Hoofstuk 1

Die beleggingsomgewing

Chapter 1
The investment setting
 In hierdie leergedeelte / In this study section
The goal of investment management is to
achieve the investor’s required rate of return

Uitkomstes
• Onderskei tussen welvaart,
belegging, spekulasie en
waagstukke/dobbelary.
• Vereiste opbrengskoers kan
verduidelik.
• Die fundamentele beginsels
van belegging kan analiseer.
• Diversifikasie gebaseer op
verskillende bateklasse kan
verduidelik.
• Die beleggingsbestuursproses
kan bespreek.
Outcomes
• Distinguish between wealth,
investment, speculation and
gambling.
• Explain required rate of return.
• Analyse the fundamental
principles of investment.
• Explain diversification based
on different asset classes.
• Discuss the investment
management process.
 1.2 Wealth, investment, speculation
and gambling
• Wealth
 Opportunity costs –
 Best return that could be earned on an alternative investment
 Return - compensate investor for the time during funds are committed, inflation and
uncertainty
 Required return – minimum return an investor will accept to compensate
time value of money, inflation and risk

 Wealth can be measured by:

 Determining the present value of the income stream, or by the present amount
available for spending.
 Net worth: The difference between the asset and the liabilities of an individual or firm.
 Asset allocation - distribute wealth among different countries and asset
classes
 1.2 Wealth, investment, speculation and
gambling

Saving Investment Speculation &

Short-term process Long-term process Gambling
 1.3 The required rate of return

Define: Required rated of return

Three components of required rate of return:
o The time value of money during the period of the
investment;
o The expected rate of inflation during the period; and
o The risk involved.

RRR = NRFR + RP
 1.3 The required rate of return

• RRFR…starting point….required rate of return.

• Time value of money is the real risk-free rate of return (RRFR),
which is the price charged for the exchange between current
goods and future goods.
• Risk-free investments, e.g. T-Bills
• Thus, to determine the required return (RR) the nominal risk-free
rate (NRFR) must first be determined and then a risk premium
(RP) must be added to compensate for the risks associated with
the investment.
• RRR = NRFR + RP
Watch video
http://www.investopedia.com/video/play/riskfree-rate-return/
 Voorbeeld: Skatkisbiljet (skatkiswissel)/
Example: Treasury bill

• Discount value = Price at which TB is traded in the market

• Principle value / face value / Par value = Bond holder receives initial price of
TB issued by the firm when TB reached maturity
• Issuer = firm (borrower) & Treasury bill holder = investor (lender)
• Investor receives no coupon (interest). Instead, investor receives the
difference between discount price and Face value = profit
• Maturity = the date on which the bond will mature (expire) and the bond issuer
will pay the bondholder the face value of the bond.
 1.3.1 Real and nominal rates of
return
Two factors influencing the nominal risk-
free rate (NRFR):
 Expected rate of inflation
 Conditions in the capital market
 1.3.1.1 Inflation and the nominal rate of
return

• The relationship between real risk-free rate (RRFR)

and nominal risk-free rate (NRFR):
• EI = expected inflation (decimal form)
• RRFR = real risk free rate of return (decimal form)

Vs.
RRFR = [ ] ×100
See Text book example on
pg. 4
 1.3.1.1 The required rate of
return
• RRR = NRFR + RP
where:

RRR=
• Thus + RP
 1.3.1.2 Demand and supply conditions in
the capital market

• Monetary and fiscal policy determine the

conditions in the capital market (demand &
supply), which cause the interest rates to
increase/decrease.
• Monetary policy…
• Fiscal policy…
 1.3.2 Risk premiums (RP)
RRR = NRFR + RP
 Increase in the RRR over the NRFR is known
as a risk premium (RP).
 The risk premium is a composite of the
following risks (TB pg. 5-6):
1. Business risk…cyclical firms vs non-cyclical firms - RP?

2. Financial risk… AAA credit rating vs BB rating; - RP?

3. Liquidity risk…Shares and bonds vs property - RP?

4. Currency risk

5. Political risk
 1.3.2 Risk premiums (RP)
RRR = NRFR + RP
Risk premiums continue…
6. Call-ability risk
– Firm needs funds to pay debt obligations
– Firm issues a bond (borrower) to bondholder (lender) = R100 000 (Face value or
principle@ 12% p.a. - compounded semi-annually. Fixed interest rate
– Issue date – 1 Jan 2020. Maturity date = 1 Jan 2030.
– Market interest rates drop at 10%. Firms pays higher interest (12%) vs market
rate.
– Expensive for firm paying 12% vs 10%.
– Firms calls bond back when it reached a specified maturity date (say after 5
years) and issue new bonds paying interest of 10%. Bondholder receives
principle (R100 000) but has to re-invest in other bonds with lower interest rate
(10% or lower)

7. Convertibility risk
E.g. converting bonds to shares. Firm therefore doesn’t have to pay face value.
Occurs when the firms underperforms. Return on share is lower vs bond yield
 Class activity
• Jy word gevra om ʼn
belegger se vereiste • You are tasked to calculate
opbrengskoers (RRR) te an investors required rate of
bereken. Die belegger return (RRR). The investor is
beplan om in ʼn goudmyn te planning to invest in a
belê. Gebruik die volgende goldmine. Use the following
insette om jou berekening inputs to do your
mee te doen: calculations:
• Die opbrengs op • The yield on Government
Staatseffekte is 5% bonds are 5%
• Die heersende inflasie is • The current inflation is 5.5%
5.5% • The expected variation in
• Die verwagte variasie in income due to strikes is 8%
inkomste as gevolg van
stakings is 8%
 Class activity
• You are tasked to calculate an investors required rate of return
(RRR). The investor is planning to invest in a goldmine. Use the
following inputs to do your calculations:
• The yield on Government bonds are 5%
• The current inflation is 5.5%
• The expected variation in income due to strikes is 8%

RRR = NRFR + RP (risk premium)

NRFR = [(1+RRFR)(1+EI) – 1] X100 + RP
= [ (1+ 0.05 )(1+ 0.055 ) ] – 1 X100 + RP
= 0.10775 x 100
= 10.775 % (NRFR) + 8% RP
RRR = 18.775%
 1.3.2 Total risk

Total risk can be divided into the following

two risks: Figure 1
• Non-systematic risk
• Systematic risk
 1.4 Fundamental principles of investment

• Time value of money (more detail in Chapter 4 & 5)

• Risk vs. return:
• Risk…
• Can be divided into:
• Non-financial; and
 Generally not considered core or directly associated to the primary business
and revenue-generating activities reflected in a firm’s balance sheet

• Financial risk
 Associated with investments.
 Decline in value of investment due to risk factors
 1.4 Fundamental principles of investment

• Return…
• Historical returns can be measured by means of the holding
period return (HPR) and the holding period yield (HPY)

• HPR - measures the change in wealth resulting from an investment

Change in price or
income

NB!!!!! – ALL
CALCULATIONS –
Use six decimals in
• A value > 1 : ? your calculations and
• A value <1 : ? steps. Round your final
• A value = 0 : ? answer off to two
decimals
 1.4 Fundamental principles of investment

• The rate of return can also be express in % on

an annual basis. Thus convert the HPR to the
HPY:
• Within 1 year
𝐻𝑃𝑌 =𝐻𝑃𝑅− 1

• Over more than 1 year n= number of years

investment is held
1
𝑛
𝐴𝑛𝑛𝑢𝑎𝑙 𝑯𝑷𝒀 − 1
See Text book example on pg. 7-8
See video on how to do the calculations available on e-fundi
 1.4.2.1 Measures of a single asset

Measures of risk of a single asset: Required rate of

• Can be measured by means of: return vs. expected
• Standard deviation (); and rate of return
• Coefficient of variance (CV)
• In order to calculate these risk measures, calculate the expected
rate of return first.

• Where:
• is the expected value or expected return
• n is the number of possible states
• ki is the rate of return associated with the i’th possible state
• Pi is the probability of the i’th state occurring
See video on how to do the calculations available on e-fundi
 Fundamental principles of investment
(continues)

 Standard deviation...

Where:
 σ is the standard deviation
 is the expected return
 ki is the outcome associated with the i’th state
 Pki is the probability associated with the i’th outcome

The greater the standard deviation the greater is the risk (uncertainty), because
of a broader distribution

See video on how to do the calculations available on e-fundi

 Fundamental principles of investment
(continues)

Standard deviation not always an appropriate measure of risk…

 Fundamental principles of investment
(continues)

 Coefficient of variation (risk per unit of return):

 Measure of relative dispersion
 Useful in comparing the risk of assets with differing
expected returns

 The higher the CV the greater the risk per unit of

expected return for an asset

See Textbook example pg. 8 – 10

See video on how to do the calculations available on e-fundi

 1.5 Diversification

• Diversification…
• Returns of a portfolio depends on the asset
allocation
• Different asset classes:
• Can be divided into two groups:
• Real assets (real estate, land, buildings and commodities )
• Financial assets (fixed-income securities – bonds & equity instruments -
shares)

Characteristics….
 1.5 Diversification Maturity date
the date on which the
principal or face value of a
Bonds bond becomes due
Inverse relationship
Firm borrows
between bond price
money and interest rates
Duration (price sensitivity measure)
Takes into account 1st coupon cash flow
up until to maturity. The longer the
duration, the more likely interest rates
can change bond prices
Convexity…
Firm (issuer) Investor (bondholder)
A non-linear change in price.
needs funds has funds available
A bond with low yield = small
change in Yield leads to big
change in P and Vice visa
Investor Yield to maturity
lends money Rate of return earned on a bond
if investor buys bond at a specific
price and holds until maturity
 1.5 Diversification

Variety of bonds
Government securities (fixed interest securities)
• Treasury(government) bond. (Long-term debt security = + 10 years. Pays
coupon semi-annually. Example of a SA government bond = R 186. Low risk
and pay low interest rates. Financing of infrastructure and power stations
• Treasury bills (Short-term debt instruments =90(SA) / 91 (US). Sold at
discount. No coupon. Redeemable at par on maturity. Profit (Par value –
discount price. Financing of wages / salaries
• Treasury notes (Medium-term debt security = 1 – 10 years. Pays coupon
semi-annually.
 1.5 Diversification
Other types of bonds
• Vanilla bond (Simplest forms of bonds. No embedded options. Issued at discount price. Pays fixed
interest. Redeemed at Par value.
• Municipal bonds (Issued by government entities to generate income to meet capital expenditure. Pays
interest periodically and repay par value at maturity
• Corporate bonds (Issued by private companies. Investors receive a higher yield vs government bonds.
• Zero- coupon bonds (Issued at discount price and redeemable at par value. Pays no interest. Maturity
date = long term. Profit (Par value – discount price)
• Preference shares ( Regarded as a fixed income security)

Bonds with embedded options (self study)

• Putable bonds, callable bonds (See Chapter 11 – pg 218)
• Convertible bonds (Bondholder have the option to return bonds in exchange for ordinary shares.

Other financial securities (self study)

• Ordinary shares
• Warrants (Derivative security. Buyer has the right (but not obligation) to buy/sell shares of a
• company at a specified price during lifetime of the warrant)
1.5 Diversification Fig 1.3
 1.5 Diversification

Other investments (Investment vehicles):

• Unit trusts (collective investment schemes)
• Investment trusts
• ETFs (types: commodity ETFs, bond ETFs, currency ETFs)
• Hedge funds
self study
(see Textbook pg. 15) AND TABLE 1.1 & 1.2
 1.5 Diversification

Table 1.1: Differences between unit trusts and investment

trusts
Unit trusts Investment trusts
May not invest more than Freedom to invest in
5% in any one security accordance with the
investment strategy of the
trust
Not listed on an exchange Listed share on the JSE,
similar to ETFs
Price determined by trust Price determined by
deed and depends on supply and demand
value underlying of
securities (NAV)
 1.5 Diversification
Table 1.2: Differences between unit trusts and hedge funds

Unit trust Hedge fund

May not invest more than 5% in any one
security
Managed by a fund manager, who gets paid
regardless of whether investors gain or lose
Freedom to invest in accordance with the
investment strategy of the trust
Managed by a general partner who earns
fees based only on investors’ profits, not
losses

Allowed to advertise Not allowed to advertise

Available to the general public by Available to high net worth individuals and
prospectus institutions by a confidential offering
memorandum and partnership agreement

Traded daily (once a day based on previous Illiquid, may not be able to redeem at any
closing price) time
Small fee to redeem Usually a lock-in period to prevent aborting
any strategy
No limit on the number of investors who can A private pool of investment capital, limited
invest in the fund to the partners
 1.5 Diversification
Table 1.2: Differences between unit trusts and ETFs
(not in text book)
Unit trust ETFs
Not traded on an exchange Traded on an exchange
Traded once a day based on previous Continuous trading on exchange
closing price throughout trading day.
Price determined based on NAV Price determined based on supply and
demand of shares traded
Exhibit higher expense ratios compared to Offer low expense ratios
ETFs.
Active investment approach. Management Passive investment approach
fees are higher due to unit trusts being
actively managed
 1.5.2.1 International diversification

International diversification…
• Benefits of international diversification:
• Risk is reduced
• Risk-adjusted return of portfolio is improved.
watch video http://www.investopedia.com/terms/r/riskadjustedreturn.asp

• Constraints and costs of international investment:

• Unfamiliarity with foreign markets
• Regulations
• Market efficiency
• Risk perception
• Costs
 Transaction costs
 International custodian costs
 Taxes
 Management fees
 1.6 Investment management
process
1
Individual – Based on life cycle of the investor
Establishing investment Life cycle of the investor
Financial institution - Must meet obligations in terms
objectives and constraints Meet obligations in terms of policies sold
of policies sold
2 Investment
Investment Policy statement
Policy statement (IPS)
(mandate/benchmark)
Establishing investment (mandate/benchmark)
Follow long term investment discipline in stead of
policy Follow long term investment
short term impulsivediscipline
approachin stead of
short term impulsive approach
3
Selecting a portfolio
Active vs. Passive management
strategy

4 Constructing an efficient portfolio

Selecting assets Selecting assets based on fundamental and/or
technical analysis
5 Measuring and evaluating Measuring performance against benchmark
performance (as stated in IPS)
 Self-evaluasie / Self-evaluation
• Onderskei tussen welvaart, belegging,
spekulasie en waagstukke.
• Verduidelik verlangde opbrengskoers.
• Definieer die tydwaarde van geld.
• Bespreek risiko teenoor opbrengs.
• Pas die verskillende metings van risiko
van ’n enkele bate toe.
• Onderskei tussen die verskillende
bateklasse.
• Bespreek die risiko/ wins eienskappe
van die verskeie bateklasse.
• Bespreek internasionale diversifikasie.
• Bespreek die
beleggingsbestuursproses.
• Distinguish between wealth, investment,
speculation and gambling.
• Explain required rate of return.
• Define the time value of money.
• Discuss risk versus return.
• Apply the different measures of risk of a
single asset.
• Distinguish between the various asset
classes.
• Discuss the risk/ return characteristics of
the various asset classes.
• Discuss international diversification.
• Discuss the investment management
process.
 Self-study

VRAAG 1 QUESTION 1
• Jy koop ʼn huis vir R985 000. • You purchase a house for R985 000.
Binne een jaar kan jy gemaklik die Within one year you can easily sell
huis verkoop vir R1000 000. Nadat the house for R1 000 000. After 5
jy 5 jaar daar gebly het besluit jy years you decide to sell as end up
om te verkoop en verkoop wel die selling for R1 250 000.
huis vir R1 250 000. i. What is the holing period return
i. Wat is die houperiode-opbrengs (HPR) and holding period yield
en houperiode-opbrengskoers (HPY) after one year?
na een jaar? ii. What is the annual holing period
ii. Wat is die jaarlikse houperiode- rate (HPR) and annual holding
opbrengs en jaarlikse period yield (HPY) after five
houperiode-opbrengskoers na years?
vyf jaar?