FINANCIAL MARKETS AND INSTITUTIONS

(21BSP422) OUTLINE ANSWERS

January 2022 2 Hours (+30 mins for download/upload)

Answer the question in Part A and any TWO other questions from Part B.

This is a (1b) online examination, meaning you have a total of 2 hours plus an additional 30
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answering. However, you must produce your own responses to the exam questions and you
should not copy or reproduce content from a source without quotation marks and a citation.
Students who do this will be marked down for poor scholarship or the work will be considered for
Academic Misconduct in line with regulation XVIII.

You must clearly identify the question and part, as required, in your answer, either through the
numbering system or by including the relevant exam question and/or part as a heading.

You may include headings, bullet points etc to help with clarity as required. Graphs and images may
also be included and should be appropriately referenced.

In text citations should use the Harvard style in accordance with the School of Business and
Economics guidelines. You do not need to include a reference list.

All marks remain provisional until moderated

Page 1 of 7
 PART A

This question is worth 30 of the total available marks.

Question 1. Please provide a short explanation of FIVE of the following EIGHT concepts
or phrases. Each explanation is worth a maximum of 6 marks.

(a) The buy side and sell side of securities markets

(b) Market volatility

(c) Variability in credit spreads

(d) Separation of ownership and control

(e) Order execution in a limit order book

(f) Foreign exchange dealing

(g) Smart beta

All these concepts/ phrases are covered in lecture notes. Marks will be available for the
both the clarity and completeness of the explanation. In order to provide clarity an answer
might provide a supporting example as an illustration. Marks will be awarded out of six,
according to the following criteria:

1/6 a confused or largely irrelevant effort at explanation

2/6 an incomplete or partial explanation

3/ 6 a limited explanation, demonstrating some basic understanding

4/6 a good explanation, demonstrating a clear understanding

5/6 a full explanation with little ambiguity, demonstrating a sound understanding

6/6 a complete and precise explanation, demonstrating a full understanding

Page 2 of 7
 PART B

(use the separate pink answer booklet to answer questions from this section)

Answer any TWO of the questions in this part of the exam. Each question is worth 35
marks.

Question 2. Irrational Exuberance

(a) Outline the ‘efficient markets hypothesis’, explaining its implications for the risk and
returns achievable from pursuing active trading strategies.
[20 marks]

The first part of this can be answered directly from lecture notes, highlighting the role
of information and the EMH that information is fully reflected in market prices. Some
credit for distinguishing different forms of the EMH and briefly discussion of empirical
testing of the EMH. The final part of this needs discussion of the implications fo the
EMH for predictability and that any returns from trading can only be compensation for
accepting risk, i.e. adjusting for risk active management cannot do better than
passive exposure to the market.

(b) Are the recent historically high levels of equity prices consistent with fundamental
based valuation, based on reasonable estimates of the present discounted value of
future cash flows?
[15 marks]
.
Can be argued either way. In either case the answer needs some theoretical
justification. An answer saying that equities are overpriced may refer to Shiller’s work on
excess variability of market prices and also to behavioural explanations of market prices.
An answer saying that they are not overpriced can refer to lower required returns because
of lower real interest rates and falling equity risk premium. The best answers will use
historical episodes to illustrate their arguments – e.g. the dot com ‘bubble’ in technology
stocks or the railway mania of the 1840s – but these an also be used , either to argue that
fundamentals are always uncertain, hence not possible to say that today’s prices are
inconsistent with fundamentals; or to point out to previous episodes of substantial market
correctons as evidence of overpricing.

Question 3. Bonds and bond risks

(a) Review, with supporting evidence, the impact of changes in output and inflation on
the price and yield of government and corporate bonds.
[20 marks]

This can be answered from lecture material, but the answers, to get full credit, will need
to be well focused, distinguishing: long run impact of inflation raising yields and
lowering prices; short run relationships between monetary policy, inflation and bond
prices (distinnguising short term and longer term yields on government bonds, noting
that longer term yields are normally higher than short,and the possibility of yield curve
inversion); and the impact of cyclical output decline on default risks and hence on
corporate bond credit spreads( the best answers will recognised that that impacts are
larger on longer maturity bonds and those of lower credit quality; and also the impact of
Page 3 of 7
 declining market liquidity in periods of falling output and heightened market risk
aversion).

(b) Supply chain problems, energy shortages and a tight labour market have increased
inflation substantially across the world in the past year. What impact will this higher
inflation have on bond prices and yields? [15
marks]

A basic answer will refer to tightening of monetary policy, resulting in increasing bond
yields and falling prices. Better answers will note that the expected tightening of
monetary policy is already reflected in current bond prices and yields; but the big
issue of market participants are the substantial uncertainties about this current
inflation, whether it is temporary and will abate without a substantial tightening of
monetary policy or require more aggressive tightening than currently anticipated.

Question 4. Corporate governance

(a) Discuss the advantages and disadvantages of family ownership and control
compared to outside investors holding a majority of a firm’s equity,

[20 marks]

This is discussed at some length in the lecture material and in supporting readings.
Good answers will discuss a variety of pros and cons. Pros of family ownership include
avoiding separation of ownership and control, focus on long term performance, attention to
wider community, ethical and stakeholder interests rather than a narrow focus on
increasing stock price, and the incentive benefits of family mangers having most of their
wealth tied up in the company.. Cons include difficulty in raising external investment
funding, the lack of diversification of owners wealth, resistance to change and new ideas
(entrenched by the weakness of the market for corporate control of family owned firms)
and succession problems between generations.The best answer will refer to empirical
evidence from the suggested readings or other sources. They are likely to recognise that
firms have a life cycle in which over time, for larger firms, they shift from family or founder
ownership to outside ownership. They may also point out how retaining a large or
controlling interest, while selling some share on the public market may address some of
the cons of family ownership.

(b) Are corporate ownership arrangements in countries such as the US and the UK,
where relatively few firms are family owned, preferable to those of other countries?

[15 marks]

Open ended. Could be answered either as a defence of anglo saxon

arrangements emphasising the openness to change with an active market for
corporate control; or as a critique highlighting the problems of separation of
ownership and control and also of excessive remuneration for sernior
management of public companies. The best answers will recognised arguments
on both sides and may argue that the differences between countries are more
apparent than real, reflecting in part the different stages of firm lifecycle ni the
early industrialising UK and UK.

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Question 5. Computer based trading and financial market stability.

(a) Outline the limit-order book arrangements used for equity markets, comparing them
with the quote-driven dealer trading used in foreign exchange and OTC derivative
markets.

[20 marks]
Can be answered direct from the lecture material. Requires an example of a limit-order
book distinguishing market and limit orders , or failing that a clear explanation of the
trading mechanism involved. Briefer description of dealer driven markets needed. The
best answers will refer to market depth and recognise the challenge of providing market
liquidity and how dealer markets, with dealers committing capital to support trading, can
be better at providing liquidity. Some credit for noting how the distinction between limit
and dealer markets is being eroded by technology.

(b) On balance, taking account of impact on liquidity and market stability, has the
increasing computerisation of trading been beneficial to long-term investors?

Can be argued either way. Essential thought that answers should recognise both costs
and benefits of computerisation. In normal conditions greater liquidity and ability to trade
medium to large quantities of shares without substantial market price impact, through
‘alögorithmic trading’. Also, greater competition and lower margins for buy side
transactions. Concerns though about role of high frequency trading, especially in relation
to “dark pools” and greater difficulty in executing very large share transactions without a
major impact on market price. May also note that computerisation is spreading across
markets with greater use of platforms for placing limit orders across all markets.

[15 marks]

Page 5 of 7
 Question 6. Benchmark Fixing and Bank Ethics.

(a) Explain the role of dealers in foreign exchange markets and the methods they use to
manage their risks and return.
[20 marks]

Covered in some detail in lecture materials. Should explain the role of dealers in offering
bid and ask quotes to clients. That the difference between the two is their trading margin
and as long as buy and sell orders are roughly balanced then the role if profitable and low
risk. Risks though rise in periods of market imbalance when dealers build up either long or
short inventories. They can partially hedge these through trading anonymously with other
dealers through Interdealer brokers such as ICAP-Tullet Preborn, but this does not remove
aggregate risk exposure. Aggregate exposure can be dealt with by adjusting bid and ask
prices, to encourage a reversal of client orders. Also dealers can hedge using either OTC
or exchange traded derivatives, limiting their losses in the even of major price moves over
short time periods, but paying option premiums or carry costs for this protection. Typically
dealers will partially not fully hedge. Best answers will note that the underlying source of
dealer profits is liquidity provision, meeting the ‘demand for immediacy’, and that dealers
benefits from economies of scale and consequent netting offsets that lower risks, but
ultimately profits depend on good capital management, being able to ride out and profit
from periods of uncertainty and market illiquidity.

(b) Foreign exchange dealers have been found to have exploited their clients to their own
advantage on many occasions .e.g through “banging the close”: What measures do
you think are required to contain this problem and why do you believe they are
needed?

This is an open ende question. Answers need to outline the problems of market
maniplaton and should highlight the lack of transparency in dealer transactions for clients.
Better answers will recognise that the 4m fix and banging the close was not the only
problem of acting against client interests. Several solutions could be discussed, including
strong penalties on individuals for not looking after their clients interest, use of technology
to make benchmarks such as the 4pm fix less subject to manipulation, or making dealer
transactions less opaque, revealing which transations are taken directly on behalf of
clients (effectivel like equity brokers) and which are dealers balance sheet transactions.

[15 marks]

Page 6 of 7
Question 7. Active versus Passive Fund Management.

(a) Describe and distinguish mutual funds, investment trusts and exchange traded funds.
Why have an increasing share of assets under management, over the past two
decades, been invested in exchange traded funds rather than mutual funds or
investment trusts?
[20 marks]

Expecgting a clear and complete comparison of the three types of funds, based on lecture
notes. There are some traps. Mutual funds can be either active or passive (this is not a
distinguishing feature) but ETFs are based on underlying indices and so passive.
Investment truasts are largel active. An explantation of the partial exception of smart beta
ETF fund merits some additional credit. Pricing should also be discussed, how ETFs track
indices closely and can be sold relatively quickly and easily because they are exchange
traded. The key role of the ETF market maker in maintaining pricing close to benchmark
needs to be disussed. That mutual fund unit price keeps close to net asset value per
share, but with some delays and costs in redemption. That investment trusts suffer from
the problem of discount in market value relative to net asset value, with no market maker
keeping the two aligned. A thorough answer will be able to address the final part of the
question fairly easily, pointing to the increasing preference for passive trading and the low
costs, liquidity and transparency of ETFs accounting for their increasing popularity.

(b) In what circumstances, if any, can active management create value for investors?

[15 marks]

Students are anticipating a question about active versus passive management This
question looks at this from the other perspective, when does active management create
value? Answer might adopt the position “never” and rehearse the strong empirical
evidence favouring passive over active investment. The best answer will though note that
there are exceptions, some funds and fund managers that do outperform the market on a
fairly consistent or at least occasional basis. To be fully persuasive they need examples
and/ or evidence of such outperformance. There are many examples. Here they may refer
to Graham style fundamental based investment, but they should note that the recent track
record with current share prices so high is not a good track record. They might refer to
successful active trading in periods of market stress especially for some instruments like
many corporate bonds for which markets are not particularly liquid They might refer to
some successful hedge fund trading strategies including e.g. forex carry trade. They could
refer to my PIMCO perpetual which successfully outperformed a passive strategy in global
bond markets over several decades. They could refer to liquidity trades conducted by John
Merriweather at Salomon Brothers and subsequently at LTCM.

A.K.L. MILNE

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