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FINANCIAL MARKETS 2 SOLUTIONS – MAY 2013SECTION A(60 MARKS)Answer ALL questions from this section.QUESTION 1The conventional four objectives of economic policy are as follows;such as constraining inflation-a low and stable rate of inflation. Many economists argue that low inflation is a necessary prerequisite for achieving sustainable economic growth.maintaining an exchange rate-a satisfactory balance of payments which is usually taken to mean equilibrium on the current account of the balance of payments implies that a country is able to pay its way in international terms and to purchase imports, while a surplus would imply that its stock of overseas net assets is, in addition, increasing.Achieving full employment-Usually meaning high and stable level of employmenteconomic growth-high rate of economic growth over time leads to increase in the living standards of the population. Therefore, inevitably, governments will focus on this goalYes, sometimes they are conflicts. One kind of conflict involves deciding which goal should take precedence at any point in time. any point in time. For example, suppose there’s a recession and the government works to prevent employment losses from being too severe; this short-run success could turn into a long-run problem if monetary policy remains expansionary too long, because that could trigger inflationary pressures. So it’s important for the government to find the balance between its short-run goal of stabilization and its longer-run goal of maintaining low inflation. Another kind of conflict involves the potential for pressure from the political arena. For example, in the day-to-day course of governing the country and making economic policy, politicians may be tempted to put the emphasis on short-run results (e.g. stabilizing exchange rate by managing it) rather than on the longer-run health of the economy. Wages and prices will begin to rise at faster rates if monetary policy stimulates aggregate demand enough to push labor and capital markets beyond their long-run capacities. In fact, a monetary policy that persistently attempts to keep short-term real rates low will lead eventually to higher inflation and higher nominal interest rates, with no permanent increases in the growth of output or decreases in unemployment. As noted earlier, in the long run, output and employment cannot be set by monetary policy. In other words, while there is a trade-off between higher inflation and lower unemployment in the short run, the trade-off disappears in the long run. Policy also affects inflation directly through people’s expectations about future inflation. For example, suppose the Central Bank eases monetary policy. If consumers and businesspeople figure that will mean higher inflation in the future, they’ll ask for bigger increases in wages and prices. That in itself will raise inflation without big changes in employment and output. QUESTION 2The Purchasing Power Parity (PPP) theory is based on the idea that a basket of goods should cost the same regardless of the currency in which it is sold. if the exchange rate is US$1/MK400 and US$1/R1.50; The cost a basket of goods in Malawi, Given that a basket of goods in South Africa costs ZAR10, 000 would be: MK2,666,666.67(2 marks)At the end of the year the cost of goods in Malawi Kwacha will be;MK2,666,666.67 + (MK2,666,666.67 x 3%) = MK2,746,667.67in South Africa will be;R10,000 + (R10,000 x 15%) = R11,500 At US$1/R1.50, this is equal to US$7.666.67An At US1/MK400 this is equal to MK3,066,666.67Therefore it is better to buy the basket of goods in Malawi because of the low inflation rate. (5 marks)The UK investor will achieve the same when either investment matures and this can be illustrated below;Beginning of the yearExchange ?1 m for US$1.5 million at the spot rate of US$1.5 m at the spot rate of US$1.5/?1.00 Buy US$1.5 m government bonds yielding 8% Arrange a one-year forward transaction at US$/?1.5283 to sell dollarsEnd of yearExchange US$1.62 m (US$1.5 m x 1.08) with a bank which agrees to a forward exchange at the beginning of the year at the rate of 1.5283 to produce 1.62 ÷ 1.5283 = ?1.06. This is equal to amount that would have been received by investing in UK government bonds, 6% over the year. The differential between between the spot and forward rates exactly offsets the difference in interest rates. (8 marks) (Total 15 marks)QUESTION 3Contrast the following terms;Yield to maturity is the rate of return that the owner of the instrument would earn by holding the instrument until maturity or the stated date at which final principal and the interest payments are due. It can also defined as the interest rate that equates the present value of payments received from a debt instrument with its value today. While Yield curve is a chart or graph showing yields on similar bonds with different terms to maturity Nominal Yield is the coupon return on a bond divided by the bond’s face value while Currency Yield is the coupon return on a bond divided by the bond’s market price (5 marks)E-love Sugar Limited issues a coupon bond with K1,000 face value that will pay you a coupon payment of K100 per year for ten years and at maturity date repay you f K1,200 (the price that you can sell it if you hold it to maturity). The current price of the bond is MK800. Suppose you invest in the bond now and hold it to maturity, what is the bond’s;Nominal Yield= K100/K1000 = 10%(2 marks)Coupon Return = 10%(2 marks)Currency yield at maturityK100/K800 = 8%(3 marks)Yield to maturity if the price of the bond is MK1, 000 (same as the par value).10% (yield to maturity is equal to coupon rate if market price is equal to face value) (3 marks)QUESTION 4What is meant by the following terms in relation to options;Intrinsic Value of an option, at any time, is its economic value if it is exercised immediately.(2 marks)Time value is the premium over the intrinsic value and is also referred to as Time premium. Time value arises because of the potential for the market price of the underlying to change in a way that creates intrinsic value. The longer the time over which the exercisable the greater the chance the price will move to give intrinsic value.(2 marks)When an option has intrinsic value, it is said to be In the Money (2 marks) An option for which the strike price is equal to the current price is said to be At the money (2 marks)When the strike price of a call option exceeds the current asset price, the call option is said to be Out of Money (2 marks)intrinsic and time value on each of the following options given a share price of 732 tambala?OptionIntrinsic ValueTime Value700 call32 tambala23.5 tambala750 call028 tambala700 put017.5 tambala750 put18 tambala22 tambala (5 marks) (Total 15 marks)SECTION B(40 MARKS)Answer ANY TWO questions from this section. QUESTION 5In May 2012, Malawi moved from one exchange rate regime to a different one. Malawi moved from a Fixed Exchange rate regime to a floating exchange rate (fully flexible exchange rate). A fixed exchange rate is where a country assigns to itself an exchange rate whereby The Flexible exchange rate system-is an exchange rate system whereby a nation allows market forces to determine the international value of its currency (2 marks)Advantages and Disadvantages of each of the two exchange rate regimes?Fixed Exchange RateFloating Exchange RateAdvantages1Provides Exchange rate stability provides a basis for expectationsAutomatic eradication of imbalances2Stability encourages increased tradeReduced need for reserves-in theory, no need at all3Reduced danger from international currency speculationRelative freedom for internal economic policy4Imposes increased discipline on internal economic policyExchange rates change in relatively smooth steps5Domestic price stability not endangered through import pricesMay reduce speculation (rates move freely up or down)Advantages1Requires large reservesIncreased uncertainty for traders2Internal economic policy largely, dictated by external factorsDomestic price stability may be endangered through import prices3No automatic adjustment-danger of large changes in ratesMay increase speculation through co-ordinated buying or selling(18 marks)QUESTION 6A Malawian importer of cars from Japan is currently concerned about financial risks on his import transaction. The three main types of financial risk faced by the Malawian importer are;Transaction exposure (risk)- the risk that the cost of the transaction, of the proceeds from a transaction, in terms of the domestic currency may change due to changes in exchange rate. In this case if the exchange rate increases i.e. Malawi Kwacha depreciates then Malawian importer would be required to pay more.Translation exposure- is the foreign exchange risk that results from the conversion of the value of a firm’s foreign currency denominated assets and liabilities into a common currency value. However, this will not have effect in the Malawian importerEconomic exposure-is the risk that changes in exchange values might alter a firm’s present value of the future income stream. (6 marks)Discuss 5 ways in which the Malawi importer may avert or mitigate the above identified risks?Matching- The Malawian importer matches the inflows and outflows in different currencies caused by his trading, etc, i.e. if he also exports to Japan then it would be prudent to deal on the forex markets for the unmatched portion of the total transaction.(2 marks)Netting –If the Malawian importer has a subsidiary (ries) in other countries then. Netting is where the subsidiaries settle intra-organisational currency debts for the net amount owed in a currency rather than the gross amount. However this will not apply if the Malawian importer has no subsidiaries in other countries. (2 marks)Do nothing –Under this policy the Japanese firm invoices the Malawian importer, waits then exchanges into Malawi Kwacha at whatever spot rate is available then. Perhaps an exchange rate gain will be made, perhaps a loss will be made. Many firms adopt this policy and take a “win some, lose some” attitude. Given the fees and other transaction costs of some hedging strategies this can make sense. (2 marks)Leading-is where the Malawian importer would bring forward payment from the original due date the payment of a debt or even upfront payment if he foresees a depreciation of the Kwacha by the due date. (2 marks) Lagging-is the where the Malawian importer postpones payment beyond the due date. Delaying (lagging) of payments is particularly useful if you are convinced exchange rates will shift significantly between now and the due date. . (2 marks) (10 marks)A futures exchange market is a market for contracts that ensure the ensure the future delivery of a foreign currency at a specified exchange rate. Unlike forwards, futures contracts are exchangeable exchange markets prevent the problem of counterparty risk.(4 marks)QUESTION 7Analysis of the organizational structure of a collective investment schemes and the importance of key levels in the structure.Fund Managers- Either a Fund Manager or a Corporate body or an institution or an individual that manages the collective investment scheme. The fund managers will handle operation, human resource and finance of the collective scheme.Fund Administrators-manages trading, reconciliations, valuation and unit pricingBoard of Directors or Trustees-persons who are entrusted with safeguarding the assets and ensure compliance with laws, regulations and rules of the collective investment scheme Shareholders/Unit holders-persons who own (or have rights to) the assets and associated income of the collective investment scheme(8 marks)The Capital Market Development Act governs Collective Investment Schemes in Malawi and its three objectives areTo protect interests of investors, creditors and the publicTo ensure that collective investment schemes have adequate cushion of capital to absorb lossesTo promote self discipline in the management of collective investment schemes(4 marks)The disclosure requirements for any Collective Investment Scheme in Malawi;Prospectus-No operator of a collective investment scheme shall offer for sell any securities of which it is issuer, unless such scheme has issued a prospectus the disclosures of which shall meet the requirements under the Companies Act and has been approved by the BankEvery operator of a collective investment scheme shall promptly make disclosure to the Bank, its stakeholders and the public any material information with regard to the development, composition, value and profitability of its investments at the time such information becomes known, by means of written notice timely delivered to such persons or, in lieu of such notice in the case of stakeholders, by publication in a newspaper of general circulation in Malawi; provided, however, that an operator of a collective investment scheme shall not be obliged to make disclosures on purchases and sales of portfolio investments before finalizing such transactions if the collective investment scheme has good reason to believe that such disclosure might be harmful of its interests and those of its stakeholders(8 marks) (Total 20 marks)QUESTION 8The expectations Hypothesis of the term structure states the following common-sense proposition: The interest rate on a long-term bond will equal an average of short-term interest rates that people expect to occur over the life of the long term bond. For example, if people expect that short term interest rates will be 10% on average over the coming five years, then the expectations hypothesis predicts that the interest rate on bonds with five years to maturity will be 10% too. If shorter term were expected to rise higher after this five year period, so that average short-term interest rates over coming twenty years is 11%, then the interest rate on bonds with twenty years maturity would be 11% too and would be higher than interest rates on five year bonds. We can see that the explanation provided by the expectations hypothesis for why interest rates on bonds of different maturities differ is that short term interest rates are expected to have different values at future dates.The starting point of this theory is that buyers of bonds do not prefer bonds of one maturity over another, so that they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. Bonds which have this characteristics are said to be perfect substitutes. What this means in practice is that if bonds of different maturity are perfect substitutes, then the expected return on these bonds must be equal.The Expectations Hypothesis is an elegant theory that provides an explanation of why the term structure of interest rates (as represented by yield curves) changes at different times. When the yield curve is upward sloping (Curve C in figure above) the expectations Hypothesis suggests that short term interest rates are expected to rise in the future. In the case in which the long-term rate is currently above the short-term rate, the average of future short term rates is expected to be higher than the current short-term rate, which can occur only if short term interest rates are expected to rise..Limitation of Expectation Hypothesis theoryThe expectations is an attractive theory because it provides a simple explanation of the behaviour of the term structure, but unfortunately it has a major shortcoming. There is one important empirical fact that is inconsistent with this theory. Yield curves are usually upward sloping, implying that short term interest rates are usually expected to rise in the future. In actual practice short-term interest rates are just as likely to fall as they are to rise. If the Expectations Hypothesis is a complete theory, then the market’s expectations about movements in the short-term interest rates are inconsistent with the actual movements. Economists are uncomfortable because they find appallingly hard to believe that the bond market can be that foolish. The Expectations Hypothesis has been modified to account for this inconsistency, as we will see when we discuss the Preferred Habitat Theory.Segmented Markets Theory/ Market segmentation theory- This theory of the term structure sees markets for different maturity bonds as completely separated and segmented. The interest rate for each maturity bond is then determined by the supply and demand for that maturity with no effects from expected returns on the other maturity bonds.The Segmented Markets Theory starts with the premise that bonds of different maturities are not substitutes at all, so that the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity. The theory of the term structure is then at the opposite extreme to the Expectations Hypothesis which assumes that bonds of different maturity are perfect substitutes.The argument for why bonds of different maturities are not substitutes is that investors have strong preference for bonds of one maturity but not for another, and so they will only be concerned with the expected returns for bonds of the maturity they prefer. This might occur because they have a particular holding period in mind, and if they match the maturity to the desired holding period, then they can obtain a certain return with no risk at all. For example, people who have a short holding period would prefer to hold short-term bonds. On the other hand, if you were putting funds away for your young child to go to college, your desired holding period might be much longer and you would want to hold longer term-bonds. In the Segmented Markets Theory the differing yield curve patterns our figure above are accounted for by the differing supply and demand for bonds of different maturities. The yield curve slopes upward because, according to the Segmented Markets Theory, the demand for short term bonds is relatively higher than for longer term bonds, with the result that short term bonds have a higher price and a lower interest rate. A downward sloping yield curve would indicate that the demand for long-term bonds is relatively higher and their yields will then be lower. Since yield curves are usually upward sloping, the theory indicates that, on average, people usually prefer to hold short term bonds rather than longer-term bonds. Although the Segmented Markets Theory can explain why yield curves usually tend to slope upwards, it is still has a major flaw. Because it sees bond markets for different maturities as completely segmented, there is no reason for a rise in interest rates on a bond of one maturity to affect the interest rate on a bond of another maturity. Therefore it can not explain the empirical fact that interest rates on bonds of different maturities tend to move together.This far we are in a weak position of having two important empirical facts to explain, although each one of our two theories of the term structure is able to explain one but not the other. A logical step to solve this problem is to combine both theories, which leads us to the Preferred Habitat Theory.Preferred Habitat Theory-This theory states the following: The interest rate on a long term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond, plus a risk premium that responds to supply and demand conditions for that bond.The theory takes the view that bonds of different maturities are substitutes so that the expected return on one bond does influence the expected return on a bond of a different maturity, but it also allows investors to prefer one bond over another. We might then think of investors as having a preference for bonds of one maturity over another, thus having a bond market where they are more comfortable to reside; we then might say that they have a preferred habitat. Investors still care about the expected returns on bonds with a maturity other than their preferred maturity, and so they will not allow expected returns on one bond to get too far out of line with that on another bond with a different maturity. Since they prefer bonds of one maturity over another, they will be willing to buy bonds that do not have the preferred maturity only if they earn a somewhat higher expected return. If investors prefer the habitat of short term bonds over longer bonds, for example, they might be willing to hold short term bonds even though they have a lower expected return. This means that investors would have to be paid a positive risk premium to be willing to hold a long term bond. Such an outcome would modify the expectations Hypothesis story by adding a positive risk premium term to the equation, which describes the relationship between long term and short term interest rates. Is the Preferred Habitat Theory consistent with the two empirical facts discussed before. It explains why interest rates on different maturity bonds move together over time: A rise in short term interest rates indicates that short term interest rates will, on average, be higher in the future and that long term interest rates will rise along with them. The preferred habitat theory also explains why yield curves are usually upward sloping by considering the risk premium to be positive as a result of people’s preference for holding short term bonds. Even if short term interest rates are usually expected to stay the same on average in the future, long term interest rates will be above short term rates. Therefore yield curves that slope upwards should be the norm.END OF THE EXAMINATION PAPER ................
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