Download FINANCIAL MARKE TS 1 NOV 2010 S OLUTIONS

FINANCIAL MARKETS SOLUTIONS NOV 2010
SECTION A
Q1
(a) financial institution is an organization / company or association that offer or deal
with financial goods and services. This sort of institution use financial system
thereby acting as an intermediary in facilitating the flow of capital by bringing savers
and borrowers together. (4Marks)
(b) i Depositories
These are financial institution that accept and manage deposit and give out loans.
They use government insured deposits such as savings account and certificate of
deposit. This
Category is most comprised of banks and credit unions. 3 Marks
ii Contractual Savings
These institutions receive periodic payments in form of premiums from customers
to fund insurance policies or pension reserves. This category is most comprised of
fund managers and insurance companies. (3Marks)
iii Specialised
These are financial institutions which provide a range of financial functions but do
not issue government insured deposit. They comprise of brokers, underwriters and
investment funds. (3Marks)
(c ) Financial instrument is any contract that gives rise to both a financial asset of
one party and a financial liability or equality instrument of another. (2Marks)
Q2
a Hedgers
Basically hedging is an act of offsetting or eliminating risk exposure therefore a
hedge is a financial strategy that reduces the risk of capital losses arising from any
risk associated with an asset class. Hedgers will enter in such transactions with an
aim of protecting a business or assets against adverse changes in some
underlying. Normally, the investment bought will tend to have opposite – value
movement to the underlying. (5Marks)
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b) Speculators
These are economic units that profit through purchase of financial contractors on
the basis that favorable price changes will occur with short period of time. They
take a position in the financial instrument and assets with a view to obtaining a
profit in changes in value. They accept high risk in anticipation of high reward.
These players are also attracted to derivative market because derivatives are more
liquid than the underlying. They are needed in the market because they bring in
liquidity. (5Marks)
c)Arbitrageurs
Arbitrage is an act of exploiting price difference on the same instrument or similar
securities by simultaneously selling the overpriced security and buying the under
priced security. They help to ensure pricing efficiencies – their acts of buying or
selling tend to reduce anomalies. (5Marks)
Q3
a) Three characteristics of money market are as follows
-
They are usually sold in large denomination (1Mark)
-
They have low default risk (1Mark)
-
They mature within the year (1Mark)
Three purposes of money market
- Low cost of source find (1Mark)
- Interim investment that gives higher return (1Mark)
Source of working capital (1Mark)
b)
i
Price
=100-(rate x tenor/365) (1Mark)
=100-(11.80 x 182/365) (1Mark)
=100-(5.8838)
= 94.1162
(1Mark)
ii The following are reasons why Treasury Bill was favored against commercial
paper
-
Treasury bill is less riskier than commercial paper since it is issued by
government. ( 2 Marks)
2
-
Treasury bill has ready secondary market while such market is difficult to find
for commercial paper. (2 Marks)
iii Any two of the following (2 Marks)
- Repurchase agreement
- Negotiable certificate of deposit
-
Bankers acceptances
Q4
a)
Liability side
The institution accept deposit and do not hold these deposit in cash reserves but
rather invest in less liquid assets so as to earn an interest. A depositor may request
withdrawal at the time the cash reserve is not there. The institution can handle this
liquidity borrowing additional funds as sell of some of its assets to meet the liquidity
need. (3Marks)
Asset side
Just as deposit drains can cause liquidity problem, borrowers in exercise of the
loan commitment entered into can result into the financial institution having to find
ways of funding this commitment which can either be done by selling off its assets,
running down assets and borrowing addition funds. (3Marks)
Q4b
i
Assets
Liabilities
K’000
Cash
28 000
Money market investment
60 000
K’000
Deposits
150
000
Inter bank borrowing
30
000
Loans
100 000
Corporate tax
8
000
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(3Marks)
ii
market to
Changes by a reduction of 20 00 000 can either be on cash or money
meet the same reduction on deposit.
Cash
8 000
Deposit
130
000
Money market investment
60 000
Inter bank borrowing
Loans
100 000
Corporate tax
30
000
8
000
- Adjust the correct figure
- Correct lay out
(1Mark)
(1Mark)
List four characteristics of negotiatable certificate of deposit
-
Issued at par in bearer form with interest paid semi – annually.
-
Fixed interest (coupon) rate.
-
Yield on NCDs are determined by the supply and demand conditions.
-
Interest rates are negotiable.
(4Marks)
Q5
a) A public sale of shares is the sale of company shares to the public commonly
through an I P O. The issuing company will involve an investment banker who
underwrites the issue. (3Marks)
Private placement is where a seller contracts a investor and negotiates a price
for the issue. Often the buyer will be a large institutional investor who will agree to
hold the securities for about two years or until the company register the issue and
the maximum of investor to be involved . (3Marks)
b) 1 The investment bankers are used in the pricing of the security. For securities
offered to the public for the first time, it can be difficult to determine the price
so that the public has no exposure. The investment banker being experts in
handling such similar transactions can correctly to valuation and fix the right price
(4Marks)
2 The investment bankers help in marketing the security through their contacts
with brokerage houses. In most cases these bankers will have the trust of public in
exercising due to diligence in evaluating the risk of the films. As such their
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involvement will enhance the public have confidence in the security being
offered.This then will enable the issuer to raise the required amount of money.
(4Marks)
3 The bankers will be helpful in preparing the fillings required by the securities
and Exchange commission and arranging for the rating of the security. The bankers
will then set for SEC approval of the issue. The registration of security is a lengthy
and costly process and will be required before the securities are offered to the
public. The intention of the SEC requirements is to protect the public by requiring
the issuer to provide information ( 4 Marks)
c)
The Preferred Share holder hold claims over assets of the company and has
priority over Ordinary Share holder but come behind bond holder. (2Marks)
Q6
i
Government Stock
The risk of default is negligible. Hence this tends to form base level for return in the
market. The only certainty concerns the movement of the interest rate over time
and hence longer dated stocks will carry a higher rate of interest. (3Marks)
ii Company Loan Stock
Although there is some risk in default on the company stock which is also known as
corporate bond. The stock is usually secured against a corporate asset. (3Marks)
iii Preference Shares
These are generally riskier than loan stock since the rank behind debt in event of
liquidation, although they rank ahead of ordinary shares. They return takes the
form of a fixed percentage dividend on the par value of the share. (3Marks)
iv Ordinary Shares
Ordinary shares carry a high level of risk. Dividends are paid out of distributable
profits after all liabilities have been paid and can be subject to large in fluctuation
from year to year. However there is the potential for significant capital appreciation
in times of growth. In general, the level of risk will vary with the operational and
financial gearing of the company and nature of the market in which it operates.
(3Marks)
b) An overvalued currency is one in which current market value is stronger than
the predicted by a theory or models while undervalued currency is one in
which current market value predicted by a theory or model. (2Marks)
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c) i
Cost in Malawi Kwacha (MK)
Sale in South Africa (in MK)
= MK45 000
= 3500 X 15 (1Mark)
= 52 500
Therefore the trade makes a profit of = 75 00 (52 500 – 45 000) (1Mark)
ii Any of the two for (4Marks)
Cotton demand
There will be high demand of Malawi cotton which may result in price raise
Cotton supply
There will be increased supply of cotton in South Africa in which may eventually
lead to decrease in price of cotton.
Kwacha Demand
There would be increased demand for kwacha which might then lead to
appreciation of the Kwacha in relative to the Rand.
Q7
a) Swaps are financial instrument contracts in which parties to the transactions
exchange flow of payment. It is an exchange of cash obligation. (2Marks)
b)i Currency Swap
An exchange of payment flow denominated in different currencies. (2Marks)
ii Bill Swap
Is Swap where two parties to the arrangement agree simply to trade streams of
payment to which each is entitled. (2Marks)
iii Swaption
A contract that grants the right to enter into a swap when the swap’s market
price reaches an exercise or strike price.( 2 marks)
iv Forward Swap
Is a Swap which delays the actual swap transaction for a period ranging from a
few days to a years. (2Marks)
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c) Spot market is a foreign exchange market for contracts requiring the immediate
sale or purchase of an asset usually two or three days while forward market is a
deal arranged to exchange currencies at some future date at a price agreed now.
The deal is usually settled in one, two or six months. (4Marks)
d i) The rate to be used is 6.5230
Amount realized
= USD 21 500 x 6.5230
=
ii
R140 244.50 (2Marks)
In three months time the rate quoted is R6.5230+(601/100000 (1 Mark)
R6.5280+(611/100000) (1Mark)
= R6.5831-6.5891 (1Mark)
Therefore in three months time the realized will be
= R6.5831 x USD21500
= R141 536.65
Q8
Corporate bond
(1Mark)
12 Marks
This bond type is issued by large corporations when they need to borrow funds for
long periods. Most corporate bonds pay interest semi-annually and are callable
meaning that the issuer may redeem the bond any time.
The issuer and the funds provider will sign an indenture which is a contract that
details the lender’s rights and privileges and the borrower’s obligations. Any
collateral offered as security to the bondholder will also be described in the contract
The degree of risk varies widely among issues because the risk of default depends
on the company’s health, which can be affected by a number of variables. The
interest rate varies with the level of risk where a higher risk bond will have to pay
high rates and vice versa
Managers of the company are employed by the shareholders hence they will tend
to protect and be directed by the employer. In this view , bondholder interest may
not be well looked after .Because of this , the bond contract many include restrictive
clause which will restrain managers from doing certain actions.
This bond type will have a call provision which will give the issuer right to retire the
issue most commonly for those with restrictive clauses as sometime the clause
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may not in the best interest of shareholders .Because of this call provision ,
bondholders will require a higher rate than for the one without the call provision.
Floating rate bond
8 Marks
This bond type which is also known as a floater has the coupon rate payment which
is adjustable .The adjustments are tied to an interest rate index such as Treasury
Bill interest rate.
The value of this bond depends on exactly how the coupon payments are defined
.In most cases, the coupon adjust with a lag to some base rate
The bond will have a put provision which spells out the holder’s right to redeem the
note at par on the coupon payment date after some specified amount of time
The coupon rate will have a floor and a ceiling meaning that it is subject to
minimum and maximum. As such the bond is said to be capped and the upper and
lower rates are sometimes collar
Sometimes floating rates bonds are linked to inflation and coupon rate adjustment
is done according to the rate of inflation
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