FINANCIAL SECTOR TALENT ENRICHMENT PROGRAMME
INVESTMENT BANKING HANDBOOK
First Edition April 2010
© 2010 Institut Bank-Bank Malaysia
All rights reserved. No part of this publication may be reproduced or transmitted in any material form or by any means, including photocopying and recording, or stored in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication, without the written permission of the copyright holder. Written permission must also be obtained before any part of this publication is stored in a retrieval system of any nature. Application for permission should be addressed to Institut BankBank Malaysia.
Published by Institut Bank-Bank Malaysia (35880-P) Wisma IBI, 5 Ja;an Semantan Damansara Heights, 50490 Kuala Lumpur Tel: 603-20956833 (General Line), 603-20938803 (Qualifications), 603-20958922 (CPD) Fax: 603-20952322 (General Line), 603-20957822 (CPD) Website: www.ibbm.org.my E-mail:
[email protected]
The development and production cost for this handbook is subsidized by the Staff Training Fund
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Foreword The Financial Sector Talent Enrichment Program is an industry-driven post graduate initiative of the financial services industry. Deriving from an idea promulgated by the Governor of Bank Negara Malaysia, Tan Sri Dato‟ Seri Dr Zeti Akhtar Aziz, FSTEP was established in September 2007 to address the shortage of skilled talents in the financial services sector. The program aims to produce highly trained young professionals for the financial services industry. Banking in Malaysia is a fast-changing and dynamic industry with new developments taking place all the time. The development the Malaysian domestic economy would also need to change to a more productive structure that is more innovation-driven and knowledge intensive. The role of the financial sector therefore will also evolve from being an enabler of growth to becoming an important catalyst and driver of economic growth and development. This will create increased demand for highly trained and competent workforce to serve the financial industry. FSTEP therefore was established as part of the overall talent development initiatives to contribute to the process of building and expanding a sustainable pool of talent to best serve the present and future needs of the industry. FSTEP occupies a unique niche within the financial services industry, providing a training programme to equip participants with the essential knowledge and skills as well as to nurture them to become well-rounded individuals to support the growth of the industry. Through active collaboration of industry players, training modules were designed to blend technical knowledge and personal development insight, which enables participants to optimise their learning through a mix of classroom training based on case studies, complemented by hands-on exposure through on-the-job training. In writing this handbook, the author adopted an approach to comply with the syllabus of the financial services stream, as outlined by FSTEP. As such, the handbook will serve to augment the teaching and learning process to bring about maximum impact on the participants of FSTEP. FSTEP participants should review the handbook material prior to every class to expedite and maximize their understanding of the subject. We wish to register our appreciation to IBBM, the author, the reviewer and many others for the selfless contribution to this handbook and for their unwavering advice in steering the handbook to successful completion. FSTEP Management March 22, 2010 Investment Banking Authors: Amirullah Abdullah Reviewer: Megat Othman Megat Shamsuddin
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Overview The syllabus comprises the structure, functions, processes, products and services in the investment banking sector. Discussions cover investment banking operations, compliance and regulatory framework, fixed income securities, equity markets and stock broking business, financial statement analysis, derivatives markets and risk management. The personal development element focuses on developing appropriate skills and competencies which are needed to apply the knowledge and dynamics of investment banking, while the reality of site exposure to the business of investment banking is an integral part of experiential learning. Module Coverage The goal of this module is to help participants to understand and apply the core contents of investment banking and to assist them to do this efficiently and effectively. Objectives i.
Describe the financial system in Malaysia, Financial Sector Master Plan, Capital Master Plan and the impacts of globalization on Malaysian banking industry.
ii.
Discuss the role, structure, core activities and the key players in investment banking.
iii.
Discuss the compliance and regulatory framework in investment banking; BNM Guidelines for Investment Banks, Securities Industry Regulations and Rules of Bursa Malaysia Securities Berhad.
iv.
Describe the types, elements and characteristic of fixed income securities issued by the public and private sector.
v.
Understand and apply the concepts and techniques of Corporate finance, Mergers & Acquisitions , Divestitures.
vi.
Apply the concepts of time value of money in pricing and valuation of fixed income securities.
vii.
Discuss the elements and characteristics of shares and the equities market in which these investment instruments are traded.
viii.
Describe the main operations of a stock broking company and the trading, clearing and settlement system of Bursa Malaysia Securities Berhad.
ix.
Explain how financial ratios are used to evaluate the financial position and performance of a company.
x.
Describe the top down approach to security analysis and the valuation of equity securities using the dividend discount model and the earnings multiplier model.
xi.
Discuss the elements and characteristics of derivatives, particularly options and futures and the trading of these instruments in Malaysia.
xii.
Explain the importance of risk management, and the role and responsibilities of the risk management unit within an investment bank.
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Module Outline This module comprises eleven main topics: Topic 1 Overview of the Banking Business
This topic provides the reader with an overview of the banking business. The function of the banking system is to ensure smooth flow of money from those who have it [savers] to those who want to use it [borrowers], so that the latter can make an effective use of the same, in the process benefiting themselves, the savers and the economy as a whole.
Topic 2 Overview of Investment Banking
This topic introduces the reader to the role, structure and the core activities of investment banking. To put it simply, an investment bank acts as an intermediary, and matches sellers of stocks and bonds with buyers of stocks and bonds. Other key functions would be those of Corporate Finance and Debt capital market
Topic 3 Compliance and Regulations in Investment Banking
The purpose of this topic is to provide the reader with background information on the regulation of the investment banking industry. We will look at the key regulators and the guidelines and legislation which affect investment banking.
Topic 4 Malaysian Fixed Income Securities
In this topic we shall discuss types of fixed income securities available in the market. A wide variety of debt securities products are available in the Malaysian bond market, such as fixed coupon bearing bonds, asset-backed securities, convertible bonds, callable bonds, etc.
Topic 5 Corporate Finance- Mergers and Acquisitions (M & A) & Divestitures
This topic will engage participants into the basics and key components of M & A and Divestitures. This module will also touch on the financing modes and the typical processes.
Topic 6 Understanding Bonds
This topic describes the general characteristics of a bond and the risk associated with it. We will explain the mechanics of bonds valuation using the present value concepts, the term structure of interest rates and the ratings of corporate bonds.
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Topic 7 Understanding Securities and Stock broking Business
In this topic we will provide the reader with an understanding of the stock broking business, one of the core components of investment banking. The main operations of a stock broking company usually include dealing or trading, accounts and contract departments because the stock broking business revolves around the buying and selling of shares.
Topic 8 Malaysian Equity Markets
This topic discusses equity securities and the equity market in which these investment instruments are traded. Among others, we will discuss the structure of the Malaysian equity markets, the concept of shares, the various equity hybrids and the classification of shares for investment purposes.
Topic 9 Financial Statement Analysis
In this topic, we will describe three principal financial statements, namely the balance sheet, income statement and cash flow statement and discuss in detail the use of financial ratios to assess company performance.
Topic 10 Valuation of Equities
In this topic, students shall be exposed to fundamental analysis, specifically the top down approach to analysis. We will illustrate the two commonly used methods to equity valuation, i.e. the dividend discount model and the earnings multiplier model.
Topic 11 Understanding Derivatives Markets
This topic is aimed at providing the reader with an understanding of the concept and uses of derivatives, specifically the futures and options contract. Among others we will discuss the role of derivatives and trading of options and futures in Malaysia
Topic 12 Risk Management in Investment Banking
In this topic we will discuss the types of risk faced by investment banks, the risk management system and the role and responsibilities of the risk management unit. We will also provide the reader with the risk measurement techniques, specifically the VAR and stress testing techniques.
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Table of Content 1 OVERVIEW OF BANKING BUSINESS Preview - Topic Objectives 1.1 Introduction 1.2 Financial System - Constituents 1.3 Financial System of Malaysia 1.4 Banking System 1.5 Financial Markets 1.6 Importance of Banking Business to the Economy 1.7 Financial Sector Master Plan 1.8 Capital Market Master Plan 1.9 Impact of Globalization - Recent Developments
14 15 16 17 17 20 20 21 22 23
Summary Activity Q&A Suggested Answers to Activity
25 26 27
2 OVERVIEW OF INVESTMENT BANKING Preview - Topic Objectives 2.1 Introduction 2.2 Commercial Banking Vs. Investment Banking 2.3 Establishment of Investment Banks in Malaysia 2.4 Role and Key Functions of Investment Banks 2.5 Overview of Core Activities of an Investment Banks 2.6 Roles and Responsibilities of the Middle Office
28 29 29 30 31 32 34
Summary Activity Q&A Suggested Answers to Activity
35 36 37
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Table of Content 3 COMPLIANCE AND REGULATORY FRAMEWORK IN INVESTMENT BANKING Preview - Topic Objectives 38 3.1 Introduction 39 3.2 Bank Negara Malaysia 39 3.3 Securities Commission 41 3.4 Bursa Malaysia Securities Berhad 43 3.5 Securities Offences - Prohibited Conduct under the SIA 45 Summary Activity Q&A Suggested Answers to Activity
47 48 49
4 UNDERSTANDING BONDS Preview - Topic Objectives 4.1 Introduction 4.2 Bonds Terms and Features 4.3 Risks in Bonds Investments 4.4 Bond valuation 4.5 Bond Yields 4.6 Price Yield Relationship 4.7 Term Structure of Interest Rates and Yield Curve 4.8 Ratings of Corporate Bonds 4.9 Bonds Issued by Foreign Entities
50 51 51 52 54 56 57 58 59 61
Summary Activity Q&A Suggested Answers to Activity
62 63 65
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Table of Content 5 MALAYSIAN MONEY AND DEBT MARKET SECURITIES Preview - Topic Objectives 5.1 Introduction 5.2 Primary and Secondary Market for Dect Securities 5.3 Government Securities and Money Market Instruments 5.4 Money Market Instruments Issued by Banks and Financial Institutions 5.5 Private Debt Securities
66 67 67 67 68 69
Summary Activity Q&A Suggested Answers to Activity
73 74 75
6 UNDERSTANDING SECURITIES AND STOCKBROKING BUSINESS Preview - Topic Objectives 6.1 History and Developments of Securities Industry in Malaysia 6.2 Functions of a Stockbroking Division 6.3 The Trading System 6.4 Clearing and Settlement 6.5 Central Depository System 6.6 Trading on Bursa Malaysia Securities Berhad 6.7 Financially Distressed Listed Companies 6.8 Outline of a Trade Trasaction 6.9 Account Structure
76 77 78 79 79 81 81 83 84 84
Summary Activity Q&A Suggested Answers to Activity
85 86 87
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Table of Content 7 MALAYSIAN EQUITY MARKET Preview - Topic Objectives 7.1 Introduction 7.2 Basic Functions of a Stock Market 7.3 The Malaysian Stock Market 7.4 Types of Securities Traded on Bursa Malaysia Securities Berhad 7.5 Classifications of Shares for Investment Purposes 7.6 Participants in the Malaysia Equity Markets
88 89 89 90 90 94 95
Summary Activity Q&A Suggested Answers to Activity
96 97 98
8 UNDERSTANDING DERIVATIVES MARKETS Preview - Topic Objectives 8.1 Introduction 8.2 General Description of Derivatives 8.3 The Role of Derivatives 8.4 The Main Players in the Derivatives Markets 8.5 Introduction to Futures 8.6 Introduction to Options 8.7 Regulatory Framework and Structure of The Malaysian Derivatives Markets
99 100 100 103 104 105 107 115
Summary Activity Q&A Suggested Answers to Activity
117 118 120
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Table of Content 9 CORPORATE FINANCE - MERGERS AND ACQUISITIONS (M&A) AND DIVESTITURES Preview - Topic Objectives 9.1 Introduction 9.2 Initial Public Offering (IPO) 9.3 Mergers and Acquisitions 9.4 Divestitures Summary Activity Q&A Suggested Answers to Activity
10 RISK MANAGEMENT IN INVESTMENT BANKING Preview - Topic Objectives 10.1 Introduction 10.2 What is Risk Management? 10.3 Classification of Risks 10.4 Risk Management - The process and system 10.5 Role and Responsibilities of the Risk Management Unit 10.6 Risk Management Techniques 10.7 Basel Capital Accord Summary Activity Q&A Suggested Answers to Activity
121 122 122 134 134 138 139 140
141 142 142 142 142 145 146 149 150 151 152
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Table of Content 11 FINANCIAL STATEMENT ANALYSIS Preview - Topic Objectives 11.1 Introduction 11.2 Objectives of Financial Analysis 11.3 Financial Information 11.4 Financial Ratio Analysis Summary Activity Q&A Suggested Answers to Activity
12 VALUATION OF EQUITIES Preview - Topic Objectives 12.1 Introduction 12.2 The Top Down Approach to Analysis 12.3 Basic Valuation Model 12.4 Price Earning (PE) Model 12.5 Measurement Investment Return Summary Activity Q&A Suggested Answers to Activity
153 154 154 154 158 169 170 172
173 174 174 175 178 179 180 181 183
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Table of Content
APPENDIX 1 KLCI Futures – Contract Specifications 2 Crude Palm Oil Futures – Contract Specifications 3 KLIBOR Futures – Contract Specifications 4 KLCI Options – Contract Specifications
185 186 187 188
GLOSSARY 1 Glossary
189
REFERENCES 1 References
207
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Topic 1 Overview of Banking Business Preview This topic provides the reader with an overview of the banking business. The banking system, comprising commercial banks, investment banks, and Islamic banks, is the primary mover of funds and the main source of financing to support economic activities in Malaysia. The non-bank financial intermediaries, comprising development financial institutions, provident and pension funds, as well as insurance companies and takaful operators, complement the banking institutions in mobilizing savings and meeting the financial needs of the economy. Topic Objectives At the end of this topic, you should be able to:– i.
Discuss the constituents of the financial system.
ii.
Explain the structure of the financial system of Malaysia.
iii.
List the objectives of Bank Negara Malaysia.
iv.
Explain the main functions of commercial banks, investment banks, and Islamic banks.
v.
Explain the importance of the banking business to the economy.
vi.
Describe the Financial Sector Master Plan and Capital Market Master Plan.
vii.
Discuss the impact of globalization on Malaysian banks.
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Overview of Banking Business
1.1 Introduction A Bank is a familiar word and we all know that banks form an integral part of the very financial system. So, to understand banks and banking, it is desirable to get a macro perspective of the financial system as a whole. This leads us to the fundamental question as to what constitutes the financial system. The Financial System is a set or aggregation of institutions, instruments, markets and services. A complex interplay of these components makes the financial system vibrant. As with any other system, the financial system too has a paramount objective, i.e. to ensure smooth flow of money from those who have it [savers] to those who want to use it [borrowers], so that the latter can make an effective use of the same, in the process benefiting themselves, the savers and the economy as a whole. 1.2 Financial System – Constituents Financial Institutions are engaged in the business of „money or finance‟. They can be further classified into three categories: i.
Intermediaries
ii.
Non-Intermediaries
iii.
Regulatory Agencies
1.2.1
Intermediaries
Intermediaries are the financial institutions that accept deposits from the savers and channel the same as lending/ investment to the users. In other words, financial intermediaries function as a bridge between the savers and the users in any economy. The financial intermediaries by their smooth „conduit function‟ make the economy infinitely more efficient in the usage of money. Examples of financial intermediaries are: i.
Conventional Banks,
ii.
Islamic Banks
iii.
Investment Companies,
iv.
Non-Banking Finance Companies [NBFCs],
v.
Insurance companies,
vi.
Mutual funds,
vii.
Stock Brokerages,
viii.
Credit Card Companies
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1.2.2 Non-Intermediaries These are popularly known as Supranational. These institutions fund the users of money, but, as a matter of policy, do not accept deposits from ordinary savers. They get funds from their owners or members as capital contribution or subscription & not from depositors. Classic examples of such institutions are: i.
Asian Development Bank.
ii.
World Bank.
iii.
International Monetary Fund (IMF).
1.2.3 Regulatory Agencies These are agencies whose sole function is to monitor and regulate the functioning of the intermediaries and non-intermediaries and are referred to as „Regulatory Authorities‟. They are like the traffic cops that lay down the “Do‟s and Don‟ts” for the players in the market. To make their regulations enforceable, these agencies are generally armed with punitive powers, which can be exercised in case of noncompliance by any of the players. Examples: Banking Sector: In the Malaysian context, Bank Negara Malaysia is the regulatory agency vis-à-vis the banking system. In US it is called the Federal Reserve Bank. Capital Market: Financial regulators, such as the U.S. Securities and Exchange Commission and in Malaysia, the Securities Commission is responsible for regulating the capital market segment to ensure that investors’ interests are protected. 1.3 Financial System of Malaysia The Malaysian financial system is structured into two major categories: 1. Financial Institutions The Financial Institutions comprise Banking System and Non-bank Financial Intermediaries. 2. Financial Market. The Financial Market in Malaysia comprises four major markets namely: i. ii. iii. iv.
Money & Foreign Exchange Market, Capital Market, Derivatives Market, and Offshore Market.
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Banking System 1. Bank Negara Malaysia 2. Banking Institutions Commercial Banks Investment Banks Islamic Banks 3. Others Representative Offices of Foreign Banks
Derivatives Market 1. 2. 3.
Equity Derivatives Commodity Derivatives Financial Derivatives
Sources: Bank Negara Malaysia 1.4 Banking System The banking system consists of Bank Negara Malaysia (Central Bank of Malaysia), banking institutions (commercial banks, investment banks and Islamic banks) and a miscellaneous group (representative offices of foreign banks). The banking system is the largest component of the financial system, accounting for about 67% of the total assets of the financial system as at 2007. The summary background information and functions of the banking institutions mentioned above are set out as follows:-
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1.4.1 Bank Negara Malaysia (BNM) Bank Negara Malaysia (the Central Bank of Malaysia) was established on 26 January 1959, under the Central Bank of Malaya Ordinance 1958. The objectives of BNM are as follows: i. To issue currency and keep reserves to safeguard the value of the currency; ii. To act as a banker and financial adviser to the Government; iii. To promote monetary stability and a sound financial structure; and iv. To influence the credit situation to the advantage of Malaysia. To meet its objectives, the Bank is vested with legal powers under various laws to regulate and supervise the banking institutions and other non-bank financial intermediaries. The Bank also administers the country's foreign exchange control regulations and act as the lender of last resort to the banking system. 1.4.2 Financial Institutions The following table provides and overview of the number of financial institutions as at end-September 2008: Table 1: Number of financial institutions as at end-September 2008:
Financial Institution
Total
Malaysian Controlled Institutions
- Foreign Controlled Institutions
Commercial Banks
22
9
13
Investment Banks
15
15
-
Islamic Banks*
15
10
5
International Islamic Banks
1
-
1
Insurers
41
25
16
Islamic Insurers (takaful operators)
8
8
-
International Takaful Operators)
1
-
1
Reinsurers
7
3
4
Islamic reinsurers (re-Takaful operators)
3
1
2
Development financial institutions
13
13
-
-
*Includes one foreign Islamic bank that commenced operations in October 2008 Sources: Bank Negara Malaysia
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1.4.3 Commercial Banks The commercial banks are the largest and most significant providers of funds in the banking system. The main functions of commercial banks are to provide: i.
Retail banking services such as the acceptance of deposit, granting of loans and advances, and financial guarantees;
ii.
Trade financing facilities such as letters of credit, discounting of trade bills, shipping guarantees, trust receipts and Banker‟s Acceptances;
iii.
Treasury services;
iv.
Cross border payment services; and
v.
Custody services such as safe deposits and share custody.
Commercial banks are also authorized to deal in foreign exchange and are the only financial institutions allowed to provide current account facilities. 1.4.4 Investment Banks Investment Banks are those that provide investment related services. They do not provide direct credit as done by Commercial Banks. The main activities rendered by an Investment Bank include: i.
Help companies, governments and their agencies to raise money by issuing and selling securities in the primary market.
ii.
Assist public and private corporations in raising funds in the capital markets (both equity and debt).
iii.
Provide financial services such as the trading of fixed income, foreign exchange, commodity, and equity securities and act as intermediaries in trading for clients.
iv.
“Underwrite" stock and bond issues and other types of financial transactions.
v.
Operate as both brokerages and investment banks.
vi.
Advice on mergers and acquisitions.
1.4.5 Islamic Banking In Malaysia, separate Islamic legislation and banking regulations exist side-by-side with those for the conventional banking system. The legal basis for the establishment of Islamic banks was the Islamic Banking Act (IBA), which came into effect on 7 April 1983. The IBA provides BNM with powers to supervise and regulate Islamic banks, similar to the case of other licensed banks. As at 2008, Malaysia has seventeen full-fledged Islamic banks, three of which are from the Middle East, providing a broad spectrum of financial products and services based on Shariah principles. At the same time, there are seven conventional banks three of which are major foreign banks, offering Islamic banking products and services via the Islamic banking window set up.
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1.4.6 Non-bank financial intermediaries (NBFIs) NBFIs complement the banking institutions in mobilizing savings and meeting the requirements of specific economic sectors. These institutions also play an important role in the development of the capital market and in providing social security. Development financial institutions (DFIs), provident and pension funds, insurance companies, takaful operators, savings institutions and unit and property trusts account for the bulk of total assets of NBFIs. 1.5 Financial Markets The Financial Markets mainly comprises:1) The Money and Foreign Exchange markets, and 2) The Capital and Derivatives Markets 1.5.1 The Money and Foreign Exchange markets The money and foreign exchange markets are integral to the functioning of the banking system, firstly, in providing funding to the banking system, and secondly, serving as a channel for the transmission of monetary policy. These are governed by the Malaysian Code of Conduct for Principals and Brokers in the Wholesale Money and Foreign Exchange Markets in January 1994 which set out the market practices, principles and standards to be observed. 1.5.2 The Capital and Derivatives Markets The capital markets in Malaysia comprise the conventional and Islamic markets for medium to long term financial assets. The conventional markets consist of two main markets, namely the equity market dealing in corporate stocks and shares, and the public and private debt securities. Malaysia has a single derivatives exchange known as Bursa Malaysia Derivatives Berhad (formerly known as Malaysian Derivatives Exchange or MDEX). This new exchange which began on 11 June 2001 was the result of a merger by Malaysia‟s two previous derivatives exchanges COMMEX (Commodity and Monetary Exchange of Malaysia) and KLOFFE (Kuala Lumpur Option and Futures Exchange). The Malaysian capital markets will be discussed in greater detail in later topics. 1.6 Importance of Banking Business to the Economy Economists and policy makers have recognized that finance has been widely accepted as important prerequisite for sustaining long-run economic growth. Faster growth, more investment and greater financial depth all come partly from higher saving. For living standard to rise, a healthy flow of saving and investment must be sustained.
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The economic functions of banks include: 1) Issue of money, in the form of banknotes and current accounts subject to cheque or payment at the customer's order. These claims on banks can act as money because they are negotiable and/or repayable on demand, and hence valued at par. 2) Netting and settlement of payments – banks act as both collection and paying agents for customers, participating in interbank clearing and settlement systems to collect, present, be presented with, and pay payment instruments. 3) Credit intermediation – banks borrow and lend back-to-back on their own account as middle men. 4) Credit quality improvement – banks lend money to ordinary commercial and personal borrowers (ordinary credit quality), but are high quality borrowers. The improvement comes from diversification of the bank's assets and capital which provides a buffer to absorb losses without defaulting on its obligations. 5) Maturity transformation – banks borrow more on demand debt and short term debt, but provide more long term loans. In other words, they borrow short and lend long. 1.7 Financial Sector Master Plan BNM launched the Financial Sector Master Plan 2001 – 2010 on March 1, 2001. The objective of the plan is to develop a more resilient, competitive and dynamic financial system with best practices, that supports and contributes positively to the growth of the economy throughout the economic cycle, and has a core of strong and forward looking domestic financial institutions that are more technology driven and ready to face the challenges of liberalization and globalization. The characteristics of the Financial Sector Master plan are as follows: i.
An increasingly more diversified financial sector that would meet the needs of a diversified economic structure. A competitive environment is likely to result in banking institutions and insurance companies with differentiated strategies and market niches.
ii.
The insurance industry will be more dynamic and increase in size. A more liberalized environment will be created and the competition among local and foreign insurance will be greater. This will bring down costs and premium, and sizable increase in business volume.
iii.
A more significant Islamic banking and Takaful industry with greater global orientation, with Malaysia positioned as the regional Islamic financial center.
iv.
A focused set of development financial institutions, strengthened by the formulation of common rules and regulations.
v.
A modern financial infrastructure supported by an efficient and effective payment system, a deep and liquid capital market and a strong consumer protection framework.
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The implementation of the Financial Sector Master Plan for the banking sector is summarized as follows:
Phase I 2001-2003
Phase II 2004-2007
Phase III After 2007
The main objective in the transition is to develop a core set of strong domestic banking institutions. Therefore, initial steps shall focus on measures that seek to strengthen the capability and capacity of domestic banking institutions, create an environment where the best domestic banking institutions emerge, and building and enhancing the financial structure. Following the initial phase in which domestic banking institutions have built greater capacity and capability to compete, the playing field for incumbent foreign players will increasingly be leveled. This will begin with the removal of some of the restrictions on foreign players to add further competition to the industry. Given the intensifying degree of global competition and greater assimilation into the global arena, the banking sector needs to be prepared for greater liberalization. As a result, new foreign competitors will be introduced in the third phase development.
1.8 Capital Market Master Plan The Securities Commission revealed the Capital Market Master Plan 2001 – 2010 on February 22, 2001. The vision of the Malaysian Capital Market is to be internationally competitive in all core areas necessary to support Malaysia‟s basic and capital investment needs, as well as its longer-term economic objectives. The plan envisaged further liberalization of the stock broking industry, derivatives market, investment management, equity and bond markets and Islamic capital market. In order to achieve the vision, six key objectives have been identified to form the basis for the Master plan‟s main strategic initiatives and specific recommendations. These objectives are as follows: 1. To be the preferred Fund-Raising center for Malaysian companies. 2. To promote an effective investment management industry and a more conducive environment for investors. 3. To enhance the competitive position and efficiency of market institutions. 4. To develop a strong and competitive environment for intermediation services. 5. To ensure a stronger and more facilitative regulatory regime. 6. To establish Malaysia as an International Islamic Capital Center. The master plan contains a three-phase development plan for the 10-year period. It starts with strengthening the capital markets, goes on to gradually deregulating and 22
liberalizing, and progresses to expanding the depth and breadth of the markets. The final goal is to build a capital market that is mature and internationally competitive. The implementation of the Capital Market Master Plan can be summarized as follows:
2001 - 2003
Expand domestic capacity and strengthen the foundation for further competition through progressive deregulation and selective liberalization, with some relaxation of barriers to entry in certain nascent areas of the capital market in order to accelerate development of these sectors
2004 - 2005
Progressively expand market access and gradually remove barriers to entry across other capital market segments, and further develop the breadth and quality of services and infrastructure
2005 - 2010
Implement further expansion plans towards becoming a mature capital market and developing its international positioning in areas of competitive and comparative advantage
1.9 Impacts of Globalization – Recent Developments 1.9.1 What is Globalization? Globalization means different things to different people. Generally, it refers to an economic process that leads to increasing integration of economies around the world. As a result of increased integration, there is increasing economic interdependence among these economies through markets for goods, services, and factors of production.
1.9.2 The Pros and Cons of Financial Globalization Pros i.
To the emerging market economies like Malaysia, globalization allows them to further develop their capital markets by broadening and diversifying the structure of national capital markets to include the development of tradable securities. Such development complements the traditional role played by the banking systems to meet financing needs of these economies. It also encourages financial innovation and spurs economic growth.
ii.
From the borrowers' perspective, financial globalization provides more choices of financial instruments which they can tap at competitive costs from a broader range of providers. Therefore, firms can reduce their borrowing costs and enhance their competitiveness.
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Cons i.
ii.
Financial markets have become more volatile and this poses a threat to financial stability, particularly to the banking system. The current financial crisis which has translated into an economic crisis and its aftermath effects (in terms of large output and welfare loss) supports this point. Globalization of the financial markets also results in excessive volatility of asset prices. The recent financial crisis showed that asset prices (such as property prices, commodity prices and share prices) were overshot before they burst. Worse still, they were substantially misaligned from economic fundamentals for a relatively long period of time.
1.9.3 Recent Developments in Asia and the World A key implication of globalization for the finance and capital market is that of heightened global competition for business amid the increased cross-border interaction and integration of markets and their participants. The emergence and expansion of market economies, the removal of trade barriers, greater cross-border interconnectivity, the spread of education and the impact of applied technology are all increasing the degree of integration of global financial markets and competition therein. Over the last two decades, the emerging market economies, including Malaysia, have become more integrated through financial markets. During this period, these economies had introduced measures to gradually liberalize their financial markets, following the successful pursuit of export-led industrialization in the 1970s and 1980s.
1.9.4 Liberalization of the Financial Sector In Malaysia, the gradual but progressive liberalization of foreign exchange administration rules undertaken since 2003 has led to significant benefits in terms of providing enhanced flexibility of the financial sector, contributing to reducing the cost of doing business as well as expanding the scope of activities of the financial sector. In April 2009, several liberalization measures were implemented to further increase international investors‟ participation in the Malaysian capital market. These liberalizations measures are consistent with the objectives committed under the Financial Sector Master Plan (FSMP) to develop a resilient, diversified and efficient financial sector. The liberalization package encompasses measures on the conventional and Islamic finance sector as follows:
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A. Issuance of New Licenses i.
Up to two new licensees will be offered to Islamic banking, commercial banking and family takaful in 2009 to foreign players that will bring in specialized expertise to address gaps in the financial sector and spur the development of targeted economic sectors;
ii.
Up to three new commercial banking licences will be offered in 2011 to worldclass banks that can offer significant value propositions to Malaysia;
B. Increase in Foreign Equity Limits i.
Existing domestic Islamic banks, investment banks, insurance companies and Takaful operators that wish to scale up their operations and expand into global markets are given greater flexibility to enter into strategic partnerships with foreign players through an increased foreign equity limit of up to 70%. For Islamic banks, they will be required to maintain a paid-up capital of at least USD1 billion;
ii.
A higher foreign equity limit beyond 70% for insurance companies will be considered on a case-by-case basis for players who can facilitate consolidation and rationalization of the insurance industry. Existing foreign insurers that participate in the process will be accorded flexibility in meeting the divestment requirement.
Summary In this topic we have briefly provided an overview of the Malaysian Banking System. We discussed the financial market intermediaries and briefly explained their functions and importance to the economic development of the country. The current forces of globalization, deregulation in the financial sector and the development of information and communications technology are some of the factors leading to intense competition faced by the financial markets of emerging economies. In an environment of increasing liberalization and globalization, Malaysia is consistently assessing and reviewing significant financial market developments and regulatory issues. The FSMP and CMMP has been drawn up as a comprehensive blueprint for the Malaysian financial market and will spearhead the reform and improvement needed to establish local and global credibility for the country‟s financial market.
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Activity – Q&A 1. Which of the following institutions is classified as a non-bank financial intermediary? A. CIMB B. MAYBANK C. Bank Pembangunan D. Affin Bank 2. The following are services rendered by a commercial bank, EXCEPT: A. Custody services such as safe deposits and share custody. B. Perform submissions on equity and bond issuances to the Securities Commission. C. Trade financing facilities such as letters of credit and discounting of trade bills. D. Retail banking services such as the acceptance of deposit and granting of loans. 3. Highlight three strategies to develop the financial sector in Malaysia. (You may mention the strategies outlined in the Financial Sector Master plan.) 4. List three economic functions of banks.
26
Suggested Answers to Activity 1. C 2. B 3. Strategies to develop the financial sector as stipulated in the Financial Sector Master plan is as follows (choose any three): Building capacity with measures to enhance the capability of financial Institutions to complete and become more efficient and effective. Measures to promote stability. Regulatory and institutional infrastructure would be further enhanced, while a more efficient consumer protection framework would be instituted. Gradual deregulation of the domestic financial market to bring about greater Competition between various financial institutions. Introduce new foreign competition and prepare the banking sector for greater Liberalization. Expansion of domestic banking institutions to foreign markets, and the potential “threat” from new and aggressive non-financial players would also serve as an incentive for incumbent players to remain competitive. 4. The economic functions of banks include (choose any three): Issue of money, in the form of banknotes and current accounts subject to cheque or payment at the customer's order. These claims on banks can act as money because they are negotiable and/or repayable on demand, and hence valued at par. Netting and settlement of payments – banks act as both collection and paying agents for customers, participating in interbank clearing and settlement systems to collect, present, be presented with, and pay payment instruments. credit intermediation – banks borrow and lend back-to-back on their own account as middle men. Credit quality improvement – banks lend money to ordinary commercial and personal borrowers (ordinary credit quality), but are high quality borrowers. The improvement comes from diversification of the bank's assets and capital which provides a buffer to absorb losses without defaulting on its obligations. Maturity transformation – banks borrow more on demand debt and short term debt, but provide more long term loans. In other words, they borrow short and lend long.
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Topic 2 Overview of Investment Banking
Preview This topic provides the reader with an overview of investment banking. The introduction of investment banks in Malaysia is aimed at strengthening the capacity and capabilities of domestic banking groups to contribute towards economic transformation and to face the challenges of liberalization and globalization. Topic Objectives At the end of this topic, you should be able to– i.
Discuss the differences between commercial banks and investment banks.
ii.
Discuss the establishment of investment banks in Malaysia.
iii.
List the key players in the local Investment Banking landscape.
iv.
Describe the role and key functions of investment banks.
v.
List the core activities of investment banks.
vi.
Describe the structure of an investment bank.
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Overview of Investment Banking
2.1 Introduction British and European merchant banks had been a dominant force in the international banking scene for a long time. However, there was a shakeout in the 1990s, and one by one, many of these merchant banks started to drop out, either due to unsustainable losses or as a result of industry consolidation. By the time the dust had settled, a clear trend emerged - the European merchant banks had lost tremendous ground to the better equipped US banks operating under the investment banking model. Investment banks differ from commercial banks, which take deposits and make commercial and retail loans. In recent years, however, the lines between the two types of structures have blurred, especially as commercial banks have offered more investment banking services. Investment banks may also differ from brokerages, which in general assist in the purchase and sale of stocks, bonds, and mutual funds. However some firms operate as both brokerages and investment banks. In Malaysia, all the investment banks operate as both brokerages and investment banks. 2.2 Commercial banking vs. Investment banking While regulation has changed the businesses in which commercial and investment banks may now participate, the core aspects of these different businesses remain intact. In other words, the difference between how a typical investment bank and a typical commercial bank operates is simple: A commercial bank takes deposits for checking and savings accounts from consumers while an investment bank does not. We'll begin examining what this means by taking a look at what commercial banks do. Commercial Banks The typical commercial banking process is fairly straightforward. You deposit money into your bank, and the bank lends that money to consumers and companies in need of capital (cash). You borrow to buy a house, finance a car, or finance an addition to your home. Companies borrow to finance the growth of their company or meet immediate cash needs. Companies that borrow from commercial banks can range in size from the dry cleaner on the corner to a multinational conglomerate. Let's take a minute to understand how a bank makes its money: On most loans, commercial banks earn interest anywhere from 5 to 14 percent. Ask yourself how much your bank pays you on your deposits - the money that it uses to make loans. You probably earn a paltry 1 percent on a current account, if anything, and maybe 2 to 3 percent on a savings account. Commercial banks thus make lots of money, taking advantage of the large spread between the interest paid on deposits (2 percent, for example) and their return on funds loaned (ranging from 5 to 14 percent).
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Investment Banks An investment bank in Malaysia operates with a slight difference. The Investment bank is allowed to accept deposits of more than RM500, 000-00 and hence, also has an inventory of cash deposits. It, however, does not lend as a business activity unless if lending is linked to a capital market transaction (i.e. intermediate in nature, serving as a bridging loan). In essence, an investment bank acts as an intermediary, and matches sellers of stocks and bonds with buyers of stocks and bonds. Note, however, that companies use investment banks toward the same end as they use commercial banks. If a company needs capital, it may get a loan from a bank, or it may ask an investment bank to finance equity or debt (stocks or bonds). Investment banks typically sell public securities (as opposed private loan agreements). Technically, securities such as Maybank stock or Genting AAA bonds, represent government-approved stocks or bonds that are traded either on a public exchange or “traded-over-the-counter” through an approved dealer. The dealer is the investment bank. 2.3 Establishment of Investment Banks in Malaysia The framework on the creation for investment banks was introduced in 2005 following the successful rationalization of commercial banks and finance companies. The framework provided for the development of full-fledged investment banks through consolidation, integration and rationalization between merchant banks, stock broking companies and discount houses. The establishment of investment banks would require the merchant banks, stock broking companies and discount houses within the same banking groups to be merged before the new entities are transformed into investment banks. Discount houses which did not have merchant banks in their groups would also merge with another discount house to become merchant banks, and subsequently be transformed into investment banks when they merge with stock broking companies. The integration exercise is aimed at: i.
Strengthening the capacity and capabilities of domestic banking groups to contribute towards economic transformation and developing a more resilient, competitive and dynamic financial system to face the challenges of liberalization and globalization;
ii.
Enhancing their efficiency and effectiveness by minimizing duplication of resources and overlapping of activities, leveraging on common infrastructure and reaping benefits of synergies and economies of scale.
iii.
Strengthening their potential to capitalize on business opportunities, increase their competitive advantage and leverage on a larger capital base to support their expanded range of activities. Customers will also benefit from wider access to financial services at more cost-effective prices.
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2.3.1 Key Players in the Local Investment Banking Landscape As at December, 2008 there are 15 fully fledged Investment Banks in Malaysia. All the banks are locally owned and they operate as brokerages and investment banks. Table 2: List of Investment Banks in Malaysia No.
Investment Banks
Ownership
1
Affin Investment Bank Berhad
L (Local)
2
Alliance Investment Bank Berhad
L
3
AmInvestment Bank Berhad
L
4
CIMB Investment Bank Berhad
L
5
ECM Libra Investment Bank Berhad
L
6
Hong Leong Investment Bank Berhad
L
7
Hwang-DBS Investment Bank Berhad
L
8
KAF Investment Bank Berhad
L
9
Kenanga Investment Bank Berhad
L
10
Maybank Investment Bank Berhad
L
11
MIDF Amanah Investment Bank Berhad
L
12
MIMB Investment Bank Berhad
L
13
OSK Investment Bank Berhad
L
14
Public Investment Bank Berhad
L
15
RHB Investment Bank Berhad
L
Sources: Bank Negara Malaysia 2.4 Role and Key Functions of Investment Banks Investment banks primarily have two functions. i.
Raising and investing capital. They assist public and private corporations in raising funds in the primary capital markets (both equity and debt). Investment banks primarily serve as intermediaries between corporations or governments that want to attract investment capital and investors wanting to invest capital. They also act as intermediaries in trading for clients.
ii.
Advising clients on strategic actions. Investment banks assist with corporate reorganizations and advising on strategic matters such as mergers & acquisitions, divestitures, corporate defense strategies, joint ventures, privatizations, spin-offs and leveraged buyouts. 31
In the strictest definition, investment banking is the raising of funds; both in debt and equity. However, only a few small firms in the world solely provide this service. In Malaysia, all the investment banks are heavily involved in providing additional financial services for clients, such as the trading of fixed income, foreign exchange, and equity securities. It is therefore acceptable to refer to both the "Investment Banking Division" and other 'front office' divisions such as "Fixed Income" as part of "investment banking," and any employee involved in either side as an "investment banker." 2.5 Overview of the Core Activities of an Investment Bank. 2.5.1 Corporate Finance The bread and butter of a traditional investment bank, corporate finance generally performs two different functions: i) Mergers and acquisitions advisory On the mergers and acquisitions (M&A) advising side of corporate finance, bankers assist in negotiating and structuring a merger between two companies. If, for example, a company wants to buy another firm, then an investment bank will help finalize the purchase price, structure the deal, and generally ensure a smooth transaction. ii) Underwriting. In this role, investment banks are financial intermediaries in securities offerings. They verify financial data and business claims, facilitate pricing, and perform due diligence. Most underwritings are “firm commitment” underwritings in which investment banks purchase the securities from the issuer and distribute them to the public. Services offered include: i.
Advising and preparing companies for floatation on the stock exchanges.
ii.
Identifying potential merger partners and take-over targets for clients and advising on mergers and acquisitions and take-over transactions.
iii.
Devising and executing strategies for capital raising activities through placement of securities, secondary issues of securities, special issues, convertible loans and other capital market instruments.
iv.
Providing advice from corporate restructuring exercises to restructure a company‟s gearing or business operations.
v.
Offering independent evaluation of corporate transactions and valuation of companies/business/securities and assets.
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2.5.2 Debt Capital Markets. The debt capital markets department provides the investment banks corporate clients with the expertise in structuring debt financing programs via debt securities instruments, conventional or Islamic. Services offered include: i.
Advising and arranging for the issuance of debt securities.
ii.
Underwriting the issuance of debt securities.
iii.
Subscribing the issuance of debt securities.
iv.
Placement of debt securities.
v.
Agency role throughout the tenure of the debt securities.
2.5.3 Equity Markets/Stock broking. The Equity Capital Markets department manages the investment banks activities in the primary and secondary equity and equity-linked markets. Equity Capital Markets assists companies in accessing the equity capital market for their financing requirements. Services offered include: i.
Arranging, structuring and underwriting a of an equity issuance.
ii.
Placement of stock and shares.
iii.
Trading of stock and shares.
iv.
Advising on investment activities.
v.
Custody and nominee services.
2.5.4 Derivatives and Structured Products. Derivatives and Structured Products has been a relatively recent division as derivatives have come into play, with highly technical and numerate employees working on creating complex structured products which typically offer much greater margins and returns than underlying cash securities. Services offered include: i.
Advising, originating and issuing of products/structures.
ii.
Designing products/structures with modified risk-return profiles.
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2.5.5 Treasury. Authorized to accept call deposits and fixed term deposits. The Treasury division engages in proprietary trading in money market and fixed income instruments. Services offered include: i.
Accepting deposits from wholesale customers (RM500,000 and above).
ii.
Buy and sell Money Market instruments.
iii.
Buy and sell Debt capital Market instruments.
2.5.6
Research.
Research analysts follow stocks and bonds and make recommendations on whether to buy, sell, or hold those securities. Stock analysts (known as equity analysts) typically focus on one industry and will cover up to 20 companies' stocks at any given time. Some research analysts work on the fixed income side and will cover a particular segment, such as high yield bonds or Malaysian Government Securities. Salespeople within the I-bank utilize research published by analysts to convince their clients to buy or sell securities through their firm. Corporate finance bankers rely on research analysts to be experts in the industry in which they are working. Reputable research analysts can generate substantial corporate finance business as well as substantial trading activity, and thus are an integral part of any investment bank. 2.6 Roles and Responsibilities of the Middle Office and Back Office Departments. 2.6.1 Middle Office. The main function of the Middle Office is Risk Management which involves analyzing the market and credit risk that traders are taking onto the balance sheet in conducting their daily trades, and setting limits on the amount of capital that they are able to trade in order to prevent 'bad' trades having a detrimental effect to a desk overall. Another key Middle Office role is to ensure that the above mentioned financial risks are captured accurately (as per agreement of commercial terms with the counterparty) correctly (as per standardized booking models in the most appropriate systems) and on time (typically within 30 minutes of trade execution). In recent years the risk of errors has become known as "operational risk" and the assurance Middle Offices provide now include measures to address this risk. When this assurance is not in place, market and credit risk analysis can be unreliable and open to deliberate manipulation.
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2.6.2 Back Office i. Operations This is where the operational activities of the investment bank take place. Operations involve data-checking trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers. While it provides the greatest job security of the divisions within an investment bank, it is a critical part of the bank that involves managing the financial information of the bank and ensures efficient capital markets through the financial reporting function. The staff in these areas need to understand in depth the deals and transactions that occur across all the divisions of the bank. ii. Technology Every major investment bank has considerable amounts of in-house software, created by the Technology team, who are also responsible for Computer and Telecommunications-based support. Technology has changed considerably in the last few years as more sales and trading desks are using electronic trading platforms. These platforms can serve as auto-executed hedging to complex model driven algorithms.
Summary In this topic we have provided the reader with an overview of investment banking. We started by explaining the difference between commercial banks and investment banks. We then discussed the framework for investment banks in Malaysia and briefly explained their role and functions. We end this topic by describing the core activities and the typical structure of and investment bank.
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Activity – Q&A 1. The following are services rendered by an investment bank, EXCEPT: A. Assist public and private corporations in raising funds in the capital markets. B. “Underwrite" stock and bond issues and other types of financial transactions. C. Trade financing facilities such as letters of credit and discounting of trade bills. D. Advice on mergers and acquisitions. 2. The following are services offered by the Treasury division of an investment bank, EXCEPT: A. Accepting deposits from wholesale customers (RM500, 000 and above). B. Buy and sell Money Market instruments. C. Advise on mergers and acquisitions. D. Buy and sell Fixed Income securities. 3. Describe the role and key functions of investment banks. 4. Explain the rationale for the integration of merchant banks, stock broking companies and discount houses into investment banks.
36
Suggested Answers to Activity 1. C 2. C 3. Investment banks primarily have two functions. Raising and investing capital. They assist public and private corporations in raising funds in the primary and secondary capital markets (both equity and debt). Investment banks primarily serve as intermediaries between corporations or governments that want to attract investment capital and investors wanting to invest capital. They also act as intermediaries in trading for clients. Advising clients on strategic actions. Investment banks assist with corporate reorganizations and advising on strategic matters such as mergers & acquisitions, divestitures, corporate defense strategies, joint ventures, privatizations, spin-offs and leveraged buyouts. 3. The integration exercise is aimed at: strengthening the capacity and capabilities of domestic banking groups to contribute towards economic transformation and developing a more resilient, competitive and dynamic financial system to face the challenges of liberalization and globalization; enhancing their efficiency and effectiveness by minimizing duplication of resources and overlapping of activities, leveraging on common infrastructure and reaping benefits of synergies and economies of scale. Strengthening their potential to capitalize on business opportunities, increase their competitive advantage and leverage on a larger capital base to support their expanded range of activities.
37
Topic 3 Compliance and Regulatory Framework in Investment Banking
Preview The purpose of this topic is to give you background information that provides you with a feel for the regulation of the investment banking industry as well as the key regulators. The investment banking industry is governed by several different pieces of legislation to ensure orderly markets and encourage investment. Topic Objectives At the end of this topic, you should be able to– i.
Discuss the key features of the BNM Guidelines for Investment Banks.
ii.
Describe the role and functions of the SC.
iii.
List the sources of securities law.
iv.
Describe The Capital Markets and Services Act 2007 (CMSA).
v.
Discuss the role and duties of the stock exchange.
vi.
Relate the conduct of business by participating organizations in relation to The Rules of Bursa Malaysia Securities Berhad.
vii.
Discuss the areas covered by the Rules of Bursa Malaysia Securities Berhad in relation to trading by the participating organizations.
38
Compliance and Regulatory Framework in Investment Banking.
3.1 Introduction Developments in the global financial markets over the recent years have placed great scrutiny on the effectiveness of regulatory and supervisory oversight regimes around the world. These recent events have emphasized the crucial need for sound regulatory and supervisory frameworks which keep pace with the rapidly evolving financial landscape. Investment banks in Malaysia are co-regulated by Bank Negara Malaysia and the Securities Commission. They hold two licenses issued pursuant to the Banking and Financial Institutions Act 1989 and the Securities Industry Act 1983 respectively. In carrying out their duties, Bank Negara Malaysia and the Securities Commission adopt an objective-driven approach to maximize efficiency and effectiveness in regulating investment banks. 3.2 Bank Negara Malaysia. Bank Negara Malaysia regulates the activities of financial institutions through the Banking and Financial Institutions Act, 1989 (BAFIA) which was enacted to provide laws for the licensing and regulation of institutions carrying on banking, financing and investment banking activities. 3.2.1 Banking and Financial Institutions Act, 1989 (BAFIA). The Banking and Financial Institutions Act, 1989 (BAFIA) was passed in Parliament and came into force on October 1, 1989. The BAFIA has effectively replaced the Banking Act 1973 and the Finance Companies Act 1969. The Islamic Banking Act 1983, however, is not affected. 3.2.2 The Anti-Money Laundering and Anti-Terrorism Financing Act 2001 (AMLAFA). Money laundering is a process by which proceeds derived from criminal / illegal activities are converted to legitimate funds. It embodies all transactions that disguise, conceal or impede the establishment of the illegal origins, location or ownership of the funds. Money laundering can be carried out in three stages: a. Placement : The money launderer disposes cash proceeds derived from illegal activities e.g. using illegal funds to settle a loan in cash. b. Layering : The money launderer separate illegal proceeds from the source through transactions that disguises audit trail and provide anonymity c. Integration: The money launderer returns the proceeds to the economy as normal business funds. The Anti-Money Laundering and Anti-Terrorism Financing Act 2001 (AMLAFA) was gazetted on 5 July 2001. AMLAFA provides comprehensive new laws for the 39
prevention, detection and prosecution of money laundering, the forfeiture of property derived from, or involvement in money laundering and the requirements for record keeping and reporting of suspicious transactions for reporting institutions. AMLAFA addresses the following broad issues:i. Money laundering offences. ii. Financial Intelligence Unit. iii. Reporting obligations. iv. Powers of investigation, search and seizure. v. Powers of freezing, seizure and forfeiture of property. 3.2.3 BNM Guidelines on Investment Banks The Guidelines on Investment Banks (the Guidelines) were issued jointly by BNM and the SC pursuant to Section 126 of the Banking and Financial Institutions Act 1989 (BAFIA) and Section 158 of the Securities Commission Act 1993 (SCA). It sets out the requirements and processes for the setting up of the investment bank and the regulatory framework within which the investment bank would operate. I.
Key Features of the Regulatory and Supervisory Framework for Investment Banks in Malaysia. Dual regulation and supervision by Bank Negara Malaysia and the Securities Commission. Clear accountabilities minimize regulatory gaps and overlaps i.
Arrangements formalized under a Memorandum of Understanding between the two agencies ensure that responsibilities are unambiguous and well-defined.
ii.
Bank Negara Malaysia is responsible for the prudential regulation of investment banks to ensure their safety and soundness and the overall stability of the financial system.
iii.
The Securities Commission is responsible for the investment banks‟ business and market conduct in order to promote market integrity and investor protection in the capital market.
iv.
Cohesive arrangements facilitate prompt and decisive action by the two agencies.
v.
Similar regulatory and supervisory regime to commercial banks
Prudential regulation of investment banks i.
Investment banks are subject to prudential requirements, which are similarly applied to commercial banks, including Basel II, limits on
40
exposures to single counterparties, connected lending restrictions and corporate governance standards. Supervisory and surveillance framework i.
Comprehensive and holistic risk assessments are conducted on the investment banks‟ businesses and overall health, including the conduct of on-site examinations.
ii.
Enables early detection and pre-emptive action to be taken to address emerging risks and vulnerabilities in individual investment banks.
iii.
Banking groups that have both commercial banks and investment banks are supervised on a consolidated basis to enable comprehensive assessments of their safety and soundness. Bank Negara Malaysia is also organized internally to support such oversight, with a dedicated department supervising financial conglomerates.
II. Scope of Activities i.
III.
Investment banks will retain all activities based on the types of licenses they held prior to the rationalization. Investment banks will therefore continue to accept wholesale deposits; conduct lending activities to complement their fee based activities and provide a wide array of investment banking activities which include, amongst others, financial advisory, underwriting, portfolio management and equity brokerage services. Minimum Capital Requirements
i.
To ensure that investment banks are well-capitalized, the minimum capital funds requirement for investment banks that are not part of banking groups will be set at RM500 million, while the other investment banks would be required to comply with the requirement of RM2 billion on a group basis.
3.3 Securities Commission The Securities Commission (SC) is a statutory body entrusted with the responsibility of regulating and systematically developing Malaysia‟s capital markets. It has direct responsibility in supervising and monitoring the activities of market institutions and regulating all persons licensed under the Capital Markets and Services Act 2007 (CMSA). Its main roles under the Securities Commission Act 1993 are: i.
To act as a single regulatory body to promote the development of capital markets;
ii.
To take responsibility for streamlining the regulations of the securities market, and for speeding up the processing and approval of corporate transactions.
41
iii.
To promote and maintain fair, efficient, secure and transparent securities and futures markets; and to facilitate the orderly development of an innovative and competitive capital market in Malaysia.
Among SC's many regulatory functions include: i.
Registering the prospectuses for all securities except those issued by unlisted recreational clubs;
ii.
Regulating all matters relating to securities and futures contracts;
iii.
Regulating the take-over and mergers of companies;
iv.
Regulating all matters relating to unit trust schemes;
v.
Licensing and supervising all licensed persons;
vi.
Supervising exchanges, clearing houses and central depositories; and
vii.
Encouraging self-regulation and ensuring proper conduct of market institutions and licensed persons.
3.3.1 Sources of Securities Law The legislation, which affects the securities industry, is as follows: i. Securities Commission Act 1993 (SCA). ii. Capital Markets and Services Act 2007 (CMSA) iii. Securities Industry (Central Depositories) Act 1991 (SICDA). iv. Companies Act 1965 (CA). 3.3.2 Capital Markets and Services Act 2007 (CMSA) The Capital Markets and Services Act 2007 (CMSA) repeals the Securities Industry Act 1983 (SIA) and the Futures Industry Act 1993 (FIA). The CMSA which takes effect on 28 September 2007 introduces a single licensing regime for capital market intermediaries. Under this new regime, a capital market intermediary will only need one license to carry on the business in any one or more of the following regulated activities: i. Dealing in securities; ii. Trading in futures contracts; iii. Fund management; iv. Advising on corporate finance; v. Investment advice; and vi. Financial planning. Licensing ensures an adequate level of investor protection, including the provision of sufficient safeguards to protect investors from default by market intermediaries or problems arising from the insolvency of such intermediaries. More importantly, it 42
instills confidence among investors that the organizations and people they deal with will treat them fairly and are efficient, honest and financially sound. The chart on the next page highlights the structure of the securities regulatory system in Malaysia. Chart 2: Structure of the Securities Regulatory System in Malaysia.
SCA
Companies Act 1965
CMSA
Companies Commission Of Malaysia.
SC
Bursa Malaysia Securities Bhd.
Bursa Malaysia Depository Sdn. Bhd.
Bursa Malaysia Derivatives Bhd.
Bursa Malaysia Bursa Malaysia Securities Clearing Bhd. Derivatives Clearing Bhd. Bhd BhdBhd Sources: Securities Commission. 3.4
Labuan International Financial Exchange Inc.
Bursa Malaysia Securities Berhad. Bursa Malaysia Securities Berhad, like other exchanges, was developed to meet two basic and complementary needs: a business need for raising funds, and an individual‟s or company‟s desire to invest saving efficiently. The duties of the stock exchange are set out in S.11 of the Capital Markets and Services Act 2007 (CMSA) and include the following: i.
It shall be the duty of the stock exchange to ensure, so far as may be reasonably practicable, an orderly and fair market for securities that are traded through its facilities. 43
ii.
In performing this duty, the stock exchange shall: -
act in the public interest and ensure that where any interest that is required to be served under any law relating to corporations conflict with the interest of the public, the latter shall prevail.
-
ensure that the participants of the stock exchange, participating organizations and corporations whose securities are listed on the stock exchange comply with the rules of the stock exchange that apply to such participant, participating organization or corporations.
A stock exchange must provide adequate and properly equipped premises for the conduct of its business; competent personnel for the conduct of its business and automated system with adequate capacity, security arrangements and facilities to meet emergencies. As a participating organization of Bursa Malaysia Securities Berhad the conduct of business by investments banks shall be governed by the Rules of Bursa Malaysia Securities Berhad (Chapter 4) which addresses the following: i.
Prohibition against unapproved sales methods (such as share hawking) and advertising of securities for sale or purchases Rule 401.1(1)(a).
ii.
Dealing only with other participating organizations or a participant of another recognized stock exchange Rule 401.1(1)(d).
iii.
Prohibition on advertising except in the manner approved or determined by Bursa Malaysia Securities Berhad Rule 401.2(1).
iv.
Prohibition against employing a former participant who committed a default under the Rules of Bursa Malaysia Securities Berhad or securities laws or was expelled from participation Rule 401.1(1)(g).
v.
Not engaging in or being a party to unlawful practices Rule 401.1(1)(f).
vi.
Refraining from engaging in or being a party to any unethical practices that may damage the confidence of investors and hamper the sound development of the stock market Rule 401.1(20).
In relating to trading, the Rules of Bursa Malaysia Securities Berhad also covers the following areas: i.
Automated trading system (Rule 701).
ii.
Transactions by employees and directors of participating organizations (Rule 7020).
iii.
Complaints (Rule 403.2).
iv.
Dealing in securities (Rule 601).
v.
Delivery and settlement (Chapter 8).
vi.
Fees and charges including brokerage, SC levy, clearing fees and a system maintenance fees (Chapter 10). 44
vii.
Dealer‟s representatives (Rule 310).
viii.
Penalties in relation to conduct by dealer‟s representatives (Chapter 13).
The penalties for non-compliance with the Rules of Bursa Malaysia Securities Berhad include fines, suspension or expulsion of participating organizations and reprimand, fine, suspension of right to trade, having name struck off the register or having restriction placed on activities relating to functions for dealer‟s representatives (Rule 1304) 3.5 Security Offences – Prohibited Conduct under the CMSA The following are some of the conducts prohibited under the CMSA:(1) Short Selling Short selling is the practice whereby the seller sells securities which, at the date of the agreement for sale, it does not own but intends to acquire before the delivery date. The seller that engages in short selling is relying on the market price of the securities dropping between the date of the sale contract and the date for delivery under that contract, thus providing a profit. Naturally, short selling is more prevalent in a bear market where the odds of such a decline in price are considerably better than in a bull market. The danger of short selling from the securities market point of view is that the seller may be unable to purchase the securities in time for delivery and will therefore default on the contract. Section 98 of CMSA prohibits a person from selling securities to a purchaser unless at the time of the sale, the person (or their agent) has presently exercisable and unconditional right to vest the securities in the purchaser. The CMSA, however, also sets out a limited number of circumstances in which short selling is permitted and note these exceptions, particularly in relation toi.
Odd lots.
ii.
Pre-existing contract for purchase conditional only upon payment or receipt of transfer or title money market.
iii.
Securities as prescribed by the Minister.
iv.
Securities of a class designed by Bursa Malaysia Securities Berhad where the sale is made in accordance with the Rules of Bursa Malaysia Securities Berhad.
45
(2) False Trading and Market Rigging Transactions S.175 (1) of the CMSA prohibits a person from creating; causing to be created or doing anything that is calculated to createi.
A false or misleading appearance of active trading of.
ii.
A false or misleading appearance with respect to the market for.
iii.
a false and misleading appearance of the price of,
iv.
Any securities on a stock market in Malaysia.
S.175(3) provides that a person shall be deemed to have created a false or misleading appearance of active trading if such person has entered into a transaction where there is no change in the beneficial ownership or where it has prearranged the transaction. (3) Stock Market Manipulation. S.176(1) of the CMSA prohibits a person from entering into transactions that have or are likely to have the effect of raising, lowering or pegging, fixing, maintaining or stabilizing the price of securities for the purposes which may include inducing others to acquire or dispose of the securities of the corporation or related corporation. A “transaction” includes unexecuted bids and offers. This is irrespective of whether another person is included. (4) False or Misleading Statement in Relation to Securities. A person must not make a statement or disseminate information that is false or misleading in a material particular and i.
is likely to induce the sale or purchase of securities by other persons.
ii.
is likely to have the effect of raising or lowering, maintaining or stabilizing the market price of securities,
iii.
When he or she makes or disseminates it, the person–
Does not care whether the statement or information is true or false, or knows or ought to reasonably know that it is false or misleading. (5) Fraudulently Inducing Persons to Deal in Securities It is an offence to induce or to attempt to induce another person to deal in securities byi.
Making or publishing any statement, promise or forecast that the maker knows to be misleading, false or deceptive.
ii.
Dishonestly concealing material facts.
iii.
Recklessly making or publishing dishonestly or otherwise any statement of promise or forecast that is misleading, false or deceptive.
iv.
Recording or storing in, or by means of any mechanical, electronic or other device information that the maker knows to be false or misleading in a material particular. 46
Persons who are subjected to his prohibition include officers of a company in relation to a company prospectus or to a stock broking company advising clients about an issue or sale of securities. (6) Insider Trading The rationale for prohibiting insider trading includes the following: i.
Fairness and transparency in the market place, equal access to information for all market participants.
ii.
Market integrity.
iii.
Corporate disclosure and good corporate governance.
iv.
Prevention of injury to the company, its shareholders and investor.
Those who trade on privileged or price-sensitive information to make quick profits in the market are said to be profiteering at the expense of those who do not have access to the same inside information. Those occupying privileged positions may hoard information or keep it away from the public because they feel or they know that once the information is made public, it will cause the price of the shares issued by the company to rise or fall. By keeping this information to themselves, they make large profits by buying or selling the stock before its price rises or they may protect themselves by selling stock before its price falls. If the information was made freely available, then they would not have had the unfair advantage.
Summary This topic is intended as a brief introduction, by way of providing an overview of the compliance and regulation of investment banks in Malaysia. We started by looking at the key features of the BNM Guidelines on Investment Banks before briefly considering the functions of the SC and the legislation which affects the securities industry. We then briefly examined the areas covered by the Rules of Bursa Malaysia Securities Berhad in relation to the conduct of business and trading of the participating organizations. We end this topic by looking at the various security offences and prohibited conduct under the SIA
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Activity – Q&A 1. All of the following are true, EXCEPT: A. Investment banks will hold two licenses, issued pursuant to Section 5 of BAFIA and Section 64 of the CMSA respectively. B. Investments banks are allowed to accept deposits subject to a minimum amount of RM500.000. C. Bank Negara Malaysia regulates the activities of financial institutions through the Banking and Financial Institutions Act, 1989 (BAFIA). D. SC will be responsible for the approval of the appointment and reappointment of directors and CEOs of investment banks. 2. Which of the following is NOT a source of securities law? A. Securities Commission Act 1993 (SCA). B. Capital Markets and Services Act 2007 (CMSA). C. Banking and Financial Institutions Act, 1989 (BAFIA). D. Securities Industry (Central Depositories) Act 1991 (SICDA). 3. The entire following are conducts prohibited under the SIA, EXCEPT: A. Stock market manipulation. B. Short selling. C. Buying-In. D Market rigging. 4. List three regulatory functions of the SC. 5. What is the danger of short selling from the securities market point of view?
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Suggested Answers to Activity 1. D 2. C 3. C 4. SC's regulatory functions (choose any three): Registering the prospectuses for all securities except those issued by unlisted recreational clubs; Regulating all matters relating to securities and futures contracts; Regulating the take-over and mergers of companies; Regulating all matters relating to unit trust schemes; Licensing and supervising all licensed persons; Supervising exchanges, clearing houses and central depositories; and Encouraging self-regulation and ensuring proper conduct of market institutions and licensed persons. 5. The danger of short selling from the securities market point of view is that the seller may be unable to purchase the securities in time for delivery and will therefore default on the contract.
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Topic 4 Understanding Bonds
Preview This topic discusses the general characteristics of bonds. The basic concepts of valuing a bond and the relationship between price and yield of the bond will be highlighted. Topic Objectives At the end of this topic, you should be able to– i.
Describe bond terms and features.
ii.
Identify the risks associated with bonds.
iii.
Calculate the price of a bond.
iv.
Differentiate between the types of bond yields.
v.
Explain the price to yield relationship.
vi.
Discuss the term structure of interest rates.
vii.
Identify bonds according to their credit rating.
viii.
Discuss bonds issued by foreign entities.
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Understanding Bonds 4.1 Introduction A bond is a debt security in which the issuer owes the holders a debt, and depending on the terms of the bonds, is obliged to pay interest (coupon) and to repay the principal at the maturity date. Bonds are normally issued by firms and governments. It allows the issuer to tap funds from the financial markets for various purposes which may include business expansion. In its simplest form, it may be regarded as a loan. 4.2 Bond Terms and Features Bonds have specific characteristic features and terms as follows: a) Nominal Value The nominal value of a bond is the par or face value. Sometimes the nominal value is also referred to as the principal value, which is the amount that the issuer has agreed to repay the bondholder at the maturity date. In view of this, the principal is also called the redemption or maturity value. b) Coupon Rate The coupon rate is the nominal interest rate that determines the actual interest the bond holder receives on owning the bond. The interest payment is known as coupon payments. It is paid either annually, semi-annually, quarterly or monthly as stipulated in the bond agreement. Example If an investor owns a RM100, 000 bond with a coupon rate of 7%, the annual interest payment is, RM100, 000 x 7% = RM7, 000 c) Term to Maturity The term to maturity is the number of years over which the issuer of the bond has promised to meet the conditions and obligations of the bond issue. During this time, therefore, the bondholder is paid the promised coupon payments. It also indicates the time period remaining before the bondholder is paid back the principal in full. The term to maturity is also `important as a factor that affects both the bond yield and price. d) Trust Deed The trust deed is a legal agreement detailing the insurer‟s obligations related to the bond issue. It contains the terms of the bond issue and any restrictive provisions placed on the company, known as restrictive covenants. The restrictive covenants may include a call provision or the requirement of the company to set up a sinking fund. The trust deed is administered by an independent trustee. e) Trustee The trustee is the third party with whom the trust deed is made. The job of the trustee is to ensure that the terms and conditions of the trust deed are carried out. As the trust 51
deed also contains provisions in the event of default, the trustee would, in the event of default, undertake action to protect the interest of the bondholders. f) Type of Issuer A key feature of a bond is the nature of the issuer. In Malaysia the issuers of bonds can be the government, banks, financial institutions and companies. g) Yield The yield is the effective interest rate earned on the bond investment. The discount rate or interest rate that an investor wants from investing in a bond is called the required yield. It is different from the coupon rate, which is fixed at issue. Price of bonds is quoted in relation to their yields. As the required yield increases, the price of the bond decreases. h) Embedded Options Embedded options are specific characteristics stipulated in the bond indentures. These options include: i.
Callability – this option allows the issuer to call or redeem the bonds based on pre-specified prices determined at the time of issue and a predetermined call schedule. Call provisions act to protect the issuer by allowing it to call on the bond when interest rates fall or when its creditworthiness has improved (hence allowing it to borrow at more favorable rates). Because of the call option, callable bonds are sold at a lower price than a non-callable bond.
ii.
Putability – this option gives the bondholder the right to sell the bond to the issuer at a specified price prior to maturity. If interest rates have risen and/or the creditworthiness of the issuer has deteriorated so that the market price of such bonds have fallen below par, the bondholder may choose to exercise the put option and require the issuer to redeem the bonds at the put price.
i) Sinking Fund In a sinking fund bond, the issuer periodically puts aside money for the eventual repayment of the debt. This particular provision may be included in the bond trust deed to protect investors. 4.3 Risks in Bond Investments Fixed income instruments, of which bonds are a part, face fixed income risk. Understanding the risk involved in such investments is important when valuing fixed income securities and deciding upon whether or how much to invest in such instruments. Bonds may expose the investor to one or more the following risks: (a) Interest Rate Risks The uncertainty in income for the investor may result from the change in bond price as a result of changes in market interest rates. An increase in the current market rates will make the existing bond unattractive since an alternative investment now can fetch a higher rate of return. An increase in the demand for an alternative security will 52
motivate investors to dispose of their existing bonds, hence pushing down the price of the bonds. (b) Reinvestment Risks The yield from a bond is always under the assumptions that the coupon amount is reinvested. This stems from the idea of compounding interest. However, an investor is faced with the risk that the current rate of interest might fall. Should this happen, the coupon payment that they receive will be reinvested at a lower rate. (c) Redemption Risks (or Risk of a Call) A bond that allows the issuer to redeem or recall the security, poses risks to its investors. A bond that is recalled earlier than maturity will deprive the investors from the potential income that they may otherwise receive. A bond may be recalled because the market interest rates have fallen and the issuer will now want to issue a new bond with a lower coupon payment. The investor will therefore lose potential income since they are offered a new but lower coupon rate. (d) Default or Credit Risks As the name implies, default or credit risk is the risk that the issuer of a bond is unable to make timely the promised interest and principal payments on the issue. (e) Inflation Risks Inflation risk or purchasing power risk is the risk that the value of the cash flows from the bond will not be enough to compensate for the loss in the purchasing power due to inflation. If the coupon rate of a bond is 5% and the inflation rate is 6%, this means that the purchasing power of the coupon has declined. Therefore, unless the investor buys floating-rate bonds where the interest rate is pegged or periodically reset according to a predetermined benchmark, he will be exposed to inflation risk associated with fixed interest investments. (f) Liquidity Risks The ability to convert the bond into cash immediately without eroding its value is very important for an investor who does not wish to hold the bond until maturity. Unless an economy has a liquid secondary market for bonds, investors will be faced with this type of risks. g) Exchange-Rate Risk Also referred to as currency risk, occurs when an investor decides to buy or an issuer decides to sell a bond denominated in foreign currency. The dollar cash flows, therefore, are dependent on the exchange rate at the time the payments are received. h) Volatility Risk The risk that a change in volatility will affect the price of a bond adversely is called volatility risk. For example, take the case of a callable bond where the potential for price gain is limited in a declining interest rate environment due to the fact that 53
investors increasingly expect the issuer to exercise the option to call or redeem the bond at the call price as interest rate falls. 4.4 Bond Valuation The price/value of a bond is the present value of the expected cash flow from the bond. The expected cash flows are the coupon payments and the face value. These cash flows are then discounted at the required rate of return. This rate of return is normally called the yield of the bond which will depend vastly on the present market interest rate. Specifically the value of a bond is: Bond value = Present value of coupons + Present value of face value Therefore determining the price requires: i. ii.
An estimate of expected cash flow. An estimate of appropriate required yield.
The cash flow for straight bonds consists of: i. ii.
Periodic coupon payment to maturity date. Generally the coupon interest payment is made every six months. The par (principal) value at maturity.
Example A 20-year bond with a 10% coupon rate and a par or maturity value of RM1, 000 has the following cash flow from coupon interest: Annual coupon interest payment = RM1, 000 x 10 = RM100 Semi-annual coupon interest payment = RM100/2 = RM50 Therefore, there are 40 semi-annual cash flows of RM50, and a RM1, 000 cash flow 20 years from now. The required yield to discount the expected cash flow is determined by investigating the yields offered on comparable bonds in the market, in this case a non-callable bond of the same credit quality and same maturity. Example: Coupon Bearing Bond A five year bond has 8% coupon rate and nominal value RM1,000, with interest paid annually. Calculate the value of the bond given that the yield to maturity is 6%. Therefore:
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Where C Pn T i
= coupon payment = principal payments at maturity period = number of years to maturity = interest rate
Annual coupon interest payment = RM1, 000 x 8% = RM80 Using financial calculator: N = 5; PMT = 80; FV = 1,000; I/Y = 6; CPT → PV = − RM1,084.25 Where N PMT I/Y FV
= number of years = coupon payment = the interest rate = the face value
The bond value can also be calculated using factor tables: Pb
= C (PVIFAi,n) + Pn (PVIFi,n) = C (PVIFA6%,5) + Pn (PVIF6% 5) = 80(4.2124) + 1,000 (0.7473) = 336.99 + 747.3 = RM1, 084.2
Calculating the Present Value Interest Factor. The present value interest factors can be obtained from factor tables or calculated using the following formulas: PVIFi,n:
PVIFAi,n:
Where; i = interest rate n = number of periods
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Example: Zero Coupon Bonds XYZ limited issued a zero coupon bond maturing in 10 years time. The face value of the bond is RM1, 000. If the market interest rate for comparable bond is 9%, the price of the zero coupon bond is given by:
= 1,000/(1.09)10 = RM 422.41 or 42.241% As you can see from this example, zero coupon bonds are sold at a very deep discount price as this type of bond never pays coupon payments.
Example: Callable Bond It is now December 2003, and you are considering the purchase of an outstanding corporate bond that was issued exactly 2 years ago. The bond has a 9.5% annual coupon and 29 years original maturity (it matures in December, 2030). The bond has a call provision and allows the issuer to call off the bond 10 years from the issue date with the call price of RM1090. Currently the market interest rate is 9%. Calculate the value of the bond today if the issuer does call off the bond 10 years from the issue date. Given; CP = Call value = RM1,090 C = 9.5% x 1,000 = RM95 N = 10 − 2 = 8 years i = 9% Pb = = = =
C (PVIFAi,n) + CP(PVIFi,n) C (PVIFA9%,8) + CP (PVIF9%,8) 95(5.5348) + 1090(.5019) RM1,072.877
4.5 Bond Yields 1) Yield to Maturity The rate of return earned from investing in bonds until the bond matures is termed as yield to maturity. Yield to maturity is also viewed as the promised rate of return accruing to investors. The yield to maturity can be calculated using the following formula:
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Let‟s say in the market there is a three-year RM1, 000 bond, with a coupon rate of 10%, and it is going at a price of RM951.97. Fitting these values into the above equation will show:
You could substitute values for r until you find a value that forces the sum of the PVs on the right side of the equal sign to equal RM951.97. It involves finding r by trial-and error and is a tedious process, but as you might have guessed, it is easy with a financial calculator. The answer is 12%. 2) Current Yield The current yield measures the current income rate. The current yield of a bond is just the coupon payment divided by the price. Annual coupon payment of bond Current yield = Current market price 3) Yield to Call If you purchased a bond that is callable, where issuers can call or redeem their bond when the market interest rate is generally falling, you would not have the option of holding the bond until it matures. Thus, you lose the chance to earn YTM. The investor should understand that if the current interest rates are well below the coupon rate, there would always be a possibility that the bond will be called. Investors will therefore estimate its expected return as the yield to call (YTC) and not YTM. To calculate the YTC, we solve the following equation for r:
Here, N is the number of years until the company can call the bond. The call price is the amount the issuer has to pay in order to call the bond. The price is normally set above the par value. This normally will compensate investors for the reinvestment risk faced when bonds are recalled. 4.6 Price Yield Relationship i.
A fundamental property of a bond is that its price is inversely proportionate to the change in required yield. The reason is that the price of the bond is the present value of cash flows.
ii.
As the required yield increases, the present value of cash flow decreases, hence, the price decreases. 57
iii.
The opposite is true when the required yield decreases, the present value of cash flow increases, therefore, the price of the bond increases. 4.6.1 Reasons for Bond Price Changes The price of the bond will change for one or more of the following three reasons: i.
There is a change in the required yield that is tied to changes in the credit quality of the issuers.
ii.
There is a change in the price of the bond selling at a premium or a discount without any change in required yields, simply because the bond is moving toward maturity.
iii.
There is a change in the required yield owing to a change in comparable bonds (i.e. a change in the yield required by the market).
4.7 Term Structure of Interest Rates and Yield Curves The term structure of interest rates shows the: i.
Relationship between long-term and short –term interest rates.
ii.
Relationship between yield of a security and term to maturity of the security.
The term structure of interest rates is represented graphically by the yield curve. The yield curve shows the yield to maturity, for example, for bonds (from the same issuer) which only differs in terms of the maturity date. A different yield curve will exist for different issuers and for different security types from the same issuer. Over time, the yield curve may change. The Shape of the Yield Curve i.
A normal yield curve is formed when the long-term rates are greater than shortterm rates, so the curve has a positive slope. It tends to prevail when interest rates are at low or modest level.
ii.
A flat yield curve represents the situation where the yield on all maturities is essentially the same. This type of curve rarely exists for any period of time.
iii.
An inverted yield curve reflects the condition where long-term rates are less than short-term rates, giving the yield curve a negative slope. It tends to occur when rates are relatively high, but with the expectations to decrease.
iv.
With a "humped" yield curve, rates in the middle of the maturity spectrum are higher or lower than those for both short and long maturity bonds.
Figure 1: Shapes of the Yield Curve
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4.8 Rating of Corporate Bonds Credit rating is an objective and impartial third-party opinion on the ability and willingness of an issuer of a debt instrument to make full and timely payments of principal and interest over the life of that instrument. A rating is also designed to rank, within a consistent framework, the degree of future default risk of a particular debt relative to other debts in the market. In Malaysia, the ratings are done by either one of two existing domestic credit rating agencies, Rating Agency Malaysia (RAM) and Malaysian Rating Corporation (MARC) Berhad. Rating Scale The rating scale is a convenient and readily available investment tool for market participants to assess risk exposure when making investment decisions on fixed income instruments Although credit rating represents a useful and reliable investment tool to help in decision making, the ultimate choice of investment will depend on individual risk preferences and purchase acceptance criteria of the investors themselves. RAM’s rating scale and definition for corporate debt instruments Long-term Ratings Rating AAA AA
Definition Issues rated AAA are judged to be of the best quality and offer the highest safety for timely payment of interest and principal. High safety for timely payment of interest and principal.
A
Adequate safety for timely payment of interest and principal. More susceptible to changes in circumstances and economic conditions than debts in higher-rated categories.
BBB
Moderate safety for timely payment of interest and principal. Lacking in certain protective elements. Changes in circumstances are more likely to lead to weakened capacity to pay interest and principal than higher-rated debts.
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BB
Inadequate safety for timely payment of interest and principal. Future cannot be considered as well-assured.
B
High risk associated with timely payment of interest and principal. Adverse business or economic conditions would lead to lack of ability on the part of the issuer to pay interest or principal.
C
Very high risk of default. Factors present make them vulnerable to default. Timely payment of interest and principal possible only if favorable circumstances continue.
D
Payment of interest and/or repayment of principal are currently in default or face imminent default, whether or not formally declared.
Short Term Ratings Rating
Definition
P1
Very strong safety with regard to timely payment on the instrument.
P2
Strong ability with regard to timely payment of obligations.
P3
Adequate safety with regard to timely payment of obligations. Instrument is more vulnerable to the effects of changing circumstances than those rated in the P1 and P2 categories.
NP
High investment risk, with doubtful capacity for timely payment of short-term obligations.
MARC’s rating – Long-term debt ratings Investment Grade AAA
Indicates that the ability to repay principal and pay interest timely basis is extremely high.
AA
Indicates a very strong ability to repay principal and pay interest on a timely basis, with limited incremental risk compared to issues rated in the highest category.
A
Indicates that the ability to repay principal and pay interest is strong. These issues could be more valuable to adverse developments, both internal and external than obligations with higher ratings.
BBB
The lowest investment grade category; indicates an adequate capacity to repay principal and pay interest. More vulnerable to adverse developments, both internal and external than obligations with higher ratings.
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Non-investment Grade While not investment grade, this rating suggests that likelihood to default is considerably less than for lower rated issues. However, there are significant uncertainties that could affect ability to adequately service debt obligations.
BB
B
Indicates a higher degree of uncertainty and therefore, greater likelihood of default. Adverse developments could negatively affect repayment of principal and payment of interest on a timely basis.
C
High likelihood of default, with little capacity to address further adverse changes in financial circumstances.
D
Payment in default.
MARC’s Ratings – Short-term debt ratings Investment Grade MARC-1
The highest category; indicates a very high likelihood that and principal and interest will be paid on a timely basis.
MARC-2
While the degree of safety regarding timely repayment of principal and payment of interest is strong, the relative degree of safety is not as high as issues rated.
MARC-3
The lowest investment grade category; indicates that while the obligation is more susceptible to adverse developments , both internal and external, the capacity to serve principal and interest on a timely basis is considered adequate.
Non-investment Grade MAC-4
The lowest category; regarded as non-investment grade and therefore speculative in terms of capacity to service interest and principal.
4.9 Bonds Issued by Foreign Entities Following are types of bonds issued by foreign entities. These are debt instruments issued by a resident (government or corporation) but denominated in a currency other than the local one. i.
Euro dollar bond, a US dollar denominated bond issued by a non US entity outside the US.
ii.
Yankee bond, a US dollar denominated bond issued by a non US entity in the US market.
iii.
Kangaroo bond, an Australian dollar denominated bond issued by a non Australian entity in the Australian market.
iv.
Maple bond, a Canadian dollar denominated bond issued by a non Canadian entity in the Canadian market. 61
v.
Samurai bond, a Japanese Yen denominated bond issued by a non Japanese entity in the Japanese market.
vi.
Bulldog bond, a pound sterling denominated bond issued in London by a foreign institution or government.
vii.
Matrioshka Bond, a Russian rouble denominated bond issued in the Russian Federation by non Russian entities.
viii.
Arirang bond, Korean won denominated bond issued by a non Korean entity in the Korean market.
Summary The topic begins with explaining the general characteristics of bonds and the risks associated with it. Then, it followed by showing the reader how fixed income security is priced by using the present value of the expected future cash flows, discounted at an appropriate discount rate. Provided with the idea of how compounding and discounting techniques work, the reader is able to calculate the price of some fixed income securities and relate the factors and variables that affect pricing.
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Activity – Q&A 1. A coupon bond: A. pays interest on a regular basis (typically semi-annually). B. does not pay interest on a regular basis, but pays a lump sum at maturity. C. can always be converted into a specific number of shares of common stock in the issuing company. D. always sells at par. 2. Which of the following is TRUE about the call feature of a bond? It: A. stipulates whether and under what circumstances the bond holders can request an earlier repayment of the principal amount prior to maturity. B. describes the credit risk of the bond. C. describes the maturity date of the bond. D. stipulates whether and under what circumstances the issuer can redeem the bond prior to maturity. 3. The interest rate risk of a bond is the: A. Risk related to the possibility of bankruptcy of the bond's issuer. B. Risk that arises from the uncertainty about the bond's return caused by changes in interest rates over time. C. Unsystematic risk caused by factors unique in the bond. D. Risks related to the possibility of bankruptcy of the bond's issuer and that arises from the uncertainty of the bond's return caused by the change in interest rates. 4. If the market rate of interest is greater than the coupon rate, the bond will be valued: A. Less than par. B. At par. C. Greater than par. D. Cannot be determined. 5. What is the present value of a three-year security that pays a fixed annual coupon of 6 percent using a discount rate of 7 percent? A. 92.48. B. 100.00 C. 101.75 D. 97.38.
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6. An analyst observes a 5-year, 10% coupon bond with semiannual payment. The face value is RM1000. How much is each coupon payment? A. RM50 B. RM25 C. RM500 D. RM100 7. The bond's yield-to-maturity is: A. The discount rate that equates the present value of the cash flows received with the price of the bond. B. Based on the assumption that the yield curve is flat. C. Based on the assumption that the bond is held to maturity and all coupons are reinvested at the yield-to-maturity. D. All of these are correct. 8. A downward sloping yield curve generally implies: A. interest rates are expected to increase in the future. B. longer-term bonds are riskier than short-term bonds. C. shorter-term bonds are less risky than longer-term bonds. D. interest rates are expected to decline in the future. 9. Define the following in relation to a bond: a) Coupon rate. b) Term to maturity. c) Embedded options. 10. Give two reasons for bond price changes.
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Suggested Answers to Activity 1. A 2. D 3. B 4. A 5. D 6. A 7. D 8. D 9. a) Coupon rate is the rate quoted on the bond. The interest payment is known as coupon payments. It is paid either annually, semi-annually, quarterly or monthly as stipulated in the bond agreement. b) The term to maturity is the number of years over which the issuer of the bond has promised to meet the conditions and obligations of the bond issue. It also indicates the time period remaining before the bondholder is paid back the principal in full. c) Embedded options are specific characteristics stipulated in the bond indentures. These characteristics may include the option to call the bond at an earlier date before maturity. Another type of option is when bonds can be converted to equity. The latter is known as convertible bonds. 10. The price of the bond will change for one or more of the following three reasons: i. ii.
iii.
There is a change in the required yield that is tied to changes in the credit quality of the issuers. There is a change in the price of the bond selling at a premium or a discount without any change in required yields, simply because the bond is moving toward maturity. There is a change in the required yield owing to a change in comparable bonds (i.e. a change in the yield required by the market).
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Topic 5 Malaysian Money and Debt Market Securities
Preview This topic introduces money and debt market securities in the Malaysian context. Areas covered include the types of money market and debt instruments available in the market. Topic Objectives At the end of this topic, you should be able to– i. Explain the primary and secondary market for debt securities. ii. Discuss the structure of money and debt markets. iii. Describe the types of debt securities issued by the Malaysian government. iv. Describe the types of money market instruments issued by banks and financial institutions v. Discuss Private Debt Securities (PDS). vi. Distinguish between short term, medium term and long term debt instruments.
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Malaysian Money and Debt Market Securities
5.1 Introduction The money and debt securities markets are markets for short-term and long- term debt instruments. Their main function is to intermediate between the providers of capital (investors and savers) and the user of capital (corporations and government). Generally, debt instruments perform well during stable economic conditions and low inflation environments. 5.2 Primary and Secondary Markets for Debt Securities Primary Market The primary market is where issues or new issues of government and corporate securities are traded for the first time. The securities offered might be a new type for the issuer or it may be additional amount of a security used to raise funds previously. The main characteristic to note is that these securities raise funds for the issuer. Secondary Market After the securities are purchased in the primary market in which they are first offered, they are traded subsequently in the secondary markets if the original buyer wishes to sell securities to another buyer, and so on for further buying and selling transactions. As the secondary market involves the trading of securities initially sold in the primary market, it provides liquidity to the individual or institutions that have acquired the securities. The secondary market also provides a gauge as to the price levels for primary issues for potential issuers, reflecting the prevailing market prices as determined by investor and industry expectations. 5.3 Government Securities and Money Market Instruments. The Malaysian Government fixed income securities and money market instruments are marketable debt instruments issued by the Government of Malaysia to raise funds from the domestic capital market to finance the government's development expenditure and working capital. The central bank, Bank Negara Malaysia in its role as banker and adviser to the Government, advises on the details of Government securities issuance and facilitates such issuance through various market infrastructures that it owns and operates. The various forms of Government securities in Malaysia are: Bank Negara Monetary Notes (BNMN) BNMN are securities issued by Bank Negara Malaysia replacing the existing Bank Negara Bills (BNB) for the purpose of managing liquidity in the conventional financial market. The maturity of these issuances has been lengthened from one year to three years. New issuances of BNMN may be issued either on a discounted or a coupon-bearing basis depending on investors' demand.
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Discount-based BNMN will be traded using the same market convention as the existing Malaysian Treasury Bills (MTB) while the coupon-based BNMN will adopt the market convention of Malaysian Government Securities (MGS). Malaysian Treasury Bills (MTB) MTB are short-term securities issued by the Government of Malaysia to raise shortterm funds for Government's working capital. Bills are sold at discount through competitive auction, facilitated by Bank Negara Malaysia, with original maturities of 3-month, 6-month, and 1- year. The redemption will be made at par. MTB are tradable on yield basis (discounted rate) based on bands of remaining tenure (e.g., Band 4= 68 to 91 days to maturity). The standard trading amount is RM5 million, and it is actively traded in the secondary market. Government Investment Issues (GII) The GII were introduced in July 1983 (then known as Government Investment Certificates or GIC). The GII are non-dividend-bearing government securities issued based on Islamic principles to enable Bank Negara Malaysia and other institutions to invest their liquid funds on an Islamic basis. Since March 2005, there are now profitbased GII, with dividends paid semi-annually. Similar with MGS, GII are issued through competitive auction by Bank Negara Malaysia on behalf of the Government. The GII issuance program is pre-announced in the auction calendar with issuance size ranging from RM1 billion to RM3.5 billion and original maturities of 3-year, 7- year, 5-year and 10-year. Malaysian Government Securities (MGS) MGS, also called government bonds, are gilt-edged securities as they represent the borrowings of the best name in the country – the government. They are issued by the government to finance long-term development projects. The maturity period of a bond can run up to 30 years, although so far, the longest period bond issued has an original tenure of 21 years. Coupon payments are made semi-annually. MGS are issued by auction and by subscription but can also be bought from the secondary market or from BNM. The price of government bonds is influenced by BNM‟s price list published monthly, as well as the prevailing supply and demand situation for the bond in particular and the money market in general. 5.4 Money Market Instruments Issued by Banks and Financial Institutions Negotiable Instrument of Deposits Introduced in May 1979 as Negotiable Certificate Of Deposit and now known as negotiable instrument of deposit (NID), this instrument is a receipt for a time deposit in ringgit placed with a designated bank. Unlike the receipts for ordinary “fixed deposit”, the NID is negotiable. The name of the depositor is not stated on the NID and the issuer undertakes to pay the principal sum of the deposit to whoever is the bearer of the NID on the date of maturity.
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There are four types of NIDs, which banks in Malaysia are permitted by BNM to issue. They are: Short term negotiable instrument of deposit (SNID) Long term negotiable instrument of deposit (LNID) Zero negotiable instrument of deposit (ZNID) Floating rate negotiable instrument of deposit (FRNID) Bankers Acceptances Bankers acceptances (BAs) are negotiable bills of exchange drawn by commercial firms (in this case, the borrower) and accepted by a bank. The funds are used to finance underlying trade transaction, such as export, imports or domestic trade. On endorsing the BA, the accepting bank assumes the primary obligation to discharge the BA on maturity. The popularity of the BA stems from the fact that for prime borrowers, loans below the prime rate can be easily obtained, especially when the money market is flush and interest rates are low. Also, for those who are not prime borrower, they can have access to bank credit at a more competitive cost by being able to use the banks‟ good name. For the investor, the BA offers a relatively secure and liquid investment coupled with an attractive rate of return.
5.5 Private Debt Securities (PDS) In domestic market terminology, long term PDS are known as corporate bonds to distinguish them from the short-term notes or papers. Bonds with tenure of 7, 10, 12 and 15 years have been issued in the market to fund long gestation and capital intensive projects, such as independent power projects, ports, airports and highways. Spurred by strong economic growth, and supported by the efforts of regulators and market participants, the corporate bond market has expanded considerably over the years. The corporate bond market registered an average annual growth of 7% since 2000, reaching the size of RM210.7 billion as at end-December 2006.
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Figure 2: PDS Issues by Types of Instrument For 2006
Corporations issue corporate bonds for the purpose of meeting the company‟s financing needs. The corporation, as the issuer, may issue these bonds based on Islamic or conventional principles, and with interest payments, e.g. fixed or floating bonds or without interest attached, e.g. zero-coupon bonds. Let us look at some of these debt instruments in more detail. Long (to medium) Term i. Straight bond Straight bonds have a fixed coupon rate and mature on a date fixed at the time of the issue. In some debt markets, they are also called “plain vanillas” as these bonds often do not have any credit enhancement or other features (e.g. callable features). Coupon payment is made either semi-annually or annually. At maturity, the nominal amount is paid to the bond holder.
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ii. Convertible bond Convertible bonds are fixed income securities that grant its holders the right to convert into a predetermined number of the issuer‟s ordinary shares as an option for the investor during a predetermined period. The conversion price is set at the time of issue and is the price at which the bond can be converted into the equity or share on offer. The coupon rate is typically lower than it would be for a comparable straight bond, as the holder has the right of conversion. iii. Exchangeable bond Exchangeable bonds grant its holders the right to exchange the bond for the stock of a company other than the issuer (usually a subsidiary or company in which the issuer owns a stake) at some future date and under prescribed conditions. The difference between an exchangeable bond and a convertible bond is that a convertible bond gives the holder the option to convert bond into shares of the issuer. iv. Floating-rate bond Note that the coupon rate of a fixed-coupon bond is fixed for the entire life of the bond. The coupon rate of a floating-rate bond is instead pegged to an agreed benchmark. This benchmark is a reference rate, such as the KLIBOR (the 6-month KLIBOR for the semi-annual coupon or 12-month KLIBOR for coupon payable annually), and as this reference rate rises and falls, the floating rate also moves accordingly; typically reset periodically at a stated margin over the reference rate. v. Zero-coupon bond Zero-coupon bonds are fixed income securities sold at discount, pay no periodic interest or coupon and have a final maturity equal to nominal value. They pay principal and interest only upon maturity. The difference between the purchase price and the redemption value equals the return on investment. vi. Islamic bond Islamic bonds are essentially fixed rate instruments, which have been structured on the Islamic principles of deferred payment sale. They are part of the Islamic PDS, which were first introduced in Malaysia in 1990. Islamic bonds may be issued at a discount, with redemption at full nominal value at maturity, or they may be issued at nominal value, with a fixed stream of annual or semi-annual dividend payments. For an Islamic instrument to be issued in the capital market it will have to undergo a process of evaluation and each submission must be accompanied by the Syariah Advisory Council‟s endorsement before it can be approved.
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vii. Secured and unsecured bond In the case of secured bonds, the debt payments are secured by a pledge of the issuer‟s assets, typically shares, a building or land. In the event of default, the investors in these secured bonds have a claim on the assets. Conversely unsecured bonds which are referred to as debentures are not backed by any collateral. In the event of default the bond holders only have a general claim on the issuing company. viii. Mortgage-backed securities (MBSs) MBSs are backed (secured) by pools of mortgage loans, which not only provide collateral but also the cash flows to service the debt. A mortgage-backed security is any security where the collateral for the issued security is a pool of mortgages. An example of a mortgage-backed security is the Cagamas bonds which were introduced in October 1987 with the commencement of operations of the national mortgage corporation (Cagamas Bhd). ix. Asset backed securities (ABSs) Similar to residential mortgages; credit card balances, auto loans, bank loans, receivables etc. can also be securitized into what are known as asset backed securities (ABS). These are securities whose cash flows are linked to a pool of underlying loans/financial instruments. While the above types of underlying assets are the most common, innovative ABSs have also been created. In one case, singer David Bowie sold a US$55 million ABS issue where the underlying assets were the royalties from 25 of his albums released prior to 1990. Medium Term i. Medium-term note (MTNs) MTNs are debt papers issued typically on maturities of between one and five years or more for long gestation projects. Therefore, maturities are not necessary medium term. MTNs are issued based on conventional or Islamic principles. MTNs were introduced as an alternative to short-term financing in the commercial paper market and long-term borrowing in the corporate bond market. Although they share many similar features with long-term corporate bonds, they differ in their primary distribution process. MTNs are sold by investment banks and other brokerdealers acting as agents without any underwriting obligations. They also differ from corporate bonds in that they are sold in relatively small amounts either on a continuous or on an intermittent basis.
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Short Term i. Notes issuance facility (NIF) NIF is a basic short-term debt instrument issued by corporations. Borrowers issue short-term notes under an issuance facility provided by a banking syndicate. The notes have maturities of up to one year, the most common ones being one, three and six months. Upon maturity, the notes are either redeemed at par or the principal is roll over. Only the discounted “interest” is paid by the issuer to the note holders at the time of the roll over. ii. Commercial paper Corporate borrowers issue commercial papers, which are short term promissory notes, to raise short term funds for seasonal and working capital needs and for bridge financing of long term projects. Commercial paper is unsecured and usually issued by large corporations with strong credit standing.
Summary A wide variety of debt securities products are available in the Malaysian bond market, such as fixed coupon bearing bonds, floaters, asset-backed securities, convertible bonds, callable bonds, etc. Spurred by strong economic growth, and supported by the efforts of regulators and market participants, the corporate bond market has expanded considerably over the years. Corporations have turned their attention towards the bond market as a viable alternative to bank borrowings and the equity market. Investors are also able to adjust their risk-return profile through the trading of various securities available in the market.
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Activity – Q&A 1. Which of the following statements regarding Malaysian Government securities is FALSE? A. MTB are sold at a discount through competitive auction. B. GII is non-interest-bearing government securities issued based on Islamic principles. C. MGS are issued by the government to finance long-term development projects. D. None of the above. 2. Which of the following statements about zero-coupon bonds is FALSE? A. The lower the price, the greater the return for a given maturity. B. A zero coupon bonds may sell at a premium to par when interest rates decline. C. All interest is earned at maturity. D. A zero-coupon bond provides a single cash flow at maturity equal to its par value 3. What is the main difference between convertible bonds and exchangeable bonds? 4. Define the following. a) Mortgage-backed securities (MBSs). b) Secured bonds. 5. List the four types of NIDs, which banks in Malaysia are permitted by BNM to issue.
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Suggested Answers to Activity 1. D 2. B 3. The main difference between a convertible bond and an exchangeable bond is that a convertible bond gives the holder the option to convert the bond into shares of the issuer while exchangeable bonds grant its holders the right to exchange the bond for the stock of a company other than the issuer. 4. a) MBSs are backed (secured) by pools of mortgage loans, which not only provide collateral but also the cash flows to service the debt. A mortgage-backed security is any security where the collateral for the issued security is a pool of mortgages. b) Secured bonds are bonds which the debt payments are secured by a pledge of the issuer‟s assets, typically shares, a building or land. In the event of default, the investors in these secured bonds have a claim on the assets. 5. The four types of NIDs are: 1) Short term negotiable instrument of deposit (SNID) 2) Long term negotiable instrument of deposit (LNID) 3) Zero negotiable instrument of deposit (ZNID) 4) Floating rate negotiable instrument of deposit (FRNID)
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Topic 6 Understanding Securities and Stock broking Business Preview This topic is aimed at providing the reader with an understanding of the stock broking business in Malaysia. Stock broking companies typically carry out a range of activities including trading and broking for Bursa Malaysia-listed instruments and other securities, offering investment advice, and providing nominee/custodian services. Topic Objectives At the end of this topic, you should be able to– i.
Briefly outline the history and development of the securities industry in Malaysia.
ii.
Describe the main functions of the stock broking division.
iii.
Discuss the trading, clearing and settlement system of Bursa Malaysia Securities Berhad.
iv.
Describe the Central Depository System.
v.
Explain minimum bids.
vi.
Differentiate the types of orders.
vii.
Discuss PN4. PN17 and GN3 companies.
viii.
Describe the procedures for trading on Bursa Malaysia Securities Berhad.
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Understanding Securities and Stock broking Business. 6.1 History and Development of the Securities Industry in Malaysia The securities industry of Malaysia effectively began in the late 19 th century as an extension of the presence of British companies in the rubber and tin industries. Consequently: i.
In 1930, the Singapore Stockbrokers‟ Association, the first formal organization in the securities business, was set up.
ii.
In 1960, the Malayan Stock Exchange was formed and public trading of shares began.
iii.
In 1964, the Stock Exchange of Malaysia was created with the secession of Singapore from Malaysia; the common stock exchange continued to function, but as the Stock Exchange of Malaysia and Singapore (SEMS).
iv.
The Companies Act came into force in 1965, providing a comprehensive legal framework in governing companies.
v.
This was followed by the formation of the Capital Issues Committee (CIC) in 1968 to guide the development of the securities industry. The SEMS was separated into the Kuala Lumpur Stock Exchange Berhad (KLSEB) and the Stock Exchange of Singapore (SES). Malaysian companies continued to be listed on SES and vice-versa.
vi.
The rapid development of the securities industry led to the birth of the first law on securities regulation, the Securities Industry Act was enacted in 1973.
vii.
In 1976 a new company limited by guarantee, the Kuala Lumpur Stock Exchange took over operations of KLSEB as the stock exchange.
viii.
The company was later renamed as the Kuala Lumpur Stock Exchange (KLSE) in 1994. To provide better supervision and control of the securities, the SIA was passed by the Parliament to replace the 1973 Act.
ix.
Computerization of the clearing system began with the formation of a central clearing house, Securities Clearing Automated Network Services Sdn Bhd (SCAN) in 1984.
x.
The Kuala Lumpur Composite Index (KLCI), regarded as the main market barometer, was launched in 1986.
xi.
In 1988, the Second Board was launched to enable smaller companies, which are viable and have strong growth potential to be listed. In the following year, SCORE (System on Computerized Order Routing and Execution) was implemented.
xii.
In 1992, fully automated trading (both order entry and matching) was introduced. The delisting of Singapore incorporated companies from the KLSE and vice versa, was made effective as at 1 January 1990. The
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Malaysian Central Depository Sdn Bhd was set up to implement and operate the Central Depository System (CDS). xiii.
In 1993, the SC was established with the mission to promote and maintain fair, efficient, secure and transparent securities and futures markets and to facilitate the orderly development of an innovative and competitive capital market.
xiv.
The beginning of 2004 marked a new era for the Malaysian capital market. The KLSE was demutualised as consequence to the passing of the Demutualization (Kuala Lumpur Stock Exchange) Act 2003. In this demutualization exercise, the KLSE converted itself from a company limited by guarantee to a company limited by shares. The business of stock broking was vested in a new company, known as Malaysian Securities Exchange Berhad (MSEB). At the same time, KLSE Holdings Berhad and its group of companies undertook a branding exercise and as a consequence of that Bursa Malaysia was established.
xv.
In May 2009, the SC and Bursa Malaysia launched a new board structure which saw the merging of Bursa‟s Malaysia Main Board and Second Board into a single board for established corporations known as the “Main Market”. The MESDAQ Market was also transformed into an alternative market open to companies of all sizes and from all economic sectors known as the “ACE Market”.
6.2 Functions of the Stock Broking Division While the operations of the stock broking division within an Investment Bank may vary slightly from one to another, depending on the size of business; the type of clientele and level of computerization of the stock broking division, the function of the stock broking divisions are essentially similar. The stock broking division may do some or all of the following: i.
Advise clients on possible investments.
ii.
Take orders from clients to buy or sell securities.
iii.
Execute transactions via WinSCORE (stock broking company front-end trading system).
iv.
Ensure payment is received from buying clients.
v.
Ensure that when a client buys or sells shares, all appropriate benefits flow, e.g. dividends, new issue, etc.
vi.
Conduct research and report on the performance of listed companies and their securities.
vii.
Transact business as a principal and arbitrage between markets.
The main operations of the stock broking division usually include dealing or trading, accounts and contract departments because the stock broking business revolves around the buying and selling of shares. 78
There are two types of dealer‟s representatives: i.
Salaried or paid dealer‟s representatives.
ii.
Commissioned dealer‟s representatives more commonly known as „remisier‟.
6.3 The Trading System From 1961 to 1989, Bursa Malaysia Securities Berhad (formerly known as Kuala Lumpur Stock Exchange or KLSE) had an open outcry system of trading. Under this system, bids and offers were shouted by participating organizations‟ trading room clerks to the exchange‟s board writer. The board writer then posted the bids and offers on the exchange board. A transaction only occurred when a bid and an offer matched, and the transaction was then recorded on the board. The exchange‟s System on Computerized Order Routing and Execution (SCORE) replaced the open outcry system of trading on 13 November 1989. The Automated Trading System (ATS) comprises two major computer systems: i.
SCORE which is the central computer engine responsible for the matching of all orders.
ii.
The WinSCORE system (stock broking company front-end trading system) which is responsible for credit control management, order and trade routing, and confirmation.
6.4 Clearing and Settlement Clearing Clearing refer to the process of determining obligations and accounting for the exchange of money and securities, between market counterparties to the trade. Bursa Malaysia Securities Clearing Sdn Bhd is the organization which provides clearing services for participating organizations of Bursa Malaysia Securities Berhad. All participating organizations of Bursa Malaysia Securities Berhad are clearing participants of Bursa Malaysia Securities Clearing Sdn Bhd. These are the major objectives of Bursa Malaysia Securities Clearing Sdn Bhd: i.
To provide facilities for clearing contracts between clearing participants and for “delivering” or “receiving” stocks and securities or paying or receiving payment for participants in connection with securities transactions
ii.
To provide clearing facilities between clearing participants and their clients.
Settlement Settlement refers to the completion of a transaction, wherein securities and corresponding funds are “delivered” and credited to the appropriate accounts. The Fixed Delivery and Settlement System (FDSS) were established by Bursa Malaysia Securities Berhad to facilitate clearing and settlement. 79
The FDSS is summarized in the Table 3. In describing the FDSS, the starting point is the date of the contract known as T. Each step that needs to be undertaken is then described in terms of having to be completed by a specified number of market days from this date. Table 3: Ready Basis Contract Scheduled Delivery Time Events 1.
Date of contracts.
2.
Delivery of Securities.
T*
T+1
T+2
T+3
By such time(s) as may be prescribed by Bursa Malaysia Depository Sdn. Bhd. Not later than 3.00 pm.
2.1.
Transfer of Securities.
2.2.
Book entry delivery.
2.3.
Automatic buying-in.
3.
Settlement (money)
3.1.
PO to selling client.
Not later than 12.30 pm.
3.2.
Bursa Malaysia Securities Clearing Sdn.Bhd to PO.
Not later than 10.00 am.
3.3.
PO to Bursa Malaysia Securities Clearing Sdn.Bhd.
Not later than 10.00 am.
3.4.
Buying client to PO (Closing-off purchase position).
Not later than 12.30 pm.
4.
T+4
Not later than 9.00 am Between 8.30 am-12.30 pm, 2.00 pm-5.00 pm.
Automatic buying-in.
4.1.
PO to selling client.
Not later than 12.30 pm.
4.2.
Bursa Malaysia Securities Clearing Sdn. Bhd to PO.
Not later than 10.00 am.
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4.3. 5.
PO to Bursa Malaysia Securities Clearing Sdn. Bhd.
Not later than 10.00 am. By T+4
Selling out.
6.5 Central Depository System The CDS is a computerized system for the central handling of securities for the Malaysian stock market, operated by Bursa Malaysia Depository Sdn Bhd. Under the CDS, delivery of shares is done through book entry, and there is no physical movement of scrip. This make the delivery and clearing of shares more efficient and convenient. Instead of delivery and receipt of share certificates, a seller‟s account is debited and a buyer‟s account is credited with the relevant number of shares for each transaction. All physical scripts of listed companies under the CDS are kept in the form of jumbo certificates registered in the name of Bursa Malaysia Depository Nominees Sdn Bhd. These jumbo certificates do not have any street value. 6.6 Trading on Bursa Malaysia Securities Berhad A. Trading Hours and Trading Lots Shares are normally traded in specific amounts called Board Lots of 100 units. Any amount less than board lots are called special lots or odd lots. B. Minimum Bids The minimum bid is the permissible change of the offer to buy price over the previous done or quoted price. For example, if the last done of a company is RM3.10, the next buying or selling quote must be least 2 sen above or below RM3.10, i.e. either RM3.12 or RM3.08. It cannot be RM3.11 OR RM3.09. The minimum bids for different price ranges are set out in Schedule 4 of the Rules of Bursa Malaysia Securities Berhad and are as follows: Table 4: Minimum Bids for Different Prices Ranges Market Price of Shares (RM)
Minimum Bids (sen)
Below RM1.00
0.5 sen.
RM1.00 – RM9.99
1 sen.
RM10.00 – RM99.98
2 sen.
RM100 and above
5 sen.
Sources: Bursa Malaysia
C. Orders 81
The types of orders that may be entered through SCORE arei.
Limit order – An order which is to be executed at the price entered into the system or better.
ii.
Market order – An order which is to be executed at the matching price in relation to board lots.
D. Transaction Costs In addition to the cost of the shares bought or sold, the client will have to pay the following charges: i. Brokerage Rates Brokerage is payable by both buyer and seller. With effect from 2 January 2008, the brokerage payable for all trades shall be the minimum prescribed or shall be on a fully negotiated basis between its clients, subject to a maximum of 0.70% of the contract value, whichever is higher. The minimum brokerage rate is as follows: Table 5: Minimum Brokerage Rate Category of Trade
Minimum Brokerage Rate*
Inter-broker
Fully negotiable
Institutional
Fully negotiable
Retail trades valued above RM100,000
0.3% of contract value
Retail trades valued below RM100,000
0.6% of contract value
Online routed retail trades (via ECOS)** & ***
Fully negotiable
Trades executed less than a board lot***
Fully negotiable
Trades where cash upfront has been given prior to the execution of the trades***
Fully negotiable
Same day buy and sell trades
0.15% of contract value
Sources: Bursa Malaysia N.B:
*
Fixed brokerage - always subjected to the fixed brokerage of RM2.00 on transaction of loan instruments and RM40.00 on any other transaction. ** Participating Organization‟s Electronic Client-Ordering System approved by Bursa Malaysia. *** The minimum fixed brokerage of RM40.00 is not applicable for these transactions ii. Clearing Fees 0.03% of transaction value (payable by both buyer and seller) with a maximum of RM1000.00 per contract. There is no minimum fee imposed. iii. Stamp Duty The stamp duty chargeable on transactions on the stock market of Bursa Malaysia is: 82
RM1.00 for RM1000.00 or fractional part of value of securities (payable by both buyer and seller), and effective 17 March 2003, the stamp duty shall be remitted to the maximum of RM200. iv. Registration Fees RM3.00 fee is charged per share certificate which is payable to the company registrar for issuance of new certificates. Example: An investor bought 10,000 shares of IOI Corp at RM4.32 per share. How much does he need to pay the stock broking firm? Answer:
RM
Gross amount: 10,000 x RM4.32 Brokerage:
RM43, 200 x 0.06
43,200.00 2,592.00
Stamp duty: (RM1.00 for RM1000.00 or fractional part of value)
44.00
Clearing fee:
12.96
RM43, 200 x 0.03%
Total amount due
45, 848.96
6.7 Financially Distressed Listed Companies – PN4, PN17 & GN3 PN4 Company PN4 refers to Practice Note 4 of Bursa Malaysia that covers listed companies who are in poor financial condition and who are required by the stock exchange to provide proposal/s to restructure or revive the company. This practice note has since 2005 been replaced by requirements under PN17 but rules for PN4 companies continue to apply to those who classified as such. PN17 Company A listed company that is financially distressed or does not have a core business or has failed to meet minimum capital or equity (not less than 25% of the paid up capital). A PN17 company must submit to Bursa Malaysia their plan on how to regularize or face possible delisting. GN3 Company A company designated as an Affected Listed Company because its poor or adverse financial condition and level of operations fall into the criteria described in Bursa Malaysia's Guidance Note 3.
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6.8 Outline of a Trade Transaction
6.9 Account Structure In order to be eligible to open a securities account, the criteria sets out under Rule 25.02 of the Rules of Bursa Malaysia Depository Sdn. Bhd. are as follows: i. Over 18 years old. ii. A corporation within the meaning of s. 4 of the Companies Act 1965. iii. A public authority or instrumentality or agency of the government of Malaysian or any state. iv. A co-operate society v. A statutory body under an Act of Parliament vi. A trustee or trust corporation vii. A society or trust corporation viii. A society registered under the Societies Act 1966, or ix. Statutory bodies incorporated under an Act of Parliament. However, such persons are not eligible to open a securities account if theyi. Have been adjudicated bankrupt and remain un-discharged at the time of application ii. Are mentally disordered 84
Summary We started this topic by providing the reader with a history and development of the securities industry in Malaysia before briefly considering the functions of the stock broking company. We then described the trading, clearing and settlement system of the Bursa Malaysia Securities Berhad. We also briefly discussed the category of financially distressed listed companies before ending this topic by looking at the procedures for trading on Bursa Malaysia Securities Berhad.
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Activity – Q&A 1. Assume that an investor bought 20,000 shares of PLUS Bhd on 1 st June 2009. When is his last date of payment? A. 3rd June 2009 B. 4th June 2009 C. 5th June 2009 D. 2nd June 2009 2. What is the minimum bid for a stock that is currently trading at RM3.30? A. 1 sen B. 2 sen C. 3 sen D. 5 sen 3. Assume that an investor sold 15,000 shares of Kulim Bhd at RM5.55 per share. The total net amount due to him is: A. RM84, 354.98 B. RM78, 146.02 C. RM78, 171.02 D. RM84, 354.02 4. What are the major objectives of Bursa Malaysia Securities Clearing Sdn Bhd?
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Suggested Answers to Activity 1. B 2. A 3. B 4. The major objectives of Bursa Malaysia Securities Clearing Sdn Bhd are: To provide facilities for clearing contracts between clearing participants and for “delivering” or “receiving” stocks and securities or paying or receiving payment for participants in connection with securities transactions. To provide clearing facilities between clearing participants and their clients.
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Topic 7 Malaysian Equity Markets Preview This topic introduces the reader to the Malaysian equity markets and the types of securities traded on the Bursa Malaysia Securities Berhad. The stock market is one of the important markets facilitating the flow of funds between the business, public, private household and also the overseas sector. Topic Objectives At the end of this topic, you should be able to– i.
Discuss the importance and structure of Malaysian equity markets.
ii.
Explain stock exchange indices.
iii.
Relate the concept of shares and the various equity hybrids.
iv.
Explain the changes in number of shares issued.
v.
Describe the classification of shares for investment purposes.
vi.
Discuss participants in the Malaysian equity markets.
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Equity Markets 7.1 Introduction Shares represent ownership of ordinary shares in a company. Companies issue shares because they want to raise money for their business operations. Investors buy shares because they want to earn a return on their investment, either through dividends or through a capital gain. Buying a share, however, is very different from buying a real asset, such as land or buildings, machines or knowledge that can be used as goods and services. Buying shares is buying a financial asset, whereby the asset bought is merely a claim on real assets or income generated by a company. In fact, equity holders are not promised any particular payment except for a right to dividend when declared and voting rights. If a company is successful in its earnings performance, the value of the share of the company rises, and the shareholder will earn a capital gain on the share as a result; if not, the share declines and the shareholder may incur losses. 7.2 Basic Functions of a Stock Market From a macro perspective, the stock exchange bridges the gap between the borrowers, e.g. private companies in need of borrowing money for long periods or to raise permanent capital, and investors who wish to invest money. The stock market is one of the important markets facilitating the flow of funds between the sectors comprising the business, public, personal or private household sectors and also the overseas sector. By increasing the investment options available to individuals and institutions, a stock market would: i.
Increase the funds available to the finance industry.
ii.
Direct the flow of new savings toward investment in industries where expansion of facilities is most desirable (channeling of funds to productive activities).
Bursa Malaysia Securities Berhad, like other exchanges, has developed to meet two basic and complementary needs: a business need for raising funds, and an individual‟s or company‟s desire to invest savings efficiently. The stock market is made up of two markets: i.
The primary market which allows a company or government to raise initial capital. This is usually done by a company issuing a prospectus through an underwriting stock broking company. The primary market embraces issues of debentures, preference shares and notes, as well as the equity securities of listed companies, and is used by governments and companies, both public and private. By issuing securities such as shares which offer the prospect of dividends and capital gains, businesses can attract savings. Hence, the stock market channels savings 89
into productive areas of the economy and this speeds economic growth and raises living standards. ii.
The secondary market is the central market place provided by the stock exchange where people can buy and sell securities, which have been previously issued to the market. It is an auction system and the price of the share is determined by supply and demand.
7.3 The Malaysian Stock Market As at the end of August 2009, there were a total of 997 companies listed on the MAIN Market of Bursa Malaysia Securities Berhad with a total market valuation or capitalization of approximately RM876 billion. In 1973, when the KLSE first commenced operations, market capitalization stood at approximately RM600 billion. On the ACE Market, there were a total of 129 companies listed with a market capitalization of RM5.2 billion. 7.3.1 Indices In general, indices for a stock exchange are calculations made on an index number basis to indicate the movements in the general level of prices securities listed on the stock exchange. Indices are used as indicators of the performance of the stock market as a whole. A stock market index can be based on all the stocks listed on a stock exchange or on only a sample of stocks. Some indices are computed on the simple average closing price basis while others are derived using a weighted average method. The indices of Bursa Malaysia Securities Berhad are calculated electronically every one minute. They are made available to subscribers of market information (e.g. Stock broking companies) 7.3.2 FBM Kuala Lumpur Composite Index The FBM Kuala Lumpur Composite Index (FBMKLCI) measures the performance of the whole Malaysian stock market. It is a capitalization-weighted index, which means that the index is weighted according to the market capitalization of the constituent stocks. Thus, companies with a higher market capitalization have a larger weighting in the index. There are 30 components stocks that make up the FBMKLCI. 7.4 Types of Securities Traded on Bursa Malaysia Securities Berhad. There are many different types of securities, which are traded on Bursa Malaysia Securities Berhad, as follows: i. Ordinary Shares Also called equity shares, this is the risk capital of a company. Ordinary shares give holders the rights of ownership in the company, such as the right to share in the profits, the right to vote in general meetings and to elect and dismiss directors. Obligations of ownership are also conferred and this may result in the loss of an investor's money if the company is unsuccessful. Ordinary shares usually form the 90
bulk of a company's capital and have no special rights over other shares. In the event of liquidation, ordinary shares rank after all other liabilities of the company. Changes in Number of Shares issued The price of a share is related to the market capitalization of the company and the number of shares that have been issued. The company can take action to increase the number of shares on issue. This can be done with the issuance of: i.
rights issue
ii.
bonus issue
Other situations where the number of a company may be altered are in the case of share buyback and capital reduction. Share buyback refers to companies buying back their own shares. As the name implies, capital reduction involves reduction in the paid-up capital of a company. Capital reduction commonly occurs when a company seeks to write-off capital that is no longer represented by assets. This occurs after a company‟s asset fall in value or the company has suffered trading losses. A company may also reduce capital as part of a reconstruction exercise. A. Rights Issue Rights issue applied to the privilege granted to the shareholders to acquire additional shares directly from the issuing company. To raise capital through the issuance of additional ordinary shares, a company may offer each shareholder the right to buy shares in direct proportion to the number of shares already owned. For example, the offer may be based on the right to buy one additional share for each ten shares held. The subscription price for the new shares is usually lower than the current market price. This induces the shareholders to take up the rights issue. Why Rights are issued? Reasons a company may choose to raise additional funds through a rights offering may include: i.
Raising capital for expansion of business or repayment of loan facilities.
ii.
Giving existing shareholders the opportunity to acquire additional shares, at discount to the market price.
The rights issue provides existing shareholders with the opportunity to maintain their proportionate interest in the company. The price of the rights tends to rise and fall in the secondary market as the price of the ordinary fluctuates, although not necessarily in the same degree. B. Bonus Issue Bonus issues, unlike rights issue, do not result in the company raising new finance. This is a free issue of stocks to the stockholders based on the number of stocks already owned. For example, a 1 for 3 bonus issue means that the shareholder is entitled for one free share for every three shares already held. 91
Bonus issues represent a capitalization of accumulated reserves, simply bringing nominal capital in line with the capital used. The overall value of the company remains unchanged because the earning capacity (assets) remains unchanged. ii. Preference Shares These are shares which carry the right to dividend (normally fixed) which ranks for payment before that of ordinary shareholders. Preference shares may be preferred also as regards to distribution of assets upon dissolution of the company. Preference shares generally carry no voting rights, but voting rights may be made contingent upon failure to pay dividends on preference shares for a certain period of time. There are various types of preference shares: i.
Participating preference shares are entitled to participate in the profits beyond the fixed dividends, by way of an additional fluctuating dividend if the company is successful.
ii.
Cumulative preference shares are preference shares which, apart from having a preferential right to receive a fixed dividend ahead of ordinary shares, also carry the right of any arrears of the preference dividends which may have built up.
iii.
Non-cumulative preference shares are preference shares which are not entitled to any arrears in dividends.
iv.
Redeemable preference shares may be redeemed by the company at a stated redemption price on advance notice of a period of time. It is usual to set a redemption price above the par value to compensate the owner for the involuntary loss of his investment.
v.
Convertible preference shares are preference shares which carry the right to be made convertible, at the option of the holder, into another class of shares, normally into ordinary shares.
iii. Loan Stocks A loan stock is a security issued by a company in respect of a loan made by investors. Loan stocks may be secured, unsecured, convertible or non-convertible, but are often unsecured, unlike debentures. A debenture is similar to a mortgage. It is a longterm loan secured on certain fixed or floating assets of a company. a. Unsecured loan stocks carry higher risk than debentures, and in the event of a winding-up, unsecured loan stock holders rank alongside all other unsecured creditors. b. Convertible loan stocks carry the right to be converted into ordinary shares of the company on pre-arranged terms and within a limited period. The objective of issuing a convertible loan stock is to obtain fixed interest finance at a relatively
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low rate of interest and at the same time make it attractive to potential holders by the offer of equity participation at a later date. iv. Warrants/Transferable Subscription Rights (TSRs) Warrants/TSRs give the holders the right, but not an obligation, to subscribe for new ordinary shares at a specified price during a specified period of time. The warrants/TSRs (usually attached to an issue of loan stock) are issued by the company. Warrants have a maturity date (up to 10 years) after which they expire worthless unless the holder had exercised to subscribe for the new shares before the maturity date. v. Call Warrants Call warrants also give a right, but not an obligation, to buy a fixed number of shares at a specified price within a limited period of time. But unlike warrants/TSRs, call warrants are issued by third parties based on existing shares. Therefore, they do not increase the issued capital or dilute the earnings of the company as a warrant/TSR would do. Call warrants have maturity dates of not more than two (2) years. vi. Property Trusts A property trust fund involves a listed company which invests its funds in landed properties. It operates just like a unit trust except that it invests in property rather than shares. It therefore provides investors access to retail and commercial properties. vii. Closed-end Funds A closed-end fund involves a listed company which invests in shares of other companies. A close-end fund company has a fixed number of shares in issue at any point of time, the price of which will fluctuate according to net asset value and market forces viii. Exchange Traded Fund (ETF) Exchange Traded Fund (ETF) is an investment fund that trade like stocks. Cheap, flexible, and tax-friendly, it allows investment of any size in a myriad of different portfolios of securities, equities, bonds, commodities etc. ETF is more than just cheap fund. It is an entirely different animal from unit trust funds. ETF can be bought and sold instantaneously on a stock exchange as opposed to unit trust funds, which almost always trade at end-of-day prices. ETF is designed to track performance of an index. It offers additional benefits of diversification and market tracking while retaining the features of convenience and flexibility of ordinary stocks. Investors can buy or sell ETF through their stockbrokers anytime during trading hours.
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7.5 Classification of Shares for Investment Purposes Not all shares are identical. It is common for investors to describe shares as being: i.
Blue chip.
ii.
Growth.
iii.
Cyclical.
iv.
Income.
v.
Defensive.
vi.
Speculative.
Often, it is not easy to differentiate between types of shares, but investors have the general idea of what each item mean. Let us also examine these terms: Blue Chips Blue chips are shares of major companies that have had long and unbroken records of high earnings and good dividends. In short, blue chips are usually companies with well-established, stable and mature businesses, including great financial strength. In contrast to blue chips, market participants also refer to third liners and second liners. Third liners are shares with poor fundamentals while second liners are shares considered by market players to grade somewhere between third liners and blue chips. Examples of blue chips are Tenaga and Genting Berhad. Growth Shares Growth shares are shares of companies whose sales and earnings are growing faster than the economy and the industry. As such, they are likely to show positive earnings surprises. Given that these companies often finance their growth with retained earnings, their dividends are low. Very often, these companies yield very high capital gains, but beware, they are also very risky. Examples of growth shares are Alam Maritim Resources Berhad and Kencana Petroleum Berhad. Cyclical Shares Cyclical shares refer to companies whose earnings track the business cycle. When business conditions in the economy improve, the earnings and share price rise and when business conditions decline, the earnings and share price decline. For example, companies in the steel, automobile and the heavy machinery industries will do well during economic expansions while their earnings would be poor in economic contractions. A cyclical share has a tendency to post changes in its rate of return which are greater than the changes in overall market rates of return. An example of cyclical share is DRB-HICOM Berhad. Income Shares Some shareholders invest in shares because they wish to live off the income that they receive. They want current income. Some companies tend to pay very high, generous dividends and, as a result, their shares are referred to as income shares. An example of income share is Maxis Berhad. 94
Defensive Shares Defensive shares are those of companies whose future earnings are likely to withstand an economic downturn, with relatively low business risk and moderate or low financial risk. In view of this, the rate of return of a defensive share is not expected to decline during an overall market downturn or it will decline less than the overall market. Companies that are considered defensive include those in the consumer necessities or public utilities sectors. An example of income share is Nestle Berhad. Speculative Shares A speculative share has a high probability of low or negative return and it may be still overpriced, leading to a high probability that the market would adjust the share price to its true value in the future. Consequently, the share will pose share capital losses to the investor. In this way, speculative share pose great risk to the investor. For example, speculative shares include those of an oil exploration company or a company that is a potential take-over target. An example of speculative share is Ranhill Berhad 7.6 Participants in the Malaysian Equity Market There is a diverse range of investors, investment strategies used and product available in the stock market. The type of users of the stock market can be categorized into two basic groups: institutional investors and retail investors. A. Institutional Investors The institutional investors are represented by a variety of institutions that include pension funds, life and general insurance funds, unit trust funds, corporate investors and international investors. Institutional investors tend to use stock selection methods, such as the bottom-up approach, top-down approach and technical analysis. Although they tend to work within a basic structure to their equity portfolios, they try to be flexible within this structure. That is, institutional investors have the option to increase or reduce their exposure to their chosen segments of the equity market according to their perception of the future prospects of these segments. Indeed, they will probably, from time to time, increase or reduce their overall exposure to the equity market. B. Retail Investors Retail investors in the Malaysian stock market include short term and long term investors. Some retail investors in the Malaysian stock market are speculators. Others are more conservative and tend to deal only in blue chip stocks. Some retail investors who have a high net worth may have professional fund managers who manage their portfolio on a discretionary basis in accordance with the client‟s specific investment requirements. Other investors may have a portfolio of investments that they manage personally. It may include a spread of investments across equity, property, fixed interest and cash investment vehicles. Often, such a portfolio will have an emphasis on low risk capital growth and high-income bearing instruments via dividends and interest. 95
Summary This topic discusses equity securities and the equity markets in which these investment instruments are traded. Specifically, the elements and characteristics of shares, and investment in shares are discussed. This section also examines the instances of additional share issue to shareholders, which may be in the form of bonus and rights issue. The different classifications of shares for investment purposes are discussed as a preliminary to understand investment planning and setting of investment objectives.
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Activity – Q&A 1. Which of the following is a difference between primary and secondary capital markets? A. Primary markets are where stocks trade while secondary markets are where bonds trade. B. Both primary and secondary markets relate to where stocks and bonds trade after their initial offering. C. Secondary capital markets relate to the sale of new issues of bonds, preferred, and common stock, while primary capital markets are where securities trade after their initial offering. D. Primary capital markets relate to the sale of new issues of bonds, preferred, and common stock, while secondary capital markets are where securities trade after their initial offering. 2. Which of the following statements is FALSE? A. Unsecured loan stocks carry higher risk than debentures B. Preference shares give holders the rights of ownership in the company C. Exchange Traded Fund is designed to track performance of an index D. A property trust fund involves a listed company which invests its funds in landed properties. 3. All of the following are types of securities traded on the stock exchange EXCEPT: A. Exchange Traded Fund. B. Call warrants. C. Unit trust. D. Loan stocks. 4. Give two reasons why Rights are issued? 5. What is the difference between warrants/TSRs and call warrants? 6. Define the following:a) Growth shares. b) Cyclical shares.
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Suggested Answers to Activity 1. D 2. B 3. C 4. Reasons a company may choose to raise additional funds through a rights offering may include: a. Raising capital for expansion of business or repayment of loan facilities. b. Giving existing shareholders the opportunity to acquire additional shares, at discount to the market price. 5. Warrants/TSRs are issued by the company while call warrants are issued by third parties. 6. a) Growth Shares Growth shares are shares of companies whose sales and earnings are growing faster than the company and the industry. As such, they are likely to show positive earnings surprises or above average risk-adjusted rates of return. Given that these companies often finance their growth with retained earnings, their dividends are low. Very often, these companies yield very high capital gains, but beware, they are also very risky. b) Cyclical Shares Cyclical shares refer to companies whose earnings track the business cycle. When business conditions in the economy improve, the earnings and share price rise and when business conditions decline, the earnings and share price decline. For example, companies in the steel, automobile and the heavy machinery industries will do well during economic expansions while their earnings would be poor in economic contractions. A cyclical share has a tendency to post changes in its rate of return which are greater than the changes in overall market rates of return.
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Topic 8 Understanding Derivatives Markets Preview This topic is aimed at providing the reader with an understanding of the concept and uses of derivatives, specifically the futures and options contract. Futures and options have become very important instruments in investments as they increase the alternatives available to investors and allow investors to use different strategies to meet their investment objectives. Topic Objectives At the end of this topic, you should be able to– i.
Describe the four different types of derivatives contract.
ii.
Differentiate between exchange traded and OTC derivatives.
iii.
Discuss the role of derivatives.
iv.
Describe the concept of futures contract.
v.
Discuss the futures markets and futures trading in Malaysia.
vi.
Describe the concept of option contract.
vii.
Discuss basic option trading strategies.
viii.
Describe option trading in Malaysia.
ix.
Explain the basic functions of Bursa Malaysia Derivatives Berhad.
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Understanding Derivatives Market 8.1 Introduction Among the most innovative and most rapidly growing markets to be developed in recent years are the markets for financial future and options. Futures and options trading are designed to protect the investor against interest rate risks, exchange rate risks and price risks. In the financial futures and options markets, the risk of future changes in the market prices or yields of securities are transferred to someone (an individual or an institution) who is willing to bear that risk. Financial futures and options are used in both short-term money markets and long-term capital markets to protect both borrowers and lenders against the risks involved. 8.2 General Description Derivatives A derivative is a security that derives its value from the value or return of another asset or security. The underlying asset can be physical assets which include agricultural commodities, metals and sources of energy or financial assets which include stocks, bonds and currencies. Basically there are four different types of derivatives contracts: i.
Forward contract – an agreement to buy or sell a specified quantity of asset at a specified price, with delivery at a specified time and place.
ii.
Futures contract – a forward contract that is standardized and exchange traded. The main differences with forwards are that futures are traded in an active secondary market, are regulated, backed by the clearing house and require a daily settlement of gains and losses.
iii.
Option – a contract that gives it owner the right but not the obligation, to conduct a transaction involving an underlying asset at a predetermined future date and at a predetermined price.
iv.
Swap – a derivative contract in which two counterparties agree to exchange one stream of cash flows against another stream.
8.2.1 Exchange traded derivatives Exchange traded derivatives are derivatives that originate and are traded on formalized exchanges. Trading of derivatives on most exchanges is based on the open outcry system on the physical trading floor. The open outcry system is where the traders transact through a combination of hand signals and speech. However, some exchanges are moving towards electronic trading system. For example, Bursa Malaysia Derivatives Berhad has a screen-based trading system. Derivatives traded on an exchange are highly standardized as to the type and maturity of the instrument. This standardization promotes liquidity as it makes it easier for market participants to deal in the instruments.
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8.2.2 Over-the-counter (OTC) derivatives OTC derivatives, notably forwards and swaps are not traded through a formalized trading system. Instead, participants arrange deals through face-to face meetings or through the telephone. Unlike derivatives trading on formalized exchanges, an OTC derivative contract is not standardized. This lack of standardization has its benefits as it allows the parties to negotiate and determine contract specification that will meet their needs. There is usually no clearing house for OTC derivatives. As such, the risk default is also greater. 8.2.3 Clearing house Each exchange has a clearing house. The clearing house guarantees that traders in the futures market will honor their obligations. The clearing house does this by splitting each trade once it is made and acting on the opposite side of each position (i.e. the buyer to every seller and the seller to every buyer). With this, the clearing house allows each side of the trade to reverse positions later without having to contact the other side of the initial trade. With a clearing house, traders need not worry about the other side defaulting. In Malaysia, the derivatives clearing house is the Bursa Malaysia Derivatives Clearing Berhad To safeguard the clearing house, traders are required to post a margin and their accounts on a daily basis. There are basically three types of margin. 1. Initial margin: Margin required on the first day of the transaction. This is what the futures trader puts up initially - "good faith" money. 2. Maintenance margin: Margin requirement on any other day, other than the initial day of the transaction. Margin account balances are monitored, and the maintenance margin is the minimum requirement to be left in the account. 3. Variation margin: When balances fall below the maintenance margin, funds must be deposited to bring the margin account balance back up to the initial margin requirement This additional margin is referred to as the variation margin.
Example: Suppose the FBMKLCI futures is quoted at 1,200 points. Lets assume that Trader A short one contract FBMKLCI futures while Trader B long one contract. At the time of initiation of contract, both parties would be required to post margin. This margin is the initial margin.
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The initial margin is typically a percentage of the total value of transaction, usually 10% to 20% (depending on whether it is individuals or institutions at the perceived credit risk by brokers). The maintenance margin is usually a percent of the initial margin. For simplicity, let us say that initial margin is 10%, and maintenance margin is 70% of initial margin. Marking to market process which is done on a daily basis, recognizes the gains and losses of each party as future prices changes subsequently to their having entered the contract. This recognition is done by crediting and debiting each party‟s account at the end of each trading day. Loses will result in debit (minus) or reduction in margin balance while gains are recorded as credits or additions to existing margin. Table 6 illustrates the margining and marking to market process for the first 5-day period using hypothetical futures settlement prices. On day 0, which is the day both parties enter into the contract the settlement price happens to be the same as the price they went into. On day 0, columns (3) and (4) show a margin balance of RM 6,000. This is the initial margin (10% of contract value) which has been arrived as follows: Initial margin (IM) IM
= 0.10 x contract value = 0.10 x 1,200 points x RM50 = RM6,000
Refer to appendix for contract specifications The assumed maintenance margin is 70% of initial margin. Thus, the ringgit amount of the maintenance margin would be: Maintenance Margin (MM) = 0.70 x IM MM = 0.70 x RM6,000 = RM4,200 This means that if either party‟s margin balance falls below RM4,200, he would receive a margin call from his broker. Table 6 Marking to Market and Margins (1) day
(2) FBMKLCI Futures Settlement price
(3) Margin Account Trader A Short position (RM)
Balance (RM)
(4) Margin Account Trader B Long position (RM)
Balance (RM)
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0 1 2 3 4 5
1200 1180 1170 1180 1150 1145
6000 +1000 +500 - 500 +1500 +250
6000 7000 7500 7000 8500 8750
6000 - 1000 - 500 +500 - 1500 +2500** - 250
6000 5000 4500 5000 3500* 6000 5750
* Margin call triggered; ** Additional margin payment On day 1, the FBMKLCI futures falls to 1,180 points. A fall in the futures index would profit the short position but work against the long position. This represents movement of funds out of the „losing‟ account and into the „gaining‟ account. Since day 1 price fell by 20 index points, the adjustment amount would be:
20 x RM50 = RM1000
The same calculations apply for day 2 to 5. On day 4 marking to market, the long position‟s margin balance falls to RM3, 500. As this is below the maintenance margin level of RM4,200, the long position will receive a margin call from his broker, requiring him to pay an additional of RM2,500 (RM6,000 – RM3,500) of margin. This amount has to be paid within a stipulated time the next day. 8.3 The Role of Derivatives 1. Risk management Because derivative prices are related to the price of the underlying spot market goods, they can be used to manage the risk of owning the spot items. i.
Hedging – hedging is the prime social rationale for derivatives trading. For example, buying the spot item and selling futures contract or call option reduces the investor‟s risk. If the good‟s price falls, the price of the futures or option contract will also fall. The investor can then repurchase the contract at the lower price, affecting a gain that can at least partially offset the loss on the spot item.
ii.
Speculating – derivative markets provide an alternative and efficient means of speculating. Many investors prefer to speculate with derivatives rather than with the underlying securities. The ease with which speculation can be done using derivatives in turn makes it easier and less costly for hedgers.
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2. Operational advantages Derivatives markets offer several operational advantages. i.
ii.
iii.
8.4
Lower transaction costs – commission and other trading costs are lower for traders in these markets. This makes it easy and attractive to use these markets in lieu of the spot markets. Liquidity – derivative markets often have greater liquidity than the spot markets. This is partly due to the smaller amount of capital required for participation in the derivative markets. Short selling – securities markets impose several restrictions designed to limit or discourage short selling that are no applied to derivative transactions. Consequently, many investors sell short in these markets in lieu of selling short the underlying securities.
The Main Players in the Derivatives Markets Three main players in the derivatives market are Hedgers, Arbitrageurs, and Speculators. 1. Hedgers Hedgers use derivative markets to manage or reduce risk. They are typically businesses that use derivatives to offset exposures resulting from their business activities. An example will be a palm oil producer who can lock in the current market prices by selling their crop in the futures market. 2. Arbitrageurs Arbitrageurs use derivatives to engage in arbitrage. Arbitrage is the process of trying to take advantage of price differentials between markets. Arbitrageurs closely follow quoted prices of the same asset/instruments in different markets looking for price divergences. Should the prices be divergent enough to make profits, they would buy on the market with the lower price and sell on the market where the quoted price is higher. In addition to merely watching the prices of the same asset in different markets, arbitrageurs can also arbitrage between different product markets, for example, between the spot and future markets or between futures and option markets. 3. Speculators Speculators, as the name suggest, merely speculate. For example, if they expect a certain asset to fall in value, they will short (sell) the asset. If their expectation comes true they would make profits from having shorted the asset. On the other hand, if the price increased, they would make losses on their short position.
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8.5 Introduction to Futures. 8.5.1 Definition and Concepts of Futures. Futures are an agreement between two parties in which the buyer agrees to buy from seller, the "underlying asset" or other derivative, at a future date at a price agreed on today. Futures contracts are highly standardized. A futures contract specifies the quality and quantity of the goods to be delivered, the delivery time, and the manner of delivery. For each futures contract, there must be a buyer and seller. The buyer of a futures contract is said to have taken the long position while the seller of a futures contract is said to have taken a short position. 8.5.2 Closing a futures position A futures position may be closed out via three different methods. i.
Enter into an offsetting contract – given that the other side of your position is held by a clearing house, if you make an exact opposite trade to your current position, the clearing house will net your positions out leaving you with a zero balance.
ii.
Delivery – you can take physical delivery of the goods where delivery will be made according to contract specifications to the designated location or by making cash settlement for any gains or losses.
iii.
Exchange for physicals – find a trader with an opposite position to your own and deliver the goods and settle up off the floor of the exchange. Exchange for physicals are different from delivery in that the transaction is negotiated and settled off the exchange.
8.5.3 Types of futures contract There are four fundamental types of contracts: i.
Agricultural and metallurgical contracts – physical goods contracts cover a wide range of products such as agricultural goods, livestock, forest products, textiles, foodstuff and mineral. An example of agricultural futures contracts is crude palm oil futures which are traded on BMDB.
ii.
Indexes – most index futures are stock indexes. An index futures trading does not actually require actual delivery. The trader‟s obligation will be fulfilled by reversing the trade or through cash settlement. An example is FBMKLCI futures which are traded on BMDB.
iii.
Interests earning assets – in the United States interest rate futures started trading in 1975 and have experience tremendous growth since then. An example of interest rate futures in Malaysia is the three-month KLIBOR futures contract which is traded on BMDB.
iv.
Foreign currencies – the foreign exchange market represents the case of futures market that exists simultaneously with an active forward market. The forward market for foreign exchange is much larger than the futures market. 105
8.5.4 Pricing a Futures Contract Mathematically, the future price could be written as:
Where F t,T So rf c Y
= futures price for a contract with maturity from t, to T (t =today, T = maturity) = current spot price of the underlying asset = annualized risk free interest rate (being the proxy for the Opportunity cost of later payment) = annualized storage cost in percent (inclusive of shipping /handling, Shrinkage, spoilage etc.) = convenience yield (annualized percentage)
The above equation is commonly known as the Cost-of-Carry Model (COC). Since the equation also tells us what the equilibrium futures price should be given the spot price, it is also known as the Spot-Futures parity equation. Example Suppose the spot price of CPO is quoted at RM1, 400 per ton. The annualized rf rate = 6% and annual storage cost per ton = RM 44 per ton. What is the fair price of a CPO futures contract maturing in 3 month (90 days)? F t,T
=
F 90
= = = = =
Price per contract
1100 (1 + 0.06 + 0.04 – 0) 1100 (1.10) 1126.53 per ton RM1, 126.53 x 25 tons RM28, 163.25
Futures price are arrived at through the interaction of hundreds of buyers and sellers trading on an exchange; such prices are by definition “market-clearing price”. The price would reflect currently available information and demand-supply conditions. 8.5.5 Equity Futures – FBMKLCI Futures Equity futures are futures contract based on shares. In Malaysia, the trading of equity based futures contracts commenced in December 1995 with the launch of the Kuala Lumpur Composite Index (KLCI) futures contracts which are traded on BMDB. The FBMKLCI futures contract is simply an agreement between the buyer and the seller to respectively deliver and take delivery of the basket of shares that make up the index. The KLCI futures contract is settled in cash. This means that on the last trading day, any outstanding contracts are settled by reference to the price of the underlying stock index.
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8.5.6 Commodity Futures – Crude Palm Oil Futures Crude palm oil futures which are traded on BMDB are the only crude palm oil futures in the world. It is an active and liquid market which provides a global benchmark for the price of crude palm oil as well as a market for risk management. 8.5.7 Interest Rate Futures. The Kuala Lumpur Interbank Offer Rate (KLIBOR) futures are traded on the BMDB. KLIBOR futures are the first exchanged-traded interest rate derivative in Malaysia and the only ringgit interest rate futures in the world. KLIBOR futures are primarily used for hedging fluctuations in interest rate. Trading in KLIBOR futures commenced in May 1996. KLIBOR futures are based on a three-month interbank deposit in the Kuala Lumpur wholesale money market having a principal of RM1 million. The futures price is quoted as an index calculated at 100 minus the interest rate per annum. For example, a deposit quoted in the cash forward market at the rate of 7.5% would have an index price of 92.50 in the futures market. This means that when interest rates fall in the cash market, a long futures position (i.e. bought futures position) increases in value. As interest rates rise, the futures position falls. In essence, when you buy a KLIBOR futures contract at 93.75, you have entered into an agreement to lend RM1, 000,000 at the rate of 6.25% per annum for a term of three months beginning on the date of expiry of the futures contract. If you sell a KLIBOR futures contract at 92.50, you have entered into an agreement to borrow RM1, 000,000 at the rate of 7.50% per annum for the period three months beginning on the date of expiry of the futures contract. 8.6
Introduction to Options 8.6.1 Definition and Concepts of Options An option contract gives it owner the right but not the obligation, to conduct a transaction involving an underlying asset at a predetermined future date (the exercise date) and at a predetermined price (the exercise or strike price). Options give the option buyer the right to decide whether or not the trade will eventually take place. The seller of the option has the obligation to perform if the buyer exercises the option. An American style option allows the owner to exercise the option at any time before or at expiration. A European style option, on the other hand, allows the owner to only exercise at expiration. At expiration, both options are identical. Before expiration, however, they are different and may have different values. If two options are exactly identical except that one is an American style option and the other is a European style option, the value of the American style option would either be equal to or worth more than the European style option.
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8.6.2 Types of options There are two basic types of options: i.
Call option – gives its owner the right to buy the underlying asset at a specified price for a specified time period.
ii.
Put option – gives its owner the right to sell the underlying asset at a specified price for a specified time period.
For every owner of an option, there must be a seller. The seller of the option is also called the option writer. There are four possible options positions: i.
Long call: the buyer of a call option – has the right to buy an underlying asset.
ii.
Short call: the writer (seller) of a call option – has the obligation to sell the underlying asset.
iii.
Long put: the buyer of a put option – has the right to sell an underlying asset.
iv.
Short put: the writer (seller) of a put option – has the obligation to buy the underlying asset.
8.6.3 Moneyness The concept of moneyness deals with the question of when the option has value: A call option is said to be: i.
In-the-money when the share price (S) is above the strike price (X) [S > X]. Example: If you buy a call option on XYZ stock at an exercise price of RM3.50 and the current market price is RM5.00, then the call option of XYZ stock is said to be in-the-money.
ii.
Out-of-the-money when the share price is below the strike price [S < X]. Example: If you buy a call option on XYZ stock at an exercise price of RM3.50 and the current market price is RM3.00, then the call option of XYZ stock is said to be out-of-the-money.
iii.
At-the-money when the share price is the same as the strike price [S = X]. Example: Exercise price of the call option is RM3.50 and the current market price of the stock is also RM 3.50
A put option is said to be: i.
In-the-money when the share price is below the exercise price [S < X]. Example: If you buy a put option on XYZ stock at an exercise price of RM3.50 and the current market price is RM3.00, then the put option of XYZ stock is said to be in-the-money.
ii.
Out-of-the-money when the share price is above the exercise price [S > X]. Example: If you buy a put option on XYZ stock at an exercise price of RM3.50 and the current market price is RM5.00, then the put option of XYZ stock is said to be out-of-the-money. 108
iii.
At-the-money when the share price is the same as the exercise price [S = X]. Example: Exercise price of the call option is RM3.50 and the current market price of the stock is also RM 3.50
The above situations will be illustrated with pay off diagrams under the sub-topic basic option strategies. 8.6.4 Intrinsic value vs. time value An option‟s intrinsic value is the amount by which the option is in-the-money. It is the amount that the option owner would receive if the option were exercised. An option has zero intrinsic value if it is at the money or out of the money, regardless of whether it is a call or a put option. An option‟s time value is the amount by which the option premium exceeds the intrinsic value and is sometimes called the speculative value of the option. For a particular option, the sum of these values equals the option's total value: Option value = intrinsic value + time value 8.6.5 Types of underlying assets An option contract must relate to an identifiable asset. Among the assets that can used are common shares, equity indexes, futures contracts, debt instruments, foreign currencies or commodities. These assets are known as underlying assets.
be
An option on futures is an option that uses a futures contract as the underlying asset supporting the option (a regular option contract is called an option on physical. With a call option on futures, when the option is exercised, the holder of the option will receive: i.
a long position in the underlying futures contract having the settlement price prevailing at the time the option is exercised; and
ii.
an unrealized profit that equals the settlement price minus the exercise price of the futures option; or
iii.
A realized profit that equals the settlement price minus the exercise price, if he chose to close the position (sell the futures contract).
The writer of the option will receive a loss which equals the future settlement price minus the exercise price. 8.7.6 Basic Option Strategies In this section, we shall consider some basic option trading strategies and when to use them. 1. Long Call Position Suppose you are bullish on ABC but instead of buying the stock, you decide to buy a call option on ABC stock with an exercise price of RM12.00 at 20 sen
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premium. What is the payoff to this long call position? (Note that this strategy gives investor an unlimited profit but limited losses to the premium paid) Stock Price
(P/L) Payoff
9.50 (.20) 10.00 (.20) 10.50 (.20) 11.00 (.20) 11.50 (.20) 12.00 (.20) 12.20 0 12.50 .30 13.00 .80 13.50 1.30 14.00 1.80 14.50 2.30 Payoff (P/L: Long Call Position (Outlook: Bullish)
A long call strategy is certainly superior to that of a long stock or long futures position in that the loss potential is now limited to the cost of the premium. At any stock price above RM12.20, the long call position makes profit. Assuming that the underlying ABC stock price is RM14.00, the profit to the long call position is RM1.80. The breakeven point for calls is the exercise price plus premium. 2. Short Call Position You are bearish to neutral about ABC stock. A call option on the stock at exercise price of RM12.00 is 20 sen. You decide to short the call. What is your pay off? Stock Price
(P/L) Payoff
9.50 10.00 10.50
.20 .20 .20 110
11.00 11.50 12.00 12.20 12.50 13.00 13.50 14.00 14.50
.20 .20 .20 0 (.30) (.80) (1.30) (1.80) (2.30)
Payoff (P/L): Short Call Position (Outlook: Neutral to Bearish)
Assuming that the underlying ABC stock price is RM14.00, the loss to the short call position is RM1.80. Maximum gain to the short call position is the premium. For calls at expiration: i.
The call holder will exercise the option whenever the stock‟s price exceeds the strike price.
ii.
The sum of the profits and losses of the buyer and seller of the call option is always zero. Option trading is a zero sum game » long profits = short losses. Call Option
Buyer (long) Seller (short) Breakeven
Maximum loss Premium Unlimited
Maximum gain Unlimited Premium X + premium
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3. Long Put Position You are bearish about ABC stock, rather than short the stock, you buy a put with exercise price of RM12.00 at a 15 sen premium. What is the payoff to this strategy? Stock Price
(P/L) Payoff
9.50 10.00 10.50 11.00 11.50 11.85 12.00 12.50 13.00 13.50 14.00 14.50
2.35 1.85 1.35 0.85 0.35 0 (0.15) (0.15) (0.15) (0.15) (0.15) (0.15)
Payoff (P/L): Long Put Position (Outlook: Bearish)
4. Short Put Position You are bullish to neutral about ABC stock. A put option on the stock at an exercise price of RM12.00 is selling for 15 sen. You decide to short the put. What is the payoff strategy? Stock Price
(P/L) Payoff
9.50 10.00 10.50 11.00
(2.35) (1.85) (1.35) (0.85) 112
11.50 11.85 12.00 12.50 13.00 13.50 14.00 14.50
(0.35) 0 0.15 0.15 0.15 0.15 0.15 0.15
Payoff (P/L): Short Put Position (Outlook: Neutral to Bullish)
For puts at expiration: i.
The put holder will exercise the option whenever the stock‟s price is less than the strike price.
ii.
The sum of the profits between the buyer and seller of the put option is always zero. Put Option
Buyer (long) Seller (short) Breakeven
Maximum loss Premium X − Premium
Maximum gain X − Premium Premium X − Premium
5. Protective put Protective put also known as portfolio insurance is a long share plus a long put. This is basically an investment management technique to protect a share portfolio from severe drops in value. With portfolio insurance, your downside losses are minimized while your upside potential is left alone.
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Portfolio Insurance – Illustration Suppose you had just gone long (purchased) one lot (100 units) of XYZ stock at a price of RM15.00 each for a total investment of RM1,500.00. You believe this stock has long term potential but wish to protect yourself from any short term downside movement in price. Suppose a 3 month, at the money put option on XYZ stock is being quoted at RM0.15 each or RM15 per lot (RM 0.15 x 100). The appropriate strategy to hedge the long stock position would be: Long 1, 3-month, XYZ Put @ RM0.15 Combine position: i. Long 1 lot, XYZ stock @RM15 ii. Long 1, 3-month XYZ Put @RM0.15 The table below shows the payoff to the long stock, long put and the combined position for a given range of stock prices at option maturity in three month. Stock Price at maturity
Value of long stock position
Profit/Loss to Long put position @ 0.15
Value of combined position at maturity
8.00 12.00 15.00 18.00 20.00
800 1,200 1,500 1,800 2,000
685 285 (15) (15) (15)
1,485 1,485 1,485 1,785 1,985
Notice that at prices below RM15.00, the long put becomes profitable and offsets the loss in the long stock position. For example, at a stock price of RM8.00, the long stock position is worth RM800; a loss of RM700 from the original stock value of RM1, 500. However, this loss is almost fully offset by the gain from the put option. The profit of RM685 from the put is arrived as follows: Proceed from Exercise of Puts Less cost of Stock delivered on Exercise Less Premium paid on Puts Profit form Puts
= RM1, 500 = (RM800) = (RM15) = RM685
At any price at or above RM15.00, the puts would obviously not be exercised. Thus the loss will equal to the premium paid.
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8.6.7 Options trading in Malaysia The Bursa Malaysia Derivatives Berhad is the only Malaysian exchange offering options contracts in Malaysia. Trading options on BMDB is as straightforward as trading futures. Bids and offers are entered into an automated system by exchange members and the transaction is executed when a match is made. 1. Index Options – FBMKLCI Options (OKLI) An option on an index can be thought of as the trading of a portfolio of shares that tracks the share market. Index options usually exclude dividend payments and voting rights and as such are not exact substitutes of ownership in the shares. Example The buyer of a call option on the FBMKLCI has the right to buy the index at the exercise price. Assume that the FBMKLCI is currently trading at 1,120 points. If the call option buyer exercises a FBMKLCI option with an exercise price of 1,100, he receives the difference in cash between the strike price (1,100) and the current index level (1,120) multiplied by RM100 (20 x RM100 = RM2,000) The seller of the same call will have to pay the difference between the strike price and the current index level. 2. Share options Share options are written based on the shares of the company. The number of shares will generally be based on the board lots traded on the exchange. The underlying shares on which options are traded on Bursa Malaysia Derivatives Berhad are the shares traded on the Bursa Malaysia. Share options do not give rise to the creation of new equity for the underlying company. The writer and seller of share options are not necessarily connected to the company. 8.7
Regulatory Framework and Structure of the Malaysian Derivatives Markets 8.7.1 Securities Commission (SC) The SC provides for the regulation of, and advises the Ministry of Finance on, all matters relating to the securities and futures industry. 8.7.2 Bursa Malaysia Derivatives Berhad In Malaysia, the sole exchange offering both futures and exchange-traded options is Bursa Malaysia Derivatives Berhad. In performing its duty, the exchange shall act in the public interest having particular regard to the need of the protection of investors. Like all futures exchanges, the basic functions of Bursa Malaysia Derivatives Berhad are: i. ii. iii. iv.
To provide facilities whereby buyers and sellers can meet to trade contracts. To ensure open and competitive trading. To set and enforce rules for operating in the futures market. To collect and disseminate market and price information. 115
The following products are currently traded on the Exchange: 1. Equity Derivatives i. ii. iii.
FBM Kuala Lumpur Composite Index Futures (FKLI). FBM Kuala Lumpur Composite Index Options (OKLI). Single Stock Futures (SSFs).
2. Commodity Derivatives i. ii. iii.
Crude Palm Oil Futures (FCPO). USD Crude Palm Oil Futures (FUPO). Crude Palm Kernel Oil Futures (FPKO).
3. Financial Derivatives i. ii. iii.
3-Month KLIBOR Interest Rate Futures (FBK3). 3-Year Malaysian Government Securities Futures (FMG3). 5-Year Malaysian Government Securities Futures (FMG5).
iv.
10-Year Malaysian Government Securities Futures (FMG10).
8.7.3 Bursa Malaysia Derivatives Clearing Berhad Bursa Malaysia Derivatives Clearing Berhad acts as the clearing house for contracts traded on markets operated by Bursa Malaysia Derivatives Berhad (BMDB). The clearing house is vital in the overall management of systemic risk in the market. Regulated under the Capital Markets and Services Act 2007 (CMSA), Bursa Malaysia Derivatives Clearing Berhad has established rules to govern its contractual relationship with member companies of Bursa Malaysia Derivatives Berhad. 8.7.4 Market Intermediaries – Futures Broker Like the stock broking companies, futures broker play a critical role in the futures industry as the link between the client and the futures market. The basic functions of a futures broker are as follows: i.
Advise clients on possible trading strategies.
ii.
Take orders from clients.
iii.
Execute transactions via WinScore.
iv.
Ensure margin payment is received from clients.
v.
Provide basic accounting records and transaction documents to clients.
vi.
Transact business as principal and arbitrage between markets.
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The main operations of a futures broking company usually include dealing or trading, accounts and contract departments because the futures broking business revolves around the buying and selling of derivative instruments.
Summary In this topic, we have briefly looked at the general concept of derivatives, specifically futures and options. We explained the difference between exchange traded and over-thecounter and discussed the role of derivatives instruments. We have also described the three major futures contracts in Malaysia, namely the crude palm oil futures contract, the KLCI futures contracts, and KLIBOR futures contracts. In addition to the futures, we have also illustrated and described the KLCI options contracts.
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Activity – Q&A 1. All of the following are characteristics of futures contracts EXCEPT: A. They are liquid. B. The clearinghouse is a party to every contract. C. They trade in a dealer (over the counter) market. D. The contract size is standardized. 2. All of the following are methods to close out a futures position EXCEPT: A. Delivery of the underlying commodity. B. Allowing the contract to expire without taking action. C. Engaging in an offsetting trade in the futures market. D. Through an exchange for physicals with another trader. 3. A finance manager of a large corporation was informed that the firm would require borrowing some funds in three months time. Current interest rates are based on the three-month KLIBOR rate of 8% per annum. As the finance manager expects interest rate to increase during this period, he decided to lock in the current interest rates. He can do so by: A. Buying KLIBOR futures contract. B. Buying and selling corresponding KLIBOR futures contract. C. Selling KLIBOR futures contract. D. Buying KLIBOR futures. 4. Which of the following statements about futures contract is NOT accurate? A. Equity futures are futures contract based on shares which are traded on Bursa Malaysia Derivatives Berhad (MDEX). B. The KLCI futures position can be closed through an exchange for physicals with another trader. C. The crude palm oil futures traded on MDEX are the only crude palm oil futures in the world. D. KLIBOR futures have a principal amount of RM1 million and are traded on MDEX.
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5. Which of the following option strategies is a long position option strategy? A. Writing a put option. B. Writing a call option. C. Buying a put option. D. Writing a naked call option. 6. A call option that is in the money: A. Has an exercise price less than the market price of the asset. B. Has an exercise price greater than the market price of the asset. C. Has a value greater than its purchase price. D. Is selling for more than its intrinsic value. 7. Describe how a futures position can be closed. 8. What is the underlying instrument of the KLIBOR futures?
9. Describe the protective put strategy.
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Suggested Answers to Activity. 1. C 2. B 3. C 4. B 5. C 6. A 7. A futures position may be closed out via three different methods. 1) Enter into an offsetting contract – given that the other side of your position is held by a clearing house, if you make an exact opposite trade to your current position, the clearing house will net your positions out leaving you with a zero balance. 2) Delivery – you can take physically delivery of the goods where delivery will be made according to contract specifications to the designated location or by making cash settlement for any gains or losses. 3) Exchange for physicals – find a trader with an opposite position to your own and deliver the goods and settle up off the floor of the exchange. Exchange for physicals are different from delivery in that the transaction is negotiated and settled off the exchange. 8. The underlying instrument of the KLIBOR futures is the Ringgit interbank time deposit in the Kuala Lumpur wholesale money market with a three month maturity on a 360-day year. 9. Protective put also known as portfolio insurance is a long share plus a long put. This is basically an investment management technique to protect a share portfolio from severe drops in value. With portfolio insurance, the downside losses are minimized while upside potential is left alone.
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Topic 9 Corporate Finance
Preview This topic provides the reader with an overview of Corporate Finance. Corporate Finance services are one of the key components of an Investment Bank in Malaysia. Participants will be able to comprehend the basic structure of a generic Unit in an operating Investment Bank. Topic Objectives At the end of this topic, you should be able to– i.
Discuss the advantages and disadvantages of public floatation exercise.
ii.
Describe the requirements to be complied with by applicants for listing on Bursa Malaysia Securities Berhad
iii.
Identify the functions of an M & A unit.
iv.
Discuss the typical process and structuring of an M & A.
v.
Understand the typical process of Divestitures.
vi.
Understand the financial evaluations of Divestitures.
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Corporate Finance – Mergers and Acquisitions (M&A) and Divestitures
9.1 Introduction In this topic, we will look at initial public offering of ordinary issues (IPOs), mergers and acquisitions (M&A) techniques and divestitures or demergers including equity carve-outs, spin-offs and split-ups. However, unlike the many references that you may find on the topic of M&A, defense tactics used in hostile takeovers will not be discussed here as most of these tactics are not applicable in the Malaysian context. 9.2 Initial Public Offering of Ordinary Issues (IPOs) There are several reasons why companies may wish to “go public”, i.e. to float its securities. On the other hand, there are also drawbacks. Public company status and listing is not always the most appropriate (or feasible) means of raising capital. Each company deciding to go public must weigh where the balance of advantage lies and decide whether the compromises involved are worthwhile. Advantages Access to equity capital The principal advantage of a public flotation is access to additional equity capital. Fund raised from the initial issue of securities are available to launch or expand operations, increase working capital or reduce borrowings. The establishment of a market for the company‟s securities and a broader shareholder base generally enhance its capacity for further equity capital raisings in order to satisfy its funding requirements without increasing its debt funding. Secondary market for shares The facility to resell on the secondary market is an attractive feature to shareholders who know they can readily sell their shares at a price determined by the market. The value of a listed company‟s shares tends to be enhanced by their liquidity and marketability, whereas the valuation and disposal of unlisted shares are more difficult. Heightened corporate image A further advantage of public company listing is the improved corporate image that results from the prestige and public exposure of listing on the stock exchange. This can be important for consumer sales- orientated companies and generally for other companies, as it will ultimately help stimulate growth in the company and attract new business. Attract key employees A listed company may be in a better position to attract and retain key personnel and other staff by offering shares or options as part of their remuneration package.
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Disadvantages Dilution of control Dilution of control of existing owners is an obvious disadvantage flowing from flotation. Depending on the extent of the dilution, there is the possibility of an increased risk of take over. Increased responsibility of directors Directors of a public company assume additional responsibilities and are legally obligated to act in the best interest of all shareholders. Costs There are explicit costs associated with floatation, both in terms of time and money. These include the initial costs of conversion to a public limited company, the costs of issuing a prospectus, underwriting fees, professional advisory fees, accounting and legal fees, listing fees, and other continuing expenses, such as the increased costs of producing annual reports Less control over the company’s direction Certain transactions to be carried out by the company may be subject to a vote of shareholders. In particular, if the controlling shareholders are interested in the transaction, they may not be able to vote to ensure that the proposed transaction is implemented. The controlling shareholder will be unable to vote in respect of their shares and the outcome will be dependent on the vote of other shareholders. 9.2.1 Listing and Flotation on Bursa Malaysia Securities Berhad Flotation or an initial public offering usually involves making offer or issue of securities to the public at large that are subsequently listed on the stock exchanges for the first time. This is known as an issue in the “primary market”. It is the official listing and quotation of securities for trading by the public on the stock exchange (known as the “secondary market”), which completes the process of flotation. To qualify to float the securities of a company on Bursa Malaysia Securities Berhad, the company must meet the various requirement of the SC as set out in its issues Guidelines and it must comply with the Listing Requirements of Bursa Malaysia Securities Berhad. The quantitative and qualitative requirements that are to be fully complied with by applicants for listing on the Main Market and ACE Market of Bursa Malaysia Securities Berhad are as follows:
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Table 7: Quantitative Criteria Aspect
Main Market
ACE Market
Three (3) Alternative Routes for Listing (a) Profit Test
Uninterrupted profit after tax
No minimum operating track record or
(“PAT”) of 3 - 5 full financial years
profit requirement
(“FY”), with aggregate of at least RM20 million; and PAT of at least RM6 million for the most recent full FY
(b) Market
A total market capitalization of at
Capitalisation Test
least RM500 million upon listing; and
-
Incorporated and generated operating revenue for at least 1 full FY prior to submission
(c) Infrastructure
Must have the right to build and operate an
Project
infrastructure project in or outside
Corporation test
Malaysia:-
-
with project costs of not less than RM500 million; and for which a concession or licence has been awarded by a government or a state agency, in or outside Malaysia, with remaining concession of licence period of at least 15 years Applicant with shorter remaining concession or licence period may be considered if the applicant fulfills the profit requirements under profit test IPO price Public Spread
Minimum RM0.50 each
No minimum
At least 25% of the Company's share
At least 25% of the Company's share
capital; and
capital; and
Minimum of 1,000 public
Minimum of 200 public shareholders
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shareholders holding not less than
holding not less than 100 shares each
100 shares each
Bumiputera Equity
Allocation of 50% of the public spread
Requirement*
requirement to Bumiputera investors on best effort basis**
No requirement upon initial listing.
Allocation on best effort basis** of 12.5% of their enlarged issued and paid-up share capital to Bumiputera investors: within 1 year after achieving Main Market profit track record or 5 years after being listed on ACE Market, whichever is the earlier
* Companies with MSC status, BioNexus status and companies with predominantly foreignbased operations are exempted from the Bumiputera equity requirement. ** Please refer to SC‟s website on the process of allocation on best effort basis. Table 8: Qualitative Criteria Aspect Sponsorship
Main Market Not applicable
ACE Market Engage a Sponsor to assess the suitability for listing Sponsors need to remain with the company for at least 3 years post listing
Core Business
An identifiable core business which it
Core business should not be holding of
has majority ownership and
investment in other listed companies
management control Core business should not be holding of investment in other listed companies Management
Continuity of substantially the same
Continuity of substantially the same
Continuity and
management for at least 3 full financial
management for at least 3 full financial
Capability
years prior to submission
years prior to submission or since its incorporation (if less than 3 full
For market capitalization test, since the
financial years)
commencement of operations (if less than 3 full financial years)
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Financial
Sufficient level of working
Sufficient level of working capital for
Position &
capital for at least 12 months;
at least 12 months
Liquidity
Positive cashflow from the operating activities; and No accumulated losses based on its latest audited balance sheet as at the date of submission
Lock-up Period
Promoters' entire shareholdings for six
Promoters' entire shareholdings for six
(6) months from the date of admission
(6) months from the date of admission, subsequent selling down with
Subsequent selling down with
conditions
conditions for companies listed under Infrastructure Project Corporation test Transaction with
Must be based on terms and conditions
Must be satisfactorily addressed
related parties
which are not unfavourable to the
before submitting any listing
company
application to the Exchange
All trade debts exceeding the normal
Sponsor must ensure all trade debts
credit period and all non-trade debts,
exceeding normal credit period and
owning by the interested persons to
all non-trade debts, owning by the
the company or its subsidiary
interested persons to the company or
companies must be fully settled prior
its subsidiary companies must be
to listing
fully settled prior to listing
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Table 9: The Listing Process
9.2.2 The Adviser Where a company plans to float its shares and raise funds by issuing or offering securities to existing shareholding and institutional investors, it generally appoints an investment bank which will act as its adviser to manage the flotation exercise, as well as act as an underwriter. By having the issue of securities underwritten, the company is guaranteed that: The amount of funds sought will be raised, as the underwriter at the offer/issue price will take up any shortfall of shares offered. The funds will be raised on agreed terms and conditions. The funds will be available at specified time. 9.2.3 Role of the Adviser The functions and responsibilities of an adviser include the following: Advising the company on the structure of the flotation scheme Managing the issue, e.g. preparing the timetable and overseeing the preparation of the prospectus Ensuring the company complies with the requirement of the securities laws, Issues Guidelines and Listing Requirement of Bursa Malaysia Securities Berhad. Making the necessary applications to the SC, Bursa Malaysia Securities Berhad and other regulatory authorities 127
Ensuring that prospective investors are well informed via the prospectus Ensuring that the company achieves the required spread of shareholders necessary to enable the securities of the company to be admitted for listing and quotation on Bursa Malaysia Securities Berhad Arranging sub-underwriters to share the risk of under-subscription of the securities offered to the public Taking up any shortfall of shares offered to the public (with sub-underwriters where appointed) In addition to investment banks, an applicant company relies on other advisers, including public accounting and law firms to provide professional advice. These advisers have a professional responsibility to satisfy themselves and based on all available information, ensure that the application is suitable for the specific proposal being submitted for the consideration of the SC. 9.3 Mergers and Acquisitions A merger can be defined as the combination of two companies of roughly equal size, pooling their resources together into a single business. The shareholders/owners of both premerger companies have a share in the ownership of the merged business and the top management positions after the merger. In contrast, an acquisition, or take-over, occurs when one company acquires from another company either a controlling interest in the company‟s shares or a business operation and its assets. The management control of the company, or business, will also be taken over. The distinction between mergers and take-over is not always clear. The techniques used for mergers are often the same as those used in take-over. As the term M&A is used quite loosely, it is often not differentiated. The differences between the two relate mainly to: (i) (ii) (iii)
The relative size of the individual companies; Management control of the combined business; and Ownership of the combined business.
However, based on the newly introduced Malaysian Accounting Standard (MASB 21) on business combination, a merger will have to satisfy the following criteria: i. Prior the combination, each of the combining enterprises must have been have an autonomous and independent business enterprises; ii. The fair value of one enterprise is nor significantly different from that of the other enterprise. iii. Not party to the combination can be identified as the acquirer or aquiree, either by its own board or management or by that of the other party to the combination; iv. All parties to the combination, as represented by the Boards of Director or their appointees, participate equally in establishing the management structure for the combined enterprise and in selecting the management personnel, and such decision 128
are made on the basis of consensus between the parties to the combination rather than virtue of exercise of voting rights; v. The combination is effected in a single transaction or completed within one year after its initiation and there are no further conditional provisions; vi. The substantial majority , if not all, of the voting equity shares of the combining enterprises are exchanged or pooled; vii. The shareholders of each enterprise maintain substantially the same voting rights and interest in the combined enterprise, relative to each other after the combination as before and the voting rights are immediately exercisable; and viii. There have been no separate deals or plans by any of the combining enterprises to change the composition of the shareholdings or the voting or distribution rights, or to dispose of major assets within a period of two years the date of the combination. 9.3.1 Typical M&A process The process of acquiring a company would normally start with a search for potential acquisition candidates (or in the case of, mergers partners). Prior to approaching the target company, the management of the acquiring company should have an indicative value that they would pay for the assets to be acquired. Negotiation would normally commence as soon as the management (or owners) of the target company is interested to deal. However, there are circumstances where approvals from regulatory authorities‟ would have to be obtained for the effected party to commerce negotiation. An example is when a financial institution is a party to the transaction; hence, the prior approval of Bank Negara Malaysia would have to be obtained. The diagram in the next page outlines the process of a typical M&A.
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Figure 3: Typical M&A Process Search for suitable candidate Identify target Screening process
Identify target
Make approach
Negotiation
Signing of conditional sale and purchase agreement
Due diligence
Unsatisfactory
Satisfactory
Not agreed
Abort transaction
Agreed
Renegotiation
Not approved
Application to authorities
Approvals obtained Implementation
Because the ultimate aim of M&A is to increase shareholders value, the decision to undertake an M&A should only be made after considering the factors impacting shareholders value which include: 130
i.
iii.
- What would the acquisition cost be? - What is the highest price payable for the target company? Shareholder factor - Would the acquisition be regarded as desirable, by the acquiring company‟s shareholders and the stock market in general? Purchase consideration - What is the mode of consideration?
iv.
Other factors
ii.
Price factor
- What are the potential integration, management and business issues arising from the transaction?
Companies contemplating an M&A should at least consider the above factors. Some of these factors are discussed in further detail in sub-section 3.3. 9.3.2 Financing for M&A The mode of consideration for M&A is typically in any of the following form: i. ii. iii. iv.
Cash; Share; Debt paper; or Combination of the above.
Cash Acquiring companies generally prefer to issue shares and/ or debt papers (these instruments were discussed in previous topics) as consideration. However there are instances where the acquiring company would prefer a cash acquisition. This may be due to the following reason: i. ii. iii.
iv.
Cash acquisitions are generally quicker to complete; Cash acquisitions may be cheaper as it avoids the cost associated with a new share issue; Shareholders of the acquiring company may not be appreciate their shareholdings being diluted by a substantial new issue of shares to the vendor as a result of the acquisition; and The company has surplus cash for investment.
9.3.3 Structuring an M&A Generally, all corporate restructuring exercises share a common objective of creating shareholder value. A strategic approach should be adopted in structuring an M&A, which begins with the strategic planning stage that is not shown in the above flowchart. This stage involves the formulation of corporate strategy by the top management of the company. Competitive analysis would have to be conducted to identify synergistic inter-relationships between the company‟s businesses and other businesses that it may 131
wish to enter. Such relationships should correspond to the company‟s corporate strategy and should represent opportunities to create a competitive advantage. The table below shows how possible corporate strategies are matched with corporate objectives: Result of position assessment Operating at maximum production capacity Lacking key customer in a target sector Need to expand the product range Need to increase market share
Bridging the gap Acquire a company making similar products operating substantially below capacity. Acquire a company with the right customer profile Acquire a company with a complementary product range Acquire the right competitor
In the event that the company is able to indentify distinctive synergies in the acquisition candidate, then the candidates would be worth more to the buying company as compared to the selling company or other competitive bidders who cannot exploit such synergies. In searching for suitable candidates, the company should develop a list of good acquisition candidates. More than one source should be used to build up a profile of each potential target. Further information on the potential target should be gathered and studied. Information sources include: i. ii. iii. iv. v. vi.
Analyst reports (for public-listed companies) Trade journals and publications; Trade associations; Research studies; Business contacts; M&A professionals.
Depending on the industry being targeted, other types of information sources may be exploited. In the screening stage, candidates should be ranked in order of desirability and candidates that do not meet the company‟s requirements should be eliminated. The screening process may be carried out in two stages: i. ii.
Eliminating candidates that would not meet strategic requirement, such as size, geographical area, product mix, market share; and Financial evaluation.
Once the best candidates have been identified, more detailed analysis for each will be initiated. The synergistic inter-relationships identified in the earlier stage are then 132
simulated with each of the identified candidates to see if the synergy is possible and realizable. In the financial evaluation stage of the acquisition, the company will try to determine: i. ii. iii. iv.
The maximum price payable for the target company; Principal risk areas; Cash flow and balance sheet implications of the acquisition; and The best way of structuring the acquisition.
To estimate the maximum acceptable purchase price of the target company, the standalone value of the target and the value of acquisition benefits must first be assessed. Thus, the maximum acceptable purchase price can be computed by aggregating the stand-alone value of the target and the value of acquisition benefits. From this equation, if the buyer pays the maximum acceptable purchase price, we note that the entire value of the acquisition benefits goes to the seller. Alternatively, if the actual price paid for the acquisition is lower than the maximum acceptable purchase price, the difference between the two will be the value created for the buyer. However, there are times when a buyer is willing to pay even more than the maximum acceptable purchase price. For instance, when an acquisition is viewed as integral part of a long-term global strategy and the long term benefits indirectly arising from the acquisition may not be quantifiable and have not been incorporated when estimating the maximum acceptable purchase price. In such cases, the value created by the implementation of the overall strategy should be considered. The final step would be for the acquiring company to conduct a self-evaluation and to assess how its value is affected by each of the different candidates and acquisition options. Self-evaluation is an important part of the restricting process which is often omitted. Advantages of self-evaluation are, it: i. ii. iii.
Provides management and Board of Directors with a base for responding quickly and responsibly; Highlights the need for divestment or other restricting opportunities; and Offers the company a basis for assessing the competitive advantages of a cash offer versus a share exchange offer.
After considering the aforesaid factors, the acquisition candidates are then narrowed down to the acquisition target. The management of the buying company will then approach the target company. If the parties of the target company are interested in exploring the acquirer‟s proposal, negotiations will commence. The success of negotiations will depend to a large extent on the quality of the research done on the target company in the earlier stages.
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9.4 Divestitures Mergers and acquisitions are not always good strategies for a business. These are times when a demerger is preferred. A demerger (the opposite of merger) involves divestures. It is the splitting up of a corporate body into two or more separate and independent bodies. Some of the reasons for divestitures/demergers could be: i. ii. iii. iv.
A subsidiary/associate/investment is not adding value or eroding value. The buyer may be the management of the subsidiary, i.e., management buyout; A subsidiaries/associate/investment does not or longer fits in with the group‟s strategic plan; Subsidiaries/associates/investment with high risk could be sold to reduce the business risk of the group as a whole; and To profit from the sale of the subsidiaries/associate/investment.
In Malaysia, divestitures are more commonly known as disposals. Disposals by a corporation may be in the form of fixed assets such as plant and equipment, land and properties, investment, interest in associates and subsidiaries or an entire division of the company which could comprise all the mentioned assets. When a company decides to divert part of its operations, it will try to get the highest value by selling off the business unit, or selling individual assets. Disposals/divestures are normally to third party and may be structured in several ways as follows: i. ii. iii. iv. v.
Full disposal; Equity carve-outs; Spin-offs; Splits-offs; and Split-ups.
These methods of divesture are described in the ensuing sections. As in an acquisition, the value of the identified assets is important to the entire restructuring. To arrive at the value, the methods used are similar to the valuation methods used in valuing an acquisition target. Even though similar valuation methods are used by both acquiring and disposing companies, the result may be different as different assumptions may have been used. Moreover, the needs and perceptions of both parties are different. A company contemplating a divesture must evaluate the financial effects of its decision. Failure to do so may lead to the following potential problems: i. ii. iii. iv.
Economies of scale may be lost; The post demerger group will have lower turnover, profits and status than the group before the demerger; As a result of (i) and (ii) above, there may be higher overhead costs as a percentage of turnover; and Vulnerability to take-overs may increase as the size of the group decreases. 134
9.4.1 Typical divestitures process. A typical divestiture process begins with the management of the parent company conducting a thorough financial analysis of the various alternatives available for it to increase shareholders value. The restricting plan formulated and would point towards a divesture and cover details of the assets to be disposed and those to be retained other issues such as retention of employees and cost of restricting (e.g. retirement/retrenchment benefits for employees) should also be considered. Buyers of the assets would need to be identified and contacted. This followed by the negotiation process. In the case of a public-listed company, there are additional regulatory requirements imposed on the listed company. The company is required to make the relevant announcement at appropriate time and is subject to compliance with the Listing Requirements of the Bursa Malaysia Securities Berhad and SC Guidelines. The diagram on the next page depicts the typical divestiture process. Figure 4: Divestiture Process Restricting decision by the Board of Directors (“BOD”)
Formulate a restructuring plan Board of Directors approves the restructuring plan which includes divestitures
Identify buyer
Negotiation
Signing of sale & purchase agreement
Shareholders‟ and regulatory approvals. 135 Completion of deal.
9.4.2 Financial evaluation of divestures The following steps form a typical financial evaluation process for divesture: Figure 5: Financial Evaluation Process Step 1 Estimate after tax cash flow
Step 2 Determine business‟s discount rate
Step 3 Calculate present value of after tax cash flow (v)
Step 4 Deduct market value of business‟s liabilities (L) (v)-(L)
Step 5 Compare divestiture proceeds (P) with net value from step 4
Step 6 Decision making
The after-tax cash flows of the business should be estimated after taking into consideration the effects of the disposal on the cash flow of the parent company (in the event that the activities of the parent company are closely related to the subsidiary/ asset to be disposed). Thereafter, the present value of the cash flow would be calculated based on a discount rate after taking into consideration the risk associate with the business. A good proxy for the discount rate would be the cost of capital of other firms that are in the same business and similar sale. In step 4, the market value of the business‟ liabilities (L) is deducted from the present value (V) of the cash flow from the asset. The value derived here is then compares to divesture proceeds (P) to be obtained from the sale. From a financial standpoint: i. ii.
If P > (V-L), the parent company should sell the business; and If P < (V-L), the parent company should keep the business.
9.4.3 Equity carve-out Equity carve-out is a term used for the sale of an equity interest in a subsidiary to an outside party. This is normally a substantial stake. Companies undertake equity carveout for various reasons. Some of the more common reasons are: i. ii. iii. iv.
As financing technique i.e. to raise funds; To reduce exposure to a riskier line of business. Corporate down-sizing; and Subsidiary is a financial drain on the group.
As equity carve-outs involve an outside party, a new set of shareholders would be introduced to the subsidiary whereas, in spin-off, the shareholders of the spun-off company will be the same shareholders as the parent company. Another difference is that the parent company in an equity carve-out will receive cash inflow when the purchase consideration is paid in cash whereas in a spin-off, the parent company would receive shares in the spun-off company. The shares in the spun-off company would then distribute to the shareholders of the parent company. The buyer normally would 136
require due diligence to be carried out on the asset. In Malaysia, next to full disposal equity cave-outs are common than the other forms of divestures. 9.4.4 Spin-off A large group that does not wish to continue to run or own a subsidiary may want to spin it off. There could be a variety of reasons why this is done; one example is the lack of financial resources to develop the business. In a spin-off, a shell company („New co”) would be incorporated and the assets to be hived off would be transferred to new-co by the parent company. The consideration to parent of the spun-off company would be in the form of shares in new-co. These shares would then be distributed on a pro-rata basis to the shareholders of the parent the spunoff entity. In this spin-off structure, the parent company does not receive any cash flow from transaction. Figure 6: Spin-off Structure Shareholders
Shareholders Shareholders
100%
Parent company distributes new- co shares to shareholders
% Consideration issue ordinary shares
Parent company 100%
%
100%
Inject assets
%
Parent company
Parent company100%
%
New co
100%
New co
100%
% New-co/ spun off company
Although spun-off companies have the same shareholders as their parent company, the management of these companies is normally different. Spin-offs may improve efficiency and streamline management within the new structure. The value of the separated part of the business may be easier seen as they are no longer hidden within a conglomerate. In addition, after spin-off, shareholders have opportunities to adjust the proportions of their shareholdings between the different companies created to match their investment objectives. In the event that a series of spin-offs is carried out by the parent company leading to entire group being spun off, the result is a split-up. A split-up is where some of the shareholders of the parent company are given shares in a division in exchange for their shares in the parent company.
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Summary In this topic, we looked at the mechanisms and techniques of initial public offerings, mergers and acquisitions (M&A) and divestitures/demergers including equity carve-outs, spin-offs and split-ups. Specifically, the typical process and structure of each of the above mentioned corporate exercises were discussed.
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Activity – Q&A 1. What factors might affect the choice between cash or share consideration for acquisitions? A. Shareholding structure of the acquirer. B. Cash flow of Acquiree Company. C. Profit of the acquiree company. D. Compositions of the Board of Directors. 2. All of the following are ways to structure a divestiture EXCEPT: A. Equity carve-out. B. Spin-off. C. Leveraged buy-out. D. Full disposals. 3. Which of the following statements is TRUE in relation to a spin-off: A. Spun-off companies normally have the same management team as the parent company. B. Spin-offs provide the parent company with positive cash flows. C. Spin-offs are the same as equity carve-out. D. Spun-off companies have the same shareholders as their parent companies. 4. List down three reasons why a company may wish to “go public”. 5. What are the differences between mergers and take-over‟s? 6. List down three reasons for divestitures/demergers.
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Suggested Answers to Activity 1. B 2. C 3. D 4. The differences between the mergers and take-overs relate mainly to: 1) The relative size of the individual companies; 2) Management control of the combined business; and 3) Ownership of the combined business. 5. The reasons include (choose three): 1) 2) 3) 4)
Access to equity capital. Secondary market for shares. Heightened corporate image. Attract key employees.
6. Some of the reasons for divestitures/demergers could be: 1) A subsidiary/associate/investment is not adding value or eroding value. The buyer may be the management of the subsidiary, i.e., management buyout; 2) A subsidiaries/associate/investment does not or longer fits in with the group‟s strategic plan; and 3) Subsidiaries/associates/investment with high risk could be sold to reduce the business risk of the group as a whole.
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Topic 10 Risk Management in Investment Banking. Preview In this topic, we will provide the reader with an overview of risk management in investment banking. The primary function of risk management is to protect shareholders capital and at the same time ensuring that the firm takes on the risk required to generate a reasonable return on capital. Topic Objectives At the end of this topic, you should be able to– i.
Define risk management,
ii.
Describe the risk management process,
iii.
Discuss the types of risks faced by investment banks,
iv.
Discuss the role and responsibilities of the risk management unit,
v.
Discuss risk measurement techniques,
vi.
Describe the Basel II Accord.
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Risk Management in Investment Banking. 10.1 Introduction Risk arises when there is a possibility of more than one outcome and the ultimate outcome is unknown. Risk can be defined as the variability or volatility of unexpected outcomes. It is usually measured by the standard deviation of historic outcomes. Though all businesses face uncertainty, investment banks face some special kinds of risks given their nature of activities. 10.2 What is Risk Management? There is a difference between risk measurement and risk management. While risk measurement deals with quantification of risk exposures, risk management refers to “the overall process that a financial institution follows to define a business strategy, to identify the risks to which it is exposed, to quantify those risks, and to understand and control the nature of risks it faces”. The primary function of risk management is to protect shareholders capital and at the same time ensuring that the firm takes on the risk required to generate a reasonable return on capital. 10.3 Classifications of Risks There are different ways in which risks are classified. One way is to distinguish between business risk and financial risks. Business risk arises from the nature of a firm‟s business. It relates to factors affecting the product market. Financial risk arises from possible losses in financial markets due to movements in financial variables. It is usually associated with leverage with the risk that obligations and liabilities cannot be met with current assets. Another way of decomposing risk is between systematic and unsystematic components. While systematic risk is associated with the overall market or the economy, unsystematic risk is linked to a specific asset or firm. While the assetspecific unsystematic risk can be mitigated in a large diversified portfolio, the systematic risk is non-diversifiable. Parts of systematic risk, however, can be reduced through the risk mitigation and transferring techniques. 10.4 The Risk Management Process The concept behind a risk management process is quite simple. It is the process of anticipating and analyzing risks and coming up with effective and efficient ways of managing as well as eradicating them. Below are the different steps that are involved in this process: i. Risk identification. ii. Risk assessment and evaluation. iii. Risk control and mitigation. iv. Monitor/ review the risk management process. 142
1) Risk Identification The first step involves identifying risks. Certain risks could be quite obvious whereas a few others may need a certain amount of anticipation. Though all businesses face uncertainty, investment banks face some special kinds of risks given their nature of activities. The nature of some of these risks is discussed below: A. Market Risk Market risk is defined as any fluctuation in the value of the portfolio resulting from changes in market prices, such as interest rates, exchange rates and share prices. Market risk results from trading activities that can arise from customerrelated businesses or from proprietary positions. Market risks can result from macro and micro sources. Systematic market risk results from overall movement of prices and policies in the economy. The unsystematic market risk arises when the price of the specific asset or instrument changes due to events linked to the instrument or asset. Volatility of prices in various markets gives different kinds of market risks. Thus market risk can be classified as equity price risk, interest rate risk, currency risk, and commodity price risk. While all of these risks are important, interest rate risk is one of the major risk that banks have to worry about. The nature of this risk and currency risk is briefly explained below. Interest rate risk is the chance that changes in interest rates will adversely affect a security‟s value. As interest rates change, the prices of many securities fluctuate; they typically decrease with increasing interest rate, and they increase with decreasing interest rates. Most of investment vehicles are subject to interest rate risk. Although fixed income securities are most directly affected by interest rate movement, they also affect other long-term investment vehicles such as common stock and mutual fund. Exchange rate or currency risk is the variability of returns caused by currency fluctuations. Return received from investment abroad may reduce in value due to weak currency exchange. B. Credit Risk Credit and counterparty risk is defined as the possibility of losses due to an unexpected default or a deterioration of creditworthiness of a business partner. Credit risk arises primarily from lending activities through loans as well as commitments to support clients‟ obligations to third parties, i.e. guarantees. In sales and trading activities, credit risk arises from the possibility that the counterparties will not be able or willing to fulfill their obligation on transactions on or before settlement date. In derivatives activities, credit risk arises when counterparties to derivative contracts, such as interest rate swaps, are not able to or willing to fulfill their
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obligation to pay us the positive fair value or receivable resulting from the execution of contract terms. C. Liquidity Risk Liquidity risk arises due to insufficient liquidity for normal operating requirements reducing the ability of banks to meet its liabilities when it falls due. This risk may result from either difficulties in obtaining cash at reasonable cost from borrowings (funding or financing liquidity risk) or sale of assets (asset liquidity risk). One aspect of asset-liability management in the banking business is to minimize the liquidity risk. While funding risk can be controlled by proper planning of cash-flow needs and seeking newer sources of funds to finance cash shortfalls, the asset liquidity risk can be mitigated by diversification of assets and setting limits of certain illiquid products. D. Operational Risk Operational risk is not a well-defined concept and may arise from human and technical errors or accidents. It is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and technology or from external events. While people risk may arise due to incompetence and fraud, technology risk may result from telecommunications system and program failure. Process risk may occur due to various reasons including errors in model specifications, inaccurate transaction execution, and violating operational control limits. Due to problems arising from inaccurate processing, record keeping, system failures, compliance with regulations, etc., there is a possibility that operating costs might be different from what is expected, affecting the net income adversely. 2) Risk Assessment and Evaluation This is the next step as part of the risk management process. Once all the risks have been identified, it is time to assess and evaluate each one of them. Risk assessment or analysis should be done both qualitatively as well as quantitatively. Determine how big a threat each risk is, what could be its consequence, its impact, etc. Each risk will have a likelihood factor i.e., a probability factor. On the basis of its impact and its likelihood factor, the bank can prioritize different risks as serious, moderate, mild, etc Risk evaluation basically involves comparing the identified and analyzed risks with the bank's preset goals and objectives. The bank can then choose to grade risks and decide the future course of action to be taken based on how severely the risk is likely to impact their goals, objectives and targets. 3) Risk Control and Mitigation The next step involves preparing a risk control and mitigation plan. Risk control and mitigation planning includes the specifics of what should be done, when it should be
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accomplished, who is responsible, and the resources required to implement the risk mitigation plan. The intent of risk mitigation planning is to answer the question: What is the best mitigation approach? For each root cause or risk, the type of mitigation must be determined and the details of the mitigation described. A person or group that will have responsibility for addressing each risk will be identified, and the benefit of implementing the risk mitigation plan is determined for each risk. Once alternatives have been analyzed, the selected mitigation option should be incorporated into existing program/project plans or documented separately as a risk mitigation plan. An overall risk mitigation plan is developed for the project/task to implement the individual risk mitigation plan for each particular risk, and contingency plans are developed for selected critical risks in case the impact of the risk is realized. 4) Monitor/ Review the Risk Management Process This is not the next step as such; rather it is something that happen on a continuous basis at all stage of the risk management process. The intent of risk monitoring/tracking is to ensure successful risk mitigation. It answers the question “How are things going?” by: i. ii. iii. iv.
Communicating risks to all affected stakeholders. Monitoring risk mitigation plans. Reviewing regular status updates. Alerting management as to when risk mitigation plans should be implemented or adjusted. Risk monitoring is the activity of systematically monitoring and reviewing the performance of risk mitigation actions. It feeds information back into the other risk activities of identification, analysis, mitigation planning, and mitigation plan implementation. Risks are updated in the Actions/Issue/Risk log and are tracked until closure. The key to the monitoring activity is to establish a management indicator system. It should be designed to provide early warning when the likelihood of occurrence or the severity of consequence exceeds pre-established thresholds/limits or is trending toward exceeding pre-set thresholds/limits so timely management actions to mitigate these problems can be taken. 10.5 Role and Responsibilities of the Risk Management Unit The role of the risk management unit is to provide oversight and management of all risks in the firm, and to ensure that the risk management process is in place and functioning, and that there is an on-going process to continuously manage the bank‟s risks proactively. Duties and Responsibilities: i.
To review, assess and recommend strategies, policies and risk tolerance relating to the management of the bank‟s risk for board approval. 145
ii.
To ensure that the risk policies and procedures are aligned to the business strategies and risk return directions of the board.
iii.
To review, assess and ensure that there is adequate framework for risk identification, risk measurement, risk monitoring and control, and the extent to which these are operating effectively.
iv.
To ensure that infrastructure, resources and systems are in place for risk management i.e. ensuring that the staff responsible for implementing risk management systems performs those duties independently of the bank‟s risk taking activities.
v.
To ensure that there is a consistent risk management standard and practices, and a coordinated process of making and managing risk on an independent firm‟s wide risk management framework.
vi.
To keep the board informed of the bank‟s risk profile.
vii.
To review and report to the board, management‟s periodic reports on risk exposures, risk portfolio composition, risk management activities, and overall bank-wide risks under stress scenario.
10.6 Risk Measurement Techniques Many risk measurement and mitigation techniques have evolved in recent times. Some of these techniques are used to mitigate specific risks while others are meant to deal with overall risk of a firm. In this section we outline two essential measurement techniques used to manage and measure market risk. 10.6.1 Value at Risk. Value at Risk or VAR measures the expected loss of an investment over a given horizon under normal market conditions at a given confidence level. For example, a VAR of RM1 million for one day at a 5 percent probability means that the firm would expect to lose at least RM1 million in one day 5 percent of the time. Some prefer to express such a VAR as a 95 percent probability that a loss will not exceed RM1 million. In this manner, the VAR becomes a maximum loss with a given confidence level. The significance of a RM1 million loss depends on the size of the firm and its aversion to risk. But on thing is clear from this probability statement: a loss of at least RM1 million would be expected to occur once every 20 trading days, which is about once per month. The basic idea behind VAR is to determine the probability distribution of the underlying source of risk and to isolate the worst given percentage of outcomes. Using 5 percent as the critical percentage, VAR will determine the 5 percent of outcomes that are the worst. The performance at the 5 percent mark is the VAR.
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In a normal distribution, a 5 percent VAR occurs 1.65 standard deviations from the expected value. A 1 percent VAR occurs 2.33 standard deviations from the expected value. The figure next page illustrates the principle behind VAR when the distribution of the portfolio change in value is continuous. Figure 7
Methods of estimating VAR There are three methods of estimating VAR. i) Parametric Method The parametric method, also called the variance-covariance method assumes a normal distribution and uses the expected value and variance to obtain the VAR. Since the method is implicitly based on the assumption of a normal distribution, it is only valid for traditional assets and linear derivatives. If the portfolio contains options, the assumption of a normal distribution is no longer valid. Option returns are highly skewed and the expected return and variance of an option position will not accurately produce the desired result. We illustrate the parametric method with an example. Suppose a portfolio manager holds a portfolio that is worth RM32 million with an expected return of 11.5 percent and a standard deviation of 14.25 percent.
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Now let us calculate this portfolio‟s VAR at a 5 percent level for one week. First we must convert the annualized expected return and standard deviation to weekly equivalents. This is done by dividing the expected return by 52 (number of weeks in a year) and dividing the standard deviation by the square root of 52, which is 7.21. This gives us 0.115/52 = 0.0022 and 0.1425/7.21 = 0.0198. Under the assumption of a normal distribution, the return that is 1.65 standard deviations below the expected return is: 0.0022 – 1.65(0.0198) = –0.0305 The portfolio would be expected to lose at least 3.05 percent 5 percent of the time. VAR is always expressed in dollars, so the VAR is RM32,000,000(0.0305) = RM976,000 in one week 5 percent of the time or one out of twenty weeks. ii) Historical Method The historical method estimates the distribution of the portfolio‟s performance by collecting data on the past performance of the portfolio and using it to estimate the future probability distribution. This method uses actual value data from a historical period to determine the VAR. Obviously it assumes that the past distribution is a good estimate of the future distribution which is not necessarily so. The main advantage of the historical method is that it is appropriate for all types of instruments, linear and non-linear since distribution assumptions are not required. iii) Monte Carlo Simulation Method The Monte Carlo simulation method is based on the idea that portfolio returns can be fairly easily simulated. To obtain the VAR, Monte Carlo simulation generates random outcomes based on an estimated probability distribution. Monte Carlo simulation is probably the most widely used method by sophisticated firms. It is the most flexible method because it permits the user to assume any known probability distribution and can handle relatively complex portfolios; however, the more complex the portfolio the more computational time required. Indeed Monte Carlo simulation is the most demanding method in terms of computer requirements. Nonetheless, the vast improvements in computer power in recent years have brought Monte Carlo simulation to the forefront in risk management techniques. 10.6.2 Stress Testing VAR measures market risk in a normal market environment, while stress testing measures market risk in an abnormal market environment. In addition to estimating VAR, a risk manager will often subject the portfolio to a stress test, which determines how badly the portfolio will perform under some of the worst and most unusual circumstances. Consider the Asian financial crisis in 1997 where a portfolio can lose up to fifty percent of its value. Although that kind of event is extremely rare, a risk manager might test the firm‟s portfolio tolerance for such an event happening again. If the performance is tolerable, then the portfolio risk is assumed to be acceptable. Stress 148
testing can be quite valuable as a supplement to VAR and other techniques of risk management. Yet, stress testing has its own criticisms, including the fact that it places a tremendous emphasis on highly unlikely events. 10.7 Basel Capital Accord The Basel Committee for Banking Supervision – an international standard setting body was established by the Central Bank Governors of the Group of Ten Countries at the end of 1974. The Committee's members now come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accord or Basel I. This system provided for the implementation of a credit risk measurement framework with the aim to establish a minimum capital standard by the end of 1992. In 1996 the Basel I Accord was amended also to require capital for market risks. In January 2001 The Basel Committee launched a document commonly referred to as the Basel II Accord to ensure that any large company dealing in banking will have enough ready financial resources to cover all the risks it could face. Basel II also requires that details of their risks, capital and risk management practices be published by these corporations to improve transparency, comparability and business disciplines internationally. The Basel II Accord comprises of three pillars, namely, capital adequacy, supervisory review process and market discipline. Basel II Document in Summary 1. The First Pillar – Capital Adequacy Requirements a. The Committee allows banks a choice in calculating their capital requirements for credit risk. One method is the standardized approach basis, supported by external credit assessments. The other is an internal rating based [IRB] system subject to the clear approval of the bank‟s management. b. Considerations must include risk weighting, net of specific provisions, on the bank‟s book exposures. 2. The Second Pillar - Supervisory Review Process The five main features of the Supervisory Review Process are as follows: a. Board and senior management oversight; b. Sound capital assessment; c. Comprehensive assessment of risks; d. Monitoring and reporting; and e. Internal control review. 3. The Third Pillar - Market Discipline 149
Market discipline disclosure requirements complement the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2). Such disclosures will allow market players to assess capital adequacy of the bank and also provide comparability with other banks. At the same time it should reflect assessment and management of risk by senior management.
Summary In this topic we looked at the risk management in investment banking. We briefly discussed the classifications of risks before describing the risk management process. We looked at the risk measurement techniques, specifically the VAR and stress testing techniques. We also provide the reader with the role and responsibilities of the risk management unit before ending this topic by describing the Basel Capital Accord.
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Activity – Q&A 1. All of the following statements are true EXCEPT: A. Risk measurement is part of the risk management process. B. Credit risk is also known as default risk C. Liquidity risk arises primarily from changes in market prices. D. Operational risk may arise from human and technical errors or accidents 2. All of the following are methods for estimating VAR EXCEPT: A. The parametric method B. The historical method C. Monte Carlo simulation method D. Stress Testing 3. What is the primary function of risk management? 4. Define the following: a) Market risk b) Credit risk c) Operational risk 5. List three duties and responsibilities of the risk management unit. 6. What is the difference between VAR and Stress testing?
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Suggested Answers to Activity 1. C 2. D 3. The primary function of risk management is to protect shareholders capital and at the same time ensuring that the firm takes on the risk required to generate a reasonable return on capital. 4. a) Market risk is defined as any fluctuation in the value of the portfolio resulting from changes in market prices, such as interest rates, exchange rates and share prices. b) Credit risk is defined as the possibility of losses due to an unexpected default or a deterioration of creditworthiness of a business partner. c) Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and technology or from external events 5. Duties and responsibilities of the risk management unit (choose three): i.
To review, assess and recommend strategies, policies and risk tolerance relating to the management of the bank‟s risk for board approval.
ii.
To ensure that the risk policies and procedures are aligned to the business strategies and risk return directions of the board.
iii.
To review, assess and ensure that there is adequate framework for risk identification, risk measurement, risk monitoring and control, and the extent to which these are operating effectively.
iv.
To ensure that infrastructure, resources and systems are in place for risk management i.e. ensuring that the staff responsible for implementing risk management systems performs those duties independently of the bank‟s risk taking activities.
v.
To ensure that there is a consistent risk management standard and practices, and a coordinated process of making and managing risk on an independent firm‟s wide risk management framework.
vi.
To keep the board informed of the bank‟s risk profile.
vii.
To review and report to the board, management‟s periodic reports on risk exposures, risk portfolio composition, risk management activities, and overall bank-wide risks under stress scenario.
6. VAR measures market risk in a normal market environment, while stress testing measures market risk in an abnormal market environment.
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Topic 11 Financial Statement Analysis
Preview In this topic, we will look at how to analyze financial statements and measure the performance of a company. Financial analysis is important because the information derived is useful and important to strategic decision making. Topic Objectives At the end of this topic, you should be able to:– i.
explain the objective of financial analysis
ii.
Recognize how financial statements are used to assess company performance.
iii.
Describe the three principal financial statements, i.e. the balance sheet, income statement and cash flow statement and type of information contained in them.
iv.
Discuss and illustrate the techniques of financial statement analysis, namely cash flow analysis and ratio analysis.
v.
Illustrate the use of ratios to gain insights into a company‟s liquidity, operating performance, growth potential, financial risk and market performance.
vi.
Discuss the limitation of ratio analysis.
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Financial Statement Analysis
11.1 Introduction The ultimate goal of a corporation is to allocate resources efficiently so that shareholder value is maximized. Given this, the question is how senior executives do, and how investors of a corporation measure the organization‟s progress in meeting this goal. In other words, what is a measure of corporate financial performance that can be used to gauge a company‟s progress in maximizing shareholder value? Traditionally, the most direct measure of financial performances is the company‟s share price. However, the use of share prices may not allow the manager to be effective in assessing past performance of the company because they also reflect future expectations of the company. In fact, share prices are not necessarily responsive to the actions of executives of the company. A good performance measure must be responsive to management‟s action and decisions. Good performance measurement is also important in determining the compensation for managers, which should ultimately be tied to changes in shareholder value. 11.2 Objective of Financial Analysis The main objective of financial analysis is to determine the comparatives measures of risk and return for the purpose of making investment or credit decisions. These decisions require financial estimates of the future. Historical financial statements of a company provide a basis for estimating future performance. There are three general areas of financial analysis that would provide information on a company‟s performances: i. Profitability - the ability of the company to provide a reasonable level of return on investment ii. Liquidity - the ability of the company to meet its obligations as they fall due; and iii. Financial stability - the ability of the company to meet its debt servicing obligations . 11.3 Financial Information There are three principal financial statements; the balance sheet, the income statement and the cash flow statement. Let‟s take a brief look at each one of them: 11.3.1 The balance sheet The balance sheet reports major categories and amounts of assets, liabilities and shareholders‟ equity and their inter-relationships at a specific point in time. In essence, a balance sheet shows what the company owns, what it owes and the value of the company accruing to its owners at a specific point in time.
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Understanding the balance sheet, its individual items and their relationship with one another is vital to balance sheet analysis. The user of a balance sheet should have an understanding of the accounting policies adopted for reporting of the items in the balance sheet. Basically, a company holds assets to generate profits and these assets are either funded with the shareholder‟ equity or liabilities. As such: Assets = Shareholders‟ equity + Liabilities An increase of one side of the equation will correspondingly result in an equal increase on the other. The main items in the Balance Sheet As stated above, assets, liability and equity are the three main components of the balance sheet. Carefully analyzed, they can tell investors a lot about a company's fundamentals. 1) Assets Assets provide probable future economic benefits controlled by an entity as a result of previous transactions. Assets can be created by operating activities (e.g., generating net income), investing activities (e.g., purchasing manufacturing equipment), and financing activities (e.g., issuing debt). There are two main types of assets: Current Assets. Current assets comprise unrestricted cash or other asset held for conversion into cash within a relatively short period, usually within 12 months. Current assets usually comprise of inventory or stock (goods acquired for sale), account receivables or trade debtors (amounts due to business in the form of debtors), prepayments (or benefits of paid expenditure which are yet to come e.g. rent paid) and cash in hand or at bank. Non-current Assets Non-current assets or long-term assets are those that are not likely to be converted into cash within 12 months. Apart from fixed assets, non-current assets also include intangible assets (e.g. goodwill) and investments. Fixed assets are physical assets, such as the company‟s premises comprising land and building, furniture and fittings, and plant and equipment. These fixed assets are acquired for their continuous use in the business. 2) Liabilities Liabilities are obligations owed by an entity from previous transactions that are expected to result in an outflow of economic benefits in the future. Liabilities are created by financing activities (e.g., issuing debt) and operating activities (e.g., recognizing expense before payment is made).
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Current Liabilities Any amounts owing that is expected to be settled in the normal course of the company‟s operating cycle, or are due for repayment during the next 12 months are classified as current liability in the balance sheet. Current liabilities include account payables or trade creditors (arise when a company obtains a credit for purchase of goods and services from its supplier), accruals (arise when a company incurs an expense in a particular period but payment has not been made in that period), bank overdraft and other non-trade creditors. Non-current Liabilities Non-current liabilities or long-term liabilities comprise a variety of debts that are not due for repayment in the next 12 months. Typically, non-current liabilities represent bank loans and bondholder debts. 3) Shareholders’ Equity Shareholders‟ equity is classified as the value of the company (or entity) to the owners. Equity is created by financing activities (e.g., issuing capital stock) and by operating activities (e.g., generating net income).This section of the balance sheet includes contributed capital, any minority (non-controlling) interest, retained earnings, treasury stock, and accumulated other comprehensive income. Contributed capital is the total amount paid in by the common and preferred shareholders. Preferred shareholders have certain rights and privileges not possessed by the common shareholders. Minority interest (non-controlling interest) is the minority shareholders‟ prorata share of the net assets (equity) of a subsidiary that is not wholly owned by the parent. Retained earnings are the undistributed earnings (net income) of the firm since inception; that is, the cumulative earnings that have not been paid out to shareholders in dividends. Treasury stock is stock that has been reacquired by the issuing firm but not yet retired. Treasury stock reduces stockholders‟ equity; it does not represent an investment in the firm. Treasury stock has no voting rights and does not receive dividends. Accumulated other comprehensive income includes all changes in stockholders‟ equity except for transactions recognized in the income statement (net income) and transactions with shareholders such as issuing stock, reacquiring stock, and paying dividends. 11.3.2 The Income Statement The income statement reports the performance of the company resulting from its operating activities. Its measure the profit or loss of the company over a period time. Unlike the balance sheet, the income statement is a flow statement between two points in time.
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Principally, the income statement would consist of two items: 1) Revenue Revenue is defined by the Malaysian Accounting Standards Board as the “gross inflow of economic benefits during the period arising in the course of the ordinary activities of an enterprise when those inflows result in increase in equity, other than increase in relating to contributions from equity participants”. In the normal course of business, revenue is earned from selling the product or services of the company. Revenue can also come from other sources such as gains from investment or interest received from investment. These are normally described as other forms of revenue. 2) Expenses Expenses are basically the outflows from the delivery of product or goods, rendering of services or other activities for the purpose of earning revenue. They are incurred by the company in its day-to-day operations; for example costs of raw materials, wages, rent, advertising and utility cost. Profit is derived when revenues exceed expenses. If expenses exceed revenues, the company will incur a loss. In summary: Profit or (loss) = Revenue - expenses Profits can be classified into either operating profits or extraordinary profits. Operating profits arise from the normal operating of the company. Normal operating activities of a company are activities undertaken by the company as part of its business and related activities in which the company engages. On the other hand extraordinary items are income or expenses that arise from events or transactions that are clearly distinct from the ordinary activities and therefore are not expected to recur regularly (e.g. losses of profits arising from a natural disaster).
11.3.3 The Cash Flow Statement A cash flow statement shows the outflows and inflows of cash and cash equivalents from operating, and other activities over and accounting period. The cash flow statement allows the user to assess the company‟s ability to generate cash and cash equivalents and examine their utilization. Cash equivalents are highly liquid, shortterm investments that are readily convertible to cash. Examples of such investment are demand deposits and bank overdrafts. The cash flow statement provides useful information to its users and enables them to: - gauge the company‟s ability to generate positive net cash flows; - gauge the company‟s ability to meet its obligations to creditors, the government;
shareholders and
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- ascertain the company‟s financing needs; - explain differences between the company‟s operating profit after tax and associated cash inflows and outflows; and - Gauge the company‟s flexibility in funding. Cash flows are categorized into three categories as follows: i) Cash flow from operating activities Operating activities encompass the principal revenue producing activity of the enterprise and other activities that are either financing or investing activities. The amount of cash flow arising from operating activities is a key of indicator of the operating capability of the company, the extent to which the operations of the company have generated sufficient cash flows to repay loans, and ability of the company to pay dividends and make a new investment without recourse to external sources of financing. ii) Cash flow from investing activities. Investing activities relate o acquisitions and disposals of long-term assets and other investments not included in cash equivalents. This category of cash flows shows the extent to which expenditures have been made for resources intended to generate future income and cash flows (i.e. cash payment for acquisitions, cash receipts or payment for forward or future contract, etc). iii) Cash flow from financing activities. Financing activities result in changes in the size and composition of the equity capital and debt of the company. This will allow the user to gauge the claims on the future cash flows by providers of capital and the sources of finance. Examples include cash proceeds from issuance of share or borrowing, cash repayments on borrowings, etc. 11.4 Financial Ratio Analysis Ratios are useful tools of financial statement analysis because they conveniently summarize data in a form that is more easily understood interpreted and compared. Important relationships between various items in the financial statements can be expressed in the form of ratio analysis. We have divided ratio analysis into five major categories which will focus on different aspects of the financial characteristics of a company. They are i. ii. iii. iv. v.
Liquidity ratios, Operating performance ratios, Financial risk ratios, Growth ratios and Share market ratio.
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Example: Let‟s look at an extract of XYZ Berhad income statement and balance sheet. Items
FY 2009 RM
FY 2008 RM
Net sales
415,000
320,000
Cost of goods sold
290,000
230,000
Gross profit
125,000
90,000
Operating expenses
89,140
59,900
Operating profits
35,860
30,100
Interest expense
3,000
2,400
Net profit before tax
32,860
27,700
Tax
14,100
12,300
Net profit after tax
18,760
15,400
Balance sheet of XYZ Berhad Items
FY 2009 FY 2008 RM RM ________________________________________________________________________ Assets Current Assets Cash Marketable securities Accounts receivable Inventory Prepaid expenses Total current assets
5,500 1,500 61,600 76,000 900 145,500
4,200 2,400 52,000 63,000 600 122,200
45,000 1,800 46,800
40,000 1,600 41,600
192,300
163,800
Fixed assets Plan and equipment Investment
Total assets
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Current liabilities Account payable Notes payable Accruals 12% debenture
22,000 5,700 30,000 57,700 25,000
24,100 3,000 27,300 54,400 20,000
Total liabilities
82,700
74,400
Share capital Reserves Retained profits
28,000 7,500 74,100
22,000 5,500 61,900
109,600
89,400
Shareholders’ fund Total liabilities and Shareholders’ funds
192,300
163,800
11.4.1 Ratio Analysis i. Liquidity ratios Liquidity basically indicates the ability of the company to meet its short-term financial obligations. a. Current ratio The current ratio measures the number of times current liabilities are covered by current assets. It indicates the ability of the company to meet its current debt as they fall due. The current ratio is sometimes referred to as working capital ratio and it is computed as follows:
Current ratio = Current assets/current liabilities
Examples: Based on the previous example of XYZ, its current ratios in 2008 and 2009 were: Current ratio in 2009 = 145,500/57,700 = 2.52 times Current ratio in 2008 = 122,200/54,400 = 2.25 times
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As shown above, there was a slight improvement in the current ratio from 2008 to 2009. b. Quick assets ratio (acid test) Some people feel that current assets may not be a good gauge of the company‟s ability to meet its short-term obligations as some current assets such as inventories and prepayment may not be easily converted into cash. As such, an alternative to current ratio is the quick asset ratio which is computed as follows Quick asset ratio Quick asset ratio
= (Current assets – Inventory – Prepayment)/current liabilities) = (Cash + Marketable Securities + Receivables)/current liabilities)
Example: For XYZ, its quick ratio in 2009 and 2008 were: Quick asset ratio in 2009 = (5,500 + 1,500 + 61,600)/57,700 = 1.19 times Quick asset ratio in 2008 = (4,200 + 2,400 + 52,000)/ 54,400 = 1.08 times The quick asset ratio of XYZ is still above 1, indicating that its current liabilities are adequately covered by the more liquid current assets of the company. ii. Asset management ratios Asset management ratios indicate how well a company uses its asset. Ineffective use of asset results in: a. the need for more finance b. unnecessary interest costs c. a corresponding lower return on the capital used a. Total asset turnover ratio This ratio measures the effectiveness of the company‟s use of its total assets in generating sales. It can be computed by dividing net sales by total assets (or average total assets). Total asset turnover = Net sales/total asset or Total asset turnover = Net sales/average total assets
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Example: XYZ total asset turnover in 2009 was: Total asset turnover
= 415,000/192,300 = 2.16 times
This value should be compared to other companies in the industry. A high total asset turnover could imply too few assets in the company for generation of potential sales. On the other hand, a low total asset turnover could imply that capital is tied up in excess assets. b. Account receivable turnover The account receivable turnover analyses the quality of the account receivable. It indicates how fast the company collects their receivables. This is an important indicator because the faster the collection, the better the effect on the company‟s cash flow. Account receivable turnover is computed by dividing net sales by accounting receivable (or average account receivables)
Account receivable turnover
= net sales/account receivable or = net sales/average account receivable
Account receivable turnover Note: Average receivables can be computed by taking the sum of receivables at the beginning of the period and at the end of the period and dividing it by two. Example: Account receivable turnover in 2009 = 415,000/61,600 = 6.74 times To determine if this is good or not, it should be compared with the company‟s credit policy and the industry norm. c. Inventory turnover The inventory turnover calculates the company‟s efficiency in managing its inventory. Inventory turnover can be calculated relative to sales or cost of goods sold. The preferred turnover ratio is cost of goods sold as it does not include the profit margin implied in sales. Inventory turnover can be computed by dividing cost of goods sold by inventory (or average inventory). Inventory turnover = Cost of good sold/inventory or inventory turnover = cost of good sold/average inventory
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Example: The inventory turnover of XYZ in 2009 was: Inventory turnover in 2009
= 290,000/76,000 = 3.82 times.
You wouldn‟t want a low inventory turnover which implies that capital is being tied up and that inventory is perhaps obsolete. d. Equity turnover Equity turnover can be computed by dividing net sales by shareholders‟ funds (or average shareholders; funds) Equity turnover Equity turnover
= Net sales/shareholders‟ funds or = Net sales/average shareholders‟ funds
The difference between this ratio and total asset turnover is that it excludes current liabilities, long-term debt and preference equity. A company can increase its equity turnover ratio by increasing its debt to equity ratio. Example: XYZ equity turnover ratio in 2009 was: Equity turnover = 415,000/109,600 = 3.79 times. iii. Profitability ratios Operating profitability ratios measure two aspects of profitability, the profit margin and the return on assets employed. a. Operating profit margin Operating profit is computed by taking gross profit les sales and administration expenses (but before interest and taxes). The operating profit margin is computed dividing operating profit by net sales. Operating profit margin
by
= Operating profit/net sales
The variability of operating profit over time is an indication of business risk of the company.
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Example: The operating profit margins of XYZ in 2009 and 2008 were: Operating profit margin in 2009
= 35,860/415,000 = 8.64%
Operating profit margin in 2008
= 30,100/320,000 = 9.41%
In the above example, XYZ operating profit margin declined in 2009. This decline would mainly be due to an increase in operating expenses (i.e. from RM59, 900 in 2008 to RM89 in 2009). This figure should also be compared to industry norms. b. Net profit margin The net profit margin refers to net profit per ringgit of sales. The net profit used is operating profit after taxes. The ratio is computed by dividing net profit after tax by net sales. Net profit margin = Net profit after tax/net sales
Example: The net profit margins of XYZ in 2008 and 2009 were: Net profit margin in 2009 Net profit margin in 2008
= 18,760/415,000 = 4.52% = 15,400/320,000 = 4.81%
XYZ net profit margin decreased in year 2009 in comparison to year 2008. c. Return on owner’s equity Return on owner‟s equity (ROE) measures returns to the capital provided by the owners after accounting for payments to all other capital providers. The ROE can be computed by dividing net profit after tax and minority Example: The return on owner‟s equity in 2009 was: Return on owner‟s equity in 2009
= 18,760/109,600 = 17.12%
This ratio should be compared with other ratios of similar companies. The rate of return should match the perceived risk of the company. The DuPont system The DuPont system is another method of computing ROE. The DuPont system breaks the ROE into several components to provide the analyst with an inside into the courses of changes in the companies‟ performance. In computing the equity 164
turnover and total asset turnover respectively, average shareholders‟ funds and average total asset would give a more accurate result. However, for illustrative purpose we have use year-end figures of the same in demonstrating the DuPont system. ROE = Net profit after tax Net sales = Profit margin
x
Net sale.
x
.
Shareholders‟ fund
Total assets x Total assets turnover
Total assets .
x
financial leverage
Example: Based on this, the ROEs of XYZ and 2008 were: ROE in 2009
= 18,760/415,000 x 415,000/192,300 x 192,300/109,600 = 4.52% x 2.16 x 1.75 = 17.09%
ROE in 2008 = 15,400/320,000 x 320,000/163,800 x 163,800/89,400 = 4.81% x 1.95 1.83 = 17.16% The above example shows that the ROE of XYZ declined slightly in 2009 in comparison to 2008. The decline was caused by declines in net profit margin and financial leverage in 2009. At the same time, total asset turnover increased in 2009. This could imply management‟s efficiency in the management of assets. iv. Financial risk ratios Financial risk ratios basically measure the uncertainty to equity holders due to the company‟s use of fixed obligation debt securities. This financial uncertainty exists in addition to the company‟s business risk (which can be measured via standard deviation or variation). As a company increases its debt obligation, it would have to service the loan with interest payments which are fixed obligations. During bad times, the decline earnings will be worsened by these fixed obligations. Debt financing also increases the financial risk of company due to the increased possibility of default and bankruptcy. There are generally two types of ratio that will help measure financial risk. They are those that examine the proportion of debt compared to equity and those that look at the cash flow available to pay fixed financial charges. Proportion of debt to equity a. Debt to equity ratio The debt/equity ratio indicates the proportion of the company‟s capital that is derived from debt compared to other sources of capital (preference equity, common equity and retained earnings). A higher proportion of debt compared to equity makes the earning of the company more volatile and increase the financial risk of the company.
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The debt to equity ratio is computed as follows: Debt to equity ratio
= Total long-term debt/total equity
Example: The debt to equity ratio of XYZ in 2008 and 2009 were: Debt to equity ratio in 2009
= 25,000/109,600 = 22.81% Debt to equity ratio in 2008 = 20,000/89,400 = 22.37% This figure has to be compared with the industry average. Based on the example above, XYZ debt obligations relative to its equity increased slightly in 2009 compared to the previous year. b. Long-term debt/total capital ratio This ratio measures the proportion of long-term debt to capital and can be as follows:
computed
Long-term debt/total capital = Total long-term debt Total capital
Total capital includes all long-term debt, any preference equity and total common equity. Example: The long-term debt/total capital ratio of XYZ in 2008 and 2009 were: Long-term debt/total capital in 2009
= 25,000/163,800 = 13.00%
Long-term debt/total capital in 2008
= 20,000/163,800 = 12.21%
Again, this ratio indicates an increase in the company‟s financial risk. c. Interest coverage ratio This ratio indicates the number of times interest charges are covered by earnings of the company. The interest coverage ratio is computed as follows: Interest coverage
=
Operating profit__ Debt interest charges
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Example: The interest coverage ratios of XYZ in 2008 and 2009 were: Interest coverage in 2009
= 35,860/3,000 = 11.95 times.
Interest coverage in 2008
= 30,100/2,400 = 12.54 times.
These coverage ratios are high. However gain, these figures have to be compared to industry averages. The interest coverage also showed a decline in 2009 which may indicate higher financial risk for the company compared to the previous year. v. Market performance ratios. Investors purchase shares for a return on investment. This return would consists of capital gain (or losses) and dividends. a. Gross dividends per share Gross dividends per share calculate dividends as a percentage of the par value of the share. For example, a share with a par value of RM1 that pays a 10% gross dividend would pay a gross dividend of 10 sen. The gross dividends per share figure are computed as follows: Gross dividends per share = Gross dividends/number of ordinary shares Note that net dividends per share are computed by dividing net dividends by the number of ordinary shares. b. Dividend yield The dividend yield measures the percentage of the share‟s market value that is paid as dividends. It is computed as follows: Dividend yield = dividends per share/market price per share Net dividend yield is computed by dividing net dividend by the market price per share. c. Price earnings ratio The price earning multiple (PE multiple) is commonly used to assess share value. The PE multiple represents the price; investors are willing to pay for every ringgit of earnings. The PE multiple can be computes a follows: PE multiple
= Market price per share/earning per share
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d. Net tangible assets per share The net tangible assets per share is the total shareholder‟s funds less intangible assets divided by the number of issued and paid-up ordinary shares of the company and can be expresses as follows: NTA per share
= Net tangible assets/number of ordinary shares
Example: Let‟s assume xyz gross dividend for the year 2010 was RM20, 000. The number of ordinary shares in issue is 28,000. The par value of the shares is RM1 per share. The current market value of the shares is RM5 per share. XYZ recorded an earning per share of RM1.20 per share in the year 2010. Compute the gross dividends per share, gross dividend yield and PE multiple of XYZ. Gross dividends per share
=
20,000/28,000
= RM0.71 Gross dividend yield
= 0.71/5 = 14.2%
PE multiple
= 5/1.20 = 4.17 times
11.4.2 Limitations of Financial Ratios The limitations of financial ratios include: i.
Financial ratios are not useful when viewed in isolation. They are only valid when compared to those of other firms or to the company‟s historical performance.
ii.
Comparisons with other firms are difficult because of different accounting treatments (e.g. different depreciation methods).
iii.
It is difficult to find comparable industry ratios when analyzing firms that operate in multiple industries.
iv.
Conclusions cannot be made from viewing one set of ratios. All ratios must be viewed relative to one another.
v.
Determining the target or comparison value for a ratio is difficult, requiring some range of acceptable values.
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Summary This topic relates the various components of the income statement, balance sheet and cash flow statement. The techniques of financial ratio analysis to assess performances and financial positions of companies and its limitations were also discussed. For a meaningful analysis, the ratios of a company should be compared with those of other companies in the same industry. Financial statement users have access to a wide range of data and information sources in their analysis. However, it is the objective of the analysis that will dictate to a large extent the approach taken in the analysis. The starting point, however, should always be the financial statements.
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Activity – Q&A 1. Which of the following would NOT be a component of cash flow from investing? A. Sale of land. B. Purchase of securities. C. Dividends paid. D. Purchase of equipment 2. Which of the following ratios would NOT be used to evaluate how efficiently management is utilizing the firm‟s assets? A. Payables turnover. B. Gross profit margin. C. Total asset turnover. D. Fixed asset turnover. 3. Which of the following items is NOT in the numerator of the quick ratio? A. Cash. B. Marketable Securities C. Inventory. D. Receivables. 4. Earnings before interest and taxes (EBIT) are also known as: A. Operating profit. B. Gross profit. C. Net profit. D. Earnings before income taxes 5. With other variables remaining constant, if profit margin rises, ROE will: A. Fall. B. Remains the same. C. Increase. D. initially falls and then increase.
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6. Let‟s assume Alpha Bhd gross dividend for the year 2010 was RM16, 000. The number of ordinary shares in issue is 30,000. The par value of the shares is RM1 per share. The current market value of the shares is RM6 per share. XYZ recorded an earnings per share of RM1.10 per share in the year 2010. Compute the gross dividends per share, gross dividend yield and PE multiple of XYZ. 7. What are the limitations of ratio analysis?
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Suggested Answers to Activity 1. C 2. B 3. C 4. A 5. C 6. Gross dividends per share
= =
16,000/30,000 RM0.53
Gross dividend yield
= =
0.53/6 8.83%
PE multiple
= =
6/1.10 5.45 times
7. The limitations of financial ratios include: Financial ratios are not useful when viewed in isolation. They are only valid when compared to those of other firms or to the company‟s historical performance. Comparisons with other firms are difficult because of different accounting treatments (e.g. different depreciation methods). It is difficult to find comparable industry ratios when analyzing firms that operate in multiple industries. Conclusions cannot be made from viewing one set of ratios. All ratios must be viewed relative to one another. Determining the target or comparison value for a ratio is difficult, requiring some range of acceptable values.
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Topic 12 Valuation of Equities Preview In this topic, students are exposed to fundamental analysis and the various approaches to valuation of equities. The topic begins with the top down approach to fundamental analysis before describing in detail the dividend discount model and the earnings multiplier model. Topic Objectives At the end of this topic, you should be able to– i.
Describe the top down approach to fundamental analysis.
ii.
Discuss the effect of government monetary and fiscal policy on the economy.
iii.
Illustrate the Dividend Discount Model and how it relates to the security evaluation process.
iv.
Illustrate the Price Earnings Ratio Model.
v.
Describe the limitations of each model.
vi.
Explain the total return approach to measuring investment returns.
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Valuation of Equities 12.1 Introduction Every asset, financial as well as real, has value. The key to successfully investing in and managing these assets lies in understanding not only what the value is, but the sources of the value. Valuation is done in a number of ways based on various types of concepts and inputs that are available or accessible to the analyst. There is no single generally accepted method for determining the correct true valuation of a company share. Various recognized valuation techniques for arriving at the value are available, but these may all provide different numbers. The techniques based on cash flows, assets or earnings, nevertheless, provide a range of results upon which discussion and decision making can be done, to eventually fix on a suitable transaction price, for example, in a negotiation for take-over or in evaluation of an investment for purchase or sale. 12.2 The Top-down Approach to Analysis One of the common practices by analysts is what we can call a „top-down‟ approach. The top-down approach is typically used not just because it is common practice. Empirical evidence indicates that the economic environment has significant effects on firm earnings. The top-down, three-step approach to security valuation starts with a forecast of the direction of the general economy. Next, based on this economic forecast, project the outlook for each industry under preview. Third, within each industry, select the firms most likely to perform the best given these economic and industry forecasts. As indicated, this approach is a three-step analytical process: Economic analysis → industry analysis → stock analysis Step 1: Forecasts macroeconomic influences. Fiscal policy is a direct approach to affect aggregate demand in an attempt to manage the rate of economic growth. Tax cuts encourage spending (demand) and speed up the economy; tax increases discourage spending and slow economic growth. Government spending creates jobs, thus increasing aggregate demand. Monetary policy is used by the central bank to manage economic growth. Decreasing the money supply causes interest rate to rise, putting upward pressure on costs and downward pressure on demand. Increasing the money supply reduces interest rate and increases demand. Inflation can result from increasing the money supply too fast. Rising interest rates reduce the demand for investment funds and rising consumer prices reduce product demand. From a global (export/import) perspective, the potential domestic economic impact from political changes in major international economies must be considered. Step 2: Determine industry effects.
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Identify industry that should prosper or suffer from the economic outlook identified in Step 1. Consider how these industries react to economic change: some industries are cyclical, some are counter-cyclical, and some are non-cyclical. Consider global economic shifts: an industry‟s prospects within the global business environment determine how well or poorly individual firms in the industry will do. Thus industry analyst should precede company analysis. Step 3: The top-down approach finally comes down to picking the right, i.e. most valuable, stock. This involves the valuation of a company. In addition to the model we are going to introduce, of course there are many other models based on free cash flow, operating cash flow, price/cash, price/sales, etc. 12.3 Basic Valuation Model In the basic valuation model, we will look at some cash-flow based valuations: (a) The Discounted Dividend Model or Dividend Discount Model. (b) The Constant Growth Model or Gordon Growth Model. (c) Multistage Growth Model. A. Discounted Dividend Mode/ Dividend Discount Model. The Discounted Dividend Model (DDM) works on the simple concept that future cash flows i.e. dividends are discounted to reach a present value or price that is then used as the basis upon which a buy, sell or hold decision is made. This approach is to take the value of the share as corresponding to the present value of the stream of dividends the company is expected to pay in the future. Assume that a share is held for an infinite period, the basic DDM can be expressed as follows:
Where: P0 = value or estimated price for share. D1… Dn = Dividends from one year to infinity. k = the rate of expected return. Under normal circumstances, shares would not be held for an infinite period. Assuming that the shares are held for two periods and then sold, the value of the share based on the DDM can be expressed as per the next page:
Where: P2 = expected price of the share at the end of year two. 175
For example, an investor has just purchased 1000 shares of ABC Bhd and expects to hold the shares for two years. ABC Bhd promises a dividend of RM0.50 at the end of the first year and RM 0.60 at the end of the second year. After two years, the share can be sold at RM2.20. Let‟s assume that the rate of return expected by the investor is 10%. The present value of the share is:
= RM2.77 Based on the estimated value of RM2.77 per share, the investor can establish if the market price is over or undervalued (if undervalued – buy and if overvalued – do not buy). Discounted dividend model are best suited for companies in the expansion or maturity life-cycle phases. These companies have more predictable dividend payments and comprise a large portion of total return compared to growth companies. B. Constant Growth Model/Gordon Growth Model. Since projections of ringgit dividends in reality cannot be made through infinity, several versions of the DDM have been developed, based on different assumptions about future growth. Where the dividend payment by the company is constant, the constant growth dividend model is used to value the company. This model can be used to value a company that is in steady state, with dividends growing at a rate expected to stay stable in the long term. The constant growth model can be expressed as follows:
Where: D0 (1 + g) or D1 = expected dividend one year from now. k = the required rate of return g = constant growth rate in dividend For example, XYZ Bhd has just paid a dividend of 10 sen. The required rate of return is 8% and dividends are expected to grow at 4% forever. What is the value of XYZ‟s shares? First find the expected DPS or D1: D1 = DPS0 (1 + g) = 0.10 (1.04) = 0.104 176
Now we have: P0 =
0.104 0.08 – 0.04 = RM2.60
Therefore, the price of the share is RM2.60. Calculating the Earnings Growth The growth rate is a measure of the quality of investments, i.e. the return on equity (ROE), multiplied by a measure of the quantity of investment, i.e. the investment rate as measured by the plowback ratio. Therefore: g = ROE x plowback ratio = R0E x b Where: g b
= expected growth rate = plowback ratio or retention ratio, which is the percentage of earnings retained in the company ROE = the return on equity of the company For example, a company has after tax profits of RM100 million and it pays dividends totaling RM40 million. Its ROE is 15% and this is expected to remain constant. What rate of growth do we expect from this company? First, calculate the plowback ratio: The company paid out dividends of RM40 million. Therefore it retained profits of RM60 million. The plowback ratio is: RM60 million x 100% = 60% RM100 million Then the expected growth rate is: g = 0.60 x 0.15 = 0.09 or 9% While the constant growth model is a conceptually simple yet powerful approach to valuation equity, its use is limited to companies that are growing and declaring dividend at a stable growth rate. C. Multistage GrowthModel. In some instances, we may find firms with non-constant growth rates. This normally occurs at the beginning of the firm‟s or industry‟s life. Growth is highest in the early periods. However, this high growth cannot persist as competition exists and new firms will be attracted into the industry. Let‟s use an example to explain the situation. A firm is expected to experience a 30% growth per year for the next three years. After that period, it is forecasted that growth 177
will be normal at 5% per year forever. The required rate of return is 10%. The price of the share can be determined as below:
Notice that we have a time horizon of 3 years in the formula and we need to determine the price at the end of the time horizon. The end price is the constant growth dividend model. If the current dividend is RM1.00, then the price of the share is:
Limitations in this model include: i.
Defining the length of the non-stable growth period. While in theory, the duration of the growth phase can be linked to product life-cycles and project opportunities, it is difficult in practice to convert these considerations into a specific time period
ii.
The assumption that the growth is high during the initial period and is transformed overnight to a lower stable rate at the end of the period. While these sudden transformations in growth can happen, it is much more realistic to assume that the shift from high to stable growth happens gradually over time.
12.4 Price Earning (PE) Ratio Model Another model to value a share is by using the PE ratio. This model is also known as the earnings multiplier model.
The above formula can be interpreted as a measure of the investors‟ willingness to buy shares to get an expected return. It also measures the level of confidence of investors on the firm. The constant growth dividend model can also be used to calculate the PE ratio. If we recall back, the formula is:
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If the model is divided by expected earnings (E1), the model will become:
The above formula showed that PE ratio will depend on the dividend payout ratio (D1/E1), the required rate of return (k) and growth rate for dividend (g). For example, let‟s say a firm expects to earn RM2 per share and pays dividends of RM1. The rate of return expected by the investors is 15% and the growth rate is 10%. The PE ratio is:
We will multiply the PE ratio with the forecasted earnings to obtain the estimated price of the share. Using the above example, when earnings are RM2, the estimated price is: P/E = 10 P
= 10 x RM2 = RM20
The main problem with PER model is that a ratio at best is an estimate that provides a guide to a theoretical value or level for reference purposes. In the case of PER, it appears that companies with low PERs outperform the market and companies with high PERs underperform the market on a risk-adjusted basis In reality, however, this does not work in all cases. 12.5 Measuring Investment Returns The total return of an investment typically consists of two components: i.
Capital gains or losses which result from the difference between the value of the investment at the end of the holding period (selling price) and its original course (purchase price).
ii.
Income received from the investment during the period in which the investment is held, e.g. dividend income from equity investment and interest income from fixed income investment.
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The period during which you own an investment is called a holding period and the return for that period is the holding period return (HPR). Holding period return can be expressed as follows: Ending value of investment HPR = Beginning value of investment Note: Ending value includes capital gains/losses plus dividend or interest income. Example: You bought Public Bank shares at RM10.00 per share in year 1 and received a dividend of 15 sen. You then sold the shares in year 2 at RM12.00 per share. RM12.00 + RM0.15 HPR = RM10.00 = 1.215 Investors generally evaluate returns in percentage term on an annual basis, which is called the holding period yield (HPY). HPY converts the holding period return to an annual percentage rate. HPY is equal to HPR minus 1. Using the above example, the HPY of the investment is: HPY = HPR – 1 = 1.215 – 1 = 0.215 or 21.5% Summary The role of equity valuation and the basic methods and concepts in equity valuation are related to provide the reader with knowledge and an understanding of how the pricing of equities is done at a theoretical level. This topic focused on the top down approach that begins from analyzing the economy, industry and finally the company. In other words, financial statement analysis is not done in isolation and a wider and deeper understanding of the economy, industry and company factors affecting the company performance is also necessary.
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Activity – Q&A 1. If the federal government wanted to expand economic growth, it would promote policies that: A. reduces taxes. B. raises taxes. C. raises interest rates. D. reduce federal subsidies 2. Use the following information on Ramada Bhd to compute the current stock price. Dividend just paid = RM0.20 Required rate of return = 10% Dividends are expected to grow at 6% forever A. RM5.20 B. RM5.30 C. RM5.50 D. RM6.50 3. MTB Bhd has after tax profits of RM90 million and it pays dividends totaling RM27 million. Its ROE is 12% and this is expected to remain constant. What rate of growth do we expect from this company? A. 9.4% B. 9.8% C. 8.4% D. 8.8% 4. According to the earnings multiplier model, all else equal, as the required rate of return on a stock increases, the: A. P/E ratio will increase. B. P/E ratio will decrease. C. earnings per share will increase. D. earnings per share will decrease.
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5. According to the earnings multiplier model, all else equal, as the dividend payout ratio on a stock increases, the: A. P/E ratio will increase. B. P/E ratio will decrease. C. required return on the stock will increase. D. required return on the stock will decrease. 6. Assume that a firm has an expected dividend payout ratio of 20%, a required rate of return of 9%, and an expected dividend growth of 5%. What is the firm's estimated price-to-earnings (P/E) ratio? A. 5.00. B. 2.22. C. 10.00 D. 20.00 7. Describe the top-down approach to security valuation. 8. What are the limitations of the multistage growth model? 9. Describe the components of the total return of an investment.
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Suggested Answers to Activity 1. A 2. B First find the expected DPS or D1: D1
= = =
DPS0 (1 + g) 0.20 (1.06) 0.212
Now we have: P0
= =
0.212 / 0.10 – 0.06 RM5.30
3. C First, calculate the plowback ratio: The company paid out dividends of RM27 million. Therefore it retained profits of RM63 million. The plowback ratio is: RM63 million x 100% = 70% RM90 million Then the expected growth rate is: g = 0.70 x 0.12 = 0.084 or 8.4% 4. B P/E = Expected dividend payout/k – g An increase in the required rate of return will result in the denominator (k – g) to increase. Hence, P/E will decrease. 5. A P/E = Expected dividend payout/k – g An increase in the dividend payout ratio will result in the numerator (D 1/E) to increase. Hence, P/E will increase. 6. A P/E = Expected dividend payout/k – g = 0.20/0.09 – 0.05 = 5.00 7. The top-down, three-step approach to security valuation starts with a forecast of the direction of the general economy. Next, based on this economic forecast, project the outlook for each industry under preview. Third, within each industry, select the firms most likely to perform the best given these economic and industry forecasts.
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8. Limitations of the multistage model include: 1. Defining the length of the non-stable growth period. While in theory, the duration of the growth phase can be linked to product life-cycles and project opportunities, it is difficult in practice to convert these considerations into a specific time period 2. The assumption that the growth is high during the initial period and is transformed overnight to a lower stable rate at the end of the period. While these sudden transformations in growth can happen, it is much more realistic to assume that the shift from high to stable growth happens gradually over time. 9. The total return of an investment typically consists of two components: 1. Capital gains or losses which result from the difference between the value of the investment at the end of the holding period (selling price) and its original course (purchase price). 2. Income received from the investment during the period in which the investment is held, e.g. dividend income from equity investment and interest income from fixed income investment.
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Appendix Appendix 1: KLCI Futures – Contract Specifications Contract code
FKLI
Underlying security
FBM Kuala Lumpur Composite Index (KLCI)
Contract size
FBM KLCI multiplied by RM50.00 Contract value = Price x Contract Multiplier
Minimum price fluctuation
0.5 index point valued at RM25.00
Contract months
Spot month, the next month and the next 2 quarterly months. The calendar quarterly months are March, June, September and December.
Daily price limits
20% per trading session for the respective contract months except the spot month contract. There shall be no price limits for the spot month contract. There shall be no price limit for the second month contract for the final 5 business days before expiration.
Trading hours
8.45 am to 12.45 pm and 2.30 pm to 5.15 pm
Final trading day
The last business day of the contract month
Final settlement value
The final settlement value shall be average value, rounded to the nearest 0.5 of an index point (values of 0.25 and o.75 and above being rounded upwards) of the FBMKLCI for the last half hour of trading on Bursa Malaysia Securities Bhd on the final trading day excepting the highest and lowest values.
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Appendix 2: Crude palm oil futures – contract specifications Contract code
FCPO
Contract size
25 metric tons
Minimum price fluctuations
RM1 per metric ton
Contact months
Spot month and the next 5 succeeding months, and thereafter, alternate months up to 24 months ahead
Trading hours
10.30 am to 12.30 pm and 3.00 pm to 6.00 pm
Daily price limits
RM100 per metric ton above or below the settlement prices of the preceding day for all months, except the spot month. Limits are expanded when the settlement of all the three quoted months immediately following the current month, in any day are at limits as follows: Day Limit(RM) First 100 Second 150 Third 200 Daily price limits will remain at RM200 when the preceding day‟s settlement prices of all the three quoted months immediately following the current delivery month settle at limits of RM200. Otherwise it shall to the basic limit amount of RM100
Speculative position limit
500 contracts net long or net short for any delivery month or all delivery months combined
Last trading day
Contract expires at noon on the 15th of the spot month, or if the 15th is a non-market day, the preceding business day
Tender period
1st business day to the 20th business day of a delivery month or if the 20th is a non-market day, the preceding business day
Contract grade and delivery points
Crude palm oil of good merchantable quality, in bulk, unbleached, in port tank installations located at the option of the seller at Port Kelang, Penang and Pasir Gudang. Free fatty acid of palm oil delivered into port tank installations shall not exceed 4%, and from port tank installations shall not exceed 5%. Moisture and impurities shall not exceed 0.25%.
Deliverable unit
25 metric tons plus or minus not more than 2%. Settlement of weight difference shall be based on the simple average of the daily settlement prices of the delivery month from: (i) the first business day of the delivery month to the day of tender, if the tender is made before the last trading day of the delivery month; or (ii) the first business day of the delivery month to the business day immediately preceding the last day of trading if the tender is made on the last trading day or thereafter.
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Appendix 3: KLIBOR Futures – Contract Specifications Contract code
FKB3
Underlying instrument
Ringgit interbank time deposit in the Kuala Lumpur wholesale money market with a three month maturity on a 360-day year
Contract size
RM1000 [quoted in index terms (100 minus yield)]
Contract months
Quarterly cycle months of March, June, September and December up to 5 years ahead, and 2 serial months
Minimum price fluctuation
0.01% (1 tick) which is equivalent to RM25 (RM1,000,000 x 3/12 x 0.01%) per contract.
Reportable positions
Open position of 100 or more lots in any one delivery month, at the close of trading of each business day
Transaction limit
Maximum number of contracts associated with a bid or offer by a member is 500 contracts.
Trading hours
9.30 am to 12.30pm and 2.30 pm to 5.00 pm
Final trading day and maturity date
Trading ceases at 11.00 am (Malaysian time) on the 3 rd Wednesday of the delivery month, or the 1st business day immediately following the 3rd Wednesday of the delivery month if 3rd Wednesday of the delivery month is not a business day
Final settlement
Cash settlement based on the cash settlement rate
Cash settlement rate
The cash settlement rate is determined by the clearing house obtaining KLIBOR 3-month rate from the Reuters reference page “KLIBOR” at 11.00 am on the last day of trading
Speculative position limit
2,000 contracts, net gross open position for all delivery months.
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Appendix 4: KLCI Options – Contract Specifications Contract code Underlying Instrument
Calls; C OKLI Puts ; P OKLI Kuala Lumpur Composite Index (KLCI)
Contract size
KLCI multiplied by 100
Minimum price fluctuation
0.1 OKLI index point valued at RM10
Contract months
Spot month, the next month, and the next 2 calendar quarterly months. The calendar quarterly months are March, June September and December
Trading hours
8.45 am to 12.45 pm and 2.30 pm to 5.15 pm
Final trading day
The last business day of the contract month
Final settlement
Cash settlement based on the final settlement value
Final settlement value
The final settlement value shall be the average value, rounded upwards or downwards to one decimal point (0.05 being rounded upwards) of the KLCI for the last hour of trading on the Bursa Malaysia Securities Bhd on the final trading day excepting the highest and lowest value.
Exercise price intervals
20 index points intervals for spot month and next month. 40 index points intervals for the next nearest 2 quarters
Options series
At the start of the trading day, there shall be at least an inthe-money strike price, an out-of -the-money strike price and an approximate at-the-money strike price for each contract month of both the call and put options series A new option series will not be introduced if it would expire in less than 10 business days before the expiration date
Exercise
European style exercise. Options shall be exercised in accordance with the rules of the clearing house.
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Glossary 1. American style option An option contract that allows the owner to exercise the option at any time before or at expiration of contract. 2. Anticipatory hedge A hedging strategy that involves entering into a futures position now in anticipation of a cash transaction in the future. 3. At best/at market Often used in stock broking trades to mean at lowest possible price for buys and highest possible price for sells. 4. At par Par value means the nominal or face value at which an investment instrument is denominated. The par value of a RM 10 currency note is RM 10. The par value of a share would be the value at which the share is denominated and issued. For most shares, this would be RM 1 (par value). Thus, when a share has a par value of RM 1 and its market price is also RM 1, we say the share value is at par. 5. At-the-money option An option is at-the-money if the strike price of the option is equal to the market price of the underlying security. 6. Asset An asset is any item of monetary value which a company owns or is owed. Assets are used by companies to earn profit. Assets can take many form, including cash, equipment and property. 7. Auction The process of buying and selling securities by (i) offering them for tender, (ii) accepting bids from potential investors, and (iii) allocating them to the highest bidder(s). In “reserve” auctions, there is a minimum bid or reserve price; if the bidding does not reach the minimum, there is no sale. In “absolute” or “no reserve” auctions, the sale is guaranteed, with only the price to be determined by the highest bid (offered price). 8. Authorized capital A company has to register an amount of capital that is authorized by its members for issue now or in the future. 9. Balance sheet A statement of financial condition that summarizes a company‟s assets, liabilities, and owner‟s equity.
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10. Banker’s Acceptances (BAs) (BAs) This is a bill of acceptance drawn on and accepted by a bank, a common form of trade finance. Because it represents a direct liability of the bank, it is easily traded in the secondary market. 11. Bank Negara Malaysia (BNM) Bank Negara Malaysia, the central bank of Malaysia that issues currency, oversees monetary control and the banking institutions in the country and acts as the banker and financial adviser to the Government of Malaysia. 12. Basel II Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. 13. Bear market A market where prices of most securities are falling. [Opposite: Bull market] 14. Benchmark A reference, e.g. a price or yield or index that is used to compare the performance of one with another. 15. Bid price The price offered by a party who is willing to buy at that price. [Opposite: Offer price] 16. Book value The value of an asset as shown in the books of accounts. 17. Bottom-up approach In investing, this would mean taking a micro view, emphasizing on detailed analysis of particular companies that meet certain chosen criteria, before considering industry and overall economic conditions, trends and outlook. [Opposite: Top-down approach] 18. Bonds Bonds are simply long term debts owed by an issuer to an investor (the bond holder) evidenced by a certificate called a bond. Long term usually refers to over 5 years. Bonds may be issued by government agencies or corporations and may be listed. Coupon: This refers to the certificate attached to a bond which entitles the holder to receive the interest payment due under the bond.
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19. Bourse Another term for an Exchange dealing in securities or commodities. 20. Bull market A market where prices of most securities are rising. [Opposite: Bear market] 21. Bull Run A prolonged period of generally rising prices in stock markets, usually characterized by euphoric buying by speculators and ending when events trigger general market price declines. 22. Cagamas (Malaysia) Cagamas Berhad, the National Mortgage Corporation in Malaysia. Cagamas is the major issuer of asset-backed securities. 23. Cagamas Instruments (Malaysia) Debt securities issued by Cagamas Berhad (National Mortgage Corporation). There are four types of Cagamas issues: Floating Rate Bonds, Fixed Rate Bonds, Cagamas Notes, and Sanadat Mudharabah Cagamas. 24. Call option An option that gives the holder the right, but not the obligation, to purchase a specified number of the underlying asset, (e.g. shares) at a given price and time. The seller or the writer of the option has the obligation to perform. 25. Call provisions States when and how a company can redeem bonds outstanding prior to their maturity. 26. Capital Adequacy Framework The capital adequacy framework (also known as the Risk-Weighted Capital Adequacy Framework) sets out the approach for the computation of minimum capital required by a banking institution in order to operate as a going concern entity. 27. Capital appreciation The increase in value of an investment over its original cost. 28. Capital Asset Pricing Model (CAPM) A model reflecting the relationship between risk and expected return used for pricing of securities in terms of risk. The idea behind this is that the expected return of a security is the return from risk free investment (representing the time value of money) and a risk premium. If the projected or expected return of a contemplated investment is less than the return arrived at under CAPM, the investment should not be undertaken.
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29. Capital gain/loss Gain or loss on disposal of an asset, representing the difference between the net sale proceeds and the cost. The capital adequacy framework (also known as the Risk-Weighted Capital Adequacy Framework) sets out the approach for the computation of minimum capital required by a banking institution in order to operate as a going concern entity. 30. Capital Markets and Services Act 2007 (CMSA) An Act to consolidate the Securities Industry Act 1983 (Act 280) and the Futures Industry Act 1993 (Act 499), to regulate and to provide for matters relating to the activities, markets and intermediaries in the capital markets. 31. Carve-out The sale of an interest in a subsidiary to another party. 32. Cash flow The amount of cash a company receives and pays out in a particular period. 33. Cash market The market where securities trades are current dated, i.e. for immediate delivery. Also called the spot market. [Opposite: Futures market] 34. Chinese wall A barrier that supposedly exists between departments in an investment banking outfit that prevents communication of price-sensitive and confidential insider information. 35. Circuit breaker This is a mechanism that may kick in when a market (such as the stock market) to prevent it falling or rising beyond a certain specific limit. So, for example, when the market drop reaches a certain percentage, trading may be suspended. Circuit breakers were introduced after the record Dow Jones October 1987 crash. 36. Closing price The price quoted for the last (closing) transaction for a given trading day. [Opposite: Opening price] 37. Commercial paper A short term debt owing by a prime credit-rated company and evidenced by tradeable bills or promissory notes. 38. Companies Act 1965 The Act of Parliament that governs companies.
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39. Consumer banking This is a term loosely used by banks generally to cover lending activities to consumers, such as credit cards, hire purchase, housing loans and renovation loans. 40. Contract A transaction in accordance with the rules of the relevant exchange, evidenced by a contract note. 41. Conversion price The ringgit value at which convertible securities can be converted into common shares, as specified when the convertible is issued. 42. Conversion ratio The number of shares received in exchange for each convertible security when a conversion takes place. 43. Convertibles These are debt instruments that carry convertibility features, unlike straight bonds. The convertibility allows the holder the option to redeem or convert into equity wholly or partially, depending on the terms of the instrument. 44. Counter A term commonly used in the stock broking industry to refer to a particular share, e.g. the stock exchange code for this counter is ABC. 45. Counterparty risk This is the risk of one party to a contract defaulting on delivery. 46. Coupon interest A bond has coupons attached for interest payments, each representing one interest payment. The interest is payable based on the stated coupon rate. 47. Coupon rate This is the interest rate stated in the bond coupon (see coupon) as payable by the issuer. 48. Credit risk The risk of a borrower failing to honour his debt obligations 49. Cum Cum- is a prefix meaning with [Opposite: ex-]. Cum-dividend with reference to a share means the holder of the share is entitled to dividend declared on the share [Opposite: ex-dividend]. Cum-rights means shares are accompanied by the right to subscribe for new shares [Opposite: ex-rights]. Likewise, cum-bonus means shares are accompanied by a right to a share distribution in the form of bonus shares [Opposite: ex-bonus]. 193
50. Currency derivatives Where the derivative's underlying components are two different currencies, e.g. currency swap. 51. Currency risk The risk of loss in converting foreign currency into local currency in relation to a foreign investment. 52. Debenture Two meanings in the financial world: One is another name for bonds. The other meaning refers to the collateral documentation signed between the lending bank/s and a borrower whereby the borrower pledges all its assets, both fixed (plant, equipment, etc.) and floating (stocks, receivables, cash, etc.) as collateral for the loan. 53. Debt instruments Indebtedness acknowledged by an issuer for funds raised and evidenced in written form as a debt instrument. 54. Diversification The spreading of risk through investing in different types of investments by sector, industry, region, etc. 55. Dividend A payout (in cash or in kind) out of a company's profits available for distribution to shareholders. 56. Dividend cover The number of times a dividend could be paid out of the company's net profit. 57. Dividend yield The dividend expressed as a percentage of the current price of the share. 58. Earnings before interest and tax (EBIT) Net income or profit before interest and tax. Used to assess interest servicing ability. 59. Earnings before interest, tax, depreciation and amortization (EBITDA) Net income or profit before interest, tax, depreciation and amortization. Used to assess the extent of operating profit of a business and its ability to generate operating cash flow. 60. Earnings per share Earnings divided by the number of shares in issue, i.e. the earnings attributable to each share.
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61. Electronic Trading Platform (ETP) This is a computerized network set up by Bursa Malaysia that serves as a trading platform to enable dealers to trade in Malaysian bonds electronically. 62. European style option An option that can be exercised only at the maturity date. 63. ExIs a prefix for without [Opposite: Cum]. 64. Ex-dividend Refers to the price of a share quoted the day after a dividend entitlement date. For an ex-div share, the buyer does not get the dividend which is kept by the seller. The market takes this into account when determining the ex-div price. Ex-all would refer to a share where all entitlements (including bonus and rights) are excluded. 65. Exercise price The price at which the buyer of a call (put) can purchase (sell) the underlying asset during the life of the option. 66. Face value The value denominated for a share upon issue. 67. Fixed-Coupon Bond Long-term debt paper that carries a predetermined and fixed interest rate. The interest rate is known as coupon rate and interest is payable at specified dates before bond maturity. 68. Flattening yield curve This is when yields between short term and long term debt instruments narrow (such that the yield curve looks flat). 69. Floating-Rate Bond A debt security issue where the coupon rate is reset periodically (on the coupon reset date, in advance of the period to which it applies) based on a formula which has the following general form: reference rate + quoted margin. 70. Foreign exchange The system to facilitate international trade by which instruments such as currency, notes, bills and cheques in one currency are used to settle payment in another currency. 71. Forex Short for foreign exchange market which refers to the over the counter market where buyers and sellers transact foreign currencies.
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72. Forward rate The price stated as payable at a specified future date in a forward contract, as opposed to spot rate. 73. Fully valued A company's shares are considered fully valued if one sees the company's intrinsic value and potential for growth as fully recognized by the market. 74. Fundamental analysis The analysis of a company's historical performance data and strategic profile (strengths and weaknesses, positioning etc.). Practitioners of this technique believe that sooner or later the price of a share reflects its true value based on its fundamentals even though market may misprice along the way. [Opposite: Technical analysis] 75. Futures market A market where futures are traded. In Malaysia, the futures market is done through Bursa Derivatives Malaysia. 76. Goodwill Excess of the purchase price over the fair market value of the net assets acquired under the acquisition method of accounting. 77. Gross profit Revenue from sale of goods minus cost of goods sold 78. Hedge The use of the futures or options market to reduce or completely offset a risk exposure from market fluctuations. 79. Holding period The length of time that a security is held by the investor. 80. Holding period return (HPR) The rate of return over a specific time period. 81. Holding period yield (HPY) The total return from an investment for a given period of time, stated as percentage. 82. Index component stock A stock that is a component of an index, e.g. TENAGA is one of the component stocks of the KLCI. 83. Initial Public Offering (IPO) This is the initial offer of securities by a company to the public through a stock exchange.
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84. Inverse yield curve The opposite of a normal yield curve, when long term interest rates are lower than short term interest rates (and the yield curve slopes downwards). 85. Investment advisory services Services provided to customers by investment advisers covering areas such as investment and wealth management/financial planning. These may be individuals licensed by the Securities Commission of Malaysia as investment advisers or authorized representatives of banks. 86. Investment banking Wholesale banking (as opposed to retail/consumer banking) covering corporate finance, fund raising, underwriting of securities, wealth management, and treasury and investment products that target the institutional, corporate and high-net worth markets. 87. Instrument Denotes any form of funding medium – mostly those used for financing in financial markets. 88. Issuer A legal entity that offers or sells debt securities for the purpose of financing its operations. It is also called the debtor or borrower. 89. Joint venture A joint undertaking involving two or more partners with a common business objective, e.g. to construct a bridge. 90. Junk bonds Bonds that are rated as below investment grade (see bond rating). Higher risk of default because of not-so-strong financial condition and/or other adverse factors, but giving higher yields than investment grade bonds (see BBB rated bonds in investments instrument map). 91. Large caps Listed companies, often blue chips, with a large capital base. [Opposite: Small caps] 92. Leveraged buyout Takeover of a company using its (the acquiree's) assets as collateral to borrow to finance the acquisition. 93. Liquidation The process of winding up a company by selling its assets, settling its liabilities and distributing the surplus (if any) to shareholders. 94. Loan stock/notes Debt securities issued by a company for subscription. 197
95. MAIN Market MAIN market in Malaysia refers to the board where companies listed are mostly large and established ones. Bursa Malaysia sets rules and conditions for entry as a MAIN market candidate, including a minimum paid up capital of RM 60 million. 96. Malaysian Government Securities (MGSs) Tradeable long term bonds issued by the Government of Malaysia to raise funds for development financing. Considered highest rated for investments in Malaysia. 97. Monetary notes Short term notes issued by Bank Negara. Like T Bills, monetary notes are considered almost risk free. Traded in the secondary market. 98. Manipulations The act of transacting in the securities of a company that will have or is likely to have the effect of raising or lowering or maintaining the price of the company's securities on a stock market, with the intention of inducing other persons to purchase or subscribe for the company's securities. Such acts are illegal under the Securities Industry Act 1983. 99. Market cap Short for market capitalization. It is the theoretical market value of the company, arrived at by multiplying the share price by the number of shares outstanding. 100. Market correction Refers to the opposing movement in prices generally in a market after a period of continued rise or fall. When the market trend is upwards, a correction may offer opportunities for purchase of stocks. 101. Maturity When a debt or bond is due to be repaid. In insurance, it is the time when the policy expires. 102. Maturity value The amount payable upon maturity. 103. Mortgage Backed Security (MBS) This a bond representing an interest in a pool of mortgage assets where the investor receives the proportionate share of net cash flow arising from the pool instead of bond interest and principal. 104. Merchant banking This is an English term for investment banking. See investment banking. 105. Merger A legal combination of two or more entities into one. 198
106. Mid caps Listed companies with medium sized market capitalization. 107. Money market deposits These are short-term deposits, usually from overnight to three months, placed with a financial institution in the money market. An individual may make such deposits but unlike fixed deposits, money market deposits from individuals are subject to a minimum limit of RM 500,000. 108. Money market instruments A money market is the place where financial institutions with surplus liquidity lend to financial institutions who want to use short term funds. It is also a market where short term financial instruments are traded over the counter. Instruments traded in this market are called money market instruments. 109. Municipal Bond A bond issued by state, city or other local government or its agencies. Potential issuers include cities, counties, redevelopment agencies, school districts, publicly owned airports and seaports, and any other governmental entity (or group of governments) below the state or central government level. Municipal bonds may be general obligations of the issuer or secured by specified revenues. 110. Negotiable Instruments of Deposit (NID) Previously known as Negotiable Certificates of Deposit (NCD). A NID is an instrument evidencing a deposit with a financial institution for a fixed amount for a fixed period. NIDs can be traded in the secondary market. 111. Net Asset Value (NAV) The fair value of assets less liabilities. In the unit trust industry, this refers to the market value of the assets less liabilities of a fund. The NAV per unit would be the NAV divided by the number of units in circulation. Take for example; a fund has assets with a market value of RM 100 million and liabilities of RM 10 million and units in circulation of 50 million. Its NAV would be RM 90 million (100 million - 10 million) and its NAV/unit would be RM 1.80 (NAV RM 90 million divided by 50 million). 112. Net Book Value (NBV) The book value of assets (including intangible assets in the books, such as goodwill) less liabilities. Book value represents the value in the books net of accumulated depreciation and amortization. Often used as a reference valuation.
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113. Net Tangible Asset (NTA) The book values of tangible assets (thus excluding intangible assets such as goodwill) less liability. Book value represents the value in the books net of accumulated depreciation and amortization. One of the common methods of valuing businesses. 114. Nominee A party appointed to hold shares in his own name on behalf of the beneficial owner. A person nominated to receive proceeds of an insurance policy either beneficially or as trustee for beneficiaries. 115. Odd lot Less than 100 share (a board lot). An odd lot is harder to transact since they are not of standard size and are generally traded at a discount to a board lot. 116. Offer price The price offered by a party who is willing to sell at that price. [Opposite: Bid price] 117. Opening price The price of the first (opening) transaction for a given trading day. [Opposite: Closing price] 118. Over-the-counter (OTC). This refers to trading outside an exchange, such as Bursa Malaysia, usually through a dealers' network (e.g. trading of bonds). 119. Paid up capital The amount of capital issued and already paid up by members 120. Pari passu On par, equal standing. A share ranks pari passu with the others in its class, i.e. it has exactly the same rights and privileges as any other share in its class. 121. Pre-emptive right For a private limited company in Malaysia, shareholders have pre-emptive rights, meaning should one shareholder wish to sell his shares, and such shares must first be offered to existing shareholders in proportion to their shareholdings. Only when such offer is not accepted may the sale be made to a third party but at no less than the price that was offered to existing shareholders.
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122. Price/Earnings ratio Or Price/Earnings (P/E) multiple. This is a valuation method that measures the number of times the price for a share is represented by its earnings per share. The valuation becomes meaningful when compared with the P/E multiples of others. 123. Price-Yield Relationship The inverse relationship between bond price and required yield. The price of the bond is equivalent to the present value of its cash flows. As the required yield increases, the present value of the cash flow decreases; hence the price decreases (the converse also being true). 124. Private banking A banking service that endeavors to provide to high net worth individuals personalized financial planning covering asset protection, accumulation, diversification and distribution. 125. Private debt securities (PDSs) Notes or bonds issued by companies (the private sector) under conventional or Islamic structures. Require rating and approval of the Securities Commission. 126. Profit-taking Realizing a gain by selling a security at higher than cost or by buying a security, in the case of a short sale, at lower than selling price. 127. Prospectus The document issued to the public to invite for subscription of new securities the purchase of existing securities. Such a document would provide the prospective investor information about the company that is promoting its shares, its financial position and business prospects.
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128. Quote In finance and stock broking, the statement of the current market price of a security. 129. Real Estate Investment Trusts (REITs) An investment trust, that invests in real estate for rental income and capital gains. 130. Realized A gain or loss is said to be realized when an investment is sold. [Opposite: Unrealized). 131. Redeemable Can be redeemed, either at the option of the holder or at the option of the issuer, depending on the terms of the issue.
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132. Registrar of Companies (ROC) The public official appointed to administer the Companies Act 1965 and the Securities Industry Act 1983. 133. Remisier An agent of a stock broking company who trades for customers and earns a commission from the trades. 134. Reserves This refers to the portion of shareholders' funds (equity) in the balance sheet that is not capital, representing undistributed profits and other reserves. 135. Retail banking Often used interchangeably with consumer banking, retail banking is the provision of banking services, such as savings and deposits and consumer financing, to the mass (retail) market. 136. Return Refers to all gains and income from an investment, usually measured by the rate of return on investment (ROI) which is the return (gain & income from investment - cost of investment) divided by the cost of investment, expressed a percentage.
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137. Return on Equity (ROE) It measures the efficiency in the use of equity by an enterprise to generate profit. It is the return calculated by taking net profit after tax divided by average equity, expressed as a percentage. 138. Risk Uncertainty regarding an outcome 139. Risk-adjusted return The return earned on an asset adjusted for the amount of risk involved with that particular asset. 140. Risk-free rate Rate of return earned on a riskless asset. 141. Risk management The process of identifying risks and planning the steps to mitigate or eliminate such risks. For example, hedging is part of risk management. 142. Second liners A term referring to stocks that are not quite blue chip investments. Smaller listed companies may even be referred to as third liners.
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143. Securities Commission (SC) The Securities Commission of Malaysia supervises and regulates the securities environment. 144. Securities Commission Act 1993 The Act of Parliament under which the Securities Commission was established on 1 March 1993. 145. Securities Industry (Central Depositories) Act 1991 An Act of Parliament which governs the activities relating to the Central Depository. 146. Share buyback This refers to a listed company purchasing its own shares, up to the limit authorized by its shareholders. 147. Share split A share split is one where the share is further divided into smaller units, e.g. a RM 1 share could be split to two RM 0.50 shares. 148. Special Investment Vehicle (SIV) A special purpose vehicle that borrows short term money at short term rates and lends long term money or buys long term securities at higher interest rates. The principle risk in investing in a SIV is its exposure to interest rate fluctuations and a run on liquidity if lenders demand money all at once. 149. Special Purpose Vehicle (SPV) A corporate body set up for a single specific purpose, usually to isolate financial risk, with no other activity. Issuers of collateralized debt obligations (CDOs) usually do the borrowing through a SPV. 150. Spot Spot transaction refers to a transaction done for immediate delivery (the number of days for settlement depends on the rules governing the particular trade). 151. Spot price Refers to the price quoted for immediate delivery in securities and commodity trading, as opposed to futures. 152. Standard deviation A measure used to examine the dispersion of a set of data from its mean. It is the square root of variance.
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153. Stress testing Stress testing measures market risk in an abnormal market environment. Stress test determines how badly the portfolio will perform under some of the worst and most unusual circumstances. 154. Stop loss order An order given to a broker to buy or sell a security/forward contract 'at best', if the price for the security moves above (for buy) or below (for sell) a specified limit. The purpose of such an order is to limit the loss (hence stop loss) should the price move against expectations. 155. Systematic risk The risk that is inherent in the market, and cannot be reduced through diversification. 156. Systemic risk The risk of the collapse of a financial system, caused by a failure of one bank that in turn, triggers a default by other banks. For example, the collapse of one or more hedge funds can trigger the collapse of banks that financed them which in turn causes a breakdown in the financial system. 157. Take-over Transfer of control of a company from one group of shareholders to another group of shareholders 158. Technical analysis An analysis, that seeks to interpret trading patterns through historical price and volume movement. 159. Thinly traded Listed shares that are not often traded, such as small cap shares or those that make up a small float are said to be thinly traded. Thinly traded shares tend to be more volatile in price because there is a wider gap between the bid and offer price for trading. 160. Top-down approach A sequential approach to security analysis that entails making forecasts from the macroeconomic viewpoint such as the economy, followed by the industry and finally, the individual company. 161. Total return This is made up of all elements of income from an investment, such as dividends and capital gains. 162. Treasury The treasury function in investment banking covers money market, currency and derivative trading activities. 204
163. Treasury Bills (T Bills) These are short term zero-coupon notes issued by the Government of Malaysia to finance working capital. Considered to be the most risk-free investment in the Malaysian context & traded in the secondary market. 164. Trust A sum of money or asset/s held and administered by a trustee company on behalf of the beneficiaries of the trust. 165. Trustee A person or trust company entrusted with a trust fund, comprising a sum of money and/or assets, by another for the benefit of named beneficiaries. In the case of the trust company, it normally holds the trust fund assets in its own name to be administered and distributed in accordance with the terms of the governing trust deed. 166. Underwriter One who guarantees a minimum subscription or take-up for a share offering in the stock exchange. In the event the offer to the public falls short of the underwritten amount, the underwriter will have to take up the shortfall. 167. Underwriting The process by which, an issue of securities to the public is backed by undertakings from underwriters, to take up any shortfall in subscription or purchase. 168. Underwritten An issue of securities to the public is said to be fully underwritten when there are sufficient underwriters who have undertaken to purchase or subscribe in the event there is a shortfall in take-up. In insurance, it refers to the risk being accepted by insurer/s. 169. Universal bank A bank that offers a full range of services, from investment banking to insurance to commercial banking. 170. Unsystematic risk Risk that can be reduced through diversification. 171. Variance of returns A measure of dispersion based on a set of data points in relation to their mean value. 172. Volatility A measurement of risk based on the standard deviation of the asset‟s return.
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173. Warrants An instrument that gives its holder the right (but not the obligation), to purchase a specified number of shares, at a specified price for a given period of time. The writer of a warrant has the obligation to perform. 174. Wealth management This term and private banking is often used interchangeably. Please see private banking. 175. Writer of the option The seller of a put or call option contracts that are obligated to buy or sell the underlying security if the options are exercised. 176. Yield Income earned from capital invested, expressed as a percentage. Thus, the simple yield for an annual income of RM 10 from a capital investment of RM 100 would be 10% [(10/100) x 100]. 177. Yield to Call The interest yield that will be realized on a callable bond if it is held from the point of purchase until the date when it can be called by the issuer. The yield to call reflects the fact that lower overall return may be realized if the issuer avoids some later interest payments by retiring the bonds early. 178. Yield to maturity YTM - the yield that would be realized if a bond holding was held until maturity, hence the term yield to maturity. It takes into account any discount from or premium to face value which needs to be amortized over the remaining life of the bond. Any discount will make YTM greater than current yield while any premium will make YTM less than current yield. 179. Yield to Put The interest rate that makes the present value of the cash flows to the put date, plus the put price on that date as set forth in the put schedule, equal to the bond's price. 180. Zero coupon bonds Bonds that do not pay interest (hence zero coupon) but are issued at a steep discount. Popular underlying instrument for principal guaranteed derivatives. 181. Zero sum game A situation where an individual, can only gain to the detriment of another party.
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References: i. -
Securities Commission Examination Study Guide: Module 6, Stock Market & Securities Law. Module 7, Financial Statement Analysis and Asset Valuation. Module 12, Investment Management and Corporate Finance. Module 14, Futures and Options.
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Equity and Fixed Income. CFA Program Curriculum, Volume 5 (CFA Institute, 2008).
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Derivatives and Alternatives Investments. CFA Program Curriculum, Volume 6 (CFA Institute, 2008).
ii. iii. iv.
An Introduction to Derivatives and Risk Management. Chance/Brooks (International Student Edition)
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The Internet – various sources.
vi.
Bank Negara Malaysia website : www.bnm.gov.my
vii.
Securities Commissions of Malaysia website: www.sc.com.my
viii.
Various presentation slides of the Financial Sector Talent Enhancement Programme (FSTEP)
ix.
Diploma In Investment Banking Handbook –IBBM
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www.bankinginfo.com.my
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FINANCIAL SECTOR TALENT ENRICHMENT PROGRAMME (a programme managed by Institut Bank-Bank Malaysia) LEVEL 1, DATARAN KEWANGAN DARUL TAKAFUL 4, JALAN SULTAN SULAIMAN 50000 KUALA LUMPUR
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