© ALL RIGHTS RESERVED

The Institute of Banking & Finance

Dec 2019 (Version 2.8)

No part of this Study Guide may be reproduced, stored in a retrieval system, or

transmitted in any form by or any means, electronic, electrical, chemical, mechanical,
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Institute of Banking & Finance (IBF).

IBF shall not be responsible or liable for any loss or damage whatsoever that may be
caused by or suffered as a result of reliance on any statement, error or omission contained
in this Study Guide.

This Study Guide contains information believed to be correct, current or applicable at the
time of compilation. The reader or user is advised to seek professional assistance where
appropriate.

You shall not modify, remove, delete, augment, add to, publish, transmit, sell, resell,
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in whole or in part, in print or electronic form, and you shall not aid or permit others to
do so.
Acknowledgements
IBF would like to express its gratitude to the following individuals for their contributions
and support in the development of CMFAS Study Guide and Examinations:

CMFAS Examinations Board

Mr Richard Teng, Singapore Exchange Limited (Chairperson)

Ms Grace Mok, Singapore Exchange Limited
Ms Yolanda Constantine, Monetary Authority of Singapore
Mr Kenneth Kaw, Monetary Authority of Singapore
Ms Lim Mei Shern, Monetary Authority of Singapore
Mr Rodney Lim, Nikko Asset Management Asia Limited
Ms Karen Tiah, Allen & Gledhill LLP
Ms Rachel Eng, WongPartnership LLP
Mr TK Yap, OCBC Securities Pte Ltd
Mr Kan Shik Lum, DBS Bank Ltd
Ms Yit Chwee Fung, UOB Bank Ltd
Ms Kao Shih Teng, Lion Global Investors Ltd
Ms Yvonne Ong, CapitaCommercial Trust Management Limited
Mr Martin Siah, Standard Chartered Bank

Study Guide Writers

Mr Lim Hock Kheng

Candidates who have passed the CMFAS examinations are encouraged to continue on
their learning journey by attending IBF accredited programmes. For more information,
please visit www.ibf.org.sg.

ii
Preface
Module 6 – Securities Products and Analysis

The objective of the CMFAS Module 6 – Securities Products and Analysis (M6) Exam is to
test candidates on their knowledge and understanding of securities products, as well as
the tools and techniques to analyse these products.

Candidates are required to pass the relevant modules of the CMFAS examinations
pertaining to the regulated activity that they intend to conduct. Once they have passed
the relevant CMFAS examinations, candidates must ensure that their notification to act
as an appointed representative is lodged with MAS on the Public Register via the
Representative Notification Framework (RNF), before they can commence any dealings in
regulated activities. For details, please refer to the relevant MAS Notice under the
Securities and Futures Act (SFA) – SFA 04-N09.

Organisation of the Study Guide

The Study Guide consists of 12 chapters, each devoted to a specific area of securities
products that the candidates will need to know in order to pass the M6 Exam.

Each chapter begins with a list of learning objectives and a chapter introduction, and ends
with a chapter summary. Examples and case studies are also used where appropriate in
the Study Guide to enhance candidate’s understanding of key learning points and
application of issues discussed.

A summary of each chapter is provided below:

Chapter 1 - 2: Provides an overview of the investment and financial markets and

highlights the importance of risk and return which underlies any
investment decision.

Chapter 3 - 6: Provides an understanding of fundamental analysis, industry &

economic analysis, technical & quantitative analysis and portfolio
management, which underlines the evaluation of major securities
products.

Chapter 7 – 11: Provides a basic understanding of the characteristics, features and

valuation concepts and techniques of major securities products such as
equities, fixed income securities, warrants, unit trusts, REITs,
exchange-traded funds and foreign exchange.

Chapter 12: Provides case studies on various securities products to demonstrate

the application of investment tools and analysis.

iii
To assist candidates in the review of the study materials, we have included a set of review
questions, answer key and formulae sheets at the end of the Study Guide.

A list of essential readings is also provided for candidates to read beyond the guide itself.
Candidates should ensure that they complete the essential readings before attempting
the examination.

The Appendices are provided for candidates’ reference and to enhance their
understanding of the important concepts on securities products covered in the study
guide chapters.

Study Guide Updates

The Study Guide is updated at appropriate intervals to reflect changes and developments
in the financial industry. Candidates should ensure that they have the latest version of the
Study Guide before sitting for the examination. Please refer to the Study Guide Updates
page on the IBF website or contact IBF directly to check for the latest updates.

Candidates should note that the study guide contains information believed to be correct,
current or applicable at the time of compilation.

The Study Guide is available in electronic/PDF format. Upon successful registration of the
exam, candidates will be able to access and download a complimentary copy of the study
guide from their IBF Portal Account. Please note that access to the study guide will expire
on the registered exam date.

Important Notes about the Exam

The M6 Exam is conducted at the Assessment Centre of IBF. The examination comprises
of 100 multiple-choice questions (MCQ), which include 3 case studies of 10 MCQ
questions for a duration of 2 hours. The passing mark is 70%.

The exam includes questions that test candidates’ knowledge, understanding and
application of the relevant securities products.

Candidates are advised to bring along a non-programmable financial calculator for use
during the examination. A formulae sheet will be provided during the examination.

For more information on the examination rules, regulations and other administrative
procedures, please refer to the IBF website at www.ibf.org.sg.

iv
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Contents
Chapter 1 - Investments And Financial Markets
1.1 Introduction….......................................................................................................... 1
1.2 Financial Assets........................................................................................................ 2
1.3 Financial Markets……………………………………………………………………………………………….. 4
1.4 The Fund Management Process……......................................................................... 8
1.5 Summary…………………………………………………………………………………………………………….. 9

Chapter 2 - Risk And Return

2.1 Risk and Return………............................................................................................... 11
2.2 Summary………..………............................................................................................... 17

Chapter 3 – Investment Analysis – Understanding Financial Statements

3.1 Investment Analysis…………...................................................................................... 18
3.2 Fundamental Analysis……........................................................................................ 19
3.3 Understanding Financial Statements....................................................................... 19
3.4 Summary………..………............................................................................................... 35

Chapter 4 – Investment Analysis – Macroeconomic Analysis

4.1 Economic Analysis................................................................................................... 36
4.2 Industry Analysis………….......................................................................................... 44
4.3 Summary………..………............................................................................................... 49

Chapter 5 – Technical Analysis & Quantitative Analysis

5.1 Overview…………………………………………...................................................................... 51
5.2 Technical Indicators................................................................................................. 53
5.3 Trends, Support and Resistance Levels................................................................... 54
5.4 Significance of Volume............................................................................................. 55
5.5 Share Price and Volume Techniques…………............................................................ 55
5.6 Charts and Chart Patterns....................................................................................... 58
5.7 Elliot Wave Theory.................................................................................................. 63
5.8 Quantitative Analysis............................................................................................... 64
5.9 Summary………..………............................................................................................... 65

Chapter 6 – Portfolio Management

6.1 Introduction……………………………............................................................................... 67
6.2 The Portfolio Management Process........................................................................ 68
6.3 Portfolio Theory….................................................................................................... 74
6.4 Performance Measurement.................................................................................... 83
6.5 Summary………………………………………………………………………………………………..…………… 93

Chapter 7 – Equity Securities

7.1 Introduction………………………………............................................................................ 95
7.2 Types of Equity Securities........................................................................................ 96
7.3 Types of Ordinary Shares......................................................................................... 98
7.4 The Efficient Market Hypothesis............................................................................. 99
7.5 Passive versus Active Management Strategies…..................................................... 99

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7.6 Share Market Indices……………….............................................................................. 100
7.7 Time Value of Money, Dividend Yield and Earnings Yield…..................................... 102
7.8 Equity Valuation Approaches ……............................................................................ 108
7.9 Absolute Valuation Approaches ….......................................................................... 109
7.10 Relative Valuation Ratios ……………………………………................................................. 113
7.11 Initial Public Offerings ……....................................................................................... 121
7.12 Depositary Receipts …............................................................................................. 123
7.13 Summary………..………............................................................................................... 125

Chapter 8 - Fixed Income Securities

8.1 Introduction………………............................................................................................ 128
8.2 Characteristics of Bonds.......................................................................................... 128
8.3 Price Quotations…………........................................................................................... 130
8.4 Bonds Markets…...................................................................................................... 131
8.5 Types of Bonds…………………..................................................................................... 133
8.6 Special Features of Bonds........................................................................................ 134
8.7 Asset-Backed Securities........................................................................................... 135
8.8 Bond Ratings............................................................................................................ 137
8.9 Sources of Risk......................................................................................................... 138
8.10 Bond Valuation........................................................................................................ 140
8.11 Relationship between Bond Price and Market Yield…............................................ 142
8.12 Relationship between Coupon Rate, Market Yield and Price.................................. 143
8.13 Duration and Convexity……………………………………..................................................... 143
8.14 Time Path of a Bond………………………………………………………………………………………….… 145
8.15 Yield Measures........................................................................................................ 145
8.16 Term Structure of Interest Rates……………………………............................................... 148
8.17 Analysis of Convertible Bonds ……………..………………................................................ 149
8.18 Summary………..………............................................................................................... 154

Chapter 9 – Unit Trusts, REITs and Exchange-Traded Funds

9.1 Introduction….......................................................................................................... 156
9.2 Unit Trusts…………………………………………................................................................... 157
9.3 Real Estate Investment Trusts (REITs)………………………............................................. 164
9.4 Business Trusts……................................................................................................... 166
9.5 Stapled Securities.................................................................................................... 167
9.6 UCITS………………………………………............................................................................... 167
9.7 Exchange-Traded Funds……..................................................................................... 168
9.8 Summary………..………............................................................................................... 171

Chapter 10 - Warrants
10.1 Definition and Terminology..................................................................................... 173
10.2 Warrant Valuation................................................................................................... 175
10.3 Factors Affecting the Price of a Structured Warrant………….................................... 177
10.4 Warrants Market Makers........................................................................................ 178
10.5 Summary………..………............................................................................................... 179

Chapter 11 - Foreign Exchange

11.1 Introduction……………………….................................................................................... 180
11.2 Foreign Exchange Markets...................................................................................... 181
11.3 Foreign Exchange Rate Quotations…….................................................................... 182
11.4 Forward Foreign Exchange Contracts...................................................................... 184

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11.5 Risks in Foreign Exchange........................................................................................ 188
11.6 Summary………..………............................................................................................... 188

Chapter 12 – Case Studies

12.1 Financial Planning for Retirement…........................................................................ 189
122 Portfolio Management............................................................................................ 189
12.3 Fixed Income Investments…………............................................................................ 190
12.4 Equity Valuation...................................................................................................... 191
12.5 Warrants and Foreign Exchange……........................................................................ 192
12.6 Unit Trusts, REITs and Business Trusts.................................................................... 192

Appendix A - Review Questions.................................................................................. 193

Appendix B - Formulae Sheet...................................................................................... 200

Appendix C - Essential Readings.................................................................................. 210

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1 | Chapter 1 – Investments and Financial Markets

Chapter 1:
Investments and Financial Markets

Learning Objectives

The candidate should be able to:

 Describe what makes up the financial markets
 Define the term “financial assets”
 Distinguish between financial assets and real assets
 Describe the types of money market securities
 Describe the types of capital market securities
 Explain the differences between the “primary market” and the “secondary market”
 Identify the characteristics of a good financial market
 Distinguish the money market from the capital market
 Discuss broadly what are the bond markets, the equities markets and the options and futures
markets
 Understand the inter-markets relationships and how the economy is sustained by the financial
markets

1.1 Introduction

1.1.1 What are Investments and Financial Markets?

An investment is a commitment of funds to a specific asset to generate a favourable future return.

Investments can be made in financial assets or real assets. A financial asset represents a financial claim
that is documented and represented in a legally enforceable form e.g. a stock, or a bond. On the other
hand, real assets are claims on physical asset e.g. real estate or gold.

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Table 1.1.1: Financial Assets and Real Assets

(Note: This list shows examples of financial assets and real assets, and is not exhaustive)

Financial Assets Real Assets

Equities – Direct claims Real Estate
 Ordinary shares1  Commercial buildings
 Warrants  Shopping centers
 Options  Residential buildings
Funds / collective investment schemes Commodities
 Mutual funds / unit trusts  Oil
 Exchange-traded funds  Grains
 Pension funds Precious Metals
Creditor Claims  Gold
 Savings accounts  Silver
 Money market instruments Precious Stones
 Commercial paper  Diamonds
 Treasury bills, notes & bonds  Rubies
 Corporate bonds Collectibles
Preference shares1  Art
Commodities Futures  Antiques
 Stamps

Financial markets are where assets are bought or sold, borrowed or lent, or transacted in various ways,
among the participants in the market such as issuers, investors, speculators, hedgers and intermediaries.

Investments can be made in various instruments that are also called securities. These include equity
securities such as shares and unit trusts, and debt securities such as short-term money market paper or
long-term fixed income bonds. More sophisticated investors may invest in derivative securities such as
equity options and futures.

Similarly, there are many different markets in which investments may be transacted, such as the equities
market, money market, fixed income market, commodities market, options and futures market and the
foreign exchange market.

1.2 Financial Assets

Financial assets are typically paper (or electronic) claims on the issuer, which may be the public sector i.e.
government (e.g. Singapore Government) and its agencies (e.g. Housing Development Board), a
supranational (e.g. World Bank) or the private sector i.e. a corporation (e.g. Keppel Corporation)

Financial assets may be broadly classified under broad asset classes such as debt, equity funds and
derivative instruments or securities.

1 Ordinary shares and preference shares are also known as common stock and preferred stock in the U.S.A

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1.2.1 Debt Securities

Debt securities are interest-bearing instruments that include treasury bills, fixed rate bonds, certificates
of deposit, commercial paper and debentures.

1. Short-term Money Market Securities

Money market instruments as an asset class are relatively low-risk, highly liquid, short-term debt
instruments issued by governments, financial institutions and corporations. The minimum denominations
of these securities are relatively large and the size of the transactions can be substantial. The maturities
of money market securities range from 1 day to 1 year and are often less than 90 days. Instruments traded
in the money market include Treasury bills, commercial papers and negotiable certificates of deposits.

Treasury bills are issued by central banks on behalf of the government to raise short-term funds to
finance government expenditure. As obligations of the government, they are considered to be free of
default. As such, they are normally used as a proxy for the risk-free rate of return. They are issued on a
discounted basis by tender and payable or redeemable, at face value on maturity date.

Repos or repurchase agreements are key short-term funding arrangements for banks. A repurchase
agreement (a form of borrowing) is the sale of a security at a specified price with a simultaneous
commitment by the seller (borrowing party) to buy the security back from the purchaser (the lending
party) at a specific price for a specific future date. The effective interest is the difference between the
purchase price and the sale price. A reverse repo (a form of lending) is the converse transaction of a repo
i.e. purchase of a security (by the lending party) combined with a forward sale of the security (by the
borrowing party), at specified prices and dates.

Commercial papers refer to short-term unsecured promissory notes issued by a corporation. Like Treasury
bills, commercial papers are discounted money market instruments.

A banker's acceptance is a time draft drawn on a bank by a customer, in which the bank agrees to pay a
particular amount at a specified future date. It is created to facilitate commercial trade transactions,
particularly for international trade. Banker's acceptances are negotiable instruments that the holder can
discount in the money market i.e. sell it for less than its redemption value.

A certificate of deposit (CD) is a certificate issued by a bank in exchange for a deposit of funds placed with
the bank. Yields on CDs are quoted on an interest-bearing basis.

2. Fixed Income Securities

Fixed income securities are long-term fixed borrowings by the issuers. The investor would lend a certain
amount of money, called the principal, to the issuer and in return, the issuer agrees to make periodic
interest payments, and at the maturity date, to repay the principal. Fixed income securities are also called
“bonds”.

Singapore has one of the most developed bond markets in Asia. Investors can choose from various types
of local currency bonds such as Singapore Government securities, statutory board securities,
supranational bonds and corporate bonds.

A Eurobond is an international bond denominated in a currency not native to the country where it is
issued. These include Eurodollar bonds, Euro yen bonds and bonds denominated in Euros. A Eurodollar
bond is denominated in US dollars and sold outside the United States to non-US investors. For example,
a Japanese company can issue Euro yen bonds for sale in London. Yankee bonds are sold in the United

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States and denominated in US dollars, but are issued by foreign corporations or governments. Domestic
bonds are bonds sold by an issuer within its own country in that country's currency.

1.2.2 Equity Securities

Unlike fixed income securities, equity securities represent an ownership interest in a company. There are
two forms of equities, ordinary shares and preference shares. Ordinary shareholders are entitled to elect
the directors of the company and vote on company issues. Each owner is usually allowed to cast votes
equal to the number of shares owned. Preference shares are technically an equity security but are also
considered a hybrid security because they have limited rights to vote (i.e. they can vote only in limited
circumstances) and resemble both equity and fixed income instruments. In terms of priority of payment
or claims over the company’s assets, creditors have the highest priority, followed by preference
shareholders, then ordinary shareholders, who have residual claim.

1.2.3 Derivatives

Derivatives derive their values from the price of an underlying asset such as equities, fixed income or
market index values. Derivatives include options, warrants, futures and convertible securities. A
structured product is a derivative that has an investment return that is pre-determined with reference to
the performance of one or more underlying assets.

An option gives the buyer the right to buy (call option) or to sell (put option) a specific amount of an
underlying asset within a specific period at a specific price.

A warrant is a right to buy a given number of shares from the issuing company at a specified priced over
a given time period (usually over a number of years)

A futures contract is an agreement providing for the future delivery of a particular asset between a buyer
and a seller at a predetermined price. A futures contract can be cash settled or physically settled i.e. by
delivery of the asset. Futures contracts are available on commodities and financial instruments, including
equity market indices, currencies and fixed income securities. Futures contracts are on traded on
standardized terms.

A convertible security gives the holder the right to convert the security into a predetermined number of
ordinary shares of the issuer within a specified period of time. It usually pays interest and has a yield that
is higher than equity but less than fixed income / corporate bond. The difference is the value of the
embedded share option.

1.3 Financial Markets

Financial markets provide the platform for market participants to carry out their investment and funding
decisions, as well as other related activities. Financial markets have seen extensive liberalization and
global consolidation, development of information technology which enabled alternative market platforms
such as Electronic Communications Network (e.g. Instinet), and the rapid development of online
technology which allows professional and retail investors to use brokerage services through computer
networks and personal devices such as smartphones.

The rapid advance of technology has also enabled high frequency trading, which relies on computer
speed and power to gain access to financial flows. A similar adaptation using advanced technology is
algorithm trading, which uses technology to enhance liquidity through price discovery.

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Figure 1.3(a) below provides a general outline of the structure of financial markets in terms of asset
classes:
Figure 1.3(a) - Structure of the Financial Markets

The Financial
Markets

Debt Securities Equity Securities Derivatives Foreign Exchange

Shares, Options, Futures, Spot,

Money Market,
Swaps, Structured
Fixed Income Preference shares Forward
Products

Participants in financial markets include:

 Investors – retail investors, private bank investors, institutional investors (including fund management
companies)
 Issuers – public and private sector companies
 Intermediaries –broker/dealer firms and market makers
 Regulators
 Electronic exchanges – for equities, debt, derivatives, and commodities
 Infrastructure providers – clearing house, central depositary, communications networks, trade
repositories
 Financial institutions in distributing and underwriting initial public offerings (IPOs), and in maintaining
the secondary markets

The figure below illustrates how financial markets sustain economic growth.

Figure 1.3(b) – How Financial Markets Sustain Economic Growth

Equity

Capital Arrangers & Capital Capital

Seekers Intermediaries Providers Providers
Issuers of $ Investment $ Wholesale Retail
stocks, banks,
$
investors, i.e. investors, i.e.
bonds, underwriters, banks, hedge/ individuals,
distributors, Pension funds, small firms
brokerages insurance
companies

Equity
Besides regulated exchange-based capital markets, there is an increasing level of activity in the private
equity or mezzanine financing market, where capital seekers and providers negotiate funding and
investments for mergers, acquisitions or buy-outs. In such pre-primary market sectors, capital seekers
raise funds from private investors, as opposed to the regulated exchange-based capital markets where
investors raise funds from the general public. In some forms, this is referred to as “shadow banking”.

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1.3.1 Primary Market

The primary market is one where new issues of securities issued by a company are listed on the stock
exchange and sold to the public. New sales of debt or equity securities take place in the primary markets
through IPOs (Initial Public Offerings). The issuers of these securities receive cash from the subscribers
(buyers) of these new securities, who in turn receive financial claims that previously did not exist.

1.3.2 Secondary Market

After new securities have been sold in the primary market, the securities will be listed on the exchange
and begin trading in the secondary markets. Secondary markets involve buying and selling of securities
initially sold in the primary market. The proceeds from a sale in the secondary market do not go to the
original issuer but to the current owner (investor) of the security. Secondary markets provide liquidity,
which is essential to the proper functioning of the capital markets.

1.3.3 Characteristics of a Good Financial Market

What distinguishes a good market from another? Investors should consider the following when evaluating
the quality of a financial market:
1. Availability of information. An investor enters a market to buy or sell a security quickly at a price
justified by the prevailing demand and supply. To determine the appropriate price, participants need
timely and accurate information on the volume and prices of past transactions and on all currently
outstanding bids and offers.
2. Liquidity. This refers to the access to good market prices at which investors can buy/sell a security
at a price not substantially different from the prices for previous transactions, assuming no new
information is available. A security's likelihood of being sold quickly is referred to as its marketability,
which is a necessary but not a sufficient condition for liquidity. Another component of liquidity is
price continuity, which means that prices do not change much from one transaction to the next,
unless new information becomes available. A continuous market requires depth, which means there
are numerous buyers and sellers willing to trade at prices around current prices, preventing drastic
price movements.
3. Transaction cost. An efficient market is characterised by low transaction costs. This means that all
aspects of the transaction entail low costs, including the cost of reaching the market, the actual
brokerage cost involved in the transaction, and the cost of transferring the security. This attribute is
referred to as internal efficiency.
4. Bid-offer spread. This is the spread between the bid and offer price for a security. In efficient
markets, this spread is very fine because it reflects wide and deep market-making activities where
market makers readily quote two-way prices. Liquid and efficient financial markets usually have
reliable market makers, resulting in narrow bid-offer spreads.
5. Information efficiency. This means that prices adjust quickly to new information regarding supply or
demand, so prices reflect all available information about the security.
6. Price Discovery. Price discovery is one of the most important functions of any financial market. If all
of the above are in place, price discovery will be more efficient, creating a market where the prices
of securities being traded will usually be transparent and responsive to market forces.

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1.3.4 Bond Markets

The largest domestic bond market in the world is the US bond market. The US government, through the
Treasury Department issues Treasury notes and bonds with maturities greater than 1 year. The Treasury
Department is the largest single issuer of debt in the world, making the Treasury market the most active
and also the most liquid market in the world. The usual method of issuing Treasury bills, notes and bonds
is through an auction where dealers are invited to submit competitive bids.

The Eurobond market remains a very important market for investors who are interested in foreign
currency bonds, particularly over the last few years when Quantitative Easing (QE) by central banks has
resulted in very low interest rates, leading investors to seek higher returns through long-term bond issues.
Due to the worldwide distribution of both investors and traders, the dealing and settlement procedures
for Eurobonds are governed by the rules of the Association of International Bond Dealers (AIBD), a body
comprising professional participants in the international bond markets.

Although a substantial number of corporate bonds are listed on the exchanges of major countries, such
as the New York Stock Exchange (NYSE), trading of bonds is mostly done "over-the-counter" (OTC)
through bond dealers, which comprise mostly banks and large investment banking firms.

In Singapore, the Monetary Authority of Singapore (MAS) is working to revitalize the Singapore bond
market as part of its policy to develop Singapore as a major financial centre. Singapore government
securities and treasury bills are issued through MAS. To improve the liquidity and broaden the bond
market, MAS issued its first 10-year government bond in July 1998 and its first 15-year government bond
in September 2001. Issuing long-dated government bonds helps to provide a more accurate benchmark
yield curve to both investors and corporate issuers. Statutory boards have been encouraged to finance
themselves through bond issues with two inaugural issues from Jurong Town Corporation (JTC) and
Housing and Development Board (HDB) in early 1999. Supranational like Nordic Investment Bank and
International Finance Corporation have also taken advantage of the liberalisation measures to issue SGD
bonds. Local corporations have also been active in raising funds through the issue of SGD bonds.

1.3.5 Equity Markets

Ordinary shares, preference shares and warrants are traded in the equity markets. Equity markets in
different countries vary in terms of their size, liquidity, degree of regulation, trading and settlement
systems, and restrictions on foreigners in buying equities.

Until 2013, the Singapore equity market enjoyed the highest market capitalization in Southeast Asia. At
the end of 2012, it had about 1.1% of the global stock market capitalization, which is about half of that of
Hong Kong.

In terms of size at the end of 2012, the US stock market is the largest in the world, accounting for more
than one-third of the world's stock market capitalisation. The next largest markets are China, Japan and
the United Kingdom. France has continental Europe's largest stock market, followed by Germany while
Switzerland is home to some of the largest global companies in the world such as Nestle. Though relatively
small compared to the markets in US and Europe, there has been growing interest in the equity markets
in the Asian region. After Japan, Hong Kong is the next largest Asian market.

Liquidity is largely related to the size of the market, and is an important consideration when dealing in
smaller Asian markets such as Indonesia and Thailand and emerging or frontier markets in Latin America
and elsewhere.

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Some countries have restrictions on purchases of equities by foreigners. In Thailand, a ceiling is set on the
share ownership by foreigners, which resulted in a dual pricing for 'local' and 'foreign' tranches of shares
in the stock market.

With the globalisation of securities markets, there is a move towards scripless settlement to resolve
inefficiencies from handling voluminous papers. Settlement periods vary amongst the securities markets.
For example, in China, the settlement period is T+0 (i.e. settlement on the day of the trade date), where
the philosophy is that an investor must have the funds on hand to make the purchase. Both the US and
Singapore have shortened settlement periods from T+3 to T+2 2 (i.e. 2 business days after the trade date),
which is the same as that for Hong Kong.

Some countries have one national stock exchange while others may have more than one exchange. Japan
has 8 stock exchanges with the Tokyo Stock Exchange (TSE) dominating the country's equity markets.
Besides the NYSE and the American Stock Exchange (Amex), the US has several regional exchanges that
list small companies with geographic interest.

Securities that are not listed on an organized exchange may be traded in the OTC market. In the US, the
OTC market is a negotiated market consisting of a network of dealers or market makers who stand ready
to buy and sell securities at market prices. Unlike brokers, dealers have a vested interest in transactions
and they earn the spread between the bid and offer prices.

1.3.6 Options and Futures Markets

The options and futures markets are experiencing tremendous growth as more derivative securities are
being introduced and traded. The oldest and the largest of the futures exchange is the Chicago Board of
Trade (CBOT) which had a trading volume of 2,890 million contracts for 2012. Asian futures exchanges
are also growing at a phenomenal rate as investors in the region become more sophisticated. The trading
volume in the Singapore Exchange–Derivatives Trading Limited (SGX-DT) was 81 million contracts in 2012.

Options in the United States trade on the exchange floors, such as the Chicago Board Options Exchange
(CBOE), using a system of market makers. The market maker quotes bid and ask prices, and floor brokers
can trade with the market maker or with other floor brokers. The options clearing corporation (OCC) acts
as an intermediary between the brokers representing the buyers and the sellers (writers). Thus the OCC
becomes the buyer for every seller and the seller for every buyer, guaranteeing that all contract
obligations will be met.

Futures contracts are traded on electronic futures exchanges. Futures trades are cleared through the
clearing house each business day. The clearing house allows participants to easily reverse a position
before the futures contracts mature, because the clearing house keeps track of each participant's
outstanding contracts.

1.4 The Fund Management Process

Investors have a wide range of financial products to choose from and often hold multiple products in their
investment portfolio. Therefore licensed representatives and financial advisors should be familiar with
the fund management process, which aims to manage clients or investors’ portfolios in line with their
clients’ investment objectives.

2 SGX-ST Rule 9.1A.1 – Settlement Basis and Eligibility for Clearing by CDP. Refers to 2 exchange business days after the trade day.

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The fund management process is generic to various types of firms such as asset management firms,
brokerages, hedge funds, institutional funds, private banking, investment banking, large corporations, the
pension/superannuation industry, and even sovereign wealth managers.
Figure 1.4 – The Fund Management Process
Asset Allocation
• Risk and Return
• Countries – developed, emerging, frontier
• Economic, Industry &
• Asset class – Cash, debt, equities,
Country Analysis
derivatives, commodities
Valuation: Stocks / Bonds / Derivatives Selection:
 Financial Statements • Which stocks – value vs growth
 Fixed Income & Equity • Which bonds – yield vs capital
Valuation appreciation vs credit risk ratings
 Credit Risk Ratings • Technical charting & signals
 Technical Analysis • Quantitative models

Products – Equities, Bonds, Futures, Options, Warrants, Foreign The

Exchange, Unit Trusts & Managed Funds Investment
Client
 Trading costs Execution of client
 Execution efficiency orders
 Price liquidity and bid-offer spread • Frequency
 Sales vs Execution vs Trading • Order size

 Risk models Portfolio management

 Profitability performance  Investment philosophy
 Diversification  Process
 Market timing  Portfolio evaluation

In Figure 1.4.1, the boxes framed in dashed outline refer to the various functions that are typically carried
out in the fund management process, by different people. The arrows at the bottom show the various
functions in the fund management process. Different functions will be involved in different parts of the
process. Someone who is a research analyst will be much more involved in the analyses of financial ratios,
valuation ratios, economic and industry analysis. A quantitative analyst (or “quant”) will be more involved
in quantitative analysis such as developing algorithms and risk models that attempt to predict stock
market price movements. A dealer or trader will be more involved in the execution of trade orders,
whereas a sales person will be more involved in selling fund management services or research to clients.

It is hoped that the reader will be able to understand the different processes and functions in fund
management, through the various chapters that address each of these in turn.

1.5 Summary

1. Financial assets may be broadly classified as debt securities, equity securities, collective investment
schemes or funds and derivatives.

2. Money market instruments are highly liquid, short-term debt instruments with maturities below one
year.

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3. Fixed income debt securities are borrowings by issuers who agree to make periodic interest
payments and to return the principal to the investor on maturity date.

4. Equity securities represent ownership interest in a corporation. The two types of equity securities
are ordinary shares and preference shares.

5. Derivative securities derive their values from various underlying assets. Options, warrants, futures
and convertible bonds are examples of derivative securities.

6. The primary market is where new securities are distributed (sold) by the issuer to investors. The
secondary market is where the securities are traded after they have been distributed in the primary
market.

7. In evaluating the quality of a financial market, investors have to consider the following factors,
namely the availability of information, liquidity, transaction cost, the bid-offer spread and
informational and price discovery efficiency.

8. The trading of bonds is mostly done "over-the-counter" through bond dealers rather than through
organized exchanges.

9. Equity markets in different countries vary in terms of size, liquidity, degree of regulation, trading and
settlement systems and restrictions on foreigners in buying equities.

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Chapter 2:
Risk and Return
�
Learning Objectives

The candidate should be able to:

Explain the concepts of risk and return in the management of investments

� Explain the relationship between risk and return in the context of the risk-return tradeoff

� Identify the components of the total return on an investment

� Explain the statistical measures of risk

� Compute standard deviation and coefficient of variation as risk measures

� Identify the various risks associated with investments

2.1 Risk and Return

In the last chapter, we saw that an investment is the commitment of funds to a specific asset to generate
a favourable return. Such a return is by no means guaranteed, because all investments attract risks. The
fund management process lies in the management of these risks, and to seek to maximize the returns for
any given level of risks taken.

Hence, an investor must always consider both risks and return when making investment decisions. One
cannot be separated from the other. In this chapter, we look at the investment concepts behind the fund
management process, and learn how to apply the understanding of risks and returns, as well as the
analysis of investments, in seeking to maximize returns with minimum risks.

2.1.1 Risk-Return Tradeoff

Depending on the risk profile of the investor, the choice of financial assets to invest in may vary. An
investor with a low appetite for risk will be fearful of losing any part of his capital and, will consider
relatively safe money market instruments, which provide a steady flow of interest income. In contrast,
the investor with a higher risk appetite (e.g. desires capital growth) and is prepared to lose some or all of
his capital, will consider more risky securities such as equities, with the expectation for a greater return.
This is the tradeoff between expected return and risk for all investors. In Figure 2.1.1(a) we can see a
positive correlation between risk and return. Higher levels of return must be offered to compensate for
higher risk.

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Figure 2.1.1(a) – Positive Correlation between Risk and Return

The higher the risk, the higher the expected return and conversely, the lower the risk the more modest
the return. Investors seek the highest possible return for a minimum amount of risk, implying that a
favourable risk-reward ratio must exist for an investor before he is prepared to commit his funds.

Cash is the least risky due to its role as a medium of exchange and its liquidity. However, government
bonds do carry counterparty risks, which in recent years, has impacted on the traditional ‘riskless’ view of
the market on sovereign debt.

Within each asset class, there will be a risk continuum in which mature equities markets (e.g. United
States) are perceived as less risky compared to emerging equities markets (e.g. Sri Lanka).

A bellwether risk indicator for the US stock market (and indirectly, for the global equities market due of
the importance of the US economy) is the Chicago Board of Exchange (CBOE) Volatility Index, more
popularly known as “VIX”. This shows the market’s expectation of the 30-day volatility, and is also referred
to as the “investor fear gauge”. Higher XIX means more risk and volatility is expected. VIX values of more
than 30 generally indicate a high volatility, while values less than 20 are generally indicate relative
stability. See Figure 2.1.1(b) below.
Figure 2.1.1(b) - VIX Chart

Source: yahoo.finance.com

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At the height of the Lehman crisis in October 2008, VIX shot up to more than 80, while during the European
Debt Crisis it went as high at 48, compared to the more stable period shown in Figure 2.1.1(b) above.

2.1.2 Measures of Return

To evaluate the attractiveness of investments, we must be able to measure the rate of return and risk
involved in an investment accurately.

1.� Components of Total Return

Total return (on a pre-tax basis) on an investment comprises two components:

a.� Current income. This is income received from the investment during the period in which the
investment is held, such as dividends from shares and interest income from fixed income securities
or fixed deposits.
b. Capital gain or loss. The prices of equity securities and bonds may either appreciate or decline
resulting in capital gain or loss.

Therefore, the total return on a security is:

Income + Capital Gain or Loss

Total Return =
Purchase Price

The capital gain or loss is the difference between the beginning (or purchase) price and the ending (or
sale) price. The equation can also be written as:
CFt + (PE -PB )
Total Return =
PB
where
CFt = sum of cash flows during the measurement period t
PE = price at the end of period t or sale price
PB = price at the beginning of the period or purchase price
�
Computation of Total Return

Assume you purchase 1,000 shares of XYZ Company for $5 per share and receive a dividend per share
of $0.20. You sold the shares one-year later at $6. The rate of return is:

$0.20 + ($6 - $5)

Total Return = = 0.24 or 24%
$5

2.� Expected Rate of Return

Previously we considered the historical rates of return. An investor will be interested in the expected rate
of return, i.e. the future rate of return, which may or may not be realised. If the investor expects a return
of 15% on his investment, this is referred to as a point estimate. This return is usually based on a certain
economic outlook. Given that we are dealing with an uncertain future, a number of possible returns can
and will occur.

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Probability values can be assigned to all possible returns and the expected rate of return is defined as:
n

ER=  ri pi
i=1

where
E(R) = expected return on a security
ri = ith possible return
pi = probability of the ith return ri
n = number of possible returns

The expected rate of return is thus the weighted average of possible returns from a given investment,
with the weights being probabilities.

Computation of Expected Rate of Return

Suppose an investor believes an investment can provide different rates of return depending on different
possible economic scenarios. The investor might estimate probabilities for each of the economic
scenarios based on past experience and the current outlook as follows:

Economic Scenarios Probability Return

Economic boom 0.20 25%
Recession 0.20 -30%
Stable 0.60 15%
1.00

ER=0.200.25+0.20-0.30+(0.60)(0.15)
= 0.05 - 0.06 + 0.09�
= 0.08 or 8%

2.1.3 Measures of Risk

Risk refers to the uncertainty of returns associated with a given investment. In simple terms, risk is the
volatility or degree of fluctuation in the value of assets such as stocks. The most widely used statistical
measure of risk is the variance or standard deviation, which measures the dispersion of the distribution
of the actual return about the average return. The smaller the dispersion, the lower the risk of the
investment.

1.� Variance and Standard Deviation

The variance of returns (σ2) is measured as follows:

σ2 =  pi ri -E(R)2

The standard deviation of returns (σ) is the square root of the variance:

∑ pi ri -E(R)2
σ = or σ = √σ2

where all terms are as defined previously.

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Computation of Variance and Standard Deviation

Referring to the previous example, the variance and standard deviation of the security are as follows:

Possible Return Probability (pi) ri p i ri - E(R) [ri - E(R)]2 pi [ri - E(R)]2

(ri)
0.25 0.20 0.05 0.17 0.0289 0.00578
-0.30 0.20 -0.06 -0.38 0.1444 0.02888
0.15 0.60 0.09 0.07 0.0049 0.00294
1.00 E(R) = 0.08 0.03760
Variance (σ2) = 0.03760
Standard deviation (σ) = 0.03760 = 0.1939 or 19.39%

Volatility refers to the standard deviation of the security calculated as shown in the example. Variance is
only the first calculation that has to be made to get to standard deviation. If a share price has a standard
deviation of 19.39%, (assuming this is calculated on a daily price change basis), then we are saying that
the share has a daily volatility of 19.39%. This is also known as the historical volatility, which is different
from the implied volatility that is implied from price of a share option.

2.� Coefficient of Variation

Very often, investments have varying rates of return and standard deviations. In evaluating such
investments, another measure of risk, the coefficient of variation, is required. The coefficient of variation
(CV) measures the risk per unit of expected return and is defined as:
Standard Deviation of Returns
CV =
Expected Rate of Return

Use of Coefficient of Variation

Consider the following two investments:

Investment A Investment B
Expected return 0.10 0.15
Standard deviation 0.08 0.20

Based on expected return, Investment B seems to be more attractive. However, it has a higher risk than
Investment A as indicated by the higher standard deviation.

A calculation of the respective coefficients of variation reveals that Investment B has a higher risk per
unit of return as follows:

CVA = 0.08/0.10 = 0.80

CVB = 0.20/0.15 = 1.33

On a risk per unit of return basis, Investment A is more attractive.

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2.1.4 Risks in Investments

Risk may be defined as any event that contributes to the variability of an investment outcome. A positive
risk outcome results in a higher return while a negative risk outcome will result in a lower return, or even
a loss.

The risks from investing may be broadly classified under market risks, liquidity risks, counterparty risks
and operational risks (see Figure 2.1.4). Financial losses can materialize from any one or more of these
sources at any time during the period of investment.

Figure 2.1.4 – Classification of Investment Risks

Investment Risks
Counterparty Risks Market Risks Liquidity Risks Operational Risks
•� Concentration risk •� Equity prices •� Funding •� Systems failure
•� Country risk •� Interest rates •� Market / •� Principal-agent
•� Failure to pay interest •� Foreign exchange price issues
•� Failure to pay principal rates •� Market complexity
•� Change in credit standing / •� Commodity
rating prices
•� Failure to honor any •� Real estate prices
contractual agreement •� Volatility rates

Market risks result in financial losses if prices move against the investor. These are the main risks of any
investment, i.e. buying a share at $10 which now trades at $9, or selling an option on a share at a volatility
of 5%, which now trades at a volatility of 6%.

Liquidity risks can result in high financial costs if there is a liquidity crunch and interest rates rise to
abnormally high levels.1 On the other hand if there is poor market/price liquidity, i.e. few buyers and
sellers in the market, the bid-offer spread will widen, and make trading costs more costly.

Counterparty risks describe the risk of the potential failure of the other party to honour the contract
between the two parties, typically the buyer and seller. In the context of investments in bonds, or equities,
counterparty risk could come from the potential failure of the issuer. The near default of sovereign
borrowers such as Portugal, Ireland, Greece and Spain in 2012 reminds us that even sovereign debt is not
risk-free, in spite of the fact that their cost of borrowing is often described as the “risk-free” rate.
Concentration risk means having disproportionately too much risk to a few counterparties.

Operational risks can arise from the suspension of a listed share or the closure of an exchange for various
reasons from technical glitches to a force majeure event such as the outbreak of war. Over the last few
years, the establishment of high frequency trading (HFT) based on complicated trade algorithms has
added to the complexity with the use of powerful infrastructures for market trading. While HFT has
reduced trading costs, it has also been criticized as giving unfair financial flow information to those

�������������������������������������������������
1 Metallgesellschaft went bankrupt because it could not raise enough funds to meet the huge margin calls from the collapse in

oil prices. Although interest rates were not abnormally high in this case, the absolute cost in meeting the margin calls caused it
to go bankrupt.

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participants with the capacity to build such infrastructures2. As HFT relies on operational infrastructure
and computer technology, operational risks can be higher.

In the fund management process, risk control limits, policies and procedures are typically put in place to
manage each of these risks, across a diversified portfolio, according to the investment mandate, also
known as the investment policy statement.

2.2 Summary

1. There is a positive relationship between risk and return. Investors who desire higher returns will have
to contend with higher risk and vice versa.

2. There are two main measures of return – the components of total return and the expected rate of
return

3. Risk from investments can be analysed by looking at the variance and standard deviation of the asset
prices. The standard deviation is also the price volatility of each asset class.

4. When evaluating investments with varying rates of return and standard deviation, the coefficient of
variation, a relative risk measure, is required. It measures the risk per unit of return.

5.� All investments are exposed to risks. These risks include counterparty risks, market risks, liquidity
risks and operational risks. Within each of these risks, there are other specific risks that affect the
returns on investments.

�������������������������������������������������
2 “Flash Boys – A Wall Street Revolt” – Michael Lewis

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Chapter 3:
Investment Analysis ­ Understanding
Financial Statements

Learning Objectives

The candidate should be able to:

 Explain what is meant by fundamental analysis in the overall context of investment analysis
 Read and interpret the three major financial statements – the balance sheet, the income statement
and the statement of changes in cash flow
 Analyse a company’s financial performance using financial ratios
 Explain the liquidity of a company, using the current, quick and cash ratios
 Explain financial risk and leverage in a company, using the debt to equity ratio, total debt to total
assets ratio, interest coverage and total fixed charge coverage
 Analyse a company’s operating efficiency using total asset turnover, inventory turnover, days to
sell inventory, receivables turnover and the collection period for accounts receivable
 Analyse profitability in relation to sales or capital using gross profit margin, operating profit margin,
net profit margin, return on assets, return on equity and earnings per share
 Understand the use of valuation ratios in estimating the value of a share
 Understand what good quality of financial statements and good quality of earnings mean
 Explain the importance of comparative and trend analysis
 Identify the limitations in the use of financial ratios to analyse a company’s performance

3.1 Investment Analysis

Investment analysis broadly refers to an evaluation and assessment of economic, industry and market
trends, earnings prospects and ratios, and various other factors to determine suitable investment
strategies. The various approaches to investment analysis are illustrated as follows.

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Figure 3.1 – Approaches to Investment Analysis

This chapter explains how to read and interpret financial statements, and use financial statements analysis
to evaluate companies. Economic, industry and country analysis will be covered in Chapter 4, and lastly,
technical and quantitative analysis will be discussed in Chapter 5.

3.2 Fundamental Analysis

Fundamental analysis is the evaluation of share prices using economic analysis, industry analysis and the
company’s financial statements to answer the question: What is the value of the share, given its earnings
and dividends prospects within the economic and industry climate the company is operating in?

Fundamental analysis often employs a "top­down" approach where the analysis is done in three stages:
 Economic analysis
 Industry analysis
 Company analysis

For international equity and fixed income securities, country risk must also be assessed.

3.3 Understanding Financial Statements

It is worth noting here that the term “company analysis” is not necessarily the same as the analysis of
financial statements. The share of a well­run and profitable growth company is not necessarily a good
investment, if its market value already reflects its growth potential. The purpose of analysing financial
statements is to verify the potential value of a company after economic and industry analysts have
identified this company as a potential investment.

Analysis of financial statements involves the evaluating of a company’s financial data typically found in its
annual reports. Companies’ annual reports are part of legal and regulatory requirements of exchange­
listed companies by the country’s securities regulatory authority. Financial data refers to data in the
company’s accounts that make up the financial statements that investors use to make investment
decisions. The objectives of this analysis are to read, interpret and understand the financial soundness of
a company and its business viability, through financial ratios analysis.

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When analysed over several accounting periods, financial ratios help investors identify underlying trends
in the company’s financial position and to determine the amount, timing and volatility of the company’s
future earnings.

Although financial data make up most of the data for investment analysis, it is also important to look at
non­financial data in the annual report such as the Directors’ Report and the yearly business review.
Qualitative data can also be found in industry reports, brokers’ research and government publications.

In this section, we will examine the major financial statements, the computation and analysis of financial
ratios, return on equity, look at the differences between strong and weak financials, the quality of
earnings, and understand how to apply different ratios for different analytical objectives.

3.3.1 Major Financial Statements

Financial statements provide information on the resources available to management, how these
resources are financed, and what the company accomplished with them. The three major financial
statements are the balance sheet, income statement and the statement of changes in cash flow.

The balance sheet shows the financial condition of a company at a point in time, typically the company’s
financial year­end. There are three parts in the balance sheet: assets, liabilities and shareholders' equity.
 Assets represent the resources owned by the company. They include cash, motor vehicles, property,
plant and equipment, accounts receivables, etc.
 Liabilities are amounts owed by the company to parties (e.g. banks and non­banks) outside the firm
who have lent money to the firm or vendors who have supplied goods or services on credit. These
obligations or debts may be accounts payable, bank loans or overdrafts.
 Shareholders’ equity is equivalent to total assets minus total liabilities, and represents the amount
that shows how the company has been financed by ordinary and preferred shares. It is also equivalent
to the company’s share capital plus retained earnings minus treasury shares.

The relationship between these three elements is a self­balancing mathematical equation:

Assets = Liabilities + Shareholders' Equity

The income statement or profit and loss statement is a summary of the firm’s revenues and expenses
over a given time period (half­year or a year). It gives information on the firm’s efficiency, control, and
profitability. Efficiency is indicated by the sales generated during the period, whereas expenses indicate
control, and earnings derived from these sales indicate profitability.

The statement of changes in cash flows or funds statement acts as a bridge between the balance sheet
and income statement. It shows how funds were raised (i.e. the sources of these funds), and how these
funds have been used.

An example of a Balance Sheet, an Income Statement and a Statement of Changes in Cash Flow of a
hypothetical company, Fulton Corporation Limited, are shown in Tables 3.3.1(a) – (c) respectively.

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Table 3.3.1(a) ­ Balance Sheet as at 31 December 2013 of Fulton Corporation Ltd

2013 2012
Notes $'000 $'000
Assets
Current Assets
Cash and cash equivalents 15 8,000 10,000
Inventories 12 12,000 10,000
Trade Receivables 13 20,000 20,000
Short­term investments 14 50,000 45,000
Sub­total: 90,000 85,000

Non­Current Assets
Property, Plant & Equipment 9 130,000 120,000
Goodwill 10 30,000 30,000
Intangible Assets 11 60,000 50,000
Sub­total: 220,000 200,000
Total Assets 310,000 285,000
Equity and Liabilities
Equity
Share Capital, $1 par value per share 4 100,000 100,000
Retained Earnings 95,000 75,000
Revaluation Reserve 5 15,000 10,000
Total Equity 210,000 185,000

Non­current liabilities
Long­term borrowings 6 35,000 50,000
Current Liabilities
Trade and other payables 7 35,000 25,000
Short­term borrowings 8 10,000 8,000
Current portion of long­term borrowings 6 15,000 15,000
Current tax payable 9 5,000 2,000
Total Current Liabilities 65,000 50,000
Total Liabilities 100,000 100,000

Total Equity and Liabilities 310,000 285,000

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Table 3.3.1(b) ­ Income Statement for the year ended 31 December 2013 for Fulton Corporation Ltd

2013 2012
Notes $’000 $’000

Sales 16 120,000 100,000

Cost of sales 17 (65,000) (55,000)
Gross profit 55,000 45,000

Other income 18 17,000 12,000

Distribution costs 19 (10,000) (8,000)
Administrative expenses 20 (18,000) (16,000)
Interest Expense 22 (5,000) (6,000)
Total Expenses: (16,000) (18,000)

Earnings before tax 39,000 27,000

Income Tax 23 (12,000) (9,000)

Net Income 27,000 18,000

Table 3.3.1(c) ­ Statement of Cash Flows for the year ended 31 December 2013 for Fulton Corporation Ltd

2013 2012
Notes $'000 $'000

Profit before taxation

Cash generated from operations 20 2,210 2,000
Interest paid 22 (1,500) (1,200)
Income tax paid 23 (1,200) (750)
Net cash from operating activities (490) 50

Cash flows from investing activities

Purchase of property, plant and equipment 21 (1,820) (2,300)
Purchase of intangible assets 21 (750) (1,200)
Proceeds from sale of equipment 18 150 120
Proceeds from sale of intangible assets 18 180 250
Interest received 18 1,500 1,050
Net cash used in investing activities (740) (2,080)

Cash flows from financing activities

Proceeds from issue of share capital 4 3,000 ­
Proceeds from long term borrowings 6 3,030 300
Dividend paid 21 (500) 500
Net cash used in financing activities 5,530 5,530

Net increase in cash and cash equivalents 4,300 3,500

Cash & cash equivalents at start of the period 3,700 200
Cash & cash equivalents at end of the period 8,000 3,700

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3.3.2 Analysis of Financial Ratios

inancial ratios analysis is a very established and popular method to interpret companies’ financial
accounts. Based on the company’s financial accounts, one can evaluate the company’s financial strength,
the “quality” of its earnings and its past, present and future performance, using simple mathematical
ratios. When properly applied, these ratios can help to answer important questions about the company.

Figure 3.3.2 – Important Questions Answered by Financial Ratios

What is the profitability of How is the company financing

investments in real assets? itself?
 Return on assets  Debt to Equity ratio
 Return on equity  Debt to Total Assets ratio
 Gross profit margins  Interest Coverage ratio
 Net profit margins  Current ratio
 Earnings per share  Quick ratio

How efficiently is the firm utilising its assets?

 Total Assets Turnover
 Inventory Turnover
 Receivables Turnover
 Collection period of receivables

Key financial ratios in the following categories will be examined:

 Liquidity ratios
 Leverage ratios
 Operating efficiency / activity ratios
 Profitability ratios

3.3.3 Liquidity Ratios

Liquidity may be defined as the availability of funds at any given time, and at a reasonable cost. Liquidity
ratios indicate the ability of the firm to meet its short­term financial obligations.

Banks are governed by liquidity ratios levels specified by their respective local authorities. One of the
lessons learnt from the global financial crisis in 2008 was the importance of liquidity, not just for banks
but also for companies. While liquidity can be expensive in times of high interest rates, firms will have to
manage their liquidity using these ratios. Generally, higher and better quality liquidity makes long­term
funding more attractive than short­term funding.

1. Current Ratio

The most common liquidity ratio is the current ratio, which measures the degree to which current assets
cover current liabilities as follows:
Current Assets
Current Ratio =
Current Liabilities

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For Fulton Corporation Limited, the current ratios were:

90,000
2013: = 1.38 times
65,000

85,000
2012: = 1.70 times
50,000

Conventional wisdom suggests a current ratio of 2 or more, but there is a cost to having too much liquidity.
Companies are now more efficient in managing their working capital, resulting in generally lower current
ratios.

2. Quick Ratio

Also known as the acid test ratio, it has the same denominator as the current ratio but its numerator
excludes inventories because these are considered less liquid.

The quick ratio is calculated as follows:

Current Assets - Inventories
Quick Ratio =
Current Liabilities

This ratio indicates the amount of highly liquid assets that are available to cover current liabilities.
Generally, a quick ratio of more than one is considered a healthy sign of liquidity. Fulton’s quick ratios
were:
78,000
2013: = 1.20 times
65,000
75,000
2012: = 1.50 times
50,000

Quick ratios vary across industries. For example the quick ratio of a supermarket may be as low as 0.2
because a supermarket’s current assets are “fast moving consumer goods” financed by short­term
suppliers’ credit.

Current and quick ratios are susceptible to manipulation of financial reporting dates, otherwise known as
“window dressing”. For example, toward the financial year­end, the collection of receivables may be
pushed up, inventory may be reduced to below normal levels, and purchases may be delayed. Proceeds
from these actions can be used to pay off current liabilities. One should also note that an equal increase
in both current assets and current liabilities can have misleading outcomes because such equal increases
for the numerator and denominator will lead to a lower ratio if it was previously more than 1, and to a
higher ratio if it was previously less than 1.

Quick ratios are not as meaningful for non­retail / merchandising companies such as real estate firms,
banks and other financial institutions.

3.3.4 Leverage Ratios

Leverage ratios help to understand the firm’s financing mix between debt and equity, and to determine
the amount of financial risk in the firm’s financing structure. Specifically, leverage ratios help to measure
the firm’s capacity to meet principal and interest repayments. For investment analysis, these ratios are
useful for bondholders, whose main risks are defaults on principal and interest payments by the firm.
Otherwise, these ratios are more useful when analysed together with other financial ratios of the firm.

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One of the principal considerations in managing the firm’s short and long­term borrowings is the extent
of leverage. While a higher leverage will increase the return on equity and reduce any potential dilution
on earnings, it also increases the firm’s total borrowings, which might lower the firm’s credit rating,
especially when it is borrowing through the issuance of bonds.

1. Debt to Equity Ratio

The debt to equity ratio measures the relationship between total debt and shareholders' equity. Debt
includes all long­term fixed obligations, including subordinated convertible bonds. Deferred taxes may or
may not be included. Operating leases, especially if these are extensive, have to be included as an estimate
of the present values of the lease payments.

By stating its total debt as a factor of its total equity, it can be seen how much the firm is reliant on external
borrowings, i.e. debt. The greater the debt, the higher the leverage, and the greater the impact in
increasing the firm’s return on equity (ROE). However, the greater the debt, the harder it is for the firm
to generate sufficient income to repay the debt.

The ratio is calculated as follows:

Total Debt
Debt/Equity Ratio =
Total Shareholders' Equity

The debt to equity ratios for Fulton were:

100,000
2013: = 0.48 times
210,000
100,000
2012: = 0.54 times
185,000

2. Debt to Total Assets Ratio

This measures the relationship between debt and total assets. It is a comprehensive indicator of the
portion of debt used to finance the firm’s assets. It includes all borrowings, whether long­term or short­
term debt, and all assets including intangibles.

The ratio is calculated as follows:

Total Debt
Debt to Total Assets Ratio =
Total Assets

The total debt to total assets ratios for Fulton were:

100,000
2013: = 0.32 times
310,000
100,000
2012: = 0.35 times
285,000

This debt to total assets ratio indicates that about 32% of Fulton’s assets were financed with debt at the
end of 2013. Over the 2­year period, there was a decline in the firm's debt burden as indicated by the
falling debt to equity ratios, and the debt to total assets ratios.

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3. Interest Coverage

The interest coverage ratio or times interest earned ratio indicates how many times the fixed interest
charges are covered by the earnings of the company. A higher ratio of earnings relative to interest charges
indicates lower financial risk.

The interest coverage ratio is computed as follows:

Earnings Before Interest and Taxes
Interest Coverage =
Interest Expense

For Fulton, the interest coverage ratios were:

44,000
2013: = 8.30 times
5,000
33,000
2012: = 5.50 times
6,000

The interest coverage ratio depends on the earnings volatility of the firm. In a slowing economy, the
earnings may not be sustainable, while the interest obligations remain, leading to a higher financial risk
for the firm. This ratio is especially relevant for bond investors, whose primary risk is the issuer’s continued
ability to meet its interest and principal payments on time.

4. Total Fixed Charge Coverage

This ratio measures how well earnings cover total fixed financial charges including any fixed lease
payments and any preferred dividends paid out of earnings after taxes. It is expressed as:

Earnings Before Interest, Taxes and Lease Payments

Fixed Charge Coverage =
Interest Expense + Lease Payments + Preferred Dividend/(1 - Tax Rate)

It should be mentioned that debts are carried at their original cost in the balance sheet, and are not
revalued. Therefore if interest rates have risen, the debt will still be shown at the original cost, although
the firm carries a refinancing advantage from the difference between its original borrowing cost and the
current higher market interest rates.

3.3.5 Operating Efficiency / Activity Ratios

Efficiency ratios measure how efficiently the management uses its assets and capital to generate sales.
These ratios measure the speed at which the company converts its inventory to sales and its receivables
to cash. In fact, they are part of the input for what is known as the cash conversion cycle, one of several
measures of management effectiveness. It measures the rate at which a firm converts cash on hand by
following the cash as it is first converted into inventory, then through sales to accounts receivables and
then back into cash. Again, these measures are more relevant for firms that sell fast moving consumer
goods, and which generally collect cash for their sales.

1. Total Assets Turnover

This ratio indicates the effectiveness of the firm's use of its assets. The higher the asset turnover ratio, the
greater the efficiency of the company in using its assets to generate sales. The ratio is computed as
follows:

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Sales
Total Assets Turnover =
Average Total Assets

Fulton’s Total Assets Turnover ratio in 2013 was:

120,000
2013: = 0.40 times
(310,000 + 285,000)/2

Fulton’s total assets turnover ratio is low at 0.40 times, possibly because fixed assets, goodwill and
intangible assets already make up 71% of total assets. The ratio should be compared with other firms in
the industry, because it varies substantially between industries. Total assets turnover ratios range from 1
for large capital­intensive industries to over 10 for some retailing operations. It can be affected by the use
of leased facilities, because such leases may be on or off the balance sheet.

Asset ratios can be affected by factors other than a firm's efficiency. For example, a high ratio relative to
the industry might imply too few assets for the potential business (sales) or the use of outdated, fully
depreciated assets.

2. Inventory Turnover

This ratio measures the average rate of speed with which inventories move through and out of the firm.
A high inventory Turnover ratio means a rapid rate of sale for share and hence higher profits. It is
calculated as follows:
Sales
Inventory Turnover =
Average Inventory

Some analysts prefer to use the cost of goods sold because inventories are stated at cost. Sales, on the
other hand, include a profit. As the cost of goods sold figure is normally not available, the sales figure is
used as a substitute.

The inventory turnover ratio for Fulton was:

120,000
2013: =10.9 times
(12,000 + 10,000)/2

Again, the emphasis should be on the firm's performance relative to the industry, because inventory
turnover ratios vary widely. A high ratio is normally desired as it indicates efficiency. On the other hand,
it can also indicate inadequate inventory for the current sales volume, which can lead to shortages, back
orders, and eventually lost sales. Too low an inventory ratio relative to the industry average may mean
excess inventory and possibly obsolete physical stock.

3. Days to Sell Inventory

Another way to express the Inventory Turnover ratio is as the required number of days to sell inventory.
365 days
Days to Sell Inventory =
Average Inventory Turnover
Average Inventory
or =
Sales / 365

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For Fulton, the number of days required to sell off the inventory was 33.5 days.
365
2013: = 33.5 days
10.9

4. Receivables Turnover

This ratio indicates how many times, on average, the receivables are generated and collected during the
year. It is computed as follows:
Sales
Receivables Turnover Ratio =
Average Accounts Receivables

For Fulton, the receivables turnover ratio was:

120,000
2013: = 6.00 times
(20,000 + 20,000)/2

5. Collection Period for Accounts Receivables

Given the receivables turnover ratio, the number of days it takes, on average, to collect accounts
receivables can be determined as follows:

365
Collection Period =
Average Accounts Receivables Turnover

Average Accounts Receivables

or =
Sales / 365

The accounts receivables collection period for Fulton was:

365
2013: = 60.8 days
6.00

To determine whether this collection period is good or bad, it should be compared to the firm's credit
policy and the industry average. If the industry average is 60 days, a collection period of 70 days would
indicate slow­paying customers, which increases the capital tied up in receivables and possibility of bad
debts. A figure substantially below the norm may indicate overly stringent credit terms relative to
competitors, which could be detrimental to sales.

3.3.6 Profitability Ratios

Profitability may be analysed in relation to sales or capital.

1. Gross Profit Margin

Gross profit is the profit after deducting cost of goods sold from sales, but before deducting selling,
general and administrative expenses. The gross profit margin is:
Gross Profit
Gross Profit Margin =
Sales

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The gross profit margins of Fulton were:

55,000
2013: = 45.8%
120,000
45,000
2012: = 45%
100,000

2. Operating Profit Margin

Operating profit is gross profit minus selling, general and administrative expenses. The operating profit
margin is:
Earnings Before Interest and Tax
Operating Profit Margin =
Sales

The operating profit margins of Fulton were:

44,000
2013: = 36.7%
120,000
33,000
2012: = 33.3%
100,000

The operating profit margin is a measure of the firm's ability to operate efficiently. Operating profits
before interest and taxes reflect earnings before the financing decision is accounted for as a result of
deducting the interest expense and before the provision of income taxes.

The variability of the operating profit margin over time is an indicator of the firm’s business risk. Business
risk is the uncertainty of income that is caused by the firm's industry. In turn, this uncertainty is due to
the firm's variability of sales due to its products, customers, and the way it produces its products.

In some instances, investors add back depreciation expense and compute a profit margin that consists of
earnings before interest, taxes, depreciation and amortisation (EBITDA). This alternative operating profit
margin reflects all controllable expenses. It can provide insights into the profit performance of heavy
manufacturing firms with large depreciation charges. It can also indicate earnings available to pay fixed
financing costs.

3. Net Profit Margin

Net income is profits after taxes but before dividends on preference and ordinary shares. The net profit
margin measures net income as a percentage of sales:
Net Income
Net Profit Margin =
Sales

For Fulton, the net profit margins were:

27,000
2013: =22.5%
120,000

18,000
2012: =18.0%
100,000

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4. Return on Assets

The return on assets (ROA) measures the overall efficiency of the firm in managing its total investment in
assets. It is normally expressed before interest but could be before or after tax. Profit before interest is
used to separate management or operational efficiency from financing decisions and to enable
comparison of efficiency with companies with different capital structures.
Pre Tax Income + Interest Expense
Return on Assets =
Average Total Assets
Net Income + Interest Expense (1-Tax Rate)
or =
Average Total Assets

Fulton’s ROA was 15.1% on a pre­tax basis and 14.8% on an after­tax basis.
39,000 + 5,000
Pre­Tax Basis: = 14.8%
(310,000 + 285,000)/2
27,000 + 5,000 (1 - 12,000/39,000)
After­Tax Basis: = 10.2%
(310,000 + 285,000)/2

5. Return on Equity

ROE indicates the rate of return on the equity capital provided by the shareholders.
Net Income
Return on Equity =
Average Common Equity

In 2013, Fulton generated a ROE of 13.7%.

27,000
2013: =13.7%
(210,000 + 185,000)/2

6. Earnings per Share

Earnings per share (EPS) is an important measure for assessing the profitability of a firm. The calculation
of EPS depends on the capital structure of the firm.
Net Income Available to Common Shareholders
Earnings Per Share =
Average Number of Common Shares Outstanding

The EPS of Fulton at the end of 2013 was:

27,000
2013: = $0.27
(100,000 + 100,000)/2

If the company issued any convertible bonds, share options or other instruments where there is an option
to purchase new shares, then there is a need to consider a 'worst case' scenario, and use the number of
shares that would be in existence if all the options were exercised. This is referred to as 'fully diluted'
earnings.

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3.3.7 Valuation Ratios

There are various equity valuation tools available to an investor, as shown in Figure 3.3.7 below.

Figure 3.3.7 – Equity Valuation Tools

In this section, relative valuation techniques will be discussed. Other valuation techniques such as
Discounted Cash Flow (also referred to as absolute valuation techniques) will be addressed in Chapter 7
(Equity Securities).

1. Price­Earnings Ratio

The price­earnings ratio (P/E ratio), also known as the earnings multiplier, is an indication of how much
the market is willing to pay per dollar of earnings. It is calculated as the ratio of the current market price
to the firm's earnings per share. Thus, if a share is selling for $5.00 and has earnings of $0.40 per share,
its P/E ratio is 12.5 times.
Market Price Per Share 5.00
P/E Ratio = = = 12.5x
Earnings Per Share 0.40

The earnings per share figure used by analysts is usually the forecast figure rather than the historical
figure, thus providing a prospective P/E ratio. Shares in growth companies would typically sell at high
multiples compared to the average share, because of their expected higher earnings growth.

The P/E ratio is a widely reported valuation ratio used in prospectuses of new share issues, brokerage
reports and newspapers covering share information.

2. Price­to­Book Value Ratio

Book value per share gives the asset value of each ordinary share based on the company's accounts. It is
calculated by dividing the shareholders' funds by the number of shares outstanding. The book value is one
of the most fundamental determinants of share prices. However, there are analysts who feel that it is
what the company earns that determines a share price. In certain industries, such as investment
companies, banks or insurance companies, book value is more important, as many of the assets of these
companies are in investments that can be turned into cash. Note, however, that this calculation is based
on book and not market values. Companies with conservative accounting policies therefore have
misleading book values and analysts often adjust their assets to market values for analysis purposes.

The price­to­book ratio (P/B ratio) compares the market price per share to the book value of the company:
Market Price Per Share
P/B Ratio =
Book Value Per Share

Most strong companies sell at premiums over book values whereas the weaker ones sell at discounts.
During periods when the stock market is weak, sound companies can trade at substantial discounts to the

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book value, providing investors with good bargains. Constant reinvestment of earnings usually adds to
the financial strength of a company through an increase in shareholders' funds, which increases its book
value.

3. Price­to­Cash Flow Ratio

The advantage of using this ratio compared to the PE ratio is that earnings can be influenced by the
company’s accounting practices and possibly be subject to interpretation manipulation. Cash flows are
less subjective. This ratio uses either the free cash flow or the operating cash flow as the denominator.

4. Price­to­Sales Ratio

The advantage of using this ratio is similar to that in the Price­to­Cash Flow ratio i.e. the denominator in
this case, sales volume, is less subjective than earnings. Also, supporters of the use of this ratio cite that
sales are indispensable for growth of the company and its earnings. Without sustainable sales growth,
earnings are unlikely to grow. This ratio may also be useful for start­up companies who do not have any
earnings yet.

3.3.8 Quality of Financial Statements

Analysts sometimes refer to the “quality of a company’s earnings” or the quality of its balance sheet. This
typically is a reference to the reliability of the financial statements. A quality financial statement should
reflect the economic and financial reality of the company’s financial health and prospects, and not reliant
on biased or self­serving accounting treatment and interpretations that make the company appears more
profitable and attractive as an investment than it actually is.

Signs of a strong balance sheet or high quality financial statements are:

1. Limited use of debt or leverage, as this reduces or minimizes the financial risk from excessive
borrowing. A low debt also implies that the company has sufficient credit limits to draw from if that
is needed.
2. Assets that are generally carried below market values i.e. underpriced. Companies that have
intangible assets1 such as patents, goodwill, trademarks or valuable proprietary research may
undervalue these assets. On the other hand, a company that uses obsolete or inferior technology is
in fact over­pricing these assets because their true market values will be below original costs. A bank
with an overly optimistic view of its credit quality will result in an understated volume of non­
performing loans.
3. Conservative revenue recognition policies and principles, that do not change just to reflect higher
sales, as well as conservative accounting of unrealized income by deferring its recognition until the
income is realized in cash and generally adequate provisioning for losses and expenses.
4. Realistic recognition of bad debts or trade receivables. A rising average collection period usually
means that bad debts may increase in the future.
5. Absence of off­balance sheet activities. When liabilities have been arranged off­balance sheet, such
as in operating leases, it is important to account for these when estimating the true financial position
of the company. Airlines typically rely extensively on leasing their aircrafts, and have significant off­
balance sheet liabilities from these leases.

1
In December 2012, a Muddy Waters’ report on Olam’s treatment of impairment of its intangible assets caused Olam’s stock
price to fall by more than 30%.

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Quality of Earnings ­ A company with good quality of earnings has earnings that are realistic, sustainable
and repeatable. Table 3.3.8.1 illustrates further various accounting “practices” that impact the quality of
a firm’s quality of financial statements and earnings.

Table 3.3.8.1 – Practices that Impact the Quality of Financial Statements

Category Observation / Examples

Revenues  Fictitious revenue / customers

(overstated, or
 Repeated recognition of the same goods / services produced / sold
aggressive
revenue  Booking of prepayments as current revenue
recognition)
 Booking of the full revenue when only a deposit is provided
 Booking revenues prior to customer acceptance
 Classifying non­operating gains as operating income
 Aggressive recognition of consignment sales with recourse

Expenses  Wrongly capitalizing expenses

(understated, or
 Lengthening the period of depreciation
liberal treatment
of expense  Low provision for bad debts or other potential liabilities
recognition)
 Usage of other accounting assumptions or treatments to recognize lower
expenses

Balance Sheet  Use of off­balance sheet financing and other transactions, especially to hide
liabilities

Operating Cash  Operating earnings are not synchronized with operating cash flow
Flow
 Increase in capital expenditure in previous years not yielding increase in
operating cash flow in future years
 Treating bank overdraft increase as operating cash flow

3.3.9 Comparative and Trend Analysis

Financial ratios, if used in isolation, can be quite meaningless. For example, an asset turnover of four times
may be normal for some firms but unhealthy for others. It would be more meaningful if the results can be
compared with other companies in the same industry.

Besides comparing with industry averages, trend analysis, which involves studying the past performance
record of the company, can provide valuable insights into the financial health of the company. A company
that shows a rising earnings trend would be considered to be more attractive than one that is showing a
falling earnings trend.

Economic, industry and business cycles affect the performance of all companies. To have a good
understanding of the companies’ performance, it is necessary to cover at least one cycle, and to track the
overall performance over a cycle. Otherwise the analysis could be misleading and indicate that the
company is doing well, when actually it is at the crest of a cycle that is just about to turn down.

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Most companies publish a 5­Year Financial Summary as part of their annual reporting. In the sample
below, the Group 5­Year Financial Summary of Singapore Telecommunications Limited (Singtel) is
presented. Although not shown, key financial ratios such as earnings per share, net asset value and the
dividend payout, also form part of the 5­Year summary.

Figure 3.3.9 – Sample of Singtel’s 5­Year Financial Summary

Source: info.singtel.com/annual report/2013

3.3.10 Limitations of Ratio Analysis

Ratio analysis has limitations, and while not invalidating the use of the technique, one must keep this in
mind when using them to analyse companies. Some of the limitations are:
1. Each company may have different accounting policies, and adjustments are required to make the
figures comparable;
2. Consolidated accounts are used for groups of companies. It is often difficult to determine the
performance of one company within the group;
3. The figures stated in the accounts may not represent the rest of the year, e.g. year­end stocks may be
drawn down to abnormally low levels to reflect a strong financial position or window dressing;
4. The analyst should be alert to special situations that may depress profitability, such as research and
development costs on new products;
5. When doing trend analysis, it is important to note the possible effects of inflation and general
economic conditions that are cyclical;
6. It is important to read the footnotes of financial statements, as these contain additional information
on the company’s financial situation; and
7. When doing company comparisons, the companies used should be similar in terms of industry sector
and size.

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3.4 Summary

1. There are several approaches to investment analysis ­ fundamental analysis, technical analysis and
quantitative analysis.

2. The objective of fundamental analysis is to determine the intrinsic value of a security. Fundamental
analysis is a three­step investment process that begins with economic analysis, followed by industry
analysis, and finally with individual company and equity share analysis. Country Analysis is also
required for investing in international markets.

3. The three major financial statements are:

 The balance sheet, which shows the financial condition of a company at a point in time;
 The income statement, which is a summary of the revenue and expenses of a firm during some
period of time; and
 The statement of changes in cash flow, which shows the changes in the firm’s cash position from
one year to another.

4. Financial ratios can be grouped into the four categories:

 Liquidity ratios, which include the current ratio, quick ratio and cash ratio are liquidity ratios that
measure the ability of the firm to meet future short­term financial obligations.
 Leverage ratios, which indicate the firm’s dependency on external sources of financing and the
earnings available to pay fixed financial charges. Measures of leverage include debt­equity ratio,
debt­to­total assets ratio, interest coverage ratio and fixed charge coverage ratio.
 Operating efficiency ratios, which measure how efficient the management uses its assets and
capital to generate sales; and
 Profitability ratios, which analyse profitability in relation to sales (e.g. gross margin, operating profit
margin and net profit margin) or in relation to capital (e.g. ROE and ROA).

5. Valuation ratios such as Price/Earnings ratio, Price/Book Value ratio, Price/Cash Flow ratio and
Price/Sales ratio are relative valuation techniques that compare the value of one stock against
another in regard to how the market values the stock compared to the firm’s own numbers such as
earnings, book value, cash flow and sales.

6. The quality of a firm’s financial statements and earnings depend on good accounting practices,
conservative revenue recognition principles, limited reliance on external debt, understating rather
than overstating asset values and including all financial risks (including off­balance sheet items).

7. The analysis of the financial statements of a company should always be carried out not just using one
year’s data, but with data over say 5 years, so that trends which are more important than one
snapshot picture at a specific point in time, can be identified.

8. Financial ratios should be analysed relative to the industry, the firm's competitors and the firm's
historical ratios.

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 Chapter 4 – Investment Analysis - Macroeconomic Analysis| 36�

Chapter 4:
Investment Analysis - Macroeconomic
Analysis

Learning Objectives

The candidate should be able to:

Economic Analysis

� Describe economic analysis as part of the framework of fundamental analysis

� Explain Gross Domestic Product as an indicator of economic performance

� Describe the relationship between economics and the financial markets

� Explain the three main classes of economic indicators - leading, coincident and lagging indicators

� Follow the economic calendar releases, and interpret the data that are released

� Analyze the influence of the economy on stock and bond prices in regard to money supply,
inflation, interest rates, fiscal policy and political factors
Industry Analysis

� Explain the importance of industry analysis

Discuss the concept of the industry life cycle and its relevance in industry selection

� Describe Michael Porter’s five competitive forces and how these sustain profitability and above-
average returns on invested capital

� Explain the business cycle and its implication for investors

4.1 Economic Analysis

The current state of the economy and the expectations for its future performance have direct and
significant effects on all types of financial markets, whether equities, fixed income, derivatives, or
commodities. Bull markets are invariably accompanied by general economic growth, while bear markets
are associated with economic stagnation or recession. Because of the close link between the economy
and financial markets, it is important for investors to have a good understanding of macroeconomic
factors and concepts, such as gross domestic product (GDP) growth, inflation, interest rates, and
monetary and fiscal policies.

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4.1.1 Economic Activity and Financial Markets

Economic activity influences financial markets through the expected level of earnings and dividends, and
the quality of such earnings and dividends relative to other securities. Economic activity can be measured
in terms of specific economic data, where the development of such data, will result in gains or losses from
investments in the financial markets. In addition to economic data, one has to evaluate other information
such as management capability, product quality and industry growth trends.

Investors today look for returns globally in developed, emerging and frontier markets. It has become
necessary to evaluate the global economic scenario for comparative returns and not just the domestic
economy.

4.1.2 Gross Domestic Product (GDP) as a Measure of Economic Performance

The GDP is the most widely used measure of economic performance. It measures the market value of
goods and services produced in the domestic economy during a specific time period, usually one year.

To determine the GDP, four basic components need to be considered, namely:

i.� Consumption expenditures of individuals on goods and services;
ii.� Private investments in capital goods, which consist of capital expenditures for replacement of
equipment and for expansion in the supply of capital assets;
iii.� Government spending that includes both investment and consumption services. Education, defense,
infrastructure development and health services are included in the government component; and
iv.� Net exports i.e. total exports less total imports. Net exports may be either positive or negative. When
the country sells more to foreigners than they buy, net exports will be positive.

The direction in which these components move can give some insight into the direction of the economy
as well as the industries that make up the economy.

4.1.3 Economic Activity and Security Markets

1.� The Business Cycle

The business cycle reflects the up-and-down movements in the general level of economic activity. While
no single business cycle is identical, it does have a common framework. There is a business peak, a
contraction phase, a recessionary trough followed by an expansionary phase.

Figure 4.1.3.1 – The Business Cycle

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Because of the strong relationship between the stock market and the overall economy, it is generally
believed that an ability to accurately predict the turning points in the business cycle will enhance one's
ability to forecast major turning points in stock prices.

There is an interesting relationship between the economy and the stock market. Stock market peaks and
troughs have typically preceded turning points of general business activity. In other words, stock prices
tend to turn before the economy. One explanation is that investors have good foresight about business
prospects and discount future earnings in anticipation of either strong or weak economic growth. Another
theory is that stock price reversals help to cause subsequent economic reversals by affecting consumer
and business confidence and spending decisions.

2.� The Economic Calendar

The table below shows the Singapore 2014 economic calendar. Similar calendars for countries in the
developed, emerging and frontier markets are published by various organizations. Investors need to
monitor releases of new economic data to evaluate the impact of such data on the financial markets.

Table 4.1.3.2 – Singapore Economic Calendar

Source: http://www.tradingeconomics.com/singapore/calendar

4.1.4 Economic Indicators

Economic indicators are commonly used to give warnings of changes in economic activity. Three types of
economic indicators are commonly used - leading indicators, coincident indicators and lagging indicators.

Leading indicators usually reach peaks or troughs before corresponding peaks or troughs in aggregate
economic activity.

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Composite leading indices (CLI) have been compiled by organizations such as the Organization for
Economic Co-operation and Development (OECD), to forecast growth and contraction in an economy. The
CLI is a predictive tool to gauge if or when an expansion or recession will happen. It serves as a useful
advanced warning tool for policymakers and investors in financial markets.

The Singapore CLI is an aggregation of 9 economic indicators that shows a leading relationship with the
growth cycles of the Singapore economy. The CLI components or indicators have been selected based on
certain key criteria such as leading cyclical properties, economic significance, timeliness, periodicity and
quality of the data.

Singapore’s Composite Leading Indicators (published by Singapore Department of Statistics) are:

•� Total New Companies Formed
•� Money Supply (M2)
•� Stock Exchange of Singapore Indices
•� Business Expectations for Wholesale Trade
•� Business Expectations for Stock of Finished Goods (Manufacturing)
•� US Purchasing Managers’ Index (Manufacturing)
•� Total Non-Oil Seaborne Cargo Handled
•� Domestic Liquidity Indicator
•� Total Non-Oil Retained Imports

As GDP is an important economic indicator that policymakers and economists focus on, it is helpful to
assess the lead of the CLI with respect to GDP. The CLI is a good short-term indicator of turning points in
the economy, but it does not tell investors anything about the magnitude of these shifts.

Coincident indicators have peaks and troughs that roughly coincide with the peaks and troughs in the
business cycle. These include the Index of Industrial Production and Total Employment.

Singapore’s growth chronology is based on the growth cycles identified from the Composite Coincident
Index (CCI). The CCI is an aggregation of economic indicators that show coincident relationships with the
growth cycles of the economy.

Singapore’s Composite Coincident Indicators, as published by Singapore Department of Statistics, are:

•� Gross Domestic Product (GDP) at Constant Prices
•� Index of Industrial Production
•� Non-Oil Domestic Exports at Constant Prices
•� Total Employment
•� Retail Sales Index at Constant Prices, excluding motor vehicles

A third category, the lagging indicators, experience their peaks and troughs after those of the aggregate
economy.

The Conference Board1 Lagging Indicators are:

•� Average Duration of Employment
•� Inventory to Sales Ratio, Manufacturing and Trade
•� Labour Cost per Unit of Output, Manufacturing
• Average Prime Rate
•� Commercial and Industrial Loans

�������������������������������������������������
1The Conference Board is an objective, independent source of economic and business knowledge with one agenda: to help
member companies understand and deal with the most critical issues of today. (www.conference-board.org)

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•� Consumer Installment Credit to Personal Income Ratio

•� Consumer Price Index for Services

In addition to these, market observers also use other economic indicators to assess their impact on the
financial markets. In Singapore, these include the following, other than the GDP:
1.� Unemployment Rate – This is indicative of the health of the economy. Usually a high unemployment
rate suggests that the economy is not growing enough for new jobs to be created.
2.� Consumer Price Index – This measures the price level of goods and services purchased by households.
It is usually cited as an indicator of inflation.
3.� Foreign Exchange Reserves – A country with positive balance of payments from year to year, whether
this comes from the trade account (exports exceed imports) or the capital account (capital inflows
exceed capital outflows), will accumulate more foreign exchange reserves. In countries with severe
balance of payments deficits, the foreign exchange reserves are used as a measure of the number of
months of imports equivalent by that country.
4.� Trade Account – This measures the difference between exports and imports of goods and services. A
country with a widening of its trade account can become the target of speculative attack because this
deficit makes the country a “debtor nation”. In the second half of 2013, both the Indian Rupee and
the Indonesian Rupiah came under attack and were significantly depreciated because of the widening
deficits in their trade accounts.
5. Manufacturing Purchasing Managers Index (PMI) – This is a key indicator of the expansion or
contraction of the manufacturing sector and is closely watched by investors who have exposures to
the industrial sector of the economy.

4.1.5 Money Supply and Financial Markets

Studies on the monetary history in the United States have shown that declines in the rate of growth of
money supply have preceded business contractions, while increases in the growth rate of the money
supply have preceded economic expansions. An important facet of monetary policy is the rate at which
the Federal Reserve allows the money supply to grow.

To implement planned changes in monetary policy, the Federal Reserve engages in open market
operations, and the buying or selling of Treasury bonds to adjust bank reserves and, eventually, the money
supply. Liquidity is created when the Federal Reserve buys bonds. Conversely, liquidity is tightened when
the Federal Reserve sells bonds. This change in liquidity will affect bond prices first, and then common
stocks and finally the economy. This liquidity transmission scenario implies that the initial effect of a
change in monetary policy appears in financial markets (bonds and stocks) and only later in the aggregate
economy.

The financial crisis of 2008 resulted in the greatest recession since the US Great Depression of the 1930s.
To stimulate consumption, employment and growth, the US as well as the UK and other European
countries, embarked on various Quantitative Easing (QE) programmes, resulting in very low interest rates.
QE was initiated by the Federal Reserve to stimulate the US economy after it went through a major
recession following the global financial crisis of 2008. The Federal Reserve openly tied the QE to lowering
the level of unemployment, and announced during the QE programme that the easing will continue until
US unemployment falls below 7%. The negative impact of an extended easing is the fear of inflation,
although it is interesting to note that the International Monetary Fund has sounded a warning that
inflation is too low in Europe, leading to the risk of deflation as price levels continue to fall and growth
grinds to a halt.

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Money supply can also increase from credit creation as seen in Table 4.1.5 below. A bank takes in a new
deposit and lends out 90% of this, keeping 10% as statutory reserves. This process makes its rounds
through other banks in the system, leading to a 10-fold increase in money supply.

Table 4.1.5 – Increasing Money Supply from Credit Creation

Bank’s Position New Deposit New Investments New Reserves

Original Amount 10,000 9,000 1,000
2nd round 9,000 8,100 900
3rd round 8,100 7,290 810
4th round 7,290 6,561 729
After all rounds 100,000 90,000 10,000

Money supply can also come from external sources for the following reasons:
1.� Funds seeking higher yields (carry trade transactions that seek to earn the interest differential
between a low interest currency, e.g. US Dollars and a higher interest rate currency e.g. Indonesian
Rupiah). This is sometimes referred to as “hot money”;
2.� Funds seeking higher stock market returns in emerging markets and sometimes frontier markets; or
3.� Funds seeking higher quality of credit, also referred to as “flight to quality”. This happened in the 3 rd
quarter of 2013, when Asian markets were trounced because of the announcement of the QE taper,
which led to funds flowing out of Asia back to the US and Europe.

Hot money typically drives up financial asset prices (e.g. the Indonesian stock market before the Rupiah
started to weaken from a widening trade account and the QE taper) and will be attracted to markets with
positive economic fundamentals and accommodative monetary policies.

On the other hand, if the market perceives that money supply growth will lead to higher inflation, stock
prices will react negatively due to inflationary fears. Also, whether monetary policy actually affects stock
prices depends on whether the market has anticipated it (in which case there will be no effect). Some
studies have shown that stock prices move before changes in the money supply, suggesting that stock
prices reflect anticipated changes in the money supply before the changes actually come about.
Therefore, the investor may enjoy superior returns if he is able to forecast unanticipated changes in
money supply growth.

Unlike most countries (e.g. United States and Germany), Singapore does not have independent policy
targets for interest rates and money supply. Because of its open economy, Singapore’s monetary regime
centers around the management of its exchange rate, because this can have a major influence on local
inflation and the country’s international competitiveness. Money supply, on the other hand, is basically
endogenous and will only have limited impact on economic activity. It is not possible to set independent
policy targets for both exchange rates and interest rates, as one determines the other.

Quantity Theory of Money

The following formula, known as Fisher’s "exchange of equation", shows the relationship between money
supply and price levels:
M X V = P X Q
where:
M = Stock of money (currency outside banks plus demand deposits)
V = Velocity of money circulation (number of times per period that an average unit of money changes
hands/accounts)

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P = General price level or a price index

Q = The number of transactions made in an economy during a year

The significance of this equation is that when it is fully operative, the central bank will not be able to
increase output by increasing money supply, because as M increases, the price level, P, will increase (more
money chasing goods, causing inflation), and the velocity of money, V (which is socially determined i.e.
decided by consumers) will then determine the output, Q.

4.1.6 Inflation, Interest Rates and Financial Markets

Inflation and Interest Rates. There is a strong relationship between inflation and interest rates. When
investors expect an increase in the rate of inflation, they would increase their required rates of return by
a similar amount in order to derive constant real rates of return. The cost of borrowing will increase with
rising inflation.

Interest Rates and Bond Prices. There is an inverse relationship between interest rates and bond prices.
If interest rates rise, the higher discount rate used to discount the future cash flows will result in a lower
intrinsic bond value. To understand this relationship, consider an investor deciding on a good time to buy
bonds. Since interest rate inflection points have more or less coincided with business cycle peaks, the
best time to buy bonds is when the peak of the business cycle is reached, not before. Bond prices under
this scenario are at their lowest point, when interest rates are at their highest. The best time to sell bonds
is when a new economic advance begins following a recession. At such times, bond prices are usually at
their highest, while interest rates are at the lowest.

Interest Rates and Stock Prices. The relationship between interest rates and stock prices is more complex.
The cash flows from stocks can change along with interest rates, and the change in cash flows can either
offset or augment the change in interest rates.

Consider the following scenarios:

•� Positive scenario – Interest rates rise due to an increase in the rate of inflation, and likewise,
corporate earnings increase because firms are able to pass on the cost increases to consumers in the
form of higher prices. In this case, stock prices may remain fairly stable, because the required rate of
return (k) is completely offset by the growth rate in earnings (g).
•� Slightly negative scenario – Interest rates rise but there is little change in expected cash flows
because firms are unable to increase prices to match higher costs. This will result in a fall in stock
prices, as k increases but g remains constant.
•� Very negative scenario – Interest rates rise while cash flows decline because the rise in interest rates
result in a fall in sales revenue and earnings. Stock prices will decline significantly because k will
increase as g declines, causing a large increase in the k-g spread.

The effect of interest rate changes on stock prices will thus depend on the effect of interest rates on the
cash flows of the companies. Therefore, although an inverse relationship has generally been held between
inflation, interest rates and the returns on stocks, this inverse relationship does not always hold true. In
addition, even when it is true for the overall market, certain industries or segments of the economy may
have earnings and dividends that react positively to inflation and interest rate changes. In such an
instance, their stock prices would be positively correlated with inflation and interest rates.

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4.1.7 Fiscal Policy

Fiscal policy refers to the use of government taxation and expenditure policies to influence aggregate
demand and supply. The government withdraws money from the economy as a whole through taxation,
and injects it back through government spending. Fiscal policy initiatives, such as tax cuts, can encourage
spending, whereas additional taxes on cigarettes and liquor can discourage spending. Increases or
decreases in government spending on education, health and infrastructure development, influence the
general economy. These policies affect the business environment, especially firms that rely directly on
such expenditures.

Government spending also has a strong multiplier effect. For example, an increase in road building
increases the demand for earthmoving equipment and concrete materials. As a result, in addition to the
construction workers, the employees in those industries that supply the equipment and materials have
more to spend on consumer goods, and this raises the demand for consumer goods, which in turn benefits
another set of suppliers.

A budget surplus exists when government revenues from taxes and fees exceed government spending.
When total government spending exceeds total revenue from taxes and fees, there will be a budget
deficit. Budget deficits may be financed from surpluses accumulated during prior years. Alternatively, the
government may borrow either domestically or overseas through the issue of bonds. A budget deficit
could be short-term or long-term in nature. If it is expected to be temporary, the impact on the market
is likely to be muted or short-lived. However, if the deficit is expected to grow indefinitely, it can have
serious negative consequences. The cost of borrowing is likely to go up as investors will demand higher
interest rates to compensate for the higher risks involved. This will cause bond yields to rise.

4.1.8 Political Analysis (also known as Country Risk)

Besides monetary and fiscal policy actions, events such as wars and political upheavals in foreign countries
produce changes in the business environment that add to the uncertainty of sales and earnings
expectations and, therefore, the risk premium required by investors. The reunification of East and West
Germany was viewed as a very positive event, and led to a significant increase in economic activity across
Europe. However, the Arab Spring in Syria, the attempts in Thailand to oust the Prime Minister, or the
Russian annexation of Crimea in Ukraine, have all been disastrous events for these various economies, in
spite of the wealth in natural resources in the cases of Syria and Thailand.

When analyzing the domestic political environment, investors should be aware of political developments
such as elections, changes in political leadership, dissent in a particular party and stated party policies and
guidelines.

In the global financial crisis of 2008, several countries almost went into default. Portugal, Ireland, Greece
and Spain took a significant amount of time to recover from their economic failures, which necessitated
bailouts from the International Monetary Fund. These countries had over-borrowed and when their
economies slowed down and real prices collapsed, they became unable to service the interest on their
borrowings and principal repayments.

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4.2 Industry Analysis

4.2.1 What is Industry Analysis?

Industry analysis is as important as economic analysis when making investment decisions. Just as it is
difficult for a company to perform well in a difficult economy, it is unlikely that a firm in a troubled industry
will do well. An investor therefore has to consider the prospects of the industry for each stock.

In this section, three approaches to industry analysis will be considered. First, the industry life cycle, and
the potential risk and return at each stage of the cycle, is examined. Next, Michael Porter's five
competitive forces, which determine the profitability of an industry, are discussed. Lastly, business cycle
analysis, which explains the performance of companies in relation to the economy, is explained.

4.2.2 Importance of Industry Analysis

Industry analysis is important for the following reasons:

i.� The rates of return among different industries vary widely during a given time period because of the
different mix of products and services, and different business cycle sensitivities to the economic and
market environment;
ii.� Industries display different rates of return over time. In other words, an investor cannot simply
extrapolate past industry performance into the future; and
iii. During any time period, the risk levels of different industries vary widely which means that a continual
analysis of the risk factors for alternative industries is required.

4.2.3 Industry Classification

For analytical purposes, there is a need to classify industries. Industries are normally classified according
to their principal business. However, when companies are diversified in their lines of business, it is not
easy to place them in a specific industry. SGX uses the Industry Classification Benchmark 2, which has 10
industry classifications that are further divided into various sub-classifications according to their
definitions.

The 10 industries are:

1.� Oil & Gas
2.� Basic Materials
3.� Industrials
4.� Consumer Goods
5.� Health Care
6.� Consumer Services
7.� Telecommunications
8.� Utilities
9.� Financials
10.�Technology

As at 31 December 31 2013, the 10 industries are split into 10 super sectors which make up the Straits
Times Index (STI), representing the top 30 companies by market capitalisation:
�������������������������������������������������
2 The Industry Classification Benchmarks, or ICB, are published by the FTSE Group. FTSE is owned by the London Stock Exchange.

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Table 4.2.3 – Singapore Straits Times Index as at December 31, 2013

�
Company Index Weight Supersector
Keppel 5.96 Oil & Gas
SembCorp Industries 1.83 Oil & Gas
SembCorp Marine 1.38 Oil & Gas
Hutchison Port Holdings Trust 1.61 Industrial Goods & Services
Jardine Matheson Holdings 5.89 Industrial Goods & Services
Jardine Strategic Holdings 3.39 Industrial Goods & Services
Noble Group 1.53 Industrial Goods & Services
SIA Engineering 0.42 Industrial Goods & Services
Singapore Technologies Engineering 2.30 Industrial Goods & Services
Golden Agri-Resources 1.31 Food & Beverage
Olam International 0.81 Food & Beverage
Thai Beverage 1.98 Food & Beverage
Wilmar International Limited 2.69 Food & Beverage
Jardine Cycle & Carriage 1.34 Retail
Singapore Press Holdings 2.45 Media
ComfortDelGro 1.51 Travel & Leisure
Genting Singapore 3.40 Travel & Leisure
Singapore Airlines 1.96 Travel & Leisure
Singapore Telecom 10.01 Telecommunications
StarHub 0.93 Telecommunications
DBS Group Holdings 11.10 Banks
Oversea-Chinese Banking 10.33 Banks
United Overseas Bank 9.29 Banks
Capitaland 2.87 Real Estate
CapitaMall Trust 1.85 Real Estate
CapitaMalls Asia 1.00 Real Estate
City Developments 2.12 Real Estate
Global Logistic Properties 3.24 Real Estate
Hongkong Land Holdings 3.28 Real Estate
Singapore Exchange 2.23 Financial Services
Total 100.00

4.2.4 Industry Life Cycle

A useful framework for analysing industry trends is the concept of the industry life cycle. The purpose is
to evaluate the general health and current stage of the industry.

Over time, the development of an industry can be divided into five stages:
•� Early development
•� Rapid expansion
•� Mature growth
•� Stabilisation and market maturity
•� Deceleration of growth and decline

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Figure 4.2.4 shows the growth path of sales during each stage of the life cycle. Besides sales estimates,
the analysis of an industry’s life cycle can also provide some insights into profit margins and earnings
growth.

Figure 4.2.4 – Industry Life Cycle

i.� Early development. This is also referred to as the pioneering or start-up stage. It is often characterized
by a new technology or a new product, for example, desktop computers in the 1980s, and the new
generation of 5G phones today. Microsoft’s Android phones are battling Apple’s iPhone for market
dominance. During this stage, sales growth tends to be modest and profit margins are either very
small or negative. The demand for the industry's product or service is low and companies incur high
start-up costs.

A large number of start-up firms may be attracted to the new industry but few survive this stage as
competitive pressures build up and losses are incurred due to high start-up costs and low levels of
initial sales. Investors’ risk in an unproven company is high but so are expected returns if the company
succeeds. At this stage, it may be difficult to identify who are the likely "winners", but once identified
correctly, the rewards can be very high.

ii.� Rapid accelerating growth. In the second stage of the life cycle, as awareness of the product or
service grows, a market develops and demand picks up significantly. The industry expands its capacity
to meet rising demand. The limited number of firms who had survived the early development stage,
will face less competition and individual firms can experience substantial backlogs.

Rising sales growth, coupled with greater efficiency, result in accelerating growth in profits. During
this phase, profits can more than double from the low earnings base. The profit margins are also very
high.

An example of this stage of industry life cycle are industrial robotics in China, where only 20% of the
industries use any form of industrial robots currently. As such, the growth potential has been
described as phenomenal.

iii.� Mature growth. After the explosive growth in the previous stage, the industry enters the mature
growth stage. Demand for the industry product or service is largely satisfied. Sales growth stays above
average, but it no longer accelerates. For example, if the overall economy is growing at 8%, sales for
the industry may grow at a steady annual rate of 15-20%. Attracted by the rapid growth of sales and

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high historic profit margins, competition is likely to increase, resulting in profit margins declining to
normal levels.

The online auction industry in the US is at this stage. The first online auctions took place in the 1980s
but this did not take off until the mid-1990s when Yahoo, eBay, Onsale and others entered the market,
but it was not till the shakeout during the late 1990s, and the early 2000s, that buyers and sellers
started to coalesce around eBay.

iv.� Stabilisation and market maturity. Probably the longest phase of the life cycle, the industry growth
rate tends to be in line with the growth rate of the overall economy. Profit growth of individual
companies may vary depending on the ability of management to control costs. Products become more
standardised and less innovative. The market place is full of competitors, resulting in tight profit
margins and rates of return on capital eventually become equal to or slightly below the competitive
level.

v.� Deceleration of growth and decline. In the last phase of the life cycle, the industry's sales growth
declines because of shifts in demand or emergence of substitutes. The growth of the industry is unable
to keep pace with the economic growth. Profit margins continue to be squeezed, and some firms
experience low profits or even losses. Firms that remain profitable may show very low rates of return
on capital and investors begin thinking about alternative uses for the capital tied up in this industry.

An example of an industry that is at a decline stage is the record industry selling audio CDs or tapes.
With the advent of the internet and YouTube, sales in the traditional music record industry has almost
come to a halt, replaced by the likes of iTunes store and other on-line sales distributors.

An understanding of the growth pattern of an industry and of the various stages of growth helps investors
to assess the growth potential of different companies in an industry. According to investment principles,
the investor should select industries that are in the rapid accelerating growth stage or mature growth
stage of the industry cycle. More aggressive investors may consider industries in the early stage, which
offer the highest potential returns but also the greatest risk. Industries that are in the stagnation or
declining stage should be avoided. Comparing the sales of an industry to the activity in the economy
should help investors identify the industry's stage within the industry life cycle.

4.2.5 Competitive Forces and Industry Structure

Another framework for sector/industry analysis is the model proposed by Michael Porter, who believed
that the competitive environment of an industry, and the intensity of competition among the firms in that
industry, determine the firm’s ability to sustain above-average rates of return on invested capital.

According to Porter, there are 5 basic competitive forces that determine the industry profitability:
•� Rivalry among existing competitors
• Threat of new entrants
•� Threat of substitute products
•� Bargaining power of buyers
•� Bargaining power of suppliers

In industries where the 5 forces are favourable, many companies earn attractive returns. In industries
where pressure from one or more of the forces is intense, it is harder to command good returns despite
management efforts.

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i.� Rivalry among the existing competitors. The intensity of rivalry influences prices as well as the costs
of competing in areas such as plant, product development, advertising, and sales force. Rivalry is more
intense when there are many firms of relatively equal size competing in the industry. Both local and
foreign competitors must be considered in determining the number and size of competitors. Slow
growth causes competitors to fight for market share. The desire to sell at full capacity to cover high
fixed costs results in price cutting and greater competition in some industries. Exit barriers, such as
specialized facilities or labour agreements, can keep firms in the industry despite below-average or
negative rates of return.

ii.� Threat of new entrants. The threat of entry places a limit on prices and shapes the investment
required to deter entrants. Although the number of existing competitors in the industry may be few,
one must assess the possibility of new entrants and increasing competition. High barriers to entry
include low current prices relative to costs, large capital requirements, substantial economies of scale
or the need for extensive distribution channels to compete. Similarly, high costs of switching products
or brands, such as those required to change a computer or telephone system, keep competition low.
In addition, government policy can limit the number of competitors by imposing licensing
requirements or limiting access to materials. Without some of these barriers, it might be very easy for
competitors to enter an industry, increasing the competition and driving down potential rates of
return.

iii.� Threat of substitute products. Substitute products limit the profit potential of an industry because
they limit the prices that firms can charge. Although almost everything has a substitute, one must
determine how close the substitute is in price and function to the product in the industry. As an
example, the threat of substitute glass containers adversely affected the metal container industry.
Glass containers kept declining in price, forcing metal container prices and profits down.

iv.� Bargaining power of buyers. Buyers can influence the profitability of an industry because they can
bid down prices or demand higher quality or more services by bargaining among competitors. Buyers
become powerful when they purchase large volumes relative to the sales of a supplier. The most
vulnerable firm is a one-customer firm that supplies a single large manufacturer, as is common for
auto parts manufacturers or software developers. Buyers will be more conscious of the costs of items
that represent a significant percentage of the firm's total costs, or if the buying firm is feeling cost
pressures from its own customers. Also, buyers who know a lot about the costs of supplying an
industry will bargain more intensely; for example, when the buying firm supplies some of its own
needs and also buys from other suppliers.

v.� Bargaining power of suppliers. Suppliers can alter future industry returns if they increase prices or
reduce the quality or services they provide. Suppliers are more powerful if there are fewer of them,
and if they supply critical inputs to industries, for which few if any substitutes exist. This becomes
essentially a sellers’ market, in which a few sellers have the market power to dictate their terms of
sales and service to the buyers. When analysing supplier bargaining power, it is important to consider
labour's power within each industry because powerful labour unions can upset even strong suppliers.

By examining these competitive forces, the intensity of competition and the long-run profit potential of
an industry can be determined. As the competitive structure of an industry is not constant, regular
updates of an industry's competitive environment is necessary.

4.2.6 Business Cycle Analysis

Another way to analyse industries is to look at their ability to operate in relation to the overall economy.
The earnings performances of some companies tend to move in line with business cycles, outperforming

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the industry when the economy is good and under-performing it when economic conditions are bad.
Some industries are able to cope with the recession reasonably well, while others perform badly during a
recession. Investors have to pay attention to these relationships.

Most investors usually seek growth industries, where earnings are expected to be significantly above the
average of all industries, and such growth may occur notwithstanding setbacks in the economy. Cell
phones have been a growth industry in the past, as have audio CDs and computers. But current and future
growth industries now include mobile devices game applications and music purchased via internet stores.
One of the primary goals of security analysis is to identify growth industries.

Least affected by recession and economic adversity are the defensive industries. The food and public
utilities industries are considered to be defensive. People must continue to eat regardless of the economy.
Even so, there are certain segments of the food industry that clearly fall into the growth category e.g. fast
food stores in China, and specialist coffee chains in Singapore.

The sales and earnings of cyclical industries are greatly affected by the business environment. Such
companies do exceptionally well during economic expansions and badly during economic contractions.
Durable goods are a good example of products in a cyclical industry. When times are good, demand for
durable goods such as cars and refrigerators will rise. During a recession, purchases of durable goods may
be postponed as consumers can often make do with existing old units.

Interest-sensitive industries are sensitive to expectations about changes in interest rates. The financial
services industry and the real estate industry are examples of interest-sensitive industries.

What are the implications of these classifications to investors?

To predict the performance of an industry, investors should carefully analyse the stage of the business
cycle and its likely responses to changes in the economy which may be as diverse as the balance of
payments, the trade account, inflation and unemployment, just to name a few. If the economy is heading
into a recession, cyclical industries are likely to be affected more than other industries, whereas defensive
industries are the least likely to be affected. The outcome of industry analysis will enable the investor to
select the industry that fits its risk and return requirements.

4.3 Summary

1.� Fundamental analysis aims to determine the intrinsic value of a security. Fundamental analysis is a
3-step investment process that begins with economic analysis, followed by industry analysis, and
finally with individual company and stock analysis. Country analysis is also required for investing in
international markets.

2.� Economic indicators are used to give early warnings of changes in economic activity. The three classes
of economic indicators are the leading indicators, the coincident indicators and the lagging indicators.

3.� Some studies indicated that stock prices move before changes in the money supply, suggesting that
stock prices reflect anticipated changes in the money supply before the changes actually come about.
Therefore, to enjoy superior returns, one must be able to forecast unanticipated changes in money
supply growth.

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4.� Economic indicators are used to give early warnings of changes in economic activity. There are 3
major types of economic indicators; the leading indicators, the coincident indicators and the lagging
indicators.

5.� Money supply can be influenced by the inflow of funds from external sources such as carry trade
transactions, flight to quality and the search for higher returns.

6.� There is a strong relationship between inflation and interest rates. When investors expect an increase
in the rate of inflation, they would increase their required rates of return by a similar amount in order
to derive constant real rates of return. This is why investors refer to the real rate of return, which is
the nominal interest rate less the rate of inflation.

7.� There is a negative relationship between interest rates and bond prices. The effect of interest rate
changes on stock prices depends on its effect on the cash flows of the companies.

8.� Fiscal policy refers to the use of government taxation and expenditure policies to impact on
aggregate demand and supply. A budget deficit exists when government spending exceeds total
revenue. Investors require higher interest rates if they perceive that the budget deficit will grow
indefinitely.

9.� Investors should be aware of political developments such as elections, changes in political leadership,
dissent in a particular party and stated party policies and guidelines.

10.� Industry analysis is important because of varying rates of return and risk levels among industries. The
earnings performances of industries are not constant and hence there is a need to be updated over
time.

11.� A useful framework for analysing industries is to examine where they are in the industry life cycle.
The development of an industry can be divided into five stages: early development, rapid expansion,
mature growth, stabilisation and decline.

12.� Another framework for industry analysis is to consider Porter's 5 competitive forces that determine
the intensity of competition within an industry, which in turn affects industry profitability. The five
competitive forces are rivalry among existing competitors, threat of new entrants, threat of
substitute products, bargaining power of buyers and bargaining power of suppliers.

13.� The business cycle of the industry should also be looked at, by evaluating the earnings performance
of companies in relation to the overall economy.

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Chapter 5:
Technical Analysis & Quantitative
Analysis

Learning Objectives

The candidate should be able to:

� Explain the philosophy and assumptions in the application of technical analysis to investment
decisions

� Discuss the challenges to technical analysis

� Describe the various technical indicators

� Distinguish between support and resistance levels

� Describe share price and volume analysis techniques

� Explain chart patterns such as head and shoulders, double tops and bottoms, consolidation
rectangles, triangles, flags and pennants, wedges and gaps in identifying price trends

� Explain Elliott Wave Theory as a technical analysis approach

� Describe the essentials of quantitative analysis

5.1 Overview

5.1.1 What is Technical Analysis?

Besides fundamental analysis, another approach to security evaluation is technical analysis. Though
controversial in nature, many traders employ some form of technical trading rules or indicators to make
investment decisions. In this chapter, the basic philosophy and assumptions underlying technical analysis,
its challenges and common technical indicators and chart patterns are examined. The Elliott Wave Theory,
a popular technical analysis approach based on sets of cycles and ratios movements, will also be
described. Finally, we will discuss quantitative analysis and how it is applied to the investment process.

5.1.2 Basic Philosophy and Assumptions

Technical analysis refers to the methodology of forecasting fluctuations in securities prices. This
methodology can be applied to individual securities, the entire market and in any asset class such as
foreign exchange, gold or bonds.

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Technical analysis uses charts, technical trading rules and indicators. It is sometimes called market or
internal analysis because it studies demand and supply conditions based on market data such as price
changes and trading volume. This differs from fundamental analysis, which focuses on external factors
such as economic variables that impact the industry or company.

Technical analysis believes that prices are determined by demand and supply, which is in turn affected by
both fundamental and non-fundamental factors such as macroeconomic forces, market sentiments and
speculative forces. Technical analysts therefore study past price and volume behavior to identify shifts in
supply and demand forces, from which they predict future price behaviour for individual securities or the
whole market. Technical analysts are not concerned about a security's fair value.

The assumptions underlying technical analysis are:

i.� A security’s market value is determined only by its supply and demand;
ii.� Supply and demand is affected by both rational and irrational factors. These factors include not only
economic variables employed by the fundamental analysts but also hopes, fears, opinions, moods
and guesses of numerous potential buyers and sellers. The market weighs all these factors
automatically and continually;
iii.� Prices of individual securities and the overall market move in trends, which tend to persist over an
appreciable length of time;
iv.� Trends develop in reaction to changes in the supply-demand balance. Such changes can be detected
in the action of the market itself; and
v.� Chart patterns tend to repeat themselves.

Generally, technicians and non-technicians accept assumptions (i) & (ii). Most would agree that, at any
point in time, the price of a security is determined by its supply and demand. Most would also agree that
supply and demand is governed by many variables. The only difference in opinion might concern the
influence of irrational factors - technicians expect irrational factors to persist while market analysts expect
only a temporary effect with rational beliefs prevailing in the long run. Certainly, everyone would agree
that the market continually weighs all these factors.

Opinions differ over assumption (iii) about the speed of adjustment of share prices to changes in supply
and demand. Technicians believe that new information affecting supply and demand enters the market
over a period of time rather than at one point in time, due to the fact that there are different sources of
information or because some investors have better or faster access to the information than others.
Therefore prices are expected to adjust gradually to reflect the gradual flow of information. Because the
speed of adjustment is gradual, prices are expected to move in trends that persist over long periods.

Assumption (iv) says that as prices move from one equilibrium value to a new equilibrium value, technical
analysts believe that this price change can be detected sooner or later in charts. Technical analysts hope
to benefit by being among the first to detect a shift in trend.

5.1.3 Challenges to Technical Analysis

The Efficient Market Hypothesis as discussed in Chapter 7 (Equity Securities) presents the greatest
challenge to technical analysis. Studies, which tested the weak-form efficient hypothesis, generally
support the notion that prices adjust rapidly to new information coming into the market. Because markets
discount all information very quickly, there is no way for technical analysts to take advantage of that
information.

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According to the random walk theory, share prices follow a random walk, which means each price moves
independently and randomly. Therefore, whether past price data can be used to predict future prices is
questionable.

Another criticism against technical analysis is that many technicians are familiar with chart patterns and
act on them at the same time. Thus, many chart patterns become self-fulfilling prophecies as waves of
buying or selling are created in response to buy or sell signals in the charts. For example, if a popular
technical analysis trading rule is followed by many market participants, some participants will act first,
causing prices to change quicker than expected, so that only those who act earliest will benefit. The
popularity and the resulting competition will eventually negate the value of the technical trading rule.

Chart reading can be a very subjective exercise. It is not unusual to have several interpretations of the
same chart pattern. Thus, there is always an element of doubt and disagreement in interpreting chart
patterns.

5.2 Technical Indicators

Technical analysts use many technical indicators to help them 'beat' the market. They are discussed
broadly under price-based indicators, which attempt to mine information from current and historical
market prices.

5.2.1 Price-based Indicators

1. Moving Average

A moving average is the average of the security’s closing price over a given period of time. The usefulness
of a moving average is in the inclusion of past prices to obtain the moving average. Typically, each day of
the moving average is given the same weighting. Hence in a 100-day moving average, each day is given a
weighting of 1. A more sophisticated moving average might give higher weightings to more recent prices
than older prices. The moving average is more stable than the daily price. If the current market price
starts to trend up or down from the moving average, this usually indicates a reversal in price changes.

2. Advance-Decline Line (Breadth Index)

Daily movements of an index can be misleading, because the index is based on the movement of selected
shares, which may not represent the overall market. The advance-decline (A/D) line, which is an index
that covers all securities traded, is designed to overcome this weakness. The A/D line measures, on a
cumulative daily basis, the net difference between the number of shares traded on the SGX, for example,
that have price advances and those that have price declines, in a particular period (usually a day or a
week). The net advance or decline is calculated by subtracting the number of declines from the number
of advances. The A/D line is drawn by plotting a running total of these numbers over time.

The A/D line is compared to an index such as the Straits Times Index (STI), and normally rises and falls in
line with the STI. If both are rising (declining), the market is said to be technically strong (weak). In a rising
market, any divergence between the index and A/D line is of concern because it means that most shares
are not participating in the rising market, and indicates a market peak. On the other hand, if the A/D line
is rising and the index is declining, it signals a reversal of the falling trend.

Other price-based technical indicators include Bollinger Bands, momentum oscillators and the Relative
Strength Index.

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5.3 Trends, Support and Resistance Levels

While charts are used to study the movements of the overall market and individual securities, trend lines
and trend channels are used to identify trends. An uptrend is represented by a rising trend line joining a
series of ascending lows while a downtrend is represented by a falling trend line connecting a series of
descending highs. Figure 5.3(a) illustrates both rising and falling trend lines.

Figure 5.3(a) – Trend lines

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wn
t re
nd
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�
nd
p tre
U

The trading range between the top and bottom trend lines is called the trend channel, which may be
rising, flat or declining. Figure 5.3(b) illustrates a rising trend channel. As long as share prices stay within
this rising channel, the technician would hold the share and ride with the trend.

Figure 5.3(b) – Rising Trend Channel

resistance�
channel�

support�

The support level is the price range where a substantial increase in demand is expected. At this level,
prices are relatively attractive for buyers who had missed the opportunity to buy earlier. As prices
increase, a resistance level develops when buyers refuse to pay higher prices. At the same time, sellers
may be attracted by higher prices to take profits on their share holdings. This supply of shares is called
“overhanging” the market.

A movement through and beyond either the support or resistance level is considered a breakout and
signals a strong confirmation and continuation of the primary trend. A breakout above the resistance level
is a bullish signal, and a breakout below the support level indicates further price declines. Besides
determining the trend, technical analysts are also alert to signs of reversals. A penetration below the
support line as illustrated in Figure 5.3(c) would be a sell signal as it indicates a reversal in the uptrend.

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Figure 5.3(c) – Trend Reversal

5.4 Significance of Volume

Besides monitoring price movements, technical analysis also monitors trading volume. Volume, defined
as the number of shares transacted, shows the intensity of excess demand or supply is at a particular point
in time, and reflects changes in investors' attitudes.

For example, if share prices advance on low volume, the enthusiasm implied from the price rise is not as
strong as when a price rise is accompanied by very high volume. Therefore, a price increase accompanied
by heavy volume relative to the share's normal trading volume is an indication of bullish activity. In a
sustained bull market, if prices "correct" downward on declining volume, this may mean a lull followed by
a continuation of the rally. On the other hand, a rally, which develops on contracting volume, could signal
a possible trend reversal. Similarly, a price decline with heavy volume is very bearish, because it reflects
a strong and widespread desire to sell the share. A slow rise in prices on heavy volume may be a bearish
sign as it may reflect excess supply over demand, which limits price appreciation.

5.5 Share Price and Volume Techniques

Three share price and volume techniques are discussed here, namely the Dow Theory, the Moving
Average Line and Relative Strength Index.

5.5.1 The Dow Theory

The Dow Theory, named after its creator Charles Dow, is the oldest and most popular method used to
identify long-term trends in the share market. The Dow Theory is based on the movements of the Dow
Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA).

The Dow Theory postulates 3 movements in the market: the primary movement, the secondary
movement, and the daily fluctuations. The primary movement is the market trend, which lasts from
several months to several years. The trend is either bullish (up) or bearish (down). Historically, bear
markets last for a shorter period of time than bull markets. The Dow Theory attempts to determine the
primary movement in the market.

The secondary movement of the market is shorter in duration than the primary movement, and opposite
in direction. The secondary movement usually lasts from several weeks to months, and usually retraces
one-third to two-thirds of the previous advance (decline) in a bull (bear).

Day-to-day fluctuations are considered random and have no forecasting value for long-term investors. In
Dow Theory, these are not considered to have any impact on long-term price trends.

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Figure 5.5.1(a) – Line Chart of Daily Closing Prices with Dow Theory Signals

Dow Theory forecasts are based upon the primary and secondary movements of the market. The purpose
of Dow Theory is to determine where the market is and where it is going, but not the magnitude of the
movements. In practice, Dow Theory states that if the swings of the market index is successively higher
and the successive lows are also higher, then the market trend is up and investors are in a bull market.
Conversely, if the successive highs and successive lows are lower, then the market direction is down and
investors are in a bear market.

Figure 5.5.1(b) shows how Dow Theory could be used. The trend from P 1 to P3 is bullish, because P2 is
higher than P1 and P3 is higher than P2, and also because L2 is higher than L1 and L3 is higher than L2.

Figure 5.5.1(b) – Upward Primary Trend

Figure 5.5.1(c) shows a primary downtrend. When the market trend changes, P 2 is lower than P1 and P3 is
lower than P2. Likewise L2 is lower than L1.

Figure 5.5.1(c) – Downward Primary Trend

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A new primary trend will only be confirmed when both the DJIA and DJTA give the same signals. When
the two averages diverge from each other, the Dow Theory assumes that the prior trend is maintained.

The main weaknesses of the Dow Theory are:

a.� It relies too heavily on the DJIA, which contains a narrow range of shares. DJIA shares are characterized
by old, large "blue chip" companies. Aggressive "high-tech" companies are under-represented in the
DJIA;
b.� It is slow in identifying a major trend and may miss an important price move or be "whiplashed" (i.e.
be caught by a short-term price reversal, although the long-term trend is intact but not yet visible);
c.� It uses the Transportation Average, which comprises mainly shares of railway companies, which no
longer have a major impact on the economy;
d.� It is designed to identify the major trend and hence is not very useful for trading the short trend;
e.� It is market-oriented and identifies the direction of the major trend, but does not help to identify
which shares to buy or sell; and
f.� It is primarily based on price behaviour and pays limited attention to trading volume.

5.5.2 Moving Average Line

Technicians compute moving averages of a series, so that erratic price changes are smoothened out and
the general underlying trend can be clearly observed. A 200-day moving average is normally used to
identify the long-term trend while a 20 or 30-day moving average is used to identify the short and
intermediate trend.

Trend changes are identified not by a change in the direction of the moving average, but by a crossover
of the moving average by the index itself. If the overall price trend of a share or the market has been
down, the moving-average price line would generally lie above current prices. If prices reverse and break
through the moving-average line from below, accompanied by heavy trading volume, most technicians
would consider this a very positive change and expect a reversal of the declining trend.

In contrast, if the price of a share were rising, the moving-average line would also be rising but would be
below current prices. If current prices broke through the moving-average line from above accompanied
by heavy trading volume, this would be considered a bearish pattern that would signal a reversal of the
long-run rising trend.

5.5.3 Relative Strength Index

The relative strength index of a given share is calculated as the ratio of the share's price to a market index,
or an industry index. A rising ratio indicates that the share is performing better than the market, while a
declining ratio shows that it is underperforming the market. If an individual share or an industry group is
outperforming the market, technicians believe it will continue to do so. In a declining market, if the share
price declines less than the market, the share's relative strength ratio will continue to rise. Relative
strength is normally used to decide what share to buy, for it is obviously best to choose one that is likely
to outperform the market or industry.

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5.6 Charts and Chart Patterns

Charts are the technical analyst’s main tools. There are different charts, which suit different types of
analyses. Some of these include:
•� Line charts
•� Bar charts
•� Candlestick charts
•� Point and figure charts

Most of these will have chart points to show the high, low, opening and closing prices for each trading
day.

Technicians believe that chart patterns can be used to predict future price movements. There are two
types of price patterns – reversal and continuation. Reversal patterns indicate that an important reversal
in trend is occurring. The continuation patterns suggest that the market is only taking a pause, possibly
to correct a short term overbought or oversold condition, after which the existing trend is expected to
resume.

5.6.1 Head and Shoulders

The head and shoulders pattern is a reversal pattern and is probably one of the more reliable indicators
of major reversal patterns. The upright head and shoulders formation occurs at market top. It consists of
a "left shoulder", a "head", and a "right shoulder":

Left shoulder - 1st strong price rally normally accompanied by heavy volume, followed by a price decline
with considerably less volume.

Head - Prices advance again on high volume to reach a higher level than the top of the left shoulder before
falling on lower volume. Prices will fall below the top of the left shoulder but above or near the low of
the left shoulder.

Right shoulder - A 3rd rally occurs, but this time on less volume than the volume during the formation of
either the left shoulder or the head. Prices fail to reach the height of the head and fall through the
neckline.

A breakout is confirmed if the price closes below the neckline by 3% of the share price. Once penetrated,
the potential magnitude of decline is measured by the distance between the head and the neckline,
projected downward from the neckline as shown in Figure 5.7.1(a).

Figure 5.6.1(a) – Upright Head and Shoulders

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While the upright head and shoulders formation indicates a market peak, the inverse head and shoulders
formation indicates a market bottom (Figure 5.6.1 (b)).

Figure 5.6.1(b) – Inverse Head and Shoulders

5.6.2 Double Tops and Bottoms

A double top is a reversal pattern indicating a market top. It consists of two "tops" separated by a valley
in prices. The main feature of a double top is that the 2nd top is formed with distinctly lower volume than
the 1st. A double top is confirmed when the neckline is broken on the way down. Refer to Figure 5.6.2(a).

Figure 5.6.2(a) – Double Top

A double bottom occurs in a bear market and signals a potential reversal in trend. The formation of the
1st bottom is normally accompanied by heavy volume while the 2 nd bottom is usually dull with little trading
volume. Volume increases significantly on the breakout. Some "double" patterns extend to form triple
tops or bottoms. As for the double top, a double bottom formation is confirmed if the neckline is broken
on the way up. Refer to Figure 5.6.2 (b).

Figure 5.6.2(b) – Double Bottom

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5.6.3 Consolidation Rectangles

A consolidation rectangle is formed when prices move sideways within a narrow range for an extended
period of time. It is usually a continuation pattern. A breakout from the consolidation rectangle would be
technically significant with a break upwards indicating a bullish trend and a break downwards signaling
further weakness. During the formation of the rectangle, it is difficult to predict which way the price will
ultimately break. Therefore, it is assumed that the prevailing trend will continue until proven otherwise.
Refer to Figure 5.6.3.

Figure 5.6.3 – Consolidation Rectangles

5.6.4 Triangles

Triangles are formed with four points of contact – two support and two resistance points. There are
generally three types of triangle formation.

Symmetrical triangles are formed by price consolidations bounded by an upward sloping support line and
a downward sloping resistance line. A breakout may occur on either side of the symmetrical triangle and
is an indication of a major move in the same direction. Refer to Figure 5.6.4(a).

Figure 5.6.4(a) – Symmetrical Triangle

Ascending triangles are bullish indicators, formed by price consolidations bounded by an upward sloping
support line and an almost horizontal line. The ascending triangle indicates that buyers are more
aggressive than sellers are. Once the supply is absorbed by the new owners, prices are expected to
advance rapidly as shown in Figure 5.6.4(b).

Figure 5.6.4(b) – Ascending Triangle

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Descending triangles are bearish indicators, and are consolidations within an almost horizontal support
line and a downward sloping resistance line. Sellers are more aggressive resulting in lower rally peaks
while buyers are buying at a set price. Once demand is filled at the floor of the descending triangle, prices
will fall sharply if there are any remaining sellers. Refer to Figure 5.6.4(c).

Figure 5.6.4(c) – Descending Triangle

5.6.5 Flags and Pennants

The flag formation looks like a flag on the chart and may be described as a parallelogram of price
fluctuations. It usually occurs after a sharp, almost vertical rise or fall in price with declining volume. As
the flag is completed, prices break out in the same direction that they were moving in before.

In a rising market, the flag is usually formed with a slight downtrend, whereas in a falling market it has a
slight upward bias. Volume is normally very heavy just before the flag formation begins. As the pattern
develops, volume dries to almost nothing, only to explode as the price works its way through the
formation. Flags can take as few as 5 days to as many as 3-5 weeks to form. Essentially they represent a
period of controlled profit taking in a rising market. Refer to Figure 5.6.5 (a).

In a falling market, the flag is also accompanied by declining volume. Since this type of flag represents a
formation with an upward bias in price, the volume implication (i.e. rising price with declining volume) is
essentially bearish. When the price breaks down from the flag, the almost vertical slide, which preceded
the formation of the flag, resumes. Although volume tends to pick up at this point, it does not have to be
explosive, unlike the breakout from a flag formed during an upward move. Refer to Figure 5.6.5 (b).

Figure 5.6.5(a) – Flag Formation in a Rising Market

Figure 5.6.5(b) – Flag Formation in a Falling Market

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A pennant is formed after a sharp rise or fall in price with lower volume during its formation. The
difference between a pennant and a flag is that the pennant is formed by a series of converging instead
of parallel lines. Refer to Figure 5.6.5 (c).

Figure 5.6.5(c) – Pennant

5.6.6 Wedges

A wedge is formed by a series of converging peaks and troughs. The converging lines in a wedge both
move in the same direction.

In a rising wedge, both boundary lines slant upwards. A rising wedge usually develops on a falling price
trend. Following its completion, prices usually fall very sharply especially if volume is high. Rising wedges
are characteristic of bear market rallies. Refer to Figure 5.6.6 (a).

A falling wedge is bounded by converging lines, which slant downwards. It represents a temporary
interruption of a rising trend. When prices move out of a falling wedge, they are likely to drift sideways
before they begin to rise. Refer to Figure 5.6.6 (b).

Figure 5.6.6(a) – Rising Wedge

Figure 5.6.6(b) – Falling Wedge

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5.6.7 Gaps

A gap represents a price range where no transactions occur. Gaps occur when the share’s lowest traded
price for a specific period is higher than the highest traded price in the previous period. On a chart, a gap
appears as an empty vertical space between one trading period and another. Daily gaps are more common
than weekly gaps or monthly gaps. A gap is closed or covered when the price retraces the whole range of
the gap. A gap may be covered in a few days, a few weeks or months, or never at all. The principle is that
all gaps will eventually be covered. However, this is not always the case. Accordingly, trading strategies
should not be implemented solely on the assumption that the gap will be filled in the immediate future.
(See Figure 5.6.7)

There are three types of gaps. A breakaway gap appears when a price breaks out of a price pattern.
Generally, the development of a breakaway gap emphasizes the bullishness or bearishness of the
breakout. To confirm a change to bullish sentiment, an upside breakout should be accompanied by
relatively heavy volume. Runaway gaps or continuation gaps occur during rapid, straight-line rises or
falls when price trends accelerate and emotions run high. Runaway gaps occur halfway between a
previous breakout and ultimate duration of the move. Runaway gaps are also known as measuring gaps.
Exhaustion gaps represent the end of a rapid rise or fall and is the last in a series of runaway gaps. When
it is formed, it is not easy to ascertain whether the gap is another runaway gap or an exhaustion gap.
Generally breakaway gaps develop at the beginning of a move, runaway gaps in the middle of a move,
and exhaustion gaps at the end of a move.

Figure 5.6.7 – Gaps

5.7 Elliot Wave Theory

In his study of equity prices in 1938, R.N. Elliott came up with the Elliott Wave Theory, which states that
prices move in cycles of waves and sub-sets of waves, and exhibit the Golden Ratio (1.618) 1. Each cycle
comprises of a 5-wave advance and a 3-wave retreat.

�������������������������������������������������
1Elliot Wave charts exhibit patterns that are related to Fibonacci’s series (0,1,1,2,3,5,8,13,21…..) where each number in the
series is obtained by adding any two consecutive numbers to obtain the next in the series ( e.g. 0+1=1, 1+1=2, 1+2=3, 2+3=5,
and so on). As the Fibonacci series progress, the ratio of consecutive numbers (e.g. 13÷21) will approach the Golden mean of
1.618.

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In Elliot Wave charts, the markets move in 5 wave and 3 wave patterns, and the turning points that create
these patterns are often at Fibonacci support and resistance levels (61.8, 161.8, etc.).

Figure 5.7 – Elliott Waves

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5.8 Quantitative Analysis

Quantitative analysis essentially involves the abstraction of the market reality, which is made up of the
economy, financial markets and its environment, into relationships that are built into a financial model.
The objectives of these models are to identify price anomalies, arbitrage possibilities and price
relationships, and lately even the speed and access to market information that will give an advantage to
the investor in his portfolio management decisions.

The significance and importance of quantitative analysis is evidenced by the rapid growth of the use and
development of quantitative analysis in financial markets. Quantitative analysis uses statistics, probability
and calculus for variety of purposes such as market pricing, algorithm trading, asset allocation, risk
management, modeling trading strategies, portfolio optimization and identifying trading and investment
opportunities in the markets.

Quantitative analysts are typically called “quants” or “rocket scientists”. Within an organization, quants
could be employed in the front office to develop trading strategies using complex mathematical tools, or
in the risk management department to measure the risks that have been bundled into a transaction or
product.

Quant funds are funds that extensively use quantitative analysis in their fund management decisions. One
can look at this development as the outcome of the financial markets becoming more sophisticated in
their understanding and measurement of risks. While less sophisticated traders might just look at the
basic price change, quants will look at the breakdown of this change so that specific risk profiles can be
created to benefit from these changes. Typically, therefore, instead of just looking at the first order of
price change i.e. delta, quants will look at the price changes in their 2 nd and 3rd order derivatives.

However, there is some controversy about the usefulness and the fairness of using such models. For
example, the hedge fund, Long Term Capital Management, relied extensively on quantitative analysis, and
despite their elegance and mathematical robustness ran into huge losses. High frequency trading, which
relies on physical transmission speeds and complex price discovery algorithms are under intense scrutiny,
and regulators recognize that these funds have to be more.

Given the push factors of rapid advances in computer prowess and technology, and increasing global
competition in the financial markets, quantitative analysis will continue to develop as a tool that is
necessary to enhance the industry’s standards in fund management and risk management.

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5.9 Summary

1.� Technical analysis, also known as market or internal analysis, involves the study of past prices and
volume data to predict the future price direction of individual securities or the aggregate market.

2.� Technical analysis assumes that market prices discount everything and prices move in trends. Any
shifts in trend can be detected on the charts.

3.� The greatest challenge to technical analysis is the Efficient Market Hypothesis, which argues that
prices adjust rapidly to new information entering the market and technical analysts cannot take
advantage of such information. In addition, chart patterns can become self-fulfilling prophecies as
traders often act in concert in response to buy or sell signals.

4.� Technical indicators used include the A/D line and moving average. The A/D line or breadth index
measures the movement of all securities traded in the aggregate market. Moving averages are
calculated to obtain a smooth curve, so that erratic price changes are smoothened out and the
general trend can be more clearly observed.

5.� According to the Dow Theory, there are 3 movements in the share market – the primary movement,
the secondary movement and the daily fluctuations. The objective of the Dow Theory is to identify
the primary trend of the market.

6.� The moving average line helps to smooth out the erratic movements in share prices so that the
underlying trend is distinct. Crossovers between the moving average and the index are used to
indicate trend reversals.

7.� The relative strength index is useful for identifying shares, which are likely to outperform the market
or industry.

8.� Various types of charts used for technical analysis, including line chart, bar chart, candlestick chart,
and point and figure chart.

9.� There are two types of chart patterns – reversal and continuation. Reversal patterns, which indicate
reversals in trends, include the head and shoulders formation, and double tops and bottoms.
Consolidation rectangles, triangles, flags, pennants and wedges are continuation patterns.

10.� The Elliott Wave Theory sees price movements in cycles of 8 waves in each cycle, in which there are
5 advance waves where prices rise, and 3 retreat waves where prices fall.

11.� Quantitative analysis involves the building of financial models that try to express the market and
economic reality in terms of arbitrage and investment opportunities.

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Chapter 6:
Portfolio Management
Learning Objectives

The candidate should be able to:

Portfolio Management Process

� Describe and explain the portfolio management process

Explain how investment policies are established

� List and explain the investment objectives in the investment policy statement

� Describe the contents of a typical investment policy statement

� Discuss and explain the investment constraints in portfolio management

� Explain asset allocation and the difference between strategic and tactical asset allocation

Portfolio Theory

� Appreciate how investment portfolios are constructed and managed

� Explain the investment management principles behind diversification and portfolio risk

� Distinguish between systematic and nonsystematic risks, particularly in the hedging of each of
these risks

� Compute the correlation coefficient and using it to determine the extent of diversification of risks
in a portfolio

� Calculate portfolio return and risk

� Show how portfolio risks can be diversified internationally

� Understand and explain the Capital Asset Pricing Model and the risk-free rate

� Explain the Capital Market Line for the portfolio's risk-return trade off

� Explain the Security Market Line for the portfolio's risk-return trade off

� Use the Security Market Line to determine overvalued and undervalued securities

� Explain the Arbitrage Pricing Theory, and how it compares with CAPM

Performance Measurement

� Compute and measure investment returns across different cash flow assumptions and movements
in the portfolio

� Use Dollar-weighted rate of return to measure performance

� Use Time-weighted rate of return to measure performance

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� Compare the advantages/disadvantages of Dollar-weighted versus Time-weighted rates of return

� Describe the Modified Dietz Method, in assuming a constant rate of return on the portfolio over
the measurement period

� Appreciate the Global Investment Performance Standards for investment management
performance

� Explain the Risk-adjusted Measures of Performance such as the Sharpe Measure, Treynor Measure
and the Jensen Differential Return Measure

� Describe Performance Attribution as a means to measure a portfolio against an established
benchmark.

6.1 Introduction

This chapter is divided into three parts. The first part deals with the construction of an investment
portfolio. Specifically, we will examine the determinants of the investment policy - the investor's
objectives and constraints. In addition, we will also discuss strategic and tactical asset allocation for a
portfolio.

The second part deals with the development and application of portfolio theory, starting with Harry
Markowitz’s Modern Portfolio Theory on diversification and correlation, systematic and non-systematic
risks, and William Sharpe’s Capital Asset Pricing Model as a way to understand risk and return in the
market, and to evaluate shares for investments.

The third part deals with the performance of the portfolio, covering how investment returns are
measured, and using risk-adjusted performance measures such as the Sharpe Ratio, Treynor’s Ratio and
the Jansen Differential return measure. Lastly, we look at performance attribution analysis and the
various contributors to investment performance.

At this point, it would be useful to review the fund management process that was shown in Chapter 1.

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Figure 6.1 – The Fund Management Process

•� Risk and Return Asset Allocation:

•� Economic, Industry & Countries – developed, emerging, frontier
Country Analysis Asset class – cash, debt, equities, derivatives

Valuation: Shares / Bonds / Derivatives Selection:

•� Financial Ratios •� Which shares – value vs growth?
Analysis
•� Which bonds – yield vs capital
•� Valuation Ratios
appreciation vs credit risk ratings
Analysis
•� Technical charting information and
•� Credit Risk Ratings
signals
•� Technical Analysis
•� Quantitative models
•� Quantitative Analysis The
Investment
Products – Equities, Bonds, Futures, Options, Warrants, Foreign Exchange, Client
Unit Trusts & Managed Funds

•� Trading costs Execution of Client Orders:

•� Execution efficiency •� Frequency
•� Price liquidity and bid- •� Order size
offer spread •� Risk hedging
•� Sales vs Execution vs
Trading

•� Risk models Portfolio Management:

•� Profitability •� Investment philosophy
performance •� Process
•� Diversification •� Portfolio evaluation
•� Market timing

Fund management covers more than just portfolio management. The boxes in Figure 6.1 shows the other
related activities i.e. research and analysis, sales, execution (dealing), portfolio management and client
reporting. It should be noted the above processes or functions might take place concurrently or in a
different sequence, as different firms may have different organizational structures and processes.

6.2 The Portfolio Management Process

This section deals with the activities of portfolio management processes.

6.2.1 Portfolio Management Process for Retail Investors

Portfolio management involves the evaluation of the risk and returns of investments for the purpose of
constructing investment portfolios that will yield an optimum return for the investor. This has to take into
account the investor's investment objectives, risk profile and any constraints and circumstances that are
unique to him.

The portfolio management process will also depend on the nature of the client. Generally, individual
(retail) clients have shorter time-horizons than institutional clients. Among individual clients, investor

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objectives will differ from pure retail clients to private bank clients, whose assets under management are
significantly higher. Figure 6.2.1(a) below shows different types of clients.

Figure 6.2.1(a) – Different Client Categories1

In this chapter, we will focus on portfolio management for individuals, particularly retail investors. As
illustrated in Figure 6.2.1(b), the portfolio management process for individual investors is a dynamic,
continuous and systematic one with the following elements:
a.� Setting investment objectives. The investor's objectives, requirements, preferences and constraints
are analyzed. The aim is to define a level of acceptable risk that the investor can take and the expected
return that is reasonable for that level of risk.
b.� Developing and implementing strategies. This involves setting guidelines to determine the allocation
of assets and defining under what circumstances and by what means this allocation may vary.
c.� Monitoring market conditions. Market conditions and shifting relative values of various asset classes
and securities in the market place are closely monitored. In addition, the investor's needs,
circumstances and objectives are evaluated periodically.
d.� Reviewing and adjusting the portfolio. Portfolios adjustments are made at appropriate times to
reflect changes in the market or the investor's requirements.
e.� Measuring investment portfolio performance. This step involves measuring the performance of the
portfolio and then evaluating that performance relative to a benchmark.

The portfolio objectives, constraints and strategy should always be stated clearly in a written document.
A well-drafted investment policy provides the discipline and stability required for an efficient
management of the portfolio, reducing whipsaw reactions to temporary price swings or even protracted
volatility.

1
The terms used in this illustration may differ from those used in the context of Singapore’s regulatory framework.

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Figure 6.2.1(b) - The Portfolio Management Process for Retail Investors

6.2.2 Determinants of the Investment Policy Statement

The investment policy statement or “investment mandate” belongs to the client and not to the portfolio
manager. Therefore, it is essential that the investment manager spend sufficient time with the client to
help her define her investment goals, acceptable levels of risk and any constraints and preferences. This
analysis, coupled with the manager's understanding of capital markets, creates the investment policy
statement.

A typical investment policy statement (IPS) will include the following:

1.� Introduction – describes the investor;
2.� Statement of purpose – expression of the purpose of the IPS;
3.� Statement of duties and responsibilities – lays down the respective duties and responsibilities of the
client, the custodian of the client’s assets and the investment manager;
4.� Procedures – sets out the processes for maintaining and updating the IPS;
5.� Investment objectives – e.g. capital appreciation, income generation or wealth preservation;
6.� Investment constraints – e.g. liquidity requirements, time horizon, tax considerations, regulatory and
legal requirements, and unique circumstances peculiar to the investor);
7.� Investment guidelines – provides guidance for the execution of the of the policy (e.g. is leverage
permitted, are there loss limits, asset size limits, non-permissible activities or markets, and so on);
8.� Evaluation and review – describes how evaluation and review of the portfolio will be carried out
under the IPS;
9.� Appendices on strategic asset allocation, rebalancing policy – investors often specify a policy
portfolio (e.g. conservative portfolio, balanced portfolio or aggressive portfolio) as part of their
investment objectives

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1.� Investment Objectives

Return Requirements and Risk Tolerance - In defining the investment objectives, emphasis should be
placed on risk because the parameters of risk taking are what define the manager's freedom to manage
the portfolio investments. Investment management has no control over market returns because no one
controls security prices. However, investment management can control risks.

A useful framework for analyzing the risk appetite of individual investors is the life cycle approach.

Life Cycle Approach - An individual's risk and return preferences are often related to the stage of the life
cycle at which she is currently located:
•� 1st stage (early career) - priorities include saving for liquidity purposes, buying a home and obtaining
life insurance and then investments. Given the need to service a large housing loan and a possibly a
car loan, assets tend to be small relative to liabilities. But because the individual is young and has a
long time horizon with a growing stream of discretionary income, he can undertake high-return, high-
risk, capital growth-oriented investments.
•� 2nd stage (mid-career) - the individual can establish a serious investment program noting that
liabilities should be substantially reduced. While the time horizon remains quite long, it is not so long
that capital preservation is unimportant. The investor can continue to undertake high-risk, high-
return, capital growth-oriented investments, but should reduce overall risk exposure.
•� At the late career stage, when the individual is near retirement, there is a greater emphasis on income
needs and capital preservation. Assets significantly exceed liabilities. Time horizon is shorter and the
investor's portfolio is typically shifted to significantly lower return, lower risk assets with large
dividend or interest payment components and relatively secure asset values.

While the life cycle approach is generally used to portray the risk and return preferences of individuals,
each individual's risk tolerance is unique. The risk profile of an individual is affected by other factors such
the investor's net worth, health, family situation, future financial commitments, familiarity with
investments, job stability and emotional temperament.

2.� Investment Constraints

Liquidity Requirements - Liquidity requirements vary considerably from one investor to another and thus
must be clearly communicated. Investors must carefully assess their own situation to determine liquidity
needs. If one is investing funds to be used for the next mortgage payment or the coming semester's
tuition, then immediate liquidity is essential, and financial assets would be preferred. To meet such
liquidity needs, funds should be invested in high quality, short-term debt instruments such as Treasury
bills and commercial paper, which can be easily sold. If assets held have poor marketability, such as real
estate or shares in a closely held business, liquidity needs should be monitored carefully.

In practice, few investment companies actually hold a liquidity reserve given that most financial assets
are highly liquid. Shares and bonds can generally be sold within a matter of minutes at a price close to
their market values. Shortfalls in liquidity are normally met through the sale of financial assets.

Time Horizon - Time horizon is defined as the investment planning period of the investor. The time frame
of the client is important as it affects the nature of investments selected and the investment strategies.

Investors with a long investment horizon can absorb and smooth out the ups and downs of risky
combinations of assets like ordinary share portfolios. These investors can build portfolios of riskier assets
with more risky investment strategies.

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Investors who have a shorter investment horizon tend to have less volatile portfolios, typically consisting
of more bonds than shares, with the former of higher quality and shorter duration and the latter of higher
quality and lower volatility.

Tax Considerations - To determine investment returns, the fund manager must consider the tax
implications for her clients. Consideration must be given to:
• The client's income tax bracket;
•� Different tax treatments from different assets (tax-exempt or not); and
•� Different components of total return (dividends or interest income versus capital gains).

Investors in high tax brackets should consider tax-exempt fixed income securities if their taxable
equivalent return exceeds the return on comparable taxable bond issues. Equities with a large capital
gain component relative to dividend income may be more attractive compared to high income yielding
shares for investors in high tax brackets.

Regulatory and Legal Constraints - Institutional investors such as insurance companies are regulated with
regard to their investments. Generally, institutional investors are more regulated than private individual
investors. An individual using his personal savings has greater freedom in deciding what he wants to
invest in. However, if he is using his CPF2 money to invest, his investment will be governed by the CPF
Investment Scheme, which specifies the types of investments and quantum that can be invested.

Clients' Unique Needs or Preferences - It is the fiduciary duty of fund managers to ensure that clients'
instructions are adhered to. It is important to understand the client’s preference or restriction. Some
clients may specify a limit on equity investments and/or foreign currency exposure. These preferences
and instructions from the clients must be clearly spelt out in the investment policy and be in writing in
order to avoid misunderstanding in the future.

6.2.3 Asset Allocation

The purpose of the asset allocation process is to maximize return at a level of risk consistent with the
investor's objective within a portfolio. It has always been vigorously debated whether asset allocation is
more important than securities selection in portfolio performance. A study by Brinson, Hood and
Beebower3 showed that 91.5% or more of a portfolio's return comes from asset allocation, and therefore
less than 10% can be attributed to the actual security selection. Furthermore, it was found that asset
allocation has a much greater impact on reducing total exposure to risk than picking an investment vehicle
in any single asset category. Clearly, asset allocation is an important aspect of portfolio management.

At the asset allocation stage, economists and market strategists will give their input regarding their broad
expectations on macroeconomic factors and market trends, because these will affect the returns of the
various asset classes.

There are two types of asset allocation:

•� Strategic asset allocation
•� Tactical asset allocation

2 The Central Provident Fund (CPF) is a social security savings plan for Singapore Citizens and Permanent Residents, and
encompasses retirement, healthcare, home ownership, family protection and asset enhancement.
3 “Determinants of Portfolio Performance” by Gary P: Brinson, L. Randolph Hood, and Gilbert L. Beebower, Financial Analysts
Journal (January-February 1995)

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1.� Strategic Asset Allocation

Strategic asset allocation refers to how a portfolio's funds are divided among the various asset classes,
given the client's risk tolerance, preferences and requirements and the portfolio manager's long-term
forecasts of expected returns, variances and co-variances of various asset classes. It constitutes the
"policy", "long-run" or "strategic" asset mix. The asset mix is normally expressed in terms of the
percentage of total value invested in each asset class. For example, a strategic asset mix may be:

Asset Classes Allocation

Equities 40%
Bonds 50%
Cash equivalents 10%
Total portfolio 100%

Such an approach can be termed a constant mix strategy. Changing capital market conditions from period
to period do not influence predictions concerning asset returns. Changing circumstances from period to
period do not influence the investor's attitude toward risk.

Maximum and minimum limits can also be allocated to each asset class, to give it a potential range of
different risk profiles that may be appropriate under different market conditions. The available and
permissible asset classes have to be clearly defined by the nature of the assets i.e. cash, bonds, shares,
and also by sector, industry and geographical region or country. There may be sub-categories under each
of these.

The asset mix depends on the investor’s return objectives and risk tolerance. The lower the tolerance for
risk, the more conservative the asset mix. A conservative asset allocation (low-return/low-risk) relies
heavily on bonds and short-term securities to provide more stable returns, and there is more emphasis
on current income and capital preservation. An aggressive portfolio that seeks capital gains might have
the highest exposure to ordinary shares and less to bonds and short-term securities, thereby increasing
the expected portfolio return and risk.

2.� Tactical Asset Allocation

This refers to active strategies that seek to enhance performance by shifting the asset mix of a portfolio
in response to the changing patterns of reward available in the capital markets. The goal is to take
advantage of inefficiencies in the relative prices of securities in different asset classes. Tactical changes
in asset mixes are driven by changes in predictions concerning asset returns. For example, if the outlook
for equities is favourable, the allocation mix can be changed as follows:

Asset Classes Initial Allocation New Allocation

Equities 40% 50%
Bonds 50% 45%
Cash equivalents 10% 5%
Total portfolio 100% 100%

Tactical asset allocation models can be divided into three groups: valuation approaches, cyclical
considerations and a combination of the two.

The valuation approach seeks to identify the relative value of an asset class. In general, asset classes that
are considered expensive are sold, and those considered cheap are purchased. The most common
valuation approach is the risk premium approach or spread approach. Basically, if the expected return
on equities relative to bonds is above average, an above-average allocation is made to equities. However,

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if the expected return on equities relative to bonds is below average, a lower allocation is made to
equities. This is also referred to as the equity bond yield gap.

The cyclical consideration approach is based on the view that cycles in share prices and bond yields are
closely related because of macroeconomic factors. For example, equity market movements typically
precede changes in economic activity. Managers adopting this approach will attempt to identify one or
more components of general economic activity that are believed to be good predictors of market
movements.

6.3 Portfolio Theory

This section addresses the risk and return issues in an investment portfolio. It will look at the development
of Modern Portfolio Theory proposed by Harry Markowitz in 19524, which addresses the issue of risk
diversification across a portfolio of risky assets, to arrive at an optimal market portfolio. We will also look
at the development of the Capital Asset Pricing Model (CAPM) by William F. Sharpe in 1964 5 to describe
the relationship between an asset’s risk and return.

Portfolio theory deals with the creation of optimal portfolios that maximize expected returns consistent
with acceptable levels of risk. We will also address the usefulness and application of portfolio theory in
practical investment management today.

6.3.1 Diversification and Portfolio Risk

Diversification is the financial equivalent of the old saying, "Don't put all your eggs in one basket." Studies
have shown that as the number of different securities in the portfolio is increased, we can reduce portfolio
risk. Diversification can be achieved by selecting shares across industries, in different countries or by
investing in different asset classes.

Let us consider an investment portfolio of only one share - an automobile company. There are two broad
sources of uncertainty associated with this 'portfolio'. First, there is the risk that comes from changes in
the general economic environment, such as the business cycle, interest rates and currency movements.
Besides these macroeconomic factors, there are firm-specific factors, such as the firm's success in
marketing, introduction of new car models and certificate of entitlement (COE)6 prices. These factors are
unique to the firm and may not affect other firms in the economy.

Now consider a simple diversification strategy where we include another share - an oil and gas company
- in the portfolio. What will happen to portfolio risk? To the extent that the firm specific influences on
the two shares differ, portfolio risk will be reduced. For example, the rise in fuel prices will hurt the
automobile firm but will boost the returns of the oil and gas company. The two effects offset each other
and help to stabilize the portfolio’s return.

4 “Portfolio Selection” by Harry Markowitz; The Journal of Finance, Vol. 7, No. 1. (March 1952)
5 “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk” by William F. Sharpe; The Journal of Finance,

Vol. 19, No. 3 (Sep., 1964)

6 A Certificate of Entitlement (COE) represents a right to vehicle ownership in Singapore for 10 years. Anyone who wishes to

register a new vehicle in Singapore must first obtain a COE through a competitive bidding process. When demand is high, the
cost of a COE will rise.

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As we add more securities to the portfolio, we continue to limit the exposure to firm-specific factors, and
portfolio volatility should continue to decline. The first few shares cause the largest decrease in portfolio
risk. Studies have shown that 51% of portfolio standard deviation is eliminated as we increase from 1 to
10 securities. Unfortunately, the benefits of diversification do not continue as we add more securities. As
more shares are added, the marginal risk reduction is small. Theoretically, a portfolio that is invested in
all the shares in a given market will completely diversify its risk, with only systematic risk remaining.

When all risk is firm specific, diversification can reduce risk to virtually risk-free levels as shown in Figure
6.3.1. To the extent that virtually all securities are affected by the common macroeconomic factors, we
cannot eliminate our exposure to these risk sources. For example, if all shares are affected by the business
cycle, we cannot avoid some exposure to business cycle risk, no matter how many shares we hold.

Figure 6.3.1 - Portfolio Risk as a Function of the

Number of Shares in the Portfolio

The risk that remains even after extensive diversification is called market risk or systematic risk, namely
the risk that is attributed to market-wide risk sources. In contrast, the risk that can be eliminated by
diversification is called firm-specific risk or nonsystematic risk.

6.3.2 Systematic and Nonsystematic Risks

Therefore, from the preceding section we see that risk measures can be divided into two general types of
risk: systematic risk and nonsystematic risk.

Systematic risk (also known as undiversifiable risk) results from factors outside the firm's control. It is
caused by factors such as changes in the economic, political and sociological environments, which affect
the prices of all marketable securities. Interest rate risk and inflation risk are examples of systematic risk
and cannot be eliminated by diversification.

Nonsystematic risk (also known as firm specific risk) can be controlled and minimized through
diversification. It is that portion of total risk that is peculiar to a firm or industry. Factors such as company
strategies, management errors, new product developments and market innovations that impact on a
company's earnings potential cause nonsystematic variability of returns in a firm. Since nonsystematic
risk is caused by factors that affect specific firms or industries, it can be minimized by investing in a broad
number of different firms.

As nonsystematic risk can be theoretically minimised through diversification, it can be reduced to zero by
having a well-diversified portfolio, which contains shares that are non-correlated with each other.

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Total risk = Systematic risk + Nonsystematic risk

These two investment risks have practical implications for the equity investor:
•� Systematic risk cannot be diversified away and thus there is little the investor can do to protect himself
against such risk (other than to stay out of the market); and
•� Firm-specific or nonsystematic risk, on the other hand, can be reduced by having a diversified portfolio
of shares as individual shares face risks peculiar to themselves. The larger the number of shares in
the portfolio, the lower the overall portfolio level of specific risk the investor is exposed to i.e. the
greater the diversification of specific risks.

6.3.3 Correlation Coefficient

Correlation coefficient ρ, (“ρ” is pronounced "rho") measures the extent to which the returns of any two
securities are related. It denotes only association, not causation. Correlation coefficient ranges from
+1.0, indicating perfect positive correlation, to -1.0 indicating perfect negative correlation. With perfect
positive correlation, the returns have a perfect direct linear relationship. It means that the two securities
have identical return patterns. With perfect negative correlation, the securities' returns have a perfect
inverse linear relationship to each other. When one security's return is high, the other is low. If the
correlation coefficient is zero, then the returns of the securities are independent or uncorrelated.

For successful diversification, we should seek securities that are uncorrelated to one another in terms of
risk. If returns of securities are correlated, then risk could not be reduced significantly. Specifically, it is
noted that:
•� Combining securities with perfect positive correlation with each other provides no reduction in
portfolio risk. The risk of the resulting portfolio is simply a weighted average of the individual risks of
the securities;
•� Combining two securities with zero correlation will bring about some reduction to the overall risk level
of the portfolio. If more securities with uncorrelated returns are added to the portfolio, significant
risk reduction can be achieved. However, portfolio risk cannot be eliminated; and
•� Combining two securities with perfect negative correlation with each other could eliminate portfolio
risk altogether. This is the principle behind hedging strategies.

In the real world, these extreme correlations are rare. Securities typically have some correlation with
each other. Thus, although portfolio risks can be reduced, it usually cannot be completely eliminated.

6.3.4 Calculating Portfolio Return and Risk

The expected return of a portfolio is a weighted average of the expected returns of the individual
securities in the portfolio and can be calculated as follows:
n

Rp =
w i r i
i=1

where
Rp = expected return on the portfolio
wi = portfolio weight for the ith security
ri = expected return on ith security
n = number of different securities in the portfolio
∑wi = 1.0

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Although the expected return of a portfolio is a weighted average of its expected returns, portfolio risk
(measured by the variance or standard deviation) is not a weighted average of the risk of the individual
securities in the portfolio.

For a two-asset case, the formula for calculating portfolio risk is as follows:

Portfolio risk (σp ) = w21 σ21 + w22 σ22 + 2w1 w2 ρ1,2 σ1 σ2

where
w1 and w2 = portfolio weights given to security 1 & security 2
σ1 and σ 2 = standard deviation of security 1 & security 2
ρ1,2 = correlation coefficient of security 1 and 2

Calculating Portfolio Return and Risk

Consider the following portfolio which consists of two securities A and B.

Security Expected Return Standard Deviation Weight in Portfolio

A 18% 20% 40%
B 9% 10% 60%

The correlation coefficient between Security A and Security B is 0.8.

Expected return on the portfolio

= (0.4)(18) + (0.6)(9)
= 7.2 + 5.4 = 12.6%

Portfolio risk

=w21 σ21 + w22 σ22 + 2w1 w2 ρ1,2 σ1 σ2

= 0.42 x 0.22 + 0.62 x 0.12 + 2(0.4)(0.6)(0.8)(0.2)(0.1)

= √0.0064 + 0.0036 + 0.00768

= √0.01768
= 0.1330 or 13.30%

If ρ = 1, then σp = 14%
If ρ = 0, then σp = 10%
If ρ = -1, then σp = 2%

These calculations show the impact that combining securities with less than perfect positive correlation
will have on portfolio risk. The risk of the portfolio decreases steadily from 14% to 2% as the correlation
coefficient declines from +1.0 to -1.0.

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6.3.5 International Diversification

Portfolio risk reduction can also be achieved through international diversification. Studies have shown
that movements in share prices in different countries are fairly un-correlated.

International portfolios can be constructed independently on two dimensions:

i.� Geographical diversification by picking shares in all countries
ii.� Diversification by selecting shares across industries

Inherent in international diversification is the risk of fluctuating exchange rates of foreign currency
investments (called foreign exchange risk). One way to remove foreign exchange risk from international
portfolio investment is to hedge foreign holdings through forward exchange contracts.

6.3.6 The Capital Asset Pricing Model

Derived by Sharpe, Lintner and Mossin in the mid-1960s, the Capital Asset Pricing Model (CAPM) deals
with the equilibrium relationship between the risk and the expected return of risky assets.

The CAPM is based on the following assumptions:

i.� Investors evaluate portfolios on the basis of risk and return.
ii.� Investors are rational investors who want to maximize return for a given level of risk and minimise
risk for a given level of return.
iii.� Individual assets are infinitely divisible, which means that it is possible to buy or sell fractional shares.
iv.� Investors can borrow or lend at the risk-free rate of return.
v.� There are no taxes or transaction costs involved in buying or selling assets.
vi.� There is no inflation or any change in interest rates, or inflation is fully anticipated.
vii.� All investors have the same one-period time horizon.
viii. Information is freely and instantly available to all investors.
ix.� Investors have homogenous expectations of risk, return and covariances of securities.
x.� Capital markets are in equilibrium.

Based on the CAPM assumptions, all investors have the same expected returns, covariances and time
horizon. Therefore, they will arrive at the same optimal portfolio of risky assets, which is referred to as
the Market Portfolio (M). The market portfolio is completely diversified and therefore only has systematic
risk remaining. Even with perfect diversification, systematic risk cannot be eliminated because it is the
result of macroeconomic factors that affect the value of all securities and the market as a whole. All assets
are included in portfolio M in proportion to their market value.

In theory, the market portfolio should include all risky assets worldwide, both financial (bonds, options,
futures, etc.) and real assets (gold, real estate, etc.) in proportion. However, in practice, the market
portfolio is often proxied by the portfolio of all ordinary shares, which, in turn, is proxied by a market
index such as the S&P 500 Composite Index.

CAPM introduces another asset to the universe of assets under consideration, namely the risk-free asset.
The risk-free asset has no risk and provides a risk-free rate of return (Rf). Its variance of return is zero and
the covariance between the risk-free asset and any risky asset will be zero.

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Given the analysis above, we can now derive two important relationships between expected returns and
risk:
•� The capital market line, which specifies the equilibrium relationship between expected return and
total risk for efficiently diversified portfolios.
•� The security market line, which specifies the equilibrium relationship between expected return and
systematic risk. It applies to individual securities as well as portfolios.

1.� Uses of CAPM

CAPM is used to evaluate share investments using the market benchmark risk-return to see if the
investment gives a fair return. Second, CAPM can make an educated guess for pricing IPOs. In spite of
its many shortcomings, CAPM is still used in the industry to offer insights into risk-return relationships in
the market.

2.� The Capital Market Line

The capital market line (CML) in Figure 6.3.6.2(a) shows the risk-return tradeoff for efficient portfolios.
Efficient portfolios consist of the optimal portfolio of risky assets and the risk-free asset. In equilibrium,
all investors will end up with portfolios somewhere on the CML.

Figure 6.3.6.2(a) – Capital Market Line

The equation for the CML is:

E(Rm ) - Rf
E(Rp ) = Rf + σp
σm

where
E (Rp) = expected return on any efficient portfolio on the CML
Rf = rate of return on risk-free asset
E (Rm) = expected return on market portfolio M
σm = standard deviation of the returns of market portfolio
σp = standard deviation of the efficient portfolio being considered

The slope of the CML, [E (Rm) - Rf]/ σm is the market price of risk for efficient portfolios. It indicates the
additional return that the market requires for each percentage increase in the portfolio's risk, i.e. its
standard deviation of return.

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Based on the equation for the CML, the expected return for any portfolio on the CML is equal to the risk-
free rate plus the product of the market price of risk and the standard deviation of the portfolio.

3.� The Security Market Line

While the CML applies only to efficient portfolios, the security market line (SML) depicts the risk-return
tradeoff for all assets, whether individual securities, inefficient portfolios, or efficient portfolios. Figure
6.3.6.3(a) shows the SML.

Figure 6.3.6.3(a) – The Security Market Line

The risk of a security or portfolio is the volatility of the return of the security or portfolio relative to the
volatility of the market portfolio's return. This relative measure of risk is referred to as beta (β). The beta
of the market portfolio is 1. If a security or portfolio (other than the market portfolio) has a beta greater
than 1, this means that it contains proportionately higher risk than the market portfolio, and should
therefore be compensated with a higher return. A beta of less than 1 means that the security or portfolio
has a risk lower than the market portfolio, which would also mean lower returns. For example, a security
with beta of 1.5 indicates that, on average, security returns are 1.5 times as volatile as market returns. A
risk-free asset has a beta of zero, or put another way, a risky asset with a beta of zero will yield the risk-
free rate of return.

The CAPM relates the expected rate of return for any security or portfolio with the relevant risk measure
as follows:

E (Ri) = Risk-free Rate + Risk Premium = Rf + βi (Rm - Rf)�

where
E (Ri) = expected return on security or portfolio
Rf = risk-free rate
Rm = expected return of overall market
βi = volatility of asset or portfolio relative to that of the market
The difference between Rm and Rf is also known as the equity risk premium

This equation shows that securities with betas greater than the market beta of 1 should have larger risk
premiums than that of the average share and therefore require higher rates of return. This is exactly what
investors should want since beta is a measure of risk and greater risk should be accompanied by greater
return. Conversely, securities with betas less than that of the market are less risky and should have
required rates of return that are lower than that for the market as a whole.

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Using CAPM to calculate Expected Rate of Return on a Share

Assume that the beta for share of Company A is 1.20. Given a risk-free rate of 5% and a market return
of 18%, the expected rate of return for share of Company A is:

E(R) = 0.05 + 1.20(0.18 - 0.05) = 0.206 or 20.6%

4.� Source of Alpha

If the return on the market is expected to be 14%, a share has a beta of 1.2, and the risk free rate is 6%,
the SML would predict an expected return on the share of:

Er)) = rf + βrm - rf ) = 6 + 1.214 - 6)) = 15.6%

If one believes the share will give a return of 17%, its implied alpha would be 17 – 15.6 = 1.4%. At 15%,
the share’s alpha would be negative at -0.6.

Investors should buy positive alpha, and sell (or go short) negative alpha. Investor demand for a positive
alpha will increase its price. As the share price rises, other things being equal, expected return falls,
reducing and ultimately eliminating the same alpha that first created the excess demand. Conversely, a
drop in demand for the negative alpha share will reduce its price, pushing its alpha back up to zero. In
the end, such buying and selling pressure will leave most securities with zero alpha values most of the
time, so unless your analysis tells you otherwise, you should assume alpha is zero.

5.� Overvalued and Undervalued Securities

The SML may be used to identify securities that are overvalued or undervalued.

Figure 6.3.6.3(b) - Overvalued and Undervalued Securities Using the SML

Shares that lie above the SML provide above-average expected return given their respective betas and
are therefore considered underpriced. Shares that lie below the SML are overpriced as they offer lower
returns for a given level of risk.

However, it should be noted that in a perfectly efficient market, all shares should lie on the SML. If they
do not, the market mechanism would force it to the SML. If the shares lie above the SML, demand for
such shares would push the prices of these shares up thereby reducing the shares' expected return.

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Similarly, if the shares lie below the SML, pressure to sell these shares would push the prices of these
shares down. With lower prices, the expected returns of these shares are correspondingly increased.
Thus the buying and selling of attractive and unattractive shares would continue until the equilibrium
point is reached, that is, when all shares lie on the SML.

6.� Expensive or Cheap Markets

The SML is also useful in reflecting the value of markets at any point in time. A steep SML indicates that
a large incremental return can be earned in the market by increasing risk by a small amount - the market
may be excessively risk-averse and therefore cheap. On the other hand, a flat SML indicates that there is
little incremental return in the market for taking additional risk, and that the market is ignoring risk. Such
a market may be overvalued as shown in Figure 6.3.6.3(c).

Figure 6.3.6.3(c) - Expensive and Cheap Markets Using the SML

6.3.7 Arbitrage Pricing Theory

One of the main criticisms against the CAPM is the inability to observe or properly measure the return on
the market portfolio which consists of all risky assets. In addition, the CAPM assumptions are largely
unrealistic. CAPM is essentially a single factor model where the volatility of security prices is only
explained by the market.

In response to these criticisms, Stephen Ross developed an alternative asset pricing model in the early
1970s - the Arbitrage Pricing Theory (APT) - which is a multifactor equilibrium pricing model.

APT, like the CAPM, has the following assumptions:

i.� Investors have homogeneous beliefs;
ii.� Investors are risk-averse utility maximizers;
iii.� Markets are perfect, so that factors like transactions costs are irrelevant; and
iv.� Returns are generated by a factor model.

In contrast to the CAPM, the APT does not assume:

i.� A single-period investment horizon;
ii.� The absence of taxes;
iii. Borrowing and lending at the risk-free rate; and

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iv.� Investors' selection of portfolios on the basis of expected return and variance of return.

A factor model takes the view that there are underlying risk factors that affect the realised and expected
returns of securities. These risk factors represent broad economic forces and not company-specific
factors.

These risk factors have three characteristics:

i.� Each risk factor must have a pervasive influence on share returns. Firm-specific events are not APT
risk factors.
ii.� These risk factors must influence expected return.
iii.� At the beginning of each period, the risk factors must be unpredictable to the market as a whole. The
rate of inflation is not an APT risk factor because it is partially predictable. Unexpected inflation - the
difference between actual inflation and expected return - is an APT risk factor.

Economic factors might include real economic growth, inflation, changes in interest rates and political
uncertainties. APT assumes that there are several underlying factors generating returns for the security:

Ri = E(Ri ) + bi1 f1 + bi2 f2 + … + bin fn + ei

Where:
Ri = actual (random) rate of return on security i in any given period t
E (Ri) = expected return on security i
f = deviation of a systematic factor F from its expected value
bi = sensitivity of security i to a factor
ei = random error term, unique to security i

The actual return for security i will be equal to its expected return if the factors are at expected return
(that is there are no deviations of the factors from expected values) and the random error term is zero.

The problem with APT is that the factors are not well specified, at least in the future. Most empirical
studies suggest that there are 3 to 5 factors influencing security returns. Roll and Ross identified 5
systematic factors:
•� Changes in expected inflation
•� Unanticipated changes in inflation
•� Unanticipated changes in industrial production
•� Unanticipated changes in the default-risk premium
• Unanticipated changes in the term structure of interest rates

Investors can enhance return by identifying the few factors affecting asset returns. An investment
manager can structure the portfolios to expose them to one or more of these risk factors or he can hedge
or neutralise the portfolios.

6.4 Performance Measurement

We have discussed the major components of the investing process. One important issue that remains is
the "bottom line" of the investing process: evaluating the performance of a portfolio. In evaluating the
performance we want to answer the following questions:
•� How well or how badly is the manager performing, relative to a benchmark?

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•� What factors contributed to the success or failure?

In this section, we will examine the types of composite performance measures, which consider both risk
and return and performance attribution analysis, which helps to identify the reasons for good or bad
performance.

6.4.1 Measuring Investment Returns

A proper measure of total return captures both the income component and the capital (gains or losses)
component of return. Performance measurement is typically measured over a regular time period e.g.
monthly or quarterly. Return measurements are relatively simple if there are no cash flow movements
during the measuring period but become more complicated when there are movements in cash flows i.e.
deposits or withdrawals by the client. In this section, we will look at the methods of measuring investment
returns based on different assumptions of cash flows.

1.� No deposits or withdrawals

In the simplest case, where there are no withdrawals or deposits from the client, the market value of a
portfolio can be measured at the beginning and end of a period, and the rate of return is calculated as:
VE - VB
Return on the Portfolio Rp =
VB
where:
VE = end value of the portfolio
VB = beginning value of the portfolio

Portfolio Return - No Movement of Cash Flows

If a portfolio has a market value of $30 million at the beginning of the quarter, and a market value of
$35 million at the end of the quarter, then the return on the portfolio is:
$35m - $30m
Rp =
$30m
= 16.7%

2.� Deposits or withdrawals at the end of measuring period

Measurement of portfolio returns becomes complicated when the client either adds or withdraws money
from the portfolio.

Portfolio Return - Cash Flow Movements at End of Period

Consider a portfolio with a market value of $50 million at the beginning of the quarter. Suppose the
client deposits $5 million into the portfolio just before the end of the quarter, and subsequently the
market value at the end of the quarter is $53 million. When calculating the return on the portfolio, the
deposit of $5 million has to be deducted from the end value, thus providing a return of -4%.

$53m - $5m) - $50m

Rp =
$50m
= -4.0%

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In general, if a deposit or withdrawal occurs just before the end of the period, the return on the portfolio
should be calculated by adjusting the end market value of the portfolio:

(Vε + Withdrawals - Deposits) - VB

Rp =
VB

3.� Deposits or withdrawals at the beginning of measuring period

If a deposit or withdrawal occurs just after the start of the period, then the return on the portfolio should
be calculated by adjusting the beginning market value of the portfolio. In the case of a deposit, the
beginning value should be increased by the dollar amount. In the case of a withdrawal, the beginning
value should be decreased by the dollar amount.

Vε - (VB + Deposits - Withdrawaals)

Rp =
VB + Deposits - Withdrawals

Portfolio Return - Cash Flow Movements at Start of Period

If the $5 million deposit in the previous example was received at the beginning of the quarter, the
return should be -3.6 percent.
$53m - ($50m + $5m)
Rp =
$50m + $5m
= -3.6%

4.� Dollar-Weighted Rate of Return (DWR)

When deposits or withdrawals occur sometime between the beginning and end of the period, the DWR
can be used to calculate the return on the portfolio. The DWR is equivalent to the internal rate of return.
It equates all cash flows, including ending market value, with the beginning market value of the portfolio.

Portfolio Return - Dollar Weighted

If the $5 million deposit in the previous example was made in the middle of the quarter, the DWR is
calculated by solving the following equation for r:

-$5m $53m
$50m = +
(1 + r) (1 + r)2

r = -1.92% (semi-quarterly return)

The quarterly return is (1 - 0.0192)2 -1 = -3.8%7

7 This
is a loss. In the first half of the quarter, the loss was 1.92%, resulting in a lower value of 0.9808. In the second half of the
quarter, there is another 1.92% loss on the 0.9808. Hence (1 – 0.0192)2 or (0.9808) x (0.9808).

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5.� Time-Weighted Rate of Return (TWR)

Alternatively, TWR can be used to compute a portfolio's performance when cash flows occur between the
beginning and end of a period. Calculating the TWR requires information about the value of the portfolio
before each cash flow occurs.

Portfolio Return - Time Weighted

Consider the following information:

Portfolio value at beginning of quarter $50 million

Portfolio value just before deposit $49 million
Deposit in middle of quarter $5 million
Portfolio value immediately after deposit $54 million
Portfolio value at end of quarter $53 million

Return of portfolio for first half of the quarter is:

$49m - $50m
Rp =
$50m
= -2.0%

Return for portfolio for second half of quarter is:

$53m - $54m
Rp =
$54m
= -1.85%

The quarterly return is computed linking the two rates of return as follows:
RP = 1 - 0.02)1 - 0.0185) - 1
= -3.81%

If there are frequent cash flows, substantial calculations are necessary.

6.� Annualizing Returns

Based on the quarterly returns, the annualized geometric return (compounded annual growth rate or
CAGR) can be calculated as follows:

Annual Return = 1+ r1 )1+ r2 )1+ r3 )1+ r4 ) – 1

Where r1, r2, r3, r4 = quarterly returns.

In the example below, the annualized geometric rate i.e. the CAGR is calculated over a 5-year period.

Calculating Annualized Returns - Compounded Annual Growth Rate

A portfolio grew from $100 to $250 in 5 years. The annualized geometric return, which is the
compounded annual growth rate (r), is given by:
250 = 100 x (1 + r)5
r = 20.1%

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7.� Dollar-Weighted Return Versus Time-Weighted Return

The two methods of calculating returns, the DWR and the TWR, can produce different results, and at times
these differences are substantial. In general, the DWR method of measuring a portfolio's return for the
purpose of evaluating the performance of the portfolio manager is regarded as inappropriate. This is
because the DWR is strongly influenced by the size and timing of the cash flows over which the investment
manager has no control. For evaluating the performance of the portfolio manager, the TWR is more
appropriate as the objective is to measure the performance of the portfolio manager independent of the
actions of the client.

8.� Modified Dietz Method

An essential part of calculating a true TWR is the valuation of the portfolio just before each cash flow. In
practice, cash flows often occur intra-month when portfolio valuations may not be available. The Dietz
method overcomes the need to know the valuation of the portfolio on the date of each cash flow by
assuming a constant rate of return on the portfolio during the period. The original Dietz method assumes
that all cash flows occurred at the midpoint of the period.

The modified Dietz method weights each cash flow by the amount of time it is held in the portfolio. The
formula for estimating the TWR using the modified Dietz method is:
VE - VB - CF
Rp =
VB + WCF
Where:
CF = net cash flow over the period
WCF = weighted cash flow

The formula for WCF is:

n - ti
WCF =
CFi
n
i
where:
CFi = cash flow on day ti
n = number of days in the period

The numerator of the WCF formula is based on the assumption that the cash flows occur at the end of the
day. If cash flows were assumed to occur at the beginning of the day, the numerator would be (n - t i + 1).
Whichever method is used, being consistent is important.

Portfolio Return - Modified Dietz Calculation

A portfolio has a value of $10 million at the beginning of a month. During the month, there was a cash
inflow of $100,000 on day 12 and $200,000 on day 18. At the end of the month, the portfolio value was
$11 million. Using the modified Dietz formula, the return on the portfolio is calculated as follows:
30 - 12 30 - 18
WCF = 100,000 × + 200,000 ×
30 30
= 60,000 + 80,000 = 140,000

11,000,000 - 10, 000,000 - 300,000

Rp =
10,000,000 + 140,000
= 6.90%

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The main advantage of the modified Dietz method is that it does not require portfolio valuation for the
date of each cash flow. Its main disadvantage is that it provides a less accurate estimate of the true TWR.
It can be affected by cash flows, especially if these are large relative to the size of the portfolio or when
the cash flows occur during periods of high market volatility.

9.� Global Investment Performance Standards (GIPS)

Prior to February 2005, the Association of Investment Management and Research (AIMR) issued and
prescribed the minimum standards for the presentation of investment portfolio performance.

On 4 February 2005, the Chartered Financial Analysts Institute Board of Governors approved the revised
Global Investment Performance Standards (GIPS), which create a single global standard of investment
performance reporting and increase minimum standards worldwide. The GIPS standards replaced the
various country-specific performance standards and are widely accepted among the international
industry of investment managers.

Some of the fundamental principles include:

1.� Total return, accounting for realized and unrealized capital gains and income, must be used to
measure portfolio investment performance;
2.� Time-weighted returns must be used;
3.� Portfolios must be valued (marked to market) at least monthly, and returns have to be geometrically
linked i.e. the compounded annual growth rate (CAGR) must be used for annualized returns;
4.� Performance must be calculated after deducting actual trading expenses (e.g. brokerage,
commissions, etc.);
5.� Dividends, interest income and other sources of time-based income have to be accrued and
accounted for in the portfolio performance;
6.� The annual returns for all years must be shown. If the investment management company is more
than 10 years, a 10-year performance record must be presented. Otherwise the performance record
has to be presented for the number of years since its inception;
7.� Disclosure of whether performance results were calculated gross or net of investment management
fees; and
8.� The use of leverage and derivatives has to be expressly disclosed.

6.4.2 Risk-Adjusted Measures of Performance

In evaluating the performance of the portfolio manager, it is inadequate to just consider returns without
considering the risk taken to achieve these returns.

There are 3 generally recognised methods of measuring risk-adjusted returns, also referred to as the
composite measures of portfolio performance:
•� Sharpe performance measure
•� Treynor performance measure
•� Jensen differential return measure

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1.� Sharpe Performance Measure

Developed by William Sharpe, this measure relates the portfolio's excess return, or return above the risk-
free rate to the portfolio's total risk. The numerator is also referred to as the risk premium. The total risk
of the portfolio is measured by the standard deviation.

The Sharpe portfolio performance measure is defined as:

Rp - Rf
Sharpe measure, S =
σp
where:
Rp = average rate of return for portfolio
Rf = risk-free rate of return
σp = standard deviation of return for portfolio

The Sharpe measure is thus a measure of the excess return per unit of total risk (standard deviation). The
higher the Sharpe measure, the better the portfolio performance.

Sharpe Risk-Adjusted Performance Measure

Consider the performance of the following portfolios:

Portfolio Annual Return Standard Deviation

A 0.10 0.15
B 0.16 0.20
Market 0.13 0.18

Assuming a risk-free rate of 6%, the Sharpe measures for these portfolios are as follows:
0.10 - 0.06
SA =
0.15
= 0.27 or 27%

0.16 - 0.06
SB =
0.20
=0.50 or 50%

0.13 - 0.06
SM =
0.18
= 0.39 or 39%

Portfolio A has the lowest excess return per unit of total risk and underperforms both portfolio B
and the aggregate market portfolio. In contrast, portfolio B performs better than portfolio A and
the aggregate market portfolio.

2.� Treynor Performance Measure

The Treynor measure relates the average excess return on the portfolio during some period (exactly the
same variable as in the Sharpe measure) to its systematic risk as measured by the portfolio's beta.
Rp - Rf
Treynor measure, T =
βp
where βp = beta for portfolio

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In this case, we are calculating the excess return per unit of systematic risk. The Treynor measure implies
that systematic risk is the proper measure of risk to use when evaluating portfolio performance. It
implicitly assumes that the portfolio is well diversified, that is, unsystematic risk is completely eliminated.

Treynor Risk-Adjusted Performance Measure

Consider the performance of the following portfolios:

Portfolio Annual Return Beta

A 0.14 0.9
B 0.18 1.1
Market 0.20 1.0

Based on a risk-free rate of 6 percent, the Treynor measures for these portfolios are:

0.14 - 0.06
TA =
0.9
= 0.089 or 8.9%

0.18 - 0.06
TB =
1.1
= 0.109 or 10.9%

0.20 - 0.06
TM =
1.0
= 0.140 or 14%

3.� Sharpe Versus Treynor Measures

The main difference between the Sharpe and Treynor performance measures lies in the definition of risk.
The Sharpe performance measure considers total risk as measured by the standard deviation of returns,
while the Treynor measure considers systematic risk as measured by the beta of the portfolio.

If the portfolios are perfectly diversified - that is, the correlation coefficient between the portfolio return
and the market return is 1.0 - the two measures will provide identical rankings because beta approaches
1, i.e. there is only systematic risk because the portfolio behaves identically with the market. As the
portfolios become less well diversified, the possibility of differences in rankings increases. This leads to
the following conclusion: the Sharpe measure accounts for the extent of a portfolio’s diversification
during the measurement period. Differences in rankings between the two measures can result from
substantial differences in diversification in the portfolio. If a portfolio is inadequately diversified, its
performance ranking using the Treynor measure will be higher than its ranking if we use the Sharpe
measure, because the Treynor measure understates the total risk in the portfolio by ignoring the
nonsystematic risks, which are present in an inadequately diversified portfolio.

4.� Jensen Differential Return Measure

The Jensen measure of performance is based on the CAPM and measures the risk-adjusted return as
alpha. It is a good measure only if two portfolios under comparison have the same beta. As such, it is not
a good measure of performance in its own right.

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The Jensen measure uses CAPM to determine the expected return on a portfolio (R e) given the market's
performance during the measurement period (Rm), the risk-free rate (Rf) and the portfolio's beta.

The expected return on a portfolio is given as:

Re = Rf + βp (Rm - Rf )

The portfolio's alpha is then the difference between the portfolio's actual return during the period and
the return that would be expected from the CAPM.

αp = Rp - Re
= Rp - [Rf + βp (Rm - Rf)]

A positive alpha reflects superior performance while a negative alpha indicates inferior performance.

6.4.3 Performance Attribution

Performance attribution seeks to determine the reasons why a portfolio manager did better or worse
than a properly constructed benchmark with complete risk adjustment. Its purpose is to decompose the
total performance of a portfolio into specific components that can be associated with specific decisions
made by the portfolio manager.

Attribution analysis often begins from the broadest asset allocation choices and progressively focuses on
finer details of portfolio choice. The difference between the performance of a managed portfolio and
that of a benchmark portfolio may be expressed as the sum of the contributions to performance of a
series of decisions made at the various levels of the portfolio construction process. For example, one
common attribution system decomposes performance into three components:
a.� Asset allocation choices across equity, fixed-income and money markets;
b.� Industry (sector) choice within each market;
c.� Security choice within each sector.

Part of the analysis process involves identifying a benchmark of performance (called the bogey) for
comparing the portfolio's results. The bogey is designed to measure returns if a "passive" strategy were
adopted. Weights assigned to the bogey portfolio will depend on the risk tolerance of the investor. Any
difference between the portfolio's results and the passive benchmark must be due to either asset
allocation bets or security selection bets.

1.� Characteristics of Good Benchmarks

Good useful benchmarks should be

•� Unambiguous – the asset class, securities, names and composition should be clearly stated;
•� Investable – the benchmark portfolio should be practically and realistically investable as an actively
managed portfolio;
•� Measurable – the returns on the benchmark portfolio can be obtained from the market, and its
performance measured;
•� Consistent with the investment manager’s investment philosophy; and
•� Bought in by the investment manager as an acceptable benchmark.

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Portfolio Performance Benchmark with a Bogey Portfolio

To illustrate, consider the following hypothetical managed portfolio and bogey portfolio which invest
in equities, bonds and money market securities:

Managed Portfolio
Asset Classes Weight Actual Return Weighted Return
Equities 0.70 7.50% 5.25%
Bonds 0.10 2.00% 0.20%
Cash 0.20 0.50% 0.10%
5.55%

Bogey Portfolio
Asset Classes Benchmark Weight Benchmark Return Weighted Return
Equities 0.60 6.00% 3.60%
Bonds 0.30 1.50% 0.45%
Cash 0.10 0.50% 0.05%
4.10%

Excess return = 5.55% - 4.10% = 1.45%

The benchmark weights have been set at 60% equities, 30% bonds, and 10% cash. The return on the
bogey portfolio is 4.10%. Given a return of 5.55% on the managed portfolio, this represents an excess
return of 1.45%.

The next step is to allocate the 1.45% excess return to the separate decisions that contributed to it.

2.� Asset Allocation Decision

The effect of the manager's asset allocation choice can be computed by comparing the weights of the
managed portfolio and the bogey portfolio as follows:

Asset Classes Actual Benchmark Excess Benchmark Contribution to

Weight Weight Weight Return Performance
Equities 0.70 0.60 0.10 6.00% 0.60%
Bonds 0.10 0.30 -0.20 1.50% -0.30%
Cash 0.20 0.10 0.10 0.50% 0.05%
0.35%

Asset allocation contributed 0.35% to the portfolio's overall excess return of 1.45%. The major factor
contributing to the outperformance is the higher weighting of equities, which provided a return of 6%.

3.� Sector and Security Selection Decisions

The remaining excess return of 1.10% is attributed to sector selection and security selection as illustrated
below:

Asset Actual Benchmark Excess Actual Contribution to

Classes Return Return Return Weight Performance
Equities 7.50% 6.00% 1.50% 0.70 1.05%
Bonds 2.00% 1.50% 0.50% 0.10 0.05%
1.10%

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Equity return is 7.50% versus a return of 6%for the benchmark. The bond return is 2.00% versus 1.50% for
the bond index. The superior performance in both equities and bonds weighted by proportions invested
in each asset class contributed 1.10% to the overall excess return.

A summary of the portfolio attribution is as follows:

Percentage
Asset allocation 0.35%
Sector and security selection
- Equities 1.05%
- Bonds 0.05% 1.10%
Excess Return of Portfolio 1.45%

6.5 Summary

The Portfolio Management Process

1.� The portfolio management process is a dynamic, continuous and systematic one which involves the
following elements: (a) setting investment objectives, (b) developing and implementing strategies,
(c) monitoring market conditions, (d) reviewing and adjusting the portfolio, and (e) measuring
investment performance.

2.� In defining the investment policy, the following objectives and constraints have to be analysed:
investor's return requirement and risk tolerance, liquidity requirements, time horizon, tax
considerations, legal and regulatory constraints, and client's unique needs and preferences.

3.� Asset allocation involves determining the weighting of each asset class in a portfolio so as to
maximize return at a level of risk consistent with the investor's objectives.

4.� There are two approaches to asset allocation. Strategic asset allocation constitutes the long-run asset
mix and is not affected by changing capital market conditions. Tactical asset allocation seeks to
enhance return by shifting the asset mix of a portfolio in response to changes in the capital markets.

Portfolio Theory

5.� Studies have shown that portfolio risk is reduced as we increase the number of securities in the
portfolio.

6.� There are two sources of risk: systematic risk and nonsystematic risk. Systematic risk is attributed to
macroeconomic factors. It cannot be eliminated by diversification. Nonsystematic risk or firm-
specific risk can be controlled and minimised through diversification.

7.� For successful diversification, we should seek securities that are unrelated to one another in terms
of risk. If returns of securities are related, then risk cannot be reduced significantly. Portfolio risk is
lowest when the returns of shares are negatively correlated.

8.� The capital asset pricing model (CAPM) is concerned with the equilibrium relationship between the
risk and the expected return on risky assets.

9.� The capital market line specifies the equilibrium relationship between expected return and total risk
for efficiently diversified portfolios.

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10.� The security market line specifies the equilibrium relationship between expected return and
systematic risk. It applies to individual securities as well as portfolios.

11.� Beta is the relative measure of risk of a security or portfolio. It indicates the volatility of the return
of the security or portfolio relative to the volatility of the market portfolio's return.

12.� The security market line (SML) is useful for identifying overvalued and undervalued securities, as well
as cheap and expensive markets.

13.� According to the arbitrage pricing theory (APT), security returns are affected by a few risk factors
which represent broad economic forces.

Performance Measurement

14.� A proper measure of total return must consider both the income and capital components. Return
measurements have to adjust for any deposits into or withdrawals from the portfolio.

15.� For evaluating the performance of the portfolio manager, the time-weighted return is more
appropriate than the dollar-weighted return since it is not influenced by the size and timing of cash
flows.

16.� The modified Dietz method of computing returns is widely used as it does not require the valuation
of the portfolio on the date of each cash flow. The modified Dietz method weights each cash flow by
the amount of time it is held in the portfolio.

17. The Global Investment Performance Standards (GIPS) create a single global standard of investment
performance reporting and increase minimum standards worldwide.

18.� The most common composite measures of portfolio performance are:

•� Sharpe measure which relates the portfolio's excess return to the total risk (standard deviation)
of the portfolio;
•� Treynor measure which relates the portfolio's excess return to the portfolio's systematic risk
(beta);
•� Jensen differential return measure, which measures the difference between the portfolio's actual
return and the return that would be expected from the CAPM.

19.� The Treynor measure implicitly assumes that the portfolio is well diversified. If a portfolio is
inadequately diversified, its ranking by the Treynor measure can be misleadingly higher than its
ranking by the Sharpe measure.

20.� Performance attribution is concerned with why a portfolio manager did better or worse than the
benchmark portfolio. The performance of a portfolio is decomposed into specific components to
determine the reason for superior or inferior performance.

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Chapter 7:
Equity Securities
Learning Objectives

The candidate should be able to:

� Describe the characteristics of equity securities, namely ordinary share and preference shares.

� Explain the differences between ordinary share and preference share.

Distinguish among various types of ordinary shares for investment and portfolio management
purposes, such as blue chip shares, growth shares, income shares, cyclical shares, defensive
shares and hard asset shares.

� Understand the differences between absolute and relative valuation approaches.

� Understand yield and return ratios used in equities analysis, such as dividend yield, price-
earnings ratio, price-to-book value ratio, price-to-sales ratio, price-to-cash flow ratio and
Enterprise Value-to-EBITDA ratio, and their relevance to different types of companies.

� Describe the composition and computation of share market indices.

� Discuss investment management strategies (passive and active), and distinguish between the
two in the context of the Efficient Market Hypothesis.

� Use the concept of time value of money in cash flow discounting methodology.

� Apply share valuation models in determining intrinsic values of shares, such as the Dividend
Discount Model, Constant Growth Model, Multiple Growth Case (Model), Zero Growth Model,
Earnings Multiplier Models

� Understand how prospectuses for Initial Public Offerings are read and analyzed.

� Describe depositary receipts as a means of investing in foreign markets

7.1 Introduction

Among the financial assets available for investment, equity securities constitute a major asset class.
Despite the volatility associated with equity investments, the potential for substantial capital gains
remains a major draw for investors.

This chapter begins with an outline of the general characteristics of ordinary share and preference share.
We will look at different types of companies and their shares from a valuation perspective, the issues
involved in the construction of share market indices and the concept and application of the time value of
money, dividend yield and earnings yield.

We will address the Efficient Market Hypothesis and explain its implications for passive and active
approaches to investment strategies.

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This chapter also covers the two main approaches to equity valuation of ordinary share: absolute
valuation and relative valuation, and the pros and cons of each of these.

7.2 Types of Equity Securities

The two forms of equities are ordinary shares and preference shares.

7.2.1 Ordinary Shares

Ordinary shares, also known as equity securities or equities for short, are ownership shares in a
corporation. As a shareholder, one stands to profit when the company profits. Shareholders are also
legally entitled to vote on major policy decisions, such as electing directors and issuing new shares. The
more shares one owns, the greater one’s voting power. Minority shareholders, on the other hand, may
not have sufficient votes to exert pressure on the management of the corporation.

Investors buy equities for both capital appreciation and dividend income. Ordinary dividends are not
annual guaranteed payments. The amount and frequency can vary depending on the performance and
dividend policy of the company. Compared to other investment securities, ordinary share offers both the
greatest rewards and the highest risks, over long periods of time.

Two important characteristics of ordinary share as an investment are residual claim and limited liability.

Residual claim means that shareholders are the last in line among all those who have a claim on the assets
and income of the corporation. If a company is liquidated, the shareholders generally have a claim to
what is left of the corporation’s assets only after all the other claimants such as the tax authorities,
employees, suppliers, bondholders and other creditors have been paid. For a firm that is not in
liquidation, shareholders can benefit from the part of operating income that remains after interest and
taxes have been paid. The management can either pay this surplus as cash dividends to shareholders or
reinvest it in the business to increase the value of the company.

Limited liability means that the greatest amount shareholders can lose, in the event of failure of the
corporation, is their original investment. Creditors have recourse only to the assets of the corporation.
Corporate shareholders are not personally liable for the obligations of the company.

A corporation can undertake a corporate action referred to as a ‘rights issue’, where rights are issued to
the shareholders, giving them an option to purchase a stated number of new shares (the rights issue) at
a specified price. This prevents the voting rights of existing shareholders from being diluted. These rights
may be renounceable or non-renounceable. Renounceable rights have value and can be traded, while
non-renounceable rights are not transferable and cannot be traded. A company can undertake a
placement where no rights are issued to existing shareholders.

7.2.2 Preference Shares

Although technically an equity security, a preference share is considered a hybrid security because it
resembles both fixed-income and equity instruments. As an equity security, a preference share has an
infinite life and pays dividends. Most preference shares are callable by the issuer, although there is
typically a period of protection against such a call. Usually the issuer will not call in the first 5 years of the
life of the preference shares. Although not as prevalent, non-callable preference shares may also be

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issued. These carry a lower rate of return than the callable ones because the issuer has no option to
redeem the shares.

A preference share resembles a fixed-income security in that the dividend is specified and known in
advance. In effect, a preference share can provide a stream of income very similar to that of a bond. The
difference is that the stream continues indefinitely, unless the preference shares are called or otherwise
retired. Because of its stipulated payments, preference shares are viewed by most investors as somewhat
equivalent to a fixed income security, and therefore considered an alternative to bonds.

Preference share dividends are specified as an annual dollar amount or as a percentage of par value. The
issuer can decide not to pay the preference dividend if earnings are insufficient. Although this dividend
is specified, failure to pay it does not result in a default, as is the case with bonds.

Investors regard preference shares as less risky than ordinary shares because preference dividends are
specified and must be paid before ordinary share dividends can be paid. Preference shares are riskier than
bonds however, because bondholders are paid first in cases of liquidation. Preference shareholders do
not have voting rights except in the event of financial distress. Companies may issue several classes of
preference shares, with each class having different benefits. The main distinctions are the method and
amount of dividend payment, and the special privileges related to each class.

In summary, preference shares are “preferred” because of the benefits. First, it has a priority in
redemption if the company liquidates. Second, its dividend rates are fixed and also given a priority to be
paid over dividends for ordinary shares.

1.� Cumulative Feature

Although common in the past, most preference shares today do not have this cumulative feature that
requires all past unpaid preference share dividends to be paid before any ordinary share dividends are
declared. The purpose is to provide some degree of protection for the preference shareholder because
preference share dividends do not enjoy the same legal right as the interest that is paid to bondholders.
The cumulative feature secures the rights of preference shareholders to receiving dividends before
ordinary shareholders receive any.

2.� Callable Feature

Most preference shares are callable by the issuer at a stated redemption price, usually only after a number
of years from its issue. The call feature allows the issuing firm to replace its preference share if interest
rates fall. Callable preference share normally carries a higher yield compared to similar preference share
without the call feature. The initial redemption price is usually set at a premium above the par value. By
setting the initial call price above par, the investor is protected from an early call that carries no premium.

3.� Participation Feature

The participation feature allows the preference shareholder to receive extra dividends when there are
sufficient earnings. Although a participation feature is attractive to the investor, it is not a common
feature in preference shares.

4.� Convertibility Feature

Although not common, the owner of a convertible preference share has the right to exchange his
preference share for a specified number of shares of ordinary shares. This convertibility feature is
attractive to the investor and reduces the cost of the preference shares to the issuer. Essentially, the
issuer has sold an option to the investor, and the cost of the premium on the option to the investor is

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reflected in the lower yield on the preference shares. Investors will generally exercise the conversion
from preference shares to ordinary shares if there is an appreciation in the price of the ordinary shares.

7.3 Types of Ordinary Shares

As part of equity valuation, ordinary shares are analyzed according to their respective classifications.
Ordinary shares can be classified according to the type of company it belongs to, under the following
categories:

Blue Chip Shares - Blue chip shares are high-grade, investment-quality issues of major companies, which
have long and consistent records of earnings and dividend payments. The term is used to describe the
ordinary share of large, well-established, stable and mature companies of great financial strength. The
ability to pay steady dividends, during bad as well as good years for a long period, is an indication of
financial stability.

Blue chips hold important, if not leading, positions in their respective industries where they are usually
pacesetters, and they frequently determine the standards by which other companies in their fields are
measured. These are companies whose management have shown foresight in growing the company
without jeopardizing current earnings. Such companies typically have the advantage of size - in a
recession, they should be able to maintain earnings at stable levels and then record strong earnings gains
in an economic upswing because they have the resources for sustainable earnings. Investors who seek
safety and stability, and are conservative in their approach, usually turn to blue chip shares.

Growth Shares - These are stocks of companies whose sales, earnings and market shares are growing
faster than the economy and the average for their industry. These companies are usually aggressive with
strong research teams. They normally pay relatively small dividends as most earnings are retained for
expansion purposes. Key characteristics of growth companies include having a solidly entrenched position
in an expanding market, distinctive or unique products, and high profitability in most cases by preempting
a special part of the market.

Income Shares - These are shares of companies that pay higher than average dividend yields. These
include mature companies, which can generate large cash flows that are not required for expansion
purposes.

Income shares are attractive to investors who buy shares for current income. They are often sought by
trust funds, pension funds, endowment funds, and charitable and educational foundations. Selecting
income shares can be a very tricky business. The share may be paying a high dividend yield because its
price has fallen due to the fact that there is considerable uncertainty as to whether the dividend can be
maintained in the light of declining earnings. Or the share may also be that of a lackluster company in an
unpopular industry with little future.

Cyclical Shares - These are shares of companies whose earnings and prices fluctuate with the business
cycle, or are accentuated by it. When business conditions are bright, the company enjoys strong earnings
growth and the ordinary share price rises. When business conditions deteriorate, the share price drops
as earnings growth declines. Shares of construction, marine, shipbuilding and retailing companies may
be regarded as cyclical shares.

Defensive Shares – The earnings of defensive companies have a high likelihood of withstanding economic
downturn or uncertainty. Companies that provide consumer with the necessities of life, such as
pharmaceuticals and food, tend to be less volatile than cyclical shares and growth shares. If a recession
is expected, there would be a growing interest in these 'recession-proof' shares.

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Hard Asset Shares - These are shares of companies that own valuable assets. Often, such valuable assets
are in the form of property or investments that have appreciated in value. Investors normally show strong
interest in these shares when their share prices trade below their net asset values.

Foreign Shares - Investors may seek diversification across different equity markets by investing in markets
of other countries. This forms part of the fund management process for a global portfolio, as it carries out
asset allocation by geography across the world. Participation in foreign shares can take place via:
•� Direct Investment - Investors can purchase foreign shares directly on the respective share exchanges
to diversify risk away from the home market. However, this may be complicated by withholding taxes
and significant transaction costs, or regulations that limit foreign ownership.
•� Depository Receipts (DRs) - DRs represent shares of companies. SGX offers American DR trading via
GlobalQuote, Global DRs and Singapore DRs. DRs also enable investors to buy and hold foreign
securities without going to the foreign share exchange directly. They provide ready access to foreign
markets that may have barriers to foreign ownership and capital flow.
•� Exchange-Traded Funds (ETFs) - ETFs replicate a broad-based index like the Straits Times Index (STI)
or the Standard and Poor’s (S&P) 500. Investors who buy an ETF effectively acquire the market risk
profile of an investment in the shares of the underlying foreign index. Refer to Chapter 11 of this study
guide for more coverage.
•� Foreign Shares with Dual Listings - Some shares have a double listing, e.g. in both Singapore and
their home country. Dual listing refers to the practice of listing a security on a foreign share exchange
in addition to its local exchange. To the investor, such listings enhance liquidity. Dual listings allow a
share to continue trading in another exchange after one exchange has closed.

7.4 The Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) states that prices of shares in the market always fully reflect all
the information available on the shares. EMH further posits that market prices will move in a random
walk, i.e. move in an unpredictable way, because there is no new information that is not already known.
New information is, by definition, unpredictable, and therefore share prices that move in response to new
information will move unpredictably. Random walk movement is simply unpredictable, which is not the
same as irrational.

The implication is that there is no advantage that can be derived from the analysis of individual shares,
industries or even the economy, because the market is perfectly efficient in factoring in all information
available into the share prices, through the behavior of market participants.

7.5 Passive versus Active Management Strategies

Investors can either adopt a passive or active approach in selecting and managing equity portfolios. The
strategy adopted will depend on a number of factors, including the investor's expertise, time, and
temperament, and his views about market efficiency, as described above.

7.5.1 Passive Strategy

The EMH concept implies that it is not possible to outperform the market through active share selection
and analysis. It does not make sense to buy and sell securities frequently because this will generate large

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brokerage commissions without enhancing expected performance. Passive management, characterized

by a buy-and-hold strategy, is thus recommended. The investor believes that such a strategy will, over
the long term, produce results that are just as good as strategies that require active management.

Alternatively, an investor can invest in an equity index fund or portfolio. Index funds are designed to track
the performance of a selected market index. A manager of an equity index portfolio is judged on how
well he tracks the target index. Expenses including research costs, management fees and brokerage
commissions, are kept at a minimum.

7.5.2 Active Strategy

The successes of investors such as Warren Buffet, and the existence of numerous asset management
firms, show that most investors do not subscribe to the EMH and in fact, favour an active approach to
equity investing. The use of valuation models and the constant analysis of the economy, industry and
individual companies are indications of active management. The objective of active management is to
outperform the market on a risk-adjusted basis. Active investors believe they have some advantages over
other market participants. Such advantages could include superior analytical skills, or access to
information that is not available to other institutional investors. Security selection, sector rotation and
market timing are examples of active strategies.

Security Selection - Value share specialists believe they can outperform the market by selecting securities
that they believe are undervalued. Such shares are typically selected using fundamental security analysis
or through the use of valuation models such as the dividend discount model or P/E ratio model. Value
share specialists tend to look for low P/E shares, shares that are trading below their intrinsic values .

Sector Rotation - This strategy involves shifting sector weights in the portfolio in order to take advantage
of sectors that are expected to outperform, and avoiding or underweighting sectors that are expected to
underperform the market average. Under the Industry Classification Benchmarks, the market is classified
into 10 industries, which are further sub-divided into super sectors and sectors. A sector is the smallest
sub-set of an industry. It is quite common in sector i.e. industry analysis to divide ordinary shares into
broad sectors, such as interest-sensitive shares, cyclical shares and defensive shares. Each of these sectors
is expected to perform differently during the various phases of the business cycle. Interest-sensitive
shares are expected to underperform during periods of high interest rates. Cyclical shares are expected
to do well in an economic upturn and badly in an economic downturn. Defensive shares are not hurt as
badly during the downside of the business cycle. Effective strategies involving sector rotation depend
heavily on an accurate assessment of current economic conditions. Rotating a portfolio’s investments by
industry therefore diversifies and reduces the portfolio’s risks.

Market Timing - When equities are expected to do well, market timers try to achieve superior
performance by shifting from cash equivalents to equities. When equities are expected to do poorly, the
opposite occurs. Market timing strategies thus involve active asset allocation.

7.6 Share Market Indices

The general movement of the share market is usually measured by a share market average or index
consisting of a group of securities that is supposed to reflect the entire market. The composition of the
index, the weight given to each security and the method of calculation are important considerations in
the construction of a share market index or average.

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There are three main weighting schemes used:

•� Price-weighted series;
•� Value-weighted series; and
•� Un-weighted or equal-weighted series.

7.6.1 Price Weighted Series

A price-weighted series is an arithmetic average of current prices. Share prices are added together and
divided by the number of securities. The divisor has to be adjusted when there are capital changes, such
as rights and bonus issues, and changes in the sample over time. Because the series is price weighted, a
high-priced share carries more weight than a low-priced share.

The Dow Jones Industrial Average (DJIA) is a price-weighted average comprising of 30 large, well-known
industrial shares. The DJIA has been criticized because it uses only 30 non-randomly selected blue-chip
shares, which are not considered to be representative of the shares listed on the New York Share Exchange
(NYSE).

7.6.2 Value Weighted Series

A value-weighted series is generated by deriving the initial total market value of all shares in the series
(market value = number of shares outstanding x current market price). This figure is typically established
as the base and assigned an index value (normally 100). Subsequently, the new market value is computed
for all securities in the index, and this new value is compared to the initial 'base' value to determine the
percentage of change, which in turn is applied to the beginning index value to compute an updated value.
�
Example – Value Weighted Share Index

Day 1
Share No. of Shares Share Price ($) Market Value ($)

A 1,000,000 5.00 5,000,000

B 3,000,000 3.00 9,000,000
C 5,000,000 10.00 50,000,000
Total : 64,000,000
Base value equal to an index of 100.

Day 2
Share No. of Shares Share Price ($) Market Value ($)
A 1,000,000 5.20 5,200,000
B 3,000,000 3.10 9,300,000
C 5,000,000 10.50 52,500,000
Total : 67,000,000

Current Market Value

New Index Value = x Beginning Index Value
Base Value
67,000,000
= x 100
64,000,000
= 1.05 x 100 = 105

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There is an automatic adjustment for bonus and rights issues, and other capital changes in a value-
weighted index because the decrease in share price is offset by an increase in the number of shares
outstanding. In a value-weighted index, the importance of individual shares in the sample is dependent
on the market value of the shares. Price changes for large market value shares have a greater impact on
the index value than price changes for low market value shares.

The Standard & Poor's (S&P) 500 is a value-weighted index comprising the top 500 based principally on
market capitalization. It accounts for around 75% of the total market capitalization. The Straits Times
Index is also weighted by market capitalization. It replaced the previous market index, the Straits Times
Industrial Index, which was price-weighted.

7.6.3 Un-weighted or Equal-weighted Series

In an un-weighted index or equal-weighted index, all shares carry equal weight regardless of their price
and/or market value. A $2 share is as important as a $10 share, and the total market value of the company
is not important. Changes in the index may be based on the arithmetic or geometric average of the
percent price changes for the shares in the index. The Value Line Composite Average is an equal-weighted
geometric average of share prices. More than 80 percent of the shares comprising the Value Line Average
are listed on the NYSE.

Example – Equal Weighted Share Index

Share Share Price ($) Index of Change

Day 1 Day 2
A 5.00 5.20 1.04
B 3.00 3.10 1.03
C 10.00 10.50 1.05

Geometric Average
= (1.04 x 1.03 x 1.05)1/3
= 1.040

Index value (Day 1) x 1.040

= Index Value (Day 2)

7.7 Time Value of Money, Dividend Yield and Earnings Yield

7.7.1 Time Value of Money

Money has time value. This concept is important in financial markets because cash flows take place at
different points in time. The interest received from bonds take place once a year over the life of the bond,
and likewise, dividends when declared, are typically paid annually. Using discounted cash flow techniques
to account for the time value of money, is necessary in making the correct investment analysis and
decisions. The principle behind the time value of money is that a dollar received in the future is worth
LESS than a dollar received today. This is because the dollar received today can be invested to make a
return over time. The time value of a sum of money depends on the date of its receipt and the interest
rates prevailing at that time.

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7.7.2 Simple and Compound Interest

If an investor deposits $10,000 for a fixed period of 1 year, at a rate of 2.5%, then the principal is $10,000,
the interest period is 1 year and the interest rate is 2.5%. If this is a deposit in Singapore Dollars, the day-
basis will be 365 days i.e. each year is considered to have 365 days for the purpose of computing interest.

Simple interest is calculated with the following formula:

Principal x Interest Rate x Interest Period
Simple Interest =
36,5001

Example – Simple Interest

Assume a USD 1 million deposit with a bank, earning interest at 8.00% for 91 days.

The simple interest is

(1,000,000 x 8.00 x 91) / 36,000 = USD 20,222.22

Compound interest is best described as the “earning of interest on interest”, as seen in the example
below.

Example – Compound Interest

Assume the USD 1 million deposit placed earlier at 8% is now rolled over for another 91 days at 8%
again. The compounded interest is:

1,020,222.22 x 8.00 x 91/36000 = USD 20,631.16

The total interest earned = USD 20,222.22 +20,631.16 = USD 40,853.38.

The compounded interest rate is (40,853.38/1,000,000 x 36000/182) = 8.08%

7.7.3 Future Value

With the time value principle, the future value (FV) of a sum of money or a cash flow can be calculated.
The formula2 to compute the value of an investment, if compounded annually at a rate of k for n years,
is:
FVn = PV1 + kn
where:
FVn = future value of the investment at the end of n years
PV = present value or original amount invested at the beginning of the first year
n = number of years during which the compounding occurs
k = annual interest (or discount) rate

�������������������������������������������������
1 The denominator depends on the currency’s “day basis”. Singapore dollar interest is based on a 365-day basis. US Dollars
interest is based on a 360-day basis. See above Example on Simple Interest.
2 It
is advisable to be familiar with financial / statistical calculators which can perform discounted cash flow and statistical
analysis. Excel spreadsheets are also highly recommended for investment computations and analysis.

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Example – Future Value with Annual Compounding

If $1,000 is placed in a savings account paying 5% interest compounded annually, the amount in the
account at the end of 10 years would be:

FVn = $1,000 (1 + 0.05)10

= $1,000 (1.62889)
= $1,628.89

7.7.4 Compounded Annual Growth Rate

The compounded annual growth rate (CAGR) is the effective rate that is earned on the initial cash flow. In
the above example on Future Value with Annual Compounding, the CAGR can be worked out backwards.
If the initial cash outlay of $1,000 and the final cash amount of $1,628.89 after 10 years is known, the
CAGR can be computed with the following formula:
1
FV n
CAGR =   - 1
PV
where:
CAGR = the compounded annual growth rate
FV = future value
PV = present value
n = number of years in the time period

Substituting the FV of $1,628.89, PV of $1,000 and n of 10:

1
1,628.89 10
CAGR =   -1
1,000
= 0.05 or 5%

So far, it is assumed that the compounding period is annual, although of course, compounding can be on
a daily, monthly, quarterly, semi-annual or annual basis.

If we invest $1,000 for 5 years at 5% interest compounded semiannually, we are really investing our
money for 10 six-month periods, during which we receive 2.5% interest each period. If it is compounded
quarterly, we receive 1.25% interest per period for 20 three-month periods. This process can be
generalized, giving us the following formula for finding the future value of an investment for which
interest is compounded more than once a year:
FVn = PV(1 + k/m)mn
where m = number of interest periods in the year

Example – Future Value with Quarterly Compounding

If we place $1,000 for 10 years at 5% interest compounded quarterly, the investment will grow to
$1,643.62 at the end of 10 years.

FVn = $1,000 (1 + 0.05/4)40

= $1,000 (1.0125)40
= $1,000 (1.64362)
= $1,643.62

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7.7.5 Present Value of a Single Cash Flow

Discounting is the opposite of compounding, being the process of finding the present value of a future
sum. The process of discounting helps in determining the attractiveness of investment projects. The
formula for calculating the present value is as follows:
FVn
PV =
(1 + k)n
where:
PV = present value of the future sum of money
FVn = future value of the investment at the end of n years
n = number of years to the receipt of payment
k = annual discount (or interest) rate

Example – Discounting to Get Present Value

Given a discount rate of 6%, the present value of $1,000 to be received 5 years from today is:

PV = $1,000 / (1.06)5
= $1,000 / 1.3382
= $747.26

The interest rate in present value calculations is commonly known as the discount rate. The discount rate
can be interpreted in two ways. If the company already has the money in hand, the discount rate is the
rate of return that could be earned on alternative investments. If the firm must raise the money by selling
securities, the discount rate is the rate of return expected by holders of the securities. In other words, it
is also the investor's opportunity cost.

The discount rate is frequently used to adjust the investment cash flows for risk and is hence known as
the risk-adjusted discount rate. The actual discount rate is at least the risk-free government bond yield
that has the same maturity as the intended holding period of the investment.

7.7.6 Annuities

Annuities are a series of fixed cash flows (payable or receivable) at a stated frequency and time. Examples
of annuities are monthly principal plus interest payments on home mortgages and fixed rate coupon
payments on a bond.

The present value of an annuity can be calculated with the formula below:
1- (1 + i)-n
PVannuity = C ×  
i
where
C = cash flow per period
I = interest rate
N = number of payments

� �

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Example – Present Value of an Annuity

An amount of $1000 is paid every year for 5 years. The rate of discount for 5 years is 3%. The present
value of this stream of cash flows is

1 - (1+0.03))-5
PVannuity =1000×  0.03
= $4,579.71

With a financial calculator:

Input -1,000 = PMT

Input n=5 and i=3
Press PV to get $4,579.71

The future value of an annuity is given by the formula

(1 + i)n -1
FVannuity = C ×  
i
where
C = cash flow per period
I = interest rate
N = number of payments

Example – Future Value of an Annuity

An amount of $1000 is paid every year for 8 years. The rate of discount for 8 years is 5%. The future
value of this stream of cash flows is

(1+0.05))5 -1
FVannuity =1000 ×  0.05
 = $9,549.11

With a financial calculator:

Input -1,000 = PMT

Input n=8 and i=5
Press FV to get $9,549.11

7.7.7 Dividend Yield

The dividend yield is the income component of a share's return, stated as a percentage of the current
market price of the share. For example, if the market price of a share is $2 and the annual gross dividend
is $0.10, the dividend yield is 5%.

Dividend Per Share

Dividend Yield = x 100
Market Price Per Share

= (0.10 / 2.00) * 100

= 5%

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It should be noted that the gross dividend declared, is normally quoted as a percentage of the par value
(stated or face value) of share and does not reflect the investment return to the shareholder.

The dividend payout ratio is the ratio of dividends to earnings. It indicates the percentage of a firm's
earnings paid out as cash to its shareholders. For example, if a company earns $0.40 per share and pays
out a dividend of $0.10 per share, the dividend payout ratio is 25%. The retention ratio is the opposite of
the dividend payout ratio, and indicates the percentage of a firm's current earnings retained for
reinvestment purposes.

Example – Expected Dividend Yield

As an example of how an investor can make a quick estimate of a share’s price implied by the expected
dividend, take a company such as engineering, property and manufacturing company King Wan Corp.
Stock-broking company, DMG & Partners, expected King Wan to pay a 1.5 cent dividend in 2013, rising
to 3.0 cents in 2014.

A 3 cent dividend on King Wan, whose share price was 31 cents at the time of DMG’s report, would
have translated into a high dividend yield of 9.7%. However, DMG did not expect this to last and in fact
expected some "yield compression", meaning that as the share price rose, the dividend yield on the
share will go down. If we have a dividend yield expectation of 7.5% on a dividend of 3 cents, the implied
share price will be 3 cents / 7.5% i.e. 40 cents.

Real estate investment trusts (REITs) can be valued like this as they are required to pay out 90% of their
distributable income, and their earnings can be predictable.

7.7.8 Earnings Yield

Earnings yield is the Earnings/Price ratio, expressed as a percentage. Earnings yields are usually compared
against bond yields to assess if share prices are over or under-valued. The difference is referred to as the
yield gap. Theoretically, lower bond yields mean lower rates of discounting, so that the present value of
a stream of earnings or dividends will result in a higher present value (current share price).

Figure 7.7.7 – Earnings Yield and 10-year Bond Yield

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7.8 Equity Valuation Approaches

There are two broad approaches to equity valuation (see Figure 7.8 below) - the absolute valuation
approach uses discounted cash flow analysis to determine the intrinsic value (fair value) of a share, while
the relative valuation approach relies on the comparison between a share’s current market price and its
internal value determined on the basis of earnings, book value, sales, cash flow or its EBITDA (earnings
before interest, tax, depreciation and amortization).

In absolute valuation, the intrinsic value of the share is compared to its current market value. If the
intrinsic value is greater than the market price, it is undervalued i.e. the market is valuing the share LOWER
than what it is intrinsically worth. On the other hand, if the intrinsic value is less than the market value,
then the share is overvalued i.e. the market is valuing the share HIGHER than its intrinsic worth.

In relative valuation, the share’s price multiple (Price / Earnings ratio, Price to Book Value ratio, etc.) is
compared to its peers. A share that has a lower multiple is considered undervalued, and vice versa. In
practice, a few relative valuation ratios are used together to obtain a more realistic valuation.

Figure 7.8 – Equity Valuation Approaches

�
7.8.1 Absolute vs Relative Valuation

Absolute and relative valuation approaches have the following advantages and disadvantages.

Advantages Disadvantages

1.� Discounted cash flow analysis is 1.� Choice and estimation of discount rate can
widely accepted as a way of be problematic.
Absolute determining current value.
2.� Growth rates and duration of growth can
Valuation 2.� Flexibility in making changes to cash be difficult to obtain.
flows to reflect changing growth
rates over time.

1.� Uses current market value for 1.� If the current market prices at the time of
valuation and comparison with the valuation are either very high or very low,
general share market, similar this will affect the valuation as it is being
Relative industries and across other carried out at extreme market levels.
Valuation industries.
2.� Need to have a good set of comparable
entities to allow the relative valuation to be
carried out.

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7.9 Absolute Valuation Approaches

7.9.1 Dividend Discount Model

The intrinsic value of an asset can be determined by using the discounted cash flow approach to determine
the present value of a security. According to the dividend discount model (DDM), the intrinsic value of a
common share is the present value of all future dividends:
D1 D2 D3 D∞
Po = + + +…+
(1 + k) (1 + k) (1 + k)
2 3 (1 + k)∞
where:
P0 = intrinsic value or theoretical value of the share today
Dt = dividends expected to be received during period t
k = required rate of return (discount rate) on the share

There are immediate problems with the above equation:

i.� The last term in the equation indicates that investors are dealing with infinity. They must value a
stream of dividends that may be paid forever, since ordinary share has no maturity date;
ii.� The dividend stream is uncertain; there is no specified number of dividend payments, if in fact any
are paid at all; and
iii. The primary objective of most investors in ordinary share is to sell the shares at a profit rather than
to collect dividends.

To account for the subsequent sale of the common shares, the DDM may be modified as follows:
D1 D2 Dn Pn
Po = + +…+ n+
(1 + k) (1 + k)2 (1 + k) (1 + k)n
where:
n = holding period
Pn = expected selling price of the share at the end of year n.
�
Example – Dividend Discount Model
Assume a holding period of 3 years and the estimated dividend payments for share of Company A at the
end of each year is:

Year 1 $1.00 per share

Year 2 $1.05 per share
Year 3 $1.10 per share

The expected sale price for the share at the end of 3 years is $10. Given a 12% required rate of return,
the value of the share of Company A is:
1.00 1.05 1.10 10.00
Po = + + +
(1.12) (1.12) (1.12) (1.12)3
2 3

= 0.8929 + 0.8371 + 0.7830 + 7.1178

= $9.63

To make an investment decision, one would compare this estimated value for the share to its market
price to determine whether one should buy.

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7.9.2 Constant Growth Model

When dividends are expected to grow at a constant rate (g) over time, the model is generalised as follows:

D0 (1 + g) D0 (1 + g)2 D0 (1 + g)3 D0 (1 + g)∞

P0 = + + +…+
(1 + k) (1 + k)2 (1 + k)3 (1 + k)∞
where:
P0 = intrinsic value or theoretical value of the share today
D0 = dividend payment in the current period
g = constant growth rate of dividends
k = required rate of return (discount rate) on the share

The above equation can be simplified to:

D1
P0 =
k - g

where D1 = dividend expected to be received at the end of year 1

This model is more suitable for the valuation of very large or broadly diversified companies.

The constant-growth model is often referred to as the Gordon model (named after Myron J. Gordon, who
played a large part in its development and use).

The constant-growth model makes the following assumptions:

i.� Dividends grow at a constant rate.
ii.� The constant growth rate will continue for an infinite period.
iii.� The required rate of return (k) is greater than the infinite growth rate (g). If it is not, the model gives
meaningless results because the denominator becomes negative.
Based on the constant-growth model formula, the required rate of return can also be derived:
D1
Required Rate of Return k = + g
P0

Example - Constant Growth Model

Assume Alpine Limited is currently paying dividends per share of $0.20 and investors expect dividends
to grow at a rate of 5% a year for the foreseeable future. For investments at this risk level, investors
require a return of 12% a year.

The estimated price of Alpine is:

D1
P0 =
k-g
$0.20 (1.05)
= = $3.00
0.12 - 0.05

Note that the current dividend (D0) must be compounded one period because the constant growth
model formula uses, the dividend expected to be received one period from now (D 1), as an input.

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It is noted however, that a small change in any of the original estimates (namely k and g) will have a
significant impact on the value of the share as depicted in the following examples:

a. Assume k increases from 0.12 to 0.13

g = 0.05
k = 0.13

Then D1 = $0.20 (1.05) = $0.21

$0.21
P0 = = $2.63
0.13 - 0.05

b. Assume g increases from 0.05 to 0.06

g = 0.06
k = 0.12
D1 = $0.20 (1.06) = $0.212
$0.212
P0 = = $3.53
0.12 - 0.06

These examples show that a small change of 1% in either g or k produces a large difference in the
estimated value of the share. The crucial relationship that determines the value of the share is the spread
between the required rate of return (k) and the expected growth rate (g). Anything that causes a decline
in the spread will cause an increase in the computed value, whereas any increase in the spread will
decrease the computed value.

7.9.3 Estimating Expected Growth Rate of Dividends

The growth rate of dividends (g) is a function of the return on equity (ROE) and the retention rate.
Specifically, the growth rate is:

g = Retention Rate × Return on Equity = RR × ROE

A firm can increase its growth rate by increasing its retention rate (reducing its dividend payout ratio) and
investing these added funds at its historic ROE. Alternatively, the firm can maintain its retention rate but
increase its ROE.

Example – Calculation of Growth Rate

If a firm retains 60% of its earnings and has a ROE of 15%, its estimated growth rate is:

g = RR x ROE
= 0.6 x 0.15
= 0.09 or 9%

7.9.4 Multiple Growth Model

Many companies grow at a rapid rate for a number of years and then slow down to a more stable growth
rate. Other companies pay no dividends for a period of years, often during their early-growth period. The

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constant-growth model cannot be used to value these firms and an alternate model is required. Such a
variation of the DDM is the multiple-growth model.

Multiple growth is defined as a situation in which the expected future growth in dividends must be
described using two or more growth rates. A two-period growth model assumes near-term growth at a
rapid rate for some period (typically, 2 to 10 years) followed by a steady long-term growth rate that is
sustainable (i.e. a constant-growth rate). The equation for a two-period growth model can be written as:
n
D0 (1 + g1 )t Dn (1 + gc )t 1
P0 =  +
1 + kt k - gc 1 + kn
t=1

where:
P0 = intrinsic or estimated value of the share today
D0 = current dividend
g1 = supernormal (or subnormal) growth rate for dividends
gc = constant-growth rate for dividends
k = required rate of return
n = number of periods of supernormal (or subnormal) growth
Dn = dividend at the end of the abnormal growth period

In the equation, the first term on the right side defines a dividend stream covering n periods, growing at
a high (or low) growth rate of g1, and discounted at the required rate of return, k. The second term on
the right side is the constant-growth version discussed earlier, which takes the dividend, expected for the
next period, n+1, and divides by the difference between k and g. This value must be discounted back to
time period zero by multiplying by the appropriate discount factor.
�
Example - Multiple Growth Model
Neptune Limited currently pays a dividend of $0.10 per share. The dividend is expected to grow at the
higher rate (g1) of 12% for three years. Thereafter, the new growth rate (gc) is expected to be a
constant 6% a year. The required rate of return is 10%.

The first step in the valuation process is to determine the dollar dividends in each year of supernormal
growth.

D0 = $0.10
D1 = $0.10 (1.12) = $0.112
D2 = $0.10 (1.12)2 = $0.125
D3 = $0.10 (1.12)3 = $0.140
To determine the expected price of the share at the beginning of year 4, when constant growth is
expected, the constant growth model is used.
D4
P3 =
k - gc
0.140 (1.06)
=
0.10 - 0.06
= $3.71

The last step is to determine the sum of the present values of the streams of dividends and value of
the share at the beginning of year 4.

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0.112 0.125 0.140 3.71

P0 = + + +
(1.10) (1.10) (1.10) (1.10)3
2 3

= 0.1018 + 0.1033 + 0.1052 + 2.7874

= $3.10

Intrinsic Value

After obtaining the intrinsic value of the share, this value is compared with the prevailing market price of
the share. If the intrinsic value is greater than the market price, the share is considered to be undervalued
and should be purchased. On the other hand, if the market price is greater than the intrinsic value, the
share will be considered overvalued and should be avoided or sold.

A problem with intrinsic value is that it is derived from a present value process involving estimates of
uncertain (future) benefits and the use of (varying) discount rates by different investors. Therefore the
same asset may have many intrinsic values; it depends on who, and how many, are doing the valuing. This
is why, for a particular asset on a particular day, some investors are willing to buy and some to sell.

Nevertheless, this problem of varying estimates of value does not render valuation models useless as
investors require an intelligent estimate of the value of an asset in order to make sound investment
decisions.

7.9.5 Zero-Growth Model

The owner of a preference share receives a fixed dividend for an infinite period. Because preference share
is a perpetuity, its value is simply the stated annual dividend divided by the required rate of return as
follows:
Dividend
P0 =
Discount Rate

Example - Zero-Growth Model

A preference share has a $100 par value and pays a dividend of $7 a year. Given a required rate of return
of 8%, what is the intrinsic value of the preference share?

Value of preference share = $7 / 0.08 = $87.50

7.10 Relative Valuation Ratios

7.10.1 Price-Earnings Ratio (P/E) and the Price-Earnings Growth Ratio (PEG)

The price-earnings ratio (P/E ratio), also known as the earnings multiplier, is an indication of how much
the market is willing to pay per dollar of earnings. It is calculated as the ratio of the current market price
to the firm's earnings per share (EPS). Thus, if a share is selling for $5.00 and has earnings of $0.40 per
share, its P/E ratio is 12.5.
Market Price Per Share
PE Ratio =
Earnings Per Share

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= 5.00 /0.40
= 12.5

The P/E may be “trailing” or “leading”. A trailing P/E, also known as the “current P/E”, is the one that is
typically published in newspapers’ share listings. It is the current market price divided by the most recent
four quarters of EPS. Leading P/E is the current market price divided by the forecast earnings for the next
year and usually referred to by analysts to provide a prospective P/E ratio.

Growth shares would typically sell at high multiples compared to the average share, because of their
expected higher earnings growth. The P/E ratio is compared with other companies in the same industry,
to obtain a relative sense of this ratio. The P/E ratio is a widely reported valuation ratio used in
prospectuses for issues of new shares, in brokerage reports and newspapers covering share information.

This approach estimates the price of a share using the basic equation below:
P0 = Estimated Earnings × P/E Ratio = E1 × P0 /E1

The typical P/E formulation uses estimated earnings for the next 12 months, i.e. uses the leading or
prospective P/E.

Example – Use of P/E Ratio

A share with estimated earnings of $0.30 per share for the next 12 months will sell for $4.50 if investors
are willing to pay 15 times estimated earnings.

This price will change as estimates of earnings or the P/E ratio changes.

�
1.� Determinants of the P/E Ratio

The constant-growth dividend discount model can be used to indicate the variables that determine the
P/E ratio.

Starting with the equation of constant-growth model:

D1
P0 =
k - g

Dividing both sides by expected earnings, E1:

D1 /E1
P0 /E1 =
k - g
The equation indicates that the P/E ratio is determined by:
•� The expected dividend payout ratio, (D/E);
•� The required rate of return on the share (k); and
•� The expected growth rate of dividends for the share (g).

The following relationships should hold, other things being equal:

•� The higher the payout ratio, the higher the P/E;
•� The higher the expected growth rate, g, the higher the P/E; and
•� The higher the required rate of return, k, the lower the P/E.
�

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Example - Calculation of P/E Ratio

Assume a share has an expected dividend payout ratio of 60%, a required rate of return of 12% and an
expected growth rate for dividends of 6%.
D1 /E1
P0 /E1 =
k - g
0.60
=
0.12 - 0.06
= 0.60 / 0.06
= 10.0

Assume k = 0.13 and g = 0.05:

P/E = 0.60/0.08 = 7.5

Assume k = 0.11 and g = 0.07:

P/E = 0.60/0.04 = 15.0

In this example, it can be seen that the spread between k and g has a significant influence on the P/E
ratio. On the other hand, although the dividend payout ratio has an impact, it is normally stable and has
little effect on year-to-year changes in the P/E ratio.

2.� P/E Ratios and Interest Rates

The P/E ratio is related to the required rate of return. The required rate of return, in turn, is related to
interest rates. As interest rates increase, required rates of return on all securities generally increase.
Based on these relationships, an inverse relationship between P/E ratios and interest rates is to be
expected. As interest rates rise (decline), other things being equal, P/E ratios should decline (rise).

3.� Advantages and Disadvantages of P/E Ratios

Advantages:
i.� Earnings is a significant and important driver of investment value.
ii.� P/E ratios are widely used in the market and to that extent is more influential as the value indicator
in the market.

Disadvantages:
i.� The company may have a loss, and a negative denominator in the ratio will result in a meaningless
number.
ii.� Earnings can be very volatile, which makes future earnings hard to forecast with any degree of
accuracy.
iii.� Earnings are subject to accounting differences among companies because of differences in revenue
recognition, treatment of expenses etc.
iv.� The P/E ratio will be affected by capital structure changes e.g. if a firm increases its number of shares
outstanding, the EPS will fall, resulting in a higher P/E ratio.

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4.� Price Earnings Growth Ratio (PEG)

One criticism of the P/E ratio is that this ratio could be the same for two companies in the same industry
although the outlook for the two companies could be very different. To address this, analysts use a crude
rule of thumb3, the PE Growth ratio (PEG ratio). The PEG ratio is simply the P/E ratio divided by the
expected % growth in earnings:
PE
PEG =
% Growth in Earnings

PEG is most widely used for high growth companies and industries. In factoring the growth earnings, the
PEG ratio becomes an indicator of whether the current share price is understated or overstated, in respect
of its prospective growth in earnings. A low PEG ratio indicates an undervalued share.

As an example, if the P/E Ratio is 30 and the % growth in earnings in 15%, this gives a PEG ratio of 2. A
PEG ratio of less than 1 is indicative of an undervalued share, while ratios of 4 or higher indicate
overvalued shares.

One should bear in mind that the PEG ratio is limited by the uncertainty of the estimated growth, and is
on a year-to-year basis.

7.10.2 Price to Book Value Ratio

The price-to-book ratio (P/B ratio) compares the market price per share to the book value of the company:
Market Price Per Share
P/B Ratio =
Book Value Per Share

Book value per share is calculated by dividing shareholders’ equity by the number of ordinary shares
outstanding. The P/B ratio is best suited for companies with a large number of tangible fixed assets such
as buildings, factories, machineries and equipment. In other industries such as investment companies,
banks or insurance companies, book value is more important, as their assets are in the form of
investments that can be turned into cash. Note, however, that this calculation is based on book and not
market values. However, the use of book values is misleading if the current market values of the assets
are substantially different from the book values e.g. if bank loans have become non-performing, the
market value of these loans may be near to zero, whereas the book value of the loans remains the same.

1.� Calculation of P/B Ratio

Taking Fulton Corporation as an example (see Figure 7.10.2.1 - Balance Sheet for Fulton Corporation
Limited Balance Sheet as at 31 December 2013 below), the book value per share can be calculated by
taking the total shareholders’ equity ($210 million), divided by the number of common ordinary shares
outstanding (100 million), to give a book value per share of $2.10.

�������������������������������������������������
3The PEG ratio is not based on any financial law. It is crude because the numerator and denominator are not expressed in the
same units.

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Table 7.10.2 - Balance Sheet as at 31 December 2013 of Fulton Corporation Ltd

2013 2012
Notes $'000 $'000
Assets
Non-Current Assets
Property, Plant & Equipment 9 130,000 120,000
Goodwill 10 30,000 30,000
Intangible Assets 11 60,000 50,000
Sub-total: 220,000 200,000

Current Assets
Inventories 12 12,000 10,000
Trade Receivables 13 20,000 20,000
Short-term investments 14 50,000 45,000
Cash and cash equivalents 15 8,000 10,000
Sub-total: 90,000 85,000
Total Assets 310,000 285,000

Equity and Liabilities

Equity
Share Capital, $1 par value per share 4 100,000 100,000
Retained Earnings 95,000 75,000
Revaluation Reserve 5 15,000 10,000
Total Equity 210,000 185,000

Non-current liabilities
Long-term borrowings 6 35,000 50,000

Current Liabilities
Trade and other payables 7 35,000 25,000
Short-term borrowings 8 10,000 8,000
Current portion of long-term borrowings 6 15,000 15,000
Current tax payable 9 5,000 2,000
Total Current Liabilities 65,000 50,000
Total Liabilities 100,000 100,000

Total Equity and Liabilities 310,000 285,000

If the market price of Fulton Corporation is $18, then the P/B ratio is
Market Price Per Share
P/B Ratio =
Book Value Per Share
18
=
2.1
= 8.6�

This ratio should be compared with other companies in the same industry to see if it is high or low.
�

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2.� Advantages and Disadvantages of Price to Book Value Ratios

Advantages:
i.� Book value is cumulative and is usually positive, unlike EPS;
ii.� Book value is usually more stable than EPS, which can be more volatile; and
iii.� Book value is well suited for companies with liquid assets i.e. banks and investment companies whose
assets can be readily converted to cash – however non-performing loans will affect the book value
of banks, and even the market values of liquid assets can change because of market factors.

Disadvantages:
i.� Companies with intangible assets, such as patents and proprietary research knowledge, cannot be
fairly measured using book value; and
ii.� Accounting differences in the treatment of depreciation expenses or the impact on the book value
of technology that has become obsolete.

7.10.3 Price to Sales Ratio

Another valuation technique is the Price to Sales ratio (P/S Ratio). This is calculated by dividing the current
market share price by its sales per share, i.e. the annual sales divided by the number of ordinary shares
outstanding. It indicates the number of times the market is willing to pay for a firm's sales revenue per
share.

Proponents of this ratio hold the view that strong and consistent sales growth is indicative of a growth
company, and that this is a fundamental requirement for earnings to grow.

This ratio should be used with caution. It does not present a complete picture because it does not take
into account the expenses and liabilities of a company. Besides, a lower P/S ratio is not necessarily a
positive indicator because a lower P/S ratio may also indicate the company is unprofitable.

1.� Calculation of P/S Ratio

Assuming that a company with a current share price of $15 has annual sales of $6 billion and 450 million
ordinary shares outstanding, the sales per share will be $6 billion divided by 450 million i.e. 13.33.
Current Market Share Price
Price to Sales Ratio =
Sales Per Share
15
=
13.3
= 1.13

2.� Advantages and Disadvantages of Price to Sales Ratios

Advantages:
i.� Generally, sales figures are less subject to manipulation compared to earnings;
ii.� Sales are positive, unlike EPS, which can be negative. This is useful for companies which are new
start-ups and which have no earnings yet;
iii.� Sales are more stable than EPS which could be quite volatile; and

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iv.� Suited for shares of mature companies, because these are likely to have more established markets,
compared to a young company just starting out.

Disadvantages:
i. High sales revenues do not necessarily mean the company is profitable;
ii.� Sales revenue practices, even where the sales numbers are not being manipulated within a
company, can vary from one company to another, and may result in difficulty in comparing sales
revenues between different firms; and
iii.� Expenses are not included, and this makes comparison between two companies with the same P/S
ratio incomplete, or worse, misleading because the company with the lower cost structure actually
means it is a better-managed company.

7.10.4 Price to Cash Flow Ratio

This ratio is popular because of concerns over the potential manipulation of earnings. Cash flows are much
less prone to manipulation, and usually, operating cash flow, also referred to as free cash flow, is used.
Operating cash flow refers to the total amount of cash generated by a company through its general
operations. It is found in the Statement of Cash Flows under “Cash generated from operations”.

The Price to Cash Flow ratio is calculated as below:

Current Market Share Price
Price to Cashflow Ratio =
Cashflow Per Share

Table 7.10.4 - Statement of Cash Flows for the year ended 31 December 2013 for Fulton Corporation Ltd

2013 2012
Notes $'000 $'000
Profit before taxation
Cash generated from operations 20 2,210 2,000
Interest paid 22 (1,500) (1,200)
Income tax paid 23 (1,200) (750)
Net cash from operating activities (490) 50

Cash flows from investing activities

Purchase of property, plant and equipment 21 (1,820) (2,300)
Purchase of intangible assets 21 (750) (1,200)
Proceeds from sale of equipment 18 150 120
Proceeds from sale of intangible assets 18 180 250
Interest received 18 1,500 1,050
Net cash used in investing activities (740) (2,080)

Cash flows from financing activities

Proceeds from issue of share capital 4 3,000 -
Proceeds from long term borrowings 6 3,030 300
Dividend paid 21 (500) 500
Net cash used in financing activities 5,530 5,530

Net increase in cash and cash equivalents 4,300 3,500

Cash & cash equivalents at start of the period 3,700 200
Cash & cash equivalents at end of the period 8,000 3,700

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If the market price of Fulton Corporation is $18 and it had 100 million shares outstanding as at 31
December 2013, then the Price to Cash Flow ratio is:

Current Market Share Price

Price to Cashflow Ratio =
Cashflow Per Share
18
=
$2.21 million / 100 million
�
= 8.14

1.� Advantages and Disadvantages of Price to Cash Flow Ratios

Advantages:
i.� Cash flows are less likely to be manipulated, compared to earnings.
ii.� Cash flows are generally more stable than earnings.
iii.� Cash flows are independent of accounting methods.
Disadvantages:
i.� Non-cash items, such as deferred revenue, will not be taken into consideration.
ii.� Cash flows can be from operating, investing or financing activities, and the choice of cash flow used
will affect the valuation among companies.

7.10.5 Enterprise Value to EBITDA Ratio

This ratio is also referred to as the enterprise multiple or the earnings before interest, taxes, depreciation
and amortization (EBITDA) multiple, and is usually used to determine the value of oil and gas companies.

Enterprise value refers to the share’s market capitalization plus debt, minority interests and preference
shares, minus total cash and cash equivalents. This is especially applicable to oil and gas firms, which
typically have a lot of debt.

The EV/EBITDA ratio cannot be manipulated by the changes in capital structure. Another benefit of the
EV/EBITDA ratio is that it makes possible fair comparison of companies with different capital structures.

7.10.6 Valuation of New Media and Life Sciences

Research indicates that there is a preference to use Discounted Cash Flow Analysis for the valuation of
new media companies (such as Facebook), because a significant amount of its “economic value” lies in its
information and connectivity assets. Rigorous analysis of Facebook’s balance sheets and financials is
unlikely to reveal as much as using traffic volume, number of subscribers, and other indicators that show
the penetration and spread of its network.

Life sciences are dependent on the success of trial results. Successful trial results will cause the share
price to rise and conversely, negative results will depress the share price. In addition to this, news of a
potential merger or acquisition will also bolster interest in a life science share.

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7.11 Initial Public Offerings

In Singapore, listing on the SGX Mainboard requires the fulfillment of “quantitative requirements” spelt
out by the exchange. However, listing on Catalist (SGX’s secondary board), is supervised by a “sponsor”
(the equivalent of Issue Manager for the Mainboard listing) and no quantitative requirements are needed.
Sponsors decide on the suitability of the candidate company seeking a listing. Sponsors are qualified
professional firms with experience in corporate finance, and mergers and acquisitions.

In any Initial Public Offering (IPO) listing process, the issuer will make all the preparation necessary in
order to obtain approval from the Singapore Exchange to list its share either on the Mainboard or the
secondary board. To do this, the issuer will have to engage an investment bank or a member company
of the SGX to be its lead manager or sponsor. Underwriters such as brokerages and other financial
institutions will also be involved. The lead manager earns management fees, while the underwriters will
earn underwriting fees from the issuer. Lawyers will be needed to draft the various IPO prospectus and
related documents, while public accountants will prepare the audited financial reports.

Once the IPO has been approved, the issuer will distribute its prospectus to institutional and retail
investors. However, if there is pre-placement activity, the institutional investors may see the offering
before the retail investors. IPOs are usually distributed in two tranches – a private placement tranche and
a public retail tranche. The private tranche comprises institutional investors and preference customers of
brokerages and banks, while the public tranche comprises retail investors. Usually, the private tranche
takes up the major portion of the offering among a small group of investors, while the retail tranche is
smaller and much more widely distributed.

The commencement of offer in the IPO begins from the date of registration of the prospectus to MAS,
and typically closes around 5 days later. The share applications received will then be allocated or if
necessary, balloted because of over-subscription, within a few days. Trading begins the next business day
after allocation, and the shares commence trading on a “ready” basis i.e. bought or sold for settlement 3
days after the transaction date, i.e. T+3.

When deciding whether to subscribe to an IPO, potential investors should be aware of the following risks:
1.� Vendor shares i.e. the issuers are selling their own holdings, rather than new shares in the market.
The obvious risk here is of the issuers offloading their own shares to the public. Potential investors
have to watch out for this, and also for presence of a lock-up option. The lock-up option places a
moratorium on the sale of the issuer’s shares for a period of time. In a way, this is the issuer’s
expression of confidence in the company that is being brought public with the IPO.
2.� Deferred shares or share options that have been distributed before the IPO, potentially risks dilution
of earnings to the new IPO investors, because the earnings per share will be depressed once these
deferred shares or share options are equitized.

3. The over-allotment option (also known as the Greenshoe option), gives the issuer the right to increase
its offering through an over-allotment of shares. IPOs with this option can use this option to stabilize
its secondary market price if the share price of the IPO performs poorly on initial trading. Not all IPOs
carry this over-allotment option.

4.� Potential IPO investors should also look out for the issuer’s right to “clawback”. This term refers to
the re-allocation of share subscription between institutional and retail investors. In such an instance,
the “clawback” provision will be invoked, and retail investors will get a higher allocation of a share
that will probably not enjoy any institutional support in the secondary market.

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In addition to the specific IPO risks above, investors have to carry out their own due diligence on IPOs and
evaluate these by studying the prospectus carefully. IPO prospectuses can be found in the “OPERA Public
Portal” on the Monetary Authority of Singapore website (www.mas.gov.sg).

When evaluating the prospectus, the following should be noted:

1.� Underwriters - The underwriters of the IPO would generally purchase any shares which are not
subscribed with the IPO.
2.� Business Model - The business model, strategy and industry competition analysis should be
examined. This is usually discussed in sections on Management’s Discussion, Business and
Government Regulations.
3.� Use of Proceeds – If these are to be used to pay off a large amount of debt, there may not be enough
left for the expansion of its operations. Also, if the proceeds will be used to be existing shareholders,
this may be a bail-out at the expense of new investors.
4.� Management - The experience and background of the company’s management, especially that of
key appointment holders such as the Chief Executive Officer and the Chief Financial Officer etc.,
should be examined to validate their experience and track records.
5.� Financial Analysis - A financial analysis of its balance sheet, income statement and statement of cash
flows should be conducted, using the financial ratios and equity valuation ratios covered earlier in
this chapter, with special attention being paid to:
a.� Overly rapid expansion of sales figures;
b.� Inventory growing faster than sales;
c.� Unusual fall in free cash flow; or
d.� Aggressive acquisitions.
6.� Timing – The “quiet period” and “lockup period” of the IPO, which may vary from exchange to
exchange, should be noted. The quiet period is the time that typically spans the lodging of the
prospectus to the closing of the offer, and during this period, no promotion of the share is permitted.
After this period, the underwriters’ analysts will usually write up bullish commentaries for the IPO
share, pushing up demand for it. The “lockup period” refers to the moratorium period during which
pre-IPO investors and promoters are not allowed to sell their shares.
7.� There should be no conflicts of interest between the existing owners and management.
Other than the IPO market, shares can also be issued as secondary offerings. A secondary offering is
typically carried out as a financing exercise for the company. These could be in the form of rights issues,
which could be renounceable or non-renounceable. Rights issues are basically an offer to existing
shareholders to purchase additional shares in proportion to their holdings. In order to prevent dilution of
their earnings, existing shareholders would have to take up these rights, but it also means putting up more
money for the additional shares. In a rights issue, the company will lodge an Offer Information Statement
(OIS) instead of a prospectus with MAS.

In addition to this, a secondary offering could also be made as a compliance placement to meet regulatory
requirements with regard to the distribution of shares.

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7.12 Depositary Receipts

7.12.1 Depositary Receipts (DRs)

Depositary receipts (DRs) offer a simple and convenient way to overcome the obstacles to issuing and
investing in overseas markets. Such obstacles can include inefficient cross-border settlements, imperfect
information flow and unfamiliar market practices.

For issuers, DRs offer a number of competitive advantages such as:

i.� Including a broad and diversified investor exposure, which may improve liquidity;
ii.� Enhanced visibility for the company’s products or services in an overseas market; and
iii.� A flexible mechanism for raising capital.

DRs are equity securities that trade in an investors’ home market (e.g. Singapore) and represent an
underlying security in the foreign issuers’ home market (e.g. U.S.).

7.12.2 American Depositary Receipts (ADRs)

American Depositary Receipts (ADRs) are the most common type of depositary receipts and trade on the
NYSE, Nasdaq or the Over-the-Counter markets in the U.S. Hence, an ADR is a non-U.S. company’s equity
security that trades in the U.S. as though it were an U.S. equity security. In 2010 SGX launched ADR
GlobalQuote to allow for trading of a number of ADRs in Singapore.

There are 3 levels of ADRs as follows:

•� Level 1 ADRs, which trade in the traditional US over-the-counter market and are not listed on any US
securities exchange such as the New York Stock Exchange or NASDAQ;
•� Level 2 ADRs, which are listed on a US securities exchange (such as the New York Stock Exchange or
NASDAQ); and
• Level 3 ADRs, in which the issuer uses a listed ADR program to offer new shares to US investors in a
capital raising exercise.

Sponsored Level 2 and 3 ADRs are both are issued under a deposit agreement with a depositary bank.
Level 2 ADRs do not involve raising, but Level 3 ADRs allow new capital raisings. Unsponsored ADRs are
issued by banks, but without a formal agreement between the depositary bank and the issuer of the ADRs.

Global Depositary Receipts, or GDRs, are generally issued offshore from the U.S. GDRs are commonly
listed on the London Stock Exchange, Luxembourg Stock Exchange or the SGX.
Singapore Depositary Receipts (“SDRs”) are depositary receipts listed on SGX, allowing non-Singapore
companies to access investors in Asia. The principal characteristics of SDRs are similar to those of other
forms of depositary receipts, such the ADRs and GDRs. Refer to Figure 7.12.1(a).

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Figure 7.12.1(a) – How Singapore Depositary Receipts Work

7.12.3 Risks of Investing in DRs

1.� DRs carry currency risks because of the currency in which the ADR is denominated, the currency the
share is denominated and the investor’s home currency.

2.� DRs also carry price risk, which is essentially the price of the underlying share. However, American
DRs often trade at a premium to the underlying share because of regulatory restrictions on overseas
holdings of the share

3.� Higher counterparty risks in DRs, when compared to investing in SGX-listed shares because of
potential limitations on DR conversion if the depositary bank closes its transfer books at any time or
at any time such conversion cannot be supported in connection with the performance of its duties.
Another potential counterparty risk is that of financial or operational failure of the depositary bank
or its custodian in their processing obligations in respect of the DR.

4.� DRs that have only one listing e.g. single-listed ADRs that are not listed in their home markets.
Surrendering these single-listed ADRs will end up with the investors holding unlisted common shares
that are not traded and that have no transactional liquidity. It is not advisable to convert ADRs into
unlisted shares.

5. DRs bought on GlobalQuote may be terminated or delisted, without informing the holder. If this
happens the holder can try to sell before it is delisted, of it is a dual listed DR, it may be converted
into shares. DRs listed on GlobalQuote are not subject to listing requirements from the SGX.

6.� Not all DRs have two-way fungibility which means that the Depository Receipts (ADRs/GDRs) can be
converted into the underlying shares & the underlying shares can be converted into DRs. All DRs have
underlying shares backing them. The DRs are issued and traded outside the country of the issuer, but
the underlying shares backing the receipts are lodged in custody with a custodian in the country of
the issuer.

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7.13 Summary

1. The two most important characteristics of ordinary share are its residual claim and limited liability
features. Residual claim means that in the event of liquidation, ordinary shareholders are the last to
be paid. Limited liability means that the losses of shareholders are limited to their original
investment.

2. Legally, a preference share is an equity security. However, it is often viewed as a hybrid security
because it has both the characteristics of a fixed income security and equity security.

3. There are different classes of preference share. The method and amount of dividend payment, and
special benefits distinguish each class.

4.� Ordinary share can be classified as blue chip shares, growth shares, income shares, cyclical shares,
defensive shares, hard asset shares and foreign shares.

5.� The Efficient Market Hypothesis (EMH) states that prices of shares in the market always fully reflect
all the information available about the shares.

6. If the market is totally efficient, passive strategies such as buy-and-hold or indexing are
recommended.

7.� Active investors believe they have some advantages over other market participants and are thus able
to achieve superior performance. Active strategies include share selection, sector rotation, and
market timing.

8.� The general movement of the share market is usually measured by a share market average or index
consisting of a group of securities that is supposed to reflect the entire market.

9.� A price-weighted series is an arithmetic average of share prices.

10.� A value-weighted series considers the total market value of shares in the computation of a share
market index.

11.� In the construction of an unweighted-index, all shares carry equal weight regardless of their price
and/or market value.

12.� Money has time value. The principle behind the time value of money is that a dollar received in the
future is worth LESS than a dollar received today.

13.� Compounding is the process of determining the future value of a present sum of money while
discounting is the process of finding the present value of a future sum.

14.� Dividend yield measures the income component of a share's return.

15.� Earnings yield is the reciprocal of the Price/Earnings ratio i.e. it is the Earnings/Price ratio, expressed
as a percentage.

16.� The two broad approaches to equity valuation absolute valuation approach are the absolute
valuation approach and the relative valuation approach.

17. In the absolute valuation, the intrinsic value that is determined for the share through discounted cash
flow analysis, is compared to its current market value. If the intrinsic value is greater than the market,

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it is undervalued i.e. the market is valuing the share LOWER than what it is intrinsically worth, and
vice versa.

18.� In relative valuation, a comparison is made between the share’s price multiple (PE ratio, Price to Book
value ratio, etc.) and its peers within the same industry, to see if the share is valued higher or lower
than its peers. A share that has a lower multiple is considered undervalued, and vice versa.

19.� In practice, a few of relative valuation ratios are used together to obtain a more realistic valuation.

20.� According to the dividend discount model, the intrinsic value of an ordinary share is the discounted
value of all future dividends.

21.� When dividends are expected to grow at a constant rate, the constant-growth model is used.

22.� If no growth is expected, the dividend discount model reduces to a perpetuity. The zero-growth
model can be used to value preference share since dividend is fixed.

23.� If two or more growth rates are expected, a multiple-growth model can be used to determine the
intrinsic value of a share.

24.� The dividend discount model is sensitive to the spread between the required rate of return (k) and
the dividend growth rate (g).

25.� According to the earnings multiplier approach, the price of a share is the product of its earnings and
a multiplier.

26.� The price-earnings ratio is an indication of the number of times that the market is willing to pay for
the earnings of a company.

27.� There is an inverse relationship between price-earnings ratio and interest rate.

28.� The price-to-book ratio is a multiple that the market places on a company's book value.

29.� The price to sales ratio indicates the number of times the market is willing to pay for a firm’s sales
revenue.

30.� The price to cash flow ratio is deemed more reliable because cash flow is less subject to manipulation
than earnings.

31.� Depositary receipts are equity securities that trade in an investor’s home market and represent an
underlying security in another domicile i.e. the issuer’s home market. For example, American DRs
are certificates of ownership issued by US banks or brokers and represent claims to a certain number
of shares of a specific foreign company. They provide a means for US investors to invest in non-US
companies in a form that is most familiar and convenient to them.

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Chapter 8:
Fixed Income Securities
Learning Objectives

The candidate should be able to:

 Describe the characteristics of a fixed income instrument such as a bond
 Define and explain the various terminology used in fixed income securities
 Explain the credit risk in holding bonds
 Describe the issuers and their motivation in issuing bonds
 Describe the primary and secondary bond markets
 Explain how prices are quoted in the trading of bonds
 Discuss various special features in bond issuance, and explain their significance to investors
 Describe high yield bonds, and their implied bond rating
 Discuss asset-backed fixed income instruments
 Describe features of a the internal and external bond markets, and the Eurobond market
 Explain the differences among the various grades of debt rating by a rating agency such as
Standard and Poor’s
 State the various risks that a fixed income investor is exposed to
 Calculate the value of a bond based on the bond calculation formula
 Calculate the bond equivalent yield for bonds that pay interest more often than once a year
 Explain the relationship between bond price and market yield
 Explain the relationship between coupon rate, required yield and price
 Explain why bond prices converge to par on maturity
 Explain the concepts of duration and convexity and the implications for bond price risk
 Understand what is meant by price value of a basis point (PVBP) and how this is used to monitor
the price risks in a bond portfolio
 Calculate various risk measures such as current yield and yield to maturity (YTM ) to make
investment decisions
 Explain reinvestment risk, and how it is affected by the coupon rate and the maturity of the bond
 Discuss the term structure of interest rates and how it is shaped by expectations theory and
liquidity preference
 Analyze convertible bonds for investment purposes, including the conversion parity price and
conversion premium

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8.1 Introduction

Besides equities, fixed income securities or bonds, represent another major asset class for investors. In
fact, bond investment represents about one-half of the value of all publicly traded financial securities in
the world. The variety of fixed income instruments is diverse, ranging from sovereign government bonds
to corporate bonds, and from 'plain vanilla' bonds to bonds with embedded options and other structured
elements.

This chapter will cover the basic characteristics of bonds, types of bonds and the sources of risk associated
with bond investments. The chapter will also examine the principles of bond valuation, different measures
of bond returns, the relationship between interest rates and bond prices, the concepts of duration,
convexity, present value of 1 basis point (PVBP) and the term structure of interest rates. Building on this
understanding of basic bond valuation, the valuation of convertible bonds and their risk-reward
characteristics will be discussed in the last section of this chapter.

8.2 Characteristics of Bonds

A bond is defined as a debt security on which the issuer makes regular interest payments to the
bondholder on specified dates, and repays the principal to the bondholder on the maturity date.
Therefore, a typical coupon bond obligates the issuer to make periodic payments of interest, called
coupon payments, to the bondholders on specified dates during the life of the bond, and then to repay
the principal (the money borrowed by the issuer), at its maturity.

Usually, the coupon rate that is payable on the bond is fixed for the life of the bond, giving rise to the term
“fixed income” bonds. The debt securities market may be divided into three maturity segments based on
the issue’s original maturity:
i. M oney market instruments which are short-term issues of one year or less;
ii. M edium-term notes with maturities of more than one year but less than ten years; and
iii. Long-term bonds with maturities of usually ten years or more.

Within the bond market, there are also short-term bonds (up to 5 years), medium-term bonds (up to 10
years), and long-term bonds (more than 10 years).

The remaining lives of debt obligations change constantly as the issues progress toward maturity. Thus,
bonds that have been outstanding in the secondary market for any period of time eventually move from
long-term to medium-term to short-term.

8.2.1 Terminology

The par value (face value) or principal represents the redemption value of the bond. This is the amount
that will be repaid to the investor at maturity. For most bonds the par value is $1,000. The par value of
a bond is not the same as the market value of the bond, which may rise or fall depending on market
factors that impact its value, such as interest rate movements.

The coupon of a bond represents the periodic interest payments made to the bondholders over the life
(or holding period) of the bond. The coupon rate when multiplied by the principal or par value of the
bond provides the dollar value of the coupon payment. Coupon payments are typically paid on an annual
or semi-annual basis.

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In Singapore, the bonds issued by the Government are scripless, and ownership of Singapore Government
Securities is reflected as electronic book entries. Otherwise, bonds may be issued as bearer bonds or
registered bonds, but since most markets have progressed to electronic trading and settlement platforms,
there are probably few bonds that are issued as bearer bonds today (given also the high security risk of
such ownership).

An important feature of a bond is term-to-maturity, which indicates the number of years remaining to
the maturity of the bond. There are two different types of maturity - most corporate bonds are typically
term bonds, which have a single maturity date. In contrast, serial bonds have a series of maturity dates
and are essentially bundles of bonds issued at the same time, but with different maturities.

8.2.2 Security for Bonds

Every bond issue is a contractual obligation between the issuer and the investor. The promises of a
corporate bond issuer and the rights of investors are specified in a contract called a bond trust deed.
Within this deed, a trustee is legally appointed to look after the interests of the bondholders and to ensure
that all the provisions under the deed are met, including the timely payments of interest and principal.

Failure to pay either the principal or interest due constitutes legal default, and court proceedings can be
instituted to enforce the contract. Bondholders, as creditors, have a prior claim over ordinary and
preferred shareholders on both income and assets of the corporation for the principal and interest due
to them.

Bonds can have different types of collateral. Secured (senior) bonds are backed by a legal claim on some
specified property of the issuer in the case of default. For example, mortgage bonds are secured by real
estate assets.

Unsecured debentures are not secured by a specific pledge of property. This, however, does not mean
that debenture bondholders have no claim on the property or earnings of the issuers; they have the claim
of general creditors on all assets of the issuer not pledged specifically to secure other debt. Subordinated
(junior) debentures have a claim on the income and assets of the issuer that is subordinated to secured
debt, debenture bonds, and often after some general creditors. Income bonds are considered to be junior
debentures as the issuer can omit or delay the payment of interest if the firm's earnings are too low.

8.2.3 Issuers

Bond issues can be classified as follows:

 Government and government-related bodies; or
 Corporations.

The government issues bonds to pay for various government projects such as infrastructure development
and the provision of essential services, such as health and education. In some countries, such as the
United States, government agencies are quite active in issuing bonds to finance their programmes. In
Singapore, government-linked corporations tap the bond market for funds rather than sourcing directly
from the government.

Besides raising funds through equity securities or bank loans, corporations can also raise funds through
the issue of bonds to the public. The corporate sector provides the most diverse issues in terms of type
and quality.

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8.3 Price Quotations

For pricing purposes, fixed income securities can be classified as discount or coupon securities. Fixed
income securities with maturities of 1 year or less, such as Treasury bills or commercial paper, are discount
securities while fixed income securities with maturities of more than 1 year are coupon securities.

8.3.1 Discount Basis

Treasury bills are quoted on a bank discount basis. The yield on a bank discount basis is calculated as
follows:
D 360
Yd = ×
F t
where:
Yd = annualized yield on a bank discount basis (expressed as a decimal)
D = dollar discount, which is equal to the difference between the face value and price
F =face value
t =number of days remaining to maturity1

Calculation of Yield on a Discount Basis

A Treasury bill that has 90 days to maturity and a face value of $100,000 and is selling for $98,000 would
be quoted at 8.0 percent on a bank discount basis.

D = $100,000 - $98,000 = $2,000

$2000 360
Yd = × = 8.0%
$100,000 90

Though it is widely used, the quoted yield on a bank discount basis is not a meaningful measure of return
from holding a Treasury bill because it is calculated based on the face value rather than on the actual
dollar amount invested.

8.3.2 Price Basis

The prices of fixed income securities of more than one year are quoted as a percentage of par value.
Assuming a par value of $1,000, a quote of 98.50 represents $985 and a quote of 95¾ represents $957.50.

US Treasury bonds and notes are quoted in thirty-seconds (1/ 32) of a percentage point, whereas
corporate bonds are quoted in eighths of a percentage point. Specifically a quote of 90-24 for a Treasury
bond means 90 24/ 32.

All fixed income securities trade on an accrued interest basis. This means that the buyer of a bond must
pay the seller the price of the bond plus the interest that has been earned on the bond since the last
interest payment date. Assume an 8% bond that pays semi-annual interest on 1 June and 1 December. If
the bond is sold on 1 September, the seller is entitled to accrued interest of $20 ($80 x 3/ 12) for the three
months that the seller has held the bond.

1 The numerator of 360 as well as the denominator t will follow the Day Count Convention of the respective market. Day count

convention refers to the practice in each market to use either 360 or 365 days to represent a year, and whether it should be
actual or 30 days for each calendar month.

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8.4 Bond M arkets

Before discussing the types of bonds, we should look at the different bond sectors. Essentially the bond
market can be divided into the internal bond market and the external bond market.

Figure 8.4 – Bond Market Sectors

As illustrated in the figure above, in the context of the Singapore bond market, the domestic bond market
comprises Singapore Government Securities and corporate bonds issued by Singapore companies. The
foreign bond market refers to foreign issuers who have issued their bonds in the Singapore bond market.

Global bond portfolios invest 40% or more of their assets in foreign bonds. Some world bond portfolios
follow a conservative approach, favouring high-quality bonds from developed markets. Others are more
adventurous, and own some lower-quality bonds from developed or emerging markets. Some portfolios
invest exclusively outside the U.S., while others invest regularly in both U.S. and non-U.S. bonds.

8.4.1 The Singapore Bond Market

The bond market in Singapore comprises the Government securities (Treasury bills and bonds), as well as
corporate bonds. Singapore Government Securities (SGS) were initially issued to meet banks' needs for a
risk-free asset in their liquid assets portfolios. The Singapore Government does not need to finance its
expenditures through the issuance of government bonds as it operates on a balanced budget policy and
often enjoys budget surpluses. Hence, the issuance of SGS serves primarily to:
1. Build a liquid SGS market to establish a benchmark yield curve for the pricing of Singapore dollar
private debt securities;
2. Encourage the growth of an active secondary market, both for cash transactions and derivatives, for
the purposes of risk management; and
3. Attract domestic and international issuers and investors to participate in the Singapore bond market.

At the end of 2013, the SGS market accounted for 52% of the SGD 305 billion total bonds outstanding,
with the remaining issues of 35% from corporates. Singapore's corporate bond market continued to
expand in 2013, with outstanding bonds rising 6.7% to SGD 116 billion at end-December.

The Housing and Development Board (HDB) was the top issuer, with SGD17.6 billion worth of bonds
outstanding at the end of 2013, with United Overseas Bank second, at SGD4.6 billion in outstanding bonds
and CapitaLand third, with SGD4.5 billion. Other significant bond issuers included the Development Bank
of Singapore, Temasek and Singapore Power.

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8.4.2 Eurobond M arket

The Eurobond market is an international bond market. A Eurobond can be defined as a bond that is:
 Underwritten by an international syndicate;
 Offered at issuance simultaneously to investors in a number of countries; and
 Issued outside the jurisdiction of any single country.

Eurobonds derive its name from the fact that they were originally bond issues sold in Europe (typically
London). The Eurobond market is divided into the different currencies in which the issues are
denominated. For example, when Eurobonds are denominated in USD, they are referred to as Eurodollar
bonds. Eurobonds denominated in Japanese yen are referred to as Euroyen bonds.

8.4.3 Primary and Secondary Bond Markets

The primary and secondary bond markets are necessary for the proper functioning of the bond market.
Each of these markets serves a different function for issuers and investors.

1. Primary Bond Market

Bonds are issued to the public in the primary bond market. Singapore Government Securities are sold at
auctions through Primary Dealers. When a company decides to raise funds with a bond issue, it will need
to appoint an investment bank to help with the management, underwriting and distribution of the bonds.
For their effort, the investment bank (or a syndicate of underwriters) will be paid management and
underwriting fees, generally based on the amount of bonds that are issued.

Bonds and other debt securities that will be sold to accredited or institutional investors are exempted
from prospectus requirements. However, an offering memorandum is used. Issuers of bonds and similar
debt securities that will be sold to retail investors are required to prepare a prospectus unless the issuer
is already listed on SGX. If that is so, only an Offer Information Statement is needed.

Bonds may be issued directly by the borrower, or through a Collective Investment Scheme. In Singapore
most of these are bond funds. The parties that are involved in a bond fund prospectus include the
M anager, the Trustee, Principal and other Distributors of the fund, custodian, solicitors and auditors. In
addition, the following factors should also be noted:
 Credit rating of the issuer, and its debt structure if the bond is meant to raise funds for the issuer. If
it is a bond fund under a collective investment scheme, look out for the investment focus of the
M anager and the credit rating of the bonds that are within this focus
 Will there be a reliable secondary market for the bond? If this a bond fund, would the Net Asset
Value (NAV) units of the fund be calculated regularly?
 Are there cross default clauses? The presence of cross default means that the issuer may be
considered insolvent if one of its related entities becomes insolvent.
 The status of the bonds in regard to how they rank against the other liabilities of the issuer

2. Secondary Bond Market

After the bonds have been sold in the primary market, they can be traded in the secondary market. The
secondary market may be the exchange where the bond is listed (for retail bond issues), or the over-the-
counter (OTC) market. Other than being a place where bonds can be bought and sold, the secondary

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market also serves an important market function in benchmarking the market values of traded bonds and
the yields that are obtainable from them. Such information is necessary for the market valuation of bond
portfolios, and for establishing benchmark yield curves for bonds with different credit ratings. Typically,
the market looks at the spread over the yield on Government issues i.e. the difference between the
corporate bond yield and the Government bond yield.

8.5 Types of Bonds

8.5.1 Floating Rate Bonds

In contrast to a coupon rate that is fixed for the entire life of the bond, the coupon rate on floating-rate
securities is periodically reset based on some predetermined benchmark e.g. SIBOR (Singapore Interbank
Offered Rate). For example, the coupon rate may be reset every six months at a rate equal to a spread of
100 basis points over the six-month Treasury bill rate. Floating-rate securities are attractive to some
institutional investors because the securities allow investors to buy an asset with an income stream that
matches more closely the floating or flexible nature of some of their liabilities.

8.5.2 Zero Coupon Bonds

Zero coupon bonds do not make any periodic coupon payments. They are sold at prices far below their
par values, i.e. they are sold at deep discounts. At maturity of the bond, the investor will receive the par
value of 100. The difference between the maturity value and the purchase price generates an effective
interest rate, or rate of return.

There are several attractions in zero coupon bonds. They offer maturities that fit investors' particular
requirements, such as a child's education needs or one’s retirement. Reinvestment risk is eliminated as
zero coupon bonds can lock in a fixed rate of return if they are held to maturity. There is no reinvestment
risk because there is no coupon. Zero coupon bonds also offer the maximum price responsiveness to
interest rate volatility, as they respond sharply to changes in interest rates.

There are potential disadvantages associated with zero coupon bonds. Firstly, holders must be alert to
zero coupon bonds with call features. The call feature potentially limits capital appreciation when interest
rates decline because the issuers are likely to redeem the bonds. Secondly, zero coupon bonds are the
most volatile bonds with regard to price movements. A given rise in interest rates will negatively impact
the price of a zero coupon bond much more than a coupon bond. If the bonds are held to maturity, then
the interim volatility will not be a concern. Lastly, liquidity may be limited for such bonds.

8.5.3 Convertible Bonds

Convertible bonds are bonds that can be converted at the holder's option into ordinary shares of the
issuing company, within a specified time period. Yields on convertible bonds are generally lower than
those on comparable straight bonds because of the conversion privilege, which the bondholder effectively
pays for, through the lower interest rate on the convertible bond. There is potential capital appreciation
from increases in the underlying share price (through the option), a fall in interest rates or an
improvement in the credit rating of the issuer.

Convertible bonds are advantageous to the issuer because they allow the issuer to refinance at a lower
rate and defer potential dilution of earnings. This is because the bonds conversion rate is set above the
share’s current market price, making it unattractive to convert into shares at the time of issue. If the

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share price appreciates, it may be worthwhile to exercise the conversion. At this point, depending on the
amount of conversion from bonds to shares, there will be dilution of earnings to that extent.

8.5.4 Covered Bonds

Covered bonds have a long history in Europe that dates back to 1769. Though many banks have come
and gone since then, these bonds have never experienced a default, and partly because of this appeal,
and also as a response to the global financial crisis of 2007-2008, covered bonds are now issued in many
countries around the world.

The M onetary Authority of Singapore released guidelines in December 2013 to allow local banks to sell
covered bonds. Generally, a covered bond is a highly rated paper, backed against bank assets, and
typically costs less to issue than unsecured bonds. A bank in acquisition mode might consider a covered
bond offering as an additional and more attractive way to raise funds.

8.5.5 High-Yield Bonds

Bonds with a credit rating below triple B (BBB) are called high-yield bonds or junk bonds. High-yield bonds
are securities that trade primarily on their creditworthiness as opposed to the level of interest rates. The
yields of many high-yield securities reflect a variety of factors such as the small size of the company or a
lack of credit history.

There are complex bond structures in the junk bond area, particularly for bonds issued for leveraged
buyout (LBO) financing and recapitalizations. To reduce the heavy interest payment, firms involved in
LBOs and recapitalizations will issue deferred coupon structures that permit the issuer to avoid using cash
to make interest payments for a period of 3-7 years. There are three types of deferred-coupon structures:
• Deferred-interest bonds are the most common type of deferred-coupon structure. These bonds sell
at a deep discount and do not pay interest for an initial period, typically from three to seven years.
• Step-up bonds pay coupon interest. However, the coupon rate is low for an initial period and then
increases ("steps up") to a higher coupon rate thereafter.
• Payment-in-kind bonds give the issuer an option to pay cash at a coupon payment date or give the
bondholder a similar bond (i.e. a bond with the same coupon and a par value equal to the amount of
the coupon payment that would have been paid). The period within which the issuer can make this
choice varies from five to ten years.
• Perpetual bonds have no maturity. Such bonds pay a higher coupon rate to compensate the investor
for an indefinite holding period. Perpetual bond issuers are not legally obligated to redeem these
bonds although there is usually an option for the bonds to be redeemed by the issuer on specific
dates, usually five years after the bond issuance. These bonds rank before equities, in the order of
discharge in an event of default.

8.6 Special Features of Bonds

Unlike 'plain vanilla' or 'straight' bond, which is a basic fixed-income security with no special features,
some bond issues have special features. These features can affect the coupon or maturity of the bond.

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8.6.1 Call Provisions

A bond with a call feature or call provision gives the issuer the right to retire the debt, fully or partially,
before the maturity date. This is in contrast to a non-callable bond where the issuer cannot retire the
bond before maturity.

The call provision is attractive to issuers as it gives them the flexibility to control financing costs if and
when interest rates move downward. The call feature can also be useful for corporations wishing to
escape the restrictions that may be in the bond indenture, as a legal requirement for the bond issue.

The call provision is, however, unattractive to investors who run the risk of losing a high-coupon bond
when interest rates decline. To protect the investor from an early redemption, there may be a provision
limiting the issuer's right to call the bond for a certain period of time after the date of issue. Another
disadvantage for the investor is that the prospect of a call limits the upside price potential of the bond in
a falling interest rate environment. Because of these disadvantages, bonds with call features carry higher
yields than non-callable bonds.

The call price, i.e. the price at which the bond may be called, is normally higher than the par value of the
bond issue. The difference between the call price and par value is the call premium. The call premium
tends to be higher in the early life of the bond and declines gradually towards par as the bond approaches
maturity.

8.6.2 Sinking-Fund Provision

Corporate bond indentures may require the issuer to retire a certain amount of the outstanding debt each
year. If so, the issuer may purchase the amount of bonds to be retired in the open market if their price is
below par, or the company may make payments to the trustee who will then call the bonds for redemption
using a lottery. The purpose of a sinking-fund provision is to reduce credit risk.

Some sinking fund provisions may have embedded options that allow the issuer the option to accelerate
the repayment of the principal. An example is the doubling option, which grants the issuer the right to
retire twice the amount of debt the sinking fund requires. While the acceleration provision is supposedly
included in an indenture to reduce the credit risk of an issuer, by allowing the issuer to retire more of the
principal prior to the maturity date, it is effectively a call option granted to the issuer.

8.6.3 Put Provisions

Putable bonds give the bondholder the right to sell the bonds back to the issuer at par value on designated
dates. A put provision helps to limit the downside risk of the bond. When interest rates rise resulting in
a decline in the bond price, the investor can “put” or sell the bond to the issuer at par. As with a
convertible bond, the investor has effectively bought a put option from the issuer, and will pay for it with
a lower coupon rate.

8.7 Asset-Backed Securities

Asset- and mortgage-backed securities are typically securities created by lenders from pooling illiquid
asset cash flows, through securitisation, for sale to investors. The primary difference between asset-
backed securities (ABS) and mortgage–backed securities (M BS) is the underlying asset upon which the
securitised asset is based. M BS are securities created from the pooling of mortgages whereas ABS evolved
out of M BS and are created from the pooling of non-mortgaged assets.

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ABS represent an interest in a wide range of pooled assets which include (amongst others):
 Auto loans and leases
 Consumer loans
 Credit card receivables
 Royalty payments

One of the most popular forms of M BS, particularly in the United States, where the Federal Home Loan
M ortgage Corporation (Freddie M ac) and Federal National M ortgage Association (Fannie M ae) issued
large amounts of M BS. With their funding advantage, they purchased and invested in huge numbers of
mortgages and M BS with lower capital requirements than other regulated financial institutions and banks.
This was one of the contributors to the sub-prime crisis in 2007.

The asset securitisation market in Singapore was active when it commenced in 2006, but became very
quiet following the financial crisis in 2007. Examples of recent M BS issues in Singapore include the
commercial M BS structured and sold by DBS Singapore which dealt with pre-sales of properties under
construction. The progress payments on the property were securitised and provided construction finance.
Another deal, which was structured and lead-managed by HSBC for Courts Asia, used two distinct SPVs
(special purpose vehicles) – one in M alaysia and one in Singapore - to structure a multi-currency multi-
jurisdiction transaction, using Courts’ loan receivables as assets for the SPVs.

8.7.1 Collateralized Debt Obligations

A collateralized debt obligation (CDO) is structured by an investment manager or a bank, by pooling

together cash flow-generating assets, which are then repackaged and sold to investors. The investors
purchase the CDOs, which are typically issued by a Special Purpose Vehicle (SPV) and secured and backed
by the asset acquired i.e. bonds or loans.

Figure 6.2 - Basic CDO Structure

CDOs that are backed by a pool of bonds are also known as collateralized bond obligations (CBO), while
those that are backed by a pool of loans are known as collateralized loan obligation (CLO). Therefore,
within the CDO structure, a fund manager will look after a portfolio of assets (the debt securities i.e. bonds
or loans that have been purchased). The proceeds from the issuance of the CDOs effectively finances the
assets acquired.

Hence, a CDO is effectively a vehicle for an investment manager to gather assets for investments to
generate management fees, or to carry out a form of arbitrage in the market, earning a yield between the
return on the assets, and the rate paid to the CDO investors.

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8.8 Bond Ratings

Credit risk of bonds is gauged by quality ratings assigned by commercial rating companies. The three
largest credit-rating agencies are M oody's Investor Service, Fitch Ratings and Standard & Poor's (S&P). As
independent organizations with no vested interest in the issuers, they provide objective assessments of
the credit risk of the issuers and their securities. For illustration purposes, S&P will be used in the
discussion for this section.

S&P's bond ratings consist of letters ranging from AAA, AA, A, BBB, and so on, to D. The first four
categories, AAA through BBB, represent investment grade bonds. Issues that carry a rating below the top
four categories, i.e. from BB and below, are referred to as non-investment-grade bonds, or more
popularly as high-yield bonds or junk bonds.

Issuer credit ratings can be either long-term or short-term. Short-term ratings are generally assigned to
those obligations that are considered short-term in the relevant market. In the U.S., that means
obligations with an original maturity of no more than 365 days. Short-term ratings are also used to indicate
the creditworthiness of an obligor with respect to put features on long-term obligations. The result is a
dual rating, in which the short-term rating addresses the put feature, in addition to the usual long-term
rating. M edium-term notes are assigned long-term ratings.

Table 8.8(a) – Long-Term Ratings of S&P2

Category Definition
AAA An obligor rated 'AAA' has extremely strong capacity to meet its financial commitments.
'AAA' is the highest issuer credit rating assigned by S&P.
AA An obligor rated 'AA' has very strong capacity to meet its financial commitments. It differs
from the highest-rated obligors only to a small degree.
A An obligor rated 'A' has strong capacity to meet its financial commitments but is somewhat
more susceptible to the adverse effects of changes in circumstances and economic
conditions than obligors in higher-rated categories.
BBB An obligor rated 'BBB' has adequate capacity to meet its financial commitments. However,
adverse economic conditions or changing circumstances are more likely to lead to a
weakened capacity of the obligor to meet its financial commitments.
BB An obligor rated 'BB' is less vulnerable in the near term than other lower-rated obligors.
However, it faces major ongoing uncertainties and exposure to adverse business, financial,
or economic conditions which could lead to the obligor's inadequate capacity to meet its
financial commitments.
B An obligor rated 'B' is more vulnerable than the obligors rated 'BB', but the obligor
currently has the capacity to meet its financial commitments. Adverse business, financial,
or economic conditions will likely impair the obligor's capacity or willingness to meet its
financial commitments.
CCC An obligor rated 'CCC' is currently vulnerable, and is dependent upon favorable business,
financial, and economic conditions to meet its financial commitments.
CC An obligor rated 'CC' is currently highly vulnerable. The 'CC' rating is used when a default
has not yet occurred, but S&P expects default to be a virtual certainty, regardless of the
anticipated time to default.

2 Source: http:/ / www.standardandpoors.com/spf/ general/RatingsDirect_Commentary

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Table 8.8(b) – Short-Term Ratings of S&P3

Category Definition
A-1 An obligor rated 'A-1' has strong capacity to meet its financial commitments. It is rated in
the highest category by Standard & Poor's. Within this category, certain obligors are
designated with a plus sign (+). This indicates that the obligor's capacity to meet its financial
commitments is extremely strong.
A-2 An obligor rated 'A-2' has satisfactory capacity to meet its financial commitments. However,
it is somewhat more susceptible to the adverse effects of changes in circumstances and
economic conditions than obligors in the highest rating category.
A-3 An obligor rated 'A-3' has adequate capacity to meet its financial obligations. However,
adverse economic conditions or changing circumstances are more likely to lead to a
weakened capacity of the obligor to meet its financial commitments.
B An obligor rated 'B' is regarded as vulnerable and has significant speculative characteristics.
The obligor currently has the capacity to meet its financial commitments; however, it faces
major ongoing uncertainties which could lead to the obligor's inadequate capacity to meet
its financial commitments.
C An obligor rated 'C' is currently vulnerable to nonpayment that would result in a 'SD' or 'D'
issuer rating, and is dependent upon favorable business, financial, and economic conditions
for it to meet its financial commitments.
R An obligor rated 'R' is under regulatory supervision owing to its financial condition. During
the pendency of the regulatory supervision the regulators may have the power to favor one
class of obligations over others or pay some obligations and not others.
SD & D An obligor rated 'SD' (selective default) or 'D' is in default on one or more of its financial
obligations including rated and unrated financial obligations but excluding hybrid
instruments classified as regulatory capital or in non-payment according to terms.
BB; B; Obligors rated 'BB', 'B', 'CCC', and 'CC' are regarded as having significant speculative
CCC & characteristics. 'BB' indicates the least degree of speculation and 'CC' the highest. While
CC such obligors will likely have some quality and protective characteristics, these may be
outweighed by large uncertainties or major exposures to adverse conditions.

8.9 Sources of Risk

There are several sources of risk associated with investments in fixed income securities.

8.9.1 Interest Rate Risk

Bond prices are most vulnerable to interest rate changes. There is an inverse relationship between
interest rates and bond prices. As interest rates rise (fall), the prices of bonds will fall (rise). This is also
referred to as the delta risk. For an investor who intends to hold a fixed income security to maturity, the
intermediate price volatility is not of any profit and loss concern. However, if the investor plans to sell
the fixed income security before maturity, an increase in interest rates will translate into capital loss.

3
Source: http:/ /www.standardandpoors.com/spf/ general/RatingsDirect_Commentary

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8.9.2 Reinvestment Risk

The interest income received from a fixed income security is usually reinvested. However, in an
environment where interest rates are ever changing, one is never sure of the rate at which future interest
coupons can be reinvested. This is referred to as reinvestment risk. There is the risk that the interest rate
at which interim cash flows can be reinvested will decline resulting in a lower expected return.
Reinvestment risk is greater for higher coupon bonds and longer holding periods.

The impact of interest rate movements on interest rate risk and reinvestment risk are opposite to each
other. Therefore, a rise in interest rates will have on one hand, the effect of pushing down the bond price
(reason – the bond price must fall to give the investors the higher market yield, because the coupon is
fixed), and on the other, the reinvestment risk will have the effect of pushing up the bond price (reason –
interest received from the fixed coupons can be re-invested at a higher rate). These are not fully offsetting,
and generally, the effect of the reinvestment risk will slightly mute the effect of the interest rate risk.

8.9.3 Timing or Call Risk

Callable bonds are subject to the risk of bond redemption by the issuer before the maturity date. From
the investor's viewpoint, there are three disadvantages associated with the call feature. First, issuers are
likely to redeem the bonds when interest rates decline, thus exposing the investor to reinvestment rate
risk from having to replace the proceeds of the redeemed bonds with bonds offering lower yields. Second,
the potential for capital appreciation is limited, as the market price of a callable bond will not rise much
above the call price. Lastly, the cash flow pattern of a callable bond is not known with certainty.

8.9.4 Credit Risk

Credit risk or default risk refers to the risk that the issuer of the bond will be unable to make timely
principal and interest payments as agreed in the terms of issue. M ost corporate bonds pay a higher yield
than comparable US Treasury securities, which are regarded as free of credit risk.

Normally, investors are concerned more with changes in the perceived credit risk than with the actual
event of default. Even though the likelihood of an actual default may be small, a change in perceived
credit risk of the issuer can have an immediate and significant impact on the value of a security.

Investors typically look at the rating agencies’ commentaries to get some fore-warning of any impending
lowering of credit rating, or of any negative comments that will affect this rating.

8.9.5 Inflation or Purchasing Power Risk

The cash flows from fixed income securities are fixed in dollar terms. Therefore as the general price level
rises, the value of the cash flows in real terms declines. Inflation risk refers to the risk that the real return
will be lower than the nominal (dollar) return.

Inflation risk is actually the risk of unanticipated inflation. If inflation is anticipated and is factored into
the price of the bond, then investors are compensated for anticipated inflation.

8.9.6 M arketability or Liquidity Risk

M arketability or liquidity risk refers to the ease with which a security can be sold at or near its true value
in the secondary market. An indication of the marketability of a security is the size of the spread between
the bid and offer quoted by the dealer. The greater the spread, the greater the marketability risk in closing

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out a position. For an investor who plans to hold the bond until maturity date, marketability risk is less
important.

8.9.7 Exchange Rate or Currency Risk

The SGD cash flows of a foreign currency denominated bond are dependent on the foreign exchange rate
at the time the payments are received. If the foreign currency depreciates relative to the SGD, then fewer
SGD will be received. This is referred to as exchange rate, or currency risk. On the other hand, if the
foreign currency appreciates relative to the SGD, the investor will enjoy currency gains.

8.9.8 Volatility Risk

The price of a bond that has an embedded option depends on the level of interest rates and other factors
that influence the value of the embedded option. One of the factors is the expected volatility of interest
rates. This is also referred to as the vega risk. Specifically, the value of an option rises when expected
interest-rate volatility increases. The risk that a change in volatility will adversely affect the price of a
security is called volatility risk.

8.9.9 Political Risk

Sometimes the government can declare withholding taxes on a bond or declare a tax-exempt bond
taxable. There also may be capital controls imposed on the remittance of funds. These actions can
adversely impact the value of the security. The possibility of any political or legal actions adversely
affecting the value of a security is known as political or legal risk.

8.9.10 Event Risk

Sometimes, the ability of the issuer to make interest and principal payments may be seriously impaired
because of a natural catastrophe or some regulatory change, or a takeover or corporate restructuring.
These risks are referred to as event risk and will result in a downgrading of the issuer by rating agencies.

8.9.11 Sector Risk

Bonds in different sectors of the market respond differently to environmental changes because of a
combination of some or all of the above risks, as well as others. Examples include discount versus
premium coupon bonds, industrial versus utility bonds, corporate versus mortgage-backed bonds. The
possibility of an adverse differential movement of specific sectors of the market is called sector risk.

8.10 Bond Valuation

The value of a bond equals the present value of its expected cash flows. The cash flows from a bond are
the periodic interest payments to the bondholder and the repayment of principal at its maturity.
Therefore, the current value of a bond is the total present value of the interest payments plus the present
value of the principal repayment, where the discount factor is the required rate of return on the bond.
We can express this in the following present value formula:
C1 C2 C3 Cn M
P = + 2 + 3 +…+ +
1 + k (1 + k) (1 + k) ( 1 + k) ( 1 + k) n
n

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n
Ct M
= t+
(1 + k) (1 + k)n
t=1

The above equation applies to bonds, which pay annual interest. In the case of bonds, which pay interest
semiannually, the equation is:
2n
Ct M
P = t+ 2n
t=1
(1 + k/ 2) (1 + k/ 2)
where
P =present value of the bond today (t = 0)
Ct =coupon payments for each period t
M =maturity value
n =years to maturity
k =required market yield i.e. the yield that is currently available in the market for this maturity

The interest rate or discount rate (k) that an investor wants from investing in a bond is called the required
rate of return. The required yield is the yield offered by comparable bonds with the same maturity and
of the same credit quality.

Calculation of Bond Price

Consider a 10-year bond with par value of $1,000 and a coupon of 8%. Given a required market yield
6% per year, what price would you pay for the bond?

Compute the bond value assuming:

a. Annual coupon payments
b. Semiannual coupon payments.

a. Assuming annual coupon payments

80 80 80 80 1,000
Price = + 2 + 3 + … + 10 +
1.06 1.06 1.06 1.06 1.0610
This can be calculated with a financial calculator (See Figure 8.10(a) below) with the input of the
numbers below:
• n =number of interest rate periods, in this example, n =10
• PM T =the coupon payment paid each year, PM T =80
• FV =future value at the end of 10 years, FV = 1,000
• i =rate of discount

Figure 8.10(a) – Financial Calculator

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Press PV to obtain the present value of the cash flows.

PV =$1,147.21

b. Assuming semiannual coupon payments

40 40 40 40 1,000
Price = + 2 + 3 +…+ 20 +
1.03 1.03 1.03 1.03 1.0320
=$1,148.80

Note that in the computation, the number of periods must be doubled and hence, the discount rate
must be divided by two.

8.10.1 Valuation of a Zero Coupon Bond

Zero coupon bonds do not make any periodic coupon payments. The only cash flow is the maturity value.
Therefore, the price of a zero coupon bond is simply the present value of the maturity value.
M
P = 2n
(1 + k/ 2)

Calculation of Bond Price for a Zero Coupon Bond

Given a required rate of return of 9%, compute the price of a zero coupon bond that matures in 15 years
with a par value of $1,000.
1,000
P =
(1.045)30
= $267.00

The semi-annual rate of 4.5% and the interest period of half a year are used to make the valuation
consistent with semi-annual coupon bonds.

To use the financial calculator, input the following:

FV =1,000
n =30 (for 30 half years)
i =4.5% (annual return of 9% ÷2)

Press the PV button to obtain:

PV = $267.00

8.11 Relationship between Bond Price and M arket Yield

There is an inverse relationship between bond price and market yield i.e. bond prices change in the
opposite direction from the direction of market yields. This is because the price of the bond is the present
value of the cash flows. As market yields increase, because interest rates increase, the present value of
the cash flows decreases; hence the bond price decreases. The reverse is also true. When market yields
decrease, the present value of the cash flows increases and therefore the price of the bond rises.

Table 8.11(a) shows the prices for a 10-year maturity, 12% coupon bond for market yields of 10%, 12%
and 14%. It is noted that as the required yield rises, the bond value declines.

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Table 8.11(a) – Price-Yield Relationship for a 10-year, 12% Coupon Bond

Required Yield Bond Value

10% 112.46%
12% 100.00%
14% 89.41%

This inverse relationship between bond price and required yield is illustrated in Figure 8.11(b) below:

Figure 8.11 (b) - Relationship between Bond Price and Required Yield

8.12 Relationship between Coupon Rate, M arket Yield and Price

Generally, when a bond is issued, the coupon rate is set at approximately the prevailing yield in the
market. Assume you bought an 8% coupon bond at par. The yield on the bond would be 8%. When the
market yield is equal to the coupon rate, the price of the bond is its par value i.e. 100.

M arket yields are always changing. If market yields rise above the coupon rate to 9%, the investor will
have to be compensated for the higher yield through an adjustment in the bond price. This is
accomplished when the bond price falls below its par value. When the price of a bond trades below its
par value, it is said to be selling at a discount.

If the market yield falls below the coupon rate to 7%, the price of the bond will move up to adjust for the
lower yield. When the price of a bond trades above its par value, it is said to be selling at a premium.
The relationship between coupon rate, market yield, and price can be summarized as follows:
 When the coupon rate equals the market yield, the bond price will trade at its par value;
 When the coupon rate is lower than the market yield, the bond price will trade at a discount; and
 When the coupon rate is higher than the market yield, the bond price will trade at a premium.

8.13 Duration and Convexity

Duration and convexity are concepts that are important to understand in the risk management of a fixed-
income bond portfolio.

The duration of a bond is affected by its coupon rate, yield, and remaining time to maturity. It is a linear
measure of the approximate price sensitivity of a bond to small interest rate changes of not more than
1% or 100 basis points. Duration is higher for bonds with lower coupons, lower yields and longer
maturities.

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The following points clarify how these three properties affect a bond’s duration:
 If the coupon and yield are the same, duration increases with remaining period to maturity;
 If the maturity and yield are the same, duration increases with a lower coupon; and
 If the coupon and maturity are the same, duration increases with a lower yield.

M odified duration is used to calculate changes in bond prices from small changes in interest rates.
Typically, a bond portfolio’s overall duration is calculated to monitor the profit and loss sensitivity of the
portfolio to small changes in interest rates. The portfolio duration is the weighted average of the
durations of all the bonds in the portfolio.

Figure 8.13(a) – Duration and Convexity

8.13.1 Convexity

Duration is an imperfect way of measuring a bond’s price change; the price sensitivity is linearly
approximated when in fact it exhibits a sloped or “convex” shape. With positive convexity, the yield will
fall if duration increases. Positive convexity means that for large changes in interest rates, the amount of
price appreciation will be greater than the amount of price depreciation. Positive convexity favours the
investor because regardless of whether interest rates rise or fall, a higher convexity bond will always have
a higher price than a lower convexity bond. In negative convexity, the amount of price appreciation is less
than the amount of price depreciation for large interest rate changes. See Figure 8.13(a) above.

Convexity is directly related to the coupon rate and the bond’s remaining term to maturity. The lower the
coupon, the higher the convexity. Zero coupons have the highest convexity.

8.13.2 Present Value of a Basis Point (PVBP or PV01)

The PVBP or PV01 is used as a risk management tool for bond portfolio. It is the change in the present
value for the entire bond portfolio for a one basis point movement in interest rates. Typically, a limit may
be set for the total PVBP effect, for parallel movements in interest rates of 100 basis points, 200 bps and
300 bps.

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8.14 Time Path of a Bond

Over time, holding all other factors constant, a bond's price must converge to its par value towards the
maturity date, because it will be redeemed at par. Therefore, the price of a bond selling at a discount will
increase as the bond moves toward maturity and the price of a bond selling at a premium will decline over
time, holding all other factors constant. For a bond selling at par, its price will remain at par as the bond
moves toward the maturity date.

8.15 Yield M easures

The most common measures of bond yield quoted by bond dealers are the current yield and yield-to-
maturity.

8.15.1 Current Yield

Current yield measures the rate of return from the annual interest payments of the bond as a percentage
of its market price.
Annual Interest Payment
Current Yield =
Bond Price

For example, a 10-year, 6% coupon bond with a par value of $1,000 and a price of 115% would provide a
yield of 5.22%.
$60
Current Yield= = 5.22%
$1,150

The current yield considers only the annual interest payment and does not account for any potential
capital gain or loss that the investor may realize if the bond is held to maturity.

8.15.2 Yield-to-M aturity

The yield-to-maturity (YTM ) is a measure of the rate of return that will be earned on a bond if it is bought
now and held till maturity. It is the interest rate or discount rate that will make the present value of the
bond equal to the actual market value of the bond. Therefore, discounting the bond’s cash flows by the
yield to maturity will give a present value equal to the price at which the bond was purchased.

Calculation of Yield to M aturity of a Bond

Given a price of $1148.80, determine the YTM of a 10-year bond with a par value of $1,000 and a
coupon of 8%. Interest payment is on a semiannual basis.

The YTM (k) for the bond can be determined by solving the following equation:
C1 C2 C3 C2n M
P = + 2 + 3 + … + +
1 + k/ 2 (1 + k/ 2) (1 + k/ 2) ( 1 + k/ 2) 2n ( 1 + k/ 2) 2n
40 40 40 40 1,000
1,140.80 = + 2 + 3 +…+ 20 + 20
1 + k/ 2 (1 + k/ 2) (1 + k/ 2) (1 + k/ 2) (1 + k/ 2)

The YTM is determined using a trial-and-error process that equates the left-hand side of the equation
with the right-hand side. In practice, a financial calculator can be used to determine YTM .

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Input the following in the financial calculator:

n =20
PV =-1,148.80
PM T =40
FV =1000

Press the “ i ” button to get the yield to maturity of 3.00%, on a semi-annual basis.

The market convention is to annualize the semi-annual yield by doubling its value. The YTM computed
on the basis of this market convention is called the bond-equivalent yield. It is the effective annual
yield of the bond.

The proper way to annualize the semiannual yield is to apply the following formula:
Effective annual yield = (1 + Semiannual Interest Rate)2- 1

Therefore, the effective annual yield is (1.03)2 - 1 =6.09%

An approximation formula exists for calculating YTM . It relates the net annual effective cash flow to the
average amount of money invested in the bond during the holding period. Effectively, the investor is
assumed to have an average investment of this amount in the bond as the price gradually converges to
$1,000, as it must by the maturity date.
Annual Interest Payment ±Amortised Gain or Loss
Approximate YTM =
( Current Market Price + Par Value) / 2

Consider the bond above in “Calculation of Yield to M aturity of a Bond”.

80 - 148.80 / 10
Approximate YTM =
(1,148.80 +1,000)/ 2
=65.12/ 1,074.40
=6.06%

It is easier to compute the YTM for a zero-coupon bond. To find the YTM , we substitute zero for the
coupon payments into the present value model and solve for k.
1/ 2n
k M aturity Value
= - 1
2 Price

For example, for a 15-year zero coupon bond with a maturity value of $1,000, selling for $300:

k $1,000 1/ 30
= -1
2 $300
=0.0409 or 4.1%

Note that the number of periods is equal to 30 semi-annual periods, which is double the number of years.
The bond-equivalent yield is 8.35%.

The YTM is a more meaningful measure of return compared to the current yield as it considers both
current coupon income and any capital gain or loss, which the investor will realize by holding the bond to
maturity. Besides, the timing of cash flows is also accounted for in the YTM .

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The YTM assumes that the coupon payments are reinvested at an interest rate equal to the YTM . The
investor will only realize the YTM stated at the time of purchase if:
 The coupon payments can be consistently reinvested at the YTM ; and
 The bond is held to maturity.

With regard to the first assumption, the risk that an investor faces is that future reinvestment rates may
be different from the YTM at the time the bond is purchased. This is the reinvestment risk, which was
covered earlier in this chapter. If the bond is not held to maturity, the price of the bond may have to be
sold for at a different level from its purchase price, resulting in a return that is different from the YTM .
The risk that a bond will have to be sold at a loss because interest rates have risen (resulting in a lower
bond price), is referred to as interest rate risk or price risk.

8.15.3 Reinvestment Risk

The maturity and coupon of the bond affect the degree of reinvestment risk.

First, for a given YTM and a given coupon rate, the longer the maturity, the more the bond's total dollar
return is dependent on the interest-on-interest to realize the YTM at the time of purchase. In other words,
the longer the maturity, the greater the reinvestment risk.

Second, for a given maturity and a given YTM , the higher the coupon rate, the more dependent the bond's
total dollar return will be on the reinvestment of the coupon payments in order to produce the YTM
expected at the time of purchase. This means that holding maturity and YTM constant, higher coupons
will carry higher reinvestment risk because of the higher cash flow amount from the higher coupon. The
converse is also true. So, a zero coupon bond has no reinvestment risk if it is held to maturity.

8.15.4 Taxable Equivalent Yield

Some bonds are exempted from tax. Accordingly, the stated rate on these bonds will be lower than that
on comparable non-exempt bonds. To make the return on these bonds comparable to those of taxable
bonds, the taxable equivalent yield (TEY) can be calculated. The formula of TEY is:
Tax Exempt Yield
Taxable Equivalent Yield =
1 - Marginal Tax Rate

An investor in the 28% marginal tax bracket who invests in a 5-year a tax-exempt bond with an YTM of 7%
would have a tax equivalent yield of:
0.07
= 9.7%
1 - 0.28

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8.16 Term Structure of Interest Rates

The relationship between a security's yield-to-maturity and its term to maturity is known as the maturity
structure or term structure of interest rates. It is also referred to as the yield curve.

8.16.1 Types of Yield Curves

Figure 8.16.1(a) on the following page shows four different types of term structures or yield curves.

Figure 8.16.1(a) - Types of Yield Curves

The rising yield curve is the most common. It is seen when the yields on short-term issues are low and
rise consistently with longer maturities. A rising yield curve is a signal that interest rates are expected to
rise in the future i.e. the entire yield curve will move upwards. The declining yield curve is seen when the
yields on short-term issues are higher than the yields on longer maturities. This generally indicates lower
interest rates in the future. A humped yield curve is formed when yields on intermediate-term issues are
higher than yields on short-term issues, and rates of long-term issues decline to levels below those for the
short-term and then level out. When the yields on short-term and long-term issues are the same, this will
result in a flat yield curve.

8.16.2 Theories of Interest Rates

Three major theories of interest rates are used to explain the different types of yield curves. They are the
expectations theory, the liquidity preference theory and the market segmentation theory.

1. Expectations Theory

One important assumption in the expectations theory is that investors have perfect foresight regarding
future spot rates. The shape of the yield curve is determined by the interest rate expectations of investors.

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When the market expects interest rates to rise, lenders will prefer to lend for shorter periods, forcing
interest rates down in the shorter periods. Conversely, borrowers will prefer to borrow for longer periods,
forcing interest rates up in the longer maturities. These opposing pressures create an upward sloping
yield curve.

On the other hand, if the market expects interest rates to fall, lenders will prefer to lend at the longer end
of the curve (forcing interest rates down at the longer end of the curve), and borrowers will prefer to
borrow in the shorter periods (forcing interest rates up in the short end of the curve), resulting in a
downward sloping yield curve.

When the market is ambivalent about the direction of interest rates, the yield curve will tend to be flatter.

Suppose the interest rate on a 1-year Treasury bill is 6%. After one year, the yield on a new 1-year Treasury
bill is expected to rise from its current 6.5% to 8%. There are two options for an investor with a 2-year
time frame. He can invest in one-year Treasury bill on a rolling basis, which will provide him an average
yield of 7%:
Annual rate of return= [(1.06)(1.08)]1/ 2 - 1 =0.07

Alternatively, he can invest in a 2-year security. He will require a yield of 7%, the average of the 6%he
could expect in the first year and the 8% forecast in the second year.

2. Liquidity Preference Theory

The theory of liquidity preference argues that the shape of the yield curve should always be upward
sloping and that any other shape would be a temporary aberration. Because of the greater impact from
the price volatility of long maturity securities (compared to shorter maturities), investors will require a
higher return to hold long-term securities relative to short-term securities. From a lender’s perspective,
he will prefer short-term loans. Higher yields will be required to induce them to lend long-term.

Since short-term securities are more easily converted into cash without the risk of large price movements,
investors are willing to pay a higher price for short-term securities and thus receive a lower yield. This
again justifies an upward sloping yield curve.

3. Market Segmentation Theory

The market segmentation theory presumes that investors have their own maturity preferences, which are
dictated by the nature of their liabilities. As an example, life insurance companies with long-term liabilities
prefer long-term bonds while banks tend to prefer short-term liquid securities to match the nature of
their deposits. The yield for each maturity is determined solely by the supply and demand in each
"segment". The theory holds that activities of long-term borrowers and lenders determine rates on long-
term bonds. Similarly, short-term trades set short-term rates.

8.17 Analysis of Convertible Bonds

A convertible bond is a fixed income security that gives the holder the right to convert the bond into a
predetermined number of shares of the ordinary share of the issuer within a specified time period.
Exchangeable bonds grant the bondholder the right to exchange the bonds for the ordinary share of a
firm other than the issuer of the bond. A major reason for adding a convertible feature to the debt security
is to increase the attractiveness of the issue thus ensuring a market for it.

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Convertible bonds are issued by companies as part of their fundraising activities. A convertible feature is
attached to the bond as a sweetener, thereby allowing the company to issue the bonds at lower yields
than comparable straight bonds, thus lowering its financing costs.

Analysis of a Convertible Bond

The following hypothetical bond, Genesis convertible bond, can be used to illustrate the analysis of a
convertible bond:

M aturity =10 years

Coupon rate =4%
Conversion ratio =40
Par value =$1,000
M arket price of Genesis convertible bond =$1,100
M arket price of Genesis common share =$24 per share
Annual dividend =$0.35 per share

8.17.1 M inimum Value of a Convertible Bond

A convertible bond can be considered as a "double" security, consisting of a straight bond and a call option
to purchase common shares of the issuing company. Therefore, in determining the value of a convertible
bond, it is necessary to consider both aspects of the bond. First, we want to consider the value of the
convertible as a straight bond. Second, we want to consider the conversion value, the value of the shares
when conversion takes place.

1. Investment Value

The bond value, also referred to as the straight value or investment value is the value of the convertible
bond without the conversion feature. It is calculated based on the cash flows of the convertible if there
is no conversion. To determine the bond value, we need to know the market yield on a comparable
straight bond. Given the market yield, we will discount the bond's cash flows thus deriving the bond
value.

Suppose the market yield on comparable straight bonds is 8 percent, the value of Genesis convertible
bond is $732.
n
Ct M
Bond Value = t + n = $731.60
(1 + k) (1 + k)
t=1

2. Conversion Value

The conversion value of a convertible bond is the market value of the ordinary share for which it can be
exchanged. For the Genesis convertible bond, the conversion value is:

Conversion value =Conversion Ratio x M arket Share Price

=40 x $24
=$960

The minimum price of a convertible bond is the greater of its:

 Conversion value, or
 Investment value

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Given a conversion value of $960 and an investment value of $728, the minimum price of Genesis
convertible bond is $960. If the bond sells below $960, say at $728, arbitrageurs would buy the bond for
$728 and convert it, and sell the shares at $24 per share. This would result in a profit of $232 per bond.
If the investment value is higher than the conversion value, the convertible bond will trade at its
investment value. If it trades below its investment value, at $700, the yield would be 8.5 percent, which
is greater than comparable straight bonds. Investors would buy the convertible bond, thus bidding up the
price until the yield falls to 8 percent.

8.17.2 Conversion Ratio and Conversion Price

The conversion ratio represents the number of shares of ordinary share for which the convertible bond
(CB) can be exchanged.
Par Value of CB
Conversion Ratio =
Conversion Price

In the case of Genesis convertible bond, the conversion ratio is 40, which means that a $1,000 par value
convertible bond is exchangeable for 40 shares of ordinary share.

Given the conversion ratio we can derive the conversion price. The conversion price for Genesis bond is:
Par Value of CB
Conversion Price =
Conversion Ratio
$1,000
=
40
=$25

8.17.3 Conversion Parity Price

The price that an investor effectively pays for the ordinary share if the convertible bond is purchased and
then converted into ordinary share is known as the conversion parity price. It is calculated as follows:
Market Price of CB
Conversion Parity Price=
Conversion Ratio

For Genesis convertible bond, the conversion parity price is:

$1,100
Conversion Parity Price =
40
=$27.50

If the investor purchases Genesis convertible bond and converts it to convertible share, he is effectively
paying $27.50 per share. The conversion parity price can be considered as a breakeven point. Once the
share price reaches that value, the investor is assured of not making a loss. Any further increase in the
share price will result in the same percentage increase in the value of the convertible bond.

8.17.4 Conversion Premium

The investor who purchases Genesis convertible bond instead of the underlying share is paying a premium
of $3.50 ($27.50 - $24) or 14.6% over the current share price. This is the conversion premium, which is
the difference between the convertible's market price and the higher of its bond value and conversion
value. It can be expressed as an absolute value or as a percentage.

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For Genesis bond, the conversion premium is calculated as follows:

Conversion premium ($) =M arket Value of CB - M inimum Value

=$1,100 - $960 =$140
Market Value of CB - Minimum Value
Conversion Premium ( %) =
Minimum Value
$140
=
960
=14.6%

Normally, a convertible bond trades at a premium to its straight value or conversion value. This is because
the convertible bond has an embedded option equivalent to a call option on the underlying security at a
strike price of $25. The price differential between the convertible bond and its straight value is therefore
effectively, the value of the embedded call option. An investor is willing to paying the higher price for the
convertible because of the potential for significant capital gains when the share price appreciates. At the
same time, his downside risk is limited to the straight value of the bond.

8.17.5 Breakeven Time

The current yield of a convertible bond is normally higher than the dividend yield from the ordinary share
because the convertible bond is essentially a bond with an embedded option. The investor is not entitled
to capital gain on the underlying share. Investors compare the attractiveness of convertible bonds by
looking at how fast it takes to recover the conversion premium from the income differential between the
bond income and the dividend income.

By comparing the conversion premium and the income differential, we are able to calculate the breakeven
time or payback period, which is:
Conversion Premium
Breakeven/ Payback =
Bond Income - Dividend Income

For the Genesis convertible bond, the conversion premium is $140.

Coupon interest from bond
=0.04 x $1,000 =$40

Dividend income
=Conversion Ratio x Dividend per Share
=40 x $0.35 =$14

Differential between bond income and dividend income

=$40 - $14 =$26
Breakeven time =$140/ $26 =5.38 years

The breakeven time does not consider the time value of money. However, it is a useful indicator of the
relative attractiveness of a convertible bond.

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8.17.6 Downside Risk

The investment value is usually used as a measure of the downside risk of a convertible bond. To measure
the downside risk, we compare the market price of the convertible bond with the investment value as
follows:
Market Price of CB
Premium Over Straight Value ( %) = -1
Investment Value

The downside risk for Genesis convertible bond is:

Premium over straight value =$1,100/ $728 - 1 =51%

Despite its use in practice, this measure of downside risk is flawed because the straight value changes as
interest rates change.

8.17.7 Investing in Convertible Bonds

Convertible bonds offer investors a unique combination of an income stream from a fixed income security
and an opportunity to participate in the capital appreciation of the underlying ordinary share. They offer
upside potential and downside protection. The yield on a convertible bond is usually higher than the
dividend yield of the underlying security but lower than the yield of a comparable 'plain vanilla' bond.

M ost convertible bonds are callable. The possibility of a forced conversion when the share price is higher
than the conversion parity value will limit the speculative appeal of the convertible bond.

When the share rises above its conversion “strike” price, the convertible bond price will mainly be
influenced by that of the underlying share. If the share price for the convertible bond in the example
above rises to $50, the bond will have a minimum value of $2,000, and the investor will make a clear profit
from conversion. When the convertible is trading at a reasonable conversion premium, its value will be
influenced by interest rates, the price of the underlying share, and its volatility. When the convertible is
trading at or below the investment value, the embedded option is worthless because the underlying share
price is substantially below the conversion “strike” price. Under this scenario, the convertible trades like
a straight bond.

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8.18 Summary

1. A bond is a debt security on which the issuer makes regular interest payments to the bondholder on
specified dates, and repays the principal to the bondholder on the maturity date.

2. Treasury bills are quoted on a bank discount basis. Though widely used, it is not a meaningful measure
as the quoted yield is calculated based on the face value rather the actual dollar amount invested.
Coupon bonds are quoted on a price basis and buyers of the bonds must compensate the sellers for
any interest accrued since the last interest payment date.

3. Essentially the bond market can be divided into the internal bond market and the external bond
market.

4. In the context of the Singapore Bond M arket, the Domestic Bond M arket comprises Singapore
Government Securities and corporate bonds issued by Singapore companies. The foreign bond
market refers to foreign issuers who have issued their bonds in the Singapore Bond M arket.

5. The Eurobond market is divided into different sectors based on the currency in which the issue is
denominated. Eurobonds can be denominated in any currency, the most popular issues being USD
dollar denominated, called Eurodollar bonds.

6. Special bond features include callable bonds, putable bonds, convertible bonds, bonds with sinking-
fund provision, zero-coupon bonds and floating rate bonds.

7. The secondary market also serves an important market function in benchmarking the market values
of the bonds being traded and the yields that are obtainable from them.

8. Convertible bonds are advantageous to the issuer because they allow the issuer to refinance at a
lower rate if the opportunity presents itself and they defer potential dilution of earnings.

9. Bonds with a quality rating below triple B (BBB), are called high-yield bonds or junk bonds.

10. Asset-backed securities may be secured against auto loans and leases, consumer loans, commercial
assets and credit cards.

11. A collateralized debt obligation (CDO) is a structured by an investment manager, or a bank, pooling
together cash flow-generating assets, which are then repackaged and sold to investors

12. The credit risk of bonds is rated, primarily by Standard & Poor's Corporation, by Fitch Ratings and by
M oody's. Ratings range from AAA (the highest) to D (bonds in default).

13. Bonds with credit rating below triple B are known as high-yield bonds. Deferred-interest bonds, step-
up bonds and payment-in-kind bonds have deferred coupon structures.

14. Bonds are most vulnerable to interest rate risk. Other sources of risk include reinvestment risk, call
risk, credit risk, inflation risk, liquidity risk, currency risk, volatility risk, political risk, event risk and
sector risk.

15. The value of a bond is the present value of its future cash flows. For a coupon bond, the cash flows
comprised of periodic interest payments and the principal value. For a zero-coupon bond, the price
is equal to the present value of its principal.

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16. There is an inverse relationship between bond prices and the required yield.

17. The impact of interest rate movements on interest rate risk and reinvestment risk are opposite to
each other.

18. When the coupon rate equals the required yield, the bond price will trade at its par value. When the
coupon rate is less than the required yield, the bond price will trade at a discount. When the coupon
rate is greater than the required yield, the bond price will trade at a premium.

19. The duration of a bond is basically affected by its coupon rate, yield, and remaining time to maturity.
It is a linear measure of the approximate price sensitivity of a bond to small interest rate changes of
not more than 1% or 100 basis points.

20. Positive convexity means that for large changes in interest rates, the amount of price appreciation
will be greater than the amount of price depreciation.

21. The PVBP or PV01 is used as a risk management tool for bond portfolio. It is the change in the present
value for the entire bond portfolio for a one basis point movement in interest rates.

22. Over time, holding all other factors constant, the price of a bond will converge to its par value on the
maturity date

23. There are two conventional bond yield measures: the current yield and yield-to-maturity. The current
yield considers only the annual interest payment but fails to account for both interest-on-interest and
capital gain or loss. The YTM is a measure of the average rate of return that will be earned on a bond
if it is bought now and held till maturity. It assumes that coupon payments are reinvested at the YTM .

24. The relationship between a security's yield and maturity is known as the term structure of interest
rates. There are four different types of term structures or yield curves: the rising yield curve, the
declining yield curve, the humped yield curve and the flat yield curve.

25. There are three major theories of interest rates to explain the shapes of the yield curve: the
expectations theory, the liquidity preference theory and the market segmentation theory.

26. A convertible bond is a fixed income security which gives the holder the right to convert the bond into
a predetermined number of shares of the common share of the issuer within a specified time period.

27. Analysis of a convertible bond requires calculation of the investment value, conversion value,
conversion parity price, conversion premium and breakeven time. The minimum price of a
convertible bond is the greater of its conversion value or its investment value.

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Chapter 9:
Unit Trusts, REITs and
Exchange­Traded Funds

Learning Objectives

The candidate should be able to:

 Define a unit trust and describe its features

 Distinguish between unit trusts and investment trusts
 Define the advantages of investing in unit trusts
 Describe the major types of unit trusts
 Discuss the evaluation of unit trusts
 Evaluate the charges and fees in unit trusts
 Explain what is a Real Estate Investment Trust (REIT)
 Explain what are stapled securities
 Explain how the bid and offer prices of unit trusts are determined
 Describe the CPF Investment Scheme
 Compare REITs and Business Trusts, and explain their differences
 Describe Exchange Traded Funds
 Understand the role of exchange traded funds (ETFs) in investments
 Delineate the advantages and risks of investing in ETFs investments

9.1 Introduction

Instead of buying securities that are listed on an exchange and using the services of a broking company, the
investor may also invest in unit trusts managed by investment companies. These are also known as pooled
investments, and include open­end and closed­end unit trusts. In Singapore, most of these are known as
Collective Investment Schemes (CIS), and they are governed by the Code on Collective Investment Schemes
(Code on CIS) which is issued by MAS.

This chapter looks at different types of CIS such as unit trusts such as REITs, stapled securities and other forms
of funds such as business trusts and exchange traded funds.

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9.2 Unit Trusts

9.2.1 Overview of Unit Trusts

A collective investment scheme involves pooling funds from different investors, and putting these under the
management of an independent trustee for the purpose of investing these funds under a fund manager or
several fund managers. In Singapore, the Code on CIS sets out the best practices on the management,
operation and marketing of schemes that trustees and managers are expected to observe. In the US, a CIS is
known as a mutual fund and may not be issued in the form of a trust.

In Singapore, the unit trust is the most common form of CIS. It is set up to pool the financial resources of
small investors to invest the funds in securities under the management of professional fund managers. The
funds – the actual cash and investments – are registered in the name of and held by the trustee, whose job
is to safeguard the investors and ensure that the managers carry out their job within the terms of the trust
deed. This document, which is an agreement between the trustee and the managers, sets out the aims and
objectives of the trust, the charges for management and the basic rules of operation.

A unit trust is based on the principle of dividing a fund into equal portions referred to as units. Each unit
represents exactly the same proportion of the value of the shares held by the trust. For example if a unit
trust's investments are worth $10 million and if there are 5 million units issued, each unit will be worth $2.
Most unit trusts' investments are valued daily, and each day the previous day's valuation prices are published
in the newspapers and serve as the opening dealing prices for that day. The value of a unit trust is its net
asset value, or NAV. The NAV is the value of the unit trust’s assets minus its liabilities.

The managers do not hold the investments; nor do they issue or redeem units. This is done by the trustee,
who holds the trust's cash, shares and other investment assets. The trustee will create new units when there
are new purchases and redeem units when the unit holders liquidate their holdings. Hence the capitalization
of unit trusts is "open", with the number of units outstanding changing on a daily basis. In Singapore, most
unit trusts are “open­ended” and are not listed on the exchange 1 and are offered to retail public investors.
The “open­end” feature describes the availability of fresh units that the fund manager can sell to retail
investors. Closed­end funds do not issue fresh units ­ the number of units is fixed, and these funds are usually
sold to accredited investors via private placements.

Typically, a prospectus will be issued, detailing the investment objectives, focus and approach, its
performance, fee charges, and so on. Unit trusts are more suitable as medium to long­term investments, for
the purpose of generating good dividend income. Foreign funds (not incorporated in Singapore) may also be
offered to the public if these are ‘’recognized funds’’ for retail distribution.

9.2.2 Advantages of Investing in Unit Trusts

There are many benefits from investing in unit trusts:

1. Diversification and divisibility. By pooling investors' money, unit trusts enable shareholders to hold
fractional shares of many different securities. A diversified portfolio of securities can shield the investors
from large losses.

1
All CIS are posted on the MAS website masnet.mas.gov.sg/opera/sdrprosp.nsf. Another useful website for funds in Singapore is
www.fundsingapore.com.

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2. Small capital outlay. The initial investment outlay (e.g. $1,000 to $5,000) is affordable to the individual
investor. For this amount, average investors can invest in portfolios of securities that would otherwise
be out of their reach.
3. Professional management. Most unit trusts have full­time staff of security analysts and portfolio
managers who have experience in managing investments, and will be able to respond quickly to changes
in market conditions.
4. Flexibility. The choice of unit trusts does not need to be restricted to the initial purchase. Some
investment companies allow the unit trust holders to switch between a "family of funds" – i.e. the unit
holder can switch from one fund to another conveniently. Switching between funds provides unit
holders more flexibility as they can respond to changes in their investment plans and market
movements. For example, if the investment plan changes from low to moderate risk, the unit holder
could switch from an income fund to an equity fund.
5. Liquidity. Unit holders can sell their holdings to the trustees, who must buy back the units based on the
unit trust’s NAV less the relevant charges. If the investor held shares in 30 companies, it could be more
time­consuming to sell all of them.
6. Lower transaction costs. By trading large blocks of securities, investment companies can achieve
substantial savings on brokerage fees and commissions.
7. Security. The assets of a unit trust are always legally held on the investors' behalf by an independent
trustee, and not by the fund manager.

9.2.3 Disadvantages of Investing in Unit Trusts

1. Sales charges. Relatively high sales charges are incurred when an investor buys into a unit trust, and
transaction costs can be high if there is frequent buying and selling of unit trusts.
2. Management fees. Unit trusts pay annual management fees to the fund manager regardless the fund’s
performance. Investors should compare the fees among different funds, as high management fees will
affect the fund’s return.

9.2.4 Major Types of Unit Trust Funds

Unit trusts can be classified in terms of the assets they invest in, such as money market funds, equity funds
and bond funds. The following are examples of various types of unit trust funds in Singapore:

Money market funds hold short­term (typically less than one year) fixed­income instruments, such as bank
certificates of deposit, commercial paper, and Treasury bills. Because of the large denominations involved in
dealing directly, these funds provide an avenue for investors seeking competitive money market rates.
Interest income is earned and credited daily. Investors in money market funds normally do not pay a sales
charge or a redemption charge but they do pay a management fee.

Bond funds invest in fixed­income securities. Some specify that only particular types of bonds will be
purchased. There are corporate bond funds, US government bond funds, convertible bond funds, high­yield
bond funds and so on.

Equity funds invest only in equity securities. A few specialized investment companies concentrate on the
securities of firms in a particular industry or sector. For example, there are chemical funds, aerospace funds,
technology funds and gold funds. Others provide a convenient means for holding the securities of firms in a
particular country, such as Korea and Japan funds. The funds may have a regional orientation, such as
European or Asian equity funds, while others may be globally invested.

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Balanced funds invest in both equity and fixed­income securities. The basic objectives of balanced funds are
to generate income as well as long­term capital growth. These funds typically hold relatively constant mixes
of bonds and equities. They have fairly limited price rise potential, but provide a high degree of safety and
moderate to high income potential. Somewhat similar to balanced funds are flexible income funds. These
funds seek to "provide liberal current income". Flexible income funds often alter the proportions of equities
and bonds periodically in attempts to rebalance the fund composition with market expectations.

Index funds are designed to track the performance of a specific market index. The fund is "passively
managed" in a fairly static portfolio and is always fully invested in the securities of the index that it tracks. If
the overall market advances, a good index fund follows the rise and vice versa if the market declines. The
management fees of index funds are significantly lower than those charged by active managers.

Multi­asset funds generally consist of more than 2 asset classes. In addition to the equities and fixed income
securities, multi­asset funds include other assets like private equity and commodities. The premise of multi­
asset funds is that by diversifying into various differing asset classes, the funds will be able to withstand
different investment conditions as each asset class contributes to the returns at different points of the market
cycle. In addition, the fund manager will provide his professional service of making tactical calls.
Consequently, the investor would not need to rebalance his portfolio when market conditions change. Multi­
asset funds are suitable for investors who wish to be well diversified and are willing to rely on a fund manager
to make the investment calls.

Fund of Funds is a unit trust whose objective is to invest all or substantially all of its assets with different fund
managers to be managed on a dedicated basis or to be invested in pooled investments or schemes.

Multi­manager funds invest in two or more external funds managers or other unit trusts. The main selling
point of a multi­manager fund is the availability of a larger set of expertise. For example, a global equity multi­
manager fund may be investing into several regional mutual funds. Each of these regional unit trusts is
managed by a professional who specializes in that specific region.

Multi­manager funds are easily confused with multi­asset funds as multi­asset funds may also engaged
several underlying fund managers to manage the different asset classes. Both use a set of subsidiary fund
managers. It should be noted that more fees are incurred when more sub­fund managers are involved.

Capital guaranteed funds offer investors a capital guarantee and are targeted at risk­averse investors. Most
of these funds have similar structures, allocating most of the capital in low risk assets such as fixed income
securities and money market instruments, which help to preserve the capital at maturity. The remaining
balance is invested in riskier assets such as options linked to equities, funds or indices, or directly into
equities. This portion provides the potential upside in return. The maturity of the funds is determined by the
expiration date of the guaranteed part. Usually, the capital guarantee will apply only if the funds are held to
maturity. It should be noted that capital protected funds are different from capital guaranteed funds.

Hedge funds, unlike traditionally managed funds, employ a wide variety of investment techniques such as
the use of derivatives, short selling and arbitrage to generate returns. They tend to focus on achieving
absolute returns rather than relative performance against a market index. In a market­neutral fund, each
long position is offset by a short position of equal value. This reduces the fund's correlation with the market.
The name 'hedge fund' can be a misnomer noting that hedge funds are not necessarily "hedged". For
example, a hedge fund manager may take directional bets on the markets, that is, they can be net long or
short. Hedge fund managers often invest their own money in their funds and are paid a performance fee.

Other hedge funds such as absolute return funds, quant funds and high frequency trading funds use
different investing styles to make a return. Absolute return funds were popular when markets were volatile
in the mid­to late 2000s. The investment objective of absolute return funds is to consistently have a positive

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return regardless of whether the market is going up or down. Such funds are structured around low
correlation with the market (low beta) and employ synthetic short positions to profit from falling prices.

Quant funds use price and market modeling based on complex mathematical algorithms to seek out investing
and trading opportunities in the market. Quite probably, the best known example is Long­Term Capital
Management, whose board of directors included Myron S. Scholes and Robert C. Merton, who shared the
1997 Nobel Memorial Prize in Economic Sciences for a "new method to determine the value of derivatives".

High frequency trading (HFT) is another strategy used by some hedge funds to beat the market. Some hedge
funds have reported significant profits from using high frequency trading. HFT relies on mathematical
algorithms and high­speed data transmission to seek out profitable investing and trading opportunities in the
market.

A family of funds or umbrella fund is a set of funds with different investment objectives offered under one
unit trust. Umbrella funds generally permit their investors to switch from one fund to another within the
family, at little or no cost. This feature allows the sub­investor to change his investment strategy as the need
arises without incurring high transaction costs.

Some unit trusts may offer regular savings plans (RSPs) whereby a fixed sum of money is invested in the unit
trust at regular intervals. This dollar­cost averaging strategy allows investors to overcome the price volatility
in the unit trust.

Investors in Singapore are allowed to tap on their CPF funds to invest in unit trusts. In May 1998, the
government lifted virtually all investment restrictions on CPF­approved unit trusts. Fund managers of CPF­
approved unit trusts are allowed to invest in equities in most Asian countries and the major developed
countries such as the United States, Japan and Germany. To protect the interests of CPF members, fund
managers who manage CPF cash must report vital information quarterly to the CPF Board. In addition, an
independent investment consultant is appointed to set up a performance evaluation system to monitor the
performance of CPF­approved unit trusts.

9.2.5 Evaluating Unit Trusts

When evaluating whether a particular unit trust is suitable for a prospective investor, several factors need to
be considered.

1. Investment Objectives and Time Horizon

Investors have different investment objectives and time horizons. Depending on their needs, some unit
trusts are more suitable than others. Knowing the investor’s investment objectives is essential to choosing
the right unit trust. Generally, unit trusts are more suited to investors with medium to longer­term
investment horizons. Figure 9.2.5(a) shows the risk continuum of various types of funds, with money market
funds being least risky, and specialized funds being most risky.

Figure 9.2.5(a) – Risk Continuum of Unit Trust Funds

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2. Diversification

A common motivation for investing in a unit trust is to have a diversified portfolio through the various
securities that are in the fund. Depending on the investment objectives, some funds are very narrowly
focused and only invest in a very limited number of stocks. For example, a unit trust whose investment
objective is to achieve growth by investing in China­related large cap companies will have less diversification
than another unit trust which aims to achieve growth by investing in global large­cap companies.

3. Expenses

Expenses can affect the performance of the unit trust in the long run. However, this is not the only factor in
evaluating unit trusts. Funds with a lower expense ratio can constantly underperform its peers, and vice
versa. Expenses incurred through management fees and administrative charges should also be considered.
These costs are not trivial and because they vary from one unit trust to another, they should be taken into
account.

Another expense that should be considered is transaction costs. These costs will depend largely upon the
amount of turnover in the investment portfolio and the liquidity of the securities traded.

4. Performance

Past performance is another factor that has to be considered in selecting a unit trust. While "past
performance is no guarantee of future performance", it is a useful guide for investors. A unit trust is usually
managed relative to a benchmark so that the investor is able to compare the fund’s return against the
benchmark. If the unit trust’s return is higher than the benchmark, the fund manager has done well and vice
versa. However, one cannot look at this in isolation.

For example, the unit trust may have done well because the fund manager has taken excessive risks. Thus,
it is necessary to look at both risks and return using risk­adjusted measures such as the Sharpe and Treynor
performance measures (see Chapter 6). One should look at the unit trust’s long­term performance such as
the 3­year track record, rather than its short­term performance, which tends to be volatile. The review
should include the fund’s performance in both rising, falling and ambivalent markets.

Likewise for a unit trust invested in bonds (bond fund), it is useful to compare the performance of the bond
against its benchmark for periods when interest rates are rising as well as declining. Bond funds are typically
benchmarked against their durations. The duration of a bond fund is approximately the average cash flow
weighted life (maturity) of the portfolio. Generally, high duration bond funds have higher price risk sensitivity
than low duration bond funds. However it also depends on interest rate expectations ­ low duration bond
funds perform better in a rising interest rates regime, while high duration bond funds perform better in a
falling interest rates regime.

“Past performance is not indicative of future performance” ­ this sentence is usually disclosed in most of the
marketing materials for unit trusts, as it is a regulatory requirement. This is especially true if the performance
of a unit trust is heavily dependent on a star fund manager and if the fund manager decides to leave the
company, the performance of the unit trust could be affected.

A good practice would be to look at the fact sheet for the unit trust. The fund managers distributing these
will update the fact sheets for every unit trust they manage, giving potential investors a good idea of the
fund’s objective, composition and performance. An example of a fact sheet is shown in Figure 9.5.2.4 below.
A prospective investor should look at the NAV, the funds size, asset allocation, fees and compare these with
other offerings. The top holdings, country exposure and industry exposure are also very useful information
that the investor should use to compare with other funds.

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Figure 9.2.5.4 – Example of a Fact Sheet

5. Fund Size and Capacity

A small fund size can affect the performance of the unit trust as the fixed expenses in running the fund can
offset its performance. For example, a SGD 10,000 legal expense that is billed to a SGD 8 million fund is
insignificant (0.00125%). However, when billed to a SGD 1 million fund, the impact is greater, as it is 0.01%
of the fund. Such expenses will in turn contribute to the total expense ratio of the fund.

On the other hand, unit trusts that have grown very big may run into capacity issues. For example, a unit
trust with funds of SGD 10 billion, will be huge relative to the market. With such a large size, the fund
manager will not be as nimble as smaller players and may face difficulty in adding value. Thus, when a unit
trust reaches its optimal capacity, it will typically stop accepting any fresh subscriptions.

9.2.6 Fees and Charges

Unit trusts can be subdivided into no­load funds and load funds. A no­load fund does not impose an initial
sales charge on the fund, i.e. the units are priced at NAV. The bid and offer prices are the same. A load fund
is sold to investors at NAV plus a sales commission (i.e. the load). Most load funds are sold by brokers,
financial planners, and employees of insurance companies. The load serves as a commission for the services
of these people in distributing the unit trusts. The front load is usually 1.5 to 5% of the NAV. In addition to
selling charges, all unit trusts charge annual management fees to compensate professional managers. This
fee typically ranges from 0.5 to 2.0% of the NAV and it is accrued daily and debited directly from the unit
trust.

When unit holders want to sell their shares, they usually receive an amount equal to the NAV of the unit trust
multiplied by the number of shares sold. However, some funds impose a realization charge or redemption
fee. This is also referred to as the back­end load. This fee may be waived if the investor has owned the units
for more than a stipulated period (e.g. for 60 days). Its basic purpose is to discourage investors from selling
their units right after buying them. By discouraging such in­and­out trading, the unit trust avoids the
transaction costs associated with having to sell securities frequently in order to satisfy some investors' desires
to sell their units rapidly.

Under an umbrella fund structure, a switching fee of about 1% may be imposed when the unit holder
switches from one sub­fund to another. Constant switching of funds can thus be an expensive affair for unit
holders. Other charges include annual trustee, custodian and audit fees. These are operating costs and are

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deducted from the assets of the unit trust. These charges can be accrued daily, monthly, or as and when they
occur. Trustee fees are usually between 0.1 to 0.15%.

There are costs involved in setting up a unit trust that would include legal, trustee and marketing costs.
These costs can be a one­time charge to the unit trust or be amortized over a number of years.

In addition, investment companies may charge a distribution fee annually. It pays for advertising, promoting,
and selling the unit trust to prospective purchasers. Sometimes it is coupled with a load charge that is paid
when units are initially purchased.

9.2.7 Bid / Offer Prices and NAV

The principle of the unit trust is that the incoming unit holder buying new units should pay a sum sufficient
to purchase an amount of the underlying securities in the trust in proportion to his holding, including the
expenses necessary for that purchase. To achieve equity between incoming and outgoing unit holders, unit
trust valuations show two prices, an offer price and bid price. The offer price is the price at which managers
offer to sell units and the bid price is the price at which they will repurchase units from existing unit holders.

The offer price is the price at which the investor will buy the unit trust. It represents the cost of creating new
units exactly equal in value to existing units on the basis of market prices at the latest valuation. The steps
involved in calculating the offer price are:
i. Determine the market value of the unit trust’s securities at the exchange­listed offer prices. This is the
NAV per unit.
ii. Add expenses related to purchase of securities such as stockbrokers' commission and clearing fees.
iii. Add cash held by trust, and accrued income.
iv. Add manager's initial charge.

Conversely the bid price is the price at which the investor would sell the unit trust. It is equivalent to the NAV
of each unit in the event that the securities were all sold and the proceeds distributed in cash to unit holders.
The steps involved in calculating the bid price are:
i. Determine the market value of the unit trust’s securities at the exchange­listed bid prices. This is the NAV
per unit.
ii. Deduct expenses related to sale of securities.
iii. Add cash held by trust, and accrued income.

9.2.8 CPF Investment Schemes and Risk Classification System

The CPF Board has classified the approved unit trusts under different categories of risk. The Risk Classification
System splits the investment risk associated with a unit trust into two axes: equity risk and focus risk.

Equity risk is related to the proportion of the "riskier' types of investments in the unit trust. The greater the
proportion of assets invested in stocks, the higher the equity risk. Conversely, the greater the proportion of
investments in bonds and cash, the lower the equity risk. There are four categories of equity risk:
 Higher risk – equity funds
 Medium to high risk – balanced funds
 Low to medium risk – bond funds
 Lower risk – cash funds

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Focus risk reflects how focused the investments of the unit trust are in one particular geographical region,
country, industry or individual company outside of Singapore. There are two categories of focus risk: broadly
diversified or narrowly focused:
i. A broadly diversified unit trust will tend to have investments that are spread across relatively more
geographical regions, countries, industries and individual companies.
ii. A narrowly diversified unit trust will tend to have investments that may be focused in particular
geographical regions, countries, industries or individual corporations.

In general, a unit trust will have a higher level of focus risk because it is relatively less diversified. For example,
a unit trust that invests in shares of companies from around the world would have lower focus risk (i.e. more
broadly diversified) than a unit trust that invests in shares of Japanese corporations only. The Japan­only unit
trust would have higher focus risk because it is less diversified (invests in one foreign country only).

Currently, there are a substantial number of CPF­approved unit trusts which fall into the higher equity risk­
narrowly focused risk category. These unit trusts have been divided further within this risk category:
 Regional – Unit trusts that have a regional exposure e.g. North America, Europe, Asia or Emerging
Markets;
 Sector – Unit trusts with specific industry exposure e.g. healthcare, technology and biotechnology; and
 Country – The unit trusts are country specific e.g. Japan, China.

These broad sub­groups have been provided to make it easier for CPF members to perform comparisons
across unit trusts that are roughly similar in terms of geographic focus.

9.3 Real Estate Investment Trusts (REITs)

9.3.1 Overview of REITs

A REIT is collective investment scheme (CIS) for real estate, where the funds of individual investors are pooled
together to invest in real estate assets. In Singapore, REITs are governed by requirements set out in the
Property Funds Appendix in the Code on CIS. So a REIT is in fact a unit trust that is predominantly invested
in real estate and real estate related assets, hence its name “Real Estate Investment Trust”. A simple way to
understand a REIT is to see it as a passive investment vehicle that engages in real estate investments for the
collection of rent.

In many respects, a REIT is similar to any other unit trust, providing the benefits of diversification, professional
management, affordability and liquidity. Yet, a REIT can be different from a typical unit trust as it requires a
wider range of specialists to manage it. Unlike equities and bonds, where market values can be readily
obtained from the stock exchanges or bond dealers, market values of properties are not readily available.
Regular valuations have to be conducted to determine the NAV of the REIT or is a property being sold.

There are many different types of REITs. It can be sector­specific, e.g. REITs that invest in retail malls.
Alternatively, it consists of investments in different property sectors such as healthcare, hospitality,
industrial, offices and retail. REITs are long­term investments, which are subject to the fluctuations of the
property cycle.

In Singapore, REITs are listed on the SGX Mainboard. An unlisted property trust would be constituted in
exactly the same way as listed REITs. The difference would be that listed REITs are publicly traded, while

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property trusts are not. Unit trusts are typically invested in listed stocks, while REITs are invested in physical
real estate and related assets. Also, unit trusts that are not REITs are typically not listed.

9.3.2 Risks of Investing in REITs

The risks associated with investing in REITs vary and depend on the characteristics and features of each REIT,
which includes the geographical location of the properties. Investors should consider not only the expected
yield, but also the concentration, quality and lease tenor of the underlying properties.

Some of the risks associated with investing in REITs include:

1. Market Risk. REITs are listed and traded on a stock exchange, like stocks and other securities such as
exchange traded funds. The price is dependent on the supply and demand for each REIT, exposing the
investor to market risk, just as in any other share traded on the exchange. REIT prices reflect the outlook
for the specific sectors (e.g. healthcare, hospitality, industrial, offices, retail etc.), the state of the
property market, the economic outlook, management of the REIT, interest rates, and other factors.
Investors must be able to bear this price volatility.

2. Income Risk. REITs are attractive because they are required by law to distribute at least 90% of their
income each year2. However, a REIT may not be able to pay any dividend if it incurs an operating loss.
This loss might come from the expiration of leases, lower occupancies, falling rentals, or even contractual
failure of the tenants. The investor should evaluate if the REIT has taken any measure to mitigate these
risks, such as lease tenor, quality of tenants and types of tenants.

3. Concentration Risk. As a unit trust, REITs afford some extent of risk diversification and may be vulnerable
to concentration risk if a substantial portion of the income is derived from only a few property assets,
or assets within the same industry e.g. hospitality. If the REIT depends on a small number of tenants for
its rental income, it is also exposed to concentration risk. 



4. Liquidity Risk. Although REITs themselves can be bought or sold on the exchange, the underlying
properties of the REITs may not be easily liquidated because the market for physical real estate is private,
with buyers and sellers dealing bilaterally with each other instead of through an exchange. This exposes
REITs to liquidity risk as they cannot dispose or alter the composition of the investments quickly in a
falling property market.

5. Leverage Risk. If a REIT uses debt to finance the acquisition of underlying properties, there is leverage
risk. It also means there is less income for distribution because the debt has to be serviced. In Singapore,
REITs are limited to 35% debt limit, this may be increased to 60% if a rating is obtained.

6. Refinancing Risk. As REITs are required to distribute at least 90% of their income annually to unit
holders, it is not easy for them to build up cash reserves for debt repayment and or capital expenditures.
REITs usually have to resort to fresh borrowings, or raise funds in the capital markets through medium
term notes or rights issue. If the REIT is unable to make these arrangements, it may be forced to liquidate
some of its investments, which may result in a reduction in lease income.

2 Note that unlisted property trusts are not the same as REITs. Property trusts are not required by law to distribute any income.
(http://www.moneysense.gov.sg/understanding­financial­products/investments/types­of­investments/real­estate­investment­
trusts.aspx) states that distribution of income under property trusts are subject to the decision of the Board of Directors.

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9.4 Business Trusts

9.4.1 Overview of Business Trusts

Business trusts (BTs) are governed by the Business Trusts Act. Like any other trust entities, such as unit trusts,
BTs have no separate legal entity and are created by a trust deed. BTs are hybrid structures with
characteristics of both companies and trusts. BTs have become a popular form of listing on SGX, with
participation from retail operations in Japan, port infrastructures and pay television.

In Singapore, BTs are a single responsibility entity organization, and the trustee­manager is vested with the
roles of both trustee and manager of the trust assets. The trustee­manager has legal ownership of the BT’s
assets, and is responsible for looking after the unit holders’ interests and managing the business of the BT.
Investors subscribe for units in the BT and are paid dividends from the BT’s income.

9.4.2 Advantages of Business Trusts

Business trusts are an alternative form of business entity with the following advantages:
i. Limited liability of unit holders;
ii. Dividends can be paid out of operating cash flow instead of accounting profits; and
iii. Investment restrictions applicable to CIS do not apply to BTs.

A main attraction of BTs is their effectiveness in releasing value from fixed assets that are generating cash
flow income. Typically, companies such as infrastructure providers or asset­backed businesses such as ship­
owning companies or toll road operators, which have depreciating assets that reduce accounting profits
despite high positive cash flow income, will be attracted to a BT structure, because dividends can be paid out
of operating cash flow. The other attraction, especially in comparison to unit REITs, is that BTs can engage
actively in business operations whereas REITs are required by law to invest in real estate for rental income.

9.4.3 Risks in Business Trusts

BTs are subject to the same set of risks as unit trusts and REITs i.e. market risk, liquidity risk, income risk,
concentration risk and refinancing risk. In the case of BT refinancing risk, the investor should remember that
while there is no cap on its debt limit, this could become a problem if the BT takes this as an opportunity for
indiscriminate borrowing, which would create an unsustainable debt structure for the trust.

Given the wide range of businesses that are allowed to use this route for fund raising, investors should
analyse the contractual details of the BT’s assets to determine the consistency and stability of its income
sources. For example, existing port infrastructure providers on traditional shipping routes are potentially at
risk as global warming maps out new shipping routes that are more efficient and economical, creating fresh
demand for new port locations.

9.4.4 Comparison between Listed REITs and Business Trusts

The following table lists the differences between listed REITs and business trusts.

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Table 9.4.4: Comparison between listed REITs and Business Trusts

Listed REIT Listed Business Trust

Entity Constituted by a trust deed Constituted by a trust deed

Ownership Unit holders do not have individual legal Unit holders do not have individual legal
ownership of the assets but have ownership of the assets but have
beneficial interests beneficial interests

Independence of Trustee and Manager are separate and Single responsible entity is the Trustee­
Trustee and independent Manager, who is the manager of the trust
Manager assets

Trust objective Passive investments Allowed to be actively engage in business

operations

Dividend Mandatory distribution of minimum of No mandatory minium. Can distribute

distribution 90% of annual income dividends from operating cash flow

Gearing 35% limit. If rated, 60% limit No limit

Restrictions on Minimum 90% to be generated by None

investments rental income

Regulations Securities & Futures Act, Code on CIS Business Trusts Act

Taxation Tax exempt for individual unit holders Single­tier taxation

9.5 Stapled Securities

A stapled security is created when an issuer lists two or more securities that are bound together to be traded
as one instrument on the exchange. The stapled security would share the same investor. For example, a
number of Singapore REITs invested in the hospitality sector are stapled to a business trust (see Section 9.4)
together for a listing. Stapled securities are popular with issuers because they combine a passive income
security with an active income security, which enhances the attractiveness of the issue as a whole. From the
investor’s perspective, stapled securities provide some diversification for business risks.

In a stapled security, the issuer is bound by the regulation specific to each of the security being stapled.
Therefore, if a REIT and a business trust are stapled together, the issuer has to pay the minimum 90% of
annual income to unit holders on the REIT, but is free from paying dividends on the business trust. Such
stapled securities cannot be marketed as REITs.

9.6 UCITS

UCITS is the acronym for Undertakings for Collective Investment in Transferable Securities and is a European
Union directive, applicable in the UK since 2002. The original UCITS objectives were to remove the barriers

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to cross­border distribution and marketing of funds, by allowing funds to invest in a wider range of financial
instruments. It provides the “passport” for funds to be sold internationally.

The attraction of UCITS to retail investors globally lie in the common standards of disclosure and the
consistent level of investment guidelines for the funds. A further attraction is that under UCITS III, funds can
invest in a wide range of assets, beyond the usual equities and bonds. For example UCITS III allows the use
of derivatives and index tracking products to limit risks or increase returns.

Since 2006, MAS has allowed UCITS to be distributed and sold in Singapore, if these meet the local regulatory
conditions. According to a report by PWC, the number of UCITS funds registered for sale in Asia is increasing
quickly. As at December 2011, 5,614 UCITS funds were registered for sale, up from 5,434 in December 2010.
Singapore accounted for approximately 2,125 of these funds, and Hong Kong for a further 1,240. At the end
of 2012, Singapore had 2,409 UCITS registered. 3 Asian countries under the leadership of APEC (Asian­Pacific
Economic Co­operation), are trying to structure their own version of a collective investment security, to
function as a regional funds passport.

9.7 Exchange­Traded Funds

Exchange­traded funds (ETFs) are open­ended investment funds, which are designed to track the
performance of specific indices or fixed baskets of stocks or debt securities. The underlying stocks may
comprise local or international securities. In addition to stocks, the ETF may also be based on other asset
classes such as commodities, money market, currency or fixed income. Through ETFs, investors have access
to a wide range of asset classes, markets and sectors.

In Singapore, ETFs are listed and traded on the stock exchange. They are also traded on various stock
exchanges including the United States, United Kingdom, Germany and Hong Kong. Some of the more popular
ETFs include the S&P 500 SPDRs (pronounced as "Spiders") that tracks the S&P 500 Index and DJIA DIAMONDS
that tracks the Dow Jones Industrial Average.

SPDR Straits Times Index ETF

The SPDR STI ETF is Singapore’s first locally created exchange traded fund, designed to track the
performance of the Straits Times Index (STI). Originally listed as street TRACKS STI, it was listed and traded
on SGX­ST since April 2002. The ETF’s investment objective is to replicate as closely as possible, before
expenses, the performance of the Straits Times Index.

Table 9.7: Features of the SPDR STI ETF

Trading name STI ETF 100

About 1/100th of STI level. For example, if the STI is at 1,700, each unit of STI ETF
Pricing
100 will be priced at $17.00.

Minimum bid size $0.01

Board lot size 100 units

3
PWC Report – “Distributing funds in Asia’s growth market” (http://www.pwc.com/gx/en/asset­management/asset­management­
insights/distributing­funds­asia­growth­market.jhtml)

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Dividend yield is expected to approximate the yield on the STI. Investors can
Dividend yield
expect to receive dividends twice a year.

Annual costs 0.3% (includes management fee, trustee fee and other fund expenses)

An ETF is like a mutual fund that tracks the performance of the STI. Listed on the Singapore Exchange (SGX),
units in the ETFs can be bought and sold by investors during trading hours like any stock listed on the
Exchange. This is unlike mutual funds, which can only be bought or sold at the end of the day with the mutual
fund manager. They are passive investment instruments seeking to replicate the price movement of a
benchmark index made up by a basket of securities. If the replication is good, the price movement of the
ETF should basically follow the benchmark.

The NAV reflects the value of the ETF unit owned by the investor. The ETF NAV is determined at the daily
close of trading of all market(s) that the ETF is invested in, with the process typically explained in the Trust
Deed of the Prospectus. The NAV per unit represents fair value or the basis for the ETF market price. The ETF
market price can deviate from NAV per unit, as price will be determined by investor sentiment, affecting
supply and demand for the units. The STI ETF will invest in the component stocks of the STI in proportion to
their respective weights in the index.

ETFs have been designed to minimize commissions and expense ratios compared to an average mutual fund.
Annual fees are lower because ETF are passively managed funds. The main cost from an ETF arises from total
expense ratio and brokerage commissions when buying or selling an ETF. Investors can buy and sell the STI
ETF, which is listed on the SGX and will pay normal brokerage commissions for the transactions. It is also
possible to buy ETFs from primary or participating dealers, who effectively purchase the ETF shares from the
ETF sponsor, and then offers these to the market.

Unlike a typical unit trust that creates units for each investor when he purchases units, units of STI ETF will
only be created or redeemed in sizes of 100,000 units by participation dealers. To create an ETF share, the
participating dealer has to deposit a specified portfolio of stocks that closely approximates the underlying
securities of the index to the trustee of the ETF. To redeem, ETF shares are delivered to the trustee of the
ETF in exchange for the underlying basket of securities.

ETFs on the exchange are quoted for bid and ask prices. These prices do not necessarily reflect the fund’s
NAV. Although the ETF price tracks the fund’s NAV, it is not necessarily the same. If the exchange listed price
deviates from the NAV, arbitraging will reduce the differential between the price and the NAV. For example,
when the traded price of an ETF is higher than its NAV, an arbitrageur will sell the ETF shares and buy the
underlying portfolio of securities. If the traded price of the ETF falls below the NAV, the arbitrageur will sell
the underlying portfolio of securities and buy ETF shares.

9.7.1 Types of ETF Structures

Cash­replication vs. Synthetic Replication ­ ETFs are either physically or synthetically replicated to structure
the basket of stocks or bonds that make up the index that is being traded by the ETF. Physically replicated
ETFs comprise cash holdings of the actual securities in the proportions that comprise the index. Synthetically
replicated ETFs comprise statistically correlated holdings of securities, which together mimic the price
behavior of the index. Synthetically replicated ETF may use swaps or derivatives to create the index.

1. Cash or Direct Replication

Direct or cash replication is more common in ETFs. There are two ways of doing this:

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i. Full replication, where the ETF purchases all the listed stocks in the exact proportions comprising the
index; or
ii. Representative sampling, where the ETF invests in a subset of the index, comprising the more dominant
stocks in the index. This method is used when the stocks comprising the index are not liquid.

2. Synthetic Replication

Synthetic replication uses swaps and derivatives to mimic the index. One advantage of this replication
method is the reduction of the tracking error between the index and the basket of underlying assets. A
disadvantage is the counterparty risk in which the counterparty to the contract might default on its
obligations.

An example of synthetic replication is an ETF that uses a total returns swap, instead of creating the synthetic
basket of securities. A total return swap is contractual arrangement to swap or exchange interest or return
obligations, Swap­based ETFs usually do not pay dividends. Instead, they enter into total return swaps where
the counterparty to the ETF will deliver periodic payments of income and capital gains return on the basket
of stocks that make up the reference index. The swap­based ETF would pay a fee to the counterparty that is
contractually obligated to deliver the returns of the reference index to the ETF.

9.7.2 Investment Strategies with ETFs

ETFs may be used with the following strategies:

i. As a long­term buy­and­hold strategy;
ii. For short­term tactical trading because of price transparency of ETFs and their liquidity;
iii. With core­satellite allocations, where the fund is made up of a core of board­based index, and an outer
satellite of more risky stock pickings with higher risks and return;
iv. Hedging against other risks in the investment portfolio; and
v. Converting cash to equities through investing in ETFs, to minimize the cash drag 4 on the portfolio. This
is known as “cash equitization”.

9.7.3 Securities Borrowing and Lending for ETFs

Securities lending is a practice where ETFs pay agents to lend out shares in their portfolios to other investors,
and the ETFs will earn interest for lending the stocks. The ETF will transfer the stocks to another investor over
the lending period (e.g. 30 days) in exchange for collateral, such as cash or other securities, which is
equivalent of e.g. 105% of the shares’ value. The ETF will do a reverse transaction with the borrower if it
needs to sell the stock, i.e. it can borrow the stocks that have been lent. Alternatively, the ETF can make use
of the collateral.

Usually, the stock borrowers are investors who have sold the stock short and need to borrow the stock for
delivery, in anticipation of a price fall in the stock, at which time the investor will buy back the stocks at a
lower price and return these to the ETF provider.

Securities borrowing and lending creates counterparty risks for the ETF. If the borrower is unable to fulfill its
obligations under the securities lending arrangements, the ETF will face a loss equal to the value of the stocks
that were lent.

4
The underperforming of a portfolio from holding too much idle cash that has not been invested

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9.7.4 Advantages of Investing in ETFs

The following are some of the advantages of investing in ETFs:

1. Diversification. Buying ETF shares allows investors to gain exposure to a diversified portfolio of
securities;
2. Small capital outlay. Diversification can be achieved with a small capital outlay;
3. Low costs. The annual management fees for ETFs are normally less than 1% as against 1% to 2% charged
for actively managed unit trusts. In addition, there are no initial charges or redemption fees when
trading ETFs;
4. Liquidity. ETF shares are traded any time during the trading hours on an exchange. Unit trusts, on the
other hand, can only be transacted at their daily closing NAVs; and
5. Transparency. Investors know the basket of securities, which are represented in the ETF while
traditional unit trusts usually provide information of their portfolio holdings only on a quarterly,
semiannual or annual basis.

9.7.5 Risks of Investing in ETFs

The risks in cash­replicated and synthetically replicated ETF are different in the following respects:
1. Tracking error is greater in cash­replicated ETFs than in synthetically replicated ones, principally because
synthetically replicated ETFs can get more precise tracking using swaps and derivatives; and
2. Synthetically replicated have counterparty risks from the swap and derivative arrangements they enter
into.

Other risks are:

3. Market and Sector risks. When the prices of the underlying securities fall, the value of ETFs will suffer.
Sector related funds may be negatively impacted by the performance of specific sectors which they are
tracking. Also, the volatility of the underlying stocks or assets may not be reflected in the volatility of
the ETF price i.e. high tracking error.
4. Foreign exchange risk. Investments in ETFs that have constituent securities that are traded in foreign
currencies, are subject to foreign exchange risk; and
5. Taxation. Non­US investors holding US­established ETFs may be subject to US withholding tax on
dividends and other distributions.
6. Liquidity. Market makers are designated by ETF Fund managers to provide continuous bid/ask quotes.

In the ETF market, low trading volume is not necessarily indicative of low liquidity. ETFs behave like open­
end funds, and the number of shares can expand or contract based on investor demand.

9.8 Summary

1. A unit trust is a collective investment vehicle set up to pool the financial resources of small investors and
invest the funds in assets to be managed by professional fund managers. There are various types of unit
trusts, e.g. money market funds, bond funds, specialized hedge funds.

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2. Investors of unit trusts transact directly with the investment company, which will redeem its own units
at or near its NAV. The capitalization is "open" with the number of outstanding units changing as and
when unit holders purchase or redeem their units.

3. The NAV is the value of the unit trust’s assets, less its liabilities.

4. There are many advantages associated with investment in unit trusts which include the benefits of
diversification, affordability, professional management, flexibility to switch from one sub­fund to
another, liquidity, lower transaction costs and security.

5. A load fund is sold to investors at NAV plus a sales charge, while no­load funds do not incorporate a sales
charge. Besides the sales commission, there are other fees and charges such as management fees,
redemption fees, trustee and audit fees.

6. There is a wide variety of unit trusts available ranging from those that are dedicated to one asset to
others which are hybrids comprising different asset classes. Unit trusts with "umbrella" structure
provide investors with the flexibility to switch from one sub­fund to another, while index funds are
"passively managed" to track the performance of a particular index such as a stock index. Other unit
trusts may incorporate features such as regular savings plan or insurance coverage.

7. A REIT is an investment vehicle where the funds of individual investors are pooled together to invest in
real estate assets to earn rental income.

8. A stapled security is created when an issuer lists two or more securities that are bound together to be
traded as one instrument on the exchange. For example, a REIT and a business trust can be combined
to form a stapled security that is traded on the stock exchange. The stapled security will comprise an
equal share of the REIT and the business trust.

9. A business trust is a fund that has a hybrid structure that has the characteristics of a company and a
trust. It has a single responsibility management structure in the Trustee­Manager.

10. The attraction of UCITS to retail investors globally lie in the common standards of disclosure and the
consistent level of investment guidelines for the funds.

11. The CPFIS Risk Classification System splits the investment risk associated with a unit trust into two
components: equity risk and focus risk. Equity risk refers to the proportion of assets invested in shares
while focus risk reflects how diversified the investments are across geographical regions, countries,
industries or securities.

12. In selecting a unit trust, the unit holder has to determine whether the investment objectives of the unit
trust are congruent with his personal investment objectives; the amount of load charges and other fees
imposed by the investment company; and the performance record of the unit trust.

13. Securities lending is a practice where ETFs pay agents to lend out shares in their portfolios to other
investors. The ETFs will earn interest for lending the stocks.

14. Exchange traded funds (ETFs) are open­end investment funds listed on an exchange and are designed
to track the performance of specific indices or baskets of underlying assets, in various asset classes. Cash
replicated ETFs comprise cash holdings or representative samplings of the actual securities in the
proportions that comprise the index. Synthetically replicated ETFs comprise statistically correlated
holdings of securities, using swaps and derivatives to mimic the price behavior of the index. The
advantages of investing in ETFs include the ability to diversify with a small capital outlay, low transaction
costs, liquidity and transparency regarding the underlying securities represented in the portfolio.

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Chapter 10: ���

Warrants�
Learning Objectives

The candidate should be able to:

Describe the features of stock warrants

Explain the valuation of warrants, using intrinsic value, conversion price and warrant premium

Describe the gearing ratio in the context of warrant pricing

Understand the determinants of the minimum and maximum values of warrants

Illustrate how the warrant premium is influenced by the life of the warrant, price volatility of the
underlying stock, dividend on the underlying stock, leverage, interest rates and size of the warrant
issue

10.1 Definition and Terminology

A warrant is an equity call option that can be exercised to buy into the shares of the issuing company, at
a given strike price and for a given amount. These are also known as “company warrants” on the SGX.
Warrants are traded on the SGX and may be considered as long-dated equity call options. While call
options expire within a few months, warrants typically have maturities of a few years.

Warrants are generally issued by corporations as a 'sweetener' attached to an offering of bonds or rights
issues. This allows the issuer to finance itself at a lower interest rate and hence reduce its financing cost.
The warrants can be detached from the host security and then traded separately. When the warrants are
exercised, new shares will be issued, increasing the number of shares outstanding and resulting in a
dilution of the issuer's earnings among its shareholders. This is different from straight equity options,
which do not cause earnings in dilution, because no new shares are issued when these are exercised.

In recent years, there has been a proliferation of structured warrants1 (in Singapore, these are also
referred to as “covered warrants”). Unlike company warrants, which are issued by the corporation of the
underlying security, structured warrants are issued by a third-party such as a bank e.g. Development Bank
of Singapore and Deutsche Bank. Structured warrants are different from company warrants because:

�������������������������������������������������
1 In Singapore, structured warrants are also referred to as “covered warrants”. This actually departs from established option
terminology in which a covered option is one that is written because the option writer already owns the underlying asset. The
use of the word “covered” refers to the fact that the option writer’s risk is already covered because he already owns the stock.
In the context of Singapore, we shall however use the word “covered warrants” with the same meaning as “structured warrants”.

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1.� Structured warrants can be either “call” or “put” warrants, whereas company warrants are only call
warrants since a company cannot sell put options as this would mean the company would potentially
be buying back its own stocks from writing options
2.� Structured warrants have shorter durations, usually not more than six months
3.� Unlike company warrants, the exercise of structured warrants will not result in dilution of earnings
in the company as no new shares will be issued. Structured warrants are cash-settled on maturity
i.e. without the delivery of the underlying shares. The settlement of structured warrants takes place
according to the calculations below:
For Call Warrants: (Settlement Price of Underlying at Expiry – Exercise Price of Warrant) ÷
Conversion Ratio of Warrant
For Put Warrants: (Exercise Price of Warrant – Settlement Price of Underlying at Expiry) ÷
Conversion Ratio of Warrant

Some of the important features of warrants are as follows:

a.� Underlying security. This refers to the security that can be purchased upon conversion of the warrant.
b.� Exercise price. This is the price at which the warrant holder can buy the underlying security. Typically,
when warrants are issued, the exercise price or strike price is set above the prevailing share price.
c.� Conversion ratio. The conversion ratio states the number of warrants required for the conversion of
one share.
d.� Expiration date. The last date that a warrant can be exercised.

Unless the warrants are converted into the underlying shares, their holders do not receive dividend
income.
Figure 10.1– Company (Covered) Warrant Term Sheet

ACMA�LTD�W160707

Last�Date/�Time�to�submit�Subscription�Notice 7/7/16�17:00
Listing�Date 12-Jul-13
Expiry�Date 7-Jul-16
Outstanding�Balance 1,395,526,880
Price ($) as at 2014-20-06 0.004
High�for�the�year�($) 0.013
Low�for�the�year�($) 0.004
High�for�the�month�($) 0.009
Low�for�the�month�($) 0.004
Exercise�Price SGD�0.03500�
Underlying�Stock ACMA�LTD.
Underlying�Stock�Price�($)�as�at�2014-06-20� 0.024
Conversion�Ratio 1�warrant(s)�:�1��share(s)
Cash�($) 0
Premium/(Discount)�(%)�(Cash) 62.5
Premium/(Discount)�(%)�(Bonds)
Gearing�(x) 6
Source: www.sgx.com

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10.2 Warrant Valuation

Let us consider the warrants of Polaris Securities as an example. The Polaris warrants are trading at $1.20
while its share price is $1.80. One warrant can be converted into one Polaris share at an exercise price of
$1.00. The following sections illustrate the calculations of intrinsic value, conversion price, warrant
premium and gearing ratio based on Polaris warrants.

10.2.1 Intrinsic Value

The intrinsic value of a warrant is the difference between the current share price and the exercise price.
(SP - EP)
Intrinsic Value =
n
= ($1.80 - $1.00) ÷ 1
= $0.80

where:
SP = share price
EP = exercise price
n = conversion ratio

10.2.2 Conversion Price

This is the total price that the investor has to pay for converting the warrants into the underlying security.
Conversion price = nWP + EP
= $1.20 + $1
= $2.20

where WP = warrant price

10.2.3 Warrant Price and Warrant Premium

The difference between the warrant price and the intrinsic value is the warrant premium (in the context
of conventional options, this is time value). It is the magnitude by which the warrant price is higher than
its intrinsic value. The term “premium” in warrant premium is not the same as the term used in
conventional options, in which the premium is in fact the option price. Here, warrant premium refers
only to the time value of the warrant.
Warrant premium ($) = nWP + EP – SP
= $1.20 + $1.00 - $1.80
= $0.40

The above computation gives the warrant premium in dollar terms. To calculate the warrant premium in
percentage, the formula is:
nWP + EP - SP × 100
Warrant Premium % =
SP
1.20 + 1.00 - 1.80 × 100
= 22.2%
1.80

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Investors are interested in warrants mainly because of the leverage opportunity. Leverage offers the
potential for greater percentage gains (and losses) than the underlying share for a given change in the
price in the underlying share.

Assume, for example, the share price of Polaris increased by 100% to $3.60. The intrinsic value of the
warrant would be $3.60 - $1.00 = $2.60. This would represent a gain of $1.40 per warrant or 117%. Most
probably, the warrant would sell for more than $1.40.

10.2.4 Gearing Ratio

The gearing ratio compares the price of a warrant relative to the share price. Gearing gives investors the
ability to participate in the performance of the underlying share at a lower price.
Gearing ratio = SP / nWP
= 1.80 / 1.20 = 1.5x

10.2.5 Minimum Value and Maximum Value

Warrants trade between a minimum value and a maximum value.

The maximum value of a warrant is the underlying share price. Most warrant prices never trade at their
maximum value because warrants expire – the warrant premium falls as the warrants approach
expiration.

The minimum value of a warrant is the difference between the price of the underlying share and the
exercise price.
Minimum value = SP – EP
= intrinsic value if SP > EP
=0 if SP ≤ EP

In the Polaris example, when the share price of Polaris is $1.80, the minimum value of Polaris warrant is
$0.80, which is the intrinsic value of the warrant. When the share price is greater than the exercise price,
the warrant is said to be in-the-money. If the share price of Polaris drops to $0.50, the minimum value of
the warrant is zero, since things do not sell for negative prices. In this case, the exercise price is greater
than the share price and the warrant is said to be out-of-the-money. When the exercise price is equal to
the share price, the warrant is trading at-the-money.

Can the warrant price fall below the intrinsic value? When the share price of Polaris is $1.80, consider
what will happen if the warrant trades below the intrinsic value of $0.80, say at $0.60. At $0.60,
arbitrageurs could realize immediate trading profits by buying the warrants and exercising them at the
exercise price of $1, thus earning a riskless profit of $0.20 or 11%.

Figure 10.2.5 illustrates the relationship between the warrant price and the underlying share price.

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Figure 10.2.5 – Relationship between Warrant Price and Share Price

When the share price is less than the exercise price, the minimum value of the warrant is zero as
represented by the horizontal line. As the share price rises above the exercise price, the minimum price
becomes positive and rises. Notice that as the price of the underlying share continues to increase, the size
of the premium decreases. This is because as the share price rises, the leverage potential of the warrant
declines, with each given rise being a smaller percentage of the share price as it rises. Also, note that the
line representing the maximum price for the warrant is drawn at a 45-degree angle, meaning that the
maximum price of the warrant is equal to the share price.

10.3 Factors Affecting the Price of a Structured Warrant

The price of a structured warrant is the speculative value which investors are willing to pay for the
warrant. It depends on a number of factors:
i.� Life of the warrant. Other things being equal, the longer the time before the warrants expire, the
greater the warrant price. A warrant that is out-of-the-money may become attractive later as the
share price appreciates. As the life of the warrant gets shorter, it will lose its speculative value. On the
day before the warrants expire, they are worth their intrinsic value. On the day after the warrants
expire, they are worthless.
ii.� Underlying share price. Warrants are affected by the price of the underlying shares. Call warrants
are worth more if the price of the underlying shares rises, and conversely, put warrants are worth
more if the price of the underlying shares falls.
iii.� Exercise price. The exercise price influences the warrant premium because of its effect on intrinsic
value i.e. Exercise Price less Share Price. The greater the intrinsic value, the higher the price of the
warrant.
iv.� Price volatility of the underlying share. The more volatile the price of the underlying share, the more
likely the warrant will appreciate during a given time period. Investors are willing to pay larger
premium for such a warrant. The market will price the warrant based on the volatility of the
underlying share. The term “implied volatility” refers to the market quotation for pricing the warrant.
Buyers of warrants will be “long” volatility, and conversely sellers or writers of warrants are “short”
volatility. Holding other variables constant, if an investor purchases a warrant at an implied volatility
of 7% and sells the warrant at an implied volatility of 8%, he will make a profit because the higher
volatility will result in a higher warrant price. Conversely, a seller at 7% volatility will have a loss on
his warrant position if volatility falls below 5%, other things being equal.

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v.� Dividend on the underlying share. Although warrant holders are not entitled to dividends, the
declaration of dividends will have a mild effect, with call warrants “losing” out (call warrant’s price
becomes slightly lower) and put warrants “benefiting” (put warrant’s price becomes slightly higher).
vi.� Leverage. Warrants that have greater leverage opportunities than others are able to command higher
prices.
vii.� Interest rates. The higher the interest rate, the greater the hedging cost for call warrants written by
the issuer, who has to delta hedge by buying back the shares, resulting in a higher price for call
warrants. Conversely, hedging put warrants will be cheaper because higher interest rates, resulting
in lower put warrant prices.
viii.�Size of warrant issue. The more warrants a company has outstanding, the larger the potential
earnings dilution of the existing shares. If the warrants were deep in-the-money, the conversion of
the warrants would increase the number of outstanding shares and reduce the value of each share.
Thus, there is a negative relationship between the size of the warrant issue and the warrant premium.
Table 10.3.1 - Factors Influencing Structured Warrants

Structured
Call warrants Put Warrants
Remaining life of warrant   
Exercise price   
Underlying share price   
Volatility   
Dividends expectations   
Interest rates   

10.4 Warrants Market Makers

In Singapore, the SGX rules require company issuers and third-party issuers of warrants to appoint a
market maker for the warrants that they issue. These are known as Designated Market Makers (DMMs),
who are required to make bid and offer prices continuously during underlying market trading hours. The
bid-offer prices essentially represent the warrant prices, which are influenced by the factors above. The
warrant price is made up of intrinsic value and time value. An option pricing model such as Black-Scholes
is used to calculate the warrant price. The main determinant would be the volatility.

During market trading hours, DMMs will use the implied volatility, which is variable throughout the day.
If no prices are available, market participants can calculate the historical volatility of the underlying share
of the warrant, to determine what the price would be. The historical volatility, as mentioned earlier in
the section on options, is the statistical volatility of the underlying share price over a given period of time.

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10.5 Summary

1.� Company warrants are call warrants and are only issued by the company. Structured warrants are
issued by a third-party, usually a bank. Both call and put structured warrants can be issued.

2.� Company warrants are settled with a delivery of shares. Structured warrants are cash-settled i.e. no
delivery of shares.

3.� A warrant gives the investor an option to buy a stated number of shares of common stock at a
specified price within a specified period of time. Unlike common shares, warrants expire and warrant
holders are not entitled to dividend payments.

4.� In addition to the fundamental value of the underlying share, the warrant investor has to consider
the intrinsic value, warrant premium, gearing ratio and the expiration date of the warrant when
evaluating warrants.

5.� The maximum value of a warrant is the underlying share price. The minimum value of a warrant is
the difference between the underlying share price and the exercise price. When the share price is
less than the exercise price, the minimum value is zero.

6.� The warrant price or speculative value which investors are willing to pay for a warrant depends on
the life of the warrant, price volatility of the underlying share, dividend yield on the underlying share,
leverage opportunity, interest rate level and size of the warrant issue.

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Chapter 11: �

Foreign Exchange

Learning Objectives
The candidate should be able to:

� Describe the features of the foreign exchange market

� Understand how foreign exchange rates are quoted

� Understand the difference between direct and indirect quotations and cross quotations

� Calculate cross rates from indirect quotes in USD against other currencies

� Understand the bid-offer spread

� Distinguish between a spot and a forward transaction

� Explain how the forward foreign exchange market works, the concept of forward premium and
discounts and their relationship with the interest rates of the two currencies being quoted

� Calculate the forward exchange rate

� Use the interest rate parity theorem to explain movements in the forward exchange rates, in
particular the concept of interest covered arbitrage

� Explain the quotations of forward rates

�
�
11.1 Introduction

The foreign exchange market today is global and growing rapidly in response to deregulation and
globalization. It is borderless, with financial flows moving in and out of different markets and locations,
with diminishing regard for national boundaries. It is effectively a global communication network with
overlapping market segments, i.e. money markets, equity markets, derivatives and commodities.

When we consider investments in foreign currencies we have to contend with foreign exchange risk. The
values of foreign currencies fluctuate daily, and can affect international investments significantly.
Portfolio managers must be aware of these fluctuations, which can either enhance investment returns
through exchange gains or depress investment returns through exchange losses. It is therefore important
to understand how foreign exchange rates are determined, how the foreign exchange market operates,
and how best to use it in financial transactions.

In addition, investing in a foreign currency involves another investment decision – which currency to use
to fund the investment? Should the investor borrow in a foreign currency or should he convert funds

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from his base currency? These actions result in foreign exchange and interest rate risk exposures.
Therefore, we will also look at two derivative products, namely interest rate swaps and currency swaps,
and examine how these are used to manage interest rate risk.

11.1.1 Definition and Terminology

A foreign exchange transaction involves the purchase of one currency against the sale of another currency
for settlement or delivery on a specified date. The rate of exchange is the price per unit of one of the
currencies expressed in units of the other currency.

Usually, foreign exchange transactions are spot deals i.e. made for delivery in two working days (value
spot), but there is also a market for same day delivery (value today) and next day delivery (value
tomorrow, or value tom).

Foreign exchange risk positions are described as long or short. For example, if an investor borrowed USD
to fund a SGD investment, he would sell the USD spot for SGD. His foreign exchange position will be
described as short USD and long SGD. The only way to cover a foreign exchange position is to enter into
the opposite transaction i.e. in this example, the investor has to sell spot SGD and buy USD. After doing
this, the investor’s foreign exchange risk is zero. We say his foreign exchange position is “squared”.

For investors, it is important to decide what the base currency is. The base currency is the operating
currency for the investor, and all his profits and losses will be measured in this currency. Holding
investments in any currency other than the base currency is a source of foreign exchange risk, which has
to be managed.

11.2 Foreign Exchange Markets

In the foreign exchange market, financial institutions, commercial banks, business firms, governments or
their central banks, and individuals, tourists, speculators or investors buy and sell foreign currencies.
Unlike the stock market or futures market, the foreign exchange market does not refer to any specific
geographical location, such as a stock exchange. The transactions are done through a complex
communication network of computer terminals, telephones, faxes, telexes, cables and communication
satellites and even personal digital devices such as smartphones. The foreign exchange markets work
round the clock, and although markets open and close throughout a 24-hour trading day, there are
operations with 24-hour dealing starting the day in Sydney, then Tokyo, Singapore/Hong Kong, London,
New York and San Francisco.

“Trading in foreign exchange markets averaged US$5.3 trillion per day in April 2013. This is up from
US$4.0 trillion in April 2010 and US$3.3 trillion in April 2007. FX swaps were the most actively traded
instruments in April 2013, at US$2.2 trillion per day, followed by spot trading at US$2.0 trillion. Trading
is increasingly concentrated in the largest financial centres. In April 2013, sales desks in the United
Kingdom, the United States, Singapore and Japan intermediated 71% of foreign exchange trading,
whereas in April 2010 their combined share was 66%.”
Source: 2013 BIS Triennial Central Bank Survey

Figure 11.2 below is an illustration of the role of the foreign exchange market in global investment flows.

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�
Figure 11.2 – The Role of Foreign Exchange in Global Investments

The Foreign Exchange Market

A Global Financial Transaction: American Fund Manager Buys Indonesian Equity

American Bank buys

American Fund USD / sells IDR American Bank in
Manager in Philadelphia New York

Fund Manager Indonesian

buys Bank Bank buys USD
Mandiri shares / sells IDR

UK Investment Bank in Bank Mandiri in

Hong Kong Jakarta

11.3 Foreign Exchange Rate Quotations

Foreign exchange rates can be quoted on a direct, indirect or cross basis, and are quoted to the fourth
decimal place. The last digit of the quote is called a pip (= 0.0001).

11.3.1 Indirect Quotes/European Convention

Most currencies are quoted in European terms. This is also referred to as an indirect quote as it expresses
the value of one US dollar in the foreign currency it is quoting. For example:
•� USD/CNY1 6.6186 (means 1 USD = 6.6186 Chinese Yuan)
•� USD/JPY 101.86 (means 1 USD = 101.86 Japanese yen)
•� USD/SGD 1.2520 (means 1 USD = 1.2520 Singapore dollars)

In the USD/SGD quotation, the US dollar (USD) is referred to as the base currency, while Singapore Dollar
(SGD) is referred to as the counter-currency or term currency. As the US dollar is the most widely accepted
currency, most quotations are in the indirect convention.

11.3.2 Direct Quotes/American Convention

Exceptions to the indirect quote are currencies in the old 'sterling bloc' comprising the UK pound sterling,
the Australian dollar and the New Zealand dollar. The quote expresses the value of one unit of foreign
currency in US dollar terms. A quote expressed in this way is known as a direct quote. The Euro is also
quoted in this manner. For example:
•� GBP/USD 1.6816 (means 1 Pound Sterling = USD 1.6816)
•� AUD/USD 0.9235 (means 1 Australian dollar = USD 0.9235)

�������������������������������������������������
1 Technically, CNY is the onshore Renminbi, while CNH is the offshore Renminbi.

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•� NZD/USD 0.8630 (means 1 New Zealand dollar = USD 0.8630)

•� EUR/USD 1.3622 (means 1 Eurodollar = USD 1.3622)

11.3.3 Cross Quotes

Although most foreign exchange transactions involve the US dollar as one of the currencies, the increasing
importance of other major currencies in international transactions has resulted in direct quotation of two
non-US dollar currencies. These quotes are referred to as cross rates. For example:
•� SGD/CNY 4.9795 (means SGD 1 = CNY 4.9795)
•� AUD/SGD 1.1570 (means AUD = SGD 1.1570)

Cross rates can be calculated easily from the US dollar rates for each currency.

Cross Rate for SGD/JPY

Determine the cross rate SGD/JPY given:

USD/JPY = 101.86
USD/SGD = 1.2520

SGD 1.2520 = JPY 101.86

SGD 1 = JPY 101.86/1.2520
= JPY 81.36

Therefore SGD/JPY = 81.36, that is one Singapore Dollar can be exchanged for 81.36 Japanese Yen.

Cross Rate for GBP/SGD

Suppose we want to determine the cross rate GBP/SGD given:

GBP/USD = 1.6816
USD/SGD = 1.2520

The calculation is different here because of the different method of quoting sterling.
GBP 1 = USD 1.6816

Therefore, USD 1 = GBP 1 / 1.6816

= GBP 0.5947

GBP 0.5947 = SGD 1.2520

GBP 1 = SGD 1.2520 / 0.5947
= SGD 2.1053

11.3.4 Reciprocity

An interesting point to note in the exchange rate quotation is its reciprocity. For example, SGD/USD
0.7987 can be expressed as USD/SGD 1.2520. The calculation is as follows:

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�
SGD 1 = USD 0.7987
USD 1 = SGD 1/0.7987 = SGD 1.2520

11.3.5 Bid-Offer Spread

A bank or an authorized foreign exchange market maker will always provide two prices when asked for a
quote. The first price is the one at which the bank will buy a currency (known as the bid) and the second
is the price at which the bank will sell a currency (the offer).

For example, USD/SGD 1.2520-25 means that the bank dealer will pay SGD 1.2520 to buy 1 USD. He will
sell 1 USD for SGD 1.2525. The spread of 5 basis points is the bank's profit margin. The spread varies
according to market conditions and the value of the transaction involved. The greater the uncertainty
and volatility in the market, the wider will be the spread. The party asking for a quote will always buy at
the offer rate, and sell at the bid rate. In market parlance, we say that when asking for a quote, the price
is always against the price taker i.e. the party looking for a quote.

11.3.6 Settlement Dates

The date when both parties of a foreign exchange transaction deliver their respective currencies is known
as the value date or settlement date.

A spot transaction is a contract in which one currency is exchanged for another for settlement usually in
2 business days. For example, a foreign exchange deal transacted on Monday, 26 th May 2014 will be
settled on Wednesday, 28th May 2014. The two-day period gives ample time for both parties to exchange
the currencies. As Saturdays and Sundays are not considered working days, a spot deal done on Thursday
and Friday will be settled on the following Monday and Tuesday respectively. If there is a public holiday
on one of these days, the settlement date will be pushed to the next working day such that settlement
will always take place after 2 business days.

A spot foreign exchange deal is one which is done for delivery 2 business days after the date of transaction
e.g. if an investor had, on trade date 23 June, bought USD and sold SGD, it will receive USD and deliver
SGD on spot value date, 25 June.

Market participants transact spot foreign exchange to cover forex exposures, pay in foreign currencies,
switch liabilities or assets for yield reasons, hedging purposes, or simply to trade in the currency.

Forward transactions are contracts to exchange one currency for another at some future date, later than
spot, at a rate of exchange that is determined on the trade date. The purpose of forward deals is to
establish and fix the cost of exchange for a known foreign exchange commitment at some future date.

11.4 Forward Foreign Exchange Contracts

There are two reasons why an investor will enter into a forward exchange contract: to hedge a currency
exposure, and to speculate by taking a position in the currency.

An investor who has bought or sold foreign securities may want to cover his foreign currency exposure by
fixing a forward exchange rate. By covering his exposure, through locking into a known forward foreign
exchange rate, the investor also forfeits potential gains from favourable movements in market rates.

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These transactions, where there is only a single forward transaction, are normally referred to as
'outrights'.

Some investors or traders may not have an initial currency exposure but hope to profit by taking a view
on the direction of the foreign currency. They would buy the foreign currency if it is expected to appreciate
and vice versa.

11.4.2 Forward Rates

A forward transaction is made up of two components:

•� Spot exchange rate; and
•� Interest differential expressed in foreign exchange rate terms.

The forward rate is therefore dependent on the movement of the spot exchange rate of the currency pair,
and the respective interest rates for each of the two currencies. As an example, the 3-mth forward rate
for USD/SGD depends on the spot rate for USD/SGD, the 3-month interest rate for USD and the 3-month
interest rate for SGD.

The interest differential between the two currencies is converted into forward points, or swap points,
which are either added to or subtracted from the current spot rate.

Hence,
Forward exchange rate = Spot rate ± Forward points

When forward points are added to the spot rate, we say that the forward rate is at a premium. When
they are subtracted from the spot rate, the forward rate is at a discount.

Generally, the currency of the country with the higher interest rates will trade at a forward discount
(forward rate is cheaper than the spot rate) to that of the other; the currency with the lower interest rates
will trade at a forward premium (forward rate is more expensive than the spot rate).

11.4.3 Calculating Forward Points

The general formula for calculating forward points is as follows:

S x (Rc - Rb) x n/360
Forward Points =
1 + Rb x n/360
where:
S = spot rate
Rc = annualized interest rate of counter-currency
Rb = annualized interest rate of base currency
n = number of days from spot date to the forward date
�
How to Calculate Forward Points

Suppose the prevailing market rates are:

Spot USD/SGD = 1.2520

Rb = RUS = 1.75% p.a.
Rc = RSGD = 0.75% p.a.
n = 30 days

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�
USD/SGD forward points
1.2520 × (0.0075 - 0.0175) × 30/360
=
1 + 0.0175 × 30/360
= -0.0010 / 1.0015
= SGD 0.0010 or -10 points (forward USD are at a discount)

The 30-day USD/SGD forward rate will be quoted at a discount, which is USD/SGD 1.2510.

Sometimes, supply or demand for outright forwards can be so great that the forward rate will not reflect
the interest differential. When this happens, there is room for arbitrage between the money market and
the foreign exchange market.

There is also proprietary trading of the forward foreign exchange market because banks take trading
positions based on their expectations of the swap points movements i.e. the relative movements between
the interest rates of the two currencies. This is also known as forex gap trading.

It is important to note that the forward points are only a reflection of the relative interest rates of the
currencies. They are not an indication of what the future spot rates of the currencies will be.

11.4.4 Interest Rate Parity

The value of the premium or discount can be theoretically computed from the interest rate parity
theorem. This theory states that (except for the effects of small transaction costs) the forward premium
or discount should be equal to the difference in the national interest rates for securities of the same
maturity. If the interest rate parity relationship is violated, arbitrageurs will be able to make risk-free
profits in foreign exchange markets. Their actions will force the forward and spot exchange rates back
into alignment.

According to the interest rate parity theorem, the relationship between the spot rate and forward rate is:
n
1 + Rc ( )
F = S  360
n 
1 + Rb ( 360 )

where:
F = forward rate
S = spot rate
Rc = annualized interest rate of counter-currency
Rb = annualized interest rate of base currency
n = number of days

We can illustrate the interest rate parity theorem by using two currencies, the USD (counter currency)
and GBP (base currency).
�
Interest Rate Parity with USD and GBP

If RUSD = 0.06 and RGBP = 0.05 annually, while pound spot is USD 1.50, then the forward price for a 1-year
contract would be:

F = USD 1.50 (1.06/1.05) = USD 1.5143 per GBP

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What if the interest rate parity relationship is violated? For example, suppose the forward price is USD
1.5100 instead of USD 1.5143.

The following strategy can be taken to reap arbitrage profits.

1.� Borrow GBP 1,000,000 for 1 year at 5% per annum. After one year, the arbitrageur will need to
repay GBP 1,050,000.
2.� Sell the borrowed pounds into dollars at the spot exchange rate of USD 1.50. He receives GBP
1,000,000 x 1.50 = USD 1,500,000.
3.� Invest the dollars for 1 year at 6% per annum. He will receive USD 1,500,000 x 1.06 = USD 1,590,000
at the end of one year.
4.� Enter into a 1-year forward contract to buy GBP 1,050,000 at forward price of USD 1.5100. At the
end of 1 year, the arbitrageur will need to pay GBP 1,050,000 x 1.5100 = USD 1,585,500.

After 1 year, the arbitrage position is closed out as follows:

1. Receive USD 1,590,000 from the US dollar deposit.
2. Pay USD 1,585,500 to obtain GBP 1,050,000 at an exchange rate of USD 1.5100.
3. Pay GBP 1,050,000 toward the principal and interest on the GBP 1,000,000 loan.
At the end of 1 year, the arbitrageur's net position is zero because all the transactions are closed out.
However, he makes a profit of (USD 1,590,000 – USD 1,585,500) = USD 4,500. Effectively, the
arbitrageur has sold GBP position at 1.5143 (USD 1,590,000 / GBP 1,050,000), and bought the GBP in
the forward market at the lower rate of 1.5100. This arbitrage was accomplished by simultaneously
borrowing in one currency, investing in another currency, and covering the exchange position in the
forward exchange market. The entire process is known as covered interest arbitrage.

11.4.5 Forward Rate Quotes

Most market information services show forward rates not as outright rates of exchange but as margins,
in points, above or below the spot rate.
For example:
Spot 1-mth 2-mth
USD/JPY 119.22/25 52/51 106/104
AUD/USD 0.6475/80 17/21 36/43

Sometimes, the forward points do not have a sign in front of them. To derive the outright rates, the
convention is:
•� Subtract the points from the corresponding spot rates if the forward points are descending (e.g.
52/51). For example:

Spot 1-mth Outright

USD/JPY 119.22/25 -52/-51 119.2148/119.2449
•� Add the points to the spot rates if the forward points are ascending (e.g. 17/21). For example:
Spot 1-mth Outright
AUD/USD 0.6475/80 +17/+21 0.6492/0.6501

On an intuitive basis, the forward points are always quoted from smaller to bigger. This can only be true
if 52/51 are negative i.e. -52/-51.

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11.5 Risks in Foreign Exchange

Like any asset class, foreign exchange has its own risks. Compared to the other asset classes, most foreign
exchange trading is very short-term, with proprietary trading making profits and losses over very short
trading periods that may be as brief as minutes. Participants in the foreign exchange market have to
manage the following risks:
•� Market risk – movement and volatility of foreign exchange rates;
•� Price liquidity in less traded currencies, and even in major currencies when there is an extreme
market event e.g. a major power failure;
•� Credit risk – when counterparty fails to honour the deal. In forex transactions, credit risk is a % of the
total amount because the transaction is an exchange (buy and sell), and not an outright extension of
credit;
•� Settlement/delivery risk – counterparty fails to pay on time (one has to see settlement risk as a
specific counterparty credit risk which takes place in the period just before the settlement takes place.
In forex, this is 2 days before payment). CLS has reduced the delivery risk significantly;
•� No liquidity risk as currencies are exchanged bilaterally; and
• Minimal documentation for foreign exchange, although the International Foreign Exchange Master
Agreement (IFEMA) and other netting arrangements are used to reduce the netting risks.

11.6 Summary

1.� A foreign exchange transaction involves the purchase of one currency against the sale of another
currency for settlement or delivery on a specified date. Foreign exchange rates can be quoted on a
direct, indirect or cross basis.

2.� A spot transaction is a contract in which one currency is exchanged for another for settlement usually
in two working days. A forward transaction is a contract to exchange one currency for another at
some future date, later than spot, at a rate of exchange which is determined on the trade date.

3. An investor may enter into a forward exchange contract to hedge a currency exposure or to speculate
by taking a currency position.

4.� The major factor determining the forward rate of one currency against another is the difference in
interest rates in the two countries over the specific forward period. The interest differential is
converted into forward points or swap points which are either added to or subtracted from the
current spot rate.

5.� Generally, the currency of the country with the higher interest rates will trade at a forward discount
to that of the other; the currency with the lower interest rates will trade at a forward premium.

6.� According to the interest rate parity theorem, the relationship between the spot rate and forward
rate is:
n
1 + Rc ( )
F = S  360
n 
1 + Rb ( 360 )
�

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Chapter 12:
Case Studies
12.1 Financial Planning for Retirement

Linda Tung, aged 45, has current savings of $950,000 and an additional $250,000 invested in a bank time
deposit of 3 months. Her total financial assets come up to $1,200,000.

At a savings rate of 2% compounded annually, she estimates that she should have about $1,500,000 when
she retires at 65. This will provide an annuity of $91,735 for 20 years until she reaches 85. However, after
taking her commitments and lifestyle into account, she estimates that she will need a post-retirement
income of $120,000 from her retirement at age 65 up to when she reaches 85.

The shortfall between $120,000 and $91,735 is $28,265. Linda expects that she will have financial assets
of $1,500,000 when she retires. This will give her an annuity of $91,735 at an interest rate of 2% per
annum. To produce the additional annuity of $28,265, she will need to build up an amount of financial
assets in excess of the$1,500,000. We have to calculate the present value of the capital required 20 years
from now, when she is 65 that can be converted into the additional annuity of $28,265 over the following
20-year period until she turns 85.

Using a financial calculator:

�� Input n = 20, i = 2%, PMT = 28,265 and then press PV.

This will give us a PV of $462,173. This means that Ms Tung has to build an additional future capital in 20
years’ time of $462,173, so that she will be able to increase her post-retirement annual income to
$120,000 a year. See Figure 12.1 below.

Figure 12.1 – Calculating the PV in 20 years’ time

for the additional annuity of $28,265
Today�
+�
PV�=�462,173�
Cash�Flow�
20�years�

0 Ms Tung’s�age�
65� 85�

Each�of�these�is�an�annuity�of�
$28,265�over�a�20-year�period.�
-�

12.2 Portfolio Management

Walter Koh’s funds are in current savings and fixed deposits with banks. His objective is not to touch his
savings. However, of his $2,000,000 with the bank, he is willing to have $500,000 managed more actively,

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and is prepared to risk $100,000 of it in full. Interest and dividend income is more important than capital
gains for him.

Castor & Pollux shares have been recommended by Mr Koh’s advisor because of potential alpha returns
based on its past market return of 9.5% on this share. Castor & Pollux has a beta (β) of 1.2, and an equity
risk premium of 6%. The risk-free rate is 3%.

We will construct a portfolio for the $500,000 that Mr Koh is prepared to allocate for investment
management. From his investment objectives, it is clear that Mr Koh is a conservative investor. Of the
total investment portfolio, he is prepared to invest 80% in low-risk assets, and up to 20% in high-risk
assets, with a maximum of 5% in very high-risk assets e.g. commodities or derivatives. Mr Koh’s
investment mandate includes money market funds, government bonds, high-grade corporate bonds,
equities and commodities as asset classes within his portfolio.

First we set the minimum limits for the 80% low-risk assets. We can set a minimum of 30% for money
market funds and government bonds, and 20% for corporate bonds. We have to set the maximum for
each of these asset classes as well. The maximum for money market funds and government bonds can
be set at 50%, and corporate bonds maximum limit at 30%. See the Table 12.2 below.

The expected return on Castor & Pollux, using CAPM is

E

r = Risk free rate + β (Market return - Risk free rate)

Applying this Castor & Pollux has an expected return of 10.2%. As the past market return of 9.5% is not
higher than the expected return calculated using CAPM, there are no Alpha returns. Mr Koh should not
buy these shares if he is looking for Alpha.

Table 12.2 - Strategic Asset Allocation proposed to Mr Walter Koh

Asset class Min Max

Money Market funds 30% 50%
Government bonds 30% 50%
Corporate bonds (high grade) 20% 30%
Equities –Developed Markets (80% index and 20% individual stocks) 0% 20%
Commodities / Precious metals 0% 5%

12.3 Fixed Income Investments

Mr David Lee was offered the following USD bonds:

Maturity Yield to Maturity

Glenville Corp. 14% callable bond 10-year 5.8%
Glenville Corp. 6% non-callable bond 10-year 5.5%

Generally, the market expects interest rates to be steady to firm.

Between the two bonds, Glenville Corp. 14% callable bond is recommended for the following reasons:
i. Given the same maturity, the higher coupon bond with lower convexity would experience lower price
volatility than the lower coupon bond for a given change in market interest rates. In other words, the

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low coupon bond would depreciate by a higher percentage than the high coupon bond when interest
rates rise, resulting in a higher capital loss;
ii.� The 14-percent coupon bond has a greater reinvestment advantage as the higher coupons are
reinvested in a rising interest rate environment; and
iii.� The 14-percent bond is callable, but this will be unlikely if the market expects interest rates to rise.

(Another issue to consider would be the outlook for USD, noting the bonds are denominated in USD.)

12.4 Equity Valuation

Mr David Lee’s private banker recommended the ordinary shares of Ashton Computer Company, which is
currently trading at $6.50.

Ashton just paid an annual dividend of $0.10 a share. For the next five years, the earnings and dividends
of Ashton are expected to grow at 15 percent a year. Thereafter, growth is expected to fall to 10 percent.
The required rate of return for the equity market is 12 percent. The forecast earnings per share for next
year is $0.40. The overall market price-earnings ratio is about 20 times.

To determine if the current share price of $6.50 is attractive, we use the multi-stage dividend discount
model to calculate the intrinsic value of Ashton shares, and then compare it with the current share price
in the market. The prospective PE ratio is also calculated and compared to the overall market PE ratio.

a. Projected dividends for next 6 years:

D1 = $0.10(1.15) = $0.115
D2 = $0.10(1.15)2 = $0.132
D3 = $0.10(1.15)3 = $0.152
D4 = $0.10(1.15)4 = $0.175
D5 = $0.10(1.15)5 = $0.201
D6 = $0.10(1.15)5(1.10) = $0.221
D6
D1 D2 D3 D4 D5 (k - g)
P0 = + + + + +
1 + k (1 + k)2 (1 + k)3 (1 + k)4 (1 + k)5 (1 + k)5
0.221
0.115 0.132 0.152 0.175 0.201 (0.12-0.10)
= + + + + +
1.12 1.122 1.123 1.124 1.125 1.12 5

= $0.1027 + $0.1052 + $0.1082 + $0.1112 + $0.1141 + $6.2701

= $6.81

b. Prospective PER of Ashton Limited = $6.50/0.40 = 16.25 times.

c. Ashton is attractive because:

•� Its share price of $6.50 is below the intrinsic value of $6.81.
•� Its PER of 16.25 times is less than the overall market average of 20 times.

(Besides comparing the PER of Ashton with the PER of the overall market, it would also be helpful to
compare the company's PER with the industry's PER.)

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Module 6 – Securities Products and Analysis
 Chapter 12 – Case Studies | 192

12.5 Warrants and Foreign Exchange

Ms JL Tan is looking at the structured warrants of Poseidon Lines, a shipping company.

Today, Poseidon is trading at $2.50, and its warrants at $1.30. The conversion ratio is 1:1, at an exercise
price of $1.50. Ms Tan expects Poseidon’s share price to rise to $4.00 and wants to know her gain on the
warrants in % terms if she buys them today.

If the price of the Poseidon warrants rises to $4.00, its intrinsic value will be $ (4.00 – 1.50) ÷ 1 = $2.50.

Ms Tan’s potential capital gain on the warrants at today’s price is:

$2.50 ÷ $1.30 = 192%

Ms Tan has sold some of her ADRs denominated in USD, and will receive USD 50,000 2 business days from
today. She wants to sell them for SGD, and has received two quotes as shown below:

Quote A: USD/SGD 1.2500 – 1.2550

Quote B: USD/SGD 1.2475 – 1.2500

The best rate for her to sell USD against SGD is 1.2500 in Quote A. The numerically identical rate of 1.2500
in Quote B is the rate at which the bank will sell USD.

12.6 Unit Trusts, REITs and Business Trusts

Mr James Lim is considering to invest in unit trusts, REITs or business trusts and wants to know which of
these best suits his investment needs. Mr Tan is more interested in yield than in capital gain, and believes
in the diversification of his risks. He is also more interested in a steady stream of income than in making
large trading gains from trying to read market trends.

All three are similar in that they offer Mr Tan an opportunity to invest in his choice of industry without
having to tie up all his investment funds in one share, or a limited number of shares.

Unit trusts offer Mr Tan the chance to be invested across various industries, or across various shares
within the same industry. Most unit trusts in Singapore are open end, and Mr Tan can either buy more
new units from the manager, or redeem them. Unit trusts in Singapore are typically not listed, so Mr Tan
essentially has only one source for the redemption of his holdings.

Business trusts, like unit trusts and REITs, are constituted with a trust deed, although in the case of
business trusts, these have the characteristics of both a company and a trust. Business trusts can pursue
more aggressive investment strategies, because unlike REITs, they are not restricted in their investments.
REITs on the other hand, are restricted in their investments. Basically, REITs are property trusts that own
commercial or residential properties which give a good cash return from the lease or rental income of
these properties. REITs are legally obligated to distribute at least 90% of their annual income. REITs are
passive investment vehicles that buy into good lease and rental income properties.

Given these differences, Mr Tan should invest in REITs.

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193 | Appendix A ­ Review Questions

Appendix A
Review Questions

Chapter 1: Financial Markets

1. A good financial market is characterised by all of the following except:

a. liquidity
b. informational efficiency
c. few buyers and sellers
d. low transaction costs
Answer: c

Chapter 2: Risk and Return

2. The coefficient of variation is defined as:

a. expected return divided by standard deviation
b. expected return divided by variance
c. standard deviation divided by expected return
d. variance divided by standard deviation
Answer: c

Chapter 3: Investment Analysis – Understanding Financial Statements

3. Which of the following actions will increase the current ratio of a company?
a. Delaying the next payroll
b. Writing down impaired assets
c. Reducing accounts payables
d. Selling inventory for cash
Answer: c

4. Axle Company has current assets of $11,400, inventories of $4,000, and a current ratio of 2.6x. What
is Axle's acid test ratio?
a. 1.69 times
b. 1.35 times
c. 0.74 times
d. 0.35 times
Answer: a

5. Jensen Company has an annual interest expense of $30,000. If Jensen's times interest earned ratio is
2.9x, what is Jensen's earnings before interest and taxes?
a. $117,000
b. $ 87,000
c. $ 60,000

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 Appendix A ­ Review Questions | 194

d. $ 57,000
Answer: b

Chapter 4: Investment Analysis – Macroeconomic Analysis

6. The government can stimulate the economy by:

a. increasing government borrowing
b. decreasing money supply
c. increasing government spending
d. decreasing government spending
Answer: c

7. What type of stocks would an investor purchase in an economic downturn?

a. Cyclical stock
b. Asset stock
c. Defensive stock
d. Income stock
Answer: c

8. Which of the following factors are considered in an analysis of the degree of competition in an industry?

I. degree of capital intensity

II. rivalry among existing competitors
III. threat of new entrants
IV. bargaining power of suppliers

a. I and II only
b. II and III only
c. II, III and IV only
d. All of the above
Answer: c

Chapter 5: Technical Analysis & Quantitative Analysis

9. The technical analyst:

a. buys shares whose intrinsic value is higher than the market price
b. tends to be long­term oriented
c. studies the prospects of earnings growth in forecasting future price trends
d. studies price and volume patterns of stocks
Answer: d

10. Which of the following is not a bullish indicator?

a. Ascending triangles
b. Descending triangles
c. Double bottoms
d. Reverse heads and shoulder
Answer: b

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195 | Appendix A ­ Review Questions

Chapter 6: Portfolio Management

11. Which statement about portfolio diversification is correct?

a. Proper diversification can reduce or eliminate systematic risk
b. Diversification reduces the portfolio's expected return because diversification reduces a
portfolio's total risk
c. As more securities are added to a portfolio, total risk typically would be expected to fall at a
decreasing rate
d. The risk­reducing benefits of diversification do not occur meaningfully until at least 30 individual
securities are included in the portfolio
Answer: c

12. Under the Capital Asset Pricing Model, the expected return of a security is affected by:
a. risk­free rate
b. market rate of return
c. security's beta
d. all of the above
Answer: d

13. Which one of the following is not a systematic risk factor?

a. interest rate risk
b. market risk
c. business risk
d. inflation risk
Answer: c

14. If you wish to reduce the risk of your portfolio, you would select stocks that are:
a. perfectly positively correlated
b. perfectly negatively correlated
c. not correlated
d. highly correlated
Answer: b

15. The best measure of a portfolio manager's performance, when there are frequent withdrawals of
funds from the portfolio, is the:
a. time­weighted return
b. dollar­weighted return
c. realised rate of return
d. arithmetic mean
Answer: a

16. The Sharpe performance measure is defined as:

a. the difference between the portfolio's excess return and the portfolio's total risk;
b. the difference between the portfolio's excess return and the portfolio's systematic risk;
c. the difference between the actual return on the portfolio and the return that would be expected
from the capital asset pricing model;
d. none of the above.
Answer: d

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 Appendix A ­ Review Questions | 196

Chapter 7: Equity Securities

17. An investment increases from $300 to $421 in five years. What is the annual discount rate?
a. 5 percent
b. 6 percent
c. 7 percent
d. 8 percent
Answer: c

18. All other factors being constant, the price­earnings ratio of a company will decline when:
a. the level of inflation is expected to fall
b. the yield on Treasury bills rises
c. investors become less risk averse
d. the dividend payout ratio increases
Answer: b

19. The constant­growth dividend discount model is most appropriate in valuing the stock of a:
a. new venture expected to retain all its earnings for several years
b. rapidly growing company
c. moderate growth, “mature” company
d. company with valuable assets not yet generating profits
Answer: c

20. Which of the following is true about callable preference shares?

a. Their yields are generally lower than similar preference shares without the call feature
b. They are likely to be redeemed when interest rates are falling
c. The call premium rises over time
d. None of the above
Answer: b

21. A firm can increase its growth rate by:

a. increasing its dividend payout ratio
b. reducing its retention rate
c. increasing its return on equity
d. none of the above
Answer: c

22. You plan to buy the common stock of Delta Company. The company is expected to pay a dividend of
$0.15 and the stock price is estimated at $2.00 one year from now. Given a required rate of return of
12 percent and a holding period of one year, what is the maximum price you would pay for the stock
today?
a. $1.79
b. $1.92
c. $1.85
d. $2.15
Answer: b

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197 | Appendix A ­ Review Questions

Chapter 8: Fixed Income Securities

23. The interest rate risk of a bond normally is:

a. greater for shorter maturities
b. lower for longer maturities
c. lower for higher coupons
d. none of the above
Answer: c

24. The yield­to­maturity and current yield on a bond are equal when:
a. the bond price is trading above its par value
b. the bond price is trading at a discount to its par value
c. the coupon and market interest rate are equal
d. market interest rates begin to level off
Answer: c

25. As compared with bonds selling at par, deep discount bonds will have:
a. greater reinvestment risk
b. greater price volatility
c. less call protection
d. none of the above
Answer: b

26. A downward sloping yield curve generally implies:

a. interest rates are expected to increase in the future
b. long­term bonds are riskier than short­term bonds
c. interest rates are expected to decline in the future
d. short­term bonds are less risky than long­term bonds
Answer: c

27. What is the value of a bond that matures in 3 years, has an annual coupon rate of $110, and a par
value of $1,000. Assume a required rate of return of 11%.
a. $330
b. $970
c. $1,000
d. $1,330
Answer: c

Chapter 9: Warrants

28. The warrant premium is affected by:

I. The length of time before expiration date
II. The size of the cash dividends paid on the underlying shares
III. The intrinsic value of the warrant
IV. The number of warrants issued by the company

a. I, II & III
b. I, III & IV
c. I, II & IV
d. I, II, III & IV
Answer: d

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29. A warrant with an exercise price of $1.00 is trading at $1.20. One warrant converts to one share. What
is its conversion price?
a. $1.00
b. $1.20
c. $2.20
d. $0.20
Answer: c

Chapter 10: Unit Trusts, REITs and Exchange­Traded Fund

30. Unit Trusts can be purchased using:

a. cash only
b. CPF only
c. Cash &/or CPF
d. Credit terms only
Answer: c

31. Which of the following are advantages of investing in ETFs?

I. Diversification
II. Small capital outlay
III. Low costs
IV. Transparency

a. I & II
b. II & III
c. I, II & IV
d. I, II, III & IV
Answer: d

Chapter 11: Foreign Exchange

32. The primary factor determining the forward rate of one currency against another is:
a. the level of foreign reserves
b. interest­rate differential
c. forecast of trade figures
d. economic growth
Answer: b

33. Which of the following are reasons to use foreign exchange options?

I. To protect against interest rate movements

II. To protect against exchange rate movements
III. To make a profit through trading

a. I & II
b. II & III
c. I & III
d. I, II & III
Answer: b
Capital Markets and Financial Services Examinations
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199 | Appendix A ­ Review Questions

34. In GBP/FFR you are quoted the following prices by four different banks. You are a buyer of French
francs. Which rate is the best for you?
a. 8.4790/00
b. 8.4793/98
c. 8.4792/95
d. 8.4789/94
Answer: b

35. The spot GBP/FFR is quoted 8.3580/90 and the 3­month outright is 8.3930/50. What are the forward
points?
a. 35/36
b. 360/350
c. 350/360
d. 340/350
Answer: c

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 Appendix B - Formulae Sheet | 200
�

Appendix B
Formulae Sheet
Please note that this Formulae Sheet will be provided during the M6 Exam. The examination might not
cover all formulas provided.

Risk and Return

1 Measures of Return
Income + Capital Gain or Loss
(i) Total Return on a Security = �
Purchase Price

(ii)�Expected Rate of Return = E(R) = ∑ni= 1 ri pi �

where E(R) = expected return on a security

ri = ith possible return
pi = probability of the ith return ri
n = number of possible returns

2 Measures of Risk

(i)� Variance of Returns = σ2 = ∑ pi ri - E(R)2

(ii)� Standard Deviation of Returns = σ = √σ2

Standard Deviation od Returns

(iii)� Coefficient of Variation = CV =
Expected Rate of Return

Investment Analysis – Understanding Financial Statements

3 Liquidity Ratios

Current Assets
(i)� Current Ratio =
Current Liabilities
Current Assets - Inventories
(ii)� Quick Ratio =
Current Liabilities

4 Leverage Ratios

Total Debt
(i) Debt/Equity Ratio =
Total Shareholders' Equity

Total Debt
(ii) Debt to Total Assets Ratio =
Total Assets

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�

Earning Before Interest and Taxes

(iii) Interest Coverage = Interest Expense

Earnings Before Interest, Taxes and Lease Payment

(iv) Total Fixed Charge =
Interest Expense + Lease Payments + Preferred Dividend /(1-Tax Rate)
Coverage

5 Operating Efficiency / Activity Ratios

Sales
(i) Total Assets Turnover =
Average Total Assets

Sales
(ii) Inventory Turnover = �
Average Inventory

365 days
(iii) Days to Sell Inventory =
Average Inventory Turnover
Average Inventory
Or =
Sales/365

Sales
(iv) Receivables Turnover =
Average Accounts Receivables
365
(v) Collection Period =
Average Accounts Receivables Turnover

Average Accounts Receviables

Or =
Sales / 365

6 Profitability Ratios

Gross Profit
(i) Gross Profit Margin =
Sales
Earnings Before Interest and Tax
(ii) Operating Profit Margin =
Sales
Net Income
(iii) Net Profit Margin =
Sales
Pre-Tax Income + Interest Expense
(iv) Return on Assets =
Average Total Assets

Net Income + Interest Expense (1-Tax Rate)

Or =
Average Total Assets
Net Income
(v) Return on Equity = Average Common Equity

Net Income Available to Common Shareholders

(vi) Earnings Per Share =
Average Number of Common Shares Outstanding
7 Valuation Ratios

Market Price Per Share

(i)� Price / Earnings Ratio =
Earnings Per Share

Capital Markets and Financial Services Examinations

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 Appendix B - Formulae Sheet | 202
�

Market Price Per Share

(ii)� Price/Book Ratio =
Book Value Per Share

Investment Analysis – Macroeconomic Analysis

8 Quantity Theory of Money

(i) M × V = P × Q

where:
M = stock of money (currency outside banks plus demand deposits)
V = velocity of money circulation (number of times per period that
an average unit of money changes hands/accounts)
P = general price level or a price index
Q = the number of transactions made in an economy during a year

Portfolio Management
9 Calculating Portfolio Return and Risk

(i) Expected Return of a Portfolio = Rp = ∑ni=1 wi ri

where Rp = expected return on the portfolio

wi = portfolio weight for the ith security
ri = expected return on ith security
n = number of different securities in the portfolio
∑wi = 1.0

(ii) Portfolio Risk = σp = w21 σ21 + w22 σ22 + 2w1 w2 ρ1,2 σ1 σ2

where wi and w2 = portfolio weights given to security 1 and security 2 respectively

σ1 and σ2 = standard deviation of security 1 and security 2 respectively
ρ1,2 = correlation coefficient of security 1 and 2
�
10 Capital Asset Pricing Model
E(Rm ) - Rf
(i) Capital Market Line (CML): E(Rp ) = Rf + σp
σm

where E(Rp) = expected return on any efficient portfolio on the CML

Rf = rate of return on risk-free asset
E(Rm) = expected return on market portfolio M
σm = standard deviation of the returns of market portfolio
σp = standard deviation of the efficient portfolio being considered

(ii) ERi = Risk-free Rate + Risk Premium

= Rf + βi(Rm – Rf)

where E(Ri) = expected return on security or portfolio

Rf = risk-free rate
Rm = expected return of overall market
βi = volatility of asset or portfolio relative to that of the market
The difference between Rm and Rf is also known as the equity risk premium

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203 | Appendix B - Formulae Sheet
�

11 Arbitrage Pricing Theory

Ri = E(Ri ) + bi1 f1 + bi2 f2 + … + bin fn + ei

where Ri = actual (random) rate of return on security I in any given period t

E(Ri) = expected return on security i
F = deviation of a systematic factor F from its expected value
bi = sensitivity of security I to a factor
ei = random error term, unique to security i
�
12 Measuring Investment Returns
(i) Return on the Portfolio (No Deposits or Withdrawals):

VE - VB
Rp =
VB

where VE = end value of the portfolio

VB = beginning value of the portfolio

(ii) Return on the Portfolio (Deposits or Withdrawals at end of measuring period):

(Vε + Withdrawals - Deposits) - VB

Rp =
VB

(iii) Return on the Portfolio (Deposits or Withdrawals at beginning of measuring period):

Vε - (VB + Deposits - Withdrawals)

Rp =
VB + Deposits - Withdrawals

(iv) Annualizing Returns:

Annual Return = 1+ r1 1+ r2 1+ r3 1+ r4  – 1

where r1, r2, r3, r4 = quarterly returns.

(v) Estimating the TWR using the modified Dietz method:

VE - VB - CF
Rp =
VB + WCF

where:
CF = net cash flow over the period
WCF = weighted cash flow

The formula for WCF is:

n - ti
WCF =
CFi
n
i

where:
CFi = cash flow on day ti
n = number of days in the period

Capital Markets and Financial Services Examinations

Module 6 – Securities Products & Analysis�
 Appendix B - Formulae Sheet | 204
�

13 Risk-Adjusted Measures of Performance

(i) Sharpe Performance Measure
Rp - R f
Sharpe measure, S =
σp

where:
Rp = average rate of return for portfolio
Rf = risk-free rate of return
σp = standard deviation of return for portfolio

(ii) Treynor Performance Measure

Rp - Rf
Treynor measure, T = β
p

where βp = beta for portfolio

(iii) Jensen Differential Return Measure

The expected return on a portfolio is given as:

Re = Rf + βp (Rm - Rf )

The portfolio's alpha is then the difference between the portfolio's actual return during the
period and the return that would be expected from the CAPM.
αp = Rp - Re
= Rp - [Rf + βp (Rm - Rf)]

Equity Securities
14 Time Value of Money
(i) Future value of an investment if compounded annually at a rate of k for n years:

FVn = PV1 + k n

where:
FVn = future value of the investment at the end of n years
PV = present value or original amount invested at the beginning of the first year
n = number of years during which the compounding occurs
k = annual interest (or discount) rate

(ii) Compounded annual growth rate (CAGR) is the effective rate that is earned on the initial
cash flow:
1
FV n
CAGR =   - 1
PV

where:
CAGR = the compounded annual growth rate
FV = future value
PV = present value
n = number of years in the time period

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�

(iii) Future value of an investment for which interest is compounded more than once a year:

FVn = PV(1 + k/m)mn

where m = number of interest periods in the year

15 Present Value of a Single Cash Flow

Present value of an investment:

FVn
PV =
(1 + k)n

where:
PV = present value of the future sum of money
FVn = future value of the investment at the end of n years
n = number of years to the receipt of payment
k = annual discount (or interest) rate

16 Annuities
(i) Present value of an annuity:

1 - (1 + i)-n
PVannuity = C × 
i

Where:
C = cash flow per period
I = interest rate
N = number of payments

(ii) Future value of an annuity

(1 + i)n -1
FVannuity = C × 
i

where:
C = cash flow per period
I = interest rate
N = number of payments

17 Dividend Yield
(i) Dividend Yield:

Dividend Per Share

Dividend Yield = x 100
Market Price Per Share

(ii) Dividend Discount Model:

D1 D2 D3 D∞
Po = + + +…+
2
(1 + k) (1 + k) (1 + k) 3 (1 + k)∞

Capital Markets and Financial Services Examinations

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 Appendix B - Formulae Sheet | 206
�

where:
P0 = intrinsic value or theoretical value of the share today
Dt = dividends expected to be received during period t
k = required rate of return (discount rate) on the share

(iii) Dividend Discount Yield for subsequent sale of the common shares:

D1 D2 Dn Pn
Po = + +…+ n+
(1 + k) (1 + k) 2 (1 + k) (1 + k)n

where:
n = holding period
Pn = expected selling price of the share at the end of year n.

18 Constant Growth Model

(i) Constant Growth Model where dividends are expected to grow at a constant rate (g) over
time:
D0 (1 + g) D0 (1 + g)2 D0 (1 + g)3 D0 (1 + g)∞
P0 = + + +…+
(1 + k) (1 + k)2 (1 + k)3 (1 + k)∞

where:
P0 = intrinsic value or theoretical value of the share today
D0 = dividend payment in the current period
g = constant growth rate of dividends
k = required rate of return (discount rate) on the share

(ii) The above equation can be simplified to:

D1
P0 =
k-g

where D1 = dividend expected to be received at the end of year 1

(ii) Required rate of return under the Constant Growth Model

D1
Required Rate of Return k = + g
P0

19 Estimating Expected Growth Rate of Dividends

(i) The growth rate of dividends (g) is a function of the return on equity (ROE) and the retention
rate: g = Retention Rate x Return on Equity = RR x ROE

20 Multiple Growth Model

(i) For a two-period growth model:
n
D0 (1 + g1 )t Dn (1 + gc )t 1
P0 =
+
1 + k t k- gc 1 + k n
t=1

where:
P0 = intrinsic or estimated value of the share today

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�

D0 = current dividend
g1 = supernormal (or subnormal) growth rate for dividends
gc = constant-growth rate for dividends
k = required rate of return
n = number of periods of supernormal (or subnormal) growth
Dn = dividend at the end of the abnormal growth period

(ii) Zero-Growth Model

Dividend
P0 =
Discount Rate

21 Valuation Ratios

Market Price Per Share

(i) Price-Earnings Ratio (P/E) =
Earnings Per Share
PE
(ii) Price Earnings Growth Ratio (PEG) =
% Growth in Earnings
Market Price Per Share
(iii) Price to Book Value Ratio (P/B) =
Book Value Per Share
Current Market Share Price
(iv) Price to Sales Ratio =
Sales Per Share
Current Market Share Price
(v) Price to Cash Flow Ratio =
Cash Flow Per Share

Fixed Income Securities

22 Price Quotations
D 360
(i) Yield on a Bank Discount Basis = Yd =
F× t
where Yd = annualised yield on a bank discount basis (expressed as a decimal)
D = dollar discount, which is equal to the difference between the face
value and price
F = face value
t = number of days remaining to maturity

Bond Pricing, Return Measures and Interest Rates

23 Bond Valuation
(i) Value of Bond (With Annual Interest):
n
Ct M
P =
t+
(1 + k) (1 + k)n
t=1

where P = present value of the bond today (t = 0)

Ct = coupon payments for each period t
M = maturity value
n = years of maturity
k = required rate of return (also known as yield to maturity)

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�

(ii) Value of Bond (With Semi-Annual Interest):

2n
Ct M
P =
t+
t=1
(1 + k/2) (1 + k/2)2n

M
(iii) Value of a Zero-Coupon Bond = P = 2n
(1 + k/2)

24 Yield Measures
Annual Interest Payment
(i) Current Yield = �
Bond Price
(ii) Yield to Maturity (k) can be determined by solving the following equation for k:

C1 C2 C3 C2n M
P= + + +…+ +
2
1 + k/2 (1 + k/2) (1 + k/2)3 1 + k/2 2n 1 + k/2 2n

(iii) Effective Annual Yield = (1 + Semi-Annual Interest Rate)2 – 1

Annual Interest Payment ± Amortised Gain or Loss

(iv) Approximate Yield To Maturity =
Current Market Price + Par Value /2

(v) Yield to Maturity (k) for a Zero-Coupon Bond can be determined by solving the following
equation for k:

k Maturity Value 1/2n

=  - 1
2 Price
Tax Exempt Yield
(vi) Taxable Equivalent Yield =
1 - Marginal Tax Rate

25 Analysis of Convertible Bonds

(i) Conversion Value = Conversion Ratio x Share Price

Par Value of Convertible Bond

(ii) Conversion Ratio =
Conversion Price
Market Price of Convertible Bond
iii Conversion Parity Price =
Conversion Ratio

(iv) Conversion Premium ($) = Market Value of CB - Minimum Value

Market Value of CB - Minimum Value

(v) Conversion Premium % =
Minimum Value
Conversion Premium
(vi) Breakeven/Payback Period =
Bond Income - Dividend Income
Market Price of Convertible Bond
(vii) Premium Over Straight Value % = - 1
Investment Value

Capital Markets and Financial Services Examinations

Module 6 – Securities Products & Analysis�
209 | Appendix B - Formulae Sheet
�

Warrants
26 Warrant Valuation

(i) For Call Warrants: (Settlement Price of Underlying at Expiry – Exercise Price of Warrant) ÷
Conversion Ratio of Warrant

(ii) For Put Warrants: (Exercise Price of Warrant – Settlement Price of Underlying at Expiry) ÷
Conversion Ratio of Warrant

(SP - EP)
(iii) Intrinsic Value =
n
�
where SP = share price
EP = exercise price
n = conversion ratio

(iv) Conversion Price = nWP + EP

where WP = warrant price (call)

(v) Call Warrant Premium ($) = nWP + EP – SP

nWP + EP - SP ×100
(vi) Call Warrant Premium % = SP

SP
(vii) Gearing Ratio = nWP

(viii) Minimum Value of Warrant = SP – EP

= Intrinsic Value if SP > EP
= 0 If SP ≤ EP

Foreign Exchange
27 The Forward Foreign Exchange Contract
S x (Rc - Rb) x n/360
(i) Forward Points =
1 + Rb x n/360

where S = spot rate

Rc = annualised interest rate of counter-currency
Rb = annualised interest rate of base currency
n = number of days from spot date

(ii) Interest Rate Parity:

n
1 + Rc ( )
F=S  360
n 
1 + Rb (
360 )

where F = forward rate

S = spot rate
Rc = annualised interest rate of counter-currency
Rb = annualised interest rate of base currency
n = number of days

Capital Markets and Financial Services Examinations

Module 6 – Securities Products & Analysis�
 Appendix D - Essential Readings |210
�

Appendix C
Essential Readings

1.� Analysis of Investments and Management of Portfolios / Frank K. Reilly, Keith C. Brown
2.� Fundamentals of Investment Management / Geoffrey A. Hirt, Stanley B. Block
3.� Essentials of Investments / Zvi Bodie, Alex Kane, Alan J. Marcus
4.� Fundamentals of investments: Valuation and Management / Bradford D. Jordan, Thoman W.
Miller, Steven D. Dolvin
5.� Investments: Principles of Portfolio and Equity Analysis / Michael G. McMillan, et al.
6.� Technical Analysis plain and simple: Charting the markets in your language / Michael N. Kahn

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Capital Markets and Financial Services Examinations

Module 6 – Securities Products and Analysis�