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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