INSTITUTE OF BANKERS IN MALAWI
ADVANCED DIPLOMA IN BANKING EXAMINATION
SUBJECT: FINANCIAL MARKETS 2 (I0BM – AD320)
Date: Wednesday 6th November, 2013
Time Allocated: 3 hours (13:30 – 16:30 pm)
SUGGESTED SOLUTIONS
SECTION A
I)
(60 MARKS)
Nominal yield is the coupon return on a bond divided by the bond’s face
value
(1 Mark)
II)
III)
IV)
V)
Yield to maturity is the rate of return on a bond if it is held until it matures
which reflect the market price of the bond, the bond’s coupon rate return,
and any capital gain from holding the bond to maturity.
(1 Mark)
Yield curve is a chart giving the relationship among yields on bonds that
differ only in their terms to maturity.
(1 Mark)
Coupon return is a fixed interest rate that a bond yields each year.
(1 Mark)
Currency yield is the coupon return on a bond divided by the bond’s
market price.
(1 Mark)
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.
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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.
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.
c) Structure of interest rate risk is the relationship among yields on financial
instruments that have the same maturity but differ because of variation in default risk,
liquidity and tax rates
(1 Mark)
(Total 15 Marks)
Question 2
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.
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.
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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 %
(4 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)
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
( 2 Marks)
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
Q 2 BWP
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Panel (a)
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 Q1L
Panel (d)
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 S1 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 S L to S’L in panel C. a decrease in
supply of loanable funds in Botswana causes an increase the Botswana interest rate
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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.
(13 Marks)
(Total 15 Marks)
Question 4
Compute d1 and d 2
d1 
d1 
in ( Pa / Pe )  (r  0.5s 2 )t
s t
in (15 / 20)  (0.06  0.5 x0.283 2 )5
0.283 x 5
Step 2: Compute d1 and d 2
N ( d1 ) = 0.5 + 0.1293 = 0.6293
N ( d 2 ) = 0.5 – 0.1179 = 0.3821
Step 3: Use formula
Value of a call option = Pa N (d1 )  Pe N (d 2 )e  rt
= 15 x 0.6293 – 20 x 0.3821 x e  ( 0.06 x 5)
= MK 3.8 Million
Summary
Conventional NPV on first option with no contract
Value of call option on contract with CSC
Strategic NPV
MK
(2)
3.8
1.8
Given that the NPV is now positive the option for contract with CSC makes the project
viable.
(Total 15 Marks)
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SECTION B
(40 MARKS)
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
(4 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.
(4 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.
(4 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.
(4 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
(4 Marks)
(Total Marks 20 Marks)
Question Six
Year
Coupon MK
80
Face
Value
MK
80
1
MK
80
2
MK
80
3
MK
80
4
MK
80
5
MK
80
6
MK
80
7
MK
80
8
MK
80
9
MK
80
10
MK 80
MK1,000
MK
80
MK
80
MK
80
MK
80
MK
80
MK
80
MK
80
MK
80
MK
80
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MK
1,080
7
For Example, Eastern hotels were issued a bond with 10 year to maturity. The Eastern
hotels bond has an annual coupon of MK 80. Similar bonds have a yield to maturity of
8%. Based on our preceding discussion, the Eastern hotels bond will pay MK 80 per
year for the next 10 years in coupon interest, and in the tenth year will pay the owner
MK 1,000.00 to the bond holder.
Present Value can be calculated as follows = MK 1,000/1.08 10 = MK1, 000/2.1589 =
MK 463.19
Second the bond offers MK 80 per year for 10 years; the present value of this annuity
stream is: Annuity present value  MK 80 x (1  1/1.0810 )/0.8
= 80 x (1 -1/2.589)
= MK 80 x 6.7101
= MK 536.81
We can now add the values for the two parts together to get the bond’s value
Total bond Value = MK 463.19 + MK 536.81 = MK 1,000
This bond sells for exactly its face value. This is not coincidence. The going interest
rate in the market is 8%. Considered as an interest –only loan, what interest rate does
this bond have? With an MK 80 coupon, this bond pays exactly 8 percent interests
only when it sells for MK 1,000.
To illustrate what happens as interest rates changes, suppose that a year has gone
by. The Eastern hotels bond now has nine years to maturity. If the interest rate in the
market has risen to 10%, what will the bond be worth? To find out, we repeat the
present value calculations with 9 years instead of 10, and a 10% yield instead of 8%
yield. First the present value of the MK 1,000 paid in nine years at 10% is: -
Pr esent Value  MK 1,000 / 1.109  MK 1,000 / 2.3579  MK 424.10
Second, the bond offers MK 80 per year for 10 years; the present value of this annuity
stream is: -
Annuity present value  MK 80 x (1  1 / 1.10 9 ) / 0.10
 MK 80 x (1  1 / 2.3579) / 0.10
 MK 80 x 5.7590
 MK 460.72
We can now add the values for the two parts together to get the bond’s value.
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Total bond value = MK 424.10 + 460.72 = MK 884.82
The nominal capital loss will be MK115.18
Therefore the bond should sell for about MK 885.00 in the vernacular; we say that this
bond, with its 8% coupon, is period to yield 10% at MK 885.00 The X Co bond now
say that this bond with its 8% coupon is priced to yield 10% at MK 885.00
Likewise if the bond was selling at 6% PV would be MK 591.89 and total annuities
would be MK 544.14
Total bond value would be MK 1,136.03
The nominal capital gain will be MK136.03
(Total 20 Marks)
Question 7
i) It is to be expected that short-term interest rates are lower than long term
interest rates. A long term debt carries greater risk because there is longer to
run to redemption. Funds are aloso tied up for a longer period. A higher interest
rate should thus compensate.
In some instances long – term rates will be lower if the view is that current rates
of interest are high. Long term debt may be an opportunity to lock into high
rates of interest.
(5 Marks)
ii) - Government Policy as money supply and inflation can be controlled.
- Inflation rates – theoreritical interest rates should be a combination of a
real return and an adjustment.
- Exchange rate policy high domestic rate relative to non- domestic rates
encourages foreign investment and thus a strengthening of the exchange
rate.
(5 Marks)
iii) A rise in interest rate seeks to control inflation by restricting consumer demand
for goods and services. Prices fall or do not rise so much due to reduced
demand.
Problems which can rise are: -
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1) High interest rates result in increased mortgage repayments which may
encourage a demand for higher wage settlements
2) The effects may be slow to work
3) Industry is hit by high finance costs which result in lo capital investments
and job losses and the possibility of a recession
(5 Marks)
iv) A rise in interest rates relative to non-domestic interest rates should have the
effect of the strengthening the domestic currency as capitalf lows into the
country to take advantage of the rates.
Problems which can arise are: 1) The domestic economy may remain the unsound, eg there are large
balance of payments deficits. Further rises may be necessary to avoid an
outflow of funds.
2) A strong domestic currency makes it harder to export and easier to import.
This may be the opposite effects of the intended.
(5 Marks)
Total Marks (20 Marks)
Question Eight
a) 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.
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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.
(12 Marks)
(a)
Intrinsic Value – the intrinsic value of an Option is its economic value if it is
exercised immediately
Strike Price – is a fixed price for exercising the option at the maturity date.
(6 marks)
(b)
The intrinsic value
MK 200 – MK 150
The intrinsic Value is MK 50.00
(2 marks)
(Total 20 Marks)
END OF EXAMINATION PAPER
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