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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/8/10/2019 Introduction_to_Financial_Markets.pdf
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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
The market defined .................................................................................................................. 1158.1
Characteristics of the market ................................................................................................... 1168.2
Equity market instruments ....................................................................................................... 1218.3
Equity market participants ....................................................................................................... 1258.4
9 The derivatives market ................................................................................................. 129
The market defined .................................................................................................................. 1299.1
Characteristics of the market ................................................................................................... 1309.2
Derivative instruments ............................................................................................................. 1319.3
Participants in the derivatives market ...................................................................................... 1439.4
10 The commodities market ............................................................................................. 149
The market defined .................................................................................................................. 14910.1
Characteristics of the market ................................................................................................... 15010.2
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
shareofpricebeginning
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
shareofpricebeginning
dividendcash
shareofpricebeginning
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