Monash University Semester One Final Examination 2012 Faculty of Business and Economics Department of Accounting and Finance EXAM CODES:AFC2000 TITLE OF PAPER:FINANCIAL INSTITUTIONS AND MARKETS EXAM DURATION:3 hours READING TIME:10 minutes SOLUTIONS ONLY SECTION A (20 Marks) In questions requiring a day count convention, assume 365 days unless otherwise stated. 1. The term structure of interest rates: *a. describes the relationship between maturity and yield for similar securities. b. ranks security yield according to the default risk structure. c. describes how interest rates vary over time. d. escribes the pattern of interest rates over the business cycle. 2. The liquidity premium theory of the term structure of interest rates is best supported by what type of yield curve? a. A decreasing curve over time. b. A flat yield curve. *c. An increasing yield curve over time. d. None of the above. 3. Maturity gap analysis is: a. a measure of the difference between the duration of a bank’s assets and the duration of its liabilities. *b. a comparison of the value of assets that will either mature or be repriced within a given time interval with the value of liabilities that will either mature or be repriced during the same time period. . when a bank adjusts its asset and liability durations to zero. d. how much the cumulative gap will change during a future interval. 4. Banks participate in the markets for interest rate and currency forwards, futures, options and swaps because: *a. they may use derivatives to speculate on the direction of changes in interest rates or currency exchange rates. b. they may use derivatives to earn higher profits. c. derivatives are bank’s source of fund. d. b and c. 5. Which of the following statements is not true about repurchase agreements? a. These are a form of secured borrowing by a bank. b.
They are settled in federal funds. *c. These are seldom used by the Federal Reserve for making temporary reserve positions adjustments. d. Treasury securities are often used in this type of transaction. 6. When firms issuing commercial paper use a backup line of credit, it: a. increases the credit risk for investors. *b. decreases the credit risk for investors. c. has no impact on investors. d. decreases the marketability of commercial paper. 7. A firm buys $1,000,000 of a 30-day commercial paper issue $995,450. The yield on this commercial paper is: *a. 5. 56% b. 5. 46% c. 5. 49% d. 5. 54% 8.
The sale of securities to the public via an investment banker by a new corporation raising funds is called a. a seasoned offering. b. a secondary offering. *c. an initial public offering. d. a best efforts offering. 9. The security market line represents: a. the amount of risk demanded for each unit of return. *b. the rate of return for each unit of risk. c. the sum of the systematic and unsystematic risks. d. the risk/return tradeoff over time. 10. A farmer growing wheat is ______ in wheat and may hedge price risk by ______ wheat futures. a. short; long b. buying; selling c. selling; buying *d. long; selling 11.
The value of an option varies directly with: a. the price variance of the underlying commodity. b. the time to expiration. c. the level of interest rates. *d. all of the above. 12. Index arbitrageurs: *a. buy and sell huge quantities of shares whenever the value of a share-index futures contract is not equal to the value of its underlying shares. b. buy and sell huge quantities of shares whenever the value of a share-index futures contract is equal to the value of its underlying shares. c. buy huge quantities of shares whenever the value of a share-index futures contract is not equal to the value of its underlying shares. . sell huge quantities of shares whenever the value of a share-index futures contract is not unequal to the value of its underlying shares. 13. What action would the holder of a maturing call option take with an option which cost $300, had a strike price of $50 and the market value of the stock was $52? a. Let the option expire unexercised *b. Exercise the option c. Request that the $300 be returned d. None of the above 14. If the cost of yen per dollar changes from 100 to 110 yen per dollar, a. the yen has appreciated against the dollar. b. the dollar has depreciated against the yen. c. the dollar has appreciated against the yen. d. the cost of a yen has increased in terms of dollars. 15. Significant trade deficits, imports exceeding exports, should have what effect on a country’s exchange rate? a. Trade levels do not affect exchange rates. b. The country’s currency should appreciate in value relative to their major trading countries. *c. The country’s currency should depreciate in value relative to their major trading countries. d. None of the above are correct. 16. An importer who must pay yen in 60 days may hedge the foreign exchange risk: a. in the forward market.
b. in the spot market today. c. in the spot market 60 days from now. d. all of the above 17. While life insurance protects the insured against the economic consequences of premature death, annuities protect against: *a. the economic consequences of living too long. b. varying interest rates. c. aggressive beneficiaries. d. default by life insurance companies. 18. Life insurance companies have a portion of their assets invested in common stocks most likely because: a. there’s no other way to finance whole life insurance policies. *b. he company probably offers variable-life insurance policies. c. it reduces the risk of the corporate bond portfolio. d. common stockholders desire a small amount of their return in life insurance. 19. Discount brokers compete against full-service brokerage firms by offering: a. discounted new issues to investors. *b. offering fewer brokerage services and passing the savings on to the investors. c. cash management services to investors. d. margin credit to investors’ accounts. 20. Private placements have several advantages over public securities offerings. They are a. ess costly in terms of time and money than registering with the Security Investment Commission. b. the issuers do not have to reveal confidential information. c. the terms of a private placement are easier to renegotiate. *d. all of the above (20 ? 1 mark = 20 marks) SECTION B (80 Marks) Question 1 During their meeting in February 2012, RBA decided to keep interest rate on hold at 4. 25% pa despite an overwhelm market expectation for a rate cut. Outline and explain THREE possible issues that RBA has to consider in making that decision. Discuss the impact of this decision on the value of Australian dollar. 10 marks) Discuss any THREE of the following issues: 1) International economic outlook: The global market condition remains unstable. Students can extend these issues and discuss the situation in China, and Europe. 2) The domestic market condition: GDP growth is slow. Overall business condition is difficult except for the resource sector. Discussion on business and consumer spending. 3) Domestic labour market: unemployment rate remain just above the 5%. 4) Inflation is within the band. (2. 5 marks each. Note: students don’t have to mention all of the above details to receive full mark.
As long as they understand that these are the important issues that RBA has to consider in marking their rate decision. ) Impact of the decision of AUD. Because the market expect a rate cut, the money market has already price for a rate cut in the current AUD value. Hence, when the rate was keep on hold, the value of AUD increased. (2. 5 marks) Question 2 a) What is the current capital adequacy requirement for Australian banks? Explain why APRA focus on regulating banks’ capital? • The current capital adequacy standards are consisted with the Bank of International Settlements’ (BIS) Basel II. APRA regulated ADIs must adhere to an 8 per cent capital adequacy ratio (CAR). • The ratio of capital to risk adjusted assets must be at least 8 per cent. (1. 5 marks) • These statements divide capital into: • Tier 1 capital; and • Tier 2 capital. • Tier 1 capital must make up at least 50 per cent of total capital. (1. 5 marks) • Capital is important because it’s the only source of fund available to observe loss. (2 marks) b) A major part of bank’s liquidity management is asset management. Explain bank asset management. • Asset management: maintaining sufficient cash and noncash assets that can be quickly converted to cash. 1 mark) • Asset management classifies bank assets into four groups: • Primary reserves : Primary reserves are immediately available to accommodate liquidity demands. • Secondary reserves: Secondary reserves provide banks with additional liquidity while earning some interest income. • Bank loans: Bank loans are undertaken once the bank has satisfied its liquidity needs.
• Investments: Open market investments are then undertaken once loan demand has been satisfied. (1 mark each) (5 + 5 = 10 marks) Question 3 a) A $1000 bond with an 8. 2% coupon rate, interest paid annually, and maturing in six years is currently yielding 7. % in the market. What is the current price of the bond? b) Calculate the duration of the above mentioned bond. c) Given the current interest rate for a 8 years term loan is 6 % pa (compounded annually) and the current interest rate for a 6 years term loan is 5. 5% pa (compounded annually). Estimate the two year forward rate starting 6 years from today. (3+ 4 + 3 = 10 marks) [pic] Question 4 a) Define a money market and discuss its main role. The most important economic function of the money market is to provide an efficient means for economic units to adjust their liquidity positions. 2m) The money markets are where depository institutions and other businesses adjust their liquidity positions by borrowing or investing for short periods of time. (1. 5 m) The money market consists of a collection of markets, each trading a distinctly different financial instrument. There is no central exchange for money markets, such as the Australian Stock Exchange for the equity markets, because they are over-the-counter (OTC) markets. (1. 5m) b) A bank agrees to buy T-bills from a securities dealer for $997,250, and promises to sell the securities back to the dealer in 4 days for $997,575.
Calculate the yield on this reverse repo for the bank. [pic] (5 + 5 = 10 marks) Question 5 a) What characterise a market exhibiting market depth and market resilience? A market exhibits market depth would have many bid and ask offer below the best bid and best ask. (2. 5 m) A market exhibits market resilience if new orders pour in promptly in response to price changes resulting from temporary order imbalances. For a market to be resilient, investors must be able to quickly learn of the price changes.
The advent of the Internet has greatly increased resilience because all traders, no matter how large or small, can monitor market movements in real time. (2. 5m) b) What is the value of a stock expected to pay a constant $5 dividend each year forever starting 5 years from today, if the market required rate of return is 18%? P4 = 5/0. 18 = 27. 78 (2mk) P0 = P4/(1. 18)^4 = 14. 33 (3mk) (5 + 5 = 10 marks) Question 6 a) Explain the role of the margin account on a futures exchange? The margin account protects futures market participants from default resulting from adverse price movements.
As contracts are marked to market daily, increases in value are added to the margin account and decreases in value are subtracted. The exchange maintains these accounts so participants needn’t worry about default risk. (4m) b) An index fund has earned 10% return for their portfolio in the current financial year and wishes to look in that return. The fund manager decides to use the index future to hedge their market risk. The fund is currently tracking ASX S&P 200 perfectly, the total portfolio is 10 million, the SPI future contract is selling at 4000, at $25 per point.
Show how the manager can fully hedge their market exposure. Demonstrate how this hedging work if the ASX S&P 200 end up at 3960 point at the end of the year. [pic] (4 + 6 = 10 marks) Question 7 a) Significant trade deficits, imports exceeding exports, should have what effect on a country’s exchange rate? The country’s currency should depreciate in value relative to their major trading countries. (5m) b) An importer based in Austria that imports kangaroo meat from Australia wishes to buy Australian dollars (A$) with Austrian Schilling (ATS). The following rates are quoted: In AustriaUS$ 1 = ATS 15. 650 – 15. 2660 In Melbourne A$ 1 = ATS 8. 9750 – 8. 9830 In Hong KongATS 1 = A$ 0. 1110 – 0. 1115 Determine the best Australian dollar against Austrian Schilling rate (i. e. express one unit of A$ in terms of ATS) at which one may buy Australian dollar with Austrian Schilling Evaluate at this rate the cost in Austrian Schilling of buying 5,000 kg of the premium kangaroo meat that cost A$12 per kilo. In Melbourne(A$1 = ATS 8. 9750 – 8. 9830 In Hong Kong(A$1 = ATS 8. 9686 – 9. 0090 Therefore, the best rate to buy Austrian Schilling is in Melbourne, i. e. A$1 = ATS 8. 9830 (2. m) Cost of buying the premium kangaroo meat= 5000 x 12 x 8. 9830 = ATS 538,980 (2,5m) (5 + 5 = 10 marks) Question 8 a) What is project finance? Explain the main difference between project finance lending and normal business lending. b) Explain the difference between defined benefits and accumulation superannuation plans. (5 + 5 = 10 Marks) a) Project finance is lending to the investment project as a separate legal entity. (2m) Project finance differs from other lending applications in a number of ways: a. The project itself (not the company involved) is financed. b.
Finance is usually on a limited recourse basis. c. Syndication is involved to share the risk among financiers. (1m each) b) ‘Defined benefit plans’ are a traditional industrial-era arrangement under which an employer promises benefits set by some formula based on years of service and average pay. The employer is fully responsible for delivering the promised benefits. (2. 5m) “Defined contribution plans” are the modern arrangement. Contributions defined as some percentage of salary are paid in by the employee and/or employer. The employee decides how the contributions are invested. (2. 5m)
