Book title: Understanding
Financial Markets & Instruments
An American option is a put or call option that can be exercised
and settled at any time from the date that the option is written, up to
the date that the option expires.
The simultaneous purchase and sale, in two different markets, of
a financial asset, a commodity, currency, or bill of exchange, in order
to profit from a price discrepancy.
True arbitrage is risk-free.
The arbitrage process plays a central role in ensuring that prices
are consistent in different markets.
An investor who believes that the market or the value of a particular
share is going to decrease.
describes a situation where the majority of shares are dropping
in price and the market is generally declining.
A sale of shares before they are purchased.
In reality, a bear sale (or SHORT SALE) is the sale of an undertaking
to supply a certain number of shares at a specified future date.
The Eskimos who used to sell polar bear skins to European traders
originated bear selling. The
demand for polar bear skins varied depending on whether they were fashionable
or not. The Eskimos, realising
this, took the opportunity when the demand for skins was strong to sell
not only their current stock of skins, but also their next hunting trip's
skins. In this way they actually
sold the skins of polar bears that they had not yet killed to take advantage
of the higher prices. If
the demand (and therefore the price) had dropped by the time of their
next visit to the trading post they would have made a wise decision.
The term was adopted by share markets to describe a situation where
someone who felt strongly that the price of a share was about to fall
could, in fact, take advantage of his foresight by selling the shares
at current prices for delivery in a few months time when he could buy
them much more cheaply. Bear
sales on the JSE must be done at a price that is higher than that of the
last transaction in that share.
Security for the bear sale must also be given and the fact that
it is a bear sale must be disclosed.
Only about 1% of deals on the JSE is bear because of the high risks
involved - if the shares go up instead of down, theoretically there is
no limit to the extent of your loss.
A bear squeeze occurs when a share or commodity has been heavily
short sold on a strong expectation that it will fall, instead of which
it rises. Investors who have
bear sold then hasten to buy the asset to cover their bear positions.
If the asset is in short supply, the price quickly rises to absurd
levels in what is called a bear squeeze.
In the derivatives market a bear squeeze often follows a period
of negative sentiment when the price of a contract reverses and shorts
and call option writers pile into the market to cover naked positions,
rapidly driving prices up.
The second letter of the Greek alphabet, used by Wall Street to
describe the volatility of a stock relative to a stock market index.
Beta is regarded by some as a measure of stock market risk.
BID PRICE: The price offered by a buyer for a share, commodity, future, option or other instrument.
BROKER'S NOTE: A confirmation sent to the buyer or seller of shares by his stockbroker detailing price, quantity, date, dealing costs, and the net amount due to or from the client.
BULL: An investor who believes that the value of a particular contract, share, sector or the market as a whole is on the increase.
CAPITALISATION ISSUE: Also called "bonus issues", these involve no transfer of cash between the company and its members. They occur when a company feels it desirable to convert part of its reserves (profits from earlier years that have not been paid out as dividends) into new shares. This often arises if the number of shares in issue is small in relation to the total value of the business, making them hard to come by or too highly priced to be easily traded. The effect from a member's (shareholder's) point of view is to give him a greater number of shares than he already has. As the company itself has not grown any larger or smaller in the process, and his percentage holding has remained unchanged, his stake merely consists of more shares, each representing less of the company.
CARRY TRANSACTION: A transaction where an asset is bought from a holder for a specific settlement date and simultaneously sold to the same party for settlement at a later date. This can be done to obtain finance instead of using a repo transaction. In the case of the carry transaction the grantor of the finance becomes the owner of the asset for the period between the two settlement dates.
CASH SETTLEMENT: Cash settlement is a mechanism that allows certain options and futures to be settled without delivery of the underlying asset taking place. Instead of physical delivery of grain, dollars, or scrip, cash settlement results in the difference between the contract price and the spot price at expiry being paid to the long position if prices have risen, or vice versa if prices have fallen. For options the difference between the current settlement price on the underlying asset and the option's strike price is paid to the option holder when the option is exercised.
CLOSE-OUT DATE: The expiry date of SAFEX-listed futures and options.
COMMODITIES CONTRACT: A contract obliging one person (the seller) to supply to another person (the buyer) a specified quantity and grade of a particular commodity on a certain date at an agreed price, and obliging the buyer to accept delivery of the commodity. The term can mean either a future or forward contract. Settlement can sometimes be in cash.
CONSIDERATION: The settlement amount or amount paid at settlement of a bond transaction. This amount is determined by calculating the all-in-price using the rate (YTM) at which the transaction was concluded.
COUPON RATE: The rate paid on the nominal value of a fixed interest-bearing money or capital market investment such as a bond.
CUM DIV: Shares are said to be cum div in the period between declaration of the dividend and the last day to register for the dividend. A sale of shares while they are cum div passes on the right to the next dividend to the transferee (or buyer).
CUM INTEREST: Interest-bearing instruments are said to be cum interest before or on the next LDR date and after the previous interest payment date.
DERIVATIVE INSTRUMENT: A financial instrument such as a future or option that relies on another underlying asset to "derive" its value. For example, the JSE gold index underlies the all-gold share index future. Similarly, the option on the R153 bond depends on the value of the R153 itself.
DOW-JONES: An index of 30 blue-chip companies trading their shares on the New York Stock Exchange. Although this is a relatively small sample of the total number of shares traded, it is widely used as an indicator of the whole exchange and the American share markets generally.
EARNINGS PER SHARE: A company's earnings (profit) divided by the number of ordinary shares in issue, usually expressed as a number of cents per share.
EARNINGS YIELD: Earnings per share expressed as a percentage of the current market price of the share. For example, a company with 25 cents earnings per share and a market price of 250 cents would have an earnings yield of 10%.
EQUITY: Equity means "ownership". In a company, that portion of share capital which carries risk and shares in profits through dividends that are dependent on profitability, is known as "equity". Ordinary shares are often called "equities", and other types of shares, which share in the risk to a lesser extent (such as convertible or participating preference shares) are known as "near equities". The equity of a company is the share capital and reserves of the company, which is the same as its net assets.
EURODOLLAR: US dollars held outside America and traded freely for other currencies.
EUROPEAN OPTION: Unlike an American option, the European option can only be settled on the expiry date and not during the life of the option. It is sometimes pointed out that European options can be exercised at any time (i.e., the exercise notice or declaration can be delivered well before the expiry date), but this is of no value, as the settlement only occurs on expiry, by which time changes in the price of the underlying asset may have made the option unprofitable.
EX DIV: A share is ex div once the last day to register has passed. Any sales after the last day to register are done on the basis that the dividend accrues to the buyer, even if it has not yet actually been paid out.
EX INTEREST: Interest-bearing instruments are said to be ex-interest after the LDR date and on or before the next interest payment date. For transaction with a settlement date falling in this period, the buyer will receive the full amount of interest for the interest period on the interest payment date.
EXPIRY DATE: The last date on which the rights attached to an option may be exercised. The day after expiry the option has no value. Also used to refer to the date on which a futures contract matures (therefore anonymous with delivery date). On the expiry date the value of an option is normally equal to the intrinsic value of an option limited to a minimum or R0.
FINANCIAL FUTURE: A futures contract on a financial asset. It is thus a contract to buy and sell through an exchange a financial asset on a certain future date at a price determined at the closing of the contract between two parties.
FORWARD CONTRACT: A forward contract is an agreement between two principals respectively to buy and sell a commodity at some specified future date for a set price. Both parties are obliged. The primary difference between forward contracts and futures contracts is that the latter are standardised and traded through an exchange, enabling a secondary market in the contracts themselves to develop.
FUTURES MARKET: A market for standardised forward contracts. Buyers and sellers in the futures market commit themselves respectively to buying and selling commodities, currencies, or other instruments at a specified future date and at a predetermined price. These markets enable producers and consumers to plan ahead by fixing the price they will pay or receive in the future, enabling them to reduce the risk of price fluctuations.
FUTURES CONTRACT: An agreement in which the seller undertakes to deliver a commodity or other instrument at a specified future time and at a predetermined price, and the buyer undertakes to accept delivery. Futures contracts differ from forward contracts only in that they are standardised in terms of delivery, grade, payment terms, and certainty of performance, and that they are traded through exchanges.
HEDGE: To take a position that off-sets an existing position in order to reduce the price risk in the open position. A fund manager might be obliged in terms of his mandate to hold a percentage of his portfolio in gilts. If he fears that interest rates will rise (thus driving gilt prices down), he can hedge his gilt holding by selling an E168 futures contract so that the profits on the future off-set the losses on the gilts.
IN-THE-MONEY: A call option which has a strike price below the market price of the underlying asset, or a put option which has a strike price above the asset price. The option would have a positive intrinsic value.
INDEX: A weighted or unweighted average of the prices of a group of shares, commodities or other instruments. The JSE indices are weighted according to market capitalisation and exclude 20% of the smallest quoted companies in the respective sector.
INDI FUTURE: SAFEX's industrial index future, based on the JSE's industrial index.
INITIAL MARGIN: The security deposit that must be placed with the exchange when trading in future or option contracts listed on SAFEX. This deposit must be placed in terms of the net position in each of the different instruments traded on the exchange.
JET: Johannesburg equities trading system - the electronic trading system on the Johannesburg stock exchange.
JOBBER: This term actually refers to a London stockbroker who only buys and sells shares from other stockbrokers. In South Africa, the term is used to refer to any broker who buys and sells shares for himself, and even more broadly, anyone who buys and sells shares quickly, looking for short-term profits.
LAST DAY TO REGISTER (LDR): This phrase is most commonly used in connection with dividends or interest paid on interest-bearing instruments. When a dividend is declared, the directors of the company announce the day on which the list of registered shareholders will be fixed for purposes of the dividend. Anyone holding a share on the LDR is eligible for the dividend; an investor who buys with settlement on or before LDR will receive the dividend, even if he sells the day after. LDRs for bonds are published with the particulars of the bond and is currently one month before interest payment date. With the demobilising of scrip into a central depository and electronic settlements, it is possible that LDRs on future bond issues will be much closer to the interest payment date. Rights issues and bonus issues also have LDRs.
LONG POSITION: A long position in any instrument is when the holder of the instrument is the owner or beneficial owner thereof.
MARK-TO-MARKET: The process of recalculating the net profit or loss on each client's open positions at the end of each trading day (or more often if required). This will result in the open position being shown at market value. Funds are withdrawn from or deposited into the client's margin account so that the balance reflects his net profit or loss. The system ensures that the overall liabilities of market participants are kept to a minimum. The daily mark-to-market price (MTM) is set by the exchange each evening as the mid-point of the best bid and the best offer at close of trade.
MARKET CAPITALISATION: The value that the market place ascribes to a listed company. This can be calculated by multiplying the number of shares in issue by their current market price.
MARKET MAKER: An exchange member who is always willing to make a price and thereby helps to create a liquid market. Market makers trade as principals (for their own account), and quote two-way prices in order to try and maintain a balanced book.
MARKET RATE: The rate at which interest-rate securities trade in the secondary market at a specific stage.
MATURITY DATE: The date on which a bond or debenture falls due for repayment. The term is also used interchangeably with expiry date to refer to the expiry date of an option.
MONEY MARKET: The market for short term and very-short-term paper. The money market is not a physical marketplace, but a communications network which allows merchant banks, large corporations, the government, and the Reserve Bank to deal with one another and arrange lines of credit with one another.
NAKED OPTION: An option that has been sold by a writer who does not have a position in the cash market to cover the option.
NEGOTIABLE CERTIFICATE OF DEPOSIT (NCD): An NCD is a fixed deposit receipt which is negotiable in the secondary market, which means that the holder thereof can sell it to a third party. Interest on NCDs is usually paid six-monthly in arrears if the term exceeds one year, and on maturity if the term is less than one year. The price of NCDs fluctuates, depending on the prevailing interest rate.
NIL PAID LETTERS (NPL): A security which is temporarily listed on the stock exchange and which represents the right to take up shares of a certain company at a certain price on a certain date. Nil paid letters are the result of a rights issue to the existing shareholders (or debenture holders) of a company. A rights issue is a method of raising additional capital by offering existing shareholders the opportunity to take up more shares in the company, usually at a price that is well below the market price of the shares. NPLs usually trade for a period of four weeks.
OFFER PRICE: The price at which a market participant is willing to sell. The bid price and the offer price together make up the double in the futures market.
OPEN POSITION: An open position in any instrument is when a short or a long position in an instrument is not hedged against price or interest-rate risk by using derivatives or opposite transactions.
OPTION: An option gives the holder the right but does not impose an obligation to buy (call) or sell (put) an underlying asset at a predetermined price at any point within a specified period of time. The writer is obliged to sell or buy if called upon to do so, and in return for shouldering this obligation receives a once-off-non-refundable payment known as a premium.
OUT-OF-THE-MONEY: An option which has a negative intrinsic value (i.e. for a call, where the strike price is above the market price, or vice versa for a put).
OVERNIGHT OPTION: An option that is live from 4:00 p.m. and expires at 10:00 a.m. the following morning.
OVER-THE-COUNTER (OTC): This refers to any transaction which is made outside of a regulated and organised exchange. This means, inter alia, that due performance is not guaranteed beyond the means of the parties to the transaction, and that the transaction may be difficult to renegotiate in a secondary market. OTC deals are usually made over the telephone rather than over a counter.
PAR VALUE: The price for which a share was first sold to the public. Normally, the market price quickly exceeds the par value as the company grows and makes profits. The objective of the par value is to enable the "asset base" of the company to be clearly established at its inception so that no illegal erosion of that base can take place.
POINTS: Specific to gilts or interest rate market trading, a basis point or a point is equal to one-hundredth of one percent. A move from 17,25% to 17,26% in the quoted YTM for the R153, for example, is a one basis point move. A change in the quotation from 17,250% to 17,255% (referred to as "seventeen point two five and a half") is half a basis pointmove. In the forex market, a basis point is equal to 0,0001 in the foreign exchange rate quotation.
PRICE/EARNINGS RATIO: The market price of a share divided by the earnings per share. This is the reciprocal of the earnings yield (EPS/price). It is preferred to the E.Y. by many investors because its relationship with price is straightforward rather than inverse: an "expensive" share has a high P/E but a low E.Y.
PROMISSORY NOTE: This is defined by the Bills of Exchange Act as an unconditional order in writing made by one person to another, signed by the maker, and engaging to pay on demand or at a fixed or determinable future time, a certain sum of money, to a specified person or his order or to bearer.
PUT OPTION: A put option gives the holder the right but does not impose an obligation to sell a specified asset (financial, physical, or notional) at a set price within a specified time period or on a specific date.
REPO RATE: The rate at which a loan is granted when an asset is given as collateral or security for the loan, and where the asset will be repossessed by the borrower to redeem the loan.
REPO TRANSACTION: A transaction where a loan is granted and an asset is given as collateral or security for the loan. The borrower pays interest on the loan granted by the lender by taking the asset given as security or collateral back at redemption of the loan (known as the repossession of the asset) at a value determined by the rate on the loan, known as the repo rate. The grantor of the loan never becomes the owner of the asset given as security or collateral.
REDEMPTION DATE: The date on which redeemable preference shares, debentures or loans will be redeemed by the company. These are really forms of long-term indebtedness, which clearly have to be paid back on pre-determined dates.
RIGHTS ISSUE: An offer of additional shares to existing shareholders, usually at a discount to the current market price. When a company wishes to raise additional capital, one of the ways it can do so is by offering more shares to its existing shareholders. Normally the right to buy these shares is represented by renounceable nil paid letters of allocation (NPLs) which entitle the holder to buy the shares at a certain price.
SCRIP: Share market jargon for share certificates.
SCREEN MARKET: A system of trading which relies on an electronic computer network to link market participants, in contrast to a trading floor where dealers physically congregate.
SEAT: One buys "a seat" on an exchange in order to become an exchange member. SAFEX seats were originally issued at R25 000 and traded as low as R4 000 in 1991. In 1994 seats were changing hands at R175 000.
SETTLEMENT: The physical delivery of the payment and the instrument or underlying instrument between the buyer and seller.
SETTLEMENT DATE: The date on which a transaction is given effect and on which payment and delivery takes place. In the gilts market, for example, settlement takes place on the third business day after the trade. Share index futures are settled on 15 (or next business day) March, June, September, and December. On the JSE transactions are settled on the seventh business day after the trade. This will soon change to 5 business days after the trade, and later to three.
SHORT POSITION: A short position in an instrument is when the instrument is sold or an option is written without the seller/writer being the owner of that instrument or the holder of an opposite option.
SPOT MARKET: Any market in which goods change hands "on the spot". Traders in the spot market (or cash market) make transactions for immediate payment and delivery. In contrast to the futures market, where payment and delivery occur at a future date.
STRIKE PRICE: The set price at which a call option holder has the right to buy the underlying asset, or at which a put option holder has the right to sell the underlying asset.
TERM TO MATURITY: The period left until the redemption of a loan. In the case of a bond, the period left until the repayment of the nominal amount on redemption date.
UNDERLYING ASSET: The asset that underlies a derivative instrument such as a futures or option contract. Futures and options are negotiable instruments in their own right, but their price depends on an underlying asset such as a commodity or share.
VARIATION MARGIN: Also called the mark-to-market margin, it is the cash flow that is settled between the exchange and any participant with an open position in an instrument traded on SAFEX, based on the movement in market value of that instrument of the previous day.
VOLATILITY: The degree to which a time series deviates from its average. The higher the volatility of an asset's price, the greater the variability of potential return. Volatility is therefore a measure of risk. Expected volatility, which is one of the variables used in option pricing models, is generally based on historical volatility (i.e. it is assumed that the past volatility of the asset will not change materially in the future). "Implied volatility" is the degree of volatility implied in an option's premium, which is derived by solving the option pricing model for volatility rather than price (all the other variables can be quantified exactly).
WARRANT: Term used sometimes to refer to a long-term call or put option on a share or basket of shares.
WRITER: The first seller of a call or put option, also known as the grantor. The option writer assumes the obligations attached to the option, namely, to buy or sell the specified asset if called upon to do so.
YIELD CURVE: A yield curve is a plot of yields-to-maturity against the term to redemption. The normal (positively sloped) yield curve occurs when long-term securities give a higher return than short-term securities. The inverse yield curve occurs when near-dated stocks have a higher YTM than far-dated stocks.
YIELD-TO-MATURITY (YTM): The yield that an investor would get on an investment such as a bond, if the investor kept the investment to maturity. The yield-to-maturity (or yield-to-redemption) of a bond is the calculated yield taking into account (a) the present value of the principal at redemption, (b) the present value of the periodic coupon payments for the remaining life of the bond, and (c) the present value of interest earned on the coupon payments. Gilts are traded on the YTM, and the all-in price which has to be paid is worked out once a deal is concluded.
ZERO-RATED COUPON BONDS: Bonds that do not pay interest on the nominal amount of the instrument. These bonds are usually issued at a discount to the nominal value, similar to that of short-term discount instruments such as BAs and treasury bills.