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 (60 MARKS)
I) Nominal yield is the coupon return on a bond divided by the bond’s face value (1 Mark)
II) 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)
III) Yield curve is a chart giving the relationship among yields on bonds that differ only in their terms to maturity.
(1 Mark)
IV) Coupon return is a fixed interest rate that a bond yields each year.
(1 Mark)
V) 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.
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.
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 SBWP
S’BWP
A F2 B
S1
S2 F1
B A
DBWP DBWP D’BWP
Q Q
QBWP QBWP QBWP QBWP
Panel (a) Panel (b)
RBW
S’L SL S’L
SL
B R1MW A
R2BW
R1BW R2MW B
A
DL DL
QL QL QL QL
Panel (c) 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 SBWP 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 S2.
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 SL to S’L in panel C. a decrease in supply of loanable funds in Botswana causes an increase the Botswana interest rate 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 and
Step 2: Computeand
N () = 0.5 + 0.1293 = 0.6293
N () = 0.5 – 0.1179 = 0.3821
Step 3: Use formula
Value of a call option =
= 15 x 0.6293 – 20 x 0.3821 x
= MK 3.8 Million
Summary
MK
Conventional NPV on first option with no contract (2)
Value of call option on contract with CSC 3.8
Strategic NPV 1.8
Given that the NPV is now positive the option for contract with CSC makes the project viable.
(Total 15 Marks)
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 / 1 / 2 / 3 / 4 / 5 / 6 / 7 / 8 / 9 / 10Coupon / MK 80 / MK 80 / MK 80 / MK 80 / MK 80 / MK 80 / MK 80 / MK 80 / MK 80 / MK 80 / MK 80
Face Value / MK1,000
MK 80 / MK 80 / MK 80 / MK 80 / MK 80 / MK 80 / MK 80 / MK 80 / MK 80 / MK 80 / MK
1,080
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 = 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: -
= 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: -
Second, the bond offers MK 80 per year for 10 years; the present value of this annuity stream is: -
We can now add the values for the two parts together to get the bond’s value.
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.