FOREWORD

So here is the deal, if you’re embarking on doing this paper as a self-study candidate, just know
there is no single source book that covers the whole syllabus relating to this subject, and even if it
exists, Kasneb will still fuck you {pardon my French} by setting questions of advance level
subjects, something I discovered later, on my way to complete the certification. You’re better off
going to a training institution, but again how easily can you access a CIFA accredited college? It
happened 2 weeks to exam, when I sat down to attempt to revise past papers, and it dawned on
me that I had been reading wrong materials. Next, I remember walking away from the exam
room after bullshitting for one hour, having accepted my L, and decided to study for my next
exam paper. These notes are a product of my frustration as I retook the paper for the second
time, and I have decided to do my part by creating some reading material for all those attempting
the subject. The notes aren’t comprehensive but should give you an idea what the subject is all
about. The more you know the easier it is to survive in the exam.

ACKNOWLEDGEMENT
I have prepared this document by collecting information primarily from the Kasneb
recommended reading books list. I therefore categorically state that I do not claim any copyright
on this document. I do not vouch for its correctness and any oversight is unintentional and I
apologize for not being diligent with my notes. Want to get in touch [email protected].
 MARKET ORGANISATION AND STRUCTURE
1. FUNCTIONS OF FINANCIAL SYSTEM

A financial system is a system that links savers who have money to invest and
spenders/borrowers who need money. It consists of 3 main components

 Financial Markets
 Financial Intermediaries & Financial Institutions
 Financial Regulators

Financial market is a market where financial assets are exchanged. It facilitates the flow of funds
in order to finance investments by firms, governments and individual’s i.e. flow of funds from
surplus units (savers) to deficit units (borrowers) of the economy. It is a market in which buyers
and sellers trade financial securities {stocks and bonds} and commodities at low transaction
costs and at prices that reflect supply and demand

Financial institutions are financial intermediaries who play the role of collecting money from
savers and invest it financial assets e.g. Banks, Pension Funds, Insurance companies, Mutual
Funds. Their main role is to allocate efficiently funds where lenders and borrowers can’t deal
directly in the financial market.

Financial regulators perform the role of monitoring and regulating the market participants in the
financial system. Due to the role played by financial markets in economies, governments have
considered it necessary to regulate certain aspects of these markets. These regulations always
arise due to market failure, which make markets not to be competitive. The rules and regulations
are designed to serve several purposes:

1. Disclosure regulations- which require issuers of securities to disclose a large amount of

information to actual and potential investors e.g. profit warnings and takeover threats.
Their main intention is to prevent defrauding of investors by concealing relevant
information.
2. Financial Activity regulations – consist of rules about traders of securities and trading on
financial markets e.g. market manipulation, front running and insider trading. They
promote competition and fairness in the trading of securities and trading on financial
markets.
3. Regulation of financial institutions – a form of governmental monitoring that restricts
these institutions activities in vital areas of lending, borrowing and funding. They are more
of operational rules e.g. capital requirements, asset concentration and liquidity position.
 They help in promoting stability of financial institutions, and deter them from taking
excessive risks.

It should be noted laws and regulations governing financial markets also have their own
weaknesses, such as:
 Limited coverage, vague and ambiguous
 Slow to catch up to market innovations e.g. crypto currencies.
 Different or overlapping regulatory frameworks.
 Effectiveness depends on market participants, interpretation and compliance

1.2 FLOW OF FUNDS

There are 2 basic mechanisms by which funds flow through the financial system. Providers
{Lenders} and users {Borrowers} of capital may interact through financial markets or through
financial intermediaries.

1. Direct finance – which involves movement of funds through the financial markets i.e. the
providers of capital have a direct claim on the users of capital e.g. Owning ordinary shares
in a company gives a claim on assets and earnings.
2. Indirect finance – which involves movement of funds through financial
intermediaries/institutions who act as middlemen between lenders and borrowers of
capital. In this case investors/savers don’t have direct claims on borrowers’ assets or
earnings.

Functions of financial systems

1. Pooling of funds – Allow transfer of funds from those entities who have surplus funds to
invest those who need funds to invest in real assets.
2. Capital Formation – Business require finance which is made available by banks and
financial institutions by mobilizing savings which creates capital.
3. Facilitate payments and settlements – Offer a convenient mode of payment for goods
and services which facilitates quick and easy transactions.
4. Provide liquidity – Provide investors with a platform or opportunity to sell their
investments with ease
5. Economic development – Can be used by governments to influence the macro-economic
variables for example by making credit cheaper through controlling level of interest rates
and inflation.

1.3 FINANCIAL INTERMEDIATION

It refers to the process where a financial intermediary channels funds from units in surplus
{savers} to those who don’t have enough funds {Borrowers} to carry out a desired activity.

The main financial intermediaries include

 - Insurance companies - Investment Banks - Commercial Banks
- Pension Funds - Mutual Funds/Unit Trusts

The roles of financial intermediaries include

- Pooling of funds by obtaining funds from lenders and lending to borrowers
- Engage in asset transformation
- Provide a payment mechanism
- Diversification of risk for investors
- Manage financial assets of clients

There are different types of intermediation

1.Denomination/Size intermediation – refers to the process of a financial intermediary
accepting small amounts of savings/deposits from individuals and pooling these funds to make
large loans to corporates or government that have large funding requirements.

2.Risk intermediation – A financial intermediary/banks are able to minimize the risk of

individual loans by diversifying their investments, pooling of risks, screening and monitoring of
borrowers, holding capital and reserves as a buffer for unexpected losses.

3.Maturity intermediation – A financial intermediary will borrow short term funds from savers
with short to medium term deposit period and provide those funds to long term borrowers who
require long term committed funds. This always creates a mismatch of assets and liabilities of
the financial intermediary.

4. Information intermediation – Refers to the process where a financial institution uses their
skills to gather and process information from the financial market participants. As such these
institutions have an information advantage and savers are willing to place funds with them
knowing that they will be directed to the appropriate borrowers without the former having to
incur information costs.

5. Liquidity intermediation – refers to the matching of highly liquid investments {deposits} from
savers which can be converted into cash quickly with the illiquid investments {loans} to borrowers
which involve high risk of default and transaction costs.

CHALLENGES OF FINANCIAL INTERMEDIATION

MACRO FACTORS
- Lack of stable macro-economic fundamentals such as high inflation rates & interest rates,
depreciating local currency, huge government debt which hinders easy flow of funds.
- Poor attraction of capital flows from investors due to macro-economic instability, slow
economic growth and underdeveloped capital markets.
 - Slow financial sector development {in banking & stock markets} which affect success of
financial deepening in the markets.
- Political risk and instability which reduce capital flows in a country.

MICRO FACTORS
- -Lack of capability by financial institutions e.g. risk analysis expertise, inappropriate
policies and financial instruments to clients.
- Weak regulatory and legal policies.
- Slow adoption of technology innovations in delivering financial services
- Social and cultural factors such as illiteracy of both clients and employees providing
financial services.

NOTE: DISINTERMEDIATION refers to the elimination of financial intermediaries between suppliers

of funds{Investors} and users of funds{Borrowers}.This is achieved by investing directly in the
capital markets in order to earn high returns and reduce commission costs.

CHARACTERISTICS OF A GOOD FINANCIAL MARKET/SYSTEM

-Timely and accurate information is available on price and volume of past transactions
- It is liquid i.e. assets can be sold or bought quickly at a price close to the prices of the previous
transactions.
- Low transaction costs e.g. brokerage costs
- Resilient i.e. capacity to adjust to both normal business cycles and severe economic shocks.
- Fair treatment of market participants i.e. transactions are transparent, honest and non-
discriminatory.

1.4 CLASSIFICATION OF ASSETS AND MARKETS

Practitioners often classify assets and markets in which they trade by various common
characteristics to facilitate communications with their clients, with each other, and with
regulators. Markets may be classified on the basis of:

A. The timing of delivery, which include

1. Markets for immediate delivery known as spot markets
2. Markets where delivery occurs at some point in the future include forward, futures
and options markets.

B. Who the seller is.

1. Markets in which securities are sold by issuers {where funds flow from the
purchaser to the issuer} also known as primary markets
2. Markets in which securities are sold by investors {where funds flow between
traders} referred to as secondary markets
 C. The maturity of instruments that are traded.
1. Markets that trade debt instruments maturing in one year or less also known as
money markets.
2. Markets that trade instruments of longer maturities are referred to as capital
markets.

D. The types of securities:

1. Publicly traded debt, equities and shares in pooled investment vehicles that hold
these securities are referred to as traditional investment markets.
2. Hedge funds, private equity, commodities, real estate securities and properties, and
securitized debts are part of alternative investment markets.

The most actively traded assets are securities, currencies, contracts, and commodities.
Securities generally include debt instruments, equities, and shares in pooled investment vehicles.
Securities may be classified as:

A. Type of assets:

1. Real Assets which are tangible/physical assets that are used as part of production of
goods and services e.g. PPE, real estate and commodities.
2. Financial assets which are intangible assets which are expected to provide future benefits
in the form of a claim to future cash. They include equity/debt instruments, currencies
and derivative contracts

B. Whether the securities are public or private securities.

1. Public securities trade in public markets (e.g. exchanges). Issuers of public securities
are normally required to comply with strict rules and regulatory standards.
2. Private securities can only be purchased by qualified investors and are normally
illiquid.

C. According to if they are debt or equity instruments:

1. Debt/fixed income instruments are promises to repay borrowed money. Payments
{which include interest and principal amounts} may be pre-specified or may vary
according to a fixed formula based on a reference rate. Examples include bonds,
commercial paper, and certificates of deposits, treasury bills and repos.
2. Equity instruments represent ownership rights in companies. They include ordinary
shares, preference shares and warrants. Pooled investment vehicles {such as mutual
funds/ETFs/hedge funds} shares which represent ownership in the assets held by
them are also considered as equities.
 Currencies are monies issued by national monetary authorities and primarily trade in the
foreign currency market. Retail currency trades occur through ATM machines. Credit/debit cards
when transactions are executed in currencies different from the currency held in customer’s
accounts. Some of the currencies are regarded as reserve currencies i.e. currencies that national
central banks and other monetary authorities hold in significant quantities e.g. USD and Euro.

Contracts are agreements between two or more parties to do something in the future. A
contract’s value depends on the value of its underlying, which may be a commodity, a security, an
index, an interest rate, or even another contract. Contracts may be settled in cash or may require
physical delivery, and may be classified on the basis of:
A. The nature of the underlying asset:
1. If the underlying asset is a physical asset, the contract is referred to as a physical
contract.
2. If the underlying asset is a financial asset, the contract is referred to as a financial
contract.

B. The timing of the delivery:

1. If the contract requires immediate delivery {3 days or less}, it is referred to as a
spot contract and trades in the spot market.
2. If the contract requires delivery to be made in the future, it may be a forward,
futures, swap or an options contract

A forward contract is an agreement between two parties, where one (the long position) has the
obligation to buy, and the other (the short position) has an obligation to sell an underlying asset
at a fixed price (established at the inception of the contract) at a future date. Forward contracts
are used to reduce pre-existing risk. The main challenges of forward contracts are 1)
counterparty risk which refers to the risk that the other party in the contract will fail to honor the
terms of the contract. 2) Liquidity risk since the forward contract cannot be traded without the
consent of the other party.

A futures contract is a standardized forward contract traded on an organized exchange which

act as clearinghouse that guarantees the performance of traders i.e. ensure no trader fails to
honor the contract.

A swap contract is an agreement between 2 parties to exchange a series of cash flows, which
depend on future asset prices or interest rates, at periodic settlement dates over a certain period
of time. The main uses of swaps include 1) reduce borrowing and transaction costs. 2) Overcome
currency exchange barriers. 3) Manage exposure of underlying assets.

An option contract allows the holder (the purchaser) of the option to buy or sell, an underlying
instrument at a predetermined price, at or before a specified date in the future. Options that can
only be exercised at their expiration dates are known as European options, whilst options that
can be exercised anytime until or at their expiration dates are known as American options.

Commodities include precious metals, energy products, industrial metals and agricultural
products. Commodities may trade in the spot markets (for immediate delivery) or in the
forward/futures market (for delivery in the future). Investors can gain exposure to commodities
by purchasing (1) the physical commodity (2) Shares of natural resources/commodity related
companies (3) commodity derivatives

Financial assets have certain properties that determine or influence their attractiveness to
different classes of investors and issuers. The properties of financial assets include:
1. Moneyness – some financial assets are used as a medium of exchange or in settlement of
transactions {currencies}, whilst other assets, although not money, are very close to
money in that they can be transformed into money at a little cost, delay or risk. {Near
money e.g. treasury bills}. Moneyness is clearly a desirable property for investors
2. Divisibility and denomination – where divisibility relates to the minimum size in which a
financial asset can be liquidated and exchanged for money. The smaller the size, the more
the financial asset is divisible e.g. treasury bills are sold in denominations of KSH 100000.
3. Reversibility – refers to the cost of investing in a financial asset and then getting out of it
and back into cash again {also known as turnaround cost or round trip cost}. Investors
tend to purchase financial assets where the bid-ask spread is low.
4. Cash flow and return predictability – the return that an investor will realize by holding a
financial asset depends on all the cash distributions that the financial asset will pay its
owners e.g. dividends on shares or coupon payments on bonds. Investors are attracted to
financial assets that generate returns above the inflation rate. The returns predictability
of financial assets can also be used to determine their value. Generally the riskiness of an
asset can be equated with the uncertainty or unpredictability of its return.
5. Liquidity – which mostly implies how much sellers stand to lose if they wish to sell
immediately as against engaging in a costly and time-consuming search for buyers.
Financial assets that incur a small loss indicate high liquidity and are preferred by
investors.
6. Tax status – where different financial assets attract different taxes depending on the
issuer, length of time the asset is held and type of income generated.
7. Currency – due to the global integration of financial markets, financial assets can be
denominated in different currencies. Investors select these financial assets bearing in the
forex risk involved.
1.5 STRUCTURE OF FINANCIAL MARKETS.
PRIMARY MARKETS
These are markets in which companies and governments sell their securities to investors for
the first time. Companies may raise capital by borrowing money or by issuing equity.
Governments may raise funds by borrowing money. The main primary market transactions
include IPO’s, private placements and rights offerings

A private placement is a process where an investment bank identifies potential qualified

investors and distributes securities to them at a specified price. These qualified investors are
mostly institutional investors such as pension funds, insurance companies and mutual funds.
The main benefits of private placements include. Less regulatory oversight; lower cost of
regulatory compliance; cheap to investors due to the illiquidity of the securities.

SECONDARY MARKETS
Equity instruments are traded among investors in a secondary market in which no new capital is
raised and the issuer does not benefit directly from the sale. The secondary markets are divided
into 2: Organized stock exchanges and over the counter {OTC} markets.

Organized exchanges are central trading locations in which securities of companies are traded.
Securities that are traded on an exchange are said to be listed securities. To be listed, the issuer
of the security must apply for and satisfy requirements established by the exchange. The main
securities being shares, bonds and derivatives.

Some of the roles of organized exchanges include:

 Supervision of trading to ensure fairness and efficiency
 Authorization and regulation of market participants e.g. brokers and dealers
 Create an efficient price discovery environment for the securities
 Dissemination of information i.e. data vending and company announcements
 Organization of the settlement of transactions
 Regulation of the admission of companies to the exchange

Exchanges have usually been mutual organizations that are owned and operated on a non-
profit basis for the benefit of their members, those who operate on the trading floor. The
ownership by the members is reflected in the memberships or “seats”, which provide floor
access or trading privileges as well as ownership rights. As the profits derived from these
trading privileges increase, the prices of the seats increase and the value of the member’s
equity in the exchange increases. Eventually this leads to a conflict of interests between the
exchange members and their customers e.g. members refusing to adopt technological
innovations that can benefit their customers for fear of reduction in their trading income.
 Demutualization is a process where a company owned by its members converts into a public
equity based company owned by shareholders. The members are given shares or equity in
exchange for their seats and access privileges.

The drivers for many exchanges that have converted from membership organizations to
publicly owned equity-based demutualized organizations are:
 Access to capital for development of the exchange such as adoption of new
technology.
 Adoption of new corporate governance frameworks.
 Competition especially from technology based systems e.g. cross networks
 Globalization of capital markets

The benefits of demutualization include:

 A more flexible corporate governance structure by aligning the interests of the
customers of the exchange with those of the owners of the exchange.
 Access to wider sources of finance and efficient allocation of capital
 Introduction of a wider range of investment products and sources of revenue for the
exchange
 Ability to tap into foreign markets which can result to high inflows of foreign direct
investments.

The transformation of membership exchanges to publicly owned exchanges isn’t always

smooth, as sometimes challenges occur. Challenges of demutualization include:
 Abuse of its position as both a market participant and a market regulator to its own
advantage
 Lack of support from some of the members in the demutualization process
 Lack of a regulatory framework for securities exchanges listed
 Political uncertainties and economic policies affect performance of the securities
exchange.
 Regulation policies can be sacrificed for the sake of short term maximizing of
shareholders profits.

OTC market is a market where geographically dispersed traders/dealers are linked to one
another through a telecommunication system, and mainly trade in “unlisted securities”. The OTC
market can also be used as a springboard for listing to the main exchange market. Some of the
features of such markets include:
 No membership requirements
 No listing requirements for companies
 Less information disclosure requirements
 Low liquidity due to minimal trading of securities
Some of the functions of the secondary market include:
 Help in assessing the fair value of financial instrument
 Reduces the transaction costs involved in trading financial instruments
 Investors benefit from the liquidity of the markets

A continuous market is a market that determines the prices of the equity instruments
continuously throughout the day. It ensures liquidity of the market throughout the trading
session

A call auction market is a market where orders are batched or grouped together for a
simultaneous execution at the same price at certain times during the day. Such markets aim at
defining an auction price that maximizes the trading volume.

Secondary markets are characterized based on their trading procedures:

1. Quote Driven/Dealers Markets/Price Driven markets – a market which allows dealers to
adjust their quotes continuously to reflect supply and demand. Investors trade with dealers
only. They are also known OTC markets since the trading takes place on the dealers’ office
counter e.g. bond markets and forex markets. Depending on the instrument traded, the
dealers work for commercial banks, for investment books, for broker-dealers, or for
proprietary trading houses.
2. Order Driven Markets – a market which allows buyers and sellers to submit their orders
through a broker who matches the buy orders with the sell orders. They can either be call
or continuous markets. Such markets can be found in exchanges and alternative trading
venues, which have settlement systems to ensure the trades are settled e.g. stock
exchange and futures exchange. An order matching system is run by an exchange, a broker,
or an alternative trading system which uses rules to arrange trades based on the orders the
trader submit.
3. Brokered Markets – is a market which brokers arrange trades among their clients. These
markets involve brokers who deal in assets that are unique e.g. Block securities and real
estate.

Some of the challenges being faced by Nairobi Securities exchange {NSE} are:
 Political instability due to frequent cases of insecurity and a high political risk.
 Lengthy listing procedures due to strict eligibility listing requirements.
 Illiquidity of some securities leading to lack of competitiveness.
 Winding up of some brokerage firms and restructuring of listed firms affecting
investors’ confidence.
 Insider trading is yet to be fully eliminated.
 Lack of depth in the market in terms of products offered e.g. derivatives and asset
securitizations.
1.6 AUTOMATION OF SECURITY EXCHANGES
Automated Trading System {ATS} is a system of trading where trades are executed online. It
allows traders to establish and program specific rules for both trade entries and exits that are
automatically executed via a computer. Almost every automated trading system is an order-
driven system. Order-driven matching systems are characterized by two sets of rules:
1. Order matching rules which match buy orders to sell orders. They rank buy and sell orders
based on 1) Price precedence where the highest priced buy orders and lowest priced sell
orders are ranked first. 2) Display precedence where displayed quantities have precedence
over undisplayed quantities at the same price. 3) Time precedence where orders that
arrived first have precedence over orders that arrived later with the same price and with
the same display status.
2. Trading pricing rules determine the prices at which matched trades take place. Prices may
be determined based on the any of the following: 1) a uniform pricing rule where the
same price is used for all trades. This rule is used by call markets where the market
chooses the price that maximizes total quantity traded. 2) A discriminatory pricing rule
where the limit price of the order or quote that arrived first determines the trade price.
Continuous trading markets use this rule. 3) A derivative pricing rule which uses the
midpoint of the best bid and ask quotes from another market. Crossing networks use this
pricing rule.

The advantages of ATS

- Reduce cost of transactions for investors who trade significant volumes by eliminating
financial intermediaries.
- Greater liquidity i.e. companies trade with each other despite their locations which brings
more buyers and sellers in the market.
- Greater competition which is achieved by removal of barriers in the industry which results
to globalization.
- Increased transparency i.e. it is easier to find price of securities when information is
flowing electronically.
- Tighter spreads i.e. due to increased liquidity, transparency and competition spreads are
tightened.

Some of the limitations of ATS

- Difficult to audit trading transactions
- There’s a spectre of unethical trading practices from some market participants
- Unauthorized trading in clients shares
- Not all systems are transparent on their trading transactions
The most common ATS systems include crossing networks and darkpools

Crossing networks are electronic trading venues that don’t display quotes but anonymously
match large orders at a single price {mostly the price prevailing in security’s secondary market}.
The systems allow institutional investors to cross trades {match buyers and sellers} directly via a
computer. Some of the pros for such networks include; provide anonymity and minimize both
trading and impact costs. The cons are execution rates tend to be low and there is risk of trading
at poor prices

Darkpools are private crossing networks in which participants {mostly institutional investors}
submit orders to cross trades at externally specified prices and, thus provide anonymous sources
of liquidity (hence the name “dark”). No quotes are involved, just orders at the externally
determined price and, thus, there is no price discovery. Some of the pros for darkpools include,
can be used in block trading to minimize impact costs; offer favorable bid-ask prices for
institutional traders; prevent information leakage {anonymous trading} and volume discovery. Its
main limitations is lack of transparency which hinders investors from accessing the demand and
supply of a security, and no price discovery.

1.7 CENTRAL DEPOSITORY SYSTEM

A depository refers to a custodian {Banks/brokerage firms} that holds securities on behalf of the
clients. To prevent loss of securities, most of the securities are issued in electronic form.

Dematerialization – refers to the process of converting paper share certificates into electronic
form which ensures all the securities held by a depository are in electronic form.

Immobilization – refers to the process whereby physical share certificates are deposited with a
central depository with a view to having them eventually entered into electronic form ready for
trading.

The benefits of dematerialization or CDS accounts

 Immediate transfer of securities which saves time on the transfer process.
 Avoid loss or mutilation of share certificates including the risk of theft.
 All securities {stocks/bonds} are held in a single account.
 Avoid duplication of securities.
 Minimizes investor disputes and arbitration costs

The main stakeholders of the central depository system include

Capital Markets Investor Compensation Fund Custodian Banks
Stockbrokers Nairobi Securities Exchange CMA
1.8 INTERNATIONALIZATION OF FINANCIAL MARKETS

Like most industries, the investment industry is not static. It is constantly changing to meet new
needs and to react to events and evolution in financial markets. Globalization has led to
integration of financial markets throughout the world to form international financial markets.
Internationalization is a general term used to describe the substantial increase in the presence of
banks and other financial institutions doing business outside their domestic markets. The
following factors have contributed to the internationalization of financial markets:

1. Competition. Competition in the investment industry is fierce and manifests itself through
innovative investment product and service offerings, pricing, and performance. Also global
competition has forced governments to deregulate/liberalize various aspects of their financial
markets so that their enterprises can compete effectively around the world

2. Technology. Technology, and computerization in particular, has dramatically decreased trade

processing costs and increased trade processing capacity. It has also spurred the development
and analysis of innovative types of investment products and vehicles.

3. Globalization. Investors look outside their domestic markets to diversify their investments and
generate higher returns. These foreign investments contribute to economic development and to
the overall profits of the investment industry.

4. Regulation. Globally, there is a trend toward greater regulation of the financial services
industry, including the investment industry. International co- operation among financial
regulators has played and should continue to play an important role in raising global standards of
securities regulation.
 2. MARKETING FINANCIAL SERVICES
Marketing is an approach to business which focuses on improving business performance by
satisfying customer needs. While in general terms, marketing processes and activities are
relevant to all organizations, it should be noted that services in general and financial services in
particular are rather different from any other physical goods. Therefore the kind of marketing
applied by General Motors Kenya would not work for CIC unit trust fund. Financial services broadly
covers a whole range of banking services, insurance, stock trading, asset management, credit
cards, forex and trade finance, just to mention a few. The art of marketing is to try to understand
the challenges that financial services present and try to identify creative and sensible approaches
which overcome the challenges.

2.1 CHALLENGES OF MARKETING FINANCIAL SERVICES

The challenges facing marketing financial services:
 Lack of consumer trust on the financial services being marketed.
 Lack of consumer awareness and financial literacy on the available services
 Unexciting financial products which make it difficult to attract and retain consumers
 Limited differentiation i.e. most financial services are all alike e.g. Mshwari & KCB mpesa
 Geographic dispersion of financial institutions is limited, hence a limited reach to clients
 Rapid changing consumer tastes and state of current economic environment
 Regulations which put restrictions on the contents of financial services advertisements

2.2 CONSUMER DECISION PROCESS

The consumer decision process in financial services involves the following steps:
1. Need recognition, in which the consumer recognizes that there is a discrepancy between
what is ideal and what is experienced. Financial services advertisements that focus on the
need recognition step attempt to create a sense of discrepancy between ideals and the
consumer’s actual experienced state. This can be accomplished by raising perceptions of
what is considered ideal. For example, the ideal level of insurance coverage can be raised by
informing consumers in an ad of the amount of financial protection needed in order to
recover from economic losses resulting from an accident or mishap. Reminding consumers
of the unfavorable state of their existing insurance coverage can also highlight discrepancies
between ideal and actual states. For example, a company selling term life insurance policies
might present an advertisement that portrays the head of a household who has the
responsibility of a mortgage and must also overlook the future of two dependent children
but has no life insurance coverage to financially protect them. By doing so, the advertiser
has created a sense of insecurity in the viewer by highlighting “what is” as opposed to “what
should be,” causing the viewer to recognize the necessity of having life insurance coverage.
Similarly, a company selling supplemental health insurance might focus the advertisement
on informing viewers of the financial needs that arise in case they are unable to work due to
 medical conditions or accidents. Supplemental health insurance policies often cover portions
of expenses such as lost wages, healthcare bills not covered by insurers, and other related
expenses that traditional insurance policies do not cover. However, consumers’ lack of
knowledge of this fact and the unique benefits of supplemental policies may be used as a
primary focus of an advertisement in order to help them recognize their need for such
coverage.

2. Information search. In this phase, consumers who have recognized their need for a particular
financial service begin to gather relevant information about various competitors in the
marketplace. A financial services advertisement targeted to consumers in this phase would
need to focus on creating memorable messages that consumers would be able to recall in
subsequent phases of the decision process. Brand names that are memorable, advertising
content that is unique, and ad messages that have a long-lasting impact on the consumer’s
mind would characterize successful advertising in this phase of the decision process.

3. Pre-purchase evaluation is the next phase in the consumer decision process. It consists of an
elaborate process in which consumers evaluate the various alternatives available to them in
the marketplace and, based on the attributes that the alternatives possess, form a judgment
as to which one represents the best option. Financial services advertising that focuses on
this phase of the decision process would attempt to create uniquely beneficial perceptions
of the product or service being advertised. Attributes that market research would have
established to be the most relevant in the consumer’s mind would typically be used as a
basis for differentiation. For example, an investment firm might highlight the individualized
nature of the advice and support that it provides to its clients because it has empirically
established this to be of primary importance to many of its investors.

4. Purchase, consumption, and post purchase evaluation. To tap into the purchase and
consumption phases of the decision process, advertising content could focus on creating
trials for financial services such as insurance and warranty products. For example, a direct
mail campaign could promote a three-month trial of an automobile roadside assistance
insurance policy that would facilitate consumer consumption of the service. Following this
trial period, a certain percentage of consumers who have found the peace of mind
associated with having the service available to them would subsequently subscribe to the
policy. In addition, the content of an advertisement might highlight the post-purchase
impact of consumer decisions in a financial services context. The content may for example,
include testimonials from customers who have had a good experience with the claims
service of an insurance company, report customer satisfaction ratings, or highlight the many
benefits available to clients of a particular financial services provider.

It is important to recognize that each of the steps in the decision process would be most relevant
to specific types of financial services. If the average consumer generally does not recognize that
he may need a particular type of financial service, advertising focused on the need recognition
phase of the decision process would be required. On the other hand, if consumers are generally
aware of their needs but do not know which competitors offer particular benefits, an advertising
focus on information search and pre-purchase evaluations is needed. In such cases, advertising
content should help differentiate one’s offerings from those of competitors. It is also important
to recognize that most financial services advertisements focus on the first three steps of the
consumer decision process, during which initial preferences are formed.

The domain of retail financial services can be classified into the following categories:
a) Savings products which involve accumulation of large sums from small
contributions e.g. savings bank accounts, pension schemes, Sacco’s and mutual
funds.
b) Investing products that involve the deployment of lump sum amounts for the
purpose of capital growth or income generation e.g. corporate/government
bonds or investment in equity shares or mutual funds.
c) Credit products which involve borrowing of funds for immediate consumption
from future earnings e.g. credit cards, overdrafts and mortgages.
d) Insurance products which provide consumers with financial protection against
risks resulting from various life events e.g. life assurance and general policies,
annuities.
e) Financial advisory and brokerage services

2.3 PRICING FINANCIAL SERVICES

Pricing is one of the most important decisions in the marketing of financial services. Price
represents the sole source of revenue for a financial services organization, which can be used to
cover the firms’ expenditures. Price also communicates to the market the identity, market
positioning and intentions of a financial service organization. Price can also be used as a signal of
quality to customers. The following methods are used in pricing financial services:
a) Cost-based pricing – where the price is set in such a manner that the costs of providing a
financial service are covered and a particular level of profit secured by applying a mark up
to the unit cost of service. Higher mark ups generate higher levels of profits most of the
time due to the high levels of risk involved in providing the financial service. Lower mark
ups are meant to generate a large volume of transactions and indicate low risks
associated with the provision of the service.
b) Parity pricing – where the price is set according to what competitors are charging. In this
case the price set can be below or above the competing prices. It requires establishing a
primary competitor or a market leader, the applying a multiplier factor to the competitor’s
price. It reduces price wars.
c) Value based pricing – where the price is set based on what the customers perceive to be
the value of a financial service. Value parameters such as brand name, geographical
dispersion and customer service relations are quantified then added to the final price to
 be charged. This approach ensures that a financial service is broken into its sub-
components and all valuable features of the service are accounted for in the final price.
d) Regulation based pricing – the price is determined by the forces of legislation and
regulation that govern particular categories of financial services. Such kind of pricing
ensures that the prices charged to consumers are equitable and all segments of
population have access to financial products.

Challenges in Pricing Financial Services

Financial services prices are unique in several ways and some of these unique aspects are listed
below:

a. Financial services prices are often multi-dimensional: one of the most notable
characteristics of financial services prices is that they are complex and often consist of
multiple numeric attributes, which the consumer is likely to find stressful and avoid
carrying out demanding arithmetic. For example a mortgage metrics will include interest
payments, the down payment required, penalties and number of payments.

b. Elusive Measures of Quality: the pricing of financial services is the elusive and intangible
nature of the quality of a financial service. Objective levels of service quality as
determined for example by the likelihood that a mutual fund will have good returns, the
transaction processing accuracy and efficiency of a commercial bank are difficult to
assess. The fact that these measures of quality are difficult if not impossible to quantify
often forces consumers to examine other pieces of information, in particular price, as an
indicator of service quality. Therefore, while a high price may discourage some
consumers from purchasing a financial service. It may also serve as a positive signal for
others and may increase their desire to use the service.

c. Economic Forces: the attractiveness of a financial service may be affected by the general
economic environment. For example, in order to appreciate the value of an investment
option a consumer must compare the expected rate of return with the rates of return
experienced in the financial markets. As a result, financial services providers need to take
relevant economic indicators such as interest rates and stock market returns into account
when setting prices for specific prices for specific financial products and services.

d. Poor Consumer Price Knowledge: the pricing of financial services needs to take into
account the fact that consumer memory for financial services prices is quite weak. The
unexciting and complicated nature of financial services often results in poor recall of the
prices of financial services. For example, many consumers have a difficult time
remembering the cost of their banking services, such as the monthly maintenance fees
for current account services and ATM transaction charges etc. As a result, the general
 level of price knowledge with which consumers interact with financial services providers
might be quite limited.

e. Difficulty in Determining Customer Profitability: the profitability associated with a given

customer may be difficult to assess. This is because a single customer may purchase
multiple services from a financial services provider, some of which are highly profitable
and others present losses. For example, a bank customer might use the bank’s current
and savings account services, which may not be highly profitable to the bank. However,
she may also conduct her investment and retirement planning, which are typically higher
margin services, at the same bank. Therefore, while certain transactions will be loss
making, high profit making services should compensate for this shortfall making the
individual a highly valuable customer to the bank overall.

f. Indeterminable Costs: determining the costs associated with a specific financial product or
service might be a numerically challenging task given the fact that various elements of a
financial services organization contribute to the service experience that is delivered to the
customer. The limited liability to pinpoint costs accurately therefore complicates the task
of pricing a financial service.

g. Conflicts of Interest: the pricing of financial services is further complicated by the

significant conflicts of interest that may exist in the selling process. For example, brokers
may recommend only products that generate the highest margins or commissions.
Therefore, the link between price and the incentive mechanism used to compensate the
broker might influence the types of products that the broker would be to recommend
products with a price structure that provides her with the higher commission earnings.
This further complicates the pricing decision by introducing issues of trust and ethics to
the already complex price setting process.

2.4 ADVERTISING FINANCIAL SERVICES

Advertising is a fundamental part of most successful marketing strategies in both
financial and non-financial services. It is the primary mechanism by which marketers create
awareness among consumers about their products and services. However it has a special role in
the marketing of financial services since financial services are generally intangible. The intangible
nature of financial services stems from the fact that they cannot touched, tested, felt or
visualized. As a result, consumers’ perceptions of quality are often based on the image
associated with the company. This places the burden of informing consumers about the
beneficial aspects of a financial service on the shoulders of the advertiser. As a result, the
financial services advertisers have to educate consumers on the unique and beneficial features of
their services. Financial services advertising facilitates differentiation of a company from its
leading competitors.
 Advertising in financial services can be formally defined as marketing communications carried
out through the mass media or through direct marketing means, with the intention of motivating
the purchase of specific financial products or encouraging particular forms of financial behavior.
Broadcast media such as television and radio, as well as print media such as newspapers and
magazines are often used to execute advertising campaigns for financial services. In addition a
growing trend in financial services marketing involves using direct advertising methods such as
direct mail and direct e-mail to elicit consumer responses.

Unique Aspects of Advertising in Financial Services

Several factors differentiate the advertising process in financial services from advertising in other
contexts or markets.

Vague Product/Service Attributes: One of the challenges in advertising financial services is that
consumers may not be fully aware of the various dimensions that constitute a financial service.
Consumers’ limited knowledge and education about the choices facing them in the marketplace
can result in inefficient and uncompetitive market conditions. Advertising may facilitate
consumer education and can help consumers understand the unique benefits of a financial
service.

Quality is intangible One of the challenges facing financial services advertisers is the fact that
the quality of financial services is rarely quantifiable. This may be true for consumers who have
already used a financial service as it is, and for those who are considering using it for the first
time. For example, the claims payout behavior of a car insurance company is generally unknown
to the majority of the company’s customers. This is because, insurance companies operate
through the sharing of risks across a large number of customers, and as a result most policy
holders do not experience losses. It is the rare few that do who may have an accurate
assessment of the payout behavior of the insurance company. It is the task of the financial
services advertiser to create an understanding and appreciation for the underlying qualities of an
advertised financial offer. In the case of a mutual fund for example, revealing the qualifications
of the fund manager or the past performance of the fund may help convey the sense of quality
that consumers may expect. Without advertising, these aspects of quality would be largely
unknown to the masses.

Unexciting Products: financial services transactions typically are not carried out on a frequent
basis and generally do not create a great deal of excitement and interest for most individuals.
For example, consumer involvement with the benefits of an insurance policy, the rates of return
on an investment product or the current account services provided by a commercial bank rarely
cause a great deal of excitement and enthusiasm. In addition, the quantitative and contractual
nature of financial services requires considerable cognitive effort and mathematical processing
before consumers can fully appreciate the merits of an advertised offer. This makes the process
of advertising financial services more difficult since the audience will generally be uninvolved in
absorbing and appreciating the presented information. The high level of complexity associated
with financial services makes evoking positive emotional responses more challenging than it
would be for consumer goods such as cars, clothing or electronics.

Limited Ability to Visually Communicate Financial Products: one of the unique challenges in
advertising financial products is the fact that they may not always be communicated to
consumers in ways similar to how consumer goods are advertised. For example, a car
manufacturer may feature pictures of a care in a magazine or footage of the car’s handling
abilities in a TV advertisement. Visualization increases the sensory input of the consumer and
creates a sensation similar to the consumption of the product. This increases the cognitive and
emotional impact that advertising generates in the consumer. Contrast this with a situation in
which one attempts to advertise an insurance policy or an investment product. The challenge to
the advertiser is to determine how to present and communicate visually such abstract and
intangible products. The challenges in visual communication of financial services often require
experienced, attentive and creative development of ad content in order to excite the viewer about
the useful aspects of the financial service.

Regulations: the practice of financial services advertising is further complicated by the

massive number of regulations that restrict the contents of financial services advertisements and
the number of regulatory agencies that closely monitor and influence ad content. One of the
primary objectives of regulations in financial services markets is to ensure that marketers do not
present consumers with misleading information. The advertiser’s creative process may become
restricted due to these regulations and often requires the involvement of compliance specialists
to oversee the content of a financial services advertisement. Such restrictions and regulations
are far less present in advertising other forms of services and goods making the task of financial
service advertising a highly unique specialization.

Success Factors in Financial Services Advertising

Several factors influence successful advertising in financial services. In assessing the quality
of an advertising of an advertising campaign, one may use the factors outlined below as a
checklist to diagnose potential areas for improvement.

a. Having a Unique Selling Proposition: A fundamental requirement for advertising financial

services is to possess a unique selling proposition. A unique selling proposition reflects
the one attribute that a financial services provider must possess that makes it uniquely
superior to its competitors. Not possessing a unique selling proposition implies that there
is no basis for differentiation between one’s offering and other choices that the consumer
might have.

b. Target Marketing: successful financial services advertising requires that the financial
services being promoted are relevant to the targeted groups of consumers. While this is
 true of all advertising, it is especially true in financial services marketing since consumer
needs in financial services significantly vary from one consumer to the next. A mismatch
between the financial service being advertised and the target audience could result in a
complete loss of advertising effectiveness. For example, selling mortgages to college
students most of whom may not yet be thinking of owning homes, promoting high-end
investment products to low income families etc.

c. Creating memorable ads: successful advertising often requires the completion of all
phases of the communication process – exposure, attention and processing. However the
creation of a memorable advertising message is critical to generating long term impact.
Memorable ads might be recalled years after the consumer has been exposed to them,
with subsequent effects on sales. This can be achieved through creative execution of
advertising, use of humor or emotions and a carefully planned schedule of media
exposures. Use of memorable brand names, celebrities and creative jingles can help
improve consumers’ recall of the ad.

d. Facilitating Consumer Action: the fact that financial services are often individually
customized to specific consumer needs and typically require one on one contact in order
to be sold means that advertisers should facilitate the process for consumers to contact
the financial services provider. This may require the inclusion of toll free telephone
numbers, web site addresses, instructions on how to obtain additional information etc. All
advertisements that do not provide this information may not be very effective, especially
for financial services providers that have a low market share and lack a well-recognized
brand name or large scale presence in the retail environment.

e. Co-ordinated use of media: a successful advertising strategy used in a variety of markets

is referred to as coordinated media campaigns. This involves the simultaneous use of
various media to display ads with similar messages. For example, a TV ad featuring the
celebrity might be combined with a direct mail ad featuring the celebrity on the outside of
the promotional envelopes. Targeting consumers through various forms of media but
with the same message significantly improves the impact of the advertising campaign.

f. Use of Direct Marketing: financial services advertising in developed markets has recently
become more reliant on the use of direct marketing techniques , reflected in an array of
activities such as direct mail, direct email and telemarketing. These forms of advertising
are uniquely capable of initiating personal communications between the financial services
provider and potential or existing customers.
 Steps in Advertising Financial Services
Several steps are essential for successful execution of advertising campaigns in financial
services as follows:

1. Identification of Advertising Objectives

The first step is to determine the objectives of the advertising campaign, reflecting the
overall marketing strategy of the company. For example, the objective on advertising
campaign might be to generate new policies for an insurance product or to increase the
level of consumer awareness of the brand or the company. Recognizing or identifying the
exact objective of an ad campaign is critical to accurate assessment of its merits and
potential.

2. Budget Determination
The next step in the advertising process is to determine the budget required to carry out
the ad campaign. Often, the required budget is significantly different from what is
available and may be dictated by the organizational budgetary constraints.

3. The Return on Investment

The next step is to establish the return on investment associated with the advertising
campaign. Clearly negative return on investment would imply no further action on the
campaign.

4. Developing the Contents of the Ad

The next step in the advertising process is to develop the contents of the ad. In this step,
the services of advertising agencies that specialize in producing financial services ads are
required.

5. Media Selection, Scheduling and Campaign Execution

The next step is to determine the media that will be used. In general, financial services
that are more complex and require the communication of detailed information tend to
rely on print forms of advertising. Television advertising, which capitalizes on multiple
sensory inputs, tends to be the most effective although often the most expensive. Once
the media to be used for an ad campaign has been determined by the ad agency, a media
schedule needs to be developed in order to achieve the original objectives of the ad
campaign which had been identified in the first step. This task is often carried out by the
advertising agency that has been hired to carry out the campaign.

6. Measurement
The final step is to assess the impact of the ad campaign through formal market research
or examination of company records. It is critical to measure and record sales levels and
other advertising responses following an ad campaign in order to determine the financial
 effects of the invested advertising dollars. Such measures may help fine-tune the
advertising strategy of the company and provide estimates for optimizing future
advertising campaigns.

2.5 DISTRIBUTION OF FINANCIAL SERVICES

Distribution in financial services marketing is concerned with how the service is delivered to a
consumer, making sure that it is available in a location and at a time that is convenient for the
customer, at the right price. Therefore a delivery channel to be effective, it will require the right
product to be facilitated to the right people, at the right place and time.
The channels of distribution are divided into 2:
1. Direct distribution which is concerned with the provision of goods/services from
manufacturer/provider to customer in the absence of an intermediary who is under
separate ownership, control or management. All the steps involved in acquiring a
customer and selling a product are done by the product/service provider.
Advantages of direct distribution include:
 Control of brand value and corporate reputation
 Control of customer experience and interaction
 Control of regulatory obligations
 Clarity and consistency of internal communication with a customer

Disadvantages of direct distribution include:

 Limits distribution coverage of financial services
 Limits market share which results to restricted sales volumes
 Requires considerable amount of capital e.g. branch networks

2. Indirect distribution which involves the use of agents of one form or another that are
owned by third party organizations.
Advantages of indirect distribution
 Provider can focus on core competencies
 Allow rapid penetration to both local & international markets
 Increase in sales volume due to access to a wide market
 Avoidance of set up costs associated with new delivery channels
 Ability to focus on product quality and costs

Disadvantages
 High regulatory risks
 Loss of control over brand value, customer experience and reputation
 Long term distribution contracts can limit strategic options
 Can result to undue reliance on dominant distributors
 The distribution channels used for financial services are diverse, most common channels
are:
i. Specialist financial services branch networks e.g. bank/saccos offices
ii. Non-financial services retailers e.g. supermarkets point of sale or credit cards
iii. Face to face sales channels e.g. financial advisors, direct sales reps or insurance agents
iv. Telephone selling via outbound and inbound call centers and direct mail
v. The internet e.g. online banking or mobile app banking
vi. Direct response advertising including newspapers, magazines, radio and TV.

Technology is having a revolutionary impact on the distribution of financial services and this
technology manifests itself in various forms. While the internet is likely to be the most
revolutionary influence in the near future, phone and ATM technologies are also likely to have a
profound impact. Some of the advantages of technology driven delivery channels include:
1. Provides customer access of services anywhere and anytime
2. Lowers administration costs
3. Encourages diversity and choice through easy entry by new providers
4. Lessens demands placed on branch networks and face to face sellers
5. Better customer relations and interactions

Some of the weaknesses of technology delivery channels will include:

1. Security risks and online frauds
2. Non user friendly websites can cause customer dissatisfaction
3. Not suited for complex products or services that require face to face interaction
4. Can result to financial exclusion especially for customers who don’t have access to
internet

2.6 NEW PRODUCT INTRODUCTION IN FINANCIAL SERVICES MARKETS

A new product can be defined as a genuine innovation, a modified product, improving on
efficiency & effectiveness or adding new features. The new product introduction process is a
fascinating aspect of financial services marketing. A new product can be introduced at a
considerably quicker pace in financial services markets than in most other markets. This is
largely attributed to the fact that the introduction of new financial products and services does not
necessarily require the development of entirely new physical objects or the deployment of
elaborate and technologically sophisticated product development procedures. Extensive levels
of research may not necessarily be needed for financial services due to the comparatively lower
costs of product introductions and the limited technological nature of financial services. The rate
of innovation in financial services has been further accelerated in recent years as a result of the
deregulation of the financial services sector and the introduction of new electronic technologies
for the processing of financial transactions. The result has been the emergence of innovative
financial products and services that are highly relevant to the unique needs of individual
customers.
 New products are introduced to the market because they can significantly improve the
consumer’s experience or help serve unique consumer needs that are not satisfied by existing
products and services on the market. This is often achieved in one of two different ways. The
first is the introduction or modification of existing product attributes or the merger of the existing
products in the market place. For example a debit card is a result of the merger of the credit card
and the personal current account. Similar to using cheques, using a debit card results in the
withdrawal of funds from one’s bank account.

Methods for Identifying New Product Needs

A variety of techniques are used to identify new financial product opportunities.

a) Observational Methods
A common approach to identifying new product opportunities in financial services is to utilize
what the existing employees may already feel to be needs of the customers. For example,
managers of a commercial bank branch may have noticed long customer lines forming in the
bank teller area inside the bank branch. Further discussion with the bank tellers and a study of
the transactions that take place may reveal that a significant proportion of the customers who
come to the branch do with the purpose of depositing cheques and cash. This may help the
management conclude that the flow of traffic in the customer service area may be improved by
introducing an instant deposit machine whereby customers can directly deposit their cash or
cheques and not have to wait in long lines to see a teller. These are like ATM like devices that
only facilitate the depositing of funds and unlike ATMs do not dispense cash.
New product opportunities may be identified through observation of other modes of in which a
financial services organization interacts with its customers. For example, a surveillance video of
a bank branch may be able to reveal that long lines are accumulating at either the bank teller
area or the ATM area of the bank. This may prompt the management to examine the cause for
the accumulation of the long lines, thereby identifying the transactions that may be accelerated
either through the introduction of new services or the modification of existing ones.
While the observation method for identifying new financial services is frequently utilized, there
are several drawbacks to this approach. One drawback is that this approach may be highly biased
by what becomes available at the time or the location where the observations are being made.
For example, the location of a bank branch may result in a series of observations that are most
relevant and specific to customers who work or live in the vicinity of that specific branch. As a
result, the views and opinions of customers are made, and the wider spectrum of consumer
opinions and the full range of potential new product opportunities may not be captured through
this approach.

b) Open –Ended Questioning

A second approach that is frequently used in identifying new product opportunities is what is
often referred to as qualitative or open ended questioning. This approach advances the
observation method discussed above by facilitating direct communication with customers of a
financial services organization. Often, this approach requires conversing with a representative
sample of customers through means such as intercept interviews in a bank branch, where
customers are stopped and asked to respond to a series of general questions or reached through
telephone interviews. This technique requires one to utilize an open format of questioning to
probe the specific needs that customers might have and to identify new services of potential
interest to them. The primary consideration in this method is not to restrict the scope of
customer responses, but rather to allow customers to express their opinions and thoughts freely.
In an interview, the customer might be asked an open ended question such as: “what factors
prevent you from using the instant deposit machine in the bank branch?” Responses obtained
from a sample of customers on the above question can then be studied, categorized into various
types of answers, and then tabulated in order to identify what the majority of customers believe
is restricting them from using this service. The open ended questioning approach is a relatively
quick method for obtaining objective evidence on the nature of consumer response to a new
financial service as well as to an existing service that may be experiencing difficulty gaining
acceptance in the market place. Typically the required sample size associated with this method is
anywhere between 50 to 300 respondents.

c) Focus Groups
Focus groups further advance one’s ability to conduct open ended questioning by engaging
groups of customers rather than an individual customer. The fundamental idea behind a focus
group is very similar to that of open ended questioning with the distinct difference of the use of a
group of customers gathered in a common location rather than individual existing customers-
typically about 10 – are invited to a focus group facility. Focus groups utilize a trained market
researcher as a moderator who presents the participants in the focus group session with a series
of general questions aimed at soliciting their opinions. The flow of the discussion is then
managed by the moderator. The focus group participants’ thoughts are recorded through both
video and audio recording of the session, for subsequent analysis. Often focus group results are
provided in written format to the client, and these results may then help identify new product
opportunities or provide the necessary insights into how to improve the marketing of a newly
introduced financial service.

d) Attribute Ratings
A more technical approach for identifying new product and service opportunities is achieved by
asking customers to rate the importance of various attributes for an existing financial service on
numeric rating scales. The customer may be asked for example to rate the various aspects of a
commercial bank on a scale of 1 to 5 (with 5 being ‘very important “and 1 being “not important at
all”. The customers’ ratings of the attributes may then provide insights into what weaknesses a
particular financial service might have or what potential opportunities might exist for the
introduction of new services. In analyzing attribute rating data, two approaches are often used.
One approach is to examine the service attributes by computing the average rating associated
with that particular attribute. While this approach is relatively simple, it presents the numeric
challenge of establishing whether differences in averages across the various attributes truly
exist. This problem stems from the fact that the average attribute ratings for various service
attributes are often in close proximity to one another, and identifying significant differences
across the averages can become a difficult statistical task requiring large sample sizes.

e) Conjoint Analysis
Conjoint analysis is a technique that is used to determine how consumers form their overall
impressions of a new service or product based on its attributes. Through the use of this
technique, one is able to explain how the consumers value each individual service attribute and
predict how these attribute values are combined to form an overall judgment of an existing
service, as well as new services not yet introduced to the market place. This process can then
help identify promising new services for market introduction. For example, consider credit card
offers, which vary in term of their interest rates, annual fees as well as their refund and benefits
programs. In designing a new credit offer, a credit card company would need to evaluate how
each of these different attributes are evaluated by the consumer and the extent to which each
helps improve or deplete consumer opinions. Conjoint analysis enables one to address these
questions in a numeric and scientific manner. In conjoint analysis, one provides a consumer with
an array of hypothetical service offerings and asks for the consumer’s general perceptions of
each offer using a rating scale, such as a like-dislike numeric response scale. The service
characteristics are varied through changes in the attributes described to the consumer, and the
resulting changes in consumer ratings are then measured. By doing this, one is able to quantify
the effects that a given attribute has on consumer preferences for the service. One would also be
able to estimate the extent to which variations in any attribute influence consumer perceptions of
the service. This enables the identification of service characteristics that are likely to result in the
most favorable consumer responses.

The Process of Developing a new product

1. Justification for the product/ concept -tell us why we need a new product. Possible
reasons could be competitive pressure, or current product are declining or they are no
longer profitable or are now expensive to maintain.

2. Idea generation - brainstorming meeting/seminar, internally e.g. customers telling you

how they want to be served or externally {engage consultants} where ideas can arise
inside or outside the org. They can result from formal search procedures e.g. market
research or informally they may involve their org. in creating the means of delivery the
new service product they may involve the org in obtaining rights to the service products
like a franchise.

3. Screening of Ideas - it is mainly concerned with checking out which ideas will justify the
time, expense & managerial commitment of further research & study. A company should
do a cost benefit analysis {chose the highest benefit with the lowest cost}. Feasibility
 studies. Check ideas with possibility of performance with the available resources i.e. the
human resources, finance, IT. Come up with an idea selection criteria

4. Concept Development and testing - ideas surviving the screening process then have to be
translated into product concepts. In the service product this means concept development
& testing. Concept Development – it is concerned with translating the service product idea
where the possible service product is defined in functional and objective terms into a service
product concept, meaning the company tries to build into the product idea. Concept testing
involves taking the concepts developed after the stages of ideas generation & idea
screening and getting reactions from groups of target customers.

5. Product development –there is need for coordination and organization it requires the
translation of the idea into an actual service product for the market. Typically this means
that there will be an increase in investment in the project. Staff may have to be recruited
or trained, facilities may have to be constructed, and communication systems may need
to be established. The tangible elements of the service product will be designed and
tested. Unlike goods the development involve attention to both the tangible elements the
service product and service product delivery system.

6. Testing - testing of new service product may not always be possible. A bank may make a
new service available initially on a regional basis e.g. ATMs. Product launch must be done
on piecemeal basis then commercialization. Some new products do not have such an
opportunity. There is a need to be very tactical.

7. Commercialization - this stage represents the firms’ commitment to a full scale launch of
the new service/product. In undertaking the launch Kotler suggest 4 basic decision apply:
when to introduce the new service product; where to launch the new service product
whether local, regional or national; to whom to launch the new service product and how
to launch the new service product.

Benefits of New Product Development

 Repositioning or rejuvenating of existing products.
 It’s likely to result in companies producing products that fulfill the current need in the
market.
 It minimizes the chances of product failure.
 It enables companies to identify key selling points i.e. what enables them to
outcompete others.
 It removes unnecessary duplication.
Developing a Marketing Plan
The development of formal marketing plans is vital to the long-term health of a financial services
organization and the steps that are involved in developing a marketing plan for a financial
services organization are as follows;
1. Understanding the Market Environment - the first step in the market planning process is
for the marketing managers to obtain an accurate understanding of the environment in
which the business operates. It is critical to recognize emerging trends that have affected
the business in the past and those that will influence its future. This analysis requires one
to examine the demographics of potential and existing customers, to understand
emerging technologies that may influence the process of selling and servicing financial
products and services and to recognize the economic forces that can affect the business.
It also important to gain an appreciation for the potential impact of regulations on the
business and to understand trends that may influence the attractiveness of the
company’s offerings to customers. Furthermore, a study of the competitive spectrum
and actions and capabilities of competitors in the marketplace is essential.

2. Opportunity Identification - once the environment of the financial services organization

has been closely examined, the management must be able to identify opportunities for
improvement and growth. In this step, both the potential opportunities in the market
place, as well as potential threats that may limit the company’s growth need to be
assessed, and the strengths and weaknesses of the company, when contending with
these forces need to be explicitly identified. The objective of this phase is to ensure that
the strengths of the business match the opportunities upon which it will capitalize.

3. Setting Goals - In this step, the management should begin to set specific goals for the
planning horizon. These goals should reflect the company’s capabilities as well as the
customers’ needs and requirements for the offered services. The number of goals
identified should be limited to avoid a loss of focus and the inability to prioritize marketing
activities. It is important that while goals are set at high levels, they reflect realistic and
achievable objectives so that the organization as a whole can place faith on the contents
of the marketing plan and the overall mission it will guide. Typically, the goals are set for
time horizons ranging from six months to three years.

4. Specifying an Overall Strategy - once the goals have been identified it is critical to specify
the overall strategy that would help achieve them. The strategy should be based on the
various capabilities of the business that would have been identified in step 2. For
example the strategy could be based on competitive pricing, though which price
reductions result in higher levels of new customer acquisitions. The strategy can also
focus on image-building advertising campaigns, cost reduction measures, or the use of
referral based marketing programs to capitalize on networks of customers. The
 marketing strategy could also incorporate partnerships with other organizations that may
improve the competitive position of the company.

5. Determining the Expected Financial Results of the Company - The next step in the market
planning process is to quantify the results that may be expected as a result of
implementing the plan. In this phase, the effects of on three vital signs of business
performance need to be quantified: profits, return on investment and revenues.

6. Specifying Actions and Timing - The final step in the market planning process is to
explicitly outline and detail the activities that will take place throughout the planning
period. In doing so, it is important to develop a chronological order to specify when the
various aspects of marketing a financial service will be carried out.

Financial service providers and agents, aim at achieving customer retention and loyalty by
using the following strategies:
- Offer only proven and high quality products or services
- Demonstration of customer appreciation and quick service delivery
- Provide responsive and proactive customer services
- Share customer testimonials with existing/potential customers
- Educate customers about the industry
 3. FINANCIAL MARKETS
There are various types of financial markets, depending on the financial instruments being
traded. They include money markets, bond markets, equity markets, derivatives markets,
mortgage markets and the foreign exchange market.

3.1 MONEY MARKETS

A money market is a market for trading short term debt securities with a maturity of less than
1 year. The purpose of money markets is to facilitate movement of short term funds from units
with excess/surplus funds to those market participants who lack funds for their short term
needs. Financial institutions purchase money market securities in order to earn a return while
maintaining adequate liquidity while other financial institutions issue money market securities
when experiencing a temporary shortage of cash.

The money market helps businesses to adjust their liquidity position by borrowing, lending or
investing for short periods of time.

Characteristics of money market instruments include:

-Short term in nature -Low default risk of instruments involved -High liquidity
-Involve large denominations (wholesale market) that minimize transaction costs

Some of the benefits of an efficient money market include:

 Improves liquidity management for market participants
 Provides a good alternative to long term borrowing through cheaper costs of short term
funding.
 Helps in development of both primary, secondary and forex markets
 Can be used by central bank to implement monetary controls
 Provides access to a wide range of market participants for government securities thus
allowing better pricing.

Due to the size of transactions involved in money markets only financial institutions are the main
participants .The market participants can either be classified into borrowers {Government,
Corporate companies, commercial and investment banks} and investors/lenders {Insurance
companies, pension funds, mutual funds and treasury departments of large companies}. Just to
discuss a few:
A. Money Markets Mutual Funds – use the proceeds from shares/units sold to invest in treasury
bills, commercial paper, certificates of deposits and Repos.
 B. Insurance Companies – need to maintain a portion of their investment portfolio in money
market securities for liquidity purposes and paying claims.

C. Pension Funds – also need to maintain part of their investment portfolio for liquidity
purposes or for liquidation and taking positions in securities.

D. Commercial Banks – purchase treasury bills and Repos to maintain liquidity and also
borrow/lend funds in the inter-bank market.

The money market instruments are made up of:

1. Discount instruments – Debt securities issued/sold at a discount and redeemed at their par
value on maturity e.g. Treasury bills, commercial paper and banker’s acceptance.

2. Add on instruments – Debt securities sold at par value but redeemed at par value plus
interest on maturity e.g. Certificates of Deposits, Repos.

3.1.1 TREASURY BILLS

A short term negotiable debt security issued and fully backed by the government. Some of the
characteristics of T-bills include:
- They are free from default/credit risk since they are backed by the government
- They are highly liquid due to their short maturity period and active secondary market
- They don’t pay interest instead trade at a discount.

For an investor to bid for the T-bills they must set up an account with the treasury. The treasury
will always have a specified amount of funds it plans to borrow which dictates the amount of T
Bills bids it will accept for that maturity. Investors can submit competitive bids {an order for a
given quantity of bills at a specified offered price} or Non Competitive bids {an order to purchase
bills at an average price of successful competitive bids}. The Treasury ranks bids on a descending
order and accept bids in that order until the entire issue is absorbed by both the competitive and
non-competitive bids. Competitive bidders face 2 risks: - Bid too high and overpay for the bill OR
bid too low and be shut out of the auction.

Treasury bills can be sold in a variety of ways to investors, and these techniques include:

1. A public issue, where the central bank offers stock at a fixed price and hopes investors will
purchase sufficient stock that there is little unsold stock left over.
2. A tender issue, where the central bank sets a minimum tender price and then invites bids
at or above this minimum price. Financial institutions and investors bid for the stock, and
on the basis of these bids the minimum price at which the issue can be sold is calculated.
Those that have a bid above the calculated price are entitled to a full allocation and the
 remainder of the issue is distributed on a pro rata basis to those bidding at the relevant
price.
3. An auction issue, where the central bank invites bids and sets no minimum price. The
issue is then sold to those that bid the highest price at the price at which they bid until all
the stock is sold. This is the most common technique of selling T Bills since the
government can be sure of selling all the stock and revenue may be enhanced by selling
the stock at different prices.
4. A direct placement, where the central bank negotiates directly with financial institutions
{investment banks} to sell stock at an agreed price. The financial institutions then
distribute the stock to clients and other investors.
5. Additional tranches of existing issues, in which the central bank offers additional tranches
of stock that are already actively traded.

Bid to cover ratio is the ratio of the amount that was actually bid and the amount of T Bills
offered; if the number is greater than 1 it shows that there were more bids than the amount on
offer {oversubscription}. Where an under subscription occurs, it is a sign of lack of confidence in
the government’s financial situation and/or indigestion in a market faced with an exceptionally
high volume of government borrowing.

The Treasury bill discount represents the percentage discount of the purchase price from face
value for newly issued bills.

T BILL DISCOUNT = (FACE/PAR VALUE – PURCHASE PRICE) × 360

FACE VALUE n

N = Number of days of the Investment holding period e.g. 90 days, 182 days or 360 days

The Treasury bill yield represents the difference between the selling price and purchase price. If
the bill is held to maturity the yield should be the difference between purchase price and face
value.

T BILL YIELD = (SELLING PRICE – PURCHASE PRICE) × 365

PURCHASE PRICE n

N = Number of days the T Bill is held by the investor.

QUESTION
Calculate both the bond equivalent yield and discount basis yield for a 6 month T. Bill issued at
Kshs 9500 with a face value of KShs 10,000.

Solution:
 Discount basis yield = 10,000 – 9,500 × 360
10,000 182

= 9.89%

Bond Equivalent yield = 10,000 – 9,500 × 360

9,500 182

= 10.41%

NB: The T Bill yield will always be higher than the T Bill discount if the Treasury bill is held to
maturity. This is because the yield is earned on the purchase/discounted price and not on the face
value.

3.1.2 COMMERCIAL PAPER

It is a short term unsecured debt instrument issued only by well-known creditworthy firms to
borrow money at rates lower than the bank rates. It is normally issued to provide liquidity or to
finance a company’s investment in inventory and trade receivables [working capital
requirements]. Money Market Funds are the major investors of commercial papers. Commercial
paper is classified as either direct paper or dealer paper. Direct paper is sold by issuing firm
directly to investors without using a securities dealer as an intermediary. For a dealer-placed
commercial paper, is where the issuer uses the services of a securities firm/investment bank to
sell its paper. The secondary market for commercial papers is limited and therefore most are
held to maturity. Most commercial papers are issued with maturities of 270 days or less. In most
cases the issuers are required to maintain with a bank lines of credit in case they are unable to
pay off the maturing commercial paper. In more developed capital markets, commercial papers
can be used as a medium-term source of finance by rolling over issues i.e. as one issue matures,
another one is launched.

Commercial paper does not pay interest and is priced at a discount from par value, and therefore
at any point in time the yield in commercial papers is slightly higher than that of T Bills due to the
credit risk carried by the commercial paper and the liquidity risk due to lack of a secondary
market. The nominal return to investors who retain the paper until maturity is the difference
between the price paid for the paper and the par value. Thus commercial paper yield can be
determined using the formula for T Bill yield.

When a firm plans to issue a commercial paper, the cost of borrowing the funds is uncertain until
the paper is issued. When calculating the cost of borrowing, the firm will need to adjust for the
transaction costs {charged by CP dealers} by deducting them from the proceeds received.
 Example
If an investor purchases a 30-day commercial paper with a par value of Kshs 1,000,000 for a
price of 995,000. Calculate the CP bond equivalent yield and discount basis yield if the investor
holds the paper until maturity.

Solution
CP yield = Par Value – Purchase Price
Purchase Price

= 1,000,000 – 995,000 × 360

995,000 30
= 6.03%

CP Discount yield = 1,000,000 – 995,000 × 360

1,000,000 30

= 6%

3.1.3 CERTIFICATES OF DEPOSITS

A certificate of deposit is a certificate issued by a bank that indicates that a specified sum of
money has been deposited at the issuing depository institution. CDs are issued by banks for short
term financing of their business operations, and the primary purchasers of CDs are corporate
treasurers interested in maximizing the return of their firms excess funds while maintain the
liquidity and safety of their principal. A CD bears a maturity date and a specified interest rate, and
it can be issued in any denomination. A CD may be non-negotiable or negotiable. In the former
case, the initial depositor/investor must wait until the maturity of the CD to obtain the funds. Any
withdrawals before the maturity date attract early withdrawal penalties. In contrast, a negotiable
CD allows the initial depositor (or any subsequent owner of the CD) to sell the CD in the open
market prior to maturity date. A negotiable CD is also called a bearer instrument {that means
whoever holds the instrument at maturity receives the principal and interest}
The rate of returns generated by CDs depend on three factors: (1) the credit rating of the
issuing bank, (2) the maturity of the CD, and (3) the supply and demand for CDs.

Negotiable CDs are add-on instruments, with interest paid over and above the principal
amount using a 360 day year. Negotiable CDs must offer a slightly higher yield above the T-Bill
yield with the same maturity in order to compensate for less liquidity and safety.

Example
An investor purchased a negotiable CD a year ago in the secondary market for 990,000. The
investor redeems it upon maturity and receives Kshs 1,000,000. The investor also receives
interest of Kshs 40,000. Calculate the annualized yield on the investment.
 Solution
Negotiable CD Yield = (1,000,000+40,000) – 990,000
990,000
= 5.05%

3.1.4 BANKERS ACCEPTANCE

These are trade-related negotiable bills issued by companies but accepted or guaranteed by
banks in return for a fee. By accepting a banker’s acceptance, the bank unconditionally promises
to pay the holder/bearer the face amount of the bill at maturity, even if the bank encounters
difficulty collecting from the issuer. The act of the bank substituting its creditworthiness for that
of the issuer makes banker’s acceptances to be marketable instruments that can be freely traded
in the secondary market.

Most banker’s acceptances arise in international transactions between exporters and

importers of different countries. An exporter that is ending goods to an importer whose credit
rating is not known will often prefer that a bank act as a guarantor. Exporters can hold a banker’s
acceptance until the date at which payment is to be made, but they frequently sell the
acceptance before then at a discount to obtain cash immediately. The investor who purchases
the acceptance then receives the payment guaranteed by the bank in the future.

Banker’s acceptance are issued at a discount to face value, and since there is a possibility that
a bank will default on payment, investors are exposed to a small degree of credit risk, thus the
return for banker’s acceptance is likely to be slightly above the T-Bill yield.

3.1.5 REPURCHASE AGREEMENTS/REPOS

It is an arrangement where one party sells securities to another with an agreement to
repurchase them at a specified date and specified price. The buyer of the securities is effectively
the lender, while the seller of the securities is the borrower, who is using the securities as
collateral for a secured cash loan at a fixed rate of interest. In other words it is a loan backed by
securities e.g. T bills/T. Bonds. Many central banks use repos and reverse repos in government
securities as part of their open market operations.

There are three types of repo maturities: Overnight repos {where the securities are sold for one
day and bought back the next day}, Term repos {bought back after more than a day} and Open
repos {which don’t have a specific end date}.

In repos, the repurchase price is always greater than the original sale price, which is in fact, is
the interest on the loan, which when annualized and expressed as a percentage of sales price, is
known as the repo rate. The repo rate will always be lower than the interbank rate, since it
involves a collateralized borrowing. There is no one repo rate i.e. rates vary from transaction to
transaction depending on the following factors:
a. Quality of the collateral – The higher the credit quality and liquidity of the collateral, the
lower the repo rate.
b. Term of the repo – The effect of the term of the repo on the rate depends on the shape of
the yield curve.
c. Delivery requirement – If delivery of the collateral to the lender is required, the repo rate
will be lower. If collateral can be deposited with a bank of the borrower, a higher repo rate
is charged.
d. Availability of collateral – The more difficult it is to obtain the collateral, the lower is the
repo rate.
e. Interbank rate – The higher the interbank rate, the higher the repo rate.

Question
Consider a firm that enters into a repo agreement to sell a 4% 12 year bond with a nominal
value of KSHS 1,000,000 and a market value of KSHS 970,000 for KSHS 940,000. The firm is
required to buyback the bond after 90 days at KSHS 947,050. Calculate the repo rate and the
Repo margin/Haircut

Solution
Repo rate = (947,050/940,000) – 1 = 0.75%
Annualized rate of return = 0.75% × 360/90 = 3%
Repo margin = (940,000/970,000) – 1 = -3.1%

NB: The repo margin protects the lender in the event the value of the security decreases over
the term of the repo agreement. The amount by which the market value exceeds the value of the
loan is called margin.

Functions of the repo market include:

 Provide an efficient source of money market funding
 Provide a secure home for liquid investments i.e. can’t be defaulted
 Facilitate central bank operations when implementing monetary policies
 Ensure liquidity is maintained in the secondary debt market.
 Provide faster settlement times which mitigates chances of bank runs or systemic risk.

One specific money market is the interbank market, which is the market in which banks lend to
each other. They do this because commercial banks are required to maintain reserves, with
central bank. This market therefore, allows banks with excess liquidity to lend funds to banks
with a shortage of funds, often overnight and usually on an unsecured basis. The interbank rate
is always determined by the supply and demand for the funds. The interbank rate is always
higher than the repo rate, because the lending is done on unsecured basis. The interbank rate
varies depending on the respectability and safety of the banks involved i.e. banks with lower
respectability and safety will have to pay more than the benchmark rates set by the safest
institutions.

3.2 BOND MARKETS

A bond is a contractual agreement between the issuer and the bondholders. The issuer of the
long term debt security {bond} is obligated to pay interest/coupon payments periodically {most
of the times semi-annually} and the par value/principal at maturity. Some of the basic features of
a bond include: issuer of the bond; the maturity of the bond; the par value of the bond; the
coupon rate offered on the bond and the payment frequency; the currency in which bond
payments will be made to investors.

The bond market aka the credit or fixed income market, is the financial market where
participating firms can issue new debt in the primary market, or buy/sell debt securities in the
secondary market in the form of bonds. They are used to assist in the transfer of funds from
individuals, corporations and government units with excess funds to companies and government
units in need of long term debt funding. The main participants in the bond markets include;
commercial banks, mutual funds, investment banks. Insurance companies and pension funds.
Bond markets generally deal in three types of securities: (1) Treasury bonds (2) municipal bonds,
and (3) corporate bonds.

3.2.1 TREASURY BOND

These are long term debt securities issued by the government agencies to finance national
debt and other government related expenditures. Treasury notes and bonds are always backed
by the full faith and credit of current standing government and are, therefore, default risk free
{the government can always print money to pay off the debt if necessary}. They tend to have low
interest rates because they have no default risk, which at times can even be lower than the rate
of inflation. The T-bond secondary market is highly liquid and often the latest T-bond offering is
used as a proxy for long-term interest rates. The main investors of T-bonds are pension funds
and institutional investors.

They are divided into;

a. Treasury notes – which have a maturity period of 1-10 years and are sold at full market
price
b. Treasury bonds – which have a maturity of 10 years or longer and are also sold at full
market price.

3.2.2 MUNICIPAL BONDS aka LOCAL AUTHORITY BONDS

These are debt securities issued by state, county and local governments either to fund
temporary imbalances between operating expenditures and receipts or to finance long-term
capital outlays for activities such as school construction, public utility construction, or
transportation systems. Tax receipts or revenues generated from a project are the source of
repayment on municipal bonds.
Basic municipal bonds consist of:
a. General obligation bonds where the principal and the interest payment on such bonds is
supported by the municipal government ability to tax. They don’t have specific assets
pledged as security or a specific source of revenue allocated for repayment.
b. Revenue bonds where payments on such bonds are generated from the revenues/cash
flows of the projects the bond issue is financing. They are sold to finance a specific
revenue-generating project.

The yield offered by a municipal bond differs from the yield on Treasury bond with the same
maturity for three reasons:
1. A municipal bond must pay a risk premium to compensate for the possibility of default
risk
2. Lack of active market for municipal bonds results to liquidity risk and therefore a liquidity
risk premium is factored in the yield.
3. Since the income from municipal bonds is tax exempt they offer lower yields.

3.2.3 CORPORATE BONDS

Corporate bonds are long term securities issued by corporations that promise the
bondholder coupon/interest payments on a semi-annual basis. They are issued to finance capital
investments of companies. Corporate bonds can differ based on several characteristics such as
bond structures, coupon rates, maturity dates and credit quality. Some of the types of corporate
bonds include:
- Debentures/loan notes
- Convertible bonds
- Junk bonds
- Fixed rate bonds
- Floating rate bonds

A bond indenture is a contractual agreement between the issuer and the bondholder which
specifies the rights and obligations of the bond issuer and the bond holders.

To raise capital, companies always sell new bonds in the primary bond market. The new bonds
may be issued through (1) Public offering where any member of the public may purchase the
bonds. (2) Private placement where only a select group of qualified investors {large institutional
investors} are allowed to invest in the issue.

Corporate bonds have a default risk and their yield will always contain a risk premium to reflect
the credit risk. The credit risk is reduced if there are any provisions that call for periodic
retirement {sinking fund} of some of the principal amount outstanding during the term of the
loan.
A bullet bond is one that only makes periodic interest payments, with the entire principal
amount paid back at maturity.
An amortizing bond is one that makes periodic interest and principal payments over the term
of the bond.
A balloon payment bond is one that makes a large final payment at the end of maturity period
of the bond to retire it.

Challenges facing Kenya bond markets include:

 High and unstable interest regime.
 Lack of appropriate regulation to protect investors from insider dealing and fraud
 Lack of financial innovation {e.g. asset backed securities} to attract more investors
 Liquidity risk due to lack of an active secondary bond market
 The market is vulnerable to external shocks from international economic environment.
 Lack of proper institutional structures which can help issuers with the process of
structuring and issuing bonds.

Some of the factors that affect bond prices include:

a. Level of inflation – where a high inflation is compensated by increase in interest rates,
hence higher return on bonds.
b. Economic growth – where increase in economic growth, tends to generate upward
pressure on interest rates, which reduces prices of the existing bonds.
c. Budget deficit – a wide a government deficit is likely to force the government increase its
borrowings. This can result to investors bidding interest rates up to lend the government.
d. Credit risk premium – which depends on the credit rating/worthiness of the issuer. An
issuer with a poor credit risk will offer bonds with a higher interest rate to investors, which
results to low bond prices.

Due to the expansion of international financial markets, investment banks have actively been
involved in the sale of foreign bonds by governments and corporations in the international bond
markets.

International bond markets are those markets that trade bonds that are underwritten by
international syndicate, offer bonds to investors in different countries, issue bonds outside the
jurisdiction of any single country, and offer bonds in unregistered form.

International bonds can be classified into three main groups: Eurobonds, foreign bonds, and
sovereign bonds.
 Eurobonds are long-term bonds issued and sold outside the country of the currency in which
they are dominated e.g. Kenya government issuing dollar-denominated bonds in America or
Europe. Some of the advantages of issuing Eurobonds are: No withholding tax on coupon
payments; Access to a wide pool investors rather than be restricted in the domestic market; Less
regulatory requirements; Prestige associated with issuing bonds in the international bond
market; Access to cheap funds/low interest rates. Some of the disadvantages include: Exchange
rate risk which can result to excessive payments; Issue costs can be high; Reputational risk as
international investors scrutinize the issuer.

Foreign bonds are long-term bonds issued by firms and governments outside of the issuer’s
home country and are usually denominated in the currency in which they are issued rather than
their own domestic currency e.g. A Kenyan company issuing a rand-denominated public bond
rather than shilling-denominated bond in South Africa. A domestic bond is a bond issued in a
domestic market by a domestic issuer e.g. a Kenyan company issuing bonds to Kenyan investors

Sovereign bonds are government-issued debt. They are always backed by the “full faith and
credit” of the national government. Sovereign bonds issued in local currency are usually
considered safer than those issued in foreign currency, as governments have the power to raise
taxes and print local currency to repay local-currency denominated loans.

3.2.4 STRUCTURED NOTES

These are debt securities linked to a derivatives position, so as to debt instruments with
more interesting risk-return features than those offered in the corporate bond market e.g. a debt
security can have a floating rate over its life, which allows the coupon to be reset based on a
benchmark interest rate, equity index or individual stock price, a forex rate or a commodity index.
Examples of structured notes include inverse floating rate notes and step up notes. Structured
notes are used to gain exposure to alternative asset classes, allow investor to participate
indirectly in markets they are restricted, and to enhance the yield of an investor.

3.2.5 EXCHANGE TRADED NOTES

These are debt instruments in which the issuer promises to pay a return based on the
performance of a specific fixed-income index after deducting specified fees. They don’t have
periodic coupon payments and principal repayments. The return to the investors depends on the
performance of the underlying index.

Bond investment strategies

Portfolio managers of financial institutions follow a specific strategy for investing in bonds.
Diversification is a principal strategy in bond investment. Bond portfolio investment strategies
can be classified into passive, active, matched funding, contingent and structured strategies.
Passive strategies consist of:
 a. Buy and hold strategy which involves buying and holding bonds with the desired
levels of credit quality, coupon rate, term to maturity and indenture provisions.
b. Laddered strategy which involves buying bonds with different maturities e.g. 1, 3
or 5 years. The principal amount of a laddered portfolio is repaid at regular
defined intervals. This strategy is used to manage interest rate risk e.g. where
interest rates are rising, the maturing principal can be invested at higher rates.
c. Barbell strategy where investments are made in bonds with short-term maturity
and long-term maturity. This strategy is meant to provide liquidity and higher
returns. The long-term bonds are meant to provide high coupon rates, while the
short-term bonds provide liquidity.
d. Indexing strategy which involves holding a bond portfolio that replicates a selected
fixed-income index.

For active strategies, the fixed-income manager will form a portfolio of bonds that will attempt
to produce superior risk-adjusted returns compared to a benchmark index. The strategies rely on
uncertain forecasts of future interest rates. They include:
a. Substitution swap which is a type of bond swap whereby an investor exchanges one bond
with a lower yield for another with a higher yield, yet the two bonds have the same
financial characteristics.
b. Inter-market spread swap also a type of bond swap whereby an investor moves out of
one market segment and into another because the investor believes that segment is
significantly underpriced relative to the other. The investor is speculating the spread
between 2 different bond markets e.g. Eurobond and domestic market.
c. Pure yield swap refers a bond swap whereby an investor exchanges one bond for another
to obtain a higher yield over the long term, with little attention paid to the near-term
outlook for the bonds’ respective market segments or for the markets as a whole. It
involves buying bonds with higher yield at maturity, and selling bonds with lower yield at
maturity.

In matching strategies, portfolio managers create a bond portfolio that will generate periodic
income that can match the periodic expenses. In this case a portfolio of bonds are selected that
will provide a stream of payments from cash flows, such as coupons and principal repayments,
that will exactly match specified liability schedules.

Contingent strategies allow bond managers to realize higher returns through active strategies
while focusing on bond immunization techniques to ensure a minimal return over the investment
horizon. Immunization techniques are strategies that permit an investor to meet a promised
stream of cash outflows with a degree of certainty.
3.3 EQUITY MARKETS

It is a market where equity securities are traded. Equity markets facilitate the flow of funds
from individual or institutional investors to companies. An active equity market is always a major
source of capital for companies at the same time investor’s benefit from the growth of the
business through dividend payments. Equity markets facilitate equity investment into firms and
the transfer of equity investments between investors.

There are 2 types of equity securities i.e. ordinary shares and preference shares. In addition to
ordinary shares and preference shares there are other, more unusual, types of shares;
a. Non-voting shares or reduced voting shares mostly issued by family-controlled firms
which additional equity finance need but wish to avoid the diluting effects of an ordinary
share issue. These shares are often called ‘A’ shares or ‘B’ shares and usually get the
same dividends and the same share of assets in a liquidation as voting shares.
b. Golden shares are shares with extraordinary special powers e.g. the right to block a
takeover or to restrict the influence of minority shareholders. Such shares prevent
potential predators from buying shares and then using them to outvote the company’s
existing owners.
c. Deferred shares are ordinary shares that rank lower normal ordinary shares for an agreed
rate of dividend, so in a poor year the ordinary holders might get their payment while
deferred ordinary holders receive nothing e.g. Kenya Airways retail investors after the
restructuring.

The investors in equity markets they can be classified as individual or institutional. Some of the
institutional investors include:

A. Commercial banks – who issue shares to boost their capital base and manage trust funds
that usually contain stocks.

B. Equity mutual funds – who use the proceeds received from selling units to individual
investors to purchase shares.

C. Insurance companies – who issue shares to also boost their capital base and invest a large
proportion of their premiums in the stock market.

D. Investment banks – who place new issues of shares, offer advice to companies considering
acquiring the shares of other companies, execute buy and sell stock transactions for investors.
3.3.1 INITIAL PUBLIC OFFERINGS {IPO}

An IPO {aka unseasoned equity offering/Going public} is a public offering where shares of a
company are sold to the general public, on a listed securities exchange, for the first time. This
process allows a private company to transform into a public company.

Some advantages of IPO:

 Improved company transparency
 Easy access of finance through the equity or debt markets
 Provide an exit opportunity for the owners
 Provide a means of price discovery
 Tax incentives for newly listed companies

The disadvantages of IPO are:

 High issue costs i.e. marketing and underwriting fees
 High costs due to disclosure requirements
 Loss of control of the company due to wider dispersed ownership
 Increases the potential of a takeover bids.

The IPO process will generally consist of the following steps:

1. Appointment of an Investment bank to underwrite the offering
2. Registration of the offer document/prospectus to the securities exchange.
3. Marketing of the issue
4. Post issue activities

The traditional process of issuing new securities involves investment banks. The investment
banks serve the following purpose: Advice the issuer on terms and timing of the offering, buy the
securities from the issuer {underwriting} and distribute the securities to the public.

Underwriting refers to the process of an investment bank taking the risk of buying newly issued
securities from a company and reselling them to investors. There are basically 3 types of
underwriting agreements:

A. Firm commitment contracts – where the underwriting firm purchases the entire issue as a
block for a commission and agrees to pay the issuer the full value of the security on or before the
closing date of the issue, whether it is fully subscribed or not. The investment bank takes the risk
of any unsold shares.

B. Best effort contract – where the underwriter agrees to sell as much of the securities as he
can at an established price, but can return any unsold shares to the issuer without any financial
responsibility.
 C. Stand by contract – is where the underwriter agrees to purchase whatever shares remain
after it has sold all the shares it can to the public. This underwriting method guarantees the
issuing company will raise a certain amount of money. It is mostly used during rights offering.

The basic compensation received by the underwriter is known as the underwriter spread. It is
always the difference between the underwriters buying price and the reoffering price. This
underwriting commission is made up of:
 Management fee – for managing the issue
 Underwriting fee – for bearing the risk of underwriting
 Selling fee – compensation for distribution of shares
 Incentive fee – incentivize participating banks to perform {in a syndicate underwriting}

Green shoe option – refers to a situation where the underwriter is allowed to buy additional
shares at the offering price if the issue is oversubscribed.

Roadshow – refers to travelling of company managers to various cities and making large
presentations for large institutional investors so to win them over.

Flipping shares – refers to a situation where investors purchase a share at its IPO price and sell
the shares immediately they are listed which results to unusual high returns. Only possible if the
shares have huge demand. Intention of investor is to capitalize on initial return that occurs in IPO.

Syndicated offering – refers to a security offering conducted by several investment banks, who
help the lead underwriter build the book of orders

Most exchanges permit the following methods to price IPO’s

A. Book building – This is where the lead underwriter solicits indications of interest in the IPO
by institutional investors as to the number of shares that they demand at various possible
prices. The investors’ orders are sorted according to price, quantity and the seriousness of
their bids, then this data is used to establish a price for the issue and the allocation of the
shares.

B. Fixed price Offering – The company offers shares to the public by inviting subscriptions
from institutional and retail investors. Normally the shares offer price is fixed and made
known in advance. The demand for the securities is only known after the closure of the
issue. This method is also known as offer for sale.

C. Uniform price auction/Tender Mechanism – The underwriter conducts an auction in which

investors bid {above a minimum reserve price} for the shares. The offer price is then
 determined based on the submitted bids, probably the highest price accommodating the
sale of all shares. This method is also referred to offer for sale by tender. This method is
useful in situations where it is very difficult to value a company, for instance where there
is no comparable company already listed or where the level of demand may be difficult to
assess.
D. Introductions – These do not raise new money for the company. If the company’s shares
are already quoted on another stock exchange or there is a widespread of shareholders,
with more than 25% of the shares in public hands, the Exchange permits a company to be
‘introduced’ to the market. This is the cheapest method of flotation since there are no
underwriting costs and relatively small advertising expenditures.

E. Placement - In a placing, shares are offered to selected institutional investors {insurance

and pension funds} instead of the general public. The costs of this method are
considerably lower than those of an offer for sale.

IPO’s have received negative publicity because of several abuses. Some of the common abuses
include:
A. Spinning – occurs when the underwriter allocates shares from an IPO to corporate executives.
The underwriter expects the executives to remember the favor and award them any investment
banking business in the future.

B. Laddering - occurs when the underwriter requires investors to purchase additional shares in
the after-market in return for being assigned substantial quantities of IPO shares in the next IPO.
The intention is to bid up the shares above the offer price so as to build an upward price
movement.

C. Excessive commissions – some brokers charge excessive commissions when demand is high
for an IPO. Investors are always willing to pay the price because they believe they can recover the
cost on the first day of trading.

D. Distorted Financial Statements – Where financial statements are distorted it will result to
incorrect valuations of the offer price, and investors might end up paying too much if it later turns
out the earnings of the company were exaggerated.

The offer price is always influenced by the prevailing market and industry conditions. Most
underwriters tend to underprice the IPO’s in order to ensure its success. Some of the
explanations and theories for IPO underpricing include:

1. It is assumed that underwriters operate in an environment that lacks competition, which

provides them with some bargaining power, and offer shares at a discount, which
 minimizes their marketing efforts{cheap shares are easier to sell} and reduce their risks
{price support and reputation damage}.
2. Underpricing of an IPO is used to trigger massive demand for the shares. To prevent
investors from losing interest, the IPO is issued at a discount to attract or win over the first
investors. Their buying behavior initiates demand from other investors.
3. It is used as a signaling model for future secondary offerings. If an IPO is successful, it
improves the stakes for future offerings due to investors feel good after the IPO. The
underpricing establishes a good reputation and enhances future opportunities.
4. It is used as an implicit insurance model, whereby by underpricing the IPO, the underwriter
reduces the chance of lawsuits and reputation damage from investors if the new
investment declines below its offering price.
5. Due to information asymmetry, it is assumed the underwriter to have more information
about the demand for the shares than the firm going public, therefore by underpricing the
underwriter is rewarded for valuing and selling the company shares which strengthens their
reputation among investors.

NOTE: An undersubscribed IPO paints an unfavorable picture to the company’s future prospects
according to the public opinion on its future i.e. the company might find it difficult to raise capital
on subsequent offerings.

Cross listing refers to the listing of a company’s shares in a different securities exchange than
its primary/domestic securities exchange. The benefits of cross listing include:
 A broader diversification of its capital resources across international boundaries
 Minimize any chances of a takeover from domestic competitors due to global distribution
of the shareholders.
 Increased liquidity of the company’s securities
 Exposure to broader capital markets to exploit growth opportunities

Some of the barriers to cross listing include: increases disclosure requirements costs and
increased marketing costs due to managing investor relations.

Foreign investors face restrictions when investing on many emerging markets. These
restrictions can take many forms:
i. Foreign ownership can be limited to a maximum percentage of the equity capital of
companies listed on the foreign market.
ii. Free float is often small because the government is the primary owner of many
companies, which limits the free shares available to foreign or domestic private investing.
iii. Discriminatory taxes that are sometimes applied to foreign investors e.g. withholding tax
on dividends.
iv. Foreign currency restrictions can be applied, including repatriation of income or capital.
 Technological advancements have led to growth and integration of global capital markets.
When capital flows freely across borders, markets are said to be integrated. The ability to
exchange information quickly through electronic networks has helped both the investors
{diversify portfolio by investing in foreign companies}, and companies {easy to raise cheap capital
and expand shareholder base beyond local markets}. An increasing number of countries have
dropped foreign capital restrictions {which were meant to restrict foreign ownership of domestic
companies}, as a result, more and more countries are becoming increasingly open to foreign
investment. The main methods for investing in foreign equity securities include:
I. Direct investing which simply refers to buying and selling of equity securities directly in the
foreign markets.
II. Depository receipt which refers to a security that represents ownership in a foreign firm
and is traded in the markets of other countries in local market currencies.
III. Investing in international mutual funds that invest in several foreign countries excluding
home country.
IV. Purchase of international ETF’s that are made up of international stock indexes.

Despite the growing liberalization of many financial markets in most countries, there are still
potential challenges which limit foreign investment. These barriers include:
i. Political risk where some countries have high political risk which has negative impact on
the value of local investments. Also poor legal structures to protect investors in some
countries.
ii. Most markets are not efficient due to their small size which creates liquidity risk for
investors. Lack of information and poor disclosures from companies makes investors
avoid such companies.
iii. Transaction costs for international investments tend to be very high compared to those of
domestic investments e.g. brokerage commission, custodial fees and taxes
iv. Currency risk where unstable exchange rates result to high volatility in the values of
foreign investments {Can always hedged by derivatives}.
v. Different reporting standards.

3.3.2 SHARE OFFERING AND REPURCHASES

Even after an entity has gone public, it may issue more shares or repurchase some of the shares
that it previously issued.

A secondary share offering is a new share offering by a specific company whose share are
already listed in a stock exchange. It is also known as a seasoned equity offering which allows a
company to support their expansion. A company can either issue new shares at the existing
market price or issue shares to existing shareholders {Rights issue}.
A preemptive rights offering grants the existing shareholders the right to buy some portion of
the new shares which are always issued at a price below the market price. This allows the current
shareholders maintain their proportionate equity interest and avoid dilution.
 A share repurchase is a transaction in which a company buys back its own ordinary shares.
Insiders {Corporate Executives} believe that their firm’s share price is undervalued, and they use
the firm’s free cash flows to purchase a portion of its shares at the perceived low market price.
Companies use three methods to repurchase shares:

1. Buy in the open market – Once authorized by the Board of directors a company
repurchase a certain number of shares at the prevailing market price.

2. Buy a fixed number of shares at a fixed price – Achieved by making a tender offer to
repurchase a specific number of shares at a price that is usually at a premium to the
current market price.

3. Buy by direct negotiation – The company negotiates directly with a large shareholder to
buy back a block of shares usually at a premium to the market price.

Advantages of share repurchases

 Investors view a repurchase as a positive signal. Investors see repurchases as a
statement by management that their shares are undervalued.
 A repurchase gives shareholders a choice. They can sell or not sell. With a cash dividend,
shareholders must accept the payment and pay the taxes.
 A large block of share may be “overhanging” in the market, keeping the price of the share
down. A repurchase can remove this overhanging block of share.
 Large-scale changes in capital structure may be brought about with repurchases.
 A repurchase gives the firm flexibility. If a firm’s excess cash flows are thought to be only
temporary, management can make the distribution in the form of a share repurchase
rather than paying higher cash dividends that cannot be maintained.

Disadvantages of repurchases
 It may be difficult to fix a price which is beneficial to all involved, and therefore a
possibility the company might overpay on the repurchased stock.
 Capital gains tax is likely to be paid from whom the shares are purchased. In most
countries capital gains tax rates are high compared to dividend withholding tax.
 It increases gearing of the company due to the reduced equity.
 Repurchasing of shares may be viewed as a failure by the company to manage the funds
profitably for shareholders.
 Selling shareholders may not understand the implications of a repurchase.
 3.3.3 MARKET ORDERS
These are instructions that investors who want to trade in shares give to brokers and dealers.
The instructions contained in an order include; specification of the security to trade; quantity to be
transacted; exposure of the order; purchase or sale transaction.

Most orders will have additional instructions attached to them e.g. Execution instructions on
how to fill the order or Validity instructions which indicate when the order may be filled.

The prices at which investors are willing to buy shares are called bid prices and those at which
they are willing to sell are called ask/offer prices. Some traders who are willing to trade at various
prices may also indicate the quantities that they will trade at those prices. Those quantities are
known as bid sizes and ask sizes. The highest bid in the market is the best bid, and the lowest ask
in the market is the best offer. The difference between the best bid and best offer is market bid-
ask spread. The spread is influenced by the following factors:

1. Order costs – which include costs of processing orders, recording transactions and ordering
costs.
2. Inventory costs – which include the cost of maintaining an inventory of a particular share. It
represents the opportunity cost because funds can be used for other purpose.
3. Competition – If multiple dealers are actively trading in a particular share it will result to a
small spread.
4. Volume – Shares which are more liquid have a less chance of experiencing abrupt changes
in price. The liquidity of a share determines its spread.
5. Risk – A risky company will have a volatile share price which will result to a higher spread.

Market order is an order to buy or sell a certain quantity of a security at the best price available in
the market.

Limit order is an order to buy or sell a certain quantity of a share at a specified price or better. The
trade occurs when the specified price is available.

Stop loss order is an order the trader specifies a selling price below the current market price of a
share. If the price falls below the specified price the order becomes a market order immediately.

Stop buy order is an order where the trader specifies a purchase price that is above the current
market price.

Good till cancelled order is a limit order that remains in effect until it is executed or cancelled. The
trader decides when to cancel the order.

Day order is an order which must be executed day it is received or it expires if unfulfilled.
Hidden order is an order that is only exposed to the broker or exchange market that receive it and
cannot be seen by other traders until the order is filled.

In a market there are different types of traders with different motivations to trade. They include

Noise trader – a trader whose trades are not based on information or any meaningful financial
analysis.

Day trader/Stag – an investor who attempts to profit by making rapid trades in a day. The
trader must close out all trades before the market closes.

News trader – a trader who makes trading or investing decisions based on news
announcements and corporate actions. Sometimes known as an informed trader since they make
their buy/sell decision based on public information and analysis.

Scalper – An investor who holds a position for a very short period of time in an attempt to
benefit/profit from the bid-ask spread.

Swing trader – a trader who attempts to capture gains in a position within 1-4 days using
technical analysis to look for securities with short term price momentum. The trader is interested
on price trends and patterns.

There are 3 types of trading transaction costs:

 Explicit trading costs which are the direct costs of trading e.g. taxes and brokers
commission
 Implicit trading costs which are indirect costs of trading e.g. bid-ask spreads & price
impact costs
 Opportunity costs which involve missing trading opportunities due to limit orders.

3.3.4 TRADING POSITIONS

A position refers to the quantity of an asset/security that an individual/institution owns or
owes.
An investor is said to be long if they own an asset/security which value is likely to increase
when prices increase e.g. ownership of bonds, shares, currencies or commodities. Long positions
benefit from an appreciation of prices in the assets.
An investor is in a short position if they sell assets/securities that they don’t own. The shorting
process involves borrowing the security, selling the security, repurchasing the security in the
future and returning to the owner. Short positions benefit from decrease in asset/security prices
i.e. selling at high prices and repurchasing at lower prices.
 An investor can purchase securities either with cash or a combination of both cash and
borrowed funds {margin loan}. The funds are always lend by the broker who charges an interest
above T bills rate known as call money rate.

LEVERED POSITIONS
This involves purchasing securities at a margin by borrowing some of the purchase price. The
securities themselves act as collateral for the borrowed funds. The act of borrowing is known as
“to leverage” a position. Buying securities on a margin can greatly increase the potential
gains/losses for a given amount of equity in a position because the trader can buy more
securities on a margin than they could afford i.e. if the share price appreciates the investors
return is enhanced while if security prices decline the investors’ losses are magnified.
Traders who buy securities on margin are subject to minimum margin requirements

Initial margin requirement is the minimum fraction/percentage of the total purchase price that
an investor must pay as an equity share, while the remainder is borrowed from the broker.
Trader’s equity is that portion of the security price that the buyer must supply i.e. the amount of
cash that must be deposited as guarantee for the leveraged position. This requirement is set by
the security exchange and it ensures brokers don’ lend more than the specified percentage of the
market value of the shares. This helps in discouraging excessive speculation and ensures greater
stability in the markets. It is calculated as follows:

INITIAL MARGIN = (NUMBER OF SHARES × PRICE) – BORROWED AMOUNT

NUMBER OF SHARES × PRICE

INITIAL MARGIN = 1 / LEVERAGE RATIO

Leverage ratio is the ratio of the value of the position to the value of the equity investment in it.
The maximum leverage ratio for a position financed by a margin loan equals 1 divided by the
minimum margin requirement. The ration indicates how much more risky a leveraged position is
relative to an unleveraged position e.g. a share bought at an initial margin of 40% will have a
leverage ratio of 2.5, which implies if the share price was to increase/decrease by 10% the
investors’ return will increase/decrease by 25% {10%× 2.5}. Leverage enhances an investor’s
returns, but also magnifies losses.

Maintenance margin is the minimum amount that is required by the broker to maintain the
margin account and to protect against default. Simply put, the required proportion of equity
investment to the total value of the position meant to protect the broker from share price
declines. Participants whose margin balances drop below the required maintenance margin must
replenish their accounts. Always compare the actual margin {using current share price} with the
maintenance margin provided to know if a margin call is required
 A margin call is a notice to deposit additional cash or securities in a margin account. An investor
will receive a margin call from the broker {specifying the additional cash required} when the
investor’s actual margin falls below the minimum maintenance margin {which would happen if
share price fell}. Sometimes instead of the investor putting additional cash, they can opt to sell
some of the shares to reduce their leverage.

QUESTION
An investor buys 1000 shares of company ABC on a margin and holds the position for exactly 1
year during which the stock pays a dividend. Assuming interest on the margin loan is 5% and
dividend of 10cts/share are paid at the end of the year. The following information is provided:
The purchase price is KSHS 20/share, selling price KSHS 15/share, leverage ratio is 2.5 and
trading commission is 1% per share. Calculate the return on investment for the investor

Solution
Total purchase price {1000shares × 20} = 20000
Leverage ratio of 2.5 is equal to an initial margin of 40% {1/2.5}
Initial equity (cash) investment by investor = 40% × 20000 = 8000
Total equity investment including commission = 8000 + {1000×1%} = 8010
The amount borrowed from the broker is = 12000 {20000-8000}

The equity investment remaining after the sale is computed as follows:

Proceeds from sale {1000shares×15} = 15000
+ Dividends received {1000shares× 0.1} 100
- Repayment of borrowed funds/margin loan (12000)
- Interest paid {12000× 5%} (600)
- Trading commission paid {1000shares×1%} (10)
Remaining equity investment 2490

Return on investment = (2490 – 8010)/8010 = - 0.69 or - 69%

NB: The realized loss is greater than the 25% decrease in the share price primarily because of
leverage and interest paid on the borrowed funds. Ignoring dividends, commission and interest
paid the expected return on investment would have been – 62.5% {- 25% × 2.5}

QUESTION
An investor purchased 100 shares of XYZ Ltd at KSH 90 by borrowing funds at an initial margin
of 50%. The maintenance margin is set at 40%. Calculate at what price a margin call will be
made?
Solution
Total purchase price {100shares × 90} 9000
Equity investment was {9000 × 50%} 4500
 Borrowed funds {9000 – 4500} 4500
Call price = Borrowed funds / Number of shares (1 – maintenance margin)
= 4500/ {100 shares × (1 – 0.4)}
= KSH 75

Assume the share price falls to KSH 60, calculate the amount of cash that the investor will be
required to add to their margin account to maintain the levered position?
Solution
To reduce the amount of money borrowed, the investor will need to add an amount of cash
that will bring the maintenance margin back to 40%.
The actual margin using the current share price is = Current market value – Borrowed funds
Current market value
= (100shares× 60) – 4500
100shares ×60
= 25%
Therefore the investor needs to add 15% of current market value position to bring the
maintenance margin back to 40%. The investor should add KSH 900 {15% × 6000} in the margin
account. This will reduce the borrowed funds from KSH 4500 to KSH 3600

SHORT POSITIONS
Short selling involves borrowing securities which you don’t own and selling them at the
market price with expectation of profit from buying and returning the securities at a lower price in
the future i.e. “SELL HIGH, BUY LOW”. The short seller 1) simultaneously borrows and sells
securities through a broker. The proceeds from the short sale are held by the broker as collateral
for the borrowed securities and the short seller receives interest on the held proceeds. 2) The
seller must return the securities at the request of the lender or when the short sale is covered,
and 3) the short seller must pay any dividends to the lender of the securities as they are due, and
must deposit a margin as a guarantee of payment in case the share price appreciates and results
to losses.

Short interest is the total number of shares of a particular stock that have been sold by
investors but have not yet been covered. It is calculated by dividing the number of shorted shares
with total number of shares outstanding. If short interest increases it implies that most investors
believe the share is overvalued and it is likely to reduce in the future.

Short interest ratio is the number of shares shorted divided by the average daily trading
volume. It determines how many days it will take short sellers to cover their positions. The longer
the number of days, the longer it will take the investor to cover their position.

Short squeeze occurs when short sellers are unable to buy the stock to close out their
positions. This results in bidding up the share price as they frantically seek to buy the stock
before its price rises further. It occurs on stocks that have a small free float or are illiquid and not
publicly traded.

There are various factors that affect share prices:

a) Economic factors which relate to the economy performance of the country. They include
GDP growth, movement of interest rates and forex rates.
b) Market related factors such as investor’s sentiments and market anomalies
c) Firm specific factors e.g. changes in dividend policy, earnings surprises, acquisitions and
divestitures.

3.3.5 REGULATION OF SHARE TRADING

Regulation of share exchange markets is necessary to ensure that investors are treated fairly.
This discourages trading malpractices which might discourage investors from participating in the
market. The main forms of trading regulations include:

A. Circuit breakers/collars – these are restrictions on trading when share prices or share index
increase/fall beyond a specified threshold level {known as pre-defined tripwires}. The
intention is to stop trading of shares in response to the large decline in a single day of share
prices. It minimizes panic selling

B. Trading Halt – it is whereby the share exchange imposes a trading halt on a particular share
to allow participants more time to receive and absorb material information that affects the
share prices e.g. merger. It reduces price volatility. There are 2 types of trading halts:
1. Market halt – which involves stopping the trading of all listed securities during a trading
session. It can be caused by technical failure of the ATS.
2. Security halt – which involves temporary suspension of trading in particular security during
a trading session. It can be caused by unusual market movements in price/volume of the
security.

C. Capital Markets Authority – a government body bestowed with authority to monitor capital
markets by ensuring full disclosure of material information that could affect the value of
shares. It also oversees any cases of insider trading.

D. Taxes imposed on share transactions – achieved by charging capital gains tax to discourage
active trading of shares.

E. Front running – It is an illegal activity where a broker buys or sells shares in his/her own
name while taking advantage of advance knowledge of pending orders from his clients.

F. Churning is the excessive trading by a broker in a client’s account largely to generate

commissions, without regard to the client’s investment objectives or goals.
 3.4 MORTGAGE MARKETS
A mortgage loan, or simply mortgage, is a loan secured by the collateral of some specified real
estate property, which obliges the borrower to make a predetermined series of payments. The
mortgage gives the lender the right if the borrower defaults (i.e. fails to make the contracted
payments) to “foreclose” on the loan and seize the property in order to ensure that the debt is
paid off. The interest rate on the mortgage loan is called the mortgage rate/contract rate.

Most of the financial intermediaries that originate mortgages obtain their funding from
household deposits. They also obtain funds by selling some of the mortgages that they originate
directly to institutional investors in the secondary market. These funds are then used to finance
more purchases of homes and properties. The main participants in the mortgages include:
commercial banks, credit unions/saccos and mortgage companies.

When financial institutions use the following criteria when determining a borrower’s repayment
liability:
1. Level of equity invested by the borrower – the down payment represents the equity
invested by the borrower. The lower the level of equity invested, the higher the probability
that the borrower will default.
2. Borrower’s income level – borrowers who have a lower level of income relative to the
periodic loan payments are more likely to default on their mortgages.
3. Borrower’s credit history – borrowers with a history of credit problems are more likely to
default on their loans than those without credit problems.

Mortgages can be classified in various ways. Most common classification criteria is:
A. Prime versus Subprime mortgage where the mortgages can be classified according to
whether the borrower meets the traditional lending standards. A prime mortgage is a
mortgage given to a borrower who meets the traditional lending standards, whilst
subprime mortgage is a mortgage offered to borrowers who do not qualify for prime
loans because they relatively have a low income or high existing debt, or can make only a
small down payment.
B. Insured versus conventional mortgage where the mortgages are classified as government
insured or conventional. An insured mortgage that are guaranteed by the government,
thereby protecting it against the possibility of default by the borrower whilst a
conventional mortgage is guaranteed by private insurance firms so that the lending
financial institution is able to avoid exposure to credit risk {the insurance premium is
passed to the borrower}.

Various types of residential mortgages are available to homeowners, including the following:
 Fixed-rate mortgages
 Adjustable-rate mortgages
 Graduated-payment mortgages
  Growing-equity mortgages
 Second mortgages
 Shared-appreciation mortgages
 Balloon-payment mortgages.

Challenges facing the mortgages market in Kenya include:

 Affordability due to low levels of disposable income
 Lack of a long term funding mechanism.
 Lack of understanding and awareness of mortgage product by consumers
 High interest rates regime which make mortgages perceived to be expensive
 Lack of housing supply to match with consumer demand
 Lack of clear regulations and laws relating to property registration

Investing in mortgages exposes a financial institution to default risk and prepayment risk.
Instead a financial institution can engage in pooling and repackaging of loans/mortgages into
securities in a process known as securitization. Basically several small mortgages loans are
packaged together and sold in the form of shares {known as mortgage backed securities}. The
interest and principal payments from the mortgages are then passed to investors who purchased
the shares.

The benefits of securitization are:

 Makes illiquid assets become tradable
 Creates an alternative investment asset class for investor’s portfolio
 Used as a risk sharing and risk management tool
 Frees capital for lending by removing some assets from the balance sheet.

Asset securitization refers to the issuance of securities that have a pool of assets as collateral.

3.5 FOREIGN EXCHANGE MARKETS

A foreign exchange market is a market which allows trading of foreign currencies. Commercial
banks and forex bureaus serve as financial intermediaries in this market. Some of the
characteristics of foreign exchange markets include:
1. Involves a huge volumes of transactions
2. It is the most liquid market
3. High geographical dispersion
4. Low margins compared to other markets due to low spreads
5. No centralized market as most deals are done over the counter {OTC}

The forex market is divided into 2:

1. Wholesale/interbank market which refers to a market that facilitates the exchange of
currencies between banks. The interbank consists of a network of corresponding banking
 relationship in which large commercial banks maintain corresponding banking accounts
with one another by maintaining demand deposit accounts.
2. Retail/client market which refers to a market that facilitates the exchange of currencies
between banks and their clients.

There are actually 5 basic foreign exchange products:

1) Spot transactions
2) Forward contracts
3) Foreign currency futures contracts
4) Foreign currency swaps
5) Currency options
The last four are referred to as foreign exchange derivative contracts

Foreign market participants can be categorized into:

 International banks
 Bank customers {companies and retail customers}
 Non-bank dealers {Pension funds, mutual funds, investment companies}
 Forex brokers
 Central banks

The main functions of foreign exchange markets are:

 To facilitate international trade
 Provide hedging facilities to limit foreign exchange risk
 To speculate so as to take advantage of anticipated exchange rate changes
 Allow investors to convert between currencies in order to move funds in/out of foreign
assets/investments.
 For arbitrage to take advantage of short-term discrepancies between prices in different
currencies or market places

Foreign exchange transactions can be conducted either in the

a) Spot market which involves immediate purchase or sale of foreign exchange currencies. A
spot rate which refers to the current or prevailing exchange rate of currency is used in the
transactions
b) Forward market which involves exchange of currencies that will occur in the future. A
forward rate which refers the rate at which a currency can be exchanged in the future is
applied in such transactions.

Banks and forex dealers generally don’t charge commissions on foreign currency transactions
instead they make profit from the bid-ask spread. The bid/buy price is always listed first
indicating the price the dealer is willing to buy the foreign currency, ask/offer price is always listed
second showing the price the dealer is willing to sell foreign currency. The dealer will always win
in terms of quotes and less heavily traded currencies together with currencies that have greater
volatility will always have higher spreads. The size of the spread can be affected by various
factors such as the assessment of currency risk, the volatility of the market, the liquidity of the
currency, and the trading time of the day.

Cross exchange rate is an exchange rate between two currencies that is derived from each
currency’s relationship with a third currency. Cross rates are used when there is no active market
in a currency pair.

Foreign exchange exposure is the risk of financial impact due to changes in foreign exchange
rates and, in general, there are three types of foreign exchange exposures
1. Transactions exposures which impact a company’s profit or loss and cash flows as a result
from having foreign currency transactions
2. Translation exposures which impact a company’s balance sheet and result from
translation of foreign subsidiaries
3. Economic exposures which relate to a company’s exposure to foreign markets and
suppliers.

Market participants who use foreign exchange markets tend to take positions based on their
expectations of future exchange rates. This might require them to develop forecasts of specific
exchange rates. There are numerous methods available for forecasting exchange rates
1. Technical forecasting which involves the use of historical exchange rates data to predict
future values. Past historical exchange rate trends can be used to provide an indication of
future exchange rate movements.
2. Fundamental forecasting which is based on fundamental relationships between economic
variables and exchange rates e.g. high inflation results to depreciation currency.
3. Market based forecasting which involves developing forecasts from market indicators
such as the spot rate or the forward rate.
4. Mixed forecasting which involves the use of all the above 3 methods to predict future
exchange rates. Each method is allocated a weight, and the most reliable technique is
given a higher weight.

Exchange rates are basically determined by the demand and supply of a particular currency as
compared to other currencies. A currency’s supply and demand are influenced by a variety factors
which are:
1) Level of inflation – a country with a low inflation rate than another country will see an
appreciation in the value of its currency.
2) Level of interest rates – a country with high interest rates always attracts capital inflows
hence its domestic currency appreciates.
 3) Level of government debt – a country with high government debt is likely to be perceived
to have a high default risk which results to bond investors to withdraw their investments.
This results to a depreciation of the domestic currency.
4) Political stability – a country with high political risk or political instability is likely to deter
foreign investors as result home currency will depreciate.
5) Balance of payments – a country with a large current account deficit {arising due to high
imports compared to exports} causes its domestic currency to depreciate.

Market psychology is the overall sentiment/feeling that a market is experiencing at any

particular time e.g. greed, fear, hopes and expectations of investors. Market psychology is
perhaps the most difficult but it does influence the foreign exchange market in a variety of ways:
1. Flights to quality – where unsettling international events might force investors to move
their assets from risky assets to safe investments. In this case, there will be greater
demand for currencies perceived to be stronger than their counterparts which results to
appreciation of the safe currency.
2. Long term trends – where currency markets always operate in long, pronounced trends
i.e. the cycles in the market are always affected by economic and political trends.
3. Economic numbers – such as growth in GDP & inflation have an immediate impact on
short term market moves.
4. Technical trading considerations – where technical analysts use price charts to predict
market patterns.
5. Buy the rumor, sell the fact – the tendency for the price of currency to reflect the impact of
a particular action before it occurs, and when the anticipated event occurs the price reacts
in the opposite direction. This may also be referred to as market being “oversold” or
“overbought”

The policy framework adopted by a country’s central bank to manage its currency’s exchange
rate is called an exchange rate regime. Highly volatile exchange rates create uncertainty that
undermines the efficiency of real economic activities, and the financial transactions required to
facilitate those activities, consequently this forces the central bank to intervene. Exchange rate
systems can be classified according to the degree by which exchange rates are controlled by the
government. They are
1) Fixed exchange rate system – a system where a currency’s value relative to other
currencies is fixed by the government. The exchange rate is held constant or allowed to
fluctuate within a narrow boundary.
2) Freely floating exchange rate system – a system in which the relative values of currencies
are determined by market forces without government interventions or restrictions. It is
also known as ‘clean float”.
3) Managed floating exchange rate system – a system in which the relative values of
currencies freely float, however central banks are allowed to intervene to prevent
currencies from moving too far in a certain direction. It is also known “dirty float”
 4) Pegged exchange rate system - a system where the currency value is pegged to another
currency’s value or to a unit of account e.g. a government can peg its currency value to
that of a stable currency such as USD.
5) Currency board – an exchange rate system in which a country fixes its exchange rate
against “reserve currency” and maintains 100% backing of the national money supply
with financial assets in the reserve currency.

A reserve currency is a currency that is held in significant quantities by many governments and
financial institutions as part of the foreign exchange reserves.

Some of the factors which have led to improved forex trading are listed as follows:
 Growth of technology innovation
 Lower transaction costs and transparency in the market.
 Increased market liquidity arising from increase in market participants
 Growing importance of foreign exchange currencies as an asset class for a portfolio.
 Efficient settlement policies and procedures

Arbitrage is the capitalizing on market discrepancies in the prices quoted in the forex market
by simultaneously buying and selling currencies. It can also involve simultaneous lending and
borrowing in different currencies to take advantage of higher interest rates. There are 3 kinds of
arbitrage:
a. Locational arbitrage which occurs when the spot rate of a given currency varies among
different locations. This disparity in rates occur since information isn’t always immediately
available to all banks/dealers which creates opportunity for arbitrage.
b. Covered interest arbitrage which occurs when interest rate parity theory doesn’t hold,
thereby allowing certain arbitrage profits to be made risk free from borrowing in one
currency and lending in another currency.
c. Triangular arbitrage which involves cross exchange rates of non-domestic currencies,
where an arbitrageur can exploit the difference between actual quoted rates and the
“should be” rates.

3.6 DERIVATIVES SECURITIES MARKETS

Derivatives are contracts that derive their value from the performance of an underlying asset,
event or outcome. Derivative contracts may be classified as physical or financial depending on
whether the underlying instruments are physical products or financial securities. Derivatives
contracts can be used for risk management/hedging, speculation, arbitrage and part of portfolio
diversification.
Derivatives markets are markets for contractual instruments whose performance is
determined by the way in which another instrument or asset performs.
 A financial futures contract is a standardized agreement to deliver or receive a specified
amount of a specified financial instrument at a specified price and date. The buyer of the contract
receives the financial instrument and the seller of the contract delivers the instrument. The main
features of a futures contract are:
- Identity of the underlying commodity or financial instrument
- Futures contract size and futures price
- Maturity/expiration date of the contract
- The delivery and settlement procedure

The main types of futures contracts include:

a) Interest rate futures – this are futures contracts on which the underlying is fixed income
securities. Their value depends on debt securities or indices of debt securities.
b) Stock index futures – this are futures contracts on which the underlying is a portfolio of
shares represented by a stock index. The contract allows for buying and selling of a stock
index for a specified price at a specified date.
c) Currency futures – a standardized agreement to deliver or receive a specified amount of a
specified foreign currency at a specified price {exchange rate} and date.

There 2 types of markets that have been established to facilitate trading of futures contracts.
They include:
a) Futures exchange which is an organized exchange for trading futures which are subject to
daily settlement procedures. The exchange clears, settles and guarantees all futures
transactions. Some of the attributes of the exchange include: use of standardized
contracts; have a clearinghouse; there is market transparency and a system of margining.
b) Over the counter which is a market where the futures are traded among dealers, brokers
and the public off an organized exchange. The transaction are more tailor made to the
specific preferences of the traders. Some attributes of such markets include: there is
contract flexibility; existence of counterparty risk; low market transparency and they are
unregulated markets.

The main functions of a derivatives market include

1. Facilitate hedging of risk through sophisticated risk management and reduce the cost of
protection against risk
2. Assist in standardization of commodity/financial instruments contracts in cash markets
since the derivatives contracts are standardized
3. They contribute to the integration of global capital markets hence improving investment
levels
4. They help to minimize the adverse effects of volatile commodity prices
5. They allow speculation which provides liquidity in the markets.

Some of the few challenges why derivatives markets are not developed in Kenya are
 1. Low level of investor sophistication in the products involved {options/futures}
2. Inadequate liquidity to encourage speculation and hedging
3. Inadequate risk management policies and procedures
4. Lack of a regulatory framework
5. Lack of standardized of grade or type of commodities to certain quality standards.

There are 2 reasons for trading financial futures; to speculate on prices of the securities and; to
hedge existing exposure to adverse security price movements. The main traders involved in a
futures market include:

Speculators – are traders who take positions in the market so as to profit from expected
changes in futures contracts prices over time. They bet on the price of an asset to go up or down.
They can either be;
1. Day traders – who attempt to capitalize on price movements during a single day. They
close out all their positions by the end of the trading day.
2. Position traders – who maintain a futures position for a longer period than a day, and
therefore attempt to capitalize on price movements over an extended time horizon

Hedgers – are traders who take positions in the financial futures markets to reduce their
exposure to future adverse movements in interest rates or share prices. Their main intention is to
protect a position.

Arbitrageurs – are traders who simultaneously purchase or sell an asset at different prices
without suffering any risk of loss. They take offsetting positions in two or more instruments to
lock in a profit.

Users of futures contracts must recognize the various types of risks exhibited by such contracts
and other derivative instruments:
1. Market risk – refers to the fluctuations in the value of the instrument as a result of market
conditions
2. Basis risk – the risk that changes in value of the futures contract and the underlying aren’t
the same. This is likely to affect hedgers were a perfect hedge isn’t easy to achieve.
3. Liquidity risk – refers to potential price distortions due to a lack of liquidity. It occurs in thin
markets manifested by few dealers and wide bid-ask spreads.
4. Credit risk – the risk that a loss will occur because a counterparty defaults on the contract.
It exists in OTC transactions on which parties rely on the creditworthy of each other.
5. Operational risk – the risk of losses as a result of inadequate management or controls. It
occurs due to the breakdown in the operations of a risk management system.
 Some of the advantages of equity/stock index futures are:
a) Leverage - where for a small amount {initial deposit margin} it provides access to a
substantial equity exposure.
b) Low transaction costs compared to direct purchase of the shares in terms of brokerage
and taxes.
c) Diversification – by providing an easy access to a diversified portfolio of shares
d) Liquidity – due to an active secondary market which allows easy market access and prices
are determined in a transparent manner.
e) Minimize counterparty risk due to guarantee from the clearing house.

Some of the investment strategies that can be adopted by institutional investors using stock
index futures include:
1. Speculate on the movement of the stock market.
2. Index arbitrage i.e. exploit returns due to mispricing of the futures contracts.
3. Tactical asset allocation to generate short term returns.
4. Creating a portfolio insurance i.e. by protecting the value of the portfolio.
5. Constructing indexed portfolios.
6. Controlling the risk of a stock portfolio to generate the required beta.
7. Hedging against adverse stock price movements.

Financial engineering is the process of creating new financial products or hybrid instruments
from other financial products. This has resulted to a surge in significant financial innovations.
Generally, financial innovation refers to both technological advances that facilitate access to
information, trading and means of payment. These new financial products/services are always
assumed to have the intention of circumventing regulations, or taking advantage of tax
loopholes in tax rules. Financial engineering is considered to be important, since introduction of
new financial instruments leads to efficient redistribution of risk among market participants. The
main causes of financial innovation include:
 Increased volatility of interest rates, inflation, equity prices, and exchange rates
 Advances in computer and telecommunication technologies
 Competition among financial intermediaries i.e. investment banks
 Incentives to circumvent existing regulations and tax laws
 Changing global patterns of financial wealth

Types of financial innovations include the following:

1. Marketing-broadening innovations – which seek to increase the liquidity of markets by
attracting new investors, and providing new opportunities for borrowers.
2. Risk-management innovations – which have the effect of redistributing financial risk
exposure from agents that are risk averse to agents that are willing to undertake risk.
3. Arbitraging innovations – where the investors try to exploit arbitrage opportunities either
within or between different markets, often to take advantage of loopholes in the
regulatory or tax framework.
4. Pricing innovations – which seek to reduce the cost of achieving a specific investment
objective.
5. Marketing innovations – in addition to innovative financial instruments, financial markets
are also adept at finding innovative methods of selling and distributing financial products.
 4. SECURITY MARKET INDICES
A security market index is a group of securities representing a given security market, market
segment or an asset class. The value of an index is calculated on a regular basis using either the
actual or estimated market prices of the individual securities known as constituent securities,
within the index. Most of the times the security index is used to measure the performance of
markets or as a benchmark when evaluating a portfolio.

Security market indexes can be classified into 3 groups:

1. Those produced by security exchanges based on all securities traded in the exchange e.g.
NSE All-Share index
2. Those produced by organizations that subjectively select securities to be included in the
index e.g.
3. Those where securities selection is based on an objective measure such as market-cap of
a company e.g. NSE 20 Share Index and FTSE NSE Kenya 25 Index

The percentage change in value of an index over some time interval is known as the index
return. The index return is always important than the index value. Each security market index
may have two versions depending on how returns are calculated:
1. A price return index which reflects only the prices of the constituent securities within the
index
2. A total return index which not only reflects the prices of the constituent securities but also
the reinvestment of all income received since inception.
At inception, the values of the price and total return versions of an index are equal. As time
passes, however, the value of the total return index, which includes the reinvestment of all
dividends and/or interest received, will exceed the value of the price return index by an increasing
amount.

Indexes are intended to represent the behavior of a market. So when constructing an index
the following should be considered:
a. Determining the market, market segment or asset class should the index represent? The
target market can either be based on an asset class {equities/bonds} or other
characteristics {economic sector/company size}. The index may consist of all securities in
the target market {NASI index} or just a representative sample of the target market {NSE
20 index}
b. Determine the method of weighting the securities in the index. The main methods used to
weight the constituent securities in an index include: price weighted, equal weighted,
market capitalization weighted or fundamentally weighted.
 c. Determining how to rebalance the index. Rebalancing refers to adjusting the weights of
the constituent securities in the index. This is necessary since the weights of the
constituent securities change as their market prices change.
d. Determining when reconstitution of the index is required. Reconstitution is the process of
changing {adding and removing} the constituent securities in an index. This is important
so as to ensure the index is only made of constituent securities that still meet criteria for
inclusion.

The main uses of security market indices include

 Gauge market sentiments by indicating the collective opinion of market participants.
 Act as a benchmark on performance evaluation of actively managed portfolios/funds.
 Serve as the foundation for creation of investment products e.g. Index funds & ETFs.
 Act as proxies for asset classes in asset allocation models.
 Applied as proxies for measuring beta and risk adjusted returns.
 Evaluate the financial variables that influence overall security price movements.

4.2 WEIGHTING METHODS

Once the stocks to be included in an index are selected, the stocks must be combined in
certain proportions to construct the index. The weighting decision determines how much of each
security to include in the index and has a substantial impact on an index’s value. There are 3
methods that are used to weight the constituent securities in an index 1) price-weighted, 2)
market-capitalization weighted or, 3) equal weighted.

A. PRICE WEIGHTED INDEX

In a price-weighted index the weight of each constituent security is determined by
dividing its price by the sum of the prices of all constituent securities. The value of the
price-weighted index is determined by dividing the sum of security values by the divisor,
which is typically set at inception to equal the initial number of securities in the index.

Price weighted index value = sum of stock prices

number of stocks in index after adjustments

As the stock prices change, the divisor should remain constant unless there is a
corporate event, where in such a situation the divisor should be adjusted so that the
index value is not affected by the event in question. Examples of these corporate events
that would result to an adjustment of the divisor include Share split/reverse share split,
bonus issue/stock dividend or a rights issue.

QUESTION
 At the market close in day 1, share A has a price of Ksh 10, share B has a price of Kshs
20 and share C has a price of Ksh 90. Assuming share C splits “2 for 1” on day 2, calculate
the new divisor/denominator for the index?

Solution
The price weighted index value {before share split} = 10+20+90
3
= 40
New price of share C =90/2 = Ksh 45
Assuming no price changes on other shares the new divisor is:
= sum of share prices {10+20+45}
Price weighted index value before split 40

= 1.875

QUESTION
A price-weighted index consists of one share each of 5 securities. The prices of these
securities for the year ended 2008 and 2009 are given below

Securities Price at end of 2008 Price at end of 2009

A 30 34
B 22 28
C 35 31
D 50 54
E 48 44

a. Calculate the value of the index at the beginning of 2009

= 30+22+35+50+48 185 = 37
5 5

b. Calculate the weights of each security at start of 2009

Weight of security = price of each security
sum of the prices of all constituent securities

Security A = 30/185 = 16.2%

Security B = 22/185 = 11.9%
Security C = 35/185 = 18.9%
Security D = 50/185 = 27%
Security E = 48/185 = 26%
 Observation: High priced securities have a greater weight and therefore have a higher
impact on the index value.

c. Calculate the price return of the index in 2009

New index value = 34+28+31+54+44 191 = 38.2
5 5

Index return = (38.2/37) – 1 = 3.24%

B. MARKET-CAPITALIZATION WEIGHTED INDEX

Also known as value weighting, the weight on each constituent security is
determined by dividing its market capitalization by the sum of market capitalization of all
the securities in the index. Market capitalization or value is calculated by multiplying the
number of shares outstanding by the current market price per share.
The initial market value is assigned a base number set at an arbitrary value e.g. 100,
1000 or 10000, and a new index value is computed periodically. The change in the index
is measured by comparing the new market value to the base market value.

Market-cap index value = sum of current market values × Base index value
sum of market values of base period

QUESTION
A market-weighted equity index consists of 5 securities whose prices and number of
shares outstanding are given below.

Securities Price at the end of 2008 Price at the end of 2009 Shares Outstanding
A 30 34 4000
B 22 28 6000
C 35 31 2000
D 50 54 2500
E 48 44 3000

a. Calculate the weight of each security in the index at the start of 2009

Securities Market Cap ( outstanding shares × market price) Weight %

A 30×4000 shares = 120000 120/591 = 20.3%
B 22×6000 shares = 132000 132/591 = 22.3%
C 35×2000 shares = 70000 70/591 = 11.8%
D 50×2500 shares = 125000 125/591 = 21.2%
E 48×3000 shares = 144000 144/591 = 24.4%
 Total market capitalization = 591000 100%

Observation: Securities with high capitalization have a heavy weight hence any small
changes in their capitalization will have a huge impact on the index value.

b. Assuming the base index value is 10000, calculate the index value at the end of
2009

Mkt-cap index value = (34×4000+28×6000+31×2000+54×2500+44×3000) × 10000

591000
= 10710

c. Calculate the price return index for 2009

Price return of index = (New Index Level/Base index level) – 1
= (10710/10000) – 1
= 7.1%

NOTE: The calculation of value weighted indices is moving towards a free float basis and
away from a total capitalization basis. Free float is the number of shares in the
constituent security that are available to the investing public. Free float basis deducts the
shares held by controlling shareholders, government, founding families and institutional
investors from the total number of outstanding shares to determine the market float.
Therefore the float adjusted market-capitalization weighted index is based on the total
value of shares available for purchase and not on the full outstanding shares.

C. EQUALLY WEIGHTED INDEX

This method assigns an equal weight to each constituent security, regardless of its price
or market cap, at inception i.e. all securities have equal influence on the index
irrespective of the sizes of the companies. The assumption is that the index portfolio is
made up and maintains an equal amount investment in each security in the index. The
change in value of an equally weighted index is normally calculated through geometric
mean, even though arithmetic mean can be applied.

QUESTION
An equal-weighted index with an initial value of 10000 consists of 5 securities whose
prices at the end of 2008 and 2009 are as follows,

Securities Price at end of 2008 Price at end of 2009

A 30 34
B 22 28
 C 35 31
D 50 54
E 48 44

a. Calculate the number of shares of each security included in the equal-weighted index
Since the index consists of 5 securities, each security will be assigned a weight of 20%
in the index. As the total value of the index is 10000, the value assigned for each security
is 2000 {10000/5}

Securities Number of shares {weight value/market price}

A 2000/30 = 66
B 2000/22 = 90
C 2000/35 = 57
D 2000/50 = 40
E 2000/48 = 41

b. Calculate the index value at end of 2009

Equally-weighted index value = {66×34+90×28+57×31+40×54+41×44}
= 10495

Using geometric mean

Securities Percentage Price Changes
A 34/30 = 1.1%
B 28/22 = 1.3%
C 31/35 = 0.9%
D 54/50 = 1.1%
E 44/48 = 0.9%

= 10496

c. Calculate the price return for the index

Price return index = (10495/10000) – 1
= 4.95%
PRACTICE QUESTION
An analyst has gathered the following data about the shares of the following companies
X, Y and Z.

Company Number of outstanding shares Price @ end of Yr1 Price @ end of Yr2
X 10000 40 50
Y 6000 30 20
Z 9000 50 40

Company Y’s shares underwent a “2 for 1” share split.

A. Construct the 3 indexes and compute the price return of each index. Assume a base
level of 3000 where applicable

A share split is an increase in the number of shares outstanding and a proportionate

decrease in the price per share such that the total market value of equity, as well
investors’ proportionate ownership in the company, doesn’t change. For example a “3 for
1” split means each shareholder will receive 3 shares for every 1 they hold in the
company. Share splits are intended to drive share prices towards an attractive trading
range which reduces investors’ transaction costs, which also enhances the liquidity of the
shares.

Solution
New price of the shares after the split will be 15 {30/2} and the shares will increase to
12000 from 6000.

Company No. Shares Share price No. Shares Share price Share price
before split before split after split after split end of Yr2
X 10000 40 10000 40 50
Y 6000 30 12000 15 20
Z 9000 50 9000 50 40
Total 120 Total 105 110

1. Price weighted index

Index value before the split = 120/3 = 40
Due to the share split the divisor should be adjusted = 105/40 = 2.625
Index value for Yr2 = 110/2.625 = 41.90
Index price return = (41.90/40) – 1 = 4.75%

2. Market-cap weighted index

Market cap in Yr1 = (10000×40+12000×15+9000×50) = 1030000
 Market cap in Yr2 = (10000×50+12000×20+9000×40) = 1100000
Index value in Yr2 = (1100000/1030000) × 3000 = 3204
Index price return = (3204/3000) – 1 = 6.8%

3. Equally weighted index {Using geometric mean}

Company X price return percentage = 50/40 = 1.25%
Company Y price return percentage = 20/15 = 1.33%
Company Z price return percentage = 40/50 = 0.8%

Index price return = (3302/3000) – 1 = 10.1%

B. Recalculate the indexes if the shares of company X underwent a reverse share split of
“1 for 2”

A reverse share split is a reduction in the number of shares outstanding with a

corresponding increase in share price, with no change to the company’s underlying
fundamentals. For example a 1:2 reverse share split means one share is given for every
2 shares held in the company. The objective of a reverse share split is to increase the
price of the share to a higher, more marketable range, and avoid the negative
connotations of a penny stock.

Solution
New price of the shares after the reverse split will be 80 {40×2} and the shares will
decrease to 5000 from 10000

Company No. shares Share price No. shares Share price Share price
before split before split after split after split end of Yr2
X 10000 40 5000 80 50
Y 6000 30 6000 30 20
Z 9000 50 9000 50 40
Total 120 Total 160 110

Price weighted index

Index value before the split = 120/3 = 40
Due to the share split the divisor should be adjusted = 160/40 = 4
Index value for Yr2 = 110/4 = 27.5
Index price return = (27.5/40) – 1 = -31.25%

Market cap weighted index

Market cap in Yr1 = (5000×80) + (6000×30) + (9000×50) = 1030000
 Market cap in Yr2 = (5000×50) + (6000×20) + (9000×40) = 730000
Index value in Yr2 = (730000/1030000) × 3000 = 2126
Index price return = (2126/3000) – 1 = -29.1%

Equally weighted index

Company X price return percentage = 50/80 = 0.625%
Company Y price return percentage = 20/30 = 0.67%
Company Z price return percentage = 40/50 = 0.8%
Index valu
Index price return = (2080/3000) – 1 = -30.7%

4.3 TYPES OF EQUITY INDICES

They include the following:
a. Domestic equity index which is an index that is made up of domestic companies shares
which can be based on various components such as market capitalization, economic
sector or value/growth.
b. Global/multi-market index which consist of both domestic and international companies
shares. Such index is used by investors who take a global approach to equity investing
without any particular bias towards a particular country or region.

4.4 TYPES OF FIXED INCOME INDICES

A wide variety of fixed income indices exist which can be classified along the following
parameters: type of issuer {government/company}, credit quality {investment grade/junk} or
maturity. Bond indexes fall into 3 basic categories:
1. Investment-grade bond indexes – which reflects the performance of fixed income
securities according to their credit rating.
2. High yield bond indexes – which track the yields of different fixed income securities. Most
high yield fixed income securities tend to have poor credit ratings.
3. Global bond indexes – which tend to be dominated by sovereign bonds issued by
governments e.g. Eurobonds.

The nature of the fixed-income markets and fixed-income securities leads to challenges when
constructing and replicating a fixed-income index. Some of these challenges include: the
numbers of securities in the fixed-income universe is high; lack of availability of pricing data and
liquidity of securities since most bonds are not actively traded; price volatility of bonds is
constantly changing.

Index staleness – is a condition that occurs when an index does not reflect all current price
information because some of the securities haven’t traded recently.
 Fundamental index – is an index in which the constituent securities satisfy some particular
fundamental metrics e.g. revenue, dividend payouts or earnings.

Capped index – is an index that has a limit on the weight of any single security, setting a
maximum percentage on the relative weighting of a component that is determined by its market
capitalization.

4.5 INDICES REPRESENTING ALTERNATIVE INVESTMENTS

Most investors seek to lower the risk or enhance the performance of their portfolios by
investing in asset classes other than equities and fixed income. Interest in alternative assets and
investment strategies has led to the creation of indices designed to represent broad classes of
alternative investments. Some of these major indices include:
a. Commodity indices which consist of futures contracts on one or more commodities such
as agricultural products, metals and energy commodities {oil/natural gas}.
b. REIT indices which represent the market for real estate securities {shares of publicly listed
REITs}. A real estate investment trust is a closed-end investment company that
specializes in investing in mortgages, property, or real estate company shares.
c. Hedge fund indices which reflect the returns on hedge funds. This indices rely on
voluntary disclosures from hedge funds, as it is not mandatory for disclosure of
information for hedge funds.
 5. MARKET EFFICIENCY
Efficient market theory is a theory that states that the market share price of an entity will
reflect all the information that is relevant for that share and no investor can profit by earning
abnormal return by trying to find buying and selling opportunities in the market.

Therefore an informationally efficient market is one which security prices reflect new
information quickly and rationally. Therefore and efficient market is a market in which security
prices reflect all past and present information.

Investment managers and analysts are interested in market efficiency because the extent to
which a market is efficient affects how many profitable trading opportunities exist. This helps
investors decide which investment strategies to adopt to maximize their returns depending on
the efficiency or inefficiency of the market.
1. In a highly efficient market, a passive investment strategy {buying and holding a broad
market portfolio} that does not seek superior risk adjusted returns is preferred as it entails
lower costs. This is because it is difficult to find inaccurately priced securities.
2. By contrast, in a very inefficient market, opportunities are likely to exist for an active
investment strategy {since securities maybe mispriced} to achieve superior risk adjusted
returns. In an inefficient market, an active investment strategy should outperform a passive
investment strategy on a risk adjusted basis.

Market efficiency is based on the following assumptions:

1. A large number of profit maximizing participants are analyzing and valuing securities
independent of each other.
2. New information comes to the market in random fashion and news announcements are
independent of each other in regard to timing
3. Competing investors attempt to adjust their estimates of security prices rapidly to reflect
the effect of information received.
4. Expected returns implicitly include risk in the price of the security.

NB. If the assumptions don’t hold {especially in emerging markets} then an investor can make
abnormal returns in such markets.

A perfect efficient market has the following characteristics:

1. Minimal transaction costs i.e. brokerage fees and taxes
2. All market participants have the same expectations regarding asset prices, interest rates
and other economic factors
3. Entry to and exit from the market is free
4. Information has no cost and is freely available to all market participants
 5. A large number of buyers and sellers are involved and therefore no one dominates the
market.
No financial market in the world is a perfect market. This is because a perfect financial
market should be free of transaction costs and any impediment to the interaction of supply and
demand of financial assets. Economists refer to these various costs and impediments as frictions.
The costs associated with frictions generally result in buyers paying more than in the absence of
frictions and/or sellers receiving less. For financial markets, frictions include:
 Commissions charged by brokers
 Bid-ask spreads charged by dealers
 Order handling and clearance charges
 Taxes {notably on capital gains} and government-imposed transfer fees
 Costs of acquiring information about the financial asset
 Trading restrictions, such as exchange-imposed restrictions on the size of a position in
the financial asset that a buyer or seller may take
 Trading halts imposed by regulators where financial asset is traded.

There are 3 components of efficient markets:

1. Operational efficiency which involves low transaction costs and minimum price impacts for
large orders.
2. Informational efficiency which requires prices to reflect all the available information
relating to the securities
3. Allocational efficiency which involves allocating resources to efficient use or assets that
are likely to generate higher returns.

The market value/market price of the asset is the price at which an asset can currently be
bought or sold. It is determined by the interaction of demand and supply for the security bought
in the market.

Intrinsic/fundamental value is the value of the asset that reflects all its characteristics
accurately. It is determined by considering all the information available regarding the asset.
Sometimes defined as the present value of all expected cash flows of the asset.

In an efficient market the market value and the intrinsic value should be almost the same. On
the other hand in an inefficient market the two values will differ significantly which creates
trading opportunities due to the mispricing.

The following factors affect a markets efficiency:

1. Number of market participants – the greater the number of active market participants
{investors/financial analysts} that analyze an asset or security, the greater the degree of
efficiency in the market.
 2. Information availability and financial disclosure – the availability of accurate and timely
information regarding trading activities and traded companies contributes to market
efficiency. All investors should have access to the necessary information to value securities
3. Limits to trading - such as difficulties in executing trades quickly, shorting of securities or
high trading costs impede market efficiency.
4. Transaction costs and information acquisition costs – investors have to consider transaction
costs and information acquisition costs when evaluating the efficiency of a market.

5.2 FORMS OF MARKET EFFICIENCY

Eugene Fama developed a framework for describing the degree to which markets are efficient.
In his efficient market hypothesis, markets are efficient when prices reflect all the relevant
information at any point in time. Fama defines 3 forms of efficiency:

Weak form efficiency – assumes that the current security prices reflect all the past market data,
which refers to all historical price and trading volume information. Under this hypothesis, past
trading data is already reflected in the current prices and investors cannot predict future prices by
extrapolating prices or patterns of prices from the past. The conclusion is that an investor cannot
achieve excess returns using technical analysis. Tests of whether securities are weak-form
efficient require looking at patterns of prices. The following approaches are used:
a) Serial correlation tests – which try to look for any correlation between security prices
changes at different points in time that would imply a predictable pattern.
b) Run tests – which examine whether any significance can be attached to the direction of
price changes by examining the length of the runs of successive price changes of the
same sign.
c) Filter tests – which try to identify any significant long-term relationships in security price
movements by filtering out short term changes.

Semi strong form efficiency – assumes that the current security prices reflect all publicly known
and available information. Publicly available information includes financial statement data and
financial market data. Therefore a market that quickly incorporates all publicly available
information into its prices is semi strong efficient. The conclusion is that an investor cannot
achieve abnormal returns using fundamental analysis. Semi-strong form tests include:
a) Event studies – which involve measuring the speed and accuracy of share price response
to new information such as announcement of earnings, dividends or M&A.
b) Regression tests – which are based on the assumption that the best estimate for future
returns is the long run historical rate of return, therefore an investor should not be able to
outperform a semi-strong estimates in the long or short term.

Strong form efficiency – assumes that the current security prices reflect both public and private
information. In this case company insiders would not be able to make abnormal returns from
trading on the basis of private information. Therefore the security prices reflect everything that
the management of a company knows about the financial condition of the company that has not
been publicly released. Strong form tests include:
a) Insiders – due to regulatory requirements, company insiders who have access to inside
information are unable to make above average returns due to disclosures of their insider
dealings
b) Fund managers – who have resources to acquire and analyze information have been
unable to outperform the market consistently.
c) Analysts test – investors could not outperform a market by following an analysts
recommendation advice.

Market efficiency is difficult to test due to;

a) Risk adjustment problem – where it is difficult to measure risk precisely and define risk
b) Relevant information problem – where it is impossible to know whether all information
was relevant when explaining market behavior
c) Dumb luck problem – some fund managers who constantly outperform the market due to
luck and random chance.
d) Data snooping problem – where discovery of patterns through observation of data can be
used to outperform the market but it’s difficult to know if the patterns are real.

Random walk hypothesis is a theory that states share price changes have the same distribution
and are independent of each other, so any past movement or trend of a share price or market
cannot be used to predict its future movement. This implies that future price cannot be predicted
by looking at the present price. Critics/technical analysts say that shares do maintain a price trend
over time, and therefore an investor can outperform the market by timing it.

The implications for investors if the stock market is efficient:

a) Payment for investment research will not produce above average returns
b) There are no bargains {underpriced} shares to be found in the stock market
c) Studying published accounts and investment tips will not produce above average returns

The implications for company and its managers if the stock market is efficient:
a) Share prices reflect a company’s value and market expectations about its future
performance and returns, all managers decisions are immediately reflected in the share
price
b) Cosmetic manipulation of accounting information or massaging of EPS will not mislead
the market
c) The timing of new issue of shares is not important since shares are never underpriced.

The implications of EMH include

 Securities markets are weak form efficient and therefore past trends in prices cannot be
used to earn superior risk-adjusted returns.
  Securities markets are also semi-strong efficient, and therefore, investors who analyze
information should consider what information is already factored into a security’s price,
and how any new information may affect its value.
 Securities markets are not strong form efficient and this is because insider trading is
illegal.

The implication of EMH on portfolio management is that, if markets are weak and semi-
strong form efficient, active management is not likely to earn superior risk-adjusted returns on a
consistent basis. In this case passive portfolio management should outperform active
management.

Fundamental analysis is the examination of publicly available information and the formulation
of forecasts to estimate the intrinsic value of assets. It involves the estimation of an asset’s value
using company data, industry and economic data. Buy and sell decisions depend on whether the
current market price is less than or greater than the estimated intrinsic value.

Technical analysis is the analysis of past patterns of prices and trading volume so as to identify
recurring patterns in the trading data that can be used to guide investment decisions.

Passive management strategies the investor doesn’t try to outperform the market. They include
1) Buy and hold strategy – which involves purchasing a portfolio of shares and holding them
to the end of some investment horizon. There is no active buying and selling of shares
once the portfolio is created.
2) Indexing – which involves designing a portfolio of shares to track the total return
performance of a benchmark index.
Active management strategies is an approach to investing in which a portfolio manager/investor
seeks to outperform a given benchmark portfolio by one or more of the following: (1) timing
market transactions using technical analysis, (2) identifying undervalued or overvalued stocks
using fundamental security analysis or (3) selecting stocks according to one of the market
anomalies

5.3 MARKET ANOMALIES

Most markets are assumed to be efficient, nonetheless potential inefficiencies or anomalies,
which result to mispricing of securities, tend to occur. An anomaly occurs when a change in the
price of an asset cannot be explained by release of new information into the market. Such a
situation, arising from market inefficiency, can be exploited to produce abnormal returns. The
anomalies can be classified into the following categories:

A. Time series/calendar anomalies which were identified using a time series of data and mostly
rely on time. They include
 1. January effect/turn-of-the-year effect where the stock market returns in January are
significantly higher compared to the rest of the months of the year, with most of the
abnormal returns reported during the first five trading days in January.
2. Turn-of-the-month effect where returns tend to be higher on the last trading day of
the month and the first 3 trading days of the next month.
3. Day-of-the-week effect where the average Monday return is negative and lower than
the average returns for the other four days, which are all positive.
4. Holiday effect where returns on shares in the day prior to market holidays tend to be
higher than other days.

B. Accounting anomalies which are changes in share prices that occur after the release of
accounting information. They include:
1. P/E ratio effect where firms with low P/E ratios tend to have higher returns relative to
the market, while high P/E ratio shares have significantly inferior results.
2. Earnings surprise effect where investors can be able to earn abnormal returns using
publicly available earnings information by purchasing shares of companies that
announce positive earnings surprise.
3. Earnings momentum effect which states that shares of firms with high growth rates
tend to outperform the market.
4. Market/Book value ratio where firms with high book/market value ratio have a higher
risk-adjusted rate of return compared to firms with low book value ratios.

C. Firm anomalies which are always related to the specific characteristics of a firm. Examples
1. Size firm/small firm effect where shares of smaller companies outperformed shares of
larger companies on a risk-adjusted basis.
2. Neglected firm effect where the shares of firms that are not followed by many analysts
or active investors tend to yield excess returns. The excess returns appear to be
caused by the lack of institutional interest in the firms
3. Institutional holdings effect where shares of firms that are owned by few institutions
tend to have higher returns than those owned by many institutional investors.

D. Event anomalies where price changes occur due to an identified event. They include:
1. Insider trading where the greater the number of insiders buying the shares of a firm
the more likely its price will go up and generate future returns.
2. Analysts’ recommendations which has an opposite reaction in that, the more the
number of analysts recommend the purchase of a share, the more likely its price will
go down and generate lower returns.
3. Value line effect

Some of the reasons why market anomalies persist include

 Lack of theoretical explanation i.e. the anomaly isn’t well understood to be exploited
  Transaction costs i.e. the trading costs on the anomaly are higher compared to the return
 Irrational behavior i.e. investors sentiments/perceptions which run counter to rational
trading
 Trading restrictions e.g. where market regulations don’t allow shorting of overpriced IPOs
 Limited capital to exploit the anomaly
 Small profit opportunities i.e. the profit to be gained from exploiting the anomaly isn’t
enough

5.4 BEHAVIORAL FINANCE

It is a field of study that examines investor behavior, how cognitive biases result to
anomalies, and evaluates the impact of investor behavior on financial markets. It
attempts to explain why individuals make the decisions that they do, whether these
decisions are rational or irrational. Traditional finance models, assume that investors
process all available investment information in a rational manner, and will act accordingly
to maximize their returns, but this is not the case due to irrational behavior and repeated
errors in judgment from investors. Therefore it might be possible to explain that some
market anomalies can be due to behavioral biases. Some of these biases include:

1. Loss Aversion which refers to the tendency of individuals disliking losses more
than they like gains of an equal amount i.e. the pain of making a loss is 3 times
higher than the pleasure of making a gain. This results in a strong preference for
avoiding losses as opposed to achieving gains. This is can be used to explain
overreaction from investors in markets.
2. Herding which occurs when investors trade on the same side of the market in the
same securities, or when investors ignore their own private information and/or
analysis and act as other investors do. This results to trading that occurs in
clusters and is not necessarily driven by information.
3. Overconfidence bias where investors have an inflated view of their ability to
process and interpret information about a security. Overconfident investors may
not process information appropriately, and if there is a sufficient number of these
investors, stocks will be mispriced.
4. Confirmation bias is a tendency for people to seek out supporting information
after making a decision and to avoid or ignore new information that would call the
decision into a question e.g. a belief that Centum is a “good” company with high
growth may be extended by investors to include a belief that Centum shares is a
“good” stock.
5. Escalation bias is the tendency of investors to commit more funds to a position
that has gone down {also known as averaging down}. It occurs when investors
undervalue information that is in opposition to the original purchase decision, and
overweight the importance of information indicating the original decision was a
 “proper” one, they will tend to average down too often, escalating the size of their
positions.
6. Gambler’s fallacy is where investors’ estimates of future probabilities are affected
by recent outcomes. People assume that a departure from what occurs on
average, or in the long run, will be corrected in the short run.
7. Prospect theory – a theory which emphasizes among other things that investors
tend to behave differently when they face prospective gains or losses. The theory
focuses on gains and losses, and the tendency of investors to be risk averse with
regard to gains, but risk taking when it comes losses. Contrast with Regret theory
which says people anticipate regret if they make a wrong choice, and take this
anticipation into consideration when making decisions.
8. Money illusion effect is a tendency to be confused between real buying power and
nominal buying power due to not accounting for inflation effects.
9. Illusion of control bias refers to the tendency of investors believing that they can
control or influence the outcome of uncontrollable events. It results to
overconfidence bias.
10. Mental accounting, where investors keep track of gains and losses from different
investments in separate mental accounts, and treat those accounts differently.
11. Disposition effect, where investors are quick to realize gains {by selling winners},
but avoid realizing losses {by selling losers}.
12. Representativeness, where investors assess probabilities of future outcomes
based on how similar they are to current state e.g. investors assume good
companies or good markets are good investments.
13. Hindsight bias is the tendency by investors, after an event has occurred, to think
that they knew the outcome of that event in the beginning. It affects future
forecasting.
14. Conservatism, where investors are slow to react to new information and continue
to maintain their prior views or forecasts.

Other behavioral biases that have been put forth to explain observed investor behavior
include: Regret aversion bias, Recency bias, Self-attribution bias, Availability bias, House money
effect, myopic loss aversion, Endowment effect, Hot hand fallacy, Sunk cost fallacy,
Anchoring/Framing bias.
 6. FINANCIAL INTERMEDIARIES
Financial institutions are the key players in the financial markets as they perform the function
of intermediation and thus determine the flow of funds. They channel funds from institutions and
individuals who have a financial surplus to institutions and individuals who wish to borrow funds.

Financial mobilization is the process of transferring funds from those who have and are not
willing to spend i.e. savers to those who don’t have and are willing to spend i.e. borrowers.

Financial institutions can be classified into depository and non-depository institutions. Deposit-
taking institutions consist of commercial banks and credit unions. The non-depository institutions
consist of finance companies, insurance, pension funds, investment banks and investment
companies.

Some of the benefits of using the services of financial intermediaries include:

1. Organize exchanges, brokerages and alternative trading systems that match buyers to
sellers.
2. Provide liquidity on demand to traders.
3. Run banks that match investors to borrowers by taking deposits and making loans.
4. Run insurance companies that pool uncorrelated risks.
5. Provide investment advisory services that help investors manage and grow their assets at
low cost.
6. Organize clearinghouses that ensure everyone settles their trades and contracts.
7. Organize depositories that ensure nobody loses their assets.

6.1 COMMERCIAL/RETAIL BANKS

A bank is a financial institution that accepts deposits and channels those deposits into lending
activities, either directly or through capital markets. Their focus is on mass-market products such
as current and savings accounts, mortgages and credit cards.

Offshore banks are banks located in jurisdictions with low taxation and regulation, which
provides financial and legal advantages. They normally provide wealth management services to
high-net worth families and individuals. Advantages of offshore banking include (1) greater
privacy of their clients (2) protection against local political or financial instability (3) low or no
taxation since the banks are located in tax havens. The disadvantages of offshore banks are (1)
only available to wealthy individuals locking out most customers (2) most are involved in money
laundering from organized crime or terrorist groups (3) always located in remote areas which
might be difficult to access.
 Islamic banking activities are consistent with Islamic principles (Sharia’s). The Sharia prohibits
the fixed or floating payment or acceptance of specific interest or fees (known as riba) for loans
of money.

Agency banking is a form of branchless banking whereby a bank enters into a contract with an
agent/retail outlet to perform banking services on behalf of the bank. Some of the factors that
have influenced agency banking are 1) changes in technology 2) adoption of new delivery
channels for products and services 3) regulatory oversight and support 4) minimize costs
involved to sustain brick and mortar branches. Some of the benefits of agency banking include 1)
increased income through commissions 2) increase customer base 3) increased product
penetration 4) convenience for banking customers 5) cut costs for bank by avoiding to set up a
branch. Agency banking also has its own challenges that range from lack of security on most
areas where the agencies are set up to fraud cases where the KYC rules are not upheld. Poor
customer service and lack of confidentiality by some retail agents have also resulted to the slow
uptake of agency banking.

Online/internet banking is where most banks allow customers to access their account
information and conduct routine banking business via secured websites. Typical services include
account review, bill payment, wire transfer of funds and application for new loans. The primary
appeal of internet banking is its convenience due to ease of transactions and monitoring of
accounts anytime from any place provided there is internet connection. The primary
disadvantage of internet banking is security concerns.

6.2 SAVINGS AND LOANS ASSOCIATIONS AND CO-OPERATIVE SOCIETIES/CREDIT UNIONS

A sacco is a not-for-profit depository institution that is operated as a cooperative and offers
financial services such as low-interest loans, to its members/depositors. The key objective of a
sacco is to mobilize savings and advance credit/loans on the collateral of such savings. Saccos
used to be prohibited from serving the general public. Rather, in organizing a credit union,
members are required to qualify under the saccos common bond requirements. Most common
bonds are occupational {i.e. members work for the same employers or in the same industry e.g.
Mwalimu sacco or Bandari sacco}; some are associational {i.e. members belong to the same
religion, trade association, or trade union} However due to liberalization of the sacco industry and
approval from the regulator, most saccos now, take deposits from the general public. The
primary objective of saccos is to satisfy the depository and borrowing needs of their members.
The member deposits {called shares, representing ownership stake in the sacco} are used to
provide loans to other members in need of funds. Earnings from these loans are used to pay
interest on member deposits {aka dividends}.
Since credit unions are not-for-profit organizations, their earnings are subject to lower tax
rates. This low taxes allow saccos to offer higher rates on deposits and charge lower rates on
some type of loans compared to banks.
Saccos are divided into 2 categories:
 1. Deposit-taking saccos – which undertake deposit taking business e.g. operating savings
accounts, ATMs, money transfers etc.
2. Non-deposit taking saccos – whose activities are limited to non withdrawable deposits,
used as collateral for credit to members.

Some of the challenges that affect Kenyan Saccos include

1. They don’t have access to the national payment system
2. They have no open market for their shares, which make it difficult to liquidate shares
quickly.
3. There is no mechanism for sacco to use or raise supplementary capital as part of their
regulatory capital or fund their activities.
4. They cannot access the lender of last resort facility available to commercial banks during
liquidity challenges.
5. They have no operational mechanisms to allow inter-borrowing among themselves.

6.3 INSURANCE COMPANIES

These companies are in the business of assuming the risks of adverse events in exchange for
cash inflows in the form of insurance premiums. Insurance companies and individuals offset the
risks they face by pooling their risks. The primary source of funds for insurance companies are
policy premiums, which are used to purchase long term government and corporate securities.
There are 2 types of insurance companies:

1) Property and casualty insurers {General insurers} who cover assets such as homes, cars
and businesses. Most of their investments have short term horizon due to the
unpredictability of payments.

2) Life insurer who cover death or serious injury of an individual. They can afford to engage
into risky investments due to the long term nature of payoffs.

Moral Hazard occurs when people are less careful about avoiding losses once they have
purchased insurance. This leads to losses occurring more often with insurance than without.

Adverse selection occurs when those who are at most risk buy insurance causing insured losses to
be greater than average losses

Some of the functions of insurance companies include:

 Offer insurance products at a low premium with high level of security
 Reinsure risk they can’t bear or diversify
 Determine of which risks the insurer can undertake {known as underwriting}
 Asset-liability management i.e. matching investment in assets with insurance liabilities
 Determining premiums to be charged on the risks and probabilities of insured events
 Some of the challenges affecting insurance companies in Kenya include:
 Low disposable incomes from citizens
 Poor attitudes by citizens towards insurance cover especially life insurance
 Cumbersome claims procedures that discourage clients
 Fraud in the industry and collapse of some insurance companies
 Inappropriate products which makes insurance to be considered a product for the rich

Strategies that can enhance insurance penetration in Kenya:

 Increase consumer awareness of insurance products available
 Introduction of new innovative products to cater for everyone.
 Aggressive marketing by insurance companies
 Improve distribution channels of insurance services by embracing technology
 Improving customer service by ensuring claims are paid within reasonable time
 Implementing a fair price model and flexible payment plans for low income households

The main types of risks insurance companies face include:

i. Underwriting risk which is the risk relating to insurance contracts in which the premiums
charged don’t adequately cover the claims the company has to pay.
ii. Investment risk is the risk of volatility in financial markets that will impact the results of
operations and finance. Investment assets and provisions for claims are exposed to
interest rate changes.
iii. Market risk is the risk of economic losses resulting from price changes in capital markets
iv. Credit risk which occur as a result of changes in the financial situation of a counterparty
e.g. issuer of a bond.
v. Operational risks where potential losses are likely to occur from inadequate processes,
technical failure, internal procedures, breakdown of infrastructure and IT security.

6.4 PENSION COMPANIES

A pension plan is an asset pool that accumulates over an individuals working years and is
paid out during their non-working years. Pension funds collect pension contributions from
employees and invest the funds in government and corporate securities. There are 2 types of
pension plans:

A defined contribution plan where the benefits to be provided to the employee will depend on
the accumulated contributions and the pension fund investment performance. The contributions
to the fund are specified in advance.

A defined benefit plan where the contributions to be made into the plan are dictated by the
benefits that will be provided in the future. The burden is on the employer to provide adequate
funds to ensure the agreed benefits are paid to the employee.
 Factors that have contributed to the growth of the pension fund industry
 Increased confidence due to an oversight body {RBA}
 Improved investment portfolio returns through diversification
 Greater transparency and accountability through audited financial statements
 Increased member awareness through AGM’s and public education
 Security of pension plan assets due to separation of custody from pension fund

Some of the challenges still facing the retirement benefits industry include:
 Low coverage as informal sector is never covered
 Underfunding of pension schemes
 Imprudent asset management
 Non-payment of pension contributions by employees

6.5 INVESTMENT COMPANIES

An investment company is a collective investment scheme that pools funds of investors, and
invest in appropriate securities, so as to achieve stated investment objectives, in return for a
management fee. There are 4 major types of investment companies: open-end mutual funds,
closed-end mutual funds, exchange-traded funds and unit investment trusts. These pooled
investment vehicles issue securities that represent shared ownership in the assets that the
entities hold.
The advantages of such companies include: investors are able to access professional
investment management services; allow investors participate in the purchase or ownership of
large assets; less expensive to trade than the underlying asset hence reduce transaction costs
e.g. REITs are much liquid than the actual real estate; allows ownership of a diversified pool of
risks which enhance investment returns. Some of the disadvantages of investment companies
include: investors have no direct control over the investments; investors have no say on what
securities should be invested in; investors can’t decide when to trade on their assets to reduce
their tax liabilities.

6.5.1 MUTUAL FUNDS

A mutual fund is an investment company that sells shares and uses the proceeds to
manage a portfolio of securities. Mutual funds are also known as open ended funds since they
have the ability to issue or redeem{repurchase} shares on demand i.e. Investors purchases and
sales are deposits and redemptions to and from the fund. Therefore the outstanding number of
shares keeps fluctuating on a daily basis.
The fund manager determines the price at which investors can purchase or sell shares in the
fund which is Net Asset Value {NAV} per share. It is calculated as follows:

NAV = MARKET VALUE OF THE FUND

No. OF SHARES OUTSTANDING
 Market value of fund = Market value of all assets that constitute the fund plus accrued interest
plus dividends less fund expenses and liabilities.

Question
Suppose today a mutual fund contains 1000 shares of sasini ltd, currently trading at KShs
15, 2000 shares of KCB ltd currently trading at KShs 45, and 1500 shares of Safaricom ltd
currently trading at KShs 20. The mutual fund has no liabilities and 10,000 shares outstanding
held by investors. Calculate the fund’s NAV.

Solution
NAV = (1000×15 + 2000×45 + 1500×20) ÷ 10,000
= KShs 13.5

Mutual funds generate returns to investors in 3 ways:

 Pass any earned income{interest/dividends} as a dividend distribution to investors
 Distribute capital gains arising from sale of securities within the fund
 Through mutual fund share price appreciation i.e. increase in NAV

There are different categories of mutual funds, just to mention a few they include
1. Equity mutual funds that only invest in shares of different companies
2. Bond mutual funds that only invest in different types of bonds
3. Money market funds that invest only in money market securities
4. Balanced/hybrid mutual funds that invest in both shares and bonds

The following costs are incurred by an investor of mutual funds:

1. Redemption fees/Back end load charge – for redeeming shares in the mutual fund
2. Management fees – fees paid to investment managers including for advisory
3. Trading costs of the fund
4. Administration costs incurred by the fund
5. Front end load charges – commission charged at the time of purchase shares in the fund

6.5.2 UNIT TRUSTS/ CLOSE END FUNDS

This is a mutual fund that has a fixed number of shares that are bought and sold only in the
secondary market i.e. after an IPO the fund doesn’t buy or sell shares. A unit trust always issues
its shares at a premium to the market value of the underlying portfolio {NAV} e.g. A trust which
has a portfolio worth Kshs 5m may sell 5000 shares to investors at a price of Kshs 1500 per
share, in this case the NAV is Kshs 1000 (5,000,000/5000 shares) which is lower than the trading
price. The premium serves as compensation for issuance costs.
 The main types of costs involved in a unit trust include; portfolio transaction costs;
administrative fees and investment management fees.

NB: The liquidity of a mutual fund is provided by the investment company that manages it,
whereas the liquidity of a closed end fund is provided by dealers or securities markets.

6.6 HEDGE FUNDS

A hedge fund is an investment fund that pools capital from financially sophisticated investors
and invests in a variety of assets, using complex risk management techniques. Hedge funds are
set up in a limited partnership structure i.e. the general partners who are the hedge fund
managers and the limited partners who are the qualified/sophisticated investors to the fund.

Some of the distinguishing characteristics of hedge funds include:

 Complex investment strategies/styles
 Less transparent as they are less regulated
 High minimum investment levels since they target specific investors
 Limited liquidity due to lock up periods of investors’ capital
 Performance based compensation instead of AUM compensation

A qualified/sophisticated investor is a type of investor who is deemed to have sufficient investing

experience and knowledge to weigh the merits and risks of an investment opportunity. These
investors are wealthy enough and well informed enough to tolerate and accept substantial
losses. They include institutional investors and High Net worth Individuals {HNWI}.

High water mark is a specified net asset level that a fund must exceed before
performance/incentive fees are paid to the hedge fund manager.

Hurdle rate is a specified minimum return that must be earned by the investor {limited partners}
before the incentive fee is applied on profits.

Lock up period is a minimal initial holding period for investments during which no part of the
investment can be withdrawn.

Advantages of hedge funds

 A superior risk-return trade off
 Low correlation with other investments
 Performs better in both positive and negative market environments.

Disadvantages of hedge funds

 The performance of the fund depends on the skills, experience and talent of fund
manager
  Due to lock up periods imposed by hedge funds there is limited liquidity
 Lack of clear regulations and disclosure requirements which can result to manipulation of
information

A typical hedge fund fee arrangement has 2 components:

1) Management fee – which is a constant percentage applied to the net asset value of the
fund
2) Incentive fee – which is a form of profit sharing wherein fund managers receive a stated
percentage of the profits.

Some of the investment strategies that are used by hedge funds include:

6.7 FUNDS OF FUNDS

These are investment vehicles that invest in other hedge funds. They only invest in hedge
funds that are likely to outperform the market or hedge funds with good investment strategies
and are likely to generate higher returns. The advantage to the investor is that the fund manager
has expertise in selecting the best hedge funds which offers a diversification benefit.

Advantages of FOF
 Efficient risk diversification
 Affordability and accessibility especially for small investors
 Professional management and asset allocation
 Better internal and external transparency

Disadvantages of FOF
 Higher professional costs/charges
 Lack of control which results to duplication or over diversification
 Liquidity problems due to the inherent liquidity problem in hedge funds.

6.8 EXCHANGE TRADED FUNDS AND INDEX FUNDS

An exchange traded fund is a special type of fund that invests in a portfolio of shares and
bonds and is typically designed to mimic the performance of a specified index.

Advantages of ETFs
 Provide an efficient method of diversification
 Trade like shares and therefore they can be margined or shorted
 Allow better risk management if the underlying is derivatives in the ETF
 Investors know the exact composition of the of the fund at all times
 Efficient operating ratios and reduction of fund expenses
 Disadvantages of ETFs
 There are few indexes{ especially small cap shares} to track and a portfolio might not be
well represented
 Investors may encounter some efficient markets that results to large bid-ask spreads
arising from low volume trading
 Large investors may opt for index funds with lower operating expenses and lower tax
consequences
 Has no significant effect for traders with long term investment horizons

An index fund is a pooled investment vehicle that invests in securities that are structured to track
the returns of a specific index called the benchmark index.

6.9 PRIVATE EQUITY FIRMS

These are pooled investment vehicles that invest in the equity of private companies or public
companies that want to convert to private companies. Private equity firms provide money to
companies at different stages of their development. Most of the time when a private equity fund
purchases a business, it tends to acquire majority stakes which helps them to assume control,
and is able to restructure the business in a manner that will improve its performance.

Just like hedge funds, private equity firms are set up in a partnership form i.e. general partners
and limited partners. Private equity firms make money through 2 mechanisms:
1. Management fees – which are calculated as a percentage of the committed capital. It is
paid by the limited partners to general partners to compensate management of the
private equity investments.
2. Carried interest/incentive fee – which is a share of profits made out of the private equity
investments. This ensures that general partners’ interests are aligned with limited partner
interests.

Committed capital is the amount of capital provided to the private equity fund by investors. It is
typically not all invested immediately but is “drawn down “{invested} as securities are identified
and added to the portfolio.

There are several methods of exiting an investment in a portfolio company:

 Trade sale i.e. sale the portfolio company to another strategic buyer
 IPO i.e. sell some of the portfolio company shares to the public
 Secondary sale i.e. sell the portfolio company to another private equity firm
 Write off i.e. liquidate the investment and take losses if unsuccessful
6.10 FINANCIAL ADVISORY FIRMS
A financial advisory firm acts as an intermediary between corporation issuing securities and
investors by providing the following services; origination, underwriting, distribution of shares,
advising and private placement of securities. Financial advisory firms engage in
 Investment banking
 Brokerage services
 Securitization of mortgages
 Advisory and financing services for companies

Their main sources of income include: restructuring fees, trading commissions, investing their
own funds {proprietary trading}, advisory fees and underwriting fees.
 7. FINANCIAL MARKETS REGULATION
Regulation is important because it attempts to prevent, identify and punish investment
industry behavior that is considered undesirable. Regulations are rules that set standards for
conduct and that carry the force of the law i.e. enforced by government authorized bodies {CMA}

The reasons for government regulating financial markets include:

- Ensure fairness to all market participants in terms of information i.e. information
asymmetries and insider information
- Enhance efficiency and avoid confusion by having an effective dispute resolution system
- Ensure healthy financial markets that foster capital formation and economic growth
- Support economic stability by discouraging companies from engaging in activities that can
cause systemic failure.
- Protect consumers from abusive and manipulative practices in the market.
- Improve society achieve its social objectives and prevent money laundering.

It should also be noted that excessive regulation of the financial system can hamper efficient
operation of the financial markets. Some of the unintended consequences of excessive
regulations include:
- It stifles innovation in the financial markets
- It creates regulatory evasion especially if the regulations are not in the interest of
investors
- It creates moral hazard
- The compliance costs for most market participants tend to increase
- Discourages investors from participating in the financial markets

Asymmetric information occurs when buyers and sellers do not have access to the same
information; sellers usually have more information than buyers. For financial transactions,
asymmetric information refers to the fact that issuers of securities know more than investors
about the credit quality of the securities being issued. Asymmetric information problems always
occur in two forms:
1. Adverse selection which refers to a situation in which sellers have relevant information
that buyers lack {or vice versa} about some aspect of product quality. Adverse selection
problems occur before a financial transaction takes place e.g. financial troubled business
will hesitate to disclose its financial position when trying to secure a loan.
2. Moral hazard refers to the risk that the existence of a contract will change the behavior of
one or both parties to the contract. Moral hazard problems occur after the transaction
takes place e.g. an individual driving an insured car may take few precautions when
driving.
7.1 CATEGORIES OF FINANCIAL REGULATIONS

A.GOVERNMENT SAFETY NET PROVISIONS

It refers to the actions of the government to help banks and financial institutions that are
facing financial difficulties. There are 2 objectives of government safety nets, reduce bank
runs/bank panic and act as a form of protection for depositors/creditors. Forms of government
safety net include:
1. Deposit Protection Fund – A statutory insurer body which requires financial institutions to
pay insurance premiums on all the deposits they hold.
2. Lender of Last Resort/Discount Window – refers to credit facilities in which financial
institutions borrow funds from the central bank so as to meet their liquidity needs and prevent
bank runs. The financial institutions are required to have high quality liquid assets to pledge as
collateral.

B. RESTRICTIONS ON ASSET HOLDINGS

Refers to financial regulations which limit the amount of risky assets, investments or
transactions that a financial institution should engage. Risky assets provide financial institutions
with higher returns when they pay off but can also have material negative results if they perform
poorly. The restrictions include:
- Amount of assets held in form of shares, derivatives and real estate.
- Promote diversification by limiting loans to specific sectors or individual borrowers.

C. CAPITAL ADEQUACY REQUIREMENTS

Refers to a situation where financial institutions are forced to hold a large amount of equity
capital, so that the institutions have more protection if they engage in risky transactions or
investments. Capital requirements can take the form of:
1. Setting the minimum leverage ratio {capital/total assets}
2. Risk based capital requirements which require a certain percentage of capital above risky
assets.

D. FINANCIAL SUPERVISION/PRUDENTIAL REGULATION

It is the regulation of deposit taking institutions and supervision of the conduct of these
financial institutions including setting down rules which limit risk taking. There are two aims of
financial supervision: Ensure the safety of depositors’ funds and promote stability in the financial
system. There are 3 forms of financial regulations
A. chartering of financial institutions – which involves vigorous screening of new financial
institutions so as to prevent undesirable people controlling them. Chartering involves examining
quality and experience of management, applicants’ initial capitalization and projected earnings
prospect. Once the requirements are satisfied the financial institution is given license for
operation.
 b. Bank Examination – where regulators/bank examiners make unannounced visits to banks to
study if a bank is following regulations. The regulators examinations are intended to promote
and maintain safe and sound banking practices, and avoid fraudulent transactions being “swept
under the rug ahead.”
c. Assessment of risk management– where on-site examinations try to reduce excessive risk
taken by a financial institution. This involves evaluating the soundness of bank’s management
processes with regards to controlling risk. This is achieved by checking the quality of oversight
provided by the Board and senior management, the quality of the risk measurement and
monitoring systems and checking the adequacy of internal controls to prevent fraud.

E. DISCLOSURE REQUIREMENTS
Regulators require financial institutions adhere to certain standard accounting principles and
disclose a wide range of information that helps the market assess the quality of the financial
institution portfolio and exposure to risk. Disclosure requirements help in deterring financial
institutions from taking excessive risk and improve the quality of information available to make
informed decisions. Disclosure requirements cover quarterly reports, amount of reserves/capital,
credit exposure and off balance sheet financing.

F. RESTRICTIONS ON COMPETITION
These are government legislations designed to protect banks from competition on the
grounds that increased competition can result to an increase in risk taking by banks, which
increases the danger of bank failure. Pressure to report good profitability in challenging
economic environment can result to a bank engaging in risky transactions to improve its
performance. One form of restriction is preventing non-bank institutions from competing with
banks by engaging in banking business. The disadvantages of the restrictions include higher
charges to consumers and decreased efficiency of banking institutions.

The consequences of regulatory failure include:

1. Financial contagion in the economy
2. Loss of savings by market participants
3. Loss of confidence and trust in the financial services industry

Systemic failure is the failure of the entire financial system including loss of access to credit and
collapse of financial markets.

Regulatory forbearance is a policy by a regulator, not to close an economically insolvent

financial institution, and allowing it to continue in operation.

Regulatory Arbitrage is a form of financial engineering where banks take advantage of

differences in regulatory systems to gain greater freedom to act as they wish, e.g. by operating in
a country with lax regulations.
 Regulatory/Agency Capture occurs when those that are supposed to be regulated take some
control of the regulatory process. Then they modify the regulations to suit their {producers}
interests rather than the consumers e.g. safaricom

Competitive Laxity is when financial centres that try to impose strict rules are subject to the
threat of financial institutions taking their business to a different jurisdiction and so are more
likely to be lax.

Net regulatory burden is the difference between the private costs of regulations and the private
benefits for the producers of financial services.

Financial contagion refers to the collapse of one financial institution which results to a loss of
confidence in other financial institutions possibly causing them also to collapse.

7.2 FINANCIAL DEEPENING

Refers to increase in investments of financial instruments or a shift in investments from real
estate to financial markets. Financial deepening always occurs as a result of proper legal
framework in the financial markets, innovations in the markets, need to diversify risk and
optimizing of technology.

Benefits and shortcomings of financial deepening

7.3 FINANCIAL REPRESSION

It is defined as a set of policies, laws and regulations and quantitative restrictions and controls
imposed by the government which don’t allow financial markets to operate at the optimal level.

The consequences of financial repression include:

- Low returns in the financial markets
- Slow development of the financial markets
- Shift of investments from financial assets to non-financial assets
- Creates asset pricing distortions in the financial markets
- Promotes moral hazard because of the desire to evade regulations

Financial repression is implemented through the use of

1. Capital controls where domestic residents are restricted in investing abroad
2. High reserve and liquidity requirements
3. Interest rate caps on bank assets and liabilities
4. Limit on the size of bank loans in some economic sectors
5. Management of foreign exchange rate.
7.4 FINANCIAL LIBERALIZATION
Refers to a process that involves the elimination of various forms of government interventions
in financial markets or elimination of financial repression.

The benefits if financial liberalization include:

-Attraction of foreign capital inflows due to high rates of return.
- Greater fiscal discipline by the government, as they don’t control the market.
- Rapid rise in other forms of financial savings due to financial deepening
- Efficient banking industry with a variety of products and better client service due to
competition

The challenges of financial liberalization include:

- Regulatory challenge
- Unstable political environment
- Asymmetric information
- Emergence of informal financial institutions
- Management of capital inflows and outflows (money laundering)

7.5 BANK RUNS AND PANICS

A bank run refers to a sudden and unexpected increase in deposit withdrawals from a deposit
taking institution. A bank run develops when the demand for withdrawals occurs at a fast rate
than the bank can meet its obligations.

A bank panic is a systemic or contagious run on the deposits of the banking industry as a whole.
It occurs when depositors lose faith in the whole banking system and engage in a bank run on all
banks.

The causes of bank runs and bank panics include

 Concerns about a bank’s solvency relative to other banks
 The contagion effect
 Poor performance reported by banks e.g. losses in the P & L
 Changes in investor preferences i.e. prefer holding T Bills relative to bank deposits.

The following techniques can be used to mitigate a bank run

 Borrow from the interbank market
 Borrow from central bank as a “Lender of Last Resort”
 Stop convertibility by minimizing/capping the amount of withdrawals
 Sale of financial securities such as T Bills {Fire sales}
Some of the causes of financial crisis in financial markets include
 High leverage on investments which increases bankruptcy risks
 Asset-liability mismatch in financial institutions
 Regulatory failures and untamed financial liberalization of markets
 Financial contagion

8. INFORMAL FINANCE
8.1 Nature of Informal Finance
The informal financial markets provide financial services to economic agents that do not have
access to formal financial markets. The majority of rural population in many developing
economies rely on informal financial market. Small irregular savers cannot not access credit from
many financial institutions, thus they have to rely on informal finance.

Borrowing may be imprudent for many Small and Micro enterprises but virtually all can benefit
from access to conventional, safe, and remunerative deposit facilities for storing liquidity and
accumulating capital. In many economies the formal sector is not able to serve all the SMEs thus
the need for informal finance.

Small borrowers are limited by:

 Collateral requirements
 Low levels and irregular incomes
 Highly skewed incomes

Small borrower households therefore are exposed to high risk profile which makes them less
attractive to the formal lenders. Therefore, they rely on informal financial markets for credit, for
both investment and consumption

Characteristics of Informal Financial Institutions

Informal finance is able to tailor contracts to fit the individual dimension, requirements, and
tastes of a wide spectrum of lenders and borrowers. Informal financial institutions:
- Operate in the form of self-help organizations
- Provide savings and credit facilities for small farmers in rural areas and for lower-income
households and small-scale enterprises in urban areas
- Procedures for informal schemes are usually simple and straight forward; as they
emanate from local cultures and customs.
- Mobilize rural savings and small savings from low income urban areas
- Provide their services at times and days which are convenient for their members
- Access to credit is simple, non-bureaucratic, and little based on written documents
 Processing of credit is simple and direct which allows for prompt approval and a minimum
delay in disbursement. Rejections are rare, but the level of risk is reflected in the interest
rate charged
- Collateral requirements on loans are to local conditions and borrowers capacity. The
conditions might be based either on regular contributions or other regular activity to
determine the borrowers’ capacity to repay the loans.
- Transactions costs are low compared to those of formal institutions.
- Informal groups are conversant to problems of their members and therefore they are
able to deal with repayment difficulties of their members in a pragmatic manner which
might call for rescheduling of debt
- The informal sector has dense and effective network at the grass roots level for close
supervision and monitoring of borrower activity; particularly their cash flows; whether
they are members of an informal association or not. This contributes to efficient
mobilization of savings and high repayment rates.
- Information tends to be easily transmitted because regular meetings of members serve
as a forum for dissemination of information.
- Charges competitive lending rates though at times comparable to those that are charged
by formal financial institutions. There is little connection between lending and deposit
rates
- Do not usually keep written records, but may sometimes maintain a listing of borrowers
and members contributions or savings
- The volume and availability of loanable funds are subject to seasonal fluctuations since
they do not receive subsidies from government or any other form of support
- Have been accused of charging exorbitant interest rates particularly the moneylenders
- Some are said to operate within highly localized social spheres due to the lender’s need
for intimate knowledge of borrowers, for social leverage in lieu of collateral or for
opportunities to recover debt through interlinked contracts.
- Lenders do not mobilize funds from the community, so there occurs no intermediation of
public savings

Types of Informal Financial Institutions

Informal financial institutions are defined as groups that are collectively owned and managed
by members. These groups mobilize savings from individuals and provide short term loans to
members, at varying interest rates, depending on their structure. They operate at the community
or village level in rural areas that often lack commercial or formal providers of financial products
and services. They include:

Relatives and Friends: These are close lenders with collateral free loans and usually at no interest.
The borrower is able to finance urgently needed expenditures quickly with little transaction cost,
no lengthy appraisal process, little or no paper work. The most important feature of this form is
reciprocity “the expectation that the borrower is willing to provide a loan to the lender sometime
in the future”. Maintaining the long-term relationship far outweighs the cost of default.

Rotating Savings and Credit Associations (ROSCAs): Provides a means of accumulating savings for
the purchase of indivisible goods more quickly. They pool in savings from members each period
and rotate the resulting funds among them using certain rules. The process is repeated each
period until each member receives their credit. Examples include the Merry-Go-Round and the
Village Table Banking Associations.

Moneylenders: Borrowers approach money lenders when the amount of credit required is larger
than can be obtained from socially close lenders (friends/relatives). Money lenders charge explicit
interest rates in order to obtain real positive returns on their capital. Moneylenders lend to well-
known borrowers although they can also lend to unknown borrowers if punitive measures on
default are feasible. Lending may be secured by physical collateral or by social collateral such as
group guarantees. These loans are generally expensive but they are usually open to the public.
SMEs are said to prefer borrowing from moneylenders because such loans can be arranged
promptly, involve low transaction costs and bear no restrictions on the use of funds.

Tied Credit: Loans are frequently tied to complementary transactions in land, labour or
commodities to minimize problems of inadequate information about the credit worthiness of the
borrower and lack of suitable physical or social collateral. Traders disburse credit to farmers in
exchange for the right to market the growing crop, shopkeepers increase sales by providing
credit for food, farm inputs, and household necessities. The lender is able to keep close
association with the borrower and can screen the borrower better for future loans.

Loan Brokers: who act as intermediaries between those who have excess credit and those who
are in need of credit at a fee. Where they have a contact point, it becomes relatively easier for
both category of clients. Typically loans are relatively large and cover a longer period of time than
other informal financial activities.

Merchants: who exchange goods for credit or extend credit and promise to receive repayments in
terms of real goods as agreed with the borrower. Shopkeepers may sometimes double as
merchants. At higher level however merchants may extend relatively huge amounts of loans. The
price of the commodity is adjusted as compensation for a loan. The advantage they have is that
through the sale/purchase of commodities, information is accumulated about the borrower,
which enables the merchant to better assess the clients ability to repay.

Welfare Associations: Persons who share common interests come together, make contributions
and provide certain agreed services to the members.
Self-Help Groups: Members come together, make contributions and the activities are guided by
certain principles. These groups usually extend credit to their members and organize other
activities such as get-togethers among other activities

Implications of Informal Finance to Policy

Credible long-term partnerships which enhances self-enforceability is important
Tailoring financial services to specific demand patterns; such as emergency loans, education
loans and others made available on short notice is another consideration
Promoting more efficient informal financial institutions to formal financial institutions
Linking Informal Markets to Formal Markets
-Encouraging offering of institutional financial services to SMEs
-Putting in place measures for enforcing policies to enable enforcement of contracts
It remains to be demonstrated that SMEs can finance productive investments using short-term
loans at extremely high real interest charges. It is valid to assume that when small businesses
borrow they expect a return in excess of the cost of funds. Yet it would be astonishing to find
investments yielding a return of more than 40% per month in the normal course of business
given that most SMEs operate in intensely competitive industries. Moreover, at such high profit
rates no business would remain small for very long.
While little is known about why SMEs borrow on very unfavorable terms, it is quite clear that a
profitable market exists for loans bearing interest rates far higher than those currently charged
by formal and semi-formal institutions. Robust activity and high monopoly rents by
moneylenders imply that they face insufficient competition from alternative agents, be they
formal or informal. The absence of competitive, efficient and well-integrated financial markets
implies loss of potential welfare, efficiency and growth. Most informal finance takes place in
extremely fragmented transactions some at zero interest. Experience in many countries
demonstrate that small enterprises and low-income households can be much better served
through either informal markets or innovative formal sector programs.

Experience from other countries indicate that informal financial markets tend to expand in
response to repression of the formal financial market; but this is not a constructive basis for
policy. A more positive policy proposal for promoting informal finance is to eliminate restrictions
hindering their growth. Given the inherently bureaucratic nature of government programs it is
tempting to conclude that government can do nothing to foster informal markets beyond
establishing a facilitating legal environment. Government can however pursue limited indirect
actions to help nurture informal financial market development. At a minimum, government can
encourage informal financial markets by broadcasting information to potential financial
entrepreneurs about the legal environment, business opportunities and techniques for
establishing informal saving and credit associations. These low-cost options can be pursued
without introducing the heavy hand of bureaucracy into the informal financial market
mechanism. Even such limited efforts to intensify competition and diversify IFMs will pay off if
they help to promote more affordable and better integrated flows of informal finance for SMEs
and low-income households.

Market promoting interventions directed to formal sector institutions are likely to be most
effective. Incentives and assistance can be provided to facilitate the testing of innovative
programs to deliver low-cost financial services to nontraditional clientele.

At the micro-level, providing secure and remunerative deposit facilities for storing liquidity and
accumulating savings will generate direct utility gains. With improved access to finance,
entrepreneurs can take advantage of income-generating opportunities and smooth out income
fluctuations. In the long-run, the goal should not be to extend credit to the SMEs but rather to
make more widely available an efficient mix of competitive financial services, both deposits and
loans, through financially sound formal, semi-formal, and informal institutions.