An introduction to the bond market in South Africa with special reference to risk, risk evasion and strategy formulation
Thesis (MBA)--Stellenbosch University, 1984.
The capital market is a field of very specialised financial knowledge and expertise. The latter is concentrated in relatively few people who manage vast portfolios of such assets. I was introduced to the South African capital market early in 1983. In an effort to comprehend the intricacies of my new surroundings I started to look for something to read to answer the many questions I had. Very little is written about the South African capital market, even more so for readers who are not well acquainted with this subject. This technical report endeavours to fill such a need. It surveys risk, risk management and strategy formulation pertaining to the holding of a single or portfolio of bonds. Chapter 1 is a general introduction. It surveys the growth of the capital market, the reason for such growth and briefly points out the parameters of thereof. It introduces the financial intermediaries that are responsible for the matching of demand and supply and briefly points out the difference between the money- an capital markets. Three important concepts, yield to maturity, a yield curve and the price calculation of a bond is explained and three important general shapes that the yield curve might adopt, is introduced. Chapter 2 takes account of the risk that is presently associated with the holding of a single or a portfolio of bonds. The effects of inflation, changes in the level of applicable yield to maturities and the reinvestment risk is explained and quantified given a particular scenario of ex ante contingencies. Less quantifiable elements of risk, namely, marketability, political and default risk and the role of emotions and expectations, are discussed and possible problems in this regard are pointed out. Chapter 3 turns to a more theoretical discussion of risk. It looks at the expected rate of return on a single or portfolio of bonds and reviews the method of measuring expected risk in terms of a standard deviation. Chapter 3 concludes by making the important remark that risk is an esoteric concept which is based on an expected scenario of contingencies of each investor. Central to the discussion is the formation of a scenario pertaining to the relevant variables concerning the bond investment market. Chapters 4 and 5 are dedicated to two lesser known concepts, duration and immunisation. Each bond has its own unique duration. That is the time period during which a loss of capital value will be exactly equal to the gain in interest earned on invested coupons received in the case of an upwards move in the applicable yield to maturity curve, and vice versa. Chapter 5 uses this feature to immunise a bond portfolio against loss of return. This method, however, needs considerable study before it can be used as a portfolio management tool since it is based on parallel movements of the yield to maturity curve. Chapter 6 introduces a new· feature, namely options on bonds, of the South African bond market. It defines options and explains the strategic utilization thereof in both bear and bull markets. Chapter 7 is a practical discussion of strategy formulation in the bond market. It defines strategic decision making and describes the investment process, and its dynamics in terms of strategy formulation and execution. Active and passive portfolio management and the main problem encountered in South Africa pertaining to strategy execution are briefly discussed. Two different portfolio tactics that are employed, namely, options and switching, to enhance portfolio performance (earnings) are introduced. The chapter makes mention of the present state of the art of portfolio management and concludes that portfolio managers must above all be people who can cope with, and anticipate change.