Financial Institutions What is the defining characteristic of a derivative? The defining characteristics is that it exists on the back of anothe

AF1100 – Financial Institutions

Tutorial Questions – Week 9

Question 1 – What is the defining characteristic of a derivative?

The defining characteristics is that it exists on the back of another security. If this other security was to cease to exist, so would the derivative.

Question 2 – What determines the price of a derivative?

The price of a derivative is a function of a number of variables, depending on the derivative. In some instances, the derivative is only an exchange of securities or security for cash, and since the terms are defined for both parties, there is no market value as such (e.g. currency future, where at maturity each side sells a currency in exchange for another), whereas in other instances, the price is a result of two sources of value: intrinsic and time value.

Intrinsic value is the difference between the exercise and the market value of the underlying security (e.g. an option to buy shares in a company for £2, when the market price is currently £2.20 has an intrinsic value of £0.20), while the time value is the possibility that executing the derivative will result in a gain at maturity due to change in the market price of the underlying asset between now and the maturity date (e.g. in the example above, time value is given by the possibility that the share price will increase further between now and maturity and in so doing creating more value to the buyer of the option.

Question 3 – For what purpose would someone use a derivative?

There are two purposes of using derivatives:

· When one has a risky position, we can use derivatives to reduce or eliminate the risk of the existing position – this is called hedging

· When one doesn’t have a risky position, but we believe there will be a change in market conditions in a certain direction, we can put ourselves in a position to generate a profit when (and if) that change does take place, by using derivatives, in which case we are creating a risky position – this is called speculating

Question 4 – Who are the four main operators in derivatives markets?

The four main operators in the derivatives markets are:

· End-user – the investor who is buying/selling the derivative for one of the two purposes described in the previous question

· Market-maker – financial institutions who ensure the market “exists” by providing quotes that are taken up by the end-users

· Regulator – the name says it all, these are the bodies responsible for regulating the market, i.e. creating the rules under which the market is going to operate and ensuring they are adhered to buy all the participants

· Financial engineering – this are the financial institutions that create derivative products, i.e. identify needs appearing in the market (either by hedgers or speculators) and develop products for which there is likely to be a demand as they serve the needs previously identified.

Question 5 – What are the three main types of derivative product?

The main types of derivatives are: futures, forwards, options, and swaps (see lecture notes, book and/or previous tutorial questions solutions for further details).

Question 6 – Compare the risk & reward for the buyer of a derivative with the risk & reward for the seller (“writer”) of a derivative.

The buyer is the one who is paying to have control, while the seller is the one being paid to allow the buyer to have control.

As such, the buyer gets what they want, i.e. reduction/elimination of risk if they are hedgers or taking of risk if they are speculators.

In all cases, once the seller agrees to the trade, they are dependent on what the buyer will do, especially when the derivative involves an option, which will be up to the buyer to exercise while the seller will have to do what the buyer wants.

In all cases, buyers and sellers have different expectations about the future value/price of the underlying asset, as both expect to not loose (hedger) or make money (speculator) when entering a derivative trade.

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AF1100 – Financial Institutions

Tutorial Questions – Week 4

Question 12.1 – See end of book for recommended solution

Question 12.2 – See end of book for recommended solution

Question 12.3 – The resourcing of the internal audit department must be reviewed. Additional staff may be required where additional responsibilities are being assigned. Any new staff will probably need different skills and backgrounds to those already employed within the internal audit team.

Reviewing risk management systems requires good business awareness and formal accounting training is unlikely to be an important attribute. Where the responsibilities involve promoting risk awareness within the company, it is vitally important for staff to be able to communicate effectively with managers and to work as members of a management team.

Question 12.4 – See end of book for recommended solution

Question 12.5 – The chairman may help to improve the working relationship between the two groups in various ways. To deal with the concerns of the executive directors, the chairman should:

· Implement a rigorous recruitment and selection process to ensure that, in the future, directors of the right calibre are appointed.

· Provide induction and training programmes for non-executive directors to help them achieve a better understanding of the business and the challenges and problems that must be faced.

· Monitor the performance of individual directors against clearly established criteria and ensure that those that fail to meet the criteria either improve or are dismissed.

· Ensure that board meetings concentrate on strategic matters, to which non-executive directors should contribute, and do not become side tracked by detailed operational matters.

To deal with the concerns of the non-executive directors, the chairman should:

· Try to ensure that all directors receive the timely information on all relevant matters.

· Provide ‘clear-the-air’ meetings where directors can express their concerns.

· Discourage cliques and informal meetings to which only certain directors are invited.

· Call timely board meetings so that non-executive directors are given the opportunity to contribute towards important decisions.

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AF1100 – Financial Institutions

Tutorial Questions – Week 10

Duska et AL’s Accounting Ethics – Discussion Questions 1-5 chapter 1 – page 29

Question 1

Throughout this chapter of the book, there are various mentions to numbers from the accounting system and uses made of those, but we can summarise the key ideas as follows:

· Accounting information is prepared for the company’s shareholders who use that information to make investment decisions (whether to buy, sell or keep shares in the company)

· All other users (employees, customers, competitors, lenders, etc.) have access to the published information and they then use it to make their own decisions, as well

· As such, reliability of all stakeholders on the quality of the accounting information is high and that puts the onus on the accountants to produce quality and timely information

Question 2

If you look at page 19 of the book, there is a list of different roles that are fulfilled by accountants, and each of them requires different skills, use of personal judgement and use of appropriate techniques and principles.

As such, there is not a single body of knowledge all accountants need to possess, but rather a common knowledge base which then needs to be developed/augmented by each individual accountant, which is tailored to the role they are taking on. Thus the concept of art and craft, as each role will be different.

Question 3

Accountants perform their duties in the public’s best interest. As such, any information that is relevant for the public to understand the true performance of a company needs to be disclosed and it is the obligation of the accountant to do so.

See section on Ethics of Disclosure in the book.

Question 4

See book section on Roles an Accountant can Fulfil, which includes a good identification of the different roles of the accountant and the potential ethical issues they might face.

Question 5

The main aim of the preparation of accounts is to present a true picture of the company’s performance, so the development of accounting standards is driven by that objective. In order to do so, standards try to ensure there is a consistent approach in the accounting of similar transactions by all companies, while at the same time ensuring there are rules that apply to all transactions a company can face.

See also discussion on the Development of Explicit Accounting Standards and Regulations on this chapter of the book for further details.

Duska et AL’s Accounting Ethics – Discussion Questions 1-6 chapter 2 – page 52

Question 1

See the sections on “Actions” and “Social Practices, Institutions and Systems” on this chapter of the book, for a good explanation of these concepts and the differences between them.

Question 2

Very complete answer and discussion, listing the five reasons for studying ethics in the section of the chapter titles “Why Study Ethics”.

Question 3

Ethical analysis, as the name indicates, is about understanding whether a professional’s actions can be classified as ethical or not. Being ethical can have different meanings, but the assessment of whether an action is ethical or not needs to be done in light of the six principles recognised in the AICPA code of ethics, as listed and discussed on page 42 of this chapter of the book.

Question 4

This is more of five reasons rather than four, and they covered in significant details in the five sections of the chapter starting with Questions to Ask to Justify and Action: the Basis of Ethical Theory.

The five subsequent questions, heading each section are the key questions one needs to ask when deciding whether an action is ethical or not and making sure the correct answer is given to each of them constitutes the reasons to evaluate the ethics of the action.

Question 5

An ethical dilemma exists when there is a conflict between the reasons listed in the previous question. For example, if an action is in the best interest of the accountant but it goes against a commitment previously made, the accountant is facing a conflict of interest.

Question 6

Any example from your own experience (doesn’t need to be accounting related, as we as individuals frequently face ethical dilemmas as well) or that you might have heard of is acceptable.

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AF1100 – Financial Institutions

Tutorial Questions – Week 6

Chapter 5 (H&B) – Questions for Discussion 1-6

Question 1 – As discussed in class, the key differences between the money and the capital markets are:

· Liquidity – money markets are more liquid, because

· Length of transactions – money market transactions are mostly short (or very short) term, unlike capital markets

· Access – only banks, governments and very large corporations access the money market, making it

· Security – a very safe market

In terms of the reasons for accessing the money market, then all participants can go in as listed and explained on page 118 of H&B. These participants are:

· Lenders and borrowers

· Brokers

· Issuing houses

· Market-makers

· Arbitrageurs

· Speculators

· Hedgers

Question 2 – Please see list on page 122 of H&B for money market instruments issued at a discount and on a yield basis

When an instrument is issued on a yield basis, the initial amount transferred is the face value of the instrument and the repayment is made for the face value plus the interest. When an instrument is issued on a discount basis, the initial amount transacted is the face value minus the discount and at redemption the amount exchanged is the face value.

As an example of a quoted 5% and assuming a face value of £1,000. This makes the redemption value of the CD equal to £1,050 and the issue amount of the treasury bill equal to £950.

As such the return of the CD will be (1,050 – 1,000) / 1,000 = 5%, while the return of the treasury bill will be (1,000 – 950) / 950 approx.= 5.263%

This is what will always happen, i.e. the instrument issued at a discount will offer a higher return if the quoted rate is the same

Question 3 – In order to address this question, we need to understand that the impact is not a “direct one, as we are discussing long term interest rates and Commercial paper is a short-term instrument.

Companies issue a mix of short and long-term debt, depending on their investment needs and the type of assets they own, but that mix is flexible. As such, if there is a sentiment in the market that long term interest rates are likely to be going down, companies will be shifting some of the debt they need to issue from long to short term. Considering the issuers of debt instruments are the ones making it available in the market, i.e. the supply side, we should see an increase in the supply of commercial paper.

Question 4 – A large sale of Government bonds increases the supply of low-risk instruments for investors, which is likely to reduce the demand for money market instruments, as investors have a safer alternative for their available funds.

As for the first part of the question, the answer is a little trickier, as it depends on the current situation in the market. While logic indicates that increasing the supply of financial instruments allows investors a more diverse range of investment alternatives, thus leading them to invest more resulting in an increase in liquidity, there is the danger that, if the market is already very liquid, this large issue will divert funds from other investments thus commitment significant cash resources to these bonds resulting in a reduction in liquidity in the market.

Question 5 – Please read through section 5.3 of H&B for a more detailed discussion of central bank’s implementation of monetary policy and its impact on the money markets. The key instruments are:

· Setting of interest rates

· Lending via “discount window”

· Open market operations

· Repurchase agreements

Question 6 – A repo agreement is one way of borrowing/lending without the issue of a new security, as one side sells an existing financial instrument to the other with an agreement to repurchase it a later date, with a pre-agreed price.

Repos are short term instruments and other lending and interest rates are linked to the repo rates. As such, if the central bank is concerned about the rate of growth of credit, it will attempt to increase interest rates by using the repo market. This can be achieved by selling instruments today (in this way already reducing the money available in the market for credit) and agreeing to buy back on “generous” terms, i.e. a repurchase price that results in a high interest rate, thus leading to an increase in the market interest rates.

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AF1100 – Financial Institutions

Tutorial Questions – Week 7

Chapter 6 (H&B) – Questions for Discussion 1-10

Question 1 – Without a secondary market, there would be no primary market, or if still existed it would be much smaller. In the primary market, borrowers raise funds from lenders/shareholders, but what allows these to lend/buy shares is the fact that they know that if they ever need the funds they are lending/investing back, they will be able to get them by selling them to other lenders at, and this is essential, a price that is fair, i.e. without significant loss of value.

Without this “guarantee” the risk would be too high considering the lenders would need to find a buyer and, since there would be no active, competitive market, the buyer would be able to set a very low price in order to buy the security.

Question 2 – In general, the prices of goods and services increase over time (inflation), meaning the purchasing power of money is reduced over time. As such, in order to be able to acquire the same goods in the future, a larger amount of money will be necessary. For example, if inflation is 5% over one year, and at the start we could buy a certain basket of goods with £100, at the end of that year, we would need £105. These amounts are called “equivalent”, i.e. £100 is the present equivalent of £105 in a year’s time and £105 is the equivalent in a year’s time of £100 today.

The processes of calculating these equivalent amounts are called discounting (calculating the present equivalent of a future amount) and compounding (calculating the future equivalent of a present amount).

When we are buying and selling securities, we are paying today for cash flows we will receive in the future, and in most cases at various different points in the future, and therefore in order to find how much we are willing to pay, we need to discount all those future cashflows (at a rate of return that we think appropriate for the investment we will be doing) to today.

Question 3 – Bond prices, whether they are short or long term bonds, depend solely on the interest rate (commonly known as yield). As such, a long term bond will be more volatile as any change in interest rates affects the bond for longer, but interest rates don’t tend to vary much in the short term, and therefore none of the bonds are likely to have high sort-run price volatility.

Share prices, on the other hand, depend (and are therefore affected) on a large number of variables (company related, sector related and economy related) so the probably of one or more events that affect one or more of those many variables is much greater and the share is likely to have the largest short-run price volatility. The industry in which the company operates is also significant, in this instance being a “technology” sector, which therefore can change significantly if a new technic/discovery happens.

Question 4 – Both bonds will be selling at a discount (i.e. below face or par value) as the rate you are getting (the coupon rate of 8%) is less than the rate you require (the market rate of 10%), so this is not a good investment, everyone will want to sell, so the price will go down until the equilibrium is reached, which is when the redemption yield (or yield to maturity) is equal to the required, in this instance 10%, which will be the redemption yield of both bonds.

As for the price, the longer the bond, the bigger the impact of any rate differential (between coupon and market rate) so the 10 years bong will be cheaper than the three year bond.

Question 5 – The two most obvious are liquidity (banks and other financial institutions have regular required payments, thus holding instruments that can regularly be converted into cash is beneficial) and price volatility, as the price of short dated securities is less volatile and therefore this is less risky for institutions that have regular payments to make.

Question 6 – A quote-driven market is when the bid and ask quotes of market makers are available and any buyers or sellers go to these market makers and buy or sell in line with those quotes. In an order-driven market all the bid and ask quotes of any market participants are available and anyone can match any quotes for a trade to take place.

Question 7 – According the Capital Asset Pricing Model, the return of the share is given by the following formula: Rj = Rf + β * (RM – Rf) in this instance 5 + 1.1*10 = 16%.

According the Dividend Growth Model, the price is given by P = D1 /(K – g), where K is the required return on the share calculated in line with the CAPM.

In this case the fair price of the share should be P = 20*(1+0.06)/(0.16-0.06) = 212 pence or £2.12, so if it is trading at £2.50, they are overpriced, so your friend should sell.

The variables are:

Rj – required return on security j (also K)

Rf – return on a risk free investment

RM – return of the market portfolio (RM – Rf = market risk premium)

β – assesses the level of risk of the security relative to the market portfolio risk

D1 – dividend in period one (next period) which can be calculated as D0 * (1 + g), with D0 being the most recently paid dividend

G – growth rate of dividend

Question 8 – Capital risk is the risk that the value of your investment will be different from what you expect at the time of redemption/sale. You are not told what is the timeframe of your investment, but the book was publish in 2007, so the second bond will be a very short one and therefore the capital risk is virtually non-existent, so that would be the obvious choice. Two other issues to note:

· Because the Treasury is for 2020, which is 13 years into the future, it intends to indicate that the probability that you’ll need the capital prior to maturity is high, thus making the capital risk higher

· For two bonds of the same maturity, as a rule the one with the lowest coupon rate (unless it is too low and therefore potentially much lower than market rates, which is not the case with a 5% rate) is the one with the lowest capital risk and the price volatility will be lower.

Question 9 – Clean price – the price of the bond immediately after the payment of a coupon, meaning there is an integer number of periods to maturity

Dirty price – the price of the bond at any other times, which includes a number of whole coupons but also a percentage of interest already accrued since the payment of the most recent coupon.

Accrued interest – interest that is already incurred as the period to which it refers has already started, but only becomes due at the agreed payment date (in the case of a bond, the coupon payment date). To note that interest is normally paid in arrears, thus accrued but not yet paid interest existing.

Interest yield – yield is a synonym of return, which is what you earn from an investment, so interest yield in the return you receive in the form of interest.

Redemption yield – yearly return earned in an interest-paying investment (e.g. bond) if you hold the investment until maturity.

Question 10 – Market capitalisation – Market value of the equity of a company, calculated as the price per share multiplied by the total number of outstanding shares.

Dividend yield – as per explanation of interest yield in the previous question, this is the return earned in an investment in the form of dividend, where dividend is a cash payment made from the company to shareholders

P/E ratio – price per share (P) represents future performance of the company (as explained in Q2 above, the price is equivalent to the present value of all the future cash flows generated by buying the share), whereas E stands for Earnings Per Share (EPS), which represents (recent) past performance of the company. The ratio therefore is a metric of how well investors expect the company to perform relative to its current performance and the higher it is, the higher the expectations.

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AF1100 – Financial Institutions

Tutorial Questions – Week 8

Question 1 – What is the difference between nominal and real interest rates?

Nominal rates are the rates that are normally quoted on loans or investments/deposits and are unaffected by inflation. Real rates on the other hand reflect the change in value/wealth effectively achieved. The relationship between the two rates, using variables consistent with the ones in the H&B book, is as follows: (1+i) = (1+r)(1+P), where i represents the nominal rate of interest, r the real rate of interest and P the inflation rate.

For example, if you make a deposit today that pays you a nominal rate of 4% and inflation during the coming year is 3%, when you collect the money deposit at the end of the year, your wealth will have gone up by:

(1+0.04) = (1+r)(1+0.03) r = 1.04/1.03 – 1 r = 0.971%, meaning in real terms you are 0.971% richer.

Question 2 – What is the term structure of interest rates?

The term structure of interest rates is also called the yield curve and it represents the relationship between interest rates (or government bond yields, as they are considered risk-free) and different terms or maturities. When graphed, the term structure of interest rates normally has an upward slope due to the higher risk associated with longer term investments, but under certain conditions it can have different shapes. The yield curve is simultaneously a consequence but also an indicator of the current state of an economy.

While the yield curve can be used to represent any category of bonds, it should be representing bonds of the same level of risk, so that the only difference in rates can be explained by the different maturities (and consequent liquidity preference). As such, considering governments bonds exist for all maturities unlike bonds of a single corporation, normally government bond rates.

Question 3 – What is the yield curve? How does it normally slope?

Little trick question… same answer as above…

Question 4 – What does a reverse yield curve signify?

More commonly known as inverted yield curve, it is a situation where short-term interest rates are higher than long term rates. When an inverted yield curve exists, it is an indication that the market is expected interest rates to go down, which is normally a signal of lack of confidence, i.e. that the market expects a downturn or even a recession happening soon.

Question 5 – What is the loanable funds theory for determining interest rates?

Loanable funds theory states that the interest that exists in a market are the result of equilibrium between supply and demand of loanable funds in that market. Loanable funds is a term that refers to money available for lending, so it includes al forms of loans (bank loans, deposits, bonds, etc.).

Whenever there is a change in the amount of supply or demand of loanable funds, a new equilibrium is achieved. For example, is there is an increase in supply, the supply line moves to the right, leading to a new equilibrium initially at a lower interest rate, which is likely to lead to an increase in demand for funds, leading the demand line to move to the right with a consequent increase in interest rates. This final equilibrium rate is likely to be lower than the starting point prior to the increase in supply of loanable funds.

Question 6 – What is wrong with the loanable funds theory?

The main criticism of the loanable funds theory is that it combines real factors like savings or investment with monetary factors like bank credit. Savings can be used for many purposes rather than simply for lending, and on the other hand lending can take place without prior availability of savings.

Question 7 – How does the liquidity preference theory tackle this problem?

By introducing the (correct) notion that investors prefer more liquid assets over less, the liquidity preference theory goes away from the notion that savings match lending instead suggesting that lenders/investors will demand higher rates of return (premium) in order to be willing to lend for longer periods, as those attract higher risk.

Question 8 – What is interest rate parity between different currencies?

Interest rate parity derives from the notion that hedged returns from investing in different currencies should be the same regardless of their interest rates. In order to ensure that happens, exchange rate over time need to change to offset any benefits that a country with a higher interest rate offers to an investor.

The following formula represents the interest rate parity

F0 = S0 * (1 + id) / (1 + if) or F0 / S0 * (1 + if) = (1 + id)

Question 9 – How are covered and uncovered interest rate parity different?

When there is interest rate parity, there are no abnormal return opportunities, as there is equilibrium in the market. As such, it is the absence of the parity (i.e. there is a mispricing) that allows for arbitrage.

In covered interest rate parity, as the name says, your position is covered, i.e. in the case of mispricing, you confirm all the relevant trades in the present even if some take place in the future, so you know all your future cash flows and therefore profit you will make is risk free.

In an uncovered position, prices are such that, if they remain unchanged, you will be able to make a profit, but your position is open (or uncovered) so it is possible that between now and the future point in time at which the profit will be made, prices will correct to eliminate the profit opportunity or even reverse and lead to a loss.

Question 10 – What is meant by “purchasing power parity” between two currencies?

Purchasing Power Parity means that the relative cost of a similar product should be the same in different locations (normally countries). For example, if the exchange rate between two countries is 1.5 units of currency of b to one unit of currency of a, if a product costs 3 unit of currency in the country a, it should cost 4.5 units of currency in country b.

Question 11 – What is the difference between fixed and floating exchange rates?

In a fixed exchange rate system, the exchange rate between two currencies is fixed, so even if there are disparities in the performance of the two economies, the exchange rate will not change to compensate for those disparities.

In a floating exchange rate system, the exchange rate between two currencies if allowed to change. Changes will be driven by the relative desirability of the economies of the two countries, with the best performing becoming more attractive for investors, thus increasing demand for the currency and an increase in its value

Question 12 – What are the arguments for & against fixed and floating e-rates?

The key advantages and disadvantages of a fixed exchange rate system are:

· Advantages:

· Avoids currency fluctuations, thus providing more certainty” which also leads to…

· Encouraging firms to invest

· Avoids devaluation of the currency, which leads to less competitive exporters and more expensive imported goods and services

· Incentive to keep inflation low to avoid future devaluations

· Disadvantages:

· P

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