Download FINANCIAL MARKE TS 2 SOLUTIONS NOV 2014

INSTITUTE OF BANKERS IN MALAWI
ADVANCED DIPLOMA IN BANKING EXAMINATION
SUBJECT: FINANCIAL MARKETS II
Date:
Time Allocated: 3 hours (13:30 – 16:30 pm)
SUGGESTED SOLUTIONS
SECTION A
1.
FROM:
To:
Subject:
(60 MARKS)
MEMO
Martyre Consulting Group (MCG)
Government of Martyred
Economic policy choices for 2014/15 fiscal year
a) Monetary Policy relates to the control of some measure (or measures) of the
money supply and /or the level and structure of interest rates. The importance
attached to monetary policy within a government’s policy package will depend
not only upon its view of the operations of the economy but also upon its
decision it has reached regarding the priority given to different objectives
(2 Marks)
b) Fiscal Policy is concerned with decision regarding the level and structure of
government expenditure and taxation. Given the importance of the level of
government expenditure and taxation in determining the size of the public
sector borrowing requirement of the debt repayment, fiscal policy also involves
decisions regarding the size of the public sector borrowing requirement.
(2 Marks)
c) Exchange rate policy involves the targeting of a particular value of the
exchange rate relative to any one currency may carry particular weight the
value of the currency relative to the country’s major trading partners in general
is more likely to be objective.
(2 Marks)
d) Price and Income Policy is intended to influence the rate of inflation by means
of either statutory or voluntary restriction upon increase in wages, dividends
and/ or prices and incomes over which such a policy may prevail, and the
degree of statutory control involved, is subject to considerable variation.
(2 Marks)
e) National Debt Management Policy is concerned with the manipulation of the
outstanding stock of government debt instruments held by the domestic private
sector with the objective of influencing the level and structure of interest rate
and/ or the availability of reserves asset to the banking system
(2 Marks)
A qualification examined by the Institute of Bankers in Malawi
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(Total Marks 10 Marks)
Actual as at 30th June 2013
Target for 30th June 2014
Policy
Key economic indicator
Martyre Kwacha/USD
Minimum wage
Inflation
Income tax
Treasury bills issued
350
MK 18,000
30%
30%
MK 500 Bn
400
MK 30,000
20%
40%
MK 700 Bn
Exchange rate policy
Price & Income policy
Monetary policy
Fiscal Policy
National Debt Policy
(3 marks)
3. It is important that government takes a mixture because one policy has an influence
on the outcome for another policy i.e. a pursuant of fiscal policy has impact on the
monetary policy
(2 marks)
Question 2
FROM:
To:
Subject:
a)
b)
Officer
Supervisor
Response to petition by movement for justice
Reserve requirements; Banks and building societies need to hold a base of
reserve asset for prudential purposes. If and when a bank or building society
false to its minimum desired reserve asset ratio it will have to turn away any
incoming demands for loans or else seek to acquire additional reserve assets
from which to expand its lending
Special deposits are deposits that reserve bank of Malawi may require certain
banking institutions to deposits, equal to a specified proportion of certain
element of their deposits liabilities, are the frozen at the reserve bank of Malawi
and may not be used as part of the reserve asset within the system.
c)
Supplementary special deposits are additional deposit are deposit that banking
institutions had to make at the reserve bank of Malawi if and when a category
of their deposit liability exceeded an upper limit set by the reserve bank of
Malawi.
d)
‘Moral suasion refers to the range of informal request and pressure that reserve
bank of Malawi may exert over banking institutions. The extent to which this is a
real power of the bank relative to direct controls is open to question, since
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much of the pressure that the bank would exert would involve the institutions
taking actions that were not in their commercial interest.
e)
Direct controls involve the Reserve Bank of Malawi in issuing directives in order
to attain particular targets. Thus for example, the RBM might impose control on
interest rates payable upon deposits, impose limits on the volume of credit
creation or direct banks priorities lending banks priorities lending according to
type of customers.
Total Marks (10 Marks)
i) The prices for banking services –
Direct control
ii) The banks to open agencies in districts –
Moral suasion
iii) High lending rate –
Direct control
iv) Banks corporate social responsibilities –
Moral suasion
v) Increased capital requirement –
Reserve requirement
(5 Marks)
(Total 15 Marks)
Question 3
i)
Covered interest parity is condition relating the interest rate differential on
similar financial assets in two nations to the spot and forward exchange
rates, in equilibrium; the interest differential on the two assets is equal to the
forward premium or discount. If covered interest parity does not hold,
financial arbitrage is possible, and individuals will move savings from one
nation to another.
Uncovered interest parity is a condition relating the nominal interest rate
differential on two similar financial instruments to the expected change in
the spot exchange rate. If there is a sizable amount of foreign exchange risk
or country risk, the interest rate differential may also reflect a risk premium,
which compensates individuals for the additional risk they assume.
(5 Marks)
ii) Open ended Investment Scheme is any collective investment scheme which
offers for sale on a continuous basis or has outstanding any security which
is redeemable at the holder’s option. Another distinguishing feature is that
the scheme agrees to buy back shares from investors at any time.
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Both terms refer to types of investment schemes.
(5 Marks)
Leading is the bringing forward from the original due dates the payment of
a debt while lagging is the postponement of a payment beyond the due
date.
Similarities: Both terms refer different ways of hedging against foreign currency risks.
(5 Marks)
Crawling peg is an exchange rate arrangement in which a country peg its
currency to the currency of another nation but allows the parity value to
change at regular time intervals. The most common argument foe pegged
exchange rates is that reducing exchange rate volatility and uncertainty may
yield gains in economic efficiency.
Currency basket peg is an exchange rate system in which a country pegs
its currency to the weighted average value of a basket or selected number
of currencies. The most common argument pegging one’s currency is that it
reduces exchange rate volatility and uncertainty may yield gains in
economic efficiency.
Similarities: Both terms refer to different exchange rate systems
(4 Marks)
(Total 15 Marks)
Question 4
i)
Fund Manager is a corporate body or an institution or an individual that
manages the collective investment scheme. The fund managers will handle
operation, human resources and finance of the collective investment
scheme. Mostly fund managers are financial institutions like banks, discount
houses, and brokers.
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ii)
Fund Administrators mages the trading, reconciliations, valuation and
unit pricing.
iii)
Board of Directors or trustees are persons who are entrusted with
safeguarding the assets and ensuring compliance with laws, regulations
and rules of the collective investment scheme.
iv)
Unit holders these are persons who own (or rights to) the assets and
associated income of collective investment scheme.
(8 Marks)
a) Load open-ended investment scheme is a scheme that charges a sale fee for
shares sold. The offering price for a share of a load scheme equals the net
asset value plus sale charge, which can be as large as 7.5 -8% of the net asset
value.
A Load open-ended investment scheme imposes no initial sales charge so it
sells shares at their asset value. Some of these funds charge a small
redemption fee of about one-half of %
(5 Marks)
a) Cost of shares = MK 5,000,000.
Number of shares
= 1,000,000 shares
5% of MK 5,000,000.00 = MK 250,000.00
Therefore 1,000,000 shares costing MK 4,750,000.00
The cost per share is MK 4.75
(3 Marks)
(Total 15 Marks)
SECTION B
(40 MARKS)
Question 5
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1. Transaction exposure is the risk that the cost of a transaction, or the
proceeds from a transaction, in terms of the domestic currency, may change
due to changes in exchange rates
Transaction exposure is created when a firm agrees to complete a foreign
currency denominated transaction some future time in the future.
Translation exposure is the foreign exchange risk that results from the
conversion of the future value of a firm’s foreign currency denominated
assets and liabilities into a common currency value.
Translation risk arises because financial data denominated in one currency
are then expressed in terms of another currency. Between two accounting
dates the figures can be affected by exchange rate movements, greatly
distorted comparability.
The translation exposure has two elements the balance sheet effect
(Financial Position Effect) assets and liabilities denominated in a foreign
currency can fluctuate in value in home currency terms with forex market
changes.
The profit and loss account effect (Comprehensive Income Effect) currency
changes can have an adverse impact on the profit because of the
translation of foreign subsidiary units.
Economic exposure is the risk that changes in exchange values might
alter a firm’s present value of future income stream. Economic exposure
affects the ability of a firm to compete in a particular market over an
extended period of time.
(9 Marks)
i)
ii)
iii)
iv)
v)
vi)
Invoice customer in the home currency
Do Nothing
Netting
Matching
Leading and lagging
Money market hedge
(One of them)
(1 Mark)
i)
ii)
iii)
Expansion of agricultural export base – More agricultural products will be
commercial and exported there by creating foreign currency for the
country
Explorations of mining- the exploration of minerals and exportation of
minerals will bring more create a forex base for the country as a majority
of the minerals will be sold to other countries.
Regional Transport integration – where the transport system is
integrated regionally the cost of transportation will be low, and therefore
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the prices of the goods will also be low, making the goods compete at
the international markets
iv) Foreign direct investment – the foreign companies will provide startup
capital in foreign currency and this will boost the local forex reserve.
Increased domestic manufacturing – will slow the import base thereby
creating a low pressure to provide import cover.
(10 Marks)
v)
(Total 20 Marks)
Question 6
Segmented markets theory
Segmented market theory is a theory of the term structure of interest rates that views
Bonds with differing maturities as non-substitutable, so that their yields differ because
They are determined in separate markets.
The key idea behind the segmented markets theory of the term structure of interest
rates in that financial instruments with differing terms to maturity are not perfect
substitutes .consequently , they essentially are traded in separate financial markets
,even though they may be nearly identical instruments in all respect other than in their
terms to maturity.
Then the interactions between supply and demand conditions within each individual
market determine each instrument’s yield.
The expectation theory
The expectation theory of the term structure of interest rates that views bonds with
differing maturities as perfect substitutes, causing their yields to differ solely because
traders anticipate that short – term interest rates will rise or fall.
A theory that can shed light on both of these issues is called the expectation theory of
the term structure of interest rates, we can illustrate that basic features of the
expectation theory be examining a setting in which an individual plans to save funds
over a two – year period. The individual confronts two possibilities.
One option is to hold a two year bond for two years to maturity or to hold a year bond
but roll it for two years.
Naturally the individual would be willing to hold either one –year bond or either a two
year bond only if he expects that his return over the two would be the same.
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The preferred habitat theory
Preferred habitat theory of the term structure of interest rates that views bonds as
imperfectly substitutes, so that yields on long term bonds must be greater than those
on short term bonds even if short-term interest rates are not expected to rise or fall
The key assumption on preferred habitat theory is that holding all other factors
constant investors usually prefer to hold financial instruments with shorter maturities.
The reason is that short term instruments are more liquid hence desired as compared
to long term instruments.
(Total 20 Marks)
Question 7
Current Price – is the underlying price
The current price will change as the price of the underlying asset changes. For
a call option as the underlying price increases.
(4 Marks)
Strike Price – is the strike price which is fixed for the life of the option. All
other factors equal, the lower the strike price, the higher for a call option.
(4 Marks)
Time to expiration – An option is wasting asset. That is, after the expiration
date the option, ha no value. All other factors equal, the longer the time to
expiration of the option, the higher the option price. This is because, as the time
expiration decreases, less time remains for the underlying asset’s price to rise
(for a call buyer) or fall (for a put buyer), and therefore the probability of a
favorable price movement decreases.
(4 Marks)
Expected price volatility of the underlying asset over the life of the option.
The greater the expected volatility (as a measure by the standard deviation or
variance) of the price of the underlying asset, the more an investor would be
willing to pay for the option, and the more an option writer would demand for it.
(4 Marks)
Short – term, risk free interest rate over the life of the option
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Buying an option on the same quantity of the underlying asset makes the
difference between the asset price and the option available for investment at an
interest rate at least as high as the risk-free rate.
(4 Marks)
Total Marks (20 Marks)
Question Eight
The four panels below relate to a Malawi Kwacha currency and a Botswana pula
currency, in relation to interest rates Vis a Vis supply and demand for these two
countries.
S (K/BWP)
F (K/BWP)
SBWP
S’BWP
A
SBWP
F2
S1
S2
B
F1
B
A
DBWP D’BWP
Q BW P
DBWP
Q BW P
Q 1 BWP
Q 2 BWP
Q 1 BWP
Panel (a)
Q 2 BWP
Panel (b)
RBW
S’L
S’L
SL
SL
B
R1MW
R2BW
R1BW
A
R2MW
B
A
DL
Q 2 L Q1 L
Panel (c)
DL
Q 2 L Q1 L
Panel (d)
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Each of these market frameworks at an initial equilibrium indicated by point ‘A’ Panel a
show the spot market for the Botswana pula, panel b) displays the forward market for
the pula, panel c illustrates the loanable funds (L) market in Botswana, and panel d
displays the market for loanable funds in Malawi.
To move savings into Malawi, individuals must exchange the Botswana pula for the
kwacha, so there is an increase in the demand for the kwacha. The increase in
demand for the kwacha corresponds to an increase in the supply of the pula, shown
by a shift of the supply curve in panel ‘a’ from S BWP to S’BWP as shown in panel a, the
increase in the supply of the pula in the spot market causes a decline in the spot rate,
or depreciation of the pula relative to the kwacha, shown by the movement from S 1 to
S 2.
Botswana individuals who purchase Malawi treasury instrument will likely desire to
receive their principal and interest in pula upon maturity If these individuals cover their
exposure to foreign exchange risk, they will purchase the pula forward. This is
illustrated by an increase in the demand for pula in the forward market, shown by a
shift from DBWP to D’BWP in panel b, the increase in the demand for the pula on the for
the pula on the forward market will cause the Pula to appreciate relative to the
kwacha, as shown by an increase in the forward rate from F1 to F2.
The flow of savings out of Botswana causes a decrease in the supply and loanable
funds, shown by the shift of the supply curve from SL to S’L in panel C. a decrease in
supply of loanable funds in Botswana causes an increase the Botswana interest rate
from RBW1 to RBW2. The flow of savings into Malawi causes an increase the supply of
loanable funds from SL to S’L in panel d which causes Malawi interest rate to decline
from RMW1 to RMW2.
(Total 20 Marks)
END OF EXAMINATION PAPER
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