FINANCIAL MARKETS AND REGULATION [CFI1203]

REVISION QUESTIONS WITH SELECTED SUMMARY ANSWERS

INTRODUCTION TO FINANCIAL MARKETS [CFI1203]

1. What does the financial system do for a modern economy?

Financial systems support the market economy allowing to:
 Allocate scare resources efficiently.
 Pricing and management of the risk involved in lending money.
 Introduce risk as regards to human trust.
 Channeling funds from surplus sectors to deficit sectors. Create the required financial
claims.

2. What have been the major factors contributing to growth in the foreign financial markets?
Answer:
1. The amount of savings available for investment in foreign countries has increased.
2. International investors have looked to the United States for better investment opportunities.
3. The Internet has helped provide additional information on foreign markets and overseas
investment opportunities.
4. Specialized intermediaries such as country-specific mutual funds and ADRs have been developed
to facilitate overseas investments.
5. The euro has had a notable impact on the global financial system by being an important currency
for international transactions.
6. Deregulation of foreign markets has allowed many new investors to participate in international
investing.

3. Discuss the advantages to deficit and surplus units of using organized financial markets and financial
intermediaries
Answer (student,s answer based on knowledge of the financial system)

4. Discuss the economic functions of financial markets

Answer (elaborate on the following)
1) Price discovery
2) Asset valuation.
3) Arbitrage.
4) Liquidity
5) Raising capital.
6) Commercial transactions.
7) Investing.

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 8) Risk management.
9) Reduction of transaction costs

5. Distinguish between the following types of markets:

a) Primary markets and secondary markets
b) Money and capital markets
c) Internal and external markets
d) Cash and derivatives market
e) Spot and futures market

Answer (refer to your notes)

6. Discuss how secondary markets benefit issuers and investors.

Answer:
The secondary markets provide liquidity to investors after their initial purchase of the security. This
liquidity encourages them to purchase the security at the initial offer. The current market price also
reflects current prospects for the firm and the competitiveness of the issue relative to similar
securities. Corporate treasurers follow their stocks' price closely because the stock price reflects how
well their firm and the market are performing. The current security price also provides information
about the cost of obtaining any additional funds.

7. What determines the price of financial instruments? Which are riskier, capital market instruments or
money market instruments? Why?
Answer:
The price of any financial instrument is the present value of future cash flows discounted at an
appropriate rate. A small change in interest rates causes a large change in present value of distant
cash flows. Hence, the prices of long-term capital market instruments are more sensitive to changes
in interest rates than prices of short-term instruments. In addition, distant cash flows for stocks are
not known with certainty. Changing economic prospects can cause very large changes in current
stock values. Money market instruments have predictable cash flows and mature in one year or less,
so they are much less risky.

8. Identify and briefly describe the properties that determine the attractiveness of financial assets to different
investors.
Answer (elaborate on the following)
1) Moneyness.
2) Divisibility & Denomination
3) Reversibility
4) Cash Flow
5) Maturity Period
6) Convertibility
7) Currency
8) Liquidity
9) Predictable Returns
10) Tax Status of Returns

9. Explain why financial intermediaries are among the most regulated sectors in the world?

Answer (check your notes)

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10. How can brokers and dealers make money? Which activity is riskier? Why?

Answer:
An asset broker assists buyers and sellers of securities by providing a mechanism for buyers or sellers to
process their orders. If the broker simply assists one party in finding another party, the broker charges a
small fee called a commission. An asset dealer buys the security for his or her own account at the bid
price and then sells the security at a higher ask price. The dealer profits by earning the bid-ask spread or
the difference between the buy and sell price. The dealer's function is riskier because the dealer must
maintain an inventory of the asset and honor quotes to buy and sell. If the security is risky, the value of
the inventory can fluctuate with market prices. The broker takes less risk because he or she does not own
the security.

11. The financial service sector has experienced tremendous growth in the recent past.
Required:
In relation to the above statement, explain five factors that might have contributed to such
growth.(10 marks)

12. Briefly provide the role, economic functions and components of Financial Markets
13. Identify and briefly explain the forces of change that shape financial markets of the future

INTEREST RATES: DETERMINATION AND TERM STRUCTURE

14. Consider the following yields to maturity:

Years to Maturity Yield to Maturity

1 3.0%
2 3.5%
3 3.9%
4 4.4%
5 4.8%
6 5.2%

(a) Graph the yield to maturity against the time to maturity.

8
6 Years to
4 Maturity
2 Yield to
Maturity
0
1 2 3 4 5 6

(b) Is this yield curve consistent with any of the yield curve theories? Explain.
This is an upward-sloping yield curve. (NB read more about the upward sloping yield curve)

15. If a three-year security has a yield of 5%, and a two-year Treasury security has a yield of 4.5%, what is

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 the one-year forward rate two years from now?

ANS C
(1 + 0.05)3 = (1 + 0.045)2 (1 + f); 1.157625 = 1.092025 (1 + f); f = 6.01%.

16. A corporate treasurer is considering borrowing funds for 10 years. How can the corporate treasurer use
forward rates in determining whether to borrow today or postpone borrowing?
By calculating the forward rates, based on today‟s rates for various maturities, he/she can derive the
slope of the yield curve, which suggests the expectations for interest rates in the future.

17. What is the meaning of the forward rate in the context of the term structure of interest rates?

MONEY MARKET

18. (a) What are money market securities?

(b) What are the four main characteristics of money market securities?

Answer:
(a) Money market securities are basically financial debt instruments which are aimed at fulfilling the
short-term requirements of the business. The maturity period of these debt instruments is generally
one year or less. Treasury bills and commercial papers may be considered as the example of money
market securities.
(b) The main characteristics of money market securities include opportunity cost, low default risk and
liquidity.
Opportunity cost: A company should aim at raising funds through these money market securities at
an optimum level. Excess cash holdings may lead to opportunity cost for the company which might
be impending in the long run of the business.
Low default risk: Money market instruments generally involve low default risk. It is because these
securities have a maturity period of about one year or less. This less maturity period reduces the
chance of nonpayment of principal and its respective interest. Consequently, it helps in the
minimization of the risk so arising in the case of such securities.
Liquidity: Money market instruments generally provide high liquidity. These securities can be
converted into cash and cash equivalents as and when needed. Further, generally, no cost is incurred
with respect to such conversion into cash and cash equivalents.
The high rate of return: These money market instruments generally generate considerably a good
return. This is served as a new investment opportunity among the various potential investors in the
market.

19. Study the following table and critically give a summary of the main characteristics that distinguish
between the money market instruments provided on the table.

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20. (a) What are money market securities?
(b) What are the four main characteristics of money market securities.

SOLUTION
(c) Money market securities are basically financial debt instruments which are aimed at fulfilling the
short-term requirements of the business. The maturity period of these debt instruments is generally
one year or less. Treasury bills and commercial papers may be considered as the example of money
market securities.
(d) The main characteristics of money market securities include opportunity cost, low default risk and
liquidity.
Opportunity cost: A company should aim at raising funds through these money market securities at
an optimum level. Excess cash holdings may lead to opportunity cost for the company which might
be impending in the long run of the business.
Low default risk: Money market instruments generally involve low default risk. It is because these
securities have a maturity period of about one year or less. This less maturity period reduces the
chance of nonpayment of principal and its respective interest. Consequently, it helps in the
minimization of the risk so arising in the case of such securities.
Liquidity: Money market instruments generally provide high liquidity. These securities can be
converted into cash and cash equivalents as and when needed. Further, generally, no cost is incurred
with respect to such conversion into cash and cash equivalents.
The high rate of return: These money market instruments generally generate considerably a good
return. This is served as a new investment opportunity among the various potential investors in the
"market.

21. Explain why treasury bills are considered to be “riskless”.

ANSWER:
Treasury bills are short-term money market instruments issued by government and backed by it.
Therefore market participant view these government securities as having little or even no risk

22. Treasury Bills

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 (a) Investors require a 4 percent annualized return on a one-year T-bill with a $10,000 par value. What is
the price that they are willing to pay?
Answer
P = $10,000/1.04 = $9,615.38
(b) An investor purchases a T-bill with a six-month (182-day) maturity and $10,000 par value for $9,800.
If this T-bill is held until maturity, what is its yield:
Answer
((SP-PP)/PP) x (365/n)

Y T = 10,000 - $9,800 x 365 = 4.09%

$9,800 182
(c) Suppose the investor plans to sell the T-bill after 120 days and forecasts a selling price of $9,900 at
that time. What is the expected annualized yield based on this forecast?

Answer
YT = (($9,950 - $9,800)/ $9,800) x (365 /120) = 4.65%

(d) What conclusion do you draw from the above?

Answer: The higher the forecasted selling price, the higher the expected annualized yield

23. Using a practical example describe the sequence of steps in the creation of a Banker‟s Acceptance.
Answer [refer to notes]

24. Using a practical example describe the sequence of steps in the creation of a Banker‟s Acceptance.
Answer [refer to notes]

25. Explain why treasury bills are considered to be “riskless”.

ANSWER:
Treasury bills are short-term money market instruments issued by government and backed by it.
Therefore market participant view these government securities as having little or even no risk

26. What is the difference between money market instruments quoted „on a discount basis‟ and „on a yield basis‟?

FIXED SECURITIES /BOND MARKET

27. What are the characteristics of bonds that make them distinctly different from (a) preference shares (b)
ordinary shares?
Answer (read notes)

28. What determines the price of financial instruments? Which are riskier, capital market instruments or
money market instruments? Why?
Answer:
The price of any financial instrument is the present value of future cash flows discounted at an
appropriate rate. A small change in interest rates causes a large change in present value of distant
cash flows. Hence, the prices of long-term capital market instruments are more sensitive to changes
in interest rates than prices of short-term instruments. In addition, distant cash flows for stocks are
not known with certainty. Changing economic prospects can cause very large changes in current
stock values. Money market instruments have predictable cash flows and mature in one year or less,
so they are much less risky.

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29. What is a convertible bond?
A convertible bond is a bond with the usual standard features, but in addition, they can be
exchanged for another type of asset. The most common conversion is one that allows the
bond to be converted into ordinary shares of the bond-issuing company, being a flexible
financing option.

30. The following example illustrates the sensitivity of bonds to interest rates changes. Consider two bonds A
and B. Both bonds initially have a 10% discount rate.
Notice that when the discount rate increases to 12%, the price of Bond B changes more than the price of
Bond A.
Bond Maturity Coupon Rate Price at 10% Price at 12% % of Change
Bond A 5 years 10% $1,000 $926.40 7.36%
Bond B 30 years 6% $661.41 $515.16 $17.10
Required:
Explain three characteristics of bonds with respect to interest rates that are being revealed from the
above bonds.
Answer
1) Bond prices move inversely with interest rates.
2) Bonds with longer maturities experience greater percentage price changes for a given change in
interest rates.
3) Bonds with lower coupon rates experience greater percentage price changes for a given change in
interest rates

31. Describe the main risks that are associated with bond trading:
Answer: (expand on the following)
a) Interest rate risk
b) Default risk

32. Consider the following two bond issues.

 Bond A: 5% 15-year bond
 Bond B: 5% 30-year bond
Neither bond has an embedded option.
Both bonds are trading in the market at the same yield.
Which bond will fluctuate more in price when interest rates change? Why?
ANSWER
All other factors constant, the longer the maturity, and the greater the price change when interest rates
change. So, Bond B is the answer.

33. The following table examines two bonds that are similar in all respect except bond C has 15 years to
maturity while Bond D has 20 years to maturity.
Price Sensitivity of Bonds C and D
Bond C Bond D
Yield Change 15-year, 8% coupon 20-year 8% coupon
Yield Price ($) % Price Change Yield (%) Price ($) % Price
(%) Change
-2% 9.94 86.68 +16.01 11.73 73.38 +16.01
Before 11.94 74.66 0.00 13.73 63.25 0.00
Change

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 +2% 13.94 65.06 -12.87 15.73 55.15 -12.80
Required:
Explain two important characteristics of bonds that are being revealed in the above table.

Answer
The table shows two important points:
1) Holding coupon and maturity constant, a bond with a higher yield has lower price sensitivity.
2) Coupon and maturity are generally not equal across bonds.

34. (a) What is the importance of credit ratings for bond markets?
- Provide individual and institutional investors with information that assists them in
determining whether or not the issuers of debt obligations and fixed-income securities will be
able to meet their obligations with respect to those securities, that is,
- CRAs play a key role in financial markets by helping to reduce the informative asymmetry
between lenders and investors, on one side, and issuers on the other side, about the
creditworthiness of companies (corporate risk) or countries (sovereign risk).

(b) Discuss the recent debate that has resulted in misgivings on the use of bond credit ratings.
 The effectiveness of the debt rating system has been debated due to the subprime crisis of 2007,
which revealed the system's flaws when highly-rated structured securities were suddenly
revealed to be of very questionable value.
 The loans supporting these structured securities were made to marginally qualified borrowers
and were often backed by very inadequate collateral, but these circumstances did not result in
significant downgrades from ratings agencies.
 Questions have been raised as to whether this could have been a result of
- potential conflict of interest arising when a rating agency offers consulting or other
advisory services to issuers it rates since issuers could be unduly pressured to purchase
advisory services in return for an improved rating
- Barriers to entry and lack of competition in the industry.
- Lack of Transparency over CRAs‟ ratings methodologies, procedures, practices and
processes.

35. Explain how the mortgage markets facilitate the flow of funds that lead to economic growth.

- The financial intermediaries that originate mortgages obtain their funding from household
deposits. They also obtain funds by selling some of the mortgages that they originate directly to
institutional investors in the secondary market.
- These funds are then used to finance more purchases of homes, condominiums, and commercial
property.
- Overall, mortgage markets allow households and corporations to increase their purchases of
homes, condominiums, and commercial property and thereby finance economic growth.

36. Provide main types of mortgages, after which you examine the various types of residential mortgages that
are available to homeowners.
Main types of mortgages
- Prime versus Subprime Mortgages
- Insured versus Conventional Mortgages
Residential mortgages
- Fixed-Rate Mortgages
- Amortising Fixed-Rate Mortgages.
- Adjustable-Rate Mortgages

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 - Graduated-Payment Mortgages
- Growing-Equity Mortgages
- Second Mortgages
- Shared-Appreciation Mortgages
- Balloon-Payment Mortgages

37. What is the value of a 5-year 7.4% coupon bond selling to yield 5.6% assuming the coupon
payments are made semiannually?

38. What is the value of a zero-coupon bond paying semiannually that matures in 20 years, has a
maturity of $1 million, and is selling to yield 7.6%.

STOCK MARKET

39. Explain 4 of the main differences between an ordinary share and a preference share.
* Clearly explain four differences between a common share and a preference share
Ordinary shares give their holders claims to variable future streams of income and those
payments paid out if profits are known as dividends.
Preference shares as their name indicates, they have preference over the ordinary shares.
The differences are:
a) Preference shareholders are entitled to a fixed dividend payment before any dividend
is distributed to ordinary shareholders.
b) As the dividend does not change, the price of the preference stock is relatively stable.
c) Preference shareholders are not part owners of the company, and they don‟t have any
voting rights at general meetings. Whereas ordinary holders do have voting rights.
d) Preference shareholders hold a claim on assets that has priority over the claims of
common or ordinary shareholders, but after creditors and bondholders.

40. How is the dividend on a corporate equity different from the interest payment on a corporate
bond?
The main difference is that a dividend has the right to a share of the profits, although
dividends are not guaranteed. However, interest payments on corporate bonds are legally
compulsory. Dividends are usually higher than bond interests.

41. Discuss how secondary markets benefit issuers and investors.

Answer:
The secondary markets provide liquidity to investors after their initial purchase of the security. This
liquidity encourages them to purchase the security at the initial offer. The current market price also
reflects current prospects for the firm and the competitiveness of the issue relative to similar
securities. Corporate treasurers follow their stocks' price closely because the stock price reflects how
well their firm and the market are performing. The current security price also provides information
about the cost of obtaining any additional funds.

42. (a) What is an Initial Public Offering (IPO)?

Initial public offering (IPO) means issuing public equity, i.e. when a company is engaged in offering
of shares and is included in a listing on a stock exchange for the first time. It allows the company to

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 raise funds from the public.

(b) Examine the advantages and disadvantages of Initial Public Offerings (IPOs)
Answer
The following are important advantages and disadvantages of initial public offerings (IPOs).
Advantages of IPOs:
(a) Possibility to obtain funds to finance investment.
(b) The price of a company‟s shares acts as a measure of the company‟s value.
(c) Increases of company financial independence (e.g. from banks) due to listing of
a company‟s shares on a stock exchange.
(d) Possibility to diversify investments of current company owners by selling stakes
in the company in a liquid market.
(e) Increased recognition of the company name.
(f) Improved company transparency.
(g) A disciplining mechanism for managers.
Disadvantages of IPOs:
(a) High issuance costs due to underwriters‟ commission, legal fees, and other charges.
(b) High costs due to disclosure requirements.
(c) Risk of wider dispersed ownership.
(d) Separation of ownership and control which causes „agency problems‟.
(e) Divergence of managers‟ and outside investors‟ interests.
(f) Information asymmetry problems between old and new shareholders.
(g) Risk of new shareholders focusing on short-term results.

43. (a) What is meant by the term listing?

Listing means the admission of securities of a company to trading on a stock exchange.
(b) What are the advantages and disadvantages of listing on an organized stock exchange?
Advantages of listing on the stock exchange to the corporation and its shareholders are:
1. The ability to sell shares on the stock exchange makes people more willing to invest in
the company.
2. Investors may accept a lower return on the shares and the company can raise capital more
cheaply.
3. Stock exchange provides a market price for the shares, and forms basis for valuation of a
company.
4. The information aids corporate governance, allows monitoring the management of the
company.
5. Listing makes takeover bids easier, since the predator company is able to buy shares on the
stock market.
6. The increased transparency may reduce the cost of capital.
However there are several Disadvantages of listing, which include:
1. Listing on the stock exchange is costly for the company.
2. It requires a substantial amount of documentation to be prepared, e.g. audited and
prepared according to IFRS financial statements.
3. It increases transparency, which may cause problems in terms of market competition and in
takeover cases.

44. Discuss the economic significance of the stock exchange

Answer:

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 (a) Raising capital for businesses
(b) Mobilizing savings for investment
(c) Liquidity
(d) Better Allocation of Capital

(e) Facilitating company growth

(f) Redistribution of wealth
(g) Corporate governance
(h) Creating investment opportunities for small investors
(i) Government capital-raising for development projects
(j) Barometer of the economy
(k) Contributes to economic growth

45. Explain how brokers and dealers make money? Which activity is riskier? Why?
Answer:
 An asset broker assists buyers and sellers of securities by providing a mechanism for buyers or
sellers to process their orders. If the broker simply assists one party in finding another party, the
broker charges a small fee called a commission.
 An asset dealer buys the security for his or her own account at the bid price and then sells the
security at a higher ask price. The dealer profits by earning the bid-ask spread or the difference
between the buy and sell price.
 The dealer's function is riskier because the dealer must maintain an inventory of the asset and
honor quotes to buy and sell. If the security is risky, the value of the inventory can fluctuate with
market prices. The broker takes less risk because he or she does not own the security.

46. Explain the meaning of efficient markets. Why might we expect markets to be efficient most of the time?
In recent years, several securities firms have been guilty of using inside information when purchasing
securities, thereby achieving returns well above the norm (even when accounting for risk). Does this
suggest that the security markets are not efficient? Explain.
ANSWER:
 If markets are efficient then prices of securities available in these markets properly reflect all
information. We should expect markets to be efficient because if they weren‟t, investors would
capitalize on the discrepancy between what prices are and what they should be. This action
would force market prices to represent the appropriate prices as perceived by the market.
 Efficiency is often defined with regard to publicly available information. In this case, markets can
be efficient, but investors with inside information could possibly outperform the market on a
consistent basis. A stronger version of efficiency would hypothesize that even access to inside
information will not consistently outperform the market.

47. Identify and briefly describe the main types of orders that are made while trading stocks on the stock
exchange.
Answer (elaborate on the following)
Market order
Limit order
Buy limit order (stop buy order
Sell limit order (stop loss order
Market-if-touched order
Stop order Fill-or-kill order
Good-till-cancelled order

48. Explain the main distinctions between leading, lagging and coincident indicators giving examples of each.

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 Answer
Economic Indicators
Leading economic indicators are those economic series that tend to rise or fall in advance of the rest
of the economy.
Examples are:
- Manufacturers‟ new orders (consumer goods and materials industries)
- Yield curve slope
- Stock prices
- Money supply
- Index of consumer expectations.
Lagging indicators move after the broad economy.
Examples are:
- Average duration of unemployment
- Ratio of trade inventories to sales
- Change in index of labour cost per unit of output
- Average prime rate charged by banks
- Commercial and industrial loans outstanding
- Change in consumer price index for services
Coincident indicators move in tandem with the broad economy.
- Employees on nonagricultural payrolls
- Personal income less transfer payments
- Industrial production
- Manufacturing and trade sales

49. (a) What are stock market indexes?

Stock market indexes are measures of the price performance of stock portfolios, which are formed to
represent a stock market as a whole or a specific segment of the market, or sub- indexes. (further, the
student can provide examples)

(b) Examine the uses of stock market indexes.

Indexes have a number of uses:
1. To measure and monitor market movements;
2. To provide a means of ascertaining changes in aggregate wealth over time.
3. To perform a role as barometers of the economy; in particular stock market movements tend to
be leading indicators which means that they provide indications of likely future changes in the
level of activity in the economy as a whole.
4. Fourth, they provide a means of evaluating the performance of fund managers by providing
benchmarks against which portfolio managers can be compared.
5. To provide the basis for derivative instruments such as futures and options;
6. To provide the framework for the creation of tracker funds, which is to reflect the performance
of a stock market.
7. To be used by capital market models, in particular the capital asset pricing model (for discount
rates for capital projects, estimating required rates of return on shares, deriving fair rates of
return for utilities).

50. Explain the difference between the nominal value and market value of an ordinary share.
A nominal value (or face value) is the issue value and will be printed on the share
certificate that all shareholders will be given by the company when they buy their shares.
A market value which is the current price at which the shares could be traded on the stock
exchange.

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51. What is the significance and the utility of the following formula: Ke = DIV(1+g)/P + g?
The expression Ke = DIV(1+g)/P + g comes from the Gordon and Shapiro formula to value
shares: P = DIV(1+g)/(Ke–g). In these formulas, P and DIV are known and Ke and g are
unknown. Some people take as g (expected growth of dividends) the average of
expectations of analysts, and afterwards they calculate Ke (Ke calculated in such way is
usually called implicit). But Ke calculated in this way is just one of several which can be
calculated. The formula allows us to obtain pairs (Ke, g) which satisfy the equation

52. Examine the factors that affect stock prices.

Answer [the discussion can be done under the following sub-headings]
Stock prices are driven by three types of factors: (1) economic factors, (2) market-related factors,
and (3) firm-specific factors.
Economic Factors
A firm‟s value should reflect the present value of its future cash flows. Investors therefore consider
various economic factors that affect a firm‟s cash flows when valuing a firm to determine whether its
stock is over- or undervalued.
 Impact of Economic Growth:
 Impact of Interest Rates:
 Impact of the Exchange Rate:
Market-Related Factors
Market-related factors also drive stock prices. These factors include investor sentiment and the so-
called January effect.
 Investor Sentiment:
 January Effect:
Firm-Specific Factors
■ Change in Dividend Policy:
■ Earnings Surprises:
■ Acquisitions and Divestitures:
■ Expectations:
Tax Effects
.
53. (a) Define the term “risk”
(b) Identify and briefly define the various sources of risks
(c) Distinguish between systematic and nonsystematic risk

(a) Risk is the chance that the actual return on an investment will be different from the expected return.
The more diverse such outcomes, the more risky the security.
Alternatively,
Risk is the potential variability in future cash flows. The wider the range of possible events that can
occur, the greater the risk.
(b) Sources of Risk (define these)
 Interest Rate Risk
 Market Risk
 Inflation Risk
 Business Risk
 Financial risk
 Liquidity Risk

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  Exchange Rate Risk
 Country Risk
 etc
(c) Systematic (Market) Risk
 Attributable to broad macro factors affecting all securities.
 Encompasses interest rate, market, and inflation risks.
Nonsystematic (non-market, unique) Risk
 Attributable to factors unique to a security.
 Associated with such factors as business and financial risk as well as liquidity risk.

54. The current market prices of three stocks are given below. The current dividends, dividend
growth rates, and required rates of return are also given. The dividend growth rates are perpetual.

Current Dividend Required

Stock Current Dividend (t = 0) Growth Rate of
Price Rate Return
Que Corp. $25.00 $0.50 7.0% 10.0%
SHS Company $40.00 $1.20 6.5 10.5
True Corp. $20.00 $0.88 5.0 10.0

Find the value of each stock with the Gordon growth model.

V = 0.50(1.07) = 0.535 = $17.83

Que 0.10 — 0.07 0.03

Use the same approach to find the value of SHS and True Corp

55. Describe four benefits that might accrue to a firm that undertakes cross boarder listing of its
shares.(8 marks)

56. In relation to secondary market indices, discuss the following terms:

a) Domestic stock indices (2 marks)
b) Global stock indices (2 marks)

DERIVATIVES MARKET

57. Define the term “derivative”, and further, identify and describe the major uses of derivatives.
Answer
Derivatives are contracts that derive their value from the performance of an underlying asset, event,
or outcome.
Derivatives provide the following uses:
(1) Derivatives can be used to manage risks associated with the underlying, but they may also result
in increased risk exposure for the other party to the contract.
(2) Derivatives allow companies and investors to manage future risks related to raw material prices,
product prices, interest rates, exchange rates, and even uncontrollable factors, such as weather.
(3) They also allow investors to gain exposure to underlying assets while committing much less
capital and incurring lower transaction costs than if they had invested directly in the assets.

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 (4) Risk aversion tools: One of the most important services provided by the derivatives is to control,
avoid, shift and manage efficiently different types of risks through various strategies like hedging,
arbitraging, spreading, etc.
(5) Prediction of future prices: Derivatives serve as barometers of the future trends in prices which
result in the discovery of new prices both on the spot and futures markets.
(6) Enhance liquidity: In derivatives trading no immediate full amount of the transaction is required
since most of them are based on margin trading. As a result, large number of traders, speculators
arbitrageurs operate in such markets. So, derivatives trading enhance liquidity and reduce trans-
action costs in the markets for underlying assets.
(7) Assist investors: The derivatives assist the investors, traders and managers of large pools of funds
to devise such strategies so that they may make proper asset allocation, increase their yields and
achieve other investment goals.
(8) Integration of price structure: Derivatives smoothen out price fluctuations, squeeze the price
spread, integrate price structure at different points of time and remove gluts and shortages in the
markets.
(9) Catalyse growth of financial markets: The derivatives trading encourage the competitive trading
in the markets, and different risk taking preference of the market operators like speculators,
hedgers, traders, arbitrageurs, etc. resulting in increase in trading volume in the country. They
also attract young investors, professionals and other experts who will act as catalysts to the
growth of financial markets.
(10) Brings perfection in market: Lastly, it is observed that derivatives trading develop the market
towards ‘complete markets’. Complete market concept refers to that situation where no particular
investors can be better off than others, or patterns of returns of all additional securities are spanned
by the already existing securities in it, or there is no further scope of additional security.

58. Distinguish between the following markets:

(a) Cash and derivatives market
(b) Spot and futures market

Answer (refer to notes chapter one notes)

59. Compare and contrast amongst the four main derivative contracts
Answer (expand on the following)
There are four main types of derivatives contracts:
(1) forward contracts (forwards) is an agreement between two parties in which one party agrees
to buy from the seller an underlying at a later date for a price established at the start of the
contract.
 The future date can be in one month, in one year, in five years, or at any other specified
date.
 Investors primarily use forward contracts to lock in the price of an underlying and to gain
certainty about future financial outcomes.
(2) futures contracts (futures), is a standardised agreement that obligates the seller, at a
specified future date, to deliver to the buyer a specified underlying in exchange for the
specified futures price.
 The buyer of the contract is obligated to take delivery of the underlying, and the seller of
the contract is obligated to deliver the underlying, although settlement may be with cash.
 Futures contracts are standardised contracts that trade on exchanges.
 Standardised terms of futures contracts include the underlying; size, price, and expiration
date of the contract; and settlement.
(3) option contracts (options), An option is a contract in which the option seller grants the option
buyer the right to enter into a transaction with the seller to either buy or sell an underlying

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 asset at a specified price on or before a specified date.
 In an option contract, the buyer of the option has the right, but not the obligation, to buy
or sell the underlying.
 Options are termed unilateral contracts because only one party to the contract (the seller)
has a future commitment that, if broken, represents a breach of contract. Unilateral
contracts expose only the buyer to the risk that the seller will not fulfill the contractual
agreement.
 The buyer of the contract will exercise the right or option if conditions are favourable or
if specified conditions are met.
(4) swap contracts (swaps) are derivatives in which two parties exchange (swap) cash flows or
other financial instruments over multiple periods (months or years) for mutual benefit, usually
to manage risk, that is,
a swap is an agreement whereby two parties (called counterparties) agree to exchange periodic
payments.
 The cash amount of the payments exchanged is based on some predetermined
principal amount, which is called the notional principal amount or simply notional
amount.
 The cash amount each counterparty pays to the other is the agreed-upon periodic rate
times the notional amount.
 The only cash that is exchanged between the parties are the agreed-upon payments,
not the notional amount.

60. Companies A and B have been offered the following rates per annum on a $20 million five year
loan;
Fixed Rate Floating Rate
Company A 5.0% LIBOR + 0.1%
Company B 6.4% LIBOR + 0.6%
Company A requires a floating-rate loan; company B requires a fixed-rate loan. Design a swap
that will net a bank, acting as intermediary, 0.1% per annum and that will appear equally
attractive to both companies
Answer
A has an apparent comparative advantage in fixed-rate markets but wants to borrow floating. B has an
apparent comparative advantage in floating-rate markets but wants to borrow fixed. This provides the
basis for a swap. There is a 1.4% per annum differential between the fixed rates offered to the two
companies and 0.5% per annum differential between the floating rates offered to the two companies. The
total gain to all parties from the swap is therefore 1.4 - 0.5 = 0.9% per annum. Because the bank gets
0.1% per annum of this gain, the swap should make each of A and B 0.4% per annum better off. This
means that it should lead to A borrowing at LIBOR -0.3% and to B borrowing at 6.0%. The appropriate
arrangement is shown below:

5% Company A 5.3% Financial 5.4% Company

Institution B
LIBOR LIBOR LIBOR+0.6%

61. Risks that a swap dealer could confront with in arranging two legs of an interest swap deal.
(DBMI)
a) Default Risk: Risk if one of the parts fail to meet the obligations set in the swap contract.
Therefore, despite the swap dealers seek to build a portfolio with swaps that offset each
other, they are exposed to risks.

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 b) Basis Risk: Risk that the normal relationship in between two floating rates might change
and make the dealer experience a loss.
c) Mismatch Risk: Risk in which a swap dealer cannot offset one swap through another
because there is a mismatch in the needs of the dealer and the other party.
d) Interest Rate: Risk of a change in the swap portfolio value due to a change in interest rate,
which could result in a loss for the swap dealer

62. What is the difference between a long forward position and a short forward position?
Answer
When a trader enters into a long forward contract, she is agreeing to sell the underlying asset for a
certain price at a certain time in the future. When the trader enters into a short forward contract, she is
agreeing to sell the underlying asset for a certain price at a certain time in the future

63. Explain the significance of the Futures Exchanges being regulated and what the key features of
the Futures Exchanges are.
As a recognized marketplace, any futures exchange is a regulated marketplace and has had to
adopt certain operational arrangements and procedures: having a clearing house,
operating a margin system and at the end of each trading day all open positions are marked to
market. Removing default risk for any user of the market. Furthermore, due to the
regulation, pricing is more transparent, it is easier to buy and sell due to the
standardization.Making the future contract more liquid and flexible than a forward deal
64. What is the difference between entering into a long forward contract when the forward price id $50
and taking a long position in a call option with a strike price of $50?
Answer
In the first case the trader is obliged to buy the asset for $50. (The trader does not have a choice). In the
second case the trader has an option to buy the asset for $50. (The trader does not have to exercise the
option)

FOREIGN EXCHANGE MARKETS

65. Explain the specific functions that are used to define the foreign exchange market.
Answer
(1) Facilitates the conversion of one country‟s currency into another.
– Through the buying and selling of currencies.
– Allows global firms to move in and out of foreign currency as needed.
(2) Sets and quotes exchange rates.
– This is the ratio of one currency to another.
– These rates determine costs and returns to global businesses.
• (3) Offers contracts to manage foreign exchange exposure.
– These hedging contracts allow global firms to offset their foreign currency exposures and
manage foreign exchange risk.
– Thus, they can concentrate on their core business.

66. Briefly describe the 4 functions of the Foreign Exchange Market.

1. Transfer of purchasing power across international borders: Since it allows companies to trade
internationally.

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 2. Setting of currency exchange rates: foreign exchange market acts as the locus for establishing
the price of the asset being traded. The forces of demand and supply within the market set
currency exchange rates.
3. Protection from exposure to foreign exchange risk: Since forward contract can be set to
reduce exposure to FX rates, hedging their positions
4. Arbitrage: It facilitates arbitrage or lack of it.
5. Facilitation of speculation: As the willingness to increase risk to make a profit.

67. What have been the major factors contributing to growth in the foreign financial markets?

Answer:
1. The amount of savings available for investment in foreign countries has increased.
2. International investors have looked to the United States for better investment opportunities.
3. The Internet has helped provide additional information on foreign markets and overseas investment
opportunities.
4. Specialized intermediaries such as country-specific mutual funds and ADRs have been developed to
facilitate overseas investments.
5. The euro has had a notable impact on the global financial system by being an important currency for
international transactions.
6. Deregulation of foreign markets has allowed many new investors to participate in international
investing.

68. Identify and justify techniques you would use to forecast specific exchange rates to be used for
derivative trading.
Answer (expand on the following)
1) Technical forecasting:
2) Fundamental forecasting
3) Market-based forecasting
4) Mixed forecasting

69. With the use examples distinguish between a direct and indirect quotation.
Answer (refer to notes)
Direct Quotation:
 This is also known as price quotation.
 The exchange rate of the domestic currency is expressed as equivalent to a certain number of
units of a foreign currency.
 It is usually expressed as the amount of domestic currency that can be exchanged for 1 unit or
100 units of a foreign currency. Assuming the USD to be the domestic currency, the direct
exchange rate specifies the value of a currency in U.S. dollars. For example, the Mexican peso
may have a value such as $0.10 while the British pound is valued at $2.00.
 The more valuable the domestic currency, the smaller the amount of domestic currency needed to
exchange for a foreign currency unit and this gives a lower exchange rate.
Indirect Quotation
 This is also known as the quantity quotation. The exchange rate of a foreign currency is
expressed as equivalent to a certain number of units of the domestic currency.
 This is usually expressed as the amount of foreign currency needed to exchange for 1 unit or 100
units of domestic currency.
 From the above example, the indirect exchange rate will specify the number of units of a currency
equal to a U.S. dollar. For the example values given here, the indirect exchange rates are 10

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 pesos per dollar and 0.50 pounds per dollar. The indirect exchange rate is the reciprocal of the
direct exchange rate.
 The more valuable the domestic currency, the greater the amount of foreign currency it can
exchange for and the lower the exchange rate.

70. Distinguish between spot and forward exchange rate

Answer (refer to notes)
 The spot market is the exchange market for payment and delivery today. In practice, "today"
means today only in the retailer tier. Currencies traded in the wholesale tier spot market have
customary settlement in two business days.
Forward Exchange Rate:
 Quotes for future transactions in a currency (3 business days and out).
 Forward markets are used by businesses to protect against unexpected future changes in
exchange rates.
 Forward rate allows businesses to “lock” in an exchange rate for some future period of time.

71. Briefly describe a currency swap.

Answer
A currency swap is a contract, in which two parties agree to swap payments based on different
currencies. It enables borrowers to exchange debt service obligations denominated in one currency
for equivalent debt service obligations denominated in another currency. By swapping future cash
flow obligations, the two parties can manage currency risk.

72. Company X wishes to borrow U.S. dollars at a fixed rate of interest. Company Y wishes to borrow
Japanese yen at a fixed rate of interest. The amounts required by the two companies are roughly the same
at the current exchange rate. The companies have been quoted the following interest rates, which have
been adjusted for the impact of taxes:
Yen Dollars
Company X 5.0% 9.6%
Company Y 6.5% 10.0%
Design a swap that will net a bank, acting as intermediary, 50 basis points per annum. Make the swap
equally attractive to the two companies and ensure that all foreign exchange risk is assumed by the bank.
Answer
X has a comparative advantage in yen markets but wants to borrow dollars. Y has a comparative
advantage in dollar markets but wants to borrow yen. This provides the basis for the swap. There is a
1.5% per annum differential between the yen rates and a 0.4% per annum differential between the dollar
rates. The total gain to all parties from swap is therefore 1.5-0.4=1.1% per annum. The bank requires a
0.5% per annum, leaving 0.3% per annum for each of X and Y. The swap should lead X borrowing
dollars at 9.6-0.3=9.3% per annum and to Y borrowing yen at 6.5-0.3=6.2% per annum. The
appropriate arrangement is therefore as shown below. All foreign exchange risk is borne by the bank.

Yen 5% Company Yen 5% Financial Yen 6.2%Company Y

X Institution
Dollars 9.3% Dollars 10% Dollars 10%

73. An investor enters into a short forward contract to sell 100,000 British pounds for US dollars at an
exchange rate of 1,4000 US dollars per pound. How much does the investor gain or lose if the exchange
rate at the end of the contract is (a) 1.3900 and (b) 1.4200?
Answer
(a) The investor is obligated to sell pounds for 1.4000 when they are worth 1.3900. The gain is (1.4000-
1.39000) x 100,000 = $1,000

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 (b) The investor is obligated to sell pounds for 1,4000 when they are worth 1,4200. The loss is (1.4200-
1.4000) x 100,000 = $2,000
74. Explain how you would use the different types of derivatives in the foreign exchange markets.
Answer (Briefly explain the following)
Use of Foreign Currency Derivatives for Hedging
Use of Foreign Currency Derivatives for Speculating
Use of Foreign Currency Derivatives for Arbitrage

REGULATION OF FINANCIAL MARKETS

75. What is the purpose of the Securities Act and/or Securities Exchange Act? Do these laws prevent
investors from making poor investment decisions? Explain.
ANSWER:
The Securities Act and Securities Exchange Act is intended to assure complete disclosure of relevant
financial information on publicly offered securities, and prevent fraudulent practices when selling these
securities, as well as provide the disclosure requirements to secondary market issues. It also declared a
variety of deceptive practices illegal, but does not prevent poor investments. [you may need to elaborate
by sighting examples or referring to the Acts in your country]

76. Distinguish amongst the Basel I, II and III frameworks and further examine the extent to which
Zimbabwe has embraced these accords.
Answer (Refer to your assignment and notes)

77. Most governments throughout the world regulate various aspects of financial activities because they
recognize the vital role played by a country‟s financial system. Identify the four main forms of regulation
that is appropriate for financial activities.

Answer
The four main forms of regulation of financial activities are
(1) Disclosure regulation requires that any publicly traded company provide financial information
and nonfinancial information on a timely basis that would be expected to affect the value of its
security to actual and potential investors.
(2) Financial activity regulation comprises rules about traders of securities and trading on financial
markets. Probably the best example of this type of regulation is the set of rules prohibiting the
trading of a security by those who, because of their privileged position in a corporation, know
more about the issuer‟s economic prospects than the general investing public (insiders). Another
example of financial activity regulation is the set of rules imposed by the SEC regarding the
structure and operations of exchanges where securities trade.
(3) The regulation of financial institutions is a form of governmental monitoring that restricts their
activities. Such regulation is justified by governments because of the vital role played by financial
institutions in a country‟s economy. The justification for such rules is that it reduces the
likelihood that members of exchanges may be able, under certain circumstances, to collude and
defraud the general investing public.
(4) Government regulation of foreign participants involves the imposition of restrictions on the
roles that foreign firms can play in a country‟s internal market and the ownership or control of
financial institutions.

78. (a) What is financial regulation?

(b) Examine the main reasons for financial system regulation
Answer

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 (a) Financial regulation is a form of regulation or supervision, which subjects financial institutions to
certain requirements, restrictions and guidelines, aiming to maintain the integrity of the financial
system. This may be handled by either a government or non-government organization.

(b) Main reasons for financial system regulation: Regulation is necessary

(1) To ensure consumer‟s confidence in the financial industry.
(2) To ensure system stability i.e. the safety and soundness of the financial system;
(3) To provide smaller (individuals), retail clients with protection. Caveat emptor does not apply to
financial contracts due to their complex and opaque nature, and;
(4) To protect consumers against monopolistic exploitation.

79. Identify and describe the activities of the principal agencies that are responsible for Financial
Regulation and Supervision in Zimbabwe.

Answer (elabor)ate on the activities of the following

1. Reserve Bank of Zimbabwe (RBZ),
2. The Ministry of Finance and Economic Development
3. The Deposit Protection Corporation,
4. The Securities Exchange Commission (SEC) and
5. The Insurance and Pensions Commission.

80. What do the credit rating agencies do?

Answer
Rating agencies help in providing trust and confidence in financial markets by rating borrowers on
their creditworthiness of outstanding debt obligations.

81. Debate “Central Banks should be responsible for financial stability policy and regulation.”

82. Regulation of Financial Institutions. Financial institutions are subject to regulations to ensure that they
do not take excessive risk and they can safely facilitate the flow of funds through financial markets.
Nevertheless, during the credit crisis, individuals were concerned about using financial institutions to
facilitate their financial transactions. Why do you think the existing regulations were ineffective at
ensuring a safe financial system?
ANSWER:
During the credit crisis in 2008, the failure of some financial institutions caused concerns that others
might fail, and disrupted the flow of funds in financial markets. The primary cause was that financial
institutions experienced massive mortgage defaults. They should have recognized that subprime
mortgages (unqualified borrowers, low down payment) may default. In addition, regulators should have
recognized that subprime mortgages may default and could have imposed regulations to limit an
institution‟s exposure to subprime mortgages

83. Global Financial Market Regulations. Assume that countries A and B are of similar size, that they have
similar economies, and that the government debt levels of both countries are within reasonable limits.
Assume that the regulations in country A require complete disclosure of financial reporting by issuers of
debt in that country, but that regulations in country B do not require much disclosure of financial
reporting. Explain why the government of country A is able to issue debt at a lower cost than the
government of country B.
ANSWER:

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 Investors are more willing to invest in debt securities issued by the government of country A because
there is more transparent information that would suggest country A can cover its payments owed on its
debt. If the government of Country B does not disclose its financial information, investors cannot assess
the financial condition and ability of the government to cover its payments owed on its debt. Thus, they
are less willing to invest in debt securities issued by country B, so country B will have to offer a higher
yield to entice investors.

84. Identify and briefly describe the following Core Principles for Effective Banking Supervision that are
used as minimum standard for sound prudential regulation and supervision of banks and banking systems.
(a) Supervisory powers, responsibilities and functions [select any four]

Select and elaborate on four of the following principles on supervisory powers,

responsibilities and functions
Principle 1 – Responsibilities, objectives and powers:
Principle 2 – Independence, accountability, resourcing and legal protection for supervisors:
Principle 3 – Cooperation and collaboration:
Principle 4 – Permissible activities:
Principle 5 – Licensing criteria:
Principle 6 – Transfer of significant ownership:
Principle 7 – Major acquisitions:
Principle 8 – Supervisory approach:
Principle 9 – Supervisory techniques and tools:
Principle 10 – Supervisory reporting:
Principle 11 – Corrective and sanctioning powers of supervisors:
Principle 12 – Consolidated supervision:
Principle 13 – Home-host relationships:

(b) Prudential regulations and requirements [select any four]

Select and elaborate on four of the following principles on regulations and requirements
Principle 14 – Corporate governance:
Principle 15 – Risk management process:
Principle 16 – Capital adequacy:
Principle 17 – Credit risk:
Principle 18 – Problem assets, provisions and reserves:
Principle 19 – Concentration risk and large exposure limits:
Principle 20 – Transactions with related parties:
Principle 21 – Country and transfer risks:
Principle 22 – Market risks:
Principle 23 – Interest rate risk in the banking book:
Principle 24 – Liquidity risk:
Principle 25 – Operational risk:
Principle 26 – Internal control and audit:
Principle 27: Financial reporting and external audit:
Principle 28 – Disclosure and transparency:
Principle 29 – Abuse of financial services:

85. Critically analyse the standard justification for governmental regulation of financial markets.

86. In Zimbabwe, who are the regulators of financial markets?

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