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Edition  5,  June   2019 This   workbook   relates   to   syllabus  version   12   and   will   cover   examinations   from   10  September  2019  to  9  September   2020

I n t ern a tional   I n t r odu c tion   to   Securities   &    I n v estme n t ( A frica)

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Welcome   to   the   Chartered   Institute   for   Securities   &   Investment’s   International   Introduction   to   Securities   &  Investment  study   material. This   workbook   has   been   written   to   prepare   you   for   the   Chartered   Institute   for   Securities   &   Investment’s  International  Introduction  to  Securities  &  Investment   examination. Published   by: Chartered Institute  for  Securities   &  Investment ©   Chartered   Institute   for   Securities   &   Investment   2019   20  Fenchurch   Street London  EC3M   3BY Tel:  +44  20  7645   0600 Fax:  +44  20  7645   0601 Email:   customersupport@cisi.org    www.cisi.org/qualifications Author: Kevin  Rothwell,  Chartered   MCSI   Tom   Minney Reviewers: JB  Beckett,  Chartered   MCSI   Natasha   Manrai This   is   an   educational   workbook   only   and   the   Chartered   Institute   for   Securities   &   Investment   accepts   no   responsibility   for   persons   undertaking   trading   or   investments   in   whatever   form. While  every  effort  has  been made  to  ensure  its  accuracy,  no  responsibility  for  loss  occasioned  to  any  person   acting   or   refraining   from   action   as   a   result   of   any   material   in   this   publication   can   be   accepted   by   the  publisher  or   authors. All  rights  reserved.  No  part  of  this  publication  may be  reproduced,  stored in  a  retrieval  system,  or   transmitted,   in   any   form   or   by   any   means,   electronic,   mechanical,   photocopying,   recording   or   otherwise   without  the  prior  permission  of the  copyright  owner.  Warning:  any unauthorised  act  in  relation  to  all   or  any  part  of the  material  in  this  publication  may  result  in  both  a  civil  claim  for  damages and   criminal   prosecution. A  learning  map,  which  contains  the  full  syllabus,  appears  at  the  end  of  this  workbook.  The  syllabus   can   also   be   viewed   on   cisi.org   and   is   also   available   by   contacting   the   Customer   Support   Centre   on   +44   20   7645   0777.   Please   note   that   the   examination   is   based   upon   the   syllabus.   Candidates   are   reminded   to   check the  Candidate Update  area  details (cisi.org/candidateupdate)  on  a  regular  basis  for  updates  as  a   result   of   industry   change(s)   that   could   affect   their   examination. The  questions  contained  in  this  workbook  are  designed  as  an  aid  to revision  of  different  areas  of  the   syllabus   and   to   help   you   consolidate   your   learning   chapter   by   chapter.   They   should   not   be   seen   as   a   ‘mock’   examination   or   necessarily   indicative   of   the   level   of   the   questions   in   the   corresponding   examination. Please  note  that,  as  part  of  exam  security,  hand-held  calculators  are  not  allowed  in  CISI  exam  venues.   Candidates  must  use  the  onscreen  calculator  for  all  CISI  CBT  exams in  all  languages  in  the  UK  and   internationally. Workbook  version:  12.1  (June   2019)

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Learning  and  Professional  Development  with  the   CISI The   Chartered   Institute   for   Securities   &   Investment   is   the   leading   professional   body   for   those   who   work   in,   or   aspire   to   work   in,   the   investment   sector,  and   we   are   passionately   committed   to   enhancing   knowledge,   skills   and   integrity   –   the   three   pillars   of   professionalism   at   the   heart   of   our   Chartered   body. CISI  examinations  are  used  extensively  by  firms  to  meet the  requirements of  government  regulators.    Besides   the   regulators   in   the   UK,   where   the   CISI   head   office   is   based,   CISI   examinations  are   recognised   by   a  wide  range  of  governments  and  their regulators,  from  Singapore  to  Dubai and  the  US.  Around  50,000   examinations  are  taken  each  year,  and  it  is  compulsory  for  candidates to  use  CISI learning  workbooks  to   prepare  for  CISI  examinations  so  that  they  have  the  best chance  of  success.  Our workbooks  are   normally   revised  every  year  by  experts  who  themselves  work in  the  industry  and  also  by  our  Accredited  Training   Partners,   who   offer   training   and   elearning   to   help   prepare   candidates   for   the   examinations.   Information   for   candidates   is   also   posted   on   a   special   area   of   our   website:   cisi.org/candidateupdate. This  workbook  not only provides  a  thorough  preparation  for  the  examination  it  refers  to,  it  is  also  a   valuable  desktop  reference  for  practitioners,  and studying  from  it  counts  towards  your  Continuing   Professional  Development  (CPD).  Mock  examination  papers, for  most  of  our  titles,  will  be  made  available   on   our   website,   as   an   additional   revision   tool. CISI   examination   candidates   are   automatically   registered,   without   additional   charge,   as   student   members   for  one  year  (should  they  not be  members  of  the  CISI  already),  and  this  enables  you  to  use  a  vast  range   of  online  resources,  including  CISI  TV,  free  of  any  additional  charge. The  CISI  has  more than  40,000  members,  and  nearly  half  of  them  have  already  completed  relevant  qualifications  and  transferred  to  a   core  membership  grade.  You  will  find  more  information  about  the next  steps  for  this  at  the  end  of this   workbook.

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The   Financial   Services   Sector   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   . The  workbook  commences  with  an  introduction  to  the financial  services  sector  and   examines  the role of the sector  and  the  main  participants  that  are  seen in  financial  centres  around  the   globe.

The   Economic   Environment   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   . An  appreciation  of  some  key  aspects  of  macroeconomics  is  essential to  an  understanding  of the  environment  in  which  investment  services  are  delivered.  This  chapter  looks  at  some  key  measures  of  economic  data  and  the role of  central  banks   in  management   of the  economy.

Financial   Assets   and   Markets   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   . This chapter  provides an  overview  of the  main  types  of  assets  and  then  looks  in   some  detail  at  the  range  of financial markets  that  exist,  including  the  money  markets,   property  and  foreign   exchange.

Equities/Stocks   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   . The  workbook  then  moves  on  to examine  some  of the  main  asset classes  in  detail,   starting with  equities.  It  begins  with  the  features,  benefits  and  risks  of  owning  shares   or  stocks,  looks  at  corporate  actions  and some  of the  main world  stock  markets  and   indices,   and   outlines   the   methods   by   which   shares   are   traded   and   settled.

Bonds   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   . A  review of  bonds  follows  which  includes  looking  at  the key  characteristics  and  types    of   government   and   corporate   bonds   and   the   risks   and   returns   associated   with   them.

Derivatives   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   . Next  there  is  a  brief  review of  derivatives  to  provide an  understanding  of the  key   features   of   futures,   options   and   swaps   and   the   terminology   associated   with   them.

Investmen t   Fund s   .   .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     . 	 111 The  workbook  then turns  to  the  major  area  of  investment  funds  or  mutual  funds/  collective  investment  schemes.  The  chapter  looks  at  open-ended  and  closed-ended   funds,   exchange-traded   funds,   hedge   funds   and   private   equity.

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Regulatio n   an d   Ethic s     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     .     . 	 131 An  understanding  of  regulation  is essential  in  today’s  investment  industry.  This   chapter  provides an  overview  of  international  regulation  and  looks  at  specific  areas,   such  as  money  laundering  and  insider  trading,  as  well  as  a  section  on  professional   integrity  and   ethics.

Other   Financial   Products   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   . The  workbook  concludes  with  a  review of the  other  types  of  financial  products,   including   loans,   mortgages   and   protection   products,   including   life   assurance.

Glossary   .	.   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .

Multiple   Choice   Questions   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .

Syllabus   Learning   Map   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .

It   is   estimated   that   this   workbook   will   require   approximately   70   hours   of   study   time.

What  next? See   the   back   of   this   book   for   details   of   CISI   membership. Need  more  support  to  pass  your  exam? See   our   section   on   Accredited   Training   Partners. Want  to  leave   feedback? Please   email   your   comments   to   learningresources@cisi.org

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This  syllabus  area  will provide  approximately  2  of  the  50  examination   questions

Introduction The  Role  of  the  Financial  Services   Sector Financial   Markets Participants Technological  Advances  and  Other   Developments

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The  Financial Services   Sector Introduction In   this   chapter,   we   will   look   at   the   role   that   the   financial   services   sector   undertakes   within   both   the   local   and  the  global   economy. Stock  markets  and  investment instruments  are  not  unique  to  one  country,  and  there  is  increasing   similarity  in  the  instruments  that  are  traded  on  all  world  markets  and  in  the  way  that  trading  and   settlement  systems  are   developing. This   chapter   looks   at   how   the   sector   is   structured   and   looks   in   detail   at   some   of   its   key   participants. The  Role  of  the  Financial  Services   Sector The  world  is  becoming  increasingly  integrated  and  interdependent,  as  trade  and  investment  flows  are   global  in   nature. With this  background,  therefore, it  is  important  to  understand  the  core role that  the  financial  services   sector   performs   within   the   economy   and   some   of   the   key   features   of   the   global   financial   services   sector. The  financial  services sector  provides  the link  between  organisations  needing  capital  and  those  with   capital  available  for   investment. For  example,  an organisation  needing  capital  might  be  a  growing  company,  and  the  capital  might  be  provided  by  individuals  saving  for their retirement  in  a  pension  fund.  It  is the  financial  services sector   that  channels  money  invested  to  those  organisations  that  need  it,  and  provides  execution,  payment,   advisory  and  management   services. It  is accepted  that  the  financial  services sector  plays  a critical  role  in  all  advanced  economies,  and  that   the   services   it   provides   can   be   broken   down   into   three   core   functions: The   investment   chain   –   through   the   investment   chain,   savers   and   borrowers   are   brought   together.   Savers  provide financing  to businesses,  and  businesses  that  wish  to  grow  offer  opportunities  for   savers   to   take   part   in   the   growth   and   resulting   potential   returns.   The   efficiency   of   this   chain   is   critical   to   allocating   what   would   otherwise   be   uninvested   capital   to   businesses   that   can   use  it  to   grow   their   enterprises,   as   well   as   the   savings   pools   of   the   investors.   This   chain   therefore   raises   productivity   and,   in   turn,   improves   the   competitiveness   of   those   financial   markets   within   the   global   economy. Risk  –  in  addition  to  the  opportunities  that  the  investment chain  provides  for  pooling  investment   risks,   the   financial   services   sector   allows   other   risks   to   be   managed   effectively   and   efficiently   through   the  use  of  insurance,  and  increasingly  through  the  use  of  sophisticated  derivatives.  These  tools  help  businesses  cope  with  global  uncertainties  as diverse as  the  changing  value  of  currencies,  the   incidence  of  major  accidents  or  extreme  weather  conditions.  They  also  help  households  protect   themselves  against  everyday   contingencies. Payment  systems  –  payment  and  banking  services  operated  by  the  financial  services sector   provide  the  practical  mechanisms  for  money  to  be  managed,  transmitted  and  received  quickly   and   reliably. It  is  an  essential  requirement  for  commercial  activities  to  take  place  and  for  participation   in  international  trade  and  investment.  Access  to  payment systems  and  banking  services is  a  vital   component   of   financial   inclusion   for   individuals. 3

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Financial   Markets Equity   Markets Equity   markets   are   the   best   known   of   the   financial   markets   and   facilitate   the   trading   of   shares   in   quoted   companies. The   World   Federation   of   Exchanges   provides   data   from   the   global   stock   exchanges.   As   illustrated   in   the   following  graph,  global  market  capitalisation  was  over  US$78  trillion  towards  the  end  of  2018  (note   that  not  all  stock  exchanges  provide  data  to  the  World  Federation  of  Exchanges  so  actual  figures  may   well  be  higher).  Global  market  capitalisation is the  total  value  of  shares  quoted  on  the  world’s  stock  exchanges. Global  Market   Capitalisation 90,000,000 80,000,000 70,000,000 60,000,000 50,000,000 40,000,000 30,000,000 20,000,000 10,000,000 0

Source:  World  Federation   of  Exchanges At   the   time   of   writing,   the   New   York   Stock   Exchange   (NYSE)   was   the   largest   exchange   in   the   world   and had  a  domestic  market  capitalisation of  over  US$22  trillion  (domestic  market  capitalisation  is   the   value   of   shares   listed   on   an   individual   exchange). The  other  major  US  market,  Nasdaq ,  was  ranked as  the  second  largest,  with  a  domestic  market   capitalisation of  around  US$10  trillion,  meaning  that  the  two  New  York  exchanges  account  for   around   40%   of   all   exchange   business. Japan  Exchange  Group,  which  includes  the  Tokyo Stock  Exchange  (TSE),  is the  world’s  third   largest   market   and   had   a   domestic   market   capitalisation   of   over   US$5   trillion. The   Shanghai   Stock   Exchange   is   the   world’s   fourth   largest   exchange,   with   a   domestic   capitalisation  of  close to  US$4   trillion. In  Europe,  the largest  exchanges  are  the  London  Stock  Exchange  (LSE) ,  Euronext ,  Deutsche   Börse   and   the   SIX   Swiss   Exchange. Many  African  countries  have  stock exchanges.  The  largest  include  South  Africa’s  Johannesburg   Stock  Exchange  (JSE),  which  had  market  capitalisation of  US$865  billion  at  31  December  2018,   Morocco’s   Bourse   de   Casablanca,   the   Egyptian   Exchange   and   the   Nigerian   Stock   Exchange

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

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The  Financial Services   Sector Rivals  to  traditional  stock  exchanges  have also  arisen  with  the  development  of  technology  and   communication   networks   known   as   multilateral   trading   facilities   (MTFs) .   MTFs   are   systems   that   bring   together   multiple   parties   that   are   interested   in   buying   and   selling   financial   instruments   including   shares,   bonds  and  derivatives .  These  systems  are  also  known  as  crossing  networks  or  matching  engines  that   are   operated   by   an   investment   firm   or   another   market   operator. We   will   look   at   equities   and   equity   markets   in   more   detail   in   chapter   4. Bond   Markets Although   less   well-known   than   equity   markets,   bond   markets   are   larger   both   in   size   and   value   of   trading.  However,   the   volume   of   bond   trading   is   lower,  as   most   trades   tend   to   be   very   large   when   compared   to   equity  market   trades. The   amounts   outstanding   on   the   global   bond   market   now   exceed   US$100   trillion.   Domestic   bond   markets   account  for  around  70%  of  the  total,  and  international  bonds  for  the  remainder.  Governments  are  the  largest   issuers   of   bonds,   followed   by   financial   corporations. The  bonds  traded  range  from  domestic  bonds  issued  by  companies  and  governments, to  international   bonds   issued   by   companies,   governments,   and   supranational   agencies   such   as   the   World  Bank.   Although   the   US   has   the   largest   bond   market,   trading   in   international   bonds   issued   by   companies,   governments,   and   supranational   agencies   such   as   the   World   Bank   and   the   African   Development   Bank.   Although   the   US   has   the   largest   bond   market,   trading   in   international   bonds   is   predominantly   undertaken   in   European   markets.   South   Africa   has   Africa’s   largest   bond   market   with   bond   markets   also   growing   in   other   African   countries. Foreign  Exchange  (FX)   Markets Foreign exchange  (FX)  markets  are  the largest of  all  financial  markets,  with  average  daily  turnover  in   excess of  US$5   trillion. The   strength   of   one   currency   in   relation   to   another   and   the   rate   at   which   one   currency   is   exchanged   for   another  is  set  by supply and  demand. For  example,  if  there  is  strong demand  from  Japanese  investors   for   US   dollars,   the   US   dollar   will   rise   in   value   relative   to   the   Japanese   yen. There  is  an  active  FX  market  that  enables governments,  companies  and  individuals  to  deal  with   their  cash inflows  and  outflows  denominated  in overseas  currencies. The  market  is  provided  by  the   major  banks,  who  each  provide  rates  of  exchange  at  which  they  are  willing  to  buy  or  sell currencies.   Historically,  most FX  deals  were  arranged over  the  telephone.  Now,  however, electronic  trading  is   becoming  increasingly   prevalent. As  FX  is  an  over-the-counter  (OTC)  mar ket,  meaning one  where  brokers/dealers  negotiate  directly   with  one  another, there  is  no   central  exchange  or clearing house.  FX  trading  is  concentrated  in  a  small   number  of  financial   centres. The  Bank  for  International Settlements  (BIS)  releases  figures  on  the  composition  of the  FX  market  every  three  years.  The  latest  report,  published  in  2016,  shows  that  market  activity  has  become  ever   more  concentrated  in  a  handful  of  global  centres.  As  you  can  see  in  the  chart  below,  FX  transactions   are  concentrated  in  five  countries,  with  the  UK  as  the  main  global  centre,  historically  reflecting its   geographic   position   in   the   middle   of   the   US   and   Asian   time   zones. 5

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Main  Locations  for  FX   Trading Others   23% UK   37% Japan   6% Hong  Kong   7% Singapore   8% US   19% Source:  Bank   for  International  Settlements FX  trading  has  been  slower to  develop  in  many  African  countries,  including  those which have   maintained  exchange   controls. Derivatives   Markets Derivatives  markets  trade  a  range  of  complex  products  based  on  underlying  instruments,  including   currencies,   indices,   interest   rates,   equities,   commodities   and   credit   risk. Derivatives   based   on   these   underlying   elements   are   available   on   both   the   exchange-traded   market   and   the   OTC   market.   An   OTC   market   is   where   trading   takes   place   directly   between   parties   rather   than   on   an  exchange  and  the  trading  of derivatives is  increasingly  moving  from OTC to  trading  on  exchange.  The   largest of the  exchange-traded  derivatives markets is the  Chicago  Mercantile  Exchange  (CME),  while   Europe   dominates   trading   in   the   OTC   derivatives   markets   worldwide.   Based   on   the   value   of   the   notional   amounts  outstanding,  the  OTC  derivatives markets  worldwide  are  about  four  times the  size  of  stock   quoted  on  stock   exchanges. Interest  rate  derivatives contracts  account  for  the  majority  of  outstanding  derivatives  contracts,   mostly   through  interest  rate  swaps.  In  terms of  currencies,  the  interest  rate  derivatives  market  is  dominated   by   the   euro   and   the   US   dollar,   which   have   accounted  for  most   of   the   growth   in   this  market   since   2001.   The   growth   in   the   market   came   about   as   a   reaction   to   the   2000–02   stock   market   crash   as   traders   sought   to  hedge  their  position  against  interest  rate  risk.  The  next largest  segment  is  FX  derivatives,  which  are   used  to  speculate  on  currency  movements  and  to  hedge  the risks of currency  positions. Equity-linked   contracts,  credit  derivatives  and  commodity  contracts  form  the next  major  segments and  these  are   used   to   hedge   against   risk   or   for   speculation. We   will   look   at   derivatives   in   more   detail   in   chapter   6. Insurance   Markets Insurance  markets specialise  in  the  management  of  personaI  risk,  corporate  risk  and  protection  of  life   events. Globally,  the  US, Japan,  China  and  the  UK  are  the largest  insurance  markets.  The  following  table   shows   the   top   ten   largest   markets   by   insurance   premiums   according   to   a   study   published   in   July   2018   by   Swiss   Re.

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Top  10  Insurance   Markets Ranking Country Share   of   the   World   Market 1 US 28.15% 2 China 11.07% 3 Japan 8.63% 4 UK 5.79% 5 France 4.94% 6 Germany 4.56% 7 South   Korea 3.70% 8 Italy 3.18% 9 Canada 2.44% 10 Taiwan 2.40%

Source:  Swiss   Re The  market  is led  by  a  number  of  major  players  who  dominate  insurance  activity  in  their  sector  or    region;  some  of the largest  are  China  Life,  Allianz  and  AXA.  South  Africa  is  by  far  the largest  insurance   market   in   Africa,   and   there   is   growth   in   other   markets,   especially   in   North   and   East   Africa. Another  well-known  organisation  is  Lloyd’s  (the  world’s  specialist  insurance  market  and  often  referred   to as  Lloyd’s  of  London); with  a  history  dating  back  over  300  years,  it  is  one  of the largest  insurance   organisations  in  the  world.  Lloyd’s  insures  specialist  and  complex  risks  in  casualty,  property,  energy,   motor, aviation,  marine  and  reinsurance.  It  has  a  reputation  for  innovation,  for  example,  developing   policies  for aviation,  burglary  and  cybercrime,  and  is  known  across  the  world  as  the  place  to  bring   unusual,  specialist  and  complicated   risks. Less  well  known  to  the  general  public  is the  reinsurance  industry.  Just  as  individuals use  insurance to   protect  against  the  risk  of  needing  to make  a  claim,  insurers  protect  themselves  by  using  reinsurance  companies.  An  insurer  may  seek  to  hedge  some  of the risks  associated with  the  insurance  policies   it   has   written   by   laying   off   some   of   that   risk   with   a   reinsurer. The   reinsurance   contract   can   cover   an   entire   insurance   portfolio   or   single   risks;   it   may   involve   sharing   all   premiums   and   losses   or   just   those   exceeding  a  threshold,   and   it   can   also   cover   large   one-off   risks,  such   as   major   construction,   satellites   or   large   sporting   events.   Some   of   the   largest   reinsurers   in   the   world   are   Munich   Re,   Swiss   Re,   Hannover   Re,   Berkshire   Hathaway,   and   Lloyd’s   of   London.

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4.	 Participants Learning   Objective 1.1.1	 Know   the   role   of   the   following   within   the   financial   services   sector:   retail/commercial   banks;   savings  institutions;  investment  banks; private banks;  retirement  schemes;  insurance   companies;  fund  managers;  stockbrokers;  custodians;  third party  administrators  (TPAs);   industry   trade   bodies;   sovereign   wealth   funds;   peer-to-peer/crowdfunding The  number  of  organisations  operating  in  the  financial  services sector is  wide  and  varied.  Each  carries   out   a   specialised   function,   and   an   understanding   of   their   roles   is   important   in   order   to   understand   how   the   sector   is   organised   and   how   participants   interact. Although  each participant is  described  as  a  separate  organisation  in  the  following  sections,  the nature  of   financial   conglomerates   means   that   some   of   the   largest   global   firms   may   have   divisions   carrying   out   each of  these   activities. 4.1	 Investment   Banks Investment  banks  provide  advice  and  arrange  finance  for  companies  that  want to  float  on  the   stock  market,  raise  additional  finance  by  issuing  further  shares  or  bonds,  or  carry  out  mergers  and   acquisitions. They  also  provide  services  for  institutional  firms  that  might  want to invest  in shares  and   bonds,   in   particular   pension   funds   and   asset   managers. Typically,   an   investment   banking   group   provides   some   or   all   of   the   following   services: Finance-raising   and   advisory  work,   both   for   governments   and   for   companies.   For   corporate  clients,   this  is  normally  in  connection  with  new  issues  of  securities  to  raise  capital,  as  well  as  giving  advice   on  mergers  and   acquisitions. Securities-trading  in  equities,  bonds  and  derivatives  and  the  provision  of  broking and  distribution   facilities. Treasury  dealing  for  corporate  clients  in  currencies,  including  ‘financial  engineering’  services  to   protect   them   from   interest   rate   and   exchange   rate  fluctuations. Investment  management  for  sizeable investors,  such  as  corporate  pension  funds,  charities  and  very   wealthy   private   clients.   In   the   larger   investment   banks,   the   value   of   funds   under   management   runs   into   many  billions   of  dollars. Only  a  small  number  of  investment  banks  provide  services  in  all  these  areas.  Most  others tend to    specialise  to  some  degree  and  concentrate  on  only  a  few  product  lines.  A  number  of  banks  have   diversified  their  range  of  activities  by developing  businesses  such  as  proprietary  trading,  servicing   hedge   funds,   or   making   private   equity   investments.

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The  Financial Services   Sector 4.2	 Custodian   Banks Custodians  are  banks  that  specialise  in  safe  custody  services,  looking  after  portfolios  of  shares  and   bonds  on  behalf of  others,  such  as  fund  managers,  pension  funds  and  insurance  companies.  Activities   they undertake   include: Holding   assets   in   safekeeping,   such   as   equities   and   bonds. Arranging   settlement   of   any   purchases   and   sales   of   securities . Asset  servicing  –  collecting  income  from  assets,  namely  dividends  in  the  case  of  equities  and   interest   in   the   case   of   bonds,   and   processing   corporate   actions. Providing   information   on   the   underlying   companies   and   their   annual   general   meetings  (AGM) . Managing  cash   transactions. Performing   FX   transactions   when   required. Providing  regular  reporting  on  all  activities  undertaken  that  affect  the  holdings  in  a  portfolio,   including   all   trades,   corporate   actions   and   other   transactions. Cost  pressures have driven  down  the  charges  that  a  custodian  can make  for its  traditional  custody   services   and   have   resulted   in   consolidation   within   the   industry.   The   custody   business   is   now   dominated   by  a  small  number  of  global  custodians  who  are  often  divisions  of  major  banks.  Among  the  biggest   global   custodians   are   the   Bank   of   New   York   Mellon   and   State   Street. Generally,   they   also   offer   other   services   to   their   clients,   such   as   stock   lending,   measuring   the   performance   of   the   portfolios   of   which   they   have   custody   and   maximising   the   return   on   any   surplus   cash. Retail/Commercial   Banks Retail/commercial  banks  are  known  by  different  names  in  different  countries.  They  are  the  financial   institutions  that  provide  services,  such  as  taking deposits  from,  and lending  funds  to,  retail  customers,   as  well  as  providing  payment  and money  transmission  services.  They  may  also  provide  similar   services   to  business   customers. Historically,  these  banks  have  tended  to  operate  through  a  network  of  branches  located  on  the  high   street,   but   increasingly   they   are   moving   to   telephone   and   internet-based  services.  As   well   as   providing   traditional   banking  services,  larger   retail   banks   also  offer  other   financial   products,   such   as   investments,   pensions and  insurance.  Banks  that  offer  multiple services  such  as this  are  known  as  ‘financial   conglomerates’.  The  BIS  defines  a  financial  conglomerate  as  ‘ any  group  of  companies  under  common   control  whose  exclusive or  predominant  activities  consist  of  providing  significant  services  in  at  least  two   different   financial   sectors   (banking,   securities,   insurance) ’. Savings   Institutions As  well  as  retail  banks,  most  countries  also have  savings  institutions  that  started  off  by  specialising  in   offering   savings   products   to   retail   customers,   but   now   tend   to   offer  a   similar   range   of   services   to   those   offered  by   banks.

Scene 16

They  are  known  by  different  names  around  the  world,  such  as  cajas  in  Spanish-speaking  countries,   credit  unions  in  North  America  and building  societies  in  Australia  and  the  UK.  They  are  typically  jointly   owned   by   the   individuals  that   have   deposited   or   borrowed   money   from   them   –   the   members.  In   some   African  countries  savings  organisations  are  called  savings  and  credit  cooperatives  (SACCOs).  In  many   countries   there   are   also   microfinance   institutions   and   informal   savings   clubs   and   associations. Over   the   years,   many   savings   institutions   have   merged   or   been   taken   over   by   larger   ones.   More   recently,  a  number  have  transformed  themselves into  banks  that  are  quoted  on  stock  exchanges  –  a  process   known  as   demutualisation. Peer-to-Peer  (P2P)  and   Crowdfunding A  more  recent  development  in  the  banking  sector  has  been  the  emergence  of  competitors  to  the   traditional   role   of   banks   in   the   form   of   peer-to-peer   (P2P)   lending   or   crowdfunding. In   the   traditional   banking   model,   banks   take   in   deposits   on   which   they   pay   interest   and   then   lend   out   at  a   higher   rate;   the   spread   between   the   two   is   where   they   earn   their   profit.   P2P   lending   cuts   out   the   banks   so  that  borrowers  often  receive  slightly  lower  rates,  while savers  get  far  improved  headline  rates,  with   the   P2P   firms   themselves   profiting   via   a   fee. In  exchange  for  accepting  greater  risk,  savers can  earn  higher  returns  which  can  be  very  useful  during   periods  of  low  interest  rates.  Available  rates  vary  depending  on  the  type  of  borrower  that  the  P2P   site  lends  to  and  the  risk  the lender is  prepared to  accept.  The  deposit  is  lent  out  to  individuals  and   businesses,   but  it  may   take   time   before   all   of   a   large   deposit   is   lent   and   interest   is   earned.   No   interest   is   paid  while  it  is  waiting  to  be  lent  out.  Immediate withdrawals  are  not  always  possible  and,  where they   are,   may   take   time   and   incur   a   charge   or   a   reduced   interest   rate. Insurance   Companies As  mentioned  above,  one  of the key  functions  of the  financial  services sector is  to allow  risks  to  be   managed   effectively. The   insurance   industry   provides   solutions   for   much   more   than   the   standard   areas,   such   as   life   cover   and   general insurance   cover. Protection  planning  is  a  key  area  of  financial  advice,  and  the  insurance industry  provides  a  variety  of   products  to  meet  many  potential  scenarios.  These  products  range  from  payment  protection policies   designed  to  pay out  in  the  event  that  an  individual  is  unable  to  meet  repayments  on  loans  and   mortgages,   to   fleet   insurance   against   the   risk   of   an   airline’s   planes   crashing. Insurance   companies   collect   premiums   in   exchange   for   the   coverage   provided.   This   premium   income   is   invested   in   equities   and   bonds   and,   as   a   result,   the   insurance   industry   is   a   major   investor   in   both   equity   and  bond  markets.  Insurance  companies  will  also  hold  a  large  amount  of  cash  to  be  able  to  satisfy   any   claims   that   may   arise   on   the   various   policies   and,   if   required,   will   liquidate   investment   holdings.

Scene 17

The  Financial Services   Sector Retirement   Schemes Retirement  schemes  (or  pension  schemes)  are  one  of the key  methods by  which individuals  can make   provision  for their retirement  needs.  There  are a  variety  of  retirement  schemes  available,  ranging  from   ones   provided   by   employers,   to   self-directed   schemes. Traditionally,  company pension  schemes  provided  an  amount based  on  the employee’s  final  salary   and  number  of years of  service.  Nowadays,  many companies  find this  too  expensive  a  commitment,   given  rising  life-expectancy  and  volatile  stock  market  returns.  Most  companies  offer  new  staff  defined  contribution  schemes,  when both  the  firm  and  the  employee  contribute to  an  investment  pot.  At   retirement,   the   accumulated   fund   is   used   to   provide   a   pension. Many  individuals  are  not  members  of  company  schemes  and  instead  provide  for their  retirement   through   their   own   personal   retirement   schemes   (self-directed   schemes). Taken  overall,  retirement  schemes  are large,  long-term investors in  shares,  bonds  and  cash.  Some  also   invest   in   physical   assets   like   property.   To   meet   their   aim   of   providing   a   pension   on   retirement,   the   sums   of   money   invested   in   pensions   are   substantial. Fund   Managers Fund   managers,   also   known   as   investment   managers,   portfolio   managers   or   asset   managers,   run   portfolios   of  investments  for  others.  They  invest  money  held  by  institutions,  such  as  pension  funds  and  insurance   companies,   as   well   as   wealthier   individuals.   Some   are   organisations   that   focus   solely   on   this   activity;   others   are   divisions   of   larger   entities,   such   as   insurance   companies   or   banks.   Fund   management   is   also   known   as   asset   management.   The   global   asset   management   industry   has   more   than   doubled   in   size   since   2000,   with   the  Organisation  for  Economic  Co-operation  and  Development  (OECD)  and  the International   Monetary   Fund   (IMF)   estimating   that   there   are   over   US$90   trillion   of   funds   under   management. Investment   managers   will   buy   and   sell   shares,   bonds   and   other   assets   in   order   to   increase   the   value   of   their   clients’  portfolios.  They  can  be subdivided  into  institutional  and  private  client  fund  managers. Institutional   fund   managers   work   on   behalf   of   institutions,   for   example,   investing   money   for   a   company’s   pension   fund   or  an  insurance company’s  fund,  or  managing  the  investments of  a  mutual  fund. Private client  managers   invest   the   money   of   relatively   wealthy   individuals.   Obviously,   institutional   portfolios   tend   to   be   larger   than   those   of   regular   private   clients. Fund  managers  charge  their  clients  for  managing  their  money.  Their  charges  are  often  based  on  a   small  percentage  of the  value  of the  fund  being managed  and  may  also have  charges  linked to  the   performance   achieved. Other   areas   of   asset   management   include   running   so-called   hedge   funds   and   the   provision   of   investment   management   services   to   institutional   entities,   such   as   charities   and   local   government   authorities.

Scene 18

4.9	 Stockbrokers and  Wealth  Managers Stockbrokers arrange  stock  market  trades  on  behalf of  their  clients,  who  are  investment  institutions,   fund   managers   or   private   investors.   They   may   advise   investors   about   which   shares,   funds   or   bonds   they   should buy  or,  alternatively,  they  may  offer  execution-only  services,  when  the  broker  executes  a  trade   on  a client’s  instruction  without  providing  advice.  Many  stockbrokers  now  offer  wealth  management   services   to   their   clients   and   so   are   also   referred   to   as   wealth   managers. In   many   European   and   global   markets,   stockbrokers   can   be   divided   into   four   main   categories: Execution-only  stockbrokers  –  these  offer  telephone  or internet-based  trade  execution  and   settlement  for  retail clients.  No  advice  is  offered  and commission  is  charged  per  trade.  They  are    aimed   at   day   traders   and   investors   who   are   confident   in   making   their   own   investment   decisions   and,   typically,  investors  with  small   portfolios. Robo-advisers  –  a  recent  innovation,  a  robo-advisor  is  an online  wealth  management  service that   provides  automated,  algorithm-based  portfolio  management  advice  without  the  use  of  human    financial planners.  The  robo-advisor  typically  charges  a  monthly  or  annual  fee  based  on  the  size  of   the   portfolio   (amount   of   assets   under   management). Advisory  and  discretionary  wealth  managers  –  these  offer  a  wealth  management  service  to   private  investors  –   either  advice  only  or  a  fully  managed  (discretionary)  service.  Their  target market   ranges  from  mass  affluent  to  high  net  worth  clients  with large  portfolios  and  they  charge  fees  for   management   of   the   portfolio   based   on   the   value   of   the   portfolio. Institutional  brokers  –  these  are  stockbrokers  who  arrange  trades  on  behalf of  large  institutions.   Their   skill   lies   in   their   ability   to   execute   what   are   typically   large   trades   in   the   market,   without   having   a  significant adverse  effect  on  the  share  price.  This  may involve breaking  up  a  large order  into   smaller  trades  and  executing them  through  a  variety  of  different  trading  venues  so  as to  minimise   their   impact   on   the   market.   Institutional   brokers   usually   charge   basis   point   fees   per   trade. Like   fund   managers,   stockbrokers   look   after   client   assets   and   charge   custody   and   portfolio   management   fees  in  these   markets. However,  in  many  African  markets,  stockbrokers  are  still  licensed as  brokers,  dealers  or  both.  A  broker   sells   securities   to   investors   on   behalf   of   issuers,   provides   investment   advice   and   acts   as   agent   to   buy   and   sell  securities  on  behalf of  clients.  They  can  also  act  as  sponsoring  broker  for  an  issuer  that  wishes  to    list   securities   on   a   stock   exchange,   ensuring   the   issuer   fulfils   the   issuing   and   listing   requirements   of   the   regulator  and  the exchange.  Dealers undertake  the  same functions  as  brokers,  but  they can  also  trade   on   secondary   markets   on   their   own   behalf   –   buying   securities   they   believe   are   underpriced   and   aiming   to   make   a   profit   by   selling   them   at   a   higher   price. 4.10	 Private   Banks Private  banks  provide  a  wide  range  of services  for their  clients,  including  wealth  management,  estate   planning,  tax  planning,  insurance,  lending and  lines  of  credit.  Their  services  are  normally targeted   at  clients  with  a  certain  minimum  sum  of  investable  cash,  or  minimum  net  worth.  These  clients  are    generally   referred   to   as   high   net   worth   individuals   (HNWIs).

Scene 19

The  Financial Services   Sector Private  banking  is  offered  both by  domestic  banks  and by  those operating  ‘offshore’.  In  this  context,   offshore   banking   means   banking   in   a   jurisdiction   different   from   the   client’s   home   country   –   usually   one   with  a  favourable  tax   regime. Competition   in   private   banking   has   expanded   in   recent   years   as   the   number   of   banks   providing   private   banking  services  has  increased  dramatically.  The  private  banking  market  is  relatively  fragmented,  with   many  medium-sized  and   small  players. The  distinction between  private  and  retail  banks  is  gradually  diminishing  as  private  banks  reduce   their   investment   thresholds   in   order   to   compete   for   this   market;   meanwhile,   many   high   street   banks   are   also   expanding   their   services   to   attract   the   ‘mass   affluent’   and   HNWIs. 4.11  Sovereign  Wealth  Funds   (SWFs) A  sovereign  wealth  fund  (SWF)  is  a  state-owned  investment  fund  that  holds  financial  assets  such  as   equities,  bonds,  real  estate,  or other  financial  instruments.  Examples  of  SWFs  include  the  Norway   Government  Pension  Fund,  Abu  Dhabi  Investment  Authority,  SAMA  Foreign  Holdings  of  Saudi  Arabia   and  China  Investment  Corporation.  At  least  12  African  countries  had SWFs  in  2018,  and  more  were   preparing   funds,   mostly   in   order   to   preserve   some   revenues   from   commodity   exports   for   the   benefit   of   future   generations. SWFs   are  defined   as   special   purpose   investment   funds   or   arrangements   owned   by   a  government.   Their   key  characteristics   are: SWFs   hold,   manage,   or   administer   assets   to   achieve   financial   objectives. They   employ   a   set   of   investment   strategies   which   include   investing   in   foreign   financial   assets. The   assets   of   an   SWF   are   commonly   established   out   of   balance  of   payments   surpluses,   official   foreign   currency  operations,  the  proceeds  of  privatisations,  fiscal  surpluses,  and  receipts  resulting  from   commodity   exports. Sovereign  wealth  funds  have  emerged  as  major  investors in  the  global  markets  over  the  last  ten   years,   but   they   date   back   at   least  five   decades   to   the   surpluses   built   up   by   oil-producing   countries   and,  more   recently,   to   the   trade   surpluses   that   countries   such   as   China   have   enjoyed. Sovereign  wealth  funds  have colossal  funds  under  management  and  are  predicted to  grow beyond   the  US$10  trillion  mark  within  a  few  years.  African  SWFs  have  managed  up  to  US$160   billion,  although   the   total   assets   under   management   has   fallen   considerably   to   below   US$90   billion   since   a   decline   in   oil   prices   and   linked   to   governance   changes   in   some   countries. They   are   private   investment   vehicles   that   have   varied   and   undisclosed   investment   objectives.   Typically,   their  primary  focus  is  on  well-above-average  returns  from  investments  made  abroad.  Their  size  and   global  diversification  allows  them  to  participate  in  the  best opportunities,  spread  their  risks  and,  by   diverting   their   funds   overseas,   prevent   the   overheating   of   their   local   economies.   They   may   also   use   part   of   their   wealth   as   reserve   capital   for   when   their   countries’   natural   resources   are   depleted. For  some  of the  wealthiest SWFs,  it  should  be  noted  that  the  term  ‘sovereign’  is  not  synonymous  with   public   ownership.

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SWFs  are  becoming  increasingly  important  in  the international  monetary  and  financial  system,   attracting   growing   attention.   This   growth   has   also   raised   several   issues: Official  and  private  commentators have expressed  concerns  about  the  transparency  of  SWFs,   including  their  size  and  their  investment  strategies,  and  that  SWF  investments  may be  affected  by   political   objectives. There  are  also  concerns  about  how  their  investments  might  affect  recipient countries,  leading  to   talk  about  protectionist  restrictions  on  their  investments,  which  could  hamper  the international  flow of   capital. In  response  to these  concerns,  the International  Working  Group  of  Sovereign  Wealth  Funds  (IWG)  has   been   formed   and   has   published   a   set   of   24   voluntary   principles,   the   Generally   Accepted   Principles   and   Practices for  Sovereign  Wealth  Funds,  known  as  the  Santiago  Principles.  This is  leading  to  increasing   transparency,  with  a  number  of  countries,  including  some  African  countries,  now  publishing  annual   reports   and   disclosing   their   assets   under   management. Trade   Bodies The  investment industry  is  a  dynamic,  rapidly  changing  business,  and one  that  requires  co-operation    between  firms  to  ensure  that  the  views  of  various  industry sections  are  represented,  especially  to   governments and  regulators,  and  that  cross-firm  developments  can  take  place  to  create  an  efficient   market   in   which   those   firms   can   operate. This   is   the   role   of   the   numerous   trade   bodies   that   exist   across   the   world’s   financial   markets.   Examples   of  these   that   operate   globally   are   the   International   Capital   Market   Association   (ICMA),   which   concentrates   on  international  bond  dealing,  and  the International  Swaps  and  Derivatives  Association  (ISDA),  which  produces   standards   that   firms   that   operate   in   OTC   derivatives   follow   when   dealing   with   each   other. Third-Party Administrators   (TPAs) Third-party  administrators  (TPAs)  undertake  investment  administration  on  behalf of  other  firms,  and   specialise   in   this   area   of   the   investment   industry. The   number   of   firms,   and   the   scale   of   their   operations,   has   grown   with   the   increasing   use   of   outsourcing  by   firms.   The   rationale   behind   outsourcing   has   been   that   it   enables   a  firm  to   focus   on   the   core   areas   of   its   business  (for   example,   investment   management   and   stock   selection,   or   the   provision   of   appropriate   financial   planning)   and   leave   another   firm   to   carry   on   the   administrative   functions   which   it  can   process   more   efficiently. Mobile  Money   Providers In  some  African  countries,  where  regulation  allows  it  and  the  population  is  keen,  the  mobile  network   operators   (MNOs)   which   provide   mobile-telephone   services   also   offer   mobile-money   transfer   and   other   services.   The   MNOs   are   not   usually   regulated   as   financial   services   firms   themselves,   but   often   work   with   banks,  lending  organisations  and  insurance  companies. Kenya  is  one  of the  leading  countries where   mobile   money   is   transforming   some   financial   activities   and   there   are   26   million   mobile   money   accounts  out   of   a   population   of   some   51   million   people.   However,   cash   still   accounts   for   the   largest   proportion   of   transactions.   Africa   leads   the   world   is   use   of   mobile   money,   with   an   estimated   100   million   Africans   (one  in  ten adults)  being  active  users  of  mobile  financial  services.  Financial  technology   (FinTech)  companies   and   banks   are   increasing   competition   for   mobile   banking   customers. 14

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The  Financial Services   Sector 5.	 Technological  Advances  and  Other   Developments Technology  and  the  demand  for  greener  solutions  are  changing  the  way  that  the  financial  services  sector   operates. Technology  is  embedded  in  everything  we  do,  changing  the  way  we  live,  work,  and  experience the   world.   Advances   in   technology   have   radically   altered   how   we   use   the   internet   and   communicate   which,   in  turn, are  disrupting  traditional   industries. Financial  technology,  known  as  FinTech,  is  impacting  on  the  conservative  banking  and  wealth   management  industry  and  therefore  requires the  development  of  new  digital  services  and  platforms.   People across  all  generations  are  now  digitally proficient  and  they desire  constant  access  to   sophisticated   tools   and   services,   with   clients   of   financial   services   firms   being   no   different. We   have   looked   already   at   how   challenger   banks,   P2P   lending,   robo-advice   and   mobile   financial   services   are  challenging  the  long-established  provision  of  banking  and  investment  services.  Technological   developments  in  communications  are  also  changing  the  face  of the  industry.  Today,  we  communicate   using  the  latest  apps  or  buy  products online  based  on  the  artificial  intelligence  (AI)  recommendations   of  digital  providers.  Customers  are  demanding  the  same  range  of  digital  capabilities  that  they  have  become  used  to  for  other  products  and  services.  As  an  example,  China’s  fund management  industry   has  gone  from  fledgling  asset  management  to  global  pioneer in  a  short  number  of years  in  terms  of   how  fund  purchases  take  place.  In  2012,  only  a  handful  of  investors  made  fund  purchases online  but,   according   to   a   survey   by   the   Asset   Management   Association   of   China,   more   than   two-thirds   of   investors   now   subscribe   to   funds   via   mobile   phone   apps. Green finance  and  sustainable  finance  are  becoming  increasingly  important  topics in  the  financial   services  sector.  Sustainable  finance  refers  to  the  process  of  taking  due  account  of  environmental  and   social  considerations in investment  decision-making,  leading  to increased  investments in  longer  term   and   sustainable   activities.   Climate   finance   is   an   emerging   form   of   green   finance   available   for   projects   in   developing   countries   which   helps   reduce   emissions   or   adapt   to  climate  change.   This   is   achieved  either   via   increasing   the   revenues   available   to   public   and   private   development   projects,   such   as   tariff   support   or  carbon  finance,  or  by improving  project capital  structure,  for  example  by  reducing   the  costs  of  debt   and   equity.

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Think   of   an   answer   for   each   question   and   refer   to   the   appropriate   section   for   confirmation. Name   two   African   stock   exchanges. Answer  Reference:  Section   3.1 What   are   the   main   types   of   services   provided   by   investment   banks? Answer  Reference:  Section   4.1 What   services   does   a   custodian   offer? Answer  Reference:  Section   4.2 How   does   a   mutual   savings   institution   differ   from   a   retail   bank? Answer   Reference:   Sections   4.3   and   4.4 What   is   protection   planning   and   what   scenarios   can   protection   policies   provide   cover   for? Answer  Reference:  Section   4.6 What   is   the   main   reason   African   countries   have   been   establishing   sovereign   wealth   funds? Answer  Reference:  Section   4.10 What   sectors   of   the   financial   services   sector   do   the   International   Capital   Market   Association   (ICMA)   and   the   International   Swaps   and   Derivatives   Association   (ISDA)   represent? Answer  Reference:  Section   4.12 What   is   the   role   of   a   third-party   administrator? Answer  Reference:  Section   4.13

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This  syllabus  area  will provide  approximately  3  of  the  50  examination   questions

Introduction Factors  Determining  Economic   Activity Central   Banks Inflation

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The  Economic   Environment 1.	 Introduction In  this  chapter  we turn to  the  broader  economic environment  in  which  the  financial  services sector   operates. First,   we   will   look   at   how   economic   activity   is   determined   in   various   economic   and   political   systems,   and   then   look   at   the   role   of   governments   and   central   banks   in   the   management   of   that   economic   activity. Finally,  the chapter  concludes  with  an  explanation  of  some  of the key  economic  measures  that   provide  an   indication   of   the   state   of   an   economy.

2.	 Factors  Determining  Economic   Activity Learning   Objective 2.1.1	 Know   the   factors   which   determine   the   level   of   economic   activity:   state-controlled   economies;   market   economies;   mixed   economies;   open   economies Every  country  has  a  set  of  characteristics,  such  as  natural  resources  and  a  skilled  workforce,  which  can   influence   their   ability   to   grow   their   economy. While  it  is  not  just  economic  factors that  influence  economic  development, they  are  important  for   understanding   the   capacity   or   the   ability   of   an   economy   to   develop   on   its   own.   There   are   several   factors  affecting  economic  growth,  and  it  is  helpful to  split  them into  demand-side  factors  (eg,  consumer   spending) and  supply-side  factors  (eg,  productive  capacity).  Each of  these  factors  influences  the   available   economic   resources   and   growth   opportunities   within   a   country. Economic systems  are  the  means  by  which  countries  determine  how  they  will  use  these resources  to    resolve  the  basic  problem  of  what,  how  much, how,  and  for  whom, to  produce.  The  main  types  are    a  planned  economy,  a  market  economy and  a  mixed  economy, while  an  open  economy  refers  to  a   country’s   economic   relationship   with   the   rest   of   the   world.   Each   of   these   are   considered   below. 2.1	 State-Controlled  Economies A  state-controlled  economy  is  one  in  which  the  state (in  the  form  of the  government)  decides  what is   produced   and   how   it   is   distributed;   they   are   also   known   as   planned   economies   or   command   economies.   The  best-known  example  of  a  state-controlled  economy  was  the  Soviet  Union throughout  most  of the   20th   century. Sometimes  these  economies  are  referred  to as  ‘planned  economies’,  because  the  production  and   allocation of  resources  is  planned  in advance  rather  than  being  allowed to  respond  to  market  forces.   The  perceived  advantage  of  a  planned  economy  is  suggested  to  be low  levels  of  inequality  and   unemployment,  with  the  common  good  replacing  profit  as  the primary incentive of  production.   However,   this   may   not   be   the   case   and   large   inequalities   can   arise,   as   seen   in   countries   such   as   Russia   and   Venezuela. The  need  for  careful  planning  and  control can  bring  about  excessive  layers  of  bureaucracy,   and   state   control   inevitably   removes   a   great   deal   of   individual   choice. 19

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These   latter   factors   have   contributed   to   the   reform   of   many   planned   economies   and   the   introduction   of   a   more   mixed  economy   (covered   in   more   detail   in   section   2.3).   Many   African   countries   sought   to   follow   a   planned   economy   model   in   the   1960s   and   1970s,   but   most   have   reformed   to   more   mixed   economies.   In   recent   years,   one   or   two   countries   have   been   heading   back   towards   more   centralised   control. Market  Economies In   a   market   economy,   the   forces   of   supply   and   demand   determine   how   resources   are   allocated. Businesses  produce  goods  and  services  to  meet  the  demand  from consumers.  The  interaction  of   demand  from  consumers  and supply  from  businesses  in  the  market  will  result  in  the market-clearing   price  –  the  price  that  reflects  the  balance  between  what  consumers  will  willingly  pay  for  goods  and   services,   and   what   suppliers   will   willingly   accept   for   them. If  there  is  oversupply,  the  price  will  be low  and some  producers  will  leave  the  market.  If  there  is   undersupply,   the   price   will   be   high,   attracting   new   producers   into   the   market. There  is  a  market  not only  for  goods  and  services,  but  also  for  productive  assets,  such  as  capital   goods   (eg,  machinery),  labour  and  money.  For  the  labour  market,  it  is the  wage  level that  is  effectively  the   ‘price’,  and   for   the   money   market   it   is   the   interest   rate. People   compete   for   jobs   and   companies   compete   for   customers   in   a   market   economy.   Scarce   resources,   including  skilled  labour,  such  as  that  provided  by  a  football  player,  or  a  financial  asset,  such  as  a   share  in  a  successful company,  will  have  a  high  value.  In  a  market  economy,  competition  means  that  inferior  football players  and  shares in unsuccessful  companies  will  be  much  cheaper  and, ultimately,   competition  could  bring  about  the  collapse  of the  unsuccessful  company,  and  result  in  the  inferior   football   player   seeking   an   alternative   career. Mixed  Economies A   mixed   economy   combines   a   market   economy   with   some   element   of   state   control.   The   vast   majority   of   established   markets   operate   as   mixed   economies   to   a   lesser   or   greater   extent. While   most   of   us   would   agree  that  unsuccessful   companies   should   be   allowed   to   fail,   we   generally   feel   that   the   less   able   in   society   should   be   cushioned   from   the   full   force   of   the   market   economy. In  many  mixed  economies,  governments  provide  welfare  systems  to  support  the  unemployed,  the   infirm   and   the   elderly,   in   tandem   with   the   market-driven   aspects   of   the   economy.   Governments   will   also   spend   money   running   key   areas   such   as   defence,   education,   public   transport,   health   and   police   services. Governments   raise   finance   for   this   public   expenditure   by: collecting   taxes   directly   from   wage-earners   and   companies collecting   indirect   taxes   (eg,   sales   tax   and   taxes   on   petrol,   cigarettes   and   alcohol),   and raising   money   through   borrowing   in   the   capital   markets.

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The  Economic   Environment 2.4	 Open  Economies In   an   open   economy   there   are   few   barriers   to   trade   or   controls   over   foreign   exchange. Although  most  western  governments  create  barriers  to  protect  their  citizens  against  illegal  drugs  and   other dangers, they generally  have  policies to allow or  encourage  free  trade.  African  countries  would   benefit   from   increased  trade  with  their  neighbours   but   progress   is   held   back   by   obstacles,   such   as  lack   of   infrastructure,   high   transport   costs   and   bureaucracy. From  time  to  time,  issues  will arise  when one  country  believes  another  is  taking  unfair  advantage   of  trade  policies  and  will  take  some  form  of  retaliatory  action,  possibly including  the  imposition  of   sanctions.   For   example,   trade   tensions   between   the   US   and   other   countries   have   seen   the   US   introduce   tariffs  on  imports  to  protect  their  domestic  industry;  this  has  led  to  international  concerns  about  the   rise  of protectionism.  When  a  country prevents  other countries from  trading  freely  with  it  in  order  to    preserve   its   domestic   market,   this   is   usually   referred   to   as   protectionism. The   World   Trade   Organization   (WTO)   exists   to   promote   the   growth   of   free   trade   between   economies.   It   is,  therefore,   sometimes   called   upon   to   arbitrate   when   disputes   arise.

3.	 Central   Banks Traditionally,   the   role   of   government   has   been   to   manage   the   economy   through   taxation   and   economic   and  monetary  policy ,  and  to  ensure  a  fair  society  by  the  state  provision  of  welfare  and  benefits  to   those  who  meet  certain  criteria,  while  leaving  businesses  relatively  free  to  address  the  challenges  and   opportunities  that   arise. Governments  can  use  a  variety  of  policies  when  attempting  to reduce  the impact of  fluctuations  in  economic  activity.  Collectively,  these  measures  are  known  as stabilisation policies  and  are  categorised   under  the  broad  headings  of  fiscal  policy  and  monetary  policy.  Fiscal  policy  involves  making   adjustments  using  government  spending  and  taxation,  while  monetary policy  involves  making   adjustments   to   interest   rates   and   the   money   supply. Rather   than   following   one   or   another   type   of   policy,   most   governments   now   adopt   a   pragmatic   approach   to   controlling   the   level   of   economic   activity   through   a   combination   of   fiscal   and   monetary   policy.   In   an   increasingly   integrated   world,   however,   controlling   the   level   of   activity   in   an   open   economy   in   isolation   is  difficult,  as  financial  markets,  rather  than individual  governments and  central  banks,  tend  to  dictate   economic   policy. Governments  implement  their  monetary  policies  using  their central bank,  and  a  consideration  of  their  role  in  this  implementation  is  noted  below. Central  banks  are  guided  in  their activities  by  the  Bank  for   International Settlements  (BIS)  which was  established in  1930. The  BIS  has 60  member  central  banks   representing  countries from  around  the  world  which,  together,  make  up  approximately  95%  of  world   gross  domestic  product  (GDP).  The  South  African Reserve  Bank  and  the  central  Bank  of  Algeria  are  the  African   members   of   the   BIS.   The   mission   of   the   BIS   is   to   serve   central   banks   in   their   pursuit   of   monetary   and   financial  stability,  to   foster   international   cooperation   in   those   areas   and   to  act   as  a  bank   for   central   banks. 21

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3.1	 The  Role  of  Central   Banks Learning   Objective 2.1.2	 Know   the  role  of  central  banks Central  banks  operate  at  the very  centre  of  a  nation’s financial  system.  They  are  usually  public  bodies   but,  increasingly,  they  operate  independently  of  government  control or  political  interference.  They   usually have  the  following   responsibilities: acting   as   banker   to   the   banking   system   by   accepting   deposits   from,   and   lending   to,   commercial   banks acting   as   banker   to   the   government managing  the  national   debt regulating  the  domestic  banking   system acting  as  lender of  last  resort  to  the  banking  system in  financial crises  to prevent  the  systemic  collapse  of the  banking   system setting   the   official   short-term   rate   of   interest controlling  the  money   supply issuing  notes  and   coins holding   the   nation’s   gold   and   foreign   currency   reserves influencing  the  value  of  a  nation’s  currency  through  activities  such  as intervention  in  the currency  markets providing   a   depositors’   protection   scheme   for   bank   deposits. The  following  table  shows  details  of  some  of the  world’s  main  central  banks  and  two leading  African   central   banks.

The  Federal  Reserve  System  in  the  US  dates back to  1913. The  Fed,  as  it  is  known,   comprises  12  regional  Federal  Reserve  Banks,  each of  which monitors  the  activities   of,  and   provides   liquidity   to,   the   banks   in   its   region. The  Federal  Open  Market  Committee  (FOMC)  takes  responsibility  for  decisions,   which  are  directed  towards  its  statutory  duty  of  promoting  price stability  and   sustainable  economic   growth. The   FOMC   meets   every   six   weeks   or   so   to   examine   the   latest   economic   data   in   order  to  gauge  the health of the  economy and  determine  whether  the  economically   sensitive  Fed  funds  rate  should  be  altered.  Very  occasionally  it  meets  in  emergency   session,  if  economic  circumstances   dictate. As  lender of  last  resort  to  the  US  banking  system,  the  Fed  rescued  a  number  of  US   financial  institutions  and  markets  from collapse  during  the  financial   crisis,  including   the   financing   of   government   bailouts   of   the   US   auto   industry   and   agency   mortgage   associations.  In  doing  so,  it  prevented widespread  panic,  and  prevented  systemic   risk   from   spreading   throughout   the   financial   system.

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European   Central   Bank   (ECB) The  ECB  is  based  in  Frankfurt. It  assumed  its central  banking  responsibilities  upon   the   creation   of   the   euro,   on   1   January   1999. It  is principally  responsible   for  setting monetary policy  for  the  entire  eurozone,  with   the   objective   of   maintaining   internal   price   stability.   Its   objective   of   keeping   inflation,   as defined  by  the  harmonised  index  of  consumer  prices  (HICP),  ‘ close  to  but  below   2%  in  the  medium  term ’  is  achieved  by  influencing those  factors that  may  influence   inflation,   such   as   the   external   value   of   the   euro   and   growth   in   the   money   supply. The  ECB  sets  its  monetary policy  through  its  president  and  council,  the  latter  of   which   comprises   the   governors   of   each   of   the   eurozone’s   national   central   banks. Bank  of   England   (BoE) The  UK’s  central bank,  the  BoE,  was  founded  in  1694,  but  it  wasn’t  until  1997,  when   the  BoE’s  Monetary  Policy  Committee  (MPC)  was  established,  that  the  Bank  gained   operational  independence  in setting  UK  monetary  policy,  in  line  with  that  of  most   other  developed   nations. The  MPC’s  primary  focus  is  to  ensure  that  inflation is kept  within  a  government-set   range.   It   does   this   by   setting   the   base   rate,   an   officially   published   short-term   interest   rate   and   the   MPC’s   sole   policy   instrument. In addition  to  its  short-term  interest  rate-setting  role,  the  BoE  is  one  of the  UK’s    regulators,   and   assumes   responsibility   for  all  other   traditional   central   bank   activities –  with  the  exception  of  managing  the  national  debt  and  providing  a  depositors’  protection  scheme  for  bank   deposits. Bank   of   Japan   (BoJ) The  BoJ  began  operating  as  Japan’s  central  bank  in  1882  and, like  the  BoE,  gained   operational  independence  in   1997. The   Bank   is   responsible   for   the   country’s   monetary   policy,   issuing   and   managing   the   external   value   of   the   Japanese   yen,   and   acting   as   lender   of   last   resort   to   the   Japanese   banking   system. South   African   Reserve   Bank   (SARB) The  Bank  was  established in  1921.  Its  primary  purpose  is  to  achieve  and  maintain   price stability  in  the  interest  of  balanced  and  sustainable  economic  growth  in   South  Africa.  Together with other  institutions,  it  also plays  a  pivotal  role  in   ensuring   financial   stability. Central   Bank   of   Nigeria Full  operations  began  in  1952. The Bank’s  objectives  include  ensuring  monetary   and  price  stability,  issuing  currency,  maintaining  external  reserves  and  promoting   a  sound  financial  system,  as  well  as  acting  as banker  and  advisor  to  the  federal   government.

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Inflation In  this  next  section we  look  at  the impact of  inflation .  We  will  look  first  at  how  goods  and  services  are   paid   for   and   how   credit   is   created,   and   then   at   its   interaction   with   inflation. Credit   Creation Learning   Objective 2.1.3	 Know   how   goods   and   services   are   paid   for   and   how   credit   is   created Most   of   what   we   buy   is   not   paid   for   using   cash.   We   find   it   more   convenient   to   pay   by   card   or   electronic  payment.   Cash   is   still   popular   in   Africa,   however   payment   methods,   such   as   cards   and   mobile   payments   via   mobile   phones,   are   becoming   more   widespread. It   is   fairly   easy   (subject   to   the   borrower’s   credit   status)   to   buy   something   now   and   pay   later,   for   example   by  going  overdrawn,  using  a  credit  card  or  taking out  a  loan.  Loans  will  often  be  for  more  substantial   purchases,  such  as  a  house,  a car  and,  sometimes,  furniture.  Buying  now  and  paying  later  is  generally   referred   to   as   purchasing   goods   and   services   ‘on   credit’. The  banking  system  provides  a  mechanism  by  which  credit  can  be  created.  This  means  that  banks  can   increase   the   total   money   supply   in   the   economy. Example     	 New   Bank   sets   up   business   and   is   granted  a  banking  licence. It   is   authorised   to   take   deposits   and   make   loans.  Because  New  Bank  knows  that  only  a  small  proportion  of the  deposited  funds  are  likely  to  be   demanded  at  any  one  time, it  will  be  able  to  lend  the  deposited  money  to  others.  New  Bank  will   make   profits   by   lending   money   out   at   a   higher   rate   than   it   pays   depositors.   These   loans   provide   an   increase   in   the   money   supply   in   circulation   –   New   Bank   is   creating   credit. By  this action  of  lending  to  borrowers,  banks  create  money and  advance  this to  industry,  consumers   and  governments.  This  money  circulates  within  the  economy,  being  spent  on  goods  and  services  by   the   people   who   have   borrowed   it   from   the   banks.   The   people   to   whom   it   is   paid   (the   providers   of   those   goods   and   services)   will   then   deposit   it   in   their   own   bank   accounts,   allowing   the   banks   to   use   it   to   create   fresh  credit  all  over   again. It  is estimated  that  this  credit  creation  process  accounts  for  96%  of the  money  in  circulation  in  most   industrialised  nations,  with  only  4%  being  in  the  form  of  notes  and  coins  created  by  the  government.   If  this  process  were  uncontrolled,  it  would  lead  to  a  rapid  increase  in  the  money supply  and,  with  too  much   money   chasing   too   few   goods,   to   an   increase   in   inflation. Understandably,  therefore,  central  banks  aim  to keep  the  amount  of  credit  creation  under  control  as    part   of   their   overall   monetary   policy.   They   will   aim   to   ensure   that   the   amount   of   credit   creation   is   below   the   level   at   which   it   would   increase   the   money   supply   so   much   that   inflation   accelerates.   A   central   bank 24

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The  Economic   Environment will   do   this   through   changes   to   interest   rates   in   order   to   influence   demand   for   loans:   when   interest   rates   are   high,   people   borrow   less;   when   rates   are   low,   the   opportunity   cost   of   leaving   the   money   in   the   bank   is  lower,   so   people   will   spend.   The   cost   of   borrowing   to   spend   is   also  lower,  so   people   will   spend   more,   or make  larger   purchases. 4.2	 The  Impact  of  Inflation Learning   Objective 2.1.4	 Understand   the   meaning   of   inflation/deflation:   measurement;   impact;   control Inflation is  a  persistent increase  in  the  general  level  of  prices.  There  are a  number  of  reasons  for  prices   to  increase,  such  as  excess  demand  in  the  economy,  scarcity  of  resources  and  key  workers or rapidly   increasing  government  spending.  Most  western  governments  seek  to control  inflation  at  a  level  of   about   2–3%   per   annum   –   not   letting   it   get   too   high   (or  too   low)   –   and   many   African   governments   also   seek   to   control   inflation,   sometimes   at   slightly   higher   levels. High   levels   of   inflation   can   cause   problems: Businesses   have   to   continually   update   prices   to   keep   pace   with   inflation. Employees   find   the   real   value   of   their   salaries   eroded. Those   on   fixed   levels   of   income,   such   as   pensioners,   will   suffer   as   the   price   increases   are   not   matched   by  increases  in   income. Exports  may become   less  competitive. The  real  value of  future  pensions and  investment  income becomes  difficult  to  assess,  which  might  act   as   a   disincentive   to   save. There  are,  however,   some   positive   aspects   to   high   levels   of   inflation: Rising  house  and  asset prices  contribute to  a  ‘feel-good’ factor  (although  this  might  contribute  to   further   inflation,   as   asset   owners   become   more   eager   to   borrow   and   spend   and   lead   to   unsustainable   rises   in   prices   and   a   subsequent   crash). Borrowers   benefit,   because   the   value   of   borrowers’   debt   falls   in   real   terms   –   ie,   after   adjusting   for   the   effect   of   inflation.   In   particular,   governments   may   borrow   and   then   encourage   inflation   so   they   have   to   pay   back   less   in   real   terms. Inflation  also erodes  the  real  value  of  a  country’s  national  debt  when  the  debt  is  in  local  currency,   which  can  benefit  an  economy  in  difficult  times.  However,  this  does  not  help  when  a  country  has  borrowed  in  international   currencies. The  following  chart  shows  the inflation  rates for  the  UK,  US  and  the  G7  since  1980,  and highlights   how   governments   managed   to   take   control   of   inflation   and   reduce   it  from   the   damaging   levels   of   the   1970s  and  early   1980s.

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Source:   IMF Central  banks  use  interest  rates  to control  inflation.  They  set  an  interest  rate  at  which  they  will  lend to   financial   institutions,   and   this   influences   the   rates   that   are   available   to   savers   and   borrowers.   The   result   is   that   movements   in  a   central   bank’s  rate  affect  spending   by   companies   and   their   customers   and,   over   time,  the  rate  of   inflation. Changes   in   base  rate  can   take   up   to   two   years   to   have   their   full  impact   on   inflation,   so   the   central   bank  has   to   look   ahead   when   deciding   on   the   appropriate   monetary   policy.   If   inflation   looks   set   to   rise   above   target,  then  the  central  bank  raises  rates  to  slow  spending  and  reduce  inflation. Similarly,  if  inflation   looks   set   to   fall   below   its   target   level,   it   reduces   bank   rates   to   boost   spending   and   inflation. As   well   as   experiencing   inflation,   economies   can   also   face   the   problems   presented   by   deflation.   Deflation   is   defined   as   a   general  fall  in   price   levels.   Although   not   experienced   as   a   worldwide   phenomenon   since   the 1930s, deflation  has  been  seen in  an  increasing  number  of  countries,  including  Japan,  and  in  eurozone   countries,   such   as   Greece   and,   to   a   lesser   extent,   Spain. While   it   may   seem   that   lower   prices  are   good,   deflation   can   ripple   through   the   economy,   such   as   when   it  causes  high  unemployment,  and  can turn  a  bad  situation,  such  as  a  recession,  into  a  worse   situation,   such  as  a  depression. Deflation can  spiral  where  it  creates  a  vicious  circle  of  reduced  spending  and  a   reluctance   to   borrow   as   the  real   burden   of   debt   in   an   environment   of   falling   prices   increases.   Deflation  can  then  become  a  self-reinforcing  loop  –   falling prices  create  the  circumstances  for  prices  to  continue   falling  and   lead  to  a  depression. It  should  be  noted  that  falling prices  are  not  necessarily  a  destructive  force  per  se  and,  indeed,  can  be   beneficial   if   they   are   as   a   result   of   positive   supply   shocks,   such   as   rising   productivity   growth   and   greater   price   competition   caused   by   the   globalisation   of   the   world   economy   and   increased   price   transparency. There   are   various   measures   of   inflation,   but   the   most   common   term   encountered   is   the   consumer   price   index   (CPI) . 26

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

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The  Economic   Environment In Europe  and much  of  Africa,  for  example,  the  main  measure  is the  CPI.  In  Europe,  this  is  also  known   as  the  HICP  and  is  a  measure  of inflation  that  is  prepared  in  a  standard way  throughout  the  European   Union.   It   excludes   mortgage   interest   payments,   mostly   because   a   large   proportion   of   the   population   in   continental   Europe   rent   their   homes,   rather   than   buying   them. Most  countries measure  inflation  in  a  similar  way  to  Europe,  with  the  majority  using  the  term  ‘CPI’  for   their  index,  although  there  are  some  differences  in  how  it  is  calculated.  The  advantage  of  a  common    way   of   measuring   inflation   is   where   it   needs   to   be   compared   on   a   like-for-like   basis   with   other   countries. It  is  important to  recognise,  however,  that there  are  different  ways  of  calculating  inflation,  and  that   different   measures   may   give   alternative   pictures   of   what   is   happening   in   the   real   global   economy. 4.3	 Measures  of  Economic   Data Learning   Objective 2.1.5	 Understand   the   impact   of   the   following   economic   data:   gross   domestic   product   (GDP);   balance   of payments;  level  of   unemployment In addition  to  inflation  measures  like  the  CPI,  there  are a  number  of  other  economic  statistics  carefully   watched  by governments and by  other  market  participants  as  potentially  significant indicators  of  how   economies  are   performing. 4.3.1	 Gross  Domestic  Product   (GDP) At   the   very   simplest   level,   an   economy   comprises   two   distinct   groups:   individuals   and   firms.   Individuals   supply  firms  with  the  productive  resources  of the  economy  in  exchange  for  an  income.  In  turn,  these   individuals   use   this   income   to   buy   the   entire   output   produced   by   firms   employing   these   resources.   This   gives   rise   to   what   is   known   as   the   circular   flow   of   income. Simplified  Model  of  the   Economy

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This   economic   activity   can   be   measured   in   one   of   three   ways: by   the   total   income   paid   by   firms   to   individuals by   individuals’   total   expenditure   on   firms’   output by   the   value   of   total   output   generated   by   firms. GDP  is the  most  commonly used  measure  of  a  country’s output.  It  measures  economic  activity  on  an   expenditure   basis   and   is   typically   calculated   quarterly   as   follows:

Gross  Domestic   Product consumer   spending plus government   spending plus investment plus exports less imports equals GDP

Economic   Growth There  are  many  sources  from  which  economic growth  can  emanate,  but  in  the  long  run  the  rate  of   sustainable   growth   (or   trend   rate   of   growth)   ultimately   depends   on: the   growth   and   productivity   of   the   labour   force the  rate  at  which an  economy  efficiently  channels  its  domestic  savings  and  capital  attracted  from   overseas   into   new   and   innovative   technology   and   replaces   obsolescent   capital   equipment the   extent   to   which   an   economy’s   infrastructure   is   maintained   and   developed   to   cope   with   growing   transport,  communication  and  energy   needs. In  a  mature  economy,  the  labour  force  typically  grows  at  about  1%  per  annum,  though  in countries   such  as  the  US,  where  immigrant  labour  is  increasingly  employed, the  annual  growth  rate  has been   in  excess of  this.  Africa  has  a  young  population  and  will  enjoy  a  demographic  boost  as  more  people   enter   the   labour   force,   provided   they   can   find   productive   employment.   Long-term   productivity   growth   is  dependent  on  factors  such  as  education  and  training  and  the utilisation of  labour-saving  new   technology.  Moreover, productivity  gains  are  more  difficult  to  extract  in  a  post-industrialised   economy   than   in   one   with   a   large   manufacturing   base. Given  these  factors,  the  US’s  long-term  trend  rate  of  economic  growth  has  averaged  nearly  3%.   However,  in  developing  economies,  including  some  African  countries,  economic  growth  rates  of  up   to  10%  per  annum  are  not uncommon.  Some  of the  top  ten  fastest-growing  economies  are  in  Africa,   although   much   growth   is   starting   from   very   underdeveloped   economic   levels. The   fact   that   actual   growth   fluctuates   and   deviates   from   trend   growth   in   the   short   term   gives   rise   to   the economic cycle ,  or  business   cycle.

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Time When  an  economy  is  growing  in  excess of  its  trend  growth  rate,  actual  output  will  exceed  potential   output,  often  with  inflationary  consequences.  However,  when  a  country’s  output  contracts  –  that  is,   when  its  economic  growth  rate  turns negative  for  at  least  two  consecutive  calendar quarters  –  the   economy  is  said  to  be  in  recession,  or  entering  a  deflationary  period,  resulting in  spare  capacity  and   unemployment. 4.3.2	 Balance  of   Payments The  balance  of  payments  is  a  summary  of  all  the  transactions  between  a  country  and  the  rest  of the   world.  If  the  country imports more than  it  exports, there  is  a  balance  of  payments  deficit. If  the   country   exports   more   than   it   imports,   there   is   a   balance   of   payments   surplus. The  main  components  of the  balance  of  payments  are  the  trade  balance,  the  current  account  and  the   capital   account.

The trade  balance   comprises: a  visible  trade  balance  –  the  difference  between  the  value of  imported   and   exported   goods,   such   as   those   arising   from   the   trade   of   raw materials  and  manufactured   goods and  an  invisible  trade  balance  –  the  difference  between  the  value   of  imported  and  exported  services,  arising  from  services  such  as  banking,  financial  services  and   tourism. If   a   country   has   a   trade   deficit   in   one   of   these   areas   or   overall,   this   means   that  it  imports more than  it  exports,  and  if  it  has  a  trade  surplus,  it   exports  more than  it   imports.

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Current  Account The  current  account  is  used  to  calculate  the  total  value  of  goods  and   services   that   flow   into   and   out   of   a   country. The  current  account  comprises  the  trade  balance  figures  for  the   visibles   and   invisibles. To  these  figures  are  added  other  receipts,  such  as  dividends  from   overseas   assets   and   remittances   from   nationals   working   abroad. Capital   Account The capital  account  records  international  capital  transactions  related   to  investment in  business,  real  estate,  bonds  and  stocks.  This  includes   transactions  relating  to  the  ownership  of  fixed  assets  and  the  purchase   and   sale   of   domestic   and   foreign   investment   assets. These  are  usually  divided  into categories  such  as  foreign  direct   investment,  when  an  overseas  firm  acquires  a  new  plant or  an  existing   business, portfolio  investment  which  includes  trading  in stocks  and   bonds,  and  other  investments,  which  include  transactions  in  currency   and  bank   deposits.

For  the  balance  of  payments  to  balance,  the  current  account  must  equal  the  capital  account  plus  or   minus   a   balancing   item   –   used   to   rectify   the   many   errors   in   compiling   the   balance   of   payments   –   plus   or   minus   any   change   in   central   bank   foreign   currency   reserves. A   current  account   deficit   resulting   from   a   country   being   a   net   importer   of   overseas   goods   and   services   must   be   met   by   a   net   inflow   of   capital   from   overseas,   taking   account   of   any   measurement   errors   and   any   central   bank   intervention   in   the   foreign   currency   market. Having   the   ‘right’   exchange   rate   is   critical   to   the   level   of   international   trade   undertaken,   to   international   competitiveness  and  therefore  to  a  country’s  economic  position. This  can  be  understood by  looking   at   what   happens   if   a   country’s   exchange   rate   alters. If  the  value  of  its  currency  rises,  then  exports  will  be  less  competitive,  unless producers  reduce  their   prices,   and   imports   will   be   cheaper   and   therefore   more   competitive.   The   result   will   be   either   to   reduce   a   trade   surplus   or   worsen   a   trade   deficit. If  its  value  falls  against  other  currencies  then  the  reverse  happens:  exports  will  be  cheaper  in  foreign   markets   and   so   more   competitive,   and   imports   will   be   more   expensive   and   therefore   less   competitive.   A   trade   surplus   or   deficit   will   therefore   see   an   improving   position. 4.3.3	 Level  of   Unemployment The   extent   to   which   those   seeking   employment   cannot   find   work   is   an   important   indicator   of   the   health   of   the   economy.   There   is   always   likely   to   be   some   unemployment   in   an   economy   –   certain   people   are   in   the   process   of   looking   for  a  new   job   that   better   suits  them,  or   they  are  returning   to   the   workforce   after   some   time   off,   or   they   could   be   new   immigrants,   or   lacking   the   right   skills,   or   are   living   in   areas   in   which   it  is  difficult  to find  work.  Economists  refer  to this as  the  ‘natural rate  of unemployment’.  Higher  levels  of  unemployment  indicate  low  demand  in  the  economy  for  goods  and  services  produced  and  sold  to   consumers   and,   therefore,   low   demand   for   people   to   provide   them.

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

High  unemployment  levels  will  have  a  negative  impact  on  a  government’s  finances. The  government   will   need   to   increase   social   security/welfare   payments,   and   its   income   will   decrease   because   of   the   lack   of  tax  revenues  from  the  unemployed.  Care  needs  to  be  taken  when  looking  at  official   unemployment   figures   as   the   latest   trends   that   use   fixed   hour   contracts   of   employment   in   the   gig   economy   can   distort  these   statistics   and   disguise   higher   underlying   unemployment   figures. Unemployment  figures  can  be contentious  in  some  African  countries,  where  many  people  work  in   subsistence   jobs,   such   as   smallholder   farming   or   informal   trading,   where   it   is   hard   to   make   a   living.   Most   would  prefer  to  work in  paid  employment,  but  there  are  too  few  formal  jobs or other opportunities.   These  workers  are  usually  classed as  ‘employed’  or  ‘underemployed’,  as  often the  jobs  are  not  very  productive.   Different   classifications   can   lead   to   different   figures   on   levels   of   employment.

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Think   of   an   answer   for   each   question   and   refer   to   the   appropriate   section   for   confirmation. What   are   the   key   differences   between   state-controlled   and   market   economies? Answer   Reference:   Sections   2.1   and   2.2 Which   international   organisation   has   the   role   of   reducing   trade   barriers? Answer  Reference:  Section   2.4 What   are   the   main   functions   of   a   central   bank? Answer  Reference:  Section   3.1 Name   two   African   central   banks   that   have   price   stability   as   one   of   their   core   objectives. Answer  Reference:  Section   3.1 What   would   be   the   effect   of   uncontrolled   growth   in   the   money   supply? Answer  Reference:  Section   4.1 Which   payment   methods   are   common   in   Africa? Answer  Reference:  Section   4.1 What   are   the   negative   effects   of   inflation? Answer  Reference:  Section   4.2 What   economic   measure   is   used   as   an   indicator   of   the   health   of   the   economy? Answer  Reference:  Section   4.3.1 What   does   the   balance   of   payments   represent? Answer  Reference:  Section   4.3.2 What   is   the   impact   of   high   unemployment   levels   on   the   economy? Answer  Reference:  Section   4.3.3

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This  syllabus  area  will provide  approximately  7  of  the  50  examination   questions

Introduction Providing   Information Asset   Classes Foreign  Exchange   (FX)

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Financial  Assets  and   Markets 1.	 Introduction Before  we  look  at  financial  assets  and  markets,  we  will  examine  some  of the  ways  in  which  investors   are  provided  with  information  about  financial  products  and  services.  This chapter  will  then  provide  an   overview   of   the   main   asset   classes   and   then   looks   particularly   at   the   money   market,   the   property   market   and  foreign  exchange   (FX). Subsequent   chapters   will   look   in   more   detail   at   equities,   bonds   and   derivatives.

2.	 Providing   Information Learning   Objective 3.1.1	 Know   relevant   sources   of   information   for   investment   products,   costs   and   charges:   key   investor  information   documents;   prospectuses;   financial   statements;   financial   data A  key  principle  of the  regulation  of  financial  markets is  to  ensure  that  investors  are  provided  with   clear   information  about  financial  products  and  services  so  that  they can make  an  informed  decision  as  to    whether  a  product  or  service  is  suitable  for  them.  The  standards  and  accuracy  of  information  provided   can  vary  according  to  regulation  and  market  practice  in  different  countries.  This  information  can  take   many   forms,   but   some   of   the   main   types   are   discussed   below. In   many   countries,   when   an   individual   is   seeking   information   about   financial   services   and   products,   there  is  a  wide  range  of  financial data available  on  websites  to  help  them  refine their choices.  It  is  important   to   remember   that   these   are   not   providing   advice   but   are   directing   individuals   to   solutions   that  are  potentially  suitable  for  them.  The  individual  will  need  to undertake  further  research  to    ensure   that   this   is   the   case   or   seek   advice   from   a   financial   adviser. When  a  financial   adviser  first  meets   with  a  client,   they  are   required   to   provide   investors   with   details  of  their  firm,  its  services  and  the  charges  that  it  makes.  This  will  include  disclosing  to  the  client   whether  the  advice they  are  providing  is  independent  or  restricted  to  the  products  of the  firm  for   which   they   work.   Where   they   are   independent,   this   usually   means   that   they   will   recommend   from   all   of   the   products   available   in   the   market   place   rather   than   restricting   their   choice   to   only   those   offered   by  their   firm. Once an  adviser  has  determined  the  needs,  investment  objectives  and  risk profile  of  a  client,  they   will   make   recommendations   that   they   consider   meet   the   needs   of   the   client.   They   will   usually   make  these  in  the  form  of  a  written  report  that  sets  out  the  client’s  needs,  their  recommended solutions   and   the   reason   why   they   consider   these   to   be   the   right   option. When recommending  products  or  services,  financial  services  firms  will  also  provide  full   explanatory   brochures  on  their  products,  which  are  sometimes  known  as  key  features  documents  (KFDs).   These   will  set  out  the detailed terms of the  products  and  services,  and  should  explain  in  clear  terms  how   each   product   or   service   operates,   what   the   costs   are   and   what   the   client   can   expect   from   the   product

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Asset   Classes In  this  section,  we  take  an  introductory  look  at  the  characteristics  of the  principal  asset  classes,   namely   cash,  bonds,  equities  and   property. Cash   Instruments Nearly   all   investors   keep   at  least   part   of   their   wealth   in   the   form   of   cash,   which   will   be   deposited   with   a   bank   or   other   savings   institution   to   earn   interest.   Cash   investments   take   two   main   forms:   cash   deposits   and money  market   instruments. Cash   Deposits Learning   Objective Know   the   characteristics   of   fixed-term   and   instant   access   deposit   accounts Understand   the   distinction   between   gross   and   net   interest   payments Be   able   to   calculate   the   net   interest   due   given   the   gross   interest   rate,  the   deposited   sum,   the   period  and  tax   rate Know   the   advantages   and   disadvantages   of   investing   in   cash Cash deposits  comprise accounts  held  with  banks  or  other  savings  institutions.  They  are  held  by  a  wide   variety   of   depositors   –   from   retail   investors   through   to   companies,   governments   and   financial   institutions. The   main   characteristics   of   cash   deposits  are: The   return   simply   comprises   interest   income   with   no   potential   for   capital   growth. The   amount   invested   (the   capital)   is   repaid   in   full   at   the   end   of   the   investment   term. The  interest  rate  paid  on  deposits  will  also  vary  with  the  amount  of  money  deposited  and  the  time   for   which   the   money   is   tied   up. Large   deposits   are   more   economical   for   a   bank   to   process   and   will   earn   a   better  rate. Fixed-term   accounts   involve   the   investor   tying   up   their   money   for   a   fixed   period   of   time   such   as   one,   two   or   three   years,  or   where  a   fixed   period   of   notice   has   to   be   given,   such   as   30   days,   60   days   or   90 36

or  service.  Other examples  of  these  are  the key  investor information  documents  and  prospectuses   prepared  by  mutual   funds. Once   a   client   has   bought   a   product   or   agreed   to   a   service,   they   can   expect   to   receive   regular   financial   information  and  reports to  update  them  on  performance.  For  example,  a  discretionary  investment   manager  will  send  periodic  statements  to  their  clients  that  show  the  updated composition  of  their   investment  portfolio  and  its  performance.  Similarly,  mutual  funds  will  provide summarised  or   detailed   financial   statements   and   reports   on   the   fund.

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Financial  Assets  and   Markets days.   In   exchange   for   tying   up   their   funds   for   these   periods,   the   investor   will   demand   a   higher   rate   of   interest   than   would   be   available   on   accounts   that   permit   immediate   access. Instant  access  deposit  accounts  typically  earn the  lowest  rates  of  interest  of the  various deposit   accounts   available. Current   (US:   checking)   accounts   will   generate   an   even   lower   rate,   and   sometimes   pay   no   interest   at   all. Generally,  interest  received  by  an  individual  is  subject  to  income  tax.  In  many  countries,  some  tax  is   deducted  at  source  –  that  is,  by  the deposit-taker before  paying  the  interest  to  the depositor.  The   ‘headline’ rate  of  interest  quoted  by  deposit-takers,  before  deduction  of  tax,  is  referred  to as  gross   interest,   and   the   rate   of   interest   after   tax   is   deducted   is   referred   to   as   net   interest. For   this   exam,  it   is   necessary   to   be   able   to   calculate   the   net   interest   due,   so   study   the   example   and   then   practice   this   using   the   three   exercises.   The   answers   to   the   exercises   are   at   the   end   of   this   chapter. Example     	 Stefan is  entitled  to  5%  gross  interest  on  ZAR200  deposited  in  XYZ  Bank  for  a  year,  and  tax  at  15%   is  deducted  before  payment  of the  interest  (in  South  Africa,  the  tax  is  known  as  withholding  tax  on   interest). Stefan   will  earn   ZAR200  x  5%   =   ZAR10   interest   on   his   bank   deposit   before   the   deduction   of   any   tax.   He   will receive  ZAR8.50 from  XYZ  Bank.  XYZ  Bank  will  subsequently  pay  the  ZAR1.50  of  tax  on  behalf  of   Stefan  to  the  tax   authorities. This   can   be   summarised   as   follows: Gross   interest   earned:   ZAR200   x   5%   =   ZAR10. Tax   deducted   by   XYZ   Bank:   15%   x   ZAR10   =   ZAR1.50. Net   interest   received   by   Stefan:   ZAR10   x   85%   =   ZAR8.50.

Exercise   1      	 Aashif  pays  tax  at  20%,  and  all  of the  tax  is  deducted  at  source.  He  has  had  €3,000  on  deposit  at  XYZ    Bank   for  a  year,   earning   4%   gross  interest.  How   much   interest   does   Aashif   receive,   and   how   much   tax   is   deducted?

Exercise   2      	 Maria  pays  tax  in  her  country  at  20%.  Maria  has  €10,000  on  deposit  at  XYZ  Bank  earning  3%  gross    interest.   What   is   the   net   rate   of   interest   she   is   earning?

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Exercise   3      	 Simone   pays   tax   at   20%,   all   of   which   is   deducted   at   source.   She   has   had   €10,000   on   deposit   at   XYZ   Bank   for   six   months,   earning   3%   per   annum   gross   interest.   How   much   interest   does   Simone   receive   at   the   end   of   six   months,   and   how   much   tax   is   deducted? Advantages and   Disadvantages There   are   a   number   of   advantages   to   investing   in   cash: One  of the key  reasons  for  holding  money  in  the  form  of  cash  deposits  is  liquidity .  Liquidity  is the  ease  and  speed  with  which an  investment  can  be  turned into cash  to  meet  spending  needs.  Most   investors   are   likely   to   have   a   need   for   cash  at  short   notice   and   so   should   plan   to   hold   some   cash   on   deposit   to   meet   possible   needs   and   emergencies   before   considering   other   less   liquid   investments. The  other  main reasons  for  holding  cash investments  are  as  a  savings  vehicle  and  for  the  interest  return   that   can   be   earned   on   them. A   further   advantage   is   the   relative   safety   that   cash   investments   have   and   that   they   are   not   exposed   to   market   volatility,   as   is   the   case   with   other   types   of   assets. Investing   in   cash   does   have   some   serious   drawbacks,   however,   including: Banks  and  savings  institutions  are  of  varying  creditworthiness  and  the  risk  that  they  may  default   needs   to   be   assessed   and   taken   into   account. Inflation   reduces   the   real   return   that   is   being   earned   on   cash   deposits   and   often   the   after-tax   return   can  be   negative. Interest   rates   vary,   and   so   the   returns   from   cash-based   deposits   will   also   vary. During  periods  of  low  global  interest  rates,  charges  on  money  market  accounts  or  funds  can   result   in negative  or  flat   returns. Although  banks  and  savings  institutions  are  licensed,  monitored  and  regulated,  it  is  still  possible  that   such   institutions   might   fail,   as   was   seen   in   the   aftermath   of   the   2008   financial   crisis.   Deposits   are   therefore   also   protected   by   a   government-sponsored   compensation   scheme   in   some   countries   (including   several   African  countries  and  under  consideration in  some  others).  This  will  repay  any deposited  money  lost,   typically   up   to   a   set   maximum,   due   to   the   collapse   of   a   bank   or   savings   institution.   The   sum   is   generally   fixed  so  as to  be  of  meaningful  protection to  most  retail  investors,  although  it  would  be  of  less  help   to   very  substantial   depositors. When   cash   is   deposited   overseas,   depositors   should   also   consider   the   following: The   costs   of   currency   conversion   and   the   potential   exchange   rate   risks   if   the   deposit   is   not   made   in   the  investor’s  home   currency. The   creditworthiness   of   the   banking   system   and   the   chosen   deposit-taking   institution,   and   whether   a   depositors’   protection   scheme   exists   and   if   non-residents   are   protected   under   it.   Not   every   country   operates   one,   and   so   the   onus   is   on   the   investor   or   their   adviser   to   check. The   tax   treatment   of   interest   applied   to   the   deposit. Whether   the   deposit   will   be   subject   to   any   exchange   controls   that   may   restrict   access   to   the   money   and  its  ultimate   repatriation.

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3.1.2	 Money   Markets Learning   Objective Know   the   difference   between   a   capital   market   instrument   and   a   money   market   instrument Know   the   definition   and   features   of   the   following:   Treasury   bill;   commercial   paper;   certificate   of   deposit Know   the   advantages   and   disadvantages   of   investing   in   money   market   instruments The  money  markets  are  the  wholesale  or  institutional markets  for  cash  and  are  characterised  by  the   issue,   trading   and   redemption   of   short-dated   negotiable   securities.   These   can   have   a   maturity  of   up   to   one   year,   though   three   months   or   less   is   more   typical. By  contrast,  the  capital  markets  are  the  long-term providers  of finance  for  companies,  either  through   investment in  bonds   or  shares. Owing  to  the short-term nature of the  money  markets,  most  instruments  are  issued  at  a  discount  to    their   face  value   to   save   on   the   administration   associated   with   registration   and   the   payment   of   interest.   Although  accessible  to  retail  investors  indirectly  through  collective  investment  (mutual) funds,  direct   investment   in   money   market   instruments   is   often   subject   to   a   relatively   high   minimum   subscription   and   therefore   tends   to   be   more   suitable   for   institutional   investors. Examples   of   the   main   types   of   money   market   instruments   are   shown   below.

Treasury  bills  –  these  are  usually  issued  weekly  by  or  on  behalf  of   governments,   and   the   money   is   used   to   meet   the   government’s   short-   term  borrowing   needs. Treasury  bills  are  non-interest-bearing instruments  and  so  are   sometimes  referred  to as  ‘zero  coupon’  instruments.  Zero  coupon  bonds   are   discussed   further   in   chapter   5. Instead  of  interest  being  paid out  on  them,  they  are  issued  at  a   discount   to   par   –   ie,   a   price   of   less   than   US$100   per   US$100   nominal   –   and   commonly   redeemed   after   three   months.   For   example,   a   Treasury  bill   might   be   issued   for   US$998   and   mature   at   US$1,000   three   months   later.  The  investor’s return  is the  difference  between  the  US$998   they   paid,   and   the   US$1,000   they   receive   on   the   Treasury   bill’s   maturity.

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These  money  market  instruments  are all  bearer  instruments  for  which  the  issuer  does  not  maintain   a  register of  ownership.  In  most  markets,  ownership  is  simply  evidenced  by  holding  the  instruments  although, in  practice,  these  are  immobilised  centrally  in  vaults  by  central  securities  depositories   (CSDs)   or  similar   agencies. Settlement   of   stock   market   trades   in   money   market   instruments   is   typically   achieved   through   the   same   settlement   system   that   is   used   for   equities   and   bonds,   and   is   commonly   settled   on   the   day   of   the   trade   or  the  following  business   day. As  mentioned  earlier,  the  money  market  is  a  highly  professional  market  that  is  used by  banks  and   companies   to   manage   their   liquidity   needs.   It   is   not   readily   accessible   by   private   investors,   who   instead   need   to   utilise   either   money   market   accounts   offered   by   banks,   or   money   market   funds. A   money   market   account   is   perhaps   better   described   as   a   money   market   deposit   account.   It   is   essentially   a  savings  account  that  typically  requires  a  substantial  minimum  balance  and  notice  period.  As  it  is  a   form  of  bank  account,  the  depositor  generally  has  the  safety  net of  some  form  of  depositor   protection   scheme  in  some   countries. 40

Certificates  of   Deposit Certificates  of  deposit  (CDs)  –  these  are  issued  by  banks  in  return for   deposited  money:  think  of  them  as  tradeable  deposit  accounts,  as   they   can   be   bought   and   sold   in   the   same   way   as   shares. For  example,  ABC  Bank  might  issue  a  CD  to  represent  a  deposit  of   US$1  million from  a  customer,  redeemable  in  six  months.  The  CD   might  specify  that  ABC  Bank  will  pay  the  US$1  million  back,  plus   interest   of,   say,   2.5%   of   US$1   million.   If   the   customer   needs   the   money   back  before six  months  has  elapsed,  they can  sell  the  CD  to  another  investor in  the  money   market. Until the  late  1960s,  a  rigidity  in  the  interbank  market  meant  that   deposits,  once  taken,  could not be  traded  during  their  life.  To   overcome   this,   certificates   of   deposit   were   introduced   which   could   be   traded   on   a   secondary   market.   By   market   convention,   it   is   a   short-term   marketable  instrument  with  a  maturity  of  up  to  five  years,  although   the vast  majority  are  issued  for  periods  of  less  than  six  months.   Interest  can  be  at  a  fixed  or  variable  rate,  although  they  may  also  be  issued   at   a   discount   and   without   a   coupon. Commercial   Paper Commercial   paper   (CP)   –   this   is   the   corporate   equivalent   of   a   Treasury   bill.  Commercial  paper  is  issued  by  large  companies  to  meet their   short-term   borrowing   needs.   A   company’s   ability   to   issue   commercial   paper   is   typically   agreed   with   banks   in   advance. For  example,  a  company might  agree with  its  bank  to  a  programme   of  US$10  million  worth  of commercial  paper.  This  would  enable  the   company  to  issue various  forms  of commercial  paper  with  different   maturities  (eg,  one  month,  three  months  and  six months),  and   possibly   different   currencies.   As   with   Treasury   bills,   commercial   paper   is   zero   coupon   and   issued   at   a   discount   to   its   par   value.

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Financial  Assets  and   Markets In  contrast,  a  money  market  fund  is  actually  a  money  market  mutual  fund,  a  collective  investment   scheme which  pools  investors’  money  to invest  in  short-term  debt  instruments,  such  as  Treasury  bills   and   commercial  paper.  There  is   a   range   of   money   market   funds   available   and   they   can   offer   two   major   advantages  over  money  market accounts.  An  obvious  advantage  is the  pooling  of  funds  with other   investors,  which  gives  the  investor  access  to assets they  would  not  otherwise  be  able  to invest  in.  The   returns  on  money  market  funds  tend  to  also  be  greater  than  a  simple  money  market  account  offered   by  a  bank,  mainly  because  the  investor  is  taking  a  greater risk  since  such  funds  are  not  covered  by  the   depositor  protection   scheme. Advantages and   Disadvantages Cash  deposits provide  a  low-risk  way  to generate  an income  or  capital  return,  as  appropriate,  while   preserving   the   nominal   value   of   the   amount   invested.   They   also   play   a   valuable   role   in   times   of   market   uncertainty.  However,  they  are  unsuitable  for  anything  other  than  the  short  term  as,  historically,  they   have underperformed  most  other  asset  types over  the  medium  to  long  term.  Moreover,  in  the  long   term,  the  return  from  cash  deposits  has  often  been  barely  positive  after  the  effects  of inflation  and   taxation  are  taken  into   account. So,   money   market   investments   can   be   used   instead   to   fulfil   a   number   of   roles   within   a   client’s   portfolio,   including: as   a   short-term   home   for   cash   balances as   an   alternative   to   bonds   and   equities   (particularly   in   uncertain   times). As   seen,   money   market   deposit   accounts   can   be   used   as   a   temporary   home   for   idle   cash   balances   rather   than  using  a  standard  retail  deposit  account.  For  the  retail  investor,  these  accounts  can  at  times  offer    higher   returns   than   can   be   achieved   on   standard   deposits,   and   are   offered   by   most   retail   banks. The  disadvantage  is  that  the  higher  returns  can  usually  only  be  achieved with  relatively  large   investments.  As  an  alternative, a  money  market  fund  can  produce  greater  returns  due  to  the  pooled   nature   of   this   collective   investment   vehicle,   which   can   access   better   rates   than   smaller   deposits. Money  markets  also  offer  a  potentially  safe  haven  in  times of  market  falls.  When  markets  have  had  a   long  bull  period  and  economic prospects  begin  to  worsen,  an  investor  may  want to  take  profits  at  the   peak  of the  market  cycle  and  invest  the  funds  raised  in  the  money  markets until  better  investment   opportunities   arise. The   same   rationale   can   be   used   when   the   investor   does   not   want   to   commit   new   cash   at   the   top   of   the   market   cycle.   The   nature   of   money   market   instruments   means   that   they   offer   an   alternative   investment   that   gives   limited   exposure   to   any   appreciable   market   risk. Within  a client’s  normal  portfolio  of investments,  a  proportion  of the  investments  will  be  held  as  cash.   Money  market  investments  can  therefore  be  the vehicle  for  holding  such  asset  allocations,  and  are  in   competition   with   other   short-term   deposit   accounts. Money   market   funds,   therefore,   can   have   a   core   role   to   play   in   an   investment   portfolio.   It   does   need   to   be   remembered,   however,   that   they  still carry  some   risks,   and   the   level   of   risk   varies   between   one   type   of  instrument  and  another. The  short-term nature of the  money  market  instruments  provides  some   protection,   but   short-term   interest   rates   fluctuate   frequently,   which   will   result   in   some   price   volatility. 41

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3.2	 Bonds It   is   impossible   to   consider   asset   classes   without   looking   at   bonds.   Below   is   a   brief   description   of   bonds.   These   will   be   more   fully   covered   later   in   this   workbook,   in   chapter   5. Bonds   are   essentially   debt   notes   or   IOUs   –   the   issuer   of   the   bond   receives   money   from   the   initial   buyer   of   the   bond   and   undertakes   to   pay   the   holder   of   the   bond   regular   interest,   and   then   return   the   money   (the capital)  at  a  particular future   date. Although  bonds  rarely  generate as  much  comment  as  shares,  they  are  the larger  market  of the  two in   terms of  global  investment  value.  Bonds  are  roughly  equally  split  between  government  and  corporate   bonds. Government  bonds  are  issued  by  national  governments  (eg, Japan,  the  US,  Italy,  Germany,  the  UK,   Kenya,   Namibia   and   South   Africa). Supranational bonds  are  issued  by  agencies,  such  as  the  European  Investment  Bank,  the  World Bank   and   the   African   Development   Bank. Corporate bonds  are  issued  by  companies,  such  as  large  banks,  other large  listed  companies  and   stateowned   enterprises,   such   as   utilities. Bonds   are   generally   less   risky   than   shares,   providing   that   their   issuers   remain   solvent.   Investments   such   as   government   bonds   have,   until   recently,   been   regarded   as   being   of   particularly   low   risk,   as   it   has   been   regarded  as  unlikely  that  a  government  will  default,  ie,  fail  to  pay  the  interest  or  repay the  capital  on   the   bond.   Although   this   has   happened,   it   usually   occurs   when  a  country   undergoes   a  turbulent   regime   change   or   encounters   serious   economic   problems,   such   as   those   seen   in   Greece.   Côte   d’Ivoire   defaulted  temporarily   during   a   regime   change   some   years   ago,   but   has   since   rebuilt   investor   confidence. Corporate   bonds,   however,   can   face   more   real   default   risks,   namely   that   the   company   could   go   bust. Both  carry  interest  rate  risk,  which  means  that  the  price  of the  bond  could  fall  substantially  if  interest   rates rise   sharply. 3.3	 Equities Again,  it  is  impossible  to  consider  asset  classes  without also  looking  at  equities.  Below  is  a  brief   description   of   equities.   These   will   be   more   fully   covered   later   in   this   workbook,   in   chapter   4. Equities,   or   ‘shares’   or   ‘stocks’,   are   another   major   asset   class. Holding   shares   in   a   company   is   the   same   as   having   an   ownership   stake   in   that   company.   So   a   shareholder   in,  say,  ABC  bank  is  a  part-owner  of  ABC.  Income  will  be  in  the  form  of  regular  dividends  paid,  plus  a   potential   capital   gain   if   the   company   does   well   and   the   share   price   rises.

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Financial  Assets  and   Markets Shares   in   ABC  are,   however,   riskier   than   bonds,   for   the   following   reasons: At  the  extreme  end  of the  spectrum,  there  is  always  the  risk  that  the  company  could  go  into  liquidation  (but,  of  course,  in  this  case  the  holder  of  a  bond  issued  by ABC  may  also  be  likely  to    lose   out). More   likely   is   the   chance   that   the   shares   may   go   down   in   value,   instead   of   up   as   the   investor   hopes. In   addition,   there   is   the   risk   that   ABC   will   have   a   poor   trading   year:   if   it   makes   little   or   no   profit,   it   may  be   unable   to   pay   a   dividend   –   or   may   pay   a   lower   one   than   in   previous   years.   This   is   a   serious   risk   for   an   investor   relying   on   dividend   income. The major  reason  an  investor  would  prefer  equities  over  bonds  is the potentially  greater  benefits  that   can   arise   from   owning   shares,   namely   dividends,   and   the   prospect   of   capital   growth. In   the   past,   equity   investments   have   outperformed   bonds   and   cash   over   the   longer   term,   that   is   a   period   of   ten   years   or   more,   but   the   position   today   is   less   clear. Property Learning   Objective Know   the   characteristics   of   property   investment:   commercial/residential   property;   direct/   indirect   investment Know   the   potential   advantages   and   disadvantages   of   investing   in   property Property   as   an   asset   class   is   unique   in   its   distinguishing   features: Each   individual   property   is   unique   in   terms   of   location,   structure   and   design. Valuation  is  subjective,  as  property  is  not  traded  in  a  centralised  marketplace,  and continuous  and   reliable  price data  is  not   available. Property   is   subject   to   complex   legal   considerations   and   high   transaction   costs   upon   transfer. It   is   relatively   illiquid   as   a   result   of   not   being   instantly   tradeable. It   is   also   illiquid   in   another   sense:  the   investor   generally   has   to   sell   all   of   the   property   or   nothing   at   all.   It   is   not   generally   feasible   for   a   commercial   property   investor   to   sell,   for   example,   one   factory   unit   out  of  an  entire  block  (or  at  least,  to  do  so  would  be  commercially  unattractive)  –   and  a  residential   property   owner   cannot   sell   his   spare   bedroom   to   raise   a   little   cash. Since   property   can   only   be   purchased   in   discrete   and   sizeable   units,   diversification   is   made   difficult. The  supply  of  land  is  finite  and  its  availability  can  be  further restricted  by  legislation  and  local   planning   regulations.   Therefore,   price   is   predominantly   determined   by   changes   in   demand. There   can   be   further   uncertainties   concerning   property   investment   in   cities   without   strong   systems   of   urban   planning   or   compensation   (for   instance,   a   road   might   be   built   across   the   front   of   a   property)   and   also   in   cities   where   registration   of   property   ownership   does   not   work   well. Only  the largest  investors,  generally  institutional  investors,  can  purchase  sufficient  properties to  build   a  diversified  portfolio.  They  tend  to  avoid  residential  property  (although  some  have  diversified  into    sizeable  residential  property  portfolios)  and  instead they  concentrate  on  commercial  property,  such   as   shops   and   offices,   industrial   property   and   farmland.

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Some   key   differences   between   commercial   and   residential   property   are   shown   in   the   table   below.

Residential   Property Commercial   Property Direct   investment Range  of  investment   opportunities,   including  second  homes,  holiday   homes  and   buy-to-let Size of  investment  required  means   direct  investment in  commercial   property  is  limited  to  property   companies  and  institutional   investors Tenancies Typically  short  renewable   leases Long-term  contracts  with   periods   commonly   in   excess   of   ten   years Repairs Landlord  is   responsible Tenant  is  usually   responsible Returns Largely   linked   to   increase   in   house   prices Significant  component  is   income   return  from  rental   income

As  an  asset  class,  property  has  at  times  provided  positive  real  long-term  returns  allied  to  low  volatility   and   a  reliable  stream  of   income.   An   exposure   to   property   can   provide   diversification   benefits   owing   to   its   low   correlation   with   both   traditional   and   alternative   asset   classes. Many  private  investors have  chosen  to  become  involved in  the  property  market  through  the   buy-to-let  market  or  simply  by  buying  a  second  home.  Other  investors  wanting  to  include property  within  a  diversified  portfolio  generally seek  indirect  exposure  via  a  mutual  fund,  property  bonds  issued   by  insurance  companies,  or  shares  in  publicly  quoted  property  companies.  It  needs  to  be  remembered,   however,  that  investing  via  a  mutual  fund  does  not  always  mean  that  an  investment  can  be  readily    realised.  During  2008,  property  prices  fell  across  the  board  and,  as  investors  started  to  encash holdings,   property   funds   brought   in   measures   to   stem   outflows   and,   in   some   cases,   imposed   12-month   moratoria   on   encashments.   A   repeat   of   this   was   seen   in   2016   with   funds   imposing   moratoriums   due   to   a   large   stream   of   redemptions  by  investors.  Funds such  as  real  estate  investment  trusts  (REITs)  are  increasingly  available  in   some  African   markets. However,   property   can   be   subject   to   prolonged   downturns,   and   its   lack   of   liquidity,   significant   maintenance   costs,   high   transaction   costs   on   transfer  and   the   risk   of   having   commercial   property   with   no   tenant   (and,   therefore,  no  rental  income)  really  makes  only  commercial  property  suitable  as  an  investment  for  long-   term   investing   institutions,   such   as   pension   funds.   The   availability   of   indirect   investment  media, however,   makes   property   a   more   accessible   asset   class   to   those   running   smaller   diversified   portfolios.

International  Introduction  to Securities &  Investment
(Africa)

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 Welcome   to   the   Chartered   Institute   for   Securities   &   Investment’s   International   Introduction   to   Securities   &  Investment  study   material. This   workbook   has   been   written   to   prepare   you   for   the   Chartered   Institute   for   Securities   &   Investment’s  International  Introduction  to  Securities  &  Investment   examination. Published   by: Chartered Institute  for  Securities   &  Investment ©   Chartered   Institute   for   Securities   &   Investment   2019   20  Fenchurch   Street London  EC3M   3BY Tel:  +44  20  7645   0600 Fax:  +44  20  7645   0601 Email:   customersupport@cisi.org    www.cisi.org/qualifications Author: Kevin  Rothwell,  Chartered   MCSI   Tom   Minney Reviewers: JB  Beckett,  Chartered   MCSI   Natasha   Manrai This   is   an   educational   workbook   only   and   the   Chartered   Institute   for   Securities   &   Investment   accepts   no   responsibility   for   persons   undertaking   trading   or   investments   in   whatever   form. While  every  effort  has  been made  to  ensure  its  accuracy,  no  responsibility  for  loss  occasioned  to  any  person   acting   or   refraining   from   action   as   a   result   of   any   material   in   this   publication   can   be   accepted   by   the  publisher  or   authors. All  rights  reserved.  No  part  of  this  publication  may be  reproduced,  stored in  a  retrieval  system,  or   transmitted,   in   any   form   or   by   any   means,   electronic,   mechanical,   photocopying,   recording   or   otherwise   without  the  prior  permission  of the  copyright  owner.  Warning:  any unauthorised  act  in  relation  to  all   or  any  part  of the  material  in  this  publication  may  result  in  both  a  civil  claim  for  damages and   criminal   prosecution. A  learning  map,  which  contains  the  full  syllabus,  appears  at  the  end  of  this  workbook.  The  syllabus   can   also   be   viewed   on   cisi.org   and   is   also   available   by   contacting   the   Customer   Support   Centre   on   +44   20   7645   0777.   Please   note   that   the   examination   is   based   upon   the   syllabus.   Candidates   are   reminded   to   check the  Candidate Update  area  details (cisi.org/candidateupdate)  on  a  regular  basis  for  updates  as  a   result   of   industry   change(s)   that   could   affect   their   examination. The  questions  contained  in  this  workbook  are  designed  as  an  aid  to revision  of  different  areas  of  the   syllabus   and   to   help   you   consolidate   your   learning   chapter   by   chapter.   They   should   not   be   seen   as   a   ‘mock’   examination   or   necessarily   indicative   of   the   level   of   the   questions   in   the   corresponding   examination. Please  note  that,  as  part  of  exam  security,  hand-held  calculators  are  not  allowed  in  CISI  exam  venues.   Candidates  must  use  the  onscreen  calculator  for  all  CISI  CBT  exams in  all  languages  in  the  UK  and   internationally. Workbook  version:  12.1  (June   2019)

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 What  next? See   the   back   of   this   book   for   details   of   CISI   membership. Need  more  support  to  pass  your  exam? See   our   section   on   Accredited   Training   Partners. Want  to  leave   feedback? Please   email   your   comments   to   learningresources@cisi.org

International Introduction to Securities & Investment (Africa)

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