock have made in the
enterprise.
7. Earnings per share Profits after taxes – preferred stock dividends Shows the earnings available to
Common stock outstanding owners of each share of common
stock.
Liquidity ratios
1. Current ratio Current assets Indicates the extent to which the
Current liabilities claims of short-term creditors are
covered by assets that are
expected to be converted to cash
in a period roughly corresponding
to the maturity of the liabilities.
2. Quick ratio (or acid- Current assets – inventory A measure of the firm’s ability to
test ratio) Current liabilities pay off short-term obligations
without relying on the sale of its
inventory
3. Inventory to net Inventory A measure of the extent to which
working capital Current assets – current liabilities the firm’s working capital is tied
up in inventory.
Leverage ratios
1. Debt-to-assets ratio Total debt Measures the extent to which
Total assets borrowed funds have been used to
finance the firm’s operations.
2. Debt-to-equity ratio Total debt Provides another measure of the
Total stockholders’ equity funds provided by creditors
versus the funds provided by
owners.
3. Long-term debt-to- Long-term debt A widely used measure of the
equity Total shareholders’ equity balance between debt and equity
in the firms’ long-term capital
structure.
4. Times-interest-earned Profits before interest and taxes Measures the extent to which
or coverage ratio Total interest charges earnings can decline without the
firm becoming unable to meet its
annual interest costs.
5. Fixed-charge coverage Profits before taxes and interest plus lease obligations A more inclusive indication of the
Total interest charges plus lease obligations. firm’s ability to meet all of its
fixed-charge obligations.
Activity ratios
1. Inventory turnover Sales When compared to industry
Inventory of finished goods averages, it provides an indication
of whether a company has
excessive or perhaps inadequate
finished goods inventory.
2. Fixed asset turnover Sales A measure of the sales
Fixed assets productivity and utilization of
plant and equipment.
3. Total asset turnover Sales A measure of the utilization of all
Total assets the firm’s assets; a ratio below
the industry average indicates the
company is not generating a
sufficient volume of business
given the size of its asset
investment.
4. Accounts receivable Annual credit sales A measure of the average length
turnover Accounts receivable of time it takes the firm to collect
the sales made on credit.
5. Average collection Accounts receivable Indicates the average length of
period Annual sales /365 time the firm must wait, after
making a sale, and before it
receives payment.
The Dupont cascade or system of analysis is applied to the firm’s financial statements to dissect
and assess its financial condition. It combines or merges the balance sheet and the income
statement into two summarized measures of profitability: that is, return on total assets (ROA)
and return on common stock or equity (ROE).
The Du Pont formula multiplies the firm’s net profit margin by its total asset turnover to
calculate the firm’s return on total assets (ROA) as follows:
Another useful Du Pont analysis could be produced by viewing how ROE depends upon return
on assets and leverage. The breakdown of the relationships is as follows:
The use of the financial leverage multiplier shows the impact of leverage on owners’ return.
Study the chart on the Du Pont system on the next page which sets out the relationships that link
return on assets (ROA) with the firm’s turnover ratio and its profit margin.
Sales
minus
Lost of goods
sold
minus Earnings
available for
Operating common stock
expenses holders Net profit
Income Divided by margin
Statement
minus Sales
Interest
Expense
minus
Return on
Taxes multiplied by Total
Assets
minus
Preferred
Dividends
Sales
Current
Assets divided by Total Asset Return on
Turnover multiplied by Equity
plus Total (ROE)
Assets
Net fixed
Assets
Balance
Sheet
Current
Liabilities
Total
plus Liabilities Total
Liabilities &
Long- plus Stockholders
term Equity = Total
debt Stockholders Assets
Equity Financial
divided by Leverages
Multiplier
Common (FLM)
Stock Equity
Ratios are a useful way to analyse financial statements. Ratios are of no use if they are simply
used mechanically. They require analysis and sound judgment. To be meaningful they need to be
compared with earlier year ratios and ratios of firms in the same business.
Most of the problems that arise when analyzing financial ratios are due to the ambiguous
disclosure requirements set out in GAAP.
Depreciation
The rates used are often subject to manipulation, that is why, above all else, consistency should
rule. Investors are not able to judge whether the depreciation charge is adequate. Furthermore,
useful comparisons cannot be made with other companies in similar industries.
Capitalised expenses
An example here is advertising expenses. Is it an investment in the firm’s brand or is it an
expense item? The GAAP asserts that a consistent policy of capitalizing or expensing should
be followed.
Tax rates
Anomalies may arise here due to any of the following: foreign operations, tax losses, deferred
tax, etc.
Current assets
Consideration must be given to bad debts, stock write-downs and valuations.
Fixed assets
The effects of inflation and revaluation must be considered. Management should be in a position
to manipulate the revaluation process for income-smoothing purposes.
Investments
Careful attention must be paid to investments in non-performing subsidiaries and cross- share
holdings.
Inventory
The valuation of inventory is very open to manipulation.
PART FIVE
DERIVATIVE MARKETS
CONTENTS
CHAPTER 11
CHAPTER ELEVEN
OBJECTIVES:
After reading this chapter you will be able to:
Understand the types of derivatives available in the investment market.
Understand why derivatives are used in investment strategies.
Understand how derivative markets operate.
Understand how some of the derivatives are valued.
11.1 Introduction
Derivative instruments play a vital role in the economy and are very useful to the investment
community. Derivatives offer an opportunity to limit the risks faced by investors and firms.
As derivative securities, options are innovations in risk management. The prices of these
securities are determined by or derived from the prices of other securities. These contracts are
now traded on many exchanges.
Derivatives, both futures and options contracts, work on the principle of agreeing a price now for
delivery and payment at a future date. We can think of this as deferred delivery.
This section is purely an introduction to the subject and serves to introduce some of the terms,
concepts, strategies and the valuation of the most common derivatives, especially the options
contract.
11.2 Options
Definition
An option is a contract that gives the holder the right, but not an obligation, to buy or sell an
asset at a specific price (or predetermined price) at any time before the expiration date of the
option.
Terminology
To understand options, one must understand the terminology associated in their usage. The
following are important terms that are specifically applicable to options:
Exercise price or strike price
The exercise price (strike price) is the price per share at which the common stock (or
underlying asset) may be purchased (in the case of a call) or sold to the writer (in the
case of a put).
Expiration date
This is the last date at which an option can be exercised. The expiration dates for options
contracts vary from common stock to common stock (or asset to asset).
Option premium
The option premium is the price paid by the option buyer to the writer (seller) for the option
whether it be a put or call. The premium is stated on a per-share basis.
Types of options
A call option
This option gives the holder the right, but not an obligation, to buy an underlying
asset (e.g.: 1000 shares of a particular common stock at a specified price any time
prior to a specified expiration date.
Note, calls allow investors to speculate on a rise in the price of the underlying asset
without buying the asset itself.
Put option
This option gives the holder the right, but not an obligation, to sell an underlying
asset (e.g.: 1000 shares of a particular common stock at a specified price prior to a
specified expiration date). If the contract is exercised, the shares are sold by the
owner (buyer) of the put contract to a writer (seller) of the contract.
Usually investors purchase puts if they expect the stock price (asset price) to fall,
because the value of the put will rise, as the stock price declines. The put, allows the
investor to speculate on a decline in the stock (asset) price without selling the
common stock (asset) short.
European options, on the other hand, can be exercised at any time but can only be
settled on expiration date.
Put and call options are created by sellers who write a particular contract. These writers or
investors seek to profit from their beliefs about the underlying assets’ likely performance just as
the buyer does.
According to Jones (2004:508), “the buyer and the seller have opposite expectations about the
likely performance of the underlying stock, and therefore the performance of the option”, that is:
The call writer, expects the price of the stock to remain roughly steady or perhaps
move down.
The call buyer, expects the price of the stock to move upward relatively soon.
The put writer, expects the price of the stock to remain roughly steady or perhaps
move up.
The put buyer, expects the price of the stock to move down relatively soon.
An investor who is optimistic about Company ABC’s prospects, instructs his broker to buy a
June call on ABC (selling at R64,50 ) at a strike price of R65,00 and his premium is R6,50 (that
is, R650 because 100 shares are involved). The investors pay the premium (ignore brokerage
and commissions).
Three courses of action are possible with the above option:
The third course of action: The option could be sold in the secondary market.
If ABC’s share price appreciates, the price of the call will also appreciate. The investor could
easily sell the call in the secondary market to another investor who wishes to speculate (at a
higher premium price).
Here the writer creates a put contract and sells it for a premium that a buyer pays. The writer
believes the underlying asset is likely to remain flat or appreciate, whereas the buyer believes
that the asset price is likely to decline. Sometimes, unlike a buyer, a writer might have to take
action in the form of taking delivery of the asset.
Example:
A writer sells a July ABC put at an exercise price of R70,00 (selling, say at R69,50). The
premium is R5,75 (for 100 shares it would be R5,75 x 100 =R575), which is paid by the buyer of
the put.
Assume the price of ABC shares decline to R60 near the expiration date..
The put owner (buyer) who did not own such shares before, would instruct his broker to
purchase 100 shares of ABC (total of R6000 ) on the open market. The owner of the put
can now exercise the put (to sell the shares), which means the chosen writer must accept 100
shares of ABC and pay the put owner R70 per share (total : R 7000) although the current market
price is only R60,00 each.
Again, we must note that just as in the case of a call, the put may also expire worthless, or the put
owner can sell the put in the secondary market.
The general framework, in option valuations, is to examine the determinants of the value of a put
or a call. There is a special relationship between the exercise price of the option and the current
stock price.
If So > E, a call is in the money (has value) and a put is out of money (no value).
If So = E, an option is at money
Intrinsic value means the amount that the buyer would recover if he/she exercised the option
immediately.
Time value means the time value portion of the premium, is that amount that the buyer pays in
excess of the intrinsic value. The amount of time value, depends on the time remaining until
expiration.
It is obvious that the longer the time until expiration, the greater the chance of an out-of-the-
money option coming into the money. Therefore, the time value portion of the premium is
greater than for an option expiring in a few days’ time. The time value portion of the premium is
however, not directly proportional to the length of time until expiration. For options with three
months or longer to expiration, the initial time value delay is minimal. However, during the last
four to six weeks of its “lifetime”, this time value delay becomes precipitous, that is, negatively
exponential.
There are three other determinants to take into account when assessing the fair value of an option
price, viz:
The price of the underlying asset, relative to the strike price of the option.
The short-term, or risk-free interest rate.
The volatility of the underlying asset.
Assume that on 1 April ABC’s share closes at R27,50 and that a June call option with a strike
price of R25,00 is available. This option is in the money because :
Example :
A June put is available at a strike price of R30,00. The current market price is R27,50.
The time value can be calculated as the difference between the option price and the intrinsic
value,
Example :
Assume the call and put option price for the previous example was R3,50 and R3,30
respectively. The intrinsic value (already calculated) is R2,50.
From the above we can deduce the premium for an option as the sum of its intrinsic value and its
time value, or :
The valuation formula uses the stock price, the risk-free interest rate, the time to maturity, and
the standard deviation of the stock return..
Study this formula in section 15.3. Bodie et al (2008:527-528) and the example 15.2 on page
512 very carefully.[Ensure that you know how to use this formula for examination purposes].
Protective put
Here an asset is combined with a put option that guarantees minimum proceeds equal
to the put’s exercise price.
Covered calls
A covered call situation is the buying of a share of stock with the simultaneous sale of
call on that stock.
Straddle
This is a combination of a call and a put, each with the same exercise price and
expiration date.
Spreads
This strategy is a combination of two or more call or put options on the same asset
with differing exercise prices or times to expiration.
Collars
This is also an options strategy that brackets the value between two limits. For
example if a share is selling at R100 each, a lower limit of R90 could be placed on the
value by buying a protective put with an exercise price of R90.
Futures and forwards are similar to options, in that, they also specify the purchase or sale of
some underlying asset at some future date. The only difference between options and futures and
forward contracts is that the holder of an option is not obligated to either buy or sell, while the
holder of a futures or forward contract, carries the obligation to go through with the agreed-upon
transaction.
The futures and forward contracts is another tool that may be used to hedge or reduce the risk of
loss, but at the same time it also reduces the return possibilities to the unhedged portion.
Definition
“A futures contract is a contract to buy or sell at a specified future settlement date a designated
amount of a specific commodity or asset” (Jones, 2004:543)
“A forward contract is an agreement between two parties that calls for delivery of a commodity
(tangible or financial) at a specified future time at a price agreed upon today. Each contract has a
buyer and a seller” (Jones, 2004:543).
Futures price: the price agreed upon between the buyer and seller to be paid on
maturity.
Long position: the buyer purchasing the asset.
Short position: the seller or trader who commits to deliver the asset.
It must be noted that the price of a futures contract is not a prediction of the future price of the
underlying asset; rather, it is derived mathematically.
There are three main elements in the price calculation of a futures contract:
Futures price = cash price and cost of carry – cash flow (if any)
Example 1
(Future price of a non-income producing asset)
The current gold price is 380 dollars per ounce. Suppose that the cost of borrowing (380 dollars)
for a period of three months is 20 dollars and that the cost of insuring and storing an ounce of
gold for this same period is equivalent to 5 dollars, then the three-month future price on an ounce
of gold should be:
FP = CP + CC – CF
Where : CP = cash price
CC = cost of carry
CF = cash flow
The price of a three-month future contract on one ounce of gold should therefore be $405.
Should the future contract price be any different, there would be arbitrage opportunities! The
future price as calculated above is also referred to as “fair value”. Therefore, if the advertised
price is say, $ 410, this too is not fair value, as it is too low. Arbitrage opportunities exist under
both circumstances.
Example 2
(Future contract price of an income-producing asset)
Calculate the fair value of price (FVP) of a three-month futures contract on the All Share Index
(ALSI). The following data is available:
This, however, would be advertised on the screen as 104 904 ÷ 10 (contracts) = 10 390 (as there
are no decimal points permitted)
Once again, should the advertised price for a three-month future ALSI contract be anything
other than 10 390, then it does not represent fair value and arbitrage opportunities exist.
In addition to the above examples, study Bodie et al (2008:567-568), section 17.3 for
examinations.
Options
1. You buy a share of stock, write a one year call option with X = R10, and buy a one-
year put option with X = R10. Your net outlay to establish the whole portfolio is R9,
50. The stock pays no dividends. Calculate the risk-free interest rate.
2. An investor writes a call option with X = R50 and buys a call with X = R60. The
options are the same stock and have the same maturity date. One of the calls sells for
R3,00, the other sells for R9,00.
Required:
Draw the payoff graph for this strategy at the option maturity date.
2. You are attempting to value a call option with an exercise price of R100 and one
year to expiration. The underlying stock pays no dividends. Its current price is
R100, and you believe it has a 50% chance of increasing to R120 and a 50% chance
of decreasing to R80. The risk free rate of interest is 10%. Calculate the call
options value using the two-state price model.
1. Zvi Bodie, Alex Kane, Alan J. Masrcus – Chapter 15, 16 & 17.
Solution
Question 1
The following payoff table shows that the portfolio is riskless with time-T value equal to R10.
Therefore, the risk-free rate is: [(R10/R9.50) – 1] = 0.0526 = 5.26%
Position ST < 10 ST > 10___
Buy stock ST ST
Short call 0 - (ST – 10)
Long put 10 - ST 0________
Total 10 10
Question 2
This strategy is a bear spread. The initial proceeds are: (R9 - R3) = R6. The payoff is either
negative or zero:
Position ST < 50 50 < ST < 60 ST > 60
Long call (X = 60) 0 0 ST – 60
Short call (X = 50) 0 -(ST – 50) -(ST – 50)
Total 0 -(ST – 50) -10
Breakeven occurs when the payoff offsets the initial proceeds of R6, which occurs at a stock
price of ST = R56.
60
0 ST
50
-4 Profit
-10 Payoff
Question 3
Step 1:
Calculate the option values at expiration. The two possible stock prices are:
S+ = R120 and S- = R80. Therefore, since the exercise price is R100, the corresponding two
possible call values are: C+ = R20 and C- = R0.
Step 2:
Calculate the hedge ratio: (C+ - C-))/S+ - S-) = (20 – 0)/ (120 – 80) = 0.5
Step 3:
Form a riskless portfolio made up of one share of stock and two written calls. The cost of the
riskless portfolio is: (S0 – 2C0) = 100 – 2C0 and the certain end-of-year value is R80.
Step 4:
Calculate the present value of R80 with a one-year interest rate of 5% = R76.19
Step 5:
Set the value of the hedged position equal to the present value of the certain payoff:
R100 – 2C0 = R76.19
Step 6:
Solve for the value of the call: C0 = R11.90
Notice that we never use the probabilities of a stock price increase or decrease. These are not
needed to value the call option.
PART SIX
CONTENTS
CHAPTER 12
CHAPTER TWELVE
OBJECTIVES:
After studying this chapter you would be able to:
Formulate investment procedures and objectives for individuals and institutional
investors.
Examine the constraints on individuals and institutional investors in constructing an
investment portfolio.
Have an overview to some portfolio management strategies.
12.1 Introduction
This chapter discusses the investment process and examines the objectives and constraints within
an investment process environment.
We can identify a five-step procedure for an investment process and for making investment
decisions. These steps may be viewed as functions of the investment management process, which
must be undertaken for each potential investor client whose money is to be managed.
We will briefly state these steps as follows (Gordon et al: 2001:392):
In this first step the broker or investment adviser must be able to identify the investor’s
investment objectives. In particular this regards his or hers attitude towards the trade-off between
risk and expected return. The portfolio objectives of an individual investor will be heavily
influenced by the stage in their life cycle.
Matching future liabilities: examples of these are private clients with specific income
requirements, life assurance companies, pension companies, etc.
Note: the above are not mutually exclusive and a fund may require an element of both.
Once the objectives have been determined, the investor must make a choice of an investment
strategy or policy to meet the requirements. This is often termed as tactics and involves a
choice between either active or passive management.
The second step is to identify mispriced situations by means of careful scrutiny pertaining to
individual securities or sectors of securities. Apply fundamental and technical analysis methods
to identify these appropriate securities.
Having performed the security analysis, choose and identify the specific securities in which to
invest, along with the proportion of investable wealth to be put into each security. The weighing
of securities in the portfolio could be based on the optimizing principles developed by a portfolio
theory. The most efficient portfolio is one that will satisfy the objectives and constraints of the
investor.
Since the performance of the securities in a portfolio have to be monitored periodically, this step
involves the evaluation of the portfolio to determine which securities are to be sold and which
securities are to be purchased to replace them. Whether new securities could be added into the
portfolio (under the assumption the investor has more investable funds).
The final step is to evaluate the performance of the portfolio. Here the actual performance of the
portfolio is determined in terms of the risk and expected return. The comparison of performance
can be made with that of an appropriate “benchmarked” portfolio.
Investors may have identical or differing attitudes towards risk. But these different investors or
institutions may choose investments to match their circumstances. Some of these circumstances
or factors that impact on their choice are tax, requirements for liquidity, or a flow of income or
various other regulatory requirements.
Families may demand a high liquidity portfolio, as opposed to banks and trusts that are subjected
to legal limitation on the types of assets they may hold, in their portfolio.
This refers to the speed and ease with which an asset can be converted to cash between the
following two dimensions: time dimension (how long it will take to sell) and the price
dimension (the discount from fair market price).
Investment horizon
This is the planned liquidation date (or maturity date) of the investment. The procedure
invokes the question: When would the cash be required?
Regulations
This concerns the “prudent investor rule”. This really concerns the “fiduciary responsibility
of a professional investor”, that is, the professional investor who manages other peoples’
money.
The professional investor must be able to give the potential investor “honest investment
advice and display good ethics in the conduct of his duties”.
Tax considerations
This consideration is central to all investment decisions, e.g. capital gains tax, income tax on
all income and accruals, etc.
Unique needs
Investors come from different industries, business environments, private sector, etc. These
investors have special circumstances, which are unique to their work situation and
requirements. Other unique needs also depend on the investor’s life cycle and earnings (e.g.
young, middle aged, or close to retirement, etc)
Refer to Table 21.2. Bodie et al (2006:708), which summarizes the types of objectives and
constraints that investors face as they construct portfolio investments.
? THINK POINT
Describe the major characteristics of endowment funds that distinguish it from pension funds.
CHAPTER 13
TECHNICAL ANALYSIS
CHAPTER THIRTEEN
TECHNICAL ANALYSIS
OBJECTIVES:
After reading this chapter you would be able to:
Understand the meaning of Technical Analysis.
Understand the application of technical analysis in investment and portfolio
management.
13.1 Introduction
There are two approaches to security analysis, namely, fundamental analysis and technical
analysis. This chapter gives you an overview of technical analysis and how it is applied in
analyzing a security for investment purposes.
Technical analysis can be applied to bonds, currencies and commodities as well as common
stocks. Technical analysis involves the aggregate stock market, industry sectors, or individual
common stocks. We will restrict our discussion to common stocks. Technical analysis also gives
us some answers to make a “buy” or “sell” decision concerning securities. Technical analysis is
best when it is combined with information from fundamental analysis.
According to Jones (2004:424), technical analysis can be defined as the use of specific market-
generated data for the analysis of both aggregate stock prices (market indices or industry
averages) and individual stocks.
Sometimes, technical analysis is called internal analysis, because it utilizes the record of the
market itself to attempt to assess the demand for and supply of shares of a stock or the entire
market.
Further to the above, an article from the internet (http:// www.finpipe.com/techan.htm) states
that, “technical analysis is an art in which quasi-statistical techniques and formal statistics are
used to determine the existence and strength of trends in financial time series and to identify
turning points in these trends. If you can do this with a reasonable degree of accuracy, then you
can improve your chances of making a profitable trade.”
The basic philosophy of technical analysis is that share prices tend to move in trends which
persist for an appreciable length of time. Changes in trend can be detected sooner or later in the
action of the market itself. The price adjustment is not abrupt as suggested by the EMH because
there is a gradual flow of information from insiders, to high-powered analysts, and eventually to
the mass of investors.
The following are some of the tools that a technical analyst might use to complete an analysis of
a security:
13.3.1 Charts
The primary trend: this trend, which lasted for at least a year was bullish or
bearish. Here, if the markets made successive higher highs and higher lows then
the trend was up. Lower highs and lower lows indicated the trends were down.
The secondary trends: these trends were corrective reactions to the primary trend.
They only lasted for a few months and retraced one-third to two-thirds of previous
secondary trends.
Minor trends: these are short-term movements that lasted for up to a few weeks.
Secondary Reactions/trends
Index level
Primary trend
time
Moving averages
Moving averages are calculated for a variety of periods, such as 10 days, 20 days, 30 days,
90 days, etc.
The price of the share for each of the 10 days are added and divided by 10 to give a 10-day
moving average.
Using a one -, five and two hundred day moving averages, a “buy” or “sell” signal could only
be confirmed when both the one day and five day averages moved through the 200-day
average.
Patterns
It is believed that a variety of patterns give good predictions. One of the best known is the
head and shoulders pattern. Below is the diagram that depicts the head and shoulders pattern.
Head
Right shoulder
price Left shoulder
Time
When the right shoulder falls through the neckline, a bearish signal is given.
4. Read the Profile Media (Latest Edition) Stock Exchange Handbook. Profile Media.
This is the relationship between price changes and trading volumes. Breadth is a market
indicator. It refers to the number of advancing issues to the number of declining issues.
Technicians contend that price alone is somewhat inadequate and investors should also examine
the volume of trading that accompanies price changes.
Finally, there are other methods, which could be followed, such as, information from insider
trading (illegal) and opinions.
The above discussion on technical analysis is rather brief, however, you must refer to Bodie et al
(2008:279), for more details to assist you to make a more informed “buy” or “sell” decision.
? THINK POINT
Choose a reputed Company that is registered on the JSE or another exchange and draw a 90-
day moving average table for its security. Also draw a business cycle for this same security
and discuss the “buy” or “sell” aspect.
Investigate the following website for more information on technical analysis and “buy” and
“sell” recommendations. www.decisionpoint.com
CHAPTER 14
PERFORMANCE EVALUATION
CHAPTER FOURTEEN
PERFORMANCE EVALUATION
OBJECTIVES:
This chapter introduces you to the issues involved in evaluating portfolio
Performance.
To give an overview of some of the interpretations of what constitutes “good
performance”.
To introduce some efficient measures of security analysis.
14.1 Introduction
Therefore, this chapter, briefly dwells on the framework for evaluating portfolio performance,
some interpretations of what constitutes “good performance” and a discussion on measures of
efficient security analysis.
The following are some of the more obvious factors that must be considered in measuring
portfolio performance:
Since these two factors are on the opposite side of the same fund, both must be evaluated if
intelligent decisions are to be made. For a portfolio to be evaluated properly, one must
determine whether the returns are representative of the given risk involved. Therefore, to
evaluate correctly, the performance must be evaluated on a risk-adjusted basis.
Investors must be careful when making comparisons of portfolios over various time periods.
Owing to differential risk, the time element must be adjusted if valid performance of
portfolio results is to be obtained.
For example, if two different funds of the same type are being hailed as top performers, the
reason could be attributed to the funds using two different time periods to measure
performance, that is, the one fund could be using the 10 years ending, December 2004, and
the other one using 5 years ending, June 2004.
Appropriate benchmarks
The evaluation of the performance of a portfolio, given its risk, becomes meaningful only
when the results are compared to a legitimate alternative. According to Jones (2004:589), the
measurement process must involve relevant and obtainable alternatives, that is, the
benchmark portfolio must be a legitimate alternative that accurately reflects the objectives of
the portfolio being evaluated.
Other considerations
Other considerations that could enhance the evaluation of a portfolio’s performance are:
The risk-adjusted measures of portfolio performance were developed in the sixties. These
measures were based on the concepts of capital market theory and recognizing the fact that risk
and return played an important role in portfolio investment. Therefore, to derive a meaningful
answer, returns must be adjusted for risk.
This section will discuss three methods of risk adjustment performance. All of these measures
have their roots in the CAPM as they were all developed roughly at the same time.
For our illustration of the measures, the following symbols would apply:
NB: The bars over rp, rm and rf denotes the fact, that, because the rates may not be constant
over the measurement period, we are taking the sample average.
This formula measures the excess returns per unit standard deviation or risk. So for a given
portfolio return, a lower Sharpe ratio will be desired as it indicates a lower level or risk or
volatility.
rp r f
S p
p
This is a measure of excess return per systematic risk unit. A lower ratio is also desirable here.
The Jensen measure is about the return over and above that predicted by the CAPM, given the
portfolios’ beta and the average market return. This is the portfolio alpha value.
1. Based on current yields expected capital gains, the expected rates of return on
portfolios A and B are 11% and 14%, respectively. The beta of A is 0,8 while that of B is
1,5. The T-bill rate is currently 6%, while the expected rate of return of the index is 12%.
The standard deviation of portfolio A is 10% annually; while that of B is 31%, and that of
the index is 20%.
1.1 If you currently hold a market index portfolio, would you choose to add either of
these portfolios to your holdings? Explain.
1.2 If instead you could invest only in bills and one of these portfolios, which would you
choose?
Bodie et al : (2006:602)
Solution
E(r) __
1.1 Stock A 11% 10% 0.8
Stock B 14% 31% 1.5
Market index 12% 20% 1.0
Risk-free asset 6% 0% 0.0
Ideally, you would want to take a long position in Stock A and a short position in
Stock B.
1.2 If you hold only one of the two stocks, then the Sharpe measure is the appropriate
criterion:
11 6
SA 0.5
10
14 6
SB 0.26
31
Therefore, using the Sharpe criterion, Stock B is preferred.
CHAPTER 15
INTERNATIONAL DIVERSIFICATION
CHAPTER FIFTEEN
INTERNATIONAL DIVERSIFICATION
OBJECTIVES:
After studying this chapter you should have an overview of the importance of international
diversification, the risks, and the methods available to diversify a portfolio internationally.
15.1 Introduction
The central theme of portfolio theory, concerns the merits of diversification. It is sensible to hold
within a portfolio many different assets, which will obviously balance the risk-return trade-off,
especially in an efficient capital market. So far, we have considered traditional domestic
securities and some less traditional ones, such as options and futures.
This chapter allows the reader to consider holding foreign securities to diversify his/her portfolio
choosing international assets. Although it may be prudent for an investor to engage in
international diversification he must be aware of the inherent risks involved. Therefore,
international diversification calls for prudent portfolio planning strategies.
International diversification is nothing new, it is basically an extension of the local market into
foreign markets. In fact, the investor now has a greater variety of assets to choose from in the
diversification process. But, what the investor must be wary of, is that diversifying into one
economy or economic bloc has its dangers. This would place a restriction on his universe of asset
classes. Furthermore, world markets are often not correlated because one economy might have a
bear run while another economy may be faced with a bull run. So, different sectors of the world
economy move at a different pace. Therefore, a more geographically diversified a portfolio, the
greater the risk reduction possibilities. That is, the rates of return of the various countries will
not be highly correlated.
In recent years, many smaller countries have initiated organized stock exchanges. These
countries (the eastern Asian countries), which have in common, a relatively low (compared with
western countries) level of per capita gross domestic product (GDP) with improved political and
economic stability, may be referred to as emerging markets. These markets have extended the
world investment market giving the investor an added choice. Investments in these markets seem
to have proven attractive to many institutional investors.
The Financial Times Stock Exchange 100 index (FT-SE) for the London Stock exchange.
The TSE 300 composite Index for the Toronto Stock Exchange.
Consult the latest edition of the Wall Street Journal for more information on international equity
indices.
On an international level, the indices produced by Morgan Stanley Capital International are also
widely used. Each index is based on a value-weighted portfolio of stocks in a particular country.
All these stocks can be purchased by foreigners.
The following are some of the more important risks that should not be disregarded by potential
investors.
Currency exchange rate: A strong, stable base currency should always be chosen
when measuring international returns. A country may appear to have a booming
stock market or particular asset class, but this maybe offset by that country having
a relatively weak currency.
If one studies Morgan Stanley Capital International (MSCI) world index region and country
weights at the start of 2000, one can see that the US makes up nearly half of the world’s equity
market by capitalization. The next biggest market is JAPAN and then the UK. If it is argued
how the countries of the European Union (EU) have adopted euro, then they should be treated as
a single entity, thus making Euroland the second largest equity market. At this stage it must also
be noted that although most of the commentary focuses on equity, the world bond market is in
fact larger than the world equity market consisting of dollar bonds, yen bonds and Euroland
bonds.
The following pie chart, illustrates the components of world equity and bond markets.
Source : Lofthouse, S (2001 : 371)
UK Bonds - 2%
2% 5%
Ohio Equities - 5%
5%
26%
UK Equities - 5% 6%
Japanese Equities - 6%
5%
Ohio bonds - 5%
Euroland Equities - 8%
Japanese Bonds - 7% 8%
Euroland Bonds - 13%
US Equities - 23% 7%
US Bonds - 26% 23%
13%
The fundamental reason for investing internationally is the benefit that arises from the
opportunity to invest in an additional range of securities, which together have a relatively low
correlation to the domestic market. The opportunity also lends itself to construct a portfolio with
a lower standard deviation that would be possible if only domestic assets were considered.
Solnik & de Freitas (cited by Bodie et al) used a natural factors framework to demonstrate an
application of multifactor models of security returns, and the following table shows some of their
results for several countries.
TABLE : 15.1
AVERAGE R-SQR OF REGRESSION ON FACTORS
SINGLE FACTOR TESTS
LOCALLY WORLD INDUSTRIAL CURRENCY DOMESTIC JOINT TEST ALL
4 FACTORS
Switzerland .18 .17 .00 .38 .39
West Germany .08 .10 .00 .41 .42
Australia .24 .26 .01 .72 .72
Belgium .07 .08 .00 .42 .43
Canada .27 .24 .07 .45 .48
Spain .22 .03 .00 .45 .45
United States .26 .47 .01 .35 .60
France .13 .08 .01 .45 .55
United Kingdom .20 .17 01. .53 .81
Hong Kong .06 .25 .00 .79 .35
Italy .05 .03 .01 .35 .33
Japan .09 .16 .00 .26 .85
Norway .17 .28 .01 .84 .31
Netherlands .12 .07 .02 .34 .33
Singapore .16 .15 .02 .32 .43
Sweden .19 .06 .01 .42 .46
All Countries .18 .23 .01 .42 .46
Source : Bruno Solnik (1996) International Investments, 3rd ed (P.37), Addison & Wesley
Ref : Bodie, Z; Kane, A; Marcus A.J (2002) Investments, TATA, McGraw-Hill
The first 4 columns of table 15.1 present the R-square (or R2, measures the percentage of return
volatility of company’s stock that can be explained by the particular factor treated as the
independent or explanatory variable) of various one-factor regressions.
Solnik and de Freitas estimated the factor regressions for many firms in a given country and
reported the average R-square across the firms in that country.
The table shows that the domestic factor seems to be the dominant influence on stock returns.
The domestic index alone generates an average R2 of .42 across all countries. If, adding the three
additional factors (last column of the table) increases average R-square only to .46. This is
consistent with the low cross country correlation coefficients in Table 15.2 showing the value of
international diversification. (Bodie, Z et al (2002) Investments)
TABLE 15.2
Correlation of Un-hedged Asset Returns, 1980 – 1993.
Stocks Bonds
Asset/Country US GER UK JAP AUS CAN FRA US GER UK JAP AUS CAN FRA
STOCKS
United States 1,00
Germany 0,37 1,00
United Kingdom 0.53 0,47 1,00
Japan 0,26 0,36 0,43 1,00
Australia 0,43 0,29 0,50 0,26 1,00
Canada 0,73 0,36 0,54 0,29 0,56 1,00
France 0,44 0,63 0.51 0,42 0,34 0,39 1,00
BONDS
USA 0,35 0,28 0,17 0,15 0,00 0,27 0,19 1,00
Germany 0,08 0.56 0,30 0,35 0,05 0,13 0,46 0,40 1,00
United Kingdom 0,13 0,34 0,61 0,36 0,19 0,27 0,33 0,34 0,60 1,00
Japan 0,03 0,31 0,27 0,63 0.10 0,11 0,36 0,33 0,67 0.54 1,00
Australia 0,19 0,20 0,31 0,12 0,67 0,32 0,16 0,13 0,17 0,25 0,17 1,00
Canada 0,31 0,26 0,21 0,19 0,18 0,52 0,23 0,69 0,36 0,41 0,35 0,25 1,00
France 0,12 0,53 0,33 0,37 0,10 0,16 0,58 0,36 0,90 0,57 0,65 0,21 0,33 1,08
SOURCE: Roger G Clarke and Mark P. Kritzman, Currency Management Concepts and Practices (Charlottesville,
VA : Research Foundation of the Institute of Chartered Financial Analysis, 1996)
(Reference : Bodie, Z; Kane, A; Marcus A.J : (2002) Investments, TATA McGraw Hill Edition)
Introduction
Prior to 1994, the development of the South African financial markets was “blocked” by
constraints of the socio-political problems of the country. At that time the prevalent boycotts,
sanctions, disinvestments campaigns and isolation placed severe restrictions on the development
of the South African financial markets. New challenges emerged since 1994 to re-introduce the
South African financial markets into the global system.
Progress made in the South African markets can be illustrated by the almost explosive increases
in turnovers in the major financial markets as follows:
Secondary trading in shares on the JSE increased, in terms of number of shares traded
in
1995 – 5.1 billion
1996 – 9 billion
1997 – 17.9 billion
1998 – 34.4 billion
The total value of shares traded also increased:
1995 – R63 billion
1996 – R117 billion
1997 – R207 billion
1998 – R319 billion
As can be seen from the above statistics, there has been a steady increase in secondary trading in
shares and the total value of shares traded.
The increase in total turnover in the secondary market for bonds was also spectacular.
There was a considerable increase from just over R2 trillion in 1995 to R8,5 trillion in
1998.
Activity in the derivatives market likewise increased quite significantly over the past
few years. The number of contracts traded in both futures and options were more
than doubled from 1995 to 2004.
The South African market in foreign exchange also made its contribution to the
development of the overall financial markets. The average daily turnover, increased
from US to 2,7 billion (1995) to 8 billion in 1998.
These developments brought about major changes in the official policy approach and in
regulatory requirements for the various financial institutions.
The changes introduced by the JSE, and the Department of Finance e.g. the switch from fixed
bank rate to a fluctuating rate for repurchase transactions by the reserve bank and the upgrading
of the national payment, cleaning and settlement system, are few of the examples of the
flexibility in official policy to support these developments. As a result of these developments
there is active participation of both foreign and domestic investors in domestic and international
markets. Another important contribution was the lifting of exchange controls. The gradual
removal of exchange controls resulted in the effective withdrawals of about 70%, (or even more),
of the exchange controls that existed at the beginning of 1994. At this stage South Africa has no
effective exchange controls anymore on:
Current account transaction of the balance of payments; or
An inward or outward transfer of funds owned by non-residents;
In the case of residents, limits were introduced for amounts that can now be invested
outside of the country by corporate, institutional investors and private individuals.
(Source: Stals, C (Governor of the SARB, 1999)
In view of these developments and further relaxations South Africans are likely to benefit from
international portfolio diversification.
The document fully illustrates the risk-return trade-off from international portfolio diversification
using 18 major industrialized countries during the period 1984 – 1996. The inclusion of these
foreign securities resulted in satisfactory portfolio returns when compared with returns derived
from exclusive investment in South African securities. Furthermore, the exchange gains from
various foreign currencies generally enhanced the attractiveness of investing in foreign securities
from the point of view of a South African investor.
The results also show that the South African investor is able to accomplish significant risk
reduction when countries such as Korea, Austria, Norway, Italy, Spain and Sweden are included
in international portfolios. Further to this the currency factor is also important and is a major
element in the performance and risk components of international portfolios. The fluctuations in
the exchange rates did have a material effect on total rates because South African currency was
substantially devalued against other currencies during the study period.
This chapter attempts to discuss the evidence in support of international diversification. The
evidence shows that in international diversification the reduction in risk is uniform and
extensive.
Although mechanisms such as taxes or currency restrictions can substantially reduce return on
foreign investment relative to domestic investment, international diversification has to be
profitable for investors.
Other References
Refer to the following articles for more relevant information on the following website :
www.iassa.co.za
1. Neu-Nev, M.A; Firer,C : (1997) Benefits of Diversification on the JSE. (Investment
Analysis Journal, No. 46)
2. Barr, G.D.I; Bradfield, D.J (1987) The role played by bullion and gold shares in
international diversification. (Investment Analysts Journal, No.28).
3. Also visit : www.moneymax.co.za
Given the above considerations, the best vehicle or investment style to adopt is to choose one of
the most popular methods of international diversification, that is, to simply invest in an index
fund or index tracker. In this instance, the investor will only need to take a view on the country
or sector that the particular index tracks. The actual stock selection is then taken care of by the
index composition, which would usually be the largest cap stocks making up that stock market.
The fund manager or investor then merely has to time his entry or exit from that index. This is
essentially a passive management technique.
In conclusion, the brief discussion on international diversification merely purports to make the
reader aware why international diversification is justified even if expected returns are less
internationally than domestically. In more ways than one, international diversification has to be
profitable for most investors, unless of course, if the profits are substantially reduced by
restrictive measures (e.g. taxes, currency restrictions, etc)
? THINK POINT
1. Read the “Kings Report” on Corporate Governance which has become very important in
recent times.
2. Read the “Myburgh” report on why the rand deteriorated/depreciated against the dollar
about 3 years ago.
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