AAU SCHOOL OF COMMERCE

MARKETING DEPARTMENT
FINANCIAL MARKETS AND INSTRUMENTS

By: Mulugeta G/Medhin (PhD)

UNIT 1:INTRODUCTION TO
THE FINANCIAL SYSTEMS
Outline
• The what and why of the financial system
• The key concepts of the financial system
• The roles and functions of the financial system
• The five components of the financial system
• How the financial system functions through direct and indirect finance?
• Classification of financial institutions, financial markets, and financial
instruments
Top Stock Exchanges
Stock Exchange Market Capitalization
(Trillion USD)
NYSE 22.77
NASDAQ 16.24
Shangai Stock Exchange 6.74
Euronext 6.06
Japan Exchange Group 5.38
Shenzan Stock Exchange, China 4.7
Hong Kong Exchanges 4.56
NSE 3.34
Saudi Stock Exchange(Tadawul) 2.38
LSE Group – UK 3.1
TMX Group – Canada 2.68
SIX Swiss Exchange 1.83
Deutsche Boerse AG 1.89
Nasdaq Nordic and Baltics 1.86
ASX Australian Securities Exchange 1.68
Taiwan Stock Exchange 1.45
Tehran Stock Exchange 1.35
Johannesburg Stock Exchange 1.12
What is a financial system?

A financial Financial System

system matches the
needs of savers
a system that directly through
brings savers and financial markets
borrowers in an or indirectly
economy directly through financial
or indirectly. institutions.
 The what and why of the financial system
❑ A financial system comprises a range of financial
institutions, financial instruments, and financial
markets to facilitate the flow of funds.
❑ A financial system is essential in facilitating economic
growth fostering productivity, employment, and a
higher standard of living.
❑ Financial institutions and markets facilitate financial
transactions between the providers of funds (surplus
units) and the users of funds (deficit units or
borrowers).
❑ Surplus units (lenders or savers) invest in real assets
such as properties or financial assets such as stocks or
bonds depending on the return or yield, risk, liquidity,
and time pattern of cash flows.
Key Concepts of the Financial System

1) Risk and reward: The returns that investors expect to earn are positively related
to the risk they must bear
2) Supply and demand: The price of financial instruments such as shares, bonds,
options, futures, or swaps depends ultimately on supply and demand.
3) No-arbitrage: A trader cannot buy a financial instrument in one market at a low
price while simultaneously selling that same thing at a higher price in a different
market
4) The time value of money: An interest rate is the cost of borrowing or the price
paid to rent funds, usually expressed as a percentage.
Roles and Functions of Financial Systems

1. To transfer funds
2. To redistribute the unavoidable risk
3. To discover the price of the traded asset
4. To provide liquidity
5. To reduce the cost of transaction
6. Resource allocation function
7. Capital formation function
How the Financial System Functions:
The direct and indirect finance
Direct Finance
▪ In direct finance, borrowers borrow funds directly from lenders in financial
markets by selling them securities (also called financial instruments).
▪ Why is direct finance so important to the economy?
▪ The answer is that the people who save are frequently not the same people who
have profitable investment opportunities available to them, the entrepreneurs.
▪ Financial markets are critical for producing an efficient allocation of capital
(wealth, either financial or physical, that is employed to produce more wealth)
▪ Examples of direct financing include share issues, corporate bonds, and
government securities. These securities are discussed further in successive parts
of the training module.
 Benefits of Direct Finance Disadvantages of Direct Finance
• Direct finance is generally available only to • There can be a problem of matching the
corporations and government agencies that have preferences of lenders and borrowers.
established a good credit rating or creditworthiness. • The liquidity and marketability of a direct
• finance instrument may be of concern.
The main advantages of direct finance are as follows: • The search and transaction costs associated
• It removes the cost of a financial intermediary. with a direct issue can be quite high.
• It allows a borrower to diversify funding sources • It can be difficult to assess the level of risk of
by accessing both the domestic and international investment in a direct issue, particularly
money and capital markets. This reduces the risk default risk.
of exposure to a single funding source or market.
• It enables greater flexibility in the types of
funding instruments used to meet different
financing needs.
Indirect Finance
Indirect finance involves a financial intermediary that stands between
the lender-savers and the borrower-spenders

• The Benefits of Financial Intermediation

• asset transformation
• maturity transformation
• credit risk diversification and transformation
• liquidity transformation
• economies of scale.
Asset Transformation Maturity Transformation
▪ Financial intermediaries can ▪ Most frequently, savers prefer great liquidity in their
profitably receive small amounts financial assets, while borrowers tend to prefer a longer-
from many savers, pool them into term commitment in the funds they borrow.
larger amounts and make them ▪ By managing the deposits they receive, intermediaries are
able to make loans of a longer-term nature while
available as loans to borrowers.
satisfying savers’ preferences for shorter-term savings.
▪ Financial intermediaries engage This is referred to as maturity transformation.
in asset transformation by ▪ Financial intermediaries are able to perform such
offering their customers a wide extremes of maturity transformation for two reasons.
range of financial products. • First, it is unlikely that all savers would choose to
▪ Intermediaries specialize in the withdraw their deposits at the same time. Deposit
gathering of savings and can withdrawals during any particular period are generally
achieve economies of scale in more or less matched by new deposits.
their operations. • Second, financial intermediaries that engage in
maturity transformation rely on liability management.
Credit Risk Diversification Liquidity Transformation
▪ Savers generally prefer liquidity in their
and Transformation
investments.
▪ The credit risk exposure of the
▪ Banks have further extended liquidity
saver is limited to the risk of the
arrangements by adopting systems such as
intermediary defaulting. The
electronic networks: automatic teller machines
financial intermediary has a
(ATMs) and electronic funds transfer at point
separate loan agreement with
of sale (EFTPOS) arrangements.
the borrower and is exposed to
the credit risk of the borrower.
▪ Intermediaries specialize in Economies of Scale
making loans and therefore ▪ Financial intermediaries gain considerable
develop expertise in assessing economies of scale due to their size and the
the risk of potential borrowers. volume of business transacted and therefore
have the resources to develop cost-efficient
distribution systems.
Components of the Financial System
1) Financial institutions: Channel funds from those with surplus funds (suppliers of funds)
to those with shortages of funds (users of funds).
2) Financial markets: Provide the platform where financial assets (securities) such as
stocks and bonds are traded.
3) Financial instruments: known as financial securities, financial claims, or financial
assets are claims on future assets or earnings. They are assets to the borrowers and
liabilities to the issuers
4) Regulation of the financial system: needed to prevent market failures by improving
efficiency, reducing costs, and fostering competition.
5) Technology and financial infrastructure: improves the efficiency of financial markets
where electronic trading of stocks, bonds, and derivatives continues to replace physical
markets.
Classification of Financial Institutions
• The main function of financial institutions is intermediation to
channel funds from savers/surplus funds/ to users /deficit units/.
• Financial institutions can be classified as:
1. Depository institutions
2. Non-depository institutions.
Roles of Depository Institutions

• Depository institutions accept deposits from surplus units and provide

credit to deficit units through loans and purchases of securities.
• Roles of depository institutions.
▪ Offer deposit accounts that can accommodate the amount and liquidity characteristics
desired by most surplus units.
▪ Repackage funds received from deposits to provide loans of the size and maturity
desired by deficit units.
▪ Accept the risk on loans provided.
▪ Have more expertise than individual surplus units in evaluating the creditworthiness
of deficit units.
▪ Diversify their loans among numerous deficit units and therefore can absorb defaulted
loans better than individual surplus units could.
Types of Depository Institutions
1. Commercial Banks
2. Saving/thrift institutions
3. Credit unions
 Commercial Banks
▪ Commercial banks are the most dominant
Saving/Thrift Institutions
depository institution. ▪ Savings institutions, which are sometimes
▪ They serve surplus units by offering a wide referred to as thrift institutions include savings
variety of deposit accounts, and they transfer and loan associations (S&Ls) and savings banks.
deposited funds to deficit units by providing ▪ Like commercial banks, savings institutions offer
direct loans or purchasing debt securities. deposit accounts to surplus units and then
▪ Commercial bank operations are exposed to channel these deposits to deficit units.
risk because their loans and many of their ▪ Savings institutions can be owned by
investments in debt securities are subject to shareholders, but most are mutual (depositor
the risk of default by the borrowers. owned).
▪ Whereas commercial banks concentrate on
commercial (business) loans, savings
institutions concentrate on residential
Credit Unions mortgage loans.
▪ Credit unions differ from commercial banks and
savings institutions in that they (1) are nonprofit
and (2) restrict their business to credit union
members, who share a common bond (such as a
common employer or union).
▪ Like savings institutions, credit institutions are
sometimes classified as thrift institutions in order
to distinguish them from commercial banks.
Non Depository Institutions
• Non-depository institutions generate funds from sources other than
deposits but also play a major role in financial intermediation.
• Types of non-depository institutions
1. Finance companies
2. Mutual funds
3. Security firms
4. Insurance companies
5. Pension funds
Finance Companies Mutual Funds
▪ Finance companies raise funds by issuing ▪ Mutual funds sell shares to surplus units and
financial instruments/securities such as use the funds received to purchase a portfolio
commercial paper, medium-term notes of securities.
and bonds in the money markets and the
capital markets. ▪ Mutual funds are the dominant non-depository
financial institution when measured in total
▪ They use those funds to make loans and assets.
provide lease finance to their customers
in the household sector and the business ▪ Some mutual funds concentrate their
sector. investment in capital market securities, such as
stocks or bonds. Others, known as money
market mutual funds, concentrate in money
market securities.
▪ By purchasing shares of mutual funds and
money market mutual funds, small savers are
able to invest in a diversified portfolio of
securities with a relatively small amount of
funds.
 3. Securities Firms

▪ Securities firms include brokers, dealers, and underwriter & advisors.

▪ Some securities firms act as a broker, executing securities transactions between
two parties.
▪ The broker fee for executing a transaction is reflected in the difference (or
spread) between the bid quote and the ask quote.
▪ Securities firms often act as dealers, making a market in specific securities by
maintaining an inventory of securities.
▪ Although a broker’s income is mostly based on the markup, the dealer’s income
is influenced by the performance of the security portfolio maintained.
▪ Securities firms also provide underwriting and advising services.
▪ The underwriting and advising services are commonly referred to as investment
banking, and the securities firms that specialize in these services are sometimes
referred to as investment banks.
4. Insurance Companies 5. Pension Funds
▪ Insurance companies provide ▪ Pension funds provide an efficient
individuals and firms with insurance way for individuals to save for their
policies that reduce the financial retirement.
burden associated with death, illness, ▪ The pension funds manage the money
and damage to property. until the individuals with draw the
▪ These companies charge premiums in funds from their retirement accounts.
exchange for the insurance that they ▪ The money that is contributed to
provide. individual retirement accounts is
commonly invested by the pension
funds in stocks or bonds issued by
corporations or in bonds issued by the
government.
Classification of Financial Markets

▪ A financial market is a market in which financial assets (securities)

such as stocks and bonds can be traded (purchased or sold).
Basis of classification Types of Financial Markets
Seasoning or freshness of Primary market Secondary market
claim or security Issue
Nature of claim Debt market Equity market
Maturity of claim Money market Capital market
Timing of claim Spot/cash market Futures market
Organizational structure Exchange traded market OTC market
Structure of Financial
Markets
Financial Markets

By nature of By maturity of By timing of By organizational

claim claim delivery structure

Money Cash
Debt market Exchange traded
market market
market

Equity Capital Futures Over the counter

market market market market
Functions of Financial Markets
 Primary vs Secondary Markets
▪ A primary market is a financial market in which new issues of ▪ An important financial institution that
assists in the initial sale of securities in the
a security, such as a bond or a stock, are sold to initial buyers primary market is the investment bank. It
by the corporation or government agency borrowing the does this by underwriting securities: It
guarantees a price for a corporation’s
funds. securities and then sells them to the
▪ A secondary market is a financial market in which securities public.
that have been previously issued can be resold. ▪ Securities brokers and dealers are crucial
▪ Examples of secondary markets: New York Stock Exchange, to a well-functioning secondary market.
American Stock Exchange, NASDAQ, foreign exchange ▪ Brokers are agents of investors who match
markets, futures markets, and options markets. buyers with sellers of securities.
▪ The primary markets for securities are not well known to the ▪ Dealers link buyers and sellers by buying
and selling securities at stated prices.
public because the selling of securities to initial buyers often
takes place behind closed doors.
▪ Key functions of seconday market:
1) Liquidiy
2) Price discover
Debt and Equity Markets
1. Debt Financing
▪ A firm or an individual can obtain Issuing debt instrument, such as a bond
or a mortgage
▪ The borrower to pay the holder of the instrument fixed dollar amounts at
regular intervals (interest and principal payments) until a specified date
(the maturity date), when a final payment is made.
▪ The maturity of a debt instrument is the number of years (term) until that
instrument’s expiration date.
▪ A debt instrument is short-term if its maturity is less than a year and long-
term if its maturity is 10 years or longer. Debt instruments with a maturity
between one and 10 years are said to be intermediate-term.
Debt and Equity Markets (Cont’d…)

2. Equity Financing
• The second method of raising funds is by issuing equities, such as common stock,
which are claims to share in the net income and the assets of a business.
• Equities often make periodic payments (dividends) to their holders and are
considered long-term securities because they have no maturity date.
• Owning stock means owning a portion of the firm and thus have the right to vote
on issues important to the firm and to elect its directors.
• The main disadvantage of owning a corporation’s equities rather than its debt is
that an equity holder is a residual claimant; that is, the corporation must pay all
its debt holders before it pays its equity holders.
• The advantage of holding equities is capital gain because equities confer
ownership rights on the equity holders.
Exchange Traded and Over the Counter
Markets

• Secondary markets can be organized in two ways.

1. Exchanges, where buyers and sellers of securities (or their agents or
brokers) meet in one central location to conduct trades. The New
York and American Stock Exchanges for stocks and the Chicago Board
of Trade for commodities (wheat, corn, silver, and other raw
materials), ECX are examples of organized exchanges.
2. Over-the counter (OTC) market, in which dealers at different
locations who have an inventory of securities stand ready to buy and
sell securities “over the counter” to anyone who comes to them and
is willing to accept their prices.
Money and Capital Markets (Cont’d…)

▪ The money market is a financial market in which only short-term debt instruments (generally
those with original maturity of less than one year) are traded.
▪ The capital market is the market in which longer-term debt (generally with original maturity of
one year or greater) and equity instruments are traded. Money market securities are usually more
widely traded than longer-term securities and so tend to be more liquid.
▪ Short-term securities have smaller fluctuations in prices than long-term securities, making them
safer investments. As a result, corporations and banks actively use the money market to earn
interest on surplus funds that they expect to have only temporarily.
▪ Capital market securities, such as stocks and long-term bonds, are often held by financial
intermediaries such as insurance companies and pension funds, which have little uncertainty
about the amount of funds they will have available in the future.
 Classification of Financial
Instruments/Securities, Claims, or Assets/
• Financial instruments are claims on future assets or earnings.
• A financial instrument is issued by a party raising funds, acknowledging a financial commitment
and entitling the holder to specified future cash flows.
• For the holders a financial instrument is an asset and for the issuer a financial instrument is a
liability. However, if it represents equity, it will appear as part of shareholder funds (capital).
• A financial instrument acknowledges a financial commitment and represents an entitlement to
future cash flows.
• Financial instruments of securities can be divided into:
1. Money market securities
2. Capital market securities
3. Derivatives
Money Market instruments/Securities
• Money markets facilitate the sale of short-term debt securities by
deficit units to surplus units.
• Money market securities are debt securities that have a maturity of
one year or less.
• They have a relatively high degree of liquidity, not only because of
their short-term maturity but also because they are desirable to many
investors and therefore commonly have an active secondary market.
• Money market securities tend to have a low expected return but also
a low degree of credit (default) risk.
 Major Money Market Securities
1. Treasury bills: Securities Issued By Common Common Market
▪ T-bills with 4-week, 13-week, and 26- Investors Maturities Activities
week maturities on a weekly basis are
issued by government. Treasury bills Federal Households, 4 weeks, High
▪ Cash management bills: T-bills with government firms, and 13 weeks,
terms shorter than four weeks.
financial 26 weeks,
2. Commercial paper: a short-term debt instrument
issued only by well-known, credit-worthy institutions 1 year
corporations. Negotiable Large banks and Firms 2 weeks to Moderat
3. Negotiable certificates of deposit: issued by large certificates savings 1 year e
commercial banks and other depository institutions as of deposit institutions
a short-term source of funds.
(NCDs)
4. Repurchase agreements (Repos):
▪ One party sells securities to another Commercial Bank holding Firms 1 day to Low
with an agreement to repurchase the paper companies, 270 days
securities at a specified date finance
and price.
▪ The repo transaction represents a loan companies, and
backed by securities. If the borrower other companies
defaults on the loan, the lender has claim
to the securities. Repurchase Firms and Firms and 1 day to 15 Non-
agreements financial financial days existent
institutions institutions
Capital Market Instruments

• Capital market securities are commonly issued to finance the

purchase of capital assets, such as buildings, equipment, or
machinery.
• The three common types of capital market securities are:
1. Stocks/equity
2. Bonds
3. Mortgages
 1. Equity Securities/Stocks
▪ Stocks (or equity securities) represent partial • Preferred stock represents an equity interest in a
ownership in the corporations that issue them. firm that usually does not allow for significant
▪ The principal form of equity issued by a voting rights.
corporation is an ordinary share or common ▪ The first to receive payouts from the company.
stock. ▪ If the company is going through a loss and
▪ Ordinary shares have no maturity date; they winding up, the last payments will be made to
continue for the life of the corporation. preference shareholders before paying to equity
▪ The value of a corporation’s shares may increase shareholders.
over time, representing a capital gain. ▪ Preference shares that can be easily converted
Rights of ordinary shareholders into equity shares are known as convertible
▪ Voting right preference shares.
▪ Right to transfer ownership
▪ Some preference shares also receive arrears of
▪ Right to claim during liquidation dividends, which are called cumulative preference
▪ Liability limited by shares shares.
▪ Right to participate in profit
▪ Right issue or preemptive right
 2. Bonds
• Bonds are long-term debt securities • Treasury bonds are perceived to be free from
issued by the Treasury, government default risk because they are issued by the
government.
agencies, and corporations to finance
their operations. • Bonds issued by corporations are subject to
default risk because the issuer could default on
• Bonds provide a return to investors in its obligation to repay the debt.
the form of interest income (coupon • Corporation bond must offer a higher
payments) every six months. expected return than Treasury bonds in
order to compensate investors for that
• Since bonds represent debt, they default risk.
specify the amount and timing of • Bonds can be sold in the secondary market if
interest and principal payments to investors do not want to hold them until
investors who purchase them. maturity.

• At maturity, investors holding the debt

securities are paid the principal.
• Bonds commonly have maturities of
between 10 and 20 years.
3. Mortgages
• Mortgages are long-term debt obligations created to finance the purchase
of real estate.
• Residential mortgages are obtained by individuals and families to purchase
homes.
• Financial institutions serve as lenders by providing residential mortgages in
their role as a financial intermediary.
• Financial institutions pool deposits received from surplus units, and lend
those funds to an individual who wants to purchase a home.
• Financial institutions assess the likelihood that the borrower will repay the
loan based on certain criteria such as the borrower’s income level relative
to the value of the home.
• The home serves as collateral in the event that the borrower is not able to
make the mortgage payments.
 Derivative Securities
• In addition to money market and capital market securities, derivative securities are also traded in financial
markets.
• Derivative securities are financial contracts whose values are derived from the values of underlying assets
(such as debt securities or equity securities).
• Derivative instruments are different from equity and debt in that they do not provide actual funds for the
issuer. Funds need to be raised in either the equity or debt markets.
• Risks associated with equity or debt issues may be managed using derivative contracts.
• Many derivative securities enable investors to engage in speculation and risk management.
• Speculation Derivative securities allow an investor to speculate on movements in the value of the underlying
assets without having to purchase those assets.
• Risk Management Derivative securities can be used in a manner that will generate gains if the value of the
underlying assets declines. financial derivatives may be used to manage risk exposures related to both equity
and debt.
Four Types of Derivative Contracts
1. A futures contract is a contract to buy (or sell) a specified amount of a
commodity or financial instrument at a price determined today for
delivery or payment at a future date. Futures contracts are standardized
contracts that are traded through a futures exchange.
2. A forward contract is similar to a futures contract but is typically more
flexible and is negotiated over the counter with a commercial bank or
investment bank.
3. An option contract gives the buyer of the option the right—but not an
obligation—to buy (or sell) the designated asset at a specified date or
within a specified period during the life of the contract, at a
predetermined price.
4. A swap contract is an arrangement to exchange specified future cash
flows.
Thank you!
 UNIT 2
Money Markets and instruments
Outline
• Introduction
• The Objective and Importance of Money Markets
• Major Participants of Money Market
• Common Money Instruments, Their Yields and Values
 Introduction
• Money market refers to the network of corporations, financial institutions, investors, and
governments that deal with the flow of short-term capital.
• Liquid funds flow between short-term borrowers and lenders through money
markets
• Money markets involve debt instruments with original maturities of one year or
less
• Money market debt instruments are
• highly liquid
• easily marketable
• with low default risk
• with low cost of executing transactions.
• purchased by economic units that have excess short-term funds
• Money market instruments have active secondary markets
 Importance of Money Market
• Providing borrowers such as individual investors, government, etc. with short-
term funds at a reasonable price
• Enabling lenders to turn their idle funds into an effective investment.
• Helping central banks to regulate the level of liquidity in the economy.
• Providing an opportunity for the banks to park their surplus funds.
• Maintains a balance between the supply of and demand for the monetary
transactions
• Facilitates the financial mobility from one sector to the other
Money Market Participants
• Central Bank
• Commercial Banks
• Government
• Corporations
• Money Market Mutual Funds and Other Short-Term Investment Pools
• Futures Exchanges
• Dealers and Brokers
• Discount Houses and Acceptance Houses
Major Participants of Money Market (Cont’d)
1.Central Bank
• It is regarded as an apex institution (the monetary authority)
• No money market can exist without the central bank
• It raises or reduces the money supply and credit to ensure economic
stability in the economy
• It controls the money market through changes in the bank rate, bank
reserves and open market operations.
Major Participants of Money Market (Cont’d)
2. Commercial Banks
• Backbone of the money market
• The commercial banks put their excess reserves in different forms or
channels of investment
• Play three important roles:
• They borrow in the money market to fund their loan portfolios & satisfy
reserve requirements
• As dealers in the market for over-the-counter interest rate derivatives
• Provide, in exchange for fees, commitments that help ensure that investors
in money market securities will be paid on a timely basis
Major Participants of Money Market (Cont’d)
3. Government
• Raise funds in the money market by selling both fixed- and variable-
rate securities.
4. Corporations
• Raise funds in the money market primarily by issuing commercial
papers & banker acceptances
5. Money Market Mutual Funds and Other Short-Term Investment Pools
• purchase large pools of money market instruments and sell shares in
these instruments to investors
 Major Participants of Money Market (Cont’d)
6. Futures Exchanges
• Money market futures contracts and futures options are traded on organized
exchanges that set and enforce trading rules
7. Dealers and Brokers
• The smooth functioning of the money market depends critically on brokers and
dealers
• play a key role in marketing new issues of money market instruments and in
providing secondary markets
8. Discount Houses and Acceptance Houses
• Discount houses specialize in trading, discounting, and negotiating bills of
exchange or promissory notes
• Acceptance Houses act as agents between exporters and importers and lender
and borrower traders
 Money Market Instruments
• Treasury bills
• Negotiable certificates of deposit
• Commercial paper
• Money market funds
• Repurchase agreements (repos or RP)
• Banker acceptances (BA)
• Eurodollars
• Inter bank loans
• Short-Term Municipal Securities
 1. Treasury Bills (T-Bills)
▪ T-Bills are short-term debt obligations issued by national governments
▪ The Government buys and sells T-bills to implement monetary policy
▪ The National Bank of Ethiopia issues treasury bills on behalf of the
government with maturities of 28, 91, 182, and 364 days.
▪ T-bills are generally considered the safest of all possible investments
▪ They are virtually default risk free, are highly liquid, and have little interest
rate risk
▪ In cases where a government is unable to convince investors to buy its
longer-term obligations, treasury bills may be its principal source of
financing
 1. Treasury Bills (Cont’d)
▪ Are now popular in emerging economies with history of inflation and
political instability
▪ As countries develop reputations for better economic and fiscal
management, they are often able to borrow for longer terms rather than
relying exclusively on short-term instruments
▪ Characteristics:
▪ Virtually not default Risk
▪ Highly liquid
▪ Not taxable
▪ Minimum Denomination
 1. Treasury Bills (Cont’d)
T-Bill Auctions
• Bids are submitted by government securities dealers,
financial and nonfinancial corporations, and individuals
• Bids can be competitive or noncompetitive
• competitive bids specify the bid price and the desired quantity of
T-bills
• noncompetitive bidders get preferential allocation and agree to
pay the lowest price of the winning competitive bids
 1. Treasury Bills (Cont’d)
• General calculation for yield on Treasury bills (discount rate)

• This rate is underestimated

• Uses face value as denominator rather than price paid
• Uses 360 days rather than 365
• To calculate the true yield of a Treasury bill (investment rate) for comparison
with other money market yields, the discount must be divided by the price and
a 365-day year used.
• Example: In the weekly auction of treasury bills, an average price is Br97,912
per Br100,000 of face amount for a six-month (182-day) bills. Calculate the
annual rate of return on discount basis (discount rate) and the true yield.
1. Treasury Bills (Cont’d)
• The Price of Treasury bills is
• If the quote refers to discount rate
Price = Nominal value x [1 – (discount rate x Days to maturity/360)]
• If the quoted bill price is based on the rate of return or market yield
Price = Nominal value ÷ (1 + rate of return x Days to maturity/365)
• Example: Calculate the issue price of Treasury bills if the nominal value is
Br1 million, the discount rate is 9%, market yield is 9.5% and maturity is
28 days.
 2. Negotiable Certificates of Deposit
• A negotiable certificates of deposit (CDs) is a bank-issued time deposit that
specifies the interest rate and the maturity date
• Are interest-bearing bank deposits that cannot be withdrawn without penalty
before a specified date
• Negotiable CDs are bearer instruments and thus are salable in the secondary
market
• The redemption value and price of CDs can be calculated as follows:
• Redemption value = Initial deposit × (1 + coupon rate x term to maturity (fraction of a year))
• Price = Redemption value ÷ (1 + current short-term interest rate x days to maturity/360)
• For example, assume a Br1 million, 90-day CDs with a 9% coupon rate. Calculate
its redemption value and its price 36 days before maturity with 10% short-term
interest rate
 3. Commercial Paper (CP)
• CP is unsecured short-term corporate debt issued to raise short-term funds
(e.g., for working capital)
• Generally sold in large denominations with maturities between 1 and 270
days
• CP is usually sold to investors indirectly through brokers and dealers
• For many large, creditworthy issuers, commercial paper is a low-cost
alternative to bank loans
• Money market mutual funds (MMFs) and commercial bank trust
departments are the major investors in commercial paper.
 3. Commercial Paper (Cont’d)
• The yield and price of commercial papers are computed in
the same manner as Treasury bills.
• For example, Tana Corporation issued a 90-day, Br2,500,000 commercial
paper at a discount of Br60,000. Calculate the true yield on the commercial
papers. The paper was sold 49 days later when the market rate of return
was 10.5%. Calculate the price of the commercial paper on its date of sale.
6. Bankers Acceptance
• A Bankers Acceptance (BA) is a time draft payable to a seller of goods
with payment guaranteed by a bank
• Used in international trade transactions to finance trade in goods that
have yet to be shipped from a foreign exporter (seller) to a domestic
importer (buyer)
• Foreign exporters prefer that banks act as payment guarantors before
sending goods to importers
• Banker’s acceptances are bearer instruments and thus are salable in
secondary markets
 6. Bankers Acceptance (Cont’d)
• Bond equivalent yield of BA is calculated as follows:
Yield = (365 x discount yield) ÷ (360 – Days to maturity x Discount yield)
• The banker acceptance price using the bond equivalent yield method would then
be
Face value ÷ (1 + Bond equivalent yield x days to maturity/365)
• The Bank Discount Basis method of computing price of BA is follows:
Current price = Face value x (1 – discount yield x Days to maturity/360)
Example: Suppose a banker’s acceptance that will be paid is 90 days has a face
value of Br1,000,000 and the discount yield of 10%. Calculate
i) Bond equivalent yield
ii) Price of Bankers Acceptance using both methods
 5. Repurchase Agreement
• A repurchase agreement (repo or RP) is the sale of a security with an agreement
to buy the security back at a set price in the future
• Repos are short-term collateralized loans
• A reverse repurchase agreement is the opposite side of a repo (i.e., it is the
purchase of a security with an agreement to sell it back in the future)
• characteristics of repos
• Maturities: overnight or a few days
• Principal Amounts: usually arranged in large amounts
• Yields: agreed upon interest rate or the difference between repurchase price and initial
sales price as percentage
• Determinants of RP Rates: Interest rate on repo is set independently of the coupon rate or
rate on the underlying security.
 5. Repurchase Agreement (Cont’d)
• Yield or repo rate if the repurchase price is set above the initial sales
price can be computed as follows:
Yield = (Repurchase Price – Initial Sales Price) ÷ (Initial Sales Price x Days
to maturity/365)
• If there is an agreed repo rate, the amount of payment at maturity
would be
Initial Sales Price × (1 + repo rate x days to maturity/365)
Example
• A trader enters into a repurchase agreement with a hedge fund by agreeing to
sell Treasury bills with a market value of Br10,000,000 to a hedge fund at a repo
rate of 9% with a fixed one-week tenor. What is the total payment that the trader
must make to the hedge fund at the end of the repurchase agreement? If the
repurchase price is Br10,020,000, What will be the repo rate (yield)?
Activity 3
• What are the characteristics of money market instruments?
• What is the difference between overnight and continuing contracts of
repos?
• Assuming a face value of Br10,000, what is the price of a T-bills with
91 days to maturity if its yield is 5 percent?
 Discussion Question
• Entity A paid Br4,890,270.04 on the date of issue for a Br5,000,000 face
value T-bills with a 364-day term. Entity A received Br4,963,020.21 when it
sold it to Entity B 217 days after the date of issue. Entity B held the T-bills
until maturity. Determine the following:
i. Entity A’s actual rate of return.
ii. Entity B’s actual rate of return.
iii. If Entity A held onto the T-bills for the entire 364 days instead of selling it to Entity
B, what would its rate of return have been?
iv. Comment on the answers to (a) and (c).
Thank you
FIXED INCOME
SECURITIES

Unit III
Outline
• What is fixed Income and what is a bond
• Who buys bonds, who issues bonds, and the bond market
• The concepts of yield, coupon, and day count
• Price of a bond & the relationship between price and yield
• Yield curve
1) Overview of Fixed Income Instruments
What is Fixed Income?
• Fixed income is a broad class of financial products that
comprises any investment where the investor earns a
set payment on a pre-determined schedule.

Debt instrument
(e.g. fixed income)

and Equity instrument

(e.g. stocks)
Capital Stack
• Capital is the amount of money that the company has invested in it.
• The capital stack identifies the priority of claims on a company’s assets.
Low Risk
Low Return

Subordination
Senior Debt
Subordinated Debt

Equity High Risk

High Return
 Types Fixed Income
Common Fixed-Income investment products:-

1) Bond
2) Asset-backed securities (ABS)
3) Mortgage-backed securities (MBS)
4) Preferred securities
Introduction to Bonds cont’d…………………..

Principal Coupon

The amount that the issuer The set interest paid in a pre-
owes to the investor; paid at determined schedule (e.g.
maturity annually or semi-annually)

Par value:
$100 for calculation purposes
Government bonds:
Face value / nominal value: Minimum $100, €100 or £100
the actual investment amount Corporate bonds:
Minimum $5,000; $100,000 for higher risk bonds
Example of a 10 Year Bond
$1000

The Great Western Petroleum Company

ONE THOUSAND DOLLARS Face value / nominal value

MATURITY DATE
30 September 1970 Maturity date
$1000
TGWPC

Coupon (paid annually)

$50 $50 $50 $50 $50

Tradition of coupon

$50 $50 $50 $50 $50

Risks of Investing in Bonds
• The risks of investing in bonds are similar to time value of
money (TVM) concept.

Inflation Default risk

2) Types of Bond
 Types of Bonds
Fixed Income Instruments (Bonds) can generally be divided as follows.

Governments

Increasing Risk Sovereigns, Supranationals, and Government or

Agencies (‘SSAs’) Government-related

Government-Sponsored
Enterprises (‘GSEs’)

Corporates
US Treasuries
Maturities

1-year 2-year 10-year 30-year

Bills (<1 year) Notes (2-10 year) FRNs (2-year) Bonds (20-year+)
• • • •
• •
Zero-coupon coupon Trade in in
Discount • Trade in • Fixed rate notes price

• •
• •
Awash Barro Abay
Corporate Bond

Corporate Bonds
Coupon Offering Format
Ranking Type Series
Senior vs. Subordinate Fixed, Eurobonds
floating, zeros
Provisions
Eg Ethiopian
Callable / Putable
Rated vs. loan balance
Unrated (Eurobond)
Convertible $1Billion
 • Preference Shares
• Sometimes called Subordinated Debt, these type of fixed income
securities rank lower on the capital stack.
• Preferred fixed-income securities may not pay their coupon or principal should the
creditworthiness of the issuer deteriorate.
• This risk is called loss-absorption and hence Preferred are sometimes viewed as a hybrid
security between fixed income and equities.
• In the case of preference shares, the dividend is payable at a fixed rate as appropriation of
profits.
• However, the company may not pay a preference dividend if it does not have divisible
profits or enough liquidity.
• No such practice in Ethiopia
3) Participants of the Bond Market
Who Issues Bonds?
• Bonds are essentially loans.
• Issuers are entities that are looking for financing.
National governments
Borrow money when they have a budget deficit or to finance social mandates

Corporates
Raise money in bond markets to fund operations and growth

Regional governments and municipalities

Raise money to fund projects or when they have budget deficits

Supranationals and agencies

Examples include the World Bank and the Asian Development Bank
 Types of Issuers for Corporate Bonds
• Corporate bonds are classified into industry groups.
Consumer staples /
Materials / Industrials
Consumer discretionary

Communications /
Technology Utilities / Energy

Financials
Healthcare
Covered
Who Invests in Bonds?
Central banks / governments
Who buys bonds and why?
Assets managers
• Reasons to invest in
Insurance companies
bonds: Institutional
investors Pension funds
Liquidity
Hedge funds

Different risk profile

Corporates / family offices
relative to equities

Easy for investors to Retail Individuals

match their liabilities

investors Private banks / brokers
4) Bond Market
Bond Market
The bond market is one of the largest
Example: 2018 US bond
financial markets in the world. market
Global equity market (2018): • Bond issued: $2.2 trillion
$> 100 trillion
• Equity issued: $221 billion
Global bond market (2018): • Bond traded per day: $827 billion
$102.8 trillion
• Stock traded per day: $270 billion

Trades in all Trades 24/5 across different Most of the time

major currencies Over-the-counter
financial centers
(OTC)
External financing of American businesses in the 1970–2000 period
5) Concept of Coupon & Day Counts
Coupon and Accrued Interest
• Coupon: the set interest of a bond paid in a pre-determined schedule.
• Accrued interest: accumulated interest that is unpaid.

Accrued interest Coupon payment

Year 1 Year 2 Year 3

Day Count Basics
How is accrued interest calculated?

Day count convention affects how coupons are calculated and paid.

Day count market conventions:

Actual/Actual 30/360 Actual/365

 1) Actual/Actual Method
• Interest accrues based on the actual number of days since the last coup
payment over the actual number of total days between coupon periods.
Coupon: Coupon:
Example:
• Face value: $100
Jan 1 Mar 15 Jun 30 15 Dec 31
• Maturity: December 31 Se
74 Days p
• Annual interest: 5% 181 Days 77 Days

• Frequency: Semi-annually 184 Days

Coupon = 100 x 5% = $2.5
• Mar 15…Actual #of 2
days=31+28+15=74 Accrued i n t e r e s t o n Sep15

Accrued interest on Mar 15

• Sep 15…total Actual #of days=181-
74+77=184 74 =2.5 x
= $1.05

=2.5 x = $1.02
77

181 184
2) 30/360 Method
30/360 day count assumes:
• Every month has 30 days. 30 Days 1/12 th of the coupon evenly

• Every year has 360 days. 360 Days

Jan 1 Mar 15 Jun 30 Sep 15 Dec 31

75 Days 75 Days

Example: 180 Days 180

Days
• Face value: $100

• Maturity: December 31
Coupon = 100 x 5% = $2.5
2
• Annual interest: 5%
Accrued i n t e r e s t o n Sep15

• Frequency: Semi-annually
Accrued interest on Mar 15
75 =2.5 x = $1.04

=2.5 x = $1.04
75

180 180
3) Actual/365 Method
Actual/365: A hybrid of ACT/ACT and 30/360
• Each half of the year is 182.5 days.
• The daily rate of accrual is constant between coupon periods.

Example: Jan 1 Mar 15 Jun 30 Sep 15 Dec 31

• Face value: $100 74 Days 77 Days

182.5 Days 182.5

• Maturity: December 31 Days

• Annual interest: 5% Coupon = 100 x 5% = $2.5

2

• Frequency: Semi-
Accrued i n t e r e s t o n Sep15

Accrued interest on Mar 15

annually 74 =2.5 x = $1.05

=2.5 x = $1.01
77

182.5 1 8 2 .5
6) Bond Yield
What is Yields?
• Yields are the potential return of holding a bond.
• It is what a Investors can expect to receive:

Interest Principal Income from

Capital
payments repayments reinvesting
gain coupons
Three Measures of Yield
Generally, we look at three different measures of yield:

Flat (Current)
Yield-to-maturity Yield-to-call
yield
Annual income divided Total anticipated The return if the
by the current price of return if the bond is bond is called
the investment held to maturity before maturity
1) FLAT (Current) Yield
Current yield =
Annual dollar coupon
Current price

Example: Annual dollar coupon = 100 x 5% = $5.00

• Face value: $100
Current yield = 5 = 4.76%
105
• Coupon rate: 5%, paid
annually
• Current price: $105 Simple yield
2) Yield-to-Maturity (YTM)
• Yield-to-maturity: the internal rate of return (IRR) of all the
cash flows from the bond. Actual return
Example: 5 5 5 5 100 +5
105 = 1 + 2 + 3 + 4 +
5
• Face value: $100 1+YTM 1+YTM 1+YTM 1+YTM 1+YTM

• Term to maturity: 5 years

• Coupon rate: 5%, paid annually
Yield-to-maturity = 3.88%
• Current price: $105

An investor will only realize the YTM stated at the time

of purchase if:
1) The coupons are reinvested at the same YTM.
2) The bond is held to maturity.
7) Bond Prices and Yields
Bond Price
• A Bond is made up of a series of
1
periodic interest payments and a PV = FV x n
1 +i
principal repayment at maturity.
1
OR = FV x
• The bond price is the 1 +i /f
years x f

discounted value of all the future

cash flows generated by a bond. • PV: Present value

• FV: Future value

• The present value of all
• i: Interest rate (yield-to-maturity)
coupon payments
• n: Number of periods
• The present value of the par • f: Frequency (number of payments per year)
value at maturity
 Bond Valuation (Continued)

Basic Valuation Model:

PVIF-Present Value Interest Factor
Bond Valuation (Continued)
Example:- Bond Price
• Suppose a bond that has a 10% annual coupon and a face value of $1000.

• There are 20 years to maturity and the yield to maturity is 8%.

• What is the price of this bond?

Solution: Using the formula: I(1- 1/(1+r) n/r + FV(1+r)n
B = PV of annuity + PV of lump sum
• B = 100[1 – 1/(1.08)20] / .08 + 1000 / (1.08)20

• B = 981.81 + 214.55 = $1,196.36

 Clean Price vs. Dirty Price
There are two different prices for a bond:
• Clean price: the price that is quoted without accrued interest.
• Dirty price: the clean price plus accrued interest.
Pric
e

Coupon payment Actual “dirty” price

Accrued interest

Year 1 Year 2 Year 3

Underlying “clean” price
(The price we calculated earlier)
Time
1) Bond Price (Premium)
Example 1:
Year Future values Present values
• Bond: 3 years
• Par value: $100 1 5 4.81
• Coupon: 5% ($5 per year)
• Yield-to-maturity: 4% 2 5 4.62

3 105 93.34

Price 102.78 Trading at

premium
2) Bond Price (At Par value)
Example 2:
Year Future values Present values
• Bond: 3 years
• Par value: $100 1 5 4.76
• Coupon: 5% ($5 per year)
• Yield-to-maturity: 5% 2 5 4.54

3 105 90.70

Price 100.00 Trading at

par
3) Bond Price (At discount)
Example 3:
Year Future values Present values
• Bond: 3 years
• Par value: $100 1 5 4.72
• Coupon: 5% ($5 per year)
• Yield-to-maturity: 6% 2 5 4.45

3 105 88.16
Trading at a
Price 97.33
discount
8) Yield Curves
Yield Curves
❖ The yield curve is a graphical representation
at a point of time of the yields for a range of
maturities.
Yield (%)

❖ The yield curve DOES NOT show change

in yields over time.
❖ It can be constructed by observing and
plotting bond yields trading in the secondary
market of different maturities.
Maturity (years)
• Yield curves can plot bonds that are from:
• The upwards slope means that long- a) the same issuer (issuer yield curve)
b) the same group of issuers by industry
term investments pay a higher (sector yield curve)
return than shorter- term c) the same credit rating (rating yield curve)

investments.
•Thank You!
 Unit IV
Equity Securities & Market

Equities
Outline
• Definition of equity
• Types of Equity Securities
• Markets, Exchanges and Indexes
• Equity Categorizations
• Valuation & Trading Techniques
 Equity Securities

• Also known as stock or shares.

• Ownership stake of a company (companies may pursue equity
financing to raise money)

• Equity security types are defined by

• The nature of the issuing company and
• The particular rights that are assigned to the individual securities.
 Types of Equity Securities

• The primary types of equities:

• Common stock,
• Preferred shares,
Common Stock

What is Common Stock?

Features of Common Stock
• Major financing vehicle for
• Participate in company’s profits (through dividends
corporations.
and capital gains)
• Reflects equity ownership of a
company • Voting rights (for corporate policies and electing board
of directors)
• Also referred to as common
share, voting share, ordinary • May have multiple share classes (example: voting vs.
share non-voting)

• Higher risk relative to preferred

stock or bonds
Classes of Common Stock
• Some companies issue multiple classes of common stock with different voting rights.
• For example, Alphabet Inc., the parent company Google, has three share classes:
• Class A, ticker GOOG, which has one vote per share
• Class B, no ticker, as these shares are privately held by the founders and other insiders,
which have 10 votes per share
• Class C, ticker GOOGL, which have no voting rights
• The rationale in this case for establishing multiple classes of common stock is that
the original ownership group, Class B, wanted to retain voting control over the
direction of the company.
Preferred Stock

What is Preferred Stock? Features of Preferred Stock Types of Preferred Stock

• Reflects equity ownership of • Priority claim of assets (in a • Convertible: option to convert
a company liquidation event) and to common shares
• Also referred to as dividends, relative to common • Cumulative: unpaid dividends
preference share or shareholders are added to the next dividend
preferred share • Typically no voting rights • Participating: additional
• Higher risk relative to bonds • Fixed dividend payments participation in the upside
• Callable: shares may be
repurchased by the company
Public vs. Private Equity

Public Equity Private Equity

Corporate Finance Institute®

 Public vs. Private Equity

Public Equity Private Equity

Features Types Features Types

• Listed on public • Public company • Not listed on • Private equity

exchanges shares public exchanges • Venture capital
• Liquid (high volume) • Exchange traded • No active • Distressed capital
funds (ETFs) secondary market
• Detailed financial • Private real estate
reports • Mutual funds • Typically illiquid
• Active secondary
market
Greater liquidity and stocks can be easily traded on the exchange Illiquid investment resulting in difficulty in exiting investments
corporatefinanceinstitute.com
Stock Exchanges

Markets used by individuals and firms to

purchase and sell securities which are listed
on that exchange

Highly liquid and involve digital trading of

securities

Exchanges require companies to achieve

certain metrics prior to being listed

New York Stock Exchange (NYSE) Requirements

• 400 shareholders or more • $40M in marketcapitalization

• At least 1.1 million shares publicly listed

Corporate Finance Institute®

Over-The-Counter (OTC)

Over-The-Counter (OTC) includes securities which are not traded on public stockexchanges.

Why OTC? Benefits Disadvantages Examples

• Securities which don’t • Accessto unlisted • Less liquidity (due to • Best Market (OTCQX)
meet listing securities low volume) • Venture Market
requirements for other • Fewerregulations • Less public information (OTCQB)
exchanges
• Highly volatile • Pink Open Market
(beneficial for traders)

Corporate Finance Institute®

 Understanding Market Indexes
• Markets worldwide compute one or more indices of prices of the shares of their
country’s large companies

• Indexes: measure the current price behavior of a representative group of stocks

in relation to a base value set at an earlier point in time.

• Role:
• Market barometer
• Performance measurement against benchmarks
• Basis for index derivatives contracts and many tracker products
• To support investment research and asset allocation
• In general it depicts the market’s historical performance and use that as a guide
to understand future market behavior
Indexes

A stock index is composed of selective stocks, used to measure the performance of the chosen companies
as an aggregate.

01 02 03

Price-Weighted Index Capitalization-Weighted Index Equal-Weighted Index

Weighted by share price Weighted by market Weighted equally by

• High share price = high capitalization investment
weight • High market cap = high • Same capital invested into
weight each company
• Example: Dow Jones
Industrial Average (DJIA) • Example: S&P500 • Example: Equal Weight
ETFs
• Requires frequent
rebalancing

Corporate Finance Institute®

 Figure
The DJIA Average Compared to the S&P 500 Index from June 1, 2016 to June 1, 2018

During this period, both indexes followed a rising trend, with the DJIA gaining about 38% and the
S&P 500 gaining about 30%. (Source: Yahoo! Finance screenshot,
http://www.finance.yahoo.com.)
Global of Securities Markets

• Securities exchanges now operate in more than 100 countries worldwide.

• Top securities markets (based on dollar volume) worldwide:
• NYSE
• Nasdaq
• Shanghai
• Euronext
• London Stock Exchange
• Tokyo Stock Exchange
• Increasing number of mergers and cooperative arrangements between securities
exchanges worldwide represent steps toward a worldwide stock exchange.
• Bond markets too have become global: Investors regularly purchase government
and corporate fixed-income securities in foreign markets
 Distributions of World Equity Market
▪ The World Federation of Exchanges provides data from global stock exchanges. As
illustrated in the following graph, global market capitalization was over U$109 trillion at
the end of 2020 (note that not all stock exchanges provide data to the World Federation
of Exchanges so actual figures may well be higher).

▪ Global market capitalization is the total value of shares quoted on the world’s stock
exchanges.
 General Market Conditions: Bull or Bear

• Bull market: Conditions in security markets associated

with rising prices, investor optimism, economic recovery,
and government stimulus.
• Prolonged rising stock market, coined on the analogy that a
bull attacks with his horns from the bottom up.

• Bear Market: Conditions in security markets normally

associated with falling prices, investor pessimism,
economic slowdown, and government restraint
• Prolonged declining market, based on the analogy that a
bear swipes with his paws from the top down.
Equity Categories
Sectors &
Industries Size
Individual
• Financials • Small cap
vs. Fund
• Materials • Mid cap
• Individual • Gaming • Large cap
• Funds (ETFs, • Mega cap
Mutual)

Categories
of Equity
Security
Investor Type • Common
Cyclicality • Preferred
• Growth
• Value • Cyclical • Convertible/
• Income • Defensive Hybrid
(non-cyclical)
Classification by Market • Highest market cap size
• Lowest market cap size
Capitalization • Highest liquidity/volume of
shares traded
• Lowest liquidity/volume
Nano Cap of shares traded
• Lots of equity research
• $50M & lower • Not much equity
coverage
research coverage
Market Capitalization • Ex. iFresh Inc.

• The equity value of a firm (publicly traded shares) Micro Cap

Mega Cap
• Used as an approximation of size (no debt included) • $50M - $300M
• $200B & higher
• Ex. Aware, Inc.
• Ex. Apple Inc.

Formula
Market Cap
• Market Cap = Shares Outstanding * Price per Share
• Market cap usually fluctuates daily Large Cap Small Cap

• $10B - $200B *B = Billion USD • $300M - $2B

• Ex. General
* M = Million USD • Ex. RE/MAX
Different Sizes Electric Holdings, Inc.

• The market cap thresholds for each size vary, and Medium Cap
there are no firm guidelines (just estimates) • $2B - $10B
• These change with population, inflation, and total • Ex. Macy’s, Inc.
market value
Cyclical Vs Defensive equities

• Are two different types of stocks that behave differently in the stock market.
• Cyclical stocks are more sensitive to the overall economy, while defensive stocks are
less sensitive.
• Cyclical stocks tend to do well when the economy is growing and do poorly when the
economy is in a recession.
• Defensive stocks, on the other hand, tend to do well in both good and bad economic
times. This is because defensive stocks are not as sensitive to the overall economy.
• Defensive stocks tend to be in industries that are essential to the economy, such as utilities,
healthcare, and consumer staples.
• These industries are less likely to be affected by economic downturns, as people still need
to buy things like electricity, healthcare, and food.
Sectors

Sectors (created by S&P and MSCI) sort companies by business activity.

Consumer Consumer
Financials Utilities
Discretionary Staples

Energy Health Care Industrials Technology

Telecom Materials Real Estate

Corporate Finance Institute®

Types of Funds –Overview

Pooled Funds

Exchange Traded Funds

Mutual Funds
(ETFs)

Open-End Closed-End

Corporate Finance Institute®

Value, Growth, Income, Preservation,Absolute Return
Goal Focus (General Guidelines) Methods of Assessing Examples

• Intrinsic
Invest in stocks which
• Low Price/Book Value Ratio Valuation • Kraft Heinz
are undervalued
• Low P/E Ratio Methods • Molson Coors
Value Stocks (trading at a
• DCF Analysis
discount)
• Comps Analysis

Invest in growing • Trending Industry • Find hot sectors • Amazon

Growth Stocks companies or sectors • Trending Stock • Revenue multiple • Alibaba

Invest in securities which • AT&T

• High dividend yield • Consistent high
offer high yields for • General Mills
• Blue chip stocks dividend
Income Strategy consistent income • High yield bonds

• Safe, low risk investments • Berkshire

Preserve capital and
• Diversify geographies • Low risk Hathaway
avoid losses (reducing
• Options strategies for (reputable • Johnson & Johnson
Capital Preservation return for lower risk)
downside protection firm, safe security) • Put options

• Risk management
• Sharpe ratio (risk-
• Focus on absolute • Vanguard
Achieve positive returns adjusted
returns (not relative Alternative
and limit losses performance)
Absolute Return to a market) Strategies Fund
• Low portfolio
• Invest in a variety of (VASFX) ETF
standard deviation
securities and
Corporate Finance Institute®
instruments
Equity/Stock Valuation
Equity/Stock Valuation
• A fair investment is one that gives investors a return that matches the risk.
• Some investments are so expensive that we will not receive a fair return if we buy
them. These investments are said to be overvalued.

• Some investments are so cheap that they offer a rate of return that is a greater
reward than the risk. These investments are said to be undervalued.
• The purpose of equity valuation is to determine whether a stock is fairly priced,
overpriced, or underpriced.

• The two approaches to valuation:

• Discounted cash flow (DCF) valuation and
• Relative valuation.
Stock Valuation

• Value of a share of stock → the present value of its expected future cash
flow…
• Cash dividends paid (if any).
• Future selling price of the stock.
• The discount rate i.e., risk-appropriate rate of return to be earned on the
investment.
• No guaranteed cash flow information.
• No maturity date.
• Valuation is more of an “art” than a science.
 Stock Valuation
Table - Differences Between Bonds and Stocks
Stock Valuation

Three variations of a dividend pricing model have been used to

value common stock

1. The constant dividend model.

2. The constant growth dividend model.
3. Two-stage or multistage growth.
The Constant Dividend Model

Assumes that the firm is paying the same dividend

amount in perpetuity.
i.e., Div1 = Div2 = Div3 = Div4 = Div5 = Div∞Infinity
For perpetuities,
PV = PMT ÷ r
where r is the required rate and PMT is the cash flow.
Thus, for a stock that is expected to pay the same dividend forever,
Price = Dividend ÷ Required rate of return
The Constant Dividend Model

Example: Quarterly Dividends Forever

Let’s say that the Peak Growth Company is paying a quarterly dividend of Br 0.50
and has decided to pay the same amount forever. If Joe wants to earn an annual
rate of return of 12% on this investment, how much should he offer to buy the stock
at?
Answer
Quarterly dividend = Br 0.50
Quarterly rate of return = Annual rate ÷ 4 = 12% ÷ 4 = 3%
PV = Quarterly dividend ÷ Quarterly rate of return
Price = 0.50 ÷ 0.03 = Br 16.67
The Constant Growth Dividend Model

Example: Constant Growth Rate, (with Growth Rate Given)

Let’s say that the Peak Growth Company just paid its shareholders an annual dividend
of Br2.00 and has announced that the dividends would grow at an annual rate of 8%
forever. If investors expect to earn an annual rate of return of 12% on this investment
how much would they offer to buy the stock for?

Div0 = Br2.00; g = 8%; r = 12%

Div1 = Div0 × (1 + g)
→Div1 = Br2.00 × (1.08) → Div1 = Br2.16
P0 = Div1 ÷ (r − g) → Br2.16 ÷ (0.12 − 0.08) → Br54
Price0 = Br54
Note: r and g must be in decimals.
Nonconstant Growth Dividends

• The afromentioned models work if a firm is either expected to pay a

constant dividend amount, or is expected to have its dividends
grow at a constant rate for long periods of time.
• For most firms, the dividend growth patterns of most firms tend to
be variable, making the valuation process complicated.
• However, if we can assume that at some point in the future, the
dividend growth rate will become constant, we can use a
combination of the Gordon Model and present value equations to
calculate the price of the stock.
The Two-Stage Dividend Discount Model
Example
Fastgrowth Industries is growing, and its dividend is growing, at an annual
rate of 20%. This growth is expected to continue for three years into the
future, after which the growth is expected to slow down to a more
sustainable growth rate of 7%. Investors’ required rate of return is 15%.
The next annual dividend is expected to be $1.00.
What is the indicated share value?
The Two-Stage Dividend Discount Model
• Step 1: We will first calculate the present values of the dividends to be received
during the first three years and sum the results. Each year’s dividend increases by
20% over the previous year’s dividend.
End of PV Factor Present Value
Year Dividend @ 15% of Dividend
1 $1.00 0.86957 $ 0.870
2 1.20 0.75614 0.907
3 1.44 0.65752 0.947
Total PV of future dividends - Years 1 through 3: $2.724 or $2.72
The Two-Stage Dividend Discount Model, Cont’d…
Step 2: We next project the dividend for Year 4 by multiplying the Year 3 dividend by (1 + the growth
rate for Year 4), which is 1.07. Remember that growth is expected to slow down to 7% in Year 4. The
Year 4 dividend is therefore projected to be $1.44 × 1.07, or $1.54.

We now pretend that Year 4 is Year 1 and so the end of Year 3 is Year 0. We use the Constant Growth
Model to calculate what the value of the stock will be at the end of Year 3, assuming a required rate of
return of 15% and an annual growth in dividends of 7% going forward from the end of Year 3,
beginning with Year 4:
P3 = d4 / (r – g)
P3 = $1.54 / (0.15 – 0.07)
P3 = $19.25

However, this present value of $19.25 occurs at the end of Year 3, not at Year 0. Therefore, $19.25
must be discounted back 3 years to Year 0. We will discount it back as if it were a single sum that will
be received in 3 years. The present value factor for 3 years at 15% is 0.65752, so the present value of
$19.25 three years from now is $19.25 × 0.65752, or $12.66.
The Two-Stage Dividend Discount Model
• Step 3: The final step is to sum the present value of the future dividends for Years 1
through 3 ($2.72) and the present value of the dividends to be received from Year 4
to infinity ($12.66) to calculate the value today, at Year 0, for a share of this stock:

$2.72 + $12.66 = $15.38

$15.38 is an appropriate market price for this stock, given the projected dividends and
the 15% required rate of return by investors in the stock.
Dividend Model Shortcomings

•Need future cash flow estimates and a required rate of return, therefore
difficult to apply universally.
• Erratic dividend patterns,
• Long periods of no dividends,
• Declining dividend trends
•Need a pricing model that is more inclusive than the dividend model, one
that can estimate expected returns for stocks without the need for a stable
dividend history.
Thank You!
 Unit V
INTRODUCTION TO THE FOREIGN EXCHANGE MARKET
Training Outcomes
• Understanding the Nature, Purpose & Scope of the FX Market

• Examining the Various Exchange Rate Regimes & the Logic Behind those Policies

• Identifying Major Participants in the FX Market & the Purpose for their Involvement

• Explaining FX Market Operation: Currency Conventions & ISO Standards

• Executing Transactions in the Spot Market: Trading Mechanics & Cross Rate

• Main factors that make a given currency to appreciate/depreciate against the other currency

• Knowing how to determine the depreciation/appreciation rate of a paired currency

The What & Why of FX Market
• What is the FX Market?
• Why it exist & what does it serve?
• How it functions? & What is SWIFT?
• Where is it located? & What are the major centers of the FX market?
• What is the share of Ethiopia in the world FX Market?
• Is there a unique opportunity for Ethiopia to become an FX hub?
Form a group of five and make discussion on each of the
above points. Note for your discussion found in 7.1. of the module
 Foreign Exchange Market: Nature, Purpose & Functions

The Nature of Foreign Exchange(FX) Market

• Foreign Exchange Market is a platform whereby foreign currencies are traded.

• Foreign exchange trading refers to trading one country’s money for that of another
country.

• The kind of money specifically traded takes the form of bank deposits or bank transfers of
deposits denominated in foreign currency.

• The foreign exchange market typically refers to large commercial banks in major financial
centers, such as London, New York, Singapore, Hong Cong & Tokyo that trade foreign
currency–denominated deposits with each other.
 Foreign Exchange Market: Nature, Purpose & Functions,
Cont’d…

Function & Importance of the FX Market

❑A primary function of the FX markets is to facilitate international trade and cross boundary
investments & borrowing.

❑There is an enormous demand to buy and sell foreign currencies, arising from:
• financial flows associated with international trade in goods and services
• cross-border capital transactions involving the investment and the borrowing of funds
• speculative transactions aimed at profiting from favorable movements in future exchange
rates
• central bank transactions within the FX markets.
Foreign Exchange Market: Nature, Purpose & Functions, Cont’d…
Trading Places of the FX Market. Does it has specific trading location?
FX is mainly an OTC Market, traded through telephone and electronic networks across the glob.
The following are the major FX centers of the world with their global market share

Top 10 currency traders

% of overall volume, June 2020
Rank Name Market share
1 JP Morgan 10.78 %
2 UBS 8.13 %
3 XTX Markets 7.58 %
4 Deutsche Bank 7.38 %
5 Citi 5.50 %
6 HSBC 5.33 %
7 Jump Trading 5.23 %
8 Goldman Sachs 4.62 %
9 State Street Corporation 4.61 %

10 Bank of America Merrill Lynch 4.50 %

Foreign Exchange Market: Nature, Purpose & Functions,
Cont’d…

How it functions?
▪ The speed and efficiency of the FX markets is facilitated by sophisticated systems
such as SWIFT (Society for Worldwide Interbank Financial Telecommunications).
▪ SWIFT was founded in the 1970s and is a member-owned cooperative based in
Belgium. It links more than 10,000 banking organizations across more than 200
countries within a standardized and secure communications framework.
▪ In 2018, SWIFT had daily ‘message traffic’ of more than 30 million messages. The
messages are payment orders that are settled by the financial institutions using the
system.
▪ SWIFT is not a financial institution itself. It does not clear or settle orders or manage
accounts.
7.2. Exchange Rate Regimes
• How many exchange rate regimes do we have in the world?
• What is the logic behind those policies?
• What do you think the Ethiopian policy in this regards?

Form a group of five and make discussion on each of the above

points. Reference for your discussion found in 7.2. of the module
Exchange Rate Regimes
• Each country, or monetary union, around the world is responsible for the
determination of the country’s exchange rate regime, that is, the method by which the
exchange rate of the currency is calculated.

• There are four main types of regimes in the world

➢ Free floating exchange regime
➢ Managed float regime
➢ Crawling peg regime
➢ Linked exchange rate regime
 Exchange Rate Regimes, Cont’d…
Free Floating System
▪ A floating exchange rate regime exists when the exchange rate for the currency of a country is allowed to move
as factors of supply and demand dictate.
▪ Which means, if the demand for a currency increases in the FX markets, then that currency will appreciate
relative to other currencies. If the demand for the currency falls, then the currency will depreciate.

▪ Therefore, the exchange rate in a floating rate regime is not directly controlled by the government or the central
bank..

▪ Major currencies, such as the US dollar (USD), the UK pound sterling (GBP), the Japanese yen (JPY), the
Economic and Monetary Union of the European Union euro (EUR) and the Australian dollar (AUD), all adopt a
floating exchange rate regime, or a free float.
Exchange Rate Regimes, Cont’d…
Managed Floating System
• Countries that operate a managed float regime generally allow the currency to move within a
defined range, or band, relative to another major currency such as the USD or a group of
currencies.

• The exchange rate is allowed to adjust providing such movements do not adversely impact
upon the economic objectives of the country.

• Countries that currently use the managed float regime include China, Singapore, Malaysia and
Indonesia.

• The managed float regime may also be used to maintain competitive trade equilibrium. For
example, Chine.
Exchange Rate Regimes, Cont’d…
Crawling Peg System
• Another exchange rate regime is known as the crawling peg.

• The crawling peg allows the currency to appreciate gradually over time, but within a limited range
established by the government.

• In many ways it is similar to a managed float, but it is generally accepted in the international markets
that the currency is undervalued, particularly if fundamentals such as the country’s foreign exchange
reserves and level of exports are taken into account.

• While China contends that it operates a managed float regime, there are commentators who contend that
it is really a crawling peg regime.
Exchange Rate Regimes, Cont’d…
Linked System

• A further exchange rate regime is the linked exchange rate regime (or fixed exchange rate
regime) as is used by Hong Kong. With a linked exchange rate, a currency is directly linked to
another currency. In the case of Hong Kong, the Hong Kong dollar (HKD) is linked to the
USD.

• The Hong Kong Monetary Authority has pegged the HKD exchange rate at 7.85 HKD to the
USD.
7.3. Foreign Exchange Market Participants & Their role in the Market

▪ Who do you think the major participants in FX Market?

▪ What purpose do they fulfil by their involvement in this market?
▪ What is the main difference b/n brokers & dealers in this market?
▪ Are Arbitrageurs important in the FX market? What happen if they are
not there?

Form a group of five and make discussion on each of the above

points. Reference for your discussion found in 7.3. of the module
7.3. Foreign Exchange Market Participants & Their role in the Market

The FX markets are enormous and involve a range of different participants

around the world all conducting transactions that involve foreign
currencies.
Participants in the FX may be categorized as:
• Foreign exchange Dealers and Brokers
• Central banks
• Firms conducting international trade transactions
• Investors and borrowers in the international money markets and capital markets
• Foreign currency speculators
• arbitrageurs
Foreign Exchange Market Participants, Cont’d…

Foreign exchange Dealers and Brokers

▪ Foreign exchange dealers are organizations that act as principals in the FX market.
▪ The main FX dealers are the commercial banks & investment banks.
▪ FX dealers quote two-way prices in the market. The FX dealer is not concerned whether a transaction is a
buy or a sell as they will make a profit on the spread between the two prices.

• In addition to the dealers, there are FX brokers, whose transactions are almost exclusively with the FX
dealers and not with the public.

• The brokers act in the FX market in a role very similar to that performed by stockbrokers in the share market.
The FX brokers seek out the best exchange rates in the international markets and match buy and sell orders
that they receive from various FX dealing rooms.

• FX brokers also provide anonymity to participants until a transaction is carried out. The FX dealers pay a fee,
or brokerage, for the service provided by the brokers.
 Foreign Exchange Market Participants, Cont’d…

Central banks
The central banks of nations enter the FX markets periodically, for one or other of the following
reasons:

▪ To acquire foreign currency to pay for their government’s purchases of imports.

▪ To change the composition of the central bank’s holdings of foreign currencies as part of its
management of official reserve assets.

▪ To influence the floating exchange rate, particularly if the exchange rate is appreciating or
depreciating rapidly and, in the central bank’s view, this is not supported by economic
fundamentals.
Foreign Exchange Market Participants, Cont’d…

Firms conducting international trade transactions

▪ Businesses that export goods or services in the international markets often receive payment in
a foreign currency.

▪ Similarly, those businesses that import goods and services from the international markets will
need to pay for those goods and services, usually in a foreign currency.

▪ So their participation will be:

Exporters as a seller of foreign currencies
Importers as a buyer of foreign currencies

▪ Typically, the dominant currency of international trade transactions is the USD, but other
currencies, such as the GBP, JPY and the EUR, are also quite prominent.
Foreign Exchange Market Participants, Cont’d…

Investors and borrowers in the international money markets and capital

markets
▪ In international finance, it is well recognized that the motivations and benefits that are
available to borrowers with very good credit ratings that borrow in the international
money and capital markets.
▪ In particular, the commercial banks borrow significant sums in the international capital
markets as part of their active liability management strategies. A very large proportion
of funds borrowed in the international markets will be converted in the FX markets
into the home currency of the borrower.
▪ At the same time, corporations, institutional investors and financial institutions invest
overseas.
 Foreign Exchange Market Participants, Cont’d…

Foreign currency speculators

▪ It is estimated that over USD 7.5 trillion moves through the FX markets daily. Much of this does not
involve trade, investment or central bank transactions and therefore may be described as speculative
FX transactions. Speculative FX transactions are motivated by the pursuit of profit.
Example
The following example illustrates the steps involved.
If, today:
Spot rate: USD1 = AUD0.7725
Exchange rate expected today + n days: USD1 = AUD0.8225 Then, what do you do today as a
speculator?:
Buy USD1 at a cost of AUD0.7725 Then, at today + n days:
Sell USD1 and obtain AUD0.8225
While the example makes it look easy, there are risks involved. A loss will be made if the exchange rate
moves in a direction opposite to that expected, such as where, at today + n days, the exchange rate
turned out to be USD1 = AUD0.7672.
 Foreign Exchange Market Participants, Cont’d…

Arbitrageurs
▪ The arbitrageur is able to carry out simultaneous buy and sell transactions in two or more markets to achieve a risk-free
profit.
▪ Within the context of the FX markets, arbitrage refers to the pursuit of a profit through the conduct of simultaneous FX
transactions that involve no FX risk exposure.
▪ An arbitrage opportunity would occur if the exchange rate quoted by two or more dealers between currencies was
different.
▪ For example, a triangular arbitrage occurs when exchange rates between three or more currencies are out of perfect
alignment. This situation is illustrated below.
Consider the following rates are prevailing in the FX market:
USD1 = AUD1.3525 USD1 = SGD1.3525 AUD1 = SGD0.9870
What do you do to get profit?
It is clear that AUD1 should be equal to SGD1 as their exchange rates are identical against the USD. An arbitrage profit can
be made without risk by simultaneously:
▪ selling AUD1.3525 to receive USD1
▪ then selling USD1 to receive SGD1.3525
▪ then selling SGD1.3525 to receive AUD1.3703.
In this transaction the arbitrageur commenced with AUD1.3525 and finished with AUD1.3703, a profit of 1.78 cents. This
may not seem like much of a profit, but if it is based on typical transactions larger than AUD1 million, then such
instantaneous, risk-free profits are worthwhile.
 7.4. Operation of the FX market
• How does a dealer set prices of currencies in an FX market?

• What are the conventions in quoting currencies in the international FX markets?

• How do you understand the difference between base currency and quote/term currency?

• How do you differentiate a direct quote from the indirect quote?

• What does it mean by two ways quotations? What does it mean by bid; offer & spread?

Form a group of five and make discussion on each of the above

points. Reference for your discussion found in 7.4. of the module
7.4. Operation of the FX market

The Dealing Room

▪ The larger FX dealers, including the commercial and investment banks, provide their FX function as
part of their overall treasury operations. Within the treasury operation they establish an FX dealing
room.

▪ The number of dealers in an FX dealing room may range from a few to more than 100 depending on the
scale of an institution’s FX operations.

▪ There are a number of global electronic networks, such as Thomson-Reuters and Bloomberg, that
provide such information. The dealing rooms of large FX dealers, such as the banks, typically access
information from more than one information provider. These organizations facilitate the efficient flow
of information into the FX markets.
Operations of the FX market, Cont’d…

The Dealing Room

▪ In an FX dealing room, the array of computer screens is the most obvious manifestation of the global
communications network that links the electronic trading platforms of FX dealers.
▪ The electronic screen pages provide information on indicative buy and sell rates for a particular currency, with rates
on that currency from numerous dealers. The rates are indicative, rather than firm, since they may change within a
matter of seconds.
▪ Firm rates, at which FX dealers are prepared to transact, are obtained from each dealer’s electronic trading
platform.
▪ Retail and institutional clients are given authorized access to the electronic trading system. Other FX dealers and
brokers will also have access to the trading system.
▪ Given the nature of the communications between the market participants, and given the FX volumes traded and the
often very hectic pace of the market, FX dealers have developed conventions and a language of their own.
▪ The following sections present and explain some of the various conventions and the language used in the FX
markets.
 Operations of the FX market, Cont’d…

Spot & Forward Contract

Of the various currency contracts that can be bought or sold on the FX markets, the most
common are those that have a maturity date, otherwise referred to as the value date or delivery
date, which is:
➢ two business days after the FX contract is entered into—referred to as spot transactions, or
➢ more than two working days after the FX contract has been entered into—referred to as forward
transactions.

▪ Since a spot FX contract may involve the transfer of funds in two locations, the spot delivery date allows two
working days in both locations.
Settlement Convention of Spot
Transaction Date
Spot foreign exchange transactions are normally delivered 2 business days after the
TT++22 transaction (execution) date.

This is to allow the processing and checking of transactions across international timelines.

A USD/JPY trade executed in New York (as T+1) would have to immediately deliver (time zone difference).

US$
Trades in USD/CAD are traded T+1 due to similar time zones.
C$

Transaction Date Delivery Date Transaction Date Delivery Date

T+2 EUR/USD
Cash Flow of Spot
01 Trade Exchange Rate Notional Amount Market Value (MV)
Details USD / JPY = 109.00 US$1,000,000 ¥109,000,000

US$1,000,000
Buyer of Yen Seller of Yen

¥109,000,000

Trade Exchange Rate Notional Amount Market Value (MV)

0022 USD / JPY = 109.00 US$1,750,000 ¥190,750,000
Details

US$1,750,000
Buyer of Yen Seller of Yen
¥190,750,000
Spot & Forward Contract, Cont’d…
Forward Contract
A forward transaction may arise when, for example, an importer has to pay a foreign currency amount to an
exporter in, say, two months.
If for example, an Australian importer enter a contract denominated in EUR, the importer may be concerned
that the EUR may appreciate (increase in price) during that period.
One way of covering, or hedging, against that risk is to enter into a forward contract.
The basic features of the forward buying of the EUR are as follows:
➢ the contract to buy EUR is entered into today
➢ the price of the EUR is determined and locked in today
➢ the value or delivery date, when the local currency is paid and EUR received, is a date in the future, but
specified today
Forward contracts can be obtained for virtually any future date that the corporate client may wish; however, the standard
quoted rates are for one or more months. Hence the monthly dates are the dates corresponding to the spot dates; that is, if
today is Monday, 21 August, then:
➢ the spot delivery date is 23 August
➢ the one-month forward delivery date is 23 September
➢ the two-month forward delivery date is 23 October and so on.
 Spot & Forward Contract, Cont’d…
In addition to the spot and forward transactions, a dealer may provide what is known as short- dated transactions.
▪ Transactions entered into today, with same-day value or settlement, are referred to as ‘today’, or tod value transactions.

▪ Those entered into today, for settlement tomorrow, are referred to as ‘tomorrow’, or tom value transactions.

▪ The timeline in the following figure shows the labels for the various transactions described in this section.
Spot Market Quotations & Trading Conventions

▪ The FX market has a well-defined set of conventions governing the quotation of the price of one
currency in terms of another. Participants in the markets must be aware of these conventions, otherwise
they risk entering into an FX transaction that does not meet their requirements.

▪ For example, a firm may ring an FX dealer and ask for the price of the USD. However, the price of the
USD can be expressed in terms of any of the world’s currencies, and it is therefore necessary to be
specific: to ask for the price of the USD in terms of a named currency, such as the Japanese yen (JPY)
or the pound sterling (GBP).

▪ Further, the order in which the particular currencies are expressed, for example USD/JPY or JPY/USD,
has a specific meaning in the FX markets.

Let’s see these & other conventions which should be

known to operate/trade in FX market
 Currency Convention: Naming
Currency codes fall under ISO code 4217. They are three letters long and comprised of:

US D
GBP CAD THB ETB KES
Country Currency

However, the convention is not consistent anymore. A few confusing ones:

IDR vs. INR

Nicknames – Swissy,
(Indonesian Rupiah vs. EUR – Euro BRL – Brazilian Real
Loonie, Kiwi
Indian Rupee)
 Currency Convention: Priority
Historically, we used the stronger currency as the base currency, but there are exceptions.

Higher Priority
Euro

Pound Sterling

Australian Dollar

New Zealand Dollar

Correct Quote Incorrect Quote
United States Dollar
EUR / USD USD / EUR
Canadian Dollar
EUR / JPY JPY / EUR
Swiss Franc

Japanese Yen
Lower Priority
Currency Convention: Grouping
Exotics or Emerging
M ajors

• Freely traded in the spot and FX • Remaining currencies in the

forward markets. world.

• USD, EUR, JPY, GBP, CHF. • E.g., THB, BRL, INR, RUB

M inors Precious M etals

• Commodity currencies (e.g.,
CAD, NZD, AUD). • Currencies were at one pointed
pegged to the value of gold.
• Scandinavian currencies (e.g.,
DKK, NOK, SEK). • Gold and a few other precious
metals.
 Currency Convention: Five Significant
Figures
The number of decimal places quoted depends on the number of units in the quote. A quote with fewer than 10
units of the terms currency is quoted to four decimal places, while a quote of more than 10 units of the terms
currency is quoted to only two decimal places.

USD/JPY = 110.15 USD/CAD = 1.3067

2 Decimals 4 Decimals

Market convention is to quote to 5 significant figures (”sig figs”).

Remember that the “0.” is also considered a sig fig, so NZD/USD is 0.6593.
Convention of Base & Quote Currency

▪ The convention in the ordering of the two currencies in asking for a quotation is that the first
currency mentioned is the one whose price is being sought. It is referred to as the base
currency or the unit of the quotation, since it is the price of one unit of that currency that is
being quoted.

▪ The second currency in an FX quote is referred to as the terms/quote currency. The terms
currency is used to express the value of the base currency. The currency on the left-hand side
of a quote is the unit of the quotation and the currency on the right is the terms currency.

For example:
▪ USD/EUR means the price of USD1 in terms of EUR.
▪ GBP/USD means the price of GBP1 in terms of USD.
▪ AUD/JPY means the price of AUD1 in terms of JPY.
 TWO-WAY QUOTATION CONVENTION

▪ Dealers of FX markets should provide two way/side quotation for every currency they are trading.
▪ The bid price(the price at which the dealer buys the base currency) and the offer/ask price (the price
at which the dealer sales the base currency)
▪ Let us assume that the Australian importing firm, asks for the euro Aussie spot. Observing the above
convention, the firm would receive two sets of numbers in response to the request.
For example, the EUR/AUD spot rate might be given as:
EUR/AUD1.3755–1.3765
and would be expressed in words as ‘euro Aussie spot is one thirty-seven fifty-five–sixty-five’.
Interpreting verbal quotations
In the euro Aussie spot quote above, it can be noted that:
▪ the decimal point in the verbal quotation is not mentioned
▪ the words do not include all of the numbers in the written quotation.
 Two Way Quotation
Big Figs

EUR/USD = 1.1009-14

Points or Pips
Big Figures Points

• First 3 significant figures in an FX price. • Last 2 digits in an FX price.

• Usually ignored (price makers assume • The example shows a bid/offer spread
they’re understood). of 5 pips, or 5 points.
• Market participants typically confirm
big figures after the trade.

May be quoted as a voice trade as “09-14”.

TWO-WAY QUOTATIONS

Example 1
Telephone quote you get says: ‘Aussie Sing dollar is one twenty-seven sixty–seventy’
What does this mean? How can you write it as a quotation?

AUD/SGD1.2760–1.2770

Example 2
‘Dollar yen is eighty-two fifty-eight–sixty-six’
USD/JPY82.58–82.66

Note: When a quote states ‘the dollar’ without qualification it is referring to the USD.
 Two-way prices
Let’s see about pricing focusing on to the euro Aussie spot rate (EUR/AUD1.3755–1.3765) and the reason for there being two
numbers.
The two numbers identify the price at which the price-maker FX dealer will buy and sell the unit of the quotation.
That is:
➢ The price-maker FX dealer will buy EUR1 for AUD1.3755. From the price-taker’s point of view, it would sell EUR1 and
receive AUD1.3755 from the FX dealer
➢ The price-maker FX dealer will sell EUR1 for AUD1.3765. From the price-taker’s point of view, it receives EUR1 on
payment of AUD1.3765 to the FX dealer.

The buy price is referred to as the bid price: the price at which a dealer will buy the unit of the quotation. The sell price is
referred to as the offer price: the price at which the dealer will sell the unit of the quotation. Some market participants refer to
the sell prices as the ask price; therefore, offer and ask are the same

The above quotations reveal that the price-maker FX dealer buys low and sells high. The difference between the FX dealer’s
bid and offer quotes is referred to as the spread. This is represented in percentage terms by an Equation below:
Foreign Exchange Two Way Price: Example
EUR/USD = 1.1840-41

Note: An individual sells at the

bid, and buys at the ask/offer.
Bank’s Bid

• Left-hand side of quoted price.

• Bank buys EUR and sells USD.

Bank’s Offer

• Right-hand side of quoted price.

• Bank sells EUR and buys USD.
 Foreign Exchange Two Way Price: Example
Hitting the Correct Side – Question

Individual Wishes to Bank Quote Correct Side Correct Price

Buy EUR EUR/USD 1.2045-47 Right or Left? ?

Sell USD USD/CAD 1.2678-80 Right or Left? ?

Buy USD USD/JPY 105.50-51 Right or Left? ?

Sell CAD USD/CAD 1.2678-80 Right or Left? ?

Buy JPY USD/JPY 105.50-51 Right or Left? ?

 Foreign Exchange Two Way Price: Example
Hitting the Correct Side – Answer

Individual Wishes to Bank Quote Correct Side Correct Price

Buy EUR EUR/USD 1.2045-47 Right Hand Side 1.2047

Sell USD USD/CAD 1.2678-80 Left Hand Side 1.2678

Buy USD USD/JPY 105.50-51 Right Hand Side 105.51

Sell CAD USD/CAD 1.2678-80 Right Hand Side 1.2680

Buy JPY USD/JPY 105.50-51 Left Hand Side 105.50

 Foreign Exchange Two Way Price: Example
Execution – Example
Market makers show both bid and offer prices (“two-ways”). To avoid confusion on the direction, traders
and clients may use one word to deal on a trade.

Buy the base currency: “Mine” or “I buy”

Sell the base currency: “Yours” or “I sell”

“Where’s your market in 20

“09-14, mate.”
million EUR/USD (“euro-dollar”)?”

“Done, I buy 20 million Euros

Client “Ok, yours in 20 million.” against the U.S. Dollar at 1.2009. Market Maker
Thanks for the trade!”
TRANSPOSING SPOT QUOTATIONS

In the previous section we considered a quote EUR/AUD1.3755–65, where the EUR was the unit of the
quotation. To find the value of the AUD/EUR, the quotation would need to be transposed.

Given the EUR/AUD rate, it is possible, using a simple rule, to calculate the quote that should prevail if
the AUD is to become the base currency; that is, AUD/EUR.

The rule to transpose an existing rate is ‘reverse then invert’.

• Therefore, EUR/AUD1.3755–1.3765 will be converted to AUD/EURO as:

1. Reverse the bid and offer prices: 1.3765–1.3755
2. Take the inverse; that is, divide both numbers into one, which gives:
AUD/EUR0.7265–0.7270
CALCULATING CROSS-RATES

Within the FX markets all currencies are quoted against the USD. There are two ways in which currencies
can be quoted against the USD:

➢a direct quote, where the USD is the unit of the quotation, or the base currency
➢an indirect quote, where the USD is the terms currency and the other currency is
the unit of the quotation.
Direct quotations (such as USD/JPY) are the most common in the FX markets; however, within the
eurozone the euro is generally quoted as the base currency (EUR/USD). This also happens in most
member countries of the Commonwealth, including the UK, Australia and Singapore. An exception is
Canada, which quotes on a direct basis with the USD.
CALCULATING CROSS-RATES, Cont’d…

Why we do cross-rating

When FX transactions take place between two currencies, where neither currency is the USD, it
is necessary to calculate the cross-rate.

For example, an importer may wish to calculate the EUR/JPY exchange rate.

Assuming each currency is quoted against the USD, the calculation used in determining the
cross-rate bid and offer rates will depend on whether the USD quotes are direct or indirect:

➢Direct Quote is when USD is a base currency(quoted in the left hand side of the quotation)
➢Indirect Quote is when USD is a term currency(quoted in the right hand side of the quotation)
 CALCULATING CROSS-RATES, Cont’d…
• Crossing two direct FX quotations.
— Step 1 Place the currency that is to become the unit of the quotation first.
— Step 2 Divide opposite bid and offer rates; that is:
— Step 3 Divide the base currency offer into the terms currency bid (this gives the bid rate of the new quotation).
— Step 4 Divide the base currency bid into the terms currency offer (this gives the offer rate of the new quotation).

To reduce confusion, step 3 & 4 can be rewritten as follows:

- Divide the term currency bid by the base currency offer (TCB/BCO) >>>>> this gives the new bid rate
- Divide the term currency offer by the base currency bid (TCO/BCB)>>>>>> this gives the new offer rate
 CALCULATING CROSS-RATES, Cont’d…
Example 3
To determine the EUR/JPY cross-rate:
Crossing two direct FX quotations:
USD/EUR0.7250–55 81.40/0.7255 = 112.20
USD/JPY81.40–50 81.50/0.7250 = 112.41

What is EUR/JPY cross rate? EUR/JPY112.20–41

To reduce confusion, step 3 & 4 can be rewritten as follows:

- Divide the term currency bid by the base currency offer (TCB/BCO) >>>>> this gives the new bid rate
- Divide the term currency offer by the base currency bid (TCO/BCB)>>>>>> this gives the new offer rate
CALCULATING CROSS-RATES, Cont’d…

— Crossing a direct and an indirect FX quotation .

• Step 1 Multiply the two bid rates (this gives the bid rate of the new quotation).
• Step 2 Multiply the two offer rates (this gives the offer rate of the new quotation).

Example 4
Crossing a direct and an indirect FX quotation:
GBP/USD1.6270–75
USD/NZD1.3292–97
What is GBP/NZD?
To determine the GBP/NZD cross-rate:
1.6270 × 1.3292 = 2.1626
1.6275 × 1.3297 = 2.1641
GBP/NZD2.1626–41
 CALCULATING CROSS-RATES, Cont’d…
— Crossing two indirect FX quotations .
• Step 1 Place the currency that is to become the unit of the quotation first.
• Step 2 Divide opposite bid and offer rates; that is:
• Step 3 Divide the terms currency offer rate into the base currency bid rate (this gives the bid rate).
•Step 4 Divide the terms currency bid rate into the base currency offer rate (this gives the offer rate).

Again to reduce confusion, step 3 & 4 can be rewritten as follows:

- Divide the Base currency bid by the Term currency offer (BCB/TCO) >>>>> this gives the new bid rate
- Divide the Base currency offer by the Term currency bid (BCO/TCB)>>>>>> this gives the new offer rate

Example 5
Crossing two indirect FX quotations: To determine the AUD/GBP cross-rate:
AUD/USD0.7262–69 0.7262/1.3275 = 0.5470
GBP/USD1.3270–75 0.7269/1.3270 = 0.5477
What is AUD/GBP?
AUD/GBP0.5470–77
Important points always to remember in FX dealing
Thank You
 UNIT VI
DERIVATIVE SECURITY MARKETS

AAU, School of Commerce, Capital Market Project Office

Outline
• What are derivatives
• Derivative market participants
• The role of the clearing house
• Forward contract
• Futures contract
• Option contract
• Swap contract
• Margining and ‘marking to the market’

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 What is a Derivative? Why Derivatives?
• A derivative is a financial instrument whose value depends on or is • To hedge risks
derived from the value of the underlying asset. • To speculate (take a view on the
• The underlying assets include stocks, currencies, interest rates, future direction of the market)
commodities, debt instruments, insurance, etc. • To lock in an arbitrage profit
• Examples: futures, forwards, swaps, options, exotics… • To change the nature of a liability
• Many financial transactions have embedded derivatives.
• Derivatives are traded at:
1. Exchanges: such as the Chicago Board Options Exchange (CBOE),
CME Group (formed when Chicago Mercantile Exchange and
Chicago Board of Trade merged), InterContinental Exchange, B3
(Brazil), Tokyo Financial Exchange (Tokyo)
2. OTC: the over-the-counter (OTC) market where traders working for
banks, fund managers, and corporate treasurers contact each
other directly

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Terminologies
• The party that has agreed to buy has a long position
• The party that has agreed to sell has a short position
• With stocks, a long position means an investor has bought and owns shares of stock.
• An investor with a short position owes stock to another person but has not actually bought
them yet.
• With options, buying or holding a call or put option is a long position; the investor owns the
right to buy or sell to the writing investor at a certain price.
• Selling or writing a call or put option is a short position; the writer must sell to or buy from
the long position holder or buyer of the option.

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Profit from a Long Forward Position (K=
delivery price=forward price at time contract is entered into)

Profit

Price of Underlying at
K Maturity, ST

AAU, School of Commerce, Capital Market Project Office 212

Profit from a Short Forward Position
(K= delivery price=forward price at time contract is entered
into)

Profit

Price of Underlying
K at Maturity, ST

AAU, School of Commerce, Capital Market Project Office 213

Example
• On May 21, 2023, the treasurer of a corporation enters into a long forward contract
to buy £1 million in six months at an exchange rate of $1.2230
• This obligates the corporation to pay $1,223,000 for £1 million on May 21, 2023
• What are the possible outcomes?
1. On May 21, 2023 exchange rate of £1 was $1.2500
2. On May 21, 2023 exchange rate of £1 was $1.2130

AAU, School of Commerce, Capital Market Project Office 214

 Derivative Market Participants
Hedgers Speculators
• Use futures to reduce or limit the price risk of the • A speculator is an additional buyer of securities whenever it
asset. seems that market prices are lower than they should be.
• Speculation is the opposite of hedging.
• Hedging allows a market participant to lock in prices • A speculator holds not offset cash market position and
and margins in advance and reduce the potential for deliberately incurs price risk in order to benefit from price
unanticipated loss or competitive disadvantage. movements.
• Hedger efficiently transfers his risk to speculators.
• A hedge involves in establishing a position in the • The speculator’s view of the market could be either bullish
futures market that is equal and opposite to a position or bearish.
in the physical market. • The speculator takes a bullish view if the price of the asset is
expected to rise and a bearish view if the price is expected to
• A loss in one market should be offset by a gain in the fall down.
other market. • The speculator takes a long position with a bullish view of
• Hedging works because cash prices and futures prices the market and a short position when the market is believed
to be bearish.
are expected to move in tandem.

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Arbitrageurs
• Arbitrageurs are interested in making purchases and sales in different
markets at the same time to profit from price discrepancies between the two
markets.
• Arbitrage refers to the ability to make a cost-less, risk-less profit, by
simultaneously transacting in two or more markets.
• Arbitrageurs lock in profits when they identify cash and carry arbitrage
opportunity or reverse cash and carry arbitrage opportunity.
• Arbitrage opportunities occur either between regions, delivery periods, and
types of instruments (such as options on futures) or across a combination of
these conditions.

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The Role of the Clearing House
• The novation principle states that the clearing house of the exchange
is the central counterparty (CCP).
• The clearing house of the exchange steps into the shoes of the
defaulting party to honor the right and the privilege of the non-
defaulting trader.
• The clearing house of the exchange is a performance guarantor.

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 Forward Contracts
• A forward contract is a bilateral and binding agreement by two Advantages
parties for the purchase/sale of a specified quantity of an asset at a • Forward contracts have the advantage of
specified future time for a specified future price.
• A forward contract lets the market participant hedge the risk that locked-in future prices that permit the
future spot prices on an asset will move against him or her by determination of fixed purchasing prices.
guaranteeing a future price for the asset today. • Forward contracts also strengthen the
• Features of Forward Contracts links between a specific seller and buyer.
• Forward price • No cash changes hands until the contract
• Expiration date is finally settled;
• Underlying asset Disadvantages
• Long or short position • Forward contracts lack flexibility; getting
• Payoff out of a transaction is difficult.
• No cash due up-front • Exposure to counterparty risk.

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Forward Contracts (Cont’d…)
Illustration
• If the forward price agreed to at time 0 was $98 per
$100 of face value, in three months, the seller
delivers $100 of 10-year bonds and receives $98
from the buyer.

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 Futures Contracts
• A futures contract, like a forward contract, is an Advantages and disadvantages of futures
agreement between a buyer and a seller at time 0 Futures contracts can be used:
to exchange a standardized, prespecified asset at • To avoid the effect of fluctuations in prices.
some later date at a price set at time 0.
• To secure a processing margin.
• Futures contracts are standardized forward • To "lock in" future prices at an attractive level.
contracts.
• To improve marketing policies and financial
planning and forecasting.
Key Features
• Available on a wide range of assets The main disadvantage of using futures contracts is
• Exchange traded that:
• Specifications need to be defined: • They freeze up working capital due to margin
• What can be delivered, requirements and mark to market on a real-time
• Where it can be delivered, & basis with daily settlement.
• When it can be delivered
• Settled daily

AAU, School of Commerce, Capital Market Project Office 220

Forward Contracts vs Futures Contracts
FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash

settlement usually occurs prior to maturity

Credit risk Virtually no credit risk

AAU, School of Commerce, Capital Market Project Office 221

Futures Contracts Vs Stocks
Characteristics Futures Stocks
Contract terms Agreement or promise to perform Conveys ownership

Type of contract Standardized, no limit on the number Shares in a company, limited to the
number issued
Time factor Contracts expire Continue perpetually
Margin Good-faith deposit to ensure contract Down payment on ownership
performance
Leverage High with minimum margins required Limited with a minimum margin of
generally only 2% -15% of the contract 50% of the share price
value
Short selling Simple, involving the same process Complex, requiring an uptick in share
with the same margin requirements as price and borrowing shares to sell
going long.

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Content of the Futures Contract
• Underlying unit —One U.S. Treasury note having a face value at maturity of $100,000.
• Deliverable grades —U.S. Treasury notes with a remaining term to maturity of at least 6½ years, but not more than 10 years, from
the first day of the delivery month. The invoice price equals the futures settlement price times a conversion factor, plus accrued
interest. The conversion factor is the price of the delivered note ($1 par value) to yield 6 percent.
• Price quote —Points ($1,000) and halves of 1/32 of a point. For example, 126-16 represents 126 16/32 and 126-165 represents 126
16.5/32. Par is on the basis of 100 points.
• Tick size (minimum fluctuation) —One-half of one thirty-second (1/32) of one point ($15.625, rounded up to the nearest cent per
contract), except for inter-month spreads, where the minimum price fluctuation shall be one-quarter of one thirty-second of one
point ($7.8125 per contract).
• Contract months —The first five consecutive contracts in the March, June, September, and December quarterly cycle.
• Last trading day —Seventh business day preceding the last business day of the delivery month. Trading in expiring contracts
closes at 12:01 p.m. on the last trading day.
• Last delivery day —Last business day of the delivery month.
• Delivery method —Federal Reserve book-entry wire-transfer system.
• Settlement —U.S. Treasury Futures Settlement Procedures.
• Position limits —Current Position Limits.
• Trading hours (all times listed are central time) —Open Outcry Mon.–Fri., 7:20 a.m.–2:00 p.m. CME Globex Sun.–Fri., 5:30
p.m.– 4:00 p.m.
• Ticker symbol — Open Outcry—TY CME Globex—ZN
• Exchange rule —These contracts are listed with, and subject to, the rules and regulations of the CBOT.

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Option
 Option confers the right, but not the obligation, to buy or
sell a futures contract at a given price.
 Option holders are referred to as option buyers and
option writers are referred to as option sellers.
 In an option contract, a right need be exercised only if it is
in the interest of its holder and the short or the writer
always has an obligation.
 If the long decides to exercise his right, the short would
have no choice but to carry out his part of the deal.

AAU, School of Commerce, Capital Market Project Office

 Option Types
Call Option Put Option
• A plain vanilla call option is • A plain vanilla put option is a
a contractual agreement, contractual agreement, which
which gives the owner gives the owner (holder) of the
(holder) of the option the put option the right but not the
right but not the obligation to sell a
obligation to purchase a predetermined quantity of the
predetermined quality of underlying asset (commodities,
the underlying asset shares, indices, et.) at a specified
(commodities, shares, price (called the strike price) on
indices, etc.) at a specified the expiry date.
price (called the strike
price) on the expiry date.

AAU, School of Commerce, Capital Market Project Office

European versus American options
• In European option, the right can be exercised only on a fixed date in
the future, known as the Expiration Date of the option. If an option is
not exercised on that day, then the contract will expire.
• In the case of an American option however, the option holder has the
right to transact at any point in time, between the time of acquisition
of the right and the expiration date of the contract.
• A Bermudan option is a half-way house. It can be exercised on a set
number of days before expiry, such as one day per week.

AAU, School of Commerce, Capital Market Project Office

Comparison between Futures and Options
Instrument Nature of commitment Nature of commitment
of the long of the short

Forward/futures Obligation to acquire Obligation to sell the

contract the underlying asset underlying asset
Call options Right to acquire the Obligation to deliver
underlying asset the underlying asset
Put options Right to sell the Obligation to accept
underlying asset delivery of the
underlying asset

AAU, School of Commerce, Capital Market Project Office

Option Prices versus Exercise Prices

• Option price or option premium refers to the amount paid by the

buyer of an option to the writer of the option.
• The option premium is a sunk cost as the premium cannot be
recovered even if the transaction were not to take place subsequently
• In the case of call options, the term exercise price, also known as the
strike price, represents the amount payable by the option holder per
unit of the underlying asset, if he were to choose to exercise his
option on a subsequent date.

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Moneyness of Option
Call (Long) Put (Long)

ST > E In-the-money Out-of-the-money

ST = E At-the-money At-the-money

ST < E Out-of-the-money In-the-money

ST - Current stock price

E - Exercise price

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Long call option contract
• Type of option: Long call
• Underlying asset: XYZ
• Spot share price: $100
• Number of shares in the contract: 100
• Exercise price: $100 per contract
• Exercise style: American
• Expiry: 1 year
• Premium: $10 per contract

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$100 strike call: intrinsic value and net
Profit and Loss at expiry
Price at expiry/
Cash price Call intrinsic value Net profit and loss
50 0 -10
60 0 -10
70 0 -10
80 0 -10
90 0 -10
100 0 -10
110 10 0
120 20 10
130 30 20
140 40 30
150 50 40

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 Long call payoff

P&L

Unlimited Profit
10

0 Price
Premium
-10
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Short Call Expiry Payoff
• The buyer of an option contract has limited downside (potential
losses) but unlimited upside (potential profit).
• Like an insurance policy, the most money that can ever be lost is the
initial premium that was paid.

AAU, School of Commerce, Capital Market Project Office

Short Call Expiry Payoff (Cont’d…)
Price at expiry Net profit and loss
50 10
60 10
70 10
80 10
90 10
100 10
110 0
120 -10
130 -20
140 -30
150 -40

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 Short call payoff

P&L

10
Premium
Price
-10 Unlimited loss

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 PUT OPTION:
INTRINSIC AND TIME VALUE
 A put option is the right but not the obligation to sell the
underlying at the strike or exercise price.
 Buying a put option is a ‘bear’ position on the underlying.
 The holder profits from a fall in the share price and the maximum
loss is restricted to the initial premium paid.
 It is not possible to realize any value by immediately exercising the
contract.

AAU, School of Commerce, Capital Market Project Office

 Long Put Expiry Payoff
price at expiry Intrinsic value Net profit and loss
50 50 40
60 40 30
70 30 20
80 20 10
90 10 0
100 0 -10
110 0 -10
120 0 -10
130 0 -10
140 0 -10
150 0 -10

AAU, School of Commerce, Capital Market Project Office

Long put payoff
P&L
Substantial but limited profit

10
0 Price
-10 Limited loss (Premium)

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Short put expiry payoff
• The buyer of a put option has limited downside (potential loss), restricted to the
initial premium paid.
• The maximum upside or profit potential is not in unlimited, since prices do not fall
below zero, but normally it is still very substantial.
• The major risk is taken by the writer of the contract.
• If it is exercised the writer is obliged to take delivery of the underlying and pay a
predetermined price – the strike – whatever the actual value of the share happens to
be in the cash market.

AAU, School of Commerce, Capital Market Project Office

Short Put Payoff
P&L

10
Premium (limited Profit)
0
Price
-10

Substantial (limited) loss

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 Swaps
Salient Features of Swaps
• A swap is an over-the-counter agreement • It is a combination of forward contracts and it
between two companies to exchange cash possesses all the properties of a forward
flows in the future. contract;
• The agreement defines the dates when the • Swap is long-term in nature, while forwards
cash flows are to be paid and the way in are arranged for a short period only;
which they are to be calculated. • It requires that there is a double coincidence of
• The calculation of the cash flows involves wants, which is two parties with equal,
the future value of an interest rate, an opposite but matching needs must come into
exchange rate, or other market variable. contact with each other; and
• there may be a need for a financial
intermediary to make the two counterparties
meet.

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Common Types of Swaps
1. Interest rate swap
2. Currency swap
3. Credit swap

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 Interest Rate Swaps
• The swap buyer agrees to make a number of Illustration
fixed interest rate payments based on a principal
contractual amount (called the notional • Assume that a deal is entered into
principal) on periodic settlement dates to the on March 8, 2023, where Marathon
swap seller. Motors agrees to receive a 3-month
floating rate interest payment & pay
• The swap buyer is referred to as the fixed-rate a fixed rate of 3% per annum every 3
payer. months for 2 years to CBE on a
• The swap seller, in turn, agrees to make floating- notional principal of $100 million.
rate payments, tied to some interest rate, to the
swap buyer on the same periodic settlement
dates. 3.0%
Marathon
• The swap seller is referred to as the floating- CBE
Motors
rate payer. Floating

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Interest Rate Swap (Cont’d…)
Date Floating Rate Floating Fixed Paid Net cash flow
(%) Received (‘000s) (‘000s)
(‘000s)
June 8, 2022 2.20 550 750 -200
Sept 8, 2022 2.60 650 750 -100
Dec. 8, 2022 2.80 700 750 -50
Mar. 8, 2023 3.10 775 750 +25
June 8, 2023 3.30 825 750 +75
Sept 8, 2023 3.40 850 750 +100
Dec 8, 2023 3.60 900 750 +150
Mar 8, 2024 3.80 950 750 +200

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Currency Swaps
• Currency swap involves exchanging principal and interest payments at
a fixed rate in one currency for principal and interest payments at a
fixed rate in another currency.
• A currency swap agreement requires the principal to be specified in
each of the two currencies.
• The principal amounts in each currency are exchanged at the beginning
and at the end of the life of the swap.
• The principal amounts are chosen to be approximately equivalent using
the exchange rate at the swap’s initiation.

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 Illustration
U.S. financial institution UK financial institution • As a result of the swap, the U.K.
Exchange rate: $2£1 financial institution transforms its
fixed-rate dollar liabilities into
Finance $200 million asset portfolio with a Fund 100 million assets denominated in fixed rate pound liabilities that
£100 million issue of five-year, medium- pounds with $200 million issue of five-year, better match the fixed-rate pound
term British pound notes medium-term dollar notes cash flows from its asset portfolio.

Fixed annual coupon: 6% Fixed annual coupon: 6% • The U.S. financial institution
transforms fixed-rate pound
Exposed to the risk that the dollar will exposed to the risk that the dollar will liabilities into fixed-rate dollar
depreciate (decline in value) against the appreciate against the pound liabilities that better match the
pound over the next five years fixed-rate dollar cash flows on its
asset portfolio.
Hedge: the U.K. institution sends annual Hedge: The U.S. financial institution sends
payments in pounds to cover the coupon annual dollar payments to the U.K. financial
and principal repayments of the U.S. institution to cover the interest and principal
financial institution’s pound note issue. payments on its dollar note issue.

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Thank you!

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 TRADING

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Trading Parameters
• Base price
• Open position
• High price
• Low price
• Daily closing price
• Maximum allowable trading position
• Maximum allowable open position
• Circuit filter

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Circuit Filter

• Pre-defined in the Contract Specifications

• Circuit filter provides the maximum price range (% of variation) during a

trading day

• Varies for different commodities

• Computed on the previous day’s close price

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Margins
• In futures contract, compliance is ensured by requiring both the long
and the short to deposit a collateral in an account known as the
Margin Account.
• The margin deposit, known as the Initial Margin, is therefore a
performance guarantee.
• The amount of collateral is the potential loss that each party is liable
to incur.

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Margins (cont’d)
• Initial margin

• Special margin
• Delivery period margin

How to Set Margin

1. Absolute terms
• Initial
• Maintenance
2. Percentage terms
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Maintenance Margin and Variation
Margin
• Initial Margin: Both longs and short have to deposit a
performance bond.
• Maintenance Margin: a threshold balance to ensure that
a client always has adequate funds in his margin account.
• Margin Call: Due to adverse price movements, the
balance in the margin account may decline below the
level of the maintenance margin, the client will
immediately be asked to deposit additional funds so as to
take the balance back to the level of the initial margin.
• Variation Margin: The additional funds deposited by a
client when a margin call is referred to as the variation
margin.
AAU, School of Commerce, Capital Market Project Office
Mark-to-Market Loss Monitoring and
Establishing of Loss Limits
• Meaning of mark-to-market of Profit / Loss

• Rationale for mark-to-market loss monitoring

• Dealing with the profits by exchange

• How loss limits are established by Exchange?

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The concept of Marking to Market
• Marking to Market refers to the process of calculating the loss for one
party and the corresponding gain for the other at specified points in
time.
• A futures contract will be marked to market every day until the
position is either offset or expires.
• The party who has incurred a profit will have the amount credited to
his margin account, while the other party, who would have incurred an
identical loss, will have his margin account debited.

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Marked-to-Market (MTM) Loss
• Monitoring of MTM loss, both notional and booked incurred by
member up to the last trade.
• This is calculated on real-time basis by way of computing the
difference between actual traded price and last traded price
• Alert signals to Members at 60%, 75%, 90% of MTM Loss limit (75%
of the total deposit)
• Automatic ‘Square off’ mode, if Member crosses the permitted
MTM loss limit

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M to M loss monitoring
System generates alerts on losses
Margin Deposit of a 60% -$ 4.5 Million
Member = $ 10 million, 75%- $ 5.625 Million
M to M limit= $7.5 90%- $ 6.75 Million
million

Member gets automatically into “Square Off”

mode. Then he is restricted from taking fresh
positions and is allowed only to Square off his In case M to M Losses
existing positions built up by him. being more than $ 7.5
million

The member gets activated -

by depositing Additional Margin with Member in ACTIVE
Exchange MODE

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Example: Long position on 100 contracts with an initial margin
of 5000 Birr and Maintenance Margin of Birr 3000.

End of the Day Futures Prices

Day Futures Price
0 400
1 405
2 395
3 380
4 405
5 425
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Example (Cont’d)
Day Futures Daily Cumulative Account Margin
Price Gain/Loss Gain/Loss Balance Call

0 400 - - 5,000
1 405 500 500 5,500
2 395 (1,000) (500) 4,500
3 380 (1,500) (2,000) 3,000 2,000
4 405 2,500 500 7,500
5 425 2,000 2,500 9,500
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 Illustration
Number of contracts 500 Trading Settlement Daily Account Margin call/
Future price $100 day price gain or balance Variation
Position Long /(loss) Margin
Initial margin $7 per contract = $3,500 0 100 --- $3,500
Maintenance margin $4 per contract = $2,000
1 $99 ($500) $3,000

2 $97 ($1,000) $2,000

Trading day Settlement price 3 $98 $500 $2500
1 $99
2 $97 4 $95 ($1,500) $1000 $2,500
3 $98
4 $95

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 Value at Risk (VaR)
• The goal of risk management is to reduce the variability of
uncertain cash flows.
• VaR is a concept by means of which senior management can be
informed, via a single number, of the short term price risk faced by
the firm.
• The VaR concept encapsulates an estimate of the price risk
possessed by a portfolio of derivatives and other financial assets.
• VaR provides the dollar amount by which the value of a portfolio
might change with a stated probability during a stated time
horizon.
• A firm may estimate that there is a 1% probability that its portfolio
will decline by $ 5million during the next week.
• The decline in the value of the portfolio can be caused by changes
in the prices of the fundamental risk factors such as changes in
foreign exchange rate, interest rate changes, commodity price
fluctuation, etc.
AAU, School of Commerce, Capital Market Project Office
The Concept of Value at Risk (VaR)
• If the amount of margin or performance bond that is
collected from the parties to the contract is adequately
high, the potential for default will be insignificant.
• Value at risk or VaR, is a statistical technique for
estimating a potential loss.
• VaR implies that with a given level of probability, the
loss cannot exceed a specified amount.
• 99% VaR of an asset for a one day horizon with Birr
1,000 would mean that there is only a 1% probability
that the loss of value of the asset over a one day
holding period will exceed Birr 1,000.
AAU, School of Commerce, Capital Market Project Office
 The VaR computational methodology:
Exponential Moving Average method
• Ϭ2 t = λϬ2t–1 + (1- λ) rt 2
• Ϭ2t (the variance) is the measure of the volatility of returns
on day t
• rt is the return on the asset on day t.
• rt = (pt/pt-1) where pt is the futures price of the asset on day
t.
• λ = 0.94
• The 99% VaR is calculated based on a deviation of 3Ϭ.
• Margin requirement for short futures positions
[ e3Ϭ*t -1] X 100
• Margin requirement for long future positions
[1 - e-3Ϭ*t]AAU,
X 100
School of Commerce, Capital Market Project Office
 Numerical illustration
• Assume that:
Ϭt-1 = 0.0247 and rt = 0.0225
• Ϭ2 t = λϬ2t–1 + (1- λ) rt 2
• Ϭ2t = 0.94 x (0.0247)2 + (1-0.94) x (0.0225)2
• Ϭ2t = 0.000604
• Ϭt = 0.02457
• Percentage margin for a short position
[e3Ϭ*t -1] x 100 = 7.6495%
• The percentage of margin for a long position
[1 - e-3Ϭ*t] x 100 = 7.1059%
AAU, School of Commerce, Capital Market Project Office
Cont’d
• Assume that the futures price of an asset at the end
of the day is Birr 1,000 and that each contract is for
100 units.
• The initial margin required to keep a short position
open for the following day will be
100 x 1,000 x 0.076495 = Birr 7, 649.50
• The initial margin required to keep a long position
open for the following day will be
100 x 1,000 x 0.07105 = Birr 7,105

AAU, School of Commerce, Capital Market Project Office

ORDERS AND EXCHANGES

AAU, School of Commerce, Capital Market Project Office

What are orders?
• An order is a trade instruction given to a broker or to an
exchange.
• Order contains the following information:
• Type of order
• Buy order
• Sell order
• Order size: number of contracts
• Price
• maximum price at which we are willing to buy
• minimum price that we are prepared to sell
• market price (market orders)
• limit price (limit orders)
• Duration for which the order will remain valid
• Day order: if a suitable match is not found by the end of the day on
which the order is entered, it will automatically be cancelled.
• All or nothing or all or none (AON) order: an order must either be
filled completely or else remain unexecuted.

AAU, School of Commerce, Capital Market Project Office

Buy and sell order tickets

AAU, School of Commerce, Capital Market Project Office

Type of orders
1. Price related condition orders
i. Market Order
ii. Limit Order and a Limit Order Book
iii. Stop-Loss order
2. Time related condition orders
i. Day Orders (or End of Session Order)
ii. Good Till Cancelled Orders GTC)
iii. Good Till Date Orders (GTD)
iv. Immediate or Cancel Orders (IOC)

AAU, School of Commerce, Capital Market Project Office

Market Order
• A market buy order: executed at the best available price - the lowest of
the limit sell orders.
• A market sell order: executed at the highest of the limit prices – the
highest limit buy orders.
Priority rules
1. Price priority rule: A limit buy order with a higher limit price ranks
higher than all other limit buy order with a lower limit prices. A limit sell
order with a lower limit price ranks higher than all other limit sell orders
with higher limit prices.
2. Time priority rule: the order which comes in first is automatically
accorded priority.

AAU, School of Commerce, Capital Market Project Office

Limit Order and Limit Order Book (LOB)
• A limit order specifies the price at (or better than) which the trade
should be executed.
• Limit buy orders with high limit prices and limit sell orders with low
limit prices are said to be aggressively priced.
• A limit buy order will be placed at a price that is lower than the best
price available in the market which is the price of the best sell order
in the LOB.
• A limit sell order will usually be placed at a price that is higher than
the price of the best buy order in the LOB.

AAU, School of Commerce, Capital Market Project Office

Limit Order: specifies the price at (or better than)
which the trade should be executed

Table 4.1 Chronological Sequence of Incoming Orders.

Time a.m. Trader Order Side Order Size Limit Price
10:01 Abrar Buy 100 100
10:03 Bethel Buy 200 120
10:07 Chaltu Sell 200 110
10:10 Dereje Sell 500 125
10:15 Elias Buy 200 100
10:18 Fatuma Buy 400 Market
10:20 Gualu Sell 500 100
10:25 Harerta Sell 200 99
10:30 Lemma Buy 500 90
AAU, School of Commerce, Capital Market Project Office
LOB: Executed (Matched) order

Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader

Bethel 200 120 Chaltu 200 110

Fatuma 400 125 Dereje 400 125

Abrar 100 100 Gualu 300 100

Elias 200 100

AAU, School of Commerce, Capital Market Project Office

 LOB: Pending Orders
Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader

Lema 500 90 99 200 Harerta

- - - 100 200 Gualu

- - - 125 100 Dereje

AAU, School of Commerce, Capital Market Project Office

At 10:30 a market sell order for 500 contracts @98 placed by Roman.

Snapshot of the LOB at 10:25 a.m.

Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader

- - - 99 200 Harerta

- - - 100 200 Gualu

- - - 125 100 Dereje

AAU, School of Commerce, Capital Market Project Office

 In the absence of a limit order on the other side, the incoming
order will be converted to a limit order with a limit price equal to
the previous day’s closing price.

Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader

- - - 98 500 Roman

- - - 99 200 Harerta

- - - 100 200 Gualu

- - - 125 100 Dereje

AAU, School of Commerce, Capital Market Project Office

 Marketable Limit Order: a limit order that
can be executed upon submission
Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader

Admassu 1,500 100 125 1,300 Paulos

Sherefa 1.000 99 140 1,200 Ahmed

Moges 1,500 90 150 1,500 Kemal

AAU, School of Commerce, Capital Market Project Office

 Cont’d
• A limit buy order with a limit price of Birr 125 or more
will be executed as soon as it enters the system, as will a
limit sell order with a limit price of Birr 100 or less.
• The limit price for a marketable limit buy order must be
greater than or equal to the best offer that is available.
• The limit price of a marketable limit sell order must be
less than or equal to the best bid that is available.
• Difference between marketable limit order and market
order:
• while in the case of a market order a trader has no control
over the execution price, in the case of a marketable limit
order he can prescribe a price ceiling or a price floor
depending upon whether it is a buy or a sell order.

AAU, School of Commerce, Capital Market Project Office

Cont’d
• Assume that Samson issues a marketable limit buy order with a limit
price of Birr 130 for 300 contracts expecting that it will be matched
with the best price of Birr 125.
• Another market buy order for 3,000 contracts @150 comes in prior to
Samson’s order.
• Price will be pushed up to Birr 150.
• Since Samson has specified a price limit of Birr 130, his order will not
get executed under the circumstances.
• It will go the top of the buy side as the best bid.

AAU, School of Commerce, Capital Market Project Office

 Marketable Limit Order: Compute the
executed order book and pending order book.
Buyers Sellers

Trader Order Size Limit Price Limit Price Order Size Trader

X 3,000 150

Samsom 300 130

125 1,300 Paulos
Admassu 1,500 100

Sherefa 1.000 99 140 1,200 Ahmed

Moges 1,500 90 150 1,500 Kemal

AAU, School of Commerce, Capital Market Project Office

Stop-Loss order
• Stop loss buy order are placed above the current market price and
stop loss sell orders are placed below the current market price.
• A trigger price is specified to allow the system to activate stop loss
order once the last traded price breaches the trigger price.
• A Stop or a Stop-Loss order will be placed by a trader who has a
position in the market and would like to cut his losses and quit
immediately, if conditions were to turn adverse.

AAU, School of Commerce, Capital Market Project Office

 Snapshot of an LOB prior to the
Placement of a Stop Sell Order
Buyers Sellers
Trader Order Size Limit Price Limit Price Order Size Trader

Abebe 1,200 600.00 600.20 500 Gebre

Abdella 1,000 599.85 600.30 1,000 Mohamed

Araya 500 599.75 600.35 500 Abraham

Aysiha 800 599.55 600.40 700 Mussie

Diguma 500 599.25 600.50 300 Seifu

Eyasu 1,000 598.00 602.00 1,000 Alem

AAU, School of Commerce, Capital Market Project Office

 Cont’d
• Assume that Petros has taken a long position in 800
contracts. He has in mind a threshold price of Birr 599.60
and if the market were to trade at that level or below, he
would like to exit it immediately. In this case, Petros can
place a stop sell order with a trigger price of Birr 599.60.
• Assume that a market sell order for 4,000 contracts
comes in. It will ensure that Abebe’s, Abdella’s, Araya’s,
Aysiha’s and Diguma’s orders are fully filled.
• The last trade price will be Birr 599.25, which is less than
the trigger of Birr 599.60 specified by Petros. This will
immediately cause Petros’s order to get activated and it
will enter the system as a market sell order. In this case it
will be executed at Birr 598.00.
AAU, School of Commerce, Capital Market Project Office
Trailing stop loss Order
• Assume that you have an existing open long position of 1
contract of Gold futures which you had bought at Br
820,000 (each contract is of 1 kg) if you want to limit your
loss to Birr 5,000 what would be your stop-loss sell order
and what would be the trigger price per 10 gram?
• A stop-loss sell order would be at Birr 8,150 per 10 gm
with the trigger price at say, Br 8,151 per 10 gm.
• Assume that you have an existing open short position of
contract of gold futures which you had sold at Br 8,200
per 10 gm. The total value of one Gold futures contract at
the sale price is Br 820,000 (each contract is of kg). If you
want to limit your loss to Br, 5,000, what would be your
stop-loss buy order and what would be the trigger price?
• A stop-loss buy order would be at Br, 8,250 per 10 gm
with the trigger price at say, Br 8,249 per 10 gm.
AAU, School of Commerce, Capital Market Project Office
 Time Related Condition Orders
• Day Orders (or End of Session Order):
• Are available for execution during the current trading session.
• Remained in the system until executed or cancelled.
• Good Till Cancelled Orders GTC)
• Remain in the system until they are explicitly cancelled by the trader.
• If they are not executed by the close of trading on a given day, they will
automatically be carried forward to the next business day.
• Good Till Date Orders (GTD)
• Available for execution till the end of the date indicated in the order.
• The order ought to be cancelled if it is not executed by then.
• Various types of GTD orders: Good-this-week (GTW) and Good-this-month
(GTM) orders.
• Immediate or Cancel Orders (IOC) or Fill-or-Kill (FOK) or Good-on-sight orders
• Executed as soon as it is released into the system, failing which it stands
cancelled.
• If a sizeable order on the other side is not available, only a partial match
may be executed and the unfilled portion will be cancelled.

AAU, School of Commerce, Capital Market Project Office

Order priority rules in open-outcry
systems
• Price Priority Rule: The first person who accepts a bid
or an offer gets to trade with the trader who has
made the corresponding bid or offer.
• To encourage price competition, most open-outcry
systems will not allow a trader to bid below the best
bid that is currently available or offer above the best
offer that is currently available.
• Floor Time Preference Rule: priority is given to the
trader who was the first to bid or offer at a given price
that improved upon the previous bid or offer.

AAU, School of Commerce, Capital Market Project Office

 Thank you

AAU, School of Commerce, Capital Market Project Office

 UNIT VIII:
SECURITY ANALYSIS

11/10/2024 AAU, School of Commerce, Capital Market Project Office 288

 Outline
• Meaning and the approaches of security analysis;
• Technical and fundamental analysis;
• Economy, industry and company analysis;
• Assumptions of technical analysis;
•Technical analysis
11/10/2024 AAU, School of Commerce, Capital Market Project Office 289
Meaning and purpose of Security Analysis
• Security analysis is the analysis of financial instruments/ securities.
• It is the evaluation of a particular trading instrument, an investment sector,
or the market as a whole.
• Analysts attempt to determine the future activity of an instrument, sector, or
market.
• security analysis for investor is to identify the attractive potential
investments in securities

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 Security Analysis: Approaches

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Technical analysis
➢It is the attempt to forecast the movement of stock prices on the basis of market-
derived data.
➢Technicians (also known as quantitative analysts or chartists) usually look at
price, volume and psychological indicators over time.
➢Technicians are looking for trends and patterns in the data that indicate future
price movements.
➢Not concerned with the underlying economic variables that affect a company or
the market.

11/10/2024 AAU, School of Commerce, Capital Market Project Office 292

 Fundamental analysis
➢Various fundamental or basic factors that affect the risk-return of the securities
are examined.

➢By assessing fundamental determinates of the value of security, an estimate of

its intrinsic value can be determined.

➢The objective is to identify those securities which are perceived to be mis-priced

in the market.

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Framework for Fundamental analysis
a) Bottom-up Approach
➢ Focuses directly on a company’s fundamentals
(such as company’s product, competitive position,
financial status) to estimate company's earning
potential to determine its value in the market.
a) Top-down Approach
➢ Considers all fundamental factors to estimate
company’s earnings potential.
➢ Conduct Economy/market Analysis, Industry
Analysis and Company Analysis in order

11/10/2024 AAU, School of Commerce, Capital Market Project Office 294

Economy/market Analysis
➢Macroeconomic analysis
➢evaluates current economic environment and its effect on industry and company
fundamentals
➢the performance of a company depends on the performance of the economy
• If the economy is in recession or stagnation, ceteris paribus, the performance of companies will
be bad in general.

• if the economy is booming, incomes are rising and the demand is good, then the industries and
then companies in general may be prosperous.

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Economy Analysis…
Group Discussion
Identify macro-economic factors that affect the
performance of a company and discuss the impacts.

11/10/2024 AAU, School of Commerce, Capital Market Project Office 296

Economy Analysis…
Economic Fundamentals/variables:
➢Economic performance (GDP)
➢Business Cycles
Expansion, Peak, Contraction, Trough
➢Fiscal Policy
✓Government expenditures (demand)
✓Tax & Debt policies
➢Monetary Policy
✓Interest rates
✓Inflation rates
✓Money supply
✓Reserve requirements (commercial banks) Business Cycle
✓Margin requirements (brokerage accounts)

11/10/2024 AAU, School of Commerce, Capital Market Project Office 297

 Economy Analysis…
➢Economic and political stability

➢Government policy (GTP/ Indigenous economy policy)

➢Employment

➢Global Economy
• Import/Export

• Exchange rate

11/10/2024 AAU, School of Commerce, Capital Market Project Office 298

 Economy Analysis…
➢Demand Shocks- events that affect the demand for goods and
services
• Change in tax rates
• Change in money supply
• Change in government spending
• Change in foreign export demand
➢Supply Shocks- events that influence production capacity and
costs
• Change in price of oils
• Droughts , floods
• Changes in the educational level of an economy’s workforce
• Change in wage rates

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 Industry Analysis
➢Companies within a similar
industry will often perform
similarly due to macroeconomic
conditions helping or hurting all
companies the same across the
industry.
➢Identify some industries ….

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 Industry Analysis…
➢Evaluates outlook for particular industries
➢At any stage in the economy, there are some industries which are growing while
others are declining.
➢The performance of companies will depend among other things upon the state of the
industry.
➢If the industry is prosperous, the companies, within the industries may also be
prosperous although a few may be in a bad shape.
➢The objective is to identify sunshine industries and avoid investing in sunset
industries.

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 Industry Analysis…
Group Discussion
Identify Industry fundamentals/factors that affect the
performance of a company and discuss the impacts.

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Industry Analysis…
• Business Cycle and industries characteristics
• Industry Life Cycle
• Industry Competition
• Permanence (probability of product obsolescence)
• Vulnerability to external shocks (foreign
competition)
• Government Policy with Regard to Industry
• Labor conditions (unionization)
• Raw Material and Inputs
• Capacity Installed and Utilized
• Demand and Market
• Management
• Future Prospects

11/10/2024 AAU, School of Commerce, Capital Market Project Office 303

Industry Analysis…
Business Cycle and industries characteristics:
• Cyclical industry - performance is positively related
to economic activity
• Defensive industry - performance is insensitive to
economic activity
• Growth industry - characterized by rapid growth in
sales, independent of the business cycle
• Countercyclical industries- moves opposite to the
prevailing economic trend.
• Interest sensitive industries - are practically
sensitive to expectations about changes in the Business Cycle
interest rates.

11/10/2024 AAU, School of Commerce, Capital Market Project Office 304

Industry Analysis…
Group Discussion
1) Give at least two examples for each type of industries identified
above in Ethiopia.
2) Which industries are most attractive for investment and at what
stage of the business cycle?

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 Industry Analysis…
Industry Life Cycle:
Start-up stage:–
• characterized by extremely rapid growth.
• it is difficult to predict which firm will
emerge as industry leaders.
• Some firms will turn out to be wildly
successful and others will fail altogether.
• there is considerable risk in selecting one
particular firm within the industry.
• Birth (heavy R&D, low revenues - large
losses)
Industry Life Cycle

11/10/2024 AAU, School of Commerce, Capital Market Project Office 306

 Industry Analysis…
Consolidation Stage:-
• characterized by growth that is less rapid but still faster than that
of the general economy.
• industry leaders begin to emerge.
• The survivors from the start stage are more stable, and market
share is easier to predict.
• the performance of the surviving firms will more closely truck the
performance of the overall industry.
• Growth (building market share and economies of scale)

11/10/2024 AAU, School of Commerce, Capital Market Project Office 307

Industry Analysis…
Maturity stage:-
• characterized by growth no faster than the general economy.
• Firms at this stage sometimes are characterized as cash cows, having reasonably
stable cash flow but offering little opportunity for profitable expansion.
• The cash flow is best “milked from” rather than reinvested in the company.
• Mature growth (maximum profitability)
• Stabilization (increase in unit sales may be achieved by decreasing
prices)

11/10/2024 AAU, School of Commerce, Capital Market Project Office 308

Industry Analysis…
Minimal or negative growth stage:-
• the industry grows less rapidly than the rest of the economy or
actually shrinks.
• This could be due to obsolescence of the product, competition
from new products or competition from new low-cost suppliers.
• Decline (demand shifts lead to declining sales and profitability -
losses)
11/10/2024 AAU, School of Commerce, Capital Market Project Office 309
Industry Analysis…
Group Discussion
1) Give at least two examples of industries under each
stage of industry life cycle in Ethiopia.
2) At which stage in the life cycle are investments in an
industry most attractive? Justify.

11/10/2024 AAU, School of Commerce, Capital Market Project Office 310

Industry Analysis…
Industry Competition:-
• The intensity of competition in an
industry determines that industry’s
ability to generate above average
returns.
• To create a profitable competitive
strategy, a firm must first examine the
basic competitive structure of its
industry
• Michael Porter identified five basic
competitive factors to determine
competitive structure of an industry

11/10/2024 AAU, School of Commerce, Capital Market Project Office 311

 Industry Analysis…
1. Rivalry among the existing competitors
Rivalry increases when:
• many firms of relatively equal size compete in an industry.
• slow growth
• High fixed costs
• exit barriers, such as specialized facilities or labor
agreements.
• Low industry concentration
• Homogeneous goods
These can keep firms in the industry despite below-average or negative rates
of return.
11/10/2024 AAU, School of Commerce, Capital Market Project Office 312
 Industry Analysis…
2. Threat of new entrants
High barriers to entry:-
• Economies of scale
• First mover cost advantages- low current prices relative to costs
• Capital required
• Government/legal barriers
• Control of distribution
• Product differentiation
• high costs of switching products or brands
Higher the barriers, higher the profitability

11/10/2024 AAU, School of Commerce, Capital Market Project Office 313

 Industry Analysis…
3. Threat of substitute products
• Substitute products limit the profit potential of an industry
because they limit the prices firms in an industry can charge.
• How close the substitute is in price and function to the product in
an industry.
• The more commodity like the product, the greater the
competition and the lower the profit margins.
• Willingness to substitute
• Price-performance of substitutes

11/10/2024 AAU, School of Commerce, Capital Market Project Office 314

 Industry Analysis…
4. Bargaining power of buyers
➢Buyers can influence the profitability of an industry
➢Buyers become powerful:
✓Cost of purchase -when they purchase a large volume relative to the sales
of a supplier.
✓Profitability of buyers
✓Size & concentration of buyers relative to suppliers
✓Buyers switching costs
✓Buyer’s information -When buyers know the cost structure of the industry
✓Ability to integrate backwards

Example: Bargaining power of auto manufacturers reduces profitability of auto parts industry

11/10/2024 AAU, School of Commerce, Capital Market Project Office 315

 Industry Analysis…
5. Bargaining power of suppliers.
➢Suppliers can alter future industry returns if they increase prices or reduce the
quality of the product or the services they provide.
➢Suppliers are more powerful
✓ if they are few and are more concentrated than the industry to which
they sell ,
✓ if they supply critical inputs to several industries for which few, if any,
substitutes exist.
✓ Ability to integrate forward

11/10/2024 AAU, School of Commerce, Capital Market Project Office 316

Industry Analysis…
Group Discussion
Evaluate the degree of competition
in an industry of your choice in
Ethiopia using Porter’s Five Forces
Model.

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 Company analysis
➢Company analysis involves analyzing basic financial variables in order to
estimate the company’s intrinsic value.

➢Evaluates company’s strengths and weaknesses within industry (SWOT analysis)

➢Consider both qualitative and quantitative factors

➢Financial Analysis (covered under part III)

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 Company analysis…
Group Discussion
Identify company fundamentals/factors that
affect/indicate the performance of a company and
discuss the impacts.

11/10/2024 AAU, School of Commerce, Capital Market Project Office 319

Company Analysis: Qualitative Issues
➢ Product line (turnover, age) ➢ Availability of infrastructure,
✓ Output rate of new products ➢ Marketing and distribution,
✓ Uniqueness of the product, ➢ Components of cost-fixed and variable,
✓ Product innovation strategies ➢ Availability of raw material inputs,
✓ R&D budgets ➢ Quality of personnel,

➢ Patents and technology, ➢ Quality of management,

➢ Rating of promoters, ➢ Future plans

11/10/2024 AAU, School of Commerce, Capital Market Project Office 320

Company Analysis: Qualitative Issues
Evaluating Management Quality
“I don’t invest in products; I invest in management”
➢Age and experience of management ➢ Finance Strategy - adequate and
➢Strategic planning appropriate
✓Understanding of the global ➢ Employee/union relations
environment ➢ Effectiveness of board of
✓Adaptability to external changes directors
➢Marketing strategy ➢ commitment and competence
✓Track record of the competitive ➢ future orientation
position in its industry ➢ image building
✓ Pricing Strategy ➢ investor friendliness
✓ Sustainable growth ➢ Government relation building.

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Company Analysis: Quantitative Issues
➢Operating efficiency
• Productivity

➢Understanding a company’s risks

• Financial and business risks

➢Financial Ratio Analysis

➢Regression analysis
• Forecast Revenues, Expenses, Net Income
• Forecast Assets, Liabilities, External Capital Requirements

11/10/2024 AAU, School of Commerce, Capital Market Project Office 322

Estimating Earnings and Fair Market Value for Equity
Five Steps
1. Estimate next year’s sales revenues
2. Estimate next year’s expenses
3. Earnings = Revenue - Expenses
4. Estimate next year’s dividend per share
= Earnings Per Share * dividend payout ratio
5. Estimate the fair market value of stock given next years earnings,
dividend, ROE, and growth rate for dividends.
✓Using Gordon Growth model or P/E Model

11/10/2024 AAU, School of Commerce, Capital Market Project Office 323

 Company Analysis: Financial Statements
➢Statement of financial position /Balance Sheet
• Snapshot of company’s Assets, Liabilities and Equity.
➢Statement of profit or loss /Income statement
• Sales, expenses, and taxes incurred to operate
• Earnings per share
➢Statement of Cash flows “Financial statements are like
• Sources and Uses of funds fine perfume; To be sniffed
but not swallowed.”
➢Statement of Changes in Equity
• summarizes the transactions related to the
shareholder’s equity
AAU, School of Commerce, Capital
Market Project Office 10/4/2023
AAU, School of Commerce, Capital Market Project Office 324
 Company Analysis: Financial Analysis
➢Financial analysis is the evaluation of a company’s financial performance
and financial condition.

➢It is evaluating relationships between component parts of financial

statements to obtain a better understanding of the firm’s financial
condition and performance.

➢Its objective is to identify the firm’s current strengths and weaknesses

AAU, School of Commerce, Capital

Market Project Office 10/4/2023
AAU, School of Commerce, Capital Market Project Office 325
 Technical Analysis

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 What is Technical Analysis?
➢Technical Analysis is the forecasting of future financial price movements based
on an examination of past price movements.
➢Method of evaluating securities by analyzing statistics generated by
✓Market activity
✓Past Prices
✓Volume
➢Do not attempt to measure intrinsic value
➢Look for patterns and indicators on charts to determine future performance
➢Technicians believe that securities move in very predictable trends and patterns
➢ Some times called chartist method

11/10/2024 AAU, School of Commerce, Capital Market Project Office 327

Basic Assumptions of Technical Analysis

➢All fundamental factors are discounted by Dow Theory Assumptions:

the market and are reflected in prices. • Price discounts everything

➢Prices move in trends or waves which can

Price movements are not totally
be either upward or downward
random
➢the present trends are influenced by the
past trends and the projection of future What is more important than
trends is possible by an analysis of past Why
price trends.

11/10/2024 AAU, School of Commerce, Capital Market Project Office 328

 Dow Principles
1. Market trends move in three ways
• Primary trend
• Secondary trend
• Tertiary trend (Swing or noise)
2. Primary trends have three phases (Bullish market vs Bearish market)
• Accumulation vs Distribution phase
• Big move phase
• Excess vs Despair phase
3. Stock prices reflect news
4. Indices (Dow Industrial and Dow Transportation) must confirm trends
5. Volume must confirm trends
6. Trends exist until proven otherwise.

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Dow Theory
➢At the turn of the century, the Dow Theory laid the foundations for what was later to
become modern technical analysis.

➢Dow Theory was set by Charles Dow

➢Assumptions:

✓Price Discounts Everything

✓Price Movements Are Not Totally Random
✓What Is More Important than Why

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How might different trading styles
approach the same pattern?
Momentum traders might buy on strength near
each new high and suffer a series of small losses
until the final actual breakout to new highs.
Range traders will be selling on rallies to the
upper band because they expect the channel to
remain intact.
Breakout traders will buy as the market moves
above the channel (or above previous highs),
betting an upward move is about to begin.
Trend followers who bought earlier may remain
long the entire time with an exit stop placed below
the channel.
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What affects price trends?
• Human Psychological Tendencies
• Herd psychology
• Reverse elasticity
• Trading volume
• Open interest

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 Interrelationship of Interest, Volume, and Prices
OI Volume Price Interpretation
Up Up Up Very bullish (strong participation and
volume with higher prices)
Down Down Down Slightly bullish (weak participation and
volume with lower prices)
Up Down up Mildly bullish (strong participation but
weak volume with higher prices)

UP Down Down Mildly bearish (strong participation but

weak volume with lower prices)
Up Up Down Very bearish (strong participation and
volume with lower prices)
Down Down Up Slightly bearish (weak participation and
volume with higher prices)

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 Tools of Technical Analysis
a) Daily Fluctuation or Volatility
• Open, High, Low and close are quoted.
• Changes between Open and Close or High
and Low can be taken in absolute points or
in percentages to reflect the daily volatility

Japanese Candle Stick

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Market Project Office AAU, School of Commerce, Capital Market Project Office 4
 Tools of Technical Analysis…
b) Price Trends and Volume Trends ➢ If a price increases on heavy volume relative
➢ analysts use charts and diagrams to the stock’s normal trading volume as an
to depict the past trends and indication of bullish activity.
project the future ➢ a price decline with heavy volume is bearish.
➢ Rate of Change of prices and Volumes is
➢ Chart is used for forecasting the
depicted
future trends ( provide buy or sell ➢ Rate of Change is calculated by dividing the
signals) today’s price (volume) by the price (volume)
five days back or few days back.
➢ Price trends follow the volume
trends in general.
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 Tools of Technical Analysis…
b) Price Trends and Volume Trends

Read the open, last, high and low prices and volume of the Boeing stock on 21 July 2023.
AAU, School of Commerce, Capital
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Market Project Office AAU, School of Commerce, Capital Market Project Office 6
Tools of Technical Analysis…
➢ The secondary or intermediate
Dow Theory Trends
trend represents the correction to
➢The trends in stock prices are divided under three the primary trend and is of a short
heads duration of a few weeks to a few
✓primary, months.
✓secondary and
➢ The minor trends may be in either
✓minor.
direction for few days.
➢The primary/major trend is a long-term trend of ➢ These three trends are comparable
a year or more reflecting the basic mood of the to the tides, waves and ripples of
market showing upward or downward movement. the sea respectively.

11/10/2024 AAU, School of Commerce, Capital Market Project Office 337

Most Dow theorists do not think a new primary trend has been confirmed
until pattern of ascending or descending tops occur in both industrial and
transportation averages.

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 Tools of Technical Analysis…

c. Moving Averages
➢Shows the average value of a security’s price over a period of time

➢The most commonly used averages are of 7, 10, 50, 100 and 200 days

➢The longer the time span, the less sensitive the moving average to daily price changes

➢ Moving averages are used to emphasize the direction of a trend and smooth out price
and volume fluctuations

➢Used to identify the buy and sell signals.

11/10/2024 AAU, School of Commerce, Capital Market Project Office 339

Moving Averages
• The purpose of a moving average is to smooth out short-term ups and
downs in prices, to reveal the underlying trend.
• To compute moving averages add up the prices (closing price) for a
specific number of periods and then divide the total by the number of
periods.
• Three main types of moving averages:
1. Simple moving average (SMA)
2. Weighted moving average (WMA)
3. Exponential moving average (EMA).
• The last two place more emphasis on recent prices.
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Example
Day Closing Price 3 Day Moving Average

1 109.50
2 108.70
3 107.25 108.50
4 106.40 107.45
5 107.40 107.00
6 107.70 107.15

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11/10/2024 AAU, School of Commerce, Capital Market Project Office 342
How to use MA
• Look at the slope of the moving average line to determine the trend
visually, and position yourself accordingly.
• Note where the current price is relative to the moving average.
• If the price is above the moving average, the trend is up and you should be
long.
• if the price is below the moving average, the trend is down and you should
be short.
• Use the moving average line as a point for potential support or
resistance.

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 Tools of Technical Analysis…
d) Floating Stock and Volume of Trade

✓ Floating stock is the total number of shares available for trading

✓ volume of trade is any part of that floating stock.

✓ The higher this proportion, the higher is the liquidity of a share which is to be purchased
or sold.

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 Tools ofTechnical Analysis…
e) Advance Decline Line or Spread of the Market
➢ The breadth is measures by the number of scrips rising and falling.
➢ the breadth and the market average lines move in the same direction.
➢ If both the advance decline line and the average are rising (declining) the overall
market is said to be technically strong (weak).
➢ If the market average rises while the advance-decline line weakens or declines, this
indicates a weakening in the market; the average would therefore be expected to
reverse itself and start declining.
➢ In a bull phase there will be a large number of net rises and in a bear phase, a large
number of net falls.
➢ The ratio between Advances to declines will indicate the relative strength of upward
or downward phase.

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Market Project Office AAU, School of Commerce, Capital Market Project Office 5
 Tools of Technical Analysis…
e) Advance Decline Line or Spread of the Market An illustrative for calculation of the breadth of the
Measurement of breadth of the market involves two market is shown below:
steps:
1) Calculate the number of net
advances/declines on a daily basis.
2) Obtain the breadth of the market by
cumulating daily net
advances/declines.

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 CHARTING

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Type of Charts
1. Line charts
2. Bar charts
3. Candlestick charts
4. Point and figure chart

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Line Charts
• It provides the easiest explanation of basic chart construction.
• A basic line chart is constructed by connecting just the closing prices
for periods without regard to other values such as highs or lows.
• The periods viewed could be daily, weekly, monthly, or any intraday
period such as 60 minutes or 5 minutes.

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Line Chart (Cont’d)

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Bar Charts
• While a line chart shows only closing prices, bar charts include:
• high price
• low price
• opening price and
• closing price.
• Each bar is drawn between the high and low price for the period, and
the open and close are indicated with the small hash marks on the
left and right side of the price bar.

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Bar Chart (Cont’d)
High High

Close Open

Open Close

Low Low
Standard Japanese Standard Japanese
Bar Chart Candlestick Bar Chart Candlestick

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Bar Chart (Cont’d)

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Candlestick Chart
• Candlestick charts provide a quick visual picture of
the relationship between opens and closes and their
relative strengths or weaknesses for extended
periods.
• The body representing the difference between the
opening and closing prices, looks like a candle.
• If the closing price is above the opening price, the
body is usually clear, white, or green.
• If the closing price is below the opening price, the
body is usually solid, black, or red.

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Candlestick Chart (Cont’d)

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 Technical Analysis Tools:
Reading the Charts
• Trend Lines
• Price Patterns
• Moving Averages

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Trend Lines
• Identifying the trend is the first goal of the technical analyst
as trend lines are at the heart of analyzing price action.
• Up-trend-lines: a bull or rising market is connected by
higher lows and higher highs.
• Down-trend-lines: a bear or falling market connected by
lower highs and lower lows.
• The best and most reliable trend-lines will be older and
therefore longer.
• When a trend line is broken (price moving below an up-
trend-line or above a down-trend-line), it signals reversal of
a trendline.
• When an up-trend line is broken, longs should liquidate and
go short.
• When an down-trend line is broken, shorts should square-
off and go long.
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(Cont’d)

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 Phases of a Trend

The three phases of bullish trend The three phases of bearish trend:
1. Accumulation phase:- only select
1. Distribution phase- only select
elite of investors who perceive the elite of investors who perceive
coming things first start buying the coming things first start
shares. selling shares.
2. Big move- the followers of trend
2. Big move:- the followers of trend notice a distinct downtrend and
notice a distinct uptrend and begin begin to participate in the selling
and then the mass selling starts.
to participate in the buying and
then the mass buying starts. 3. Despair - the end of the
downtrend, all hope is lost and
3. Excess -the end of the uptrend stocks are frowned upon.
when the first elite group who
initiated the firstAAU, School
phase should
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Price Channels
• A channel is identified by constructing a parallel
line to the major trendline.
• Prices often have a similar range for each bar, so
most of the price activity occurs within the
boundaries of the two parallel lines.
• Traders use the channel lines as support and
resistance, selling when prices approach the upper
channel line and buying when they approach the
lower channel line, assuming that prices will
remain in this channel.
• Traders also trade only the breakout of a channel,
assuming that when prices drop below the lower
channel line of an uptrend, the market is reversing
its original direction.
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Cont’d

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 Support and Resistance

• Support is the floor price level where a decline may be expected to stop.
• Support is a price area that tends to lift the market or prevent prices from
going lower.
• Resistance is the ceiling price level where a rally can be expected to stop.
• Resistance suppresses prices and acts as a ceiling that prices have difficulty
penetrating.
• Technicians believe that once violated, support becomes resistance (in a
sell-off), and that resistance becomes support (in a rally).
• Go long at the support level and take short at the resistance level.

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 6750 GOLD 10GM - 1 KG - 1 MONTH (6,268.00, 6,287.00, 6,268.00, 6,276.00, +9.00000) 6750
6700 6700
6650 6650
6600 6600
6550 6550
6500 6500
6450 6450
6400 6400
6350 6350
6300 6300
6250 6250
6200 6200
6150 6150
6100 6100
6050 6050
6000 6000
5950 5950
5900 5900

15000 15000

10000 10000

5000 5000

x1000 x1000

October November December 2005 February March April May June July August September

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Chart Patterns
The three broad chart pattern categories:
1. Continuation patterns
i. Pennants or triangles
ii. Rectangles
iii. Flags
2. Reversal patterns
i. Double tops (M tops) and double bottoms (W
bottoms)
ii. Head and shoulders
iii. Rounding tops and bottoms
iv. V tops and V bottoms

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• Continuation patterns are relatively of a shorter duration.

Pennants or Triangles
1. Symmetrical Triangle:
• The future price implication of this pattern depends on the
previous trend. If this occurs following a correction to the
ongoing bull move, this could be followed by an accelerated or
continued downfall.
2. Ascending Triangle:
• Subject to previous trend this has bullish implications.
• Ascending triangles breakout up
3. Descending Triangle:
• Subject to previous trend this has bearish implications.
• Ascending triangles breakout down.

Note: Triangle is an intermediate pattern and usually takes

more than a month to form. Triangle’s of a shorter duration
could be of a different pattern such as pennant.

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 Continuation Patterns

Profit Target

1 3 buy
2
stop
4
sell
4 3
2 1

stop Profit
Target

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Cont’d

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Flags
• A flag formation is a congestion area but instead of
prices compressing to an apex as in the triangle, price
action is more erratic and appears to be a small
countertrend against the main trend.
• Flags appear like parallelograms. A bullish flag slopes
downwards from left to right. A bearish flag has an
upside slant.

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 Continuation Patterns
Profit Target

buy

sell
Profit Target

Profit Target
buy

sell

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 Reversal Chart Patterns

1. Double tops (M tops) and double bottoms (W

bottoms)

2. Head and shoulders

3. Rounding tops and bottoms

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Double Top & Double Bottom
Double top:
Double tops are measured from the
highest point to the bottom of the trough
(low) between the 2 peaks. Profit target is
then projected down from the breakout of
the second trough (low).

Double bottom:
Double bottoms are measured from the
lowest point to the peak between the 2
troughs. Profit target is measured from the
breakout of the second peak

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Cont’d

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AAU, School of Commerce, Capital Market Project Office
Head-and-Shoulders
• The head is a price peak with another peal lower that the
head (the left shoulder) and another peak lower than the
head to the right (the right shoulder).
• The line connecting the lows of the declines from the left
shoulder and head is termed the neckline.
• The neckline can be horizontal (typical H&S) like a support,
or like an up-trendline, or down-sloping like a down-
trendline.
• The pattern of H&S is complete if the right shoulder is
completed, and the decline from the right shoulder’s peak
breaks under the neckline.
• When there is breakout below the neckline, exit longs and
go short.
• False signals: the market again rally back above the neckline.

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AAU, School of Commerce, Capital Market Project Office
Inverted Head & Shoulders
Head & shoulders:
The extent of the breakout can be
estimated by measuring from the top of
the middle peak down to the neckline.

Inverted Head and Shoulders:

With inverted head and shoulders, the

neckline is drawn through the highest
points of the two intervening peaks.

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Rounding Bottoms (Saucer Bottom)
• Prices edge down in a series of lower lows and then begin to creep
higher with a series of higher lows.
• The pattern is totally completed when the chart looks like a saucer.
• When prices on the right side of the chart move above the lip of the
saucer formation, it’s a signal to buy.
• False signal: False rounding tops or bottoms occur as evidenced by a
higher high or lower low preceding the final top or bottom.

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AAU, School of Commerce, Capital Market Project Office
 Technical Vs Fundamental Analysis
Technical Analysis Fundamental Analysis
Focuses on timing and likely price changes Focuses on determining intrinsic value
Helps the decision when to buy and sell Explains:-
✓why share prices fluctuate,
✓how they are determined and
✓what to buy or sell
Focuses on factors that are available in the market (Price, Focuses on factors that are out side the market (annual
volume etc.) reports, industry reports, economic estimates, etc.)
Focuses on short term changes in the prices though Focuses on long term expected price.
intermediate and long term forecasts are also done. Typically follows buy-hold-sell strategy
Focuses more on price direction than price target or Focuses on price target; not generally bothered for short
forecast term price changes.
Simultaneously applied to many stocks Difficult to apply for large number of stocks unless a big
analysts team is set up.
Easier and faster Requires considerable time for analyzing

11/10/2024 AAU, School of Commerce, Capital Market Project Office 379

 Technical Vs Fundamental Analysis…
➢Technical analysts consider the market to be 80% psychological and 20% logical.
➢Fundamental analysts consider the market to be 20% psychological and 80%
logical.
➢Even though there are some universal principles and rules that can be applied,
technical analysis is more an art form than a science.
➢As an art form, it is subject to interpretation.
➢TA is also flexible in its approach and each investor should use only that which
suits his or her style.
➢Most agree that technical analysis is much more effective when combined with
fundamental analysis

11/10/2024 AAU, School of Commerce, Capital Market Project Office 380

Thank You!

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