INVESTMENT NOV 2012 MODEL ANSWERS
SECTION A
Question 1
1.a
Zero coupon bonds are bonds sold at a discount, and when they mature, the owner receives
the full face value of the bond. Unlike most other types of bonds, zero coupon bonds do not
make periodic interest payments. This type of bond is issued by the Treasury, federal
agencies, municipalities, corporations and stock brokerage houses themselves. Investing
in zero coupon bonds has the primary advantage of locking in a good interest rate. But the
“locking in” feature of zero coupon bonds can also be its downfall. How? If you invest in a
zero coupon bond, you lock in an interest rate for a specified period of time. That's great if
the interest rates go down during that time period because you'll be locked in at a higher
rate. However, if the interest rate go up during the time period of the bonds, not only is the
principal amount you paid for the bonds locked in at a lower rate, but you aren't getting
periodic interest payments so you can't even reinvest your interest into another investment
vehicle with a higher interest rate.
(5marks)
1.b
Governments need to raise money to carry out their spending policies – welfare, health,
education, building works, infrastructure (roads, railways etc.), the legal system etc. To the
extent that the government does not raise sufficient funding through the taxation system, it
often borrows money by issuing bonds to fund the deficit. Government bonds are also
referred to as gilts. Government bonds are usually issued in the domestic currency of the
government. These bonds are deemed to be the securest form of investment in that
currency. Governments do issue bonds in currencies other than their own and in some
cases these are considered to be a greater credit risk than those issued in the domestic
currency.
(5marks)
1.c
When you invest in corporate bonds, you are lending money to a company and in return you
receive a specific interest rate for a specific period of time. When the time period is over, or
the bond matures, you receive your original investment amount back. Corporate bonds have
maturity dates ranging anywhere from ten to thirty years. In addition, these types of bonds
are securities and you can purchase them through a broker.
The interest rate you receive on corporate bonds depends on several factors including the
length of the maturity. Generally, longer-term bonds pay higher interest rates as an incentive
for investors to lock in their funds for such a long period of time.The interest rate you receive
on corporate bonds depends even more on the strength of a corporation's finances. The
stronger that a corporation's credit record is, the less interest you'll receive on bonds it
issues. Why? It's the risk vs. safety feature. The safest bonds, those issued by financially
strong corporations, will attract investors for the safety of their investment. Corporations with
lower credit ratings must pay higher interest rates for their bonds in order to encourage
investors to take more of a risk.
(5marks)
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Question 2
2.a
Capital growth investment strategy is a widely accepted and followed portfolio
management strategy. As the name suggest, the strategy aims at capital growth, maximizing
portfolio value, over time. Before we start, here is the danger signal – capital growth strategy
is a high risk investment strategy which requires great investment discipline and money
management.
A portfolio which follows capital growth strategy is mainly comprises of equities. Often more
than 60 to 70 percent capital is invested in stocks, preferably growth stocks. Remaining
portfolio can be constituted of low profit low risk investments such as fixed income securities,
money market funds, cash, and/or precious metals like gold to limit overall portfolio risk. The
exact portfolio capital allocation depends on many things like individual profit goals, risk
tolerance,
risk
capital
involved,
portfolio
size
and
investing
experience.
Many times one can see capital growth portfolios which allocate more than 90 percent
capital to equities. Capital growth investors often prefer small and mid cap stocks over large
cap stocks, because these show greater growth and are expected to offer increased return
over time. Diversification of portfolio is important in capital growth strategy and is achieved
by investing in different products like stocks, options, futures, ETFs, funds, bonds, etc.
Portfolios which allocate most (all) of the capital to equities achieve diversification by
investing in different industry stocks, different markets, using derivatives to hedge risks, and
by investing in both high growth high risk stocks and low profit low risk stocks.
Capital growth investment strategy is a long-term strategy, which may or may not require
periodical reassessments and rearrangements of portfolio allocations. Investable stocks are
found using various growth investing tools and strategies. Active portfolio management is
recommended for experience investors, to replace low performing investments with high
performing ones. But remember, active management often requires greater costs.
The advantages of capital growth investment strategy involve faster increase in asset value
and better chance of profit than most other investment strategies. The disadvantages include
higher risk, unpredictable returns and high volatile portfolio. With capital growth strategy,
market entry and exit timings are very important; and there are too many market, risk and
economical factors to be considered. The silver lining is ‘irrespective of frequent ups and
downs, the equity market shows almost steady growth in long-term; which is higher than
most other financial markets.
Income growth investment strategy identifies sources of immediate income whether
through income stocks or bonds. There are four most commonly used fixed income
investment strategies. The intentions of these examples are not to be an all-encompassing
list of methods of investing. The examples used throughout are merely for illustrative
purposes.
The fixed-income investment strategy includes a number of types of securities, with a variety
of interest or coupon rates and credit ratings. Matching your investment objectives with the
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right securities is crucial to the success of your income investment strategy. In general, by
diversifying your fixed-income holdings, you will achieve a better balance between risks and
rewards than you would have if you concentrated your investments in a single sector or
security.
The ladder strategy of income investment strategy is a conservative strategy that works well
for investors who want to protect against unexpected movement in interest rates. It involves
dividing your money among bonds that mature at different intervals. For example, initially
you create a ladder by buying bonds with stepped maturities --one-, three- and five-years.
Then, as each bond matures, you replace it with another one having the longest maturity in
the ladder; in this instance, it is five years. Laddering maximizes returns and helps reduce
downside risk.
The barbell strategy of income investment strategy involves buying a mix of short- and longterm bonds so that the portfolio has the same price sensitivity to interest-rate changes as an
intermediate-term security. The barbell strategy of income investment strategy is generally
preferred when the yield curve is expected to flatten.
Working with a single maturity is at the heart of the bullet strategy. Generally, it is used for
one of two reasons. First, it is used to position a portfolio for an anticipated change in
interest rates. Of the strategies, bullet strategies generally outperform barbells of similar
duration when the yield curve steepens. Investors who expect the yield curve to flatten would
typically shift from a bullet structure to a barbell structure.
Finally, to focus cash flows to meet expected future expenditures such as paying college
expenses or buying a business. Zero-coupon bonds could be appropriate in these situations
because they eliminate reinvestment risk and provide a known amount of cash at maturity.
The income investment strategy that seems to be the best is the bullet strategy. (10marks)
2.b
Liquidity is the ease with which an investment can be converted to cash. As you can see,
liquidity is similar to marketability. The essential difference is that for an investment to be
liquid its value or repurchase price should be relatively consistent with the original purchase
price.
Generally, the more liquid investments have lower rates of interest. Liquidity of an
investment is determined by both the type of the investment as well as the period of
investment.
The following factors influence liquidity:



The marketability of the investment.
Whether the investment can be redeemed over the counter or on an exchange.
If the investment can serve as collateral.
(5marks)
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Question 3
The risks that influence the investment decision are summarized below:
Interest rate risk
The price of a bond will fall as interest rates rise and rise as interest rates fall. Given an
increase in interest rates, a bond sold prior to its maturity date (when par value will be
received) will realize a capital loss i.e. the bond will be sold at a price below its purchase
price. This risk is generally referred to as interest rate or market risk. The sensitivity of a
bond’s price to changes in interest rates i.e. its volatility will depend on the bond’s features.
Coupon rate: low coupon bonds are more volatile than high coupon bonds.
Maturity: the further away the maturity date the more volatile the bond.
Initial yield to maturity: bonds with higher yields to maturity at time of purchase are more
volatile than bonds with lower yields to maturity at time of purchase.
Re investment risk
Yield to maturity calculations assume that cash flows generated by a bond can be reinvested
at the yield to maturity over the life of the bond. The additional income from this reinvestment
(termed interest on interest) depends upon the prevailing interest rate at the time of
reinvestment. As it is likely that interest rates will rise or fall before maturity, all coupons
received before maturity may be reinvested at higher or lower rates than the yield to maturity
– resulting in a return that is more or less than the yield to maturity. The risk that the interest
rate at which coupons can be reinvested will decrease is called reinvestment risk. The longer
a bond’s maturity and the higher its coupon the greater its reinvestment risks. Interest rate
and reinvestment risk are counteracting i.e. interest rate risk is the risk that interest rates will
increase and reduce the price of a bond while reinvestment risk is the risk that interest rates
will fall and decrease the interest earned on the reinvestment of coupons.
Credit risk
Credit risk (also known as default risk or quality risk) is the risk that the issuer of a bond will
be unable to make timely interest and principal payments. The most widely used measure of
credit risk is the rating assigned by rating companies such as Moody’s, standard and Poor’s
and Fitch (the Duff and Phelps / Fitch IBCA merged entity). Fitch operates in RSA, as does
CA- ratings.
Inflation risk
Inflation risk is the risk that the return from investing in a bond will not offset the loss of
purchasing power due to inflation. For example if an investor purchases a bond paying a
coupon of 10% and the rate of inflation is 11%, the purchasing power of the investor’s cash
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flow has declined. Given that interest rates reflect the expected inflation rate, variable rate
bonds will have a lower inflation risk than fixed rate bonds.
Liquidity risk
Liquidity risk (also known as marketability risk) is the risk that a bond can not be sold at or
near its value. This is due to a given position in bonds being large relative to typical trading
volumes or because market conditions are unstable (for example the 1998 Asian crisis). A
measure of liquidity risk is large price movements when any attempt is made to buy or sell a
bond. Liquidity risk is less important if the investor plans to hold the bond until maturity.
Exchange rate risk
In Malawi, a bond not denominated in Malawi Kwacha has unknown kwacha cash flows. The
ruling exchange rate at time of cash flow payments will determine the kwacha value of the
payments. For example, suppose a Malawian investor buys a bond denominated in GBP. If
the GBP weakens relative to kwacha, then fewer kwachas will be received. The risk of this
happening is called exchange rate or currency risk. In contrast, should GBP strengthen
relative to the kwacha, the investor will benefit by receiving more kwacha.
Call risk
Call risk is the risk that falling interest rates will motivate a callable bond issuer to redeem –
or call – its bond before the maturity date of the bond.
Call risk is a combination of the following:


Cash flow uncertainty in that the cash flows of a callable bond are not known with
certainty.
Reinvestment risk as given that the bond has been called, it is highly unlikely that the
bondholder can reinvest in a similar instrument with an equivalent yield.
Bondholders are compensated for taking call risk by means of a lower price or higher yield.
However, it is difficult to establish if the compensation is adequate.
Volatility risk
Volatility risk is the risk that a change in volatility will adversely impact the price of a bond. It
applies to bonds with embedded options such as callable bonds because, other things
equal, option holders benefit from and option sellers are hurt by an increase in volatility and
visa versa.
(15marks)
Question 4
4.a
The characteristics of futures markets are as follows:
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
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



Contracts are standardized with trading for specific quantities in specific months.
Dealings conducted amongst members of the clearing exchange alone. Clearing houses
act as a guarantor of contract performance, i.e. the fulfillment of contract obligations by
its members through the collective financial resources of the clearing house irrespective
of what happens to the individual trader.
Trading/transaction costs are relatively low.
Daily mark-to-market process whereby all profits and losses on open futures positions
are settled daily.
Market information communicated to all participants.
The markets should have high liquidity.
(5marks)
4.b





It cannot be stolen
Its value is determined by the market forces and in inflationary times acts as a viable
store of value.
Property price cycles are usually long ensuring stability.
Its value as security is high.
The assets do not require active management
(5marks)
4.c
A repurchase agreement is a sale of securities with an undertaking by the seller to
repurchase the same securities after a stipulated period of time at a price determined at the
time of the sale. The essence of a repurchase agreement is to adjust the original maturity of
a particular money market asset to suit the needs of an investor. The buyer is said to be
making a “carry” or resale agreement or “warehousing” the particular financial asset.
Repurchase agreements are generally entered into by financial institutions because the
securities they wish to sell may not have the exact maturity desired by the purchaser. They
may also be entered into to finance holdings of securities. This would tend to be done on an
interest rate view. There are two types of repurchase agreements. The “open” agreement
gives the creator or the purchaser the option of closing the agreement at any time. The
closing would usually be the result of either an interest rate consideration or the purchaser
requiring the cash. “Term” repurchase agreements are agreements that are entered into for
a specific period, and do not offer the maker or the purchaser any options. As repurchase
agreements are entered into in respect of specific financial assets, the denominations
available are the same as those of the securities underlying the transaction.
(5marks)
6
SECTION B
Question 5
5.a
Financial markets
The economic function of financial markets is to provide channels for transferring the excess
funds of surplus units to deficit units. Financial markets constitute the mechanism that link
surplus and deficit units, by providing the means for surplus units to finance deficit units
either directly or indirectly through financial intermediaries. Financial markets provide surplus
and deficit units with additional options. Surplus units may purchase primary or indirect
securities or reduce their debt by purchasing their own outstanding securities. Deficit units
may issue securities or dispose off some financial assets previously required.
It will be evident that the participants in the financial markets are the borrowers (issuers of
securities), the lenders (buyers of securities), the financial intermediaries (buyers and
issuers of securities and other debt obligations) and the brokers. The term financial market
therefore encompasses the participants and their dealings in particular financial claims or
groups of claims and the manner in which their demands and requirements interact to set a
price for such claims (the interest rate).
Primary and Secondary markets
A fundamental distinction has to be drawn between the primary and secondary markets in
securities. The market for the issue of new securities to borrow money for consumption or
investment purposes is referred to as the primary markets. This market could include the
issue of both primary and indirect securities. It will be evident that the markets in non
negotiable instruments, such as mortgage loans, savings deposits and the life policies are
entirely primary markets.
Secondary market is the term used for the markets in which previously issued financial
claims are traded. These active markets exist in many of the securities referred to in the
previous section, but they differ in terms of liquidity.
Capital and Money Markets
The financial market is usually split into the money and capital markets. These markets
embrace both the primary or new issues market and the secondary market. The line
demarcating the money and capital markets is usually drawn on the basis of term to maturity
of the securities traded and is arbitrarily determined to be one year. The capital market is
defined as the market for the issue and trading of long term securities while the money
market is the market for the issue and trading of short term securities.
In respect of the money and bond markets two other terms need to be clarified i.e.
repurchase agreements and interest rate swaps. A repurchase agreement is simply the sale
of a previously issued security at an agreed rate of interest for a specified period of time. An
interest rate swap entails the swapping of interest obligations between two parties via a
facilitator, i.e. it is an agreement between two parties to exchange a fixed rate of interest for
a floating rate of interest in the same currency. These amounts are calculated with reference
to a mutually agreed notional amount. This amount is not exchanged between the parties.
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The term of the agreement determines whether it is a money market or capital market
transaction.
Spot, Forward and Derivative markets
When a financial instrument is traded and settled on the same or on the following day it is
termed a spot transaction. If the instrument is traded today for settlement in two weeks, it is
a forward transaction. The price of the forward transaction will be the spot price plus the
price of money for a two week term.
The derivative market is a term for the options and futures market and the former can be
split into options on spot instruments and options on futures. Both are linked to the forward
market in that their prices are largely determined by the forward price.
An option bestows on the holder the right but not the obligation to buy or sell the underlying
asset at a predetermined price during a specified period. From this it will be evident that the
holders will exercise their options only if it is profitable to do so. The holder’s potential profit
is not fixed while their potential loss is limited to the amount of the premium paid.
A futures contract is an agreement to buy from or sell to an exchange established for this
purpose a standard quantity and quality of an asset (i.e. a financial asset, commodity or
notional asset) on a specific date, at a price to be determined at the time of negotiation of the
contract. From the above it can be seen that options and futures are termed derivatives
because they are derived from specified underlying assets or notional assets.
Financial exchanges
A distinction has to be drawn between an over the counter (OTC) market and a formalised
market. OTC refers to buyers and sellers tailor making the specific financial instruments to
suit their specific needs. It could be face to face, over the telephone or via a communication
system. OTC markets may be subject to regulation or may be free of supervision by the
authorities. Most markets start in this way, progressing to become formal markets.
Formal markets (or exchanges) are usually governed by the statute and the rules and
regulations of such an exchange. In South Africa the money market is an OTC market where
as the bond and futures market are formalised. The South African futures exchange is
licensed in terms of the financial markets control Act 1989 and controls trading in all futures
and options on futures. The Bond exchange of South Africa controls trading in bonds
(licensed under the same Act) while trading in options on bonds is still a self regulated
market.
Other Related markets
As noted above the term financial markets refer to all lending and borrowing, the
intermediation of this process and the exchange of financial obligations. The markets that
are closely linked to the financial markets are the equity market and the foreign exchange
market. As these markets fall under the broad heading of financial services they will be
introduced here briefly.
The primary equity market involves the issuing of equity in a corporate entity, i.e. the
extension of ownership. The secondary equity market involves the exchange of ownership in
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a corporate body. The equity market in South Africa is formalised in the form of the
Johannesburg Stock Exchange although off market trading is allowed.
Like the equity market the foreign exchange is not primary lending and borrowing market.
Since residence (ignoring exchange controls for a moment) are able to borrow or lend
offshore or foreigners are able to lend to or borrow from local institutions the foreign
exchange market (which allows these transactions to take place ) has a domestic and
foreign lending or borrowing dimension and can be viewed as a financial market . (10marks)
5.b
Advantages of capital market investment
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The interest rate is guaranteed, i.e. it is fixed for the term of the loan.
The maturity proceeds are guaranteed in Kwacha terms.
The securities are freely negotiated at market prices.
The securities can be used as collateral for loans such as bank overdrafts.
If there is a fall in interest rates there is a change in capital gain.
The investments are secure.
Disadvantages of capital market investments
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

(6marks)
(4marks)
Capital gains made are merely a result of interest rate changes and not profit growth as
in the case of listed shares.
If interest rates rise there may be a capital loss.
The entry level of investment is quite high.
Although capital values are guaranteed inflation erodes the value in real terms.
Question 6
6.a
Debentures
A debenture is a fixed interest bearing security normally issued by companies. It is a loan
contract for a specified period of time and represents a charge on the revenues and assets
of the issuing company. Each debenture contract consists of two parts, namely the
debenture itself and the indenture or trust deed. The debenture is a primary contract
between the issuing company and the investor and represents a promise by the company to
pay interest at regular intervals and to repay the capital amount at a specific future date or
dates. The trust deed is a supplementary contract between the issuing company and the
trustees (who are representatives of the debenture holders) and sets out in detail the rights
of the individual debenture holders. It is the function of the trustees to protect the interests of
the debenture holders and to see to it that the terms of the contract are adhered to.
Although a debenture normally has a fixed interest rate, it can also be issued at a variable
rate. It should be noted that virtually no secondary markets exists for variable interest rate
debentures.
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Different kinds of debentures are issued which can be classified into three main categories
according to security, term and yield.
Debentures are issued in the names of the investors and registers are kept by the issuing
companies for the purposes of registration and transfer. In most countries the main investors
in debentures are insurance companies and pension funds who invest their discretionary
funds in debentures because company debentures do not qualify as prescribed investments.
Debentures are transferable by means of a duly completed transfer deed which must be
lodged together with the certificate at the transfer office of the relevant company. Most
transfer offices are closed for 14 days to one month prior to the interest payment date of the
debenture. At maturity, the repayment of the nominal amount plus the final interest payment
is effected upon presentation of the debenture certificate to the issuing company.
The issue and dealing mathematics for fixed interest debentures are the same as for
government bonds.
(20 marks)
Question 7
7.a



The speculator buys shares with the intention of selling them at a profit in the short
medium term. These profits are taxable as income in the year the profits are realised.
The investor buys shares to enjoy long term growth in dividend income. A long term
holding should also give rise to an eventual increase in the capital value of shares.
These capital profits are normally not taxable if they are held as long term investments or
sold to protect dividend income, or to obtain better income prospects elsewhere.
Inflation fighting investors may buy shares solely to protect their capital against inflation.
They may not need income at all. Because of the tax implications of being classed a
share dealer investors would be well advised to give their main reason for the purchase
as a long term investment.
(12 marks)
7.b
Earnings per share are a function of the sales forecast, the estimated profit margin, and the
tax effect.



Company sales forecast. Firm specific data is critical to the sales estimate. This can be
obtained from the company’s analysts’ presentation.
Estimating the company’s profit margin. Based on past results and industry norms,
calculate the company’s profit margin as a percentage of sales before depreciation and
interest expense.
Calculate the EPS estimate based on the expected sales multiplied by the company’s
profit margin after tax.
Dividend cover effectively shows what portion of a company’s earnings is paid out as
dividend. The dividend cover is calculated as follows.
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
Dividend cover = Earnings/Dividends for the year
Equity Capital
As equity does not carry a coupon rate or fixed dividend rate as preference shares it is
difficult to calculate the cost of equity.
Shareholders will want to maximise their return on the shares and therefore management is
focussed on the generation of shareholder’s wealth.
(8 marks)
Question 8
8.a
An option is out-the-money when there is no benefit to be derived from exercising the option
immediately. A call option is out-the-money when the price of the underlying instrument is
below the option exercise price.
(5marks)
An option contract is in the money if there is a net financial benefit to be derived from
exercising the option immediately. A put option is in-the-money when the price of the
underling asset is below the exercise price.
(5marks)
8.b
Two components add to an option’s price or premium:


The option’s intrinsic value. The intrinsic value of a call option is the amount by which the
market price of the underlying asset exceeds the strike price of the option. The intrinsic
value of a put option is the extent to which the strike price exceeds the price of the
underlying asset.
The option’s time value. This is the imputed monetary value of an option reflecting the
possibility that the price of the underlying asset will move so that the option will become
valuable. The time value is calculated as the option premium less the intrinsic value (if
any).
(5marks)
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