Download FIN MRKTS 1 NO VEMBER 2012 SOL UTIONS FINAL CO PY

SECTION A-NOV 2012
MULTIPLE CHOICE SOLUTIONS
1
D
21
E
2
D
22
B
3
A
23
D
4
D
24
B
5
A
25
A
6
E
26
C
7
A
27
A
8
A
28
C
9
B
29
E
10
D
30
C
11
B
31
C
12
E
32
A
13
D
33
B
14
C
34
C
15
C
35
D
16
E
17
A
18
A
19
E
20
C
SECTION B SOLUTIONS
1. Equity market is the market for equity shares. A share represents ownership in a company. Anyone
who holds/buys shares of a company he/she is called a shareholder. A shareholder owns a
percentage interest in a firm, consistent with the percentage of outstanding stock held.
There two types of companies, namely: private and public companies. Private companies are
basically owned by families or partnerships while public companies are held by members of the
public. It is very difficult to easily obtain shares in a private company than in a public company. This
is so because public companies are listed on a stock exchange and its shares can be traded easily
rather than in a private co. where its shares are not publicly traded. For shares to be on a stock
exchange a listing procedure need to take effect. A prospectus of an issuing company is released by
the financial advisor. This brings in Initial Public Offering (IPO) where all members of the public buy
shares for the first time before shares are traded on the stock exchange. This is called primary
market. After they have been offered they can later be traded on the stock exchange in what is
called a secondary market. For one to sell/buy shares which are listed they need to go through a
broker who is a member of a stock exchange. Shares of a listed company, i.e. For PCL, TNM are
traded on an organized market/stock exchange.
Shares of a listed company cannot just change hands before being traded on a stock exchange. If
one buys shares is entitled to many things, i.e. voting rights, had control if above 51% holding, have
significant influence if below 50%. The returns that one gets from shares are in two forms. Firstly,
the capital gain/loss. This is when the share price goes up/down as compared to the initial price
spent when purchasing them. Secondly, it is dividends. When a company makes profits it
implements its policy on how to go about with its profits. It distributes part of the profit to its
shareholders in form of dividends. There is no guarantee that in each year a shareholder does
receive dividends. Sometimes the companies do not make profits and hence losses. As losses cannot
be distributed therefore no dividends are declared.
To eliminate risks in share trading it is advisable that investors diversify their investment in different
companies, i.e. hold a portfolio of different company shares as it reduces the loss when different
companies perform differently in the market. A share certificate provides proof of ownership in a
company and it is the one which when selling is presented to a stock broker for trading. Examples of
broking firms in Malawi are Stockbrokers Malawi, FDH stockbrokers, CDH stockbrokers, African
Alliance.
All the shares described above are called ordinary shares/common shares. The other type is
preference shares which more like debt as it receives its share at all times before ordinary
shareholders.
2. a. Liquidity management including cash begins the portfolio mgt activities of financial institutions.
Liquidity risk arises for two reasons-a liability side reason and an asset side
The liability side reason arises whenever a financial institution’s liability such as depositors or
insurance policyholders seeks to cash in their financial claims immediately. When the liability
holders demand cash by withdrawing deposits there is need for the financial institution to borrow
additional funds or sell of assets to meet the withdrawal.
The second source of liquidity risk arises on the asset side as a result of lending commitments. A
loan commitment allow as a borrower to take down funds from a financial institution on demand.
When a loan commitment is taken down the financial institution has to fund it on the balance sheet
immediately. This creates a demand for liquidity. As with liability withdrawals and financial
institution can meet such liquidity need either by running down its cash assets, selling off other
liquid assets or borrowing additional funds.
In reality depository institutions know that in normal times only a small proportion of depositors
withdraw funds from their accounts or put their account claims back to the bank on any given day.
Normally most demand deposits act as core deposits on a day by day basis. Core deposits are those
deposits that provide a bank with a long term funding source. Deposit drains are the amount by
which cash withdrawals exceed additions, net cash flows.
b. the investor must be compensated for trying up his money in the asset for a longer period of time
and secondly there is greater risk in lending long term than short term. To compensate the investors
for this risk they might require a higher yield on longer dated investments.
c. because debt involves lower risk than equity investment we might expect yield on debt to be
lower than yields on equity shares. More usually the opposite applies and the yields on shares are
lower than on low risk debt. This situation is known as a reverse yield gap a reverse yield gap can
occur because shareholders may be willing to accept lower returns on their investment in the shortterm in anticipation that they make capital gains in the future.
3. a. The banking industry exists primarily to provide short-term loans and to accept short-term
deposits. Banks have an efficiency advantage in gathering information. Banks should be able to
provide loans more cheaply than diversified markets which must evaluate each borrower every time
a new security is offered. Furthermore short-term securities offered for sale in the money markets
are neither as liquid nor as safe as deposit placed in banks.
Money markets exist primarily to mediate the asymmetric information problem between saverlenders and borrower-spenders and banks can earn profits by capturing economies of scale while
providing this service. However, the banking industry is subject to more regulations and
governmental costs than the money markets are.
Common characteristics in money market securities are: they are sold in large denominations, they
have low default risk and they mature within one year or less form their original issue date.
b. purposes of money markets
Low cost source of funds
Well developed secondary market for the money market instruments makes the money market an
ideal place for a firm or financial institution to warehouse surplus funds for short periods of time
until they are needed. Similarly the money markets provide a low cost source of funds to firms,
government and intermediaries that need a short-term infusion of funds
Interim investment that provides higher return
Most investors in the money market who are temporarily warehousing funds are ordinarily not
trying to earn unusually high returns on their funds but rather they use the money market as an
interim investment that provides a higher return than holding cash at bank. They feel that market
conditions are not right to warrant the purchase of additional stock, or they may expect interest
rates to rise and hence not want to purchase bonds.
To meet working capital needs
Investment advisors often hold some funds in the money market so that they will be able to act
quickly to take advantage of investment opportunities they identify
Examples of money market instruments are; government treasury bills, Repurchase agreement,
Bankers Acceptance, NCDs, Commercial paper
c. Government Treasury Department-is is always a demander of money market funds and never a
supplier. The treasury is the largest of all money market borrowers worldwide. It issues T/Bills. A
short-term issue enables government to raise funds until tax revenues are received. Treasury also
issues T/bills to replace maturing issues. T/bills are favored by most investors because they are risk
free and at the same time fetch a better income than savings deposit with banks.
Reserve (Central) Bank system
It is a Treasury agent for the distribution of all government securities. The reserve bank holds vast
quantities of treasury securities that it sells if it believes that the money supply should be reduced.
Similarly, the reserve bank will purchase treasury securities if it believes that the money supply
should be expanded. The reserve bank’s responsibility for the money supply it the single most
influential participant in the market. It controls the economy through open operations and some
fiscal measure and policies.
Commercial banks
They hold a higher percentage of government securities than any other group of financial
institutions. This is partly because of regulations that limit the investment the investment
opportunities available to banks. Specifically banks are prohibited from owning risky securities such
as shares or corporate bonds. There are no restrictions against holding treasury securities because
of their low risk and liquidity. Banks are the major issuer of NCDs, banker’s acceptances,
government funds, REPOs.
4. a. Currency appreciation vs. currency depreciation
Currency appreciation is the increase in value of the local currency against other nation’s currencies.
For example suppose the exchange rate for $1 against the Kwacha value is MK168 in such a
scenario, the kwacha has gained against the US dollar if the previous rate was $1 to MK170. This
means that you now buy $1 by giving out MK168 cheaper than giving MK170/$1.
Currency depreciation is the decrease in value of the local currency against other nation’s
currencies. The opposite in our above example is true here.
b. The bid-ask spread
This is the difference between the bid price or the price offered for the purchase of a currency, and
than ask price, or price at which the currency is offered for sale. For example suppose you are going
to USA to study banking for a semester prior to your trip you want to exchange kwacha for US dollar
the bank quotes MK245 and 255. The lower rate the bid price or buying price is the number of
kwachas the bank is willing to give you in exchange for one British pound while the higher than
ask/offer price, is the number of kwachas you would have to give to the bank in exchange for the
dollar.
c.
Nominal vs. real exchange rate
A nominal exchange rate is a bilateral exchange rate that is unadjusted for changes in the two
nation’s price level while the nominal exchange rate is a bilateral exchange rate that has been
adjusted for price changes that occurred in the two nations. The nominal exchange rate tells us the
purchasing power of our own currency in exchange for a foreign currency
d. Absolute vs. relative purchasing power parity
Absolute PPP is a theory of the relationship between prices and exchange rate is absolute PPP
because it deals with absolute price levels. For example let S denote the kwacha per currency
exchange rate of the rand, MWK/ZAR. Let P denote the price level in Malawi and P* denote the
price level in SA. Then we can express absolute PPP as P=S X P*.
Relative PPP is a weaker version of PPP as it addresses price changes as opposed at absolute price
levels. Relative PPP as an exchange rate theory relates exchange rate change to the differences in
price changes across countries. %/\S = %/\P - %/\P*
e. Overvalued and undervalued currency
An overvalued currency is one in which the current market value is stronger than the predicted by a
theory or model. This currency is likely to experience a market adjustment that brings about an
appreciation in the value of the currency.
An undervalued currency is one in which the current market value is weaker than the value
predicted by a theory of model. This currency likely to experience a market adjustment that brings
about an appreciation in the value of the currency.
5. a. Demand-pull inflation occurs when the economy is buoyant and there is a high aggregate demand
which is in excess of the economy’s ability to supply.
i. Because aggregate demand exceeds supply, price rise
ii. Since supply needs to be raised to meet the higher demand there will be an increase in demand
for factors of production and so factor rewards (wages, interest rates etc) will also rise.
Cost-push inflation occurs where the cost of factors of production rise regardless of whether or not
they are short in supply. This appears to be particularly the case with wages. Workers anticipate
inflation rates and demand wage increase to compensate. Interest rates rises can also add to the
inflation because mortgage costs ill rise.
b. perceived causes of inflation and policy control inflation
-Demand-pull (high consumer demand)
Take steps to reduce demand in the economy by high taxation, to cut consumer spending, lower
government expenditure and high interest rates
-Cost push factors
Take steps to reduce production costs and prices rises through de-regulating labour market,
encouraging greater productivity in industry, applying controls over wage and price rises.
-Import cost-push factors
Take steps to reduce the quantities or the price of imports, such a policy might involve trying to
achieve either an appreciation or depreciation of the domestic currency
-excessively fast growth in the money supply
Take steps to try to reduce the rate of money supply growth perhaps by cutting the public sector
borrowing requirement, trying to control or reduce bank lending, trying to achieve a balance of
trade surplus, maintaining interest rates at a level that might deter money supply growth.
-expectation of inflation
Pursue clear policies which indicate the government’s determination to reduce the rate of
inflation.