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TUTORIAL AND SELF STUDY QUESTIONS

BAFI 3182
FINANCIAL MARKETS

In this document you will find tutorial and self-study questions.


The tutorial questions are selected questions highlighted in yellow, you will have to prepare
solutions for this question for your tutorials. You will have to be ready to discuss these questions in
your tutorial. At the end of you tutorial you will have a 10 minute quiz with multiple choice questions
related to the tutorial question.
Self-study questions should also be attempted following the lecture.

Essay Questions

Topic 1:

Introduction to Financial Markets

1. Clearly distinguish between direct and indirect financing.


Direct financing:
Funds are transferred directly from surplus economic units to deficit economic units
Primary financial assets are issued directly from deficit units to surplus units
Indirect financing:
Financial institutions act as intermediaries, borrowing from surplus units and lending to deficit units
Primary financial assets are issued by deficit units to intermediaries, and secondary financial assets
are issued by intermediaries to surplus units
2. Give two examples of how a company might raise funds through direct finance and two examples of
how it might raise funds through intermediated finance.
Direct: Firms issue shares to investor, issue bonds to lenders
Indirect: Firms take a loan from the bank, ask for investment from insurance companies
3. What are the advantages of indirect (intermediated) finance to:
(a)
borrowers,
Pool the resources of small savers to fund large investment
Greater certainty of availability of funds
Allow longer-term loans
Lower interest rate
Do not discriminate against small borrowers
(b)
lenders, and
Asset transformation: offer wide range of products
Allow range of maturity length
Credit risk reduction and diversification
Offer high liquidity
Convenience
Low transaction costs
(c)
The national economy.
Encourage economic growth by facilitating flow of money
Improve efficiency by economies of scale
Are there any disadvantages?

Increased cost of funds for borrowers


Reduced return from lending for savers
Less likely for secondary financial assets (e.g. bank deposits) to be securitised (i.e. Transformed into
financial securities) so that they can be traded in a secondary market. Primary financial assets (e.g.
Housing loans can be securitized into CDOs)
4. Every time funds are lent and borrowed financial assets are created. Explain
Represent a claim or a right that a surplus economic unit holds over a deficit economic unit. They
represent an entitlement to future cash flows.
Represent a financial liability of a deficit economic unit (ie. the party issuing the financial assets).
5. Clearly distinguish between the primary and secondary finance markets for shares and government
bonds.
Primary markets:

Markets in which financial assets are first created, e.g. Facebook IPO
Markets in which funds flow from surplus economic units to deficit economic units
Secondary markets:

Markets in which existing financial assets are traded


Deficit economic units do not directly participate in secondary market transactions

6. Select two different financial assets and distinguish between them in terms of:
Bond
(a)
Return: interest / coupon
(b)
Risk: bankruptcy of issuer
(c)
Liquidity: can be sold/purchased for cash
(d)
time pattern of return: interest each term, principal at the maturity date
Share
(a) Return: dividend, capital gain
(b)
Risk: bankruptcy of issuer, decrease of share price
(c)
Liquidity: can be sold/purchased for cash
(d)
time pattern of return: year-end, interim dividend
7. From the perspective of both surplus (lenders) and deficit (borrowers) economic units, clearly
distinguish between debt and equity instruments.
Debt:
Represent an obligation on the part of the borrower to repay principal and interest. Eg.
a. Bank deposits and loans
b. Contractual savings eg. Life insurance savings
c. Discount securities
d. Fixed interest securities
Equity:
Represent an ownership claim over the profits and assets of a business. Eg.
Ordinary shares in a company
8. What is the importance of an efficiently operating secondary market to the corresponding primary
market?
Trading of stock on the secondary market frees investors to sell when the need arises while allowing
companies to continue using the money to finance growth over longer periods of time.
The ease of selling stock on the secondary market affects the willingness of investors to buy stock on
the primary market
A company may implement controls to stop the devaluing of its stock, which could affect future
investment in the company. Companies consider secondary market stock prices when making
management decisions about growth and expansion.
9. What is the role of investment and merchant banks and commercial banks? Give example of each of
them in Australia?
Commercial banks:

The core business of banks is often described as the gathering of savings (deposits) in order to provide
loans for investment.
They also provide a wide range of off-balance-sheet transactions such a underwriting, issue of
derivatives or execute Fx transactions.
Commonwealth Bank
Investment and merchant banks:

Mainly provide advisory services to support corporate and government clients, e.g.:
advice on mergers and acquisitions, portfolio restructuring, finance and risk management

May also provide some loans to clients but are more likely to advise on raising funds directly in capital
markets.
Morgan Stanley

Essay Questions

Topic 2:

The Flow of Funds and Determination of Interest Rates

1. Explain the nature and functions of interest rates.


2. If $20,000 is held in an account for six years and interest is paid at the rate of 6% p.a., compounded
monthly, what is the balance in the account at the end of the six years assuming no withdrawals?
3. Which of the following two interest rates provides the greatest return on an investment?
(a) 6.2% compounded monthly
(b) 6.0% compounded weekly (show workings)
4. Clearly
distinguish
between
the
level
and
Can monetary policy also affect the structure of
5.

structure
of
interest rates?

interest
If so,

Explain the loanable funds theory of interest rates, outlining the main determinants of
for and supply of loanable funds.

6. What is the shape of the current yield curve?

rates.
how?

the demand

Explain the reasons for this shape.

7. Distinguish between the pure expectations theory, the liquidity premium theory and the market
segmentation theory of determining the shape of the yield curve. How do these theories differ in terms
of their underlying assumptions?
8. With reference to the Australian Flow of Funds - Sectoral Balances, recent years, describe recent
changes to the pattern of surplus and deficit sectors
9. Why banks are the big winners when the yield spreads widen?

Essay Questions

Topic 3:

The Money Market

1. You are the owner of a small business in need of short term financing of less than $100,000. The
funds are to be used to fund ongoing costs and accounts payable. What are the borrowing options
available to you?
2. You are the treasurer of a large corporation in need of short term domestic financing over the next 6
months. Funding is required both on a daily basis and for 3 and 6 month periods. What are your
borrowing options?
3.

(a) Explain the role of the following parties to a commercial bill: drawer, acceptor and discounter.
(b) Which of the above parties is the surplus economic unit and which party is the deficit economic
unit?
(c) Which of the roles listed in a above does a bank perform?

4.

A corporation calls bank X and Y for a quote on overnight cash.


Bank X quotes: 6.80/6.90
Bank Y quotes: 6.85/6.95
(a) At what rate will Bank X lend overnight cash?
(b) What rate will Bank Y pay for an overnight deposit?
(c) Which bid should the corporation accept?
(d) Which offer is the most attractive?

5.

A corporation calls Bank X and Y for their 30 day bank bills rate.
Bank X quotes: 7.00/6.95
Bank Y quotes: 6.98/6.93
(a) At what rate is bank Y willing to buy 30 day bills?
(b) Which bid is the most attractive?
(c) Which offer is the most attractive?

6.

You are a corporation with $50m to invest in 90 day bank bills and receive the following quotes.
Which one do you accept?
A. 7.04/6.99
B. 7.06/7.01
C. 7.05/7.00

7. What are the Eurocurrency markets? In what ways are they similar and in what ways different from the
domestic money markets?
8. Outline the main features of the different types of finance available in the short term Euromarkets.
9. How investment banks participate in the Money Market?
Mixed Question
(Topic 2 & 3)
1. Compare the yield of the following discount securities with Bank Accepted Bills? Please explain the
reason if their yields are different from each other.
Treasury Notes, Bank Endorsed Bills, Promissory Notes, Certificate of Deposits.

Extra Questions Topic 3


The following are designed to give you practice in the mathematics associated with bill (and other discount
instrument) financing. In assessment tasks you will only be required to calculate the market price of a
discount security ie, questions a d.
a

At what price would the same bill sell in the secondary market if it had only 30 days to maturity were
trading at a yield of 9.5% pa.?

At what price would the bill in (b) sell if the yield was 11% pa. rather than 9.5% pa.?

At what price would the bill in (b) sell if the yield on comparable bills was 8% pa. rather than 9.5%
pa.?

What is the yield on a 180 day bill, which has 45 days to maturity, if it is selling at $99 100 and has a
face value of $100 000?

Essay Questions

Topic 4A:

The Foreign Exchange Market

1. Name the commodity (unit) currency, the terms currency, the bid offer rates, and the spread in each of
the following quotes:
(a)
USD/EUR 0.7475-85
(b)
AUD/JPY 92.10-20
(c)
GBP/USD 1.4350-60
2. In the following quotes, what will the bid and the offer mean to the price-maker and the price-taker?
(a)
USD/EUR 0.7475-85
(b)
AUD/USD 0.9725-35
(c)
AUD/EUR 0.7425-50
3.

(a)
(b)

If Bank ABC is quoting a spot rate of AUD/USD 0.9765/68 at what rate will Corporation XYZ
buy spot Australian dollars?
If bank ABC is quoting a spot rate of AUD/USD .9751/56 at what rate will Corporation XYZ
sell spot Australian dollars?

4.

Consider the following two spot rates for AUD/HKD that are quoted by two market makers.
Bank A:
6.5422-32
Bank B:
6.5423-33
(a) If you wanted to buy HKD what rate will you accept?
(b) If you wanted to sell HKD what rate will you accept?

5.

In the previous question suppose you are Bank A and you were hit on the left hand side of your quote.
Then which of the following are true statements?
(a) You have sold AUD
(b) You have bought HKD
(c) You have sold HKD
(d) You have bought AUD
(e) You have undertaken a. and b.
(f) You have undertaken c. and d.
(g) You have undertaken b. and d.
(h) You have undertaken a. and c.

6.

You are an Australian Bank and market maker that has provided the following quote to a calling bank:
AUD/USD = .9723-28
and the calling bank has hit you on the right side of your quote for the AUD 5 million. Assuming you
wish to square your position which way should you move your quote for the next prospective caller?
Fully explain your reasoning.
7. Using the above example in question 6, assume the calling bank has hit you on the left hand side of
your quote for AUD 10 million. What would your next quote be and why?

Essay Questions

Topic 4B:

The Foreign Exchange Market

8. Cross Rate Exercises:


(a) Given the spot rates AUD/USD 0.6755/60 and USD/YEN 83.65/84, calculate the s pot
AUD/YEN rate
(b) Given the spot rates AUD/USD 0.9705/60 and GBP/USD 1.5785/90, calculate the spot AUD/GBP
rate
9.

If interest rates in the USA are 5.55% for 92 days and interest rates in Australia 4.95% for 92 days,
calculate the 92 day forward outright rate given a spot rate AUD/USD of .9755. (Your answer should
show your calculations).

10.

If interest rates in Australia are higher than those in other countries, would you expect the Australian
dollar to appreciate or depreciate? Explain your answer.
11. Explain the purchasing power parity hypothesis of exchange rate determination. Using this
hypothesis, explain the implication for Australias exchange rate if Australia were to experience higher
inflation than its main trading partners.
12. Outline and explain the reasons why an Australian company may borrow funds offshore rather than
domestically.
13. From what you know and looking at the graph below, what has been the behaviour of the Australian
dollar against the United States dollar since 2000? Could you explain what have been some of the
drivers of this behaviour?

Mixed Questions

Topic 4

1. Briefly explain the impact of changes in inflation, relative interest rates, relative national income
growth and government intervention on foreign exchange market?

2. What is the relation between Gold market and foreign exchange?


3. One foreign investor wants to buy Australian Treasury bond, assuming all other variables to be
constant what will happen to AUD?
Extra Questions Topic 4
1. (a)
(b)
(c)
(d)
(e)

2.

3.

If Bank ABC is quoting a spot rate of AUD/USD .9789/94 at what rate will Corporation XYZ sell
spot US dollars?
If Bank ABC is quoting a spot rate of USD/YEN 99.70/80 at what rate will Corporation XYZ buy
spot YEN?
If Bank ABC is quoting a spot rate of USD/YEN 99.70/80 at what rate will Corporation XYZ sell
spot US dollars?
If Bank ABC is quoting a spot rate of AUD/YEN 88.97/07 at what rate will they sell spot
Australian Dollars to Bank DEF?
If Bank ABC is quoting a spot rate of AUD/YEN 88.97/07 at what rate will Corporation XYZ buy
spot Australian Dollars?
Cross Rate Exercises:
(a) Given the spot rates USD/EUR 0.7475/85
and
USD/GBP 0.6342/65
Calculate the spot GBP/EUR rate
(a) Given the spot rates AUD/USD
and
GBP/USD 1.5760/70
0.9705/40 Calculate the spot rate
GBP/AUD
Quotes:
(a)
If Bank ABC is quoting a spot rate of AUD/USD .9777/82 at what rate will they sell spot
Australian dollars to Corporation XYZ?
(b)
If Bank ABC is quoting a rate of AUD/USD .9777/82 at what rate will they sell spot Australian
dollars to Bank DEF?

Essay Questions

Topic 5:

The Debt-Capital Market

1.

Given that a company can raise funds through short-term or long-term finance, what is the main
criterion it should use in making this decision?

2.

Given that a company can raise funds through the issue of either equity or debt, what factors explain
the debt/equity ratio the firm will adopt?

3.

What is the present value of a four year bond with a face value of $1000 which pays an annual coupon
of 7.5% but is currently trading at 8%? Is the bond trading at a premium or a discount?

4.

Explain the main determinants of the type(s) of debt instruments (financial assets) a corporation will
sell in order to raise funds.

5.

Explain the meaning of the concepts of securitisation and disintermediation with respect to the
corporation debt market.

6.

Select three different financial instruments sold by corporations to raise medium term to long term
finance. For each of these instruments:

7.

(a)

Outline the likely buyers of these financial assets; and

(b)

Distinguish between them, from the perspective of the buyers, in terms of risk, return, liquidity
and time pattern of returns.

Distinguish between:

Domestic bonds

Foreign bonds

Eurobonds

International bonds

Dual currency bonds

8.

Why financial leverage or gearing ratio is important for the firm?

9.

What is the underlying reason for the bonds in the two below sentences?
If yield > Coupon rate, then Price < Face Value"
If Yield < Coupon rate, then price > Face value

10.

Firm ABC is short of fund and need to decide whether to access funds from the money market or
capital market, how can ABC management make this decision?

Mixed Questions
1.

Topic 2 & 3 & 5

(a) The bond with a face value of 1000$ and 2 years to maturity, paying annual coupons of 10% and
currently trading at the yield of 10%. Calculate the price of the bond?
(b) `If the interest rate (market yield) unexpectedly rises to 12 %, at what price investor can sell the
bond?
(c) Is the bond now trading at a premium, discount or par? Explain

2.

Which of the following has the highest present value?


(a)

Commercial bill with face value of 80000$ and the yield of 7 % with 60 days to maturity.

(b)
3.

The bond with the face value of 100000$ and 5 years to maturity, paying annual coupons of 7
% and currently trading at a yield of 5%?

What is the difference between Treasury bill and government bonds?

News analysis

Topic 5

1. What is the underlying reason for the spike in the yield of government bonds in the following countries?

Essay Questions

Topic 6:

The Equities-Capital Market

1. (a)
What are the role and objectives of Australian Stock Exchange?
(b)
What methods does it adopt to achieve these objectives?
2. Clearly distinguish between the primary and secondary share markets. Explain why liquidity in the
secondary market is important to both shareholders and corporations.
3.

4.

Distinguish between
(a)
Ordinary shares and preference shares.
(b)
Share options and warrants.
(a)
(b)

Explain the difference between a private placement, a public issue and a rights issue.
What is the function of a prospectus?

5. Given that companies can use both debt and equity finance to raise funds, explain why a corporation
would prefer to use equity finance.
6.

(a)
(b)

What are the major reasons for investing in shares?


Are there any risks when you invest in shares? Explain.

7.

What is the difference between limited liability by shares and liability by guarantee?

8.

What is the difference between bonus shares and right issues?


9. Say, BHP represents 12% of the market overall, how much is the weight that BHP carrys in any
market index when the index is value weighted? Briefly explain value weighted index?
10. What is the difference between systematic and non-Systematic risk?
11. Describe the two most commonly used investment analysis?

Mixed Questions

(Topic 1, 2, 3, 4, 5)

1.

Distinguish between ordinary shares and treasury bonds in terms of:


(a) risk
(b) return
(c) liquidity
(d) time pattern of returns

2.

Compare the preference shares with debt securities?

Practical Questions Topic 6:

The Equities-Capital Market

1. Use the following information from 2012- 10K Annual reports of Apple and
Nokia .

(i) Calculate the ROE Return on Equity for Apple and Nokia in 2012. What does ROE
measure? Which company provides a higher return to shareholders?
(ii) Calculate the Price to Earnings (PE or P/E) ratio for Apple and Nokia in 2012.
(iii) Explain briefly what the PE ratio measures. What do the P/E ratios for Apple and
Nokia tell you about the share price of these two companies? Can you compare the P/E ratios
and conclude that the stock of one company is cheaper than the other?
(iv) Explain briefly what the PEG or PE/g ratio measures and why it is a better valuation
multiple than PE.
(v) Calculate the PEG (PE/g) ratio for Apple and Nokia where g = growth rate in Net
Income. Which stock would you recommend as a better buy (less expensive)? Explain clearly
your answer.

2. Suppose Microsoft, Inc. reported earnings per share around $0.75. If Microsoft is in an
industry with a ratio ranging from 30 to 40, what is a reasonable price range for Microsoft?

3. Ebay, Inc. went public in September of 1998. The following information on shares
outstanding was provided in the final prospectus filed with the SEC.
In the IPO, the Ebay issued 3,500,000 new shares. The initial price offered to the public was
$18.00 per share. The final first-day closing price was $44.88.
(i) If the investment bankers retained $1.26 per share as fees, what was the net
amount of Equity that Ebay raised?

(ii) What was the market capitalization of Ebay at the end of the first day?

Essay Questions

Topic 7:

The Derivatives Market

1.

(a) What is meant by the term derivative?


(b)
What are derivatives used for?

2.

Outline the basic features of:


(a)
Options

(b)
(c)
(d)
3.

Forward Contracts
Futures
Swaps

Distinguish between:
(a)
Call Options and Put Options
(b)
European Options and American Options

4.
(a)
(b)
(c)
(d)
(e)
(f)

Indicate whether the following options are in-the-money, at-the-money or out-of-the-money:


Type of Option Exercise price
Underlying asset price
Call
$40
$40
Call
$40
$45
Put
$50
$45
Put
$50
$50
Call
$50
$45
Put
$45
$50

5.

If you were in the following situations, would you buy or sell futures contracts to hedge your
exposure?
(a)
A gold-mining company plans to sell gold in the future.
(b)
A jeweller plans to buy gold in the future.
(c)
An investor owns a number of blue-chip shares and wants to protect the value of his portfolio.
(d)
An investor plans to buy Treasury bonds in the future.
(e)
An investor has already bought Treasury bonds.

6.

Provide an example of each of the following:


(a)
Derivatives which are traded in OTC markets.
(b)
Derivatives which are traded on an exchange.

7. What are the fundamental differences between the following derivatives, in terms of their effect on the
parties to the derivative, how they are traded and their usefulness in different situations?
(a)
Options and forward contracts.
(b)
Forwards and futures
Practical Questions
Topic 7:
The Derivatives Market
1. A US company will be going to London in June to purchase GPB 100,000 in new machinery.
The current spot and futures exchange rates are given by his bank:
Exchange Rates GBP/USD
Period

Rate

Spot

1.5342

March

1.6212

June

1.6901

September

1.7549

(i) Describe the kind of risk is the company exposed to?

(ii) Describe how the company can use futures contract to fully hedge its position.
(iii) Does the company need to unwind its futures position? (
(iii) When June arrives, the actual exchange rate is GBP/USD = 1.725. Calculate how
much money the company can save if it enters into a futures contract.

2. Suppose the current GBP/USD spot rate is 1.9905 and the JPY/USD yen spot rate is
$0.00779. The following forward rates are also quoted:

Forward Rates
60 days
90 days

GBP/USD
1.9597
1.9337

JPY/USD
0.007754
0.007736

(i) Explain what someone who enters into a 60-day forward contract to deliver British
pounds is agreeing to do.
(ii) Explain what someone who enters into a 90-day forward contract to take delivery of
Japanese yen is agreeing to do.
(iii) Compare the spot and forward rates for GBP/USD and JPY/USD: what can you infer
about the relationship between U.S. and British short-term interest rates and U.S. and
Japanese short-term interest rates?

Essay Questions
Topic 8:

The Changing Financial system and Role of Financial Institutions

1.

Outline and explain the main causes of change in the financial system?

2.

Identify the four main categories of banks off-balance-sheet business and use an example to explain
each category.

3.

(a)
(b)

What are Basel 2 three pillars, explain the aim of each pillar?
What are the roles of local regulators in relation to the Basel II capital accords?

4.

(a)
(b)

What are the main categories of financial institutions in Australia?


By which regulatory body is each category of financial institution supervised?

5.

(a)

Referring to the recent crisis in the credit market, describe how a pool of mortgages can be
securitised?
(b) Reflecting on globalisation, explain why the U.S credit crisis had an impact on non U.S financial
institutions?

6.

(a)
(b)

Why do Governments intervene into the operation of finance markets?


Outline the main way in which the Australian Government intervenes into Australian finance
markets.

7.

Explain the difference between open market operations and direct controls as methods of intervention.
Give examples of both.