Fstep Manual Investment Banking Final

First Edition April 2010

FINANCIAL SECTOR TALENT ENRICHMENT PROGRAMME

INVESTMENT BANKING HANDBOOK

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© 2010 Institut Bank-Bank Malaysia

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material form or by any means, including photocopying and recording, or stored in any

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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 Bank-

Bank 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

http://www.ibbm.org.my/

mailto:[email protected]

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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 14

1.1 Introduction 15

1.2 Financial System - Constituents 16

1.3 Financial System of Malaysia 17

1.4 Banking System 17

1.5 Financial Markets 20

1.6 Importance of Banking Business to the Economy 20

1.7 Financial Sector Master Plan 21

1.8 Capital Market Master Plan 22

1.9 Impact of Globalization - Recent Developments 23

Summary 25

Activity Q&A 26

Suggested Answers to Activity 27

2 OVERVIEW OF INVESTMENT BANKING


2.1 Introduction 29

2.2 Commercial Banking Vs. Investment Banking 29

2.3 Establishment of Investment Banks in Malaysia 30

2.4 Role and Key Functions of Investment Banks 31

2.5 Overview of Core Activities of an Investment Banks 32

2.6 Roles and Responsibilities of the Middle Office 34

Summary 35

Activity Q&A 36


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Table of Content

3 COMPLIANCE AND REGULATORY FRAMEWORK IN INVESTMENT BANKING


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 47

Activity Q&A 48


4 UNDERSTANDING BONDS


4.1 Introduction 51

4.2 Bonds Terms and Features 51

4.3 Risks in Bonds Investments 52

4.4 Bond valuation 54

4.5 Bond Yields 56

4.6 Price Yield Relationship 57

4.7 Term Structure of Interest Rates and Yield Curve 58

4.8 Ratings of Corporate Bonds 59

4.9 Bonds Issued by Foreign Entities 61

Summary 62

Activity Q&A 63


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Table of Content

5 MALAYSIAN MONEY AND DEBT MARKET SECURITIES


5.1 Introduction 67

5.2 Primary and Secondary Market for Dect Securities 67

5.3 Government Securities and Money Market Instruments 67

5.4 Money Market Instruments Issued by Banks and Financial Institutions 68

5.5 Private Debt Securities 69

Summary 73

Activity Q&A 74


6 UNDERSTANDING SECURITIES AND STOCKBROKING BUSINESS


6.1 History and Developments of Securities Industry in Malaysia 77

6.2 Functions of a Stockbroking Division 78

6.3 The Trading System 79

6.4 Clearing and Settlement 79

6.5 Central Depository System 81

6.6 Trading on Bursa Malaysia Securities Berhad 81

6.7 Financially Distressed Listed Companies 83

6.8 Outline of a Trade Trasaction 84

6.9 Account Structure 84

Summary 85

Activity Q&A 86


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Table of Content

7 MALAYSIAN EQUITY MARKET


7.1 Introduction 89

7.2 Basic Functions of a Stock Market 89

7.3 The Malaysian Stock Market 90

7.4 Types of Securities Traded on Bursa Malaysia Securities Berhad 90

7.5 Classifications of Shares for Investment Purposes 94

7.6 Participants in the Malaysia Equity Markets 95

Summary 96

Activity Q&A 97


8 UNDERSTANDING DERIVATIVES MARKETS


8.1 Introduction 100

8.2 General Description of Derivatives 100

8.3 The Role of Derivatives 103

8.4 The Main Players in the Derivatives Markets 104

8.5 Introduction to Futures 105

8.6 Introduction to Options 107

8.7 Regulatory Framework and Structure of The Malaysian Derivatives Markets 115

Summary 117

Activity Q&A 118


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Table of Content

9 CORPORATE FINANCE - MERGERS AND ACQUISITIONS (M&A) AND

DIVESTITURES



9.2 Initial Public Offering (IPO) 122

9.3 Mergers and Acquisitions 134

9.4 Divestitures 134

Summary 138

Activity Q&A 139


10 RISK MANAGEMENT IN INVESTMENT BANKING



10.2 What is Risk Management? 142

10.3 Classification of Risks 142

10.4 Risk Management - The process and system 142

10.5 Role and Responsibilities of the Risk Management Unit 145

10.6 Risk Management Techniques 146

10.7 Basel Capital Accord 149

Summary 150

Activity Q&A 151


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Table of Content

11 FINANCIAL STATEMENT ANALYSIS



11.2 Objectives of Financial Analysis 154

11.3 Financial Information 154

11.4 Financial Ratio Analysis 158

Summary 169

Activity Q&A 170


12 VALUATION OF EQUITIES



12.2 The Top Down Approach to Analysis 174

12.3 Basic Valuation Model 175

12.4 Price Earning (PE) Model 178

12.5 Measurement Investment Return 179

Summary 180

Activity Q&A 181


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Table of Content

APPENDIX

1 KLCI Futures – Contract Specifications 185

2 Crude Palm Oil Futures – Contract Specifications 186

3 KLIBOR Futures – Contract Specifications 187

4 KLCI Options – Contract Specifications 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 non-

compliance 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. Money & Foreign Exchange Market,

ii. Capital Market,

iii. Derivatives Market, and

iv. Offshore Market.

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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:-

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. Equity Derivatives

2. Commodity Derivatives

3. Financial Derivatives

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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


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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

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.

Phase II

2004-2007

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.

Phase III

After 2007

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

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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. 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.

ii. 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:

25

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 world-

class 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.

26

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.

27

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.

28

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.

29

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).

30

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.

31

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


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.

http://www.bnm.gov.my/index.php?ch=13&cat=banking&type=MB&sort=lf&order=asc

http://www.bnm.gov.my/index.php?ch=36&pg=114&ac=45&cat=banking&type=MB















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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.

33

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.


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.


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.


i. Advising, originating and issuing of products/structures.

ii. Designing products/structures with modified risk-return profiles.

34

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.


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.

35

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.

36

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.

37


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.

38

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


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.

39

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

40

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

41

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. 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.

III. 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.

42

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

43

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.

Sources: Securities Commission.

3.4 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.

SCA

CMSA Companies Commission

Of Malaysia.

Companies Act 1965

SC

Bursa Malaysia Securities Bhd.

Bursa Malaysia Depository Sdn.

Bhd.

Bursa Malaysia

Derivatives Bhd.

Bursa Malaysia

Derivatives Clearing Bhd.

BhdBhd

Bursa Malaysia

Securities Clearing Bhd.

Bhd

Labuan International

Financial Exchange Inc.

44

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).

45

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 to-

i. 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.

46

(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 create-

i. 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

by-

i. 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.

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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?

49


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


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

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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

53

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

54

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. An estimate of expected cash flow.

ii. An estimate of appropriate required yield.

The cash flow for straight bonds consists of:

i. Periodic coupon payment to maturity date. Generally the coupon interest

payment is made every six months.

ii. 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 = coupon payment

Pn = principal payments at maturity period

T = number of years to maturity

i = 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 = number of years

PMT = coupon payment

I/Y = the interest rate

FV = 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:

57

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.

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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 short-

term 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 Definition

AAA Issues rated AAA are judged to be of the best quality and offer the highest

safety for timely payment of interest and principal.

AA 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.

60

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

BB 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.

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.

62

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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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. 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).

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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


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 short-

term 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 profit-

based 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 broker-

dealers 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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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


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 19th 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.

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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.

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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 T* T+1 T+2 T+3 T+4

1. Date of contracts.

2. Delivery of Securities.

2.1. Transfer of Securities.

By such time(s) as

may be prescribed

by Bursa Malaysia Depository Sdn.

Bhd.

Not later than 3.00

pm.

2.2. Book entry delivery.

Not later than

9.00 am

2.3. Automatic buying-in. Between 8.30 am-12.30 pm,

2.00 pm-5.00 pm.

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. 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. PO to Bursa Malaysia Securities

Clearing Sdn. Bhd. Not later than 10.00 am.

5. Selling out. By T+4

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

RM1.00 – RM9.99

RM10.00 – RM99.98

RM100 and above

0.5 sen.

1 sen.

2 sen.

5 sen.

Sources: Bursa Malaysia

C. Orders

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The types of orders that may be entered through SCORE are-

i. 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:

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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 43,200.00

Brokerage: RM43, 200 x 0.06 2,592.00

Stamp duty: (RM1.00 for RM1000.00 or fractional part of value) 44.00

Clearing fee: RM43, 200 x 0.03% 12.96

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 they-

i. Have been adjudicated bankrupt and remain un-discharged at the time of application

ii. Are mentally disordered

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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 1st 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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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


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

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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

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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.

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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 long-

term 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.

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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.

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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.

97

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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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.

99

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


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) = 0.10 x contract value

IM = 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

(4)

Margin Account

Trader A

Short

position

(RM)

Balance

(RM)

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. 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.

ii. 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.

iii. 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.

8.4 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.

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8.5.4 Pricing a Futures Contract

Mathematically, the future price could be written as:

Where

F t,T = futures price for a contract with maturity from t, to T (t =today,

T = maturity)

So = current spot price of the underlying asset

rf = annualized risk free interest rate (being the proxy for the

Opportunity cost of later payment)

c = annualized storage cost in percent (inclusive of shipping /handling,

Shrinkage, spoilage etc.)

Y = 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 = 1100 (1 + 0.06 + 0.04 – 0)

= 1100 (1.10)

= 1126.53 per ton

Price per contract = 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.

107

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.

109

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 be

used are common shares, equity indexes, futures contracts, debt instruments,

foreign currencies or commodities. These assets are known as underlying assets.

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

110

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

10.00

10.50

11.00

11.50

12.00

12.20

12.50

13.00

13.50

14.00

14.50

(.20)

(.20)

(.20)

(.20)

(.20)

(.20)

0

.30

.80

1.30

1.80

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?


9.50

10.00

10.50

.20

.20

.20

111

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

Maximum loss Maximum gain

Buyer (long) Premium Unlimited

Seller (short) Unlimited Premium

Breakeven X + premium

112

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?


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?


9.50

10.00

10.50

11.00

(2.35)

(1.85)

(1.35)

(0.85)

113

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

Maximum loss Maximum gain

Buyer (long) Premium X − Premium

Seller (short) X − Premium Premium

Breakeven 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.

114

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 = RM1, 500

Less cost of Stock delivered on Exercise = (RM800)

Less Premium paid on Puts = (RM15)

Profit form Puts = 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. To provide facilities whereby buyers and sellers can meet to trade contracts.

ii. To ensure open and competitive trading.

iii. To set and enforce rules for operating in the futures market.

iv. To collect and disseminate market and price information.

116

The following products are currently traded on the Exchange:

1. Equity Derivatives

i. FBM Kuala Lumpur Composite Index Futures (FKLI).

ii. FBM Kuala Lumpur Composite Index Options (OKLI).

iii. Single Stock Futures (SSFs).

2. Commodity Derivatives

i. Crude Palm Oil Futures (FCPO).

ii. USD Crude Palm Oil Futures (FUPO).

iii. Crude Palm Kernel Oil Futures (FPKO).

3. Financial Derivatives

i. 3-Month KLIBOR Interest Rate Futures (FBK3).

ii. 3-Year Malaysian Government Securities Futures (FMG3).

iii. 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.

117

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-the-

counter 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.

118

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.

119

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.

120

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.

121

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


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.

122

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

(“PAT”) of 3 - 5 full financial years

(“FY”), with aggregate of at least

RM20 million; and

PAT of at least RM6 million for the

most recent full FY

No minimum operating track record or

profit requirement

(b) Market

Capitalisation Test

A total market capitalization of at

least RM500 million upon listing; and

Incorporated and generated operating

revenue for at least 1 full FY prior to

submission

-

(c) Infrastructure

Project

Corporation test

Must have the right to build and operate an

infrastructure project in or outside

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 Minimum RM0.50 each No minimum

Public Spread At least 25% of the Company's share

capital; and

Minimum of 1,000 public

At least 25% of the Company's share

capital; and

Minimum of 200 public shareholders

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shareholders holding not less than

100 shares each

holding not less than 100 shares each

Bumiputera Equity

Requirement*

Allocation of 50% of the public spread

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 foreign-

based 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 Main Market ACE Market

Sponsorship Not applicable 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

has majority ownership and

management control

Core business should not be holding of

investment in other listed companies

Core business should not be holding of

investment in other listed companies

Management

Continuity and

Capability

Continuity of substantially the same

management for at least 3 full financial

years prior to submission

For market capitalization test, since the

commencement of operations (if less

than 3 full financial years)

Continuity of substantially the same

management for at least 3 full financial

years prior to submission or since its

incorporation (if less than 3 full

financial years)

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Financial

Position &

Liquidity

Sufficient level of working

capital for at least 12 months;

Positive cashflow from the

operating activities; and

No accumulated losses based on

its latest audited balance sheet as

at the date of submission

Sufficient level of working capital for

at least 12 months

Lock-up Period Promoters' entire shareholdings for six

(6) months from the date of admission

Subsequent selling down with

conditions for companies listed under

Infrastructure Project Corporation test

Promoters' entire shareholdings for six

(6) months from the date of admission,

subsequent selling down with

conditions

Transaction with

related parties

Must be based on terms and conditions

which are not unfavourable to the

company

All trade debts exceeding the normal

credit period and all non-trade debts,

owning by the interested persons to

the company or its subsidiary

companies must be fully settled prior

to listing

Must be satisfactorily addressed

before submitting any listing

application to the Exchange

Sponsor must ensure all trade debts

exceeding normal credit period and

all non-trade debts, owning by the

interested persons to the company or

its subsidiary companies must be

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

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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) The relative size of the individual companies;

(ii) Management control of the combined business; and

(iii) 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

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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

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:

Search for suitable

candidate

Screening process

Due diligence

Signing of

conditional sale and

purchase agreement

Negotiation

Make approach

Identify target

Satisfactory Unsatisfactory

Abort transaction Renegotiation

Not approved

Application to

authorities

Approvals obtained

Implementation

Not

agreed

Identify target

Agreed

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i. Price factor - What would the acquisition cost be?

- What is the highest price payable for the target

company?

ii. Shareholder factor - Would the acquisition be regarded as

desirable, by the acquiring company‟s

shareholders and the stock market in general?

iii. Purchase consideration - What is the mode of consideration?

iv. Other factors - 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. Cash;

ii. Share;

iii. Debt paper; or

iv. 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. Cash acquisitions are generally quicker to complete;

ii. Cash acquisitions may be cheaper as it avoids the cost associated with a new

share issue;

iii. 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

iv. 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

132

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 Bridging the gap

Operating at maximum production capacity Acquire a company making similar

products operating substantially below

capacity.

Lacking key customer in a target sector Acquire a company with the right

customer profile

Need to expand the product range Acquire a company with a

complementary product range

Need to increase market share

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. Analyst reports (for public-listed companies)

ii. Trade journals and publications;

iii. Trade associations;

iv. Research studies;

v. Business contacts;

vi. 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. Eliminating candidates that would not meet strategic requirement, such as

size, geographical area, product mix, market share; and

ii. 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

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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. The maximum price payable for the target company;

ii. Principal risk areas;

iii. Cash flow and balance sheet implications of the acquisition; and

iv. The best way of structuring the acquisition.

To estimate the maximum acceptable purchase price of the target company, the stand-

alone 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. Provides management and Board of Directors with a base for responding

quickly and responsibly;

ii. Highlights the need for divestment or other restricting opportunities; and

iii. 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. A subsidiary/associate/investment is not adding value or eroding value. The

buyer may be the management of the subsidiary, i.e., management buyout;

ii. A subsidiaries/associate/investment does not or longer fits in with the group‟s

strategic plan;

iii. Subsidiaries/associates/investment with high risk could be sold to reduce the

business risk of the group as a whole; and

iv. 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. Full disposal;

ii. Equity carve-outs;

iii. Spin-offs;

iv. Splits-offs; and

v. 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. Economies of scale may be lost;

ii. The post demerger group will have lower turnover, profits and status than the

group before the demerger;

iii. As a result of (i) and (ii) above, there may be higher overhead costs as a

percentage of turnover; and

iv. Vulnerability to take-overs may increase as the size of the group decreases.

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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”)

Signing of sale & purchase

agreement

Formulate a restructuring

plan

Board of Directors approves

the restructuring plan which

includes divestitures

Identify buyer

Negotiation

Shareholders‟ and

regulatory approvals.

Completion of deal.

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9.4.2 Financial evaluation of divestures

The following steps form a typical financial evaluation process for divesture:

Figure 5: Financial Evaluation Process

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. If P > (V-L), the parent company should sell the business; and

ii. 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 carve-

out for various reasons. Some of the more common reasons are:

i. As financing technique i.e. to raise funds;

ii. To reduce exposure to a riskier line of business.

iii. Corporate down-sizing; and

iv. 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

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

137

100%

%

Inject assets

Consideration

issue ordinary shares

100%

%

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 spun-

off entity. In this spin-off structure, the parent company does not receive any cash flow

from transaction.

Figure 6: Spin-off Structure

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.

100%

%

Shareholders

Parent

company

New co

100%

%

Shareholders

Parent

company

New co

Parent company distributes new- co shares to shareholders

Shareholders

Parent

company

New-co/ spun off

company

100%

%

100%

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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.

140


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) Access to equity capital.

2) Secondary market for shares.

3) Heightened corporate image.

4) 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


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 asset-

specific 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.

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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 customer-

related 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. Communicating risks to all affected stakeholders.

ii. Monitoring risk mitigation plans.

iii. Reviewing regular status updates.

iv. 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.

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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.

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.

Figure 7

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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

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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

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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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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‟ pro-

rata 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, short-

term 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, shareholders and

the government;

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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. Liquidity ratios,

ii. Operating performance ratios,

iii. Financial risk ratios,

iv. Growth ratios and

v. 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 FY 2008

RM 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 5,500 4,200

Marketable securities 1,500 2,400

Accounts receivable 61,600 52,000

Inventory 76,000 63,000

Prepaid expenses 900 600

Total current assets 145,500 122,200

Fixed assets

Plan and equipment 45,000 40,000

Investment 1,800 1,600

46,800 41,600

Total assets 192,300 163,800

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Current liabilities

Account payable 22,000 24,100

Notes payable 5,700 3,000

Accruals 30,000 27,300

57,700 54,400

12% debenture 25,000 20,000

Total liabilities 82,700 74,400

Share capital 28,000 22,000

Reserves 7,500 5,500

Retained profits 74,100 61,900

Shareholders’ fund 109,600 89,400

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:

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

Current ratio = Current assets/current liabilities

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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 = (Current assets – Inventory – Prepayment)/current liabilities)

Quick asset ratio = (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

Account receivable turnover = net sales/average account receivable

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 = Net sales/shareholders‟ funds

or

Equity turnover = 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 by

dividing operating profit by net sales.

Operating profit margin = 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 = 18,760/415,000

= 4.52%

Net profit margin in 2008 = 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

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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 x Net sale. x . Total assets .

Net sales Total assets Shareholders‟ fund

= Profit margin x Total assets turnover 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 computed

as follows:

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:

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

Gross dividends per share = Gross dividends/number of ordinary shares

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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:

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.

NTA per share = Net tangible assets/number of ordinary shares

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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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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


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.

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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

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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 = expected growth rate

b = 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

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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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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


An increase in the dividend payout ratio will result in the numerator (D1/E) to increase.

Hence, P/E will increase.

6. A


= 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


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 3rd

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 Calls; C OKLI

Puts ; P OKLI

Underlying Instrument 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


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 in-

the-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.

191

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.

192

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.

193

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].

194

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.

195

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. Ex-

Is 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.

196

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.

197

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.

198

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.

199

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.

200

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 or

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.

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 as

a percentage.

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.

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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.

ii. Equity and Fixed Income.

- CFA Program Curriculum, Volume 5 (CFA Institute, 2008).

iii. Derivatives and Alternatives Investments.

- CFA Program Curriculum, Volume 6 (CFA Institute, 2008).

iv. An Introduction to Derivatives and Risk Management.

Chance/Brooks (International Student Edition)

v. 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

x. www.bankinginfo.com.my

http://www.bnm.gov.my/

http://www.sc.com.my/

http://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

Fstep Manual Investment Banking Final

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