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UNIVERSITY OF DAR ES SALAAM

FACULTY OF COMMERCE AND MANAGEMENT DEPARTMENT OF FINANCE

Bachelor of Commerce (BCom) FN 302: Securities Analysis and Portfolio Management

FINANCIAL ASSETS AND MARKETS: A Quick Revision Taxonomy of Financial Assets: A distinction exists between Real Assets and Financial Assets. Real Assets are assets used to produce goods and services while financial assets are claims on real assets. A financial instrument is an asset representing a unit of a right to:

• a financial obligation ( a debt instrument) • an ownership of a going concern (an equity instrument) • A financial transaction (a derivatives or a stock/bond market Index)

Thus, the broad groups of financial assets are Debt instruments, Equity securities, Derivatives, Stock and Bond Market Indexes and Mutual fund securities. NOTE: The terms financial assets, financial instruments and securities are often used

interchangeably. However, when it comes to financial markets ‘security’ is the most commonly used term. Ownership to most securities is transferable as most securities are traded in stock exchanges.

Debt securities differ in aspects such as the issuer, length to maturity, yield type, issue type, collateral, and convertibility (mainly into equity securities) Equity securities are basically shares (stocks) differing in:

• Preference in dividend and liquidation (Common; Preferred) • Redemption (redeemable; non-redeemable) • Voting rights • Whether they are Domestic or Foreign

Classification of financial instruments There are different ways of classifying financial instruments and most of them are not mutually exclusive. The two most common approaches involve classifying securities into debt and equity securities while the other focuses on the maturity (short- and long-term maturing securities) which also relates to liquidity. The classification given here is in relation to financial markets with the key reason being because at a latter time we will also be discussing financial markets. The financial markets can be divided into money markets and capital markets and consequently we have money market instruments and capital market instruments.

• Money market instruments include short-term, liquid, low-risk debt securities. Money market instruments are sometimes called cash equivalents. They include: o Treasury bills are the most marketable of all money market instruments. Most

money market instruments have fixed denominational face value and they are sold at discount

o Certificates of deposit are time deposits at a bank. A time deposit may not be withdrawn from the bank prior to maturity. CDs are usually negotiable. A negotiable instrument can be sold to another investor. Short-term CDs are very marketable, but long-term CDs are less so

o Commercial paper represents the short-term unsecured debt issued by large corporations. The original maturity ranges up to 270 days. The minimum

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denomination is usually very large (in US it is $100,000). Thus most small investors only own commercial paper through a money market mutual fund

o Bankers’ acceptances: These are short-term obligations of large well-known commercial banks. Acceptances sell at a discount from face value, just like T-bills. The face amounts vary

o Eurodollars: Eurodollars are dollar-denominated deposits at banks outside of the U.S. Most Eurodollar deposits are for large sums and maturity is less than six months. The interest rate is a bit above the CD rate typically

o Repurchase Agreements (REPOs) and Reverse REPOs. A repurchase agreement is a contract between parties that calls for the sale of securities today at one price and the buying back of the same securities later at a higher price. The price difference is the interest paid

o The interbank money market funds: These funds represent excess reserves arising from money that commercial banks keep on deposit at the central bank. Since at any given time some banks will have excess funds in their accounts and other banks will not have enough, a market has arisen for these deposits whereby banks with excess reserves sell them to those that are falling short. Thus the interbank money market rate is the rate that commercial banks charge each other for short-term loans and it is a widely watched rate in the money market

• The capital markets include longer-term and riskier securities than those found in the

money market. The capital markets can be divided into the bond market (the fixed income capital market) and the equity markets. The fixed income capital market (or bond market) consists of longer-term borrowing instruments than those that trade in the money market. The fixed-income capital market can be divided into publicly and privately issued instruments. Publicly Issued Instruments include o Treasury Bonds and Notes. These are obligations of the federal government. They

make semiannual payments and are sold at or near par value usually in large denominations. T-note maturities range up to ten years, while T-bonds are issued with maturities ranging from 10 to 30 years. Some of these bonds are callable the government has the right, but not the obligation, to buy these bonds back from the investor. The call price is typically par value plus one year’s accrued interest.

o Government Agency Debt: some government agencies issue their own bonds to finance their activities. Although not technically a direct obligation of the government, the market assumes that the government would bail out an agency in financial distress—as a result, federal agency debt has a small yield spread over Treasury debt.

o Municipal Bonds (munis) are issued by state and local governments. The interest payments on munis are often exempt from income tax. There are two types of munis: general obligation and revenue bonds. § General obligation bonds are guaranteed by the taxing authority of the

issuer. § Revenue bonds are guaranteed by the project being financed and thus

present a bit more risk than general obligation bonds. Of course, municipalities in other countries issue bonds too

o Privately issued debt instruments include corporate bonds and mortgage backed securities § Corporate bonds are long-term debt issued by private corporations. They

typically pay semiannual coupons and return the face value at maturity. Many corporate bonds also feature options, such as a conversion feature. Convertible bonds can be turned in to the corporation for a specific number of shares in the issuer. Obviously convertible bonds are worth more than an otherwise-identical bond and is reflected in a lower coupon rate

§ Mortgage-backed securities are either an ownership claim in a pool of

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mortgages or an obligation that is secured by such a pool. Mortgage lenders originate loans and then sell packages of these loans in the secondary market. The mortgage originator continues to service the loan; that is collecting interest and principal payments and sending them along

• Equity market securities include common stock and preferred stock.

o Common stock is a residual claim on the assets and earnings of a firm. This means that common stockholders are in line behind other claimants in the event of bankruptcy. Common stock features limited liability—the most an investor can lose is his original investment. While many firms pay a regular cash dividend, there is no obligation to pay common shareholders a dividend. The common stockholders do vote for the membership of the board of directors. Management that cuts the common dividend without a good reason may find themselves out of a job

o Preferred stock features a fixed dividend. Although the firm can skip preferred dividends without triggering bankruptcy the firm has to pay the arrearages before it can pay common dividends. The tax treatment on preferred dividends differs from debt payments. Interest expense is tax deductible to the firm, but dividend payments are not. Finally, many of the innovative options that have been pioneered on corporate bonds are beginning to appear in preferred stock.

• There are also other securities that are ‘cocktail’ in nature and not directly related a

specific security. They include o Derivatives securities that include options, futures, forwards, and swaps. o Mutual fund securities that are issued by firms that specialize in raising equity to

invest in financial assets. They are also cocktail securities with some being exchange traded while others are non exchange traded

o Stock and Bond Market Indexes which are “cocktail” securities that track average (market) returns of stocks and bonds. The most known traded indices in the US are the S&P500, NASDAQ Composite, and Russell3000

FINANCIAL MARKETS: A Quick Recap Financial markets act as interface between sellers and buyers of (structured) financial securities – enabling borrowers [or existing holder] to sell, and savers to buy financial instruments. Conceptually the term financial intermediary is broader than financial markets. One way to classify markets in general is the organizational view: In this view we have:

• Direct search markets are the least organized market. Buyers and sellers must search each other out directly and negotiate a price. An example of a transaction in such a market would be the sale of used textbook where the seller advertises on a campus bulletin board or a student newspaper

• Brokered markets represent the next step up from direct search markets. A broker offers search services to buyers and sellers. A good example is the real estate market

• Dealer markets feature dealers who buy and sell particular assets for their own account. Typically dealers are willing to buy at one price (the bid price) and willing to sell at another price (the ask price). They make their profit on the spread

• Auction markets have all traders meet at one place to buy or sell an asset. A Stock Exchange is an auction market

The most common approaches to classifying financial markets include: Ø On the basis on the “time" or “when” an instrument is traded where we have Primary

markets and Secondary markets o Primary markets are those in which newly issued claims are sold to initial

buyers. In this market the securities come from the borrower who issue the securities to raise funds (the proceeds go to the borrower)

o Secondary markets are those in which previously issued claims are resold. The

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issuer of the securities is not involved and does not receive the funds. The funds flow from the buyer to previous holder of the security

Ø On the basis of coverage where we have “domestic” and international markets: This may be relevant, for example, with respect to diversification where by a portfolio that is fully diversified based on the domestic market still carries specific risks attributable to that market from the international viewpoint.

Ø Based on the term to maturity of the traded instruments: This is what we saw above

where markets are classified into money market for short term instruments and capital markets for long term instruments

Ø Based on trading places/methods: Here we have:

o auction market (exchange) ("open" offer and bid process); o over-the-counter market (contact between the seller’ and buyer’s brokers mainly

using telephone or computer with information not available to other parties); o third market (an institutional market to facilitate trades of larger blocks of

exchange-listed securities away from the exchange); o fourth market (investors trading directly with other investors without the

intermediation of a broker) Ø Based on claims traded and settlement: cash market and derivative market

o Cash market are markets where the actual instruments are sold for immediate delivery

o Derivative market (options or futures) are markets where "securities" derived from the actual instruments (hence the name derivatives ) are sold. Theoretically a derivative involves future delivery of a specific (actual) instrument at a predetermined price. In practice, however parties settle transactions using financial settlements based on the prevailing price difference (between the agreed price and market price at the settlement date)

The view about financial markets: An important view about financial markets is that they are (assumed to be) competitive and efficient. This view has several implications including the following:

• Securities trading in the financial markets are fairly priced and we expect to find few, if any, grossly mispriced securities

• By being efficient, financial markets process information rapidly making “market timing” very difficult

• Investing in financial markets involves Risk-Return tradeoff – if you want higher returns, you have to accept higher levels of risk. If you want lower levels of risk, you must accept lower levels of return. An optimizing investor will aim either at maximizing return for given level of risk or minimizing risk for a given level of return. The idea that you can aim at maximizing return while minimizing risk is wrong: You can either sleep well or eat well!

Recent Trends in financial markets: There are three trends that have changed the investment environment: globalization, securitization and financial engineering

• Globalization is the tendency toward worldwide investment environment, and the integration of national capital markets and cross-listing of securities . Mergers have not only been for firms but also for security exchanges and economies. A striking example is the introduction of the euro – the common currency in Europe – which now rivals the US dollar, Pound Sterling and the Japanese Yen. Advances in telecommunications technology has also worked in connecting markets and reducing transaction costs (and time)

• Securitization and Financial Engineering are closely related. Securitization is the

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process of pooling loans into standardized securities that are backed by these loans, which can then be traded like any other security. Securitization offers opportunities for investors and originators. Financial Engineering refers to repackaging services of financial intermediaries. It includes bundling and unbundling of cash flows, as well as slicing and dicing of cash flows. The goal is to develop securities with custom-tailored risk attributes. Many derivative securities are products of financial engineering and can be combined in different ways to create synthetic securities that are sold and traded in the financial markets. Others include products of financial engineering include strips, swaps, collateralized mortgage obligations (CMOs), dual purpose funds, and principal/interest splits.

Financial Market Institutions A number of institutions operate in financial markets – primarily facilitating the intermediation process by providing liquidity, risk sharing, and information services. The key institutions include investment banks, brokers, dealers and specialists: Investment banks are ‘stand-alone’ banks or subsidiaries or departments of commercial banks that help businesses in raising new capital in primary markets. The largest and well-known investment banks in the world include Morgan Stanley, Merrill Lynch, Goldman Sachs, Credit Suisse First Boston, Lehman Brothers and Salomon Smith Barney (SSB) which is a subsidiary of Citigroup. Investment banks help businesses in raising new capital in primary markets in different ways:

• Advising them the best way to raise funds including which instruments to issue, when to issue them and how;

• Underwriting firm's new issue by guaranteeing a price to the issuing firm: In underwriting, an investment bank is taking a risk that it may be left with some unsold securities or may sell some of the securities at a price below that guaranteed to the issuer. On the other hand it stands to profit from selling the securities at a higher price. The difference between the higher price and the guaranteed price is known as the spread.

• As an alternative to underwriting an investment bank can sell a new issue on an all-or-none basis or on a best effort basis. In all-or-none the issuer receives nothing unless the whole issue is sold. In best effort no guarantee is given but the investment bank "promises" to devote its best effort and sell as much of the issue as it can

• For a large issue a number of investment banks come together and form a syndicate to underwrite/sell the issue. The lead investment bank, also known as lead manager, manages the issue, keep large part of the spread and bear large part of the risk. Other members of the syndicate bear varying levels of risk and earn varying levels of rewards.

Investment banks also invest their own funds - an aspect traditionally known as merchant banking. In recent years this aspect is manifested by investment banks acting as venture capitalists. Other services provided by investment banks include advice in corporate restructuring, merges and acquisition, de-leveraging (selling stock to reduce debt) as well as brokerage services

Why Use an Investment Bank in issuing securities? An investment bank is better placed in collecting financial market information. The result is: risk sharing, low information costs, reputation to attract and instill confidence in potential investors, and wide market reach as investment banks deal with institutional and foreign investors The main sources of revenue for an investment bank are the spread and fees. Other source is dividends from investments. Brokers, dealers and specialists help facilitate exchange (trading) in secondary markets.

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Brokers only match the ultimate buyers and sellers; Dealers hold inventory of securities as well as trade between ultimate buyers and sellers; Specialists are dealers specializing in one or few securities Specialists are also known as market makers as they maintain a "fair and orderly market" by dealing personally in the market. That is, they standby, ready to trade in their account for the purpose of making the market. For example, when supply outstrip demand for a particular security, market makers jump in to buy that security while they also standby to sell when demand outstrip supply. Specialists can act as brokers or dealers: As brokers, specialists "cross trades" matching limit buy and sell orders at market prices; as dealers, specialists stand ready to buy and sell shares from their own inventory. This helps to maintain a "fair and orderly market" Brokers' main source of revenues is the commission they earn from buyers and seller of securities. Dealers earn most of their revenues as spread (the difference between the price at which they buy securities and the one at which they sell them) Securities markets and security market institutions are regulated. In Tanzania this is done by the Capital Markets and Securities Authority (CMSA).The objectives of the regulations are to ensure disclosure of information, to prevent fraud, protect investors and to restrict trading based on inside information. The extent of the regulations varies from one country to another and among other things it depends on “the level of development” of the markets and the institutions. The following can help understand this:

• Much of the securities industry in the USA relies on self regulation. For example the New York Stock Exchange [NYSE] has much of the responsibility for day-to-day oversight of trading on their exchange. The National Association of Securities Dealers (the NASD in NASDAQ) oversees trading of OTC securities. The Securities and Exchanges Commission (SEC) plays a limited regulatory role.

• To provide some measure of sanity during a market crash, "circuit breakers" have been provided to slow or stop trading during periods of extreme volatility. One example of a circuit breaker is that a one-hour trading halt will be declared if the Dow Jones Industrial Averages falls by 250 points or more within one trading day (or a shorter halt depending upon how much time is left in the trading day). Circuit breakers are not common for price increases.

• Insider trading refers to trading on inside information1 . Inside trading is illegal in some countries (such as Tanzania and the United States) but is legal in some other countries (such as Japan).

How Securities are issued and traded The market for issues of new securities is known as the Primary Market (Firms issue new securities in this market). New issues of securities can be either seasoned or unseasoned

• Seasoned new issues are securities offered by companies that already have similar securities outstanding

• Unseasoned new issues represent the first sale of a stock by a formerly private company. This is also known as Initial Public Offering (IPO)

• IPOs are commonly underpriced relative to the price at which they could be marketed. Such underpricing is reflected in the price jumps that occur on the date when the shares are first traded in public security markets.

1 Inside information is nonpublic information about a company or security that is known to "insiders" such as employees of the company, but not by the general public. There is no satisfactory definition of what exactly constitutes insider trading; but if something "feels wrong" you should probably l isten to your instincts!

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• Not all IPOs are underpriced. Some go down in price or are undersubscribed (that is, not enough buyers come forward to take up all of the stock being offered).

New issues of both stocks and bonds typically are marketed by investment bankers

• Underwritten vs. "Best Efforts" • Negotiated vs. Competitive Bid

Private Placements is a sale to a limited number of sophisticated investors not requiring the protection of market regulators registration. Institutions dominate the private placement market (e.g. pension funds), although a few (very) high net-worth individual investors participate. This market is a very active market for debt securities, but not active for stock offerings. In shelf registration a firm is allowed to register securities and gradually sell them to the public for two years following the initial registration. Why does it make sense for shelf registration to be limited in time? Because conditions at the firm may change hence making the information provided on registration less useful. Thus, there is a trade-off between lowering issues costs for the firm and providing up-to-date information to investors. Transactions in the Secondary Market: Secondary market transactions are done through submitting orders to intermediaries. An order is an instruction to a broker about a planned transaction; i.e. it is a set of instructions on how to complete the order. There are different types of orders including the following:

• Market Order: buy or sell orders on a set number of shares for immediate execution at the current (market) price. A market order is submitted if immediate execution is more important than the price the seller gets – hence market orders are usually for immediate execution.

• Limit Order: buy or sell orders on a set number of shares for execution when (or if) the market price reaches a limit specified by the investor. It is often submitted when the price one gets is more important than immediate execution. Note that a limit order may not get filled since the stated conditions may not be achieved. There are four types of limit orders:

o Limit sell order: An order to sell if the price reaches or goes above a certain specified limit. This is a profit selling action for investors who want to cash in.

o Limit buy order: An order to buy if the price reaches or goes below a certain specified limit. This is an action by investors who want to jump into the foray believing that the buying price is right.

o Stop Loss Order: a limit order specifying sale of a stock if the price drops below a specified level. If you are long the stock, a stop loss order can limit your losses in the event of a price decline

o Stop Buy Order: a limit order specifying purchase of a stock if the price rises above a specified level. If you are short the stock, a stop buy order can limit your losses in the event of a price increase.

The validity of a limit order can be stated as:

• Fill-or-kill – for immediate execution or cancellation. • Day order – expires at the close of the trading day • Open order (good-till-cancelled) – remains in force until cancelled by the investor

Summary of Conditions and Action for limit Orders

Condition

Price Below the limit Price above the limit

Action Buy Limit buy order Stop buy order

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Sell Stop-loss order Limit Sell order Settlement Transactions must be settled within a prescribed period.

• The purchaser delivers the cash; the seller delivers the stock within the period. • Keeping your shares with your broker in a street name instead of in your safety deposit

box greatly facilitates rapid settlement, as does the use of a clearinghouse Trading in the Secondary Market Trading on Exchanges

• Investors place orders with their retail brokers, who contact co-workers in their firm, (commission brokers) who are on the floor of the exchange. If the commission brokers are overloaded they will pass the order on to a floor broker, an independent member of the exchange. In any event the specialists are central to the process

Trading on the OTC market

• The OTC market is a dealer market. An investor engages a broker who then shops around the offers of various dealers to find the best trading opportunity

• There is no centralized trading floor and dealers are located anywhere. This is in contrast to exchange trading, where all transactions are negotiated through the specialist.

• One disadvantage of this decentralized market structure is that the investing public is vulnerable to trading through, which refers to the possibility that dealers can trade with the public at their quoted bid or asked prices even if other customers have offered to trade at better prices.

Concept Check: Consider a dealer in an over-the-counter market with the following quotes for Alpha Inc’s shares: Ask: Tshs. 1700; Bid: Tshs: 1660. Suppose there are four clients – W, X, Y and Z – who have submitted orders to the dealer as follows:

W: Market order to sell one Alpha share X: Market order to buy one Alpha share Y: Limit-sell order for one Alpha share at Tshs. 1680 Z: Limit-buy order for one Alpha share at Tshs. 1670

i. Considering each order separately determine, with supporting explanations, if the order is going to be filled and the price at which it is to be filled

ii. Does this situation illustrate the problem of trading through? Explain

Costs The costs of trading include commissions and spreads – the explicit and implicit "costs of doing business".

• Commissions are fees paid to a broker for making the transaction. There are full service brokers and discount brokers. Like any other service, some firms focus on price and some firms focus on customer service. The commission structure is generally a fixed fee plus a variable charge based on the number of shares bought or sold

• Spreads are the implicit cost of trading with dealer. A securities dealer is no different than a lumber dealer: to stay in business he needs to buy at wholesale and sell a bit higher at retail.

o Bid price is the price at which the dealer will buy securities o Ask price is the price at which the dealer is willing to sell his securities to you o Spread: ask – bid

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o Actively traded stocks have relatively narrow bid-ask spreads while thinly traded stocks have wider spreads

• Combination: on some trades both commissions and bid-ask spreads are paid Margin Trading and Short Sale Trading on margin (for stocks) means the investor borrows part of the purchase price of the stock from his broker. There is a maximum margin and is often set by the market regulators. In the US the maximum margin is set by the Federal Reserve and is currently 50% – that is you can borrow up to 50% of the stock value.

• Maintenance margin is the minimum amount equity in trading can be before additional funds must be put into the account. Note that the equity is the difference between the market value of the security and the amount initially ‘borrowed’

• Margin call is a notification from broker that you must put up additional funds to maintain your margin

Short-selling a security involves selling a security that the seller does not hold for future delivery or ‘borrowing a security and selling it with a promise of returning the security in the future. The purpose of selling short is to profit from a decline in the price of a security. A successful short seller first "sells high" and then "buys low". The mechanics of selling short is as follows:

1. If the stock price is rising but you believe that it will decline, borrow the stock through a dealer

2. Sell the borrowed stock and deposit proceeds and margin in an account with your broker

3. Closing out the position: buy the stock on the open market (hopefully at a lower price than you sold the borrowed shares for) and return shares to the party from which is was borrowed.

You do need money to be able to sell a stock short—not just pessimism. If the initial margin is 50% you have to deposit 50% of the initial sale of the stock with your broker as well as the proceeds of the sale. For example, if you had Tshs50, 000 to invest you could afford to short 100 shares of a Tshs 1000 stock. The initial sale would raise Tshs 100,000. Together with your Tshs 50,000 this Tshs 100,000 would reside with your broker

There are often some conditions that have to be made for a short sell to take place. In the US, for example, the Securities and Exchange Commission (the SEC) only allows short-sell when the stock price is rising! CONCEPT CHECK: Suppose that you are bullish on DAHACO and you have Tshs 200,000 to invest. The stock is currently selling at a price of Tshs 800 per share. You ‘borrow’ an additional Tshs 200,000 from your broker at the interest rate of 10% per year and invest Tshs 400,000 in the stock (i.e. buy 500 shares). The maintenance margin is 30%. How far can the price of DAHACO fall before you will get a margin call? CONCEPT CHECK: You observe that shares of Obsolete Technology are selling at a price of Tshs 1,200 per share. Your research indicates that the shares are overvalued and should be selling for a price to closer to Tshs 850 per share. You decide to short sell 100 shares. The maintenance margin is 25% and that the initial margin is 50%. What would be the expected return on investment if you were correct and the shares were to sell for an ending price of Tshs 850 per share?

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The Dar es Salaam Stock Exchange (DSE) (Most of the materials here are extracts from the DSE website)

Introduction The Dar es Salaam Stock Exchange (DSE) was incorporated in September 1996 as a private company limited by guarantee and not having a share capital under the Companies Ordinance (Cap. 212). The DSE is therefore a non-profit making body created to facilitate the Government implementation of the economic reforms and in future to encourage the wider share ownership of privatized and all the companies in Tanzania and facilitate raising of medium and log-term capital. The formation of the DSE followed the enactment of the Capital Markets and Securities Act, 1994 and the establishment of the Capital Markets and Securities Authority (CMSA), the industry regulatory body charged with the mandate of promoting conditions for the development of capital markets in Tanzania and regulating the industry. The governing organ of the DSE is the Council of the Exchange, which consists of 10 members representing various interest groups in the society. These are:

• Three Licensed Dealing Members representing brokers/dealers. • Two Associate members representing listed companies. • One Associate member representing institutional investors. • Two Associate members representing professions. • One Associate member representing the public and • The Chief Executive Officer who is an ex-officio member.

The DSE offers certain competitive advantages as incentives to encourage public participation in the securities market. They include:

• No withholding tax on interest is charged for both corporate and Government bonds of three years tenor and above.

• 5% withholding tax is charged on dividend payable for listed equities against 10% charged for unlisted equities.

• 0% Stamp Duty on transfer of listed security against 6% for unlisted security, and • 0% Capital Gain tax on disposal of listed security against 10% for unlisted security

Trading at the DSE Trading activities at the DSE commenced on 15th April 1998 after two years of background preparatory work under the stewardship of the Government through the Capital Markets and Securities Authority. The opening of the Trading Floor coincided with the listing of TOL Limited (formerly Tanzania Oxygen Limited), as the first company on the new Exchange. Currently DSE has three broad groups of traded securities: Ordinary shares , corporate bonds, and Government bonds. There are eight (8) listed equities (including two that are cross-listed from the Nairobi Stock Exchange in Kenya), six (6) corporate bonds and ten (10) Government bonds.

• Trading takes place four times during the week on Tuesdays, Wednesdays, Thursdays and Fridays starting from 10.00 a.m. to 12.00 noon. However due to the low level of activity, trading sessions ends before 12.00 noon.

• Trading is conducted at the DSE Floor under Continuous Open Outcry Auction Trading System. The Representatives of Licensed Dealing Members converge at the trading floor and trade by shouting their orders to the board writer who records the order on the board. Trading is commenced and ended by the ringing of a bell.

• A public gallery is at the back of the trading Floor from where members of the public can view and listen to trading as it takes place through a glass wall that separates the public gallery and the trading floor. Proceedings on the Floor are relayed to the public address system.

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Delivery, Settlement and the Central Depository System The delivery and settlement of securities traded is centralized at the DSE.

• For equities delivery and settlement on DVP (Delivery versus Payment) 5 business days following the transaction date (i.e. DVP T+5).

• Delivery and settlement of Bonds is effected through the DSE on DVP 3 business days following the transaction date (i.e. DVP T+3)

A Central Depository System (CDS) which acts as a ‘bank’ for securities has been installed. Before any security is traded on the DSE, it must be deposited into the Central Depository where CDS accounts are opened for every investor. The CDS went into operation on 1st June 1999. Fidelity Fund A fidelity fund is provided to compensate persons who suffer pecuniary loss from any defalcation committed by Licensed Dealing Member firms, any of its directors, partners or employees in relation to any money or other property entrusted to the DSE member company or firm. Compensation is limited to one hundred thousand shillings. Listing Requirements

NO. CRITERIA FIRST LIST (TIER) SECOND LIST (TIER) OTC LIST 1. Company status Duly incorporated as a

public company (securities freely transferable)

Duly incorporated as a public company (securities freely transferable)

Duly incorporated as a public company (securities freely transferable)

2. Prior existence1 At least, three consecutive years of audited accounts

At least, three consecutive years of audited accounts

3. Paid up Capital TShs. 50 million minimum "Rights issues" within three months)

TShs. 25 million minimum "Rights issues" within three months)

4. Public Holdings (as a % of Issued Securities)2

25% minimum (excluding employees).

10% minimum (excluding employees).

5. Amount of:-3 a. Preference or equity shares b. Corporate Debt

TShs. 40 million - minimum TShs. 30 million - minimum

TShs. 20 million - minimum TShs. 15 million - minimum

6. Minimum No. of Holders

1000 300

7. Documentation Prospectus for public offering

Prospectus for public offering

Prospectus approved with CMSA and filed with Registrar of Companies

8. Working Capital Sufficient Sufficient 9. History of Profitability Good profit and dividend

record (3 years) Good profit and dividend record (2 years)

1 In exceptional cases, the Council may accept a shorter period if that is desirable in the interests of the company or investors and the Council is satisfied that investors will have the necessary information available to arrive at an informed judgment 2 Exceptionally, a lower percentage may be accepted by the Council where the amount of securities of the same class and the extent of their distribution would enable the market to operate with a lower percentage. 3 This does not apply to additional listings of securities of the same class.

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Listing Fees

Fee Description Fee Amount/Rate Initial Listing fees (when a company comes to the market for the first time)

0.2% of the value of the securities to be listed subject to a minimum of TShs.2,000,000/= and a maximum of TShs.20,000,000/=

Additional Listing Fees (payable by a company already listed and is seeking listing of additional securities)

0.1% of the market value of the additional securities subject to a minimum of TShs.1,000,000/= and a maximum of TShs.10,000,000/=

Additional Listing Fees (payable by a company already listed and is seeking listing of additional securities) Annual Listing Fees (payable annually by all listed companies)

0.05% of the market capitalisation of listed securities at a particular date subject to a minimum of TShs.2,000,000/= and a maximum of TShs.10,000,000/=

Offer for sale fees (payable by a holder of large block of securities in a listed company offering to sell the block to the public investors)

0.15% of the market value of the securities being sold subject to a minimum ofTShs.2,000,000/= and a maximum of TShs.10,000,000/=.

Commission rates and Taxes Equities

Considerations Brokerage Commission

Transaction Fee

Fidelity Fund Fee

Total Cost to Investor

On the first TShs.10,000,000 1.70 0.28 0.02 2.00

On the next TShs.40,000,000

1.50 0.28 0.02 1.80

On any sum above TShs.50,000,000

0.80 0.28 0.02 1.10

Bonds Transaction Size Applicable Commission Up to Tshs. 40 million 1/16% On any additional amount exceeding Tshs. 40 million 1/32% Minimum commission Tshs. 5,000/=

Central Depository (CDS) Fee is TShs.100/= per transaction.

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Stock-Market Indicator Series Stock and Bond Market Indexes are indicators that track average returns of stocks and bonds. Market indices are important for a number of reasons:

• They indicate the overall direction and performance of the market • They are often the basis of comparing performance of managers: if Ali and Bahati are

Fund Managers the first question to ask may be, did they beat the market? Operationally, did they outperform some relevant stock index?

• They are basis for derivatives. A good example would be futures contracts on the S&P 500 stock index.

Examples of Indexes • US: Dow Jones Industrial Average (30 Stocks), Standard & Poor’s 500 Composite,

NASDAQ Composite, NYSE Composite, Wilshire 5000 • Others: Nikkei 225 & Nikkei 300, FTSE (Financial Times of London),Dax (Germany),

CAC 40 (Paris), EAFE, Zurich SMI, Milan The Dow Jones Industrial Average (DJIA) is the best-known, oldest (since 1896), and most popular series. It tracks the New York Stock Exchange using price-weighted average of 30 large well-known industrial stocks listed on NYSE. (It started with 12 stocks then 20 stocks until October 1st, 1928) These stocks are often leaders in their industry. Currently, the 30 stocks in the DJIA are:

1. Alcoa Inc, 2. Altria Group, Inc, 3. American Express Co, 4. American International

Group Inc, 5. Boeing Co, 6. Caterpillar Inc, 7. Citigroup Inc, 8. Coca-Cola Co, 9. DuPont Co, 10. Exxon Mobil Corp,

11. General Electric Co 12. General Motors Corp, 13. Home Depot Inc, 14. Honeywell International

Inc, 15. Hewlett-Packard Co, 16. International Business

Machines Corp, 17. Intel Corp, 18. J.P. Morgan & Co 19. Johnson & Johnson, 20. McDonald's Corp

21. Merck & Co, 22. Microsoft Corp, 23. 3M, 24. Pfizer Inc, 25. Procter & Gamble Co, 26. SBC Communications, 27. United Technologies

Corp, 28. Verizon Communications

Inc, 29. Wal-Mart Stores Inc 30. Walt Disney Co

In addition to the Industrial Average, the Dow-Jones has indicator series for Transport (airlines, railroads, freight forwarders etc) and Utilities (power generation, water supplies etc). This is why some corporate heavyweights such as American Airlines, UPS and Fedex are not in the above list. Differentiating Factors in Constructing or using Market Indexes Market indices differ in terms of how they are constructed particularly with respect to: the sample, weighting of sample members and computational procedure

• The sample focusing on three issues: the Size; the breadth and the “source” o The Sample Size focuses on how representative the index and whether it does

seem to track the portion of the market that the index creators are interested in o The Sample Breadth, like the size focuses on the needs of the index creator, on

whether to have a broad or narrow sample (stocks to be included). While a narrow index may fail to track all sections of the market a too broad index may include inactive securities that may drag down the market

o Sources: Generally, stock indices track market performance. Hence they are not necessarily constructed from prices. The issue is to ensure that the measured returns are economically meaningful

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• Weighting of sample members (Price-weighted series; Value-weighted series; Unweighted (equally weighted) series

o Price weighted: the average is computed by adding the prices of the stocks and dividing by the number of stocks in the index. The DJIA is a price-weighted index. Over its 100-year plus history, adjusting for stock splits has turned the divisor into a multiplier. That’s why the DJIA can be at 11,000 even though none of the stocks costs that much

o A market value weighted index is calculated as a weighted average of the returns of each security in the index, with weights proportional to outstanding market value. The S&P500 and NASDAQ averages are market value weighted

o Equally weighted indexes, such as the Value Line Index are computed as a simple average of returns of the stocks in the index.

• Computational procedure o Arithmetic average involves computing an index and have all changes, whether in

price or value, reported in terms of the basic index; o Geometric average is also used

More on Weighting the sample members and the Computational Procedures Price-weighted average Price-weighted average index is obtained by taking the sum of the prices of all stocks in the index and dividing it by a ‘divisor’. This divisor is not necessarily the same as the number of stocks in the index as it changes due to stock splits, consolidations, spin-offs, stock substitutions (changes in the sample) as well as mergers and acquisition activities. The movement in a price weighted index is influence by the sizes of the included stocks and often this leads to distortions. Columns 3 and 4 in Table 1 illustrate how the index changes from Time T to Time T+1 and distortions associated with the weighting. In both cases one stock has increased by 10% from time T to time T+1 (Stock A for Case I and stock C for Case II). However the percent increase in the index is different in the two cases Table 1

Time T Time T+1 Stock Case I Case II

A 100 110 100 B 50 50 50 C 30 30 33

SUM 180 190 183 Divisor 3 3 3 Average 60 63.3 61

Percentage Change 5.5% 1.7%

A price weighted index implicitly assumes that an investor holds the stocks in proportion to their prices rather than in proportion to their value in the overall market or in equal proportions. The Nikkei-Dow Jones Average (Nikkei 225) is the best-known series in Japan. It is a price-weighted series formulated by Dow Jones and Company and computed as an arithmetic average of prices for 225 stocks (representing 15 percent of all stocks) on the First Section of the Tokyo Stock Exchange (TSE) Change in the Divisor of a Price Weighted Index due to stock split Column 3 in Table 2 illustrates how the divisor to a Price Weighted Index changes if, in Time T, there is a stock split for one stock (Stock A in this case). Since we are talking about time T, the 2-for-1 stock split index is unchanged at 60. But since the split has changed the sum of the prices we need to find a number (X) that if it is used as the divisor to the new sum we will end with the same index of 60.

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Columns 4 and 5 illustrates the downward bias that a Price Weighted Index introduces by reducing weighting of fastest growing companies whose stock splits Criticism of the DJIA

• The main criticism of DJIA is that it is limited to 30 non-randomly selected blue-chip stocks and does not represent a vast majority of stocks

• The other criticisms come from the index being a Price Weighted Index. Thus, the divisor needs to be adjusted every time one of the companies in the index has a stock split, a new stock is included or an existing one is dropped. Also it introduces a downward bias by reducing weighting of fastest growing companies whose stock splits

Table 2

2 for 1 split (Stock A)

Time T+1: Price of Stock A increases by 10%

Time T Time T Without Split With 2 for 1 split

A 100 50 110 55 B 50 50 50 50 C 30 30 30 30

SUM 180 130 190 135 Divisor 3 X 3 2.1667 Average 60 60 63.3 62.3067

Percentage Change Hence the new

divisor (X) is 2.1667 5.5% 3.8462%

Market Value-Weighted Series Market Value-Weighted Series is basically an indicator of change in market capitalization of all firms included in the index. It is computed as follows:

1. First, derive the initial total market value (capitalization) of all stocks used in the series Market Capitalization = Number of Shares Outstanding X Current Market Price

2. Second, assign a beginning index value (100) and new market values are compared to the base index

3. The index value on day t, Indext for value weighted series is computed as:

ndexValueBeginningINPNP

Indexbb

ttt *

ΣΣ

=

Where Pt = ending prices for stocks on day t Nt = number of outstanding shares on day t Pb = ending price for stocks on base day Nb = number of outstanding shares on base day

Notice that the weighting in the index depends on market value hence the index automatically adjusts for stock splits and right issues. On the other hand a sale of additional shares or an issue of shares to pay for acquisition will need a change in the divisor. A Market Value-Weighted Series such as the Standard and Poor’s Composite 500 (S&P500) takes into account that some firms are larger than others. This may also reflect the belief that a diversified portfolio is likely to have the different stocks in proportion to their value in the overall market (rather than in proportion to their prices or in equal proportions) S$P500 is also more broadly based index of 500 firms which is another improvement over DJIA. Wilshire 5000 is the ultimate US equity index so far computed of the market value of all NYSE and AMEX stocks plus actively traded OTC stocks (It actually include about 7000 stocks despite its name). Other indices are Russell3000, the NASDAQ 100 and NASDAQ Composite (of nearly 3000 OTC stocks) Unweighted Price Indicator Series In an Unweighted Price Indicator Series all stocks carry equal weight regardless of price or market value. Thus a change in the index is computed as some arithmetic or geometric

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average of the percent price changes for the stocks in the index. Value Line and the Financial Times Ordinary Share Index compute a geometric mean of the holding period returns and derive the holding period yield from this calculation. An Unweighted Price Index may be used by individuals who randomly select stocks and invest the same monetary amount in each stock Other market specific indices include the Dow Jones World Stock Index. Introduced in January 1993, the Dow Jones World Stock Index covers 2,200 companies worldwide and is organized into 120 industry groups. 33 countries representing more than 80 percent of the combined capitalization of these countries are included. These countries are grouped into three major regions: Asia/Pacific, Europe/Africa, and the Americas. Each country’s index is calculated in its own currency as well as in the U.S. dollar Bond-Market Indicator Series Bond-Market Indicator Series are relatively new and not widely published. Their need was mainly due to the growth in fixed-income mutual funds which increase the need for reliable benchmarks for evaluating performance. Bond-Market Indicator Series are difficult to create and compute for a number of reasons:

• The universe of bonds is much broader than that of stocks • The range of bond quality varies from Treasury securities to bonds in default • Bond market changes constantly with new issues, maturities, calls, and sinking funds • Bond prices are affected by duration, which is dependent on maturity, coupon, and

market yield • Correctly pricing individual bond issues without current and continuous transaction prices

available poses significant problems There are different Bond Indexes including

• Investment-Grade Bond Indexes: In the US, four investment firms maintain indexes for Treasury bonds and other investment grade (rated BBB or higher) bonds. The relationship among these bonds is strong (correlations average 0.95) and the returns for all these bonds are driven by aggregate interest rates - shifts in the government yield curve

• High-Yield Bond Indexes: These indices cover non investment-grade bonds (rated BB, B, CCC, CC, C). Relationship among alternative high-yield bond indexes is weaker than among investment grade indexes .

• Global Government Bond Market Indexes: The Global bond market is dominated by government issues. Several indexes are created by major investment firms. Most of them measure total rates of return and use market-value weighting and trader pricing but sample sizes differ as do numbers of countries included

• Composite Stock-Bond Indexes: Beyond separate stock indexes and bond indexes for individual countries, a natural step is a composite series that measures the performance of all securities in a given country. This allows examination of benefits of diversification with a combination of asset classes such as stocks and bonds in addition to diversifying within the asset classes of stocks or bonds . One such index is the Merrill Lynch-Wilshire U.S. Capital Markets Index (ML-WCMI). It is a market-value weighted index that measures total return performance of the combined U.S. taxable fixed income and equity markets . It is a combination of Merrill-Lynch fixed-income indexes and the Wilshire 5000 common-stock index tracking over 10,000 stocks and bonds

Comparison of Indexes over time Correlations among monthly equity price changes . Most differences are attributable to differences in asset classes , market segments and sample. In the US for example, there is lower correlations between NYSE series and AMEX series or NASDAQ index than between NYSE alternative series (S&P 500 and NYSE composite). There is also low correlation in global returns to U.S. returns which supports global diversification.

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Group Assignment 1 o Construct a market index for the Dar es Salaam Stock Exchange (DSE) adhering to

the following conditions: • The base date has to be between January 1st 2001 and September 30th 2001

starting with an ALL SHARE Index (Explanation to justify your selection of the base date may attract some bonus points)

• Use any relevant computational methods (Explanations for your choice of the method are REQUIRED)

o Track the index by computing end of the month index value for each month up to December 31st 2005. You need to provide explanations as to whether any modifications to the index – addition of new stocks, dropping some stocks – during the pe riod are justified. If so then make the appropriate modifications stating the immediate effects and reflecting such changes in the subsequent index values. NOTE that your index needs to have at least four stocks as at December 31st 2005. (Though it is not necessary, it is highly recommended to have at least one change in the index. Bonus points MAY be awarded)

o Plot the index over the period (from your base date to December 31st 2005) o Identify significant monthly change in the value of the index and provide possible

explanation for at least one change. o Compare the your DSE index with another index of your choice for the January

2002 to December 31st 2005 period (for convenience use the index values on the Monday of the Second week of January as your starting values) • Plot the two indices in one graph assigning the starting values a value of 100 • Explain the observed pattern paying particular attention to key similarities and

differences and probable reasons behind the patterns (Credit will be awarded for reasoning that is logical)

ADDITIONAL ISSUES

i. This assignment represents five percent (5%) of all evaluation points for this course.

ii. For consistency it is suggested that data from DSE is collected by the class as a whole. Thus ensure that only one person or team goes to DSE to collect the relevant data

iii. Most data for major indices are available on the Internet such as the respective Stock Exchange sites

iv. The assignment has to be computer typed and graphs plotted using a software with graph plotting features such as the Excel (The instructor reserves the right to require a group to submit a soft-copy of their assignment including all relevant workings)

v. The deadline for submitting the assignment is Friday, March 24th 2006