FINANCIAL MARKET 1
DATE: AUGUST 2011
SECTION A
1 Describe the following terms:
a) Purchasing Power Parity
b) Unsecured bonds
c) Mutual funds
( 5 Marks )
( 5 Marks )
( 5 Marks )
2 Describe any THREE categories of financial markets (15 Marks)
3 a) Why is cross rate important in foreign exchange transactions (2 Marks)
b) A Malawian vendor holds a foreign currency denominated account with a local bank account and is
intending to use these funds to pay off a supplier based in Washington DC. The invoice total is USD
2,000.Calculate the amount of Rand that will be debited to satisfy the invoice given the rate of MK 152
to a Dollar and Mk 24 to a Rand (4 Marks)
c) List any THREE types of information that a Negotiable Certificate of Deposit normally contains (3
Marks)
d) According to the theory called Fisher’s Effect, outline THREE components of a nominal rate. (6 Marks)
4 a) Explain the information that stock market indexes give to investors (4 Marks)
b) Calculate the total return on investment in three years time, given the following and ignoring tax
and transaction costs:
i) 500,000 shares bought just before dividend payout at K10.50 per share
ii) Current dividend rate is K 1.10 per share
iii) Steady dividend growth rate of 9 % per annum
iv) Predicted share price in three years time immediately after dividend payout is K 15.00
(11 Marks)
ANSWERS SECTION A
1 a) Purchasing Power Parity is a theory of the relationship between the prices of traded goods and
services, and the exchange rates. The theory has two versions namely absolute PPP which relates to
price levels of two countries and the exchange rates, and relative PPP which relates to inflation rates
and the rate of change in exchange rate between two countries. (5 Marks)
1
b) Unsecured bonds are bonds that are only backed by the general creditworthiness of the issuer and
not by specific collateral. In event of default, the bondholder must go to court to seize assets. An
example of unsecured bond is debenture. Collateral pledged to other debtors will not be available to the
holders of debentures. Because of the risk involved, debentures offer higher interest rate than
comparable secured bond (5 Marks)
c) Mutual Funds are financial intermediaries that acquire funds by selling shares to many individuals and
use the proceeds to purchase diversified portfolios of shares and bonds. Mutual funds allows
shareholders to pool their resources so that they take advantage of lower transaction costs when
buying large blocks of stocks or bonds.Shareholders are also allowed to hold more diversified portfolios
than they otherwise would. Shareholders can redeem their shares anytime but value of the shares will
be determined by the value of mutual fund’s holding of securities. Fluctuation of fund value makes the
investment riskier. ( 5 Marks )
2. Three categories of financial markets are (3 Marks)
-Capital Markets
- Money Markets
- Derivatives Markets
Or Foreign Markets
Capital Markets are used by companies to raise capital funds for expansion and other projects. Investors
who participate in this market invest in longer term instruments such as shares, bonds and real estate (5
Marks)
Money market is a market where liquid financial instruments and very short term maturities of 7 days to
one year are traded. This also offers as an avenue where investors in capital market can warehouse and
accumulate capital for longer term investment. Most popular instruments are Treasury bills, Repos and
NCDs (5 Marks)
Derivative Markets
This market trades in types of financial instruments whose performance is based on the behavior of the
value of underlying assets. The most commonly used assets are commodities, shares, bonds, share
indices, currencies and interest rates .The derivative instruments include futures, forwards, swaps,
options and forward rate agreements ( 5 Marks)
Or
Foreign Markets
2
Foreign exchange markets are markets that facilitate an exchange of one currency into another.
Basically these markets provide an arrangement of valuing transactions and delivering payments, and in
the process promoting the flow of goods, services and assets from one country to another (5 marks)
3 a) A cross rate being a bilateral exchange rate calculated from two bilateral exchange rate is able to
show the relationship of any two foreign currencies to a third one. ( 2 Marks )
b) Cross rate =MK 152 X USD
MK 24 X Rand
= 6.3333
( 2 Marks )
To pay USD 2,000
The Rand amount will be 6.3333 x 2,000
= R 12,666.60
( 2 Marks )
c) Any three of these (3 Marks)
The NCD will contain the following information:
-
Name of issuer
Date of issue
Maturity date
Amount of deposit ( Face value )
Rate of interest
d) The following are the components of nominal rates ( 6 Marks )
1 There is real rate of return on the investment
2 There is compensation for the decrease in the value of the money originally invested
3 There is compensation for the fact that the value earned on the investment is worthless because of
inflation
4 a) Stock Market indexes are useful in monitoring the behavior of a group of stocks. By reviewing the
behavior, investors are able to gain some insights as to how a broad group of stocks have performed.
The indexes can also be used as benchmark in stock valuation (4 Marks)
3
STEP ONE
b) Cost of 500,000 shares = 500,000 x 10.50
= 5,250,000
( 1 Mark )
Dividend Received now = 500,000 x1.10
= 550,000
( 1 Mark )
STEP 2
Dividend year 1
= 1.10 x 1.09
=1.199
= 500,000 x 1.199
= 599,500
Dividend year 2
( 2 Marks )
= 1.10 x1.09x1.09
=1.3069 x 500,000
=653,450
Dividend year 3
( 2 Mark )
= 1.10 X 1.09 X 1.09 X 1.09
= 1.4245 X 500,000
= 712,250 ( 2 Marks )
STEP 3
a) Total dividends = 550,000 + 599,500 + 653,450 + 712,250
= 2,515,200 ( 1 Mark )
b) Sell proceeds = 500,000 x 15.00
= 7,500,000 (1 mark)
STEP 4
c) Return on Investment
=2,515,200 + 7,500,000 – 5,250,000
= 4,765,200 (1 mark)
4
SECTION B
5 a) In what way are futures contracts similar to forward contracts? ( 2 Marks )
b) Outline four factors that distinguish futures contracts from forward contracts
( 8 Marks )
c) Describe two Treasury bill tendering systems commonly applied in world money markets and name
the system which has been adopted by the Malawi market ( 5 Marks )
d) During the Treasury bill auction held on 24 June, 2011, the authorities raised an amount of K3. 2
Billion.60 % of the value went at the bid price of 99.2015 while 25 % and 15 % of the value went at
98.9520 and 97.9675 bid prices respectively.
Required to calculate;
i) Weighted Average Price of the auction ( 3 Marks )
ii) Yield on the 91 day Treasury bill that was allotted at the bid rate of 97.9675 ( 2 Marks )
6) You work at head office of PRV Bank in the finance section and your duties include looking into
liquidity issues of the bank. Describe three ways which can be used by the bank to measure its liquidity
exposure (12 Marks)
b) Suppose a 12% per annum bond of K5, 000,000 whose interest is payable once a year will mature in 5
years time and the ruling interest rate in the market is 10%.Calculate the following;
I .present value of the bond
ii. interest payable on the bond
iii. present value of annuity
iv.face value at year 5 which is inclusive of interest earned ( 8 Marks)
7) a) Define the term interest rate and why it is useful in Money markets. ( 2 Marks )
b)Mention and briefly explain any five factors that affect the general level of interest rates (15Marks)
c) Given a required real rate of return of 15 % and a ruling inflation rate of 7 % , calculate nominal
rate (3 Marks )
8 a) Outline five steps to be undertaken in a banker`s acceptance transaction involving a Malawian
importer and a Japanese exporter (10 Marks)
b) Explain in detail why most investors engage in hedge and arbitrage type of transactions. (10 Marks)
5
ANSWERS SECTION B
5a) They are both agreements between parties to undertake a transaction at an agreed price on a
specified future date (2 Marks)
b) Futures and Forward contracts differ in the following ways:
1 Futures contract are standardized legal agreements while Forwards are tailor-made contracts to
meet the requirements of the parties. ( 2 Marks )
2 Future contracts are exchange –based instruments traded on a regulated exchange while Forwards
are not traded on the exchange. ( 2 Marks )
3 Buyers and Sellers of Futures contracts transact through a clearing house while counterparties in
forward contracts deal directly with each other. ( 2 Marks )
4 Forwards are riskier agreements than Futures contracts that is why Futures have wider market appeal.
( 2 Marks )
c) The tendering systems are as follows:
1 – Dutch Tendering system allots Treasury bills in descending order of price until the total amount
offered is absorbed.( 2 Marks )
2 – American Tendering system allots Treasury bills to all bidders according to the average of entire bid
price ( 2 Marks )
Malawi market applies Dutch Tendering system ( 1 Mark )
d)
i) Weighted Average Price = (0.60 x 99.2015)+(0.25 X 98.9520)+( 0.15 X 97.9675 ) 1 Mark
=59.5209 +24.7380 +14.6951 ( 1 Mark )
=98.9540 ( 1 Mark)
ii)Yield
= 100 – 97.9675 x 365
97.9675
= 8.30 %
( 1 Mark )
91
( 1 Mark )
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6 a)
1 SOURCE AND USE OF LIQUIDITY STATEMENT
The bank can use the statement of net liquidity that lists sources and uses of liquidity on daily basis. ( 3
Marks )
2 PEER GROUP RATIO COMPARISONS
This way demands the bank to compare certain key ratios and balance sheet features with peers in the
industries. Some of the commonly used ratios are loan to deposit, borrowed funds to total assets and
lending commitments to asset ratios (3 Marks)
3 LIQUIDITY INDEX
Jim Pierce developed liquidity index and the bank can use this .The index measures the potential lose
that an institution can suffer by sudden or fire- sale disposal of assets compared to a fair market value
The greater the difference between fire-sale and fair value the less liquid the portfolio of assets. (3
Marks)
4 FINANCING GAP AND FINANCING REQUIREMENTS
This way requires the bank to measure its financing gap which is the difference between its average
loans and average core deposits. If the average loan deposits less average core deposit give positive
result, the bank is in liquidity problem. ( 3 Marks )
b)
Present Value of the bond = 5,000,000 / 1.10 to the power of 5 ( 1 Mark)
Interest payable
=5,000,000 / 1.6105
( 1 Mark)
= 3,104,625.89
( 1 Mark)
= 0.12 x 5,000,000
= 600,000
Present value of Annuity
( 1 Mark)
=600,000 x ( 1 – 1/1.10 to the power of 5)/0.10 (1 Mark)
= 600,000 x ( 1 – 1/1.6105)/0.10
= 600,000 x ( 1 – 0.62)/ 0.10
( 1 Mark)
=600,000 x(0.38/0.10)
= 2,280,000
(1 Mark)
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Total value
= 3,104,625.89 + 2,280,000
= 5,384,625.89
( 1 Mark)
7 a) Interest rate is the price charged for use of borrowed funds and it is useful because it compensates
owners for loss of use of an asset. ( 2 Marks )
b) The following are the factors that affect the general level of interest rates :( ANY FIVE OF THESE)
1 NEED FOR REAL RETURN
Investors normally want to earn a real rate of return on their investment which will depend on factors of
investment risk. (3 Marks)
2 INFLATION
Nominal rate of interest should be sufficient to cover the expected rate of inflation over the term of the
investment and be able to provide real return. ( 3 Marks )
3 UNCERTAINITY ABOUT FUTURE RATE OF INFLATION
When investors are uncertain about inflation and there about what future nominal and real interest will
be, they are likely to demand higher interest rate to persuade them to take a risk.( 3 Marks )
4 LIQUIDITY PREFERENCE OF INVESTOR S AND DEMAND FOR BORROWING
High rate have to be offered to motivate savers to invest their surplus funds. When demand to borrow
increases, interest rates will rise ( 3 Marks )
5 BALANCE OF PAYMENT
When a country has a continuing deficit on the current account of its balance of payments, and
authorities are unwilling to depreciate their currency, interest rates have to be raised to attract capital
into the country. In this way ,the country can then finance the deficit by borrowing abroad ( 3 Marks)
6 INTEREST RATES ABROAD
The rate of interest in one country can be influenced by the external factors such as interest rates in
other countries and expectations about the exchange rate. When interest rates in overseas countries
are high, rates on domestic currency investments must be comparably high to avoid capital transfers
abroad and a fall in exchange rate . (3 Marks )
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C)
1 +R = (1 +r) (1 +h) (1 Mark)
=(1 +0.15 ) (1 +0.07)
=1.2305 (1 Mark)
R =1.2305 - 1
=0.2305
= 23.05 % (1 Mark)
8 a) The following are five steps to be followed ( 2 Marks each)
1 The importer requests its bank to send an irrevocable letter of credit to the exporter
2 The exporter receives the letter, ships the goods and is paid by presenting to its bank the letter along
with proof that the merchandise was supplied.
3 The exporter`s bank creates a time draft based on the letter of credit and sends it along with proof of
shipment to importer’s bank.
4 The importer’s bank stamps the time `` accepted’’ and send the banker`s acceptance back to the
exporter`s bank so that the exporter `s bank can sell it on the secondary market.
5 The importer deposits funds at his local bank sufficient to cover the banker`s acceptance when it
matures.
b) Basically hedging is an act of offsetting or eliminating risk of exposure and most investors will enter
into such an action as a strategy to reduce capital loses arising from interest rate or currency risks
associated with some underlying assets. The hedge financial instrument is able to achieve the desired
results because it tends to have opposite –value movement to the underlying. With the hedge financial
instrument, the market is able to transfer risk from an individual or corporation to another willing and
able to bear that risk. (5 Marks)
On the other hand, arbitrage is an act of exploiting price differences on the same financial instrument or
similar securities. This is achieved by simultaneously selling the overpriced security and buying the
underpriced security. The buying and selling is immediately done upon realizing that the security is
trading at a lower and higher price. Apart from profiting from price differences, arbitrage also helps to
ensure price efficiencies by reducing pricing anomalies. (5 Marks)
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