INSTITUTE OF BANKERS IN MALAWI
DIPLOMA IN BANKING EXAMINATION
SUBJECT: FINANCIAL MARKETS 1(IOBM – D203)
Date: Thursday, 2nd May 2013
Time Allocated: 3 hours (13:30 – 16:30 hours)
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) Discuss and compare hedging transaction exposure using the forward contract vs. money market instruments. When do the alternative hedging approaches produce the same result? (5 marks)
b) Cray Research sold a super computer to the Max Planck Institute in Germany on credit and invoiced Deutschmark (DM) 10 million payable in six months. Currently, the six-month forward exchange rate is $1.50/DM and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $1.43 in six months.
i. What is the expected gain/loss from the forward hedging? (5 marks)
ii. If you were the Financial Manager of Cray Research, would you recommend hedging this DM receivable? If so why or why not? (3 marks)
iii. Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward exchange rate quoted today. Would you recommend hedging in this case? Give reasons to your answer? (2 marks)
(Total 15 marks)
QUESTION 2
a) Explain the five basic differences between the operation of a currency forward market and a futures market. (10 marks)
b) Mention and explain two types of participants who make the derivatives market function. (5 marks)
(Total 15 marks)
QUESTION 3
a) Janet can buy a discount bond for $500 from Britney which matures exactly 5 years from now. The bond’s par value is $1000. Britney claims that this bond’s yield to maturity is 20%. Is she being truthful? You are required to prove Britney’s claim. (6 marks)
b) On January 23, 2001, the yield to maturity of Treasury bonds that mature on 1st October 2031. What happened to the price of these bonds on this day? (4 marks)
c) Assume that ABC stock pays an annual dividend of $5 per share; this dividend is expected to grow at 3% annual rate. According to the Gordon growth model, what is a fair price for a share of ABC stock? Use a discount rate of 5%.
(5 marks)
(Total 15 marks)
QUESTION 4
a) Give three reasons why it is more difficult to value common stock than it is to value a bond? (6 marks)
b) Focus PLC paid a dividend this year of $9,000,000. The company expects the dividend to rise by 6% a year in perpetuity. This expectation is shared by the investors in the stock market. The current return expected by investors from shares in the same industry Focus is 16%.
Required:
i. What would you expect the total market value of the shares of Focus PLC to be? (5 marks)
ii. If it is now rumoured in the stock market that interest rates are about to rise and shareholders will want to earn extra 3% on their shares. What change would be expected in the value of the shares of Focus PLC? (4 marks)
(Total 15 marks)
SECTION B (40 MARKS)
Answer ANY TWO questions from this section
QUESTION 5
Lately there has been a general outcry in the financial circles about lack of liquidity in the market and this has caused panic on investors and financial institutions.
a) Describe four main causes of liquidity squeeze in the Malawi financial sector.
(16 marks)
b) Propose some measures that a country can take in order to correct the illiquidity situation. (4 marks)
(Total 20 marks)
QUESTION 6
You plan to visit Geneva, Switzerland in three months to attend an international business conference. You expect to incur the total cost of Swiss Frank (SF) 5,000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy the three-month call option on SF with the exercise rate of $0.64/SF for the premium of $0.05 per SF. Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland.
a) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward contract. (2 marks)
b) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on SF. (8 marks)
c) At what future spot exchange rate will you be indifferent between the forward and option market hedges? (5 marks)
d) Briefly illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate under both the options and forward market hedges. (5 marks)
(Total 20 marks)
QUESTION 7
a) Describe the difference between a swap broker and a swap dealer. (4 marks)
b) What is the necessary condition for a fixed-for-floating interest rate swap to be possible? (2 marks)
c) Discuss the two basic motivations for a counterparty to enter into a currency swap.
(4 marks)
d) Discuss five risks confronting an interest rate and currency swap dealer.
(10 marks)
(Total 20 marks)
QUESTION 8
A company has received a substantial loan from commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. The company has obtained a credit line to satisfy temporary funds needs. Besides, in order to solve unexpected liquidity problems, it can sell short term government securities, which it has bought half a year ago. The economic forecasts are rather optimistic, thus in order to satisfy the rising demand, the company may be in need to increase its production capacity by about 40 percent over the next two years. However, the company is concerned about potential slow down in the economy due to possible actions of the Central Bank aimed at sustaining the inflation rate low. The company needs funding to cover payments to suppliers. It is also considering other possibilities of financing in the money market. The interest rate that the company is paying for its line of credit is less than the prevailing commercial paper interest rate of highly rated companies.
Explain if the company should:-
a) Issue commercial paper on this prevailing interest rate. (6 marks)
b) Sell its holding of government securities to cover the payments to suppliers. (6 marks)
c) Use its credit line. (4 marks)
d) Which alternative has the lowest cost for the company? Provide the reasoning.
(4 marks)
(Total 20 marks)
END OF THE EXAMINATION PAPER
5
A qualification examined by the Institute of Bankers in Malawi