Investment Management (1)[1488]

INVESTMENT MANAGEMENT
Fifth edition
J MARX
EDITOR
JS DE BEER
RT MPOFU
RH MYNHARDT
Van Schaik
PUBLISHERS
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First edition 2003

Second edition 2006
Third edition 2010
Fourth edition 2013
Fifth edition 2017
ISBN 978 0 627 03463 3

eBook ISBN: 978 0 627 03464 0
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PREFACE
The introduction of an undergraduate paper in Investment Management at

the University of South Africa (Unisa) necessitated a book on the topic that
could be used for a one-semester module. Most works on the topic were
either too voluminous, or were aimed at the postgraduate level, or
overemphasised the situation in the United States. A suitable South African
book on the topic could not be found.
Against this background, the authors embarked on an ambitious project to

write a book on Investment Management. Considerations taken into account
by the authors included the following:
Since three of the authors had participated in the Chartered Financial

Analyst (CFA) programme offered by the CFA Institute, they realised the
need to prepare graduates for Level I of the programme. The book
therefore had to address the Level I learning outcome statements (LOS)
of the CFA Institute pertaining to investment analysis and portfolio
management that prevailed at the time of writing. The work could
obviously not cover the LOS pertaining to statistics and real estate as
well as all the LOS pertaining to economics.
The volume of the book had to be limited to match the time available to
students to study the topic.
The book had to serve as an introduction to the topic of investment
analysis, and therefore provide definitions of a vast variety of concepts,
yet at the same time stimulate interest in the topic and even encourage
postgraduate studies in Investment Management.
It had to include South African examples.
The authors trust that the book has met these requirements and that readers
will find the work both interesting and valuable.
Johan Marx
June 2016
CONTENTS
PART 1 The investment background

Chapter 1 The investment setting
1.1 Introduction
1.2 Wealth, investment, speculation and gambling
1.3 The required rate of return
1.3.1 Real and nominal rates of return
1.3.2 Risk premiums
1.4 Fundamental principles of investment
1.4.1 Time value of money
1.4.2 Risk versus return
1.5 Diversification
1.5.1 Diversification using local asset classes
1.5.2 International diversification
1.6 Investment management process
1.6.1 Establishing investment objectives and constraints
1.6.2 Establishing an investment policy statement
1.6.3 Selecting a portfolio strategy
1.6.4 Selecting the assets
1.6.5 Measuring and evaluating performance
1.7 Summary
References and further reading
Self-assessment questions
Chapter 2 Organisation and functioning of securities markets
2.1 Introduction
2.2 Characteristics of well-functioning securities markets
2.2.1 Availability of information
2.2.2 Liquidity and price continuity
2.2.3 Transaction costs
2.2.4 External efficiency (informational efficiency)
2.3 Primary and secondary markets
2.4 Market structures
2.4.1 Types of transaction
2.4.2 Trading system
2.5 South African securities markets
2.5.1 Equities
2.5.2 Bonds
2.5.3 Financial derivatives
2.5.4 Commodity derivatives
2.5.5 Interest rate derivatives
2.6 Market indices
2.6.1 Uses of market indices
2.6.2 Factors in constructing indices
2.6.3 Weighting schemes
2.6.4 Bond market indices
2.6.5 Using an appropriate index
2.7 Major changes in global securities markets
2.8 Summary
References
Annexure to Chapter 2: Sources of investment information
Chapter 3 Investment theory

3.1 Introduction
3.2 Efficient market theory
3.2.1 Assumptions of the efficient market
3.2.2 Forms of the efficient market hypothesis
3.2.3 Implications of the efficient market theory
3.3 Investment theory
3.3.1 Risk and return: the security market line
3.3.2 Markowitz efficient frontier
3.4 Asset pricing theories and models
3.4.1 Capital asset pricing model
3.4.2 Arbitrage pricing theory
3.5 Summary
Chapter 4 The time value of money

4.1 Introduction
4.2 Nominal and effective interest rates
4.3 Future value
4.3.1 Annual compounding
4.3.2 Intra-year compounding
4.3.3 The future value of an annuity
4.4 Comparing future value and present value
4.5 Present value
4.5.1 The present value of a single amount
4.5.2 The present value of a mixed stream
4.5.3 The present value of an annuity
4.5.4 The present value of a perpetuity
4.6 Variations of future and present value techniques
4.6.1 Deposits to accumulate a future sum
4.6.2 Loan amortisation
4.6.3 Determining growth rates
4.7 Determining the net present value and internal rate of return
4.7.1 Net present value
4.7.2 Internal rate of return
4.8 Summary
References
Chapter 5 Valuation principles and practices

5.1 Introduction
5.2 Valuation concepts
5.2.1 Par value
5.2.2 Market value
5.2.3 Book value
5.2.4 Fair (intrinsic) value
5.3 Required input variables for valuation purposes
5.3.1 Cash flows (returns)
5.3.2 Timing
5.3.3 Discount rate
5.4 Valuation of financial securities
5.4.1 Bond valuation
5.4.2 Preference shares
5.4.3 Ordinary shares
5.4.4 Valuation of investment trusts
5.4.5 Warrants
5.5 Summary
Chapter 6 Fundamental analysis

6.1 Introduction
6.2 Three-step valuation process
6.3 Economic forecasting
6.3.1 Index of leading economic indicators
6.3.2 Economic forecasting models
6.3.3 Market signals
6.4 Macroeconomic analysis
6.4.1 Gross domestic product
6.4.2 Interest rates
6.4.3 Inflation
6.4.4 Budget deficit of the government
6.4.5 Balance of payments
6.4.6 Exchange rates
6.4.7 Unemployment rates
6.5 Industry analysis
6.6 Company analysis
6.7 Summary
PART 2 Equity analysis

Chapter 7 Industry analysis
7.1 Introduction
7.2 The global economy
7.3 Exchange rates
7.4 The domestic economy
7.5 Business cycles
7.5.1 Marking the cycle
7.5.2 Timing the cycle
7.5.3 Can the cycle be predicted?
7.5.4 Methods used in determining the reference turning point of the
business cycle in South Africa
7.5.5 Conclusion
7.6 Industry analysis
7.6.1 Defining an industry
7.6.2 Sensitivity to the business cycle
7.6.3 Industry life cycle
7.7 Industry structure and performance
7.7.1 The threat of new entrants
7.7.2 The bargaining power of suppliers and the bargaining power of
customers
7.7.3 The threat of substitute products and services
7.7.4 The intensity of rivalry among competing firms
7.8 Competitive strategies
7.8.1 Strategic groups
7.8.2 Porter’s generic competitive strategies
7.8.3 SWOT analysis
7.9 Summary
Chapter 8 Company analysis

8.1 Introduction
8.2 Statement of financial performance
8.2.1 Capital costs versus revenue costs
8.2.2 Operational or revenue costs
8.3 Statement of financial position
8.3.1 Assets
8.3.2 Liabilities
8.4 Cash flow statement
8.5 Statement of cash flows
8.5.1 Cash flow identity
8.5.2 A closer look at operating cash flow
8.5.3 Analysing cash flows
8.5.4 Profit versus cash flow
8.6 Financial analysis
8.6.1 Statistical analysis
8.6.2 Subjective analysis
8.6.3 Ratio analysis
8.6.4 Concluding remarks on financial analysis
8.7 Leasing
8.7.1 Advantages of leases
8.7.2 Operating lease
8.7.3 Capital lease
8.8 Summary
Chapter 9 Company valuation

9.1 Introduction
9.2 Investment styles
9.2.1 Growth share or earnings momentum
9.2.2 Value investing
9.3 Measures of value added
9.3.1 What is value added?
9.3.2 Economic profit
9.3.3 Economic value added (EVA®)
9.3.4 Cash value added and the concept of strategic investments
9.3.5 CVA versus EVA® models
9.3.6 Market value added
9.3.7 The secret to creating value
9.3.8 The odds of creating value
9.3.9 Sources of value added
9.3.10 Recommendations
9.4 Earnings multiplier model
9.4.1 Estimating earnings per share for an industry
9.5 Using dividend discount models to value growth shares
9.6 Alternative growth models
9.6.1 Two-stage dividend discount model and H-model
9.6.2 Three-stage dividend discount model
9.6.3 Growth duration model
9.7 Advantages and limitations of dividend discount valuation models
9.8 Relative valuation ratios
9.8.1 Price/earnings ratio
9.8.2 Dividend yields
9.8.3 Price/sales ratios
9.8.4 Price/asset value ratios
9.8.5 Price/cash flow ratio
9.9 Summary
Chapter 10 Technical analysis

10.1 Introduction
10.2 A summary of the underlying assumptions
10.3 Basic charts
10.3.1 Line charts
10.3.2 Bar charts
10.3.3 Volume bar charts
10.4 Indicators
10.4.1 Price fields
10.4.2 Volume
10.4.3 Open interest
10.4.4 The time element
10.4.5 Support and resistance
10.4.6 Linear regression
10.4.7 Trend lines
10.4.8 Supply and demand
10.4.9 Trends
10.4.10 Resistance becomes support
10.5 Moving averages
10.5.1 Interpretation of moving average
10.5.2 Merits
10.6 Leading versus lagging indicators
10.7 Dow Theory
10.7.1 Interpretation and assumptions
10.8 Overbought/oversold oscillator
10.9 Absolute Breadth Index
10.10 Breadth Thrust
10.11 Line studies
10.12 Market indicators
10.12.1 Categories of market indicators
10.12.2 Relative Strength Index
10.12.3 Positive Volume Index
10.13 Challenges to technical analysis
10.14 Summary
PART 3 The analysis of bonds

Chapter 11 Bond fundamentals
11.1 Introduction
11.2 The bond market in South Africa
11.2.1 The Johannesburg Stock Exchange
11.2.2 Government bonds
11.2.3 Municipal bonds
11.2.4 Corporate bonds
11.3 Bond fundamentals
11.3.1 Pricing a bond
11.3.2 Principal value
11.3.3 Coupon rate
11.3.4 Term to maturity
11.3.5 Market value
11.3.6 Yield to maturity
11.4 Bond risk exposures
11.4.1 Interest rate risk
11.4.2 Credit risk
11.4.3 Yield curve risk
11.4.4 Liquidity risk
11.4.5 Call risk
11.5 Bond ratings
11.6 Alternative bond structures
11.6.1 Coupon bonds
11.6.2 Zero-coupon bonds
11.6.3 Bonds with embedded options
11.6.4 Floating rate notes
11.7 Summary
Chapter 12 Valuation of bonds
12.1 Introduction
12.2 Bond calculations
12.2.1 Valuation using a single discount rate
12.2.2 Valuation using multiple discount rates
12.2.3 Valuation of a zero-coupon bond
12.3 Yield measures
12.3.1 Nominal yield
12.3.2 Current yield
12.3.4 Yield to call
12.3.5 Yield to put
12.3.6 Realised (horizon) yield
12.3.7 Spot and forward rates
12.4 Yield curve
12.4.1 Expectations theory
12.4.2 Liquidity preference theory
12.4.3 Segmented market theory
12.5 Measurement of interest rate risk
12.5.1 Duration
12.5.2 Convexity
12.6 Summary
PART 4 Portfolio management

Chapter 13 Portfolio management
13.1 Introduction
13.2 Investment policy statement (IPS)
13.3 Objectives and constraints
13.3.1 Objectives
13.3.2 Constraints
13.3.3 Stage of life
13.4 Asset allocation
13.4.1 Strategic asset allocation
13.4.2 Tactical asset allocation
13.5 Portfolio construction
13.5.1 Measuring return
13.5.2 Measuring risk
13.5.3 Covariance and correlation
13.5.4 Portfolios
13.5.5 Mean-variance analysis
13.5.6 Correlation and diversification
13.5.7 Three-asset portfolio
13.6 Equity portfolio management strategies
13.6.1 Indexing
13.6.2 Buy-and-hold
13.6.3 Market timing
13.7 Bond portfolio management strategies
13.7.1 Passive strategies
13.7.2 Active strategies
13.7.3 Matched-funding techniques
13.7.4 Contingent immunisation
13.8 Summary
Chapter 14 An introduction to derivative instruments

14.1 Introduction
14.2 Trading environment
14.2.1 Derivatives markets and instruments
14.2.2 Purposes and benefits of derivatives
14.2.3 Criticisms of derivatives
14.3 Terminology and concepts
14.3.1 Arbitrage
14.3.2 Hedging
14.3.3 Speculation
14.3.4 Insurance
14.3.5 Short selling
14.3.7 Marking to market
14.3.8 Leverage or gearing
14.3.9 Long and short
14.3.10 Delivery or settlement
14.4 Futures contracts
14.4.1 Futures basics
14.4.2 Futures price and value
14.4.3 Hedging an equity portfolio
14.5 Options
14.5.1 Options basics
14.5.2 Options pricing
14.5.3 Put-call parity
14.5.4 American-style options
14.5.5 Options “Greeks”
14.5.6 Trading strategies
14.6 Swaps
14.6.1 Interest rate swaps
14.6.2 Currency swaps
14.6.3 Equity swaps
14.7 Summary
Chapter 15 Evaluation of portfolio management

15.1 Introduction
15.2 Fundamental issues in performance measurement
15.3 Performance measurement
15.3.1 The Treynor Performance Index
15.3.2 The Sharpe Performance Index
15.3.3 The Jensen Measure
15.3.4 A comparison of the different measures
15.4 Performance attribution analysis
15.5 Portfolio performance presentations
15.5.1 Reporting total return
15.5.2 Evaluation of performance fees
15.5.3 Benchmark portfolios
15.5.4 Measurement of allocation effect
15.5.5 Measurement of selection effect
15.6 Summary
PART 5 Foreign exchange

Chapter 16 Foreign exchange management
16.1 Introduction
16.2 Foreign investment by South African residents
16.3 The foreign exchange market
16.3.1 What is foreign exchange and how does it trade?
16.3.2 Foreign exchange conventions
16.3.3 The bid-ask (or bid-offer) spread
16.3.4 Direct and indirect quotation
16.3.5 Currency appreciation and depreciation
16.3.6 Cross rates
16.3.7 Currency arbitrage
16.3.8 The forward foreign exchange market
16.4 Exchange rate determination and behaviour
16.4.1 Economic and political factors
16.4.2 International parity relationships
16.5 Foreign exchange investments as an alternative asset class
16.6 Summary
Chapter 17 The role of corporate governance in shareholder protection

17.1 Introduction
17.2 The business environment
17.2.1 External and internal factors
17.2.2 Corporate governance and the business environment
17.3 Corporate governance environment
17.3.1 Governance legislation
17.3.2 Governance regulations
17.3.3 Industry codes
17.4 Corporate governance principles
17.4.1 The responsibilities of the Board and senior management
17.4.2 Risk management
17.4.3 Compliance
17.4.4 Disclosure and transparency
17.5 Corporate governance framework
17.5.1 The Board
17.5.2 Committee structures
17.5.3 Operational divisions and support functions
17.6 Ethics in the business environment
17.7 Summary
Annexure A
Annexure B
Index
PART
1
The investment background

OVERVIEW
Part 1 consists of the following chapters:
Chapter 1 The investment setting

Chapter 2 Organisation and functioning of securities markets
Chapter 3 Investment theory
Chapter 4 The time value of money
Chapter 5 Valuation principles and practices
Chapter 6 Fundamental analysis
Chapter 1 explains the concept of required rate of return and deals with the
difference between investment, speculation and gambling. It also explains
the time value of money, risk, and return and diversification. Asset classes
such as real and financial assets are also examined, and attention is given to
international diversification.
Chapter 2 sets out the organisation and functioning of securities markets. It

explains the characteristics of securities markets, and the role of financial
markets as primary and secondary markets. Price-driven and order-driven
systems are also dealt with.
Chapter 3 looks at developments in investment theory, focusing

particularly on efficient market theory, investment theory and asset pricing
theories and models, such as the capital asset pricing model (CAPM) and
the arbitrage pricing theory (APT).
Chapter 4 explains the concept of the time value of money. It deals with
nominal and effective interest rates, moving on from there to the calculation
of future and present value. Attention is also given to net present value and
internal rate of return (IRR).
Chapter 5 deals with valuation principles, including the discount rate and
growth rate of dividends. The chapter also explains the basic valuation
models.
Chapter 6 clarifies fundamental analysis – a top-down approach which

studies macroeconomic prospects, industry prospects and company
prospects. This is an important point of departure for the identification of
the financial assets that should be included in a portfolio.
1 The investment setting
1.1 INTRODUCTION
The goal of investment management is to achieve the investor’s required

rate of return. This chapter gives an explanation of the required rate of
return, and distinguishes between wealth, investment, speculation and
gambling.
The fundamental principles of investment, namely time value of money,

risk versus return and diversification are also analysed.
Risk and its relationship with required return are explained, followed by an
explanation of how the risk of an individual asset can be measured.
The chapter also looks at diversification based on different asset classes and
gives an overview of international diversification. Asset classes are broadly
classified as real assets and financial assets.
The chapter concludes with an overview of the investment management

process.
1.2 WEALTH, INVESTMENT, SPECULATION AND

GAMBLING
Wealth may be created by putting assets to their most productive use in

order to earn a return that will exceed the opportunity cost of making the
investment. The opportunity cost is the best return that could be earned on
an alternative investment. The return should compensate the investor for the
time during which the funds are committed, the expected rate of inflation,
and the uncertainty of the future financial benefits expected from the
investment. This is also referred to as the “required rate of return” of the
investor. The goal of investment management is to find investments that
satisfy the investor’s required rate of return.
Wealth may be measured in various ways. It may be measured by

determining the present value of an income stream or the present value of
an amount available for spending or consumption. It may also be measured
in terms of net worth. Net worth is the difference between the assets and the
liabilities of an individual or firm. Net worth can only be increased by
investing in assets that will increase in value and/or by paying off liabilities.
The most important decision in creating wealth is to decide upon asset

allocation. This is the process of deciding how to distribute an investor’s
wealth among different countries and asset classes for investment purposes.
An asset class comprises securities that have similar characteristics,
attributes and risk/return relationships. The asset allocation decision is a
component of the portfolio management process and is the key factor in
successful investment and the creation of wealth.
Investment may be defined as the current commitment of money, based on

fundamental research, to real and/or financial assets for a given period in
order to accumulate wealth over the long term. The investor may be an
individual, a company, a pension fund, an investment company investing on
behalf of individuals, or a government. Investment is preceded by saving –
in other words, by postponing current consumption.
Speculation involves the commitment of money in the hope of making an

extraordinary profit based on presumptions about the risks and possible
returns associated with a particular transaction.
Gambling involves betting on an uncertain outcome and taking a risk for

the sake of the enjoyment of risk itself, and accepting any return (even a
low return or a loss).
As indicated earlier, the goal of investment management is to find
investments that meet the investor’s required rate of return. The key
determinants of the required rate of return are explained in the following
section.
1.3 THE REQUIRED RATE OF RETURN
The required rate of return is the minimum return an investor should accept
from an investment to compensate him for deferring consumption.
The three components of an investor’s required rate of return are the

following:
The time value of money during the period of the investment

The expected rate of inflation during the period
The risk involved
The time value of money here refers to the real risk-free rate of return
(RRFR), which is the price charged for the exchange between current goods
(consumption) and future goods (consumption). The RRFR is the starting
point in determining an investor’s required rate of return. A risk-free
investment is one which provides the investor with certainty regarding the
amount and timing of the expected returns. Investors view treasury bills
(called T-bills) as risk free, because government has the unlimited ability to
raise revenue from taxes which may, inter alia, be used to service its debt
(i.e. to pay interest and to pay off loans).
To determine the required return, the investor has to determine the nominal
risk-free rate of return and add risk premiums to compensate for risks
associated with the investment. Each of these aspects is explained in greater
detail below.
1.3.1 Real and nominal rates of return
The rate of inflation influences a country’s nominal rates of interest.
Inflation causes a decrease in the purchasing power of a monetary unit, such
as the South African rand.
Two factors influence the nominal risk-free rate (NRFR), namely the
expected rate of inflation and the conditions in the capital market.
1.3.1.1 Inflation and the nominal rate of return

The relationship between the NRFR and the RRFR is given by the
following equation:
NRFR = [(1 + RRFR)(1 + EI) –1] × 100
where:
RRFR = real rate of return (in decimal form)

EI = expected inflation (in decimal form)
Rearranging the equation above enables one to calculate the RRFR on an

investment as follows:
(1+NRFR)
RRFR = [ – 1] × 100
(1+EI)
Example: Assume the RRFR is 3% and the expected rate of inflation is

5%. The NRFR is 8.15%, calculated as follows:
NRFR = [(1 + 0.03)(1 + 0.05) – 1] × 100

= 8.15%
Alternatively, if the nominal rate and the expected inflation rate are
available:
(1 + 0.0815)
RRFR = [ – 1] × 100 = 3%
(1 + 0.05)
In practice the observed or quoted rates on investments are the nominal
rates.
The higher the expected rate of inflation, the higher the nominal rates of
interest. This is also evident from Monetary Policy Committee (MPC)
decisions of the South African Reserve Bank (SARB). Increases in
expected inflation normally lead to increases in nominal interest rates (and
vice versa).
1.3.1.2 Demand and supply conditions in the capital market

Capital markets bring together investors (who want to invest their savings)
and demanders of funds (such as a government that wishes to finance its
budget deficit or companies that wish to expand). Monetary policy and
fiscal policy determine the conditions in the capital market.
Monetary policy refers to the policy of the central bank (SARB in the case
of South Africa) on the control of interest rates based on its expectations
about growth in the economy, the inflation rate and the exchange rate of the
local currency. A growing economy requires companies to expand.
Expansion by companies which has to be financed by means of debt
increases the demand for funds, which can cause interest rates to increase.
The way inflation influences interest rates has been explained above, and
the way the exchange rate and interest rates influence one another is
explained in Chapter 16.
Fiscal policy is determined by the extent to which a government finances its

expenditure by means of taxes and debt. The greater the deficit (the part of
the budget which cannot be financed by taxes), the more money the
government has to borrow in the capital market.
Changes in monetary and fiscal policy affect the demand and supply
conditions in the capital market and cause interest rates to either increase or
decrease. This is explained in greater detail in Chapter 6.
1.3.2 Risk premiums

An increase in the required rate of return over the NRFR is known as a risk
premium (RP). The required RP is a composite of the major sources of risk.
Reilly and Brown (2013) identify the following major types of risk:
Business risk
Financial risk
Liquidity risk
Market risk
Political risk
Callability risk
Convertibility risk
These are briefly discussed below.
Business risk
Business risk refers to the extent of certainty (or lack thereof) about a firm’s
cash flows as a result of the nature of its business. Firms which are sole
suppliers with little or no competition (monopolies) or which provide
products or services for which the demand is inelastic (such as food and
medicine) have greater certainty about their income and cash flows. Such
firms require lower risk premiums than cyclical firms (e.g. motor
manufacturers).
Financial risk
Financial risk refers to the financial leverage (gearing) employed by a firm.
The greater the extent to which debt in relation to equity is used to finance
the firm, the greater the financial leverage and the greater the financial risk.
Financial risk is the possibility that a firm will not be able to service its debt
(in other words that it will default). Any default influences a firm’s
creditworthiness, which leads to a re-rating by credit agencies.
A firm’s ability to raise additional debt financing by issuing bonds depends

to a large extent on credit ratings. Credit ratings give an indication of the
default risk of a firm. AAA rated bonds have a lower risk of default than
BBB bonds, and AAA bonds can therefore provide a lower yield than BBB
rated bonds. Selling new bonds/debentures increases financial risk, which
may impact negatively on a firm’s credit ratings and complicate its future
financing activities. If so, the firm would either not be able to raise further
debt finance, or it would have to offer a greater yield or be subjected to
stricter restrictive covenants.
Should a firm with an AAA credit rating, for example, default and get a BB
rating, then one would have to add a risk premium for this increase in risk.
Liquidity risk
Liquidity refers to the speed of a transaction (time needed to convert an
asset to cash), as well as to the price at which an investment can be sold.
Liquidity risk thus refers to the effort and certainty of trading a specific
investment instrument in the secondary financial markets. Liquid
investments (such as government bonds) are relatively easy to trade and
thus charge a price or liquidity premium. In contrast, under illiquid market
conditions (applicable to, e.g., property or private equity) execution is often
difficult and can only be successful at a lower-than-anticipated price.
Market risk
Market risk refers to adverse movements in the value of equities,
currencies, interest rates and commodities. Currency risk, for example,
refers to the probability of receiving a reduced amount of a domestic
currency when investing in a security that makes payments (in the form of
dividends, interest or principal) in a currency other than the portfolio’s legal
tender. For example, a weak South African rand increases the value of
foreign assets, benefiting a South African investor with an exposure to
international securities. This risk exposure increases as an investment
portfolio becomes more international, and in some cases it could be
detrimental for portfolios to contain equities from emerging economies.
Political risk
Political risk (also called country risk) arises from international and
domestic political risk. International investors face political risks such as
the expropriation of non-residents’ assets and foreign exchange controls.
Domestic political risk arises from changes in legislation and taxes.
The following two sources of risk, namely callability risk and convertibility
risk, may also require a risk premium.
Callability risk
Callability risk refers to the variability of return that derives from the
possibility that bonds or preference shares may be called by the issuing
firm. Callable bonds (paying interest at, say, 12%) may be replaced by
bonds with lower yields (say 10%). This is normally done during periods of
declining interest rates.
Convertibility risk
Convertibility risk is that part of the total variability of return of a
convertible bond or a convertible preference share that reflects the
possibility that the investment may be converted into the issuer’s ordinary
shares at times or under terms which prevent the investor from achieving
his required rate of return.
Thus far the discussion has focused on risk premiums for individual assets.
Risk can be reduced by forming portfolios containing assets with negative
correlations with one another. The total portfolio risk declines as more
securities are added to a portfolio. Adding more shares to the portfolio may
eliminate some of the risk, but not all of it.
Total risk may be divided into two parts: non-systematic (sometimes called
“company-specific” or “diversifiable”) risk, and systematic (sometimes
called “market” or “non-diversifiable”) risk; so that:
Total risk = non-systematic risk + systematic risk
Non-systematic risk relates to events that affect individual companies, such

as the implementation of strategies such as innovation (new product
development), market development (selling existing products in new
markets), diversification (by investing internationally or nationally) and
other activities unique to an individual firm. Because these events occur
somewhat independently, they can be largely diversified away so that
negative events affecting one firm may be offset by positive results from
another firm.
Systematic risk includes general economic conditions, the impact of

monetary and fiscal policies, inflation and political and other events that
affect all firms. Because these risks remain whether or not a portfolio is
formed, the relevant risk is systematic risk. The only risk a well-diversified
portfolio has is systematic risk. Therefore, the contribution of any one
security to the risk of a portfolio is its systematic risk.
1.4 FUNDAMENTAL PRINCIPLES OF INVESTMENT
1.4.1 Time value of money

Time value of money refers to the phenomenon that an amount of money
can increase in value because of interest earned from an investment over
time. Time value of money is used extensively to perform valuations, which
are explained in detail in Chapters 4 and 5.
1.4.2 Risk versus return

Risk is the uncertainty about whether an investment will earn its expected
rate of return. Risk may also be viewed as uncertainty about future
outcomes or the probability of an adverse outcome.
Risk can be divided into non-financial and financial risk. Non-financial or

pure risk is an exposure to uncertainty that has a non-monetary outcome or
implication. Non-financial risk is usually associated with pure danger or
hazard. People face this type of risk on a daily basis. Examples include
smoking (health risk) and speeding (safety risk). What distinguishes these
risks from financial risk is that there can be no financial benefit from an
increased exposure to this risk category. For example, it is obvious that
individuals cannot stand to gain financially from increasing their exposure
to health and safety risks. In other words, a loss or “downside” is possible
(e.g. death), but the most favourable outcome is not an “upside”; it is the
absence of the downside loss (e.g. loss of life). Thus, no gain is possible
relative to the starting position.
Financial risk is associated with a distribution of possible outcomes,

including both negative and positive scenarios. Accordingly, financial risk
can be described as the probability of experiencing an event that has a
negative financial implication, thus a loss. While non-financial risk is an
important and everyday part of human existence, this book focuses on
financial risk, which is predominantly associated with investments, where
investors face the risk of an unexpected decline in the value of their
investments due to risk factors.
Return refers to the sum of cash dividends, interest and any capital
appreciation or loss resulting from an investment. Historical returns may be
measured by means of the holding period return (HPR) and the holding
period yield (HPY).
The HPR is one of the measures of the change in wealth resulting from an
investment.
Example: If you invest R1000 at the beginning of the year and receive
R1120 at the end of the year, the return for the period is:
Ending value of investment
1 120
HPR = =
Beginning value of investment 1 000
= 1.12
A value greater than one indicates an increase in wealth or a positive rate of

return. A value less than one indicates a decline in wealth. A value of nil
would indicate the loss of all one’s money.
In order to express the rate of return in percentage terms on an annual basis,

one can convert the HPR to the HPY. This makes the comparison of
investment alternatives possible.
The HPY is equal to the HPR minus one:
HPY = HPR – 1
Using the figures from the above-mentioned example:
HPY = 1.12 – 1 = 0.12 = 12%
An annual HPY may be found by:

Annual HPR = HPR1/n
where n = number of years the investment is held.
Example: Assume an investment cost R1000 and is worth R1450 after

three years. The HPR is 1.45, calculated as follows:
Ending value of investment
1 450
HPR = =
Beginning value of investment 1 000
=1.45
1/3
Annual HPR = 1.45 = 1.1319
Annual HPY = 1.1319 – 1 = 0.1319 = 13.19%
≈ 13.2%
Keep in mind that the above annual HPY assumes a constant annual yield
for each year, compounded. Also, the end value of the investment may be
the result of a change in the price of the investment alone, income from the
investment alone, or a combination of price change and income.
The above-mentioned explanations are used for historical returns. A

distinction can also be drawn between the required rate of return and the
expected rate of return. Recall that the required rate of return is the
minimum rate of return that one should accept from an investment to
compensate for the time value of money, inflation and risk. The expected
return is a weighted average of all possible (expected) returns, where the
weights are the probabilities assigned to each potential return that could be
achieved (Sears & Trennepohl, 1993: 13).
The risk/return principle simply means that the greater the risk, the higher
the investor’s required rate of return will be.
Next, we explain the measures of risk and clarify the calculation of
expected return.
1.4.2.1 Measures of risk of a single asset

The risk of a single asset may be measured by means of the standard
deviation and the coefficient of variation (CV). In order to calculate these
measures of risk one has to calculate the expected rate of return first.
Expected return
The expected return is calculated by multiplying the probabilities of
occurrence by their associated outcomes, so that:
n
Expected return = k̄ = ∑ ki × Pi
i=1
where:
k = the expected value or expected return

n = the number of possible states
ki = the rate of return associated with the i’th possible state
Pi = the probability of the i’th state occurring
Thus, the expected return is the weighted average of the possible outcomes
(ki values), with the weights being determined by the probability of
occurrence (Pi values). An example of how the expected (mean) rates of
return may be calculated is the following (Marx & de Swardt, 2013: 112):
State of the Probability of state Associated rate of Weighted value (%) (2) ×
economy (1) occurring (2) return (3) (3) = (4)
Company A:
Boom 0.30 30% 9%
Normal 0.40 15 6
Recession 0.30 –10 –3
1.00 exp. k = 12%
Company B:
Boom 0.30 12% 3.6%
Normal 0.40 10 4.0
Recession 0.30 8 2.4
1.00 exp. k = 10%
Expected rates of return will generally not be equal to the actual, or ex post,
rates of return. The actual rate of return depends on which specific state of
the economy occurs. Once the expected value has been calculated, the
standard deviation can be determined.
You first have to calculate the expected return, which is equal to the sum of
the return (k) multiplied by the probability of the return (P).
First we first look at the expected return for Company A:

n
¯
¯¯
k = ∑ ki × P i
i=1
= (0.3 × 30) + (0.4 × 15) + (0.3 × −10)
= 9 + 6– 3
= 12%
Then we work out the expected return for Company B:

n
¯
¯¯
k = ∑ ki × P i
i=1
= (0.3 × 12) + (0.4 × 10) + (0.3 × 8)
= 3.6 + 4 + 2.4
= 10%
Now we can calculate the standard deviation for Company A:

2
σ = √∑ (k − k̄ ) × Pik
i i
2 2 2
= √((130 − 12) × 0.3) + ((15 − 12) × 0.4) + ((−10 − 12) × 0.3)
2 2 2
= √((18) × 0.3) + ((3) × 0.4) + ((−22) × 0.3)
= √((324) × 0.3) + ((9) × 0.4) + ((484) × 0.3)
= √(97.2) + (3.6) + (145.2)
= √246
= 15.6842
The exp(k) that you are referring to is the 30% return minus the 12%
expected return that you calculated. The method can be followed for
Company B.
Standard deviation
One measure of risk or variability is the standard deviation. The standard
deviation is a measure of total risk. It measures how “tightly” the
probability distribution is centred around the expected value. Looking at
Figure 1.1, it is easy to see that B’s possible rates of return are relatively
more tightly bunched than those of A.
Figure 1.1 Discrete probability distributions for two fictitious companies, A and B
However, it is hard to say much more about the riskiness of the two shares
(A and B) without some measure that allows us to determine the spread of
the distribution. The standard deviation is such a measure. It is defined as:
 n
 2
 ¯
σ = ∑ (ki – ki ) × Pki
⎷
n=1
where:
σ = the standard deviation

k = the expected return
ki = the outcome associated with the i’th state
Pki = the probability associated with the i’th outcome
Note that the standard deviation (σ) is the square root of the variance (σ2) of
a distribution.
Example: The standard deviation for A is 15.68% and for B it is 1.55%

(approximated). The following is how the variance and standard deviations
are calculated:
i k exp(k) exp(k)2 × Pi = exp(k)2Pi

1 30% 12% 18 324 × .30 = 97.2
2 15 12 3 9 × .40 = 3.6
3 –10 12 – 22 484 × .30 = 145.2
σ2 = 246.0%
3
2
2
¯
Variance (σ ) = ∑ (ki − ki ) × Pki = 246
i=1
Standard deviation = σ = √246% = 15.6842%
i k exp(k) exp(k)2 × Pi = exp(k)2Pi

1 12% 10% 2 4 × .30 = 1.2
2 10 10 0 0 × .40 = 0
3 8 10 –2 4 × .30 = 1.2
σ2 = 2.4%
3
2
2
¯
Variance (σ ) = ∑ (ki − ki ) × Pki = 2.4
i=1
3 2
Standard deviation = σ = √∑ (ki − k̄i ) × Pki
i=1
σ = √2.4% = 1.5492%
Keep in mind that the bigger the spread of the distribution, the larger the
standard deviation. These results confirm our observation from Figure 1.1
that B’s rates of return are much tighter compared with those of A. In other
words, there is more total risk associated with A because it has a larger
standard deviation.
Two additional points should be made concerning standard deviations. First,

the scale of measurement for the standard deviation is exactly the same as
for the original data and the expected value. In our example, the original
unit of measure was the percentage rate of return. Both the expected value
and the standard deviation are expressed in exactly the same unit. The
information contained in a probability distribution may therefore be
summarised by reporting its expected value and standard deviation. This
statement assumes that the probability distributions are relatively normal.
This assumption, although not strictly true for securities, allows
considerable simplification. Also, for groups of securities in a portfolio, the
portfolio returns tend to be approximately normal.
The second point is that for as long as we are talking about single securities,
the standard deviation, which measures total risk, is the appropriate
measure of risk. If that security is part of a non-diversified portfolio, then
the standard deviation is still a valid measure of risk. (A non-diversified
portfolio might contain two securities, with 95% represented by one
security and only 5% of the portfolio invested in the second security.)
However, when we consider a security that is in a diversified portfolio with
a number of other securities, the standard deviation is not the most
appropriate measure.
The significance of a standard deviation may be evaluated in terms of a
normal distribution. An example of a normal distribution is given in Figure
1.2. A normal probability distribution is one that always resembles a bell-
shaped curve. It is symmetrical: in other words, from the peak of the graph,
the curve’s extensions are mirror images of each other. For normal
probability distributions, 68% of the possible outcomes will lie between +1
and –1 standard deviations from the expected value, 95% of all outcomes
will lie between +2 and – 2 standard deviations from the expected value,
and 99% of all outcomes will lie between +3 and – 3 standard deviations
from the expected value. This corresponds with a common approach to risk,
namely to view risk as determined by the variability on either side of the
expected value, since the greater this variability, the less confident one is
about the outcomes associated with an asset or investment.
Figure 1.2 Normal distribution, with ranges
The standard deviation measures risk on both sides of the expected value. If
the distribution is skewed, with a long tail in one direction or the other, both
the expected return and the standard deviation may be deficient. In those
cases, some other measure is often needed. In reality, however, the returns
on most financial securities are not normally distributed, but rather
lognormal.
The lognormal distribution is positively skewed, with small losses more
likely and extreme gains less likely. In many cases this proves problematic
since most investment pricing models, such as the capital asset pricing
model (CAPM), are based on assumptions of normality with equal
probability of losses and gains. The distribution assumption is, however, not
critical and for the purposes of this book we will simply assume that returns
on all assets exhibit a normal distribution.
Coefficient of variation
The coefficient of variation is a measure of relative dispersion that is useful
in comparing the risk of assets with differing expected returns. When
expected returns differ, the standard deviation should be standardised and
the risk per unit of return calculated. This is accomplished by using the
coefficient of variation (CV). The higher the CV, the greater the risk. To
calculate the CV, the standard deviation is divided by the expected return.
σ
CV =
k̄i
Example: Using the standard deviations and the expected returns for assets
A and B, the CVs are 1.307 (15.684 ÷ 12) and 0.1549193 (1.549193 ÷ 10)
respectively. Based on the CV and assuming the investor is risk averse,
asset B would be preferred because of its lower CV. Asset B has less risk
per unit of expected return than asset A.
1.5 DIVERSIFICATION
Diversification refers to a method of reducing the unsystematic risk of a

portfolio by investing in various asset classes. In fact, the single most
important determinant of return of a portfolio is asset allocation. The
different asset classes and the arguments for international diversification are
explained here.
1.5.1 Diversification using local asset classes
The main asset classes are equity investments (dividend-earning
investments), bonds (interest-earning investments), real estate (rent-earning
investments) and cash. Asset classes can be divided into two groups: real
assets and financial assets.
1.5.1.1 Real assets

Real assets generally involve some kind of tangible asset. An example is
real estate, such as land and buildings in the form of shopping centres,
offices, industrial and residential property. Real assets may also be
commodities, such as gold, platinum and diamonds, as well as
manufacturing equipment. Art and collectible items (such as coins and
stamps) are also examples of real assets.
According to Sears and Trennepohl (1993: 27), the characteristics of a real

asset are the following:
It does not have the same liquidity as a financial asset. Liquidity here
refers to the ability to convert the asset to cash relatively quickly at a
price close to fair market value.
Information on its value is not always readily available.
The characteristics of financial assets are the obverse of the above.
1.5.1.2 Financial assets

Financial assets represent legal claims to some future benefit and are also
called financial instruments or securities.
Examples of financial assets are fixed income securities (such as bonds,

debentures and preference shares) and equity instruments (such as ordinary
shares, known as “common stock” in the US).
Fixed income securities

Fixed income securities are mainly bonds and preference shares. Other
forms of fixed income securities are demand deposits (interest-bearing
cheque accounts), savings accounts, certificates of deposit, money market
funds, eurodollar deposits, treasury bills, treasury notes and banker’s
acceptances.
A certificate of deposit has a stipulated maturity date (ranging between a

month and five years), pays interest at a fixed rate and is evidenced by a
certificate that sets forth the conditions of the deposit.
Money market funds invest money on behalf of investors in money market

instruments such as treasury bills and certificates of deposit. They offer a
low risk, high liquidity investment.
A eurodollar deposit is a dollar-denominated deposit held in a commercial

bank located outside the US.
A treasury bill is a government security with a maturity of less than a year

that pays no periodic interest, but yields the difference between its par value
and its discounted purchase price. A treasury note, on the other hand, is a
government security that pays interest periodically and has a maturity
ranging between one and ten years. (Treasury bonds are government
securities with maturities of more than ten years that pay interest
periodically.)
A banker’s acceptance is a short-term security (normally with an original

maturity of less than 270 days) created when a bank accepts responsibility
on behalf of a borrower to repay an investor; in other words, payment is
guaranteed by both the borrower and the accepting bank. The banker’s
acceptance is a promissory note issued at a discount. These securities are
either held by the accepting bank, sold through dealers or placed directly
with investors.
Bonds
Bonds are securities (contracts) that raise debt financing for private firms or
public utility firms. These firms use the debt to finance their fixed and/or
current assets. The bond is an undertaking by the issuer (the borrower) to
the bondholder (the lender) promising to pay interest (normally every six
months until maturity) and to pay back the principal (at maturity).
Reilly and Brown (2012: 67–69) identify the following kinds of bond:
Secured bonds offer assets as collateral should the issuing firm not be
able to meet its obligations.
Mortgage bonds are backed by liens on specific assets, such as land and
buildings. In the event of bankruptcy, the proceeds from the sale of the
assets are used to pay off the mortgage bondholders. Normally, the
instalments on mortgage bonds provide for both an interest payment and
a repayment of a part of the principal in accordance with an amortisation
schedule.
Collateral trust bonds are mortgage bonds of a kind, except that the
assets backing the bonds are financial assets, such as shares and high-
quality bonds.
Equipment trust certificates are mortgage bonds secured by specific
equipment, such as the aircraft of an airline.
Debentures are promises to pay interest and principal, but they pledge no
specific assets as collateral in the event of the firm not fulfilling its
promise. The bondholder therefore relies on the success of the borrower
to make the promised payment. Debentures nevertheless have restrictive
covenants (indentures) restricting the company from issuing any
additional debentures unless certain conditions are met.
Bonds may also be senior or subordinated. A senior secured bond has the
lowest risk of distress or default, because investors in these bonds have
higher priority claims to the assets in case the borrower goes bankrupt.
Subordinated bonds are similar to debentures, but in the case of default,
subordinated bondholders enjoy claims to the assets of the firm only after
the firm has satisfied the claims of all senior secured bond and debenture
holders.
Income bonds stipulate interest payment schedules, but the interest is due
and payable only if the borrower earns the income to make the payment
by the stipulated dates. Should the firm not be able to pay the interest, it
is regarded as being in arrears and if the necessary income is
subsequently earned, the interest must be paid off. An income bond is
therefore not as safe as a mortgage bond or debenture, and offers a higher
return to compensate investors for the added risk.
Convertible bonds have the interest and principal features of other bonds,
with the added characteristic that the bondholder has the option to return
them to the firm in exchange for ordinary shares.
Treasury bonds are government securities with maturities of more than
ten years that pay interest periodically. Sometimes these government
bonds are also called gilts. Examples of these bonds are the R153
maturing in 2009 and the R184 maturing in 2006.
Zero-coupon bonds promise no interest payments during the lifetime of
the bond, but only the principal at maturity. An example is a zero-coupon
bond promising to pay R100 000 five years from now. At a required
return of 8% and assuming semi-annual compounding, the bond would
have to be sold at R67 556.42 (calculated by means of a financial
calculator using 100 000 as FV, 4 as I/YR, 10 as N and computing PV).
All bonds include indentures. The indenture lists the obligations of the
issuer to the bondholder, including the payment schedule, and features such
as call provisions and sinking funds. A call provision specifies when a firm
can call the bonds before maturity and redeem them. A firm normally uses
the call provision during times of declining interest rates so that current
bonds can be replaced by other bonds paying a lower interest rate. A
sinking fund provision specifies payments the issuer must make to redeem a
given percentage of the outstanding issue prior to maturity.
Preference shares
Preference shares are regarded as fixed income securities because most
preference share dividends are fixed, for example at 7% of par value or R7
preference shares. Preference shareholders receive their dividends first,
before ordinary shareholders receive theirs; they also have priority over
ordinary shareholders in the event of liquidation or bankruptcy. Dividends
on preference shares are usually cumulative; in other words, unpaid
dividends accumulate and must be paid in full before any dividends may be
paid to ordinary shareholders.
A preference share may be callable, in which case it is said to be
redeemable. It may also be convertible into ordinary shares at some
specified conversion ratio (Bodie, Kane & Marcus, 2013: 39).
A preference share is therefore a hybrid security, because in some ways it

resembles a bond and in other ways it resembles an ordinary share.
Equity
The equity of a company consists mainly of the capital raised through the
sale of ordinary shares. This section focuses on ordinary shares and a
derivative related to ordinary shares, namely warrants.
Ordinary shares
Ordinary shares give the investor all the privileges and rights of ownership
in the firm, but with a limited extent of liability, which is measured by the
amount invested in the firm.
As a shareholder, the owner of ordinary shares has two rights: the right to
vote during the election of directors, and a pre-emptive right, that is the
right of refusal on any new share offerings. For example, if a shareholder
owns 5% of a company and the company decides to issue a further 100 000
shares, the shareholder must be given an opportunity to buy 5 000 shares in
order to maintain his shareholding at 5%. If the shareholder does not
exercise this right, his shareholding will be diluted and he might end up
owning only 1% of the ordinary shares of the company. In this respect the
shareholder should participate in any rights issues. A rights issue offers
ordinary shareholders the opportunity to take up additional shares in
proportion to their present shareholding as described above.
South African shareholders used to be issued with share certificates after

buying the shares of a company via a stockbroker. However, the JSE Ltd
(JSE) has discontinued the use of share certificates and now uses a system
called Share Trading Totally Electronic (STRATE) instead. With STRATE,
shareholders’ particulars are kept on computer and no share certificates
have to be exchanged for a transaction to be completed, thus improving the
technical efficiency of the market. Shareholders who insist may be issued
with share certificates, but they have to pay a stockbroker the cost of
rematerialisation. They also have to accept that the sale of such shares will
take longer to complete compared to using STRATE and the electronic
register. The cost of custodianship can nevertheless be eliminated.
Unlike bonds, ordinary shares have no maturity. However, some companies

do buy back ordinary shares from investors and, in some cases, cancel these
shares. This is usually done in order to reduce the number of ordinary
shares issued, thus improving the earnings per share (eps) and return on
equity (ROE) ratios.
Warrants
Warrants are derivative securities that give the holder the right to buy a
stated number of the ordinary shares of the issuing company at a specified
price, called the exercise price, during the life of the warrant. Warrants are
similar to call options, except that they are issued by a company whose own
ordinary shares are the underlying asset. Warrants also have a limited life,
normally two years, during which they may be exercised. Warrants do not
pay dividends, nor do they carry voting rights.
Other investments
There is a variety of other investments available to investors. Some of these
investments are called collective investment schemes, because the funds
contributed by investors are pooled by an investment institution and
invested on behalf of the investors in the kind of assets referred to so far.
The following investments are worth mentioning:
Collective investment schemes (unit trusts)

Investment trusts
Exchange traded funds
Hedge funds
Participation bonds schemes
Unit trusts
Unit trust companies receive investors’ money, issue sub-shares (units) to
investors, pool the money and invest it on behalf of unit holders in
diversified portfolios consisting of various securities. In order to ensure that
unit trusts are sufficiently diversified, unit trust managers are required not to
invest more than 5% of the assets of the fund in any one security. The
service provided to investors is instant diversification and professional asset
management.
Investment trusts
Investment trusts receive investors’ money after selling ordinary shares of
the company to them. The investors’ money is pooled and invested on their
behalf in various securities. Here the investors are called the “participants”
of the share plan. Table 1.1 summarises the differences between unit trusts
and investment trusts.
Table 1.1 Differences between unit trusts and investment trusts
Unit trusts Investment trusts

May not invest more than 5% in any one Freedom to invest in accordance with the
security investment strategy of the trust
Not listed on an exchange Listed share on the JSE
Price determined by trust deed and depends Price determined by supply and demand
on value of underlying securities
According to the JSE, exchange traded funds, or ETFs, are “listed

investment products that track the performance of a group or ‘basket’ of
shares, bonds or commodities. These ‘baskets’ are known as indices. An
example of an index is the FTSE/JSE Top 40 Index. An ETF can be bought
or sold in the same way as an ordinary share. Investors save time and
money as ETFs enable an investor to invest in a variety of asset classes
through a single listed investment product”. They therefore also provide
instant diversification by giving the investor exposure to different sectors,
asset classes, types of share, commodities or government bonds.
Hedge funds
Hedge funds may be described as a pool of private capital structured as a
limited partnership with the objective of consistently achieving returns
exceeding market returns under all market conditions by investing in any
asset class and by using any investment strategy, including leverage,
derivatives and arbitrage. The hedge fund serves as a hedge against market
downturns.
Participants in a hedge fund consist of the investors (called the limited

partners) and the investment manager (called the general partner). Most
general partners have their own money invested in the fund. The general
partner’s compensation is incentive based and depends on the performance
of the fund. A performance fee is usually paid when a threshold (hurdle
rate) is reached. If the fund does not perform above the hurdle rate, no
profit is reallocated to the general partner. Some funds also use a so-called
high water mark. The high water mark is the highest net asset value
previously attained at the end of any prior period. Here the performance fee
becomes due only after the fund value has exceeded this high water mark.
Though the structure is a partnership, investors are limited partners (silent)

and participation is limited to subscription and profits (or losses) with no
liability for the actual company. The structure is managed unilaterally by
the general partner, whose rules and methods, as itemised in the partnership
agreement, are absolute. Since a hedge fund is owned by a few high-net-
worth individuals and/or institutions, it cannot be sold in the open market,
thereby limiting liquidity.
In the US the minimum investment ranges between $250 000 and $1 000
000. A minimum lock-in period, during which no withdrawals are expected,
ranges between three and five years.
Table 1.2 summarises the differences between unit trusts and hedge funds.
Table 1.2 Differences between unit trusts and hedge funds
Unit trust Hedge fund

May not invest more than 5% of Freedom to invest in accordance with the investment
its assets in any one security strategy of the fund
Managed by a fund manager, Managed by a general partner who earns fees based
who gets paid regardless of only on investors’ profits, not losses
whether investors gain or lose
Allowed to advertise Not allowed to advertise
Available to the general public Available to high-net-worth individuals and institutions
by prospectus (satisfying certain requirements) by a confidential offering
memorandum and partnership agreement
Traded daily Illiquid, may not be able to redeem at any time
Small fee to redeem Usually a lock-in period to prevent aborting any strategy
No limit on the number of A private pool of investment capital, limited to the
investors who can invest in the partners
fund
Participation bond schemes

A participation bond scheme pools funds received from investors and lends
them out by means of first mortgage bonds over commercial or industrial
properties. In other words, each loan granted by a manager is funded by a
group of investors who participate in that specific loan – hence the name
participation bond. There are therefore two distinct but closely related
products within a participation bond scheme, namely property finance and
participation bond investments.
1.5.1.3 Risk/return characteristics of the various asset classes

Academics and practitioners alike agree that the most important
consideration in investment planning is the relationship between expected
risk and the subsequent expected level of return. A wide variety of
investment alternatives is available to the investor, ranging from virtually
risk-free government securities (such as treasury bills) to highly risky
derivative instruments. Figure 1.3 depicts a classical economic view of the
risk/return characteristics and trade-off of some of the major asset classes
available to investors. The differences in risk level between the investment
instruments are due to the different sources of risk faced by the investors.
For example, real estate is considered riskier than bonds due to differences
in liquidity between the two markets.
Figure 1.3 The risk/return characteristics of various assets
The reasoning behind Figure 1.3 is relatively straightforward: without an

increasing exposure to risk, investors cannot expect to increase wealth
substantially by earning an increasing return on their investments. The
question, however, is how much risk is required and what level of return
can be expected in the financial markets?
1.5.2 International diversification

Solnik and McLeavey (2014) argue that investors should engage in
international diversification and that the benefits exceed the constraints and
costs.
International diversification may be achieved by investing directly in

foreign bonds and/or shares, by investing in unit trusts (mutual funds) that
invest internationally or by investing in depository receipts. Depository
receipts are locally traded securities that represent a claim to foreign shares.
Such a receipt is like a share certificate and is generally kept by a bank. The
investor is entitled to receive all dividends and capital gains associated with
these shares, although he is still exposed to exchange rate risk.
1.5.2.1 Benefits of international diversification
Solnik and McLeavey (2014) identify the following two benefits of
international diversification:
Risk is reduced.
The risk-adjusted return of the portfolio is improved.
1.5.2.2 Constraints and costs of international investment

Solnik and McLeavey (2014) also identify the following constraints and
costs of international investment:
Unfamiliarity with foreign markets. Investors are often unfamiliar with

foreign languages, cultures, markets, trading procedures and ways of
financial reporting. This psychological barrier in itself creates
uncertainty.
Regulations. In some countries regulations limit the amount of foreign
investment that may be undertaken by local investors, very often for
currency control purposes. Governments may also impose limits on
foreign ownership to a certain maximum percentage of the capital of each
local firm.
Market efficiency. Once an investment has been made, it may be difficult
to get out of some national markets on a large scale; in other words,
liquidity might present a problem. Capital controls and price
manipulation by speculators may also discourage international
diversification.
Risk perception. Once again, unfamiliarity sometimes causes certain risk
perceptions. International diversification, however, requires that currency
risk should be managed by means of options and futures contracts.
Costs. The costs of international investments tend to be higher than those
of domestic investments. Explanations for the relative higher costs are
the following:
– Transaction costs such as brokerage commission range between 0.1%
and above 1% in many countries compared to 0.1% in the US.
Deregulation of capital markets may reduce transaction costs in future.
– International custodian costs tend to be higher for international
investments because normally a master custodian and a network of
sub-custodians are used in every country where investments are made.
The higher costs are also ascribed to the multi-currency system of
accounting, reporting and cash flow collection.
– Taxes may reduce the return on foreign investments, and even if taxes
may be reclaimed after a certain period, the time lag still creates an
opportunity cost.
– Management fees charged by international portfolio managers tend to
be higher than those charged by domestic portfolio managers. This is
because of the cost of international database subscriptions, data
collection, research, international accounting systems, travel and
communication.
1.6 INVESTMENT MANAGEMENT PROCESS
The investment management process may be presented as shown in Figure

1.4. Each of the above-mentioned elements of the investment process is
now briefly explained.
Figure 1.4 The investment management
process
The investment process described here is a general approach. Note,

however, that the investment policy statement (IPS) of an individual and an
institutional investor will differ considerably from one another. Institutional
investors include pension funds, foundations, endowments, insurance
companies and banks.
1.6.1 Establishing investment objectives and constraints

The investment objectives depend on the investor.
If the investor is an individual, the investment objective is strongly
influenced by the phase of his life cycle. Generally speaking, there is an
inverse relationship between age and risk tolerance. A young investor may
want substantial growth and be prepared to accept risk by investing in the
ordinary shares of a growth firm. Investors in their mid-career phase still
have a long time horizon and may be prepared to tolerate risk, but they may
prefer portfolios with less aggressive, more conservative characteristics.
The long time horizon (say 20 years) enables their investments to recover
from short-term fluctuations, such as poor or even negative returns (for 2 or
3 years during the 20-year period). An investor approaching retirement will
probably exhibit a low tolerance to risk and may prefer capital preservation
and investment in money market funds or other fixed-income securities.
If the investor is a financial institution, like an insurance company, it must

invest in such a way as to be able to meet its obligations in terms of the
policies sold, as well as earn a return for the company which sold the
policies. A pension fund must, similarly, invest with the objective of
meeting its pension obligations towards its beneficiaries. Pension funds
may be either defined benefit pension funds or defined contribution funds.
A defined benefit fund exposes the employer to risk, because if the
investments of the fund do not perform well enough to meet its obligations,
the firm is required to make an additional financial contribution to the fund.
With the defined contribution fund, the employee accepts the risk of how
the investments of the fund will perform.
Investor constraints refer to the investor’s knowledge and experience of

investments, as well as capital and cash flow limitations.
If the investor uses a broker or investment company to manage the

investments on his behalf, the broker or investment company assumes a
fiduciary duty. The fiduciary duty requires that the broker or investment
company should act for the benefit of its clients and place the clients’
interests before its own.
A key duty of any investment or wealth manager with a fiduciary duty is

the creation and maintenance of an investment policy statement.
1.6.2 Establishing an investment policy statement
An investment policy statement (IPS) is a written statement which guides
and controls investment decision making because it represents the longterm
objectives of the investor, with due cognisance of the objectives and
constraints of the investor.
The process for generating an IPS is the same for both individual and
institutional clients, but time horizons and unique circumstances play a
more prominent role in the case of individuals’ IPSs.
The written IPS encourages both the investor and the fiduciary to follow a
long-term investment discipline rather than a short-term, impulsive
approach.
The IPS dictates the appropriate investment strategies to be followed,

including the asset allocation decision, the investment style to be pursued,
and the appropriate way to monitor and evaluate performance. The asset
allocation decision indicates how the investor’s wealth will be distributed
between the various asset classes. The IPS should state the ranges within
which the weight (proportion) of each asset class may vary. An example
could be that bonds should make up 10% to 15% of the portfolio, ordinary
shares 40% to 50% of the portfolio and real estate 35% to 50%.
The process of maintaining the IPS is continuous and dynamic. The

fiduciary has to monitor the market environment and possible changes in
the investor characteristics. Normally this has to be done at least once a
year.
1.6.3 Selecting a portfolio strategy

According to Bodie et al., an investor may pursue either an active or a
passive portfolio strategy.
An active portfolio strategy uses information and forecasting techniques to

seek a better performance than would be expected from a well-diversified
portfolio of securities.
A passive portfolio strategy involves minimal expectational input and relies
instead on diversification to match the performance of some market index,
for example the JSE All Share Index (ALSI).
1.6.4 Selecting the assets

This involves the construction of an efficient portfolio. An efficient
portfolio is one that provides the greatest return for a given level of risk.
The assets may be selected based on fundamental and technical analysis.
1.6.5 Measuring and evaluating performance

This involves measuring the portfolio performance and comparing it to an
appropriate benchmark. Normally the benchmark(s) would be indicated in
the IPS. Care must be taken to ensure that the investors’ needs are still
satisfied. The investors’ objectives and constraints must also be reviewed
periodically, but at least annually, in order to determine whether any
changes to the investment objectives are required, and subsequently to the
investment policy and strategy.
1.7 SUMMARY
The goal of investment management is to achieve the investor’s required

rate of return (RRR).
The three components of an investor’s required rate of return are the time
value of money and the expected rate of inflation (EI) during the investment
period, as well as the risk premium (RP).
This chapter has distinguished between wealth, investment, speculation and

gambling.
An overview of various types of real and financial assets was given.

Examples of real assets are real estate, commodities, manufacturing
equipment, art and collectible items. Examples of financial assets are bonds,
preference shares and ordinary shares.
The fundamental principles of investment were explained. The fundamental

principles are time value of money, risk and return, and diversification.
The calculation of expected return, as well as measures of risk, namely the

standard deviation and the coefficient of variation (CV), were explained.
The holding period return (HPR) and holding period yield (HPY) as
measures of historical returns were clarified. Diversification based on local
asset classes and international diversification were explained.
The chapter concluded with an overview of the investment management

process. The investment management process consists of establishing
investment objectives and constraints, writing an investment policy
statement (IPS), selecting a portfolio strategy, selecting assets and, finally,
measuring and evaluating performance.
REFERENCES AND FURTHER READING
Bodie, Z., Kane, A. & Marcus, A.J. 2013. Essentials of investments. New York: McGraw-Hill.
Brigham, E.F. & Ehrhardt, M.C. 2014. Financial management: theory and practice, 4th ed. Mason,
OH: South Western/Cengage Learning.
DeFusco, R.A., McCleavey, D.W., Pinto, J.E., Runkle, D.E. & Anson, J.P. 2007. Quantitiative
investment analysis, 2nd ed. Hoboken, NJ: Wiley.
Marx, J. & De Swardt, C.J. 2013. Financial management in southern Africa, 4th ed. Cape Town:
Pearson.
Reilly, F.K. & Brown, K.C. 2012. Investment analysis and portfolio management, 10th ed.
Independence, KY: Cengage Learning.
Sears, R. S. & Trennepohl, G.L. 1993. Investment management. Orlando, FL: Dryden.
Solnik, B. & McLeavey, D.W. 2014. Global investments, 6th ed. New York: Pearson.
WEBSITES
https://www.fitchratings.com/site/home
http://www.hedgefund-index.com/d_marketrisk.asp
http://www.investopedia.com/
https://www.jse.co.za/trade/equity-market/exchange-traded-products/exchange-traded-funds
https://www.moodys.com/
https://www.standardandpoors.com/en_US/web/guest/home
1. Investment may be regarded as buying:
(a) ordinary shares for the sake of enjoying risk and accepting any return
(b) ordinary shares in the hope of making a quick profit based on a presumption
(c) real estate, ordinary shares and bonds based on fundamental analysis in order
to increase one’s wealth over the long term
(d) real estate for its liquidity and availability of information about its value
2. The most important determinant of wealth creation is:
(a) fundamental analysis

(b) technical analysis
(c) asset allocation
(d) portfolio management
3. The beginning value of an investment in the Satrix 40 share is R500. After 3 years
the ending value is R760. The annual holding period yield (HPY) is closest to:
(a) 1.52%
(b) 14.96%
(c) 20.48%
(d) 26.00%
4. The real risk-free rate of return (RRFR) is 3% and the expected rate of inflation
(EI) is 4.5%. The nominal risk-free rate of return (NRFR) is equal to:
(a) 1.500%
(b) 7.635%
(c) 9.259%
(d) 13.500%
5. A retired investor has R1.2 million to invest. The investor should invest in:
(a) ordinary shares only

(b) ordinary shares, art and antiques
(c) real estate and money market funds
(d) ordinary shares, warrants and antiques
6. Evaluate the riskiness of the following two investments by calculating the following
for each of the alternatives:
(a) the expected return

(b) standard deviation
(c) coefficient of variation (CV)
Investment A Probability Associated return

Boom 0.3 25%
Normal 0.4 20%
Recession 0.3 10%
Investment B Probability Associated return

Boom 0.3 16%
Normal 0.4 12%
Recession 0.3 8%
Solutions
1. (c) Investment may be regarded as buying real estate, ordinary shares and bonds
based on fundamental analysis in order to increase one’s wealth over the long
term.
2. (c) Asset allocation is the most important determinant of portfolio performance.
3. (b) The annual holding period yield is closest to 14.96%.
HPR = 760 ÷ 500 = 1.52
Annual HPR = 1.521/3 = 1.520,333 = 1.1498
Annual HPY = 1.1498 –1 = 0.1496 = 14.98%
4. (b) NRFR = [(1 + 0,03)(1 + 0,045) – 1] × 100 = 7.635%
(c) The investor should invest in real estate and money market funds (based on
capital preservation and liquidity needs at this stage of the life cycle).
6. Investment A Pr Ass. return Weighted

Boom 0.30 25 7.5%
Normal 0.40 20 8%
Recession 0.30 10 3%
1.00 Exp. k = 18.5%
Investment A Pr Ass. return Weighted

Boom 0.3 16 4.8%
Normal 0.4 12 4.8%
Recession 0.3 8 2.4%
1.00 Exp k = 12%
Investment A
Ass. return Exp. k Ass. k – exp. k x2 Pr Weighted
25 18.5 6.5 42.25 0.3 12.675
20 18.5 1.5 2.25 0.4 0.9
10 18.5 –8.5 72.25 0.3 21.675
sum = 35.25
σ = 5.9371710435
CV = 0.3209281645
Investment B
Ass. return Exp. k Ass. k – exp. k x2 Pr Weighted
16 12 4 16 0.3 4.8
12 12 0 0 0.4 0
8 12 –4 16 0.3 4.8
sum = 9.6
σ = 3.098386677
CV = 0.2581988897
2 Organisation and functioning
of securities markets
2.1 INTRODUCTION
A market is simply the means by which buyers and sellers are put in contact
with one another for the purpose of trading goods and/or services. A
securities market enables buyers and sellers to trade securities (financial
assets). The securities traded may be ordinary shares, preference shares,
bonds, warrants, options and futures.
From the above-mentioned description, it should be clear that a market does

not have to be a physical place, as long as the buyers and sellers can
communicate with one another. Advances in communication and computer
technologies increase the possibility of trading from remote locations
without buyers and sellers meeting one another in person at a given
physical location.
A market does not necessarily own the goods or services that are traded.
The market may provide either a physical location or an electronic system
that facilitates communication between buyers and sellers, and provides
information and facilities enabling the transfer of ownership.
Markets are often taken for granted, yet they play a vital role in price
discovery and in ensuring the smooth transfer of ownership of assets in an
economy. Price discovery is the process of ascertaining the correct
economic value of assets. It is vital for efficient markets that free or low-
cost information should reach as many market participants as possible so
that security prices accurately indicate the fair value of the securities.
However, not all financial markets function equally well.
This chapter explains the characteristics of well-functioning markets, the
differences between primary and secondary markets, how markets operate
and how indices are calculated.
2.2 CHARACTERISTICS OF WELL-FUNCTIONING

SECURITIES MARKETS
Not all markets are equally efficient. An efficient market is one in which
investments that have higher expected returns also have higher levels of
risk. The following are characteristics of well-functioning markets (Reilly
& Brown, 2012: 88):
2.2.1 Availability of information

In order to determine an appropriate price, participants must be able to
timeously and accurately determine the volume and prices of past
transactions and all current bids and offers. Well-functioning markets offer
timely and accurate information on the price, volume and prevailing bid and
ask prices.
2.2.2 Liquidity and price continuity

Liquidity here refers to assets which can be bought and sold quickly at a
price close to the prices of previous transactions. Price continuity means
prices do not change much from one transaction to the next unless
substantial new information becomes available. Price continuity requires
depth, which means numerous potential buyers and sellers must be willing
to trade at prices above and below the prevailing market price.
2.2.3 Transaction costs

In a well-functioning market, transactions can be concluded at low costs,
including the cost of reaching the market, the actual brokerage cost and the
cost of transferring the asset.
2.2.4 External efficiency (informational efficiency)
In a well-functioning market, prices rapidly adjust to new information. The
prevailing prices are regarded as fair because they reflect all available
information about the assets and hence the expected returns implicit in the
current price of each security will reflect its risk. A market should be
informationally efficient if the following apply:
A large number of competing, profit-maximising, independent

participants analyse and value securities.
New information arrives randomly.
The competing investors attempt to adjust prices rapidly to reflect the
new information.
The implication of the above is that price changes will be independent and
random.
2.3 PRIMARY AND SECONDARY MARKETS
Financial markets serve as both primary and secondary markets.
A primary market sells newly issued securities of companies (“new issues”)

and is also involved in initial public offerings (IPOs).
In the case of new issues, the firm has already issued and sold shares to the
public, which are traded in the secondary market. An example of a new
issue would be if Mittal SA Ltd decided to issue 1 million additional
ordinary shares at 300 cents each.
An IPO involves the sale of ordinary shares of a company to the public for
the first time. An example of an IPO would be if a company, say Growth
Link (Pty) Ltd decided to list on the JSE and issued a prospectus offering
investors 5 million shares at 100 cents each. The prospectus provides
extensive details of the financial performance of the firm prior to the listing
and shows that it meets the listing requirements, along with a registration
statement and details of the company’s operations. Normally the prospectus
is prepared and distributed by investment bankers.
New issues and IPOs are typically underwritten by investment bankers.

Underwriting can take one of three forms: negotiated, best effort basis, or
competitive bids. With negotiated underwriting the investment banker
acquires the total issue of shares from the company and undertakes to
successfully sell all the shares. If not all the shares are sold to investors, the
underwriter undertakes to buy those shares that could not be sold to
investors. If a best effort basis is used, the investment banker does not buy
the whole issue, but merely acts as a broker and sells whatever it can at the
stipulated price. With competitive bids the issuing company specifies the
securities to be issued and solicits investment banks to undertake the IPO.
Investment bankers also give advice to the company on the characteristics
of the issue and do a valuation of the shares to determine the price at which
they should be sold.
Private placement is an alternative to an IPO. A private placement involves

selling the ordinary shares to a small, selected group of interested investors.
The benefit to the issuing company is lower issuing cost (sometimes called
flotation cost), while for the investor buying the issue (or a part of it) these
cost savings translate into a higher rate of return.
The financial market serves as a secondary market once the shares are
traded among investors. A firm which has sold its shares in the primary
market has the funds available for an indefinite period and may use these to
finance its fixed and current assets. Investors may buy and sell the shares in
the secondary market, but the firm retains the original amount of capital
raised. This amount depends on the number of shares sold, multiplied by
the par value at which they were sold. An example might be a company that
sold 10 million shares at a par value of 200 cents each, thus raising R20 000
000 in financing. Once the shares are traded among investors they assume a
market value, which depends on the supply and demand for the shares.
The secondary market supports the primary market by giving investors

liquidity, price continuity and depth. Investors would be hesitant to buy
securities in the primary market if they expected that they would not be able
to sell these securities if they wanted or needed to do so. Also, without the
liquidity offered by a secondary market, investors would have to be
compensated by much higher rates of return in order to convince them to
invest in what are perceived to be illiquid securities.
The secondary market also supports the primary market by providing

information about current prices and yields. Investment bankers and issuers
of securities in the primary market study the prevailing prices and yields
and take these into consideration when planning new issues or IPOs,
because these prices and yields reflect investors’ expectations.
Over and above the primary and secondary market there are also third and
fourth markets.
“Third market” describes over-the-counter (OTC) trading of listed shares by

involving a broker. This market may be used by investors to trade shares
that are either suspended on the exchange or while the exchange is closed.
“Fourth market” describes direct trading of securities between two parties

with no intermediary broker. This simply involves the sale of securities
directly between individuals or institutions at a mutually acceptable price
(normally the prevailing price on the exchange).
2.4 MARKET STRUCTURES
Market structures refer to the way in which a market is organised and the
role members of the exchange play in completing transactions. As indicated
earlier, liquidity is an important feature of efficient markets. The members
and the way the exchange operates play an important part in ensuring
liquidity.
To become a member of the JSE one must satisfy the requirements laid
down by the Rules and Directives of the Exchange and by the Stock
Exchange Control Act, 1985 (as amended). Details of the requirements may
be found at http://www.jse.co.za.
A broker must also be a member of the South African Institute of

Stockbrokers. To qualify for membership, applicants must, inter alia,
be at least 21 years of age

have passed the membership examination
be fit and proper in terms of criteria as determined by the Institute
have been continuously employed by a member of the JSE for at least six
months.
The various types of transactions and the way the JSE operates are now
briefly explained.
2.4.1 Types of transaction

There are five major types of transaction that investors can enter into,
namely market orders, limit orders, short sales, special orders and margin
transactions.
Market orders are orders to buy or sell securities at the best prevailing price.
Investors often indicate “sell at best” or “buy at best” for these transactions.
Market orders provide liquidity to investors who are willing to accept the
prevailing market price. Limit orders specify the buy or sell price.
Example: An investor expects Absa shares to decline to 2 500 cents and

submits a bid to buy 100 Absa shares at 2 500 cents when the current
market indicates 2 600 cents buy and 2 650 cents sell. The shares will only
be bought once they reach the limit order. Usually the investor must
indicate how long the limit order will be outstanding. A limit order may be
instantaneous (“fill or kill”); good for a day, a week, or a month; open-
ended (no time limit specified); or good until cancelled (GTC).
Short sales involve the sale of shares the investor does not own with the
intention of buying them back at a lower price at a later stage. He would
have to borrow them from another investor, sell them in the market and
subsequently replace them at (hopefully) a price lower than the price at
which he sold them. The investor who lends the shares receives the
proceeds as collateral and can invest this in short-term, riskfree securities. A
short sale can usually only be made on the uptick trade – in other words at a
price higher than the last trade price. Otherwise, short sellers will force a
profit on a short sale by pushing the price down through continually selling
short. In addition, the short seller must pay the lender of the shares the
dividends due to him. The purchaser of the short sale share receives the
dividend from the firm, so the short seller must pay the lender a similar
dividend. A short seller must also post the same margin as an investor who
acquired the shares. This margin may be unrestricted securities owned by
the short seller (Bodie, Kane & Marcus, 2013: 72–73).
Special orders include stop loss orders and stop buy orders. A stop loss
order is a conditional market order that directs the trade should the share
price decline to a predetermined level.
Example: An investor buys a Didata share at 1 000 cents and expects the
share to recover to 2 000 cents. However, it could go down. The stop loss
order indicates to the broker that he should sell it if the price declines to 900
cents. Once the share reaches 900 cents, the stop loss order becomes the
market sell order.
A stop buy order is used by short sellers who want to minimise any loss if
the share increases in value.
Example: An investor sells Paracon shares short at 85 cents, and expects

the price will decline to 70 cents. A stop buy order can protect the investor
by instructing the broker to buy the share if its price increases to 90 cents.
Margin transactions involve the use of borrowing (leverage) to pay for

shares purchased, while the balance is paid for in cash. Buying on margin
means the investor pays for the shares with some cash and borrows the rest
from the broker while making the shares available as collateral. The broker
benefits from the interest paid by the borrower, and normally the interest
rate is 1% to 1.5% higher than the rate charged by banks.
2.4.2 Trading system
The JSE used floor trading (also called the open outcry method) until 7 June
1996, after which the exchange converted to the Johannesburg Equities
Trading system (JET). JET involved the following:
A continuous order-driven system with central market principles

Dual trading capacity, complemented by members voluntarily acting as
market-makers
Fully negotiable brokerage with clients
A new electronic settlement system, called Share Transactions Totally

Electronic (STRATE), has since been introduced. The STRATE initiative is
enabled through the dematerialisation of equity scrip in a Central Securities
Depository. This dematerialisation facilitates settlement and the transfer of
ownership by electronic book entry, which eliminates certificates or
documents of title.
Shares listed on the JSE normally trade in round lots of at least 100 shares.
Odd-lots are permitted and certain brokers provide a service to investors to
trade odd-lots. Odd-lots result from, inter alia, dividend shares where, say,
22 shares are paid out as dividends instead of cash. Normally the cost of
buying and selling odd-lots is higher than that of round lots.
2.5 SOUTH AFRICAN SECURITIES MARKETS
The JSE is South Africa’s major capital market, assisting corporate firms in
raising finance, and equally providing a platform for financial institutions,
pension funds (such as the Government Employees Pension Fund) and
individuals to invest in financial assets.
The JSE offers five financial markets, namely

equities
bonds
financial derivatives
commodity derivatives
interest rate derivatives.
The JSE acquired the South African Futures Exchange (SAFEX) in 2001
and the Bond Exchange of South Africa (BESA) in 2009. In 2003, the JSE
launched an alternative exchange, AltX, for small and mid-sized listings,
followed by the Yield X for interest rate and currency instruments.
2.5.1 Equities
Investors can invest in the ordinary shares of companies. Ordinary shares
enable the investor to vote (inter alia for the directors of the company), earn
dividends from the profits of the firm (if the board of directors declares
dividends) and gain from capital gains (increases in the share price if the
company is managed well).
A company may list on either the main board or the AltX of the JSE. In
order to list on the JSE, a firm has to meet certain minimum requirements.
Some of the requirements are summarised in Table 2.1. These requirements
are subject to change and updates are published at http://www.jse.co.za.
Table 2.1 Principal requirements for a listing on the JSE (June 2016)
Criteria for the main board

Minimum subscribed capital R50 000 000
Minimum equity shares issued 25 000 000
Percentage held by the public 20%
An audited profit history for the previous three years, of which the last shows a profit before
tax of at least R15 000 000
For listing on the AltX, a company issuing shares must, in addition to
the above, comply with the following requirements:
1. The applicant issuer must appoint a registered Designated Adviser (DA).
2. The applicant issuer must have a share capital of at least R2 000 000.
3. The public must hold a minimum of 10% of each class of equity security to ensure
reasonable liquidity.
4. The directors of AltX companies must have completed the AltX Directors Induction
Programme.
5. The applicant issuer must appoint an executive financial director and the DA must be
satisfied that the financial director has the appropriate experience to fulfil his or her role.
6. The applicant issuer must produce a profit forecast for the remainder of the financial year
during which it will list and for one full financial year thereafter.
Source:
https://www.jse.co.za/content/JSERulesPoliciesandRegulationItems/JSE%20Listings%
20Requirements.pdf
Examples of companies that have ordinary shares listed on the main board
of the JSE include Capitec Bank Holdings Ltd and Mondi Ltd.
2.5.2 Bonds
The JSE trades corporate bonds, government (treasury) bonds and repo
bonds (repurchase agreements).
Corporate bonds are issued by companies such as Steinhoff International

Holdings and Standard Bank of SA Ltd.
Treasury bonds (sometimes called gilts) are government securities with

maturities of more than ten years, which pay interest periodically (normally
every six months) and the principal at maturity.
According to the JSE, repurchase agreements (repo bonds or RPs) involve

“the sale of securities, together with an agreement for the seller to buy them
back, usually for more than the original sale price. In effect, a spot sale is
taking place, combined with a forward contract. The spot sale means that
money is transferred to the borrower in exchange for transferring the
security to the lender. The forward contract ensures that the lender’s loan
will be repaid and the collateral will be returned to the borrower. The price
difference gives the lender[s] a return on the money they have lent, similar
to earning interest”. These kinds of transaction are done mainly by banks
and asset managers in order to obtain short-term financing, and by
speculators who wish to short the market.
2.5.3 Financial derivatives

According to the JSE, “the equity derivatives market, formally Safex, was
established in 1988 to provide a secure and efficient on-exchange market
for trading derivatives in South Africa. Today the market provides
professional traders and private investors with a platform for trading
futures, exchange traded CFDs, options and other sophisticated derivative
instruments in a liquid and transparent environment. The regular
administration of margins prevents participants from accumulating large
unpaid losses, which could impact on the financial position of other market
users (systemic risk). In addition, all contracts are cleared by the JSE Clear
clearing house which reduces the credit risk from a traditional over-the-
counter transaction”.
2.5.4 Commodity derivatives

The JSE enables the trading of futures and options on white maize, wheat,
soya beans and sorghum in order to enable commercial producers, millers
and consumers to hedge themselves against adverse movements in the
prices of these commodities. Speculators also attempt to make a profit from
short-term movements in futures prices. Contracts are priced in rand per
ton.
2.5.5 Interest rate derivatives

Investors can also trade on the interest rate derivatives market, using futures
and options on government debt and state-owned company debt, and STIRs
(Short Term Interest Rate) Futures, namely Jibar Futures and LTIRs (Long
Term Interest Rate Futures), namely Swap Futures.
Some shares are listed on exchanges in different countries. Examples of

South African shares listed on the JSE and the London Stock Exchange
(LSE) during June 2016 are given in Table 2.2.
Table 2.2 Some shares listed on both the JSE and LSE (dual listing) at 1 June 2016
Anglo American plc Sappi Ltd

Barloworld Ltd SABMiller plc
Investec plc Tongaat Hulett Ltd
Source: http://www.jse.co.za
Since some securities are listed on more than one exchange, arbitrage is
possible. Arbitrage is the possibility of making a riskless profit by
simultaneously buying a security in one market and selling it in another
market at a higher price without making a capital commitment or
investment.
The above-mentioned securities markets are just three of the many financial
markets worldwide worldwide. In fact, the trading of securities takes place
continuously 24 hours per day because trading begins and ends somewhere
in the world during daylight. This is sometimes referred to as the global 24-
hour securities market. Reilly and Brown (2012: 98) regard the New York
Stock Exchange (NYSE), London Stock Exchange (LSE) and Tokyo Stock
Exchange (TSE) as the major segments of this global 24-hour securities
market. The hours these markets are open (and in relation to South Africa)
are set out in Table 2.3.
Table 2.3 The trading times of some of the major stock exchanges
Stock market Local time South African time

Tokyo 09:00–11:00 02:00–04:00
13:00–15:00 06:00–08:00
Johannesburg 09:00–17:00 09:00–17:00
London 08:15–16:15 09:15–17:15
New York 09:30–16:00 15:30–22:00
The performance of a market (as reflected by indices) that has closed in one
country gives important clues about trends in capital markets to a market in
another country at commencement of trade. Market indices therefore need
to be interpreted correctly.
2.6 MARKET INDICES
Market indices are a convenient way of providing investors with an

indication of the movement of the aggregate market. If the overall market
rises, an investor with a diversified portfolio of assets will expect that his
portfolio will also increase in value. Details of the various indices are
published daily in newspapers and reported on television. A list of these
publications and broadcasters appears in the annexure to this chapter.
However, many investors do not know how to use and interpret the indices.
2.6.1 Uses of market indices

According to Reilly and Brown (2012: 116), security market indices are
used for the following purposes:
As benchmarks to evaluate the performance of professional portfolio

managers. Any investor should be able to randomly select shares and
bonds and earn a rate of return comparable to the market return. A
superior portfolio manager should be able to outperform an individual
investor and the market.
To create and monitor an index fund. The objective of an index fund is to
track the performance of the specified index over time and to at least
achieve similar rates of return. The fund (portfolio) may consist of either
ordinary shares or bonds.
To measure market rates of return in economic studies. Investment
analysts study the factors that influence local market movements and the
correlation between various markets.
To predict future market movements. Technical analysts believe past
price changes can be used to predict future movements.
As a proxy for the market portfolio of risky assets when calculating the
systematic risk of an asset. In terms of capital market theory the relevant
risk of an asset is its systematic risk. Systematic risk is the relationship
between the rates of return for a risky asset and the rates of return for a
market portfolio of risky assets.
2.6.2 Factors in constructing indices

The factors used in constructing an index are the following:
The size, breadth and source of the sample. The sample should be
representative of the total population.
The weight given to each constituent of the sample. The weighting
scheme may be a price-weighted series or a value-weighted series or an
equally weighted series.
The calculation procedure, whether it is an arithmetic average or
geometric average of the constituents, or an index that reflects all
changes reported in terms of the basic index.
2.6.3 Weighting schemes

As indicated above, the weighting scheme may be one of the following:
A value-weighted series calculated by determining determining the initial

total market capitalisation of all shares used in the series:
Market capitalisation = number of shares issued × price per share
This figure is used as the base (initial) figure and assigned an index
value (say, 100). Thereafter a new market value is calculated for all the
securities included in the index. This is compared to the base value to
determine the percentage change and related to the beginning index
value.
A price-weighted series is an arithmetic average of current prices, which
means that index movements are influenced by the differential prices of
the constituents. The price index is defined as the total market
capitalisation divided by the index divisor, referred to as the k-factor.
Total market index
Index value =
Index divisor
The index divisor or the k-factor is attached to all corporate actions in an

attempt to adjust these actions to keep the index constant. Any capital
structure change (such as a share split) needs to be accommodated in the
index divisor.
An equally weighted series (or unweighted series) is an index of shares

where each share carries an equal weight regardless of its price or market
value.
Examples of a few indices of various securities markets are given in Table

2.4.
Table 2.4 Examples of a few indices of various securities markets
Number of
Name of index Weighting Source of shares
shares
Dow Jones Industrial Average Price 30 New York Stock Exchange
(NYSE)
S&P 500 Market 500 New York Stock Exchange
value (NYSE), OTC
Nasdaq Composite Market OTC
value
Nikkei Average Price 225 Tokyo Stock Exchange
(TSE)
Financial Times Actuaries Index Market 700 London Stock Exchange
(FTSE) All Share value (LSE)
Hang Seng Index Market 33 Hong Kong
value
JSE Actuaries All Share Index (JSE Market 461 JSE Limited
ALSI)* value
* Note that the JSE also calculates sectoral indices, for example
the Gold Index (GLDI), the Financial Index (FINI) and the Industrial
Index (INDI).
2.6.4 Bond market indices

Bond market indices are also used as benchmarks to evaluate the
performance of bond portfolios and to measure rates of return. According to
Reilly and Brown (2012: 127), the creation and calculation of a bond index
are more difficult than those of an equity market index, for the following
reasons:
The universe of bonds is much broader than that of shares.

The universe of bonds changes constantly because of new issues, bond
maturities, calls and bond sinking funds.
The volatility of prices for individual bonds and bond portfolios changes
because bond price volatility is affected by duration. Duration in turn is
influenced by changes in maturity, coupon and market yield.
Problems exist in pricing the individual bond issues in an index
compared to the current and continuous transactions prices available for
most shares used in share indices.
In South Africa there are three main bond indices, namely the All Bond
Index (ALBI), the Government Bond Index (GOVI) and the Other Bond
Index (OTHI). These South African bond market indices are explained in
Chapter 10.
2.6.5 Using an appropriate index

Not all indices are equally appropriate as benchmarks. An analyst should
use an index that is consistent with the investment universe and philosophy.
Failure to apply this principle will result in incorrect conclusions.
Example: A portfolio manager investing worldwide should not use the JSE
All Share Index (ALSI) as a benchmark. It would be advisable rather to
consider the Salomon-Russell World Equity Index, which covers 22
countries, plus a composite world index.
2.7 MAJOR CHANGES IN GLOBAL SECURITIES

MARKETS
Some of the major changes that have occurred during the past two decades
in global securities markets are summarised below:
Negotiated (competitive) commissions. Stock exchanges have moved

away from regulated, fixed commissions charged by brokers who do not
promote competitiveness and efficiency. In the US the use of fixed
commissions led to a practice known as “soft dollars”. This is a form of
compensation to a portfolio manager which is generated when he
commits the investor (his client) to paying higher brokerage fees in
exchange for the manager receiving additional services (investment
research for example) from the broker. The CFA Institute (formerly the
AIMR) had to introduce measures in their Code of Ethics to deal with
“soft dollars”. Negotiated commissions were introduced at the LSE in
1986, and the JSE only followed suit in 1996.
The influence of block trades. Block trades involve the sale of a large
number of shares, for example 60 000 shares offered for sale by a unit
trust company at R120 each. Brokers do not like to buy such blocks and
resell them in smaller blocks of, say, 10 000 shares each, because of the
large amount involved and the risks associated with such large
transactions. If such a large block is sold instantly and directly in the
market, the share price may decline significantly.
The influence of share price volatility. Share price volatility may increase
as a result of the dominance of stock markets by institutional investors
and block trades (as suggested above).
New exchanges and consolidations. New exchanges have recently
opened in emerging economies, such as Poland, Sri Lanka, China,
Hungary and Peru. On the other hand, exchanges in developed countries
are consolidating (merging) in order to obtain economies of scale. The
high cost of electronic trading and the benefits of attracting more
members to consolidated exchanges have played a major role in this
regard. For example, in the US the National Association of Securities
Dealers (NASD) merged with the American Stock Exchange (AMEX),
and the Philadelphia Stock Exchange joined the NASD/AMEX shortly
thereafter.
Increased automisation. South Africa has discontinued the trading of
shares by means of the auction method, also known as the open outcry
method. Under this method a trader on the floor gave preference to
bigger transactions at the expense of the transactions of small investors in
an attempt to maximise the commission earned. South Africa has also
discontinued the use of share certificates, a process known as
dematerialisation, and moved to Share Trading Totally Electronic
(STRATE). These steps were taken in order to improve the efficiency of
the JSE and to bring it in line with overseas stock exchanges.
2.8 SUMMARY
This chapter described the characteristics of well-functioning markets and

explained the differences between primary and secondary markets, how
markets operate and how indices are calculated.
Well-functioning markets offer timely and accurate information on the

price, volume, and prevailing bid and ask prices. They also offer liquidity,
low transaction cost and informational efficiency.
A securities market serves as both a primary and a secondary market. As a

primary market it helps investment bankers sell new issues and initial
public offers (IPOs). The secondary market ensures liquidity, price
continuity and depth to the primary market. The secondary market also
gives a reflection of investors’ expectations by providing information about
prices and yields.
Security market indices are used as benchmarks to evaluate the

performance of professional portfolio managers, to create and monitor an
index fund, to measure market rates of return in economic studies, for the
prediction by technical analysts of future market movements and as a proxy
for the market portfolio of risky assets when calculating the systematic risk
of an asset.
The factors used in constructing an index are the size, breadth and source of
the sample, the weight given to each constituent of the sample and the
calculation procedure.
The weighting scheme may be a price-weighted series, a value-weighted

series or an equally weighted series.
Some of the changes that have taken place in stock exchanges during the
past two decades were explained. These include negotiated commissions,
block trades and resultant greater volatility, new exchanges in emerging
economies, consolidations in developed economies, and increased
automisation.
REFERENCES
WEBSITES
http://www.jse.co.za
http://www.jse.co.za/about/history-company-overview
http://www.jse.co.za/content/JSERulesPoliciesandRegulationItems/JSE%20Listings%20Requirement
s.pdf
1. A market is efficient if:
(a) timely and accurate information is available

(b) a large number of participants analyse and value securities
(c) price continuity does not prevail
(d) (a) and (b) above
2. The trading of securities directly between two institutions takes place in the:
(a) primary market

(b) secondary market
(c) third market
(d) fourth market
3. Mr Almeroux Loubser calls his broker and instructs that 1 000 Old Mutual shares
be sold at 1 660. Assume Old Mutual shares are currently trading at 1 650. Mr
Loubser expects the share price to decline to 1 600 and borrows the shares from
RMB Asset Managers. This is an example of a:
(a) limit order

(b) short sale
(c) margin transaction
(d) special order
4. A market index may be used for … and should be …
(a) benchmarking; representative of the population

(b) predicting movements; reflective of all changes in the economy
(c) measuring rates of return; representative of the sample
(d) creating an index fund; registered with the Financial Services Board
5. “Soft dollars” refers to the:
(a) weakening of the dollar against the pound sterling

(b) paying of higher brokerage by a fund manager so that his clients may receive
investment research reports
(c) paying of higher brokerage by an investor so that his fund manager may obtain
investment research reports
(d) weakening of the dollar against the rand
Solutions
1. (d) A market is efficient if, inter alia, timely and accurate information is available
and a large number of participants analyse and value securities.
2. (d) Shares are traded directly between institutions in the so-called fourth market.
3. (b) It is an example of a short sale.
4. (a) A market index may be used for benchmarking and should be representative
of the population.
5. (c) “Soft dollars” means an investor pays higher brokerage so that his fund
manager may receive investment research reports from the broker.
ANNEXURE TO CHAPTER 2: SOURCES OF
INVESTMENT INFORMATION
Publications
Business Day
Financial Mail
F&T Weekly
The JSE Handbook
MacGregor’s Who Owns Who
Quarterly Bulletin of the South African Reserve Bank
Sunday Times Money
Internet
http://www.cfainstitute.org CFA Institute
http://www.fsb.co.za Financial Services Board (FSB)
http://www.iNetBFA.com
http://www.jpmorgan.com JP Morgan
http://www.jse.co.za The JSE Limited (JSE)
http://www.resbank.co.za South African Reserve Bank (SARB)
http://www.unittrustsurvey.co.za Quarterly unit trust survey
http://www.valueline.com Value Line
DStv television broadcasts

Bloomberg’s
CNN
BBC
Summit Television
CNBC
Databases
Bureau for Financial Analysis
iNetBFA
Academic journals
Financial Analysts Journal
Financial Review
Investment Analysts Journal
Journal of Finance
Journal of Financial Economics
Journal of Financial and Quantitative Analysis
Journal of Financial Research
Journal of Fixed Income
Journal of Portfolio Management
Real Estate Finance
Societies
Investment Analysts Society of Southern Africa (IASSA)
PO Box 131
Ferndale
2160
CFA Institute
PO Box 3668
Charlottesville
Virginia 22903
United States of America
3 Investment theory
3.1 INTRODUCTION
Investment theory attempts to explain the way in which investors specify

and measure risk and return in the valuation process.
The efficient market theory, which is explained in this chapter, is an

important component of investment theory. It deals, inter alia, with the
three forms of the efficient market hypothesis: the weak, semi-strong and
strong forms.
Broadly speaking, investors are faced by systematic and unsystematic risk.

They deal with risk by constructing portfolios which are diversified
(invested in various asset classes in order to reduce risk). Investment theory,
particularly Markowitz’s modern portfolio theory, explains risk aversion as
a phenomenon. The basic assumptions of investor behaviour are also
explained.
There are two important theories about risk and return – these are the
capital asset pricing model (CAPM) and the arbitrage pricing theory (APT).
Each of these theories attempts to identify the risk factors faced by
investors and to quantify these so that the required rate of return can be
determined. Each of these models can be used to determine whether an
asset is over or undervalued.
3.2 EFFICIENT MARKET THEORY

An efficient market may be defined as one in which the prices of securities
adjust rapidly to the arrival of new information. This implies that the
current prices of securities reflect all the information about a security. An
efficient market is also one in which investments with higher expected
returns have higher levels of risk. As indicated in Chapter 2, not all markets
may be regarded as equally efficient.
3.2.1 Assumptions of the efficient market

The following are the assumptions of an efficient market:
It requires a large number of independent, competing, profit-maximising

participants who analyse and value securities.
New information regarding securities comes to the market in a random
fashion. The timing of the announcements is independent.
The competing investors attempt to adjust security prices rapidly to
reflect the effect of the new information. It is also assumed that the
adjustment is unbiased.
Investors therefore expect price changes to be independent and random.

They also assume that the expected returns implicit in the current price of a
security are a reflection of its risk. There are three forms of the efficient
market hypothesis (EMH): the weak, the semi-strong and the strong form.
3.2.2 Forms of the efficient market hypothesis

The weak form assumes that current security prices fully reflect all security
market information. Security market information includes security prices,
trading volume and rates of return.
The semi-strong form assumes that security prices adjust rapidly to all
public information. The semi-strong form encompasses the weak form
because all the market information is considered to be public. Public
information is regarded as market information plus information such as
economic and political news, as well as news about companies such as
mergers and acquisitions, earnings and dividend announcements.
The strong form assumes security prices fully reflect all information, from
both public and private sources. The strong form extends the assumption of
efficient markets to assume perfect markets. A perfect market would exist if
all information were cost free and available to everyone at the same time.
3.2.3 Implications of the efficient market theory

The efficient market theory has implications for investment analysts and
portfolio managers. Investment analysts use fundamental and/or technical
analysis.
3.2.3.1 Implications for fundamental analysts

Fundamental analysts believe security values depend on underlying
economic factors. Fundamental analysis requires the analyst to estimate
macroeconomic prospects, such as gross national product (GNP), inflation
and interest rates. Based on the macroeconomic prospects, the fundamental
analyst has to identify the industries that stand to gain most from the
expected macroeconomic conditions. Within the industries identified, the
fundamental analyst has to identify companies that are undervalued. The
fundamental analyst will recommend buying a security if the market value
is below intrinsic value and selling it if the market value is above intrinsic
value. The implication of the EMH hypothesis for fundamental analysis is
that above-average rates of return can only be achieved if one has access to
reports of superior analysts and if one is able to invest (buy) before the rest
of the market realises there is a discrepancy between market value and
intrinsic value (superior market timing).
3.2.3.2 Implications for technical analysts

Technical analysts use graphs and charts to identify buying and selling
signals from market information. They believe individual investors do not
analyse information and act immediately. Rather, investment professionals
disseminate information to aggressive investors and the information
gradually reaches the rest of the market. They also contend that security
prices move in persisting trends. The EMH states that security prices fully
reflect all relevant information and adjust rapidly. The implication of the
efficient market hypothesis for technical analysis is that the use of historical
trading information only should not enable the investor to generate
abnormal returns, particularly if risk and transaction costs are taken into
consideration.
3.2.3.3 Implications for portfolio managers

Portfolio managers can either manage portfolios actively or passively (buy-
and-hold). Normally the passive strategy is pursued if the portfolio manager
does not have superior analysis, nor the time and ability to do asset
allocation in order to be a superior investor. In that event the portfolio
manager would have to
establish risk preferences and construct a portfolio that matches the

acceptable risk level
completely diversify so that the portfolio performance moves in line with
the market
minimise transaction costs by minimising taxes, reducing trading
turnover and investing in liquid securities (to avoid losses due to illiquid
securities). Liquid securities are normally those included in the
calculation of indices.
One of the implications of the EMH for portfolio management, given the
above-mentioned considerations, is that the equity portfolio manager
without superior analysis, time and ability to do asset allocation, should set
up an index fund (also called a market fund). An index fund is a portfolio
designed to duplicate the composition and performance of a selected market
index series, such as the All Share Index (ALSI), the Financial Index
(FINI), the Gold Index (GLDI) or Industrial Index (INDI) of the JSE. In
South Africa, exchange traded funds (ETFs) fulfil this need and one may
invest in an EFT tracking the financial index (FINI), the Resources Index
(RESI), the top 40 companies and several others. For details, visit
http://www.jse.co.za.
3.3 INVESTMENT THEORY
Investment theory attempts to explain the way in which investors specify

and measure risk and return in the valuation process. Because investors are
rational, as risk increases so will their required rate of return.
The development of investment theory was accelerated once a concept

known as the riskfree asset was introduced by researchers such as Sharpe
(1964), Lintner (1965) and Mossin (1966). A risk-free asset is an asset with
zero variance, which has zero correlation with all other risky assets, and
which produces a risk-free rate of return (Rf). This implies a standard
deviation (σRf) of zero for the risk-free asset, because its expected return
will equal its actual return. On the other hand, a risky asset is characterised
by uncertain future returns which can be measured by the variance (σ2) or
standard deviation (σ) of expected returns.
3.3.1 Risk and return: the security market line

The security market line (SML) reflects the best combinations of risk and
return available on alternative investments. A portfolio consisting of risk-
free assets and combinations of alternative risky assets can be constructed.
The standard deviation of such a portfolio is the linear proportion of the
standard deviation of the risky asset portfolio. On a graph such a
combination creates a straight line between the assets, because both the
expected return and the standard deviation of return are linear
combinations. This may be regarded as a security market line (SML), an
example of which appears in Figure 3.1.
Figure 3.1 The security market line (SML)
Individual investors will choose investments based on their risk preferences

as demonstrated by risk indifference curves, which are illustrated in Figure
3.2. With high risk aversion the investor would be prepared to accept a
relatively low rate of return and an optimal investment, as indicated by
point A in Figure 3.2, while with low risk aversion the investor may be
prepared to accept a higher return for additional risk and an optimal
investment, as indicated by point B in Figure 3.2. The steeper the
indifference curves the higher an investor’s risk aversion.
Figure 3.2 Risk indifference curves on the SML
Three changes may occur with respect to the SML, namely movements
along the SML, changes in the slope of the SML or a parallel shift in the
SML.
A movement along the SML would be due to a change in the perceived
risk of an investment. The consequence is that an investment is now
required to generate a higher return if it is to remain an attractive
investment alternative. The SML remains unchanged, as indicated in
Figure 3.3(a).
Figure 3.3 Changes in the SML
Changes in the slope of the SML would be caused by a change in the

return required per unit of risk. This change occurs because the market
risk premium is not constant over time. If the market risk premium
changes, this will affect the required return for every risky asset even if
there is no change in each asset’s risk profile. This is illustrated in Figure
3.3(b).
A parallel shift would occur if there was a change in the nominal risk-
free rate. This shift would affect the return required on all assets. This is
illustrated in Figure 3.3(c).
Investors face systematic and unsystematic risk when making investment

decisions (see Figure 3.4). Systematic risk is that element of risk in a
security that cannot be diversified away. The risk is caused by factors that
influence the entire market. Examples are changes in interest rates, inflation
and exchange rates between currencies. Unsystematic risk, on the other
hand, can be diversified away. Research indicates that an investor needs
around 12 diverse securities in a portfolio to eliminate most of the
unsystematic risk (Evans & Archer, 1968: 761–767; Tole, 1982: 5–11).
Figure 3.4 Systematic and unsystematic risk
3.3.2 Markowitz efficient frontier

The Markowitz efficient frontier represents that set of portfolios (of risky
investments) that has the maximum return for every given level of risk, or
the minimum risk for every level of return. Individual securities are
unlikely to be on the efficient frontier due to the benefits of diversification.
Figure 3.5 excludes the possibility of combining investments which are, or

are close to being, perfectly negatively correlated. This is consistent with
the real world. Consequently the efficient frontier is a curve (not a straight
line) which will not touch the y axis.
Figure 3.5 The efficient frontier
Markowitz regards portfolio risk as the square root of the weighted average
of the individual variances plus the weighted covariance between pairs of
individual assets, which translates into the following equation for the
measurement of portfolio risk (σp):
 n n n

2 2
σp =  ∑ w σ + ∑ ∑ wi wj COVi,j
i i
⎷
i=1 i=1 j=1
For a two asset portfolio the Markowitz portfolio risk equation simplifies
to:
 2

 2 2
σp = ∑w σ + 2wi wj COVi,j
i i
⎷
i=1
The above-mentioned aspects are explained in greater detail in Chapters 14

and 15.
3.4 ASSET PRICING THEORIES AND MODELS
The two most common theories about asset pricing are the capital asset
pricing model (CAPM) and the arbitrage pricing theory (APT). In both
instances it should be remembered that investors are risk averse, and that
for any increase in risk they require an increase in their required rate of
return. The asset pricing theories therefore reason that if one could measure
the risk, one should be able to determine the required rate of return.
3.4.1 Capital asset pricing model

The CAPM indicates the return an investor should require from a risky
asset assuming that he is exposed only to the asset’s systematic risk as
measured by beta (β). The rationale is that for any level of risk, the SML
indicates the return that could be earned by using the market portfolio and
the risk-free asset. This provides a benchmark return against which one can
assess any investment.
The assumptions of the CAPM, the impact of the risk-free asset and the
calculation and interpretation of beta (β) are explained below.
3.4.1.1 Assumptions of capital market theory

The following assumptions underpin capital market theory:
Investors are risk averse and rational. Each investor wants to invest
somewhere on the efficient frontier in line with his required risk and
return levels.
Investors can borrow or lend any amount at the risk-free rate (Rf).
Investors have homogeneous expectations: in other words, they estimate
identical probability distributions for future rates of return.
Investors have the same one-period time horizon, which could be a
month, six months or a year.
Investments are infinitely divisible. This means one is able to buy or sell
fractions of any asset or portfolio.
There are no taxes or transaction costs involved in buying or selling
assets.
There is no inflation, or any change in interest or inflation rates is fully
anticipated.
Capital markets are in equilibrium; in other words, all assets are properly
priced in line with their risk levels.
3.4.1.2 Calculation and interpretation of beta (β)

The equation used in CAPM is:
Required return = Rf + βi (km – Rf)
where:
Rf = the risk-free rate of return

βi = beta
km = return on the market portfolio
The market risk premium is found by km – Rf.
One may calculate the beta of an individual security and for a portfolio. The
beta (β) of an individual security may be found by means of the following
equations:
Systematic risk of security i
β =
Market risk
Covariancei,m
β =
Variancem
Corri,m σi σm
β =
2
σm
Graphically, beta (β) can be interpreted as shown in Figure 3.6.

Figure 3.6 Graphical interpretation of beta (β)
The beta of a portfolio (βp) is the weighted average of the individual betas.
The weights should reflect the proportion of the portfolio’s value
represented by each asset.
βp = wiβi + wjβj + … wnβn
where:
βp = beta of the portfolio

w = weight (proportion) of portfolio
βi = beta of asset i
Example: A portfolio consists of the following assets with associated betas:
Security Beta Value

X 0.9 R1 000 000
Y 1.2 R2 000 000
Z 0.7 R2 000 000
The beta of the portfolio may be calculated as follows:

R1 000 000 R2 000 000 R2 000 000
βp = ( ) × 0.9 + ( ) × 1.2 + ( ) × 0.7
R5 000 000 R5 000 000 R5 000 000
β = (0.2 × 0.9) + (0.4 × 1.2) + (0.4 × 0.7)

p
β = 0.18 + 0.48 + 0.28 = 0.94

p
3.4.1.3 Capital market line

Thus far the SML has made no provision for lending and borrowing. If an
investor is able to borrow at the risk-free rate, then the risk and return will
increase in a linear fashion along the original line (Rf–M) as indicated in
Figure 3.7. This extension dominates all assets or portfolios below the line
on the original efficient frontier. The newly created efficient frontier is a
straight line from the risk-free rate (Rf) tangent to point M, and is called a
capital market line (CML). This implies that all portfolios on the CML are
perfectly positively correlated.
Figure 3.7 Capital market line (CML) assuming lending or borrowing at the
risk-free rate
Because Portfolio M lies at the point of tangency, it has the highest

portfolio possibility line, and every investor would want to invest in
portfolio M and borrow or lend to be somewhere on the CML. This
portfolio must include all risky assets. A portfolio that includes all risky
assets in proportion to their market value is called the market portfolio. The
investor could invest part of his portfolio in the risk-free asset and the rest
in the risky portfolio M, or he could borrow at the riskfree rate and invest
the borrowed sum in the risky asset portfolio (Reilly & Brown, 2012: 198).
For an investor to be on the CML efficient frontier, he initially decides to

invest in the market portfolio (M). This is the investment decision.
Subsequently, based on his risk preferences, he will make a separate
financing decision to either borrow or lend to attain his preferred point on
the CML. Tobin calls this division of the investment decision and the
financing decision the separation theorem (Tobin, 1958: 65–85).
One of the differences between the CML and the SML is that risk is
measured by means of variance in the case of the CML, while risk is
measured by means of beta in the case of the SML. Beta and the use of
CAPM are explained in the next section.
3.4.1.4 Using CAPM to assess an asset
An investment in an asset can be assessed by means of CAPM to determine
whether an asset is over or undervalued. The estimated rate of return is the
actual holding period rate of return that the investor anticipates, assuming
the assets are so priced that their estimated rates of return are consistent
with their levels of systematic risk. Any security with an estimated rate of
return that plots above the SML is considered to be undervalued (and vice
versa). In a highly efficient market, all assets should plot on the SML, but in
a less efficient market assets may at times be mispriced due to investors
perhaps being unaware of all the relevant information (Reilly & Brown,
2012: 207).
Example: The estimated return on the market is 15% and the risk-free rate
is 8%. Assume Afgri’s beta is 1.25 and the estimated rate of return is 17%.
Using the CAPM, one can determine whether the shares are over or
undervalued.
Required return = 8% + 1.25(15% – 8%)

= 8% + 1.25(7%)
= 8% + 8.75%
= 16.75%
This indicates that the Afgri share is undervalued by 0.25 percentage points,
calculated by subtracting the required return (16.75%) from the estimated
return (17%).
Graphically, this is illustrated in Figure 3.8. For illustrative purposes, two

other assets have also been indicated on the graph. Asset A is plotted on the
SML to illustrate an asset which is properly valued (priced), while asset B
is overvalued (overpriced) and plotted below the SML.
Figure 3.8 Plot of estimated returns on SML
One of the other uses of the required rate of return may be found in the
dividend discount model (DDM). The DDM is explained in Chapter 5.
The CAPM has been criticised by Roll and Ross (1980), particularly the
choice of a market proxy as a benchmark when evaluating portfolio
performance. This has led to the development of the arbitrage pricing
theory (APT).
3.4.2 Arbitrage pricing theory

The arbitrage pricing theory (APT) is an alternative to the CAPM and was
developed by Ross in 1976.
3.4.2.1 Assumptions of APT

The APT has three major assumptions:
Capital markets are always perfectly competitive.
Investors always prefer more wealth to less wealth with certainty.
The stochastic process generating asset returns can be represented as a k-
factor model.
3.4.2.2 APT model

The k-factor model can be represented as follows:
Ei = λ0 + λ1bi1 + λ2bi2 + … + λkbik
where:
λ0expected return on an asset with zero systematic risk

=
λi = risk premium related to each common factor
bi = pricing relationship between the risk premium and
asset i
The common factors may include macroeconomic factors, such as growth

in GNP, interest rate changes, inflation and changes in exchange rates. The
bi is a measure of the responsiveness of asset i to common factors 1 to k.
The precise variables and the number of variables to be included in an APT
model have not yet been conclusively determined by researchers.
Example: An analyst has used a multiple regression model to determine the

relationship between the Absa share price (the dependent variable) and a set
of independent variables, namely growth in GNP, interest rates and the
exchange rate between the US dollar and South African rand (ZAR). The
analyst uses an expected return on an asset with zero systematic risk of 12%
and the following APT model to determine the required rate of return, E(r):
E(r) = 12% + 0.2 (ΔGNP) – 0.5 (Δi) + 0.3 (Δ$/ZAR)

If the increase in the GNP is expected to be 3%, the prime interest rate is
expected to increase by 1 percentage point, and the rand is expected to
strengthen against the dollar by 0.02 percentage points, then the required
rate of return on Absa may be calculated as follows:
E(r) = 12% + 0.2(3%) – 0.5(1%) + 0.3(0.02)

= 12% + 0.6 – 0.5 + 0.006
= 12.106%
If the estimated return on Absa is 15%, then the share is regarded as

undervalued based on the APT model. If the estimated return is 10%, the
Absa share is regarded as overvalued.
3.4.2.3 A comparison of CAPM and APT

The CAPM and the APT may be compared as follows:
CAPM APT
Only considers one factor influencing an asset’s Considers many factors that may influence
return, namely the beta (β) an asset’s return
Assumes that unique risk can be diversified Assumes that unique risk is diversified
away
3.5 SUMMARY
The chapter defined and distinguished between systematic and unsystematic

risk. The rational investor is risk averse and demands an increase in his
required rate of return for any given increase in the risk associated with an
investment.
The Markowitz efficient frontier was explained. The chapter showed how
the presence of a risk-free asset changes the characteristics of an efficient
frontier. The security market line (SML) was described. The SML may be
used to determine whether an asset is overvalued or undervalued. The
connection between the SML and the capital asset pricing model (CAPM)
was explained. The SML and the CAPM may be used to determine
expected (required) rates of return for risky assets.
The chapter discussed the two most common theories on how risk and
return may be specified and measured in the valuation process, namely the
CAPM and the arbitrage pricing theory (APT). The chapter concluded with
a brief description of the APT. The similarities and differences between the
CAPM and APT were summarised.
Evans, J.L. & Archer, S.H. 1968. Diversification and the reduction of dispersion: an empirical
analysis. Journal of Finance, 23(5): 761–767, December.
Roll, R. & Ross, S.A. 1980. An emperical investigation of the APT. Journal of Finance, 35(5),
December.
Ross, S.A. 1976. The arbitrage theory of capital asset pricing. Journal of Economic Theory, 13(2):
341– 360, December.
Tobin, J. 1958. Liquidity preference as behaviour towards risk. Review of Economic Studies, 25(2):
65–85, February.
Tole, T.M. 1982. You can’t diversify without diversifying. Journal of Portfolio Management, 8(2):
1. For a portfolio consisting of two shares, the most preferred correlation coefficient
between the two shares should be:
(a) –1
(b) 0
(c) +0.5
(d) +1
2. The SML depicts:
(a) the market portfolio as the optimal portfolio of risky securities

(b) a security’s expected rate of return as a function of its systematic risk
(c) the relationship between a security’s return and the return of an index
(d) the complete portfolio as a combination of the market portfolio and the risk-free
asset
3. The covariance between share A and the market is 0.9 and the variance of the
market is 0.8. The beta of the share equals:
(a) 0.10
(b) 0.20
(c) 0.88
(d) 1.13
4. A security with a β = 0 is an asset with:
(a) more systematic risk than the market

(b) less systematic risk than the market
(c) no systematic risk
(d) the same systematic risk as the market
5. An analyst has gathered the following information:
Expected return on the market = 15%
Risk-free rate = 8%
Estimated rate of return of Nedcor share = 17%
Beta of Nedcor = 1.25
Based on the above-mentioned information, which of the following statements is
correct? The Nedcor share is:
(a) properly valued

(b) overvalued by 0.25 percentage points
(c) undervalued by 1.40 percentage points
(d) undervalued by 0.25 percentage points
Solutions
1. (a) –1, because one would want to combine assets with a negative correlation.
2. (b) The SML depicts a security’s expected rate of return as a function of its
systematic risk.
3. (d) β = 0.9 ÷ 0.8 = 1.125 ≈ 1.13
4. (c) A security with a β = 0 is an asset with no systematic risk.
5. (d) Required return = 8% + 1.25(15% – 8%) = 16.75%
Required return < estimated return, share is undervalued by 0.25 percentage
points.
4 The time value of money
4.1 INTRODUCTION
When we speak of the time value of money, we mean that an amount of

money today is worth more than it will be at some point in time in the
future. A rand that is available today can be invested (a cash outflow) to
earn a return (cash inflows in the form of dividends, interest, rental income
or capital gains). If you expect to receive an amount of money in the future,
then there is an opportunity cost involved in waiting to receive the amount.
If you had the amount at your disposal, you may have either invested it and
earned a return, or avoided interest charges on financing (such as an
overdraft or loan).
The time value of money is a matter of interest which may be earned if

money is available today and invested, or the opportunity cost if an amount
will only be received at some future date instead of immediately.
In this chapter you will learn how to account for differences in the timing of
inflows or outflows of cash by mastering the basic interest and discounting
calculations.
An interest calculation involves calculating the end value, called the future
value (FV), of an amount which is invested in the present. Discounting
calculations are the opposite of interest calculations. Discounting
calculations involve the calculation of the present values (PV) of amounts
which will only be received at some time in the future.
Time value of money calculations may be done by using interest and

discounting factors in conjunction with an ordinary calculator or by simply
using a financial calculator. Interest and discounting tables provide either an
interest factor which can be used to determine the future value of an
amount, or discounting factors to determine the present value of an amount
to be received at some future date. The use of these tables is explained in
the examples of the various calculations in this chapter. The tables are
included in Annexure B at the end of this book.
The time value of money should not be confused with a decrease in

purchasing power as a result of inflation. Inflation refers to a continuous
rise in the general level of prices of goods and services. Inflation influences
the nominal rate of interest, as was explained in Chapter 1. In this chapter
all calculations are based on nominal interest rates.
4.2 NOMINAL AND EFFECTIVE INTEREST RATES
The annual rate at which many investments for periods of 30 or 90 days or

12 months are quoted is the nominal interest rate. One may, for example,
make an investment that pays interest at a nominal annual rate of 10%. The
effective interest rate adjusts the nominal rate based on the frequency of
compounding employed and the number of days assumed in a year. Interest
is compounded when the amount earned on the initial principal becomes
part of the principal at the end of the first compounding period.
The effective rate may be computed as follows:

n
inom
ieff = (1 + ) –1
N
where:
ieff = the effective annual rate of interest

inom = the nominal annual interest rate
N = the number of compounding intervals per year
Investors must be careful when comparing different interest rates. They
have to seek the best possible returns available. The effective rate should be
used when evaluating returns (yields), otherwise important yield differences
may be overlooked. The interest rates banks and other financial institutions
quote on savings accounts are often effective rates. If there is only one
compounding interval per year (n = 1), then the effective rate is equal to the
nominal rate. The more regularly interest is compounded during a year (the
shorter the compounding interval), the higher the effective interest rate.
Example: To illustrate this relationship, consider the impact of

compounding based on a 10% annual nominal interest rate.
Compounding interval Effective rate (%)

Annually (N = 1) 10.000
Semi-annually (N = 2) 10.250
Quarterly (N = 4) 10.381
Monthly (N = 12) 1 0.471
Daily (N = 365) 10.515
An investor is evaluating two investments. First National Bank (FNB)

quotes a nominal annual rate of 16.5% compounded semi-annually.
Standard Bank (SB) quotes a nominal annual rate of 16.4% compounded
daily. Which one of the two investments should the investor select in order
to obtain the best possible return (yield)? To resolve this, one has to
calculate the effective interest rate:
2
0.165
FNB ieff = (1 + ) − 1
2
= 0.17181 or 17.18%
365
0.164
SB ieff = (1 + ) − 1
365
= 0.017817 or 17.82%
Based on the above conversion from nominal to effective rates, the best
return (yield) would be achieved on the Standard Bank investment, with an
effective rate of 17.82% compared to the effective rate of First National
Bank of 17.18%.
As indicated earlier, in the rest of this chapter, all rates of interest quoted
will be the annual nominal interest rates (unless indicated otherwise). The
time value of money techniques will now be explained, starting with the
calculation of future values.
4.3 FUTURE VALUE
The concept of future value involves the calculation of interest on a present

amount to result in some future amount.
The amount on which interest is paid is known as the principal. Future

value is the amount to which the principal (be it a lump sum or series of
cash flows) will grow by a given future date when compounded at a certain
interest rate. The interest rate may be expressed as “x”% interest
compounded either annually, semi-annually, quarterly, monthly, weekly or
daily. The compound rate is the rate applicable when interest is earned not
only on the original principal, but also on the accumulated interest from
previous periods (also called earning interest on interest).
The principles of future value are quite simple, regardless of the period of
time involved. In this chapter we discuss three types of compounding:
annual compounding, intra-year compounding, and finding the future value
of an annuity.
4.3.1 Annual compounding

The actual method by which future value is determined with annual
compounding can be illustrated by means of a simple example.
Example: If an investor placed R10 000 in a savings account paying 10%

interest compounded annually, then at the end of the first year he would
have earned R1 000 in interest. The value of his investment will be R11000;
R10000 representing the initial principal and R1 000 in interest. The future
value at the end of the first year is calculated as follows:
Future value at the end of year 1
= R10 000 (1 + 0.10)
= R11000
The above example may be illustrated using a time line such as the one
contained in Figure 4.1.
Figure 4.1 Time line illustrating future

value at the end of year 1
Notes on using the HP10BII+ financial calculator and performing bond

calculations
• Set the calculator to 1 payment per annum (12 default setting)
All the required inputs should now be adjusted manually to account for the
compounding frequency (i.e. semi-annually, quarterly, monthly, weekly or daily).
Confirming the payments per annum setting clears all the registers (removes
previously stored values).
The convention with bonds is semi-annual coupon payments (compounding

frequency). Therefore, the time period (N) input should be multiplied by 2 and the
interest rate (I/YR) and coupon payment (PMT) inputs should be divided by 2. With
any one of these three variables as an output (the calculated value), the opposite
adjustment should be made – that is, divide the N-value by 2 or multiply either the
I/YR-value or PMT-value by 2, depending on which variable is calculated.
A present value (PV) input should always by negative, representing an outflow of
money, with the principal (FV) and payment (PMT) values positive, representing
inflows or revenue. You will notice that the calculator output when calculating the
bond price (PV) is always negative.
You can set the display (number of decimals) of the HP10BII+ to four. Always
round to four decimals while calculating and only round the final answer to two
decimals to avoid large rounding errors.
However, using your calculator’s memory function (store and recall keys) in
conjunction with the bracket keys [( )] would avoid any rounding errors. Any
calculated value can be stored in one of the calculator’s registers (0 to 9 numerical
keys) to be recalled and used in subsequent calculations.
Please consult the user’s guide for your calculator on the proper use of these and
other relevant functions.
The calculation can also be done using a financial calculator:
If the investor left his money in this investment for another year and
capitalised the interest, he would be paid interest at the rate of 10% on the
new principal of R11 000. At the end of year 2 the investment would be
worth R12 100:

= R11 000 (1 + 0.10) = R12 100
Alternatively, the calculation could be done as follows:

= R10 000 (1 + 0.10)(1 + 0.10)
= R10 000 (1.10)2
= R10 000 × 1.21
= R12 100
By means of a financial calculator:
The general formula which can be used to calculate the future value of an
amount is:
FVn = PV(1 + i)n
where:
FVn the future value of the amount at the end of n

= periods
PV = the initial principal
i = the annual rate of interest paid
n = the number of periods of the investment
Figure 4.2 Time line illustrating future value at the
end of year 2
Regardless of whether one is using a financial calculator or the tables, a

fundamental relationship will always exist between interest rates, time
periods and future value factors. Looking at Table 1 in Annexure B, the
future value interest factors for one rand (FVIFi,n), one should note the
following:
1. The factors in the table are those for determining the future value of one
rand at the end of the given period.
2. The future value interest factor for a single amount is always greater
than one.
3. As the interest rate increases for any given period, the future value
interest factor also increases. Thus the higher the interest rate, the
greater the future value.
4. For a given interest rate, the future value of a rand increases with the
passage of time. Thus, the longer the period of time the greater the
future value.
4.3.2 Intra-year compounding

Intra-year compounding of interest refers to the situation where interest is
compounded more often than once a year. Savings institutions compound
interest semi-annually, quarterly, monthly, weekly or daily. Intra-year
compounding changes the frequency with which the interest is calculated,
and this requires adjustments to the number of periods (N) and the interest
payable (I/YR) as indicated in Table 4.1.
Table 4.1 Adjustments to periods and interest payable arising from intra-year
compounding
Compounding Adjustment Adjustment

during a one- to number to interest Explanation
year period of periods rate
Semi-annually N × 200 I/YR ÷ 200 Instead of the nominal interest rate being paid
once a year, one-half of the interest rate is paid
twice a year.
Quarterly N × 400 I/YR ÷ 400 Instead of the nominal interest rate being paid
once a year, one-quarter of the interest rate is
paid four times a year.
Monthly N × 120 I/YR ÷ 120 Instead of the nominal interest rate being paid
once a year, one-twelfth of the interest rate is
paid twelve times a year.
Weekly N × 520 I/YR ÷ 520 Instead of the nominal interest rate being paid
once a year, one fifty-second part of the interest
rate is paid fifty-two times per year.
Daily N × 365 I/YR ÷ 365 Instead of the nominal interest rate being paid
once a year, one three-hundred-and-sixty-fifth
part of the interest rate is paid three-hundred-
and-sixty-five times per year.
Example: Assume a firm invested R10 000 for a period of two years at
12% interest per annum, calculated monthly. This means the interest rate
becomes 1% (i = 1) payable 24 times (n = 12 × 2 = 24). The future value at
the end of year two may be calculated as follows:
By means of the future value interest factor (FVIF) table:

= R10 000 × FVIF1%,24
= R10 000 × 1.270
= R12 700
The slight difference in answers may be ascribed to the fact that the FVIF
table only takes three digits into account, whereas the financial calculator
takes ten digits into account.
4.3.3 The future value of an annuity

An annuity is a series of equal cash flows for each of a specified number of
periods. These cash flows may be received or deposited. An annuity
typically consists of cash flows similar to the following:
Year Cash flow

1 R12 000
2 R12 000
3 R12 000
There are two types of annuity, namely an ordinary annuity and an annuity
due. If an annuity consists of amounts received or deposited at the end of
each period it is known as an ordinary annuity. If an annuity consists of
amounts deposited or received at the beginning of each period it is known
as an annuity due.
Future value of an ordinary annuity

The calculation of the future value of an ordinary annuity may be simplified
using Table 2 in Annexure B (the FVIFA table). The values in the FVIFA
table assume that deposits are made at the end of each period. The
calculation of the factors contained in Table 2 may be explained using the
following example.
Example: If one had to determine the FVIFA16%,5 then the FVIFA is found
by adding together the FVIF16% for four periods (n) plus one (1). This
involves the following:
n FVIF16%
4 1.811
3 +1.561
2 +1.346
1 +1.160
5.878
0 +1.000
6.878
The following formula can be used to calculate the future value of an

ordinary annuity by means of the interest factors in Table 2.
FVAn = PMT × FVIFAi,n
where:
FVAn = the future value of an annuity at the end of n periods

PMT = the amount invested periodically (e.g. annually)
FVIFA = the future value interest factor for an annuity
i = the annual interest rate
Example: If one wanted to calculate the future value of R12 000 invested
annually (at the end of each year) for five years in succession earning 15%
annual interest, the calculation is done as follows:

= R12 000 × FVIFA15%,5
= R12 000 × 6.742
FV of PMTn = R80 904
(Once again the difference is the result of the number of digits used in the
FVIFA table versus the ten digits of the financial calculator.)
The above calculation can also be illustrated by means of a time line such
as the one contained in Figure 4.3.
Figure 4.3 Time line illustrating the future value of an ordinary annuity
Future value of an annuity due

If an amount of R12 000 (PMT = R12 000), is invested at the beginning of
each year at an interest rate of 15% (i = 15%) over the same period, the
value of the investment would be R93 044.86 at the end of the five-year
period. This calculation can be illustrated by a time line such as the one in
Figure 4.4.
Figure 4.4 Time line illustrating the future value of an annuity due
By means of the FVIF table:
Beginning Amount Number of year Future value interest Future value at

of years deposited compounded factors (FVIF) end of year
(PMT)
1 R12 000 5 2.011 R24 132
2 R12 000 4 1.749 R20 988
3 R12 000 3 1.521 R18 252
4 R12 000 2 1.322 R15 864
5 R12 000 1 1.150 R13 800
Total future value at the end of 5 years = R93 036
First set the calculator to BEG so that it assumes the cash flows occur at the
beginning of each period.
(Once again, the difference between the amounts obtained by means of the
FVIF and the financial calculator is the result of differences in the number
of decimals used.)
Using the figures provided through the use of the tables and assuming that
the same amount is invested (PMT = R12 000 in our example) at the same
rate of interest (i = 15%), then the difference in future value between an
ordinary annuity and an annuity due amounts to R12 132 (by means of
the tables) or R12 136.28 (by means of a financial calculator). This
difference between R93 044.86 (of the annuity due) and R80 908.58 (of the
ordinary annuity) is the result of the differences in the timing of the
investments (at the beginning versus the end of periods). In the case of the
ordinary annuity the amount invested (PMT = R12 000 in our example) in
the last period (n = 5 in our example) is merely added to the investment at
the end of period 5 without any time elapsing for it to earn interest. The
number of periods for which compounding takes place is four. However, in
the case of the annuity due, interest is earned also on the final deposit
because it occurred at the beginning of the fifth period.
4.4 COMPARING FUTURE VALUE AND PRESENT VALUE
Future value and present value are simply the inverse of each other.
Mathematically this is expressed as follows:
The future value of a single amount is found by:
FVn = PV(1 + i)n
whereas present value of a single amount is found by:

1
PVn = FVn × n
(1+i)
In terms of future value versus present value factors, the PV is the

reciprocal of the FV for the same discount rate and time period, so that
1
PVn =
FVn
This observation can be confirmed by dividing a present value interest

factor for i% and n periods, PVIFi,n, into 1 and comparing the resulting
value to the future value interest factor given in Table 1 in Annexure B for
i% and n periods, FVIFi,n. The two values should be equivalent. Because of
the relationship between present value interest factors and future value
interest factors, we can find the present value interest factors if we have a
table of future value interest factors. From Table 1 we see that the future
value interest factor for 10% and five periods is 1.611. Dividing 1 by this
value yields 0.621, which is the present value interest factor given in Table
3 for 10% and five periods.
Having established this relationship between future and present value, we

now proceed to present value calculations.
4.5 PRESENT VALUE
It is often useful to determine the present value of a future sum of money.

The concept of present value, like the concept of future value, is based on
the belief that the value of money is affected by the timing of its receipt.
The axiom underlying this belief is that a rand today is worth more than a
rand that will be received at some future date. In other words, the present
value of a rand that will be received in the future is less than the value of a
rand in hand today.
The actual present value of a rand depends largely on the earning

opportunities of the recipient and the point in time at which the money is
expected. This section explores the present value of a single amount, a
mixed stream and an annuity.
4.5.1 The present value of a single amount

The process of finding present values, or discounting cash flows, is actually
the inverse of compounding. It is concerned with answering the question,
“If I can earn i% on my money, what is the most I would be willing to pay
for an opportunity to receive Rx n periods from today?” Instead of finding
the future value of present rand invested at a given rate, discounting
determines the present value of a future amount, assuming that the decision
maker has an opportunity to earn a certain return, i, on the money. This
return is often referred to as the discount rate, required return, cost of
capital or opportunity cost. The discounting process can be illustrated by a
simple example.
Example: You have the opportunity to receive R1000 one year from now. If
you can earn 16% by investing the amount, the present value of the R1000
is:
R1 000
PV = = R862.07
1.16
To simplify the present value calculation, tables of present value interest

factors can be used. The table for the present value interest factor, PVIFi,n,
gives values for the expression 1 ÷ (1+i)n where i is the discount rate and n
is the number of periods involved. Table 3 in Annexure B presents present
value interest factors for various discount rates and periods.
Using the present value interest table, the general formula for determining
present values (PVn) can be expressed as follows:
PVn = FVn × PVIFi,n
where:
FVn = the amount at the end of the n periods

the present value
PVn =
PVIF = present value interest factor
i = the interest rate
This expression indicates that to find the present value, PVn, of an amount
to be received in a future period, n, we have merely to multiply the future
amount, FVn, by the appropriate present value interest factor from Table 3.
An example should help clarify the use of the formula.
Example: You have the opportunity to receive R1000 one year from now. If
you can earn 16% by investing the amount, the present value of the R1000
may be calculated as follows.
By means of tables:
Present value of a FV of R1 000

= R1 000 × PVIF16%,1
= R1 000 × 0.862
= R862
4.5.2 The present value of a mixed stream

Quite often in financial management there is a need to find the present
value of cash flows to be received in various future periods. Two basic
types of cash flow streams are possible: the mixed stream and the annuity.
A mixed stream of cash flows reflects no particular pattern, while an
annuity is a pattern of equal annual cash flows (the cash flows are the same
each year). Since certain shortcuts can be used in finding the present value
of an annuity, it will be discussed separately from mixed streams.
To find the present value of a mixed stream of cash flows, determine the
present value of each future amount in the manner described in the
preceding section, then add all the individual present values to find the
present value of the stream. An example should clarify this process.
Example: It is expected that the following cash inflows will be received

over the next five years:
Year Cash flow

1 1 000
2 1 200
3 1 300
4 1 100
5 1 400
Period Cash inflow (1) Present value Present value (1) × (2)
interest factors (2)
1 R1 000 0.893 R893.00
2 R1 200 0.797 R956.40
3 R1 300 0.712 R925.60
4 R1 100 0.636 R699.60
5 R1 400 0.567 R793.80
Total present value of mixed stream = R4 268.40
If a minimum return of 12% can be earned, the present value of the above-
mentioned cash flows can be illustrated by the time line in Figure 4.5 and
the calculations thereafter.
Figure 4.5 Time line illustrating the present value of a mixed stream
4.5.3 The present value of an annuity

The present value of an annuity can be found in a manner similar to that
used for a mixed stream, but a shortcut is possible. The following is an
example of how the present value of an annuity can be determined.
Example: It is expected that an annuity will provide a cash flow of R1 000

per year. If a return of 12% can be earned, the present value of the annuity
may be determined as indicated in Figure 4.6.
Figure 4.6 Time line illustrating the present value of an annuity
The calculations used in the preceding example can be simplified by

recognising that each of the five multiplications made to get the individual
present values involved multiplying the annual amount (R1 000) by the
appropriate present value interest factor. This method of finding the present
value of the annuity can also be written as an equation:
PVn = PMT × PVIFAi,n
where:
PMT =the amount of the annuity at the end of each period

PVn =the present value
PVIFA =present value interest factor for an annuity
i =the discount rate
n =the number of periods of the investment
Thus the present value of an annuity can be found by multiplying the annual
amount received by the sum of the present value interest factors for each
year of the annuity’s life.
Using interest factors for an annuity

Table 4 in Annexure B is a table of present value interest factors for an
annuity for specified rates and periods. It simplifies even further the
calculations required to find the present value of any annuity. The interest
factors in the table are derived by summing the PVIFs used to determine the
present value of the annuity by means of the long method.
The interest factors in Table 4 actually represent the sum of the first n
present value interest factors in Table 3 for a given discount rate. The
formula for the present value interest factor for an n-year annuity with end
of year cash flows that are discounted at i% is PVIFAi,n.
The problem presented earlier involving the calculation of the present value
of a five-year annuity of R1000 assuming a 12% opportunity cost can be
easily worked out with the aid of Table 4. The present value interest factor
for a one rand annuity in Table 4 for 12% and five periods, PVIFA12%,5y, is
3.605. Multiplying this factor by the R1 000 annuity provides a present
value for the annuity of R3605.
Period Present value interest factor

1 0.893
2 0.797
3 0.712
4 0.636
5 0.567
Total 3.605
4.5.4 The present value of a perpetuity

A perpetuity is an annuity with an infinite life. The perpetuity never stops
providing its holder makes continual annual payments at the end of each
year.
The present value of a perpetuity may be determined by:
PV of perpetuity = PMT × PVIFAk∞ = PMT × 1
Example: Assume you receive a perpetuity of R1 000 per year (at the end
of each year) for an indefinite period and that the discount rate is 5%. The
PVIFA is 1 divided by 0.05, which is 20.
The present value of the perpetuity

= R1000 × 20 = R20 000
This is equivalent to an investor investing R20 000 today and earning 5%

interest on the amount each year, enabling the investor to withdraw R1 000
per year indefinitely without withdrawing any of the initial R20 000.
4.6 VARIATIONS OF FUTURE AND PRESENT VALUE

TECHNIQUES
Future value and present value techniques have a number of variations.

Three of these variations are presented in this section:
The calculation of the deposits needed to accumulate a future sum

The amortisation of loans
The determination of interest or growth rates
4.6.1 Deposits to accumulate a future sum

One may wish to determine the annual deposit necessary to accumulate a
certain amount of money many periods hence. The solution to this problem
is closely related to the process of finding the future value of an annuity.
Earlier in this chapter, the future value of an n-year annuity, FVn, was found
by multiplying the annual deposit, PMT, by the appropriate interest factor
from Table 2, FVIFAi,n.
The relationship of the three variables has been defined and is repeated
here:
FVn = PMT × FVIFAi,n
We can find the annual deposit required to accumulate FVAn rand, given a
specified interest rate, i, and a certain number of periods, n, by solving the
above formula for PMT. Isolating PMT on the left side of the formula gives
us:
FVn
PMT =
FVIFAi,n
Once this is done, we have only to substitute the known values of FVAn and
FVIFAi,n into the right side of the formula to find the annual deposit
required.
Example: Suppose you realise that an amount of R100 000 will be required
five years from now. If you wish to make equal annual end-of-year deposits
in an account paying an annual interest of 12%, you must determine what
size annuity will result in a sum equal to R100 000 at the end of year 5.
By means of the tables:

FVn R100 000
PMT = = = R15 740.60
FVFA 6.353
12%,5

4.6.2 Loan amortisation
The expression “loan amortisation” refers to the determination of the equal
annual loan payments necessary to provide a lender with a specified interest
return and repay the loan principal over a specified term. The loan
amortisation process involves finding the future payments (over the term of
the loan) so that its present value just equals the amount of initial principal
borrowed (given the loan interest rate). Lenders use loan amortisation tables
to find these payment amounts. In the case of a home mortgage, these tables
are used to find the equal monthly payments necessary to amortise or pay
off the loan at a specified interest rate over 20 to 30 years.
The discussion here will deal only with the amortisation of loans on which
end of year payments are made, since the tables in this text are based on
end-of-year amounts. Amortising a loan actually involves creating an
annuity out of a present amount.
Earlier in this chapter, the present value, PVn, of an n-period annuity of an

amount of rands was found by multiplying the annual amount, PMT, by the
present value interest factor for an annuity from Table 4, PVIFAi,n:
PVn = PMT × PVIFAi,n
To find the equal annual payment, PMT, required to pay off or amortise the
loan, PVn, over a certain number of periods at a specified interest rate, we
need to solve the formula for PMT. Isolating PMT on the left side of the
formula gives us:
PVn
PMT =
PVIFAi,n
Once this is done, we have only to substitute the known values of PVn and
PVIFAi,n into the right side of the formula to find the annual payment
required.
Example: A firm borrows R6 000 000 at 14% and agrees to make equal
annual end-of-year payments over ten periods. To determine the size of the
payments, the ten-year annuity discounted at 14% that has a present value
of R6 000 000 must be determined. This process is actually the inverse of
finding the present value of an annuity.
PVn R6 000 000
PPMT = =
PVIFA14%,10 5.2161168
= R1 150 281
A loan amortisation schedule can be drawn up to show the interest and

principal repayments:
End of Loan payment Beginning of Interest Principal End of year

year year principal principal
.14 × (2) (1) – (3)
(1) (2) (3) (4) (2) – (4)
1 1 150 281 6 000 000 840 000 310 281 5 689 719
2 1 150 281 5 689 719 796 561 353 721 5 335 998
3 1 150 281 5 335 998 747 040 403 242 4 932 757
4 1 150 281 4 932 757 690 586 459 695 4 473 061
5 1 150 281 4 473 061 626 229 524 053 3 949 009
6 1 150 281 3 949 009 552 861 597 420 3 351 589
7 1 150 281 3 351 589 469 222 681 059 2 670 530
8 1 150 281 2 670 530 373 874 776 407 1 894 123
9 1 150 281 1 894 123 265 177 885 104 1 009 019
10 1 150 281 1 009 019 141 263 1 009 019 0
Note: If the amount was payable in monthly instalments, one would have
calculated it in the following manner by means of a financial calculator:
4.6.3 Determining growth rates
It is often necessary to calculate the compound annual growth rate
associated with a stream of cash flows. In doing this, either future value or
present value interest tables are used as described in this section. The
simplest situation is where one wishes to find the growth rate of a cash flow
stream. This case can be illustrated by the following example.
Example: You wish to determine the growth rate of the following stream of
dividends received:
Year Cash flow (cents)

2009 160
2008 150
2007 145
2006 135
2005 101
By means of the tables:
Growth occurred for four years. To find the rate at which this occurred, the
amount received in the earliest year is divided by the amount received in the
last year. This gives us the present value interest factor (PVIF) for four
years, which is 0.6313 (R1,01 ÷ R1,60). The interest rate in Table 3
associated with the factor closest to 0.6313 for four years is the rate of
interest or growth rate associated with the cash flows. Looking across year
4 of Table 3 shows that the factor for 12% is 0.636. This is the growth rate
to the nearest integer.
4.7 DETERMINING THE NET PRESENT VALUE AND

INTERNAL RATE OF RETURN
An investor can evaluate an investment decision based on the net present

value (NPV) and the internal rate of return (IRR). These calculations can
also be done using time value of money techniques and a financial
calculator, as will be explained here.
4.7.1 Net present value

Net present value (NPV) measures in monetary terms (rand) how much
value an investment will generate. For an investment to be acceptable, the
NPV must be greater than zero. An NPV of less than zero indicates the
investment will not add any value – in fact, value will be lost.
The NPV is found by discounting all the expected cash inflows back to
present value and subtracting the initial investment (cash outflow). The
expected future cash flows are discounted back to present value at the
required rate of return of the investor. The required rate of return is strongly
influenced by the opportunity cost of making the investment, such as the
return which could have been earned on the best possible alternative
investment of similar risk. If the risk is not the same, then the investor
would have to include a risk premium in his required rate of return.
Example: An investor has a required rate of return of 10% and can invest
R100 000 with PSG Konsult in order to earn the following annual cash
flows over the next five years:
Year Cash inflow

1 R22 000
2 R24 000
3 R26 000
4 R32 000
5 R38 000
Using a financial calculator:
Sine the NPV is greater than zero, the investment will add value and is
therefore acceptable.
4.7.2 Internal rate of return

The internal rate of return (IRR) measures in percentage terms (%) whether
an investment will be acceptable. For an investment to be acceptable, the
IRR must exceed the required rate of return.
Example: Using the same figures from our PSG Konsult example above
and by means of a financial calculator:
The IRR equals 11.696%, which is greater than the required rate of 10%.
The investment is acceptable. Had the IRR been less than the required rate
of return, one would not make the investment.
4.8 SUMMARY
The key concepts related to the time value of money are future value and
present value. These have been explained in this chapter.
Nominal and effective rates of interest were also explained.
Future value relies on compound interest to measure the value of future

amounts. When interest is compounded, the initial principal or deposit in
one period, along with the interest earned on it, becomes the beginning
principal of the following period; this is also known as capitalising interest
or earning interest on interest.
Present value is the inverse of future value. One can determine the present
value of a single amount, an annuity and a perpetuity.
By manipulating the formulas for the future and present value of single
amounts and annuities in certain ways, the deposits needed to accumulate a
future sum, loan amortisation and growth rates can be calculated.
The use of time value of money calculations in determining the net present
value (NPV) and internal rate of return (IRR) of investments was explained.
The present value calculations are also used extensively to perform
valuations, which are covered in greater detail in the rest of this book.
Notes on using the HP10BII+ financial calculator and performing bond

calculations
Set the calculator to 1 payment per annum (12 default setting)
All the required inputs should now be adjusted manually to account for the
compounding frequency (i.e. semi-annual, quarterly, monthly, weekly or daily).
Confirming the payments per annum setting clears all the registers (removes
previously stored values).
The convention with bonds is semi-annual coupon payments (compounding

frequency). Therefore, the time period (N) input should be multiplied by 2 and the
interest rate (I/YR) and coupon payment (PMT) inputs should be divided by 2. With
any one of these three variables as an output (the calculated value), the opposite
adjustment should be made – that is, divide the N-value by 2 or multiply either the
I/YR-value or PMT-value by 2, depending on which variable is calculated.
A present value (PV) input should always be negative, representing an outflow of
money, with the principal (FV) and payment (PMT) values positive, representing
inflows or revenue. You will notice that the calculator output when calculating the
bond price (PV) is always negative.
You can set the display (number of decimals) of the HP10BII+ to four. Always
round to four decimals while calculating and only round the final answer to two
decimals to avoid large rounding errors.
However, using your calculator’s memory function (store and recall keys) in
conjunction with the bracket keys [( )] would avoid any rounding errors. Any
calculated value can be stored in one of the calculator’s registers (0 to 9 numerical
keys) to be recalled and used in subsequent calculations.
Please consult the user’s guide for your calculator on the proper use of these and
other relevant functions.
REFERENCES
Gilman, L.J. Principles of managerial finance – global and southern African perspectives, 2nd ed.
Cape Town: Pearson.
Marx, J., Ngwenya, S. & Grebe, G.P. 2015. Financial management for non-financial managers, 3rd
ed. Pretoria: Van Schaik.
WEBSITE
http://www.resbank.co.za
1. R10 000 is invested in a savings account at 20% p.a. compound interest for ten
years. Calculate the end value of the investment.
2. You invest R3 600 per year for ten successive years (at the end of each year) in a
savings account at 15% p.a. compound interest. What will be the end value in the
savings account?
3. R10 000 is invested in a savings account for ten years at 20% p.a. compound
interest, but the interest is calculated semi-annually. What is the end value of the
investment?
4. Calculate the difference between the following investment proposals:
(a) R1000 is invested annually for 5 successive years at 10% p.a.

(b) R2051,85 is invested for 5 years at 20% p.a. compound interest.
5. You are to receive an amount of R1 700 eight years from now. However, if you
could have received the amount right now and invested it you would have been
able to earn 8% interest p.a. on the amount. What would the amount be worth if
you could receive it now instead of waiting eight years?
6. Calculate the present value of R25 000 received annually for ten successive years
using a discount rate of 17%.
7. What amount must be invested annually (at the end of each year) for five
successive years at 12% p.a. compounded interest in order to yield R25 000?
8. Calculate the growth rate of the following stream of cash flows:
2006: R1 517
2004: R1 210
2005: R1 312
2003: R1 080
9. A bank has granted you a loan of R20 000. It has to be repaid at the end of each
year over a period of ten years. The bank charges 14% interest per year on the
loan. What is the amount payable at the end of each year in order to pay back the
loan?
10. What is the difference between R1 000 invested at 10% p.a. compounded interest
for five years if:
(a) interest is calculated annually?

(b) interest is calculated semi-annually?
Solutions
1. 61 917.36, calculated as follows:

or
10 000 × 6.192 = R61 920 (using Table 1)

2. R73 093.39, calculated as follows:
or
R3 600 × 20.304 = R73 094.40 (using Table 2)

3. R67 275 (rounded), calculated as follows:
or
R10 000 × 6.727 = R67 270 (using Table 1)

4. Approximately R1 000 (rounded), calculated as follows:
(a)
(b)
or
(a) R1 000.00 × 6.105 = R6 105

(b) R2 051.85 × 2.488 = R5 105
R1 000
5. R918 (rounded), calculated as follows:
or
R1 700 × 0.540 = R918 (using Table 3)

or
R25 000 × 4.659 = R116 475 (using Table 4)

or
R25 000
= R3 935.15
6.353
8. 12%, calculated as follows:

or
R1 080
= PVIF = 0.7119 or 0.712 if rounded off
R1 517
see Table 3: 12% (approximated to the nearest 1%)

or
R20 000
= R3 834.36
5.216
10. (a)
(b)
1 628.90 – 1 610.51 = 18.39
or
R1 000 × 1.629 = R1 629 (semi-annually)
R1 000 × 1.611 = R1 611 (annually)
Difference = R18
5 Valuation principles and
practices
5.1 INTRODUCTION
Valuation refers to the process of finding the so-called fair value of an asset.
This is also called the intrinsic or estimated value of an asset. The value of
any asset is the present value of all future cash flows the asset is expected to
generate.
Valuation plays an important role in investment decisions. An investor

should base his investment decisions on a comparison of the fair (intrinsic)
value with the prevailing market value. If the fair value exceeds the market
value, the investor should buy the asset and be able to earn a positive return
from it. If the fair value is less than the prevailing market value, the investor
should not buy the asset.
This chapter focuses on the valuation of financial assets, such as bonds,

preference shares and ordinary shares. First, various concepts related to
valuation are explained. This is followed by an explanation of the input
variables required for valuation purposes. Valuation models that may be
used for the valuation of bonds, preference shares, ordinary shares and
warrants are explained.
5.2 VALUATION CONCEPTS

There are various types of value. To provide greater clarity about value, the
following types of value are defined here:
Par value
Market value
Book value
Fair (intrinsic) value
5.2.1 Par value

Par value (also called face value) refers to the arbitrarily assigned value of a
financial asset. It is the value at which a financial asset is originally issued
in the primary market. An example is the ordinary shares of IST Ltd which
were issued at 220 cents each in September 1998.
The par value is important for accounting purposes, because the statement
of financial position of a company shows the shareholders’ interest at par
value.
5.2.2 Market value

Once a share trades in the secondary market (the stock exchange) its value
is determined by what buyers are prepared to offer and what sellers are
willing to accept. A share issued at a par value of 220 cents may start
trading at 220 cents, but it will assume a market value once the share price
trades above or below the par value in the secondary market.
Two concepts are closely associated with market value, namely market
value added and market capitalisation. Market value added is the amount by
which the ordinary shares of a firm have increased in market value over a
certain period. Market capitalisation is the number of shares which have
been issued by a firm multiplied by the market value per share.
5.2.3 Book value

The term “book value” is used for both non-current assets and ordinary
shares.
The book value of non-current assets is the value of assets such as land,
buildings, plant and equipment indicated on a firm’s statement of financial
position. The book value of non-current assets is the cost of buying and
installing these assets minus accumulated depreciation.
The book value of ordinary shares is the par value per share times the
number of shares issued, plus cumulative retained earnings, plus capital
contributed in excess of par.
5.2.4 Fair (intrinsic) value

The fair (intrinsic) value of any asset may be determined by means of the
generic valuation model, which determines value by calculating the present
value of the cash flows expected from an asset:
n
CFt
Value = ∑
t
t=1 (1 + k)
where:
CFt = net cash flow from asset

k = required rate of return
5.3 REQUIRED INPUT VARIABLES FOR VALUATION

PURPOSES
The key inputs to the valuation process are cash flows, timing and the
discount rate.
5.3.1 Cash flows (returns)

The value of any asset depends on the cash flow(s) it is expected to
generate during the period it is owned. To have value, an asset need not
necessarily generate monthly or annual cash flows; it may generate
intermittent cash flows or even a single cash flow at any point during its
ownership.
5.3.2 Timing
Because of risk and the time value of money, earlier cash flows are
preferred to later cash flows. It is customary to specify the timing along
with the estimates of cash flow.
5.3.3 Discount rate

The discount rate should reflect the risk–return relationship of the asset
concerned. Risk describes the chance of an expected outcome not
materialising. In general, the lower the risk or more certain the cash flow(s),
the lower the value of an asset (and vice versa). In terms of the time value
of money, the lower the risk, the lower the discount rate to be used in
calculating the present value. The higher the risk, the higher the discount
rate one has to use in calculating the present value. Marx & de Swardt
(2013: 171).
The required rate of return may be estimated in several ways. Recall from
Chapter 1 that the key determinants of the required rate of return are the
real risk-free rate of return, plus the expected rate of inflation during the
holding period, plus a risk premium. The required rate of return may also be
estimated by means of the CAPM and APT, which are explained in Chapter
3.
The growth rate used in many of the valuation models may be calculated by
multiplying the return on equity (ROE) by the retention ratio. The retention
ratio is the proportion of earnings which is not paid out as dividends and
may be calculated by 1 – payout ratio. The growth rate (g) is calculated as:
g = ROE × retention ratio

= ROE × (1 – payout ratio)
Example: Assume Pick n Pay Ltd has a payout ratio of 20% and its ROE =
15%. This implies a retention ratio of 80%. The firm’s growth rate is 12%,
calculated as follows:
g = 15% × 0.80 = 12%
The valuation of financial securities is explained in the following section.
5.4 VALUATION OF FINANCIAL SECURITIES
This section explains the valuation of bonds, preference shares, ordinary

shares, investment trusts and warrants.
5.4.1 Bond valuation

This section focuses on models which may be used for the valuation of
bonds.
Companies use bonds as one of their forms of long-term debt financing.

Bonds enable companies to borrow money from a diverse group of lenders
for periods (maturities) ranging from 10 to 20 years. Normally the interest
is paid semi-annually; in other words, at the end of every six months. A
bond is normally an interest-only loan, meaning that the borrower will pay
the interest every period, but none of the principal will be repaid until the
end of the loan. The regular interest payments are called the bond’s
coupons. The annual coupon divided by the face value is called the coupon
rate of the bond. An example will illustrate these concepts.
Example: Bonds will be issued at a par value of R1000 each. Interest is

paid semi-annually and the required rate of return is equal to the bond’s
coupon rate of 14% (I = R140). The initial maturity is 10 years. Half the
interest (7%) is paid semi-annually (every six months). The number of
periods is 10 × 2 = 20. The value of the bond may be determined as
follows:
(R140 ÷ 2) × PVIFA7%, 20 periods
= R 70 × 10.594 =R 741.58
R1 000 × PVIF7%, 20 periods
= R1 000 × 0.25842 =R 258.42
R1 000.00
The bond has a value of R1 000, which is equal to the par value; this is
always the case when the required rate of return is equal to the coupon
interest rate. (A business or financial calculator may also be used to
calculate the value of the bond.) The calculation of the bond value is
graphically illustrated in Figure 5.1.
Figure 5.1 A graphical representation of the valuation of a bond
5.4.1.1 Yield to maturity (YTM)

Yield to maturity (YTM) refers to the rate of return investors earn if they
buy a bond at a specific price and hold it until maturity. The YTM has to be
considered when analysing and/or investing in bonds.
The YTM on a bond with a current price equal to its par (face) value will
always equal the coupon rate. Where the bond value differs from the par
value, the YTM will differ from the coupon interest rate.
The YTM may be either approximated or calculated using a financial
calculator.
Example: Assume Capitec Bank Ltd has issued bonds at R1 000 000 each.
A bond currently trades at R1 100 000 and has 5 years to maturity. Further
assume that interest is paid annually at R112500 per annum. Calculate the
YTM.
Approximating the YTM involves the use of the following equation:

M–DB0 M+DB0
Approximate yield= I + divided by
n 2
where:
I = the annual interest (as an amount)

M = the par value
DB0 = the current value of the bond
n = the years to maturity
The approximation of the YTM can be done as follows:

1 000 000–1100 000 1 000 000 + 1100 000
Approximate YTM =112 500 + ÷ = 12.6%
5 2
The approximate yield to maturity is 16%. A more precise answer may be

obtained using a financial calculator.
Calculating the yield to maturity with a financial calculator may be done as

follows: using an HP10BII+ calculator, press C ALL (clear all) to clear the
memory. Press 5 and N to indicate the number of years to maturity. Next,
press 112500 and PMT to indicate the amount of interest, followed by 1
000000 and FV to indicate the bond’s maturity value. Next press 1 100 000,
then ± and PV to indicate the present value. The calculator now has all the
required data to perform the calculation of the YTM. To calculate the YTM,
press I/YR. The answer displayed is 8.69%.
5.4.1.2 Bond value, required returns and the time to maturity

The value of a bond varies during its lifetime and is influenced by a variety
of forces in the economy. In this section, attention is given to required
returns and time to maturity.
Required returns
Whenever the required return on a bond differs from the coupon rate, the
bond’s value will differ from its par value. If the required rate of return
differs from the coupon rate, it is either because economic conditions have
changed, causing a shift in interest rates, or because the firm’s risk has
changed. An increase in interest rates and/or the riskiness of the firm will
raise the required rate of return, and vice versa.
When the required return is greater than the coupon rate, the bond value
will be less than its par value. In that event the bond will sell at a discount.
Should the required rate of return fall below the coupon rate, the bond value
will be greater than the par value. The bond is then said to be trading at a
premium.
Time to maturity
Whenever the required return is different from the coupon interest rate, the
length of time to maturity affects bond value.
When the required return is different from the coupon rate and assumed
constant until maturity, the value of the bond will approach its par value as
the passage of time moves the bond’s value closer to maturity.
The shorter the length of time until maturity, the less responsive its market
value is to a given change in the required return. This may be ascribed to a
reduction in interest rate risk as the maturity date approaches.
5.4.2 Preference shares

The value of a preference share may be determined by means of the
following equation:
Dp
Vp =
kp
where:
Vp = value of preference share

Dp = dividend of preference share
kp = required rate of return on preference share
Example: Assume a company issues 6% preference shares at 100 cents

each. The dividend will amount to 0.06 × 100 cents, which is equal to 6
cents per share. An investor has a required rate of return of 3.5% or 0.035.
The value of the preference share should be:
6
Vp = = 171 cents
0.035
The investor should consider buying the share if it trades at a price below
171 cents and if it assists in diversifying his portfolio.
5.4.3 Ordinary shares

This section focuses on ways in which investors could do the valuation of
ordinary shares. One may distinguish between models which discount
future cash flows and relative valuation techniques.
Applying the generic model to ordinary shares:

∞
DPSt
Value of share = ∑
t
t=1 (1 + k)
where:
DPSt = dividends per share

The valuation of ordinary shares may be done following one of two

approaches, namely discounted cash flow techniques or relative valuation
techniques.
Discounted cash flow techniques which may be used for the valuation of
ordinary shares are the constant growth model, the two-stage dividend
discount model, the three-stage dividend discount model and the no-growth
model.
5.4.3.1 Constant growth model

The constant growth model is also known as the Gordon growth model or
dividend discount model (DDM):
DPSl
Value of share =
k–g
where:
DPS1 dividends per share expected one year from

= now
k = required rate of return on ordinary share
g = constant annual growth rate
Example: Assume a company is expected to pay a dividend of R3.20 next

year. The growth rate of the firm is 17.2% and the investor’s required rate
of return is 20%. The value of the share should be:
DPSl 3.20
Value of share = = = 114.28
k−g 0.20−0.172
The investor could consider buying the share if it trades below R114.28 and
if it will enhance the risk–return characteristics of his portfolio.
The limitations of the DDM are that:
It is relevant only to firms growing at a constant and perpetual rate.

As the growth rate (g) converges with the discount rate (k), the value
goes to infinity.
In line with the above, if the growth rate (g) exceeds the required rate of
return (k), the value of the share cannot be determined.
The DDM is appropriate for the valuation of a firm that has the following
features:
Stable earnings growth rate at or below the nominal growth rate in the
economy
Well-established dividend payout policy that is likely to continue into the
future
A payout ratio consistent with the assumption of stability
Stable leverage and beta
Utility companies are particularly well suited due to their regulated prices,
stable growth and high dividends. In the South African context the model
may be used, for example, for the valuation of Eskom SOC Ltd.
5.4.3.2 Two-stage dividend discount model

This model makes provision for two stages of growth:
An initial phase of extraordinary growth

A subsequent steady state of no growth or stable growth
If the initial phase lasts n years, the DDM model can be represented as:
n
DPSt Pn
Value of share = ∑ +
t n
t=1 (1 + k) (1 + k)
where:
DPSt = dividend per share expected in period t

k = required rate of return of ordinary share
Pn = share price at the end of year n
Example: Assume a company’s most recent dividend (D0) was 15 cents per
share. The dividends are expected to increase by 12% annually over the
next 3 years. At the end of the 3 years the growth rate is expected to drop to
a 10% annual growth rate indefinitely. The shareholders’ required return is
15%.
The formula for the two-stage dividend growth model is as follows:

D1 D2 D3 D4 D5 P5
V0 = + + + + +
1 2 3 4 5 5
(1+r) (1+r) (1+r) (1+r) (1+r) (1+r)
Step 1: Determine the expected future cash flows:
D0 = 15.00
D1 = 15.00(1.12) = 16.80
D2 = 16.80(1.12) = 18.82
D3 = 18.82(1.12) = 21.08
D4 = 21.08(1.10) = 23.19
P3 = 23.19
0.15−0.10
= 463.72
Step 2: Calculate the intrinsic value of the share:

16.80 18.82 21.08 463.72
V0 = + + +
2 3 3
1.15
(1.15) (1.15) (1.15)
= 14.61 + 14.23 + 13.86 + 304.91
= 347.51 cents or R3.48
OR
Having completed the first step, you can also use your financial calculator
to complete the second step as follows.
HP10BII+
Input Function
0 CF0
16.80 CF1
18.82 CF2
484.80 CF3
15% I/YR
NPV
347.60 cents or R3.48
The limitations of the two-stage DDM are:
Defining the length of the high-growth period is problematic.

Unrealistic growth assumptions are made.
The value estimate is highly sensitive to assumptions about the stable
growth rate.
The model is best suited to firms experiencing high growth, but where the
sources of high growth are expected to disappear (e.g. patent rights that
may expire or barriers to entry that may disappear).
5.4.3.3 Three-stage dividend discount model

t=n1 t
EPS0 (1 + g) × πa
Value of share = ∑
t
t=1 (1 + k)
High-growth phase
t=n2
DPSt
+ ∑
t
t=nl+1 (1 + k)
Transition phase
t
EPSn2 (1 + gn) × πn
n
(k − g ) (1 + k)
n
Stable growth phase
where:
EPS = earnings per share
DPS1 = dividends per share expected one year from now
k = required rate of return on ordinary shares
ga = growth rate in high-growth phase of n years
gn = stable growth rate
πa = payout ratio in high-growth phase
πn = payout ratio in stable growth phase
Example: Assume a company’s most recent dividend (D0) was 15 cents per
share. The dividends are expected to increase by 12% annually over the
next 3 years. At the end of the 3 years the growth rate is expected to drop to
an 11% annual growth rate for 2 years. The growth rate after the first 5
years is then expected to remain constant at 10% per annum indefinitely.
The firm’s required return is 15%.
The formula for the three-stage dividend growth model is as follows:
D1 D2 D3 D4 D5 P5
V0 = + + + + +
1 2 3 4 5 5
(1+r) (1+r) (1+r) (1+r) (1+r) (1+r)
Where: P5 =
D6
k−g
Step 1: Determine the expected future cash flows:
D0 = 15.00
D1 = 15.00(1.12) = 16.80
D2 = 16.80(1.12) = 18.82
D3 = 18.82(1.12) = 21.08
D4 = 21.08(1.11) = 23.40
D5 = 23.40(1.11) = 25.97
D6 = 25.97(1.10) = 28.57
P6 = 28.57
0.15−0.10
= 571.36
Step 2: Calculate the intrinsic value of the share:
V0 = 16.80
1.15
+
18.82
(1.15)
2
+
21.08
(1.15)
3
+
23.40
(1.15)
4
+
25.97
(1.15)
5
+
571.36
(1.15)
5
= 14.61 + 14.23 + 13.86 + 13.38 + 12.91 + 284.07

= 353.06 cents or R3.53
OR
Having completed the first step, you can also use your financial calculator
to complete the second step as follows.
HP10BII+
Input Function
0 CF0
16.80 CF1
18.82 CF2
21.08 CF3
23.40 CF4
597.33 CF5
15% I/YR
NPV
353.06 cents or R3.53
The share currently has a fair (intrinsic) value of R3.53 and the investor
should buy the share if it trades below R3.53 and if it will enhance the risk–
return characteristics of his portfolio.
This model is very flexible and can therefore, in theory, be used for any
firm regardless of changes in growth rates, payout policies or risk. The most
important limitation is that of accurately estimating the various variables in
the model.
5.4.3.4 No-growth model

Since no growth is expected, the value of the firm is the discounted value of
the perpetual stream of earnings (E):
E
V =
k
where:
V = value of the firm

E = perpetual stream of earnings
Example: Assume a company maintains earnings per share at 84 cents. The

firm has a required rate of return of 9.8%. The fair (intrinsic) value of the
share may be found by:
84 (cents)
E
V = = = 857 (cents)
k 0.098
The investor should buy the share if it trades below R8.57 and if it will
enhance the risk–return characteristics of the portfolio.
5.4.3.5 Measures of relative value

Relative valuation models are used for investment purposes mainly for
ranking shares of similar firms or firms from the same sector. Measures of
relative value include the P/E ratio, the P/BV ratio, the P/S ratio and the
P/CF ratio. Each of these measures of relative value is explained below.
Price/earnings ratio
The price/earnings (P/E) ratio may be calculated as follows:
Current market price
P/E =
Expected 12 month earnings per share
The determinants of the P/E ratio may be evaluated in terms of the constant
growth model as follows:
Payout ratio (1+g )
n
P/E =
k–g
n
The P/E ratio is determined by the:
Expected dividend payout ratio

Estimated required rate of return (k)
Expected growth rate of dividends for the share (g)
Example: Assume a company has a current market price of R495 and the
firm’s earnings per share (eps) are expected to amount to 1 550 cents. The
firm’s P/E equals:
P/E = R495 ÷ R15.50 = 32 times
Price/book value ratio

Price/book value ratio = market price of share ÷ book value of share
Example: Assume the ordinary shares of a company trade at R26.50 and

the firm’s book value of shares is R5 per share. The P/BV ratio is:
P/BV = R26.50 ÷ R5 = 5.3 times
The P/BV is used mainly for the valuation of bank shares.
Price/sales ratio
The price/sales (P/S) ratio is calculated as follows:
Pn
P/S =
Sn+1
where:
Pn = the price of the share in period n

Sn+1 = the expected sales per share

the firm’s expected sales per share are R1.10 per share. The P/S ratio is:
P/S = R10.55 ÷ R1.10 = 9.6 times
Care should be taken when using the P/S ratio, because it should only be
applied to firms in the same industry. The P/S ratio varies from one industry
to another. The company could have a relatively high sales level and a
subsequently relatively high P/S compared with a company from another
sector.
Price/cash flow ratio

According to Reilly & Brown (2012: 332), the price/cash flow (P/CF) ratio
is found by:
Pt
P/CF =
CFt+1
where:
Pt = the price of the share in period t

CFt+1 = the expected cash flow per share of the firm

the firm’s cash flow per share is 45 cents per share. The P/CF ratio is:
P/CF = R10.55 ÷ R0.45 = 23.44 times

The P/CF ratio is used to supplement the P/E ratio because a firm’s cash
flow is subject to less accounting manipulation than reported earnings.
5.4.4 Valuation of investment trusts

Investment trusts pool the funds of investors who have bought shares in the
investment trust and invest the funds in a portfolio of financial assets.
Normally the shares of investment trusts are listed on a securities exchange.
Net asset value (NAV) measures the market value of an investment

company’s assets (which consist mainly of financial assets) after deducting
all liabilities, divided by the number of shares issued. NAV may be
Total assets – Total liabilities
NAV =
Number of issued shares
The investment analyst may compare the NAV as a discount to the share
price in order to determine whether the share is over- or undervalued. In the
latter case the market is generally not too concerned about asset values
when pricing the share. NAV is ideal for the valuation of the shares of
investment trusts listed on a securities exchange.
Example: Assume a company has issued 143 380 ordinary shares and that
the firm’s shares are trading at R10 each. The firm’s total assets amount to
R2 800 000 and total liabilities to R850 000. Further assume that
investment trust companies normally trade at a discount of 20% to NAV.
The NAV of the company’s shares is calculated as follows:
NAV = R2 800 000–R850 000
143 380
=
R1 950 000
143 380
= R13.60
At an NAV of R13.60 per share the company’s shares are at a discount of

26.47% (3.60/13.60). Since a discount of 20% is regarded as the norm, the
share price of 26.47% as a discount to NAV may be indicating that the share
is undervalued [should trade at R(13.60 × 0.80) = R10.88] by the market
and offers a buy opportunity to investors.
A firm with substantial assets but with low profits may trade at a discount
to NAV. According to Kinghorn (1987: 67), a discount may indicate a
number of things, for example:
Dividend cover is excessively high. In other words, investors are of the

opinion that the firm retains too much of its earnings for reinvestment in
assets instead of paying them out as dividends.
The firm is experiencing financial difficulties, implying an asset market
value below book value – as the firm’s financial position deteriorates, so
NAV increases in importance to the shareholders.
Returns on assets are low.
Recent investments have not yet improved the profitability of the firm.
Management is poor.
5.4.5 Warrants
Warrants are equity call options sold by a company whose shares are the
underlying asset of the options. Warrants do not pay dividends, do not
afford holders any voting rights, but give the holder the right to buy a
certain number of shares at a set price from the issuing company (Strong,
2007: 343).
If the option is exercised by the warrant holder, the company will issue new
ordinary shares. An increase in the number of ordinary shares has several
implications. Most importantly, it increases the number of ordinary shares.
The increase in the number of shares reduces earnings per share (eps) and
the dividends per share, and ultimately the value of the ordinary shares.
This phenomenon is called dilution.
Warrants have predetermined exercise prices and expiration dates.
The value of an option will therefore depend on the value of the shares of
the particular company. Galai and Schneller (1978) propose the following
warrant valuation model: for a warrant at expiration date t, the warrant will
be worth
Vt +Nw X
Wt = max [ − X, 0]
N+Nw
where:
N = current number of ordinary shares issued

Nw the number of new shares created if the warrants are
= exercised
Vt = the value of the firm before the warrants are exercised
X = the exercise price
The terminal value can be found by:

1
Wt = [ ] Ct
1+(Nw ÷N)
where:
Ct = the expiration date value of a regular call option with otherwise

identical terms to those of the warrant
The value of a warrant should, prior to expiration, be equal to the value of

the call diluted by the factor [1 + (Nw ÷ N)]-1.
The theoretical minimum value is the warrant’s intrinsic value. The intrinsic
value is the greater of zero and the amount by which the share price exceeds
the exercise price.
Example: Assume a share price of R20 and a warrant with an exercise

price of R15. This warrant should always sell for at least R5. The intrinsic
value of the warrant is R5. If the exercise price is below the current share
price, the warrant is said to be in-the-money. If the share price declines to
R12, the warrant will be out-the-money. The difference between the market
price of the warrant and its minimum value is largest when the share price
equals the exercise price.
5.5 SUMMARY
Value refers to the present value of all cash flows that may be earned from
an asset. It is sometimes also referred to as fair value, intrinsic value or
estimated value.
Valuation plays a key role in investment decisions. Valuation models for

bonds, preference shares, ordinary shares, investment trusts and warrants
were explained in this chapter.
The valuation of ordinary shares may be done following one of two

approaches, namely discounted cash flow techniques, or relative valuation
techniques. Discounted cash flow techniques include the constant growth
model, the two-stage discounted cash flow model (DCFM), the three-stage
DCFM and the no-growth model. Relative valuation models include the
price/earnings (P/E) ratio, the price/book value (P/BV) ratio, the price/sales
(P/S) ratio and the price/cash flow (P/CF) ratio. Investment trusts may be
valued using net asset value (NAV).
Galai, D. & Schneller, M.I. 1978. Pricing warrants and the value of the firm. Journal of Finance,
33(5): 1333–1342.
Kinghorn, F. 1987. Starting on the stock exchange. Finance Week, Johannesburg.
Marx, J. & De Swardt, C.J. 2013. Financial management in southern Africa, 4th ed. Cape Town:
Pearson.
Strong, R.A. 2007. Management for practical investing, 4th ed. Mason, OH: Thomson.
WEBSITES
http://www.monevator.com/investment-trust-discounts-and-premiums/
https://www.researchgate.net/publication/5150842_Japan_and_Hong_Kong_Exchange-
Traded_Funds_ETFs_Discounts_Returns_and_Trading_Strategies
1. The key inputs to the valuation process are
(i) cash flows

(ii) timing
(iii) required return
(iv) depreciation
Which of the following combinations is correct?
(a) (i) and (ii)

(b) (i) and (iii)
(c) (i), (ii) and (iii)
(d) (ii), (iii) and (iv)
2. J. Stern acquires an asset that is expected to generate cash flows of R2 200, R0,
R4 400 and R11 000 at the end of years 1, 2, 3 and 4 respectively. J. Stern’s
required rate of return is 18%. The value of the asset equals:
(a) R10219.00
(b) R14432.00
(c) R17600.00
(d) R31154.20
3. Momentum Investments Ltd has a required rate of return of 15%. It is considering
investing in SAB Miller bonds which will be issued at a par value of R1 000 with a
coupon interest rate of 12% (paid annually) and an initial maturity of 10 years. The
value of the bond is approximately:
(a) R247.00
(b) R602.28
(c) R849.28
(d) R1000.00
4. Citizen Bank is expected to pay an annual dividend of 90 cents per share
indefinitely and the required rate of return equals 18%. The value of the share
equals:
(a) R0.16
(b) R5.00
(c) R10.62
(d) R16.20
5. The constant rate of dividend growth for RA Investments is 8%. The firm is
expected to pay an annual dividend (D1) of R2.50 next year. The required rate of
return (ks) equals 18%. The value of the share (P0) equals:
(a) R 9.62
(b) R13.89
(c) R25.00
(d) R31.25
6. I&J Ltd is expected to have earnings per share of R2.50 next year. The average
P/E ratio for firms in the food sector is 18. The value of the firm’s ordinary shares
is … each.
(a) R7.20
(b) R13.89
(c) R20.50
(d) R45.00
7. I&J Ltd has a beta (β) of 1.2, while the market return equals 18% and the risk-free
rate of return equals 12%. The firm is expected to pay a dividend (D1) of R8.64
next year. The firm’s ordinary shares are worth … each.
(a) R10.37
(b) R45.00
(c) R48.00
(d) R72.00
8. Assume Liberty Ltd’s most recent dividend (D0) was 20 cents per share. The
dividends are expected to increase by 15% annually over the next 3 years. At the
end of the 3 years the growth rate is expected to drop to a 12% annual growth
rate for 2 years. The growth rate after the first 5 years is expected to remain
constant at 10% per annum indefinitely. The firm’s required return is 15%. The fair
(intrinsic) value of a Liberty share is closest to:
(a) R5.26
(b) R9.59
(c) R10.99
(d) R15.59
9. Lonfin Ltd has issued 10 000 000 ordinary shares and the firm’s shares are
trading at R5.50 each. The firm’s total assets amount to R100 000 000 and total
liabilities to R60 000 000. Further assume that investment trust companies similar
to Lonfin normally trade at a premium of 20% to NAV. The NAV of Lonfin shares is:
(a) 150 cents

(b) 300 cents
(c) 400 cents
(d) 550 cents
10. Assume the ordinary shares of RMB Holdings Ltd trade at R9.80 and the firm’s
book value of shares is R0.82 per share. The firm has an earnings yield of 7% and
a dividend yield of 3.9%. The P/BV ratio is closest to:
(a) 0.08
(b) 10.9
(c) 12
(d) 16
Solutions
1. (c)
2. (a) R10 219, calculated as follows:
R2 200 × 0.847 = 1 863.40
R0 × 0.718 = 0.00
R4 400 × 0.609 = 2 679.60
R11 000 × 0.516 = 5676.00
10 219.00
3. (c) R849.28, calculated as follows:

R 120 × PVIFA15%, 10 years = R120 × 5.019 = R602.28
R1 000 × PVIF15%, 10 years = R1 000 × 0.247 = R247.00
R849.28
4. (b) P0 =
D1
ks
R0.90
=
0.18
=R5.00
5. (c) P0 =
D1
ks –g
R2.50
=
0.18–0.08
=R25.00
6. (d) P0 = EPS × P/E = R2.50 × 18 = R45.00

7. (b) ks = Rf + b(km – Rf) = 12% + 1.2(18% – 12%) = 19.2%
D1
P0 =
ks
R8.64
=
0.192
=R45.00
8. (a)
End of year Dn ×FVIFg,1 =Dt
1 20 ×1.150 =23
2 23 ×1.150 =27
3 27 ×1.150 =31
4 31 ×1.120 =35
5 35 ×1.120 =39
Next, the sum of the expected future dividends is calculated using the
required rate of return (ks) of 15%.
Dt × PVIF15%,t = PV
23 × 0.870 = 20
27 × 0.756 = 20
31 × 0.658 = 20
35 × 0.572 = 20
39 × 0.497 = 19
Sum of PV of dividends = 99
The value of the share at the end of year 5 may be found by first calculating
the expected dividend at the end of year 6:
D6 = D5 × (1 + g) = 39 × (1 + 0.10) = 39 × 1.1 = 43 cents
Knowing D6, one can apply the constant growth model for the period beyond
year 5:
43
Ps = = R8.60
0.15−0.10
PV of R8.60 = R8.60 × 0.497 = R4.27

value of the share, P0, is the sum of the dividends for years 1 to 5, plus the
value of the share at the end of the initial growth period (from year 6
onwards):
P0 = R0.99 + R4.27 = R5.26
The share currently has a fair (intrinsic) value of R5.26 and the investor
should buy the share if it trades below R5.26 and if it will enhance the risk–
return characteristics of his portfolio.
9. (c) NAV =
R100 000 000–R60 000 000
=
R40 000 000
= R4
10 000 000 10 000 000
At an NAV of R4 per share and the Lonfin shares trading at R5.50, the shares
are at a premium of 37.5% (1.5/4) to NAV. Since a premium of 20% is
regarded as the norm, the NAV of R4 may be indicating that the share is
overvalued by the market and offers a sell opportunity to investors.
10. (c) R9.80 ÷ R0.82 ≈12 times
6 Fundamental analysis
6.1 INTRODUCTION
Fundamental analysis refers to the process of analysing the macroeconomic,

industry and company-specific factors influencing the risk and return
characteristics of an investment. It assumes that any decrease in the risk
and/or increase in the return of an investment increases the value of an
asset. Fundamental analysis thus aims to identify investments that are
undervalued by the market and offer an opportunity for gain.
Fundamental analysis is not the only way in which investments may be

evaluated. The alternative is called a bottom-up approach or stock picking.
This approach uses the valuation models (explained in Chapter 5) without
considering macroeconomic and industry influences on the prospects of a
company or companies valued.
Fundamental analysis could be used in conjunction with technical analysis,

which involves the use of charts which plot market information such as
prices and volumes to assist the investor with his investment decisions. In
such instances fundamental analysis is used to identify undervalued
investments and technical analysis is used to determine the timing of the
investment.
Fundamental analysis is relevant to the valuation of all asset classes. The

main asset classes are equity investments (dividend-earning investments),
bonds (interest-earning investments), real estate (rent-earning investments)
and cash. This book focuses on investment in equities and bonds. Part 2
explains the analysis of equity investments and Part 3 the analysis of bonds
in greater detail. This chapter is therefore a brief introduction to
fundamental analysis, aimed at emphasising the significance of
macroeconomic influences on investment decisions. The chapter starts by
explaining the three-step, top-down valuation process.
6.2 THREE-STEP VALUATION PROCESS
The three-step valuation process requires an analysis of the macroeconomic

prospects, followed by industry analysis and company analysis.
Fundamental analysis is therefore regarded as a top-down approach to
investments.
Fundamental analysis assumes that the risk and return of investments are
strongly influenced by macroeconomic conditions, such as growth in gross
domestic product (GDP), interest rates, inflation and exchange rates.
Fundamental analysis ultimately results in the valuation of certain assets.

Valuation discounts future returns (dividends, interest or proceeds from the
sale of the asset) to present value. Thus, fundamental analysis emphasises
future developments in the economy or the industry and the influence these
will have on the assets under consideration. The analyst has to ask himself
which industries (or sectors) stand to gain most from the expected economic
prospects, and within such industries, which companies stand to gain most.
Once the analyst has answered these questions, he is in a position to
determine the fair (intrinsic) value of the assets under consideration. This
process is graphically represented in Figure 6.1.
Figure 6.1 Overview of fundamental analysis
Since the analyst is making a study of future economic prospects, he has to

make use of economic forecasting methods.
6.3 ECONOMIC FORECASTING
Three of the methods that may be used for economic forecasting are the
following:
An index of leading economic indicators

Economic forecasting models
Market signals
6.3.1 Index of leading economic indicators

An index of leading economic indicators provides a composite statistic
comprised of a number of variables that have historically changed prior to
similar moves in the general business cycle. Examples of leading economic
indicators are net gold reserves, gold ore milled, the number of new
motorcars sold and the number of new companies registered.
6.3.2 Economic forecasting models

Economic forecasting models employ the relationships among variables
that are theoretically valid and whose parameters can be determined using
various forms of regression analysis. The idea is to find stable relationships
that may be used for the prediction of key economic variables such as GDP,
inflation, interest rates and unemployment based on currently observable
variables.
6.3.3 Market signals

Market signals provide clues about upcoming economic events from real-
time market data. Investment analysts monitor sensitive, highly competitive
markets such as the gold market and the foreign exchange market for this
purpose.
Example: Increases in the price of gold, increases in interest rates and a

decrease in the value of the domestic currency could mean the investor is
detecting an upcoming deterioration in the purchasing power of the
domestic currency.
The following section explains the key macroeconomic variables analysed

by investment analysts.
6.4 MACROECONOMIC ANALYSIS
Macroeconomic analysis may either be performed by economists appointed

by investment firms for this purpose or bought from research institutions
such as the Bureau of Economic Research at the University of Stellenbosch.
Macroeconomic analysis involves various measures used to assess the

condition of the macroeconomic environment in which companies are
operating. These include the GDP, inflation and interest rates, exchange
rates, budget deficits, the balance of payments and unemployment rates.
Any changes or trends in these variables could influence the sentiment of
consumers and the business community alike.
Example: A weakening of the South African rand (ZAR) against major

currencies such as the US dollar ($), pound sterling (£) and euro (€)
normally leads to an increase in the price of imported goods, an increase in
inflation and an increase in interest rates in South Africa. As a result of the
increase in inflation and interest rates, consumers experience a decline in
disposable income and respond in the following ways: the less wealthy
might decide to spend less on clothing, while the more wealthy might
decide to spend less on entertainment and dining at restaurants. The result
could be a decline in the sales and profitability of retail firms, entertainment
firms and restaurants. Firms selling on credit might also experience an
increase in bad debt. Firms could also experience an increase in their cost of
capital and could become hesitant to undertake any expansion projects. The
end result could be a negative sentiment among both consumers and the
business community.
Each of the key factors in macroeconomic analysis is now explained,

starting with the GDP.
6.4.1 Gross domestic product

GDP reflects the total market value of all final goods produced domestically
during a specific period. GDP is not synonymous with gross national
product (GNP). The latter measures the output produced by the nationals of
a country. GNP is therefore calculated by taking the GDP, plus income
received by citizens for factors of production supplied abroad, minus
income paid to foreigners for their contribution to domestic output.
Inflation makes it necessary to distinguish between nominal and real GDP.

Nominal GDP is expressed at current prices. It is also referred to as money
GDP. Real GDP adjusts for changes in price levels (inflation) by means of
the GDP deflator:
Real GDPt = Nominal GDPt ×

GDP deflatort–n
GDP deflatort
where:
real GDPt = GDP in year t – n prices
t = current year
t – n = number of years prior to period t
The GDP deflator is a price index that reveals the cost of purchasing the
items included in GDP during the period, relative to the cost of purchasing
these same items during a base year (t – n years ago). The base year is
assigned a value of 100.
Real GDP may be estimated, according to the Keynesian view, as follows:
Real GDP = planned C + I + G + X

where:
C = planned consumption
I = planned investment
G = planned government expenditure
X = planned net exports
Macroeconomic equilibrium is expected if real GDP is equal to planned

aggregate expenditure (planned C + I + G + X). If real GDP (total output) is
expected to be less than total planned expenditure, the tendency of output is
to expand (and vice versa).
The estimation of GDP is not straightforward. Some of the problems

experienced are the following:
It is difficult to estimate the value of goods and services not sold in a
market (for example, goods produced by government and sold at cost).
Unrecorded economic activity such as that of the informal sector is
difficult to establish.
Despite these problems, changes in GDP still reflect changes in the

aggregate level of economic activity. An investment analyst studying GDP
must ask himself what the prospects are for either growth in GDP or a
decline in GDP, as well as the impact this will have on the various
industries and companies operating in the economy.
An expected growth in GDP is an indication of an expanding economy,

which offers opportunities to firms to increase their sales and profitability.
The opposite is also true, namely that a decline in expected GDP signals a
possible decline in sales and profitability for most firms. One way in which
firms may overcome a decline in sales and profitability in the local
economy is to export goods (if feasible).
The GDP of a country does not always experience positive growth.

Sometimes countries may experience recessions which, if not managed
properly by means of monetary and fiscal policy, may lead to a depression.
Recession refers to a decline in real GDP and an increase in unemployment
for two or more successive quarters. Depression refers to a decline in real
GDP and an increase in unemployment extending beyond at least two
successive quarters.
6.4.2 Interest rates

Interest rates refer to the rate of compensation agreed to between borrowers
and lenders of money. Commercial banks act as intermediaries between
savers (depositors) and borrowers. Commercial banks cannot, however,
lend out all their available funds because they are required by legislation to
keep some of their funds in cash to meet demands for payments by
depositors. The percentage of cash to be held (called the reserve
requirement or cash ratio) is determined by the central bank (the SARB in
the case of South Africa or the Federal Reserve (FED) in the case of the
US). The central bank attempts to control the money supply by means of its
monetary policy. The central bank does not only enforce a certain reserve
requirement (cash ratio), it also
acts as the lender of last resort to the banking sector and influences
interest rates by raising or lowering the rate at which the central bank
lends to the commercial banks (this rate is known as the repo rate or
minimum lending rate)
reduces the level of money supply in the economy by issuing treasury
bills, which then absorb some of the money in circulation
rediscounts bills and other short-term instruments on behalf of
commercial banks
acts as the government’s banker by managing the country’s gold and
foreign reserves.
Interest rates are thus influenced by the monetary policy pursued by a

country’s central bank. Monetary policy could either be expansionary or
restrictive. Table 6.1 summarises the tools which may be used to effect an
expansionary or a restrictive monetary policy.
Table 6.1 Tools used to effect monetary policy
Tool Expansionary monetary policy Restrictive monetary policy

Reserve Reduce reserve requirements Raise reserve requirements
requirements
Open market Purchase additional government securities, Sell previously bought
operations which releases funds into the economy and government securities, which
expands the money supply will reduce the money supply
Repo rate Lower the repo rate, which will encourage Increase the repo rate, which
more borrowing from the central bank will discourage borrowing from
the central bank
The investment analyst must ask himself whether interest rates are expected
to increase or decrease during the period under consideration and, if so,
what the expected impact on the economy will be. An expansionary
monetary policy leads to lower interest rates, which, generally speaking,
result in increases in share and bond prices. Under expansionary monetary
policy, companies are expected to experience lower risk and improved
returns.
6.4.3 Inflation
Inflation refers to the rate at which the general level of prices is rising.
Inflation results in a decline in the purchasing power of money and may be
measured in terms of either the production price index (PPI) or the
consumer price index (CPI). The inflation rate may be calculated as
follows:
PIt –PIt–1
Inflation rate (%)= × 100
PIt–1
where:
PI = price index (either the PPI or CPI)
t = period t
t – 1 = one year prior to year t
The PPI measures the rate and level of price increases on goods
manufactured and imported (including capital and intermediate goods). The
PPI is estimated and published by Statistics SA on a monthly basis. The
prices used in their estimates are measured at the first significant economic
transaction.
The CPI (sometimes referred to as headline inflation) measures the rate and
level of price increases experienced by consumers over a given period on a
so-called basket of goods and services commonly purchased by households.
A distinction is also drawn between core inflation and the CPI(X). Core
inflation is calculated by excluding items from the CPI basket on the basis
that their prices are highly volatile, subject to temporary influences or
influenced by government policy and/or intervention. CPI(X) excludes the
influence of mortgage bond rates on inflation.
Examples: The following are examples of items excluded from the CPI
calculation to obtain the so-called core basket: fresh and frozen meat, fish,
vegetables, fresh fruit and nuts, interest rates on mortgage bonds and
overdrafts, as well as value added tax (VAT).
According to Mohr (2014: 120), there is a link between PPI and CPI. Any
change in the rate of increase of the PPI gives an indication of change in the
CPI at a later stage. Due to differences in the variables used in the
computation of these two measures of inflation, the increase in PPI will not
necessarily match the increase in CPI. The influence of changes in interest
rates and VAT, for example, is not included in the calculation of the PPI, but
it is reflected in the calculation of the CPI.
The investment analyst must ask himself if inflation is expected to increase

or decrease during the period under consideration and, if so, what the
expected impact on the economy will be. The analyst should distinguish
between the impact of anticipated and unanticipated inflation. Anticipated
inflation is expected by most decision makers and taken into account when
financial planning is done. Unanticipated inflation is not expected by most
decision makers.
Some of the harmful effects of inflation are the following:
Unanticipated inflation alters the outcomes of capital expenditure

projects of firms, thereby increasing risk.
Inflation distorts the information delivered by prices. Some prices
respond quickly while others change more slowly. Unanticipated
inflation will change relative prices as well as the general price level.
People will respond to high and variable rates of inflation by spending
less time producing and more time trying to protect themselves from
inflation.
6.4.4 Budget deficit of the government

A budget deficit means government spending exceeds tax revenues and the
deficit has to be financed by means of debt. A budget deficit means an
increase in the demand for funds, which, if the supply of funds does not
increase simultaneously, could lead to an increase in interest rates.
Government could, however, finance the budget deficit by borrowing from
financial institutions abroad. This is a sensible strategy if it can be done at
lower interest rates abroad compared to local rates and if government
hedges against adverse movements in the exchange rate of the local
currency.
The budget deficit is usually announced in the annual budget speech of the
Minister of Finance when the national budget is tabled in Parliament. If
government spending equals tax revenues, the budget is said to be balanced.
Spending less than tax revenue results in a budget surplus, with the result
that government can either repay its borrowings or reduce tax rates.
The budget deficit and the way in which it is financed are part of a
country’s fiscal policy. The Keynesian view of fiscal policy is that it may be
used in an expansionary, restrictive or counter-cyclical way. An
expansionary fiscal policy is suggested when an economy is operating
below its potential output. An expansionary fiscal policy involves
increasing government expenditure and/or lowering tax rates to increase the
budget deficit. It leads to increased aggregate demand, increased output, a
move to full employment and an increase in the general price level. A
restrictive fiscal policy involves decreasing government spending and/or
increasing tax rates in order to combat inflation which has been created by
excessive aggregate demand. A counter-cyclical fiscal policy tends to move
the economy in an opposite direction from the forces of the business cycle.
The use of a budget deficit may lead to a so-called crowding-out effect. The
crowding-out effect is the result of increased government borrowing, which
leads to an increase in the demand for loanable funds, higher interest rates,
a reduction in consumer spending and lower investment by business.
The investment analyst must ask himself if the budget deficit is expected to
increase or decrease during the period under consideration and, if so, what
the expected impact on the economy will be.
6.4.5 Balance of payments

The balance of payments is a summary of the value of economic
transactions between residents from the reporting country and residents of
other countries for a certain period (a quarter or a year). The balance of
payments account reflects all payments and liabilities to foreigners and all
payments and obligations received from foreigners. A current account
deficit means a country imports more than it exports, while a surplus means
a country exports more than it imports.
According to Mohr (2014: 168), about 80% of South African imports are
capital and intermediate goods. This could be interpreted as positive in
terms of South Africa’s growth prospects and wealth creation because these
assets are imported with the intention of using them for productive
purposes. If the majority of imports were consumer goods to be used for
consumption and not for productive purposes, this would not make a
significant contribution to wealth creation.
Trade between countries creates a demand and supply for currencies, which
is one of the main determinants of exchange rates. A persistent trade deficit
for South Africa implies that South Africans are creating a demand for
foreign currencies that exceeds the demand for South African rand. The
imbalance places downward pressure on the value of the rand in relation to
the other currencies. Once a trade balance deficit is announced, one may
expect the value of the rand to decrease; in other words, the rand
depreciates. A trade surplus will have the opposite effect and the rand will
appreciate against foreign currencies.
6.4.6 Exchange rates

The exchange rate is the rate at which one unit of domestic currency (say,
South African rand) can be converted into a foreign currency (say, euro).
An exchange rate could either be fixed or floating. A fixed exchange rate is
an exchange rate that is set at a fixed rate by government policy. A floating
exchange rate exists if the value of the currency is determined by market
forces; in other words, by supply and demand.
The supply and demand for any currency is the result of trade between
countries. In order to purchase goods from Europe, South Africans must
purchase euros, thereby creating a demand for euros and a supply of rand.
To purchase goods from South Africa, European countries must purchase
rand with euros. This creates a supply of euros and a demand for rand. Any
change that alters the quantity of imports relative to exports therefore brings
about an appreciation or depreciation of a nation’s currency.
According to Gwartney, Stroup, Sobel and Macpherson (2006: 397–401),

the factors that cause a change in a floating exchange rate are the following:
Differences in the growth of income of countries. A country with a slow

growth of income (relative to that of its trading partners), which causes
its imports to lag behind its exports, will experience an appreciation of its
currency. A country with a rapid growth of income (relative to trading
partners), which stimulates imports relative to exports, will experience a
depreciation of its currency.
Differences in rates of inflation. A country with a rate of inflation lower
than that of its trading partners will experience an appreciation of its
currency. A country with a rate of inflation higher than that of its trading
partners will experience a depreciation of its currency.
Changes in real interest rates. A country with a domestic real interest
rate greater than real interest rates abroad will experience an appreciation
of its currency. A country with domestic real interest rates lower than real
interest rates abroad will experience a depreciation of its currency.
Monetary and fiscal policy also has an impact on exchange rates. An

unanticipated shift to a more expansionary monetary policy results in a
short-term depreciation of a currency, because an expansionary monetary
policy will lead to accelerated domestic economic growth, increased
inflation and lower real interest rates.
A shift to a more restrictive fiscal policy leads to the following two results:
Domestic currency appreciates due to reduced aggregate demand,

economic slowdown and decreased inflation.
Domestic currency depreciates due to a fall in real interest rates caused
by reduced government borrowing.
Since capital is highly mobile, the second result will dominate in the short
term. The change in the balance of imports and exports caused by the first
result will take longer before it influences the exchange rate.
The investment analyst must ask himself whether exchange rates are
expected to increase or decrease during the period under consideration and,
if so, what the expected impact on the economy will be. An appreciating
exchange rate tends to stimulate imports and discourage exports, while a
depreciating exchange rate tends to have the opposite effect, namely to
discourage imports and to stimulate exports. Exchange rates also influence
inflation. A weakening of the rand against other currencies leads to
increases in the cost of goods imported to South Africa, higher prices and a
higher inflation rate in South Africa.
6.4.7 Unemployment rates

Unemployment rates indicate the percentage of the labour force seeking
employment. To be classified as unemployed a person must be
actively seeking employment, or

waiting to begin or return to a job.
Thus the unemployed are persons who are potential entrants or re-entrants
to the job market, persons who lost or resigned from their previous
positions, or who have been retrenched. Normally, full-time students,
household workers, retirees and the disabled are not regarded as part of the
labour force, but as part of the civilian population in general. The labour
force consists of those who are either employed by firms or self-employed.
In South Africa, persons aged 15 and older are included in the calculation,
while in the US persons aged 16 and older are included.
The unemployment rate is calculated as follows:

Number of persons unemployed
Unemployment rate =
Civilian population
Another ratio that could be used for the assessment of employment levels is
the labour force participation rate. The labour force participation rate is
Civilian labour force
Labour force participation rate =
Civilian population
There are three types of unemployment – frictional, structural and cyclical

unemployment. Gwartney et al. (2006: 176–178) ascribe frictional
unemployment to imperfect information, which means that employers are
not fully aware of all available employees and their qualifications, and/or
available employable people are not aware of job opportunities. Structural
unemployment occurs when job opportunities exist but the skills required
by employers differ from those of the unemployed workers. Cyclical
unemployment is due to recessionary business conditions and insufficient
aggregate demand for labour.
The investment analyst must ask himself if unemployment will increase or

decrease during the period under consideration. An increase in
unemployment is an indication that either the growth rate of real GDP is
slowing down or that real GDP is declining. An increase in unemployment
also indicates that a decline in income per capita and disposable income
may be expected, which signals a possible decline in sales and profitability
for most firms.
6.5 INDUSTRY ANALYSIS
Industry analysis involves an assessment of the risk and return

characteristics of various industries as part of fundamental analysis. The
goal of industry analysis is to distinguish between industries expected to
experience growth and those that will decline as a result of the
macroeconomic prospects. The analyst also has to determine whether the
industry is in its growth phase, whether it has reached maturity, or whether
it has started to decline. The effects of factors influencing growth prospects,
such as growth or decline in population figures, government regulation,
taxes and subsidies, employment patterns and income distribution, have to
be forecast and evaluated. Industry analysis is explained in greater detail in
Chapter 7.
6.6 COMPANY ANALYSIS
Company analysis involves an assessment of the risk and return

characteristics of specific companies. A company’s ability to generate cash
flows from operating activities, as opposed to financing and investment
activities, is of particular importance.
Since a company’s financial performance is strongly influenced by the

decisions of its management, it is important to evaluate the quality of the
firm’s management. Good corporate governance is essential if the
shareholders’ interests are to be served. The results of management’s
decisions may be evaluated by means of financial ratios based on the
financial statements of the company. To the investment analyst future
performance is of prime significance, and historical ratios merely provide
him with an indication of some of the relationships that might be used in
drawing up pro forma statements of comprehensive income and statements
of financial position for analytical purposes.
Company analysis is explained in greater detail in Chapters 8 and 9.
6.7 SUMMARY
Fundamental analysis refers to the process of analysing the macroeconomic,

industry and company-specific factors that influence the risk and return
characteristics of an investment.
The three-step valuation process requires an analysis of the macroeconomic
prospects, followed by industry analysis and company analysis.
Fundamental analysis is therefore regarded as a top-down approach to
investment.
Methods of economic forecasting include the use of an index of leading

economic indicators, economic forecasting models and market signals.
The macroeconomic analysis involves a study of the growth in real GDP,

interest rates, inflation, exchange rates, budget deficits, trade balances and
unemployment rates.
Gwartney, J.D., Stroup, R.I., Sobel, R.S. & Macpherson, D.A. 2006. Economics: private and public
choice, 11th ed. Mason, OH: Thomson.
Mohr, P. 2014. Economic indicators. Pretoria: Unisa Press.
WEBSITES
http://www.finance.gov.za
http://www.resbank.co.za
http://www.statssa.gov.za
1. Fundamental analysis is a top-down approach because it:
(a) studies top management first, followed by an analysis of its influence on the
profitability of the firm
(b) studies macroeconomic prospects followed by an analysis of industry
prospects and company prospects
(c) studies top management first, followed by an analysis of its influence on middle
management
(d) applies valuation models first and then uses technical analysis for timing
purposes
(e) studies top management first, followed by an analysis of its influence on
middle and lower management
2. Real GDP is determined by:
(a) planned consumption and government expenditure

(b) planned consumption, the budget deficit and net imports
(c) actual consumption, interest rates and exchange rates
(d) planned consumption, investment, government expenditure and net exports
(e) none of the above
3. Expansionary monetary policy leads to:
(a) lower taxes, increased consumption and higher imports

(b) lower interest rates, increased consumption and higher net exports
(c) lower interest rates, increased consumption and lower net exports
(d) lower interest rates, increased consumption and an appreciation of the
domestic currency
(e) none of the above
4. Restrictive fiscal policy leads to:
(a) lower consumption, private investment and government spending

(b) increased consumption, private investment and government spending
(c) lower consumption and government spending, and a depreciation of the
domestic currency
(d) lower consumption and an increase in inflation
(e) lower consumption, lower private investment and an increase in interest rates
5. Unemployment is caused by:
(a) a lack of information about job opportunities

(b) a lack of skills
(c) imports
(d) recessions
(e) all of the above
Solutions
1. (b) Fundamental analysis is a top-down approach because it studies

macroeconomic prospects followed by an analysis of industry prospects and
company prospects.
2. (d) Real GDP is determined by planned consumption, investment, government
expenditure and net exports.
3. (c) Expansionary monetary policy leads to lower interest rates, increased
consumption and lower net exports.
4. (a) Restrictive fiscal policy leads to lower consumption, private investment and
government spending.
5. (e) All the statements indicate reasons for unemployment.
PART
2
Equity analysis
OVERVIEW
Chapter 7 Industry analysis

Chapter 8 Company analysis
Chapter 9 Company valuation
Chapter 10 Technical analysis
Part 2 continues our examination of fundamental analysis of equity

(ordinary shares), with the emphasis on industry and company analysis. The
section also explains technical analysis.
Chapter 7 explains industry analysis. It looks at the influence of

macroeconomic conditions on industries, the life cycle concept, the
competitive forces in an industry and the competitive strategies firms may
pursue, such as cost leadership and differentiation. The chapter concludes
with an explanation of the analysis of strengths, weaknesses, opportunities
and threats (called SWOT analysis).
Chapter 8 looks at the three important financial statements, namely the

statement of comprehensive income, the statement of financial position and
the cash flow statement, which are used in company analysis.
Chapter 9 looks at ways in which companies may be valued. The chapter

continues the discussion on valuation (Chapter 5) by focusing on measures
of value added. Examples of value added are economic value added (EVA),
cash value added (CVA) and market value added (MVA). The earnings
multiplier and the H model are also explained.
Chapter 10 explains technical analysis. Technical analysis attempts to

exploit recurring and predictable patterns in share prices to generate trading
profits. The chapter explains technical indicators such as the line chart, bar
chart, volume, open interest, support and resistance levels, trend lines,
moving averages, Dow theory, overbought/oversold indicator and the
absolute breadth index.
7 Industry analysis
7.1 INTRODUCTION
Industry analysis is critical to understanding equity valuation in that it gives

an opportunity to understand the industry in which a company operates (see
Figure 7.1). When determining an appropriate share price, for example, a
securities analyst must have a good forecast of the expected future
dividends and earnings of a company. In the previous chapter this concept
was discussed at great length under the heading of fundamental analysis.
The analyst has to have a good understanding of the factors that determine
the value of future company dividends and earnings. According to finance
theory, mostly attributed to Myron Gordon (1962), the price of a company’s
shares is influenced by the forecast future dividend and expected growth
rate of its earnings. It would, however, be folly to look at company value
only in relation to future earnings and dividends without discussing the role
of external business variables. Examples of external variables are
competitive intensity and the existence of monopolies in an economy,
which can lead to lower earnings growth or higher earnings growth
respectively.
Some companies’ earnings are affected more by macroeconomic variables

than industry factors.
Example: Telkom, the South African telecommunications company, has for

many years been protected from competition by legislation. Its earnings are
mostly influenced by economic performance and monitored by the state
regulator. However, with the advent of cellular phone companies like
Vodacom, MTN and Cell C, Telkom’s competitive factors have changed.
Cellphones have many advantages over land lines, such as the following,
which make them more attractive to users:
They are trendy or fashionable.

They are cheaper to acquire and operate.
They involve low maintenance costs.
The user needs the minimum infrastructure.
The advent of cellphones has, therefore, had an adverse effect on Telkom’s

potential earnings.
7.2 THE GLOBAL ECONOMY
The global economy refers to trade that takes place on an international

level, where a company’s market extends beyond the political borders of its
physical location. We start our analysis of a company’s prospects by
looking at globalisation effects. Some of the issues that are affected by the
international economy are a company’s export prospects, export and local
prices, external and internal competition from foreign companies, and the
profits it makes on investments abroad. Even though the economies of most
countries are linked in a global macroeconomy, there is considerable
variation in the economic performance across countries at any time.
Economic research has shown that the national economic environment can
be a crucial determinant of a company’s performance. It is far harder for
businesses to succeed in a contracting economy than in an expanding one.
Just to illustrate the importance of understanding the global arena and

international impact on business performance, the following illustration is
important.
Illustration: On the occasion of the Golden Jubilee of the Organization of

African Unity (OAU) in May 2013, Africa’s political leadership
acknowledged past achievements and challenges and rededicated itself to
the Pan African vision of “an integrated, prosperous and peaceful Africa,
driven by its own citizens and representing a dynamic force in the
international arena.” The African Union Summit tasked the African Union
Commission (AUC), supported by the New Partnership for Africa’s
Development (NEPAD) Planning and Coordinating Agency (NPCA), the
African Development Bank (AfDB) and the UN Economic Commission for
Africa (UNECA), to prepare a 50-year continental agenda. Agenda 2063
was developed through an extensive consultative process involving various
African stakeholders, including the youth, women, civil society
organisations, the Diaspora, African think tanks and research institutions,
government planners, the private sector, the African media, inter-faith
leaders, the Forum for Former African Heads of State and Government,
African island states and others. The preparation of Agenda 2063 also
included an extensive review of African development experiences, analysis
of the challenges and opportunities of today, as well as a review of national
plans, regional and continental frameworks and technical studies, including
drawing on publications and research materials from many institutions and
organisations. The plans and the frameworks reviewed contributed insights
for the development of the priorities that form a platform for Agenda 2063,
in particular the First 10 Year Implementation Plan.
For example, of the seven continental aspirations, Aspiration 1 looks at a

prosperous Africa based on inclusive growth and sustainable development.
Some of the goals that are relevant and critical for any business on the
continent are:
African people will have a high standard of living and quality of life and
well-being.
The citizens will be well educated and there will be a skills revolution
underpinned by science, technology and innovation for a knowledge
society that will be broad based.
The citizenry will be healthy.
Cities, peri-urban and rural communities will be equipped with modern
communication, sanitation, education and health facilities and will be
vibrant, dynamic market economies; people will have access to
affordable and decent housing, including housing finance, together with
all the basic necessities of life, and social capital will be valued and
preserved.
Economies will be structurally transformed through industrialisation,
manufacturing and value addition to create shared growth through private
sector development, entrepreneurship and decent jobs for all.
Agriculture will be modernised for scaled-up production, improved
productivity and value addition through commodity transformation and
services; it will contribute to farmer and national prosperity, and food and
nutrition security.
The continent will embed, principally, adaptation processes to maintain
healthy ecosystems and preserve the African natural environment – as the
largest remaining reserve of pristine waters, old-growth forests and land
in the world.
In addition, the global environment holds greater political and other risks
than are typically encountered in a domestic environment.
Illustration: In 2016 the International Monetary Fund (IMF) significantly

cut South Africa’s economic growth outlook from 1.3% to 0.7%, the lowest
forecast on record so far. The growth projection for 2017 was revised down
to 1.8% from 2.1%. On paper, although South Africa was among the
region’s largest economies, its growth rate was expected to be negatively
affected by lower commodity prices and higher borrowing costs. Subdued
economic growth means lower investment spending by the private sector
and modest job creation. It also means that sovereign credit rating
downgrades remain a possibility. In May 2016, Moody’s Investors Service
downgraded the government of South Africa’s debt rating to Baa2 from
Baa1.
The outlook on the rating was changed to stable from negative. This was
largely expected by the market, given prior rating downgrades by Standard
& Poor’s (S&P) and Fitch. The key drivers of the rating downgrade were
poor medium-term growth prospects due to structural weaknesses,
including ongoing energy shortages, as well as rising interest rates, further
deterioration in the investor climate and a less supportive capital market
environment, which is a concern given that South Africa is highly
dependent on external capital. The global economic growth outlook for
2016 year was reduced from 3.6% to 3.4%, while that for 2017 was revised
from 3.8% to 3.6%. The global growth revisions reflected to a large degree
a weaker pick-up in emerging economies.
Zimbabwe, on the other hand, for the period 2009–2012 was marked by an
economic rebound following the introduction of the multiple currency
system, with the economy growing at an average rate of 11.0% per annum.
However, GDP growth decelerated sharply from 10.6% in 2012 to 4.5% in
2013 and an estimated 3.1% in 2014. Real GDP was projected to improve
marginally to 3.2% in 2015. This projected marginal improvement was on
the back of planned investments in agriculture, mining, communications
and other infrastructure projects, including in the water and energy sectors.
Against the background of weak domestic demand, tight liquidity
conditions and the appreciation of the US dollar against the South African
rand, inflation was slightly negative in 2014, and it is projected to remain
low in 2016. Industrial capacity utilisation continues to decline in
Zimbabwe, and is estimated at 36.3% owing to underproduction and lack of
competitiveness. The real exchange rate overvaluation relative to the South
African rand has caused a loss in external competitiveness, as it has made
imports cheaper than domestically produced goods and exports more
expensive. As a result of the increasing demand for imports and the
dwindling exports, the external sector position is under severe pressure,
with an estimated current account deficit of around 23.1% in 2014. The
country is at high risk of debt distress, with an unsustainable external debt
estimated at US$8.4 billion at the end of 2014.
7.3 EXCHANGE RATES
An exchange rate is the rate at which one unit of a domestic currency can be
converted into a foreign currency. This is an important factor affecting
economic growth. Figure 7.2 illustrates the fall in the value of the rand
against the US dollar in 2001, and this is compared to other currencies
during that year. The rand lost more than 20% of its dollar value between
January and July 2001. The implications of this loss in value translate to
increased inflation due to the high costs of imported inputs.
Figure 7.2 Real effective exchange rates – rand against major currencies
Source: South African Reserve Bank, http://www.resbank.co.za
The fluctuation of exchange rates implies that prices of imported goods will
also fluctuate, becoming more expensive with any fall in the value of the
local currency. For example, in June 2016 South Africans needed about 16
rand to purchase one US dollar, or, equivalently, one rand could be
converted into 6 US cents. In comparison, in 1994, one US dollar was
equivalent to 5 rand. Whereas South Africans needed R5 to purchase US$1
worth of goods in 1994, in June 2016 they required R16 to purchase the
same value of imported goods! This type of fluctuation leads to an
escalation in input costs for South African companies, which can lead to
lost production, job losses, reduced profits and poor economic performance.
However, the opposite is true for locally produced goods that are exported
to other countries. An exchange rate of US$1 = R16 implies that R1 =
US$0.06 and an exchange rate of US$1 = R5 is equivalent to R1 =
US$0.20. These two different exchange rates tell us that Americans in 1994
needed US$0.20 to buy R1 worth of South African goods, but in 2016 they
needed only US$0.06 to buy R1 worth of South African goods! Between
March 2012 and December 2010 the rand appreciated against the US dollar,
which made South African goods exported to the US and other world
makets more expensive and led to lost sales.
In essence, for South Africans a falling exchange rate favours exports,
while an appreciating exchange rate favours imports. With the abolition of
the financial rand, the South African currency has been under a managed
floating regime, which has led to the rand’s significant losses in value
against the currencies of its major trading partners.
The ratio of purchasing power is called the “real” or inflation-adjusted

exchange rate. The change in the real exchange rate measures how much
more or less expensive imported goods have become to South African
consumers, accounting for both exchange rate fluctuations and inflation
differentials across countries.
7.4 THE DOMESTIC ECONOMY
The domestic economy refers to the economy of a country within its

political borders. The macroeconomic environment has a direct impact on
the performance of a company. The different macroeconomic variables
affect companies’ earnings by creating either a positive environment
conducive for growth or a negative one, which tends to reduce growth in
earnings.
An important factor in forecasting the performance of the market is the

assessment of the status of the economy as a whole. The ability to forecast
the macroeconomy can lead to higher-than-average investment
performance. It is, however, not enough to forecast the macroeconomy well.
One must forecast it better than one’s competitors to earn abnormal profits.
Some of the key variables in the domestic macroeconomy are gross
domestic product (GDP), unemployment, inflation, interest rates and the
budget deficit. These were discussed in greater detail in Chapter 6.
7.5 BUSINESS CYCLES

A business cycle is the recurring pattern of recession followed by recovery.
The economy recurrently experiences periods of expansion and contraction,
although the length and depth of these cycles may be irregular.
Figure 7.3 illustrates a business cycle with upward (expansion) and

downward (contraction) phases. The transition points across cycles are
called peaks and troughs. A peak is the transition from the end of an
expansion to the start of a contraction. A trough occurs at the bottom of a
recession just as the economy enters a recovery. As the economy passes
through different stages of the business cycle, the relative profitability of
different industry groups might be expected to vary.
Figure 7.3 Composite leading business cycle indicator
Example: At a trough, just before the economy begins to recover from a

recession, one would expect that cyclical industries (those with above-
average sensitivity to the state of the economy) would tend to outperform
other industries. Examples of cyclical industries are producers of durable
goods, such as cars or washing machines. Because purchases of these goods
can be deferred during a recession, sales are particularly sensitive to
macroeconomic conditions. Other cyclical industries are producers of
capital goods, that is, goods used by other companies to produce their own
products. When demand is slack, few companies will be expanding and
purchasing capital goods. Therefore, the capital goods industry bears the
brunt of a slowdown, but does well in an expansion. Examples of cyclical
companies are Iscor (world steel prices tend to follow a cyclical pattern)
and SAPPI, which is in the paper industry.
In contrast to cyclical companies, defensive industries have little sensitivity

to the business cycle. These are industries that produce goods for which
sales and profits are least sensitive to the state of the economy. Defensive
industries include food producers and processors, pharmaceutical
companies and public utilities. These industries will outperform others
when the economy enters a recession.
The cyclical/defensive classification corresponds well to the notion of

systematic or market risk introduced in our discussion of portfolio theory.
When perceptions about the health of the economy become more optimistic,
for example, the prices of most shares will increase as forecasts of
profitability rise. Because the cyclical companies are most sensitive to such
developments, their share prices will rise the most. Thus, companies in
cyclical industries will tend to have high-beta shares. In general, then,
shares of cyclical companies will show the best results when economic
news is positive, but they will also show the worst results when that news is
bad. Conversely, defensive companies will have low betas and performance
that is relatively unaffected by overall market conditions.
If your assessments of the state of the business cycle were reliably more
accurate than those of other investors, choosing between cyclical and
defensive industries would be easy. You would choose cyclical industries
when you were relatively optimistic about the economy, and you would
choose defensive companies when you were relatively pessimistic. As we
know from our discussion of efficient markets, however, attractive
investment choices will rarely be obvious. It is usually not apparent that a
recession or expansion has started or ended until several months after the
fact. With hindsight, the transitions from expansion to recession and back
might be obvious, but it is often quite difficult to say whether the economy
is heating up or slowing down at any moment.
Government policymakers battle to eliminate business cycles using fiscal or
monetary policy. It is also true that nobody, policymakers included, can
predict turning points sufficiently far in advance. Given the lags in both the
formulation and implementation of macroeconomic policy, by the time the
start of a recession is detected, it is too late for any countermeasures to take
effect. Of course, the difficulty in spotting the onset of a recession or
recovery is not unique to government economists – it is a challenge for
investors as well.
Markets and the economy often are not synchronised. The substance of Paul
Samuelson’s quote “Markets and the economy often are not synchronised,
so it comes as no surprise that many investors dismiss economic forecasts
when planning their market strategies” in Newsweek remains true more
than 50 years later (Samuelson, 1966). Yet investors should not dismiss the
business cycle too quickly when choosing a portfolio. The share market still
responds powerfully to changes in economic activity. Although there are
many “false alarms”, as in 1987 when the market collapse was not followed
by a recession, shares almost always fall before a recession and rally
vigorously at or even before signs of an impending recovery. If you can
predict the business cycle, you can beat a simple buy-and-hold strategy for
equity investments.
But this is not easy. To make money by predicting the business cycle, you
must be able to identify peaks and troughs of economic activity before they
occur – a skill very few, if any, economists possess. Business cycle
forecasting is popular not because it is successful – most of the time it is not
– but because the potential gains from successfully calling business booms
and busts are so large. But before we do this, it is important to look at who
calls the business cycle.
7.5.1 Marking the cycle

“Marking the cycle” refers to investors’ ability to determine exact points in
time when a recession is expected. It is commonly assumed that a recession
occurs when real GDP, the most inclusive measure of economic output,
declines for two consecutive quarters. But this is not necessarily so. For
example, between 1802 and 1997, there were 41 US recessions, averaging
nearly 18 months, while expansions averaged almost 38 months. This
means that, over 195 years, a third of the time was spent in recession.
However, since the Second World War there have been nine recessions,
averaging 10 months, while the expansions have averaged 50 months.
7.5.2 Timing the cycle

Timing the cycle refers to investors’ ability to use their knowledge of
recession times to switch out of specific investment securities, like shares,
into other investment securities, like treasury bills, and then return to shares
when prospects for recovery look good. This way, investors can earn excess
returns. Excess returns are calculated by assuming that investors who lead
the business cycle switch out of shares and into bills before the peak of
business expansions and switch back before the trough of recessions.
In contrast, investors who lag the business cycle switch out of shares and
into bills after the cycle peak and back into shares after the cycle trough.
The excess returns are measured relative to a buy-and-hold share strategy of
the same risk as the timing strategies employed previously.
Excess return is minimal over a buy-and-hold strategy if investors switch

into bills at the peak and into shares at the trough of the business cycle.
Some studies have shown that investors switching into bills just one month
after the business cycle peak and back into shares just one month after the
business cycle trough lose about 0.6% a year compared with the buy-and-
hold strategy. Interestingly, it is more important to forecast troughs than
peaks. An investor who buys shares before the trough of the cycle gains
more than an investor who sells shares an equal number of months before
the business cycle peak.
7.5.3 Can the cycle be predicted?

Given the cyclical nature of the business cycle, it is not surprising that the
cycle can, to some extent, be predicted. Economists have developed a set of
cyclical indicators to help forecast, measure and interpret short-term
fluctuations in economic activity. Leading economic indicators are those
economic series that tend to rise or fall in advance of the rest of the
economy. Coincident and lagging indicators, as their names suggest, move
in tandem with or somewhat after the broad economy.
7.5.3.1 Leading indicators
Leading indicators are the following:
Average weekly hours of production workers (manufacturing)

Average weekly initial claims for unemployment insurance
Manufacturers’ new orders (consumer goods and materials industries)
Vendor performance lower deliveries diffusion index
Contracts and orders for plant and equipment
New private housing units authorised by local building permits
Change in manufacturers’ unfilled orders (durable goods industries)
Change in sensitive materials prices
Share prices, 500 ordinary shares
Money supply (M2)
Index of consumer expectations
7.5.3.2 Coincident indicators

Coincident indicators are the following:
Employees on non-agricultural payrolls

Personal income less transfer payments
Industrial production
Manufacturing and trade sales
7.5.3.3 Lagging indicators

Lagging indicators are the following:
Average duration of unemployment

Ratio of trade inventories to sales
Change in index of labour cost per unit of output
Average prime rate charged by banks
Commercial and industrial loans outstanding
Ratio of consumer instalment credit outstanding to personal income
Change in consumer price index for services
The share market price index is a leading indicator. This is as it should be,
as share prices are forward-looking predictors of future profitability.
Unfortunately, this makes the series of leading indicators much less useful
for investment policy since by the time the series predicts an upturn, the
market has already made its move. While the business cycle may be
somewhat predictable, the share market may not be. This is just one more
manifestation of the efficient market hypothesis.
The money supply is another leading indicator. This makes sense in the
light of our earlier discussion concerning the lags surrounding the effects of
monetary policy on the economy. An expansionary monetary policy can be
observed fairly quickly, but it might not affect the economy for several
months. Therefore, today’s monetary policy might well predict future
economic activity.
Other leading indicators focus directly on decisions made today that will
affect production in the near future. For example, manufacturers’ new
orders for goods, contracts and orders for plant and equipment, and housing
starts all signal a coming expansion in the economy.
Millions of rand in South Africa, or billions of dollars globally, are spent

trying to forecast the business cycle. As this section shows, it is not
surprising that many share markets employ so many economists desperately
trying to predict the next recession or upturn since doing so dramatically
increases returns. But the record of predicting exact cycle turning points is
poor.
The South African Reserve Bank has identified the turning points of the
business cycle in South Africa since 1946. These upper and lower turning
points (or peaks and troughs) have generally been regarded as the reference
turning points in the South African business cycle, in other words, in the
cyclical movement of the economy.
7.5.4 Methods used in determining the reference turning point

of the business cycle in South Africa
The lower reference turning point in the business cycle is determined using
several methods. These include the calculation of composite leading and
coincident business cycle indicators, the comprehensive historical diffusion
index and the current diffusion index. It is important to note, however, that
the identification of a reference turning point is never a purely statistical
exercise.
Economic events and developments occurring near a possible turning point

have to be considered in order to pinpoint the turning point to a particular
month, especially when the statistical methods employed do not all point to
exactly the same turning point date.
7.5.4.1 The composite business cycle indicators

A composite business cycle indicator is compiled by integrating various
economic indicators into a single indicator time series. These composite
indicators portray the movement of and turning points in the business cycle.
The composite leading business cycle indicator comprises individual
indicators which tend to shift direction ahead of changes in the business
cycle. A change in the direction of the composite leading business cycle
indicator is usually an early indication that a turning point in the business
cycle may be imminent. The composite coincident business cycle indicator
combines a number of economic time series which usually move in
harmony with the business cycle. A change in the direction of the
composite coincident business cycle indicator – generally occurring after
the composite leading business cycle indicator has changed direction –
indicates that a turning point might have been reached. Figure 7.4 illustrates
the composite business cycle indicator.
Figure 7.4 Composite coincident business cycle indicator
7.5.4.2 The historical diffusion index

The historical diffusion index may be defined as a measure of the dispersion
of the changes in a number of economic time series in a specific period,
mostly a calendar month. The historical diffusion index was constructed
from a total of 230 seasonally adjusted economic time series. These time
series cover economic processes such as production, sales, employment and
income in different sectors of the economy. The specific turning points of
the cyclical component of each of the series are determined. A set of
specific peak and trough dates is obtained in this way for each time series.
A series is regarded as decreasing for each period subsequent to a peak, up
to and including the following trough. Conversely, a series is regarded as
increasing for each period subsequent to a trough, up to and including the
following peak. The historical diffusion index value for a particular month
is then obtained by expressing the number of increasing time series as a
percentage of the total number of time series considered.
The sectoral contributions are weighted according to each relevant sector’s

contribution to gross value added. An index value below 50 therefore
indicates that more than half of the series considered are decreasing at a
particular date, implying that the economy is in a downward phase of the
business cycle. Conversely, an index value exceeding 50 indicates that more
than half of the series considered are increasing at a particular date,
implying that the economy is in an upward phase of the business cycle. The
historical diffusion index is illustrated in Figure 7.5.
Figure 7.5 Historical diffusion index (deviation from the long-term trend)
7.5.4.3 The current diffusion index

The current diffusion index is a comprehensive composite index compiled
from the actual month-to-month symmetrical percentage changes in each of
the 230 seasonally adjusted time series used in constructing the historical
diffusion index. A weight is allocated to each series according to the
contribution to gross value added of the activity that the time series reflects.
The deviation of the current diffusion index from its long-term trend is a
quantitative indication of the cyclical movement in general economic
activity. The current diffusion index is illustrated in Figure 7.6.
Figure 7.6 Current diffusion index (deviation from long-term trend)
7.5.4.4 Statistical results

The results obtained from the methods described above clearly indicate that
a downward phase of the business cycle occurred in the South African
economy after 2008 and 2014 (the latest upper reference turning point). The
current results also confirm the November 2014 upper reference turning
point. As the discussion below indicates, the analysis also revealed that a
lower reference turning point in the business cycle had already been
reached.
7.5.4.5 The composite business cycle indicators

After declining markedly for almost two years, the composite leading
business cycle indicator – expressed as the deviation from its long-term
trend – reached a lower turning point in September 1998. After that the
indicator increased moderately for a period of five months, followed by
more significant increases during the remainder of 1999. The decisive
change in the direction of the composite leading business cycle indicator
after September 1998 was an early indicator that a reference turning point
in the business cycle could soon be reached.
The composite coincident business cycle indicator – expressed as the

deviation from its longterm trend – followed a declining time path during
the whole of 1997 and 1998. After reaching a trough in May 1999, the
indicator increased steadily during the latter half of 1999 and into 2000.
This trough in the composite coincident business cycle indicator followed
the lower turning point reached eight months earlier in the composite
leading business cycle indicator.
The cycle continued to increase into 2004, confirming the boom in the
South African economy. A strong rand, weak US dollar and low inflation
can be cited for this strengthening of the cycle. Unfortunately, the global
downturn from 2007 to 2016 has negated all gains.
7.5.5 Conclusion
The worst course an investor can take is to follow the prevailing sentiment
about economic activity. This will lead to buying at high prices when times
are good and everyone is optimistic, and selling at the low when recession
nears its trough and pessimism prevails. Lessons to investors are clear.
Beating the share market by analysing real economic activity requires a
degree of prescience that forecasters do not yet have. Turning points are
rarely identified until several months after the peak or trough has been
reached. By then, it is too late to act.
7.6 INDUSTRY ANALYSIS
Industry analysis examines variables in a particular industry within an

economy, be it a domestic or global economy. Some of the variables are
production indices, business cycles and the degree of operating leverage.
Industry analysis is important for the same reason that macroeconomic
analysis is: just as it is difficult for an industry to perform well when the
macroeconomy is ailing, it is unusual for a company in a troubled industry
to perform well. Similarly, just as has been seen that economic performance
can vary widely across countries, performance can also vary widely across
industries.
7.6.1 Defining an industry

In simple terms, an industry is a collection of companies with similar
products and/or distribution strategies. It may, however, be difficult in
practice to decide where to draw the line between one industry and another.
Example: The education industry contains companies and organisations

with widely differing products and prospects. Traditionally, universities
offered graduate and postgraduate education, while technikons offered
certificates, diplomas and graduate programmes. However, with the major
changes in the higher education sector, recent trends show that universities
have increased their offerings to match those of technical and vocational
colleges, and vice versa. Even within universities or vocational colleges,
product offering methodologies differ. Some of the methodologies are
distance learning, classroom-based learning, and online-based learning or a
combination of these. The forecast performance of these defined groups
differs widely, suggesting that they are not members of a homogeneous
industry.
A useful way to define industry groups in practice is given by Standard

Industry Classification (SIC) codes. These are codes assigned by the South
African government for the purpose of grouping companies for statistical
analysis. The first two digits of the SIC codes denote very broad industry
classifications. The third and fourth digits define the industry grouping
more narrowly. Companies with the same four-digit SIC code are therefore
commonly taken to be in the same industry. Many statistics are computed
for even more narrowly defined five-digit SIC groups. SIC industry
classifications are, however, not perfect.
Example: Both Pick n Pay and Woolworths might be classified as

department stores. While the former is a high-volume “value” store, the
latter is a high-margin elite retailer. Are they really in the same industry?
Still, SIC classifications are a tremendous aid in conducting industry
analysis since they provide a means of focusing on very broadly or
narrowly defined groups of companies.
7.6.2 Sensitivity to the business cycle

Not all industries are equally sensitive to changes in economic conditions.
Once the analyst has forecast the state of the macroeconomy, it is necessary
to determine the implication of that forecast for specific industries. Not all
industries are equally sensitive to the business cycle. The tobacco industry
is virtually independent of the business cycle. Demand for tobacco products
does not seem to be affected by the state of the macroeconomy in any
meaningful way. This is not surprising, since tobacco consumption is
determined largely by habit and is a small enough part of most budgets not
to be given up in hard times.
Car production, by contrast, is highly volatile. During recessions,

consumers can try to prolong the lives of their cars until their income is
higher. For example, during the global recession of 2008 to 2010, when
general retail sales slumped, sales of new cars dropped drastically. It was
more apparent in April 2009, when total motor trade sales slumped to a
25% drop within a short period of 10 months from July 2008. This is
illustrated in Figure 7.7.
Figure 7.7 Indicators of real ecnomic activity: Trade: number of new
vehicles sold
Three factors determine the sensitivity of a company’s earnings to the

business cycle.
First is the sensitivity of sales. Necessities show little sensitivity to business

conditions. Examples of industries in this group are food, drugs and medical
services. Other industries with low sensitivity are those for which income is
not a crucial determinant of demand. Tobacco and alcohol products are
examples of this type of industry. In contrast, companies in industries such
as machine tools, steel, cars and transportation are highly sensitive to the
state of the economy.
The second factor determining business cycle sensitivity is operating

leverage, which refers to the division between fixed and variable costs.
(Fixed costs are those the company incurs regardless of its production
levels. Variable costs are those that rise or fall as the company produces
more or less product.) Companies with a greater proportion of variable as
opposed to fixed costs will be less sensitive to business conditions. This is
because, in economic downturns, these firms can reduce costs as output
falls in response to falling sales. Profits for companies with high fixed costs
will swing more widely with sales because costs do not move to offset
revenue variability. Companies with high fixed costs are said to have high
operating leverage, as small swings in business conditions can have large
impacts on profitability.
Example: Consider two companies operating in the same industry with

identical revenues in all phases of the business cycle: recession, normal, and
expansion. Company A has short-term rentals on most of its equipment and
can reduce its rental expenditures when sales decline. It has fixed costs of
R5 million and variable costs of R1 per unit of output. Company B has
long-term leases on most of its equipment and must make lease payments
regardless of economic conditions. Its fixed costs are higher at R8 million,
but its variable costs are only R0.50 per unit. Company A will do better in
recessions than company B, but not as well in expansions. This is because
Company A’s costs move in conjunction with its revenues to help
performance in downturns, but impede performance in upturns.
Degree of operating leverage measures the sensitivity of profits to changes

in sales. Operating leverage can be quantified by measuring how sensitive
profits are to changes in sales. The degree of operating leverage is defined
as:
Percentage change in profits
DOL =
Percentage change in sales
Example: DOL greater than 1 indicates some operating leverage. If DOL

equals 2, then for every 1% change in sales, profits will change by 2% in
the same direction, either up or down. Economists have shown that the
degree of operating leverage increases with a company’s exposure to fixed
costs. In fact, one can show that DOL depends on fixed costs in the
following manner
Fixed costs
DOL = 1 +
Profits
The third factor influencing business cycle sensitivity is financial leverage,

which is the use of borrowing. Interest payments on debt must be paid
regardless of sales. They are fixed costs that also increase the sensitivity of
profits to business conditions.
Investors do not necessarily prefer industries with lower sensitivity to the

business cycle. Companies in sensitive industries have high-beta shares and
are riskier. But while they swing lower in downturns, they also swing
higher in upturns. As always, the issue you need to address is whether the
expected return on the investment is fair compensation for the risks borne.
7.6.3 Industry life cycle

A typical industry life cycle might be described as having four stages: a
start-up stage characterised by extremely rapid growth; a consolidation
stage characterised by growth that is less rapid but still faster than that of
the general economy; a maturity stage characterised by growth no faster
than that of the general economy; and a stage of relative decline, in which
the industry grows less rapidly than the rest of the economy, or actually
shrinks. This industry life cycle is illustrated in Figure 7.8. Let us turn to an
elaboration of each of these stages.
Figure 7.8 Industry life cycle
7.6.3.1 Start-up stage

The early stages of an industry are often characterised by a new technology
or product, such as VCRs or personal computers in the 1980s, or
bioengineering in the 1990s. At this stage, it is difficult to predict which
companies will emerge as industry leaders. Some companies will turn out to
be wildly successful, and others will fail altogether. Therefore, considerable
risk is involved in selecting one particular company within the industry.
At the industry level, however, sales and earnings will grow at an extremely
rapid rate since the new product has not yet saturated its market. For
example, in 1980 very few households had VCRs. The potential market for
the product was therefore the entire set of television-watching households.
In contrast to this situation, consider the market for a mature product like
refrigerators. Almost all households in the US already have refrigerators, so
the market for this good is primarily composed of households replacing old
refrigerators. Obviously, the growth rate in this market at that time was far
less than for VCRs.
7.6.3.2 Consolidation stage
After a product has become established, industry leaders begin to emerge.
The survivors from the start-up stage are more stable and market share is
easier to predict. Therefore, the performance of the surviving companies
will more closely track the performance of the overall industry. The
industry still grows faster than the rest of the economy as the product
penetrates the marketplace and becomes more commonly used.
7.6.3.3 Maturity stage

At this point, the product has reached its full potential for use by
consumers. Further growth might merely track growth in the general
economy. The product has become far more standardised and producers are
to a greater extent forced to compete on the basis of price. This leads to
narrower profit margins and further pressure on profits. Companies at this
stage are sometimes characterised as “cash cows”, companies with
reasonably stable cash flow but offering little opportunity for profitable
expansion. The cash flow is best “milked from” rather than reinvested in the
company.
7.6.3.4 Relative decline

In this stage, the industry might grow at less than the rate of the overall
economy, or it might even shrink. This could be due to obsolescence of the
product, competition from new products or competition from new low-cost
suppliers.
At which stage in the life cycle are investments in an industry most

attractive? Conventional wisdom is that investors should seek companies in
high-growth industries. This recipe for success is simplistic, however. If the
security prices already reflect the likelihood for high growth, then it is too
late to make money from that knowledge. Moreover, high growth and fat
profits encourage competition from other producers. The exploitation of
profit opportunities brings about new sources of supply that eventually
reduce prices, profits, investment returns and, finally, growth. This is the
dynamic behind the progression from one stage of the industry life cycle to
another.
The famous portfolio manager Peter Lynch (1990) makes this point in One
up on Wall Street. He says the following:
Many people prefer to invest in a high-growth industry, where

there’s a lot of sound and fury. Not me. I prefer to invest in a low-
growth industry … In a low-growth industry, especially one that’s
boring and upsets people (such as funeral homes), there’s no
problem with competition. You don’t have to protect your flanks
from potential rivals and this gives you the leeway to continue to
grow.
In fact, Lynch uses an industry classification system in a very similar spirit

to the life cycle approach we have described. He places companies in the
following six groups:
1. Slow growers. These are large and aging companies that will grow only
slightly faster than the broad economy. These companies have matured
from their earlier fast-growth phase. They usually have steady cash
flow and pay a generous dividend, indicating that the company is
generating more cash than can be profitably reinvested in the company.
2. Stalwarts. These are large, well-known companies like Coca-Cola, SAB
Miller and Colgate-Palmolive. They grow faster than the slow growers,
but are not in the very rapid growth start-up stage. They also tend to be
in non-cyclical industries that are relatively unaffected by recessions.
3. Fast growers. These are small and aggressive new companies with
annual growth rates in the neighbourhood of 20% to 25%. Company
growth can be due to broad industry growth or to an increase in market
share in a more mature industry.
4. Cyclicals. These are companies with sales and profits that regularly
expand and contract along with the business cycle. Examples are car
companies, steel companies and the construction industry.
5. Turnarounds. These are companies that are in bankruptcy or soon might
be. If they can recover from what might appear to be imminent disaster,
they can offer tremendous investment returns. A good example of this
type of company would be Apple. In the mid-1990s, Apple was on the
ropes. It was like Rocky 4 in many ways, except that Apple was
Sylvester Stallone, and Drago took the form of the computing colossus
that is Microsoft. Back in 1997, Apple needed a life preserver and Bill
Gates was there to lend a helping hand. How Apple got there is rather
complicated, as were the terms of the US$150 million loan that
Microsoft gave it, but in the end, both companies won. Apple is now
the world’s most valuable company – actually the most valuable
company in history – at US$700 billion. Considering that it was once
on the brink of bankruptcy, that is as good a turnaround as any.
6. Asset plays. These are companies that have valuable assets not currently
reflected in the share price. For example, a company may own or be
located on valuable real estate that is worth as much or more than the
company’s business enterprises. Sometimes the hidden asset is tax-loss
carry forwards. Other times the assets may be intangible. For example,
a magazine or newspaper company might have a valuable list of
subscribers. These assets may not immediately generate cash flow and
so may be more easily overlooked by analysts attempting to value the
company.
7.7 INDUSTRY STRUCTURE AND PERFORMANCE
The relationship between industry structure, competitive strategy and

profitability is important to investors. Michael Porter (1985) highlighted
five determinants of competition: threat of entry from new competitors,
rivalry between existing competitors, price pressure from substitute
products, the bargaining power of suppliers and the bargaining power of
buyers. An illustration of these forces can be found at
http://en.wikipedia.org/wiki/Porter_Five_Forces_analysis.
7.7.1 The threat of new entrants

The ease with which firms can enter into a new market or industry is a
critical variable in the strategic management process. In some industries the
barriers to entry are minimal. In other industries, the barriers to entry are
formidable. These barriers can take on many forms, among them the
following:
The amount of capital needed to enter into a specific industry may be

great enough to deter entrants.
The current participants in the industry may have product lines protected
by patents.
The switching costs for the company’s customers may be great enough to
pose a barrier to entry to a new firm.
Other factors are discussed below.
Example: There are a large number of small computer-oriented software

firms in South Africa. Entry into this industry does not require a vast
amount of capital. Instead, one needs a rather small number of highly
imaginative and qualified programmers able to develop niche products that
find a home in an ever-expanding marketplace. Because the major portion
of the costs are incurred in the development phase with production costs
absorbing relatively small amounts of money, a successful new product
entry can prove to be highly profitable, thus providing the capital and
marketing base needed to challenge a firm that may previously have been in
a leadership position.
The same cannot be said for the jet aircraft industry. The up-front costs for
designing, developing and producing a jet-powered aircraft are estimated to
be in the R40 to R50 billion category. This would be an immense amount of
money for a firm to risk as the cost of entry into an otherwise stable
business. Equally important as a barrier to entry would be the lack of
availability of a highly skilled management, engineering and production
workforce. From a practical perspective, this group would have to be put
together before any initial effort on the design of a new aircraft could go
forward. And they would have to be bid away from firms already in the
industry with a subsequent disruption of salary and wage scales within the
industry.
Patent rights may similarly be a barrier to entry in a specific industry, for
example, the ethical drug industry. And many public utilities are, in effect,
granted monopoly rights that act as barriers to entry to other firms. As can
be seen, given the complexities of the different barriers to entry which will
vary from one industry to another, it is best not to generalise about these
matters. Instead each potential situation needs to be treated as if it were
unique, and subsequent judgements made on this basis. Here an aside is
extremely important. What may be true for a domestic marketplace may not
be so for a global marketplace. For many of the reasons discussed above, in
the early 1970s it was unlikely that the American car industry (General
Motors, Ford and Chrysler) could be upstaged by the entry into the US
market of another US company. But this did not hold for a foreign
competitor with the required resources (capital, complete knowledge of the
required technologies, management skills, marketing skills, etc.). Japanese
firms with these qualities entered and gradually came to dominate a
significant portion of the US market for cars.
7.7.2 The bargaining power of suppliers and the bargaining

power of customers
Though treated separately earlier, it is often impossible to discuss the
bargaining power of suppliers and customers separately. This is because of
the joint relationship between suppliers and customers in which they
normally seek to maximise their bargaining power vis-à-vis one another.
And, very often, as we discuss below, outsiders intervene in the process,
thus establishing new relationships within a previously stable industrial
sector.
The car industry provides some excellent case history here. Until the mid to
late 1970s, Ford, Chrysler and General Motors were able to maintain
extremely strict franchise relationships with their dealers. One of the
covenants of these franchise relationships restricted a dealer to representing
only one of the Big Three. Moreover, in keeping with standard practice
within the industry, the dealers had to follow business policies and
procedures established by the manufacturer. Because most Big Three
franchises were then quite profitable, the dealers responded reasonably well
to most of the manufacturer’s (supplier’s) dictates. In other words, for as
long as the American consumer was reasonably satisfied with the price and
quality of American-made cars, the bargaining power of the Big Three with
respect to their dealers went unchallenged. However, the American
consumer became disenchanted with many of the products being offered by
the Big Three and began looking for alternatives.
It was then that the Japanese entered the US market. Their initial entry was
with a line of small, fuel-efficient, low-priced vehicles. However, consistent
with policies established and enforced by the Japanese government, the
Japanese manufacturers were required to attain a quality level in their cars
that was superior to that of their American competitors. But they also
needed a network of dealers if they were to penetrate the US market
economically.
By offering a substantial financial package to potential dealers and avoiding

the issue of exclusivity, the Japanese successfully challenged traditional
American franchising practices. Given the poor sales, profit and quality
record in the early 1970s of many American brand names, many dealers
jumped at the opportunity to challenge the Big Three on their own turf.
Although this would earlier have cost them their Big Three franchise, at this
juncture they were willing to take the risk, given the alternatives made
available to them by a new force in the marketplace. In sum, the bargaining
relationship between supplier and customer within the car industry changed,
or perhaps a better word would be moderated. Although the typical dealer
has to be extremely responsive to the demands and requirements of the car
manufacturer, the multi-firm dealer has gained a goodly amount of off-
setting bargaining power. This is a supplier– customer relationship that the
Big Three would not have tolerated earlier.
7.7.3 The threat of substitute products and services

Technically, the entry of the Japanese automotive industry into the US
should not be characterised as the threat of a new product since a car is a
car. But less technically, it can be regarded as the substitution of Japanese-
made cars for American-made cars. A more clear-cut case of the effective
threat of substitute products, and one that is familiar to most people, is the
substitution of the personal computer for the typewriter. From all practical
perspectives, the personal computer has replaced the typewriter as the key
writing instrument, both at the office and at home. In the process, an
otherwise large, viable and profitable industry has been upstaged by new
product introductions from an otherwise non-competing industry.
A similar but less dramatic case can be found in the substitution of the
ballpoint pen for the fountain pen that was in common usage not too many
years ago. As with the computer/typewriter case, different technological
skills are needed for the mass manufacture of ballpoint as opposed to ink-
filled pens. But the factor of price and convenience has clearly been a
determining factor here.
However, it should be recognised that an analysis of the potential for

substitute products upstaging an existing market is, in point of fact, a
difficult task. This is because of the difficulty of imagining or predicting the
existence of a substitute product before it makes its appearance in the
marketplace. To avoid strategic surprises, senior management must devote
adequate resources to the personnel capable of following the marketplace
and able to interpret changes in the technological and/or marketing frontier
as they occur. In the computer/typewriter industry, the substitute product
represented a significant change in technology. In the instance of the car,
the change was driven more by marketing than by technological factors. In
the case of the ballpoint pen, price and convenience were the driving forces.
In other words, each case stands on its own and must be analysed on a case-
by-case basis.
7.7.4 The intensity of rivalry among competing firms

This is the last of the five competitive forces, and the one whose content is
the most focused. Before moving directly into a discussion of this force, it
is worthwhile to go back to basic economic theory and review the concept
of oligopolistic competition. This, as you may remember, is the situation in
which there are relatively few firms (usually three or four) competing
within an industry, but in such a way as to minimise the effects of price-
based competition. Prior to the entry of the Japanese into the US
marketplace, the domestic car industry was a classic example of this form
of competition. With its 53% share of the US market, General Motors was
then the price leader within the industry. In the late summer, just prior to the
introduction of its latest line of cars, it would announce its new price
schedules. Shortly thereafter, both Ford and Chrysler would do the same,
but with price changes virtually equal to those set earlier by General
Motors. There was no collusion involved! Rather, each of the firms
understood that price-based competition would not necessarily lead to
increases in the size of the marketplace and, thus, each fastidiously avoided
price-based competition. There was even a year when General Motors
announced that it was increasing its prices by 10% to offset a predicted
decline of 10% in market demand.
Similar administered price policies obtained across many large-scale US

industries in which a limited number of large firms controlled a major
portion of the market. It is not that these firms would not actively compete
with each other, but rather that price was not the cutting edge of their
various strategies. This, of course, changed when foreign competitors with
protected domestic markets elected to compete in the US. With their home
markets often protected by tariff and non-tariff barriers, foreign producers
could use price as a major element in their overall international corporate
strategies. Their longer-term goals were, of course, market share and the
economies of scale that market share brings. In other words, their strategy
was one of intense rivalry, with price used as the initial cutting edge of their
strategic plan.
The transition to competitive factors other than price in the strategic

management equation can be illustrated by the history of the Wal-Mart
organisation in the US (and globally). Having established itself as the
hallmark within the discount industry, Wal-Mart can now successfully
compete on other than a low-price basis. However, in the small-to-medium-
size business sector, the intensity of rivalry among competing firms can be
extremely strenuous, especially if the firms are competing within a
relatively stable, slow-growth industry.
7.8 COMPETITIVE STRATEGIES

Competitive strategies are essential elements in giving an organisation a
competitive advantage – something that sets it apart and gives it a
competitive edge. Some analysts believe that we live in an age of hyper
competition. This means that the competition among competing firms is
very intense and getting more so. Hyper competition ensures that no
organisation’s competitive advantage will last for long. All competitors
must constantly seek to find new ways to add value for the customer.
7.8.1 Strategic groups

The question of strategic groups is addressed by looking at an
organisation’s competitors. Who are they? It is critical for strategic
managers to answer this question correctly. A wrong answer virtually
guarantees that the wrong strategy will be developed. A firm within an
industry seldom competes with all other firms in its industry. In most
industries, two or more clusters, or groups, of firms can be identified by the
types of market they serve. The firms within each group compete most
closely with each other, and do not compete heavily with firms outside their
group. All firms do, however, need to remain vigilant in case of an attack
from a firm in another group whose managers may decide to invade new
turf. Managers in any firm may decide to broaden their market to include
another group’s customers. They may pick a firm they believe is weakest to
attack.
To visualise strategic groups more clearly, we now examine the dynamics

within the South African car industry (see Figure 7.9). The positioning of
firms within this industry is hypothetical here, done for illustrative purposes
only. Not all competitors are shown in these industries; only enough to
show the dynamics of competitive thinking.
Figure 7.9 Strategic groups in the South African car industry
The two dimensions on which each car brand is categorised are the market
segments served and the combination of price/quality as perceived by
customers. Mercedes, Jaguar, Volvo, Audi and BMW serve an elite market.
These brands have high prices and an image of high quality, serving a few
market segments. Hyundai, Daewoo and Fiat represent the other extreme.
They serve the low-income market segment with low prices and low
perceived quality. The larger group, consisting of GM, Ford, Chrysler,
Nissan, Toyota, Honda and VW, serves the broadest number of market
segments. This is because each of these brands offers a range of cars to
attract customers looking for various price/quality combinations. None of
these cars reaches as low as the cheapest Hyundai, and none reaches as high
as the most expensive Mercedes, Jaguar or BMW. But between these
extremes lies a huge and varied market.
The key point in analysing a strategic group chart like the one in this
example is that a firm’s strongest competitive threats usually come from the
firms within its group. But it is important to watch for a possible invasion
from firms in one of the other groups. For example, Chrysler’s greatest
threats come from GM, Ford, Nissan and Toyota. These brands compete
with similar cars aimed at the same target markets. Yet recently Mercedes
and BMW have been aiming some less expensive models at Toyota and its
mid-market rivals. Toyota and the others must construct barriers to entry or
mount some counterattack to protect their hard-won markets. On the other
hand, Toyota may want to launch an attack at the Mercedes’ low-end
vehicles. To do so successfully, Toyota executives need to understand
Mercedes’s strengths and weaknesses, its points of vulnerability. This will
help them decide how best to mount such an attack. A carefully constructed
and thoughtfully studied strategic group chart can help managers choose the
best strategies in situations like these.
7.8.2 Porter’s generic competitive strategies

Competitive strategy is the choice an organisation or business unit makes
about how it is going to compete in its particular industry or market. By far
the best known and most widely used set of competitive strategies is
Porter’s generic strategies. These are discussed below.
Porter sees three ways in which a firm can gain a competitive advantage:
cost leadership, differentiation, or focus. He calls these generic strategies
because they can be applied to a firm in any industry. A cost leadership
strategy is one in which a firm strives for the lowest costs in the industry
and offers its products or services to a broad market at the lowest prices. A
firm that uses a differentiation strategy is one that tries to offer products or
services with unique features that customers value. The value added by the
uniqueness lets the firm command a premium price. The focus strategy may
be either a cost leadership or a differentiation strategy aimed at a narrow,
focused market. We now have four different strategies, which we can model
as follows:
Cost leadership
Broad-market differentiation
Focus cost
Focus differentiation
These are analysed in greater detail in Table 7.1.

Table 7.1 Generic competitive strategies
Cost leadership Focus (cost or differentiation)

Characteristics: Advantages:
Low level of differentiation is Company has power over buyers since focuser
required. may be only source of supply.
Aims for average customer. Customer loyalty protects from new entrants and
Uses knowledge gained from past substitute products.
production to reduce production Easier to stay close to customer and monitor his
costs. needs.
Adds new product features only
after the market demands them.
Advantages: Risks:
Cost advantage protects from new The firm may be at the mercy of powerful suppliers
entrants. since focuser buys in small quantities.
Can reduce price to protect from Small volume means higher production costs (this
new entrants. is why it is important to be able to command a high
price).
Risks: Change in consumer tastes or a technological
change could cause a focuser’s niche to disappear.
Competitors may leapfrog the
Cost leaders or big differentiators may produce
technology, nullifying the firm’s
products that satisfy customers’ needs. The
accumulated cost reductions.
focuser is subject to constant attack.
Competitors may imitate the
technology (e.g. IBM clones in PC
industry).
Differentiation
Characteristics:
The key to differentiation is perceived quality, the actual product quality and after-sales
service. Perceived quality differs from actual quality in that you need to create a belief in the
customers’ minds that what they are buying is of good quality.
Key is perceived quality (whether real or not)

Actual product quality
Service after sale
Advantages:
Service after sale
Perceived quality and brand loyalty insulate company from threats from any of the four
forces:
– Price increases from powerful suppliers can be passed on to customers who are willing
to pay.
– Buyers have only one source of supply.
– Brand loyalty protects from substitutes.
– Brand loyalty is a barrier to new entrants.
Risks:
Imitations are more of a threat today because of production technology.

How long can the firm sustain a particular differentiation advantage? The “shelf life” for
such advantages is getting shorter and shorter.
How high can the managers raise the firm’s price before customers will be willing to
switch?
Customer tastes may change and wipe out competitive advantage.
The case study that follows illustrates the use and effects of those strategies
in practice.
CASE STUDY: COMPETITIVE STRATEGIES IN THE SOUTH AFRICAN ORGANIC

JUICES INDUSTRY
Introduction
The South African organic juices market is becoming increasingly competitive, with
growth rates slowing and consumer demand stabilising in many countries.
Competition is stepping up and companies need to re-examine their strategies if they
are to achieve positive business growth. The strategic options available to juice
companies can be illustrated by Porter’s (1985) generic competitive strategies (see
Table 7.1).
Cost leadership strategy

Juice companies can acquire competitive advantage via a cost leadership strategy.
This is usually gained by companies that are able to achieve economies of scale in
production and marketing. Such companies buy raw materials in bulk and produce
organic juices on a large scale. They are thus able to market organic juices at low
prices and this is usually to the mainstream food retailers.
South Africa has organic juice companies that have gained market leadership using
this strategy. Conventional juice companies undertake this strategy in the organic
juices market because of their large production capacity and established contacts.
This strategy is not viable for new entrants that have low financial resources and
specialised products.
Differentiation strategy
A differentiation strategy involves marketing a product that is clearly distinguishable
from others in the marketplace. In the organic juices market, this means the product
has attributes that are distinct from others, in the form of flavour, juice type or other
characteristics.
Examples of companies undertaking this strategy are those that specialise in “not
from concentrate” (NFC) or freshly pressed organic juices. Competitive advantage is
gained by positioning these products differently from those organic juices that
compete on price (cost leadership strategy). The Ceres Fruit Juices brand is an
example of this strategy in practice.
Focus strategy
Whereas the previous two strategies are industry-wide strategies, the focus strategy
involves a segmentation approach. It covers companies focusing on specific
segments of the organic juice market. Segments may be identified on the basis of
flavours, juice type or marketing channels. Competitive advantage is gained via a
cost focus or a differentiation focus.
With a cost focus strategy, a company attempts to gain competitive advantage by

being the low-cost provider to the segment. An example would be a company that
offers a wide range of specialised juices (e.g. organic mixed-vegetable juices) at low
prices.
Companies that opt for a differentiation focus strategy would market a distinct or
unique product in the target segment. There are many examples of companies that
use this strategy in the South African organic juices market.
What strategy to deploy?

As competition steps up in the South African organic juices market, it is essential that
companies adopt one of the three fundamental strategies outlined in the model.
According to Porter, companies that “get stuck in the middle” and do not have a clear
strategy could face business failure. So which strategy is the most applicable?
The most appropriate strategy depends upon a number of factors, which include the
company’s ambitions, corporate resources, current market position and the stage of
market development. Small dedicated organic food companies could obviously not
adopt a cost leadership strategy, and this strategy would also be difficult for new
entrants in countries that are showing slow market growth.
The cost leadership strategy is the favoured route of conventional juice companies,
which have achieved success in countries like Italy and the UK. A focus strategy is
probably the most practical for smaller companies, although the potential of target
segments has to be accurately measured.
None of these strategies is inherently good or bad. Strategists must examine the
results of the SWOT (strengths, weaknesses, opportunities or threats) analysis to
determine which one is best for the firm. In the next section, we briefly examine the
characteristics of a SWOT system of analysis.
7.8.3 SWOT analysis

SWOT analysis refers to the analysis of strengths, weaknesses,
opportunities or threats facing a company. SWOT analysis is one of the
most frequently used of all business analysis tools. On the surface it seems
simple, but there are many layers that can be added. This is a good “first
pass” tool to use as you analyse a company. It helps you sort out the “big
picture” issues. In this section we look at how we use these terms for this
analysis.
7.8.3.1 Strengths
These are resource strengths, capabilities, competitive assets, core
competencies and distinctive competencies. Basically, the analysis should
answer the question: What does my company do well?
Focus on core competencies.

Do not just focus on “warm fuzzies”. Does using Total Quality
Management (TQM) techniques really help the company improve or is it
“flavour of the month”?
Be careful to get past the company’s rhetoric on the mission statement.
Do not believe everything you read in the company’s advertisements and
marketing slogans. Sometimes a marketing slogan is just a slogan. Dig
deeper.
7.8.3.2 Weaknesses
What does the company do poorly? In what areas are the competitors
kicking the company’s tail?
What are the major themes that continue to plague the company?
Look especially at the financials. Is the debt-to-equity ratio too high?
What are the trends? If the company continues to have financial problems
year after year, this is a weakness.
7.8.3.3 Opportunities
What new product (or service or process) is out there that the company has
not grasped yet?
Look also at timing. If the company is playing “catch-up” every time

something new comes along, it is missing opportunities.
What does the company do to find out what’s on the horizon?
Forecasting and trends analysis should keep it up to date.
If the company uses the term “we missed the boat” often, it is missing
opportunities.
7.8.3.4 Threats
What stands in the way of the company’s success in the future? Threats may
be internal or external.
Look at internal issues for coming disasters. If the company has an aging
workforce and expects more than 50% of its employees to retire in the
next five years, this is a threat. The threat is that it will probably have a
major loss of “institutional memory” in the near future.
External threats are often taking place on the drawing boards of
competitors or government agencies. What new technologies are being
developed that will make the company’s product (or production process)
obsolete? Is a government agency threatening to outlaw the product or
create legislation to reduce its use? (Examples are the gun industry, the
tobacco industry.)
Big “ah-ha”: If you can see it coming, avoid it. What can the company do
to prevent the threat from damaging profits?
Use the SWOT analysis on your own company and on competitors. This
helps you see why they are doing better in some areas.
7.9 SUMMARY
The focus in this chapter was to introduce the role of industry variables in
the performance of a company. Global variables, domestic macroeconomic
variables, business cycles and industry life cycle all contribute to the overall
performance of an industry. In conclusion, the strategic alignment of the
business, the generic strategies adopted and a greater understanding of the
external and internal environments of the business all contribute to the
overall performance of the company. In the next chapter, we shall look at
company analysis, which will lead us to a discussion on company valuation.
Bodie, Z., Kane, A. & Marcus, A.J. 1998. Essentials of investments. Boston, MA: Irwin/McGraw-
Hill.
Gordon, M.J. 1962. Investment, financing and valuation of the corporation. Homewood, IL.: RD
Irwin.
Lynch, P. 1990. One up on Wall Street. New York: Penguin Books.
Porter, M.E. 1985. Competitive advantage: creating and sustaining superior performance. New
York: The Free Press.
Porter, M.E. 1990. Competitive strategy. New York: The Free Press.
Samuelson, P. 1966. Newsweek. Science and stocks, 19 September.
Siegel, J. 2001. Markets and the business cycle. Financial Times, June: 18.
South African Reserve Bank,
http://www.resbank.co.za/Research/Rates/Pages/SelectedHistoricalExchangeAndInterestRates.asp
x, Accessed: 1 July 2016
South African Reserve Bank, Composite leading business cycle indicators,
http://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/7350/Composite%20
Business%20Cycle%20Indicators_Jun2016.pdf
South African Reserve Bank, Composite coincident business cycle indicator,
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Business%20Cycle%20Indicators_Jun2016.pdf, Accessed: 1 July 2016
South African Reserve Bank, Historical diffusion index: deviation from long-term trend,
https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/7196/04Note%20%
E2%80%93%20Business%20cycles%20in%20South%20Africa%20from%202009%20to%20201
3.pdf, Accessed: 1 July 2016
South African Reserve Bank, Current diffusion index: deviation from long-term trend,
https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/7196/04Note%20%
E2%80%93%20Business%20cycles%20in%20South%20Africa%20from%202009%20to%20201
3.pdf, Accessed: 1 July 2016
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sold, http://www.resbank.co.za/Research/Statistics/Pages/OnlineDownloadFacility.aspx,
Accessed: 1 July 2016
1. Modest sales growth and small or negative profits are characteristic of which
phase of industrial development?
(a) Pioneering development

(b) Rapidly accelerating growth
(c) Mature growth
(d) Stabilisation and market maturity
2. The decline stage of the industry life cycle is most likely to be characterised by:
(a) slowly growing sales

(b) a search for product differentiation
(c) a rapidly increasing return on equity
(d) an emphasis on production efficiencies
3. Which of the following should result in a higher industry P/E?
(a) A higher required return

(b) A decrease in an industry’s business risk
(c) A decrease in an industry’s growth rate
(d) An increase in an industry’s liquidity risk
4. Which of the following does not figure in the calculation of an industry’s return on
equity?
(a) Total asset turnover

(b) Profit margin
(c) Financial leverage
(d) Dividend payout
5. Which of the following will tend to depress profit margins in an industry?
(a) Little rivalry among existing competitors

(b) A large threat of substitute products
(c) Little bargaining power on the part of buyers
(d) Little bargaining power on the part of suppliers
6. The method of industry analysis that relies on finding relationships between
industry sales and economic variables is called:
(a) input–output analysis

(b) industrial development
(c) industry–economy technique
(d) macro-forecasting
7. Discuss the concept of an industry life cycle by describing each of its four phases.
Solutions
1. (a)
2. (d)
3. (b)
4. (d)
5. (b)
6. (c)
7. The following model answer is suggested for question 7:
The concept of an industrial life cycle refers to the tendency of most industries to go
through various stages of growth that, to some extent, resemble those of a person.
Generally, four stages are talked about with no uniformity in the length of each stage.
The rate of growth, the competitive environment, profit margins and pricing strategies
tend to shift as an industry moves from one stage to the next, although it is usually
difficult to pinpoint exactly when one stage has ended and the next has begun.
The initial stage is characterised by perceptions of a large market and great optimism
about potential profits. Little or no profits are usually achieved, however, in this stage
and there is usually a high rate of failures. In the second stage, often called rapid
expansion or follow-through, growth is high and accelerating, the markets are
broadening, unit costs are declining and quality is improving. The third stage, usually
called mature growth, is characterised by decelerating growth caused by such things
as maturing markets and competitive inroads by other products. Finally, an industry
reaches a stage of full maturity in which growth slows or even declines.
Product pricing, profitability and industry competitive structure often (though not
necessarily) vary by phase. Thus, for example, the first phase usually encompasses
high product prices, high costs (R&D, marketing, etc.) and a (temporary) monopolistic
industry structure. In phase two (rapid expansion), new entrants appear and costs fall
rapidly due to the experience curve. Prices generally do not fall as rapidly, allowing
profit margins to increase. In phase three (mature growth), growth begins to slow as
the product or service begins to saturate the market, and significant price reductions
become less common. There is a choking out of competitors as quality and other
non-price factors become more important as competitive tools. In the final stage,
industry cumulative production is so high that production costs have stopped
declining, profit margins are thin (assuming competition exists) and the fate of the
industry depends on the extent of replacement demand and the existence of
substitute products/services.
Note: The chapter refers to four stages of the industrial life cycle:
Start-up
Consolidation (rapid expansion)
Maturity (mature growth)
Relative decline (deceleration)
8 Company analysis
8.1 INTRODUCTION
In Chapter 7 we explored industry analysis, focusing on the role of the

industry in shaping the profitability of a company. In this chapter, we show
how investors can use financial data as inputs into company analysis. We
start by reviewing the basic sources of such data: the statement of financial
performance, the statement of financial position and the statement of cash
flows. We finish the discussion by looking at various techniques of financial
analysis, including ratio analysis and the DuPont system of analysis.
8.2 STATEMENT OF FINANCIAL PERFORMANCE
The statement of financial performance looks at the performance of a

company over a given period. In this section, we look at the statement of
financial performance in detail, and we cover the following:
The difference between capital and revenue costs

The things you can expect to find on a statement of financial
performance
The way a statement of financial performance is laid out
The judgements accountants make when they are preparing the statement
of financial performance
8.2.1 Capital costs versus revenue costs
It is important to understand the way a company classifies its costs. Costs
may be classified as one of the following:
Capital costs, relating to buying or improving assets

Revenue costs, relating to the sales in the period
A simple example will explain the difference between revenue and capital
costs. Decorating your home is a revenue cost: you don’t get any extra
value for a well-decorated house! Putting in an extra bathroom is a capital
cost: you can expect to recover some or most of the money when you sell
the house. The South Africa Revenue Service (SARS) issues guidelines on
different types of expenditure. The following is an extract from the 2002–
2003 income tax guidelines published by SARS.
Capital expenditure
In general, capital expenditure is an amount paid or a debt incurred for the
acquisition, improvement or restoration of an asset. However, capital
expenditure is not necessarily confined to assets. Expenditure designed to
extend the scope of a business, as distinct from maintenance or expenditure
incurred to create or to protect a source of income, or to acquire an enduring
advantage for the benefit of trade, is regarded for tax purposes as
expenditure of a capital nature. Examples of capital expenditure
(http://www.sars.gov.za/it/brochures/it_20_bu.pdf):
Land and buildings (including transfer costs)

Additions, alterations and improvements to any assets used by the
business, for example buildings, plant, machinery, furniture and fittings,
etc.
Cost of material, labour and installation of capital assets
Goodwill
Expenditure to eliminate competition
Expenditure to protect capital or assets, including rights
Legal expenses referring to capital or assets
8.2.2 Operational or revenue costs

Operational costs are the costs of materials, labour and overheads used in
sales, excluding any VAT or similar taxes. The Companies Act and
guidelines from SARS clearly specify which costs are to be included under
operating profit in companies’ determination of operating profit.
Net profit is an accounting concept and is a term used to describe the

calculation of the profit a business makes from an accounting point of view.
Taxable income, on the other hand, is a tax term that is used to describe the
amount on which a business’s tax is calculated.
The amounts will often be different. The reason for this is the basic
differences in the income and deductions taken into account in determining
the two amounts. For example, certain income of a capital nature may be
fully included for accounting purposes, while only a portion thereof may be
included for tax purposes. On the deduction side there may be timing
differences in respect of the depreciation of capital assets or special
deductions/allowances for tax purposes, which will cause differences in the
deductions between accounting and taxation. Nevertheless, the
determination of net profit from an accounting point of view is an important
building block in the determination of the business’s taxable income. Every
business must first prepare a set of financial statements (statement of
financial performance and a statement of assets and liabilities). From the
statement of financial performance, which determines the business’s net
profit/loss, certain adjustments can be made to compute the business’s
taxable income or assessed loss. This calculation is normally referred to as
the tax computation.
8.3 STATEMENT OF FINANCIAL POSITION

The purpose of the statement of financial position is to show the financial
condition of an accounting entity at a particular date. The statement of
financial position reports on assets, which are the resources of the firm;
liabilities, which are the debts of the firm; and shareholders’ equity, which
is the owners’ interest in the firm. The assets are derived from two sources:
creditors and owners. At any given time, the assets must equal the
contribution of the creditors and owners. This is expressed in the
accounting equation:
Assets = Liabilities + Equity
The statement of financial position is a “snapshot” of the organisation at a

particular moment. It shows the assets and liabilities of the organisation at
that moment. A typical statement of financial position is presented in Table
8.1.
Table 8.1 Classic Medical (Pty) Ltd and subsidiaries consolidated statement of
financial position
December 31 2015 2014

ASSETS
Fixed assets:
Property, plant and equipment – at cost: (notes 1 and 6)
Land 1 696 1 266
Buildings and improvements 8 863 8 751
Furniture, fixtures and equipment 4 135 3 342
Transportation equipment 2 293 2 058
Funds held for construction 1 493 –
18 480 15 417
Less accumulated depreciation and amortisation (4 352) (3 354)
Total property, plant and equipment – net 14 128 12 063
Investments – marketable securities (note 5) 132 287
Current assets:
Cash and temporary cash equivalents (note 2) 9 310 11 135
Accounts receivable (less allowance for discounts and bad debts: 30 717 19 733
2015: R1 282; 2014: R724
Inventories (notes 1 and 3) 31 071 21 846
Notes receivable – officers and employees 90 –
Other current assets 1 164 723
Total current assets 72 352 53 437
Total assets 87 817 66 585
LIABILITIES AND SHAREHOLDERS EQUITY

Shareholders’ equity:
Ordinary share capital* 3 126 3 121
Additional paid-in capital 10 411 10 339
Retained earnings 28 935 24 759
*Authorised 16 000 000 shares in 2015 and 8 000 000 shares in 42 472 38 219
2014; R0.50 par value; issued and outstanding 6 252 245 in 2015
and 6 242 131 in 2014
Less net realisable loss on marketable equity securities 11 21
Total shareholders’ equity 42 461 38 198
Long-term liabilities 12 735 9 580
Current liabilities:
Current maturities of long-term loans 757 749
Notes payable 5 448 –
Accounts payable 21 562 14 559
Accrued liabilities:
Retirement plan contribution 1 100 900
Income taxes 574 503
Other 876 801
Other current liabilities 1 247 564
Total current liabilities 31 564 18 076
Other liabilities:
Deferred income taxes 989 687
Other 68 44
Total other liabilities 1 057 731
Total liabilities and shareholders’ equity 87 817 66 585
8.3.1 Assets
Assets are probable future economic benefits obtained or controlled by a
particular entity as a result of past transactions or events. Assets may be of a
physical nature, such as land, buildings, inventory of supplies, material or
finished product. Assets may also represent legal claims; examples are
patents and amounts due from customers.
Assets are divided into two major categories: current and non-current (long
term). Current assets are listed on the statement of financial position in
order of liquidity – the ability to be converted into cash. Current assets
typically include cash, marketable securities, short-term receivables,
inventories and pre-paids. In some cases, assets other than these may be
classified as current. In these instances, management is indicating that they
expect the asset to be converted into cash during the operating cycle or
within one year. An example is land held for immediate disposal.
8.3.2 Liabilities
Liabilities are probable future sacrifices of economic benefits arising from
the present obligations of the business to transfer assets or provide services
to other entities in the future as a result of past transactions or events.
Liabilities are classified as either current or non-current (long term).
8.4 CASH FLOW STATEMENT
The cash flow statement shows the flow of funds or cash in the business. It
focuses on the sources and uses of cash, with the emphasis on cash from
operations, cash from investing activities and cash from financing activities.
The statement of financial position and statement of financial performance
do not adequately indicate changes in cash flow. Transactions such as the
sale of ordinary shares and the purchase of equipment do not appear on the
statement of financial performance. These types of transaction are reflected
on the statement of financial position, but they are not summarised in a
meaningful manner.
The statement of financial position indicates the financial position of the

entity at a given time; however, it does not indicate how the entity arrived at
this financial position.
The statement of financial performance shows the profit or loss for a period,
but it does not indicate how funds from operations were used.
The need for cash flow statements arises from the following:
Financial managers need accurate forecasts of cash flows to make

accurate investment and financing decisions.
Investment bankers and deal makers need to know how much to bid for a
company in an acquisition and/or merger.
Managers need to know what cash flows are generated by assets to get
feedback on their strategic decisions.
Investors and creditors need to know how much cash is generated from
assets and operations to determine the financial solvency of a company.
Statements of GAAP and IFRS South African Statements of GAAP are

accounting standards issued and approved by the Accounting Practices
Board (APB) in South Africa. The APB is an independent national
standard-setting body in South Africa. Until the FRSC is established it is
necessary to also comply with Statements of GAAP issued by the APB.
This means compliance with IFRS which includes applying the AC 500
series. Unlisted companies or entities are not compelled to prepare financial
statements in accordance with IFRS, but may prepare financial statements
in terms of Statements of GAAP or IFRS or IFRS for SMEs if they meet the
scope requirements of that standard. The statements below therefore refer to
the application of GAAP but are equally applicable to IFRS.
Certain assumptions made in the compilation of financial information need

to be discussed briefly. It is a well-known fact in finance that Generally
Accepted Accounting Practice (GAAP) procedures lead to differences in
net profit versus true cash flows. Some of the reasons for these differences
are the following:
GAAP governs audited financial statements.

GAAP’s objective is to provide a consistent account of a firm’s financial
status based on historical cost, where revenues and expenses are matched
over the appropriate time period.
Accounting is concerned with presenting the net profit of the firm.
One of the financial manager’s duties is to ensure that the firm always
has sufficient cash flows to meet demands for payments. However, cash
flow does not equal GAAP net profit.
Depreciation and other non-cash items are included in GAAP net profit.
Items are recorded on an accrual basis, not when the money actually
comes into the firm.
Market values are used in respect of certain assets and liabilities, rather
than book value.
8.5 STATEMENT OF CASH FLOWS
The statement of cash flow summarises the flow of cash receipts (inflows)
and cash payments (outflows) during a given period. It organises cash flows
into three primary categories:
Operating cash flows. Cash flows from operations equal cash received
from sales of goods and services minus cash paid for operating goods and
services.
Investment cash flows. The acquisition of non-current assets, such as
property, plant and equipment, usually represents a major ongoing use of
cash.
Financing cash flows. A firm obtains cash from short and long-term
financing and equity issues. Cash is used to pay dividends, repay
borrowings and repurchase shares.
In developing the statement of cash flows, it is important to distinguish
between sources of cash and uses of cash. Sources of cash include activities
that bring cash into the firm. These include decreases in assets and increases
in liabilities. Uses of cash include activities that send cash out of the firm.
These include increases in assets and decreases in liabilities. Below is an
outline of the statement of cash flows that can be used as a template to
determine the different sources and uses of cash. For each group of
activities, sources (+) and uses (–) of cash are identified.
Operating activities
+ Net profit
+ Depreciation
+ Any decreases in current assets (except cash)
+ Any increase in current liabilities
– Any increase in current assets (except cash)
– Any decrease in current liabilities
Investment activities
+ Ending fixed assets
– Beginning fixed assets
+ Depreciation
Financing activities
– Dividends
+ Increases in notes payable of long-term debt
– Decreases in notes payable of long-term debt
+ New equity raised
– Equity repurchased
Statement of cash flows format:

Cash flows from operating activities
Operating profit or loss of integrated enterprises xxxx
Elimination of non-operating charges and income:
– Depreciation and provisions (1) xxxx
Gross operating profit or loss xxxx
Change in operating working capital requirement (2) xxxx
Net operating cash flow xxxx
Other cash inflows and outflows linked to operating activities:

– Finance charges xxxx
– Investment income xxxx
– Dividends received from enterprises accounted for by use of the xxxx
equity method
– Company tax, net of capital gains tax on disposals xxxx
– Extraordinary charges and income linked to operating activities xxxx
– Other xxxx
Net cash flow from operating activities xxxx
Cash flows from investing activities
Acquisition of fixed assets xxxx
Disposal of fixed assets, net of tax xxxx
Effect of changes in the scope of consolidation (3) xxxx
Net cash flow from investing activities xxxx
Cash flows from financing activities
Dividends paid to shareholders of the parent enterprise xxxx
Dividends paid to minority shareholders of integrated enterprises xxxx
Share capital increases in cash xxxx
Loan issues xxxx
Loan redemptions xxxx
Net cash flow from financing activities xxxx
Change in cash position xxxx

Opening cash position xxxx
Closing cash position xxxx
Effect of foreign exchange rate changes xxxx
(1) Excluding provisions for current assets

(2) To be itemised by major headings (stocks, operating debts receivable
and payable)
(3) Purchase or sale price increased or decreased by the cash position
acquired or expended – to be itemised in a note to the accounts
8.5.1 Cash flow identity

The cash flow statement gave us an indication of the sources and uses of
cash. In this section, we discuss further the different elements of cash flow
(see Table 8.2 for an example). So, what is cash flow identity? We define it
as follows:
Cash flow from assets = Cash flow to creditors + Cash flow to shareholders
Table 8.2 Classic Medical (Pty) Ltd and subsidiaries consolidated statement of cash
flows
For the year ended 31 December 2015 2014

Cash and temporary cash equivalents, beginning of year 11 135 2 628
Sources of cash:
Analysing operating activities:
Net income 5 027 4 002
Add (subtract) items not affecting cash:
Depreciation 1 328 995
Amortisation of deferred charges 61 51
Donated property 91 –
Profit on sale of property and securities (2) (106)
Increase in accounts receivable (5 088) (3 719)
Increase in inventories (4 868) (5 186)
Increase (decrease) in other current assets (81) (580)
Decrease in notes payable (198) –
Increase (decrease) in accounts payable 4 096 4 270
Increase (decrease) in accrued liabilities (172) 187
Increase in other current liabilities 645 109
Increase in other liabilities 322 342
Other – net 132 31
Cash from operations 1 293 396
Analysing financing activities:
Proceeds from disposal of property and securities 694 238
Proceeds from long-term obligations 1 500 3 375
Proceeds from sale of ordinary shares – 10 959
Proceeds from share options exercised 85 60
Net proceeds 2 279 14 632
Total sources of cash 3 572 15 028
Application of cash:
Analysing investing activities:
Increase in other assets 108 314
Purchase of marketable securities – –
Purchase of property, plant and equipment 2 054 4 801
Funds held for construction 1 413 –
Reduction of long-term obligations 975 749
Cash dividends paid 851 657
Net proceeds 5 401 6 521
Acquisition of Naster Surgical Supplies (Pty) Ltd not requiring cash transactions:
Notes payable:
Naster shareholders 4 777 –
Bank 3 500 –
Accounts payable 2 907 –
Accounts receivable (5 896) –
Inventories (4 357) –
Property, plant and equipment – net (463) –
Purchase price of operating lease (575) –
Other – net 111
Cash provided from acquisition 4 –
Increase (decrease) in cash and temporary cash equivalents (1 825) 8 507
Cash and temporary cash equivalents (end of year 9 310 11 135
In our definition, let us define other components of cash flow calculations.
Cash flow from assets = Opening cash flow – Net capital spending –
Additions to net working capital (NWC)
Operating cash flow = Earnings before interest and tax (EBIT) +
Depreciation – Taxes
Net capital spending = (Ending net fixed assets – Beginning net fixed
assets + Depreciation)
Additions to NWC = (Ending NWC – Beginning NWC)
Cash flow to creditors = Interest payments – Net new borrowing =
Interest payments – (Ending long-term debt – Beginning long-term debt)
In our discussion in this book, interest payments equal interest expenses

recorded on the statement of financial performance. Net new borrowings
equal the difference between new long-term debt issued and long-term debt
retired. These numbers can be found on the firm’s statement of financial
position. Other important definitions are given below.
Cash flow to shareholders = Dividend payments – Net new equity raised

= Dividend payments – [(Ending ordinary share + Ending paid-in
surplus) – (Beginning ordinary share + Beginning paid-in surplus)].
Dividends are recorded as a note to the statement of financial
performance. If dividends are not reported in this way, dividends can be
calculated by using the following identity: Net profit = Dividends paid +
Additions to retained earnings
Net new equity equals the difference between new equity raised and
equity repurchased. These numbers can be found on the firm’s statement
of financial position.
8.5.2 A closer look at operating cash flow

Operating cash flow = EBIT + Depreciation – Taxes
The EBIT of the firm is arrived at after deducting depreciation.

Depreciation should be added back since it is a non-cash item when
calculating operating cash flow. By adding depreciation, we have a cash
flow number that includes costs associated with operating activities and
non-cash items. Taxes are included in operating cash flow because the taxes
are paid on the revenues associated with operating activities. Other
definitions of the calculation of changes in net working capital (NWC) are
as below:
Cash flow from assets = Cash flow to creditors + Cash flow to

shareholders
Cash flow from assets = Operating cash flow – Net capital spending –
Additions to NWC
Operating cash flow = Earnings before interest and tax (EBIT) +
Depreciation – Taxes
Net capital spending = (Ending net fixed assets – Beginning net fixed
assets + Depreciation)
Additions to net working capital (NWC) = (Ending NWC – Beginning
NWC)
Cash flow to creditors = Interest payments – Net new borrowing =
Interest payments – (Ending long-term debt – Beginning long-term debt)
Cash flow to shareholders = Dividend payments – Net new equity raided
= Dividend payments – [(Ending ordinary share + Ending paid-in
surplus) – (Beginning ordinary share + Beginning paid-in surplus)]
8.5.3 Analysing cash flows

We now focus our attention on the timing of the cash flows. Management
requires more information regarding the actual flows of cash, not just the
sources. In this section we will discuss the flows of cash, and how a
business can manage the timing of cash flows.
Effective cash flow management has four basic steps:
1. Differentiate between cash flow, profits and sales.

2. Set up systems to monitor the flow of cash through the business.
3. Learn to recognise the warning signs of poor cash management, such as
overextended receivables, large write-offs of bad debt, phone calls from
irate suppliers asking for the “promised cheque in the mail”, bank
overdrafts and a lack of timely, reconciled bank statements.
4. Develop effective strategies to help the business cope with negative
cash balances before a cash crisis arises.
Beware of these alarming, false entrepreneurial premises:
“All we need to stop the haemorrhaging is to create more sales.” In

reality, the business must develop the “right” kind of sales: accounts that
pay on time and have adequate profit margins. The “wrong” kind of sales
can lead to bankruptcy.
“Profits equal increased cash flow.” The lag between spending cash to
produce the sales and collecting the cash from the sales is actually one of
the things that contribute to cash flow problems.
“Capital is unlimited.” A closer look at large South African companies
that have filed for liquidation or bankruptcy, like Saambou Bank, shows
that even though capital may be adequate, a business can nevertheless be
liquidated due to lack of adequate cash flow. A business must have
enough capital to begin with, and the capital must last long enough for
the business to generate sufficient cash internally to pay its bills, arrange
for outside financing or attract new capital.
8.5.4 Profit versus cash flow

Profit is an accounting concept. Profit is what is left over after paying
expenses. Bankers are concerned with a company’s track record of
profitability when a business loan is sought. Historically, profitability, or
lack thereof, greatly affects a company’s perceived ability to repay a loan –
that is, to service its debt.
Cash, on the other hand, is the lifeblood of your business. You cannot spend
profits, and a business cannot stay open, without steady cash flow. Many
business owners do develop annual cash flow projections for their bankers
and include these projections as part of their overall business plans. Most
projections from closely held companies, however, are created by outside
accounting firms and little attention is given to the realism of the underlying
assumptions. Major emphasis tends to be placed on a positive bottom line,
which does not adequately address positive cash flow throughout the year.
Unfortunately, few businesses go on to use a cash plan to actually monitor

cash inflow and outflow. Rather, cheque book management tends to prevail
until the next crisis looms, with the loan officer knocking at the door to ask
why the goals of the plan were not achieved.
The business owner must ensure that his or her entrepreneurial spirit
embraces the necessary discipline to constantly monitor and forecast
changes to cash availability. The business should be in a position to predict
cash deficiencies and devise operating strategies to correct shortfalls, carry
out cost-cutting action steps and thereby provide a sound financial basis to
avoid the “cash flow disease”.
8.6 FINANCIAL ANALYSIS
The future of the analyst has taken on a new dimension because of the
sophistication of new computer systems to manage accounts receivable and
credit management. But even with these new tools, the analyst faces a
higher level of risk due to downsizing, recapitalisation, undercapitalisation,
leverage buyouts, bankruptcies and fraud. We also live in a time when
domestic and international economic turmoil affects not only the JSE, but
also the financial condition of many corporations worldwide. Because of
the adverse conditions impacting daily business decisions, it is important
that credit and financial decision making be brought to a higher, world-class
level. The analyst must be equipped with the most sophisticated financial
analysis software that measures financial risk against industry standards,
and must be able to evaluate the financial statements and footnotes at a
level “below the surface”. (Tables 5.3 and 5.4 are examples of statements of
financial position.)
Table 8.3 ABC (Pty) Ltd statement of financial position
ABC (Pty) Ltd

STATEMENT OF FINANCIAL POSITION AS AT
31 Dec. 2015 Dec. 2014 Dec. 2013
31 31
Rand Rand Rand
ASSETS
Current assets
Cash at bank 1 405 435 3 452 419 1 308 172
Trade debtors (Accounts receivable) 6 454 008 4 051 818 3 951 380
Inventory (stock) 315 701 386 793 376 775
Other current assets 12 989 651 9 284 656 2 847 448
Prepayments 1 140 618 468 362 525 884
Total – current assets 22 305 413 17 644 048 9 009 659
Non-current assets
Machinery/equipment/office equipment 918 653 765 804 2 036 732
Land and buildings 1 708 012 1 650 000 1 350 000
Less: Accumulated depreciation (2 031 108) (1 551 911) (673 587)
Other non-current assets 3 523 744 2 105 401 3 339 151
Investment in subsidiaries/associates 67 510 57 191 39 371
Intangible assets 1 234 762 1 467 893 1 542
678
Total – non-current assets 5 421 573 4 494 378 7 634 345
Total – assets 27 726 986 22 138 426 16 644 004
EQUITY & LIABILITIES
Current liabilities
Bank overdraft 359 411 528 010 1 438 945
Shareholders for dividend (Proposed 250 000 394 092 51 518
dividend)
Trade creditors (Accounts payable) 3 423 033 3 625 400 3 475 767
Short-term loans payable 6 114 517 4 293 009 3 071 512
Accruals 2 663 441 1 436 269 990 500
Other current liabilities 1 329 877 1 678 438 1 188
187
Total – current liabilities 14 141 279 11 955 218 10 216 429
Non-current liabilities
Unsecured long-term debt 35 563 24 800 199 877
Secured long-term debt – 3 796 –
Long-term debt provisions 67 738 116 997 380 513
Other non-current liabilities 8 247 642 5 441 130 3 213
503
Total – non-current liabilities 8 350 943 5 586 723 3 793 893
Total – liabilities 22 492 222 17 541 941 14 010 322
Shareholders’ funds
Ordinary share capital 157 157 157
Share premium account 2 000 000 2 000 000 1 365 000
Other reserves 532 447 539 142 239 142
Retained profit 2 702 160 2 057 186 1 029
383
Total – net worth 5 234 764 4 596 485 2 633 682
Total – equity & liabilities 27 726 986 22 138 426 16 644 004
Table 8.4 ABC (Pty) Ltd statement of financial performance
ABC (Pty) Ltd

STATEMENT OF FINANCIAL PERFORMANCE FOR THE YEARS ENDED 31
DECEMBER
31 Dec. 2015 31 Dec. 2014 31 Dec. 2013
Rand Rand Rand
Sales/revenues 42 858 628 41 122 633 29 123 934
Cost of sales 37 794 392 35 321 796 25 760 715
Gross profit 5 064 236 5 800 837 3 363 219
Other income 1 251 984 1 535 584 883 447
Gross margin 6 316 220 7 336 421 4 246 666
Selling general & administration costs 621 622 733 642 424 667
Other non-cash costs 4 113 917 3 536 063 2 173 600
Depreciation & amortisation 1 023 249 1 088 973 625 055
Operating profit 557 432 1 977 743 1 023 344
Financial charges 188 772 286 204 287 865
Profit before tax 368 660 1 691 539 735 479
Tax (29%) 77 911 490 546 213 289
Profit after tax (net profit) 290 749 1 200 993 522 190
Dividend declared 250 000 394 092 51 518
Retained profit 40 749 806 901 470 672
Dividend per share R0.13 R0.24 R0.04

Number of people employed at year-end 110 105 95
Number of issued shares 2 000 000 1 652 000 1 250 000
Share price R2.15 R7.53 R4.15
This new age of sophisticated software and computer systems should assist
the analyst in minimising risk and bad debt write-off. Unfortunately, we live
in an age where financial and economic risks have dramatically increased.
The cash flow and equity positions of many corporations have reflected
dramatic volatility, due to instability in the marketplace, competition and
international economic conditions. Sustaining competitive advantages, for
many companies, can add to corporate cash flow problems. Dealing with
factors that contribute to a higher level of risk requires analysts and credit
management teams with diverse levels of knowledge. This knowledge is
usually in the field of financial and economic risk analysis. What is required
at that level is forensic financial analysis.
Let us look at three types of financial analysis that an analyst may use to
assess the financial health of a company. These are statistical analysis,
subjective analysis and ratio analysis.
8.6.1 Statistical analysis
A statistical analyst will do the following:
Perform financial and ratio trending analysis to determine dramatic

deviations.
Use industry and economic standards to assist in determining the level of
condition and trend.
Utilise bankruptcy risk and cash flow analysis – it is imperative to
determine the level of risk.
Evaluate contingencies to determine if the potential of material impact
exists.
Find out if the company is in compliance with credit agreements and
evaluate the rate of financing.
Investigate and assess footnotes for previous or current indictments of
criminal fraud.
Be concerned about any substantial suit(s), lien(s) or judgement(s) that
could have a material impact on the company.
8.6.2 Subjective analysis

Subjective analysis is another critical part of the analysis process. It
involves the use of information which is not truly factual, arising mostly
from observations of behavioural changes. These changes might be signs of
impending difficulty within a company. Studying payment habits to
suppliers over a period of three to five years is critical. Drastic deviations in
payment habits with suppliers over the short and long term may be an
indication that cash flow problems exist or that there is a potential for
bankruptcy or fraud. An analyst is advised to request a change in credit
references every three years to establish whether there have been any
drastic changes in payment habits. There should be concern about dramatic
changes in payment habits to suppliers and the way payments are being
made in relation to industry standards or payment terms. The length of time
a company has been in business is also very important. In general, a
company that has been in business for less than five years has a higher
probability of bankruptcy or fraud than older firms. Antecedent information
from a credit rating agency report will give background information
regarding the company’s history and operations, as well as the history of its
officers. The analyst should be concerned about resignations or changes in
executive management.
8.6.3 Ratio analysis

Financial ratios are usually expressed in percentages or times. A ratio can
be computed from any pair of numbers. Given the large quantity of
variables included in financial statements, a very long list of meaningful
ratios can be derived. There is no standard list of ratios or standard
computation of such, and each author and source on financial statement
analysis uses a different list. Several types are listed below, which are
discussed fully in this chapter (see example in Table 8.5). These can be
categorised into the following groups:
Liquidity or short-term solvency ratios. These are measures of a firm’s

ability to meet its current obligations. These statement of financial
position ratios include the current and quick ratios, which give us an
indication of how well the organisation manages its working capital and
operating cycle. In the case of the current ratio, the benchmark is often
said to be around 1.5, but statistics show that the South African average
is, in fact, well below this level.
Leverage or long-term solvency ratios. These measure the degree of
protection that providers of long-term funds have. South African gearing
levels are on average much lower than in, say, Germany, where the banks
have traditionally provided the bulk of company finance. Accounting and
reporting issues which are again significant here include questions of
debt/equity classification, asset valuation, valuation of pension fund
liabilities, and the treatment of finance leases and deferred taxes. A key
question is: Are all liabilities to be regarded as debt?
Activity or asset management ratios. These measure the efficient use of a
firm’s current assets. Share turnover, debtor days, total asset turnover and
similar ratios are all relevant to an evaluation of efficiency, which itself
drives profit. Idle or slow-moving assets are bad news for the investor,
and management will be blamed if this is allowed to happen. In addition
to the ratio values themselves, the trend from year to year is considered
equally important. It is worth noting, however, that international norms
do vary – the average invoice payment period in the UK is about 45 days
and in Italy 90 days! In South Africa, it is about 60 days, though big
companies like Pick ‘n Pay can take up to 90 days to settle. Accounting
issues such as asset valuation and the treatment of goodwill are again
important when making inter-company comparisons.
Profitability ratios. These measure the earning ability of a firm. They
include profit and loss items such as gross margin, operating margin and
net margin, as well as performance measures such as the return on assets,
on capital employed, and on equity. Since most accounting choices affect
profit directly (e.g. capitalisation of costs) or indirectly (subsequent
amortisation), this category is particularly difficult to compare among
companies in the same country, let alone across borders. Again, it is also
worth remembering that no standard definition of key ratios such as
return on capital (ROCE) exists.
Market value ratios. This means going beyond financial statements and
using stock price data. Although of limited interest to the lender,
investors are particularly keen on knowing such statistics as earnings per
share (EPS), price/earnings (P/E), dividend yield, cash flow per share and
the total market capitalisation. In fact, several of these statistics are
calculated and published in financial newspapers every day. In addition
to some of the accounting issues already mentioned above, important
market-driven international variations do exist, in P/E ratios for example,
and these are only partly explained by accounting differences.
Table 8.5 ABC (Pty) Ltd ratio analysis
ABC (Pty)
Ltd RATIO ANALYSIS
Ratio type Formulae Dates
31 Dec. 31 Dec. 31 Dec.
2015 2014 2013
Liquidity ratios
Current ratio Current assets
1.57 × 1.48 × 0.88 ×
Current liabilities
Quick ratio 1.56 × 1.44 × 0.85 ×

Current assets – Inventory
Current liabilities
Net working capital Current assets – Current R8 164 R5 688 (R1 206
liabilities 134 830 770
There has been a general improvement in the liquidity position of ABC Ltd. Both the current
and quick ratios have improved over the three-year period. Compared to 2013 when ABC
had 88c current assets for every R1 of current liabilities, in 2015 ABC had R1.57 current
assets for R1 of current liabilities. The working capital ratio has also improved substantially.
Financial leverage ratios
Total debt (Total assets – Total equity)
81% 79% 84%
Total assets
Debt to equity (Total assets – Total equity)

4.30 × 3.82 × 5.32 ×
Total equity
Gearing Long-term debt

30% 25% 23%
Long-term debt + Equity
Times interest earned EBIT

2.95 × 6.91 × 3.55 ×
Interest expense
Cash coverage EBIT + Depreciation

8.37 × 10.72 × 5.73 ×
Interest expense
The debt ratio has improved but gearing has worsened, mostly because there is a shift to
using long-term debt rather than short-term debt. This is also supported by the low
coverage ratio of 2.95 times
Asset management ratios
Inventory turnover Cost of sales
119.72 × 91.32 × 68.37 ×
Inventory
Days’ sales inventory 365

3.05 days 4.00 days 5.34 days
Inventory turnover
Debtors’ turnover Cost of sales

6.64 × 10.15 × 7.37 ×
Debtors
Days’ sales in 365

54.96 days 35.96 days 49.52 days
receivables Debtors’ turnover
Total assets turnover Sales

1.55 × 1.86 × 1.75 ×
Total assets
Inventory turnover has improved, indicating that the stock is moving fast. Also, the number
of days in inventory has dropped. However, the debtors’ turnover has dropped, leading to
an increase in the debtors’ days. This could imply that the company is pushing stock, but
selling a lot on credit. Need to keep track of collections.
Profitability ratios
Net profit margin Net profit
0.68% 2.92% 1.79%
Sales
Gross profit margin Gross Profit

11.82% 14.11% 11.55%
Sales
Return on assets Net profit

1.05% 5.42% 3.14%
Total assets
Return on equity 5.55% 26.13% 19.83%

Net profit
Total equity
A big drop in net profit margin as well as return on assets and on equity, but gross profit still
steady. Significant because ABC earned less sales in its total assets (total assets turnover).
This is in line with our previous assessment that ABC is moving stock via credit sales in
order to boost turnover.
Market value ratios
Earnings per share Net profit
R0.15 R0.73 R0.42
(EPS) Number of shares
Price/earnings (P/E) Market price

R14.79 R10.36 R9.93
Earnings per share
Book value per share Total assets

R13.86 R13.40 R13.32
Number of shares
Market-to-book value Market price

0.16 × 0.56 × 0.31 ×
Book value per share
EPS dropped very significantly, but P/E has continued to increase. This implies that the
market is still confident in the company. Book value per share also increased as a result of
an increase in assets. Market-to-book value is very low, implying that the shares are
undervalued. In other words, the market is prepared to pay only 16 cents for every R1 of
assets.
To facilitate our discussion of financial ratio analysis, we are going to use a

comprehensive example using information in Tables 8.3 and 8.4. First, a
brief summary of what each ratio measures.
8.6.3.1 Liquidity ratios or short-term solvency

The current ratio indicates a firm’s ability to meet its short-term obligations.
The current ratio includes current assets, such as inventories, that may not
be able to be converted into cash in the very short term. The quick ratio or
acid-test ratio is computed by including only current assets that can be
converted quickly into cash. This excludes inventories or stock.
8.6.3.2 Long-term solvency or financial leverage ratios

The total debt ratio or, simply, the debt ratio, takes into account all debt of
all maturities to all creditors. This is the sum of current liabilities and non-
current liabilities. The ratio is calculated by dividing total assets minus total
equity, or total liabilities, by total assets.
The debt/equity ratio is the ratio of total debt to total equity.

The gearing or long-term debt ratio excludes short-term debt. The
amount of short-term debt outstanding often changes. Also, accounts
payable may be a reflection of trade practices rather than of debt
management policy.
The times interest earned or interest coverage ratio measures the multiple
of the current level of debt that a firm could support given its current
level of earnings.
The cash coverage ratio measures the multiple of the current level of debt
that a firm could support given its current level of cash available.
Analysis of a firm’s capital structure is essential to the evaluation of its

long-term risk and return prospects. Leveraged firms accrue excess returns
for their common shareholders so long as the rate of return on the
investments financed by debt exceeds the cost of debt. The benefits of
financial leverage bring additional risks, however, in the form of fixed costs
that adversely affect profitability if demand declines. Since priority is given
to interest and principal payments to debt holders, these claims can have a
severely negative impact on a firm when adversity strikes. The inability to
meet these obligations can lead to default and possibly to bankruptcy. In
this sense, financial leverage works in two ways: it enhances the return to
shareholders during profitable years, but during periods when sales are low,
the leverage works the other way and produces returns that are worse than
would be expected without the borrowing.
An example of how financial leverage affects a company follows.
Example
Current and proposed capital structures for Company ABC
Current Proposed
Assets R8 000 000 R8 000 000
Debt R0 R4 000 000
Equity R8 000 000 R4 000 000
Debt/equity ratio 0 1
Share price R20 R20
Shares outstanding 400 000 200 000
Current Proposed
Interest rate 10% 10%
Current capital structure: no debt

Recession Expected Expansion
EBIT R500 000 R1 000 000 R1 500 000
Interest 0 0 0
Net income R500 000 R1 000 000 R1 500 000
ROE 6.25% 12.50% 18.75%
EPS R1.25 R2.50 R3.75
Proposed capital structure: debt = R4 000 000

Recession Expected Expansion
EBIT R500 000 R1 000 000 R1 500 000
Interest R400 000 R400 000 R400 000
Net income R100 000 R1 100 000 R1 100 000
ROE 2.50% 27.50% 27.50%
EPS R.50 R5.50 R5.50
For ease of illustration, taxes have been ignored in this example. Currently,
Company ABC has no debt in its capital structure. The company is
considering a restructuring of its capital structure that would involve R4
000 000 of debt, which would be used to repurchase 200 000 shares of
stock (R4 000 000/R20 per share), leaving only 200 000 shares outstanding.
After restructuring, the company would have a debt to equity ratio of 1
(50% debt and 50% equity). The interest expense at a rate of 10% would be
R400 000. The three scenarios described involve different assumptions
about the firm’s earnings before interest and taxes (EBIT). Notice the return
on equity (ROE) and EPS numbers for the no debt capital structure
compared with those of the capital structure with debt. The EBIT numbers
are the same, of course, under both structures. When debt is used, the
company has an interest expense to pay each year. This lowers net income
for each of the three scenarios – recession, expected and expansion.
However, because there are fewer shares outstanding, the ROE and the EPS
are improved when the expected and expansion scenarios occur.
Note what happens during the recession scenario – the capital structure with
no debt achieves better numbers. This is because interest expense is simply
too much to handle with an EBIT of R500 000. This really brings to life
leverage and the risks involved in using it. During good times, when
demand is high and revenues are large, returns are greater than without
leverage. However, if the economy turns sour and sales drop off, returns are
worse than without leverage.
8.6.3.3 Asset management
Inventory turnover measures how many times a firm has sold off its
entire inventory.
Days’ sales in inventory measures how long it took a firm to sell its
current inventory.
Receivables turnover measures how fast a firm collects on the sales of
inventory.
The days’ sales in receivables measures how long it took a firm to collect
its credit sales.
The total asset turnover measures how much work the firm got out of its
total assets.
8.6.3.4 Profitability
The net profit margin measures how well a firm is managing its costs
relative to its sales revenues.
The return on assets measures how hard a firm’s assets are working.
The return on equity measures how efficiently equity is being employed
to generate profit.
8.6.3.5 Market value measures

These can only be calculated directly for publicly traded companies.
The P/E ratio measures how much investors are willing to pay per rand of
current earnings. EPS measures the return or profitability per share of
invested capital.
The market-to-book ratio measures the market value of the firm’s
investment relative to its historical costs. It measures growth prospects.
8.6.3.6 Liquidity, activity, financial leverage and profitability

ratios
The number of ratios that can be calculated from the figures in a company’s
financial statements is virtually without limit. In practice, relatively few are
actually useful. Ratios derived from historical statements are used to
evaluate criteria such as the following:
The degree to which the company’s financial condition is strong,

adequate or weak
Whether the company will be able to meet its obligations as they fall due
(i.e. whether the company will remain liquid and solvent)
Whether the company’s trade debtors and stocks are satisfactorily current
and liquid
Whether the company is realising a satisfactory volume of sales relative
to its investment in current and fixed assets
The extent to which profits can decline before the company would be
unable to meet fixed charges such as interest, lease payments, rentals and
loan repayments
Whether the company is earning a satisfactory rate of return on sales,
assets and owners’ equity
If the company were to fail, the extent to which its assets could fall in
value from the statement of financial position figures before unsecured
creditors would sustain losses
Four types of ratio – classifiable as liquidity, activity (or turnover), financial

leverage and profitability ratios – are customarily used.
Each of these four aspects of a firm’s financial condition (i.e. liquidity,
activity, financial leverage and profitability) can be gauged in more than
one way by means of ratios; it is often advisable to evaluate more than one
criterion. In some instances, two similar ratios will provide essentially the
same information in different guises. For example, the ratios of debt to total
assets and debt to shareholders’ equity are both measures of the proportion
of the firm’s overall financing that has been provided by creditors or
lenders. In other instances, two ratios of a given type may disclose
essentially different information. For example, the current ratio and the acid
test (or quick ratio) are both measures of liquidity. If the firm has
substantial stocks, the acid test ratio is a more stringent test of liquidity than
the current ratio since stocks are included in the numerator of the current
ratio but not in that of the acid test ratio.
Proportionate increases in the numerator and denominator of a ratio leave

the ratio unchanged. For example, if the current assets of a firm increase
from R6 million to R8 million and current liabilities from R3 million to R4
million, the current ratio remains unchanged at 2. In such a case, if the
current ratio were considered on its own, it would be concluded that the
firm’s financial position had not changed. Such a conclusion could,
however, be hazardous. Further investigation might disclose that current
assets and current liabilities had risen to levels that were too high in relation
to the firm’s sales, and possibly that some of the firm’s current assets were
becoming rather illiquid. In such a case the current ratio, taken alone, would
be misleading. In general, then, it is ill-advised to evaluate on the basis of a
single financial ratio by itself without referring as well to other aspects of
the firm’s financial condition and profitability.
Liquidity and activity ratios

The generally accepted norm for current ratios is 2: 1 and for acid test
ratios, 1: 1. The current ratio indicates the ability of a firm to meet its short-
term commitments by means of short-term assets in the form of cash, trade
debtors and stocks. The lower a firm’s current ratio (e.g. below 1.5 : 1) the
greater the inference of financial frailty. A too-high current ratio suggests
possibly excess stocks and/or debtors and/or cash that may be hampering
the firm’s longer-term profitability. The acid test ratio is an indication of the
shortterm ability of a firm to meet its current liabilities without having to
liquidate stocks, the least liquid of current assets.
When comparing the liquidity of two or more companies, the quality of the
debtors and stocks of the two firms must also be considered; neither the
current ratio nor the acid test ratio provides information on such qualities.
One measure of asset quality is the rate at which an asset, say debtors, is
turning over as measured by its relationship to sales; or, in the case of
stocks, the rate at which these are turning over as measured by their
relationship to cost of sales.
If the analyst is concerned with the level of year-end stocks it is the year-
end stocks that should be related to cost of sales. Such a stock turnover ratio
can then be compared with similar ratios for other firms and with prior
years’ ratios for the same firm. To determine whether there is a quality
difference in the debtors, the credit terms of the two companies could be
compared and the ageing schedules of their debtors examined to ascertain
amounts that are past due and for what periods.
The considerably quicker stock turnover of one company over another

might also warrant enquiry. While superficially one company’s stock
management may appear to be considerably better than that of the other
one, other explanations are possible. The apparently more effective
company may be carrying rather limited stocks and thereby losing sales.
The two companies may be selling to different classes of customers and be
using different channels of distribution, or they may have a different
product mix. Also, one company may be selling a considerable part of its
output on consignment, with large stocks held by consignees, or it may be
carrying large safety stocks as a precaution against possible interruption of
deliveries from one or more of its suppliers.
Ratio analysis is useful in identifying possible areas of difficulty or

weakness in a company’s financial structure and management. If such areas
emerge it is then necessary to investigate further to ascertain why the
company’s ratios differ from those of other firms or from its previous
standards.
Financial leverage ratios
The financial ratios are used to determine a company’s dependence on
borrowed capital. The use of borrowed capital to “lever” earnings is
sometimes put forward by companies as an argument for more borrowings.
This does not, however, always hold true: borrowing capital increases
default risk and places increased pressure on profitability.
A useful measure of a firm’s ability to repay its debt obligations is the fixed
charges coverage ratio. This ratio is arrived at by adding up all of a
company’s fixed interest charges plus all fixed dividends, and dividing the
total into the company’s profits before tax. However, the limitation of the
fixed charges coverage ratio is that the numerator – earnings before taxes
and fixed charges – is only a superficial measure of a firm’s capacity to
make required payments, while the denominator may not include all
required payments. The fixed charges coverage ratio is nevertheless useful
because payments under loan agreements and financial leases (as distinct
from operating leases) frequently comprise a firm’s largest financial
obligations.
To more accurately assess a firm’s future ability to make credit repayments,

cash forecasts should be prepared (see above and below) based on fair
assumptions of sales volumes, selling prices and operating costs. The
probability that the borrower will be able to comply with the repayment
provisions of the proposed credit may then be estimated.
Profitability
Profitability is often more important in judging the desirability of granting
long-term credit, whereas short-term credit decisions may depend more on
the level or extent of a firm’s liquidity.
Ratio trends
Important changes in a firm’s financial situation may emerge from an
analysis of the trends of its financial ratios over a number of years. While it
is useful to compare the ratios of one firm with those of other firms in the
same industry or with industry averages, it is also advisable to determine
whether a firm’s financial condition or profitability is improving or
deteriorating and, if so, in what respects.
The direction in which a firm’s financial condition and profitability have

been moving are important since they may very well indicate future
positions. However, sales and profit trends can reverse, sometimes abruptly,
and it is unwise to forecast earnings merely by extrapolating from previous
trends. It is desirable to analyse in depth the strengths and weaknesses not
only of the particular company but also of the industry in which it operates.
In this regard, the Bureau for Financial Research at the University of
Pretoria publishes firm and industry ratios.
8.6.3.7 Discussion of financial ratio formulae

Turnover ratios
Accounts payable turnover ratio
Total supplier purchases
Accounts payable turnover =
Average accounts payable
The accounts payable turnover ratio shows the number of times that
accounts payable are paid throughout the year. A falling accounts payable
turnover ratio indicates that the company is taking longer than before to pay
its suppliers.
Payment period
365 days × Accounts payable
Payment period =
Cost of sales
The payment period indicates the average period for paying debts related to
inventory purchases.
Inventory turnover ratio
Cost of sales
Inventory turnover =
Average inventory
The inventory turnover ratio measures the number of times a company sells
its inventory during the year. A high inventory turnover ratio indicates that
the product is selling well. The inventory turnover ratio should be done by
inventory categories or by individual product.
Age of inventory ratio
365 days
Age of inventory =
Inventory turnover ratio
The age of inventory ratio shows the number of days that inventory is held
prior to being sold. An increasing age of inventory ratio indicates a risk that
the company is becoming unable to sell its products. Individual inventory
items should be examined for obsolete or overstocked items. A decreasing
age of inventory may represent under-investment in inventory. The age of
inventory ratio is also referred to as the number of days inventory, days
inventory or inventory holding period.
Payment period to average inventory period
Payment period to average inventory period
Payment period
=
(Average inventory period)
A payment period to average inventory period above 1 : 1 (100%) indicates

that the inventory is sold before it is paid for (inventory does not need to be
financed). The average inventory period is also known as the inventory
holding period.
Payment period to operating cycle
Payment period to operating cycle
Payment period
=
(Average inventory + Collection period)
A payment period to operating cycle ratio above 1 : 1 (100%) indicates that

the inventory is sold and collected before it is paid for (inventory does not
need to be financed). A high payment period to operating cycle ratio
indicates that the company may be vulnerable to tightened terms of
payments from its suppliers. The average inventory period is also known as
the inventory holding period.
Accounts receivable turnover ratio
Annual credit sales
=
Average accounts receivable
This is the ratio of the number of times that the accounts receivable amount
is collected throughout the year. A high accounts receivable turnover ratio
indicates a tight credit policy. A low or declining accounts receivable
turnover ratio indicates a collection problem, part of which may be due to
bad debts.
Collection period
Average collection period

Average accounts receivable
=
Annual credit sales ÷ 365 days
The formula above can be restated to incorporate the accounts receivable

turnover ratio as follows.
Since accounts receivable turnover ratio

365 days
=
Average collection period
it means that average collection period

Average accounts receivable×365 days
=
Annual credit sales
1×365 days
=
(Annual credit sales/Average accounts receivable)
365 days
=
The average collection period calculation uses the average accounts

receivable over the sales period. The collection period or average
collection period must be compared to those of competitors to see whether
the credit given, and customer risk, is in line with the industry. A high
collection period shows a high cost in extending credit to customers.
Asset turnover ratio
Sales
Asset turnover =
Fixed assets
A low asset turnover ratio suggests inefficient utilisation or obsolescence of

fixed assets, which may be caused by excess capacity or interruptions in the
supply of raw materials.
Inventory conversion ratio
Sales × 0.5
Inventory conversion ratio =
Cost of sales
The inventory conversion ratio indicates the extra amount of borrowing that
is usually available when the inventory is converted into receivables.
Cash turnover ratio
Cost of sales
Cash turnover =
Cash
365 days
=
cash balance ratio
The cash turnover ratio indicates the number of times that cash turns over in
a year.
Bad debts ratio
Bad debts
Bad debts ratio =
Accounts receivable
The bad debts ratio is an overall measure of the possibility of the business
incurring bad debts. The higher the bad debts ratio, the greater the cost of
extending credit.
Average obligation period
Accounts payable
Average obligation period =
Average daily sales
The average obligation period ratio measures the extent to which accounts
payable represents current obligations (rather than overdue ones).
Breakeven point
Fixed costs
Breakeven =
Unit price – Unit variable costs
The breakeven point is the point at which a business breaks even (incurs
neither a profit nor a loss). The breakeven point is the minimum amount of
sales required to make a profit. Increasing breakeven points (period to
period) indicates an increase in the risk of losses.
Cash breakeven point
(Fixed costs – Depreciation)
Cash breakeven point =
Contribution margin per unit
The cash breakeven point indicates the minimum amount of sales required
to contribute to a positive cash flow.
Liquidity ratios
Current ratio
Current assets
Current ratio =
Current liabilities
The current ratio is used to evaluate liquidity, or the ability to meet short-
term debts. High current ratios are needed for companies that have
difficulty borrowing on short-term notice. The generally acceptable current
ratio is 2 : 1 and the minimum acceptable current ratio is 1 : 1.
Acid test ratio
(Current assets – Inventory)
Acid test =
Current liabilities
The acid test ratio measures the amount of cash immediately available to
satisfy short-term debt. This is also known as the quick ratio.
Cash ratio
Current assets – Inventory – Accounts receivable
Cash ratio =
Current liabilities
Cash + Marketable securities

=
Current liabilities
The cash ratio (cash and marketable securities to current liabilities ratio)
measures the immediate amount of cash available to satisfy short-term debt.
Cash balance ratio (days cash balance)
(Cash × 365 days)
Cash balance ratio =
Cost of sales
The cash balance ratio is also referred to as days cash balance. The cash
balance ratio indicates the number of days that a company can pay its debts,
as they become due, out of current cash.
Cash debt coverage ratio
Cash debt coverage
(Cash flow from operations – Dividends)
=
Total debt
The cash debt coverage ratio shows the percentage of debt that current cash
flow can retire. A cash debt coverage ratio of 1 : 1 (100%) or greater shows
that the company can repay all debt within one year.
Days of liquidity
(Quick assets × 365 days)
Days of liquidity =
Year’s cash expenses
The days of liquidity ratio indicates the number of days that highly liquid
assets can support without further cash coming from cash sales or collection
of receivables. Quick assets are all cash and marketable securities.
Margin of safety ratio
(Expected sales – Breakeven sales)
Margin of safety =
Breakeven sales
The margin of safety ratio shows the percentage by which sales exceed the
breakeven point.
Leverage ratios
Capital acquisition ratio
Capital acquisition ratio
(Cash flow from operations – Dividends)
=
Cash paid for acquisitions
The capital acquisition ratio reflects the company’s ability to finance capital
expenditures from internal sources. A ratio of less than 1 :1 (100%)
indicates that capital acquisitions are draining more cash from the business
than it is generating.
Capital employment ratio
Capital employment ratio
Sales
=
(Owner’s equity – Non-operating assets)
The capital employment ratio is also referred to as the capital employed

ratio. The capital employment ratio shows the amount of sales which the
owners’ investment in operations generates.
Long-term debt ratio
Long-term debt ratio
Long-term debt
=
(Owners’ equity + Long-term debt)
The long-term debt ratio or capital structure ratio shows the percentage of
long-term financing represented by long-term debt. A capital structure ratio
over 50% indicates that a company may be near its borrowing limit (often
65%).
Capital to non-current assets ratio
Owners’ equity
Equity to non-current assets ratio =
Non-current assets
A higher capital to non-current assets ratio indicates that it is easier to meet

the debt and creditor commitments of the business.
Debt to equity ratio
Debt to equity ratio
(Long-term debt + Short-term debt)
=
Total owners’ equity
Debt to equity ratio is also referred to as debt ratio, financial leverage ratio
or leverage ratio. The debt to equity (debt or financial leverage) ratio
indicates the extent to which the business relies on debt financing. The
upper acceptable limit of the debt to equity ratio is usually 2 : 1, with no
more than one-third of debt in long term. A high debt to equity ratio
indicates possible difficulty in paying interest and principal while obtaining
more funding.
Debt ratio
Total liabilities
Debt ratio =
Total assets
The debt ratio is sometimes used as a collective name for debt to capital
ratio, debt to equity ratio or financial leverage ratio. The debt ratio shows
the reliance on debt financing. A high debt ratio is unfavourable because it
indicates that the company is already overburdened with debt.
Gearing ratio
Gearing
Total borrowings
=
Total owners’ equity + Total borrowings
Gearing ratio is the contribution of owners’ equity to borrowed funds. The

ratio explains the degree to which the business is funded by the owners as
against the borrowed funds. Gearing is basically defined as the ratio
between a company’s borrowing (debt) and owners’ equity (i.e.
shareholders’ funds). It is synonymous with the word “leverage”. There are
a number of gearing ratios, the most common of which are debt equity ratio
and interest coverage or times interest earned.
Interest coverage ratio
EBIT
Interest coverage ratio =
Interest charges
The interest coverage ratio is also referred to as the times interest earned
ratio. The interest coverage ratio indicates the extent to which earnings are
available to meet interest payments. A lower interest coverage ratio means
less earnings are available to meet interest payments and that the business is
more vulnerable to increases in interest rates.
Non-current assets to non-current liabilities
Non-current assets
Non-current ratio =
Non-current liabilities
This ratio indicates protection (collateral) for long-term creditors. A lower

ratio means that there is a lower amount of assets backing longterm debt.
Operating leverage
Percentage change in EBIT
Operating leverage =
Percentage change in sales
The operating leverage reflects the extent to which a change in sales affects
earnings. A high operating leverage ratio, with a highly elastic product
demand, will cause sharp earnings fluctuations.
Profitability ratios
Gross margin ratio
Gross profit
Gross profit margin =
Revenue
Gross profit margin ratio is also called gross margin ratio. To calculate
gross profit subtract cost of sales (variable costs) from sales (i.e. Gross
profit = Revenue – Cost of sales). A low gross profit margin ratio indicates
that low amounts of earnings, required to pay fixed costs and profits, are
generated from revenues. A low gross profit margin ratio indicates that the
business is unable to control its production costs. The gross profit margin
ratio provides clues to the company’s pricing, cost structure and production
efficiency. The gross profit margin ratio is a good ratio to use as a
benchmark against competitors.
Return on assets ratio
Net profit after tax
Return on assets =
Total assets
The net income to assets ratio is also referred to as the return on assets ratio.
The net income to assets ratio provides a standard for evaluating how
efficiently financial management employs the average rand invested in the
firm’s assets, whether that rand came from investors or creditors. A low net
income to assets ratio indicates that the earnings are low for the amount of
assets. The net income to assets ratio measures how efficiently profits are
being generated from the assets employed. A low net income to assets ratio
compared to industry averages indicates inefficient use of business assets.
Profit margins
Net profit from operations
Operating profit margin =
Revenue

Net profit margin =
Revenue
Profit before tax

Pre-tax profit margin =
Revenue
These profit margin ratios state how much profit the company makes for
every rand of sales. The operating margin is also referred to as operating
profit margin, or EBIT to sales ratio. The operating profit margin ratio
determines whether the company makes sufficient operating profits to cover
its fixed (overhead) costs. The net profit margin ratio is the most commonly
used profit margin ratio. A low profit margin ratio indicates that low
amounts of earnings, required to pay fixed costs and profits, are generated
from revenues. A low profit margin ratio indicates that the business is
unable to control its production costs. The profit margin ratio provides clues
to the company’s pricing, cost structure and production efficiency. The
profit margin ratios are good ratios to use as benchmarks against
competitors.
Return on common equity
Return on common equity
(Net profit after tax – Preferred share dividend)
=
(Shareholders’ equity – Preferred shares)
The return on common equity ratio shows the return to common

stockholders after factoring out preferred shares. A return of over 10%
indicates there is enough to pay common share dividends and retain funds
for business growth.
Return on investment
Return on equity =
Shareholders’ equity
The return on investment (ROI) ratio provides a standard return on

investors’ equity. ROI is a key ratio for investors.
Investment ratios
Dividend payout ratio
Dividend per share
Dividend cover =
EPS
The dividend cover or dividend payout ratio shows the portion of earnings
that is paid out in dividends. A low dividend payout ratio indicates that a
large portion of the profits is retained and is likely to be invested for
growth.
Dividend yield ratio
Dividend per share
Dividend yield =
Price per share
The dividend yield is the yield (return) a company pays out to its
shareholders in terms of dividends.
P/E ratio
Market price per share
P/E =
Earnings per share
A decrease in the P/E ratio may indicate a lack of confidence in the

company’s ability to maintain earnings growth. P/E values are usually
similar for companies in the same industry. For comparisons, a company
with a P/E higher than the industry average shows greater earning potential
and is likely to earn higher returns for investors. The share price is likely to
increase for a period of time until this advantage is eaten away over time as
competitors copy this advantage (price, new product, etc.).
Earnings per share
Profits after tax
EPS =
An increase in the number of issued shares can lead to a dilution of

profitability. This is because every R1 of profits made is now spread over
many shares issued. It is like dividing one cake to feed many party-goers! A
strong EPS tells the market that the company has good profit potential and
this can lead to substantial increases in the share price. The reverse can also
be true.
Total assets
Book value per share (BVPS) =
An increase in the number of issued shares can lead to dilution of book

value. This is because every R1 of assets made is now spread over many
shares issued.
Market to book value
Share price
Market to book value (MBV) =
The MBV compares the share price and the BVPS. In other words, it
addresses the question: How much are investors prepared to pay for R1
book value of assets on the market? If the MBV is greater than 100%, it
implies that investors are prepared to pay a premium for the shares of the
company, while an MBV of less than 100% implies that the shares are
selling at a discount. The analyst needs to look out for exceptional items or
changes in accounting policy that can lead to an increase in the MBV ratio.
For example, a significant amortisation of intangible assets can lead to
reduced net fixed assets, which can lead to a decrease in the BVPS. This
can lead to an increase in the MBV ratio. Does that give a positive signal to
investors about the future earnings potential? Maybe it does, but one needs
to be careful of cosmetic changes to the statement of financial position in
terms of the information relayed to the market.
Other accounting ratios

Advertising to sales ratio
Advertising costs
Advertising to sales ratio =
Revenue
The advertising to sales ratio calculates the extent to which advertising is a

cost of sales. It is the inverse of the sales to advertising ratio or return on
advertising. A ratio above 0.1 : 1 (10%) is of concern because it indicates
that advertising is not generating over 10 times its cost in sales.
Altman’s z-score
1.2a+1.4b+3.3c+d 0.6f
z-score = +
e g
where:
a = working capital
b = retained earnings
c = operating income
d = sales
e = total assets
f = net worth
g = total debt
The Altman z-score is a bankruptcy prediction calculation. The z-score

measures the probability of insolvency (inability to pay debts as they
become due):
1.8 or less indicates a very high probability of insolvency.

1.8 to 2.7 indicates a high probability of insolvency.
2.7 to 3.0 indicates possible insolvency.
3.0 or higher indicates that insolvency is not likely.
Audit ratio
Audit costs
Audit ratio =
Revenue
A high audit ratio indicates that more audit time was required because of
problems with the company’s accounting records or control procedures.
However, since “high” is relative, a better way of understanding this ratio is
to look at the trend or compare it with audit ratios of similar companies in
the industry.
8.6.3.8 Concluding comments on ratio analysis

When analysing the statement of financial performance, you must evaluate
the trending pattern of net sales, gross profit margin, operating profit
margin and net profit margin. Vertical and horizontal analysis will identify
dramatic increases or decreases, which need to be investigated to determine
whether unusual patterns exist in the trend. Evaluate what factors
contributed to the changes. This process will familiarise you with the
negative and positive conditions, and will also assist you in looking for
signs of bankruptcy or fraud. The analyst must also monitor the financial
trend and be concerned about the following conditions of the statement of
financial performance:
Net sales – downward trend. If sales increased or decreased, what were

the contributing factors?
Gross profit margin – dramatic decreases or increases? Were conditions
influenced by increased costs associated with competition and economic
conditions, or have poor decisions related to sales strategies and
inventory management impacted the level of cost of sales and gross
profit? Be suspicious of dramatic increases in gross profit, especially
when sales reflect a downward trend.
Operating profit margin – dramatic increases or decreases? Why did
operating profit increase during a period of decreased sales, or decrease
during a period of increased sales? Be concerned about the level of
operating costs, as well as extraordinary charges related to restructuring
or reorganisation.
Interest expense – dramatic increases. Has interest expense increased or
decreased, and are earnings before interest and tax adequate to satisfy
interest expense?
Net profit margin – be concerned about dramatic increases or decreases
in profitable and/or unprofitable conditions.
Bringing your analysis skills to a higher level requires comprehension of

the statement of financial performance, statement of financial position, cash
flow analysis and footnotes. This involves an in-depth knowledge of the
components that make up the statement of financial position, and the ability
on your part to extract and determine those factors that impact those
conditions.
Performing an analysis of the statement of financial position and statement

of financial performance requires assessment of the following financial
components and ratios:
Working capital. Working capital is affected by slow turnover of accounts

receivable, inventory and accounts payable. Analyse the statement of
financial performance to evaluate the level of profitability, and assess the
current ratio, quick ratio and cash flow analysis to determine the negative
and positive aspects contributing to the condition.
Cash flow. Dramatic increases or decreases can impact profitability.
Additional influences may include changes in short-term or long-term
debt, financing rate, increased interest expenses, slow accounts
receivable, inventory and accounts payable turnover. Increases in
investments involving fixed assets, joint ventures or acquisitions can also
influence liquidity and/or cash flow.
Net worth. A decreased net worth can be attributed to a trend of
unprofitability and deduction of intangibles due to goodwill, patents,
franchises, copyrights and cost in excess of market value.
Accounts payable. Caution should be exercised regarding a company
with a high accounts payable or slow turnover. This condition indicates
that the company is using other suppliers to finance operations. Take
extra precautions regarding companies that have no bank financing
vehicles and use internally generated funds as a means of cash flow.
Long-term debt. Be concerned about excessive borrowing, and evaluate
the financing rate as well as the company’s record of compliance
regarding the credit agreement. Analyse the leverage condition, taking
into consideration the deduction of intangible assets from the net worth.
Be concerned if the condition is highly leveraged and sales are down and
the condition is unprofitable.
Fixed assets. Excessive investments into fixed assets could put a strain
on cash flow, working capital and future sales growth. Be concerned if
the fixed assets/net worth ratio exceeds 80%. If this red flag exists, then
you must evaluate the impact on cash flow and working capital, as well
as the turnover of accounts receivable, inventory, accounts payable and
changes in the level of sales and gross profit.
Current ratio. This ratio should be used in conjunction with the quick
ratio, accounts receivable and inventory turnover, to determine the
overall liquidity position. Without knowledge of all of the components
that make up the current ratio, a false impression can be created.
Quick ratio. The importance of this ratio is critical, especially if cash is
weak and the turnover of accounts receivable is slow. This ratio is a red
flag because if these weaknesses persist, short-term creditors may be
impacted due to poor cash flow.
Accounts receivable turnover. A slow turnover of accounts receivable
may result in potentially increased debt and weaker cash flow. Allowing
slow turnover to persist over the short and long terms may impact
profitability due to bad debt write-offs and increased bank financing to
maintain growth.
Inventory turnover. This is a very critical ratio, because a slow inventory
turnover affects profitability and a company’s ability to grow in the short
and long term. If inventory continues to increase during a period of
decreased sales, this should raise concern about the quality of inventory
relative to valuation and how much of the inventory is slow moving or
obsolete.
Accounts payable/sales ratio. A high percentage of slow turnover
indicates that the company is potentially using other suppliers to finance
operations. In a condition where the leverage position is high, caution
should be exercised due to concerns regarding the total debt position and
accounts receivable turnover.
Total debt/equity ratio. This ratio is one of the more critical ratios
because it measures the relationship between the interest of all creditors
and owners’ equity. The higher the debt in relation to equity, the more
leveraged the position, which may result in potentially weaker cash flow,
higher interest expense and more restrictions relative to ratio covenants
and bank compliance.
Current debt/equity ratio. This ratio is a measure of the relationship
between short-term creditors and owners’ equity. When evaluating this
ratio, be concerned about the relationship between short-term creditors
and accounts payable. If the ratio is highly leveraged, evaluate the bank
financing rate, compliance with the covenant agreement, and the turnover
of accounts payable.
Fixed assets/net worth ratio. Measuring the components that impact
liquidity is important during the analytical process. If this ratio is greater
than 75%, the liquidity position can be affected because of a heavy
investment of fixed assets. Caution should be exercised if this condition
exists.
Assets/sales ratio. This important ratio measures the operating
efficiencies and should be evaluated in relation to industry standards.
Negative conditions may be attributed to management and/or operating
deficiencies.
Sales/net working capital ratio. This ratio identifies the potential of an
excessive or weak working capital position for the volume of sales; it,
too, should be compared to industry standards. Substantial increases in
sales may affect a company’s ability to meet current obligations.
It is imperative that industry standards and current economic conditions are

used to determine the condition and trend of critical ratios. Trending
analysis is essential when determining drastic deviation, which could result
in detecting imperfections and inaccurate statistics in the statement of
financial position and statement of financial performance. Detailed
knowledge of the ratios and financial statement components will improve
your ability to analyse a company’s financial condition and level of risk.
8.6.3.9 DuPont model

The DuPont model is an expression that partitions a firm’s return on equity
(ROE) into three components:
Profit after tax Sales Total assets
ROE = × ×
Sales Total assets Total equity
Or: ROE = Profit margin × Total assets turnover × Equity multiplier

Or: ROE = Profit margin × Total assets turnover × (1 + Debt/Equity
ratio)
The DuPont model identity tells us that a firm’s ROE depends on:
1. Operating efficiency
2. Asset use efficiency
3. Financial leverage
The ROE can also be written as a function of a firm’s ROA:

Profit after tax Total assets
ROE = ×
Total assets Total equity
Or: ROE = ROA × Equity multiplier
Ordinary share value drivers

Given the decomposition of ROA into profit margin and turnover in the
traditional DuPont analysis, the factors directly relevant to the creation of
total equity value by increasing ROE, then include the following:
1. Net profit margin on sales

2. Turnover of average total assets (TAT)
3. Equity multiplier
Since net profit margin (profit after tax/sales) and total asset turnover
(sales/average total assets) rates are interrelated, it is difficult to predict the
effect of a marginal increase in one of these variables on the firm’s market
value.
Example: If the firm faces a downward-sloping demand curve, then

attempting to increase the profit margin through an increase in the market
price of its products results in a reduction in the quantity of the product
demanded. The effect of this price increase on sales and the asset turnover
rate therefore cannot be determined without first specifying the demand
curve. Likewise, the effect on equity value of an increase in asset turnover
requires specification of its effect on the profit margin, which requires
knowledge of the firm’s cost function.
The task facing corporate managers is to increase both profit margins and
turnover rates through greater efficiency and productivity. For example,
managers must find ways to reduce the cost of their products (without
sacrificing quality) or corporate overheads so that profit margins will
increase for reasons other than an increase in the price of the firm’s
products. Likewise, managers must continually find ways to reduce the
amount of invested capital. This can be accomplished, for example, by
employing more efficient manufacturing methods to reduce work-in-
process inventories.
The significance of DuPont analysis

Fundamentally, any decision that influences product prices, per unit costs,
volume or efficiency/productivity (output per unit of input) will impact
profit margin or turnover ratio. And any decision that affects the amount
and type of debt and equity used will impact the financial structure as well
as cost.
These financial concepts are important to understand because every

business in the world is competing for capital. Money flows where the
perceived risk-adjusted return is greatest. If companies understand these
financial concepts, they can better understand where they might be able to
help their customers the most. They need to understand how they deliver
value to their customers.
Marketing value involves much more than a pep rally/sales meeting “rah-
rah”. It is a culture: a mindset, a strategy. To do it well, you first need to be
able to define it. Understanding the financial concepts allows you to focus
on the key questions you should answer to help define your value.
How do you or how can you help your customers do the following?
Increase the price per unit of product they sell by adding new features
and benefits to their products, services and systems.
Decrease the variable cost to produce, acquire or sell the unit.
Increase the number of units sold.
Decrease the overhead by increasing their efficiency of operations.
Increase asset turnover by minimising the customer’s work in process or
finished goods inventory (and therefore total assets), and by decreasing
fixed assets by outsourcing some processes, enabling some capital assets
to be sold.
To truly add value and set yourself apart from the competition, you need to
know how to help your customers
control one or more of their critical costs, or

exploit one or more of their critical revenue sources.
Ask yourself these two key questions about what you sell, and your
opportunities to add value to your customers will increase dramatically.
The DuPont model helps us link marketing efforts, via the sales variable in
the formula, and financial return as measured by ROE.
8.6.3.10 Interpretation of current period price-to-book (P/B) and

price/earnings (P/E) ratios
Penman (1996) demonstrates that P/B is related to the expected growth rate
in book value. Note that the current level of profitability (ROE) is not a
factor in the P/B ratio.
To achieve a high P/B ratio, therefore, managers must not only earn an
abnormally high ROE, but must also realise these extraordinary earnings
over an ever-increasing investment base (BV). The “normal” P/B ratio of
1.0 is realised only in the event that the firm is not expected to realise
positive residual profit. If the firm is not expected to earn the required rate
of return that its shareholders expect, then its P/B ratio will be less than 1.0.
Penman (1996) further demonstrates that the P/E ratio is related to both
current and expected profitability. If current profitability (ROE) is viewed
as “low” relative to expected profitability, then the P/E ratio will be high;
and if current profitability is viewed as “high” relative to expected
profitability, then the P/E ratio will be low. The P/E ratio, therefore, reflects
the market’s perception of the extent to which earnings are viewed as
transitory and likely to revert to a higher or lower level in the future.
It is important to note that the P/E is determined by the relationship between

current and future profitability. One cannot infer unambiguously the level of
future profitability from this ratio. For example, a firm with poor future
prospects, but even poorer current performance, would still report a high
P/E ratio.
8.6.4 Concluding remarks on financial analysis

8.6.4.1 Financial ratios: can you trust them?
Financial ratios are certainly important but they do have their limitations!
Those of us with a grounding in accounting already know that financial
information, although often (and naively) assumed to be precise, is
necessarily based on significant assumptions and varying underlying
principles. This means that accurate financial comparisons between
companies (even those within South Africa) cannot be made without a
considerable amount of additional research and even restatement. In a
cross-border analysis situation, the problem is further compounded by
important accounting differences.
Despite this, traditional performance indicators such as profit margin,

ROCE, EPS and the P/E ratio are widely published and used in decision
making, often, one suspects, without any great attention being paid to what
lies behind them. For example, banks, credit rating agencies, auditors,
investment analysts, merger and acquisition teams and the financial press
all use such financial ratios in their daily work.
If we are to get the maximum information from a set of ratios, we must first
of all accept that standard definitions do not exist. For example, what
exactly is included in the numerator and denominator of ROCE? Should
“capital employed” include debt and minority interests or not?
The lack of consistent definitions is exacerbated by the fact that the

underlying accounting policies on which the figures themselves are based
can be significantly different. For example, does the company choose to
revalue its fixed assets or its marketable securities? Does it elect to
capitalise development costs, or interest on construction projects? How
does it treat goodwill – as an asset or as a charge against equity?
Because of these potentially very material differences, we are forced to

conclude that companies in the same sector may have wildly varying ratios
for reasons other than genuine differences in economic performance.
To give another example, what exactly is “gearing”? It is certainly true that

several measures exist (e.g. debt/equity, debt/assets) and that they can be
calculated in different ways. For example, do they take account of short-
term creditors, long-term provisions such as pensions and taxes, and
minority interests? How about intangibles that have been written off to
equity rather than capitalised – consider the effect on gearing (and on profit)
of a decision to write off goodwill to reserves, rather than capitalising it.
When calculating, say, debtor days or share turnover, do we take year-end
or average statement of financial position figures? (Even averaging two
statement of financial position figures might fail to reflect seasonal
variations.) When we look at interest cover, care must be taken to use the
gross interest figure and not an interest expense figure that might be net of
interest received or interest capitalised (figures taken from the cash flow
statement can be a useful alternative to the statement of financial
performance in such cases).
In comparing return on equity, we must consider whether the company has

revalued its assets or not – upwards revaluations produce a higher equity
base (through the revaluation surplus) and subsequently lower profits
(because of the additional depreciation expense). Even when considering
simple ratios such as gross profit margin, we must remember that what one
company has included in cost of sales, another may well have included in
administrative and distribution expenses.
These problems may be keener in countries where there is no uniform chart

of accounts and where more accounting options are acceptable in the search
for a “true and fair view”. In other countries companies may, in theory, find
it easier to deal with this aspect as they often have more rigorous
presentation guidelines and more prescriptive standards. However, in some
cases, the level of disclosure is often significantly lower, and accounts may
well be based on tax regulations rather than accounting standards.
8.6.4.2 Return on equity and systematic ratio analysis

Investors can use financial ratios to understand better the pressures affecting
a company’s ROE. Properly interpreted, ratios provide keen insight into the
sources and adequacy of profits, the efficiency of assets committed to the
firm, solvency risk and liquidity risk. The key to their effective use is to
view financial ratios not as independent numbers but, instead, as pieces of a
jigsaw puzzle. Individually, they tell only a little about the whole, but taken
together, the entire picture of financial health comes into focus.
8.6.4.3 DuPont analysis emphasises the importance of ROE

If the joint analysis of ratios is to be useful, there must be some organising
paradigm that provides the necessary structure and linkages. DuPont
analysis is one such approach for non-financial firms. A virtue of DuPont
analysis is its simplicity. Three fundamental ratios derive one summary
ratio: return on equity (ROE).
The ratios that determine ROE reflect three major performance dimensions
of interest to all loan analysts: statement of financial performance
management, or how much profit a company can generate per sales dollar;
and two aspects of statement of financial position management – how well
assets can generate sales and the amount of solvency risk. The ratios also
indicate that there are several paths a business can use to gain a return for
its owners: margin, volume and leverage.
An attractive feature of DuPont analysis is its focus on the return earned by

the firm’s owners as the key ratio. Businesses exist because owners commit
capital to a venture in order to generate a return commensurate with risk.
An ROE below the required level is generally a signal that the firm has a
significant weakness. In our competitive economy, weak firms must either
improve or die. This makes ROE a good metric of overall performance.
Further, a low ROE places two limits on a firm’s access to new capital.
First, the most important source of equity to the typical business is
internally generated funds. Firms with low ROEs simply do not produce
much by way of retained earnings. This can lead to funding problems and
excessive solvency risk. Second, a poor ROE can restrict external equity.
For closely held companies, low returns may discourage owners from
further investment. Publicly traded companies will find that the lower the
ROE is relative to investors’ required return, the lower the share price will
be. After all, a firm that cannot earn its investors’ required return is
subtracting rather than creating shareholder value. This makes the sale of
shares much more dilutive and, in some cases, prohibitively expensive.
While DuPont analysis technically only includes the three ratios discussed
above, the framework can be extended to incorporate most major financial
ratios. It helps to think of the ratios as analogous to parts of a tree. The
trunk is ROE and there are three major branches: profit margin, total asset
turnover and assets to equity. Each of these three branches in turn further
divides to include more ratios. One caution: while the three major ratios can
be multiplied together to obtain ROE, the same is not true along each of the
three branches. The purpose here is to relate all of the ratios not
mathematically but conceptually.
8.6.4.4 Industry characteristics strongly influence components

of ROE
The major factors affecting the structure and performance of any firm are
the nature of the product, the firm’s customers, marketing strategy and
production technology. Within an industry the common underlying factors
give rise to a similar structure for the ratios. The primary causality runs
from asset efficiency to profitability. The nature of the industry will largely
dictate the accounts receivable, inventory and fixed asset requirements.
Together, these individual assets will determine the overall asset needs
(measured as the total asset turnover). With the total asset efficiency set, a
minimum level of profit margin must be earned for the firm to generate an
adequate ROE.
Example: If investors’ required minimum ROE is 18%, the total asset

turnover is 2.0, and assets to equity is 2.5, then, using the DuPont identity,
ROE = Net profit margin × Total asset turnover × Equity multiplier, the
firm will need to have a profit margin of at least 3.6% (3.6% × 2.0 × 2.5 =
18%). Firms that cannot earn that margin will eventually fall by the wayside
through voluntary withdrawal or bankruptcy. At the other extreme, over
time, firms with profit margins above the requirement will generally find
their margins decreasing. The combination of market entry and exit together
with pricing policies in our competitive economy makes profit margin the
primary adjusting element of the DuPont relationship. The recent wave of
corporate downsizings is another example of how businesses adjust margins
(in this case through operating expense reduction) to restore or maintain
ROEs at competitive levels.
8.6.4.5 DuPont analysis can be enhanced to gain new insights

into profit margins and leverage
An advantage of DuPont analysis is simplicity. The three major ratios show
that a business can take one of three routes to gain an adequate ROE:
margin, volume (total asset turnover), or leverage (assets to equity). While
this view works well initially, its simplicity can mask some important
details, particularly with respect to financial leverage. For example, if we
go back to the basic relationship, it appears that as leverage increases
(assets to equity), ROE will also rise.
The problem with this thinking is that another effect of an increase in

leverage is larger interest expense which, in turn, causes a decrease in the
profit margin and ROE. Thus, leverage spreads its effects over two ratios,
making it hard to disentangle the impact of leverage and operations.
Furthermore, profit margin is not really an accurate measure of operations,
since it combines operations with financial leverage.
A solution to this limitation is to increase the number of ratios in the ROE

decomposition. There are many ways to do this, but the following
breakdown keeps the number of ratios small while permitting a more
complete separation of operations and financial leverage. The only
difference between this approach and the simpler one is that the net profit
margin now shows as three pieces. Asset efficiency and statement of
financial position leverage remain the same.
The first of the three new ratios, operating margin, relates operating profit
to sales. Because operating profit is shown before any deduction for
interest, this ratio measures the underlying profitability of the business and,
except for the impact of leases, is independent of how the firm finances
itself.
The second ratio divides earnings before taxes by operating profit. This
ratio measures the effect on the statement of financial performance on
financial leverage. As financial leverage and interest expense increase, this
ratio decreases. To see this, consider a situation where there is no interest
expense or non-operating profit. Earnings before taxes and operating profit
would be identical and the value of the ratio would be one. When interest
expense increases, earnings before taxes decrease and the ratio falls below
one.
The final new ratio is net profit divided by earnings before taxes. This
measures the effect of taxes and is actually equivalent to one minus the
effective tax rate. As with the previous ratio, the maximum value is one.
When a firm moves into a tax situation, the ratio falls. For example, with an
effective tax rate of 35% the tax factor equals 0.65.
This new decomposition includes two financial leverage ratios: one from
the statement of financial performance (earnings before taxes to operating
profit) and one from the statement of financial position (assets to equity).
Multiplying the two together gives the total effect of financial leverage on
ROE. For an increase in financial leverage to have a positive effect on
ROE, the statement of financial position effect must be greater than the
statement of financial performance effect. The following rearranges the
ROE relationship by putting the two leverage ratios together in a bracket at
the end to emphasise the total leverage effect.
Operating income Sales Assets
Net income Net income EBT
= × × × ×
Equity Sales EBT Assets Operating income Equity
This more detailed analysis shows that operating profitability, taxation,

asset efficiency and leverage determine ROE.
Despite the complexities of an individual situation, DuPont analysis

provides the structure to systematically identify the strengths and
weaknesses of any company. Financial ratios, common-size statements of
financial performance and common-size statements of financial position all
provide pieces of the puzzle. DuPont analysis provides the road map for
putting the pieces together to obtain the final picture. At the same time, the
method focuses on the appropriate overall performance standard: return to
the equity investor.
8.7 LEASING
Leasing is a method of financing non-current assets, like equipment and

vehicles, which normally gives the company the use of the asset during the
life of the lease period. At times, most businesses find it necessary to
consider alternative ways of financing to acquire equipment. Of all the
methods, leasing is one of the most prevalent, practical, flexible and
dynamic. For virtually any type of equipment, leasing can make good
business sense.
8.7.1 Advantages of leases

Some examples of the most popular equipment leases include trucks/rolling
share, construction, manufacturing, material handling, food processing, hi-
tech equipment and computer systems. Businesses of every size are taking
advantage of the wide variety of services that provide the following:
Conservation of operating capital. Acquire the equipment you need

without depleting valuable cash reserves.
Improved expense forecasting and budgeting. With fixed rate and
payments, leasing improves fiscal control, reduces risk and facilitates
easier budgeting.
Enhanced financial ratios. Purchased equipment impacts the statement of
financial position. Operating lease structures are off statement of
financial position, and may improve leverage and rate-of-return ratios.
Tax advantages. With proper structuring, lease payments may be treated
as a simple business expense. Other types of leases allow you to retain
the typical benefits of ownership, including depreciation.
Convenience. Most lease agreements offer lease lines of credit, 100%
financing, flexible payment terms and other features that make leasing a
convenient alternative to purchasing.
8.7.2 Operating lease

Most operating leases are typically characterised by a fair market value
purchase option to purchase the equipment at lease end. This option is
particularly attractive to companies in a continual upgrade cycle who want
to use equipment without ownership, but also want to return equipment at
lease end and avoid technological obsolescence.
The operating lease usually results in the lowest payment of any financing
alternative and is an excellent strategy to bypass some capital budgeting
restraints. It typically qualifies for off statement of financial position
treatment and can result in improved ROA due to a lower asset base. It can
also result in higher reported earnings in the early years of the lease.
8.7.3 Capital lease

Under a capital lease arrangement, the lease transfers ownership of the
property to the lessee by the end of the lease term. The lease contains a
bargain purchase option. The lease term is equal to 75% or more of the
estimated economic life of the leased property. The present value at the
beginning of the lease term of the minimum lease payments equals or
exceeds 90% of the excess of the fair value of the leased property to the
lessor at the inception of the lease over any related investment tax credit
retained by the lessor and expected to be realised by the lessor.
8.8 SUMMARY
To conclude, it is important to note that company analysis using financial

ratios is certainly important, but that ratios do have their limitations!
Accounting information and the drawing of financial statements are based
on significant assumptions and varying underlying principles. In order for a
proper analysis of a company to be undertaken and a sound understanding
of it to be acquired, a considerable amount of additional research and even
restatement of some assumptions are necessary. In a cross-border analysis
situation, the problem is further compounded by important accounting and
taxation differences.
In addition, traditional performance indicators such as profit margin,

ROCE, EPS and the P/E ratio, which are widely used in decision making,
need to be better understood. Also, the major factors affecting the structure
and performance of a firm, the nature of the product, the firm’s customers,
marketing strategy and production technology are important attributes in
coming to a better understanding of a company’s financial strength.
Finally, cash is the lifeblood of every business. You cannot spend profits,
and a business cannot stay open, without steady cash flow. Many business
owners do develop annual cash flow projections for their bankers and
include these projections as part of their overall business plans. Major
emphasis tends to be placed on a positive bottom line, but this does not
adequately address positive cash flow throughout the year.
The next chapter looks at issues of company valuation by examining

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1. Operating profit margin is defined as:
(a) EBDIT/Sales
(b) EBIT/Sales
(c) EBT/Sales
(d) EAT/Sales
2. Which of the following is not subtracted from sales to arrive at net income?
(a) Depreciation
(b) Interest
(c) Dividends
(d) Taxes
3. A company that can earn rates of return greater than its required return is called a:
(a) cyclical company

(b) defensive company
(c) growth share
(d) growth firm
4. A speculative share is characterised by:
(a) a high probability of a very high rate of return
(b) a high probability of low or negative rates of return
(c) a low probability of low returns
(d) being underpriced
5. Which of the following would allow a company to pursue a cost leadership
strategy?
(a) Economies of scale

(b) Patents
(c) Volume purchasing
(d) All of the above
6. Which of the following is compatible with the idea of a growth company?
(a) Perfectly competitive markets

(b) Constant growth for an infinite period
(c) Non-competitive factors
(d) Equilibrium in product and financial markets
7. A company earns a positive rate of return on its investments but less than its
required return. It should:
(a) pay out more earnings as dividends

(b) retain more earnings
(c) issue new shares
(d) make more such investments
8. In a negative growth model:
(a) earnings are negative

(b) rates of return are negative
(c) earnings are growing but by less than they should
(d) dividends are zero
9. In growth models, which of the following does not affect the capital gain
component?
(a) Retention ratio

(b) The relation between the firm’s rate of return and its required rate of return
(c) The time period for superior investments
(d) All of the above affect it
10. If one used the constant growth dividend discount model for a true growth firm:
(a) its value would be negative

(b) its value would be zero
(c) its value would be infinite
(d) its value would be finite but unknown
11. Which of the following is not assumed in the growth duration model?
(a) The market values shares in proportion to earnings

(b) Higher P/Es imply higher growth rates
(c) The investments being compared have equal risk
(d) Dividends are used to purchase further shares
12. A defensive share is best characterised as:
(a) having low systematic risk

(b) generally retaining a large portion of earnings
(c) being heavily influenced by aggregate business activity
(d) usually having an active rather than a passive dividend policy
13. The incremental franchise P/E is a function of all of the following except:
(a) the expected return on new opportunities

(b) the ability of management
(c) the current cost of equity
(d) the current ROE on investment
14. Foleys (Pty) Ltd has a beta of 1.3 and a risk-free rate of 7%. Find Foleys required
return if the expected market return is:
(a) 12%
(b) 14%
Solutions
1. (a)
2. (c)
3. (d)
4. (b)
5. (d)
6. (c)
7. (a)
8. (c)
9. (d)
10. (c)
11. (b)
12. (a)
13. (b)
14. (a) Ri = 0.07 + 1.3(0.12 – 0.07) = 0.07 + 1.3 (0.05)
= 0.07 + 0.065
= 0.135 or 13.5%
(b) Ri = 0.07 + 1.3(0.14 – 0.07) = 0.07 + 1.3 (0.07)
= 0.07 + 0.091
= 0.161 or 16.1%
9 Company valuation
9.1 INTRODUCTION
In Chapter 8, we showed how investors can use financial data as inputs into
share valuation. We reviewed the basic sources of such data: the statement
of comprehensive income, the statement of financial position and the
statement of cash flows. Chapter 8 introduced basic financial analysis,
based on those financial statements. In this chapter we extend this analysis
to look at the overall company valuation (see Figure 9.1).

9.2 INVESTMENT STYLES
A good company is not necessarily a good investment, because the share of

a good company may be priced too high. Likewise, the share of a bad
company may be overpriced. Therefore, it is always necessary to compare
the price of a share to its intrinsic value (“fair value”), which is discussed in
Chapter 5. Our discussion here focuses on these issues of company
valuation. The confusion between good companies and good shares leads to
differences in investment styles. Two such styles are
growth share or earnings momentum investing

value investing.
9.2.1 Growth share or earnings momentum

Growth share or earnings momentum investing is an investment style that
supports the premise that good companies are good investments. Often such
companies are leaders in their industry, they have strong statements of
financial position, good earnings growth, high operating cash flow and they
operate in an industry with excellent growth prospects. The idea is to be
invested in the best companies of the best industries. “If you want to make
your pile, be in style” is the theme of this investment philosophy.
9.2.2 Value investing

On the other hand, value investing is a style that states that undervalued
shares are good investments. It looks for a “margin of safety” reflected by
the discount below intrinsic value at which a share is priced. Both
philosophies have their adherents.
Growth companies are companies with the management capability and

the opportunity to undertake investment projects that produce rates of
return greater than their weighted average costs of capital. As a result,
such companies tend to have above-average growth in sales and earnings,
relative to other firms of equal risk. Such a condition cannot last for ever,
however, since competition will eventually cause rates of return to
regress to levels that just compensate for the risk being taken.
Growth shares, on the other hand, are shares with above-average
expected rates of return given their risk. They are generally undervalued
shares with a reasonable prospect of becoming properly valued in the
near term. Clearly, growth companies do not represent growth shares.
Indeed, studies have suggested that recognised growth companies are
often overpriced and are, therefore, poor investments.
Defensive companies are companies not likely to react sharply to a
decline in the general level of economic activity.
Defensive shares are shares with low betas, regardless of the nature of the
company.
Cyclical companies are companies whose sales and earnings tend to rise
and fall sharply with fluctuations in the business cycle.
Cyclical shares are high-beta shares whose returns rise and fall sharply in
bull and bear markets.
Speculative companies are firms whose business involves great risk.
Speculative shares are overpriced shares whose returns might be
abnormally low because of their overvaluation.
From this brief discussion, it is clear that investors’ beliefs determine their
investment styles. While it is true that investing in undervalued shares can
lead to high returns, the ability of an investor to detect these undervalued
shares is the subject of this chapter. Our discussion starts by looking at
value added.
9.3 MEASURES OF VALUE ADDED
Many companies have embraced – and others have felt obligated to look at
– performance measures that depart from the traditional accounting-based
measures such as earnings per share and return on investment. These new
“value-based” measures include economic value added (which is Stern
Stewart’s registered EVA® method), shareholder value increase, economic
value creation and market-value-added. Related measures include Holt
Value Associates’ and Boston Consulting’s CFROI and Alcar’s Discounted
Cash Flow Analysis. Many variants of value-added measures have been
spawned and many consulting firms are selling value-based products. These
measures have been used in compensation arrangements, capital decision
making and financial disclosures.
9.3.1 What is value added?

We say that a firm has added value over a period of time when it has
generated a profit in excess of the firm’s cost of capital. This profit is
typically referred to as the economic profit, a concept developed by
economists in the 19th century. It is also referred to as economic value
added (EVA®).
9.3.2 Economic profit

Economic profit was established long ago. As an illustration, consider the
writing of Alfred Marshall (1890) over 100 years ago:
When a man is engaged in business, his profits for the year are
the excess of his receipts from his business during the year over
his outlay for his business. The difference between the value of
the share of plant, material, etc. at the end and at the beginning of
the year is taken as part of his receipts or as part of his outlay,
according as there has been an increase or decrease of value.
What remains of his profits after deducting interest on his capital
at the current rate … is generally called his earnings of
undertaking or management.
Today we see this concept developed in every text on the principles of

economics. The idea of economic profit is the basis of the capital budgeting
techniques of net present value and the internal rate of return, which can be
found in finance texts going back 30 years. Economists have been
preaching the concept of economic profit for over 100 years and finance
professors have been putting students through the rigour of net present
value and internal rate of return for decades.
In the texts of the late 1960s and early 1970s, the cost of capital is referred
to as the “minimum acceptable return” or the “minimum revenue required”.
Profit is defined as earnings in excess of the cost of capital. Along with
promotion of the concept of economic profit, economics and finance
professors have been discouraging the use of accounting-based performance
measures for many years. So why the change of heart? Most of this change
can be accredited to Stern and Stewart’s efforts to develop a product that
has its foundation in economic and financial theory.
9.3.3 Economic value added (EVA®)

EVA® is the financial performance measure that comes closer than any
other to capturing the true economic profit of an enterprise. EVA® is also
the performance measure most directly linked to the creation of shareholder
wealth over time. The Stern Stewart EVA® model guides companies
through the implementation of a complete EVA-based financial
management and incentive compensation system that gives managers
superior information – and superior motivation – to make decisions that will
create the greatest shareholder wealth in any publicly owned or private
enterprise.
Put most simply, EVA® is net operating profit minus an appropriate charge
for the opportunity cost of all capital invested in an enterprise. This is not
just the borrowed capital, but also equity capital. As such, EVA® is an
estimate of true “economic” profit, or the amount by which earnings exceed
or fall short of the required minimum rate of return that shareholders and
lenders could get by investing in other securities of comparable risk.
The capital charge is the most distinctive and important aspect of EVA®.
Under conventional accounting, most companies appear profitable, but
many in fact are not. As Peter Drucker put the matter in a Harvard Business
Review (1995) article:
Until a business returns a profit that is greater than its cost of
capital, it operates at a loss. Never mind that it pays taxes as if it
had a genuine profit. The enterprise still returns less to the
economy than it devours in resources … Until then it does not
create wealth; it destroys it.
EVA® corrects this error by explicitly recognising that when managers

employ capital they must pay for it, just as if it were a wage. By taking all
capital costs into account, including the cost of equity, EVA® shows the
dollar amount of wealth a business has created or destroyed in each
reporting period. In other words, EVA® is profit the way shareholders
define it. If the shareholders expect, say, a 10% return on their investment,
they “make money” only to the extent that their share of after-tax operating
profits exceeds 10% of equity capital. Everything before that is just
building up to the minimum acceptable compensation for investing in a
risky enterprise.
Example: Assume that you have a firm with investments of R100 million.
Also assume that the return on capital employed (ROC) of the firm is 15%
and that the firm intends to make annual additions to capital investments of
R10 million (investments are at the beginning of each year). The weighted
average cost of capital (WACC) is 10%. Assume that all of these projects
will have infinite lives. After year 5, assume that investments will grow at
5% a year forever, with ROC on projects being equal to the cost of capital
(10%).
Firm value using the EVA® approach is determined as follows:
Capital invested in assets in place = R100m
(0.15 – 0.10)(100)
EVA from assets in place =
0.10
= R50m
Beg. of year EVA calculation (million) PVIF PVIF

Calculation [(ROC – WACC) × New 1/(1 + calculation
investment]/WACC WACC)n–1 EVA × PVIF
1 5 1 5
2 5 0.909 4.545
3 5 0.826 4.130
4 5 0.751 3.755
5 5 0.683 3.415
Add: EVA of assets in place 50
Total EVA from existing assets & assets in place 70.845
Current assets in place 100
Value of firm R170.845
million
Where PVIF = present value interest factor
n = number of years
WACC = weighted average cost of capital
ROC = return on capital
Note: The calculation of (0.15 – 0.10) recognises that there is a cost of

capital that has to be taken into account when calculating the value of the
firm in accordance with EVA® principles.
Stern and Stewart developed EVA® to help managers incorporate two basic
principles of finance into their decision making:
The first is that the primary financial objective of any company should be
to maximise the wealth of its shareholders.
The second is that the value of a company depends on the extent to which
investors expect future profits to exceed or fall short of the cost of
capital.
By definition, a sustained increase in EVA® will bring an increase in the

market value of a company. This approach has proved effective in virtually
all types of organisation, from emerging growth companies to turnarounds.
This is because the level of EVA® is not what really matters. Current
performance is already reflected in share prices. It is the continuous
improvement in EVA® that brings continuous increases in shareholder
wealth.
Economic value added (EVA®) is the after-tax cash flow generated by a
business minus the cost of the capital it has deployed to generate that cash
flow. Representing real profit versus paper profit, EVA® underlies
shareholder value, increasingly the main target of leading companies’
strategies. Shareholders are the players who provide the firm with its
capital; they invest to gain a return on that capital.
The concept of EVA® is well established in financial theory, but the term
has only recently moved into the mainstream of corporate finance, as more
and more firms adopt it as the base for business planning and performance
monitoring. There is growing evidence that EVA®, not earnings, determines
the value of a firm. The chairman of an American-based company, AT&T
Plc, stated that the firm had found an almost perfect correlation over the
past five years between its market value and EVA®. Effective use of capital
is the key to value; that message applies to business processes, too (Keen,
1995).
The main differences between EVA®, EPS, ROA and discounted cash flow
– the most common calculations – as measures of performance, are as
follows:
Earnings per share tell nothing about the cost of generating those profits.
If the cost of capital (loans, bonds, equity) is, say, 15%, then a 14%
earning is actually a reduction, not a gain, in economic value. Profits also
increase taxes, thereby reducing cash flow, so that engineering profits
(through accounting tricks) can drain economic value. As Bennett
Stewart, the leading authority on EVA®, comments, the real earnings are
the equivalent of the money that owners of a well-run mom-and-pop
business stash away in the cigar box. Renowned investor Warren Buffett
(1987) calls these “owners’ earnings” real cash flow after all taxes,
interest and other obligations have been paid.
ROA is a more realistic measure of economic performance, but it ignores
the cost of capital. In its most profitable year, for instance, IBM’s return
on assets was over 11%, but its cost of capital was almost 13% (Keen,
1995). Leading firms can obtain capital at low costs, via favourable
interest rates and high stock prices, which they can then invest in their
operations at decent rates of return on assets. That tempts them to expand
without paying attention to the real return – economic value added.
Discounted cash flow is very close to economic value added, with the
discount rate being the cost of capital.
Determining a firm’s cost of capital requires making two calculations, one

simple and one complex. The simple one figures the cost of debt, which is
the after-tax interest rate on loans and bonds. The more complex one
estimates the cost of equity and involves analysing shareholders’ expected
return implicit in the price they have paid to buy or hold their shares.
Investors have the choice of buying risk-free treasury bonds or investing in
other, riskier securities. They obviously expect a higher return for higher
risk. To attract investors, weak firms must offer a premium in the form of a
lower stock price than stronger firms can command. This lower price
amounts to the equivalent of a higher interest rate on loans and bonds; the
investor’s premium increases the firm’s cost of capital.
Cash flow and the cost of capital employed to generate that flow have
become the key determinants of business performance, with EPS
increasingly a misleading or even damaging target for strategy and
investment. When a firm switches from FIFO (first in, first out) to LIFO
(last in, first out), its cost of goods assumes the price of the most recent
purchases of materials in inventory. This typically reduces its profits
because the older purchases cost less than the more recent ones. Yet the
firm’s stock price will rise, even though its reported profits drop, because it
pays less in taxes, thus increasing its after-tax cash flow. The money spent
to acquire the goods in inventory is exactly the same, regardless of which
method is used, but LIFO increases economic value added.
The key business processes of the firm concern capital. That fact is
obscured by accounting systems that expense salaries, software
development, rent, training and other ongoing costs integral to a process
capability and that treat the cost of displacing workers – a frequent by-
product of process re-engineering, downsizing and the like – as an
“extraordinary item” on the statement of financial position. By treating
processes as capital assets or liabilities, firms can and should ensure that
they contribute directly to economic value added.
EVA® is a model based on a company’s accounting. Its mechanism is
therefore like accounting:
Sales
– Operating expenses
– Tax
= Operating profit
– Financial requirement
= EVA®
The “financial requirement” is calculated as the defined capital (an adjusted

statement of financial position) multiplied by a suitable WACC, or the
expected “rate of return by investors”. You will recall, from corporate
finance theory, that WACC is the weighted average cost of capital based on
the company’s long sources of finance. The calculation of WACC uses the
following formula:
WACC = kewe+kdwd+kpwp
where:
ke = cost of equity
we = weight of equity in capital structure
kd = cost of debt
wd = weight of debt in capital structure
kp = cost of preference shares
wp = weight of preference shares in capital structure
EVA®’s capital base is formed by the company’s (or unit’s) statement of

financial position:
Example:
Company ABC 1999 2000 2002 2001
Defined capital base 450 500 600 620
Sales 234 258 305 420
Operating expenses –200 –205 –243 –285
Tax 0 –3 –10 –28
Operating profit 34 50 52 107
Financial requirement* –45 –50 –60 –62
EVA® –11 0 –8 45
* (10% of defined capital base)
In the above table, ABC made accounting profits between 1999 and 2001.
However, when a charge for capital was made against the profits, it showed
that ABC was profitable from an EVA® perspective only in 2001.
Some of the advantages of EVA® are the following:
EVA® is closely related to net present value (NPV). It is closest in spirit

to corporate finance theory, which argues that the value of the firm will
increase if you take positive NPV projects.
It avoids the problems associated with approaches that focus on
percentage spreads – between ROE and cost of equity, and ROC and cost
of capital. These approaches may lead firms with high ROE and ROC to
turn away good projects to avoid lowering their percentage spreads.
It makes top managers responsible for a measure they have more control
over – the return on capital and the cost of capital are affected by their
decisions – rather than one that they feel they cannot control as
effectively – the market price per share.
It is influenced by all of the decisions managers have to make within a
firm – the investment decisions and dividend decisions affect the return
on capital (the dividend decisions affect it indirectly through the cash
balance) and the financing decision affects the cost of capital.
Having looked at the EVA® concept, let us look at another value-based

measure: cash value added (CVA). At the end of this section we summarise
the two and look at their differences and at how both methods can be of use
to companies as they determine their value.
9.3.4 Cash value added and the concept of strategic

investments
Cash value added (CVA) is a net present value model that uses the net
present value approach to calculate company value. This method classifies
investments into two categories – strategic and non-strategic investments.
Strategic investments are those of which the objective is to create new value
for the shareholders, such as expansion, while non-strategic investments are
the ones made to maintain the value the strategic investments create. A
strategic investment (e.g. in a new product or an investment in a new
market, etc.) is followed by several non-strategic investments. A strategic
investment may be in a tangible or an intangible asset; the traditional view
of whether or not an outlay of cash is an investment does not matter here.
What we believe in our company to be a value-creating cash outlay is what
we then should define as a strategic investment.
The strategic investments form the capital base in the CVA model because
the shareholders’ financial requirements should be derived from a
company’s ventures, not chairs and tables (which accounting’s capital base
consists of while disregarding strategic investments in intangibles). This
means that all other investments with the purpose of maintaining the
original value of the venture must be considered as “costs”, such as buying
new chairs and tables.
The CVA model starts off by calculating an operating cash flow demand
factor (OCFD) from each strategic investment (which is the first of four
factors that determine value) made in the company. The aggregate of every
strategic investment’s OCFD in a business unit is the business unit’s capital
base. The OCFD is calculated as the cash flow (the second of our four
factors), an equal amount in real terms every year, which, discounted using
the proper capital cost (the fourth factor), will give the investment an NPV
of zero over the strategic investment’s economic life (the third factor). The
OCFD is a real annuity, but adjusted for actual annual inflation (not the
average inflation). The OCFD must be covered by the operating cash flow
(OCF), which is the cash flow before strategic investments but after non-
strategic investments, in order for the strategic investment to create value.
The OCFD is not in any way a prediction of what the future OCF will be. It
is a constant benchmark for the future cash flows (and historic cash flows
since these analyses can be made for historic as well as for future analyses).
The OCFD is “fixed” in real terms over the investment’s economic life to
illustrate the financial logic. Our understanding of how our company’s, or
business unit’s, cash flow is related to that can be called business logic. It is
difficult, and sometimes impossible, to understand our business logic if we
do not have, in real terms, a fixed benchmark.
A strategic investment creates value if the OCF (see below) exceeds the
OCFD over time. This can be presented as follows:
+ Sales
– Costs
= Operating surplus
+/– Working capital movement
– Non-strategic investments
= Operating cash flow (OCF)
– Operating cash flow demand (OCFD)
= Cash flow value added (CVA)
The CVA represents the value creation from the shareholders’ point of view.
This can be expressed using monthly, quarterly or yearly data. It can also be
expressed as an index:
Operating cash flow
CVA index =
Operating cash flow demand
The CVA index can be split up into four margins (in relation to sales):
Operating surplus margin – WCM – Non-strategic investment margin
CVA index =
Operating cash flow demand margin
where:
WCM = working capital movement
These, together with sales, form the CVA concept’s five major value
drivers:
Operating surplus Working capital movement
CVA= ( −
Sales Sales
Non-strategic investments OCFD

− − ) × Sales
Sales Sales
Table 9.1 shows a simple example of what a CVA calculation could look
like in a company. It is an example with only one strategic investment of
100. The operating cash flow demand is calculated as the cash flow that
will give the investment of 100 a net present value of zero over the
economic life of 11 years and with a capital cost of 15%. Inflation is 3%.
Tax can be included in the cash flow or in the WACC, which is done here.
Table 9.1 An illustration of CVA calculation
1997 1998 1999 2000 2001 2002 2003 2004

Sales 160 170 250 185 200 215 200
Less: Costs –150 –150 –220 –160 –170 –180 –155
Operating surplus 10 15 30 25 30 35 45
Less: Working capital movement 0 –1 –6 5 –1 –1 1
Less: Non-strategic investments –1 –3 –1 –3 –12 –4 –3
Operating cash flow 9 11 23 27 17 30 43
Less: Operating cash flow demand 17 18 18 19 19 20 20
Cash value added –8 –6 5 8 –2 10 23
CVA index 0.53 0.64 1.29 1.42 0.88 1.51 2.11
Average discounted CVA index 1.10
Strategic investments –100
Cash flow –100 9 11 23 27 17 30 43
CVA is a concept based solely on cash flow. Not even an opening balance,
using the current or adjusted statement of financial position, which is
common in other so-called cash flow models (those are, of course, not true
cash flow models) is used. There is, of course, much more to this concept (it
is an entire financial management concept), but what is stated here is
sufficient to enable comparison of the framework to the EVA®. The CVA
discussed here was developed in Sweden by Ottosson and Weissenrieder
(1996). It should not be confused with The Boston Consulting Group’s cash
value added, which is a development of their cash flow return on
investment (CFROI) concept. The two models are not similar in their basic
approach, that is the way they calculate the return and value of a business,
or how they present their result. They have unfortunately, though, been
named using the same three words, but that is the only similarity.
9.3.5 CVA versus EVA® models

Some readers may think that EVA® and CVA seem similar. In theory they
are, but not in reality. Their theoretical similarities go as far as the intended
adjustments to cash flow are concerned. However, in reality this is not so
since not all adjustments to cash flow are made fully by the EVA® model.
Companies implement EVA® because it is easy to understand – they

understand what they have always been working with, namely the
accounting process. This is not, however, what an organisation should try to
understand because they have then understood something that is not very
relevant for managing a company. The objective of value-based
management is not to further understand accounting, but instead to increase
the understanding of the point that the key objective of financial
management is to increase shareholder value or corporate value, by taking
into account the relevant costs associated with all investments. On the
contrary, most people in an organisation probably need to know it less than
they do today. Again, EVA® is not too bad in theory but, just like
accounting in real life, EVA® might be easy to implement because it is
“accounting reality”. It can be implemented in the way most accounting
systems can, in other words, the organisation is given new directives which
people blindly follow.
CVA is at the border between the business reality and the financial reality.
The implementation is an interactive process between the people active in
the business reality (technicians, controllers, etc.) and those active in the
financial reality (company headquarters, owners’ representatives, etc.).
Implementing CVA might therefore be perceived as being more difficult
than implementing EVA® because it requires more attention from the
organisation. This attention is, however, the attention necessary (and
wanted) in order to reach the level of change in the organisation towards
shareholder value.
A correctly focused value-based management concept has the organisation

focusing on the relevant issues. It is based on the four factors that determine
value: strategic investments (tangibles or intangibles), the operating cash
flow they generate, the strategic investments’ economic lives and their
capital cost. Experience shows that it is crucial for the strategic dialogue
that the process is not disturbed by any irrelevant issues, but instead gets a
chance to focus on the relevant. With accounting today, some relevant
issues are discussed and many irrelevant ones are included, while many that
are relevant are excluded because accounting is not focused on the four
factors that determine value. EVA® might improve this, but then to a
limited extent (depending on the goal of the EVA® implementation), so it
will still be based on accounting and the issues accounting triggers. A
value-based management concept based on financial theory will give the
company the possibility to increase the quality of its financial analyses (the
possibility will turn into ability when the company’s knowledge of value
theory and value-based management increases). EVA® might provide the
company with slightly better analyses, but the quality will be far from what
it would be if the goal is set higher than what can realistically be achieved
with EVA®.
The two functions will have an effect on the intrinsic value of the company,
which in the long run will have an effect on the market value. If the
company wants its intrinsic value over time to equal its market’s valuation,
then the investor relations function must also be value based. The company
should, for example, communicate issues such as its capital allocation
(where are strategic investments made?), investment strategies in its
business groups, information on its profitable growth areas and analysis of
its operating cash flow (the components). Some analysts and media might
not immediately observe this new information since they do not observe the
market mechanism today, that is discounted cash flow. That will, however,
only be a temporary situation because more and more analysts are turning
to the discounted cash flow view.
9.3.6 Market value added
The goal of a company’s value-based management (and shareholder value)
process is to make the shareholders as wealthy as possible, but how is that
measured? Stern and Stewart have introduced a measure for this purpose
called “market value added”. According to Stewart (1991: 40),
shareholders’ wealth is maximised only by maximising the difference
between the firm’s total value and the total capital that investors have
committed to it. They call this difference “market value added” or MVA:
MVA = Total value – Total capital
The total value is the market values of debt and equity. The total capital is
the adjusted total assets from the statement of financial position. It is
adjusted according to the EVA® concept. Figure 9.2 illustrates the
relationship between total value added and market value added.
Figure 9.2 Total value added and market value added
Stern and Stewart frequently have listings published in many countries of

the current MVA ratings. These are often discussed in companies as
something important and relevant, but are they? Whatever the reasoning, it
can be agreed that shareholders’ wealth is maximised only by maximising
the difference between the firm’s total value and the total capital investors
have committed to it.
9.3.7 The secret to creating value

Value is not created out of thin air. In fact, if product and factor markets are
perfectly competitive, there should be no excess profits (this is basic
economic theory). It is only through market imperfections that firms can
earn excess profits – that is, invest in positive net present value projects.
Keys to a perfectly competitive market are:
Costless entry and exit

Increasing marginal costs of production
Undifferentiated products
9.3.8 The odds of creating value

Creating value requires an advantage that prevents investments from being
priced fairly and economic profits being driven to zero. We should not
expect value creation from every business for every period of time. If we
observe “value creation”, we should inquire:
Is this a measurement error?

If not, what is the source?
9.3.9 Sources of value added

The sources of value added stem from basic economics. These advantages
are often referred to as “drivers”:
Economies of scale. A given increase in production, marketing or

distribution results in a less than proportional increase in cost (i.e. there
are cost advantages to being large and there are high capital
requirements, e.g. IBM with mainframes in 1960s).
Economies of scope. Efficiencies are gained when an investment can
support many activities (e.g. 3M and its adhesives technology).
Cost advantages. Companies enjoy cost advantages not available to new
entrants (e.g. McDonald’s and its locations; Microsoft and its Windows
operating system).
Product differentiation. Companies invest in capacity to differentiate
products, through patents, reputation (brand name), technological
innovation and service (e.g. Coca-Cola [advertising], Disney,
McDonald’s).
Access to distribution channels. Well-developed distribution channels
provide a competitive advantage.
Government policy. Government regulations can limit the entry of
potential competitors.
9.3.10 Recommendations
Creating value requires that investors use multiple measures to determine
the strength of a company. Reliance on a single measure is not advisable. It
is recommended that companies should use both traditional metrics and
valuebased metrics. Briefly, the following are recommendations about value
metrics:
There is still a need for rigorous and independent testing of value metrics.
There is a need to apply thorough testing to see whether value metrics
help investment performance and to control for market movements and
risk.
Rigorous and independent testing of a value-added approach to financial
management needs to be carried out.
Some of the challenges facing value-added metrics are:
How are value-added principles applied?

How do you quantify the difference between a firm that uses, say, EVA®
for compensation for top management only, with a firm that uses EVA®
for all management levels?
How do you account for the different adjustments that individual
companies make?
How do you account for the degree of discretion regarding making
adjustments?
9.4 EARNINGS MULTIPLIER MODEL
The constant growth dividend discount model can be reformulated into an

earnings model by assuming that the earnings per ordinary share of a
company will forever grow at the same constant growth rate as dividends
(gE) when a “steady state” equilibrium has been achieved, so that the
earnings in any year (t) can be computed by
Et= E0(1 + g)t
and that the payout ratio is also constant, so that dividends will be related to
earnings by the relationship:
DIVt = D/Et
where:
DIV = dividend paid in year t
D/E = payout ratio × earnings per share
Under these circumstances:

D/E
P/El =
rs −g
Note that this model does not imply that the value of an ordinary share is
based on its future earnings per share; rather, value is based on its future
dividends per share, which are related to the earnings per share when a
stable equilibrium is achieved.
Example: If the ordinary share of a mature company has a payout ratio of

45%, a growth rate of 10%, and should provide a total return of 15% to its
investors, an appropriate P/E ratio for the share is:
0.45
P/E1 = = 9X
0.15 − 0.10
If the company is expected to earn R5.25 per share next year, the current
value of the share is:
Price = (P/E1) × (E1) = (9) × (R5.25) = R47.25
The earnings model has important implications regarding the behaviour of

P/E ratios:
P/E ratios are properly based on forecast earnings rather than past
earnings.
A share’s P/E ratio depends directly upon the payout ratio (K). Since
dividends are paid in cash, the payout ratio (K) can be large only if
reported earnings approximate cash (or distributable) earnings. Reported
earnings that approximate operating cash flow are good quality earnings.
This can be interpreted to mean that the P/E ratio tends to be high when
the quality of earnings is high.
A share’s P/E ratio will rise (fall) as the long-run growth rate outlook
rises (falls). Thus, an acceleration in growth prospects will tend to raise a
P/E ratio. However, constant growth prospects, even if high, should not
cause the current P/E ratio to change.
P/E ratios vary inversely with the discount rate. Therefore, P/E ratios
tend to rise (fall) if either interest rates fall (rise), or if the risk of the
company decreases (increases). The former depends upon general
economic conditions; the latter depends upon the business risk, financial
risk, and liquidity risk in the company or the share as measured by
conventional securities analysis.
The most important factor determining a P/E ratio is the spread between
the required return (rs) and growth (g).
9.4.1 Estimating earnings per share for an industry

Industry and market price-to-earnings multipliers can be determined using
the same microeconomic approach used to determine company multipliers.
The three variables that determine an industry or market multiplier are:
1. The payout ratio (K) of the industry, which may be related to its stage
of development.
2. The required return (rs), which depends upon the level of the risk-free
rate and the perceived risk in the industry or the economy.
3. The perceived secular growth rate of the industry or the economy. For
an industry, the perceived growth rate depends upon whether the
industry is exhibiting rapid growth, mature growth (in line with the
overall economy), or declining growth. This depends largely upon the
extent to which the demand for the industry’s products has become
saturated.
For the economy as a whole, the real growth rate is related to the growth
rate of the labour force, the growth rate in the average work week and the
growth of productivity. The nominal growth rate of an economy is a
function of these factors, plus the rate of inflation.
Example: Estimate the price-to-earnings ratio for the S&P 500 Index,
assuming the payout ratio of the index is 30%, the risk-free rate is 5%, the
equity risk premium is 3%, long-run real growth rate of the economy is
2.5% and the inflation rate is 3.5%.
K
P/E1 =
rs −g
K
=
(rRFR +rerp )−(g +INFL)
r
0.30
= = 15X
(0.05+0.03)−(0.025+0.035)
where:
INFL = rate of inflation
g = dividend growth rate
p = current share price
E = earnings per share
r = required rate of return
Example: Estimate the price-to-earnings multiplier for an industry
operating in the economy described in the previous example that is growing
at a nominal rate of 8% per year, has an equity risk premium of 6% and a
payout ratio of 25%.
K 0.25
P/E1 = = = 8.33X
rs −g (0.05 + 0.06 − 0.08)
Industry price-earnings multiples can also be determined using a

macroeconomic approach. This approach measures the P/E ratio of an
industry relative to that of the share market index. The objective is to
determine what the normal P/E ratio of an industry is relative to the P/E
ratio of the market as a whole and then to attempt to determine whether or
not there is any reason for the normal relative P/E ratio to change. If there is
no reason to expect an industry’s P/E ratio to change relative to that of the
market (no slowing down of relative sales growth, no change in relative
risk, and so forth) the industry should be over weighted in a portfolio if its
relative P/E ratio is well below average; it should be under weighted in a
portfolio if its relative P/E ratio is well above average.
9.5 USING DIVIDEND DISCOUNT MODELS TO VALUE

GROWTH SHARES
One disadvantage of the constant growth dividend discount model and all of
its variations is that they only apply to those situations where the growth
rate of the company is constant forever. This is because the model produces
a nonsensical negative price for a share whose growth rate exceeds the cost
of the company’s equity capital:
DIV
P =
rs −g
where:
DIV = dividend per share
r = expected rate of return
P = share price
While a company’s growth rate can exceed its cost of equity for a time, it
cannot do so forever, because the cost of its equity capital equals the
nominal secular growth rate of the economy, plus an equity risk premium.
No company can grow faster than the nominal secular growth rate of the
economy forever or it would, eventually, become the entire economy.
Therefore, the practical upper limit for the growth rate that should be used
in the constant growth dividend discount model valuation formula is the
nominal growth rate of the economy in which the company operates. For a
company that operates entirely in the domestic economy, this is the national
economic growth rate; for multinational companies, this is the growth rate
of the world economy.
If a company is expected to grow 1 or 2% faster than the economy for a

short period of time, the constant growth model can still be used by
calculating the share’s value on the assumption that the dividend will grow
at the economy’s growth rate and by adding an extra premium to the
resulting value. Mature, cyclical companies can be valued using this model
by taking the long-run growth rate of the company’s normal earnings power
as a proxy for the dividend growth rate. In general, however, an important
limitation that must be imposed on the constant growth dividend discount
model is that the cost of equity capital must exceed the growth rate of the
dividend (which should not exceed the longrun growth rate of the economy)
for the constant growth dividend discount model to be applicable. Because
of this limitation, the constant growth dividend discount model is suitable
for valuing mature companies with well-established dividend policies,
whose growth rate is no larger than that of the general economy.
9.6 ALTERNATIVE GROWTH MODELS

Whenever a company’s current average annual growth rate is higher than
the growth rate of the economy in which the company operates and cannot
be expected to persist forever, the constant growth dividend discount model
cannot be used to value its ordinary share. Instead, the general (long form)
version of the dividend discount model has to be employed, which
resurrects the “infinity” problem. Therefore, some special models have been
developed to handle situations where the company’s growth rate is higher
than that of the general economy and will not persist forever. Four such
techniques are the following:
Two-stage dividend discount model

H-model
Three-stage dividend discount model
Growth duration model
9.6.1 Two-stage dividend discount model and H-model

The two-stage dividend discount model is the DDM in which dividend
growth is assumed to level off only at some future date. The H-model is a
somewhat realistic version of a two-stage dividend discount model. It
assumes only two stages of growth, a high-growth stage and maturity, but
during the intervening period between the two stages the growth rate is
assumed to decline linearly from the high-growth rate to the maturity
growth rate, as shown in Figure 9.3.
Figure 9.3 Two-stage dividend discount model
Notice that, by definition, the period of declining growth is 2H years (H is

called the “half-life” of the high-growth period). While the model makes a
realistic assumption about growth, it makes an entirely unrealistic
assumption about the payout ratio: it assumes that the payout ratio remains
constant at its current level throughout the future life of the company.
The valuation formula for the H-model is as follows:

DIV0 (1+g ) DIV0 H(g −g )
M HI M
P = +
rs −g rs −g
M M
As in the two-stage model, the H-model assigns a value to the mature

growth of the company consistent with the Gordon constant growth
dividend discount model, plus a premium value for the high (but declining)
initial period of growth. Furthermore, the higher the value of H (i.e. the
longer the higher-than-mature growth rate persists), the greater will be the
value of the share.
Example: A company pays a dividend of R0.50 per share. The dividend is
growing at a 20% rate, but its long-run growth rate at maturity is expected
to be 6%, which will be attained in 20 years. Assume that the company’s
cost of equity capital is 15%. What is the value of the share according to the
H-model?
According to the H-model, the value of the ordinary share is:

DIV0 (1+g ) DIV0 H(g −g )
M HI M
P = +
rs −g rs −g
M M
0.50(1.06) 0.50(20/2)(0.20−0.06)
= +
0.15−0.06 0.15−0.06
= R13.67
9.6.2 Three-stage dividend discount model

A very realistic way to handle the growth share problem is to make the
assumption that companies undergo three stages of development: a high
growth stage, a decelerating growth stage and maturity. Figure 9.4 shows
the various stages of the three-stage dividend discount model.
Figure 9.4 Three-stage dividend discount model

Once the growth patterns are defined, a computer can calculate the future
dividends to be expected through year t2, beyond which the growth rate
stabilises at gM. Because the dividend’s growth rate is constant after year t2,
the value of the share at the end of year t2 can be determined using the
constant growth dividend discount model. Once computed, the value of the
share at the end of year t2 can replace all of the dividends from year t2+ to
infinity, on a present-value basis.
Example: A company pays a R0.50 dividend. The dividend is expected to

grow at a 20% rate for the next 3 years (stage I, rapid growth). Thereafter,
over the subsequent 5 years, its growth should decline linearly (stage II,
declining growth), ultimately reaching a stable, mature growth rate of 10%
per year (stage III, maturity). If the company’s cost of equity capital is 15%,
what is the intrinsic value of the ordinary shares? Using the growth rate
assumptions, the dividends for the next 8 years should be:
DIV0 = R0.50
DIV1 = 0.50 × 1.2 = R0.60
DIV2 = 0.60 × 1.2 = R0.72
DIV3 = 0.72 × 1.2 = R0.86
DIV4 = 0.86 × 1.18 = R1.02
DIV5 = 1.02 × 1.16 = R1.18
DIV6 = 1.18 × 1.14 = R1.35
DIV7 = 1.35 × 1.12 = R1.51
DIV8 = 1.51 × 1.10 = R1.66
The present value of the dividends from year 9 to infinity can be

represented by the value of the share at the end of the eighth year (its
terminal value), which is R36.52:
DIV9 DIV8 (1+g ) (1.66)(1.10)
m
P8 = = = = R36.52
rs −g rs −g 0.15−0.10
m m
The current value of the share is, therefore, R16.43:
0.60 0.72 0.86 1.02 1.18 1.35 1.51 1.66 36.52
P = + + + + + + + + = R16.43
1 2 3 4 5 6 7 8 8
(1.15) (1.15) (1.15) (1.15) (1.15) (1.15) (1.15) (1.15) (1.15)
Alternatively, using the current market price of the share, a computer can
calculate the discount rate that will equate the present value of the future
dividends, implied by the growth rate projections, with the current market
price. This is done by a trial-and-error (reiterative) computer program. The
discount rate, so calculated, would be the total return implied by the current
market price, given the analytical assumptions about future growth during
each stage of the company’s development and the length of each stage.
This kind of analysis can be performed on every company in a universe to

determine the total return offered by each share in the universe, based upon
each share’s current market price, and analytical assumptions about its
growth prospects and the duration of above-average growth. Of course,
varying the assumptions about growth rate and length of each stage of
growth will generate different prices or total return levels. Assigning
probabilities to each assumption set can generate a probability distribution
for the total return of each share. The width or standard deviation of these
probability distributions would measure the risk of each share. Therefore, it
is possible to develop a set of risk and return para-meters for a universe of
shares that may be used to make portfolio decisions.
9.6.3 Growth duration model

Growth shares usually sell at a premium P/E ratio relative to the average
shares that comprise a market index. Therefore, another way of valuing a
growth share is to determine whether or not its premium P/E ratio is
justified. The growth duration model makes this determination by using the
following formula:
T
(P/E) 1+g +Ds
Share s
= ( )
(P/EMarket ) 1+g +DM
m
where:
D = annual growth rate in earnings
T = growth duration
To use this model, the known values of the P/E ratios of the share and the
share market index, the current yields of the share and the share market
index, and the assumed current (high) growth rate of the share’s dividend
and the growth rate of the share market’s dividend (assumed to be equal to
the nominal growth rate of the overall economy) are fed into the model, and
the equation is solved for “T”, which is the “growth duration”, that is the
length of time that the current high growth rate of the company must endure
in order to justify the share’s current premium P/E ratio relative to that of
the share market index. If “T” appears to be a reasonable length of time for
the high growth rate to endure, the share is deemed to be reasonably priced;
if “T” appears to be unreasonably short or unreasonably long, the share is
deemed to be under- or overvalued, respectively.
Alternatively, the analyst can estimate the values for the growth duration
(T), the current high growth rate of the company, the growth rate of
dividends paid by the share market index, and feed them into the growth
duration model, together with the current yields of the share and the share
market index. The model could then be used to solve for the premium P/E
ratio that is justified for the share. The attractiveness of the share can be
determined by comparing the P/E ratio premium at which it is trading in the
marketplace to the amount of premium that appears to be justified.
The growth duration model assumes that the growth rate of a company is
the primary determinant of its P/E ratio. This leads some analysts to
conclude that shares with high growth rates should have high P/E ratios and
vice versa. This is not necessarily true, however, because
the growth duration model ignores risk; it assumes the share’s risk is
average, which is probably not correct.
company growth rates must be estimated, and the estimates might be
wrong. If this is the case, a P/E ratio premium that appears to be too high
or too low might simply mean that the analyst’s assumptions are wrong,
rather than that the shares are mispriced.
For the growth duration model to be valid, the following conditions must
hold:
The share’s risk and the share market index’s risk must be equal.
The growth estimates must be accurate.
The share market as a whole must be correctly valued.
9.7 ADVANTAGES AND LIMITATIONS OF DIVIDEND

DISCOUNT VALUATION MODELS
The main advantage of dividend discount-based models is their simplicity.

In addition, empirical studies suggest that these models are able to
distinguish undervalued from overvalued shares over the long run, although
they do not outperform the market every year.
Why, in an efficient market, should analysis of this sort work? One answer
is that DDMs tend to conclude that shares with low P/E ratios or high
dividend yields are undervalued. There are studies suggesting that shares
with these characteristics do outperform other shares. Thus, the DDM really
is similar to the low P/E-high yield “anomaly” in the efficient market.
There are, however, at least six disadvantages of dividend discount models:
1. The models apply only to dividend-paying shares, or to shares that may

not pay a dividend currently, but a dividend stream can be projected in
the future.
2. Risk is not an explicit variable of the models. While the cost of equity
capital (rs) is related to risk, the exact relationship between rs and risk is
largely subjective.
3. The analyst’s estimates of g and rs may be in error. If they are, DDM
rankings will be in error. It is not possible to determine whether a
highly ranked share is really undervalued (mispriced), or whether the
growth rate and cost of equity assumptions were too optimistic. To help
correct for this problem, an information coefficient may be used. This
can be done by using the correlation coefficient between past analyst
forecasts and actual results as an adjustment factor to be applied to
future estimates.
4. Small changes in rs and g produce large differences in valuation.
Example: Assume a share with a dividend estimate of R2.00 per share.

Interest rates are 9% on bonds and the equity risk premium is in the
range of 3–5%. The growth rate of the dividend is expected to be in the
range of 6–10%. What is the range of value for the share? Since rs and g
are ranges, the value of the share is also a range:
DIV1
P =
rs −g
2.00
PLOW = = R25
0.14−0.06
2.00
PHI = = R100
0.12−0.10
The share price can be justified if it is anywhere between R25 and R100!
Realistically, there is no single discount rate (rs) or growth rate (g) that
can be applied to a share. Instead, reasonable ranges of these values
should be estimated. But when rs and g are ranges, there is a value range
for the share. These value ranges are often quite wide. Most of the time,
the price of a share will be somewhere near the middle two-thirds of the
computed value range. In that case, there is little confidence in the
direction the share’s price might take in the future. This inability to
make precise predictions about a share’s future price movement is the
essence of the efficient market concept, which states that the rates of
return of shares are largely unpredictable.
5. The models do not reflect the value of underutilised assets, unless they
are adjusted to reflect them by a separate analysis.
6. The model tends to orient investors towards high-yielding shares. While
studies suggest that such shares do tend to outperform the market over
long periods (but not every year), buying shares that pay high dividends
might be disadvantageous to taxable investors.
9.8 RELATIVE VALUATION RATIOS
Valuation models, such as the DDM, the discounted cash flow model and
others, force the analyst to consider the fundamental factors that lend value
to a firm (dividend-paying capability, free cash flow, risk, growth, and so
forth). Other commonly used valuation methods, notably P/E ratios,
price/book value ratios, price/sales ratios, and so forth, attempt to assess the
value of firms and their shares simply by comparing their prices relative to
some scaler (earnings, book value, sales, and so forth).
Example: If there are two shares, one trading at R40 with earnings of
R2.00 per share and the other trading at R20 with earnings of R1.00 per
share, both are selling at a multiple of 20 times earnings. Therefore, they
are valued the same relative to the scaler earnings.
The “multiple” approach to valuation has the advantages of being intuitive,

easy to compute and easy to understand. The multiple can be used as a
proxy for risk and growth. Its weakness is that it is a form of financial
relativism, insofar as no attempt is made to understand why the multiples
are what they are. In other words, the relative valuation approach based on
multipliers offers no objective way to measure value across companies and
across time. In the example above, the fact that the two shares both sell at
20 times earnings only tells us that they are valued equally relative to the
scaler; no information is conveyed about why the multiple should be 20
times earnings. Indeed, if some other scaler were used, such as cash flow,
book value, sales, square feet of floor space, passenger revenue-miles
flown, or any one of a host of other factors, it is probable that the ratio of
prices of the two shares to any of these other scalers would not be the same,
as they are relative to earnings; indeed, the price/sales and price/book value
ratios might not even produce the same rankings of relative value between
the two shares.
It can be concluded, therefore, that valuing shares on the basis of

multipliers of one or more scalers is a short-cut approach that produces
rules of thumb, but little insight regarding the factors that lend value to a
company. Using multiples for valuation purposes frees the analyst from
having to explicitly consider assumptions about risk, growth, payout ratios
and similar fundamentals, but this is actually a weakness and not a strength.
When the market makes systematic errors, the multiplier approach builds
those errors into security valuations. Multiples reflect market moods; in
using them, the analyst substitutes his or her judgement for the market’s
judgment. This may not be a good idea. Warren Buffett (1987) passed along
the following advice to Berkshire Hathaway, Inc. shareholders:
Without fail, Mr. Market appears daily and names a price at which
he will either buy your interest (in a business) or sell you his.
Even though the business … may … be stable, Mr. Market’s
quotations will be anything but. For, sad to say, the poor fellow
has incurable emotional problems. At times he feels euphoric and
can see only the favourable factors affecting the business. When
in the mood, he names a very high price because he fears that you
will snap up his interest and rob him of imminent gains. At other
times he is depressed and can see nothing but trouble ahead for
both the business and the world. On these occasions, he will name
a very low price, since he is terrified that you will unload your
interest on him …
But, like Cinderella at the ball, you must heed one warning or
everything will turn into pumpkins and mice: Mr. Market is there
to serve you, not to guide you. It is his pocketbook, not his
wisdom, that you will find useful. If he shows up some day in a
particularly foolish mood, you are free to either ignore him or to
take advantage of him, but it will be disastrous if you fall under
his influence. Indeed, if you aren’t certain you understand and can
value your business far better than Mr. Market, you don’t belong
in the game.
Despite its shortcomings, the multiplier method of valuing securities is
widely used.
9.8.1 Price/earnings ratio

Earnings are believed to be an important determinant of value.
Consequently, it is natural that earnings would be a commonly used scaler
against which the price of a share can be compared to determine its value.
Two types of P/E ratio are commonly used: trailing 12-month P/E ratios,
which measure the current price of a share relative to the company’s
earnings per share reported for the previous 12-month period; and year-
ahead P/E ratios, which measure the current price of a share relative to the
projected earnings per share of the company over the next year. On a
theoretical basis, the latter are a better measure of value than the former,
because value should be based on the future outlook of a company rather
than on its past.
However, trailing 12-month earnings per share are often used as the scaler
in the financial media when, for legal or other reasons, the publisher of such
ratios does not want to be responsible for the accuracy of earnings forecasts.
Trailing 12-month P/E ratios are objectively correct facts, while year-ahead
P/E ratios are subjective opinions. In addition, trailing 12-month P/E ratios
are usually used for historical research studies, because they are objective.
Because it is difficult to know what the year-ahead earnings forecasts were
in times past, the trailing 12-month P/E ratios are the only reliable data the
researcher can obtain.
Often relative P/E ratios are used to rank the relative values of companies
over time (see example in Table 9.2). A relative P/E ratio is the P/E ratio of
a share or industry divided by the P/E ratio of either the share market index
or an index of peer group shares. This approach normalises the P/E ratio of
a particular share, thereby eliminating the impact of a general rise or fall in
overall market valuations on the value of a target share. Factors that can
cause the relative P/E ratio of a share or industry to change include the
following:
A company’s growth rate might change relative to that of the average

company.
The risk of a share might change relative to that of the average share, as
measured by the volatility of sales, the amount of financial leverage in
the firm, and the liquidity of the shares.
The quality of a company’s (or industry’s) earnings can change relative to
that of the average company (or the market).
A company’s or an industry’s recent earnings behaviour might change
relative to its normal long-term growth rate.
Table 9.2 Comparisons of P/E multiples in the JSE
Identifier Security P/E Multiple

J203 JSE All Share Index 12.57
VODJ.J Vodacom Group Ltd 18.12
REMJ.J Remgro Ltd 16.69
MNDJ.J Mondi Ltd 14.63
OMLJ.J Old Mutual Plc 14.57
SOLJ.J Sasol Ltd 14.25
SNHJ.J Steinhoff International Holdings NV 14.12
SLMJ.J Sanlam Ltd 13.56
FSRJ.J Firstrand Ltd 11.76
MTNJ.J MTN Group Ltd 11.56
SBKJ.J Standard Bank Group Ltd 9.62
NEDJ.J Nedbank Group Ltd 8.36
BGAJ.J Barclays 8.35
P/E ratios are not objective standards of value. Like all multiples, they are
most useful in ranking the shares of comparable companies at a particular
moment in time. When confidence is low and investors are fearful, the P/E
ratio of the JSE index tends to be in the 10–15 range; when investors are
confident and optimistic, the JSE All-Share Index’s P/E ratio tends to be in
the 12–15 range. Even higher JSE All-Share P/E ratios may prevail if
speculation is rampant or a “new era” theory of market valuation is
emerging.
9.8.2 Dividend yields
The dividend discount model assumes that dividends are the primary
determinant of value for shares. If this is true, it would appear natural to use
a price/dividend ratio as a measure of value. However, it is common
practice to use the reciprocal of the price/dividend ratio (the dividend yield)
instead. It is more difficult to value individual shares on the basis of their
dividend yield than on the basis of their P/E ratios, because dividends tend
to be more stable than earnings. Thus, a company whose earnings are
accelerating rapidly but whose dividend growth is more stable than earnings
exhibits a declining trend in its dividend yield and a stable P/E ratio, as the
share’s price responds to the more rapidly rising earnings in anticipation of
higher dividends in future years. Similarly, if earnings are falling, while the
dividend is stable, the dividend yield might be rising, even as the P/E ratio
remains stable.
While share prices usually respond more to earnings than to dividends,

dividends have one advantage over earnings as a determinant of value in
that they are not as susceptible to accounting choices made by management
and other factors, such as inflation, which may affect the quality of reported
earnings per share. During periods when accounting choices or high
inflation produce a low quality of reported earnings, investors often place
more weight on the dividend yield as a measure of value; when the quality
of earnings is high, the P/E ratio is usually more highly regarded as a
measure of value.
Because dividends are not as volatile as earnings and, therefore, are not
believed to be sensitive enough to changes in a company’s fundamental
economic condition, the dividend yield is often applied more to valuing the
share market as a whole, rather than as a measure of the value of individual
shares. For the market as a whole, the dividend yield tends to fall below the
yield on treasury bills when there is excessive optimism; it rises above the
yield on treasury bonds during periods of pessimism. During periods of
excessive speculation, the market’s dividend yield can fall to very low
levels (less than 2%).
9.8.3 Price/sales ratios

P/E ratios are volatile because earnings are volatile. Furthermore, if
earnings are abnormally low, P/E ratios may be abnormally high and vice
versa. To properly evaluate P/E ratios, it is advisable to measure a share’s
price relative to “normalised earnings” or the earnings power of a firm,
rather than relative to the earnings that actually will be (or have been)
reported. But this is difficult to do, because “normalised earnings” or a
company’s earnings power are difficult to ascertain. Furthermore,
companies in an early stage of development may have negative earnings but
very good long-term prospects. P/E ratios have no meaning for such
companies because, at this stage in their development, current earnings are
not the primary source of value; rather, the source of their value is the
company’s long-term future earnings potential.
For companies in the early stages of their development or whose earnings

are highly volatile, sales are often believed to be the primary determinant of
value. This concept makes sense if it is assumed that, in the long run, viable
firms will earn some normal profit margin. In that case, sales (and sales
growth), which tend to be more stable than earnings, may be used as a
proxy for the potential earnings power of a firm.
For most large companies, the price/sales ratio should be in the range of 0.4
to 0.8. If a large share’s price/sales ratio is above this range, it may be
overpriced; below this range, it could be underpriced (provided it is
financially sound and reasonably profitable). Major exceptions to the above
generalisation include shares of companies with high inventory turnover
ratios and very low profit margins, such as grocery chains, which should
have lower price/sales ratios, and small companies with very good long-
term growth potential, or firms with exceptionally high profit margins. The
price/sales ratios of such firms can reach levels well above 2.0.
9.8.4 Price/asset value ratios

Companies may be valued relative to their book values. Indeed, empirical
studies have indicated that shares that sell at low price-to-book value ratios
have outperformed those selling at high price-to-book value ratios. The
rationale for using book value as a scaler for measuring share values is that
the earnings of a company equal its return on equity times its book value.
While the return on equity may be volatile in the short run (which causes
earnings and the P/E ratio to be volatile), a company’s return on equity
usually reverts to some stable, long-term, mean value over longer periods.
If this is the case, a firm’s book value per share may serve as a proxy for
“normalised” earnings per share; accordingly, it can be used as a measure of
long-term value.
One problem with this analytical approach is that book value is an arbitrary
measure, derived from applying accounting conventions to the valuation of
assets and liabilities on a statement of financial position. Since IFRS uses
historical cost, rather than market values, to measure asset and liability
values, book values are not generally relevant to the valuation of securities.
Liquidation value per share might be more relevant, but only when the
concern might eventually be sold for the scrap value of its assets.
The Q-ratio, developed by Tobin (1965), is a popular measure of relative

value that is based on asset values. This ratio is defined as:
VE +VD
Q =
VA
where:
VE = market value of a company’s total equity (preference and ordinary
shares)
VD = market value of a company’s total debt
VA = replacement value of company’s assets
A share whose Q-ratio is under 1.0 is considered to be a bargain, because a

Q-ratio this low implies that all of the securities of the company (its shares
and bonds) could be purchased in the marketplace for less than the value of
the company’s real net assets. Q-ratios over 1.0, however, do not necessarily
mean that a company’s securities are overvalued, since the value of a
company depends as much upon how its management uses its assets to
create value as it does on the value of those assets in liquidation. Q-ratios
above 1.0 are very common; they simply mean that the market is willing to
pay for management’s skill in using assets to create economic value.
From a more analytical perspective, the valuation of a share on the basis of
its book value is done by using a simplistic constant cash flow model. To do
this, assume that a company is able to generate a constant annual stream of
cash flow (CF) from a given net asset capital base. Under this assumption,
the price of the ordinary share (P) would be:
CF1
P =
Rs
where:
rs = the required return demanded by the market on equity
If R is defined as the return on book value (measured on the basis of cash

flow generation capability), then the cash flow produced from the existing
book value would be:
CF1 = R × B
Therefore, the value of the share would be:

R × B
P =
rs
Note that if the market capitalisation rate equals the return on equity earned
by the company, the value of the share will equal its book value per share
under the simplistic assumptions employed in this model. In this context,
“book value” must be measured as the fair market value of the firm’s net
assets.
R × B rs × B
P = = = B
rs rs
However, if the return required by the market to justify investing in the

share does not equal the return earned by the company on its book value,
the market value of the shares will not equal their book value per share. In
that case, still using rather simple assumptions, the value of the shares will
be:
R × B R − rs
P = = B + × B
rs rs
Note that this formulation states that the value of a share (under very simple
assumptions) equals its book value per share (B) plus another term. This
other term can be positive (if R > rs), zero (if R = rs), or negative (if R < rs).
This second term R−rs
rs
may be viewed as being the market value of the
× B
firm’s “goodwill”. In this context, “goodwill” should not be confused with

the accounting concept of goodwill; rather, it should be viewed as being the
extra value that is added to a company’s book value from a variety of
factors (reputation, location, uniqueness of product, brand identification,
management skill, and so forth) that render the company worth more than
its “brick and mortar” net assets. Firms that earn a return on book value (R)
that exceeds the required market return (rs) have a positive goodwill, and
will sell above book value; firms that earn a return on book value (R) that
falls short of the required market return (rs) will sell below book value and
have a negative goodwill.
Unfortunately, even this analytical approach presents problems difficult to

overcome:
First, there is uncertainty regarding what is the proper value of the market
return (rs).
Second, the measurement of a firm’s book value is difficult because
accounting conventions do not necessarily measure true economic worth.
Indeed, if accounting conventions did measure true economic worth, then
book value and market values would (theoretically) be identical, and the
entire valuation problem moot!
Third, book values change for reasons often unrelated to the economic
operation of the business. For example, mergers and acquisitions will
cause a company’s book value to change; if a company has assets located
in a foreign country, a change in the exchange rate of currencies will
cause its book value to change. This being the case, it is difficult to
determine what the return on book value will be, since it will be in a
constant state of flux. For these reasons, it is very difficult to use book
value per share as the basis for valuing a company, or for measuring its
potential earnings power unless some very simplistic (and unrealistic)
assumptions are made.
While these alternative valuation methods are popular, they should rather be
classified more as rules of thumb that may be used to rank the relative
values of shares of companies with similar characteristics (e.g. similar
growth rates, risk, and so forth). They are not good methods of determining
the relative value of shares of dissimilar companies. Neither are they good
ways of determining value across time, because they are influenced by
factors such as inflation, interest rates, demographics, investor psychology
and the economic outlook.
9.8.5 Price/cash flow ratio

Many investors believe that cash flow and, sometimes, earnings before
interest, tax and depreciation (or EBITDA) is a more important determinant
of value than earnings. This is especially true when differences in
accounting make the earnings among companies non-comparable.
9.9 SUMMARY
In this chapter we looked at company valuation, focusing more on the

determination of shares and a company in general. A good company is not
necessarily a good investment, because the share of a good company may
be underpriced, and vice versa, the share of a bad company may be
overpriced. Therefore, it is always necessary to compare the price of a share
to its intrinsic value. Many companies have embraced – and others have felt
obligated to look at – performance measures that depart from the traditional
accounting-based measures such as earnings per share and return on
investment. In this chapter, we have looked at EVA® and CVA as
alternative methods of determining value by classifying investments into
two categories, strategic and non-strategic. Finally, the constant growth
dividend discount model was reformulated into an earnings model by
assuming that the earnings per ordinary share of a company will forever
grow at the same constant growth rate as dividends when a “steady state”
equilibrium has been achieved. Industry and market price-to-earnings
multipliers were determined by using microeconomic approaches that are
used to determine company multipliers.
We indicated that for an industry, the perceived growth rate depends upon
whether that industry is exhibiting rapid growth, mature growth (in line
with the overall economy), or declining growth. This depends largely upon
the extent to which the demand for the industry’s products has become
saturated. One disadvantage of the constant growth dividend discount
model, and all of its variations, is that they apply only to those situations
where the growth rate of the company is constant for ever. This is because
the model produces a nonsensical negative price for a share whose growth
rate exceeds the cost of the company’s equity capital.
The next chapter introduces technical analysis. Having determined the

values of shares in this chapter, we hope to be able to analyse these shares
to identify profit opportunities and determine trends in their movements.
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1. Dunlop Tyre Company Ltd is expected to earn R2.00, R2.20, and R2.40 per share
in each of the 3 years respectively. At the end of the third year, the stock is
expected to sell at a current yield of 3%. It is Dunlop’s policy to employ a dividend
payout ratio of 25%. If an investor demands a 15% return for investing in Dunlop
stock, how much should he be willing to pay for the shares today?
(a) R14.38
(b) R13.25
(c) R18.25
(d) R12.63
2. Waterkloof (Pty) Ltd is expected to pay a dividend of R4.00 per share next year. If
Waterkloof’s long-term dividend growth rate is 5% per year and its cost of equity
capital is 12%, its ordinary shares have a value of approximately:
(a) R33.38
(b) R57.25
(c) R23.50
(d) R31.75
3. Inxa (Pty) Ltd’s current dividend is R2.00 per share. Its cost of equity capital is
15% and its long-term secular dividend growth rate is 4% per year. The value of
Inxa’s ordinary shares is approximately:
(a) R18.18
(b) R13.33
(c) R18.91
(d) R13.87
4. The Atom Company employs a policy of maintaining a dividend payout ratio of
40%. If the company’s earnings are expected to be R6.00 per share next year, its
cost of common equity capital is 11% and its earnings growth rate is 5%, Atom
Company ordinary shares should sell at how many times next year’s estimated
earnings?
(a) 16.7
(b) 9.1
(c) 10.0
(d) 6.7
5. The dividend discount model is a special form of a general class of security
valuation models called:
(a) Monte Carlo models

(b) discounted cash flow models
(c) Gordon models
(d) Graham and Dodd models
6. Newly issued treasury bills are yielding 6%. For the past several months, the rate
of inflation has been averaging 4%. During the next several months, the rate of
inflation is expected to average 5%. The real risk-free rate should be
approximately:
(a) 1.5%
(b) 2.0%
(c) 1.0%
(d) 6.0%
7. Newly issued treasury bills are yielding 5%, the expected rate of inflation is 3%,
and the cost of common equity capital of Inxa (Pty) Ltd is estimated to be 12%.
Under these circumstances, the real risk-free rate and the equity risk premium of
Inxa ordinary shares are approximately:
REAL RISK-FREE RATE EQUITY RISK PREMIUM

(a) 8% 12%
(b) 7% 9%
(c) 5% 7%
(d) 2% 7%
8. The equity risk premium is primarily related to:
(a) the level of interest rates

(b) the outlook for inflation
(c) the volatility of a company’s sales
(d) all of the above
9. The financial risk of a firm is primarily determined by:
(a) the firm’s debt-to-equity ratio

(b) the trading volume in the firm’s shares
(c) the probability that the company’s assets might be expropriated by a
government
10. If an investor invests solely in stocks of companies domiciled in the investor’s own
country, the investor does not have to be concerned with:
(a) business risk

(b) financial risk
(c) liquidity risk
(d) currency risk
11. Which of the following statements is the least accurate?
(a) Country risk is similar to political risk.

(b) Financial risk is the same as liquidity risk.
(c) Business risk is independent of management quality.
(d) South African investors who invest in foreign securities have to worry about
both country risk and currency risk.
12. Business risk depends upon all of the following factors except the:
(a) volatility of a company’s sales

(b) amount of debt in a company’s capital structure
(c) amount of fixed costs in a company’s cost structure
(d) volatility of the prices of a company’s raw materials
13. Companies with high fixed costs and low variable costs:
(a) typically have a high breakeven point and a low degree of operating leverage
(b) typically will experience high profit volatility if sales are only slightly volatile
(c) typically will experience slow profit growth when sales rise above the
breakeven point because of the impact of high fixed costs
(d) typically are poor investments because they are too risky
14. Which of the following statements is false?
(a) Economic profit margins (EBDIT/sales) are negatively related to the degree of
competition in an industry, i.e. the greater the competition, the lower economic
profit margins are likely to be.
(b) Depreciation expenses and interest expenses mostly represent embedded
costs.
(c) Barriers to entry are important factors that affect the degree of competition in
an industry, while exit barriers have little impact on the competitive structure of
an industry.
(d) The extent to which a firm can choose between adopting a high profit
margin/low volume versus a low profit margin/high volume strategy largely
depends upon its pricing flexibility.
15. ACM Gadget (Pty) Ltd produces gadgets, which it sells for R5.00 each. The
company’s fixed costs are R10 million, consisting of R2 million of depreciation and
amortisation expenses and R8 million of cash fixed costs. The variable costs
associated with gadget production are R3.00 per unit. ACM’s accounting and cash
breakeven points are:
ACCOUNTING BREAKEVEN CASH BREAKEVEN

POINT POINT
(a)2 000 000 gadgets 4 000 000 gadgets
(b)2 000 000 1 000 000
(c) 5 000 000 4 000 000
(d)1 000 000 5 000 000
16. Far East Ltd produces widgets, which it sells for R80 each. The company’s cost
structure consists of depreciation and amortisation of R40 million and R10 million
of cash fixed costs. The variable cost per widget is R60. The company is in the
30% tax bracket. If the company is expected to produce and sell 4 million widgets
in the upcoming year, its estimated operating profit and operating cash flow after
income tax are:
OPERATING PROFIT OPERATING CASH FLOW

(a) R40 000 000 R30 000 000
(b) R21 000 000 R61 000 000
(c) R40 000 000 R20 000 000
(d) R30 000 000 R70 000 000
17. State at least two major advantages and three major disadvantages of each of the
following three valuation methodologies:
(a) Multistage dividend discount model

(a) Absolute and relative price/earnings ratio
(a) Absolute and relative price/book ratio
Solutions
0.25(2.40)
0.25(2.00) 0.25(2.20) 0.25(2.40) 0.03
1. (a) 1.15
+
2
+
3
+
3
= 14.40
(1.15) (1.15) (1.15)
2. (b) 4.00
= 57.14
(0.12−0.05)
3. (c) 2.00(1.04)
= 18.91
0.15−0.04
4. (d) 40
= 6.7
(0.11−0.05)
5. (b) Dividends are the cash flows paid to ordinary shareholders.

6. (c) rF = rrF + E(INFL)
6% = rrF + 5%
rrF = 1.0%
7. (d) rF = rrF + E(INFL) rCE = rF + rERP)
5% = rrF + 3% 12% = 5% + rERP
rrF = 2.0% rERP = 7.0%
8. (c) The equity risk premium is related to the unique risk of a business, such as
its business risk (which is related to its volatility of sales), financial risk,
liquidity risk, currency risk and country risk. Interest and inflation risks
primarily impact on the nominal risk-free rate.
9. (a) Financial risk is related to the way a firm is financed. Option (b) refers to
liquidity risk and (c) refers to country risk.
10. (d)
11. (b) Financial risk is related to how a firm is financed; liquidity risk refers to the
ability to buy and sell the shares quickly without having to give up a large
price concession.
12. (b) The way a company is financed affects its financial risk.
13. (b) Option (a) is incorrect because operating leverage will be high in this case;
(c) is incorrect because profit growth will be high under these conditions; (d)
is incorrect because whether or not the investment is good depends upon its
price and not only its risk.
14. (c) Industry competitive structures depend on both entry and exit barriers.
15. (c) 0 = (P – V)QABE – CF
0 = (R5 – 3)QABE – R10 000 000
QABE = 5 000 000 gadgets (accounting breakeven)
0 = (P – V)QCBE – CFC
0 = (R5 – 3)QCBE – R8 000 000
QCBE = 4 000 000 gadgets (cash breakeven)
16. (b)
NOPAT = EBIT (1 – T)
= [(R80 – 60)(4 000 000) – R50 000 000](1 – 0.30)
= R21 000 000
OCF = NOPAT + depreciation
= R21 000 000 + R40 000 000
= R61 000 000
17. Advantages and disadvantages
(a) Multistage dividend discount model
Advantages
1. Excellent for comparing vastly different companies

2. Solid theoretical framework
3. Ease in adjusting for risk levels
4. Dividends relatively easy to project
5. Dividends not subject to accounting
6. Flexibility in use and more realistic than constant growth model
Advantages
1. Excellent for comparing vastly different companies

2. Solid theoretical framework
3. Ease in adjusting for risk levels
4. Dividends relatively easy to project
5. Dividends not subject to accounting
6. Flexibility in use and more realistic than constant growth model
Disadvantages
1. Need to forecast well into the future

2. Problem with non-dividend-paying companies
3. Most investors not looking to collect a stream of dividends
4. Problem with high-growth companies (g > k)
5. Problems projecting “forever after” ROE and payout ratio
6. Small changes in assumptions may have big impact
7. Need technology for more advanced models
8. Quality of payouts may differ
(b) Absolute and relative price/earnings ratio

Advantages
1. Widely used by investors

2. Easy to compare with market and other companies in specific industries
Disadvantages
1. Difficult with volatile companies

2. Need to determine what is “normal”
3. Difficult to project earnings
4. Effect of accounting differences
5. Many factors influence multiples
6. Can be used only for relative rather than absolute measurement
7. Point-in-time “snapshot”
8. Does not address quality of earnings
9. Problem with companies with no income
(c) Absolute and relative price/book ratio

Advantages
1. Incorporates some concept of asset values

2. Easy to compute even for companies with volatile or negative earnings
3. Easy to compare with market and specific industries
Disadvantages
1. Subject to differing accounting rules
2. Affected by non-recurring items and share repurchases
3. Subject to historical costs
4. Book may be poor guide to actual asset values
10 Technical analysis
10.1 INTRODUCTION
In Chapter 9 we presented valuation principles, which laid the background

for the understanding of equity analysis. This chapter is an introduction to
technical analysis and presents basic concepts and terminology. It contains
concise explanations of numerous technical analysis tools in a reference
format. Technical analysis is in most instances an attempt to exploit
recurring and predictable patterns in share prices to generate abnormal
trading profits. Technical analysis is accepted as a viable analytical
approach by most universities and brokerage firms. Rarely are large
investments made without reviewing the technical climate. Yet even with its
acceptance, the number of people who actually perform technical analysis
remains relatively small.
10.2 A SUMMARY OF THE UNDERLYING ASSUMPTIONS
In order to achieve these abnormal profits, technicians (or “chartists” as

they are sometimes called), make a number of assumptions. These are:
Market value is determined solely by the interaction of supply and

demand.
Supply and demand are governed by numerous factors both rational and
irrational. The market continually and automatically weighs all these
factors. (A random walker1 would have no qualms about this assumption
either. He would, however, point out that any irrational factors are just as
likely to be on one side of the market as on the other.)
Disregarding minor fluctuations in the market, share prices tend to move
in trends which persist for an appreciable length of time. (The random
walker would disagree with this statement. For any trend to persist there
has to be some collective “irrationality”.)
Changes in trends are caused by shifts in demand and supply. These
shifts, irrespective of why they occur, can be detected sooner or later in
the action of the market itself. (In the financial economist’s view the
market – through the price – will instantaneously reflect any shifts in the
demand and supply. However, knowledge that the demand or supply has
shifted after it has already been reflected in the price is worthless.)
10.3 BASIC CHARTS
The foundation of technical analysis is the chart. In this case, a picture truly
is worth a thousand words. This section introduces basic charts, such as line
charts, bar charts and volume bar charts.
10.3.1 Line charts

A line chart is the simplest type of chart. As shown in Figure 10.1, the
single line represents the security’s closing price on each day. Dates are
displayed along the bottom of the chart and prices are displayed on the
side(s).
Figure 10.1 Line chart
A line chart’s strength comes from its simplicity. It provides an uncluttered,

easy-to-understand view of a security’s price. Line charts are typically
displayed using a security’s closing prices.
10.3.2 Bar charts

A bar chart displays a security’s opening (if available) high, low and closing
prices. Bar charts are the most popular type of security chart. As illustrated
in the bar chart in Figure 10.2, the top of each vertical bar represents the
highest price the security traded during the period, and the bottom of the bar
represents the lowest price it traded. A closing “tick” is displayed on the
right side of the bar to designate the last price at which the security traded.
If opening prices are available, they are signified by a tick on the left side of
the bar.
Figure 10.2 Bar chart
10.3.3 Volume bar charts

Volume is usually displayed as a bar graph at the bottom of the chart (see
Figure 10.3). Most analysts monitor only the relative level of volume and,
as such, a volume scale is often not displayed.
Figure 10.3 ABC Ltd volume bar char
Figure 10.3 displays “zero-based” volume. This means the bottom of each
volume bar represents the value of zero. However, most analysts prefer to
see volume that is “relative adjusted” rather than zero-based. This is done
by subtracting the lowest volume that occurred during the period displayed
from all of the volume bars. Relative adjusted volume bars make it easier to
see trends in volume by ignoring the minimum daily volume.
Figure 10.4 displays the same volume information as in the previous chart,
but this volume is relative adjusted.
Figure 10.4 ABC Ltd relative volume bar chart
10.4 INDICATORS
An indicator is a mathematical calculation that can be applied to a security’s

price and/or volume fields. The result is a value that is used to anticipate
future changes in prices. A moving average fits this definition of an
indicator: it is a calculation that may be performed on a security’s price to
yield a value that can be used to anticipate future changes in prices. In the
following sections we briefly review a number of indicators.
10.4.1 Price fields

Technical analysis is based almost entirely on the analysis of price and
volume. The fields which define a security’s price and volume are
explained below.
Open. This is the price of the first trade for the period (e.g. the first trade
of the day). When analysing daily data, the open is especially important
as it is the consensus price after all interested parties were able to “sleep
on it”.
High. This is the highest price the security traded during the period. It is
the point at which there were more sellers than buyers (i.e. there are
always sellers willing to sell at higher prices, but the high represents the
highest price buyers were willing to pay).
Low. This is the lowest price the security traded during the period. It is
the point at which there were more buyers than sellers (i.e. there are
always buyers willing to buy at lower prices, but the low represents the
lowest price sellers were willing to accept).
Close. This is the last price the security traded during the period. Due to
its availability, the close is the price most often used for analysis. The
relationship between the open (the first price) and the close (the last
price) is considered significant by most technicians.
Volume. This is the number of shares (or contracts) that were traded
during the period. The relationship between prices and volume (e.g.
increasing prices accompanied by increasing volume) is important.
Open interest. This is the total number of outstanding contracts (i.e. those
that have not been exercised, closed, or expired) of a future or option.
Bid. This is the price a market maker is willing to pay for a security (i.e.
the price you will receive if you sell).
Ask. This is the price a market maker is willing to accept (i.e. the price
you will pay to buy the security).
10.4.2 Volume
Volume is just what the name implies: the volume of contracts traded on a
given day. When volume is heavy, the market is said to be very liquid. That
means you can get in or out of the market in almost any size position quite
easily. When volume is light, the market is said to be “thinly traded”. This
means you have to be careful to use specific price orders for buying or
selling or local traders can really take advantage of you.
Technical “buy” or “sell” signals occurring on light volume often prove to

be false signals. They can be accomplished by just a few traders trading
large positions and do not necessarily reflect the collective thinking of the
marketplace. That is why it is better to act on technical signals accompanied
by high volume. That means a lot of “opinions” were expressed in a
particular day’s trade and probably accurately reflected the prevailing view
of future market direction – for a while at least!
Heavy volume accompanied by rising prices implies that a large amount of

potential selling is being absorbed and any overhead resistance will be
minimal. The most important principle regarding volume is that it normally
accompanies the trend. In a healthy trend, volume should be increasing with
the trend, whether it be up or down. When the volume begins to back off, it
is the first sign that the rally may be running out of players and you should
be looking for a “sell” signal on the chart. But similarly, a healthy bear
market should also be attracting heavier and heavier volume as prices
decline.
Rules for interpreting volume:
Rising volume and price are a normal phenomenon. This combination

indicates that the market is in sync and has no forecasting value, except
that it is normal to expect the final top in prices to be preceded by a peak
in volume.
Volume normally leads price. A new high in price that is not confirmed
by volume should be suspect, and the current trend may be about to
reverse.
Rising price and falling volume are abnormal and indicate a weak rally.
Volume measures the enthusiasm of buyers relative to sellers. Higher
prices and lower volume indicate the market is rallying because there is a
shortage of sellers, not because buyers are enthusiastic. Sooner or later
the market will reach a price level that attracts sellers. When this occurs,
prices will fall substantially.
A parabolic rise in prices and a sharp increase in volume are
unsustainable, which typically results in an exhaustion move. Exhaustion
is characteristic of an important market turning point. Its significance will
depend upon the nature of the buying frenzy relative to its time span. A
buying panic spread over four or five days will have far less significance
than one that gradually builds over a number of weeks.
The reverse set of circumstances epitomises a selling climax. The
implications and principles for a buying panic hold true for a selling
climax, but in this case the trend reverses from down to up. Selling
climaxes normally, but not always, represent the final low of a declining
price trend. By definition, the rise in price following a selling climax is
accompanied by declining volume. This is one of the rare times that a
volume and price divergence is normal. It is important to note that
subsequent rallies will be accompanied by expanding volume, even
though the actual level will be below that experienced during the selling
climax.
When prices test an important low and are accompanied by lower
volume, this should be interpreted as a bullish cue. It is not important
whether the first low is marginally violated by the second low or the
second low holds just above the first. This almost non-existent volume
indicates a complete lack of selling interest.
An expansion of volume following a price peak during a consolidation,
or accompanied by a downward price-pattern completion is a bearish
sign because it indicates that volume is not going with the trend.
Choppy market activity characterised by a price that has been rallying for
some time accompanied by heavy volume are bearish signs.
An accumulation phase in a market is identified by stabilisation in prices
and a marked increase in volume. It is extremely bullish if prices break
out to the upside along with increasing volume.
Record volume coming off a major low is generally a reliable signal that
a significant bottom has been put in place and should never be
overlooked. Widespread disbelief in the rally by traders is an excellent
confirming signal.
Open interest is mostly used with option contracts, which are explained in
detail in Chapter 14. Unlike volume, which only measures the number of
contracts traded on the day, open interest refers to the cumulative number of
outstanding trades to date. And a “trade” refers to both the long and the
short side of every contract, not the sum total of each. In other words, one
short position matched by one long position represents one trade in open
interest. If 100 players hold one contract each, or 100 contracts, and their
position is matched by just 10 players with 10 contracts each, the open
interest is 100. It does not matter how many players are involved or what
the distribution of contracts among them is.
10.4.3.1 Rules for interpreting open interest
If prices are rising and open interest is increasing at a rate faster than its
five-year seasonal average, a bullish scenario is represented. More
participants are entering the market, involving additional buying, and
purchases are generally aggressive in nature.
If the open interest numbers flatten following a rising trend in both price
and open interest, take this as a warning of an impending top.
High open interest at market tops is a bearish signal. If the price drop is
sudden, this forces many “weak” longs to liquidate. If that begins to
happen, open interest will decline. But if open interest can remain flat
through a price break, then you know there are at least as many new
people coming in to buy as weak longs being chased out. That is a sign
the break is probably only corrective in nature – and temporary.
An unusually high or record open interest in a bull market is a warning
signal. When the rising trend of open interest begins to reverse, expect a
bear trend to begin.
A breakout from a trading range will be much stronger if open interest
rises during the consolidation. This situation is caused by traders caught
on the wrong side of the market when the breakout finally comes. When
the price moves out of the trading range, these traders are forced to
abandon their positions. In other words, the greater the rise in open
interest during a period of consolidation, the greater the explosiveness of
the subsequent move.
Rising prices and a faster-than-normal seasonal decline in open interest is
bearish. This situation develops because short-covering (liquidation of
previous short positions), not fundamental factors, is fuelling the rising
prices. In this situation, money is flowing out of the market.
Consequently, when the short-covering ends, prices will fall.
If prices are declining and open interest is rising faster than the seasonal
average, this is evidence of new short positions being acquired. As long
as this process continues, prices will continue to fall, but once these bears
begin to cover their short positions by buying them back, the market will
soon turn up.
A decline in both price and open interest indicates liquidation by
frustrated traders with long positions. As long as this trend continues, it is
a bearish sign. Once open interest stabilises at a lower level, the
liquidation is over and prices are then in a position to rally.
10.4.3.2 Price, volume and open interest interpretations: rising

market
Volume and open interest both increasing indicates buyers are bidding
prices higher at an accelerating rate, drawing in new players on the short
side. This is the healthiest condition for a bull market with plenty of
upside potential remaining.
Volume increasing, but open interest flat is usually the next stage of a
bull market, as previous shorts are forced to cover their positions amid
rising losses, neutralising the influx of new positions.
Volume still increasing, but open interest declining shows that a
combination of previous shorts covering their losses and early longs
taking profits now more than offsets new entrants to the market. The
market is beginning to run out of new buyers.
Volume declining, but open interest increasing means that liquidation of
prior positions has now subsided and bulls once again are adding
positions faster than old players are liquidating. Buyers and sellers are
more nervous and taking smaller positions.
Volume declining, but open interest flat again means that not only are
both bulls and bears less interested in adding to positions, but that
liquidation of prior positions is once again neutralising the number of
new positions.
Both volume and open interest declining is the weakest possible time for
a bull market before a major top. It means there are few willing to trade
and profit taking by prior longs is more than offsetting the addition of
fresh long positions. This is typically the last gasp of a bull market,
before bearish psychology takes over and the sellers assume control of
the trend, ending the bull market and beginning a downtrend through
aggressive selling.
10.4.3.3 Price, volume and open interest interpretations:

declining market
Volume and open interest both trending higher means sellers (bears) are
in control and aggressively driving prices lower at an accelerating pace.
This is the healthiest picture possible if you are looking for lower prices.
Volume increasing with open interest flat is the next stage of a bear
market, as previous longs are forced to cover their positions amid rising
losses, neutralising the influx of new short positions.
Volume still increasing, but open interest declining shows a combination
of previous longs covering their losses and early shorts taking profits,
which now more than offsets new entrants to the bear market. The market
is starting to run out of new sellers.
Volume now declining, but open interest increasing means that while
liquidation of prior positions has now subsided and bears are once again
adding new short positions faster than old players are liquidating, buyers
and sellers are taking smaller positions.
Volume declining, but open interest flat again means that not only are
bulls and bears less interested in adding to positions, but that liquidation
of prior positions is once again neutralising the number of new positions.
This is a sign the bear market has about run its course.
Both volume and open interest declining. This is the weakest possible
situation for a bear market before a major bottom. It means there are few
willing to trade and profit taking by prior shorts is more than offsetting
the addition of fresh short positions.
10.4.4 The time element

This section presents the time element in technical analysis. Much of
technical analysis focuses on changes in prices over time. Consider the
effect of time in the following charts, each of which shows a security’s price
increase from R25 to around R50. Figure 10.5 shows that the security’s
price increased consistently over a six-month time period. This chart shows
that investors continually reaffirmed the security’s upward movement.
Figure 10.5 The time element
What once looked expensive may one day look cheap as expectations
evolve. This is an interesting aspect of point and figure charts, because
these charts totally disregard the passage of time and display only changes
in price.
10.4.5 Support and resistance

Think of security prices as the result of a head-to-head battle between a bull
(the buyer) and a bear (the seller). The bulls push prices higher and the
bears push prices lower. The direction prices actually move reveals who is
winning the battle.
Using this analogy, consider the price action of Company X in Figure 10.6.
During the period shown, note how each time prices fell to the R45.50
level, the bulls (i.e. the buyers) took control and prevented prices from
falling further. That means that at the price of R45.50, buyers felt that
investing in Company X was worthwhile (and sellers were not willing to
sell for less than R45.50). This type of price action is referred to as support,
because buyers are supporting the price of R45.50.
Figure 10.6 Support

Similar to support, a resistance level is the point at which sellers take
control of prices and prevent them from rising higher. Consider Figure 10.7.
Note how each time prices neared the level of R51.50, sellers outnumbered
buyers and prevented the price from rising.
Figure 10.7 Resistance
The price at which a trade takes place is the price at which a bull and bear
agree to do business. It represents the consensus of their expectations. The
bulls think prices will move higher and the bears think prices will move
lower. Support levels indicate the price where the majority of investors
believe that prices will move higher, and resistance levels indicate the price
at which a majority of investors feel prices will move lower.
The development of support and resistance levels is probably the most

noticeable and reoccurring event on price charts. The penetration of
support/resistance levels may be triggered by fundamental changes above or
below investor expectations (e.g. changes in earnings, management or
competition) or by self-fulfilling prophecies (investors buy as they see
prices rise). The cause is not as significant as the effect – new expectations
lead to new price levels.
Figure 10.8 shows a breakout caused by fundamental factors. The breakout
occurred when the company released a higher-than-expected earnings
report. How do we know it was higher than expectations? By the resulting
change in prices following the report!
Figure 10.8 Breakout on earnings report
10.4.6 Linear regression

Linear regression is one of the accepted standards for identifying major
trends. This statistical model, based on volatility, produces a centre line, or
equilibrium price, around which prices will fluctuate; and buy and sell lines
that define the range of projected price fluctuation. In theory, 90% of all
prices will fall between the buy and sell lines. Long-term investors can buy
with a minimum of risk when the price approaches the buy line and sell
with maximum reward at the sell line. Figure 10.9 illustrates a linear
regression chart of Company X.
Figure 10.9 Linear regression
10.4.7 Trend lines

Trend lines are a result of market fluctuations. Markets fluctuate up and
down in a succession of peaks and troughs. If the peaks are getting higher
and higher, the trend is said to be up. Conversely, if the troughs are getting
lower and lower, the trend is down. Sometimes, both of these trends are
evident at the same time. This is a mixed trend and indicates a market trying
to decide whether to continue the previous trend or establish a new one. A
line can be drawn between successive peaks or troughs to graphically
illustrate the trend. It takes two points to define a trend and a third to
confirm it. The top line is termed the line of resistance and the line
connecting the troughs is termed the support line. Trends are most often
broken down into three categories: primary, secondary and minor.
Identifying the trend and the magnitude of the trend is the key to chart
analysis.
10.4.8 Supply and demand

There is nothing mysterious about support and resistance – it is classic
supply and demand. The supply line shows the quantity (i.e. the number of
shares) that sellers are willing to supply at a given price. When prices
increase, the number of sellers also increases as more investors are willing
to sell at these higher prices.
Figure 10.10 Trend lines
The demand line shows the number of shares that buyers are willing to buy
at a given price. When prices increase, the number of buyers decreases as
fewer investors are willing to buy at higher prices. At any given price, a
supply/demand chart shows how many buyers and sellers there are.
In a free market these lines are continually changing. As investor

expectations change, so do the prices buyers and sellers feel are acceptable.
A breakout above a resistance level is evidence of an upward shift in the
demand line as more buyers become willing to buy at higher prices.
Similarly, the failure of a support level shows that the supply line has
shifted downward. The concept of supply and demand is the foundation of
most technical analysis tools. Charts of security prices give us a superb
view of these forces in action.
10.4.9 Trends
In an earlier section, we discussed how support and resistance levels can be
penetrated by a change in investor expectations (which results in shifts of
the supply/demand lines). This type of change is often abrupt and “news
based”. In this section, we review trends. A trend represents a consistent
change in prices (i.e. a change in investor expectations). Trends differ from
support/resistance levels in that they represent change, whereas
support/resistance levels represent barriers to change. As shown in Figure
10.11, a rising trend is defined by successively higher low prices. A rising
trend can be thought of as a rising support level – the bulls are in control
and are pushing prices higher.
Figure 10.11 Rising trend line
Figure 10.12 shows a falling trend. A falling trend is defined by

successively lower high prices. A falling trend can be thought of as a falling
resistance level – the bears are in control and are pushing prices lower.
Figure 10.12 Falling trend line
Just as prices penetrate support and resistance levels when expectations

change, prices can penetrate rising and falling trend lines.
A good way to quantify expectations following a breakout is with the

volume associated with the price breakout. If prices break through the
support/resistance level with a large increase in volume and the traders’
remorse period is on relatively low volume, it implies that the new
expectations will rule (a minority of investors are remorseful). Conversely,
if the breakout is on moderate volume and the “remorseful” period is on
increased volume, it implies that very few investor expectations have
changed and a return to the original expectations (i.e. original prices) is
warranted.
10.4.10 Resistance becomes support

When a resistance level is successfully penetrated, that level becomes a
support level. Similarly, when a support level is successfully penetrated,
that level becomes a resistance level. An example of resistance changing to
support is shown in Figure 10.13. When prices broke above the resistance
level of R45.00, the level of R45.00 became the new support level. This is
because a new “generation” of bulls who had not bought when prices were
less than R45 (they did not have bullish expectations then) are now anxious
to buy any time prices return near the R45 level.
Similarly, when prices drop below a support level, that level often becomes
a resistance level that prices have difficulty in penetrating. When prices
approach the previous support level, investors seek to limit their losses by
selling (see Figure 10.13).
Figure 10.13 Resistance becomes support
10.5 MOVING AVERAGES
Moving averages are one of the oldest and most popular technical analysis
tools. This chapter describes the basic calculation and interpretation of
moving averages. A moving average is the average price of a security at a
given time. When calculating a moving average, you specify the time span
to calculate the average price (e.g. 25 days).
A “simple” moving average is calculated by adding the security’s prices for

the most recent n time periods and then dividing by n; for example, adding
the closing prices of a security for the most recent 25 days and then
dividing by 25. The result is the security’s average price over the last 25
days. This calculation is done for each period in the chart. Note that a
moving average cannot be calculated until you have n time periods of data.
For example, you cannot display a 25-day moving average until the 25th
day in a chart.
Figure 10.14 25-day simple moving average
Since the moving average in this chart is the average price of the security
over the last 25 days, it represents the consensus of investor expectations
over the last 25 days. If the security’s price is above its moving average, it
means that investors’ current expectations (i.e. the current price) are higher
than their average expectations over the last 25 days, and that investors are
becoming increasingly bullish on the security. Conversely, if a day’s price is
below its moving average, it shows that current expectations are below
average expectations for the last 25 days.
10.5.1 Interpretation of moving average

The classic interpretation of a moving average is to use it to observe
changes in prices. Investors typically buy when a security’s price rises
above its moving average and sell when the price falls below its moving
average.
“Buy” arrows are drawn on the chart in Figure 10.15 when a security’s
price rose above its 200-day moving average; “sell” arrows are drawn when
the price fell below its 200-day moving average.
Figure 10.15 Moving average buy-sell signal
Long-term trends are often isolated using a 200-day moving average. You
can also use computer software to automatically determine the optimum
number of time periods. Ignoring commissions, higher profits are usually
found using shorter moving averages.
10.5.2 Merits
The merit of this type of moving average system (i.e. buying and selling
when prices penetrate their moving average) is that you will always be on
the “right” side of the market – prices cannot rise very much without the
price rising above its average price. The disadvantage is that you will
always buy and sell late. If the trend does not last for a significant period of
time, typically twice the length of the moving average, you will lose money.
10.6 LEADING VERSUS LAGGING INDICATORS
A moving average is an example of a trend-following, or -lagging,

indicator. (See Figure 10.16.) These indicators are superb when prices move
in relatively long trends. They do not warn you of upcoming changes in
prices; they simply tell you what prices are doing (i.e. rising or falling) so
that you can invest accordingly. Trend-following indicators cause you to
buy and sell late and, in exchange for missing the early opportunities, they
greatly reduce your risk by keeping you on the right side of the market.
Figure 10.16 Lagging indicator
Another class of indicators are leading indicators. These indicators help you
profit by predicting what prices will do next. Leading indicators provide
greater rewards at the expense of increased risk. They perform best in
sideways-trading markets.
Leading indicators typically work by measuring how overbought or

oversold a security is. This is done with the assumption that a security that
is oversold will bounce back. (See Figure 10.17.)
Figure 10.17 Leading indicator
What type of indicator you use, leading or lagging, is a matter of personal

preference. Most investors are better at following trends than predicting
them. Many successful investors prefer leading indicators.
10.7 DOW THEORY
In 1897, Charles Dow developed two broad market averages: the “Industrial
Average” included 12 blue-chip stocks and the “Rail Average” comprised
20 railroad enterprises. These are now known as the Dow Jones Industrial
Average and the Dow Jones Transportation Average. The Dow Theory
resulted from a series of articles published by Charles Dow in The Wall
Street Journal between 1900 and 1902. The Dow Theory is the common
ancestor of most principles of modern technical analysis.
Interestingly, the theory itself originally focused on using general stock
market trends as a barometer for general business conditions. It was not
originally intended to forecast stock prices. However, subsequent work has
focused almost exclusively on this use of the theory.
10.7.1 Interpretation and assumptions

The Dow Theory comprises six assumptions:
10.7.1.1 The averages discount everything

An individual stock’s price reflects everything that is known about the
security. As new information arrives, market participants quickly
disseminate the information and the price adjusts accordingly. Likewise, the
market averages discount and reflect everything known by all stock market
participants.
10.7.1.2 The market is made up of three trends

At any given time in the stock market, three forces are in effect: the primary
trend, secondary trends and minor trends. Figure 10.18 illustrates these
trends.
Figure 10.18 Primary, secondary and minor trends
The primary trend may be either a bullish (rising) market or a bearish

(falling) market. The primary trend usually lasts more than one year and
may last for several years. If the market is making successive higher highs
and higher lows the primary trend is up. If the market is making successive
lower highs and lower lows, the primary trend is down.
Secondary trends are intermediate, corrective reactions to the primary trend.

These reactions typically last from one to three months and retrace from
one-third to two-thirds of the previous secondary trend. Figure 10.18 shows
a primary trend (line A) and two secondary trends (B and C).
Minor trends are short-term movements lasting from one day to three
weeks. Secondary trends typically consist of a number of minor trends. The
Dow Theory holds that, since stock prices over the short term are subject to
some degree of manipulation (primary and secondary trends are not), minor
trends are unimportant and can be misleading.
10.7.1.3 Primary trends have three phases

The Dow Theory says that the first phase is made up of aggressive buying
by informed investors in anticipation of economic recovery and long-term
growth. The general feeling among most investors during this phase is one
of “gloom and doom” and “disgust”. The informed investors, realising that
a turnaround is inevitable, aggressively buy from these distressed sellers.
The second phase is characterised by increasing corporate earnings and

improved economic conditions. Investors will begin to accumulate stock as
conditions improve.
The third phase is characterised by record corporate earnings and peak

economic conditions. The general public (having had enough time to forget
about their last “scathing”) now feel comfortable participating in the stock
market – fully convinced that the stock market is headed for the moon.
They now buy even more stock, creating a buying frenzy. It is during this
phase that those few investors who did the aggressive buying during the
first phase begin to liquidate their holdings in anticipation of a downturn.
Figure 10.19 illustrates three phases of the Dow Industrials during the years
leading up to October 1987.
Figure 10.19 Primary trends phases
In anticipation of a recovery from the recession, informed investors began

to accumulate stock during the first phase (box A). A steady stream of
improved earnings reports came in during the second phase (box B),
causing more investors to buy stock. Euphoria set in during the third phase
(box C), as the general public began to buy stock aggressively.
10.7.1.4 The averages must confirm each other

The Industrials and Transports must confirm each other in order for a valid
change of trend to occur. Both averages must extend beyond their previous
secondary peak (or trough) in order for a change of trend to be confirmed.
Figure 10.20 shows the beginning of a bull market, say in 1992.
Figure 10.20 Averages in different market segments
Confirmation of the change in trend occurred when both averages rose

above their previous secondary peak.
10.7.1.5 The volume confirms the trend

The Dow Theory focuses primarily on price action. Volume is only used to
confirm uncertain situations. Volume should expand in the direction of the
primary trend. If the primary trend is down, volume should increase during
market declines. If the primary trend is up, volume should increase during
market advances. Figure 10.21 shows expanding volume during an up
trend, confirming the primary trend.
Figure 10.21 Volume confirms the trend
10.7.1.6 A trend remains intact until it gives a definite reversal

signal
An up trend is defined by a series of higher highs and higher lows. In order
for an up trend to reverse, prices must have at least one lower high and one
lower low (the reverse is true of a down trend). When a reversal in the
primary trend is signalled by both the Industrials and Transports, the odds
of the new trend continuing are at their greatest. However, the longer a
trend continues, the progressively smaller become the odds of the trend
remaining intact..
10.8 OVERBOUGHT/OVERSOLD OSCILLATOR

The overbought/oversold (OB/OS) indicator shows when the stock market
is overbought (and a correction is due) and when it is oversold (and a rally
is due). Oscillators are so named because their value oscillates between a
predefined range. Also called momentum indicators, they are the most
widely used tools of seasoned traders, yet the least-understood tools used by
beginning traders. The sole function of momentum indicators is to measure
the rate at which prices rise and fall, and then present them in a graphical
format. These indicators often give advanced warning of the latent strength
or weakness in a specific price trend.
As with all OB/OS-type indicators, extreme readings may be a sign of a

change in investor expectations and might be followed by a correction.
Figure 10.22 shows the overbought/oversold indicator.
Figure 10.22 OB/OS graph
“Buy” and “sell” arrows are drawn when the indicator penetrates a given
level, say +200/–200 levels in Figure 10.22. The OB/OS indicator works
very well in this type of trading-range market.
The overbought/oversold indicator is a tenperiod exponential moving

average of the difference between the number of advancing and declining
issues. The OB/OS indicator is an excellent tool to use in combination with
other technical tools, to either support or refute other technical signals.
The advantage of the technical interpretation of overbought and oversold

areas is that they represent an intelligent point for anticipating a trend
reversal. By definition, an overbought condition is a market that has risen
too far and/or too fast to be sustained. A temporary pullback is inevitable,
even if the move is eventually destined to go much higher. By definition, an
oversold condition is a market that has fallen too far and/or too fast to be
sustained. At least a temporary rally is likely, even if the move will
eventually make new lows.
What causes overbought and oversold conditions? Rising prices attract

optimism, positive news stories and bullish sentiment. Falling prices attract
pessimism, negative news and bearish sentiment. The overbought or
oversold areas are where you should consider taking profits, reducing your
exposure by tightening your stops or hedging your position. Reactions are
almost always reversed at the oversold line. This trait is characteristic of a
“bull” market. Anticipation by eager traders to sell tops causes this
formation.
Oscillators normally peak and bottom at roughly the same time as prices.
However, this is not always the case. Momentum indicators can and do turn
ahead of price; this is known as divergence. Divergence is a conflict
between momentum and price. When momentum indicators do not confirm
the price action, beware. The prevailing trend may be about to reverse.
Divergences in and of themselves do not signal that the trend has reversed.
That can only come from some kind of trend-reversal signal generated by
price itself. This signal can take many forms: a price pattern completion, a
moving average cross-over or some other signal.
Generally, the more divergence that occurs, the greater its significance.
Initial divergence indicates a need for corrective action in the market, but a
failure of price to respond indicates that fewer informed investors are
buying or selling as more uninformed buyers and sellers are moving into
the market. This additional distribution means that the corrective process,
when it finally does begin, is likely to be that much more severe. The time
separating the divergent action is also important. Usually, the greater the
time span, the greater the significance.
The use of oscillators helps to furnish early warning signals of the loss of
momentum. However, all indicators, regardless of how sound, can and do
fail from time to time. That is why it is best to follow at least two and
preferably several oscillators, looking for trades where you have agreement
among the oscillators as to whether you should buy or sell.
10.9 ABSOLUTE BREADTH INDEX
The Absolute Breadth Index (ABI) is a market momentum indicator that

was developed by Norman G. Fosback. The ABI shows how much activity,
volatility, and change are taking place on the New York Stock Exchange,
while ignoring the direction prices are headed.
You may think of the ABI as an “activity index”. High readings indicate
market activity and change, while low readings indicate lack of change. In
Fosback’s book, Stock market logic (1976: 40), he indicates that
historically, high values typically lead to higher prices three to twelve
months later. Fosback found that a highly reliable variation of the ABI is to
divide the weekly ABI by the total issues traded. A ten-week moving
average of this value is then calculated. Readings above 40% are very
bullish and readings below 15% are bearish.
Example: Figure 10.23 shows an index and a five-week moving average of

the ABI. Strong rallies occurred every time the ABI’s moving average rose
above 310. The ABI is calculated by taking the absolute value of the
difference between an exchange’s advancing issues and its declining issues.
Absolute value (i.e. ABS) means “regardless of sign”. Thus, the absolute
value of –100 is 100 and the absolute value of +100 is also 100.
Figure 10.23 Absolute Breadth Index
10.10 BREADTH THRUST
The Breadth Thrust indicator is a market momentum indicator. The Breadth

Thrust is calculated by dividing a ten-day exponential moving average of
the number of advancing issues by the number of advancing plus declining
issues.
A “Breadth Thrust” occurs when, during a ten-day period, the Breadth

Thrust indicator rises from below 40% to above 61.5%. A “Thrust”
indicates that the stock market has rapidly changed from an oversold
condition to one of strength, but has not yet become overbought.
Example: Figure 10.24 shows the Breadth Thrust indicator of a share

market index. Horizontal lines are drawn on the Breadth Thrust indicator at
40.0% and 61.5%. Remember that a Thrust occurs when the indicator
moves from below 40% to above 61.5% during a ten-day period. In 1984 in
the US, one analyst wrote:
At the time this discussion on the Breadth Thrust is being written

(18/12/84), the NYSE has gained only 1.6% since the “Thrust”. If
the market fails to go higher in the next six to twelve months, it
will be the first false signal generated by the Breadth Thrust
indicator in 39 years! With historical average gains of almost
25%, we feel the odds are in our favour when we go with the
Thrust (Seyles, 1984).
Figure 10.24 Breadth Thrust
The NYSE did in fact go higher in the ensuing months. Twelve months after
the Thrust occurred the NYSE was up 21.6%. Twenty-one months after the
Thrust occurred, the NYSE was up a whopping 51%. Trust the next thrust
…
10.11 LINE STUDIES

Line studies are technical analysis tools that consist of lines drawn on top of
a security’s price and/or indicator. These include the support, resistance, and
trend line concepts already discussed. Figure 10.25 illustrates several line
studies. On the figure you will notice Fibonacci arcs and retracements.
These are now briefly discussed.
Figure 10.25 Line studies
Fibonacci arcs and retracements

Fibonacci arcs and retracements help anticipate support and resistance
levels along with price targets. After making long, sustained moves in one
direction, many markets retrace a part of the move before continuing on
further. The Fibonacci indicator, popularised by Ralph Nelson Elliot (1997),
is used to try to forecast potential support levels and price targets based on
the height of the overall move and any wave patterns.
For example, if a stock increased from R5 to R10 and then slipped back
50%, this retracement would take it to R7.50 before it continued upwards
again.
Fibonacci retracements
Fibonacci retracements are based on a trend line drawn between a
significant trough and peak. If the trend is rising, the retracement lines will
descend from 100% to 0%. If the trend line is falling, the retracement lines
will ascend from 0% to 100%. Horizontal lines are drawn at the common
Fibonacci levels of 38%, 50%, and 62%. As the price retraces, support and
resistance often occur at or near the Fibonacci retracement levels. Fibonacci
arcs
Fibonacci arcs can be added to the same chart, or they can be charted alone.
The arcs are drawn centred on the last peak or trough, crossing the original
trend line at the points where the retracement lines intersect. The price will
tend to “react” to both the arcs and the retracement levels, as they provide
support and resistance.
10.12 MARKET INDICATORS
All of the technical analysis tools discussed up to this point were calculated
using a security’s price (e.g. high, low, close, volume, etc.). There is another
group of technical analysis tools designed to help you gauge changes in all
securities within a specific market. These indicators are usually referred to
as “market indicators”, because they gauge an entire market, not just an
individual security. Market indicators typically analyse the stock market,
although they can be used for other markets (e.g. futures).
While the data fields available for an individual security are limited to its
open, high, low, close, volume (see section 10.4), and sparse financial
reports, there are numerous data items available for the overall stock
market. For example, the number of stocks that made new highs for the day,
the number of stocks that increased in price, the volume associated with the
stocks that increased in price, and so on. Market indicators cannot be
calculated for an individual security because the required data are not
available.
Market indicators add significant depth to technical analysis, because they
contain much more information than price and volume. A typical approach
is to use market indicators to determine where the overall market is headed
and then use price/volume indicators to determine when to buy or sell an
individual security. The analogy being “all boats rise in a rising tide”, it is
therefore much less risky to own stocks when the stock market is rising.
10.12.1 Categories of market indicators

Market indicators typically fall into three categories: monetary, sentiment
and momentum. Monetary indicators concentrate on economic data such as
interest rates. They help you determine the economic environment in which
businesses operate. These external forces directly affect a business’s
profitability and share price. Examples of monetary indicators are interest
rates, the money supply, consumer and corporate debt, and inflation.
Sentiment indicators focus on investor expectations, often before those

expectations are discernible in prices. With an individual security, the price
is often the only measure of investor sentiment available. However, for
large markets, many more sentiment indicators are available. These include
the number of odd-lot sales (i.e. what are the smallest investors doing?), the
put/call ratio (i.e. how many people are buying puts versus calls?), the
premium on stock index futures, the ratio of bullish versus bearish
investment advisors, and so on.
“Contrarian” investors use sentiment indicators to determine what the

majority of investors expect prices to do; they then do the opposite, the
rationale being that, if everybody agrees that prices will rise, there are
probably not enough investors left to push prices much higher. This concept
is well proven – almost everyone is bullish at market tops (when they
should be selling) and bearish at market bottoms (when they should be
buying).
The third category of market indicators, momentum, shows what prices are
actually doing, but do so by looking deeper than price. Examples of
momentum indicators include all of the price/volume indicators applied to
the various market indices (e.g. the Moving Average Convergence
Divergence (MACD) of the Dow Industrials), the number of stocks that
made new highs versus the number of stocks making new lows, the
relationship between the number of stocks that advanced in price versus the
number that declined, and the comparison of the volume associated with
increased price with the volume associated with decreased price.
Given the above three groups of market indicators, we have insight into:
The external monetary conditions affecting security prices. This tells us

what security prices should do.
The sentiment of various sectors of the investment community. This tells
us what investors expect prices to do.
The current momentum of the market. This tells us what prices are
actually doing.
10.12.2 Relative Strength Index

The Relative Strength Index (RSI) is a popular oscillator. The name is
slightly misleading as the RSI does not compare the relative strength of two
securities, but rather the internal strength of a single security. A more
appropriate name might be “Internal Strength Index”.
When the RSI was introduced, a 14-day RSI was recommended. Since then,
the 9-day and 25-day RSIs have also gained popularity. Because you can
vary the number of time periods in the RSI calculation, an experiment to
find the period that works best for an investor is suggested. The fewer days
used to calculate the RSI, the more volatile the indicator.
The RSI is a price-following oscillator that ranges between 0 and 100. A

popular method of analysing the RSI is to look for a divergence in which
the security is making a new high, but the RSI is failing to surpass its
previous high. This divergence is an indication of an impending reversal.
When the RSI then turns down and falls below its most recent trough, it is
said to have completed a “failure swing”. The failure swing is considered a
confirmation of the impending reversal.
In general, there are five uses of the RSI when analysing commodity charts.
These methods can be applied to other security types as well. The RSI
usually tops above 70 and bottoms below 30. It usually forms these tops
and bottoms ahead of the underlying price chart.
The RSI often forms chart patterns such as head and shoulders or triangles
that may or may not be visible on the price chart.
Failure swings. Failure swings, also known as support or resistance

penetrations or breakouts, are where the RSI surpasses a previous high
(peak) or falls below a recent low (trough).
Support and resistance. The RSI shows, sometimes more clearly than
prices themselves, levels of support and resistance.
Example: Figure 10.26 shows ABC Ltd’s RSI. A bullish divergence

occurred during July and August as prices were falling while the RSI was
rising. Prices subsequently corrected and trended upward. The RSI is a
fairly simple formula, but is difficult to explain without pages of examples.
Figure 10.26 Relative Strength Index for ABC Ltd
10.12.3 Positive Volume Index

The Positive Volume Index (PVI) focuses on days where the volume
increased from the previous day, the premise being that the “crowd” takes
positions on days when volume increases.
Interpretation of the PVI assumes that on days when volume increases, the
crowd-following, “uninformed” investors are in the market. Conversely, on
days with decreased volume, the smart money is quietly taking positions.
Thus, the PVI displays what the not-so-smart-money is doing. (The
Negative Volume Index displays what the smart money is doing. See
http://www.equis.com/free/taaz/negvolind.html.) Note, however, that the
PVI is not a contrarian indicator. Even though the PVI is supposed to show
what the not-so-smart-money is doing, it still trends in the same direction as
prices. Because rising prices are usually associated with rising volume, the
PVI usually trends upward.
10.13 CHALLENGES TO TECHNICAL ANALYSIS
It is futile to assign an intrinsic value to a share certificate. One share of

Anglo, for example, was worth R260 in September 1994, but you could buy
it for only R150 in June 1999. By March 2000 it was selling for R340 and
just one year later for R200. This sort of thing, this wide divergence
between presumed value and intrinsic value, is not the exception; it is the
rule and it is going on all the time. The fact is that the real value of DiData
is determined at any given time solely, definitely and inexorably by supply
and demand, which are accurately reflected in the transactions
consummated on the floor of the exchange.
Of course, it is freely admitted that the statistics which the fundamentalists

study play a part in the supply and demand equation. But there are many
other factors affecting it. The market price reflects the differing fears and
guesses and moods, rational and irrational, of hundreds of potential buyers
and sellers, as well as their needs and resources – in total, factors which
defy analysis and for which no statistics are obtainable but which
nevertheless are all synthesised, weighted and finally expressed in the one
precise figure at which a buyer and seller get together and make a deal. This
is the only figure that counts.
A fitting conclusion to the discussion on technical analysis is a list of

lessons that have been learned, both from others and the hard way:
Do not compound your losses by averaging down (i.e. do not keep

buying additional shares at lower prices). It is tempting to think that a
loss “does not count” until the position is closed – but it does!
Whenever you own a security, ask yourself if you would buy it today. If
you would not buy it, you should consider selling it.
Do not get distracted by others’ investment prowess. Most investors only
discuss their successes, threatening your focus and confidence.
Wise investments are not made from the heart, they are made using
logical approaches that minimise risks and maximise opportunities.
Master the basics. Most investors spend their time looking for easy
money (which is not an easy search) instead of learning the key factors to
security prices – supply and demand.
10.14 SUMMARY
Technical analysis is in most instances an attempt to exploit recurring and

predictable patterns in share prices to generate abnormal trading profits. It
is accepted as a viable analytical approach by most investors. Rarely are
large investments made without reviewing the technical climate. Yet even
with its acceptance, the number of people who actually perform technical
analysis remains relatively small. A brief summary of some of the tools of
technical analysis discussed in this chapter follows here. Line charts are the
simplest type of chart. The single line represents the security’s closing price
on each day. Dates are displayed along the bottom of the chart and prices
are displayed on the side(s). A bar chart displays a security’s opening (if
available), high, low and closing prices. Bar charts are the most popular
type of security chart.
Volume is usually displayed as a bar graph at the bottom of the chart. Most
analysts monitor only the relative level of volume and as such, a volume
scale is often not displayed. Much of technical analysis focuses on changes
in prices over time. Linear regression is one of the accepted standards for
identifying major trends. This statistical model, based on volatility,
produces a centre-line, or equilibrium price, around which prices will
fluctuate, and buy and sell lines that define the range of projected price
fluctuation.
Support and resistance levels may be penetrated by a change in investor

expectations (which results in shifts of the supply/demand lines). This type
of change is often abrupt and “news-based”. Moving averages are one of
the oldest and most popular technical analysis tools. This chapter described
the basic calculation and interpretation of moving averages. A moving
average is the average price of a security at a given time. The
overbought/oversold indicator shows when a stock market is overbought
(and a correction is due) and when it is oversold (and a rally is due). As
with all OB/OS-type indicators, extreme readings may be a sign of a change
in investor expectations and may not be followed by the expected
correction.
Finally, historians who have examined the behaviour of financial markets

over time have challenged the assumption of rationality that underlies much
of efficient market theory. They point to the frequency with which
speculative bubbles have formed in financial markets, as investors buy into
fads or get-rich-quick schemes, and the crashes with which these bubbles
have ended, and suggest that there is nothing to prevent the recurrence of
this phenomenon in today’s financial markets.
In the next chapter, we look at the fundamentals of the analysis of fixed

interest securities. This covers, among other topics, basic characteristics of
bonds or debentures, the calculation of the holding period return of a bond
or debenture, and the different risk exposures associated with bonds or
debentures.
Achelis, S.B. 2000. Technical analysis from A to Z. New York: Equis International.
Hill.
Brown, D. & Jennings, R.H. 1989. On technical analysis. Review of Financial Studies, 2: 527–552.
Elliott, R.N. 1997. R.N. Elliott’s market letters: 1938–1946. New York: New Classics Library.
Fosback, N.G. 1976. Stock market logic. London: Institute for Econometric Research.
Seyles, P. 1984. The Breadth Thrust works. Wall Street, 18 December.
1. Which of the following is a contrary opinion rule?
(a) Short sales by specialists

(b) Confidence Index
(c) OTC–JSE volume
(d) All of the above
2. Which of the following is not an assumption of technical analysis?
(a) Prices are a function of supply and demand.

(b) Prices adjust rapidly and completely to new information.
(c) Prices tend to move in trends.
(d) Supply and demand are determined by many factors, both rational and
irrational.
3. Technical analysis stands in opposition to which form of the efficient market
hypothesis?
(a) Weak
(b) Semi-strong
(c) Strong
(d) Super-strong
4. Which of the following is closest to the underlying assumption of contrary opinion
rules?
(a) The market, on average, is right.
(b) Small investors, on average, are wrong.
(c) Large investors, on average, are right.
(d) Small investors, on average, are right.
5. Which of the following is an advantage of technical analysis?
(a) It relies on financial statements.

(b) It only has to identify a pattern in prices.
(c) It is very subjective.
(d) Trading rules do not change with market conditions.
6. Which of the following rules is a contrary opinion rule that relies on cash
balances?
(a) Debit balances in brokerage accounts

(b) Short sales by specialists
(c) Advance decline ratio
(d) Mutual fund cash balances
7. Which of the following is true about block trades?
(a) A block uptick is probably started by a seller.

(b) A block downtick is probably started by a seller.
(c) A value around 1.20 is bearish.
(d) A value around 0.70 is bullish.
8. If the current price rises through the 200-day moving average from below, this is:
(a) a positive signal

(b) a negative signal
(c) a neutral signal
(d) possibly a positive signal, but it needs confirmation
9. Two assumptions of technical analysis are that security prices adjust:
(a) gradually to new information, and study of the economic environment provides
an indication of future market movements
(b) rapidly to new information, and study of the economic environment provides an
indication of future market movements
(c) rapidly to new information, and market prices are determined by the interaction
between supply and demand
(d) gradually to new information, and prices are determined by the interaction
between supply and demand
10. Which one of the following would be a bullish signal to a technical analyst using
contrary opinion rules?
(a) The level of credit balances in investor accounts declines.
(b) The ratio of bearish investment advisors to the number of advisory services
expressing an opinion increases.
(c) A large proportion of speculators expect the price of stock index futures to rise.
(d) The ratio of over-the-counter (OTC) volume to the exchange (JSE) volume is
relatively high.
11. Which one of the following would be a bearish signal to a technical analyst?
(a) The debit balances in brokerage accounts increase.

(b) The market shows poor performance when compared to individual stocks.
(c) The yield differential between high-quality and low-quality bonds increases.
(d) The ratio of short sales by specialists to total short sales becomes abnormally
low.
Solutions
1. (c)
2. (b)
3. (a)
4. (b)
5. (b)
6. (c)
7. (d)
8. (a)
9. (d)
10. (b)
11. (c)
1 Definition of the random walk theory: It is an economic theory according to which market
price movements move randomly. This assumes an efficient market. The theory also assumes
that new information comes to the market randomly. Together, the two assumptions imply that
market prices move randomly as new information is incorporated into market prices. The
theory further implies that the best predictor of future prices is the current price, and that past
prices are not a reliable indicator of future prices.
PART
3
The analysis of bonds

OVERVIEW
Chapter 11 Bond fundamentals

Chapter 12 Valuation of bonds
Fixed interest securities are one of the asset classes the investor has to
include in his portfolio in order to achieve diversification
Chapter 11 explains the basic characteristics of bonds, the calculation of

the holding period return and risk exposures of bonds. The rating of bonds
and the use of bond indices are also explained, followed by an overview of
bonds with embedded options and international bonds.
Chapter 12 looks at bond valuation, the price-yield relationship of bonds,

the theory of yield curves, duration and convexity.
11 Bond fundamentals
11.1 INTRODUCTION
A bond is a long-term loan with fixed interest payments where an investor

agrees to loan money to a company or government in exchange for a
predetermined interest rate. The company issues bonds to various interested
parties in the capital market. These are purchased with the understanding
that the company will pay back its original loan amount plus any interest
that is due by a set date, which is called the bond’s maturity date. Bonds
should not be confused with mortgage bonds, which are bonds secured by a
mortgage on one or more assets, such as real estate.
National and local governments as well as public enterprises issue bonds to

finance infrastructure and fund development through the procurement of
private capital in the capital market. The capital market can be divided into
a primary and a secondary market. In the capital market new bonds are
issued into what is called the primary market. In the secondary capital
market the bonds are generally sold by and transferred from one investor to
another.
For the investor, the capital or bond market offers risk diversification,
encouraging increased savings and investment. The bond market is
normally perceived as a wholesale market focused on institutional products
and clients, which include pension funds, insurance companies and
investment banks. Institutional investors allocate assets (funds under
management) primarily between equities and bonds, which is the traditional
approach to asset allocation.
11.2 THE BOND MARKET IN SOUTH AFRICA
The South African bond market is often perceived as a leader among

emerging-market economies. It is highly liquid and worth approximately
180 billion US dollars, with a total turnover exceeding two trillion US
dollars in 2011. This debt market is the largest listed debt market in Africa,
in terms of both market capitalisation and liquidity. The South African
government is the largest issuer of debt; other issuers include South African
State-owned companies such as Telkom. Corporate companies and banks
also issue bonds for funding purposes. Non-resident trading (foreign
investors) in South African bonds has risen substantially, with foreign
ownership of government bonds exceeding 30% during 2012.
11.2.1 The Johannesburg Stock Exchange

In South Africa the Johannesburg Stock Exchange (JSE) has regulated the
debt market in South Africa since 2009. Before 2009 the bond market was
regulated by a private company, the Bond Exchange of South Africa. The
JSE is currently ranked the 19th largest stock exchange in the world by
market capitalisation, and the largest stock exchange on the African
continent. It offers both primary and secondary capital markets across a
wide range of bonds. In addition, it offers post-trade and regulatory
services. The JSE also offers a variety of bond-based derivatives
instruments, which include bond futures, forward-rate agreements, swaps
and standard bond options.
Investors buy bonds in order to earn regular interest payments and receive
the funds invested after a predetermined period. Bonds that are listed on the
JSE Debt Board improve the issuers’ ability to raise finance because the
Board allows investors to sell the loan to other investors should they wish to
do so.
11.2.2 Government bonds

A government bond is a bond issued by the South African government
denominated in the country’s own currency, namely rand. Government
bonds are usually referred to as risk free because the government can raise
taxes or create additional currency in order to redeem the bond at maturity.
A prerequisite for a sustainable and strong bond market is a well-developed

and well-functioning government bond market. The reason for this is that
government bonds provide risk-free yields and are used as benchmarks off
which corporate bonds are priced.
An example of a South African government bond is the R186, which carries

a coupon rate of 10.5% and matures on 21 December 2026. South African
bonds normally trade in denominations of one million rand.
In addition, the government of South Africa issues retail bonds to the

general public. A minimum of R1000 (i.e. the principal) is required to
purchase a bond, subject to a maximum of R1 million. No fees,
commissions or charges are payable. Depending on the specific term, each
bond earns a fixed interest rate (i.e. coupon) as determined at the time of
purchase. Each bond will trade at par since the coupon rate will always
equal the prevailing market rate when transacting. The coupon interest is
also paid twice a year. Redemption occurs at maturity with the option to
reinvest for another term.
11.2.3 Municipal bonds

Municipal bonds are issued by South African government entities to
generate income with which to meet capital expenditure on, for example,
the construction of highways, bridges and schools. In South Africa the City
of Johannesburg Metropolitan Municipality was the first to launch publicly
listed bonds in 2004.
There is often very little information available concerning individual

municipal bonds and this forces investors to rely heavily on the credit
ratings. It is preferable for investors to find out who is responsible for
servicing the interest payments on the bonds and the underlying economics
of the issuer.
An example of a municipal bond is the City of Cape Town 12.57% CCT01

(2008–2023) bond. Municipal bonds trade at a spread above the
corresponding RSA bonds as they are tax exempt but not risk free. Tax-
exempt bonds offer lower yields compared to taxable bonds because those
yields are after-tax yields. The higher an investor’s marginal tax rate, the
more attractive a tax-exempt issue becomes compared to a taxable issue. A
taxable or a tax-free yield should be converted to an after-tax yield (ATY)
or taxable equivalent yield (TEY) respectively in order to compare different
issues.
11.2.4 Corporate bonds

Corporate bonds are issued by private companies to obtain debt financing
for projects or capital/business expansion. A risk premium (margin or
spread) is added to the government yield curve or specific government
reference bond in order to price these bonds. The size of this premium is
determined by the creditworthiness of a particular issuer.
Financial services (ABSA, Standard Bank, Old Mutual and Sanlam),

mining (Anglo American), manufacturing (Barloworld and SAB Miller)
and construction companies (Group Five) are among those that have bonds
listed on BESA.
The corporate bond market comprises a much smaller percentage of the

nominal value in issue compared to the government bond market.
Compared to government bonds, corporate bonds generally have a higher
risk of default. This risk depends upon the specific corporation issuing the
bond, the current market conditions and government bonds to which the
corporate bond issuer is being compared, and the rating of the corporate.
Corporate bondholders are compensated for this risk by receiving a higher
yield than they would for government bonds.
11.3 BOND FUNDAMENTALS
A bond is a fixed income security that promises to pay a stream of annual or

semi-annual payments for a given number of years and to repay the loan
amount at the maturity date. The bond issuer borrows money (a debt
obligation) from the bondholder in order to acquire money for capital
expansion or to finance a specific project. An external source of finance, as
opposed to owner’s capital (private company), debt financing is an
alternative to equity financing (issuing of shares) or taxes (government or
municipalities).
11.3.1 Pricing a bond

In South Africa the following two formulas are used to price bonds:
Bonds with more than six months to redemption

d
1
d 1 n
2 i
V g (an + e) + 100V
i 2 i
where: d1 = number of days from settlement date to next interest

date
d2 = number of days from last to next interest date or
from settlement date to next interest date or from
settlement date to next interest date if settlement
falls on an interest date
1 = yield at which bond trades, as a percentage
Vi = 1 / (1 + 1/200)
= present value of 1 payable in six months’ time
g = coupon as a percentage
n = number of complete six-month periods from net
interest date to redemption date
ani = (1 – Vin) / (1/200)
= present value of an annuity of 1 per six months,
payable in arrears
= 1 if the bond is cum and 0 if ex
Accrued interest = d2 e–d1
365
× g
Clean price = All-in price – Accrued interest
Bonds with less than six months to redemption
g
Unrounded all-in price =

100 + e ×
2
d
1 i
1+ ×
365 100
with definitions as mentioned above.

Source: Bond Exchange of South Africa (2005)
11.3.2 Principal value

The principal value is also known as the face value, future value,
redemption value or par value. The principal value is the amount owed by
the issuer (borrower) to the bondholder (lender) at the maturity of the bond.
In the secondary bond market, the principal value is normally traded at R1
million. There are, however, instances where investors can trade bonds at
nominal values of less than R1 million.
Depending on the prevailing market rate, a bond may sell at par, below par
or above par value. When the market rate of a particular bond is below that
bond’s coupon rate, the bond will be trading at a premium (above par), and
if the market rate is higher than the coupon rate of that particular bond, the
bond will be trading at a discount (below par).
For example, if a bond with a par value of R1 million is selling at a

premium (i.e. the current market rate is lower than the coupon rate of the
bond), it can be bought for more than R1 million. If a particular bond is
selling at a discount (i.e. the current market rate is higher than the coupon
rate of the bond), it can be bought for less than R1 million.
11.3.3 Coupon rate

The coupon rate of a bond is the amount of interest paid per year expressed
as a percentage of the face value of the bond to be paid by the borrower.
The majority of bonds are semi-annual paying bonds with half the total
coupon payment disbursed every six months.
There are also zero-coupon bonds available in the market that do not pay
interest, but are sold at the initial offering to investors at a price less than
the par value. When held to maturity, the bond is redeemed for par value.
For example, the South African government bond R208 carries a coupon
interest rate of 6.75%. This means that interest will be paid to the investor
holding the bond amounting to 6.75% of the principal value of the bond on
a semi-annual basis. Thus, if the investor holds a R208 bond with a
principal value of R1 million, the South African government will pay
interest to the value of R33 750 every six months to that investor for as long
as the bond is in his or her possession. This will continue until the bond
matures on 31 March 2021.
11.3.4 Term to maturity

The term to maturity of a bond is the number of years over which the issuer
has contracted to meet the conditions of the obligation set out in the terms
of the bond. The maturity of a bond thus refers to the date that the debt will
cease to exist, at which time the issuer will redeem the bond by paying the
principal value to the holder of the bond.
For example, in the case of the R208 South African government bond, the
term to maturity is the time up to 31 March 2021, on which date this
particular bond will cease to exist.
11.3.5 Market value

The market value or price of a bond is the present value of all cash flows
(principal and coupon payments) discounted at the prevailing market rate.
The size of the coupon rate in relation to the market rate determines
whether the bond trades at par (i.e. the coupon rate equals the market rate),
at a discount (i.e. the coupon rate is less than the market rate) or a premium
(i.e. the coupon rate is larger than the market rate).
There are different determinants of the market value of a bond, and these
include market interest rates and the credit rating of the issuer. Another
important factor is the features of the particular type of bond. For example,
some bonds may be called (paid off) by the issuer company when the
particular company deems it appropriate. This early “calling” of a bond
means that fewer interest payments will be made to the investor.

The yield to maturity is the composite rate of return of all payouts, coupons
and capital gain (or loss), and represents the total return on a bond if held
until maturity and assuming that all coupons were reinvested at the yield to
maturity.
This internal rate of return sets the total cash flows received equal to the
market price and includes all compound interest (i.e. interest on interest)
plus any capital gain or loss. The yield to maturity and the market rate used
to discount all cash flows in determining the bond’s price or market value
are one and the same.
11.4 BOND RISK EXPOSURES
The following are among the main risk exposures that will affect the value
of a bond and/or portfolio of bonds.
11.4.1 Interest rate risk

Interest rate risk can be defined as the risk to which a portfolio or institution
is exposed because future interest rates are uncertain.
Bond prices are interest rate sensitive. If rates rise, then the present value of
a bond will fall. This can also be thought of in terms of market rates: if
interest rates rise, then the price of a bond will have to fall for the yield to
match the new market rates. In addition, the longer the duration, the more
sensitive it will be to movements in interest rates.
Interest rate risk thus refers to the effect of changes in the prevailing market
rate on the return of a bond, and comprises price risk and reinvestment risk.
11.4.1.1 Price risk
Price risk is the uncertainty associated with potential changes in the price of
a bond caused by changes in interest rate levels and rates of return in the
economy. This risk occurs because changes in interest rates affect changes
in discount rates, which in turn affect the present value of future cash flows.
This specific relationship is an inverse relationship, which means that if
interest rates (and discount rates) rise, prices fall.
Price risk only becomes relevant when a bond is sold before maturity (i.e.
the holding term is shorter than the maturity term) at a market rate different
from the yield to maturity (market rate at inception).
11.4.1.2 Reinvestment risk

Reinvestment risk stems from the market rate (the current reinvestment
rate) being different from the yield to maturity (the assumed reinvestment
rate). However, reinvestment risk is contra price risk, and applies regardless
of the holding term. An increase in the market rate subsequent to buying a
bond would result in a lower bond price (capital loss) but higher
reinvestment income.
A decrease in the market rate will, however, bring about a capital gain along
with a loss in reinvestment income. The overall return depends on the size
of the capital gain or loss versus the gain or loss in investment income. The
optimal outcome would see the opposing effects cancelling out, with the
realised return equalling the yield to maturity regardless of any changes in
the market rate.
11.4.2 Credit risk

Credit risk is the risk that the creditworthiness of a bond issuer will
deteriorate, increasing the required return (market rate plus risk premium)
on that bond and decreasing its value. Credit risk comprises default risk,
credit spread risk and downgrade risk.
11.4.2.1 Default risk

Default risk is defined as the possibility that the issuer will fail to meet its
obligations regarding the payment of coupons and the eventual principal in
a timely manner. Bonds issued by the government are, for the most part,
immune to default. Bonds issued by companies and municipalities are more
likely to be defaulted on, since they can run into financial difficulties or go
bankrupt.
11.4.2.2 Credit spread risk

A credit spread is the difference in the yield between different bonds due to
their different credit quality. The credit spread reflects the additional net
yield an investor can earn from a bond with more credit risk relative to one
with less credit risk. The credit spread thus reflects the extra compensation
investors receive for bearing credit risk.
Credit spread risk is measured by the size of the yield differential (risk
premium or spread) of a particular bond above a default-free government
bond. If the bond is callable by the issuing company, the credit spread
increases, reflecting the added risk that the bond may be called.
11.4.2.3 Downgrade risk

Downgrade risk is the risk that a bond’s price will decline due to a
downgrade in its credit rating. Credit ratings, assigned by agencies such as
Moody’s, are indicators of default risk on a bond. Lower ratings suggest
that a bond issue is riskier than an issue with higher ratings, which in turn
leads to a lower price. A downgrade therefore leads to a lower price.
Downgrade risk arises from the deteriorating financial condition of a

company, and is a risk every bond faces to a certain extent.
11.4.3 Yield curve risk

Yield curve risk arises from a non-parallel shift in the yield curve – that is,
the shape of the yield curve changes due to the yields of bonds with
different maturities changing by different amounts. Changes in the shape of
the yield curve may negatively impact bond values.
11.4.4 Liquidity risk
The liquidity risk in bonds is given by the difficulty of being able to sell
securities quickly at an attractive price. Liquidity risk applies only to the
investor who is looking to sell its bonds before the due date. Investors that
keep their bonds until maturity will receive the principal of the bonds plus
interest on their face value.
Liquidity risk may be caused by a series of events and/or characteristics of

the bond itself, such as small market volumes because of poor ratings, small
face values and callable bonds.
11.4.5 Call risk

Call risk is the risk faced by a holder of a callable bond if a bond issuer
takes advantage of the callable bond feature and redeems the issue prior to
maturity. The bondholder will receive payment on the value of the bond and
could therefore be investing the funds obtained in a less-favourable
environment, such as one with a lower interest rate.
Usually, bond issuers will call their bonds, or one particular bond, as a
result of the high rates they are paying on them. If interest rates have
declined since a bond was first issued, the issuer will often call it once it
becomes callable and will create a new issue at a lower rate.
11.5 BOND RATINGS
A bond rating is a grade given to bonds that indicates their credit quality. A
bond rating is thus a measure of the likelihood of a bond’s default. Credit
rating agencies conduct a specific credit analysis in order to provide bonds
with a rating. The criteria and the ratings themselves may change from time
to time. Credit rating agencies such as Standard & Poor’s, Moody’s and
Fitch provide such evaluations of a bond issuer’s financial strength or its
ability to pay a bond’s principal and interest in a timely fashion.
Bond ratings are important to bond investors as they are used to make
investment decisions. For example, if a bond has a low rating and an
investor is risk averse, the investor will be unlikely to invest in that bond as
it could lead to an increased possibility that the investor will lose the
amount invested.
Bond ratings are expressed with letters ranging from AAA, which is the
highest rating, to C (“junk”), which is the lowest. Different rating services
use the same letter grades but use various combinations of upper- and
lower-case letters to differentiate themselves.
This is how the Standard & Poor’s rating system works:
AAA and AA: high credit-quality investment grade

AA and BBB: medium credit quality investment grade
BB, B, CCC, CC and C: low credit quality (non-investment grade) or
“junk bonds”
D: bonds in default for non-payment of principal and/or interest
There are ten different credit ratings, or grades, that each agency publishes.
These range from a possible “investment grade” to a possible “in default”
rating. In addition, each company offers refinements, or additional
granularity, to these codes such as a plus or minus sign to indicate direction
or relative standing within a particular rating category.
Table 11.1 shows the relative rating systems for the three above-mentioned
bond rating agencies.
Table 11.1 Bond rating grades
Credit risk Moody’s Standard & Poor’s Fitch ratings

Investment grade
Highest quality Aaa AAA AAA
High quality Aa AA AA
Upper medium A A A
Medium Baa BBB BBB
Not investment grade
Lower medium Ba BB BB
Lower grade B B B
Poor grade Caa CCC CCC
Speculative Ca CC CC
No payments/bankruptcy C D C
In default C D D
Source: http://www.money-zine.com
11.6 ALTERNATIVE BOND STRUCTURES
The following are the basic bond structures available to both the issuer and
holder (investor):
11.6.1 Coupon bonds

Coupon bonds offer the benefit of receiving an interest payment on a semi-
annual basis. This is in contrast to other types of bond issue, where the
payment of interest may take place on an annual or biannual basis, or even
be delayed until the bond reaches full maturity. With a coupon bond, the
interest payments are provided on a frequent basis, with the face value of
the bond being paid in full when the bond reaches maturity.
An advantage of a coupon bond is that it creates a steady source of income

for the bondholder. Depending on the structure of the actual bond issue, the
amount of the interest payment will vary. Some of this type allow for a
fixed coupon payment, while others allow for a variable coupon payment
based on a floating system of calculating the interest due at a given point in
time.
The total return on this bond is made up of these coupon payments, the
reinvestment income on the coupons and a capital gain or loss component,
depending on whether the bond was sold at a discount (below par) or
premium (above par). The market price of a bond converges to and reaches
par at maturity. The yield to maturity gives an indication of the total return,
provided that all coupons were reinvested at that yield.
11.6.2 Zero-coupon bonds

Zero-coupon bonds are bonds that do not pay interest during their life.
Instead, investors buy them at a deep discount from their face value, which
is the amount they will be worth when they mature. On maturity, the
investor will receive one lump sum equal to the initial investment plus the
imputed interest.
The difference between the discounted initial market price and the bond’s
par value represents the total return on this type of bond. All the interest is
therefore earned at maturity in the form of a gain in capital, and the lower
the price of a zero-coupon bond, the greater the return to the investor.
The lack of cash flows prior to maturity eliminates reinvestment risk, and
price risk is also non-existent if held until maturity regardless of any
changes in the market rate or yield curve shifts. The holder is exposed to
high price risk (large fluctuations in price) when planning to sell the bond
before maturity.
The maturity dates on zero-coupon bonds are usually long term and they do
not mature for ten, fifteen or more years. These long-term maturity dates
allow an investor to plan for a long-range goal. With the deep discount, an
investor can put up a small amount of money that can grow over many
years.
11.6.3 Bonds with embedded options

An embedded option is a component of a bond and usually provides the
bondholder or the issuer with the right to take some action against the other
party. An option is a right but not an obligation to opt for a more favourable
outcome (i.e. exercise the option) and these particular options as they relate
to bonds are embedded in the sense that they are an integral part of the bond
contract. The following are types of bond with embedded options:
11.6.3.1 Callable bonds

A callable bond is a type of bond that allows the issuer to retain the
privilege of redeeming the bond at some point before it reaches the date of
maturity. On the call date, the issuer has the right, but not the obligation, to
buy back the bond from the bondholder at a defined call price. Technically
speaking, such bonds are not really bought and held by the issuer but are
instead cancelled immediately.
Should the market price exceed the call price due to a falling market rate,
the bond will be called (option exercised), allowing the issuer to refinance
at the prevailing lower rate. Bondholders, on the other hand, may have the
right to sell (i.e. put or return) a bond to the issuer prior to maturity and at a
price close to par.
Investors investing in callable bonds have the benefit of a higher coupon

than they would have had with a straight, non-callable bond. If interest rates
fall, the bonds will likely be called, and they can only invest at the lower
rate.
11.6.3.2 Putable bonds

Bonds that are putable include an option for the investor to mature the debt
at an earlier date than the final stated maturity date. Putable bonds are
advantageous to the buyer of the bond and offer a lower yield than
comparable non-putable securities. The investor will want to take advantage
of the put option and mature the bonds early if interest rates rise between
the time they are issued and the put date. If interest rates fall and the bond is
not put back to the issuer, the investor in the bond will have the
disadvantage of earning a lower yield level until the maturity date than if
the same bond was bought as a non-putable security.
11.6.3.3 Convertible bonds

Convertible bonds give the holder the option to exchange them for a
predetermined number of shares in the issuing company. When first issued,
convertible bonds act just like regular corporate bonds. Companies offer
lower yields on convertible bonds because they can be changed into shares
and thus bondholders benefit from a rise in the price of the shares. If the
shares perform poorly, there is no conversion and investors are stuck with
the bonds’ sub-par return.
11.6.3.4 Extendable bonds

An extendable bond gives its holder the right to extend its initial maturity at
a specific date or dates. The investor initially purchases a shorter-term bond
combined with the right to extend its term to a longer maturity date. An
investor purchases an extendable bond to have the ability to take advantage
of potentially falling interest rates without assuming the risk of a long-term
bond. As interest rates fall, the price of a shorter-term bond rises less than
the price of a longer-term one. The extendable bond then begins to behave
as a longer-term one. If, however, interest rates rise, the extendable bond
will behave as a shorter-term one.
11.6.3.5 Retractable bonds

A retractable bond provides the investor who owns a longer-term bond with
the right to withdraw (retract) it at a specific date. For example, it can be
used if an investor believes that interest rates will rise and bond prices will
fall, but is not willing or able to sell out of bonds completely. This investor
can buy a longer-term retractable bond which behaves initially as a similar-
term long-term bond. As interest rates rise, the bond will fall in price. Once
the bond’s price is low enough, it will begin to behave as a short-term bond
and its price fall will be much less than that of a normal long-term bond. At
worst, the investor can retract it at the retraction date and receive the par
amount to reinvest.
11.6.3.6 Exchangeable bonds

An exchangeable bond allows the bondholder to exchange it, at a certain
price, for common shares in a company other than the one that issued the
debt security. The number of shares received for each bond and the price
paid for them are determined when the exchangeable debt is issued.
Normally, the common shares are in a subsidiary of the company that

initially issued the exchangeable bond. Exchangeable debt is a low-risk
investment, but it affords the investor a great amount of flexibility because
the bond can be exchanged for another asset with higher risk and a higher
return.
Exchangeable bonds are similar to convertible bonds, the difference being

that in a convertible bond the common shares that the investor may buy are
those of the company issuing the bond rather than those of a subsidiary.
11.6.4 Floating rate notes

Floating rate notes are bonds that pay a fluctuating rate of interest. The
coupon on such a bond varies period by period, depending on the prevailing
market rate. In essence, these bonds have coupons that are reset periodically
according to a reference rate (LIBOR or JIBAR) plus or minus a stated
margin.
A cap (upper limit) or a floor (lower limit) may be put in place to protect
against fluctuations in the coupon rate. The issuer limits or caps the
maximum interest paid, while the holder would like to limit the minimum
interest received.
When both limits are present simultaneously, the combination is called a

collar. Floating rate notes are less susceptible to changes in the market rate
as the resetting mechanism aligns the coupon rate with the prevailing
market rate, causing the bond to always trade close to par.
11.7 SUMMARY
A bond is a fixed-term obligation (upon the issuer) making interim interest
payments (to the holder) with a final settlement at the end of the loan
period. Government (national and local), public enterprises and private
companies obtain private funding or financing by listing their issues on the
Bond Exchange of South Africa (capital market exchange). Institutional and
retail investors obtain a risk-free (government issues) or lower-risk (other
issues) and lower return investment as compared to equity, thereby
diversifying their investment portfolios.
Equity and bonds represent the two major asset classes available to
investors, and the representation (i.e. weighting) of each largely determines
the risk and return of a portfolio as dictated by the investment policy
statement (IPS). A bond has five basic features: its face value, market value,
coupon, its term and its yield to maturity. The main risks associated with
bonds relate to changes in the interest rate and term to maturity as well as to
the credit rating of an issuer. The different bond structures establish the
response of a particular issue to changes in the trading environment.
Bond exchange of South Africa. 2005. Bond pricing formula – specifications. Available at:
http://www.jse.co.za/Libraries/BESA_Bond_pricing/bond_pricing_Formula_-_final.sflb.ashx
(accessed 16 April 2016).
Choudhry, M. 2010. An introduction to bond markets, 4th ed. Chichester: Wiley & Sons.
Fabozzi, F.J. 2012. Fixed income analysis, 8th ed. Upper Saddle River, NJ: Prentice Hall.
Fabozzi, F.J. 2012. Bond markets, analysis and strategies, 7th ed. Hoboken, NJ: John Wiley & Sons.
Johannesburg Stock Exchange. 2016. Available at: http://www.jse.co.za (accessed January 2016 to
April 2016).
Money-zine. 2015. Bond ratings. Available at: http://www.money-
zine.com/Investing/Investing/Bond-Ratings/ (accessed 8 February 2016).
1. Identify the incorrect statement regarding bond fundamentals:
(a) The bond issuer borrows money from the bondholder in order to acquire
money for capital expansion or to finance a specific project.
(b) The principal value is the amount owed by the bondholder to the issuer at the
maturity of the bond.
(c) The maturity of a bond refers to the date that the debt will cease to exist, at
which time the issuer will redeem the bond by paying the principal value to the
holder of the bond.
(d) The yield to maturity and the market rate used to discount all cash flows in
determining the bond’s price or market value are one and the same.
2. A non-callable, AA-rated, 15-year zero-coupon bond is most likely to have
(a) default risk

(b) price risk
(c) call risk
(d) reinvestment risk
3. The liquidity risk in bonds can best be described as
(a) the risk that a bond’s price will decline due to a downgrade in its credit rating
(b) the difference in the yield between different bonds due to their different credit
quality
(c) the risk that the creditworthiness of a bond issuer will deteriorate, increasing
the required return on that bond and decreasing its value
(d) the difficulty of being able to sell securities quickly at an attractive price
4. Which of the following statements is true regarding floating rate notes with caps
and floors?
(a) A combination of a cap and a floor is called a combo.

(b) A cap is an advantage to the holder, while a floor benefits an issuer.
(c) A floor is an advantage to the holder, while a cap benefits an issuer.
(d) A cap sets the minimum coupon rate to be received by the holder of a floater.
5. If an investor believes that interest rates will rise and the value of bonds will fall,
which type of bond provides the investor, who owns a longer-term bond, with the
right to withdraw it at a specific date?
(a) Retractable bond

(b) Convertible bond
(c) Extendable bond
(d) Callable bond
Solutions
1. (b)
2. (b)
3. (d)
4. (c)
5. (a)
12 Valuation of bonds
12.1 INTRODUCTION
Bond valuation involves the discounting of all cash flows (coupon and
principal) at the prevailing market rate. This single discount rate that
reduces a bond’s cash flows to its market price represents a bond’s yield,
subject to specific conditions. A change in yield affects the price of the
bond (the investor’s asset) and ultimately the return on this investment. A
number of market and security-specific variables impact on the eventual
outcome and benefit obtained from investing in bonds. Bonds are the other
major asset class (after equity) and offer a lowe-risk, lower-return
alternative to equity. The performance of an investment portfolio largely
depends on the ratio of equity to bonds that will suit a specific investor. A
suitable equity–bond range is imposed by the return required by an investor
and the willingness and ability of that investor to assume risk.
12.2 BOND CALCULATIONS
The value or price of a bond is simply the present values of all future cash
flows. These cash flows comprise the periodic coupon payments (coupon
rate times the principal or par value) and the principal repayment to be
received at the maturity of the bond as shown in equation 12.1.
VCR;DR = ∑ [(
CR×PAR
) (1 +
DR
)
–(t×n)
] + PAR(1 +
DR
)
–(t×n)
(12.1)
n n n
where:
CR = coupon rate
DR = discount rate
PAR = principal, face or par value
n = number of coupon payments per annum
t = time to coupon and principal payments
The price of a bond can also be determined using the time value of money
(TVM) keys on a financial calculator (e.g. Hewlett Packard 10BII+). In
fact, assuming a single discount rate, all bond calculations should be
performed with a financial calculator. Given any four TVM variables, the
outstanding fifth variable can be calculated with the relevant inputs and
output (in some instances) adjusted for the frequency of coupon payments.
The following five keys, with slight variations depending on the specific
make or model, represent the TVM variables on a financial calculator:
12.2.1 Valuation using a single discount rate

While the risk-free rate is used to value government bonds, a risk premium
should be added to the risk-free rate to arrive at the appropriate discount
rate for valuing corporate bonds. The added risk premium compensates for
the greater credit risk, liquidity risk, etc. associated with corporate issues.
Pricing or valuating a bond assuming a flat term structure (i.e. same
discount rate across all periods) allows the use of a financial calculator
since the actual calculation is simply the sum of the present value of an
ordinary annuity (coupon payments) and the present value of a single
amount (principal value).
The size of the discount rate (market rate) relative to the coupon rate (i.e.
lower, higher or equal to) determines whether a bond is issued at a discount,
a premium or at par.
Relation Effect Issue

Coupon rate < Discount rate Bond price < Principal value Discount bond
Coupon rate > Discount rate Bond price > Principal value Premium bond
Coupon rate = Discount rate Bond price = Principal value Par value bond
This discount rate is the rate available to investors and should the issuer
offer a rate of return (coupon) lower than this market rate, the investor is
compensated by means of a below-par purchase price. The eventual final
payout (including the principal value) at maturity should see the investor in
effect earning the market rate (if certain assumptions hold true). Conversely,
should the issuer offer a coupon rate that exceeds the market rate, the
investor is charged a premium (an amount above par value and therefore a
higher price). The final payout once again results in the investor effectively
having earned the market rate. Figure 12.1 shows that large coupon
payments correspond to an above-par initial price advancing over time
(decreasing) to and finally converging with the par value at maturity. Small
coupons match up with a below-par initial price that moves towards
(increases) and ultimately reaches par.
Figure 12.1 Price converging on par
The following three calculations demonstrate the pricing of bonds using

equation 12.1 and the HP10BII+ financial calculator, confirming the trading
“below-above-at par” principle mathematically.
Trading at a discount (coupon rate smaller than the market rate)

Consider a bond that will pay 8% interest (coupon payment) every 6
months for 2 years on a principal of R100 with a 10% market rate.
V8%; 10% =
–(0.5×2)
0.08×100 0.10
( ) (1 + )
2 2
+ 4(1.05)–2 + 4(1.05)–3 + 104(1.05)–4

= R96.45
Trading at a premium (coupon rate larger than the market rate)

months for 2 years on a principal of R100 with a 6% market rate.
V8%; 6% = (
0.08×100
2
) (1 +
0.06
2
)
–(0.5×2)
+ 4(1.03)–2 + 4(1.03)–3 + 104(1.03)–4

= R103.72
Trading at par (coupon rate equal to the market rate)

months for 2 years on a principal of R100 with an 8% market rate.
V8%; 8% =
–(0.5×2)
0.08×100 0.08
( ) (1 + )
2 2
+ 4(1.04)–2 + 4(1.04)–3 + 104(1.04)–4

= R100.00
These calculations also highlight an important principle of bond pricing,
namely the inverse relationship between yield and price. A higher (lower)
yield results in a lower (higher) price. This is graphically depicted in Figure
12.2, showing the negatively sloped (convex shape) price– yield curve.
Figure 12.2 Price–yield curve
It is reasonable to assume that interest rates will not be uniform during the
term of a bond, but will in fact differ across time periods. Expected future
interest rates may increase or decrease depending on the prevailing
macroeconomic conditions and forecasts. Although a variable per-period
discount rate may be more appropriate to determine the likely return on a
bond investment, the adoption of a single rate (the prevailing market rate) is
required to determine a bond’s market price.
In South Africa the price of a bond is expressed per R100. To calculate the
value of a R1 million bond, the price is therefore simply divided by 100 and
multiplied by 1 million.
12.2.2 Valuation using multiple discount rates

A more correct way to value the periodic cash flows of a bond is to use a
different discount rate applicable to the period in which a cash flow will be
received. This approach necessitates the use of equation 12.1 and not the
TVM function of a financial calculator.
months for 2 years on a principal of R100. The appropriate annualised
discount rates are 6.8% (6-month), 7.2% (12- month), 7.6% (18-month) and
8.0% (24-month) respectively.
V10%; Variable
–(0.5×2)
0.10×100 0.068
= ( )(1 + )
2 2
+ 5(1.036)–2 + 5(1.038)–3
+105(1.04)–4
= R103.72
The market price of this bond is above its par value and it therefore trades at
a premium due to a coupon rate that exceeds the respective discount rates
(interest rates available in the market).
12.2.3 Valuation of a zero-coupon bond

A zero-coupon bond has only one cash flow – the principal or face value
paid at maturity. This value is discounted at the appropriate interest rate and
for the required number of periods. The pricing of a zero bond should be
consistent with the pricing of a semi-annual coupon bond, and although
there are no intermediate coupon payments, 6-month discounting periods
have to be used to standardise pricing calculations and enable comparisons.
Equation 12.1, which is the sum of the present value of an ordinary annuity
(coupon payments) and the present value of a single amount (principal
value), is altered by omitting the annuity component.
V0%;DR = PAR(1 +
DR
n
)
–(t×n)
(12.2)
Consider a 2-year zero-coupon bond at a 10% market rate.

–(2×2) 100
0.10
V0%;10% = 100(1 + ) = = R82.27
4
2 1.05
Present value of a single amount:

At prevailing market rates of 6% and 8% the value of this bond would be
R88.85 and R85.48 respectively. Note that zero-coupon bonds always trade
at large discounts to par.
12.3 YIELD MEASURES
The yield or return of a bond can be measured in a variety of ways –

namely the nominal yield, the current yield, the yield to maturity (most
common) and the realised yield (most accurate). A yield to call and a yield
to put should also be calculated where applicable. A sample bond is used to
demonstrate and explain the various yield measures.
The sample bond is a 9.2% semi-annual paying bond priced at R110.78

with 12 years to maturity. The bond can be called in 4 years at R107.50 (a
put-option substitute for the call provision in section 12.3.5).
12.3.1 Nominal yield

The nominal yield is simply the coupon rate of a particular issue. This
sample bond with a 9.2% coupon therefore has a 9.2% nominal yield.
12.3.2 Current yield

The current yield only considers a bond’s annual interest income, ignoring
any capital gains or losses, or reinvestment income. It is a measure of the
current income from the bond as a percentage of its price. The formula for
the current yield is:
CY =
Annual coupon payment
Bond price
(12.3)
Considering the 9.2% coupon rate (R9.20 annual interest) and the R110.78
price of the sample bond, the current yield is:
9.2
CY = = 8.30%
110.78
Note that as the current yield is based on the annual coupon interest, a semi-
annual bond and an annual bond with the same price and coupon rate would
have the same current yield.

The yield to maturity (YTM) is an annualised internal rate of return based
on a bond’s price, coupon payments and par value (i.e. cash flows). The
single discount rate used to price a bond is, in fact, the bond’s YTM.
Bond price = CPN1 (1 + YTM)–1

+ CPN2 (1 + YTM)–2 + …
+ (CPNt + PAR) (1 + YTM)–t (12.4)
This equation can be solved with an iterative (trial and error) process, trying
different values for the YTM until the sum of the present values of the cash
flows is equal to the price of the bond. This is easily achieved with the help
of a financial calculator that finds the appropriate discount rate that will
result in the two sides of the formula being equal.
The yield to maturity is therefore 7.80% (3.9002 × 2) representing the

internal rate of return that sets the summed discounted cash flows equal to
the market price of R110.78. This yield (2 times the semi-annual rate) is
referred to as the bond equivalent yield (BEY) or semi-annual-pay yield.
The YTM accounts for the coupon income and any capital gain or loss as
well as the timing of the cash flows. The calculated YTM will only be
realised if the bond is held to maturity and assuming that all coupon
payments can be reinvested at the yield to maturity.
Yield to maturity for an annual coupon bond

Calculating an annual-pay yield reveals the link between a bond equivalent
yield (a bond calculation convention) and an effective yield. Using the same
sample bond, but assuming annual coupon payments, the YTM is 7.79%
To facilitate comparison between annual and semi-annual pay bonds, the

bond equivalent yield should be converted to an effective yield (EY) in the
following manner:
EY = [(1 +
BEY
)
2
− 1] × 100
(12.5)
2
2
0.078004
EY = (1 + )
2
= (1.0795 − 1) × 100
= 7.95%
Or alternatively, the effective yield can be converted to a BEY:
BEY = [(1 + EY)1/2 – 1] × 100 × 2 (12.6)

BEY = [(1.077854)1/2 – 1] × 100 × 2 = 7.64%
The sample bond (semi-annual) has a 7.80% BEY or 7.95% EY compared

to the sample bond (annual) with a 7.64% BEY or 7.79% EY. The higher
yield obtained from semi-annual payments is the result of compounded
interest (i.e. interest on interest).
Yield to maturity for a zero-coupon bond

You may recall that a zero-coupon bond is priced as if it were a semi-
annual-pay bond. The calculated yield should thus be expressed as a bond
equivalent yield. The YTM of a zero-coupon can be calculated as an EY
using equation 12.7 and converted to a BEY using equation 12.6, or
calculated directly using equation 12.8.
EY0% = [(
PAR
)
1/t
− 1] × 100
(12.7)
Bond price
BEY0% = [(
PAR
)
1/2t
− 1] × 100 × 2
(12.8)
Bond price
Consider the two-year zero-coupon bond used to illustrate the valuation of

this type of bond and priced at R82.27.
1/2
100
EY0% = [( ) – 1] × 100 = 10.25%
82.27
BEY = [(1.1025)1/2 – 1] × 100 × 2 = 10%
Or alternatively:
1/4
100
BEY0% = [( ) – 1] × 100 × 2 = 10%
82.27
Recall from Chapter 11 that the major risk faced by bondholders is interest
rate risk. Interest rate risk comprises price risk and reinvestment risk. A
zero-coupon bond has no price risk if held until maturity, and no
reinvestment risk as there are no intermediate cash flows (coupon
payments) to reinvest. A zero-coupon bond is therefore the ideal instrument
to immunise bond portfolios.1
12.3.4 Yield to call

A bond issue may include a provision that gives either the bond issuer or
the bondholder the right to carry out a specified action (exercise an
embedded option) to his or her advantage.
The most common type of option embedded in a bond issue is a call or

redemption provision. The issuer has the right to call the bond at a
predetermined price (the call price), which is normally at or above par. This
type of bond usually has a higher return (compared to an identical non-
callable bond) to compensate for the risk of it being called early. A call
feature is advantageous to the issuer and detrimental to the holder. Bonds
are commonly called and redeemed when prevailing interest rates have
dropped significantly since the time the bonds were issued, allowing the
issuer to refinance (new issue) at a lower rate (higher price). A call issue
effectively allows the issuer to shorten the maturity of a bond.
The yield to call is used to calculate the yield on a callable bond that is
priced at a premium to par as the yield to call (YTC) may be less than the
YTM. The callable bond may have a period of call protection in which the
bond cannot be called. The call price is substituted for the par value and the
number of periods until the call date is substituted for the time to maturity
as illustrated by the sample bond in the following calculation:
The yield to call is therefore 7.66% per annum, which is lower than the
YTM of 7.80%, confirming the disadvantage to the holder.
12.3.5 Yield to put

The yield to put applies to a bond with a put feature selling at a discount
when it is likely that the yield to put (YTP) will be higher than the YTM.
This provision is advantageous to the holder, forcing the issuer to
repurchase the bond prior to maturity at a predetermined price. Bonds are
commonly offered for redemption when prevailing interest rates have risen
significantly since the time the bonds were issued, allowing the holder to
reinvest (new issue) at a higher rate (lower price).
The put price (normally par) is substituted for the par value and the number
of periods until the put date is substituted for the time to maturity as
illustrated by the sample bond (altered to include a put feature) in the
calculation below.
The sample bond is a 9.2% semi-annual paying bond selling at R91.88
(YTM is 10.4%) with 12 years to maturity. The bond is putable at par in 4
years.
The YTP is 11.81% per annum, which is higher than the YTM of 10.40%,
confirming the advantage of this feature to the holder.
12.3.6 Realised (horizon) yield

The realised or horizon yield, also referred to as the total return on a bond
investment, takes account of the expected per-period reinvestment rates
during the investment.
Assume that an investor buys the 9.2%, 12-year sample bond at R110.78
(ignore all call or put provisions). This investor has a 5-year investment
horizon and has the following expectations:
The first six semi-annual coupon payments can be reinvested from the
time of receipt to the end of the investment horizon at an annual interest
rate of 8%.
The last four semi-annual coupon payments can be reinvested from the
time of receipt to the end of the investment horizon at an annual interest
rate of 10%.
The required yield to maturity on 7-year bonds at the end of the
investment horizon will be 10.3% (after 5 years, the sample bond is a 7-
year bond).
Step 1
Calculate the coupon income and interest over the investment horizon.
Years 1–3 (6 coupons of R4.60 reinvested at 4%)
Remember to clear all the registers before starting any new TVM
calculation.
Should you not want to clear the registers in order to retain some previously
calculated value(s), simply input a zero value (0) in the TVM key not
required for a specific calculation (e.g. PV key).
Future value of an annuity:
Future value of a single amount:
The coupons received in the first 3 years plus the interest earned thereon for
the total period will amount to R35.69.2
Years 4–5 (4 coupons of R4.60 reinvested at 5%)
The coupons received in the last 2 years plus the interest earned thereon for
that period will amount to R19.83.
The coupon interest plus reinvestment income for the total 5-year period
(10 coupon payments) is R55.52 (R35.69 + R19.83).
Step 2
Calculate the projected sale price of the bond.
Due to the expected increase in market rates the investor will experience a
capital loss (lower bond price, i.e. price risk), selling the bond at only
R94.61 (bought at R110.78). Some of the loss will be recovered from the
larger reinvestment income on the coupon payments.
Step 3
Calculate the total return on the bond.
The total return components are the selling price plus interest income
(ending value), and the purchase price (beginning value). The total future or
ending value in this instance is R150.13 (R94.61 + R55.52) with the
beginning value at R110.78.
Doubling 3.0862% gives a total return (realised or horizon yield) of 6.17%.3
Recall that the yield to maturity of this bond was calculated as 7.8%, but
that depends on the assumptions of reinvesting all coupons at the YTM and
the bond being held until maturity holding true.
12.3.7 Spot and forward rates

Recall that the yield to maturity is the single discount rate used to price a
bond. However, the appropriate discount rates for cash flows at different
points in time are typically not the same and the yield curve is therefore not
flat, but either upward or downward sloping. These rates, referred to as zero
rates or spot rates, are derived from treasury bonds (government issues) of
varying maturities and coupons via a process called bootstrapping or
stripping. This process effectively removes any coupon, reducing each bond
to a zero-coupon bond at a particular maturity, establishing the zero rate or
spot rate curve. Theoretically, spot rates are the discount rates (yields) for
zero-coupon bonds. Forward rates in turn are derived from these spot rates.
Spot rates
Assume the maturities, yields and coupon rates as presented in Table 12.1,
with each bond trading at par. All coupons will be stripped (removed),
thereby generating a per-period zero-coupon rate (an adjusted YTM) and
constructing a zero rate or spot rate curve.
Table 12.1 Coupon bond details

Maturity (months) YTM (%) CR (%) Price (R)
6 7 7 100
12 8 8 100
18 9 9 100
24 10 10 100
6-month spot rate (SR6)
The 6-month spot rate will always equal the yield to maturity since the bond
will only make one payment at maturity. The 6-month spot rate is therefore
7%. No calculation required.
Equation 12.1 is solved with the bond price set equal to the discounted cash
flow values. Each cash flow for a particular maturity should be discounted
at the relevant per-period spot rate (SR). You know the 6-month spot rate to
be 7%, therefore:
100 = 4(1.035)–1 + 104(1 + ½SR12)–2

= 3.8647 + 104(1 + ½SR12)–2
(1 + ½SR12)2 = 104
(100–3.8647)
1 + ½SR12 = (1.0818)1/2
½SR12 = 0.0401
SR12 = 0.0802 → 8.0201%
The 12-month spot rate is 8.02%.

The same procedure is followed to determine the 18-month spot rate,

inserting SR6 and SR12 into the equation and solving SR18.
100 = 4.5(1.035)–1 + 4.5(1.0401)–2 + 104.5(1 + ½SR18)–3
= 8.5075 + 104.5(½SR18)–3
(1 + ½SR18)3 = 104.5
(100–8.5075)
1 + ½SR18 = (1.1422)13
½SR18 = 0.0453
SR18 = 0.0906 → 9.0613%
The 18-month spot rate is 9.06%.

The same procedure is followed to determine the 24-month spot rate,

inserting SR6, SR12 and SR18 into the equation and solving SR24. Note that
the cash flow of each particular period (in this instance R5 coupons and
R100 par) is discounted at the spot rates as calculated. The 24-month spot
rate is 10.13%, calculated as follows:
100 = 5(1.035)–1 + 5(1.0401)–2 + 5(1.0453)–3 + 105(1 + ½SR24)–4

½SR24 = 0.0507
SR24 = 10.1304%
The annualised rates are all bond equivalent rates (i.e. doubled semi-annual
rates). (see Table 12.2.)
Table 12.2 Calculated spot rates
Maturity 6-month 12-month 18-month 24-month

Period (t) 1 2 3 4
Spot rate (r) 3.50% 4.01% 4.53% 5.07%
Spot rate (BEY) 7.00% 8.02% 9.06% 10.13%
Forward rates
A forward rate is the interest rate applicable to a future period. The length
of the future period and the pre-period is specified (e.g. a 3-year rate, 1 year
from now). Forward rates are derived from the calculated spot rates and the
link between these two rates is evident from the following graphical
illustration and the application of equation 12.9.
Forward rates are calculated using the following equation:
fm = [(
(1+rt+n )
t+n
)
1/(n)
– 1] × 100 × 2
(12.9)
p t
(1+rt )
where:
f = forward rate
n = difference between subsequent periods
p = length of future period (months)
m = starting point of future period
With the semi-annual spot rates as calculated inserted into equation 12.9,
the 6-month forward rate, 6 months from now is calculated at 9.05%.
6f6
1/(2–1)
=
2
1.0401
[( ) – 1] × 100 × 2
1
1.035
= 9.0450%
6f12
1/(3–2)
=
3
1.0453
[( ) – 1] × 100 × 2
2
1.0401
= 11.1556%
6f18
1/(4–3)
=
4
1.0507
[( ) – 1] × 100 × 2
3
1.0453
= 13.4136%
Similarly, the 6-month forward rate, 12 months (11.16%), and 18 months

(13.41%) from now are calculated, as well as the 12-month forward rate, 12
months from now (12.28%).
12f12
4 1/(4–2)
1.0507
= [( ) – 1] × 100 × 2
2
1.0401
= 12.2816%
Note that investing at either the four 6-month forward rates, or the two 1-
year forward rates results in earning the 2-year spot rate (10.13%),
illustrating the link between spot rates and forward rates.
1 + SR24 = (1.07 × 1.0905 × 1.1116 × 1.1341)1/4

= (1.0802 × 1.1228)1/2 = 1.1013
12.4 YIELD CURVE
A yield curve or term structure of interest rates is simply a plot of the yields
of bonds against their maturities. Only bonds of similar risk (i.e. quality) are
plotted on the same yield curve. The most common type of yield curve plots
treasury securities since they are considered risk free and are used as a
benchmark for determining the yields on other bonds. The shape of the
yield curve is closely watched because it helps to give an idea of future
interest rate changes and economic activity. The slope of the yield curve is
also seen as important: the greater the slope, the greater the gap between
short- and long-term rates. Yield curves can take on just about any shape,
but the four more distinct or general shapes are discussed below.
Normal or upward sloping

A normal yield curve is one in which longer maturity bonds have higher
yields compared to shorter-term bonds due to investors requiring a higher
rate of return for taking the added risk of lending money for a longer period
of time. Under ordinary conditions the yield curve slopes upward to the
right [Figure 12.3(i)], called a normal or positive yield curve because long-
term bonds offer higher yields than short-term bonds. When the yield curve
is positive, investors anticipate strong future economic growth and higher
future inflation, although no radical changes in rates are expected.
Figure 12.3 Yield curve shapes
Inverted or downward sloping

An inverted or negative yield curve is one in which the shorter-term yields
are higher than the longer-term yields [Figure 12.3(ii)], which can signal an
upcoming recession. Inverted yield curves are characterised by unstable
financial conditions and occur during periods of restricted monetary policy,
as the South African Reserve Bank increases its repo rate, draining money
from the banking system (curbing the extension of credit) to cool
inflationary pressures in the economy. Investors expect sluggish economic
growth and lower inflation.
Flat
Yields are all equal at every maturity [Figure 12.3 (iii)]. A flat yield curve is
one in which the shorter- and longer-term yields are very close to each
other, which is also a predictor of an economic transition. This shape
signifies that investors have no opinion on the movement (up or down) of
interest rates and are unsure about future economic growth and inflation.
Humped
A humped yield curve is one in which the yields on intermediate-term
issues are above the yields on short-term issues and the rates on long-term
issues decline to levels below those for the short-term issues before
levelling out [Figure 12.3(iv)]. This is a fairly unusual formation, where
medium-term rates are higher than short-term and long-term rates, and is
commonly thought of as a precursor to a recession.
There are three basic theories on the term structure and the shape of the
yield curve – namely the expectations theory, the liquidity preference theory
and the segmented market theory.
12.4.1 Expectations theory

This theory (also known as the Pure Expectations Theory) is the most
widely accepted yield curve theory and states that forward rates are solely a
function of expected future spot rates. Expectations of rising short-term
rates create a positive yield curve and vice versa. A weakness of this theory
is the assumption that investors have no preferences regarding different
maturities and the associated risks.
12.4.2 Liquidity preference theory

Forward rates reflect investors’ expectations of future rates plus a liquidity
premium (positively related to maturity) to compensate them for exposure
to interest rate risk. Investors, however, always prefer the higher liquidity of
short-term bonds and any deviance from an upward sloping yield curve is
only temporary. The yield premium increases with maturity due to the
interest rate risk. This is also known as the Biased Expectations Theory.
12.4.3 Segmented market theory

This theory proposes that lenders and borrowers are confined to certain
maturity segments due to restrictions (either legal or practical) on their
maturity structure and will therefore not be enticed to shift out of these
maturity ranges. That means the shape of the yield curve is completely
determined by the supply and demand for securities within each maturity
segment. Higher demand implies higher prices and lower yields. The yields
for a given maturity range will be determined independently of those for all
other maturity ranges. This theory can be used to explain any shape of the
yield curve. A supplemental explanation, known as the Preferred Habitat
Theory, is that any investor would demand to be compensated for moving
out of a certain sector and taking on additional risk.
12.5 MEASUREMENT OF INTEREST RATE RISK
Interest rate risk can be defined as the risk that changing market rates will
impact negatively on the return of a bond. The interaction between price
and yield, coupon and reinvestment, as well as the timing of cash flows,
establishes the extent of this risk.
The duration–convexity approach to measuring interest rate risk or price

sensitivity provides an approximation of the actual interest rate sensitivity
of a bond or a portfolio of bonds. Quantifying this rate sensitivity facilitates
the comparison and selection of bonds, depending on current and future
market conditions and actual or intended exposures. In a declining interest
rate environment, an asset manager would lengthen the duration of a bond
portfolio (weighted average of the individual bond durations) in order to
take full advantage of the increase in value through an increased interest
rate sensitivity. If future increases in the market rate are anticipated, the
duration of a bond portfolio should be shortened, thereby limiting the
concomitant decline in bond values. Duration thus allows for managing the
price sensitivity of a bond portfolio.
12.5.1 Duration
Some useful generalisations for assessing interest rate risk or price
sensitivity are the following:
Long-term bonds are subject to more interest rate risk than short-term
bonds.
Low-coupon bonds are subject to more interest rate risk than high-
coupon bonds.
Low-yield bonds are subject to more interest rate risk than high-yield
bonds.
These “higher” risk bonds all have a relatively longer duration and greater
price sensitivity. Duration captures the risk attributes (i.e. term, coupon and
yield) of a bond in a single number that measures the sensitivity of a bond’s
market price to changes in the market rate. Expressed in terms of years,
duration represents the average lifetime of a bond’s stream of cash flows –
that is, the effective maturity of a bond. The effective maturity of a coupon-
paying bond will be less than its actual maturity, as it is the weighted
average of the individual maturities of the cash payments. Alternatively,
and more correctly, duration measures the approximate percentage change
in price due to a change in the market rate as shown in equation 12.10.
Duration =
Percentage change in price
Change in yield as a decimal

= % (12.10)
12.5.1.1 Properties of duration

Option-free bonds have the following properties:
The duration of a zero-coupon bond will equal its term to maturity.
The duration of a coupon bond will always be less than its term to
maturity.
There is a positive relationship between term to maturity and duration.
There is an inverse relationship between coupon and duration.
There is an inverse relationship between yield to maturity and duration.
A long-term, zero-coupon bond will have a long duration and contains a

large price risk component (no coupons, no reinvestment risk) if not held
until maturity. A short-term, high-coupon bond will have a short duration
with low price risk and moderate reinvestment risk as the bulk or all of the
total return is made up of interest (reinvested coupons). The duration–
maturity/coupon/yield relationship is illustrated in Section 12.5.1.3. First,
however, we look at the actual calculation of duration.
12.5.1.2 Calculation of duration

As referred to earlier, the duration of a coupon-paying bond will be less
than its maturity as it is the weighted average of the individual maturities of
the cash payments. The Macaulay duration method, therefore, sums the
weighted discounted cash flows to arrive at a basic duration value (i.e. the
Macaulay duration). Discounting the Macaulay value at the yielfd to
maturity will produce what is known as modified duration. However, a
shorter and more straightforward method, called effective duration,
produces the same end-result (i.e. effective duration equals modified
duration). Effective duration, unlike the modified duration approach, also
accounts for any embedded options and is expressed as a percentage.
The effective duration equation 12.10 requires the pre-calculation of bond

prices – those being the actual (original) market price, and the prices
assuming a one per cent up and down movement in the market rate.4
D =
V_ –V+
2V0 ( y/100)
(12.10)
where:
V– = bond value if the yield decreases by Δy
V+ = bond value if the yield increases by Δy
V0 = original bond price
Δy = percentage change in yield used to calculate V– and V+
Although commonly expressed in years, duration is interpreted as the

approximate percentage change in a bond’s price for a one per cent change
in the market rate (regardless of the assumption of the percentage change in
yield). Stating that duration becomes longer (or shorter) simply infers
higher or more (lower or less) interest rate sensitivity.
The 9.2% semi-annual paying bond priced at R110.78 (YTM is 7.8%) with
12 years to maturity is used to illustrate the concept of duration.
V– V0 V+
FV 100 100 100

PMT 4.6 4.6 4.6
I/YR* 3.4 3.9 4.4
N 24 24 24
PV? –119.4740 –110.7830 –102.9282
* Semi-annual bond. Therefore, the 1% adjustment to the 7.8% (3.9%)

YTM results in the 6.8% (3.4%) and 8.8% (4.4%) values used to calculate
the higher and lower bond prices required for equation 12.11.
D =
119.4740–102.9282
2110.78300.01
= 7.4676 (12.11)
The price of this 12-year, 9.2% bond will change by 7.47% for every 1%
change in the market rate. In order to approximate a change in price given a
specific change in yield, one has to calculate the duration effect. A 100
basis point (1%) change is assumed to facilitate the illustration.
Duration effect
%ΔPD = –D(Δy) (12.12)
%ΔPD(1) = –7.4676(±1) = ±7.4676%
Estimating prices with duration

PD = V0 × (1 ± %ΔPD) (12.13)
PD(±1) = 110.78 × (1 ± 0.074676)
PD(–1) = 110.78 × (1 + 0.074676) = 110.78 × 1.074676 = R119.05
PD(+1) 110.78 × (1 – 0.074676) = 110.78 × 0.925324 = R102.51
=
This can be compared to the actual values as previously calculated:
Actual minus estimated (1% decrease in yield):

R0.42 (R119.47 – R119.05)
Actual minus estimated (1% increase in yield):
R0.42 (R102.93 – R102.51)
Note the discrepancy. This will be accounted for in the convexity

adjustment (see Section 12.5.2.1). The next section illustrates the duration–
maturity/coupon/yield relationship referred to earlier.
12.5.1.3 Duration–maturity/coupon/yield
Relationship between term to maturity and duration – positive

A long(er) maturity signifies a longer duration and higher interest rate
sensitivity (more risk). Duration for the 12-year, 9.2% coupon bond
yielding 7.8% is 7.47. An equivalent bond with a longer maturity (15
years) has an increased duration of 8.49.
Relationship between coupon and duration – inverse

A low(er) coupon signifies a longer duration and higher interest rate
sensitivity (more risk). Duration for the 12-year, 9.2% coupon bond
yielding 7.8% is 7.47. An equivalent bond with a lower coupon (7.8%)
has an increased duration of 7.72.
Relationship between yield to maturity and duration – inverse

A high(er) yield signifies a shorter duration and lower interest rate
sensitivity (less risk). Duration for the 12-year, 9.2% coupon bond
yielding 7.8% is 7.47. An equivalent bond with a higher yield (10.4%)
has a decreased duration of 6.95.
Duration allows for the comparison of bonds with different attributes (i.e.
maturity, coupon and yield). A 12-year, 9.2% coupon, 7.8% yield bond’s
interest rate risk (duration of 7.47) is assessed relative to a benchmark bond
(corresponding treasury bond) or another bond, for example a 10-year, 6%
coupon, 6% yield bond with a duration of 7.45. Note that the 10-year and
12-year maturity bonds offer a similar interest rate risk exposure, owing to
differences in coupon and yield. Either bond can thus be bought (asset) to
match with an existing and corresponding liability.5
12.5.1.4 Portfolio duration

A portfolio’s duration is equal to the weighted average of the durations of
the bonds in the portfolio. The weight is proportional to how much of the
portfolio consists of a certain bond.
Portfolio duration = w1D1 + w2D2 … + wkDk (12.14)
Consider a portfolio of three bonds with a total market value of R10 935
000:
R6000 000 market value of Bond A with a duration of 5.5

R3400000 market value of Bond B with a duration of 7.8
R1535000 market value of Bond C with a duration of 12.3
Portfolio duration
= w1D1 + w2D2 … + wkDk
6 000 000 3 400 000 1535 000
= ( ) 5.5 + ( ) 7.8 + ( ) 12.3
10 935 000 10 935 000 10 935 000
= (0.549×5.5)+(0.311×7.8)+(0.140×12.3)
= 7.17
Therefore, if rates change by 100 basis points (1%), the portfolio’s value
will change by approximately 7.17%. (Note that the individual bonds will
not change by this much because each will have its own duration).
Dollar duration, or in this instance, Rand duration, measures the rand

change in the value of a bond or a bond portfolio due to a change in market
interest rates. Rand duration is generally used by professional bond fund
managers as a way of approximating the portfolio’s interest rate risk.
Rand duration = Duration × Change in yield × Market value (12.15)
The rand value of one basis point (0.01%) in this instance is:
Rand durationp = 7.17 × 0.0001 × 10 935 000

= R7 840
This can also be determined by calculating and adding the rand durations
for individual bonds:
Rand durationA = 5.5 × 0.0001 × 6 000 000

= R3 300
Rand durationB = 7.8 × 0.0001 × 3 400 000
= R2 652
Rand durationA = 12.3 × 0.0001 × 1 535 000
= R1 888
Therefore, assuming a 50 basis point (0.5%) decrease or increase in interest
rates, the value of this portfolio would increase or decrease by
approximately R(7 840 × 50) = R392 000.
The primary limitation of the portfolio duration measure is that each of the
bonds in the portfolio must change by an equal number of basis points, or
there must be a parallel shift in the yield curve for the duration measure to
be useful.
Because duration ignores the curvature of the price–yield relationship, it is

a poor approximation of price sensitivity to larger yield changes. A
convexity adjustment accounting for the convex shape of the price–yield
curve improves the accuracy of the duration measure.
12.5.2 Convexity
The price change in response to rising rates is smaller than the price change
in response to falling rates for option-free bonds. This effect is due to
convexity (a non-linear change in price) and requires the duration value to
be modified or tweaked. Convexity for option-free bonds is always positive
– that is, the adjustment will effect a larger increase in price while reducing
the decrease in price as approximated by duration. Convexity moves in
unison with duration in that a higher convexity value coincides with a
higher duration value. As with duration, a longer maturity, lower coupon
and lower yield result in a larger convexity effect. This can be observed
from Table 12.3 which summarises the duration and convexity values for a
particular bond, assuming changes in yield, maturity and coupon
respectively.
Table 12.3 Summary of duration and convexity values
12-year, 9.2% coupon bond Higher yield Longer maturity Lower

yielding 7.8% 10.4% 15 years coupon 7.8%
Price R110.78 R91.88 R112.25 R100.00
Duration 7.47 6.95 8.49 7.72
Convexity 37.74 33.92 50.80 39.68
Convexity is a desirable trait. If you have two bonds with equal duration but
one has greater convexity, you would prefer the bond with greater convexity
because it would have better price performance whether yields fall (greater
increase in price) or rise (smaller decrease in price). Increases in price are
underestimated while any decrease in price is overestimated, as depicted in
Figure 12.4.
Figure 12.4 Convexity adjustment
The next section illustrates the calculation of the convexity and total
(duration plus convexity) effects.
12.5.2.1 Calculation of convexity

The effective convexity equation 12.14 requires the pre-calculated bond
prices as used in the duration equation. Refer to equation 12.11 and the
values used.
C =
V+V+ –2V0
2V0 (Δy/100)
2
(12.16)
119.4740+102.9282–(2 × 110.7830)
C =
2
2 × 110.7830 × (0.01)
= 37.7440
A convexity effect, to be added to the duration effect, needs to be

calculated. Note that, as previously, a 100 basis point (1%) change is
assumed in order to facilitate the illustration.
Convexity effect
(12.17)
2
%ΔPC = C(
Δy
100
) × 100
%ΔPC(1) = 37.7440(
1
100
) × 100 = 0.3774%
ΔPC(1) = 110.78 × (0.0037744) = R0.42
The convexity adjustment is R0.42 up and down, and this corresponds with
the discrepancies as calculated. Adding the convexity effect to the (±)
duration effect value gives the total effect, which is an accurate indication
of interest rate sensitivity.
Total effect
Total effect = Duration effect + Convexity effect
%ΔPT = – D(Δy) + [C(

Δy
)
2
× 100]
(12.18)
100
%ΔPT(1) = – 7.4676(±1) + [37.7440(

1
100
) × 100]
%ΔPT(–1) = – 7.4676(–1) + [37.7440(

1
100
) × 100]
= 7.4676% + 0.3774%
= 7.8450%
2
%ΔPT(+1) = – 7.4676(+1) + [37.7440(

1
100
) × 100]
= –7.4676% + 0.3774%
= –7.0902%
Estimating prices with duration and convexity

PT = V0 × (1±%ΔPT) (12.19)
PT(–1) = 110.78 × (1 + 0.078450)
= 110.78 × 1.078450 = R119.47
PT(+1) = 110.78 × (1 – 0.070902)
= 110.78 × 0.929098 = R102.93
A small modification (convexity adjustment) to duration provides for a

more accurate estimation of a change in price in response to a 1% change in
yield, as evident from the final results.
12.5.2.2 Negative convexity

A callable bond exhibits negative convexity, meaning that the price
appreciation in response to a decreasing market rate is limited (termed price
compression). A call provision effectively caps (sets upper limit) the value
of the bond since the issuer can call the bond from the holder. As Figure
12.5 illustrates, as the yield falls and the price approaches R107.50 (call
price), the price– yield curve (broken line) rises more slowly than that of an
identical but option-free bond. The price rises at a decreasing rate; the curve
bends over to the left, exhibiting negative convexity. At higher yields
(above y*) callable bonds perform in a similar way to non-callable bonds,
displaying positive convexity. The price of a callable bond is less than that
of an otherwise identical straight bond. This difference in price is the value
of the call provision to the issuer.
A put provision, on the other hand, provides a floor value (lower limit) for
the bond since the bondholder can put the bond to the issuer at a
predetermined price. As Figure 12.5 illustrates, as the yield increases and
the price approaches R100, the price–yield curve (broken line) drops more
slowly than that of an identical but option-free bond. The price declines at a
decreasing rate, the curve bends upwards, presenting a flatter slope and less
price sensitivity to yield changes (lower duration). At lower yields (below
y*) putable bonds perform in a similar way to non-putable bonds,
displaying positive convexity. The price of a putable bond is higher than
that of an otherwise identical straight bond. This difference in price is the
value of the put provision to the bondholder.
Figure 12.5 Call and put provisions
12.6 SUMMARY
Various calculations related to a bond’s price and yield can be performed

and an important feature of a bond is the inverse price–yield relationship.
Yields (zero or spot rates) on different maturity bonds of similar quality
determine a specific term structure of interest rates (i.e. shape of a particular
yield curve) and are used to derive forward rates. With bond prices totally
dependent on the prevailing market rate, a bond’s price or interest rate
sensitivity (measured by its duration) determines its suitability for inclusion
in a portfolio. Current exposures (liabilities) or interest rate forecasts dictate
the composition of a bond portfolio. Either offsetting an exposure (duration
matching of assets and liabilities) or managing an exposure (lengthening or
shortening of duration) requires the constant valuation and trading of
alternative bond issues.

BESA. 2007. Available at: http://www.bondexchange.co.za (accessed October 2008 to December
2008).
Choudhry, M. 2006. An introduction to bond markets, 3rd ed. Chichester, West Sussex: Wiley &
Sons.
Fabozzi, F.J. 2007. Fixed income analysis, 2nd ed. Upper Saddle River, NJ: Prentice-Hall.
JSE. Johannesburg Stock Exchange, Sandton, Gauteng. Available at: http://www.jse.co.za (accessed
in March 2016).
1. Identify the bond with the greatest interest rate risk:
(a) A 5% 5-year bond yielding 4%

(b) A 5% 10-year bond yielding 6%
(c) A zero-coupon 15-year bond yielding 6%
(d) A 10% 20-year bond yielding 8%
2. Calculate the realised yield of the following bond: coupon rate 13% (semi-annual);
maturity date 15 July 2015; transaction date 15 July 2003; YTM 15.5%;
reinvestment rate 9%; market price R86.56.
(a) 12.5%
(b) 13.5%
(c) 14.5%
(d) 15.5%
3. An investor can decide to invest in (i) a 1-year, zero-coupon bond yielding a spot
rate of 10.50% per annum, or (ii) a 6-month, zero-coupon bond yielding a spot
rate of 10.30% per annum, and then reinvest this return in a new bond. Calculate
the forward rate 6 months from now that would leave an investor indifferent
between these two options.
(a) 10.30%
(b) 10.50%
(c) 10.70%
(d) 10.90%
4. Calculate the duration of a 3-year, 7% semi-annual bond yielding 6%.
(a) 1.9857
(b) 2.6814
(c) 2.8107
(d) 2.8888
5. A 9-year bond has a yield to maturity of 10% and an effective duration of 6.54
years. If the market yield changes by 50 basis points, the bond’s expected price
change is:
(a) 3.27%
(b) 3.66%
(c) 5.00%
(d) 6.54%
6. If you expected interest rates to fall, you would prefer to own bonds with:
(a) long durations and high convexity

(b) long durations and low convexity
(c) short durations and high convexity
(d) short durations and low convexity
7. A 6% coupon bond pays interest semi-annually, has a duration of ten, sells for
R800, and is priced to yield 8%. If the market rate increases to 9.5%, the
predicted decrease in price, using the duration concept, is:
(a) R72
(b) R80
(c) R96
(d) R120
8. The current price of a bond is R102.50. If the market rate changes by 0.5%, the
bond’s price changes by R2.50. What is the duration of this bond?
(a) 2.44
(b) 3.87
(c) 4.88
(d) 5.02
9. Assume a bond with an effective duration of 10.5 and a convexity of 97.3. Using
both of these measures, the estimated percentage change in price for this bond in
response to a decline in yield of 200 basis points is closest to:
(a) 17.11%
(b) 19.05%
(c) 22.95%
(d) 24.89%
10. A straight 5% bond has 2 years remaining to maturity and is priced to yield 6%. A
callable bond that is the same in every respect as the straight bond, except for the
call feature, is priced at R917.60. What is the value of the embedded call option?
(a) R45.80
(b) R63.81
(c) R82.40
(d) R99.13
Solutions
1. (c)
The zero-coupon 15-year bond yielding 6% is subject to the most interest rate
risk. The combination of a long term to maturity, no coupon payments and a low
yield results in a relatively longer duration and greater price sensitivity.
2. (a)
Future value of an annuity (24 coupons invested at 9%):
The total return components are the principal value plus interest income (ending
value), and the purchase price (beginning value). The total future or ending value
in this instance is R370.98 (R100.00 + R270.98) with the beginning value at
R86.56.
Doubling 6.2514% gives a total return (realised or horizon yield) of 12.50%.

3. (c)
2
1/(2–1)
1.0525
6 f6 = [( 1
) – 1] × 100 × 2 = 10.70% (12.9)
1.0515
SR12 = [(1.103 × 1.107)1/2 – 1] × 100 = 10.50%

4. (b)
V_ V0 V+
FV 100 100 100
PMT 3.5 3.5 3.5
I/YR 2.5 3.0 3.5
N 6 6 6
PV? –105.5081 –102.7086 –100.0000
105.5081–100.0000
D =
2×102.7086×0.01
= 2.6814 (12.11)
5. (a)
50
%ΔPD(0.5) =– 6.54 (±
100
) = ±3.27% (12.12)
6. (a)
Bonds with longer durations would benefit most from increasing bond prices as
interest rates fall, due to higher interest rate sensitivity. Higher convexity bonds
are always preferred to lower convexity bonds as they perform better, whether
yields fall (greater increase in price) or rise (smaller decrease in price).
7. (d)
150
ΔPD(1.5) =– 10 × ( %) × 800 =– R120
100
For every 1% change in yield, the bond’s price will change by 10% or R80. An
increase of 1.5% in yield will result in a R120 (R80 × 1.5) decrease in price.
8. (c)
(2.50)/
102.50
Duration = (
0.005
) = 4.88 (12.10)
9. (d)
2
2
%ΔPT(–2) = – 10.5(–2) + [97.3( 100 ) × 100] (12.16)
= 21% + 3.89%
= 24.89%
10. (b)
Calculate the price of the straight bond (always assume semi-annual
compounding if not stated):
The value of the embedded call option is R63.81, representing the difference
between the straight bond (R981.41) and the callable bond (R917.60) which
trades at a larger discount to par.
1 Immunisation ensures that the value of a bond portfolio at the end of a holding period is at
least as large as it would have been had interest rates been constant.
2 The future value can also be calculated as R30.5117(1.04)4 = R35.69.

1/10
3 The total return can also be calculated as [( 150.13
110.78
) – 1] × 100 = 3.0862%; (2 × 3.0862) =
6.17%
4 Any assumption on the size of the change in the market rate (e.g. half a per cent or two per
cent, etc.) would suffice, obviously resulting in different up and down bond prices, but ending
with the same final duration value.
5 Asset–liability management (ALM) is the practice of managing risks that arise due to
mismatches between the assets and liabilities of a company (opposite sides of the statement of
financial position). Any exposure to changing interest rates is limited by matching the duration
of a company’s assets to the duration of its liabilities.
PART
4
Portfolio management
OVERVIEW
Chapter 13 Portfolio management

Chapter 14 An introduction to derivative instruments
Chapter 15 Evaluation of portfolio management
Chapter 13 explains the objectives and constraints of portfolios, asset

allocation and the construction of portfolios. The management of equity
portfolios and fixed interest security portfolios is explained.
Chapter 14 explains the derivative instruments which could be used for

either hedging or speculative purposes. Derivative instruments, in a
portfolio management context, could be used to change the risk/return
characteristics of a portfolio. Futures, options and swaps are explained.
Chapter 15 explains the evaluation of portfolio management. It looks at the

fundamental issues and performance management. Sharpe and Treynor’s
measures of portfolio management performance are also explained.
13 Portfolio management
13.1 INTRODUCTION
Portfolio management comprises all the processes involved in the creation

and maintenance of an investment portfolio and deals specifically with
security analysis and selection, as well as portfolio evaluation and
modification. This process attempts to maximise return at a given level of
risk and determines an optimal asset allocation as well as ensuring
sufficient diversification. There are two main forms of portfolio
management, namely passive and active management. Passive management
simply tracks a market index in order to achieve a return equal to the
market return. Active management attempts to exceed the market return by
actively managing a portfolio through investment decisions based on
research, analysis and valuation.
Investing in securities such as shares and bonds can be very profitable and
rewarding, but involves a great deal of risk and requires knowledge, as well
as expertise. Educated investors rarely invest in a single security, but
diversify and invest in a number of different asset classes and a variety of
securities in those asset classes, thereby constructing a portfolio of assets.
Creating a portfolio helps to reduce risk, without sacrificing returns.
Portfolio management deals with the analysis of individual securities, as
well as with the theory and practice of optimally combining securities into
portfolios. Investors need to understand the fundamental principles and
analytical aspects of portfolio management in order to profit from actively
managing their portfolios.
Investors have to choose among a large number of securities and optimally

divide and allocate funds to the selected individual securities. The return
realised from the portfolio has to be measured and the performance of the
portfolio has to be evaluated. In addition, the risk-return characteristics of
individual securities and of portfolios change, and these require constant
review and monitoring.
13.2 INVESTMENT POLICY STATEMENT
The initial and very important step is to draft an investment policy

statement (IPS), which defines the general investment goals or objectives.
The IPS describes the strategies that will be used to meet these objectives
and contains specific information on issues such as asset allocation, risk
tolerance and liquidity requirements. Every investor should benefit from
having an IPS as it provides the foundation for all future investment
decisions. It serves as a benchmark, setting goals and creating a systematic
review process. The IPS is intended to keep investors focused on their
objectives during short-term fluctuations in the market and provides a
baseline from which to monitor the performance of their investment
portfolios.
An IPS is a document that guides and controls investment decision making.

The investment process is dynamic and allows changes in circumstances to
be incorporated into overall investment decisions while always taking the
objectives and constraints of an investor into consideration. An IPS
represents the long-term objectives of the investor and any deviations from
these initial guidelines will be temporary. Steps in the process include the
following:
To determine and evaluate the investor’s risk and return objectives

To determine portfolio constraints
To define the appropriate investment strategy based upon an analysis of
these objectives and constraints as well as market expectations
To determine the proper asset allocation suited to meet the investor’s
objectives and constraints
To execute portfolio decisions and, after a certain period, evaluate
performance
To make modifications or adjustments to the portfolio as needed to
ensure adherence to the originally stated objectives and constraints
13.3 OBJECTIVES AND CONSTRAINTS
Rate of return objectives are mostly tempered by an investor’s risk

tolerance, but other factors also apply. These are constraints, such as time
horizons, income and liquidity needs, tax considerations, legal and
regulatory requirements, and unique preferences or circumstances. These
objectives and constraints, considered in the light of investment market
expectations (expected returns, return volatilities and return correlations),
will dictate the appropriate investment strategies to be followed, including
asset allocation and selection, the investment style to be pursued, and the
appropriate way to monitor and evaluate performance.
Each investor has a unique combination of goals, time horizons, liquidity

needs, tax circumstances, risk tolerances and attitudes towards investing.
The first step in both investment planning and management includes
defining these investment objectives and constraints to determine
investment strategy and which types of investment are appropriate.
Objectives and constraints include the following:
Objectives are the financial goals the investor is seeking to achieve

(retirement, education, etc.).
Risk tolerance level is a measure of an investor’s willingness, ability and
need to accept risk (i.e. loss of capital) when purchasing an investment.
Time horizon is a measure, such as retirement or life expectancy, of the
amount of time available to achieve a financial goal.
Expected rate of return is the expected annual rate of return over the time
horizon based upon risk tolerance.
Liquidity is the ability to convert an investment into cash without losing
principal, which would be an important consideration for an investor with
limited assets or short-term goals.
Marketability is the speed and ease with which an investment can be
purchased or sold.
Taxes are considerations that include the investor’s tax bracket and the
types of cash flow, such as interest, dividends and short- or long-term
capital gains. After-tax returns should be analysed in assessing which
investments are appropriate.
Unique considerations are limitations that individuals may have on what
types of investment are suitable for their portfolio. For example, some
investors would prefer not to own shares in tobacco or alcohol
companies, or invest in certain foreign countries.
13.3.1 Objectives
The major objectives for an investor are determining risk and return
parameters, which are done in conjunction with each other. Returns must be
commensurate with the level of risk, and any discrepancy must be resolved.
13.3.1.1 Risk
An investor will have both a willingness and an ability to take risk. The
ability to take risk can be quantified (in terms of a standard deviation) and
is determined by the investor’s time horizon, and the size of the portfolio
and income relative to the investor’s goals. If these goals are small relative
to the portfolio size and the time horizon is long, the investor has a greater
ability to take risk. If the goals are large relative to portfolio size and the
time horizon is short, the ability to recover from any unfavourable
outcomes will be impaired and risk tolerance greatly reduced. Time horizon
is the ultimate driving force that dictates an investor’s risk tolerance – the
longer the horizon, the greater the ability to take on risk.
To measure an investor’s ability to take risk requires an assessment of the

following:
Investor’s short, medium and long-term goals
The next one to three years are usually defined as a short-term goal. An
example might be an overseas holiday or a new car. Generally, stable and
more conservative investments like cash are used to achieve short-term
investing goals. Paying a deposit on a house or setting up a business in the
next three to five years are medium-term investment goals. Generally, a mix
of conservative and income-producing growth investments are used to
achieve medium-term goals. Goals over five years away are generally
considered long-term investment goals. Examples may be saving an amount
for children’s education, a holiday house or retirement. Generally, long-term
investors are willing to invest in growth assets such as shares or property.
Importance of meeting those goals

Risk is a far more important consideration in attaining primary or critical
goals than in achieving secondary goals. Goals related to financial security,
maintaining a current lifestyle and providing for family members are
classified as primary. Goals related to luxury items, acquiring second homes
or taking vacations are important but are secondary to the critical goals,
which should be met first.
Amount of volatility the portfolio can bear before jeopardising any

goals
Financial goals must be realistic for the current size of the portfolio and the
investor’s ability to make future contributions to the portfolio. If the
required return on the portfolio must be increased to the point that the
portfolio is just too risky, the goals must be re-evaluated. Higher-risk
investments like shares generally have the potential for higher returns.
While they may be volatile and fluctuate in the short term, over the longer
term they have the potential to achieve capital gain and protect an
investment against inflation. On the other hand, fixed-term deposits or
fixed-interest investments generally provide income but have lower
potential for capital gain. After allowing for tax, these investments may not
keep pace with inflation over the long term.
Therefore the questions to be asked are the following:

What is the individual’s investment time frame?
– Short term → next year’s holiday

– Medium term → buying a home
– Long term → lifestyle in retirement
What does the investor want to achieve from the investment?
– Income → cash available right now

– Growth → nest egg for the future
Does the investor want easy access to the investment?
– Short- or long-term investments

– Flexibility → the ability to change plans if needed
– Liquidity → the ability to sell an asset quickly or withdraw money if
needed
Willingness to take risk is subjective and is determined by the

psychological profile of the investor. There is no hard and fast rule for
judging an investor’s willingness to take risk.
If a conflict arises between the ability and willingness to take risk, the
investor’s willingness (if less than his or her ability to take risk) should
receive precedence. If willingness is greater than ability, the ability should
be honoured. A return objective that cannot be accomplished given the risk
tolerance should be reassessed.
13.3.1.2 Return
Return requirements are dictated by spending and growth objectives. A
distinction is drawn between a required and a desired level of return. The
return necessary to meet an investor’s long-term financial goals is a
required return. Desired returns are associated with non-primary or
secondary goals and objectives. Discrepancies between risk and return must
be resolved by evaluating and adjusting these desired return levels.
Returns should be considered from a total return perspective – spending

objectives represent the income component, while growth objectives
represent the capital gain component of total return. Attention to portfolio
growth (to guard against inflation) should always be the focus, even with a
substantial income requirement.
To measure an investor’s return objectives, the following should be done:
Assess the time horizon. The longer the horizon, the more concerned the
investor should be with inflation and real (inflation-adjusted) returns,
keeping in mind that risk tolerance also increases with the time horizon.
Assess the liquidity requirements. The return required to meet any
current and on-going obligations should be calculated.
Translate specific wealth objectives into annualised return objectives.
Weight the total return according to capital gains (growth) or income
generation (liquidity).
13.3.2 Constraints
The major investment constraints include time horizon, liquidity, tax
concerns, legal and regulatory factors, and unique circumstances.
13.3.2.1 Time horizon

Goals are sorted into three distinct time horizons:
Pre-retirement. The time from developing an IPS to retirement

Retirement. The projected number of years after retirement that the
investor will live on the proceeds from the portfolio
Post-retirement. The disposition of wealth after death
However, a time horizon is generated every time an investor’s
circumstances change significantly. A currently employed investor will
have at least two time horizons or life stages – remaining working years and
retirement years. Additional time horizons are generated within a stage of
life once a planned expense is significant enough to alter an IPS. The length
of each time horizon (short or long term) will affect portfolio construction.
The time horizons or circumstances of people related to an investor may
also impact on his or her IPS – for example, an investor’s parents may pass
away and leave significant assets to the investor or to his or her children,
who in turn may be entering tertiary education or need money to start their
own business.
13.3.2.2 Liquidity
This constraint relates to the ability to meet everyday needs as well as
unexpected events:
Normal expenses (high-priority or ongoing needs). The anticipated needs

for cash usually tied to living expenses
Sufficient surplus (immediate needs). The reserves to meet emergencies,
such as unexpected medical expenses and uninsured losses
Major planned events (timed or shifting needs). Vacations, home
remodelling, etc., leading to withdrawals from the portfolio
Ongoing liquidity needs are those recurring expenses that need to be paid
over upcoming time periods and are serviced through a combination of cash
and income generation. A portion of any portfolio should be allocated to
cash or cash equivalents (i.e. money market instruments), and selling
securities (reducing the asset base) should be avoided. Immediate liquidity
needs are expenses that require immediate settlement or within a very short
time period and should be financed through a reserve or emergency fund.
Taxes are commonly an immediate liquidity need that should be addressed.
Shifts in ongoing needs, such as major planned events, require changes in
liquidity as the spending date comes closer. Funds, for example, needed in
three months to purchase a house should be removed from the value of the
portfolio before determining a required return.
Transaction costs (liquidating assets or withdrawing money), volatility
(uncertainty regarding price) and illiquid holdings (e.g. a home or shares in
a privately held company) all depress liquidity or restrict access to cash.
13.3.2.3 Tax concerns

Some general classifications of tax are the following:
Income tax. Taxes paid on cash flows (e.g. salary or wages, rental
income, dividends or interest income)
Capital gains tax. Taxes paid on the price appreciation of assets sold
Transfer tax. Taxes paid on assets transferred through inheritance, gifts or
when acquiring property
Dividend tax. Tax the shareholder pays on the dividend, which is taxed at
a rate of 15% (at the time of writing). This is withheld by the company
paying the dividend or an intermediary, and paid over to SARS. The net
dividend is then paid to the shareholder. This cost is therefore shifted
from the company to the shareholder.
Taxes paid at the end of a holding period reduce the final value of the
portfolio. However, taxes paid in an interim time horizon have an impact on
the portfolio through a reduction of compounding benefits. The following
are some of the ways to reduce the adverse impact of tax effects on a
portfolio:
Tax deferral. Paying taxes at the end of the investment-holding period

will minimise the effect of taxes. This is accomplished by low turnover
(i.e. less trading) and offsetting portfolio gains with portfolio losses.
Tax avoidance. Invest in annuities and pension plans.
Tax reduction. Invest in securities that require less direct tax payment.
Capital gains may be taxed at lower rates than income or dividend
payments, so securities that generate returns mainly as gains offer the
investor a lower effective tax rate.
Wealth transfer tax. Minimise taxes by planning the transfer of wealth
from one party to the next without involving a sale. Considerations as to
when a transfer will be made are also important. If wealth is transferred
at death, taxes will have been deferred as long as possible. If wealth is
transferred prior to death, the younger or less wealthy recipient may be
taxed at a lower rate.
13.3.2.4 Legal and regulatory factors

The legal and regulatory factors that apply to individual investors are
mainly associated with taxes and transfer of personal property requiring
professional or legal advice.
13.3.2.5 Unique circumstances

Miscellaneous details or requests that should be kept in mind, such as out of
the ordinary expenses or disallowed investments, appear in this section.
These can include the presence of large numbers of private company shares,
large return requirements relative to low risk tolerances or short time
horizons, and investor-imposed constraints against certain investments
based on personal beliefs or principles. Special needs constraints relate
specifically to an investor’s family, business and other areas of life that are
important to him or her.
13.3.3 Stage of life

Stage of life classification assumes the investor’s investment horizon to be
one of the primary drivers of a suitable investment policy – the younger the
investor, the longer the investment horizon and the more aggressive the
investment strategy.
Life-cycle investing (see Figure 13.1) aligns strategy to the stage or phase
reached in an individual investor’s life. Investment strategies change during
an individual’s lifetime as there is an inverse relationship between age and
risk tolerance. Younger investors have more opportunities to recover from
market downturns and can therefore tolerate higher levels of risk with their
portfolios geared for aggressive growth. Investors in mid-career still have a
long time horizon and they can tolerate risk, but their portfolios should
become less aggressive and be more conservative, especially as they
approach retirement. Investors approaching retirement age may soon not be
able to rely on a steady source of income to offset any negative portfolio
performance. Investors in this later stage of life exhibit a low tolerance for
risk. A life-cycle investing approach starts with a comparatively high-risk,
high-return strategy that gradually moves to low risk and low return over
the years, and is broadly divided into four phases, namely the accumulation,
consolidation, spending and gifting phases.
Figure 13.1 Life-cycle investing
13.3.3.1 Accumulation phase

Young people with a long time to retirement can invest on a long-term basis
which can be heavily weighted in equity. In the accumulation phase, the
individual is accumulating net worth to satisfy short-term needs (e.g. house
and car purchases) and long-term goals (e.g. retirement and children’s
education). In this phase, the individual is willing to invest in moderately
high-risk investments in order to achieve above-average rates of return.
13.3.3.2 Consolidation phase

As people grow older and the time to retirement shortens, they require a
lower-risk portfolio to ensure preservation of what they have accumulated.
The equity exposure should gradually reduce in favour of bonds. In the
consolidation phase, an investor has paid off many outstanding debts and
typically has earnings that exceed expenses. In this phase, the investor is
becoming more concerned with long-term needs of retirement or estate
planning. Although willing to accept moderate portfolio risk, the investor
should not be willing to jeopardise current accumulated savings.
13.3.3.3 Spending phase

People spend their accumulated savings after retirement. In the spending
phase, the typical investor is retired or semi-retired. During the period in a
person’s life following retirement, earning income ceases and the person
lives off investments and/or money saved for retirement. During the
spending phase income may decrease substantially but this is likely to
coincide with a decrease in living expenses. Children are usually no longer
dependent on their parents, and major debts (such as mortgages) may be
paid off. Travelling, relaxing and enjoying retirement are the principal goals
of someone living in their spending phase. While attempting to maintain the
nominal value of accumulated savings, the investor should also guard
against inflation.
13.3.3.4 Gifting phase

People with reasonable savings are unlikely to spend all their money during
their remaining lifespan and start giving it away. The gifting phase is often
concurrent with the spending phase. The individual believes that the
portfolio will provide sufficient income to meet expenses, plus a reserve for
uncertainties. Believing that there are excess amounts available in the
portfolio, the investor may decide to give or donate money or assets to
family and friends, or charitable organisations, or establish trusts to
minimise estate taxes. The investor’s focus shifts from capital accumulation
to estate planning and tax minimisation. A large amount of accumulated
wealth may provide for the current and future needs of family and friends,
as well as fund charities through philanthropy. The gifting phase of a
successful investor’s life can be the most personally fulfilling reward for a
commitment to long-term investing.
In a simplified life cycle, an investor’s funds should be moved from equity
to bonds over the years to gradually adjust (decrease) an investor’s
exposure to risk. Assume that an individual invests in a retirement fund and
that this fund’s assets are invested primarily in equity (common or ordinary
shares) funds and bonds (fixed-income or interest). The funds move along a
glide path, becoming more conservative as investors near retirement. For
younger investors, for example, a fund starts with 90% in equity funds. At
retirement, equity holdings would have dropped to 55%. Upon reaching the
target retirement date, the investor begins to gradually ratchet down the
equity exposure over the ensuing 30 years, ending at 20% equities and 80%
bonds at age 95. Alternatively, a constant allocation of 40% in equity and
60% in bonds will provide more protection against inflation.
The basic 80/20 or age-in-bonds rule to asset allocation can be applied –

that is, if an investor is 20 years old, an 80/20 (equity/bonds) asset
allocation would be optimal. Conversely, at 80 years old, the investor
should be invested 20% in equity and 80% in bonds. There are other rules
of thumb – for instance, with the [110 minus age] in equities rule, a 50-
year-old investor should have a 60/40 equity/bonds allocation. More risk-
seeking investors can use the [120 minus age] in equities rule, advising the
50-year-old investor to have a 70/30 equity/bonds asset allocation.
The time frame of an investor’s financial goals must be considered. When

close to retirement an investor should focus on the preservation of capital
rather than on appreciation or growth. Growth comes with greater risk and,
while investing in equity has the potential for large capital gains, this same
potential for growth can also turn into large losses. A capital preservation
strategy protects the principal or invested amount and requires investing in
or shifting money to relatively safe, but low-yielding products (e.g. cash
and/or bonds). Even though there is a lower risk of loss of the original
capital, it is important for the investor to realise that reliance only on the
safest products could mean that many financial or retirement goals may not
be met.
Alternatively, an asset allocation strategy that seeks to maximise capital

appreciation or to increase the value of a portfolio or asset over the long
term can be followed. Portfolios with the goal of capital growth consist
mainly of equities. The exact proportion of equities to other assets in the
portfolio will vary according to the individual investor’s investment
horizon, financial constraints, investment goals and risk tolerance. In
general, a capital growth portfolio will contain approximately 65% to 70%
equities, 20% to 25% bonds, and the remainder in cash or money market
securities. While seeking high returns, this mixture still protects the investor
somewhat against a severe loss in portfolio value if the higher-risk equity
portion of the portfolio performs badly. An aggressive portfolio strategy
also aims to maximise capital growth, but of the total portfolio value, and
these strategies are of considerably higher risk, sometimes consisting
entirely of equities.
The objective for a current income portfolio of securities is to provide high

dividend (equity) and fixed-interest payments (bonds) to satisfy an
investor’s steady income requirements. Current income portfolios are often
created for individuals in their retirement years because steady income is
needed for living expenses. Income is generated from bond interest
payments and dividends. A current income portfolio is moderately
conservative as it contains a large percentage of bonds and high-quality
equity shares.
13.4 ASSET ALLOCATION
Asset allocation involves dividing an investment portfolio among different

asset categories, such as equity, bonds and cash. The asset allocation that
works best for an investor at any given point will depend largely on the time
horizon and his or her ability (and willingness) to tolerate risk. When it
comes to investing, risk and reward are interlinked. All investments involve
some degree of risk and the reward for taking it on is the potential for a
greater investment return. If an investor has a financial goal with a long
time horizon, he or she is likely to make more money by investing in asset
categories with greater risk, such as equity shares or bonds, rather than
restricting his or her investments to assets with less risk, such as cash
equivalents (i.e. money market securities). However, investing solely in
cash-equivalent securities may be appropriate for short-term financial goals.
For most financial goals, investing in a mix of equity, bonds and cash can
be an appropriate strategy. The characteristics of the three major asset
categories are as follows:
Equity has historically had the greatest risk and highest returns among the
three major asset categories. As an asset category, shares offer the
greatest potential for growth. However, the volatility of shares makes
them a very risky investment in the short term, but investors willing to
accept the volatile returns of shares over long periods of time generally
have been rewarded with strong positive returns.
Bonds are generally less volatile than shares but offer more modest
returns. As a result, investors approaching a financial goal might increase
their holdings relative to their equity holdings because the reduced risk of
holding more bonds would be attractive to them despite their lower
potential for growth.
Cash and cash equivalents such as savings deposits and money market
funds are the safest investments, but offer the lowest return of the three
major asset categories. The chances of losing money on an investment in
this asset category are generally very low. The principal concern for
investors investing in cash equivalents is the risk that inflation will
outpace and erode investment returns over time.
Equity, bonds and cash are the most common asset categories and are the
ones investors would likely choose from when investing in a retirement
savings programme or a tertiary education savings plan. However, other
asset categories, including real estate, precious metals and other
commodities as well as private equity, also exist, and some investors may
include these within a portfolio for added diversification. By including asset
categories with investment returns that move up and down under different
market conditions within a portfolio, an investor can protect against
significant losses. Market conditions that cause one asset category to do
well often cause another to have average or poor returns. By investing in
more than one asset category, investors reduce the risk that they will lose
money, and their portfolio’s overall investment returns will be less volatile.
The practice of spreading money among different investments to reduce risk
is known as diversification. By selecting the right group of investments,
investors should be able to limit their losses and reduce the fluctuations of
investment returns without sacrificing too much potential gain. In addition,
asset allocation is important because it has a major impact on whether
investors will meet their financial goals. Not including enough risk in a
portfolio may result in not earning a large enough return to meet any goals.
On the other hand, too much risk may lead to severe losses and no money to
meet these financial goals.
Determining the appropriate asset allocation model for a financial goal is a

complicated task as it involves selecting a mix of assets that has the highest
probability of meeting specific goals at an acceptable level of risk. Getting
closer to meeting these goals, the mix of assets should be adjusted
accordingly. The asset allocation decision is the most important judgement
an investor can make with respect to investments, and is even more
important than selecting individual securities. Many investors use asset
allocation as a way to diversify their investments among asset categories. A
diversified portfolio should be spread both between and within asset
categories, so in addition to allocating funds among shares, bonds, cash
equivalents and possibly other asset categories, one also needs to spread
investments within each asset category. The key is to identify investments
in segments of each asset category that may perform differently under
similar market conditions. One way of diversifying investments within an
asset category is to identify and invest in a wide range of companies and
industry sectors, but the equity portion of an investment portfolio will not
be diversified by investing in only four or five individual shares. At least a
dozen carefully selected individual shares are needed to be truly diversified.
The equity portion of an investment portfolio will only be fully diversified
by investing in at least a dozen carefully selected individual shares.
The most common reason for changing an asset allocation is a change in

time horizon. For example, most people investing for retirement hold less
equity and more bonds and cash equivalents as they get closer to retirement
age. One may also need to change an asset allocation if there is a change in
risk tolerance, financial situation or the financial goal itself. Rebalancing is
bringing a portfolio back to its original asset allocation mix. This is
necessary because over time some of the investments may become out of
alignment with the investment goals as some investments will grow faster
than others. By rebalancing, investors ensure that a portfolio does not
overemphasise one or more asset categories and the portfolio is returned to
a comfortable level of risk. When rebalancing one needs to review the
investments within each asset allocation category and if any of these are out
of alignment with the investment goals, one may have to bring them back to
their original allocation within the asset category. It may be advisable for
investors to rebalance their portfolio on a regular time interval, such as
every six or twelve months. Alternatively, it can be rebalanced only when
the relative weight of an asset class increases or decreases more than a
certain percentage that was identified in advance.
Strategic and tactical asset allocation both refer to a particular mix of

equity, bonds, cash and potentially other asset classes.
13.4.1 Strategic asset allocation

At the inception of the portfolio, a base policy mix is established, based on
expected returns and risk. Then the asset class mixes are rebalanced to
target weights according to the original mix, usually at regular intervals
such as monthly or quarterly, to maintain a long-term goal for asset
allocation. There is no attempt to purposely deviate from the original
determined weights, and the emphasis is on preserving the fixed weights
because they ultimately relate to a larger performance objective based on
historical data.
13.4.2 Tactical asset allocation

Over the long run, a strategic asset allocation strategy may seem relatively
rigid. It may therefore be necessary to occasionally engage in shortterm
tactical deviations from the mix in order to capitalise on unusual or
exceptional investment opportunities. This flexibility adds a component of
market timing to the portfolio, allowing an investor to participate in
economic conditions that are more favourable for one asset class than for
others. The objective of tactical asset allocation is to move among various
asset classes to create an additional source of return. Tactical asset
allocation is a moderately active strategy, since the overall strategic asset
mix is returned to when desired short-term profits are achieved. The
investor must be able to recognise when shortterm opportunities have run
their course, and then rebalance the portfolio to the long-term asset position.
Economic forecasts, market assessments, and equity and bond research are
of primary importance at this stage.
13.5 PORTFOLIO CONSTRUCTION
Diversification in a share portfolio refers to the attempt by the investor to

reduce exposure to risk by investing in various companies across different
sectors, industries or even countries, thereby spreading investments across
various sectors or industries with low correlation to each other, and thus
reducing price volatility. This is because different industries and sectors do
not move up and down at the same time or at the same rate, which provides
for a more consistent overall portfolio performance. However, it is
important to remember that no matter how diversified a portfolio is, risk can
never be eliminated. Risk associated with individual shares (i.e.
unsystematic risk) can be reduced, but there are inherent market risks (i.e.
systematic risk) that affect nearly every share, and no amount of
diversification can prevent this. A well-diversified equity portfolio can,
however, effectively reduce unsystematic risk to near-zero levels while still
maintaining the same expected return level a portfolio with excess risk
would have. According to the modern portfolio theory, one would come
very close to achieving optimal diversity after adding about the 20th share
to one’s portfolio. This does not suggest that buying any 20 shares equates
with optimum diversification. One needs to buy shares that are different
from each other, whether by company size, industry, sector, country, etc. –
that is, buying shares that are uncorrelated (i.e. those that move in different
directions during similar times).
As a general rule of thumb, investors should hold 15–20 shares in their

portfolio. A well-balanced portfolio with approximately 20 shares
diversifies away the maximum amount of market risk. Owning additional
shares takes away the potential of big gainers significantly impacting the
performance of a portfolio. In other words, if one diversifies too much, one
might not lose much, but one will not gain much either.
The above relates to diversification within a portfolio of shares. An

investor’s overall portfolio should also diversify among different asset
classes, meaning allocating a certain percentage to bonds, commodities, real
estate, alternative assets, and so on.
An investor should construct (initial selection) and modify (omit and add
securities) his or her portfolio knowing what is creating the total risk and
return profile of the portfolio. In order to know that, one needs to look in
more detail at how to actually measure risk and return. In selecting
individual securities to be included in a portfolio, one has to calculate the
return and risk associated with each one as well as the correlation between
the securities selected for possible inclusion.
13.5.1 Measuring return

The word “return” is used in a number of different ways. Firstly, one can
look back at the performance of an investment – that is, the historical return
on an investment using actual data. An absolute return can be calculated,
which is simply the profit in monetary units that the investment yielded. If
this is expressed as a percentage relative to the initial amount of money
invested, a relative return is established. This percentage can also be stated
in terms of the additional return compared to the risk-free rate of return and
is known as alpha or the excess return. A R100 investment that is valued at
R110 after one year would result in a R10 absolute return, a 10% relative
return and, assuming a risk-free rate of 4%, a 6% excess return.
Secondly, one can look forward at the likely levels of return an investment
may yield in the future – that is, the expected return on an investment using
estimated data in conjunction with the probabilities of various levels of
returns. The word “return” therefore is being used in a backward- or
forward-looking sense.
13.5.1.1 Historical return

As stated, a historical or actual return records the past performance of a
security or index (basket or compilation of securities). Analysts review
historical return data when trying to predict future returns. Investors looking
to interpret historical returns should keep in mind that one cannot assume
that the future will be like the past. The older the historical return data are,
the more likely they are to be less useful when predicting future returns.
Historical returns are calculated as follows:
Historical (arithmetic) return

=
Totalled returns
Number of periods
(13.1)
Historical (geometric) return
= [((1 + r1 ) (1 + r2 ) … (1 + rn ))
1/n
− 1] × 100 (13.2)
Therefore, simply determine the mean return over different past periods.
An arithmetic mean (see Table 13.1) is calculated by totalling all the returns
and dividing that total by the number of periods. For example, if you know
a given investment had returns of 15%, 10%, 5% and a negative return of
5% over the past four years, the arithmetic mean would be equal to 6.25%:
Historical (arithmetic) return

(15+10+5−5)
= = 6.25%
4
Table 13.1 Arithmetic return
Period Return (%) Contribution

1 15 3.75
2 10 2.50
3 5 1.25
4 –5 –1.25
Average (k) 6.25%
A geometric mean is calculated by adding 1 to all returns in decimal form
and multiplying these values, after which the resultant value is annualised.
For example, if you know a given investment had returns of 15%, 10%, 5%
and a negative return of 5% over the past four years, the geometric mean
would be equal to 5.99%:
Historical (geometric) return

1/4
(1 + 0.15) (1 + 0.10)
= [( ) − 1] × 100
(1 + 0.05) (1 − 0.05)
1/4
= [((1.15) (1.10) (1.05) (0.95)) − 1] × 100
0.25
= [(1.26) − 1] × 100
= 5.99%
A geometric mean is always less than or equal to an arithmetic mean.

Geometric average returns are more accurate than arithmetic average
returns, because investment returns are not independent of each other.
13.5.1.2 Expected return

Expected returns are best estimates of what returns might be over some
future time period, and are based on historical return data or projection
models of different possible scenarios. Each scenario is assigned a
probability of occurrence. The result of weighting each scenario by its
probability of occurrence is the expected return – that is, the return an
investor expects to receive for investing in a given asset given a probability
distribution for the possible rates of return. However, the overall profit
expected to be received from an investment in the future may be very
different from the actual returns received.
An expected return is calculated as follows:
Expected return = ∑ (Probability of return) (Possible return)
(13.3)
n
E (R) = ∑ Pi [Ri ]
i=1
Therefore simply multiply the probability of each possible return by the
return outcome itself. For example, if you know a given investment had a
30% chance of earning a 15% return, a 40% chance of earning 10%, a 20%
chance of earning 5% and a 10% chance of earning a negative 5%, the
expected return would be equal to 9.0% (see Table 13.2).
Table 13.2 Expected return
Probability (%) Return (%) Contribution

30 × 15 = 4.5
40 × 10 = 4.0
20 × 5 = 1.0
10 × –5 = –0.5
E(R) = 9.0%
E(R) = [(0.3 × 15) + (0.4 × 10) + (0.2 × 5) + (0.1 × –5)] = 9.0%
Take note that assigning a probability of 25% to each possible outcome

would result in an expected return of 6.25% which equals the historical
(arithmetic) return.
13.5.2 Measuring risk

Risk is defined as some measure of the spread or dispersion of the
distribution of possible outcomes. The most common measures of risk are
the variance and the standard deviation.
Using the information in Table 13.3, the variance and standard deviation
calculations are illustrated.
Table 13.3 Returns
Period Returns (%) Probability(%) Returns (%)

Security A Security B Security A Security B
1 15 10 30 15 10
2 10 15 40 10 15
3 5 12 20 5 12
4 –5 5 10 –5 5
Average (k) 6.25 10.50 E(R) 9.00 11.90
13.5.2.1 Variance
Even though variance and standard deviation values can be calculated using
expected data, they are usually based on past performance or historical data.
Assuming that population data (i.e. all available data) are used, the summed
squared differences between the actual and mean returns are divided by the
number of periods (n) as shown. When applied to sample data (i.e. data
sampled from the population), the summed total is divided by (n – 1) to
avoid statistical bias.
n
¯
¯¯
∑ (Ri − R i )
2
(13.4)
i=1
2
σ =
n
2 2 2 2
(15−6.25) +(10−6.25) +(5−6.25) +(−5−6.25)
2
σ =
A 4
= 54.69
2 2 2 2
(10−10.5) +(15−10.5) +(12−10.5) +(5−10.5)
2
σ =
B 4
= 13.25
A standard deviation is simply the square root of the variance as calculated.
13.5.2.2 Standard deviation

A useful property of standard deviation is that, unlike variance, it is
expressed in the same units as the data.
2
σA = √σ = √54.69 = 7.40%
A
2
σB = √σ = √13.25 = 3.64%
B
With return data, standard deviation is expressed as a percentage. For
example, a portfolio may have a standard deviation of 8%, which represents
one “standard” unit of deviation from the average. If the average expected
return of a portfolio is 10% and it has a standard deviation of 8%, then the
majority of the time it would be expected that the returns of that portfolio
would fall into a range bound by the expected return plus or minus one
standard deviation. Thus, if the expected return is 10% and the standard
deviation is 8%, then our range of returns would be 18% (10% plus 8%)
and 2% (10% minus 8%). In other words, in most years an investment
portfolio with an expected return of 10% and a standard deviation of 8%
would deliver a return of between 2% and 18%. The smaller the standard
deviation, the more accurately one can predict what the return of one’s
portfolio will be in any given year. If the portfolio has a standard deviation
of 8%, then the range of possible returns is fairly high. The portfolio could
make as little as 2% or as much as 18%.
13.5.3 Covariance and correlation

Covariance is a measure of the degree to which the returns on two risky
assets move in tandem. A positive covariance means that asset returns move
together (similar behaviour). A negative covariance means that returns
move inversely (opposite behaviour). The sign of the covariance therefore
shows the tendency in the linear relationship between asset returns.
Possessing financial assets that generate returns that have a high covariance
with each other will not provide much diversification. For example, if share
A’s return is high (low) whenever share B’s return is high (low), then these
shares are said to have a positive covariance (i.e. a strong linear
relationship). If investors want to hold a diversified portfolio, they should
identify and select financial assets with returns that exhibit a weak linear
relationship and therefore have a low covariance with each other. The
covariance between the returns of two assets is calculated as follows (using
the information in Table 13.3):
(13.5)
n
¯
¯¯ ¯
¯¯
∑ (Ri − R i ) (Rj − R j )
i=j=1
Covij =
n
(15 − 6.25) (10 − 10.5) + (10 − 6.25)
(15 − 10.5) + (5 − 6.25) (12 − 10.5) +
(−5 − 6.25) + (5 − 10.5)

Covij =
4
= 18.125
The positive value of 18.125 shows that these share prices tend to change or
behave in similar fashion to some degree. However, the magnitude of the
covariance is not that easy to interpret. The normalised version of the
covariance, the correlation coefficient, shows by its magnitude the strength
of the linear relation and is calculated as follows:
ρij =
Covij
σi σj
(13.6)
18.125
ρij = = 0.67
(7.40)(3.64)
The correlation coefficient is a single number that describes the degree of

relationship or dependence between two variables. The calculated value
will always be between –1.0 and +1.0. The most familiar measure of
dependence between two quantities is Pearson’s correlation (ρ). It is
obtained by dividing the covariance of the two variables by the product of
their standard deviations. The Pearson correlation is +1 in the case of a
perfect positive (increasing) linear relationship (i.e. correlation), –1 in the
case of a perfect decreasing (negative) linear relationship (i.e. anti-
correlation), and some value between –1 and 1 in all other cases, indicating
the degree of linear dependence between the variables. As it approaches
zero there is less of a relationship (closer to uncorrelated). The closer the
coefficient is to either –1 or 1, the stronger the correlation between the
variables. If the variables are independent, Pearson’s correlation coefficient
is 0, but the converse is not true because the correlation coefficient detects
only linear dependencies between two variables. Therefore, perfect positive
correlation (a correlation coefficient of +1) implies that as one security
moves, either up or down, the other security will move in lockstep in the
same direction. Alternatively, perfect negative correlation means that if one
security moves in either direction, the security that is perfectly negatively
correlated will move in the opposite direction. If the correlation is 0, the
movements of the securities are said to have no correlation and they are
completely random. In practice, perfectly correlated securities are rare;
rather, one will find securities with some degree of correlation.
13.5.4 Portfolios
The important factor to consider when adding a security to a portfolio is not
the new security’s own variance but its average covariance with all the
other securities in the portfolio. Buying risky assets with a low correlation
with each other is the classic risk-reducing strategy. If the number of
securities is large (and the weights are small), covariances become the most
important determinant of a portfolio’s variance. The importance of
covariances is illustrated by determining the number of covariances per
portfolio. For an n asset portfolio there are n(n –1)/2 covariance terms, and
n variance terms. For example, a portfolio comprising 12 shares has 12
variance terms and 66 unique covariance terms. Compare that to a portfolio
of two assets which has two variance terms, and one covariance term, thus
an asset’s influence on a portfolio’s variance primarily depends on how it
co-varies with the other assets in the portfolio.
13.5.4.1 Measuring portfolio return

The expected return on a portfolio is calculated as the weighted average of
the expected returns on the shares which comprise the portfolio. The
weights reflect the proportion of the portfolio invested in the shares. This
can be expressed as follows:
(13.7)
n
E (RP ) = ∑ wi E[Ri ]
i=1
For a portfolio consisting of two assets, the above equation can be

expressed as follows:
E(RP) = w1E(R)1) + (1 – w1)E(R2) (13.8)
13.5.4.2 Measuring portfolio risk

Portfolio volatility is a function of the correlations ρij of the component
assets for all asset pairs (i, j). The volatility (variance or standard deviation)
of a portfolio reflects not only the volatility of the shares that make up the
portfolio but also how the returns on the shares which comprise the
portfolio vary together. The portfolio variance is calculated as follows:
(13.9)
n n n
2 2 2
σ = ∑w σ + ∑ ∑ wi wj σi σj ρij
P i i
i=1 i=1 j=i+1
For a portfolio consisting of two assets, the standard deviation can be

expressed as follows:
σP = √w σ
2
1
2
1
+ (1 − w1 ) σ
2 2
2
+ 2w1 (1 − w1 ) ρ1,2 σ1 σ2 (13.10)
13.5.5 Mean-variance analysis

Mean-variance analysis is the use of expected returns and variances of
individual securities as well as the covariance among security returns to
analyse the risk-return trade-off of combinations of these individual
securities (i.e. portfolios). Using the information in Table 13.4, calculate the
expected return and standard deviation of this two-asset portfolio.
Table 13.4 Two-asset portfolio
A B
Amount invested (R) 40 000 60 000
Expected return (%) 11 25
Standard deviation (%) 15 20
Correlation 0.3
First, determine the weight of each share relative to the entire portfolio.
Since the investments are R40 000 and R60 000 respectively, the total value
of the portfolio is R100 000.
wA = 40 000/100 000 = 0.40
wB = 60 000/100 000 = 0.60
Next, determine the weighted average expected return of the portfolio:
E(RP) = wAE(RA) + wBE(RB)

= (0.40 × 11) + (0.60 × 25)
= 19.4%
Finally, calculate the standard deviation of the portfolio:

Covij = ρij σi σj
(13.11)
2 2 2 2
σP = √W σ + W σ + 2WA WB ρA,B σA σB
A A B B
2 2 2 2
= √(0.4) (0.15) + (0.6) (0.20) + 2 (0.4) (0.6) (0.3) (0.15) (0.2)
= 14.94%
Note that the total risk of the portfolio declined (compared to single assets
A and B) while the return increased (compared to single asset A). It is
possible to determine the minimum-variance distribution of funds in order
to obtain the lowest possible total risk for a two-asset portfolio.
13.5.5.1 Minimum-variance allocation

In the previous example, the expected return and standard deviation of one
possible combination, 40% in A and 60% in B, were calculated. There are
actually an infinite number of possible combinations of these two shares.
The data in Table 13.5 show some of these combinations, and it is clear that
the lowest portfolio standard deviation allocation would be between 60%
(13.72%) and 80% (13.74%) invested in security A.
Table 13.5 Combinations
wA 100% 80% 60% 40% 20% 0%

wB 0% 20% 40% 60% 80% 100%
E(RP) 11.0% 13.8% 16.6% 19.4% 22.2% 25.0%
σP 15.0% 13.74% 13.72% 14.9% 17.1% 20.0%
A more exact weighting can be calculated as follows:
(13.12)
2
σ −ρ1.2 σ1 σ2
2
W1 =
2 2
σ +σ −2ρ1.2 σ1 σ2
1 2
2
(0.2) −(0.3)(0.15)(0.20)
W1 =
2 2
(0.15) +(0.20) −2(0.3)(0.15)(0.20)
= 69.66% → 70%
Investing 70% of funds in security A and 30% in security B would achieve

minimum portfolio variance at a weighted average return of 15.2% and the
lowest possible portfolio standard deviation of 13.6% – that is, the highest
return at the lowest risk:
E (RP ) = (0.7 × 11) + (0.3 × 25)
= 15.2%
2 2 2 2
σP = √(0.7) (0.15) + (0.3) (0.20) + 2 (0.7) (0.3) (0.3) (0.15) (0.2)
= 13.6%
The minimum-variance weighting is governed by the correlation between

the two securities.
13.5.6 Correlation and diversification

Diversification reduces volatility while maintaining return. As the
correlation between two assets decreases, the benefit of diversification
increases as there is less of a tendency for returns to move together. The
separate movements of each share reduce the volatility of a portfolio to a
level below that of its individual constituents. This is illustrated in Figure
13.2 where the minimum-variance frontier (i.e. graph of the lowest possible
portfolio variance or standard deviation that is attainable for a given
portfolio expected return) bulges to the left as the correlation between two
assets decreases. The lower the correlation (closer to –1), the greater the
bulge and as the correlation moves toward +1, the bulge flattens out. If the
correlation equals +1, the minimum-variance frontier is a straight line
between the two end points (100% security A or B) and there is no benefit
to diversification as the share returns move in unison. If the correlation
equals –1, the minimum variance frontier is two straight-line segments,
depicting a portfolio combination of security A and security B with a
standard deviation of zero.
Figure 13.2 Effect of correlation on the benefit of

diversification
The individual expected return/risk combinations for security A and

security B are 11/15 and 25/20 respectively (refer to Table 13.5).
Constructing a two-asset portfolio by investing 40% of the funds in security
A and 60% in security B (correlation = 0.3) would result in a 19.4/13.9
return/risk combination. However, minimum-variance asset allocation (i.e.
lowest possible risk combination at given correlation) requires 70% of the
funds to be invested in A and only 30% in B, resulting in a 15.2/13.6
combination. Assuming a perfectly negative correlation of –1, it can be
shown that a 57–43 distribution of funds between A and B would result in
zero risk at a 17% combined return.
2
(0.2) −(−1)(0.15)(0.20)
W1 =
2 2
(0.15) +(0.20) −2(−1)(0.15)(0.20)
= 57.14% → 57%
E (RP ) = (0.57 × 11) + (0.43 × 25)
= 17.0%
2 2 2 2
σP = √(0.57) (0.15) + (0.43) (0.20) + 2 (0.57) (0.43) (−1) (0.15) (0.2)
= 0.0%
13.5.7 Three-asset portfolio

With a three-asset portfolio, covariances are more influential than with a
two-asset portfolio – there are three covariances now instead of one. As one
adds more assets, covariances become a more important determinant of the
portfolio’s variance (diversification). Calculate the expected return and
standard deviation of the portfolio shown in Table 13.6.
Table 13.6 Three-asset portfolio
A B C
Amount invested (R) 40 000 25 000 35 000
Expected return (%) 11 25 15
Standard deviation (%) 15 20 25
Correlations
A and B 0.3
A and C 0.1
B and C 0.5
Just as in the two-asset case, the expected return on a portfolio of three

assets is the weighted average of the returns on the individual assets:
E(RP) = w1E(R1) + w2E(R2) + w3E(R3)

= (0.40 × 11) + (0.25 × 25) + (0.35 × 15)
= 15.9%
The standard deviation of a portfolio of three assets is not simply the
average of the individual standard deviations. As with the two-asset case, it
is also a function of the correlations among the returns of the three assets.
2
W σ
1
2
1
+ W σ
2
2
2
2
2
+ W σ
3
2
3
+ 2W1 W2 ρ1.2 σ1 σ2 + (13.13)
σP = √
2W1 W3 ρ1.3 σ1 σ3 + 2W2 W3 ρ2.3 σ2 σ3
2 2 2 2 1/2
(0.4) (0.15) + (0.25) (0.20)
⎡ ⎤
2 2
⎢ +(0.35) (0.25) ⎥
⎢ ⎥
⎢ ⎥
=⎢ +2 (0.4) (0.25) (0.3) (0.15) (0.2) ⎥
⎢ ⎥
⎢ ⎥
⎢ ⎥
⎢ +2 (0.4) (0.35) (0.1) (0.15) (0.25) ⎥
⎣ ⎦
+2 (0.25) (0.35) (0.5) (0.2) (0.25)
= 14.48%
Note that the portfolio’s standard deviation is less than that of any of the
component securities’ standard deviations due to the correlation between
these asset returns.
13.6 EQUITY PORTFOLIO MANAGEMENT STRATEGIES
Equity represents a large part of an investor’s portfolio, depending on the

investor’s age and stage of life cycle (i.e. ability to take risk). There is no
single investment strategy that is right for every investor. Chances are that
during an investor’s investment lifetime, he or she will utilise one or more
investment strategy in an attempt to achieve his or her goals and make
money in the equity markets. Each strategy offers a different risk and return
profile and suitability for different investors, once again depending on each
individual’s own goals and willingness (or ability) to take risk. There are
two generic approaches or categories to managing equity portfolios, namely
passive management and active management. Strategies can also be
classified as value investing, growth investing or income investing, as well
as a buy-and-hold strategy (passive) or a market-timing strategy (active).
With passive management (or passive investing), an investor invests in
accordance with a predetermined strategy that does not entail fore-casting,
market timing or some form of analysis to select or pick a particular share.
This strategy minimises trading and investing fees, and avoids having to
correctly anticipate the future. A popular method (the most common
approach) is to mimic the performance of a specified index (i.e. indexing).
Buy-and-hold is another passive investment strategy in which an investor
buys shares and holds them for a long period of time, regardless of
fluctuations in the market. Even though the investor actively selects shares,
once included in a portfolio short-term price movements are not taken into
account or adjusted for.
Active management (or active investing) refers to a portfolio management

strategy where specific shares are selected with the goal of outperforming
some investment benchmark index. Active investing is the opposite of
passive investing (specifically indexing) where the goal is not to outperform
but to match the benchmark index return. This strategy relies on market
timing (i.e. technical analysis) and identifying value or growth shares – that
is, share selection via fundamental analysis (top-down approach) or share
picking (bottom-up approach). A buy-and-hold strategy also relies on either
fundamental analysis or share picking, but not market timing.
Passive and active investing are the extremes of portfolio management. The
middle road between these two approaches is semi-active management –
that is, enhanced indexing or risk-controlled active strategies. A semi-active
manager attempts to earn market-matching or even market-exceeding
returns with reduced risk. This type of investing, considered a hybrid
between active and passive management, refers to any strategy that is used
in conjunction with index funds for the purpose of outperforming a specific
benchmark in an attempt to amplify the returns of an underlying portfolio or
index fund while also minimising the effects of tracking error or risk.
Although tracking risk (also called active risk) will increase, the enhanced
indexer believes that the incremental returns more than compensate for the
small increase in risk. Enhanced indexing resembles passive management
because enhanced index managers cannot (in principle) deviate
significantly from commercially available indices. Enhanced indexing
strategies have low turnover and lower fees than actively managed
portfolios. However, enhanced indexing also resembles active management
to a certain extent because it allows managers the latitude to deviate from
the underlying index.
Value investing attempts to identify shares with expected higher intrinsic

values than currently priced by the market. These shares are bought and
held with the expectation that the market will bid the share price up to its
proper value. The investor therefore targets companies that are undervalued.
Value share companies may pay shareholders dividend income and may
trade at lower prices in relation to their earnings or book value.
Growth investing attempts to identify shares of firms with investment

opportunities that earn more than the firm’s cost of capital. The investor
targets companies that have high growth earnings. These companies may
have above-average, price-to-book ratios and sales and earnings growth, but
below-average dividend yields. The majority of company earnings are
retained, with no or low dividend pay-outs in order to invest in new and
highly profitable projects. Companies can therefore either retain their
profits for growth or pay them out as dividends. Higher growth always
comes from reinvesting profits within the business at high rates of return.
Growth investing is probably more appropriate for investors with longer
time horizons who should be willing to accept increased risk exposure in
expectation of greater long-term returns on their investment.
Income investing is a strategy where the investor targets companies that

generate current income (as opposed to growth of capital) in the form of
high-yielding dividends. Income investments tend to be conservative and
are probably more appropriate for investors who may be approaching
retirement or are currently retired. They can also be appropriate for
investors who are looking to temporarily protect their capital or gains they
have made in the market.
13.6.1 Indexing
Indexing involves a portfolio that attempts to match the performance of
some specified benchmark. An investor’s expectations concerning specific
securities are therefore not incorporated in constructing the portfolio. By
tracking an index, an investment portfolio achieves good diversification and
low turnover. Retail investors typically do this by buying into one or more
index funds which in turn track these indices. An index fund or index
tracker is a collective investment scheme, usually a mutual or exchange-
traded fund (ETF) that aims to replicate the movements of an index of a
specific financial market or a set of rules that are held constant, regardless
of market conditions. Tracking can be achieved by holding all of the
securities in the index in the same proportions as the index, or statistically
sampling the index and holding securities that represent the index. The lack
of active management generally gives the advantage of lower fees and
lower taxes as a result of limited trading. Of course, any management and
trading fees reduce the return to the investor relative to the index. In
addition it is usually impossible to precisely mirror the index as the models
for sampling and mirroring cannot be 100% accurate. The difference
between the index performance and the fund performance is known as the
tracking error.
13.6.2 Buy-and-hold
Basically, direct equity investment strategies include a buy-and-hold
strategy versus a market-timing strategy, and a value-oriented strategy
versus a growth-oriented strategy.
Buy-and-hold is an investment strategy in which shares are bought and then

held for a long period, regardless of the market’s fluctuations. An investor
who implements a buy-and-hold strategy actively selects shares, but once in
a position is not concerned with short-term price movement. A buy-and-
hold strategy can be considered a passive strategy because the investor
makes very few, if any, changes to his or her investments and is not
concerned with short-term profits but rather with long-term appreciation.
Two additional benefits to the buy-and-hold strategy are that trading
commissions can be reduced, and taxes can be decreased or deferred by
buying and selling less often and holding longer, therefore shares are
selected for their strong earning potential and appreciation over the long
term. Generally, as long as the share’s underlying fundamentals hold true
(or at least according to expectations), the share is retained in the portfolio,
even though there may be price swings. When the underlying fundamentals
no longer support the share, it is sold. Buy-and-hold does not mean holding
a share to infinity.
13.6.3 Market timing

A market-timing strategy is more of a shortterm than a buy-and-hold
strategy. The investor attempts to predict the future direction of the market
using historical data, technical indicators, economic data and experience.
Market timing can be considered an active strategy because the investor
continuously monitors his or her investments and places buy and sell orders
to take advantage of profitable conditions or to protect recent gains. The
buy-and-hold strategy is therefore a long-term approach to investing while
market-timing is a short-term one. However, while market timing does
involve placing buy and sell orders, simply buying into or getting out of
shares does not mean an investor cannot have a long-term approach or
strategy. In addition, timing the market does not mean that an investor has
an increased risk exposure. Market timers may in fact decrease their risk
exposure by being out of the share market during periods when the markets
are significantly overvalued or overbought, and the risk of downside losses
is greater than the upside potential.
13.7 BOND PORTFOLIO MANAGEMENT STRATEGIES
Bond investing is not as simple as buying the bond with the highest yield.
There are multiple options available when it comes to structuring a bond
portfolio, and each comes with its own trade-offs. The four principal
strategies used to manage bond portfolios are the following:
Passive strategies
Active strategies
Matched-funding techniques
Contingent immunisation
13.7.1 Passive strategies
Passive management is most common when an investor wants bonds in
order to receive a regular and predictable income stream and/or return of
capital invested at a known future date. There are two major passive
strategies:
Buy-and-hold
Indexing
13.7.1.1 Buy-and-hold strategy

The buy-and-hold strategy seeks to select a portfolio based only on the
objectives and constraints of the investor with the intent to hold these bonds
to maturity. This involves buying bonds that match the investor’s
requirements in terms of yield, maturity and duration, while also examining
features such as quality, coupon rate, call features and sinking funds. These
investors do not trade actively to earn returns; rather they look for bonds
with maturities or durations that match their investment horizon. They are
typically looking to maximise the income-generating properties of bonds
which are assumed to be safe and predictable sources of income. Cash flow
from the bonds can be used to fund external income needs or can be
reinvested in the current portfolio, invested in other bonds or other asset
classes. In a passive strategy, there are no assumptions made as to the
direction of future interest rates, and any changes in the current value of the
bond due to shifts in the yield are not important. By holding securities to
maturity, any capital change resulting from interest rate changes is
neutralised or ignored. The bond may be originally purchased at a premium
or a discount, while assuming that full par will be received upon maturity
and the only variation in total return from the actual coupon yield is the
reinvestment of the coupons as they occur.
13.7.1.2 Indexing
Indexing involves attempting to build a portfolio that will match the
performance of a selected bond portfolio index. The main objective of
indexing a bond portfolio is to provide a risk–return characteristic closely
tied to the targeted index. While this strategy carries some of the same
characteristics of the passive buy-and-hold, it has some flexibility. Just like
tracking a specific share index, a bond portfolio can be structured to mimic
any published bond index. A bond index portfolio will have the same risk–
return characteristics as the index it is based on because a portfolio
comprising a representative set of securities (e.g. in terms of maturity or
duration) is formed and rebalanced over time so as to track the index
reasonably closely. One also needs to consider the transaction costs
associated with not only the original investment, but also the periodic
rebalancing of the portfolio to reflect changes in the index.
13.7.2 Active strategies

These strategies require major adjustments to portfolios, trading to take
advantage of interest rate fluctuations, etc. There are five major active bond
portfolio management strategies:
Interest rate anticipation

Valuation analysis
Credit analysis
Yield spread analysis
Yield curve strategies
Bond swaps
In each strategy, the manager hopes to outperform the buy-and-hold policy

by using insight, judgement, experience and skill.
13.7.2.1 Interest rate anticipation

This is the riskiest strategy because the investor must act on uncertain
forecasts of future interest rates. They are designed to preserve capital when
interest rates rise (and bond prices fall) and to get as much capital
appreciation as possible when interest rates decline. This can be obtained by
altering the maturity or preferably the duration of a portfolio. Longer-
duration portfolios will benefit the most from an interest rate decrease, and
vice versa. If an increase in interest rates is expected, the portfolio would be
structured to have the lowest possible duration. The problem faced with this
type of strategy is the risk of mis-estimating interest rate movements as it is
difficult to accurately predict them. An investor should be concerned with
the direction of the change in interest rates, the magnitude of the change
across maturities and the timing of the change. Since duration is a more
accurate measure for bond volatility, it is used to adjust the portfolio.
Duration is lengthened in an effort to capture an increase in value when the
prediction is that interest rates will fall. Conversely, if interest rates are
expected to rise, the move would be to shorten the duration of the portfolio
to preserve capital.
13.7.2.2 Valuation analysis

The portfolio manager looks for undervalued bonds – those that have a
calculated value (according to the analyst) higher than the current market
price, or those whose expected yield to maturity is lower than the current
one. This strategy requires continuous evaluations and frequent trading
based on the analysis. The basic premise of valuation is based on the
portfolio manager’s ability to identify and purchase undervalued securities
and avoid those that appear to be overvalued. This takes some experience
and in-depth knowledge of the bond markets, and can be done on a large
scale or across a handful of bonds. The ability to exploit slight deviations in
price (caused by any number of inefficiencies, up to and including a
temporary lack of demand or the intrinsic value of embedded options) can
significantly add to overall returns.
13.7.2.3 Credit analysis

A credit analysis strategy involves detailed analysis of the bond issuer to
determine expected changes in its default risk and ultimately in the credit
rating of the issuer. Analysts try to determine if the bond rating agencies are
going to change the company’s rating. Rating changes are prompted by
internal changes (e.g. changes in important financial ratios) within the firm
as well as external changes (e.g. changes in an industry or the economy). To
be successful in utilising bond rating changes, one must accurately predict
when the bond rating change will occur and take action prior to the change
– that is, speculate on the change in credit rating to possibly make a profit.
If a portfolio manager anticipates a rise in the credit rating of the issuer, the
bond will be bought before the change and sold at a higher price after the
rating has increased. Bond issues that are expected to be downgraded will
be sold or ignored.
13.7.2.4 Yield spread analysis

A portfolio manager would monitor the yield relationships between various
types of bonds and look for abnormalities. Yield spreads are determined by
the pricing of bonds in various segments of the market, and the unique
characteristics of the bonds (e.g. maturity, coupon and sector) relate to the
varying prices and related yields. The yield spread is the difference between
the yield of two securities or between a security and a benchmark, and is
seen to widen during periods of economic contraction and uncertainty as
investors require higher risk premiums and to decrease during periods of
expansion. With yield spread analysis the portfolio manager monitors yield
relationships between various types of bonds and seeks out abnormalities in
spreads. If the spread is considered to be abnormally high, the portfolio
manager would adjust the portfolio to take advantage of a return to a normal
spread. Investors have the opportunity to profit from this strategy by
accurately predicting changes in spreads or changes in the term structure of
interest rates. It is therefore important to be very familiar with the implied
spreads, and have the ability and knowledge to move swiftly to take
advantage of opportunities. Potential drawbacks of this strategy are the
numerous trades that are required as well as the risks inherent in the
incorrect timing of interest rate changes.
13.7.2.5 Yield curve strategies

By anticipating movements in the yield curve, portfolio managers can
attempt to earn above-average returns on their bond portfolios. Yield curve
strategies focus on spacing the maturity of bonds in a portfolio in an attempt
to boost returns in different interest rate environments (see Figure 13.3).
Figure 13.3 Yield curve strategies
Riding the yield curve

If the current term structure slopes up and it is expected to remain
unchanged, then buying longer-term bonds produces higher returns over
time due to additional capital gains as their yields fall over time. As a bond
approaches maturity on an upward-sloping yield curve, it is valued at
successively lower yields and higher prices. Using this strategy, a bond is
held for a period of time as it appreciates in price and is sold before
maturity to realise the gain. As long as the yield curve remains normal or in
an upward slope, this strategy can continuously add to the total return on a
bond portfolio.
Bond ladders, barbells and bullets

These are strategies that will help investors balance their bond portfolio to
achieve their desired result. The terminology of these strategies actually
reflects the character of that strategy. In a barbell strategy, the maturities of
the securities in a portfolio are concentrated at two extremes, such as five
years and twenty years. In a ladder strategy, the portfolio has equal numbers
of securities maturing periodically, usually every year. In general, a bullet
strategy outperforms when the yield curve steepens, while a barbell
outperforms when the curve flattens. Investors typically use the laddered
approach to match a steady liability stream and to reduce the risk of having
to reinvest a significant portion of their money in a low interest-rate
environment.
Bond ladders. A bond ladder staggers the maturity of bonds while

creating a schedule for reinvesting the proceeds as each bond matures.
Because the holdings are not concentrated in one time period, the risk of
being caught holding a significant cash position when reinvesting is less
optimal is reduced. Ladders are popular among those investing in bonds
with long-term objectives, such as saving for tertiary education, or for
retirees or others trying to create a predictable income stream. The
exposure to interest rate volatility is reduced because the bond portfolio
is now spread across different coupons and maturities. Laddering,
however, can require a substantial commitment of assets over time.
Bond barbells. With a barbell strategy, one purchases short and long-term
bonds only, theoretically providing the best of both worlds. By owning
longer-term bonds, one locks in higher interest rates, while owning
shorter-term securities gives greater flexibility to invest in other assets
should rates fall too low to provide sufficient income. If rates should rise,
the short-term bonds can be held to maturity and then reinvested at the
higher prevailing interest rates. This strategy allows a manager to take
advantage of rates when they are high, without limiting the investor’s
financial flexibility.
Bond bullets. When pursuing a bullet strategy one purchases several
bonds that mature at the same time, minimising interest rate risk by
staggering the purchase dates. A portfolio is structured so that the
maturities of the securities are highly concentrated at one point on the
yield curve. For example, most of the bonds in a portfolio may mature in
10 years. This is an effective approach when one knows that the proceeds
from the bonds will be needed at a specific time. All bonds mature at
roughly the same time, ensuring the investor has sufficient funds to
finance any purchase. By buying bonds at different times and during
different interest rate environments, the investor is hedging interest rate
risk.
13.7.2.6 Bond swaps

This involves liquidating a current position and simultaneously buying a
different issue in its place with similar attributes, but with a chance for
improved return. Examples of this approach include pure yield pickup
swaps, substitution swaps and rate anticipation swaps. While these
transactions can involve anything from little risk (yield pickup swaps) to
great risk (rate anticipation swaps), they all are based on the premise that it
is possible to improve portfolio performance as a result of changing market
conditions.
Pure yield pickup swap

The pure yield pickup swap involves the swapping of lower-coupon for
higher-coupon bonds, thus realising an automatic increase in current yield
and yield to maturity. The analyst does not need to predict any future rate
changes, and the swap is also not based on any imbalance in yield spread or
credit quality. The major risk is that future reinvestment rates might not be
as high as expected, resulting in lower than expected total return on the
investment. If the portfolio manager does not swap the existing bonds with
bonds of same maturity and/or credit quality, the investment might be
exposed to higher interest rate risk and/or higher default risk.
Substitution swap
A substitution swap replaces one bond with another that has very similar
characteristics such as coupon rate, time to maturity, rating quality, and call
and sinking fund features. A bond is purchased if it is overpriced, or sold if
it is underpriced while the bond that is replaced is determined to be properly
priced. The bond portfolio profits when the mispriced bond moves to the
proper equilibrium price.
Interest rate anticipation swap

An interest rate anticipation swap depends on the bond portfolio manager’s
ability to forecast interest rate changes. If he or she anticipates that interest
rates will increase (fall), the duration of the bond portfolio is decreased
(increased). Longterm, zero-coupon and discount bonds perform best
during interest rate declines because their prices are more sensitive to
interest rate changes. Floating-rate, short and intermediate-term, call-able
and premium bonds perform best when interest rates are rising because they
limit the downside price volatility involved in a rising yield environment;
their price fluctuates less on a percentage basis than a par or discount bond.
Rate anticipation swaps tend to be somewhat speculative, and depend
entirely on the outcome of the expected rate change. Moreover, shorter and
longer-term rates do not necessarily move in a parallel fashion. Different
economic conditions can impact various parts of the yield curve differently
to the extent that if the anticipated rate change does not come about, a
decline in market value could occur.
13.7.3 Matched-funding techniques

The matched-funding techniques incorporate the passive buy-and-hold
strategy and active management strategies. The manager tries to match
specific liability obligations due at specific times to a portfolio of bonds in a
way that minimises the portfolio’s exposure to interest rate risk (the
uncertainty of returns due to possible changes in interest rates over time).
These techniques are designed for situations where future liabilities can be
predicted with some degree of accuracy, for example a pension fund
required to make future payouts to pensioners over their expected lifetimes.
Meant to avoid or offset risk, they typically require constant monitoring and
many transactions to achieve the intended goal. A variety of match-funding
techniques came into being and the most prevalent strategies will be
discussed.
13.7.3.1 Dedicated portfolios

Dedication refers to a passive portfolio management technique that involves
the matching of future cash inflows with future liabilities and may be used
as an alternative to immunisation or in combination with it. The most
conservative manner in which to dedicate a portfolio would be to construct
a portfolio of high quality bonds that will be held until maturity in order to
provide a predictable stream of cash flows from coupon payments and
repayment of principal at maturity – a pure cash-matched dedication. The
objective of this series of cash inflows is to exactly match the timing of a
predictable series of cash outflows. Alternatively, the portfolio manager
may opt to create a portfolio of which the cash flows do not exactly match
the liabilities, but to reinvest any inflows that precede the liability claims.
This technique is called dedication-with-reinvestment and allows for higher
returns and lower cost as the cash flows are reinvested without
compromising the safety of the portfolio. As dedicated portfolios are
usually made up of high-quality bonds, there is generally no need to
rebalance them.
13.7.3.2 Classical immunisation

Classical immunisation (see Figure 13.4) is a strategy that attempts to
ensure that a change in interest rates does not affect the current or future
value of a portfolio. The idea behind immunisation is to match the duration
(not the maturity) of assets and liabilities, therefore protecting the portfolio
against interest rate fluctuations. Duration, or the average life of a bond, is
commonly used in immunisation as it is a much more accurate predictive
measure of a bond’s volatility than maturity. A portfolio has been
immunised if its value at the end of the period is the same (or higher) than it
would have been if interest rates had not changed during the investment
horizon, assuming that interest rate changes will affect short and long-term
rates by the same amount. There are two components of interest rate risk,
namely price risk (a decline in price due to an increase in the interest rate)
and reinvestment risk (coupons reinvested at lower current interest rates).
Interest rates have opposing effects on price and reinvestment risk, and
bond portfolio managers attempt to eliminate these two interest rate risks by
offsetting them. Most non-zero-coupon portfolios require frequent
rebalancing to maintain the modified duration/investment horizon
matching. As time passes and the investment horizon shortens, so does the
duration of the bond portfolio but at a slower pace than term to maturity.
Duration is also affected by changes in interest rates, and it takes constant
rebalancing to keep track of a duration-matching immunisation strategy.
Note that zero-coupon bonds face no price risk (if held until maturity) or
reinvestment risk.
Figure 13.4 Classical immunisation
13.7.3.3 Horizon matching

Horizon matching is a combination of cash-matching dedication and
immunisation. The liability stream is divided into two time horizons. The
bond portfolio is constructed to provide a cash match for liabilities during
the first time horizon and to cover liabilities during the second time horizon
by using duration matching (i.e. immunisation). Horizon matching ensures
that liabilities will be met with certainty during the early years, but allows
for more flexibility in the second time horizon of the portfolio. One of the
problems of classical immunisation is that it is not able to accommodate
non-parallel shifts (i.e. short and long-term rates not changing by the same
amount) in the yield curve. Non-parallel shifts mostly occur in the short end
of the yield curve and therefore horizon matching eliminates the problem of
non-parallel shifts as the shortterm liabilities are covered by cash matching.
Different combinations of horizons should be considered so as to determine
which combination of certainty against flexibility will best suit the needs of
the portfolio.
Figure 13.5 Horizon matching
13.7.4 Contingent immunisation

Contingent immunisation is a mixed passive-active strategy in which the
portfolio manager replaces an active with an immunisation strategy if the
return on the portfolio falls below a set threshold. For example, if ruling
interest rates are 12%, the immunisation plan might be used to lock in a
return of 10%, thus allowing a 2% safety net to actively seek higher returns.
If the potential return drops to 10%, the immunisation strategy will apply
and the duration of the portfolio will be adjusted to match the duration of
the liabilities. As long as the rate of return on the portfolio exceeds a
prescribed safety net return (i.e. the minimum acceptable return), the
portfolio is managed actively. If the portfolio’s return declines to the safety
net return, immunisation mode is triggered to lock this rate in.
Contingent immunisation is a type of structured active management

strategy. Other structured strategies also seek to match or exceed the
performance of specific future liabilities but typically involve
supplementing the bonds held in the portfolio with derivative positions.
13.8 SUMMARY
The portfolio management process always starts with the investor and
understanding his or her needs and preferences. For a portfolio manager the
investor is a client, and the first and often most significant part of the
investment process is understanding the client’s needs and risk preferences.
For an individual investor constructing his or her own portfolio this may
seem simpler, but understanding one’s own needs and preferences is just as
important a first step as it is for the portfolio manager. The next part of the
process is the actual construction of the portfolio, which can be divided into
three sub-parts:
The first of these is the decision on how to allocate the portfolio across
different asset classes defined broadly as equities, bonds, cash
(equivalents) and real assets (such as real estate, commodities and other
assets).
The second component is the asset selection decision, where individual
assets are picked within each asset class to make up the portfolio. In
practical terms, this is the step where the shares and bonds are selected.
The final component is execution, where the portfolio is actually put
together. Here investors must weigh the costs of trading against their
perceived needs to trade quickly.
An investor needs to know and understand the basics of investing and the
theory of portfolio management in order to apply any of the different
investment strategies. There is potential for success with almost every
investment strategy, but the prerequisites for success vary. Success depends
mainly on an investor’s attitude towards risk, the level of portfolio
diversification, the size of a portfolio and the investment period. The ideal
investment strategy for a specific investor will reflect his or her particular
circumstances. Investment strategies that work for some investors do not
work for others. Consequently, there can be no one investment strategy that
can be labelled best for all investors.
Fabozzi, F.J. 2007. Fixed income analysis, 2nd ed. Upper Saddle River, NJ: Prentice Hall.
Jordan, B.D. & Miller, T.W. 2008. Fundamentals of investments: valuation and management, 4th ed.
New York: McGraw-Hill.
Kaplan Schweser. 2007. Level 3 Book 1: Ethics, quantitative methods, and behavioral finance. La
Crosse, WI: Kaplan Schweser.
Kaplan Schweser. 2007. Level 3 Book 2: Portfolio management for private wealth and institutional
clients; economic concepts; asset allocation. La Crosse, WI: Kaplan Schweser.
Kaplan Schweser. 2007. Level 3 Book 3: Management of fixed income portfolios; global bonds and
fixed income derivatives; equity portfolio management. La Crosse, WI: Kaplan Schweser.
Reilly, F.K. & Brown, K.C. 2012. Investment analysis and portfolio management, 10th ed. Mason,
OH: Thomson South-Western.
1. A risk-averse investor owning shares in Blue Corporation decides to add the

shares of either Yellow Corporation or Green Corporation to her portfolio. All three
shares offer the same expected return and total risk. The covariance of returns
between Blue and Yellow is –0.05 and Blue and Green is +0.05. Portfolio risk is
expected to:
(a) decline more by buying Yellow Corporation

(b) decline more by buying Green Corporation
(c) increase by buying either Yellow or Green Corporation
(d) decline or increase, depending on other factors
2. The return on an asset added to a portfolio is less than perfectly positively
correlated with the returns of the other assets in the portfolio but has the same
standard deviation. What effect will adding the new asset have on the standard
deviation of the portfolio’s return? The standard deviation
(a) will increase

(b) will decrease
(c) may increase or decrease, depending on the asset allocation model
(d) may increase or decrease, depending on the individual securities mix in the
portfolio
Use the following information to answer questions 3 to 6.
Probability of occurence Security A Security B

50% 12% 10%
25% 10% 11%
25% 8% 9%
3. Calculate the required rate of return for A and B.
(a) A 10.0% B 10.5%

(b) A 11.0% B 11.5%
(c) A 10.5% B 10.0%
(d) A 12.0% B 10.0%
4. Calculate the standard deviation of both securities.
(a) A 0.71 B 1.66

(b) A 0.85 B 1.66
(c) A 1.71 B 1.66
(d) A 1.66 B 0.71
5. Calculate the covariance of security A and security B.
(a) 0.50
(b) 0.40
(c) 0.15
(d) 0.25
6. Calculate the correlation between the two securities.
(a) 0.21
(b) 0.35
(c) 0.42
(d) –0.21
7. Use the information you obtained in the previous three questions to calculate the
portfolio risk if the investment is 50% in A and 50% in B.
(a) 1.030
(b) 0.770
(c) 0.087
(d) 0.910
8. Which of the following is the most valid justification for including real estate as part
of an investment portfolio?
(a) High liquidity

(b) Low project-specific risk
(c) Low management and information costs
(d) Low correlation of real estate with shares and bonds
9. In comparing a 65-year-old to a 25-year-old, all the following statements will
generally be true, except:
(a) The 65-year-old needs more liquidity than the 25-year-old does.
(b) The 65-year-old will seek less risk exposure than the 25-year-old.
(c) The 65-year-old should only invest in short-term cash deposits, while the 25-
year-old’s investment should be mainly in equities.
(d) The 25-year-old should invest as much as possible in tax deferred plans while
the 65-year-old may no longer desire this type of investment.
10. The correlation coefficient of portfolio X’s and the market’s returns is 0.95 and the
correlation coefficient of portfolio Y’s and the market’s returns is 0.60. Which of the
following statements best describes the levels of portfolio diversification?
(a) Both portfolio X and portfolio Y are well diversified.

(b) Both portfolio X and portfolio Y are poorly diversified.
(c) Portfolio X is well diversified and portfolio Y is poorly diversified.
(d) Portfolio X is poorly diversified and portfolio Y is well diversified.
Solutions
1. (a)
A positive covariance means that asset returns move together and a negative
covariance means that returns move inversely. Financial assets that generate
returns that have a positive covariance with each other will not provide much
diversification. A risk-averse investor wanting to hold a more diversified portfolio
would prefer to add financial assets with returns that exhibit a weak linear
relationship and therefore have a low or negative covariance with each other.
1. (b)
Whenever the returns of two assets are less than perfectly positively correlated,
there will be benefits of diversification. As the correlation between two assets
decreases, there is less of a tendency for their returns to move together. The
separate movement of returns serves to reduce the volatility of a portfolio to a
level that is less than that of its individual components. By diversifying it is possible
to maintain or even increase expected returns while reducing risk (standard
deviation).
2. (b)
3. (c)
kA = (0.50 × 12) + (0.25 × 10) + (0.25 × 8) = 10.50%
kA = (0.50 × 10) + (0.25 × 11) + (0.25 × 9) = 10.50%
4. (d)
2 2 2
σA = √0.50(12– 10.5) + 0.25(10– 10.5) + 0.25(8– 10.5) = 1.6583
2 2 2
σB = √0.50(10– 10) + 0.25(11– 10) + 0.25(9– 10) = 0.7071
5. (a)
CovAB = 0.50 [(12 – 10.5)(10 – 10)]
+ 0.25 [(10 – 10.5)(11 – 10)]
+ 0.25 [(8 – 10.5)(9 – 10)]
= 0.50
6. (c)
CovAB 0.50
r = = = 0.42
σA σB (1.66 × 0.71)
7. (a)
2 2 2 2
σP = √(0.50 × 1.66 ) + (0.50 × 0.71 ) + 2 (0.50 × 0.50 × 0.50) = 1.03
8. (d)
The most important factor to consider when adding an asset class to a portfolio is
its average covariance with all the other asset classes in the portfolio. Returns on
real estate and shares have a low correlation, whereas returns on real estate and
bonds are generally uncorrelated.
9. (c)
A life-cycle investing approach starts with a comparatively high-risk, high-return
strategy that gradually moves to low risk, low return over the years. However, an
investment portfolio should always be well diversified. Older investors should not
invest in short-term cash deposits only.
10. (c)
The market containing all possible investment choices represents the ultimate or
optimum in diversification. Therefore, a portfolio that exhibits a high(er) correlation
with the market is assumed to be relatively more diversified.
14 An introduction to derivative
instruments
14.1 INTRODUCTION
Accepting risk is essential to building wealth. Investors have to take risks to

exploit potentially profitable opportunities. Risks that are not profitable
must be avoided in order to take on more risks that are advantageous.
Derivatives enable the shedding and economical retention of risk, namely
the management of risk.
Evaluating the economic value of taking risks and shedding risks

necessitates the quantification of risks, which in turn requires statistics.
Tracing the impact of risks on investor wealth requires economic and
financial analysis. Finally, knowing how a derivatives position will affect
the risks to which an investor is exposed requires an understanding of
derivative instruments and how they are priced.
The inherent danger in utilising derivatives (leveraged instruments) is that

they do not just reduce risk: they also have the capacity to create risk owing
to an enhanced uncovered exposure. Ultimately, the primary purpose of
derivative instruments remains the protection of an existing exposure, either
by containing any potential upside or downside (hedging), retaining the
upside while limiting the downside (insurance) or aligning the exposure to
future expectations (transformation).
This chapter describes the trading environment for derivative instruments,

provides the relevant market terminology and concepts and gives an
overview and analysis of the three major derivative categories, namely
futures (forwards), options and swaps. The objective is to illustrate the basic
functioning and application of derivatives. A non-dividend-paying equity
share, therefore, features as the reference asset in the majority of examples
and illustrations.
14.2 TRADING ENVIRONMENT
The Johannesburg Stock Exchange (JSE) represents the formal exchange

market for financial assets in South Africa. In the spot market, assets are
traded for immediate payment and delivery, as opposed to the derivatives
market where spot market instruments are traded for future delivery and
payment. Share prices reflect the expectations of investors about the future
prospects of companies, while bond prices adjust to prevailing market rates.
Commodity prices are largely determined by supply and demand, as well as
future availability. Originating from these share prices, bond prices (interest
rates) and commodity prices, derivative values and price movements are
determined by the type or category of derivative product.
The JSE offers primary and secondary capital markets across a diverse
range of securities. The JSE launched an alternative exchange, Alt X, for
small and mid-sized company listings in 2003, followed by the Yield-X in
2007 providing a regulated exchange for the trading of derivatives on fixed-
interest securities and currencies. In addition, the JSE acquired the South
African Futures Exchange (SAFEX) in 2001 and the Bond Exchange of
South Africa (BESA) in 2009. The JSE currently comprises three distinct
markets, namely an Equity Market, a Debt Market and a Derivatives
Market.
The JSE Equity Market consists of the Main Board and the Alt X, providing
companies and investors with listing and investment opportunities to cater
for their specific needs. A large number of JSE-listed companies also have
listings on other stock exchanges throughout the world. A diverse range of
companies of different sizes and sectors and other securities such as
debentures (as opposed to bonds – Debt Market) and warrants (as opposed
to options – Derivatives Market) are listed on the Main Board. The AltX is
the JSE’s board for good-quality, small and medium-sized high-growth
companies. The AltX provides smaller companies with access to capital,
while providing investors with exposure to fast-growing smaller companies
in a regulated environment.
The JSE regulates the largest listed Debt Market in Africa, both by market
capitalisation and by liquidity. It has done so since 2009, when it acquired
the Bond Exchange of South Africa. Investors can access Government and
Corporate Bonds as well as Repurchase Agreements through the Debt
Market. The JSE also offers a variety of bond-based derivatives, including
Bond Futures, Forward Rate Agreements (FRAs), Vanilla Swaps and Bond
Options.
The JSE Derivatives Market offers a variety of derivatives, including

futures and options on equities, bonds, indices, interest rates, currencies and
commodities (agricultural, energy and metal). All derivative trades are
margined and guaranteed by JSE Clear (formerly known as SAFCOM), the
clearing house for all exchange-traded derivatives in South Africa, thus
eliminating counterparty credit risk.
14.2.1 Derivatives markets and instruments

Individual derivative contracts are created on and traded in two distinct but
related types of markets, namely exchange-traded (ET) and over-the-
counter (OTC) markets. ET derivatives are commoditised instruments with
fixed contract terms in order to facilitate trading. OTC derivatives, on the
other hand, are negotiated instruments, also referred to as structured
derivatives because they are tailored or structured to the requirements of
individual investors or borrowers.
The two major or general derivatives categories are forward commitments

and contingent claims and the three generic types of derivatives – futures
(forwards), options and swaps – are assigned to each according to the rights
and/or obligations attached to a particular contract. Futures contracts are ET
forward commitments with forward contracts as their OTC equivalents.
Options contracts are both ET and OTC contingent claims.
Exchange-traded contracts Over-the-counter contracts
Exchange-traded (ET) contracts have Over-the-counter (OTC) contracts are all
standard terms and features, and trade on an customised transactions created by two
organised derivatives exchange facility parties through a telephone- and computer-
referred to as a futures exchange. linked network of dealers.
Features: Features:
They are tradable financial instruments. Financial institutions often act as market
makers for the more commonly traded
They are market-to-market (settled daily).
instruments.
Performance is guaranteed by the
Exchange’s clearing house. Trades are typically much larger than
trades in the ET market.
They are highly liquid (active secondary
There is usually some default risk in an
market) owing to the standardised nature
OTC trade.
of all contracts.
The ET market is smaller than the OTC They are less liquid owing to the tailor-
market in terms of total trading volume. made structure of all the transactions.
Forward commitments are contracts in which the two parties enter into an
agreement to engage in a transaction at a later date at a price established at the start.
Within this category the two major classifications are ET contracts (futures) and OTC
contracts (forward contracts and swaps).
A forward contract is an agreement between two parties in which one party,

the buyer, agrees to buy from the other party, the seller, an underlying asset
at a future date at a price established today. The contract is customised and
each party is subject to the possibility that the other party will default.
A futures contract is a variation of a forward contract that has essentially

the same basic definition, but with some clearly distinguishable additional
features, the most important being that it is not a private and customised
transaction. It is a public, standardised transaction that takes place on a
futures exchange.
A swap is a variation of a forward contract that is essentially equivalent to a

series of forward contracts. It is an agreement between two parties to
exchange a series of future cash flows. Typically, at least one of the two
series of cash flows is determined by a later variable outcome, such as a
floating interest rate based on London Inter-Bank Offered Rate (LIBOR) or
Johannesburg Inter-Bank Agreed Rate (JIBAR).
Contingent claims are contracts in which the payoffs occur if a specific event
happens. Contracts of this kind are generally referred to as options, and confer the
right but not the obligation to buy or sell an underlying asset from or to another party
at a fixed price over a specific period of time.
Call options grant the holder (long position) the opportunity to buy the
underlying security at a price below the current market price, provided that
the market price exceeds the call strike before or at expiration (specified
contingency).
Put options grant the holder (long position) the opportunity to sell the
underlying security at a price above the current market price, provided that
the put strike exceeds the market price before or at expiration (specified
contingency).
The option seller (short position) in both instances receives a payment

(premium) compelling performance at the discretion of the holder.
Combinations of options lead to different exposures and the incentive to
contract as depending on how either the long or short holder perceives
market direction and expectations.
Credit derivatives: Credit risk is the risk of default on a debt that may arise
from a borrower failing to make the required payments. A credit derivative
is an OTC derivative designed to transfer credit risk from one party to
another. By synthetically creating or eliminating credit exposures, they
allow institutions to manage credit risks more effectively. The basic credit
derivative structures include credit default swaps, total return swaps and
credit-linked swaps.
14.2.2 Purposes and benefits of derivatives

Apart from their main purposes of hedging existing and/or expected asset
holdings and protecting asset portfolio values, derivatives serve as
instruments for:
Speculation: Derivatives can derive profit from changes in interest rates and
equity markets, fluctuations in currency exchange rates and changes in
global supply and demand for commodities (such as agricultural products),
precious and industrial metals and energy products (such as oil and gas).
Diversification: Adding some of the wide variety of derivative instruments

available to a traditional portfolio of investments can provide global
diversification in financial instruments and currencies, help hedge against
inflation and deflation, and generate returns that are not correlated with
more traditional investments.
The benefits attributed to derivative instruments are price discovery, risk

management, improved market efficiency and reduced transaction costs:
Price discovery: Derivative market prices depend on a continuous flow of

information and require a high degree of transparency. A broad range of
factors, such as climatic conditions, political situations, debt default and
environmental pollution, impact the supply and demand of assets
(commodities in particular) and therefore the current and future prices of
the underlying asset on which the derivative is based. New information and
the way markets absorb it constantly changes the price of assets; this
process is known as price discovery. The price of a futures contract with the
shortest time to expiration often serves as a proxy for or indicator of the
expected future price of the underlying asset. Options aid in price discovery
in the way market participants view the volatility of the markets, because
options are a form of insurance in that they protect investors against losses
while allowing them to participate in the asset’s gains. If investors
anticipate volatile markets, the prices of option contracts will increase.
Risk management: Risk management is the process of identifying the

desired and actual levels of risk and altering the latter to equal the former.
This process falls into the categories of hedging and speculation. Hedging
has traditionally been defined as a strategy for reducing the risk in holding a
market position, while speculation has referred to taking a position on the
way the markets will move. Hedging and speculation strategies, along with
derivatives, are tools or techniques that enable companies to manage risk
more effectively.
Improved market efficiency: Derivatives provide an alternative to investing
in the actual assets. For example, investors who want exposure to a specific
stock index can buy a stock index fund or replicate the fund by buying
stock index futures and investing in risk-free bonds. Either of these methods
will give them exposure to the index without the expense of purchasing all
the assets included in the index. If the cost of implementing these two
strategies is the same, investors will be neutral as to which they choose. If
there is a discrepancy between the prices, investors will sell the more
expensive asset and buy the cheaper asset until prices reach equilibrium (a
process called arbitrage) – thereby improving market efficiency.
Reduced transaction costs: As stated, derivatives provide an alternative to

investing in the actual assets. In addition, transaction costs are much lower
in the derivatives market, primarily because the commission and trading
costs payable to traders are much lower when compared with the
transaction costs in the spot market.
14.2.3 Criticisms of derivatives

Although professional traders and money managers can use derivatives
effectively, the odds that a casual investor will be able to generate profits by
trading in derivatives are mitigated by the fundamental characteristics of the
instrument. The following factors are relevant to assessing derivatives:
Leverage: Futures markets offer highly leveraged trading. High leverage is

normally considered an advantage to the professional trader or fund
manager, but the inexperienced trader might find that the use of high
leverage can also be a disadvantage because leverage magnifies losses as
well as profits. The biggest advantage of derivatives for the retail investor is
the ability to trade in markets with a limited amount of capital. However,
this advantage can quickly turn into a disadvantage for the underfunded or
inexperienced trader, since a few bad trades could deplete a small account
due to the high leverage provided.
Speculation: The main purpose of derivative markets is to hedge and

protect existing or expected exposures to market movements – that is, to
manage risk. Using derivatives to speculate on market direction and
movements is viewed by some as a form of legalised gambling, enabling
users to make bets on the market. However, derivatives offer benefits that
extend beyond those of hedging or speculation by making markets more
efficient and helping investors to discover asset prices.
Lifespan: Options are time decaying and as each day passes and the
expiration date approaches, investors lose more and more time value (the
premium in excess of intrinsic value) and the option’s value decreases. The
time decay characteristic of options is a disadvantage for buyers and an
advantage to sellers. However, unique strategies can be developed with
options, providing an advantage to both buyers and sellers.
Direction and market timing: In order to speculate successfully with

derivatives, investors must predict accurately the direction in which the
market or index will move (up or down) and the minimum magnitude of the
move during a set period of time. Any mistake here almost guarantees a
substantial investment loss.
Costs: The difference in price between the highest price that a buyer is
willing to pay for an asset and the lowest price for which a seller is willing
to sell it (i.e. the bid-ask spread) for derivatives can be large. Therefore,
simultaneously buying and selling the same derivative security will result in
an immediate loss, even before factoring in other trading costs or
commissions.
In summary, derivative securities are complex financial instruments and

most beginners lack the knowledge and understanding required to trade
futures and options successfully. Even professional traders can get into
trouble through the misuse of derivative contracts. However, individual
traders as well as the financial markets in general benefit from the
availability and flexibility of these securities, but education and experience
are required to trade these complex products.
14.3 TERMINOLOGY AND CONCEPTS

Arbitraging activities are fundamental to establishing fair values. Similarly,
trading activities such as hedging, speculation and short selling all facilitate
an efficient market, promoting liquidity and determining market prices.
Open interest, leverage (gearing) and margining are concepts associated
with derivatives trading, along with the terminology unique to the futures,
options and swaps markets. The “basics” of derivatives are dealt with in the
sections leading up to the pricing (analysis) of these instruments.
Figure 14.1 Margining
Hedgers enter derivative markets to reduce a pre-existing exposure to risk;

speculators actively take risks and bet on the future direction of the market;
arbitrageurs take positions in two or more economically related markets
simultaneously to exploit theoretical/actual mis-pricings. Each of these
market participants contributes to the functioning of securities markets.
14.3.1 Arbitrage
Arbitrage is the simultaneous purchase and sale of identical or equivalent
financial assets in order to benefit from a discrepancy in their price
relationship. Theoretically, arbitrage is any trading strategy requiring no
cash where there is some probability of making a profit without incurring
the risk of a loss. The purchase of any security must be financed by
borrowing or short selling another security. The worst possible outcome
should result in a zero gain for the arbitrageur. Since the key characteristic
is that there is no risk of a loss, all other possible outcomes should generate
some profit. However, owing to the speculative nature of arbitrage, actual
arbitrage operations necessitate the taking of some risk because of specific
institutional factors (e.g. trading rules imposed by management) and
technological factors (e.g. practical constraints on exploiting mis-pricings).
If arbitrage is accepted as a low-risk trading strategy, there are obvious links
to hedging (risk transference) as well as to speculation (risk acceptance).
Cash-and-carry arbitrage involves transacting simultaneously in the futures

market and spot market, while put-call-parity arbitrage and boundary
arbitrage require a sequential series of activities in the options market and
underlying market respectively.
The arbitrage principle is the essence of derivative pricing models.
Arbitrage and replication: A portfolio composed of the underlying asset

and a risk-free asset (e.g. treasury bonds – short-term government debt
obligations) could be constructed to have exactly the same cash flows as a
derivative and is called a replicating portfolio. Since the replicating
portfolio and derivative have the same cash flows, they would have to sell
at the same price – the law of one price. Replication is performed in order
to exploit price differentials and to lower transaction costs. It is the essence
of arbitrage.
Risk neutrality: The risk premium compensates investors for the uncertainty
of making an investment. A risk-seeking investor prefers risky investments
to risk-free investments and will pay money to assume risk; the risk
premium will therefore be negative. Conversely, a risk-adverse investor
expects to receive money to assume risk and so the risk premium will be
positive. The risk-neutral investor is indifferent to risk and neither requires
nor demands a risk premium; the premium is therefore zero. This risk-
neutral assumption removes the risk-aversion of an investor as a factor in
determining derivative prices. Once risk has been eliminated in this way,
the expected return becomes equal to the risk-free rate for all investors and
assets can therefore be assumed to grow, and can be discounted at the risk-
free rate. Risk-neutral pricing enables the payoff of a derivative to be
replicated using the underlying asset and the risk-free rate. The market price
of this derivative and the replicating strategy must be exactly the same
under the principle of no arbitrage, regardless of risk preferences.
14.3.2 Hedging
Hedging is the practice of offsetting the price risk inherent in any spot
market position by taking an equal but opposite position in the futures
market. Short (not owning) the intended purchase, a long hedge involves
buying a futures contract to protect against a possible rise in the price of an
asset, thereby locking in the price for future payment. Long (owning) an
asset, the short hedge protects against a possible decline in the asset price
by selling a futures contract and securing the selling price. The acquired
derivative security will profit from the very same events that impose the
losses on the underlying market. The opposite is also true (derivative loss
resulting from a gain in the underlying) and this represents the only cost to
entering into a futures contract – the forfeiture of any favourable spot price
movements. Risk is neutralised and transferred to someone for whom
holding that particular risk would reduce an existing but opposite exposure.
A counterparty without a pre-existing exposure (speculator) would accept
the risk (long or short the derivative asset) to possibly benefit from an
anticipated movement in price.
14.3.3 Speculation
Speculation involves the buying, holding and selling of assets to profit from
fluctuations in price over the short term, as opposed to buying for long-term
gains (buy and hold) or income (dividends). Associated with day trading, it
relies on market timing and implies a riskier proposition than investing.
14.3.4 Insurance
Options provide leverage and protection. The protection or insurance
feature distinguishes options (contingent claims) from futures contracts
(forward commitments) in that options establish a maximum potential loss
while retaining all the upside potential minus the cost of insurance
(premium). Futures contracts, on the other hand, lend themselves to hedging
(i.e. opposite of offsetting outcomes, thereby limiting any upside potential).
The initial outlay (margin payment), in contrast to an option premium, does
not represent a cost, but the early fractional payment of a future obligation.
14.3.5 Short selling

Analogous to shorting an asset, selling an asset short is a legitimate trading
strategy where a security is borrowed and sold by an investor with a
commitment to purchase and replace it at a later stage. This complex and
high-risk strategy of selling a security not owned is used to capitalise on an
expected decline in price and can lead to substantial losses should the
opposite occur. A broker, as instructed by a client, will borrow shares from
another client and sell them in the market. This short position can be
maintained indefinitely, provided there are always shares for the broker to
borrow. Running out of shares to borrow, the broker will be forced to close
out immediately (he will be short-squeezed). The investor is required to
maintain a margin account with the broker as a guarantee that the short
position will not be relinquished if the share price increases. The percentage
deposited as the initial margin represents a restriction on short selling as this
limits the use of funds from the short sale.

Open interest, used to measure liquidity, is the total number of options or
futures contracts long or short in a delivery month or market that have been
entered into and not yet liquidated by an offsetting transaction or fulfilled
by delivery. Indicative of the level of commercial activity, a rise or fall in
open interest shows that money is flowing into or out of a futures contract
or option. While volume (number of contracts traded) indicates market
activity, open interest indicates the depth (liquidity) of a market. The short
interest is always equal to the long interest, and rising open interest is
considered good for the current trend and shows that those participants
benefiting from a current move in the market (up or down) are prepared to
enlarge their commitments and not cash out. A declining open interest is
indicative that the losers are liquidating and the winners cashing in, with an
insufficient number of new players moving in to replace them.
14.3.7 Marking to market

The initial margin determines the level of gearing obtained from entering
into a futures contract and forms part of marking a contract to market. This
procedure revalues a futures contract on a daily basis and adjusts the open
position to reflect profits and losses resulting from price movements that
occurred during the last trading session. It is equivalent to closing the
contract at the end of each day, settling gains and losses, and opening a new
contract. The amount by which an account changes on any given day is
referred to as the settlement variation, and should this cause the account
value to fall below the maintenance margin (minimum account balance), the
investor receives a margin call and has to deposit an additional amount
(variation margin) to bring the account balance to the initial margin. The
mark-to-market process ensures that the counterparties all meet their
obligations in terms of the futures contract. Failure to comply with a margin
call will result in the close out and financial settlement of the position.
There are three types of margin, as shown in Figure 14.3: the initial,
maintenance and variation margin. The initial margin is fairly low,
equalling about one day’s maximum price fluctuation, and must be posted
before any trading takes place. With the daily settlement process (called
marking-the-account-to-market), any losses for the day are removed from
the trader’s account and any gains are added to the trader’s account. Both
the long and short counterparties have to open and maintain a margin
account – that is, deposit money into the account when entering into a
contract and sustaining a minimum balance (top up as and when required)
as determined by the size of the futures position.
Example: A portfolio manager bought fifty ALSI index-futures on Monday

morning with the index at 30 000. The nominal value of this purchase was
(50 × R10 × 30 000) which amounted to R15 million. The initial margin
was 50 × R18 000 (6% margin requirement per contract) totalling R900
000. The settlement value of the index on Monday was 29 900 which
generated a settlement variation of 50 × R10 × (30 000 – 29 900) totalling
R50 000. This amount was removed from the account, leaving a balance of
R850 000. Since the balance on this account exceeded the maintenance
margin, [50 × 16 000 (maintenance margin per contract) = R800 000], no
payment into the margin account was required. The settlement value on
Tuesday was 29 750 and this generated a settlement variation of 50 × R10 ×
(29 900 – 29 750) totalling R75 000. When this amount was removed from
the margin account, the remaining balance of R775 000 was below the
maintenance margin requirement of R800 000. Therefore, the portfolio
manager received a margin call and had to pay in an additional R125 000
(variation margin) to restore the margin account to the initial level of R900
000. Should the market move in the portfolio manager’s favour, any amount
in excess of the initial margin can be withdrawn.
14.3.8 Leverage or gearing

Derivatives are inherently leveraged and, in the context of futures contracts,
leverage refers to gearing and originates from the margining system. It is
the relatively small amount of money (initial margin – a fraction of the
maximum position size) required to maintain an open position and control a
larger investment. Equated to risk, with futures contracts leverage is
indicative of the exposure to a potentially large loss (maximum position
size).
With options contracts, the small amount of money providing an enlarged

exposure (leverage) to a potential payoff is the premium or price of a
particular option. In this instance, the risk is limited to the premium paid
(maximum loss), also representing the cost (reduction of potential payoff)
of obtaining the enhanced exposure. The premium, therefore, exposes the
investor to a potentially large(r) profit, but also limits the size of any loss
(provides protection).
14.3.9 Long and short

Buying, holding or going long a particular futures contract refers to entering
into a contract to buy an asset at a predetermined price on a specific date.
Phrasing it as “buying a contract” simply means that a party contracted to
buy an asset in the future.
Selling, writing or going short a particular futures contract refers to entering

into a contract to sell an asset at a predetermined price on a specific date. It
is the opposite of buying a contract, and phrasing it as “selling a contract”
simply means that a party contracted to sell an asset in the future.
The actual contract is therefore not bought or sold; it is entered into and
requires the future purchase or sale of some asset. Being long (hold or buy)
or short (write or sell) a contract only assigns the opposing positions and
obligations of the counterparties.
With options contracts, going or being long (buying or holding a contract)

confers the right (not the obligation) to transact according to predetermined
terms and specifications. Shorting (writing or selling) an options contract
imposes the obligation to perform at the discretion of the holder of the
contract. Whether a counterparty has to buy or sell the underlying asset is
determined by the type of option, namely a call option (right to buy) or a
put option (right to sell). A call option holder (long) has the right to buy a
particular asset in the future. Conversely, a put option seller (short) has the
obligation to buy an asset should the put holder exercise the paid-for right
to sell the asset.
With a vanilla interest rate swap the counterparties do not go long or short,
but rather enter into a contract to pay fixed and receive floating interest
rates on a notional principal (fictitious amount). A currency swap, on the
other hand, sees the two counterparties exchanging actual currencies and
paying interest denominated in that currency. A fixed for floating interest
exchange in combination with a currency swap is the standard or basic
currency swap configuration (vanilla type) with the pay-floating rate based
on the local currency, and the pay-fixed rate on some foreign currency. The
domestic counterparty, therefore, pays a fixed rate on a foreign currency
and receives a floating rate on the local currency (paid by the foreign
counterparty).
14.3.10 Delivery or settlement

Very few futures contracts entered into lead to the physical settlement or
delivery of the underlying asset. Most contracts are closed out early via an
opposite or offsetting transaction (i.e. shorting the identical contract
previously longed or vice versa). Even intending to actually own the
underlying, the long counterparty will close out (realise a profit or loss) and
transact in the spot market. The realised futures market profit or loss, added
to the spot market price would result in effectively attaining the price
(locked in) contracted at. Taking delivery of a commodity involves
additional storage and transportation costs. Many financial futures, such as
those on share indices, are settled in cash since it is impractical to deliver
the underlying asset (i.e. the share index constituents). When a contract is
settled in cash, all outstanding contracts are declared closed and the final
settlement price is set equal to the spot price of the underlying asset.
An existing futures position can be maintained by switching or rolling over

to a new contract with a later maturity. The process of extending the
settlement date on an open position by rolling it over to the next settlement
date is called a rollover. The cost of a rollover is calculated as the difference
between the price of the contract closed and the price of the contract
opened.
An options position can be liquidated before the expiry date by exercise

(American style exercise and by the holder only) or closed out (buyer or
seller). The majority of options are not actually exercised but profits are
taken by trading or closing out a position. The close out or cancellation of a
long position is fulfilled by a closing sale with the holder receiving the
current option price or premium. A short position is terminated via a closing
purchase with the investor paying a premium.
An existing swap is neutralised by entering into a new swap. In this

neutralising swap the pay-fixed party would simply contract to be the
receive-fixed counterparty. The cash flows from the new swap will
effectively cancel the cash flows of the existing swap.
14.4 FUTURES CONTRACTS
A futures contract is a standardised ET (exchange-traded) commitment to

buy or sell an underlying asset at a future date and at a price derived from
the asset’s current market price, namely a futures price. The following
sections cover the hedging properties of these instruments, the price and
value of a particular contract, arbitraging strategies and the hedging of an
equity portfolio.
14.4.1 Futures basics
Holding a position in the market exposes the investor to the risk of adverse
market movements, namely market risk. Market risk encompasses equity
risk, interest rate risk, currency risk and commodity risk. Equity risk (the
risk that share price will change) is quantified in terms of a standard
deviation (absolute measure) or beta (relative to the market). Equity risk
exposures, either long (owning a share) or short (intending to own a share),
can be eliminated (zero beta, i.e. hedged) or adjusted (reducing or
increasing beta) by taking a position in an equity futures contract. Bond and
interest rate futures protect against changing bond prices and interest rates;
currency futures can account for fluctuations in foreign exchange rates;
while commodity futures provide security for grains and metals traders.
Whatever the underlying asset, taking an opposite futures market position in

an optimal number of suitable contracts will neutralise a spot market
position. The following section illustrates the interaction between spot and
futures prices and the matching but opposite outcomes due to changing spot
market prices.
14.4.1.1 Hedge profiles

The principle of hedging (fixing a purchase or sales price) is illustrated in
Figure 14.2, showing that any change in the value of an asset, owing to a
changing spot price, is countered by an opposite change in the value of a
futures contract.
Figure 14.2 Hedge profiles
A short position in the spot market refers to the anticipated purchase of an

asset not currently owned. A hypothetical loss would result from any
increase in the price of this asset as the investor will have to pay this
increased price once the asset is actually bought. By entering into a long
futures contract, as shown in Figure 14.2 (long hedge), any loss in the spot
market is cancelled out by an equivalent gain in the futures market, thereby
locking in the price as stipulated in the futures contract (intersection of
short asset and long futures profiles).
A long position in the spot market refers to the anticipated sale of an asset
currently owned. A loss would result from any decrease in the price of this
asset as the investor would have to accept this reduced price once the asset
was actually sold. By entering into a short futures contract, as shown in
Figure 14.2 (short hedge), any loss in the spot market is cancelled out by an
equivalent gain in the futures market, thereby locking in the price as
stipulated in the futures contract.
The outcomes in the spot market and the futures market should be
determined independently and netted to arrive at the combined or final
outcome.
Example: An investor bought 1 000 Aspen Pharmacare Holdings (APN)

shares at the beginning of a year at R300 per share. At the time of buying
these shares he also shorted 10 March cash-settled single stock futures
contracts (APNQ) at R307. At the expiration of the SSF contract, the spot
price of Aspen closed at R310. This hedge realised an assured profit of R7
000 (ignoring transaction and opportunity costs) compared with a likely
unhedged profit of R10 000.
Spot market outcome 1 000 × R(310 − 300) R10000

Futures market outcome 10 × 100 × R(307 − 310) − R3000
Net result (R307 per share locked in) R7000
However, had the spot price declined to R295 (or any price below R307),
the investor would still have made a profit of R7 000 due to the shorted
futures contract.
The shaded areas in Figure 14.2 represent the gains or losses from a futures
position. It should be evident that a loss in the spot market effects a gain in
the futures market. Likewise, any gain in the spot market is offset by a
corresponding loss in the futures market. The futures price contracted at is
therefore the price effectively received or paid for a specific asset,
regardless of what transpires in the spot market. The investor foregoes any
potential spot market profits along with the losses (ultimately the rationale
for hedging) and this fact should be acknowledged and accepted when
contracting in the futures market.
14.4.1.2 Basis risk

Stating that an opposite futures market position in an optimal number of
suitable contracts will neutralise a spot market position assumes that the
futures contract is derived directly from the underlying being hedged. A
perfect hedge will result in a zero combined gain or loss to the investor as
the futures price moves in unison (equal but opposite changes) with the spot
price.
However, should a substitute futures contract (proxy) be used due to the

unavailability of any contracts based specifically on the underlying to be
hedged, basis risk becomes an issue. Uncertainty regarding the exact date
on which the underlying will be bought or sold and the close out of a
futures contract before expiration also affect the final outcome.
The basis is the amount by which a spot price differs from the futures price
(b = S – F), and basis risk is the uncertainty as to this difference between
the spot and futures price. A constant difference, all other factors remaining
equal or unchanged, will result in a perfect hedge.
The position of a short hedger (long asset, short futures) improves as the
basis increases or widens (spot price increases more than futures price), and
weakens when the basis decreases. The opposite is true for a long hedger.
Example: The Aspen-SSF case was an example of a near-perfect hedge

since the futures contract was derived from the specific underlying asset.
However, using an index futures contract to hedge the same Aspen
Pharmacare Holdings (APN) portfolio would introduce basis risk and could
result in a possible unexpected gain or loss to the investor.
Assume the Aspen (APN) portfolio of R300 000 (1 000 shares at R300
each) can be hedged by selling 25 ALMI (Mini ALSI) futures contracts
with the Top40 Index (ALSI) level at 49 000. After three months and with
Aspen at R310, the index level stood at 49 800.
Spot market outcome 1000 × R(310 − 300) R10000
Futures market outcome 25 × (4 900 − 4 980) − R2000
Net result R8000
This hedge effectively resulted in a selling price of R308 per share. An

ending index level of 50 200 would have resulted in an effective price of
R307 per share (same as the SSF hedge). However, the spot price increased
more (in relative terms) than the index level (i.e. a strengthened basis), thus
improving the position of the hedge (smaller loss). The reverse (weakened
basis) would have caused a larger futures loss and a smaller net profit.
The following should be noted:
Each SSF contract comprises one hundred underlying shares.

Each ALSI futures is ten times the index level; each ALMI contract is
one-tenth of the index.
Margin accounts have to be opened and maintained with all futures
market transactions.
Examples exclude any commissions, brokerage, clearing fees and
additional margin percentages (market maker).
14.4.2 Futures price and value

The price (F) of a futures contract is largely determined by the underlying
spot price and the prevailing risk-free rate. Although other factors, namely
dividends (dividend-paying or yielding shares and indices), foreign risk-free
rates (currency futures), storage costs (commodities) and transaction costs
also play a role, the basic pri-cing formula as it applies to non-dividend-
paying shares is provided here. The value (f) of a specific futures contract is
determined in relation to the initial futures price or delivery price (K) as
calculated.
14.4.2.1 Futures price

The futures price of a non-dividend-paying share is the spot price adjusted
for the risk-free rate (r) and the period to expiry or delivery (t). Simply
stated, it is the per-period compounded spot price. The initial futures price
is referred to as the delivery price (K).
F = S(1+r)t = K (14.1)
Should the actual or market price deviate from this calculated or theoretical
price, an arbitrage opportunity may present itself (see Section 14.4.2.3).
Example: Suppose a 9-month futures contract is entered into on a non-

dividend paying share when the share price is R60 and the risk-free interest
rate is 10% per annum. The futures price is calculated as follows:
F = 60(1.10)9/12 = R64.45 = K
14.4.2.2 Futures value

The futures value (f) is the discounted difference between the initial futures
price or delivery price (K) and any subsequent futures prices (F) before
expiry. The initial value (at initiation of the contract) is set to be zero while
the ending value is the difference between the delivery price and the spot
price at expiry as the futures price converges to and finally equals the spot
price at expiry.
f = (F–K)(1+r)–t (14.2)
Or alternatively:
f = S–K(1+r)–t (14.3)
This value can be positive or negative depending on the position (long or

short) taken in the futures contract, with any close out or reversal requiring
the opposite transaction (i.e. sell when previously bought or vice versa).

dividend-paying share when the share price is R60 and the risk-free interest
rate is 10% per annum (as above). An investor has just taken a short
position in this contract. Three months later, the price of the share is R55
and the risk-free interest rate is still 10% per annum. The value of this
futures contract is calculated as follows:
Initial value = 0 (at the initiation of the contract with a delivery price of
R64.45)
Current futures price (3 months into the contract with 6 months remaining)
F = 55(1.10)6/12 = R57.68
The value of this futures contract to the short position holder
f = –(57.58 – 64.45)(1.10)–6/12 = R6.45
Or alternatively
f = –[55 – 64.45(1.10)–6/12] = R6.45
The initial contract was sold at R64.45 and can be reversed (closed out) by
buying it back at R57.68, representing a gain of R6.45 in present value
terms. A long position in the contract would realise a loss of R6.45 if closed
out at that stage.
14.4.2.3 Arbitrage opportunity

Any deviation from the theoretical or fair value as calculated may lead to a
specific arbitrage strategy to exploit and profit from this discrepancy. Once
again the basic principle is illustrated, keeping in mind that any actual
arbitrage opportunity is subject to transaction costs, restrictions on short
selling, and differential borrowing and lending rates.
With a market price (P) exceeding the theoretical price (F), cash-and-carry
arbitrage is executed.
Cash-and-carry arbitrage (P > F):
Sell the futures contract at the quoted market price (P).

Borrow money at the risk-free rate for the period until expiry.
Buy the underlying at the spot price.
With a market price (P) lower than the theoretical price (F), reverse cash-
and-carry arbitrage is executed. Reverse cash and carry arbitrage (F > P):
Buy the futures contract at the quoted market price (P).

Sell the underlying at the spot price.
Invest or lend the money at the risk-free rate for the period until expiry.
The principle of buying low and selling high applies. With cash-and-carry
arbitrage the overpriced (too expensive) futures contract is sold and the
underlying asset is bought with borrowed funds. Reverse cash-and-carry
involves buying the underpriced (inexpensive) futures contract, selling the
underlying and investing the proceeds.

dividend-paying share with a share price of R60 and a risk-free interest rate
of 10% per annum (as above). The futures price (F) was calculated to be
R64.45 (theoretical or fair value). Assume that the actual futures price (P)
available in the market is (a) R65 and (b) R64. Ignoring all transaction and
other relevant costs, the appropriate arbitrage strategy and profit are
determined as follows:
(a) Cash-and-carry arbitrage (65 > 64.45):
Sell the futures contract at R65.

Borrow R60 at 10% for the 9 months (owes R64.45).
Buy the underlying share at R60.
After 9 months, repay the loan and deliver the share under the contract,
receiving R65 and realising a profit of R0.55 (difference between actual and
fair price).
(b) Reverse cash and carry arbitrage (64.45 > 64):

Buy the futures contract at R64.
Sell the underlying share at R60.
Invest R60 (proceeds) at 10% for 9 months (owns R64.45).
After 9 months, withdraw the investment and take delivery of the

share under the contract, paying R64 and realising a profit of
R0.45 (fair price minus actual price).
14.4.2.4 Carrying charges

The costs and/or benefits associated with storing a physical commodity or
holding a financial instrument over a defined period of time are referred to
as carrying charges. These carrying charges include borrowing costs (i.e.
interest), storage (including insurance) costs and any cash flows (dividends
or coupons) generated by the underlying asset, as well as the convenience
yield of holding an asset (non-monetary benefit) and not wanting to sell it.
These monetary and non-monetary costs and benefits need to be
incorporated into the price and value of a forward (or futures) contract.
Any cost incurred from holding the underlying asset increases the forward
price and any benefit generated from holding the asset should result in a
lower forward price. Holders of forward and futures contracts are not
entitled to receive any dividends or coupon payments from the underlying
asset. Therefore, borrowing and storage costs would result in a higher
forward price, while cash inflows and any convenience yield (due to
relative scarcity and high demand) reduce forward prices.
14.4.2.5 Forward and futures price differential

Futures prices fluctuate in an open and competitive market and the
marking-to-market process results in each futures contract being settled
daily. Forward contracts, however, are only settled at expiration. Futures are
essentially free of default risk, but forwards are subject to default risk.
Ignoring the credit risk issue, it can be concluded that any differences
between forward and futures prices are due to the marking-to-market
process. Therefore:
The price of a futures contract will equal the price of an otherwise
equivalent forward contract if interest rates are known or constant.
Under this condition, any effect of the addition or subtraction of funds
from the marking-to-market process can be shown to be neutral.
The price of a futures contract will equal the price of an otherwise
equivalent forward contract if interest rates are uncorrelated with futures
prices.
If interest rates are positively correlated with futures prices, futures will
carry higher prices than forwards:
– Traders with long positions will prefer futures over forwards because
futures will generate gains when interest rates are going up (and
futures prices are going up as they are positively correlated) and
traders can invest these gains for higher returns.
– Traders will incur losses when interest rates are going down and they
can borrow money to cover these losses at lower rates.
– Gold futures contracts are good examples in this case as gold futures
prices and interest rates tend to be positively correlated.
If futures prices are negatively correlated with interest rates, traders will
prefer not to mark to market and forward prices will carry higher prices.
– Interest rate futures are good examples in this case as interest rates and
fixed-income security prices move in opposite directions.
14.4.2.6 Forward Rate Agreements

A Forward Rate Agreement (FRA) is a forward contact on a short-term
interest rate, usually LIBOR or JIBAR, in which cash flows at maturity are
calculated on a notional amount and are based on the difference between a
predetermined fixed forward rate (the FRA rate) and the market rate
prevailing on that date. The settlement date of an FRA is the date on which
cash flows are determined.
Parties to this agreement want to protect themselves against future

movements in interest rates. By entering into an FRA, the parties lock in an
interest rate for a stated period of time starting on a future settlement date,
based on a specified notional principal amount. The buyer of the FRA
enters into the contract to protect itself from a future increase in interest
rates, wanting to fix its borrowing cost today. The seller of the FRA wants
to protect itself from a future decline in interest rates, wanting to hedge the
return obtained on a future deposit.
14.4.3 Hedging an equity portfolio

A portfolio of equities can be hedged by shorting share index futures, for
example an All Share Index (ALSI) futures contract. The underlying share
index represents the market or a certain section of that market (e.g. the
industrial or financial sector). The optimal number of contracts required to
hedge an equity portfolio depends on the value or size of the portfolio and
the value of the specific futures contract (R10 times the index level), as well
as the portfolio’s beta (sensitivity to market movements).
The optimal number of contracts (N) is calculated as follows:
N = β
VP
VF
(14.4)
Example: A company has a R20 million portfolio with a beta of 0.9. With
the Top40 Index (ALSI) level at 48 000, the optimal number of contracts
required to protect the value of this portfolio is determined as follows:
20 000 000
N = 0.9 = 38
10×48 000
Thirty-eight ALSI share index futures contracts should be shorted.
A hedged position has a beta of zero (i.e. risk eliminated) or at least close to
zero depending on the actual number of contracts shorted (rounded
number). However, beta can also be adjusted (increased or decreased) to be
non-zero. By simply reducing the exposure, a portfolio manager may sell
less than the optimal number of contracts. Conversely, increasing the
exposure in a bull market would require the purchase of index futures,
resulting in a higher beta value and therefore an increased sensitivity
(amplified return) to an upward trending market.
14.5 OPTIONS
Options are more versatile than futures, not only providing leverage and
insurance (protection), but also allowing for different combinations and
strategies (e.g. covered call and protective put, straddle, bull and bear
spreads) depending upon the investor’s market expectations and intentions.
Probable drawbacks concern the more complex calculations and intricate
behaviour of option prices. Five different variables, namely delta (change in
option price due to changing underlying price), gamma (change in delta due
to changing underlying price), theta (time decay), vega/kappa (changes in
implied volatility) and rho (changes in interest rates), referred to as the
“Greeks”, impact upon an option price to varying degrees. Although both
futures and options facilitate investing or speculation by providing an
enlarged spot exposure, the main distinction between futures and options
concerns their primary use or purpose: the hedging function of futures
versus the insurance function of options.
The basics on options with regard to notation, payoffs, moneyness and

value are dealt with in the next section.
14.5.1 Options basics

14.5.1.1 Definitions and terminology
The following are the most common definitions and terms required for a
discussion of the workings and application of options:
Call option. This is an option to buy an asset (the underlying) at a certain

price (strike or exercise price) on or before a specified expiration date.
Put option. This is an option to sell an asset (the underlying) at a certain
price (strike or exercise price) on or before a specified expiration date.
Exercise. The option holder exercises his or her right to either buy or sell
the underlying asset at the exercise or strike price.
European-style option. This kind of option can be exercised and settled
only on its expiration date.
American-style option. This kind of option can be exercised and settled
on or before its expiration date (most common type).
Time value of money. This is the before expiration or exercise interest
portion of an option value over and above its intrinsic or exercise value
related to the present (discounted) value of the strike price.
Moneyness. Moneyness is the degree to which an option is in-the-money
and likely to be exercised, thereby having a payoff.
Payoff. This refers to the difference between the spot and strike prices
when exercised.
Breakeven price. This is the spot price at which the holder breaks even
(zero profit) after accounting for the cost of obtaining the option.
Profit or loss. This is the payoff minus the cost of obtaining the option
(premium).
14.5.1.2 Options notation and variables

Table 14.1 sets out the five main variables (excluding dividends) that
influence the value/price or premium of an option, namely the underlying
asset’s spot price, the strike or exercise price, the volatility (standard
deviation) of the underlying asset, the time to maturity or expiration and the
risk-free rate of return.
Spot price (S)

The value of a call option increases with an increase in the underlying spot
price owing to the spot minus strike payoff structure of call options. The
opposite effect will occur with put options, with an increase in the spot
price leading to a smaller payoff (X > S) or even resulting in the put option
having no value (S > X).
Strike price (X)

The value of a call option is smaller with a larger strike price owing to the
spot minus strike payoff structure of call options. The opposite effect will
occur with put options, with a larger strike price increasing the probability
of a put option moving into the money and resulting in a payoff (X > S)
should the spot price decline to below the strike price.
Table 14.1 Option notation and variables
Variable Notation State Call option value Put option value

Spot price S Increase Increase Decrease
Strike price X Higher Lower Higher
Volatility σ Higher Higher Higher
Time to maturity t Longer Higher Uncertain
Interest rates r Higher Higher Lower
Call option C or c max(0; S – X)
Put option P or p max(0; X – S)
Volatility (σ)
Volatility is the degree of fluctuation (rate of change) in the price of the
underlying security and is mathematically expressed in terms of standard
deviation. High volatility (severe changes in price) equates to high risk and
an increased probability of either a spot market loss or gain and an option
ending up in the money. A call holder benefits from price increases but has
a limited downside risk (price decreases), thus the call option value will
increase with an increase in volatility. Conversely, a put holder benefits
from price decreases but has a limited exposure to price increases. The put
option therefore also increases with an increase in volatility. Although not
directly observable in the market, volatility (estimated or implied) has a
very strong effect on option prices and is a critical variable in pricing
options.
Time to expiration (t)

In general, the longer the time to expiration the more valuable the option,
since additional time allows for any favourable move that might occur in
the underlying. The exception to this rule is European put options, where an
extended exercise period delays the receipt of payment and results in lost
interest. Longer-term European put options tend to be worth more only in
combination with higher volatility and lower interest rates. Additional time
is beneficial to the holder of an American put option, as early exercise is
always possible. Call options in all instances benefit from paying the
exercise price later, thereby earning additional interest.
Interest rates (r)

The impact of higher interest rates on call option prices is twofold: the
delayed payment for the underlying earns higher interest, and smaller
discounted strike values (before exercise or expiration) result in higher call
option prices. The reverse is true for put options in that the opportunity cost
(interest) of waiting to sell the underlying is higher, while a lower
discounted strike has an unfavourable impact on the put payoff structure.
Even so, interest rates have a relatively small impact on option values
compared to other variables.
14.5.1.3 Options payoffs

The call holder can exercise his right to purchase the underlying should the
spot price exceed the strike price, as may be seen from Figure 14.3. The
shaded area depicts the outcome to the call holder, depending upon the
movements in the spot price. The call writer payoff profile (broken line) is
the mirror image of the call holder profile, with equal but opposite
outcomes. The intrinsic or exercise value (the value at exercise or
expiration, excluding any time value of money) of a call option is the
greater of the spot price minus the strike price; or zero. The call holder will
only exercise the option if the share price exceeds the strike price, that is,
when the option has an intrinsic value (in-the-money). The potential profit
to the call holder is unlimited, while that of the call writer is limited to the
premium received. Conversely, the maximum loss to the call holder is the
premium paid, while the potential loss to the call writer is unlimited.
Figure 14.3 Buying or selling a call option
Exercising the call option when the spot surpasses the strike results in
recouping some of the premium paid. At the breakeven price (call strike
plus premium) the total premium is recouped. With a spot price moving
above the breakeven, a potentially unlimited profit (difference between spot
and breakeven price) transpires.
The put holder can exercise his right to sell the underlying should the strike
price exceed the spot price, as may be seen from Figure 14.4. The shaded
area depicts the outcome to the put holder depending upon the movements
in the spot price. The put writer payoff profile (broken line) is the mirror
image of the put holder profile, with equal but opposite outcomes. The
intrinsic or exercise value of a put option at expiration is the greater of the
strike price minus the spot price; or zero. The put holder will only exercise
the option if the strike price exceeds the spot price, that is, when the option
has an intrinsic value (in-the-money). The potential profit to the put holder
is limited to the breakeven value (put strike minus premium), while that of
the put writer is limited to the premium received. Conversely, the maximum
loss to the put holder is the premium paid, while the potential loss to the put
writer is limited to the breakeven value.
Figure 14.4 Buying or selling a put option
Exercising the put option when the spot moves below the strike will result
in the holder recouping some of the premium paid. At the breakeven price
(put strike minus premium) the total premium is recouped. With a spot price
moving below the breakeven, a limited profit (difference between spot and
breakeven price) is established. The profit is limited to the breakeven value,
assuming a spot price of zero (no value).
To exercise or not to exercise, that is the question. The answer depends on

the “moneyness” of the option – that is, on the type of option and whether it
would be profitable to the holder. Figure 14.5 shows the different states of
an option, namely in-the-money, at-the-money and out-the-money. These
states are reliant upon a changing spot–strike relationship and the respective
call and put payoff structures. A sizable difference between the variable
spot price and the fixed strike price labels an option as being far in or out of
the money. The price of an option also depends on the state of moneyness,
with in-the-money options being more expensive.
Figure 14.5 Moneyness
The following sections discuss the pricing of options, the relationship

between put and call values, and the acceptable bounds within which these
call and put values can fluctuate.
14.5.2 Options pricing

Binomial pricing involves a method referred to as the risk-free portfolio
(no-arbitrage argument) method.1 A portfolio consisting of a long position
in delta (Δ) number of shares and a short position in one option is assumed.
The value of delta as calculated makes the portfolio riskless, and the
portfolio must therefore earn the risk-free rate of interest. The delta of an
option is the ratio of the change in the price of the option (f) to the change
in the price of the underlying (S). It is the number of units of the underlying
that should be held for each option shorted in order to create a riskless
hedge.
As shown in Figure 14.6, making assumptions regarding the up (S+) and
down (S–) values (percentage change relative to the current spot, S, or
actual value) of the underlying, allows the calculation of delta (14.5). The
respective future intrinsic values of the option (f+ and f–) are determined by
the strike price (X), the assumed future spot prices (S+ and S–), and whether
it is a call or put option.
Delta (Δ) = with – 1 ≤ ΔP < 0 ≤ ΔC < 1 (14.5)

+ –
f –f
+ –
S –S
f = ΔS – (ΔS+ – f +)(1 + r)–t (14.6)
Figure 14.6 One-period binomial model
Having determined delta, the current option price (f) is calculated using
equation 14.6. This one-period binomial model can be extended to include
multiple periods, allowing for different assumptions regarding the price
movements and the risk-free rate during each period (i.e. at each stage or
node). This feature distinguishes the binomial model (a discrete time model,
i.e. with fixed intervals or time-steps) from the Black-Scholes model (a
continuous time model) which only requires a prevailing assumption on the
volatility of the underlying.2
Example: A non-dividend-paying share is currently trading at R60. This

share price is expected to go up by 15% or down by 15% over the next 6-
month period. The risk-free interest rate is 10% per annum. The price (c) of
a 6-month European call option on this share with a R65 strike is
determined by a one-period binomial model in the following manner.
Delta (Δc) = 4–0
69–51
= 0.2222
c = (0.2222 × 60)–[(0.2222 × 69)– 4](1.10)–6/12

= R2.53
14.5.3 Put-call parity

Call and put prices with the same strike and expiry are related and should
be consistent with each other. With the assumption that the options are not
exercised before expiry, this theory only holds for European-style options.
A long position in the underlying (spot) plus the put value should equal the
present value (PV) of the strike price plus the call option value.
S + p = c + X(1 + r)–t (14.7)
Divergence from this theoretical equality may offer a profit-taking

opportunity described as put-call parity arbitrage.
14.5.3.1 Put-call parity arbitrage

Equation 14.7 can be rearranged in the following manner in order to
determine an appropriate arbitrage strategy:
c – p ≠ S – X(1 + r)–t (14.8)
Presented in this format, the difference between the call and put values
(left-hand side) should be equal to the difference between the underlying
spot price and the discounted strike price (right-hand side). Exploiting any
discrepancy requires a specific sequence of transactions, depending upon
which “side” is the largest (i.e. overvalued).
Should the (c – p) value exceed the [S – PV(X)] value, the following

strategy would apply:
c – p > S – X(1 + r)–t: sell call; buy put; borrow the PV(X) and buy the
underlying spot
Should the [S – PV(X)] value exceed the (c – p) value, the following

strategy would apply:
c – p < S – X(1 + r)–t: buy call; sell put; sell the underlying spot and
invest the PV(X)
Both strategies involve selling the overvalued (expensive) side and buying
the undervalued (inexpensive) side. The actual amount borrowed or
invested and eventual profit would depend on the option prices, the price of
the underlying security and the prevailing lending and borrowing rates. The
methodology as described simply indicates what to buy and what to sell in
exploiting an observed put-call disparity. Also important to realise is that
significant transaction costs may render any put-call parity arbitrage
opportunity obsolete.
Example: A European call option and put option on a non-dividend-paying

share on the shares of ABC Limited both have a strike price of R28 and a
time to expiration of 6 months. The call option trades at R7.50 and the put
option trades at R4.00. The current risk-free interest rate is 15% per annum
and the current share price is R30. Any arbitrage opportunity, strategy and
profit are determined using equation 14.8.
7.5 – 4 ≠ 30 – 28(1.15) –6/12

3.50 ≠ 3.89
Overvalued
Buy call – 7.50
Sell put + 4.00
Sell spot + 30.00
Invest PV(X) – 26.11
Arbitrage profit R0.39
This “buy the undervalued side and sell the overvalued” method provides
an arbitrage strategy that will lead to some arbitrage profit depending on the
actual market variables.
14.5.3.2 Options bounds

The minimum (lower bound) and maximum (upper bound) values for
options prior to expiration provide the band or range within which an option
price could trade without the possibility of arbitrage (i.e. the exploitation of
a discrepancy in fair value).
Upper bound Lower bound

Call options c≤S c ≥ S – X(1 + r)–t
Put options p ≤ X(1 + r)–t p ≥ X(1 + r)–t – S
The value of a European call option should not exceed the price of the
underlying, or be less than the difference between the spot price and
discounted strike price, as formulated in equation 14.9.
[S – X(1 + r)–t] ≤ c ≤ S (14.9)
The value of a European put option, similarly, should not exceed the
discounted strike price, or be less than the difference between the
discounted strike price and the underlying spot price, as formulated in
equation 14.10.
[X(1 + r)–t – S] ≤ P ≤ X(1 + r)–t (14.10)
Any trading outside of these bounds should lead to a combination of trades

involving the option and its underlying, taking advantage of this temporary
mispricing and bringing the price back into line.3
Example: The price of a 6-month European put option on a non-dividend-

paying share when the share price is R60, the strike price is R65 and the
risk-free rate of interest is 10% per annum, should trade within these
bounds:
[65(1.10)–6/12 – 60] ≤ p ≤ 65(1.10)–6/12

1.98 ≤ p ≤ 61.98
Trading within these bounds would rule out any boundary arbitrage.
14.5.4 American-style options

As noted earlier, American-style options can be exercised early. This extra
discretionary feature adds value in some cases and the price of American
options must therefore be no less than their European counterparts.4
Accounting for this early exercise possibility requires adjustments to the
put-call parity principle, options bounds and options values.
14.5.4.1 Early exercise

It is never optimal to exercise an American call option on a non-dividend-
paying share before the expiration date, for the following two reasons:5
Delaying exercise delays payment of the strike price and the holder is
able to earn interest for a longer period of time. Since the share pays no
dividends, no potential income is forfeited.
An unexercised call option provides insurance against a rising share
price, but once exercised (pre-expiry) any chance (however remote) of a
fall in price is also eliminated. Should the spot be below the strike at
expiration, early exercise would have been suboptimal as the option
ended up out of the money. Therefore, at expiration a call holder can
decide between the lower of the spot or the strike. With early exercise
only the strike price prevails.
On the other hand, an American put option should always be exercised
early if sufficiently deep in the money. This early exercise feature becomes
more attractive as the spot price and volatility decrease, and interest rates
increase (all impacting negatively on put values – refer to Table 14.1). Early
exercise results in the advance receipt of the purchase price (strike) and the
interest thereon for the remaining until-expiration period.
14.5.4.2 Pricing
The pricing of an American option is similar to that of a European option,
with the exception that any calculated price should be compared to the
corresponding intrinsic or if-exercised value when applicable. The larger of
the calculated (using the binomial model) and the intrinsic values should be
used in subsequent calculations.6 Should the intrinsic value exceed the
calculated value, early exercise may be optimal (see the previous discussion
on early exercise), with the American-style version proving more valuable
(i.e. expensive) than the European option. With all calculated values larger
than the corresponding intrinsic values, early exercise is not optimal and the
value of an American option is equal to that of its European counterpart.
14.5.4.3 Bounds
The bounds within which American-style options should trade are adjusted
to accommodate the possibility of early exercise. American-type options
should in all instances be worth at least as much as the matching European-
type options, and in some cases more. The lower bound for the American
call option is therefore higher, with both the upper and lower bounds of the
American put option adjusted higher (time value of money portion
removed) to account for the undiscounted strike price.
(S – X) ≤ C ≤ S (14.11)
The lower bound of an American call option is simply the difference

between the spot and strike prices as shown in equation 14.11. Ignoring the
time value of money component will result in increased minimum and
maximum put values as shown in equation 14.12.
(X – S) ≤ P ≤ X (14.12)
The basic put-call parity theorem does not hold for American-style options
as these options may trade within certain bounds that allow for early
exercise (similar to the minimum and maximum option values). The parity
equation is, therefore, also adjusted for a range of possible values.
S – X ≤ C – P ≤ S – X(1 + r)–t (14.13)
The difference in price between an American call and put can be as large as
the time value of money component (maximum) inherent in a before-
expiration option. Knowing either C or P, the corresponding put or call
should trade within certain bounds. In other words, the upper and lower
bounds for a specific American call (put) option relate to a fixed value of its
equivalent put (call).
Example: The prices of 6-month American call and put options on a non-
dividend-paying share when the share price is R60, the strike price is R65
and the risk-free rate of interest is 10% per annum, should trade within
these bounds:
(60 – 65) ≤ C ≤ 60
0 ≤ C ≤ 60
(65 – 60) ≤ P ≤ 65
5 ≤ P ≤ 65
Assuming the call actually trades at R2.53, the put should trade within the
following bounds:
60 – 65 ≤ C – P ≤ 60 – 65(1.10)–6/12
–5 ≤ 2.53 – P ≤ –1.98
5 ≥ P – 2.53 ≥ 1.98
7.53 ≥ P ≥ 4.51
The call price of R2.53 equals the European value calculated under Section
14.5.2 and the corresponding European put should trade at R4.51 (dictated
by put-call parity). The equivalent American-style put would therefore trade
between R4.51 (actually at R5 or higher as indicated by the lower bound)
and R7.53. Recollect that an American call should always be equal to the
equivalent European call owing to the fact that it is never optimal to
exercise early on a non-dividend-paying share. An American put can,
however, always be exercised early if sufficiently deep in-the-money, and
must therefore trade higher (be more expensive) than its European
counterpart.
14.5.5 Options “Greeks”

The underlying variables influencing option values were shown to be the
spot price (S), the strike price (X), volatility (σ), time to expiration (t) and
the risk-free rate (r). The isolated independent effect of each variable
(excluding the strike or exercise price) measures the sensitivity of an
option’s price to changes in that variable. These sensitivity measures are
called the “Greek Letters” or “Greeks” in reference to the notation used.
Delta measures the sensitivity of an option’s price to changes in the spot

price of the underlying share. Stated differently, delta is the amount by
which the price of an option will change with a one unit (R1) change in the
underlying. Delta is the slope of an option’s prior-to-expiration curve as
shown in Figure 14.7 (call option) and Figure 14.8 (put option), the size of
which is determined by the option’s state of moneyness and time to
expiration.
Figure 14.7 Delta of a call option
Figure 14.8 Delta of a put option
The delta of a call option ranges from 0 and +1 and, as can be seen from
Figure 14.7, the slope of the prior-to-expiration curve (i.e. delta) increases
(becomes steeper) when the option moves from out-the-money to in-the-
money. An at-the-money call option will have a delta of 0.5, indicating that
it will rise by R0.50 with a R1 increase in the underlying share, and that it
has a 50% (approximated) probability of ending up in-the-money.
An option is an indirect leveraged position in the underlying. As such, the
delta value also establishes the number of corresponding shares effectively
exposed to. Each option’s contract is normally based on one hundred shares
of the underlying (contract size). Therefore, a position in five at-the-money
call contracts has a total of 250 deltas (i.e. 5 × 100 × 0.5), meaning that the
investor effectively bought 250 shares. Should the underlying share price go
up by R1, the value of the exposure (portfolio of options) will rise by R250.
This leveraged or enhanced exposure may also result in a large loss due to a
small decrease in the underlying share price, and that is the inherent risk
associated with derivative instruments.
Conversely, a pre-existing exposure (e.g. owning 1000 equity shares) can be

delta hedged by shorting twenty [i.e. 1000 ÷ (100 × 0.5)] at-the-money call
option contracts, or buying twenty at-the-money put options contracts (delta
of –0.5). The absolute values of corresponding call and put options always
add up to one, with the delta of a put option ranging from –l and 0
depending on the moneyness, as shown in Figure 14.8. The same principles
apply to put options, except that put deltas are negative as put holding
profits from declining share prices.
A positive delta (long call and short put) value means that the option’s price
moves in the same direction as the underlying share, while a negative delta
(long put and short call) establishes an inverse relationship between the
option and its underlying share.
Time to expiration, in addition to and reliant on moneyness, also influences

the value of an option’s delta. The delta of an in-the-money option will
increase as time to expiration approaches, while the delta value of an out-
the-money option will decrease. Nearer-term in-the-money options have
higher delta values than longer-term options with the same strikes.
Delta constantly changes as the spot price changes and also because of time
decay. This rate of change in delta as it moves in-the-money or out-the-
money is governed by gamma. Gamma is largest for options that are at-the-
money and smallest for options far in or out of the money. When a spot
price increases by a small amount, delta increases by gamma times that
amount.
Vega measures the risk from changes in implied volatility (i.e. estimated
magnitude of price fluctuations as indicated by current price data) and is the
second most important factor in establishing options prices apart from the
underlying price itself. Vega is most sensitive when the option is at-the-
money, tapering off as the spot moves farther above or below the strike.
Theta measures how fast the price of an option decays with time. The
option premium effectively depreciates on a daily basis (theta is always
negative) and at an increasing rate. With the passing of each day, the
amount of time value remaining on the option decreases. At expiration only
the intrinsic or exercise value remains. Theta is higher nearer to expiration
and lower further away from expiration.
Rho is the risk associated with a rise or fall in interest rates. Large changes
in the risk-free rate during the relevant time frame (time to expiration) are
unlikely and rho is therefore the least significant factor in the pricing of
options. Call options will gain from an increase in interest rates (positive
rho), while put options values will be reduced (negative rho). Rho values
will be largest for in-the-money, long-dated options.
Summary: options “Greeks”

Delta A measure of an option’s sensitivity to changes in the price of the
underlying
Gamma A measure of delta’s sensitivity to changes in the price of the
underlying
Vega A measure of an option’s sensitivity to changes in the volatility of
the underlying
Theta A measure of an option’s sensitivity to time decay
Rho A measure of an option’s sensitivity to changes in the risk-free
interest rate
14.5.6 Trading strategies

Options can be used to create a wide range of risk-limiting, fixed-profit
strategies. Strategies involving a single option and a share (the covered call
and protective put strategies), combinations (positions in both calls and
puts, e.g. straddles and strangles), and spreads (positions in options of the
same type, e.g. bull and bear spreads) are illustrated and presented as the
most basic and common options strategies applied.
14.5.6.1 Covered call strategy

Owning the underlying share, calls can be sold to generate income
(premiums) with the expectation that these calls will lapse unexercised. The
short call is “covered” in that the underlying share is owned and available
for delivery, should the call be exercised. This is a viable strategy when the
underlying share price is expected to remain at current levels (i.e.
unchanged over the short term). The call is written out-the-money (strike
above the spot), and therefore unlikely to end up in-the-money and being
exercised.
The potential payoffs of this strategy are illustrated in Figure 14.9, showing
a short call at a strike price above that of the current spot price and therefore
out-the-money. Should the spot price overtake the strike, the call holder will
exercise. The maximum profit then is the difference between the high strike
price (X) and lower initial spot price (S0) plus the premium (c) received,
that is (X – S0 + c). The maximum loss occurs at a current spot price (ST) of
zero and is the initial spot price less the premium received, which is also the
breakeven price (BE). However, if the call writer anticipates little
movement in the underlying share price, the call holder is not able to
exercise, retaining the full premium received and thereby generating
income in a stable or flat market.
Figure 14.9 Covered call strategy
14.5.6.2 Protective put strategy

This strategy, also called portfolio insurance, entails buying a put when
owning the underlying in order to “protect” the value of a share or portfolio
of shares; paying a premium and buying insurance against adverse
(downward) price movements in the underlying; and establishing an
acceptable minimum portfolio value (i.e. the strike level) while retaining
any upside or increase in portfolio value, less the premium paid (cost of
insurance).
The potential payoffs of this strategy are illustrated in Figure 14.10,

showing a long put at a strike price that determines a minimum portfolio
value (current level or below). Should the spot price decline below the
strike, the put holder will exercise. The maximum loss occurs at a current
spot price (ST) of zero and is the initial spot price minus the strike price,
adding the premium paid (S0 – X + p). The maximum profit is unlimited
(only reduced by the premium) and calculated by subtracting the initial spot
price (S0) from the higher current spot price (ST) while accounting for the
premium (p) paid, that is (ST – S0 – p). This strategy breaks even (costs
covered) at the initial spot plus put premium.
Figure 14.10 Protective put strategy
14.5.6.3 Straddle
A straddle is the combination of a long call option and a long put option on
the same asset and with the same strike and expiration. Even though a
relatively large movement in share price is anticipated, the direction of
change (up or down) is uncertain.
Figure 14.11 shows that should the share price remain unchanged at the
current level (close to the strike), a loss will be made. Any potential loss is
limited (maximum) to the total cost of the strategy (i.e. the call and put
premiums paid). Only once the spot price moves beyond any of the two
breakeven values (A and B) will this strategy return a profit. These
breakeven values are the strike price plus and minus the total cost incurred
(premiums). The potential gain to the straddle holder is unlimited with an
increasing spot price (call exercised), but limited to the lower breakeven
value (A) in the event of the underlying price decreasing to zero (put
exercised).
Figure 14.11 Straddle
A strangle is similar to a straddle (LC plus LP), but it is a less expensive

strategy, with the call purchased at a higher strike and the put purchased at a
lower strike (each more out-the-money and therefore lower priced). This is
a combination of options based on the same underlying and with the same
expiration, but with different strikes and at a smaller initial outlay, requiring
a larger move (either direction) in the spot price to profit.
14.5.6.4 Bull and bear spreads

The bull and bear spreads can be constructed with either calls or puts. Two
call or put options on the same underlying and expiration but with a
difference in strike (i.e. the spread) are bought and sold respectively to
either benefit from a rise (bull spread) or fall (bear spread) in the market.
The maximum gain or loss in all instances is restricted and determined by
the type of option and outlook on the market (positive or negative).
Call options (right to buy) are associated with a bullish or positive market.
Combining a long in-the-money call with a short out-the-money call will
result in a bull spread and a payoff pattern as illustrated in Figure 14.12. If
both the long call at the lower strike (XL) and the short call at the higher
strike (XH) are exercised (by the respective holders), following an increase
in the spot price as anticipated (bull market), the maximum profit wil be the
difference between the two strike prices plus the cost of implementation
(XH – XL – cL + cH). In the event of an unanticipated fall in the market
price, this strategy limits the maximum possible loss to the cost of
implementation since neither option is exercised.
Figure 14.12 Bull call spread
A bull put spread can similarly be constructed with the long put out-the-
money (low strike) and the short put in-the-money (high strike).7
Put options (right to sell), on the other hand, tend to be associated with a
bearish or negative market. Combining a long in-the-money put with a short
out-the-money put will result in a bear spread and a payoff pattern as
illustrated in Figure 14.13 (the inverse of the bull put spread). If both the
long put at the higher strike (XH) and the short put at the lower strike (XL)
are exercised (by the respective holders), following a decrease in the spot
price as anticipated (bear market), the maximum profit will once again be
the difference between the two strike prices plus the cost of implementation
(XH – XL – pH + pL). In the event of an unanticipated rise in the market
price, this strategy limits the maximum possible loss to the cost of
implementation since neither option is exercised.
Figure 14.13 Bear put spread
A bear call spread can similarly be constructed with the long call out-the-
money (OTM) (high strike) and the short call in-the-money (ITM) (low
strike).
ITM = in-the-money OTM = out-the-money

Call options
Long Short
Bull spread ITM – low X OTM – high X
Bear spread OTM – high X ITM – low X
Put options
Long Short
Bull spread OTM – low X ITM – high X
Bear spread ITM – high X OTM – low X
14.6 SWAPS
A swap is an agreement between two parties, facilitated by a swap dealer, to

exchange a series of cash flows based on a notional principal over a
specified future period. There are five basic kinds of swaps: interest rate
swaps, currency swaps, equity swaps, commodity swaps and credit swaps.
The following sections focus on the fixed-for-floating interest rate swap and
the fixed-for-fixed currency swap. Equity swaps are also covered in brief.
The parties entering into interest rate or currency swap contracts typically
have existing exposures requiring a series of payments or receipts (fixed or
floating liabilities or investments denominated in the local or a foreign
currency). These cash flows are transformed by substituting or exchanging
the originating source of these commitments.
14.6.1 Interest rate swaps

The most common interest rate swap is the plain vanilla interest rate swap,
where one party (a company or financial institution) agrees to pay its
counterparty a periodic fixed rate on a notional principal over the tenor of
the swap. In return, the counterparty agrees to pay a periodic floating rate
on the same notional principal. Payments are made in the same currency
and only the net payment is exchanged. The floating rate is generally based
on the local JIBAR (Johannesburg Inter-Bank Agreed Rate) or international
LIBOR (London Inter-Bank Offered Rate). Lower funding costs or higher
investment yields, certainty on future obligations (pay-fixed side of the
swap) or taking advantage of current or expected future market conditions
(i.e. declining or rising interest rates) are likely motives for entering into
interest rate swaps.
14.6.1.1 Valuation of interest rate swaps

An interest rate swap can be valued in terms of bond prices. The respective
prices of a fixed-rate bond and a floating-rate bond are calculated with the
difference between these two prices representing the value of the swap.
Value of a pay-fixed, receive floating swap:
Vpay-fixed = Bfloat – Bfixed (14.14)
Value of a pay-floating, receive fixed swap:
Vpay-float = Bfixed – Bfloat (14.15)

Recall that the price of a bond is simply the sum of all discounted cash
flows plus the discounted principal or face value.
Fixed-rate bond (steps to follow):
Calculate the per-period fixed payment.

Calculate the present values of each fixed payment and the principal
value.
Add up all the present values to arrive at the price of the fixed-rate bond
(Bfixed).
Floating-rate bond (steps to follow):
Calculate the next floating payment.8

Add the floating payment to the principal value.
Calculate the present value of this amount as the price of the floating-rate
bond (Bfloat).
Example: Under the terms of an interest rate swap, a financial institution

has agreed to pay 10% per annum (compounded quarterly) and to receive 3-
month JIBAR in return on a notional principal of R10 million with
payments being exchanged every 3 months. The swap has a remaining life
of 9 months. The JIBAR rates are 11.8% (last payment date), 12.5% (3-
month), 13.0% (6-month) and 13.2% (9-month) respectively. Determine the
value of the interest rate swap to the financial institution.
Fixed-rate bond:
Fixed = (10 000 000 ×

0.10
4
) = R250 000
−1
Bfixed = 250 000(1 +

0.125
4
)
−2
0.13
+250 000(1 + )
4
−3
0.132
+10 250 000(1 + )
4
= R9 775 648
Floating-rate bond:
Bfloat = R10 000 000*
Value of interest rate swap:
Vpay-fixed = 10 000 000 – 9 775 648

= R224 352
* Note that the value of the floating-rate bond is equal to the principal value since the valuation date
coincides with the payment date.
14.6.2 Currency swaps

A currency swap is different from an interest rate swap in that there are two
principals, one in each currency, with the counterparties generally
exchanging these principals on the effective date and returning them at the
maturity date. The cash flows are denominated in different currencies, and
the periodic interest payments are therefore not netted but made in the
appropriate currency by the respective counterparties.
In a plain vanilla currency swap the floating--rate cash flows are in the local
currency, while the fixed-rate cash flows are based on a foreign currency.
The simplest kind of currency swap occurs when each party pays a fixed
rate of interest on the currency it receives (i.e. a fixed-for-fixed currency
swap).
Currency swaps allow companies to gain access to foreign currency funds

that might be too costly to obtain from a foreign bank. Also, a company that
issued a foreign currency bond earlier may wish to convert or transform it
into a domestic obligation by entering into a receive-fixed foreign currency,
pay-fixed (or floating) domestic currency swap. An investment
denominated in a foreign currency can likewise be transformed into a
domestic investment.
Example: A US company has a liability of $15 million in fixed-rate bonds
outstanding at 4%. A UK company has a liability of £10 million in fixed-
rate bonds outstanding at 6%. The exchange rate is $1.50/£. The US
company enters into a fixed-for-fixed currency swap with a swap dealer in
which it pays 6.1% on £10 million and receives the swap rate of 4% on $15
million. The UK company also enters into a fixed-forfixed currency swap
with the same dealer, in which it pays the swap rate of 4% on $15 million
and receives 6% on £10 million. Calculate each party’s effective borrowing
rate, the principal cash flows and the first-year net cash flows (assume
annual settlement).
By entering into this currency swap, the US company has effectively

transformed a $15 million 4% liability into a £10 million 6.1% liability. The
UK company transformed a £10 million 6% liability into a $15 million 4%
liability. The principals are exchanged at the beginning and at the maturity
of the swap, with each company gaining access to funds in a foreign
currency that might be too costly to obtain from a bank, possibly in order to
finance a purchase in that currency.
US company UK company
Pay 4% on $15 million (fixed liability) 6% on £10 million (fixed liability)
Receive 4% on $15 million (swap rate) 6% on £10 million
Pay (effective rate) 6.1% on £10 million 4% on $15 million (swap rate)
Principal £10 million (received and returned) $15 million (received and returned)
Net cash flow (0.061 × £10 million) = £610 000 (0.04 × $15 million) = $600 000
Swap dealer (0.01 × £10 million) = £10 000 (commission)
14.6.2.1 Valuation of currency rate swaps
A currency swap can also be valued in terms of bond prices. The respective
prices of a domestic bond and a foreign bond are calculated, with the
difference between these two prices representing the value of the swap.
Value of a pay-foreign, receive-domestic currency swap:9
Vpay-foreign = Bdomestic – (XR)Bforeign (14.16)
Value of a pay-domestic, receive-foreign currency swap:10
Vpay-domestic = (XR)Bforeign – Bdomestic (14.17)
Domestic bond (steps to follow):
Calculate the per-period fixed payment on the domestic principal.

value.
Add up all the present values to arrive at the price of the domestic bond
(Bdomestic).
Foreign bond (steps to follow):
Calculate the per-period fixed payment on the foreign principal.

value.
Add up all the present values to arrive at the price of the foreign bond
(Bforeign).
Convert the foreign bond price at the current exchange rate
[(XR)Bforeign].
Example: Suppose there is a flat-term structure of interest rates in both

South Africa and the US. The South African interest rate is 12% and the US
interest rate is 5% per annum. A financial institution has entered into a
currency swap in which it pays 3% per annum in US dollars (USD) and
receives 10% per annum in South African rand (ZAR). Payments are done
once a year. The principals in the two currencies are $10 million and R70
million respectively. The swap will last for 2 years and the current exchange
rate is R7.00/$. Determine the value of the currency swap for the financial
institution.
Domestic bond:
Fixed = (70 000 000 × 0.10) = R7 000 000

Bdomestic = 7 000 000(1.12)–1
+ 77 000 000(1.12)–2
= R67 633 929
Foreign bond:
Fixed = (10 000 000 × 0.03) = R300 000

Bforeign = 300 000(1.05)–1
+ 10 300 000 (1.05)–2
= $9 628 118
(XR)Bforeign = 7 × 9 628 118

= R67 396 825
Value of currency swap:

Vpay-foreign = 67 633 929 – 67 396 825
= R237 104
14.6.3 Equity swaps

An equity swap is a contract where one party makes payments based on an
equity position. The counterparty may make payments based on another
equity position, a bond or just fixed payments. An investor with a large
position in a specific share can swap that share’s return for the return on an
index. An investor with a large position in equities who wants to diversify
into bonds can achieve this synthetically with an equity-for-debt swap.
Switching index returns on different sectors (e.g. industrial for financial or
gold) or large and small cap shares, are all attainable. The only limitation to
the uses and possibilities of these over-the-counter instruments is finding a
counterparty (via a swap dealer) willing to take the other side of the deal.
14.7 SUMMARY
This chapter focused on the basic derivatives instruments: futures, options

and swaps. Portfolio management, and therefore the management of market
or financial risk, requires the effective use of these leveraged instruments.
The actual spot market exposure and the intention of each individual
investor determine the most appropriate type of derivatives contract. In
general, futures contracts fulfil a hedging function, while options contracts
provide insurance. Swaps can change the nature of assets or liabilities and
allow for the exchange of virtually any cash flows. Derivatives
simultaneously offer portfolio protection and portfolio enhancement,
affording portfolio managers the flexibility to create and modify various
investment strategies.
BESA. 2007. Available at: http://www.bondexchange.co.za (accessed October 2008 to November

2008).
Chance, D.M. 2003. Analysis of derivatives for the CFA® program. Charlottesville, VA: AIMR.
De Beer, J.S. 2008. The impact of single stock futures on the South African equity market. MCom
dissertation. Pretoria: University of South Africa.
Hull, J.C. 2008. Fundamentals of futures and options markets, 6th ed. Upper Saddle River, NJ:
Pearson, Prentice-Hall.
JSE. 2013. Johannesburg Stock Exchange, Sandton, Gauteng. Available at: http://www.jse.co.za
(accessed in March 2016).
Kolb, R.W. & Overdahl, J.A. 2007. Futures, options, and swaps, 5th ed. Malden, MA: Blackwell
Publishing.
Stulz, M.S. 2003. Risk management and derivatives. Mason, OH: Thomson, South-Western.
1. Suppose a 9-month futures contract is entered into on a non-dividend-paying

share when the share price is R60 and the risk-free interest rate is 8% per annum.
An investor has just taken a long position in this contract. Six months later, the
price of the share is R55 and the risk-free interest rate is 8.5% per annum. The
delivery price and value of this futures contract are closest to:
(a) R61.17 R7.44

(b) R61.17 R7.37
(c) R63.57 –R7.37
(d) R63.57 –R7.28
2. A 3-month futures on a share trading at R95 is available for R98 per contract. The
risk-free interest rate is 10% per annum. The following transactions will generate
an arbitrage profit:
(a) Borrow R98, buy the contract and sell the share
(b) Short the contract, borrow R95 and buy the share
(c) Sell the share and the futures contract, invest R95
(d) Sell the contract, invest R98 and buy the share
3. A non-dividend paying share is currently trading at R50. This share price is
expected to increase or decrease by R10 over the next three-month period. The
risk-free interest rate is 8% per annum. The delta (Δp) and price (p) of a 3-month
European put option on this share with a R50 strike should be close to:
(a) –0.5 R4.43

(b) 0.5 R4.43
(c) –0.5 R5.38
(d) 0.5 R5.38
4. A European call option and put option on the shares of ABC Limited both have a
strike price of R26 and a time to expiration of 6 months. The call option trades at
R3.50 and the put option trades at R3.00. The current risk-free interest rate is
12% per annum and the current share price is R25. The following transactions will
generate an arbitrage profit:
(a) Borrow money; buy put; sell call; buy spot

(b) Sell call; buy put; sell spot; invest proceeds
(c) Sell put; borrow money; buy call; buy spot
(d) Buy spot; sell call; invest proceeds; buy put
5. A share trading at R15 is expected to increase to R19 or decrease to R13 over the
next month. What is the probability of a R17 strike put on this share ending up in-
the-money? Is this put currently in, out or at-the-money?
(a) 33% in-the-money

(b) 33% out-the-money
(c) 67% out-the-money
(d) 67% in-the-money
6. An investor owns 20 000 Absa shares. He would like to protect the value of this
portfolio by entering into either a single stock futures contract or a put options
contract with a 0.6666 delta on this share. How many SSF contracts or options
contracts will this investor have to buy or sell to achieve this?
(a) Sell 200 SSF contracts, buy 300 put options

(b) Buy 200 SSF contracts, sell 300 put options
(c) Sell 200 SSF contracts, sell 133 put options
(d) Buy 200 SSF contracts, buy 133 put options
7. A call with a strike price of R25 costs R3. A put with a strike price of R20 costs R2.
A trader uses these options to create a strangle. What is the maximum potential
loss (per option) of this strategy, and for which two values of the spot price does
the trader break even with a profit of zero?
(a) R1 R15 and R30

(b) R5 R15 and R30
(c) R1 R18 and R28
(d) R5 R18 and R28
8. You wish to obtain an exposure to a specific share. Suppose that you buy a call
with a R70 strike at R6.75. Calculate the effective price paid to purchase the share
if the share price at expiration is R65 and R78 respectively.
(a) R71.25 R71.75

(b) R71.25 R76.75
(c) R71.75 R71.75
(d) R71.75 R76.75
9. A put option with a R60 strike (R8 premium) and a put option with a R70 strike
(R14 premium) are available on a certain share. What combination of these
options would result in a bull put spread, and what is the maximum potential profit
of this strategy?
(a) Long put (R60) plus short put (R70) R4

(b) Long put (R70) plus short put (R60) R4
(c) Long put (R60) plus short put (R70) R6
(d) Long put (R70) plus short put (R60) R6
10. Under the terms of an interest rate swap, a financial institution has agreed to pay
9% per annum (compounded quarterly) and to receive 3-month JIBAR in return on
a notional principal of R10 million, with payments being exchanged every 3
months. The swap has a remaining life of 10 months. The interest rate is 8% for
all maturities. Determine the value of the interest rate swap to the financial
institution.
(a) –R29 351

(b) –R29 351
(c) –R96 458
(d) –R96 458
Solutions
1. (d)
K = 60(1.08)9/12 = R63.57 (14.1)
F = 55(1.085)3/12 = R56.13
f = (56.13 – 63.57)(1.085)–3/12 = –R7.28 (14.2)
2. (b)
F = 95(1.10)3/12 = R97.29 (14.1)

Cash and carry arbitrage (98 > 97.29):
Sell the futures contract at R98.
Borrow R95 at 10% for the three months (owes R97.29).
Buy the underlying share at R95.
3. (a)
0–10 (14.5)
Delta (Δp) = =– 0.5
60–40
p = (–0.5 × 50) – [(–0.5 × 60) – 0](1.08)–3/12 = R4.43 (14.6)
4. (a)
3.5 – 3 ≠ 25 – 26(1.12)–6/12
0.50 ≠ 0.43
Overvalued
Sell call +3.50
Buy put –3.00
Borrow PV(X) +24.57
Buy spot –25.00
Arbitrage profit R0.07
5. (d)
0–4
Delta (Δp) = 19–13 = –0.6666 → 67% probability of ending up in-the-money X(17)
> S(15) and the put is therefore currently in-the-money
6. (a)
20 000
SSF = 100
= 200 (short)
Puts = 20 000
= 300 (long)
100 × 0.6666
7. (b)
Strangle constructed by buying both the call and put options.
Cost (outflow) = R3 + R2 = R5 (maximum loss when neither option is exercised).

Breakevens at (20 – 5) = R15 and (25 + 5) = R30.
8. (d)
At a spot of R65 the call will not be exercised. Share bought in spot market at
R65.
Effective cost = R65 + R6.75 = R71.75
At a spot of R78 the call will be exercised. Share bought at the strike of R70.
Effective cost = R70 + R6.75 = R76.75 or [78 (spot) + 6.75 (premium) – 8 (profit)]
= R76.75
9. (c)
Bull put spread constructed by:
Buying the out-the-money put (R60 strike at R8)

Selling the in-the-money put (R70 strike at R14)
Cost (inflow) = R14 – R8 = R6 (maximum profit when neither option is exercised)
10. (c)
Fixed-rate bond:
Fixed =
0.09
(10 000 000 × ) = R225 000
4
−1/3 −4/3
Bfixed = 225 000(1 + 0.08
) + 225 000(1 +
0.08
)
4 4
−7/3
0.08
+225 000(1 + )
4
−10/3
0.08
+10 225 000(1 + )
4
= R10 229 351
Floating-rate bond:
0.08
Float = (10 000 000 ×
4
) = R200 000
−1/3
Bfloat = 10 200 000(1 +
0.08
)
4
= R10 132 894
Value of interest rate swap:
Vpay-fixed = 10 132 893 – 10 229 351

= –R96 458
1 Another binomial pricing method, referred to as risk-neutral (probability-based) valuation,

sets the probability of an up movement (p) and down movement (1 – p) in price, thereby
assuming the return on the underlying to be equal to the risk-free rate and that the value of an
option today is its expected future payoff discounted at the risk-free rate.
2 The Black-Scholes model uses the five variables that influence an option price (i.e. spot
price, strike price, volatility, time to expiration and the risk-free rate) to calculate the
theoretical price of an option, assuming that any changes to a variable over any given time are
distributed normally (i.e. a symmetrical, bell-shaped division of values concentrated around an
average value).
3 Referred to as boundary arbitrage and involving the purchase of the option and the sale or
purchase of the underlying.
4 These terms have nothing to do with Europe or America, but simply distinguish between
options exercisable at or before expiration. Both types of options trade on world markets with
the American-style exercise dominating.
5 Different rules apply to call options on dividend-paying shares, indices, currencies and
futures contracts.
6 This does not, for example, apply to American call options on non-dividend-paying shares.
Also, it is only relevant to multiple-stage binomial models where a decision on optimality at
each node or stage is required.
7 Any reference to the options being either in or out-the-money simply differentiates between
these options in relative terms. It may as well be stated that one should be more in-the-money
or less out-the-money relative to the other, depending on the actual strike and underlying
prices.
8 At the time a floating payment is made, the floating-rate bond is worth the principal value.
Should the valuation date therefore coincide with the payment date, the price of the floating-
rate bond would equal the principal value.
9 The assumption is that a foreign currency is received and that the local company has to pay
interest on this foreign amount. This kind of swap typically provides access to a foreign
currency or facilitates the conversion or transformation of a foreign investment to a domestic
investment.
10 The assumption is that the domestic currency is received and that the local company has to
pay interest on this domestic amount. This kind of swap typically facilitates the conversion of
foreign debt to domestic debt.
15 Evaluation of portfolio
management
15.1 INTRODUCTION
History does not repeat itself (financial markets have proved this
repeatedly). However, Barke (1797) and Santayana (1952) philosophically
wrote that those who do not learn from history are condemned to repeat it.
Investors need to determine their required rate of return and state it in their
investment portfolio statements (IPSs). They need to determine if the
portfolio has achieved the required rate of return, and evaluate historical
risk and returns in order to formulate a clear indication of how well or
poorly their portfolio has performed. Not only does the performance of the
portfolio as such need to be evaluated, but also that of the portfolio
manager. The incentives of a portfolio manager are normally linked to the
achievement of return targets which were agreed upon.
The purpose of this chapter is to explain the evaluation of portfolio

performance by means of different performance measurement and
evaluation techniques. We evaluate the various performance measurement
techniques and illustrate performance attribution analysis. The major
traditional methods for calculating this risk-adjusted portfolio performance
are the Treynor Performance Index, the Performance Index and the Jensen
Measure. Special attention is also given in the chapter to the Global
Investment Performance Standards (GIPS™) of the CFA Institute®.
15.2 FUNDAMENTAL ISSUES IN PERFORMANCE
MEASUREMENT
The concepts of diversification, correlation and portfolio management were

introduced in the previous chapters. Clearly, asset allocation is the major
determinant of portfolio performance. Depending on the mandate, a
portfolio manager may follow an active or passive investment style. Owing
to transaction costs and taxes, an active portfolio management style seldom
outperforms a passive one. Also, an active management style is closer to
speculation than to pure investment (as explained in Chapter 1). Attention
will now be given to ways of evaluating the ex post performance of an
investment portfolio against either the original goals and objectives set out
in the portfolio construction phase or against benchmark performance
measurements.
Normally, the majority of investors are risk averse. Therefore it is important

when selecting or evaluating the performance of a portfolio manager for
investors to base the evaluation on their original risk and return objectives,
as indicated in their investment portfolio statements (IPSs). Two issues have
to be addressed in this regard:
Performance relative to risk. The ability of the portfolio manager to

diversify the portfolio and thereby eliminate unsystematic risk is the first
topic in the chapter and is known as performance measurement.
Performance relative to time and other portfolios. The performance of
the portfolio manager compared to benchmarked market performance
entails evaluation of both the manager’s sector and the security selection.
This is dealt with later in the chapter and is known as performance
attribution analysis.
15.3 PERFORMANCE MEASUREMENT

Both risk and return are a integral parts of the investment management and
portfolio construction decision. Thus evaluating the return/performance of a
portfolio will be an incomplete exercise without taking the risk of the
portfolio into consideration.
Risk aversion implies that a rational investor would, for a given amount of
risk, prefer a higher over a lower return or, for a given amount of return,
prefer a lower risk over a higher risk. Given this, once we have considered
the risk of a portfolio, we can relate this risk to the return of the portfolio to
ascertain whether the return was sufficient to reward the investor for the
extent of risk incurred.
The following example is used throughout this chapter to illustrate the

different performance measures and the merit of each one. Keep in mind
that the results of the Treynor and the Sharpe performance evaluation ratios
produce relative and not absolute rankings of performance. Assume for the
following examples an annual risk-free rate of return (rf) of 7%.
Example:
Portfolio A Portfolio B Market index

Return of portfolio (rp) 12.50% 16.59% 12.50%
Standard deviation of portfolio (σp) 2.71% 5.44% 4.92%
Portfolio beta (βp) 0.80 1.35 1.00
15.3.1 The Treynor Performance Index

As discussed in Chapter 1, a distinction can be made between risk that is
unique to a company and is diversifiable in nature, and undiversifiable risk
that results from general market fluctuations. Treynor (1965) contends that
unique (unsystematic) risk should theoretically be non-existent in a
completely diversified portfolio. Given this, risk-adjusted performance
evaluation should preferably focus on the portfolio’s relevant
undiversifiable systematic risk than on the total risk of a portfolio. In
previous chapters we illustrated that this systematic portfolio risk may be
measured by an investment portfolio’s beta (βp) value. The Treynor
Performance Index (TPI) of 1965 may be calculated as follows:
TPI = (Portfolio’s average rate of return – Risk-free rate of return) ÷

Beta coefficient for portfolio
Mathematically, this is illustrated as follows:
TPI = (rp – rf) ÷ βp
where:
rp – rf = risk premium
βp = beta of portfolio
Example:
Portfolio A = (12.5% – 7%) ÷ 0.80 = 6.88%

Portfolio B = (16.59% – 7%) ÷ 1.35 = 7.10%
Market index = (12.50% – 7%) ÷ 1.00 = 5.5%*
*The TPI value for the market index will always by default equal the market risk premium (rp – rf)
since the beta of the market index is by definition always exactly 1.
The TPI indicates the portfolio’s return per unit of risk. A portfolio has
achieved superior performance if its TPI value exceeds that of the market
risk premium (rp – rf). According to the Treynor measure, portfolio B
performed better than both portfolio A and the market index.
The rationale behind this is that a larger number would indicate that a
higher return for a given risk, or a lower risk for a given return, was
accomplished. This is consistent with the risk-averse assumption of
Markowitz, which would indicate that greater values of the TPI would lead
to higher returns per unit of risk.
15.3.2 The Sharpe Performance Index

The Sharpe Performance Index (SPI) also yields a single value that can be
used for investment performance rankings. The principle underlying Nobel
laureate William F. Sharpe’s 1966 measure is similar to Treynor’s measure,
except that Sharpe makes no distinction between the two diversifiable risk
categories. Sharpe uses the standard deviation (σp) as a measure of total
risk. The SPI may be calculated as follows:
SPI = (Portfolio’s average rate of return – Risk-free rate of return) ÷

Standard deviation of portfolio’s return (σp)
Mathematically, this can be formulated as follows:
SPI = (rp – rf) ÷ σp
where:
rp – rf = risk premium
σp = standard deviation of portfolio
The SPI also indicates that a higher number shows a higher return for a
given risk (thus a higher risk-adjusted average rate of return), or a lower
risk for a given return. In view of this, it is also known as the reward-to-
variability ratio. Sharpe therefore evaluates the portfolio manager on the
basis of both rate of performance and diversification. The following
example illustrates the use of the SPI.
Example:
Portfolio A = (12.5% – 7%) ÷ 2.71% = 2.03

Portfolio B = (16.59% – 7%) ÷ 5.44% = 1.76
Market index = (12.5% – 7%) ÷ 4.92% = 1.12
According to Sharpe’s measure, portfolio A performed better than both

portfolio B and the market index.
Similar to Treynor, the rationale is that a larger number would indicate that
a higher return for a given level of risk, or a lower risk for a given return,
was achieved. Sharpe’s measure is widely used and often quoted by
portfolio managers. Its popularity is attributed to the simplicity of its risk
measure (standard deviation) as opposed to other measures that rely on
more complicated measures, as does the TPI, which uses beta, nor does it
rely on any specific asset pricing model as is the case with the Jensen
Measure. The Jensen Measure is based on the capital asset pricing model
(CAPM).
15.3.3 The Jensen Measure

Michael Jensen based his performance evaluation in 1968 on the CAPM,
which is explained in Chapter 3. You will recall that the expected return of
an asset or portfolio of assets can be calculated as follows by means of the
CAPM:
Required return = rf + βp (rm – rf)
where:
rf = risk-free rate of return

βp = portfolio beta
rm = return of market
The Jensen Measure indicates the excess actual return (referred to as

“alpha”) that a portfolio produced over the return required of the portfolio
indicated by the CAPM. This may be calculated as follows:
Jensen’s alpha (α) = rp – [rf + βp (rm – rf)]
where:
rp = actual historical return of portfolio

The logic behind Jensen’s alpha is that if a portfolio is performing
according to its CAPM expectations, it will have an alpha value of zero.
Superior performance will be indicated by positive alpha values and inferior
performances by negative alpha ones.
Example:
Portfolio A = 12.5% – [7% + 0.80 (12.5% – 7%)] = 1.1%

Portfolio B = 16.59% – [7% + 1.35 (12.5% – 7%)] = –2.17%
Market index = 12.5% – [7% + 1.00 (12.5% – 7%)] = 0%*
*Logically, the Jensen Measure for the market portfolio will always be 0% by default since alpha is a
measurement of performance relative to the market portfolio.
According to the alpha measure, portfolio B produced a superior

performance over that of portfolio A due to its larger excess return. Thus,
the alpha indicated that the manager of portfolio AB added superior value
relative to the expected return, given portfolio A’s beta.
As can be deduced from the formula, the Jensen Measure assumes that the
return on an investment portfolio is a linear regression function of the risk-
free rate of return, plus a risk premium. Jensen’s alpha is normally
calculated by running a linear regression of the time series of portfolio
returns in excess of the risk-free interest rate against the market’s returns in
excess of the risk-free interest rate. The slope of the resulting line equals
beta (βp), while the intercept indicates alpha (αp).
15.3.4 A comparison of the different measures

Table 15.1 gives a summary of the results for the risk-adjusted portfolio
performances according to the TPI, the SPI and the Jensen Measure.
Table 15.1 Summary of performance measures
Performance measure Portfolio A Portfolio B Market index Best performer

Treynor Performance Index 4.22 4.39 3.80 Portfolio B
Sharpe Performance Index 1.40 0.91 0.77 Portfolio A
Jensen Measure 0.38% 0.91% 0% Portfolio B
One must keep in mind that the measures do not often yield the same
conclusion – sometimes contradicting results and conclusions are the result
of the different measures of risk used in each calculation. The key to
interpreting these contradicting conclusions lies in the degree of
diversification of the individual portfolios. As explained in the previous
chapters, if a portfolio is well diversified, its unique or unsystematic risk
will be irrelevant because it has been eliminated as part of the portfolio-
construction process. If that is the case, total risk will now equal systematic
or market risk alone (refer to Figure 3.4 for a graphic illustration of this
concept).
If the performances of two well-diversified portfolios are measured and

compared, one should logically find no difference between their Treynor
and Sharpe measures since both portfolios have no unique risk and their
respective total risk (or s to Sharpe) should equal their market risk (or β to
Treynor). One can thus conclude that the Treynor and the Sharpe ratios will
be in agreement on rankings of portfolios that are completely (perfectly)
diversified. What conclusion will one reach if there is a contradiction
between the Treynor and Sharpe measures? Portfolios that are not well
diversified should have an inferior rating, according to the Sharpe measure.
This is due to their high unique risk because of a lack of diversification.
Since the advantages of diversification are acknowledged, one should
favour measures that reward diversification and also penalise lack of
diversification. Because of this one would favour the Sharpe measure in
cases of contradiction. In our example the measures indicate that portfolio
A appears to be better diversified.
15.4 PERFORMANCE ATTRIBUTION ANALYSIS

Portfolio managers using fundamental analysis for their investment
decisions do asset allocation based on prospects for the economy, and
specific sectors and companies within those sectors who stand to gain most
from positive developments, such as an increase in sales due to an increase
in gross domestic product, increases in exports, lower inflation and lower
interest rates.
Attribution analysis evaluates whether portfolio managers achieved

significantly different returns compared to a benchmark portfolio, which
could be either superior or inferior returns. The difference between the
return of the portfolio being evaluated (rp) and the benchmark portfolio (rB)
is regarded as the sum of the contributions of a series of decisions made
during the portfolio construction process. The three components of
attribution analysis thus consist of
the asset allocation choices between equity, fixed income securities and
money market investments
industry or sector choice
specific securities selected within each industry or sector.
The difference between the rates of return of the portfolio and the
benchmark portfolio may be found by
n n
rp − rB = ∑ wpi rpi − ∑ wBi rBi
i=1 i=1
where:
rp =return of the portfolio being evaluated

rB =return of the benchmark portfolio
Σ =sum of the subsequent calculation, from case 1 to case n
w =weight of each asset in the portfolio
r =return of each asset in the portfolio
The above equation may be rewritten in order to determine the contribution
from each asset class as follows:
Contribution from asset allocation … (wpi – wBi)rBi

+ Contribution from security selection wpi(rpi – rBi)
= Total contribution from asset class i wpirpi – wBirBi
The benchmark portfolio is assumed to rule out asset allocation and security
selection; in other words, it follows a passive investment strategy. The
benchmark portfolio is therefore weighted similarly to known indices, such
as the JSE All Share Index (JSE ALSI) and the All Bond Index (ALBI). In
this way the effect of asset allocation and security selection can best be
determined.
Example: Assume a portfolio manager achieved a return of 8.67% on her

portfolio by investing 70% in equity, earning a return of 9.9% from equity,
20% in bonds earning a return of 6.3%, and 10% in money market funds
earning 4.8%. This has to be compared to a benchmark portfolio. Taking the
JSE ALSI and the ALBI into account, the benchmark portfolio achieved the
following return:
Return on the managed portfolio =

8.67%
Minus return on benchmark = 7.11
portfolio
Excess return of managed =
portfolio 1.56%
Asset class Weight (wB) Return of index during period (rB) Weighted return (wB × rB)
Equity (JSE ALSI) 0.60 8.2 4.92
Bonds (ALBI) 0.30 5.7 1.71
Money market 0.10 4.8 0.48
Return of benchmark portfolio = 7.11
In view of the above one may say that the portfolio manager is overweight
in equity and underweight in bonds (fixed income securities). The influence
of asset allocation and of selection within markets may be analysed as
follows:
Asset Weight in managed Benchmark Excess Market Contribution to

class portfolio (1) weight (2) weight (3) return (4) performance (5) = (3) × (4)
Equity 0.70 0.60 0.10 8.2 0.82
Bonds 0.20 0.30 –10.0 5.7 –0.57
Money 0.10 0.10 0.00 4.8 0.00
market
Contribution of asset allocation = 0.25
Since her portfolio managed to achieve an excess return of 1.56%, the

contribution from the selection of particular securities within sectors or
industries should be 1.56% – 0.25% = 1.31%. It could also be calculated as
follows:
Market Portfolio Index Excess Portfolio Contribution (5) =

performance (1) performance (2) performance (3) weight (4) (3) × (4)
Equity 9.9 8.2 1.7 0.70 1.19
Fixed 6.3 5.7 0.6 0.20 0.12
income
Contribution of selection within markets = 1.31
The superior performance of the managed portfolio compared to the

benchmark portfolio may be ascribed to superior performance in both the
equity and fixed income markets, and also to superior selection within the
equity and bond markets. However, in the case of the above example the
contribution from asset allocation is 0.25% and the contribution from
selection within markets is 1.31%. In this case the portfolio manager seems
to have superior information which enables her to select specific securities
very well.
One may also further analyse the contribution from the selection of equities
and the selection of fixed income securities. The following table illustrates
the contribution analysis of the equities that contributed 1.19% to the
portfolio outperforming the benchmark portfolio. This is done here by
performing a sector contribution analysis:
Beginning weights
PortfolioBenchmark Active Sector Sector allocation
weights return contribution
Sector (1) (2) (3) = (1) – (4) (5) = (3) × (4)
(2)
Oil and gas 12.0 9.4 2.6 4.58 0.1191
Chemicals 3.0 2.4 0.6 3.92 0.0235
Basic resources 8.0 3.1 4.9 8.30 0.4067
Construction and materials 0.0 1.5 –1.5 2.42 –0.0363
Industrial goods and 5.0 11.0 –6.0 2.67 –0.1602
services
Automobiles and parts 0.0 2.5 –2.5 3.42 –0.0855
Food and beverage 8.0 3.8 4.2 7.25 0.3045
Personal and household 6.0 4.5 1.5 6.49 0.0974
goods
Health care 12.0 8.4 3.6 9.32 0.3355
Retail 2.0 4.5 –2.5 4.80 –0.1200
Media 0.0 2.9 –2.9 2.33 –0.0676
Travel and leisure 0.0 1.9 –1.9 2.86 –0.0543
Telecommunications 8.0 4.7 3.3 10.60 0.3498
Utilities 0.0 4.5 –4.5 1.89 –0.0851
Banks 20.0 14.4 5.6 10.50 0.5880
Insurance 3.0 5.6 –2.6 8.25 –0.2145
Financial services 2.0 6.0 –4.0 7.35 –0.2940
Technology 11.0 8.9 2.1 3.95 0.0830
100.0 100.0 0.0 1.1900
A similar analysis of the fixed interest securities (bonds) could be done.

However, the above adequately explains how to do an attribution analysis
of a portfolio. Attention will now be given to the guidelines for reporting
and presenting portfolio performance.
15.5 PORTFOLIO PERFORMANCE PRESENTATIONS
Portfolio managers have to report on the performance of their portfolios

from time to time, either internally to their management or externally to
clients. Unfortunately, some portfolio managers may be tempted to
manipulate figures and misrepresent some of the returns they have
achieved.
Until the early 1990s, portfolio managers’ performance presentations to

their clients and the public were unregulated, without any uniformity in
calculation. The most common form of performance measurement was
primarily a measure of the internal rate of return (IRR), generally computed
for periods of one year or longer. Some portfolio managers even tended to
indicate performance for only a selection of superior-performing portfolios
over certain time frames when these portfolios outperformed market
indices. The following sections describe guidelines for the fair presentation
of portfolio performance and results.
15.5.1 Reporting total return

In 1993 the Association for Investment Management and Research™
(AIMR™) (now the CFA Institute®) introduced the first Performance
Presentations Standards (AIMR-PPS™). The AIMRPPS were incorporated
into the CFA Global Investment Performance Standards (GIPS) during
2006. The purpose of the GIPS is to promote greater comparability,
accuracy and fairness in the presentation of investment portfolio
performance. Uniformity under the GIPS includes, for example, the
performance of all discretionary accounts covering arbitrary time periods
and the exclusion of simulated or backtested results. Investment firms can
claim to be compliant with the GIPS set of minimum guidelines as long as
they meet the mandatory rules regarding all composite, calculation,
presentation and disclosure requirements.
The following is a selection of some of the important guidelines included in

the AIMR-PPS (CFA Institute, 2012):
Total return (including realised and unrealised gains) must be included in
the calculation of investment performance.
Time-weighted rates of returns must be used.
If composite return performance is presented, the composite must contain
all actual fee-paying accounts. Composite results may not link simulated
or model portfolios with actual performance.
The basic purpose of total return calculations is to account for any positive
or negative changes in portfolio values over time. These changes in values
are usually expressed as a percentage increase or decrease in initial
portfolio value, adjusted for any withdrawals or contributions during the
specific period.
Performance presentation must disclose whether performance results are

calculated gross or net of management fees, and what the firm’s fee
schedule is.
The CFA Institute revised the GIPS for the international investment
community. The purpose of the GIPS is, on an international scale, to strive
for uniformity and global standardisation in the calculation and presentation
of investment performance. In addition, the GIPS potentially acts as a
minimum international performance presentation standard in countries
where local standards and regulations are inadequate or even non-existent.
The GIPS basically consists of a series of guidelines that firms are required
to follow in order to claim compliance.
The five broad categories in the GIPS performance requirements and

recommendations methodology are input data, calculation methodology,
composite construction, disclosures, and presenting and reporting. The
following is a brief selection as an example of some of the specific
guidelines included in the GIPS (CFA Institute, 2012):
All actual fee-paying discretionary portfolios must be included in

composites which are defined according to similar strategies and/or
investment objectives.
A GIPS-compliant history for a minimum of five years (or since
inception) must be shown.
the GIPS require firms to use certain calculation and presentation
methods and to make certain disclosures along with the performance
record.
15.5.2 Evaluation of performance fees

Portfolio management fees are traditionally based on investments included
in the portfolio by the portfolio manager. The purpose of performance fees
is to reward managers to the extent that increasing returns increase the
value of investments in the portfolio. Whether the performance of the
portfolio comes from general market movements or can be attributed to the
skill of the portfolio manager is irrelevant.
Nowadays, however, an increasing number of investors are showing their

preference for a move away from this traditional compensation towards an
incentive fee, which attempts to link a portfolio manager’s reward more
unequivocally to his or her investment management skill.
Under this new and increasingly popular fee structure, a basic fee that is
less than the manager’s normal (traditional) performance fee is paid. After a
certain period, the manager will receive a predetermined bonus or incentive
if the portfolio return exceeds an agreed benchmark return. Investors
should, however, be extremely careful in the setting of such fee structures
so that the portfolio manager does not have any incentive or temptation to
arbitrarily change the risk configuration of the investment portfolio.
When evaluating investment portfolio performance, a clear indication

should also be given as to whether the total returns presented are based on
market values taken before or after deduction of the portfolio management
fees and any other management expenses. This is because management fees
are normally significant items and can make a significant impact on returns.
15.5.3 Benchmark portfolios

Performance attribution analysis using benchmark portfolios dates back to
the late 1960s when academics began applying the concepts of the CAPM,
and later on using the arbitrage pricing theory (APT) by assessing the
performance of portfolio managers relative to market benchmarks. As
explained earlier, the process starts off by defining an appropriate passive
benchmark for a managed portfolio.
Benchmark portfolios are passive and unmanaged portfolios that reflect a

specific portfolio manager’s investment style. The primary purpose of a
benchmark is to set a realistic, achievable performance standard, so that, by
closely replicating a portfolio manager’s investment style and risk level,
any differences in accomplishment that may arise between the manager and
the benchmark can be attributed to the manager’s active decision. These
active decisions might include sector selection, security selection, market
timing, and so forth.
The appropriate benchmark should include the type of instruments and

securities that are representative of the manager’s portfolio and should
ideally be a published market index such as, for example, the JSE ALSI for
an equity portfolio, or the ALBI in the case of a bond portfolio.
The portfolio’s returns in excess of its benchmarks (also referred to as

active rewards) are calculated for each historical measurement interval. The
objective of this analysis is to correlate the excess returns with active
decisions that the portfolio manager has made. If a manager’s portfolio
outperforms the benchmark portfolio, the performance reward might be
attributed to the active decisions made. The portfolio might include superior
shares (share selection) or may even have been switched to during bull
markets (market timing), which positively affected returns relative to the
predetermined benchmark. If the manager is skilled at these active
decisions, the cumulative excess returns should be positive over the long
term, reflecting an active reward attributable to skill.
15.5.4 Measurement of allocation effect

Reviewing the previous paragraph, clearly one of the crucial steps in
portfolio management is the asset allocation decision. Once this has been
made, however, the portfolio manager can, depending on his or her
investment mandate, alter the original asset allocation. Measurement of the
asset allocation effect entails determining the impact of the decision to
allocate assets differently from the original asset allocation decision. The
measurement is applied to portfolios constructed by means of tactical asset
allocation, which are those where the portfolio manager will alter the asset
mix depending on various market conditions. Tactical asset allocation was
introduced in Chapter 13 as the structuring of a mix of securities towards
undervalued markets in response to changing economic and market
conditions in order to enhance portfolio returns.
The allocation effect is calculated simply as the difference between the

return of the new, tactically allocated portfolio and the return of the original
allocated portfolio. That is, the allocation effect is the difference between
the actual return a portfolio received and what it would have received if the
portfolio asset allocation had been done based purely on the objectives and
constraints of the investor (the original policy portfolio) without any
consideration of market timing or valuation of individual investment
instruments.
15.5.5 Measurement of selection effect

The selection effect measures the impact of individual investment selections
on the total return of a portfolio. The purpose is to determine whether the
portfolio manager made individual investment decisions/selections that are
better or worse than all of the securities in the benchmark index.
15.6 SUMMARY
Asset allocation has the greatest influence on portfolio performance.

Investors have to evaluate the actual performance against the required rate
of return set out in the investment portfolio statement (IPS) which needs to
be formulated during the construction phase of the portfolio. Given the fact
that the majority of investors are risk averse, it is important when selecting
or evaluating the performance of a portfolio manager that the investor bases
the evaluation on both risk and return measures. Two issues were addressed
in this chapter:
Performance relative to risk. The ability of the portfolio manager to

diversify the portfolio and thereby eliminate unsystematic risk – known
as performance measurement – was the first topic in the chapter. We
discussed the major methods for calculating risk-adjusted portfolio
performance, including the Treynor Performance Index, the Sharpe
Performance Index and the Jensen Measure.
Performance relative to time and other portfolios. The performance of
the portfolio manager compared to benchmarked market performance
entails evaluation of both the manager’s sector and the security selection.
This was dealt with in the latter part of the chapter and is known as
performance attribution analysis. Attention was also given to the Global
Investment Performance Standards (GIPS™) of the CFA Institute, as
well as to the evaluation of performance fees and problems in setting
benchmark portfolios.
CFA Institute. 2012. Global Investment Performance Standards™. Charlottesville, VA. Available at:
https://www.cfainstitute.org/learning/products/publications/ccb.v2012.n4.full.aspx
Elton, E.J., Gruber, M.J., Stephen J. & Goetzmann, W. Modern portfolio theory and investment
analysis, 6th ed. New York: Wiley.
Treynor, J.L. 1965. How to rate management of investment funds. Harvard Business Review, 43(1):
Jan.–Feb.
1. Which one of the following statements is false? (a) Benchmark portfolios are
passive and unmanaged portfolios that reflect a manager’s particular investment
style.
(b) Whether the performance of the portfolio comes from general market
movements or can be attributed to the skill of the portfolio manager is
generally thought to be irrelevant.
(c) The Treynor Performance Index is normally calculated by running a linear
regression of the time series of portfolio returns in excess of the risk-free
interest rate against the market’s returns in excess of the risk-free interest
rate.
(d) The performance of the portfolio manager compared to benchmarked market
performance entails evaluation of the manager’s market timing and security
selection.
2. Which of the following is not a guideline included in the CFA-GIPS?
(a) Total return (including realised and unrealised gains) must be included in the
calculation of investment performance.
(b) Time-weighted rates of returns should not be used.
(c) If composite return performance is presented, the composite must contain all
actual fee-paying accounts.
(d) Performance presentation must disclose whether performance results are
calculated gross or net of management fees and what the firm’s fee schedule
is.
3. _______ contends that unique risk should theoretically be non-existent in a
completely diversified portfolio, and performance evaluation should thus focus
only on the portfolio’s undiversifiable systematic risk.
(a) Treynor
(b) Sharpe
(c) Jensen
(d) Markowitz
(e) Stern
4. Which one of the following statements is true?
(a) The allocation effect measures the impact of individual security selections on
the total return of a portfolio.
(b) Jensen contends that unsystematic risk should theoretically be non-existent in
a completely diversified portfolio.
(c) The Sharpe Performance Index also indicates that a higher number shows a
higher return for a given risk (thus a higher risk-adjusted average rate of
return), or a lower risk for a given return.
(d) The Sharpe Performance Index may be calculated as follows: (Portfolio’s
average rate of return – Risk-free rate of return) ÷ Beta coefficient for portfolio.
5. Josephine Njuguna, a portfolio manager at Vega Capital, uses the CAPM for
making recommendations to her clients. She has gathered the following
information (assume a risk-free rate of return of 6%):
Expected return Standard deviation Beta

Security A 12% 36% 0.7
Security B 17% 25% 1.2
Market index 14% 15% 1.0
(a) Calculate the expected return for each security.

(b) Identify and justify which security would be more appropriate for an investor
who wants to (i) add this security to a well-diversified portfolio, or (ii) hold this
security as a single-security portfolio.
6. Godfrey Marozva, an analyst at PSG Investments, would like to evaluate the
following three funds (assume a risk-free rate of return of 6%):
Fund Expected return Standard deviation Beta

AAA 16% 5.02% 1.00
BBB 13% 4.04% 1.05
CCC 9% 3.02% 0.89
Market index 12% 3.50% 1.00
Calculate the Sharpe Performance Index, Jensen’s alpha and the Treynor
Performance Index for the three funds as well as the market index. Comment on
the performance of the portfolios.
7. Virgil Fick invested 80% in equity, earning a return of 11%; 10% in bonds, earning
a return of 6%; and 10% in money market funds, earning 5%. This has to be
compared to a benchmark portfolio. Taking the JSE ALSI and the ALBI into
account, the benchmark portfolio achieved the following return:
Asset class Weight Return of index during Weighted return (wB ×

(wB) period (rB) rB)
Equity (JSE 0.60 9.5 5.7
ALSI)
Bonds (ALBI) 0.30 5.6 1.68
Virgil invested his portfolio as follows, compared to the benchmark portfolio:
Beginning weights
Sector Portfolio (1) Benchmark (2)
Oil and gas 10.0 12.0
Chemicals 2.4 2.4
Basic resources 8.0 5.0
Construction and materials 2.0 1.5
Industrial goods and services 7.6 9.0
Automobiles and parts 0.0 2.5
Food and beverage 10.0 3.8
Personal and household goods 6.0 4.5
Health care 11.0 8.4
Retail 2.0 4.5
Media 1.0 2.9
Travel and leisure 1.0 1.9
Telecommunications 6.0 4.6
Utilities 0.0 4.5
Banks 14.0 12.0
Insurance 2.0 5.6
Financial services 6.0 6.0
Technology 11.0 8.9
(a) Calculate the return for Virgil’s portfolio and the benchmark portfolio.
(b) Determine the influence of asset allocation and the influence of the selection of
assets within markets.
(c) Perform a sector contribution analysis in order to account for the portfolio
manager’s ability to outperform the benchmark portfolio.
Solutions
1. (d)
2. (b)
3. (a)
4. (c)
5. (a) Security A = 6% + 0.7(14% – 6%) = 11.6%
Security B = 6% + 1.2(14% – 6%) = 15.6%
(b) (i) Security A. Its lower beta will be positive for the overall portfolio risk.
(ii) Security B. When a security is held in isolation, standard deviation is the
relevant risk measure. For assets held in isolation, beta as a measure of
risk is irrelevant.
6. The portfolios are indicated in ranking sequence (best to worst):
The Sharpe Performance Index = (rp – rf) ÷ <o>p

(1) AAA = (16% – 6%) ÷ 5.02% = 1.99
(2) BBB = (13% – 6%) ÷ 4.04% = 1.73
(3) Market = (12% – 6%) ÷ 3.50% = 1.71
(4) CCC = (9% – 6%) ÷ 3.02% = 0.99
Jensen’s alpha = rp – [rf + bp (rm – rf)]

(1) AAA = 16% – [6% + 1.00(12% – 6%)] = 4.00%
(2) BBB = 13% – [6% + 1.05(12% – 6%)] = 0.70%
(3) Market = 12% – [6% + 1.00(12% – 6%)] = 0.00%
(4) CCC = 9% – [6% + 0.89(12% – 6%)] = –2.34%
The Treynor Performance Index = (rp – rf) ÷ ßp

(1) AAA = (16% – 6%) ÷ 1.00 = 10.00
(2) BBB = (13% – 6%) ÷ 1.05 = 6.67
(3) Market = (12% – 6%) ÷ 1.00 = 6.00
(4) CCC = (9% – 6%) ÷ 0.89 = 3.37
7. The benchmark portfolio achieved the following return:
Asset class Weight Return of Weighted return

(wB) index during (wB × rB)
period (rB)
Equity (JSE ALSI) 0.60 9.5 5.70
Bonds (ALBI) 0.30 5.6 1.68
Return of benchmark portfolio = 7.86
Return on the managed portfolio = 9.90%

Minus return on benchmark portfolio = 7.86
Excess return of managed portfolio = 2.04%
Beginning weights
Sector PortfolioBenchmark Active Sector Sector
(1) (2) weights return (4) allocation
(3)
contribution (5)
= (3) × (4)
Oil and gas 10.0 12.0 –2.0 4.58 –0.0916
Chemicals 2.4 2.4 0.0 3.92 0.0000
Basic resources 8.0 5.0 3.0 8.30 0.2490
Construction and 2.0 1.5 0.5 2.42 0.0121
materials
Industrial goods and 7.6 9.0 –1.4 2.67 –0.0374
services
Automobiles and 0.0 2.5 –2.5 3.42 –0.0855
parts
Food and beverage 10.0 3.8 6.2 7.25 0.4495
Personal and 6.0 4.5 1.5 6.49 0.0974
household goods
Health care 11.0 8.4 2.6 9.32 0.2423
Retail 2.0 4.5 -2.5 4.80 –0.1200
Media 1.0 2.9 –1.9 2.33 –0.0443
Beginning weights
Sector PortfolioBenchmark Active Sector Sector
(1) (2) weights return (4) allocation
(3) contribution (5)
= (3) × (4)
Travel and leisure 1.0 1.9 –0.9 2.86 –0.0257
Telecommunications 6.0 4.6 1.4 10.60 0.1484
Utilities 0.0 4.5 –4.5 1.89 –0.0851
Banks 14.0 12.0 2.0 10.50 0.2100
Insurance 2.0 5.6 –3.6 8.25 –0.2970
Financial services 6.0 6.0 0.0 7.35 0.0000
Technology 11.0 8.9 2.1 3.95 0.0830
100.0 100.0 0.0 0.7051
PART
5
Foreign exchange
OVERVIEW
The increased importance of international diversification necessitates a

sound understanding of foreign exchange.
Chapter 16 explains foreign exchange conventions, including direct and

indirect quotations. Cross rates and currency arbitrage are also explained.
Exchange rate determination and behaviour are strongly influenced by
economic and political factors. The chapter concludes with an explanation
of the relationship between the interest rates, inflation rates and exchange
rates of countries within a covered interest rate parity framework.
Chapter 17 explains the role of corporate governance in shareholder

protection. The business environment has become increasingly volatile and
the management of firms have to ensure economic sustainability in the
interest of all shareholders (including shareholders such as pension funds).
The chapter explains the business environment, governance legislation and
the principles of corporate governance. It also provides a corporate
governance framework. In addition, the role of ethics is explained.
16 Foreign exchange
management
16.1 INTRODUCTION
The globalisation of the investment management activity has emphasised

the importance of managing an investment’s foreign exchange exposure.
Large flows of funds shift between countries and are ultimately reconciled
into gains and losses on valuations when converted to the home currency of
the investor. The rate of exchange between the currencies of countries can
be volatile and can have a significant and long-lasting influence on the
value of an investment. To understand the importance of investment timing
in terms of the value of one country’s currency against another, we only
have to remember the South African (SA) rand’s exchange rate antics
against the US dollar, illustrated in Figure 16.1. This figure shows that the
rand weakened by nearly 30% against the US dollar from 1 January 2015 to
31 December 2015.
Figure 16.1 Daily close of the USD/ZAR exchange rate from 01 January 2015
to 31 December 2015
Source: http://www.resbank.co.za
A basic understanding of how the foreign exchange market can influence

investment returns is therefore an essential part of any investment
practitioner’s armoury. To equip you with this knowledge, we discuss the
following topics in this chapter:
Foreign investment by South African residents

The foreign exchange market
Exchange rate determination and behaviour
Foreign exchange investments as an alternative asset class
16.2 FOREIGN INVESTMENT BY SOUTH AFRICAN

RESIDENTS
The South African investor, whether an individual, institution or business,
is limited by exchange control regulations in terms of diversification into
foreign assets as well as hedging against foreign exchange exposures. (See
http://www.resbank.co.za for the exchange control manual.)
An individual South African investor may not invest more than R10m
outside the Common Monetary Area. Institutional investors’ investments
abroad are limited by the size of their total retail assets. Retirement funds,
long-term insurers and investment managers registered as institutional
investors for exchange control purposes are allowed to transfer a maximum
of 25% of their retail asset base offshore.
From an investment manager’s perspective it is unfortunate that exchange

control regulations in South Africa limit investors’ ability to diversify and
manage the international purchasing power of their investment portfolios
appropriately. However, even within the constraints of this regulatory
environment, there are some investment management tools that can be used
to improve the timing of investments and hedge exchange rate exposures.
16.3 THE FOREIGN EXCHANGE MARKET
16.3.1 What is foreign exchange and how does it trade?

A currency is a unit of exchange, facilitating the transfer of goods and
services. It is a form of money, where money is defined as a medium of
exchange rather than a store of value. Generally, each country has its own
specific currency that it uses as the dominant medium of exchange. To
facilitate trade between countries there are exchange rates, which are the
prices at which currencies are exchanged against each other. The exchange
rate between countries can also be defined as the purchasing power of one
country against another.
The foreign exchange market facilitates the exchange of purchasing power

denominated in one currency for that of another currency. The foreign
exchange market is not a physical market, but consists mainly of banks and
foreign exchange brokers that bring buyers and sellers of foreign exchange
together. The majority of foreign exchange transactions occur in the
interbank market between major banks, including the central banks of the
world.
There are four main categories of foreign exchange transactions:
A currency trade executed for immediate delivery (usually within two

business days of the trade) is said to be a spot foreign exchange
transaction that takes place in the spot market.
Currencies can also be bought or sold for delivery at a future date,
usually up to one year. Such transactions are called forward foreign
exchange transactions (contracts) and take place in the forward market.
The currency swap market consists of a combination of spot and forward
transactions.
Currency futures are standardised foreign exchange contracts in terms of
amount and maturity date (usually at the end of every quarter) and are
traded through a formal exchange such as the Chicago Mercantile
Exchange (see http://www.cme.com/edu). Physical delivery on the
underlying asset does not usually take place since these instruments are
generally used by market participants to hedge against foreign exchange
exposure and by speculators to profit (or lose) from the movement in the
futures’ underlying spot foreign exchange rate.
There are also three main categories of foreign exchange market

participants:
Importers and exporters buy and sell goods from and to foreign buyers
and sellers. They generally exchange their domestic currency for the
foreign currency.
Foreign investors can either invest directly in a country (for example the
Indian company Tata International investing in South Africa as the
second fixed telephone line operator) or indirectly through financial
instruments such as ordinary shares or South African government bonds.
Speculators are generally economic agents who operate in the foreign
exchange market purely to make a profit from buying or selling one
currency against another.
16.3.2 Foreign exchange conventions

In this book we follow the currency quotation convention adopted by the
Financial Markets Association (ACI) to denote a currency pair. (The ACI
Model Code can be downloaded from
http://www.aciforex.com/mktpractice/model_code.htm.) This convention
uses two currencies’ Swift codes separated by an oblique, with the first
currency being the base currency (i.e. the unit of currency known – 1 unit of
base currency) to denote a currency pair. Table 16.1 lists a few of the codes
which are used in this chapter.
Table 16.1 List of currency codes
Country Swift code

South Africa ZAR (SA rand)
United States of America USD (US dollar)
Germany EUR (Euro)
Switzerland CHF (Swiss franc)
United Kingdom GBP (British pound)
Canada CAD (Canadian dollar)
Japan JPY (Japanese yen)
New Zealand NZD (New Zealand dollar)
Example: EURZAR denotes the euro against the South African rand with
the euro as the base currency (vocalised as “euro/rand”) and USDJPY
denotes the US dollar against the Japanese yen with the dollar as the base
currency (vocalised as “dollar/yen”).
16.3.3 The bid-ask (or bid-offer) spread

Currencies do not trade through a formal exchange but through a network
of large multinational banks and currency brokers. Since there is no formal
exchange, these large multinational banks are generally the market makers
for various currencies. They will make two-way prices, showing both a buy
rate (bid) and a sell rate (ask or offer) at which they are willing to buy or
sell one currency against another. The mid rate refers to the mid-point
between the bid and ask rates. The mid rate is generally quoted as the rate at
which a currency trades against another if dealers are not making a firm
tradable two-way price.
The bid-ask spread, which is the difference between buy and sell rates,
represents the market maker’s profit margin. The bid price should always be
lower than the ask price to ensure a profit for the market maker. Figure 16.2
shows a table of bid-ask rates quoted by a bank.
Figure 16.2 Foreign exchange spot and bid rates
Symbol Bid Ask

USDZAR 15.1574 15.1677
EURZAR 16.7934 16.8031
EURUSD 1.1079 1.1082
GBPUSD 1.3401 1.3403
AUDUSD 0.7437 0.7440
USDCHF 1.0211 1.0214
USDJPY 102.394 102.404
EURJPY 113.383 113.387
Source: http://www.oanda.com
The following example will explain the mechanics of how a market maker
operates.
Example: Bank A shows a two-way price in EURUSD of 1.1079/1.1082.

Client A needs to sell 10 million EUR and client B needs to buy 10 million
EUR against the USD. Bank A will buy from client A at 1.1079, and
immediately sell to client B at 1.1082, realising a profit of the difference
between 1.1079 and 1.1082 or 0.0003 USD cents. In this example the
market maker’s profit is 10 million EUR × 0.0003 USD = 3 000 USD. The
difference of 0.0003 cents is also referred to by market participants as a 3
pip spread (0.0003 × 10 000 = 3). If we express the 3 pips as a percentage
of the ask rate of the exchange rate, the costs amount to 0.0003/1.1082 =
0.03%.
The 3 000 USD seems like a measly profit for a 10 million EUR
transaction. However, if you consider that according to the Bank for
International Settlements (see http://www.bis.org), the daily turnover in the
foreign exchange market in April 2014 amounted to 5.5 trillion USD, it
becomes obvious that the foreign exchange market is a large profit centre
for banks.
There are various factors that influence the bid-ask spread that market
makers are willing to offer:
Liquidity in this context is defined as the amount of supply and demand

in the currencies that make up an exchange rate. For large economies like
the US, Europe and Japan, the large foreign exchange flow that results
from their foreign trading accounts, as well as the foreign investment
flows in financial assets such as government bonds and ordinary shares,
creates sufficient liquidity for market makers to offer small bid-ask
spreads. For exchange rates such as EURUSD and USDJPY, the bid-ask
spread is usually between 1 (institutional clients) and 3 pips (retail
clients). These spreads are usually firm for values up to 10 million EUR.
For amounts above 10 million EUR, the market maker will usually
increase the spread to ensure that it can make a profit on the transaction.
With the increased use of technology, the number of participants in the
foreign exchange market is increasing daily, causing liquidity to increase
and bid-ask spreads to narrow.
The liquidity for currencies such as the ZAR is much lower and market
makers in the ZAR therefore demand larger bid-ask spreads. The
USDZAR bid-ask spread given in Figure 16.2 is 103 pips (1.03 cents) or
0.7% of the ask rate [(15.1677 – 15.574)/15.1677].
Market volatility. The market maker can, during volatile times (just after
big news events such as an unexpected interest rate announcement)
increase its bid-ask spreads. During these volatile times market makers
will find it difficult to match buyers (demand) and sellers (supply) since
either the demand or supply side will temporarily withdraw its bids or
offers from the market.
16.3.4 Direct and indirect quotation

Quotations that represent the number of USD per foreign currency are
referred to as direct quotations. The EURUSD is an example of a direct
quotation, since it represents the number of USD 1.1082) per EUR (1).
Quotations that represent the number of foreign currency per dollar are
referred to as indirect quotations. The USDZAR is an example of an
indirect quotation, since it represents the number of ZAR (15.1677) per
USD (1).
16.3.5 Currency appreciation and depreciation

Using the direct quotation, a foreign currency is said to appreciate relative
to the USD if its exchange rate to USD increases. In other words, more
USD is required to purchase 1 unit of the foreign currency.
Example: If the EURUSD bid exchange rate increases from 1.1079 to

1.1179, the EUR is said to have appreciated against the USD by 1 cent, or
the USD is said to be weaker (has depreciated) against the EUR by 1 cent.
The percentage appreciation can be calculated as (1.1179 – 1.1079)/1.3107
= 0.90%.
Using the indirect quotation, a foreign currency is said to depreciate relative

to the USD if its exchange rate to USD increases. In other words, more of
the foreign currency is required to purchase 1 USD.
Example: If the USDZAR bid exchange rate increases from 15.1000 to

15.3000, the ZAR is said to have depreciated against the USD by 20 cents,
or the USD is said to have appreciated against the ZAR by 20 cents. The
percentage depreciation can be calculated as (15.3000 – 5.8000)/15.1000 =
1.33%.
16.3.6 Cross rates

A cross exchange rate is an exchange rate between two currencies neither of
which is the USD, for example the ZAR and the EUR. The cross rate is
calculated as the ratio of the exchange rate of the EUR to the USD, divided
by the exchange rate of the ZAR to the USD. In other words, the cross rate
is calculated by dividing the direct quotation of the EUR by the direct
quotation of the ZAR against the USD.
Example: Assume the EURUSD exchange rate is currently priced at a mid

rate of 1.1081 and the USDZAR at 15.1595. If we want to calculate the
EURZAR cross rate, we need to express both currencies in terms of dollars.
We therefore need to convert the indirect quotation of the ZAR into a direct
quotation as follows (remember that the direct quotation is the inverse of
the indirect quotation):
1 1
ZARUSD = = = 0.0659
USDZAR 15.1595
We can now calculate the EURZAR cross rate:

EURUSD 1.1081
EURZAR = = = 16.8148
ZARUSD 0.0659
There are some general conventions in the interbank market for quoting one
currency in terms of another. Figure 16.2 gives a list of generally accepted
quoting conventions. For example, the ZAR is generally quoted against the
USD as USDZAR.
16.3.7 Currency arbitrage

The “law of one price” states that there must be a single price that applies to
a country’s currency. The concept of risk-free arbitrage, or the opportunity
to earn a certain profit with no capital investment, is based on this law.
16.3.7.1 Triangular arbitrage

Triangular arbitrage results from a discrepancy in the cross exchange rate
between two currencies. If the cross rate is not properly quoted, arbitrage
may be used to capitalise on the discrepancy and realise a risk-free profit.
Example: Assume that the following mid spot exchange rates are observed
in the market:
Mid rate
EURUSD 1.1080
USDJPY 102.39
EURJPY 113.37
To determine whether triangular arbitrage is possible we first need to

calculate an implicit EURJPY cross rate using the EURUSD and USDJPY
exchange rates:
Step 1: Convert the USDJPY mid rate into a direct quotation.

1 1
JPYUSD = = = 0.009767
USDJPY 102.39
Step 2: Calculate the EURJPY mid cross rate.
EURJPY = EURUSD
JPYUSD
=
1.1080
0.009767
= 113.44
In this example triangular arbitrage exists, since we can sell EUR against
the JPY at 113.44 and immediately buy it back in the market at the quoted
rate of 113.37, thereby realising a risk-free profit of 7 JPY cents. These
arbitrage opportunities do not exist for long, because traders will continue
to buy the quoted EURJPY rate until the arbitrage opportunity dissipates.
Cross rates are therefore, for the most part, consistent with observed rates.
16.3.8 The forward foreign exchange market

A forward foreign exchange transaction allows a business or individual to
arrange, in advance, to buy or sell a predetermined amount of currency at a
predetermined future date and price. In a forward contract, a commitment is
irrevocably made on the transaction date, but delivery (i.e. the settlement of
currency) takes place on a later date set in the contract.
In general, forward transactions are used as a hedging instrument against

future movements in the spot foreign exchange rate. Let us explore this
through an example.
Example: Suppose an American has invested in a zero-coupon South

African government bond maturing in 4 months on 31 July 2016. The
redemption value of her investment is R5m and she would prefer to lock in
her exchange rate exposure today. A local bank offers her a USDZAR
forward rate quote for 31 July 2016 of 15.4000/4319 (the USDZAR spot
rate at the time of the quote is 15.1574/1750). If she accepts the quote, she
can sell her R5m exposure today for settlement on 31 July 2016 at 15.4000
for 324 675.32 USD (R5m/15.4000). No cash will change hands today. If
the ZAR trades at 15.0000 on 31 July 2016, she has foregone the
opportunity to receive an additional 8 658.01 USD (324 675.32 –
(R5m/15.0000)) for her investment in SA. However, if the rand trades at
16.0000, she is 12 175.32 USD richer since she has locked in a conversion
rate of 15.4000. Irrespective of where the USDZAR trades on 31 July 2016,
her USD proceeds would be locked in at 324 675.32 USD.
16.3.8.1 The forward discount or premium

Forward exchange rates are often quoted as a premium or discount to the
spot exchange rate. If the forward exchange rate is trading above the spot
exchange rate, the forward rate is said to trade at a premium. If the forward
rate trades below the current spot rate, the forward rate is said to trade at a
discount. For example, if the current EURUSD spot rate is quoted at
1.1079/82 and the 3-month forward rate at 1.1090/98, the forward rate
trades at a 0.0016 USD cent (1.1098 – 1.1082) premium per EUR. The
forward premium or discount is commonly calculated as an annualised
percentage deviation from the spot rate using the following formula:
Premium/Discount = (
Forward rate – Spot rate
Spot rate
) × (
12
Maturity in months of forward

) × 100
In the example above the annualised EURUSD forward premium is
Premium = (
1.1098−1.1082
1.1082
) × (
12
3
) × 100
= 0.58%
It is interesting to note that the bid-ask spread for forwards is generally

higher than for spot rates. This is mainly because there is less liquidity in
the forward market than in the spot market. Furthermore, the bid-ask spread
increases with an increase in the maturity of the forward contract.
16.3.8.2 Interest rate parity: the forward discount and the

interest rate differential
Interest rate parity (IRP) is a relationship that links spot exchange rates,
forward exchange rates and interest rates. IRP asserts that the difference
between the spot and forward exchange rates is equal to the difference
between interest rates prevailing in the money markets for
lending/borrowing in the respective currencies. Arbitrageurs will ensure
that this relationship holds for all currencies that are part of the free
international market.
Let us explore this relationship with an example.
Example: The current EURUSD exchange rate is 1.1079/82, the annual

interest rate for 3-month euros is 1.50% and for dollars 2.00%. The 3-month
EURUSD forward foreign exchange rate is 1.1085/91.
We can use the following three steps to determine whether interest rate
parity holds for this example.
Step 1: We borrow 100 000 EUR at an interest rate of 1.50% p.a. for three
months. Note that we will always borrow in the currency with the lower
interest rate and invest in the currency with the higher interest rate. After
three months we have to repay the 100 000 EUR and interest of 375.00
EUR (100 000 × 3/12 × 1.50%) for a net amount of 100 375.00 EUR.
Step 2: We use the 100 000 EUR to raise dollars against the euro by selling
the EURUSD spot exchange rate at 1.1079 to raise 110 790.00 USD. We
can now invest the USD proceeds for three months at 2.00% p.a., earning
553.95 USD interest for a net amount of 111 343.95 USD after three
months.
Step 3: For IRP to hold, the net proceeds from USD investment converted
back to EUR at the forward foreign exchange rate of 1.1091 should be
equivalent to the amount of EUR required to repay the lender of the 100
000 EUR. Let us determine whether this is the case. The USD proceeds of
111 343.95 USD converted to EUR at the forward foreign exchange rate is
111 343.95/1.1091 = 100 391.26 EUR, which is equivalent to the 100
375.00 EUR required to repay the lender. We are therefore in exactly the
same position as we were three months ago, with no opportunity to make
risk-free profits. We can therefore contend that IRP in this example holds.
For IPR to hold, the forward premium/discount should equal the discounted
interest rate differential between two currencies. The forward premium in
the above example is:
Premium =
1.1091−1.1079 12
( ) × ( ) × 100
1.1082 3
= 0.5%
The EURUSD forward foreign exchange rate trades at an annualised

premium of 0.5% against the spot EURUSD exchange rate, which is equal
to the annualised interest rate differential between the 3-month euro and
dollar deposits of 2.00% − 1.5% = 0.5%. Forward rates are therefore a
function of the interest rate differential between currencies.
The IRP relationship can also be expressed by the following mathematical

formula:
1
1+(rcur × )
12
F = S ×
2
1+(rcur–base × )
12
where:
F = the forward exchange rate
S = the spot exchange rate
rcur = the interest rate on the currency that is not the base currency
rcur-base = the interest rate on the base currency
t = maturity in months of the forward
If we take our example above, we can calculate the EURUSD forward

foreign exchange rate and compare it to the quote we received from the
banks. We can then determine whether arbitrage exists.
2
1+(0.02× )
12
F = 1.1079 × = 1.1091
2
1+(0.0150× )
12
In this example the forward rate that we have calculated is exactly equal to
the EURUSD ask rate in our example. IRP therefore holds. The above
example is also known as covered interest arbitrage – that is an arbitrage
transaction which exploits covered interest differentials.
16.4 EXCHANGE RATE DETERMINATION AND

BEHAVIOUR
Answering the question of what is the appropriate level of exchange

between two countries’ currencies is difficult at the best of times and
requires a lot more space than we have available in this chapter. We
therefore limit the scope of this section to the basic economic and political
factors that determine the level at which a country’s currency is exchanged
for that of another. We then use international parity relationships to observe
how these economic and political factors interact in determining the levels
of exchange rates.
16.4.1 Economic and political factors

16.4.1.1 Supply and demand
At the simplest possible level, the price of a currency that forms part of a
floating exchange rate system, as with any other commodity, is generally
determined by supply and demand. The supply and demand in a currency is
dependent on market participants such as importers and exporters, foreign
investors and speculators.
To explain how these market participants influence the demand and supply
of a currency, let us assume that the equilibrium exchange rate between the
USD and ZAR is 15.0000. Look at Figure 16.3(b). On the vertical y-axis we
have the exchange rate measured as the price of a USD in ZAR. On the
horizontal x-axis we have the quantity of USD traded (QD = demand for
USD, QS = supply of USD, Q* = equilibrium). Also remember that any
demand for ZAR is equivalent to a supply of USD and vice versa.
Figure 16.3 Foreign exchange supply and demand curves
US importers wishing to buy South African goods need to sell USD to buy
ZAR. Conversely, a South African importer wishing to buy US goods needs
to sell ZAR to buy USD. If the USDZAR exchange rate, for whatever
reason, was at 12.000, South African goods would appear expensive to US
importers, since more USD would be required to buy South African goods.
The supply of USD from Americans would therefore decline. Conversely,
US goods would look cheaper to South Africans, thereby increasing the
demand for USD by South Africans. The excess supply/demand curve in
Figure 16.3(a), where XS represents excess supply and XD represents
excess demand, is calculated as the difference between the demand and
supply curves in Figure 16.3(b). When there is more demand for USD than
supply in this two-country model, the USDZAR exchange rate will adjust
upward along the excess demand curve until the excess demand for USD
relative to the ZAR is eliminated and the exchange rate is in equilibrium.
16.4.1.2 Balance of payments

The balance of payments account for a country is a summary of all the
transactions between that country and the rest of the world. The format of
this account is set up according to standard international conventions and
consists of a current account and a capital (or financial) account.
The current account covers transactions for which there are no future claims
and simply involve an exchange “here and now”. The two main
components of the current account are the difference between a country’s
imports (e.g. SA imports oil) and exports (e.g. SA exports gold)

services received (e.g. paying for the use of a US patent) and rendered
(e.g. selling the rights to a book to a UK publisher).
The overall current account surplus/deficit is, for many purposes, the single
most important figure in the balance of payments. It indicates the balance
between the demand and supply of goods and services in the economy and
the net amount of foreign currency either received on these goods and
services (current account surplus) or required to purchase these goods and
services (current account deficit).
The capital (or financial) account balance represents the net value of all
direct investments, portfolio investments in equity, bonds and other
financial instruments as well as net deposits and loans made by residents
abroad and by nonresidents in the home country.
Interaction between the current account and the capital account
A deficit in a country’s current account suggests that a country is spending
more money on foreign goods and services than it receives from exports of
goods and services to foreign countries. Because it is selling its currency (to
buy foreign goods and services) in greater quantities than the foreign
demand for its currency, the value of the currency will, in theory, decrease.
The opposite will apply for current account surpluses.
While this theory seems rational, it does not always work in the manner
stated. It is possible that the currency of a country with a current account
deficit will remain stable or even appreciate if foreigners have a net appetite
to invest in that country – that is, the country has a surplus on its capital
account equal to or greater than the deficit on its current account. This
demand for the currency places upward pressure on its value, thereby
offsetting the downward pressure caused by the current account deficit.
16.4.1.3 Relative inflation rates

A country’s exports and imports depend on the relative prices of foreign
and locally produced goods, which in turn influence the demand and supply
of currencies and therefore exchange rates. What would happen if the
inflation rate in South Africa suddenly increased significantly while the
inflation rate in the US remained the same? A higher inflation rate in South
Africa relative to the US would imply that products that serve as substitutes
for each other would be more expensive in South Africa than in the US. The
South African demand for US products would increase, with a simultaneous
increase in the demand for USD to pay for these goods. The increase in
inflation should reduce the demand for South African products, with a
simultaneous decline in the demand for ZAR. The excess demand for USD
relative to ZAR would cause the ZAR to depreciate against the USD,
moving up the excess demand curve as depicted in Figure 16.3(a) until a
new equilibrium price for the USDZAR was reached.
16.4.1.4 Relative interest rates

Changes in relative interest rates can also influence the investment in
foreign securities, which in turn influence the supply and demand for
currencies and therefore the exchange rates. For example, US interest rates
are in a rising interest rate cycle at the time of writing compared to the euro
zone, where interest rates are expected to remain unchanged for the
foreseeable future. US firms are therefore likely to reduce their demand for
EUR, since US interest rates are now more attractive than euro rates. US
interest rates will also look more attractive for euro zone firms with excess
cash, increasing the demand for USD deposits and reducing the demand for
EUR deposits. Due to an increase in the demand for USD and a decline in
the demand for EUR, the equilibrium EURUSD exchange rate should
decrease as EUR is sold for USD.
In some cases the exchange rate between countries is also influenced by

interest rates in other countries. For example, interest rates in Australia,
New Zealand and the UK could be significantly higher than interest rates in
the US. Therefore, euro zone firms with excess cash have alternative cash
investment options. In this case the supply of EUR for USD would be
smaller than it would have been without the high interest rates in AUD,
NZD and GBP currencies.
16.4.1.5 Real interest rates

While relatively high interest rates may attract foreign inflows to invest in
high yields, they may reflect expectations of high inflation. Since high
inflation can put downward pressure on a local currency, this may
discourage some foreign investors from investing in securities denominated
in that currency. For this reason it is helpful to consider real interest rates
which adjust the nominal interest rate for inflation as follows:
Real interest rate ≈ Nominal interest rate – Inflation
This relationship is called the Fisher effect and we discuss it in greater

detail later in the chapter. Expected real interest rates are commonly
compared among countries to assess exchange rate movements. The reason
for this is that the relationship combines nominal interest rates and inflation,
both of which influence exchange rates. Other things held constant, there
should be a high correlation between the real interest rate differential and a
currency’s value.
16.4.1.6 Government policies
Government policies may influence the equilibrium exchange rates of their
currencies in many ways, including the following:
Affecting macro variables such as interest rates and inflation through

their monetary and fiscal policies
Imposing foreign exchange and foreign trade barriers
Intervening in the foreign exchange market
Governments are responsible for setting the exchange rate regime in a

country. There are three types of exchange rate regime: floating, fixed and
pegged. We will now discuss each of these.
In a floating exchange rate regime the exchange rates between two

currencies fluctuate freely and are determined by supply and demand
factors. All major currencies in the world are traded freely. A floating
exchange rate regime does not stop a country’s central bank from
intervening in the market, though. This bank is, however, only one of
many market participants and the judgement is still out on whether any
central bank intervention is successful in the long run. A good example
of such an intervention is the action taken by the Bank of Japan (BOJ),
which in 2004 bought more than 350 billion USD against the JPY in an
effort to weaken the JPY against a weak dollar. This was done to support
Japan’s export-driven economy against competition from exports from
China (whose currency is pegged against the USD). Notwithstanding this
massive intervention, the JPY weakened by 4% over the year.
In a fixed exchange rate regime the exchange rate between two currencies
remains fixed at a preset level known as official parity. The advantage of
a fixed rate system is that it eliminates exchange rate risk and brings
discipline to government policies. It is particularly useful for emerging
countries. The disadvantage of a fixed rate system is its lack of long-run
credibility. As soon as a country runs into economic problems, there will
be strong speculation and political pressures to remove the fixed rate
system and push for a sizeable devaluation, with major economic
disruption.
A pegged exchange rate regime is a compromise between a flexible and
fixed rate system. A country may decide to peg its currency against a
major currency or a basket of currencies. The currency is usually allowed
to fluctuate in a small band around the targeted pegged exchange rate.
Periodic adjustments to the level of the peg can take place to reflect
trends in economic fundamentals. The most important peg in the world
currently is the Chinese yuan, which is pegged against the USD. The
approximately 10% decline of the USD against a basket of currencies
since 2001 has significantly improved the competitiveness of China’s
exports, since its currency has weakened in tandem with the weaker
USD. China currently runs both a current and a capital account surplus.
Most of the current account surplus is as a result of its trading activities
with the US. Based on our discussion in Section 16.4.1.2 of the balance
of payments, we would have expected the yuan, if it was freely traded, to
strengthen against the USD. A strengthening yuan would have
contributed to reducing the US’s current account deficit, but this burden
is currently carried by the currencies of the countries with a floating
exchange rate regime. China is the second-largest economy in the world
and this peg is causing major global imbalances. Pressure is building on
China to remove the peg or at least adjust it to account for the current
economic fundamentals. China, second only to Japan, has amassed nearly
$500 billion in reserves.
16.4.1.7 Final word on economic and political factors

In reality, the actual demand and supply curves of a country’s exchange
rate, and therefore the true equilibrium price, will reflect all the above
factors simultaneously. The individual explanations above were used to
work logically through the mechanics of how supply and demand, relative
inflation and interest rates, the balance of payments and government
policies affect a country’s exchange rate.
It is also important to note that it is not only the actual value of the
underlying factors that influences exchange rates, but also market
participants’ expectations of what future inflation, interest rates and
stability in government policies will be.
16.4.2 International parity relationships
We now give you a simple theoretical framework that explains the
interrelationship between exchange rates, inflation and interest rates. We
focus on the purchasing power parity relationship, which links spot
exchange rates to inflation, and the international Fisher relationship where
exchange rates are linked to interest rates and expected inflation.
16.4.2.1 Purchasing power parity: the exchange rate and the

inflation differential
The purchasing power parity theory (PPP) states that the exchange rate
between two currencies is in equilibrium when their domestic purchasing
powers at that rate of exchange are equivalent. In other words, a basket of
goods and services should cost the same in two countries once you take the
exchange rate between the two countries into account.
The concept of PPP has two applications. It can be used as a theory of

exchange rate determination or to compare living standards across
countries.
PPP as a theory of exchange rate determination

As a theory of exchange rate determination, the simplest and strongest form
of PPP (absolute PPP) is based on an international multi goods and services
version of the law of one price. The law of one price implies that in the
absence of transaction costs, competitive arbitrage should force the same
goods and services to sell for the same price, expressed in a given currency,
across countries. Under absolute PPP, the exchange rate is simply equal to
the ratio of the domestic to the foreign price of a given aggregate bundle of
goods and services.
To illustrate the law of one price, let PD and PF be the average domestic
and foreign currency prices of a basket of goods and services, and E the
exchange rate (expressed as the price of foreign exchange). Thus, the law of
one price implies that
PD = E × PF
The exchange rate between the two countries can therefore be calculated as
follows:
PD
E =
PF
The above formula implies that the real exchange rate is therefore a
constant. In practice, however, absolute PPP does not hold because of, for
example, significant transaction costs (including transport costs, tariffs,
taxes and information costs) and other non-tariff trade barriers that make
arbitrage costly.
A weaker version of PPP, known as relative PPP, holds that the exchange
rate between two countries should eventually adjust to account for
differences in their inflation rates. That is, countries that follow monetary
policies with different inflation rate objectives should expect to see
adjustments in their exchange rate. Let us assume that ID and IF are the
inflation rates in the domestic and foreign currency respectively. If ID > IF,
and the exchange rate between the currencies of the two countries does not
change, then the purchasing power on foreign goods is greater than on
home goods. In this case PPP does not exist. Similarly, if IF > ID, and the
exchange rate does not change, PPP will not exist since the purchasing
power on home goods is greater than on foreign goods.
According to relative PPP, the future exchange rate between countries (Et)
is therefore a function of the spot exchange rate today adjusted for the
change in the underlying inflation rate in the domestic and foreign
currencies. Relative PPP can be expressed by the following mathematical
formula:
(16.1)
t
(1+ID )
Et = E0 ×
t
(1+IF )
where:
ID = the inflation rate in the domestic currency

IF = the inflation rate in the foreign currency
t = a time in the future
E0 = the spot exchange rate today (PD/PF)
From the above formula we can infer that the exchange rate between two
countries (from the home currency’s perspective) will appreciate if the
inflation rate in the foreign currency exceeds the inflation rate in the home
currency.
We can use the following example to explain how relative PPP may be used
to forecast future exchange rates.
Example: Assume that the mid spot exchange rate for USDZAR is
currently 15.1500, the South African inflation rate is 7.00% and the US
inflation rate is 1.00%. Calculate the expected future exchange rate 3 years
from now under relative PPP.
3
(1+0.0700)
E3 = 15.1500 × [ ] = 18.0136
3
(1+0.0100)
In the above example the domestic inflation rate exceeds the foreign
inflation rate. We would therefore expect the home currency to depreciate
against the foreign currency over this 3-year period.
PPP as a comparison of living standards

To compare living standards across countries, PPP exchange rates are
constructed by comparing the national prices for a basket of goods and
services. These rates are used to translate different currencies into a
common currency so as to measure the purchasing power per capita income
in different countries. However, the PPP exchange rate constructed in this
manner is not an accurate measure of the equilibrium value of the market-
determined exchange rate.
One of the best examples of this application of the PPP is The Economist’s
Big Mac Index. Figure 16.4 represents the Big Mac Index as at 31 January
2014. We can observe that a Big Mac is nearly twice as expensive in
Switzerland as it is in Finland. Based on the law of one price, an
enterprising individual could buy Big Mac burgers in Finland and sell them
in Switzerland until the price differential disappeared. However, as
mentioned earlier, the law of one price does not hold in practice due to the
effect of tariffs, transportation costs, taxes and so on.
Figure 16.4 The Big Mac Index published

by The Economist
Source: http://www.economist.com
This expression of PPP is, however, useful as a basic benchmark of the

standards of living between countries. A South African on holiday in
Hungary would therefore be able to enjoy, in relative terms, a much cheaper
Big Mac than the poor South African businessman in Switzerland.
16.4.2.2 The international Fisher effect: the interest rate and
expected inflation rate differentials
The international Fisher effect (IFE) uses interest rates rather than inflation
rate differentials to explain the change in exchange rates over time. It is
closely related to the PPP though, since there is a high correlation between
interest rates and inflation.
The relationship between interest rates and inflation, first put forward by
Fisher in 1930, proposes that the nominal interest rate, rn, in any period is
the product of the real interest rate, rr, and the expected inflation rate over
the term of the interest rate, E(I):
(1 + rn) = (1 + rr)(1 + E(I)) (16.2)
Fisher proposed that real interest rates are relatively stable over time and
that fluctuation in interest rates is therefore caused by a change in inflation
expectations. The international version of the Fisher relation links the
interest rate differential between two countries with the difference in
expected inflation as follows:
[
1+rnD
1+rnF
] = [
1+rrD
1+rrF
] × [
1+(E(ID ))
1+(E(IF ))
] (16.3)
where:
D = domestic
F = foreign
All other symbols as defined earlier.
The international Fisher effect assumes that real interest rates between
countries are equal. This makes intuitive sense because real interest rates
are all that matter to investors. If real interest rates were higher in the home
country than a foreign country, capital would flow from the foreign country
to the home country. This capital inflow would increase until the expected
real rates of return were equivalent. If the real rates of return between the
two countries were the same, then:
[
1+rrD
1+rrF
] = 1 (16.4)
Let us consider formula 16.3 again. If we substitute the real rates of return
with 1 (the assumption that real rates of return would be the same across
countries), and we substitute the expected inflation rate component with
formula 16.1 (relative PPP) we are left with the following formula:
1+rnD Et (1+rnD )
[ ] = 1 × or [ ] × E0 = Et
1+rnF E0 (1+rnF )
By combining relative PPP with the Fisher effect we can infer that
exchange rates over time will only change in response to changes in
nominal interest rates. We can now use the above formula to see how
interest rate differentials influence expected exchange rates (Et) with the
following example.
Example: The 1-year ZAR interest rate is currently 7.05%, the 1-year USD
interest rate is 3.50% and the current USDZAR mid spot rate is 15.1500. In
1 year the expected exchange rate would be:
(1+1.075)
[ ] × 15.1500 = 15.7355
(1+1.035)
In this example we would expect the ZAR to depreciate against the USD,
because interest rates and therefore the expected inflation rate in South
Africa are higher than in the US.
16.5 FOREIGN EXCHANGE INVESTMENTS AS AN

ALTERNATIVE ASSET CLASS
Many asset managers do not regard foreign exchange as an asset class

worthy of including in their portfolios. However, if we consider the basic
attributes of major currencies (e.g. the EURUSD, USDJPY, GBPUSD and
USDCHF), such as high liquidity, little if any default risk, a virtually 24-
hour market, significant volatility and a whole range of liquid derivate
products, including options and futures, then it is evident that foreign
exchange may be thought of as an alternative asset class.
There are many commercial trading advisors (CTAs) that trade vast sums of
money on behalf of clients in the foreign exchange market daily. These
funds are called managed foreign exchange funds and their objective is to
profit from movements in spot foreign exchanged rates.
These funds have different mandates and may be either leveraged or

unleveraged accounts. With leveraged accounts the CTA can use the capital
invested in the fund and leverage it up 100 times the invested capital,
depending on the amount of capital and the foreign exchange broker the
CTA uses. This leverage helps the CTAs to obtain superior rates of return
(with obvious increases in volatility in returns) on their portfolios.
The significant advances in technology have also opened the foreign

exchange market to the retail investor. With as little as $5 000, a foreign
exchange broker will allow retail investors to trade a maximum of $500 000
($5 000/0.01) in the foreign exchange market. This ability to leverage your
investments significantly is a big lure for retail investors, but few have the
acumen and discipline to trade this market successfully.
16.6 SUMMARY
In this chapter we started by explaining that a currency is a unit of

exchange, facilitating the transfer of goods and services. It is a form of
money, where money is defined as a medium of exchange rather than a
store of value.
Turning to the foreign exchange market, we showed that it allows

currencies to be exchanged in order to facilitate international trade or
financial transactions. Large multinational banks serve as market makers in
this market and make prices in the spot and forward markets.
The bid-ask spread, which is the difference between buy and sell rates,
represents the market maker’s profit margin.
It was noted that quotations that represent the number of USD per foreign
currency are referred to as direct quotations. Quotations that represent the
number of foreign currency units per USD are referred to as indirect
quotations.
Triangular arbitrage results from a discrepancy in the cross exchange rate

between two currencies. If the cross rate is not properly quoted, arbitrage
may be used to capitalise on the discrepancy and realise a risk-free profit.
The chapter explained that the equilibrium exchange rate between two
currencies at any point in time is based on supply and demand conditions.
Supply and demand are influenced by relative inflation and interest rates,
the balance of payments and government policies.
The purchasing power parity theory (PPP) was discussed. The theory states
that the exchange rate between two currencies is in equilibrium when their
domestic purchasing powers at that rate of exchange are equivalent. PPP
theory suggests that the equilibrium exchange rate will adjust by the
inflation rate differential between two countries. PPP is also useful to
compare living standards across countries.
We explained that the international Fisher effect (IFE) focuses on the

relationship between interest rates and exchange rates and states that the
interest rate differentials explain the exchange rate adjustments between
countries.
We showed that the theory of interest rate parity (IRP) focuses on the
relationship between the interest rate differential and the forward premium
(or discount) at a given point in time.
In concluding the chapter, we considered the merits of foreign exchange as

an alternative asset class.
Copeland, L. 2014. Exchange rates and international finance, 6th ed. New York: Addison-Wesley.
Madura, J. 2015. International financial management, 12th ed. New York: South Western College.
Solnik, B. & Mcleavy, D. 2009. International investments, 6th ed. New York: Addison-Wesley.
WEBSITES
http://www.aciforex.com
http://www.bis.org
http://www.cme.com/edu
http://www.economist.com
http://www.reservebank.co.za
http://www.reuters.com
1. If the USDZAR exchange rate is quoted at 15.1500/15.1650, then:
(a) an investor can buy ZAR against the USD at 15.1650

(b) an investor can sell ZAR against the USD at 15.1500
(c) the USDZAR is trading at a midpoint of 15.1575
2. The EURUSD mid spot rate is 1.1010. Calculate the exchange rate of the EUR
against the USD on an indirect basis.
3. You are given the following midpoint exchange rates. Calculate the EURCHF
cross rate:
EURUSD = 1.1010
USDCHF = 0.9875
4. Which one of the following exchange rates has a higher bid-ask spread and why:
the EURUSD or the USDZAR?
5. John Mazelike specialises in cross rate arbitrage. He notices the following
midpoint quotes:
EURUSD: 1.3095
NZDUSD: 0.7280
NZDEUR: 0.5525
Ignoring transaction costs, does John have an arbitrage opportunity based on
these quotes? If there is an arbitrage opportunity, how will he profit from it if he has
USD 1 million available for this purpose?
6. The AUDUSD spot exchange rate is 0.7743/47 and the 3-month forward rate is
0.7692/0.7701.
(a) Is the AUD trading at a premium or a discount relative to the USD in the
forward market?
(b) Compute the annualised forward premium/discount on the AUD relative to the
USD.
7. The current USDCAD exchange rate is 1.2380/85, the annual interest rate for 3-
month CAD is 2.54% and for USD 3.10%. The 3-month EURUSD forward foreign
exchange rate is 1.2360/69. Calculate whether IRP holds for this example.
8. Consider SA and the US. Interest rates in SA are greater than interest rates in the
US. Which of the following is true?
(a) ZAR is expected to appreciate relative to USD, and ZAR should trade with a
forward discount.
(b) ZAR is expected to appreciate relative to USD, and ZAR should trade with a
forward premium.
(c) ZAR is expected to depreciate relative to USD, and ZAR should trade with a
forward discount.
(d) ZAR is expected to depreciate relative to USD, and ZAR should trade with a
forward premium.
9. Assume that the mid spot exchange rate for EURZAR is currently 16.8010, the SA
inflation rate is 6.00% and the euro inflation rate is 1.25%. Calculate the expected
future exchange rate in 1 year from now under relative PPP.
10. According to the international Fisher effect, if the annual nominal USD interest rate
is 3.10% and the annual nominal JPY interest rate is 0%, then the JPY should
_______ relative to the USD over the next year.
(a) appreciate by 3.10%

(b) be unchanged
(c) depreciate by 3.10%
Solutions
1. (d)
2. USDEUR = 1/1.1010 = 0.9083
3. First express USDCHF in a direct quotation basis: CHFUSD = 1/1.09875 = 1.0127
EURUSD 1.1010
EURCHF = = = 1.0872
CHFUSD 1.0127
4. The liquidity in the ZAR is much lower than in the EUR. Dealers in the USDZAR
would therefore find it more difficult to match buyers and sellers than they would in
the EURUSD. This would result in the USDZAR attracting a higher bid-ask
spread.
5. The implicit NZDEUR cross rate is 0.5559 (0.7280/1.3095). The quoted rate in the
market is 0.5525. Triangular arbitrage is therefore possible. The quoted rate is
therefore undervalued relative to the implicit cross rate. John’s arbitrage profits are
Step 1: Sell the 1m USD to raise 763 650.25 EUR (1 000 000/1.3095)
Step 2: Use the quoted cross rate to sell 763 650.25 EUR to raise 1 382 172.39
NZD (763 650.25/0.5525).
Step 3: Use the 1 382 172.39 NZD to buy 1 006 221.50 USD at the quoted rate of
0.7280.
John has realised a risk-free profit of 6 221.50 USD.
6. The mid-point of the AUDUSD spot rate is 0.7745 and of the forward rate 0.7699.
(a) 1 AUD will cost 46 USD cents (0.7745 – 0.7699) less 3 months from now. The
AUD therefore trades at a discount to the USD in the forward market.
0.7699–0.7745
(b) Annualised discount=( ) × (
12
3
) × 100 = 2.38%
0.7745
7. The mid-point USDCAD spot rate is 1.2383 and the mid-point forward rate is
1.2365.
3
1+(0.0254× )
12
The calculated USDCAD forward rate is 1.2383 × = 1.2366

3
1+(0.0310× )
12
The calculated forward rate is virtually the same as the quoted forward rate. IRP
therefore holds with no opportunity to make risk-free profits.
8. (d)
1
(1+0.060)
9. E1 = 16.8010 × [ 1
] = 17.5892
(1+0.125)
10. (a)
17 The role of corporate
governance in shareholder
protection
17.1 INTRODUCTION
In the previous chapters we focused on several aspects relating to

investment management. In this last chapter we shift our attention to an
aspect that has received much publicity in the last few years and which has
a direct influence on the business world, namely corporate governance or
the lack thereof. In the wake of the global financial crisis of 2008/2009, the
case of the energy company Enron is often used to illustrate that the
absence of corporate governance procedures and frameworks was largely to
blame for this crisis.
Corporate governance in a company can be regarded as a method of

governing the company through the establishment of its business culture
and policies, with a direct influence on its employees from the highest to
the lowest levels. Corporate governance can, when executed effectively,
contribute to preventing corporate scandals, fraud and the civil and criminal
liability of the company, as well as to the overall financial stability of a
country or a region. It also enhances a company’s image in the public eye as
responsible and worthy of shareholder capital.
The main objective of sound corporate governance is to contribute to

improving the company’s corporate performance and accountability in
creating sustainable long-term shareholder value. Good corporate
governance requires direction from the Board of Directors, ongoing risk
analysis and internal control.
Companies usually have formal corporate governance policies. These
would include, among others, the composition and responsibilities of the
Board of Directors, the roles of the different Board-appointed committees,
the role of the chairman, and codes of conduct and business ethics. Boards
of Directors answer to shareholders and not to management. In addition,
companies must provide timely and complete disclosures to their
shareholders.
This chapter focuses on the essence and nature of corporate governance as

it relates to shareholder value, the business environment and especially
companies. The corporate governance environment is explained and
includes the role of legislation, regulations and existing industry codes on
governance. In addition, a governance framework is explained. The chapter
concludes with a discussion of ethics in the business environment.
17.2 THE BUSINESS ENVIRONMENT
A company can be described as an operation that provides products and/or

services to its clients. In providing these products and services the
company is involved in activities such as accounting, buying, selling,
producing and distributing. The company does not operate in isolation but
has direct interaction with its immediate environment, which includes a
physical, political and economic environment. In addition, the company is
influenced by external and internal factors present in this environment.
17.2.1 External and internal factors

The environment in which a company operates consists of a number of
external and internal factors that influence it. These factors could also
influence each other and this could have an effect on the company as well.
For example, the National Credit Act (34 of 2005) in South Africa is an
external factor that influences the lending operations of banks and other
credit providers as it endeavours to restrict reckless lending to clients.
Figure 17.1 depicts some of the external and internal factors that have an
influence on the operations of companies.
Figure 17.1 External and internal factors that

influence companies
External factors are factors from outside the company and can be
classified as follows:
Technological factors: These are technological innovations that can be

either beneficial to or detrimental to the company. These innovations
include advances in online shopping, mobile banking and social media.
Political factors: These are firstly governmental activities which include
laws, regulations, tariffs and other trade barriers. Secondly, they also
encompass political conditions such as protests, civil unrest and even
war.
Macroeconomic factors: These are economic factors that affect the entire
economy of a country. Examples of these factors are the level of interest
rates, unemployment rates, currency exchange rates, consumer
confidence and the inflation rate.
Microeconomic factors: These are factors that can affect a particular
company and include market size, supply, demand, relationships with
suppliers and the number and strength of the company’s competition in
the marketplace.
Social factors: These are factors related to society in general that affect
the company. Examples of such factors are social movements and
changes in consumer preferences.
Internal factors are events that occur inside the company and can be
classified as follows:
Financial changes: These occur when there are adverse movements in

the financial position of a company. An example of this is when there is a
dramatic downward trend in sales and/or profits which necessitates the
down-scaling of operations. They can also occur when the company is
acquired by another company.
Employee morale: This can be described as the job satisfaction and
feelings of wellbeing an employee of a company has within the place of
employment. Low employee morale in the workplace can lead to lower
productivity, absenteeism and lower customer satisfaction.
Management changes: Changes in management, for whatever reason, are
a reality for any company. If the situation is not managed in the correct
manner, managers’ departures can lead to a downturn in productivity and
ultimately in lower income and profits for the company.
Culture changes: A company culture can be described as the values and
practices shared by the management and staff of that particular company.
Companies with an adaptive culture which is aligned to its business goals
can outperform their competitors.
Strategic changes: This factor can be described as the restructuring of a
company’s plans in order to achieve an important business objective.
This restructuring can, for example, include changing the company’s
policies, target market, products or organisational structure.
17.2.2 Corporate governance and the business environment
Market observers are of the opinion that the generally traditional market-
based, capitalistic, macroeconomic business environment has entered a new
era. This new era shows signs of the economic, political and surrounding
influences and circumstances not having returned to their pre-crisis norms.
Corporate governance practices are already playing an important role in
determining how successfully companies may be able to adapt to this new
business environment.
Figure 17.2 shows the main areas of the business environment where
enhanced corporate governance has a major influence.
Figure 17.2 Main areas of

influence of corporate
governance in the business
environment
17.2.2.1 Risk aversion
Across the world authorities have introduced regulations and guidelines
specifically aimed at discouraging the taking of excessive risk by
companies. An example of this is the rules instituted by the Securities
Exchange Commission in the US in terms of reporting and disclosure. The
result of these requirements is that companies are already becoming more
business-risk averse and more conservative in their business activities.
17.2.2.2 Environmental sustainability

The increased focus on corporate governance has stimulated the
development, implementation and reporting of environmentally sustainable
business practices by companies. Business environmental sustainability
issues now involve considerations other than maximising shareholder value.
Issues such as the protection of natural resources, the values of society in
general and responsible investment are also taken into consideration. In this
context responsible investment means that companies have to sustain a
delicate balance between environmental sustainability considerations and
the company’s fiduciary duty to its shareholders. An example of responsible
investment may be a pension fund that follows a policy of not investing in
the shares of companies manufacturing cigarettes, alcoholic products or
military equipment.
17.2.2.3 Unemployment levels

In the wake of the 2008/2009 financial crisis, lower levels of employment
became a reality to the economies around the world. Companies not only
had to employ fewer people, but also had to adjust both employee and
executive compensation and benefit arrangements. The result was that
companies are now more cautious when pursuing their strategies,
particularly from an employment point of view.
17.2.2.4 Increased regulation

Regulatory and supervisory bodies are becoming increasingly involved in
private sector business through increased legislation, regulation and direct
intervention. This involvement and intervention is not limited only to the
financial services industry, but also extends into private industry business
sectors. The result is that a company’s relationship with regulators and
supervisors is becoming increasingly important to the company’s financial
success. Companies therefore need to focus on how best to manage their
activities in the context of all the applicable ethical and legal requirements.
17.2.2.5 Globalisation
Business has had to take globalisation into account as this had resulted in
increased competition. Companies now have to compete not only with local
businesses, but also with companies from other countries. Many companies
have also expanded their activities to other, foreign countries, resulting in
these companies adapting their corporate governance practices to take into
account the ethical business practices of, and relationships with, foreign
countries and legislators.
17.2.2.6 Economic growth

The post-financial crisis era has been marked by an increasingly
challenging business environment. One of the challenges is that companies
are struggling to remain focused on delivering long-term value to their
shareholders in the face of increasing competition. The result is that
companies are under increased pressure from shareholders demanding
higher short-term returns. These pressures lead to some companies
implementing specific governance policies and practices to boost their
short-term returns. Some companies, for example, have removed obstacles
prohibiting mergers and acquisitions, and have introduced less onerous
voting requirements.
17.3 CORPORATE GOVERNANCE ENVIRONMENT
The essence of the corporate governance environment is that it specifies the

rights and responsibilities of different participants in the company with
regard to both one another and outside parties. Although the corporate
governance environment differs from country to country, it can be divided
into three basic components, namely governance legislation, regulations
and industry codes.
Efficient corporate governance legislation, regulations and codes help

companies to operate more effectively, and could facilitate access to capital,
mitigate risk and protect against mismanagement. In addition, they make
companies more accountable and transparent to investors and provide the
tools to respond to stakeholder concerns.
17.3.1 Governance legislation

There has always been a link between good governance and the law, and
good governance cannot exist separately from the law. As a consequence,
several acts were promulgated across the world in the wake of the
2008/2009 financial crisis and other financial disasters, such as Worldcom,
Enron and Tyco. These acts are not a set of best practice guidelines, but a
set of requirements a company has to comply with. These acts were aimed
primarily at improving corporate governance and accountability. In the US,
for example, all public companies must comply with these acts. An example
of such an act is the Sarbanes-Oxley Act, which aims to protect
shareholders and the general public from accounting errors and fraudulent
practices in companies, as well as to improve the accuracy of corporate
disclosures. The consequences for non-compliance with these acts are fines,
imprisonment or a combination of both.
South Africa as a country has also introduced specific legislation over a

period of time aimed at improving corporate governance and accountability.
Table 17.1 lists specific examples of the corporate governance legislation in
South Africa.
Table 17.1 Corporate governance legislation in South Africa
Corporate governance legislation in South Africa

Corporate governance legislation in South Africa
Companies Act (71 of 2008)
Electronic Communications and Transactions Act (25 of 2002)
The Mutual Banks Act (124 of 1993)
The Competition Act (89 of 1998 as amended)
The Employment Act (55 of 1998)
The National Environmental Management Act (107 of 1998)
The Promotion of Access to Information Act (2 of 2000)
The Public Finance Management Act (1 of 1999 as amended)
Source: http://www.acts.co.za
17.3.2 Governance regulations

A regulation can be described as a rule of order with the force of law that is
prescribed by a competent authority which relates to the actions of those
entities under that particular authority’s control. The objective of
regulations is to provide the basic principles for the effective functioning of
a particular company. These regulations are created and supervised by
specific authorities, which can be either governmental supervisors or non-
governmental supervisors. Non-governmental supervisors are also known
as self-governing bodies.
These regulations also contain guidelines on good corporate governance

and requirements pertaining to regular reporting by the company to its
particular supervisor(s). An example of a governmental supervisor is the
South African Reserve Bank, which supervises the activities of banks in
South Africa using the regulations of the South African Banks Act.
17.3.3 Industry codes

Industry corporate governance codes can be found around the world, in
countries such as the UK, Australia and South Africa. These codes consist
of a set of principles of good corporate governance aimed at companies
listed on the stock exchanges in these countries, as well as other companies
in other economic sectors. Compliance with these principles is monitored
by specific supervisory bodies. The basis of these codes is “comply or
explain”. Some countries have introduced more than one corporate
governance code because of the diversity of economic activities in these
countries.
An example of this is found in South Africa where companies listed on the

JSE have to comply with the principles contained in the King III Report on
Corporate Governance in South Africa (2009). Companies’ compliance
with this code is monitored by the JSE itself. The King III Code is a
principles-based approach and provides general guidelines on best practice
in corporate governance. Public listed companies have to disclose how they
have complied with the King III Code, and explain where and why they
have not applied the Code.
Table 17.2 lists the main codes of corporate governance found around the
world.
Table 17.2 Corporate governance codes
Country Corporate governance code

South Africa King III Code on Corporate Governance
United Kingdom UK Corporate Governance Code
Australia Corporate Governance Principles and Recommendations
Austria Austrian Code of Corporate Governance
Canada Corporate Governance Guideline
Germany German Corporate Governance Code
Russia Russian Code of Corporate Governance
United States Full CII Corporate Governance Policies
Source: http://www.ecgi.org
Despite the variety of codes available in the different countries, these codes
share similar themes pertaining to corporate governance. These includes the
following:
Leadership: This includes the composition and functioning of the Board
of Directors, the division of responsibility, the role of the chairperson and
the role of non-executive directors.
Effectiveness: This requires that the Board and its committees have the
appropriate balance of skills, experience, independence and knowledge
of the company to enable them to discharge their respective duties
effectively.
Accountability: This requires that the Board should present a fair,
balanced and understandable assessment of the company’s position and
prospects.
Remuneration: This is designed to promote the long-term success of the
company.
Relationships with shareholders: This requires the Board to have
responsibility for ensuring that a satisfactory dialogue with shareholders
takes place.
17.4 CORPORATE GOVERNANCE PRINCIPLES
The primary goal of good corporate governance is to safeguard the

stakeholders’ interest in accordance with public interest on a sustainable
basis. Good corporate governance in a company, country or region is a way
of creating market confidence and business integrity, which are essential to
satisfy the need for equity capital for long-term investment. In business,
corporate governance can be regarded as the relationships between a
company’s management, the company’s Board, its shareholders and other
stakeholders of the company. These relationships provide the structures for
setting the company’s objectives, for the methods of reaching its set
objectives and for monitoring its performance. They also define the way
authority and responsibility are allocated and how corporate decisions are
made.
In order to establish good governance and satisfy the primary goal of good
governance, there are a number of principles that need to be taken into
account. Companies differ from each other and are often active in different
sectors of the marketplace. There are, however, principles that are
applicable to all companies and these can be grouped as follows:
The company’s Board and senior management

Risk management
Compliance
Disclosure and transparency
17.4.1 The responsibilities of the Board and senior management

The Board of a company is the governing body elected by the shareholders
of such a company. The Board has ultimate responsibility for the company’s
business strategy and financial soundness, personnel decisions, internal
organisation and governance structure, risk management and compliance.
The Board may delegate some of its functions, but not its responsibilities, to
Board-appointed committees if deemed necessary.
The Board should exercise its duties in compliance with applicable national
and international laws, regulations and applicable supervisory standards. In
addition, the Board should establish the company’s organisational structure
in order to enable the Board and senior management to carry out their
responsibilities and facilitate effective decision making and good
governance. The Board should appoint the company’s Chief Executive
Officer as well as other senior management.
The senior management group consists of individuals responsible and

accountable for the sound and prudent day-to-day management of the
company. Under the guidance of the Board, senior management should
implement business strategies, risk management systems, a risk culture, and
processes and controls for managing the risks to which the company is
exposed. The Board should hold senior management accountable for their
actions and specify the consequences when those actions are not meeting
the Board’s specific performance expectations.
17.4.2 Risk management
In the world of business, risk management refers to those activities that
identify potential risks in advance, analyse them and then take steps to
reduce or eliminate those risks. If companies do not pay attention to risk
management while making business or investment decisions, this might
have a negative effect on the company’s activities, including financing and
investments.
Companies should have a risk management function responsible for

overseeing risk-taking activities across the company. This function should
have authority within the company to do so. The risk management function
has several key activities: these include identifying material risks, assessing
these risks and measuring the company’s exposure to these risks. In
addition, this risk management function should develop and implement a
risk governance framework, monitor risk-taking activities, establish an
early-warning system for when risk limits are breached, and report to senior
management on the level of risk in the company.
17.4.3 Compliance
Compliance, in business terms, can be described as the company’s ability to
operate according to an act, regulations, a set of rules, standards or
supervisory requirements. Depending on its activities, a company normally
has to comply at two levels, namely:
1. Compliance with acts, regulations and other external rules imposed on

the company
2. Compliance with internal rules imposed by the company itself
A business should therefore establish a compliance function with Board-

approved compliance policies and processes for identifying, assessing,
monitoring and reporting, and advising on compliance risk for the company
as a whole.
The compliance function should be independent from all senior

management to avoid undue influence in the performance of its compliance
duties. In addition, the compliance function should report to the Board
directly.
17.4.4 Disclosure and transparency

Accurate disclosure of information regarding the governance of a company
is an important part of corporate governance. It is beneficial for every
company to provide clear, timely and reliable information to its
stakeholders. This information should also be accessible to all stakeholders.
The objective of transparency with regard to corporate governance is to

provide stakeholders with the necessary information to enable them to
assess the effectiveness of the Board and senior management in governing
the company.
For example, a company should be transparent and disclose material

information on the company’s objectives, organisational and governance
structures, and major shareholders.
17.5 CORPORATE GOVERNANCE FRAMEWORK
A corporate governance framework is a structure in a company intended to

serve as a support or guide for the rules, practices and processes by which
such a company is managed and controlled. An efficient corporate
governance framework in a company facilitates fairness, accountability,
responsibility and transparency. In addition, effective corporate governance
processes protect the Board, senior management and employees in the
fulfilment of their duties, and establish stakeholder confidence in the
company.
The primary goal of a governance structure in a company should be that it

supports leadership, sustainability and corporate citizenship. Figure 17.3
depicts an example of the possible components of a typical governance
framework.
Figure 17.3 A typical governance framework
A typical governance framework consists of at least three layers, namely

the Board, a committee layer and an operational and support function layer.
17.5.1 The Board

The Board is in full control of the company and is ultimately accountable
and responsible for the performance of the company. The Board’s specific
responsibilities include, among others, reviewing and guiding the corporate
strategy, establishing key policies and objectives, understanding the key
risks faced by the company, determining the risk appetite and overseeing
the processes in operation to mitigate these key risks.
The Board also has overall responsibility for managing the company and for
maximising shareholder value. In discharging its responsibilities, the Board
is supported by senior management, together with various Board-appointed
committees. These Board-appointed committees have specific terms of
reference and have appropriately skilled members.
17.5.2 Committee structures

The Board of a company is supported by Board committees, as shown in
Figure 17.3 depending on its own activities or requirements prescribed by
the supervisor. These committees have delegated responsibility to assist in
specific matters. Each committee has its own charter or terms of reference
which set out its purpose, composition and duties.
The Audit Committee has a specific role in corporate governance. It should

provide oversight of financial reporting, risk management, internal control,
compliance, ethics, management, internal auditors and the external auditors.
The main purpose of the Risk and Compliance Committee is to provide
assistance to the Board in ensuring that the company has effective risk
management processes that identify and monitor the key risks facing the
company.
The one committee that is the exception to the rule is the company’s
Executive Committee, which is responsible for the day-to-day management
of the company. In addition, it provides the Board with information, advice
and recommendations, strategies, plans and policies to enable the Board to
make informed decisions.
17.5.3 Operational divisions and support functions

Companies are becoming more focused on operational divisions and
support functions due to less stable business environments and more intense
competition in many markets. They are placing increasing emphasis on
flexibility and performance results. In terms of governance, operating
divisions and support functions report to the company’s Executive
Committee.
An operational division can be described as a department or section in a

company that is involved in the day-to-day activities of the company,
specifically conducted for the purpose of generating profits. These
operational divisions each fulfil a specific role in the company, but always
support the goals of the company. The most common operational
departments found in companies are manufacturing, production, marketing
and sales, and in some cases research and information technology
departments.
A support function in a company can be described as a department or

section that also contributes to the efficient and effective delivery of the
company’s goals. These departments are not income generators by
themselves, but rather cost centres. They include departments such as
human resources, procurement, finance and administrative services.
In terms of good governance, there are three requirements when it comes to

operational divisions and support functions, namely:
1. Establishing priorities in line with the company’s overall strategy and

the enabling role of the function
2. Aligning the operating activities to deliver value in line with the critical
priorities
3. Allocating resources according to these priorities By meeting these
requirements, companies can effectively determine the degree of
control and the level of resources and funding needed to reach the
company’s goals.
17.6 ETHICS IN THE BUSINESS ENVIRONMENT
Ethics in the business environment revolves around an individual’s

judgements about what is right and what is wrong. Business decisions are
taken within a company by an individual or group. By deciding on the right
course of action, the decision to behave ethically is a moral one.
Ethical behaviour can bring significant benefits to a company. These

benefits include:
Increased sales and profits due to the acquisition of new customers and
the retention of existing customers
Enabling long-term relationships with employees and increased
productivity
Attracting new talented employees
Attracting new investors to the company
In contrast, unethical behaviour may damage a company’s reputation and
make it less appealing to investors and stakeholders.
Requirements for ethical behaviour in business include the following:
Behaviour: All companies should specify what is deemed to be

acceptable behaviour.
Integrity: Companies should endeavour to be honest and do the right
thing at all times.
Accountability: Companies should take responsibility for all their actions.
Commitment: Companies should place a high level of importance on
dedication.
Ethical behaviour concerns not only the company’s customers, employees

and investors, but also its supply chain, distribution process, dealings with
suppliers and manufacturing processes. Companies should therefore adopt
an ethical approach in business. A company’s core values should influence
all business decisions throughout the whole value chain. The company’s
position on ethical issues should be clearly communicated both internally
and externally to ensure that it is fully understood, thereby extending an
invitation to stakeholders to share in it.
17.7 SUMMARY
Companies view corporate governance as the structure and relationships

that determine its direction and performance. The Board of Directors is
central to good corporate governance but it also includes the company’s
relationship to the other stakeholders such as shareholders, employees,
customers, suppliers and creditors. In addition, good corporate governance
depends on the legal, regulatory and ethical environment of the company.
Good corporate governance in business has several characteristics. These
include aspects such as participation, accountability, transparency,
responsiveness and compliance. Also included is the important issue of
business ethics. Very few companies have come close to achieving good
governance in entirety. However, to ensure sustainable business
development, companies should take the necessary actions to try to reach
this goal with the aim of making it a reality.
WEBSITES
http://www.corporatecomplianceinsights.com
http://www.acts.co.za
http://www.businessdictionary.com
http://www.dineshbakshi.com
http://www.ecgi.org
https://www.bcgperspectives.com
https://www.bis.org
https://www.oecd.org
1. Read the following definition. These are economic factors that affect the entire
economy of a country. Examples of these factors are the level of interest rates,
unemployment rates, currency exchange rates, consumer confidence and the
inflation rate. Choose the correct economic factor:
a) Social factor
b) Microeconomic factor
c) Financial changes
d) Macroeconomic factor
e) Increased regulation
2. Decide whether the following statement is true or false. The senior management
group of a company consists of a group of individuals responsible and
accountable for the sound and prudent day-to-day management of the company.
a) True
b) False
3. The objective of ..................... with regard to corporate governance is to provide
stakeholders with the necessary information to enable them to assess the
effectiveness of the Board and senior management in governing the company.
a) Accountability
b) Responsiveness
c) Transparency
d) Integrity
e) Ethical behaviour
4. Describe how a corporate governance framework contributes to shareholder
protection.
5. Study the following article and then answer the question below.
AFRICAN BANK BAILOUT
August 2014
African Bank Limited (ABL) is a commercial bank in South Africa. The bank
stated on Wednesday that it was facing a record loss and needed R8.5 billion
to survive. By Friday, the share price had fallen to 31 cents, one-twentieth of its
value one month earlier in July. The company’s loans have been split in two, on
one side the “bad loans”, on the other side, the “good loans”. The company has
been bailed out by the Reserve Bank up to R7 billion for the “bad bank” and
other major private banks have had to underwrite a R10bn capital raise for the
“good bank”. CEO Leon Kirknis has since given in his resignation.
Peter Attard Montalto, an emerging-markets analyst at Nomura, said “The

failure of [African Bank] is about over-hype within the unsecured credit market
and a business with no diversification.” Indeed, over the last few years, African
Bank has been providing loans that were not backed by assets. Moreover, just
before the global financial crisis in 2008, the Bank made an acquisition of the
furniture retailer Ellerine Holdings Ltd for the amount of 800 million dollars. The
crisis then took a toll on their investment, considerably weakening the
company.
To offer unsecured loans, banks are putting themselves and ultimately the
South African economy at a great risk. The current system forces Government
institutions to intervene to save the company. This illustrates how banks are no
longer in the best position to provide unsecured consumer loans.
Source: https://www.lendico.co.za/blog/african-bank-bailout-136.html
What were the two main reasons for the collapse of African Bank according to the
article?
Solutions:
1. d) Macroeconomic factor
2. a) True
3. c) Transparency
4. A corporate governance framework is a structure in a company intended to serve
as a support or guide for the rules, practices and processes by which such a
company is managed and controlled. Such a framework contributes to
environmental, social and economic sustainability, lowering risk and thus reducing
the required rate of return of investors, enhancing financial performance and
contributing to increases in share prices. Ultimately, shareholders are protected if
the framework is applied consistently and if an ethical organisational culture is
established and maintained.
5. Reasons for the failure:
Providing loans that were not backed by assets.
Just before the global financial crisis in 2008, the Bank made an acquisition of
the furniture retailer Ellerine Holdings Ltd for the amount of 800 million dollars.
The crisis then took a toll on their investment, considerably weakening the
company.
ANNEXURE A
CFA Institute
CODE OF ETHICS AND STANDARDS OF PROFESSIONAL CONDUCT
PREAMBLE
The CFA Institute Code of Ethics and Standards of Professional Conduct are fundamental
to the values of CFA Institute and essential to achieving its mission to lead the investment
profession globally by promoting the highest standards of ethics, education, and
professional excellence for the ultimate benefit of society. High ethical standards are critical
to maintaining the public’s trust in financial markets and in the investment profession. Since
their creation in the 1960s, the Code and Standards have promoted the integrity of CFA
Institute members and served as a model for measuring the ethics of investment
professionals globally, regardless of job function, cultural differences, or local laws and
regulations. All CFA Institute members (including holders of the Chartered Financial
Analyst® [CFA®] designation) and CFA candidates must abide by the Code and Standards
and are encouraged to notify their employer of this responsibility. Violations may result in
disciplinary sanctions by CFA Institute. Sanctions can include revocation of membership,
revocation of candidacy in the CFA Program, and revocation of the right to use the CFA
designation.
THE CODE OF ETHICS

Members of CFA Institute (including CFA charterholders) and candidates for the CFA
designation (“Members and Candidates”) must:
Act with integrity, competence, diligence, respect and in an ethical manner with the
public, clients, prospective clients, employers, employees, colleagues in the investment
profession, and other participants in the global capital markets.
Place the integrity of the investment profession and the interests of clients above their
own personal interests.
Use reasonable care and exercise independent professional judgment when conducting
investment analysis, making investment recommendations, taking investment actions,
and engaging in other professional activities.
Practice and encourage others to practice in a professional and ethical manner that will
reflect credit on themselves and the profession.
Promote the integrity and viability of the global capital markets for the ultimate benefit of
society.
Maintain and improve their professional competence and strive to maintain and improve
the competence of other investment professionals.
STANDARDS OF PROFESSIONAL CONDUCT
I. PROFESSIONALISM
A. Knowledge of the Law. Members and Candidates must understand and comply with all
applicable laws, rules, and regulations (including the CFA Institute Code of Ethics and
Standards of Professional Conduct) of any government, regulatory organization,
licensing agency, or professional association governing their professional activities. In
the event of conflict, Members and Candidates must comply with the more strict law,
rule, or regulation. Members and Candidates must not knowingly participate or assist in
and must dissociate from any violation of such laws, rules, or regulations.
B. Independence and Objectivity. Members and Candidates must use reasonable care
and judgment to achieve and maintain independence and objectivity in their professional
activities. Members and Candidates must not offer, solicit, or accept any gift, benefit,
compensation, or consideration that reasonably could be expected to compromise their
own or another’s independence and objectivity.
C. Misrepresentation. Members and Candidates must not knowingly make any
misrepresentations relating to investment analysis, recommendations, actions, or other
professional activities.
D. Misconduct. Members and Candidates must not engage in any professional conduct
involving dishonesty, fraud, or deceit or commit any act that reflects adversely on their
professional reputation, integrity, or competence.
II. INTEGRITY OF CAPITAL MARKETS

A. Material Nonpublic Information. Members and Candidates who possess material
nonpublic information that could affect the value of an investment must not act or cause
others to act on the information.
B. Market Manipulation. Members and Candidates must not engage in practices that
distort prices or artificially inflate trading volume with the intent to mislead market
participants.
III. DUTIES TO CLIENTS

A. Loyalty, Prudence, and Care. Members and Candidates have a duty of loyalty to their
clients and must act with reasonable care and exercise prudent judgment. Members and
Candidates must act for the benefit of their clients and place their clients’ interests
before their employer’s or their own interests.
B. Fair Dealing. Members and Candidates must deal fairly and objectively with all clients
when providing investment analysis, making investment recommendations, taking
investment action, or engaging in other professional activities.
C. Suitability.
1. When Members and Candidates are in an advisory relationship with a client, they
must:
a. Make a reasonable inquiry into a client’s or prospective client’s investment
experience, risk and return objectives, and financial constraints prior to making
any investment recommendation or taking investment action and must reassess
and update this information regularly.
b. Determine that an investment is suitable to the client’s financial situation and
consistent with the client’s written objectives, mandates, and constraints before
making an investment recommendation or taking investment action.
c. Judge the suitability of investments in the context of the client’s total portfolio.
2. When Members and Candidates are responsible for managing a portfolio to a specific
mandate, strategy, or style, they must make only investment recommendations or
take only investment actions that are consistent with the stated objectives and
constraints of the portfolio.
D. Performance Presentation. When communicating investment performance information,
Members and Candidates must make reasonable efforts to ensure that it is fair,
accurate, and complete.
E. Preservation of Confidentiality. Members and Candidates must keep information about
current, former, and prospective clients confidential unless:
1. The information concerns illegal activities on the part of the client or prospective
client,
2. Disclosure is required by law, or
3. The client or prospective client permits disclosure of the information.
IV. DUTIES TO EMPLOYERS

A. Loyalty. In matters related to their employment, Members and Candidates must act for
the benefit of their employer and not deprive their employer of the advantage of their
skills and abilities, divulge confidential information, or otherwise cause harm to their
employer.
B. Additional Compensation Arrangements. Members and Candidates must not accept
gifts, benefits, compensation, or consideration that competes with or might reasonably
be expected to create a conflict of interest with their employer’s interest unless they
obtain written consent from all parties involved.
C. Responsibilities of Supervisors. Members and Candidates must make reasonable
efforts to ensure that anyone subject to their supervision or authority complies with
applicable laws, rules, regulations, and the Code and Standards.
V. INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTIONS

A. Diligence and Reasonable Basis. Members and Candidates must:
1. Exercise diligence, independence, and thoroughness in analyzing investments,
making investment recommendations, and taking investment actions.
2. Have a reasonable and adequate basis, supported by appropriate research and
investigation, for any investment analysis, recommendation, or action.
B. Communication with Clients and Prospective Clients. Members and Candidates
must:
1. Disclose to clients and prospective clients the basic format and general principles of
the investment processes they use to analyze investments, select securities, and
construct portfolios and must promptly disclose any changes that might materially
affect those processes.
2. Disclose to clients and prospective clients significant limitations and risks associated
with the investment process.
3. Use reasonable judgment in identifying which factors are important to their
investment analyses, recommendations, or actions and include those factors in
communications with clients and prospective clients.
4. Distinguish between fact and opinion in the presentation of investment analysis and
recommendations.
C. Record Retention. Members and Candidates must develop and maintain appropriate
records to support their investment analyses, recommendations, actions, and other
investment-related communications with clients and prospective clients.
VI. CONFLICTS OF INTEREST

A. Disclosure of Conflicts. Members and Candidates must make full and fair disclosure of
all matters that could reasonably be expected to impair their independence and
objectivity or interfere with respective duties to their clients, prospective clients, and
employer. Members and Candidates must ensure that such disclosures are prominent,
are delivered in plain language, and communicate the relevant information effectively.
B. Priority of Transactions. Investment transactions for clients and employers must have
priority over investment transactions in which a Member or Candidate is the beneficial
owner.
C. Referral Fees. Members and Candidates must disclose to their employer, clients, and
prospective clients, as appropriate, any compensation, consideration, or benefit received
from or paid to others for the recommendation of products or services.
VII. RESPONSIBILITIES AS A CFA INSTITUTE MEMBER OR CFA CANDIDATE

A. Conduct as Participants in CFA Institute Programs. Members and Candidates must
not engage in any conduct that compromises the reputation or integrity of CFA Institute
or the CFA designation or the integrity, validity, or security of the CFA Institute programs.
B. Reference to CFA Institute, the CFA Designation, and the CFA Program. When
referring to CFA Institute, CFA Institute membership, the CFA designation, or candidacy
in the CFA Program, Members and Candidates must not misrepresent or exaggerate the
meaning or implications of membership in CFA Institute, holding the CFA designation, or
candidacy in the CFA program.
ANNEXURE B
Table 1 Future value interest factors for R1 compounded at k% for n periods: FVIFk,n = (1+i)n
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 25% 30% 35%
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100 1.110 1.120 1.130 1.140 1.150 1.160 1.200 1.250 1.300 1.350
2 1.020 1.040 1.061 1.082 1.103 1.124 1.145 1.166 1.188 1.210 1.232 1.254 1.277 1.300 1.323 1.346 1.440 1.563 1.690 1.823
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331 1.368 1.405 1.443 1.482 1.521 1.561 1.728 1.953 2.197 2.460
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464 1.518 1.574 1.630 1.689 1.749 1.811 2.074 2.441 2.856 3.322
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611 1.685 1.762 1.842 1.925 2.011 2.100 2.488 3.052 3.713 4.484
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772 1.870 1.974 2.082 2.195 2.313 2.436 2.986 3.815 4.827 6.053
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949 2.076 2.211 2.353 2.502 2.660 2.826 3.583 4.768 6.275 8.172
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144 2.305 2.476 2.658 2.853 3.059 3.278 4.300 5.960 8.157 11.03
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358 2.558 2.773 3.004 3.252 3.518 3.803 5.160 7.451 10.60 14.89
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594 2.839 3.106 3.395 3.707 4.046 4.411 6.192 9.313 13.79 20.11
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853 3.152 3.479 3.836 4.226 4.652 5.117 7.430 11.64 17.92 27.14
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.138 3.498 3.896 4.335 4.818 5.350 5.936 8.916 14.55 23.30 36.64
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452 3.883 4.363 4.898 5.492 6.153 6.886 10.70 18.19 30.29 49.47
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.797 4.310 4.887 5.535 6.261 7.076 7.988 12.84 22.74 39.37 66.78
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177 4.785 5.474 6.254 7.138 8.137 9.266 15.41 28.42 51.19 90.16
16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426 3.970 4.595 5.311 6.130 7.067 8.137 9.358 10.75 18.49 35.53 66.54 121.7
17 1.184 1.400 1.653 1.948 2.292 2.693 3.159 3.700 4.328 5.054 5.895 6.866 7.986 9.276 10.76 12.47 22.19 44.41 86.50 164.3
18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560 6.544 7.690 9.024 10.58 12.38 14.46 26.62 55.51 112.5 221.8
19 1.208 1.457 1.754 2.107 2.527 3.026 3.617 4.316 5.142 6.116 7.263 8.613 10.20 12.06 14.23 16.78 31.95 69.39 146.2 299.5
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.727 8.062 9.646 11.52 13.74 16.37 19.46 38.34 86.74 190.0 404.3
21 1.232 1.516 1.860 2.279 2.786 3.400 4.141 5.034 6.109 7.400 8.949 10.80 13.02 15.67 18.82 22.57 46.01 108.4 247.1 545.8
22 1.245 1.546 1.916 2.370 2.925 3.604 4.430 5.437 6.659 8.140 9.934 12.10 14.71 17.86 21.64 26.19 55.21 135.5 321.2 736.8
23 1.257 1.577 1.974 2.465 3.072 3.820 4.741 5.871 7.258 8.954 11.03 13.55 16.63 20.36 24.89 30.38 66.25 169.4 417.5 994.7
24 1.270 1.608 2.033 2.563 3.225 4.049 5.072 6.341 7.911 9.850 12.24 15.18 18.79 23.21 28.63 35.24 79.50 211.8 542.8 1343
25 1.282 1.641 2.094 2.666 3.386 4.292 5.427 6.848 8.623 10.83 13.59 17.00 21.23 26.46 32.92 40.87 95.40 264.7 705.6 1813
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.06 13.27 17.45 22.89 29.96 39.12 50.95 66.21 85.85 237.4 807.8 2620 8129
35 1.417 2.000 2.814 3.946 5.516 7.686 10.68 14.79 20.41 28.10 38.57 52.80 72.07 98.10 133.2 180.3 590.7 2465 9728 36449
40 1.489 2.208 3.262 4.801 7.040 10.29 14.97 21.72 31.41 45.26 65.00 93.05 132.8 188.9 267.9 378.7 1470 7523 36119 *
45 1.565 2.438 3.782 5.841 8.985 13.76 21.00 31.92 48.33 72.89 109.5 164.0 244.6 363.7 538.8 795.4 3657 22959 * *
50 1.645 2.692 4.384 7.107 11.47 18.42 29.46 46.90 74.36 117.4 184.6 289.0 450.7 700.2 1084 1671 9100 70065 * *
* FVIF > 99999
n
t−1
Table 2 Future value interest factors for a R1 annuity compounded at k% for n periods: FVIFk,n = ∑ (1 + i)
t=1
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 25% 30% 35%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.00
2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100 2.110 2.120 2.130 2.140 2.150 2.160 2.200 2.250 2.300 2.35
3 3.030 3.060 3.091 3.122 3.153 3.184 3.215 3.246 3.278 3.310 3.342 3.374 3.407 3.440 3.473 3.506 3.640 3.813 3.990 4.17
4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641 4.710 4.779 4.850 4.921 4.993 5.066 5.368 5.766 6.187 6.63
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105 6.228 6.353 6.480 6.610 6.742 6.877 7.442 8.207 9.043 9.95
6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716 7.913 8.115 8.323 8.536 8.754 8.977 9.930 11.259 12.756 14.4
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487 9.783 10.089 10.405 10.730 11.067 11.414 12.916 15.073 17.583 20.4
8 8.286 8.583 8.892 9.214 9.549 9.897 10.26 10.64 11.03 11.44 11.86 12.30 12.76 13.23 13.73 14.24 16.50 19.84 23.86 28.6
9 9.369 9.755 10.16 10.58 11.03 11.49 11.98 12.49 13.02 13.58 14.16 14.78 15.42 16.09 16.79 17.52 20.80 25.80 32.01 39.7
10 10.46 10.95 11.46 12.01 12.58 13.18 13.82 14.49 15.19 15.94 16.72 17.55 18.42 19.34 20.30 21.32 25.96 33.25 42.62 54.5
11 11.57 12.17 12.81 13.49 14.21 14.97 15.78 16.65 17.56 18.53 19.56 20.65 21.81 23.04 24.35 25.73 32.15 42.57 56.41 74.7
12 12.68 13.41 14.19 15.03 15.92 16.87 17.89 18.98 20.14 21.38 22.71 24.13 25.65 27.27 29.00 30.85 39.58 54.21 74.33 101
13 13.81 14.68 15.62 16.63 17.71 18.88 20.14 21.50 22.95 24.52 26.21 28.03 29.98 32.09 34.35 36.79 48.50 68.76 97.63 138
14 14.95 15.97 17.09 18.29 19.60 21.02 22.55 24.21 26.02 27.97 30.09 32.39 34.88 37.58 40.50 43.67 59.20 86.95 127.9 188
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 25% 30% 35%
15 16.10 17.29 18.60 20.02 21.58 23.28 25.13 27.15 29.36 31.77 34.41 37.28 40.42 43.84 47.58 51.66 72.04 109.7 167.3 254
16 17.26 18.64 20.16 21.82 23.66 25.67 27.89 30.32 33.00 35.95 39.19 42.75 46.67 50.98 55.72 60.93 87.44 138.1 218.5 344
17 18.43 20.01 21.76 23.70 25.84 28.21 30.84 33.75 36.97 40.54 44.50 48.88 53.74 59.12 65.08 71.67 105.9 173.6 285.0 466
18 19.61 21.41 23.41 25.65 28.13 30.91 34.00 37.45 41.30 45.60 50.40 55.75 61.73 68.39 75.84 84.14 128.1 218.0 371.5 630
19 20.81 22.84 25.12 27.67 30.54 33.76 37.38 41.45 46.02 51.16 56.94 63.44 70.75 78.97 88.21 98.60 154.7 273.6 484.0 852
20 22.02 24.30 26.87 29.78 33.07 36.79 41.00 45.76 51.16 57.27 64.20 72.05 80.95 91.02 102.4 115.4 186.7 342.9 630.2 115
21 23.24 25.78 28.68 31.97 35.72 39.99 44.87 50.42 56.76 64.00 72.27 81.70 92.47 104.8 118.8 134.8 225.0 429.7 820.2 155
22 24.47 27.30 30.54 34.25 38.51 43.39 49.01 55.46 62.87 71.40 81.21 92.50 105.5 120.4 137.6 157.4 271.0 538.1 1067 210
23 25.72 28.84 32.45 36.62 41.43 47.00 53.44 60.89 69.53 79.54 91.15 104.6 120.2 138.3 159.3 183.6 326.2 673.6 1388 283
24 26.97 30.42 34.43 39.08 44.50 50.82 58.18 66.76 76.79 88.50 102.2 118.2 136.8 158.7 184.2 214.0 392.5 843.0 1806 383
25 28.24 32.03 36.46 41.65 47.73 54.86 63.25 73.11 84.70 98.35 114.4 133.3 155.6 181.9 212.8 249.2 472.0 1055 2349 517
30 34.78 40.57 47.58 56.08 66.44 79.06 94.46 113.3 136.3 164.5 199.0 241.3 293.2 356.8 434.7 530.3 1182 3227 8730 232
35 41.66 49.99 60.46 73.65 90.32 111.4 138.2 172.3 215.7 271.0 341.6 431.7 546.7 693.6 881.2 1121 2948 9857 32423 *
40 48.89 60.40 75.40 95.03 120.8 154.8 199.6 259.1 337.9 442.6 581.8 767.1 1014 1342 1779 2361 7344 30089 * *
45 56.48 71.89 92.72 121.0 159.7 212.7 285.7 386.5 525.9 718.9 986.6 1358 1874 2591 3585 4965 18281 91831 * *
50 64.46 84.58 112.8 152.7 209.3 290.3 406.5 573.8 815.1 1164 1669 2400 3460 4995 7218 10436 45497 * * *
* FVIFA > 99999
1
Table 3 Present value interest factors for R1 discounted at k% for n periods: PVIFk,n = n
(1+i)
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 25% 30% 35%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.870 0.862 0.833 0.800 0.769 0.741
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.812 0.797 0.783 0.769 0.756 0.743 0.694 0.640 0.592 0.549
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 0.731 0.712 0.693 0.675 0.658 0.641 0.579 0.512 0.455 0.406
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 0.659 0.636 0.613 0.592 0.572 0.552 0.482 0.410 0.350 0.301
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 0.593 0.567 0.543 0.519 0.497 0.476 0.402 0.328 0.269 0.223
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 0.535 0.507 0.480 0.456 0.432 0.410 0.335 0.262 0.207 0.165
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 0.482 0.452 0.425 0.400 0.376 0.354 0.279 0.210 0.159 0.122
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 0.434 0.404 0.376 0.351 0.327 0.305 0.233 0.168 0.123 0.091
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 0.391 0.361 0.333 0.308 0.284 0.263 0.194 0.134 0.094 0.067
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 0.352 0.322 0.295 0.270 0.247 0.227 0.162 0.107 0.073 0.050
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 0.317 0.287 0.261 0.237 0.215 0.195 0.135 0.086 0.056 0.037
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 0.286 0.257 0.231 0.208 0.187 0.168 0.112 0.069 0.043 0.027
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 0.258 0.229 0.204 0.182 0.163 0.145 0.093 0.055 0.033 0.020
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 0.232 0.205 0.181 0.160 0.141 0.125 0.078 0.044 0.025 0.015
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 0.209 0.183 0.160 0.140 0.123 0.108 0.065 0.035 0.020 0.011
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 0.188 0.163 0.141 0.123 0.107 0.093 0.054 0.028 0.015 0.008
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 0.170 0.146 0.125 0.108 0.093 0.080 0.045 0.023 0.012 0.006
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 0.153 0.130 0.111 0.095 0.081 0.069 0.038 0.018 0.009 0.005
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 0.138 0.116 0.098 0.083 0.070 0.060 0.031 0.014 0.007 0.003
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 0.124 0.104 0.087 0.073 0.061 0.051 0.026 0.012 0.005 0.002
21 0.811 0.660 0.538 0.439 0.359 0.294 0.242 0.199 0.164 0.135 0.112 0.093 0.077 0.064 0.053 0.044 0.022 0.009 0.004 0.002
22 0.803 0.647 0.522 0.422 0.342 0.278 0.226 0.184 0.150 0.123 0.101 0.083 0.068 0.056 0.046 0.038 0.018 0.007 0.003 0.001
23 0.795 0.634 0.507 0.406 0.326 0.262 0.211 0.170 0.138 0.112 0.091 0.074 0.060 0.049 0.040 0.033 0.015 0.006 0.002 0.001
24 0.788 0.622 0.492 0.390 0.310 0.247 0.197 0.158 0.126 0.102 0.082 0.066 0.053 0.043 0.035 0.028 0.013 0.005 0.002 0.001
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092 0.074 0.059 0.047 0.038 0.030 0.024 0.010 0.004 0.001 0.001
30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057 0.044 0.033 0.026 0.020 0.015 0.012 0.004 0.001 * *
35 0.706 0.500 0.355 0.253 0.181 0.130 0.094 0.068 0.049 0.036 0.026 0.019 0.014 0.010 0.008 0.006 0.002 * * *
40 0.672 0.453 0.307 0.208 0.142 0.097 0.067 0.046 0.032 0.022 0.015 0.011 0.008 0.005 0.004 0.003 0.001 * * *
45 0.639 0.410 0.264 0.171 0.111 0.073 0.048 0.031 0.021 0.014 0.009 0.006 0.004 0.003 0.002 0.001 0.000 * * *
50 0.608 0.372 0.228 0.141 0.087 0.054 0.034 0.021 0.013 0.009 0.005 0.003 0.002 0.001 0.001 0.001 * * * *
* PVIF = .000 when rounded to three decimal places
n
1
Table 4 Present value interest factors for a R1 annuity discounted at k% for n periods: PVIFk,n = ∑
t
t=1
(1 + i)
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 25% 30% 35%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.870 0.862 0.833 0.800 0.769 0.741
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 1.713 1.690 1.668 1.647 1.626 1.605 1.528 1.440 1.361 1.289
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 2.444 2.402 2.361 2.322 2.283 2.246 2.106 1.952 1.816 1.696
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 3.102 3.037 2.974 2.914 2.855 2.798 2.589 2.362 2.166 1.997
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 25% 30% 35%
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 3.696 3.605 3.517 3.433 3.352 3.274 2.991 2.689 2.436 2.220
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 4.231 4.111 3.998 3.889 3.784 3.685 3.326 2.951 2.643 2.385
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 4.712 4.564 4.423 4.288 4.160 4.039 3.605 3.161 2.802 2.508
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 5.146 4.968 4.799 4.639 4.487 4.344 3.837 3.329 2.925 2.598
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 5.537 5.328 5.132 4.946 4.772 4.607 4.031 3.463 3.019 2.665
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 5.889 5.650 5.426 5.216 5.019 4.833 4.192 3.571 3.092 2.715
11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 6.207 5.938 5.687 5.453 5.234 5.029 4.327 3.656 3.147 2.752
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 6.492 6.194 5.918 5.660 5.421 5.197 4.439 3.725 3.190 2.779
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 6.750 6.424 6.122 5.842 5.583 5.342 4.533 3.780 3.223 2.799
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 6.982 6.628 6.302 6.002 5.724 5.468 4.611 3.824 3.249 2.814
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 7.191 6.811 6.462 6.142 5.847 5.575 4.675 3.859 3.268 2.825
16 14.72 13.58 12.56 11.65 10.84 10.11 9.447 8.851 8.313 7.824 7.379 6.974 6.604 6.265 5.954 5.668 4.730 3.887 3.283 2.834
17 15.56 14.29 13.17 12.17 11.27 10.48 9.763 9.122 8.544 8.022 7.549 7.120 6.729 6.373 6.047 5.749 4.775 3.910 3.295 2.840
18 16.40 14.99 13.75 12.66 11.69 10.83 10.06 9.372 8.756 8.201 7.702 7.250 6.840 6.467 6.128 5.818 4.812 3.928 3.304 2.844
19 17.23 15.68 14.32 13.13 12.09 11.16 10.34 9.604 8.950 8.365 7.839 7.366 6.938 6.550 6.198 5.877 4.843 3.942 3.311 2.848
20 18.05 16.35 14.88 13.59 12.46 11.47 10.59 9.818 9.129 8.514 7.963 7.469 7.025 6.623 6.259 5.929 4.870 3.954 3.316 2.850
21 18.86 17.01 15.42 14.03 12.82 11.76 10.84 10.02 9.292 8.649 8.075 7.562 7.102 6.687 6.312 5.973 4.891 3.963 3.320 2.852
22 19.66 17.66 15.94 14.45 13.16 12.04 11.06 10.20 9.442 8.772 8.176 7.645 7.170 6.743 6.359 6.011 4.909 3.970 3.323 2.853
23 20.46 18.29 16.44 14.86 13.49 12.30 11.27 10.37 9.580 8.883 8.266 7.718 7.230 6.792 6.399 6.044 4.925 3.976 3.325 2.854
24 21.24 18.91 16.94 15.25 13.80 12.55 11.47 10.53 9.707 8.985 8.348 7.784 7.283 6.835 6.434 6.073 4.937 3.981 3.327 2.855
25 22.02 19.52 17.41 15.62 14.09 12.78 11.65 10.67 9.823 9.077 8.422 7.843 7.330 6.873 6.464 6.097 4.948 3.985 3.329 2.856
30 25.81 22.40 19.60 17.29 15.37 13.76 12.41 11.26 10.27 9.427 8.694 8.055 7.496 7.003 6.566 6.177 4.979 3.995 3.332 2.857
35 29.41 25.00 21.49 18.66 16.37 14.50 12.95 11.65 10.57 9.644 8.855 8.176 7.586 7.070 6.617 6.215 4.992 3.998 3.333 2.857
40 32.83 27.36 23.11 19.79 17.16 15.05 13.33 11.92 10.76 9.779 8.951 8.244 7.634 7.105 6.642 6.233 4.997 3.999 3.333 2.857
45 36.09 29.49 24.52 20.72 17.77 15.46 13.61 12.11 10.88 9.863 9.008 8.283 7.661 7.123 6.654 6.242 4.999 4.000 3.333 2.857
50 39.20 31.42 25.73 21.48 18.26 15.76 13.80 12.23 10.96 9.915 9.042 8.304 7.675 7.133 6.661 6.246 4.999 4.000 3.333 2.857
INDEX
A
absolute breadth index (ABT) 199
accounts receivable turnover ratio 134
acid test ratio 135
active strategy 261
advertising to sales ratio 138
Altman’s z-score 139
American-style option 289
arbitrage 275
arbitrage opportunity 282
arbitrage pricing theory (APT) 43
APY model 43
assumption 43
asset allocation 3, 249
strategic asset allocation 251
tactical asset allocation 251
asset turnover ratio 134
audit ratio 139
average obligation period 135
B
bad debts ratio 134
bond 27
bond rating 216
bond swap 264
bond valuation 67
bond with an embedded option 217
book value 66
book value per share 138
breadth thrust 200
breakeven point 135
business cycle 95
business environment 337
business risk 5
buy-and-hold 260
C
call option 273
call risk 216
callability risk 6
callable bond 218
capital acquisition ratio 136
capital asset pricing model 40
assupmtions 40
beta (β) 40
capital employment ratio 136
capital market 5
capital to non-current asset ratio 136
cash balance ratio 135
cash breakeven point 135
cash debt coverage ratio 135
cash flow statement 120
cash ratio 135
cash turnover ratio 134
cash value added (CVA) 156
CFA Institute 348
chart 180
bar chart 180
line chart 180
volume bar chart 180
coincident indicator 97
collection period 134
commodity derivative 28
company analysis 86, 117
competitive strategy 108
contingent immunisation 266
convertibility risk 6
convertible bond 218
corporate bond 212
corporate governance 337
corporate governance principle 342
compliance 343
disclosure and transparency 343
responsibilities of the Board 342
risk management 342
cost leadership 110
coupon bond 216
coupon rate 214
credit derivative 273
credit risk 215
credit spread risk 215
current ratio 135
D
days of liquidity 135
debt ratio 136
debt to equity ratio 136
default risk 215
delivery or settlement 278
derivative 273
diversification 273
improved market efficiency 274
price discovery 273
reduced transaction cost 274
risk management 274
speculation 273
derivative instrument 271
determinants of competition 105
bargaining power of the customer 106
bargaining power of the supplier 106
intensity of rivalry among competing firms 107
threat of new entrant 106
threat of substitute product and service 107
differentiation 110
diversification 11, 257
financial asset 11
real asset 11
dividend payout ratio 138
dividend yield ratio 138
domestic economy 95
Dow theory 194
downgrade risk 215
DuPont model 141
E
earnings multiplier model 160
earnings per share 138
economic forecasting 80
economic forecasting model 80
leading economic indicator 80
market signal 80
economic growth 340
economic value added (EVA®) 155
effective interest rate 47
efficient market theory 35
environmental sustainability 339
equities 26
ethics 344
accountability 345
behaviour 345
commitment 345
integrity 345
exchange rate 94
exchange rate behaviour 325
economic and political factor 326
international parity relationship 329
exchangeable bond 218
exchange-traded (ET) contract 272
expectations theory 230
extendable bond 218
external and internal factor 338
F
fair (intrinsic) value 66
financial analysis 124
financial derivative 27
financial leverage ratio 132
financial risk 5
financial table 350
fiscal policy 5
floating rate note 219
focus 110
foreign exchange 320
currency future 320
currency swap market 320
forward market 320
spot market 320
foreign exchange convention 321
bid-ask spread 321
bid-offer spread see bid–ask spread
cross rate 323
currency appreciation and depreciation 322
currency arbitrage 323
direct and indirect quotation 322
forward contract 273
Forward Rate Agreement (FRA) 283
fundamental analysis 79
future value 48
annual compounding 48
future value of an annuity due 52
future value of an annuity, the 51
intra-year compounding 50
futures contract 273
G
gambling 4
gearing ratio 136
globalisation 340
governance framework 343
Board, the 343
committee structure 344
governance legislation 340
governance regulation 340
government bond 212
Greeks 290
Delta 290
Rho 292
Theta 291
Vega 291
gross margin ratio 137
growth duration model 165
growth rate 59
H
hedge fund 15
hedging 276
hedging an equity portfolio 283
H-model 162
I
increased regulation 340
indexing 259
indicator 182
linear regression 186
open interest 184
price field 182
supply and demand 188
support and resistance 185
time element 185
trend 190
trend line 188
volume 183
industry analysis 86, 91, 101
industry classification 105
asset play 105
cyclical 105
fast grower 105
slow grower 105
stalwart 105
turnaround 105
industry code 341
industry life cycle 104
initial public offerings (IPOs) 24
insurance 276
interest coverage ratio 136
interest rate derivative 28
interest rate risk 214, 230
convexity 233
duration 230
internal rate of return 60
international diversification 15
benefits of international diversification 16
constraints and costs of international investment 16
inventory conversion ratio 134
investment 3
investment management process 17
evaluating performance 18
investment objective and constraint 17
investment policy statement 18
portfolio strategy 18
selecting the asset 18
investment policy statement 243
objective and constraint 244
investment style 151
growth share 151
value testing 151
investment theory 37
investment trust 73
J
Johannesburg Stock Exchange (JSE) 211
L
lagging indicator 98
leading indicator 97
leasing 145
capital lease 146
operating lease 146
leverage or gear 277
limit order 25
line study 201
liquidity and activity ratio 132
liquidity preference theory 230
liquidity risk 5, 215
loan amortisation 58
long and short 278
long-term debt ratio 136
M
macroeconomic analysis 81
balance of payment 84
budget deficit 83
exchange rate 84
gross domestic product 81
inflation 82
interest rate 82
unemployment rate 85
margin of safety ratio 135
margin transaction 26
market 23
market indicator 201
market indices 28
market order 25
market risk 6
market timing 260
market to book value 138
market value 65, 214
market value added 159
market value ratio 127, 129
marking the cycle 97
marking to market 277
Markowitz efficient frontier 38
matched-funding technique 264
classical immunisation 265
dedicated portfolio 264
horizon matching 265
measures of relative value 72
price/book value ratio 72
price/cash flow ratio 73
price/earnings ratio 72
price/sales ratio 72
measures of value added 152
economic value added (EVA®) 152, 153
monetary policy 5
moving average 190
municipal bond 212
N
net asset value (NAV) 73
net present value 59
nominal interest rate 47
nominal rates of return 4
non-current asset to non-current liability 137
O
open interest 276
operating leverage 137
operational division and support structure 344
option 284
American-style option 284
call option 284
European-style option 284
exercise 284
put option 284
option payoff 285
options pricing 286
ordinary share 69
constant growth model 69
no-growth model 72
three-stage dividend discount model 71
two-stage dividend discount model 70
overbought/oversold oscillator 197
over-the-counter (OTC) contract 272
over-the-counter (OTC) trading 25
P
par value 65
passive strategy 260
payment period to average inventory period 134
payment period to operating cycle 134
P/E ratio 138
performance attribution analysis 306
performance measurement 304
Jensen Measure 305
Sharpe Performance Index 304
Treynor Performance Index 304
performance presentation 309
allocation effect 310
benchmark portfolio 310
performance fee 310
reporting total return 309
selection effect 311
political risk 6
portfolio 255
portfolio construction 251
measuring return 252
measuring risk 252
portfolio management 243
preference share 69
present value 54
annuity 55
deposits to accumulate a future sum 57
mixed stream 55
perpetuity 57
single amount 54
price risk 215
price/earnings (P/E) ratio 142
price-to-book (P/B) ratio 142
primary market 24
private placement 24
profit margin 137
profitability ratio 127
put option 273
putable bond 218
put-call parity 288
R
reinvestment risk 215
relative valuation ratio 166
dividend yield 169
price/asset value ratio 169
price/earnings ratio 167
price/sales ratio 169
required rate of return 4
retractable bond 218
return of investment 138
return on assets ratio 137
return on common equity 137
risk aversion 339
risk of a single asset 8
coefficient of variation 11
expected return 8
standard deviation 8
risk premium 5
risk versus return 6
S
secondary market 24
security market line (SML) 37
segmented market theory 230
Share Transactions Totally Electronic (STRATE) 26
short sales 25
short selling 276
South African Institution of Stockbrokers 25
special order 26
speculation 4, 276
stage of life 247
accumulation phase 248
consolidation phase 248
gifting phase 248
spending phase 248
statement of financial performance 117
statement of financial position 118
asset 118
liability 120
stop buy order 26
swap 273, 294
currency swap 295
equity swap 297
interest rate swap 294
SWOT analysis 112
opportunity 112
strength 112
threat 113
weakness 112
T
technical analysis 179
assumption 179
term to maturity 214
three-stage dividend discount model 163
time value of money 6, 47
timing the cycle 97
trading strategy 292
bull and bear spread 293
covered call strategy 292
protective put strategy 292
straddle 293
U
unemployment level 339
unit trust 15
V
variables for valuation purpose 66
cash flow (returns) 66
discount rate 66
timing 66
W
warrant 73
wealth 3
weighted average cost of capital 155
well-functioning market 23
availability of information 23
informational efficiency 24
liquidity and price continuity 23
transaction cost 24
Y
yield curve 229
yield curve risk 215
yield measure 224
current yield 224
nominal yield 224
realised (horizon) yield 226
spot and forward rate 227
yield to call 225
yield to maturity (YTM) 224
yield to put 226
yield to maturity (YTM) 67, 214
Z
zero-coupon bond 217

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INVESTMENT MANAGEMENT

No part of this publication may be reproduced, stored in a retrieval system, or transmitted

First edition 2003

ISBN 978 0 627 03463 3

Commissioning editor Rosemary Lerungoana

Website addresses and links were correct at time of publication.

This book has been reviewed by independent peer reviewers.

The introduction of an undergraduate paper in Investment Management at

Against this background, the authors embarked on an ambitious project to

Since three of the authors had participated in the Chartered Financial

PART 1 The investment background

Chapter 3 Investment theory

Chapter 4 The time value of money

Chapter 5 Valuation principles and practices

Chapter 6 Fundamental analysis

PART 2 Equity analysis

Chapter 8 Company analysis

Chapter 9 Company valuation

Chapter 10 Technical analysis

PART 3 The analysis of bonds

PART 4 Portfolio management

Chapter 14 An introduction to derivative instruments

Chapter 15 Evaluation of portfolio management

PART 5 Foreign exchange

Chapter 17 The role of corporate governance in shareholder protection

The investment background

Part 1 consists of the following chapters:

Chapter 1 The investment setting

Chapter 2 sets out the organisation and functioning of securities markets. It

Chapter 3 looks at developments in investment theory, focusing

Chapter 6 clarifies fundamental analysis – a top-down approach which

The goal of investment management is to achieve the investor’s required

The fundamental principles of investment, namely time value of money,

The chapter concludes with an overview of the investment management

1.2 WEALTH, INVESTMENT, SPECULATION AND

Wealth may be created by putting assets to their most productive use in

Wealth may be measured in various ways. It may be measured by

The most important decision in creating wealth is to decide upon asset

Investment may be defined as the current commitment of money, based on

Speculation involves the commitment of money in the hope of making an

Gambling involves betting on an uncertain outcome and taking a risk for

1.3 THE REQUIRED RATE OF RETURN

The three components of an investor’s required rate of return are the

The time value of money during the period of the investment

1.3.1.1 Inflation and the nominal rate of return

NRFR = [(1 + RRFR)(1 + EI) –1] × 100

RRFR = real rate of return (in decimal form)

Rearranging the equation above enables one to calculate the RRFR on an

Example: Assume the RRFR is 3% and the expected rate of inflation is

NRFR = [(1 + 0.03)(1 + 0.05) – 1] × 100

1.3.1.2 Demand and supply conditions in the capital market

Fiscal policy is determined by the extent to which a government finances its

1.3.2 Risk premiums

These are briefly discussed below.

A firm’s ability to raise additional debt financing by issuing bonds depends

Total risk = non-systematic risk + systematic risk

Non-systematic risk relates to events that affect individual companies, such

Systematic risk includes general economic conditions, the impact of

1.4 FUNDAMENTAL PRINCIPLES OF INVESTMENT

1.4.1 Time value of money

1.4.2 Risk versus return

Risk can be divided into non-financial and financial risk. Non-financial or

Financial risk is associated with a distribution of possible outcomes,

A value greater than one indicates an increase in wealth or a positive rate of