KENYATTA UNIVERSITY

SCHOOL OF BUSINESS

UNIT NAME: FINANCIAL MARKETS AND INSTITUTIONS

UNIT CODE: BAC 305

DEPARTMENT: ACCOUNTING AND FINANCE

LECTURER: DR. IRUNGU

NAME REG NO
OCHIENG LEAKY ODHIAMBO D33/1350/2018
 QUESTION 1A

Role of Interest Rates and Their Usage in Securities Valuation

Interest rates play an important role in the valuation of securities such as bonds, shares and

other securities. The role of interest rates and their usage in securities valuation are listed

below.

1.Role of Interest Rate on the Stock Market

Interest rates affect the stock market. They may either increase the stock prices or

reduce the stock prices. When the central bank increases the discount rates, this indirectly

affects the stock markets. The increase in the discount rate creates a ripple effect on the

economy first. The cost of borrowing becomes high, especially to the banks and other

financial institutions, which therefore means that the financial institutions also charge a

higher price to the consumers. Moreover, the cost of borrowing and financing debt also

increases. The consumers are therefore left with minimal money to even pay their bills and

also invest. They will therefore reduce their spending, which means that the business

spending will also reduce, which ultimately slows the growth and investment of companies.

The net effect of this is that there will be a decrease in earnings and growth which ultimately

leads to a reduction in stock prices.

2. Role of interest rate on the Bond Market

Interest rates have an effect on the bond market, specifically on their prices and the

return on certificate of Deposits (CDs). There exists a relationship between interest rate and

the prices of bonds. An increase in the interest rate leads to a decrease in the bond prices,

while a decrease in the interest rates produces an increase in the bond prices. Moreover, the
interest rate also has an effect on the maturity value of the bonds depending on the

fluctuations that longer terms bonds have. Businesses and the government mainly raise funds

through selling bonds. They usually raise funds when the interest rates are low in order to

fiancé any new ventures.

3.Role of Interest Rates on Expectations.

The rise and fall of interest rates may increase the expectations or reduce the

expectations that investors have. It may also have an effect on the psychology of investors.

For example, when the central bank announces an increase in the federal rate, business and

individuals will reduce their spending. The net effect of this is a reduction in earnings and a

reduction in stock prices.

4.Role of Interest Rate as a Monetary Policy Primary Tools

The interest rate plays a crucial role in monetary policy in the following ways. The

central bank, usually through the Open Market Operations, uses interest rates as a tool for

buying and selling securities which have an impact on the economy. Moreover, the deposit

rates also have an impact on the lending rates, which may impact business decisions.

Business decisions, on the other hand, impact economic growth and employment.

QUESTION 1B

Effects of Interest Rate Change and Risk Structure

To explain the effect of interest rate change and Risk structure, we examine two of the

following;

1. Risk Structure of Interest Rates

 2. Term Structure of Interest Rates

1.Risk Structure of Interest Rates

The Risk Structure of interest rates may be explained by the behaviour of bonds. This is

mainly because the interest rates on bonds change on a yearly basis and also due to the facts

that the spreads on the various types of bonds also change on a yearly basis.

There are three main risk factors.

I. Default Risk Factor

The default risk factor may be described as the probability that a bond issuer will

default the interest payments. The default risk nature of a bond, therefore, has an influence on

the interest rates of bonds. On the other hand, there are default-free bonds such as

Government bonds. The difference between the interest on bonds with default risk and those

without default risk is what is known as risk premium, which is a good indicator of how

much more in terms of the interest must persons get in order to hold a bond with default risk.

The following is a summary of how the risk factor on bonds affects bond pieces and interest

rates.

Corporate Bond Market- price ↓, interest rate↑

Treasury Bond Market- price ↑, interest rate ↓

Risk premium= interest rate of corporate bond- interest rate of Treasury Bond.

II. Liquidity Factor

The liquidity factor of a bond also has an effect on its interest rate. The more liquid an asset

is, the higher the interest rate and the price of the asset or security.

The difference between the liquidity of the corporate bonds and the treasury bonds is called

the liquidity premium.

2. Term Structure of Interest Rates

The term structure of bonds may also be referred to as the maturity date of bonds. The

maturity of bonds also affects the interest rates of bonds. In simple terms, the interest rate is

dependent on different maturities of bonds. Usually, the shorter the term structure of a bond,

the higher the interest rate and vice versa. An example is given below.

A 3-month Treasury bond- 4.85%

A 2-year Treasury bond- 4.50%

QUESTION 2

Connection Between Ethical Responsibility of the Banking Industry and the

Management of Financial Institutions

Ethical responsibility refers to how the behaviour of a given firm or business is ideally

acceptable by society and is not guided or dependent on the law. Ethical banking how

banking practices are acceptable within the society and the general environment. In orders for

us to identify the connection responsibility of the banking industry and the management of

the financial institutions, it is first important to outline the ethical responsibility of the

Banking industry followed by how financial institutions are managed.

Ethical responsibility of the Banking industry

The ethical responsibility of the banking industry is listed below;

I. Screening clients so that they know if the clients are credit worthy or the clients'

activities are ethical.

II. Participating in Corporate Social Responsibility (CSR) involves giving back to

society and creating a positive relationship among locals.

III. The other responsibility is making sure that the ethics within the banking industry are

consistent.

The management of financial institutions

In the fast-changing world, management of financial institutions has never been easy due to

the constant competition, available risk factors, mergers and acquisitions. The first step in the

management of financial institutions recognises the various items within financial institutions

such as loans and deposits, securities, reserves and other physical assets. Some of the ways

institution may manage these components include the following;

I. The financial institutions may manage assets by diversifying in different asset

portfolio, for example, investing in securities.

II. Financial institutions may manage their capital assets by having a steady dividend

pay-out system and retention level.

III. The financial institutions may manage risk by having loan borrowers provide

collaterals, screening and monitoring loans borrowers, rationing credit and using

credit insurance.
Connection

From the above illustrations, it is evident that banks have an ethical responsibility

while financial institutions have management responsibility. The two are connected in that

banks are financial institutions, and also they share similar ethical responsibilities. For

example, financial institutions such as the banking industry have a managerial duty to ensure

that the customer's assets inform of securities are well managed through diversification.

Moreover, both of them have an ethical responsibility of screening customers and business

and make sure that their activities are legal and morally acceptable.

QUESTION 3

How a weakened banking sector, rising interest rates and Asymmetric Information can

contribute to the onset of both a currency and financial crisis

The following are how the banking sector, rising interest rates and asymmetric information

can contribute to the onset of both a currency and financial crisis.

Weakened banking sector

A weakened banking sector means that a given bank has extremely low bank capital.

Banking capital may be defined as the amount of money owed to the shareholder after all the

assets are liquidated. The role of the bank capital is that it acts as a buffer against insolvency

so long as it is positive. However, when the bank capital is very low compared to the assets,

bank managers often tend to take risks. Shareholders, in such cases, are pushed to the wall,

and they have no choice but to force the managers to act more prudently. A banking sector

that has less capital may aggregately damage the economy. First, the bank may not be in a

position to provide loans to creditworthy customers. Moreover, an increase in the level of the
low banking capital may cause more panic and expose the vulnerability of banks, which may

lead to a financial crisis.

Rising Interest Rates

Interest rates cause an increase in funding costs. This, therefore, means that the cost of

getting loans are high, which also translates to investment costs. Rising interest rates may

also lead to an increase in the export prices to offset the high costs of investments. The high

prices lead to an increase in the prices of goods and services, leading to a subsequent

decrease in the demand for those goods and services. The net effect of this is a decrease in

current accounts, which may lead to a fall in the exchange rates, leading to a currency crisis.

Asymmetric information

This may be described as a situation where one party has some information that

another party lacks. In the financial markets, the situation may occur when the borrower has

some formations that the lender lacks. The lender thee may find it had to gauge whether the

given borrower will default the loan or not. The lender's credit history may not be sufficient

to provide the full information that the lender may lead. Asymmetric information may also

mean that the lender lacks information about the investment decisions and the risk factors of

those investment decisions. The net effect of asymmetric information may lead to a financial

crisis, especially when the lenders default on the amount borrowed.

 References

Bebczuk, R. N., & Bebczuk, R. N. (2003). Asymmetric information in financial markets:

introduction and applications. Cambridge University Press.

Kolb, R. (Ed.) (2018). The SAGE encyclopaedia of business ethics and society. (Vols. 1-7).

SAGE Publications, Inc., https://www.doi.org/10.4135/9781483381503

Choi, T. H., & Pae, J. (2011). Business ethics and financial reporting quality: Evidence from

Korea. Journal of Business Ethics, 103(3), 403-427.