Download MAY 2010. FINAL doc - Institute of Bankers in Malawi

MODEL ANSWERS
SECTION A
Question 1
(a)
(b)
The two components of an investor’s required rate of return are as follows;

The time value of money during the period of the investment. (2 marks)

The expected rate of inflation during the period. (2 marks)
The fundamental principles of investment are as follows;

Time value of money: this is the influence that interest rates have on the
value of money over a period of time. (2 marks)

Risk versus return: Risk refers to uncertainty about the occurrence of a
future outcome. Risk can be divided into financial and non financial risk.
Financial risk is the possibility that a future event will diminish the value of
an investment. Financial risk is measured by the standard deviation and
the coefficient of variation. Non financial risk is exposure to uncertainty
which is non monetary in nature, e.g. health and safety risk. Return refers
to the capital appreciation or loss in the form of cash dividends or interest
resulting from investment. Historical returns are measured by the holding
period return (HPR) and holding period yield (HPY), whereas future
returns are measured by the expected return and required rate of return.
(4marks)
(c)
Students must choose any five from the following asset classes (5 marks)







Equity
Fixed income securities (which would include bonds, shares and bank
deposits)
Debt instruments
Real estate
Art objects
Rare stamps
Currencies
Question 2
(a)
An investment Manager would take the following steps:

Establish investment objectives and constraints. (2 marks)

Establish the investment policy. (2 marks)
1
(b)

Select a portfolio strategy. (2 marks)

Select assets. (2 marks)

Measure and evaluate performance. (2 marks)
The expected rate of return is the rate expected to be realised from an
investment and is calculated by multiplying the probabilities of occurrence by
their associated outcomes. The required rate of return is the minimum return
an investor would require from an investment, given the riskiness of the
instrument. If the expected return is less than the required return, the
investment is not worth pursuing. (5 marks)
Question 3
Interest – bearing instruments are instruments that pay interest on the initial
investment amount to the holder. They include: (2.5 marks)

Overnight/time/term deposits
(1 mark)

Negotiable certificate of deposit
(1 mark)

Reserve bank debentures
(1 mark)

Repurchase agreements
(1 mark)

Roads board bridging bonds
(1 mark)
Discount instruments are instruments that do not pay interest to the holder,
but are purchased at a discount on the nominal value. They include: (2.5
marks)

Treasury bills
(1 mark)

Bankers Acceptances
(1 mark)

Commercial paper
(1 mark)

Promissory notes
(1 mark)

Land bank bills
(1 mark)

Capital project bills
(1 mark)
Question 4
The Securities Industry and Financial Markets Association in U.S.A and Asia classify
the broader bond market into five specific bond markets. (15 marks)

Corporate
2




Government & agency
Municipal
Mortgage backed, asset backed, and collateralized debt obligation
Funding
SECTION B
Question 5
Primary markets are markets dealing in the issue of new securities. These can be
initial public offerings (IPOs) for public companies, government bonds or other
private and public sector funding programs. In a primary market, the security is sold
directly to the investor from the company or organization itself. As in the case with
IPOs, it is a purchase between the company and the investor. In the case of
municipal bonds, it is the purchase of the debenture directly from the municipality.
Primary markets are a vital part of the capital markets and underlying strength of the
economy. (5 marks)
Secondary Market Once something has gone through its offering in the primary
market, it will then be made available in secondary markets such as stock
exchanges and through brokerage firms. There may be a specified period before the
issue can be sold on a secondary market to allow it to preserve the strength and
integrity of the offering as in cases with IPOs. Once securities are on the aftermarket,
they can be bought and sold based on demand. Securities exchanges are the "store"
that these securities are sold with sales forces extending through brokerage firms.
The information presented on the nightly news with market ups and downs is
referring to the secondary markets most often. (5 marks)
The secondary markets support the primary market by:

Giving investors liquidity, price continuity and depth. Investors would be
hesitant to purchase new securities if they did not have the opportunity to sell
them at a later stage. (5 marks)

Providing information about current prices and yield. Prices and yield in the
secondary market are taken into consideration when investment bankers plan
for new issues of securities. (5 marks)
Question 6
(i) Required return (ABC) = Rf + Bi (Km –Rf)
= 0.07 + 2.4 (0.12 – 0.07)
= 0.19
= 19%
Required return (XYZ)
= Rf + Bi (Km –Rf)
3
= 0.07 + 0.8 (0.12 - 0.07)
= 0.11
= 11%
(ii) Required return (XYZ) = Rf + Bi (Km –Rf)
= 0.08 + 0.8 (0.12 - 0.08)
= 0.112
= 11.2%
It would offer a higher return. (20 marks)
Question 7
(a)
FV =
K10,816
PV =
Principal added:
K10,000
Interest added:
Period No.
01/01/08
0
K400
K416
←6 months→
06/30/08
1
←6 months→
12/31/08
2
n = 2 semi-annual periods; i = 4% per semi-annual period
(5 marks)
(b)
Input
Function
1000
PMT
5
N
7
I
CPT
4
FV
5750.74
(5 marks)
Question 8
(a)
The top down approach involves an analysis of microeconomic influences and
industry analysis before the company can be analysed. The bottom up
approach uses valuation techniques to value assets without considering the
influences of macroeconomic and industry forces on the prospects of the
company. (5 marks)
(b)
A restrictive monetary policy has the effect of raising the market interest rates,
which, in turn, increases companies’ borrowing costs and thus affects the
profitability of companies. Individuals would also be affected because it would
be expensive for them to borrow money from the bank to finance their homes,
motor vehicles and other durable goods. (5 marks)
(c)
The idea behind the three step valuation process is to identify the
macroeconomic influences that may impact on the company’s ability to
generate earnings. Once you have identified these factors, it is easier to
analyse the earning capabilities of industries and companies. (5 marks)
(d)
The following is a list of porter’s five forces

The threat of substitute products (1 mark)

The threat of the entry of new competitors (1 mark)

The intensity of competitive rivalry (1 mark)

The bargaining power of customers (1 mark)

The bargaining power of suppliers (1 mark)
5