Financial Institution and Markets -Revision Notes for 2009-10 Exams

The format of the exam is the same as the last year’s exam.There are six questions to answer any four. Each question is worth 25 marks.All questions have three subquestions each.There are three mixed-topic questions with their subquestions from different topics/lectures and the remaining three questions are single topic questions, i.e. all their subquestions are from a single lecture.The three mixed-topic questions are essay-type theoretical questions. Like in the past exam papers, these subquestions can ask for definitions, explanations or discussion of theoretical concepts like the comparison of money and capital markets or primary and secondary markets; the role of government in the regulation of financial markets; the role and function of the central bank and its responsibilities in issues like risk, liquidity and capital adequacy; the role of banks and financial institutions in risk transformation; the motivation and incentives of various participants like the stock brokers and dealers in the investment process; the recent developments in the financial markets etc.The other three single-topic questions have some essay parts/subquestions and some simple calculations.All parts of the exam questions have been discussed in the class and covered in the notes. The simple calculations are similar to the examples in the handouts. You should focus the revision in reading the textbook parts that are covered in the handouts.The last two year exams can guide you on your preparation for the exams.The calculations subquestions are simple applications and can refer to securities traded in the international financial markets like equities and bonds and to some exchange rate calculations.In equities markets we might be also interested in issue like initial public offerings and subsequent issues of shares; as well as in issues related to distribution of dividends and valuation approaches.In bonds we are concerned with the various types of bonds and their features; the various measures of yield; the impact of time to maturity on prices for premium, par or discount bonds; impact of changes in interest rates on bond prices as well as issues related to yields and valuation of straight bonds and callable bonds.In foreign exchange markets we are principally concerned about issues related to the function of foreign exchange markets; the growth and importance of foreign exchange markets; the participants in these markets and their needs and motivation; as well as how the arbitrage argument is utilised. We are also considering the implications of the covered interest parity for the spot and forward exchange rates.These notes include some examples of numerical calculations and the exam papers of the last two years with suggested answers to their relevant numerical parts.

EXAM 2008-09Answer FOUR from the SIX questions. All questions carry the same weight. QUESTION 1. (Answer all parts of this question)

(a) Explain the rationale for government intervention in the regulation of financial markets. You can include in your discussion arguments in relation to market failure such as moral hazard, asymmetric information, externalities and principal-agent problems.

(b) Describe the major functions of a financial centre and its contribution to a national economy.(c) Explain the role of financial institutions as intermediaries in maturity transformation and risk

management. [25 Marks]

QUESTION 2. (Answer all parts of this question)(a) Define and compare the money and capital markets.(b) Describe the motivation of arbitrageurs, hedgers and speculators for trading in the financial

markets.(c) Explain the function of a broker in security investments and describe the nature and use of a

margin account. Include in your discussion an explanation of the benefits and risks of the use of margin accounts to invest.

[25 Marks]

1

QUESTION 3. (Answer all parts of this question)(a) Explain the role of the Bank of England with respect to the other banks and the Government.(b) Describe the phenomenon of Bankassurance in the European banking industry.(c) Discuss the advantages and disadvantages for companies of raising equity capital through listing

in a stock market.[25 Marks]

QUESTION 4. (Answer all parts of this question)(a) Describe the role and function of stock markets as both primary and secondary markets for equity

capital.(b) Explain why some companies distribute dividends and others do not. Why those companies that

do distribute dividends try to maintain a relatively constant level of growth of the distributed dividends?

(c) Amalthia plc is an established food distribution company. The company is all-equity financed with 1,000,000 common shares and the book value of assets is £3,000,000. The earnings are £4,000,000 and the company has just distributed £2 per share dividend. If Amalthia plc is expected to have a constant growth of 5% and the required rate of return is 10%, find the share price, market-to-book value, dividend yield, P/E ratio and total returns.

[25 Marks]

QUESTION 5. (Answer all parts of this question)(a) Describe the main features of a straight bond and compare it with a zero coupon bond. Explain

how the returns are realised in each case and how these returns are affected by an increase in interest rates before maturity.

(b) Explain why the current yield for a bond selling at premium is higher than the yield to maturity, whereas for a bond selling at discount, the current yield is lower than the yield to maturity. Explain what happens to this difference of yields as the bond approaches maturity.

(c) A callable bond has a face value £100, a coupon rate of 9% paid annually and six years to maturity. The bond can be called at any time after year 3 at £116. Currently, this bond sells at par. If the interest rate at year three is 4%, explain whether the issuer will then exercise the call option to redeem the bond.

[25 Marks]

QUESTION 6. (Answer all parts of this question)(a) Explain the role and functions of the major participants in the foreign exchange market. Give a

simple example of an international exporter selling overseas to illustrate how the activities of the other participants in the foreign exchange market facilitate the needs of this exporter.

(b) Discuss how the cross-currency arbitrage argument is used to explain the exchange rate between two currencies given the exchange rates of these two currencies in terms of a third currency. As an illustration, if the pound is trading at 1.40 dollars per pound and the euro is trading at 1.20 dollars per euro, what is the euros per pound exchange rate?

(c) Define the spot and forward foreign exchange rates. Discuss how the covered interest parity provides a relationship between the spot exchange rate, the forward exchange rate and the two interest rates. If the spot rate is 1.50 dollars per pound, the UK interest rate is five percent and the US interest rate is one percent, what is the dollar per pound forward rate?

[25 Marks]NOTE:You might find the following formulas useful for calculations:

Pd g

r g00 1

( )

( )

2

TT

T r

P

rP

)1(

)1(

11

r

C 0

CIP: Sr

SrrF

)1(

)( *

ANSWERS - EXAM 2008-09QUESTION 1:1a) The government has the authority and responsibility to ensure that financial markets operate efficiently and uses its power to intervene in cases of market failure. A number of problems can contribute into market failure, such as:The externalities problem.

• The problems of the financial sector spread and become problems of the whole economy:– The financial system provides the payment mechanism for the whole economy.– The financial institutions provide the environment for interaction of savers and borrowers.– Banking scandals and failures have affected the entire financial system of countries and

harmed their economic progress.The problem of asymmetric information.

• The directors and managers of companies and financial institutions have superior information to other corporate outsiders:

– The published corporate statements and accounts provide only a partial view of corporate affairs.

– Trading on insider information is illegal for investor protection.– Financial institutions and companies are large listed companies and subject to additional

disclosure requirements for important events that have significant share price implications.The moral hazard problem.

• Insurance against an undesirable event might make it more likely to happen. Investors become more risk prone if they do not suffer the result of their risky behavior:

– Risk protection makes both individual investors and financial institutions more risk lovers.– The deposit insurance protection schemes remove the risk from depositors, which might

encourage them to deposit with high interest rate offering banks.– Financial institutions might invest in riskier projects to compete on offering higher interest

rates to their depositors.The principal – agent problem.

• The directors and managers of financial institutions act as agents of shareholders and investors. Therefore, they might act in their own interest instead of the interest of shareholders:

– A number of factors contribute to this problem (separation of ownership and control; self-interest and motivation of individuals; asymmetric information; asymmetric distribution of cost-benefits of managerial behavior; imperfect contracting technology; imperfect market mechanism).

– A number of proposed remedies (better monitoring of managerial behavior by an indepen-dent board of directors; more outsider directors; better contracting technology in manage-rial employment; share options and other equity based compensation incentives in manage-rial remunerations; more efficient market for corporate executives).

– Efficient market for corporate control (as an external mechanism).1b) Financial centre is the group of individuals, intermediaries and institutions that can potentially interact or participate in transactions that involve real or financial assets. The financial assets are instruments that facilitate transactions in real assets or constitute the subject of a transaction between market participants. The financial markets facilitate the trading of financial assets between market participants and the financial intermediaries facilitate the financial transactions of market participants.The Financial System provides the environment in which the individual investors and companies operate.Financial system participants:

– Individuals.

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– Companies.– Financial institutions, private and public organisations.– Governments.

Functions of the financial system:– Facilitations of transfer of money.– Primary and secondary security markets.– Financial services.

1c) Maturity transformation: Ultimate lenders and ultimate borrowers have often different investment time horizons. A private individual saver might want an account to deposit their salaries or wages and withdraw money throughout the month or use a savings account to save for longer periods of time. In contrast a company might need to borrow a large amount of money for longer time to invest in fixed assets and repay the loan over several years. A bank or building society attracts large number of small deposits in current accounts (short notice withdrawals) and creates long-term loans or mortgages.Risk transformation/reduction: Large numbers of depositors (bank liabilities) make the withdrawals more predictable and need to

hold less cash. Large number of loans (bank assets) mitigates the effect of default. Specialisation of staff and procedures in selecting customers/borrowers. Diversification of assets into loans and other investments reduces risk.Monitoring: FIs are in a position of quasi-insider and share large part of confidential information with the lender

about the financed project. FIs have the resources, technology and motivation to investigate the borrower and monitor his activit -

ies relevant to the use of the loan. The cost savings associated with monitoring make feasible the creation and operation of specialists in-

termediaries (credit rating agencies, factoring companies etc).

QUESTION 2:2a) Financial Markets can be classified on the basis of the residual time to maturity of the traded securities into:

• Money markets are the markets where securities with maturities less than 1 year are traded. • Capital Markets are the markets where securities with longer than 1 year maturities are traded.

Money Markets:• Domestic Money markets.• International Money markets (or Offshore market or Eurocurrency market).

Money Market participants:• The Treasury / Central Government. • The Central Bank (The Bank of England). • Government security dealers.• Commercial banks.• Non financial companies.

2b) Arbitrageurs try to exploit pricing imbalances between markets and realise risk-free profits. Their operation makes markets more efficient. An assumption of efficient market is that there are no arbitrage opportunities. Headgers are using the financial markets to hedge their exposure to risk. In doing so, they incur cost, i.e. this process is not free and they might eventually realise gains or losses from their positions but their aim is to reduce risk and remove uncertainty. Speculators take positions, often risky, in the expectation that prices will move towards a particular direction to their benefit.2c) To trade securities using the services of a broker you should open a cash or margin account with them. Using debt as part of an investment through a margin account is called buying on margin.A cash account is like a standard current account with a high street or e-bank. Cash from deposits by the investor or proceeds from sales of securities goes into the account and out comes cash to pay for purchase of other securities, broker fees and other costs. The investor has the balance free to his disposal.A margin account is like a current bank account with an overdraft facility. The investor can pay only a part (proportion) of the value of the securities with his own funds (initial margin requirement - IMR) and obtain a loan from the broker to pay for the balance. This borrowed balance is called debit balance or 4

brokers’ call loan. The broker keeps the securities purchased using a margin account in his street name, as collateral for the loan to the investor. For this, the investor has to agree and sign a hypothecation agreement. The broker, as register owner of the shares, receives dividends, annual reports and voting rights but he transfers them to the investor. The money for the debit balance loan often comes from another loan. The broker takes the loan from a bank, at the call money rate and offers the securities as collateral to this loan (the proceeds of which are eventually given to the investor as debit balance loan). On the call money rate the broker adds a service charge (typically around 1%) to determine the interest rate for the debit balance loan that is charged to the investor.The payment for the securities purchased by an investor using a margin account comes from two sources: a. The investor, who contributes from his own funds, the initial margin requirement andb. A loan from the broker for the balance, namely the debit balance.

balance)(Debit (IMR) investment of Value

The percentage margin is defined as the ratio of net worth or equity value of the account to the market value of the securities. Following the purchase of a security, its price may change and similarly the actual margin may differ from the initial margin requirement.

Actual Margin =

The daily estimation of the actual margin in an investor’s margin account is called mark to market.A simple example can be given.

QUESTION 3:3a) The Bank of England (BoE) is the Central Bank (CB) and is mainly responsible for the implementation of monetary policy.The CB controls the amount of money is circulation (money by public or banks) through open market operations (OMO).• In an expansionary OMO the CB increases the money circulation:

– by purchasing bills or bonds for cash. This:– increases the liabilities of the CB, i.e., the money in circulation and– also increases the CB’s assets i.e., its bills and bonds.– expansionary OMO increases demand for bills so, price up and IR down.

• In a contractionary OMO the CB decreases the money circulation:– selling bills and bonds to the public in exchange of money. This:– decreases the assets of the CB, i.e., its bills and bonds and– also decreases the liabilities of the CB, i.e., the money in circulation.– contractionary OMO decreases demand for bills so, price down and IR up.

The New Monetary Policy Framework (2003):• The UK Government sets the monetary policy objective and the inflation target in a remit which is

renewed annually every March.• The Monetary Policy Committee (MPC) is required to meet the set Government’s inflation target,

currently of a 2 per cent increase in the 12-monthly Consumer Prices Index at all times.• Deviations below target are treated as seriously as those above target.• The MPC publishes minutes of its decisions two weeks later. • Deviations of more than one percentage point above or below the target require an Open Letter

from the Governor of the Bank to the Chancellor. – To explain the cause of the deviation. How long inflation will be away from target. What

action the MPC is taking. How this will be consistent with the Government’s wider eco-nomic policy objectives.

• Policy co-ordination is facilitated by the presence of a non-voting Treasury representative on the MPC.

• The MPC also publishes a Quarterly Inflation Report 3b) Bancassurance, is the partnerhip or relationship between a bank and an insurnace company. It can be within one corporate group, i.e., one company, or as closely associated companies on the basis of specific arrangements. The bank uses the customer pool of the insurance company to sell its products and the insurance company uses the bank sales channel in order to sell insurance products. This allows both companies to gain by maintaining smaller direct sales teams as their products. Insurance 5

products are sold through the bank to bank customers by bank staff and vise versa. Bank staff sale insurance contacts for the customers. Bank staff are trained by the insurance company. The two companies might share the commission and other profits and the insurance policies are processed and administered by the insurance company. Bancassurance differs from conventiional model that insurance companies operate with larger sales teams and working with brokers and third party agents. Bankassurance has emerged in Europe following the market integration and liberalisation of banking and insurance industries in 1980s and 90s.3c) Companies use the stock markets to raise external equity capital for their investment needs and operational cash flows.Advantages in using capital markets to raise external investment funds:

– Growth – Status– Flexibility– Realisation of wealth

Disadvantages in using capital markets to raise external investment funds:– Disclosure – Investor pressure– Acquisitions– Insider dealing

QUESTION 4:4a) When a company needs to raise equity capital for the first time is seeking listing in a stock exchange. The process involves issuing shares to private and institutional investors, in what we call initial public offering (IPO). The issued shares are subsequently traded in the stock market between investors. This subsequent share trading in the secondary market has no cash implications for the company but offers liquidity to existing investors who decide to liquidate part or all of their investment and the opportunity of buying shares to new investors, which increases their appeal to investors. The existence and operation of well functioning stock markets enables companies to raise long-term capital, which is vital for corporate growth and social prosperity. The terms stock exchanges and stock markets are used interchangeably despite the fact that the latter is a broader term including other markets where shares are traded. In seasoned equity offerings (SEOs) publicly listed companies raise additional share capital.1b) Companies can retain part of at times the whole of their earnings to invest in new projects and fund their expansion. Companies that have high growth and opportunities to invest in positive NPV projects might not distribute dividends. This is not necessarily bad for their investors, since it results in high growth, i.e. capital gains. If investors want, need or prefer cash, they can liquidate part of their growing investment to substitute for lost dividend income. Additionally, dividend distribution is not compulsory and companies stop or reduce dividend payments, if their do not have cash, for a year or longer period. However, unanticipated dividend reductions have normally negative effect on share price. Some companies that have more cash than positive NPV investment opportunities can either build up reserves for future expansion or increase dividends or distribute extraordinary dividends for a number of years. Dividends are often taxed higher than capital gains in most of the industrial countries. Additionally, the retained profits are cheaper funds than the externally raised finance. Therefore, given the advantages of not distributing profits but retaining them, companies should be doing so. However, there are theoretical problems with that and in practice companies do distribute dividends. For example, if a company never

pays dividends ( dt 0 ): PE d

rtt

t0

1 1

( )

( ) P0 0 , its share price is zero. In practice this is not the case

(see Microsoft that didn’t pay dividends for a number of years and its share price grew phenomenally due to its investment in its high growth opportunities.Further expansion of the discussion (but not necessary in the context of this question) is possible by discussing why then in practice companies distribute dividends. Three explanations can be discussed, i.e. the distribution of dividends reduces agency cost, the Signalling hypothesis (signal to the markets) by dividend announcements and the tax clientele effect.

4c) Price: = £42

BV = = 3 MTBV = Dividend yield: = = 14

6

Dividend yield: = = 0.05

The PE ratio is: PE = = = = 10

Total Returns: TR = 0.05 + 0.05 TR = 0.10

QUESTION 5:5a) Straight or bullet bond pays coupons at a given rate for the life of the bond at predetermined time intervals, usually semi-annually or annually. At maturity, it pays the face value with the last coupon payment. Zero-coupon bond pays no coupons and is sold at discount to its face value. At maturity it pays the face value and the realised capital gains make the overall return for the investors.5b) The yield to maturity is the overall rate of return for the investor, assuming that the received coupon payments are reinvested at the same rate as the coupon rate. The current yield is the coupon rate, i.e. the coupon over bond price. This ignores capital repayment at redemption data. The coupon rate is the rate that is paid as coupon payment and is calculated as coupon over the face value. If the bond sells at premium, the current rate is lower than the coupon rate as the coupon is divided by the market value, which is higher than face value. In this case, the yield to maturity is lower than current yield the current rate as it includes the capital losses at redemption. Therefore, in general, for a bond that sells at premium, we have: yield to maturity < coupon rate < current yield. This reverses for the bonds selling at discount. 5c) The bond issued initially at par. This means that at issue the yield-to-maturity (YTM) is equal to the coupon rate 9%. The initial investor at the time of issue expects to realise 9%, if he holds the bond to maturity and the bond is not called earlier. This 9% is the cost to the issuer that does not change before maturity or early redemption using the call option.However, at the end of year 3 and 3 years before maturity, the interest rate drops to 4%. That means that the bond price increases (cost increases) and the issuer might be able to refinance the loan cheaper. However, for earlier redemption the issuer has to pay £116. He will redeem the bond earlier (using the provision of the call option), if the redemption price £116 is lower than the cost of serving the bond to the end, i.e. the value of the bond at year 3, which is:

= 24.98 + 88.90 = £113.88

Therefore, the issuer will not redeem the bond at the end of year 3. For this, he would have had to pay £116 but keeping the bond to maturity, it will only cost him £113.88.

QUESTION 6:6a) The main players in the Forex market are commercial banks and foreign exchange brokers.They keep in contact via telephone, fax and online.The major Forex centres are: London, New York, Tokyo, Singapore and Frankfurt.The US $ is called vehicle currency and is the most widely used and traded currency.Many products are priced and traded in $ US Such as: Oil. Gold, coffee, tin etc.It is often cheaper to buy a currency through $US (for example: convert first Euros to $ and then buy pesos, instead of direct purchase of pesos with Euros). Retail clients: multinational or international companies and investors, Commercial banks: execute buy and sell instructions of their clients or trade on their own account.Foreign Exchange brokers: Each financial centre has just a handful of authorised brokers through which commercial banks execute their trades.Central Banks: Despite the fact that exchange rates post 1973 fluctuate freely, central banks sometimes intervene to buy and sell their currencies in an attempt to influence the rate.

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6b) Cross-currency arbitrage suggests that for any currency, the exchange rate depends to their exchange rates to a third currency. In other words, the exchange rate between two currencies is linked to their exchange rates to any third currency traded in the market. If we assume that the exchange rates of $ to £ and Euro are: $1.40/£1 and 1Euro=1.20$. This implies that the exchange rate of Pound-Euro should be: 1.40/1.20=1.167.The UK interest rate is 5% and the US interest rate is 1%. The spot rate of pound to dollar is $1.50/£1. To calculate the one-year forward rate, we will be using the covered interest parity (CIP) formula and we will estimate whether the dollar is at forward premium or discount.

Therefore, the one-year forward pound rate is at an annual forward discount, since £1 forward buys less dollars (1.44) against the spot rate of 1.50. The discount is: (F-S)/S = [(1.44-1.50)/1.90] = -0.04 or -4%

EXAM 2007-08Answer FOUR from the SIX questions. All questions carry the same weight.

QUESTION 1. (Answer all parts of this question)(a) Describe the functions of a financial centre and explain how it serves the needs of its major parti -

cipants and contributes to national economy.(b) Explain the role of financial institutions as intermediaries in respect to maturity transformation;

risk management and provision of an efficient monitoring mechanism.(c) Describe briefly the main assets and liabilities of a bank.

[25 Marks]QUESTION 2. (Answer all parts of this question)

(a) Explain the differences between a sight draft, a certificate of deposit and a banker’s acceptance. Additionally, discuss how the banker’s acceptance is created and how it serves the needs of the in-volved parties.

(b) Describe the money markets and contrast them to capital markets.(c) Explain the role of the Bank of England in respect to market operations and its relationship to

other banks and the Government.[25 Marks]

QUESTION 3. (Answer all parts of this question)(a) Explain the rationale for government intervention in the regulation of financial markets. Focus

your discussion on the market failure argument in respect to externalities, asymmetric informa-tion, moral hazard and principal-agent problems.

(b) Why do investors use margin accounts to invest in securities? Explain how a margin account works and discuss the advantages and disadvantages in its use. What is the impact of the level of the Initial Margin Requirement (IMR) on the risk and returns of the investor? For illustrative pur-poses use and example with an IMR of 50% and IMR 10%.

(c) Describe the major role and functions of the World Bank[25 Marks]

QUESTION 4. (Answer all parts of this question)(a) Companies use the stock markets to raise equity capital. Describe the advantages and disadvant-

ages of companies going public. Ignore the details and technicalities of the process.(b) Explain what a rights issue is and compare it with the initial public offerings (IPOs) and seasoned

equity offerings (SEOs).(c) Spectra plc is a newly listed all-equity electronics company with 4,000,000 outstanding ordinary

shares. Its earnings are 100p per share and the dividend distribution policy is to distribute 50% of earnings. The total book value of assets is £16,000,000. If Spectra plc is expected to have an initial period of 20% growth per annum for the next 10 years and subsequently constant growth of 6% and the required rate of return is 12%, find the share price, market-to-book value, dividend yield, P/E ratio and total returns.

[25 Marks]QUESTION 5. (Answer all parts of this question)8

(a) Compare and contrast a callable and a puttable bond. Include in your discussion the advantages and disadvantages for issuing companies and investors.

(b) What are the similarities and differences between the current yield, coupon rate and yield to ma-turity (ytm) for a straight bond? Explain why the current yield of a straight bond that sells at premium is higher than the ytm and why, other things equal, the premium declines as we approach maturity.

(c) A callable bond has a face value £1,000, coupon rate of 10% paid annually and 10 years to matur -ity. The call option provides that the bond can be called at any time after year 4 at £1,150. Cur-rently, at the beginning of the first year, this bond sells at par. Explain whether the issuer will call the bond or not after year 4, if the interest rate at that time is 5%. Show clearly your calculations.

[25 Marks]QUESTION 6. (Answer all parts of this question)

(a) Explain the cross-currency arbitrage and its implications for the exchange rates. As an example, find and justify the equilibrium exchange rate of £ to Euro, if the exchange rate of £ to $ is 1£=$1.90 and $ to Euro is 1Euro=1.40$. Describe what will happen if this equilibrium rate does not apply and give a numerical illustration using an arbitrary higher or lower £ to Euro rate.

(b) Describe the major currency exchange regimes that are currently used and highlight the advant-ages and disadvantages of floating exchange rate regime compared to those of fixed exchange rates.

(c) Assume that the current spot rate $/£ is $1.96/£1 and the UK interest rate is 3% whereas the US interest rate is 9%. Calculate the one-year forward rate using the covered interest parity (CIP) for -mula and explain whether the Sterling is at forward premium or discount.

[25 Marks]NOTE:You might find the following formulas useful for your calculations:

h

hhdP

T 11100 +

gr

ggd

r

Ts

T

11

)1(

1 0 ; where:

=

where: = the share price; = the current dividend; = the supernormal growth rate; g = the normal growth rate; r = the required rate of return and T = the time (in years) of supernormal growth.

CIP:

ANSWERS - EXAM 2007-08QUESTION 1:1a) Financial System is the group of individuals, intermediaries and institutions that can potentially interact or participate in transactions that involve real or financial assets. The financial assets are instruments that facilitate transactions in real assets or constitute the subject of a transaction between market participants. The financial markets facilitate the trading of financial assets between market participants and the financial intermediaries facilitate the financial transactions of market participants.The Financial System provides the environment in which the individual investors and companies operate.Financial system participants:

– Individuals.– Companies.– Financial institutions, private and public organisations.– Governments.

Functions of the financial system:– Facilitations of transfer of money.– Primary and secondary security markets.– Financial services.

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1b) Maturity transformation: Ultimate lenders and ultimate borrowers have often different investment time horizons. A private individual saver might want an account to deposit their salaries or wages and withdraw money throughout the month or use a savings account to save for longer periods of time. In contrast a company might need to borrow a large amount of money for longer time to invest in fixed assets and repay the loan over several years. A bank or building society attracts large number of small deposits in current accounts (short notice withdrawals) and creates long-term loans or mortgages.Risk transformation/reduction: Large numbers of depositors (bank liabilities) make the withdrawals more predictable and need to

hold less cash. Large number of loans (bank assets) mitigates the effect of default. Specialisation of staff and procedures in selecting customers/borrowers. Diversification of assets into loans and other investments reduces risk.Monitoring: FIs are in a position of quasi-insider and share large part of confidential information with the lender

about the financed project. FIs have the resources, technology and motivation to investigate the borrower and monitor his activit -

ies relevant to the use of the loan. The cost savings associated with monitoring make feasible the creation and operation of specialists in-

termediaries (credit rating agencies, factoring companies etc).1c) In the liabilities side of the balance sheet we can see:1. The small item ‘notes outstanding’ which refers to private bank notes.2. The sterling deposits that constitute the majority of a bank’s liabilities. This mainly comes from individuals and firms. Around 45% of those deposits are sight deposits, i.e. payable in demand.3. A fifth of a bank’s deposits are foreign currency deposits.4. Finally, the other major part of bank liabilities is the items in suspense or transmission (such as cheques drawn and in the course of collection) and capital and other funds (such as issued share capital, long-term debt and reserves).In the asset side of the retail banks balance sheet we have:1. Cash in form of notes and coins is a relatively small fraction of a bank’s assets (around 0.7%).2. Another small item is the cash balances with the BoE. This is mainly the 0.15%, non-interest-bearing, compulsory ‘cash ratio’ required on all liabilities exceeding £400m.3. Market loans provide additional liquidity. These are mainly short-term loans made in money markets.4. The bills are mainly Treasury bills or bank bills.5. The repo bills are claims refer to sale and repurchase agreements, where banks acquire balances through the operation of a new system of monetary control.6. The investments of a retail bank are mainly in holding marketable securities. These are mainly government bonds or government guaranteed stocks and therefore have the characteristics of low default risk and marketability.7. Sterling advances are the main asset of a retail bank, which is her around 50% of the total assets. Major parts of these advances are:

Overdraft facilities to corporate clients Term loans to business (increasingly since mid 70s) Personal lending (increasingly since 80s): Mortgages Unsecured lending.

8. Other currency and miscellaneous assets include Advances in other currencies (20%)Market loans and investments in other currencies (80%)Miscellaneous assets include the bank’s physical assets (premises and equipment)9. The final item, Banking Department lending to Central Government, refers to the Banking Department of the BoE, which is included in the retail banks classification owing to its involvement in the clearing system.

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QUESTION 2:2a) Certificate of Deposit (CD) is a certificate issued by a deposit-taking institution that a deposit has been made.

• Negotiable.• Non negotiable (marginally lower rates).• Non negotiable CDs:

– Large denominations (> £1m).– Retail CDs (> £50,000).

• In the US are issued under the Federal Deposits Insurance Corporation.• The interest rates are a marginally less than those of sight deposits.

Banker’s acceptance is the financial instrument by which a bank guarantees the repayment of a loan to the holder of the security.

• They are used mainly to facilitate the international trade.EXAMPLE: “Foreign cars USA (FC)” importer – “Citibank”“British car manufacturer (BCM)” – “NatWest”FC asks Citibank to issue a letter of credit which will guarantee payment $2m in 60 days.The letter of credit is forwarded to NatWest.NatWest pays $2m to the BCM after shipment.NatWest will present the shipping documents and the LOC to Citibank.Citibank stamps “Accepted” on the LOC, which has become banker’s acceptance.Citibank will pay the holder $2m upon maturity.2b) Financial Markets:

• Money markets are the markets where securities with maturities less than 1 year are traded. • Capital Markets are the markets where securities with longer than 1 year maturities are traded.

Money Markets:• Domestic Money markets.• International Money markets (or Offshore market or Eurocurrency market).

Money Market participants:• The Treasury / Central Government. • The Central Bank (The Bank of England). • Government security dealers.• Commercial banks.• Non financial companies.

2c) The Central bank (CB) is usually responsible for the monetary policy.The CB controls the amount of money is circulation (money by public or banks) through open market operations (OMO).• In an expansionary OMO the CB increases the money circulation:

– by purchasing bills or bonds for cash. This:– increases the liabilities of the CB, i.e., the money in circulation and– also increases the CB’s assets i.e., its bills and bonds.– expansionary OMO increases demand for bills so, price up and IR down.

• In a contractionary OMO the CB decreases the money circulation:– selling bills and bonds to the public in exchange of money. This:– decreases the assets of the CB, i.e., its bills and bonds and– also decreases the liabilities of the CB, i.e., the money in circulation.– contractionary OMO decreases demand for bills so, price down and IR up.

The New Monetary Policy Framework (2003):• The UK Government sets the monetary policy objective and the inflation target in a remit which is

renewed annually every March.• The Monetary Policy Committee (MPC) is required to meet the set Government’s inflation target,

currently of a 2 per cent increase in the 12-monthly Consumer Prices Index at all times.• Deviations below target are treated as seriously as those above target.• The MPC publishes minutes of its decisions two weeks later.

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• Deviations of more than one percentage point above or below the target require an Open Letter from the Governor of the Bank to the Chancellor.

– To explain the cause of the deviation. How long inflation will be away from target. What action the MPC is taking. How this will be consistent with the Government’s wider eco-nomic policy objectives.

• Policy co-ordination is facilitated by the presence of a non-voting Treasury representative on the MPC.

• The MPC also publishes a Quarterly Inflation Report

QUESTION 3:3a) Government intervention is rationalized on the grounds of ‘market failure’ as manifested in the following problems:

1. The externalities problem.2. The problem of asymmetric information.3. The moral hazard problem.4. The principal-agent problem.

The externalities problem.• The problems of the financial sector spread and become problems of the whole economy:

– The financial system provides the payment mechanism for the whole economy.– The financial institutions provide the environment for interaction of savers and borrowers.– Banking scandals and failures have affected the entire financial system of countries and

harmed their economic progress.The problem of asymmetric information.

• The directors and managers of companies and financial institutions have superior information to other corporate outsiders:

– The published corporate statements and accounts provide only a partial view of corporate affairs.

– Trading on insider information is illegal for investor protection.Financial institutions and companies are large listed companies and subject to additional disclosure requirements for important events that have significant share price implications.The moral hazard problem.

• Insurance against an undesirable event might make it more likely to happen. Investors become more risk prone if they do not suffer the result of their risky behavior:

– Risk protection makes both individual investors and financial institutions more risk lovers.– The deposit insurance protection schemes remove the risk from depositors, which might

encourage them to deposit with high interest rate offering banks.– Financial institutions might invest in riskier projects to compete on offering higher interest

rates to their depositors.The principal – agent problem.

• The directors and managers of financial institutions act as agents of shareholders and investors. Therefore, they might act in their own interest instead of the interest of shareholders:

– A number of factors contribute to this problem (separation of ownership and control; self-interest and motivation of individuals; asymmetric information; asymmetric distribution of cost-benefits of managerial behavior; imperfect contracting technology; imperfect market mechanism).

– A number of proposed remedies (better monitoring of managerial behavior by an indepen-dent board of directors; more outsider directors; better contracting technology in manage-rial employment; share options and other equity based compensation incentives in manage-rial remunerations; more efficient market for corporate executives).

– Efficient market for corporate control (as an external mechanism).3b) To trade securities using the services of a broker you should open a cash or margin account with them. Using debt as part of an investment through a margin account is called buying on margin.A cash account is like a standard current account with a high street or e-bank. Cash from deposits by the investor or proceeds from sales of securities goes into the account and out comes cash to pay for purchase of other securities, broker fees and other costs. The investor has the balance free to his disposal.12

A margin account is like a current bank account with an overdraft facility. The investor can pay only a part (proportion) of the value of the securities with his own funds (initial margin requirement - IMR) and obtain a loan from the broker to pay for the balance. This borrowed balance is called debit balance or brokers’ call loan. The broker keeps the securities purchased using a margin account in his street name, as collateral for the loan to the investor. For this, the investor has to agree and sign a hypothecation agreement. The broker, as register owner of the shares, receives dividends, annual reports and voting rights but he transfers them to the investor. The money for the debit balance loan often comes from another loan. The broker takes the loan from a bank, at the call money rate and offers the securities as collateral to this loan (the proceeds of which are eventually given to the investor as debit balance loan). On the call money rate the broker adds a service charge (typically around 1%) to determine the interest rate for the debit balance loan that is charged to the investor.The payment for the securities purchased by an investor using a margin account comes from two sources: a. The investor, who contributes from his own funds, the initial margin requirement andb. A loan from the broker for the balance, namely the debit balance.

balance)(Debit (IMR) investment of Value

The percentage margin is defined as the ratio of net worth or equity value of the account to the market value of the securities. Following the purchase of a security, its price may change and similarly the actual margin may differ from the initial margin requirement.

Actual Margin =

The daily estimation of the actual margin in an investor’s margin account is called mark to market.3c) The World Bank Group is comprised of four affiliates:

1. The International Bank for Reconstruction and Development (IBRD)2. The International Development Association (IDA)3. The International Finance Corporation (IFC)4. The Multilateral Investment Guarantee Agency (MIGA).

The IBRD (or WB) was created during the Bretton Woods conference (1944).• WB concentrates on long-term development. WB and IMF hold their annual meetings jointly and

membership in the IMF is a prerequisite for WB membershipWB must lend for productive purposes and stimulate economic growth in developing countries.The IDA is a WB affiliate that gives loans to the governments of the poorest members countries that are not qualified for IBRD loans.

• Contributions from the wealthiest members.• Loans are interest-free and up to 35 to 40 years. • 5-8% of the total financing to the less developed countries comes from IBRD and IDA.

The IFC was established in 1956 and makes private sector investment.• It has 170 countries members.• IFC advises governments on the fiscal, legal and regulatory frameworks.• IFC attracts international investors to the host country security markets.• IFC relies on capital markets for its funding and is an active participant in privatizations.• MIGA is the newest member of the WB group (1988).• Formed by 42 WB member countries (now 160+ members).MIGA provides insurance protection for foreign investors against noncommercial risk in developing countries:• Currency transfer risk: risk that conditions for converting and repatriating currency will deterio-

rate.• Expropriation risk: the risk of being unwillingly deprived thi investment or the benefits from the

investment.• Risk of war, revolution and civil disturbance.MIGA may insure for equity investments, up to 90% (+up to 450% of investm for earn) or for loans and loan guarantees 90% principal + 135% of principal for accrued interest.

QUESTION 4:

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4a) Companies use the Financial system to raise external capital for investments.Advantages in using capital markets to raise external investment funds:

– Growth – Status– Flexibility– Realisation of wealth

Disadvantages in using capital markets to raise external investment funds:– Disclosure – Investor pressure– Acquisitions– Insider dealing

4b) Primary market is where companies raise new capital by issuing new shares.• New shares are offered to the investors by investment banks.• There are two types of primary market issues:

– Initial public offerings (IPOs) is the issue of shares in a company for the first time.– Seasoned new issues are additional issues of shares by companies that they have already

issued shares trading in a stock exchange.4c)

1. Price:

h

hhdP

T 11100 +

gr

ggd

r

Ts

T

11

)1(

1 0

where: (1+h) = h = h = h = 0.0714.

Therefore:

7.4518 + 17.6099 = £25.0617

2. MTBV = = = 6.27

3. Dividend yield: = = 0.02394 or 2.39%

4. The PE ratio is: PE = = = = 20.88

5. TR =

We use , which is the weighted average of the growth over the two periods. The weights are the proportion of the price contribution of each period. The relative contribution of the first period of 10 years supernormal 20% growth to the price is:

= 0.297

and the relative contribution of the second period of 6% growth thereafter is:

= 0.703

= = 9.98%

TR = +9.98% = 2.39% + 9.98% = 12.38%

QUESTION 5:5a) Callable bond is the bond that has a call option embedded, which gives the issuer the right to call/redeem the bond earlier than its maturity. The issuer might use this option, if subsequently to the issue of the bond the interest rates fall and becomes more profitable to refinance the borrowing with new 14

lower cost bond. The option of a bond issuer to redeem a bond before maturity offers flexibility to the management in respect to control over corporate gearing. Additionally, it is beneficial for the issuer to redemption early a high-coupon bond and replace it with another with lower coupon. This happens when the bond initially issued at times of high interest rates that subsequently decline. A callable bond offers this valuable option to the issuer but this comes at the expense of the investor that holds such a bond. Therefore, a callable bond should have lower price than a similar plain vanilla bond, this will compensate the investor for potential loss at early redemption. Alternatively, the lower price represents the offset of the value of the call option for the issuer.5b) The yield to maturity is the overall rate of return for the investor, assuming that the received coupon payments are reinvested at the same rate as the coupon rate. The current yield is the coupon rate, i.e. the coupon over bond price. This ignores capital repayment at redemption data. The coupon rate is the rate that is paid as coupon payment and is calculated as coupon over the face value. If the bond sells at premium, the current rate is lower than the coupon rate as the coupon is divided by the market value, which is higher than face value. In this case, the yield to maturity is lower than current yield the current rate as it includes the capital losses at redemption. Therefore, in general, for a bond that sells at premium, we have: yield to maturity < coupon rate < current yield. This reverses for the bonds selling at discount. 5c) The bond issued initially at par. This means that at issue the yield-to-maturity (YTM) is equal to the coupon rate 10%. The initial investor at the time of issue expects to realise 10%, if the issuer does not redeem the bond early and he holds the bond to maturity. This 10% is the cost to the issuer that does not change before maturity or early redemption using the call option.However, at the end of year 4 and 6 years before maturity, the interest rate drops to 5%. That means that the issuer can refinance the loan cheaper or the price of bond increases. However, for earlier redemption the issuer has to pay £1,150. He will redeem earlier the bond (using the call provision), if the redemption price £1,150 is lower than the cost of serving the bond to the end, i.e. the value of the bond at year 4, which is:

= 507.57 + 746.22 = £1,253.78Therefore, the issuer will redeem the bond at the end of year 4. For this, he will pay £1,150 but will gain by saving on the cost of £1,253.78 to service the bond to redemption.

QUESTION 6:6a) Cross-currency arbitrage suggests that for any currency, the exchange rate depends to their exchange rates to a third currency. In other words, the exchange rate between two currencies is linked to their exchange rates to any third currency traded in the market. If we assume that the exchange rates of $ to £ and Euro are: $1.90/£1 and 1Euro=1.40$. This implies that the exchange rate of Pound-Euro should be: 1.90/1.40=1.36.If the exchange rate £-Euro is 1.75Euros/£1, you can make risk-free profit by using pounds to buy Euros and selling $.You can sell £1 to buy 1.75 Euros then use these proceeds to buy $2.45 and use $1.90 of these proceeds to buy £1 (leaving you $0.55 profit).6b) At Bretton Woods conference in 1948, the major western economies adopted a pegged exchange rate regime. This was abandoned in 1973.Since then the major currencies in the world have floating exchange rates but a number of alternative systems also exist:• Floating exchange rates

– The currencies fluctuate freely and the exchange rate is determined by demand and supply.• Fixed exchange rates

– Governments fix (or peg) the value of the currency to another major currency, usually the $ US.

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6c) The UK interest rate is 3% and the US interest rate is 9%. The spot rate of pound to dollar is $1.96/£1. To calculate the one-year forward rate, we will be using the covered interest parity (CIP) formula and we will estimate whether the dollar is at forward premium or discount.

Therefore, the one-year forward pound rate is at an annual forward premium, since £1 forward buys more dollars (2.0742) against the spot rate of 1.96.The discount is: (F-S)/S = [(2.0742-1.96)/1.96] = 0.0583 or 5.83%.

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