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MAN605/705 Investment Management Lecture Notes Week 1: Introduction to Financial Markets & Instruments
Agenda <ul><li>Class List </li></ul><ul><li>Review Course Outline </li></ul><ul><li>Review Objectives </li></ul><ul><li>In...
Objectives <ul><li>Know what investment is about. </li></ul><ul><li>Understand exactly what is meant by the term ‘financia...
Assessment
Lecture Content <ul><li>Investments: Background & Issues </li></ul><ul><ul><li>Financial vs. Real Assets </li></ul></ul><u...
Investment <ul><li>Definition </li></ul><ul><ul><li>The current commitment of funds for a period of time in order to deriv...
Financial vs. Real Assets <ul><li>Real Assets </li></ul><ul><ul><li>Real assets create or store wealth. </li></ul></ul><ul...
Taxonomy of Financial Assets  <ul><li>Fixed Income Securities </li></ul><ul><ul><li>Money Market Instrument </li></ul></ul...
Financial Markets & the Economy <ul><li>Time Shifting of Expenditure </li></ul><ul><ul><li>Time Value of Money </li></ul><...
Investment Process & Markets <ul><li>Process </li></ul><ul><ul><li>Top Down vs. Bottom up </li></ul></ul><ul><ul><li>Asset...
Market Players <ul><li>The Issuers </li></ul><ul><ul><li>Those that borrow and raise capital </li></ul></ul><ul><ul><li>Us...
Recent Trends <ul><li>Globalisation </li></ul><ul><ul><li>Change in the view of the world </li></ul></ul><ul><ul><li>ADR’s...
The Money Market <ul><li>Short-term debt market. </li></ul><ul><li>Any FI security with maturity of less than 12 months. <...
The Bond Market <ul><li>Also known as the Fixed Income Capital Market. </li></ul><ul><li>Long-term (more than 12 months to...
Bond Market Players <ul><li>Issuers </li></ul><ul><ul><li>Governments/Treasury (Sovereign Debt) </li></ul></ul><ul><ul><li...
Alternative Bonds <ul><li>TIPS / Inflation linked or Indexed bonds </li></ul><ul><ul><li>(Treasury Inflation protected Sec...
What determines Interest Rates? <ul><li>Risk Premia </li></ul><ul><ul><li>Sovereign Risk </li></ul></ul><ul><ul><li>Curren...
Term Structure of Interest Rates <ul><li>Bond rates usually higher than short-term rates. Why? </li></ul><ul><ul><li>More ...
Equities <ul><li>Common Shares/equity securities as ownership. </li></ul><ul><li>We do not use the term ‘stock’. It is an ...
Equities Trading <ul><li>Trading </li></ul><ul><ul><li>Listed share trades on an exchange. </li></ul></ul><ul><ul><li>Pric...
Derivatives Markets <ul><li>Derivative instrument. </li></ul><ul><ul><li>Security with a payoff that depends on the price ...
Option Contracts <ul><li>Call option is a right, but not the obligation, to buy a specific asset at a specific (exercise) ...
Using Derivatives <ul><li>Why use derivatives? </li></ul><ul><ul><li>Hedge Risk of price changes. </li></ul></ul><ul><ul><...
For Session <ul><li>Additional Reading </li></ul><ul><ul><li>www.investopedia.com/university/advancedbond </li></ul></ul><...
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  1. 1. MAN605/705 Investment Management Lecture Notes Week 1: Introduction to Financial Markets & Instruments
  2. 2. Agenda <ul><li>Class List </li></ul><ul><li>Review Course Outline </li></ul><ul><li>Review Objectives </li></ul><ul><li>Investment Introduction </li></ul><ul><ul><li>Financial Assets </li></ul></ul><ul><ul><li>Financial Markets </li></ul></ul><ul><ul><li>Financial Securities </li></ul></ul><ul><li>Next Week </li></ul>
  3. 3. Objectives <ul><li>Know what investment is about. </li></ul><ul><li>Understand exactly what is meant by the term ‘financial securities’ </li></ul><ul><li>Basic knowledge of financial markets in SA. </li></ul><ul><li>Know the types and characteristics of all the major traded financial instrument. </li></ul><ul><li>Identify the major participants in financial markets </li></ul>
  4. 4. Assessment
  5. 5. Lecture Content <ul><li>Investments: Background & Issues </li></ul><ul><ul><li>Financial vs. Real Assets </li></ul></ul><ul><ul><li>Taxonomy of Financial Assets </li></ul></ul><ul><ul><li>Financial Markets & the Economy </li></ul></ul><ul><ul><li>Investment Process & Markets </li></ul></ul><ul><ul><li>Market Players </li></ul></ul><ul><ul><li>Recent Trends </li></ul></ul><ul><li>Major Financial Market Instruments </li></ul><ul><ul><li>Money Market </li></ul></ul><ul><ul><li>Capital Market </li></ul></ul><ul><ul><li>Equity Market </li></ul></ul><ul><ul><li>Derivative Markets </li></ul></ul>
  6. 6. Investment <ul><li>Definition </li></ul><ul><ul><li>The current commitment of funds for a period of time in order to derive future payments that will compensate the investor for: </li></ul></ul><ul><ul><ul><li>The time the funds are committed. -RRFR </li></ul></ul></ul><ul><ul><ul><li>The expected Inflation rate of that time. - E(Inf) </li></ul></ul></ul><ul><ul><ul><li>The uncertainty of the future payments. - Rp </li></ul></ul></ul><ul><ul><li>This rate of return that the investor demands for compensation as described above is known as the ‘ Required Rate Return’ - R(Ret) </li></ul></ul><ul><ul><li>You will invest when the expected rate of return E(Ret)> required rate of return. </li></ul></ul>
  7. 7. Financial vs. Real Assets <ul><li>Real Assets </li></ul><ul><ul><li>Real assets create or store wealth. </li></ul></ul><ul><ul><li>Real assets are usually physical assets. </li></ul></ul><ul><ul><li>Can be intangible, such as copyright, patent, brand name. </li></ul></ul><ul><ul><li>Examples: Property, Vehicles, Business, Patent. </li></ul></ul><ul><ul><li>No-one else’s liability. </li></ul></ul><ul><li>Financial assets </li></ul><ul><ul><li>Financial Assets are also known as paper assets. </li></ul></ul><ul><ul><li>Financial assets contains a distinct promise. </li></ul></ul><ul><ul><li>Some right is implied. Can be a right to certain or uncertain cash flow, voting rights etc. </li></ul></ul><ul><ul><li>Examples: Currency Notes, Equity, Bonds, Promissory notes. </li></ul></ul><ul><ul><li>Someone else's liability. </li></ul></ul><ul><li>Quiz: What type of asset are the following. </li></ul><ul><ul><li>R10 note, R5 Coin, Kruger Rand, Patent, Goodwill, Education, Housing Bond. </li></ul></ul>
  8. 8. Taxonomy of Financial Assets <ul><li>Fixed Income Securities </li></ul><ul><ul><li>Money Market Instrument </li></ul></ul><ul><ul><li>Bonds (Capital Market) and Money Market Securities </li></ul></ul><ul><ul><ul><li>Predefined cash flow over a period </li></ul></ul></ul><ul><li>Equities </li></ul><ul><ul><li>“ Ownership”/Voting rights </li></ul></ul><ul><ul><li>Public & Private </li></ul></ul><ul><ul><li>Types of shares: </li></ul></ul><ul><ul><ul><li>O’s, N’s, Low voting, Prefs & Convertibles </li></ul></ul></ul><ul><li>Derivatives </li></ul><ul><ul><li>Is based on the value an ‘underlying’ asset </li></ul></ul><ul><ul><li>Options (OTC vs. Exchange Traded) </li></ul></ul><ul><ul><li>Future Contracts </li></ul></ul>
  9. 9. Financial Markets & the Economy <ul><li>Time Shifting of Expenditure </li></ul><ul><ul><li>Time Value of Money </li></ul></ul><ul><li>Allocation of Risk </li></ul><ul><li>Separation of Ownership & Management </li></ul><ul><ul><li>The Agency Problem </li></ul></ul><ul><li>Corporate Governance </li></ul><ul><ul><li>Accounting Standards </li></ul></ul><ul><ul><li>Analyst Impartiality </li></ul></ul><ul><ul><li>Board Responsibility </li></ul></ul><ul><li>Read Case Studies </li></ul><ul><ul><li>Scandal Scorecard (Bodie Table1.4) </li></ul></ul>
  10. 10. Investment Process & Markets <ul><li>Process </li></ul><ul><ul><li>Top Down vs. Bottom up </li></ul></ul><ul><ul><li>Asset Class, sector, security </li></ul></ul><ul><li>Risk-Return trade-off </li></ul><ul><ul><li>Risk: Probability of a loss (below threshold/expected return) over a certain period. </li></ul></ul><ul><ul><li>How do we measure risk? </li></ul></ul><ul><ul><li>Higher expected return is a compensation for Risk </li></ul></ul><ul><ul><li>Diversification and MPT </li></ul></ul><ul><li>Market Efficiency </li></ul><ul><ul><li>Is all information already discounted? </li></ul></ul><ul><ul><ul><li>Dividend test </li></ul></ul></ul><ul><ul><li>Active vs. Passive management </li></ul></ul><ul><li>Primary & Secondary Market </li></ul>
  11. 11. Market Players <ul><li>The Issuers </li></ul><ul><ul><li>Those that borrow and raise capital </li></ul></ul><ul><ul><li>Usually Government & Corporates </li></ul></ul><ul><li>The Investors </li></ul><ul><ul><li>Those with surplus savings </li></ul></ul><ul><ul><li>Retirement funds, Investor funds, individuals </li></ul></ul><ul><ul><li>Can also be Government and Corporates </li></ul></ul><ul><li>The Intermediaries </li></ul><ul><ul><li>Investment Banks, Stock Brokers, Securities Exchanges. </li></ul></ul><ul><ul><ul><li>Market Makers, IPO’s </li></ul></ul></ul><ul><ul><li>Investment Vehicles, E.g.. Unit Trusts/Mutual funds </li></ul></ul><ul><ul><ul><li>Wholesale and retail financial markets </li></ul></ul></ul><ul><ul><li>On/Off balance sheet financing. </li></ul></ul><ul><ul><ul><li>Intermediation vs. Disintermediation </li></ul></ul></ul><ul><li>The Regulators </li></ul><ul><ul><li>SARB and FSB in SA, FSA in UK, SEC in the US. </li></ul></ul>
  12. 12. Recent Trends <ul><li>Globalisation </li></ul><ul><ul><li>Change in the view of the world </li></ul></ul><ul><ul><li>ADR’s </li></ul></ul><ul><ul><li>Euro & ECB </li></ul></ul><ul><li>Securitisation </li></ul><ul><ul><li>Issuance of securities, using a pool (usually of lesser quality) securities of other cash flow generating asset(s) as collateral. </li></ul></ul><ul><ul><li>ABS </li></ul></ul><ul><ul><ul><li>Brady Bond, Mortgage Backed Securities (SA Home loans) </li></ul></ul></ul><ul><ul><ul><li>Ziggy Stardust (David Bowie) </li></ul></ul></ul><ul><li>Financial Engineering </li></ul><ul><ul><li>Bundling & unbundling E.g.. Strips </li></ul></ul><ul><ul><li>Tax implications </li></ul></ul><ul><li>Computer networks </li></ul><ul><ul><li>Instant access </li></ul></ul><ul><ul><li>Day Traders </li></ul></ul>
  13. 13. The Money Market <ul><li>Short-term debt market. </li></ul><ul><li>Any FI security with maturity of less than 12 months. </li></ul><ul><li>FRN’s can be longer dated, but act and are priced as MM instruments. </li></ul><ul><li>MM Unit trusts are priced at R1 </li></ul><ul><li>Examples </li></ul><ul><ul><li>TB’s, BA’s, ST Debentures, CD’s, NCD’s, Commercial paper or PN’s (Promissory Notes) </li></ul></ul><ul><ul><li>Repos and Reverse Repos. </li></ul></ul><ul><li>Interbank Market </li></ul><ul><ul><li>LIBOR </li></ul></ul><ul><li>MM Yields </li></ul><ul><ul><li>Instruments usually trade at discount not a yield. </li></ul></ul><ul><ul><li>Low risk but not risk-free. </li></ul></ul><ul><ul><li>TB’s has almost no default risk, but has interest rate risk. </li></ul></ul><ul><ul><li>Risk premium – What banks/Corporates have to pay (in yield) above TB’s. </li></ul></ul>
  14. 14. The Bond Market <ul><li>Also known as the Fixed Income Capital Market. </li></ul><ul><li>Long-term (more than 12 months to maturity) Debt instruments. </li></ul><ul><li>Examples </li></ul><ul><ul><li>Government bonds, corporate bonds, notes & debentures. </li></ul></ul><ul><ul><li>Exceptions: FRN’s act and is priced as a MM instrument but traded on the Bond Market. </li></ul></ul><ul><ul><li>Credit Risk </li></ul></ul><ul><ul><ul><li>Gilts, Para-statals, Munis, Corporate, High Yield, Junk </li></ul></ul></ul><ul><ul><ul><li>Guarantees, Collateral, Convergence, Consolidation, Options </li></ul></ul></ul><ul><ul><li>Foreign Bonds </li></ul></ul><ul><ul><ul><li>Sovereign vs. Credit bonds </li></ul></ul></ul><ul><ul><ul><li>Issue Currency (Eurobonds, Yankee banks, Samurai/Nippon Bonds) </li></ul></ul></ul><ul><li>Traded on Price or Yield </li></ul><ul><li>Tax issues </li></ul><ul><ul><li>Interest eared vs. interest bought/sold </li></ul></ul><ul><ul><li>Capital Gains Tax </li></ul></ul><ul><ul><li>Tax on Retirement Funds </li></ul></ul><ul><ul><li>Tax free equivalent </li></ul></ul>
  15. 15. Bond Market Players <ul><li>Issuers </li></ul><ul><ul><li>Governments/Treasury (Sovereign Debt) </li></ul></ul><ul><ul><li>Parastatals/government agencies (ESCOM, Transnet etc.) </li></ul></ul><ul><ul><li>Municipalities </li></ul></ul><ul><ul><li>Corporations </li></ul></ul><ul><li>Market Makers & Traders & Intermediaries </li></ul><ul><ul><li>Investment Banks, Exchange & Stock Brokers </li></ul></ul><ul><ul><li>SARB </li></ul></ul><ul><li>Investors </li></ul><ul><ul><li>Retirement Funds </li></ul></ul><ul><ul><li>Unit Trust/Mutual Funds </li></ul></ul><ul><ul><li>Investment trusts/investment companies/Private Equity </li></ul></ul><ul><ul><li>Banks </li></ul></ul><ul><ul><li>Corporate treasurers </li></ul></ul><ul><ul><li>Individuals/Syndicates </li></ul></ul><ul><li>Rating Agencies </li></ul><ul><ul><li>Finch, Moody’s, Standard &Poor’s </li></ul></ul><ul><ul><li>Investment grades: High & Medium, BB+ and above </li></ul></ul><ul><li>Regulator </li></ul><ul><ul><li>FSB in SA </li></ul></ul>
  16. 16. Alternative Bonds <ul><li>TIPS / Inflation linked or Indexed bonds </li></ul><ul><ul><li>(Treasury Inflation protected Securities) </li></ul></ul><ul><ul><li>Principle and coupon increases with inflation index. </li></ul></ul><ul><li>Strips </li></ul><ul><ul><li>Splitting the coupons and principle </li></ul></ul><ul><li>Corporate Bonds </li></ul><ul><ul><li>Mortgage backed bonds </li></ul></ul><ul><ul><li>Asset Backed Securities (ABS) </li></ul></ul><ul><ul><li>Variable/Floating Rate Notes </li></ul></ul><ul><ul><ul><li>Coupon is linked to a market interest rate, usually a money market rate. </li></ul></ul></ul><ul><ul><li>Zero Coupon Bonds </li></ul></ul><ul><ul><li>High Yield Bonds </li></ul></ul><ul><ul><ul><li>Speculative grade and junk bonds </li></ul></ul></ul><ul><ul><li>Callable & puttable Bonds </li></ul></ul><ul><ul><li>Convertible Bonds </li></ul></ul><ul><ul><li>Subordinated of Junior Debt </li></ul></ul><ul><li>Price Quotes </li></ul><ul><ul><li>Quoted as YTM or R% </li></ul></ul>
  17. 17. What determines Interest Rates? <ul><li>Risk Premia </li></ul><ul><ul><li>Sovereign Risk </li></ul></ul><ul><ul><li>Currency Risk </li></ul></ul><ul><ul><li>Credit risk (Corporate) </li></ul></ul><ul><li>Expected Inflation </li></ul><ul><li>In SA the expected inflation and Government deficit funding (crowding out effect) is the major determinants of bond rates. </li></ul><ul><li>Factors determining bond rate are: </li></ul><ul><ul><li>Quality of issue </li></ul></ul><ul><ul><li>Term to maturity </li></ul></ul><ul><ul><li>Indenture provisions: Collateral, call features and sinking fund provisions </li></ul></ul><ul><ul><li>Denomination - Exchange rate (country risk) </li></ul></ul>
  18. 18. Term Structure of Interest Rates <ul><li>Bond rates usually higher than short-term rates. Why? </li></ul><ul><ul><li>More Risky </li></ul></ul><ul><ul><li>Expectations of higher interest rates </li></ul></ul>
  19. 19. Equities <ul><li>Common Shares/equity securities as ownership. </li></ul><ul><li>We do not use the term ‘stock’. It is an Americanism and confusing since ‘stock’ can also refer to a bond or inventory. </li></ul><ul><li>Characteristics. </li></ul><ul><ul><li>Residual claim (last in the row). </li></ul></ul><ul><ul><li>Limited liability. </li></ul></ul><ul><ul><li>Dividends are tax free in SA except for STC. </li></ul></ul><ul><li>Classes of shares. </li></ul><ul><ul><li>Ordinary shares. </li></ul></ul><ul><ul><li>Preferred shares (popular for individuals because it is tax-free.) </li></ul></ul><ul><ul><li>Redeemable/Convertible prefs. </li></ul></ul><ul><ul><li>N-shares. (No or low voting shares) </li></ul></ul>
  20. 20. Equities Trading <ul><li>Trading </li></ul><ul><ul><li>Listed share trades on an exchange. </li></ul></ul><ul><ul><li>Priced in cents. </li></ul></ul><ul><ul><li>Trading floor replaced by computer trading. </li></ul></ul><ul><li>Why hold equities? </li></ul><ul><ul><li>Dividends (cash flow stream). </li></ul></ul><ul><ul><li>Capital Appreciation (Growth). </li></ul></ul><ul><ul><li>Control: Through voting and board appointments. </li></ul></ul><ul><ul><li>Security: </li></ul></ul><ul><ul><ul><li>Backed by real assets legislation and regulation. </li></ul></ul></ul><ul><ul><li>Liquidity: </li></ul></ul><ul><ul><ul><li>Easily and cheaply traded for cash. </li></ul></ul></ul>
  21. 21. Derivatives Markets <ul><li>Derivative instrument. </li></ul><ul><ul><li>Security with a payoff that depends on the price of another security. (the underlying instrument) </li></ul></ul><ul><li>Futures Contracts </li></ul><ul><ul><li>Obliges party to purchase or sell an asset at a agreed price at a specific future date. </li></ul></ul><ul><ul><li>Enables Forward selling/buying. </li></ul></ul><ul><ul><li>Short & Long positions. </li></ul></ul><ul><ul><li>Neutralising vs. gearing. </li></ul></ul><ul><ul><li>Exchange traded and only settled on expiry. </li></ul></ul>
  22. 22. Option Contracts <ul><li>Call option is a right, but not the obligation, to buy a specific asset at a specific (exercise) price on or before a specified date. </li></ul><ul><li>Put option is a right but not the obligation, to buy a specific asset at a specific price on or before a specified date. </li></ul><ul><li>Choice to execute or not. </li></ul><ul><li>Not to be confused with a right of first refusal. </li></ul><ul><li>Price of options is known as a premium. </li></ul><ul><li>OTC or exchange traded. </li></ul><ul><li>Options are available on share, bonds, interest rates, currencies, futures and even options. </li></ul><ul><li>American vs. European </li></ul><ul><li>Vanilla vs. Exotics </li></ul>
  23. 23. Using Derivatives <ul><li>Why use derivatives? </li></ul><ul><ul><li>Hedge Risk of price changes. </li></ul></ul><ul><ul><ul><li>Offset future exposures. </li></ul></ul></ul><ul><ul><ul><li>Guarantee profits. </li></ul></ul></ul><ul><ul><li>Leverage opportunities of price changes. </li></ul></ul><ul><ul><ul><li>Less capital needed to get similar exposures. </li></ul></ul></ul><ul><ul><li>Underlying security my not be available. </li></ul></ul>
  24. 24. For Session <ul><li>Additional Reading </li></ul><ul><ul><li>www.investopedia.com/university/advancedbond </li></ul></ul><ul><ul><li>www.jse.co.za </li></ul></ul><ul><ul><li>www.bondexhange.co.za </li></ul></ul><ul><ul><li>www.safex.co.za </li></ul></ul><ul><li>Markets, Funds, Indices & Trading </li></ul>
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