Introduction_to_Financial_Markets.pdf

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The South African Institute of Financial Markets

Introduction to Financial Markets

Ingrid Goodspeed: May 2013


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Preface

The Registered Person Examination (RPE) has been designed as an entry-level qualification for the

South African financial markets. The qualification has eight modules:

The Regulation and Ethics of the South African Financial Markets (compulsory module)

Introduction to the Financial Markets (compulsory module)

The Equity Market (elective module)

The Bond Market (elective module)

The Derivatives Market (elective module)

The South African Money Market (elective module)

The South African Foreign Exchange Market (elective module)

Agricultural Products Market Dealers Examination (elective module)

The objective of this module is to provide the student with the necessary information to understand

the financial markets in South Africa and internationally and to prepare the student for the South

African Institute of Financial Markets Introduction to Financial Markets examination.

The guide is structured as follows: chapter 1 outlines the financial system of which financial markets

are an integral part. Chapter 2 discusses the macro-economic environment in which financial

markets function. Chapters 3 and 4 introduce the quantitative aspects of financial markets

respectively, the time value of money and statistics. Chapters 5, 6, 7, 8, 9 and 10 focus on the

features, instruments, and participants of the foreign exchange, money, bond, equity, derivatives

and commodities markets respectively. Chapter 11 outlines savings and investment instruments.

Portfolio management - the process of putting together and maintaining the proper set of assets

(such as those discussed in chapter 5 to 10) to meet the objectives of the investor - is considered in

chapters 12 and 13.

Students are encouraged to keep up to date with local and international financial market

developments. The following internet sites may prove useful:


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South Africa

JSE Ltd www.jse.co.za

Financial Services Board www.fsb.co.za

National Treasury www.treasury.gov.za

Strate Ltd www.strate.co.za

South African Reserve Bank www.reservebank.co.za

International

Bank for International Settlements www.bis.org

International Monetary Fund www.imf.org

World Bank www.worldbank.org

New York Stock Exchange www.nyse.com

London Stock Exchange www.londonstockexchange.com

NYSE Euronext (including LIFFE) www.euronext.com

World Federation of Exchanges www.world-exchanges.org
http://www.jse.co.za/http://www.jse.co.za/http://www.fsb.co.za/http://www.fsb.co.za/http://www.treasury.gov.za/http://www.treasury.gov.za/http://www.strate.co.za/http://www.strate.co.za/http://www.reservebank.co.za/http://www.reservebank.co.za/http://www.bis.org/http://www.bis.org/http://www.imf.org/http://www.imf.org/http://www.worldbank.org/http://www.worldbank.org/http://www.nyse.com/http://www.nyse.com/http://www.londonstockexchange.com/http://www.londonstockexchange.com/http://www.euronext.com/http://www.euronext.com/http://www.world-exchanges.org/http://www.world-exchanges.org/http://www.world-exchanges.org/http://www.euronext.com/http://www.londonstockexchange.com/http://www.nyse.com/http://www.worldbank.org/http://www.imf.org/http://www.bis.org/http://www.reservebank.co.za/http://www.strate.co.za/http://www.treasury.gov.za/http://www.fsb.co.za/http://www.jse.co.za/


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Table of contents

1 The financial system ......................................................................................................... 8

2 The economy .................................................................................................................. 28

3 Time value of money ...................................................................................................... 54

4 Introduction to statistical concepts ................................................................................ 68

5 The foreign exchange market ......................................................................................... 88

6 The money market ......................................................................................................... 96

7 The bond and long-term debt market .......................................................................... 106

8 The equity market ........................................................................................................ 115

9 The derivatives market ................................................................................................. 129

10 The commodities market ............................................................................................. 149

11 Investment instruments ............................................................................................... 159

12 Introduction to portfolio theory ................................................................................... 175

13 Portfolio Management ................................................................................................. 209

Glossary .................................................................................................................................. 220

Bibliography ........................................................................................................................... 225

Appendix A: Formula sheet Introduction to the financial markets ....................................... 227


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Detailed table of contents

1 The financial system ......................................................................................................... 8

The financial system defined ........................................................................................................ 81.1

The flow of funds and financial intermediation ........................................................................... 91.2

Functions of the financial system ............................................................................................... 191.3

Financial market rates ................................................................................................................ 211.4

Determining financial market prices .......................................................................................... 231.5

2 The economy .................................................................................................................. 28

Economic systems ....................................................................................................................... 282.1

The flows of economic activity ................................................................................................... 302.2

Economic objectives ................................................................................................................... 332.3

Economic policy .......................................................................................................................... 332.4

Business cycle ............................................................................................................................. 362.5

Economic indicators .................................................................................................................... 412.6

Globalisation of financial markets .............................................................................................. 502.7

3 Time value of money ...................................................................................................... 54

Introduction ................................................................................................................................ 543.1

The yield curve ............................................................................................................................ 553.2 Interest rate calculations ............................................................................................................ 583.3

Present and future value of an annuity ...................................................................................... 623.4

Present and future values of unequal cash flows ....................................................................... 633.5

Net present value ....................................................................................................................... 643.6

Internal rate of return................................................................................................................. 653.7

4 Introduction to statistical concepts ................................................................................ 68

Introduction ................................................................................................................................ 684.1

Descriptive statistics ................................................................................................................... 694.2

Inferential statistics .................................................................................................................... 794.3

5 The foreign exchange market ......................................................................................... 88

The market defined .................................................................................................................... 885.1

Characteristics of the market ..................................................................................................... 895.2

Foreign exchange market instruments ....................................................................................... 905.3

Foreign exchange market participants ....................................................................................... 925.4


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6 The money market ......................................................................................................... 96

The market defined .................................................................................................................... 966.1

Characteristics of the market ..................................................................................................... 966.2

Money market instruments ........................................................................................................ 976.3

Money market participants ...................................................................................................... 1026.4

7 The bond and long-term debt market .......................................................................... 106

The market defined .................................................................................................................. 1067.1

Characteristics of the market ................................................................................................... 1067.2

Bond and long-term debt instruments ..................................................................................... 1077.3

Bond and long-term debt market participants ......................................................................... 1117.4

8 The equity market ........................................................................................................ 115



Equity market instruments ....................................................................................................... 1218.3

Equity market participants ....................................................................................................... 1258.4

9 The derivatives market ................................................................................................. 129



Derivative instruments ............................................................................................................. 1319.3

Participants in the derivatives market ...................................................................................... 1439.4

10 The commodities market ............................................................................................. 149



Commodity market instruments .............................................................................................. 15110.3

Participants in the commodity market ..................................................................................... 15410.4

11 Investment instruments ............................................................................................... 159

Introduction .............................................................................................................................. 15911.1

Cash .......................................................................................................................................... 15911.2

Deposits .................................................................................................................................... 15911.3

Equities ..................................................................................................................................... 16111.4

Bonds and long-term debt instruments ................................................................................... 16111.5

Retail savings bonds ................................................................................................................. 16111.6

Money market instruments ...................................................................................................... 16111.7

Commodities ............................................................................................................................. 16111.8


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Products made available by long-term insurance companies .................................................. 16211.9

Annuities ................................................................................................................................... 16211.10

Retirement funds ...................................................................................................................... 16311.11

Collective investment schemes ................................................................................................ 16511.12

Hedge funds .............................................................................................................................. 16611.13

Property .................................................................................................................................... 16811.14

Private equity ............................................................................................................................ 17111.15

Collectibles ................................................................................................................................ 17211.16

12 Introduction to portfolio theory ................................................................................... 175

Introduction .............................................................................................................................. 17512.1

Markowitz portfolio theory ...................................................................................................... 17612.2

Sharpes index models.............................................................................................................. 18812.3

Multi-factor models .................................................................................................................. 20112.4

Arbitrage pricing theory ........................................................................................................... 20412.5

13 Portfolio Management ................................................................................................. 209

The portfolio management process defined ............................................................................ 20913.1

The portfolio management process ......................................................................................... 21013.2

Case Study: John Smith Trust.................................................................................................... 21413.3

Glossary .................................................................................................................................. 220

Bibliography ........................................................................................................................... 225

Appendix A: Formula sheet Introduction to the financial markets ....................................... 227


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1 The financial system

This chapter provides a conceptual framework for understanding how the financial system works.

Firstly the financial system is defined. Then the elements of the financial systems within the context

of the flow of funds are discussed. Thereafter the central role that financial markets and

intermediaries play in the financial system is considered. Finally the chapter describes how financial

market prices are determined.

Learning Outcome Statements

After studying this chapter, a learner should be able to:

define the financial system and understand the roles, functions and interrelationship of its

elements

understand financial intermediation, financial instruments and the flow of funds in the financial

system

know the structure and mechanics of the financial markets and its participants

name the characteristics of an efficient financial market

describe the types of financial markets: spot and forward, primary and secondary, exchanges

and over-the counter and interbank markets

name the functions of the financial system

understand the various measures of risk and return

define fundamental and technical analysis and their usefulness within the context of the

efficient market hypothesis.

The financial system defined1.1

The financial system comprises the financial markets, financial intermediaries and other financial

institutions that execute the financial decisions of households, firms/businesses and governments.

The financial system performs the essential economic function of channeling funds from those with

a surplus of funds (i.e., net savers who spend less than their income) to those who wish to borrow

(i.e., net spenders who wish to spend more than their income). Thus the financial system acts as an

intermediary between surplus and deficit economic units. As such the financial system plays an

important role in the allocation of funds to their most efficient use amongst competing demands. In

a market system such as the South African financial system, this allocation of funds is achieved


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through the price mechanism with prices being set by the forces of supply and demand within the

various financial markets.

The scope of the financial system is global. Extensive international telecommunication networks link

financial markets and intermediaries so that the trading of securities and transfer of payments can

take place 24 hours a day. If a company in South Africa wishes to finance a major investment, it can

issue shares and list them on the New York or London stock exchanges or borrow funds from a

European or Japanese pension fund. If it chooses to borrow the funds, the loan could be

denominated in Euro, Yen, US Dollars or South African Rand.

The flow of funds and financial intermediation1.2

Flow of funds reflects the movement of funds from those sectors that are sources of funds or capital,

through intermediaries (such as banks, mutual funds, and pension funds), to sectors that use the

funds or capital to acquire physical or financial assets.

The financial system has four elements: lenders and borrowers; financial institutions; financial

instruments and financial markets. The interaction between these is shown in figure 1.1.

1.2.1 Lenders and borrowers

Lenders are the ultimate providers of savings while borrowers are the ultimate users of those

savings. Both are non-financial entities and are referred to as surplus and deficit economic units

respectively.

Lenders can be referred to as investors in that they expend cash on the acquisition of financial assets

such as bonds and shares and real or tangible assets such as land, buildings, gold, and paintings.

Lenders and borrowers can be categorised into four sectors: household, business or corporate,

government, and foreign. The household sector consists of individuals and families. In South Africa it

also includes private charitable, religious and non-profit bodies as well as unincorporated businesses

such as farmers and professional partnerships. The corporate sector comprises all non-financial firms

or companies producing and distributing goods and services. The government sector consists of

central and provincial governments as well as local authorities. The foreign sector encompasses all

individuals and institutions situated in the rest of the world.


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Usually the household sector is a net saver and thus a net provider of loanable or investable funds to

the other three sectors. While the other three sectors are net users of funds, they also participate on

an individual basis as providers of funds. For example a business with a temporary excess of funds

will typically lend those funds for a brief period rather than reduce its indebtedness i.e., repay its

loans. Similarly while the household sector is a net provider of funds, individual households do

borrow funds to purchase homes and cars.

Figure 1.1: Financial intermediation and the flow of funds

The excess funds of surplus units can be transferred to deficit units either through direct financing or

indirectly via financial intermediaries.

Direct financing can only occur if lenders requirements in terms of risk, return and liquidity exactly

match borrowers needs in terms of cost and term to maturity. Direct financing usually involves the

use of a financial market broker who acts as a conduit between lenders and borrowers in return for

a commission.

Financial intermediaries perform indirect financing by making markets in two types of financial

instrumentsone for lenders and one for borrowers. To lenders they offer claims against

themselves known as indirect securities, tailored to the risk, return and liquidity requirements of the


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lenders. In turn they acquire claims on borrowers known as primary securities. Thus the surplus

funds of lenders are invested with financial intermediaries that then re-invest the funds with

borrowers.

1.2.2

Financial intermediaries

Financial intermediaries are financial institutions that expedite the flow of funds from lenders to

borrowers. Types of financial intermediaries include banks, insurance companies, pension and

provident funds and collective investment schemes (also referred to as unit trusts or mutual funds).

Banks accept deposits from lenders and on-lend the funds to borrowers. Insurers and pension- and

provident funds receive contractual savings from households and re-invest the funds mainly in

shares and other securities such as bonds. In addition insurers perform the function of risk

diversification i.e., they enable individuals or firms to distribute their risk amongst a large population

of insured individuals or firms.

Collective investment schemes pool the funds of many small investors and re-invest the funds in

shares, bonds and other financial assets with each investor having a proportional claim on such

assets. Collective investment schemes play a risk diversification role in that they spread the risk by

investing in number of different securities.

1.2.3 Financial instruments

Financial instruments or claims can be defined as promises to pay money in the future in exchange

for present funds i.e., money today. They are created to satisfy the needs of financial system

participants and as a result of financial innovation in the borrowing and financial intermediation

processes, a wide range of financial instruments and products exists.

Financial claims can be categorised as indirect or primary securities. Within these two categories,

financial instruments can be marketable or non-marketable. Marketable instruments can be traded

in secondary markets, while non-marketable instruments cannot. To recover their investment,

holders of marketable securities can sell their securities to other investors in the secondary market.

To recover their investment, holders of non-marketable financial instruments have recourse only to

the issuers of the securities.


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Non-marketable claims generally involve the household sector (also called the retail sector) while

marketable claims are usually issued by the corporate and government sectors (or the wholesale

sector).

Examples of the different categories of financial instruments are shown in table 1.1.

1.2.4

Financial markets

1.2.4.1 Definition

Financial markets can be defined as the institutional arrangements, mechanisms and conventions

that exist for the issuing and trading (i.e., buying and selling) of financial instruments.

A financial market is not a single physical place but millions of participants, spread across the world

and linked by vast telecommunications networks that brings together buyers and sellers of financial

instruments and sets prices of those instruments in the process.

1.2.4.2 Characteristics of good financial markets

In general, the characteristics of a good financial market are:

Provision of timely and accurate price and volume information on past securities transactions

and prevailing supply and demand for securities

Provision of liquidity i.e., the degree to which a security can be quickly and cheaply turned into

cash. Liquidity requires marketability, price continuity and market depth. Marketability is a

securitys ability to be sold quickly. Price continuity exists when prices do not change from one

Table 1.1: Financial Instruments

Primary securities

Issued by ultimate borrowers

Indirect securities

Issued by financial intermediaries

Marketable Non-marketable Marketable Non-marketable

Bankers

acceptances/bills

Trade bills Promissory notes

Commercial paper

Company

debentures

Treasury bills

Government bonds

Shares of listed

companies

Hire-purchase and

leasing contracts

Mortgage advances Overdrafts

Personal loans

Shares of non-

listed companies

Negotiable

certificates of

deposit (NCD)issued by banks

Bank notes (issued

by the central

bank) Savings accounts

Term or fixed

deposits

Insurance policies

Retirement

annuities


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transaction to another in the absence of substantial new information. Market depth is the ability

of the market to absorb large trade volumes without a significant impact on prices i.e., there are

many potential buyers and sellers willing to trade at a price above and below the current market

price

Internal efficiency i.e., transaction costs as a percentage of the value of the trade are low - even

minimal

External or informational efficiency i.e., securities prices adapt quickly to new information so

that current market prices are fair in that they reflect all available information on the security.

1.2.4.3 Financial market participants

There are a number of participants in financial markets:

Borrowers issue securities

Lenders (or investors) buy or invest in securities

Financial intermediariesexpedite the flow of funds from lenders to borrowers. As such they are

issuers and buyers of securities and other debt instruments

Brokers (or agents)act as conduits between lenders and borrowers or buyers and sellers in

return for a commission

Financial advisorsprovide investors with recommendations, guidance or proposals for the

purchase of or investment in financial instruments. Financial advisors such as investment banks

provide advice to corporate borrowers and / or issuers of securities

Dealers (or jobbers) buy and sell securities for their own account

Market makersstand ready to buy or sell certain securities at all times. They quote both a bid

and an offer price to the market and profit from the spread between bid and offer prices as well

as from changes in market prices. Market makers adjust their bid or offer prices depending upon

positions that they hold and/or upon their outlook for changes in prices

Hedgers are exposed to the risk of adverse market price movements and mitigate the risk by

using hedging instruments such as derivatives

Speculators try to make a profit by taking a view on the market. If their view is correct, they

make profits. If their view is wrong, they make losses

Arbitrageursattempt to make profits by exploiting inefficiencies in market prices. They

simultaneously buy securities in the market where the price is relatively cheap and sell securities

in the market where the price is relatively expensive; thereby making risk-less profits.

These categories of financial market participants are not necessarily mutually exclusive. For example

a financial intermediary such as a bank may, given the range of its business activities, be a financial

advisor, market marker, dealer, broker, speculator, arbitrageur and hedger.


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1.2.4.4 Types of financial markets

Financial markets can be described amongst others as cash and derivatives markets; spot and

forward markets; primary and secondary markets; financial exchanges and over-the-counter

markets; and interbank markets.

1.2.4.4.1

Cash and derivatives markets

Cash and derivatives markets are discussed with reference to figure 1.2.

Figure 1.2: Cash and derivatives markets

The foreign exchange, money, bond and equity markets are all considered cash markets because

transactions executed in these markets will result in physical flows of cash at some time or another.

The commodities market - a market for the buying and selling of commodities i.e., physical goods

such as oil, gold, wheat - is a cash market but not a financial one. There are markets for the sale of

other physical goods and / or physical investments such as the property, art and antiques. On the

other hand, the financial market as defined in 1.2.4.1 is a market for the buying and selling of

financial instruments.

The foreign exchange market is the international forum for the exchange of currencies. The money

market is the marketplace for trading short-term debt instruments while the bond market deals in

longer-term debt issues. The distinction between money and bond markets is mainly based on

maturity. Most money market instruments have maturities of less than one year while bonds are


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issued with terms of more than one year. Both money and bond markets instruments are interest-

bearing debt instruments.

Shares or equities i.e., participation in the ownership of a company - trade on equity markets.

Together the equity and bond markets form the capital market, i.e., the market in which

corporations, financial institutions and governments raise long-term funds to finance capital

investments and expansion projects.

Derivatives are financial instruments the values of which are derived from the values of other

variables. These variables can be underlying financial instruments or commodities in the cash

market. For example a currency option is linked to a particular currency pair in the foreign exchange

market, a bond futures contract to a certain bond in the bond market and an agricultural future to

maize or wheat in the commodities market. Derivatives can be based on almost any variablefrom

the price of soya to the weather in Rome. There is trading internationally and in South Africa in

credit, electricity, weather and insurance derivatives.

While a distinction has been drawn between foreign exchange, money, bond, equity and derivatives

markets, several financial instruments straddle the division between these markets. These are called

hybrid financial instruments. For example a convertible bond is a hybrid of bond and equitysecurities. It pays a fixed coupon with a return of the principal at maturity unless the holder chooses

to convert the bond into a certain number of shares of the issuing company before maturity.

1.2.4.4.2 Spot and forward markets

A spot market is a market in which financial instruments are traded for immediate delivery. Spot in

this context means instantly effective. The spot market is sometimes referred to as the cash market.

A forward market is a market in which contracts to buy or sell financial instruments or commodities

at some future date at a specified price are bought and sold.

1.2.4.4.3 Primary and secondary markets

The primary market is the market for the original sale or new issue of securities. Issuers or borrowers

in the primary market may be raising capital for new investment or they may be going public i.e.,

converting private capital into public capital.


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The secondary market is a market in which previously-issued securities are resold. The proceeds

from a sale of such securities do not go to the issuer of the securities but to their seller - the previous

owner.

A stock exchange is a secondary market in which equities are traded. It is also a primary market

where shares are issued for the first time.

A secondary market can be a call market or a continuous market. A call market is a market on which

individual securities trade at specific times. Buy and sell orders are accumulated for a period. Then a

single price is set to satisfy the largest number of orders and all the orders are transacted at that

price. The method is used in smaller markets and to establish the opening price in larger markets. A

continuous market is a market in which securities trade at any time the market is open.

Securities traded on a secondary market can be priced by order (or auction) or by quote (or dealer).

Order-driven or auction markets: In an order driven market buyers and sellers submit bid and ask

prices of a particular share to a central location where the orders are matched by a broker.

Prices are determined principally by the terms of orders arriving at the central marketplace. The

JSE and most US securities exchanges are order-driven

Quote-driven or dealer markets:In a quote driven market individual dealers act as marketmakers by buying and selling shares for themselves. In this type of market investors must go to a

dealer and prices are determined principally by dealers bid/offer quotations. NASDAQ is a

quote-driven market. The London Stock Exchange has both an order- and quote-driven system -

its more liquid shares are traded on its order-driven system.

1.2.4.4.4 Exchanges and over-the-counter markets

Exchanges are formal marketplaces where financial instruments are bought and sold. They are

governed by law and the exchanges rules and regulations.

An over-the-counter (OTC) market involves a group of dealers who provide two-way trading facilities

in financial instruments outside formal exchanges. OTC dealers stand ready to buy at the bid price

and sell at the (higher) ask or offer price hoping to profit from the difference between the two

prices.

In South Africa and internationally money and foreign exchange markets are OTC markets.


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Internationally, apart from corporate bond trading on the New York Stock Exchange, bond markets

are usually OTC markets. In South Africa the JSEs Interest Rate Market (the formerBond Exchange

of South Africa, which became a wholly-owned subsidiary of the Johannesburg Stock Exchange (JSE)

in June 2009) regulates trading in bonds.

Generally equities are exchange traded. The JSE regulates trading in South African equities.

Commodities and derivatives are traded on-exchange and over-the-counter.

The main differences between OTC and exchange-traded markets are shown in table 1.2.

Table 1.2: Difference between over-the-counter markets and exchanges

Characteristic Over-the-counter Exchange-traded

Type of contract

Range from highly standardised

(exchange look-alike) to tailor made

to the specific needs of the two

contracting parties with respect to

underlying securities, contract size,

maturity and other contract terms

Fully standardised with contract

terms determined by the exchange

Credit risk - the risk

that a trading party

defaults

Each party to the contract assumes

counterparty credit risk

The exchange clearing house assumes

the counterparty credit risk of all

trading parties

Trading

Trading takes place between two

trading parties bilaterally agreeing a

contract

Trading parties generally remain

anonymous

Regulation of market

Market participants make use of

standard master agreements

developed by industry associations

such as ISDA1

Law and the rules and regulations of

the exchange

Market liquidity Lower than exchange traded markets Higher than OTC markets

The major advantage of over-the-counter markets is the ability to tailor-make securities to meet the

specific needs of the trading parties. The advantages of an exchange relative to an over-the-counter

market are lower credit risk, anonymity of trading parties, greater market regulation and higher

market liquidity.

1ISDAthe International Swaps and Derivatives Association - is a New York based trade organisation that

strives to make global OTC derivatives markets safe and efficient


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1.2.4.4.5

Interbank markets

An interbank market is a wholesale money market for the offering of deposits between banks in a

range of currencies usually for periods not exceeding 12 months. Interbank markets are over-the-

counter markets and can be national or international.

The Bank for International Settlements and the International Monetary Fund define the

international interbank market as an international money market in which banks lend either to each

other, cross-border or locally, in foreign currency large amounts of money usually for periods

between overnight and six months.

Interbank markets play at least two roles in the financial system. Firstly interbank markets can be

used by central banks to transmit the influence of monetary policy by adding or draining liquidity

from the financial system more effectively. Secondly, well-functioning interbank markets effectively

channel liquidity from banks with a surplus of funds to those with a liquidity deficit.

Various interest rates are used in the interbank market. These include the Johannesburg Interbank

Agreed Rate (JIBAR), the London Interbank Offered Rate (LIBOR), the Euro Interbank Offered Rate

(EURIBOR) and the Tokyo Interbank Offered Rate (TIBOR).

1.2.5 Financial market indices

Financial market indices attempt to reflect the overall behaviour of a group of shares or other

securities such as bonds. Examples of South African financial market indices are the FTSE/JSE All

Share Index, BESA money Market Index and South African Hedge Fund Index. International indices

include the U.K.s FTSE All-Share, the U.S.s NYSE Composite and Standard & Poors 500 Index (S&P

500)., and Japans TOPIX.

Financial market indices are used:

As a benchmark to measure portfolio performance

To create and track index funds. An index fund is a collective investment scheme with a portfolio

constructed to match the components of an index such as the FTSE/JSE Top 40 index

To estimate market rates of return

To predict future share price movements in technical analysis

As a proxy for the market portfolio when estimating systematic risk (see chapter 12).


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Functions of the financial system1.3

The core functions of the financial system are:

Channeling savings into real investment

Pooling of savings

Clearing and settlement of payments

Managing risks

Providing information.

1.3.1 Channel savings into investment

The financial system operates as a channel through which savings can finance real investment i.e.,

tangible and productive assets such as factories, plants and machinery. It channels funds from those

who wish to save (surplus economic units) to those who need to borrow (deficit economic units) to

such purchase or build such assets.

Channeling savings can take place:

Over time. The financial system provides a link between the present and the future. It allows

savers to convert current income into future spending and borrowers current spending into

future income.

Across industries and geographical regions. Capital resources can be transferred from where

they are available and under-utilised to where they can be most effectively used. For example

emerging markets such as Poland, Russia, Brazil and South Africa require large amounts of

capital to support growth while mature economies such as Germany, the United Kingdom and

the United States tend to have surplus capital.

1.3.2 Pooling savings

The financial system provides the mechanisms to pool small amounts of funds for on-lending inlarger parcels to business firms thereby enabling them to make large capital investments.

In addition individual households can participate in investments that require large lump sums of

money by pooling their funds and then sub-dividing shares in the investment e.g. collective

investment schemes.


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1.3.3 Clearance and settlement of payments

The financial system provides an efficient way to clear and settle payments thereby facilitating the

exchange of goods, services and assets. Payment facilities include bank notes, cheques, debit and

credit card payments and electronic funds transfers.

1.3.4 Management of risk

Financial intermediaries transform unacceptable claims on borrowers to acceptable claims on

themselves i.e., the risky long-term loans of borrowers are transformed into less-risky liquid assets

for surplus units.

This transformation process is shown in table 1.3. For example banks accept short-term deposits

from lenders and transform these into long-term loans for borrowers. In this process the bank

assumes liquidity risk. Banks accept relatively small amounts from several lenders and pool these to

lend large amounts to borrowers. In this process the bank assumes liquidity risk and credit risk with

respect to the borrowers. Lenders on the other hand are exposed to the banks creditworthiness.

1.3.5 Information provision

The financial system communicates information on the following:

Table 1.3: Intermediation role of banks

Banks transform- Lenders/investorsassets Borrowersloans Risk assumed bybanks

MaturityShort-term e.g. demand

depositsLong-term e.g. 5-year loan Liquidity risk

DenominationSmall amounts e.g. savings

accounts

Large amounts e.g. housing

loanLiquidity risk

Interest rate Fixed rate e.g. fixed depositVariable rate e.g. variable-

rate loanInterest-rate risk

Currency Local currency Foreign currency Exchange rate risk

Credit exposure

Investor is exposed to the

bank in respect of credit

risk i.e., to the

creditworthiness of the

bank

The bank is exposed to the

borrower in respect of

credit risk i.e., to the

creditworthiness of the

borrower

Credit risk


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Borrowers creditworthiness: It is costly for individual households to obtain information on a

borrowers creditworthiness. However if financial intermediaries do this on behalf of many small

savers, search costs are reduced

The prices of securities and market rates: This supports firms in their selection of investment

projects and financing alternatives. In addition it assists asset managers to make investment

decisions and households to make savings decisions

Financial market rates1.4

There are essentially three financial market rates:

Interest rates

Exchange rates

Holding period return

1.4.1 Interest rates

An interest rate is the price, levied as a percentage, paid by borrowers for the use of money they do

not own and received by lenders for deferring consumption or giving up liquidity.

Factors affecting the supply and demand for money and hence the interest rate includes the

following: Production opportunities.Potential returns within an economy from investing in productive,

cash-generating assets

Liquidity.Lenders demand compensation for loss of liquidity. A security is considered to be liquid

if it can be converted into cash at short notice at a reasonable price

Time preference.Lenders require compensation for saving money for use in the future rather

than spending it in the present

Risk.Lenders charge a premium if investment returns are uncertain i.e., if there is a risk that the

borrower will default. The risk premium increases as the borrowers creditworthiness decreases.

Sovereign (government) debt generally has no risk premium within a country and therefore pays

a risk-free rate. A country risk premium may apply outside a countrys borders

Inflation.Lenders require a premium equal to the expected inflation rate over the life of the

security


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1.4.2 Exchange rate

The exchange rate is the price at which one currency is exchanged for another currency. The actual

exchange rate at any one time is determined by supply and demand conditions for the relevant

currencies within the foreign exchange market.

1.4.3 Holding period return

Interest rates are promised rates i.e., they are based on contractual obligation. However other

assets such as property, shares, commodities and works of art do not carry promised rates of return.

The return from holding these assets comes from the following two sources:

Price or capital appreciation (depreciation) i.e., any gain (loss) in the market price of the asset

Cash flow (if any) produced by the asset e.g., cash dividends paid to shareholders, rental income

from property. Not all assets produce cash flows e.g. commodities.

The holding period return (HPR) is the total return on an asset or portfolio of assets over the period

it was held. Holding period return does not take into account reinvestment income between the

time cash flows occur and the end of the holding period.

For example assume at the beginning of the year a share is bought for R50. At the end of the year

the share pays a dividend of R2.50 and is sold for a price of R55. In this case the holding period of the

investment is one year. The HPR for the share is 15.0%; calculated as follows:

%0.1500.50

50.2

00.50

00.5000.55

)(

shareofpricebeginning

dividendcash


shareofpricebeginningshareofpriceend

cashflowlossgaincapitalHPR

If the share price it is sold for is R45 at year end the holding period return is 5%; calculated as

follows:

%0.5

00.50

50.2

00.50

00.5000.45

HPR


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Assume a painting is purchased at the beginning of 2001 for R2 000. At an auction on 31 December

2009 the painting is sold for R3 000. In this case the holding period is 9 years. The art investors

holding period return is 50.0%; calculated as follows:

%0.50

00002

00020003

)(

cashflowlossgaincapitalHPR

The 50% return represents the return over 9 years. It may be more convenient for comparative

purposes to convert this to an effective annual rate as follows:

yearsinperiodholdingn

where

HPREAR n

11 /1

%6.4

150.01 9/1

EAR

Determining financial market prices1.5

1.5.1 Fundamental and technical analysis

The two techniques frequently used to study financial market securities and their expected prices

and to make investment decisions based on such analysis are technical and fundamental analysis.

Fundamental analysis estimates the intrinsic value of a company by examining its characteristics

(such as from its financial statements) and environment including the economy and industry to

which the company belongs.

Technical analysis is not concerned about the intrinsic value of a share. Instead share price changes

are predicted from the study of graphs on which prices and sometimes trading volumes are plotted.

Technical analysts examine the price action of the stock market instead of the fundamental factors

that may impact share prices. A number of assumptions underlie technical analysis: (i) the market

value of a share is determined solely by the interaction of its demand and supply; (ii) supply and

demand are driven by both rational factors such as economic variables and irrational factors such as


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gut-feel, moods and guesses; (iii) ignoring minor fluctuations, share prices move in trends, which

persist for long periods of time; and (iv) current trends change in reaction to variations in supply and

demand and these trend changes can eventually be identified by the action of the market.

1.5.2 Efficient markets hypothesis

In contrast to both technical and fundamental analysts, proponents of the efficient markets

hypothesis (EMH) believe that share prices adjust rapidly and fully to all information as it becomes

available. Therefore neither existing nor past prices are of any help in predicting the future. This

highlights one of the most debated and controversial questions in finance - are the price movements

of financial instruments predictable or random?

According to the EMH, at any given time, financial instrument prices fully reflect all available

information. The market is efficient if the reaction of market prices to new information is

instantaneous and unbiased. The main outcome of this theory is that price movements are random

and do not follow any patterns or trends. This means that past price movements cannot be used to

predict future price movements. Rather, prices follow a random walk - an inherently unpredictable

pattern.

There are essentially the following three forms of the EMH:

The weak form of the EMH claims all past market prices and data are fully reflected in asset

prices. The implication of this is that technical analysis will not be able to consistently produce

excess returns, though some forms of fundamental analysis may still provide excess returns.

The semi-strong form of the EMH asserts that all publicly available information is fully reflected

in asset prices. The implication of this is that neither technical nor fundamental analysis can be

used to produce excess returns.

The strong form of the EMH: All information, public and private is fully reflected in asset prices.

The implication of this is that even insider information cannot be used to beat the market.

There are a number of challenges to the EMH:

The existence of stock market anomalies, which are reliable, widely known and inexplicable

patterns in asset price returns. Examples are the shares of small firms offering higher returns

than those of large ones and the January effect, which shows that higher returns can be earned

in the first month of the year.


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Behavioural finance, which examines the psychology underlying investors' decisions. This is used

to explain phenomena such as share price over- or under-reaction to new information. It implies

there are areas of predictability in the markets and contrarian strategies of buying losers and

selling winners can generate superior returns. In 1997 economics professor Paul Krugman stated

'The Seven Habits of Highly Defective Investors'. These behavioural traits make the markets

anything but efficient: think short-term; be greedy; believe in the greater fool; run with the herd;

over-generalise; be trendy; and play with other people's money. According to Krugman, he did

not see investors as a predatory pack of speculative wolves but an extremely dangerous flock

of financial sheep.


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Review questions

1.

Define the financial system.

2. What are the four elements of the financial system?

3. Name the categories that lenders and borrowers can be grouped into.

4. Differentiate between direct and indirect financing.

5.

Describe how pension funds expedite the flow of funds from lenders to borrowers.

6. Describe how banks expedite the flow of funds from lenders to borrowers.

7. List three marketable primary securities and three non-marketable indirect securities.

8. Explain the difference between primary and secondary markets.

9.

What are the core functions of the financial system?

10.

What is the one-year rate of return for a share that was bought for R100 paid no dividend

during the year and had a market price of R102 at the end of the year?


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An swer s

1.

The financial system consists of the financial markets, financial intermediaries and other

financial institutions that carry out the financial decisions of households, businesses and

governments.

2. The four elements of the financial system are:

Lenders and borrowers

Financial institutions

Financial instruments

Financial markets

3.

Lenders and borrowers can be categorised into the household sector, the business or corporate

sector, the government sector and the foreign sector.

4.

In the direct financing process, funds are raised directly by borrowers from lenders usually

though a financial market broker who acts as a conduit between the lender and borrower in

return for a commission. In the indirect financing process, also known as financial

intermediation, funds are raised from lenders by financial intermediaries and then on lent to

borrowers.

5. Pension funds expedite the flow of funds from lenders to borrowers by receiving contractual

savings from households and re-investing the funds in shares and other securities such as

bonds.6. Banks expedite the flow of funds from lenders to borrowers by accepting deposits from lenders

and on-lending the funds to borrowers.

7.

Three marketable primary securities are treasury bills, promissory notes and debentures. Three

non-marketable indirect securities are savings accounts, fixed deposits and retirement

annuities.

8. The primary market is the market for the original sale or new issue of financial instruments

while the secondary market is a market in which previously-issued financial instruments are

resold.

9.

The core functions of the financial system are to channel savings into investment, pool savings,

clear and settle payments, manage risks and provide information.

10. The return is 2% p.a.; calculated as follows:

%2

100

0

100

100102


dividendcash


shareofpricebeginningshareofpriceendHPR


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2 The economy

Financial markets operate in an economic environment that shapes and is shaped by their activities.

The objective of this chapter is to outline the interactions between the various components of theeconomy and to discuss mechanisms for determining the direction of current and future economic

activity and performance. Firstly alternative economic systems and their underlying principles will be

described. Then the flows of income, output and expenditure in a market economy will be sketched.

Thereafter the role of government in the economy will be considered. After that economic indicators

and their interpretation will be specified. Finally the globalisation of financial markets i.e., the

increasing integration of financial markets around the world will be discussed.

Learning Outcome Statements

After studying this chapter, a learner should be able to:

describe alternative economic systems

understand the flow of economic activity in a market economy

understand the economic objectives in a market economy and the tools used by authorities to

reach these objectives

define the business cycle and understand the relationship between the business cycle phases

and economic variables

understand the impact of the business cycle on different asset classes

understand the use, features and interpretation of economic indicators

understand globalisation of financial markets in a South African context.

Economic systems2.1

Scarcity exists when the needs and wants of a society exceed the resources available to satisfy them.

Given scarcity, choices must be made concerning the use and apportionment of resources i.e., whatshould available resources be used for - what goods and services should be produced or not be

produced?

The approach to resource allocationthe assignment of scarce resources to the production of goods

and services - allows a distinction to be made between those economies that are centrally planned

and those that operate predominantly through market forces.


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In a centrally planned or command economy most of the key decisions on production are taken by a

central planning authority, usually the state and its agencies. The state normally-

owns and/or controls resources

sets priorities in the use of the resources

determines production targets for firms, which are largely owned and/or controlled by the state

directs resources to achieve the targets

attempts to co-ordinate production to ensure consistency between output and input.

In the free-market or capitalist economy firms and households interact in free markets through the

price system to determine the allocation of resources to the production of goods and services. The

key features of the free-market system are:

resources are privately owned and the owners are free to use the resources as they wish

companies, which are also in private ownership, make their own production decisions

production is co-coordinated by the price system - the mechanism that sends prices up when the

demand for goods and services is in excess of their supply and prices down when supply is in

excess of demand. In this way the price system apportions limited supplies among consumers

and signals to producers where money is to be made and consequently what they ought to be

producing.

In a mixed economy the state provides some goods and services such as postal services and

education with privately-owned companies providing the other goods and services. The exact mix of

private enterprise and public activities differs from country to country and is influenced by the

political philosophy of the government concerned.

Given its focus on the ownership, control and utilization of a societys resources, the economic

problem of resource allocation has a political dimension. The link between a societys economic

system and political regime is illustrated in Figure 2.1. Just as economic systems can extend from

free-market to centrally planned, depending on the level of state intervention in resource allocation

so political systems can range from democratic to authoritarian given the degree of state

involvement in decision making.

Market economic systems are generally associated with democratic states e.g. United Kingdom as

are centrally planned economies with authoritarian states e.g. Cuba. However some authoritarian

states have or are attempting to institute capitalistic economies e.g. China. Certain democratic states

have a substantial degree of government intervention either by choice or from necessity e.g. during


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times of war. Typically demands for political change have accompanied pressures for economic

reform e.g. in Eastern Europe.

Figure 2.1: Political-economic systems

The flows of economic activity2.2

The major participants in an economy are households, firms, the government and the foreign sector.

How these interact within an economy can be described by a circular flow diagram.

In its simplest form - see figure 2.2 - the economy consists of two groups: firms and households. On

the resource or real side, households provide labour to firms and firms produce goods and services

and supply them to households for consumption. Corresponding to these real or resource flows are

financial or cash flows: firms pay households for the use of their labour and households pay firms for

the goods and services firms produce.


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Figure 2.2: Simplified circular flow of income diagram

In reality the economy is more complicated. There are leakages from the circular flow:

Savings.Money is received by households but not spent on consumption of goods and services

Imports.Money flows to foreign firms as households consume imported goods

Taxes.Money flows to the government.

At the same time as the leakages are taking place, additional forms of spending occur that represent

injections into the circular flow:

Investment spending.Firms use capital in the production process. Capital in this context refers to

assets that are capable of generating income e.g. capital equipment, plants, and premises.

Capital goods have themselves been produced. Firms borrow savings from households to invest

in capital to be used in the production of more goods and services. This generates income for

firms producing capital goods

Exports. Firms sell their production to another country in exchange for foreign exchange. Thedifference between a countrys exports and imports of goods is known as the trade balance and

reflects the countrys basic trading position

Government spending.Governments use taxation to spend on the provision of public goods and

services such as defence and education.

A more complete picture of the economy is shown in figure 2.3.


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Figure 2.3: Circular flow of income diagram

While the revised model of the economy is still simplified e.g. firms also save and buy imports, it

does show the following:

The interactions between the various components of the economy

How variations in the level of economic activity can be the result of changes in a number of

variables. If households reduce the amount of goods they purchase, firms revenues decrease.

This will impact firms need for resources such as labour and raw materials and reduce the taxes

paid to the government. A change in the amount of taxes paid to the government will impact

government spending. It will also affect the level of employment.

Inherent in the circular flow of income concept is the equality of total production, income and

expenditure for the economy as a whole. Production gives rise to income. Income is expended on

production.

The total of all expenditure within an economy is referred to as aggregate demand. The main

categories of aggregate demand are the following:

Consumer or household spending

Government spending or public expenditure

Investment spending on capital goods

Exports of goods and services less expenditure on imports of goods and services.


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Consumer spending is regarded as the most important factor in determining the level of aggregate

demand.

Aggregate supply is the total of all goods and services produced in an economy.

Economic objectives2.3

The performance of an economy is generally judged in terms of the following economic objectives:

An acceptably high rate of non-inflationary economic growth

A high and steady level of employment of the labour force

A stable general price level i.e., the avoidance of undue inflation and deflation

A favourable and stable balance of payments and

Equitable distribution of income.

In most market-based economies democratically elected governments prefer levels and patterns of

aggregate demand and supply to be determined by market forces without government interference.

However recognition that market forces alone cannot ensure that an economy will achieve the

economic objectives has resulted in state intervention occurring to some degree in all countries. The

intervention can take the form of fiscal policy, monetary policy and /or direct controls, collectively

economic policy.

Economic policy2.4

2.4.1 Fiscal policy

Fiscal policy is the use of government spending and taxation policies to influence the overall level of

economic activity. Basic circular flow analysis indicates that reductions in taxation and/or increases

in government spending will inject additional income into the economy and stimulate aggregate

demand. Similarly increases in taxation and/or decreases in government spending will weaken

aggregate demand.

Fiscal policy is said to be loosening if tax rates are lowered or public expenditure is increased. Higher

tax rates or reductions in public expenditure are referred to as the tightening of fiscal policy. In

South Africa National Treasury is responsible for the execution of fiscal policy.

Taxation and government spending are linked in the governments overall fiscal or budget position.

A budget surplus exists when taxation and other receipts of the government exceed its payments for

goods and services and debt interest. A budget deficit arises when public-sector expenditure


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exceeds public-sector receipts. A budget deficit is financed by borrowing. Expansionary fiscal policy

is usually associated with a budget deficit and contractionary fiscal policy with a budget surplus.

In South Africa the budget is presented annually to Parliament by the Minister of Finance. The

budget sets out the following:

The governments spending plans for the financial year. A financial year runs from 1 April of the

current year to 31 March of the following year

How the government intends to finance such spending e.g. through taxes and / or loans.

In his 2012 budget speech, the Minister stated that the budget was formulated to address the

challenges of creating jobs, reducing poverty, building infrastructure and expanding our economy. In

addition special emphasis was given to improving competitiveness in industry, investment in

technology, encouragement of enterprise development and support for agriculture.

The public or national debt is the total sum of all budget deficits less all budget surpluses over time.

National debt incurs interest costs and has to be paid back. It is financed by taxpayers and can be

seen as a transfer between generations. To quote Herbert Hoover: Blessed are the young, for they

shall inherit the national debt.

2.4.2

Monetary policy

Monetary policy regulates the economy by influencing the monetary variables such as:

The rate of interest.Lowering interest rates encourages (i) companies to invest in capital as the

cost of borrowing falls and (ii) households to increase consumption as disposable incomes rise

on the back of lower mortgage and overdraft rates. Rising interest rates will typically have the

opposite effect

The money supply(notes, coins, bank deposits). If the money supply is increased, interest rates

tend to fall.

The most important tools of monetary policy are:

Reserve requirements

Open-market operations

Bank or discount rate policy.

2.4.2.1 Reserve requirements

The central bank requires banks to hold a specified proportion of their assets as cash reserves -

typically against their depositors funds. By changing the reserve requirement the central bank can


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influence the money supply and credit extension. For example, if the central bank lowers the cash

reserve requirement the money supply will increase as banks extend additional credit on the back of

their increased lending capacity.

2.4.2.2

Open market operations

Open market operations involve the purchase and sale of government and other securities by the

central bank to influence the supply of money in the economy and thereby interest rates and the

volume of credit. A purchase of securitiesexpansionary monetary policyinjects reserves into the

banking system and stimulates growth of money supply and credit extension. A sale of securities

contractionary monetary policydoes the opposite.

2.4.2.3 Bank or discount rate policy

The bank or discount rate is the interest rate at which the central bank lends funds to the banking

system. In South Africa this rate is called the repurchase rate (repo rate). Banks borrow from the

central bank primarily to meet temporary shortfalls of reserves. By varying the interest rate on these

loans, the central bank is able to affect market interest rates e.g. increasing the bank rate raises the

cost of borrowing from the central bank and banks will tend to build up reserves. This will decrease

the money supply and reduce credit extension.

An accommodative or expansionary monetary policy reduces the bank (or repo) rate at which the

central bank provides credit to the banks. Monetary policy is restrictive or contractionary when the

central bank increases the bank (or repo) rate.

The South African Reserve Bank (SARB) is the central bank of South Africa. Operationally the SARB

influences the overall lending policies of banks and the demand for money and credit in the

economy indirectly through changes in bank liquidity and interest rates in the money market.

The SARB applies monetary policy in South Africa within an inflation targeting framework. An

inflation targeting framework has the following four elements:

A monetary policy goal of price stability

A numerical inflation target to make the price-stability objective operational

A time horizon to attain or return to the inflation target

Ongoing review as to whether the inflation target will or has been met.


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Production eventually reaches a ceiling due to supply constraints and bottlenecks - the upper turning

point is reached. The demand for investment funds puts upward pressure on interest rates and new

investment is no longer profitable.

Figure 2.4: Phases of the business cycle

During the contraction phase as investment demand falls, producers of capital goods lay off workers.

Increased unemployment results in decreased consumer spendingbusinesses producing consumer

goods and services cut down on production and employment. The contraction gains momentum.

The trough or lower turning point is reached when production decreases to some minimum level. At

this level consumer demand is steady as workers employed by the government or in industries

producing essential goods and services such as food and utilities retain their jobs.

Slack demand for investment funds has resulted in a fall in interest rates making new or replacementinvestment profitableat least for firms providing essentials. With steady consumer demand an

increase in investment demand will begin to lift the economy again.

The typical behaviour of economic variables in the different phases of the business cycle is outlined

in table 2.1.


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Many economic indicators also display cyclical patterns. These can lead (turn in advance of), coincide

with or lag (turn after) the business cycle. Leading indicators can be used to predict economic

Table 2.1: Phases of the business cycle

Lower turning point

(recovery or earlyexpansion) Expansion

Upper turning point

(early contraction) Contraction

Businesses

Tend to be more

liquid and less

geared with higher

profit expectations

Start borrowing to

finance expansion

Profits rise rapidlyProfits weaken

Profits weaken

further

Credit demand Relatively weak Increases strongly Weakens Weak

Current account of

the balance of

payments

SurplusSurplus becomes

smaller or negative

Deficit or small

surplus

Deficit becomes

smaller or surplus

becomes larger

Employment Relatively low Increases High Falls slowly at first

Exchange rateRelatively stable or

tending strongerTends to strengthen

Tends to weaken

Weakens

Stabilises or tends

stronger

Exports IncreaseWeaker (to supply

local demand)

Decrease or remain

weakIncrease

Fiscal policyStimulation e.g. tax

concessions

Restraint e.g. higher

taxes and/or lower

spending

Further restraint

Borrowing increases

to finance higher

expenditure

Imports Relatively low Rise sharply Remain high Decrease

Inflation Relatively low Increases Increases further Decreases

Interest rates Relatively low Rise Rise or remain high Decline

Inventory levels Low Rise Rise or remain high Decrease

Investment Low Starts to rise High Decreases

Prices Relatively low Rise rapidly High Fall slowly

Production and

sales

Start to increase

Production capacity

is at a high level

Increase rapidly

Idle production

capacity is absorbed

Limited by capacity

constraints

Decline

substantially

Production capacity Idle capacity

Idle capacity israpidly absorbed;

Requirement to

expand production

capacity

Full utilisation Utilisation falls

Salary and wage

incomesLow Rise slowly at first High Fall slowly


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developments. The SARB uses over 200 economic time series (indicators) to determine the turning

points of the South African business cycle. Using these indicators, leading, coincident and lagging

composite-business-cycle indices are produced as illustrated in figure 2.5. The indices indicate the

direction of change in economic activity; not the level.

Figure 2.5: South African composite business cycles

The longest upward phase of the business cycle since 1945 lasted 99 months from September 1999

to November 2007. In December 2007, this upward phase came to an end.

The market turbulence that began in the third quarter of 2007 with the sub-prime market meltdown

in the United States, led to worldwide financial market panic in September 2008 with the bankruptcy

of Wall Street investment bank Lehman Brothers and the near collapse and subsequent bailout of

insurer American International Group (AIG).

Credit markets seized up and liquidity evaporated. Confidence in financial institutions crumbled.

Global and domestic demand declined and South African (and world) economic growth fell steeply

throughout 2008 and into 2009.


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In response to the financial and economic crises expansionary fiscal and monetary policies have

been adopted in most parts of the world. Since the second half of 2009 there are signs that

economic activity is bottoming out and in some instances is showing signs of recovery.

Different asset classes tend to perform differently during the phases of the business cycle.

Sharestend to perform best during both the recovery and expansion phases when economic

conditions are improving and company revenues are increasing. Share prices are volatile at the

upper turning point of the cycle as investors become less certain about the future. Share prices

decline during the contraction phase of the cycle when economic conditions are deteriorating and

corporate profits are falling.

Bondsare likely to perform best during the contraction phase and lower turning point when interest

rates generally decline. Bonds tend to perform less well during the late expansion phase and upper

turning point when interest rates are apt to rise.

Propertytends to perform well during recovery and expansion when interest rates are relatively low

and employment and economic conditions are improving. Property does not perform as well during

the contraction phase when economic conditions are deteriorating and employment is declining.

Cashis generally more attractive during the contraction phase when economic conditions are

worsening and there is widespread pessimism, particularly in the business sector.

Commoditiesare likely to perform well during the expansion phase of the business cycle when

production is increasing rapidly; production capacity is at or near full utilisation and demand for

commodities is high. Commodities do not perform well during contraction when manufacturers are

reducing production and operating at less than full capacity.

Precious metalstend to perform best during the upper turning point when the demand for precious

metals like gold, platinum and silver rises for industrial purposes and as a hedge against inflation.

During the contraction phase, when industrial demand is low and inflation is declining, precious

metals may not perform as well.


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Economic indicators2.6

Economic indicators provide insights into how economies and markets are performing. Their

interpretation is important to various market participants and observers for a number of reasons.

Economists and other market analysts use economic indicators to (i) assess the performance of an

economy (ii) judge the effectiveness of a governments economic policy(iii) compare the economic

performance of different countries and (iv) form economic and market forecasts and views.

Investors use economic indicators to attempt to obtain the best investment return given risk.

Businesses use economic indicators to determine if the time is right to undertake new capital

investment projects; takeovers or mergers; or entry into new markets.

The following economic indicators will be discussed:

Gross Domestic Product (GDP)

Consumption expenditure by households

Government Spending

Investment Spending

Consumer Price Index (CPI)

Producer Price Index (PPI)

Balance of Payments.

In each case the indicator will be defined. Then how the indicator is generally presented and what

should be focused on when analysing the indicator are noted. Thereafter the timing of the indicator

with respect to the business cycle as well as the interpretation of the indicator are considered.

Finally the impact of the indicator on market variables is highlighted.


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2.6.1 Gross Domestic Product (GDP)

Definition: The total value of all goods and services produced in a country in a particular

period (usually one year).

Real (constant price) GDP reflects total economic activity after adjusting for

inflation.

There are three approaches to estimating GDP:

o production or output method sums the value added (value of production

less input costs) by all businesses (agriculture, mining, manufacturing,

services);.

o expenditure method adds all spending: private consumption such as food

and clothing; government consumption such as remuneration of public

sector employees; investment such as factories, manufacturing plants;

and exports (foreigners spending) less imports (domestic spending

abroad).

o

income method aggregates the total incomes from production and

includes employees wages and salaries, income from self-employment,

businesses trading profits, rental income, trading surpluses of

government enterprises and corporations.

Theoretically the output, expenditure and income measures of GDP should be

identical (see 2.3). In practice discrepancies exist due to shortcomings in data

collection, timing differences and the lack of informal sector data.

Presented as: Quarterly and annual totals

Focus on: Percentage changes, annual or over four quarters

Timing: Coincident indicator of the business cycle

Interpretation: Interpretation of GDP numbers depends on business cycle timing. For

example strong economic growth after an economic recession usually

indicates the utilisation of idle capacity; during the expansion phase it may

suggest the installation of new and additional capacity to add to future

production while at the peak it may imply inflationary pressures.

Likely impact on:

Interest rates High GDP growth could be inflationary if the economy is close to full capacity.

This will lead to rising interest rates as market participants expect the central

bank to raise interest rates to avoid higher inflation.

Bond prices Higher interest rates mean falling bond prices.

Share prices High growth leads to higher corporate profits this supports share prices.

However inflationary fears and higher interest rates usually impact share

prices negatively.

Exchange rate Strong economic growth will tend to appreciate the exchange rate as higher

interest rates are expected.


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Figure 2.6: South African Gross Domestic Product

2.6.2 Consumption expenditure by households

Definition: Consumption expenditure or spending by households is the total amount ofmoney spent by households in an economy. It is divided into a number of

categories including durable goods (goods expected to last more than 3 years),

semi-durable goods (goods expected to last 3 years or less), non-durable goods

(food and clothing) and services.

Consumption spending by households represents the largest proportion of

GDP. In industrialised countries it is around 60% of GDP (58.6% in South Africa -

2nd quarter of 2012).

Presented as: Quarterly and annual totals

Focus on: Real growth rates

Timing: Coincident indicator of the business cycle

Interpretation: A change in consumption spending by households has a large effect on total

production as it is the largest component of aggregate demand.

After a recession growth i

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