INSTITUTE OF BANKERS IN MALAWI

ADVANCED DIPLOMA IN BANKING EXAMINATION

SUBJECT: SOLUTIONS TO FINANCIAL MARKETS 2 (IOBM – AD320)

Date: Friday, May 2012

Time Allocated: 3 hours (13:30 – 16:30 pm)

INSTRUCTIONS TO CANDIDATES

1 This paper consists of TWO Sections, A and B.

2 Section A consists of 4 questions, each question carries 15 marks. Answer ALL questions.

3 Section B consists of 4 questions, each question carries 20 marks. Answer ANY TWO questions.

4 You will be allowed 10 minutes to go through the paper before the start of the examination, you may write on this paper but not in the answer book.

5 Begin each answer on a new page.

6 Please write your examination number on each answer book used. Answer books without examination numbers will not be marked.

7 DO NOT open this question paper until instructed to do so. SECTION A (60 MARKS)

Answer ALL questions from this section.

QUESTION 1

(a) (2 marks) i. Transaction Exposure ii. Translation Exposure iii. Economic Exposure (b) (2 marks) i. “Spot” Market-In the spot market transactions take place which are settled quickly. Officially this is described as immediate delivery, but this usually takes place two business days after the deal is struck. ii. The “forward” market-In the forward market a deal is arranged to exchange currencies at some future date at a price agreed now. The periods of time are generally one, three or six months, but it is possible to arrange an exchange of currencies at a pre- determined rate many years from now.

(c) Hedging is the act of offsetting or eliminating risk exposure (1 marks)

(d) Brief explanation of exchange rate risk management strategies; i. Matching-can be used for both intra-group transactions and those involving third parties. The company matches the inflows and outflows in different currencies caused by trade, etc, so that it is only necessary to deal on the forex markets for the unmatched portion of the total transactions. (2 marks)

A qualification examined by the Institute of Bankers in Malawi 2 ii. Netting –Multinational companies often have subsidiaries in different countries selling to other members of the group. Netting is where the subsidiaries settle intra-organisational currency debts for the net amount owed in a currency rather than the gross amount. For example, if a South African parent owned subsidiary in Malawi and sold MK2.2 MN of goods to the subsidiary on credit while the Malawian subsidiary is owed MK1.5 MN by the South African company, instead of transferring a total of MK3.7 MN the intra-group transfer is the net amount of MK700,000. (2 marks)

iii. Do nothing –Under this policy the South African firm invoices the Malawian firm for MK2.2 MN, waits three months and then exchanges into Rands at whatever spot rate is available then. Perhaps an exchange rate gain will be made, perhaps a loss will be made. Many firms adopt this policy and take a “win some, lose some” attitude. Given the fees and other transaction costs of some hedging strategies this can make sense. (2 marks)

iv. Leading-is bringing forward from the original due date the payment of a debt. (2 marks)

v. Lagging-is the postponement of a payment beyond the due date. Speeding up (leading) or delaying (lagging) of payments is particularly useful if you are convinced exchange rates will shift significantly between now and the due date. (2 marks)

(Total 15 marks) QUESTION 2 (a) An exchange rate system-is the set of rules governing the value of an individual nation’s currency relative to other foreign currency. (2 marks)

(b) Short notes explaining the following exchange rate systems; i. The Gold standard –Exchange rate system for an adopting nation because it establishes a domestic and international rate of exchange between the domestic currency and gold. (2 marks) ii. The Breton Woods-was a system of adjustable pegged exchange rates whose parity values could be changed when warranted. Each country established and maintained a parity value of its currency, or peg relative to gold or the U.S. Dollar. (2 marks)

A qualification examined by the Institute of Bankers in Malawi 3 iii. The Flexible exchange rate system-is an exchange rate system whereby a nation allows market forces to determine the international value of its currency (2 marks) iv. “ Dirty float” exchange rate system-is an exchange rate agreement in which a nation allows the international value of its currency to be primarily determined by market forces but intervenes from time to time to stabilize its currency (2 marks) (c) In your opinion; i. fixed exchange rate regime to dirty float. (1 marks) ii. In Malawi the exchange rate is managed within a set band (minimum and maximum rates are fixed) hence this is a cross between fixed exchange rate regime and dirty float. (4 marks) (Total 15 marks) QUESTION 3

(a) Term Structure of interest rates-is the relationship among yields on financial instruments with identical risk, liquidity, and tax characteristics but differing terms to maturity (2 marks)

(b) The present value of a K1000 face value coupon bond with a two year maturity and yearly coupon payments of K200 (assuming the market interest rate is 20 %).

K200 K200 K1000 PV =   (1 .20) (1 .20)2 (1 .20)2

PV=999.998 (3 mark)

(c) For a bond, face value K1000 and 8% coupon rate currently selling at K1,276.76, What would be; i. the current yield current yield would be :

A qualification examined by the Institute of Bankers in Malawi 4 Coupon payment ÷Current bond price K80/1,276.76 = 0.0627, 6.27% (3 mark) ii. the yield to maturity iii. Using a financial calculator, the yield to maturity for this bond is 6.09% (3 mark) (d) Typically, the yield curve is upward sloping, indicating that interest rates normally rise with an increase in the term to maturity of a financial instrument. Nevertheless, at various times nations can experience downward sloping yield curves. If this circumstance arises, a country’s yield curve is said to be an inverted yield curve, because interest yields fall as the term to maturity increase. (4 marks) (Total 15 marks)

QUESTION 4

(a) Compare the advantages of; (10 marks) Options  Downside risk is limited but the buyer is able to participate in favourable movements  Available on or off exchanges.  Exchange regulation and clearing house reduce counterparty default risk for those options traded on exchanges  Usually highly liquid

Futures  Specific rates are locked in  No right to let the contract lapse, as with options  No premium payable. (However margin payments are required).  Very liquid markets. Able to reverse transactions quickly and cheaply.  Exchange regulation and clearing house reduce counterparty default risk

A qualification examined by the Institute of Bankers in Malawi 5 (b) Put call parity relationship-relationship between the price of a call option and the price of a put option on the same underlying instrument, with the same strike price, and same expiration date (1 mark)

(c) When an option has intrinsic value, it is said to be “in the money”. When the strike price of a call option exceeds the current asset price, the call option is said to be “out of money”, it has no intrinsic value (4 marks)

(Total 15 marks)

SECTION B (40 MARKS)

Answer ANY TWO questions from this section.

QUESTION 5 Major advantages of a fixed vs. floating exchange rate system. Fixed Floating 1. Exchange rate stability provides 1. Automatic eradication of imbalances basis for expectation 2. Stability encourages increased 2. Reduced need for reserves-in theory, no trade need at all. 3. Reduced danger from international 3. Relative freedom for internal economic currency speculation policy. 4. Imposes increased discipline on 4. Exchange rates change in relatively internal economic policy smooth steps 5. Domestic price stability not 5. May reduce speculation (rates move endangered through import prices freely up or down).

(Total 20 marks)

QUESTION 6

A qualification examined by the Institute of Bankers in Malawi 6 Kruger gold plc, a South African mining company decided to go ahead with a MK150 million project in Malawi. The company decided to finance this project by borrowing ZAR10 million from a Bank in South Africa and exchanged this for Kwacha in Malawi at a the then ruling exchange rate of MK15.00/ZAR1.00 (Fifteen Kwacha to One Rand);

(a) Opening balance sheet for the project after this transaction (from Kruger gold’s point of view). The MK150 MN of Malawi assets are translated at MK15/ZAR 1 so all figures are expressed in the parent company’s currency; Opening balance sheet Liabilities Assets Loan ZAR10 MN MW Assets ZAR10 MN (3 marks)

(b) Now imagine that over the course of the year, the Kwacha depreciates against the Rand to MK20.00/ZAR1.00 (Twenty Kwacha to One Rand). i. Kruger gold has been exposed to, Translation risk, which arises because financial data denominated in one currency are then expressed in terms of another currency. In the above case, the figures between the two accounting dates in South Africa have been affected by the exchange rate movement and this distorts comparability. (3 marks) ii. Illustrating the effect of the exchange rate movement on Kruger gold’s accounts (Balance Sheet and Income Statement); Year end balance sheet Liabilities Assets Loan ZAR10 MN MW Assets ZAR7.5 MN Forex loss -ZAR 2.5 MN ZAR 7.5 MN ZAR 7.5 MN

*In the parent company’s accounts there is still a ZAR 10 MN loan but the asset bought with that loan, while still worth MK150 MN is only valued at only ZAR7.5 MN when translated into Rands. In the parent company’s currency terms, ZAR2.5 MN needs to be written off. (8 marks)

A qualification examined by the Institute of Bankers in Malawi 7 (c) Kruger gold could have managed the above exchange rate risk by obtaining a Kwacha loan in Malawi for the Malawian investment. Thus when the Kwacha depreciates, both the asset value and the liability value translated into Rands becomes less; Opening balance sheet Liabilities Assets Loan ZAR10 MN MW Assets ZAR10 MN

If forex rates move to MWK20/ZAR1 Year end balance sheet Liabilities Assets Loan ZAR7.5 MN MW Assets ZAR7.5 MN

(3 marks) (d) One constraint to alternative in (c) above, would be government regulations, which may require that a proportion of the investment/assets should be financed by funds from the parent. Another constraint is that the financial markets in some countries are insufficiently developed to permit large scale borrowing (3 marks) (Total 20 marks)

QUESTION 7 (a) Problems faced in the implementation of economic policy (any four of the below); i. Intermediate targets may not be effectively controlled by the instrument chosen e.g. Bank rate adjustment could be by-passed by money market by means of various forms of lending (dis-intermediation) ii. Intermediate targets may be difficult to define, e.g. while open market operations may be the instrument used to control the rate of growth of money supply, there are many different measure of money supply which do not grow in identical rates, and the choice of measure is problematic. iii. The relationship between an instrument and targets variable may be subject to change over time e.g. private sector reaction to restrain wages may differ from one period of price and incomes policy to another

A qualification examined by the Institute of Bankers in Malawi 8 iv. The wrong instrument to achieve a particular variable may be chosen- i.e. the instrument appropriate at one time may not be appropriate at another. E.g. if an increase in investment expenditure is the intermediate target, reducing interest rates will not boost investment if there is a large surplus of productive capacity at that time. Instead, an increase in the level of aggregate demand would first be required. v. The links between an intermediate target and the final objective may not be known with precision. There is a long running debate regarding the relative importance of aggregate demand on the one hand and money supply on the other, in the determination of the rate of inflation. Clearly, the operation of economic policy will inevitable be a hit-and-miss affair unless such links are reasonably well established. vi. Timing consideration may be important-changing the value of an instrument will have an immediate impact on the policy objective, even if the links in the policy chain are well established. E.g. decision to raise government expenditure takes some time to put into effect, since money cannot be spent immediately (hospitals, for example take time to design and build). When government expenditure does rise, it will take some time to have its full impact on aggregate demand; and there will be a further lag before employers recruit the labour to cope with that raised aggregate demand. Hence, it may take a considerable time before the unemployment falls. vii. Government anticipates or bases its forecasts on collection of statistics which only occurs after a lag of time and current policy making is an estimation exercise (could be wrong). (8 marks) (b) Within monetary policy context of determination of interest rate, there are three distinct effects of a change in monetary policy. These are; the liquidity effect, the income effect and the inflation effect. Explain and give examples of each of the three effects. (12 marks) Monetary policy-Liquidity effect

A qualification examined by the Institute of Bankers in Malawi 9 When monetary policy authorities purchase securities (Treasury notes/Treasury Bills) through open market operations, using newly created money then money supply is increased. In essence this provides liquidity on financial markets, which motivates the label. The security purchase increases the demand for bonds. Bond prices increase and bond yields decline i.e. nominal interest rates decline.

The above assumes sticky prices i.e. the Money market is assumed to be starting at an equilibrium position –M=f(i,Y)*P where M is money supply, i is Interest rates and Y is real output and P is prices. If M increases, and P stays constant, either Y must rise or I must decline. In the very short run-say, on the day of the money supply increase real output cannot reasonably adjust. Thus, nominal interet rates must decline when M increases. This is the liquidity effect.

Monetary Policy-Income Effect In the long term a reduction in interest rates will encourage borrowing and production raising real output-The Income effect.

Monetary Policy-Inflation effect However, where money supply increases with same output then there will be more money in circulation for the same output/goods and this will inevitably increase prices--The Inflation effect.

(Total 20 marks)

QUESTION 8

(a) Why do we have more regulation imposed on financial institutions than on other types of private corporations? (8 marks) Financial markets play an important role in an economy e.g. economic growth through facilitating transfer of surplus funds to deficient activities or operations, and Foreign Direct investment (foreigners buying shares in local companies). As such governments see it necessary to regulate certain aspects of these markets.

A qualification examined by the Institute of Bankers in Malawi 10 There exists a two way interaction between governments on one hand, and financial markets and institutions on the other. Government’s actions, like monetary policy or interest rate decisions, affect the financial markets and institutions. Similarly, the financial market’s/institutions response to a new government regulation will often prompt a new response by the government, which can cause the institutions participating in a market to change their behaviour further, and so on. The justification for this form of government regulation is that these financial firms have a special role to play in a modern economy. Financial institutions help households and firms to save; they also facilitate payments and in case of commercial banks they serve as conduit for government’s monetary policy. Failure of financial institutions means failure of the mentioned activities which will severely affect the economy.

(b) Discuss the key role of Financial Markets in an economy? (4 marks) Any four

(c) Collective Investment Schemes (CISs) may be classified according their asset orientation. Outline four classes of CISs according to their asset orientation

(any four)  Equity or sock funds-invest primarily in shares and are geared towards generating growth rather than income

 Bond funds-invest exclusively in bonds. Within bond fund there are further specifications according to currency, country and issuer.

A qualification examined by the Institute of Bankers in Malawi 11  Money market funds which invest exclusively in money market securities

 Participation bond fund which invest in first mortgage bond over commercial or industrial property

 Fund of funds-these invest in other funds to increase diversification and reduce over fund risk profile.

(8 marks)

(Total 20 marks)

END OF THE EXAMINATION PAPER

A qualification examined by the Institute of Bankers in Malawi 12