Investments

Topic 2
 Financial Markets
Financial markets are the mechanisms and
conventions that exist for transfer of funds and
financial instruments between market participants
Market participants:
 Borrowers (issuers)
 Lenders (buyers)
 Financial intermediaries (buyers and issuers)
 Brokers, fund managers, speculators
 Exchanges
 Regulators

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 Primary Markets
• The market for the issue of new securities to borrow
money for consumption or investment purposes.

• Includes issue of both primary and indirect securities

• Non-reversible instruments: only traded in primary

market

• Reversible instruments: traded in secondary market

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Issuing shares
 1. Public offering
• The company offers the shares issued to the general
public
• If the stocks are issued by a formerly private company
which is going public, this is known as an Initial Public
Offering (IPO)
• if the issued stock is from an already public company
who are now issuing additional stock, this is known as a
Seasoned Equity Offering (SEO).

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There are three ways in which shares can be sold in an
IPO:

• Offer for sale = securities sold to underwriter, who then

tries to sell them to general public

• Offer for subscription/Direct offer – the issuing company

sells the share to the public

• Public tender = securities sold to public via an auction

(i.e. directly), subject to minimum price.
 2. A rights offering
• New shares are sold to existing shareholders.
• This is a form of SEO, where firms existing shareholders
are offered the opportunity to buy a proportional
number of additional securities at a given price (which is
usually at a discount) within a fixed period of time

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 3. A private placement
 The issuing firm sells new stock directly to an investor or
a group of investors. Whilst a private placement is
significantly cheaper than a public offering, the shares
sold in a private placement cannot be traded in the
secondary market, which reduces their liquidity and thus
the price investors may be willing to pay for them.

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 4. Backdoor listing
• When a company uses an existing listed company. This
can happen in two ways:
1. Reverse takeover – the already listed company takes over
the company which wants to list (the unlisted company will
have a controlling interest in the listed one)
2. Cash shell – this is a listed company which has sold off all its
assets , therefore cash is its only asset left. The unlisted
company therefore purchases the cash shell and transfers
all its assets into it.
The mechanics of a rights offer
• A rights issues is the public issue of shares in which the
shares are first offered to existing shareholders.

• One of the provisions of the JSE says that when a listed

company wants to raise additional share capital, any new
shares issued should be offered to the existing
shareholders on a pro rata basis.

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• This is to prevent the possible dilution of shareholder
ownership

• In a rights offer each shareholder is given the right to

buy a specific number of the new shares for a specific
price. They have to use this right within a given
timeframe.

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 Example:
National Power earns R2 million after taxes and has 1
million shares in issue. The company wants to fund their
planned expansions through the use of a rights offer. They
require R5 million. Although the current market price per
share is R20ps, the new shares will be sold for R10 per
share.

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1. How many shares must they sell at this price to raise
the R5 million?

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2. As an existing shareholder, how many rights do you
need to own in order to buy one of the new shares?

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NOTE: the price the new shares can be sold for can be
changed…

If the price is set higher fewer new shares will be issued and
thus more rights will be needed to buy one new share.
If the price is set lower more new shares will be issued and thus
fewer rights will be needed to buy one new share.

Number of rights
Number of new
Subscription price needed to buy One
shares
new share

R20 250 000 4

R10 500 000 2

R5 1 000 000 1 15
3. What will the new price of the shares be after the rights
issue?

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The value of the right is therefore R3.33 (R20 – R16.67)

If an existing shareholder does not want to exercise this

right, he can sell it to an outsider. Therefore the price at
which he will sell each right is R3.33.

If: P0 is the price of the original share (which carries the

right),
PS is the subscription price of the new share,
PX is the price of the new shares (after rights are
exercised),
N is the number of rights to buy ONE share, and
R is the value of a right:
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In the NP example:

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 Secondary Markets
 Markets in which previously issued financial claims traded
 Do not raise new funds – merely facilitate transfer of
ownership
 Just like the buying and selling of a second hand car does not earn
additional revenue for the car manufacturer
 Two types:
 Dealer markets
 Over-the-counter (OTC) markets
 Dealers buy and sell for own accounts
 Dealers connected electronically
 Auction markets
 Brokers / agents match buyers and sellers, but never personally
take ownership of the commodities traded.
 Physical location – e.g. JSE

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 Secondary Markets
Benefits of active secondary market
 Assists primary market because purchasers have
assurance that they will be able to sell securities if they
need to (reversibility).
 Supplies regular updates of price information
 Helps determine prices/rates for new issues
 Indicates whether there will be demand for new issues
 Enables investors to rapidly adjust their portfolios
 Enables central bank to influence liquidity in markets by
buying and selling securities (open market operations)

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 Bond, money and capital markets
Debt market is split into money and bond markets
 Money market – securities with maturities of up to 1
year
 Also encompasses interbank market and various operations of
the Reserve Bank
 Bond market – securities with maturities of over a year
Capital markets:
 Essentially markets in which long term financial
instruments are issued and traded
 Bond markets
 Equity markets

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Johannesburg Stock Exchange (JSE)
• Three separate components
 Equities Market (“the stock exchange”)
 Interest Rate Market (incorporating the former Bond
Exchange of SA)
 Currency, Equity, Commodities Derivatives Markets
(incorporating SAFEX)

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Johannesburg Stock Exchange (JSE)
• Basic trading procedure on any exchange entails 3 steps
 Submit the order
 Accept the order with the best price
 Match the buy and sell orders – facilitated by brokers

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 Equities Market
Main Board
AltX
The alternative exchange, designed for small and
medium sized businesses
Less onerous listing requirements
Also a BEE segment – provides a secondary
market for trading in BEE scheme shares and
also aimed at facilitating market education for
holders of BEE scheme shares

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Share market information is usually displayed in
the following format:

The ‘*’ under Company name indicates that trading on the share has
been suspended, while the ‘#’ is an ex-dividend indicator.
 Bid vs Offer prices
• bid price is the price which the buyer is willing to
pay to acquire the share
• offer price is the price that the seller is willing to
accept for the share.
• The difference in the two is known as the bid/offer
spread.
• The trade becomes a matched trade when the buy
and sell orders are matched.
• The transaction is therefore concluded at the sales
price.
 the highest and lowest prices during the
trading day.

The “closing price” is therefore the last price for a particular

day and could be the bid, offer, or sales price.
“Market capitalisation” = the closing price of
the share X the number of shares in issue

the dividend yield of the share.

 Dividend Yield
• Dividends – are payments made to
shareholders from after-tax profits.

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Important dates when dealing
with dividend payments
• Declaration date
– the date on which the board of directors announces that
the company will pay a dividend

• Date of record
– the date on which the company looks at its record to see
who the shareholders are. An investor therefore has to be
listed as a shareholder to receive the dividend.

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• Cum dividend - means “with dividend”. If you
buy the stock during this period, you are
entitled to the dividend payment as well
• Ex dividend – means “without dividend”. If you
buy the stock now, you are not entitled to the
dividend payment.

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 Types of Share transactions
• There are five major types of transactions that investors
can enter into:
Example: ABC Co’s share price closed @ R31.98

• Market order
 Is an order to buy/sell securities at the best prevailing
price
 “Buy 100 shares of ABC Co at the market price” or
“Sell 200 shares of ABC Co at the market price”

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 Example: ABC Co’s share price closed @ R31.98

• Limit orders
 Specify the buying/selling price
 “Buy 200 shares of ABC Co limit R31.99” or
“Sell 100 shares of ABC Co limit R31.97”
 Usually, the investor must indicate how long
the limit order will hold for. A limit order
can therefore be instantaneous (“fill or
kill”), good for a day/week/month, open
ended, or good until cancelled (GTC)

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 Example: ABC Co’s share price closed @ R31.98

• Short sales
 Involves the sale of shares that the investor does not
actually own, with the intention of buying them back
at a lower price, at a later stage

Why would you ever want to short sell a share?

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 Example: ABC Co’s share price closed @ R31.98

• Special orders
 Two types : Stop loss orders and Stop buy
orders
 A stop loss order is an order to sell a security
once the price drops below a specified stop
price. “Sell 100 shares of ABC Co stop R31.96”
 A stop buy order is used by short sellers who
want to minimise any loss if the share
increases in value. “Buy 200 shares of ABC Co
stop R32.00”
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 Example: ABC Co’s share price closed @ R31.98

• Margin transactions
 This involves the use of borrowing to pay for shares
purchased, while the balance is paid for in cash

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 You buy R20 000 worth of shares
Margin requirement
R10 000 equity R10 000 debt = 50%
The share value goes up to R25 000

R15 000 equity R10 000 debt

The share value goes down to R15 000

R5 000 equity R10 000 debt

+R2500 margin call
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 Market Indices
• A stock market index is a method of measuring the
performance of a particular section of the stock
market.
• The performance of many of these indices are
published and updated on a daily basis.
• The key thing to remember about an index is that it is
not possible to directly invest in the index – it is
merely calculated to gauge the performance of a
certain section of the market.
• However, certain funds are created which attempt to
mirror the performance of the index, and it is possible
for an investor to invest in these (e.g. Satrix).
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 Stock Market Indices
• A stock market index is a method of measuring
performance of the stock market as a whole, or a
particular section (“sector”) of the market.
• Cannot invest directly in index, but can invest in funds
that attempt to closely track index.

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 Stock Market Indices
Broad based indices
Represent performance of whole stock market
By inference, reflects investor sentiment about
economy (hence featured on TV news shows)
SA: All Share Index (ALSI)
US: Dow Jones Industrial Average (DJIA)
Japan: Nikkei 225
Germany: Xetra DAX
UK – Financial Times Stock Exchange 100 (FTSE 100)

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 Stock Market Indices
• Specialised Indices
 Track performance of particular segment of market
 E.g. Resources, Finance, Industrial Firms

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 Stock Market Indices
Top 40 Resource 20 Mining Basic Materials Real Estate

Industrial Industrial 25 Gold Mining Construction Telecommunications

Mid Cap Financial Diamonds Forestry and Paper Industrial

Financial and
Small Cap Platinum Beverages Food and Drug Retailer
Industrial

ALSI ex res Oil and Gas Other Minerals Health Care Banks

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 Stock Market Indices
• Market Indices can be calculated according to:
 Price weighting
 Market value weighting
 Equal weighting

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 Stock Market Indices

Shares -in Final Value of

Initial millions Initial Value of Shares
Share Price Final Price (in millions) Shares (in
millions)

A R25 R30 20 R500 R600

B R100 R90 1 R100 R90

TOTAL R600 R690

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 Stock Market Indices
• Price weighting
 Simply average prices.
 Initial value of index:
 Final value of index:

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 Stock Market Indices

Shares -in Final Value of

Initial millions Initial Value of Shares
Share Price Final Price (in millions) Shares (in
millions)

A R25 R30 20 R500 R600

B R100 R90 1 R100 R90

TOTAL R600 R690

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 Stock Market Indices
• Value Weighting
 Initial value set to 100.
 Index increases according to increase in total market value:
Initial value of shares:
Final value:
Growth factor:
Final value of index=

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 Stock Market Indices

Shares -in Final Value of

Initial millions Initial Value of Shares
Share Price Final Price (in millions) Shares (in
millions)

A R25 R30 20 R500 R600

B R100 R90 1 R100 R90

TOTAL R600 R690

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 Stock Market Indices
• Equal weighting
 Prices and market valuations are ignored.
 All that matters is change in value.
 Effect of changes in value equally weighted:
A: increases by 20%
B: decreases by 10%
Growth in index: 20% + (-10%) = 10%
 Index would increase from 100 to 110.

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Cash flows between “The Firm” and
Financial Markets
Firm initially raises cash by selling shares and
borrowing money (A).
Firm invests cash in non-current assets (e.g.
Buildings, Machinery) and current assets (e.g.
Trading Stock) (B).
These assets generate cash flows (C).
 Some go to pay taxes (D).
 Some are reinvested in the firm (E).
 The remainder returns to financial markets as cash paid to
lenders (principal + interest), and shareholders (dividends)
(F).
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Cash flows between “The Firm” and
Financial Markets

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Valuing Money Market Instruments
• Two ways in which can lend and pay interest.
• First:
 can lend the principal, say R1 000-00.
 The borrower, after a year, pays back the R1 000-00, plus
interest at say 10% p.a. (R100-00)
 Therefore, the interest is “added on” to the principal.

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Valuing Money Market Instruments
 Secondly: you can start with the amount to be repaid, say
R1000-00.
 You treat this as the nominal or future or face value of the
claim against the borrower.
 Then ask yourself how much the lender would be prepared to
purchase the claim for, if say he/she wished to earn interest at
10% per annum.
Nominal or Face Value = Present Value + Interest
FV = PV + 10% x PV
1000 = 1.1 x PV
PV = 1000 / 1.1 = 909.09
 That is, to determine the amount of money a lender will pay
for the claim, you divide the repayment amount or face value
by 1 + the interest rate, a process known as “discounting”.
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Valuing Money Market Instruments
• Can classify money market instruments into two types:
 Discount securities
 Interest add-on securities

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Valuing Money Market Instruments
• Discount Securities
 Banker’s acceptances
 Commercial Paper
 Treasury Bills

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 Valuing Discount Securities
Nominal or face value (NV) – the full amount
received by the investor at the instrument’s
maturity, inclusive of the interest earned.

Consideration (C) – the price of the

instrument, having been issued, when
traded in the secondary market. Also less
Issue Price (IP) – the price paid for the than the face value, because represents
instrument when issued, which is less the present value of the instrument after it
than the face value. i.e. IP < NV. has been issued, but greater than the issue
price because interest is earned with
passage of time (IP < C < NV).

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 Valuing Discount Securities
 Following variables used in valuing:

 Days till security matures (d) – this decreases as maturity date

approaches

 Days the security is held (t)

 The discount rate (l) is the difference between nominal value and
the present value of the instrument (IP or C, depending on
whether on or beyond issue date).

 The yield (y) – the difference in value between the amount paid
for the security (IP or C) and its nominal value (NV), as an
annualised percentage of the amount paid (IP or C)

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 Valuing Discount Securities
IP = NV [1- (I/100 * d/365)]

C = NV [1- (I/100 * d/365)]

Discount = NV – IP or Discount = NV – C or Discount = C2 – C1

The actual rand value of the interest earned on the security

during the period in which it was held

Y = (Discount/IP) * (365/t) * 100 or Y = (Discount/C) * (365/t) * 100

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 Valuing Discount Securities
EXAMPLE 1
• Assume that a discount security with a nominal value of
R1million is issued at a discount rate of 17.4% per
annum for 90 days.

a) What is the issue price of the security to the investor?

b) How much does the investor earn if the security is held to
maturity?
c) What is the yield per annum to the investor if the security is
held to maturity?

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• Therefore, the investor will actually earn 18.18% by buying the
discount security, whereas the discount rate is 17.4%. The
discount rate will ALWAYS be smaller than the yield. Why?
Discount rate = discount amount/NV;
yield = discount amount/IP;
NV > IP; therefore yield > discount rate.

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 Valuing Discount Securities
EXAMPLE 2
• Assume the investor in Example 1 holds the security for
only 21 days before selling it at an unchanged discount
rate of 17.4%.
a) At what price was the security sold?
b) How much does the investor earn if the security is held for 21
days?
c) What is the equivalent yield per annum to the investor from
holding the security for 21 days?

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 Valuing Discount Securities
EXAMPLE 3
• Assume that the market discount rate falls to 17.38% per
annum during the 21 day period. At what price is the
security sold?

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• Therefore, there is an inverse relationship between the price of
the discount security and the discount rate; as the discount
rate falls the bond price increases. Why?

New, identical securities issued in the market will now be

earning less than this issue, which means investors will prefer
this security and the increase in the demand will drive the
price up

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 Valuing Discount Securities
EXAMPLE 4
• Calculate the yield on a 91 day BA if it is trading at a
discount of 12.45%.

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Valuing Interest Add-On Securities
(Money Market)
• Most common type of interest add-on security is the
NCD.
• Unlike discount instruments, yield is exactly the same as
interest rate, provided investors holds NCD to maturity.
• But if sell NCD prior to maturity, then yield is affected by
current market interest rate.

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 Valuing Interest Add-On Securities
Consideration (C): Price paid for NCD in
secondary market if purchased after issue but
before maturity

Value at maturity (VM): Nominal Value +

Nominal value (NV): NCDs are issued at Interest
nominal value (i.e. NV = IP) You always calculate the VM first for an
interest add-on security

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Valuing Interest Add-On Securities
Variables:
Annual interest rate (i)
Yield (y): Income as annualised percentage of NV
Days held (t)
Time to maturity (d)

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Valuing Interest Add-On Securities

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Valuing Interest Add-On Securities

EXAMPLE 5
• Assume an investor purchases an NCD of R1 million on 1
May, which will mature on 31 August. The interest
payable at maturity is 17.5% p.a. What amount will the
investor receive at maturity?

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Valuing Interest Add-On Securities

EXAMPLE 6
• Assume the same day that the investor
purchased the NCD at 17.5%, the yield of
equivalent length NCD’s falls to 17.25%. Should
the investor decide to sell his NCD immediately,
what would his consideration be?

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Valuing Interest Add-On Securities

EXAMPLE 7
• Suppose now the NCD is sold by the investor on
the 27th July at a yield of 17%.
 What consideration does he receive?
 What is his effective yield?

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