Subject Review Questions and Solutions
1. Capital markets may operate under auction, over-the-counter or intermediated modes. Distinguish between these types of operation.
Auction markets require the financial asset to be identical in terms of risk and cashflow & liquidity – the assets are then traded on a centralised exchange where all parties know prices – an example is the stock exchange – each share in a particular company is identical to all the others therefore you can have an auction system for selling and buying.
Over the counter markets are those in which dealers operate. By standing ready to immediately buy or sell, the dealer makes the market and provides liquidity. These markets arise when the assets aren’t identical in cashflow/risk. Examples are foreign exchange markets, forward markets.
Both auction and OTC markets are examples of direct modes – intermediated markets are those where two financial assets are created in the transfer of money from savers to borrowers. The most common entity here are banks.
Distinguish between the functions of brokers and dealers in the capital market. How does the role of a broker differ from that of financial intermediary?
Students are expected to note that dealers provide immediacy in trade and hence make a market as they hold an inventory of the assets that they deal in. Brokers on the other hand do not hold an inventory but act as sales agents making a living on sales commission. Brokers do not provide the advantages of intermediation ie (maturity, liquidity, risk or asset transformation) and hence they do not create financial assets. Brokers facilitate an existing market by bring buyers and sellers together.
3. Distinguish between a primary market and a secondary market. Why is the existence of well-developed secondary markets important to the functioning of primary markets?
Primary markets are when assets are traded for the first time ie a share float. Secondary markets are when financial assets are subsequently traded – only the ownership has changed.
Discuss advantages of financial intermediation.
From the text – students can choose from maturity transformation, liquidity transformation, credit risk transformation, asset transformation.
Explain the difference between direct and intermediated financial flows and provide two examples of each.
Processes of direct financing creates 1 financial asset and in intermediated financing two financial assets are created. Buying a share and buying a bond are examples of direct financing. Taking out a loan at a bank and having a bank accounts are examples of intermediated financing.
A 90 day bill with a face value of $100,000 and a issue yield is of 5.5% is sold after 43 days at a market yield of 6.5%. What is the holding period yield to the investor. Purchase price of bill
FV/ (1 + n/365(r))
Price = $98 662
Sale price of bill after holding 43 days is .(Remember you are now selling a bill with 47 days until maturity)
FV/ (1 + n/365(r))
Price = $99 170
Therefore HPY for the 43 days the bill was held:
SP-PP/PP x 365/43 x100
= 99170-98662/98662 x 365/43 x 100
Suppose that 60 days ago you purchased a 180 day commercial bill with a face value of $100,000 at a yield of 6.05%. You now decide to sell the bill. Current yields on the bills are as follows:
What is the holding period yield on your investment? Show workings.
HPY = 4.94%
What is the market price of a 2 year bond with a coupon rate of 8.5% (payable semi annually) and a face value of$ 100,000 if the market yield on bonds of this type is 7.5%? Remember that you can use any method you like to price the bond – the discount way I did in the first assignment solutions or by a formula – just so long as you get the right answer...
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