Download financial market 2 - Institute of Bankers in Malawi

FINANCIAL MARKET 2 – NOVEMBER 2010 ANSWERS
SECTION A
QUESTION 1
a.
Any two of the following types of foreign risk exposure
.
.
.
b.
c.
Transaction exposure (1Mark)
Translation exposure (1Mark)
Economic exposure
(1Mark)
Covered exposure is a foreign exchange risk that has been completely
eliminated with a hedging instrument. (2Marks)
while
Uncovered exposure is a foreign exchange risk that has been partly
eliminated with a hedging instrument. (2Marks)
SFP
= (Fn-S)/Sx12/Nx100
(1Mark)
= (24-22)/22x12/9x100
(1Mark)
= 2/22x12/9x100%
(1Mark)
= 24/198x100
= 12% or 12.12%
d.
(1 Mark)
The relationship between the spot exchange rate, interest rate differential
and forward rate is called interest rate parity. This means that by hedging
in the forward currency exchange market, an investor will realize the
return irrespective of whether investing domestically or in the country from
which the foreign currency originates. The mechanism that will bring
about interest arbitrage parity is called covered interest arbitrage.
(5Marks)
Q2
a.
Closed – end investment scheme is the one which issues fixed non
redeemable share which are sold at an initial offering and are then traded
in the over – the – counter market as in the case with any listed stock .
The market prices of these shares fluctuate with the value of assets held
by the scheme. The market value of the shares may be over or below the
asset held by the fund depending on the market assessment. (4Marks)
Open – end investment scheme on the other hand is the one which offers
for sale shares on a continuous basis or has outstanding any security
which is redeemable at the holders option. Investors in this scheme
contribute at any time in exchange for shares. The scheme can also
agree to buy back shares from investors at any time. The schemes net
asset value is computed on daily basis based on the number of
outstanding shares. All shares bought or sold are traded at net asset
value.
(4Marks)
b.
Initial investment
= 800 000
Sale proceeds
= 980 000 less 7%
(1Mark)
= 911 400 – 800 000
Profit on the investment
= 111 400
Rate of return on this investment
(1Mark)
(1Mark)
= 111 400 x 100/800 000
= 13.93% or 13.925% (1Mark)
c.
Any three of these for 3 marks
.
.
.
.
Investment acquire in the year
Investment disposed in the year
Portifolio of investment existing as at the end of the year and thei
valuation with a mention of basis of valuation.
A computation of the value of a unit participation of shares as units at
the end of the year.
Q3
a.
Yield to maturity is the rate of return on a bond if it is held until it matures
which reflects the market price of the bond, the bond’s coupon return and
any capital gain from holding the bond to maturity. (3Marks)
or
This is the rate of return that the owner of the instrument would earn by
holding the instrument until maturity or stated date at which final principal
and interest payments are due.
b
Perpetuity bond is a type of bond with an infinitive term to maturity / a bond
that has no maturity date. (1Mark)
ci
The relationship that exist between market interest rates and bond prices is
that whenever interest rates falls, bond prices rise and those who hold
bonds earn a nominal capital gain. In contrast, if the rates rise then bond
prices decline and investors who hold bonds incur nominal capital loss.
(4Marks)
ii Students to give any example to illustrate the point
To present this relationship in figures let assumes a bond that pay K100 per
year forever at a time when interest is 8 % and a time when interest is 9%.
Here below will be the price of the bond (2Marks)
.
At the time when interest is 8%
Price of the bond
= Coupon payment
-----------------------Market interest rate
(1Mark)
= 100/8%
(1Mark)
= 100 x 100
-----------8
= MK1250
.
(1Mark)
At the time when interest is 9%
Price of the bond
= 100/9%
(1Mark)
= 100 x 100/9
= 1 111.11
(1Mark)
The calculations clearly show the relationship that the higher the interest rate, the
lower the price of the bond.
Any five of these for 3 marks each
i
Current price of the underlying assets
The option price will change as the underlying asset changes. For a call
option , as the price of the underlying increases, (all factors be constant), the
option price increases. The opposite holds for put option because as the
price of the underlying increases, the put option price decreases.
ii
Strike price.
The strike price is fixed for the life of option. All factors being equal, the
lower the strike price, the higher for a call option. For a put option the
higher the exercise price the higher the option price.
iii
Time to expiration of the option.
An option is a wasting asset as after the expiration date the option has no
value. This follows that, the longer the time to expiration of the option, of
higher the option price. This is because as the expiration date downs near,
the lesser the time remains for the underlying price to rise for a call buyer or
fall for a put buyer.
iv
Expected price volatility of the underlying asset over the use of the option.
The greater the volatility of the prices of the underlying asset the more an
investor would be willing to pay for the option and the more the option writer
would demand for it. This is because higher volatility gives higher
probability for the price of the underlying to move in favour of the buyer
before option expiration date.
v
Short term, risk free interest rate over the life of the option.
Buying the underlying asset ties up one’s money. Buying an option on the
same quantity of the underlying assets makes the difference between the
asset price and the option price available for investment at an interest rate
at least as high as the risk – free rate. Consequently the higher the short
term, risk – free interest rate, the greater the cost of buying the underlying
and carrying it to expiration date.
vi
Anticipated cash payments on the underlying asset over the life of the
option.
Cash payments on the underlying assets tend to decrease the price of a
call option because the cash payment make it more attractive to hold the
underlying asset than hold the option. For put option, cash payments on the
underlying assets tend to increase the price.
QUESTION 4
a.
The binominal option pricing model is based on a construction of a well
hedged portifolio which combines options with the underlying asset in
order to create a risk-less position. In variably, this synthetic risk – free
portfolio requires the sale (purchase) of multiple call (puts) to offset to full
cash exposure of a single share of stock held long. The hedge ratio
changes with movements in underlying asset’s price and passage of time.
Hence demands a frequent rebalance of the portifolio with an aim of
maintaining a portifolio which earn at a risk – free rate.
(7Marks)
b
Any 4 of these assumption for 4 marks
. The model assumed no transaction cost or taxes.
. The model assumed that all securities are perfectly divisible.
. The model assumed that short selling of securities are permitted.
. Trading of securities was assumed to be continuous and that markets
are always open.
. Interest rate was assumed to have spread and risk – less, constant and
irrespective of the asset maturity.
. The spot price behaviour was assumed to log- normally distributed with
constant mean and standard deviation.
SECTION B
QUESTION 5
(a)
Collective investment scheme is a term referring to any scheme where
funds from various investors are pooled together for investment purposes
with each investor entitled to a proportional share of net benefit of the
ownership of the underlying assets. (3Marks)
(b)
Any three for 6 marks
Collective investment scheme is preffered based on the followingi
Diversification – the risk of investment is spread as funds are invested
in a range of securities.
ii
Proffesional expertise is accessed as portifolio is handled by experts.
iii
Provides choice as there are increasing number of alternative funds
from which to choose.
iv
Reduced cost benefit as investment dealings are dealt in bulk and at
reduced transaction cost.
2 Marks for each
c
The collective investment scheme is not favourable based on the following –
i
Cost in respect of funds management and advice could be avoided
if investors manages their own portifolios assuming investors are
knowledgeable
ii.
Although investors have a large variety of funds to choose from,
they have no control over the choice of individual holding within
their portfolios.
iii.
Investors have no rights associated with individual holding say right
to attending annual general meeting of the company and vote on
impacting the company.
d i
Net Asset Value is net worth of the fund/scheme translated per
each outstanding share holding. (1Mark)
ii
MK`000
= 28 000
Value of shares in listed companies
Bond value
= 14 000
Treasury bill investment
= 8 500
Fixed deposit
=
Less fees and expenses payable
=
985
------------------
NET FUND WORTH
325
50 490
------------------
Net asset value
= 50490/16500
= K3.06
Yield on investment
(1Mark)
(1Mark)
= 3.06 – 2.39/2.39
=
0.67
(1Mark)
=
0.67/2.39x100
=
28.00 % or 28.03 %
(1Mark)
QUESTION 6
i
Do nothing
Under this strategy, the exporter will have to do nothing but wait for whatever
spot rate that will be available at the time of receiving payment. This may result
into making either an exchange rate gain or loss. This policy is favourable
because in most case it provides a win some and lose some situation. It also
hedges gains fees and other transactional cost.
The policy basically is dependent on management degree of risk a version to
high cash flow variability of share holders to reported fluctuations of foreign
exchange gains and losses. 4 Marks
ii
Issuance of invoices in Malawi kwacha
This way bypasses exchange risk because it insist that foreign customers pay
supplies in domestic currency. It pass all the risk in exchange rate to the
customer.
Some customers may dislike this risk being pushed to them as such, the
marketability of cement in Zimbabwe could be adversely affected and hence
customers may opt to look for other suppliers. 4 Marks
iii
A leading and Lagging strategy
Leading in this policy refers to bringing forward from original paying date of the
debt while lagging refers to postponement of a payment to a later date. This
policy tend to be useful when one is convinced that the exchange rate will
significantly and favourably shift on those new arranged dates. The early
settlement will largely help to improve cash flow while late payment may impact
the cash flow. 4 Marks
iv
Money market hedge
Money market hedge involves borrowing in the money market immediately after
raising an invoice. The amount borrowed need to be structured in a way that
when the payment comes, it will clear off all the liability created. The funds
borrowed can easily be invested and earn interest within the settlement period.
Steps in money market hedge are as follows.
.
.
.
.
v
Invoice the customer
Borrow to an invoice amount
Sell the kwacha borrowed at spot rate and receive foreign currency now.
Receive settlement at due date.
Pay lender and clear the debt.
4 Marks
Futures contract
A futures contract is an agreement to exchange a specific amount of a currency
for another at a future date for predetermined price / rate. Futures are
standardized contracts as such they are tradable in the regulated exchanges
making it easier for the cement company in cases where they might wish to sell
the contract and ash in much easier. In efforts of hedging the currency, futures
will usually attempt to have a futures position which has an underlying
transaction.4 Marks
QUESTION 7
i
Monetary policy
The policy relates to the control of some measure of the money supply, and level
and structure of interest rates. The importance attached to this policy largely
depend on Government view on the operation of the economy and also its
priority given to different objectives, for example government may choose to
attach more importance to attainment of low inflation rate or maintain it at
reasonably high level.
5 Marks
ii
Fiscal Policy
Fiscal policy is concerned with decision regarding the level and structure of
government’s expenditure and taxation. The importance attached to expenditure
and taxation will determine level of public sector borrowing requirements.
This
policy influences the level of aggregate demand within the economy.
It is viewed to be expansionary if government increases expenditure relative to
taxation in order to boost the level of spending within an economy and thereby
bringing more people into employment and enhancing economy. On the other
hand, it is considered to be contractionary when government raises taxes relative
to expenditure as this result into reducing aggregate demand and lowering
inflation demand for imports with possible side – effects of lowering employment
and growth. 5 Marks
iii
Exchange rate policy
This policy targets a particular value of exchange rate relative to other foreign
currency. The purpose is to influence the flows within the balance of payments
and may in some case be used for such measures as exchange control, import
and quotas 5 Marks
iv
National debt management policy
This policy is concerned with the manipulation of outstanding stock of
government debt instrument held by the domestic private sector with the
objective of influencing the level and structure of interest rates and availability of
reserve asset to the banking system. This policy relates well with both fiscal and
monetary policy especially when government decision is to issue more
securities.5 Marks
QUESTION 8
Below are four reasons why financial market regulation is important
i
Protect the users and providers of financial services
Market regulation is vital as it protects users from unscrupulous or
incompetent service providers with emphasis on protecting small and
unsophisticated investors or saver. The protection is also offered to the
providers against their own greed or ineptitude.
4 Marks
ii
Promote the stability of financial institutions
Regulation contributes in maintaining the stability of the financial system,
as the failure of financial intermediary can not only cause liquidation of the
firms and unemployment to those directly involved but may also
undermine the confidence of the whole financial system.
4 Marks
iii
Promote competition and fairness in the financial market
Regulation will prevent insider dealings of employees and associates
dealing in the company’s securities before sensitive news is published. It
will also ensure that all financial institutions disclose transactional cost. In
some cases regulation will also help in simplifying financial contracts so
that all parties involved are fully aware.
4 Marks
iv
Ensure that issuer of securities do not conceal relevant information
Regulation will emphasis on dissemination of information to investors
because users of funds normally have knowledge of their affairs than their
potential lenders or investors. This helps investors from dealing with
companies without making necessary inquiries
4 Marks
b
Four objectives of economic policy are
.
A high and stable level of employment
.
A low and stable rate of inflation
.
A high rate of economic growth
.
A satisfactory balance of payment
4 Marks